Lay v. Comm'r of Internal Revenue

• Decision Date: 12 December 1977
• Docket Number: Docket No. 3922-76.
• Citation: 69 T.C. 421
• Parties: LYNDELL E. and BERNICE C. LAY, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

69 T.C. 421

LYNDELL E. and BERNICE C. LAY, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 3922-76.

United States Tax Court

Filed December 12, 1977.

Held: 1. Loan fees characterized as interest, which were paid by two accrual method partnerships in the nature of a loan discount from the principal amounts of 40-year loans, must be prorated over the entire life of each loan regardless of when the fees were actually paid.

2. A 2-percent financing fee paid by both partnerships to a mortgage banking firm was for services rendered and, therefore, is not deductible as interest in 1971.

3. The reimbursement to a partner of a FNMA preliminary commitment fee paid by him represents the cost incurred in securing a loan and, similarly, is not deductible as interest in 1971. Byron M. Eiseman, Jr., and Lewis H. Mathis, for the petitioners.

Michael J. O'Brien, for the respondent.

DAWSON, Judge:

Respondent determined a deficiency in petitioners' Federal income tax for the year 1971 in the amount of $12,749.33. Petitioner-husband is a limited partner in two partnerships that each constructed and operated a section 236 housing project under the National Housing Act. At issue is whether certain financing fees paid by these two accrual method partnerships are deductible as ordinary and necessary business expenses under section 162¹ or as interest under section 163 in the year of their respective accruals. Some concessions have been made by the petitioners.

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulation of facts, together with the exhibits attached thereto, are incorporated herein by reference and are found accordingly.

Lyndell E. Lay (hereinafter referred to as petitioner) and Bernice C. Lay resided in North Little Rock, Ark., at the time they filed their petition in this case. Their joint Federal income tax return for the calendar year 1971 was prepared on a cash basis and filed with the Internal Revenue Service Center, Austin, Tex.

Petitioner reported the amounts of $61,158 and $31,930 as his distributive share of losses from the partnerships, West Scenic Apartment, Ltd. (hereinafter referred to as West Scenic), and Oak Wood Manor, Ltd. (hereinafter referred to as Oak Wood), respectively.

West Scenic and Oak Wood maintained their books and filed their Federal income tax returns on a calendar year basis using the accrual method of accounting.

West Scenic is a limited partnership formed under the laws of the State of Arkansas. Its articles of limited partnership were adopted May 29, 1970, and filed with the county and probate clerk for Pulaski County, Ark., on June 12, 1970. Its original general partner was Harold Bell and the original limited partners were Reed S. McConnell, Joe T. Smith, John A. Kincannon, and Harold Bell.

In an amendment to the articles dated March 25, 1971, and duly filed on March 31, 1971, petitioner was substituted as a limited partner of West Scenic for Harold Bell. During the period in issue petitioner owned a 25-percent interest in the profits, losses, and distributions of West Scenic.

West Scenic was formed to acquire, construct, and operate a 150-unit apartment complex, known as West Scenic Apartments, under a federally assisted program implemented by section 236 of title II of the National Housing Act, as amended.

Oak Wood is a limited partnership formed under the laws of the State of Arkansas. Its articles of limited partnership were adopted January 25, 1971, and filed with the county and probate clerk for Pulaski County, Ark., on January 28, 1971. The original general partner was Reed McConnell Builders, Inc. (hereinafter referred to as Builders), and the original limited partners were Harold Bell, Joe T. Smith, John A. Kincannon, and Builders.

In an amendment to its articles dated March 25, 1971, and filed on March 28, 1971, petitioner was substituted as a limited partner in Oak Wood for Harold Bell. Petitioner owned a 25-percent interest in the profits, losses, and distributions of Oak Wood.

After the admission of petitioner to Oak Wood, additional limited partners were admitted whose interests in Oak Wood were acquired pursuant to a limited circulation memorandum. The admission of these additional limited partners was formalized in an additional amendment to the articles.

Oak Wood was formed to acquire, construct, and operate a 200-unit apartment complex, known as Oak Wood Manor, under a federally assisted program implemented by section 236 of title II of the National Housing Act, as amended.

A “Section 236 Program” refers to a low and middle income housing project which is eligible for a permanent Federal Housing Administration (hereinafter referred to as FHA) insured mortgage under section 236 of the National Housing Act.² A “Section 236 Program” also provides for monthly payments from the Government directly to the mortgage lender on behalf of the project owner. The owner is required to pass benefits of this subsidy along to eligible residents in the form of lower rent. The program is designed to enable the sponsor of the project, in this case the sponsors of West Scenic and Oak Wood, to reduce rentals of eligible tenants to those levels below market rates which can be afforded by low and middle income families under standards established by the Federal Government.

In 1968 petitioner organized L. E. Lay & Co., Inc. (hereinafter referred to as the Company), an Arkansas corporation engaged in the mortgage banking business. He served as the chairman of its board of directors and chief executive officer until December 1974.

During the period in which petitioner was employed by the Company, the Company provided or arranged for short-term and long-term mortgage loans for approximately 20 to 25 multifamily housing projects. The mortgages were insured against loss by the FHA.

The services of the Company, in providing or arranging financing for these multifamily housing projects, were performed personally by petitioner or by Company employees under his direct supervision.

Two of these 20 to 25 multifamily housing projects for which Company provided or arranged financing were West Scenic and Oak Wood.

On January 8, 1970, Company requested the Federal National Mortgage Association [FNMA] for a preliminary commitment to purchase a mortgage related to the West Scenic projects in the amount of $2,207,400 bearing interest at the rate of 8.5 percent per annum. On January 20, 1970, FNMA issued the preliminary commitment.

On May 6, 1970, pursuant to an FHA application, FHA executed a “Commitment For Insurance of Advances” for the West Scenic project. Under this commitment the FHA agreed to insure under the provisions of section 236 of the National Housing Act, as amended, a mortgage note in the principal amount of $2,172,400.

On June 8, 1970, Company assigned to the Prudential Insurance Co. (hereinafter referred to as Prudential) all of its right, title, and interest in the commitment, which assignment was approved on the same date by the FHA.

On June 10, 1970, Prudential agreed to loan West Scenic the principal amount of $2,172,400 for 500 months with interest at the rate of 8.5 percent per annum with monthly installments of $15,925.74 interest and principal payable beginning the 1st day of the 21st month following the month the mortgage given to secure the loan was dated. Only interest was payable on the loan for the first 20 months.

Under the terms of Prudential's commitment to make the loan for the West Scenic project, West Scenic agreed to pay to Prudential “discount” or “points” equal to 2 1/2 percent of the principal amount of the loan in the amount of $54,310. This fee was to be paid for the use of borrowed money. This fee was in addition to the annual interest charged on the mortgage loan referred to above.

On June 16, 1970, there was executed by West Scenic and Prudential a “Building Loan Agreement” for the West Scenic project. The terms of this agreement called for Prudential to make a building loan in the principal amount of $2,172,400, the proceeds of which were to be disbursed in monthly advances in amounts approved for insurance by the FHA pursuant to monthly application by West Scenic.

On June 16, 1970, West Scenic executed a deed of trust note in favor of Prudential in the principal amount of $2,172,400. Under the terms of this note, principal bore interest at the rate of 8.5 percent per annum on the unpaid balance. Interest was payable on June 1, 1970, and each month thereafter, up to and including March 1, 1972, and monthly principal and interest payments of $15,925.74 were payable on the first of every month thereafter until fully paid. Any balance remaining on March 1, 2012, was due and payable in full. West Scenic executed a deed of trust in favor of Prudential on June 16, 1970, to secure the deed of trust note.

Also on June 16, 1970, West Scenic contracted with Builders on a “cost plus” basis to construct the West Scenic project. Pursuant to the contract terms, construction was to begin within a period of 10 days and was to be completed by November 26, 1971.

On the same date a mortgagor's certificate, a mortgagee's certificate, and an agreement and certification were executed in connection with the West Scenic project. West Scenic also issued on that day a request for payment to Prudential in the amount of $201,773 covering the first advance of mortgage proceeds.

On June 16, 1970, an application was also submitted by Prudential to the FHA requesting insurance of the advance of the mortgage proceeds representing the first draw in the sum of $201,773 relative to the West Scenic project. On the same date the FHA issued its certificate of mortgage insurance covering the first draw. The FHA issued its insurance of the mortgage loan for the West Scenic project with a preliminary endorsement of the deed of trust note.

A closing statement dated June 17, 1970, prepared with regard to the West Scenic project, indicates the...