Benak v. Comm'r of Internal Revenue

• Decision Date: 07 December 1981
• Docket Number: Docket No. 866-79.
• Citation: 77 T.C. 1213
• Parties: HENRY J. BENAK and MARGARET BENAK, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

77 T.C. 1213

HENRY J. BENAK and MARGARET BENAK, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 866-79.

United States Tax Court

Filed December 7, 1981.

In 1972, P bought stock in X which was designed to qualify as sec. 1244, I.R.C. 1954, stock. Later that year, X redeemed and canceled P's shares, issuing P a 1-year, 8-percent promissory note. In 1973, X borrowed funds on which P and others guaranteed payment. In 1974, X became delinquent in its payments on the loan, and in 1975, P made a payment in satisfaction of his obligation under the guaranty. Held, P's payment pursuant to the guaranty gives rise to a nonbusiness bad debt, deductible as a short-term capital loss in the year of payment. Held, further: The note received by P from X does not constitute sec. 1244 stock. The loss on the worthlessness of such note is deductible only as a short-term capital loss. Lester M. Ponder and Catherine L. Bridge, for the petitioners.

Richard E. Trogolo, for the respondent.

SIMPSON , Judge:

The Commissioner determined a deficiency of $25,509.03 in the petitioners' Federal income tax for 1974. After a concession by the petitioners, the issues for decision are: (1) Whether the petitioners may deduct, as a business bad debt, an amount paid in satisfaction of their obligation as guarantors of a loan; and (2) whether the petitioners may deduct the amount of their investment in a corporation as a loss on section 1244 stock.

FINDINGS OF FACT

Some of the facts have been stipulated, and those facts are so found.

The petitioners, Henry J. and Margaret Benak, husband and wife, resided in Indianapolis, Ind., at the time they filed their petition in this case. They filed their joint Federal income tax return for 1974 with the Internal Revenue Service, Indianapolis, Ind. Mr. Benak will sometimes be referred to as the petitioner.

In 1957, the petitioner and another person established B & G Quality Tool and Die, Inc. (B & G), a corporation organized under the laws of the State of Indiana. B & G is in the business of manufacturing dies, molds, and special machines primarily related to the automotive industry. In 1974, B & G had approximately 40 employees. The petitioner was a 50-percent stockholder and vice president of B & G; he supervised the day-to-day manufacturing operation at the plant and worked about 55 hours a week doing so. The petitioner received $45,400 in salary from B & G in 1974. The petitioners were also 50-percent stockholders in Quality Investment Co., Inc., an Indiana corporation, which owned and leased the physical plant to B & G.

On June 23, 1972, Scottie Shoppes of Illinois, Inc. (Scottie), was incorporated in the State of Indiana. On July 1, 1972, at its first meeting, the board of directors of Scottie resolved to issue its stock in accordance with a plan that would qualify such stock under section 1244 of the Internal Revenue Code of 1954.¹ On October 4, 1972, the petitioners purchased one-third of the shares of Scottie, or 15 shares, for $15,000. During 1972, Scottie operated a fast-food franchise, leasing stores in Aurora and Joliet, Ill. In deciding to invest in Scottie, the petitioners relied on the experience of John Hulse, another stockholder who had experience in operating fast-food franchises.

On December 1, 1972, there was a special meeting of the board of directors of Scottie to discuss the financial status of the corporation and the redemption of some of its stock. At such meeting, the board resolved to redeem the stock of the petitioners and Mr. Hulse at the rate of $1,000 per share. The petitioners' shares were canceled, and in payment for such shares, they received a promissory note in the amount of $15,000 bearing interest at the rate of 8 percent. Such note was due 1 year after demand.

On August 24, 1973, Scottie borrowed $100,000 from Citizens Banking Co. of Anderson, Ind. (CBC). This loan was evidenced by a promissory note, bearing interest at the rate of 8 percent. Such note required repayment of the principal, together with accrued interest thereon, in monthly installments of $2,027.70 each, commencing on September 24, 1973. The petitioners and others guaranteed payment of such note. The purpose of the loan was to secure additional operating capital for Scottie.

In accordance with the note, Scottie made regular payments to CBC on a monthly basis starting on September 25, 1973. However, by the fall of 1974, Scottie became delinquent in its payments, making them only in September and December. It did make one additional payment of $1,127.84 in January 1975. CBC advised the guarantors that Scottie was delinquent on the loan, and the guarantors sought an extension of it. However, the extension was not granted, and on March 15, 1975, the remaining balance on the loan, $84,518.04, was paid by the guarantors. The petitioners paid $28,172.68 on that date in satisfaction of their share of the obligation under the guaranty. The petitioners never received any payment from Scottie with respect to the $15,000 promissory note or with respect to their payment under the guaranty.

On their 1974 return, the petitioners reported a total of $8,855.16 of interest income. All of such interest, except for $57.82, was derived from Treasury bills and CBC. On such return, they deducted a total of $43,172.68 based on the worthlessness of the $15,000 Scottie note and their payment of the guaranty to CBC. In his notice of deficiency, the Commissioner determined that the guaranty payment was not allowable as a business bad debt in 1974, but was allowable as a capital loss in 1975, and he determined that the $15,000 loss attributable to the Scottie note was not a small business loss in 1974, but was a capital loss due to worthlessness in 1975.

On January 3, 1980, the petitioners filed an amended return for 1975, claiming ordinary loss deductions for the guaranty payment and the $15,000 note from Scottie.

OPINION

The first issue to be decided is whether the petitioners may deduct in 1974, as a business bad debt, the amount of $28,172.68 paid in 1975 in satisfaction of their share of the guaranty on the CBC loan. Section 166(a)(1) allows a deduction for “any debt which becomes worthless within the taxable year.” However, section 166(d)(1) provides that a nonbusiness debt held by an individual is not deductible under section 166(a), but that if a nonbusiness debt becomes worthless, the loss is treated as a short-term capital loss. Section 166(d)(2) defines a nonbusiness debt as a debt other than:

(A) a debt created or acquired (as the case may be) in connection with a trade or business of the taxpayer; or

(B) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.

The petitioners maintain that their payment on the guaranty should be treated as a business bad debt because they were in the business of making investments in other small businesses and because they made the payment to protect the business reputation of B & G and its position in the community.

To distinguish a business from a nonbusiness debt, the Supreme Court in United States v. Generes, 405 U.S. 93, 103 (1972), held that the test is what the taxpayer's dominant motivation was in undertaking the obligation. See also Shinefeld v. Commissioner, 65 T.C. 1092, 1097 (1976). To be entitled to treat the guaranty payment as a business bad debt, the petitioners have the burden of proving that their dominant motivation for entering into such arrangement was for business purposes, rather than to protect their investment in Scottie. Rule 142(a), Tax Court Rules of Practice and Procedure; Welch v. Helvering, 290 U.S. 111 (1933).

It is clear that Mr. Benak's principal business was as an employee of B & G: He was the vice president of that company; he supervised its manufacturing operations; and he spent most of his working time in that activity. We recognize that a person may be in more than one trade or business, but Mr. Benak has failed to prove that he was in an investment business and that he entered into the guaranty as a part of such business. Cf. Higgins v. Commissioner, 312 U.S. 212 (1941); Smith v. Commissioner, 60 T.C. 316 (1973); sec. 1.166-8, Income Tax Regs. He testified that he had made loans to six other small businesses, but he was unable to substantiate any of such loans. Moreover, the petitioners' tax return for 1974 failed to reflect that they were deriving any income from any such investments. The petitioners have utterly failed to prove that their dominant motivation for guaranteeing the CBC loan to Scottie was a part of carrying on an investment business. See Gustin v. Commissioner, 412 F.2d 803 (6th Cir. 1969), affg. per curiam a Memorandum Opinion of this Court; Scifo v. Commissioner, 68 T.C. 714 (1977); Betts v. Commissioner, 62 T.C. 536 (1974).

Mr. Benak was both an employee and a stockholder of B & G, and he testified that he entered into the Scottie guaranty agreement to protect B & G's reputation in the community. For the petitioners to be able to treat their payment on the guaranty as a business bad debt, it would be necessary to show that their dominant motivation in guaranteeing the Scottie loan was proximately related to Mr. Benak's status as an employee of B & G rather than as an investor in such corporation. United States v. Generes, supra. The fact that a loan or payment is made in furtherance of an employer's trade or business does not mean that it is proximately related to that of the employee. Shinefeld v. Commissioner, supra ; Imel v. Commissioner, 61 T.C. 318 (1973); cf. Deputy v. du Pont, 308 U.S. 488 (1940). There is absolutely no evidence showing that the petitioners entered into the guaranty arrangement in the interest of his employment with B & G, and the testimony of Mr. Benak that he agreed to make the guaranty payment to protect the goodwill of B & G was vague and conclusory—-there was no specific information provided as to how his employment...