(318) ROBERT E. IMEL 323 business bad debt described in section 166 (d). Petitioner contends that he is entitled to deduct from ordinary income a bad debt loss in the amount of $5,000 because of the worthlessness of a debt due from W. E. Pritchett in the year 1968. Respondent contends that the loss is deductible only as a nonbusiness bad debt and, therefore, must be treated as a loss from the sale of a capital asset held for not more than 6 months. Although conceding that the $5,000 loan to Pritchett created a bona fide debt that became worthless in the year 1968, respondent denies that the debt was created in connection with petitioner's trade or business either as an employee of the Citizens Bank & Trust Co. of Pampa, Tex., or as a lender. As support for his contention that he was in the business of lending money, petitioner testified that he made eight or nine loans from 1965 through 1968. The right to deduct bad debts as business losses is applicable only to the exceptional situations in which the taxpayer's activities in making loans have been regarded as so extensive and continuous as to elevate that activity to the status of a separate business. H. Beale Rollins, 32 T. 604 (1959), affd. 276 F. 2d 368 (C.A. 4, 1960); Max M. Barish, 31 T.C. 1280 (1959); Stuart M. Sales, 37 T.C. 576 (1961). We do not find that the making of eight or nine loans in the course of a 4-year period elevates that activity to the status of a separate business. On the basis of the evidence presented, we conclude that the petitioner was not engaged in a separate business of making loans. Alternatively, petitioner argues that the debt was created in connection with his trade or business as a bank executive. The question of whether the debt is a business or nonbusiness bad debt is essentially one of fact, the determination of which depends upon whether the debt is "proximately" related to the trade or business of the taxpayer. Sec. 1.166-5(b) (2),3 Income Tax Regs. Estate of Martha M. Byers, 8 (d) NONBUSINESS DEBTS.— (1) GENERAL RULE.—In the case of a taxpayer other than a corporation- (A) subsections (a) and (c) shall not apply to any nonbusiness debt; and (B) where any nonbusiness 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. (2) NONBUSINESS DEBT DEFINED.-For purposes of paragraph (1), the term "nonbusiness debt" means a debt other than (A) a debt created or acquired (as the case may be) in connection with a trade or business of the taxpayer; or (B) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business. See also Leonard S. Krause, T.C. Memo. 1967-68; Lloyd E. Mangrum, T.C. Memo. 1960-136. Sec. 1.166-5 Nonbusiness debts. (b) Nonbusiness debt defined. For purposes of section 166 and this section, a nonbusiness debt is any debt other than— (2) A debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business. The question whether a debt is a nonbusiness debt is a question of fact in each particular case. The determination of whether the loss on a debt's becoming worthless has been (Continued) 57 T.C. 568 (1972), affirmed per curiam 472 F. 2d 590 (C.A. 6, 1973). The Supreme Court has held that in determining whether a bad debt has a "proximate" relation to the taxpayer's trade or business, the proper measure is that of dominant motivation of the taxpayer in making the loan and that only significant motivation is not sufficient. United States v. Generes, 405 U.S. 93 (1972). Petitioner testified that as a bank officer, it was part of his duties to make loans to individuals to whom the bank could not make loans directly. Petitioner stated that these loans created new business for the bank and enabled the bank to become a depository for additional funds from these individuals and corporations. The creation of new business undoubtedly would benefit the business of the bank. Evidence that the bank benefited from the making of these loans, however, does not establish that the loans were proximately related to petitioner's business as an employee of the bank. Petitioner has failed to explain the relationship between the creation of new business for the bank and his retention of his employee position. The record does not suggest that petitioner would have lost his job had he not made these loans. The record does establish, however, that petitioner and his family controlled the Pampa bank and that petitioner had a substantial investment in the bank. We conclude that petitioner's dominant motive for making the loan in issue was to secure new business for the bank and thereby protect his investment rather than retain his employee status. Accordingly, petitioner's $5,000 loss is a nonbusiness bad debt subject to short-term capital loss treatment. The second issue for decision is whether the proceeds of the $100,000 loan were used in W. E. Pritchett's trade or business so that the $30,000 payment that petitioner made in settlement of his liability as a guarantor of the loan is deductible as a bad debt loss. Section 166(f) provides generally that a payment by a taxpayer in discharge of his liability as a guarantor of a noncorporate obligation the proceeds of (Continued) incurred in a trade or business of the taxpayer shall, for this purpose, be made in substantially the same manner for determining whether a loss has been incurred in a trade or business for purposes of section 165 (c) (1). For purposes of subparagraph (2) of this paragraph, the character of the debt is to be determined by the relation which the loss resulting from the debt's becoming worthless bears to the trade or business of the taxpayer. If that relation is a proximate one in the conduct of the trade or business in which the taxpayer is engaged at the time the debt becomes worthless, the debt comes within the exception provided by that subparagraph. The use to which the borrowed funds are put by the debtor is of no consequence in making a determination under this paragraph. For purposes of section 166 and this section, a nonbusiness debt does not include a debt described in section 165 (g) (2) (C). See § 1.165-5, relating to losses on worthless securities. SEC. 166 (f). GUARANTOR OF CERTAIN NONCORPORATE OBLIGATIONS.-A payment by the taxpayer (other than a corporation) in discharge of part or all of his obligation as a guarantor, endorser, or indemnitor of a noncorporate obligation the proceeds of which were used in the trade or business of the borrower shall be treated as a debt becoming worthless within such taxable year for purposes of this section (except that subsection (d) shall not apply), but only if the obligation of the borrower to the person to whom such payment was made was worthless (without regard to such guaranty, endorsement, or indemnity) at the time of such payment. which were used in the trade or business of the borrower shall be treated as a debt becoming worthless within the taxable year. Respondent concedes that the only issue presented in determining the applicability of section 166 (f) is whether the proceeds of the August 16, 1965, note were used in the principal borrower's trade or business. Respondent argues that by using the proceeds to purchase common stock of National Fraternity, Pritchett established that he was an investor and not a promoter of corporations. Petitioner contends that Pritchett used the proceeds in his business of managing and promoting insurance companies. We are not persuaded by petitioner's argument that Pritchett used the proceeds in his trade or business as an insurance company manager or executive. Pritchett may have anticipated that by gaining control of National Fraternity he could secure for himself an executive position with the company. We believe, however, that his primary motive for purchasing shares of National Fraternity was to invest in a company that would develop and promote a type of insurance policy that he believed had great investment potential. Accordingly, we conclude that Pritchett used the proceeds of the loan for purposes of investing, which is not a trade or business. Whipple v. Commissioner, 373 U.S. 193 (1963), rehearing denied 374 U.S. 858. In support of his position, petitioner has cited Axelrod v. Commissioner, 320 F. 2d 327 (C.A. 6, 1963), reversing 37 T.C. 1053, in which the court held that loan proceeds had been used in the borrower's trade or business when one partner used the proceeds to buy out the partnership interest of the taxpayer-partner who had guaranteed the loan. The facts in Axelrod are readily distinguishable from those in the present case. In Axelrod the borrower was in the trade or business of operating a restaurant in the partnership form of business. He used the loan proceeds to increase his capital interest in a going noncorporate restaurant business in order to preserve its existence. In the present case, however, Pritchett used the loan proceeds to acquire an interest in a corporate business in which he previously had not owned any interest or held any position. Alternatively, petitioner contends that Pritchett was in the trade or business of promoting life insurance companies. In support of this argument, petitioner states that Pritchett promoted and sold the stock of three life insurance companies. We are not persuaded that Pritchett established associations with these corporations so that he could develop them as going businesses for sale to customers in the ordinary course. We conclude that Pritchett's associations with several companies were caused by his inability to locate a company that would actively promote the type of insurance policy that he had developed. Accordingly, we hold that Pritchett did not use the proceeds of the loan in his trade or business and that petitioner is not entitled to a deduction pursuant to section 166 (f). The third issue is whether section 166 determines exclusively the deductibility of the $30,000 loss that petitioner sustained in 1968 in settlement of his liability to National American. 7 The petitioner contends in the alternative that the payment of $30,000 in settlement of his liability is deductible under section 165 (c) (2) as a loss incurred in a transaction entered into for profit. Citing Putnam v. Commissioner, 352 U.S. 82 (1956), the respondent contends that petitioner's payment of $30,000 is a loss that is attributable to the worthlessness of a debt and is deductible as a bad debt loss or not at all. In Putnam the Supreme Court reasoned that instanter upon his payment in full of the guaranteed debt, the guarantor became subrogated to the rights of the creditor in the original debt so that the guarantor's loss, sustained because he was unable to recover from the debtor, must be regarded as a bad debt loss. The petitioner argues that a debt never became due him from Pritchett because he did not acquire a right of subrogation, as was the case in Putnam. Because the petitioner did not pay the whole debt, he did not acquire a right of subrogation under the law of Arkansas, the State in which the loan agreement was executed. Bank of Fayetteville v. Lorwein, 76 Ark. 245, 88 S.W. 919 (1905); North Arkansas Milling Co. v. Lipari, 231 Ark. 965, 333 S.W. 2d 713 (1960). Where the guarantor of the original debt acquires no rights of subrogation because he makes only partial payments, his payments still may be subject exclusively to bad debt treatment if the law implies a promise on the part of the principal to reimburse the guarantor for payments that he makes on the obligation. Bert W. Martin, 52 T.C. 140 (1969), affd. 424 F. 2d 1368 (C.A. 9, 1970). If we correctly understand Arkansas law, there existed an implied promise on the part of Pritchett to reimburse the petitioner for the amounts he paid in settlement of his liability on the note. In Shinn v. Kitchens, 208 Ark. 321, 186 S.W. 2d 168 (1945), the court stated that when a surety sues a principal for the amount paid by the surety on the note of the principal, the action is based on an implied contract. In Griffin v. Long, 96 Ark. 268, 131 S.W. 672 (1910), the court stated that, when one becomes a surety for a principal, a liability arises upon the part of the prin SEC. 165 (c). LIMITATION ON LOSSES OF INDIVIDUALS.-In the case of an individual, the deduction under subsection (a) shall be limited to (2) losses incurred in any transaction entered into for profit, though not connected with a trade or business; ⚫ cipal to indemnify his surety for any payment which he may be compelled to make for the principal. Although in Shinn v. Kitchens, supra, the surety paid the whole debt and in Griffin v. Long, supra, the cosurety paid his proportional share of the judgment on the note, we think it is proper to conclude that an Arkansas court would not reach a different result merely because only a part payment had been made. Such a conclusion is in accord with the weight of authority that, where the surety makes a part payment to a creditor on account of a default by the principal, the latter is under an immediate duty to reimburse the surety to the extent of the payment. See American Law Institute, Restatement of the Law of Security, ch. 4, sec. 106 (1941); 1 Brandt, Suretyship and Guaranty, sec. 228 (3d ed. 1905); Elder, Stearns Law of Suretyship, sec. 11.37 (1951). We therefore conclude that petitioner's loss of $30,000 was attributable to the worthlessness of the debt owed him by Pritchett and that it cannot be deducted under section 165 (c) (2) since section 166 exclusively determines whether the loss is deductible. The fourth issue is whether legal and travel expenses incurred by petitioner in obtaining a settlement of his liability as a guarantor are deductible pursuant to section 165 (c) (2). The petitioner contends that he is entitled to deduct $5,980.50, the amount of legal expenses incurred in obtaining the release, as a loss incurred in a transaction entered into for profit pursuant to section 165 (c) (2). In Marjorie Fleming Lloyd-Smith, 40 B.T.A. 214 (1939), affd. 116 F. 2d 642 (C.A. 2, 1941), certiorari denied 313 U.S. 588 (1941), and in Peter Stamos, 22 T.C. 885 (1954), we held that legal expenses incurred as a guarantor may be deductible under section 165(c) (2). Although these cases were decided before Putnam, it is still possible in many circumstances to consider payments resulting from guarantor transactions as payments made in a transaction entered into for profit. Mozelle Rushing, 58 T.C. 996 (1972). On the basis of the evidence presented, we believe that the guaranty was given in a transaction entered into for profit. By guaranteeing the loan to Pritchett, the petitioner hoped to assure that he would become a director of National Fraternity and to assure that National Fraternity's funds would be deposited in the Pampa bank, in which the petitioner held a substantial interest. Petitioner thereby would promote his status as an investor. Accordingly, we conclude that the legal and travel expenses incurred by petitioner in order to obtain a release from his liability on the $100,000 note are deductible under section 165 (c) (2). Decision will be entered under Rule 50. |