Deely v. Comm'r of Internal Revenue

• Decision Date: 12 March 1980
• Docket Number: Docket No. 9564-77.
• Parties: CARROLL L. DEELY and WILDA DEELY, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

73 T.C. 1081

CARROLL L. DEELY and WILDA DEELY, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 9564-77.

United States Tax Court

Filed March 12, 1980.

1. Since 1944 petitioner, with others, has organized and financed numerous corporations and other business entities. In two of the taxable years in issue, petitioner claimed as business bad debt deductions amounts owed to him by two insolvent corporations which he had organized. Held, petitioner was not engaged in the separate business of promoting, financing, managing, and organizing businesses, and the above worthless debts owing to him are deductible only as nonbusiness bad debts under sec. 166(d), I.R.C. 1954. Held, further, petitioner's subsequent recovery of a previously deducted bad debt is properly characterized as short-term capital gain. Arrowsmith v. Commissioner, 344 U.S. 6 (1952).

2. During the taxable years in issue, petitioner deducted various expenses incurred incident to the creation and promotion of these businesses. Held, such expenses were not proximately related to any trade or business engaged in by petitioner and are not properly deductible under sec. 162, I.R.C. 1954. Held, further, certain of the expenses are deductible under sec. 212, I.R.C. 1954; amounts determined. Held, further, deductions for travel and entertainment expenses disallowed for failure to substantiate as required by sec. 274(d), I.R.C. 1954. Roy J. True and William F. Pyne, for the petitioners.

Raymond L. Collins, for the respondent.

DRENNEN, Judge:

Respondent determined the following deficiencies in petitioners' income taxes:

+---------------------+
                ¦Year  ¦Deficiency    ¦
                +------+--------------¦
                ¦      ¦              ¦
                +------+--------------¦
                ¦1968  ¦1  $41,445.00 ¦
                +------+--------------¦
                ¦1972  ¦308.52        ¦
                +------+--------------¦
                ¦1973  ¦4,620.96      ¦
                +------+--------------¦
                ¦1974  ¦4,815.84      ¦
                +---------------------+
                

Due to concessions, the issues remaining for our resolution are as follows:

(1) Whether debts owing to petitioner from two corporations and becoming worthless in 1971 and 1973 are to be characterized as business bad debts under section 166(a), I.R.C. 1954,² or nonbusiness bad debts under 166(d);

(2) If we determine that the debts are properly characterized under section 166(a), is the debt owing by one corporation properly characterized as a contribution to capital;

(3) Whether the subsequent recovery of a previously deducted bad debt is properly characterized as ordinary income or short-term capital gain;

(4) Whether petitioner is entitled to certain deductions under section 162;

(5) As an alternative to (4), whether petitioner is entitled to certain deductions under section 212; and

(6) Whether certain deductions relating to travel and entertainment were substantiated in accordance with section 274(d).

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts, together with the exhibits attached thereto, is incorporated herein by reference.

Petitioners Carroll L. and Wilda Deely were husband and wife at all times material to this proceeding and resided in Dallas, Tex., at the time of the filing of the petition in this case. Petitioners jointly filed their income tax returns for the taxable years 1968, 1969, 1970, 1971, 1972, 1973, and 1974 with the Director, Internal Revenue Service Center, Austin, Tex. Wilda is a party to these proceedings by virtue of having filed a joint return. When we hereinafter refer to petitioner, we will be referring solely to Carroll.

Bad Debt Deduction

Petitioner, at an early age, obtained employment in the oil fields of Kansas. After obtaining a “rather broad experience in the oil fields,” petitioner became a drilling supervisor for a company called Western Geophysical. Around 1936, petitioner changed companies and was transferred by his new company, National Geophysical, to Dallas, Tex. Petitioner's job for National Geophysical was to open and manage a machine shop which included such equipment as lathes, milling machines, welders, and various other assorted equipment necessary to build oil and gas drilling equipment. By 1944, petitioner had terminated his employment with National Geophysical.

In 1937, while still employed by National Geophysical, petitioner and another employee formed a partnership, Griffin Tank & Welding, to engage in the business of welding tanks to be used in the oil business. Petitioner maintained his interest in this partnership at least until 1976.

After terminating his employment with National Geophysical in 1944, petitioner and three other friends created a partnership named Drilling & Service, Ltd. Petitioner conveyed to the partnership for use in its business a drilling unit that he had personally designed. In 1948, the partnership was dissolved and the partners organized a corporation named Drilling & Service, Inc. Petitioner contributed to the corporation the same drilling designs that had been used by the partnership and additionally turned over a patent he had obtained on a diamond drill bit. Petitioner maintained his interest in the corporation until 1961.

Between 1944 and 1971, petitioner became financially involved in at least 28 other enterprises.³ In most of these enterprises, petitioner became involved in the initial organization phase. Of these enterprises, nine were operated in corporate form, while the others were either operated as partnerships or joint ventures. These entities were quite diversified in their fields of operation, which included: Automobile leasing, exploration and drilling for oil and gas, exploration for strategic minerals, owning and operating an art gallery, leasing real property, operating a computer company, and matching by computer buyers and sellers of corporations. Included among these entities were Mustang Applied Science Corp. (later known as Mustang Computing Co.), and Corporate Information Exchange, Inc., whose existences are material in this dispute, infra.

In addition to contributing part of the initial capital to these various business entities, petitioner also contributed valuable services and expertise gained by him in the oil exploration and drilling business. Additionally, petitioner assisted many of these entities in obtaining financing by making direct loans to them or by personally guaranteeing the promissory notes of these enterprises. Some, but not all, of these business entities compensated petitioner in the form of salary and bonuses for his services.

Petitioner had different financial motives for investing in these enterprises. In some, he worked for a salary and for current income from dividends, while in others, from which he received neither salary nor current distributions of earnings, petitioner's stated purpose was to build these enterprises up for eventual resale.

Petitioner has maintained his interests in the entities for varying amounts of time. In one, he held his interest for 39 years, while he has sold others in approximately 2 years.

Petitioner's total investment in the 26 entities was $772,420. Additionally, between 1937 and 1976, petitioner made 10 loans to these entities in the total amount of $2,252,320. The ratio of the amounts loaned to amounts invested by petitioner was 2.91 to 1.

Petitioner has received and reported as ordinary income a total of $3,093,450 from the 26 business enterprises. Of this figure, a total of $2,746,937 was received by petitioner from six enterprises⁴ as dividends, salaries, or bonuses. This $3,093,450 represents a 400.5-percent return on petitioner's initial investment.

Petitioner never sold stock or partnership interests in any of the entities in which he was financially involved. When a sale was negotiated, it was accomplished by selling the assets of the business and petitioner's profit or loss was realized on liquidation of the entity. Petitioner has reported as long-term capital gain a total of $1,172,066 from these transactions; his net long-term capital gain on these sales was $554,814, which represents a 71.8-percent return on investment.

In addition to enterprises in which petitioner has extensive involvement, petitioner has a history of extensive investments in companies in which he has no direct involvement. He was simply a passive investor in these latter companies and he did not contribute his time, talent, initiative, expertise, or credit to such enterprises. An examination of petitioner's returns for the years in issue reveals that petitioner liquidated part or all of his passive investment in stock or securities in 59 different companies in 1968; 57 in 1969; 22 in 1970; 24 in 1971; 5 in 1972; 4 in 1973; 6 in 1974; and as a result of such liquidations, petitioner reported significant capital gains and losses.

In 1967, the concept of entering into the computer business was brought to petitioner's attention. After giving this some thought, petitioner and others organized Mustang Applied Science Corp. (Mustang), a Texas corporation. Petitioner approached this endeavor with a dual purpose—-to draw a salary and also to make the corporation a viable entity that would be attractive for a merger and for eventual sale to the public. In this regard, all of petitioner's time was spent screening candidates for a possible merger. He did not become involved in the day-to-day operations of the business, and he never drew a salary from Mustang.

Petitioner arranged a $200,000 line of credit for Mustang with his personal bank, Mercantile National Bank, at Dallas. Pursuant to this line of credit, Mustang subsequently borrowed $180,000 from the Mercantile National Bank, signing one note for $165,000 and one note for $15,000. Petitioner signed as a guarantor on both of these notes. Mustang paid all but $35,715 of the $180,000 aggregate amount of the loans.⁵

Petitioner also made an original capital contribution of $25,000 to Mustang and received in exchange therefor 25,000 shares of stock. Additional...