Lemoge v. United States, C-71-1690-CBR.

• Decision Date: 04 January 1974
• Docket Number: No. C-71-1690-CBR.,C-71-1690-CBR.
• Parties: Mary Martha LEMOGE, Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Northern District of California

378 F. Supp. 228

Mary Martha LEMOGE, Plaintiff, v. UNITED STATES of America, Defendant.

No. C-71-1690-CBR.

United States District Court, N. D. California.

January 4, 1974.

COPYRIGHT MATERIAL OMITTED

James S. Martin, Taylor & Martin, San Leandro, Cal., for plaintiff.

James L. Browning, Jr., U. S. Atty., Gary K. Shelton, Asst. U. S. Atty., San Francisco, Cal., for defendant.

MEMORANDUM OF OPINION, FINDINGS OF FACT, AND CONCLUSIONS OF LAW

RENFREW, District Judge.

Pursuant to stipulation, this case was submitted for decision upon an agreed statement of facts with attached documentary exhibits, the deposition of plaintiff, and the respective briefs of counsel.

Lemoge Electric, Inc., is a California corporation, incorporated in 1953. Plaintiff's husband had been president and sole shareholder of the corporation until his death in 1959. When her husband died, plaintiff became president and sole shareholder of the corporation.

In 1964 Lemoge Electric, Inc., was awarded a $579,647.01 subcontract to perform work on Mary's Help Hospital in Daly City. F. P. Lathrop, the general contractor, required Lemoge Electric, Inc., to secure a performance bond and a payment, labor and material bond, both of which were obtained from Argonaut Insurance Co. As a condition for obtaining the bonds plaintiff, individually, and Lemoge Electric, Inc., were required to indemnify the insurance company against any loss, damage or expense incurred as a result of the bond or in enforcing the indemnity agreement.

In 1964, Lemoge Electric, Inc., encountered financial difficulties on the Mary's Help Hospital subcontract and was unable to complete the subcontract with its own financial resources. Pursuant to the indemnity agreement with plaintiff, the Argonaut Insurance Co. declined to advance any funds to Lemoge Electric, Inc., to complete the subcontract until plaintiff had exhausted her personal assets. Accordingly, during 1965, plaintiff advanced the net sum of $66,972.65 from her personal assets to Lemoge Electric, Inc.

In June, 1966, plaintiff filed her 1965 individual income tax return and claimed a $42,172.65¹ business bad debt deduction based on these unrecovered advances to the corporation.² She also requested and received with interest a refund of the tax withheld and estimated tax payments made in 1965, less $1,000 credited at plaintiff's request to her 1966 estimated tax.

In December, 1965, plaintiff filed an Application for Tentative Carryback Adjustment (Form 1045) in which she requested that her net operating loss for 1965 of $47,039.34 be carried back and applied against her taxable income for the years 1962, 1963 and 1964.³ The adjustment was allowed, and plaintiff received $12,924.13 in refunds of tax and interest for those years.

After conducting an audit, the Internal Revenue Service determined that plaintiff was not entitled to an ordinary loss deduction for the unrecovered advances made to Lemoge Electric, Inc., in 1965 nor to a net operating loss carryback and, therefore, assessed deficiencies totaling $20,999.14 for the years 1962, 1963, 1964 and 1965. The Internal Revenue Service did allow plaintiff a $1,000 nonbusiness bad debt deduction (short-term capital loss) with respect to the 1965 advances to the corporation.

Plaintiff paid the assessed deficiencies in 1970 and on January 13, 1971, filed refund claims (Forms 843) for 1965, asserting an ordinary loss deduction under 26 U.S.C. § 165 for losses in the form of unrecovered advances made to Lemoge Electric, Inc., in 1965 by reason of the indemnity agreement, and for the years 1962, 1963, and 1964 based on a net operating loss carryback to those years from 1965. By notices dated April 30, 1971, and sent by certified mail, plaintiff was informed that these refund claims had been disallowed in full. Thereafter, plaintiff filed this action.

The case presents three legal issues. First, whether the unrecovered advances to the corporation made by reason of the indemnity agreement were deductible under 26 U.S.C. § 165(c)(2), a transaction entered into for profit, and if so, whether the excess may be carried back to the years 1962, 1963 and 1964 under 26 U.S.C. § 172. Second, whether these advances were deductible under 26 U.S. C. § 166(a) and (d), as a business bad debt, and if so, whether the excess may be carried back as above. And third, whether the 1971 refund claim which requested a § 165 refund for 1965 precludes plaintiff, under 26 U.S.C. § 7422(a), from now asserting the § 166 business bad debt request for refund.

The instant action was timely filed. This Court has jurisdiction under 28 U. S.C. § 1346(a)(1), and venue is proper under 28 U.S.C. § 1402(a)(1).

It appears that the advances made by plaintiff are not deductible under 26 U. S.C. § 165(c)(2) but may be deductible under 26 U.S.C. § 166. Sections 165 and 166 are often confused on this issue. In Hoffman v. United States, 266 F.Supp. 884 (D.Or. 1967), a case quite similar to the one before this Court,⁴ the court ruled that the loss sustained by reason of the indemnity contract was incurred in a transaction entered into for profit, although not connected with taxpayers' trade or business, and, therefore, that it was deductible under § 165(c)(2). The district court distinguished Putnam v. Commissioner of Internal Revenue, 352 U.S. 82, 77 S.Ct. 175, 1 L.Ed.2d 144 (1956), which held that an individual who guarantees an obligation of a corporation in which he holds stock is only entitled to a § 166 bad debt deduction, rather than an ordinary loss deduction under § 165(c)(2), since upon paying the creditor the stockholder is merely subrogated to the existing rights of the creditor against the corporation. "Unlike Putnam, the Hoffmans were indemnitors. An indemnitor has a primary obligation to the creditor and he is not subrogated to the creditors' rights. * * * Their the Hoffmans' loss cannot be treated as a worthless debt because the corporation owed them no debt." Hoffman v. United States, supra, 266 F. Supp. at 886.

The Hoffman case was reversed on that precise point three years later, United States v. Hoffman, 423 F.2d 1217 (9th Cir. 1970). Relying on the reasoning in Stratmore v. United States, 420 F.2d 461 (3rd Cir.), cert. denied, 398 U.S. 951, 90 S.Ct. 1870, 26 L.Ed.2d 291 (1970), the Court of Appeals rejected the distinction between guarantors and indemnitors drawn by the district court. The appellate court adopted the conclusion set forth in Stratmore that "the essence of Putnam v. Commissioner of Internal Revenue * * * was to protect the statutory scheme for a common tax treatment of all losses suffered by a corporate stockholder in providing his corporation with financing." United States v. Hoffman, supra, 423 F.2d at 1218. Such losses of stockholder-taxpayers were to be treated as capital losses under § 166(d), absent a showing that the debt was fully deductible as a business bad debt. To allow the tax result to turn on the technical subrogation rules of state law would undermine the uniformity which Putnam sought to achieve. Stratmore v. United States, 420 F.2d at 464-465; Martin v. Commissioner of Internal Revenue, 52 T.C. 140, 144-146 (1969), aff'd per curiam, 424 F.2d 1368 (9th Cir.), cert. denied, 400 U.S. 902, 91 S.Ct. 138, 27 L.Ed.2d 138 (1970). Cf. Stahl v. United States, 142 U.S.App.D.C. 309, 441 F.2d 999, 1002-1004 (1970). Therefore, plaintiff taxpayer, as a shareholder of Lemoge Electric, Inc., is not entitled to an ordinary loss deduction under § 165(c)(2) for the unrecovered advances made pursuant to the indemnity agreement, and the Court need not reach the question of loss carryback under this refund claim.

Plaintiff's second claim is that she is entitled to a business bad debt deduction under § 166(a) and (d) for the unrecovered advances to Lemoge Electric, Inc. Since this issue was not specifically raised in the 1971 claim for refund filed with the Internal Revenue Service, the Government urges that 26 U.S.C. § 7422(a) and the accompanying regulations prohibit that ground for deduction from being raised now. Plaintiff argues that the variance prohibition may not now be invoked because it has been waived and because to do so would not be consistent with the purpose of the statute.

While strict compliance with the statute and regulations in issue here is usually required, it must be remembered that these provisions were "devised, not as traps for the unwary, but for the convenience of government officials in passing upon claims for refund and in preparing for trial. Failure to observe them does not necessarily preclude recovery." Tucker v. Alexander, 275 U.S. 228, 231, 48 S.Ct. 45, 46, 72 L. Ed. 253, 256 (1927). When applying this requirement to the specific facts of each case, the court must be mindful that the basic purposes of § 7422(a) and the accompanying regulations are "to afford the Service an opportunity to consider and dispose of the claim without the expense and time which would be consumed if every claim had to be litigated," Herrington v. United States, 416 F.2d 1029, 1032 (10th Cir. 1969), and "to prevent surprise on the facts," Mayer v. United States, 285 F.2d 683, 685 (9th Cir. 1960). Thus, the court can reach a decision on the merits if the refund claim presented "facts sufficient to enable the Commissioner of Internal Revenue to make an intelligent administrative review of the claim." Scovill Manufacturing Company v. Fitzpatrick, 215 F.2d 567, 569 (2nd Cir. 1954).

The facts of the transaction in question which were set forth in plaintiff's 1971 refund claim for 1965 (Exhibit N) differ in no material way from the stipulated facts on which this case has been submitted. Plaintiff's position as sole stockholder and president of Lemoge Electric, Inc., the personal indemnity agreement, and the cash advances, in specific amounts, made to the corporation pursuant to the indemnity agreement are clearly presented in the 1971 refund claim. The instant case is...