Court Opinion

ID: 9455179
Source: CourtListenerOpinion
Date Created: 2023-08-04 19:13:43.862315+00
Date Added: 2024-06-11T17:34:29.587783
License: Public Domain

OPINION OF THE COURT
SEITZ, Circuit Judge.
Plaintiffs, taxpayers, brought an action in the district court for a refund of income taxes for the year 1959, contending that $17,088.00 they paid as guarantors of the promissory notes of corporations of which they were officers and stockholders was fully deductible either as a loss incurred in a transaction entered into for profit though not connected with a trade or business under section 165(c) (2) of the Internal Revenue Code of 1954, or, alternatively, a bad debt incurred in a trade or business, under section 166(a) and (d). The district court ruled against the taxpayers on the former contention but in favor of them on the latter. Stratmore v. United States, 292 F.Supp. 59 (D.N.J.1968). The Government appeals.
*462The case was decided by the district court on a stipulation of facts, which discloses the following. In 1959 and prior thereto the taxpayers, husband and wife, were officers and stockholders of B. B. Rider Corporation (Rider) and General Manufacturing Corporation (General), both functioning business enterprises. They acquired an interest in Rider in 1938 and were instrumental in forming General in 1950. Taxpayer, Benjamin A. Stratmore, was and still is president of both corporations. His primary duties during the past fifteen years have been to secure financing so that the corporations could meet their operational needs.
General commenced operations with a capitalization of $50,000.00, which it borrowed from Rider. Rider in turn had to borrow the money from certain individuals who would not lend the money directly to General because, at the time, General was without assets. When General’s need for capital increased, Benjamin A. Stratmore had to seek additional financing for it.
After exhausting credit with banking institutions, Stratmore was compelled to borrow money for Rider and General from certain individuals. In the typical transaction, these individuals would lend money to one of the corporations but would require the taxpayers to personally guarantee the corporate promissory notes by endorsing them. Without these endorsements the loans could not have been obtained and the corporations would have ceased functioning.
Although the aggregate amount of such loans is not set forth in the stipulation, it is clear that very substantial sums were involved. Furthermore, it was stipulated that taxpayers gave their endorsements and lent their credit to the corporations “with the expectation that said corporations’ use of these funds would provide them with increased receipts by way of salary and inhance [sic] the value of their proprietary interests in said corporations.”
The taxpayers' endorsements were executed prior to August 1957, when Rider and General filed voluntary petitions in bankruptcy seeking reorganization under Chapter XI of the Bankruptcy Act. At the creditors’ insistence, taxpayers did not file any claims. A plan of payment was approved whereby 25 per cent of the obligations owing creditors would be paid. The corporations were discharged from bankruptcy in December 1958, and thereafter, certain of the creditors demanded payment of the balance of the corporate debts from taxpayers as guarantors of the corporate notes. Taxpayers agreed to pay part of the debt owed these creditors in full settlement of their obligations as guarantors. We are concerned with the payment made by them in 1959.
On their original tax return for 1959, taxpayers treated the 1959 payment as a non-business bad debt, deductible only as a short-term capital loss. They later filed an amended return claiming that payment was entirely deductible under section 165(c) (2) of the Internal Revenue Code of 1954. In the district court, taxpayers contended that the amount they paid as guarantors of the corporate notes was either (1) a loss in a transaction entered into for profit though not connected with a trade or business, under section 165(c) (2), or (2) a bad debt incurred in a trade or business, under section 166(a) and (d).
We consider first the district court’s ruling that the payment constituted a fully deductible business bad debt. Section 166(a) and (d) provide, insofar as here pertinent, that an individual taxpayer can deduct a bad debt in full only if it is created or acquired in connection with, or if the loss therefrom is incurred in, the taxpayer’s trade or business. The test applied in resolving the issue of whether a loss is incurred in a trade or business is found in Treasury Regulation § 1.166-5(b) (2):
“For purposes of subparagraph (2) of this paragraph, the character of the *463debt is to be determined by the relation which the loss resulting from the debt’s becoming worthless bears to the trade or business of the taxpayer. If that relation is a proximate one in the conduct of the trade or business in which the taxpayer is engaged at the time the debt becomes worthless, the debt comes within the exception [fully deductible] provided by that subpara-graph.”
See also Whipple v. Commissioner, 373 U.S. 193, 201, 83 S.Ct. 1168, 10 L.Ed.2d 288 (1963).
The Government is willing to assume for purposes of this appeal that the 1959 payment by these taxpayers pursuant to their guarantees gave rise to a bad debt.1 However, it contends that, contrary to the ruling of the district court and the contention of the taxpayers, the payment was not deductible as a business bad debt because the taxpayers failed to meet their burden of showing facts from which it could be found that the loss was proximately related to their positions as salaried corporate officers, rather than to their interests as investors in the corporation.
The Government does not challenge the proposition that one acting as a salaried corporate executive can be considered to be engaged in a trade or business for purposes of the statute. This then leaves for decision the extremely difficult practical problem as to whether the taxpayers demonstrated factually that their loss as guarantors was proximately related to their business of being corporate officials, or, more concretely, to the retention and enlargement of their salaries.
The Government contends that for a bad debt to be proximately related to the separate trade or business of a stockholder-employee, it is necessary to show that his interest as an employee was the primary motivation2 for guaranteeing the corporate notes. The taxpayers, relying on Weddle v. Commissioner, 325 F.2d 849, 851 (2d Cir. 1963), argue that it only need be a “significant motivation.” The district court did not explicitly state what test it was applying. The Government further contends that, in any event, the facts here meet neither test.
We agree with the Government that the taxpayers have not met their burden of showing even a significant motivation. Because of this view we take of the record, we find it unnecessary to decide whether the correct test is one of primary motivation or of significant motivation.
The heart of the district court’s factual evaluation is found in the following portion of its opinion :
“Rider and General would have ceased to function but for the loans obtained for said corporations by plaintiffs. And those loans would not have been made without plaintiffs’ guaranty. A cessation of business by the corporations would have resulted in a loss of plaintiffs' salaried positions. It has been stipulated that plaintiffs gave their indorsements and lent their credit to Rider and General with the expectation that the use of the borrowed and guaranteed loans by the corporations would provide plaintiffs ‘with increased receipts by way of salary and enhance the value of their proprietary interests in said corporations.’ Such motivation is sufficient under the cited cases.” 292 F.Supp. at 62-63.
The stipulation clearly shows that a partial motivation for taxpayers’ endorsement of the corporate notes was to protect and enhance their proprietary inter*464ests, which, of course, is not a basis for treating a loss resulting therefrom as a business bad debt. Certainly, where both proprietary and employee motivation are admittedly present, the extent of the proprietary motivation is most relevant in determining whether there was a “significant” employee motivation. Yet, the district court made no finding as to the extent of this proprietary motivation; indeed, on the sparse record, there could be none. For example, there is not even a showing in the record of the extent of taxpayers’ stock interests and capital contributions. But even if the district court were free to consider whether there was a significant employee motivation without considering the extent of the proprietary motivation, taxpayers would still have failed to present sufficient facts to carry their burden. The district court appears to have relied heavily on the stipulation that, without the loans guaranteed by taxpayers, taxpayers’ salaries, along with the corporations, would have ceased to exist. But since taxpayers did not even provide evidence as to the amounts of their salaries, it was not possible for the district court to evaluate how important the factors of salary maintenance and increase were in their willingness to guarantee the loans.
True it is that the district court inferred from the stipulated facts that a sufficient motivation was present to fulfill the statutory requirement. But the difficulty with its approach, apart from the fact it did not articulate which standard of motivation it was applying, is that while the facts justify an inference that in endorsing the notes the taxpayers were motivated to some extent by a desire to protect and enhance their salaried positions, the facts do not warrant a finding that such action was significantly motivated by the employee factor.
We conclude that the 1959 payment by taxpayers was not a fully deductible business bad debt under section 166(a) and (d).
Taxpayers argue in the alternative that the guarantees constituted transactions entered into for profit within the meaning of section 165(c) (2) of the Internal Revenue Code of 1954, and that the payments pursuant to these guarantees resulted in losses rather than bad debts.
In Putnam v. Commissioner, 352 U.S. 82, 77 S.Ct. 175, 1 L.Ed.2d 144 (1956), the Supreme Court held that the loss sustained by a guarantor unable to recover from the debtor is by its very nature a loss from a bad debt to which the guarantor becomes subrogated upon discharging his liability as guarantor. The Court went on to decide that such a loss must be regarded as a bad debt loss, deductible as such or not at all.
The taxpayers would distinguish Putnam v. Commissioner. They assert that under New Jersey law a guarantor cannot be subrogated to the rights of a creditor until the claim of the creditor against the debtor has been paid in full. They argue that since they settled their liability on the guarantees for less than the full amount due, they never became subrogated to the rights of the creditors. Because, say taxpayers, they were not subrogated to the creditors’ rights, there was no “debt” which could “become worthless” in their hands. Therefore, they argue, their loss must fall under section 165(c) (2) as a transaction entered into for profit, though not connected with a trade or business, since it cannot be a bad debt under section 166.
The Government does not challenge taxpayers’ contention that as a matter of state law there was no subrogation here because taxpayers settled with the creditors and paid less than the full amount due on the guarantees. Rather, it contends that bad debts within section 166 include not only debts created by direct loans, but by an indirect endorsement or other type of arrangement which creates secondary or primary liability on the part of a corporate stock*465holder, whether or not the stockholder has under state law the right of subro-gation following payment.
We are by no means certain that taxpayers’ state law position is sound where, as here, the creditors’ claims against the debtor had been totally extinguished by the approval of the Plan of Reorganization prior to the taxpayers’ payment to the creditors. But we think that the essence of Putnam is the view of the Court of the Congressional purpose behind section 166(c) and the part it was intended to play in the statutory scheme for a common tax treatment of all losses suffered by a corporate stockholder in providing his corporation with financing: these losses are to be treated as capital losses. As the Court pointed out in Putnam, “There is no real or economic difference between the loss of an investment made in the form of a direct loan to a corporation and one made indirectly in the form of a guaranteed bank loan. The tax consequences should in all reason be the same * * * " 352 U.S. at 92-93, 77 S.Ct. at 180.
It is not meaningful to emphasize unduly the common law principle of subro-gation in analyzing the substantial realities upon which federal taxation is based. When the creditor turns to the guarantor for payment, the debt is already uncollectible. In both Putnam and the present case the claims against the debtors were at all relevant times no more collectible in the hands of the guarantors than in those of the original lender. To allow the tax result to turn on the presence or absence of this technical right of subrogation under state law would be to undermine the Putnam doctrine — taxpayers could change capital losses to ordinary losses almost at will. For example, every guarantor could obtain an ordinary loss simply by reaching an agreement with the creditor for payment of less than the full amount of the guarantor’s liability, and thus avoiding any subrogation. We hold that taxpayers’ payment pursuant to the guarantees was not a loss under section 165(c) (2) but rather a non-business bad debt under section 166(d).
The judgment of the district court will be reversed.

. The Government urged in the alternative in the district court that the payment should be treated as a contribution to capital, not a bad debt. The Government states in its brief that it is presently reviewing this position and has determined not to advance it until that re- . view has been completed. For tliat reason, the Government informs us, it is not raising the contribution to capital issue on this appeal.

. Niblock v. Commissioner, 417 F.2d 1185 (7th Cir. 1969).