T.C. Memo. 1998-151



                       UNITED STATES TAX COURT



    MANAHARLAL C. PAREKH AND ELIZABETH PAREKH, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 21418-95.                      Filed April 27, 1998.



     Michael D. Cropper, for petitioners.

     Michael C. Prindible, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     VASQUEZ, Judge:    Respondent determined deficiencies in

petitioners' 1990 and 1991 Federal income taxes in the amounts of

$117,021.24 and $12,343.39, respectively.

     All section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure.
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     The issues for decision are:   (1) Whether petitioners are

entitled to a deduction under section 162 or under section

165(e)1 for a $450,000 payment in connection with a guarantor

agreement; and (2) whether petitioners may include the $450,000

payment in computing net operating losses (NOL's) from the

bankruptcy estate of petitioner Manaharlal C. Parekh.

                         FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.   Petitioners, husband and

wife, resided in Odessa, Texas, at the time they filed the

petition in this case.   Petitioners filed joint Federal income

tax returns for the 1990 and 1991 taxable years.

     Manaharlal C. Parekh (petitioner) is a thoracic and

peripheral vascular surgeon who practices in the Midland/Odessa

area of Texas.


     1
        At trial, petitioners raised for the first time the
deductibility of the $450,000 payment under sec. 165(e) as a
theft loss. We will not, as a general rule, consider an issue
raised for the first time at trial since it has not been properly
pleaded. See Estate of Mandels v. Commissioner, 

, 73
(1975). When issues not raised by the pleadings are tried by
implied consent of the parties, however, the issues shall be
treated as if they had been raised in the pleadings. Rule 41(b).
The parties satisfied Rule 41(b) when they introduced the issue
at trial and acquiesced in the introduction of evidence on that
issue without objection. LeFever v. Commissioner, 

,
538-539 (1994), affd. 

(10th Cir. 1996); see also
Hardin v. Manitowoc-Forsythe Corp., 

, 456 (10th Cir.
1982).
                                - 3 -


     During the years in issue, petitioner's close friend Ignacio

Cisneros (Cisneros) was involved in insulation manufacturing.     In

November 1984, Cisneros introduced petitioner to Dwight Chester

Wheeler (Wheeler).   Cisneros, Wheeler, and petitioner were

interested in constructing an insulation manufacturing plant (the

plant).    Hoping to generate revenue for the construction of the

plant, petitioner, Cisneros, and Wheeler met on several occasions

to discuss investment opportunities.    On April 1, 1985, the three

formed a partnership called Permian Energy Co. (the partnership)

to invest in producing oil and gas properties.

     Over a period of several months, Wheeler showed petitioner

various oil wells2 (the wells) which were producing very little

oil and encouraged petitioner to put money into the partnership

so that the wells could be "worked over".   Wheeler advised

petitioner that oil and gas production would increase if the

wells were "worked over" by perforating different zones in the

geological formation.    In order for the partnership to work over

the wells, petitioner contributed additional funds to the

company.

     The partnership's checks required at least two signatures to

draw on its account.    Petitioner, Cisneros, and Wheeler had the

authority to sign the checks.   During initial operations of the

     2
        It is not clear from the record, but it appears that
Wheeler initially owned the oil leases and he contributed them to
the partnership.
                                - 4 -


partnership, Wheeler advised petitioner that he needed blank

checks drawn on the partnership account to pay for oil field

services.   Petitioner allowed Wheeler access to the requested

checks.

     From April 1 to about May 1985, the partnership had spent

$250,000 to $300,000 in working over four or five oil wells, and

production had not increased.   Wheeler approached petitioner

several times about acquiring a package of leases on "good-

producing wells" from Amoco Oil Co. (Amoco).

     On July 31, 1985, the partnership was incorporated and

became Permian Energy Co. (PEC).   Petitioner was the sole

shareholder of PEC.    The members of PEC's board of directors were

petitioners and Cisneros.

     On September 27, 1985, the board of directors of PEC

authorized and directed petitioner and Cisneros to borrow up to

$1,900,000 on behalf of PEC for the purpose of purchasing certain

oil and gas properties from Amoco.      On October 1, 1985, PEC

borrowed $1,700,000 from InterFirst Bank Odessa, N.A.,3 (the

bank) to purchase those oil and gas properties from Amoco.        PEC

and the bank executed a promissory note (the note) with an

original maturity date of October 24, 1986.      Petitioner

guaranteed the note.   After several extensions of the maturity

     3
        InterFirst Bank Odessa, N.A., subsequently became First
Republic Bank Odessa, N.A., then became NCNB Texas National Bank
of Odessa, Texas, and now is known as NationsBank.
                                 - 5 -


date, the bank and PEC agreed to a final maturity date sometime

in 1988.

     From 1986 to 1989, there was a substantial decrease in oil

production from the wells that PEC had purchased.    Additionally,

the posted crude oil prices dropped from $28 per barrel in July

1985 to $14.85 per barrel in July 1988.     PEC reported gross sales

and net losses for tax purposes as follows:


           Year Ending      Gross Oil &
             June 30        Gas Income          Net Loss

             1986              $1,649,035       $36,219
             1987                 557,892       653,955
             1988                 642,479       305,313
             1989                 177,763        85,719


Theft Loss

     On November 11, 1985, petitioner and Cisneros suspected that

Wheeler had misappropriated about $100,000 of PEC's funds which

was supposed to be used to pay a commission.    In addition,

petitioner believed that Wheeler cashed the blank checks

petitioner gave him, and he misappropriated these funds for his

personal use.   Consequently, on November 12, 1985, petitioner

changed the locks to PEC's office and informed Wheeler that he

was not to enter the office.

     In April 1986, petitioner and Cisneros met with

representatives from the Texas Rangers--the law enforcement

division for the State of Texas.    Petitioner and Cisneros
                                - 6 -


informed the Texas Rangers of their suspicion that Wheeler had

stolen money from PEC.    By the end of 1987, petitioner believed

he knew how much Wheeler had stolen from either him or PEC.

Wheeler died in 1989.

     Petitioners did not claim a theft loss deduction on their

1985, 1986, 1987, or 1989 income tax return.    On or about October

15, 1992, petitioners timely filed an amended tax return and a

claim for refund for the 1988 taxable year.    Petitioners based

their claim for refund upon a theft loss deduction in the amount

of $374,922.45 which they allege Wheeler stole from petitioner.

On July 21, 1995, the Internal Revenue Service denied

petitioners' claim for refund for the 1988 taxable year.

Default on Bank Loan by PEC

     In 1988, PEC was unable to make payments due under the note.

In August 1988, the bank turned to petitioner to perform on his

guarantor agreement.    On January 11, 1989, the bank obtained a

default judgment against petitioner (the default judgment) in the

amount of $1,105,552.75 with respect to petitioner's guaranty on

the note.   On April 13, 1989, the bank obtained from the Texas

State District Court a temporary restraining order to enjoin

petitioner from conveying, encumbering, or disposing of any of

his assets.

     On April 21, 1989, petitioner filed for protection under

chapter 11 of the Bankruptcy Code in the U.S. Bankruptcy Court
                               - 7 -


for the Western District of Texas, El Paso Division (the

bankruptcy court).   On April 27, 1989, the bank filed an Original

Verified Complaint and Application for Temporary Restraining

Order and Preliminary Injunction combined with Complaint for

Declaratory Judgment (the complaint) in petitioner's bankruptcy

case.   The complaint sought to offset a pension fund deposit

account and two commercial checking accounts maintained by

petitioner at the bank against the amount owed by PEC to the

bank.   On or about August 7, 1989, the bank filed an Amended

Proof of Claim in petitioner's bankruptcy case in the amount of

$1,108,472.60.   In response to the complaint, the bankruptcy

court entered an order (the order) in January 1990 which

permitted the bank to exercise setoff rights on $260,000 of funds

from petitioner's bank accounts and required petitioner to pay

approximately $190,000 to the bank from petitioner's property

acquired after filing the bankruptcy petition, for a total of

$450,000.

     On February 7, 1990, petitioner and his bankruptcy estate,

through bank offsets and direct payments, paid a total of

$450,000 to the bank in satisfaction of the bank's Amended Proof

of Claim.   On petitioners' 1990 joint income tax return,

petitioners claimed deductions for NOL's from the bankruptcy

estate and for expenses to protect petitioner's business

reputation in the amounts of $299,920 and $143,070, respectively.
                               - 8 -


For the 1991 taxable year, petitioners claimed an NOL carryover

from 1990 in the amount of $22,056.     Although petitioners

prepared tax returns for the bankruptcy estate for the 1989 and

1990 taxable years, they were not filed as of the time

petitioners filed the petition in this case.

                              OPINION

     The first issue is whether petitioner's $450,000 payment as

a guarantor of the note is deductible as an ordinary loss under

section 162 or under section 165(e).

     Petitioner contends that the amount in question is

deductible under section 162 or, alternatively, under section

165(e).   Petitioner alleges that Wheeler stole from PEC by

misappropriating funds from PEC.   Petitioner argues that those

losses resulted in PEC's inability to make payments due under the

note, and, consequently, the bank turned to petitioner to perform

on the note.   Petitioner also argues that, because PEC did not

financially exist separately from petitioner, he is entitled to a

theft loss deduction under section 165(e) of the amount paid to

the bank in 1990.   Alternatively, petitioner contends that the

payments were made to the bank to protect his business reputation

and therefore are deductible under section 162.

     Respondent contends that the amount paid on the guaranty is

a nonbusiness bad debt, which is deductible only as a short-term
                                - 9 -


capital loss under section 166(d) and section 1.166-9(b), Income

Tax Regs.   We agree with respondent.

Guarantor Payments

     Section 166 allows a deduction for the loss sustained on

account of a bad debt.    A deduction is allowed to the extent that

the debt becomes worthless during the year.   Sec. 166(a).

Section 1.166-9(b), Income Tax Regs., applies to a taxpayer who

enters into a transaction for profit, but not in the course of

his trade or business, to act as a guarantor, endorser, or

indemnitor.   This section of the regulations provides that "a

payment of principal or interest made * * * by the taxpayer in

discharge of part or all of the taxpayer's obligation as a

guarantor, endorser, or indemnitor is treated as a worthless

nonbusiness debt".   Section 1.166-9(b), Income Tax Regs., further

provides that neither section 163 nor section 165 will apply with

respect to such a payment.   Therefore, if the payment falls under

both sections 165 and 166, then it can be deducted only as a bad

debt under section 166.    Intergraph Corp. & Subs. v.

Commissioner, 

, 322-325 (1996), affd. without

published opinion 

(11th Cir. 1997); see Putnam v.

Commissioner, 

, 85-93 (1956); Spring City Foundry Co.

v. Commissioner, 

, 189 (1934); Horne v. Commissioner,

, 336 (1972), affd. 

(9th Cir. 1975).
                                  - 10 -


       Petitioner guaranteed the promissory note.    Upon PEC's

failure to perform on the note, petitioner was obligated to make

payments to the bank under the guarantor agreement.      With or

without a right of subrogation, a guarantor's loss generally will

be in the nature of a bad debt loss and will fall under section

166.       Black Gold Energy Corp. v. Commissioner, 

, 487

(1992), affd. without published opinion 

(10th Cir.

1994); Martin v. Commissioner, 

, 144 (1969), affd. per

curiam 

(9th Cir. 1970).      Therefore, we conclude

that the payment in the amount of $450,000 to discharge

petitioner's existing obligation under the guarantor agreement is

deductible under section 166 as a nonbusiness bad debt.4      Because

section 1.166-9(b), Income Tax Regs., provides that the guarantor

payments are a nonbusiness debt, we need not determine whether

petitioner sustained a theft loss.5

       4
        Thus, if the payment is not deductible under another
section, petitioners may deduct the $450,000 only to the extent
of net capital gains plus $3,000 and may carry forward the
remaining capital loss to succeeding taxable years. Secs. 1211
and 1212. We note that respondent has allowed a $3,000 short-
term capital loss deduction for each of the years in issue.

     We also note that petitioner makes no contention that the
$450,000 is deductible as a business bad debt.
       5
        We note that if there was a loss as a result of
misappropriations by Wheeler, it occurred before the years at
issue. Under sec. 165(e), a theft loss is deductible in the
taxable year in which the taxpayer discovers the loss.
Additionally, even if there was a loss in the years at issue, it
was sustained by PEC and not by petitioners. The record shows
                                                   (continued...)
                                  - 11 -


Business Reputation

       Petitioner argues that he may deduct the bankruptcy

settlement payments under section 162 as expenses to protect his

business reputation.       Petitioner bases the deductibility of the

payments upon the adverse business consequences that would have

resulted to his medical practice from a failure to pay the

default judgment and bankruptcy order.         Generally, a taxpayer may

deduct ordinary and necessary expenses paid or incurred in

carrying on his trade or business.         Sec. 162(a).

       We have, however, concluded that the $450,000 payment is a

nonbusiness debt.       If a guarantor's payment is found to give rise

to a debt, then the guarantor cannot deduct the payment as a

business expense under section 162.         Fincher v. Commissioner, 

, 138-139 (1995); see Horne v. Commissioner, supra at

336.       In that event, the guarantor can deduct the payment only

when, and in the amount, permitted under section 166.        See Horne

v. Commissioner, supra at 335.       We have determined that the

guarantor payment is a nonbusiness debt and, therefore, the

payment cannot be deductible under section 162.

NOL


       5
      (...continued)
that petitioner maintained PEC as an entity distinct from
himself. Where the taxpayer has availed himself of the corporate
form, this Court generally will not disregard the existence of
the corporation in order to reduce the taxpayer's tax liability.
Rink v. Commissioner, 

, 752 (1969).
                                - 12 -


     We must next determine whether the $450,000 payment is

included in the NOL's available to petitioners from the

bankruptcy estate for the 1990 taxable year.     Section 172(c)

defines "NOL" as the excess of deductions over the taxpayer's

gross income, subject to modifications of section 172(d).     In

determining whether there is an excess of deductions over gross

income, capital losses are allowed only to the extent of capital

gains.    Sec. 172(d).   Net capital losses are excluded from the

NOL computation by section 172(d)(2).

     We have concluded that petitioner's $450,000 payment is

deductible only as a nonbusiness bad debt.     Under section 166(d),

a nonbusiness bad debt is deductible only as a short-term capital

loss.    Therefore, we hold that petitioners are not entitled to

include the payment in computing NOL's from petitioner's

bankruptcy estate.

     To reflect the foregoing,

                                                Decision will be

                                           entered for respondent.