Case Name: Weldon D. Smith, Petitioner, v. Commissioner of Internal Revenue, Respondent
Court: United States Tax Court
Jurisdiction: United States
Decision Date: 1951-07-31
Citations: 17 T.C. 135
Docket Number: Docket No. 27569
Parties: Weldon D. Smith, Petitioner, v. Commissioner of Internal Revenue, Respondent.
Judges: Kern, J., dissents.
Reporter: Reports of the Tax Court of the United States
Volume: 17
Pages: 135–151

Head Matter:
Weldon D. Smith, Petitioner, v. Commissioner of Internal Revenue, Respondent.
Docket No. 27569.
Promulgated July 31, 1951.
Robert J. Lansdowne, Esq., for the petitioner.
Sheldon V. Ehman, Esq., for the respondent.

Opinion:
OPINION.
Rice, Judge:
The first issue is whether the $212,000 is "back pay" subject to the provisions of section 107 (d) of the Internal Revenue Code. Applicable portions are set forth in the margin.
Respondent argues that subsequent to January 1940 petitioner performed no services for his employer and therefore that section 107 (d) is inapplicable. While it is true that section 107 (d) is subject to strict interpretation, Norbert J. Kenny, 4 T. C. 750, 754 (1945), we feel that respondent's argument is incorrect. Petitioner was an employee of A. M. & A. under a contract running for 10 years from January 1, 1935. Due to friction which developed between petitioner and others, his duties were limited so that by 1941 he had very little other than his title of general manager. But, petitioner continued in A. M. & A.'s employ until the expiration of his contract. He had an office in the store and was there every day except when on vacation. He did whatever he could in the performance of his duties. No one else was ever named general manager. Rather, a new position was created. Nor did A. M. & A. exercise its option to terminate its contract with petitioner. Petitioner was paid his base salary of $15,000 per year and A. M. & A. did not dispute his right to "additional compensation" provided for in the employment contract, but disputed the amount.
We feel, therefore, that the $191,966.26 received falls expressly within the definition of bach pay found in section 107 (d) (2) (A) (ii) and that petitioner is entitled to treat it as provided in section 107 (d) (1).
The case of Estate of Lester O. Stearns, 14 T. C. 420 (1950), affd. (C. A. 6, 1951) 189 F. 2d 259, is distinguishable from this case, since in that case recovery was had for breach of contract following its termination by the employer. There, the petitioner did not continue as an employee while here petitioner continued as an employee until the expiration of his employment contract.
The settlement release between petitioner and A. M. & A. designated the manner in which the $212,000 was divided between the years involved in the dispute, and this division is not contested. But it failed to allocate each yearly portion between principal and interest. The parties are in agreement as to this allocation for the years 1938, 1942, and 1943, but disagree as to the allocation for the years 1944 and 1945. The petitioner claims that all of the amounts received in these latter years represent principal, since they are less than the amounts of principal he claimed for these years. The respondent, on the other hand, maintains that A. M. & A.'s computation is the correct one, namely, that the amount for each of these years is composed of both principal and interest. The difference between A. M. & A.'s computation ($73,302.44) and the settlement figure ($71,625.06) for the year 1944 is conceded by respondent to be a decrease in interest for that year, its purpose merely being to round off the entire settlement to an even amount $212,000).
While respondent is á third party to the settlement, the method which he advocates is that of one of the parties to the settlement. This method appears to be the best method advanced. It is equitable and the basis for obtaining it is evident from the computations submitted. Nor has the petitioner introduced any evidence sufficient to overcome the prima facie correctness of respondent's determination. We therefore uphold the- respondent's computation as set forth in our findings of fact.
The petitioner paid $25,000 during 1945 as legal fees incurred in the settlement for and the collection of the $212,000 from A. M. & A. The parties agree that this $25,000 is deductible but are in disagreement as to the method of doing so. The petitioner claims that the entire amount is deductible in 1945, the year in which it was paid, while the respondent asks that it be allocated over each of the years in proportion to the amount of back pay applicable to each year.
Back pay is afforded the treatment of allocation to applicable years simply because of the existence of section 107 of the Code. Without this section, the entire $212,000 would be income in 1945. Section 107 is silent as to expenses incurred in connection with any collection of back pay, and there are no regulations nor decisions which we have been able to find on the question. To limit application of section 107 to amounts received less expenses connected with collection is not a function for the Court, but rather is a task for the Congress if that is the result which they wish. We therefore hold that petitioner is entitled to deduct the $25,000 legal expense in 1945.
The second issue involves the $38,220 which petitioner deducted as a worthless debt in 1945. The respondent argues that this amount represented a capital investment rather than a loan, or, in the alternative, that it became worthless before the taxable year in question; or, if it was a debt, it was a nonbusiness debt.
Whether a contribution by a stockholder to a corporation is a capital contribution or a loan is a question which must be answered by a consideration of all the factors present in a particular case. Sam Schnitzer, 13 T. C. 43 (1949), affd. (C. A. 9, 1950), 183 F. 2d 70, certiorari denied, 340 U. S. 911 (1951). In a majority of cases of this type, there are factors indicative of either answer. The fact that deposits to Llenroc's account were begun almost immediately following incorporation and the fact that not several large deposits but a number of smaller ones (averaging several hundred dollars) were made in the course of the life of Llenroc would seem to indicate that Llenroc was inadequately capitalized at its inception. While it is true that the destruction of the herd would account for a large portion of the $19,868.78 put in by petitioner during Llenroc's first year of existence, it would not account for the money put in before the summer of 1937 when the herd was destroyed. It is also true that no interest was provided for and that most of the advances had no evidences of indebtedness.
Counterbalancing these factors are a number of considerations. One of the major items is the fact that, unlike the situations in Isidor Dobkin, 15 T. C. 31 (1950) and Edward G. Janeway, 2 T. C. 197 (1943), affd. (C. A. 2, 1945) 147 F. 2d 602, the contributions in this case were completely disproportionate to stock holdings. While there were five equal stockholders, petitioner advanced $38,220, W. L. Houck, $3,000, C. T. Houck, $325, J. E. Houck, $125, and their mother (the fifth stockholder) nothing.
In addition, there is the fact that petitioner's claim as a creditor was allowed by Llenroc's trustee in bankruptcy. The money was carried on Llenroc's financial statements as a current liability. The parties intended the money to be loans. While this intent is not a controlling factor, it does have some evidentiary value. Isidor Dobkin, supra. Another factor indicative of a loan and which distinguishes this case from the Dobhin and Janeway cases is that in this case the questionable amount was not a portion of the original corporate investment, but, rather was money subsequently advanced to Llenroc.
Having considered the enumerated factors plus all others appearing in the record we hold that the $38,220 represented a loan by petitioner to Llenroc.
Under section 23 (k) (1) a deduction is allowed for "debts which become worthless within the taxable year." The respondent argues that the debt owed petitioner by Llenroc became worthless prior to 1945. He cites petitioner's allowed deduction in his 1944 income tax return for the worthlessness of his Llenroc stock as indicative of this. The year in which a debt becomes worthless is a question of fact for this Court to determine. Redman v. Commissioner (C. A. 1, 1946), 155 F. 2d 319; W. A. Dallmeyer, 14 T. C. 1282 (1950). Although Llenroc suffered a loss each year it was in operation, its financial statement of January 31,1945, showed a deficit of $13,704.63 and a capital account of $20,000. Therefore, while a large part of the capital cushion was gone, it would still appear from the financial statement that petitioner's loan of $38,220 was not as yet worthless. It was not until the summer of 1945 that the mortgage was foreclosed and the following October that bankruptcy proceedings were begun. Up until the foreclosure, the parties still hoped that Llenroc would be successful. Con sidering all the facts, the debt was not worthless, as of January 31, 1945, and it was the events occurring during 1945 subsequent to January 31 which caused it to become so. Petitioner was correct, therefore, in claiming that 1945 was the year of worthlessness.
The last question to be resolved is whether petitioner suffered a business or a nonbusiness loss. Whether a taxpayer is entitled to a business deduction under section 23 (k) (1) of the Internal Eevenue Code, or limited to a nonbusiness deduction under section 23 (k) (4) is a question of fact. Eegulations 111, section 29.23 (k)-6. Section 23 (k) (4) of the Internal Eevenue Code provides that in the case of a nonbusiness bad debt, "the loss resulting therefrom shall be considered a loss from the sale or exchange, during the taxable year, of a capital asset held for not more than 6 months." Ordinarily a loss by an individual from a corporate investment is not considered a business loss, since the corporation and the individual are separate entities and the corporation, not the individual, carries on the business. However, where a person invests in a number of businesses and takes a part in their management over and above passively giving financial aid, it has been held that he is in the business of investing and personally participating in various ventures. Henry E. Sage, 15 T. C. 299 (1950); Vincent C. Campbell, 11 T. C. 510 (1948).
In the Sage case, the petitioner personally participated in a number of business ventures in which he had invested. We held that a loss suffered in one of the ventures was deductible as a business loss. The taxpayer was not a passive investor, nor was he concerned with only one venture. He-was engaged in a number of activities and his assets were money plus personal services. The same issue present in that case is present in the one now before us. We feel that the Sage case is applicable. Petitioner was engaged in a number of business ventures, not only giving financial assistance, but also personally participating in the varied enterprises. As such, it was a part of his regular business.
We are cognizant of A. Kingsley Ferguson, 16 T. C. 1248, but feel it is distinguishable from the instant case on its facts. In that case, petitioner failed to prove that he expended time, money and effort sufficient to constitute a business of low-cost housing ventures. From all of the facts before us, this case, like the Sage case, indicates varied ventures for which petitioner did expend sufficient time, money and effort so as to constitute a business.
Under such circumstances we hold that petitioner may deduct the $38,220 as a bad debt for 1945 arising from a business in which he was regularly engaged.
Eeviewed by the Court.
Decision will be entered v/nder Rule 50.
Kern, J., dissents.
SEC. 107. »
(d) Back Pat.—
(1) In general. — If tlie amount of the back-pay received or accrued by an Individual during the taxable year exceeds 15 per centum of the gross Income of the Individual for such year, the part of the tax attributable to the inclusion of such back pay in gross income for the taxable year shall not be greater than the aggregate of the increases in the taxes which would have resulted from the inclusion of the respective portions of such back pay in gross income for the taxable years to which such portions are respectively attributable, as determined under regulations prescribed by the Commissioner with the approval of the Secretary.
(2) Definition of back bat. — For the purposes of this subsection, "back pay'' means
(A) remuneration, including wages, salaries, retirement pay, and other similar compensation, which is received or accrued during the taxable year by an employee for services performed prior to the taxable year for his employer and which would have been paid prior to the taxable year except for the intervention of one of the following events :
*
(ii) dispute as to the liability of the employer to pay such remuneration, which is determined after the commencement of court proceedings;