United States v. GeneresAnnotate this Case
405 U.S. 93 (1972)
U.S. Supreme Court
United States v. Generes, 405 U.S. 93 (1972)
United States v. Generes
Argued November 8, 1971
Decided February 23, 1972
405 U.S. 93
CERTIORARI TO THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
Respondent taxpayer owned 44% of the stock of a closely held construction corporation, with an original investment of 38,900, and received an annual salary of $12,000 for serving as president on a part-time basis. His total income was about $40,000 a year. He advanced money to the corporation and signed an indemnity agreement with a bonding company, which furnished bid and performance bonds for the construction contracts. The corporation defaulted on contracts in 1962, and the taxpayer advanced over $158,000 to the corporation and indemnified the bonding company to the extent of more than $162,000. The corporation went into receivership and he obtained no reimbursement for thee sums. On his 1962 income tax return, the taxpayer took his loss on direct loans to the corporation as a nonbusiness bad debt, but he claimed the indemnification loss as a business debt and deducted it against ordinary income and asserted net loss carrybacks for the portion unused in 1962, pursuant to 26 U.S.C. § 172. Treasury Regulations provide that, if, at the time of worthlessness, the debt has a "proximate" relationship to the taxpayer' business, the debt qualifies as a business bad debt. In his suit for a tax refund, the taxpayer testified that his sole motive for signing the indemnification agreement was to protect his $12,000-a-year employment with the corporation. The jury was asked to determine whether signing the agreement "was proximately related to his trade or business of being an employee" of the corporation. The court refused the Government's request for an instruction that the applicable standard was that of dominant motivation and charged the jury that significant motivation satisfies the Regulations' requirement of proximate relationship. The jury's verdict was for the taxpayer
and the Court of Appeals affirmed, approving the significant motivation standard.
1. In determining whether a bad debt has a "proximate" relation to the taxpayer's trade or business, and thus qualifies as a business bad debt, the proper standard is that of dominant motivation, rather than significant motivation. Pp. 405 U. S. 103-105.
2. There is nothing in the record that would support a jury verdict in the taxpayer's favor had the dominant motivation standard been embodied in the instructions. Pp. 405 U. S. 106-107.
427 F.2d 279, reversed and remanded.
BLACKMUN, J., delivered the opinion of the Court, in which BURGER, C.J., and STEWART and MARSHALL, JJ., joined and in which (as to Parts I, II, and III) BRENNAN and WHITE, JJ., joined. MARSHALL, J., filed a concurring opinion, post, p. 405 U. S. 107. WHITE, J., filed a separate opinion, in which BRENNAN, J., joined; post, p. 405 U. S. 112. DOUGLAS, J., filed a dissenting opinion, post, p. 405 U. S. 113. POWELL and REHNQUIST, JJ., took no part in the consideration or decision of the case.
MR. JUSTICE BLACKMUN delivered the opinion of the Court.
A debt a closely held corporation owed to an indemnifying shareholder employee became worthless in 1962. The issue in this federal income tax refund suit is whether, for the shareholder employee, that worthless obligation was a business or a nonbusiness bad debt within the meaning and reach of §§ 166(a) and (d) of the Internal Revenue Code of 1954, as amended, 26
The issue's resolution is important for the taxpayer. If the obligation was a business debt, he may use it to
offset ordinary income and for carryback purposes under § 172 of the Code, 26 U.S.C. § 172. On the other hand, if the obligation is a nonbusiness debt, it is to be treated as a short-term capital loss subject to the restrictions imposed on such losses by § 166(d)(1)(B) and §§ 1211 and 1212, and its use for carryback purposes is restricted by § 172(d)(4). The debt is one or the other in its entirety, for the Code does not provide for its allocation in part to business and in part to nonbusiness.
In determining whether a bad debt is a business or a nonbusiness obligation, the Regulations focus on the relation the loss bears to the taxpayer's business. If, at the time of worthlessness, that relation is a "proximate" one, the debt qualifies as a business bad debt and the aforementioned desirable tax consequences then ensue.
The present case turns on the proper measure of the required proximate relation. Does this necessitate a "dominant" business motivation on the part of the taxpayer, or is a "significant" motivation sufficient?
Tax in an amount somewhat in excess of $40,000 is involved. The taxpayer, Allen H. Generes, [Footnote 3] prevailed in a jury trial in the District Court. See 67-2 U.S.T.C. 9754 (ED La.). On the Government's appeal, the Fifth Circuit affirmed by a divided vote. 427 F.2d 279 (CA5 1970). Certiorari was granted, 401 U.S. 972 (1971), to resolve a conflict among the circuits. [Footnote 4]
The taxpayer, as a young man in 1909, began work in the construction business. His son-in law, William F. Kelly, later engaged independently in similar work. During World War II, the two men formed a partnership in which their participation was equal. The enterprise proved successful. In 1954, Kelly Generes Construction Co., Inc., was organized as the corporate successor to the partnership. It engaged in the heavy-construction business, primarily on public works projects.
The taxpayer and Kelly each owned 44% of the corporation's outstanding capital stock. The taxpayer's original investment in his shares was $38,900. The remaining 12% of the stock was owned by a son of the taxpayer and by another son-in law. Mr. Generes was president of the corporation, and received from it an annual salary of $12,000. Mr. Kelly was executive vice-president, and received an annual salary of $15,000.
The taxpayer and Mr. Kelly performed different services for the corporation. Kelly worked full time in the field, and was in charge of the day-to-day construction operations. Generes, on the other hand, devoted no more than six to eight hours a week to the enterprise. He reviewed bids and jobs, made cost estimates, sought
and obtained bank financing, and assisted in securing the bid and performance bonds that are an essential part of the public project construction business. Mr. Generes, in addition to being president of the corporation, held a full-time position as president of a savings and loan association he had founded in 1937. He received from the association an annual salary of $19,000. The taxpayer also had other sources of income. His gross income averaged about $40,000 a year during 1959-1962.
Taxpayer Generes from time to time advanced personal funds to the corporation to enable it to complete construction jobs. He also guaranteed loans made to the corporation by banks for the purchase of construction machinery and other equipment. In addition, his presence with respect to the bid and performance bonds is of particular significance. Most of these were obtained from Maryland Casualty Co. That underwriter required the taxpayer and Kelly to sign an indemnity agreement for each bond it issued for the corporation. In 1958, however, in order to eliminate the need for individual indemnity contracts, taxpayer and Kelly signed a blanket agreement with Maryland whereby they agreed to indemnify it, up to a designated amount, for any loss it suffered as surety for the corporation. Maryland then increased its line of surety credit to $2,000,000. The corporation had over $14,000,000 gross business for the period 1954 through 1962.
In 1962, the corporation seriously underbid two projects and defaulted in its performance of the project contracts. It proved necessary for Maryland to complete the work. Maryland then sought indemnity from Generes and Kelly. The taxpayer indemnified Maryland to the extent of $162,104.57. In the same year, he also loaned $158,814.49 to the corporation to assist it in its financial difficulties. The corporation subsequently went into receivership
and the taxpayer was unable to obtain reimbursement from it.
In his federal income tax return for 1962 the taxpayer took his loss on his direct loans to the corporation as a nonbusiness bad debt. He claimed the indemnification loss as a business bad debt and deducted it against ordinary income. [Footnote 5] Later, he filed claims for refund for 1959-1961, asserting net operating loss carrybacks under § 172 to those years for the portion, unused in 1962, of the claimed business bad debt deduction.
In due course, the claims were made the subject of the jury trial refund suit in the United States District Court for the Eastern District of Louisiana. At the trial, Mr. Generes testified that his sole motive in signing the indemnity agreement was to protect his $12,000-a-year employment with the corporation. The jury, by special interrogatory, was asked to determine whether taxpayer's signing of the indemnity agreement with Maryland "was proximately related to his trade or business of being an employee" of the corporation. The District Court charged the jury, over the Government's objection, that significant motivation satisfies the Regulations' requirement of proximate relationship. [Footnote 6] The court refused the Government's request for an instruction that the applicable standard was that of dominant, rather than significant, motivation. [Footnote 7]
After twice returning to the court for clarification of the instruction given, the jury found that the taxpayer's signing of the indemnity agreement was proximately related to his trade or business of being an employee of the corporation. Judgment on this verdict was then entered for the taxpayer.
The Fifth Circuit majority approved the significant motivation standard so specified and agreed with a Second Circuit majority in Weddle v. Commissioner, 325 F.2d 849, 851 (1963), in finding comfort for so doing in the tort law's concept of proximate cause. Judge Simpson dissented. 427 F.2d at 284. He agreed with the holding of the Seventh Circuit in Niblock v. Commissioner, 417 F.2d 1185 (1969), and with Chief Judge Lumbard, separately concurring in Weddle, 325 F.2d at 852, that dominant and primary motivation is the standard to be applied.
A. The fact responsible for the litigation is the taxpayer's dual status relative to the corporation. Generes was both a shareholder and an employee. These interests are not the same, and their differences occasion different tax consequences. In tax jargon, Generes' status as a shareholder was a nonbusiness interest. It was capital in nature, and it was composed initially of tax-paid dollars. Its rewards were expectative, and would flow not from personal effort, but from investment
earnings and appreciation. On the other hand, Generes' status as an employee was a business interest. Its nature centered in personal effort and labor, and salary for that endeavor would be received. The salary would consist of pre-tax dollars.
Thus, for tax purposes, it becomes important and, indeed, necessary to determine the character of the debt that went bad and became uncollectible. Did the debt center on the taxpayer's business interest in the corporation or on his nonbusiness interest? If it was the former, the taxpayer deserves to prevail here. Trent v. Commissioner, 291 F.2d 669 (CA2 1961); Jaffe v. Commissioner, T.C. Memo