Mitchell v. C.I.R., 94-1966

• Decision Date: 16 January 1996
• Docket Number: No. 94-1966,94-1966
• Citation: 73 F.3d 628
• Parties: -401, 96-1 USTC P 50,042 Louis A. MITCHELL, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 628

73 F.3d 628

77 A.F.T.R.2d 96-401, 96-1 USTC P 50,042

Louis A. MITCHELL, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 94-1966.

United States Court of Appeals Sixth Circuit.

Decided Jan. 16, 1996.

Before: SILER and DAUGHTREY, Circuit Judges; ROSEN, District Judge. ^*

ROSEN, District Judge.

Petitioner/Appellant Louis A. Mitchell appeals a decision of the United States Tax Court disallowing a deduction of $755,172 which Mitchell had claimed as a business expense on his federal income tax return. This amount was a "restitution" payment made by Mitchell in order to keep stocks which he had obtained in violation of federal banking regulations. The IRS disallowed the claimed deduction finding that the amount paid was not deductible as an ordinary and necessary business expense. The tax court ruled in favor of the IRS, holding that the $755,172 was a capital expenditure necessary to retain ownership of the stock which had to be capitalized into the basis of the stock. For the reasons stated herein, we affirm.

I. STATEMENT OF FACTS

During 1987 and 1988, Petitioner Louis A. Mitchell served as the Chairman of the Board of Directors and Chief Executive Officer of County Savings Bank, a thrift savings and loan association in Columbus, Ohio. County Savings Bank was a wholly-owned subsidiary of First Financial Group, Inc. ("FFG"). Mr. Mitchell was also Chairman of the Board of FFG and that institution's majority stockholder, holding approximately 95% of the corporation's stock. In his capacity as an officer and director of County Savings and FFG, Mitchell had oversight responsibility for the Bank's and FFG's Investment Committees.

In 1987, County Savings Bank realized substantial capital gains from various securities transactions. In order to minimize the Bank's anticipated tax liability on its capital gains, the Investment Committee decided to sell its stock in Home and City Savings Bank. The Home and City stock was selected for sale because County Savings Bank's stock in Home and City represented the single largest unrealized capital loss in County's investment portfolio, totaling $2,079,670, and could be used to offset County Saving Bank's capital gains.

Mitchell apparently decided that he wanted to personally purchase the shares of Home and City which County Savings had decided to sell. Home and City was a publicly traded stock on the over-the-counter market; however, Mitchell wanted to purchase the stock through a private sale ¹.

Mitchell consulted with Kenneth Cooke of Price Waterhouse, who was County Savings' accountant. Mr. Cooke advised petitioner, that if he were to buy the stock through a private sale it would constitute a sale to a "related party", which would preclude the Bank from recognizing any resulting tax loss. Thus, the reason for the sale would be undermined.

Notwithstanding Cooke's advice, Mitchell decided on his own that the "related party" consequences could be avoided through a "strawman" transfer. Mitchell provided the funds for the purchase of the stock to two of the Bank's vice-presidents, Benson Scott Beaver and Charles W. Claggett, III, and had them buy the desired stock for him.

In December 1987, Beaver and Claggett purchased 286,400 shares of Home and City stock owned by Bank through a private sale conducted by Dean Witter at the price of $13 per share. In accordance with their agreement with Mitchell, Beaver and Claggett then transferred 269,400 shares of the stock to Mitchell in January 1988. Pursuant to options granted to them by Mitchell, Beaver and Claggett each retained 5,000 shares and the remaining 7,000 shares were sold to various officers of the Bank for $13 per share. At the time of the January 1988 transfer of the shares, the market price of the stock was $16 per share.

Subsequent to the sale, as part of County Savings' annual year-end audit, the Bank's Price Waterhouse accountants informed Mitchell that the structured sale of the Home and City stock still precluded the Bank from deducting the now-realized loss. Mitchell was further advised that the private sale violated 12 C.F.R. Sec. 563.41 of the Federal Home Loan Bank Board ("FHLBB") regulations, which provides that a sale to an affiliated party may be done only with the express, written permission and authority of the Principal Supervisory Agent of the FHLBB. ² The sale of the Home and City stock to the Bank's vice-presidents was made without the requisite permission. As a result, County Savings was prohibited from deducting the loss against its capital gains, effectively costing it a tax deduction of $755,172.

Upon being advised by the accountants of the failure to comply with the requirements of Sec. 563.41 and the consequences, Mitchell informed the FHLBB Supervisory Agent, Kurt Kreinbring, of the regulatory violation. Mr. Kreinbring told Mitchell that, as Chairman and CEO, and as primary purchaser of the stock, he had two options: He could either void the entire sale and return the Home and City stock to County Savings, or pay the Bank $755,172, the value of the Bank's lost tax benefit.

By this time, the market value of Home and City's stock had appreciated substantially and Mitchell's equity interest in the stock correspondingly increased to approximately $3.3 million. Not surprisingly, Mitchell decided to pay the $755,172 as restitution for the loss sustained by the Bank and keep the stock.

Mitchell included the $755,172 in his 1988 income tax return as a Schedule C loss incurred in connection with a trade or business and, thereby, attempted to deduct it under 26 U.S.C. Sec. 162 ³. The Internal Revenue Service disallowed this deduction, and on June 22, 1992 sent a notice of deficiency to Mitchell informing him that the $755,172 was a non-deductible capital expenditure. Mitchell filed a timely petition seeking redetermination of the deficiency with the United States Tax Court. A trial was held on February 14, 1994. The Tax Court determined that the $755,172 payment stemmed from the violation of 12 C.F.R. Sec. 563.41 and was done to protect Mitchell's right to retain the stock. As such, the Tax Court ruled that the restitution payment was a capital expenditure, and not a viable business deduction. Accordingly, the court ruled that the $755,172 payment had to be capitalized into the basis of the stock purchased by Mitchell. ⁴

II. DISCUSSION

A. STANDARD OF REVIEW

This matter presents for appellate review the propriety of an I.R.C. Sec. 162 deduction. The facts are uncontroverted, and the only question presented in this appeal is whether the law as applied to the facts fulfills the statutory requirement. As such, the appropriate standard is de novo review. Pollei v. Commissioner, 877 F.2d 838, 839 (10th Cir.1989); O'Neill v. Commissioner, 994 F.2d 302, 304 (6th Cir.1993).

B. THE TAX COURT CORRECTLY DETERMINED THAT THE RESTITUTION PAID BY PETITIONER TO THE BANK CONSTITUTED A CAPITAL EXPENDITURE, NOT AN ORDINARY AND NECESSARY BUSINESS EXPENSE.

The issue in this case is the application of 26 U.S.C. Sec. 162(a) of the Internal Revenue Code as it applies to "ordinary and necessary business expenses", versus 26 U.S.C Sec. 263 and the definition of a "capital expenditure". ⁵

Under 26 U.S.C. Sec. 162(a), deductions are allowed for, "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Capital expenditures under Sec. 263, however, are not deductible in the year of the expenditure, but rather must be capitalized into the basis of the capital asset and amortized over the asset's useful life.

Under 26 U.S.C. Sec. 162, voluntary expenditures incurred by a taxpayer may qualify as ordinary and necessary business expenses if such payments are made to prevent injury to the taxpayer's business reputation. Gould v. Commissioner, 64 T.C. 132, 135, 1975 WL 3011 (1975). Yet, regardless of purpose, an expense is not deductible if it is used for the acquisition of a capital asset. Barrett v. Commissioner, 96 T.C. 713, 722-24, 1991 WL 80644 (1991); Bradford v. Commissioner, 70 T.C. 584, 1978 WL 3325 (1978); Wagner v. Commissioner, 78 T.C. 910, 1982 WL 11101 (1982); Mitchell v. Commissioner, 428 F.2d 259 (6th Cir.1970), reversing and remanding 52 T.C. 170, 1969 WL 1668 (1969), cert. denied, 401 U.S. 909, 91 S.Ct. 868, 27 L.Ed.2d 807 (1971).

It is well established that, "[s]ince the inception of the present federal income tax in 1913, capital expenditures have not been deductible." Woodward v. Commissioner, 397 U.S. 572, 574, 90 S.Ct. 1302, 1304, 25 L.Ed.2d 577 (1970). Furthermore, "[i]t has long been recognized, as a general matter, that costs incurred in the acquisition or disposition of a capital asset are to be treated as capital expenditures." Id. at 575, 90 S.Ct. at 1305.

Treasury Regulation Sec. 1.263(a)-2(a) defines a capital expenditure as, "the cost of acquisition ... of ... property having a useful life substantially beyond the taxable year." The Supreme Court has also held that where a payment results in the acquisition or retention of a capital asset, the expenditure is considered capital. Godfrey v. Commissioner, 335 F.2d 82, 85 (6th Cir.1964), cert. denied, 379 U.S. 966, 85 S.Ct. 660, 13 L.Ed.2d 560 (1965). See also, Arkansas Best Corp. v. Commissioner, 485 U.S. 212, 108 S.Ct. 971, 99 L.Ed.2d 183 (1988) (holding that a taxpayer's motivation in purchasing an asset is irrelevant; the only question is whether the asset is "property held by a taxpayer (whether or not connected with his business)." Id. at 223, 108 S.Ct. at 978).

The foregoing authorities make clear that the Home and City stock at issue in this case must be considered a capital asset. The issue, therefore, is how to characterize Mitchell's restitution payment of $755,172 to the Bank, which he attempted to deduct as a business expense on his personal income tax return.

In order to determine the characterization of settlement payments, ...