Sprague v. U.S., 78-1777

• Court: United States Courts of Appeals. United States Court of Appeals (10th Circuit)
• Writing for the Court: MARKEY
• Citation: 627 F.2d 1044
• Parties: 80-2 USTC P 9621 R. Paul SPRAGUE and Mary G. Sprague, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
• Docket Number: No. 78-1777,78-1777
• Decision Date: 14 August 1980

Page 1044

627 F.2d 1044 80-2 USTC P 9621 R. Paul SPRAGUE and Mary G. Sprague, Plaintiffs-Appellants,
v.
UNITED STATES of America, Defendant-Appellee. No. 78-1777. United States Court of Appeals,
Tenth Circuit. Argued May 9, 1980.
Decided Aug. 14, 1980.

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Gene A. Castleberry, Oklahoma City, Okl., for plaintiffs-appellants.

Robert T. Duffy, Atty., Dept. of Justice, Washington, D.C., for defendant-appellee.

Before McKAY, BREITENSTEIN and MARKEY. ^*

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MARKEY, Chief Judge.

Action by R. Paul Sprague (Sprague) ¹ for refund of federal income taxes. The district court held that the taxpayers' stock transaction did not qualify for installment sale reporting and that they were therefore not entitled to a refund. Sprague v. United States, 42 A.F.T.R.2d 78-5877, 78-2 U.S.T.C. P 9650 (W.D.Okla. Aug. 2, 1978). We reverse.

Background

R. Paul Sprague was a partner in Pelham Associates (Pelham), that owned stock in IHC, Inc. (IHC). Several banks held most of the stock as collateral for loans to Pelham.

Pelham contracted to sell the IHC stock in 1970. Because the purchaser, Transairco, Inc. (Transairco), was unable to pay the $1,654,584 selling price in cash, the parties agreed to a deferred payment plan. Settlement occurred on September 10, 1970. Pelham received a $485,359.04 downpayment (approximately 29.3% of the total selling price), composed of $239,662.91 in cash and $245,696.13 in debt assumption and satisfaction by Transairco. The balance of the price was reflected in a series of notes Transairco issued to Pelham. The notes had due dates after 1970.

To secure release of the IHC stock from its creditor-banks, Pelham assigned the Transairco notes to the banks as substitute collateral for its loans. Pelham remained primarily liable on its original debts. ² Each note was made out in the exact amount Pelham owed a bank and had due dates coinciding with the due dates of a Pelham loan. The Banks were to look to Transairco only after Pelham defaulted, and to look to security supplied by Transairco only after Transairco defaulted on its notes.

Transairco had agreed to secure the notes by letters of credit but had difficulty obtaining them. To avoid delay in closing, the parties agreed in August 1970 that Transairco could supply certificates of deposit as temporary security, with the right to replace the certificates with letters of credit. In October 1970, the certificates were withdrawn and the notes were secured by nonassignable and irrevocable letters of credit having draw and expiration dates coinciding with the due dates of the notes. The letters were issued directly to the banks and could be drawn upon by them only if Transairco defaulted on its notes.

Pelham became substantially dormant shortly after the sale. With one exception, Pelham's banks received payment on Pelham's loans, when those payments came due, by drawing on the letters. The only exception occurred in 1973, when Transairco obtained an injunction prohibiting a bank from drawing on the letter assigned to it. That dispute was settled. Though Pelham made no payment of principal, it was often called upon to pay, and did pay, interest.

On his 1970 tax return, Sprague used the installment method ³ to report his share of

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Pelham's profit on the stock sale. As a result, his reported income for 1970 was more than offset by losses sustained during that year. Sprague claimed a loss carryback to 1967 and sought a $905.53 refund of his taxes for that year.

The Internal Revenue Service (IRS) refused Sprague's refund on the ground that Pelham received more than 30% of the selling price of the IHC stock in the year of sale, i. e., 1970, and thus disqualified itself and its members from reporting the sale on an installment basis. See I.R.C. § 453(b)(2), supra note 3.

In the IRS's view, Pelham constructively received year-of-sale payments equal to the value of Transairco's certificates/letters, and those payments plus the downpayment exceeded 30% of the selling price. Alternatively, the IRS felt that assignment of those certificates/letters to Pelham's banks was tantamount to Transairco's assumption of Pelham's debts and that the value of the year-of-sale debt relief plus the downpayment exceeded the 30% limit. The IRS thus increased Sprague's 1970 income to include his entire profit on the stock sale, thereby wiping out his 1967 loss carryback.

Sprague sued the Government for recovery of the $905.53 refund plus interest. Both parties moved for summary judgment. The district court denied Sprague's motion, granted the Government's, and entered a judgment that Sprague was not entitled to report his profit from the stock sale on an installment basis. Sprague appealed.

Issues

The issues are whether Pelham (1) constructively received year-of-sale payments equal to the value of the certificates/letters, or (2) realized year-of-sale debt relief by assignment of those certificates/letters to its banks, in either case receiving thereby more than 30% of the selling price in the year of sale and disqualifying Sprague from reporting his profit on an installment basis.

OPINION

I.R.C. § 453(b)(2)(B), supra note 3, provides that "evidences of indebtedness of the purchaser," for example, purchaser's notes, are not to be treated as year-of-sale payments received by a seller for the purpose of determining whether year-of-sale payments exceeded 30% of the selling price. The value of the secured Transairco notes should therefore be excluded in determining whether Pelham's year-of-sale receipts exceeded the 30% limit. ⁴ I.R.C. § 453(b)(2)(B) would thus compel reversal of the decision below. The Government, however, seeks to escape the thrust of this code provision, asserting in this case that Pelham received more than 30% in the sale year. In essence, the Government, realizing that it cannot rely on the purchaser's "evidences of indebtedness," Transairco's notes, reaches for the security underlying those notes. The distinction is here one without a difference.

(1) Constructive Receipt

The "constructive receipt" theory, relied on by the Government to justify inclusion of the value of the security behind the Transairco notes, is in truth a blend of three distinct theories.

First, the Government says the nature of the security makes the notes certain of collection. Because Pelham was virtually guaranteed collection of cash equalling the value of the security, says the Government, the security is the equivalent of cash and Pelham should be treated as if it had collected that cash at the time of sale.

We disagree. It has been long settled that secured notes stand on the same plane as unsecured notes for purposes of the installment sale limitation on year-

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of-sale payments. R. L. Brown Coal & Coke Co. v. Commissioner, 14 B.T.A. 609 (1928). ⁵ Both are mere promises to pay. The maker of either instrument permanently surrenders nothing of value except his promise. The giving of security is not payment and does not transform the promise to pay into a completed payment. It merely makes the promise more certain of fulfillment. See Williams v. Commissioner, 429 U.S. 569, 578, 97 S.Ct. 850, 856, 51 L.Ed.2d 48 (1977).

The value or cash-equivalency of the security cannot adequately serve as criterion in the present context. It would be impractical for the taxpayer and the IRS to evaluate a security and determine whether its "quality" was such as to create some indeterminate and indeterminable level of risk that the note payee would or would not get paid. Moreover, consideration of the "quality" of security would unfairly penalize those most careful and successful in protecting themselves against buyer default, who would thereby disqualify themselves from the tax advantages of installment reporting. Hence, the Government's "certainty of collection" theory must be rejected.

The second theory moves slightly closer to the traditional concept of constructive receipt. ⁶ In essence, it is argued that Pelham should be treated as though it had received the value of the security in the year of sale because it was free to convert the security into ready cash during the sale year.

That argument is meritless here. Pelham had no right to receive cash from Transairco's bank before Pelham and Transairco entered into the agreement creating the security arrangement. After the security was established, Pelham still had no enforceable right to receive cash except under the terms and conditions set out in the security instruments. Neither the certificates nor the letters could be drawn upon unless and until Transairco had defaulted on its notes. No note being due during the sale year, that restriction prevented Pelham from receiving cash in the year of sale. No ability or opportunity of Pelham to benefit from the security before Transairco's default, whether by conversion into cash or by assignment of a right to receive cash, ever existed. Hence, the traditional constructive receipt doctrine is inapplicable here. ⁷

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The third theory is that the certificates/letters were not truly security but were in reality payment for Pelham's stock. ⁸ That theory, primarily based on tax court decisions, seeks to apply "substance over form."

In Pozzi v. Commissioner, supra note 5, a buyer sought to purchase in cash but was refused. The taxpayer proposed an installment sale and the buyer accepted. The buyer opened an escrow account with cash equalling the purchase price. As each payment came due, the buyer sent a check to the escrow bank, the bank drew a check on itself in favor of the taxpayer and returned the same amount to the buyer out of the escrow account. The tax court found the transaction indistinguishable from one in which the taxpayer collected the full purchase price at the time of sale and deposited it in his own account. The installment arrangement lacked reality because the full price was at all times on deposit with the escrow bank, which merely...