J&W Fence Supply Co. v. United States ( 2000 )

In the
United States Court of Appeals
For the Seventh Circuit
Nos. 99-2132, 99-3737 & 00-1247
J&W Fence Supply Company, Inc.,
John B. Vidrine, and Cressville Vidrine,
Plaintiffs-Appellants,
v.
United States of America,
Defendant-Appellee.
Appeals from the United States District Court
for the Southern District of Indiana, Indianapolis Division.
No. IP 97-128-C Y/S--Richard L. Young, Judge.
Argued September 20, 2000--Decided October 11, 2000
Before Coffey, Easterbrook, and Evans, Circuit Judges.
Easterbrook, Circuit Judge. On its tax return for
1992 J&W Fence Supply Company took a deduction of
almost $1 million for a bad debt: a loan to
Cherry Point Forest Products, one of J&W’s
principal suppliers of raw materials (and 49% of
whose stock was owned by John Vidrine, who also
owns 100% of J&W’s stock). During 1992 Cherry
Point entered receivership in Washington, and J&W
contended that it was unlikely to see much if any
of the money it had invested. But following an
audit the IRS disallowed the deduction, with this
explanation by its Appeals Office:
The bad debts deduction of $959,736.00 as shown
on your tax return is reduced by $934,217.00
because the bad debt deducted for Cherry Point in
that amount is not allowable as a business bad
debt and as a non-business bad debt has not been
determined to be worthless in this tax year. Also
as a non-business bad debt the deduction would be
a distributive item in the year it is determined
to be worthless and would be distributed as a
short term capital loss to the shareholders.
Therefore, your taxable income is increased by
$934,217.00 for 1992.
J&W is a Subchapter S corporation; its gains and
losses are passed through to its shareholders,
whose personal taxes are at issue. Vidrine paid
the assessed taxes and filed this refund action,
where the IRS altered its position. Instead of
defending the administrative decision that the
loan was a "non-business" debt, that the loan had
not been shown to be worthless by the end of 1992
(the receivership was ongoing at year’s end), and
implicitly that Vidrine could not benefit from a
short-term capital loss in 1992, the United
States contended that J&W supplied the $1 million
to Cherry Point as equity rather than debt
capital.
One possible response by the taxpayers would
have been that the choice between debt and equity
lacks significance: wiped-out equity generates a
capital loss, just as a non-business bad debt
does. 26 U.S.C. sec.166(a)(1). (A business bad
debt, by contrast, may be deducted from ordinary
income.) Another response might have been that
the money was indeed debt rather than equity
capital for Cherry Point. The IRS contends that
the investment must be deemed equity because the
parties did not create the usual documents
(principally notes specifying rates of interest
and repayment schedules) that accompany loans.
But one could equally say that the investment
must be deemed debt because the parties did not
create the usual documents (principally shares of
stock with related deals, such as buy-sell
agreements customary in closely held
corporations) that accompany equity. If the $1
million was equity, then Vidrine owned not 49%
but more than 95% of Cherry Point’s stock, and
this change of control should have been
accompanied by many other adjustments that the
corporate records do not reflect. Thus it is
hazardous to say, as the United States does, that
an investment must be equity because it is not
documented as debt; lack of documentation does
not help us choose. (Cases such as Frierdich v.
CIR, 925 F.2d 180, 182-84 (7th Cir. 1991), and
Roth Steel Tube Co. v. CIR, 800 F.2d 625 (6th
Cir. 1986), that make much of missing
documentation do not consider the mirror image of
the inference.) J&W Fence Supply, which as a
Subchapter S corporation had to use the accrual
method of accounting, booked (and caused Vidrine
to pay taxes on) interest due from Cherry Point,
even though it never received a penny; by putting
money behind the characterization of the
transaction as debt, J&W made its claim more
believable. But this subject was not litigated in
the district court, and we discuss it no further.
Pursuing none of the options we have mentioned,
plaintiffs contended only that the choice between
debt and equity had been settled by the
Washington receivership. The receiver treated the
investment as a bona fide debt and distributed
Cherry Point’s assets accordingly, notifying all
creditors that he was doing this. One of Cherry
Point’s creditors was the IRS. Federal courts
give the decisions of state courts the same
preclusive effect that state courts themselves
afford, see 28 U.S.C. sec.1738, and Vidrine
contended that state courts in Washington would
apply issue preclusion (collateral estoppel) to
the receiver’s decision. The district court
disagreed and entered judgment for the United
States. 1999 U.S. Dist. Lexis 4035, 99-1 U.S. Tax
Cas. para.50,396, 83 A.F.T.R. 2d 1542 (S.D. Ind.
1999). At this point the taxpayers’ lawyer
appears to have realized that he had missed a
turn, because a capital-loss deduction would have
been available (though not necessarily in 1992)
whether or not the investment was treated as
equity. By a motion under Fed. R. Civ. P. 60(b)
Vidrine asked the district court to reopen the
case and direct the IRS to recognize a capital
loss deduction in 1992. The judge declined,
observing that the request came too late. 1999
U.S. Dist. Lexis 20309, 85 A.F.T.R. 2d 337 (S.D.
Ind. 1999).
Plaintiffs’ principal argument in this court is
that the district judge should have granted their
post-judgment motion, because they are entitled
to some deduction no matter how the investment is
characterized. Appellate review of decisions
under Rule 60(b) is deferential, as it must be if
litigants are to be induced to present their
arguments before rather than after judgment. See
Metlyn Realty Corp. v. Esmark, Inc., 763 F.2d
826, 831-32 (7th Cir. 1985). No abuse of
discretion is apparent on this record, given
plaintiffs’ delay. What is more, the taxpayers’
appellate brief does not discuss the tax
situation for 1993, when the debt may finally
have become worthless. See 26 U.S.C. sec.166(d).
In the district court plaintiffs contested their
taxes for both 1992 and 1993; in this court,
however, 1993 has fallen by the wayside. By
insisting on a deduction for 1992 only,
plaintiffs have abandoned more than one avenue of
reducing their taxes.
We add that the district judge did not err in
deciding the preclusion issue against the
taxpayers. No state judge addressed the choice
between debt and equity; the subject was
resolved, to creditors’ apparent satisfaction, by
the receiver. Nor did the IRS suffer a defeat,
even if the receiver’s decision could be equated
to a judicial one. All but $2,400 of the $55,000
in federal tax claims had priority over both debt
and equity interests in Cherry Point. It would
have been silly for the IRS to demand litigation
of a subject that could affect no more than
$2,400 (and would not assure payment of even that
small sum, but would just decrease the size of
the total debt claims to be satisfied from
dwindling assets). No Washington case of which we
are aware holds that a litigant is bound by the
decision concerning a subject that is contested,
if at all, only by other participants in the
case. Like the district court, we are convinced
that Washington would not deem the receiver’s
choice conclusive against federal tax collectors.
See Bar v. Day, 879 P.2d 912, 925 (Wash. 1994).
Whether these investments should be deemed debt
or equity as an original matter is a subject we
need not address, given plaintiffs’ litigating
choices in the district court.
Affirmed