Brook, Inc. v. C.I.R.
| Decision Date | 21 August 1986 |
| Docket Number | D,No. 1475,1475 |
| Citation | 799 F.2d 833 |
| Parties | -5628, 55 USLW 2134, 86-2 USTC P 9646 The BROOK, INC., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. ocket 86-4025. |
| Court | U.S. Court of Appeals — Second Circuit |
Kenneth L. Greene, Atty., Tax Div., Dept. of Justice, Washington, D.C. (Roger M. Olsen, Asst. Atty. Gen., Michael Paup, Robert S. Pomerance, Attys., Tax Div., Dept. of Justice, Washington, D.C., of counsel), for C.I.R.
Leonard J. Henzke, Jr., Washington, D.C. (Lehrfeld & Henzke, Washington, D.C., of counsel), for amicus curiae Nat. Club Ass'n.
Before MANSFIELD, NEWMAN and CARDAMONE, Circuit Judges.
The Brook, a tax-exempt social club, appeals the decision of the Tax Court, Jules G. Korner, III, Judge, upholding the Commissioner of Internal Revenue's finding that the club had made inadequate tax payments on the portion of its 1979 and 1980 earnings subject to income tax under 26 U.S.C. Sec. 511 (1982). 1 The club had avoided paying any income tax by using losses it suffered in providing meals to non-members to offset its investment income. The Tax Court concluded that 26 U.S.C. Sec. 512(a)(3)(A) 2 permitted the club to deduct from income only those expenses which were directly related to the generation of that income. Since The Brook's losses in providing meals to non-members were unrelated The facts are not in dispute. The Brook qualifies as a private social club under 26 U.S.C. Sec. 501(c)(7). Accordingly, it is subject to income tax only on its "unrelated business taxable income." 26 U.S.C. Sec. 511(a)(1). The phrase "unrelated business taxable income" as applied to social clubs is defined in 26 U.S.C. Sec. 512(a)(3)(A) as "the gross income (excluding any exempt function income) less the deductions allowed by this chapter [Chapter I] which are directly connected with the production of the gross income (excluding exempt function income) ...". Exempt function income is "the gross income from dues, fees, charges, or similar amounts paid by members of the organization as consideration for providing such members or their dependents or guests [with] goods, facilities, or services in furtherance of the purposes constituting the basis for the exemption of the organization to which such income is paid." 26 U.S.C. Sec. 512(a)(3)(B).
to the generation of the investment income, the court held they were nondeductible. We reject the Tax Court's interpretation of the Tax Code, but affirm the court's decision on a different ground. Under Sec. 512(a)(3)(A) a social club may take a deduction only if that deduction is allowed by some provision of Chapter 1 of the Code. Since the Brook's deduction of the losses it suffered in providing food to non-members is not authorized by any provision of Chapter 1, it was properly disallowed.
During the 1979 and 1980 tax years The Brook had two sources of non-member unrelated business taxable income: (i) investments and (ii) food and beverages sold to non-members at private dinner parties hosted by club members. In both years the club showed substantial investment income, but avoided paying any income tax on this taxable income by deducting from it losses incurred in the sale of meals to non-members. On its returns the Brook attributed the "direct" expenses of feeding the non-members (food, beverages, payroll, etc.) and a portion of the general overhead expenses of running the club to the activity of providing meals to non-members. The Commissioner concedes that the estimate of "direct expenses" was accurate and that the overhead costs were "properly attributable to and directly connected with the generation of nonmember income." Parties' Stipulation of Facts at 5. Once the expenses were allocated, however, it became evident that The Brook suffered substantial losses from serving meals to non-members. In fact, in both 1979 and 1980 its expenses, including the portion of general overhead allocated to the activity of providing food to non-members, were almost twice the income the non-members brought to the club. Furthermore, those years were no fluke. The Brook concedes that it incurred similar losses "for tax purposes from the sale of food and beverages to non-members" for every year between 1972 and 1983. Id.
The club lost money each year because it intentionally chose to charge non-members less for meals than it cost to provide them. Though members and non-members paid the same prices for meals, the club admits that the meal prices were "insufficient to recover the full costs [of serving those meals] including overhead." Id. at 2. The members indirectly made up part of the shortfall, at least as regards the meals they ate, through use of their non-taxable dues, which constituted "a substantial subsidy to the Club's food and beverage business." Plaintiff's Petition to Tax Court at 2. There was no similar, indirect way by which non-members paid the club the full cost of the meals the club provided. Accordingly the club concedes that it simply did not intend to make money from selling food and beverages to non-members. In its words, it "did not sell food and beverages to non-members with an intention that revenues from such sales would exceed all costs relating to such sales including overhead." Parties' Stipulation of Facts at 3.
In 1981 the Commissioner issued Rev.Rul. 81-69, 1981-1 Cum.Bull. 351, holding that when "[a] social club operates a food and beverage concession catering to non-members and has consistently sold the food and beverages at prices insufficient to recover the cost of sales[, t]he club may not The Brook petitioned the Tax Court for review of the Commissioner's decision. The Tax Court upheld the Commissioner, but on a theory the Commissioner had never advocated. The Court found that Sec. 512(a)(3)(A) required that there be a nexus between an expense and the income it was used to offset. Since there was no nexus between the food expenses and the investment income, the court disallowed the deduction. Both the Commissioner and The Brook sought reconsideration, arguing that the Court's reading of Sec. 512 conflicted with prior Tax Court decisions, the plain meaning of the statute and the Treasury Department's proposed regulations. The Tax Court, however, issued a Supplemental Decision on December 17, 1985 affirming its earlier holding.
in determining its unrelated business taxable income, reduce its net investment income by the losses from these sales to nonmembers." The Commissioner audited The Brook's 1979 and 1980 returns, and, relying on Rev.Rul. 81-69, concluded that, though the club had reported its "gross income" correctly, it owed $5,000 in back taxes. The Commissioner held that the club could only deduct expenses incurred in feeding non-members up to the amount of income the club received from that activity. The Commissioner rested his finding on the fact that, since the club had not intended to profit from the sales of food and beverages to non-members, the deductions were not allowable under 26 U.S.C. Sec. 162 3 as a trade or business expense. The Brook never suggested that the expenses were deductible under any other provision of the Code
The Brook appealed.
The determinative question on this appeal is how Sec. 512(a)(3)(A) should be interpreted. In construing a statute we usually adopt the plain and literal meaning of its language, United States v. Locke, 471 U.S. 84, 105 S.Ct. 1785, 1792, 85 L.Ed.2d 64 (1985); Consumer Product Safety Commission v. GTE Sylvania, Inc., 447 U.S. 102, 108, 100 S.Ct. 2051, 2056, 64 L.Ed.2d 766 (1980), unless it produces an interpretation which makes little sense, Chemical Mfrs. Ass'n v. Natural Res. Defense Council, 470 U.S. 116, 105 S.Ct. 1102, 1108, 84 L.Ed.2d 90 (1985); United States v. Turkette, 452 U.S. 576, 587, 101 S.Ct. 2524, 2530, 69 L.Ed.2d 246 (1981), does violence to the purposes Congress sought to serve by the statute, Chapman v. Houston Welfare Rights Organization, 441 U.S. 600, 608, 99 S.Ct. 1905, 1911, 60 L.Ed.2d 508 (1979), or is otherwise "demonstrably at odds with the intentions of [the statute's] drafters." Griffin v. Oceanic Contractors, Inc., 458 U.S. 564, 571, 102 S.Ct. 3245, 3250, 73 L.Ed.2d 973 (1982). See also Bread Political Action Committee v. F.E.R.C., 455 U.S. 577, 580, 102 S.Ct. 1235, 1237, 71 L.Ed.2d 432 (1982). 4
Section 512(a)(3)(A) defines a social club's "unrelated business taxable income" as "gross income (excluding any exempt function income) less the deductions allowed by this chapter which are directly connected with the production of the gross income." The Tax Court read the "directly connected" language to create a requirement that a deduction may only be offset against income it directly helped to generate. Since the expenses The Brook incurred in serving meals to non-members had nothing to do with generating its investment income, the Tax Court concluded that they could not be used to offset that income and should therefore be disallowed. Under this theory a social club's earnings from a specific activity in a given year would place a ceiling on the deductions that activity can generate in that year. Losses from one taxable activity could not be used to offset gains from another. We disagree with this interpretation of the statute.
In plain unambiguous language, Sec. 512(a)(3)(A) provides that allowable deductions should be taken against "gross income" and only requires that the deductions be related to the generation of that "gross income." (Emphasis added). The Code defines "gross income" as "all income from whatever source derived." 26 U.S.C. Sec. 61. The term refers to the sum total of the taxpayer's income "except [for that which is] specifically exempted." Commissioner v. Kowalski, 434 U.S. 77, 83, 98 S.Ct. 315, 319, 54 L.Ed.2d 252 (1978); Commissioner v. Glenshaw Glass Co., 348 U.S. 426,...
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