Johnsen v. C.I.R.

• Decision Date: 11 July 1986
• Docket Number: 85-1542,Nos. 85-1285,s. 85-1285
• Citation: 794 F.2d 1157
• Parties: -5396, 55 USLW 2048, 86-2 USTC P 9534 John K. JOHNSEN; Frances Johnsen, Petitioners-Appellees, Cross-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant, Cross-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 1157

794 F.2d 1157

58 A.F.T.R.2d 86-5396, 55 USLW 2048, 86-2

USTC P 9534

John K. JOHNSEN; Frances Johnsen, Petitioners-Appellees Cross-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant Cross-Appellee.

Nos. 85-1285, 85-1542.

United States Court of Appeals Sixth Circuit.

Argued and Submitted May 9, 1986.

Decided July 11, 1986.

Michael L. Paup, Glenn L. Archer, Jr., Tax Div., Dept. of Justice, Washington, D.C., Ann Belanger Durney, argued, Steven I. Frahm, for respondent-appellant, cross-appellee.

Donald J. Forman, Ginsberg & Forman, Dallas, Tex., Donald W. Geerhart, Grossman & Flask, P.C., Washington, D.C., for petitioners-appellees, cross-appellants.

Before KENNEDY and MILBURN, Circuit Judges, and JOINER, Senior District Judge ^*.

MILBURN, Circuit Judge.

John K. Johnsen ("taxpayer") and Frances Johnsen instituted this action in the United States Tax Court to challenge a determination by the Commissioner of Internal Revenue ("the Commissioner") that they owe additional taxes of $3,700.00 for the year 1976. ¹ The issue before the Tax Court was the deductibility of taxpayer's distributive share of pre-opening expenses incurred in 1976 by a limited partnership formed for the purpose of constructing and operating an apartment complex.

The Tax Court determined that the limited partnership was not engaged in the active conduct of a trade or business until 1977 when the apartments were rented out and refused to permit taxpayer to deduct his share of the limited partnership's expenses as a trade or business expense under 26 U.S.C. Sec. 162(a). Although denying business expense deductions, the Tax Court concluded that the pre-opening expenses were deductible, for the most part, under 26 U.S.C. Sec. 212, which contains no trade or business requirement. The Tax Court then adjusted the taxpayer's share of the limited partnership's losses to reflect that portion of the year during which he held an interest in the limited partnership.

The Commissioner appealed arguing that the expenses were not deductible under 26 U.S.C. Sec. 212, and the taxpayer cross-appealed arguing that the Tax Court's adjustment of his share of pro rata losses was improper. For the reasons that follow, we reverse and hold that the limited partnership's pre-opening expenses are not currently deductible under 26 U.S.C. Sec. 212.

I.

The facts are carefully set out in the opinion of the Tax Court, 83 T.C. 103 (1984), and will only briefly be set forth here. On April 11, 1976, Charles W. Greener, Allan R. Summer, and others formed Centre Square III, a general partnership. On the same date, Centre Square III, Ltd., a limited partnership, was formed. The general partners of the limited partnership were Norman L. Nelson, Jr., Greener and Sumner Architects, Inc., and Equity Advisers, Inc. The original limited partner of the limited partnership was Dee W. Dilts, who was Mr. Nelson's law partner. The parties to the limited partnership agreement intended Mr. Dilts to be a "nominee" who would have no interest in Centre Square III and who would withdraw when new limited partners were admitted. By an amended limited partnership agreement, effective September 9, 1976, Dilts withdrew as the original limited partner and was replaced by twenty-two other limited partners, including taxpayer.

On April 11, 1976, the general partnership agreed to sell its entire interest in the apartment complex project, including land, plans, specifications, and any contracts relating to the project to the limited partnership for $3,171,200.00. On the same date, the limited partnership entered into a management agreement with the general partnership. Under the terms of the agreement, the general partnership was granted total responsibility for leasing, management, and administration of the project. In exchange for its services, the general partnership would receive management and guaranty fees in the amount of 5 percent of the project's gross receipts and an additional $50,000.00 annually in the years 1976 through 1980.

On April 15, 1976, the general partnership agreed to provide the limited partnership construction financing in the amount of $3,171,200.00 in exchange for a $28,200.00 nonrefundable commitment fee to be paid by the limited partnership upon acceptance of the commitment. The general partnership also agreed to provide the limited partnership permanent financing in the amount of $3,171,200.00 in exchange for an $84,600.00 nonrefundable commitment fee to be paid by the limited partnership upon acceptance of the commitment. In August, 1976, the general partnership extended its permanent loan commitment until August 31, 1977, in return for a fee in the amount of $11,280.00.

Construction of the apartment complex began in September, 1976 and was completed in October, 1977. During 1976, the general partnership sought prospective tenants for the complex, but did not accept any rental deposits or advances during that year. Rental deposits on uncompleted units were accepted from prospective tenants beginning in January, 1977.

The offering memorandum for the limited partnership, dated April 15, 1976, provided that the 99 per cent interest belonging to the limited partners would be divided into twenty units of 4.9 per cent each. Each unit cost $47,000.00, payable in five equal installments. The first installment was due upon the limited partner's admission, and the remaining installments were due annually thereafter. On July 19, 1976, taxpayer executed the amended limited partnership agreement and drew a check for $9,400.00 in payment of his first installment.

On its 1976 United States partnership return, the limited partnership deducted $37,500.00 for "tax advisory fees," $7,500.00 for "legal fees," $50,000.00 for the "management and guaranty fees," and $66,427.00 for the "amortization of commitment fees." The limited partnership amortized the commitment fees over the duration of the commitments. The amount deducted included $15,667.00 of the construction loan fee and $50,760.00 of the permanent loan fee. The limited partnership listed the taxpayer's share of the partnership's resulting ordinary loss for 1976 as $9,568.00.

In the notice of deficiency, the Commissioner disallowed the limited partnership's deductions for legal fees, tax advisory fees, commitment fees, and management and guaranty fees. The Commissioner determined that the taxpayer had failed to show that the limited partnership was engaged in a trade or business as of December 31, 1976. The Commissioner further determined that the taxpayer had failed to show that the claimed expenses were ordinary and necessary within the meaning of 26 U.S.C. Sec. 162(a) and that the expenses were not capital in nature. Finally, the Commissioner determined that taxpayer had failed to show that deductibility of the expenses was not prohibited by 26 U.S.C. Sec. 709 and that the expenses did not represent non-deductible organizational or syndication expenses of the partnership.

The Tax Court determined that the limited partnership was not actively engaged in a trade or business in 1976 because its intended activity of operating a rental apartment complex had not commenced at that time. Consequently, no deduction for trade or business expenses under section 162(a) was permitted. However, relying on its previous decision in Hoopengarner v. Commissioner, 80 T.C. 538, 540 (1983), the Tax Court held that the management and guaranty fee, the construction loan commitment fee, a portion of the permanent loan commitment fee, and the permanent loan commitment extension fee claimed by the limited partnership in 1976 were deductible under 26 U.S.C. Sec. 212. The Tax Court disallowed the claimed deductions for legal fees and consulting and advisory fees, holding that they were incurred to organize the partnership and were not shown to be attributable to deductible tax advice. Finally, the Tax Court determined that the taxpayer's distributive share of the limited partnership's deductions must be adjusted to reflect that he was a partner for only a portion of the limited partnership's taxable year.

The parties submitted conflicting computations of taxpayer's liability, disagreeing over the adjustment necessary to reflect taxpayer's entry into the limited partnership after its tax year had begun. The Tax Court adopted the Commissioner's computation and entered its decision on November 21, 1984, determining that taxpayer owed additional taxes of $2,698.00. Taxpayer filed a motion to vacate the Tax Court's decision, contending that the court should not have adopted the Commissioner's computation adjusting his distributive share on the basis of the percentage of days in the limited partnership's taxable year during which he was a partner. Instead, according to taxpayer, the Tax Court should have imposed on the Commissioner the burden of proving that any of the deductible fees accrued prior to his becoming a partner on July 19, 1976. After holding a hearing on taxpayer's motion, the Tax Court issued a supplemental opinion upholding its earlier decision.

II.

The issue presented by the Commissioner's appeal is whether expenses incurred during the start-up or pre-opening period of a new business, which are not deductible under 26 U.S.C. Sec. 162(a) because of the "pre-opening expense doctrine," are nevertheless deductible under 26 U.S.C. Sec. 212. Section 162(a) provides that "there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Courts have consistently held that section 162(a) does not permit current deductions for start-up or pre-opening expenses incurred by taxpayers prior to beginning business operations. See Aboussie v. United States, 779 F.2d 424, 428 (8th Cir.1985); Central Texas Savings & Loan Association v. United States, 731 F.2d 1181, 1183 (5th Cir.1984); Bennett Paper Corp. v. Commissioner, 699 F.2d...