Opinion
Docket Nos. 4207-66 4808-66 5666-66 5132-67.
1969-02-20
SAMUEL R. MILBANK AND MOLLY W. MILBANK, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
James A. Glascock, Jr., for the petitioners. Edward Hance, for the respondent.
James A. Glascock, Jr., for the petitioners. Edward Hance, for the respondent.
T, an investment banker, was the prime mover in the promotion of a wallboard manufacturing plant which was to be located in Cuba. T sold stock and debentures in the Cuban project through his investment banking partnership to a number of his customers and also purchased some of the stock for himself and family. Due to difficulties encountered in the completion of the plant additional funds were necessary to prevent the failure of the venture. T, fearing that the failure of the venture might have a serious effect upon his business, caused P corporation, a corporation owned equally by T and his brother, to guarantee a bank loan to the Cuban corporation. Although T was not legally liable to the bank, it looked to him to see that the loan would be repaid. T also made a direct loan to the Cuban corporation for the same reason that he arranged the bank loan. The Cuban company was seized in 1960 by the Cuban revolutionary government and all debts owing by the corporation thereupon became worthless. T personally made payments of interest and principal due under the P corporation guaranty. Held, T's loss on his direct loan was deductible as a business bad debt under sec. 166, I.R.C. 1954; held, further, T's payments of amounts owing under the P corporation guaranty were deductible as ordinary and necessary business expenses under sec. 162.
Respondent determined deficiencies in income tax of petitioners for the taxable years 1960 to 1965, inclusive. The deficiencies so determined and the overpayments of income tax for those years claimed by petitioners here in issue are as follows:
+---+ ¦¦¦¦¦ +---+
Year Deficiencies Deficiencies Overpayments determined in issue claimed 1960 $63,117.69 $63,117.69 $743.75 1961 124,755.11 120,505.95 None 1962 4,124.82 4,124.82 None 1963 4,050.25 4,050.25 None 1964 3,690.49 3,690.49 None 1965 3,345.82 3,345.82 None
The principal issues are: (1) Whether certain loans made by petitioner Samuel R. Milbank to a Cuban corporation which became worthless in 1960 were business or nonbusiness bad debts under section 166, I.R.C. 1954; and (2) whether payments of interest and principal which petitioner made on a bank loan to the Cuban corporation which had been guaranteed by a corporation owned equally by petitioner and his brother were deductible as business bad debts, or as business expenses, or as business losses, or as losses in a transaction entered into for profit, under sections 162, 165, and 166.
FINDINGS OF FACT
Many of the facts are stipulated and are incorporated herein by reference.
The petitioners are individuals, husband and wife, and at all times pertinent hereto, including the times of filing their petitions in these cases, their legal residence has been at Huntington, Long Island, N.Y. They filed joint income tax returns for the taxable years 1960 to 1965, inclusive, with the district director of internal revenue for the Manhattan District of New York. Since Molly W. Milbank is a party to this proceeding solely because she joined in the return of his husband, Samuel R. Milbank, he will hereinafter be referred to as petitioner.
During the years 1955 to 1965, inclusive, petitioner was a principal partner in the investment banking firm of Wood, Struthers & Co. or Wood, Struthers & Winthrop, its successor, on March 29, 1963 (both hereinafter sometimes referred to as Wood, Struthers), in New York City. The firm was and is a member of the New York Stock Exchange. During those years Wood, Struthers operated primarily as a secondary underwriter of the bonds, debentures, and preferred and common stock of various enterprises, in which partners and customers of the firm often participated. The firm had a small number of regular customers. Though small in number, however, those customers were generally of substantial means. The firm placed great emphasis on investment advisory work and many of the firm's customers relied on it for investment advice.
The firm also promoted various business ventures. On a given occasion one partner or a group of partners might be particularly interested in a project and be the prime mover in it, and in other cases a different partner or group might be behind a particular project. In such cases the firm would arrange for the financing of the venture, and the partners and customers of the firm would participate in the financing through the purchase of stock or debentures or bonds, or a combination of such securities. Petitioner was a prime mover in several such projects, initiating a number of new ventures and recommending them to his customers for investment.
During the years 1955 to 1965, inclusive, petitioner was also a director of Francisco Sugar Co. (sometimes hereinafter referred to as Francisco) and Manati Sugar Co., two American-owned companies which had extensive properties in Cuba until their seizure in 1960 by the Cuban revolutionary government. Petitioner owned 300 shares of Francisco stock, out of a total capitalization of 430,000 shares, because he was required to own Francisco stock in order to be a director. Petitioner likewise had only qualifying shares in Manati Sugar Co. He was not an officer of either Francisco or Manati. Petitioner had been asked to become a Francisco director by two brothers, George Braga and Bernardo Rionda Braga, who were his close personal friends. The two Braga brothers owned the majority interest in a sugar-trading partnership, Czarnikow Rionda, which in turn controlled Francisco and Manati. There was no other business relationship between Francisco and Wood, Struthers or petitioner.
In 1955 and for several previous years the world sugar industry suffered from low prices as a consequence of oversupply. The long-range future of the sugar industry in Cuba seemed to depend upon diversification and the upgrading of byproducts of the manufacture of sugar, such as bagasse (the remainder of the sugar cane after the juice has been crushed out), into marketable products. Many attempts had been made to produce a satisfactory wallboard from bagasse prior to 1955, but these attempts were by and large unsuccessful, except for production of insulation board of low density and low tensile strength, owing to the presence of large quantities of pith in the bagasse. Pith has no cohesive power and destroys the bonding qualities of the fiber comprising the balance of the bagasse.
In 1955 there was developed and patented the Nolan process to remove pith from bagasse without destroying the length of the remaining cellulose fibers. Pilot plant tests employing this process produced a high-density wallboard, commonly known as hardboard, of an excellent quality at an indicated cost which compared most favorably with existing processes for producing hardboard from other materials.
After completion of various studies, including one by an independent engineer, Wood, Struthers decided to promote a wallboard project in Cuba. Because of petitioner's close association with the sugar industry he became the prime mover of the project. In light of the limited supply of timber in Cuba, petitioner anticipated that the project would be profitable for himself and his clients.
Petitioner asked the two Braga brothers whether they would be interested in having the wallboard plant on the property of either Francisco or Manati Sugar Co. Since such a plant would have provided them an opportunity to sell their bagasse— which had previously been an unsalable waste product— it was decided to erect the wallboard plant alongside the principal sugar mill of Francisco in the Province of Camaguey.
In order to carry on the wallboard project Compania Cubana Primadera, S.A. (hereinafter referred to as Cubana), was organized under the laws of the Republic of Liberia on May 1, 1956. Cubana qualified to do business in Cuba. It was estimated that the project would cost $3,670,000, including working capital and preoperating expenses. Cubana obtained a loan of $1,500,000 from Export-Import Bank of Washington. The further amount of $2,170,000 which it was estimated Cubana would require was raised through the sale of 770,000 shares of Cubana common stock, having a par value of $1 per share, for $770,000 and $1,400,000 of subordinated debentures at face value.
The board of directors of Cubana as of May 26, 1956, consisted of petitioner and two other partners of Wood, Struthers, two offices of Francisco Sugar Co., an officer of the Tayler Corp. (hereinafter referred to as Tayler), and an officer of Cuban Trading Co., Havana Cuba. As of the same date petitioner was president and chairman of the board of directors of Cubana.
Cubana entered into various contracts, including the following:
(i) A contract with local contractors for erection of the building to house the wallboard machinery and equipment;
(ii) A contract with Tayler for the purchase, erection and test running of the necessary production machinery;
(iii) An agreement with Tayler to provide Cubana with the necessary management to run the wallboard plant when it had been constructed;
(iv) A tileboard plant agreement with Tayler, providing for the purchase, erection and test running of additional facilities for the manufacture of tileboard;
(v) A credit agreement with Export-Import Bank of Washington, providing for the $1,500,000 Export-Import Bank loan;
(vi) A subordination agreement with the investors purchasing subordinated debentures, whereby their debentures were subordinated to the Export-Import Bank loan;
(vii) A bagasse purchase agreement with Francisco Sugar Company, providing for the necessary raw material for the project; and
(viii) A long-term lease with Francisco Sugar Company to provide Cubana with a site for the wallboard plant and bagasse storage facilities.
Cubana's bagasse purchase agreement was the product of arm's-length bargaining and provided for a purchase price which both parties regarded as fair. Later, the Braga brothers decided to make a substantial investment in Cubana.
The new plant was to utilize the Nolan process of depithing bagasse. Tayler agreed to furnish and supervise the installation of all necessary primary and secondary machinery and equipment for the plant and to conduct a satisfactory test run by June 9, 1958.
In its attempt to perform, Tayler purchased machinery and equipment which was delivered and installed by the spring of 1958. Production, however, was not in accordance with Tayler's guaranties contained in the basic agreement between Cubana and Tayler. It was necessary to furnish substantial additional equipment and to carry out substantial modifications in order to bring the plant to rated capacity. The modification program consumed the better part of the year 1959. Although somewhat limited, production continued despite the temporary interference resulting from the modification program. Cubana was able to sell all it produced during this period. Full-scale operations were recommenced in early 1960, after the modification program was completed.
As a consequence of the difficulties which were thus encountered, additional funds were required. The original authorized capital stock account of $850,000, consisting of 850,000 shares of $1 par value each (of which 770,000 shares had originally been issued), was increased to $1,800,000, consisting of 1,500,000 shares of $1 par value common stock and 30,000 shares of $100 par value preferred stock. To finance the construction of the Cubana plant and its modifications, funds substantially in excess of those originally contemplated were raised. Additional common stock and subordinated debentures of Cubana were sold at par, bringing the total amount of common shares outstanding to over 1 million shares and the total face amount of debentures to over $2,400,000. And in addition to the $1,500,000 Export-Import Bank loan, the Cuban Government Development Bank (BANFAIC) and the Trust Co. of Cuba together loaned $750,000 to Cubana secured by first mortgage bonds pari passu with Export-Import Bank. Further financing was provided by Banco Garrigo, the Trust Co. of Cuba, and First National City Bank of New York (hereinafter referred to as First National City or the bank).
Sales of Cubana shares on its organization and subsequent to that time were effected by Wood, Struthers, which received compensation for its services in connection with the Financing of Cubana. That compensation consisted of a fee of 3 1/3 percent of the money raised through Wood, Struthers' efforts, together with a right to subscribe for the purchase of shares of Cubana at $1 per share. All funds received as compensation for its services were invested in Cubana by Wood, Struthers through the exercise of this option agreement.
On March 31, 1957, when Cubana's financing as originally conceived was virtually completed, there were outstanding 764,000 shares of its common stock and $1,480,000 of its subordinated debentures, all of which had been issued at par. Wood, Struthers customers held 353,500 of those shares and $692,000 of those debentures. On September 30, 1958, after Wood, Struthers had placed additional common stock and debentures to help finance the necessary Cuban plant modifications, there were outstanding 1,033,417 shares of the common stock and $2,430,000 of the subordinated debentures, all of which had been issued at par. Wood, Struthers customers held 474,350 of those shares and $987,000 of those debentures.
The term ‘customers' used in the preceding paragraph does not include petitioner, his brother Robbins Milbank, or members of their families, Panfield Corp. (a corporation owned equally by petitioner and Robbins), Adirondack Trust (a trust for the benefit of petitioner and Robbins), Wood, Struthers partners, Francisco, or anyone who had not been a Wood, Struthers customer before Cubana was formed but who became interested in the project through some other contact. Although substantial portions of the Cubana shares and debentures registered in the name of Wood, Struthers on both March 31, 1957, and September 30, 1958, belonged to Wood, Struthers customers, such shares and debentures are excluded from the holdings of Wood, Struthers customers on those dates as given in the preceding paragraph. On March 31, 1957, there were 90,400 shares of the common stock and $161,800 of the subordinated debentures held in the name of Wood, Struthers, and on September 30, 1958, there were 86,950 shares and $158,800 of the debentures so held.
The number of shares of Cubana common stock owned on March 31, 1957, and September 30, 1958, by Panfield Corp., Adirondack Trust, petitioner, and certain other persons related to him was as follows:
+--------------------------------------------------------------+ ¦Stockholder ¦Mar. 31, 1957 ¦Sept. 30, 1958 ¦ +-----------------------------+---------------+----------------¦ ¦ ¦ ¦ ¦ +-----------------------------+---------------+----------------¦ ¦Panfield Corp ¦7,000 ¦12,500 ¦ +-----------------------------+---------------+----------------¦ ¦Adirondack Trust ¦5,000 ¦6,000 ¦ +-----------------------------+---------------+----------------¦ ¦Petitioner ¦11,600 ¦15,200 ¦ +-----------------------------+---------------+----------------¦ ¦Molly W. Milbank (wife) ¦2,000 ¦3,000 ¦ +-----------------------------+---------------+----------------¦ ¦Samuel Milbank (son) ¦Unknown ¦Unknown ¦ +-----------------------------+---------------+----------------¦ ¦Marjorie Farrar (daughter) ¦1,000 ¦1,000 ¦ +-----------------------------+---------------+----------------¦ ¦Mrs. Drumwright (daughter) ¦Unknown ¦Unknown ¦ +-----------------------------+---------------+----------------¦ ¦Robbins (brother) ¦5,000 ¦8,500 ¦ +-----------------------------+---------------+----------------¦ ¦Helen Milbank (sister-in-law)¦1,000 ¦1,500 ¦ +-----------------------------+---------------+----------------¦ ¦David L. Milbank (nephew) ¦None ¦5,000 ¦ +--------------------------------------------------------------+
Although Wood, Struthers had raised additional money from its customers and other sources to meet part of Cubana's reconstruction needs, still more funds were required to complete it. Petitioner was concerned that the project not fail through a lack of funds since so many of his customers had invested in the project as a result of his efforts. Further, other partners as well as himself and members of his family had invested in Cubana. Thus, the failure of the project at this point could have caused the loss of some of the firm's customers as well as the money he and the partners of the firm had invested in the project. Accordingly, and with this in mind, in November 1958, petitioner requested First National City to lend Cubana $300,000 for 90 days, subject to renewal at Cubana's option for an additional 90 days. The purpose of the loan was to enable Cubana to meet its pressing obligations to creditors and to cover operating costs pending its receipt of an additional $500,000 loan from Export-Import Bank, which was then under negotiation. In making this request petitioner conferred with John C. Slagle, a vice president of the Bank. Slagle felt that such a loan would be unwarranted in light of Cubana's financial position at the time. Petitioner thereupon offered his personal guaranty, and this was satisfactory to Slagle.
Prior to making final arrangements for the bank loan, however, he discussed the proposed loan and guaranty arrangement with Frank Musselman, an attorney who was doing the continuing legal work for the Cubana project. Musselman advised petitioner that because of his status as a partner in a member firm of the New York Stock Exchange a personal guaranty by him might be a reportable item under rule 420 of the exchange as a loan to or borrowing by him which would have to be reported to the exchange. Petitioner understood Musselman's advice to mean that his personal guaranty of the loan to Cubana might constitute a charge on the capital requirements of Wood, Struthers. This altered the situation since petitioner did not want to enter into an arrangement with the bank which would burden the firm or limit its ability to carry on other activities.
Subsequently, petitioner asked Musselman whether a guaranty by Panfield Corp. (referred to hereinafter as Panfield), a New York corporation owned equally by petitioner and his brother, Robbins Milbank, would necessitate an inquiry of the New York Stock Exchange. Musselman advised petitioner that putting the guaranty in this form would not constitute the kind of personal indebtedness reportable under rule 420.
Petitioner conferred again with Slagle and inquired whether the bank would make the loan on the guaranty of Panfield. In support of this proposal petitioner furnished Slagle with an income statement of Panfield for the fiscal year ended June 30, 1958, and a balance sheet of Panfield as of June 30, 1958. Panfield had a net loss of $4,732.58 for the year. The balance sheet was as follows:
+-------------------------------------------------------------+ ¦Assets ¦ ¦ +------------------------------------------------+------------¦ ¦Cash ¦ ¦ ¦1 $12,471.26¦ +------------------------+-----------+-----------+------------¦ ¦Investments: ¦ ¦ ¦ ¦ +------------------------+-----------+-----------+------------¦ ¦Stocks and bonds ¦ ¦$270,658.59¦ ¦ +------------------------+-----------+-----------+------------¦ ¦Mortgages ¦ ¦85,000.00 ¦ ¦ +------------------------+-----------+-----------+------------¦ ¦ ¦ ¦ ¦355,658.59 ¦ +------------------------+-----------+-----------+------------¦ ¦Capital assets: ¦ ¦ ¦ ¦ +------------------------+-----------+-----------+------------¦ ¦Building ¦$225,035.46¦ ¦ ¦ +------------------------+-----------+-----------+------------¦ ¦Equipment ¦5,069.45 ¦ ¦ ¦ +------------------------+-----------+-----------+------------¦ ¦Household furniture ¦697.95 ¦ ¦ ¦ +------------------------+-----------+-----------+------------¦ ¦ ¦ ¦230,802.86 ¦ ¦ +------------------------+-----------+-----------+------------¦ ¦Reserve for depreciation¦ ¦130,253.94 ¦ ¦ +------------------------+-----------+-----------+------------¦ ¦ ¦ ¦ ¦10,548.92 ¦ +------------------------+-----------+-----------+------------¦ ¦Land and improvements ¦ ¦ ¦466,127.60 ¦ +------------------------+-----------+-----------+------------¦ ¦Prepaid insurance ¦ ¦ ¦1,599.43 ¦ +------------------------+-----------+-----------+------------¦ ¦Total assets ¦ ¦ ¦936,405.80 ¦ +-------------------------------------------------------------+
Liabilities and net worth Bonds $600,000.00 Capital stock 1,000.00 Capital surplus 370,506.88 Earned surplus (deficit) ($30,368.50) Net profit fiscal year (loss) (4,732.58) (35,101.08) Total liabilities—net worth 936,405.80 Consists of bank balance $11,007.56 and Capital gain dividend 1,463.70 (Pine Street Fund) earmarked to purchase additional Pine Street stock 12,471.26
The $600,000 bonds appearing as liabilities were 50-year income bonds due July 1, 1975, and were owned equally by petitioner and Robbins.
Slagle regarded the assets of Panfield as ‘illiquid,‘ and although they offered some protection, they were not the kind of assets against which the bank would normally make a loan. However, Slagle regarded petitioner as being ‘behind’ the proposed loan, notwithstanding the absence of any legal liability on the part of petitioner to the bank to make payment in the event of default, and it was because of petitioner's moral obligation and standing in the financial community that Slagle approved the loan as guaranteed merely by Panfield.
The bank in fact made the $300,000 loan to Cubana on November 12, 1958, with the continuing guaranty of Panfield, and without any agreement, written or oral, whereby petitioner assumed any liability to the bank in respect of repayment of the loan. Petitioner's only obligation to the bank was a moral one, and the bank in fact looked to petitioner to see that the loan would be repaid. The continuing guaranty agreement from Panfield to the bank was dated November 10, 1958, and petitioner and Robbins executed subordination agreements dated November 3, 1958, whereby each of them subordinated his claim against Panfield on $300,000 unpaid principal amount of Panfield's bonds to the bank's claim against Panfield under the continuing guaranty agreement. Petitioner and Robbins, as the holders of all the outstanding shares of Panfield, also executed a consent dated November 10, 1958, to the continuing guaranty agreement of Panfield. Petitioner made no report to the New York Stock Exchange under rule 420, which he understood he might be required to make in the event that he personally guaranteed the bank's loan to Cubana.
In obtaining Robbins' consent to Panfield's guaranty of the Cubana loan, petitioner orally promised Robbins that he would be ‘back of this thing’ and would ‘relieve Panfield of all obligations so that your (Robbins') share in it will not be in any way affected.’ Also, Cubana compensated Panfield for the guaranty by paying it $7,000 in cash and by giving it the right to purchase 7,000 shares of Cubana common stock at $1 per share, which right was exercised.
The $300,000 loan and the Panfield guaranty were for a period of 90 days, subject to one 90-day renewal. It was renewed for an additional 90 days. At the end of the renewal period Cubana paid the interest but not the principal, and the bank agreed to additional renewals without releasing Panfield from its guaranty.
In December 1958, First National City made an additional loan of 50,000 Cuban pesos to Cubana, also guaranteed by Panfield and under the same agreement between petitioner and his brother. Cubana subsequently repaid the 50,000 Cuban peso loan to the bank.
At the time of this peso loan and guaranty by Panfield, Robbins became concerned about what might happen should petitioner die and the Bank thereafter invoke the guaranty against Panfield. Since his brother's promise to him was oral he requested petitioner to put in writing the agreement between them with respect to the guaranty. In response, petitioner gave him a letter dated December 5, 1958, the body of which read as follows:
You will recall my request to you as a shareholder on Panfield Corporation to consent to amendment of Panfield's Continuing Guaranty of the indebtedness of Compania Cubana Primadera, S.A. to The First National City Bank of New York in order to increase the amount thereby guaranteed to include an additional loan of 50,000 Cuban pesos from the Bank to Cubana. I have also requested that you agree as a bondholder of Panfield to subordinate you (sic) claims against Panfield to the contingent claim against it of the Bank under the Continuing Guaranty as thus amended.
In the opinion of Milbank, Tweed, Hope & Hadley, as counsel for Panfield, the enclosed written consent, which I have executed in my capacity as a shareholder and bondholder of Panfield, will accomplish the foregoing, when executed by you, without amendment of our respective Subordination Agreements dated November 3, 1958. Would you be good enough to sign and return the enclosed Consent and Agreement in the stamped self-addressed Air Mail Special Delivery envelope furnished herewith.
This will confirm my agreement with you that, should First National City Bank assert any claim against Panfield under the Continuing Guaranty and should Panfield make any payment to First National City Bank by reason thereof any detriment to Panfield shall be a first charge upon my holdings therein upon its liquidation or dissolution.
In July and August, 1959, after the bank had extended the Cubana loan guaranteed by Panfield, petitioner advanced $40,000 of his own funds to Cubana to meet payrolls at the plant during the temporary production difficulties. These advances were evidenced by demand notes which bore no interest. His motives in making these advances were the same as those which induced him to arrange for First National City's $300,000 loan guaranteed by Panfield.
In other ventures sponsored by Wood, Struthers petitioner has been asked to make loans to protect investors. Where customers of the firm invested on the basis of his recommendation he has made such loans because of his sense of responsibility to protect the customers' interest. However, where he had only an investment position but did not influence others to invest, he has declined to make such loans, although other Wood, Struthers partners made them. He has also been asked to give a guaranty in another project besides Cubana but has declined to do so since he has not influenced or recommended investment in the project to any of his customers.
On August 7 and 8, 1960, the Cuban revolutionary government expropriated Cubana's properties. Following that seizure, petitioner has never been able to obtain repayment of any portion of the $40,000 of loans which he had made to Cubana. That seizure left Cubana without assets from which any repayment could ever be made to petitioner. Those loans became completely worthless in 1960.
On August 29, 1960, shortly after Cubana was expropriated, petitioner wrote a letter addressed to Panfield to the effect that he would make the payments of principal and interest required by the guaranty which would be due as a result of Cubana's seizure. Petitioner felt that the bank had relied on his integrity in making the loan and that payment of the loan would be necessary to maintain his reputation for integrity in the business community.
On September 1, 1960, interest became due on the $300,000 loan from First National City, and Cubana was unable to make payment of such interest. Petitioner paid the accrued interest to the bank on or about September 1, 1960, and thereafter paid the interest monthly during the remainder of the year. The interest payments made by petitioner to the bank in 1960 aggregated $12,604.15. The bank demanded payment of the entire principal on or about December 29, 1960, but Cubana was unable to make any payment of such principal. Petitioner paid $50,000 of the principal to the bank on or before December 31, 1960, and arranged for renewal of the balance.
During the calendar year 1961 petitioner made additional payments of accrued interest on the Cubana loan to First National City in amounts aggregating $11,968.61, which Cubana was unable to make. The bank also demanded payment of portions of the balance of principal in 1961, but Cubana was unable to make payment of any such principal. Petitioner made payments to the bank on the principal balance of the Cubana loan during 1961 in amounts aggregating $150,000. During the calendar years 1962, 1963, 1964, and 1965 petitioner made additional payments of accrued interest, which Cubana was unable to make, in the respective amounts of $5,854.43, $5,576.37, $5,591.65, and $5,576.37 to the bank on the Cubana loan.
No part of the payments of principal and interest which petitioner made to First National City on the Cubana loan in the years 1960 to 1965, inclusive, has ever been repaid to petitioner. The seizure of Cubana's properties in 1960 left Cubana without assets from which any repayment could ever be made to petitioner.
When Cubana could not make the payments which became due from time to time on the $300,000 loan, the bank sent its demands for payment to Panfield, for the attention of petitioner. When the examining committee of the bank's board of directors was reviewing the Cubana loan in early 1961, Slagle advised the chairman of that committee that petitioner was ‘behind’ the loan and the bank was looking to petitioner for payment.
On their joint income tax return for the taxable year 1960 petitioners deducted the $40,000 lent by petitioner to Cubana in 1959 and the $50,000 principal payment and the $12,604.15 interest payments which petitioner made to First National City in 1960. On their joint income tax return for the taxable year 1961 petitioners deducted the $150,000 principal payments and the $11,968.61 interest payments which petitioner made to First National City in 1961.
On their joint income tax returns for the taxable years 1962, 1963, 1964, and 1965 petitioners deducted the respective interest payments of $5,854.43, $5,576.37, $5,591.65, and $5,576.37 which petitioner made to First National City in 1962, 1963, 1964, and 1965, respectively.
In his statutory notices of deficiency addressed to petitioners the respondent disallowed all the deductions referred to in the two preceding paragraphs, except for the $40,000 loan by petitioner to Cubana. Respondent determined that the loans of $40,000 owing from Cubana to petitioner became worthless in the taxable year 1960 and were nonbusiness bad debts. He allowed petitioners a short-term capital loss of $3,566.70 for the taxable year 1960 and a capital loss carryover from that year in the sum of $36,433.30. He also allowed petitioners a short-term capital loss of $36,433.30 for the taxable year 1961 by virtue of that capital loss carryover.
On their joint 1960 income tax return petitioners reported an overpayment of $2,803.20 in 1960 income tax and elected to have that overpayment credited on their 1961 estimated income tax. In this statutory notice of deficiency respondent made no adjustment in the credit against 1961 income tax, claimed by petitioners on their joint 1961 income tax return, for payments and credits on their 1961 declaration of estimated tax. Other than those heretofore mentioned, respondent's only adjustments affecting petitioners' 1960 income tax liability were reductions of $4,752.24 in reported partnership income and $2,795 in the claimed contributions deduction, neither of which adjustments is contested by petitioners.
OPINION
RAUM, Judge:
This case involves not only the deductibility of the various payments made by petitioner in respect of First National City's $300,000 loan to Cubana, but also the proper tax treatment of the loss sustained by petitioner on his own advances aggregating $40,000 to Cubana. We deal first with this latter issue.
1. The $40,000 Loan.— There is no dispute that this loan became worthless in 1960 and that it is deductible in full in that year unless it is a ‘nonbusiness' debt. Sec. 166(a) and (c), I.R.C. 1954. Moreover, it is also clear that if petitioner's sole relationship to Cubana were that of a stockholder, his loan to the corporation— even if related to the business of the corporation— must be treated as a non-business loan. For it has been firmly settled that the business of a stockholder and that of his corporation are distinct, and that the business of the corporation may not be regarded as his business. Whipple v. Commissioner, 373 U.S. 193; Deputy v. Du Pont, 308 U.S. 488; Burnet v. Clark, 287 U.S. 410; Dalton v. Bowers, 287 U.S. 404. But it is equally clear that the stockholder may also be engaged in an activity unrelated to his status as a stockholder, and that if such activity itself constitutes a trade or business the stockholder's loan to his corporation may qualify as a business loan provided that it is proximately related to that trade or business. Cf. Trent v. Commissioner, 291 F.2d 669 (C.A. 2), reversing 34 T.C. 910; Weddle v. Commissioner, 325 F.2d 849, 851 (C.A. 2), affirming 39 T.C. 493, 496; Kelly v. Patterson, 331 F.2d 755, 756 (C.A. 5); I. Hal Hillsap, Jr., 46 T.C. 751, 758; Louis Lesser, 42 T.C. 688, 699, acq. 1966-2 C.B. 5, affirmed on other issues 352 F.2d 789 (C.A. 9); Wilfred J. Funk, 35 T.C. 42, acq. 1961-2 C.B. 4. This was made abundantly plain in Whipple where the Supreme Court ordered a remand for further proceedings to determine whether the worthless debt there involved was proximately related to a certain business activity of the stockholder-creditor which had not theretofore been considered. 373 U.S.AT 204-205. We hold that petitioner's $40,000 advances to Cubana represented something substantially more than a mere effort to protect his stockholder interest in the corporation, cf. Jean U. Koree, 40 T.C. 961, and that it was proximately related to his business as a partner in Wood, Struthers.
There is little question that petitioner was engaged in the trade or business of investment banking. As an investment banker his income flowed primarily from the fees and commissions generated by the underwriting and promotion of various business ventures. It was in connection with that business that Wood, Struthers, with petitioner as the prime mover, undertook to promote the Cubana venture, and securities in Cubana were sold to customers of the firm. Petitioner reasonably regarded himself as being particularly responsible for the investments made by clients to whom he had recommended these securities. The firm dealt with only a comparatively small number of clients of substantial means, and petitioner feared that the failure of the venture might have a serious adverse effect upon the firm and his business, particularly since he had already sought and obtained additional financing from his clients to complete the anticipated reconstruction program. It was primarily for this reason that he made the $40,000 advances, to keep the Cubana venture from going under and thereby to protect his business relationship with his clients. We recognize, of course, that petitioner was at the same time protecting his own interest as a stockholder in Cubana, and although the matter may not be completely free from doubt it is our best judgment on the record that the advances nonetheless bore the requisite relation to his business as an investment banker. This case is thus distinguishable from Jean U. Koree, 40 T.C. 961, where on the facts before us we concluded that a stockholder-creditor's loan to a Cuban corporation was motivated primarily by his interest as a stockholder and that any possible relationship to a trade or business of the lender was at most incidental.
2. Payments on the Bank's Loan to Cubana.— In arranging for the bank's $300,000 loan to Cubana and making the payments in question petitioner was motivated by considerations similar to those pertaining to his own $40,000 loan. However, the matter arises in a more complicated context by reason of the interposition of Panfield as a guarantor. Petitioner advances a number of alternative theories in support of his claimed right to deduct the payments in question, under section 162 (business expense), section 165 (loss), and section 166 (business bad debt).
Thus, he argues that Panfield was merely an accommodation guarantor and that he was the ‘true’ guarantor with the result that when he made the payments he became subrogated to the bank's rights against Cubana which became worthless in his hands as a business bad debt under section 166. If we could accept petitioner's major premise, we would have no difficulty in approving his conclusion. For, if he were to be treated as the guarantor, the deductibility of the worthless subrogated debt would depend merely upon whether it was proximately related to his trade or business, Putnam v. Commissioner, 352 U.S. 82, and we would reach the same result here in respect thereof that we did in connection with petitioner's personal loan of $40,000 to Cubana. The difficulty with this theory, however, is that petitioner was not in fact the guarantor of the loan because the bank had no legal recourse against petitioner to compel payment. Consequently, petitioner did not become subrogated to the bank's claim against Cubana so as to furnish the basis for a debt which became worthless in his hands. In the absence of a worthless debt in petitioner's hands section 166 is inapplicable.
Nevertheless, we agree with petitioner's contention that he is entitled to the deductions in issue under section 162(a), as ordinary and necessary expenses incurred in carrying on his trade or business as an investment banker. For the same reasons already outlined in connection with petitioner's own $40,000 advances to Cubana, he also arranged the $300,000 bank loan with Panfield as guarantor and in effect agreed with his brother Robbins (the only other stockholder in Panfield) that he would personally pay any amounts that Panfield might be called upon to pay under its guaranty. The bank would not have made the loan solely upon Panfield's guaranty; it knew petitioner and his reputation for integrity in the business community and it looked to him to see that the loan would be repaid, notwithstanding the absence of any legal liability to the bank in this respect.
When the default occurred petitioner voluntarily made the payments called for under the guaranty. In thus making these payments petitioner was protecting his reputation for integrity in the financial world. The mere fact that they were voluntary vis-a-vis the bank does not deprive them of their character as ordinary and necessary business expenses. James L. Lohrke, 48 T.C. 679; C. Doris H. Pepper, 36 T.C. 886, acq. 1962-1 C.B. 4; Charles J. Dinardo, 22 T.C. 430. It is sufficient that they grew out of an arrangement between petitioner and the bank that was entered into to protect petitioner's business as an investment banker. Accordingly, we think that these payments were proximately related to his business as an investment banker and that they qualify as ordinary and necessary business expenses.
In arguing against this conclusion the Government takes the position that petitioner's payments were merely capital contributions to Panfield, citing Leo Perlman, 27 T.C. 755, affirmed 252 F.2d 890 (C.A. 2). In our view cases like Perlman are distinguishable, and the Government's attempt to apply the results in those cases to the present situation is based upon a faulty understanding of the problems. In Perlman the stockholder-creditor canceled the indebtedness of his corporation solely to strengthen its financial position. Such a purpose clearly indicates a contribution to capital since the cancellation was not proximately related to the taxpayer's own business. This is not the case here. We have already pointed out that petitioner's payments on the Cubana loan to the bank were proximately related to his investment banking business. Furthermore, it was never intended as between petitioner and Robbins that Panfield would ever be financially disadvantaged as a result of Cubana's default. In carrying out that understanding he was hardly making any capital contribution to Panfield. We hold that in the unusual circumstances of this case there was no contribution to capital, and that the payments in issue are deductible as business expenses. Accordingly, we do not consider any further alternative contentions of petitioner based upon section 165.
Decisions will be entered under Rule 50.