Court Opinion

ID: 770910
Source: CourtListenerOpinion
Date Created: 2012-04-18 10:41:36+00
Date Added: 2024-06-11T17:55:53.829082
License: Public Domain

230 F.3d 896 (7th Cir. 2000)
J&W Fence Supply Company, Inc.,  John B. Vidrine, and Cressville Vidrine, Plaintiffs-Appellants,v.United States of America, Defendant-Appellee.
Nos. 99-2132, 99-3737 & 00-1247
In the  United States Court of Appeals  For the Seventh Circuit
Argued September 20, 2000Decided October 11, 2000

Appeals from the United States District Court  for the Southern District of Indiana, Indianapolis Division.  No. IP 97-128-C Y/S--Richard L. Young, Judge.
Before Coffey, Easterbrook, and Evans, Circuit Judges.
Easterbrook, Circuit Judge.

1
On its tax return for  1992 J&W Fence Supply Company took a deduction of  almost $1 million for a bad debt: a loan to  Cherry Point Forest Products, one of J&W's  principal suppliers of raw materials (and 49% of  whose stock was owned by John Vidrine, who also  owns 100% of J&W's stock). During 1992 Cherry  Point entered receivership in Washington, and J&W  contended that it was unlikely to see much if any  of the money it had invested. But following an  audit the IRS disallowed the deduction, with this  explanation by its Appeals Office

2
The bad debts deduction of $959,736.00 as shown  on your tax return is reduced by $934,217.00  because the bad debt deducted for Cherry Point in  that amount is not allowable as a business bad  debt and as a non-business bad debt has not been  determined to be worthless in this tax year. Also  as a non-business bad debt the deduction would be  a distributive item in the year it is determined  to be worthless and would be distributed as a  short term capital loss to the shareholders.  Therefore, your taxable income is increased by  $934,217.00 for 1992.

3
J&W is a Subchapter S corporation; its gains and  losses are passed through to its shareholders,  whose personal taxes are at issue. Vidrine paid  the assessed taxes and filed this refund action,  where the IRS altered its position. Instead of  defending the administrative decision that the  loan was a "non-business" debt, that the loan had  not been shown to be worthless by the end of 1992  (the receivership was ongoing at year's end), and  implicitly that Vidrine could not benefit from a  short-term capital loss in 1992, the United  States contended that J&W supplied the $1 million  to Cherry Point as equity rather than debt  capital.

4
One possible response by the taxpayers would  have been that the choice between debt and equity  lacks significance: wiped-out equity generates a  capital loss, just as a non-business bad debt  does. 26 U.S.C. sec.166(a)(1). (A business bad  debt, by contrast, may be deducted from ordinary  income.) Another response might have been that  the money was indeed debt rather than equity  capital for Cherry Point. The IRS contends that  the investment must be deemed equity because the  parties did not create the usual documents  (principally notes specifying rates of interest  and repayment schedules) that accompany loans.  But one could equally say that the investment  must be deemed debt because the parties did not  create the usual documents (principally shares of  stock with related deals, such as buy-sell  agreements customary in closely held  corporations) that accompany equity. If the $1  million was equity, then Vidrine owned not 49%  but more than 95% of Cherry Point's stock, and  this change of control should have been  accompanied by many other adjustments that the  corporate records do not reflect. Thus it is  hazardous to say, as the United States does, that  an investment must be equity because it is not  documented as debt; lack of documentation does  not help us choose. (Cases such as Frierdich v.  CIR, 925 F.2d 180, 182-84 (7th Cir. 1991), and  Roth Steel Tube Co. v. CIR, 800 F.2d 625 (6th  Cir. 1986), that make much of missing  documentation do not consider the mirror image of  the inference.) J&W Fence Supply, which as a  Subchapter S corporation had to use the accrual  method of accounting, booked (and caused Vidrine  to pay taxes on) interest due from Cherry Point,  even though it never received a penny; by putting  money behind the characterization of the  transaction as debt, J&W made its claim more  believable. But this subject was not litigated in  the district court, and we discuss it no further.

5
Pursuing none of the options we have mentioned,  plaintiffs contended only that the choice between  debt and equity had been settled by the  Washington receivership. The receiver treated the  investment as a bona fide debt and distributed  Cherry Point's assets accordingly, notifying all  creditors that he was doing this. One of Cherry  Point's creditors was the IRS. Federal courts  give the decisions of state courts the same  preclusive effect that state courts themselves  afford, see 28 U.S.C. sec.1738, and Vidrine  contended that state courts in Washington would  apply issue preclusion (collateral estoppel) to  the receiver's decision. The district court  disagreed and entered judgment for the United  States. 1999 U.S. Dist. Lexis 4035, 99-1 U.S. Tax  Cas. para.50,396, 83 A.F.T.R. 2d 1542 (S.D. Ind.  1999). At this point the taxpayers' lawyer  appears to have realized that he had missed a  turn, because a capital-loss deduction would have  been available (though not necessarily in 1992)  whether or not the investment was treated as  equity. By a motion under Fed. R. Civ. P. 60(b)  Vidrine asked the district court to reopen the  case and direct the IRS to recognize a capital  loss deduction in 1992. The judge declined,  observing that the request came too late. 1999  U.S. Dist. Lexis 20309, 85 A.F.T.R. 2d 337 (S.D.  Ind. 1999).

6
Plaintiffs' principal argument in this court is  that the district judge should have granted their  post-judgment motion, because they are entitled  to some deduction no matter how the investment is  characterized. Appellate review of decisions  under Rule 60(b) is deferential, as it must be if  litigants are to be induced to present their  arguments before rather than after judgment. See  Metlyn Realty Corp. v. Esmark, Inc., 763 F.2d  826, 831-32 (7th Cir. 1985). No abuse of  discretion is apparent on this record, given  plaintiffs' delay. What is more, the taxpayers'  appellate brief does not discuss the tax  situation for 1993, when the debt may finally  have become worthless. See 26 U.S.C. sec.166(d).  In the district court plaintiffs contested their  taxes for both 1992 and 1993; in this court,  however, 1993 has fallen by the wayside. By  insisting on a deduction for 1992 only,  plaintiffs have abandoned more than one avenue of  reducing their taxes.

7
We add that the district judge did not err in  deciding the preclusion issue against the  taxpayers. No state judge addressed the choice  between debt and equity; the subject was  resolved, to creditors' apparent satisfaction, by  the receiver. Nor did the IRS suffer a defeat,  even if the receiver's decision could be equated  to a judicial one. All but $2,400 of the $55,000  in federal tax claims had priority over both debt  and equity interests in Cherry Point. It would  have been silly for the IRS to demand litigation  of a subject that could affect no more than  $2,400 (and would not assure payment of even that  small sum, but would just decrease the size of  the total debt claims to be satisfied from  dwindling assets). No Washington case of which we  are aware holds that a litigant is bound by the  decision concerning a subject that is contested,  if at all, only by other participants in the  case. Like the district court, we are convinced  that Washington would not deem the receiver's  choice conclusive against federal tax collectors.  See Bar v. Day, 879 P.2d 912, 925 (Wash. 1994).  Whether these investments should be deemed debt  or equity as an original matter is a subject we  need not address, given plaintiffs' litigating  choices in the district court.

Affirmed