Opinion ID: 433554
Heading Depth: 1
Heading Rank: 3

Heading: Worthlessness--Then or By-and-By?

Text: 41 The Government next challenges the jury's finding that the taxpayer's loans became worthless in 1971. 42 To deduct a bad debt, the debt must have become worthless within the taxable year. I.R.C. Sec. 166(a)(1). Worthlessness in a particular year is a question of fact, which the taxpayer has the burden of proving by a preponderance of the evidence. Eagle v. Commissioner, 242 F.2d 635, 637 (5th Cir.1957); Lunsford v. Commissioner, 212 F.2d 878, 883 (5th Cir.1954); Commissioner v. First State Bank of Stratford, 168 F.2d 1004, 1009 (5th Cir.), cert. denied, 335 U.S. 867, 69 S.Ct. 137, 93 L.Ed. 412 (1948). All of the pertinent evidence including the value of the collateral, if any, securing the debt and the financial condition of the debtor are to be considered. Treas.Reg. Sec. 1.166-2(a); Riss v. Commissioner, 478 F.2d 1160, 1166 (8th Cir.1973); Dallmeyer v. Commissioner, 14 T.C. 1282, 1291 (1950). 43 A taxpayer must prove that on January 1 of the taxable year the debts had some intrinsic or potential value, and that by December 31 the debts had lost all such value. Hubble v. Commissioner, 42 T.C.M. 1537, 1544 (1981). But a taxpayer need not be an incorrigible optimist. United States v. S.S. White Dental Manufacturing Co., 274 U.S. 398, 403, 47 S.Ct. 598, 600, 71 L.Ed. 1120 (1927). Debts are wholly worthless when there are reasonable grounds for abandoning any hope of repayment in the future, Dallmeyer v. Commissioner, 14 T.C. 1282, 1292 (1950), and it could thus be concluded that they have lost their last vestige of value. Bodzy v. Commissioner, 321 F.2d 331, 335 (5th Cir.1963). This will usually entail proof of the existence of identifiable events which demonstrate the valuelessness of the debts. Riss v. Commissioner, 478 F.2d 1160 (8th Cir.1973); Crown v. Commissioner, 77 T.C. 582, 598 (1981); Hubble v. Commissioner, 42 T.C.M. 1537, 1544 (1981). 44 So, in this essentially factual determination, if the evidence introduced at trial is sufficient under Boeing Co. v. Shipman, and the jury was properly instructed in the law, their finding that the debts became wholly worthless in 1971 will stand. 45 The record reveals ample evidence to support that finding. It is not disputed that Diversa was still operating as 1971 began. However, the evidence was overwhelming that the organization was on the brink of complete collapse. Then, of course, it was involuntarily forced into bankruptcy in March 1971. This would clearly indicate the worthlessness of at least a part of the taxpayer's unsecured and unpreferred debts. Treas.Reg. Sec. 1.166-2(c)(1). However, the institution of bankruptcy proceedings is not alone dispositive of whether debts become wholly worthless at that time. Patten & Davies Lumber Co. v. Commissioner, 45 F.2d 556, 558 (9th Cir.1930); Dallmeyer v. Commissioner, 14 T.C. 1282, 1292-93 (1950); Hubble v. Commissioner, 42 T.C.M. 1537, 1545 (1981). 46 There is other evidence of the worthlessness of the debts at that point. Both Mann Jr. and Palmer (Mann's bankruptcy counsel) testified that in March 1971 there was no reasonable probability that unsecured claims would be satisfied. 13 James A. Baker, a Dallas bankruptcy lawyer, also testified about the value of unsecured claims against Diversa. Baker represented Len Acton, the taxpayer's brokering associate and a Diversa unsecured creditor, and attended the March 1971 proceedings to assess his client's chances of being repaid. He concluded 47 that an unsecured creditor of Diversa would probably have an uncollectible claim. In my opinion it means that there would be no money paid to a person who was an unsecured creditor of Diversa at that particular time. 48 Finally, it is undisputed that by December 31, 1971 even Diversa's office-cleaning business was in default. 49 On all this evidence, the jury could properly have found that the taxpayer, in the exercise of sound business judgment based upon as complete information as was reasonably obtainable, could have determined that the debt in fact had become worthless in 1971. Minneapolis, St. Paul Railroad Co. v. United States, 164 Ct.Cl. 226, 241 (1964); accord Sollitt Construction Co. v. United States, 1 Cl.Ct. 333 (1983); Levin v. United States, 220 Ct.Cl. 197, 597 F.2d 760, 767 (1979). 50 The Government does not seek to counter this evidence. Neither does it seriously challenge the conclusion that in 1971 the taxpayer might reasonably have given up hope for any recovery of his loans to Diversa. Rather, the Government contends that the $21,000 payment in 1976 which resulted from the on-going bankruptcy proceedings precludes the estate from claiming in 1978 that the loans were wholly worthless in 1971. We disagree. 51 It is axiomatic that tax law treats each taxable year as a separate unit. Thus, a taxpayer must determine and file a return of his income and loss on an annual basis, without benefit of hindsight. This same principle has been true in determining the worthlessness of a bad debt for a particular taxable year:Subsequent events may only be used to evaluate the soundness of the belief that a debt became worthless in a certain year, and not as evidence of the fact of worthlessness.... The fact that a debt reasonably determined to be worthless in a given taxable year, is subsequently recovered in part or in full, is not in itself sufficient to prevent the deduction. 52 5 J. Mertens, Law of Federal Income Taxation Sec. 30.37 (1980); see also id. at Sec. 30.81. 53 Thus, subsequent recoveries have not precluded otherwise valid deductions. See United States v. S.S. White Dental Manufacturing Co., 274 U.S. 398, 47 S.Ct. 598, 71 L.Ed. 1120 (1927) ($130,000 investment worthless in 1918 even though $6,000 recovered in 1922); Textron, Inc. v. United States, 561 F.2d 1023 (1st Cir.1977) ($6 million loan and capital investment worthless in 1959 despite complete recovery in 1963); Patten & Davies Lumber Co. v. Commissioner, 45 F.2d 556 (9th Cir.1930) ($15,000 loan worthless in 1921 although $13,000 recovered in 1922); Woods Lumber Co. v. Commissioner, 44 B.T.A. 88 (1941) ($1,100 bad debt deduction allowed in 1935 although $150 recovered shortly after 1935); Richards & Hirschfeld, Inc. v. Commissioner, 24 B.T.A. 1289 (1931) ($2300 debt worthless in 1920 even though small payments from liquidation proceedings after 1920). 14 54 The Government argues, however, that in the cases cited above the taxpayer filed for the deduction before receiving the repayments. It asserts that the inquiry as to the worth of the debt must be determined as of the time the bad debt deduction is filed, and cites as controlling authority Brimberry v. Commissioner, 588 F.2d 975 (5th Cir.1979). 55 This argument misinterprets Brimberry. There, the taxpayer had made a loan of $175,000 to a New Orleans church in 1967, hoping to secure a construction contract from the church. Then, in 1967 and 1968, Brimberry claimed deductions of partially worthless business debts under Sec. 166(a)(2) totaling about $170,000. He based his claim on three factors. Over the two years, the SEC had filed a complaint against the church (concerning the sale of church bonds), the church had instituted Chapter X reorganization proceedings, and the church's liabilities had exceeded its assets. Both the Commissioner and Tax Court disallowed the claims in their entirety. 56 We affirmed, finding that none of the three factors justified a belief in 1968 (and a fortiori in 1967) that Brimberry's loans had become worthless in that year. 588 F.2d at 978. Significantly, we looked only to the circumstances of the taxable years in question. 15 57 We rejected the taxpayer's suggestion that events in subsequent years substantiated his claim that the debt was partially worthless in 1967 and 1968, remarking that hindsight is always 20/20. Id. at 979. For purposes of review, we said, the facts must be considered as they existed at the time the deduction was taken. Id. 58 The Government reads too much into the phrase at the time the deduction was taken. It seems plain that a deduction is taken in the year for which the expense may be charged off. 16 Thus, a bad debt deduction is taken in the year the debt is alleged to have become worthless. Under I.R.C. Sec. 166(a)(1) and Treas.Reg. Sec. 1.166-3(b), that is the only year in which the debt can be deducted. Nothing in Brimberry suggests that the time at which the deduction is taken is any time other than the end of the taxable year in question. The clear holding of Brimberry is not, as the Government asserts, that hindsight may be used up to the date that the deduction is filed for. Rather, it holds that hindsight, although always 20/20, simply does not enter into the determination of worthlessness, at least insofar as proof of the fact of worthlessness. 59 This view comports with both the tax regulations and precedent, and it just makes better sense. Treas.Reg. Sec. 1.166-(1)(f) 17 clearly recognizes that a debt may be deducted as wholly worthless even though some value may ultimately be recovered on it. The recovery is included as income for the later year; it does not invalidate the previous bad debt deduction. Moreover, as we have already said, courts have long allowed bad debt deductions where repayments were received while the claim was still pending. We find no reason, and the Government points out none, for allowing the use of hindsight in pre-filing repayment cases which would not apply with equal force to cases where the repayment is received after the deduction is filed for. The proffered distinction is unmerited. 18 60 In sum, we hold that events subsequent to a given taxable year--events which may include repayment before the bad debt deduction claim is filed--neither prove nor disprove whether the business debt was worthless in that year. If and when such a debt becomes wholly worthless must be determined from the facts and circumstances known or which reasonably could have been known at the end of the year of asserted worthlessness. 19 61 Thus, that a small repayment was made on the taxpayer's $3 million in loans before the deduction was claimed does not, as a matter of law, preclude the jury's finding of total worthlessness in 1971. Since there was sufficient evidence to support that finding, and since the District Court gave proper instructions on the law, 20 we affirm the verdict. 62