# Appendix — Horne v. Commissioner

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Appendix
- **Published:** January 1, 1978
- **Citation:** 439 U.S. 892

## Text

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 '

|

f

8

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

Ea eT ee

12

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.

4
g :

21

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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
|
?
‘
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

---

Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385005_1206%3A2. Public record. Not legal advice.