Appendix — Horne v. Commissioner

r~ Supreme Court, U. &

FILED

IN THE JUN 23 1978

SUPREME COURT OF THE UNITED 9TATES. 2001. wo cieRK

Leesan asa

—

October Term, 1977

No.

97-1824

M. SETH HORNE and MAURINE D. HORNE,

Appellants,

Vv.

COMMISSIONER OF INTERNAL REVENUE

Appellee.

APPENDIX TO

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE NINTH. CIRCUIT

HUBERT E. KELLY

Attorney for Appellants.

Of Counsel:

KELLY & KELLY

662 Security Center

222 North Central Avenue

Phoenix, Arizona 85904

VOLUME I

Pages 1-50

Opinion of United States

Tax Court

Decision of United States

Tax Court

Opinion of United States

Court of Appeals for Ninth

Circuit

Amended Order Denying

Petition for Rehearing

41

42

50

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59 T. C. No. 32

UNITED STATES TAX COURT

M. SETH HORNE AND MAURINE D. HORNE,

Petitioners v. COMMISSIONER OF

INTERNAL REVENUE, Respondent

Docket No. 2645-70

Filed November 27, 1972

Petitioner (husband) was a

partner in a three-man firm. The

three partners, as individuals, owned

all the stock in COINC, which, in

turn, owned all the stock in CORP and

CO. All three corporations performed

construction work. N/A, a bonding

company, wrote bonds for all three

corporations. All three corporations

indemnified N/A on cross-indemnity

agreements. In 1960, CO notified

N/A that it, N/A, would have to per-

form on its bond. Because the three

corporations were close to insolvency,

N/A asked COINC's stockholders to in-

demnify it. Only petitioner agreed

to do so. As a part of the sorting-

out process that followed, the part-

nership was dissolved, the partner-

ship property was distributed, the

partners exchanged interests in

various properties, and the corpo-

rations were reorganized. Concerning

the reorganization, petitioner re-

ceived all the stock in CO--to which

substantially all the assets of COINC

and CORP had been transferred--in

2

return for all his stock in COINC.

At approximately the same time,

petitioner entered into an agree-

ment whereby he became jointly

and severally liable with CO, for

any losses incurved by N/A on its

bond. CO continued in existence.

COINC and CORP became inactive.

Years later the petitioner paid

N/A roughly $600,000 and recouped

less than half of this amount from

co.

Held, on the facts, petiticner's

promise to indemnify the bonding com-

pany was not part of the purchase

price of the CO stock. Estate of

McGlothin v. Commissioner, 370 F.2d

729 (C.A. 5, 1967), attirming 44

T.C. 611 (1965) distinguished. Nor

was petitioner compensated for his

losses. Rather the losses on the so-

called indemnity agreement must be

treated as bad debt losses falling

within sec. 166, I.R.C. 1954, and

disallowed as such because they were

not worthless in the years at issue.

Petitioner was as much a guarantor as

an indemnitor. Putnam v. Commissioner,

352 U.S. 82 (1956), applicable.

Hubert E. Kelly and Charles L. Arnold,

for the petitioners.

Harold E. Patterson, for the respon-

dent.

DAWSON, Judge: Respondent determined

deficiencies in petitioners' Federal in-

come taxes for the taxable years 1966,

1967, and 1968 in the amounts of $56,280,

$23,378, and $66,078, respectively.

—————— Le

3

Petitioners have conceded one issue.

The only issue remaining for decision is

whether they are entitled to a deduction

for amounts paid in connection with an

indemnity agreement entered into by them

on behalf of their wholly owned cor-

poration. The issue is argued under

sections 162, 165, 166, and 212, Internal

Revenue Code of 1954.

FINDINGS OF FACT

Some of the facts have been stipu-

lated. The stipulation of facts, the

supplemental stipulation of facts, and

the exhibits attached to both are incor-

porated herein by this reference. We

have limited our findings to those facts

which are pertinent to our decision.

The petitioners, M. Seth Horne and

Maurine D. Horne, are husband and wife

and, at the time of filing the petition

herein, were residents of Phoenix,

Arizona. They filed joint Federal in-

come tax returns for the years 1966, 1967,

and 1968 with the district director of

internal revenue at Phoenix, Arizona.

M. Seth Horne (herein called peti-

tioner) is a real estate developer and

investor. He became interested in the

field when trying to start up a restau-

; rant in the Washington, D. C. area. Near

the end of World War II, he surveyed the

real estate business prospects in that

area and began development operations on

a full-time basis.

In 1947, petitioner was joined by

Harold A. Naisbitt, an accountant, in

a joint venture for the development of

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a piece of property in Fairfax County,

Virginia. About two years later, W. B.

Ingersoll, a practicing dentist, pur-

chased a part of petitioner's interest

in the joint venture. On-.January 5,

1951, Horne, Ingersoll and Naisbitt

formed a general partnership (herein

called HIN or the partnership) to engage

in the business of real estate development.

| Petitioner had a 65.6 percent interest

in the partnership; Ingersoll had a 20

percent interest; and Naisbitt had a

14.6 percent interest. Petitioner acted

as general manager, Naisbitt handled the

accounting problems, and Ingersoll was

available for consultation. So long as

petitioner was a partner in HIN, he did

not engage in any other business acti-

vities on a strictly individual basis.

Although he owned certain rights con-

cerning real property in his own name (as

recited in the indemnity agreement de-

tailed below), he owned them in con-

juction with his partners. Nevertheless,

due to his participation in HIN, he re-

mained in the real estate business.

The business activities of the part-

nership consisted of acquisition, zoning,

financing, and management of real pro-

perties. Its first large-scale project

was an apartment complex and shopping

center situated on_100 acres near Seven

Corners, Virginia.

-

The partnership's returns for 1952

and 1953 state that its principal busi-

ness activity was the renting of business

furniture. Its returns for 1954 through

1960 state that its principal business

activity was the performance of executive

ee

5

James Stewart and Co., Inc. (herein

called COINC) is a corporation organized

under the laws of the State of New York

in 1913. It conducted a general engineer-

ing and contracting business; and by 1951

it had acquired a respected international

reputation. In 1927, COINC caused James

Stewart Corporation (CORP) to be organized

pursuant to the laws of the State of

Delaware. CORP operated as a wholly-

owned subsidiary of COINC. It, too,

performed general engineering and contract-

ing work.

In 1951, soon after the formation of

HIN, the petitioner and his partners be-

came interested in acquiring COINC, think-

ing that COINC's construction activities

would complement the partnership's real

estate activities. On January l, 1952,

they purchased all of the common stock of

COINC, consisting of 12,168 shares, and

2,055 shares of preferred stock for a

total of $150,000. Later, on December

31, 1954, they purchased the remaining

4,533 shares of preferred stock for an ad-

ditional $150,000. After an adjustment

due to taxes assessed against COINC, the

total purchase price for both common and

preferred stock amounted to $246,406.25.

All stock was acquired in the names of

the individual partners according to

each partner's interest in HIN. Peti-

tioner's basis in the COINC stock was

services for COINC, discussed in the text

below. These statements are obviously not

controlling. Furthermore, respondent

apparently does not object to petitioner's

characterization of the partnership's busi-

ness as real estate development.

ee ee

$194,442.50.

On July 28, 1952, COINC--then con-

trolled by petitioner and his partners in

HIN--caused James Stewart Company (CO) to

be incorporated under the laws of the

State of Texas. Like CORP, CO was COINC's

wholly-owned subsidiary and performed

construction and general contracting work.

The plan was for COINC to base its opera-

tions in New York and perform contracts in

the Eastern States, for CORP to base its

operations in Chicago and perform contracts

throughout the Midwest, and for CO, based

in Texas, to service the Western part of

the country.

From the start petitioner, Ingersoll,

and Naisbitt were active in the management

of COINC as members of its board of direc-

tors. Also, petitioner was immediately

made vice president of COINC. He held

that office until 1955, when he was elevat-

ed to president and chairman of the board--

positions which he held through 1960.

Petitioner and Naisbitt were also members

of the board of both CORP and CO. In 1953,

petitioner was elected vice president of

CORP and, in 1954, chairman of its board.

Petitioner was president of CO from its

inception.

As for the relationship between the

partnership and the corporations, HIN was

the manager of COINC, and CORP and CO were

its operational arms. HIN engaged in all

phases of real estate development--though

after acquiring COINC, a great deal of the

partners’ time was devoted to overseeing

the parent and its subsidiaries. The

corporations only performed construction

work, except CO developed some land on

the Papago Indian Reservation (Papago

a a

3

Indian Project), near Sells, Arizona,

and some mining claims near Tombstone

and Camp Verde, Arizona.

For the years 1953 through 1960,

the net income of COINC, CORP, and CO,

exclusive of any net operating loss

deductions, was as follows:

Year COINC CORP CO

1953 $ 32,554.97 $ 8,707.20 $ 33,773.99

1954 9,391.29 121,644.15 (52,543.84)

1955 36,723.78 19,567.59 (77,982.91)

1956 38,379.79 236,126.55 13,621.82

1957 84,020.79 69,316.32 98,356.31

1958 (122,994.30) (329,306.37) (230,013.29)

1959 (39,547.41) (10,474.26) (165,019.40)

1960 (75,967.18) (138,196.22) (159,282.89)

During the years 1952 through 1960,

petitioner received no compensation of any

kind from COINC, CORP, or CO for services

rendered. Nor did Ingersoll or Naisbitt re-

ceive any compensation. Also, none of the

corporations paid any dividends during those

years. CORP and CO did, however, pay manage~

ment fees to COINC, and COINC in turn paid

management fees to the partnership. The

following schedule shows the fees paid by

COINC to HIN:

Year Management Fee

1952 $28,801.63

1953 33,499.92

1954 55,500.00

1955 50,000.00

1956 50,000.00

1957 61,303.94

1958 50,000.00

1959 55,000.00

1960 . 51,001.10 '

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The partnership was operated on the

accrual basis of accounting and used the

calendar year as its taxable year.

Federal income tax returns for the years

1952-1960 reveal the following:

Its

Total Total

Year Income Deductions

1952 $ 77,832.21 $ 57,903.42

1953 93,350.19 71,834.25

1954 104,044.67 72,945.84

1955 108,690.02 130,335.61

1956 191,988.41 132,255.45

1957 126,814.85 114,677.50

1958 84,000.00 119,008.29

1959 131,072.27 100,837.19

1960 156,124.04 116,322.48

Petitioner's Petitioner's Payments

Share of Share of From Part-

Ordinary Capital nership to

Year Incomel Gains2 Petitioner

1952 $ 5,937.29 $ 871.73 o

1953 5,484.86 (506.37) 7

1954 11,541.63 1,574.40 o-

1955 (14,527.50) 9,534.82 $ 16,200.00

1956 39,184.82 12,262.49 20,700.00

1957 6,541,17 12,262.49 26,492.85

1958 (37,999.98) 14,633.96 23,200.00

1959 19,834.21 122,590.14 3,803.37

1960 26,109.80 56,565.76 17,795.60

lafter payments to partners

2Including section 1231 gains.

In the conduct of their construction

business the three corporations were re-

quired to furnish performance bonds on

the jobs that they undertook. All three

Corporations obtained bonds from New

9

Amsterdam Casualty Company (herein called

New Amsterdam or the bonding company).

COINC and CORP agreed to indemnify New

Amsterdam for any losses incurred as

surety for CO, CORP and CO agreed to

indemnify New Amsterdam from any losses

incurred as surety for COINC.

Beginning in 1958 and continuing

through 1960, the corporations suffered

financial losses; by October 1960 they

were in severe financial trouble. For

its taxable year ended December 31, 1960,

CO had a net operating loss of $539,090.21,

inclusive of a net operating loss carry-

over of $379,807.32. CO's difficulties

were due to losses incurred in connection

with construction work in Southern

California and the Papago Indian Project.

In all, CO's net worth was adversely

affected by approximately $1.75 million.

As a consequence of the above difficul-

ties, in the summer of 1960, petitioner and

Naisbitt notified New Amsterdam that CO

could not complete all its contracts and

that it, as surety, would probably have to

make some performance in accordance with

the bonds written on CO's behalf. They

also informed New Amsterdam that COINC and

CORP did not have sufficient funds to meet

their obligations as indemnitors under the

cross-indemnity agreements. At this point,

the bonding company estimated its "exposure"

at approximately $1-1/5 million. Also at

this point in time none of the partners in

HIN, including the petitioner, were indivi-

dually liable to the bonding company for

amounts paid on performance bonds.

To better secure itself, New Amsterdam

requested petitioner, Ingersoll, and

Naisbitt to contract to indemnify it for

o>) NAR, one

.

10

any loss incurred on the three corporations’

bonds. Ingersoll and Naisbitt balked.

Petitioner, however, acceded. He did so

realizing that unless he agreed the cor-

porations would be taken over by the bond-

ing company, their assets would be liqui-

dated, and they would probably end up in

bankruptcy. Not only would he lose his in-

vestment in COINC but, most importantly,

his credit reputation would be ruined.

Thus, because the ability to borrow large

amounts of money is crucial to the conduct

of a real estate development business, he

could no longer participate in such a busi-

ness--on an individual basis or as a major

figure in a partnership or corporation.

Negotiations between petitioner and

New Amsterdam concerning the terms of

the indemnity agreement commenced in

October 1960 and continued until January

20, 1961, when an agreement was signed.

Naisbitt participated in the early stages

of the negotiations in order to help ef-

fectuate the separation of his and Inger-

soll's affairs from the affairs of the

petitioner. Sometime before January 20,

1961, the petitioner began the process of

acquiring clear title to a tract of land

(the Shirley Highway Property) of "very

great value." The land is located on

Shirley Memorial Highway in the City of

Alexandria, Virginia. It was being ac-

quired "out of the partnership."2

2

The details of this transaction are

unclear. It appears, however, that the

land was held in co-tenancy by the peti-

tioner, Ingersoll, and Naisbitt, and that

petitioner was in fact acquiring title

from them.

1l

Meanwhile, on November 16, 1960, New

Amsterdam instituted a suit against CO

and Mayer Central Building Corporation in

the United States District Court for the

District of Arizona asserting, among other

things, that it, New Amsterdam, was not

liable on bonds executed in connection with

a contract between CO and Mayer.

The January 20th indemnity agreement

between petitioner and New Amsterdam recites

as follows: That CO entered into eight

construction contracts, including the Mayer

Central Building Corporation contract, for

a total contract price of approximately $12

million and that New Amsterdam was surety

on those contracts; that, in addition, New

Amsterdam was surety on the Papago Project,

that claims had been and would be made

against New Amsterdam on its fond, and that

those claims would exceed $500,000; that

COINC had previously agreed to act as in-

demnitor of New Amsterdam for losses sus-

tained as surety for CO, that CORP had pre-

viously agreed likewise, that CORP and CO

had previously jointly and severally agreed

to act as indemnitor of New Amsterdam for

losses sustained as surety for COINC, and

that CO had previously agreed to act as

indemnitor of New Amsterdam for losses

Sustained as surety for it, CO; that CO

and CORP were both wholly-owned subsidiaries

of COINC and that petitioner, Ingersoll,

and Naisbitt were the sole shareholders

of COINC; that New Amsterdam had filed the

above-mentioned suit against CO and Mayer

Central Building Corporation; that the

petitioner was "in the process of acquiring"

clear title to the Shirley Highway Pro-

perty; that CORP presently held certain

rights under an agreement to purchase cer-

tain mining claims (the Charleston Claims) ;

that petitioner, Ingersoll, Naisbitt, and

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Sak ll

COINC, together with another individual,

presently held interests in-certain rights

under an agreement to purchase agriculture

lease rights in property located in Yuma

County, Arizona (the Hall-Morrison Property) ;

that petitioner, Ingersoll, Naisbitt, and

COINC, together with another individual,

presently owned certain real property and

held certain interests in grazing lands

(collectively referred to as the Palomas

Ranch Property) and tnat said property was

subject to a mortgage; that CO presently

held certain rights under a joint venture

agreement with Freesh Land Ventures, Inc.,

in land (the Papago Farm Property) owned

by the Papago Indian Tribe; and that CO

presently held a lease of mineral rights in

Yavapai County, Arizona (the Sodium Sul-

fate Mine Property) and an option involving

said property.

The indemnity agreement further pro-

vides, in summary, as follows:

1. The petitioner will obtain clear

title to the Shirley Property and convey

it to a trustee, the Mount Vernon Band

and Trust Company of Fairfax County,

Virginia, to be held as security for his

promise to indemnify New Amsterdam.

2. Petitioner and CO will cause

CORP to convey to CO CORP's rights to

and interest in the Charleston Claims.

’ 3. Petitioner and CO will cause

COINC to convey to CO CORP's rights to

and interest in the Hall-Morrison Pro-

perty and the Palomas Ranch Property,

plus (1) any amounts due from New

Amsterdam to COINC for past services ren-

13

dered? and (2) a life insurance policy on

petitioner's life, naming COINC as bene-

ficiary (petitioner and CO agreed to pay

all premiums as they became due and to de-

Signate New Amsterdam as the new bene-

ficiary).

4. Upon receiving the assets named

in 2 and 3 above, CO will transfer such

assets to a trustee, a Phoenix law firm,

so as to secure CO's promise to indemnify

New Amsterdam.

5. CO will endorse and deliver to

New Amsterdam two promissory notes executed

by one Lawrence D. Mayer and his wife Pau-

line, each in the sum of $50,000.

6. CO will assign all balances due

and to become due on the eight construction

contracts recited above; then, after all

of the above.

7. New Amsterdam will dismiss with

prejudice the action against CO and Mayer

Central Building Corporation.

8. New Amsterdam will fulfill the

Obligations of CO in connection with the

eight construction contracts recited above,

in accordance with its obligation as

surety.

9. New Amsterdam will release COINC

and CORP from their cross-indemnity agree-

ments.

3

Evidently, COINC occasionally helped

in the performance of contracts taken over

by New Amsterdam, as surety, from other

construction companies.

14

10. New Amsterdam will release CO

and CORP from their cross-indemnity agree-

ment, except as to five bonds executed in

connection with five contracts, none of

which are included among the eight con-

struction contracts recited above.

11. CO and petitioner jointly and

severally agree to pay to New Amsterdam

(1) amounts expended by New Amsterdam

pursuant to bonds issued in connection

with the eight contracts recited at the

beginning of the agreement, (2) all amounts

for which CO is obligated under its sepa-

rate indemnity agreements,4 and (3) in-

terest on all of said amounts at the rate

of 4 percent per annum.

12. All amounts due from CO and

petitioner on the above indemnity obliga-

tion will be paid in five semi-annual instal-

lments, beginning five years after the date

of this agreement.

Prior to the signing of the January.

20th indemnity agreement, but contempo-

raneous with the negotiation of the agree-

ment, the partners of HIN agreed, first,

to dissolve? the partnership and distribute

certain properties “owned by the partner-

ship” to the individual partners in ac-

cordance with the following schedule:

4

This apparently includes amounts

expended pursuant to the bond issued in

connection with the Papago Indian Project.

5

While we note that the pertinent

agreement is titled "Memorandum Agreement

of Partial Liquidation of Partnership

Assets," we accept the parties' characteri-

zation of this event as a complete dis-

solution of the partnership.

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bee

Second, the petitioner, Ingersoll, and

; Naisbitt exchanged interests in certain

; parcels of land, including those six

parcels listed above as not owned 100

percent by petitioner. Petitioner gave

up his interest in part of the "Esso

Station land” and in three tracts near

land owned by Naisbitt off Arlington

Boulevard in Fairfax County, Virginia.

In return, petitioner received the

interests of Ingersoll and Naisbitt in

the remaining portion of the "Esso

Station land," the "Hot Shoppe land,"

the "Foster Tract," "Parcel 7 of Willston

South," "Parcel 8 of Willston South,"

the “Medical Clinic land," and the

"Shirley Highway Property." Both the

dissolution/distribution and the exchange

of interests occurred pursuant to agree-

Ments dated January 1, 1961.

Shortly after the signirg of the

January 20th indemnity agreement, the

petitioner, Ingersoll, and Naisbitt agreed

to a separation of CO from COINC and CORP.

The petitioner received all the stock in

CO--heretofore held by COINC, which was in

turn owned by all three of the partners.

Ingersoll and Naisbitt were left with all

the stock in COINC and thus with the owner-

ship of both COINC and CORP. As a part of

this “settlement,” the following assets,

worth at least $555,000, were transferred

from COINC and CORP (through COINC) to

‘ CO: The Papago Farms Property, the

Palomas Ranch Property, the Hall-Morrison

Property, the Charleston Claims, a life

insurance policy on petitioner's life and

_

The three tracts apparently did not

come out of the partnership.

‘

19

accounts receivable due from New

Amsterdam. In return, COINC received

additional stock in CO. Evidently these

shares, in addition to all other shares of

CO stock held by COINC, were distributed

to petitioner in redemption of his shares

in COINC. This separation was effective

as of December 31, 1960, though not agreed

to until January 26, 1961. After the

separation there were virtually no assets

left in COINC and CORP, and both companies

became inactive. Ingersoll and Naisbitt

terminated their relationship with CO, and

petitioner resigned his offices with COINC

and CORP.

After the execution of the indemnity

agreement, CO went about its construction

business. Petitioner directed the affairs

of the company as its president and princi-

pal managing officer. During each of the

years 1961, 1962, and 1963, he received

$12,000 per year in salary. For 1964, 1965,

and 1966 he received no salary. In 1967

he received a salary of $9,500. Petitioner's

wife received $4,800 as salary in 1963.

As of January 1, 1960, CO was, however,

insolvent in that liabilities exceeded assets

by approximately $530,000, and the company

was unable to meet its debts as they matured.

At the end of calendar year 1962, CO had a

net operating loss of $677,000. Since CO

had income amounting to $457,000 in 1964,

this loss was carried forward.

In accordance with the bonding arrange-

ment and its agreement with petitioner and

CO, New Amsterdam made payments on behalf

of CO. Although New Amsterdam originally

anticipated having to pay out $1-1.5 million,

the total amount of the payment was not

determined until 1964 or 1965. Ultimately

it paid out only $597,430.44.

' _____.. j 7

20

Petitioner, pursuant to the January

20th indemnity agreement, paid the follow-

: ing amounts to New Amsterdam: $237,434.46

‘ in 1966, $121,749.22 in 1967, and $238,246.76

in 1968. The money came in large part from

the sale of the Shirley Highway Property in

1964. Petitioner then deducted one-half

of these amounts, that is, $118,717, $60,875,

and $119,123, in 1966, 1967, and 1968, res-

pectively, as "losses pursuant to Indemnity

Agreement of 1/20/61."

H

:

’

The remaining halves were treated as

loans to CO by petitioner and as accounts

payable by Co./

In 1963, petitioner organized the

Seth Horne Development Corporation under

the laws of the State of Arizona to perform

real estate development work. In March

1967, CO was merged into Seth Horne Develop-

ment Corporation, and the latter adopted

the former's name--James Stewart Company.

(We will refer to this Arizona version of

CO as CO(ARIZ).) At all pertinent times

the petitioner was the majority shareholder

Of CO(ARIZ).

The total assets, liabilities, capital,

and surplus (or deficit) of CO and its suc-

cessor, CO(ARIZ), as of 1960 through 1967

as reflected in its returns, were:

5

At first, in 1966, CO treated the en-

tire amount paid by the petitioner to the

bonding company during that year (i.e.,

$237,434.46) as paid-in capital. This was

corrected the next year, so that one-half of

the amount paid to the bonding company was

treated as paid-in capital and one-half as

an account payable.

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23

The increase in capitalization from

$25,000 tc $580,000 reflects the treatment

of the transfer of assets from COINC to

CO as a purchase of additional shares.

Stewart-Southern, Inc. (SOUTHERN) was

a California corporation which was organiz-

ed in 1955 and, in 1961, was owned 50 per-

cent by petitioner, his relatives, and his

friends (the Horne group) and 50 percent —

by outsiders. In August 1961, CO pur-

chased the stock of the Horne group in

SOUTHERN for $441,303.75. In March 1963,

CO bought the remaining stock for approxi-

mately $450,000. On June 14, 1963,

SOUTHERN was liquidated and its assets

transferred to CO. By far the most im-

portant of these assets was a piece of

property in San Diego, California, known

as the Rose Canyon Warehouse, having a

book value in excess of $2,000,000. Also

in June 1963, CO gave to petitioner a

fourth mortgage on the Rose Canyon Ware-

house. It was provided, however, that

the mortgage would be null and void if

the mortgagor, CO, paid New Amsterdam

the sum of $404,144 according to the terms

and conditions of the indemnity agreement

between petitioner and New Amsterdam.

8

The three prior mortgages existed

as follows: The first mortgage, dated

September 1, 1957, was executed in favor

of the Bank of America Trust and Savings

Association to secure payment of promis-

sory notes totaling $3,500,000. It is

not known to what extent these notes were

paid. The second mortgage, dated March

28, 1963, went to the "outsiders," the

former owners of 50 percent of SOUTHERN

to secure payment of three purchase notes

it oe el

24

At this time, June 1963, a costly

suit of the Papago Indian Tribe was

threatened against CO. The reason for

giving the fourth mortgage to petitioner

was to protect the property from execution

in the event a future law suit was lost.

The merger agreement between CO and

Seth Horne Development Corporation, lead-

ing to the creation of CO(ARIZ ), pro-

vided, among other things, for the peti-

tioner to be compensated for the release

of the fourth mortgage by the receipt of

additional shares in Seth Horne Develop-

ment Corporation (soon to be CO(ARIZ)).

A release was necessary in order to obtain

refinancing on the property. The mort-

gage was released on or about June 30, 1967.

At that time there remained less than

$450,000 of indebtedness on the Rose Canyon

Warehouse.

At all times from 1966 to 1968, CO

and its successor, CO(ARIZ), had a net

worth in the accounting sense (excess of

assets over liabilities) of over $600,000,

and in 1971 its net worth was approximately

$5,000,000.

Respondent disallowed the claimed los-

ses with this explanation:

The deductions of $118,717.00,

$60,875.00, and $119,123.00 which

you claimed for the taxable years 1966,

1967, and 1968 respectively as in-

demnity loss resulting from trans-

amounting to $750,000, exclusive of interest.

The third mortgage, dated June 4, 1963, went

to the Horne group in connection with the

purchase of SOUTHERN to secure payment

notes worth $441,303.75.

=~ Di theta Baht 8 tats

Fn bot

: NR Ditties ost Et wishes Sil tie te the ashioty-e? +

25

fers of those amounts to the New

Amsterdam Casualty Company for or

on behalf of The James Stewart Com-

pany, [CO] * * * are disallowed. It

is determined that the funds trans-

ferred represented contributions to

Capital rather than losses incurred

in a transaction entered into for

profit. If, however, it is found

that such transfers were loans, it

is determined that a bad debt de-

duction is not allowable under

Section 166 of the Internal Revenue

Code because it has not been establish-

ed that the debt became worthless in

the taxable year in which the deduction

was claimed. f[If, however, it is found

that such transfers were loans which

became worthless in the taxable year in

which the deduction was Claimed, it is

determined that the debt was a non-

business bad debt Since the debt was

a personal loan and was not created in

connection with your trade or business.

In the latter event, the losses of

$118,717.00, $60,875.00 and $119,123.00,

respectively, are subject to the limi-

tations of Section 1211 of the Internal

Revenue Code.

OPINION

In late 1960 the petitioner, Seth Horne,

held a majority interest in a three-man

partnership, HIN. Petitioner also held in-

terests in the Shirley Highway Property, the

Hall-Morrison Property, and the Palomas Ranch

Property. The three partners, as individuals,

Owned all the stock of COINC, in proportion

to their respective interests in HIN. COINC,

in turn, owned two subsidiaries, CORP and co.

CORP and CO paid management fees to COINC,

and COINC paid management fees to HIN. The

26

principal business of HIN was the holding

and development of real estate, including

the performance of construction jobs.

Petitioner's business, as of 1960 and

early 1961, was the same as that of the

partnership.

Beginning in 1958 and continuing

through 1960, the three corporations in-

curred large operating losses. For its

taxable year ended December 31, 1960,

CO alone had a net operating loss of

$539,090.21, inclusive of loss Carryovers.

In the summer of 1960, CO notified

its bonding company, New Amsterdam, that

it could not complete certain contracts

and that the bonding company would have to

Step in. New Amsterdam, upon discovering

that the three corporations were in severe

financial trouble, asked the three stock-

holders of COINC to become personally

liable for amounts paid on the Surety bonds.

Petitioner's fellow stockholders (and

Partners) refused. Petitioner, however,

agreed to indemnify the bonding company

in order to protect his credit reputation

and thus his business as a developer.

It was then agreed among the parties--

the petitioner, his partners, and the bond-

ing company--(1) that petitioner would ob-

tain clear title to the Shirley Highway

Property and transfer it to a trust as

security for his (the petitioner's) promise

to indemnify New Amsterdam; (2) that COINC

and CORP (through COINC) would transfer

certain properties and accounts receivable

having a fair market value in excess of

$555,000 to CO; (3) that petitioner's

stock in COINC would be completely re-

deemed in exchange for all the stock in

CO; (4) that COINC, CORP, and the other

27

two shareholders/partners would not be

liable to New Amsterdam; (5S) that peti-

tioner would indemnify New Amsterdam.

Among the partners it was also agreed that

HIN would be dissolved; that certain pro-

perties would be distributed to the part-

ners, who would then hold some properties

as co-tenants; and that they would exchange

interests in those parcels held in co-

tenancy so that petitioner would own certain

Parcels "free and clear." All of the above

was accomplished. Afterwards, the former

Partners went their separate ways. The

petitioner rebuilt Co's construction busi-

ness and, when the losses on the bonds were

established, reimbursed New Amsterdam. Upon

the advice of counsel the petitioner treated

One-half of his indemnity payments as loans

due from CO and one-half as Ordinary losses.

The petitioner, through his able

counsel, takes a shotgun approach. He con-

tends that the amounts in question are de-

ductible under section 165(c) (1) and (2)

or, alternatively, under section 212 or,

Perhaps more appropriately, under section

162. He aryyee that section 166, Putnam, ?

and Generes1!0 are inapplicable.

Respondent argues as follows: First,

the losses on the indemnity agreement are

3

Putnam v. Commissioner, 352 U.S. 82

(1956).

10 United States v. Generes, 405 U.S. 93

(1972).

ctecdenaiar, xn donde math tdly §

ee ae ce ee Se nae ee

wuld &

|

|

)

;

|

28

part of the purchase price of CO's stock.

Second, the petitioner suffered no losses.

He was adequately compensated for the

indemnity payments that he made. Third,

if the losses are deductible at all, they

are deductible only under section 166.

He contends that the petitioner must lose

under section 166, however, because the

debts in question are not worthless.

Finally, he claims that if the debts are

worthless, they are nonbusiness rather

than business bad debts.

To begin with, we disagree with res-

pondent that the losses on the indemnity

agreement must be treated as a part of

petitioner's basis in the CO stock. While

the facts of the sorting-out process which

followed the corporations’ financial

crisis are somewhat confusing, we are con-

vinced, after carefully reviewing them,

that petitioner's promise to indemnify New

Amsterdam was not partial consideration

for the subsidiary's stock, which Naisbitt

and Ingersoll agreed would be transferred

from COINC to petitioner in exchange for

petitioner's COINC stock. Naisbitt and

Ingersoll were never personally liable to

New Amsterdam as indemnitors or guarantors

of any of the corporations’ debts; there-

ll

The tax consequences of the corporate

reorganization are not directly at issue

in this case.

Respondent does not argue that the

losses, if allowed, are Capital losses be-

cause they are an outgrowth of the earlier,

essentially capital transaction. See

Arrowsmith v. Commissioner, 344 U.S. 6

(1952); Wener v. Commissioner, 242 F.2d 938

(C.A. 9, 1957); Rees Blow Pipe Mfg. Co.,

Leos e

|

|

|

|

29

fore, the exchange of stock was not con-

ditioned on petitioner's indemnity pro-

mise as consideration for New Amsterdam's

promise to release Naisbitt and Ingersoll.

In other words, there was no three-way

agreement. Also Naisbitt and Ingersoll

were not purchasing the release of COINC

and CORP from their cross-indemnity agree-

ments. It is apparent that both cor-

Pporations, after having transferred their

assets to CO, would be abandoned. Further-

more, there is no indication that New

Amsterdam insisted upon the reorganization

(petitioner did this) or that the transfer

of assets from COINC and CORP to CO depended

upon petitioner's entering into the agree-

ment. Cf. Estate of McGlothin v. Commissioner,

370 F.2d 729 (C.A. 5, 1967), affirming 44 T.C.

611 (1965); Albert J. Harvey, Jr., 35 T.C.

108 (1960).

In Estate of McGlothin, supra, the tax-

payer, a stockholder of P corporation, gua-

ranteed the market value of certain assets

Owned by P as part of a merger between another

corporation and P. His losses on the guaranty

agreement was a critical condition necessary

for the acquisition of the other corporation's

Stock by the taxpayer. Here we find, to the

Contrary, that the indemnity agreement,

though contemporaneous with, was not consi-

deration for the stock received in the reorgani-

zation.

41 T.C. 598 (1964), affd. 342 F.2d 990 (C.A.

9, 1965). Nor does he argue that the in-

demnification of the bonding company and the

losses pursuant thereto represent some sort

of unusual contribution to capital. See J.

Meredith Siple, 54 T.C. 1 (1970), and cases

Cited therein.

:

i

|

4

4

q

4

|

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‘

4

30

The case of Albert J. Harvey, supra,

is even farther afield. In Harvey, the

taxpayer was an employee, director, and

major shareholder of H&O corporation.

H&O being in need of funds, the taxpayer

requested a friend to personally guarantee

a loan from a bank to H&O. In consideration

for the friend's guaranty, all the share-

holders, including the taxpayer, trans-

ferred one-half of their stock to the friend.

The taxpayer then agreed to indemnify the

friend against any loss by reason of the

latter's guaranty of the loan. In con-

Sideration for this agreement to indemnify,

the friend assigned to the taxpayer all the

H&O stock which he, the friend, had pre-

viously acquired in return for his guaranty.

H&O went bankrupt; the friend paid off on

his guaranty; and the taxpayer paid the

friend in accordance with the indemnity

agreement. On these facts we held that the

losses on the indemnity agreement were part

of the purchase price of the stock received

from the friend:

The net effect of the entire trans-

action * * * was that petitioner,

being a substantial shareholder and

director of H&0O, was able to obtain

additional funds for H&0O by pledging

his property and in return he received

stock of H&0. In substance, this

transaction constitutes an acquisition

of H&O stock by petitioner for his

guaranty of the H&O loan.

* * * * * + *

Petitioner, by his indemnity

agreement, assumed a contingent lia-

bility and thus acquired the H&0O stock

without making any immediate payment

therefor.

[Albert J. Harvey, supra at 112-113.]

31

We find no such tic-for-tac consideration

in this case.

We also disagree with the contention

that petitioner was adequately compensated

by CO for the amounts paid on the indemnity

agreement and that, therefore, he suffered

no losses. Respondent points to the fact

that in 1963 petitioner was given a fourth

mortgage on a warehouse in southern Cali-

fornia. Later, the petitioner released the

mortgage in order to help CO's successor

obtain financing, receiving in return ad-

ditional shares in the successor. Peti-

tioner's explanation is that the fourth

mortgage was of indeterminable value and

was given simply to further protect the

property from execution in connection with

a foreseeable law suit. The facts are laid

Out in sufficient detail in our findings of

fact. Because we believe the testimony

given on petitioner's behalf, we find that

the fourth mortgage was not compensation

for petitioner's indemnity losses.

Turning to the sections of the Code

argued by the parties, we think it best to

proceed section by section.

Section 162. Section 162(a) allows a

deduction for all the ordinary and necessary

expenses paid or incurred in carrying on any

trade or business. For this section to be

applicable to these facts the petitioner

must show, among other things, that he was

in a business--herein the real estate develop-

ment business--to which the payments might

“proximately” relate, that the payments were

not Welch v. Helvering!2-type capital pay-

Iz

Welch v. Helvering, 290 U.S. 111 (1933).

—

32

ments made to purchase a good name, and

that he did not stand as a creditor in

relation to his principal, CO, after mak-

ing payment. Although respondent attempts

to characterize petitioner's business as

that of a corporate executive and points

to testimony to the effect that petitioner

did not engage in any business on an

individual basis so long as he was a member

of HIN partnership, the partnership's

business and hence, in this case, the peti-

tioner's business was real estate develop-

ment--from acquisition of land, to con-

struction of improvements, to management

of the property. Since he was in the real

estate development business before under-

taking the indemnity liability and remained

in that business thereafter, the disputed

amounts cannot be said to be capital expen-

ditures to acquire goodwill. Compare Welch

v. Helvering 290 U.S. lll (1933); Falstaff

Beer, Inc. v. Commissioner, 322 F. za 748

(C.A. 5, 1963); Carl Reimers Co., Inc. v.

Commissioner, 221 F.2d 66 (ClA. P 1554),

With Samuel R. Milbank, 51 T.C. 805 (1969);

L. Heller & Son, Inc., 12 T.C. 1109 (1949);

Scruggs-Vandervoort-Barney, Inc., 7 T.C.

775-T13I6y 3 Edward J. Miller, 37 B.T.A. 830

(1938). The question which remains is

whether upon payment to the bonding company

in fulfillment of the indemnity agreement,

petitioner became entitled to reimbursement

from CO or, restated, whether the Putnam

case and section 166 apply. The answer would

ordinarily lie in State statutory or case

law. Santa Anita Consolidated, Inc. 50 T.C.

536, 559-560 (1968). See also Putnam v.

Commissioner, 352 U.S. 82 (1956); Bert W.

Martin, 52 T.C. 140, 143 (1969), affirming

per curiam 424 F.2d 1368 (C.A. 9, 1970).

In this case, however, the parties have not

cited, and we have not discovered, any dis-

positive Arizona law. Nevertheless, upon

33

consideration of the general case law,

treatises, and restatements, we conclude

that the correct answer is that the

petitioner was actually both an indemnitor

and a guarantor; that he did acquire a

"remedy over" against CO, his and the

bonding company's principal, and that this

“remedy over" represents a debt falling

within the provisions of section 166. See

United States v. Hoffman, 423 F.2d 1217

(CLA. 9, 1570), for the proposition that an

indemnitor in a four-party indemnity situation

is to be treated the same as a guarantor.

See generally, United States v. Generes, 405

U.S. 93 (1972); Reid v. Pauly, 121 Fed. 652

(C.C.A. 9, 1903).

A guarantor is one who promises either

than another will perform his duty, or that,

if another does not perform his duty, he

will, non-performance by the other being a

condition precedent to the guarantor's duty

to pay. In the broader sense of the word

"surety," a guarantor is also a surety;

and, for the purposes of this discussion,

an indorser is like a guarantor. An in-

demnitor is one who promises to hold another

harmless from loss in respect to an obliga-

tion to a third person. "The great dif-

ference between the two [a guarantor and

indemnitor] lies in the character of the pro-

mise. In * * *[guaranty] the promise runs

to an obligee * * *, present or prospective.

In indemnity the promise runs to an obligor

* * *, present or prospective.” Simpson,

Handbook on the Lw of Suretyship 28 (1950).

Whether a party is a guarantor or an in-

demnitor or both depends upon an analysis

of the legal character of the actors and their

obligations, not the terminology used. In

the four-party indemnity situation, there

is, for example, a principal-contractor, a

creditor-obligee, a-surety (or guarantor)-

34

bonding company, and an indemnitor-share-

holder. The principal owes the creditor-

obligee money or, more likely, some type of

performance. The surety (or guarantor)

promises the creditor-obligee that he will

pay or perform if the principsl does not.

Clearly, in relation to the creditor-

Obligee, the surety (or guarantor) is an

Obligor. As a guarantor, however, he is

entitled as a matter of law to be reim-

bursed by his principal; in this respect,

he is also an obligee. The indemnitor

promises the surety (or guarantor) that he

will secure him against any loss on his ob-

ligation to the creditor-obligee. In this

light the indemnitor is a true indemnitor

Since his promisee, the surety (or guarantor),

is an obligor. But his promise is also an

Obligee, vis-a-vis the principal; and, in

this other light, the indemnitor is also a

guarantor, with all the rights and privileges

of a guarantor. For instance, the so-called

indemnitor in the four-party indemnity situa-

tion is entitled to subrogation to the rights

of the surety (or guarantor) against the pri-

ncipal, i.e., any rights of the creditor-

obligee against the principal acquired

through subrogation and any right to reimburse-

ment. “Much of the difficulty and confusion

that exists in the cases in distinguishing

between the contract of indemnity and the

contract of suretyship [or guaranty] lies

in the common failure to recognize the fact

that the former is always accompanied by the

latter whenever the four-party indemnity

Situation is involved." Simpson, supra at

30; Restatement of Security, §96. Thus, peti-

tioner, the indemnitor in the above illus-

tration, was as much a guarantor as an in-

demnitor. It is now well established that a

guarantor, upon payment, stands in a creditor-

debtor relationship with his principal.

In this particular case the petitioner was sub-

35

rogated to the rights of the bonding com-

pany against the corporation, rights which

the bonding company acquired through sub-

rogation from the creditors for whose bene-

fit the bonds were executed. It is equally

well established that given such a creditor-

debtor relationship, the guarantor, here

the petitioner, must look to the bad debt

provisions of section 166 for the deduction

of related losses. And there is no doubt

that the debt arising out of a guarantee

that has been performed is a debt within

the meaning of that term as used in section

166. Putnam v. Commissioner, supra.}3

See also Robert E. Gillespie, 54 T.C. 1025,

1031 (1970), and the cases cited therein.

biky

The deduction for bad debts first ap-

peared in the Act of March 2, 1867, as an

amendment to the Act of March 3, 1865, ch.

78, 13 Stat. 471, 479, which in turn amended

Sec. 117 of the Act of June 30, 1864, ch.

173, 13 Stat. 223, 281. ("* * * and in ad-

dition to one thousand dollars exempt from

income tax, as hereinbefore provided, * * *

debts ascertained to be worthless * * *.")

In the Revenue Act of 1918, the deduction

appeared in sec. 214(a)(7): “Debts ascertain-

ed to be worthless and charged off within the

taxable year * * *." Revenue Act of 1918, ch.

18, 40 Stat. 1057, 1067. In connection with

the 1918 provision, the following floor dis-

cussion took place:

Mr. Graham of Illinois. How about

losses caused by indorsements on accom-

modation paper? That is, where one signs

as security for another and makes a loss

in that way, does the bill take care of

that, so that such a loss can be deducted?

36

In United States v. Hoffman, supra,

the taxpayers, owners of an electric con-

tracting corporation, had indemnified the

bonding company which wrote bonds for the

corporation and had had to make good. They

Claimed tax refunds for the amounts lost

On the ground that these were losses de-

ductible under section 165(c)(2). The

district court held for the taxpayers, stat-

ing (266 F.Supp. 884, 886):

Putnam is not in point. Unlike

Putnam, the Hoffmans were indemnitors.

An indemnitor has a primary obligation

to the creditor and he is not sub-

rogated to the creditors' rights. See:

Howell v. Commissioner of Internal

Revenue, 8 Cir. 1934, 69 F.2d 447.

The Court of Appeals for the Ninth Circuit re-

versed, relying upon Stratmore v. United States,

420 F.2d 461 (C.A. 3, 1970), a case involving

guarantors. “That the Stratmores were guaran-

tors and the Hoffmans were indemnitors is not a

persuasive distinction between the two cases."

United States v. Hoffman, supra at 1218. The

principal of Putnam was applied. Thus the

Hoffman case treats indemnitors in a four-party

Situation like guarantors.

By far the most in-depth judicial dis-

cussion of the problem appears in Chief

Mr. Kitchin. If he charges it

off and does not hold the other man

responsible for it, it can be deducted.

56 Cong. Rec., appendix p. 678. The remaining

history of the deduction up to and including

sec. 23(k) of the I.R.C. of 1939, is traced in

footnote 9 of Putnam v. Commissioner, supra

at 85.

37

Judge Andrews' opinion in Jones v. Bacon,

40 N.E. 216 (Ct. App. N.Y., 1895), affirm-

ing 25 N.Y. Supp. 212 (1893). In that

case the indemnitor promised to hold the

plaintiff harmless if he, the plaintiff,

would guarantee. the debt of the principal

to a bank. Upon the princpal's default

the plaintiff paid the required amount to

the bank, released the principal, who was

insolvent, and sued the indemnitor on the

indemnity agreement. The indemnitor de-

fended on the ground that the release de-

feated the plaintiff's right of action.

The court so held, reasoning that but for

the release, the indemnitor would have been

Subrogated to the rights of the indemnitee

against his principal. The court said

(40 N.E. 216):

The indemnitor of the plaintiff, on

restoring to him this sum in per-

formance of the contract of indem-

nity, would be entitled to be sub-

stituted to the claim of the plain-

tiff against Kingsbury [the principal].

This stands upon the most obvious

principles of natural justice. * * *

There was no privity of contract bet-

ween the plaintiff [the indemnitee-

guarantor] and Kingsbury. On paying

the plaintiff what he had been com-

pelled to pay for Kingsbury, pursuant

to the contract of indemnity, the

indemnitor would stand as the equitable

assignee of the plaintiff of the obli-

gation of Kingsbury to him.

See also Aetna Casualty Co. v. Phoenix Co.,

285 U.S. 209, 214 Sas) 1 4

14

Because of our choice as to the dis-

position of this case, we need not consider

38

Since it is our view that a debtor-

creditor relationship did arise, section

162 cannot apply. E.g., Oddee Smith, 55

T.C. 260, 267 (1970), remanded on another

issue, F.2d _ (C.A. 5, 1972); Josef

C. Patchen, 27 T.C. 592, 600 (1956), af-

firmed in part and reversed in part on

another issue, 258 F.2d 544 (C.A. 5, 1958).

See and compare Samuel R. Milbank, supra,

where no debtor-creditor relationship

arose.

Section 165. Section 165(c) provides

a deduction, in the case of individuals,

for losses incurred in a trade or business

Or losses incurred in a transaction entered

into for profit. This provision cannot be

relied upon where section 166 is applicable.

Spring City Foundry Co. v. Commissioner, 292

U.S. igs A530) (involving section 234 (a) (4)

and (5) of the Revenue Act of 1918, 40 Stat.

1077, predecessors of sections 166 and 165);

two other grounds for finding a creditor-

debtor relationship between petitioner and

CO. (1) It is argued that as a general

rule indemnitors should be treated as

guarantors for sec. 166 purposes. Compare

United States v. Hoffman, supra, and Jones

Vv. Bacon, supra, With Howell v. Commissioner,

69 F.zd 447 (C.A. 8, 1534). (2) Tt is

argued that as a co-indemnitor who was not

directly benefited by the indemnification,

the petitioner was entitled to 100 percent

contribution from CO, the co-indemnitor

who was directly benefited, and that this

represents a sec. 166 debt. But see

Security Ins. Co. v. Johns-Manville Sales

Corp., 442 P.2d 555 (Ct. of App. of Ariz.

I968) for an example of how difficult it

is to weigh the equities in such a case.

39

Putnam v. Commissioner, supra (decided

under the Internal Revenue Code of 1939);

Inman-Poulsen Lumber Co. v. Commissioner,

: (C.A. 9, 1955) (also decided

under the Internal Revenue Code of 1939).

Section 212. Section 212 allows as

a deduction all the ordinary and necessary

expenses paid or incurred for the pro-

duction or collection of income and for

the management, conservation, or main-

tenance of property held for the production

of income. Petitioner maintains that real

estate development was his source for the

production of income and that that source

would have been impaired if he had not

agreed to enter into the indemnity agree-

Ment with the bonding company. In addition,

he says that his actions helped preserve

CO, the property from which he derived his

income. It is unnecessary to analyze these

arguments in light of the facts since peti-

tioner, whether he knew it or not, had a

fixed, readily assertable right to payment

by CO. This one fact alone makes section

212 inapplicable. Estate of Elmer B. Boyd,

28 T.C. 564, 566 (1957). Cf. Electric Tacho-

meter Corp., 37 T.Cc. 158 (1961). ,

Section 166. Section 166(a) provides

that there snall be allowed as a deduction

any debt which becomes wholly worthless

within the taxable year. Subsection (d)

provides, with respect to nonbusiness dacbts,

that any loss resulting therefrom shall be

treated as a short-term capital loss.

Paragraph 2 of subsection (d) states that

"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

40

or business."

As we have previously indicated,

it is our opinion that this is basically

a section 166 case. We might add that we

do not think that petitioner should be

viewed as a mere volunteer, nor that his

right to payment by CO should be charac-

terized as simply an unadjudicated claim.

See and compare Phillip H. Schaff, 46

B.T.A. 640 (1942).

It is unnecessary for us to decide

the question of whether the losses of the

petitioner were business or nonbusiness

bad debt losses because we find that the

debts were not worthless in the year

Claimed. It appears from the testimony

not only that some amounts--less than one-

half the total amount--have been repaid,

but also that CO was financially able to

repay additional amounts. CO never went

bankrupt. Indeed, in each of the three

years before us, CO's net worth exceeded

$600,000. The fact that there were

Operating losses does not contradict this

conclusion. Pachella's Estate v. Com-

missioner, 310 F.2d 815 (C.A. 3, 1962),

affirming 37 T.C. 347 (1961). See Higgen-

botham-Bailey-Logan Co., 8 B.T.A. 566

To reflect the conclusions reached

herein,

Decision will be entered

under Rule 50.

41

UNITED STATES TAX COURT

M. SETH HORNE and

MAURINE D. HORNE,

Petitioners, Docket No.

2645-70

COMMISSIONER OF

)

)

)

)

)

Vv. )

)

INTERNAL REVENUE, )

)

)

Respondent.

DECISION

Pursuant to the opinion of the Court

filed November 27, 1972, and incorporat-

ing herein the facts recited in the res-

pondent's computation as the findings of

the Court, it is

ORDERED and DECIDED: That there are

deficiences in income taxes due from the

petitioners for the taxable years 1966,

1967 and 1968 in the amounts of $56,280.00,

$23,378.00 and $66,078.00, respectively.

/s/ Howard A. Dawson, Jr.

Judge

Entered: February 12, 1973

42

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

M. SETH HORNE and MAURINE

D. HORNE,

Petitioner, No. 73-2349

vs.

OPINION

COMMISSIONER OF INTERNAL

REVENUE,

Respondent.

On Appeal from a Decision of the United

States Tax Court

Before: CHAMBERS, Circuit Judge,

BALDWIN,* Judge of the Court of Customs

and Patent Appeals, and WALLACE, Circuit

Judge.

CHAMBERS, Circuit Judge:

The issue in this case is whether pay-

ments of approximately $300,000 made by

taxpayer M. Seth Horne as indemnitor in

connection with obligations of corporations

in which he owned a substantial interest

are deductible as ordinary losses. Horne

was the principal partner in a real estate

Gevelopment firm which owned all the out-

standing shares of James Stewart and Co.,

Inc. (COINC). COINC had two wholly-owned

subsidiaries, James Steward Corporation

*The Honorable Phillip B. Baldwin, Judge of

the United States Court of Customs and Patent

Appeals, sitting by designation.

43

(CORP) and James Stewart Company (CO).

All three corporations were engaged in

construction and general contracting

work in which it was necessary for

them to post performance bonds as a con-

dition of obtaining the contract. The

bonds were obtained from New Amsterdam

Casualty Company (NA). Each corporation

agreed to indemnify NA against losses it

incurred as surety for the other two.

In 1960, all three corporations were

in financial trouble and NA was informed

that CO would not be able to complete its

existing contracts and that COINC and

CORP lacked sufficient funds to perform

their obligations as indemnitors. NA

estimated its liability exposure at this

time to be one million to one and a half

million dollars, and requested that Horne

and his partners agree to assume personal

indemnity obligations. Horne was willing

but his partners refused. Following this

disagreement, the partnership was dissolved

and the corporations were reorganized.

The assets of COINC and CORP were trans-

ferred to CO; Horne received all the stock

of CO in exchange for his shares in COINC;

and, COINC and CORP became inactive.

Contemporaneously with the reorcaniza-

tion, Horne agreed with NA that he and CO

would be jointly and severally liable for

any amounts expended by NA in connection

with eight contracts previously entered

into by CO, any liability incurred by CO

under the earlier cross-indemnity agree-

ments, and interest. NA agreed to release

COINC and CORP from their cross-indemnity

agreements, except as to specified contracts.

During 1966 through 1968, Horne paid

NA approximately $600,000 under the in-

44

demnity agreement and recouped less than

half of this amount from CO. At all times

during this period, CO and its successor

corporation had a net worth of over

$600,000; by 1971 its net worth was about

$5 million. On his income tax returns for

1966, 1967, and 1968, Horne treated one-half

of his indemnity payments as ordinary

losses. (The other half was teated as loans

to CO.) In the tax court, Horne argued these

losses were fully deductible from ordinary

income under Int. Rev. Code of 1954, § 165

(c) as losses incurred in a trade or business

Or under sections 162 or 212 as ordinary

and necessary expenses incurred in a trade

or business or for the production of income.

The Commissioner argued they should be de-

ductible only as non-business bad debts

under Int. Rev. Code of 1954, § 166(d).

As such, they would be treated as short term

Capital losses and be deductible only in the

taxable year in which they became worthless.

Id. § 166(d) (1) (B).1/ The tax court ac-

cepted the Commissioner's view that bad debt

treatment was appropriate and concluded that

inasmuch as CO was financially able to repay

Horne during the relevant years, the debts

were not worthless and no deduction was per-

mitted. M. Seth Horne, 59 T.C. 319 (1972).

We affirm.

The Supreme Court, interpreting pro-

visions of the 1939 Internal Revenue Code

similar to section 166, has held that pay-

ments made by a shareholder in discharge

of his obligation as guarantor of notes

issued by his corporation were deductible

only as bad debts. Putnam v. Commissioner,

352 U.S. 82 (1956). In United States v.

Hoffman, 423 F.2d 1217 (9th Cir. 1970),

we held that section 166 covers payments by

an indemnitor as well. Horne seeks to

distinguish these. authorities by arguing

45

that the essense of the Putnam rule

is that the taxpayer as guarantor ac-

quired upon payment a claim against the

corporation by subrogation. This claim

was the "debt" that became worthless.

Arguing that under the law of Arizona,

where the indemnity agreements presum-

ably were entered into, an indemnitor has

no right to subrogation, at least where

as here he is not a party to the original

transaction between principal debtor and

Surety, Horne contends that without a

remedy over against the corporation there

is no “debt" to render section 166 ap-

plicable.

We think this argument misunderstands

the operation of the statutory scheme.

The loss covered by section 166(d) is "the

loss resulting from [the worthlessness of

a nonbusiness debt]" (emphasis added); this

language, we believe, includes not only any

loss sustained by a third party, whether

acting as surety, guarantor, or indemnitor.

Thus, the section is triggered by the worth-

lessness of the principal debt, and no in-

dependent debt between principal debtor

and the third party, created by subrogation,

is necessary.

As Horne points out, the Supreme Court

in Putnam did state that the guarantor would

have a remedy over against the maker of the

notes, but we do not read this discussion

as essential to its opinion.?2/ The purpose

of section 166(d), as seen by the Court in

Putnam,3/ was to assure capital loss treat-

ment to all nonbusiness investments, whether

in the form of loans or of stock. Under

Horne's view, the taxpayer may circumvent

this policy, as well as the general require-

ment of section 166 that no deduction is to

be allowed unless the principal debt is in

46

fact worthless, by skillfully drafting

his undertaking as a promise to indemnify

or any other form of obligation which,

under the law of the particular state in-

volved, gives him no remedy over against

the principal debtor. Since, ordinarily,

no payment of indemnity will be required

unless the borrower is unable to pay the

Principal debt, the availability of such

a remedy against the borrower is likely

to be a matter of academic interest only.

See Stratmore v. United States, 420 F.24

461, 465 (3d Cir. 1970), cert. denied, 398

U.S. 951 (1970). No reason is advanced

why Congress would have intended tax con-

Sequences to flow from the mere existence

Of a right of such doubtful economic

Significance.

Our conclusion that payments under

Obligations of guaranty and indemnity are

to be treated the same is corroborated by

Section 166(f).4/ That section, inap-

Plicable in this case because it is limi-

ted to noncorporate obligations, provides

that any payments by a taxpayer in dis-

Charge of his obligation as "guarantor,

éndorser, or indemnitor," where the pro-

ceeds of the original obligations were

used in borrower's trade or business, are

to be treated as a debt becoming worthless

within the taxable year in which the pay-

ment is made. No distinction on the basis

of the existence of a_remedy over against

the borrower is made .?/

Because of our conclusion that section

166 covers the indemnity payments involved

here, deductibility under the sections as-

serted by Horne is precluded. &/ Thus,

Horne's payments are deductible only if the

underlying obligations of his corporation

were worthless at the time the payments

47

were made. Cf. Int. Rev. Code of 1954,

§ 166(f). In view of the tax court's

determination that CO possessed the re-

sources to reimburse Horne during the

period, we must conclude the obligations

were not worthless and therefore no

deduction is permitted.

The decision of the tax court is

affirmed.

FPootnote l

l. Int. Rev. Code of 1954, § 166(d)

Provides:

(d) Nonbusiness debts. -

(1) General rules. - 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 nonbusi-

ness debt becomes worthless within the taxa-

ble year, the loss resulting therefrom shall

be considered a loss from the date of ex-

change, during the taxable year, of a capital

asset held for not more than 6 months.

(2) Nonbusiness 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

48

(B) a debt the loss from

the worthlessness of which is incurred in the

taxpayer's trade or business.

Footnote 2

Cf. Bert M. Martin, 52 T.C. 140, 144-47

(1969), aff'd, 424 F.2d 1368 (9th Cir. 1970).

But see id. at 147 (concurring opinion).

Footnote 3

352 U.S. at 91-93. But see B. Bittker

& J. Eustice, Federal Income Taxation of

Corporations and Shareholders, ¥ 4.09, at

4-35 n. 72 (3d ed. 1971).

Footnote 4

Int. Rev. Code of 1954, § 166 (f),

provides:

(£) Guarantor of certain noncor-

porate obligations. - A payment 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 obli-

gation the proceeds of which were used

in the trade or business of the bor-

rower 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 the obligation of

the borrower to the person to whom

such payment was made was worthless

(without regard to such guaranty, en-

dorsement, or indemnity) at the time

of such payment.

49

Footnote 5

In discussing section 166(f), the Senate

Committee Report on the 1954 Code states:

The term "guarantor, endorser, or

indemnitor" includes not only those

persons having collateral obligations

as guarantors or endorsers but also

those persons having direct obligations

as indemnitors. S. Rep. No. 166, 83d

Cong., 2d Sess. 200 (1954).

Footnote 6

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

87 (1956); Spring City Foundry Co. v.

Commissioner, 292 U.S. 182, 189 (1934).

50

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

M. SETH HORNE and MAURINE )

D. HORNE, )

)

Petitioner- )

Appellant, ) No. 73-2349

)

Vs. ) AMENDED

) ORDER DENYING

COMMISSIONER OF INTERNAL ) PETITION FOR

REVENUE, ) REHEARING

)

Respondent- )

Appellee. )

)

Before: CHAMBERS and WALLACE, Circuit

Judges, and BALDWIN, Associate

Judge, United States Court of

Customs and Patent Appeals.

Appellant's petition for rehearing

is denied. Our disposition in this case

Simply enforces the policy embodied in § 166

(d) as developed in Putnam v. Comm'r, 352

U.S. 82, 92-93 (1956); United States v.

Hoffman, 423 F.2d 1217 (8th Cir. 1970);

Martin v. Comm'r, 424 F.2d 1368 (9th Cir.

1970), aff'd 52 T.xX. 140, 144-47 (1969);

Stratmore v. United States, 420 F.2d 461, 464-

65 (3rd Cir. 1970).

Filed: March 27, 1978