United States District Court, Northern District of Illinois, E.D
November 30, 1967
NORTHEASTERN CONSOLIDATED COMPANY, PLAINTIFF,
UNITED STATES OF AMERICA, DEFENDANT.
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.
The merger was undertaken as a statutory merger under Delaware
law and included a transfer of Northeastern's assets to
plaintiff. Plaintiff's advances to Northeastern were left
unreimbursed after the transfer in the amount of $199,791.09.
This amount, the remainder of
what plaintiff characterizes as the total "debt," was cancelled
on plaintiff's books; plaintiff then claimed it as a worthless
debt and deducted it from taxable income for the year ending
March 31, 1956. The Internal Revenue Service first allowed the
deduction, including the carryback of plaintiff's resultant 1956
net operating loss to 1955 and 1954, but then the Service
subsequently disallowed it and assessed a deficiency. Plaintiff
paid the deficiency and unsuccessfully filed claims for refund.
Those claims were denied, and plaintiff now seeks a refund
through this suit.
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
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:
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
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 & Thirteenth Realty Co., 7 Cir.,
132 F.2d 182, 186 :
`* * * the essential difference between a creditor
and a stockholder is that the latter intends to
make an investment and take the risks of the
venture, while the former seeks a definite
obligation, payable in any event.'
"In such cases, courts have stressed various factors
such as the debt-equity ratio; the use to which the
funds were put; whether outside investors would make
such advances and lack of reasonable expectation of
repayment." Id. at 905.
Very similar statements appear in United States v. Henderson,
supra, and Moughon v. Commissioner of Internal Revenue, supra.
While realizing that the factual elements establishing a bona
fide debt may vary in different cases, the courts and the tax
authorities nevertheless have attempted to formulate and adhere
to a general definition. In order for plaintiff to carry his
burden in the present case, it must show that the advances it
made to Northeastern fall within the definition. As indicated in
the quotation above, the Court of Appeals for the Seventh Circuit
early stated that a loan essentially involves "a definite
obligation, payable in any event." In a more recent decision,
that court referred to "the classic criteria of a bona fide debt
set out in Gilbert v. Commissioner of Internal Revenue,
248 F.2d 399 (2d Cir. 1957)." Sherwood Memorial Gardens, Inc. v.
Commissioner of Internal Revenue, 350 F.2d 225, 228 (7th Cir.
1965). In Gilbert, it was said,
"The classic debt is an unqualified obligation to pay
a sum certain at a reasonably close fixed maturity
date along with a fixed percentage in interest
payable regardless of the debtor's income or lack
thereof. While some variation from this formula is
not fatal to the taxpayer's effort to have the
advance treated as a debt for tax purposes, too great
a variation will of course preclude such treatment."
[Citations omitted.] 248 F.2d 402-403.
The essence of a debt for tax purposes has been more succinctly
characterized in this way:
"The important underlying principle is that no valid
debt exists unless there is an unconditional
obligation of another to pay the taxpayer." 5
Mertens, Law of Federal Income Taxation § 30.03. See
Treas. Reg. § 1.166-1(c) (1967).
These statements indicate that the various aspects of the
advances made by plaintiff must be examined here in detail in
order to see whether they constituted an unconditional obligation
upon Northeastern to repay the amounts obtained from plaintiff.
On the facts before me I cannot find that plaintiff has proved
the existence of such an obligation. In a number of respects it
appears clear to me that the intention of plaintiff, and the
practical, business significance of the advances, demonstrate
that the advances were contributions to the capital of
Northeastern. First of all, the heavy preponderance of "debt" to
equity in the financial structure of Northeastern during its
brief existence suggests that the advances were not regarded by
plaintiff as loans and should not be considered as such now. This
preponderance is not determinative, but it does seem that with
operating capital of only $12,000, the advances of over $300,000
which were used for operating expenses were necessary capital of
the sort ordinarily provided by the creation of equity interests.
Further suggesting this is, of course, the absence of any
provisions for interest, fixed maturity, or security in relation
to the advances. The only relevant formalities gone into were
entry of the advances as accounts payable on Northeastern's books
and as accounts receivable on plaintiff's.
Additionally it seems evident that the repayment of the
advances rested solely upon the success of Northeastern's
venture. There apparently were no other resources of significant
size held by Northeastern out of which plaintiff could have
secured repayment had the venture failed, and this apparently was
evident to all parties at the outset. That this consideration,
and the preponderance of debt over equity, can be taken as
indicative of an intention that the advances were to be capital
investments rather than loans is suggested by the discussion
in American Processing and Sales Company v. United States,
371 F.2d 842 (Ct. Cl. 1967). That case is relied upon strongly by
plaintiff here, but it is not persuasive authority in its favor.
The Court of Claims in that case plainly takes the approach,
which I have already discussed, of considering each case on its
"[I]n the final analysis each case must rest and be
decided upon its own unique factual flavor,
dissimilar from all others, for the intention to
create a debt is a compound of many diverse external
elements pointing in the end to what is essentially a
subjective conclusion." Id. at 848.
The court also adopts the type of general definition of debt
which I have examined. The opinion discusses a number of cases
related to the questions in the present case and concludes that
the advances there involved were loans and not contributions to
capital, "as a matter of `substantial economic reality.'" That
reality is lacking here.
It seems to me that in American Processing and in the other
case plaintiff chiefly relies upon, Byerlite Corporation v.
Williams, 286 F.2d 285 (6th Cir. 1960), the courts are taking a
pragmatic view of the business transactions involved and are
concluding that bona fide lending does take place when there are
open account advances and "credits against the advances [are]
made in the form of delivered materials." 371 F.2d at 855. In
other words, each of those cases relates to an instance in which
"the open account * * * was the product of credits and debits
resulting from mutually advantageous trading." Id. at 854. The
present case does not involve this common form of mutually
offsetting business dealings based on continuing credit and
intermittent, but assured repayment. The court in American
Processing explicitly recognized that the result on the facts
before it probably had to be different from the result in a case
like the present one. The court said that a debit balance
resulting from mutually advantageous trading activities,
"assumes a different complexion than had it been
solely cash advances, for the latter would be more
amenable to construction as capital contributions."
The present case, of course, involves "solely cash advances,"
with no repayment, credits, or reciprocal trade dealings at all.
In further support of the Government's contention that the
advances were risk capital are the plaintiff's repeated
assertions in its briefs that the activities of Northeastern were
really parts of plaintiff's own business, and that they were not
a separate corporate venture. Plaintiff apparently has made and
reiterated this point in order to indicate that there was no
intention present to invest in a separate venture, that is, in
the risks of a new corporate enterprise. A more significant
effect of plaintiff's argument, however, is that the advances to
Northeastern in fact were considered additional investments in
plaintiff's own business, or at least in a new branch of it,
with all the same risks attendant upon the stockholder's and
officers' investment of capital and effort in plaintiff itself.
As one of plaintiff's officers indicated in his deposition, the
understanding was that the advances would be repaid out of
profits made by Northeastern at a future time. This is more
plausibly the attitude of an investor than of a lender.
As one further consideration, it may be asked whether
Northeastern could have obtained cash in the amount of $300,000
in total from any other sources on the same sort of terms, or
absence of terms, as it received from plaintiff. I think it is
highly unlikely that that could have been done, especially after
it apparently was clear within a few months that Northeastern was
not making money.
On the basis of these various factual considerations, it is my
conclusion that no bona fide debt was created by plaintiff when
it made the advances to Northeastern, but rather plaintiff was
contributing to the capital of Northeastern. Consequently,
plaintiff was not entitled to a bad debt deduction for 1956.
Plaintiff urges, however, that even if the deduction was not
allowable as a bad debt under § 166, it nevertheless was
allowable as a business expense under § 162. This argument is
without merit inasmuch as plaintiff was definitely not in the
business of making advances to other companies. Plaintiff, as a
separate corporate taxpayer, was not even in the business of
constructing electrical facilities, as is indicated by the fact
that the actual operating expenses incurred through use of the
advances were deducted by Northeastern as its own expenses and
not by plaintiff. Plaintiff has not met the burden it assumed of
proving that the advances were ordinary and necessary business
expenses. See Interstate Transit Lines v. Commissioner of
Internal Revenue, 319 U.S. 590, 63 S.Ct. 1279, 87 L.Ed. 1607
Plaintiff's final argument is that it is entitled to the
deduction as a business loss by virtue of § 165 of the Internal
Revenue Code. This argument also is not persuasive. In the first
place, it is not clear that plaintiff's failure to obtain
reimbursement of the advances constitutes a "loss" within the
meaning of § 165. Rather it appears that plaintiff has
experienced a "failure of profit or the loss of potential income"
on its investment in Northeastern. 5 Mertens, Law of Federal
Income Taxation § 28.12, p. 33. If this is so, plaintiff is not
entitled to any sort of benefit at all from § 165. Secondly,
whatever actual loss has been suffered by plaintiff can be
considered a capital loss. It is true that no "sale or exchange"
appears to have taken place with regard to plaintiff's
unreimbursed interest in Northeastern; nevertheless, under the
terms of § 165(g) plaintiff's "loss" can receive only the
treatment accorded a capital loss. This result is compelled by
the case of Kalech v. Commissioner of Internal Revenue, 23 T.C. 672
(1955), in which a taxpayer's advances to a corporation were
held to be capital contributions rather than loans. See 5
Mertens, id. at § 28.38, p. 159. Section 165(g) now provides
that any loss that results when a security which is a capital
asset becomes worthless shall be treated as a loss from a "sale
or exchange" of a capital asset. In Kalech the court considered
the predecessor to § 165(g) and said, "Securities, as defined by
that section, include not only actual shares of a corporation but
the `rights to subscribe for or to receive such shares,' which is
what petitioner here had by virtue of his advances to the
corporation." Id. at 681. The present definition of "securities"
includes a similar reference to "a right to subscribe for, or to
receive, a share of stock in a corporation. This would seem
applicable, by the reasoning in Kalech, to the plaintiff's
interest in Northeastern as a result of its capital investment by
means of the advances. Thus the only possible loss deduction
available for plaintiff would be a long term capital loss, which
would not entitle it to a refund in the present case.
As an additional, alternative ground for the decision of this
case, it must be said that plaintiff is attempting here to obtain
to some extent double deductions for a single economic loss. As I
have already noted, plaintiff was allowed to benefit from
Northeastern's net operating loss; plaintiff took deductions
aggregating approximately $85,000 in its tax returns for 1959,
1960 and 1961 in this respect. The case of Marwais Steel Company
v. Commissioner of Internal Revenue, 354 F.2d 997 (9th Cir.
1965), cited by the Government, clearly indicates that double
deductions in a case such as this will not be permitted.
The Government does acknowledge that plaintiff only got $85,000
worth of deductions by reason of Northeastern's net operating
loss of over $187,000. Plaintiff contends that this discrepancy
nullifies the double deductions argument. In answer the
Government presents what appears to be a theory that the
plaintiff has made some sort of implied waiver of the various
deduction arguments it now makes. The Government says, "The point
is that the net operating loss carryover was the one claimed by
the plaintiff." I am not convinced that this waiver conception is
correct, but it is in any
event not necessary for me to decide the point now. The plaintiff
has failed to show that it is entitled to the 1956 deduction and
the carrybacks on any ground; consequently it is entitled to no
refund at all. If plaintiff had shown some basis for refund,
perhaps the double deductions argument would require a scaling
down of the recovery, even if not a total preclusion of recovery.
On the facts before me, however, I find that no refunds at all
For the foregoing reasons, I have on this day entered judgment
in favor of the defendant and against the plaintiff, with costs
to be assessed against the plaintiff.
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