Davenport v. Commissioner

70 T.C. 922, 1978 U.S. Tax Ct. LEXIS 57

• Court: United States Tax Court
• Decided: September 14, 1978
• Docket: Docket No. 5317-76
• Status: Published

Opinions

Wiles, Judge:

Respondent determined the following deficiencies in petitioners’ income taxes:

Deficiency Year Deficiency S ^

. $1,710.99 1970 .$8,584.39 OO Cl rH

...2,836.71 1972 . 1,515.45 05 Oi rH

There are three issues: whether petitioners’ loss on Greenbelt Finance, Inc. (hereinafter Greenbelt), stock, purchased in 1959, was a loss on section 1244¹ stock; whether petitioners are entitled to an ordinary loss deduction under section 165(a) for Greenbelt stock purchased in 1968; and whether petitioners are entitled to a bad debt deduction under section 166(a) for loans made to Greenbelt.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

Petitioners H. L. and Neysa C. Davenport, husband and wife, were residents of Pflugerville, Tex., when they filed their petition herein. They filed their joint income tax returns for the years in question with the Internal Revenue Service Center, Austin, Tex.

In 1940, after completing 21/2 years of college, H. L. Davenport (hereinafter petitioner) started working for Ray Green Finance Co. in Childress, Tex. In his employment, petitioner made loans and handled insurance on automobiles. In 1959, because he felt he was undercompensated, petitioner ended his employment with Ray Green Finance Co. and organized Greenbelt, a Texas corporation, for the purpose of operating a small loan business. Greenbelt was authorized and had issued 100,000 shares of $1 par common stock that was intended to qualify as section 1244 stock. Petitioner purchased 20,000 shares; 15 other investors purchased the remaining 80,000 shares. Petitioner was made president of the company and thereafter remained in that capacity. His initial salary as president was $7,200 per year. In 1969 his salary was raised to $10,800 per year and thereafter it was raised to $12,000 per year.

Following Greenbelt’s incorporation, petitioner purchased additional amounts of stock from other stockholders at various prices. By 1971 petitioner owned 76,272 shares of stock purchased at the following time and amounts:

Year acquired Number of shares Cost

1959 .20,000 $20,000.00

1964 . 2,062 1,855.80

1965 . 1,063 1,063.00

1968 . 52,147 59,841.90

1971 . 1,000 1,226.84

Total . 76,272 83,987.54

During the years before us, the remaining authorized shares were held by petitioner’s daughter and by Greenbelt as treasury stock.

Petitioner’s large purchase of stock in 1968 was a result of a directors meeting held October 17, 1968. At that meeting the directors discussed financing problems the corporation was having with two lending banks. The banks had presented Greenbelt with three options under which they would continue to lend money to Greenbelt. The option decided on by Greenbelt’s board of directors required petitioner to personally endorse all loans made to Greenbelt. Since petitioner was going to personally guarantee all loans made to Greenbelt, all the stockholders agreed that in fairness he should be allowed to purchase their stock.

From 1969 through 1971 petitioner made the following loans to Greenbelt:

Year Amount

1969 ... $6,041.14

1970 ... 12,500.00

1971 ... 50,861.34

Total 69,402.48

In March 1971, Greenbelt distributed corporate property to petitioner in partial payment of these loans. After this distribution, Greenbelt owed petitioner $35,410.35. During 1971 Greenbelt’s stock and debts held by petitioner became worthless.

Throughout its existence Greenbelt derived more than 50 percent of its gross receipts from interest. Also, during its last 5 years of existence, Greenbelt’s deductions (other than those claimed under sections 172, 242, 243, 244, and 245) exceeded its gross income.

OPINION

There are three issues for our resolution: whether petitioners’ loss on 20,000 shares of Greenbelt stock purchased in 1959 was a loss on section 1244 stock; whether petitioners are entitled to an ordinary loss deduction under section 165(a) for the remainder of their Greenbelt stock; and whether petitioners are entitled to claim an ordinary loss under section 166(a) for the loans to Greenbelt.

Section 1244 generally provides that a loss on section 1244 stock shall be treated to a limited extent as an ordinary loss. Section 1244(c) defines the term “section 1244 stock” by establishing certain requirements, only one of which is in issue. That requirement, found in paragraph (1)(E) of section 1244(c), provides that “section 1244 stock” means common stock in a domestic corporation if—

such corporation, during the period of its 5 most recent taxable years ending before the date the loss on such stock is sustained * * * , derived more than 50 percent of its aggregate gross receipts from sources other than royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities * * * ; except that this subparagraph shall not apply with respect to any corporation if, for the period referred to, the amount of the deductions allowed by this chapter (other than by sections 172, 242, 243, 244, and 245) exceed the amount of gross income. [Emphasis added.]

The parties agree that Greenbelt, during the 5 most recent taxable years ending before petitioner sustained his loss, derived more than 50 percent of its aggregate gross receipts from interest. Petitioner nevertheless contends that his Greenbelt stock qualifies as section 1244 stock, because the amount of Greenbelt’s deductions (other than sections 172, 242, 243, 244, and 245 deductions) during Greenbelt’s preceding 5 taxable years exceeded the amount of its gross income. In sum, petitioner alleges that the gross receipts test of section 1244(c)(1)(E) does not apply to Ms Greenbelt stock because of the exception emphasized in the above-quoted statute.

Respondent, in contrast, contends Greenbelt does not fall within the exception in section 1244(c)(1)(E). Respondent’s argument, briefly summarized, is that the purpose of the gross receipts test in section 1244(c)(1)(E) is to limit section 1244 benefits to “largely operating companies.” The exception to the gross receipts test is to preserve section 1244 benefits for largely operating companies that “never get off the ground.” Without this exception, respondent notes, a corporation that was intended to be largely an operating corporation, yet was unsuccessful in its business, could be disqualified by the 50-percent gross receipts test if it received a small amount of passive income.

After considering both parties’ arguments as well as the facts before us, we agree with respondent that petitioner’s Greenbelt stock, purchased in 1959, was not section 1244 stock. Therefore, petitioners are not entitled to treat their loss on the Greenbelt stock as an ordinary loss under section 1244.

Section 1244(c)(1)(E) establishes a gross receipts test under which more than 50 percent of a corporation’s gross receipts must be derived from sources other than passive income. Section 1.1244(c)-l(g)(2), Income Tax Regs., notes that the gross receipts test need not be complied with “if for the applicable period the aggregate amount of deductions allowed to the corporation exceeds the aggregate amount of its gross income.” The parties have agreed that during the applicable period Greenbelt’s properly allowed deductions exceeded its gross income. Because Greenbelt’s deductions exceeded its gross income, petitioners contend the gross receipts requirement, on its face, does not apply to Greenbelt. We disagree.

Section 1.1244(c)-l(g)(2), Income Tax Regs., continues with a qualification of the exception to the gross receipts test:

Notwithstanding * * * [the exception to the gross receipts test], pursuant to the specific delegation of authority granted in section 1244(e) to prescribe such regulations as may be necessary to carry out the purposes of section 1244, ordinary loss treatment will not be available with respect to stock of a corporation which is not largely an operating company within the five most recent taxable years * * * ending before the date of the loss. [Emphasis added.]

Respondent contends this regulation was properly authorized by section 1244(e), and further, the regulation prohibits any Greenbelt stock from qualifying as section 1244 stock. Petitioner, however, contends the Secretary has exceeded his authority in promulgating section 1.1244(c)-l(g)(2), Income Tax Regs., and contends that a company does not have to be a largely operating company if the exception to the gross receipts test is fulfilled. Accordingly, resolution of this issue hinges on whether the Secretary exceeded his authority in promulgating section 1.1244(c)-l(g)(2), Income Tax Regs., thereby imposing a largely operating company limitation over both the gross receipts test and the gross income exception found in section 1244(c)(1)(E). We conclude the Secretary properly exercised his authority.

Generally, income tax regulations must be sustained unless unreasonable. In considering the weight to be given regulations, the Supreme Court in Commissioner v. South Texas Lumber Co., 333 U.S. 496, 501 (1948), stated:

This Court has many times declared that Treasury regulations must be sustained unless unreasonable and plainly inconsistent with the revenue statutes and that they constitute contemporaneous constructions by those charged with administration of these statutes which should not be overruled except for weighty reasons.

This observation by the Supreme Court is especially significant in the case before us since section 1244(e) contains an extraordinary provision specifically delegating to the Secretary the authority to “prescribe such regulations as may be necessary to carry out the purposes of this section.” Therefore, we must determine if section 1.1244(c)-l(g)(2), Income Tax Regs., carries out the purposes Congress attempted to achieve in section 1244(c)(1)(E).

Section 1244 originated in the House as part of H.R. 13382, 85th Cong., 2d Sess. (1958), which subsequently became title II, Small Business Tax Revision Act of 1958; Pub. L. 85-866, 72 Stat. 1676. In its original form, as passed by the House, section 1244(c)(1)(E) contained only a gross receipts test, with no gross income exception. The House Report, H. Rept. 2198, 85th Cong., 1st Sess. (1958), 1959-2 C.B. 709, 711, explained the purpose of section 1244(c)(1)(E), as drafted when it passed the House:

Your committee also has imposed a restriction designed to limit this tax benefit to companies which are largely operating companies. Thus, the corporation, in the 5 years before the taxpayer incurs the loss on the stock, must have derived more than half of its gross receipts from sources other than royalties, rents, dividends, interest, annuities, and the sale of stock or securities. [Emphasis added.]

Clearly, the purpose of section 1244(c)(1)(E) was to limit benefits of section 1244 to shareholders of largely operating companies. Although the term “largely operating companies” was not defined, Congress described the kind of gross receipts — essentially passive receipts — that would prevent section 1244 treatment.

When H.R. 13382 was being debated on the Senate floor, the gross income exception to the gross receipts test was added to section 1244(c)(1)(E). Again, Congress indicated that section 1244 benefits were designed for shareholders in “largely operating companies” and the gross receipts restriction was enacted to help achieve that effect. 104 Cong. Rec. 17,090 (daily ed. Aug. 12, 1958).² Congressional history, however, goes on to say that the gross receipts restriction need not be satisfied if gross income is exceeded by allowable deductions. 104 Cong. Rec. 15,792 (daily ed. Aug. 12,1958). In creating this exception to the gross receipts restriction, nowhere did Congress indicate that the overall "largely operating company” limitation was to be ignored. It merely indicated that a restriction, the gross receipts test, did not have to be complied with under all circumstances. Properly read, therefore, the gross income exception was an exception to the gross receipts test, not an exception to the overall largely operating company limitation. Accordingly, we must conclude that the Secretary, in drafting section 1.1244(c)-1(g)(2), Income Tax Regs., merely followed the purpose of Congress by limiting section 1244 benefits to shareholders of largely operating companies. We therefore disagree with petitioner’s contention that the Secretary exceeded his authority in promulgating this regulation.

Given this interpretation, it becomes apparent that the exception to the gross receipts test was not intended as an exception to the “largely operating company” requirement. Rather, this exception is intended to protect section 1244 benefits for shareholders of corporations engaged in active, largely operating — although unsuccessful — business enterprises which, because of their unsuccessful nature, derived 50 percent or more of their gross receipts from passive investments.³

Were we to adopt petitioner’s view that the largely operating company limitation may be ignored if gross income is exceeded by allowable deductions, some extreme and illogical results would occur. For example, stock in corporations engaged in any activity — or lack of activity — could qualify for section 1244 treatment so long as the company had 5 successive loss years. As a result, shareholders in companies engaged strictly in passive investing such as purchasing and selling securities would be entitled to section 1244 treatment if the company sustained losses for 5 years. Clearly Congress did not intend to extend section 1244 benefits to shareholders of such purely passive income companies, yet petitioner’s argument would require us to grant section 1244 treatment to such shareholders. Also, under petitioner’s view of this statute, a shareholder in a purely passive company that sustained losses for 4 years would not be entitled to section 1244 treatment unless the company could continue its unprofitable ways. The effect of petitioner’s contention would be to encourage passive income companies to continue their losses once a losing pattern had been established, so that shareholders could receive section 1244 treatment. Such a line of reasoning, however, approaches absurdity. Accordingly, we must reject petitioner’s argument that section 1.1244(c)-1(g)(2), Income Tax Regs., is invalid.

Respondent’s regulation and interpretation of the gross receipts test was followed in Bates v. United States, F. Supp.

(N.D. Ohio, Mar. 29, 1976, 37 AFTR2d 76-1090, 76-1 USTC par. 9367), affd. (6th Cir., July 21, 1978). In Bates, BIC corporation was unsuccessful and had no gross receipts of any kind. In determining whether BIC’s shareholders were entitled to section 1244 losses on their stock the court noted that even though BIC had no gross receipts, its shareholders could obtain ordinary loss treatment if “BIC can qualify under the Treasury regulations as ‘largely an operating company.’” The court phrased the test, “To so qualify [as largely an operating company] it is concluded that it must be shown that if gross receipts had been received * * * from BIC’s corporate activities, it is probable that more than 50 percent of said gross receipts would have been derived from sources other than passive sources.” Applying that test, the court concluded BIC’s intended activities “could only have led to passive income.” Similarly, we conclude that Greenbelt was not largely an operating company. Its primary source of gross receipts was interest. Had Greenbelt been successful, its primary source of gross receipts would have remained interest. Under these facts we must conclude Greenbelt was not largely an operating company, and hence its stock was not section 1244 stock.

We note that the effect of our decision on this issue is to prevent stock in small loan companies, such as Greenbelt, from qualifying as section 1244 stock even though the small loan company may have actively conducted its business. This position is consistent with our cases decided under subchapter S (sec. 1371-1379), an analogous area of the Code.

Subchapter S, which was enacted by the same public law that enacted section 1244, has a termination provision, sec. 1372(e)(5),⁴ consisting of a gross receipts test similar in wording to section 1244(c)(1)(E). Furthermore, section 1372(e)(5)(B) contains an exception to the gross receipts test that is similar in purpose to the gross income exception found in 1244(c)(1)(E), i.e., protecting startup years. On many occasions this Court has emphasized that we will not look behind the extent of activities that generated the income. Consequently, interest income, whether earned from savings accounts or small loans, constitutes passive income and terminates subchapter S status. See, e.g., Buhler Mortgage Co. v. Commissioner, 51 T.C. 971, 977 (1969), affd. per curiam 443 F.2d 1362 (9th Cir. 1971), a Court-reviewed opinion in which we stated, “we cannot find that the nature of the income changes simply because the corporation earning it must engage in many activities and exert a great deal of effort in doing so.” In Marshall v. Commissioner, 60 T.C. 242, 252 (1973), affd. 510 F.2d 259 (10th Cir. 1975), also a Court-reviewed opinion, we held “interest and rental income are part of ‘passive investment income’ even though the recipient of such interest or rental income may be actively engaged in a small loan or real estate business.” Similarly, see Zychinski v. Commissioner, 60 T.C. 950 (1973), affd. 506 F.2d 637 (8th Cir. 1974), cert. denied 421 U.S. 999 (1975).⁵

Next we must decide whether petitioners are entitled to ordinary loss treatment on their Greenbelt stock purchased in 1968, and whether petitioners are entitled to ordinary loss treatment on the unrepaid portion of the loans made to Greenbelt. The parties agree that both stock and loans became worthless during 1971. The only issue, therefore, is the character of petitioners’ losses.

Petitioner contends he purchased large quantities of Greenbelt stock in 1968 for $59,841.90 and subsequently loaned Greenbelt $69,402.48 in order to protect his main source of income and employment. As such, petitioner contends his dominant motivation in purchasing the stock and making the loans was not investment, but protecting his employment. Therefore, petitioner alleges he is entitled to ordinary loss treatment when the stock and loans became worthless. In making this argument petitioner relies on Irwin v. United States, 401 P. Supp. 547 (E.D. La. 1975), and a Memorandum Opinion of this Court, Haslam v. Commissioner, T.C. Memo. 1974-97.

Respondent contends that petitioner’s dominant motivation in purchasing the additional Greenbelt stock and making the advances was investment and therefore petitioner is not entitled to ordinary loss treatment when the stock and loans became worthless.⁶

Generally, section 165(a) provides that uncompensated losses are deductible in the year sustained. Losses from worthless securities are normally treated as losses from the sale or exchange of capital assets. Sec. 165(g). Under the doctrine announced in Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955), the sale or exchange of stock may give rise to ordinary rather than capital loss if the stock was purchased and held as an integral act in the conduct of a taxpayer’s business rather than purchased or held for investment purposes. Booth Newspaper, Inc. v. United States, 303 F.2d 916, 921 (Ct. Cl. 1962).

Similarly, section 166(a) provides that debts shall be deductible in the year they become worthless. Nonbusiness bad debts, however, are treated as a short-term capital loss. Sec. 166(d)(1). In the case of an individual, the question is whether, at the time of worthlessness, the debt has a “proximate” relationship to the taxpayer’s business; whether business motivation was the dominant motivation for making and holding the loans. United States v. Generes, 405 U.S. 93, 103 (1972). If so, the loss may be an ordinary loss under section 166(a).

Petitioner’s motivation is a fact question on which he has the burden of proof. Smith v. Commissioner, 60 T.C. 316, 318 (1973). After considering all the facts before us, the circumstances surrounding the stock purchase and subsequent loans, we conclude petitioner had a significant investment purpose in purchasing the stock, and a dominant investment purpose in making the loans.

The heart of petitioner’s argument is that he purchased the Greenbelt stock in 1968 and made subsequent loans to the corporation in order to protect his primary source of income. In light of the facts, however, we find this contention incredible. From 1968 to 1971 petitioner spent more than $130,000 on stock and in loans to the corporation. During this same period his gross salary as president was between $7,200 and $12,000. We simply cannot believe that petitioner would spend so much money to protect this amount of income. Clearly, petitioner also had a significant investment motive. We are further persuaded by other facts. During the entire life of the corporation petitioner was president and a large — perhaps effectively the controlling-shareholder; from 1968 on, he was virtually the only shareholder. Under these circumstances he had little fear of losing his job as president.

Although petitioner relies on Irwin v. United States, supra, and Haslam v. Commissioner, supra, we find them unhelpful to petitioner’s contentions. First, since the briefs were submitted in this case, Irwin v. United States has been reversed, and therefore no longer constitutes reliable authority. Irwin v. United States, 558 F.2d 249 (5th Cir. 1977), revg. 401F. Supp. 547 (E.D. La. 1975). Second, the facts in Haslam v. Commissioner are clearly distinguishable. In Haslam, taxpayer had an annual salary of approximately $15,000 and invested $20,000 in the corporation. We noted that, “In our opinion, an assured salary of $15,000 per year over a period of years was a more valuable interest to petitioner than the mere possibility of recouping the already invested $20,000 * * * and the prospect of such continued employment was petitioner’s dominant motivation.” We cannot make such a finding here. Petitioner invested over $130,000 yet had a salary ranging between $7,200 and $12,000.

This salary was not so relatively large that we can say it was “a more valuable interest” to petitioner than his investment.

Accordingly, we conclude petitioner had a substantial investment motive in purchasing the stock and a dominant motive in loaning money to the corporation. Petitioners are therefore not entitled to ordinary loss treatment on either their worthless stock or their worthless debts.

To reflect the foregoing,

Decision-will be entered under Rule 155.

Reviewed by the Court.

1 All statutory references are to the Internal Revenue Code of 1954, as amended and in effect during the years in question.

2 There is no official Senate Finance Committee report that covers see. 1244. Senator Kerr, however, read into the Congressional Record a summary of the amendment prepared by the staff for the committee. 104 Cong. Rec. 17,089-17,092 (daily ed. Aug. 12,1958).

3 Without an exception to the gross receipts test, stock in a corporation engaged in the manufacture of small appliances that had very small sales, and hence small gross receipts, would not qualify as sec. 1244 stock if the company had a small amount of interest income that was equal to or exceeded the company’s gross receipts from appliance manufacture. In other words, without the exception to the gross receipts test, if passive income was equal to or exceeded nonpassive income, even stock in a largely operating company would not qualify for sec. 1244 treatment. The purpose of the exception to the gross receipts test is to protect sec. 1244 benefits for such operating corporations. Clearly, had the corporation’s main activity, manufacturing small appliances, been more successful, gross receipts from manufacturing would have exceeded gross receipts from passive investment. Denying sec. 1244 benefits to such operating companies, because the operating or manufacturing aspect of the business proved unsuccessful would defeat the intended purpose of sec. 1244, which was “to encourage the flow of new funds into small business." H. Rept. 2198, 85th Cong., 1st Sess. (1958), 1959-2 C.B. 709,711. To construe the exception to the gross receipts test as expanding sec. 1244 benefits to primarily passive business operations as proposed by petitioner, however, would generally defeat Congress’ intention of limiting the tax benefits to “largely operating companies.”

4 SEC. 1372. ELECTION BY SMALL BUSINESS CORPORATION.

(e) Termination.—

*******

(5) Passive investment income.—

(A) Except as provided in subparagraph (B), an election under subsection (a) made by a small business corporation shall terminate if, for any taxable year of the corporation for which the election is in effect, such corporation has gross receipts more than 20 percent of which is passive investment income. Such termination shall be effective for the taxable year of the corporation in which it has gross receipts of such amount, and for all succeeding taxable years of the corporation.

(B) Subparagraph (A) shall not apply with respect to a taxable year in which a small business corporation has gross receipts more than 20 percent of which is passive investment income, if—

(i) such taxable year is the first taxable year in which the corporation commenced the active

conduct of any trade or business or the next succeeding taxable year; and

(ii) the amount of passive investment income for such taxable year is less than $3,000.

(C) For purposes of this paragraph, the term “passive investment income” means gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities (gross receipts from such sales or exchanges being taken into account for purposes of this paragraph only to the extent of gains therefrom). Gross receipts derived from sales or exchanges of stock or securities for purposes of this paragraph shall not include amounts received by an electing small business corporation which are treated under section 331 (relating to corporate liquidations) as payments in exchange for stock where the electing small business corporation owned more than 50 percent of each class of the stock of the liquidating corporation.

5 Compare Doehring v. Commissioner, T.C. Memo. 1974-234, revd. 527 F.2d 945 (8th Cir. 1975). Doehring dealt with see. 1372(e)(5) prior to its amendment in 1966. Subsequent to this amendment which revised the heading of sec. 1372(e)(5) from “Personal Holding Co. Income” to “Passive Investment Income,” the Eighth Circuit, in Zychinski v. Commissioner, 506 F.2d 637 (8th Cir. 1974), reversed its position thereby agreeing with the Ninth and Tenth Circuits which have also affirmed this Court. Buhler Mortgage Co. v. Commissioner, 443 F.2d 1362 (9th Cir. 1971); Marshall v. Commissioner, 510 F.2d 259 (10th Cir. 1975). See also Doehring v. Commissioner, 527 F.2d 945,948-949 (8th Cir. 1975), explaining why the Eighth Circuit modified its position as a result of the 1966 change in sec. 1372(e)(5). Compare House v. Commissioner, T.C. Memo. 1970-125, revd. 453 F.2d 982 (5th Cir. 1972), a case dealing with pre-1966 statutory language, and Puckett v. Commissioner, T.C. Memo. 1974-235, affd. 522 F.2d 1385 (5th Cir. 1975), also dealing with pre-1966 language in which we applied the Golsen rule but noted, “We hasten to add that this decision does not reflect the thinking of this Court on the issue resolved thereby.”

6 Although the parties address these issues as to petitioner’s dominant motivation, should we conclude petitioner had a substantia] investment motive in purchasing the stock, he will not be entitled to ordinary loss treatment on the stock. See W. W. Windle Co. v. Commissioner, 65 T.C. 694 (1976), appeal dismissed 550 F.2d 43 (1st Cir. 1977), cert. denied 431 U.S. 966 (1977).