Levitt v. U.S.

• Decision Date: 05 June 1975
• Docket Number: Nos. 74-1572,74-1582,s. 74-1572
• Citation: 517 F.2d 1339
• Parties: 75-1 USTC P 9508 Ellis I. and Nelle S. LEVITT, Appellants-Appellees v. UNITED STATES of America, Appellees-Appellants
• Court: U.S. Court of Appeals — Eighth Circuit

Page 1339

517 F.2d 1339

75-1 USTC P 9508

Ellis I. and Nelle S. LEVITT, Appellants-Appellees v. UNITED STATES of America, Appellees-Appellants

Nos. 74-1572, 74-1582.

United States Court of Appeals,

Eighth Circuit.

Submitted Feb. 10, 1975.

Decided June 5, 1975.

Jeffrey E. Lamson, Des Moines, Iowa, for plaintiffs-appellants.

Stephen M. Gelber, Atty., Appellate Section, Tax Div., Dept. of Justice, Washington, D. C., for defendant-appellee.

Before BRIGHT and STEPHENSON, Circuit Judges, and TALBOT SMITH, Senior District Judge. ^*

BRIGHT, Circuit Judge.

The appeal and cross-appeal in this case require that we interpret and apply to the circumstances disclosed by the record the provisions of § 265(2) of the Internal Revenue Act of 1954, as amended, 26 U.S.C. § 265(2) (1970), which disallows a deduction for interest "on indebtedness incurred or continued to purchase or carry obligations * * * the interest on which is wholly exempt from * * * (federal income) taxes * * *." ¹

Taxpayer Nelle Levitt claimed for the years 1963-1965, inclusive, an interest deduction for loans from the Iowa-Des Moines National Bank (hereinafter Bank) carried to finance the purchase of United States Treasury bonds, the income from which is not exempt from taxation, when at all times she could have readily paid off the loans, or avoided them altogether by liquidation of her substantial holdings of tax-exempt municipal bonds.

Nelle's husband, Ellis Levitt, obtained loans from the Bank to purchase Treasury bonds while holding, as did Nelle Levitt, tax-exempt securities of substantially greater value than the amount of the loans. In common with his wife, he claimed interest deductions in the same years.

Additionally, during 1963-65, Ellis Levitt claimed interest deductions for his indebtedness to the Bank incurred to obtain funds to make certain other investments and, possibly, to repay a loan from his wife. ²

The Commissioner rejected entirely the Levitts' deduction of interest on loans incurred to purchase the Treasury bonds and rejected in part Ellis Levitt's deduction of interest on his other loans.

After paying the deficiencies assessed by the Commissioner, Mr. and Mrs. Levitt brought this suit for refund of these additional taxes. The district court sustained the Commissioner's position on deficiencies for interest on loans attributable to the Levitts' acquisition of Treasury bonds but sustained Mr. Levitt's deduction of interest on other loans from the Bank. ³ The Levitts bring this appeal (No. 74-1572) and the Government cross-appeals (No. 74-1582).

We affirm the district court with respect to Mr. and Mrs. Levitt's appeal, but we sustain the Government's position in its cross-appeal and remand for a proper allocation of the interest deduction to be disallowed on Mr. Levitt's loans for purposes other than the purchase of Treasury bonds.

We will restate the operative facts as related in the district court opinion and as contained in the parties' stipulation of facts.

Nelle Levitt

Since 1958 Mrs. Levitt has annually held in excess of $80,000 in tax-exempt municipal bonds. These holdings increased substantially from 1961 to 1965. ⁴ In October and December of 1960, she borrowed $84,000 from the Bank and applied the entire proceeds to purchase United States Treasury bonds. On September 9, 1964, she borrowed $85,891 from the Bank and purchased the same amount of Treasury bonds. In late December of 1965, she borrowed $40,000 and bought Treasury bonds in that amount. As of the end of 1964, she owned tax-exempts in the face amount of approximately $293,000; by the end of the calendar year 1965, she owned tax-exempts in the face amount of approximately $398,000. She retained all Treasury bonds acquired with bank loans; and her loan balance, equalling her investment in Treasury bonds and on which she had never paid any principal, totalled $209,891 at the end of 1965. According to the parties' briefs, Mrs. Levitt deposited no collateral (other than the Treasury bonds themselves) with the Bank as security for any of these loans. At year-end 1963, Mrs. Levitt's net worth exceeded $600,000 and, by year-end 1965, $1,000,000. She acquired the taxable United States Treasury bonds because, although purchased at a discount, they can be redeemed at par by her estate to pay federal estate taxes.

Ellis Levitt

The circumstances relating to Mr. Levitt's loans from the Bank for the purpose of purchasing Treasury bonds are similar to those of his wife. He owned tax-exempt securities in amounts substantially greater than the total value of the loans that he obtained from the Bank from 1959 through 1965. During this period he borrowed $415,000 for the specific purpose of purchasing United States Treasury bonds for the payment by his estate of federal estate taxes. In addition, Mr. Levitt borrowed $516,746 from the Bank during 1961 to 1965 for other purposes: (1) In 1961, he purchased from his employer the insurance policies carried by it on his life. He did so by borrowing $260,000 against the cash value of these policies. (2) In 1963, he borrowed $42,000 to purchase land for a real estate development construction of a post office in Des Moines. (3) In 1964, he borrowed $107,072 for construction payments on this post office. (4) In 1965, he borrowed $67,674 to purchase real estate for investment; $40,000 to pay a liability incurred in a motel venture; and $27,000 to repay a loan to his wife. ⁵

Mr. Levitt's loans were for varying terms, including notes payable upon demand notes due in one year, notes due in less than one year, and notes renewable when due. During 1963-65, his bank borrowings increased as he renewed outstanding loans in addition to taking out new loans. As of September 18, 1963, he had deposited with the Bank $165,000 in tax-exempts, $250,000 in United States Treasury bonds, and $235,000 in insurance policies, totalling $650,000 at market value, ⁶ to carry his indebtedness, which then amounted to $545,000. On September 28, 1964, he reduced his deposited tax-exempt securities to $154,000 but, by August 31, 1965, these deposits increased to $261,000 as he raised his borrowings to $934,000. As his borrowings increased from 1963 through 1965, he deposited additional Treasury bonds and additional life insurance policies with increased cash values. Consequently, the Bank held a total of $981,000 in collateral for loans in the amount of $934,000 as of year-end 1965.

I. Legal Principles.

The parties agree on the basic principles controlling this case but disagree as to their application. Those principles have been succinctly stated in Israelson v. United States, 367 F.Supp. 1104 (D.Md.1973), aff'd mem.,508 F.2d 838 (4th Cir. 1974):

The following principles are well established. Section 265(2) does not become operative merely because the taxpayer incurred or continued indebtedness at the same time that he held tax-exempt securities. Rather, the Commissioner must establish a sufficiently direct relationship between the debt and the carrying of the tax-exempt bonds. The touchstone for decision is the purpose of the taxpayer in incurring or continuing the indebtedness. A finding of a taxpayer's purpose does not depend solely upon looking into his mind and learning what he was thinking; although his intentions are relevant, his purpose may be inferred from his conduct and from the circumstances that confronted him. The taxpayer has the burden of overcoming the presumption of validity of the Commissioner's determination of deficiencies. (Id. at 1106-07 (emphasis in original).)

In Illinois Terminal R. R. v. United States, 375 F.2d 1016, 179 Ct.Cl. 674 (1967), the court enunciated the test for proving a tax-avoidance relationship between continuing a loan and purchasing or carrying tax-exempts:

The real issue here is whether the remaining loan, regardless of its size of correlation with the cost basis of other assets, was continued for the purpose of enabling plaintiff to own the Series "B" bonds of the city of Venice. Of course, the resolution of this issue requires a connection-type inquiry, which will be somewhat different from the inquiry into situations where the issue is whether indebtedness was incurred to purchase tax-exempt bonds. It is necessary to establish a sufficiently direct relationship of the continuance of the debt for the purpose of carrying the tax-exempt bonds. (Id. at 1020-21.)

See also Bishop v. Commissioner, 41 T.C. 154, 159-61 (1963), aff'd, 342 F.2d 757 (6th Cir. 1965). The court then concluded:

What plaintiff seeks to do is to receive tax-free income and at the same time deduct the interest expense attributable to obtaining that tax-free income. This is the double benefit prohibited by section 265(2). A business cannot escape taxation of income by the device of purchasing or carrying tax-exempt securities with borrowed money not required to carry on its regular functions. (375 F.2d at 1021.)

In a recent decision, the Tax Court repeated the need to prove a direct relationship between a borrowing or its continuation and the purchase or carrying of tax-exempt securities before § 265(2) becomes operative Section 265(2) does not become operative merely because the taxpayer incurred or continued indebtedness at the same time that he held tax-exempt securities. "The mere simultaneous existence of an indebtedness and the holding of tax-exempt securities does not cause section 265(2) to apply." * * * Rather, section 265(2) is applicable only when "the purpose for which the indebtedness is incurred or continued is to purchase or carry tax-exempt obligations" (emphasis supplied). * * * Thus, the deduction will be disallowed only where there is a "sufficiently direct relationship" between the incurrence or continuance of the indebtedness and the purchasing or carrying of the tax-exempt securities. (Mariorenzi v. Commissioner, 32 T.C.M. 681, 684 (1973), aff'd per curiam, 490 F.2d 92 (1st Cir. 1974) (citations omitted).)

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