Reise v. Comm'r of Internal Revenue, Docket No. 69698.

Citation35 T.C. 571
Decision Date18 January 1961
Docket NumberDocket No. 69698.
PartiesELMER REISE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
CourtUnited States Tax Court

OPINION TEXT STARTS HERE

During 1949 the petitioner paid his Wisconsin State income tax for 1948, deficiencies in his State income taxes for 1945 through 1947, interest on deficiencies in his State and Federal income taxes for 1945 through 1947, and legal fees incurred in connection with State and Federal investigations of his income tax liability to the respective entities for 1945 through 1947 which resulted in the determination of deficiencies in his State and Federal income taxes for those years. The State income tax for 1948 and the deficiencies in State and Federal income taxes for 1945 through 1947 were imposed with respect to business income. Held, that the State income tax for 1948, the deficiencies in State income taxes, interest on the deficiencies in State and Federal income taxes, and the legal expenses were ordinary and necessary expenses of the trade or business regularly carried on by petitioner, were attributable to the operation of such trade or business, and were properly deductible in computing a net operating loss carryback pursuant to section 122, I.R.C. 1939. Paul P. Lipton, Esq., Richard A. Petrie, Esq., and Robert D. Hevey, Esq., for the petitioner.

Delman H. Eure, Esq., for the respondent.

OPINION.

WITHEY, Judge:

The respondent determined a deficiency of $34,782.09 in the petitioner's income tax for 1947 and an addition to tax for that year under section 293(a) of the Internal Revenue Code of 19391 of $3,639.45.

The issues for determination are whether Wisconsin State income tax of the petitioner for 1948 and deficiencies in his State income taxes for prior years paid in 1949, interest on Federal and State income tax deficiencies for prior years also paid during 1949, together with legal fees paid by him in 1949 for services rendered in connection with Federal and State investigations of his income tax liabilities for prior years, were deductible as business expenses in computing a net operating loss carryback from 1949 to 1947 under section 122(d) of the Code.

All of the facts and evidence have been stipulated by the parties and are so found.

The petitioner is an individual residing in Milwaukee, Wisconsin, who with his wife, Lillian C. Reise, filed a timely joint Federal income tax return for 1949 with the collector of internal revenue at Milwaukee. From and including 1945 through 1949 the petitioner, operating as a sole proprietor, was engaged in business as a dealer in hides and skins. Petitioner was also engaged in the management of apartment buildings and other dwellings which he owned and held primarily for rental purposes. Petitioner also received other income in the form of dividends and interest.

The Federal and State income tax returns filed by petitioner for 1945, 1946, and 1947 were prepared on a cash basis method of accounting. There was no material difference between the amounts of net income reported in his Federal returns for the respective years and the amounts reported in his State returns for such years.

Early in 1949 the Wisconsin Department of Taxation made an investigation of the petitioner's State income tax liability for 1945 through 1947. Immediately following the foregoing investigation the respondent made an investigation of the petitioner's Federal income tax liability for the same years. As a result of his investigation, the respondent determined deficiencies in petitioner's Federal income taxes for 1945 through 1947. Substantially all of the deficiencies for those years arose from the respondent's determination that petitioner's income from sales of hides and skins should have been reported on an accrual rather than a cash basis. No change was made by the respondent with respect to the cash basis of accounting used by petitioner in reporting other income for 1945 through 1947. As a result of its investigation of the petitioner's State income tax liability, the Wisconsin Department of Taxation also determined deficiencies in petitioner's State income taxes for 1945 through 1947. In determining the deficiencies the Wisconsin Department of Taxation made essentially the same adjustments to the income reported by petitioner on his State income tax returns as respondent made in determining the deficiencies in petitioner's Federal income tax for the same years.

The petitioner's State income tax return for 1948 was filed on April 27, 1949, and the State income tax imposed for 1948 was in relation to business income.

Petitioner's income and expenses arising from sales of hides and skins during 1949 were reported and claimed on his Federal income tax return for that year on an accrual basis of accounting. All other items of income and expense were reported and claimed on a cash basis method of accounting.

During 1949 petitioner paid legal fees incurred for legal services rendered in connection with the investigations which resulted in the determination of deficiencies in his Federal and Wisconsin State income taxes for 1945 through 1947.

In determining the deficiency involved herein the respondent determined that certain deductions claimed by petitioner and his wife in computing a net operating loss for 1949 were not attributable to the operation of the petitioner's trade or business within the meaning of section 122(d)(5) of the Code and accordingly were allowable as deductions in computing the net operating loss only to the extent of $1,280.91, the total of dividends and interest, which was the reported gross income not derived from the petitioner's trade or business. The remainder of such items the respondent disallowed in determining the net operating loss for 1949. The items and amounts so disallowed and here in controversy are as follows:

+---------------------------------------------------------------------------+
                ¦Interest on Federal income taxes (1945, 1946, and 1947)         ¦$18,431.32¦
                +----------------------------------------------------------------+----------¦
                ¦Interest on State income taxes (1945, 1946, and 1947)           ¦1,297.75  ¦
                +----------------------------------------------------------------+----------¦
                ¦State income tax (1948)                                         ¦3,304.97  ¦
                +----------------------------------------------------------------+----------¦
                ¦State income taxes (1945, 1946, and 1947)                       ¦17,268.15 ¦
                +----------------------------------------------------------------+----------¦
                ¦Legal fees paid for services rendered in connection with Federal¦          ¦
                +----------------------------------------------------------------+----------¦
                ¦and State income tax investigations                             ¦2,557.93  ¦
                +---------------------------------------------------------------------------+
                

Wisconsin State income tax of the petitioner for 1948 and deficiencies in his State income taxes for prior years paid during 1949, interest on Federal and State income tax deficiencies also paid during 1949, together with legal fees paid by him in 1949 for services rendered in connection with Federal and State income tax investigations, were all ordinary and necessary expenses of the trade or business regularly carried on by the petitioner and were attributable to the operation of such trade or business.

The question for determination is whether the above-mentioned items which the respondent disallowed in computing the net operating loss for 1949 were properly deductible as business expenses under section 122(d) of the Code. 2

The respondent takes the position on brief that in computing the petitioner's net income for 1949 the legal expenses were deductible under section 23(a) of the Code,3 the interest was deductible under section 23(b), and the State income taxes were deductible under section 23(c). However, he contends that under the provisions of section 122(d)(5) those items were not attributable to the operation of the trade or business of the petitioner.

We will consider first the provisions of section 122(d)(5). Section 211 of the Revenue Act of 1939 amended section 23 of the Code by adding thereto subsection (s), which provided for the allowance as a deduction in computing net income of a net operating loss computed under section 122. The latter section also was added to the Code by section 211 of the Act. The purpose of the foregoing additions to the Code was to permit a taxpayer who, in a given year, sustains a net operating loss to deduct such loss in another year or years.

Section 122(a) defines the term ‘net operating loss' as the excess of the deductions allowed by Chapter 1— Income Tax over the gross income, with the exceptions, additions, and limitations provided in subsection (d) of that section. The report of the Committee on Ways and Means on the Revenue Bill of 1939, which became the Revenue Act of 1939, H. Rept. No. 855, 76th Cong., 1st Sess., 1939-2 C.B. 517, pertinent portions of which are set out below, 4 shows that the net operating loss contemplated by sections 23(s) and 122 was an economic loss and, as stated in the report, ‘The exceptions and limitations provided in section 122(d) are for the purpose of insuring that only an economic loss will be taken into account.’

The portion of subsection (d) of section 122 pertinent here is paragraph (5), which provides that deductions otherwise allowed by law not attributable to the operation of a trade or business regularly carried on by the taxpayer shall, in the case of a taxpayer other than a corporation, be allowed only to the extent of the amount of gross income not derived from such trade or business. The foregoing provision is a limitation on the allowance of deductions not attributable to the operation of a trade or business regularly carried on by the taxpayer. However, that provision does not purport to apply, nor does it apply, to deductions which are attributable to the operation of a trade...

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