Cudlip v. COMMISSIONER OF INTERNAL REVENUE

• Decision Date: 18 February 1955
• Docket Number: No. 12165.,12165.
• Citation: 220 F.2d 565
• Parties: William B. CUDLIP and Lynwood B. Cudlip, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Sixth Circuit

220 F.2d 565 (1955)

William B. CUDLIP and Lynwood B. Cudlip, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 12165.

United States Court of Appeals, Sixth Circuit.

February 18, 1955.

Edward L. Weber, Detroit, Mich., for petitioners.

John J. Kelley, Jr., Washington, D. C. (H. Brian Holland, Ellis N. Slack, Howard P. Locke and Walter Akerman, Jr., Washington, D. C., on the brief), for respondent.

Before MARTIN, McALLISTER and STEWART, Circuit Judges.

McALLISTER, Circuit Judge.

Petitioners, husband and wife, in their joint income tax return for 1949, claimed a deduction from gross income in the amount of $30,000 on the ground that it was a loss incurred in a transaction entered into for profit and properly allowable to them as a deduction under Section 23(e) (2) of the Internal Revenue Code, 26 U.S.C.A. The Commissioner's denial of the deduction was sustained by the Tax Court.

Petitioner, William B. Cudlip, is an attorney engaged in a legal practice having to do, principally, with banks, corporations, and business ventures. Sometime prior to 1947, he became interested in the WiRecorder Corporation, the sole asset of which, at the time of its organization in 1944 — other than the cash capital paid in — was a license agreement with Armour Research Foundation to manufacture and use products, adapting the principles of recording sound on wire and tape, under Armour patents. Under the license agreement, the corporation was required to pay Armour the amount of $10,000 as a prepayment of royalties and, in addition, to spend at least $25,000 a year for three years in research work to perfect and exploit the devices licensed under the agreement, for use in the automotive field. It was provided that if these conditions were met, the license in this field would become exclusive.

The corporation spent not only the amounts required under the agreement, but substantial sums in excess thereof. This required the borrowing of money from a bank in Detroit, and in 1947, petitioner Cudlip became a co-guarantor, with two others, in a corporation note in the amount of $90,000 for money borrowed on behalf of the corporation from the bank. In spite of the financial support given, the corporation failed, and on November 23, 1949, notified the bank that it was unable to meet its obligation on the note. Petitioner Cudlip, in accordance with his guaranty agreement, on November 25, 1949, paid the bank $30,000 of principal and $200 of interest due on the note. The other two guarantors also paid $30,000 each on their guaranty, so that no right of contribution remained in favor of any of them. The corporation was insolvent at that time; its corporate existence terminated on December 13, 1949; and petitioner Cudlip never recovered anything from the corporation for his payment.

In their joint income tax return in question, petitioners deducted, as a loss resulting from a transaction entered into for profit, the amount of $30,000 by reason of the aforementioned payment by Mr. Cudlip as guarantor of the corporate note. The Commissioner refused to allow the deduction on the ground that the loss sustained as guarantor was on a nonbusiness bad debt; and the Tax Court sustained the determination of the Commissioner.

On this review of the decision of the Tax Court, petitioners contend that the loss of $30,000, which was sustained by Mr. Cudlip by reason of his payment of that sum as guarantor of the corporation's note, was a loss resulting from a transaction entered into for profit, and that they are, accordingly, entitled to a deduction in the amount of the entire loss sustained under Section 23(e) (2) of the Internal Revenue Code, which provides:

"§ 23. Deductions from gross income. In computing net income there shall be allowed as deductions:

* * * * * *

"(e) Losses by individuals. In the case of an individual, losses sustained during the taxable year and not compensated for by insurance or otherwise ____

* * * * * *

"(2) if incurred in any transaction entered into for profit, though not connected with the trade or business."

The Commissioner insists that the loss was a non-business bad debt under Section 23(k) of the Internal Revenue Code, which provides:

"§ 23. Deductions from gross income. In computing net income there shall be allowed as deductions:

* * * * * *

"(k) Bad debts.

"(1) General rule. Debts which become worthless within the taxable year; * * *. This paragraph shall not apply in the case of a taxpayer, other than a corporation, with respect to a non-business debt, as defined in paragraph (4) of this subsection. * * *

"(4) Non-business debts. In the case of a taxpayer, other than a corporation, if a non-business debt becomes worthless within the taxable year, the loss resulting therefrom shall be considered a loss from the sale or exchange, during the taxable year, of a capital asset held for not more than 6 months. The term `non-business debt\' means a debt other than a debt evidenced by a security as defined in paragraph (3) and other than a debt the loss from the worthlessness of which is incurred in the taxpayer\'s trade or business."

Under the foregoing section, the Commissioner contends that, instead of being allowed a deduction for the entire claimed loss, petitioners are entitled only to a deduction for a non-business bad debt as a short-term capital loss.

At the outset, it is to be said that Section 23(e) (2), upon which petitioners rely, and Section 23(k) (4), upon which the Commissioner's case is based, are mutually exclusive provisions. Spring City Foundry Co. v. C. I. R., 292 U.S. 182, 189, 54 S.Ct. 644, 78 L.Ed. 1200. Section 23(e) "is the broad residuary section which covers losses not specifically covered by Section 23(k) and other similar subsections of 23." Allen v. Edwards, D.C.Ga., 114 F.Supp. 672, 674. If the losses in this case were losses from debts which "become worthless within the taxable year," within the meaning of Section 23(k), they would not be allowable under Section 23(e).

We shall first discuss the contention of the Commissioner, which was sustained by the Tax Court. He submits that Mr. Cudlip's loss may be deductible only under Section 23(k) (4) as a debt which became worthless during the taxable year; and that since, under that section, it was a non-business bad debt as to Mr. Cudlip, it is deductible only as a short-term capital loss. The Commissioner's contention is based upon the proposition that upon payment of his guaranty, Mr. Cudlip became subrogated to the rights of the bank against the corporation; that in standing in place of the bank as creditor, his loss is to be measured only to the extent that the debt is found worthless; that if the petitioner, having paid his guaranty, were ultimately to recover in full from the debtor, he would suffer no loss; that the loss resulting from payment of the guaranty is directly dependent upon the worthlessness of the debt and must be attributed thereto; and that since the taxpayer's loss is attributable to the worthlessness of the debt, he is limited, in claiming a deduction, to the provisions of Section 23(k) relating to deduction of losses from worthless debts.

In Pollak v. C. I. R., 3 Cir., 209 F.2d 57, 58, the same question that is presented in this case came before the court for decision. In its opinion, the court observed that it was doubtless true, as the Commissioner said, that under the doctrine of subrogation the corporation became indebted to the guarantor for the payments made by him on his endorsements and guaranty as and when he made them; but, the court went on, these payments were made under a legal obligation of endorsement and guaranty which the guarantor had entered into previously at a time when he believed that the corporation would prosper and that he would not lose as a result of his action. "It is utterly unrealistic", said the court, "to suggest, as the Tax Court does in its opinion in this case, that Leo L. Pollak when he entered into this transaction `fully intended and expected to be repaid by the then existing solvent corporation if he was ever called upon to make good his endorsement or guaranty'". The debt in the instant case was uncollectible from the instant it arose. The loss was not a debt which, within the meaning of Section 23(k) (4), "becomes worthless within the taxable year." "For the debt, if we call it such, was worthless when acquired and, therefore, did not and could not become worthless at any time thereafter." Pollak v. C. I. R., supra. Under similar facts, the Supreme Court, in Eckert v. Burnet, 283 U.S. 140, 51 S.Ct. 373, 374, 75 L.Ed. 911, held that the debt due by a principal debtor to the endorsers of its notes who paid them was not deductible as a bad debt because it was worthless when acquired. As Justice Holmes, in the opinion of the court, said: "There was nothing to charge off." The ruling in the Eckert case was reaffirmed in Helvering v. Price, 309 U.S. 409, 60 S.Ct. 673, 84 L.Ed. 836. To the same effect, see the recent decision of the Court of Appeals of the Third Circuit in Ansley v. C. I. R., 217 F.2d 252.

The Commissioner seeks to distinguish the decision of the Supreme Court in Eckert v. Burnet, supra, on the ground that the court's ruling applied only to debts voluntarily acquired; and he contends that Helvering v. Price, supra, is distinguishable in that it decided only that a deduction was not proper in the year in which it was sought to be taken, and did not decide which of the deduction provisions otherwise might have been applicable. In Allen v. Edwards, supra, the same contention was advanced by the Commissioner with respect to the Eckert case, and in disposing of the argument, the court said: "If a debt worthless when acquired cannot be said to `become worthless' in the hands of the taxpayer if voluntarily acquired, no reason appears why it can be said to `become worthless' in the hands of the taxpayer when involuntarily acquired. Indeed, in the Ec...