Malone v. Commissioner

T.C. Memo. 1996-408

UNITED STATES TAX COURT

JOHN A. MALONE AND BRENDA K. MALONE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 5069-94. Filed September 9, 1996.

Jill E. Bliss, for petitioners.

William McCarthy and Keith G. Medleau, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COLVIN, Judge: Respondent determined that petitioners had

deficiencies in Federal income tax of $8,276 for 1989, $21,265

for 1990, and $1,901 for 1991.

Petitioners bought all of the stock of Seattle Pump Company,

Inc. (Seattle Pump). They gave the seller a note secured by

letters of credit. The letters of credit were secured in part by
 - 2 -

a deed of trust on petitioners’ residence. Seattle Pump employed

petitioner John A. Malone (petitioner) and other members of his

family after petitioners bought the stock.

Petitioners deducted interest they paid on the notes they

used to buy the stock. Respondent disallowed the deduction on

the grounds that the interest was personal interest under section

163(h). After concessions, we must decide:

1. Whether section 163(h), which was effective for taxable

years beginning after December 31, 1986, applies to interest paid

in 1989, 1990, and 1991 on indebtedness incurred in December

1986. We hold that it does.

2. Whether the interest at issue either is trade or

business interest under section 163(h)(2)(A) or is investment

interest under section 163(h)(2)(B) and (d). We hold that the

interest is investment interest and that petitioners have not

shown that they received any investment income. Sec. 163(d).

3. Whether petitioners may deduct the interest at issue as

an expense for the production of income under section 212. We

hold they may not.

4. Whether petitioners may deduct the interest at issue as

qualified residence interest under section 163(h)(2)(D) and (3).

We hold that they may not.
 - 3 -

Section references are to the Internal Revenue Code in

effect for the years in issue. Rule references are to the Tax

Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

A. Petitioners

Petitioners are married and lived in Bothell, Washington,

when they filed their petition. From August 1977 to August 1979,

petitioner was an Internal Revenue Service revenue agent. From

August 1979 to 1984, petitioner was comptroller for a company in

Seattle. From 1984 to 1986, petitioner earned about $65,000 per

year as a vice president of a real estate development company

that converted apartments to condominiums. Petitioner had

invested in real estate and had owned other businesses. He owned

an ice business and an accounting business in the 1970's. He and

his wife owned an ice cream and candy store in the 1980's.

During the 1970's and 1980's, petitioner bought several houses

and a condominium (most jointly with his brother) as rentals or

as investments, and bought a condominium to rent to his daughter

and son-in-law.

Petitioner was unemployed in the summer of 1986. He began

to look for work for which he could earn at least $70,000 per

year.
 - 4 -

B. Seattle Pump Company, Inc.

1. Sale to Petitioners

Petitioner’s brother, Thomas Malone, is an attorney who

represented Helene Voier (Voier), the owner of Seattle Pump. She

wanted to sell her Seattle Pump stock. Petitioner studied

Seattle Pump’s books and records. He concluded that it had been

profitable and that he could earn wages of $70,000 per year from

it.

On December 19, 1986, petitioners bought all of the Seattle

Pump stock from Voier. Petitioners agreed to pay $362,000 to

Voier as follows: (a) $50,000 by January 1, 1987; (b) $50,000 by

January 2, 1987; and (c) $262,000 by January 1, 1989, with 9

percent interest. Seattle Pump's records of accounts receivable

and payable were not very accurate. Petitioners agreed to

increase the purchase price of Voier’s stock later based on the

accounts receivable and payable.

Voier agreed to finance the sale if petitioners gave

security other than Seattle Pump stock. On December 19, 1986,

petitioners signed a $312,000 promissory note payable to Voier.

The note required petitioners to pay $50,000 by January 2, 1987,

and to make monthly payments of $2,500. The balance was payable

by January 1, 1989, with interest at 9 percent. On December 19,

1986, petitioners borrowed $50,000 from Seattle Pump’s cash

reserves to make a downpayment to Voier.
 - 5 -

Petitioners offered to secure the note with their home.

Voier rejected it because she did not want to have to foreclose

on their home if they defaulted. Petitioner asked Roy Throndson

(Throndson), chief executive officer of Evergreen Bank in

Seattle, whether the bank would approve a letter of credit to

secure the note. Sometime before December 19, 1986, Throndson

said the bank could approve a letter of credit for petitioners.

Voier accepted a letter of credit as security for the note.

2. 1987 Letter of Credit

To secure the $262,000 balance owed under the promissory

note, petitioners gave Voier a letter of credit for $250,000,

dated January 16, 1987, issued by Evergreen Bank. The letter of

credit guaranteed that the bank would pay Voier if petitioners

defaulted on their promissory note to her.

The 1987 letter of credit was secured by two deeds of trust

that were dated January 16, 1987. The deeds of trust were filed

on February 17, 1987 (securing $100,000) and February 18, 1987

(securing $150,000). The $100,000 deed of trust was secured by

petitioners’ residence, which was located on 1 acre of land. The

$150,000 deed of trust was secured by 4 acres of land with no

residence which petitioners and Thomas Malone jointly owned. The

deeds of trust provided that the properties were to be reconveyed

to petitioners if they met their obligations under the 1987

letter of credit.
 - 6 -

The 1987 letter of credit allowed petitioners to pay any

amounts Voier drew on it. Thus, petitioners could have avoided

collection by Evergreen Bank by paying the bank the amount due.

Petitioners renewed the 1987 letter of credit annually.

They used the deeds of trust that secured the 1987 letter of

credit to secure later letters of credit.

Evergreen Bank required petitioners to manage and to

participate materially in the Seattle Pump business as a

condition for issuing the 1987 letter of credit. Evergreen Bank

knew petitioner had previously owned and successfully managed

other businesses.

3. Petitioners’ Operation of Seattle Pump

Petitioners became employees of and began operating Seattle

Pump when they bought Voier’s stock on December 19, 1986.

Petitioner was president, petitioner wife was vice president, and

both were employees of Seattle Pump during the years in issue.

Petitioner was responsible for business operations and hiring and

firing of employees. Petitioners ran Seattle Pump from December

19, 1986, through the date of trial.

Petitioners received wages for services they provided to

Seattle Pump during the years in issue as follows:

Year John Malone Brenda Malone
1989 $87,576.87 $4,324.00
1990 110,768.47 3,310.50
1991 9,153.84 4,420.00

Their combined wages from Seattle Pump were $35,063 in 1992.
 - 7 -

4. Modification of the Sale Agreement

On September 14, 1987, petitioners and Voier agreed to raise

the Seattle Pump stock purchase price by $40,000 based on Seattle

Pump's accounts receivable. On that date, Voier agreed not to

compete with petitioners, and petitioners agreed to give bonuses

to certain key employees. Petitioners gave Voier a promissory

note for $40,000 secured by petitioners' savings account.

5. 1989 Promissory Note and Letter of Credit

A balloon payment for the balance owing on the $262,000 note

was due in late 1988. Petitioners asked Voier to extend the due

dates of the $262,000 and $40,000 promissory notes. Voier agreed

to refinance and extend the due dates of the two notes.

On February 1, 1989, petitioners signed a $286,000

promissory note (1989 note) to Voier, which combined the

outstanding obligations of the 1986 and 1988 promissory notes and

increased the interest rate. Voier required petitioners to

secure the 1989 note with a letter of credit. Petitioners

applied to Evergreen Bank for a new letter of credit. Evergreen

Bank issued a new letter of credit on February 1, 1989 (the 1989

letter of credit) to secure the 1989 note.

As with the 1987 letter of credit, the 1989 letter of credit

allowed petitioners to pay amounts drawn on it by Voier, enabling

petitioners to avoid collection by Evergreen Bank by paying the

amount due. Petitioners used the same two deeds of trust to
 - 8 -

secure the 1989 letter of credit that they had used for the 1987

letter of credit.

6. 1990 Letter of Credit

On April 15, 1990, petitioners applied for another letter of

credit in favor of Voier to secure the 1989 note. Petitioners

obtained a letter of credit on April 16, 1990 (the 1990 letter of

credit). As with the 1989 letter of credit, the 1990 letter of

credit allowed petitioners to pay any amounts drawn on it. The

1990 letter of credit expired on April 15, 1991, and could be

renewed for 1 year.

C. 1990 Key Bank Loan

In 1990, petitioners asked Evergreen Bank for a line of

credit to cover Seattle Pump's working capital needs. Evergreen

Bank denied petitioners’ request.

Key Bank of Puget Sound (Key Bank) agreed to grant a line of

credit to petitioners if they gave Key Bank all of Seattle Pump’s

loan business. Petitioners agreed to refinance their obligation

to Voier through Key Bank. On July 1, 1990, petitioners borrowed

$285,000 from Key Bank and paid Voier in full. Evergreen Bank

reconveyed the deeds of trust to petitioners and petitioner’s

brother. Petitioners and petitioner’s brother gave one deed of

trust to secure the Key Bank Loan. The deed of trust covered the

1-acre parcel that petitioners owned and on which they lived and

a separate 4-acre parcel that petitioners and Thomas Malone
 - 9 -

jointly owned. Petitioners had borrowed money to buy the 1-acre

and 4-acre parcels.

D. Petitioners’ Interest Deductions

Petitioners claimed the following interest deductions on

Schedule C of their returns for the years in issue:
1
1989 $ 53,098
1990 54,673
1991 54,141

OPINION

A. Contentions of the Parties

Petitioners contend that they may deduct the interest at

issue. They contend that the limitation in section 163(h) on the

deduction of personal interest does not apply because they signed

the sales agreement before section 163(h) was effective, and

because Congress did not intend section 163(h) to apply to the

owners of a corporation who were also employees of the

corporation. If section 163(h) applies, petitioners contend that

they may deduct the interest at issue because it is: (1) Trade

or business interest under section 163(h)(2)(A); (2) investment

interest under section 163(h)(2)(B); (3) an expense for the

production of income under section 212; or (4) qualified

residence interest under section 163(h)(2)(D).

1
Respondent determined that petitioners may not deduct those
amounts, except respondent determined that petitioners may not
deduct $53,048 for 1989. There is no explanation for the $50
discrepancy.
 - 10 -

Respondent contends that the interest at issue is

nondeductible personal interest under section 163(h) and that

section 212 does not apply.B. Limitation on the Deduction of

Personal Interest

Generally, a taxpayer other than a corporation may not

deduct personal interest. Sec. 163(h)(1).2 Investment

2
Section 163(h) provides in pertinent part:

(h) Disallowance of Deductions for Personal Interest.--

(1) In General.--In the case of a taxpayer other
than a corporation, no deduction shall be allowed
under this chapter for personal interest paid or
accrued during the taxable year.

(2) Personal Interest.--For purposes of this
subsection, the term “personal interest” means any
interest allowable as a deduction under this
chapter other than--

(A) interest paid or accrued on indebtedness
properly allocable to a trade or business
(other than the trade or business of
performing services as an employee),

(B) any investment interest (within the
meaning of subsection (d)),

* * * * * * *

(D) any qualified residence interest (within
the meaning of paragraph (3)), and

* * * * * * *

(3) Qualified Residence Interest.--For purposes of
this subsection--

(A) In general.--The term "qualified residence
interest" means any interest which is paid or
(continued...)
 - 11 -

2
(...continued)
accrued during the taxable year on--

(i) acquisition indebtedness with respect to
any qualified residence of the taxpayer, or

(ii) home equity indebtedness with respect to
any qualified residence of the taxpayer.

For purposes of the preceding sentence, the
determination of whether any property is a
qualified residence of the taxpayer shall be made
as of the time the interest is accrued.

(B) Acquisition indebtedness.--

(i) In general.--The term "acquisition
indebtedness" means any indebtedness which--

(I) is incurred in acquiring,
constructing, or substantially improving
any qualified residence of the taxpayer,
and

(II) is secured by such residence.

* * * * * * *

(C) Home equity indebtedness.--

(i) In general.--The term "home equity
indebtedness" means any indebtedness (other
than acquisition indebtedness) secured by a
qualified residence to the extent the
aggregate amount of such indebtedness does
not exceed--

(I) the fair market value of such
qualified residence, reduced by

(II) the amount of acquisition
indebtedness with respect to such
residence.

(ii) Limitation.--The aggregate amount
(continued...)
 - 12 -

interest, interest allocable to a trade or business (other than

the trade or business of performing services as an employee), and

qualified residence interest are not personal interest. Sec.

163(h)(2). However, investment interest may be deducted only to

the extent that the the taxpayer has net investment income. Sec.

163(d).

Deductions are a matter of legislative grace and are

strictly construed. New Colonial Ice Co. v. Helvering, 292 U.S.

435, 440 (1934); Independent Co-op Milk Producers Association v.

Commissioner, 76 T.C. 1001, 1014 (1981). A taxpayer bears the

burden of proving that he or she may deduct the claimed expense.3

Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

C. Effective Date of Section 163(h)

Petitioners contend that the personal interest deduction

limits of section 163(h) do not apply to interest they paid after

2
(...continued)
treated as home equity indebtedness for any
period shall not exceed $100,000 ($50,000 in
the case of a separate return by a married
individual).
3
Petitioners called Lee E. Lott (Lott) as an expert witness.
Respondent objected because petitioners did not provide an expert
witness report before trial as required by Rule 143(f).
Petitioners' counsel said that she wanted to ask Lott if
petitioners handled their interest deductions correctly on their
tax returns. We would have not considered Lott's testimony
because it was a legal opinion. Aguilar v. ILWU Local 10, 966
F.2d 443, 447 (9th Cir. 1992); Marx & Co. v. Diners' Club, Inc.,
550 F.2d 505, 509 (2d Cir. 1977); Estate of Cartwright v.
Commissioner, T.C. Memo. 1996-286. Petitioners did not raise
this issue on brief; thus we treat it as conceded.
 - 13 -

1986 because petitioners bought the Seattle Pump stock, and

signed a promissory note for it before the effective date of that

section. We disagree.

Section 163(h) applies to taxable years beginning after

December 31, 1986. Sec. 511(e) of the Tax Reform Act of 1986,

Pub. L. 99-514, 100 Stat 2085, 2249. Petitioners paid the

interest at issue in 1989, 1990, and 1991, all of which was

during petitioners' taxable years beginning after December 31,

1986.

Petitioners contend that section 162(a)4 or section 163(a)5

allows them to deduct the interest at issue here because Congress

did not amend those sections when it enacted section 163(h). We

disagree. Section 163(h) limits the deduction of personal

interest that was previously deductible under section 163(a).

D. Whether Petitioners May Deduct the Interest At Issue as
Trade or Business Interest Under Section 163(h)(2)(A) or
Investment Interest Under Section 163(h)(2)(B)

1. Background

4
Section 162(a) provides, in part:

(a) In general. -- There shall be allowed as a
deduction all the ordinary and necessary expenses paid
or incurred during the taxable year in carrying on any
trade or business * * *.
5
Section 163(a) provides:

(a) General rule. -- There shall be allowed as a
deduction all interest paid or accrued within the
taxable year on indebtedness.
 - 14 -

Interest paid on indebtedness allocable to a trade or

business (other than the trade or business of performing services

as an employee) is not personal interest. Sec. 163(h)(2)(A).

Investment interest is not personal interest, sec. 163(h)(2)(B);

however, investment interest may be deducted only to the extent

of the taxpayer's net investment income, sec. 163(d).

Petitioners contend that the interest at issue is allocable

to a trade or business, and that it was not the trade or business

of performing services as employees. Alternatively, petitioners

contend that they may deduct the interest at issue as investment

interest under section 163(h)(2)(B). We agree that the interest

at issue is investment interest. However, we disagree that

petitioners may deduct it because they have not shown that they

had any investment income during the years at issue.

2. Whether the Interest at Issue Is Allocable to an
Investment or to a Trade or Business

Petitioners contend that the interest at issue is allocable

to the trade or business of owning and operating Seattle Pump.

Petitioner testified that he bought the stock to get a job for

himself and his family and that he believed he was not making an

investment when he bought the stock.

Petitioners contend that Miller v. Commissioner, 70 T.C. 448

(1978), supports their position that the purchase of stock in a

company to obtain a job is in connection with a trade or

business. We disagree. In Miller v. Commissioner, supra, the
 - 15 -

taxpayer borrowed money to buy a controlling interest in the

stock of a bank so that he could become the bank's president.

The corporation paid little or no dividends while the taxpayer

owned it. The taxpayer contended that he held the bank stock as

part of his trade or business of banking (and not as an

investment) because it allowed him to become the bank president.

Id. at 453. We concluded that the taxpayer ran the corporation

to increase its resale value and that the taxpayer held the stock

as an investment.

We recognize that petitioner wanted to work for Seattle

Pump; however, like Miller, the objective facts show that

petitioners held the stock as an investment, not as part of a

trade or business. The stock of Seattle Pump is a capital asset.

Petitioner researched the company before buying the stock as a

prudent investor would. He learned that Seattle Pump had been

profitable. Petitioner believed petitioners paid fair market

value for the stock. Payment of fair market value for stock

suggests that the stock was held for investment purposes; payment

of a price above fair market value would have suggested it was

not held as an investment. Id. at 456. Petitioners have held

the stock for a relatively long period of time. They have

enjoyed the benefits of stock ownership, including control of

Seattle Pump. Petitioners will benefit, as any investor would,

if the value of the stock rises. Petitioner testified that he
 - 16 -

was not counting on stock appreciation, but he did not deny that

the value of the stock could rise.

Like the corporation in Miller, Seattle Pump did not pay

dividends in the years in issue. We concluded in Miller that the

taxpayer held the stock as an investment, even though he bought

it so he could become president of the corporation. Similarly,

we believe petitioner held Seattle Pump stock as an investment

despite the fact that he served as its president.

Petitioners rely on Schanhofer v. Commissioner, T.C. Memo.

1986-166, in which we held that the investment interest

limitations under section 163(d) did not apply to interest paid

by a taxpayer who borrowed money to buy stock in the company for

which he worked. That case is distinguishable. In Schanhofer,

the taxpayer paid a substantial premium for stock that was not

marketable because of restrictions in beverage permit and

franchise agreements. The stock in Schanhofer had minimal growth

potential. In contrast, petitioners' sale of the stock of

Seattle Pump was not restricted, petitioners paid fair market

value for the stock, and they did not show that it has no growth

potential.6

6
We did not consider section 163(h) in Miller v.
Commissioner, 70 T.C. 448 (1978) and Schanhofer v. Commissioner,
T.C. Memo. 1986-166, because it had not yet been enacted; we
decided whether the interest at issue was limited by section
163(d).
 - 17 -

Petitioners' purchase of Seattle Pump stock is not a trade

or business. The Internal Revenue Code does not define trade or

business for this purpose. Commissioner v. Groetzinger, 480 U.S.

23, 27 (1987); Estate of Yaeger v. Commissioner, 889 F.2d 29, 33

(2d Cir. 1989), affg. T.C. Memo 1988-264. "[T]o be engaged in a

trade or business, the taxpayer must be involved in the activity

with continuity and regularity and * * * the taxpayer's primary

purpose for engaging in the activity must be for income or

profit." Commissioner v. Groetzinger, supra at 35. The

ownership of stocks and bonds is not generally a trade or

business under section 162. Higgins v. Commissioner, 312 U.S.

212 (1941)(managing securities investments and collecting income

therefrom generally is not a trade or business, regardless of the

amount invested, continuity of effort, or amount of time devoted

to the activity). The purchase of the stock of one company is

not ordinarily an activity of an ongoing trade or business. Id.

There is no evidence that petitioners bought any stock other than

that of Seattle Pump or that were in a trade or business of

buying stock. Devoting one's time and energies to the affairs of

a corporation is generally not, of itself, a trade or business of

the person so engaged. Whipple v. Commissioner, 373 U.S. 193,

202 (1963).

We conclude that petitioners held the Seattle Pump stock as

an investment, not as part of a trade or business. Thus, the
 - 18 -

interest at issue does not qualify under the trade or business

exception under section 163(h)(2)(A).7

3. Limitation of Deduction of Investment Interest

The amount of investment interest that a taxpayer other than

a corporation may deduct may not exceed the taxpayer's net

investment income for the taxable year. Sec. 163(d)(1).

Petitioners have not shown that they had any net investment

income during the years in issue. There is no evidence that

Seattle Pump paid dividends during the years in issue.8 We

conclude that petitioners may not deduct any of the interest at

issue as investment interest except as allowed next.

4. Phase-In Limitations

Disallowance of the deduction of net investment income

interest is phased-in during taxable years 1987 to 1990. Sec.

163(d)(6). Disallowance of personal interest is phased-in for

1987 to 1990 under different rules than for net investment

interest. Sec. 165(h)(5). Respondent determined that the

interest at issue is personal interest. Consistent with that

determination, petitioners should be entitled to an interest

7
In light of this conclusion, we need not decide
respondent's contention that petitioners' purchase of Seattle
Pump stock was properly allocable to their trade or business of
providing services as an employee. See sec. 163(h)(2)(A).
8
Petitioners do not argue that their wages are investment
income under sec. 163(d). Wages received by a shareholder are
not investment income under sec. 163(d); wages are compensation
for personal services. Sec. 162(a)(1).
 - 19 -

deduction that is no less than the amount that would be allowed

under personal interest phase-in rules for each year.

E. Whether Petitioners May Deduct the Interest At Issue as An
Expense for the Production of Income Under Section 212

Petitioners contend that they may deduct the interest at

issue as an expense for the production of income under section

212. We disagree.

Petitioners asserted without explanation in their pretrial

memorandum and posttrial briefs that they may deduct the interest

at issue under section 212. Petitioners have not cited (and we

are not aware of) any case in which a court disallowed interest

deductions under section 163 and allowed them under section 212.

Petitioner testified that petitioners bought Seattle Pump

stock so that he and his family could have jobs. Section 1.212-

1(f), Income Tax Regs., provides that taxpayers may not deduct

under section 212 the costs of seeking employment or placing

oneself in a position to begin rendering personal services for

compensation. The limits of section 163(d) would be undermined

if taxpayers could deduct under section 212 interest which is not

deductible under section 163(d).

We conclude that petitioners may not deduct any of the

interest at issue under section 212.
 - 20 -

F. Whether Petitioners May Deduct the Interest At Issue as
Qualified Residence Interest Under Section 163(h)(2)(D)

Petitioners contend that they may deduct the interest at

issue as qualified residence interest under section 163(h)(2)(D)

and (3)(A)(ii). Respondent contends that the interest paid on

the notes to Voier was not qualified residence interest.

Respondent also contends that petitioners did not prove the

amount of qualified residence interest attributable to the Key

Bank loan.

Qualified residence interest is interest that is paid or

accrued on acquisition or home equity indebtedness with respect

to any qualified residence of the taxpayer. Sec. 163(h)(3)(A).

Acquisition indebtedness is indebtedness paid to acquire,

construct, or substantially improve a qualified residence and is

secured by that residence. Sec. 163(h)(3)(B)(i). Home equity

indebtedness is indebtedness other than acquisition indebtedness

that is secured by a qualified residence if the indebtedness is

not more than the fair market value of the qualified residence

reduced by the amount of acquisition indebtedness for the

qualified residence. Sec. 163(h)(3)(C)(i).

There is no evidence of the fair market value of the

residence that petitioners contend is the qualified residence, or

the amount of acquisition indebtedness. There are no facts in

the record upon which we may estimate the fair market value or

acquisition indebtedness. In the opening brief, respondent
 - 21 -

contended that the amount of qualifying indebtedness cannot be

ascertained. Petitioners did not respond to respondent's

contention. We conclude that petitioners may not deduct any

amount as qualifying residence interest because facts needed to

calculate the deduction are not in the record.9

G. Conclusion

Petitioners may deduct interest for each year in issue under

the phase-in rules of section 163(d)(6) for investment interest

or section 163(h)(5) for personal interest, whichever is greater.

To reflect concessions and the foregoing,

Decision will be

entered under Rule 155.

9
In light of our conclusion, we need not decide respondent's
contention that petitioners have not shown that they meet the
limitations that apply to home equity indebtedness. We also need
not decide petitioners' contention that mortgage interest on
their residence is qualified residence interest under section
163(h)(3) because the residence secured the letters of credit
that in turn secured their note to Voier.