Cruttenden v. C. I. R.

• Decision Date: 15 May 1981
• Docket Number: No. 79-7066,79-7066
• Citation: 644 F.2d 1368
• Parties: 81-1 USTC P 9440 Walter W. CRUTTENDEN and Fay T. Cruttenden, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 1368

644 F.2d 1368

81-1 USTC P 9440

Walter W. CRUTTENDEN and Fay T. Cruttenden, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.

No. 79-7066.

United States Court of Appeals Ninth Circuit.

Argued and Submitted Nov. 7, 1980.

Decided May 15, 1981.

R. Russell Mather, Washington, D.C., argued for respondent-appellant; Gilbert E. Andrews, Chief, Washington, D.C., on brief.

Lewis M. Porter, Jr., Boodell, Sears, Sugrue, Giambalvo & Crowley, Chicago, Ill., for petitioners-appellees.

Appeal from a decision of the United States Tax Court.

Before NELSON and CANBY, Circuit Judges, and LARSON, ^* District Judge.

NELSON, Circuit Judge:

In this appeal we confront the ambivalent tax characteristics of a practice in the stock brokerage industry: the borrowing of securities by a brokerage firm under a subordination agreement that allows the firm to use the securities to meet its net capital requirements under stock exchange rules. While it is clear that legal title to the securities does not pass from the lender to the brokerage firm by terms of the agreement under review, we must determine whether the agreement so impairs the lender's title as to bring the lender's expenses in terminating the agreement within the scope of the rules that costs of defending or perfecting title to property, or recovering property, must be capitalized rather than deducted from ordinary income.

Taxpayer, ¹ the lender under a subordination agreement of this type, deducted legal expenses incurred in terminating that agreement and obtaining the return of loaned securities. The Commissioner disallowed the deduction and determined a deficiency in taxpayer's 1971 income tax payment. On taxpayer's petition for review, the Tax Court ruled that the disputed expenses were deductible, under section 212(2) of the Internal Revenue Code, as ordinary and necessary expenses for the management, conservation, or maintenance of property held for the production of income. ² The Commissioner has appealed, arguing that the disputed expenses are capital and cannot be deducted from current income. For the reasons given below, we affirm the decision of the Tax Court, although we do not adopt the whole of its analysis.

FACTS

The facts in this case, including those relevant to several issues not before us in this appeal, have been reported in detail in the Tax Court's published decision. We shall confine ourselves to a discussion of the circumstances under which the subordination agreements at issue here were created and terminated.

The taxpayer owned a minority interest in a closely held stock brokerage firm ultimately known as Command Securities, Inc. ("Command"), operated and primarily owned by her two sons. In 1964, to aid the firm in meeting the net capital requirements of the stock exchange to which it belonged, taxpayer executed a subordinated loan agreement under which a quantity of her securities were placed at the disposal of the firm. Taxpayer lent additional securities in 1969 under similar subordination terms in connection with an expansion of the brokerage firm. The subordination agreements allowed the borrowing firm to use the securities in its business and to pledge them as collateral to secure loans. The taxpayer's claim to return of the securities was expressly subordinated to the claims of all present and future creditors of Command.

In late 1969 and early 1970, a deal was concluded whereby an outside investor, Systems Capital Corp. ("Systems"), would acquire the outstanding shares of Command in a stock-for-stock exchange. Under a contemporaneous agreement, Systems obligated itself to return to taxpayer the various subordinated securities within six months of the date the Command acquisition was approved by the stock exchange. The agreements were signed on January 30, 1970, and exchange approval came on April 15, 1970, so that the subordinated securities were due to be returned by October 15, 1970.

Systems failed to return the securities when due, and sought an extension of the due date. After a series of negotiations, the parties hammered out a new agreement in February, 1971, under which one group of securities would be returned no later than March 10, 1971, with the remainder due no later than June 30, 1971. The new agreement, which was coupled with a new subordination agreement, contained terms which, according to taxpayer's counsel, would form the basis for a successful summary judgment should Systems again fail to perform. Systems did not fail, however, and taxpayer received her securities in 1971 as agreed.

In obtaining the return of these securities, taxpayer incurred $16,095.13 in fees from the law firm that represented her both in the initial agreement to return the securities and in the subsequent negotiations and new agreement to return them. The deductibility of that amount on taxpayer's 1971 tax return is the subject of this appeal.

DISCUSSION

Section 212(2) of the Internal Revenue Code provides that an individual may deduct "all the ordinary and necessary expenses paid or incurred during the taxable year ... for the management, conservation, or maintenance of property held for the production of income." ³ Section 263(a) of the Code prohibits deduction of capital expenditures. ⁴ These two statutory provisions form the framework of our inquiry.

The Commissioner challenges the Tax Court's determination that the disputed expenses are deductible on two grounds: first, that the expenses must be capitalized because they relate to defense or perfection of title to property; and second, that they must be capitalized because, under the applicable regulation, they relate to "recovery" of property. The two points are related but we shall address them individually. ⁵

I. DEFENSE OR PERFECTION OF TITLE

It is axiomatic in tax law that expenses incurred in the defense or perfection of title to property cannot be deducted from ordinary income as current expenses but can be recovered only as capital costs. Kasey v. Commissioner, 457 F.2d 369, 370 (9th Cir.), cert. denied, 409 U.S. 869, 93 S.Ct. 197, 34 L.Ed.2d 120 (1972); Spangler v. Commissioner, 323 F.2d 913 (9th Cir. 1963); Boagni v. Commissioner, 59 T.C. 708 (1973); Treas. Reg. § 1.263(a)-2 (1958). Those expenses are normally added to the property's basis and are recovered, if ever, either by depreciation deductions or, in the case of non-depreciable property, by a corresponding reduction in realized gain on sale or disposition of the property. I.R.C. §§ 167, 1001, 1011, 1012, 1016.

The Commissioner asks us, as he did the Tax Court, to apply this rule to the taxpayer's expenditures to obtain the return of the loaned securities. Despite some contrary intimations by the Commissioner, there is no real argument in this case that title to the subordinated securities was actually at issue in the return transaction. The Commissioner urges, however, that the various provisions of the subordination agreement so impaired taxpayer's rights in the securities as to be treated as "clouds" on title. When the securities were returned to taxpayer they were no longer encumbered by the "clouds." Expenses to obtain their return thus served to remove the "clouds" and, following the same reasoning that requires capitalization of the expenses of perfecting title, ought to be capitalized.

The relevant features of the 1964 and 1969 subordination agreements are as follows. The agreement provided that Command could use the securities in its business and hypothecate them to secure loans from banks or other lenders. Command was empowered to use the borrowed securities or the proceeds of any sale or pledge thereof as part of its capital, subject to the risks of the business. Taxpayer could withdraw any of the securities upon substituting cash or other securities of comparable quality and value. Upon termination of the loan, any cash or securities belonging to taxpayer would be returned to her, and if the exact securities were not available Command agreed to deliver to taxpayer securities which were acceptable to her and of comparable quality and value. The agreement further provided that the right to demand or receive payment or return of the borrowed securities, whether in the form of securities or cash, was expressly subordinated to the claims of all present and future general creditors of Command. The agreement did not provide for any interest payment in consideration for the use of the securities by Command; however, all dividends from the borrowed securities were transferred to taxpayer by Command. In addition, taxpayer apparently retained the right to vote the shares of stock that were loaned to Command.

The Commissioner argues that under this agreement, "taxpayer virtually ceded all her title and interest in the securities to Command." Pointing to the various provisions, the Commissioner asserts that "there is absolutely no room to dispute that Command and Command's creditors had claims to title that, at the very least, 'clouded' taxpayer's ownership interests.... As long as those shares remained in Command's possession, taxpayer had merely an income and remainder interest in them and both those interests were subject to so many conditions as to render them almost expectancies until they vested in possession.... Not until she regained possession and then only if the (return of securities) satisfied all conditions set forth in the subordinated loan agreements could taxpayer begin to assert that the securities were really 'hers.' " Reasoning, therefore, that "the legal expenses in this case arose from the taxpayer's attempt to remove the substantial cloud the subordinated loan agreements she executed left hanging over unfettered title to the investment properties," the Commissioner urges that they be treated as capital expenses to clear title.

The Tax Court, viewing the same subordination agreements (but without benefit of the Commissioner's "cloud-on-title" argum...