United States v. Generes

PETITIONER: United States
RESPONDENT: Allen H. Generes and Edna Generes
LOCATION: United States District Court for the Eastern District of Louisiana

DOCKET NO.: 70-28
DECIDED BY: Burger Court (1972-1975)
LOWER COURT: United States Court of Appeals for the Fifth Circuit

CITATION: 405 US 93 (1972)
ARGUED: Nov 08, 1971
DECIDED: Feb 23, 1972

ADVOCATES:
Max Nathan, Jr. - for respondents
Matthew J. Zinn - for petitioner

Facts of the case

In 1954, Allen Generes and his son-in-law William Kelly formed Kelly-Generes Construction Co., Inc. Generes and Kelly each owned 44% of the stock, with the remaining 12% owned by Generes’ son and another son-in-law. Generes was the president of the corporation and did not deal with the day-to-day running of the business. In addition to his position as president, he held another full-time position as the president of a savings and loan association. In 1958, Generes and Kelly signed an indemnity agreement for the corporation. In 1962, the corporation seriously underbid two contracts and went deeply into debt. Generes loaned the corporation money, but it went bankrupt, and he was unable to receive reimbursement.

On his 1962 tax return, Generes claimed the money the corporation lost as business bad debt and his direct loans to the corporation as nonbusiness bad debt. He filed a claim for a refund on the business bad debt. This claim was the subject of a jury trial in which the jury was asked to determine whether Generes’ signing of the indemnity agreement was “proximately related to his trade or business of being an employee “of the corporation. The government requested a jury instruction to clarify that “significant” motivation satisfies the requirement, but the court refused and instructed the jury that “dominant” motivation was sufficient. The jury found in favor of Generes. The U.S. Court of Appeals for the Fifth Circuit affirmed and held that the significant motivation standard was acceptable.

 

Question

Can an individual who is both employee and shareholder in a corporation claim the corporation’s losses as business bad debt for tax purposes?

Media for United States v. Generes

Audio Transcription for Oral Argument - November 08, 1971 in United States v. Generes

Warren E. Burger:

The number 28 United States against Edna Generes and Allen Generes.

Mr. Zinn, you may proceed whenever you are ready.

Matthew J. Zinn:

Mr. Chief Justice and may it please the court.

This Federal Income Tax case is here on writ of certiorari to the Court of Appeals for the Fifth Circuit.

It raises a question with which this court is familiar -- whether a shareholder in a closely held corporation is entitled to business or nonbusiness bad debt deduction.

If he is unable to collect a debt owed to him by his corporation.

The difference between a business and nonbusiness bad debt deduction is critical since the former is deductible against the ordinary income and maybe carried back as part of a net operating loss, whereas the latter is deductible only as a short term capital loss and may not be carried back to offset the ordinary income prior years.

This court’s decision in Whipple against the Commissioner in 1963, settled the question whether merely investing in a corporation is a trade or business.

The court held that it is not and consequently a mere investor in a corporation who is unable to recover his advances to the corporation, is entitled only to nonbusiness bad debt treatment.

On the other hand, since the rendering of services to a corporation for remuneration constitutes a trade or business, an employee who advances funds to his corporation in order to protect his job and salary and who is unable to collect the debt owed to him by his corporation, is entitled to a business bad debt deduction.

The problem in this case arises where a taxpayer bears the dual relationship of shareholder and employee to the corporation.

If he were merely a shareholder, then as I have said, he would be entitled only to nonbusiness bad debt treatment but if he were only an employee who advanced funds to protect his job and salary, he would be entitled to business bad debt treatment.

In the dual status situation which arises here however whether taxpayer is motivated both by desire to protect his job and salary and by desire to protect his investment, the Internal Revenue Code makes no provision for allocating the loss in part to business and in part to nonbusiness.

The loss must be characterized in its entirety as business or nonbusiness in nature even though the shareholder employee was motivated by both business and nonbusiness considerations to make a loan or guaranteed his corporation’s debts.

Section 166 (d) of the code is the relevant statute and it is set out on page 36 of our brief.

It provides that the term nonbusiness debt means the debt other than a debt created or acquired in connection with the trade or business of the taxpayer or a debt or loss from the worthlessness of which is incurred in the taxpayer’s trade or business.

The pertinent regulations are set out on pages 36 and 37 of our brief and insofar as they are relevant here, they provide as explicated in Whipple, that a debt will be considered a business bad debt, if the loss resulting from the debts becoming worthless is proximately related to maintaining the taxpayer’s trade or business.

The position of the United States in this case is that in a dual status situation the test to satisfy only if the dominant motivation for the taxpayer’s undertaking was to protect his business interest as an employee rather than his nonbusiness interest as a stockholder.

The position of the respondent is that a taxpayer is entitled to business bad debt treatment even if his dominant motivation was to protect his investment so long as he was significantly motivated by his business interest as an employee.

With this background, let me turn to the facts of the case.

Mr. Generes, the respondent and his son-in-law William Kelly, each owned 44% of the stock of the Kelly-Generes Construction Company, a corporation engaged in heavy construction work, principally for governmental authorities.

The remainder of the stock was owned by a son and another son-in-law of Mr. Generes.

The corporation had been formed in 1954 as successor to a partnership in which Mr. Generes and Mr. Kelly had been equal partners.

Mr. Kelly was the Vice-President of the corporation, was in charge of its day to day operations and received a salary of $15,000 a year for the services.

Mr. Generes was President, was principally responsible for obtaining bank financing and securing performance and bid bonds on construction jobs undertaken by the corporation and was paid a salary of $12,000 a year.

Mr. Generes’ principal employment was as President of a Savings and Loan Association for which he worked full-time and received an annual salary of $19,000 a year.

At a pretrial deposition, Mr. Generes testified that he devoted about one hour a week to the affairs of the Kelly-Generes Construction Corporation.

At trial, he testified that he spent 6-8 hours a week on the corporation’s affairs.

Mr. Generes’ original investment in the corporation was $38,900.

In addition, he advanced funds to the corporation from time to time when it was short of working capital and also guaranteed the corporation’s bank loans to enable the corporation to purchase machinery and equipment.