Cho v. Commissioner
| Decision Date | 12 October 1976 |
| Docket Number | Docket No. 5840-74. |
| Citation | 35 TCM (CCH) 1442,1976 TC Memo 318 |
| Parties | Samuel S. and Eileen S. Cho v. Commissioner. |
| Court | U.S. Tax Court |
Ton Seek Pai, for the petitioners. David R. Brennan, for the respondent.
Memorandum Findings of Fact and Opinion
Respondent determined the following deficiencies and additions to tax in petitioners' Federal income tax:
Additions to Tax
Sec. Sec
Year Deficiency 6651(a)1 6653(a)1a
1966 ..... 1,890.82 472.21 94.24
1967 ..... 1,081.51 54.47
1968 ..... 1,366.22 68.26
1969 ..... 3,590.62
The issues for decision are:
(1) Whether payments made by petitioner Samuel S. Cho in 1968 through 1969 in discharge of his obligation as guarantor on certain corporate debts were business or nonbusiness bad debts or were ordinary and necessary business expenses?
(2) Whether petitioner met the substantiation requirements of section 274 in relation to certain business expenses in 1968?
Some of the facts have been stipulated and are so found.
At the time petitioners filed their petition, they resided in Honolulu, Hawaii. Eileen S. Cho is a party solely by virtue of having filed a joint income tax return with her husband, and Samuel S. Cho will be referred to herein as petitioner.
After having served in the Air Force during the Korean War, petitioner set up his own practice as a certified public accountant in Honolulu, Hawaii. He drew his clients mainly from the Chinese-American community. He also taught accounting and taxation at the University of Hawaii.
Sometime in 1960 petitioner was diagnosed as having cancer of the larynx. He gradually lost the use of his voice and was forced to resign from his university post and substantially reduce his accounting practice. During the following eighteen month period, petitioner underwent seven operations resulting in the removal of his larynx. By some point in 1962, petitioner could communicate only through the use of pencil and paper. He concluded he could no longer function effectively full time as a C.P.A.
Petitioner responded to this misfortune by seeking a new line of business in which the ability to speak would be less important. One of his clients, a Mr. Patterson, operated a wood products company and was experienced in the purchasing of timber in the Fiji Islands. Petitioner and Patterson decided to form a company to cut and export Fijian timber, with Patterson supplying the lumbering expertise and petitioner supplying managerial and administrative skills.
Petitioner and Patterson incorporated their enterprise under the laws of the State of Hawaii on May 2, 1962. The company's name was originally Pacific Woods Corporation, but later was changed to Pacwood International, Inc. ("Pacwood"). Petitioner was president and chairman of the Board of Directors and ran the company's day-to-day affairs. He operated Pacwood from his residence, which was also the location from which he handled what remained of his accounting practice. After six months of operation, relations between Patterson and petitioner grew strained and Patterson left Pacwood.
Petitioner obtained operating capital for the new company by a variety of methods. Petitioner invested significant amounts of his own funds into Pacwood. In 1962 he put in $21,000, in 1963 an additional $13,000, and in 1964 a further $16,000. By the end of 1964 he had invested a total of $50,000 in Pacwood's common stock and owned approximately 25 percent of the total outstanding common stock. He also sold stock to his accounting clients. Among his clients who purchased stock were Herbert Y.C. Choy, an attorney who had previously handled petitioner's legal affairs (now a judge on the U.S. Court of Appeals for the Ninth Circuit), Doctor E. Wonsik You, Robert C.H. Chung, and Doctor H.T. Wong. Neither petitioner's purchases nor the other sales of common stock, which together totaled $200,000 by October 1964, generated enough funds to meet Pacwood's requirements. From the beginning of its existence Pacwood sought to borrow additional funds from various Hawaiian banks and finance companies. These lenders agreed to advance funds only after petitioner, Choy, You, Chung, and Wong each agreed to act as co-guarantors of the loans. At the time the five entered into the guaranties, they understood among themselves that petitioner alone would be responsible for paying off all guaranties.
During 1962 and 1963, petitioner's determined efforts to learn to speak by the esophageal method began to succeed. As his ability to communicate improved, he gradually increased his accounting practice. For example, in 1963 he attracted the business of a successful stock broker, Willard M.P. Wong. The time demands of Pacwood, however, had caused some of his accounting clients to receive inadequate service, including William Chung, the brother of Robert C.H. Chung. Petitioner did not decide to devote the bulk of his time to his accounting practice until some time in 1963 or 1964.
Despite petitioner's efforts to generate capital, Pacwood did not prove successful. The event precipitating Pacwood's decline was the failure in 1964 of Pacwood's supplier in Fiji to provide it with logs meeting the specifications of Pacwood's customers, causing those customers to reject the logs. Though Pacwood began legal action against the supplier, the suit proved futile. In addition, a great flood in Fiji destroyed Pacwood's logging roads and much of its equipment.
To secure the funds to rebuild the logging roads and to satisfy Pacwood's continuing needs for working capital, Pacwood's Board of Directors first tried to assess the shareholders to raise additional money. Shareholder response, however, was negative. As an alternate measure, in December 1963 the corporation issued shares of preferred stock. Although $52,000 worth of preferred stock was eventually sold, about one-half being sold to clients of petitioner's accounting practice, Pacwood's capital problems remained unsolved. By December 1965, Pacwood had overdue loans of more than $114,000 and the guarantors of the loans were forced to begin repaying the banks. A final attempt by Pacwood's Board at assessing its shareholders failed.
With no options remaining, Pacwood's Board of Directors voted on January 4, 1966 to liquidate the assets of the company. On the same day, the five guarantors formed a joint venture under which they agreed to liquidate Pacwood's assets and satisfy creditors to the extent possible. The shareholders ratified this action on December 1, 1967.
Pacwood still possessed some machinery in Fiji, some of which had been damaged in the flood. Pacwood was unable to sell or salvage any of the machinery, which had only minimal value by 1965. Pacwood's major liabilities consisted of loans outstanding of over $114,000 and additional debts of approximately $10,000. The burden of repaying the various lenders fell on the guarantors. Their payments from 1965 to 1969 were as follows:
Guarantors 1965 1966 1967 1968 1969 Total
Samuel S. Cho $10,362.67 $ 6,725.39 $ 5,702.34 $7,500.50 $30,290.90
Herbert Y.C. Choy 2,717.58 6,560.36 4,590.68 984.48 14,853.10
Dr. Robert C.H. Chung $784.64 896.08 426.93 10,575.00 12,682.65
Dr. E. Wonsik You 3,178.58 3,838.40 5,850.00 12,866.98
________ __________ __________ __________ _________ __________
TOTAL $784.64 $17,154.91 $17,551.08 $26,718.02 $8,484.98 $70,693.63
The fifth guarantor, Dr. H.T. Wong, made no payments. Beginning in 1970 petitioner shouldered the entire burden of repaying the lenders.
As early as 1965, the other guarantors had told petitioner to undertake to repay the loans by himself in accordance with their initial understanding that petitioner would pay all guaranties the five made on Pacwood's behalf. Petitioner's personal assets, however, were insufficient. His only assets were his library, several adding machines, and his home in which he had an equity of only $3,000.
Petitioner was very concerned about his relationship with the other guarantors. During the period when Pacwood was declining and his speech improving, he had successfully begun to rebuild his accounting practice, relying heavily upon the patronage of the other guarantors. His gross billings from his accounting practice showed an increase from $39,900 in 1964 to $66,851.90 in 1969. Of these amounts the four guarantors had provided 37.3 percent in 1964, 36.7 percent in 1965, and 52.3 percent in 1966. Petitioner thought that if he did not do all he could to discharge the entire guaranty obligation, the other guarantors would stop using his accounting services. However, the best arrangement that petitioner could immediately offer the other guarantors was to do their accounting for a reduced fee.
This did not satisfy Dr. W. Wonsik You, who began using a different accountant in 1968. Petitioner lost another guarantor, Robert Chung, several years thereafter, due to similar dissatisfaction. Other accounting clients told petitioner that if petitioner did not exert his best efforts to repay the guarantors they would stop using his services. Petitioner briefly considered the possibility of bankruptcy, but rejected that option because of the almost certain loss of accounting business it would entail.
During 1968, petitioner reconstructed the records of a partnership whose three partners had died. Since petitioner shared his office with a real estate broker, the parties involved met at a restaurant or cocktail lounge. Meetings occurred twice a week for over two years. Petitioner...
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