Continental Equities, Inc. v. C. I. R.

• Decision Date: 25 April 1977
• Docket Number: No. 75-1562,75-1562
• Citation: 551 F.2d 74
• Parties: 77-1 USTC P 9375 CONTINENTAL EQUITIES, INC., Petitioner-Appellee Cross-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant Cross-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 74

551 F.2d 74

77-1 USTC P 9375

CONTINENTAL EQUITIES, INC., Petitioner-Appellee Cross-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant Cross-Appellee.

No. 75-1562.

United States Court of Appeals Fifth Circuit.

April 25, 1977.

Scott P. Crampton, Asst. Atty. Gen., Gilbert E. Andrews, Acting Chief, Appellate Section, Dept. of Justice, Tax Div., Meade Whitaker, Chief Counsel, I. R. S., Jonathan S. Cohen, David E. Carmack, Leonard J. Henzke, Jr., Attys., Tax Div., Dept. of Justice, Washington, D. C., for Commissioner of Internal Revenue.

Robert A. Shupack, North Miami Beach, Fla., Eugene Short, Jr., Coral Gables, Fla., for Continental Equities, Inc.

Appeals from the Decision of the Tax Court of the United States (Florida Case).

Before JONES, COLEMAN and CLARK, Circuit Judges.

CLARK, Circuit Judge:

This appeal and cross-appeal are taken from a decision of the United States Tax Court. The Commissioner of Internal Revenue (Commissioner) challenges a ruling invalidating the assessment of an income tax deficiency against Continental Equities, Inc. (Continental). The Commissioner contends that two net operating loss deductions taken by Continental should have been disallowed. Continental cross-appeals, urging that the Tax Court erred in upholding the Commissioner's decision to allocate to Continental interest income resulting from loans it made to four related corporations. In the alternative, Continental argues that if the allocation was proper, then the Tax Court should have directed the Commissioner to award refunds to the related corporations, or allowed it to assert the equitable defense of recoupment. We affirm the approval of the allocation of income and the refusal of the request for refunds and for equitable relief, but in light of the Supreme Court's intervening decision in United States v. Foster Lumber Co., 429 U.S. 32, 97 S.Ct. 204, 50 L.Ed.2d 199 (1976), we reverse its determination that the net operating loss deductions were allowable.

I. THE APPEAL

Section 172 of the Internal Revenue Code of 1954, 26 U.S.C.A. § 172 (1967 & 1976 Supp.), ¹ authorizes a taxpayer who sustains a net operating loss in a taxable year to carry that loss as a deduction to the preceding three and the succeeding five taxable years as an offset to taxable income realized in those years. It requires that the entire amount of the loss be carried to the earliest possible taxable year, and permits any portion of the loss not absorbed by taxable income in that taxable year to be carried forward to subsequent taxable years. It further provides that

(t)he portion of such loss which shall be carried to each of the other taxable years shall be the excess, if any, of the amount of such loss over the sum of the taxable income for each of the prior taxable years to which such loss may be carried. ²

The parties have stipulated the facts to which we must apply this provision.

Continental experienced net operating losses of $67,511.31 and.$29,403.47 in its 1964 and 1965 taxable years. ³ These losses, totalling $96,914.78, were available for carryover to 1966. In 1966 Continental realized $269,298.04 of net long-term capital gains, but when its gross ordinary income was reduced by all available deductions other than net operating losses, its ordinary income was negative. The deficit amounted to $12,126.27. Thus Continental's net operating losses were greater than its ordinary income but less than the sum of its ordinary income and its capital gains. Continental initially computed its income tax liability for 1966 under both the "regular method" specified by Section 11 and the "alternative method" specified by Section 1201. ⁴ Because the tax resulting from the use of the "regular method" exceeded that resulting from the use of the "alternative method," Continental was required to employ the latter. 26 U.S.C.A. § 1201 (1976 Supp.). Since Section 1201(a) (2) does not allow a taxpayer to deduct its net operating losses from its capital gains, United States v. Foster Lumber Co., 429 U.S. at 37, 97 S.Ct. at 208, 50 L.Ed.2d at 205 (1976); Chartier Real Estate Co. v. Commissioner of Internal Revenue, 52 T.C. 346 (1969), aff'd per curiam, 428 F.2d 474 (1st Cir. 1970), Continental could not utilize the net operating losses it had accumulated during 1964 and 1965 to reduce its income tax liability for 1966. Believing that it was entitled to carry forward from its 1966 taxable year to subsequent taxable years the entire amount of those losses because it had not yet used them to reduce its actual tax liability, Continental took net operating loss deductions of $78,635.48 and $18,279.30 in its 1967 and 1969 taxable years, respectively. After auditing Continental's tax returns for 1967 and 1969, the Commissioner disallowed the deductions and issued a deficiency notice for both taxable years. When Continental challenged the deficiency assessment in the Tax Court, the issue was resolved in its favor. Continental Equities, Inc. v. Commissioner of Internal Revenue, 33 T.C.M. 812 (1974).

The Tax Court based its ruling that the net operating loss deductions were allowable solely upon the authority of its prior decision in Chartier Real Estate Co. v. Commissioner of Internal Revenue, supra. In Chartier it had held that where net operating losses exceed ordinary income net of all other deductions, but are less than the sum of ordinary income and capital gains, the amount by which the losses exceed ordinary income is available for carryover to subsequent taxable years. The foundation of Chartier is the Tax Court's creation of a special definition of "taxable income" designed solely for use in connection with Section 172(b)(2). According to Chartier, Section 172(b)(2) "taxable income" is "that taxable income to which the (net operating) loss is actually applied in computing actual tax liability." 52 T.C. at 358. Since net operating losses cannot be used to offset capital gains where the "alternative method" of computing income tax liability is employed, the Chartier interpretation excludes capital gains from "taxable income" for the purposes of Section 172(b)(2). This is at variance with the Section 63(a) general definition of "taxable income" "gross income, minus the deductions allowed by this chapter" because under Section 61 "gross income" includes capital gains, United States v. Foster Lumber Co., 429 U.S. at 36, 97 S.Ct. at 207, 50 L.Ed.2d at 203-204, and because Section 63(a) also provides that the meaning of the term "taxable income" shall be uniform throughout the Income Tax Subtitle (Sections 1 through 1564) of the Code.

In United States v. Foster Lumber Co., supra, the Supreme Court examined the interplay between Sections 63, 172, and 1201, and weighed the policy considerations supporting the Tax Court's construction of Section 172. It rejected the Chartier rule and concluded that Congress intended that the term "taxable income" as used in Section 172 include capital gains, just as it does everywhere else in the Code where no explicit modification of the Section 63(a) general definition exists. 429 U.S. 41, 97 S.Ct. at 210, 50 L.Ed.2d at 207. That decision controls the disposition of this case.

Since the amount of Continental's operating losses available for carryover to 1966 did not exceed its taxable income for that year, Continental was not entitled to carry any of those losses to subsequent taxable years. Therefore, the net operating loss deductions which it took in 1967 and 1969 must be disallowed. The decision of the Tax Court on this issue is reversed.

II. THE CROSS-APPEAL

Pursuant to his authority under Section 482 of the Internal Revenue Code of 1954, 26 U.S.C.A. § 482 (1967), ⁵ The Commissioner determined that Continental had realized unreported interest income from loans it made to four related corporations during its 1968, 1969, and 1970 taxable years. The amounts and sources of this income were as follows:

Continental's unqualified stipulation to these facts was filed with the Tax Court on April 9, 1974. One month later the Commissioner notified Continental that the interest expense correlative to the imputed interest income was deemed to have been allocated among the four related corporations as of March 18, 1974. When the Commissioner submitted his Rule 155 computation ⁶ of Continental's income tax liability based on the stipulation, Continental objected because it believed that the related corporations had not yet received refunds reflecting their shares of the income expense attributed to them. Continental argued that the statute and the applicable regulations required that such refunds be made before the interest income could be allocated to it. Assuming that they had not been made, Continental contended that the allocation was invalid. It also asserted that, in the event the allocation was sustained, Section 482 and the equitable doctrine of recoupment furnished independent grounds for compelling the Commissioner either to pay refunds to the related corporations, or to allow Continental to offset their overpayments against its current deficiency.

On December 18, 1974, the Tax Court held a hearing on Continental's objection. The transcript of the hearing indicates that all of the participants believed that the four related corporations had filed timely refund claims, and that these claims were being processed by the Internal Revenue Service in the usual manner. They were mistaken. Only two of the related corporations ever filed refund claims for their 1968-1970 taxable years. One of them, Sunshine State Industrial Park, Inc., had already received a refund for its 1970 taxable year on September 25, 1972. The only other claimant, Catamal Realty, Inc., did not request a refund until April 2, 1975. Its claim was denied on July 10, 1975, on the grounds that it was untimely. At the conclusion of the hearing, the Tax Court adopted the Commissioner's Rule 155 computation. It ruled that all of the...