Davis v. Comm'r of Internal Revenue , Docket No. 3857-75.

• Citation: 69 T.C. 814
• Decision Date: 27 February 1978
• Docket Number: Docket No. 3857-75.
• Parties: A. L. DAVIS and NEVA DAVIS, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: United States Tax Court

69 T.C. 814

A. L. DAVIS and NEVA DAVIS, PETITIONERS
v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 3857-75.

United States Tax Court

Filed February 27, 1978.

Petitioners, accrual basis taxpayers, sustained a net operating loss of $1,961,225.47 for their taxable year beginning Oct. 1, 1961, to May 27, 1962, when Mr. Davis filed a petition for an arrangement under sec. 322 of the Bankruptcy Act. From May 28, 1962, to Sept. 30, 1962, as a debtor in possession, he sustained an additional net operating loss of $58,003.72. For the taxable year ended Sept. 30, 1963, as a debtor in possession, he sustained a net operating loss of $580,630.86. On Oct. 11, 1963, Mr. Davis was adjudicated a bankrupt and a receiver was appointed, terminating the arrangement proceeding. Liquidation resulted in a deficiency estate and Mr. Davis was discharged on Dec. 2, 1963. Petitioners sustained net operating losses for the 3 taxable years preceding Oct. 1, 1961. Held, petitioners are entitled to carry forward to taxable years following the discharge in bankruptcy a net operating loss sustained prior to filing a petition for an arrangement and net operating losses sustained while a debtor in possession. Held, further, petitioners realized no income from Mr. Davis' discharge in bankruptcy pursuant to sec. 1.61-12(b), Income Tax Regs. Held, further, the net operating loss carryovers do not constitute property subject to reduction in basis required by sec. 1.1016-7, Income Tax Regs.

Petitioners advanced funds to their wholly owned corporation represented by unsecured demand notes. Held, the advances represent contributions to capital.

[69 T.C. 814]

Melvin M. Engel and Rudy M. Groom, for the petitioners.

Charles N. Woodward, for the respondent.

GOFFE, Judge:

The Commissioner determined deficiencies in petitioners' Federal income, tax as follows:

+-------------------------------+
                ¦TYE Sept. 30— ¦Deficiency ¦
                +------------------+------------¦
                ¦ ¦ ¦
                +------------------+------------¦
                ¦1968 ¦$382,081.98 ¦
                +------------------+------------¦
                ¦1969 ¦74,608.15 ¦
                +------------------+------------¦
                ¦1970 ¦68,721.09 ¦
                +-------------------------------+
                

Due to concessions, the issues for decision are:

(1) Whether petitioners may carry forward to a taxable year following a discharge in bankruptcy, net operating losses sustained prior to filing a petition for an arrangement under the Bankruptcy Act and net operating losses sustained while petitioner A. L. Davis was a debtor in possession in the

[69 T.C. 815]

arrangement proceeding which arrangement proceeding was converted to a bankruptcy proceeding followed by a liquidation;

(2) Whether petitioner A. L. Davis realized income from his discharge in bankruptcy pursuant to section 1.61-12(b), Income Tax Regs.;

(3) If the losses may be carried forward, whether they constitute property subject to a reduction in basis required by section 1.1016-7, Income Tax Regs.; and,

(4) Whether petitioners are entitled to a business bad debt deduction for advances of $133,000 made to a corporation which became uncollectable during their taxable year ended September 30, 1970.

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulation of facts and exhibits are incorporated by this reference.

A. L. Davis and his wife, Neva Davis, filed their joint Federal income tax returns for the taxable years ended September 30, 1968, September 30, 1969, and September 30, 1970, with the Internal Revenue Service Center, Austin, Tex. They resided in Houston, Tex., at the time of the filing of their petition.

For approximately 30 years, A. L. Davis and his wife, Neva Davis (petitioners), have owned and operated retail grocery stores. Petitioners first entered the retail grocery store business in 1945 by opening a small grocery store in Fort Worth, Tex. Between 1945 and 1947 petitioners purchased and sold several small grocery stores in the Fort Worth area. In 1947 they purchased a retail grocery store and established the name of A. L. Davis Food Stores. Petitioners purchased a second store in 1952. They continued to expand their business and by 1962 petitioners owned and operated 57 retail grocery stores. Petitioners were able to expand their business because their major suppliers extended payment on the merchandise they sold to petitioners on open account which was unsecured. Petitioners utilized the accrual method of accounting for all relevant years in issue.

Petitioners began to experience financial difficulties due to their rapid expansion. For each of the 3 years prior to the taxable year ended September 30, 1962, petitioners sustained net operating losses. Their trade accounts increased. The purchase of merchandise on open account increased which made it increasingly

[69 T.C. 816]

difficult to pay short-term loans. As a result of these difficulties, petitioners (as A. L. Davis Food Stores and Handymarkets) filed for an arrangement on May 28, 1962, under section 322 of the Bankruptcy Act. ¹ Mr. Davis was allowed to continue in possession of his property as debtor in possession and to operate the retail grocery stores.² Mr. Davis operated the stores until October 11, 1963. During the period that Mr. Davis operated the retail grocery stores as debtor in possession, losses were incurred as follows:

+------------------------------+
                ¦Period ¦Loss ¦
                +-------------------+----------¦
                ¦ ¦ ¦
                +-------------------+----------¦
                ¦5/28/62 to 9/30/62 ¦$58,003.72¦
                +-------------------+----------¦
                ¦10/1/62 to 9/30/63 ¦580,630.86¦
                +------------------------------+
                

The parties to the proceedings could not formulate a satisfactory arrangement. On October 11, 1963, Mr. Davis filed a Debtor's Abandonment of Proceedings for an Arrangement, Consent to Adjudication, Petition for Receiver. On the same day Mr. Davis was adjudicated a bankrupt. A receiver was appointed and operated Mr. Davis' business from October 11, 1963, to October 28, 1963. On October 28, 1963, a trustee was appointed to liquidate the business and satisfy the claims of petitioners' creditors. Mr. Davis was discharged of all debts and claims relating to the bankruptcy proceedings on December 2, 1963. The discharge included debts totaling $3,835,795.01 which were not satisfied from the bankruptcy estate. Immediately after their discharge petitioners owned their home (worth $35,000), furniture, a 1961 Oldsmobile automobile, clothing, jewelry (wedding rings), and a life insurance policy all of which were exempted from the jurisdiction of the bankruptcy proceedings.

In February 1964 petitioners again entered the grocery store business by purchasing a supermarket in a shopping center in Fort Worth, Tex. (Davis Foodway). The store was successful due to marketing techniques implemented by petitioners.³ Petitioners had been conducting business in the new store for approximately 1 year when Mr. J. C. Pace offered to buy their store. Mr.

[69 T.C. 817]

Pace was in the retail grocery business and had been a competitor of petitioners for several years. As result of Mr. Pace's offer, petitioners sold their store for $99,832.91. In addition petitioners entered into a 10-year covenant not to compete in the retail grocery business anywhere in the State of Texas with the exceptions of Houston, Tex. (100-mile radius), and El Paso, Tex. (100-mile radius). In consideration for entering into the covenant not to compete, petitioners received $300,000.

Following the sale of Davis Foodway, petitioners moved to Houston, Tex., and established a retail grocery store pursuant to the restrictions in their covenant not to compete with Mr. Pace. For the fiscal years ended September 30, petitioner reported the following amounts as gross sales and net profits from their Houston grocery store business:

+---------------------------------+
                ¦Year ¦Gross sales ¦Net profit ¦
                +------+-------------+------------¦
                ¦ ¦ ¦ ¦
                +------+-------------+------------¦
                ¦1965 ¦$74,796.73 ¦$(8,142.99) ¦
                +------+-------------+------------¦
                ¦1966 ¦2,989,778.79 ¦12,656.77 ¦
                +------+-------------+------------¦
                ¦1967 ¦5,508,754.38 ¦244,148.40 ¦
                +------+-------------+------------¦
                ¦1968 ¦8,153,633.06 ¦310,149.06 ¦
                +---------------------------------+
                

As a result of their successful operation in Houston, petitioners accumulated excess capital which they intended to invest in grocery stores. However, Mr. Davis decided to personally manage the excess capital rather than putting it into a savings account. During 1966, 1967, and 1968 petitioners made numerous advances to various companies and individuals. Petitioners purchased a significant number of short-term corporate obligations from GMAC, James Talcott, Inc., Ford Motor Co., Westinghouse Credit Corp., Montgomery Ward, and Sears Roebuck & Co. These obligations were purchased through either a bank or a broker. Petitioners also made advances to friends and relatives which included their brothers, nephew, and brother-in-law. In addition, petitioners lent money to J. P. Bowlin Co. (a.k.a. Bowlin Houston, Inc. and Aabbott Houston, Inc., hereinafter referred to as Bowlin). All of the advances to Bowlin during 1966, 1967, and 1968 were secured by accounts receivable of Bowlin. Bowlin was in the business of selling equipment to retail grocery stores and restaurants. Petitioners had known J. P. Bowlin for several years and had purchased equipment from him when they maintained grocery stores in Fort Worth, Tex. All of the advances which were secured by

[69 T.C. 818]

Bowlin's accounts receivable were either repaid or exchanged for stock in Bowlin.

Petitioners continued to purchase equipment from Bowlin when they moved to Houston, Tex. It was during this time (September 1968) that petitioners acquired controlling interest in Bowlin and eventually became the sole shareholders of Bowlin. In July 1968, Mrs. Davis began to work full time at Bowlin to lend guidance to the management. Petitioners employed a certified public accountant to maintain the corporate books of Bowlin because they were taking over the...