Howell v. Commissioner , 22 B.T.A. 140 ( 1931 )

CHARLES M. HOWELL, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Howell v. Commissioner

Docket No. 30097.

United States Board of Tax Appeals

22 B.T.A. 140; 1931 BTA LEXIS 2163;

February 16, 1931, Promulgated

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The stockholders of a trust company which was carrying more than $400,000 of slow live stock loans, in order to allay public distrust on account of the failure of a related brokerage firm through which they had been negotiated, agreed to collectively indemnify the bank up to $200,000 for any loss it might sustain through failure to collect them. The indemnity contract set forth the shareholdings of each signor and in terms provided that the liabilities created were to be "several and not joint"; it also limited the amount each stockholder was bound to pay to such ratable portion of the whole $200,000, as the stock then held by him bore to the total outstanding capital stock of the company. Near the close of the year the officials of the bank estimated that a prospective loss of at least the amount underwritten by the stockholders was inevitable on account of these loans, and the petitioner, who was one of the subscribing stockholders, paid $23,480 as his portion of the agreed indemnity. Held, that under the facts, this payment did not constitute a deductible loss to the petitioner for the year paid.

Daniel V. Howell, Esq., and Charles M. Howell, Esq., for the petitioner.

L A. Luce, Esq., for the respondent.

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LANSDON

The respondent has asserted a deficiency of $6,595.85 in income tax against the petitioner for the calendar year 1922, which this appeal seeks to review. As ground for the relief sought the petitioner alleges that the respondent committed error in disallowing a claimed deduction from his gross income of $21,120, for loss sustained in that year on account of bad debts. The petitioner also alleges that his claim of $21,120, taken in his return on account of these alleged bad debts, is $2,360 less than his actual loss on such account and, therefore, asks that his gross income for 1922 be reduced by the full sum of $23,480 in recomputing his tax liability for that year.

FINDINGS OF FACT.

The petitioner is an individual residing at Kansas City, Mo., and engaged in the general practice of law. In the taxable year he was attorney, stockholder and director of the Peoples Trust Company, a banking institution of that city that had been organized prior thereto by interests controlled by the firm of Smith & Ricker, cattle loan brokers. The firm of Smith & Ricker was a copartnership composed of G. M. Smith and George E. Ricker, both of whom were stockholders and directors of the Peoples Trust Company on March 14, 1922. G. M. Smith was also prominently connected with the Commonwealth National Bank of Kansas City, Mo., which failed in the early part of 1922. Coincident with the failure of the Commonwealth National Bank, or immediately prior thereto, in January, 1922, Smith & Ricker became financially embarrassed and assigned all of its assets to a trustee in liquidation. At the time of such assignment it was believed by the petitioner and his associates in the Peoples Trust Company that G. M. Smith personally was financially responsible to meet all the obligations of that firm, without regard to his copartner, Ricker.

In the early part of 1922, the Peoples Trust Company was the holder of more than $400,000 worth of cattle-loan paper which had been negotiated through the firm of Smith & Ricker and discounted by it in prior year. Much of this paper had been previously renewed and was either then overdue or in such condition that further renewals were required. In part it was secured by mortgages on cattle, sheep, horses or real estate, and all was endorsed by Smith & Ricker as partners and as individuals. On March 14, 1922, a meeting of the board of directors of the Peoples Trust Company was held in which the financial difficulties of Smith and Ricker were discussed. At this meeting the president of the Trust Company stated that in view of the difficulties that Smith and Ricker were in, there might be some trouble for the bank on account of their close connection with it. Also, that in view of the banks' holdings of more than $400,000 of loan paper discounted through that firm, it might "serve a useful purpose and ease public opinion" in respect to the bank if the board of directors and stockholders would guarantee the bank against loss on certain specific notes. He also suggested that, in his opinion, the best interests of the bank would be served if both Smith and Ricker would sell their stockholding in the Peoples Trust Company to other stockholders and retire from the board of directors. Minutes of this meeting are recorded in the books of the Peoples Trust Company, in recitals which, so far as pertinent here, are as follows:

The regular monthly meeting of the directors of the Peoples Trust Company was held at its banking rooms March 14th, 1922. Those members present:

W. T. Grant C. M. Howell T. H. Mastin

Wilson D. Wood

R. P. Combs J. J. Lynn E. T. Richards G. M. Payne

Aldridge Corder

O. F. Mehornay

Chas. S. Alves

Mr. Chas. M. Howell presided.

The minutes of the last monthly meeting were read and approved.

The president stated that he would like to acquaint the Board fully with reference to the Smith and Ricker paper and read a letter summarizing the information obtained up to this time, a copy of which is spread on these minutes.

On motion of Mr. W. T. Grant after some discussion the President was authorized to sign the agreement formulated by the Committee holding the personal assets of G. M. Smith and George E. Ricker which was formally carried. Mr. Howell stated that in his opinion we have up no rights in signing this agreement and it had a tendency to preserve the assets and keep them in liable hands, and that our signing it would have a moral influence on keeping the matter out of the bankrupt court.

On April 11, following, the minutes of the Peoples Trust Company show a further meeting of its board of directors, at which the following recorded action was taken:

The regular monthly meeting of the Board of Directors of the Peoples Trust Company was held at its banking rooms April 11th, 1922. Those present were:

W. T. Grant

Chas. M. Howell

T. H. Mastin R. P. Combs

Aldridge Corder

Wilson D. Wood

G. M. Payne J. J. Lynn

Chas. S. Alves

Mr. W. T. Grant presided.

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The contract drawn by Mr. Howell providing for the guaranty of $200,000 against the paper from the office of Smith and Ricker and the pledging of the money and securities to protect that guaranty was read and Mr. Howell stated that he would have it in a permanent form within a few days. A committee composed of Mr. Howell, Mr. Garvey and Mr. Alves was appointed to serve in caring for an carrying out that agreement.

At some time after the first above-mentioned meeting, on April 25th following, Smith and Ricker sold their stock holdings in the Peoples Trust Company to other stockholders, and on said last mentioned date an agreement was entered into between said trust company and its stockholders, in words and figures as follows:

INDEMNITY AGREEMENT

THIS AGREEMENT by and between the PEOPLES TRUST COMPANY of Kansas City, Missouri, a corporation engaged in the banking business (herein designated "Company") First Party, and the undersigned, Chas. S. Alves, Wilson D. Wood, J. T. Duncan, R. P. Combs, Aldridge Corder, Helene Corder, J. C. Davis, E. T. Richards, Bruce Dodson, J. W. Garvey, W. T. Grant, George T. Cook, Ethel B. Cook, R. L. Mehornay, O. F. Mehornay, R. B. Garvey, Chas. M. Howell, T. H. Mastin, U.S. Epperson, J. J. Lynn, H. E. Minty, G. M. Payne, W. F. Waller, F. L. Zahner, E. F. Swinney, Jno. A. Siemon, (herein designated "Indemnitors") Second Parties, WITNESSETH:

(1) That for and in consideration of the payment of One Dollar ($1.00) to the Indemnitors by the Company, the receipt of which is hereby acknowledged, and other valuable consideration, the Indemnitors hereby agree to severally indemnify the Company in the maximum amount to Two Hundred Thousand Dollars ($200,000.00) against loss, if any, which may be hereafter sustained on account of non-payment of certain loans now held by the Company in its assets and commonly designated as the Smith and Ricker loans. For identification, a Schedule of said loans is hereto attached and marked "Exhibit A".

(2) The indemnification herein provided for shall be several and not joint and no joint liability as between the Indemnitors is intended to be created by this instrument. Each Indemnitor hereby assumes and agrees to pay as and when same occur any loss or losses no exceeding in total Two Hundred Thousand Dollars ($200,000.00) resulting to the Company on account of said loans to the extent and in the proportion only that the stock held by him in said Company at the time of the execution of this agreement bears to the total of all the capital stock of said company then outstanding.

(3) For the purpose of securing the payment by each Indemnitor of any sums which he may be obligated to pay under this agreement, each Indemnitor agrees to deposit within ten (10) days after the execution of this agreement in cash or in bonds of the United States Government, an amount equal to that proportion of Two Hundred Thousand Dollars ($200,000.00) which the stock owned by said Indemnitor bears to the total of all of the stock of the company. Said cash or securities shall be deposited with a committee composed of J. W. Garvey, Chas. S. Alves, and Chas. M. Howell. Said committee shall have full power and authority to dispose of any or all of the securities belonging to any Indemnitor, in the event said Indemnitor does not meet the payments required of him, as herein provided, and to use the proceeds of any such sale for the purpose of liquidating the obligations of any such Indemnitor created by this agreement as they may appear.

(4) It is intended and agreed that as and when losses on said loans shall occur, each Indemnitor will pay his respective portion to the Company in cash and that upon such payment a proportionate part of the securities deposited by each Indemnitor respectively shall be returned to him by the committee hereinbefore provided for.

(5) Subject to the obligations imposed by this agreement, the cash or securities deposited by the Indemnitors shall be and remain the property of the Indemnitor respectively depositing same and all interest accruing on said securities shall accrue to and be paid to such Indemnitor.

(6) When all of the loans referred to herein and specified in "Exhibit A" have either been paid or the loss, if any, on account of non-payment of any of them shall have been determined and the indemnity thereon paid to the company, as herein provided for, the committee named in Section Three shall make a written accounting to each Indemnitor and shall return to each the cash or bonds deposited by him, less any deductions made therefrom in accordance with the provisions of Sections Three and Four hereof. Said committee is hereby empowered and authorized to do any and all things necessary to carry out the terms of this contract according to its true intent and purpose.

(7) The undersigned Indemnitors have respectively set opposite their names the amount of stock held by them at the time of the execution of this agreement, together with the amount of cash or securities which each respectively agrees to deposit as herein provided for.

Signed at Kansas City, Missouri, this 25th day of April, 1922.

Full compliance with the terms of this agreement was made by all of the signing stockholders, in virtue of which the petitioner paid over to the committee for the bank the sum of $23,480. Some collections were made by the bank upon some of the paper listed in the stockholders' contract during the summer of 1922; but, from investigations made by its officials, it became apparent before the end of that year that the bank would sustain a loss upon the whole in a sum of at least $200,000, the amount underwritten by its stockholders. In view of this situation the committee holding the funds of the stockholders, which include the $23,480 paid in by this petitioner in trust for that purpose, paid to the Peoples Trust Company the full sum of $200,000. Following this payment from the stockholders the Peoples Trust Company continued its efforts to collect upon the paper in question up to and including the year 1914. In one or two instances individual notes were either paid in full or compromised and returned to the makers, but, in all, less than $100,000 was collected. A claim was also filed by the bank against the trust estate of Smith and Ricker, and against G. M. Smith, individually, as endorsers of this paper, and some $29,000 was collected from that source which was retained by the Peoples Trust Company in further reduction of its loss. Some time late in the year 1923, the Peoples Trust Company organized the Peoples Security Corporation, to which it transferred some of the notes listed in the schedule "Exhibit A," in payment of the capital stock of that corporation, all of which it acquired. Later, the bank commissioner of Missouri objected to the Trust Company holding the stock of the Security Company and it thereupon made a pro rata distribution of that stock among its stockholders who paid cash in consideration therefor.

The petitioner keeps his books and makes his income tax return upon the cash receipts and disbursement basis. In making his income tax return for 1922, the petitioner deducted from his gross income $21,120 as a loss sustained on account of bad debts ascertained to be worthless and charged off in that year. This deduction was denied by the respondent. The petitioner now claims that through error he failed to claim in said return the full amount of his loss sustained on account of bad debts and requests that he be allowed to take credit for all of the $23,480 paid to the bank under the stockholders' indemnity agreement, in recomputing his true income tax liability for 1922.

OPINION.

LANSDON: In their contract these stockholders severally agreed "to indemnify the Company * * * against loss, if any" that it might thereafter sustain on account of nonpayment of the loans listed in the schedule attached. The gross indemnity was fixed at $200,000, but the prorated share for which each indemnitor was bound was limited to the ratio his stock ownership bore to the total outstanding stock of the bank on April 25, 1922. The amount which the petitioner was bound to pay was $23,480; and it is his contention that when that amount was paid over to the bank in December, 1922, he ipso facto became subrogated, in part, to the rights of the bank as creditor of the several makers of the uncollected notes.

Petitioner's contentions are summarized in his brief thus:

(1) By the payment of $23,480 made by the petitioner under his obligation as guarantor of the several notes, the makers of said notes became and were indebted to the petitioner in said amount.

(2) That each of the debts so owed to the petitioner by the several makers of said notes were worthless in December, 1922, and were so ascertained and determined by said petitioner to be worthless in said year, by reason and virtue of which petitioner charged the same off as a deduction for bad debts in said year and was, accordingly, entitled to take credit for the same as a deduction for bad debts in his income tax return for the year 1922.

It is obvious that the petitioner's basic error lies in the assumption that his contract made him liable as guarantor of the several unpaid notes; also, that by reason of his having, in part, paid them, the makers became indebted to him by the amount of the payment. Without attempting the impossible task of determining which, if any, or how many of these notes the petitioner acquired an interest in, in December, 1922, we think it clear that he was never, at any time, guarantor of any of them; neither did his liability to the bank depend upon the payment, either in part or in full, of any of them. The petitioner's contract was one of indemnity and no liability attached, except and until an actual loss had been sustained by the bank. It was, therefore, an original undertaking upon which the petitioner became primarily liable upon the occurrence of the conditions set forth therein. This condition was one of actual loss to the bank, and could not occur, except, and until it had failed to realize enough from the liquidation of the notes to cover its cash outlay on account of them. It had nothing whatever to do with their payment; and, since we do not know the rate of discount, or their cost, we are unable to say whether the bank ever sustained such a loss as would mature this contract, on account of them. This, therefore, is a very different situation to that of a surety or guarantor who is bound to see that the whole of an obligation, regardless of gain or loss, is paid; and the obligation to pay, in each case, is based upon different legal grounds. In the first instance, the indemnitor is primarily liable on an independent contract and the debt is his own; in the latter case the debt is that of another, which the surety or guarantor pays. ; ; ; Foster v. Williams;; ; ; ; . Where there is no substitution of debtors there can be no legal subrogation. Pomeroy on Equity, 1212; Sheldon on Subrogation, par. 14, 25, 70; ; ; ; ; ; ; ; .

A number of authorities, including cases decided by the courts and by this Board, have been cited by the petitioner, which he argues support his contentions, but, with the exception of , none of the supporting facts in the cases cited bear any semblance of analogy to these presented here. In the Dillon appeal, supra, a few of the stockholders of a reorganized bank, who, prior thereto, had guaranteed it against loss in taking over certain assets from an absorbed bank, later, upon pressure from the other stockholders, who refused to share in a prospective loss, effected a compromise in which, by paying into the bank the sum of $100,000 they were released from further obligations under their contract. This loss, being in no way shared by the other stockholders, this Board denied the contention of the Commissioner that it constituted a capital investment and allowed Dillon credit against gross income for the amount he paid, not as a bad debt, but as a loss sustained in the taxable year for which he was not otherwise compensated. In , cited by petitioner, the taxpayer had negotiated loans from a bank upon notes which he guaranteed in advance with the knowledge of the several makers. Being later obliged to pay these notes in full, this Board held that the debts survived in favor of the guarantor. In that case, as in all others cited, the doctrine of subrogation was recognized and applied to facts wherein the payor of the debt was the party secondarily liable and in which he had paid the debt of another in full. , cited by both parties, involved facts essentially different than these. In that case the stockholders purchased the notes upon which the loss was claimed from the bank and took them out. The ownership of the bad debts was not in issue.

The case at bar involves a group of notes, not one of which is claimed to have been paid, either in part or in whole, with the petitioner's money when it was turned over to the bank in December, 1922. So far as we know, no credits were given by the bank to any of the several makers upon their notes when it received the payment from its stockholders, and the record shows that later, upon payment in full or compromise, some of them were returned to the makers without reference to equities, if any, the indemnitors might assert in or to them. Some, also, were later sold by the bank to the Peoples Security Company for stock which it later sold to these stockholders for cash at par, thus realizing on them in full. The number of such notes and the amount involved in these stock transactions are not shown. The petitioner claims, however, that his payment towards making good the predetermined loss, which it was then known with certainty that the bank must ultimately sustain, entitled him, in law, no be subrogated pro tanto to the rights of the bank in and to the whole group without reference to any specific note or its makers. He concedes, however, that the interest thus acquired is subordinate to the prior equities of the bank, and that any action he might have a right to take against the several makers to collect his debt must be held in abeyance until the bank had collected the balance due it.

The contention of the petitioner in respect to such claim is opposed to the basic theory of subrogation, which, in short, means substitution, or, the elimination of the original creditor and the substitution in his place of the payor of the debt. This, of course, can be done only when the whole of the debt is paid, since there can be no partial substitution of creditors, or pro tanto subrogation. ; ; ; ; ; ; ; ; ; ; ; Sheldon on Subrogation, 118, 25 R.C.L. 1319; ; ; ; ; ; . Subrogation as to a part of a debt payable in installments has been allowed, since each installment, when due, constitutes a separate debt, capable of assignment or release.

Aside from the question of subrogation, or bad debts, the real issue which must control our decision turns upon the question whether, after all, the $23,480 paid by the petitioner to the bank represents a deductible loss. The respondent contends that under the facts and circumstances shown this payment was a capital investment in the Peoples Trust Company rather than a deductible loss, inasmuch as it was applied in reparation of the bank's surplus and represented only the petitioner's ratable portion of the whole sum paid in. There is much in the record to support the theory thus advanced by the respondent; or, if not that, to indicate that the whole fund of $200,000 paid in by the directors was a donation voluntarily made to offset the impending loss they then knew the bank must ultimately write off. Although they were not ready to concede it at that time, it is inconceivable, in view of the known conditions, that these directors did not know on April 25, 1922, when they signed this indemnity contract, that the bank had already sustained the loss they were then assuming. The Commonwealth National Bank, which was overloaded with cattle-loan paper had failed, and Smith & Ricker was in liquidation. Other banks carrying Smith & Ricker cattle paper were writing off losses on account of it, and the demoralized condition of the cattle industry generally, on account of the slump in prices, had been known for many months. In view of these facts and the further one that the bankable standing of all of these notes was then being preserved only through indulgent continuances, we think the incorrigible optimist denounced in the petitioner's brief would have been sorely taxed to find any substantial value in the bulk of them, and all the more justification for their retention in the bank assets. At this time, respecting obligations, these directors were absolute strangers to these notes. Their act in agreeing to indemnify the bank against loss on account of them was tantamount to a promise to pay at least part of these debts which they did not owe, and for which they could in no way have been held. The voluntary character of their acts in such connection, in the absence of special agreement otherwise, puts them outside of that class of involuntary payors (of other's debts) for whom the law of subrogation gives relief. Apropos to this doctrine, and in direct point, we think, to its application to the situation of these stockholders, Chancellor Johnson, in Gasden v. Brown (S. Car.), Speers, Eq., 37, 41, said:

The doctrine of subrogation is a pure unmixed equity having its foundation in the principles of natural justice, and from its very nature never could have been intended for the relief of those who were in any condition in which they were at liberty to elect whether they would not be bound; and, so far as I have been able to learn its history, it never has been so applied. If one with the perfect knowledge of the facts will part with his money, or bind himself by his contract in a sufficient consideration, any rule of law which would restore him his money or absolve him from his contract would subvert the rules of social order. (Italics supplied.)

The foregoing pronouncement of that doctrine was approved by the Supreme Court of the United States in , in an opinion written by Mr. Justice Miller, in which he stated that such was "perhaps as clear a statement of the doctrine on this subject as is to be found anywhere." The courts of Missouri have likewise sustained this interpretation. ; ; ; ; ; ; ; ; Foster v. Williams, 144 Mo.A. 219; Jacobs v. Webster, 199 Mo.A. 604.

At the time the stockholders' fund of $200,000 was turned over to the bank in December, 1922, there was a determined loss to it in that amount, caused by shrinkage in value of capital assets. This payment repaired that loss and, at the same time, increased the value, pro rata, of every share of its capital stock. It would seem, therefore, that in repairing this loss the petitioner's stock in the Peoples Trust Company was enhanced in value by the exact amount he paid into the fund and it is difficult to see wherein he sustained any loss in the transaction. . The fact that these stockholders chose to make their contributions under an agreement, rather than in response to formal assessments against themselves, as was done in the John C. Paxton case, , does not change the character of their transaction, nor their legal status in the premises. Since we have previously decided that a director of a corporation in not engaged in the business of the corporation (), there is no basis for allowing the deduction here claimed as a loss sustained in a trade or business. We are of opinion that the respondent correctly rejected the claimed deduction and his action is therefore approved.

Decision will be entered for the respondent.