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June 27, 1995


The opinion of the court was delivered by: JAMES B. MORAN

 Plaintiffs Gordon and Mary Buchanan brought this federal tax refund action alleging an overpayment of their joint tax return for 1986 and/or 1987 in the amount of $ 542,451. Plaintiffs claim that they are entitled to a deduction for those tax years under 26 U.S.C. § 166(d) for a nonbusiness bad debt. Plaintiffs and the defendant, the United States of America, have filed cross-motions for summary judgment. For the reasons set forth below, plaintiffs' motion is granted and the government's motion is denied.


 Plaintiffs' son-in-law, Stewart S. Peacock (Peacock) was the president and sole shareholder of a retail jewelry business called Spaulding & Company (Spaulding). For several years prior to 1986, Spaulding had taken out loans with the First National Bank of Chicago (First Chicago), which by mid-1986 totaled $ 1.8 million. Prior to June 1986, Spaulding and Gordon Buchanan (Gordon) were co-obligors of this debt. As collateral for Spaulding's loan, First Chicago held Gordon's 52,590 shares of Standard Oil of Ohio (Sohio).

 In May 1986, First Chicago became aware that Spaulding was experiencing financial difficulties. At that time Spaulding provided First Chicago with financial statements indicating that it was essentially insolvent. Concerned with this turn of events, First Chicago threatened to call the debt and sell Gordon's Sohio shares to pay off the loan unless Gordon agreed to become the sole obligor of the Spaulding indebtedness. Around that same time First Chicago rejected, for the first time, a loan request of Spaulding. Meanwhile, Sohio was the subject of rampant takeover rumors circulating the financial world. It seemed that British Petroleum might make a tender offer for the outstanding Sohio shares at a greatly inflated rate. Thus, by June 1986, Gordon either had to become the sole obligor of Spaulding's indebtedness or lose out on a substantial amount of money if and when British Petroleum made a tender offer.

 Not surprisingly, Gordon elected to become sole obligor of Spaulding's debt in June 1986. At that same time, Gordon tendered an additional 17,000 Sohio shares to secure a $ 300,000 loan from First Chicago, which funds he promptly turned over to Spaulding. On June 30, 1986, Gordon executed a promissory note of $ 2.1 million to First Chicago, a loan secured by the Sohio stock already in First Chicago's possession. Through this restructuring Spaulding was no longer obligated to First Chicago.

 Gordon was anxious to retain possession of his Sohio shares so that he could capitalize on the expected tender offer from British Petroleum. As a result, he borrowed $ 2.1 million from a brokerage house in April 1987, and paid off Spaulding's debt. First Chicago then released Gordon's Sohio shares. One month later Gordon sold his Sohio stock to British Petroleum in a public tender offer, which generated a capital gain in the amount of $ 4,834,465. Gordon repaid the brokerage house $ 2.1 million, as well as $ 14,000 in interest one month later.

 In June 1987, Spaulding first executed an installment note to Gordon in the amount of $ 2.1 million, plus interest, payable over a five-year period. Peacock guaranteed the installment note, pledging all his shares of Spaulding stock as collateral. Spaulding and Peacock also executed a security agreement giving Gordon a security interest in Spaulding's inventory, accounts receivable, and stock.

 Spaulding paid the required monthly payments to Gordon throughout the remainder of 1987 and up to August 1988. On November 21, 1988, Gordon filed an involuntary bankruptcy petition against Peacock and Spaulding. Subsequently, Gordon agreed to dismiss the petition after Spaulding turned over its inventory to him. On April 17, 1989, Spaulding filed a petition for voluntary bankruptcy. In this proceeding the bankruptcy court stripped Gordon of his secured status and ordered him to return Spaulding's payments made between May and August of 1988, finding that these actions were avoidable as preferences because Spaulding was insolvent at least by July 31, 1986. Gordon has since, in 1993 and 1994, recovered payments from both Peacock's and Spaulding's bankruptcy estates in the amount of $ 240,628, mostly from Peacock's bankruptcy estate, and may potentially recover about $ 65,000 more in the future.

 On December 23, 1988, and January 5, 1989, plaintiffs filed amended returns for the 1986 and 1987 tax years respectively, claiming additional deductions for nonbusiness bad debt. The Internal Revenue Service (IRS) denied plaintiffs' claims for both years.

 On June 21, 1991, plaintiffs filed this action for a federal tax refund for their joint tax returns for 1986 and 1987, claiming a deduction for a nonbusiness bad debt related to the Spaulding indebtedness. The government argues that plaintiffs are not entitled to the deduction under § 166 because they cannot prove the existence of a bona fide debt and, alternatively, because they cannot prove that that debt was completely worthless in either 1986 or 1987. Plaintiffs claim that the June 1986 restructuring of the Spaulding indebtedness created a debt from Spaulding to Gordon for $ 2.1 million and that this debt became worthless in either 1986 or 1987. The parties have filed cross-motions for summary judgment.


 A. Section 166(d)

 For plaintiffs to be successful in this refund action they must identify a specific section of the Internal Revenue Code granting them a deduction. Harco Holdings Co. v. United States, 977 F.2d 1027, 1037 (7th Cir. 1992) (holding that deductions are a matter of legislative grace). Plaintiffs claim that Gordon's financial dealings ...

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