Mccrackin v. Commissioner

 

MEMORANDUM FINDINGS OF FACT AND OPINION

 

 

FINDINGS OF FACT Some of the facts have been stipulated and are found

 

accordingly. The stipulation of facts and exhibits attached thereto are

 

incorporated herein by reference. Benjamin H. McCrackin, Jr. and Clara P.

 

McCrackin, husband and wife, resided in Birmingham, Alabama, when they

 

filed their petition in this case. Their income tax returns were prepared

 

on the cash basis of accounting. Their joint returns for the years in

 

issue were filed with the Internal Revenue Service Center, Chamblee,

 

Georgia. Prior to 1954, Mr. McCrackin was employed by Franklin Coal

 

Company, a proprietorship owned by R. T. Daniel. Mr. Daniel died in 1954,

 

and the company was acquired by his son-in-law and Mr. McCrackin. The

 

son-in-law died in 1957 and thereafter the company was owned by Mr.

 

McCrackin. The principal business activity of Franklin Coal Company prior

 

to 1954 was brokering coal but it also mined and transported coal,

 

brokered timber, loaned money, and operated a commissary. During or

 

shortly before 1954 the demand for coal declined, the mining of coal became

 

less profitable, and as a result, the company ceased mining, changed its

 

name to Franklin Coal Sales Company, and began to concentrate on its

 

brokerage activities. After his acquisition of the company in 1957, Mr.

 

McCrackin continued its operation in the same name and along the same

 

general lines. For instance, he continued to broker coal and to make

 

loans. The company also owned and managed a building, housing several flea

 

markets; a Kenworth truck, with trailer; an airplane, for crop dusting; and

 

two small businesses known as Franklin Realty Company and Franklin Supply

 

Company. For 1975, 1976 and 1978, Franklin Coal Sales had gross incomes of

 

$18,275.60, $17,465.15 and $1,495.98, respectively. For 1975 and 1976 it

 

had net incomes of $16,080.45 and $14,831.01. For 1978 it had a net loss

 

after deducting the disputed bad debts and legal fees of $73,930.79.

 

During the years 1960 through 1975 Franklin Coal Sales made 66 loans to 12

 

different borrowers none of whom were related in any way to petitioners.

 

Fifty-two of the loans totaling $432,856.00 were made from 1960 through

 

1969 to 9 different borrowers. Some of these loans were made in connection

 

with the coal brokering activities. They usually occurred when McCrackin

 

would arrange a sale of coal for a small mine owner and would advance a

 

discounted sales price to the seller of the coal and collect the full sales

 

price from the purchaser of the coal. The advance was secured by the

 

receivable and/or a bill of lading. Such discounts were not reported by

 

the petitioners as interest income but on their Schedule C for Franklin

 

Coal Sales as income from the brokerage business. During this period the

 

petitioners also made 42 loans to Frank B. Tombrello Construction Company.

 

These loans bore interest, were represented by promissory notes, and were

 

secured by accounts receivable. In or about 1970 Franklin Coal Sales

 

Company ceased its brokerage activities and Mr. McCrackin became a

 

full-time consultant for Gulf State Paper Company. He subsequently worked

 

for other firms until 1976, but in spite of this full-time employment he

 

continued to supervise the activities of Franklin Coal Sales. From 1970

 

through 1975 the company made 14 loans totaling $187,568.00 to four

 

different borrowers, including Chelsea Timber Company, the recipient of the

 

$77,100.00 in loans which resulted in the disputed losses discussed

 

hereinafter. All 14 of these loans bore interest and were secured. The

 

interest received on these 14 loans was also reported by the petitioners as

 

business income on Schedule C of their returns. Throughout the period

 

under consideration, petitioners kept the business activities of Franklin

 

Coal Sales separate and apart from their personal assets and affairs. They

 

maintained a separate bank account and a separate set of accounting records

 

for Franklin Coal Sales. In fact, their records were such that even within

 

the company the income from the loans was kept separate and apart from the

 

income from other sources. They never engaged in any formal advertising of

 

their loan activity, but in the business community in which Franklin Coal

 

Sales operated it was generally known that it, as well as its predecessor,

 

had funds available for loans. Petitioners were approached on many

 

occasions by prospective borrowers whose requests had to be declined after

 

their credit was screened by Mr. McCrackin or because petitioners' funds

 

were all committed elsewhere. During 1976 and 1977 and thereafter to the

 

date of trial they were unable to make any new loans because their funds

 

were invested in the Chelsea loans. On November 1, 1974, the petitioners,

 

doing business as Franklin Coal Sales Company, entered into an oral

 

agreement with John B. Bates, a lawyer and personal friend. Pursuant to

 

the agreement the petitioners gave Bates $47,100.00 with the understanding

 

that (1) the funds were to be held by Bates in a special trust account and

 

were not to be co-mingled by him with any other funds; (2) the funds in the

 

special account were to be disbursed for the petitioners by Bates to

 

Chelsea Timber Company in exchange for negotiable instruments payable to

 

petitioners and secured by bills of lading for carload shipments of timber;

 

and (3) payment for each carload of timber covered by a bill of lading held

 

by Bates was to be made directly to Bates for petitioners and such payment

 

was to be deposited by Bates into the special account and applied to the

 

negotiable instrument secured by that particular bill of lading. During

 

November and December of 1974, Bates advanced the entire $47,100.00 to

 

Chelsea for the petitioners. On February 4, 1975 ¹ the petitioners made a

 

separate loan to Chelsea Timber Company of $30,000.00 at a 25 percent

 

interest rate. This loan was also handled by Bates for the petitioners and

 

was secured by a second mortgage on real estate owned by Chelsea which

 

Bates assured the petitioners was worth over $400,000.00 and was subject

 

only to a first mortgage of about $100,000.00.

 

In late 1977, Mr. McCrackin became concerned about the loans made to

 

Chelsea and told Bates not to advance any more funds from the special

 

account. Upon further investigation, McCrackin discovered early in 1978

 

that many of the notes from Chelsea which were held by Bates were secured

 

by forged bills of lading and that some of the bills of lading were pledged

 

to secure more than one note. To further complicate an already bad

 

situation, James R. Nevins, the president and principal stockholder of

 

Chelsea Timber Company, was killed in an airplane crash in February of

 

1978; in May of 1978 Chelsea Timber Company ceased all operations; and

 

about the middle of 1978 the holder of the first mortgage on Chelsea's real

 

estate foreclosed and petitioners received only $1,585.75 on their second

 

mortgage. Prior to the foreclosure petitioners had attempted to purchase

 

the first mortgage in order to protect their investment in the second

 

mortgage but learned that the property was also subject to a tax lien which

 

practically eliminated their security. In August of 1978 petitioners

 

consulted with Matt Paul Scalici, an attorney, about what remedies, if any,

 

they had against Chelsea Timber Company, the estate of James R. Nevins

 

and/or John B. Bates. Mr. Scalici advised the petitioners that in his

 

opinion "the only party left to respond to you, either in damages or by way

 

of reimbursement, is Mr. Bates;" and that the petitioners should pay Mr.

 

Scalici a retainer of $2,500.00 and authorize him to proceed against Bates.

 

Pursuant to Mr. Scalici's advice petitioners pad the retainer and Mr.

 

Scalici filed a lawsuit against Bates on December 15, 1978 in the Circuit

 

Court for Jefferson County, Alabama. On February 29, 1980, a consent

 

judgment was entered against Bates for $47,100.00. In 1980 Bates also

 

entered into a written agreement with the petitioners covering the manner

 

in which the consent judgment would be paid and assigned certain notes and

 

mortgages to secure its payment.By the time of trial, he had paid $5,500 on

 

the judgment. On their 1978 return the petitioners claimed a loss in the

 

amount of $70,399.87 with respect to the $47,100.00 and the $30,000.00

 

second mortgage. The petitioners now agree that due to a mathematical

 

error the loss was incorrectly shown on the return and that the correct

 

amount of the loss should have been $69,501.87 computed as follows:

 

 

OPINION