Putnam v. CommissionerAnnotate this Case
352 U.S. 82 (1956)
U.S. Supreme Court
Putnam v. Commissioner, 352 U.S. 82 (1956)
Putnam v. Commissioner of Internal Revenue
Argued October 17, 1956
Decided December 3, 1956
352 U.S. 82
CERTIORARI TO THE UNITED STATES COURT OF APPEALS
FOR THE EIGHTH CIRCUIT
In a business venture not connected with his law practice, petitioner, a lawyer, organized a corporation, supplied its capital, and financed its operations through advances and guaranties of its debts. He wound up the corporation's affairs and liquidated its assets, but did not terminate its corporate existence. Its assets were insufficient to pay its debts, and petitioner paid $9,005 of its debts in discharge of his obligation as guarantor.
Held: in computing petitioner's income tax, this $9,005 loss was a nonbusiness bad debt loss to be given short-term capital loss treatment under § 23(k)(4) of the Internal Revenue Code of 1939, and it was not fully deductible under § 23(e)(2) as a loss "incurred in [a] transaction . . . for profit, though not connected with [his] trade or business." Pp. 352 U. S. 83-93.
1. The loss sustained by a guarantor unable to recover from the debtor is by its very nature a loss from a bad debt to which the guarantor becomes subrogated upon discharging his liability as guarantor. Pp. 352 U. S. 85-86.
2. There is no justification for consideration of petitioner's loss under § 23(e)(2) as an ordinary nonbusiness loss sustained in a transaction entered into for profit. As a loss attributable to a bad debt, it must be regarded as a bad debt loss, deductible as such or not at all. Spring City Co. v. Commissioner,292 U. S. 182. Pp. 352 U. S. 87-88.
3. Pollak v. Commissioner, 209 F.2d 57, Edwards v. Allen, 216 F.2d 794, and Cudlip v. Commissioner, 220 F.2d 565, turn upon erroneous premises. Pp. 352 U. S. 88-90.
(a) A guarantor who pays a creditor in discharge of his obligation as guarantor of the debt of an insolvent does not voluntarily acquire a debt known by him to be worthless; he involuntarily suffers a loss on a bad debt. P. 352 U. S. 88.
(b) A worthless new obligation does not arise in favor of a guarantor upon his payment to a creditor of an insolvent; he is subrogated to an existing debt which "becomes" worthless in his hands within the meaning of § 23(k). Pp. 352 U. S. 88-89.
4. Application of § 23(k)(4) to the loss here involved is in accordance with the objectives sought to be achieved by Congress in providing short-term capital loss treatment for nonbusiness bad debts. Pp. 352 U. S. 90-93.
224 F.2d 947 affirmed.
MR. JUSTICE BRENNAN delivered the opinion of the Court.
The petitioner, Max Putnam, in December, 1948, paid $9,005.21 to a Des Moines, Iowa, bank in discharge of his obligation as guarantor of the notes of Whitehouse Publishing Company. That corporation still had a corporate existence at the time of the payment, but had ceased doing business and had disposed of its assets eighteen months earlier. The question for decision is whether, in the joint income tax return filed by Putnam and his wife for 1948, Putnam's loss is fully deductible as a loss "incurred in (a) transaction . . . for profit, though not connected with (his) trade or business" within the meaning of § 23(e)(2) of the Internal Revenue Code of 1939, [Footnote 1] or whether it is nonbusiness bad debt within the
meaning of § 23(k)(4) of the Code, [Footnote 2] and therefore deductible only as a short-term capital loss.
The Commissioner determined that the loss was a nonbusiness bad debt, to be given short-term capital loss treatment. The Tax Court [Footnote 3] and the Court of Appeals [Footnote 4] for the Eighth Circuit sustained his determination. Because of an alleged conflict with decisions of the Courts Appeals of other circuits, [Footnote 5] we granted certiorari. [Footnote 6]
Putnam is a Des Moines lawyer who, in 1945, in a venture not connected with his law practice, [Footnote 7] organized Whitehouse Publishing Company with two others, a newspaperman and a labor leader, to publish a labor newspaper. Each incorporator received one-third of the issued capital stock, but Putnam supplied the property and cash with which the company started business. He also financed its operations, for the short time it was in business, through advances and guarantees of payment of salaries and debts.
Just before the venture was abandoned, Putnam acquired the shares held by his fellow stockholders and in July, 1947, as sole stockholder, wound up its affairs and liquidated its assets. The proceeds of sale were insufficient to pay the full amount due to the Des Moines bank on two notes given by the corporation and guaranteed by Putnam for moneys borrowed in August, 1946, and March, 1947.
The familiar rule is that, instanter upon the payment by the guarantor of the debt, the debtor's obligation to the creditor becomes an obligation to the guarantor, not a new debt, but, by subrogation, the result of the shift of the original debt from the creditor to the guarantor who steps into the creditor's shoes. [Footnote 8] Thus, the loss sustained by the guarantor unable to recover from the debtor is by its very nature a loss from the worthlessness of a debt. This has been consistently recognized in the administrative and the judicial construction of the Internal Revenue laws [Footnote 9] which, until the decisions of the
Courts of Appeals in conflict with the decision below, have always treated guarantors' losses as bad debt losses. [Footnote 10] The Congress recently confirmed this treatment in the Internal Revenue Code of 1954 by providing that a payment by a noncorporate taxpayer in discharge of his obligation as guarantor of certain noncorporate obligations "shall be treated as a debt." [Footnote 11]
There is, then, no justification or basis for consideration of Putnam's loss under the general loss provisions of § 23(e)(2), i.e., as an ordinary nonbusiness loss sustained in a transaction entered into for profit. Congress has legislated specially in the matter of deductions of nonbusiness bad debt losses, i.e., such a loss is deductible only as a short-term capital loss by virtue of the special limitation provisions contained in § 23(k)(4). The decision of this Court in Spring City Foundry Co. v. Commissioner,292 U. S. 182, is apposite and controlling. There, it was held that a debt excluded from deduction under § 234(a)(5) of the Revenue Act of 1918 was not to be regarded as a loss deductible under § 234(a)(4). Chief Justice Hughes said for the Court:
"Petitioner also claims the right of deduction under section 234(a)(4) of the Revenue Act of 1918 providing for the deduction of 'losses sustained during the taxable year and not compensated for by insurance or otherwise.' We agree with the decision below that this subdivision and the following subdivision (5) relating to debts are mutually exclusive. We so assumed, without deciding the point, in Lewellyn v. Electric Reduction Co.,275 U. S. 243, 275 U. S. 246. The making of the specific provision as to debts indicates that these were to be considered as a special class, and that losses on debts were not to be regarded as falling under the preceding general provision. What was excluded from deduction under subdivision (5) cannot be regarded as allowed under subdivision (4). If subdivision (4) could be considered as ambiguous in this respect, the administrative construction which has been followed from the enactment of the statute -- that subdivision (4) did not refer to debts -- would be entitled to great weight. We see no reason for disturbing that construction."
292 U.S. at 292 U. S. 189.
Here also, the statutory scheme is to be understood as meaning that a loss attributable to the worthlessness of a debt shall be regarded as a bad debt loss, deductible as such or not at all.
The decisions of the Courts of Appeals in conflict with the decision below turn upon erroneous premises. [Footnote 12] It is said that the guarantor taxpayer who involuntarily acquires a worthless debt is in a position no different from the taxpayer who voluntarily acquires a debt known by him to be worthless. The latter is treated as having acquired no valid debt at all. [Footnote 13] The situations are not analogous or comparable. The taxpayer who voluntarily buys a debt with knowledge that he will not be paid is rightly considered not to have acquired a debt, but to have made a gratuity. In contrast, the guarantor pays the creditor in compliance with the obligation raised by the law from his contract of guaranty. His loss arises not because he is making a gift to the debtor, but because the latter is unable to reimburse him.
Next, it is assumed, at least in the Allen case, that a new obligation arises in favor of the guarantor upon his payment to the creditor. From that premise, it is argued that such a debt cannot "become" worthless, but is worthless from its origin, and so outside the scope of § 23(k). This misconceives the basis of the doctrine of subrogation, apart from the fact that, if it were true that the debt did not "become" worthless, the debt nevertheless would not be regarded as an ordinary loss under § 23(e). Spring City Foundry Co. v. Commissioner, supra. Under the doctrine of subrogation, payment by the guarantor, as we have seen, is treated not as creating a new debt and extinguishing the original debt, but as preserving the original debt and
merely substituting the guarantor for the creditor. The reality of the situation is that the debt is an asset of full value in the creditor's hands because backed by the guaranty. The debtor is usually not able to reimburse the guarantor, and, in such cases, that value is lost at the instant that the guarantor pays the creditor. But that this instant is also the instant when the guarantor acquires the debt cannot obscure the fact that the debt "becomes" worthless in his hands.
Finally, the Courts of Appeals found support for their view in the following language taken from the opinion of this Court in Eckert v. Burnet,283 U. S. 140:
"The petitioner claims the right to deduct half that sum as a debt 'ascertained to be worthless and charged off within the taxable year' under the Revenue Act of 1926, c. 27, § 214(a)(7), 44 Stat. 9, 27."
"It seems to us that the Circuit Court of Appeals sufficiently answered this contention by remarking that the debt was worthless when acquired. There was nothing to charge off. The petitioner treats the case as one of an investment that later turns out to be bad. But, in fact, it was the satisfaction of an existing obligation of the petitioners, having, it may be, the consequence of a momentary transfer of the old notes to the petitioner in order that they might be destroyed. It is very plain, we think, that the words of the statute cannot be taken to include a case of that kind."
283 U.S. at 283 U. S. 141. (Emphasis added.)
That statement did not imply a determination by this Court that the guarantor's loss was not to be treated as a bad debt. [Footnote 14] This Court was not faced with the question
in Eckert. The point decided by the case was that a guarantor reporting on a cash basis and discharging his guaranty not by a cash payment, but by giving the creditor his promissory note payable in a subsequent year, was not entitled to a bad debt loss deduction in the year in which he gave the note. The true significance of the quoted language is that, although "the debt was worthless when acquired", it could not be "charged off" within the taxable year as the promissory note given for its payment was not paid or payable within that year. [Footnote 15]
The objectives sought to be achieved by the Congress in providing short-term capital loss treatment for non-business bad debts are also persuasive that § 23(k)(4) applies to a guarantor's nonbusiness debt losses. The
section was part of the comprehensive tax program enacted by the Revenue Act of 1942 to increase the national revenue to further the prosecution of the great war in which we were then engaged. [Footnote 16] It was also a means for minimizing the revenue losses attributable to the fraudulent practices of taxpayers who made to relatives and friends gifts disguised as loans. [Footnote 17] Equally, however, the
plan was suited to put nonbusiness investments in the form of loans on a footing with other nonbusiness investments. The proposal originated with the Treasury Department, whose spokesman championed it as a means "to insure a fairer reflection of taxable income," [Footnote 18] and the House Ways and Means Committee Report stated that the objective was "to remove existing inequities and to improve the procedure through which bad debt deductions are taken." [Footnote 19] We may consider Putnam's case in the light of these revealed purposes. His venture into the publishing field was an investment apart from his law practice. The loss he sustained when his stock became worthless, as well as the losses from the worthlessness of the loans he made directly to the corporation, would receive capital loss treatment; the 1939 Code so provides as to nonbusiness losses both from worthless stock investments and from loans to a corporation, whether or not the loans are evidenced by a security. [Footnote 20] It is clearly a "fairer reflection" of Putnam's 1948 taxable income to treat the instant loss similarly. There is no real or economic difference between the loss of an investment made in the form of a direct loan
to a corporation and one made indirectly in the form of a guaranteed bank loan. The tax consequences should in all reason be the same, and are accomplished by § 23(k)(4). [Footnote 21] The judgment is
"SEC. 23. DEDUCTIONS FROM GROSS INCOME."
"In computing net income there shall be allowed as deductions:"
"* * * *"
"(e) LOSSES BY INDIVIDUALS. In the case of an individual, losses sustained during the taxable year and not compensated for by insurance or otherwise --"
"* * * *"
"(2) if incurred in any transaction entered into for profit, though not connected with the trade or business; . . ."
53 Stat. 13, 26 U.S.C. § 23(e)(2).
"SEC. 23. DEDUCTIONS FROM GROSS INCOME."
"* * * *"
"(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 evidence 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."
53 Stat. 13, 56 Stat. 820, 26 U.S.C. § 23(k)(4).
13 CCH TC Mem.Dec. 458.
224 F.2d 947.
Pollak v. Commissioner, 209 F.2d 57; Edwards v. Allen, 216 F.2d 794; Cudlip v. Commissioner, 220 F.2d 565.
350 U.S. 964.
Petitioners abandoned in this Court the alternative contention made below that the loss was deductible in full as a business had debt under § 23(k)(1).
United States v. Munsey Trust Co.,332 U. S. 234, 332 U. S. 242; Aetna Life Ins. Co. v. Town of Middleport,124 U. S. 534, 124 U. S. 548; Howell v. Commissioner, 69 F.2d 447, 450; Scott v. Norton Hardware Co., 54 F.2d 1047; Brandt, Suretyship, and, Guaranty (3d ed.) § 324; 38 C.J.S., Guaranty, § 111; 24 Am.Jur., Guaranty § 125. Iowa follows this rule. Randell v. Fellers, 218 Iowa 1005, 252 N.W. 787; American Surety Co. v. State Trust & Sav. Bank, 218 Iowa 1, 254 N.W. 338. There is not involved here a question of the effect of state law upon federal tax treatment of Putnam's loss. Cf. Watson v. Commissioner,345 U. S. 544; Lyeth v. Hoey,305 U. S. 188; Burnet v. Hamel,287 U. S. 103.
The bad debt deduction provisions of earlier Revenue Acts were enacted in § 214(a)(7) of the Revenue Act of 1921, 42 Stat. 239; § 214(a)(7) of the Revenue Act of 1924, 43 Stat. 269; § 214(a)(7) of the Revenue Act of 1926, 44 Stat. 26; § 23(j) of the Revenue Act of 1928, 45 Stat. 799; § 23(j) of the Revenue Act of 1932, 47 Stat. 179; § 23(k) of the Revenue Act of 1934, 48 Stat. 688; § 23(k) of the Revenue Act of 1936, 49 Stat. 1658; § 23(k) of the Revenue Act of 1938, 52 Stat. 460; and § 23(k) of the Internal Revenue Code of 1939, 53 Stat. 12.
See, e.g., 2 Cum.Bull. 137; 5 Cum.Bull. 146; III-1 Cum.Bull. 158; III-1 Cum.Bull. 166; Shiman v. Commissioner, 60 F.2d 65; Hamlen v. Welch, 116 F.2d 413; Gimbel v. Commissioner, 36 B.T.A. 539; Roberts v. Commissioner, 36 B.T.A. 549; Sharp v. Commissioner, 38 B.T.A. 166; Hovey v. Commissioner, P-H 1939 B.T.A.Men.Dec.