Fuller, Hadwen C., et ux. v. Comm.

Decisions will be entered for the respondent.

Caleb Candee Brown, Jr., Esq., for the petitioners. William G. O'Neill, Esq., for the respondent.

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These consolidated proceedings involve deficiencies of 5,476.83 in the income tax of Hadwen C. Fuller for the year 1947, and 4,186.30

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in the income tax of Hadwen C. Fuller and Edith R. Fuller for the year 1948.

The issue to be decided is whether certain worthless loans represented business or nonbusiness bad debts. FINDINGS OF FACT. The stipulated facts are so found and are incorporated herein.

Hadwen C. Fuller (hereinafter referred to as petitioner) and Edith R. Fuller were husband and wife during the calendar years 1947 and 1948 and resided in Parish, New York. Hadwen C. Fuller filed a separate return for the year 1947 and Hadwen C. Fuller and Edith R. Fuller filed a joint return for the year 1948. Both returns were filed with the collector of internal revenue for the twenty-first district of New York.

In 1919 petitioner organized the State Bank of Parish, New York. He sold his controlling interest in the bank around 1937 but remained with the bank as a vice president. He later resigned as vice president to devote his full attention to the Parish Oil Company.

Petitioner, with an associate, organized the Parish Oil Company, Inc., in 1926. The Parish Oil Company is the distributor of Sun Oil products in six counties in New York State, and is considered the second largest Sun Oil distributor. Petitioner is the president of the company and owns 49 1/2 per cent of the stock. As part of its operations, the Parish Oil Company, Inc., has engaged in financing gasoline stations as retail outlets for its products. Petitioner personally financed several of these stations and shared in their profits. Both petitioner and the company aided in setting up gasoline stations in order to create volume of sales for the company.

Since 1926 petitioner has been interested at one time or another in several other business enterprises. These include the manufacture of grease guns and car-lifting mechanism, the promotion and operation of the Parish Broom Manufacturing Company, and the manufacture of equipment for pruning orchards and fruit trees. He is now interested in, and has spent a considerable amount of time and money promoting, a device known as a Phon-O-Larm, a type of fire alarm. At one time he assisted in the promotion of a bank in Cicero, New York, and for a time he was a director of that bank. He was also a member of a group which purchased the controlling interest in the First National Bank of Waterloo, New York.

In 1945 petitioner became interested in the frozen food industry Petitioner wished to become a distributor for United Frozen Food Distributors, Inc. (hereinafter referred to as United). In order to qualify as a distributor it was necessary to purchase stock in United. Petitioner subscribed for 30 shares of class A capital stock at 100 per share and later paid for said stock in three equal installments.

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On April 19, 1946, petitioner was issued a franchise, pertinent portions of which are as follows:

UNITED FROZEN FOOD DISTRIBUTORS, INC. DISTRIBUTOR PARTICIPATING FRANCHISE

1. This is a participating franchise in cooperative merchandising between United Frozen Food Distributors, Inc. (National Distributor) and HADWEN C. FULLER, Parish, New York

(Local Distributor), for a term of ten (10) years from date, for the exclusive territory:

OSWEGO AND ONONDAGA COUNTIES OF THE STATE OF NEW YORK

2. This franchise gives the Local Distributor the exclusive right to sell and distribute all the products bearing the label of the National Distributor, including frozen foods, low temperature storage cabinets, equipment and supplies, and to purchase these products from the National Distributor at prices which shall not exceed seven and one-half percent (7 1/2%) over National Distributor's cost on equipment and supplies and five (5%) over National Distributor's cost on food and food products.

3. National Distributor shall set aside an amount equal to forty percent (40%) of its net earnings annually, for such year, calculated after computing and deducting all taxes on such earnings, which fund shall be distributed to holders of participating franchises in direct proportion to their purchases during such year from National Distributor. * * * *

6. The Local Distributor shall maintain an adequate organization to promote the products of the National Distributor in its territory, and follow the systems prescribed by the National Distributor. * * * *

8. * * * The Local Distributor shall maintain complete records of all sales, installations, and names and addresses of purchasers of National Distributor's products, and shall furnish such data upon request. He shall also furnish financial statements when requested. * * * *

13. The Local Distributor shall under no circumstances be deemed an agent or representative of National Distributor and shall have no right to enter into contracts or commitments in the name of National Distributor and may not assign this franchise. This instrument contains the entire franchise agreement. There are no promises, representations or warranties except those here stated.

Date: 19 Apr. 1946. Hadwen C. Fuller (Distributor's Firm Name) By H. C. Fuller (Title) United Frozen Food Distributors, Inc. By R. S. Blazer V. P.

On April 26, 1946, petitioner was elected a member of the board of directors of United.

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On July 9, 1946, petitioner organized a corporation known as Parish Frozen Foods, Inc. (hereinafter referred to as Parish Foods). Petitioner purchased 100 shares of stock and Wilbur S. Oles, Jr., purchased 50 shares at 100 per share. At all times thereafter until Parish Foods was dissolved on November 13, 1947, petitioner, his wife, and Oles were directors of said corporation. Oles was the president and treasurer of Parish Foods and petitioner and his wife were vice president and secretary, respectively.

Parish Foods was organized to perform all active duties as distributor under petitioner's franchise with United. Petitioner assigned to Parish Foods his right to purchase, sell, and distribute United's products and these functions were performed exclusively by Parish Foods. Parish Foods also kept all records as distributor and made all reports to United.

In December 1946, United changed its distributor franchise agreements in order to comply with current O. P. A. regulations. Except for the provision that all purchases must be reported to United within 30 days in order to participate in the net profits of United, none of the changes are material. The language of paragraph 13 was retained verbatim in the new agreement. United entered into this new franchise agreement with all of its distributors. Substituted for the old franchise issued to Hadwen C. Fuller on April 19, 1946, was a new franchise agreement executed in December 1946 but dated the same as the old agreement. This new agreement was issued to "Hadwen C. Fuller for Parish Frozen Foods, Inc." and was signed as follows:

Parish Frozen Foods, Inc. Distributor's Firm Name By H. C. Fuller Vice-Pres. United Frozen Food Distributors, Inc. By (Name not legible) Secretary of Franchise Committee.

Parish Foods continued to perform all active duties as distributor under the franchise with United. The new franchise agreement provided that 40 per cent of the net earnings of United would be distributed to the holders of participating franchises in direct proportion to United's gross earnings from each. However, United made no profits and, hence, had none to distribute.

During 1946 petitioner loaned a total of 18,000 to Parish Foods. The money was used to pay for purchases from United. Parish Foods repaid 3,000 in 1947, but notes representing 15,000 due petitioner became worthless when Parish Foods was dissolved on November 13, 1947.

Petitioner wished to promote retail sales which would create an increased volume of business for Parish Foods. To further this end he

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was instrumental in forming Fuller Frozen Foods, Inc. (hereinafter referred to as Fuller Foods). Fuller Foods was essentially a retail store which purchased United's products from Parish Foods and sold them to the general public. The store itself was beautifully laid out and was intended as a model and encouragement for others who might wish to open similar stores to sell United's products.

Fuller Foods was incorporated on July 9, 1946. The stockholders were petitioner's son, Robert C. Fuller, who purchased 100 shares of stock at 100 per share, and William S. Oles, who purchased 50 shares. Robert C. Fuller became a director, president, treasurer, and manager of Fuller Foods. Neither petitioner nor Oles held an official position with Fuller Foods. Although petitioner purchased no stock, he loaned a total of 25,000 to Fuller Foods which was represented by demand notes executed by the corporation. Fuller Foods repaid 6,500 in 1947, but notes representing the remaining 18,500 that petitioner had loaned Fuller Foods became wholly worthless and uncollectible in 1948.

Petitioner's primary business since 1926 has been as president of the Parish Oil Company. In 1947 and 1948 he was also a Member of the Congress of the United States and spent over half of his time in Washington. When at home in Parish, New York, he spent over half of his time in his capacity as president of the Parish Oil Company. A portion of his time, while in Parish, was devoted to the business of Parish Foods, of which he was a director and the vice president. OPINION

Petitioner contends that the 15,000 unpaid balance on loans to Parish Foods and the 18,500 unpaid balance on loans to Fuller Foods which became worthless in 1947 and 1948, respectively, were business bad debts deductible in full under section 23 (k) (1), Internal Revenue Code. In opposition to the position taken by the petitioner, the respondent has determined that the loans are deductible only under section 23 (k) (4) as nonbusiness bad debts to be treated for tax purposes as short-term capital losses.

Section 23 (k) (1) authorizes the deduction from gross income of "Debts which become worthless within the taxable year" except with respect to a "non-business debt" as defined in paragraph (4). Section 23 (k) (4) provides:

(4) NON-BUSINESS DEBTS. -- In the case of a taxpayer, other than a corporation, if a non-business 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. The term "non-business debt" means a debt other than a debt evidenced by a security as defined in paragraph (3) and other than a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.

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In connection with the definition of a nonbusiness debt, H. Rept. No. 2333, 77th Cong., 2d Sess., p. 76 (1942-2 C. B. 431) states:

The question whether a debt is one, the loss from the worthlessness of which is incurred in the taxpayer's trade or business, is a question of fact in each particular case, and the determination is substantially the same as that which is made for the purpose of ascertaining whether a loss from the type of transaction covered by section 23(e) is "incurred in trade or business" under paragraph (1) of that section. The character of the debt for this purpose is not controlled by the circumstances attending its creation or its subsequent acquisition by the taxpayer or by the use to which the borrowed funds are put by the recipient, but is to be determined rather 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 is not a nonbusiness debt for the purposes of this amendment.

See also section 29.23 (k)-6 of Regulations 111.

Thus the merits of the respective contentions of the parties herein turn solely upon whether or not the petitioner was engaged in a trade or business of his own in 1947 and 1948 to which the debts in question were proximately related. Charles G. Berwind, 20 T. C. 808 (on appeal C. A. 3); Jan G. J. Boissevain, 17 T. C. 325; Robert Cluett, 3rd, 8 T. C. 1178. If the debts were not proximately related to petitioner's trade or business at the time they became worthless, they were deductible only as nonbusiness bad debts under section 23 (k) (4).

Petitioner has advanced alternative theories as to the trade or business in which he was engaged in 1947 and 1948 to which the debts in question were proximately related. First he contends that he was in the business of promoting, financing, and managing various business enterprises. He asserts that his activities bring him within the authority contained in Vincent C. Campbell, 11 T. C. 510; Henry E. Sage, 15 T. C. 299; and Weldon D. Smith, 17 T. C. 135. ¹

But, as this Court pointed out in Charles G. Berwind, supra:

The authority contained in such cases as Weldon D. Smith, 17 T. C. 135, revd. 203 F. 2d 310, Henry E. Sage, 15 T. C. 299, and Vincent C. Campbell, 11 T. C. 510, is applicable only to the exceptional situations where the taxpayer's activities in promoting, financing, managing, and making loans to a number of corporations have been regarded as so extensive as to constitute a business separate and distinct from the business carried on by the corporations themselves. * * *

Over a 30-year period petitioner has promoted, financed, and managed several corporations and has been interested in and has advanced capital to several other business enterprises. But this business activity on the part of the petitioner was spread over the years, most of it taking place long prior to 1947. Petitioner has not shown that his activities in promoting, financing, managing, and making loans to corporations

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or business enterprises were sufficiently extensive in and around 1947 and 1948 to constitute a trade or business in and of itself. On his tax returns, filed as exhibits herein, he listed himself as being president of Parish Oil Co., Inc., and a Member of Congress.

Alternatively, petitioner contends that he was in the business of being a distributor of frozen foods and low temperature storage equipment under a distributor franchise agreement with United. The evidence discloses, however, that the actual operations of the distributorship were conducted solely by Parish Foods, a corporation. It is to be noted that the franchise under which the distributorship was conducted after December 1946 designated "Parish Frozen Foods, Inc." as the distributor. Parish Foods made all purchases, sales, and distributions, kept all records, and made all reports in connection with the business. Subsequent to the incorporation of Parish Foods on July 9, 1946, petitioner's time and effort in connection with the business were, for the most part, devoted to fulfilling his duties as a director and the vice president of the corporation.

The Supreme Court made it clear in Burnet v. Clark, 287 U.S. 410, that the business of a corporation is not the business of its stockholders and officers. Therefore, petitioner cannot appropriate unto himself the business of Parish Foods. Cf. Omaha National Bank v. Commissioner, (C. A. 8) 183 F. 2d 899; Charles G. Berwind, supra.

Petitioner contends, however, that he was conducting a trade or business separate and apart from that of the corporation in that he did not assign to Parish Foods, but retained for himself, the right to participate in the net profits of United. This contention is based upon petitioner's testimony that it was orally understood with United that he would receive personally the distributor's share of the net profits of United. Essentially this distributor's right of participation consisted of a rebate to be paid by United of 40 per cent of its net profits on purchases made by the distributor. Whether or not United would have paid such participating dividends to petitioner personally we are unable to say, since United made no profits and hence made no such distribution. To have done so, however, without concurrence or authorization on the part of Parish Foods (which the record herein does not disclose) would certainly appear to be contrary to the express provisions of the franchise agreement which was executed in December 1946.

Even if we assume, for the purpose of this contention of petitioner, that there was an understanding, authorized or concurred in by Parish Foods, allowing petitioner to receive personally the participating dividends of United, it does not convert the loans into business debts. Although this right of participation would represent a possible source of income to petitioner, it would not constitute a trade or business

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A trade or business requires the expenditure of a substantial amount of time and effort, and usually entails keeping books and maintaining an office. A. Kingsley Ferguson, 16 T. C. 1248, Otis A. Kittle, 21 T. C. 79. Petitioner did not keep books or maintain an office in connection with the business. These functions were performed by Parish Foods. During 1947 and 1948, when the debts in question became worthless, petitioner devoted nearly all of his time and effort to his duties as a Member of the Congress of the United States and as president of the Parish Oil Company. Little time remained for the distributorship, and this was expended in fulfilling his duties as director and vice president of Parish Foods, not in promoting and exploiting a tentative right to a rebate on purchases made by the corporation. The distributorship was the business of the corporation. By merely retaining the right to receive directly a portion of the income from the distributorship, petitioner would not be engaging in a trade or business of his own.

Petitioner's loans to Fuller Foods, like the loans to Parish Foods, were a part of an isolated transaction by a passive investor. When the loans became worthless in 1947 and 1948, petitioner was not regularly or continuously expending an appreciable amount of time, money, and effort in a trade or business of his own to which the loans or debts were proximately related. Cf. A. Kingsley Ferguson, supra; Harold Kushel, 15 T. C. 958; Miller v. Commissioner, (C. A. 9) 102 F. 2d 476. Therefore, we must sustain the determination of the respondent that the petitioners are entitled only to deductions for nonbusiness bad debts under section 23 (k) (4) of the Code.

Decisions will be entered for the respondent.

Footnotes ¹ Revd. (C. A. 2), 203 F. 2d 310, certiorari denied 346 U.S. 816.