MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Respondent issued Doctors Hospital Management Co. (petitioner), as tax matters partner of Doctors Hospital Real Estate, Ltd. (DHRE), three notices of final partnership administrative adjustment (FPAA's). Collectively, the FPAA's covered DHRE's 1984 through 1986 taxable years. In the FPAA for 1984, respondent made an adjustment of $ 2,253,579 to DHRE's ordinary income, made an adjustment of $ 1,162,768.55 to DHRE's basis in section 38 property that is subject to the investment tax credit, and made certain adjustments to DHRE's construction-period interest, accelerated depreciation, and net qualified investment income. In the FPAA's for 1985 and 1986, respondent made ordinary income adjustments in the amounts of $ 1,470,948 and $ 1,444,580, respectively, and certain adjustments to construction-period interest, accelerated depreciation, investment interest expense, and net qualified investment income. This case is before the Court pursuant to petitioner's petition under section 62261 for readjustment of the partnership items set forth in the FPAA. 2 Prior to trial, the Court denied petitioner's three motions to dismiss for lack of jurisdiction.
After concessions by petitioner, the issues for decision are: 3
(1) Whether DHRE satisfies the noncorporate lessor requirements of section 46(e)(3) and thus qualifies for an investment credit for certain fixed equipment for 1984. We hold it does not.
(2) Whether certain investment interest claimed as an ordinary deduction must be recharacterized as investment interest. We hold it must.
(3) Whether certain construction-period interest must be capitalized or may be currently deducted. 4 We hold it may be currently deducted.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations and exhibits attached thereto are incorporated herein by this reference. DHRE's principal place of business at the time it filed the petition was Victoria, Texas (Victoria).
In 1979, a group of doctors began discussing the need for a new hospital in Victoria. The doctors organized Doctors Hospital of Victoria, Inc. (DHV) as a Texas corporation, with the intent of developing and operating a hospital. Stock was issued to 45 physicians practicing medicine in the Victoria area. The doctors then began the process of applying to the State government for a certificate of need for a new hospital. They purchased the Hohf Clinic, with its existing certificate of need for a 50-bed hospital. In June 1981, DHV obtained a certificate of need for a new 106-bed hospital. 5
After operating the Hohf Clinic for a little less than a year, the shareholders in DHV realized that they did not have the ability to develop a hospital and needed the assistance of a professional hospital management company. They chose Universal Health Services, Inc. (UHS), a Delaware corporation engaged in the business of operating and owning acute-care hospitals.
In late 1980 or early 1981, DHV obtained an option to purchase 46.889 acres of property; DHV planned to build a hospital on 12 of the acres. The DHV shareholders formed a Texas limited partnership, DHRE, comprised of 43 of the shareholders of DHV plus two other persons. During the years in issue, DHRE used the cash method of accounting and a calendar year taxable year.
In 1982, DHV, DHRE, and UHS carried out a transaction memorialized in a Stock Purchase Agreement. In that transaction, UHS formed a wholly owned Texas subsidiary, Universal Health Services of Victoria, Inc. (Subsidiary). DHV exercised its option to purchase land on which to build the hospital. DHV as lessor and DHRE as lessee entered into a Ground Lease dated January 19, 1982, pursuant to which DHV agreed to lease certain land to DHRE.
On the same day, DHRE and DHV entered into a Hospital Lease, pursuant to which DHRE agreed to lease to DHV a hospital building to be constructed on the land leased by DHV to DHRE pursuant to the Ground Lease. 6 The Hospital Lease granted DHRE the option to lease to DHV any equipment DHV proposed to lease from DHRE. DHRE had no responsibility for any expenses under the Hospital Lease; all expenses were borne by DHV as lessee.
Construction of the hospital was conducted pursuant to a written plan that was in existence on July 1, 1982, and as to which approval from a governmental unit had been requested in writing on May 14, 1981. Construction commenced before January 1, 1984. The hospital was completed in March 1984 and was placed in service on April 1, 1984. 7 The total cost was $ 13,012,403, excluding construction-period interest in the amount of $ 987,618 and the cost of the equipment. 8
On March 30, 1984, DHV, DHRE, and Subsidiary entered into an agreement to execute a deed and bill of sale to clarify that DHRE owned the hospital building. DHV agreed to lease the fixed equipment from DHRE, and DHV transferred title to DHRE by a "Bill of Sale". 9 Although the hospital was complete, DHRE had not yet obtained permanent financing; UHS and its subsidiaries had invested over $ 14 million in construction financing and equipment purchases. DHRE memorialized its debt for construction costs and fixed equipment by giving Subsidiary its note for $ 14 million while the parties continued to seek mutually agreeable third party financing.
In 1984, UHS realized that the form of the Hospital Lease failed to meet certain standards of the Financial Accounting Standards Board, and initiated renegotiation of the lease. On December 28, 1984, a renegotiated hospital lease was executed (the Revised Lease). Under both the Hospital Lease and the Revised Lease, the rent was "such amount as shall be required to maintain and service any indebtedness incurred in connection with the construction of the Hospital or in connection with any refinancing or refunding of such indebtedness." 10 Under the Revised Lease, DHV was liable for "additional rent" in the amount of $ 550,000.
The lease of the fixed equipment by DHRE to DHV was included in the Revised Lease. DHRE did not manufacture or produce the fixed equipment. Under the Revised Lease, DHRE's maximum contributions for expenses related to the fixed equipment total $ 550,000, the amount of the additional rent called for in the Revised Lease. Under the Revised Lease, even if DHRE was not liable for the full $ 550,000, DHV would still be required to pay the full $ 550,000 additional rent. Dr. William P. Sage, the treasurer of DHRE, never saw an accounting of the amounts it was required to contribute for expenses related to the fixed equipment. John Scott (Scott), an attorney, requested certain information from John Gill (Gill), area financial manager of UHS, annually, but Scott did not ask for an accounting of expenses on a lease-year basis. Gill never made an attempt to compute what the lease-year expense would be.
On December 28, 1984, DHRE received a rent payment of $ 1,327,062.42. 11 During 1985, DHRE received rent payments totaling $ 1,838,627.30. From April 1, 1984, through March 31, 1985, DHRE received rent payments totaling $ 2,120,679.78. During 1986, DHRE received rent payments totaling $ 1,785,109.94.
On March 28, 1985, DHRE received $ 550,000 from DHV. Also on March 28, 1985, DHRE wrote four separate checks to DHV, totaling $ 550,000. DHRE always intended to have the equipment it leased to DHV qualify for the investment credit, and DHRE knew it would have to contribute to the maintenance of that equipment. However, DHRE's only source of cash was rents. Without the $ 550,000 from DHV, DHRE could not have made the four payments totaling $ 550,000. For the 1986 taxable year, neither UHS, Subsidiary, nor DHV paid the $ 550,000 additional rent, and DHRE did not pay any of the amounts under the revised lease that would total $ 550,000.
DHRE worked mainly out of its checkbooks and did not keep a cash receipts and disbursements journal. DHRE deducted no expenses under section 162 on its 1984 Form 1065, U.S. Partnership Return of Income. For 1985, DHRE deducted expenses under section 162 totaling $ 6,417.28, excluding "rental expenses" of $ 550,500. For 1986, DHRE deducted expenses under section 162 totaling $ 12,837, excluding "rental expenses" of $ 550,581.65 and "rent" of $ 1,500.
OPINION
The notice of deficiency benefits from a presumption of correctness, and petitioner bears the burden of proving it erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
Investment Credit
Section 38(a) generally allows taxpayers an investment tax credit. Section 46(e)(3) allows a credit to a business lessor of personal property other than a corporation if (1) the property subject to the lease has been manufactured by the lessor or (2) the term of the lease, including options to renew, is less than 50 percent of the useful life of the property and, for the 12-month period immediately following the transfer of the property to the lessee, the sum of the deductions allowable to the lessor under section 162 (other than rents and reimbursed amounts) exceeds 15 percent of the rental income produced by such property. In enacting section 46(e)(3), Congress intended to deny an investment credit to noncorporate lessors who remain mere passive investors. Carlson v. Commissioner, 79 T.C. 215, 221 (1982), affd. 712 F.2d 1314 (9th Cir. 1983); S. Rept. 92-437, at 44 (1971), 1972-1 C.B. 559, 583; H. Rept. 92-533 at 29, 1972-1 C.B. 498, 513; see also Sutow v. Commissioner, T.C. Memo. 1992-473. DHRE, a partnership, is subject to this "noncorporate lessor" limitation. Since DHRE did not manufacture the fixed equipment subject to the lease, DHRE qualifies for the credit only if it satisfies the "useful life" and "expense" tests of section 46(e)(3).
The hospital opened on April 1, 1984; we assume this is the date on which the fixed equipment was transferred to DHV, the lessee. Therefore, the applicable 12-month period runs through March 31, 1985. DHRE did not deduct any expenses under section 162 on its 1984 Federal income tax return, and did not establish its entitlement to any expenses not so deducted. On its 1985 Federal income tax return, DHRE deducted certain expenses under section 162 totaling $ 6,417.28. 12 Assuming arguendo that DHRE incurred the entire $ 6,417.28 during the first quarter of 1985, these deductions do not exceed 15 percent of the rental income under the Revised Lease, which totaled $ 2,120,679.78. Thus, to meet the expense test, DHRE claims that the $ 550,500 it expended and deducted on its 1985 Federal income tax return was properly deductible under section 162.
The term "reimbursed amounts" is defined as amounts that the lessee or some other person is obligated to reimburse the lessor. Sec. 1.46-4(d)(3)(ii), Income Tax Regs. DHV was obligated to pay DHRE $ 550,000, in return for DHRE's $ 550,000 payment. We do not credit petitioner's argument that DHRE's payment to DHV was merely capped at $ 550,000 and might have been less. On March 28, 1985, DHRE wrote four separate checks to DHV, totaling $ 550,000, and DHRE received $ 550,000 from DHV. Without the $ 550,000 from DHV, DHRE could not have made the four payments totaling $ 550,000. In the following year, neither party actually made the offsetting "mandatory" payments to each other. 13 We find that, during the applicable 12-month period, DHV reimbursed DHRE for all expenses (other than $ 6,917.28) that DHRE would have been allowed to deduct under section 162. Cf. Sutow v. Commissioner, supra.Accordingly, because we hold that DHRE fails to meet the "expense test" under section 46(e)(3), we do not reach the issue of whether the term of the lease, including options to renew, is less than 50 percent of the useful life of the property.
Investment Interest
In any taxable year, a taxpayer is generally restricted from deducting investment interest that exceeds the taxpayer's investment income for the taxable year. Sec. 163(d)(1). Section 163(d)(4)(A) deems certain property subject to a lease to be property held for investment; any interest claimed with respect to that property is investment interest. Section 163(d)(4)(A) applies where, during the taxable year, (1) the sum of the deductions allowable to the lessor under section 162 (other than rents and reimbursed amounts) do not exceed 15 percent of the rental income produced by such property, or (2) the lessor is guaranteed a specific return or is guaranteed in whole or in part against loss of income. Nicholson v. Commissioner, T.C. Memo. 1993-183, on reconsideration, T.C. Memo. 1993-427.
Petitioner concedes that respondent's determination of 1984 net investment income is correct. In 1985, DHRE deducted $ 6,417.28 in expenses under section 162, excluding "rental expenses" of $ 550,500, which were reimbursed amounts to the extent of $ 550,000. Aside from reimbursed amounts, DHRE's expenses do not exceed 15 percent of the rental income produced by the Hospital Lease for 1985, which totaled $ 1,838,627.30. In 1986, DHRE deducted $ 12,837 in expenses under section 162, excluding "rent" of $ 1,500 and "rental expenses" of $ 550,581.65 that were reimbursed amounts to the extent of $ 550,000. DHRE's expenses, other than rent and reimbursed amounts, do not exceed 15 percent of the rental income produced by the Hospital Lease for 1986, which totaled $ 1,785,109.94. Accordingly, the interest claimed by petitioner for 1985 and 1986 is investment interest within the meaning of section 163(d)(4)(A). Based on this determination, petitioner concedes on brief that the correct amount of net investment income for 1985 and 1986 is as set forth in the FPAA's for those years. Thus, we need not reach the issue of whether DHRE was guaranteed a specific return or is guaranteed in whole or in part against loss of income.
Construction-period interest
In her FPAA's, respondent determined that DHRE's construction-period interest was not currently deductible, but must be capitalized and amortized over a 10-year period. However, respondent allowed petitioner a deduction for construction-period interest deductible by a corporate partner of DHRE. Respondent argues that DHRE must capitalize construction-period interest and amortize it over 10 years. Petitioner argues that DHRE was entitled to a current deduction for such interest.
As enacted by the Tax Reform Act of 1976, Pub. L. 94-445, sec. 201, 90 Stat. 1520, 1525, section 189(a) provided: Except as otherwise provided in this section or in section 266 * * *, in the case of an individual, no deduction shall be allowed for real property construction period interest and taxes. * * *
Sec. 189(a) (emphasis added). The Tax Equity & Fiscal Responsibility Act of 1982, Pub. L. 97-248, sec. 207(a), 96 Stat. 324, 431, amended this section, eliminating the language underscored above; the amendment appears to deny a larger group of persons a deduction for construction-period interest and taxes. As amended by Pub. L. 97-248, 96 Stat. 431, section 189(a) read: Except as otherwise provided in this section or in section 266 * * *, no deduction shall be allowed for real property construction period interest and taxes.
This amendment is generally effective with respect to taxable years beginning after December 31, 1982, with respect to construction commencing after such date. However, section 207(e)(2) of Pub. L. 97-248, 96 Stat. 432, provides in part that this amendment does not apply to the construction of a hospital if: (1) The construction is conducted pursuant to a written plan of the taxpayer which was in existence on July 1, 1982, and as to which approval from a governmental unit has been requested in writing, and (2) the construction commences before January 1, 1984. Based on the stipulated facts, petitioner has met these two elements, and is therefore subject to the preamendment rule.
Thus, the version of section 189(a) applicable to the transaction discussed herein prohibits only individuals, not partnerships, from deducting construction-period interest and taxes; DHRE is entitled to deduct such interest, and we rule for petitioner on this issue. Cf. Aboussie v. United States, 779 F.2d 424, 427 (8th Cir. 1985).
To reflect the foregoing,
Decision will be entered under Rule 155.