Underhill v. Comm'r of Internal Revenue

• Decision Date: 28 February 1966
• Docket Number: Docket No. 713-64.
• Citation: 45 T.C. 489
• Parties: WINGATE E. UNDERHILL AND MATTIE R. UNDERHILL, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

45 T.C. 489

WINGATE E. UNDERHILL AND MATTIE R. UNDERHILL, PETITIONERS,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 713-64.

Tax Court of the United States.

Filed February 28, 1966.

Wingate E. Underhill, pro se.

Eugene I. Meyers, for the respondent.

Petitioner acquired obligations in the form of negotiable promissory notes at sizable discounts. The obligations were usually secured by second deeds of trust on residential property. Petitioner treated payments during the taxable year as recovery of his cost. In prior taxable years, petitioner had treated a prorata portion of each payment as discount income. Held, with some exceptions, the obligations owned by petitioner as measured by defined critical factors were speculative. Held, further, that Petitioner was not required to report, as discount income, a prorata portion of payments on obligations found to be speculative. Held, further, petitioner is not precluded from reporting on the cost recovery basis for the taxable year because of his treatment of discount income in prior years.

TANNENWALD, Judge:

The respondent determined a deficiency in petitioners' income taxes for the year 1961 in the amount of $1,777.47.

There are two questions presented. The first involves a determination of the proper basis for reporting discount income by a cash basis taxpayer who has purchased debt obligations at less than the unpaid principal balance of the obligation at the time of acquisition. The second involves a determination whether, if the cost recovery basis is held to be proper, petitioner is precluded from utilizing such basis by section 446(e),¹ where prior to the taxable year involved he has in fact reported on the prorata basis.²

FINDING OF FACT

Some of the facts in this case have been stipulated. The stipulation and the exhibits attached thereto are incorporated herein and made a part of our findings of fact by this reference.

Wingate E. and Mattie R. Underhill are husband and wife residing in Washington, D.C. they filed a joint Federal income tax return for the calendar year 1961 on a cash basis with the district director of internal revenue, Baltimore, Md. All references herein to petitioner shall refer to Wingate E. Underhill, his wife being a party to this proceeding solely as a result of her having executed the joint return.

Petitioner is an employee of the U.S. Department of Agriculture. In 1947 petitioner began acquiring interest-bearing obligations (usually negotiable promissory notes, hereinafter sometimes referred to as notes) and has continued his acquisition of such obligations up to the present. During the years 1947 through 1961 (the taxable year involved herein), obligations acquired by petitioner were purchased at a discount from the principal amount owing at the date of acquisition. Generally the security for such obligations was second deeds of trust on residential property, although some involved security of first trusts on chattels, some first and third deeds of trust on residential property, and one a second deed of trust on vacant land. In 1949 petitioner owned 10 notes; in 1951, 20 notes; in 1954, 40 notes; in 1958, 46 notes; and in 1961 he owned 50 notes, some of which were closed out during the year.

Petitioner purchase the obligations from many sources including ‘broker-speculators,‘ i.e., licensed brokers, who bought property for the purpose of resale, taking back a trust note and immediately selling the note; ‘vendors,’ who were property owners who sold their property, taking back a trust note from the purchaser, which they sold; ‘speculators,‘ who followed the same pattern as the broker-speculators, except that they were not licensed as brokers; ‘contractors,‘ who performed services by making improvements on property, for which they received a trust note which they sold; ‘investors,‘ who purchased notes to hold but sold when they needed money; ‘brokers,‘ who were licensed real estate brokers and who sold notes on behalf of vendors; and ‘note brokers,‘ who purchased notes with the purpose of making an immediate resale at a profit. Usually the original debtor was personally obligated on the note and sometimes the person from whom petitioner acquired the note affixed his endorsement and was also personally obligated thereon. Occasionally petitioner made a direct loan taking back the obligation of the borrower.

Of the 50 notes owned by the Petitioner in 1961, 42 were secured by deeds of trust on real estate (41 of which were on residential property and one on vacant land). Of these 42 notes, 2 were secured by first deeds of trust, 33 by second deeds of trust, and 7 by third deeds of trust. Four notes were secured by operating businesses, of which 3 were secured by specific chattels and 1 was unsecured. These 4 notes were acquired by petitioner as a result of furnishing additional funds to operators of businesses whose other notes petitioner already held.

All 50 notes were acquired at a discount. Often the amount paid by petitioner was more than the equity in the property, i.e., the value of the property in excess of the amount of the then-existing prior liens. The notes provided for interest to be paid by the borrower, usually at the rate of 6 percent, and for repayment of the unpaid balances at the time of acquisition in installments over varying periods of years.

During the period from 1947 through 1961, petitioner closed out 99 separate notes, of which 5 were closed out in 1961. The 99 notes had unpaid balances at the time of acquisition totaling $106,000 and were acquired by petitioner at a weighted average discount of approximately 27 percent, or $146,300. The weighted average discount of the 50 notes owned by petitioner in 1961 was approximately 35 1/2 percent.

Of the $206,000 principal of the 99 notes closed out, petitioner collected all but $8,500. Petitioner received payment in full on 68 of 99 notes. With respect to 1 note, petitioner recovered less than his cost. On 14 notes petitioner gave ‘courtesy’ discounts, which are normally given if the borrower pays off the principal in advance. These discounts totaled $564.63. As to the other 16 notes, some were paid at relatively small discounts because petitioner thought it was in his best interest to accept less than the full amount.

Petitioner did not know in advance which notes would actually give him trouble in collection thereof. There was a limited market for the sale of obligations of the type acquired by petitioner. However, petitioner only occasionally offered obligations owned by him for sale, being primarily interested in acquiring and holding them for investment purposes.

Petitioner, in deciding whether or not to buy a given note, considered such things as the occupation and place of employment of the borrower, credit report of the borrower, amount of downpayment, location of the property, and the amount and terms of payment of prior liens. If the note had been held by its seller for any length of time, as occasionally happened, petitioner considered the regularity of payment by the borrower.

Petitioner spent approximately 12 to 15 hours per week in connection with the management of the obligations. Petitioner worked very closely with the debtors in attempting to avoid foreclosures on the property. He would help debtors who failed to keep their payments current by finding buyers for their houses, advancing funds for payments on obligations senior to his, and helping debtors who had lost their jobs find new ones. During the period 1947 to 1961, petitioner brought only one foreclosure proceeding.

Over the past 10 to 15 years real estate prices have been rising with respect to the types of property which for the most part secured obligations of the type owned by petitioner.

Petitioner has kept a complete set of books and records at all times with respect to his note activities.

Prior to the year at issue, petitioner did not report discount income for Federal income tax purposes on a cost recovery basis, but rather reported it on a prorata basis. Petitioner changed to the cost recovery basis for 1961 on the strength of Phillips v. Frank, 295 F.2d 629(C.A.9, 1961). Petitioner did not seek nor did he receive the consent of the Secretary of the Treasury or his delegate to this change.

Petitioner on his 1961 return reported the amount of $9,282.48 as ‘Interest and Discount’ income, of which he reported $6,183.16 as ‘interest’ income and $3,099.32 as ‘earned discount’ income. Respondent does not question the $6,183.16 interest income but in his deficiency notice determined that petitioner understated his earned discount income by $4,837.07.

OPINION

The first issue in this case is simple to state: Should a cash basis taxpayer, who acquires interest-bearing obligations at a discount from the unpaid principal balance at the time of acquisition, defer the inclusion in income of all payments on account of principal until he has recovered his cost, or should he include in income a prorata portion of each such payment?³

The determinative factor, as petitioner and respondent agree, is whether the obligations are ‘speculative,‘ in which event the cost recovery basis is proper, or ‘nonspeculative,‘ in which event the taxpayer is required to use the prorata basis of reporting the payments. To make such a determination, we perforce must enter the occult realm of lexicology, recognizing, as Alice in Wonderland did, that words can mean many different things. See Carroll, Through the Looking-Glass 124 (Macmillan & Co., New York, 1892). Our task is to try to introduce ‘some certitude in a landscape of shifting sands.’ See United States v. Rhode Island Hospital Trust Co., 355 F.2d 7(C.A.1, 1966).

Before proceeding to this task, it is important to note that this case does not involve a situation where the amount of the obligation cannot be calculated with any degree of certainty or where the taxpayer's right to receive payment of the obligation is conditional. In...