Robert W. and Janet L. Carlson v. Commissioner

112 T.C. No. 17

• Court: United States Tax Court
• Decided: April 30, 1999
• Docket: 8907-97, 23135-97
• Status: Unknown

Opinion

112 T.C. No. 17

UNITED STATES TAX COURT

ROBERT W. AND JANET L. CARLSON, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 8907-97, 23135-97. Filed April 30, 1999.

P is a shareholder of A, an S corporation. A is engaged in the business of selling residential timeshare units to individuals on an installment basis. A elected under sec. 453(l)(3)(A), I.R.C., to report installment sale income under the installment method. P, in his capacity as a shareholder, paid additional tax equal to the interest on the amount of tax deferred as a result of A's use of the installment method, as required under sec. 453(l)(3)(A), I.R.C. Pursuant to sec. 453(l)(3)(c), Ps deducted the payment as interest on their joint Federal income tax returns for 1993, 1994, 1995, and 1996. R disallowed the interest deductions in full on the basis that the interest constituted nondeductible personal interest under sec. 163(h)(2)(A), I.R.C. and sec. 1.163-9T(2)(i)(B), Temporary Income Tax Regs., 52 Fed. Reg. 48409 (Dec. 22, 1987).

Held: Ps may not deduct the sec. 453(l)(3)(A), I.R.C., interest on the tax incurred by P on installment sales of - 2 -

timeshares by A, because the interest is not properly allocable to a trade or business of P. See sec. 163(h)(2)(A), I.R.C.

John A. Sanders, for petitioners.

William R. McCants, for respondent.

OPINION

NIMS, Judge: In these consolidated cases, respondent

determined the following deficiencies with respect to

petitioners' Federal income taxes:

Year Deficiency 1993 $151,323 1994 223,015 1995 212,305 1996 198,426

Unless otherwise indicated, all section references are to

sections of the Internal Revenue Code in effect for the years in

issue. All Rule references are to the Tax Court Rules of

Practice and Procedure. All dollar amounts are rounded to the

nearest dollar.

The sole issue for decision is the deductibility of interest

paid by Robert W. Carlson (petitioner), an S corporation

shareholder, pursuant to an election under section 453(l)(3)(A)

(relating to installment sales of timeshares and residential

lots). - 3 -

This case was submitted with fully stipulated facts under

Rule 122. The stipulation of facts and the attached exhibits are

incorporated herein by this reference. Petitioners resided in

Freeport, Grand Bahama, Bahamas, when they filed their petitions.

Background

Petitioner formed Aqua Sun Investments, Inc. (Aqua Sun), as

a Florida corporation in 1984. Petitioner was the president and

sole shareholder of Aqua Sun from 1984 through 1995. In 1996,

petitioner's son acquired a .083 percent equity interest in Aqua

Sun, reducing petitioner's ownership percentage to 99.917

percent.

Aqua Sun was an S corporation during the years at issue.

During that time, Aqua Sun's primary business was the

development, construction, and sale of residential timeshare

units to individuals. Aqua Sun's timeshare development

activities have involved both the acquisition and the renovation

of existing buildings as well as the construction of new

facilities. All of Aqua Sun's timeshare developments are located

in either Ormond Beach, Daytona Beach, St. Petersburg, or

Kissimmee, Florida.

During the years in issue, Aqua Sun, in the ordinary course

of its business, sold residential timeshare units to individuals

on an installment basis whereby the sales price of a unit was to

be paid in installments over a specified period of time. Aqua - 4 -

Sun elected to report the income from the installment sales using

the installment method, as permitted under section 453(l)(2)(B).

During each year at issue, petitioner, in his capacity as a

shareholder, paid an additional tax equal to the interest on the

tax deferred as a result of Aqua Sun's election of the

installment method. The amount of interest was determined with

reference to petitioners' tax liability for the previous tax

year, so that the interest paid in 1993, 1994, 1995, and 1996

related to petitioners' Federal income tax liability on Aqua

Sun's installment sales of timeshare units, as reported on

petitioners' returns for 1992, 1993, 1994, and 1995,

respectively.

Petitioners computed the interest on the deferred tax

liability in accordance with section 453(l)(3)(B) and reported

the interest as a business deduction on Schedule E, Part II, of

Forms 1040 for 1993, 1994, 1995, and 1996, in the following

amounts:

Year Interest Paid 1993 $382,127 1994 563,169 1995 536,124 1996 501,077

In the notices of deficiency, respondent disallowed

petitioners' interest deductions in full because petitioners had

failed to establish that said interest payments were allowable

business interest expense deductions. - 5 -

Discussion

As stated, the sole issue for decision is whether

petitioners may deduct interest which they paid pursuant to an

election under section 453(l)(2)(B)(i) (relating to installment

sales of timeshares and residential lots).

Under section 453(b)(2)(A), an installment sale of real

property held for sale to customers in the ordinary course of

business is ineligible for installment sale treatment, since the

sale is treated as a "dealer disposition" as defined in section

453(l)(1)(B). Dispositions of timeshares and residential lots

are excepted from the dealer disposition definition, however, if

the taxpayer elects to have paragraph (3) of section 453(l) apply

to any installment obligations which arise from such

dispositions.

There are conditions attached to the privilege of exercising

the election, the only significant condition for purposes of this

case being the following: the taxpayer must agree to pay an

additional tax, taken into account under section 453(l)(3)(C) as

interest paid or accrued during the taxable year.

The parties stipulated that there is no dispute that Aqua

Sun was in the business of selling residential timeshare units

and was entitled to report income from its residential timeshare - 6 -

sales using the installment method, and there is no dispute

concerning the amount of interest that petitioner was required to

pay under section 453(l)(3).

Petitioners do not deny that the business of selling

timeshares was conducted by Aqua Sun, and not by petitioner.

They say in their opening brief that the section 453(l)(3)(C)

interest paid by petitioner arises out of, and relates directly

and exclusively to, the taxes imposed on petitioners as a result

of the trade or business activities of Aqua Sun. They thus

appear to be arguing that Aqua Sun's trade or business is to be

imputed to petitioner. Having made this connection, petitioners

go on to argue that the interest that petitioner paid falls

within the personal interest exception contained in section

163(h)(2)(A). That section provides that "personal interest"

does not include "interest paid or accrued on indebtedness

properly allocable to a trade or business (other than the trade

or business of performing services as an employee)."

Petitioners must get over one more hurdle in order to

prevail; namely, the provisions of section 1.163-9T(b)(2)(i)(B),

Temporary Income Tax Regs., 52 Fed. Reg. 48409 (Dec. 22, 1987).

This section of the temporary regulations provides that personal

interest includes interest paid under what was formerly section

453C(e)(4)(B) and is now section 453(l)(3)(C); i.e., interest - 7 -

paid on the tax deferred by reason of the installment sale of

timeshares and residential lots. Petitioners argue that this

regulation is invalid.

Respondent argues that the interest paid by petitioner as a

shareholder of an S corporation, pursuant to section 453(l)(3),

is nondeductible personal interest under section 163(h).

We agree with respondent because, whether or not section

453(l)(3) interest can ever be deemed "properly allocable to a

trade or business" under the exception to personal interest

treatment contained in section 163(h)(2)(A), the trade or

business in this case was that of Aqua Sun, and not that of

petitioners.

S corporations and partnerships, among certain other

entities, are commonly known as "passthrough entities". In

United States v. Basye, 410 U.S. 441, 448 (1973), the Supreme

Court noted that "while the partnership itself pays no taxes, * *

* it must report the income it generates * * * . For this

purpose * * * the partnership is regarded as an independently

recognizable entity." (Emphasis added). The partnership is

thereafter treated as an agent or conduit through which the

income passes; i.e., as a passthrough entity, but nevertheless a

freestanding entity. See id.

Under section 1366, relating to "Pass-thru of items to

shareholders," and specifically subsection (a)(2), nonseparately - 8 -

computed income or loss of an S corporation is defined as gross

income minus the deductions allowed to the corporation under

Chapter 1 of the Internal Revenue Code. Thus, for example,

assuming Aqua Sun were entitled to a deduction for interest on an

indebtedness incurred to finance the construction of timeshares,

Aqua Sun's gross income would be reduced by the amount of the

deduction, before the passthrough to petitioner. The interest

which petitioners seek to deduct as a trade or business expense

is not an item which passes through from Aqua Sun to petitioner,

since the tax on which the interest must be paid is not imposed

on Aqua Sun, but directly on petitioner.

Section 163(h)(1) provides that in the case of a taxpayer

other than a corporation, no deduction is allowed for "personal

interest". Among other things, personal interest is defined as

any interest allowable as a deduction under Chapter 1 of the

Internal Revenue Code other than, as we have said, interest paid

or accrued on indebtedness "allocable to a trade or business."

Sec. 163(h)(2)(A). The quoted language was substituted for

interest paid or accrued on indebtedness "incurred or continued

in connection with the conduct of" a trade or business, by the

Technical and Miscellaneous Revenue Act of 1988, Pub. L. 100-647,

sec. 1005(c)(1), 102 Stat. 3342. Petitioners argue that while

the previous language may have referred to a trade or - 9 -

business of the taxpayer, the new language broadens the scope of

section 163(h)(2)(A) to include any trade or business, which in

this case can include a trade or business of Aqua Sun.

Petitioners attempt to distinguish True v. United States, 72

AFTR 2d 93-5660, 93-2 USTC par. 50,461 (D. Wyo. 1993), affd.

without published opinion 35 F.3d 574 (10th Cir. 1994), relied

upon by respondent. On brief, petitioners acknowledge True's

holding that interest paid by an individual shareholder of an S

corporation on a tax deficiency attributable to the business of

the S corporation is not deductible by the shareholder under

section 62(a)(1) as a trade or business expense, which must be

"attributable to a trade or business of the taxpayer". In True,

the District Court held that the interest was not an allowable

trade or business deduction because the S corporation's business

activities were not attributed to the shareholders for purposes

of section 62(a)(1).

Petitioners argue that True v. United States, supra, dealt

with tax years prior to the enactment of present section 163(h).

Consequently, petitioners say, the holding in True has nothing to

do with whether such interest expense is "properly allocable to a

trade or business" under section 163(h)(2)(A). Unlike section

62(a)(1), which requires the trade or business to be conducted by

the taxpayer, petitioners contend that section 163(h)(2)(A)

merely requires that interest be "properly allocable to a trade - 10 -

or business" in order for it to constitute deductible business

interest. In petitioners' view, nothing in section 163(h)(2)(A)

requires the interest to be paid by the taxpayer conducting the

trade or business.

Petitioners seek to bootstrap deductibility of their

interest expense by analogizing their interest expense to

interest on debt incurred to acquire or increase an interest in a

passthrough entity, citing a temporary regulation and several IRS

Notices. Referring to rules for allocating interest expense for

purposes of applying sections 469 (the "passive loss limitation")

and 163(d) and (h) (the "nonbusiness interest limitations"),

section 1.163-8T(a)(3), Temporary Income Tax Regs., 52 Fed. Reg.

24999 (July 2, 1987), provides:

(3) Manner of allocation. In general, interest expense on a debt is allocated in the same manner as the debt to which such interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. This section prescribes rules for tracing debt proceeds to specific expenditures.

However, section 1.163-8T(a)(2) of the same regulations cross-

refers to paragraph (b) for definitions. Paragraph (b)(7)

defines "trade or business expenditure" as "an expenditure * * *

in connection with the conduct of any trade or business other

than the trade or business of performing services as an

employee." - 11 -

Thus, if debt proceeds are allocated by the passthrough

entity to a trade or business expense, the interest on the debt

is similarly allocated. In the case before us, however, no

proceeds of debt incurred by Aqua Sun have been allocated by Aqua

Sun to its trade or business, so allocation rules are not germane

to petitioners' position here.

As a final argument, petitioners seek to have us declare

invalid section 1.163-9T(b)(2)(i)(B), Temporary Income Tax Regs.,

52 Fed. Reg. 48409 (Dec. 22, 1987).

This provision reads as follows:

(2) Interest relating to taxes--(i) In general. Except as provided in paragraph (b)(2)(iii) of this section, personal interest includes interest--

* * * * * * *

(B) Paid under section 453C(e)(4)(B) [now section 453(l)(3)] (interest on deferred tax resulting from certain installment sales) and section 1291(c) (interest on deferred tax attributable to passive foreign investment companies); or * * *

Petitioners' challenge to the validity of this regulation is

mooted by our holding that the interest paid by petitioner

pursuant to section 453(l)(3) is not paid or incurred in a trade

or business of petitioner, so that, regardless of the validity or

invalidity of the regulation, we need not consider the merits of

petitioners' argument. - 12 -

In sum, we hold that petitioners may not deduct the section

453(l)(3)(A) interest on the tax incurred by petitioners on

installment sales of timeshares by Aqua Sun because the interest

is not properly allocable to a trade or business of petitioner,

as required under section 163(h)(2)(A).

Decisions will be entered

for respondent.