Phillips v. Frank
| Decision Date | 10 October 1961 |
| Docket Number | No. 17219.,17219. |
| Parties | Earl A. PHILLIPS and Dorothy M. Phillips, Appellants, v. William E. FRANK, District Director of Internal Revenue, Appellee. |
| Court | U.S. Court of Appeals — Ninth Circuit |
Warren V. Clodfelter, Allen A. Bowden and Birney N. Dempcy, Seattle, Wash., for appellants.
Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson, Robert N. Anderson and Michael I. Smith, Attys., Dept. of Justice, Washington, D. C., Charles P. Moriarty, U. S. Atty., Seattle, Wash., for appellee.
Before BARNES, JERTBERG and MERRILL, Circuit Judges.
This is an action to recover federal income taxes allegedly overpaid by appellants for the calendar years 1955, 1956 and 1957, recovery of which was denied by the district court. See Phillips et al. v. Frank, etc., D.C., 185 F.Supp. 349.
Appellants are husband and wife who filed joint returns on the cash basis for the taxable years above stated. The husband, Earl A. Phillips, will hereinafter be called the taxpayer.
During the years in question the taxpayer's accounting records were kept on the cash receipts and disbursements method, and during these years the taxpayer received payments on real estate contracts owned by him. All of said contracts were purchased by taxpayer in the years in question or prior thereto. Taxpayer did not perform any services in the making of the contracts, but only purchased contracts negotiated by others, the unpaid principal balances of which were payable in periodic installments. In each instance, the price paid was an agreed percentage less than the principal amount due on the contract, which percentage was not the same on all contracts. In other words, they were purchased at a discount. Contracts of the type involved were bought and sold by investors, and all of the contracts owned by taxpayer during the years in question were held as investments. Taxpayer considered each contract to have a value equal to the amount paid by him therefor at the time of the purchase. No security for payment of any of the contracts was held by taxpayer other than a right to repossess in case of default by the vendee, and no promissory note was held by the taxpayer for the unpaid balance of the purchase price.
While one of the admitted facts stated in the pretrial order is that the contracts involved in the instant case are of a type bought and sold by investors, the uncontradicted testimony before the district court is that there is no open market for the sale of the contracts in question; and that they were difficult to sell and that it took considerable time — two or three years — to dispose of them. It is further uncontradicted in the record that a large portion of the contracts purchased by the taxpayer were "highly speculative", consisting of second, and in some instances third liens, on the real properties which were the subject of the contracts, which prior liens taxpayer was required to keep "in order" so as to be able to convey title upon payment in full of the contract price. In some instances, taxpayer suffered losses due to defaults by vendees which resulted in repossessions and sales of the properties. Each contract was purchased by taxpayer on an individually negotiated basis in light of such factors as the value of the real property involved, the existence of prior liens, the burdens and responsibilities of the taxpayer, and the financial ability and credit standing of the vendee.
In posing the question for decision, the district court stated:
Phillips et al. v. Frank, etc., supra, 185 F.Supp. at page 350.
In disposing of the issue adversely to the taxpayer the district court stated:
Ibid., at page 350.
It is not completely clear in what sense the district court used the term "discount income" but the clear implication is that the court used the term to mean a charge for the use of money and, therefore, equivalent of interest. Interest in the business world commonly presupposes a debtor-creditor relationship under which a lender advances capital to a borrower who promises to pay the amount borrowed plus an additional amount as compensation for the use of money. Income earned by lending a sum of money less than the face value of the obligation received as consideration for the loan may be equivalent to interest. Such income has been frequently denominated "discount income" and we recognize that such income should have and generally has had the same tax treatment as interest.
In the instant case, taxpayer purchased for cash (no loans being involved) from vendors thereof executory contracts entered into between such vendors and other persons covering the sale and purchase of real properties. None of such vendors agreed to pay or return to taxpayer any sum, either principal or interest. The contracts were acquired by taxpayer unconditionally, not by way of security for loans. All taxpayer received from the vendors as consideration for the purchase money paid to them were assignments of executory contracts. The district court found as a fact that such contracts were purchased by taxpayer. Clearly, the transactions between the taxpayer and the several vendors were sales and purchases. Under the facts of this case it would be a great distortion to hold that any part of the contract payments received by taxpayer for the periods under review from the several vendees constitutes "discount income" and therefore equivalent of interest.
It is clear, however, that the district court regarded the amount of discount from the unpaid principal balance at which each contract was purchased as income to taxpayer and that a portion of such income was received by taxpayer as income taxable to him, as a pro-rated part of each principal payment on the unpaid principal balance of each contract.
Only four cases have been called to our attention wherein consideration has been given the tax treatment to be accorded periodic payments received by investors on notes, mortgages, or contracts relating to the sales of real properties, which notes, mortgages, or contracts were acquired by investors by purchase from vendors who, upon sale of real properties, received such notes, mortgages, or contracts from vendees of such real properties in payment, or part payment, of the purchase price of such real properties as distinguished from the tax treatment to be accorded periodic payments received by vendors from vendees on notes, mortgages, or contracts given by such vendees in payment, or part payment, of the purchase price in the sales of real properties.
The four cases were decided by the Tax Court and its predecessor, the Board of Tax Appeals.
The earliest case is Harris Trust and Savings Bank v. Commissioner of Internal Revenue, 1931, 24 B.T.A. 498. In this case taxpayer purchased a real estate contract (no promissory note involved) for $151,384.64 upon which $273,332.16 remained to be paid in 164 monthly installments. The fair market value of the contract at date of purchase was $150,000. The Commissioner urged that the transaction entered into by the taxpayer "partakes of the nature of a deferred payment sale on the installment basis and that profits should be reported yearly upon payments received." Such contention was rejected by the Board of Tax Appeals which held that the taxpayer was not required to report any taxable gain until taxpayer had received payments aggregating his costs in the acquisition of the contract.1
The next case is Vancoh Realty Co. v. Commissioner of Internal Revenue, 1936, 33 B.T.A. 918, cited by the district court in support of its decision. This case involved a corporation engaged in the business of buying at a discount notes secured by mortgages and trust deeds. The taxpayer kept its books on an accrual basis. In the course of the opinion it is stated:
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