Scott C. and Sherry L. Russon v. Commissioner

107 T.C. No. 15UNITED STATES TAX COURT
SCOTT C. AND SHERRY L. RUSSON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23686-94. Filed November 6, 1996.
P, a funeral director, is a full-time employee of
Russon Brothers Mortuary, a C corporation, all the
stock of which was owned by his father and two uncles.
In 1985, P, his brother, and two cousins (all funeral
director employees of Russon Brothers) agreed to
purchase all the stock from their fathers so that the
sons could conduct the mortuary business and earn a
living continuing the business founded and developed by
their fathers. P incurred indebtedness in order to
purchase his share of the stock. At issue is whether
interest paid on that indebtedness is deductible as
business interest or whether deductibility is subject
to the investment interest limitations of sec. 163(d),
I.R.C., as modified by the Revenue Act of 1986, Pub. L.
99-514, 100 Stat. 2085.
Pursuant to sec. 163(d)(1), I.R.C., the amount
allowable as a deduction for "investment interest" may
not exceed the taxpayer's "investment income",
sometimes known as portfolio income. "Investment
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interest" is defined in sec. 163(d)(3), I.R.C., as
interest paid on indebtedness properly allocable to
"property held for investment," a term that is defined
in sec. 163(d)(5)(A)(i), I.R.C., to include "property
which produces income of a type described in sec.
469(e)(1)," i.e., portfolio income such as dividends,
interest, etc.
Held: Since stock is the type of property that
normally pays dividends, it is covered by sec.
163(d)(5), I.R.C., as "property which produces income"
of a type described in sec. 469(e)(1), I.R.C.,
notwithstanding that in this case no dividends have in
fact been paid in the past on Russon Brothers stock.
Accordingly, interest paid by P on indebtedness
incurred to purchase the stock is subject to the
limitations of sec. 163(d)(1), I.R.C.
J. Michael Gottfredson, for petitioners.
James B. Ausenbaugh and Mark H. Howard, for respondent.
OPINION
RAUM, Judge: The Commissioner determined deficiencies in
petitioners' Federal income taxes of $4,220.50, $4,231.92, and
$3,967.60 for the taxable years 1990, 1991, and 1992,
respectively. Petitioner husband (petitioner or Scott) together
with his brother and two cousins, all employed full time as
funeral directors in a mortuary operated by a C corporation,
purchased all the stock of that corporation from its owners,
their fathers, so that they could conduct the mortuary business
full time and "earn a living." At issue is whether interest paid
on an indebtedness incurred by petitioner to purchase his share
of the stock is deductible as business interest or is subject to
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the investment interest limitations of section 163(d) as modified
by the Revenue Act of 1986, Pub. L. 99-514, 100 Stat. 2085.
Unless otherwise indicated, all section references are to the
Internal Revenue Code in effect for the tax years involved.
Petitioners resided in Centerville, Utah, when the petition
in this case was filed. Petitioner is an employee of Russon
Brothers Mortuary (Russon Brothers), a Utah corporation that was
organized as a "C" corporation in 1969 and continues as such to
the present. Petitioner began full-time employment with Russon
Brothers in September 1979 as a funeral director and has
continued full time with Russon Brothers to the present.
On December 23, 1985, Scott, his brother Brent C. Russon,
and two cousins, Robert L. Russon and D. Gary Russon, agreed to
buy all the stock in Russon Brothers from Scott and Brent's
father, Milton W. Russon, Robert's father, Leo W. Russon, and
Gary's father, Dale L. Russon. Milton, Leo, and Dale are
brothers, each of whom owned one-third of the stock of Russon
Brothers. Scott, Brent, Robert, and Gary agreed to pay their
fathers $999,000 for the stock in Russon Brothers, each son to
pay one-fourth (1/4) of the purchase price, payable ten percent
(10%) down and the balance payable in 180 equal monthly payments
with interest at nine percent (9%) on the remaining balance. The
Agreement gave the four buyers the "right to exercise the
ownership rights * * * [which] shall include * * * the right to
all the dividends from the stock," except as limited by the
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Agreement. One of the limitations provided that until the full
purchase price was paid, the buyers could not "declare or pay any
dividends or make any distributions" relating to the stock
without written permission of the sellers, the fathers.
Scott, Brent, Robert, and Gary all were funeral directors at
the time of the purchase. They were trained and taught the
mortuary business at Russon Brothers. They qualified themselves
to operate the mortuary business through schooling and while
working at Russon Brothers. On December 23, 1985, Russon
Brothers, as the Company, Scott, Brent, Robert, and Gary, as
Buying Shareholders, and Milton, Leo and Dale, as Selling
Shareholders, entered into a Stock Purchase Agreement. On
December 23, 1985, Milton, Leo, Dale, Brent, and Gary were
elected directors of Russon Brothers. The new directors then
elected Robert as president, Brent as vice president, and Scott
as secretary-treasurer of Russon Brothers.
At the time the stock was purchased Milton and Leo retired
from Russon Brothers. Dale continued as a full-time employee for
a few months in order "to receive his maximum Social Security
benefits allowable to him for retirement at age 62". Scott,
Brent, Robert, and Gary purchased the Russon Brothers stock from
their fathers so that they could manage, operate, conduct, and
participate full time in the mortuary business and earn a living
continuing a business started and developed by their fathers.
Scott did not have a substantial investment motive when he
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purchased the stock. Milton, Dale, and Leo sold the Russon
Brothers stock to Scott, Brent, Robert, and Gary so the four sons
of the three fathers could actively continue the mortuary
business.
All the assets of Russon Brothers, except for a mutual fund
acquired by the company in 1989 for $12,000 with a 1995 value of
$20,000, are used actively in the mortuary business. The
checking account of Russon Brothers has an average balance of
$70,000 with cash available of $30,000 and is all actively used
in the mortuary business.
Russon Brothers has never paid interest, dividends,
annuities, or royalties to any of its shareholders during its
existence of 26 years. Beginning before December 23, 1985, and
continuing through all years involved in the tax matter before
the Court, Scott, Brent, Robert, and Gary actively and materially
participated in Russon Brothers as an active mortuary business on
a regular, continuous, and substantial basis in excess of 40
hours per week. Scott, Brent, Robert, and Gary have never been
engaged in the trading or dealing of stocks or securities.
Section 163(a) allows "as a deduction all interest paid or
accrued within the taxable year on indebtedness." However,
section 163(d)(1) provides that "In the case of a taxpayer other
than a corporation, the amount allowed as a deduction under this
chapter for investment interest for any taxable year shall not
exceed the net investment income of the taxpayer for the taxable
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year." Section 163(d)(3) defines "investment interest" as "any
interest allowable as a deduction under this chapter * * * which
is paid * * * on indebtedness properly allocable to property held
for investment." Section 163(d)(5) defines "property held for
investment" as follows:
(A) In general. The term "property held for investment"
shall include--
(i) any property which produces income of a type
described in section 469(e)(1), and
(ii) any interest held by a taxpayer in an
activity involving the conduct of a trade or
business--
(I) which is not a passive activity, and
(II) with respect to which the taxpayer
does not materially participate.
* * * * * * *
(C) Terms.--For purposes of this paragraph, the terms
"activity", "passive activity", and "materially
participate" have the meanings given such terms by
section 469.
The income described in section 469(e)(1) includes "interest,
dividends, annuities, or royalties not derived in the ordinary
course of a trade or business", sometimes known as portfolio
income.
The dispute in this case revolves around whether the Russon
Brothers stock is "property held for investment". Respondent has
stipulated that petitioner materially participates in Russon
Brothers, and concedes that section 163(d)(5)(A)(ii) does not
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apply to petitioner. However, since stock is generally
productive of dividends, the Commissioner contends that the stock
here is covered by section 163(d)(5)(A)(i), notwithstanding that
the Russon Brothers stock has, in fact, never paid a dividend.
Accordingly, the argument continues, the Russon Brothers stock is
"property held for investment", and, as such, petitioners'
deduction for the interest is limited to their investment income.
If this case were to be decided under the Code as it existed
prior to enactment of the Tax Reform Act of 1986, Pub. L. 99-514,
100 Stat. 2085, petitioners might be entitled to prevail. Under
prior law, the term "investment interest" was defined as
"interest paid or accrued on indebtedness incurred or continued
to purchase or carry property held for investment." Sec.
163(d)(3)(D). At that time, the phrase "property held for
investment" had not been defined in the Code or the regulations.
Recklitis v. Commissioner, 91 T.C. 874, 907 (1988). To determine
whether interest should be subject to the limitations of then
section 163(d)(1)1, the Tax Court looked to whether the taxpayer
1
The 1985 version of section 163(d)(1) provides:
(1) In general.--In the case of a taxpayer other than
a corporation, the amount of investment interest * * *
otherwise allowable as a deduction under this chapter
shall be limited, in the following order, to--
(A) $10,000 ($5,000, in the case of a separate
return by a married individual), plus
(B) the amount of the net investment income * * *
by which the deductions allowable under this
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had a substantial investment intent. Miller v. Commissioner, 70
T.C. 448, 455 (1978). Whether the taxpayer had the requisite
intent was a question of fact. Id. at 455-456. The parties in
this case stipulated that petitioner did not have a substantial
investment motive when he purchased the stock. Prior to the Tax
Reform Act of 1986, he would likely have prevailed.
The Tax Reform Act of 1986 broadened the definition of
investment interest. Section 511(a) of the 1986 Act defines
"property held for investment" to include "any property which
produces income of a type described in section 469(e)(1)." 100
Stat. 2245. The definition applies uniformly to every taxpayer;
his mindset is irrelevant. As a result, the reach of the
definition under the 1986 Act is more inclusive.
Petitioners contend that the phrase "property which produces
income" in section 163(d)(5)(A)(i) is limited to property which
has actually produced one of the types of income described in
section 469(e)(1)(A). However, the Government's position here is
supported by the legislative history. In the report of the
Senate Finance Committee accompanying section 469, portfolio
income includes "gain or loss attributable to disposition of (1)
section * * * and sections 162, 164(a)(1) or (2),
or 212 attributable to property of the taxpayer
subject to a net lease exceeds the rental income
produced by such property for the taxable year.
In the case of a trust, the $10,000 amount specified in
subparagraph (A) shall be zero.
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property that is held for investment (and that is not a passive
activity) and (2) property that normally produces interest,
dividend, or royalty income." S. Rept. 99-313 at 728 (1986),
1986-3 C.B. (Vol. 3). (Emphasis added.) This committee report
runs counter to petitioners' assertions as set forth in their
brief that stock must produce a dividend before it is "property
held for investment". The report indicates that Congress did not
require the payment of interest, dividends, etc. Section
163(d)(5)(A)(i) refers to section 469(e)(1) for one definition of
"property held for investment". Inasmuch as portfolio income
under section 469(e)(1) includes property that "normally
produces" interest, dividends, etc., it follows that the
reference to section 469(e)(1) in section 163(d)(5) would also
include property which "normally produces" dividends. Certainly,
stock is the kind of property that "normally produces" dividends.
Would petitioners' position be different here if the corporation
had paid only a very small dividend over the years?
Moreover, on the record in this case, the possibility of
dividends being paid was clearly contemplated by the buyers and
sellers of the stock. Indeed, the agreement of sale of the stock
explicitly recognized that the purchasers would be entitled to
"all of the dividends from the stock", subject only to the
written consent of the sellers prior to the payment in full of
the purchase price. That condition is not at all to be regarded
as uncommon where there is a sale of all the stock of a
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corporation. Further, it should be remembered that, although the
sale may be treated as having been made at arm's length,
nevertheless the sellers were the fathers of the purchasers, and
at least in some circumstances it would seem more likely that
their consent would not be withheld than in the case of
strangers.
Petitioners contend that the purpose of the new 1986
provisions supports the allowance of the claimed deduction in
their case. To be sure, the legislative history of the 1986 Act
does disclose that Congress was concerned with plugging a
loophole that had permitted taxpayers to take deductions against
their earned income by reason of interest, expenses, losses,
etc., attributable to tax shelters and other arrangements not
related to the taxpayer's trade or business. See H. Rept. 99-426
at 299-300 (1985), 1986-3 C.B. (Vol. 2). And petitioners' rely
upon a statement of the staff of the Joint Committee on Taxation
explaining the reason for the new provisions, as follows:
Under prior law, leveraged investment property was
subject to an interest limitation, for the purpose of
preventing taxpayers from sheltering or reducing tax on
other, non-investment income by means of the unrelated
interest deduction. Congress concluded that the
interest limitation should be strengthened so as to
reduce the mismeasurement of income which can result
from the deduction of investment interest expense in
excess of current investment income, and from deduction
of current investment expenses with respect to
investment property on which appreciation has not been
recognized. [Staff of Joint Comm. on Taxation, General
Explanation of the Tax Reform Act of 1986 at 263 (J.
Comm. Print 1987); emphasis added.]
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Petitioners call attention to the fact that in this case there
would be no "mismeasurement of income which can result from the
deduction of investment interest expense in excess of current
investment income." However, there are at least several answers
to petitioners' point. In the first place, as has been stressed
earlier in this opinion, the statutory language was intended by
Congress, as shown in the report of the Senate Finance Committee,
to cover "property that normally produces interest, dividends or
royalty income." S. Rept. 99-313, supra, 1986-3 C.B. (Vol. 3) at
728. (Emphasis added.) And in this case the property involved,
stock, is of a type that "normally" produces dividends. In the
second place, as pointed out by Judge Friendly in Commissioner v.
Pepsi Cola Niagara Bottling Corp., 399 F.2d 390, 392 (2d Cir.
1968), "a legislature seeking to catch a particular abuse may
find it necessary to cast a wider net."
Further, petitioners fail to consider the fact that Russon
Brothers is a C corporation. If Russon Brothers were an S
corporation or a partnership, it appears that Scott, as an active
manager, would be entitled to deduct the interest, without
limitation, on the debt incurred to purchase the stock as a
direct owner of the business. However, as a C corporation,
Russon Brothers is a separate taxpaying entity, distinguishable
from its owners. Cf., e.g., Moline Properties, Inc. v.
Commissioner, 319 U.S. 436 (1943). Russon Brothers owns the
mortuary business, not Scott and his fellow stockholders. Scott
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is an employee of the mortuary business. As a result, he is not
entitled to deduct the interest on the debt incurred to purchase
the Russon Brothers stock as trade or business interest.
The result that we reach is in accord with Rev. Rul. 93-68,
1993-2 C.B. 72, which considers a case virtually identical with
this case. The revenue ruling explained its reasoning as
follows:
Because stock generally produces dividend income,
it is property held for investment within the meaning
of sections 163(d)(5)(A) and 469(e)(1)(A) of the Code,
unless the dividends are derived in the ordinary course
of a trade or business. In this case, any dividends
paid by X [a C corporation] would not be derived by A
[an employee and purchaser of stock in X] in the course
of a trade or business because A is neither a dealer
nor a trader in stock or securities. Thus, the X stock
purchased by A is property held for investment pursuant
to section 163(d)(5)(A), regardless of A's motives for
purchasing or holding that stock. * * * [Emphasis
added.]
Rev. Rul. 93-68, 1993-2 C.B. at 73. Although we are by no means
bound by the revenue ruling, we think its reasoning is correct,
and we have independently reached the same result here.
Section 163(d)(5)(A) contains two objective tests for
"property held for investment." We have concluded that
petitioner's stock in Russon Brothers satisfies the first test
under section 163(d)(5)(A)(i). It is therefore unnecessary to
consider the second test in subparagraph (A)(ii), although it
would seem, and the Government concedes, that the second test
does not apply here.
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Decision will be entered
for respondent.