Sorrell v. C.I.R.

• Decision Date: 01 September 1989
• Docket Number: No. 88-7331,88-7331
• Citation: 882 F.2d 484
• Parties: -5662, 89-2 USTC P 9521 Gordon S. SORRELL, Jr. and June M. Sorrell, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
• Court: U.S. Court of Appeals — Eleventh Circuit

Page 484

882 F.2d 484

64 A.F.T.R.2d 89-5662, 89-2 USTC P 9521

Gordon S. SORRELL, Jr. and June M. Sorrell, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.

No. 88-7331.

United States Court of Appeals, Eleventh Circuit.

Sept. 1, 1989.

William S. Rose, Jr., Gary R. Allen, Asst. Attys. Gen., Ann Belanger Durney, Francis M. Allegra, U.S. Dept. of Justice, Tax Div., Washington, D.C., for respondent-appellant.

Henry H. Hutchinson, Capell, Howard, Knabe & Cobbs, Montgomery, Ala., for petitioners-appellees.

Appeal from a Decision of the United States Tax Court (Alabama Case).

Before FAY and ANDERSON, Circuit Judges, and HENDERSON, Senior Circuit Judge.

ANDERSON, Circuit Judge:

This case presents the question of whether the pre-opening expense doctrine applies to deductions under Sec. 212 of the Internal Revenue Code. The Tax Court held that the investor services fee paid by a limited partnership prior to commencing business operations could be deducted currently. Because we hold that the pre-opening expense doctrine applies under these circumstances to bar current deductibility, we reverse.

I. BACKGROUND

The relevant facts in this case are not in dispute. Gordon S. Sorrell, one of the appellants, ¹ held general and limited partnership interests in five Alabama limited partnerships during the relevant tax years, 1977 and 1978. Each limited partnership was formed to develop and operate a residential apartment complex located in Mobile, Montgomery, or Tuscaloosa, Alabama. Sorrell also controlled Southern Housing Partnerships, Inc. (SHP), during this period. SHP was the managing general partner of each of these limited partnerships.

During 1977, one of the limited partnerships, Woodmere Apartments, Ltd., paid SHP $15,000 as an investor services fee. The investor services fee related to SHP's supervision of the property manager of the apartments, the duties of which included day-to-day management, reviewing and correcting the annual budgets, performing accounting, coordinating matters with the Department of Housing and Urban Development, and communicating with the limited partners. The apartments themselves were not occupied until sometime in 1978. Woodmere, the limited partnership, deducted the total amount of the fee as a guaranteed payment under Sec. 707(c) ² of the Internal Revenue Code of 1954 ("Code"). ³ See generally Cagle v. Commissioner, 539 F.2d 409, 413-14 (5th Cir.1976) (discussing application of Sec. 707(c)). ⁴ Sorrell claimed his distributive share of Woodmere's taxable loss on his 1977 return.

The Internal Revenue Service disallowed Sorrell's share of the loss to the extent it reflected the deduction of the fee, claiming that this amount was a capital expenditure subject to amortization. The IRS contended that, under the "pre-opening expense" doctrine, expenditures made prior to the commencement of the taxpayer's trade or business must be capitalized. Disagreeing, Sorrell petitioned the Tax Court for a determination of the amount's deductibility. The Tax Court determined that Woodmere was not actively engaged in a trade or business in 1977, because the apartments were not occupied until 1978. Thus, Woodmere's intended activity of operating a rental apartment complex had not yet begun and it could not take a deduction in 1977 for trade or business expenses under Sec. 162(a). ⁵ However, the court held that the investor services fee was currently deductible under another provision, Sec. 212(2). ⁶ The Tax Court reasoned that, although the pre-opening expense doctrine would bar deductions for similar payments under Sec. 162(a) of the Code, the pre-opening expense doctrine does not apply to amounts deductible under Sec. 212. Because the fee related to the management of the property held with the purpose of eventually producing income, the court held, it was a currently deductible expense under Sec. 212(2). 53 T.C.M. (CCH) 1362, 1987 Tax Ct. Memo LEXIS 351 (1987).

The IRS appealed the Tax Court's determination with respect to the investor services fee. ⁷ Thus, the question before this court on appeal is whether an expense, incurred prior to the commencement of the taxpayer's business operations, may be deducted currently under Sec. 212 of the Internal Revenue Code. ⁸

II. DISCUSSION

Courts have consistently held that Sec. 162(a), which provides for the deductibility of ordinary and necessary expenses in carrying on a trade or business, does not allow current deductions for expenses incurred by a taxpayer prior to beginning business operations. See Johnsen v. Commissioner, 794 F.2d 1157, 1160 (6th Cir.1986) (citing cases); Buell, Business Start-up Costs: Analyzing and Planning for Current Deductibility, 43 J. Tax'n 278, 278 (1975). The requirement that these expenditures be capitalized is known as the "pre-opening expense" doctrine. ⁹ The pre-opening expense doctrine has two premises. First, courts have reasoned that prior to the business's beginning to operate as a going concern, the taxpayer is not "engaged in carrying on any trade or business," pursuant to the express requirement Sec. 162(a). Johnsen v. Commissioner, 794 F.2d at 1160-61; see, e.g., Aboussie v. United States, 779 F.2d 424, 428 (8th Cir.1985); Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir.), vacated on other grounds, 382 U.S. 68, 86 S.Ct. 233, 15 L.Ed.2d 143 (1965) (per curiam). Second, courts have also articulated as an independent rationale that expenses incurred during the pre-opening period are part of the cost of acquiring the capital asset; as such they are not ordinary business expenses but rather capital expenditures. Johnsen v. Commissioner, 794 F.2d at 1161. ¹⁰

Sorrell argues that the pre-opening expense doctrine is inapplicable to Sec. 212. Section 212 provides an alternate avenue for the deduction of ordinary and necessary expenses incurred in certain types of income-producing activities not covered by Sec. 162(a). Under Sec. 212(2), expenses incurred for the management, conservation, or maintenance of property held for the production of income are deductible, even though such activity does not constitute "carrying on any trade or business" and thus the expenses attributable to it would not be deductible pursuant to Sec. 162. Brown v. United States, 526 F.2d 135, 138 (6th Cir.1975). Sorrell's argument hinges on this key distinction between Secs. 162 and 212, i.e., the latter's lack of a "trade or business" requirement. Specifically, Sorrell contends that the pre-opening expense doctrine is based on the Sec. 162 requirement that the taxpayer be engaged in a trade or business in order to deduct any expenses. Because Sec. 212 lacks any such requirement, Sorrell argues, the pre-opening expense doctrine cannot apply to Sec. 212.

That reasoning has been accepted by the Tax Court in Hoopengarner v. Commissioner, 80 T.C. 538 (1983), aff'd by unpublished opinion, 745 F.2d 66 (9th Cir.1984). In Hoopengarner, the taxpayer had a leasehold interest in a plot of undeveloped land, for which he paid a yearly rent due in advance. The taxpayer was to construct and operate an office building on the land, both of which would finally revert to the lessor. While the taxpayer engaged in 1976 in some activities in anticipation of renting the building, they did not amount to carrying on the rental business. Thus, the IRS disallowed the taxpayer's deduction of the 1976 lease payment on the ground that it was a pre-opening expense. The Tax Court, in a 10-8 split of the members of the court, reversed. As Sorrell argues before us, the Tax Court held that the pre-opening expense doctrine "has no applicability in section 212 context," because of Sec. 212's lack of a trade or business requirement. Hoopengarner v. Commissioner, 80 T.C. at 543. Because the taxpayer's ownership of the lease was held to generate income in the near future, the lease payment was deductible.

Hoopengarner, however, has not been well-received. All four courts of appeals to publish opinions on the issue have refused to follow it. ¹¹ Fishman v. Commissioner, 837 F.2d 309 (7th Cir.), cert. denied, --- U.S. ----, 108 S.Ct. 2902, 101 L.Ed.2d 935 (1988); Lewis v. Commissioner, 861 F.2d 1232, 1233 (10th Cir.1988); Johnsen v. Commissioner, 794 F.2d 1157, 1158 (6th Cir.1986); Aboussie v. United States, 779 F.2d 424, 428 n. 6 (8th Cir.1985). After considering the question closely, we join the several courts of appeals in declining to follow Hoopengarner. ¹²

Several reasons, in addition to the force of the foregoing precedent, persuade us to join these courts of appeal. We read the legislative history of Sec. 212 as strong support for this position. Prior to the enactment of the predecessor of Sec. 212, expenses incurred in connection with income-producing nonbusiness property were not currently deductible, while similar business-related expenses were. The predecessor of Sec. 212 was enacted to remedy this disparity. "The purpose of ... section 212 was to create a parity of treatment between such nonbusiness expenses and similar business expenses which had long been deductible." Johnsen v. Commissioner, 794 F.2d at 1161 (quoting Brown v. United States, 526 F.2d 135, 138 (6th Cir.1975)). ¹³ As a matter of statutory construction, it is well settled that Secs. 162(a) and 212 are to be considered in pari materia. Woodward v. Commissioner, 97 U.S. 572, 575 n. 3, 90 S.Ct. 1302, 1304-1305 n. 3, 25 L.Ed.2d 577 (1970); see also Fishman v. Commissioner, 837 F.2d 309, 311 (7th Cir.), cert. denied, --- U.S. ----, 108 S.Ct. 2902, 101 L.Ed.2d 935 (1988); Johnsen v. Commissioner, 794 F.2d at 1162 ("the restrictions and qualifications applicable to the deductibility of trade or business expenses are also applicable to expenses covered by section 212"). Under this reasoning, the pre-opening expense doctrine applied to Sec. 162 should equally be applicable to Sec. 212.

Refusing to apply the pre-opening expense doctrine to Sec. 212(2) would...