Opinion
Docket No. 40298.
1955-07-13
GEORGE J. SCHAEFER, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Ferdinand Tannenbaum, Esq., and Robert F. Welch, Esq., for the petitioner. Charles M. Greenspan, Esq., for the respondent.
Petitioner, who had been connected with the motion picture industry and had become engaged in his own individual business, organized a corporation in 1946 for the purpose of producing a particular Photoplay, estimated to cost $175,000. Petitioner paid in the total capital of $14,000 and obtained commitments for primary and secondary loans in the respective amounts of $105,000 and $40,000 plus an additional $25,000, if necessary. Prior to obtaining the loans petitioner was required by the lending institutions to put into the corporation an additional $11,000 to bring its paid-in capital up to $25,000 and to execute a personal guaranty of completion of the Photoplay should the funds available for its production prove to be insufficient, and to make personal commitments. For the additional $11,000 and $53,273.65 later advanced to complete the Photoplay, petitioner received notes providing for interest at 6 per cent per annum, all such notes being subordinated to the primary and secondary loans. Petitioner claims business bad debt deductions for these amounts for 1948. Held, under the facts, (1) the payment of the $11,000 was a contribution to capital and did not give rise to a debt, (2) the advances of $53,273,65 did give rise to a debt, (3) the debt became worthless in the taxable year, and (4) it was not a non-business debt under section 23(k) (4) of the Internal Revenue Code of 1939. Ferdinand Tannenbaum, Esq., and Robert F. Welch, Esq., for the petitioner. Charles M. Greenspan, Esq., for the respondent.
The respondent determined a deficiency in income tax against petitioner for the calendar year 1948 in the amount of $27,090.36. Petitioner, by amended petition, claims an overpayment of $3,381.10. The question is whether petitioner is entitled to a business bad debt deduction.
FINDINGS OF FACT.
Petitioner is an individual with principal office in New York, New York. He and his wife filed a joint return for 1948 with the collector of internal revenue for the second district of New York.
Petitioner's principal occupation during the taxable year was supervising the distribution of motion pictures which were produced by Enterprise Productions, Inc., hereinafter referred to as Enterprise, and released through and distributed by United Artists Corporation. Petitioner had been engaged in supervising the distribution of motion pictures for independent producers beginning in 1945.
There had been a general practice for independent producers of motion pictures to distribute their pictures through companies, such as United Artists, which were engaged in the business of distributing motion pictures. Such distributors undertook the solicitation of contracts from theaters for the exhibition of the motion pictures and the performance of all other acts connected with their distribution and the collection of gross receipts therefrom. By separate agreement an independent producer might retain petitioner to act as its supervisor of distribution. Petitioner would then act as the producer's representative in dictating the policy on the distribution of the motion picture and in approving or rejecting exhibition contracts solicited by the distributing company. Petitioner was usually paid a fee of 3 per cent of the gross receipts from the United States and 5 per cent of the producer's net receipts from foreign countries.
Enterprise had gone rather extensively into the production of motion pictures, and then petitioner was engaged, possibly in 1947, as its supervisor of distribution with United Artists, it was of the view that petitioner's usual fee was too high. An arrangement was accordingly made whereby petitioner worked for a fixed compensation instead of a commission, and in addition Enterprise paid the salaries of the office personnel.
Petitioner has been connected with the motion picture industry in various ways since 1914. He has held positions in different capacities with the World Films Corporation, Paramount Pictures Corporation, United Artists Corporation, and RKO Corporation. He served as president of the latter corporation and all its subsidiaries from 1938 to 1942. Petitioner was chosen by the motion picture industry to organize the War Activities Committee and on July 1, 1942, resigned his position with RKO Corporation to become chairman of that Committee. In 1943 he opened an office of his own in the Paramount Building in New York City, and continuously maintained such office for the conduct of his individual business until 1947 when for all practical purposes it became the office of Enterprise. Up to that time he had four to eight employees.
In 1946 Petitioner made a business trip to Hollywood, California, partly at the instigation of the Beneficial Acceptance Corporation of Newark, New Jersey, sometimes referred to herein as the BAC Corporation. It was interested in furnishing secondary financing to independent producers of motion pictures, with the primary financing being provided by the Bank of America National Trust & Savings Association of Los Angeles, California, sometimes referred to as the Bank of America.
During his visit in Hollywood petitioner was approached by William Stephens who had produced some pictures for RKO Corporation when petitioner was its president. Stephens wished to produce a motion picture which would feature a new dog, the grandson of the original Rin-Tin-Tin, and which would be based upon a story owned by Stephens. Stephens estimated the cost of the production at $175,000, and wanted petitioner to arrange the financing of the picture. Petitioner relied upon the estimate and the integrity of Stephens as well as his own judgment in seeking finances for the production of the picture.
After making inquiry of the Bank of America for primary financing and the BAC Corporation for secondary financing petitioner, on May 16, 1946, caused Romay Pictures, Inc., hereinafter called Romay, to be organized as a corporation under the laws of the State of California. Petitioner determined the capital structure of the corporation after consultation with his attorneys. Romay was originally authorized to issue 5,000 shares of common stock of $100 par value per share but under an amendment to its articles of incorporation filed with the Secretary of State of California, June 3, 1946, the authorized stock was changed to 500 shares of common stock and 500 shares of preferred stock, both of the par value of $100 per share. On June 28, 1946, it obtained a permit to sell 200 shares of its common stock at par, whereupon it issued 140 such shares to petitioner, who paid $14,000 therefor. No other shares of stock were ever issued.
Romay was organized to produce a motion picture, tentatively entitled ‘Renegades' but later called ‘The Return of Rin-Tin-Tin,‘ sometimes referred to herein as the Photoplay and sometimes as the Picture, and was never engaged in any other business. It never purchased, acquired, produced, or planned to produce any other motion picture.
Looking to the production of the Photoplay, Stephens prepared a ‘Production Budget or Final Cost’ for Romay showing an itemized estimate of production cost at $173,420.82, of which $16,200 was for the ‘Producer.’ This $16,200 was allocated, $15,000 to Stephens and $1,200 to his secretary. Stephens was to receive $10,000 in cash, and the remaining $5,000 only when net receipts from the picture should be available. This budget was used in obtaining the financing hereinafter described. It showed the estimated starting date of the picture as August 27, 1946, and the estimated finishing date as September 13, 1946.
On August 24, 1946, Romay entered into an agreement with a corporation by the name of P.R.C. Pictures, Inc., sometimes referred to as P.R.C., whereby P.R.C. was granted an exclusive license to distribute 35mm. positive prints of the Photoplay to theatres in the United States, Alaska, and Hawaii, as well as on American ships, both sea and air, for a period of 5 years from the date of delivery of the prints to P.R.C. The gross receipts from the Photoplay were to be divided 30 per cent to P.R.C. and 70 per cent to Romay, but when and after the 70 per cent of gross receipts actually received by Romay should equal the cost of production, plus the moneys first to be recouped by P.R.C. for certain advances as designated, the gross receipts thereafter accruing were to be divided 40 per cent to P.R.C. and 60 per cent to Romay. P.R.C. was permitted, without the consent of Romay, to make expenditures for advertising up to $2,500, for transportation and insurance of prints, National Board of Review fees and other censorship charges, and laboratory charge for the positive prints ordered by P.R.C. for distribution, and for which P.R.C. was entitled to reimburse itself from Romay's share of gross receipts. Romay reserved all rights not expressly conveyed and granted to P.R.C. and expressly reserved ‘all non-theatrical and non-standard gauge film (i.e., other than 35mm.) and television rights,‘ but Romay was not to distribute, exhibit, or otherwise deal with the Photoplay as a 16mm. production or otherwise deal with it in ‘all versions and forms, or the literary, dramatic or musical material contained therein, for theatrical and/or non-theatrical distribution, exhibition or exploitation for a period of 3 years from the date of delivery to PRC of the 35mm. positive print’ and was not to ‘distribute, exhibit and exploit the television rights for a period of 4 years from the date of such delivery.’
It was orally understood that petitioner should have from Romay the right to distribute the Photoplay throughout the remainder of the world for 10 per cent of Romay's gross receipts from such distribution.
Under the organization of Romay, the negotiations for the borrowed capital which would be needed in producing the Photoplay continued and loan agreements were executed, under date of August 28, 1946, between Romay and BAC Corporation, and on August 30, 1946, between Romay and Bank of America. In both instances and as a condition to their making of the loan agreements with Romay the loaning institutions required certain guaranties, commitments, and agreements of participation by and on the part of petitioner individually, and those agreements between petitioner and BAC Corporation and between petitioner and Bank of America were currently reduced to writing. In making the loan agreements both BAC Corporation and Bank of America expressly relied on the estimate of $175,000 as the contemplated amount which would be required as the production or negative cost of Photoplay.
Under the agreement between Romay and BAC Corporation, and based on the understanding that the Bank of America would advance not to exceed $105,000 of the above-budgeted negative cost, BAC Corporation agreed to loan to Romay the sum of $40,000 for use in the production of the Photoplay and to give to Bank of America a form of ‘Guaranty of Completion’ under which it would advance to Romay or the Bank an additional $25,000 in the event such sum was needed for completion of the picture. Romay was to deliver its demand negotiable 6 per cent promissory note or notes to BAC Corporation covering the $40,000, and further, agreed to pay 6 per cent per annum on the additional $25,000 from the date of execution by BAC Corporation of the completion bond for that amount to the date the obligation thereunder should be released. It was provided, however, that there should be no obligation on the part of BAC Corporation to advance the sums referred to unless and until Romay should have furnished it with copies of commitments from the Bank of America with reference to and covering the advances which were to be made by that bank to Romay, and by P.R.C. Pictures, Inc., covering the distribution of the picture which was to be made by P.R.C., and written assurances from Romay itself that the film necessary to photograph the picture and to make the necessary prints was available. BAC Corporation agreed that it was to be subordinated to the Bank of America to the extent of $105,000 and interest not in excess of 5 per cent, plus collection costs and expenses of the picture, and Romay agreed that subject to the rights of the Bank of America and the distribution agreements with P.R.C. Pictures, Inc., and with petitioner, it would assign, mortgage, and pledge to BAC Corporation all of its right title, and interest in the Photoplay as security for the repayment of the $40,000 and any further sums advanced under the completion bond. Romay also represented and warranted that it would be the sole and exclusive owner of the motion picture rights to the Photoplay throughout the world.
Aside from the commitments by Romay in the above loan agreement and as an added inducement for making that agreement, BAC Corporation required a side agreement from Romay to pay BAC from Romay's net profits an added sum equal to 10 per cent of all actual advances made by BAC to Romay. On the part of petitioner individually, it required a further payment into Romay of $11,000, an absolute and unconditional transfer to it, BAC Corporation, of 42 of the 140 shares of the common stock held by him in Romay, and a pledge of the remaining 98 shares of such stock as further security for the loans BAC Corporation was to make to Romay.
Pursuant to these requirements of him individually, petitioner immediately advanced an additional $11,000 to Romay, receiving from Romay its written promise to repay the $11,000 on demand, with interest at 6 per cent, and as additional consideration he was promised a bonus of $4,000. Petitioner also executed an agreement ratifying and approving the loan agreement between Romay and BAC Corporation and subordinating his right to repayment of the $11,000, together with ‘interest or other charges' thereon, to all indebtedness of Romay to BAC Corporation.
The side agreement required of Romay was also reduced to writing, and in addition to the provision for the 10 per cent bonus to BAC Corporation on the advances actually made under the loan agreement, it recited the understanding that BAC Corporation should have priority in the distribution of the net profits of Romay to the extent of the 10 per cent bonus and over the $11,000 advance by petitioner to Romay. It was provided, however, that in any subsequent distributions of the net profits of Romay to its stockholders, the 10 per cent bonus theretofore received by BAC should be credited against the distribution to which it would be entitled by virtue of the stock it had exacted from petitioner.
Other commitments made by petitioner and accepted by BAC Corporation to induce it to make the above loan agreement with Romay were that so long as the principal, interest, and charges on the loans by BAC Corporation to Romay should remain unpaid, petitioner would not, in the absence of written consent on the part of BAC Corporation, cause or permit (a) Romay to merge with or consolidate with any other corporation or entity, (b) a change in Romay's corporate structure, (c) any dividends to be paid on the stock of Romay, (d) Romay to incur liabilities other than in the ordinary course of business other than the $11,000 to petitioner which would be subordinated to the loans from BAC, or (e) Romay to make any loans to petitioner or to any corporation, other legal entity or individual. He also made comparable commitments to BAC Corporation for so long as it should own any stock in Romay.
The loan agreement of August 30, 1946, between Romay and the Bank of America was entitled ‘Mortgage, Pledge and Assignment (Motion Picture Photoplay).’ As facts, representations, conditions, and circumstances upon which the agreement was based it recited or took note of the representation on the part of Romay that it had commenced and would complete the production of Photoplay; the distribution agreement with P.R.C. Pictures, Inc.; the ownership of the picture by Romay; the budget estimate of $175,000 for the production or negative cost; that Romay had a paid-in capital of $25,000 which was to be used in the production of the picture; the loan agreement to a maximum of $65,000 with BAC Corporation; and the deferment by Stephens of $5,000 of the $15,000 he was to receive. It was then agreed in consideration of the premises recited and subject to certain stated conditions, among which was the delivery to the Bank of a personal agreement by petitioner, covered hereafter, that the Bank during the period from the date of the agreement to December 31, 1944, would advance the sum, whichever should be lower, of $105,000 or 60 per cent of the negative cost of the picture for use exclusively in producing the picture; the loan or loans should be evidenced by the interest-bearing promissory note of Romay for a term not to exceed 1 year; and as security for payment of the indebtedness Romay conveyed, assigned, hypothecated, mortgaged, and pledged to the Bank the Picture and all of Romay's right, title, and interest therein, which was to be a first lien and charge on the picture, both present and future. Specifically covered by the mortgage were the right to distribute, sell, license, exhibit, and otherwise exploit the Picture ‘throughout the world’ and all rent, revenue, income, compensation, and profits which should come to Romay from the release, distribution, and exploitation of the Picture. The Bank was to have the right, in the event of certain specified failures or defaults by Romay or the distributors, to declare the amount of its loan immediately due and payable and thereupon to enforce its rights under the agreement.
In satisfaction of the condition imposed by the Bank in making the above loan agreement, and under date of August 31, 1946, petitioner, individually and as the First Party, and the Bank, as Second Party, executed an agreement entitled ‘Guaranty of Completion and Subordination by George J. Schaefer.’ Preliminary to the recitation of the undertakings and commitments of petitioner, it was stated that the agreement was made with reference to ‘certain facts, conditions, and circumstances,‘ some of which were that Romay had commenced or was about to commence production of the Picture and had submitted a budget showing that ‘the estimated negative cost shall not exceed $175,000’; that a distribution agreement had been made with P.R.C. Pictures, Inc., as distributor; that the Bank was about to lend Romay up to $105,000 for use in producing the Picture and as security therefor was to have a mortgage on the Picture, the properties thereof, and the rent, revenue, income, and compensation to be obtained from the Picture; that BAC Corporation had agreed to loan up to $65,000 to Romay, which was to be subordinate to the loan of the Bank; that Romay had a ‘paid-in capital of $25,000’ which would be used in the production of the Picture; that petitioner was to have ‘a financial interest in the production of the Picture and in the benefits and advantages to be obtained therefrom’; and that as a condition of its loan to Romay, the Bank was requiring that petitioner unconditionally guarantee and assure the Bank that if for any reason Romay should fail to complete the Picture as agreed upon, petitioner, at his own cost and expense, would cause the Picture to be fully completed as a finished product for release and distribution and would defer repayment of his advances or loans until the loan by the Bank, with interest should be fully repaid. It was thereupon agreed that petitioner would guarantee completion of the Picture at his own cost, as specified, and would defer repayment of his advances and costs until loans to Romay by the Bank should have been fully paid. It was also provided that the Bank should have the right to recover from petitioner the amount of any loss upon its said loans to Romay from a failure on the part of Romay or petitioner to complete the Picture.
Pursuant to its agreement of August 28, 1946, BAC Corporation on that date loaned Romay the $40,000 therein specified and received Romay's 6 per cent demand note therefor. Romay also executed and delivered to BAC the chattel mortgage, as agreed.
The $105,000 from the Bank of America was advanced to Romay in varying amounts between September 3 and November 12, 1946, each such advance being evidenced by Romay's promissory note. The notes were to bear interest at 5 per cent and were to mature on demand or by August 1, 1948.
On November 22, 1946, BAC Corporation advanced to Romay the additional $25,000 covered by its Guaranty of Completion, thereby bringing the total of its advances to Romay to $65,000.
The money thus made available to Romay in the form of paid-in capital and as loans from BAC Corporation and the Bank of America proved to be insufficient for the completion of the Photoplay, and on November 11, 1946, petitioner made his first advance to Romay under his Guaranty of Completion to the Bank of America. The advance was in the amount of $5,000 and was evidenced by Romay's note, which was to bear interest at 6 per cent. The final cost of producing the Photoplay was $246,189.30, and beginning with the above advance of $5,000 on November 11, 1946, petitioner was ultimately required to advance a total of $53,273.65 under his Guaranty of Completion. These advances were likewise evidenced by 6 per cent promissory notes of Romay. The advances so made and the dates thereof were as follows:
+-----------------------------+ ¦Date ¦Amount ¦ +------------------+----------¦ ¦November 15, 1946 ¦$5,000.00 ¦ +------------------+----------¦ ¦February 4, 1947 ¦6,050.00 ¦ +------------------+----------¦ ¦April 9, 1947 ¦5,000.00 ¦ +------------------+----------¦ ¦April 22, 1947 ¦1,100.00 ¦ +------------------+----------¦ ¦May 1, 1947 ¦800.00 ¦ +------------------+----------¦ ¦May 15, 1947 ¦400.00 ¦ +------------------+----------¦ ¦May 29, 1947 ¦650.00 ¦ +------------------+----------¦ ¦June 25, 1947 ¦4,000.00 ¦ +------------------+----------¦ ¦June 25, 1947 ¦2,700.00 ¦ +------------------+----------¦ ¦July 17, 1947 ¦300.00 ¦ +------------------+----------¦ ¦September 1, 1947 ¦5,165.00 ¦ +------------------+----------¦ ¦October 24, 1947 ¦1,500.00 ¦ +------------------+----------¦ ¦November 3, 1947 ¦7,500.00 ¦ +------------------+----------¦ ¦November 28, 1947 ¦1,600.00 ¦ +------------------+----------¦ ¦December 5, 1947 ¦500.00 ¦ +------------------+----------¦ ¦December 29, 1947 ¦250.00 ¦ +------------------+----------¦ ¦January 22, 1948 ¦4,383.65 ¦ +------------------+----------¦ ¦March 11, 1948 ¦400.00 ¦ +------------------+----------¦ ¦March 26, 1948 ¦900.00 ¦ +------------------+----------¦ ¦May 8, 1948 ¦325.00 ¦ +------------------+----------¦ ¦May 26, 1948 ¦1,500.00 ¦ +------------------+----------¦ ¦June 5, 1948 ¦1,000.00 ¦ +------------------+----------¦ ¦August 10, 1948 ¦500.00 ¦ +------------------+----------¦ ¦August 18, 1948 ¦1,750.00 ¦ +------------------+----------¦ ¦Total ¦$53,273.65¦ +-----------------------------+
The production of the Photoplay was completed on or about April 1, 1947, at which time it was delivered to a laboratory pursuant to the agreement with P.R.C. Pictures, Inc. The picture was not released for exhibition, however, until November 1, 1947, due to the difficulty in obtaining proper prints.
On June 1, 1948, Eagle Lion Films, Inc., succeeded to the rights of P.R.C. Pictures, Inc., under the distribution agreement, and at the same time the Dominion of Canada and Newfoundland were taken from petitioner and added to its territory. Gross receipts in those two countries were to be divided 35 per cent to Eagle Lion and 65 per cent to Romay. Petitioner had not theretofore made any contracts for distribution of the Photoplay in Canada.
Presumably the same was true with respect to Newfoundland.
The Photoplay was not a type of picture that could profitably run at the first run or class A theaters. The large circuits and such theaters as Loew's and RKO in New York would not exhibit it. It was used mostly in class B theaters, which are second and third run houses.
After a motion picture has been in lease for 6 months or longer, it is a common practice in the industry for producers to request distributors to make estimates of the gross receipts which may be anticipated from the distribution of the picture. All receipts since the date of release are usually included. In November or December of 1948, petitioner requested Eagle Lion to make such an estimate of the gross receipts which might be expected from distribution of the Photoplay in the United States and Canada. It was Eagle Lion's estimate that the picture would gross $300,000 in the United States and $25,000 in Canada. This estimate included the receipts for the period the Photoplay had been in release.
Petitioner never realized any sums from the distribution of the Photoplay in the rest of the world. Quota restrictions in foreign countries made it difficult for other than good American pictures to be imported, and taking into account the import duties and the cost of dubbing into the sound track the language of the country or superimposing translations on the film, in order to comply with regulations of such country, the importation of a poor motion picture was not justified. Petitioner did in two instances make sales of foreign distribution rights to the Photoplay for Indo-China, Hong Kong, Singapore, and Malay for $1,500, which amount was received by Romay. In 1952 Romay received $7,020 on account of the sale of rights for the United Kingdom for L4,000, leaving a balance of L900 still due.
On some date not disclosed, Romay entered into an agreement with George Bagnall and Associates, Inc., whereby Bagnell became Romay's distributor for television, and on August 21, 1952, Bagnall entered into an agreement with Hauser-Nash Sales Inc., under which that concern was granted a license to telecast the Photoplay in the Chicago area for a period of 15 months in consideration of the payment of $3,000. The Chicago area had a radius of approximately 30 miles. It was hoped that similar arrangements would be made in other localities.
The total receipts from the exploitation of the Photoplay and the disposition thereof up to February 1943 were as follows:
+-----------------------------------------------------------------+ ¦Receipts from distribution of the Photoplay through Eagle Lion ¦ +-----------------------------------------------------------------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------+
Absorption of Romay's share ”Net gross” Eagle Lion's Romay's Eagle Payments Lion's Period receipts distribution share repayment made to Bank United fees for certain of America States and Canada expenses in re loan to made under Romay contract 11/1/47 to 12/31/ $228,920.72 $69,088.38 $159,832.34 $122,945.30 $36,887.04 48 1/1/49 to 12/31/ 63,737.72 19,742.99 43,994.73 74.52 43,920.21 49 1/1/50 to 4/28/51 18,428.37 5,749.44 12,678.93 1,121.47 11,557.46 Total $311,086.81 $94,580.81 $216,506.00 $124,141.29 $92,364.71
4/29/51 to 1/31/53 (Romay's share only) 2,607.48 Total paid Bank of America for Romay by Eagle Lion $94,972.19
Receipts from other sources Paid to Bank of America Received April 27, 1948, sale of Far Eastern rights $1,500.00 Received in 1952, from sale of United Kingdom rights for £ 4,000 7,020.00 (Balance due £ 900) Received in 1952, sale of T.V. rights, Chicago ($1,000 due) 2,000.00 $10,520.00
Petitioner has been a director of Romay from the date of its incorporation and has at all times been its dominating and guiding spirit. He replaced Stephens as its president in October of 1947, when it was determined that Stephens had diverted some of the funds from the production of the Photoplay to his own personal use. The audit reports of Romay for 1947, 1948, and 1949 showed Stephens as owing Romay an aggregate amount of $12,721.58.
Romay has never been dissolved or liquidated, but is still in existence. Its only asset of any substance now and since its completion has been the Photoplay.
The income reported by petitioner on his 1948 return was from several sources, but in the main it was compensation received for his services to Enterprise. He reported $90,360 in salary and $15,240 as a reimbursement of business expenses. His actual business expenses were reported as $15,429.21, however, and his net compensation for the year as $90,170.79. Other income reported consisted of interest $795.01, rentals $186, and a profit of $703.67 from the sale of residential property. His claimed deductions consisted of contributions, interest, taxes, loss from storm and miscellaneous, in a total amount of $65,671.02. Under Miscellaneous, he claimed a deduction as a ‘Business Loss' of $53,295.87, which included his advances to Romay under his Guaranty of Completion agreement with the Bank of America. There was no claim of deduction for the $14,000 paid in for the 140 shares of Romay stock at the time of incorporation, or the $11,000 paid in on or about August 27, 1946.
In his determination of deficiency the respondent disallowed the deduction claimed on account of the advances so made to Romay.
Petitioner's advances to Romay in the aggregate of $53,273.65, as above set forth, constituted business debts, and they became worthless in 1948, the taxable year herein.
The $11,000 paid to Romay by petitioner on or about August 27, 1946, was a contribution to capital and did not give rise to a debt.
OPINION.
TURNER, Judge:
We have in issue two claimed deductions as bad debts under section 23(k)(1) of the Internal Revenue Code of 1939,
one being for the $11,000 paid in or advanced to Romay on or about August 27, 1946, as above set forth, and the other for $53,273,63, in the aggregate, covering the advances made to Romay by petitioner under his Guaranty of Completion agreement with the Bank of America. Deduction of the $11,000 item was not claimed by petitioner in his return nor in his original petition, but was claimed for the first time in his amended petition.
SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:(k) BAD DEBTS.—(1) GENERAL RULE.— DEBTS which become worthless within the taxable year; or (in the discretion of the Commissioner) a reasonable addition to a reserve for bad debts; and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the amount charged off within the taxable year, as a deduction. This paragraph shall not apply in the case of a taxpayer, other than a bank, as defined in section 104, with respect to a debt evidenced by a security as defined in paragraph (3) of this subsection. This paragraph shall not apply in the case of a taxpayer, other subsection. This paragraph shall not apply in the case of a taxpayer, other than a corporation, with respect to a non-business debt, as defined in paragraph (4) of this subsection.
It is the position of the respondent that the amounts in question were part of the cost to petitioner of his Romay stock, but, in the alternative, if they are held to be debts, they were nonbusiness debts under section 23(k)(4),
and they did not become worthless in 1948, the taxable year herein.
(4) NON-BUSINESS DEBTS.— IN the case of a taxpayer, other than a corporation, if a non-business debt becomes worthless within the taxable year, the loss resulting therefrom shall be considered a loss from the sale or exchange, during the taxable year, of a capital asset held for not more than 6 months. The term ‘non-business debt’ means a debt other than a debt evidenced by a security as defined in paragraph (3) and other than a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.
The evidence shows, we think, and we have found as a fact, that the $11,000 was paid in to Romay as capital and that its payment did not give rise to a debt. It is true that it was evidenced by a writing in the form of an interest-bearing promissory note and in numerous of the agreements to which BAC Corporation was a party it was referred to as a loan. Even so, however, the surrounding facts and circumstances have convinced us that all parties considered it as effecting a capital expansion of Romay, and not as a loan. Furthermore, when the loan contract with the Bank of America was worked out some two or three days later, both Romay and petitioner represented that Romay had a paid-in capital of $25,000, which could be true only if the said $11,000 be included along with the $14,000 originally paid in for stock. It is clear that the Bank of America, in making the loan to Romay, did so on the basis of that representation. Such being the case, the petitioner's claim for the deduction of the $11,000 as a bad debt is denied. Watson v. Commissioner, 124 F.2d 437, affirming 42 B.T.A. 52. Advisedly, it would appear, petitioner, for reasons best known to himself, has specifically refrained from making any claim for the deduction of any loss of his capital investment in Romay.
Although we have reached our conclusion along a line different from that argued by petitioner, we have concluded with respect to the $53,273.65 in advances made to Romay by petitioner under his Guaranty of Completion agreement with the Bank of America, that a debtor-creditor relationship did arise, that the debt or debts were not nonbusiness debts within the meaning of section 23(k)(4), and that they did become worthless in the taxable year. The petitioner's argument is that he was, and had been, in the motion picture business generally for years and that this particular venture was a part and parcel in the conduct of that business. That argument is not, in our opinion, supported by the evidence. It is true that he had engaged in various activities in the motion picture field both on his own account and as a salaried officer or employee of motion picture producing concerns, but, so far as appears, he had never before indulged in the business of producing or financing the production of a feature picture. Accordingly, we think that his claim must stand or fall upon his participation in his individual capacity in the venture which had to do with and resulted in the production of the Photoplay.
In contemplation of law, a corporation is an entity separate and apart from its stockholders, and where an individual or group of individuals seeks the benefits of the corporate form or method for the ownership and conduct of a business, he or they may not ignore the presence or existence of the corporation, in order to avoid the disadvantages. In short, it is a free choice and except for instances when the statute may provide otherwise the advantages and disadvantages are to be taken as they come. Thus, in cases involving questions such as we have here the business of valid and subsisting corporations is not to be regarded as that of the stockholders where it is to their advantage to so regard it in order to obtain an ordinary loss deduction, as against the limited capital loss deduction, as where the corporation has been organized with nominal or inadequate capital so as to permit the capital reasonably required to be dribbled in as needed and then under the guise of paid-in capital or loans, as the resulting advantages may suggest, or where a controlling stockholder expends his own funds in the conduct of the corporation's, not his, business, and then seeks to classify the liability of the corporation to him for such advances as business rather than nonbusiness debts. See, for such cases, Alfred R. Bachrach, 18 T.C. 479, and A. Kingsley Ferguson, 16 T.C. 1248. A very noticeable aspect of such cases usually is the absence of an arm's-length relationship between the corporation and the stockholder. Such, however, is not this case, since the course of action taken and the pattern followed were not selected and determined by the petitioner alone but by and in agreement with BAC Corporation and the Bank of America, which were outside or third party interests.
It is true that petitioner had never, so far as the record shows, been engaged in the business of financing corporations through personal advances or loans, as in Vincent C. Campbell, 11 T.C. 510, and if such prior activity were essential to his case here, he would lose on the facts. On the other hand, this is not a nominal of inadequate paid-in capital case such as Alfred R. Bachrach, supra. Both BAC Corporation and the Bank of America were engaged in the business of credit financing and by the very nature of such a business they would as a matter of course be conscious of and sensitive to the adequacy or inadequacy of the paid-in capital of a prospective corporate borrower. In the instant case, however, they committed themselves to substantial credit financing of Romay on the basis of a paid-in capital of $25,000, and did not suggest or require further payments of paid-in or so-called risk capital after the amount thereof had been increased by petitioner from $14,000 to $25,000. They were not willing, however to let matters rest thereafter solely in the hands of Romay or with petitioner in his capacity as controlling stockholder and president of Romay, but required certain guaranties, commitments, and agreements of participation from him individually. In other words, the activities required were not matters left to petitioner's personal wishes or judgment and discretion as the controlling stockholder and dominant officer of Romay, but were matters in respect of which he was personally obligated under his individual contracts with the two lending institutions, and when taken as a whole these activities, which included further credit financing of Romay, if the occasion therefor arose, were in our opinion such as to make of them the conduct of a business by petitioner within the meaning of the statute and to make of the advances to Romay in the course thereof business and not nonbusiness debts under section 23(k). Such being the facts and circumstances, we do not have here a case such as Alfred R. Bachrach, supra; A. Kingsley Ferguson, supra; Jan G. J. Boissevain, 17 T.C. 325, or other cases where it was held that the indebtedness of the closely held corporation to its stockholders was not to the stockholders a business debt but a nonbusiness debt under section 23(k)(4), for the reason that the business being carried on and in the course of which the advances were made was that of the corporation and not that of the stockholders.
We accordingly conclude and hold that the indebtedness of Romay to petitioner for the advances made by him under his Guaranty of Completion agreement were business debts within the meaning of the statute, and having found on the evidence that they did become worthless in the taxable year, the determination of the respondent with respect thereto is rejected.
Reviewed by the Court.
Decision will be entered under Rule 50.