Estate of Yaeger v. C.I.R.

• Decision Date: 07 November 1989
• Docket Number: D,180,Nos. 60,s. 60
• Citation: 889 F.2d 29
• Parties: -5801, 89-2 USTC P 9633 ESTATE OF Louis YAEGER, Deceased, Judith Winters, Ralph Meisels, Abraham K. Weber, and The Bank of New York, Executors, Petitioners-Appellants, Cross-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee, Cross-Appellant. ockets 89-4045, 89-4059.
• Court: U.S. Court of Appeals — Second Circuit

Page 29

889 F.2d 29

64 A.F.T.R.2d 89-5801, 89-2 USTC P 9633

ESTATE OF Louis YAEGER, Deceased, Judith Winters, Ralph

Meisels, Abraham K. Weber, and The Bank of New

York, Executors, Petitioners-Appellants, Cross-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee,

Cross-Appellant.

Nos. 60, 180, Dockets 89-4045, 89-4059.

United States Court of Appeals, Second Circuit.

Argued Aug. 28, 1989.

Decided Nov. 7, 1989.

Roberts & Holland, New York City (Richard A. Levine, of counsel), for petitioners-appellants, cross-appellees.

Shirley D. Peterson, Asst. Atty. Gen., Gary R. Allen, Richard Farber, Mary Frances Clark, Tax Div., U.S. Dept. of Justice, Washington, D.C., for respondent-appellee, cross-appellant.

Before FEINBERG and NEWMAN, Circuit Judges, and MISHLER, Senior District Judge. ^*

MISHLER, Senior District Judge:

Petitioner appeals from a decision and order of the tax court, unofficially reported at 55 T.C.M. (CCH) 1101 (1988) (Wright, J.), that found that Louis Yaeger, deceased, was not in the trade or business of trading in securities and, therefore, that the interest he incurred in buying securities on margin was "investment interest" within the meaning of 26 U.S.C. section 163(d) and ordered that there is a deficiency due from the taxpayer for taxable years 1979 and 1980. ¹ Respondent cross-appeals an unreported order of the tax court that granted the estate's motion to dismiss its petition for lack of jurisdiction as to the 1981 taxable year because the notice of deficiency set forth an incorrect taxable year. ²

We affirm the tax court's order that there is a deficiency due from the taxpayer for taxable years 1979 and 1980. We reverse the order that dismissed so much of the petition that referred to tax year ending December 31, 1981 for lack of jurisdiction and remand for a trial on the issue of Yaeger's tax liability for the portion of the 1981 tax year ending May 11, 1981.

I. TRADE OR BUSINESS OF TRADING IN SECURITIES

A. Background

The facts as stipulated and found by the tax court are not in dispute. ³ Yaeger graduated Phi Beta Kappa from Columbia University in 1921 having studied business and finance. Upon graduation he went to work as an accountant and subsequently became employed as an auditing agent for the Internal Revenue Service. He left this employ in 1923 and went to work as a bond salesman in New York City, eventually becoming an investment counselor.

Commencing in the mid-1920s, Yaeger began actively trading stocks and bonds on the stock market on his own account in addition to conducting his investment consulting business. In the 1940s, Yaeger gave up his investment consulting business because the management of his own account had grown so demanding. Thereafter, he devoted himself exclusively to trading on his own account, which was his sole occupation until the day he died.

Prior to 1979, Yaeger maintained accounts with several brokerage firms in New York, including H. Hentz & Co. His account at H. Hentz & Co. was the largest account that firm had maintained for a United States citizen. During the period between 1979 and his death, Yaeger maintained The following chart describes the trading activity in Yaeger's various accounts throughout the years in issue:

accounts with three brokerage firms and occasionally dealt with two others.

                Year      Purchase          Sales       Number Shares Bought    Number Shares
                        Transactions     Transactions                               Sold
                1979       1,176              86             1,453,555             822,955
                1980       1,088              39             1,658,841             173,165
                

Yaeger maintained an office at H. Hentz & Co. from which he conducted most of his trading activity. For a brief period of time he also conducted his activity from another brokerage firm. H. Hentz & Co. provided Yaeger with an assistant, a telephone, use of the secretarial pool, and access to the research staff and facilities. Yaeger spent a full day at his office, researching investment opportunities and placing orders, and then returned home to read more financial reports late into the night. He worked every day of the week. When he was out of town, he maintained telephone contact with the brokers who handled his accounts. Yaeger was trading on the stock market the day before he died.

Yaeger subscribed to a distinct investment strategy. His trading strategy was to buy the stock of companies in which the stock prices were extremely undervalued and hold the stock until it reached a price that reflected the underlying value of the company. He rarely purchased "blue chip" stocks and many of the stocks he held did not pay dividends. Instead, Yaeger constantly looked for companies that were experiencing financial distress but whose underlying value was not recognized.

This strategy required thorough research that extended beyond the study of mainstream publications. He also poured over annual reports and brokerage house reports. Once Yaeger determined that the targeted company was experiencing temporary difficulties, he began to accumulate the stock. He would buy stock as it became available, although some of the stock was not frequently or actively traded and was difficult to acquire. He would initially buy small quantities of stock to avoid attracting attention from other investors. Once he obtained a sizeable amount of stock he would let his position be known. Yaeger took whatever steps he thought necessary to improve the position of the companies in which he invested, often supplying unsolicited business advice to the managers and occasionally attempting to arrange mergers or acquisitions. ⁴

In addition to selecting financially troubled companies in which to invest, Yaeger increased his gain on his investments by using margin debt. Yaeger financed his purchases by borrowing to the maximum extent allowable under law and the custom of the brokerage houses, which was generally 50 percent. If the value of his stock rose he would use that increased value as equity to support more debt. From time to time Yaeger shifted accounts from one brokerage house to another in order to maximize the volume of margin debt he could carry. Once or twice during his career Yaeger was overleveraged and suffered substantial losses when he was forced to sell enough stock to maintain his margin debt.

During the years 1979 and 1980, the ratio of Yaeger's margin debt to portfolio value was 47 percent and 42 percent, respectively. Yaeger's total stock market related debt equalled $42,154,048 in 1979 and $54,968,371 in 1980. When he died, his portfolio was subject to debt in the amount of $70,490,018.

In 1979 and 1980 Yaeger reported income in the following amounts on his federal tax return:

                1979  Character of Income         Amount
                      Long-term capital gain   $13,839,658
                      Short-term capital gain      184,354
                      Dividends                  2,339,080
                      Interest                      57,958
                                               -----------
                                               $16,421,050
                

                1980  Character of Income         Amount
                      Long-term capital gain    $1,099,921
                      Short-term capital gain      728,404
                      Dividends                  3,648,441
                      Interest                      91,717
                      Director's fees               10,600
                                               -----------
                                                $5,579,083
                

Of the stock which Yaeger sold in taxable years 1979 and 1980, the percentage of total sales of securities which he had held for twelve months or more was 88 percent and 91 percent, respectively. The purchase dates of the securities sold in 1980 ranged from March 1970 to December 1979. In 1979, Yaeger did not sell any security that had been held for less than three months and, in 1980, did not sell any security that had been held for less than six months. On schedule C of the tax returns, Yaeger deducted interest expense in 1979 and 1980 in the amounts of $5,865,833 and $7,995,010, respectively.

The sole issue considered by the tax court was whether the claimed deductions of the interest expenses Yaeger incurred in purchasing securities on margin were subject to the limitation on the deductibility of investment interest set forth in section 163(d). ⁵ This issue turned on whether Yaeger's stock market activities constituted investment activity or the activity of trading in securities as a trade or business. According to the tax court, the "pivotal inquiry" was "whether Yaeger was interested in deriving income from capital appreciation or from short-term trading." The court determined that Yaeger was an investor, not a trader, because Yaeger held his stocks and bonds for lengthy periods of time anticipating that they would appreciate in value. Thus, the interest expense he incurred was "investment interest" within the meaning of section 163(d) and subject to the deductibility restrictions of that section.

B. Discussion

Section 163 of the Internal Revenue Code generally provides for the deduction of interest incurred on indebtedness. As defined in section 163(d)(3)(D), "investment interest" is "interest paid or accrued on indebtedness incurred or continued to purchase or carry property held for investment." Section 163(d) limits the deductibility of investment interest by a noncorporate taxpayer to the extent of the taxpayer's investment income, plus $10,000. Any amount disallowed is "treated as investment interest paid or accrued in the succeeding taxable year." 26 U.S.C. Sec. 163(d)(2). Section 163(d) does not apply to interest paid to buy property for personal use or property for trade or business use. See H.R.Rep. 413, pt. 1, 91st Cong., 1st Sess. 72, reprinted in 1969 U.S.Code Cong. & Admin.News 1645, 1719 ("interest on funds borrowed in connection with a The Internal Revenue Code does not define "trade or business." Determining whether a taxpayer's trading activities rise to the level of carrying on a trade or business turns on the...