Opinion
Docket No. 79518.
1962-05-1
HAYWOOD P. MARTIN AND ROSE MARIE MARTIN, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Haywood P.Martin, pro se. Ferd J. Lotz, Esq., for the respondent.
Haywood P.Martin, pro se. Ferd J. Lotz, Esq., for the respondent.
Petitioners owned a piece of real estate and contracted with builders for the erection of a residence thereon at a fixed price. At the time the house was completed unpaid mechanics and materialmen filed liens against petitioners' property. In order to prevent foreclosure and the loss of their house petitioners paid and satisfied these claims, such payments being in excess of $6,000. At that time the debts owed by the builders, to which petitioners were subrogated by such payments, were uncollectible as against the builders. During each of the taxable years petitioners deducted $1,000 on account of nonbusiness bad debts, which deductions were disallowed by respondent. Held, petitioners entitled to such deductions.
Respondent determined deficiencies in petitioners' income taxes for the years 1953, 1954, and 1955 in the respective amounts of $352.72, $615.86, and $253.17. These deficiencies arise by reason of respondent's disallowance of certain deductions claimed by petitioners in each of the years involved. Certain adjustments made by respondent in a statement attached to the statutory notice of deficiencies were not assigned as error and are not in controversy herein.
By appropriate assignment of error petitioners contest the correctness of respondent's ‘disallowance * * * of a nonbusiness bad debt deduction in the amount of $1,000 for each of the years 1953 to 1955, inclusive, representing the amounts allowable as short-term capital losses in each of said years,‘ and his ‘disallowance * * * in the year 1953 of contributions, taxes and interest in the total amount of $943.23.’ By stipulation it was agreed that in the event we decide the bad debt issue in petitioners' favor they are entitled to the itemized deductions for contributions, taxes, and interest in the total amount of $943.23 for the year 1953 instead of the standard deduction of $1,000 allowed by the respondent in lieu of the itemized deductions claimed by petitioners.
The only question remaining for our decision is whether petitioners are entitled to a nonbusiness bad debt deduction in each or any of the years involved herein.
FINDINGS OF FACT.
Some of the facts have been stipulated. The stipulation of facts, together with the exhibits attached thereto, is incorporated herein and made a part of our findings of fact by this reference.
Petitioners are husband and wife who reside in Falls Church, Virginia. They filed joint Federal income tax returns for the taxable years 1953, 1954, and 1955 with the district director of internal revenue at Richmond, Virginia.
In March 1948 petitioners owned certain property in Fairfax County, Virginia, upon which they desired to construct a house. After preparing plans and specifications and obtaining competitive bids from various contractors they entered into a fixed-price contract for the construction of their home with Thelma L. Taylor and Robert Henry, sometimes hereinafter referred to as Taylor and Henry, respectively, who signed the contract as partners. Petitioners also applied for and received loans from First Federal Savings and Loan Association of Washington, D.C., hereinafter referred to as First Federal, in order to finance the construction.
Under its contract with petitioners First Federal made ‘progress payments' to the builders as the work progressed with which services rendered and materials furnished in the construction of the house were to be paid, and no payments were to be made unless the work had actually been done and the materials used by the builders paid for.
Construction proceeded as planned until it became apparent that it was slowing down because of a lack of building materials. There were also rumors that the builders were having financial difficulties and that they were not paying their bills. When the work was about 50 percent completed Taylor disappeared and has not been heard from since. Her partner, Henry, remained on the job, supervised the work, and ordered the materials needed to complete the job.
As a part of their contract petitioners had required the builders to obtain a surety bond to protect petitioners and the lending institution. The bond was turned over to First Federal, but it was subsequently discovered that the signature of the bondsman who was formerly an employer of Taylor had been forged to the bond by Taylor.
At or about the time the home was completed various mechanics and materialmen filed liens against petitioners' house as security for various amounts due for services and supplies furnished and for which they had not been paid by either Taylor or Henry.
Petitioners were advised by counsel that they would lose their home unless these claims were satisfied. Accordingly and in the exercise of sound business judgment the petitioners paid and satisfied these claims secured by the liens in order to protect their property which stood as security for the liens. The debts owed by Taylor and Henry to the mechanics and materialmen were uncollectible as against Taylor and Henry at the time they were paid and satisfied by petitioners.
In 1950 petitioners entered suit against Taylor, Henry and First Federal for the amounts paid. None of the pleadings in this suit have been introduced in evidence herein. Petitioners were unable to obtain service of process on Taylor, and it was only with considerable difficulty that they were able to serve process on Henry.
Neither Taylor nor Henry appeared at the trial or offered any defense whatsoever, and a default judgment was entered against Henry on April 22, 1953, in the amount of $11,547.89. First Federal defended the action and, after a jury trial which lasted 6 days, settled petitioners' claims against it for $1,500 sometime during the year 1953.
In 1953, after entry of judgment against Henry, petitioners found that he had no funds and no property in his own name against which they could enforce the judgment. No inquiry into Henry's financial standing was made prior to the institution of suit by petitioners' counsel, but it was known that Henry was engaged in other construction activities at the time suit was instituted in 1950. Petitioners' counsel undertook to prosecute their cause on a contingent fee basis, with the expectation that he would be paid from any amounts recovered from the defendant.
On their income tax returns petitioners deducted as a bad debt the amount of $1,000 in each of the years involved, as illustrated by the following entry which appeared on their return for the year 1955:
+---------------------------------------+ ¦Bad debt:Judgment approx ¦$10,500¦ +-------------------------------+-------¦ ¦Claimed this year ¦1,000 ¦ +-------------------------------+-------¦ ¦Claimed in prior years ¦2,000 ¦ +-------------------------------+-------¦ ¦Balance to be claimed in future¦7,500 ¦ +---------------------------------------+
During the taxable years the petitioners owned worthless nonbusiness debts due from Taylor and Henry in a total amount in excess of $6,000. These debts were worthless when petitioners became the creditors of such debts by reason of their involuntary payment of the original creditors.
OPINION.
KERN, Judge:
The question presented by this case concerns the propriety of the deduction of $1,000 taken by petitioners in each of the taxable years on account of the circumstances set forth in our findings of fact.
Respondent contends that the payments made by petitioners to the unpaid materialmen and mechanics ‘resulted in losses instead of bad debts which, the petitioners, as individuals, may not deduct’ under any provision of the Internal Revenue Code
and, in the alternative, that if the payments resulted in debts owned by petitioners they were valueless at the time of their creation and could not have become worthless.
The record herein does not justify a conclusion that there was a theft loss and petitioners do not so contend. Cf. Thomas Miller, 19 T.C. 1046.
Respondent also argues halfheartedly that the payments made by petitioners constituted capital expenditures which should be added to their basis for the property. This argument is without merit. The Leichner & Jordan Co., 4 B.T.A. 133; Lena G. Hill, 8 B.T.A. 1159.
We analyze the transactions here involved as follows:
When petitioners made the payments here involved they became subrogated to the debts owed to the mechanics and materialmen by the contractors and thereby became creditors of the contractors. Des Moines Furnace & Stove Repair Co. v. Lemon, 244 Iowa 316, 56 N.W.2d 923. These payments were made and the debtor-creditor relationship between the contractors and petitioners arose involuntarily on petitioners' part. They made the payments, not as gifts or contributions to capital, cf. E. J. Ellisberg 9 T.C. 463, but because they were advised by counsel that if they did not make them they would lose their home which, under the Virginia statutes, stood as security for the claims paid. In our opinion there is no distinction in principal between the circumstances of this case and those in Shiman v. Commissioner, 60 F.2d 65, Peter Stamos, 22 T.C. 885, and George After-good, 21 T.C. 60. See Houk v. Commissioner, 173 F.2d 821, in which payments made to protect the payors' interest in property were referred to as ‘made mandatory by what they considered sound business judgment.’ Where, as in the case, sound business judgment makes mandatory the payment of claims which are in effect secured by the property of the payor in order to prevent the loss of such property on foreclosure, the payment is, for all practical purposes, quite as ‘involuntary’ as it would be had the payor been a formal guarantor of the debts represented by the claims. Therefore, the creation of a debtor-creditor relationship as between the owner of the property and the original obligor of the claims as a result of subrogation was involuntary, and consequently the worthlessness of the debts at the time they were thus created
is irrelevant in considering their deductibility.
The finding as to the worthlessness of these debts at that time is made by reason of a lack of satisfactory proof to the contrary.
The case of Caroline D. Thompson, 22 T.C. 507, is distinguishable since in that case the payment of the debts resulting in subrogation was not involuntary but was motivated by tax considerations.
Because of certain omissions of proof we are unable to determine the exact total net principal amount of the debts to which petitioners became subrogated by reason of the payments here involved. Obviously, the amount of the judgment later obtained represents to a great extent the total principal amount of such debts, but it may also represent a relatively small amount of interest; and the unpaid balance of such debts may also have to reflect an adjustment on account of the settlement with First Federal. However, this case involves the deductibility over the 3 taxable years of a total amount of only $3,000 of such debts. It seems clear to us from the record (and respondent makes no argument to the contrary) that the amount of the claims of mechanics and materialmen paid by petitioners was in excess of $6,000, and we have so found.
The issue presented herein is decided in favor of petitioners.
Decision will be entered under Rule 50.