Crouch v. United States

• Decision Date: 12 January 1981
• Docket Number: Civ. A. No. 78-2317.
• Citation: 509 F. Supp. 727
• Parties: John D. CROUCH, Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — District of Kansas

509 F. Supp. 727

John D. CROUCH, Plaintiff, v. UNITED STATES of America, Defendant.

Civ. A. No. 78-2317.

United States District Court, D. Kansas.

January 12, 1981.

H. Thomas Payne and David K. Martin, Olathe, Kan., George E. Feldmiller and Charles W. German, Stinson, Mag & Fizzell, Kansas City, Mo., for plaintiff.

Robert Horwitz, Tax Division, U. S. Dept. of Justice, Washington, D. C., James P. Buchele, U. S. Atty., Kansas City, Kan., for defendant.

MEMORANDUM AND ORDER

O'CONNOR, District Judge.

This case comes before the court for ruling upon motions for summary judgment filed by plaintiff and by defendant. In this action plaintiff seeks refund of taxes plus interest and penalties in the amount of $26,378.95. As grounds for summary judgment, the United States argues (1) that plaintiff as sole shareholder of Seventeen Ventures, Inc., (Seventeen Ventures) was not entitled to deduct the corporation's net operating loss for 1970 because Seventeen Ventures' status as a Subchapter S corporation terminated by operation of law during that year; and (2) that plaintiff was not entitled to deduct interest he paid in 1970 on a loan to Seventeen Ventures. Countering defendant's motion, plaintiff seeks summary judgment for the following reasons: (1) plaintiff is entitled to deduct Seventeen Ventures' 1970 net operating loss on his individual income tax return since rental income received by Seventeen Ventures in 1970 was not "passive investment income" (a) because significant services were provided to tenants, and (b) because the corporation was actively engaged in business operations; and (2) plaintiff is entitled to deduct interest payments made on a loan to Seventeen Ventures (a) because plaintiff was directly and primarily liable for loan payments in 1970, and (b) because a Treasury Regulation allows the deduction. We will summarize the facts of this case before examining the grounds for summary judgment.

I. FACTS.

Plaintiff, a Kansas resident, is the sole shareholder of Seventeen Ventures, which owns an apartment complex in Sarasota, Florida, known as Boulevard East Apartments. Financing for purchase of the real estate and construction of the apartments was arranged with Guardian Mortgage Investors, with permanent mortgage financing through Metropolitan Life Insurance Co. (Metropolitan Life). Because these two institutions required the borrower to be incorporated, they supplied loan commitment letters to plaintiff in the following manner: a letter from Guardian Mortgage Investors addressed to "Corporation to be formed, c/o John D. Crouch," and a letter from Metropolitan Life addressed to a "Corporation to be named." On September 3, 1969, plaintiff had all stock of a dormant corporation, Seventeen Ventures, issued to him. Plaintiff also had The Fidelity State Bank of Kansas City, Kansas, issue for his personal account irrevocable letters of credit to secure the loan commitment fee and potential cost overruns on the construction project. Kansas Quality Construction, Inc., (Kansas Quality Construction) was hired to build the apartment complex. The following agreements were executed on September 5, 1969: financing agreement between Guardian Mortgage Investors and Seventeen Ventures, construction contract between Kansas Quality Construction and Seventeen Ventures, guarantee to make interest payments on construction loan by Kansas Quality Construction to Guardian Mortgage Investors indemnified by plaintiff, and contract for purchase and sale of real estate to Seventeen Ventures. On September 19, 1969, Seventeen Ventures filed an election for treatment as a small business corporation under Subchapter S of the Internal Revenue Code. Seventeen Ventures filed a tax return for the period ending December 31, 1969, as a Subchapter S corporation.

Near the end of the construction period, on April 1, 1970, an agency agreement was executed between Seventeen Ventures and Jodaco, a corporation in which plaintiff held 90% of the shares. Under this agreement Jodaco operated the apartment complex on a day-to-day basis and provided services to tenants.

Seventeen Ventures filed a regular corporation income tax return for the tax period ending December 31, 1970, instead of a Subchapter S return. On his individual income tax return for 1970, plaintiff deducted interest payments he made to Guardian Mortgage Investors during 1970, but did not deduct Seventeen Ventures net operating loss under Subchapter S. Plaintiff initially paid $9,921.00 in taxes for 1970. Seventeen Ventures, Jodaco, and plaintiff were audited for tax years 1969, 1970, and 1971. The government disallowed the interest deductions on plaintiff's individual return and assessed taxes and interest for 1970 in the amount of $16,995.95, which were paid by plaintiff. Thus, plaintiff paid a total of $26,378.95 individual income taxes during 1970. Subsequently, plaintiff filed a claim for refund of individual income taxes based upon (1) the net operating loss that Seventeen Ventures should have reported as a Subchapter S corporation, and (2) the interest plaintiff paid Guardian Mortgage Investors in 1970 on the loan to Seventeen Ventures. The government denied plaintiff's claim in its entirety.

II. STATUS OF SEVENTEEN VENTURES AS A SUBCHAPTER S CORPORATION.

Defendant argues that plaintiff should not be allowed to deduct the net operating loss of Seventeen Ventures because its status as a Subchapter S corporation terminated when Seventeen Ventures received more than 20% of its income from passive investment income through rental payments. Plaintiff counters in his motion for summary judgment that Seventeen Ventures' status as a Subchapter S corporation did not terminate for two reasons. First, because Seventeen Ventures provided significant services, under Treasury Regulation § 1.1372-4(b)(5)(vi), 26 C.F.R. § 1.1372.4(b)(5)(vi), rental income received by Seventeen Ventures was not passive investment income. Second, because Seventeen Ventures was a corporation actively engaged in business operations, its rental income in 1970 was not passive investment income. In opposition to plaintiff's motion, defendant argues: (1) that plaintiff should be barred from raising the claim of "significant services" because it was not presented in the Claim for Refund; (2) that rental income received by Seventeen Ventures was not excludable from "passive investment income" because Seventeen Ventures did not render significant services to its tenants; and (3) that the fact Seventeen Ventures is actively engaged in the rental business does not take its rental income outside the definition of "passive investment income."

Before filing a suit for refund, a taxpayer must file a claim for relief. 26 U.S.C. § 7422. In the suit for refund, taxpayer can only recover on grounds stated in the refund claim. Real Estate-Land Title & Trust Co. v. United States, 309 U.S. 13, 17-18, 60 S.Ct. 371, 373, 84 L.Ed. 542 (1940); United States v. Felt & Tarrant Mfg. Co., 283 U.S. 269, 272, 51 S.Ct. 376, 377, 75 L.Ed. 1025 (1931); Herrington v. United States, 416 F.2d 1029, 1032 (10th Cir. 1969). The controlling Treasury Regulation states that "the claim must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof." Treasury Regulation § 301.6402-2(b), 26 C.F.R. § 301.6402-2(b).

Defendant states plaintiff's refund claim did not allege that Seventeen Ventures provided "significant services" which would exclude its rent from "passive investment income" within the meaning of 26 U.S.C. § 1372(e)(5). In his claim for refund plaintiff stated as follows:

During 1970 Seventeen Ventures, Inc. received $66,269 of gross rents and $3,356 of other income all of which was entirely related to the apartment operation of such corporation. The Internal Revenue Service erroneously refused to allow the taxpayer to deduct the loss sustained in 1970 by Seventeen Ventures, Inc. solely because of the contention that such income represented "passive investment income" as defined in section 1372(e)(5), I.R.C., and resulted in the termination of the election of Seventeen Ventures, Inc. to be taxed as a United States Small Business Corporation. Such determination is erroneous since the rental of real estate has long been recognized as the conduct of a business and not "passive investment income." See Anders I. Lagreide, 23 T.C. 508, and decisions cited therein.

To allow the Commissioner to fully consider and properly decide and narrow a taxpayer's claims, the taxpayer cannot use one ground in his refund claim and an entirely different ground in a later suit. Danly Machine Corp. v. United States, 356 F.Supp. 1284, 1287 (E.D.Ill.1972), aff'd 492 F.2d 30 (7th Cir. 1974). Section 7422 of the Internal Revenue Code implies that "the grounds relied on in a suit for refund must be reasonably encompassed by those set out in the claim for refund." Herrington v. United States, 416 F.2d at 1032 (footnote omitted). Although plaintiff in his refund claim did not specifically argue that Seventeen Ventures provided "significant services" that would exclude its rental income from consideration as "passive investment income" and prevent its status as a Subchapter S corporation from terminating, we believe these grounds were "reasonably encompassed" in the claim for refund. Since both parties have fully addressed the issue, we do not believe it would be improper to consider the claim at this time. Adams v. United States, 401 F.Supp. 1142, 1151 (D.Kan.1975). Thus, we reject defendant's argument that we do not have jurisdiction to consider this claim in plaintiff's motion for summary judgment.

Plaintiff argues that Seventeen Ventures rendered significant services to its tenants that would qualify to exclude its rental income pursuant to Treasury Regulation § 1.1372-4(b)(5), 26 C.F.R. § 1.1372-4(b)(5), from "passive investment income" as defined in 26 U.S.C. § 1372(e)...