Stahl v. United States, 23179.

• Decision Date: 23 November 1970
• Docket Number: No. 23179.,23179.
• Citation: 441 F.2d 999
• Parties: Ruby Smith STAHL v. UNITED STATES of America, Appellant.
• Court: U.S. Court of Appeals — District of Columbia Circuit

441 F.2d 999 (1970)

Ruby Smith STAHL v. UNITED STATES of America, Appellant.

No. 23179.

United States Court of Appeals, District of Columbia Circuit.

Argued March 10, 1970.

Decided November 23, 1970.

Mr. David English Carmack, Atty., Department of Justice, of the Bar of the Court of Appeals of Maryland, pro hac vice, by special leave of Court, with whom Asst. Atty. Gen. Frederick B. Ugast, Messrs. Lee A. Jackson, Atty., Department of Justice, and David G. Bress, U. S. Atty., at the time the brief was filed, were on the brief, for appellant. Miss Issie L. Jenkins, Atty., Department of Justice, also entered an appearance for appellant.

Mr. Sidney J. Silver, Washington, D. C., for appellee.

Before BAZELON, Chief Judge, and TAMM and LEVENTHAL, Circuit Judges.

LEVENTHAL, Circuit Judge:

This case comes on appeal by the Government from a judgment of the District Court¹ awarding $5,532 plus interest to a taxpayer in an action for refund of overpayment of federal income tax. Because we hold that on the disputed item taxpayer was entitled to take a deduction, for a loss on a transaction entered into for profit, we affirm.

I. The Facts

On April 12, 1962, Mrs. Ruby Smith Stahl, a widowed musician and music teacher, turned securities with a market value of approximately $210,000 over to Balogh & Co., a Washington securities firm. Under an agreement between Mrs. Stahl and the firm, the securities were to be used by the firm as part of its capital so that the firm could satisfy certain SEC requirements. The securities were to be returned to her on May 12, 1963, subject, however, to the claims of all of the firm's creditors, present and future. In return Mrs. Stahl received one percent of the value of the securities per quarter, in addition to the dividend and interest income. She also became a member of the board of directors of the firm but attended only one meeting and never received notice of the others.

A subsequent agreement between the taxpayer and the firm provided that one half of the securities would be returned to her on December 15, 1963, and the other half on September 15, 1964. On October 31, 1963, however, the firm sold the securities for $257,078.90. In August, 1964, the firm filed a petition in bankruptcy. The petition showed that its liabilities exceeded its assets by more than $300,000. The bankruptcy proceedings were still pending before the District Court when it entered judgment in the case at bar.

The taxpayer claimed an ordinary loss of $87,146 (based on the $127,012 of the securities less an expected "recovery" in bankruptcy of $39,866) on her amended tax return for 1963. The Internal Revenue Service disallowed the deduction on the ground that the loss was not an ordinary loss but a capital loss in the nature of a nonbusiness bad debt. Furthermore, treatment of the loss as a nonbusiness bad debt was disallowed for 1963 since the debt was not wholly worthless at the end of that year.² The taxpayer paid the additional assessment and brought this suit for refund.

The taxpayer and the Government agree that the loss is deductible in some manner at some point in time; the dispute is over the proper characterization of the loss and hence its proper tax treatment. The District Court, agreeing with the taxpayer, held that the agreement between the taxpayer and the securities firm created not a debtor-creditor relationship but a bailment, and that the loss was consequently deductible under section 165(c) of the Internal Revenue Code, which allows deductions for losses incurred in a trade or business and losses incurred in a transaction entered for profit.³ The Government adheres to its contention that the loss was deductible under section 166(d) of the Code as a nonbusiness bad debt.

A § 166(d) loss, as contended by the Government, is subject to limitations disadvantageous to the taxpayer. A § 165 (c) loss is deductible from ordinary income. In contrast a § 166(d) loss is treated like a short-term capital loss,⁴ and as such is first applied so as to reduce low-taxed long-term capital gains (under § 1201). Any excess of loss over capital gains is deductible from ordinary income only to the extent of $1000 (under § 1211). The limitations of § 166 would be applicable even though profits earned from the transaction were taxable at ordinary income rates — rates actually paid by the taxpayer in the case at bar on profits earned in 1962. The consequence is that a taxpayer with a stand-off — because an earlier profit of, say, $10,000 was followed by a loss of equal amount, — would be subject to an overall increase in taxes.⁵ This result was mandated by Congress where the ensuing deductions fell into the category of nonbusiness bad debts. We must consider whether Congress intended it to apply in a case like the one before us.

II. Inapplicability of bad debt provisions

Section 166 of the Internal Revenue Code is captioned "Bad Debts." The section is applicable, — whether what is involved are business bad debts governed by (a), or nonbusiness bad debts governed by (d), — only in case "of a bona fide debt."⁶ Carrying forward the concept of bona fide debt, Treasury Regulation § 1.166-1(c), 26 C.F.R. § 1.66-1(c) (1970), provides:

Only a bona fide debt qualifies for purposes of section 166. A bona fide debt is a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. A gift or contribution to capital shall not be considered a debt for purposes of section 166.

A. Debt Not Established by Taxpayer's Loan of Securities to Corporation.

The District Court found no "debtor-creditor relationship" in this case. The Government leans on the recurrent use of the words "loan" and "indebtedness" in the agreement between Mrs. Stahl and Balogh and Company. But "the decisive factor is not what the payments are called but what, in fact, they are, and that depends upon the real intention of the parties." Byerlite Corporation v. Williams, 286 F.2d 285, 290 (6th Cir. 1960). This "real intention" is to be deduced from the "substance of a transaction," upon which the incidence of taxation depends. Comm'r of Internal Revenue v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 89 L.Ed. 981 (1945). Professed intentions and labeling must give way if the court finds on supporting evidence that in reality the transaction was something other than a debt. Diamond Bros. Company v. Comm'r, 322 F. 2d 725, 731 (3d Cir. 1963).

The Government argues that "when securities are delivered in order to provide capital for another, and subject to the use of another, it is reasonable to assume that their `return' can be satisfied by return of equivalent securities or cash," so that in substance, as well as label, this transaction was a loan and its consequence a debt.

The case presents an issue of the meaning of the statute, involving an ascertainment of Congressional intent, and also an issue of the understanding of the parties. Since the Government wishes to establish a general rule that the loan of securities gives rise to a debt, by reference to a putative reasonable assumption that the parties mean the obligation to be dischargeable by a return of securities or cash equivalent, it would doubtless concede the argument to be inapplicable if in a particular case that is not at all what the parties contemplated or agreed. Both as a general rule, and as to the parties before us, we cannot "assume" that the obligation to return securities in kind may fairly be taken as including a general option to return the cash equivalent. The point is simple: The return of a cash equivalent presumes a decision to sell. When to sell is an investment decision. Indeed timing is of the essence of the art of investment, both in buying and selling. There is no basis for "assuming" an intent to give the bailee free dominion to make this investment decision for the bailor. What is more fairly intended to be conveyed was the power to sell upon the appearance of the need and occasion contemplated by the agreement, the unfulfilled demands of the firm's creditors. The power to sell, by fair implication, is a power conveyed for response to a contingency. The conditional nature of this authority is underscored by the consideration that its exercise involves for the bailor not only an investment decision but tax consequences — of current liability for taxes on otherwise unrealized gains.

The conditional nature of any obligation to pay money is of significance in view of the rule that the bad debt deduction provisions are applicable only in case of an unconditional obligation of the debtor to pay the creditor. Milton Bradley Co. v. United States, 146 F.2d 541, 542 (1st Cir. 1944). And perhaps even more important than the contingent nature of any "obligation to pay a fixed or determinable sum of money," as set forth in the Treasury regulation, is the fact that even the obligation of the brokerage firm to return the securities loaned to it was subject to a condition. Mrs. Stahl expressly agreed to subordinate her right to return of the securities to the claims of all creditors of Balogh, agreed that they would be "subject to the risks of Balogh's business," and in ¶ 5, agreed that —

Neither the loan of the aforesaid securities, nor this agreement may be terminated, rescinded, or modified by mutual consent or otherwise, if the effect thereof would be inconsistent with the conditions of Rule X-15 C3-1 issued by the Securities and Exchange Commission pursuant to the Securities Exchange Act, or to reduce the net capital of Balogh below the amount required by said rule. (JA 44-45)

Balogh was thus under no absolute liability to pay, a sine qua non of the debtor-creditor relationship required to satisfy Section 166.⁷ In United States v. Henderson, 375 F.2d 36, 40 (5th Cir. 1967), cert. denied 389 U.S. 953, 88 S. Ct. 335, 19 L.Ed.2d 362 (1967), the taxpayer made advances to a corporation...