Commissioner of Internal Revenue v. Standing, 7638.

• Decision Date: 20 September 1958
• Docket Number: No. 7638.,7638.
• Citation: 259 F.2d 450
• Parties: COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. James J. STANDING and Marie S. Standing, Respondents.
• Court: U.S. Court of Appeals — Fourth Circuit

259 F.2d 450 (1958)

COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. James J. STANDING and Marie S. Standing, Respondents.

No. 7638.

United States Court of Appeals Fourth Circuit.

Argued June 9, 1958.

Decided September 20, 1958.

Carter Bledsoe, Atty., Dept. of Justice, Bethesda, Md. (Charles K. Rice, Asst. Atty. Gen., Lee A. Jackson and Harry Baum, Attys., Dept. of Justice, Washington, D. C., on the brief), for petitioner.

Dudley DuB. Cocke, Norfolk, Va., for respondents.

Before SOBELOFF, Chief Judge, HAYNSWORTH, Circuit Judge, and BARKSDALE, District Judge.

BARKSDALE, District Judge.

This is an appeal from a decision of the Tax Court involving a deficiency in income tax in the amount of $18,634.40, the opinion of the Tax Court being reported at 28 T.C. 789. The facts, so far as pertinent, may be briefly stated as follows:

Taxpayer James J. Standing, during all the times here pertinent, was sole proprietor of two businesses, a retail lumber concern and an organization engaged in building and selling houses. Taxpayer Marie S. Standing was and is his wife. In July 1951, the Commissioner proposed adjustments in the joint income tax liability of the Standings for the years 1944 through 1949 resulting in total deficiencies and penalties of $160,566.46. These deficiencies were caused by increases in the business income of the taxpayers for these years.

The taxpayers engaged an attorney, and an accountant, on a contingent fee basis to represent them in connection with the proposed deficiencies. In December of 1951, a compromise was reached, the taxpayers signing a Form 870 agreement whereby they agreed to pay a total of $90,438.95 in full settlement of the asserted taxes, interest and penalties. For service rendered in reaching this settlement, the taxpayers incurred attorneys' and accountants' fees and expenses (for simplification hereinafter referred to as "legal fees") of $14,367.16. All of this amount became due and accruable in December 1951, although only $1,500 of it was actually paid in that year. Also, in the settlement reached in December 1951, taxpayers agreed to pay $14,676.16 as interest assessed on the agreed tax deficiency for prior years. None of this amount of interest was actually paid, but the entire sum was accruable in 1951. Taxpayers were on the accrual basis for reporting business income and expense, and on a cash basis for reporting non-business deductions.

In computing "adjusted gross income" in their joint income tax return for 1951, the taxpayers claimed as business deductions both the interest assessed on the tax deficiency agreed to for prior years, and the legal fees incurred in contesting the deficiency assessment. Also they elected to and did take the optional standard deduction of $1,000.

The Commissioner determined that the legal fees and interest were not allowable as "business" deductions for the purpose of arriving at adjusted gross income. Instead, he allowed the $1,500 actually paid in 1951 on account of legal fees as a "non-business" itemized deduction from adjusted gross income, in lieu of the standard deduction taken by the taxpayers. The Commissioner's explanation for his action was that the interest and expenses involved were not business deductions, and that since the taxpayers were on a cash basis for reporting non-business deductions, the unpaid portion of these items could not be accrued and deducted in the year 1951. However, the Tax Court held that both the interest and legal fees were "business deductions" and that since the taxpayers were on an accrual basis for the purpose of reporting business income, the entire amount of these items was properly accrued in 1951, and was deductible in arriving at adjusted gross income.

The Commissioner admits that both the legal fees and interest items are deductible, but contends that the legal fees are a non-business deduction under section 23(a) (2), 26 U.S.C.A. § 23(a) (2), which is as follows:

"Non-trade or non-business expenses. In the case of an individual, all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income."

And the Commissioner further contends that the item of interest is deductible as a non-business deduction under Section 23(b), the pertinent part of which is,

"Interest. All interest paid or accrued within the taxable year on indebtedness, * * *"

On the contrary, taxpayers contend that both the item of legal fees and the item of interest are deductible under the provisions of 22(n) (1) and 23(a) (1) (A), which, so far as pertinent here, are as follows:

"§ 22. Gross income. * * *

"(n) Definition of `adjusted gross income\'. As used in this chapter the term `adjusted gross income\' means the gross income minus —

"(1) Trade and business deductions. The deductions allowed by section 23 which are attributable to a trade or business carried on by the taxpayer if such trade or business does not consist of the performance of services by the taxpayer as an employee;"

"§ 23. Deductions from gross income.

"In computing net income, there shall be allowed as deductions:

"(a) Expenses.

"(1) Trade or business expenses.

"(A) In General. All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. * * *"

The Commissioner urges that the legislative history, particularly the Committee report (S.Rep.No. 885, 78th Congress, 2nd Sess., 1944 Cum.Bull. 858) filed when Section 22(n) was added to the Revenue Code in 1944 (58 Stat. 231), shows that the adoption of "Adjusted gross income" introduced a new concept of taxation. He urges that the language of the report clearly indicates that expenses such as these under consideration are not "business deductions" deductible in arriving at adjusted gross income. He particularly relies upon the following language of the report:

"The deductions described in clause 1 Sec. 22(n) (1) above are limited to those which fall within the category of expenses directly incurred in the carrying on of a trade or business. The connection contemplated by the statute is a direct one rather than a remote one. For example, property taxes paid or incurred on real property used in the trade or business will be deductible, whereas State income taxes, incurred on business profits, would clearly not be deductible for the purpose of computing gross income. * * *"

The Treasury Regulation in regard to Section 22(n) (1), is in conformity with the Committee report, but is no more specific in its relation to the question here involved. This Regulation, in part, is as follows:

"Section 22(n) does not create any new deductions, but merely specifies which of the deductions provided in Section 23 shall be allowed in computing adjusted gross income * * *

"The deductions specified in Section 22(n) for the purpose of computing adjusted gross income are:

"(1) Deductions allowable under Section 23, which are attributable to a trade or business carried on by the taxpayer not consisting of services performed as an employee; * * *

"* * * To be deductible for the purposes of determining adjusted gross income, expenses must be those directly, and not those merely remotely, connected with the conduct of the trade or business. For example, taxes are deductible in arriving at adjusted gross income only if they constitute expenditures directly attributable to the trade or business or to property from which rents or royalties are derived. Thus, property taxes paid or incurred on real property used in the trade or business are deductible, but State income taxes are not deductible even though the taxpayer\'s income is derived from the conduct of a trade or business." (Treasury Regulation 111, promulgated under the Internal Revenue Code of 1939; Sec. 29. 22 (n)-1 as added by T.D. 5425, 1945 Cum.Bull. 10 Adjusted Gross Income.)

It is to be noted that neither the Committee report nor the Treasury Regulation specifically mentions interest on deficiency assessments of business income, nor legal expenses incurred in contesting such deficiency assessments.

Of course, legislative history, including Committee reports, carries great weight in cases of statutory ambiguity. However, here it must be noted that, when Section 22(n) (1), with its reference to Section 23, was added to the Code in 1944, Section 23(a) (1) (A) was carried forward without change, and this section had been the subject of judicial interpretation in a number of cases decided prior to 1944.

Certainly it would seem that when Congress enacted Section 22(n) (1) into law with its reference to Section 23, it was intended that Section 23(a) (1) (A) should continue to mean what the courts had construed it to mean before the enactment of Section 22(n) (1) in 1944. Prior to 1944, the Tax Court (or B. T. A.) had held that interest on income tax deficiencies or legal expenses in contesting such deficiencies, or both, were deductible as ordinary and necessary business expenses in Kissel v. Commissioner, 15 B. T. A. 1270; Louise C. Slack, etc. v. Commissioner, 35 B. T. A. 271; Estate of Brawner v. Commissioner, 36 B. T. A. 884; Greene Motor Co. v. Commissioner, 5 T.C. 314; see also W. D. Haden Co. v. Commissioner, 5 Cir., 165 F.2d 588.

The following quotation from Louise C. Slack, etc. v. Commissioner, supra (35 B. T. A. at page 281), is illustrative:

"The question involved in the third issue is whether or not the decedent properly deducted as an ordinary and necessary expense the item of $1,800 paid during the year 1931 to his attorneys for legal services rendered in connection with an appeal to this Board from the determination of a deficiency in income tax against him for the year 1923. As we have pointed out, the decedent derived substantially all of his income from real estate rentals. In our opinion his activities in connection with the management

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