Opinion
Docket No. 26522.
1952-07-18
KATE BAKER SHERMAN, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Ralph L. McAfee, Esq., and William J. Nolan, Jr., Esq., for the petitioner. William E. Murray, Esq., for the respondent.
1. The holder of a note liquidated certain of the endorser's collateral and applied the proceeds in part payment of the principal sum due on the note. The maker of the note was insolvent. Held, the endorser is entitled to a nonbusiness bad debt deduction under section 23(k)(4) of the Internal Revenue Code.
2. The holder of a note liquidated certain of the endorser's collateral and applied the proceeds to the payment of interest due on the note. Held, the endorser is entitled to an interest deduction under section 23(b) of the Internal Revenue Code.
3. The holder of certain notes liquidated the maker's collateral and applied the proceeds to the payment of interest due on the notes. Held, the maker is entitled to an interest deduction under section 23(b) of the Internal Revenue Code. Ralph L. McAfee, Esq., and William J. Nolan, Jr., Esq., for the petitioner. William E. Murray, Esq., for the respondent.
Respondent determined a deficiency in income tax of the petitioner in the amount of $7,649.52 for the calendar year 1945, resulting from the disallowance of certain interest deductions and nonbusiness bad debt losses claimed by the petitioner on her return.
The issues presented are as follows:
1. Is the petitioner entitled in 1945 to a capital loss carry-over from the year 1944 with respect to worthless debts which arose in that year as the result of payments made in that year by her through the application by the creditor of petitioner's collateral on the principal of a note made by Sherrill Sherman, on which she was the endorser and guarantor?
2. Is the petitioner entitled to a short term capital loss in 1945 for worthless debts which arose in that year as the result of payments made by her through the application by the creditor of petitioner's collateral on the principal of a note made by Sherrill Sherman, on which she was the endorser and guarantor?
3. Is the petitioner entitled to a deduction (a) for interest paid by her in 1945 on three notes made by her and (b) for interest paid by her in 1945 on a note made by Sherrill Sherman, her husband, and endorsed and guaranteed by her?
FINDINGS OF FACT.
Certain of the facts pertinent to the issues involved have been stipulated by the parties. The facts stipulated are so found and incorporated herein by this reference.
The petitioner is an individual with her residence at Chestnut Street, Clinton, New York. The petitioner's amended income tax return for the calendar year 1945 was filed with the collector of internal revenue for the twenty-first district of New York at Syracuse, New York. The return was filed on a cash basis.
In or about the year 1915 the petitioner and her husband, Sherrill Sherman, organized a corporation under the name of Sherman Sales Company, Inc. This was an automobile dealership. The petitioner and her husband were the sole stockholders. Petitioner's equity in Sherman Sales Company was substantial. Thereafter, additional capital funds were required by the corporation and both the petitioner and her husband increased their holdings in the corporation. At a later date a pressing need for working capital made it necessary for Sherrill Sherman to borrow the necessary funds on his own credit, the credit of the corporation being such that it was unable to sustain further loans. As a condition for carrying Sherrill Sherman's line of credit, the banks required the petitioner's signature as endorser.
In 1936 the Sherman Sales Company, Inc., was dissolved without assets by a proclamation of the Secretary of the State of New York.
In 1932 certain of the obligations of Sherrill Sherman, endorsed by the petitioner, were consolidated into a note in the principal sum of $36,000, upon which Sherrill Sherman appeared as maker and petitioner as endorser and guarantor. Thereafter, this note was renewed by the giving of a renewal note dated January 1, 1940, in the principal sum of $36,000. Again Sherrill Sherman appeared as maker and petitioner as endorser. In or about the year 1940 the Federal Deposit Insurance Corporation, hereinafter referred to as FDIC, became the holder in due course of this note, which the FDIC identified as Asset No. 1939.
Interest charges upon petitioner's husband's obligations which grew out of the corporation's inability to SECURE working capital on its own credit were carried by the various banks involved in the form of interest notes representing past due interest. Of these, three notes in the principal amounts of $2,994.58, $3,989.59, and $37,500 are involved herein. They were made by the petitioner and were payable to the First Citizens Bank & Trust Company of Utica, New York. These notes were acquired by the FDIC in 1940 as holder in due course at or around the time that it acquired the note in the principal sum of $36,000, referred to above.
On or about August 20, 1945, the FDIC was the holder in due course of the three notes referred to above in the principal amounts of $2,994,58, $3,989.59, and $37,500, respectively, and each was signed by the petitioner as maker. These notes were further identified by the FDIC as Assets Nos. 1934, 1935, and 1936.
On or about August 20, 1945, the FDIC liquidated certain of petitioner's assets held as collateral security for the payment of petitioner's debts and liabilities, debited the account pertaining thereto and credited the interest accounts of Assets Nos. 1934, 1935, and 1936 in the amounts of $357.32, $320.88, and $275.82, respectively.
On or about August 20, 1945, the FDIC was the holder in due course of the note in the principal amount of $36,000, dated January 1, 1940, and identified as Asset No. 1939, made by petitioner's husband, Sherrill Sherman, and endorsed and guaranteed by the petitioner. On or about August 20, 1945, the FDIC liquidated certain of petitioner's assets held as collateral security for the payment of petitioner's debts and liabilities, debited the account pertaining thereto and credited the interest account of Asset No. 1939 in the amount of $192.14. The petitioner on her 1945 Federal income tax return claimed interest deductions in the amounts of $357.32, $320.88, $275.82, and $192.14, totaling $1,146.16. Of this sum, $954.02 represented interest on the three notes signed by petitioner as maker and identified as Assets Nos. 1934, 1935, and 1936; $192.14 represented interest on the note identified as Asset No. 1939, made by Sherrill Sherman and endorsed by the petitioner. The respondent disallowed the claimed interest deduction of $1,146.16 in its entirety.
In 1944 and 1945 the petitioner made principal payments of $9,767.70 and $4,575.74, respectively, to the FDIC on the note in the principal amount of $36,000 identified as Asset No. 1939. These payments of principal were made through the application of the FDIC of income from, and proceeds of, sales of collateral of the petitioner held by the FDIC. These payments were not the act of the petitioner but rather the act of the FDIC made under its authority to liquidate and apply the collateral of the petitioner to the reduction of the obligation.
In 1944 petitioner had a net long term capital gain of $825. The petitioner claimed on her 1945 Federal income tax return a short term capital loss in the amount of $4,674.24 and a short term capital loss carry-over from a preceding taxable year, 1944, in the amount of $7,942.70, with respect to the payments of principal made by her in 1944 and 1945, and respondent disallowed these losses in their entirety.
On or about October 14, 1944, the FDIC brought actions in the United States District Court for the District of New York against the petitioner and Sherrill Sherman to collect their notes held by it, including Assets Nos. 1934, 1935, 1936, and 1939, plus interest thereon at the rate of 6 per cent annum according to the terms of the notes.
In 1945 Sherrill Sherman was 62 years old. During the years 1944 and 1945 he was insolvent. At the end of those years his assets were worth approximately $37,800 and $40,000, respectively, and his liabilities amounted to approximately $96,400 and $95,900, respectively, as shown by his balance sheets for those years.
At the end of 1944 and 1945 Sherrill Sherman was indebted to the FDIC in the approximate amounts of $37,400 and $32,200, respectively, with respect to the unpaid principal of notes executed by him and held by the FDIC, and in the approximate amounts of $3,200 and $3,400, respectively, with respect to interest claimed by the FDIC to be due thereon at the rate of 6 per cent per annum. The difference in unpaid principal between the years involved is represented by payments made in 1945 by the petitioner on Asset No. 1939 when the FDIC liquidated a portion of her collateral and applied the proceeds in payment thereon. Sherrill Sherman was indebted to the petitioner during the years involved to the extent of approximately $25,000 without regard to the applications made by the FDIC during 1944 and 1945 of proceeds derived from the sale of petitioner's collateral. Substantially all the securities owned during 1944 and 1945 by Sherrill Sherman and the income therefrom were pledged in those years with the FDIC as collateral for payment of his obligations. All income received by Sherrill Sherman from certain rental property owned by him was pledged and paid to the FDIC. The property itself was under mortgage. That income was $2,340 and $2,310 for the years 1944 and 1945, respectively.
Sherrill Sherman received salary from Roberts Hardware Company, Inc., a New York corporation of which he was president, and which was not controlled by either him or petitioner, in 1944 and 1945 of $6,000 and $5,664.94, respectively. He was first employed by that company in 1932 and became president in 1933. During 1944 and 1945 and in prior and subsequent years, Sherrill Sherman's salary was at the rate of $100 per week, plus a percentage of the gross profits, but could not in any event exceed $10,000 in any one year. From 1941 Sherrill Sherman was obligated to turn over to the FDIC any portion of his annual salary which exceeded $6,000, less Federal and New York state income taxes attributable to such portions. He received in 1944 and 1945 directors' fees in the amounts of $555 and $575, respectively, and dividends and interest income, including that which was paid directly to the FDIC with respect to securities pledged with it as collateral, in the amounts of $505 and $504, respectively. Sherrill Sherman had a net income after income taxes of approximately $6,000 in 1944 and $5,800 in 1945, which income included amounts paid to the FDIC.
In 1944 and 1945 Sherrill Sherman received income from a testamentary trust established in 1931 under the will of his mother in the amounts of $1,778.71 and $1,616.65. Under this trust he was the income beneficiary for life but had no interest in the corpus of the trust.
Sherrill Sherman was, during 1944 and 1945, the insured of certain life insurance policies, of which the petitioner and their son were irrevocable beneficiaries. Some of these policies were pledged as security for bank loans incurred to carry them.
From December 1940 petitioner and her husband, Sherrill Sherman, had been negotiating with the FDIC for a satisfactory settlement of their obligation. During this time the FDIC had been collecting interest at the rate of 6 per cent per annum on the principal notes, representing petitioner's and her husband's indebtedness. The petitioner and her husband had reached agreements with the various Utica banks involved pertaining to the interest rate on the principal sums which they owed in connection with the Sherman Sales Company, Inc. These agreements, which provided for the collection of interest at an effective rate of approximately 2 per cent, were the result of the general business failures from 1932 on. These agreements, which existed during the period from 1940 on and during the pendency of the suits brought by the FDIC against the petitioner and her husband, were not honored by the FDIC, which continued to collect interest at the rate of 6 per cent until December 1946, when an effective settlement was entered into between the FDIC, the petitioner, and her husband.
Sherrill Sherman had never declared himself in bankruptcy. He had always made a constant effort to pay his debts as they arose. Petitioner never presented a formal claim and demand or entered into a suit against Sherrill Sherman to secure payment of the amounts of her losses during 1944 and 1945 which arose out of the application of the proceeds derived from her collateral by the FDIC.
Sherrill Sherman, the principal debtor on Asset No. 1939, was insolvent during the taxable years 1944 and 1945. In 1944 and 1945 Sherrill Sherman became indebted to the petitioner in the sums of $9,767.70 and $4,575.74, respectively. These debts grew out of the application of the petitioner's collateral in payment of the principal sum due on Asset No. 1939 made by Sherrill Sherman and endorsed and guaranteed by the petitioner.
The petitioner paid interest of $1,146.16 in the taxable year 1945.
OPINION.
HILL, Judge:
Issues 1 and 2 are in reality a single issue and in this opinion will be treated as such. Petitioner as endorser guaranteed the debts of Sherrill Sherman, her husband, who had borrowed money and used the proceeds of the loan to provide working capital for a corporation, the stock of which was owned by the petitioner and Sherrill Sherman.
During 1944 and 1945 the FDIC liquidated certain collateral of the petitioner held by it and applied the proceeds in payment of the principal of the note of Sherrill Sherman identified as Asset No. 1939, which the petitioner had endorsed and guaranteed. These payments were in the amounts of $9,767.70 and $4,575.74, respectively.
In 1944 the petitioner had net long term capital gains of $825, no short term capital gains and no capital losses other than the amounts here in controversy. She treated the sum of $9,767.70 as a nonbusiness bad debt and claimed a short term capital loss under section 23(k)(4)
of $1,825 in her 1944 income tax return. In her 1945 return she claimed a capital loss carry-over of $7,942.70 ($9,767.70 minus $1,825, the sum of the net long term capital gains for 1944 plus $1,000), plus the 1945 payment of $4,575.74 as a short term capital loss under the provisions of section 23(k)(4).
SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions;(k) BAD DEBTS.—(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.
When, as here, the endorser of a note is forced to answer and fulfill his obligation of guaranty, the law raises a debt in favor of the guarantor against the principal debtor. In short, the guarantor is subrogated to the rights of the creditor against the primary debtor. Agnes I. Fox, 14 T.C. 1160; Warren Leslie, Sr., 6 T.C. 488. The petitioner bases her claim to a nonbusiness bad debt deduction on this theory, claiming debts by subrogation against Sherrill Sherman which were worthless in the years in which they arose due to his insolvency.
The respondent bases his opposition to the petitioner on this issue upon two grounds. First, the respondent argues that the sums in question do not constitute bona fide debts and, second, that assuming the existence of a debtor-creditor relationship the debts did not become worthless in 1944 and 1945. The respondent argues that the facts before us constitute a gift rather than a debt. He draws this conclusion from the close relationship between Sherrill Sherman and the petitioner. They were husband and wife. To support his conclusion the respondent relies upon Estate of Carr V. Van Anda, 12 T.C. 1158, where we said:
Intra-family transactions are subject to rigid scrutiny, and transfers from husband to wife are presumed to be gifts. However, this presumption may be rebutted by an affirmative showing that there existed at the time of the transaction a real expectation of repayment and intent to enforce the collection of the indebtedness. * * *
Applying the ‘rigid scrutiny‘ of the Van Anda case to the facts before us, we find that the petitioner had no intention of making a gift to Sherrill Sherman at the time she endorsed Asset No. 1939 or at the time she endorsed the original notes out of which Asset No. 1939 grew.
The respondent states that Sherrill Sherman never promised to pay the petitioner with respect to the sum in controversy. The respondent forgets that the obligation placed upon Sherrill Sherman by the petitioner's payments upon her endorsement of his note is not dependent upon a promise to pay but rather upon an obligation implied by the law. If Sherrill Sherman had expressly repudiated his obligation, his action would have been immaterial to the collection of the debt due and owing from him to the petitioner as the result of the payments made by her under her endorsement of his note. The obligation rests in a promise implied by the law. If we follow the respondent's argument we would have to find as a fact that at the time of making the endorsement the petitioner agreed to waive any rights against Sherrill Sherman which might arise out of his inability to pay his debt when due. The facts negative any such finding. The petitioner was no mere accommodation endorser. She stood to benefit substantially. Sherrill Sherman made the note in order to secure funds with which to provide working capital for Sherman Sales Company, Inc. The petitioner and Sherrill Sherman were the sole stockholders of that corporation. If the funds loaned by Sherrill Sherman to the corporation had been sufficient to secure its safe passage through the depression the petitioner would have benefited substantially.
To substantiate his theory of gift, the respondent also relies upon the fact that the petitioner never made a formal demand for payment against Sherrill Sherman. While under some circumstances this would be evidence of a gift, we do not think it important here. As will be pointed out shortly, Sherrill Sherman was completely insolvent during the years 1944 and 1945. For the petitioner to be entitled to a nonbusiness bad debt deduction under the provisions of section 23(k)(4), it is not necessary for her to do a useless act.
As to the respondent's contention that the debts were not worthless in 1944 and 1945, our finding of fact is dispositive. Sherrill Sherman was completely insolvent at the time the debts arose in 1944 and 1945. Our finding is based upon the balance sheets submitted by Sherrill Sherman for the years 1944 and 1945 and upon the record as a whole.
The taxpayer is not required to be an incorrigible optimist. The mere possibility that Sherrill Sherman, a man of 62 years in 1945, might one day recoup his losses and regain financial stability is not enough to warrant the respondent's conclusion that the debts were not bad for the years in which the petitioner claimed her bad debt losses. The petitioner is entitled to a nonbusiness bad debt deduction in 1945 of $12,518.44, (the capital loss carry-over of $7,942.70, plus the 1945 payment of $4,575.74) to be treated as a short term capital loss under the provisions of section 23(k)(4).
The third issue raises the question of the deductibility of certain claimed interest payments. Assets Nos. 1934, 1935, and 1936 held by the FDIC were notes made by the petitioner. They called for interest at the rate of 6 per cent per annum. In 1945 the FDIC liquidated certain of petitioner's assets which were held as collateral security for the payment of petitioner's debts, debited the collateral accounts and credited the interest accounts on these notes in the amounts of $357.32, $320.88, and $275.82, respectively. It would appear without question that the petitioner is entitled to a deduction of $954.02 under section 23(b)
of the Code for interest paid. However, the respondent argues that this is not the case. He reasons that the petitioner's interest payments were not voluntary but were the act of the FDIC in liquidating her collateral and applying the sums mentioned above towards the interest account on her notes. We find this reasoning specious. Affirmative action by the debtor in the payment of interest is not necessary where in fact his assets are applied to the payment of interest. Cf. Gertrude Rosenblatt, 16 T.C. 100.
(b) INTEREST.— All interest paid or accrued within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer), the interest upon which is wholly exempt from the taxes imposed by this chapter.
Further, the respondent argues that, since the petitioner and the FDIC were in dispute as to the amount of interest due on her obligations, the petitioner is not entitled to a deduction at the rate of 6 per cent which the FDIC collected but rather at the rate of which she contended was due, or 2 per cent. That the rate of interest was in dispute, we think, is immaterial. It is settled that a cash basis taxpayer is entitled to a deduction for amounts paid within the taxable year. Cf. Chestnut Securities Co. v. United States, 62 F.Supp. 574; G.C.M. 25298, 1947-2 C.B. 39. That in a later year not before this Court the FDIC made an adjustment in the rate of interest theretofore charged is also irrelevant. At any rate, as shown by the record, petitioner never recovered any amounts which she paid to the FDIC in years prior to 1946, the year of the adjustment.
Asset No. 1939 was made by Sherrill Sherman and endorsed by the petitioner. The interest rate thereon was at the rate of 6 per cent per annum. In 1945 the FDIC liquidated certain of petitioner's assets held as collateral security for the payment of her debts, debited the collateral account and credited the interest account of Asset No. 1939 in the amount of $192.14. The petitioner claimed an interest deduction in the amount of $192.14. The respondent disallowed the deduction on the ground that the interest paid by the petitioner was interest paid on the indebtedness of Sherrill Sherman and hence nondeductible. In support of his position he relies upon Chester A. Sheppard, 37 B.T.A. 279, holding that interest payments made on the obligation of another do not meet the statutory requirement of interest deductions. However, this truism does not sustain the respondent's position here, for the payment made by the petitioner was upon her obligation. When the FDIC found it necessary to go against the petitioner on her endorsement the petitioner was obligated not only for the principal due on Asset No. 1939 but the interest due and payable as well. See United States Fidelity & Guaranty Co., 40 B.T.A. 1010, 1019, 2 C.B. 113.
The petitioner is entitled to deduct the sum of $1,146.16 as interest paid during the taxable year 1945.
Decision will be entered for the petitioner.