Putnam v. Commissioner of Internal Revenue/Dissent Harlan

by John Marshall Harlan II

United States Supreme Court

352 U.S. 82

Putnam  v.  Commissioner of Internal Revenue

 Argued: Oct. 17, 1956. --- Decided: Dec 3, 1956

Mr. Justice HARLAN, dissenting.

Being unreconciled to the Court's decision, which settles a conflict on this tax question among the Courts of Appeals and thus has an impact beyond the confines of this particular case, I must regretfully dissent.

The Court's approval of the Commissioner's treatment of petitioner's loss as one arising from a 'nonbusiness debt,' within the meaning of § 23(k)(4) of the Internal Revenue Code of 1939, ^[1] instead of as a loss incurred in a 'transaction entered into for profit,' under § 23(e)(2), ^[2] rests on what is, in my opinion, a strained application of the equitable doctrine of subrogation. No one contends that petitioner acquired the Company's debt to the lending Bank when he entered into the agreement guaranteeing payment of that indebtedness. Rather, the Government's basic argument, as taken from its brief, is this:

'The principle is well established, both generally and in the State of Iowa (where the guaranty was executed and performed), that a guarantor who is required to make payment under his guaranty contract succeeds to the rights of the creditor by subrogation. The law implies a promise on the part of the principal debtor to reimburse the guarantor, and the guarantor's payment is treated not as extinguishing the debt but as merely substituting the guarantor for the creditor. * * * Accordingly, while a guarantor by entering into the guaranty contract and making payment thereunder puts himself in a position where he may sustain a loss, it is only if, and to the extent that, the debt which he acquires by subrogation is worthless that he actually sustains a loss. Thus, if the guarantor, having made payment under his guaranty contract, is able to recover in full from the principal debtor, he clearly suffers no loss at all. It follows, therefore, that any loss, the existence and extent of which is wholly and directly dependent upon the worthlessness of a debt, should be attributed to the worthlessness of that debt, i.e., should be considered a bad debt loss.'

The Government then adds this footnote: 'So long as payment of a debt is guaranteed by a solvent guarantor, the insolvency of the principal debtor obviously does not render the debt worthless. Consequently, if the debt which a guarantor acquires by subrogation becomes worthless, it necessarily becomes worthless in the hands of the guarantor rather than in the hands of the original creditor.'

Upon analysis, the Government's argument comes down to this: when the petitioner honored his guaranty obligation his payment was offset by the acquisition of the creditor Bank's rights against the Company on its indebtedness; in the Bank's hands those rights were worth full value, since the Company's indebtedness was secured by the guaranty; therefore petitioner's loss should be attributed to the subrogation debt, which became worthless in his hands because no longer so secured.

This argument would have substance in a case where the principal debtor was not insolvent at the time the guaranty was fulfilled; for in such a case it could be said that the acquired debt was not without value in the guarantor's hands, and hence he should not be allowed a tax deduction until the debt turns out to be worthless. But when, as here, the debtor is insolvent at the very time the guarantor meets his obligation, it defies reality to attribute the guarantor's loss to anything other than the discharge of his guaranty obligation. To attribute that loss to the acquired debt in such a case requires one to conceive of the debt as having value at the moment of acquisition, but as withering to worthlessness the moment the guarantor touches it. That the same debt in the same millisecond can have both of these antagonistic characteristics is, for me, too esoteric a concept to carry legal consequences, even in the field of taxation.

It was this departure from reality which first led the Court of Appeals for the Second Circuit to reject the Commissioner's theory, as applied to a loss incurred by a widow upon a guaranty of her husband's brokerage account which she was called upon to honor long after his death and the winding up of his insolvent estate. Fox v. Commissioner, 190 F.2d 101, 39 A.L.R.2d 873. In that case the court, after referring to the 'illusory character' of the subrogation claim which, the Tax Court held, she had acquired against her late husband upon her payment of the guaranty, went on to say, 190 F.2d at pages 103, 104:

'She (the widow) argues that the court's theory of a debt against her husband's estate amounts to a subrogation forced upon her, contrary to the equitable spirit of the doctrine, to yield her an utterly worthless claim and a very real tax liability. * * * (W)e think her argument persuasive. * * * Clearly * * * the (guaranty) transaction was not then one involving a bad debt, since she had not even made the payment which alone would give rise to a claim in her favor. Nor could payment ten years later create a debt out of something less than even the proverbial stone. It is utterly unrealistic to consider the payment as one made in any expectation of recovery over or of any legal claim for collection. Actually it was merely the fulfillment of her contractual obligation of the earlier date. The bad-debt provision thus had no direct application; only by straining the statutory language can we erect here a disembodied debt against an insolvent and long dead debtor.'

Being unable to differentiate the worthlessness of a subrogation debt claim against a nonexistent individual debtor from such a claim against an existent, but insolvent, corporate debtor, the Courts of Appeals, until the present case, ^[3] have consistently applied the reasoning of the Fox case to losses incurred on individual guaranties of corporate indebtedness where the corporation, though still in existence, was insolvent at the time the guaranty was honored. Pollak v. Commissioner, 209 F.2d 57; ^[4] Edwards v. Allen, 216 F.2d 794; ^[5] Cudlip v. Commissioner, 220 F.2d 565; ^[6] see also Ansley v. Commissioner, 217 F.2d 252. ^[7] The rationale of these four Courts of Appeals is, in my opinion, more convincing than that of the Commissioner, and I think this Court should have approved and followed it here by holding that this taxpayer's loss was fully deductible under § 23(e)(2) as a loss on a 'transaction entered into for profit,' instead of regarding it as a 'nonbusiness debt' loss, subject to capital loss treatment under § 23(k)(4).

I cannot agree with the Court that either the circumstances under which § 23(k)(4) was enacted in 1942, or the provisions of § 166(f) of the Internal Revenue Code of 1954, ^[8] point to an opposite conclusion. Section 23(k)(4) created a new category of debt losses, namely, 'nonbusiness debt' losses, which were thenceforth to be given capital loss treatment instead of the full loss deduction theretofore accorded them. ^[9] The Court finds the 'objectives sought to be achieved by the Congress,' through the enactment of this section, 'persuasive that § 23(k)(4) applies to a guarantor's nonbusiness debt losses,' in that the 'section was part of the comprehensive tax program enacted by the Revenue Act of 1942 to increase the national revenue,' in connection with World War II, and 'was suited to put nonbusiness investments in the form of loans on a footing with other nonbusiness investments.' But it seems to me that the House Ways and Means Committee Report on the bill shows that § 23(k)(4) was aimed at a specific narrow objective, namely, that of reducing revenue loss from the deduction of 'family' or 'friendly' loans which were in reality gifts. The Report states:

'C. Nonbusiness Bad Debts.

'The present law gives the same tax treatment to bad debts incurred in nonbusiness transactions as it allows to business bad debts. An example of a nonbusiness bad debt would be an unrepaid loan to a friend or relative, while business bad debts arise in the course of the taxpayer's trade or business. This liberal allowance for nonbusiness bad debts has suffered considerable abuse through taxpayers making loans which they do not expect to be repaid. This practice is particularly prevalent in the case of loans to persons with respect to whom the taxpayer is not entitled to a credit for dependents. This situation has presented serious administrative difficulties because of the requirement of proof.

'The bill treats the loss from nonbusiness bad debts as a short-term capital loss. The effect of this provision is to take the loss fully into account, but to allow it to be used only to reduce capital gains. Like any other capital loss, however, the amount of such bad debt losses may be taken to the extent of $1,000 against ordinary income and the 5-year carryover provision applies.' ^[10]

I am unable to find in this, or in any of the other legislative history to which the Court refers, any clear intimation of a broad policy to analogize generally all types of nonbusiness loans to other forms of capital investment, ^[11] still less anything which indicates that guarantors' losses were considered as falling within the new section. ^[12]

Likewise I think that the Court's reliance on § 166(f) of the 1954 Code is misplaced. That section provides that an individual taxpayer's guaranty payment discharging the obligation of a noncorporate debtor 'shall be treated as a debt becoming worthless within such taxable year,' and shall be deductible in full if (a) the proceeds of the guaranteed obligation were used 'in the trade or business of the borrower,' and (b) that obligation was worthless at the time the guarantor made payment. ^[13] The Court says that by enacting this section Congress confirmed the administrative practice of treating guarantors' losses as bad debt losses, at least so far as guaranties of certain noncorporate obligations are concerned. I cannot agree, for again I think this section had a specific and limited purpose, which did not include the thrust which the Court now gives the section. That purpose, I think, was simply to permit deduction of certain guaranty payments that were not deductible at all under the 1939 Code. Payments now deductible under § 166(f) need not be made in the course of the guarantor's 'trade or business,' nor need they be attributable to a transaction 'entered into for profit.' They are deductible, it would seem, so long as the guarantor had some expectation of being repaid-so long, in other words, as the transaction was not a gift. Under prior law such payments would not have been deductible as 'business' debts, under § 23(k) (1), ^[14] or as losses on transactions 'entered into for profit,' under § 23(e) (2), or even as 'nonbusiness' debts under § 23(k)(4), since the Fox line of cases held that such payments do not give rise to 'debts.' However, here again, as with the enactment of the § 23(k)(4) 'nonbusiness debt' provision in 1942, Congress was concerned with fending against allowance of this type of deduction in cases of fictitious 'family' or 'friendly' guaranties. Hence it was unwilling to allow the deduction to all guarantors of individual borrowings. Considering guaranties of loans sought for business purposes to be free of such infirmities, Congress attempted to obviate abuse of § 166(f) by limiting its application to guaranties of loans the proceeds of which 'were used in the trade or business of the borrower.'

In light of what seems to have been the particular congressional purpose, I think it strains § 166(f) to read it as broadly confirming the treatment of guaranty losses as bad debt losses. ^[15] Congress presumably knew of the Fox line of cases, supra, which had refused 'debt' treatment to guarantors' losses, and it is not without significance that the Senate Report on § 166(f) stated: 'If the requirements of this section are not met, the taxpayer will, as under present law, be treated taxwise under whatever provisions of the Code are applicable in the factual situation.' ^[16] It is true that § 166(f) provides that any payment included therein 'shall be treated as a debt'; but of more significance is the fact that the person claiming the deduction need not show that he in fact owned a 'debt' or that such debt had become 'worthless during the taxable year'-the requirement for deductibility of both business and nonbusiness bad debts under § 23(k)(1) and (4)-since 'for purposes of this section' § 166(f), the guarantor's loss is 'treated as' a debt 'becoming worthless within such taxable year' as the loss occurs. In other words, though assimilated to a 'debt' loss, the loss arising from the guaranty payment in fact need have none of the attributes of a debt loss in order to be deductible. The primary thrust of s 166(f) was to make deductible some kinds of losses which were theretofore not deductible, and I think that drawing from the language of the Section a definitive characterization of such losses as 'debts' involves a misplacing of emphasis.

Of still greater significance is the fact that § 166(f) losses are deductible in full. This, it seems to me, is more consistent with the view that Congress did not intend to disturb the line of cases which, following Fox, gave a full deduction under § 23(e)(2) to losses on guaranties of corporate obligations, than it is with the Court's view that § 166(f) confirms Congress' intent that such losses should be only partially deductible as nonbusiness bad debts under § 23(k)(4). Otherwise we would have the anomalous result that under the 1954 Code individual guarantors of noncorporate obligations are given better treatment than those guaranteeing corporate obligations, even though the basic limitation which Congress imposed upon the deductibility of § 166(f) losses, namely, that the proceeds of the guaranteed obligation 'were used in the trade or business of the borrower,' is always present in the case of a guaranty of a corporate obligation.

In short, I think that when the purposes and provisions of § 166(f) are taken together, it is quite evident that the section was intended to complement the decisions of these four Courts of Appeals, ^[17] and not to override them.

Finally, the Government suggests that giving guarantors' losses the same capital loss treatment as nonbusiness debt losses would make for a better tax structure, since, it is argued, both kinds of losses are comparable to losses from investments, which receive capital loss treatment under both the 1939 and 1954 Codes. ^[18] Even if that be so, this would be a matter for Congress. Our duty is to take the statute as we find it. I would reverse.

Notes

1. '(§ 23(k)) (4) Non-business debts.
2. '§ 23. Deductions from gross income.
3. 8 Cir., 224 F.2d 947.
4. Third Circuit.
5. Fifth Circuit.
6. Sixth Circuit.
7. Third Circuit.
8. '(§ 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.'
9. I.R.C.1939, § 23(k)(1), 53 Stat. 13, 26 U.S.C.(1940 ed.) § 23(k)(1), 26 U.S.C.A. § 23(k)(1).
10. H.R.Rep. No. 2333, 77th Cong., 2d Sess. 45.
11. Had this been the congressional purpose, it could have been accomplished simply by subjecting nonbusiness debt losses to the provisions of the statute dealing with worthless securities. See § 23(g)(2-4) of the Internal Revenue Code of 1939.
12. When it enacted § 23(k)(4) Congress left undisturbed § 23(e)(2) relating to the deductibility of losses on 'any transaction entered into for profit,' and that section was subsequently re-enacted, unchanged, as § 165(c)(2) of the Internal Revenue Code of 1954, 26 U.S.C.A. § 165(c)(2).
13. See note 8, supra.
14. '§ 23. Deductions from gross income.
15. The Senate Report on § 166(f) simply states: 'Your committee also provided that business had debt treatment will be available where a noncorporate taxpayer, who was the endorser (or guarantor or indemnitor) of the obligation of another, is required to pay the other's debt (and cannot collect it from the debtor). However, this treatment is to be available only where the debt represents money used in the other person's trade or business. Your committee believes that this treatment should be available in such cases since in most cases debts of this type usually are incurred because of business relationships.' S.Rep. No. 1622, 83d Cong., 2d Sess. 24-25.
16. S.Rep. No. 1622, 83d Cong., 2d Sess. 200. (Italics supplied.)
17. 77 S.Ct. 182, 183, supra.
18. I.R.C.1939, § 23(g)(2-4), 26 U.S.C.A. § 23(g)(2-4); I.R.C.1954, § 165(g), 26 U.S.C.A. § 165(g).