Lansburgh v. Commissioner

*449 OPINION

These consolidated cases are again before the Court; ² this time there is a dispute in the Rule 155³ tax computation. The Rule 155 dispute concerns the calculation of the amount petitioners had at risk under section 465 at the end of 1977 with respect to computer purchase-leaseback transactions. The amount petitioners had at risk will determine the allowability of deductions otherwise available to them. In addition, petitioners have filed a motion to abate additional interest under section 6621(c) of the Internal Revenue*32 Code of 1986 (formerly section 6621(d) of the Internal Revenue Code of 1954). To facilitate the understanding and resolution of the disagreement between the parties, we shall briefly recite the factual background of these cases.

In December 1976, petitioners entered into purchase-leaseback transactions with Greyhound Computer Corp. (lessee) involving items of computer equipment. Payment for the equipment was structured over a 6-year period. Various promissory notes were given to evidence petitioners' purchase obligation. Several of these notes (the flip-flop notes) were nonnegotiable but recourse from December 1, 1976, until March 1, 1978, at which time the flip-flop notes became negotiable and, *33 if not then in arrears, nonrecourse. In addition to the flip-flop notes, other notes (both recourse and nonrecourse) were given. In essence, it is the deductibility of the interest paid on these other notes (the non-flip-flop notes) in 1977 which is in controversy in the Rule 155 computation.

Concurrent with its purchase, the equipment was leased back to the lessee for a 6-year period. All the equipment was subject to pre-existing leases to end users.

All rental payments due petitioners from the lessee were paid to accounts maintained by petitioners at the First National Bank of Arizona (the bank). The bank made all the note payments on behalf of petitioners to the lessee. Petitioners received advices of deposits and withdrawals *450 from the bank evidencing rental payments received and note payments made. All rental payments were timely received, and all note payments were timely made. ⁴

*34 In 1976, petitioner was, for purposes of section 465, at risk to the extent of $ 436,635, ⁵ of which amount $ 408,098 was used to allow petitioner's 1976 loss. Thus, $ 28,537 of the 1976 at-risk amount was available for subsequent years.

In 1977, the computer leasing activity (the activity) generated rental income in the amount of $ 182,008.80, of which $ 48,317.40 was used to pay principal and interest on the flip-flop notes and $ 133,691.40 was used to pay interest on the non-flip-flop notes. In addition, in 1977, petitioner contributed $ 209,950 in cash to the activity, of which $ 5,950 was used to pay interest on the non-flip-flop notes. ⁶ Although the rental income and interest expenses of the activity were approximately equal, because of the depreciation allowable on *35 the computers, the activity generated a loss.

In Lansburgh v. Commissioner, T.C. Memo. 1987-491, we held that the transactions had economic substance and that petitioner had a valid business purpose for entering into the activity.

In 1977, deductions attributable to the activity exceeded $ 1,000,000. Petitioner claims entitlement to deductions for such year in the amount of $ 350,187.20, as follows:

(1) Deductions in an amount equal to the $ 182,008.80 of rental income.

(2) Deductions in an amount equal to his amount at risk, which he contends is $ 168,178.40. In this regard, petitioner claims he is entitled to: a depreciation deduction in the amount of $ 28,537, and an interest *451 deduction in the amount of $ 139,641.40, which latter amount is comprised of $ 133,691.40 paid on the non-flip-flop notes from rental income and $ *36 5,950 paid on the non-flip-flop notes from his 1977 cash contribution.

Respondent acknowledges that petitioner is entitled to a deduction in an amount equal to the $ 182,008.80 of rental income. He also acknowledges that petitioner is entitled to a further deduction equal to petitioner's amount at risk. Respondent claims, however, that petitioner's amount at risk is $ 28,537, reather than $ 168,178.40 as claimed by petitioner. Thus, respondent would allow petitioner a total deduction of $ 210,545.80, rather than the $ 350,187.20 claimed by petitioner.

In addition to the Rule 155 computational dispute, petitioners filed a motion to abate additional interest under section 6621(c), claiming "foot dragging" by respondent. Specifically, petitioners complain that respondent sought and obtained multiple extensions in the filing of his briefs (which extended the due date for the last brief by approximately 1 month) and failed to timely file his Rule 155 computation.

The purpose of section 465 is to limit the deductibility of otherwise allowable losses to the amount of the taxpayer's actual economic investment exposed to the risk of loss. Although section 465*37 had its origins in Congress' concern over the use of nonrecourse financing or other devices in tax oriented investments, the scope of section 465 is not limited to tax shelters. Peters v. Commissioner, 77 T.C. 1158, 1165 (1981).

Section 465 provides, among other things, that where an individual engages in the leasing of depreciable property, any loss claimed with respect to his investment shall be allowed only to the extent he is at risk with respect to the activity at the close of the taxable year. Sec. 465(a)(1); sec. 465(c)(1)(C). Included in the amounts for which a taxpayer is considered at risk are amounts of cash he contributed to the activity and amounts borrowed with respect to the activity. Sec. 465(b)(1). For a taxpayer to be considered at risk with respect to borrowed amounts for use in such an activity, he *452 must be personally liable for repayment of the borrowed amounts or have pledged property, other than property used in the activity, as security for the borrowed amounts. Sec. 465(b)(2).

Petitioner makes alternative arguments to support entitlement to his claimed deductions. First, he argues that the interest deduction under*38 section 163 is not subject to the at-risk limitation. Alternatively, he argues that in addition to the $ 28,537 available from 1976, the amount he had at risk at the end of 1977 should include the $ 133,691.40 paid on the non-flip-flop notes from rental income as well as the $ 5,950 paid on the non-flip-flop note from his cash contribution. Thus, he calculates his amount at risk for 1977 to be $ 168,178.40. We shall discuss his latter argument first.

Petitioner argues that the $ 133,691.40 paid on the non-flip-flop notes from rental income, together with the $ 5,950 paid on the non-flip-flop notes from his cash contribution, should be treated as money contributed by him to the activity within the purview of section 465(b)(1)(A), thereby increasing his amount at risk by $ 139,641.40. Respondent disagrees; he claims that because the activity generated a loss for 1977, the rental income does not constitute money contributed to the activity. We agree with respondent.

The statutory language of section 465 does not provide for adjustments to a taxpayer's amount at risk in the event income or loss is generated by the activity. Further, the legislative history of section 465 provides*39 limited guidance in this area. The Senate Finance Committee Report provides that:

In the case of a partnership, a partner is generally to be treated as at risk to the extent that his basis in the partnership is increased by his share of partnership income. * * * [S. Rept. 94-938, at 50 (1976), 1976-3 C.B. (Vol.3) 88.]

Section 1.465-2(a), Proposed Income Tax Regs., ⁷ describes *453 two ways in which deductions are allowable under section 465:

(1) deductions are allowable to the extent of income received from the activity in the taxable year; and

(2) losses (deductions in excess of income) are allowable to the extent the taxpayer is at risk with respect to that activity at the close of the taxable year.

*40 Petitioner claims the "computation of the taxpayer's at-risk amount (and the deductions allowable as a result) is completely separate from the computation of deductions allowable on account of income from the activity." Therefore, according to petitioner, he is entitled first to deductions to the extent of gross income received from the activity, which in his opinion is the $ 182,008.80 of gross rental income, and second to deductions to the extent of his amount at risk at the end of 1977, which in his opinion includes that part of the rental income used to pay interest on the non-flip-flop notes ($ 133,691.40). Petitioner contends that the $ 133,691.40 of rental income used to pay interest on the non-flip-flop notes constitutes a contribution of funds by him to the activity. ⁸ He also claims that, in addition to the $ 28,537 available from 1976, the $ 5,950 of outside funds used to pay interest on the non-flip-flop notes increases his 1977 amount at risk. Thus, petitioner claims his amount at risk in the activity at the end of 1977 is $ 168,178.40 ($ 133,691.40 + $ 28,537 + $ 5,950).

*41 We agree, and respondent acknowledges, that petitioner is entitled to deductions to the extent of gross income received from the activity. We also agree that deductions are allowable to the extent petitioner is at risk; however, we believe petitioner erred in his calculation of the amount he had at risk at the end of 1977.

In our opinion, a taxpayer's amount at risk is increased only if there is undistributed net income generated from the activity to which section 465 applies and then only to the *454 extent thereof. ⁹*42 The activity involved herein, while producing gross income of $ 182,008.80, generated a net loss in 1977. Were we to accept petitioner's contention that the amount at risk is to be increased by the gross income, as opposed to the net income, we would be permitting petitioner to include the gross income twice in calculating the amount of his allowable deductions, a result we believe is incorrect. ¹⁰

As of the end of 1976, petitioner had an unused amount at risk of $ 28,537 which was available for use in 1977. In 1977, petitioner contributed $ 5,950 of outside funds to pay interest on the non-flip-flop notes. Respondent failed to give petitioner credit for these funds, which in our opinion was erroneous. Adding the $ 5,950 of outside funds petitioner contributed to the activity in 1977 to the unused amount at risk of $ 28,537 results in petitioner's having $ 34,487 at risk as of the end of 1977. Sec. 465(b)(1)(A) and (b)(5).

Alternatively, petitioner argues that the interest deduction under section 163 is not subject to the at-risk limitation. He seeks sustenance from section 1.465-13(a), Proposed Income Tax Regs., 44 Fed. Reg. 32239 (June 5, 1979). That section, in pertinent part, provides:

Definition of loss; deductions from the activity. -- (a) General Rule. For the purposes of section*43 465 allowable deductions allocable to an activity are those otherwise allowable deductions incurred in a trade or business or for the production of income from the activity. * * *

Petitioner posits that section 465 covers only deductions incurred either in a trade or business, such as deductions under sections 162 or 167, or for the production of income from the activity, i.e., section 212 deductions. Petitioner then argues that because interest deductions under section 163 are allowable regardless of whether the interest is *455 incurred in connection with a trade or business or in connection with the production of income, interest deductions are not subject to the at-risk limitations. We believe this reading of the proposed regulation is too narrow.

Under section 465, a "loss" is broadly defined in section 465(d) as the excess of the allowable deductions allocable to the activity over the income received or accrued by the taxpayer during the taxable year from the activity. Moreover, the breadth of the definition of a "loss" for section 465 purposes is apparent from the legislative history which provides that the at-risk limitation applies "regardless of the kind of deductible*44 expenses which contributed to the loss." S. Rept. 94-938, at 48 (1976), 1976-3 C.B. (Vol.3) 86.

As a general proposition, we would agree with petitioner that deductibility of interest under section 163 is not conditional upon the existence of a trade or business or an activity for the production of income. However, we believe petitioner misinterprets section 1.465-13(a), Proposed Income Tax Regs. That regulation speaks to allowable deductions incurred in a trade or business or for the production of income and is not limited to trade or business or production of income per se. Petitioner's interpretation of the regulation would read out the word "incurred." Thus, in our opinion, all deductions incurred in an activity to which section 465 applies, including the interest incurred in petitioner's computer leasing activity, are subject to the at-risk limitation.

To summarize the aforesaid, for purposes of the Rule 155 tax computation, petitioner is entitled to depreciation and interest deductions for 1977 in an amount equal to the sum of the $ 182,008.80 rental income and the $ 34,487 amount at risk, or $ 216,495.80.

Petitioners, *45 relying on Betz v. Commissioner, 90 T.C. 816 (1988), allege that respondent's post trial actions in the handling of this case entitle them to an abatement of additional interest under section 6621(c). They claim this sanction should be imposed because respondent requested, and was granted, multiple extensions of time to file briefs *456 and because respondent failed to timely file a Rule 155 computation.

In Betz v. Commissioner, supra, the taxpayers timely filed a petition in June 1985. Respondent failed to timely file an answer, and in June 1987, in response to this Court's order, respondent filed a motion to file an answer out of time and lodged his answer. While we granted respondent's motion and allowed his answer to be filed, we determined that respondent should be sanctioned under Rule 104. The sanction we there thought appropriate was to deem it established that respondent erred in determining that additional interest is due under section 6621(c). Betz v. Commissioner, 90 T.C. at 823.

In reaching our decision in Betz v. Commissioner, we relied in part upon our decision*46 in Vermouth v. Commissioner, 88 T.C. 1488 (1987), a case also involving an untimely answer. In Vermouth, respondent failed to file an answer within 60 days from the service of the petition and within an additional 60 days permitted by us pursuant to an uncontested motion to extend. In our opinion the facts in the instant case do not reach the level of severity which existed in Betz and Vermouth; therefore, petitioners' motion to abate additional interest under section 6621(c) shall be denied.

To reflect the foregoing,

An appropriate order will be issued.