-
Edmund F. Ball and Virginia B. Ball, Petitioners v. Commissioner of Internal Revenue, RespondentBall v. CommissionerDocket No. 4151-68June 4, 1970, Filed
United States Tax Court *123
Decision will be entered under Rule 50 .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.Lester M. Ponder ,Anton Dimitroff Edward W. Harris III James J. McGrath , for the respondent.Tietjens,Judge .TIETJENS*1201 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 . *124 FINDINGS OF FACTSome 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, Ill 1/ 1/62 $ 45,000 3/12/62 40,000 9/10/62 35,000 12/31/62 35,000 $ 2,041.18 Liberty National Bank & Trust Co., Oklahoma City, Okla 1/ 1/62 9,212 3/ 9/62 14,511 10/ 3/62 17,097 11/ 2/62 16,747 12/31/62 16,747 641.20 Frances H. Burris 1/ 1/62 9,538 12/31/62 0 477.00 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 Co., Muncie, Ind 1/ 1/63 0 5/ 2/63 47,250 12/31/63 47,250 1,063.13 Merchants National Bank & Trust Co., Muncie, Ind 1/ 1/63 0 7/15/63 20,000 8/ 6/63 0 12/31/63 0 47.50 Liberty National Bank & Trust Co., Oklahoma City, Okla 1/ 1/63 16,747 1/ 2/63 16,579 4/17/63 15,929 7/16/63 15,458 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, Ill 1/ 1/64 $ 20,000 3/ 9/64 15,000 4/17/64 0 12/31/64 0 $ 557.47 American National Bank & Trust Co., Muncie, Ind 1/ 1/64 47,250 11/12/64 0 12/31/64 0 2,244.39 Liberty National Bank & Trust Co., Oklahoma City, Okla 12/31/63 21,558 1/ 1/64 20,532 4/14/64 19,788 5/26/64 25,988 7/13/64 24,907 10/14/64 24,588 12/31/64 24,588 1,058.60 Merchants National Bank Muncie, Ind 1/ 1/64 0 6/ 5/64 150,000 11/24/64 125,000 12/31/64 125,000 3,225.00 7,085.46 Year ending balance $ 149,588 *125 *1202 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, *1203 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., *126 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., *127 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: *1204
*128Fair 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 (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 *129 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*130 *1205 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 investments of the trust.
On April 1, 1964, due to the divergent financial requirements of the beneficiaries, the trust was terminated.
Petitioner's*131 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 Total portfolio $ 6,633,479 $ 6,150,905 Tax-exempts owned personally 208,822 211,322 One-third interest in tax-exempts owned by trust 141,961 133,720 Cost of tax-exempts owned personally 226,634 226,634 Percent of total tax-exempts to total portfolio 5.3 5.6 1963 1964 Total portfolio $ 6,778,627 $ 6,580,013 Tax-exempts owned personally 197,316 357,905 One-third interest in tax-exempts owned by trust 135,370 0 Cost of tax-exempts owned personally 211,657 369,860 Percent of total tax-exempts to total portfolio 4.9 5.4 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- *132 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.
*1206 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*133 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 onUnited States v.Atlas Ins. Co ., 381 U.S. 233">381 U.S. 233Atlas 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 prorata allocation of each item of income between the two shares. Under the Act, only the company's share was taxable, the policyholder's share was a deduction for determining 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 proration was required.All of the above seems irrelevant to the issue before us. However, the Commissioner seizes on a footnote *134 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.
*1207 The relevance of this statement tosection 265(2) is that it was made in connection with a discussion by the Court of the scope ofDenman v.Slayton , 282 U.S. 514 (1931)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 , 388 F. 2d 420Illinois Terminal Railroad Co. v.United States , 375 F. 2d 1016, 1021 (Ct. Cl. 1967)Kirchner, Moore & Co ., 54 T.C. 940 (1970)Wisconsin Cheesman, Inc. v.United States, supra at 422Bernard H. Jacobson , 28 T.C. 579 (1957)R. B. George Machinery Co ., 26 B.T.A. 594">26 B.T.A. 594Illinois Terminal Railroad Co. v.United States, supra at 1022We 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*137 tax-exempts were held. As we have indicated, this is not the result that the statute was intended to achieve.*1208 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*138 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*139 amount, $ 19,000 was *1209 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 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*141 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 .Footnotes
1. All statutory references are to the Internal Revenue Code of 1954 unless otherwise specified.↩
1. Trust terminated and petitioner obtained his share of the trust assets including tax-exempt securities.↩
2.
United States v.Atlas Ins. Co ., 381 U.S. 233">381 U.S. 2333. And cf.
Leslie v.Commissioner , 413 F. 2d 636Kirchner Moore & Co ., 54 T.C. 904">54 T.C. 904sec. 265(2)↩ applicable.
Document Info
Docket Number： Docket No. 4151-68
Citation Numbers： 54 T.C. 1200, 1970 U.S. Tax Ct. LEXIS 123
Judges： Tietjens
Filed Date： 6/4/1970
Precedential Status： Precedential
Modified Date： 10/19/2024