Honodel v. C.I.R.
| Decision Date | 15 February 1984 |
| Docket Number | 82-7343,Nos. 82-7334,s. 82-7334 |
| Citation | 722 F.2d 1462 |
| Parties | 84-1 USTC P 9133 Robert C. HONODEL and Claire E. Honodel, et al., Petitioners-Appellants, v. COMMISSIONER OF THE INTERNAL REVENUE, Respondent-Appellee. to 82-7345. |
| Court | U.S. Court of Appeals — Ninth Circuit |
J. Gordon Hansen, Hansen, Jones, Maycock & Leta, Salt Lake City, Utah, for petitioners-appellants.
Steven I. Frahnm, Tax Div., Washington, D.C., for respondent-appellee.
Appeal from the United States Tax Court.
Before KENNEDY, TANG, and POOLE, Circuit Judges.
Taxpayers appeal from the ruling of the Tax Court which determined deficiencies in taxpayers' income taxes due for the taxable years 1972, 1973, and 1975. The taxpayers assert that the court erred in finding that certain fees paid to an investment advisory firm were nondeductible capital expenditures, and that the court wrongly rejected their method of calculating the depreciable life of their real property investments.
During the years at issue, taxpayers were clients of Financial Management Service ("FMS"), an investment advisory service which provided financial management, investment, and tax analysis and advice to its clients. The stated goal of FMS was to minimize a client's income taxes while enhancing his estate. It primarily focused on real estate investments.
New clients typically were invited to attend financial investment planning sessions which helped to acquaint the client with the services provided by FMS, and at which FMS analyzed the client's existing financial position and recommended an investment and financial strategy for improving that position. Clients were then placed on an investment waiting list. If the client refused investments proposed by FMS, FMS dropped that person as a client. Each client's financial needs, position, and objectives were reviewed in periodic planning The projects recommended by FMS were arrived at by a long process, often over several years. Brokers around the country presented projects to FMS for its analysis. During the years involved here, FMS analyzed between 30 and 50 projects in order to decide which to recommend to its clients. When accepted by FMS, such projects were then recommended to clients according to their waiting list priority. While they could have declined to invest in a tendered project, none of the taxpayers chose to do so. Projects rejected by FMS were not discussed with clients. Once the projects were accepted projects, FMS engaged outside counsel to negotiate the acquisition of the properties and to prepare the necessary documentation. FMS also participated directly in the acquisition phase of accepted projects.
sessions. The success of FMS was indicated by a long investment waiting list.
The client's investment in these recommended projects was normally in the form of a limited partnership interest, purchased through capital contributions. The limited partnerships were purchased primarily for tax shelter benefits and appreciation. The policy of FMS and its clients was that each investment project would be sold off when the desired tax benefits were no longer available.
FMS charged fees in two separate methods. First, clients were charged monthly nonrefundable retainer fees, the amount depending on that individual's income level and his financial planning, tax advice, and investment needs. Second, when a client elected to invest in a project, an investment or retainer fee representing a specific percentage of the total cost of the project was assessed. Each investor in a particular project paid according to his or her respective ownership interest. The retainer fee was fixed by FMS reflecting FMS' time and effort expended in selecting that specific project, and the costs of analyzing the numerous projects which FMS had rejected.
In the years at issue, FMS did not keep detailed records of the potential investments which were investigated but not chosen, their cost, or the time and effort attributable to individual clients.
During the relevant tax periods, the taxpayers invested in four apartment complexes in Sacramento, California, and pursuant to advice given by FMS, took depreciation allowances based on their limited partnership shares. FMS did not calculate the useful lives of the apartment buildings on the basis of the physical life of each structure, but instead calculated on the "economic useful life" of the particular investment to the clients. The economic useful life calculation was measured in large part by the estimated tax benefits.
The Tax Court ruled that the monthly retainer fees paid were deductible expenses, but that the one-time fees paid when FMS clients invested in a project were part of the acquisition cost and therefore nondeductible. Honodel v. Commissioner, 76 T.C. 351 (1981). The court also determined that the "economic useful life" approach to calculating annual depreciation levels adopted by FMS was without merit. The court then held the proper basis to be the physical useful life of an apartment complex and components thereof. The taxpayers appealed.
The tax code provides to investors the same deductions for business expenses from taxable income as applies to income producing activities. Section 212 of the Internal Revenue Code of 1954 (26 U.S.C.) permits deductions for expenses charged to investment or tax advice. That section provides:
Sec. 212. Expenses for production of income
In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year--
(1) for the production or collection of income;
(2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax.
Section 212 sets forth two requirements for deductibility: first, the expenses must be "ordinary and necessary," as that term has been interpreted by the courts and Treasury Department Regulations; and second, the expenses must fall within one of the three categories established by the statute.
Taxpayers concede that part of the investment fee claimed represents the direct costs of acquisition, which are not deductible. However, they argue that the Tax Court should have allocated the investment fee so as to distinguish between this non-deductible expense and other expenses which are deductible.
The Government does not dispute that such an allocation between capital acquisition costs and deductible expenses is proper in certain cases. See Cohan v. Commissioner, 39 F.2d 540 (2d Cir.1930).
The Tax Court declined to allocate any part of the investment fee to deductible expenses. First, the court ruled that the taxpayers had failed to provide sufficient credible evidence upon which to base a reasonable allocation; and second, that as a matter of law the expenses in question were not deductible in any case. Since we agree with the second conclusion, we need not further pursue the allocation issue. We hold that as a matter of law the deductions were properly disallowed in any event.
A. The "Ordinary and Necessary" Requirement
The term "ordinary and necessary" has been used to distinguish expenditures that are nondeductible capital outlays from those that are deductible as current expenses. Commissioner v. Lincoln Savings and Loan Assn., 403 U.S. 345, 353, 91 S.Ct. 1893, 1898, 29 L.Ed.2d 519 (1971). An expenditure is a nondeductible capital outlay if it is made to acquire a capital asset. Id. at 354, 91 S.Ct. at 1899; Commissioner v. Idaho Power Co., 418 U.S. 1, 94 S.Ct. 2757, 41 L.Ed.2d 535 (1974); Spangler v. Commissioner, 323 F.2d 913, 918-19 (9th Cir.1963); Treas.Regs. Sec. 1.212-1(n).
The distinction is often close between ancillary costs related to capital assets which may properly be capitalized as part of the capital asset itself, and other related costs which should be considered costs of management and conservation of a capital asset. The Supreme Court, in the context of determining the category into which litigation expenses involving title to property should fall, held that the central inquiry should be whether the expense originated in "the process of acquisition itself." Woodward v. Commissioner, 397 U.S. 572, 577, 90 S.Ct. 1302, 1306, 25 L.Ed.2d 577 (1970). Further, in Commissioner v. Lincoln Savings and Loan Assn., 403 U.S. at 354, 91 S.Ct. at 1899, in the context of "additional premiums" paid by a savings and loan association, the court stated:
What is important and controlling, we feel, is that the [insurance] payment serves to create or enhance for Lincoln what is essentially a separate and distinct additional asset and that, as an inevitable consequence, the payment is capital in nature and not an expense, let alone an ordinary expense, deductible under Sec. 162(a) in the absence of other factors not established here. 1
Accordingly, we must examine the investment fees paid by the taxpayers to FMS to determine whether the fees originated in the process of acquisition of property, Woodward v. Commissioner, 397 U.S. at 577, 90 S.Ct. at 1306, or if they served to create or enhance, from the taxpayers' view, additional capital assets. Commissioner v. Lincoln Savings and Loan Assn., 403 U.S. at 354, 91 S.Ct. at 1899.
As we have noted, FMS performed two general services for its clients Only those clients who decided to invest in a recommended project and took advantage of FMS's acquisition function paid the investment fees. Those clients who chose not to invest and hence were not required to pay the investment fee received the exact same investment services as those who chose to invest. Conversely, petitioners could only participate in an investment if they paid the investment fee. Each petitioner voluntarily could choose to invest in the projects....
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