Halle v. C.I.R.

• Decision Date: 06 May 1996
• Docket Number: No. 95-1740,95-1740
• Citation: 83 F.3d 649
• Parties: -2125, 64 USLW 2719, 96-1 USTC P 50,250 Warren E. HALLE; Martha D. Halle, Partners Other Than the Tax Matters Partner, Petitioners-Appellants, and Kingstowne L. P., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 649

83 F.3d 649

77 A.F.T.R.2d 96-2125, 64 USLW 2719,

96-1 USTC P 50,250

Warren E. HALLE; Martha D. Halle, Partners Other Than the Tax Matters Partner, Petitioners-Appellants and Kingstowne L. P., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 95-1740.

United States Court of Appeals Fourth Circuit.

Argued Oct. 30, 1995.

Decided May 6, 1996.

ARGUED: Patrick G. Dooher, Silverstein & Mullens, Washington, D.C., for Appellants. Jonathan Samuel Cohen, Tax Division, United States Department of Justice, Washington, D.C., for Appellee. ON BRIEF: Loretta C. Argrett, Assistant Attorney General, Gary R. Allen, Kevin M. Brown, Tax Division, United States Department of Justice, Washington, D.C., for Appellee.

Before NIEMEYER and MICHAEL, Circuit Judges, and PHILLIPS, Senior Circuit Judge.

OPINION

NIEMEYER, Circuit Judge:

We are presented with the question of whether the taxpayer may deduct as interest under I.R.C. § 163(a) $900,000 in payments it made to defer the closing date of a stock purchase agreement that obligated it to buy all of a corporation's capital stock. Because the stock purchase agreement contained a liquidated damages clause limiting the taxpayer's liability on default, the Commissioner of Internal Revenue concluded that the agreement did not impose indebtedness on the taxpayer for the full purchase price and that, therefore, the $900,000 paid to defer settlement did not constitute interest on indebtedness within the meaning of I.R.C. § 163(a). The United States Tax Court sustained the Commissioner's disallowance of the claimed interest deduction.

Based on our conclusions that (1) the stock purchase agreement created indebtedness for the full purchase price and (2) the payments made to defer the settlement date compensated the selling stockholders for their forbearance of the purchase price, we hold that the payments are deductible as interest under I.R.C. § 163(a). Accordingly, we reverse the Tax Court's decision.

I

Warren E. Halle, who is in the business of land development and home construction, discovered an 1,100-acre tract of land in Fairfax County, Virginia, which he believed was suitable for residential development. During the summer of 1984, Halle began negotiations with the four shareholders of Greendale Development Company, Inc., the Virginia corporation that owned the 1,100-acre tract. When the parties reached agreement, Halle formed Kingstowne L.P., a limited partnership, to purchase all of Greendale's stock for $29 million because the 1,100-acre tract was Greendale's only asset. Halle appointed one of his companies to be Kingstowne's general partner and he and his wife, Martha Halle, became Kingstowne's limited partners.

On March 8, 1985, Kingstowne and Greendale's four stockholders entered into a Stock Purchase Agreement, which provided that "Seller hereby agrees to sell to Buyer, and Buyer agrees to purchase from Seller on the Settlement Date all of the issued and outstanding capital stock" of Greendale for $29 million. The agreement required Kingstowne to pay a $3 million deposit and the balance at settlement. The agreement established April 26, 1985, as the settlement date, but permitted Kingstowne to defer settlement up to October 1, 1985, by paying the Greendale stockholders $225,000 per month, to be adjusted on a daily basis.

When the Stock Purchase Agreement was executed, Greendale was in the final stages of obtaining rezoning from Fairfax County to allow higher density development of the land. Accordingly, the agreement required Greendale to transfer all engineering and planning for the property to Kingstowne and to bear the continuing costs of "engineering, planning, and development incurred through March 15, 1985." Thereafter, Kingstowne unconditionally assumed the obligation to pay all such costs "when due."

Finally, the contract provided that in the event of Kingstowne's default in "mak[ing] settlement ... or mak[ing] the required payment[s]" to extend the settlement date, the $3 million downpayment and any monthly installments already paid to defer the settlement date "shall be forfeited to Seller as liquidated damages." The default clause also provided that "the parties shall have no further rights or liabilities one to the other hereunder."

As required by the Stock Purchase Agreement, Kingstowne paid the $3 million downpayment to the Greendale stockholders when the agreement was executed, and it assumed the engineering, planning, and development costs of the property, eventually paying $506,779 in such costs as they accrued. Kingstowne also elected to defer settlement for four months, paying the sellers a total of $900,000 for the extension.

During the period between the execution of the Stock Purchase Agreement and settlement, Kingstowne applied for and obtained $53 million in loan commitments to finance the purchase and development of the land. It also began negotiations to sell portions of the tract and to enter into joint development ventures with third parties, exchanging preliminary drafts which could not be finalized until after settlement. In June 1985, the Fairfax County Board of Supervisors approved the rezoning of the land tract as anticipated.

On August 23, 1985, the parties settled in accordance with the terms of their Stock Purchase Agreement. Immediately after consummating the transaction, Kingstowne liquidated Greendale and assumed direct ownership of the 1,100-acre tract.

In its 1985 income tax return, Kingstowne treated the $900,000 it had paid to defer the settlement date of the Stock Purchase Agreement as deductible interest paid on the stock's purchase price. Kingstowne later sent a Form 1099-MISC to the selling stockholders of Greendale, reporting the $900,000 as miscellaneous compensation. The sellers, however, objected to Kingstowne's issuance of the form and opted to treat the fees as additional proceeds from the sale of their stock. After an examination of Kingstowne's tax return, the Commissioner issued a Notice of Final Partnership Administrative Adjustment that disallowed Kingstowne's claimed $900,000 interest deduction, which had been passed through to the partners (Halle, his corporation, and his wife).

In January 1993, Kingstowne and the Halles filed a petition in the United States Tax Court for a readjustment of partnership items. They argued that "the Commissioner should not have disallowed as interest the $900,000 paid by [Kingstowne] to defer its obligation to pay $29,000,000 purchase price during the taxable year ending September 30, 1985."

On December 22, 1994, the Tax Court denied the petition. The court initially observed that the March 8 Stock Purchase Agreement never described the monthly settlement deferment payments as "interest." The court found, moreover, that the monthly payments had not been paid on "indebtedness" because the Stock Purchase Agreement's liquidated damages clause provided that in the event of its default Kingstowne would forfeit only its $3 million deposit and any settlement deferment payments it had made. Rather than having been made "pursuant to an unconditional and legally enforceable obligation" to pay the balance of the $29 million purchase price, the $900,000 in settlement deferment payments appeared to the court to resemble amounts paid to retain the "option to complete or not complete the transaction."

This appeal was taken from the Tax Court's decision.

II

Section 163(a) of the Internal Revenue Code allows a deduction for "all interest paid or accrued within the taxable year on indebtedness." Because "deductions are a matter of legislative grace," Kingstowne bears the burden of demonstrating that its claimed interest deduction falls within the scope of § 163(a). See Midkiff v. Commissioner, 96 T.C. 724, 747, 1991 WL 83269 (1991) (citing New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440, 54 S.Ct. 788, 790-91, 78 L.Ed. 1348 (1934)), aff'd sub nom. Noguchi v. Commissioner, 992 F.2d 226 (9th Cir.1993).

Explaining that "interest" is to be given its "usual, ordinary and everyday meaning," Old Colony R.R. v. Commissioner, 284 U.S. 552, 561, 52 S.Ct. 211, 214, 76 L.Ed. 484 (1932), the Supreme Court has defined the term as "compensation for the use or forbearance of money." Deputy v. du Pont, 308 U.S. 488, 498, 60 S.Ct. 363, 368, 84 L.Ed. 416 (1940) (interpreting predecessor to § 163(a)); see also Old Colony R.R., 284 U.S. at 560, 52 S.Ct. at 213-14 (same). Because the question of whether Kingstowne's settlement deferment payments qualify as "interest" within the meaning of I.R.C. § 163(a) depends in part on whether the March 8 Stock Purchase Agreement created "indebtedness," we begin with the issue of whether the Stock Purchase Agreement imposed indebtedness on Kingstowne.

"[I]ndebtedness" as used in I.R.C. § 163(a) is a term of art; "although an indebtedness is an obligation, an obligation is not necessarily an 'indebtedness' " for tax purposes. du Pont, 308 U.S. at 497, 60 S.Ct. at 368. Indebtedness within the meaning of § 163(a) may arise in a variety of circumstances. First, it may stem from "an existing, unconditional, and legally enforceable obligation for the payment of a principal sum." Howlett v. Commissioner, 56 T.C. 951, 960, 1971 WL 2506 (1971); see also Midkiff, 96 T.C. at 744 ("The general rule of section 163(a) is that interest is deductible only if paid on an existing unconditional obligation"). Second, even if materially conditional, an existing, legally enforceable obligation may still give rise to indebtedness, so long as (1) the contingency on which the obligation rests is beyond the control of the party seeking the interest deduction, (2) the amount of the indebtedness on which the interest accrued was fixed as of the date that the interest began to accrue, and (3) the payor's liability to the payee is primary and direct. See, e.g., Journal Co. v. Commissioner, 125 F.2d 349, 350-51 (7th Cir.1942); Dunlap v. Commissioner, 74 T.C....