Warren Jones Co. v. C. I. R.

• Decision Date: 22 September 1975
• Docket Number: No. 74-1531,74-1531
• Citation: 524 F.2d 788
• Parties: 75-2 USTC P 9732 WARREN JONES COMPANY, Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 788

524 F.2d 788

75-2 USTC P 9732

WARREN JONES COMPANY, Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.

No. 74-1531.

United States Court of Appeals Ninth Circuit.

Sept. 22, 1975.

Meade Whitaker, I.R.S., Washington, D. C. (argued), for appellant.

W. V. Clodfelter, Seattle, Wash. (argued), for appellee.

OPINION

Before ELY and HUFSTEDLER, Circuit Judges, and TAYLOR, ^* Senior District Judge.

ELY, Circuit Judge:

During its taxable year ending on October 31, 1968, the Warren Jones Company, a cash basis taxpayer, sold an apartment building for $153,000. In return, the taxpayer received a cash downpayment of $20,000 and the buyer's promise in a standard form real estate contract, to pay $133,000, plus interest, over the following fifteen years. The Tax Court held, with three judges dissenting, that the fair market value of the real estate contract did not constitute an "amount realized" by the taxpayer in the taxable year of sale under section 1001(b) of the Internal Revenue Code. ¹ Warren Jones Co., 60 T.C. 663 (1973) (reviewed by the full Court). The Commissioner of Internal Revenue has appealed, and we reverse.

I. Background

On May 27, 1968, the taxpayer, a family-held corporation chartered by the State of Washington, entered into a real estate contract for the sale of one of its Seattle apartment buildings, the Wallingford Court Apartments, to Bernard and Jo Ann Storey for $153,000. When the sale closed on June 15, 1968, the Storeys paid $20,000 in cash and took possession of the apartments. The Storeys were then obligated by the contract to pay the taxpayer $1,000 per month, plus 8 percent interest on the declining balance, for a period of fifteen years. The balance due at the end of fifteen years is to be payable in a lump sum. The contract was the only evidence of the Storeys' indebtedness, since no notes or other such instruments passed between the parties. Upon receipt of the full purchase price, the taxpayer is obligated by the contract to deed the Wallingford Apartments to the Storeys.

The Tax Court found, as facts, that the transaction between the taxpayer and the Storeys was a completed sale in the taxable year ending on October 31, 1968, and that in that year, the Storeys were solvent obligors. The court also found that real estate contracts such as that between the taxpayer and the Storeys were regularly bought and sold in the Seattle area. The court concluded, from the testimony before it, that in the taxable year of sale, the taxpayer could have sold its contract, which had a face value of $133,000, to a savings and loan association or a similar institutional buyer for approximately $117,980. The court found, however, that in accordance with prevailing business practices, any potential buyer for the contract would likely have required the taxpayer to deposit $41,000 of the proceeds from the sale of the contract in a savings account, assigned to the buyer, for the purpose of securing the first $41,000 of the Storeys' payments. Consequently, the court found that in the taxable year of sale, the contract had a fair market value of only $76,980 (the contract's selling price minus the amount deposited in the assigned savings account.)

On the sale's closing date, the taxpayer had an adjusted basis of $61,913 in the Wallingford Apartments. In determining the amount it had realized from the sale, the taxpayer added only the $20,000 downpayment and the portion of the $4,000 in monthly payments it had received that was allocable to principal. Consequently, on its federal income tax return for the taxable year ending October 31, 1968, the taxpayer reported no gain from the apartment sale. The taxpayer's return explained that the corporation reported on the cash basis and that under the Tax Court's holding in Nina J. Ennis, 17 T.C. 465 (1951), it was not required to report gain on the sale until it had recovered its basis. The return also stated, however, that in the event the taxpayer was required to report gain in the taxable year of the sale, it elected to do so on the installment basis (I.R.C. § 453).

The Commissioner disagreed with the taxpayer's assertion that it had realized no gain on the sale, but he conceded that the sale qualified as an installment sale. Consequently, the Commissioner recalculated the taxpayer's gain in accordance with section 453 and notified the taxpayer that it had recognized an additional $12,098 in long term capital gain. The taxpayer then petitioned the Tax Court for a redetermination of its liability.

Section 1001 provides, in pertinent part, as follows:

(a) COMPUTATION OF GAIN OR LOSS. The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis . . . .

(b) AMOUNT REALIZED. The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received. ²

The question presented is whether section 1001(b) requires the taxpayer to include the fair market value of its real estate contract with the Storeys in determining the "amount realized" during the taxable year of the sale. ³

Holding that the fair market value of the contract was not includable in the amount realized from the sale, the Tax Court majority relied on the doctrine of "cash equivalency." Under that doctrine, the cash basis taxpayer must report income received in the form of property only if the property is the "equivalent of cash." See generally 2 J. Mertens, The Law of Federal Income Taxation §§ 11.01-11.05 (Malone rev. 1974).

The Tax Court majority adopted the following as its definition of the phrase, "equivalent of cash":

. . . if the promise to pay of a solvent obligor is unconditional and assignable, not subject to set-offs, and is of a kind that is frequently transferred to lenders or investors at a discount not substantially greater than the generally prevailing premium for the use of money, such promise is the equivalent of cash . . .

Warren Jones Co., supra at 668-69, quoting, Cowden v. Commissioner, 289 F.2d 20, 24 (5th Cir. 1961). Applying the quoted definition, the Tax Court held that the taxpayer's contract, which had a face value of $133,000, was not the "equivalent of cash" since it had a fair market value of only $76,980. Had the taxpayer sold the contract, the discount from the face value, approximately 42 percent, would have been "substantially greater than the generally prevailing premium for the use of money." ⁴

The Tax Court observed that requiring the taxpayer to realize the fair market value of the contract in the year of the sale could subject the taxpayer to substantial hardships. The taxpayer would be taxed in the initial year on a substantial portion of its gain from the sale of the property, even though it had received, in cash, only a small fraction of the purchase price. To raise funds to pay its taxes, the taxpayer might be forced to sell the contract at the contract's fair market value, even though such a sale might not otherwise be necessary or advantageous. Most importantly in the Tax Court's view, if the taxpayer were required to realize the fair market value of the contract in the year of the sale, the sale transaction would be closed for tax purposes in that year; hence, the taxpayer's capital gain on the transaction would be permanently limited to the difference between its adjusted basis and the contract's fair market value plus the cash payments received in the year of sale. If the taxpayer did retain the contract, so as to collect its face value, the amounts received in excess of the contract's fair market value would constitute ordinary income. The Tax Court also noted that requiring the cash basis taxpayer to realize the fair market value of the real estate contract would tend to obscure the differences between the cash and accrual methods of reporting.

The Commissioner does not dispute the Tax Court's conclusion that the taxpayer's contract with the Storeys had a fair market value of $76,980, or any other of the court's findings of fact. ⁵ Rather, the Commissioner contends that since, as found by the Tax Court, the contract had a fair market value, section 1001(b) requires the taxpayer to include the amount of that fair market value in determining the amount realized. ⁶

II. Statutory Analysis

The first statutory predecessor of section 1001(b) was section 202(b) of the Revenue Act of February 24, 1919, which stated:

When property is exchanged for other property, the property received in exchange shall for the purpose of determining gain or loss be treated as the equivalent of cash to the amount of its fair market value, if any . . . .

Ch. 18, § 202(b), 40 Stat. 1060. We have no doubt that under that statute, the taxpayer would have been required to include the fair market value of its real estate contract as an amount realized during the taxable year of sale.

Only three years later, however, in the Revenue Act of November 23, 1921, Congress replaced the language of the statute enacted in 1919 with the following:

On an exchange of property, real, personal or mixed, for any other such property, no gain or loss shall be recognized unless the property received in exchange has a readily realizable market value . . . .

Ch. 136, § 202(c), 42 Stat. 230. The original statute had created "a presumption in favor of taxation." H.R.Rep. No. 350, 67th Cong., 1st Sess. (1921), reproduced at 1939-1 Cum.Bull. (Part 2) 168, 175. In the 1921 Act, Congress doubtless intended a policy more favorable to the taxpayer. Interpreting the 1921 statute, the Treasury Regulations provided that

(p)roperty has a readily realizable market value if it can be readily converted into an amount of cash or its equivalent substantially equal to the fair value of the property.

Treas.Reg. 62, Art. 1564 (1922 ed.). The law established in 1921 appears to have been substantially in accord with the...