Davison v. Comm'r of Internal Revenue, 15887–94.

• Court: United States Tax Court
• Citation: 107 T.C. No. 4,107 T.C. 35
• Docket Number: No. 15887–94.,15887–94.
• Parties: Charles H. DAVISON and Lessie B. Davison, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Decision Date: 26 August 1996

107 T.C. 35
107 T.C. No. 4

Charles H. DAVISON and Lessie B. Davison, Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 15887–94.

United States Tax Court.

Aug. 26, 1996.

[107 T.C. 36]

John S. Brown, George P. Mair, William A. Hazel, Matthew D. Schnall, Donald–Bruce Abrams, and Joseph L. Kociubes, Boston, MA, for petitioners.

Charles W. Maurer, Jr., Brookline, MA, for respondent.

[107 T.C. 35]

W, a cash basis partnership, entered into an agreement in 1980 to borrow up to $29 million from J. J made an initial disbursement of $19,645,000. Pursuant to the loan agreement, J applied $227,647.22 of the initial disbursement as a credit for interest W owed to J on a previous loan. Pursuant to a subsequent modification of the 1980 loan agreement, J agreed to advance $1,587,310.46 to W to enable W to satisfy its current interest obligation to J. J made a wire transfer of $1,587,310.46 to W's bank account on Dec. 30, 1980. On Dec. 31, 1980, W made a wire transfer to J to satisfy W's current interest obligation. The net effect of the Dec. 30–31 transaction was to increase the principal amount of W's loan from J by $1,587,310.46. W claimed interest deductions of $227,647.22 and $1,587,310.46 and reported an ordinary loss on its partnership return for 1980.

R disallowed W's interest deductions, determining that the interest had not been “paid” but merely postponed. R adjusted Ps' distributive share of W's ordinary loss accordingly.

Held: W is not entitled to interest deductions under sec. 163(a), I.R.C. A cash basis borrower is not entitled to an interest deduction where the funds used to satisfy the interest obligation were borrowed for that purpose from the same lender to whom the interest obligation was owed. In those circumstances, there has been no “payment” of interest; rather, “payment” has merely been postponed.

OPINION RUWE, Judge:

Respondent determined deficiencies of $753 and $402,169 in petitioners' 1977 and 1980 Federal income taxes, respectively. After a concession by respondent, the issue for decision is whether White Tail, a general partnership, “paid” interest when it borrowed the funds used to satisfy its interest obligations from the same lender to whom the interest was owed. Petitioner Charles H. Davison was a partner in White Tail, and petitioners claimed their distributive share of the ordinary loss reported by White Tail on their 1980 Federal income tax return.

Background

This case was submitted fully stipulated. The stipulation of facts and the first supplemental stipulation of facts are incorporated herein by this reference. Petitioners resided in Greenwich, Connecticut, at the time they filed their petition. Petitioners were calendar year, cash basis taxpayers.

Petitioner Charles H. Davison is a certified public accountant. During 1979, he was head partner of the accounting firm Peat, Marwick & Mitchell, where he was associated with Samuel J. Esposito and John L. Vitale, who were also partners.

On February 1, 1979, Messrs. Davison, Esposito, and Vitale formed White Tail, a general partnership organized under Illinois law, for the purpose of entering into the agricultural business of acquiring, cultivating, and selling farm properties. Each of the partners had a one-third interest in the profits, losses, and distributions of White Tail. White Tail reported its income on a calendar year basis using the cash method of accounting.

On or about March 16, 1979, White Tail acquired approximately 11,000 acres of real property located in Hyde County, North Carolina, and certain related personal property. On or about May 2, 1980, White Tail acquired approximately 7,747

[107 T.C. 37]

acres of real property located in Hyde and Tyrrell Counties in North Carolina.

In 1979, White Tail realized $248,198 in gross revenues from farming operations and incurred $868,684 in operating expenses, exclusive of interest expense. In 1980, White Tail realized $2,098,717 in gross revenues from farming operations and incurred $2,784,169 in operating expenses, exclusive of interest expense.

White Tail's Credit Arrangements With John Hancock

On December 21, 1978, the John Hancock Mutual Life Insurance Co. (John Hancock) issued to Messrs. Davison, Esposito, and Vitale a commitment to make a first mortgage loan on the White Tail property in an amount up to $9 million. ¹ By a promissory note dated March 16, 1979, White Tail and John Hancock established the credit arrangement contemplated by this $9 million mortgage loan commitment.² Subsequently, on January 28, 1980, John Hancock issued to White Tail a First Mortgage Loan Commitment pursuant to which John Hancock agreed to advance White Tail a maximum amount of $29 million. The First Mortgage Loan Commitment required that White Tail use a portion of the funds borrowed to retire existing indebtedness to John Hancock,³ and envisioned that additional amounts would be advanced to White Tail up to the aggregate principal amount of $29 million.

By a promissory note dated May 2, 1980, White Tail and John Hancock established the 1980 John Hancock credit arrangement (the 1980 credit arrangement), as contemplated by the First Mortgage Loan Commitment.⁴ This promissory

[107 T.C. 38]

note required White Tail to pay interest on its borrowings at an annual rate of 12.25 percent, payable every January 1 commencing January 1, 1981. The promissory note also entitled John Hancock to 20 percent of White Tail's net farm income, as well as 20 percent of White Tail's net profits from land sales.

Pursuant to the establishment of the 1980 credit arrangement, John Hancock made initial disbursements on May 7, 1980, totaling $19,645,000. A portion of the $19,645,000 consisted of a credit to White Tail's prior loan account with John Hancock for $6,480,000 to pay off the principal that White Tail owed pursuant to the prior credit arrangement, and a credit to White Tail's prior loan account for $227,647.22 to satisfy the interest obligation that had accrued on the prior loan.

The 1980 credit arrangement required White Tail to make an interest payment on January 1, 1981. The amount of interest due was $1,587,310.46. Pursuant to the terms of the 1980 credit arrangement, one-half of the interest could be borrowed from John Hancock. The 1980 credit arrangement also called for a principal payment of $7,707.50 on the same date.

White Tail needed to satisfy the requirements set forth in the First Mortgage Loan Commitment in order to become eligible to make additional borrowings under the 1980 credit arrangement. These additional borrowings were characterized as “Land Development” and “Operating Funds” borrowings. Under the terms of the First Mortgage Loan Commitment, the 1980 disbursement for “Operating Funds” was subject to the following provision:

If the Borrower's Net Farm Income is insufficient to fund the interest accrued on the loan contemplated herein from date of closing to December 31, 1980, John Hancock shall disburse sufficient proceeds of this loan to fund said interest shortage; provided, however, that the amount of said Disbursement for Operating Funds shall not exceed 50% of the actual accrued interest during said period, and provided further that John Hancock's said Disbursement for such interest shortage shall not be disbursed until Borrower has advanced its portion of the actual accrued interest.

[107 T.C. 39]

Similar provisions covered the disbursement of operating funds for 1981–83. The 1980 credit arrangement remained in effect from May 2, 1980, through June 1983.

White Tail's business was unprofitable,⁵ and, in December 1980, Mr. Esposito requested that John Hancock modify the terms of the 1980 credit arrangement in order to prevent a default. On December 24, 1980, John Hancock mailed a Letter of Agreement (Letter Agreement) to White Tail c/o Mr. Esposito. The Letter Agreement states:

Gentlemen:

Reference is made to the enclosed Vote # 3, Page Three approved December 23, 1980 by our Agricultural Investment Committee, and approved today by our Committee of Finance, in which vote we have authorized the Modification of the legal papers evidencing and securing the above referenced loan.

Said Modification will capitalize certain interest due from you on January 1, 1981 and will defer certain principal due from you on the same date, all as set forth in said vote. Said Modification will further increase John Hancock's participation in the property's defined Operating Income and in the Security's Appreciation, also all as set forth in said enclosed Vote.

* * *

You have asked us to enter into this Letter of Agreement with you this week, in advance of our referrel [sic] to counsel and his preparation of the definitive documentation, in order to prevent a default in your payment due January 1, 1981.

If this Letter of Agreement is to become effective, you must sign the enclosed copy hereof and return the same to me at the Home Office, so that the same is received by me prior to December 31, 1980.

Attached to the Letter Agreement were the minutes from a December 23, 1980, meeting of John Hancock's Agricultural Investment Committee stating that the committee voted to accept the following modification of the 1980 credit arrangement:

To capitalize $793,655.23 of the $1,587,310.46 interest due January 1, 1981 and to defer the $7,707.50 principal installment due January 1, 1981 until January 1, 2001, the final maturity under FML [Farm Mortgage Loan] # 161177, White Tail Farm, 19,344 acres secured by a First Mortgage loan in North Carolina and Illinois in consideration of White Tail Farm providing John Hancock Participation as follows:

Between July 1, 1981 and January 1, 1991[,] 22% of Net Farm Income and 22% of the Net Profit From Land Sales[;]

[107 T.C. 40]

and

Between January 2, 1991 and January 1, 2001[,] 25% of Net Farm Income and 25f the Net Profit From Land Sales over Value Assigned To Land;

rather than 20% of Net Farm Income and 20% of the Net Profit From Land [Sales] as originally...