DocketNumber: Docket No. 15887-94.
Citation Numbers: 107 T.C. 35, 1996 U.S. Tax Ct. LEXIS 35, 107 T.C. No. 4
Judges: RUWE
Filed Date: 8/26/1996
Status: Precedential
Modified Date: 1/13/2023
*35 Decision will be entered under Rule 155.
W, a cash basis partnership, entered into an agreement in 1980 to borrow up to $ 29 million from J. J made an initial disbursement of $ 19,645,000. Pursuant to the loan agreement, J applied $ 227,647.22 of the initial disbursement as a credit for interest W owed to J on a previous loan. Pursuant to a subsequent modification of the 1980 loan agreement, J agreed to advance $ 1,587,310.46 to W to enable W to satisfy its current interest obligation to J. J made a wire transfer of $ 1,587,310.46 to W's bank account on Dec. 30, 1980. On Dec. 31, 1980, W made a wire transfer to J to satisfy W's current interest obligation. The net effect of the Dec. 30-31 transaction was to increase the principal amount of W's loan from J by $ 1,587,310.46. W claimed interest deductions of $ 227,647.22 and $ 1,587,310.46 and reported an ordinary loss on its partnership return for 1980.
R disallowed W's interest deductions, determining that the interest had not been "paid" but merely postponed. R adjusted Ps' distributive share of W's ordinary loss accordingly.
*36 OPINION
RUWE,
This case was submitted fully stipulated. The stipulation of facts and the first supplemental stipulation of facts*37 are incorporated herein by this reference. Petitioners resided in Greenwich, Connecticut, at the time they filed their petition. Petitioners were calendar year, cash basis taxpayers.
Petitioner Charles H. Davison is a certified public accountant. During 1979, he was head partner of the accounting firm Peat, Marwick & Mitchell, where he was associated with Samuel J. Esposito and John L. Vitale, who were also partners.
On February 1, 1979, Messrs. Davison, Esposito, and Vitale formed White Tail, a general partnership organized under Illinois law, for the purpose of entering into the agricultural business of acquiring, cultivating, and selling farm properties. Each of the partners had a one-third interest in the profits, losses, and distributions of White Tail. White Tail reported its income on a calendar year basis using the cash method of accounting.
On or about March 16, 1979, White Tail acquired approximately 11,000 acres of real property located in Hyde County, North Carolina, and certain related personal property. On or about May 2, 1980, White Tail acquired approximately 7,747 *37 acres of real property located in Hyde and Tyrrell Counties in North Carolina.
In 1979, White Tail*38 realized $ 248,198 in gross revenues from farming operations and incurred $ 868,684 in operating expenses, exclusive of interest expense. In 1980, White Tail realized $ 2,098,717 in gross revenues from farming operations and incurred $ 2,784,169 in operating expenses, exclusive of interest expense.
On December 21, 1978, the John Hancock Mutual Life Insurance Co. (John Hancock) issued to Messrs. Davison, Esposito, and Vitale a commitment to make a first mortgage loan on the White Tail property in an amount up to $ 9 million. 1 By a promissory note dated March 16, 1979, White Tail and John Hancock established the credit arrangement contemplated by this $ 9 million mortgage loan commitment. 2 Subsequently, on January 28, 1980, John Hancock issued to White Tail a First Mortgage Loan Commitment pursuant to which John Hancock agreed to advance White Tail a maximum amount of $ 29 million. The First Mortgage Loan Commitment required that White Tail use a portion of the funds borrowed to retire existing indebtedness to John Hancock, 3 and envisioned that additional amounts would be advanced to White Tail up to the aggregate principal*39 amount of $ 29 million.
By a promissory note dated May 2, 1980, White Tail and John Hancock established the 1980 John Hancock*40 credit arrangement (the 1980 credit arrangement), as contemplated by the First Mortgage Loan Commitment. 4 This promissory *38 note required White Tail to pay interest on its borrowings at an annual rate of 12.25 percent, payable every January 1 commencing January 1, 1981. The promissory note also entitled John Hancock to 20 percent of White Tail's net farm income, as well as 20 percent of White Tail's net profits from land sales.
*41 Pursuant to the establishment of the 1980 credit arrangement, John Hancock made initial disbursements on May 7, 1980, totaling $ 19,645,000. A portion of the $ 19,645,000 consisted of a credit to White Tail's prior loan account with John Hancock for $ 6,480,000 to pay off the principal that White Tail owed pursuant to the prior credit arrangement, and a credit to White Tail's prior loan account for $ 227,647.22 to satisfy the interest obligation that had accrued on the prior loan.
The 1980 credit arrangement required White Tail to make an interest payment on January 1, 1981. The amount of interest due was $ 1,587,310.46. Pursuant to the terms of the 1980 credit arrangement, one-half of the interest could be borrowed from John Hancock. The 1980 credit arrangement also called for a principal payment of $ 7,707.50 on the same date.
White Tail needed to satisfy the requirements set forth in the First Mortgage Loan Commitment in order to become eligible to make additional borrowings under the 1980 credit arrangement. These additional borrowings were characterized as "Land Development" and "Operating Funds" borrowings. Under the terms of the First Mortgage Loan Commitment, the 1980 disbursement*42 for "Operating Funds" was subject to the following provision: If the Borrower's Net Farm Income is insufficient to fund the interest accrued on the loan contemplated herein from date of closing to December 31, 1980, John Hancock shall disburse sufficient proceeds of this loan to fund said interest shortage; provided, however, that the amount of said Disbursement for Operating Funds shall not exceed 50% of the actual accrued interest during said period, and provided further that John Hancock's said Disbursement for such interest shortage shall not be disbursed until Borrower has advanced its portion of the actual accrued interest.
White Tail's business was unprofitable, 5 and, in December 1980, Mr. Esposito requested that John Hancock modify the terms of the 1980 credit arrangement in order to prevent a default. On December 24, 1980, John Hancock mailed a Letter of Agreement (Letter Agreement) to White Tail c/o Mr. Esposito. The Letter Agreement states:
Gentlemen: Reference is made to the enclosed Vote # 3, *43 Page Three approved December 23, 1980 by our Agricultural Investment Committee, and approved today by our Committee of Finance, in which vote we have authorized the Modification of the legal papers evidencing and securing the above referenced loan. Said Modification will capitalize certain interest due from you on January 1, 1981 and will defer certain principal due from you on the same date, all as set forth in said vote. Said Modification will further increase John Hancock's participation in the property's defined Operating Income and in the Security's Appreciation, also all as set forth in said enclosed Vote. * * * * You have asked us to enter into this Letter of Agreement with you this week, in advance of our referrel [sic] to counsel and his preparation of the definitive documentation, in order to prevent a default in your payment due January 1, 1981. If this Letter of Agreement is to become effective, you must sign the enclosed copy hereof and return the same to me at the Home Office, so that the same is received by me prior to December 31, 1980. To capitalize $ 793,655.23 of the $ 1,587,310.46 interest due January 1, 1981 and to defer the $ 7,707.50 principal installment due January 1, 1981 until January 1, 2001, the final maturity under FML [Farm Mortgage Loan] # 161177, White Tail Farm, 19,344 acres secured by a First Mortgage loan in North Carolina and Illinois in consideration of White Tail Farm providing John Hancock Participation as follows: Between July 1, 1981 and January 1, 1991[,] 22% of Net Farm Income and 22% of the Net Profit From Land Sales[;] *40 and Between January 2, 1991 and January 2, 2001[,] 25% of Net Farm Income and 25% of the Net Profit From Land Sales over Value Assigned To Land; rather than 20% of Net Farm Income and 20% of the Net Profit From Land [Sales] as originally provided.
On December 30, 1980, John Hancock*45 made a wire transfer of $ 1,587,310.46 to White Tail's account at the American National Bank and Trust Co. of Chicago (American National). This transfer increased the amount White Tail owed to John Hancock by $ 1,587,310.46. This amount is reflected as a deposit into the American National account on December 30, 1980. On December 31, 1980, White Tail made a wire transfer of $ 1,595,017.96 to John Hancock, representing $ 7,707.50 of principal and $ 1,587,310.46 in interest due under the 1980 credit arrangement. 6
The purpose of the $ 1,587,310.46 advance from John Hancock was to provide White Tail with sufficient funds to satisfy the interest due John Hancock on January 1, 1981, under the terms of the 1980 credit arrangement, as modified. White Tail's general ledger showed that its bank account at American National, as of December 31, 1980, was overdrawn with a negative*46 balance of $ 138,931.80. 7
On their 1980 Federal income tax return, petitioners reported an ordinary loss of $ 946,613 as their distributive share of the $ 2,839,839.09 ordinary loss reported by White Tail on its U.S. Partnership Return of Income (Form 1065) for 1980. On June 6, 1994, respondent issued a notice of deficiency adjusting petitioners' distributive share of the ordinary loss reported by White Tail. 8*47 In particular, respondent disallowed the interest deductions for amounts that White Tail claimed to have "paid" to John Hancock on May 7 and December 31, 1980, in the respective amounts of $ 227,647.22 *41 and $ 1,587,310.46. 9 Respondent adjusted petitioners' distributive share of White Tail's ordinary loss accordingly.
Before we analyze the transactions in issue, it is appropriate to state some general principles with respect to interest deductions.
*49 Under the terms of the 1980 credit arrangement, an interest payment and a principal installment were due from White Tail on January 1, 1981. In the 1980 credit arrangement, John Hancock had agreed to lend White Tail up to 50 percent of the interest that was due, so long as White Tail *42 was able to provide the remaining 50 percent. In December 1980, Mr. Esposito, one of White Tail's general partners, approached John Hancock and requested that it agree to modify the 1980 credit arrangement with respect to the required interest payment, in order to prevent a default by White Tail. In the Letter Agreement dated December 24, 1980, it was agreed that John Hancock would modify the 1980 credit arrangement so as to "capitalize" $ 793,655.23 of the $ 1,587,310.46 interest due from White Tail and defer the due date for the principal installment until January 1, 2001. 11 In the original 1980 credit arrangement, John Hancock had already agreed to lend one-half of the interest due on January 1, 1981. The effect of the modification was that all the interest due to John Hancock on January 1, 1981, would be borrowed from John Hancock.
*50 On December 30, 1980, John Hancock wired $ 1,587,310.46 to White Tail's account at American National. This increased the amount White Tail owed John Hancock by $ 1,587,310.46. On December 31, 1980, White Tail wired John Hancock $ 1,595,017.96, which John Hancock reflected as a satisfaction of White Tail's January 1, 1981, interest obligation of $ 1,587,310.46 plus a principal payment of $ 7,707.50. 12
The purpose of John Hancock's $ 1,587,310.46 advance to White Tail on December 30, 1980, was to provide White Tail with sufficient funds to satisfy the interest due John Hancock on January 1, 1981. Petitioners argue that White*51 Tail paid this interest when it made the wire transfer to John Hancock on December 31, 1980. Respondent contends that interest has not been paid but merely postponed, and, consequently, White Tail is not entitled to a deduction under
On brief, petitioners place particular reliance on prior decisions of this Court in which the deductibility of interest paid to a lender, with funds borrowed from the same lender, turns on whether the borrower exercised "unrestricted control" over *43 the funds borrowed. Petitioners argue that they are entitled to a deduction pursuant to
The concept of "unrestricted control" in cases of this nature had its origin in
In a Court-reviewed opinion, we allowed the deduction. We rejected the Commissioner's argument that the taxpayer had simply substituted a note in place of the interest payable. We found that the taxpayer did not apply for the loan for the sole purpose of obtaining funds to pay interest, and the lender did not grant the loan for that exclusive purpose. We also found that the taxpayer had several bills that were due, needed sufficient funds to pay them as well as the interest, and commingled the loan proceeds with other funds in his account, causing them to lose their identity. As a result, we found that the loan proceeds could not be traced to the payment of interest.
Six judges dissented from the majority's holding. They believed that the facts*53 demonstrated that the taxpayer borrowed the $ 4,000 for the purpose of paying interest. They believed that the substance of what occurred was no different than where a taxpayer simply executes a note to the lender in satisfaction of the current interest obligation.
In
In
We concluded that the facts in
*55 Faced with essentially the same fact pattern in We have rejected that same argument where the lender gave up control of the borrowed funds, the funds were commingled with the taxpayer's own funds, and then the commingled funds were used to prepay interest. The partnerships here acquired control of the loan proceeds as evidenced by their deposit in the partnership checking accounts outside the lender's domain. That the partnerships exercised their control over the funds for only a brief period of time does not convert the transactions into discounted loans. [
In
Two Courts of Appeals have rejected this application of an "unrestricted control" rule.
*59 The Court of Appeals for the Fifth Circuit concluded that the check exchanges between the lender and borrower were plainly for no purpose other than to finance the taxpayers' current interest obligations and, therefore, denied the interest deduction. In rejecting the taxpayers' reliance on the fact that actual checks were exchanged, the Court of Appeals stated: In ignoring these exchanges, we merely follow a well-established principle of law, viz., that in tax cases it is axiomatic that we look through the form in which the taxpayer has cloaked a transaction to the substance of the transaction. See, e.g.,
The Court of Appeals rejected the taxpayers' reliance on
In
Shortly after the reversal in Where a lender gives up control of borrowed funds, the funds are commingled with the taxpayer's other funds in an account at an institution separate from the lender, and the interest obligation is satisfied with funds from that separate account, there has been a payment of interest under
The 1-percent partner did not have signatory authority over the bank account into which the borrowed funds were deposited.
We think that similar fundamental and significant factors restricted White Tail's control over the $ 1,587,310.46 that John Hancock wired to White Tail's account on December 30, 1980. White Tail had specifically agreed to borrow this amount to satisfy its interest obligation in order to prevent a default. Use of the funds for any other purpose would have breached the terms of its agreement with John Hancock and would have resulted in White Tail's default and a likely end to its business operations. 18 In
*66 The issue before us arises when a borrower borrows funds from a lender and immediately satisfies an interest obligation to the same lender. In order to determine whether interest has been paid or merely deferred, it is first necessary to determine whether the borrowed funds were, in substance, the same funds used to satisfy the interest obligation. Whether the relevant transactions were simultaneous, whether the borrower had other funds in his account to pay interest, whether the funds are traceable, and whether the borrower had any realistic choice to use the borrowed funds for any other purpose would all be relevant to this issue. Once it is determined that the borrowed funds were the same funds used to satisfy the interest obligation, the purpose of the loan plays a decisive role.
In light of the foregoing analysis, we hold that a cash basis borrower is not entitled to an interest deduction where the funds used to satisfy the interest obligation were borrowed for that purpose from the same lender to whom the interest was owed. This test is consistent with our traditional approach of characterizing transactions on a substance-over-form basis by looking at the economic realities*67 of the transaction. We agree with the Court of Appeals in
*50 In the instant case, it is clear that the purpose of the $ 1,587,310.46 advance on December 30, 1980, from John Hancock to White Tail was to provide White Tail with funds to satisfy its interest obligation to John Hancock. White Tail's general partner had requested modification of the original 1980 credit arrangement so that the entire amount of interest could be borrowed from John Hancock, in order to prevent a default on the interest obligation. In the Letter Agreement between White Tail and John Hancock, both borrower and lender agreed that the $ 1,587,310.46 advance would increase White Tail's loan and that it would be *68 used to satisfy the current interest obligation. Checks were exchanged within a 2-day period to effect the transaction. The effect was to increase the amount of White Tail's principal loan obligation to John Hancock by the amount of interest due. The fact that the loan proceeds were run through White Tail's bank account does not affect the substance of the transaction.
The other transaction in issue also involves a situation where an interest obligation was satisfied by borrowing funds from the original lender. On May 7, 1980, following the establishment of the 1980 credit arrangement, John Hancock advanced $ 19,645,000 to White Tail. Of this amount, John Hancock applied $ 227,647.22 to unpaid interest owed under the terms of a previous loan to White Tail. John Hancock did this by crediting White Tail's prior loan account to show that White Tail's interest obligation in the amount of $ 227,647.22 had been satisfied. John Hancock simultaneously increased the principal amount due from White Tail under the new*69 1980 credit arrangement.
As stated above, we hold that interest is not deductible under the cash method of accounting where the funds used to satisfy the interest obligation were borrowed for that purpose from the same lender to whom the interest obligation was owed. That is clearly what happened on May 7, 1980, when, pursuant to the terms of the 1980 credit arrangement, John Hancock credited White Tail's prior loan account for interest due and simultaneously increased the principal due on White Tail's new loan for the same amount.
*85 Petitioners argue that the $ 227,647.22 should be considered as interest "paid", because the 1980 credit arrangement and the 1979 loan from John Hancock were "bona fide separate loans, with different interest rates and terms, and different security arrangements." Under our holding, the fact that funds used to satisfy an interest obligation to a lender are borrowed from the same lender in a second loan is irrelevant. Indeed, this Court has previously rejected the argument presented by petitioners. In where a taxpayer on the cash basis who is indebted on a note for past*70 due interest borrows from his creditor an amount in excess of this past due interest on a second note, and the creditor gives to the taxpayer the principal amount of the second note less the amount of past due interest on the first note and marks this interest "paid," we have held that no cash payment has been made which would warrant a deduction.
See also
Based on the foregoing analysis, the interest deductions claimed by White Tail on its 1980 return in the amounts of $ 1,587,310.46 and $ 227,647.22 are not allowable, and we sustain respondent's disallowance of the corresponding deductions that petitioners claimed as their distributive share of partnership loss.
1. This commitment preceded the actual formation of White Tail and its acquisition of property.↩
2. In connection therewith, White Tail executed a Deed of Trust and Security Agreement. Messrs. Davison, Esposito, and Vitale also executed a Guaranty of Note, Deed of Trust and Mortgage in the amount of $ 1 million, with the maximum individual liability of each guarantor limited to one-third of this amount. In addition, Brad Hill Farms (Brad Hill), another partnership of Messrs. Davison, Esposito, and Vitale, executed a mortgage of certain Illinois real property as further security for the $ 9 million promissory note. White Tail and John Hancock modified their agreement with a Modification of Promissory Note and Deed of Trust and Security Agreement, dated Dec. 4, 1979.↩
3. The First Mortgage Loan Commitment stated that White Tail's existing indebtedness to John Hancock was $ 6 million.↩
4. In connection with the execution of the May 2, 1980, promissory note and the establishment of the 1980 credit arrangement, White Tail executed a Deed of Trust and Security Agreement and an Option Agreement. Moreover, each of White Tail's partners executed a Guaranty of Note, Deed of Trust and Mortgage. The Guaranty of Note provided that each partner guaranteed the payment of one-third of the amount owed under the 1980 credit arrangement, up to a maximum amount of $ 1 million. Brad Hill also executed a Guaranty of Note, Deed of Trust and Mortgage. The Deed of Trust and Security Agreement was amended by an Amendment to Deed of Trust and Security Agreement, dated Aug. 26, 1980.↩
5. See
6. There is no explanation of why the $ 7,707.50 principal payment was not deferred in accordance with the modification of the 1980 credit arrangement.↩
7. This amount includes outstanding checks that had been written on, but had not yet cleared, White Tail's American National account. This amount is also shown as a liability on White Tail's 1980 U.S. Partnership Return of Income (Form 1065).↩
8. Respondent also adjusted petitioners' medical expense deduction for 1980 in the amount of $ 10,029 and their investment tax carryback to 1977 in the amount of $ 753. Both of these items are computational adjustments.↩
9. Respondent also disallowed an interest deduction for $ 17,897.04 that was borrowed from John Hancock and paid to J.H. Cochrane. Respondent now concedes that White Tail is entitled to a deduction for its interest payment of $ 17,897.04 to J.H. Cochrane.↩
10. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the taxable years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
11. We construe the term "capitalize", as used in the Letter Agreement and the minutes, to mean that the principal of the loan would be increased by the amount of interest due on Jan. 1, 1981.↩
12. The Letter Agreement dated Dec. 24, 1980, and the attached minutes indicate that John Hancock was going to allow White Tail to defer the principal payment of $ 7,707.50. Nevertheless, on Dec. 29, 1980, John Hancock billed White Tail for both principal and interest, and the wire transfer of $ 1,595,017.96 includes a principal payment of $ 7,707.50. The record contains no explanation for this.↩
13. The Court considered the taxpayer's nonliquid assets in making this determination, even though there was no indication that these assets could have been liquidated to make the required interest prepayment in December 1969. See
14. In
15. We found as a fact that the partnerships had "unrestricted physical control" over the loan advances when they were deposited to the partnerships' accounts.
16. In addition, judges of two other Courts of Appeals, although not faced with the issue, have, in dicta, criticized our application of the rule. See
17. Despite this test for determining "unrestricted control", consideration of the borrower's purpose for acquiring the additional funds was never completely disregarded. See
18. The existence of such an agreement has been held to restrict the borrower's control over borrowed funds. See
19. As we stated in we chose not to address what impact a default would have had, and found as fact that the borrower had been given "unrestricted physical control over the loan advance at the time it was deposited in the [borrower's] account."
20. Recent opinions indicate that an expanded "unrestricted control" test will likely produce the same result as the test applied in the Fifth and Ninth Circuit Courts of Appeals. See
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