Petition — Casco Bank & Trust Co. v. United States

_ Supreme Court, U. 3,

~~ FILED 3§

DEC 20 1976

MICHAEL RODAK, JR., CLERK

In the :

Supreme Court of the United States

Ocroser TERM, 1976

wn. 86-843

CASCO BANK & TRUST CO. and

RITA B. PRESTON, CO-EXECUTOR and

CO-EXECUTRIX OF THE ESTATE OF

WILLIAM A. PRESTON, JR.,

PETITIONERS,

v.

UNITED STATES,

RESPONDENT.

PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPZALS

FOR THE FIRST CIRCUIT

Rocser A. Putnam

Two Canal Plaza

Portland, Maine 04112

Counsel for Petitioners

Vereiit, Dana, PHrsricg,

Putnam & WruiAMsoNn

Of Counsel

December 17, 1976

_—— ———————————————————————— __________________

Blanchard Press, Inc., Boston, Mass. — Law Printers

INDEX

Page

I PU Mice ath, Vk Cha wierd e Co. dWERO YS. . Si. 2

td a sn wie Mabey ol 2

I ad pai. ded eV va Sd 2

Statutes and Regulations Involved ........... oes VO 2

i ad ele, Se eek a’ ce 2

Reasons for Granting the Writ .................... 6

A. The Court of Appeals’ Decision Herein Aban-

dons the Principle That Guarantors’ Losses Are

To Be Treated as Bad Debt Losses Under I.R.C.

§166 and Conflicts with the Decision of This

Court in Putnam v. Commissioner, 352 U.S. 82

EL. kv cawcacnid Coa Oe weeds AN We bef 6

B. The Decision of the Court of Appeals Herein Is

Inconsistent with Decisions of Other Circuits .. 8

ee Gite BY EVO See.) od 84a ee eu. sk ISN 13

Appendix:

Opinion of the Court for the District of Maine, dated

Be I ee LD, iba st esi) tees 14

Opinion of the Court of Appeals for the First Circuit,

dated September 21, 1975 ........................ 22

Statutes and Regulations Involved ................ 36

CrTaTIONS

Cases

Ackerson v. United States, 277 F. Supp. 475 (W.D. Ky.

ERIS a ey nacre arene ery ar eh ear a HE Pe 12

Ambassador Apartments, Inc. v. Commissioner, 406

- bf F. . eer rc ee mre re 10

A.R. Lantz Company v. United States, 424 F.2d 1330

CI rg rk cociy bre a hae al 10, 11

ii Index

Page

Baum vy. United States, 326 F. Supp. 32 (E.D. Wis.

SSI RR IRA eig Sra Ran Cee SoC Che yes SCRE sae ne 9

Bert W. Martin, 52 T.C. 140, aff’d, 424 F.2d 1368 (9th

oe. errs ee ee ee ei 9

Estate of Mixon v. United States, 464 F.2d 394 (5th Cir.

SE cw wi ssc clad aReO de wee Ree Wded Sub aes 11

French v. United States, 487 F.2d 1246 (1st Cir. 1973)

9,11

Horne v. Commissioner, 59 T.C. 319 (1972), aff’d, 523

OB EE es ee 7, 9

In re Uneco Inc., 532 F.2d 1204 (8th Cir. 1976)... 10

J. Paul Smyers, 57 T.C. 189 (1971) ........... ie. %

JS. Biritz Construction Company v. Commissioner,

387 F.2d 451 (8th Cir. 1967) .................... 10

Murphy Logging Company v. United States, 378 F.2d

SD A, Geol, seaw. Riahkew Sasa). 12

Piantation Patterns, Inc. v. Commissioner, 462 F.2d 712

(5th Cir. 1972), cert. denied, 409 U.S. 1976. ...... 11,12

Putnam v. Commissioner, 352 U.S. 82 (1956) .... 6, 7, 8, 9

Raymond vy. United States, 511 F.2d 185 (6th Cir. 1975)

10

Santa Anita Consolidated, 50 T.C. 526 (1968) ........ 12

Stratmore v. United States, 420 F.2d 461 (3rd Cir.

1970), cert. denied, 389 U.S. 951 ................ 9, 12

United States v. Generes, 405 U.S. 93 (1972) ........ is)

United States v. Hoffman, 423 F.2d 1217 (9th Cir.

NS eee a Rae a-daec aes xe cee eee 10

Statutes

Internal Revenue Code §165, 26 U.S.C. §165. .... 2, 12

Internal Revenue Code $166, 26 U.S.C. §166.

2, 7, 9, 11, 12, 13

Index iii

Regulations

Page

Treasury Regulations §1.166-1(c), 26 C.F.R. §1.166-

RE Du cub Fk bed alae s an aka bees EONS e 0 oon 46% 2

Miscellaneous

Bitrxer & Evstice, Feperan Income TaxaTION OF

CokPoRATIONS AND SHAREHOLDERS, (3d ed. 1971) .... 10

Note, Toward New Modes of Tax Decisionmaking —

The Debt-Equity Imbroglio and Dislocation in Taa

Lawmaking, 83 Harv. L. Rev. 1965 (1970) ........ 10

dnt the

Supreme Court of the United States

Ocroser Term, 1976

No. 76-

CASCO BANK & TRUST CO. and

RITA B. PRESTON, CO-EXECUTOR and

CO-EXECUTRIX OF THE ESTATE OF

WILLIAM A. PRESTON, JR.,

PETITIONERS,

v.

UNITED STATES,

RESPONDENT.

PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS

FOR THE FIRST CIRCUIT

Petitioners, Casco Bank & Trust Company and Rita B.

Preston, Plaintiffs - Appellants below, pray that a writ of

certiorari issue to review the judgment and opinion of the

United States Court of Appeals for the First Circuit

which was entered on September 21, 1976.

2

Opinions Below

The opinion of the District Court for the District of

Maine on the issue raised in this Petition is not officially

reported, but it is unofficially reported at 75-1 U.S. Tax

Cases (CCH) 99290 (1975) and is reproduced at pp. 14-21 of

the Appendix hereto (App.). The opinion of the Court of

Appeals (App. pp. 22-35) has not yet been officially re-

ported.

Jurisdiction

The decision of the First Circuit, affirming the decision

of the District Court, was entered on September 21, 1976.

This Court’s jurisdiction is invoked pursuant to 28 U.S.C.

§1254(1).

Question Presented

Whether, notwithstanding this Court’s decision in Put-

nam v. Commissioner, 352 U.S. 82 (1956), losses sustained

by a shareholder-indemnitor in discharging indemnified

corporate obligations may be treated as contributions to

capital under I.R.C. §165 rather than as bad debt losses un-

der I.R.C. $166.

Statutes and Regulations Involved

The following statutes and regulations are involved: In-

ternal Revenue Code §§165, 166, 26 U.S.C. §§165, 166;

Treasury Regulation §1.166-1(c), 26 C.F.R. §1.166-1(c). The

text of pertinent parts of the statutes and the regulation is

set forth at pp. 36-38 in the Appendix hereto.

Statement of the Case

This is an action brought by petitioners Casco Bank &

Trust Company and Rita B. Preston, as co-executor and

3

co-executrix of the estate of William A. Preston, to recover

payment of a deficiency of $57, 431. 57 in tax and interest

assessed against them by the Commissioner of Internal

Revenue for the calendar year 1968. The facts of the case

may be summarized briefly.

William A. Preston, the decedent, had been engaged in

the construction business since his discharge from military

service in 1946. In 1948, he formed a partnership with

William E. Maloney, Jr. and the business was conducted

under the name Maloney & Preston. When the partnership

was dissolved in 1964, Preston operated Maloney & Pres-

ton as a sole proprietorship, specializing in the construc-

tion of public facilities. In June 1968, Preston incorporated

the business and contributed $20,000 in capital investment

and $13,752 worth of equipment. Preston was issued fifty-

one shares of stock, his wife and attorney one share each.

From 1968 to 1971, both Mr. and Mrs. Preston were em-

ployed by Maloney & Preston, Inc. on a full-time basis and

their compensation from the corporation constituted their

sole source of livelihood.

To pursue the business of constructing public facilities,

Maloney & Preston, Inc. was required to post bid and

performance bonds. When Maloney & Preston was incor-

porated in 1968, the Maine Bonding and Casualty Com-

pany required Preston and his wife to sign an indemnity

agreement before any bonds would be issued to the new

corporation. The agreement provided, in essence, that

Maine Bonding would issue bid and performance bonds

to the corporation, but if the corporation defaulted on its

obligations, the bonding company would be indemnified by

the Prestons in their individual capacities for any losses.

In 1970 and 1971, unforeseen complications arose on the

corporation’s major construction projects. By the summer

of 1971, the corporation had defaulted on many of its

obligations. The bonding company learned of the situation

ee

4

and a meeting was held with Preston, his attorney, a claims

adjuster from the bonding company, the vice-president of

the bonding company, and the company’s attorney. The

parties arrived at the ‘‘general understanding’’ that Pres-

ton would undertake the various outstanding obligations,

which he did by advancing $105,807.46 to the corporation.

The corporation met most of its obligations and was dis-

solved by judicial process in 1971. The Prestons applied

for and received unemployment compensation.

In their 1971 personal federal income tax return, the

Prestons claimed a deduction for a business bad debt of

$105,807.46 and a loss on the worthlessness of section 1244

corporate stock in the amount of $33,752.00. The Prestons

also filed an application for tentative carryback adjustment

based on the unused portion of the claimed 1971 operating

loss, requesting a decrease in their federal income tax for

1968 in the amount of $52,023.93. The Commissioner refun-

ded this amount with interest, but later reversed this action

and assessed a deficiency of $57,431.57, taxes and interest,

which was paid. Plaintiffs brought this action to recover

that amount.

Under the statutory scheme of the Internal Revenue

Code, if Preston’s advances are characterized contributions

to capital, the amount of the advances would be added to

the basis of his stock. Loss®3 from these transactions, recog-

nized upon the stock’s becoming worthless, would ordinarily

be deductible only as capita’ losses. LR.C. §165(f) and (g).

If, however, the advances were debts due Preston from

the corporation, they would be deductible as bad debt losses.

I.R.C. §166. The tax treatment of these bad debt losses

would follow from the determination not reached by the

courts below that the debts were either business bad debts

(deductible in full from ordinary income) or nonbusiness

bad debts (deductible as short-term capital losses).

5

On March 31, 1975, trial was held before a jury which

found in special interrogatories that Preston’s advances to

the corporation created a bona fide indebtedness from the

corporation to Preston, and that Preston’s dominant moti-

vation in making the advancement was to further and to

protect his business and salary as an employee of the corp-

oration. Upon motion by the defendant, however, the Dis-

trict Judge entered judgment n.o.v. In setting aside the

jury verdict, the District Judge disregarded the effect of

the indemnity agreement on the transactions at issue and

surveyed a number of different factors to hold that there

were no ‘‘indicia of debt’’ sufficient to enable a reasonable

person to conclude that the advances made by Preston

were loans rather than contributions to capital. (App.

pp. 17-19) Entry of final judgment was deferred until No-

vember 18, 1975 when judgment was entered on another is-

sue in the same case involving deductions for losses on the

worthlessness of §1244 stock, an issue not raised in this

petition.

On September 21, 1976, the United States Court

of Appeals for the First Circuit affirmed the District

Court’s decision. The Court of Appeals stated that although

the District Court had properly looked to several factors

in characterizing Preston’s advances to the corporation as

debt or equity, the District Judge should not have disre-

garded the effect of the indemnity agreement on the trans-

actions. (App. p. 31) The Court of Appeals nonetheless

affirmed the District Court on the ground that no debtor-

creditor relationship had been created between the corpo-

ration and Preston either at the time of entering into the

indemnity agreement or when the advances were made.

(App. pp. 31-32) Although the Court of Appeals conceded

that a bona fide debt might have been created if Preston

had loaned money to the corporation at the time he signed

the indemnity agreement (App. p. 31), the Court reas-

6

oned that the indemnity agreement made it possible for

the corporation to obtain bonds which would have been

available only if the corporation had been more heavily

capitalized (App. pp. 32-33), and therefore Preston’s un-

dertaking the indemnity agreement and the performance

of obligations thereunder were in the nature of contribu-

tions to capital.

Reasons for Granting the Writ

A. THe Court og Appgats’ Decision Herein A3aNDONS

THE PrixcirLe {Har Guarantor’s Losses ARE To BE

Treatep as Bap Desr Losses Unper I.R.C. §166 anp

ConFLICTS WITH THE Decision or Tus Court in Put-

nam v. Commissioner, 352 U.S. 82 (1956).

Although the District Judge explicitly disregarded the

effect of the pre-existing indemnity agreement on Preston’s

advances to the corporation, the Court of Appeals recog-

nized that Preston made the advances to discharge his

obligations under the indemnity agreement:

Thus, whether or not the advances to M&P were tech-

nically in discharge of his obligations under the indem-

nity agreement, Preston had to pay; his only choice

was as to the form and timing of the payment. It seems

unrealistic, therefore, to view the advances in isola-

tion from the indemnity agreement which compelled

them. (App. p. 31)

Since Preston’s losses were sustained as a direct result of

his payments under the indemnity agreement, this Court’s

decision in Putnam v. Commissioner, 352 U.S. 82 (1956),

is fully applicable to this case. In Putnam, this Court held

that ‘‘the loss sustained by the guarantor unable to recover

7

from the debtor is by its very nature a loss from the worth-

lessness of a debt.’’ 352 U.S. at 85. Noting that administra-

tive and judicial constructions of the Internal Revenue

Code ‘‘have always treated guarantors’ losses as bad debt

losses’’ (352 U.S. at 86), this Court held that these losses

are to be regarded as bad debt losses, deductible as such

or not at all. 352 U.S. at 88.

The Court of Appeals, however, declined to follow the

rationale of Putnam. The Court of Appeals took the view

that no debtor-creditor relationship could have been created

between Preston and the corporation at the time the in-

demnity agreement was signed because Preston would be

expected to pay only upon the default of Maloney & Preston,

Inc. The Court of Appeals therefore concluded that Pres-

ton’s rights, through subrogation or otherwise, would be

more theoretical than real. (App. p. 32) This approach

was explicitly rejected in Putnam. It is indisputable that

the corporation’s relationship to the bonding company was

a debtor-creditor relationship upon default. The funda-

mental principle of Putnam was that the debtor-creditor

relationship is preserved when the guarantor, upon pay-

ment, is substituted for the creditor. 352 U.S. 88-89. See

also Horne v. Commissioner, 523 F.2d 1363, 1365 (9th Cir.

1975).

The Court of Appeals also declined to follow Putnam on

the ground that this Court was not called upon in that case

‘*to distinguish, as we are here, between a business (i.e.,

fully deductible) debt and an advance in the nature of a

capital contribution.’’ (App. p. 33) The Court of Ap-

peals therefore abandoned the approach of Putnam and

concluded that Preston’s advances were deductible only

under I.R.C. §165 rather than under I.R.C. 4166. In fact,

however, neither the District Judge nor the Court of Ap-

peals reached the issue of whether Preston’s losses were

business bad debts (fully deductible) or nonbusiness bad

8

debts (short-term capital loss). Putnam, in short, was dis-

tinguished on the strength of an issue that neither the Court

of Appeals nor the District Judge decided.

Most significantly, however, the decision of the Court of

Appeals represents an interpretation of the statutory

scheme in direct conflict with Putnam. Putnam held con-

clusively that guarantors’ losses were to be treated as bad

debt losses, ‘‘deductible as such or not at all.’’ 352 U.S. at

88. The approach of Putnam thus ensures common treat-

ment of guarantors’ losses as bad debt losses, and the

statutory scheme allows either a full deduction or a short-

term capital loss, depending on the circumstances of the

debt. In the twenty years since Putnam was decided, Cong-

ress has taken no steps to modify this interpretation of the

objectives of the statute. In fact, §23(k) (4) of the 1939

Internal Revenue Code exists materially unchanged in the

present I.R.C. §166(d). The Court of Appeals, however,

departing from the statutory interpretation of this Court

in Putnam, has adopted a debt-equity analysis under I.R.C.

§165 with no discernible standards to guide taxpayers and

courts in the future. Nothing in Putnam or in legislative

action prompts this new exception to the principle that ‘‘the

loss sustained by the guarantor unable to recover from the

debtor is by its very nature a loss from the worthlessness

of a debt.’’ 352 U.S. at 85. If the principles of Putnam are

to be abandoned, guidance should come from this Court or

from Congress.

B. Tue Decision or THE Court or Appgeats Herern Is

INCONSISTENT WITH Decisions or OrHer Crrcvults.

Following the decision in the Putnam case, the lower

courts have had little difficulty in confining guarantors’

losses to bad debt loss treatment under I.R.C. 4166. In recent

decisions, federal courts have consistently followed the

9

holding of Putnam that a guarantor’s loss is by its very

nature a bad debt loss, and have refused to permit taxpay-

ers to avoid the operation of L.R.C. §166. See, e.g., Horne

v. Commissioner, 59 T.C. 319 (1972), aff’d, 523 F.2d 1363

(9th Cir. 1975) ; Bert W. Martin, 52 T.C. 140, aff’d, 424 F.2d

1368 (9th Cir. 1970) ; Baum v. United States, 326 F. Supp. 32

(E.D. Wis. 1971). Having established in Putnam that guar-

antors’ losses must be deducted under I.R.C. §166 or not at

all, this Court, in a case involving an indemnitor’s losses on

bid and performance bonds identical to those in this case,

adopted a rigorous standard designed to preserve the

objective of I.R.C. §166 that nonbusiness bad debt losses

receive short-term capital loss treatment. United States v.

Generes, 405 U.S. 93 (1972); see French v. United States,

487 F.2d 1246 (1st Cir. 1973). The statutory consistency of

the Putnam and Generes standards has resulted in impor-

tant practical benefits in the form of a workable and certain

guideline for the trier of fact and a uniform approach to

the tax treatment of guarantors’ losses throughout the

circuits. The decision of the Court of Appeals, however,

represents a significant departure from these principles in

favor of an undefined and confusing standard suggested

neither by the decisions of this Court nor by congressional

action.

The argument that guarantors’ losses should be treated

as contributions to capital under a debt-equity analysis

rather than bad debt losses under Putnam was advanced

and later withdrawn by the Government in Stratmore v.

United States, 420 F.2d 461 (3rd Cir. 1970), cert. denied,

389 U.S. 951. The Court there followed Putnam in accepting

the Government’s contention that I.R.C. §166 applied not

only to debts created by direct loans, but also to those cre-

ated ‘‘by an indirect indorsement or other type of arrange-

ment which creates secondary or primary liability on the

10

part of a corporate stockholder ... .’’ 420 F.2d at 464. See

also United States v. Hoffman, 423 F.2d 1217 (9th Cir.

1970). In contrast to the consistency and certainty of the

approach of the Stratmore Court under Putnam, the Court

of Appeals in the instant case has adopted a ‘‘debt-equity’’

analysis which defines no realistic guidelines for voluntary

tax reporting or for litigation in disputed cases. The effect

of the decision of the Court of Appeals is clearly to lead a

settled point of tax law into an area in which there is little

consensus indeed. The District Judge, relying on Raymond

v. United States, 511 F.2d 185 (6th Cir. 1975), surveyed

eight different factors to determine whether Preston’s los-

ses were ‘‘debt’’ or ‘‘equity’’. The Court of Appeals for

the Ninth Cireuit, for example, has considered eleven

items. A.R. Lantz Company v. United States, 424 F.2d 1330

(9th Cir. 1970). In recent decisions, there has been uncer-

tainty on the weight to be accorded a particular criterion.

Compare J.S. Biritz Construction Company v. Commis-

stoner, 387 F.2d 451 (8th Cir. 1967) (tax avoidance motive

is a significant factor) with Ambassador Apartments, Inc.

v. Commissioner, 406 F.2d 288 (2d Cir. 1969) (refusing to

follow Biritz) and In re Uneco, Inc., 532 F.2d 1204 (8th Cir.

1976) (reversing the District Court and clarifying Biritz).

As the leading commentators have observed:

The definitional turmoil at every level of debt-equity

classification probably explains Congress’s 1969 deci-

sion to enact §385 .. ., which authorizes the Treasury

to blanket the area with regulations. Brrrxer & Evs-

TICE, FepERAL INcoME TAXATION OF CORPORATIONS AND

SHAREHOLDERS, [4.02 (3d ed. 1971).

As the Court of Appeals noted, however, regulations have

yet to be promulgated. (App. p. 34 n.9) See also Note, To-

ward New Modes of Tax Decisionmaking — The Debt-

11

Equity Imbroglio and Dislocation in Tax Lawmaking, 83

Harv. L. Rev. 1965 (1970). The uncertainty is further re-

flected in differing approaches to the scope of review on

appeal. Compare Estate of Mixon v. United States, 464 F.2d

394 (5th Cir. 1972) with A.R. Lantz Company v. United

States, 424 F.2d 1330 (9th Cir. 1970).

The decision of the Court of Appeals, while leading cases

previously governed by Putnam and Generes into this

uncertain area, provides little guidance for taxpayers and

courts in the future. The Court of Appeals conceded, for

example, that the jury could have found that Preston

reasonably believed when he signed the indemnity agree-

ment that the corporation would never be forced to call

upon him to meet its obligations. Maloney & Preston, Inc.

was a successful enterprise. (App. p. 31) In Plantation

Patterns, Inc. v. Commissioner, 462 F.2d 712 (5th Cir. 1972),

cert. denied, 409 U.S. 1976, on which the Court of Appeals

relied, however, it was stated that a major consideration in

the ‘‘debt-equity’’ classification is ‘‘whether at its incep-

tion there was a reasonable expectation that the business

would succeed on its own.’’ 462 F.2d at 723. Cf. French v.

United States, 387 F.2d 1246 (1st Cir. 1973) (circumstances

of entering into guaranty rather than circumstances of

payment control determination of ‘‘dominant motivation’’

under I.R.C. §166). Similarly, the fact that bid and perfor-

mance bonds would not have been issued without indemnity

from Preston, the basis of the Court of Appeals’ decision

(App. pp. 32-33), has been held not to be of controlling

significance in other cases. See, e.g., J. Paul Smyers, 57

T.C. 189 (1971). This consideration seems especially im-

portant where bid and performance bonds on multiple con-

struction projects are concerned, as opposed to bank loans

used to purchase capital assets. See Plantation Patterns,

Inc. v. Commissioner, 462 F.2d 712, 722 (5th Cir. 1972).

Although the Court of Appeals recognized Preston’s valu-

12

able contribution to the success of Maloney & Preston, Inc.

(App. p. 23), it did not address the question of whether

Preston’s experience and reputation in the construction

business should be considered in determining the suffici-

ency of the corporation’s capitalization. Compare Murphy

Logging Company v. United States, 378 F.2d 222, 224 (9th

Cir. 1967) with Plantation Patterns, Inc. v. Commissioner,

462 F.2d 712, 723 (8th Cir. 1972). Other cases have not

involved I.R.C. $166, but guaranteed obligations generally

have not been treated as contributions to capital. Compare

Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712

(5th Cir. 1972), cert. denied, 409 U.S. 1076, with Murphy

Logging Company v. United States, 378 F.2d 222 (9th Cir.

1967) ; Ackerson v. United States, 277 F. Supp. 475 (W.D.

Ky. 1967) ; J. Paul Symers, 57 T.C. 189 (1971) ; Santa Anita

Consolidated, 50 T.C. 536 (1968). No discernible standard

emerges from the decision of the Court of Appeals to guide

taxpayers and courts, and it is clear that the decision of

the Court of Appeals, if allowed to stand, will generate

rather than diminish uncertainty and error in a voluntary

tax reporting system and in future litigation.

Since the continued viability of the Putnam doctrine is

problematic, it is likely that a full deduction on guarantors’

losses, greatly limited under Putnam and Generes, will be

taken and litigated more often. In cases like Stratmore v.

United States, supra, involving issues once settled under

Putnam, the taxpayer is now free to assert in response to

a ‘‘contribution to capital’’ argument that losses sustained

on guaranty obligations are not governed by LR.C. §166 as

bad debt losses, but rather by I1.R.C. §165(c) (2) (loss in-

curred on a transaction entered into for profit) or by I.R.C.

§162 (ordinary and necessary business expense). The prob-

lem Putnam and the cases following it seek to remedy will

have come full circle.

The refusal of the First Circuit Court of Appeals to fol-

TT

13

low Putnam and its adoption of a ‘‘debt-equity’’ analysis

is a step with potentially far-reaching consequences. The

case by case development of the ‘‘debt-equity’’ determina-

tion has resulted in ‘‘definitional turmoil’’ with no reso-

lution in sight and, in the instant case, has now been applied

to an area of tax law once settled by the holding of Putnam

that guarantors’ losses are to be deducted under I.R.C.

§166 or not at all. If the Putnam doctrine, as followed in

other circuits, is to be abandoned for a standard difficult

to define and more difficult to apply in voluntary tax re-

porting and litigation, guidance should come either from

this Court or from Congress.

Conclusion

For the foregoing reasons, a writ of certiorari should

issue to review the order and opinion of the Court of Ap-

peals for the First Circuit.

Respectfully submitted,

Rocer A. Putnam

Counsel for Petitioners

VeERRILL, Dana, PHILBRIOK,

Putnam & WILLIAMSON

Two Canal Plaza

Portland, Maine 04112

December 17, 1976

14

APPENDIX A

UNITED STATES DISTRICT COURT

DISTRICT OF MAINE

SOUTHERN DIVISION

Civil Action 14-110-SD

CASCO BANK & TRUST CO., et als.,

PLAINTIFFS

v.

UNITED STATES OF AMERICA,

DEFENDANT

EXTRACT FROM TRIAL PROCEEDINGS

CONTAINING DEFENDANT’S MOTION FOR

JUDGMENT N.0O.V. AND BENCH RULING

OF THE COURT THEREON

Pursuant to notice, trial was held in the above-entitled

action before Honorable Edward T. Gignoux, Judge, Uni-

ted States District Court, District of Maine, and a jury,

at the United States Courthouse, Portland, Maine, com-

mencing on March 31, 1975. The following proceedings oc-

curred on April 2, 1975, immediately following return of

the jury verdict.

APPEARANCES:

For the Plaintiffs:

Rocer A. Putnam, Ese. &

Tuomas J. Van Meer, Esq.

Messrs. VERRILL, Dana, PHILBRICK,

Putnam & WILLIAMSON

Two Canal Plaza

Portland, Maine 04112

—

15

For the Defendant:

Dante J. Dinan, Esa. &

D. Patrick Mu.LuarKey, Esq.

Trial Attorneys, Tax Division

Department of Justice

Washington, D.C. 20530

(In open court at 3:07 o’clock, p.m.)

The Court: Counsel, the Court understands that the

defendant, through Mr. Dinan, wishes to make a motion at

this time.

Mr. Dinan: Thank you, your Honor. May it please the

Court. Pursuant to the provisions of Rule 50(b) of the

Federal Rules of Civil Procedure, the defendant moves

the Court to set aside the verdict of the jury rendered in

this case and to enter judgment non obstante veredicto in

favor of the defendant.

The Court: Thank you, Mr. Dinan.

Mr. Dinan: May I state, your Honor, in support of

that motion the government would make reference to the

argument made by it in support of its motion for directed

verdict at the conclusion of the evidence of the plaintiff.

The Court: Thank you, Mr. Dinan.

Mr. Dinan: Thank you, sir.

The Court: The Court understands that plaintiffs have

no objection to the Court hearing counsel and ruling upon

this motion as orally made at this time?

Mr. Putnam: No, your Honor.

The Court: Right. Do the plaintiffs wish to submit any-

thing in opposition to the motion in addition to what they

have previously submitted in opposition to the defendant’s

motion for a directed verdict?

Mr. Putnam: No, your Honor. I would merely refer

to Mr. Van Meer’s prior presentation to your Honor consis-

tent with Mr. Dinan’s prior motion at the end of the plain-

tiff’s case.

16

The Court: Thank you, Mr. Putnam.

Counsel, as the Court stated in ruling upon the defen-

dant’s motion for a directed verdict at the close of the

plaintiffs’ evidence, the Court is persuaded, after having

heard counsel, reviewed the record and reviewed the case

law as submitted to the Court by counsel for the defendant

and for the plaintiffs, that no reasonable person could

have concluded on the basis of the present record that the

advances made by Mr. Preston to Maloney & Preston, Incor-

porated, were loans and not contributions to the capital of

that corporation. Inasmuch as the plaintiffs’ entitlement to

a business bad debt deduction in the amount of $105,807.46

pursuant to Section 166(d) (2) of the Internal Revenue

Code is dependent upon a determination that the advances

in tuat amount made by Mr. Preston to the corporation

were loans and created bona fide indebtedness rather than

constituting capital contributions, the present motion must

be granted.

The most persuasive authority presented to the Court

is the very recent case of Raymond v. United States of

America, 6th Cireuit, No. 74-1575, March 5, 1975, in which

a panel of the 6th Circuit, through Circuit Judge McCree,

applied to a factual record essentially identical with that

presented here the principles enunciated by the Supreme

Court in the leading case of United States v. Generes, 405

U.S. 93 (1972). In the Generes case, the Supreme Court,

through Mr. Justice Blackmun, pointed out that the deter-

mination of whether an advance by a stockholder to a

corporation is a loan or a contribution to capital, and if a

loan, whether the stockholder’s dominant motivation was

to further his personal trade or business, must be deter-

mined, not upon the basis of the stockholder’s self-serving

characterization of the nature of the transaction, but upon

the basis of objective evidence indicating what the true

nature of the transaction was. Applying this principle in

17

Raymond, Judge McCree rointed out that the taxpayer’s

statement characterizing the advances in question as loans,

standing alone, was insufficient as a matter of law. The

Court then went on at some length to demonstrate that, on

the basis of the objective evidence in the record, no reas-

onable person could conclude that a loan transaction was

involved. :

In the present case, the only evidence supporting the

position of the plaintiffs that Mr. Preston’s advances to

his corporation were loans and not capital investments is:

(1) the statement attached to Mr. and Mrs. Preston’s 1971

Individual Income Tax return, which obviously was pre-

pared by Mr. Filar, the Ernst & Ernst tax expert, who had

conferred with Mr. Preston in January and February 1972

with respect to the preparation of his tax return; and (2)

the work sheets prepared by Mr. Bernard, the Ernst &

Ernst accountant, listing the advances in question as

‘‘amounts due shareholders’’, which work sheet entries

were entered on the corporate tax returns prepared by

Ernst & Ernst. With respect to the work sheets, it is sig-

nificant that the notations on the work sheets character-

izing the advances as ‘‘amounts due shareholder’’ were the

creation of Mr. Bernard and the advances were not so

recorded on the original books of the vorporation as kept

by Mrs. Preston and her sister. As against these two items

of evidence which plaintiffs contend show that the trans-

actions were loan transactions, the record disclosed the

following facts, each one of which was noted by Judge

McCree in Raymond as contra-indicating a loan trans-

action: (1) No notes or other written evidences of indebt-

edness were given by the corporation either at the time the

advances were made or subsequent thereto. (2) No security

or collateral of any type was given by the corporation to

Mr. Preston. (3) No interest was to be paid on the amounts

advanced. (4) No fixed date or dates were set for the re-

18

payment of the advances; indeed, there is no record indi-

cating that there was any undertaking by the corporation

to repay the advances. (5) The corporation was grossly

undereapitalized for the amount of business which it was

endeavoring to undertake. (6) Very significantly, Mrs.

Preston, who made a completely candid and honest witness

for the plaintiffs, conceded that at the time the advances

vere made by hér husband, the only hope of repayment

was that the corporation might obtain future projects; that

the advances were made by Mr. Preston to the corporation

with the hope that future earnings of the corporation might

produce funds which would not only repay the advances

but would insure the continuance of the business and

future profit; and, in her words, that her husband was

hoping for — was looking to — a return to the haleyon

days of 1969 and prior years when he was earning an in-

come of approximately $200,000-$250,000 a year. (7) It is

inconceivable that any third person or any outside lending

institution would have advanced to this corporation the

amounts advanced by Mr. Preston at the times when the

advances were made. (8) The timing of the advances, which

is significant — the corporation at the time of the advances

was in a desperate financial situation; with no funds

coming in, a serious cash flow shortage existed. In sum-

mary, every objective indication is that Mr. Preston’s

interest as a stockholder in keeping the corporation alive

and solvent was the dominant motivation for his liquidating

his personal securities and placing them in the corporation

at ihe risk of the enterprise. 3

As previously indicated, Mr. Preston’s characterization

of the transaction as loan transactions, standing alone, is

insufficient as a matter of law to establish their status. And

on this record, in the absence of any indicia of debt other

than the taxpayer’s characterization of the transactions in

the tax returns, the Court is persuaded that no reasonable

19

person could have concluded that the advances made by

Mr. Preston to the corporation were loans and not contribu-

tions to capital.

The defendant’s motion for judgment N.O.V. — that is,

to have the verdict of the jury on the present aspect of

this litigation set aside and to have judgment entered upon

this aspect of the litigation in accordance with the defen-

dant’s motion for a directed verdict, and therefore in favor

of the defendant — is granted. The Court will ask counsel

to cooperate with the Clerk in the preparation of a judg-

ment for the defendant against the plaintiffs on this as-

pect of the litigation dismissing the action with prejudice

and, unless the government raises serious objection, without

costs.

Pursuant to the provisions of F.R.Civ.P. 54(b), the Court

expressly determines that there is no just reason for delay

in the entry of final judgment upon this aspect of the case

and therefore expressly directs the entry of final judg-

ment as to the claim which counsel have agreed was sub-

mitted for determination by jury trial at this time. That

claim, the Court understands, is the claim of plaintiffs that

Mr. Preston incurred a business bad debt within the mean-

ing of Section 166(d) (2) of the Code in the amount of

$105,807.46 in the year 1971. The Court understands that

the second issue briefed by the parties, which was as to

whether in 1971 Mr. Preston incurred an ordinary and

necessary business expense in the amount of $105,807.46

under Section 162 of the Code has been waived by plain-

tiffs ane is therefore not before the Court. The third issue,

which is the only issue remaining open, is the question of

whether in 1971 Mr. Preston and Mrs. Preston incurred a

Section 1244 stock loss with respect to their Maloney &

Preston stock. That issue, the Court understands, is being

submitted to the Court on cross-motions for summary judg-

ment. The motions have been briefed and a record stipu-

20

lated, and the Court will assign them for oral argument as

soon as the Court’s calendar and the convenience of coun-

sel permits.

Mr. Mullarkey?

Mr. Mullarkey: Your Honor, with respect to the entry

of judgment pursuant to Rule 54(b) we generally take the

position that a suit for a claim for refund for any year

is one cause of action with respect to the entire year, and

it’s not properly divisible under 54(b). I don’t know wheth-

er opposing counsel has any particular reason why it should

be entered under 54(b).

The Court: The Court’s only thought was to get the

judgment on the record so that the plaintiffs could file

their appeal and the matter could be on its way up, but if

counsel prefer the Court defer the entry of any judgment

until all issues have been determined —

Mr. Mullarkey: We would, your Honor.

Mr. Putnam: We would join with government in that

aspect. We would like to wait until your Honor has ruled

on the other aspects, and if we are going to have an appeal,

take it all at once or make the final decision when all the

facts are in and your Honor has finally disposed of all

issues before him.

The Court: The only purpose was to —

Mr. Putnam: We can agree with the government on

this one.

The Court: The only purpose was to assist you, Mr.

Putnam, and also Mr. Dinan and Mr. Mullarkey in getting

this matter before the Court of Appeals and determining

whether or not Judge McCree was correct and this Court is

correct in applying Judge McCree’s rationale to these

facts.

Mr. Putnam: I think we can work it out and agree on a

form of judgment. We would just like to postpone a final

21

determination until your Honor has dealt with the 1244

issue and then we can look at where we are at that time.

The Court: Then so much of the Court’s order as direc-

ted the entry of a separate judgment on this aspect of the

case under Rule 54(b) is rescinded, and no judgment will

be entered until all issues in the case have been disposed of.

Mr. Mullarkey: Thank you, your Honor.

The Court: Is there any respect in which the Court

misstated itself in its oral ruling? Mr. Dinan?

Mr. Dinan: No, your Honor.

The Court: Other than in the result, Mr. Putnam, did

you notice any —

Mr. Putnam: Other than in the result, no, your Honor.

The Court: It’s been a very interesting case, and it

there’s nothing further —

Mr. Dinan: No, your Honor.

The Court: Fine. The Court will be in recess at this

time.

(Whereupon, these proceedings were concluded at 3:35

o’clock, p.m.)

22

APPENDIX B

United States Court of Appeals

For the First Circuit

No. 76-1051

CASCO BANK & TRUST CO., ET AL.,

PLAINTIFFS, APPELLANTS,

v.

UNITED STATES OF AMERICA,

DEFENDANT, APPELLEE,

APPEAL FROM THE UNITED STATES DISTRICT COURT

FOR THE DISTRICT OF MAINE

Before Corrtx, Chief Judge,

McEntee and Campseu, Circuit Judges.

Roger A. Putnam, with whom Thomas J. Van Meer, Charles A.

Harvey, Jr., Verrill, Dana, Philbrick, Putnam & Williamson were

on brief for appellants.

William A. Whitledge, Attorney, Tax Division, Department of

Justice, with whom Scott P. Crampton, Assistant Attorney General,

Peter Mills, United States Attorney, Gilbert E. Andrews, Elmer

J. Kelsey, and James E. Crowe, Jr., Attorneys, Tax Division,

Department of Justice, were on brief for appellee.

September 21, 1976

CampsBELL, Circuit Judge. Plaintiffs, executors of the

estate of William A. Preston, Jr., brought this action for

a refund of $57,431.57 in tax and interest assessed against

Preston by the Commissioner for the calendar years 1968

and 1971.2 At issue are deductions claimed by the tax-

The claimed deductions arose in 1971. The refund for 1968

stemmed from a proposed carryback of part of the loss incurred in

1971. Although the deficiency was assessed against the joint return

of Mr. and Mrs. Preston, we will refer to Preston as the taxpayer.

23

payer for a business bad debt and for a loss on the worth-

lessness of 4 1244 corporate stock. On the business bad

debt question, a jury found for plaintiffs but a judgment

n.0.v. was subsequently entered for the Commissioner by

the district court. The § 1244 stock issue was heard on cross-

motions for summary judgment and was also decided in

the Commissioner’s favor.

Plaintiffs appeal from both judgments. On the 4 1244

stock issue, after consideration of the briefs and argu-

ments, we are satisfied that the reasoning of the district

court was correct. We'therefore affirm on the opinion below.

We shall address ourselves herein solely to the issue of

the claimed bad debt deduction.

I.

William A. Preston entered the construction business

in 1946 and two years later formed a partnership with

William E. Maloney, Jr., entitled Maloney & Preston

(M &P). The partnership was dissolved in 1964 and Preston

continued to operate the business as a sole proprietorship,

specializing in the construction of public facilities. He

incorporated the business in 1968, contributing an initial

capital investment of $20,000, but retained certain assets

in his own name. Fifty-three shares of stock were issued:

fifty-one to Preston and one each to his wife and attorney.

In 1971 Preston contributed $13,752 worth of equipment

to M &P which was entered in the corporation’s books as

paid-in capital. Both he and wife were employed full-time

by M&P from September, 1968, until November, 1971.

Preston ran the business and Mrs. Preston served as the

bookkeeper.

Preston was the principal force behind M&P. He did

the pricing and bidding for the corporation’s contracts and

oversaw to a certain extent the work in progress. He was

also in charge of M&P’s financial affairs: he handled

its capital investments, loan accounts, and lines of credit,

24

and he authorized payment of its bills. In 1968, he re-

ported $220,277.13 income, primarily from the net profits

of the sole proprietorship. After M & P was incorporated,

Preston’s salary was set at $1,000/month for the first three

months, and $5,000/month thereafter. He reported $56,050

salary and $45,206 other income? on his income tax return

for the calendar year 1969; $31,400 salary in 1970; and.

$13,600 salary in 1971.

As part of the business of constructing public facilities,

Preston was required to obtain bid, performance, and pay-

ment bonds. His bonding was principally with Maine

Bonding & Casualty Co. (Maine Bonding), both before

and after incorporation of the business. In 1968, after

M&P was incorporated, Maine Bonding required the

Prestons individually to sign an indemnity agreement as

a condition to issuing any bonds to the corporation.*? There

was evidence that Maine Bonding required this agreement

because M & P had very limited resources — only $20,000

in its capital stock account — and therefore virtually no

working capital. The agreement provided, in essence, that

Maine Bonding would issue bonds on M&P’s contracts,

but if M&P defaulted on any obligations covered by the

bonds, Maine Bonding would be indemnified by the Prestons

for losses incurred in making good on its bonds.

Evidence was also presented of M&P’s cash flow.

2 After M &P was incorporated, those jobs which were already

in progress were maintained in the name of the sole proprietorship

but were completed by the corporation. Net profits from those jobs

went to Preston, not to M&P. The net profits from those jobs

during the period of M & P’s incorporation totalled around $67,000.

3 When the business was still a sole proprietorship, Maine Bond-

ing had required an indemnity agreement only with Mrs. Preston,

Preston himself already being individually liable for M & P’s obli-

gations as sole proprietor. The purpose of this indemnity agree-

ment was to ensure that Preston would not attempt to transfer

assets into his wife’s name and so insulate them from creditors of

the proprietorship. Otherwise, Preston’s assets were deemed suffi-

cient for Maine Bonding to act as surety without further protection.

en EE

25

Preston wou!d advance cash to the corporation as needed

and, as contract payments came in, would withdraw cash

which was not needed. No notes or other evidence of in-

debtedness were ever issued to Preston for these advances,

nor was any interest ever charged. These cash advances

were recorded on trial balance sheets as ‘‘Due Wm. A.

Preston’’.* (There were other entries on the trial balance

sheets marked ‘‘notes payable’’ to various third parties.)

The trial balance sheets were work papers drawn up by

M & P’s accountant in the course of preparing the corpo-

ration’s income tax returns. The sheets were based on

information gathered from Preston himself and from the

books and records maintained by Mrs. Preston. The net

figure of these advances and withdrawals was then recorded

on the corporate income tax return under the heading

‘‘loans from stockholders’’. The net figures recorded on

the returns under this heading were $75,412 as of March

31, 1969; $30,953 as of March 31, 1970; and $28,148 as of

March 31, 1971.

In late 1969, M&P began to experience financial diffi-

culties.» Although business had been booming, no new

jobs were on the horizon and unforeseen complications had

arisen in the two major construction projects on which

M & P was then working, the Waterville Osteopathic Hos-

pital and the Maine Maritime Academy. Maine Bonding

had issued bonds for both these projects. By the summer

*The net profits from the sole proprietorship’s contracts were

also included in this entry.

5On M & P’s corporate income tax return for its first full fiscal

year (April 1, 1969, to March 31, 1970), it reported gross sales of

$1,560,742, yielding a gross profit of $123,163. Although gross

sales increased in the ensuing fiscal year (ending March 31, 1971)

to $1,978,021, M & P suffered a gross deficit of $59,877 and a total

net operating loss of $144,403. The corporation was dissolved on

December 21, 1971, and on its tax return for the short year ending

December 31, 1971, reported a net loss of $57,521 on sales of $26,261.

26

of 1971, M&P had defaulted on many of its obligations

to subcontractors and suppliers. Maine Bonding received

a number of calls from the architect in charge of the Water-

ville Hospital project. He complained that the project

was not being completed satisfactorily, that suppliers and

subcontractors were unpaid, and that liens had been

threatened or filed against the project. George Frame, an

officer of Maine Bonding who had dealt with Preston in

the past, wrote Preston on June 18, 1971, saying that he

had received complaints and urging that the two meet.

Preston subsequently met with Frame and others and a

‘‘veneral understanding’’ was reached that Preston would

attempt to finish payment of its obligations and complete

the project to the satisfaction of the architect. Preston

afterwards personally advanced approximately $94,000 to

M &P which enabled it to do so.6 Mrs. Preston testified

that the purpose of the advances was to keep the corpo-

ration going in the hope that it would return to the ‘‘good

years’’. These advances came out of Preston’s personal

bank account and out of proceeds from the sale of certain

of his investment securities. They were recorded on the

corporation’s books in accordance with the normal proce-

dure for advances by Preston.

After the completion of the Waterville Hospital, M & P

maintained a skeleton crew in the hope that it might obtain

new contracts. No work was forthcoming, however, and the

corporation was dissolved in late 1971. The net figure listed

on the last work sheet as ‘‘due Wm. A. Preston’’ was

$105,807.46. This amount was conceded to have been un-

collectible at the time of M&P’s dissolution. It was de-

ducted by Preston on his 1971 tax return as a business bad

debt under § 166 of the Internal Revenue Code.

6 There appears to be some discrepancy in the record as to the

exact figure, but that dispute is immaterial.

ee 0 ee ee

27

Il.

A principal question for decision is whether the advances

made by Preston in 1971 to M&P created a bona fide

‘*debt’’, as that term is understood under 4 166, or whether

they should be regarded as contributions to capital, since

the two are given different tax treatment. Contributions to

capital, like gifts, cannot give rise to a bad debt deduction:

‘*Bona fide debt required. Only a bona fide debt quali-

fies for purposes of section 166. A bona fide debt is

a debt which arises from a debtor-creditor relationship

based upon a valid and enforceable obligation to pay

a fixed or determinable sum of money. A gift or

contribution to capital shall not be considered a debt

for purposes of section 166... .’’

Treas. Reg. § 1.166-1{c). In characterizing an advance

as debt or equity, ‘‘objective factors are to be considered

and given weight under the particular circumstances of

the case, along with evidence of the intent of the parties.

..’ In re Uneco, 532 F.2d 1204, 1.09 (8th Cir., 1976).

As for the respective tax treatments, if the advances

were contributions to capital, they would be added to the

basis of Preston’s stock. His loss from the transaction

would be recognized upon the stock’s becoming worthless,

and generally would be deductible only as a capital loss.

§ 165(f) & (g).7 On the other hand, if the advances are

7 Section 165, entitled ‘‘ Losses’’, provides in part:

(f) Capital losses. — Losses from sales or exchanges of capi-

tal assets shall be allowed only to the extent allowed in

sections 1211 and 1212.

(g) Worthless securities. —

(1) General rule. — If any security which is a capi-

tal asset becomes worthless during the taxable year, the

loss resulting therefrom shall, for purposes of this sub-

title, be treated as a loss from the sale or exchange, on

the last day of the taxable year, of a capital asset.

(2) Security defined. — For purposes of this subsec-

tion, the term ‘security’ means —

28

deemed to have created a bona fide indebtedness, they

would be deductible as a bad debt loss under § 166.° In

(A) ashare of stock in a corporation ;

(B) aright to subscribe for, or to receive, a share

of stock in a corporation ; or

(C) a bond, debenture, note, or certificate, or

other evidence of indebtedness, issued by a

corporation or by a government or political

subdivision thereof, with interest coupons or

in registered form. . .’’

® Section 166, entitled ‘‘Bad debts’’, provides in part:

‘*(a) General rule.—

(1) Wholly worthless debts. — There shall be allowed as

a deduction any debt which becomes worthless within

the taxable year.

(2) Partially worthless debts. — When satisfied that a debt

is recoverable only in part, the Secretary or his dele-

gate may allow such debt, in an amount not in excess

of the part charged off within the taxable year, as a

deduction.

(b) Amount of deduction. — For purposes of subsection (a),

the basis for determining the amount of the deduction for any bad

debt shall be the adjusted basis provided in section 1011 for de-

termining the loss from the sale or other disposition of property.

(d) Nonbusiness debts. —

(1) General rule. — In the case of a taxpayer other than

a corporation —

(A) subsections (a) and (c) shall not apply to any

nonbusiness debt; and

(B) where any nonbusiness debt becomes worthless

within the taxable year, the loss resulting there-

from shall be considered a loss from the sale or

exchange, during the taxable year, of a capital

asset held for not more than 6 months.

(2) Nonbusiness debt defined. — For purposes of para-

graph (1), the term ‘nonbusiness debt’ means a debt other

than —

(A) a debt created or acquired (as the case may be)

in connection with a trade or business of the

taxpayer ; or

(B) a debt the loss from the worthlessness of which

is incurred in the taxpayer’s trade or business.

(e) Worthless securities. — This section shall not apply to a

debt which is evidenced by a security as defined in section 165

(g)(2)(C).

that event, a further question would arise — whether the

debt may be properly characterized as a business or a non-

business bad debt. If business, the loss may be deducted

in full against ordinary income; and if nonbusiness, the

loss is treated as a short-term capital loss. 4 166(a) & (d).

It.

The jury, in answer to special interrogatories, found

(1) that the advances created a bona fide indebtedness on

the part of M&P to Preston, and (2) that the indebted-

ness was a business debt. The district court concluded,

however, that no reasonable person could have found that

the advances made by Preston to M &P were loans and

not contributions to capital, and consequently entered

judgment in favor of the Commissioner. In so deciding,

it relied principally upon Raymond v. United States, 511

F.2d 185 (6th Cir. 1975), a case disallowing bad debt treat-

ment to a series of advances made to a family corporation

by its principals. We agree with the district court that

the advances here cannot, under any reasonable construc-

tion, be regarded as creating an indebtedness for purposes

of § 166. Accordingly, the court correctly disregarded the

jury’s special finding. See Brown v. Lamb, 414 F.2d 1210

(D.C. Cir. 1959), cert. denied, 397 U.S. 907 (1970).

The only evidence found by the district court that the

1971 advances were loans was (1) the statement « ‘ached

to Preston’s individual income tax return and (2) the list-

ing of the advances as ‘‘ ‘amounts due shareholder’ ’’ on

(f) Guarantor of certain noncorporate obligations. — A pay-

ment by the taxpayer (other than a corporation) in discharge of

part or all of his obligation as a guarantor, endorser, or indemnitor

of a noncorporate obligation the proceeds of which were used in

the trade op business of the borrower shall be treated as a debt

becoming worthless within such taxable year for purposes of this

section (except that subsection (d) shall not apply), but only if

Bo Aigetien of Ge bervener to the persen to whem cash payment

was _was worthless (without regard to such guaranty, endorse-

ment, or indemnity) at the time of such payment... .”’

30

the trial balance sheets referred to above. With respect

to (2), the court thought it significant that these charac-

terizations were the creation of Preston’s accountant, and

that the advances were not so recorded contemporaneously

on the corporation’s original books and records. The court

cited the following evidence as contraindicating a bona fide

indebtedness :

‘*(1) No notes or other written evidences of indebt-

edness were given by the corporation either at the

time the advances were made or subsequent thereto.

(2) No security or collateral of any type was given

by the corporation to Mr. Preston. (3) No interest

was to be paid on the amounts advanced. (4) No

fixed date or dates were set for the repayment of the

advances; indeed, there is no record indicating that

there was any undertaking by the corporation to re-

pay the advances. (5) The corporation was grossly

undercapitalized for the amount of business which it

was endeavoring to undertake. (6) Very significantly,

Mrs. Preston, who made a completely candid and

honest witness for the plaintiffs, conceded that at the

time the advances were made by her husband, the only

hope of repayment was that the corporation might

obtain future projects; that the advances were made

by Mr. Preston to the corporation with the hope that

future earnings of the corporation might produce

funds which would not only repay the advances but

would insure the continuance of the business and fu-

ture profit; and, in her words, that her husband was

hoping for—was looking to—a return to the haleyon

days of 1969 and prior years when he was earning an

income of approximately $200,000 - $250,000 a year.

(7) It is inconceivable that any third person or any

outside lending institution would have advanced to

the corporation the amounts advanced by Mr. Preston

Eee,

31

at the times when the advances were made. (8) The

timing of the advances, which is significant—the cor-

poration at the time of the advances was in a desperate

financial situation; with no funds coming in, a serious

cash flow shortage existed.’’

In deciding how to characterize the transaction, the court

below properly surveyed a number of different factors,

rather than only one or two. In re Uneco, supra, 523

F.2d 1204; see Brake & Electric Sales Corp. v. United

States, 287 F.2d 426 (1st Cir. 1961). However, we think

it should not have overlooked the possible effect on this

transaction of the pre-existing indemnity agreement.

Preston was not in the position of the ordinary stockholder

who voluntarily advances money to his insolvent corpora-

tion. Under the terms of the 1968 agreement with Maine

Bonding, he was ultimately liable for any amounts which

the bonding company had to pay out under the bonds.

Thus, whether or not the advances to M&P were technically

in discharge of his obligations under the indemnity agree-

ment, Preston had to pay; his only choice was as to the

form and timing of the payments. It seems unrealistic,

therefore, to view the advances in isolation from the indem- .

nity agreement which compelled them.

Even, however, when attention is focused upon the in-

demnity agreement, we see the entire transaction not as a

loan but as a contribution to capital. True, when Preston

signed the indemnity agreement M & P was a going enter-

prise, and we shall assume that the jury could have found

that he did not then believe that he would be called upon

to indemnify Maine Bonding, since if business remained

good, the company itself would be able to meet its obliga-

tions. Had Preston loaned money to M &P in 1968, ‘‘the

genuineness of repayment prospects in the light of eco-

nomic realities’? might have indicated the creation of a

bona fide debt. American Processing and Sales Co. v. United

States, 371 F.2d 842, 857 (Ct. Cl. 1967).

32

But Preston did not loan money to M & P in 1968. What

he did loan was his personal credit, making it possible

for M&P, which was unable to secure bonds on its own

credit, to receive the essential benefits of the bonds. Not

only was no debtor-creditor relationship created between

the company and Preston in 1968, but by the nature of

the arrangement, Preston was expected to put up his own

money only if M&P should be in default, by which time

any right which Preston would acquire against M &P,

whether accruing by subrogation or otherwise, would be

more theoretical than real. Thus, we do not see the realities

of the transaction as at any time based on the creation

of a serious debtor-creditor relationship between Preston

and his company. We think the true character of the indem-

nity agreement is similar to the personal guarantee made

by a corporate officer and chief shareholder to creditors of

the corporation described by Judge Simpson in Plantation

Patterns, Inc. v. Commissioner, 462 F.2d 712, 722-23 (5th

Cir. 1972), cert. denied, 409 U.S. 1076 (1973) :

‘*The guarantee enabled Mr. Jemison to put a mini-

mum amount of cash into New Plantation immediately,

and to avoid any further cash investment in the corpo-

ration unless and until it should fall on hard times.

At the same time he exercised total control over its

management. Adding together the personal guerantee

of Mr. Jemison to the guarantee of Jemison Invest-

ment Company, which was wholly owned by him and

Mr. Jemison’s control of New Plantation, we think

that the result is that Mr. Jemison’s guarantee simply

amounted to a covert way of putting his money ‘at the

risk of the business.’ Stated differently, the guaran-

tee enabled Mr. Jemison to create borrowing power for

the corporation which normally would have existed

only through the presence of more adequate capitaliz-

ation of New Plantation.’’

33

Here the indemnity enabled Mr. Preston to make it possible

for his company to secure bonds which would otherwise

have been available only through the presence of more

adequate capitalization or collateral. We do not think

the indemnity arrangement, nor Mr. Preston’s subsequent

actions enabling M&P to pay off creditors after M&P

had defaulted, can be viewed as establishing a meaningful

debtor-creditor relationship between himself and M & P.

Plaintiffs argue that under Putnam v. Commissioner,

352 U.S. 82 (1956), unsatisfied advances made in discharge

of a guarantee are, as a matter of law, bad debt losses.

It is true that in the course of that opinion the Court

stated that administrative and judicial construction of the

internal revenue laws ‘‘have always treated guarantors’

losses as bad debt losses.’’ Id. at 86. But we think the

Court’s expansive language is limited by its context. The

issue in Putnam was whether a guarantor’s loss was to be

treated as a fully deductible loss under the predecessor to

165(¢) (2), or as a nonbusiness bad debt which received only

capital loss treatment under the predecessor to 4 166(d).

The taxpayer urged the former; the Commissioner the

latter. In upholding the Commissioner, the Supreme Court

ruled, ‘‘a loss attributable to the worthlessness of a bad

debt shall be regarded as a bad debt loss, deductible as

such or not at all.’’ Id. at 88. The Court was not called

upon in Putnam to distinguish, as we are here, between a

business (i.e. fully deductible) debt and an advance in

the nature of a capital contribution. It relied heavily on

the argument that its decision, limiting the taxpayer to

capital loss treatment, reflected the economic reality of the

transaction :

‘‘The loss [Putnam] sustained when his stock became

worthless, as well as the losses from the worthlessness

of the loans he made directly to the corporation, would

receive capital loss treatment; the 1939 Code so pro-

vides as to nonbusiness losses both from worthless

34

stock investments and from loans to a corporation,

whether or not the loans are evidenced by a security.

[footnote omitted]. It is clearly a ‘fairer reflection’

of Putnam’s 1948 taxable income to treat the instant

loss similarly. There is no real or economic difference

between the loss of an investment made in the form

of a direct loan to a corporation and one made indi-

rectly in the form of a guaranteed bank loan. The tax

consequences should in all reason be the same... .”’

Id. at 92-93. This reasoning supports the Commissioner’s

argument here that,

‘*. . . Putnam is viewed as protecting the statutory

scheme for the common tax treatment (capital loss)

of losses sustained by shareholders in providing finan-

cing for a corporation, whether directly by a loan to the

corporation or indirectly by a guaranteed loan... .’’

Since the Supreme Court handed down its decision in

Putnam, lower courts have considered whether a guaranty

of a corporation’s obligations by its stockholder is to be

treated as a loan or a contribution to capital. See Planta-

tion Patterns, Inc. v. Commissioner, supra, 462 F.2d 712;

Murphy Logging Co. v. United States, 378 F.2d 222 (9th

Cir. 1967); Ackerson v. United States, 277 F. Supp. 475

(W.D. Ky. 1967); J. Paul Smyers, 57 T.C. 189 (1971);

Santa Anita Consol., 50 T.C. 536 (1968). See also E. J.

Ellisberg, 9 T.C. 463 (1947). While these courts have

divided in characterizing claimed deductions for losses

incurred as a result of such guaranties, they have generally

approached the question as one of fact® rather than of law:

® Congress itself has acknowledged the general factual approach

to debt-equity problems. Section 385 of the 1954 Internal ue

Code, as amended provides as follows:

“‘(a) Authority to prescribe regulations. — The Secretary

or his delegate is authorized to prescribe such regulations as

may be necessary or appropriate to determine whether an

interest in a corporation is to be treated for purposes of this

title as stock or indebtedness.

35

‘¢(T }hat the advances were made in the form of guar-

anteed debt does not, in and of itself, negate their

treatment as capital contributions. Whether such debt

is to be treated as an indirect capital contribution

must be resolved by an investigation of the facts in

the light of traditional debt-equity principles.’’

Santa Anita Consol., supra, at 550. E.g., John Kelley Co.

v. Commissioner, 326 U.S. 521, 530 (1946).

Here we think the facts indicate unmistakably that Pres-

ton’s execution of the indemnity, followed by his advance-

ments at a time when his company was in financial trouble,

were contributions to capital rather than a loan creating a

specific debtor-creditor relationship. Preston, to be sure,

doubtless hoped, if business improved, to recover those

advances in one way or another. As the owner and chief

officer of M&P, he could, without difficulty, reimburse

himself if the company’s condition permitted; but we do

not think the dominant character of the transaction was

to create a debt under § 166.

Affirmed.

(b) Factors. — The regulations prescribed under this

section shall set forth factors. which are to be taken into

account in determining with respect to a particular factual

situation whether a debtor-creditor relationship exists or a

eorporation-shareholder relationship exists. The factors so set

forth in the regulations may include among other factors:

(1) whether there is a written unconditional promise to

y on demand or on a specified date a sum certain

in money in return for an adequate consideration in

money or money’s worth, and to pay a fixed rate of

interest,

(2) whether there is subordination to or preference over

any indebtedness of the corporation,

(3) the ratio of debt to equity of the corporation,

(4) whether there is convertibility into the stock of the

corporation, and

(5) the relationship between holdings of stock in the cor-

poration and holdings of the interest in question.’’

The Secretary has not as yet promulgated regulations under the

authority granted to him in this provision.

36

INTERNAL REVENUE CODE OF 1954 (26 U.S.C.) :

Sec. 165. LOSSES.

(a) General Rule.—There shall be allowed as a deduc-

tion any loss sustained during the taxable year and not

compensated for by insurance or otherwise.

(b) Amount of Deduction—For purposes of subsec-

tion (a), the basis for determining the amount of the deduc-

tion for any loss shall be the adjusted basis provided in

section 1011 for determining the loss from the sale or other

disposition of property.

(c) Limitation on Losses of Individuals.—In the case

of an individual, the deduction under subsection (a) shall

be limited to—

(1) losses incurred in a trade or business;

(2) losses incurred in any transaction entered into for

profit, though not connected with a trade or busi-

ness; and

* * *

(f) Capital Losses.—Losses from sales or exchanges

of capital assets shall be allowed only to the extent allowed

in sections 1211 and 1212.

(g) Worthless Securities.—

(1) General rule—If any security which is a

capital asset becomes worthless during the taxable

year, the loss resulting therefrom shall, for purposes

of this subtitle, be treated as a loss from the sale or

exchange, on the last day of the taxable year, of a

capital asset. |

(2) Security defined.—For purposes of this sub-

section, the term ‘‘security’’ means—

(A) a share of stock in a corporation;

* * *

Sec. 166. BAD DEBTS.

(a) General Rule.—

(1) Wholly worthless debts.—There shall be al-

lowed as a deduction any debt which becomes worthless

within the taxable year.

(2) Partially worthless debts—When satisfied

that a debt is recoverable only in part, the Secretary

or his delegate may allow such debt, in an amount not

in excess of the part charged off within the taxable

year, as a deduction.

(b) Amount of Deduction.—For purposes of subsection

(a), the basis for determining the amount of the deduction

for any bad debt shall be the adjusted basis provided in

section 1011 for determining the loss from the sale or other

disposition of property.

* * .

(d) Nonbusiness Debts.—

(1) General rule——In the case of a taxpayer

other than a corporation—

(A) subsections (a) and (c) shall not apply

to any nonbusiness debt; and

(B) where any nonbusiness debt becomes

worthless within the taxable year, the loss result-

ing therefrom shall be considered a loss from the

sale or exchange, during the taxable year, of a

capital asset held for not more than 6 months.

(2) [as amended by Sec. 8, Technical Amend-

ments Act of 1958, P.L. 85-866, 72 Stat. 1606] Non-

business debt defined—For purposes of paragraph

(1), the term ‘‘nonbusiness debt’’ means a debt other

than—

(A) a debt created or acquired (as the case

may be) in connection with a trade or business of

the taxpayer; or

38

(B) a debt the loss from the worthlessness

of which is incurred in the taxpayer’s trade or

business.

(e) Worthless Securities.—This section shall not apply

to a debt which is evidenced by a security as defined in

section 165(g)(2)(C).

TREASURY REGULATIONS ON INCOME TAX

(1954 CODE) (26 C.F.R.):

§ 1.166-1 Bap Desrts.

e * eo

(c) Bona fide debt required. Only a bona fide debt

qualifies for purposes of section 166. A bona fide debt is

a debt which arises from a debtor-creditor relationship

based upon a valid and enforceable obligation to pay a

fixed or determinable sum of money. A gift or contribution

to capital shall not be considered a debt for purposes of

section 166. The fact that a bad debt is not due at the

time of deduction shall not of itself prevent its allowance

under section 166. For the disallowance of deductions for

bad debts owed by a political party, see §1.271-1.