Court Opinion

ID: 4624996
Source: CourtListenerOpinion
Date Created: 2020-11-21 02:56:18.232474+00
Date Added: 2024-06-11T07:56:37.421328
License: Public Domain

Wilfred J. Funk and Eleanor M. Funk, Petitioners, v. Commissioner of Internal Revenue, RespondentFunk v. CommissionerDocket No. 70665United States Tax Court35 T.C. 42; 1960 U.S. Tax Ct. LEXIS 53; October 13, 1960, Filed *53 Decision will be entered under Rule 50.  1. Held, a note transferable on the books of the debtor corporation is a "security" (sec. 23(k)(3), I.R.C. 1939), and therefore the deduction for its worthlessness is limited by section 23(k)(2).  Cf.  Carl Oestreicher, 20 T.C. 12">20 T.C. 12.2. Held, loans aggregating $ 32,500 formed the basis for business bad debts; such loans to a publishing company controlled by petitioner were proximately related to his occupation as a professional writer.3. Held, advances to the corporation, aggregating $ 55,000, at a time when it was in very poor financial condition were capital contributions and not true loans; deduction for loss with respect thereto is governed by provisions relating to capital losses and may not be taken as a bad debt.  George A. Donohue, Esq., and Elden McFarland, Esq., for the petitioners.A. Jesse Duke, Jr., Esq., for the respondent.  Raum, Judge.  RAUM*42  Respondent determined a deficiency in petitioners' income tax for 1953 in the amount of $ 79,129.32.Certain adjustments have been conceded by petitioners, leaving in controversy only the respondent's disallowance of a claimed*54  bad debt deduction in the aggregate amount of $ 138,447.31 for 1953.  The dispositive questions are:1. Whether a note representing certain advances to Wilfred Funk, Inc., by petitioner was "in registered form" (sec. 23(k)(3), I.R.C. 1939), with the consequence that a deduction for worthlessness thereof must be treated as a capital loss pursuant to section 23(k)(2).2. Whether loans made to Wilfred Funk, Inc., in 1949 and 1950 resulted in business or nonbusiness bad debts in 1953.3. Whether certain advances made to Wilfred Funk, Inc., in 1952 and 1953 represented true loans or capital investments.FINDINGS OF FACT.Some of the facts have been stipulated and are incorporated herein by reference.Petitioners are husband and wife residing at Montclair, New Jersey.  Their joint income tax return for the calendar year 1953 was filed with the district director of internal revenue for Upper Manhattan, New York, New York.For many years prior to 1937 Wilfred J. Funk, referred to herein as petitioner, had been president of Funk & Wagnalls Company, a corporation engaged in publishing dictionaries, educational and other books, and a magazine known as "The Literary Digest." During this *43 *55  period petitioner became familiar with the subject of lexicography, which includes the derivation, meaning, and use of words.In 1937 petitioner resigned as president of Funk & Wagnalls Company.  Subsequently that year a corporation known as Kingsway Press, Inc., was organized.  This corporation began the publication of a pocket-sized magazine called "Your Life." The original stock capitalization of $ 7,200 was increased to $ 11,000 in 1940, 60 per cent of which was owned by petitioner and 40 per cent was owned by Douglas E. Lurton, also a former employee of Funk & Wagnalls Company.  Petitioner was president and editorial director of this company and received a salary annually which in 1953 amounted to $ 10,000; Lurton received a similar salary as vice president and editor. During the years 1937 and 1938, petitioner made loans to Kingsway Press, Inc., aggregating $ 53,200, which were repaid during the years 1939 through 1942 with interest.In 1939 a second corporation known as Your Health Publications, Inc., was organized with an initial capital stock of $ 6,000 which was increased to $ 11,000 in 1940, 60 per cent of which was owned by petitioner and 40 per cent by Lurton.  Petitioner, *56  as president and editorial director, and Lurton, as vice president and editor, each received a salary annually which in 1953 amounted to $ 9,000.  This corporation published a pocket-sized magazine called "Your Health."A third corporation known as Wilfred Funk, Inc., was organized in 1940.  This company engaged in the business of publishing books of general interest, including three books written by petitioner and one book written by petitioner together with a man named Lewis.  The capital stock consisting of 90 shares of common of a total par value of $ 450 was issued to petitioner for cash; 40 per cent of this stock was given by petitioner to two of the executives of the new corporation, Frank Henry and Spencer Armstrong.  During the first year of its operation the corporation suffered heavy initial operating losses.  The petitioner then bought back the 40 per cent minority stock interest and gave it to Lurton, who became vice president and editor. Petitioner became president and editorial director of the company.  Subsequently, in 1951, the corporate capitalization was increased and in 1951 and 1952 petitioner paid in $ 125,000 for 1,250 shares of preferred stock.In 1941 a fourth*57  corporation, Yourself Publications, Inc., was organized.  This company published a pocket-sized magazine called "Your Personality." Petitioner paid in $ 600 for 60 per cent of the capital stock and Lurton paid in $ 400 for 40 per cent of the capital stock. Petitioner, as president and editorial director, and Lurton, as vice president and editor, each received an annual salary, which in 1953 amounted to $ 3,000.  Petitioner lent this company $ 10,000 in *44  1941 which was repaid together with interest during the 4 succeeding years.A fifth corporation, Woman's Life Publications, Inc., was organized in 1942 and published a pocket-sized magazine called "Woman's Life." Petitioner paid in $ 600 for 60 per cent of the original capital stock and Lurton paid in $ 400 for the balance.  As president and editorial director, petitioner received a salary annually which in 1953 amounted to $ 3,500, and Lurton received a similar salary as vice president and editor. In 1942 petitioner lent this company $ 10,000 which was repaid together with interest during the years 1943 through 1946.Also in 1942 a sixth corporation, Publications Management, Inc., was organized.  This company rendered management*58  services and advice to petitioner's various publishing corporations and to others in the magazine field.  The $ 1,000 capital stock was paid in 60 per cent by petitioner and 40 per cent by Lurton.  Petitioner as president received an annual salary from this company which in 1953 amounted to $ 1,000.In 1944 a seventh corporation, Basic Publications, Inc., was organized by Lurton.  It published a pocket-sized magazine originally called "Success Today" but subsequently called "Marriage." Lurton paid in 60 per cent of the small capitalization and the petitioner 40 per cent, the converse of stock ownership with respect to the other six corporations organized by petitioner referred to above.  Petitioner, as vice president and editorial director, and Lurton, as president and editor, each received annual salaries which in 1953 amounted to $ 1,500.  Lurton made a loan of $ 7,500 to the company in its initial stages which was repaid.Each of the foregoing seven corporations had a small capitalization. Subsequent to the initial separate operation of Wilfred Funk, Inc., all seven corporations were operated by the same office personnel at the same premises consisting of an area of about 40 by*59  50 feet.  The corporations had no plant or facilities other than office furniture and equipment.  There were 5 or 6 office employees with an additional 8 or 10 temporary employees when a mail-order campaign was in progress.  The work consisted chiefly in gathering articles or books, titling the articles, putting them together, and sending them to a printing firm in New Hampshire for printing and distribution.  The magazines were distributed by American News Company direct from the printer.  Advertising was handled through agencies.  The books were printed by a printing company and distributed through bookstores or by mail-order coupons in magazines and newspapers.  The corporations had no facilities for printing or distribution.  It was a skeleton organization, incorporated separately for each of its various publications and enterprises.  Each of the corporations, except Wilfred Funk, Inc., had an earned surplus at the beginning of 1953.*45  Between 1937 and 1953, the petitioner's time was equally divided between his work as a writer and his work as an officer and director of each of the seven noted corporations.In 1937 Funk & Wagnalls Company published a book written by petitioner*60  called "If You Think It New!" Petitioner received royalties therefrom from 1937 to 1941, inclusive, in the total amount of $ 1,220.78.  In 1938, which was prior to the date of organization of Wilfred Funk, Inc., Funk & Wagnalls published another book written by petitioner called "When the Merry-Go-Round Broke Down." Petitioner received royalties therefrom during the year 1939 in the amount of $ 338.86.During the period 1942-1953, inclusive, Wilfred Funk, Inc., published three books written by petitioner and one by petitioner and Lewis, all on the meaning, derivation, and use of words.  During this period petitioner received a total of $ 53,315.70 as royalties from the sales of these books.  Petitioner has also from time to time written articles for the magazines he has been helping to edit and publish.  Furthermore, beginning in 1944 petitioner wrote articles, primarily in the field of lexicography, which were published in Reader's Digest magazine. During the period 1944 to 1953, inclusive, he received a total of $ 53,900 from Reader's Digest for these articles.  Through the publication of these books and articles, the petitioner has attained a considerable reputation as a literary*61  personality and an authority in the field of lexicography.Following the organization of Wilfred Funk, Inc., in 1940, petitioner from time to time in 1940, 1941, and 1942 lent it amounts totaling $ 100,000, evidenced by promissory notes of the corporation.  These notes were consolidated into a single promissory note dated December 15, 1942, which note was transferable on the books of the corporation and was redeemable upon specified notice "to the registered holder thereof at his registered address."During the years 1943 through 1949, Wilfred Funk, Inc., paid petitioner $ 37,851.89 on account of principal and $ 24,761.01 on account of interest with respect to this note.  No further payments of principal or interest were received by petitioner with respect to this note except as hereinafter noted.Beginning in 1948 through 1952, Wilfred Funk, Inc., incurred annual net losses in its operation.  In 1950 the loss amounted to $ 30,874.47, in 1951 to $ 51,621.66, and in 1952 to $ 61,069.76.  At the beginning of 1950 the earned surplus deficit was $ 18,864.31.  By the beginning of 1952 this deficit amounted to $ 101,205.10 and by the end of 1952 there was a deficit in earned surplus of *62  $ 162,014.46.During the period from October 27, 1949, to October 24, 1950, *46  petitioner made five further advances totaling $ 32,500 to Wilfred Funk, Inc., each evidenced by a promissory note.In 1950 Lurton, the then manager of Wilfred Funk, Inc., suggested that a skilled professional editor be employed since the volume of business the corporation was doing was insufficient to generate a profit.  Lurton also suggested the corporation needed additional money of approximately $ 100,000 in order to succeed.  The corporation called in the firm of business consultants, Rogers & Slade, to make an analysis and recommendation as to whether the business should be continued or liquidated.  A man named Hill of that organization made an elaborate investigation and reported that he thought the business had a great possibility of success.  Hill was then employed as manager of the corporation for several months.  However, when profits still failed to materialize, the company on or about March 14, 1951, hired Joseph Margolies, who had been an outstanding man in that field, as its general manager.Before accepting this position, Margolies, together with his lawyer, examined the financial statement*63  of Wilfred Funk, Inc., and insisted on incorporating in the employment agreement a provision that the last $ 20,000 of money lent to the company by petitioner and in addition $ 50,000 of new money contributed to the company by petitioner would be evidenced by 4 per cent $ 100-par-value preferred stock. The certificate of incorporation was accordingly amended to authorize the issuance of 1,500 shares of preferred stock, and the $ 70,000 was capitalized by the issuance of 700 shares of preferred stock to petitioner.  Subsequently, between July 21, 1951, and April 30, 1952, petitioner paid in $ 55,000 additional as capital and received 550 shares of preferred stock therefor, making the total paid in capitalization $ 450 common stock and $ 125,000 preferred stock.Despite the management of Margolies, the company continued to lose money.  During the period beginning July 29, 1952, and ending July 3, 1953, petitioner made further advances to the company as follows:Date1952AmountJuly 29$ 5,000Oct. 307,500Nov. 127,500Dec. 105,000Date1953AmountJan. 7$ 5,000Mar. 1810,000Mar. 255,000Apr. 285,000July 35,000Total55,000These advances*64  were recorded on open account on the books of account of the company and as loans on the books of account of petitioner.*47  A substantial portion of these advances was used in major efforts to produce a profitable operation.  Past experience had shown that one "best seller" would be sufficient to put the company on a profitable operating basis.  A new edition of a formerly successful book was prepared and an expensive and elaborate campaign was put on in an endeavor by mail order to revitalize the sale of this and other previously successful books.  During 1952, $ 84,434.40 was spent for direct mail advertising.  The effort was unsuccessful.Prior to July 3, 1953, petitioner decided to dispose of his interest in Wilfred Funk, Inc.  He caused an appraisal of the corporation's assets to be made and upon the basis thereof entered into an agreement with the corporation, dated July 23, 1953, whereby he undertook to accept $ 11,201.25 in full settlement of all indebtedness due him by the corporation.  At about this same time, an effort was made to interest Funk & Wagnalls Company in buying all of the stock of Wilfred Funk, Inc.  Thereafter, in December 1953 petitioner sold his entire*65  stock in Wilfred Funk, Inc., consisting of $ 450-par-value common stock and $ 125,000-par-value preferred stock, to Funk & Wagnalls Company for $ 1,000.  Although petitioner was a large minority stockholder in Funk & Wagnalls Company at the time, this transaction was negotiated at arm's length.Before purchasing such stock and continuing the business, Funk & Wagnalls Company insisted upon certain conditions precedent, one of which was the curtailment of the indebtedness of Wilfred Funk, Inc., to petitioner.  Hence, on December 15, 1953, petitioner, pursuant to his prior agreement with Wilfred Funk, Inc., agreed to accept and did accept from Wilfred Funk, Inc., the sum of $ 11,201.25 in cash and the assignment of a copyright of a value of $ 1,500 in full settlement of the entire indebtedness of $ 149,648.11.Petitioner took a $ 138,447.31 business bad debt deduction on his 1953 return based on his losses in settling with Wilfred Funk, Inc. Respondent disallowed the deduction and determined that $ 81,947.31 should be treated as a nonbusiness bad debt and that $ 55,000 should be treated as an addition to the claimed long-term capital loss on the sale of 90 shares of common stock of Wilfred*66  Funk, Inc.Petitioner was engaged in the business of writing from 1937 through 1953.  The losses on his loans and advances to Wilfred Funk, Inc., were sustained in 1953.OPINION.Petitioner presently contends that he is entitled to a business bad debt deduction for 1953 in the amount of $ 136,946.86, consisting of three separate items or groups of items, all of them involving loans or advances previously made by him to Wilfred Funk, *48  Inc.  1 That petitioner incurred these losses in 1953 is uncontroverted, the only issue being whether they are deductible in full as business bad debts, as claimed by him, or whether the deduction of one or more of the component items is limited by statute, as a loss on a registered security, nonbusiness bad debt or capital loss.*67  1. The first item in controversy grows out of a series of advances made by petitioner to Wilfred Funk, Inc., from time to time during 1940, 1941, and 1942.  These advances were evidenced by promissory notes, which were consolidated into a single promissory note in the face amount of $ 100,000, dated December 15, 1942.  Subsequent payments on that note had reduced the amount of the debt to $ 62,148.11.  However, we must agree with the Commissioner that any deduction based upon this item is limited by the provisions of section 23(k)(2) of the 1939 Code 2 relating to worthless "securities," since the note in controversy is, in our judgment, a "security" within the meaning of section 23(k)(3).  2 The note, by its terms, was transferable on the books of the corporation, and specifically referred to the holder as "the registered holder"; it was thus in "registered form," thereby falling precisely within the definition of "securities" contained in section 23(k)(3).  Cf.  Carl Oestreicher, 20 T.C. 12">20 T.C. 12.*68 Petitioner's contention that the reasons for casting the note in registered form in 1942 had ceased to exist by 1953 is beside the point.  The fact is that the form of the note remained the same, and, whether petitioner desired it or not, the provision in the note relating to transferability on the books of the company continued "to protect the holder by making invalid unregistered transfers." Gerard v. Helvering, 120 F. 2d 235, 236 (C.A. 2).  We hold that the Commissioner properly disallowed a business bad debt deduction with respect to this note.*49  2. Petitioner challenges the Commissioner's treatment of the $ 32,500 notes as nonbusiness bad debts on two grounds.  He contends that they represented business loans because they were proximately related (a) to his business of organizing, financing, and managing corporations operating in the publishing field, of which Wilfred Funk, Inc., was one; and (b) to his professional occupation as a writer.The first reason appears to be of doubtful merit.  It seems unlikely to us on the evidence that petitioner's relationship to the seven corporations (some of which represented merely different phases*69  of the same venture) could constitute the conduct of a business of organizing, financing, and managing corporations.  Cf.  Phil L. Hudson, 31 T.C. 574">31 T.C. 574; H. Beale Rollins, 32 T.C. 604">32 T.C. 604, affirmed 276 F. 2d 368 (C.A. 4).  However, we need not pass upon this point because we think petitioner's second reason is sound.There is no dispute between the parties that petitioner was a professional writer, but the Government argues that the advances in question were not proximately related to his occupation as a writer. It denies petitioner's claim that the assurance of a publishing outlet and the promotion of his reputation as a writer constituted one of the principal reasons for the organization of Wilfred Funk, Inc., and it points to evidence showing that during the period 1940 through 1953 the corporation paid or accrued royalties to authors of $ 257,483.49 of which only $ 53,315.70 was paid to petitioner.  Although there is force to the Government's position, we think that the weight of the evidence tips the scales the other way.We may readily agree with the Government that one of the purposes of establishing*70  and operating Wilfred Funk, Inc., was to create and utilize a vehicle for engaging in the publishing business, a business that cannot be attributed to petitioner in view of the corporate entity.  See Phil L. Hudson, 31 T.C. at 583, and cases cited.  But, on the evidence, we also agree with petitioner that another, and important purpose was to provide him with a ready publishing outlet for his own works and to enhance and exploit his reputation as a writer. The mere fact that the corporation published the works of a number of other authors does not at all detract from the substantial part that it was intended to play and in fact did play in the promotion of petitioner as a writer. Moreover, the use of his own name in the corporate title, even when publishing the works of other authors, was a means of keeping his name before the public to assist in the acceptance and sale of his own books.  And had Wilfred Funk, Inc., failed financially, petitioner felt it would be a serious blow to his professional reputation and prestige.  In the circumstances we hold that the $ 32,500 notes formed the basis for business bad debts.  Cf.  Tony Martin, 25 T.C. 94">25 T.C. 94;*71 J. T. Dorminey, 26 T.C. 940">26 T.C. 940; Mac Levine, 31 T.C. 1121">31 T.C. 1121.*50  3. The final series of advances, made on open account in 1952 and 1953 totaling $ 55,000, stands on a different footing.  The Commissioner determined that these advances did not represent true loans but were in reality risk capital. We think the evidence supports that position.By July 29, 1952, when the first advance of this third group was made, the financial condition of Wilfred Funk, Inc., had substantially deteriorated.  Beginning in 1948, Wilfred Funk, Inc., had been incurring annual losses continuously in its operation.  In 1950 the net operating loss was $ 30,874.47, in 1951 it was $ 51,621.66, and in 1952 it was $ 61,069.76.  At the beginning of 1952 the deficit in surplus had already sunk to $ 101,205.10 and at the end of that year it had worsened to a deficit of $ 162,014.46.  It is apparent that by the time this third group of advances was made, from July 29, 1952, to July 3, 1953, Wilfred Funk, Inc., was already in the ever-tightening grips of insolvency.  Advances made under such rapidly declining financial conditions could hardly have been made*72  with a reasonable expectation of repayment, apart from the gamble based upon possible future corporate earnings.What we said in Phil L. Hudson, 31 T.C. 574">31 T.C. 574, is peculiarly applicable here (p. 583):Whether petitioner's advances to [Wilfred Funk, Inc.] represented genuine loans rather than risk capital is open to serious question.  The need for his advances was largely attributable to [Wilfred Funk, Inc.'s] severe lack of working capital.  No notes or other evidences of indebtedness were issued in respect of these advances * * *.  It seems highly persuasive that the expectation of repayment was based only upon possible future earnings; and that petitioner was satisfied to let his money ride with the ups and downs of the venture, hoping that the [publishing] business would become profitable and that he would some day reap the fruits of a successful investment.  These circumstances strongly suggest that the advances were intended as risk capital rather than loans, * * *We conclude that a bad debt deduction in respect of the $ 55,000 advances here in controversy was properly disallowed.  Cf.  Fred A. Bihlmaier, 17 T.C. 620">17 T.C. 620.*73 Decision will be entered under Rule 50.  Footnotes1. The three components are as follows: (a) $ 62,148.11 representing the unpaid portion of a $ 100,000 note; (b) five advances evidenced by promissory notes aggregating $ 32,500, which were made between October 27, 1949, and October 24, 1950; and (c) advances on open account from July 29, 1952, and July 3, 1953, aggregating $ 55,000.  In satisfaction of his claim of $ 149,648.11, the sum of the foregoing items, petitioner received $ 11,201.25 in cash and the assignment of a copyright worth $ 1,500, thus sustaining a loss of $ 136,946.86.  However, in his return petitioner claimed a deduction of $ 138,447.31.  The difference, $ 1,500.45, is accounted for in large part by the copyright assignment; the remaining 45 cents is unexplained.↩2. SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions: * * * *(k) Bad Debts.  -- * * * *(2) Securities becoming worthless. -- If any securities (as defined in paragraph (3) of this subsection) become worthless within the taxable year and are capital assets, the loss resulting therefrom shall * * * be considered as a loss from the sale or exchange, on the last day of such taxable year, of capital assets.(3) Definition of securities.  -- As used in paragraphs (1), (2), and (4) of this subsection the term "securities" means bonds, debentures, notes, or certificates, or other evidences of indebtedness, issued by any corporation * * * with interest coupons or in registered form↩.  [Emphasis supplied.]