Stoody v. Comm'r of Internal Revenue

• Decision Date: 14 July 1976
• Docket Number: Docket No. 1127-73.
• Citation: 66 T.C. 710
• Parties: WINSTON STOODY AND SANDRA STOODY, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

66 T.C. 710

WINSTON STOODY AND SANDRA STOODY, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 1127-73.

United States Tax Court

Filed July 14, 1976.

Petitioner guaranteed the obligations of a corporation organized to operate a retail discount store. Shortly after the store opened, the business failed and the store closed. Lawsuits were filed against petitioner as guarantor of the corporation's debts. Petitioner settled the lawsuits file against him. Held, the payments made in settlement of the lawsuits filed against petitioner are deductible only as nonbusiness bad debts under sec. 166(d). Thomas H. Carver, for the petitioners.

Darrell B. McDaniel, for the respondent.

IRWIN, Judge:

Respondent determined deficiencies in petitioners' Federal income tax for the calendar years 1968 and 1969 in the amounts of $4,568 and $3,716, respectively. The sole issue raised in this litigation is whether payments made by Winston Stoody under a settlement agreement entered into to settle a lawsuit are deductible in full in the years of payment or are subject to the capital loss limitations of section 1211 of the Internal Revenue Code of 1954. ¹

FINDINGS OF FACT

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

Petitioners Winston Stoody and Sandra Stoody, husband and wife, resided in Whittier, Calif., at the time of filing their joint income tax returns for the years 1968 and 1969. Such returns were filed at the Internal Revenue Service Center in Ogden, Utah. The designation ‘petitioner’ will hereafter refer only to Winston Stoody.

In early 1961 Mr. Vincent Zazzara (hereafter referred to as Zazzara) contacted petitioner concerning the creation and operation of a retail discount store in Burbank, Calif. Although there were other individuals involved in setting up the discount store, Zazzara was the prime organizer and moving force behind the project.

The store was to operate under the name of Know ‘Em You or Know ‘Em You, Inc. Articles of incorporation of Know ‘Em You, Inc. (hereafter referred to as KEY), were filed with the secretary of state of California on June 14, 1961. However, KEY never issued stock to any shareholders, never held any shareholders' meetings, and never elected directors. The affairs of KEY were conducted almost entirely by Zazzara, as its president.

On July 6, 1961, KEY entered into a lease agreement with Gordon K. Jones and Bill H. Roberts covering the premises on which the proposed discount store was to operate. The lease was signed on behalf of the lessee, KEY, by Zazzara as president of the corporation.

Between October 17, 1961, and December 1, 1961, KEY entered into 15 lease agreements with American Guaranty Corp., whereby KEY acquired the use of equipment and fixtures necessary for the store's operation. In order to induce American Guaranty Corp. to lease the equipment and fixtures to KEY, petitioner and others executed a ‘continuing guaranty’ on October 9, 1961 (hereafter referred to as the guaranty agreement). Under this guaranty agreement petitioner guaranteed performance of all KEY's obligations under the leases executed or to be executed with American Guaranty Corp. Subsequently, on April 2, 1962, American Guaranty Corp. assigned all its interests in the lease agreements and guaranty agreement to American Guaranty Corp. of California.

The KEY store, also known as KEY co-op Store, opened for business on November 24, 1961. In March 1962 the store ceased business operations.

As a result of the failure of the discount store, many lawsuits were filed against KEY, Zazzara, petitioner, and others, by creditors of the business. Of the lawsuits instigated against petitioner, two were filed by American Guaranty Corp. of California: one in 1962 and one in 1963. Petitioner was sued in these lawsuits as guarantor of the obligations of KEY under the guaranty agreement executed on October 9, 1961.

Subsequently, American Guaranty Corp. and American Guaranty Corp. of California experienced financial difficulties and went into receivership. In 1965 a lawsuit was filed by Harry Burton, as receiver for American Guaranty Corp. and American Guaranty Corp. of California, against petitioner as one of the guarantors under the October 9, 1961, guaranty agreement. The lawsuits filed by American Guaranty Corp. of California in 1962 and 1964 were dismissed without prejudice on February 6, 1968, and January 31, 1968, respectively.

On June 28, 1968, an ‘Agreement of Settlement and Compromise and Full Release’ (hereafter referred to as the settlement agreement) was executed by American Guaranty Corp., American Guaranty Corp. of California, Harry Burton, and Winston Stoody, whereby petitioner agreed to pay American Guaranty Corp. a total of $44,400 (with payments to last over a 5-year period), in exchange for which petitioner was relieved of liability under the guaranty agreement. The lawsuit filed in 1965 by Harry Burton, as receiver for American Guaranty Corp. and American Guaranty Corp. of California, against petitioner was then dismissed with prejudice on September 12, 1968.

Pursuant to the settlement agreement petitioner paid the following amounts to American Guaranty Corp. during the years in issue:

+----------------+
                ¦Year  ¦Amount   ¦
                +------+---------¦
                ¦      ¦         ¦
                +------+---------¦
                ¦1968  ¦$10,915  ¦
                +------+---------¦
                ¦1969  ¦8,775    ¦
                +----------------+
                

Petitioner deducted the full amount of each payment on his income tax returns for the respective years. Respondent disallowed all but $1,000 of each of the claimed deductions on the ground that the losses sustained were nonbusiness bad debt losses.

At all relevant times petitioner was employed by Stoody Co., a California corporation engaged in manufacturing welding materials and equipment. In 1961 petitioner was vice president of Stoody Co. and owned about 10 percent of its stock. Employment by Stoody Co. was petitioner's only trade or business at the time the guaranty agreement was executed. Petitioner was never employed by KEY, never participated in its operations, and never performed services for it.

OPINION

The only issued which we have to decide is whether the payments made by petitioner under the settlement agreement are deductible in full in the years paid or are subject to the capital loss limitations of section 1211.

Petitioner contends that the payments made under the settlement agreement were made solely for the purpose of avoiding litigation expenses. That is, the payments were made instead or in place of attorney's fees and court costs which would have been incurred had the litigation proceeded to trial. He argues the attorney's fees would have been deductible in full and so should these settlement payments.

Further, petitioner argues, he was not liable as a guarantor of corporate obligations and the dismissals entered in his favor in the California courts are res judicata on this question. On brief, petitioner launched into a detailed discussion of his defenses to the lawsuits filed against him and how such defenses would have prevailed had the cases ever been tried.

Alternatively, petitioner claims that if we find the payments were made pursuant to his obligation as a guarantor, the debts guaranteed were noncorporate debts (making his losses fully deductible under section 166(f)). That is, KEY was not a valid corporation under California law, and the discount store was being operated by Zazzara as a sole proprietorship. It was only the obligations of Zazzara that petitioner contends were guaranteed.

Finally, petitioner argues the payments were not made under the guaranty agreement and he had no right of subrogation to American Guaranty's claims against KEY. He concludes that the losses sustained do not fall under section 6b, but rather are deductible under section 162 or section 165(c((2).

Respondent contends the payments made pursuant to the settlement agreement were made because of petitioner's obligation as a guarantor. Accordingly, they are deductible only under section 166 as bad debt losses. Respondent argues the debts were nonbusiness bad debts subject to the capital loss limitations of section 1211. Further, respondent argues that because petitioner guaranteed the debts of a corporation, section 166(f) is not applicable.

We think petitioner has misconstrued the applicable law. His motives for settling the lawsuits filed against him are irrelevant in characterizing the payments made in settlement of those lawsuits. In order to determine the deductibility of these payments, we must look to the origin of the claims settled, not at petitioner's primary purpose or motive for settling. Anchor Coupling Co. v. United States, 427 F.2d 429, 433 (7th Cir. 1970), cert. denied 401 U.S. 908 (1971); George Eisler, 59 T.C. 634, 639 (1973); Arthur H. DuGrenier, Inc., 58 T.C. 931, 937-938 (1972). This is the rule followed by the Ninth Circuit, to which an appeal from our decision herein will lie. DeMink v. United States, 448 F.2d 867 (9th Cir. 1971); Spangler v. Commissioner, 323 F.2d 913 (9th Cir. 1963). Consequently, petitioner's desire to avoid further litigation expenses is irrelevant to our decision. See Kimbell v. United States, 490 F.2d 203 (5th Cir. 1974), cert. denied 419 U.S. 833 (1974).

We realize that in determining the origin of the claims settled we are not restricted to only those claims stated in the pleadings of the lawsuits filed. Indeed, there may have been other claims which were settled by the parties. George Eisler, supra at 640. However, under our circumstances, we can find no actual or threatened claims by American Guaranty Corp. of California, American Guaranty Corp., or Harry Burton against petitioner other than those made against him as guarantor of the obligations of KEY. We think, therefore, that the payments in question should be characterized as payments made...