Williams v. Comm'r of Internal Revenue

• Decision Date: 21 March 1990
• Docket Number: Docket No. 36698-87.
• Citation: 94 T.C. 464,94 T.C. No. 27
• Parties: LLOYD E. WILLIAMS, JR. AND MILDRED A. WILLIAMS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

94 T.C. 464

94 T.C. No. 27

LLOYD E. WILLIAMS, JR. AND MILDRED A. WILLIAMS, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 36698-87.

United States Tax Court

Filed March 21, 1990.

P and another person purchased a condominium in 1983 for $1,514,000. They paid $10,000 in cash and executed and delivered a fully recourse, noninterest-bearing note in the amount of $1,504,000. The $477,000 first installment on the note was due (and paid) in 1983 just over 6 months from the date of purchase, and the $1,027,000 second, and final, installment was due in 30 years. Because of the noninterest-bearing nature of the note, sec. 483 characterized $315,482 of the first installment as interest. Only $25,463 of interest had economically accrued on the note by the due date of the first installment. HELD: neither sec. 446(b) nor sec. 461(g) restricts petitioner's deduction of his share of the $315,482 characterized as interest by sec. 483. J. Gordon Hansen and Stuart A. Fredman, for the petitioners. ^*

David L. Zoss, Lewis J. Fernandez, and James C. Lanning, for the respondent.

OPINION

CLAPP, JUDGE:

Respondent determined a $29,015 deficiency in petitioners' Federal income tax and a $7,254 addition to tax under section 6661 for the year 1983. In his amended answer, respondent increased the deficiency to $61,011.50 and conceded that section 6661 is not applicable. All section references are to the Internal Revenue Code for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

The issue is whether section 446(b) or section 461 (g) limits petitioners' interest deduction to the amount of interest that economically accrued rather than to the amount of interest determined under section 483. This is a case of first impression.

This matter is before the Court on the parties' cross-motions for summary judgment filed under Rule 121. We will treat each motion as being for partial summary judgment on the section 483 issue. Each party objects to the other party's motion on the merits. Although there remain unresolved issues of fact which preclude final resolution of this case, the parties agree, for the limited purposes of these motions, as to all facts necessary to rule on the motions. There are, therefore, no material questions of fact regarding the cross-motions for partial summary judgment.

BACKGROUND

The factual matter set forth in this case is based on undisputed documents submitted to us in support of the parties' cross-motions for partial summary judgment.

Petitioners Lloyd E. Williams and Mildred A. Williams resided in Kenilworth, Illinois when they filed their petition. Mildred A. Williams is a petitioner solely because she and her husband executed a joint income tax return. References to ‘petitioner‘ will be to Lloyd E. Williams.

The interest deduction at issue relates to petitioner's purchase of a one-half interest in a Utah condominium in 1983. On June 22, 1983, petitioner and Barry Montgomery (the buyers) entered into an agreement to purchase the condominium from RDG Associates for $1,514,000. On June 23, 1983, the buyers made a $10,000 down payment. On the same date, they executed and delivered a fully recourse, non-interest-bearing note in the amount of $1,504,000. The buyers were required to pay the note in two installments. The first installment of $477,000 was due on December 30, 1983, and the second installment of $1,027,000 is due on July 24, 2013. The buyers timely paid the first installment on the note.

Petitioners are on the cash method of accounting. When filing their 1983 income tax return, they calculated interest on the note in accordance with section 483(a), which provided:

For purposes of this title, in the case of any contract for the sale or exchange of property there shall be treated as interest that part of a payment to which this section applies which bears the same ratio to the amount of such payment as the total unstated interest under such contract bears to the total of the payments to which this section applies which are due under such contract.

Because the $1,504,000 note is non-interest bearing, it contains total unstated interest. Sec. 483(b). For this and other reasons, both payments on the note are subject to section 483. Sec. 483(c). The total unstated interest on the note equals the amount by which the total payments on the note exceed the present value of those payments. Sec. 483(b). The parties agree that total unstated interest is $994,729, or .6613889 of the total payments on the note. The parties also agree that petitioners correctly allocated this total unstated interest between the two payments on the note so that interest would comprise .6613889 of each payment. This allocation caused $315,482 of the $477,000 first payment on the note to be characterized as interest. When calculating their interest deduction for 1983, petitioners took this $315,482 figure, added the $630 in interest the buyers paid to a bank from which they borrowed funds to make the first payment on the note, and subtracted real property construction period interest of $25,964 pursuant to section 189. This gave the buyers a net interest deduction of $290,148 (not counting real property construction period interest), and petitioners calculated their share of this deduction as $145,075.

Respondent allows petitioners a $315 deduction for their share of the $630 interest payment the buyers made to the bank, but argues that the remaining $144,760 is not deductible. Respondent calculates that only $25,463 of interest economically accrued on the note between the date of purchase on June 22, 1983, and the first payment on the note on December 30, 1983. Petitioners do not disagree with this calculation. Respondent asserts that under sections 446(b) and 461(g) only petitioners' share of $25,463, or $12,731, should be allowed as an interest deduction. Although respondent does not make this calculation, it would follow that $145,010 ($12,731 subtracted from half of the $315,482 unstated interest) of petitioners' interest deduction should be disallowed. This is $250 greater than the $144,760 that respondent seeks to disallow because respondent does not correct a computational error made by petitioners when calculating their section 189 real property construction period interest. Their reported share of that amount is $250 greater than the amount of interest that economically accrued.

DISCUSSION

The issue is whether section 446(b) or section 461(g) limits petitioners' interest deduction to the amount of interest that economically accrued rather than to the amount of interest determined under section 483.

Respondent's principal argument involves section 446(b), which states that:

If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.

In Prabel v. Commissioner, 91 T.C. 1101, 1111-1112 (1988) (Court reviewed), affd. 882 F.2d 820 (3d Cir. 1989), we said:

Under section 446(b), respondent has ‘broad powers of determining whether accounting methods used by a taxpayer clearly reflect income.‘ Commissioner v. Hansen, 360 U.S. 446, 467 (1959). Respondent's authority under section 446(b) reaches not only overall methods of accounting, but also a taxpayer's method of accounting for specific items of income and expense. Sec. 1.446-1(a), Income Tax Regs.; Keller v. Commissioner, 725 F.2d 1173, 1179 (8th Cir. 1984), affg. 79 T.C. 7 (1982); Burck v. Commissioner, 533 F.2d 768, 773 (2d Cir. 1976), affg. 63 T.C. 556 (1975); Grynberg v. Commissioner, 83 T.C. 255, 267 (1984). [Fn. ref. omitted.]

This Court cannot interfere with respondent' s audit adjustments under section 446(b) unless the adjustments are ‘clearly unlawful,‘ or ‘plainly arbitrary.‘ Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979). Our task in evaluating changes in methods of accounting under section 446(b) is to determine whether respondent abused his discretion in changing the taxpayer's method of accounting. RCA Corp. v. United States, 664 F.2d 881, 886 (2d Cir. 1981), cert. denied 457 U.S. 1133 (1982). The taxpayer has a heavy burden of establishing that respondent did, in fact, abuse his discretion. American Fletcher Corp. v. United States, 832 F.2d 436, 438 (7th Cir. 1987); Record Wide Distributors, Inc. v. Commissioner, 682 F.2d 204, 206 (8th Cir. 1982), affg. a Memorandum Opinion of this Court.* * *

Respondent notes that section 1.483-2(a)(1)(i), Income Tax Regs., states:

Generally, a contract under which there is total unstated interest (within the meaning of section 483(a)) shall be treated as if such interest were actually provided for in the contract, and such unstated interest shall constitute interest for all purposes of the Code. * * *

Since unstated interest is generally treated as if it were provide d for in the contract, respondent argues that for purposes of section 446(b) we should treat $315,482 (the portion of petitioner's first installment characterized as interest by section 483) as if it were interest provided for in the contract. If we do, respondent argues, petitioners must use the economic accrual method to calculate their interest deduction. Respondent cites Prabel v. Commissioner, 91 T.C. at 1101, which involved the use of the Rule of 78's to accelerate interest payments relative to the economic accrual method. In Prabel, we concluded that the Commissioner acted within his discretion under section 446(b) when he required that the interest deductions be determined under the economic accrual method. We have reached similar results in other cases involving the prepayment of interest. Resnik v. Commissioner, 66 T.C. 74 (1976), affd. 555 F.2d 634 (7th Cir. 1977); Cole v. Commissioner, 64 T.C. 1091 (1975), affd. 586 F.2d 747 (9th Cir. 1978); Burck v. Commissioner, 63...