Hahn v. Comm'r ( 2007 )

T.C. Memo. 2007-75
UNITED STATES TAX COURT
GILBERT HAHN, JR. AND MARGOT H. HAHN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23756-04. Filed April 2, 2007.
George B. Delta and Stuart H. Gary, for petitioner Gilbert
Hahn, Jr.
Mary M. Baker, Matthew S. Campbell, James R. Hagerty, and
Haig V. Kalbian, for petitioner Margot H. Hahn.
Cleve Lisecki, Veena Luthra, and Lindsey D. Stellwagen, for
respondent.
MEMORANDUM OPINION
WELLS, Judge: The instant matter is before the Court on
petitioner Gilbert Hahn, Jr.’s Motion for Partial Summary
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Judgment.1 The issue for decision concerns discharge of
indebtedness income pursuant to section 61(a)(12). For the
reasons stated below, we shall deny petitioner’s motion. Unless
otherwise indicated, all Rule references are to the Tax Court
Rules of Practice and Procedure, and all section references are
to the Internal Revenue Code, as amended.
Background
Petitioners resided in Washington, D.C., when the petition
was filed. References to petitioner in the singular are to
Gilbert Hahn, Jr.
During 1986, petitioner obtained a $1 million line of credit
from the National Bank of Washington (the bank), which was later
increased to $2 million. During June 1988, petitioner borrowed
against the line of credit and gave the bank a promissory note in
the amount of $2 million (the note). The note provides, inter
alia: (1) The outstanding principal and interest shall be
payable on demand; (2) until demand is made, petitioner shall pay
interest quarterly on the unpaid principal balance at the bank’s
floating prime rate plus ½ percent; (3) in the event of a late
payment, petitioner shall pay a late charge of 2 percent per
1
Petitioner and his wife, Margot Hahn, filed a joint 1995
Federal income tax return and a joint petition with the Court.
Petitioner Margot Hahn now seeks relief from joint and several
liability pursuant to sec. 6015, and each petitioner has retained
separate counsel. Petitioner Margot Hahn did not join petitioner
Gilbert Hahn, Jr. in making the instant motion.
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annum in excess of the aforementioned interest rate; and (4) in
the event petitioner defaults and the bank institutes a suit to
collect on the note, the bank shall be entitled to recover as
attorney’s fees 15 percent of the unpaid principal and interest,
and costs of suit.
During August 1990, the Office of the Comptroller of the
Currency declared the bank insolvent and appointed the Federal
Deposit Insurance Corporation (FDIC) as its receiver. The FDIC
later claimed that petitioner had defaulted under the terms and
conditions of the note by failing to repay principal and
interest.
During January 1994, the FDIC filed suit against petitioner
in U.S. District Court. The FDIC complaint alleged that
petitioner owed the following amounts with respect to the note:
(1) $1,752,384 in principal; (2) $381,934 in prejudgment interest
accrued as of February 15, 1993, with interest continuing to
accrue at a daily rate of $312 until paid; (3) a late charge of 2
percent per annum on the unpaid principal; and (4) attorney’s
fees in the amount of 15 percent of the unpaid balance of the
loan.2 The complaint alleged that, except for a $25,000 payment
by petitioner in November 1993, none of the above-described
amounts had been paid. The complaint also sought costs of suit.
2
All amounts are rounded to the nearest dollar.
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Petitioner disputed the FDIC’s claim, and, during October
1995, petitioner and the FDIC entered into a settlement agreement
in which petitioner agreed to pay an additional $975,000 in
exchange for a release of the FDIC’s claims against him. The
settlement agreement states in part that petitioner “denies the
entire claim” and that petitioner and the FDIC were settling the
dispute to “avoid the time and cost of litigation”.
During November 1995, petitioner paid the FDIC the $975,000
specified in the settlement agreement. The FDIC then issued
petitioner a Form 1099-C, Cancellation of Debt, indicating that
petitioner had received $1,512,193 of income from discharge of
indebtedness. Petitioner contacted the FDIC to dispute the
issuance of the Form 1099-C, but the FDIC refused to rescind or
amend the information return.
On their joint 1995 Federal income tax return, petitioners
did not report the $1,512,193 as income. Additionally,
petitioners claimed a $999,090 deduction on Schedule C, Profit or
Loss From Business, for horse breeding and training activity.
The $999,090 represents the $975,000 payment to the FDIC and
$24,090 of legal fees reportedly paid in connection with the
settlement. Taking into account the deduction claimed on
Schedule C, petitioners reported adjusted gross income of
$460,898.
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Respondent issued petitioners a notice of deficiency for
1995 determining, inter alia, that the $1,512,193 was forgiveness
of indebtedness income and therefore taxable. Respondent also
disallowed the claimed Schedule C deduction for $999,090 and
determined an accuracy-related penalty pursuant to section
6662(a). Petitioners filed a timely petition for review with the
Court, and respondent filed an answer.
During October 2005, respondent contacted the FDIC. In
response to respondent’s inquiry, the FDIC indicated that the
$1,512,193 reported on the Form 1099-C reflected only the amount
of loan principal that was forgiven;3 as part of the settlement
agreement, the FDIC also had forgiven amounts owed for interest,
late charges, attorney’s fees, and other costs that were not
reflected in the Form 1099-C. (For convenience, we refer to the
interest, late charges, attorney’s fees, and other costs as the
related items.) Respondent filed an amendment to answer seeking
to increase the deficiency to include forgiveness of indebtedness
income attributable to the related items.
3
Respondent contends that the $1,512,193 figure was
calculated as follows: The FDIC first applied the $975,000
payment toward accrued interest of $734,809. The balance of
$240,191 was then applied to reduce the outstanding principal
from $1,752,384 to $1,512,193. This latter figure, according to
respondent, represents the amount shown on the Form 1099-C,
Cancellation of Debt. The settlement agreement does not specify
how the $975,000 was allocated, however, and for purposes of the
instant motion we do not decide if respondent’s calculation is
correct.
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During November 2006, petitioner filed a Motion for Partial
Summary Judgment. The motion states that petitioner’s gross
income does not include any amounts attributable to the related
items.4 Respondent opposes the motion.
Discussion
Summary judgment is appropriate with respect to all or any
part of the legal issues in controversy “if the pleadings,
answers to interrogatories, depositions, admissions, and any
other acceptable materials, together with the affidavits, if any,
show that there is no genuine issue as to any material fact and
that a decision may be rendered as a matter of law.” Rule
121(b); Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520
(1992), affd. 17 F.3d 965 (7th Cir. 1994). The moving party
bears the burden of proving that there is no genuine issue of
material fact, and factual inferences will be read in a manner
most favorable to the party opposing summary judgment. Dahlstrom
v. Commissioner, 85 T.C. 812, 821 (1985).
Petitioner advances two arguments in support of his motion.
Petitioner’s first contention is that because he did not receive
cash or other property when he allegedly became obligated for the
related items, he was not enriched by the forgiveness of the
4
Petitioner also contends that he did not realize discharge
of indebtedness income with respect to the principal amount of
the loan; however, petitioner does not seek summary judgment with
respect to that amount.
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obligation. Secondly, petitioner argues in the alternative that
payment of the related items would have given rise to a deduction
as ordinary and necessary business expenses of his horse breeding
and training activity.
I. Whether forgiveness of the related items could give rise to
discharge of indebtedness income
Section 61(a)(12) provides that gross income includes income
from the discharge of indebtedness. The amount of income
includable generally is the difference between the face value of
the debt and the amount paid in satisfaction of the debt. Babin
v. Commissioner, 23 F.3d 1032, 1034 (6th Cir. 1994), affg. T.C.
Memo. 1992-673. The underlying rationale for such inclusion is
that, to the extent a taxpayer is released from indebtedness, the
taxpayer realizes an accession to income due to the freeing of
assets previously offset by the liability. See United States v.
Kirby Lumber Co., 284 U.S. 1, 3 (1931); Jelle v. Commissioner,
116 T.C. 63, 67 (2001).
Petitioner contends that the Kirby Lumber Co. rationale does
not apply to the related items because he did not receive cash or
other property when he incurred a liability for such items.
Petitioner argues that the forgiveness of the obligation
therefore did not result in a freeing of assets. We disagree.
A taxpayer may realize income upon the discharge of an
obligation even though the taxpayer has not directly received
cash or other property. In Old Colony Trust Co. v. Commissioner,
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279 U.S. 716 (1929), for example, an employer paid an employee’s
State and Federal income tax liabilities. The payment
constituted income because “The discharge by a third person of an
obligation to * * * [a taxpayer] is equivalent to receipt by the
person taxed.” Id. at 729. In Harris v. Commissioner, T.C.
Memo. 1975-125, affd. without published opinion 554 F.2d 1068
(9th Cir. 1977), discharge of indebtedness income included loan
principal as well as interest, taxes, penalties, and trustee and
attorney’s fees. In Jelle v. Commissioner, supra, discharge of
indebtedness income included interest on a mortgage that was
partially forgiven. See also Earnshaw v. Commissioner, T.C.
Memo. 2002-191 (discharge of indebtedness income included a cash
advance fee posted to the taxpayer’s account), affd. 150 Fed.
Appx. 745 (10th Cir. 2005); Seay v. Commissioner, T.C. Memo.
1974-305 (taxpayer realized discharge of indebtedness income
although he never received cash).
We also disagree with petitioner’s contention that he
“received no payment of cash, property, or anything else of value
when he allegedly became liable for the [related items].” The
right to use money represents a valuable property interest. Fed.
Home Loan Mortgage Corp. v. Commissioner, 121 T.C. 254, 259
(2003). When viewed most favorably to respondent, the facts
indicate that petitioner had use of the borrowed funds beyond the
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time specified in the note. Consequently, petitioner incurred a
liability for the related items. When petitioner was released
from the liability, he realized an accession to income due to the
freeing of assets previously offset by the liability. See Jelle
v. Commissioner, supra at 67.
Petitioner nevertheless urges a contrary result, relying
primarily on Commissioner v. Rail Joint Co., 61 F.2d 751 (2d Cir.
1932), affg. 22 B.T.A. 1277 (1931); Fashion Park, Inc. v.
Commissioner, 21 T.C. 600 (1954); and Bradford v. Commissioner,
233 F.2d 935 (6th Cir. 1956), revg. 22 T.C. 1057 (1954). Those
cases are distinguishable.
Rail Joint Co. and Fashion Park, Inc. each involved a
corporate taxpayer that had issued bonds and later repurchased
them for less than par (i.e., face) value. The Commissioner
determined that each taxpayer had realized discharge of
indebtedness income equal to the difference between the
repurchase price of the bonds and their par value. Commissioner
v. Rail Joint Co., supra at 751; Fashion Park, Inc. v.
Commissioner, supra at 600.
The court in each case held that the taxpayer had not
realized income. In Commissioner v. Rail Joint Co., supra at
752, the Court of Appeals for the Second Circuit reasoned that
the taxpayer “never received any increment to its assets * * * at
the time * * * [the bonds] were retired.” In Fashion Park, Inc.
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v. Commissioner, supra at 606 (citation omitted), this Court held
that “if * * * [a taxpayer] has received upon issuance of its
bonds an amount less than it paid for their retirement it has no
accession in assets but is in fact poorer by the transaction”.
Petitioner contends that he did not realize discharge of
indebtedness because, like the taxpayers in Rail Joint Co. and
Fashion Park, Inc., he “did not wind up with anything more than
what [he] had prior to the [transaction].” Petitioner fails to
appreciate the holdings of those cases.
Rail Joint Co. and Fashion Park, Inc. were decided after the
Supreme Court’s decision in United States v. Kirby Lumber Co.,
supra. In Kirby Lumber Co., a taxpayer issued bonds in the
amount of $12,126,800 for which it received par value; i.e., the
issue price and par value were the same. The taxpayer later
repurchased the bonds for less than par value. The Supreme Court
held that the difference between the repurchase price and the par
value was income. Id. at 2-3.
The taxpayers in Rail Joint Co. and Fashion Park, Inc., in
contrast, did not receive par value for the bonds they issued.
The face value of the bonds exceeded the amount the taxpayers
received when the bonds were issued.5 Because each taxpayer
5
In Commissioner v. Rail Joint Co., 61 F.2d 751 (2d Cir.
1932), affg. 22 B.T.A. 1277 (1931), the taxpayer distributed the
bonds to its shareholders as a dividend and, therefore, received
no proceeds in return. In Fashion Park, Inc. v. Commissioner, 21
(continued...)
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later repurchased its bonds for an amount greater than the issue
price, the taxpayers did not realize income and were, in fact,
poorer by the transaction. In Fashion Park, Inc., this Court
rejected the Commissioner’s argument that the holdings of Rail
Joint Co. and Fashion Park, Inc. conflicted with Kirby Lumber
Co., noting that “‘We have consistently * * * emphasized the
issue price rather than par value in computing gain from the
discharge of obligations.’” Fashion Park, Inc. v. Commissioner,
supra at 606 (quoting Kramon Dev. Co. v. Commissioner, 3 T.C.
342, 349 (1944)); see also Rail Joint Co. v. Commissioner, supra
at 752. The holdings in Rail Joint Co. and Fashion Park, Inc.
are consistent with section 1.61-12(c)(3), Income Tax Regs.,
which provides: “If bonds are issued by a corporation and are
subsequently repurchased by the corporation at a price which is
exceeded by the issue price * * *, the amount of such excess is
income for the taxable year.”
In the instant case, petitioner did not issue bonds or other
debt instruments at a discount. Accordingly, cases such as Rail
Joint Co. and Fashion Park, Inc. are inapposite.
The third case on which petitioner relies, Bradford v.
Commissioner, supra, is also distinguishable. In Bradford, the
5
(...continued)
T.C. 600 (1954), the taxpayer originally issued $50 par preferred
stock for $5 a share. In a tax-free reorganization, the company
later issued $50 par value bonds in an exchange for the preferred
stock. Id. at 601-603.
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taxpayer’s husband had executed a note in favor of a bank. At
the husband’s request in 1938, the taxpayer substituted her own
$100,000 note for a portion of the indebtedness without receiving
any compensation in return. Id. at 936. In 1943, the bank wrote
off $50,000 of the note. In 1946, a relative purchased the note
for $50,000 with funds provided by the taxpayer and her husband,
and the note was retired. Id. The Commissioner determined that
the wife had realized $50,000 of discharge of indebtedness income
in 1946. Id.
The Court of Appeals for the Sixth Circuit held that the
taxpayer had not realized income. The court stated that while a
“mechanical application” of tax law would support the
Commissioner’s determination, the court “need not * * * be
oblivious to the net effect of the entire transaction”. Id. at
938-939. The court concluded that “by any realistic standard the
* * * [taxpayer] never realized any income at all from the
transaction”. Id. at 938. The court also concluded that
“Stripped of superficial distinctions, the Rail Joint Co. case is
identical in principle with the present case.” Id. at 939.
We note that Bradford did not involve a debt instrument
issued for less than par value. Additionally, Bradford involved
unusual facts, suggesting that it is of limited application. For
example, the court did not address whether the taxpayer’s husband
had realized discharge of indebtedness income because his tax
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liability was not at issue.6 Bradford v. Commissioner, 233 F.2d
at 939. Furthermore, in a later case, the Court of Appeals for
the Sixth Circuit questioned whether discharge of indebtedness
income might have been realized in an earlier year. Tenn. Sec.,
Inc. v. Commissioner, 674 F.2d 570, 574 (6th Cir. 1982) (“Viewing
the Bradfords as an economic unit might perhaps raise questions
of income to them collectively upon the bank’s discounting the
note.”), affg. T.C. Memo. 1978-434. We also note that
petitioner, unlike the taxpayer in Bradford, applied the loan
proceeds to obligations of his own. Accordingly, we believe that
Bradford is inapposite.
For the foregoing reasons, we conclude that petitioner may
have realized discharge of indebtedness income from the
forgiveness of the related items. Accordingly, petitioner’s
first argument fails.
II. Whether payment of the related items would be deductible as
ordinary and necessary business expenses
Petitioner’s second argument is that the payment of the
related items would have given rise to a deduction as ordinary
6
After the Court of Appeals for the Sixth Circuit issued
its opinion, the Commissioner determined a deficiency against the
taxpayer’s husband arising from the same transaction. See
Bradford v. Commissioner, 34 T.C. 1051 (1960). The notice of
deficiency was untimely due to the expiration of the applicable
limitations period for assessment, however, and we entered a
decision for the taxpayer’s husband on that ground. Id. at 1059.
Thus, neither the Court of Appeals nor this Court addressed
whether the taxpayer’s husband had realized discharge of
indebtedness income.
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and necessary business expenses of his horse breeding and
training activity. Accordingly, he argues, any amounts
attributable to the related items do not constitute income.
Section 108(e)(2) provides: “No income shall be realized
from the discharge of indebtedness to the extent that payment of
the liability would have given rise to a deduction.” In general,
a taxpayer may deduct ordinary and necessary expenses paid or
incurred in carrying on any trade or business. Sec. 162(a); see
also Commissioner v. Lincoln Sav. & Loan Association, 403 U.S.
345, 352 (1971); FMR Corp. & Subs. v. Commissioner, 110 T.C. 402,
414 (1998).
Petitioner asserts that he was in the trade or business of
breeding and training horses from 1983 until sometime in 1995.
Petitioner contends that he used most of the funds he borrowed
from the bank to finance the horse breeding activity.
Petitioner provided his own affidavit and the affidavit of his
accountant, Elliot Blum, to support his contention. Accordingly,
petitioner argues that the payment of the related items would
have given rise to a deduction under section 162(a) as ordinary
and necessary business expenses.
Respondent contends that petitioner has not established that
he used the borrowed funds for the horse breeding activity.
Respondent provided letters that petitioner wrote to the bank in
1988 and 1989 indicating that petitioner borrowed against his
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line of credit to finance real estate purchases and to pay income
taxes, insurance premiums, and other bills. In a letter dated
May 25, 1989, for example, petitioner requested that the bank
place $770,000 into his checking account, stating that “The
purpose of this loan is the payment of income taxes.”
Respondent further contends that, even if the borrowed funds
were used in the horse breeding activity, petitioner has not
established that the activity was a trade or business.
Respondent served petitioner with a request for production of
documents pursuant to Rule 72(a)(1) asking petitioner to “provide
all documents establishing that the training/breeding of horses
was an activity undertaken for profit.” Respondent asserts that
petitioner has not provided the requested information.
Petitioner counters that he conducted the horse breeding
activity in a businesslike manner, including keeping accurate
books and records and using professional advisers to assist him.
Although petitioner acknowledges that the activity generated
“considerable” losses in prior years, he contends that respondent
never disallowed the losses.
Viewing the facts most favorably to respondent, we conclude
there remains a genuine issue as to whether petitioner used the
borrowed funds in a trade or business. The affidavits of
petitioner and his accountant each assert that “most” of the
borrowed funds were used in the horse breeding activity.
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Petitioner’s letters to the bank, however, leave some unanswered
questions regarding those assertions.
We also are unable to conclude, for the purpose of the
instant motion, that the horse breeding activity was a trade or
business. To be engaged in a trade or business within the
meaning of section 162, “the taxpayer’s primary purpose for
engaging in the activity must be for income or profit.”
Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987). We
generally consider nine nonexclusive factors in deciding whether
a taxpayer has maintained the requisite profit motive. Dreicer
v. Commissioner, 78 T.C. 642, 644 (1982), affd. without opinion
702 F.2d 1205 (D.C. Cir. 1983); sec. 1.183-2(b), Income Tax Regs.
If petitioner is correct that he conducted the activity in a
businesslike manner and used expert advisers, such factors would
tend to indicate a profit motive. Sec. 1.183-2(b)(1) and (2),
Income Tax Regs. However, the activity’s history of losses and
petitioner’s financial status are factors that weigh against
petitioner. Sec. 1.183-2(b)(6), (8), Income Tax Regs.
Additionally, there are several remaining factors that are not
addressed in the pleadings and other materials submitted by the
parties.
We also note that respondent’s failure to disallow losses
from the activity in prior years does not establish that it was a
trade or business in 1995. Each taxable year stands on its own,
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and the Commissioner may challenge in a succeeding year what was
overlooked in previous years. See, e.g., Rose v. Commissioner,
55 T.C. 28, 31-32 (1970); Blodgett v. Commissioner, T.C. Memo.
2003-212, affd. 394 F.3d 1030 (8th Cir. 2005). Because material
facts remain in dispute, we conclude that the issue of whether
petitioner was engaged in a trade or business is inappropriate
for summary judgment. See Dahlstrom v. Commissioner, 85 T.C.
at 821.
To reflect the foregoing,
An appropriate order will
be issued.