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November 30, 1967


The opinion of the court was delivered by: Decker, District Judge.


This is an action arising under 28 U.S.C. § 1346(a)(1) for recovery of federal income taxes alleged to have been illegally assessed and collected. Plaintiff is a Delaware corporation engaged primarily in the construction of gas distribution facilities. At issue is the disallowance by the District Director of Internal Revenue of a "bad debt" deduction claimed by plaintiff in its federal income tax return for the 1956 fiscal year, that is, the year ending March 31, 1956. Plaintiff's claimed "bad debt" was the result of the inability of a company set up by plaintiff's sole stockholder and one of its officers to repay the major portion of monetary advances from plaintiff. Plaintiff claims that the advances were and should be regarded as loans, and the Government considers them to have been contributions to capital. Plaintiff thus asserts that the unpaid balance of the advances was deductible in full as a bad debt, while the Government argues that it was deductible only as a long-term capital loss to be offset against capital gains, of which plaintiff had none in this case.

The facts have been stipulated by the parties. Basically they are as follows: Plaintiff was incorporated in Delaware in 1949 under the name Consolidated Gas and Service Company. Its capital stock was owned entirely by John C. Donnelly, and its business was construction of gas distribution facilities. In 1954 a separate company, Northeastern Electric Construction Corporation (henceforth "Northeastern") was created, with Donnelly and Arthur Schmidt, an officer of plaintiff, as stockholders. Northeastern was set up to undertake electrical construction work for one of plaintiff's most important customers. The separate corporate entity was considered necessary because of certain rules of the electrical workers union which prevented the workers from being employed by companies not doing electrical work exclusively.

The initial capital of Northeastern was about $12,000. From the end of 1954 to March, 1956 plaintiff made advances of over $300,000 to or on behalf of Northeastern primarily for operating expenses. These advances were carried as accounts receivable by plaintiff, and no written evidences of indebtedness were given, no interest or maturity date was agreed upon, and no security was provided. Despite the advances, Northeastern incurred serious losses from its inception. In March, 1956 it was decided to merge the two companies into one, the present plaintiff known as Northeastern Consolidated Company.

As part of the merger effected in 1956, Northeastern's own net operating loss, which totaled about $187,000 at the time of the merger, was made available to plaintiff to be offset against its taxable income under the provisions of 26 U.S.C. § 381(a) and (c). Plaintiff claimed and was allowed deductions by virtue of this for 1959, 1960, and 1961, in an aggregate amount of about $85,000.

Although plaintiff's complaint in this case seeks recovery of substantial amounts for 1954, 1955, and 1956, plaintiff now concedes that the stipulations and briefs show that plaintiff's possible recovery is limited to the following:

  1954          $10.75
  1955           56,784.95
  1956                0

Plaintiff also seeks the amounts of interest made applicable by statute if it should recover. The above amount of $10.75 for 1954 is what remains after the effects of the statute of limitations for that year are recognized. The original amount for 1955 was reduced, and the amount for 1956 eliminated, by refund payments already made to plaintiff for those years on grounds distinct from those asserted by plaintiff at present. Although nothing is now sought to be recovered for 1956, the central issue in the case is, nevertheless, the bad debt deduction claimed for that year, with its carryback effects to 1955 and 1954.

The Government's assertion that the advances in question were contributions to capital, rather than loans, must be considered first, for if it is meritorious, there is no need to consider the other arguments raised by the parties. It is clear in this Circuit that the burden is upon the taxpayer in a case such as this to prove that the advances were loans rather than capital contributions. In Arlington Park Jockey Club, Inc. v. Sauber, 262 F.2d 902 (7th Cir. 1959), the court said,

  "In determining whether the cash payments * * *
  represented loans or additional capital investment,
  no single test can provide the answer. The burden of
  establishing that the advances were loans is upon the
  taxpayers." [Citations omitted.] Id. at 905.

There are many cases such as this which indicate that the taxpayer has the burden of proving that he is entitled to a bad debt deduction. United States v. Henderson, 375 F.2d 36 (5 Cir. 1967); Moughon v. Commissioner of Internal Revenue, 329 F.2d 399 (6th Cir. 1964); Baumann & Co. v. Commissioner of Internal Revenue, 312 F.2d 557 (2d Cir. 1963); Bair v. Commissioner of Internal Revenue, 199 F.2d 589 (2d Cir. 1952).

The cases also make it clear that where closely held corporations are involved, each element of the dealings between them will be closely scrutinized to determine whether advances made by one to the other are to be treated as loans. As was summarized in Arlington Park Jockey Club,

  "the courts have laid down rather stringent tests to
  determine whether advances to closely held
  corporations may be treated as loans for tax
  purposes. This court said in Commissioner of Internal
  Revenue v. Meridian & ...

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