Court Opinion

ID: 4618191
Source: CourtListenerOpinion
Date Created: 2020-11-21 02:38:06.213201+00
Date Added: 2024-06-11T07:55:25.516628
License: Public Domain

Phil L. Hudson and Gertrude Hudson, Petitioners, v. Commissioner of Internal Revenue, RespondentHudson v. CommissionerDocket No. 61391United States Tax Court1958 U.S. Tax Ct. LEXIS 9; 31 T.C. 574; December 23, 1958, Filed *9 Decision will be entered for the respondent.  Losses sustained on certain advances by a stockholder to his corporation held not deductible as a business bad debt under section 23 (k) (1), I. R. C. 1939.  Ivan Irwin, Esq., and Wentworth T. Durant, Esq., for the petitioners.S. B. Bradley, Esq., for the respondent.  Raum, Judge.  RAUM*574  Respondent determined a deficiency of $ 14,477.22 in petitioners' income tax for 1952.  The questions presented are: (1) Whether certain advances by petitioner to the H & K Manufacturing Company were loans or contributions to capital; (2) if the advances were loans, whether they are to be treated as business or nonbusiness bad debts upon becoming worthless; (3) if treated as business bad debts, whether they became worthless in 1952.FINDINGS OF FACT.Petitioners, husband and wife residing in Dallas, Texas, filed a joint return for the calendar year 1952 with the district director of internal *575  revenue for the second district of Texas.  Phil L. Hudson will hereinafter be referred to as petitioner.For more than 30 years petitioner has been engaged in the business of selling school buses as a representative of the Wayne*10  Works of Richmond, Indiana.  Petitioner at first operated as a sole proprietor but in 1934 he organized Hudson Body & Equipment Company, a corporation, to carry on the business.  The corporation was abandoned in 1936; since that time petitioner has continued the school bus business as a sole proprietor under the name of Hudson Body Company, and derives the bulk of his income therefrom.While in existence, Hudson Body & Equipment Company (the corporation) entered the business of selling and servicing road machinery, in addition to its bus business.  Because of the different nature of the two businesses, it was subsequently decided to transfer the road machinery business to a separate corporation.  Hyway Machinery Company, a Texas corporation, was organized for this purpose in 1936.  Petitioner and his wife owned all the stock of both corporations except for certain shares held by the corporations' treasurer.  Petitioner sold his stock in Hyway Machinery Company in late 1937 or early 1938.  During his period of ownership, however, petitioner advanced funds to Hyway Machinery Company in an undisclosed amount and received the corporation's notes to evidence its indebtedness.  The advances*11  were subsequently repaid with interest.  The record does not reveal the terms of the notes or the method of repayment. The purpose of the advances was to finance the purchase of machinery at a time when the credit of the corporation was extended and outside financing was difficult to obtain.In 1943 petitioner, a person identified only as Hall, and Ivan Irwin, an attorney, arranged to establish and operate a bus service between Cleburne and Weatherford, Texas, to transport soldiers to and from an army camp expected to be established in the area.  Hall contributed $ 10,000 as the entire initial capital of the venture and a corporation, Army Camp Coaches, was formed to carry on the business.  Irwin was to operate the company.  Petitioner subscribed for stock in the amount of $ 1,500 to be paid in cash but the stock was never issued, and it does not appear that petitioner ever paid in any amount of cash.  However, he transferred to the corporation two buses worth approximately $ 1,000 each with the understanding that he would be repaid the value of the buses plus interest not to exceed 10 per cent.  No note was given in connection with this transaction.  The buses were to be used to*12  hold the franchise or to be sold and their proceeds reinvested in other buses to be used for the same purpose until the army camp was established.  The buses were in fact sold.  The anticipated army camp was never established and the corporation was abandoned.  Petitioner *576  recovered neither the value of the buses nor any interest therein.Sometime prior to January 28, 1947, petitioner was contacted by H. L. Weary, a merchandiser of plastic products, for the purpose of interesting petitioner in the manufacture of plastic clothespins under a patent owned by L. W. Stinne, an acquaintance of Weary.  The clothespins in question differed from the ordinary variety of pin by a wraparound spring instead of the customary coil spring.  Weary introduced petitioner to Stinne.  John C. Kettelsen, a business acquaintance of petitioner engaged in the sale of school furniture and bus seats, became associated with petitioner in the venture and participated in the ensuing negotiations with Weary and Stinne.  Petitioner and Kettelsen organized a Texas corporation, Advance Manufacturing Company (hereinafter referred to as Advance), for the manufacture of plastic clothespins under the Stinne patent. *13  Each of the incorporators paid in "several thousand dollars" as initial capital and each received an equal amount of stock in Advance; George E. Bagwell, petitioner's accountant since 1939, was elected secretary of Advance and held a minority interest therein.  Thereafter Advance and Stinne entered into a licensing agreement.  Kettelsen was to manage the business; he obtained a plant site, acquired the necessary machinery, and commenced production.  Petitioner functioned mainly as a stockholder, taking no part in the operation of the plant. From January 28, 1947, to June 30, 1952, petitioner advanced the following amounts to Advance and received the following repayments:AdvancesRepaymentsJan. 28, 1947$ 200.00Feb. 10, 1947800.00Mar. 17, 19471,200.00Apr. 30, 1947500.00June 10, 1947338.86Aug. 12, 1947500.00Jan. 12, 1948750.00July 1, 1949$ 750.00May 31, 1950250.00May 31, 19521,359.41June 30, 195262.50Total4,288.862,421.91Net balance unpaid at dissolution1,866.95During the same period, Kettelsen advanced $ 2,700, Bagwell advanced $ 500, and a person named Farmer advanced $ 2,200.  The record does not reveal*14  the relationship of Farmer to the corporation, nor does it reveal the repayments, if any, to Kettelsen, Bagwell, or Farmer.  The advances were used to prevent overdraft of the corporation bank account, to pay operating expenses, such as freight bills and the cost of display material, and to meet royalty payments to Stinne.  The last *577  two repayments to petitioner represented sales proceeds which petitioner was permitted to retain.  It does not appear that the amount repaid petitioner included interest on the advances.At or around the same time that petitioner was investigating the possibility of manufacturing plastic pins, Weary also interested petitioner and Kettelsen in the manufacture of wooden pins under patents owned by Stinne.  Since November 24, 1945, Stinne had licensed the manufacture of wooden pins to Dal-Corporation, a Texas corporation "owned by" Sam Hamburger.  A dispute had arisen between Hamburger and Stinne regarding the terms of their license agreement and both parties desired to terminate the relationship; the desire of petitioner and Kettelsen to manufacture wooden, as well as plastic, pins afforded a convenient means of so doing.  Accordingly, a written*15  contract of sale was signed on May 8, 1947, whereby petitioner and Kettelsen acquired the machinery, equipment, and certain other assests of Dal-Corporation for $ 18,500.  They also acquired the rights under the license agreement with Stinne and the remaining term of a lease on a plant site in Dallas.  Petitioner paid $ 11,000 and Kettelsen paid $ 5,000 of a total cash consideration of $ 16,000, the balance of $ 2,500 to be paid from sales at the rate of 2 1/2 cents per gross of clothespins sold.On May 13, 1947, petitioner, Kettelsen, and Bagwell organized the H & K Manufacturing Company (hereinafter referred to as H & K), a Texas corporation, to carry on the manufacture and sale of wooden clothespins. Petitioner was elected president, Kettelsen vice president, and Bagwell secretary.  Cash in the amount of $ 1,000 was paid in as the initial minimum capital required by Texas law in order to do business; petitioner paid $ 690, Kettelsen $ 300, and Bagwell $ 10.  Of 100 authorized shares (at $ 10 per share) petitioner received 69 shares, Kettelsen 30, and Bagwell 1.  Petitioner and Kettelsen then transferred to H & K all of the assets acquired from Dal-Corporation, reflecting the acquisition*16  on the books of the corporation by the following entry:1947DebitsCreditsMay 31Purchase -- Lumber$ 102.60Purchase -- Wire2,397.40Fixed Assests -- Machinery& Equipment16,000.00Notes and Loans Payable:P. L. Hudson$ 11,000J. C. Kettelsen5,000Sam Hamburger2,500A new license agreement was executed by Stinne and petitioner, as trustee for H & K, whereby Stinne granted H & K the exclusive right to manufacture wooden pins under the Stinne patents. H & K obligated *578  itself to pay Stinne, as a license fee, 5 per cent of the factory sale price of all pins sold and, as a minimum royalty, $ 100 per month for the first 6 months of the agreement and $ 500 per month thereafter.The initial paid-in capital of $ 1,000 in cash and subsequent collections of accounts receivable proved insufficient to pay for repairs to the machinery acquired from Dal-Corporation, the purchase of new machinery, raw materials, royalty payments, payrolls, rent, and other operating expenses. Disregarding stockholder advances and repayments other than the initial $ 1,000, H & K had the following record of monthly cash receipts*17  and disbursements:ReceiptsDisbursementsMay 19471 $ 1,716.45$ 3,560.91June 19473,275.466,478.63July 19472,875.334,790.46Aug. 1947640.132,157.37Sept. 1947566.753,868.65Oct. 1947633.502,255.14Nov. 1947150.003,502.44Dec. 1947505.03922.84Jan. 194825.00830.30Feb. 1948491.133,185.54Mar. 1948663.411,269.49Apr. 1948412.172,249.77May 19481,408.232,071.75June 19481,422.702,451.68July 19481,022.231,866.04Aug. 1948545.381,548.85Sept. 1948436.07696.13Oct. 1948206.101,180.48Nov. 194841.25915.76Dec. 194886.81679.82Jan. 194920.63368.26Feb. 1949None295.27Mar. 1949None37.57Apr. 1949104.2537.47May 194924.75NoneJune 1949NoneNoneJuly 194950.0890.00Aug. 1949204.27113.45Sept. 1949, to Dec. 31, 1952327.33350.51Total17,854.4447,773.98Excess of disbursements over receipts29,919.45In numerous months collections of accounts receivable were insufficient to meet even payroll requirements, as well as other expenses incurred by the business.  Funds expended for the repair of old *18  machinery and the purchase of new machinery exceeded $ 10,500 in the fiscal year ended April 30, 1948, and $ 1,300 in the fiscal year ended April 30, 1949; no such expenditures were recorded for any subsequent fiscal year.  Royalty payments to Stinne amounted to $ 2,409.10 for the fiscal year ended April 30, 1948, and $ 2,268.50 for the fiscal year ended April 30, 1949.  After the first 6 months of the agreement, royalty payments were stepped up to $ 250 per month instead of the $ 500 per month stipulated in the licensing contract; no royalty payments were recorded after February 1949.To defray the monthly expenses of the corporation, petitioner advanced funds to H & K as follows: *579 Fiscal Year Ended April 30, 1948AdvancesRepaymentsMay 31, 1947$ 2,613.94June 30, 19471,173.70July 31, 194716.03Aug. 2, 19471,169.09Aug. 22, 19471,000.00Aug. 24, 1947100.00Sept. 8, 19473,000.00Oct. 6, 19471,000.00Oct. 27, 19471,500.00Nov. 18, 19472,500.00Dec. 9, 19471,000.00Jan. 31, 19481,000.00Feb. 9, 19481,000.00Feb. 13, 19481,000.00Feb. 29, 1948266.75Total18,339.51NoneFiscal Year Ended April 30, 1949AdvancesRepaymentsJuly 31, 1948$ 690.00Aug. 31, 19486,000.00October, 1948$ 108.00November, 1948144.41Nov. 24, 19481,000.00Nov. 30, 1948500.00Dec. 31, 1948500.00Jan. 29, 19491,000.00Total9,690.00252.41From May 1, 1949, to December 31, 1952July 12, 1949$ 500.00June 27, 195210.00Dec. 31, 1952$ 347.20Total advanced28,539.51Total repaid599.61Net advances unpaid at dissolution27,939.50*19  These advances were recorded on the books of H & K as "Accounts Payable." No notes were given nor was any date of repayment established; no interest was ever paid or accrued on the books.  The repayments of October and November 1948 represented sales proceeds retained by petitioner from sales made by him for H & K and debited to accounts payable on the corporate books.  The repayment of December 31, 1952, was a liquidation distribution upon dissolution of H & K, consisting of cash and miscellaneous assets.The only advance received by H & K, other than the amounts paid by petitioner and Kettelsen for the assets of Dal-Corporation and the periodic advances by petitioner, was $ 1,990 advanced by Bagwell on June 13, 1947, recorded in the "Notes and Loans Payable" account, and used by H & K to defray operating expenses; this amount was reduced to $ 1,490 by a repayment of $ 500 on July 12, 1949.  Bagwell reported the loss of $ 1,490 as a nonbusiness bad debt in his 1952 return.  No person other than a stockholder ever advanced funds to *580  H & K nor does the record reveal any attempt by H & K to obtain outside financing.Petitioner was not active in the management of H & K, and *20  spent only a negligible amount of time on its business although he did negotiate a few sales on behalf of the corporation.  The bulk of managerial responsibility was borne by Kettelsen.In spite of petitioner's advances, H & K showed a consistently declining economic position, as shown by the following table:Cost ofProfit (orYears endedSalessalesloss) fromsalesApr. 30, 1948$ 12,151.55$ 16,005.51($ 3,853.96)Apr. 30, 19494,346.437,789.85(3,443.42)Apr. 30, 1950232.66190.7541.91 Apr. 30, 1951294.41322.72(28.31)Apr. 30, 1952000 Dec. 31, 19524.008.65(4.65)Cash at endFixedYears endedof yearassets 1DeficitApr. 30. 1948($ 2,792.67)$ 24,391.39($ 14,119.50)Apr. 30, 194942.50 24,846.75(28,276.85)Apr. 30, 195045.56 24,846.75(30,812.25)Apr. 30, 195126.24 25,022.36(33,478.79)Apr. 30, 195226.24 25,022.36(35,981.02)Dec. 31, 19520 0(46,429.90)H & K ceased the manufacture of wooden clothespins at its Dallas plant in September 1949.  The machinery used to manufacture the pins was leased to Joe Lee Thomason, owner of the Specialty Manufacturing*21  Company, who moved it from Dallas to a plant site in Centerville, Texas, that he had leased from Edwin B. and Louis H. Franks.  It was believed Thomason could manufacture the wooden pins more cheaply at Centerville by eliminating or reducing freight expense for lumber and because the wage scale was lower than in the Dallas area.  An agreement was reached between H & K and Thomason whereby Thomason would do all the manufacturing, supplying the raw materials and labor, while H & K would do the merchandising from its Dallas office.  Thomason was to ship the finished product to H & K on consignment and was to receive a fixed portion of the sales price when the pins were sold.  Thomason in fact produced only a limited number of clothespins when, for an unexplained reason, he decided to close down the Centerville plant. From September 1949 to December 31, 1952, H & K collected only $ 312.96 of outstanding accounts receivable; all but $ 4 of this amount was collected prior to April 30, 1951.On October 24, 1949, Hamburger, owner of the then-dissolved Dal-Corporation, brought suit against H & K in the Texas District Court, Dallas County, for breach of contract.  H & K had paid only $ 233.01*22  of the $ 2,500 remaining to be paid on the purchase price of the Dal-Coorporation assets acquired in May 1947.  Hamburger alleged that the unpaid balance of $ 2,266.69 was currently due and payable in that H & K had discontinued the manufacture of clothespins and had thereby rendered performance of the contract impossible.  *581  H & K appeared and answered alleging first that it had fully complied with the contract by paying Hamburger the stipulated 2 1/2 cents per gross of pins manufactured and sold, and, second, that the manufacturing of pins had not been discontinued.  On September 28, 1950, after a full hearing on the merits, the court dismissed the complaint "without prejudice" as "prematurely brought."A payment to Hamburger was made on May 25, 1950, in the amount of $ 124.94 covering sales from May 1, 1948, through April 1950, leaving an unpaid balance of $ 2,035.32.H & K was dissolved by resolution of the board of directors approved by the stockholders on December 31, 1952.  In connection therewith all accounts between H & K, Thomason, and the Franks regarding the Centerville property were settled by agreement dated December 29, 1952.  On December 30, 1952, H & K assigned*23  all its machinery and equipment to Hamburger in satisfaction of its debt of $ 2,035.32 on the original purchase price.  Hamburger signed a complete release of all his claims against H & K.  The remaining assets of H & K, consisting of $ 4.97 in cash, $ 92 in accounts receivable, and $ 250.23 in inventory supplies, were distributed to petitioner in partial repayment of his advances since 1947; petitioner agreed to liquidate the franchise tax due the State of Texas and to pay the cost of dissolution. The certificate of dissolution was filed with the secretary of state of Texas on February 10, 1953.Petitioner reported the amount of $ 11,000, his share of the purchase price of the equipment purchased from Dal-Corporation and transferred to H & K in 1947, as a nonbusiness bad debt (short-term capital loss) on his 1952 return.  In his pleadings petitioner claimed the same $ 11,000 as a business bad debt (ordinary loss) but subsequently conceded it to be risk capital (long-term capital loss).  The amount of $ 690 which petitioner had paid in as initial capital was reported as a long-term capital loss from the worthlessness of stock. The proper treatment of these amounts is not presently*24  in controversy.In addition to the amounts above noted, petitioner claimed a business bad debt deduction of $ 27,939.90 for his subsequent advances to H & K.  Petitioner noted on his 1952 return that "at various times during the lifetime of the corporation it was necessary for him to use his personal funds to pay the operating expenses of the corporation."During 1951, 1952, and 1953 petitioner made certain "advances" to J. R. Jones of Austin, Texas, or to companies which Jones controlled.  Petitioner had nothing to do with the organizing of Jones' companies nor did he own any interest therein.  Jones was in the business of selling buses and trucks, using the names J. R. Jones, J. R. Jones Company (a corporation), and Texas Coach Company (a sole proprietorship).  All of the transactions wherein petitioner advanced funds to *582  Jones or his companies involved buses, trucks, or related items; some of the lines sold by Jones were competitive with petitioner's sales for the Hudson Body Company.  Frequently Jones and his companies were underfinanced because they had reached the maximum of "floor plan" available at the bank or finance company; in other words, inventory was available*25  which Jones thought he could resell but which he lacked funds to purchase.  On these occasions Jones arranged to obtain money from petitioner.  He would draw a draft on petitioner, mailing it to him or to his bank in Dallas with the manufacturer's certificate of origin (title certificate) and the commercial invoice if the unit had a body on it.  Petitioner would then record his advance on the books of Hudson Body Company as a purchase of the unit by Hudson Body Company from Jones.  When a unit was sold by Jones, the process was reversed; Jones would repay the advance together with an additional amount representing petitioner's share of the profit realized on the sale and petitioner would return the title certificate and invoice, if any.  Petitioner's share of the profit from sales which he financed was in effect a charge to Jones for use of the funds which petitioner advanced, similar to interest that might be charged were the transaction handled as a straight loan.  The amount thus received from Jones would be reflected on the books of Hudson Body Company as a resale to Jones of the unit previously purchased, the sales price being the original purchase price plus petitioner's share*26  of the profit.  If Jones had already sold the equipment to a third person at the time of petitioner's advance, petitioner usually would not charge Jones for use of the funds.  In some cases, where the equipment was not sold at the time of the advance, petitioner himself would make the sale, retaining a portion of the profits and remitting the remainder to Jones.  All profit realized by petitioner on these transactions was reported on petitioner's income tax return as gross profit earned by the Hudson Body Company.Petitioner handled his advances to Jones as purchases rather than loans because he was unwilling to let Jones have the money on unsecured notes or open account and because he wanted to avoid any possibility of being charged with violation of Texas usury laws.  Since the profit derived from Jones was reflected on petitioner's returns only as an indistinguishable part of the overall profit earned by Hudson Body Company, it is impossible on the record to ascertain exactly how profitable the transactions were.  However, the books of Hudson Body Company do reveal that in 1951 petitioner advanced $ 507,200.51 to Jones, J. R. Jones Company and/or Texas Coach Sales Company in 18*27  transactions covering 219 units; in 1952 he advanced $ 40,690.83 in 2 transactions covering 17 units; in 1953, $ 22,931.60 in 5 *583  transactions covering 9 units.  On one transaction in 1951 petitioner realized a profit of $ 10,000 from the sale of 70 buses.OPINION.Whether petitioner's advances to H & K represented genuine loans rather than risk capital is open to serious question.  The need for his advances was largely attributable to H & K's severe lack of working capital.  No notes or other evidences of indebtedness were issued in respect of these advances, and H & K, which kept its books on an accrual basis, did not accrue any interest in petitioner's favor 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 clothespin 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, notwithstanding that the advances were not made by all*28  stockholders in proportion to their stock ownership.  Cf.  ; ; cf.  , affirmed on another issue  (C. A. 6), reversed on another issue .However, it is not necessary to rest our decision solely on the conclusion that the advances reflected risk capital rather than loans, for we are satisfied, in any event, that they cannot qualify as "business" loans.  It must be remembered that H & K was a corporation, and there is no contention that we should disregard its corporate entity.  Certainly, it was in the clothespin business; but petitioner was not.  A large and impressive number of decisions have made it altogether too plain that the business of the corporation may not be treated as the business of the stockholder. E. g., ; ; Deputy v. du ; ;*29 ; ; , affirmed per curiam  (C. A. 3); ;  (C. A. 2);  (C. A. 4); , affirmed  (C. A. 2), certiorari denied ; , affirmed  (C. A. 10);  (C. A. 5);  (C. A. 2);  (C. A. 2);  (C. A. 6); *30  (C. A. 9).*584  As the foregoing cases show, the mere fact that a person is a stockholder in a corporation and active or interested in its affairs is not sufficient to justify treating his advances to the corporation as "business" loans.  Petitioner is apparently aware of the heavy burden that he must overcome in this connection, and seeks escape from the established rule by urging that he was in the lending business, or in the business of financing corporate enterprises.  It is true that where there is a sufficient continuity of promotional activities the facts may warrant a determination that the taxpayer's business is that of promoter, lender, or financier, and the advances in question may therefore qualify as "business" debts.  Such exceptional circumstances were thought to exist in ; ; and  (C. A. 5), relied upon by petitioner.On the record before us, however, petitioner's entrepreneurial activities were too few and too infrequent to constitute a separate business.  For some 30 years*31  he was actively engaged in the school bus business, and most of his income was derived from that business.  At times, he invested in or advanced money to other enterprises.  The so-called Jones transactions were so closely related to his bus business that they would probably qualify as "business" loans for that reason (assuming that they could be classified as loans), and may therefore be excluded from consideration here.  There remain the advances to Hyway Machinery Company, Army Camp Coaches, and Advance Manufacturing Company, in addition to the advances in controversy herein.  In our judgment these were merely occasional advances made by an investor, and, even in conjunction with the Jones transactions, did not constitute the carrying on of a promotional, lending, or financing business.  Petitioner himself testified that in every instance, except that of Hyway Machinery Company (which was really an offshoot of his bus business), the active management of the ventures was carried on by someone else, petitioner functioning mainly as a stockholder or lender.  The present case is to be sharply distinguished from the Sage, Campbell, and Giblin cases.  Petitioner herein was not*32  "so extensively engaged in the business of promoting or financing business ventures as to elevate that activity to the status of a separate business."  (C. A. 4).In view of the conclusions that we reach above, it becomes unnecessary to determine whether the debts, if any, became worthless in 1952.Decision will be entered for the respondent.  Footnotes1. Includes the initial $ 1,000 paid-in capital.↩1. Before depreciation.↩