Rev. Rul. 69-458

Advice has been requested as to what type of loss was sustained, and when it was deductible, by individual taxpayers who bought stock from a securities corporation that subsequently became bankrupt and did not deliver the stock.

The securities corporation represented to the individual taxpayer purchasers that the stock in question was being sold from its own inventory. Subsequently, it was discovered that the securities corporation did not have sufficient shares in its inventory to fill the orders, and a petition in bankruptcy was filed on behalf of the securities corporation. The representations with respect to the stock were not made with any intent to defraud.

The purchasers paid cash to the corporation to fulfill their obligations in the transaction. None of the purchasers was a dealer in securities. The stock was never delivered to the purchasers by the corporation and no refund of the money was made.

Section 166(d)(1) of the Internal Revenue Code of 1954 provides that nonbusiness bad debts are deductible as short term capital losses in the year in which such nonbusiness bad debts become worthless. Section 166(d)(2) of the Code defines a nonbusiness bad debt as a debt other than (1) a debt created or acquired in connection with the taxpayer's trade or business, or (2) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.

However, as provided in section 1.166-1(c) of the Income Tax Regulations, only a bona fide debt qualifies for purposes of section 166. A bona fide debt is defined in that section of the regulations as a debt that arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. A debt can be created by a contract or by operation of law. Birdsboro Steel Foundry & Machine Co. v. United States, 3 F. Supp. 640 (1933).

Section 165(c) of the Code provides, in effect, that losses incurred by individuals in a trade or business or in a transaction entered into for profit are deductible in full. However, section 165(f) of the Code provides that losses from the sale or exchange of capital assets are allowed only to the extent allowed in sections 1211 and 1212.

The taxpayers in this case come within the literal language of section 165(c)(2) of the Code inasmuch as their intent was to make a profit. Likewise, all of the taxpayers come within the literal language of section 166 of the Code. When their right under the contract for the delivery of the stock became unenforceable, their claim against the securities corporation became a right for repayment of money and a bona fide debtor-creditor relationship was, by operation of law, created within the meaning of section 1.166-1(c) of the regulations.

The Supreme Court of the United States held in Spring City Foundry Co. v. Commissioner, 292 U.S. 182 (1933), Ct. D. 829, C.B. XIII-1, 281 (1934), that the loss provisions and the bad debt provisions of the tax law are mutually exclusive; and that a transaction coming within the literal language of both the loss provisions and the bad debt provisions must be treated as a bad debt. The Court stated:

The making of the specific provision as to debts indicates that these were to be considered as a special class and that losses on debts were not to be regarded as falling under the preceding general provision [relating to loss deductions]. What was excluded from deduction under [the provision for deducting bad debts] can not be regarded as allowed under [the provision for deducting losses] * * *

Therefore, the losses sustained by the taxpayers who bought stock from the securities corporation that subsequently became bankrupt and did not deliver the stock, are controlled by the bad debt provisions set out in section 166 of the Code. The taxpayers are entitled to deduct these losses as short term capital losses, under the nonbusiness bad debt provisions of section 166 of the Code, in the taxable year in which the debts became worthless.