Phipps v. United States

Nichols, Judge,

delivered the opinion of the court:

This suit arises out of disputes over the tax consequences of Ogden Phipps’ partnership agreements in Smith, Barney & Co., for 1959 and for 1960-63. The business was underwriting the sale of securities and acting as a broker and dealer in securities. Lillian B. Phipps is a party solely because she signed joint tax returns with her husband for the 1959-1963 tax years involved. Although the case is presented as a single case for purposes of cross motions for summary judgment, since 1959 involves one partnership agreement and 1960-63 involves another, we deal with each agreement and its tax consequences separately. The IRS has made a disallowance for each year under IRC of 1954, § 265 (2). Plaintiff has paid and sues for refunds.

I

The agreement in effect in 1959 has been previously construed in Phipps v. United States, 188 Ct. Cl. 531, 414 F. 2d 1366 (1969), (hereinafter Phipps I), having been the same one in effect in 1958, one of the tax years there involved. We agree with plaintiff that collateral estoppel applies here and hold again for the plaintiff, since in regard to the 1959 agreement the Government has shown no change of facts or applicable law as required by Commissioner v. Sunnen, 333 U.S. 591 (1948), to lift the ban on relitigating the same issue. United States v. Bayse, 410 U.S. 441 (1973), is relied on by the Government for this, but the Court concludes at 457:

In summary, we find this case controlled by familiar and long-settled principles of income and partnership taxation. * * *

The case involved partnership income, but not the deduction of interest on indebtedness incurred to carry tax-exempt securities which was the problem in the first Phipps case and again here.

As a matter of interest, we note that the Phipps I opinion cites and quotes extensively from John E. Leslie, 50 T.C. 11 (1968). The very day before Phipps was handed down the Second Circuit reversed Leslie sub nom. Leslie v. Commissioner, 413 F. 2d 636 (1969), cert. denied, 396 U.S. 1007 (1970). This does not effect a change in the “legal atmosphere” sufficient to avoid a collateral estoppel because the quoted material from the Tax Court opinion consisted of a summary of legislative history, plus a statement of general principles, neither of which is disputed or shown to be incorrect in the Circuit Judge’s opinion.

II

Under Commissioner v. Sunnen, collateral estoppel does not carry the interpretation of one written agreement over to another, even when the terms are much the same. The 1960-63 agreements are, however, so different insofar as plaintiff is concerned, that even stare decisis would not excuse us from a careful re-examination of their tax consequences. The legal issue as to those years, that we consider decisive, is whether IEC of 1954, § 265 (2) requires that interest paid by the partnership to banks on loans, secured by pledge of plaintiffs’ tax-exempt securities, must be included in plaintiffs’ net income. So far as pertinent, the statute reads: “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. * * *”

m

Plaintiff, a former 'general partner, was for the tax years involved here a limited partner of Smith, Barney & Co., a New York firm organized as a limited partnership under New York law and having membership rights through its partners on the New York Stock Exchange (NYSE), the American Stock Exchange, the Philadelphia-Baltimore Stock Exchange, the Midwest Stock Exchange, and the Pacific Coast Stock Exchange. There were several classes of partners in the firm: (1) ordinary general partners, (2) five “deep pockets” general partners (who underwrote all losses in excess of $1,000,000), (3) retired limited partners (former general partners with guaranteed retirement incomes of at least $18,000 annually), (4) cash-contributing limited partners, (5) securities-contributing limited partners (of whom Phipps, plaintiff here, was one), and (6) partners who contributed stock exchange memberships.

It appears that Mr. Phipps’ contribution to the partnership for the years in question was primarily a personal note secured 'by pledge of securities for the firm’s use. NYSE Buie 325 (which limits members’ amount of business and available customer loan capacity to 2000 percent of the members’ “net capital”) creates a situation where member firms are always in need of additional working capital. Thus, in addition to the general capital and limited capital contributions by the partners, such 'as Phipps’ limited capital, the firms also seek various ways to include partners’ non-capital, individual trading accounts’ assets in “net capital” — without otherwise depriving individual members of legal and beneficial ownership of these individual trading accounts. (Shearson, Hammil & Co. v. State Tax Commission, 19 App. Div. 2d 245, 241 N.Y.S. 2d 764 (1963), aff'd, 255 N.Y.S. 2d 657 (1964), which exempted these trading accounts from the New York Unincorporated Business Tax, provides additional information on the operation of these trading accounts.)

Mr. Phipps’ capital contribution was supplied in the form of a Limited Capital Note — a demand, non-negotiable note— secured at 100% face value by readily marketable securities. In Phipps’ case, tax-exempt securities (such as Section 103 state and municipal bonds) were used. These securities were placed in a pledge account with the firm. Phipps was required to maintain at least 100% face value of his note in securities with an equal fair market value and also meeting a 90% “capital requirements value” as defined by NYSE rules for measuring “net capital”. Any appreciation or other excess above this two-fold valuation test could be withdrawn. The partnership paid Mr. Phipps 5% per annum on his capital contribution. The partnership paid interest on bank loans secured by plaintiffs’ tax-exempts as follows:

1960_$10,183. 22

1961_ 9,125. 00

1962_ 9, 000. 00

1963_ 9, 000. 00

The partnership deducted these amounts from the 5% payments to Mr. Phipps, paying him only a net figure.

The provisions of the partnership agreement we consider decisive, Articles IV, V and XI of the 1960 partnership agreement, are attached hereto as an appendix. They were in effect for the tax years 1960-1968, inclusive. A limited partner such as Phipps was to be “paid” 5% on the value of his note, as an expense of the business, whether or not earned, plus an additional 1% if earned. He remained owner of the pledged securities and entitled to the income resulting from them. The partnership might pledge the securities to secure its own obligations. The partnership could take as a credit on the 5% and the 1% if earned, the interest it was required to pay on loans secured by the pledged securities. If any item of “income, gain, loss, deduction or credit” with respect to pledged securities should be treated for tax purposes as received or incurred by the partnership, each such item should be “distributable entirely and solely to the partner who pledged” the securities. This last provision, in Article XI (a) had no counterpart in the agreement construed in our previous Phipps I decision.

It is defendant’s interpretation of the present agreement that the partnership considered it was paying Mr. Phipps 5% at all events, either directly or in the form of a credit for the interest to banks. Since the arrangement permitted Mr. Phipps to contribute his tax-exempts to the partnership working capital, yet still enjoy tbeir fruits, it was only fair he should pay the cost of the bank loans that made the arrangement possible. Had he chosen, as he might have, to contribute cash, there would have been no fruits, and on the other hand, no interest to the banks. The bank interest was incurred to preserve the fruits, i.e., for Mr. Phipps’ benefit. It was therefore clearly expected that interest payments made to carry the pledged securities should not fall on the partnership or on the general partners who shared the partnership profit (except the 1%) and loss, but solely on the limited partner who was enjoying the aforementioned fruits.

In Phipps I, we held for plaintiff because, assuming argu-endo that § 265(2) mandated a disallowance of the interest paid the banks, we did not see why the burden of the dis-allowance fell on the plaintiff rather than on the partners who enjoyed the profits and bore the losses. Here we are given a reason why.

IY

We considered § 265 (2) in Illinois Terminal R.R. v. United States, 179 Ct. Cl. 674, 875 F. 2d 1016 (1967). We reasoned that it was not enough for a §265(2) disallowance of the interest deduction that a taxpayer coincidentally held tax-exempt securities. There must be a nexus between the interest payments and the securities held, a “relationship”. The purpose, or the dominant purpose if there is more than one, for incurring the debt must be to carry the securities. This purpose test has been applied by other courts. Leslie v. Commissioner, supra; Wynn v. United States, 288 F. Supp. 797 (E.D. Pa. 1968), aff'd per curiam, 411 F. 2d 614 (3d Cir. 1969), cert. denied, 396 U.S. 1008 (1970); The Wisconsin Cheeseman v. United States, 388 F. 2d 420 (7th Cir. 1968).

In the latter two cases, as here, the securities were used as collateral for the loans, obviously a close and intimate relationship. Phipps, evidently a wealthy man, could have contributed working capital in several different ways, and he enjoyed that option under the Articles too. The selection of the tax-exempts obviously had a tax purpose. The case is, in that aspect not nearly as close as Illinois Terminal.

Rev. Proc. 72-18 (Sec. 3.03), 1972-1 Cum. Bull. 740, says that:

Direct evidence of a purpose to carry. tax-exempt obligations exists where tax-exempt obligations are used as collateral for indebtedness. * * * (Emphasis in original.)

In the presence of direct evidence, it is not necessary, as it was in Illinois Terminal R.R. Co., supra, to search and analyze the record for indirect evidence.

y

If Mr. Phipps had pledged ordinary securities, whose interest was taxable, we believe under Article V he would have been deemed to have received as income the full 5% without reduction. He was entitled to be:

“paid for each full year * * * an amount equal to 5% per annum.” (Emphasis supplied.)

By Treasury Regulation on Income Tax, § 1.702-1 (a):

* * * Each partner is required to take into account separately in his return his distributive share, whether or not distributed, of each class or item of partnership * * * gain, loss, deduction, or credit * * * [including] * * *

# * $ $ $

(8) (i) * * * any items of income, gain, loss, deduction, or credit subject to a special allocation under the partnership agreement which differs from the allocation of partnership taxable income or loss generally.

# * * * *

The interest payments to the banks are called “credits” against the limited partner’s 5%, in Article V, and Article XI (a) clearly tracks the above quoted “special allocation” provision. The washing out of an offset claim as part of “payment” is not new or unfamiliar to the tax law. See, e.g., Commissioner v. Hansen, 360 U.S. 446 (1958), (in which an item is deemed accruable under the “all events” test if at all events it will either be paid in cash or offset against anticipated future liabilities). See, also, Lawyers Title Guaranty Fund v. United States, 508 F. 2d 1 (5th Cir., 1975). By IRC of 1954, § 61(a) (13), the discharge of indebtedness is includable as income.

Plaintiff has furnished an affidavit issued by Smith, Barney & Company’s then Chief Accountant describing its accounting and tax reporting procedure. Even if we were to accept the affidavit in its entirety as true, that would not change the result in this case. Although the affidavit indicates that the partnership did not report on its returns for the subject years any amount of the interest deduction as having been specially allocated to the plaintiff, such an allocation is in fact what actually occurred even though not reported as such. When the interest expense paid on loans secured by plaintiff’s securities was deducted from plaintiff’s 5 percent per annum to arrive at the sum which the partnership owed plaintiff, this was the allocation. This subtraction was provided for in the partnership agreement. The affidavit, incidentally, acknowledges this subtraction in paragraph eight thereof. The erroneous treatment by the partnership of the amounts in controversy cannot change the legal effect under section 265 (2) of the express terms of the partnership agreement as shown by the above analysis.

Having the full 5% imputed to him, Mr. Phipps would, of course, in the ordinary case have the interest deduction imputed to him also, as Article XI (a) clearly requires, and he could take it as a deduction on his return.

Since the interest deduction, if allowable, would belong to Mr. Phipps, it is clear the burden of any disallowance would fall on him also. We have shown under Part TV that the interest here involved was paid to “carry” the tax-exempts within the meaning of § 265(2). It follows that Mr. Phipps is taxable for the full 5% without deduction for the interest, with respect to his 1960-63 tax years, the 5% being made up of the sums actually paid him and “credit” taken on account of his obligation to relieve the partnership of the interest paid the banks.

In regard to tax year 1959, summary judgment is granted to plaintiff and the case is remanded to the trial division for a determination of recovery pursuant to Rule 131 (c), since the record does not adequately state the full amount of back taxes, penalties, and interest to be refunded.

In regard to tax.years 1960-63, summary judgment is granted to defendant and the petition is dismissed.