Appeals from the United States District Court for the Northern District of Illinois, Eastern Division. No. 91 C 3831 James B. Moran, Judge.
Before POSNER, Chief Judge, and ROVNER and EVANS, Circuit Judges.
The government appeals for the second time from the judgment in favor of the taxpayers in this tax refund suit. After we dismissed the government's initial appeal (along with the taxpayers' cross-appeal from the refusal of the district court to impose sanctions on the government for alleged discovery abuses) because the district judge had not entered a final, appealable judgment, specifying the amount of the refund due the taxpayers, Buchanan v. United States, No. 95-3057 (7th Cir. April 9, 1996) (per curiam), the judge repaired this deficiency and entered a new judgment, from which the government prosecutes a new appeal and the taxpayers a new cross-appeal. We said in our previous opinion that we would decide the new appeals without further briefing or argument.
The taxpayers claim to be entitled to deduct, from the federal income taxes that they paid in 1986 and 1987, a nonbusiness bad debt of $2.1 million that they say became completely worthless in 1986. If the claim has merit, as the district judge ruled on cross-motions for summary judgment, the taxpayers are entitled to a refund of more than half a million dollars.
The Internal Revenue Code allows the deduction of a nonbusiness debt that "becomes worthless within the taxable year," 26 U.S.C. sec. 166(d)(1)(B). The criterion of worthlessness is interpreted strictly: the deduction is unavailable if even a modest fraction of the debt can be recovered. Treas. Reg. sec. 1.166-5(a)(2) ("wholly worthless"); Bodzy v. Commissioner, 321 F.2d 331, 335 (5th Cir. 1963) ("last vestige of value" must have "disappeared"); Clanton v. Commissioner, 70 Tax Ct. Mem. Dec. (CCH) 534 (1995) ("partial worthlessness is insufficient"). The reason for this hard line is plain. Because people rarely make nonbusiness loans to strangers, or even to friends, the domain of the nonbusiness debt is limited largely to the family. (Not entirely: some nonbusiness bad debts result simply from uninsured deposits in financial institutions that go broke. See Rev. Rul. 71-577, 1971-2 Cum. Bull. 129.) Gifts and loans within the family are difficult to distinguish; so if nonbusiness loans could easily be written off to produce a tax savings, the potential for obtaining a tax deduction for gifts to members of one's family would be immense. See H.R. Rep. No. 2333, 77th Cong., 1st Sess., reprinted in 1942-2 Cum. Bull. 372, 408-09; 2 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts para. 33.6, p. 33-21 (2d ed. 1990).
The taxpayers in this case are Mr. and Mrs. Buchanan. Their daughter was married to the owner of a retail jewelry business that over the years had borrowed heavily from a bank. Mr. Buchanan had in effect guaranteed the loans by signing the promissory notes of the jewelry business as co-obligor and by backing his assumption of the obligation with a pledge of stock. He had even borrowed $300,000 from the bank himself to reloan to the business. In 1986 the bank learned that the jewelry business was on or over the brink of insolvency. It threatened to call Buchanan's guaranty and sell some of the stock that he had pledged as collateral. In response to this threat Buchanan gave the bank his personal note, payable on demand, for $2.1 million, which was the aggregate unpaid balance of the loans that he had guaranteed ($1.8 million) plus the loan ($.3 million) that he had obtained to relend to the jewelry business. The business later gave Buchanan its note, guaranteed by the son-in-law, for this amount.
The Buchanans argue that the $2.1 million debt of the jewelry business to Mr. Buchanan arose from a nonbusiness loan that was worthless on the day he gave the bank his personal note for that amount, June 30, 1986, because the business had by that date become insolvent. Yet in the following two years, 1987 and 1988, the Buchanans received $242,000 in interest and principal from the jewelry business in partial payment of the allegedly worthless debt. It seems they should not have received any of that money. Their daughter had died shortly before her father had executed his personal note to the bank. Her widower, the son-in-law, had become the trustee of his deceased wife's estate. He improperly siphoned assets of the estate into his failing business, where they were used to pay some of his creditors, including his former father-in-law. He improperly diverted payroll taxes to the same creditors. Without these improper infusions of capital into the failing jewelry business it is unlikely that the taxpayers would have received anything on their debt unless they had sued the jewelry business promptly in 1986 and obtained a judgment, putting them ahead of the business's other unsecured creditors.
Both the jewelry business and the son-in-law later declared bankruptcy. The taxpayers expect to obtain $45,000 from the estate in bankruptcy of the former and $20,000 from the estate in bankruptcy of the latter. Although the taxpayers have been forced to pay back, as a voidable preference, $68,000 of the $242,000 in interest and principal that they received from the jewelry business before it declared bankruptcy, it appears that they have already received $241,000 from the estates in bankruptcy of the jewelry business and the son-in-law. So it looks as if they will eventually recoup $480,000 ($45,000 $20,000 $242,000 /1 $68,000 $241,000) of the $2.1 million debt. We use weasel words ("it appears," "it looks as if") because the $480,000 figure is not firm, but is merely our best surmise from a confusing record. No matter. As will soon become clear, the case must be decided the same way whether the amount recovered by the Buchanans is $480,000 or $240,000.
The $2.1 million debt of the jewelry business to Buchanan was worthless on June 30, 1986, within the meaning of the applicable provision of the Internal Revenue Code, if on that date he had (1) no reasonable prospect, Kugel v. Ryan, 289 F.2d 329 (2d Cir. 1961); Oatman v. Commissioner, 45 Tax Ct. Mem. Dec. (CCH) 214 (1982), of recovering (2) a significant, though in the sense merely of nontrivial, fraction of this amount. Rev. Rul. 71-577, supra (more than "one or two cents on the dollar"); cf. Rodgers v. Commissioner, 49 Tax Ct. Mem. Dec. (CCH) 1434 (1985). Recovery of a trivial fraction of the debt would be unlikely to cover the costs of collection, while a miraculous, unforeseen, unforeseeable, totally unexpected recovery of part or even the whole of a debt properly written off as worthless years before -- the kind of recovery that might have occurred here if in 1990 the son-in-law had won first prize in the Illinois state lottery -- would be consistent with the debt's having properly been deemed worthless in the year it was written off. See Crown v. Commissioner, 77 T.C. 582, 598 (1981); Wolfson v. Commissioner, 45 Tax Ct. Mem. Dec. (CCH) 244 (1982). A judgment of worthlessness has an inescapable predictive element, and no prediction can attain metaphysical certainty.
The proposition that the recovery of a tiny amount of a debt, even if fully anticipated rather than completely unpredictable, will not defeat a finding of worthlessness is in only superficial tension with the language quoted earlier from the treasury regulation ("wholly worthless") and the cases. That language is not intended to be taken literally. Its purpose is to emphasize that a nonbusiness debt is not deductible merely because it has lost most of its value.
Neither condition for the deduction of a nonbusiness bad debt -- a merely trivial repayment, or a miraculous repayment -- was satisfied here (a third condition, that the debt be bona fide, we are assuming is satisfied); and so clear is this that the government was entitled to summary judgment. This is so even though we may assume that the $480,000 (or whatever) that the jewelry business paid Mr. Buchanan in partial repayment of the money that he had been forced to pay the bank to honor his personal note to the bank was the payment of a debt, and not just a gift. If it was the latter, then the $2.1 million was not a debt. The argument that the $480,000 was merely a gift runs as follows. The personal note that Buchanan gave the bank was actually a form of payment to the bank, discharging the obligations of the jewelry business as well as Buchanan's prior obligations as guarantor and borrower. If so, then the jewelry business owed Buchanan nothing until it executed its own note, which came after the jewelry business was bankrupt, making the note worthless when issued. We do not consider this a realistic reconstruction of the parties' relationship. It is more realistic to regard Buchanan's $2.1 million note to the bank as a confirmation of a preexisting debt of the jewelry business to him, a debt that had value because the jewelry business was not insolvent when the debt was incurred.
We may further assume that the debt was the consequence of a series of bona fide loans to the jewelry business, that when these loans were made (including the last loan, made directly to Buchanan but with the understanding that he was going to turn around and relend the proceeds to the jewelry business) the business was solvent, and that it became insolvent on or shortly before June 30, 1986. Of course a debt is not worthless merely because the debtor is insolvent. Secured creditors often recover the full amount of their debt from an insolvent debtor, and unsecured creditors often recover a significant fraction, at least, of what they are owed by such a debtor. So far as appears, had Mr. Buchanan, upon learning from the bank when it asked him to give it his personal note that it thought his son-in-law's business insolvent, acted promptly to obtain a judgment against the business, he would have recovered a substantial fraction of the $2.1 million that it owed him. He may have forborne because of the family relation. That is the very reason for interpreting "worthless" in the provision allowing the deduction of nonbusiness debts strictly, and for regarding the failure to pursue available realistic remedies as an indicator that the debt has some value (for that is implicit in saying the creditor had ...