UNITED STATES v. GENERES
Legal provision: Internal Revenue Code
Argument of Matthew J. Zinn
Chief Justice Warren E. Burger: The number 28 United States against Edna Generes and Allen Generes.
Mr. Zinn, you may proceed whenever you are ready.
Mr. 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.
In 1962, when the corporation was in serious financial difficulty, he advanced it $158,000.
The corporation was required to the furnish performance and payment bonds in connection with its construction business, which was largely performed for governmental authorities.
Most of these bonds were written by the Maryland Casualty Company.
From 1954 to 1958, casualty as a matter of course, required Mr. Generes to indemnify it with respect to each bond issued to the corporation.
Bonds were issued on an individual job basis.
Late in 1958 to obviate the need for individual bonds on each construction job, Mr. Generes and Mr. Kelly acting for themselves individually and also for the corporation, signed a blanket indemnity agreement with Maryland Casualty.
Under this agreement, casualty agreed to add as surety for the corporation for up to a million-and-a-half dollars on anyone job and two million dollars overall.
Mr. Generes and Mr. Kelly in turn agreed to indemnify Casualty for any loss it might suffer as surety.
In 1962, the corporation defaulted on two contracts.
Maryland Casualty made good on the defaults and Mr. Mr. Generes was called upon to respond under his indemnity agreement.
He indemnified Casualty for a $162,000 which he was unable to recover from the corporation because of its bankruptcy.
He was also unable to collect the $158,000 that he had advanced to the corporation in 1962 in direct loans.
In his income tax return for 1962, Mr. Generes treated the loss on the direct loans as a nonbusiness bad debt and the commissioner allowed that loss and it is not here in dispute.
However, he treated his indemnification loss of $162,000 as a business bad debt.
The proper treatment of that $162,000 as business or nonbusiness is the sole issue before this court.
The case was tried before a jury in New Orleans.
The trial lasted one day.
Mr. Generes testified and I refer now to page 67 of the record that the only reason he signed the indemnity agreement with Maryland Casualty was to protect his part-time job with the corporation.
In response to the question whether he had given any thought at all to his investment in the corporation in guaranteeing, and his investment on my point out it consisted both of his stock interest and his direct loans to the corporation.
He testified and I quote, “No, I never once gave it a thought.”
And I quote again from page 69 of the record, “To tell you the truth about it, I never gave that a thought.
I never gave my investment a thought.”
Unknown Speaker: Mr. Zinn, incidentally are his returns in the record?
Mr. Matthew J. Zinn: I believe they are, Mr. Justice.
Unknown Speaker: Do they show roughly what his gross income was for the year in question?
Mr. Matthew J. Zinn: I think it does, Mr. Justice.
Unknown Speaker: It must include the two salary items.
Mr. Matthew J. Zinn: That is right.
Unknown Speaker: Anything more do you know?
Mr. Matthew J. Zinn: Yes, he had some dividends and I think the record shows that his income roughly with dividends and other income averaged about $40,000 a year.
Unknown Speaker: Which would take him close to 42-50%?
Mr. Matthew J. Zinn: In those days Mr. Justice, that was before enactment of the Revenue Act of 1962, so the rates were somewhat higher.
I would say 40-50% was brought, if that is what you are asking was the marginal tax bracket before the enactment of the Revenue Act of 62?
Chief Justice Warren E. Burger: Mr. Zinn, would you agree that the evidence of this case would have bought this under the dominant motive test?
Mr. Matthew J. Zinn: I think that the--
Chief Justice Warren E. Burger: I will put it in another way, if the instruction had been given as the government requested on this evidence with that instruction, it would have been no problem, it would not be here, would it?
Mr. Matthew J. Zinn: I think the government would have prevailed Mr. Chief Justice.
We wouldn't be here, no?
On the dominant--
Chief Justice Warren E. Burger: It had been prevailed that the jury had found in favor of the government on this evidence, if the jury had appropriate instructions that you requested?
Mr. Matthew J. Zinn: I think we might have been in the Court of Appeals on the grounds that there was insufficient evidence to support the verdict but we wouldn't be here.
My point was Mr. Chief Justice that it's difficult for me to believe that the jury would have found for the taxpayer.
Chief Justice Warren E. Burger: But it [Voice Overlap] different case.
Mr. Matthew J. Zinn: Only a question whether the jury’s finding was clearly erroneous and we would not be in this court on that.
Chief Justice Warren E. Burger: You are only quarreling with -- really quarreling with the instruction?
Mr. Matthew J. Zinn: That is correct sir, only with the instruction.
After getting the significant motivation instruction to which the Chief Justice has referred, the jury went out shortly after five O’clock at the close of this one-day trial and it stayed-out nearly two hours.
It returned shortly after 7:00 p.m. seeking clarification of the significant motivation instruction and I refer the court to page 129 of the record at which the jury put the following question to the trial judge and I quote, “Is the question given us, intended for us to decide whether he signed the indemnity agreement solely for the protection of his salary, investment or could it be both.”
The jury it seems clear to us was somewhat confused as to how to apply the so called significant motivation instruction.
After coming back this first time, shortly after seven O’clock, the jury went out for another 40 minutes and it returned again for clarification of the instruction and I refer the Court now to page 130 of the record.
And again at this point, the jury asked and I quote, “Would you please reread your answer to our question and possibly interpret it further,” and the trial judge undertook to do that.
The jury went back to deliberate for the third time and reached a verdict favorable to Mr. Generes.
The government’s motions for judgment n.o.v. and alternatively for a new trial were denied and on the government's appeal, the Fifth Circuit by a divided vote held at the jury had been properly instructed.
Justice Potter Stewart: But the only direct evidence on the issue of what is motivation had been what you had referred us to on pages 67 and 69, is on testimony?
Mr. Matthew J. Zinn: Yes, there is other testimony, Mr. Justice Stewart that he had some hope of getting dividends of that he was trying to build up in the state for his children and so forth but that I think is the critical evidence that he did not give his investment a thought.
Justice Potter Stewart: And that is -- he testified that his sole purpose in--
Mr. Matthew J. Zinn: That is correct.
Justice Potter Stewart: Signing this indemnity agreement was to protect his job and his salary from the job.
Mr. Matthew J. Zinn: Right, and of course, if the only purpose is that purpose, we would not be here.
The whole basis of this case is that there is a duality of purpose and a single purpose case, we think is fairly clear under this court’s decision in Whipple, where the single purpose is investment purpose and under the Trent case, which we do not disagree with where the man is solely an employee, Second Circuit decision and as required as a condition to his employment.
Justice Potter Stewart: Mr. Zinn, your point is that although, the direct evidence was that his sole motivation was to protect his salary as an employee and to protect his employment itself that nonetheless the very fact that he was a stockholder.
Mr. Matthew J. Zinn: Yes sir.
Justice Potter Stewart: Entitled you to the instruction that --
Mr. Matthew J. Zinn: That is correct and it seems clear enough on this record that the jury had some difficulty in believing that that was his sole purpose because if it was, they would not have to worry about the what the term significant meant as they did worry about it and for that reason, we think that any suggestion in the respondent's brief that the error on this record may have been harmless is not well taken.
Unknown Speaker: Just because he was in fact a stockholder?
Mr. Matthew J. Zinn: Yes, and because it is obvious that the jury did not believe that his sole interest was as an employee interest, they could have decided this, it was five O’clock, they sat whole.
We think it is somewhat unusual that a jury would spend three hours on the case like this one when it is anxious to get home for dinner.
Unknown Speaker: Is there any evidence in the record about the value of these stocks?
Mr. Matthew J. Zinn: About the value sir?
We know that his basis in the stock was $38,900, the basis on this stock.
Unknown Speaker: And what was the loan of this guarantee?
Mr. Matthew J. Zinn: $162,000 as of 1962 so as far as we are concerned.
Unknown Speaker: And what was his salary?
Mr. Matthew J. Zinn: $12,000 a year.
Unknown Speaker: Do you make an argument that he really would not guarantee loan of $160,000 just to protect his $12000 salary income?
Mr. Matthew J. Zinn: I am sorry, let me go back to get the figures right, he had made direct loans to the corporation of $158,000.
Unknown Speaker: They are not an issue here.
Mr. Matthew J. Zinn: They are not an issue here, but we think they are very relevant, because the taxpayer treated those as a nonbusiness loan, that is an investment, so his investing clearly was at least $158,000, even if the stock was worthless.
Unknown Speaker: But if you add the stocks--
Mr. Matthew J. Zinn: We add the stock, it brings -- it assuming that it had a fair market value equal to its basis, we are talking about an investment of $200,000.
Unknown Speaker: But would you -- do you make the argument that no one would guarantee a loan of this amount just to protect his $12000 salary?
Mr. Matthew J. Zinn: Yes we do.
We are talking about a guarantee here about two million dollars, Mr. Justice.
Unknown Speaker: And that is why that I want to know.
Mr. Matthew J. Zinn: Yes, we think that it restrains the imagination to think that someone who was solely an employee, solely an employee now who is making $12,000 a year in a part-time job, who had some $30,000-55,000 in assets, who was over 70 years old would, if your pardon, the expression, go on the hook for up to two million dollars in order to protect this part-time job.
Unknown Speaker: On that basis why would he do it to protect the $150,000?
Mr. Matthew J. Zinn: Well, $200,000 investment and also he had other motivations we think.
After all, it was his son-in-law who was running this business and I think another son-in-law was working in the business, the stock was owned by him individually by two of his sons-in-law and a son and so we think he had significant personal motivations here as well as nonbusiness motivations.
Our position that business bad debt treatment should be allowed in a dual status situation only where the dominant motivation for the undertaking is protection of employment rests on four considerations.
The first of these arises simply from the fact that we are faced with a situation here where we must characterize a bad debt in its entirety as business or nonbusiness in nature, even though, the taxpayer was motivated by two considerations to guarantee his corporation’s debts.
Now, the Internal Revenue code might have provided him such circumstances that half of the debt should be treated as business bad debt and half should be treated as a nonbusiness bad debt.
But that is not what it does provide, the choice has to be made.
Either it is all business or it is all nonbusiness and we submit that purely from the standpoint of logic and in the absence of any overriding policy consideration, it is far more logical to have the character of the debt determined by reference to the weightier consideration rather than by the reference to a lesser consideration.
Secondly, we have referred in our brief to several analogous situations in which the tax consequences are determined by reference to the weightier consideration.
In situations were an all or nothing choice must be made just as here and the first involves the business bad debt provision itself prior to 1942, as Mr. Justice White pointed out in his opinion in Whipple, there was no such thing as business and nonbusiness bad debts, they were simply bad debts and whether they were business and nonbusiness or otherwise, that they went unrepaid, they were deductible against the ordinary income.
The substantial loophole developed in the Internal Revenue Code where loans would be made to family members and go unrepaid and taxpayers would claim an ordinary deduction against for these loans.
So one of the primary purposes of Congress's enactment of the business nonbusiness dichotomy in 1942 was to close up this loophole.
Now you could have a situation where instead of -- as we have here for the most part, we are talking about a nonbusiness investment consideration against a business consideration, where you have primarily a nonbusiness personal consideration against a business consideration.
Now under the test that respondent proposes the significant test, a business bad debt would be allowed even if the weightier consideration was its personal consideration and we submit this would be squarely contrary to the congressional intent in 1942.
Similarly, as Mr. Justice Brennan pointed out in the Hartman case, one of the purposes of the 1942 legislation was to put nonbusiness investments in the form of loans on a footing with nonbusiness investments in the form of stock and the courts have held that where corporate stock is purchased both for business reasons and investments reasons, that dominant motivation is controlling and characterizing with that loss.
Again, to put the two on an equal footing, only the dominant standard can be applied.
Finally, we refer to the fact that in the legislative history of section 166, there are references to applying the same test as is applied under section 165, in determining whether an expense is incurred or a loss is incurred in a trade or business or in a transaction entered into for profit.
And under the Section 165 it is clear that the dominant standards controls.
And thirdly, a point that I referred to in answering Mr. Justice Stewart, we think the dominant standards is far easier to apply by a jury than the significant standard and we think it is necessary only to the point to what happened in this particular case and the difficulty that the jury encountered.
And lastly, we rely on the opinion in the Whipple case.
The gist of the opinion, it seems to us is that a presumption exist against the allowance of business bad debt treatment to stockholders whose interest on not subordinate to the interest of other stockholders and this is just as it should be, because it is a rare case in which an employee with no other interest in the corporation would undertake to advance substantial funds to a guaranteed debts of his corporation.
Application of these significant standard we believe would go a long way toward overcoming the presumption in the Whipple case as it can be seen from this case itself.
A taxpayer maybe able to overcome it simply by testifying that he did not give his investment a thought.
I should like to retain my remaining time for rebuttal, Mr. Chief Justice.
Unknown Speaker: Mr. Zinn, this is of no relevance but this case of course came up to the District Court.
Mr. Matthew J. Zinn: Yes, it is Your Honor.
Unknown Speaker: Why is it that your appendix make reference to the United States Tax Court on page one.
I assume this is an error.
Mr. Matthew J. Zinn: The record sir?
Unknown Speaker: Page one at very top, the United State Tax Court, Is this an error?
Mr. Matthew J. Zinn: Yes sir.
Chief Justice Warren E. Burger: Mr. Nathan, you may proceed.
Argument of Max Nathan, Jr.
Mr. Max Nathan, Jr.: Mr. Chief Justice, and may it please the Court.
May I say that that is not the only error that the government has made in this case.
I submit that they are attempting to mislead this court, not only as to basic facts that are involved but also as to proper interpretation of the statute.
I think it might be best if I started out by pointing out that Mr. Allen Generes was not a mere investor, as that term has been used by this court and as the government has used it here.
There is no dispute whatsoever that Allen H. Generes had as a trade or business being a Corporate Executive for a salary.
The government stipulated to that fact with me at the trial of this case and it is in the record.
So we have stipulated that he had been serving the corporation and receiving a salary as a trade or business.
Chief Justice Warren E. Burger: Where do we find that in the record, I would like to see the scope.
Mr. Max Nathan, Jr.: That is in the Pretrial Order, Your Honor, in the Pretrial Order that is issued.
Chief Justice Warren E. Burger: Can you give me the page?
Mr. Max Nathan, Jr.: I do not recall it right now.
Chief Justice Warren E. Burger: It will not take any of your time.
Mr. Max Nathan, Jr.: We have also agreed that it was stipulated with this that the taxpayer may have more than one trade or business.
As Mr. Generes did have, he was the President of Central Savings and Loan Association, for which he also received a salary.
The point here is that he rendered services to this corporation.
He received a salary of some $12,000 a year.
He was not a majority shareholder, he only owned 44% of the stocks in his corporation and no conclusions I submit can be drawn from the fact that his son-in-law happened to be also an owner of 44% of the stock.
The son-in-law had a separate different business prior to the early 1940's when these two men form the partnership together and when they incorporated, they each owned the same amount of stock but they rendered different services, they received different salaries and Mr. Generes did render services and the only evidence in the record is that the investment in this corporation was $38,900.
Now the government --
Unknown Speaker: Again the question Mr. Justice White asked, is there anything on the record showing the actual value of that investment?
Mr. Max Nathan, Jr.: No, there is not Your Honor.
Unknown Speaker: Just the book--
Mr. Max Nathan, Jr.: The evidence is that Mr. Generes deducted $38,900 in the year that the corporation went under asset capital loss.
That was his investment in the corporation, that is the only evidence in the record and the government had the opportunity to introduce such evidence if it wanted too.
Unknown Speaker: And this was the opportunity to show that it was not a lesser value than that.
Mr. Max Nathan, Jr.: That is correct.
Unknown Speaker: If he wanted to.
Mr. Max Nathan, Jr.: Yes, but we acknowledged that that was the proper value.
We never had any question about that, as a practical matter.
What you really get down to here is that over a number of years, this company was in the contracting business and you are talking about a very unique kind of business, you are talking about a business that was engaged in municipal public works contract for which they had to have payment and performance bonds and I have in testimony introduced of the Vice-President of Maryland Casualty Company, by a local insurance agent.
All of them testified, we will not grant payment in performance bonds to small corporations without the personal endorsement of the principal officers of those corporations.
As a result of this, Allen Generes and his son-in-law William F. Kelly agreed to indemnify the bonding company for writing bonds for the corporations.
It was the only way the corporation could have gotten bonds and the only way the corporation could have stayed in business.
And consequently over a number of years this was done.
Finally in 1958, a blanket indemnity agreement was executed and this is why you talk about two million dollar exposure.
The government is strongest scarecrow, I mention here, when I say, “Look he is endorsing -- why would he expose himself to two million dollars worth of liability for a simple $12,000 a year?”
The fact of the matter is, you are not really exposing yourself to anything like two million dollars worth of liability.
This meant merely that Maryland would bond contracts which aggregated a contract price of two million dollars.
That meant the corporation had contracts to perform.
It meant there would be money paid on those contracts.
There would be retainage, there will be stage payments.
Mr. Generes would only be liable to Maryland.
If the corporation did not perform the contracts and if the amount of retainage that was left in the contract was insufficient to pay Maryland off and then you had all the assets of the corporations to go against before Mr. Generes would become liable.
Chief Justice Warren E. Burger: But, I understand that argument being made by the jury and I assume you argued that proposition to the jury.
Mr. Max Nathan, Jr.: I did Your Honor.
Chief Justice Warren E. Burger: And perhaps you would have prevailed with the jury conceivably even under the government’s instruction.
Mr. Max Nathan, Jr.: Your Honor, I submit that we are entitled to prevail on the governments instruction and I contended throughout, that this was his dominant motivation --
Chief Justice Warren E. Burger: But your brother wasn't -- the government is requested the instruction was given --
Mr. Max Nathan, Jr.: By the government, it is absolutely not.
Chief Justice Warren E. Burger: Is that the only issue in this case?
Mr. Max Nathan, Jr.: That is correct.
At the time this case was tried you had the Waddell decision from the Second Circuit which had said, in a majority opinion that is significant motivation was the proper test.
And Judge Alvin Rubin who was I think, and I submit to this court, one of the most respected judges in the country in the field of tax laws, believe that the Waddell decision was correct and so instructed the jury.
In fact, it is very interesting if you read that complete charge, you will find that that charge lasted over one hour.
There are some 4500 words in it.
Almost every charge the government submitted to that jury, most of them unfavorable to the taxpayer where used examples and illustrations of business bad debts were given to the jury taken directly from the governments requested charges, they have picked one word in one paragraph from an hour long jury trial and they have ceased on that to submit that there is reversible error here.
Justice Thurgood Marshall: But the government also said that when the jury came back three different times, they were only interested in one word in that whole, how many thousand word opinion?
Mr. Max Nathan, Jr.: 4500.
Justice Thurgood Marshall: But they were only interested in one word, that is what the President said, is that right?
Mr. Max Nathan, Jr.: That is just a position your honor.
Justice Thurgood Marshall: Why you think about it that it is significant?
Mr. Max Nathan, Jr.: I think that significant motivation is a proper test to apply and I submit that it is the only workable test under the statute and that what the government is asking and the what the Solicitor General was asking you to do is to rewrite Section 166 of the Internal Revenue Code as they wish it had been written instead of as it was written.
I would submit to the court that if you look at the statute itself, you find that prior to the 1954 code, you had only one definition of business bad debt and that was a debt that was incurred in the trade or business.
That is the language of the statute, the 1939 code said the debt must be incurred in the trade or business.
Then in 1954, you have section 166 amended and you have a new Section added.
The old language that a debt which is incurred in the taxpayer’s trade or business is kept and a new test is also given and that is in page 36 of the petitioners brief, the statute decided which says and it is a backhanded wording, I submit that is one of the problems.
It defines non-business bad debt and it says, it is any debt other than a debt created or acquired as the case may be in connection with a trade or business of the taxpayer and I submit to the court that you have got to look at those words in connection with a trade or business.
That does not require the direct relationship that a loss incurred in the trade or business would require.
Unknown Speaker: I guess you are contending that if the treasury regulations instead of saying proximate, and said primary, it must be the primary motivation as the regulation had been invalid under this Act?
Mr. Max Nathan, Jr.: I think so your honor, I submit to you that the Congress of the United States should have said primarily in connection with the trade or business if that is what they had intended.
Unknown Speaker: You are relying on the statute rather than the regulation?
Mr. Max Nathan, Jr.: Your honor, I submit the regulations are correct because the regulation say that they interpret in connection with to mean there must be a proximate relationships.
Unknown Speaker: Yes, but the treasury interprets its his own regulation that it says that proximate means primary.
Mr. Max Nathan, Jr.: We do quarrel with that.
We had no quarrel with the use of the word proximate, I think I could not do so this court has inferentially approved the test of proximate relationship, I think your honor--
Unknown Speaker: But we certainly have to settle this case.
Mr. Max Nathan, Jr.: Absolutely not, I hope you have a --
Unknown Speaker: In prior, in prior—
Mr. Max Nathan, Jr.: I think not.
No, this case has not been before this court before.
It has been before three Circuits.
I think this point has not been before the court.
My point here is that the proximate, as this court has inferentially approved that I think perfectly proper.
Then the question is what do you mean by proximate and I would say that a significant relationship will be proximate and that is the basis of the argument.
You have got a statute which if congress had so intended, it might easily have said a debt created or acquired primarily in connection with a trade or business, that would have resolved the matter, I could not be here arguing the significant motivation test if Congress have said that.
What the Solicitor General is attempting to do is to amend a statute by inserting a word that Congress itself did not put in.
Unknown Speaker: Do you think it is a matter of law in connection with the trade or business means that it must be a business bad debt, if it is incurred for two reasons, one is business reason and one is non-business reason?
Mr. Max Nathan, Jr.: Provided the business reason bares this is a significant relationship.
Unknown Speaker: Let us say it be 50-50.
Then 50-50 is take in connection with the necessarily means that it is a business bad debt, even though 50% of the reason is that it is not in connection with the business.
Mr. Max Nathan, Jr.: That is correct but I would submit that there is a significant relationship in the business relationship area that gives rise to a business bad debt and if Congress did not intend that result, all Congress had to do was say primarily in connection with and that would have ended the matter and they have done that in other section of the code.
This court has interpreted other of the section to the code as for example with the capital assets, we talked about primarily for sale in the ordinary course of business and the court is interpreted the word primarily and that would have put it in to the matter here but when they say in connection with, this Commissioner of Internal Revenue issued its own regulations and used the word proximate.
I said that is what is meant here, a proximate relationship.
And then of course they get annoyed when the courts look at the word proximate and as the Second Circuit did and as the Fifth Circuit did, they see that there is an analogy in the tort law, they have not drawn on the tort law but we know that you may have more than one proximate clause and all that we are talking about there is certain nearness, a certain importance.
The point here is that this will not give rise to baseless deductions.
You cannot blame a business bad debt unless there is a significant relationship between the loss or the debt and the employees’ trade or business.
And I would submit that that test is just as easy if not easier to apply by juries and I think it is more flexible.
It is fairer to the taxpayer and it is fairer to everyone.
Justice Thurgood Marshall: Mr. Nathan, Is there anything in the record to show how many businesses, this man was in?
Mr. Max Nathan, Jr.: Only I think inferentially your honor because he had as one trade or business, that of being President of Central Savings and Loan Association.
He had another trade or business --
Justice Thurgood Marshall: Well, now you are struck with the fact that a man that can take $200000 out of his watch pocket, could not get that $12000 a year?
Mr. Max Nathan, Jr.: Mr. Justice Marshall, if I may have, I guess I would have to depart from the record but this man had to go out and mortgage everything he owned in order to come up with his money at the end.
Justice Thurgood Marshall: I feel you should not go out of the record but what is in the record, that this man has $12000 a year interest, job wise, he is willing to put $200000?
Mr. Max Nathan, Jr.: Your honor that would be somewhat misleading because what happened was that in 1962 of the end of the game really -- this corporation which had been having millions of dollars of business every year, in 1962, they seriously under bid two major contracts and the corporation became default -- they defaulted on those contracts and Maryland stepped-in in order to try to bail out the corporation and to salvage the operation.
Then in 1962 Mr. Generes made loans to the corporation of a very substantial amount, you are right.
He tried to salvage the corporation at a time when it was going under and I submit that is a big difference.
There you are talking about loans to the corporation and Mr. Generes deducted those as nonbusiness bad debts because he loaned them to them and the last year at a time when the corporation was going under.
What we are talking about in this case is not a loan to the corporation, it never was and it is misleading if we try to think of it as a loan of a corporation.
This was an agreement to a bonding company to personally indemnify that bonding company, if the bonding company would write bonds for the corporation.
In other words you started back years early.
In order to stay in business and in order to have a going business you needed bonds as a fact of life in the construction business.
Kelly-Generes Construction Company could not get jobs, if it could not get payment in performance bonds and it could not get payment and performance bonds without the personal endorsements of Allen H. Generes and William F. Kelly and as a result, Generes and Kelly both agreed to Maryland we will personally indemnify, that is not a loan to the corporation and the issue in the case was in executing the agreement to indemnify the bonding company, what was Generes’s motivation?
Now, the trail judge charged this jury that there are number of factors that they should consider and only one was the motivation but the test has now boiled down and got into this court is when he executed that indemnity agreement agreeing to indemnify Maryland so that the corporation could get bonds and go as a growing concern, he was probably was significantly motivated by the desire to protect his trade or business as a salaried option.
Unknown Speaker: What if they ruled -- assume that is business which has got a partnership, there wouldn't have been any question?
Mr. Max Nathan, Jr.: They never would have been any necessity for him to sign indemnity agreements with Maryland because then as a partner he would have been personally involved.
Unknown Speaker: But let us say he had to guarantee the bank loan.
Would there have been any question about it?
Mr. Max Nathan, Jr.: As a partner or in a corporation your honor?
Unknown Speaker: Its a partnership?
Mr. Max Nathan, Jr.: Again, he would not been personally allowed.
As a partnership, there would have been a necessity.
He can find the partnership and he as a partner would have been bound.
That raises very sticky points and I apologize for this, that the case arises from Louisiana and we have the Civil Law system and not the Common law which does creates in problems that I would rather not.
I will be happy to discuss the problems of partnership law in Louisiana but we make distinctions that are not made in the other states.
Unknown Speaker: Mr. Nathan, I am a little intrigued by comparative values here as I read these briefs, there is a good bit of talk about the value of the investment on the one hand in the salary on the other.
And all was the latter as referred to as $12000.
The difficulty I have is that the investment consists of tax paid dollars.
The salary consists of pretax dollars and hence my inquiry of Mr. Zinn as to find to get some feel for the tax bracket in which this man was, actually he is not protecting the $12000 net salaries, protecting the $12000 gross salary on your approach which I assume in actual dollars mean something far less than that doing.
Maybe $7000 or so, would you agree?
Mr. Max Nathan, Jr.: I think that is correct your honor.
But again, we do not have all of Mr. Generes’ tax returns in the record of his salary, his total income aggregated about $40000 per year.
The man had formed simple Savings and Loan Association in the 1930's and had always been the President and General Manager and he always had a good salary from that.
He had been in the contracting business long before he ever set up Kelly-Generes Construction Company.
He started out in the contracting business, he had many years of experience on it then he formed the partnership with his son-in-law in the 1940's during World War II and had been only in 1954 that they actually incorporate.
And at that point he became the owner at 44%, at that stage of the game, the investment in the corporation was $38900 and I think in order to find out what the value of that investment was and eight years later, you would have to look at all of the corporate returns and see what income the corporation had generated and so forth.
It could require a massive amount of work which we have not gotten into it at this point.
Unknown Speaker: But my inquiry is directed to the other side of the scale and I think what I am saying is that the $12000 salary, if one argues that this is what he was trying to protect in the way of cold dollars in his pocket, is a little misleading that something far less than that.
Mr. Max Nathan, Jr.: In the sense that he would have to take into consideration that he would pay ordinary income tax on his salary, I think that is correct.
Unknown Speaker: But I think the balance, if there is one is the investment on one hand against maybe $7000 pre-state income tax on the other.
Do you have an income tax?
Mr. Max Nathan, Jr.: Yes, we do your honor.
Unknown Speaker: So it is even less than—
Mr. Max Nathan, Jr.: But it is a very nominal income tax, I think it is 2% and in --
Chief Justice Warren E. Burger: Suppose that we take that approach Mr. Nathan, we would have think this on what to be the cost of the single premium annuity would produce $7000 a year at the given age of this man, you said he was around or someone that he was around 70?
Mr. Max Nathan, Jr.: He was 82 at the time of the trial.
He found it a very high premium I had submit here your honor.
But the main point is that the initial investment was only $38000—
Chief Justice Warren E. Burger: I suggest contrary, Mr. Nathan, it would be quite low premium for an annuity, a high premiums for life insurance, low premium for an annuity.
Mr. Max Nathan, Jr.: That is correct.
There is actually no way of knowing the exact amount of the investment as of 1962 but the point is that you have got a continuing indemnity agreement, I might submit that would cast some light on this that starting at the outset in 1954, at the time the initial investment was made, the bonding companies were then requiring personal endorsements and what happened was that every time Kelly-Generes got a bond or bid on a job and they had a job available to, and they needed a bond, Allen Generes and Bill Kelly went to Maryland Casualty and got a bid of bond and they personally agreed to indemnify Maryland Casualty Company and it was found that that was very inconvenient and as a result in 1958, a blanket indemnity agreement was executed so that you did not to keep going to Maryland with each job that was bid.
The corporation did have assets, we can not deny it, there is testimony in the record that would give some indication there that there were some substantial assets but that these where mortgaged up to the hilt.
Chief Justice Warren E. Burger: Does this record show Mr. Nathan the comparative deal to these gentleman out of the corporation by way of dividends and salary?
Mr. Max Nathan, Jr.: It does, there were no dividends paid.
This corporation never paid a dividend ever since--
Chief Justice Warren E. Burger: But it was only stake in that sense was the ten year existence of the corporation to continue the salary.
Mr. Max Nathan, Jr.: That is correct, it was a closely held corporation, that did have the son-in-law, then they were other son-on-laws who had about 12%, I think it is the stock of the corporation but throughout its history, the corporation never paid a dividend but it did pay his salary and it paid the salary every year and there are some years, in fact the record does show, that there were some years when the corporation operated at a deficit.
And I think over a $40000 dollar deficit of one year projected, continued to pay these salaries.
Chief Justice Warren E. Burger: But what about tort bill, lot of corporations make money and they will pay it out.
Mr. Max Nathan, Jr.: That is correct but none of those tax returns are in the record your honor.
And it was only incorporated in 1954.
We do not know what it did --
Chief Justice Warren E. Burger: That is not -- the tax is not paying the dividends; it is not really very successful.
Mr. Max Nathan, Jr.: No, but the main point is there was no return here to this man that is the kind of return that is peculiar to an investor --
Chief Justice Warren E. Burger: But the investment was the increase in every year rather substantial stake --
Mr. Max Nathan, Jr.: It would be, he was receiving a salary every year and this is what he testified -- primarily motivated, as a matter of fact, he testified that was his sole motivation when he did it and there was testimony by other parties that would support that but I would submit that in concluding, your honor, that even under a dominant motivation test as the government argues that Allen H. Generes was predominantly motivated to protect that salary the he was receiving of $12000 a year and I think that the important question --
Unknown Speaker: We would decide that question --
Mr. Max Nathan, Jr.: That is correct your honor, but I would submit that the important point for this court is the interpretation of section 166 of the Internal Revenue Code and there is where you get down the question of whether the significant motivation is the proper test or whether the dominant motivation is the proper test and for the reasons set forth in our brief and primarily because Congress itself did not save primarily in connection with the trade or business but simply in connection with the trade or business which the commissioner says and as this court has inferentially approved, there must only be a proximate relationship and I submit just as there maybe more than one cause, a man may have more than one motive.
You will not necessarily find that it is going to be easier for juries to sit down and weigh a man's motivations and decide which is the dominant and which is the less dominant anymore.
So it maybe much easier to look at one motive and decide is it significant or is it not significant and you are not going to be opening the doors to baseless deductions by simply saying the in connection with requirement means that there must be a significant relationship.
Juries do not have that much problem with the meaning of the word significant and I would submit that means important and they would know I think it would be just as easy to determine between significant and insignificant motivations as it maybe to try to weigh on a scale, the difference between a dominant motive and a less dominant motive.
For those reasons, I submit to this court that the trial judges charged to the jury was imminently fair and must imminently appropriate and that the decision of the Court of Appeals was proper and I urge the affirmance of the Court of Appeal’s decision.
Unknown Speaker: Until this case, the leading case in this field has been Waddell, the Waddell case, the opinion written by Judge Finley?
Mr. Max Nathan, Jr.: That is correct your honor.
Unknown Speaker: It appeals to the Second Circuit.
Mr. Max Nathan, Jr.: I do not know.
It is very interesting, that government made the point that if you adopt the significant motivation test, the government is going to lose every one of its cases and everybody would get a business bad debt deduction and in the very case, they decided the Waddell case, the taxpayer lost because taxpayer could not prove a significant motivation to protect --
Unknown Speaker: Didn't the Seventh Circuit decide the contrary?
Mr. Max Nathan, Jr.: The Seventh Circuit --
Unknown Speaker: And they blocked two years after Waddell --
Mr. Max Nathan, Jr.: That is correct, the Seventh Circuit in subsequent to the--
Unknown Speaker: (Inaudible)
Mr. Max Nathan, Jr.: That is correct.
Unknown Speaker: Yes.
Mr. Max Nathan, Jr.: There have been any number of other cases, in fact I might say to this court that the Generes case which we are now arguing to you has been noted in three law reviews since it has been decided.
It just came out, since our briefs were written and we had to submit memos, if the court wants.
Unknown Speaker: And besides it really was not really critical in Waddell to decide the standard, was it?
Mr. Max Nathan, Jr.: I do not think so.
Under either theory, the taxpayer could not win and that of course may very well happen if this court approves a significant motivation test.
But even under significant, if you cannot prove the significant relationship then the taxpayer cannot prevail even on that matter.
Unknown Speaker: The Court of Appeals did not even reach the standard question in Waddell right?
Mr. Max Nathan, Jr.: I did not argue the Waddell case your honor and I was not privy to all but it transpired in the case so I would not want to take that position but I would submit that the reasoning of the majority opinion in the Waddell case is very persuasive and I think it is absolutely correct.
Unknown Speaker: I would be interested in those law reviews citations, and otherwise you have --
Mr. Max Nathan, Jr.: It is right here with me, Your Honor.
You want the one that's in Texas Tech University law reviews at volume two, number two, beginning at page 318.
The other is in the University of Florida law review and I am sorry, this does not have the law review --
Unknown Speaker: Well perhaps, you can just submit it to the court.
Mr. Max Nathan, Jr.: I might say that they can split the same way the Circuits have but as again, they have gone 2:1 saying that the Generes case was properly decided by the courts below.
Chief Justice Warren E. Burger: Mr. Nathan, I noticed you hear this several times the phrase “in connection with” and perhaps I am looking at the wrong paragraph.
Were you paraphrasing?
Mr. Max Nathan, Jr.: I see No, it is a page document—
Chief Justice Warren E. Burger: Mr. Brennan just pointed out “in connection with” “in the course of, if is the paragraph that I was looking at.
Do you see a difference between the language “in connection with” and “in the course of”?
Mr. Max Nathan, Jr.: Yes, I think.
I do not say that there would be a significant difference between the two.
“In the course of” I think it shows a directness that “in connection with” does not have, just as here in Section 166; you have an A and the B.
The B says, a debt which is “incurred in.”
When you have an “incurred in,” there is a directness that I think is not the same as when you say a debt created or acquired “in connection with” a trade or business.
I would submit that by doing that Congress is saying, it does not have to be directly incurred in the business.
The relationship, as the Commissioner interpreted that must be proximate and then the question is Commissioner did not define proximate and we have to come along and define it.
That is basically what the trial judge charged the jury on that there must be a proximate relationship and I would submit just as in tort law whether there maybe more than one proximate cause, here there maybe more than one motivation and what you are looking at is the significant motivation.
I think and if the business relationship between the Taxpayer’s Act, the debt and the loss, if there is a significant relationship between that debt and the trade or business of the taxpayer then I submit that under 166 as written, the taxpayer is entitled to a business bad debt deduction and if the Commissioner of Internal Revenue disapproves of that, he wants them to have the predominant test or the dominant motivation then they should go to Congress and get Congress to amend Section 166 and say a debt created or acquired as the case maybe primarily in connection with the trade or business.
That would have resolved the point and I would not have the nerve to argue a significant motivation test to the court if Congress had put in the word 'primarily' as they have in many other sections of the code.
But they did not put it in and the Solicitor General wants you to put it in for them.
Chief Justice Warren E. Burger: Thank you Mr. Nathan.
Mr. Max Nathan, Jr.: Thank you very much your honor, it is been a pleasure and a privilege for me to appear before the Court.
Chief Justice Warren E. Burger: Glad to hear you Mr. Nathan.
Mr. Zinn, you have six minutes left.
Rebuttal of Matthew J. Zinn
Mr. Matthew J. Zinn: Thank you Mr. Chief Justice.
I should like to respond first to the principal argument which respondent makes here, it was the principal argument in his brief which focuses on subsection capital A of Section 166(d) 2, the 'in connection with' language.
As I understand the argument of respondent, he conceives that subsection B would not be sufficiently broad to allow a significant motivation standard.
Now first of all, let me point out to the court that the term proximate as it appears in the regulations under that we have quoted on page 37 applies only to subsection B, that regulation was there long before the code was amended in 1954 to add subsection A.
And we have pointed out on page 15 of our brief in footnote seven, what Congress's purpose was in enacting subsection A and it is really quite simple.
Under the law as it existed before 1954, a taxpayer who acquired a debt when he was in a trade or business and then went out of the trade or business before a final determination was made as to the worthlessness of the debt was entitled only to a nonbusiness bad debt.
The sole purpose of subsection A, as we have stated in footnote seven was to make it clear that if the taxpayer went out of business after having acquired a debt in a course of a trade of a trade or business and then the debt became worthless, he would get a business bad debt.
But this court to read in to that edition of subsection A, all that respondent urges, it seems to us would be making an awful lot out of a little.
And I urge the court to read legislative history of subsection A, it is very short and that is the sole purpose of the addition.
As far as the absence of the word primarily, I would make two points, first it seems to us that just as we are trying to read the word 'primarily' into the statute, the respondent is trying to read the word 'significantly' into the statute.
We think there is a gap there that this court has to fill and it is not a one sided gap.
It has to be filled one way or the other.
Congress simply did not contemplate this dual status case when it enacted the statute.
Chief Justice Warren E. Burger: Would you agree with Mr. Zinn that if Congress had put the word 'primarily' before the words 'in connection with' the whole task would be a big deal simplifying --
Mr. Matthew J. Zinn: I do not think we would be here Mr. Chief Justice but I think if they had put the word significantly and we would not be here either.
There is a gap there --
Chief Justice Warren E. Burger: They have used this term 'primarily' in many, many other contexts?
Mr. Matthew J. Zinn: Yes, they have but under one Section 165(c) 2 which appears on page 35 of our brief, it is referred to there as whether a loss is incurred in the transaction entered into the profit and the very same Second Circuit which held adversely to the government in Waddell has held that if loss incurred in a transaction entered into for profit, you have to look at the primary motivation of the taxpayer.
We have cited the Austin case in our brief to that effect.
The taxpayer there purchased a residence both for personal purposes and to make a profit.
It was found that the primary purpose was personal and that was the end of the case and the word 'primarily' does not appear in section 165(c) 2 as well as in section 166(d) As far as the word proximate, we would only note again that so far as the tort law is concerned, the considerations are entirely different.
You can hold more than one tort fees are libel.
Here, we have to go back to the fact, what choice has to be made?
That simply is not the case in the tort law, you can hold two or three or a greater number tort fees as libel for single tort.
And I guess, I even pointed out except in passing that the considerations that have expanded notions of proximate cause are wholly different from those that this court has to take into account in deciding this case.
One final point Mr. Nathan would have this court draw a severe distinction between loans and guarantees.
But we do not think that is permissible under the decision of this court in the Putnam case.
Mr. Justice Brennan, their writing for the court held loans and guarantees ought to be considered the same for purposes of interpretation of the bad debt provision of the code.
For these reasons then we urge reversal of the judgment below.
Justice Byron R. White: Can I ask you, it is accepted on both sides that a loss form a debt incurred just to protect an investment isn't a business debt, isn't a business loan?
Mr. Matthew J. Zinn: We of course agree with that.
I assume that the –
Justice Byron R. White: I know, but that is a --
Mr. Matthew J. Zinn: We agreed Mr. Justice White that the Trent case was correctly decided.
That is where the person is solely an employee and is required as a condition to continuing employment to make a loan or guarantee its corporation’s debts, we would agree that that is incurred in a trade or business.
Justice Byron R. White: And a loss of a kind that I was asking you about wouldn't be a deductible loss?
Just the loss of an investment is not a deductible loss?
Mr. Matthew J. Zinn: It is deductible as a capital loss but not as an ordinary loss.
Justice Byron R. White: It is not a transaction entered in to the profit.
Mr. Matthew J. Zinn: That is right, but it is a transaction, are you talking about the stock investment?
Justice Byron R. White: I am talking about 155.
Mr. Matthew J. Zinn: An investment loss?
Justice Byron R. White: Yes.
Mr. Matthew J. Zinn: It is deductible.
Justice Byron R. White: I mean I guess, a loss from a transaction entered into for profit is deductible loss.
Mr. Matthew J. Zinn: Yes, it is.
Justice Byron R. White: But an investment, isn't such a thing.
Mr. Matthew J. Zinn: That is right because it is subject to the capital asset limitations.
Chief Justice Warren E. Burger: Thank you Mr. Zinn, thank you Mr. Nathan.
The case has submitted.