Phipps v. United States

• Decision Date: 16 July 1969
• Docket Number: No. 237-67.,237-67.
• Citation: 188 Ct. Cl. 531,414 F.2d 1366
• Parties: Ogden PHIPPS and Lillian B. Phipps v. The UNITED STATES.
• Court: U.S. Claims Court

188 Ct. Cl. 531, 414 F.2d 1366 (1969)

Ogden PHIPPS and Lillian B. Phipps v. The UNITED STATES.

No. 237-67.

United States Court of Claims.

July 16, 1969.

Irving H. Bull, New York City, attorney of record, for plaintiffs. Kenneth L. MacCardle, Port Washington, N. Y., and Dunnington, Bartholow & Miller, New York City, of counsel.

Donald T. Fish, Washington, D. C., with whom was Asst. Atty. Gen., Johnnie M. Walters, for defendant. Philip R. Miller, Washington, D. C., of counsel.

Before COWEN, Chief Judge, and LARAMORE, DURFEE, DAVIS, COLLINS, SKELTON, and NICHOLS, Judges.

ON PLAINTIFFS' AND DEFENDANT'S MOTIONS FOR SUMMARY JUDGMENT

LARAMORE, Judge.

Plaintiffs, Ogden Phipps and Lillian B. Phipps, filed joint income tax returns for the calendar years 1957 and 1958. Deficiencies were assessed and paid.¹ Plaintiffs filed timely claims for refund; the claims were disallowed, and this suit followed. The parties have agreed to a stipulation of facts. Plaintiffs have moved for summary judgment and defendant has cross-moved for summary judgment.

Throughout 1957 and 1958, Ogden Phipps (referred to as taxpayer) was a limited partner in the partnership known as Smith, Barney & Co. Plaintiffs claim that the Commissioner of Internal Revenue, acting pursuant to section 265(2)² of the Internal Revenue Code of 1954, improperly included in Mr. Phipps' income amounts equal to the interest paid by the partnership with respect to partnership loans secured by pledges of tax-exempt obligations that he had contributed to the partnership.

A separate issue involves the deductibility of uninsured casualty losses. During 1957, Mr. Phipps sustained an uninsured casualty loss of $19,333.33 as the result of the death of a race horse. In the 1957 return, he offset this loss against capital gain received on the sale of other horses. Also during 1957, he sustained a $400 uninsured casualty loss on the death of a farm horse. This amount was reported as an ordinary income loss, but in the deficiency assessment, the Commissioner treated it as a section 1231 loss.³

During 1957, Mrs. Phipps sustained an uninsured casualty loss of $4,200 as a result of the death of a race horse and another uninsured loss of $6,406.25 as a result of the "breakdown" (unfit for racing) of a race horse. These were reported as capital losses. The total combined uninsured casualty losses for 1957 were $30,339.58.

During 1958, Mr. Phipps sustained uninsured casualty losses of $137,050 as the result of storm damage and $1,259.78 as the result of damage to a boat. Mrs. Phipps sustained an uninsured casualty loss of $550. These were reported as deductions from ordinary income under section 165.⁴ In his deficiency assessment, the Commissioner treated these as section 1231 losses.

On the basis of our opinion in Pennsylvania Power & Light Company v. United States, Ct.Cl., 411 F.2d 1300, decided June 20, 1969, we find that plaintiffs are not entitled to recover a refund on the uninsured casualty loss issue. We also find that plaintiffs are entitled to recover on the interest deduction issue. We will consider the interest question first.

I. Interest deduction

Mr. Phipps became a general partner in Smith, Barney & Co., a stock brokerage firm, at its formation at the close of business on December 31, 1937. As of March 31, 1956, he became a limited partner.

Mr. Phipps' initial contribution to the general partnership was $300,000 in cash. Between 1937 and 1956, his contribution was at times temporarily higher or lower in amount but it was $300,000 immediately prior to his withdrawal as a general partner.

The Articles of Partnership (as revised June 29, 1956), which converted Mr. Phipps' interest to that of a limited partner, provided for an aggregate total capital of $4,297,000, of which $3,047,000 was contributed by 23 general partners and $1,250,000 by four limited partners. As one of the limited partners, Mr. Phipps contributed $1,000,000 in agreed value securities. These securities were all issued by states, counties, cities or other political instrumentalities and are conceded to have been exempt from Federal income tax on their interest. The pertinent provision of the 1956 agreement, which explains the rights of the partnership and plaintiff with respect to the tax-exempt securities, is set forth below.⁵

The limited partners' capital contributions, including that made by Mr. Phipps, bore five percent interest per annum, plus another one percent per annum, if earned. General partners received their five percent interest on capital contributions only if earned. Mr. Phipps had an additional right to receive the tax exempt interest on the securities he had contributed. His five percent interest return, however, was reduced by an amount equal to the interest charged to the partnership to borrow capital using Mr. Phipps' securities as collateral. The Articles of Partnership provision which explains this compensation agreement is set forth below.⁶

In 1957 and 1958, Mr. Phipps was paid an amount equal to five percent of the value of his securities, as interest. From that amount, the partnership deducted the interest it had paid on loans that it made using his securities as collateral. The net amount was paid. In 1957, he was entitled to a five percent return of $48,474, less credit for interest of $28,607.14 paid by the partnership on its loans, or a net return of $19,866.87. In 1958, he was entitled to $35,998.10, less the interest paid by the partnership of $21,211.14, or a net return of $14,786.93. These amounts were paid to him. In addition, each year he received the tax-exempt interest paid by the issuers of the securities.⁷

The bookkeeping procedure which effected this agreement was described by plaintiff as follows: During the years in question, Smith, Barney & Co. made a monthly memorandum of the amount of interest it had paid on the loans. An account for "Reserve Interest on Limited Capital" was set up on its books, and at the end of each month the account was credited with the total amount of interest accrued with respect to the limited capital. This included the net amount due Mr. Phipps which the partnership calculated as 1/12th of the interest on capital contributions computed at the rate of five percent per annum, less the interest paid by the firm with respect to the loans secured by its pledge of the tax-exempt securities. At the end of the year, the account was debited for the total amount due Mr. Phipps and a credit entry was made to the General Ledger account of Ogden Phipps. When earnings and profits were sufficient, the additional one percent interest was credited to his account. Shortly after the close of the year, the amount in the General Ledger account was transferred to the Customer's Ledger account of Ogden Phipps.

After an audit, the District Director of the Internal Revenue added to his income the interest expense paid by the partnership which amounts had been deducted from his five percent return: $28,607.14 for 1957 and $21,211.14 for 1958. These sums were deemed non-deductible interest paid to carry tax-exempt obligations and were considered expenses incurred by Mr. Phipps rather than by the partnership.⁸

Plaintiffs argue that section 265(2) is inapplicable because, inter alia, Mr. Phipps did not claim any deduction for interest on the indebtedness; Smith, Barney & Co. made the loans and was obligated to pay the interest; he did not guarantee the loans, nor was he personally liable for any part of the loan and he did not participate in the negotiations for any loan. Therefore, he had no indebtedness, paid no interest, and claimed no interest deduction. Accordingly, section 265(2) is inapplicable.

We must admit that Mr. Phipps in his individual capacity neither incurred any debt, nor paid or deducted any interest. But our inquiry is not, therefore, at an end.

Recently, the Tax Court, in John E. Leslie, 50 T.C. 11 (1968), reviewed the legislative history of section 265(2). It said:

* * * The predecessor of section 265(2) first became a part of the law in the Revenue Act of 1917 (40 Stat. 300, 330, 334). The statute at that time provided that a deduction is allowed for interest paid on indebtedness "except on indebtedness incurred for the purchase of obligations or securities the interest upon which is exempt from taxation as income under this title." The Revenue Act of 1918 (40 Stat. 1066) added the words "or continued" after "indebtedness incurred."

Also in connection with the Revenue Act of 1918, the House Ways and Means Committee, stating that the statute was "difficult of administration, for in many cases it is impossible to tell for what purpose indebtedness is incurred," proposed that interest should be deductible only to the extent that it exceeded the amount of tax-exempt interest received by the taxpayer. H.Rept.No.767, 65th Cong., 3d Sess., p. 10 (1918). The Senate rejected the House proposal, and the House receded in conference. S.Rept. No.617, 65th Cong., 3d Sess., pp. 6-7 (1918); H.Rept.No.1037, 65th Cong., 3d Sess. (1919), 1939-1 C.B. (Part 2) 135. Then, in connection with the Revenue Act of 1924 and the Revenue Act of 1926, the House proposed similar amendments that would allow a deduction for interest not incurred in carrying on a trade or business only to the extent that such interest (and, in the Revenue Act of 1924, nonbusiness losses) exceeded income from tax-exempt obligations. H.Rept.No.179, 68th Cong., 1st Sess., p. 21 (1924); H.Rept.No.1, 69th Cong., 1st Sess., p. 7 (1925). The Senate again rejected the House amendments, and the House receded in the conferences, S. Rept.No.398, 68th Cong., 1st Sess., p. 24 (1924); H.Rept.No.844, 68th Cong., 1st Sess., p. 19 (1924). S.Rept.No. 52, 69th Cong., 1st Sess., p. 21 (1926); H.Rept.No.356, 69th Cong., 1st Sess., p. 21 (1926).

Finally, as a part of the Revenue Act of 1934, the House again proposed to amend the predecessor of section 265(2). * * *.

The Senate

...