Bates v. U.S., s. 76-2073-78

• Decision Date: 21 July 1978
• Docket Number: Nos. 76-2073-78,s. 76-2073-78
• Citation: 581 F.2d 575
• Parties: 78-2 USTC P 9592 Alfred O. and Margaret A. BATES et al., Appellants, v. The UNITED STATES of America, Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 575

581 F.2d 575

78-2 USTC P 9592

Alfred O. and Margaret A. BATES et al., Appellants, v. The UNITED STATES of America, Appellee.

Nos. 76-2073-78.

United States Court of Appeals Sixth Circuit.

Argued April 20, 1978.

Decided July 21, 1978.

Robert E. Glaser, Hugh M. Stanley, Jr., Arter & Hadden, Cleveland, Ohio, for appellants.

Frederick M. Coleman, U.S. Atty., Cleveland, Ohio, Scott P. Crampton, Asst. Atty. Gen., Gilbert Andrews, Tax Division, U.S. Dept. of Justice, Washington, D.C., Myron C. Baum, Michael L. Paup, Robert T. Duffy, Washington, D.C., for appellee.

Before CELEBREZZE, LIVELY and KEITH, Circuit Judges.

LIVELY, Circuit Judge.

This case concerns the requirements which must be met for a taxpayer to be entitled to the favorable tax treatment extended by Section 1244 of the Internal Revenue Code of 1954, 26 U.S.C. § 1244 (1970). ¹

Ordinarily when an investment in a corporation becomes worthless, the investor's loss is treated as a capital loss, the deductibility of which is limited by § 1211 of the Code. When a loss is suffered on stock which qualifies under § 1244, however, the investor may treat it as an ordinary loss, which is deductible from other taxable income. This is a significant advantage. For stock to qualify under § 1244 the issuing corporation must satisfy the statutory conditions.

The taxpayers all suffered losses on their stock in a family-owned small business corporation which was liquidated in 1971. Each claimed an ordinary loss pursuant to § 1244 rather than loss from the sale of a capital asset. The Commissioner of Internal Revenue disallowed the § 1244 claims and assessed deficiencies. Each taxpayer paid the deficiencies, and after claims for refund were denied, brought separate actions for refunds which were consolidated in the district court.

The facts were stipulated. Though the district court heard testimony the trial did not produce conflicts in the evidence and the findings of fact of the district court are not in dispute. Alfred Bates, his son and other members of the Bates family formed Bates Investment Corporation (BIC) in 1969. The stock in BIC was offered pursuant to a plan which met the requirements of § 1244. It was stipulated that there were valid business reasons for the formation of BIC. The purpose of forming BIC was to provide a means of re-entry into the machine tool business in which both father and son had experience. This was accomplished through the purchase by BIC of a majority of the outstanding stock of National Cleveland Corporation (National Cleveland), a publicly owned corporation engaged in manufacturing metal cutting tools. This purchase consumed practically all of the funds of BIC, which had been realized primarily from the sale of stock to members of the Bates family and the issuance of convertible debentures.

After the purchase both Alfred Bates and his son Arthur worked for National Cleveland, Arthur was employed as the salaried chairman of National Cleveland, and Alfred spent many uncompensated hours performing services for that corporation. There was no agreement that National Cleveland would pay BIC for these services. BIC never billed National Cleveland for the services of either taxpayer and no payments were made by National Cleveland to BIC.

During the existence of BIC Alfred and Arthur Bates also performed services for BIC and actively searched for other businesses which BIC might acquire. However, the only asset ever owned by BIC was the National Cleveland stock. BIC had no gross receipts during any year of its existence and it had income tax deductions in each year. National Cleveland went into bankruptcy at about the same time that BIC was liquidated.

While the government conceded that the five requirements of § 1244(c)(1)(A) through (E) of the Code were met, it contended that the taxpayers were not entitled to section 1244 ordinary loss treatment for the following reason:

(E)ven though Bates Investment Corporation may have technically met all the requirements enumerated in Section 1244 itself, it was not an operating company within the meaning of the legislative regulations promulgated by the Secretary of the Treasury Department and was therefore not a corporation which qualified as a small business corporation. District Court opinion, App. p. 145.

The "legislative regulation(s)" referred to is Treas.Reg. § 1.1244(c)-1. Specifically, the government contends that BIC was not "largely an operating company," a condition for ordinary loss treatment contained in § 1.1244(c)-1(g)(2) of the regulation. ² This portion of the regulation deals with the fifth requirement for qualifying "Section 1244 stock" set forth in § 1244(c) (1)(E) of the Code, Supra.

Section 1244(c)(1)(E) of the Code sets forth the general requirement that the corporation whose stock produces a loss to a taxpayer must have derived more than one-half of its aggregate gross receipts from sources "other than royalties, rents, dividends, interest, annuities and sales or exchanges of stock or securities . . . ." However, an exception to this requirement that at least 50 percent of gross receipts be from "non-passive" sources applies to a corporation whose allowable deductions exceed the amount of gross income. It is stipulated that BIC had no gross income and did have deductions. Thus, the taxpayers contend that the clear language of the statute brings BIC within the exception. The effect of the regulation is to deny § 1244 treatment to the stock of a loss corporation, otherwise within the exception, if the corporation is not "largely an operating company."

The statute contains no requirement that the loss be incurred with respect to stock of a corporation which is "largely an operating company." The taxpayers met each of the five requirements specified in the statute. They argue here, as in the district court, that the Commissioner of Internal Revenue as delegate of the Secretary of the Treasury had no authority to add a requirement which Congress did not include. The government responds that § 1244(e) of the Code empowered the Secretary to issue "legislative regulations," as opposed to merely interpretive regulations and that Treas.Reg. 1.1244(c)-1(g)(2) is a valid legislative regulation. Without conceding the validity of the regulation the taxpayers argue in the alternative that BIC was an operating company.

Section 1244 was added to the Internal Revenue Code as part of the Small Business Tax Revision Act of 1958. The provision for ordinary loss rather than capital gain treatment for investments in small business corporations which do not prove successful was "designed to increase the volume of outside funds which will be made available for the financing of small business." H.Rep.No. 2198, 85th Cong. 1st Sess. 1959-2 C.B., 709, 710; see J. Paul Smyers, 57 T.C. 189, 198 (1971). The same report contains this further statement with respect to eligibility for section 1244 treatment:

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 loss on the stock, must have derived more than half of its gross receipts from sources other than royalties, rents, dividends, interests, annuities, and the sale of stock or securities.

1959-2 C.B., p. 711.

The reference to sources other than royalties, rents, etc., tracks the language of § 1244(c)(1)(E) of the Code. Thus it appears that the House Ways and Means Committee equated the statutory limitation on sources of income to § 1244 corporations with a requirement that they be "largely operating companies."

This raises the question: may the Secretary by regulation make explicit that which the congressional sponsors of legislation have treated as implicit? It is clear that regulations may not be used to supply supposed omissions in a revenue act or to enlarge the scope of such a statute. Busey v. Deshler Hotel Co., 130 F.2d 187, 190 (6th Cir. 1942). Nor may a regulation be used to alter or amend a statute by prescribing requirements which are inconsistent with its language. Acker v. Commissioner of Internal Revenue,258 F.2d 568, 573 (6th Cir. 1958), Aff'd, 361 U.S. 87, 80 S.Ct. 144, 4 L.Ed.2d 127 (1959); 1 Mertens, Law of Federal Income Taxation (1974 Rev.) § 3.21, p. 46. However Congress often delegates to administrative officers, as in this case, the authority to issue regulations as necessary to carry out the purposes of a particular statute. 26 U.S.C. § 1244(e), Supra. Regulations issued pursuant to such a delegation will be sustained if "reasonably related to the purposes of the enabling legislation." Mourning v. Family Publications Service, Inc., 411 U.S. 356, 369, 93 S.Ct. 1652, 1661, 36 L.Ed.2d 318 (1972); Compton v. Tennessee Department of Public Welfare,532 F.2d 561, 564 (6th Cir. 1976). This court stated in Goldman v. Commissioner of Internal Revenue, 497 F.2d 382, 383 (6th Cir. 1974),

When, as here, Congress has expressly delegated authority to the Commissioner to promulgate regulations under a specific Code section, the resulting legislative regulations are accorded even greater weight than that normally accorded interpretative regulations.

(citation omitted).

In addition to the provision for regulations contained in § 1244(e), the Internal Revenue Code contains, in section 7805(a), a broad delegation to the Secretary to "prescribe all needful rules and regulations for the enforcement of this title (Title 26 of the United States Code) . . . ." The Supreme Court, noting the congressional delegation of authority in § 7805(a), states in United States v. Correll, 389 U.S. 299, 307, 88 S.Ct. 445, 450, 19 L.Ed.2d 537 (1967),

The rule of the judiciary in cases of this sort begins and ends with assuring that the Commissioner's regulations fall within his authority to implement the congressional mandate in some reasonable manner.

It is apparent that the Commissioner,...