Woodward v. Commissioner of Internal Revenue

• Decision Date: 02 May 1969
• Docket Number: No. 19386.,19386.
• Parties: Fred W. WOODWARD and Elsie M. Woodward, F. R. Woodward and M. Jeanne Woodward, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Eighth Circuit

410 F.2d 313 (1969)

Fred W. WOODWARD and Elsie M. Woodward, F. R. Woodward and M. Jeanne Woodward, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 19386.

United States Court of Appeals Eighth Circuit.

May 2, 1969.

Donald P. Cooney, Dubuque, Iowa, for petitioners.

Issie L. Jenkins, Atty., Dept. of Justice, Washington, D. C., for respondent; Mitchell Rogovin, Asst. Atty. Gen., and Lee A. Jackson and Harry Baum, Attys., Dept. of Justice, Washington, D. C., with her on the brief.

Before MATTHES, MEHAFFY and LAY, Circuit Judges.

MATTHES, Circuit Judge.

This case is before us on petition to review the decision of the Tax Court sustaining the determination by the Commissioner of Internal Revenue of deficiencies in the petitioners' income taxes for the year 1963. 49 T.C. 377 (1968) (opinion by Judge Tietjens reviewed by the entire court, with Judges Bruce and Fay dissenting).

The deficiencies result from deductions of litigation expenses incurred in connection with the acquisition of shares of stock by the petitioners. The petitioners contend that these expenses were incurred for the conservation, management or maintenance of property held for the production of income and thus deductible under § 212 of the Internal Revenue Code of 1954 which provides:

"In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year —

(1) for the production or collection of income;

(2) for the management, conservation, or maintenance of property held for the production of income; * * *."

The Commissioner, on the other hand, maintains that the expenses were capital expenditures under § 263 of the 1954 Code which must be added to the basis of the property rather than deducted from gross income. Section 263 provides:

"No deduction shall be allowed for —

(1) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. This paragraph shall not

apply to — exceptions, irrelevant to this case, omitted

(2) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made. * *"

Together the petitioners owned a majority interest in the Telegraph Herald, an Iowa corporation. The charter of the corporation was due to expire in 1961. The stockholders met on June 9, 1960, and by majority vote adopted a resolution extending the corporate existence of Telegraph Herald perpetually. A certificate for the renewal of the corporate charter was issued by the Secretary of the State of Iowa shortly thereafter.

The only shareholder voting against renewal was Margaret M. Quigley, who owned 379 of the 1,200 shares issued and outstanding. Under the corporation laws of Iowa it was provided that:

"In all cases of renewal, those stockholders voting for such renewal must purchase at its real value the stock voted against such renewal, and shall have three years from the date such action for renewal was taken in which to purchase and pay for the stock voting against such renewal, which purchase price shall bear interest at the rate of five percent per annum from the date of such renewal action until paid." Iowa Code § 491.25 (1958).

On February 9, 1962, all the majority stockholders, except one, joined in filing a petition in the District Court of Iowa, Dubuque County, seeking a determination of the real value of the Quigley stock. The value was determined by the district court to be $1,750 per share. This figure was lowered by the Supreme Court of Iowa to $1,650 per share. Woodward v. Quigley, 257 Iowa 1077, 133 N.W.2d 38 (1965). On rehearing the value was further reduced to $1,620. Woodward v. Quigley, 257 Iowa 1077, 1104, 136 N.W.2d 280 (1965). After the entry of final judgment in the case, the majority stockholders, on July 16, 1965, purchased the stock.

During 1963 petitioners paid attorneys', accountants' and appraisers' fees along with other costs of services rendered in connection with the determination of the value of Mrs. Quigley's stock. The respective taxpayers deducted their proportionate shares of these expenses on their income tax returns for 1963, describing them as "professional fees incurred in relation to income-producing property." The Commissioner disallowed the deductions "because the fees represent capital expenditures incurred in connection with the acquisition of capital stock of a corporation." The taxpayers timely filed petitions in the Tax Court for a redetermination of the deficiencies. As stated, the Tax Court upheld the Commissioner's action.

It has long been the government's view that the cost of defending or perfecting title to property is a capital expenditure. 26 C.F.R. § 1.263(a) — 2(c) (1968).¹ The courts have accepted this view, 4A Mertens, Law of Fed. Income Taxation §§ 25.24, 25A.16 (1966), but have added the restriction that not all expenses of litigation wherein title is involved are capital expenditures. If litigation arises concerning the title to property held by the taxpayer, the courts will look to the primary purpose of the litigation to determine the deductibility of litigation expenses.

"Thus, if the primary or sole purpose of the suit is to perfect or defend title, the expenditures are not deductible. * * * On the other hand, even though title may be involved, if its defense or perfection is not the primary purpose of the litigation, the expenditures do not encounter the barrier of the regulation\'s standard and they may qualify instead as ordinary and necessary expenses." Industrial Aggregate Co. v. United States, 284 F.2d 639, 645 (8th Cir. 1960) (citations omitted).

In the latter instance the expenses are currently deductible from gross income under § 162 or § 212 of the Internal Revenue Code of 1954 (formerly § 23(a) (1) and § 23(a) (2), respectively, of the Internal Revenue Code of 1939.²

Petitioners would extend the primary purpose test to litigation expenses incurred in the acquisition of property. They take the position that since the purpose of the litigation below was merely to value shares which the taxpayers were required by law to purchase — rather than to perfect, defend or acquire title — the expenditures were incurred for the management, conservation or maintenance of property held for the production of income, and thus deductible under § 212.

The Commissioner argues, and the Tax Court held, that the primary purpose doctrine has no application to litigation expenses directly connected with the acquisition of a capital asset. According to this view, that doctrine becomes operative only when, having acquired property, a taxpayer incurs expenditures to defend or perfect title thereto. Accepting this view of the matter, the Tax Court found that the "value-setting litigation and its attendant expenses were directly tied to the stock purchase and the expenses were part of the cost of the stock. As such, the expenses were clearly capital expenditures," under § 263 of the 1954 Code. 49 T.C. at 382.

Petitioners' reliance on the primary purpose test is misplaced. As we have mentioned, that test developed from the uncertainty surrounding the effect of Treas.Reg. 1.263(a) — 2(c), which gives as an example of a capital expenditure "the cost of defending or perfecting title to property." Rather, this case involves the cost of acquisition of property. We thus have no need to apply the primary purpose test, a test which would only be relevant to a situation where the taxpayer's ownership of or interest in a capital asset is challenged. This was the situation in Industrial Aggregate Co. v. United States, supra, where litigation expenses were incurred in connection with a dispute concerning leases which taxpayer had held for many years. In that case we applied the primary purpose test to find the litigation expenses deductible.

The test was also recognized in Iowa Southern Util. Co. v. Commissioner of Internal Revenue, 333 F.2d 382 (8th Cir.), cert. denied, 379 U.S. 946, 85 S. Ct. 438, 13 L.Ed.2d 543 (1964). There, shareholders of the taxpayer corporation brought a derivative action against the corporation's majority shareholders and former president and others, on the theory that they had secretly acquired properties at prices far less than those at which they turned them in to the taxpayer (corporation). The corporation was not allowed to deduct the litigation expenses as ordinary and necessary business expenses under § 162. While we recognized the primary purpose test in that opinion, we did not apply the test to the facts of that case. Instead, Judge Blackmun, in reaching the decision that the litigation expenses represented capital expenditures, relied on several factors to be discussed later. Apparently the court treated the expenses as incidental to the earlier purchase of the capital assets. See Spangler v. Commissioner of Internal Revenue, 323 F.2d 913, 921 (9th Cir. 1963) and Munson v. McGinnes, 283 F.2d 333 (3d Cir.), cert. denied, 364 U.S. 880, 81 S.Ct. 171, 5 L.Ed.2d 103 (1960).

Petitioners also suggest that they obtained equitable title to the stock on the date the shareholders voted against corporate renewal. They argue the purchase was subject only to valuation and payment of the purchase price. Based upon this premise, it is asserted that the expenses were not incurred to perfect title or to purchase and thus were not capital expenditures.

Iowa law does not support the taxpayers' premise. The only Iowa cases cited by petitioners are Woodward v. Quigley, supra; Robbins v. Beatty, 246 Iowa 80, 67 N.W.2d 12 (1954); State ex rel. Robbins v. Shellsburg Grain and Lumber Co., 243 Iowa 734, 53 N.W.2d 143 (1952); Melsha v. Tribune Publishing Co., 243 Iowa 350, 51 N.W.2d 425 (1952); and Terrell v. Ringgold County Mut. Tel. Co., 225 Iowa 994, 282 N.W. 702 (1938). Even Judge Bruce in his dissent was unable to read into the above cases the rule espoused by...