Schwartz v. Commissioner
| Decision Date | 24 August 1995 |
| Docket Number | Docket No. 2047-93. |
| Citation | 70 T.C.M. 526 |
| Parties | Robert Schwartz and Peggy Ann Schwartz v. Commissioner. |
| Court | U.S. Tax Court |
Phil H. Leone, Red Bank, N.J., for the petitioners. William S. Garofalo and Frank A. Racaniello, for the respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined deficiencies of $72,436, $16,652, and $679 in petitioners' 1986, 1987, and 1988 Federal income taxes, respectively.
All section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. The term "petitioner" refers to Robert Schwartz.
On November 16, 1990, petitioners filed a Form 1045, Application for Tentative Refund, on which they carried back a net operating loss from 1989 to 1986, 1987, and 1988. Respondent's disallowance of various ordinary losses claimed on petitioners' 1989 Federal income tax return has eliminated petitioners' claimed net operating loss.
After concessions, the issues for decision are: (1)(a) Whether Remark Industries, Inc. (Remark), was "largely an operating company", and if it was, (b) the amount of ordinary loss allowed under section 1244; (2) whether petitioner's advances to M. Kramer Manufacturing Co., Inc. (Kramer), were contributions to its capital, whether the advances were primarily motivated by petitioner's business of being an employee so that losses on those transactions would be ordinary losses under section 166(a), and whether the advances became worthless in 1989; and (3) similar questions arising under petitioner's payment under his guarantee of a bank loan to Kramer.
We hold that Remark was largely an operating company and that petitioners are entitled to an ordinary loss of $50,000 under section 1244. Inasmuch as we hold that the advances to Kramer did not become worthless in 1989, we need not decide their character. We hold further that petitioner's personal guarantee of the bank loan was not a contribution to capital, but that petitioner's primary motive for guaranteeing the bank loan was not petitioner's business of being an employee, so that petitioners are not entitled to a business bad debt deduction for the payment under the guarantee.
The parties have stipulated some of the facts, and the stipulations of fact and attached exhibits are incorporated in this opinion. Petitioners resided in Normandy, New Jersey, when they filed their petition.
Petitioner graduated from the University of Vermont in 1964 with a bachelor of science degree in economics. After college, he started work as a cost analyst for a small manufacturing company and advanced to plant manager. In 1972, petitioner accepted the position of president of a startup company, American Medical Corp., whose main product was to be a kidney dialysis machine. By 1980, petitioner had taken American Medical from one employee to 350 employees, and from zero revenues to almost $40 million per year.
Petitioner owned approximately 15 percent of the stock of American Medical. In 1980, 10 percent of the stock of American Medical was sold in an initial public offering. In 1982, Delmed, Inc., acquired all the stock of American Medical, and petitioner received Delmed stock and stock options having a value of approximately $4 million. In May 1982, petitioner stopped working for American Medical.
From 1972 through 1982, petitioner's sole source of earned income had been his salary from American Medical, and, during that time, he had earned approximately $125,000 per year.
Although petitioner did not leave American Medical until May 1982, he purchased a real estate brokerage firm in 1978. After petitioner left American Medical, he purchased another real estate brokerage firm and started several others. By summer 1989, petitioner no longer owned any interest in the real estate brokerage firms.
After leaving American Medical, petitioner also invested in, and advised, several emerging medical-technology companies.
During 1983, petitioner came to believe that there was a business opportunity in the manufacture and sale of "video lottery" machines. Video-lottery machines allow a player to play the typical games of chance found in a casino, e.g., poker and blackjack, against a machine. In February 1984, petitioner became aware of Kramer, which manufactured and sold video and nonvideo machines for use in amusement parks but had no experience with video-lottery machines.
On August 15, 1984, petitioner incorporated Remark in New Jersey to become a licenced manufacturer and operator of video-lottery equipment.1 On August 30, 1984, Remark purchased all the stock of Kramer to provide a manufacturing facility for Remark's video products. The net purchase price was $2,732,601, and Remark paid $50,000 in cash and gave two notes, one for $1,950,000 (later reduced by $155,399 as an adjustment to the purchase price) and the other for $888,000. Remark also agreed to pay $1,575,000 to the sellers for their covenants not to compete.
At all relevant times, petitioner owned 100 percent of the stock of Remark. Remark properly followed the formalities for designation of its stock issued to petitioner as "section 1244 stock". Petitioner capitalized Remark with $50,000, which he paid directly to the sellers of the Kramer stock. Petitioner also pledged 100,000 shares of Delmed stock as collateral for a $1 million line of credit to Remark from the First National Bank of Toms River (FNB). For purposes of this proceeding, the parties have agreed that petitioner's basis in the pledged Delmed stock was $56,000.
Petitioner attempted to position Remark to grow with the emerging video-lottery business; he expected that it would take from 3 to 7 years before Remark would become profitable. After incorporation, Remark leased facilities, in which it had its office, warehouse, and assembly (but no manufacturing) facilities. Remark provided information and suggestions to the lottery commissions of Oregon, South Dakota, North Dakota, Minnesota, and Nebraska concerning development of laws regulating video-lottery machines. Remark acquired the rights to several electronic gaming machines and related technologies, including a "heart stress machine", a trivia game, a punch board game, and debit card technology. Remark became a licenced gaming machine manufacturer in the State of Washington, and its equipment was approved by the Nebraska lottery commission. Remark and an independent operating company test marketed a video-lottery machine in Nebraska.
Remark hired a marketing director to develop Remark's identity among State lottery commissioners but did not hire any other full-time, permanent employees. Remark occasionally did hire part-time employees to assemble electronic punch boards. However, Kramer manufactured all the video-lottery machines.
On January 4, 1985, FNB lent Kramer $585,000, which was used to pay purchase price liabilities to the former owners of Kramer. The loan was payable on demand and was secured by all the accounts receivables and inventory of Remark and Kramer, 335,000 shares of Delmed stock owned by petitioner (including the 100,000 shares previously pledged), and petitioner's guarantee.
On March 22, 1985, FNB lent Kramer $55,000. The loan was payable in 30 days and was secured by petitioner's guarantee. The loan was rolled over for 30 days on April 22, 1985, and for 60 days on May 22, 1985.
On October 25, 1985, FNB lent $1 million to Remark and $400,000 to Kramer to refinance their existing loans and increase their working capital. The loans were to be repaid over 5 years with interest at FNB's prime rate plus 1 percent. The loan to Remark was secured by the accounts receivable, inventory, and contract rights of Remark, the same 335,000 shares of Delmed stock that were previously pledged, and petitioner's guarantee. The loan to Kramer was secured by the accounts receivable, inventory, machinery, equipment, vehicles, furniture, fixtures, and leasehold improvements of Kramer, and petitioner's guarantee.
Later, FNB lent Remark an additional $195,000. The date and repayment terms of this loan are not in the record, but the loan was guaranteed by petitioner.
Shortly after May 31, 1986, in order to help alleviate Kramer's cash-flow problems, petitioner reduced from $300,000 to $150,000 the annual salary he had initially set for himself as the chief executive officer of Kramer.
On November 11, 1986, Kramer borrowed $37,000 from the National Community Bank (NCB) in order to purchase a delivery truck. The loan was secured by a purchase money security interest in the delivery truck and petitioner's guarantee.
In 1987, Kramer borrowed $750,000 from Chemical Bank. The repayment terms of this loan are not in the record, but the loan was secured by Kramer's assets, petitioners' principal residence in Normandy Beach, New Jersey, a vacant lot owned by petitioners in Brielle, New Jersey, and petitioner's guarantee.
On or about April 4, 1988, FNB notified Remark that its October 25, 1985, loan was in default and demanded payment of the outstanding balance ($950,000) and accrued interest ($71,014). At about the same time, the Montana and South Dakota lottery commissions approved Remark's video-lottery machines and were about to legalize video-lottery gambling. Although Remark and Kramer projected $9.6 million of gross receipts for the fiscal year ended May 31, 1989, they needed large amounts of additional capital to produce and warehouse the video-lottery machines they would need to take advantage of the legalization of video gambling in Montana and South Dakota. In addition, Kramer had developed a popular new electronic-amusement machine that was back ordered, and Kramer needed additional capital to produce enough machines to satisfy the demand.
During 1988, Remark and Kramer applied to Chemical Bank and FNB for $2.7 million of long-term financing. The financing was to...
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