Opposition — Horne v. Commissioner

No. 77-1824

In the Supreme Court of the United States

OcToBER TERM, 1978

M. SetH Hornet ann Macrint D. HORNE, PETITIONERS

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A URIT OF CERIIORARI 10

THE UNITED STATES COURT OF APPEALS FOR

THE NINTH CIRCUIT

BRIEF FOR THE RESPONDENI

IN OPPOSITION

Wapt H. McCreet. Jr.,

Solicitor General,

Mo CARR FERGUSON,

4ysistant Attorney General,

ANN BELANGER DURNEY,

Joun A. Dupeck, JR,

4ftorneys,

Department of Justice,

Washington, D.C. 20530

In the Supreme Court of the United States

OCTOBER TERM, 1978

No. 77-1824

M. SETH HORNE AND MAURINE D. HORNE, PETITIONERS

‘ Vv.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI TO

; THE UNITED STATES COURT OF APPEALS FOR

: THE NINTH CIRCUIT

BRIEF FOR THE RESPONDENT

IN OPPOSITION

OPINIONS BELOW

The findings of fact and opinion of the Tax Court (Pet.

App. 1-40) are reported at 59 T.C. 319. The opinion of

the court of appeals (Pet. App. 42-49) is reported at 523

F. 2d 1363.

JURISDICTION

The judgment of the court of appeals was entered on

September 30, 1975, and its order denying rehearing was

entered on March 27, 1978 (Pet. App. 50). The petition

for a writ of certiorari was filed on June 23, 1978. The

jurisdiction of this Court is invoked under 28 U.S.C.

1254(1).

(1)

QUESTION PRESENTED

Whether payments petitioner made in satisfaction of his

obligation as indemnitor of the debts of a corporation, of

which he was president and majority shareholder, gave

rise to debts that had not become wholly worthless so

as to be nondeductible under Section 166(d) of the In-

ternal Revenue Code of 1954.

STATUTES INVOLVED

The pertinent provisions of Sections 165 and 166 of

the Internal Revenue Code of 1954 (26 U.S.C.) are set

forth at Pet. 3-4.

STATEMENT

Petitioner! was the principal partner in a real estate

development firm which owned all the outstanding shares

of James Stewart and Co., Inc. (COINC). COINC had

two wholly-owned subsidiaries, James Stewart Company

(CO) and James Stewart Corporation (CORP). All three

corporations were engaged in construction and general

contracting work. In the conduct of their business they

were required to furnish performance bonds and New

Amsterdam Casualty Company, a bonding company,

issued bonds to the three companies. Each corporation

agreed to cross-indemnify New Amsterdam against any

losses New Amsterdam might incur as surety for the other

two corporations (Pet. App. 3-9, 42-43).

In 1960, New Amsterdam was informed that CO would

not be able to complete its existing construction contracts

and that COINC and CORP lacked sufficient funds to

'“Petitioner™ refers to M. Seth Horne. Maurine D. Horne is a party

because she filed a joint return with her husband for the years in

issue.

perform their obligations as indemnitors under the cross-

indemnity agreements. New Amsterdam thereupon

requested that petitioner and his partners assume personal

indemnity obligations for any loss incurred on the three

corporations’ bonds. Although the other partners refused

to assume personal liability, petitioner acceded to prevent

the loss of his investment in COINC and damage to his

credit reputation. The partnership was dissolved and the

corporations were reorganized, with the assets of COINC

and CORP transferred to CO. Petitioner received all of

the stock of CO in exchange for his shares of COINC

(Pet. App. 9-10, 43).

Contemporaneously with the reorganization of the

three corporations on January 20, 1961, petitioner entered

into an indemnity agreement with New Amsterdam and

CO, pursuant to which he became jointly and severally

liable with CO for any losses incurred by New Amsterdam

as surety for CO. Subsequently, New Amsterdam made

payments on behalf of CO, and petitioner, pursuant to the

indemnity agreement, paid New Amsterdam $237,434 in

1966, $121,749 in 1967, and $238,246 in 1968. CO treated

half of the amounts paid by petitioner to the bonding

company during 1966 through 1968 as paid-in capital,

and the remaining half as an account payable to petitioner

(Pet. App. 20, 44). CO subsequeitly repaid petitioner

part of the amount treated by him as loans to CO

(Pet. App. 43-44; Tr. 177).°

On his federal income tax returns for 1966, 1967, and

1968, petitioner deducted one-half of the amounts he paid

to New Amsterdam as ordinary losses under Section 165.

The amounts deducted by petitioner as losses were the

“Tr.” refers to the trial transcript.

portions (one-half of each payment) treated as paid-in

capital (Pet. App. 20). During these same years, CO and

its successor corporation had a net worth (excess of

assets over liabilities) of more than $600,000; by 1971,

its net worth was approximately $5 million (Pet. App.

24, 43-44).

On audit, the Commissioner of Internal Revenue

disallowed the ciaimed deductions. The Commissioner

determined that the payments represented additional

contributions to the capital of the corporation, or,

alternatively, that the sums paid gave rise to nonbusiness

debts under Section 166(d) that had not become worthless

during the years in issue (Pet. App. 24-25). The Tax Court

held that the payments were debts but that they were not

worthless and therefore not deductible because CO was

financially able to repay petitioner during the years at

issue (Pet. App. 39-40).

The court of appeals affirmed (Pet. App. 42-44). It

stated: “In view of the tax court's determination that CO

possessed the resources to reimburse [petitioner] during

the period, we must conclude the obligations were not

worthless and therefore no deduction is permitted” (Pet.

App. 47).3

ARGUMENT

1. The decision below correctly held that petitioner's

payments to the surety were not deductible. Petitioner

seeks to deduct one-half of the payments as ordinary

‘Both courts rejected petitioner's alternative arguments that the

amounts paid to the surety were fully deductible as ordinary and

necessary business expenses under Section 162 or as expenses

incurred in the production of income under Section 212 (Pet. App.

31-32, 39, 46). Petitioner no longer relies upon Section 212 in support

of his claimed deduction.

——_— ee’

7 4)

losses under Section 165(c)2) or as ordinary and

necessa.y business expenses under Section 162. But

petitioner and his corporation treated the amounts in

question as paid-in capital contributions to the

corporation (Pet. App. 20).4 As such, they were not

deductible, in accordance with the rule set forth in Section

263. A shareholder's contribution of capital to his

corporation is not deductible but increases the basis of his

stock. While a capital contribution may result in a

subsequent loss upon disposition, corporate liquidation or

worthlessness of the stock, none of these occurrences took

place here. To the contrary, the record establishes that at

all times during the years in question (1966-1968),

petitioner's corporation had a net worth of more than

$600,000, and by 1971, its net worth was approximately

$5 million (Pet. App. 24, 44). Accordingly, the

corporation was a thriving going concern. Thus, even on

the assumption that the payments were not contributions

to capital, petitioner is not entitled to an ordinary

deduction under Section 165 because he sustained no loss

during the tax years in issue. See Treasury Regulations,

Section 1.165-l(a) and (b) Cf. Burns v. Commissioner, 31

F. 2d 399, 400-401 (C.A. 5); Perlman v. Commissioner,

252 F. 2d 890 (C.A. 2); Bavinger v. Commissioner, 22

B.T.A 1239.5

*The remaining half of the amounts paid by petitioner to the surety

was treated as an account payable to him, at least part of which the

corporation subsequently repaid (Pet. App. 20, 44; Tr. 177).

‘Although the Tax Court rejected (Pet. App. 28-29) the

government's argument that the payments were part of petitioner's

basis in the CO stock, it did so on the ground that petitioner's

indemnification obligation was not part of the consideration that he

paid for the acquisition of the stock from his two former partners. In

this respect, the Tax Court overlooked (Pet. App. 28-29 n. I1) the

government's additional contention that the payments repre-

sented a subsequent contribution by petitioner to the capital of

the corporation.

6

2. Alternatively, even if petitioner's payments are

viewed as a loan to the corporation,® rather than as

capital contributions, the courts below correctly

concluded that petitioner was not entitled to a bad debt

deduction under Section 166 because there was no

evidence that the debts became worthless during the years

in issue, a factual finding no longer challenged by

petitioner. Since both courts found (Pet. App. 40, 47) that

the corporation had the resources to reimburse petitioner

at all times during the years in issue, there is no basis for a

bad debt deduction.

*The courts below treated the payments as deductible, if at all, as a

nonbusiness bad debt under Section 166, rather than Section 165, on

the basis of Putnam v. Commissioner, 352 U.S. 82. There, the Court

held that payments made by a taxpayer-shareholder as guarantor of

loans to his corporation were deductible only as nonbusiness bad

debts under Section 166(d) and could not be deducted under Section

16S(c2) as losses incurred in a transaction entered into for profit.

Petitioner asserts (Pet. 15-16) that the rule of Putnam does not

apply because as indemnitor rather than a guarantor, he was not

subrogated to the rights of the lender against the debtor-corporation.

Although Putnam turned in part upon the taxpayer's right of subro-

gation, the Court in Putnam also eriphasized that in order to

xive Section 166(d) its intended effect, it was essential that al!

taxpayers who incur losses in providing financing for their

corporations should receive the same tax treatment, regardless of the

particular method of financing used. On the basis of this rationale, the

court below concluded, in accordance with Martin v. Commissioner,

52 T.C. 140, 144-146, affirmed per curiam, 424 F. 2d 1368 (C.A. 9),

certiorari denied, 400 U.S. 902, and Stratmore v. United States, 420

F. 2d 461, 464-465 (C.A. 3), certiorari denied, 398 U.S. 951, that the

Statutory scheme mandates a common tax treatment for all losses

suffered by a shareholder in providing his corporation with financial

assistance, and that differeni tax results should not turn on the

technical right of subrogation. See also United States v. Hoffman,

423 F. 2d 1217 (C.A. 9); United States v. Generes, 405 U.S. 93. (And

see H. Rep. No 94-658, 94th Cong., Ist Sess., p. 177 (1975),

describing Congress’ understanding of the present law, prior to the

repeal of Section 166(f) of the Code, as follows: “* * * in the case of a

3. Stahl v. United States, 441 F. 2d 999 (C.A. D.C.),

and Lutz v. Commissioner, 282 F. 2d 614 (C.A. 5), upon

which petitioner relies (Pet. 12, 16), are not to the

contrary. In Srahi, the taxpayer loaned securities to a

securities firm so that the firm could satisfy certain SEC

requirements. When the securities were subsequently sold

by the firm prior to its bankruptcy, the taxpayer suffered

a loss and the only question was whether it was fully

deductible under Section 165(c), or deductible only as a

nonbusiness bad debt under Section 166. The court held

that it was deductible under Section 165, on the ground

that the transaction constituted a bailment rather than a

“debt.” Unlike petitioner, the taxpayer in Stahl

unquestionably sustained a loss during the year in issue.

Moreover, the court in Stahi/ carefully distinguished

Putnam (and its subsequent application in Stratmore v.

United States, supra, and United States v. Hoffman,

supra) on the ground that the taxpayer in Siah/ was not a

shareholder in the corporation to which she gave her

securities and, therefore, the transaction did not represent

“financing provided to a corporation by a taxpayer-

stockholder to protect his pre-existing investment” (441 F.

2d at 1003).

Lutz is likewise distinguishable. There, the court upheld

the taxpayer’s claim to a business expense deduction

guarantor of a corporation obligation [a term which includes

indemnitors for purposes of Section 166(f)], any payment under the

guaranty agreement must be deducted (if at all) as a nonbusiness bad

debt. regardless of whether there is any right of subrogation, unless

the guaranty was made pursuant to the taxpayer's trade or business.”)

Since the post-Purnam cases have not regarded the state law of

subrogation as material for federal tax purposes (see also Sipie v.

Commissioner, 54 T.C. 1), and petitioner sustained no loss, there ts

no basis for petitioner's assertion (Pet. 11-14) that the decision below

conflicts with Howell v. Commissioner, 69 F. 2d 447 (C.A. 8), a case

decided 22 years prior to this Court's decision in Putnam.

under Section 162 for his voluntary payment of debts of

certain controlled farm corporations which he had paid to

protect his individual business as an agriculture produce

broker. Here, on the other hand, the record shows (Pet.

App. 4, 19) that petitioner did not engage in any business

activities on an individual basis separate from that of the

partnership or corporation. Rather, the advances were

made primarily to protect his investment in_ the

corporation. Whipple v. Commissioner, 373 U.S. 193;

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

CONCLUSION

The petition for a writ of certiorari should be denied.

Respectfully submitted.

Wave H. McCree, Jr.,

Solicitor General.

M. CARR FERGUSON,

Assistant Attorney General.

ANN BELANGER DURNEY,

JoHN A. Dupbeck, JR.,

Attorneys.

SEPTEMBER 1978.

DOJ-1978-09

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