Security Bank Minnesota v. C.I.R.

• Decision Date: 21 May 1993
• Docket Number: No. 92-2247,92-2247
• Citation: 994 F.2d 432
• Parties: -1959, 61 USLW 2759, 93-1 USTC P 50,301 SECURITY BANK MINNESOTA, Appellee, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Appellant.
• Court: U.S. Court of Appeals — Eighth Circuit

Page 432

994 F.2d 432

71 A.F.T.R.2d 93-1959, 61 USLW 2759,

93-1 USTC P 50,301

SECURITY BANK MINNESOTA, Appellee, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Appellant.

No. 92-2247.

United States Court of Appeals Eighth Circuit.

Submitted Dec. 17, 1992.

Decided May 21, 1993.

Charles Bricken, Dept. of Justice, Washington, DC, argued (Gary R. Allen, James A. Bruton and Jonathan S. Cohen, on the brief), for appellant.

Gary Hansen, Minneapolis, MN, argued (Sue Ann Nelson and Terrance A. Costello, on the brief), for appellee.

Before MAGILL, Circuit Judge, HEANEY, Senior Circuit Judge, and BEAM, Circuit Judge.

MAGILL, Circuit Judge.

This case presents an issue of first impression: whether § 1281 of the Internal Revenue Code, which requires certain taxpayers to accrue discount and interest income on certain short-term obligations, requires a commercial bank, otherwise reporting its income on the cash basis, to report interest income on short-term loans made to borrowers in the ordinary course of business as it accrues. The tax court held that § 1281 did not apply to such loans. We agree, and affirm.

I. BACKGROUND

A. Factual Background

This case involves an asserted deficiency in Security Bank's federal income tax for the taxable year 1986. The case arises on facts stipulated before the tax court.

Security Bank Minnesota (Security) is a small commercial bank in Albert Lea, Minnesota, a rural, agricultural community. It is a Minnesota corporation with its principal place of business in Minnesota. Much of Security's business consists of agricultural operating loans to farmers.

At all material times, Security was a bank as defined in I.R.C. § 581. During 1986, Security made loans of varying duration, including loans of less than one year, one year, and more than one year. These loan transactions were documented by one-page promissory notes signed by the borrower and payable to Security. Security had various business reasons for using a note with a term of one year or less; ¹ it is uncontroverted that the loans were not made for tax-motivated considerations.

During 1986, Security made certain loans that were documented by notes with a stated maturity date of the first anniversary of the note. The parties refer to these loans as "Category X Loans." During 1986, Security had interest income of $24,552.09 that had accrued, but was not yet received, on its Category X Loans.

During 1986, Security also made loans that were for a period of less than one year, which the parties refer to as "Category Y Loans." Security had interest income respecting these Category Y Loans of $80,746.42 that accrued, but was not received, in 1986.

For 1986, Security reported interest income from its Category X and Category Y Loans as it was received, pursuant to the cash method of accounting. ² Security did not report as income in 1986 the accrued, but not yet received, interest on its Category X and Category Y Loans.

Subsequently, the Internal Revenue Service audited Security's 1986 income tax return and determined that I.R.C. § 1281(a)(2) required Security to depart from its normal cash basis of reporting income and to report as taxable income for 1986 the $105,299 of accrued interest from its Category X and Category Y Loans. The Commissioner's proposed increase to Security's income for 1986 resulted in an alleged deficiency of $48,437.80 in Security's 1986 income tax. Security then filed a timely petition with the tax court, which held that I.R.C. § 1281 did not require the accrual of stated interest on undiscounted bank loans made in the ordinary course of business. This appeal followed.

I.R.C. § 1281 provides:

(a) General rule.--In the case of any short-term obligation to which this section applies, for purposes of this title--

(1) there shall be included in the gross income of the holder an amount equal to the sum of the daily portions of the acquisition discount ³ for each day during the taxable year on which such holder held such obligation, and

(2) any interest payable on the obligation (other than interest taken into account in determining the amount of the acquisition discount) shall be included in gross income as it accrues.

Section 1281 applies to short-term obligations held by certain classes of taxpayers, including "any short-term obligation which ... is held by a bank (as defined in section 581)...." I.R.C. § 1281(b)(1)(C). Finally, a short-term obligation, for purposes of § 1281, is defined as "any bond, debenture, note, certificate, or other evidence of indebtedness which has a fixed maturity date not more than 1 year from the date of issue." I.R.C. § 1283(a)(1)(A).

B. The Tax Court Decision

The tax court held that Congress did not intend to require banks such as Security to accrue the stated interest on their loans made in the ordinary course of business. The court initially noted that §§ 1281 and 1283 are contained in Subpart V of Subchapter P of the Code, concerning special treatment of bonds and other debt instruments. According to the tax court, "the common thread of the sections included in Part V (i.e., sections 1271-1288) is that amounts defined as discount are to be taken into account as ordinary income in some appropriate manner." Tax Court Op. at 14. The court concluded it would have to read the statutory provisions in that context. When it turned to the text of the statute, the tax court noted that in defining the short-term obligations covered by the accrual rules, Congress spoke in terms of obligations that are issued, but did not mention loans. According to the tax court, when Congress intends to cover loans for tax purposes, it uses the terms "loan" and "made." Failure to use those terms in § 1283 convinced the tax court that § 1283 did not clearly extend to bank loans made in the ordinary course of business.

The tax court then turned to the legislative history. It determined that in enacting §§ 1281 through 1283, Congress intended to prevent certain taxpayers from taking advantage of the special rules for deferral of discount on purchased obligations, and that such a purpose did not apply to loans such as Security's, which are not purchased and carry no discount.

II. DISCUSSION

In order to understand the issue presented here, some background is necessary. While § 1281(a) today requires the accrual of stated interest as well as discount, the original version enacted in 1984 required the accrual only of acquisition or original issue discount. Section 1281(a)(2), requiring the accrual of stated interest, was enacted as a technical correction in the Tax Reform Act of 1986, Pub.L. No. 99-514, § 1803(a)(8), 100 Stat. 2085, 2794 (1986). Both Security and the Commissioner agree that the addition of § 1281(a)(2) did not expand the kinds of obligations subject to the mandatory accrual rules. See Appellant's Br. at 21-22; Appellee's Br. at 7. Thus, the question for decision ultimately becomes whether as initially enacted in 1984, the obligations covered by § 1281 included bank loans made in the ordinary course of business.

A. The Parties' Contentions

The parties provide vastly differing interpretations of the statutory language, and both contend that the language clearly supports their position.

Security claims that as initially drafted, § 1281 applied only to obligations purchased from third parties at a discount. Security points to the references to acquisition discount in §§ 1281(a)(1) and 1283(a)(2) and argues that § 1281 applies only to investors who purchase, i.e., "acquire" short-term obligations with acquisition discount and to taxpayers who purchase or "acquire" discounted short-term nongovernmental obligations involving original issue discount. In further support of this argument, Security points to the use in various other sections in Part V (e.g., §§ 1272, 1273, 1283) of terms such as purchase, agreement, price, and issue. Security also notes that the effective date of § 1281 has always been stated in terms of instruments "acquired" after a certain date, now December 31, 1985. Technical and Miscellaneous Revenue Act of 1988, Pub.L. No. 100-647, § 1018(c)(1), 102 Stat. 3578 (1988); see also Deficit Reduction Act of 1984, Pub.L. No. 98-369, § 44(d), 98 Stat. 560 ("obligations acquired after the date of enactment," July 18, 1984), and Tax Reform Act of 1986, Pub.L. No. 99-514, § 1803(a)(8)(A), 100 Stat. 2085, 2794 (1986) (amendments "[e]ffective with respect to obligations acquired after September 27, 1985").

Security also claims that the use of the term "issue" in the definition of "short-term obligation" in § 1283 demonstrates that bank loans are not covered by the mandatory accrual rules. According to Security, when Congress wishes to deal with the tax treatment of loans, it uses the terms "loan" and "made."

The Commissioner reads the language quite differently. It claims that § 1281 initially covered all short-term obligations, see § 1283(a)(1)(A), held by a bank, discounted or not. See § 1281(b)(1)(C). The obligations in question are short-term obligations (notes with a fixed maturity date not more than one year from the date of issue), ⁴ and Security is a bank. Therefore, the Commissioner reasons, Security must accrue the interest on these loans.

The Commissioner disputes Security's contention that the use of the term "acquisition discount" in § 1281(a) limits the scope of § 1281 to discounted obligations. First, the Commissioner notes that § 1281 is not limited to obligations "acquired" in a specific manner. The statute speaks of obligations held by a bank; it does not distinguish between obligations with regard to how the holder came to possess them, but only requires that the holder in fact possess them. See § 1281(b)(1)(C). Second, the Commissioner claims that nothing in § 1281(a) can limit the scope of the obligations covered by § 1281 because § 1281(a) does not purport to define the scope of § 1281. Section 1281(b) designates which obligations are subject to the...