Opinion
Docket No. 4151-68.
1970-06-4
EDMUND F. BALL AND VIRGINIA B. BALL, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Lester M. Ponder, Anton Dimitroff, and Edward W. Harris III, for the petitioners. James J. McGrath, for the respondent.
Lester M. Ponder, Anton Dimitroff, and Edward W. Harris III, for the petitioners. James J. McGrath, for the respondent.
Petitioners owned tax-exempt securities at the same time they incurred certain indebtedness to finance business ventures. Held, the interest on the indebtedness is allowable as a deduction. Sec. 265(2), I.R.C. 1954, is inapplicable since there was no ‘sufficiently direct relationship’ between the incurrence or continuation of the debt and the carrying of the tax-exempt securities.
TIETJENS, Judge:
The Commissioner determined the following deficiencies for the indicated years in petitioners' Federal income tax:
+--------------------+ ¦Year ¦Deficiency ¦ +------+-------------¦ ¦1962 ¦$34,141.11 ¦ +------+-------------¦ ¦1963 ¦20,008.18 ¦ +------+-------------¦ ¦1964 ¦19,362.28 ¦ +--------------------+
All of the issues except one have been settled by agreement of the parties. The one remaining issue is whether petitioners incurred or continued indebtedness to purchase or carry obligations the interest on which is wholly exempt from income tax, as set forth in section 265(2), I.R.C. 1954.
If they did, then a portion of their claimed interest deduction is not allowable.
Trust terminated and petitioner obtained his share of the trust assets including tax-exempt securities*
All statutory references are to the Internal Revenue Code of 1954 unless otherwise specified. 2. United States v. Atlas Ins. Co., 381 U.S. 233, 248-249 fn. 17 (1965).
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulation and exhibits attached thereto are incorporated herein by this reference.
Edmund F. and Virginia B. Ball, husband and wife (hereinafter referred to as petitioner and Virginia), resided in Muncie, Ind., at the time the petition herein was filed. They filed joint Federal income tax returns for the taxable years 1962, 1963, and 1964 with the district director of internal revenue at Indianapolis, Ind.
During the taxable period involved petitioner incurred or continued certain indebtedness on which he claimed interest deductions which are at issue herein as follows:
+---+ ¦¦¦¦¦ +---+
Lender Date Unpaid Interest balance expense
1962 First National Bank & Trust Co. of Chicago, Chicago, ( 1/ 1/ $45,000 ill. 62 ( 3/12/ 40,000 62 ( 9/10/ 35,000 62 (12/31/ 35,000 $2,041.18 62 Liberty National Bank & Trust CO., Oklahoma City, ( 1/ 1/ 9,212 Okla. 62 ( 3/ 9/ 14,511 62 (10/ 3/ 17,097 62 (11/ 2/ 16,747 62 (12/31/ 16,747 641.20 62 Frances H. Burris ( 1/ 1/ 9,538 62 (12/31/ 0 477.00 62 3,159.38 Year ending balance $51,747
1963 First National Bank & Trust Co. of Chicago, Chicago, Ill. ( 1/ 1/63 $35,000 ( 3/12/63 25,000 ( 9/ 9/63 20,000 (12/31/63 20,000 $1,440.84 American National Bank & Trust ( 1/ 1/63 0 Co., Muncie, Ind. ( 5/ 2/63 47,250 (12/31/63 47,250 1,063.13 Merchants National Bank & ( 1/ 1/ 0 Trust Co., Muncie, Ind. 63 ( 7/15/63 20,000 ( 8/ 6/63 0 (12/31/63 0 47.50 Liberty National Bank % Trust ( 1/ 1/63 16,747 Co., Oklahoma City, Okla. ( 1/ 2/63 16,579 ( 4/17/63 15,929 ( 7/16/63 15,929 ( 7/23/63 21,558 (12/31/63 21,558 851.40 3,402.87 Year ending balance $88,808
1964 First National Bank % Trust Co. of Chicago, Chicago, ( 1/ 1/ $20,000 Ill. 64 ( 3/ 9/ 15,000 64 ( 4/17/ 0 64 (12/31/ 0 $557.47 64 American National Bank & Trust Co., Muncie, Ind. ( 1/ 1/ 47,250 64 (11/12/ 0 64 (12/31/ 0 2,244.39 64 Liberty National Bank & Trust Co., Oklahoma city, (12/31/ 21,558 Okla. 63 ( 1/ 1/ 20,532 64 ( 4/14/ 19,788 64 ( 5/26/ 25,988 64 ( 7/13/ 24,907 64 (10/14/ 24,588 64 (12/31/ 24,588 1,058.60 64 Merchants National Bank Muncie, Ind. ( 1/ 1/ 0 64 ( 6/ 5/ 150,000 64 (11/24/ 125,000 64 (12/31/ 125,000 3,225.00 64 7,085.46 Year ending balance $149,588
The origin of the outstanding loan from the First National Bank & Trust Co. of Chicago was the assumption by petitioner of a loan to B. B. & S. Properties, Inc., in 1956, which was organized in 1956 to make investments in various types of real estate ventures, with petitioner owning the preferred stock and a family trust owning the common stock. The first such venture was the purchase of land in New Mexico to be operated as a cattle ranch. Because of a serious and unforeseeable drought, the venture proved unprofitable and the cattle herd had to be liquidated at a considerable loss. Petitioner personally assumed a loan for $140,000 which First National Bank & Trust Co. of Chicago had made to B. B. & S. Properties, Inc., to avoid financial ruin. As of January 1, 1962, the unpaid balance of this assumed loan was $45,000. During the taxable period, petitioner repaid this loan making payments of $5,000 on March 12, 1962; $5,000 on September 10, 1962; $10,000 on March 12, 1963; $5,000 on September 9, 1963; $5,000 on March 9, 1964; and the remaining $15,000 on April 17, 1964.
In 1962 petitioner arranged for a loan from Liberty National Bank & Trust Co., Oklahoma City, Okla., for use in investing in oil-drilling operations. He signed a master note against which the oil operators could draw from time to time to take care of their operating and drilling expenses, and he arranged with the bank and with the other venturers in this operation that income from the venture would be paid back to the bank to reduce the note and to pay the interest on the note. The fluctuation in the figures representing the indebtedness of petitioner to Liberty National Bank & Trust Co. reflects the amounts drawn against the master note and also the amounts of income from the venture paid to the bank to reduce the amount of the note, at a given time. No funds actually passed through the hands of petitioner at any time during the taxable period as a result of this loan.
At the beginning of the taxable period, petitioner was indebted to Francis H. Burris in the amount of $9,538, resulting from an obligation in connection with petitioner's purchase of the V-L Ranch, which was entirely paid in 1962.
On May 2, 1963, petitioner borrowed $47,250 from American National Bank & Trust Co., Muncie, Ind., in order to purchase stock in the Pasteur Medical Building Corp., which was engaged in a real estate project in Oklahoma. The funds were paid directly for the purchase of the building. Petitioner sold his interest in Pasteur Medical Building Corp. and the sales proceeds were used to repay the bank on November 12, 1964. Petitioner received his profit, and again no borrowed funds actually passed through his hands.
On July 15, 1963, petitioner obtained a loan of $20,000 from Merchants National Bank & Trust Co., Muncie, Ind., to provide funds for payment of Federal income taxes, which loan was repaid August 6, 1963.
On June 5, 1964, petitioner obtained a loan of $150,000 from Merchants National Bank & Trust Co., Muncie, Ind. Of this amount,.$19,000 was used to pay off the mortgage on the V-L Ranch, which petitioner had purchased on April 2, 1962, for $121,638. The remainder was used to finance the purchase of the Indian Spring Ranch in Catron County, N. Mex., which petitioner had purchased on April 30, 1964, for $149.472.
During the years in question, petitioner owned individually and beneficially, through a revocable trust terminated in 1964, the following amounts of tax-exempt securities:
+---+ ¦¦¦¦¦ +---+
Fair market value 1/3 Fair Dec. 31— interest, E. B. market value Total Ball Heirs individually Trust 1961 $141,000 $209,000 $350,000 1962 134,000 211,000 345,000 1963 135,000 197,000 332,000 1964 1 358,000 358,000
This level of tax-exempt holdings remained relatively constant over the years involved because maturing issues were reinvested and there were no new investments. All of the tax-exempts were readily marketable, with approximately one-third being of short maturity and all of them being of good quality. Petitioner was aware during the years in issue that he carried certain amounts of tax-exempts and that he incurred interest on indebtedness which was deductible.
Petitioner's motivation in all of his loans during the taxable period was to create profitable investments, with the additional motivation in connection with the ranching venture of B. B. & S. Properties, Inc., to protect all parties concerned from bankruptcy and to protect the company from forced liquidation.
Petitioner did not give any conscious consideration, or consult any tax adviser, with respect to the possibility of selling tax-exempt securities to avoid borrowing. He did not consult a tax adviser as to the most advantageous method, from an income tax standpoint, of financing the investments, for which he borrowed, during the taxable period.
Petitioner never considered any method of financing his ventures for profit other than by borrowing the necessary funds. With the exception of the loan obtained from Merchants National Bank & Trust Co. for income tax payment in 1963, the ventures were all long-term investments. With respect to the loan from First National Bank & Trust Co. of Chicago, petitioner assumed the $140,000 obligation in an emergency situation resulting from an unforeseeable business disaster. With respect to the arrangement that petitioner had with the Liberty National Bank & Trust Co., Oklahoma City, Okla., the amount which petitioner was obligated to pay to the bank was a fluctuating figure, which could not have been settled by an initial outlay of cash. Petitioner anticipated that if the venture were successful, his investment would be self-supporting, and he would have no outstanding obligation toward the bank. With respect to the Pasteur Medical Building Corp., the venture was established as a self-liquidated transaction, with no funds, other than profits, passing through petitioner's hands. Therefore, financing these ventures through loans ‘seemed to be the natural and normal and good business approach to undertaking these ventures.’
Petitioner's father, E. B. Ball, who died in 1925, left one-third of his estate to his wife and two-ninths of his estate to each of his three children, Adelia Ball (later Adelia Ball Morris), Janice Ball (later Janice Ball Fisher), and petitioner. The estate was in the process of probate administration until 1928. From that time, the three surviving brothers of E. B. Ball acted as informal trustees of the assets of the estate until 1938, when the E. B. Ball Heirs Trust, a revocable trust (hereinafter the trust), containing the entire residue of E. B. Ball's estate, was organized. About one-third of the estate was in form of bonds, and all of the tax-exempt securities from the estate were included in the trust. The original trustees of the trust were Frank C. Ball and George A. Ball, brothers of E. B. Ball, and petitioner. Petitioner remained as a trustee until the termination of the trust. The trustees had sole responsibility for determining the investment of the trust.
On April 1, 1964, due to the divergent financial requirements of the beneficiaries, the trust was terminated.
Petitioner's investment adviser, Collett & Co., Inc., prepared annual reports showing the cost and yearend market value of the items in his investment portfolio, both personally owned and held by the trust. These reports, as of the end of the calendar years 1961 to 1964, inclusive, reflect the following:
+----+ ¦¦¦¦¦¦ +----+
1961 1962 1963 1964 Total portfolio $6,633,479 $6,150,905 $6,778,627 $6,580,013 Tax-exempts owned personally 208,822 211,322 197,316 357,905 One-third interest in tax-exempts 141,961 133,720 135,370 0 owned by trust Cost of tax-exempts owned 226,634 226,634 211,657 369,860 personally Percent of total tax-exempts to 5.3 5.6 4.9 5.4 total portfolio
John P. Collett, president and treasurer of Collett & Co., Inc., for over 36 years, advised petitioner that tax-exempt securities were a necessary part of a prudent investment portfolio, and on several occasions urged petitioner to obtain more tax-exempt securities. In his opinion, an investment portfolio should have from 5- to 40-percent, tax-exempt securities, and 5 percent is an ‘absolute minimum.’ Petitioner also felt that it was prudent investment policy to hold tax-exempt securities.
No tax-exempt security, either owned personally by petitioner or owned by the trust, was used as collateral for any loan made by petitioner and outstanding at any time during the taxable period.
The petitioner deducted interest paid on indebtedness in all of the years involved herein. The Commissioner, in his statutory notice disallowed the following amounts, stating this interest was on indebtedness incurred or continued in order to carry or purchase obligations the interest on which is wholly exempt from tax:
+------------------+ ¦Year ¦Interest ¦ +------+-----------¦ ¦1962 ¦$3,159.38 ¦ +------+-----------¦ ¦1963 ¦3,402.87 ¦ +------+-----------¦ ¦1964 ¦7,085.46 ¦ +------------------+
OPINION
We must decide if certain interest deductions claimed by petitioners in 1962, 1963, and 1964 are barred by section 265(2) which provides:
SEC. 265. EXPENSES AND INTEREST RELATING TO TAX-EXEMPT INCOME.
No deduction shall be allowed for
(2) INTEREST.— Interest on indebtedness incurred or continued to purchase or carry obligations * * * the interest on which is wholly exempt from the taxes imposed by this subtitle.
The Commissioner argues that petitioner is within the scope of section 265(2) since he held tax-exempt securities at the same time he borrowed to make investments. As his main authority, the Commissioner relies on United States v. Atlas Ins. Co., 381 U.S. 233 (1965). However, we believe his reliance is misplaced. Atlas Ins. Co. concerned itself with the statutory construction of a portion of the Life Insurance Company Income Tax Act of 1959. Under the Act, a company had to divide its investment income into two parts; the policyholder's share and the company's share with a prorate allocation of each item of income between the two shares. Under the Act, only the company's share was taxable income. The issue was whether income from tax-exempt securities had to be prorated or whether the company could allocate all of such income to its share. The Court held that a portion was required.
All of the above seems irrelevant to the issue before us. However, the Commissioner seizes on a footnote
in the opinion which he says controls the situation here.
The Court there stated:
interest can be said to be incurred or continued as a cost of producing exempt income whenever a taxpayer borrows for the purpose of making investments and in fact invests funds in exempt securities.
The relevance of this statement to section 265(2) is that it was made in connection with a discussion by the Court of the scope of Denman v. Slayton, 282 U.S. 514 (1931), which upheld the constitutionality of a predecessor of section 265(2) as applied to a dealer in tax-exempts who borrowed funds and invested them in tax-exempts.
The Commissioner argues that the above statement covers petitioner since he had tax-exempts and at the same time incurred indebtedness. We believe the Commissioner has misread the statement he relies on. We believe that that statement covers the situation where an individual borrows and uses such borrowed funds to purchase tax-exempts. Such is not the case here since taxpayer made no new investments in tax-exempts during the years in question. We come to our conclusion in this regard from the context in which the statement is found in Atlas Ins. Co., supra.
We believe that the proper rule to guide us here has already been stated. Wisconsin Cheeseman, Inc. v. United States, 375 F.2d 1016, 1021 (Ct. Cl. 1967). What these cases tell us is that the deduction is barred if there is ‘a sufficiently direct relationship’ between the incurrence or continuation of indebtedness and the carrying of tax-exempt securities. The application of the section to a particular factual setting is dependent on the purpose for which indebtedness was incurred or continued. Kirchner, Moore & Co., 54 T.C. 940 (1970).
With this test, it is clear that a ‘taxpayer is not ipso facto deprived of a deduction for interest on indebtedness while holding tax-exempt securities.’ Wisconsin Cheesman, Inc. v. United States, supra at 422; Bernard H. Jacobson, 28 T.C. 579 (1957); R. B. George Machinery Co., 26 B.T.A. 594 (1932). And it is equally clear from the legislative history, that a mechanical test was not desired Illinois Terminal Railroad Co. v. United States, supra at 1022.
And cf. Leslie v. Commissioner, 413 F.2d 636 (C.A. 2, 1969), which we noted in Kirchner Moore & Co., 54 T.C. 904, agreed with the Tax Court ‘purpose’ test, but nonetheless held the relationship between the amount of monthly loans and the purchase and carrying of tax-exempt securities made sec. 265(2) applicable.
We are of the opinion that the requisite sufficiently direct relationship between the incurring of various indebtedness by petitioner and his holding of tax-exempt securities, is absent here, except for the general one that the incurring of indebtedness allowed petitioner to retain his tax-exempt holdings. However, if this were a sufficient ground for disallowing the interest deduction, then section 265(2) would in fact be a mechanical test; i.e., the deduction would be disallowed whenever indebtedness was incurred while tax-exempts were held. As we have indicated, this is not the result that the statute was intended to achieve.
When we examine each of the debts for which the Commissioner has disallowed the interest deduction, we find that there is no relationship at all between them and petitioner's holding of tax-exempts.
1. First National Bank & Trust Co. of Chicago Loan
Petitioner's loan from First National Bank & Trust Co. of Chicago originated in 1956, when a corporation, B. B. & S. Properties, Inc., in which petitioner was a shareholder, suffered financial reverses because of a very serious drought which caused its cattle herd to be liquidated at a great loss. Petitioner personally assumed a loan in the amount of $140,000 which the bank had made to the corporation, in order to prevent its insolvency. As of the beginning of the taxable period, petitioner had paid this loan down to $45,000 and the remaining balance of $15,000 was paid on April 17, 1964.
2. Liberty National Bank & Trust Co. of Oklahoma City Loan
Petitioner's loan from Liberty National Bank & Trust Co. of Oklahoma City, Okla., was obtained for use in investing in oil-drilling operations. There was a master note against which the oil operators drew from time to time to cover expenses of the operations, and the income from the venture was paid back to the bank to reduce the note and to pay the interest thereon. This explains the fluctuation in the outstanding balances during the taxable period from a low of $9,212 on January 1, 1962, to a high of $25,988 on May 26, 1964.
3. Frances H. Burris Loan
At the beginning of the taxable period, petitioner was indebted to Frances H. Burris in the amount of $9,538, resulting from an obligation in connection with the purchase of the V-L Ranch by petitioner, which obligation was entirely paid in 1962.
4. American National Bank & Trust Co. of Muncie Loan
Petitioner borrowed $47,250 from American National Bank & Trust Co. of Muncie, Ind., on May 2, 1963, to purchase stock in Pasteur Medical Building Corp., which was engaged in a real estate project. Petitioner sold his interest in the corporation in 1964, and the sales proceeds were used to repay the bank on November 12, 1964.
5. Merchants National Bank & Trust Co. of Muncie Loan
Petitioner borrowed $150,000 from Merchants National Bank & Trust Co. of Muncie on June 5, 1964. Of this amount,.$19,000 was used to pay off the mortgage on the V-L Ranch, which petitioner had purchased on April 2, 1962, for $121,638. The remainder was used to finance the purchase of the Indian Spring Ranch in New Mexico, which petitioner had purchased on April 30, 1964, for $149,472.
The only other loan was $20,000 from Merchants National Bank & Trust Co. of Muncie on July 15, 1963, to provide funds for a payment of Federal income taxes, which was repaid on August 6, 1963.
As appears from our Findings of Fact, petitioner's motivation in regard to all these debts, except the loan to pay his income tax, was to create profitable investments. It had no direct relationship to creating tax-exempt income.
Petitioner's uncontradicted testimony supports this conclusion and does not give even an inkling of any relationship between the incurring of the debts and the holding of tax-exempts.
Finally, we believe the decision in Wisconsin Cheeseman, Inc. v. United States, supra, supports our decision here in favor of petitioner. One of the issues there concerned the interest on a mortgage incurred to finance a new plant. The Court held that the interest expense on the mortgage was deductible, even though the taxpayer held tax-exempts, because there was not a sufficient relationship shown between the two. In reaching its decision, the Court noted the following factors: (1) The tax-exempts were not used as collateral to secure the mortgage; (2) the mortgage was incurred to finance a major nonrecurring expenditure, usually financed over a long term; (3) a reasonable person would not sacrifice liquidity and security be selling tax-exempt municipal bonds in lieu of incurring mortgage debt to finance a new plant; and (4) business reasons dominated the mortgaging of the property.
Most of these reasons are applicable in the present case. All of petitioner's loans were used to finance major, nonrecurring opportunities which were conducive to long-term financing, and were not foreseeable when the tax-exempt securities were purchased. Business reasons were the sole motivation for petitioner's incurring indebtedness to finance new ventures. Petitioner owned what both he and his investment adviser considered to be an ‘absolute minimum’ of tax-exempt securities during the entire taxable period. A reasonable person in his position would not necessarily have sacrificed the liquidity and security provided by his tax-exempt holdings by liquidating these holdings instead of incurring indebtedness to finance his ventures.
We hold that the Commissioner erred in disallowing petitioner's claimed interest deductions.
Decision will be entered under Rule 50.