The opinion of the court was delivered by: AUGELLI
Plaintiffs, husband and wife, bring this action for a refund of income taxes for the year 1959, alleged by them to have been paid in error and illegally collected by defendant through the office of the District Director of Internal Revenue for the District of New Jersey. The jurisdiction of the Court is invoked under 28 U.S.C.A. § 1346(a)(1).
The facts have been stipulated and are as follows:
Plaintiffs were officers and stockholders of B.B. Rider Corporation (Rider) and General Manufacturing Corporation (General) in 1959 and prior thereto. They acquired an interest in Rider in 1938, and were instrumental in forming General in 1950.
Rider is an authorized General Motors Frigidaire dealership which sells and services Frigidaire products in northern New Jersey. Its needs for capital are fixed and vary little, if at all. It operates on a cash on completion basis.
General is engaged in the business of manufacturing precision component parts for aircraft engines for major engine manufacturers and certain agencies of the United States Government. General has varying needs for large amounts of working capital because of expensive material outlays and the long lead time between fabrication of the parts and payment from its customers. It began operating with a capitalization of $50,000.00. However, because of unforeseen problems and delays, the capital requirements became greater than anticipated.
Plaintiff Benjamin A. Stratmore was and still is president of both Rider and General. His primary duties during the past 15 years have been to secure financing for these corporations to meet their operational needs. After exhausting bank credit, Stratmore was compelled to borrow money for both corporations from a number of individuals. These persons would ordinarily loan money to either Rider or General, but as security therefor would require personal guarantees by way of indorsements on promissory notes of the corporations. Plaintiffs complied with this requirement when the loans were made and indorsed the notes of said corporations. Without the personal indorsements of plaintiffs, these loans could not have been obtained and the corporations would have ceased to function. Plaintiffs gave their indorsements and lent their credit to Rider and General with the expectation that the use of these funds by the corporations would provide them with increased receipts by way of salary, and also enhance the value of their proprietary interests therein.
In August, 1957, both Rider and General filed voluntary petitions in bankruptcy under Chapter XI of the Bankruptcy Act. A plan was agreed upon whereby creditors of the corporations were to be paid 25% of the amounts due them. As part of the plan, plaintiffs did not file any claims against the corporations in the Chapter XI proceedings. The arrangement was successfully completed, and Rider and General were discharged from bankruptcy in December, 1958.
In their income tax return for 1959, plaintiffs treated the $17,088.00 so paid to creditors as a nonbusiness bad debt under 26 U.S.C.A. § 166(d). As such, deductibility was limited to $1,000.00. On this basis, plaintiffs paid an income tax of $5,904.61, plus interest penalties of $518.58, or a total of $6,423.19. Thereafter, plaintiffs filed an amended income tax return in which they claimed, as fully deductible under 26 U.S.C.A. § 165(c)(2), the sum of $17,088.00. A claim for refund was then filed for the taxes and interest paid. No action having been taken on said claim for more than six months after submission, plaintiffs brought this action for refund.
In support of their claim for refund in this Court, plaintiffs contend that the $17,088.00 which they paid as guarantors of the promissory notes of Rider and General was either a loss incurred in a transaction entered into for profit, though not connected with a trade or business, under 26 U.S.C.A. § 165(c)(2) or, alternatively, a business bad debt incurred in a trade or business, under U.S.C.A. § 165(c)(1). Defendant, on the other hand, contends that the payments made by plaintiffs on their guarantees of the corporate notes constitute contributions to capital of the corporations or, in the alternative, that said payments constitute nonbusiness bad debts under 26 U.S.C.A. § 166(d).
Plaintiffs' contention that their loss of $17,088.00 is fully deductible under 26 U.S.C.A. § 165(c)(2) because it was incurred in a transaction entered into for profit, though not connected with a trade or business, cannot be sustained. The Chapter XI proceedings and plaintiffs' settlement on their guarantees resulted in a full discharge of the corporate obligations of Rider and General. Thus, the guarantors became subrogated to a worthless debt. A loss sustained by a guarantor unable to recover from his debtor is, by its very nature, a loss from the worthlessness of a debt, and there is no basis to consider it as an ordinary nonbusiness loss sustained in a transaction entered into for profit. Putnam v. Commissioner of Internal Revenue, 352 U.S. 82, 1 L. Ed. 2d 144, 77 S. Ct. 175 (1956).
Consideration will now be given to plaintiffs' alternative contention that the $17,088.00 was a business bad debt incurred in a trade or business, and hence fully deductible under 26 U.S.C.A. § 165(c)(1). A business bad debt must arise in connection with the taxpayer's trade or business. Whipple v. Commissioner of Internal Revenue, 373 U.S. 193, 10 L. Ed. 2d 288, 83 S. Ct. 1168 (1963). In that case a majority stockholder-officer loaned funds to his corporation and later claimed them as business bad debts. The Court held that "[absent] substantial additional evidence, furnishing management and other services to corporations for a reward not different from that flowing to an investor in those corporations is not a trade or business * * *." If plaintiffs in the case at bar had acted as guarantors solely to protect their investment, they could not claim a business bad debt loss. However, the stipulated facts establish that plaintiffs were motivated not only to protect their investments, but also to protect and increase their salaries as corporate officers. In Whipple, the Court stated:
"Nor need we consider or deal with those cases which hold that working as a corporate executive for a salary may be a trade or business. E.g., Trent v. Commissioner of Internal Revenue, 291 F.2d 669 (C.A. 2d Cir.). Petitioner made no such claim in either the Tax Court or the Court of Appeals and, in any event, the contention would be groundless on this record since it was not shown that he has collected a salary * * * or that he was owed one. Moreover, there is no proof * * * that the ...