Putnam v. Commissioner of Internal Revenue

RESPONDENT:Commissioner of Internal Revenue
LOCATION:The United States District Court for the Western District of Texas

DECIDED BY: Warren Court (1956-1957)
LOWER COURT: United States Court of Appeals for the Eighth Circuit

CITATION: 352 US 82 (1956)
ARGUED: Oct 17, 1956
DECIDED: Dec 03, 1956

Facts of the case


Audio Transcription for Oral Argument – October 17, 1956 in Putnam v. Commissioner of Internal Revenue

Earl Warren:

Number 25, Max Putnam and Elizabeth Putnam, Petitioners versus Commissioner of Internal Revenue.

Richard E. Williams:

May it please the Court.

Earl Warren:

Mr. Williams.

Richard E. Williams:

This matter is before this Court on certiorari to the Court of Appeals for the Eight Circuit which Court affirmed the decision of the United States Tax Court.

The facts in this matter are relatively simple.

The taxpayer petitioner, Max Putnam together with two other individual persons caused to be formulated a corporation known as Whitehouse Publishing Company for the purpose of engaging in the printing business.

Each of those three individuals, including the petitioner, acquired one-third of the capital stock of Whitehouse Publishing Company.

Shortly after the incorporation and after the acquisition by the corporation of the necessary fixed assets for its operations, it became necessary for it to have the short-term use of some additional operating funds.

Those funds were procured by borrowing from a bank.

And the petitioner Putnam personally guaranteed the borrowings of the corporation from the bank.

The corporate operation proved unsuccessful.

Its assets were fully liquidated, applied to the corporate obligations and after all of its assets had been so consumed, there remained an outstanding liability of the corporation to the bank with reference to which the petitioner had executed his guaranty.

There is no question here with reference to the actuality and reality of the petitioner’s loss.

The only issue is this, is the loss suffered by the petitioner, a loss resulting from a transaction entered into for profit and consequently deductible in full under Section 23 (e) (2) of the 1939 Internal Revenue Code.

Or was this loss so suffered by the petitioner, a loss resulting from the worthlessness or the fact of becoming worthless of a nonbusiness bad debts.

Now, in the lower courts, the issue has narrowed down to just that.

It is also recognized by the parties here that these Sections are mutually exclusive, that even though, and I believe it is conceited by the respondent that it is a fact that the loss did result from a transaction entered into for profit.

But even though the loss so resulted, it is not deductible under 23 (e) (2) if it is deductible under 23 (k) (4), which is the code Section relating to the deductibility of nonbusiness bad debts.

The tax — the taxpayer’s argument as set forth in its written brief is also relatively simple.

That — doesn’t mean that it’s only a question of whether it’s a capital loss or —

Richard E. Williams:

Yes, sir.


Richard E. Williams:

If it is a loss within the purview of 23 (k) (4), then it is deduct — deductible only as a short-term capital loss.

Whereas, if the loss does not fall within the purview of that Section, then it does fall within the purview of 23 (e) (2) and is deductible in full.

The taxpayer’s argument has set forth in its written brief is also relevantly simple.

And it is predicated on a series of decisions, which are cited in petitioners brief.

The cases there principally are the Pollak case, and the Cudlip case, and the Allen versus Edwards case, and the Ansley case, in which cases — and the Fox case, in which cases the so-called no debt theory was established and some several times followed by various Circuits.

The no debt theory in turn is founded upon a decision of this Court in Eckert versus Burnet, 283 U.S. 140, a case decided in 1931.

Now it’s true as the respondent points out in his brief that Eckert versus Burnet involved a different statute than the one with which we’re concerned here.

The statute then did not distinguish between business and nonbusiness bad debts, but it did provide that a loss, as a consequence of a bad debt, could be deducted provided it was ascertained to be worthless, and provided that it was charged of during the year.

Richard E. Williams:

That case also involved a loss resulting from a guaranty.

The only thing in that case that is of consequence to us here and I think it is of major consequence because that case is so heavily relied upon by the various Circuit Courts in the adoption of the so-called no debt theory is this.

The Court in Eckert versus Burnet in effect said that a debt, worthless when acquired, cannot be considered to be a debt at all.

In other words, the Court there is saying that a debt or the term debt as used in federal taxation presupposes something of value in the hands of the party who proposes to charge the debt off or to treat the worthlessness of the debt as the occasion for a deduction from taxable income.

The no debt theory actually amounts to simply this.

The execution by the petitioner taxpayer of the guaranty itself created no debt.

The performance by the petitioner of his guaranty, of the corporation’s obligation to the bank, could have freed to the debt only if there were at that time some reasonable hope and expectation on his part of recovery from the principle debt.

Which in this instance and in the factual situations embraced in the Cudlip, and Pollak, and Allen cases, which there was no reasonable expectation of recovery because the corporations in those cases and in this one, which were the principle debtors were without assets.

They have no means with which to pay with the consequence that there was no debt because there was no hope or expectation of recovery.

Also, 23 (k) (4), which the respondent wishes to apply here requires not only that there be a debt but that the debt become worthless within the taxable year and these decisions upon which we have relied call attention to the necessity under 23 (k) (4) for the active event of worthlessness to occur during the year.

And of course, that is an impossibility where there is — where the so-called debt is worthless at that time that it comes into the hands of the taxpayer, as a result of the performance of his guaranty.

Now, the respondent’s argument here and I want devote particular attention to that because we have not filed a reply brief.

Our facilities in Iowa for quickly preparing and having printed briefs are — were not adequate to enable us to prepare and file a reply brief here.

And for that reason, I do want to devote particular attention to respondent’s argument.

I want to point out that the respondent’s argument throughout is predicated upon two basic and continuing errors.

The respondent’s argument is principally that expressed by Judge Stewart in the Cudlip case in a dissenting opinion which he filed there.

The errors that continue throughout the respondent’s argument are these.

The respondent feels to distinguish between the substantive position and the substantive rights of an investor whether he be a lender or a stockholder, and the substantive position and rights of a guarantor who has performed his guaranty.

The respondent fails to recognize that the act of lending money or the act of purchasing stock create thereupon an asset in the hands of the investor or loaner-lender, whereas, the execution of a guaranty does not create or bring to the hands of the guarantor any assets whatsoever.

As a matter of fact, all it creates for him is a contingent liability.

He does not have an asset that he can sell or exchange as is the case of the lender or of the investor in corporate stock.

There is no value in his hands by reason of his execution of the guaranty, whereas, there is value in the hands if the lender or of the stock investor.

There are no earnings resulting directly to the guarantor by virtue of the execution of his guaranty but there are earnings normally inuring for the benefit of the party making a loan or the party acquiring stock.

With a result that the respondent has failed throughout to recognize that basic difference in substantive position of the investor and of the guarantor.

The guarantor may derive great indirect benefits from this guaranty as to —

Richard E. Williams:

That is true and it is on that basis that the execution of a guaranty and the lost that results therefrom are treated as being losses resulting from a transaction entered into for profit.

But there is nothing in the hands of the guarantor as a result of the execution of his guaranty that constitutes an asset.

There is nothing that he can sell.

There is nothing that he can exchange.

There’s nothing with which he can procure funds, whereas the lender or the stock investor does have an asset in his hands from the beginning.

He has the obligations of the — of these principles, does he not?

Richard E. Williams:

Who does sir?

The — the man who guaranties the debt of a principle.

Richard E. Williams:

Not until he has been called upon and has performed.

Then by subrogation —

That’s the debt if he loses it.

Richard E. Williams:

I didn’t understand that.

What is the debt that your client lost?

Richard E. Williams:

There is no debt here, according to the no debt theory.

What’s there an obligation on the — on the part of the guaranty — the person whom he guaranteed the corporation that went bankrupt?Do they owe him what he’s paid to that?

Richard E. Williams:

Technically, yes.

Technically —

I know.

Richard E. Williams:

— the corporation owed him money.

What — would that — that —

Richard E. Williams:

It was worthless.

That’s where the worthless debt arose?

Richard E. Williams:

I think perhaps that the respondent correctly states under the law of suretyship that the debt actually arises upon the loaning of the money by the original creditor.

Oh, the obligation arises?

Richard E. Williams:

Yes, sir.

And that the ranks of that principal creditor pass to the guarantor upon his performance of his obligations under the guaranty.

But, and I want to call the attention to the fact that the respondent finds it necessary to indulge into some — in some rather strained and somewhat thin reasoning in order to please something of value in the hands of the guarantor.

Now, of course, he argues first that it isn’t necessary that there’d be value there.

The same time he turns around and attempts to persuade the Court that there is value there and that argument really has set forth in the footnote appearing on the bottom of page 19 of the respondent’s brief which I’d like to read.

“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.”

Now, I — I feel that that is rather strained reasoning.

It’s an effort on the effort on the part of the respondent to satisfy the requirement of the statute that the debt or obligation must have become worthless in the hands of the taxpayer.

The statute is not referring to the occurrence of worthlessness in any other person’s hands but only in the hands of the taxpayer, and that respondent is in effect the same when — if the guarantor himself is solvent.

He in effect can owe himself.

Richard E. Williams:

He can pay himself.

And as a consequence, when he does perform his guaranty, he acquires something of value.

Well, it obviously is a fiction.

Nothing of value comes to him by the fact that he has paid off someone else’s obligation.

Well, is that the first time that a guarantor has someone owing him something?

Richard E. Williams:

Yes, sir.

That is the first time that he has someone owing him anything.


Richard E. Williams:

And it’s true there is a technical debt.

That defines that that obligation is worthless when it comes to it?

Richard E. Williams:

He knows it’s worthless before it comes to him.

The assets of the debtor are completely gone.


Richard E. Williams:

Yes, and these cases —

Not necessarily in many cases?

Richard E. Williams:

These cases that involved the so-called no debt theory only concern guaranties of corporate obligations, where the corporation is without assets.

That is the only place in which this so-called no debt theory arises and has been applied.

Now, Congress itself has very definitely recognized the difference in the substantive position of the lender or stock investor as compared with the guarantor.

Prior to the — prior to 1942, both business and nonbusiness bad debts were fully deductible from taxable income.

No distinction was made between the two.

Congress was aware of the fact that many taxpayers being in a — in a situation similar to that of the person who had loaned money were being restricted to capital loss limitations with reference to losses that they might suffer, that was through of the individual who owns stock in a corporation.

It was through the individual who owns securities as defined in the Internal Revenue law.

If they had a loss, they were subjected to the limitations of the capital loss provision.

But the ordinary lender, the nonbusiness lender was not prior to 1942, subjected to those limitations.

In Congress, in amending the law in 1942 and establishing the distinction between business and nonbusiness bad debts was recognized that the nonbusiness lender was actually in the same position and category as he who held a security that did qualify as such under the law.

And was recognizing that the so-called lender then should be subjected to the same limitations with reference to deductions upon loss, as the owner of a security becoming worthless would be subjected too.

Furthermore, proceeding from 1942 up to 1954, Congress in 1954 through the adoption of the — of the Internal Revenue Code of 1954, inserted a provision, 166 (f), which provides as follows.

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 the purposes of this Section.

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.

Now, note that Congress did not, by that enactment change the situation with reference to the ordinary lender.

Richard E. Williams:

Now, certainly the loss that the lender suffers is just as real as the loss suffered by the guarantor, or endorser, or indemnitor.

But Congress recognized through this enactment and through its failure to give the lender the same benefits that were being extended to the guarantor.

Under this enactment, Congress was recognizing the difference in the substantive position and rights of the guarantor as compared with he who actually loaned his money or with he who invested his money in the form of stock.

Now, it’s also true and I suppose it should be commented upon at this time, that Section 166 (f) relates only to guarantors of noncorporate obligations.

That poses the question as to why Congress selected only the non — the guarantor of the noncorporate obligation to extend this additional benefit to.

The Section 166 (f) actually arose in the Senate and the Senate Report Number 1622, 83d Cong., 2d Sess.200, stated that where the requirements of subsection (f) are not met, the taxpayer will as under present law be treated tax wise under whatever provisions of the code are applicable in the factual situation.

In other words, Congress again had no reason to discriminate in favor of the guarantor of a noncorporate obligation and against the guarantor of the corporate obligation.

But Congress recognized that the law as it already existed, as it was in 1942 and was from that time up until 1954, did give the guarantor of a corporate obligation, the same benefit which they now were extending by statute to the guarantor of the noncorporate obligation.

I assume they felt that was necessary for this reason, if a corporation were without assets and was technically indebted to a taxpayer there would be no question as to the permanent worthlessness of the obligation, which the taxpayer had acquired by subrogation.

Whereas, on the other hand, if the obligation were owing from a noncorporate debtor to the guarantor, there always remains the possibility of future recoupment.

So Congress did two things by the enactment of 166 (f) and it’s very clear that this is what was in their minds.

They again recognized the substantive difference between the position of the lender or stockholder as compared with that of the guarantor and they specifically recognized and gave their congressional blessing to the so-called no debt theory that was adopted by the Circuit Courts of Appeals in the Pollak, Edwards, and Ansley cases.

Now, the other basic fault in the reason of the respondent in his brief is this and that is that the respondent fails to recognize the presupposition contained in 23 (k) (4), that there must have been something — there must have been an obligation having value in the hands of the taxpayer.

Not in the hands of the principal creditor because we’re not dealing with his tax problem.

We’re dealing with the problem of the guarantor taxpayer and how can 23 (k) (4) have any application.

How can there be an obligation to become worthless unless there was at sometime in the hands of the taxpayer something of value.

With the consequence that the rule of Eckert versus Burnet, which first established for the purpose of federal tax law, a debt which was valueless at the time of the acquisition could not be deemed to become worthless in the hands of the taxpayer.

But not be deemed to be the basis of a charge off under that statute in the hands of the taxpayer remains good law.

It has been followed by the various Circuit Courts of Appeals and has been recognized by Congress as already having extended to the guarantors of noncorporate obligation, I mean a corporate obligations.

The same treatment with reference to losses as a consequence thereof, that Congress extends to Section 166 (f) of the 1955 Internal Revenue Code to those who lose as a consequence of their personal guaranties of noncorporate obligations.

John M. Harlan:

Which are the Circuits that have gone in your favor?

Richard E. Williams:

The — all of them except our own and those Circuits are the Third Circuit, yes, that’s the Pollak case.

The Sixth Circuit which is the Cudlip case.

The Fifth Circuit which is the Edwards versus Allen case.

The Ansley case, I forget which Circuit that — the Third Circuit was Ansley also.

And of course, there is also — it involves a slightly different question, there is also the Fox case, Fox versus Commissioner, 190 F.2d 101, which arose in the Second Circuit.

In which they held that where the principal debtor of being an individual was dead and his estate long closed, bankrupt, and insolvent.

That the performance by the guarantor placed nothing in his hands of value that could thereafter become worthless.

John M. Harlan:

There is a sentence, however, in Judge Clark’s opinion in that case at the end that indicates that a different result might have been reached if the principal had been alive.

Richard E. Williams:

Yes, sir.

Richard E. Williams:

And that was the point I was making a while ago that there is a difference with reference to the guarantor of a noncorporate obligation because he might thereafter continuing — continuing in existence recoup and be able to pay.

Earl Warren:

Mr. Elman.

Philip Elman:

May it please the Court.

May I say in further response of Mr. Justice Harlan’s question that there’s no dispute in this case that the principal debtor or the corporation was in existence at the time the guaranty was paid.

This is not a case of —

John M. Harlan:

Existence as a corporate —

Philip Elman:

Wasn’t —

John M. Harlan:

— irresponsible corporate shell.

Philip Elman:

It was — it was insolvent, it had no assets at the time the guaranty was paid but the particular basis of decision of the Fox case, that the debtor was not in existence, is not present here.

And the case maybe distinguished upon that ground.

I should like to say that as Mr. Williams’ —

William O. Douglas:

What the — was the debtor actually without any assets, so that no part of it (Inaudible)

Philip Elman:

The — the facts as they are reflected by the record are that this corporation became totally unsuccessful on the summer of 1947.

It disposed of all of its assets, it went out of business.

It remained as Mr. Justice Harlan said is a corporate shell.

It — at that time it was indebted to a bank in the sum of $8500, evidenced by two promissory notes, which had been signed by the taxpayer individually and as president of the corporation, so that he was apparently a co-maker.

But the Tax Court found on a basis of parole evidence that his liability was that of a — of a surety or guarantor.

Now, there’s no question that Mr. Putnam suffered a loss in 1948.

There’s no question that he’s entitled for deduction.

What is in dispute is the nature and source of that loss and the kind of deduction to which he is entitled.

The Tax Court and the Court of Appeals have held that he is entitled to a deduction for a bad debt under Section 23 (k).

Petitioner is arguing here as in the courts below that he is not entitled for a bad debt deduction, that on the contrary he is entitled to a deduction for an ordinary loss under Section 23 (e).

Now, it’s necessary for the taxpayer to make that contention because as he pointed out, 23 (k), the bad debt provision and 23 (e), are mutually exclusive.

Congress has carved out of the general category of losses.

The specific type of loss of a bad debt and if a taxpayer who has suffered a bad debt loss asserts his right to — to a deduction, he must assert it under 23 (k), the bad debt provision.

So that in this case we have an inversion of the usual situation in a tax case, it’s the Commissioner here who is arguing that the taxpayers entitled for a bad deduction, and he is asserting very vigorously that he is not.

Now, the reason he does so is — is quite obvious because both courts below have held that his loss was a nonbusiness loss, it was not incurred in his trade or business.

He’s a practicing lawyer.

He is not in the business of making investments.

So that if its bad debt loss it comes under 23 (k) (4), which is in our brief on page 32 and 33.

Philip Elman:

If it’s a nonbusiness bad debt loss, it’s treated under the statute as a short-term capital loss.

In other words, it’s deductible only against capital gains plus $1000 of his ordinary income.

So that if he doesn’t — if he can succeed in maintaining the proposition that this is not a nonbusiness bad debt, he doesn’t come on at 23 (k), then he will move over to 23 (e) (2), which is on page 31.

And he argues on that branch of the case that this guaranty was part of a transaction entered into for profit.

That he was the controlling stockholder of this corporation, was really his corporation in every sense.

That if — if this enterprise, this corporate enterprise had been successful and it was necessary to its –its success that this loan be made, and if he be co-maker on it that thereby, he was — he would be improving his prospects of deriving profit from his stock investment in the corporation.

So that on that phase of the case it’s a transaction entered into for profit but not incurred in his trade or business.

Now, he — he therefore, if successful on that argument, would be entitled to an ordinary loss under 23 (e) (2), which would be fully deductible against the ordinary income.

Now, I think it might be fair to point out that if he’s right in this contention, that he is not entitled to a bad debt deduction because the — as he calls of the no debt theory, that the debt was worthless when he acquired it through payment of the guaranty.

That while it may be down to his benefit in this case, that in the ordinary situation of a person alone, not entered into for profit, where the taxpayer is a guarantor on a loan made by a friend or associate, and he is compelled to make good on the loan because the principle is in default.

Now, in that situation, the logic of the taxpayer’s argument here would compel to conclusion that the ordinary taxpayer in that situation would have no deduction at all, because under the taxpayers theory here he wouldn’t have a bad debt deduction since there was no debt, and you couldn’t come under 23 (e) (2) because there was no profit motive.

Now, coming to the merits of the — the so-called no debt theory, which as Mr. Williams pointed out, has been accepted in three very recent decisions.

Now, the first one was in the Third Circuit in 19 — January of 1954 and the two other cases, the Cudlip case in the Sixth Circuit, from which Judge Stewart dissented, and the case in the Fifth Circuit, the Edwards and Allen case.

Prior to 1954 it had been consistently held by the Tax Court, by the Commissioner, by several Courts of Appeals, the First Circuit in Hamlen and Welch in 116 F.2d, and the Second Circuit in the Shiman case in 60 F.2d, that a guarantor’s loss was to be treated as bad debt loss.

The logic, the rationale of those decisions was quite simple, that the loss arose from a — from a debt and therefore the deduction also was to be treated as arising from the debt.

Because the — a surety or a guarantor, when he — when he pays the creditor does not there — thereby extinguish the debt by operation of the familiar principles of subrogation.

The debt remains in existence and what happens is that the surety or guarantor is substituted for the creditor, and the debt remains —

John M. Harlan:

(Voice Overlap) whether the indemnitor is there?

Philip Elman:

I think an indemnitor — indemnitor may present an entirely different situation because there the creditor is in effect indemnified for a loss he suffered.

It may — it maybe distinguishable in a sense that it would be difficult to isolate the debt.

In a — in a case like that it might be contented that the indemnitor is in — is in substance making a capital contribution.

But I think that the indemnitor’s situation raises problem which aren’t here.

And I — I would not think that the problems in that kind of case presented would have to be considered in connection with this case, where it’s clear that there was a debt prior to December 2nd, 1948 when the taxpayer paid these notes.

Under the negotiable instruments law, which is in effect in Iowa, the notes are not discharged.

The debts — the debt was not extinguished.

The taxpayer succeeded to the rights of the creditor.

Now, it’s true that — that the debt was worthless when it’s acquired but to the — the fact that a debt is worthless at its inception does not negate its existence.

A bad debt by definition is an — is a legal obligation which has a — as an obligation is valid but which is a practical matter, which is a matter a fact is uncollectible and worthless.

Now, if — if every bad if — if a bad debt were automatically a no debt, the consequence would be to — really to mutilate the concept of a — of a bad debt and I can illustrate that was a simple example.

Suppose A lends money to B, and at the time the loan is made, B is hopelessly insolvent and the note he gives is — isn’t worth the paper it’s written on.

Philip Elman:

The debt was completely worthless ab initio.

Now, that’s precisely the kind of case that comes within the bad debt provision, to deny the lender the right to take a bad debt deduction, in that situation would be almost unthinkable.

It’s never been suggested that you have — you have to — you have to find that the debt had some — some worth before you uphold the deduction.

You’re not bothered by the word become?

It becomes a debt and becomes worthless at the same time that —

Philip Elman:

Well, Your Honor, I — I think there’s no question in this — in this case that debt became worthless, because as I say on December 2nd, 1948, when it was paid it had been — it had worth for 11 months and 2 days of that year, and it became worthless on December 2nd.

And the statute says that in the case of a taxpayer, other than a corporation, a nonbusiness debt becomes worthless within the taxable year.

This — this debt, it did literally become worthless when the guarantor paid the bank and the — the argument that a debt has to have some value in the hands of the taxpayer before it can be deducted.

It would I think produce a confusion between the collectability of a debt and its existence.

If –if Mr. Putnam had brought an action after paying these — these notes, if he had brought an action sounding in debt against the corporation, the corporation couldn’t defend on the ground that there was no debt.

He couldn’t — couldn’t file a general denial thing, no debt.

It’s — the defense would be a practical , it was judgment proof.

The debt was still in existence but it couldn’t be enforced.

Now, that seems to us to be the — followed in the classic definition of a bad debt.

Now, the argument is also —

What — what —

Philip Elman:

Excuse me.

It was a loss no matter — whether it was debt or not, wasn’t it?

Philip Elman:

It’s — it’s a loss.

But the question is, how did the loss arise and — and the argument that we’re making is that the loss arose —

All right.

Are you — are you also arguing on — that is a Section 2?

Philip Elman:

Not at all, because if it’s a bad debt loss, that’s the end of the matter.

The Tax Court finding that it was bad debt loss stopped there, didn’t go on to 23 (e) (2) because as this Court has held in the Spring City case and it’s an elementary principle of tax law if — if it’s a bad debt, it can’t be an ordinary loss.

And the taxpayer —

(Voice Overlap) bad debt can’t be a loss that’s occurred to profit.

Philip Elman:

If — if the loss arises from a debt transaction, then you consider the question of deductibility under 23 (k) because Congress has specially dealt with the question of debt losses and its — it –and you can go to 23 (e) only if it’s not a case that falls within 23 (k).

Now, once you find —

Well, I understand that.

I have a loss and — and it occurred in the Tax Court as I understand it and held that this didn’t incur in the business, it wasn’t business debt, (Inaudible)

Philip Elman:

That — that’s not challenged.

The — the issue here is not whether it was a business loss or a nonbusiness loss.

It was a nonbusiness loss, that’s clear.

The question is, is it a nonbusiness loss arising from a debt, a bad debt or isn’t it?

If it’s a nonbusiness loss, arising from a bad debt, then that’s the end of the case because the Tax Court and the Court of Appeals held that the taxpayer is entitled for deduction under that provision but this taxpayer unsatisfied with that, since it’s only a capital loss —

Well, it incurred at any transaction entered into for profit.

Is this — does this fall within that?

As I understand it because —

Philip Elman:

It doesn’t fall within that if it’s — if the loss arises from a debt.

That’s the Spring City case in 292 U.S.

Stands with a proposition that a loss under 23 (e), if it’s a debt loss is to be treated entirely under 23 (k).

Felix Frankfurter:

What you are saying is that the category of 23 (k) (4) is an inclusive category of nonbusiness debt and one should determine a debt is nonbusiness as the end of the matter and we don’t ever reach these many pleadings.

Philip Elman:

Yes, I think that there’s no dispute as to that.

I don’t really think Mr. Williams challenged that.

That’s —

Felix Frankfurter:


Philip Elman:

I don’t think there’s any dispute about that proposition and if this case comes under 23 (k) (4) because it’s a loss arising from a debt that’s — that’s it.

Now, if I may go on to —

Felix Frankfurter:

But no matter — let me give a next question, this other Circuits, they rest on the fact — do they turn on the fact that this was worthless when subrogation in the corporation?

Philip Elman:

Yes, the– the reasoning of this case is this —

Felix Frankfurter:

Then before — if you acquire it, the guarantor comes in when there’s still a chance of getting something that in the next few month, a chance (Inaudible) completely, could that be in or out in the case?

Philip Elman:

Well, these cases go on — a reason that if a debt as a practical manner is worthless, it doesn’t exist.

That’s the base — the proposition is put it in as boldly as that.

And I commend to Your Honors a reading of Judge Stewart’s dissenting opinion in the Cudlip case, which I think answer that much more effectively than I could.

John M. Harlan:

Did you really think that what you said there is better than (Inaudible)

Philip Elman:

No, sir.

I couldn’t — I couldn’t —

John M. Harlan:


Philip Elman:

I couldn’t hope to present the case as well as the judges have —

John M. Harlan:

Well, in those cases go on and say that the essence of this transaction ab initio is not contrary to the debt transaction, that to require the principle the guaranty — guarantor loss subrogation refers this to a debt for tax purposes is an unrealistic approach of the problem.

Philip Elman:

Yes, sir.

John M. Harlan:


Philip Elman:

And if I — if I may respond to the argument that you’ve formulated sir —

John M. Harlan:


Philip Elman:

Well —

John M. Harlan:


Philip Elman:

I understand it.

Your paraphrase — on your paraphrase you are —

John M. Harlan:

The courts (Inaudible)

Philip Elman:

Well, the — the argument that there was no debt at all is based on — on cases which hold that a debt doesn’t arise, where there’s — where the creditor has no expectation of — of repayment.

He does — his motives are other than those and to take the — the illustration, I put a little while ago, A lending money to B and B is hopelessly insolvent.

Now, suppose we add to that one further element, that A, when he lends that money to B, knows that B is hopelessly insolvent.

And when he — when he makes that loan, he doesn’t have any hope or expectation of repayment.

Now, in those — in that situation, and there are cases that involved it.

The courts have held incorrectly that what appears to be a loan on the surface isn’t really a loan at all, because the creditor is in effect making a gratuity, a gift.

So that there are — there are cases which — which — in which language appears, which in the context of those opinions is perfectly correct and — and unchallengeable that where there’s no appropriate expectation of — of payment of the debt, it’s not a debt.

Now, to take that language, which is meaningful in the context of a voluntary loan to someone who is insolvent and to translate it vitally to a situation like this, where the debt arises involuntarily by operation of law, there is no suggestion in this case that the taxpayer was making a gift to the corporation.

If he were making a gift to the corporation, he wouldn’t be entitled to any deduction and to — and we think that if it’s an uncritical application of the — of the language in cases involving what is in substance a gratuity.

Now, in this case we have what in substance is a capital investment.

In this case the corporation was setup in 1946 by the taxpayer and two others.

He furnished all of the working capital.

He contributed a building.

He contributed a lot.

He made a direct loan from his own pocket and the with respect to the printing presses, they went to the bank and executed these two notes which he signed.

The collateral for the — one of the notes with his personal life insurance and automobile.

And as the Tax Court said, the loan wouldn’t have been made if — if a taxpayer individually hadn’t furnished this credit.

He was supplying risk capital in the form of his credit.

Now, the whole theory of our — the whole pattern of the tax law is that when one makes a capital contribution, whether it takes the form of an investment by buying stock or the form of a loan to the corporation, whether or not it’s evidenced by security.

If it’s a capital transaction and the investment is a good one, the taxpayer pays tax on capital gains.

And if the corporation fails, he is entitled to deductions on a capital loss basis.

Philip Elman:

As Judge Stewart very succinctly pointed out in his dissenting opinion in the Cudlip case, if — if the taxpayer here had borrowed the money from the bank himself, on his own credit and had turned around and lent the money to the corporation, he would have — he would have suffered a loss but would’ve been treated as a capital loss.

If he had invested in the corporation by subscribing this additional stock so the corporation could take that money and buy these printing presses, that — that too would have been deductible as a capital loss, no matter how he risked his capital.

It would have been — it would have given rise to a deduction as a capital loss.

Now, if the — if these three Circuit — Circuits are right, if a guarantor if — if the capital — if capital is risked in the form of a guaranty of a bank loan, the result would be that in that single type of investment the investor, if the — if the enterprise succeeds, pays taxes on his — on his profits as capital gains but if the corporation fails he gets an ordinary loss deduction.

Now, we’re not arguing — we’re not presenting that as an argument on the merits but I think it bears on the reasoning of those — on the reasoning of those opinions, which to some extent suggest that it’s unrealistic to treat a debt which is worthless when acquired as a debt.

I think this case is an illustration of the proposition that what in a — in a particular case may seem to be inequitable for a particular taxpayer and produces the decision in his favor may result in a rule which is a applied to other taxpayers is inequitable.

Mr. Putnam is — as out of pocket this $9000 and he certainly should be given a deduction for it but to — to say that he is entitled to a deduction for — as an ordinarily loss, what it seems to us introducing to the statute something that isn’t fair.

It will — will result in incongruities.

The Government’s argument here in a sense is a technical one because we do rely upon the doctrine of subrogation, which might be thought of as a legal fiction.

But it isn’t — it isn’t a fiction at all in the sense that the loss here arises from what originally was a debt.

Mr. Putnam’s loss arose from the fact that he was a surety on his debt.

It was the debt which gives rise to his loss and it seems that the debt should give rise to his deduction.

Felix Frankfurter:

May I suggest that the analysis should be pushed further back as you made it mainly at the moment that he signed the guaranty, became as a protection to subrogation.

Philip Elman:

He — not only that sir, before he paid on his guaranty of course as a surety.

He had a right of exoneration.

A surety’s rights are not limited to subrogation, they extend to exoneration, to reimbursement of their co-sureties.

He has right of contribution.

All those rights spring from the debt.

This is a debt transaction in its essence and it seems to us that the — what was the set of law prior to the Pollak case in 1954 was right, that a guarantor’s loss, arising from debt is a bad debt loss.

Now, Mr. Williams has mentioned the Eckert case in 283 U.S.

That was —

Before — before you go into that —

Philip Elman:

Yes, sir.

— on this question 23 (e) (2), I noticed that the question presented, won’t they — on page 2 of the brief of the petitioner.

Does he contend there that’s entered into for profit within the meaning of Section 23 (e) (2)?

Philip Elman:

Yes, sir.

And on the — on page 5, therefore the loss suffered by petitioner is not a deductible under 23 (k) but is under 23 (e) (2) now.

Philip Elman:

Yes, sir, but he points out on page 8 of his brief that the Tax Court pointed out that Sections 23 (e) and 23 (k) were mutually exclusive.

And he has not challenged that, and he couldn’t challenge it under the — under the authorities —

Of course (Inaudible) made it exclusive.

Philip Elman:

Yes, sir.

So that —

As to which one it comes under.

Philip Elman:

Yes, but if it comes under — if it comes under 23 (k), it’s — there’s a general provision and there’s a specific provision.

And in the Spring City case, this Court, an opinion by Chief Justice Hughes, held that this — this specific provision control, just as there’s a conflict between the general statute and the specific statute.

So that if — if this is a bad debt then 23 (e) controls and I think that is — that’s the premise on which this whole case is proceeded and there has been no dispute as to it.

Hugo L. Black:

You mean if it’s deductible under it, it is not deductible under the other?

Philip Elman:


Hugo L. Black:

And vice versa?

Philip Elman:

Yes, sir.

But as a qualification to the vice versa, the —

Hugo L. Black:

Yes, well then —

Philip Elman:

The — the 23 (k), the specific one, so that you first ask yourself the question, does it come under 23 (k)?

It doesn’t come under the specific one.

It’s — it’s only if it doesn’t come under, if it’s not a loss arising from a debt, then 23 (e) applies.

Now, I believe that Your Honor will find that — the preposition I’ve asserted in fact is not — not another one —

I’m sure they’re exclusive, but why is it isn’t under (k), it can’t be under (e)?

I don’t understand, but don’t go out with it anymore.

Philip Elman:

The — the difference arise — arises simply from the fact that 23 (k), the specific one, dealing specifically with debts.

Congress dealt with debt loss as right there.

It had the general provision but when — when it dealt with debts, 23 (k) was the — it was the provision that Congress intended to be governed, it should be governed.

Now, the Eckert case in 283 U.S. arose as Mr. Williams pointed out when the statute was different and at that time a bad debt not only has to be worthless but it had the charged off.

And the language in the — in the Eckert case was not that where a debt — debt is worthless when acquired, that’s no debt, that’s not in the opinion.

Mr. Justice Holmes’ opinion which is all of a page and a half, does not say that.

It says that there was nothing to charge off and he was repeating a statement made by the court below, the Second Circuit.

In that case a statement which was subsequently explained by Judge Learned Hand in the Shiman case in 60 F.2d.

In short, in the Eckert case, the taxpayer was on a cash basis when he — in the tax year concerned, he had not paid cash to the creditor.

What he had done was substitute the corporation’s notes in which he was secondarily liable.

He had substitute for those notes his own personal notes and he sought to take a deduction in that year.

And the — this Court held that the cash basis taxpayer has to pay out cash and when it — there’s an intimation in the opinion of Mr. Justice Holmes that when he does pay out cash, he is entitled for deduction.

Philip Elman:

Now, that provision — that situation arose in the Shiman case in 60 F.2d that Judge Learned Hand dealt with.

Earl Warren:

Mr. Williams, do you have something further?

Richard E. Williams:

May it please the Court.

I’d like to try to clarify this matter of 23 (e) (2) and 23 (k) (4).

As I understand it, the respondent does not contend that this loss did not result from a transaction entered into for profit.

I think the respondent concedes that but the respondent says, that since the transaction was a bad debt transaction, then it must be deducted under that Section and be subjected to its limitations.

Whereas the petitioner here has said, it was a loss from a transaction entered into for profit.

It did not result from a bad debt, consequently, the deduction shall be taken under 23 (e) (2).

And I don’t think any now we probably should have pointed out that there is a 23 (e) (1), which relates to losses resulting from the operation of a trade or business.

Now, this loss, we concede is not a loss resulting from the operation of a trade or business, but it comes within that second category of losses resulting from transactions entered into for profit.

I had intended initially and neglected to point out one thing pertaining to the facts here.

At the time that petitioner Putnam executed the first of two guaranties that were involved, he owned only one-third of the stock of this corporation.

At the time that he executed the second, he owned two-thirds of the stock.

Now, the truth of the matter is that if petitioner Putnam had been actually the controlling stockholder of this corporation, the time these guaranties were executed, I have no doubt but the Commissioner would have taken the position from the very beginning that the guaranty actually constituted a contribution to capital.

Now, being unable to do that because he cannot demonstrate that the petitioner control the corporation, he does the next best thing from his point of view.

And that is to attempt to convert what is not a debt transaction into one that is through the strained reason by which he gives this debt some value in the hands of petitioner Putnam through the theory of subrogation.

He calls attention some several times to Judge Stewart’s dissent in the Cudlip case and it’s true Judge Stewart was fearful that the decision of the majority would open the door to the substitution of guaranties for actually investment capital.

But let me point out that the Commissioner has a tool with which to combat that and he has very successfully used it in many occasions.

And that is to look at the substance of the transaction and if it does involve a contribution to capital, he need not be concerned as to the form of the transaction.

If it is a purported loan, if it is a guaranty but in fact constitutes a contribution to capital, he has the tools already and he has the decisions by which he can have such capital so treat.

Now, there has been in —

Felix Frankfurter:

It is your contention then that this doctrine for which you’re contending applied only in a situation like this, where — where the guarantor pay the debtor (Inaudible) the debtor become (Inaudible) would have to furnish to him.

Richard E. Williams:

Yes, Your Honor.

And the reason why we contended only applies in such situation as this if at the time the guarantor performs his guaranty, the principal debtor has assets, then he has procured something of a value.

Now, he owns an asset, which he never owned before.

Felix Frankfurter:

Although — although, before the year is up of being paid up, whatever (Inaudible) property is left, it becomes worthless and the stock market goes down (Inaudible)

Richard E. Williams:

I think that it — that the law requires this, if at the time of the performance of the guaranty, the right acquired by subrogation has some value.

Then I think —

Felix Frankfurter:

Wouldn’t that (Inaudible)

Richard E. Williams:

I — I think to the extent that the right has value, then it does become a debt and would thereafter be treated as one to the extent that the right acquired where subrogation does not have value, then it is a loss that resulted from the transaction entered into for profit.

Richard E. Williams:

Because up until that time there has been no asset, there has been nothing of value in the hands of the taxpayer that could become worthless.

Felix Frankfurter:

But the relation doesn’t begin at the time the guarantor paid.

It begins when he signed his name as the guaranty.

Richard E. Williams:

Well, Your Honor, is there, however, at that time any obligation owing to the taxpayer-guarantor.

Does any one owe him at that point?

And can we have a debt without an obligation?

Felix Frankfurter:

Well, the — the debt hasn’t become purported (Inaudible) but legal relations that come into being (Inaudible)

Richard E. Williams:

That may create a debt.

Thank you.