Opinion
Docket No. 1437-62.
1963-10-31
CONSTANCE M. BISHOP, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Robert H. Bishop III and Kenneth G. Humer, for the petitioner. Eugene S. Linett, for the respondent.
Robert H. Bishop III and Kenneth G. Humer, for the petitioner. Eugene S. Linett, for the respondent.
Petitioner borrowed from a bank $159,000 and purchased stocks and debentures, the dividends and interest on which were subject to income tax. Later she borrowed from another bank $159,000 with which she repaid the original loan. Subsequent to repaying the original loan, petitioner sold the securities which she had purchased with the money received from the original loan, did not repay the loan, and shortly after the sale purchased obligations the interest on which is wholly exempt from income tax in approximately the amount of the sales price received. Later in the same year she sold these tax-exempt securities and purchased other tax-exempt securities with the proceeds of these sales, which tax-exempt securities she held throughout the years here involved. Held, petitioner continued her $159,000 indebtedness to purchase and carry obligations the interest on which is not subject to income tax and therefore is not entitled to deduct the interest paid on the $159,000 loan in either of the years 1958 or 1959.
SCOTT, Judge:
Respondent determined deficiencies in petitioner's income tax for the years 1958 and 1959 in the amounts of $5,457.98 and $5,600.85, respectively. The issue for decision is whether interest paid by petitioner in 1958 and 1959 in the respective amounts of $6,446.12 and $7,057.83 was on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from income tax, within the meaning of section 265(2) of the Internal Revenue Code of 1954.
Investments are carried at cost, not fair market value.
At cost. 2 At market.
All references are to the Internal Revenue Code of 1954 unless otherwise indicated. 2. SEC. 265. * * * No deduction shall be allowed for—(2) INTEREST.— Interest on indebtedness incurred or continued to purchase or carry obligations (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest on which is wholly exempt from the taxes imposed by this subtitle. 3. For convenience, obligations the interest on which is wholly exempt from Federal income tax will be referred to herein as tax-exempt securities and other securities will be referred to as non-tax-exempt securities.
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
Petitioner, who resides at Chagrin Falls, Ohio, was at all times here material a widow, over 65 years old. She filed her individual Federal income tax returns for the taxable years 1958 and 1959 with the district director of internal revenue at Cleveland, Ohio.
Petitioner's income is derived from investments and at all times here material her total investments, exclusive of real property, had a fair market value in excess of $3,500,000. During 1958 and 1959 petitioner owned real property with a cost basis in excess of $1 million and other assets in addition to her investments having a value in excess of $200,000. Approximately 75 percent in market value of petitioner's investments, exclusive of real property, was in steel industry stocks which had a zero basis in petitioner's hands.
As a result of petitioner's heavy investment in steel stocks, petitioner and her advisers wanted to diversify petitioner's portfolio for reasons of safety. In order to diversify, cash was needed to make the investments, but petitioner did not want to sell the securities she already owned in order to obtain the desired cash, because of the large amount of capital gains tax that would result. Consequently, it was decided to resort to borrowing for the necessary cash. The loans described below were incurred and continued for this purpose.
In 1954, petitioner borrowed $159,000 from the Society For Savings, Cleveland, Ohio, using as collateral securities which were not tax-exempt obligations under section 265(2). The proceeds of this loan were immediately invested in stock and debentures of a corporation, Producing Properties, Inc., which stock and debentures were not tax-exempt obligations under section 265(2).
On June 6, 1955, petitioner established an agency account at the Cleveland Trust Co., Cleveland, Ohio, to which were transferred substantially all her investments, exclusive of real property. The activity of this agency account was thenceforth recorded by the Cleveland Trust Co. on two ledgers: (1) A ‘principal’ ledger which accounted for all capital transactions, and (2) an ‘income cash’ ledger which accounted for all receipts and disbursements of cash from dividends, interest, etc.
At all material times petitioner also maintained a commercial account at the Cleveland Trust Co. This account along with the agency account mentioned above was considered by petitioner and her investment advisers as being available for general investment purposes. Throughout this period, transfers have been made to the agency account from the commercial account. This commercial account was also used for the payment of Federal income taxes and personal expenditures.
On June 6, 1955, the date petitioner's agency account was established at the Cleveland Trust Co., petitioner borrowed $159,000 from the Cleveland Trust Co. on a demand basis with interest at 3 percent per annum, using as collateral securities which were not tax-exempt obligations under section 265(2). The proceeds of this loan were immediately used to repay the prior loan made by the Society For Savings in 1954. On February 14, 1958, the loan was increased to $215,000; and on March 14, 1958, it was further increased to $235,000. The entire $235,000 obligation is still outstanding, and no part of the principal has ever been repaid. For the taxable years 1958 and 1959, petitioner paid interest on the first $159,000 of the loan which was borrowed on June 6, 1955, in the respective amounts of $6,446.12 and $7,057.83.
On March 14, 1956, petitioner sold all her stock and debentures in Producing Properties, Inc. (which had been purchased on November 24, 1954), and $223,424.18, realizing a gain on the sale in the amount of $64,424.18. The sales proceeds were deposited in the agency account. On March 27, 1956, petitioner transferred $26,900 in cash to the agency account from her commercial account. On April 2, 1956, petitioner redeemed U.S. savings bonds and deposited the proceeds— $15,187.50 in cash— in the agency account. As a result of the above transactions, the principal ledger showed total assets and liabilities, as of April 2, 1956, as follows:
+-----------------------------------------+ ¦Investments ¦Cash ¦Liabilities ¦ +---------------+-----------+-------------¦ ¦1 $571,844.33¦$265,511.68¦$159,000 ¦ +-----------------------------------------+
Also on April 2, 1956, the income ledger of the agency account showed a cash balance of $1,677.16 and the commercial account a cash balance of $64,242.58. This made a total cash ‘pool’ as of that date of $331,431.42.
The next transaction recorded on the principal ledger was as follows: On April 5 and 10, 1956, petitioner purchased municipal bonds in the total amount of $216,875, such bonds being tax-exempt obligations under section 265(2). As a result of these transactions, the principal ledger showed total assets and liabilities, as of April 10, 1956, as follows:
+--------------------------------------+ ¦Investments ¦Cash ¦Liabilities ¦ +-------------+----------+-------------¦ ¦$788,719.33 ¦$48,636.68¦$159,000 ¦ +--------------------------------------+
On September 12 and 14, 1956, the municipal bonds purchased on April 5 and 10, 1956, were sold for $204,125, and the sales proceeds deposited in the agency account. On September 14, 1956, the principal ledger showed total assets and liabilities as follows:
+------------------------------------+ ¦Investments ¦Cash ¦Liabilities ¦ +-------------+--------+-------------¦ ¦$655,662.02 ¦$204,125¦$159,000 ¦ +------------------------------------+
Also on September 14, 1956, the income cash ledger account showed an overdraft of $2,941.17 and the commercial account a balance of $29,662.99.
The $204,125 realized from the sale of municipal bonds on September 12 and 14, 1956, was reinvested as follows:
(a) On September 18, 1956, $3,800 was reinvested in taxable securities.
(b) On September 18, 21, 24, and 27, 1956,.$200,512.50 was reinvested in obligations tax-exempt under section 265(2).
On October 5, 1956, a purchase of tax-exempt obligations in the amount of $18,050 made on September 27, 1956, was canceled, and another purchase of tax-exempt obligations in the same amount was substituted.
On December 4, 1956, tax-exempt obligations purchased on September 21 and October 5, 1956, in the total amount of $63,175 were sold for $57,400 and the sales proceeds deposited in the agency account. On December 5, 1956, the cash balance in the agency account was $86,607.39, including the $57,400 proceeds on the sale of December 4, 1956. The next transactions charged to the cash account were the purchase of $41,039 of taxable securities on December 6 and 10, 1956, and the purchase of $57,925 in tax-exempt securities on December 11, 1956.
At all times after December 3, 1956, petitioner owned municipal bonds, constituting tax-exempt obligations under section 265(2), with a total basis and fair market value in excess of $460,000.
At December 31 of each of the following years, petitioner had cash balances and investments in taxable securities and obligations tax-exempt under section 265(2) as follows:
+--------------------------------------------+ ¦Year¦Cash ¦Obligations ¦Securities ¦ +----+----------+--------------+-------------¦ ¦ ¦ ¦tax-exempt 1 ¦taxable 2 ¦ +----+----------+--------------+-------------¦ ¦1955¦ ¦$202,541.00 ¦$4,918,445.00¦ +----+----------+--------------+-------------¦ ¦1956¦$70,839.02¦466,328.56 ¦4,746,156.12 ¦ +----+----------+--------------+-------------¦ ¦1957¦77,011.07 ¦487,122.64 ¦3,024,542.31 ¦ +----+----------+--------------+-------------¦ ¦1958¦40,118.75 ¦528,314.79 ¦4,647,630.37 ¦ +----+----------+--------------+-------------¦ ¦1959¦72,501.65 ¦525,896.51 ¦5,092,132.62 ¦ +--------------------------------------------+
On March 17, 1959, petitioner's agency account at the Cleveland Trust Co. was closed, and the assets and liabilities therein were transferred to a revocable trust, with the Cleveland Trust Co. as trustee, and petitioner as settlor and sole beneficiary.
As of March 17, 1959, there were held in the agency account $137,337 of tax-exempt securities which had been purchased in September 1956, and $57,925 of tax-exempt securities purchased on December 11, 1956.
Petitioner on her Federal income tax returns for 1958 and 1959 deducted interest paid to the Cleveland Trust Co. in the respective amounts of $9,050.65 and $10,431.39. Respondent in his notice of deficiency disallowed $6,446.12 of the claimed interest deduction for 1958 and $7,057.83 for 1959 with the explanation that the disallowance was under the provisions of section 265 of the Internal Revenue Code of 1954.
OPINION
Section 265(2) of the Internal Revenue Code of 1954provides that no deduction shall be allowed for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from Federal income tax. The deductions at issue in this case are interest payments on a $159,000 loan to petitioner from the Cleveland Trust Co. Petitioner borrowed this amount from the Cleveland Trust Co. on June 5, 1955, for the purpose of repaying a loan in an identical amount which she then had outstanding at another bank and actually did use the proceeds of the loan from the Cleveland Trust Co. for that purpose. Petitioner had obtained the prior loan for the purpose of purchasing securities and had used the proceeds thereof to purchase securities the dividends or interest on which were subject to Federal income tax. It is therefore clear, and respondent does not contend otherwise, that petitioner's indebtedness to the Cleveland Trust Co. was not originally incurred to purchase or carry obligations the interest on which was not subject to Federal income tax. In March 1956 when petitioner sold the securities she had bought with proceeds of the loan which had been repaid with the $159,000 she borrowed from the Cleveland Trust Co. but instead used the proceeds to purchase tax-exempt securities.
Since she sold her non-tax-exempt securities on March 14, 1956, and did not purchase the tax-exempt securities until April 5 and 10, 1956, petitioner argues that the purchase was not necessarily with the proceeds of the sale but with her generally commingled funds. The facts, however, show otherwise. The first purchase made after the sale was of the tax-exempt securities, and the cost of such securities was almost equal to the sales price received upon the sale of the non-tax-exempt securities. Cf. Bernard H. Jacobson, 28 T.C. 579 (1957). Later in 1956 petitioner sold the tax-exempt securities she purchased in April 1956 and purchased other tax-exempt securities with the proceeds of the sale. She held some of the securities so purchased later in 1956 with a cost of in excess of $159,000 until March 17, 1959, when all her securities were turned over to a trust which she established with herself as sole beneficiary.
Against this factual background, the question is the narrow one of whether the $159,000 loan was continued to purchase or carry tax-exempt securities. Since petitioner continued to hold the tax-exempt securities purchased later in 1956 with the proceeds of the sale of the tax-exempt securities purchased in April 1956, it is clear that if the loan was continued to purchase the securities, it was continued to carry the obligations. See First Nat. Bank of Chicago v. United States, 38 F.2d 297 (Ct. Cl. 1930), affd. 283 U.S. 142 (1931).
Petitioner argues that since the loan was not secured by tax-exempt securities and all purchases were made from commingled funds in her agency account, the provisions of section 265(2) are inapplicable to her loan. Our opinion in Bernard H. Jacobson, supra, disposes of these contentions adversely to petitioner. Similar arguments were made in that case on facts substantially parallel to those in the instant case but we held that under the plain language of the statute it was not applicable only to loans secured by the tax-exempt securities purchased with the proceeds of the loan and that the section was not ‘made inapplicable simply because the transactions were carried out through custodian accounts which were also used for a myriad of transactions both personal and business in nature.’
The difference in the pertinent facts here and in Bernard H. Jacobson, supra, is that in that case the tax-exempt securities were purchased on the same day or within a few days of the date the taxpayers there involved obtained their loans and in approximately the amounts of the loans, where in the instant case the original loan, which was repaid with the loan the interest on which is here in issue, was used to purchase non-tax-exempt securities and when the securities so purchased were sold the proceeds of the sale were used to purchase the tax-exempt securities.
Our attention has been directed to no case, nor have we found one, dealing precisely with the question of when a loan not originally incurred to purchase tax-exempt securities is continued for that purpose. We have held that a loan not incurred to purchase tax-exempt securities but for the purpose of operating a taxpayer's business, was not ‘incurred or continued to purchase or carry’ tax-exempt securities even though such securities were hypothecated as security for the loan. R. B. George Machinery Co., 26 B.T.A. 594 (1932), and Sioux Falls Metal Culvert Co., 26 B.T.A. 1324 (1932). In each of those cases the tax-exempt securities, he borrowed money using such securities as collateral for the loan. Since it was clear in those cases that the loan was not incurred to purchase tax-exempt securities, the real question was whether it was incurred or continued to carry such securities. In those cases we looked to the underlying reason for the loans and held that the statute was not intended to deny to a taxpayer ‘the right to deduct interest paid for borrowed money, which money was used for the purpose of carrying on its regular business functions.’ R. B. George Machinery Co., supra.
Applying this reasoning in the instant case, the loans were continued after March 14, 1956, to enable petitioner to purchase and carry tax-exempt securities. Certainly in any ordinary sense of the word ‘continued,’ petitioner ‘continued’ her loan at the Cleveland Trust Co. after March 14, 1956, and thereafter throughout 1959. She did not repay the loan but left it outstanding. This is the generally understood meaning of the word ‘continued’ when used in connection with a loan. She continued the loan instead of repaying it with the proceeds of the sale of the non-tax-exempt securities, so that she would have the funds to purchase and hold tax-exempt securities. This, we consider to be continuing the loan to purchase and carry the tax-exempt securities.
The purpose of section 265(2) is to prevent the escape from taxation of income properly subject thereto by the purchase of tax-exempt securities with borrowed money. Denman v. Slayton, 282 U.S. 514 (1931). The purpose of this section would be too easily frustrated if a borrower could avoid its impact by the simple expedient of buying non-tax-exempt securities with the borrowed funds, then selling those securities and using the proceeds of the sale to purchase tax-exempt securities instead of repaying the loan.
As a last argument petitioner contends that section 265(2) deprives her of property without due process of law because the word ‘carry’ as employed in the statute is vague and ambiguous. The constitutionality of a predecessor to section 265(2) was upheld when attacked on other grounds. Denman v. Slayton, supra. The word ‘carry’ in the statute is not ambiguous. In First Nat. Bank of Chicago v. United States, supra, the court defined ‘carry’ according to its ordinary meaning, and we have applied that definition in this case.
We sustain respondent in his disallowance of petitioner's claimed interest deductions in the amounts of $6,446.12 and $7,057.83 for the years 1958 and 1959, respectively.
Decision will be entered for respondent.