McDonough v. Commissioner

BERNARD P. McDONOUGH AND ALMA G. McDONOUGH, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

McDonough v. Commissioner

Docket No. 7612-75.

United States Tax Court

T.C. Memo 1977-50; 1977 Tax Ct. Memo LEXIS 392; 36 T.C.M. 213; T.C.M. (RIA) 770050;

February 28, 1977, Filed

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1977 Tax Ct. Memo LEXIS 392">*392 Petitioners owned a substantial amount of tax-exempt securities which were purchased for cash, not used as collateral, and held for safe-keeping in bank accounts maintained solely for such securities and interest derived therefrom. They also owned taxable securities held in brokerage margin accounts incurring substantial interest charges thereon. Additionally, petitioners incurred bank loan interest on shortterm borrowings.

Held, petitioners have failed to prove that they did not incur or continue indebtedness to purchase or carry tax-exempt securities within the meaning of sec. 265(2); accordingly, a portion of petitioners' interest expense is disallowed.

G. Thomas Battle, for the petitioners.

David W. Otto, for the respondent.

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STERRETT

MEMORANDUM FINDINGS OF FACT AND OPINION

1977 Tax Ct. Memo LEXIS 392">*393 STERRETT, Judge: Respondent determined deficiencies in petitioners' Federal income taxes for the calendar years 1972 and 1973 in the amounts of $35,638 and $90,286, respectively.

Due to concessions ¹ by petitioners the sole issue for decision is whether petitioners "incurred or continued" indebtedness to "purchase or carry" tax-exempt securities within the meaning of section 265(2), I.R.C. 1954.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts, together with the exhibits attached thereto, are incorporated herein by this reference.

Petitioners, Bernard P. McDonough (Bernard) and Alma G. McDonough (Alma), husband and wife, resided in Parkersburg, West Virginia at the time the petition herein was filed. Their joint Federal income tax returns for the taxable years 1972 and 1973 utilized the accrual method of accounting and were filed with the Internal Revenue Service Center, Memphis, Tennessee. 1977 Tax Ct. Memo LEXIS 392">*394 Bernard and Alma are the sole and equal partners in the partnership, McDonough River Company (the partnership). ² The partnership filed U.S. partnership returns of income for the calendar years 1972 and 1973, employing the accrual method of accounting, with the Internal Revenue Service Center, Memphis, Tennessee. For convenience and conciseness, unless otherwise indicated, our findings of fact shall refer only to the taxable years 1972 and 1973.

In 1972 the partnership owned 14 barges at a cost of $352,800 and adjusted basis of $35,724; in 1973, 13 barges at an adjusted basis of $34,130. All barges were leased, through an agent, to third parties. All activity with respect to the barges, including repairs, maintenance, fees and other costs of operation, which fell upon the lessor, was handled by the agent. The agent was paid for costs incurred1977 Tax Ct. Memo LEXIS 392">*395 and the partnership had no employees. The barge rental activity was profitable and all rental operating costs were paid from barge rental income.

In addition to the barges, the partnership owned a portfolio of securities. The partnership was not in the trade or business of dealing in securities and the portfolio and its income were not utilized in its barge rental operation. The partnership portfolio of securities consisted of stocks, corporate bonds and tax-exempt securities with adjusted basis on the dates indicated as follows:

			Total Taxable 3
	Stocks	Corporate Bonds	Securities	Tax Exempt	Total
12/31/71	$1,578,487	$1,800,957	$3,379,444	$8,006,504	$ 11,385,948
12/31/72	1,043,952	1,635,864	2,679,816	8,856,387	11,536,203
12/31/73	1,418,780	1,091,200	2,509,980	9,339,010	11,848,990

Partnership sales of securities and income (loss) therefrom are as follows:

	Sale or
	Redemption at		Long-Term	Short-Term
12/31/72	Maturity	Cost	Capital Gain	Capital Gain
Stocks	$ 559,152	$1,082,476	[524,285)	$ 961
Corporate Bonds	1,118,068	996,012	121,440	616
Municipal Bonds	504,000	507,948	(2,298)	(1,650)
12/31/73
Stocks	$1,741,112	$1,475,544	$ 241,838	$23,730
Corporate Bonds	1,381,994	1,407,274	(7,256)	(18,024)
Municipal Bonds	1,646,699	1,656,808	(8,911)	(1,198)

1977 Tax Ct. Memo LEXIS 392">*396 Bernard owned securities individually other than those owned in the partnership, consisting of stocks, corporate bonds and tax-exempt securities with adjusted basis on the dates indicated as follows:

		Corporate	Total Taxable 4	Tax-Exempt
	Stocks	Bonds	Securities	Securities	Total
12/31/71	$1,735,171	$149,820	$1,884,991	$442,966	$ 2,327,957
12/31/72	1,870,302	535,162	2,405,464	466,776	2,872,240
12/31/73	1,967,497	542,465	2,509,962	741,370	3,251,332

Alma owned securities individually other than those owned in the partnership, consisting of stocks, corporate bonds and tax-exempt securities with adjusted basis on the dates indicated as follows:

		Corporate	Total Taxable 5	Tax-Exempt
	Stocks	Bonds	Securities	Securities	Total
12/31/71	$ 657,462	$0	$ 657,462	$ 98,727	$ 756,189
12/31/72	640,456	0	640,456	133,968	774,424
12/31/73	670,508	24,118	694,626	115,241	809,867

1977 Tax Ct. Memo LEXIS 392">*397

Petitioners' sales of securities and income (loss) therefrom, excluding partnership sales for 1972 and 1973, are as follows:

	Sales or Redemption		Long-Term	Short-Term
12/31/72	at Maturity	Cost	Capital Gain	Capital Gain
Stocks	$ 840,421	$215,008	$625,962	$ (549)
Municipal Bonds	225,000	225,990		(990)
12/31/73
Stocks	$ 938,618	$692,441	$235,107	$11,070
Corporate Bonds	762,319	746,425	8,671	7,223
Municipal Bonds	260,473	277,833	(16,903)	(457)

The partnership incurred interest expense of $146,989 and $131,869, respectively; the general categories of interest expense were as follows:

	Interest on	Margin Account	Bank Loan
	Prior Taxes	Interest	Interest	Total
1972	$74,273	$ 71,904	$ 812	$146,989
1973	2,757	109,668	19,504	131,929 6

1977 Tax Ct. Memo LEXIS 392">*398 During 1972 and 1973, Bernard paid interest of $39,344 and $73,213, respectively, on individual indebtedness; ⁷ the categories of interest expense were as follows:

	Margin Account	Bank Loan
	Interest	Interest	Total
1972	$33,594	$ 5,750	$39,344
1973	73,213	0	73,213

This $5,750 of bank loan interest was incurred on a $300,000 note made in October 1971 and repaid in February 1972. On February 2, 1972 petitioners received $309,359 as settlement of a 1958 income tax case. Also, the average annual interest rate charged on debit balances of brokerage margin accounts in 1972 was 6.25 percent and in 1973, 10.10 percent.

Bernard and the partnership have maintained one or more separate brokerage margin accounts continuously since 1938 and 1941, respectively, and generally each has had debit balances and interest charged thereon in said accounts. The partnership brokerage margin accounts have always been in the name of Bernard and Alama.

Bernard and the partnership each maintained brokerage1977 Tax Ct. Memo LEXIS 392">*399 margin accounts with three brokerage firms: Harris Upham & Company; Bacon Whipple & Company; and Bache & Company. The market value of taxable securities in the brokerage margin accounts maintained by each individually exceeded the respective debit balances, and all the margin accounts had debit balances upon which interest was charged as follows:

MONTH-END BALANCES IN BROKERAGE MARGIN ACCOUNTS OF McDONOUGH RIVER COMPANY

	Bacon	Bache	Harris,	Total
	Whipple &	&	Upham &
	Co.	Co.	Co.
12/31/71	1,074,812	120,832		1,195,644
1/31/72	998,459	109,803	10,545	1 ,118,807
2/28/72	1,081,653	94,880	10,599	1,187,132
3/31/72	735,673	98,189	10,648	844,510
4/30/72	894,932	82,17 1	10,702	987,805
5/31/72	938,395	79,731	10,757	1,028,883
6/30/72	926,544	79,861	10,815	1,017,220
7/31/72	1,12 1,891	153,678	10,871	1,286,440
8/31/72	1,113,376	214,592	10,930	1,338,898
9/30/72	1,165,593	215,310	10,993	1, 391,896
10/31/72	1,194,378	215,654	11,056	1,421,088
11/30/72	1,193,949	211,529	11,123	1,416,601
12/31/72	917,20 1	125,744	11,188	1,054,133
1/31/73	980,539	135,159	11,257	1,126,955
2/28/73	1,103,664	215,333	11,328	1,330,32 5
3/31/73	750,827	163,744	11,395	925,966
4/30/73	919,186	170,255	11,475	1,100,916
5/31/73	1,243,727	173,322	1 1,554	1,428,603
6/30/73	1,387,343	168,632	11,640	1,567,615
7/31/73	1,405,164	169,720	11,728	1,586,612
8/31/73	1,441,475	139,001	11,827	1,592,303
9/30/73	1,405,243	139,285	11,936	1,556,464
10/31/73	1,261,191	140,005	12,047	1,413,243
11/30/73	174,900	137,083	12,161	324,144
12/31/73	633,834	114,393	12,272	760,499

1977 Tax Ct. Memo LEXIS 392">*400 INTEREST EXPENSE MONTHLY ON BROKERAGE MARGIN ACCOUNTS OF McDONOUGH RIVER COMPANY

	Bacon,	Bache	Harris,
	Whipple &	&	Upham &
	Co.	Co.	Co.
January 1972	4,495	696	58
February 1972	4,864	448	53
March 1972	5,506	437	49
April 1972	3,804	446	53
May 1972	3,906	378	55
June 1972	4,923	379	57
July 1972	4,389	484	56
August 1972	5,061	760	58
September 1972	6,383	968	63
October 1972	5,520	1,101	62
November 1972	5,778	1,146	66
December 1972	8,010	1,328	64
Total				71,904
January 1973	4,579	633	69
February 1973	4,926	793	71
March 1973	7,230	1,054	67
April 1973	4,761	1,178	79
May 1973	5,443	1,179	78
June 1973	9,638	1,069	85
July 1973	9,396	1,228	88
August 1973	12,448	1,382	98
September 1973	11,208	1,363	109
October 1973	11,642	1,217	110
November 1973	10,993	1,203	114
December 1973	2,851	1,176	110
Total				109,668

BALANCES IN BROKERAGE MARGIN ACCOUNTS OF B. P. McDONOUGH

	Bacon,	Bache	Harris,	Total
	Whipple &	&	Upham &
	Co.	Co.	Co.
12/31/71	76,839	239,652	79,933	396,424
1/31/72	83,718	235,575	79,922	399,215
2/28/72	82, 916	236,399	80,279	399,594
3/31/72	89,543	237,382	80,477	407,402
4/30/72	89,270	232,997	79,671	401,938
5/31/7 2	88,195	234,065	79,378	401,638
6/30/72	88,976	267,888	79,750	436,614
7/31/72	87,997	263,493	78,954	430,444
8/31/72	88,196	350,246	150,298	588,740
9/30/72	89,034	391,956	151,828	632,818
10/31/72	143,851	443,900	152,54 4	740,295
11/30/72	173,922	466,754	150,773	791,449
12/31/72	116,186	682,281	151,458	949,925
1/31/73	115,395	6 44,896	151,235	911,526
2/28/73	97,608	701,910	147,967	947,485
3/31/73	91,532	601,119	133,148	825,799
4/30/73	92,522	609,937	132,349	834,808
5/31/73	107,268	445,971	132,518	685,757
6/30/73	108,525	528,092	133,415	770,03 2
7/31/73	175,547	530,071	128,403	834,021
8/31/73	174,456	239,722	127,384	541,562
9/30/73	333,643	335,218	128 ,181	797,042
10/31/73	332,924	401,877	126,548	861,349
11/30/73	248,229	434,499	126,940	809,668
12/31/73	247,904	496,418	116,707	861,029

1977 Tax Ct. Memo LEXIS 392">*401 INTEREST EXPENSE MONTHLY ON BROKERAGE MARGIN ACCOUNTS OF B. P. McDONOUGH

	Bacon,	Bache	Harris,
	Whipple &	&	Upham &
	Co.	Co.	Co.
January 1972	354	1,574	390
February 1972	578	824	357
March 1972	443	982	323
April 1972	918	1,095	354
May 1972	624	1,067	364
June 1972	780	1,144	371
July 1972	654	1,265	364
August 1972	647	1,309	460
September 1972	837	1,709	764
October 1972	708	2,004	715
November 1972	975	2,297	811
December 1972	1,458	3,290	785
Total	8,976	18,560	6,058	33,594
Other Interest				5,750
Total				39,344
January 1973	890	2,765	837
February 1973	883	3,666	856
March 1973	1,060	3,674	794
April 1973	853	4,087	891
May 1973	910	4,364	826
June 1973	1,256	2,970	896
July 1973	1,168	3,815	893
August 1973	2,102	4,303	989
September 1973	1,871	3,356	1,096
October 1973	2,453	2,725	1,107
November 1973	3,076	3,477	1,133
December 1973	2,339	3,718	1,114
Total	18,861	42,920	11,432	73,213

Although it was possible to purchase tax-exempt securities on margin and carry such securities in a brokerage margin account, no tax-exempt securities were1977 Tax Ct. Memo LEXIS 392">*402 used as collateral for any indebtedness nor were they purchased, held or owned in brokerage margin accounts maintained by the partnership or petitioners.

Beginning early in 1968 and extending through 1973, all tax-exempt securities owned by petitioners and by the partnership were held in safekeeping by Mellon National Bank and Trust Company, Pittsburgh, Pennsylvania, or by the Chase Manhattan Bank of New York City. All tax-exempt securities purchased by petitioners and the partnership are bearer bonds, and since the 1968 safekeeping arrangement was established, tax-exempt securities purchased have been delivered directly to said banks by brokers or agents making the purchases on behalf of petitioners or the partnership. The banks serviced petitioners' tax-exempt securities accounts by collecting interest as due and depositing the same to the credit of the account of the petitioners or the partnership as the case may be. Funds transferred to these accounts by the servicing banks were subsequently withdrawn by the partnership or petitioners, transferred to the credit of brokers purchasing other tax-exempt securities, or held on deposit pending instructions of petitioners or the1977 Tax Ct. Memo LEXIS 392">*403 partnership.

Bernard, Alma and the partnership had income from tax-exempt securities as follows:

	Partnership	Bernard	Alma	Total
1972	$547,355	$33,236	$7,834	$588,425
1973	567,297	31,724	8,724	607,745

Dividends and taxable interest for petitioners and the partnership are as follows:

1972	Dividends	Interest	Total
Partnership	$ 17,257	$321,529	$338,786
Petitioners	342,347	19,271	361,618
Total	$359,604	$340,800	$700,404
1973
Partnership	$ 64,640	$169,126	$233,766
Petitioners	530,633	45,010	575,643
Total	$595,273	$214,136	$809,409

The combined holdings of tax-exempt securities of the partnership and petitioners (at cost) increased or decreased by year as follows:

Year	Increase (Decrease)
1965	- 0 -
1966	$ 467,000
1967	1,186,000
1968	1,398,000
1969	5,606,000
1970	(96,000)
1971	(13,000)
1972	909,000
1973	739,000

For years 1966 through 1969, the source of funds from which these tax-exempt securities were purchased can generally be traced from specific sales of taxable securities. For later years it is not possible to trace the sources of funds of all the1977 Tax Ct. Memo LEXIS 392">*404 acquisitions of tax-exempt securities.

On the dates indicated, the adjusted basis of all the assets of the partnership, including its tax-exempt securities; the adjusted basis of all the assets owned individually by Bernard and Alma, including individually owned tax-exempts, but excluding their respective partnership capital accounts; and the total adjusted bases of all assets of the partnership and those owned individually by petitioners were as follows:

			Total Adjusted Basis
		Individually	of Assets of Partnership & Petitioners
	Partnership	Bernard	Alma	Bernard	Alma	Grand Total
12/31/71	$11,861,672	$2,440,367	$860,898	$8,371,203	$6,791,734	$ 15,162,937
12/31/72	11,834,081	3,152,513	895,482	9,069,553	6,812,522	15,882,075 8
12/31/73	12,838,138	3,829,534	901,272	10,248,603	7,320,341	17,568,944

Securities held by the partnership, or petitioners, did not include material amounts of voting stock of a corporation in which either petitioner held an 80 percent interest, and neither Bernard nor Alma was a dealer in securities within the meaning of1977 Tax Ct. Memo LEXIS 392">*405 section 1.471-5, Income Tax Regs.

The parties have stipulated that for the purposes of this case, the operation of a brokerage margin account was generally as follows: ⁹

The margin account as recorded on the broker's books reflects the debit balance, representing the amount loaned to the customer, and the securities held as collateral. The debit balance in the account is increased by the charging of interest by the broker; the charging of a service charge by the broker; the additional purchase of securities by the customer; and the withdrawal of cash by the customer. The debit balance in the account is decreased by the collection by the broker of dividends or interest for the account of the customer; the sale by the customer of securities held by the broker or to be received by him; and the deposit of cash by the customer, either in answer to a call from the broker for additional margin or voluntarily by the customer.

When the debit balance is decreased in a margin account, the equity in the account increases. An increase in the value of the collateral would have exactly the same effect. Conversely, an increase in the debit balance or a decrease1977 Tax Ct. Memo LEXIS 392">*406 in the value of the collateral would decrease the equity.

Interest charged by the broker on the margin account increases the indebtedness of the taxpayer to the broker. If the broker considers the collateral sufficient security for the increased debt, payment of the interest charged may be postponed. Payment of interest charges, as well as other charges serving to increase the debt, is effected by receipt of amounts by the broker from the taxpayer or from others for the account of the taxpayer. Receipts by the broker are reflected by credits to the taxpayer's account which serve to decrease his debit balance. That is, such credits reflect payments by the taxpayer, thereby reducing his outstanding indebtedness to the broker. In the absence of agreement to the contrary, the credits to the taxpayer's account will be first applied as payment of interest previously charged by the broker. The excess of such credits over interest due will then be applied in payment of the service charge and the principal of the debt. Charges by the broker subsequent to such payments in turn increase the debt.

A Margin account therefore, establishes a debtor-creditor relationship between the taxpayer1977 Tax Ct. Memo LEXIS 392">*407 and the broker. The fact that the collateral has a value in excess of that required, thereby creating what is sometimes referred to as a "withdrawal balance" in the taxpayer's favor, reflects a favorable equity status rather than an actual or constructive payment of any kind. That is, such a balance merely enables the taxpayer to increase his debt to the broker without furnishing additional collateral. Such increase of debt results from - (a) the charging of interest by the broker; (b) the charging of a service charge by the broker; (c) the purchase of additional securities by the taxpayer; or (d) the withdrawal of cash by the taxpayer.

In cases in which a taxpayer maintains more than one margin account with the same broker, interest charged to one account is not paid by a credit of that amount from another account if the total indebtedness of the taxpayer is in effect increased by the interest charged. Such bookkeeping entries merely serve to transfer the interest charge from one account to another.

1977 Tax Ct. Memo LEXIS 392">*408 In his notice of deficiency dated May 19, 1975, respondent disallowed interest expense of the partnership in the amount of $42,628 for the taxable year 1972 and $77,134 for the taxable year 1973. ¹⁰ The only interest of the partnership disallowed in part by the Internal Revenue Service for the year 1973 other than interest paid on brokerage margin accounts, was $19,504 ¹¹ of interest recognized upon the repayment of two bank loans in August and December 1973. The first loan was created by the partnership borrowing $325,000 from a bank in February 1973. The proceeds of this loan were used to pay the assessed income tax liabilities and interest thereon. In August 1973 the loan was repaid, along with $10,621 of interest; the primary source of repayment was a second $325,000 loan from a different bank. The second loan was repaid in December 1973, along with interest of $8,833. None of the $325,000 loan proceeds was used to purchase tax-exempt securities.

1977 Tax Ct. Memo LEXIS 392">*409 Respondent's explanation of the adjustment was "* * * that the interest on margin account and bank indebtedness was incurred or continued in order to purchase or carry tax-exempt obligations. Therefore the deductions of $72,716 in 1972 and $129,112 in 1973 claimed as interest on brokerage margin accounts and bank loans in the partnership returns are not allowed to the extent of $42,628 in 1972 and $77,134 in 1973 computed as follows:"

Year Ended 12/31/72	Total	Bernard	Alma
Total interest expense	$146,989
Less: Interest on prior
income taxes	74,273
Interest expense subject to
allocation	$ 72,716	$36,358	$36,358
Percent of total assets
invested in tax-exempt
obligations 121977 Tax Ct. Memo LEXIS 392">*410		53.5595%	63.6869%
Interest expense disallowed	$ 42,628	$19,473	$23,155
Year ended 12/31/73
Total interest expense	$131,869
Less: Interest on prior
taxes	2,757
Interest expense subject
to allocation	$129,112	$64,556	$64,556
Percent of total assets
invested in tax-exempt
obligations 12		53.3479%	66.1359%
Interest expense disallowed	$ 77,134	$34,439	$42,695

Note: The cents column for certain figures which appear under 12/31/73 is indistinguishable from the record, but this is immaterial to the resolution of this case.

Furthermore in the notice of deficiency, respondent disallowed Bernard's deductions pursuant to section 265(2) of $39,344 in 1972 and $73,213 in 1973 claimed as interest expense to the extent of $21,072 in 1972 and $39,058 in 1973 computed as follows:

	12/31/72	12/31/73
Interest expense subject to
allocation	$39,344	$73,213
Percent of total assets invested
in tax-exempt obligations	53.5595%	53.3479%
Interest expense disallowed	$21,072	$39,058

OPINION

This Court on numerous occasions has considered the applicability of section 265(2), disallowing a deduction for interest "on indebtedness incurred or continued to purchase or carry" tax-exempt obligations, and ultimately our decisions have rested upon the facts and circumstances of the particular case. The applicable legal principles are now well settled and are concisely stated in Indian Trail Trading Post, Inc.,60 T.C. 497">60 T.C. 497, 60 T.C. 497">500 (1973),1977 Tax Ct. Memo LEXIS 392">*411 affd. 503 F.2d 102">503 F.2d 102 (6th Cir. 1974).

* * * the statutory disallowance is not activated merely by the simultaneous existence of an indebtedness and the holding of tax-exempt obligations. * * * Thus, a taxpayer is not automatically required to liquidate such obligations to obtain needed funds rather than retain such obligations and obtain those funds by way of independent borrowing. * * * On the other hand, it is equally clear that a taxpayer cannot insulate himself from the prohibition of section 265(2) by merely juggling the use of his available assets so as to create a surface sanitation of the indebtedness from the acquisition or holding of the tax-exempt obligations. * * *

The touchstone for decision is the purpose of the taxpayer in incurring or continuing the indebtedness and the burden of proof is on the petitioner. * * * As we pointed out in John E. Leslie,50 T.C. 11">50 T.C. 11, 50 T.C. 11">20-21 (1968), reversed on other grounds 413 F.2d 636">413 F.2d 636 (C.A. 2, 1969): 1977 Tax Ct. Memo LEXIS 392">*412

The finding of the taxpayer's purpose does not depend solely upon looking into his mind and learning what he was thinking; although his intentions are relevant, purpose may be inferred from his conduct and from the circumstances that confronted him. * * *

To these elements may be added the further element of timing, which "can be just as important to the taxpayer as it is to the athlete or comedian." * * * Expressed in another way, the deduction will be barred if there is "a sufficiently direct relationship" between the incurring or continuing of the indebtedness and the acquisition or holding of the tax-exempt obligations. * * * In essence, the existence of "a sufficiently direct relationship" is a step along the path leading to the determination of the taxpayer's purpose within the Leslie frame of reference. [Citations omitted]

See also Swenson Land & Cattle Co.,64 T.C. 686">64 T.C. 686, 64 T.C. 686">695-6 (1975); Handy Button Machine Co.,61 T.C. 846">61 T.C. 846, 61 T.C. 846">851-2 (1974).

In1977 Tax Ct. Memo LEXIS 392">*413 applying these principles to the facts of the instant case, we will consider, separately, interest incurred on the bank loans and brokerage margin accounts. Interest expense of the partnership and petitioners under these categories will be aggregated unless otherwise specifically stated.

Petitioners on brief recognize that the key to this case is our determination of the purpose of the indebtedness incurred by them. They submit that the record is clear that the direct purpose of the margin account indebtedness was to permit the acquisition of taxable securities having a market value in excess of cash deposited in the margin accounts. Brokerage margin accounts have been maintained since 1938 by petitioners, since 1941 by the partnership, while tax-exempt securities were first purchased in 1966, more than 25 years after petitioners first purchased taxable securities on margin. This history shows, in light of the fact that tax-exempt securities were purchased for cash and segregated from the brokerage margin accounts, an ordinary and customary method used by petitioners in pursuing taxable investments, separate and apart from the tax-exempt securities purchased and held by petitioners1977 Tax Ct. Memo LEXIS 392">*414 during the years in issue. Furthermore, petitioners contend that the very nature of a brokerage margin account is that the indebtedness relates solely to the securities held by the broker. Margin account debit balances fluctuate with the activity of the securities purchased and sold and do not remain a constant fixed loan. Also, petitioners argue that the record does not indicate that the liquidation of tax-exempt securities would have lowered the margin indebtedness; under the aforenoted history of the margin account debit balances, Bernard, with more cash available, would probably have purchased more taxable securities on margin.

With respect to interest incurred on bank loans, petitioners contend all such loans were on a short-term basis and had no direct or indirect relationship to tax-exempt securities purchased or held. The indebtedness incurred by the partnership in 1973 was for the payment of assessed income tax liabilities and petitioners argue that short-term borrowing was more appropriate then to identify and isolate tax-exempt securities of an equivalent amount, especially when such securities were not freely marketable and entrusted for safekeeping by the two aforesaid1977 Tax Ct. Memo LEXIS 392">*415 banks. Bernard's indebtedness repaid in 1972 was apparently in anticipation of an expected income tax refund and such anticipatory receipt does not support an inference that the indebtedness was incurred for the purpose of purchasing or carrying tax-exempt securities. Finally, petitioners conclude that although it can be argued that equal amounts of cash could have been obtained from liquidating tax-exempt securities owned by them, to disallow the interest on the bank borrowing under the circumstances of this case would result in a mechanical test which has not been favored by the courts in the application of section 265(2).

After careful scrutiny of the entire record we are of the opinion that petitioners have failed to overcome the presumption of validity of respondent's determinations of deficiencies. See Israelson v. United States,367 F. Supp. 1104, 1107 (D. Md. 1973) affd. without opinion 508 F.2d 838">508 F.2d 838 (4th Cir. 1974). On the record in this case, a finding of the absence of the prohibited purpose of section 265(2) would be based on pure conjecture. We are cognizant of the fact that 1977 Tax Ct. Memo LEXIS 392">*416 under section 265(2) the "* * * circumstances may be such as to make it difficult or impossible, without fault on the part of the taxpayer, to prove a material fact necessary to establish * * *" the deduction. Bishop v. Commissioner,342 F.2d 757">342 F.2d 757, 342 F.2d 757">759 (6th Cir. 1965). However this does not relieve petitioners of their burden. As previously stated by petitioner and conceded, "* * * the pivotal inquiry here is whether there was a 'purposive connection' or a 'sufficiently direct relationship' between the continuation * * *" of petitioners' indebtedness and their ownership of tax-exempt securities. 64 T.C. 686">Swenson Land & Cattle Co.,supra at 696.

In view of this admitted rule of law we are perplexed by the failure of Bernard to testify. Conceivably his testimony could have altered our view of this case. However, petitioners were represented by competent counsel and in such circumstances it is not the province of the Court to second-guess. Nonetheless, we do note our holding in Wichita Terminal Elevator Co.,6 T.C. 1158">6 T.C. 1158, 6 T.C. 1158">1165 (1946) to the effect "that 1977 Tax Ct. Memo LEXIS 392">*417 the failure of a party to introduce evidence within his possession and which, if true, would be favorable to him, gives rise to the presumption that if produced it would be unfavorable."

The record is inconclusive to establish petitioners' (purposes) in regard to the margin account indebtedness. Although there is a lengthy history of taxable securities purchased on margin prior to the acquisition of tax-exempt securities for cash in 1966, we are unable to infer from the facts whether their intent remained unchanged subsequent to their first purchase of tax-exempt securities. The fact that tax-exempt securities were purchased for cash, not used as collateral and segregated from the securities on margin is not determinative. Mere juggling of assets to create "a surface sanitation" will not insulate petitioners from section 265(2). Moreover in substance, we are unable to differentiate a margin account debit balance from a revolving demand bank loan in which securities are pledged to the bank with income therefrom payable to the bank to cover, in part, interest and principal payments due on such loan.

Similarly, because of lack of testimony we are unable to find the absence of the1977 Tax Ct. Memo LEXIS 392">*418 prohibited purpose with respect to the bank loans. We have no evidence concerning the amount of cash and liquid assets of petitioners for the years in issue. In light of the substantial amount of proceeds received from sales or redemptions at maturity of tax-exempt securities for the years in issue, the evidence presented does not show that tax-exempt securities were unmarketable or incapable of liquidation to meet petitioners' short-term borrowing needs.

Finally, we believe that respondent makes a fair point when he cites as significant the fact that over 75 percent of the total partnership assets and between 16 to 22 percent of the petitioners' individual holdings were invested in tax-exempt securities. Such a substantial investment in tax-exempt securities makes it more difficult to accept an argument that in effect the relationship between loans and tax-exempt securities was merely happenstance.

In short, on the basis of the entire record, and our awareness that the result under section 265(2) should not be based upon a mechnical test, petitioners have not presented sufficient evidence to rebut the presumption of correctness of respondent's determinations of deficiencies. 1977 Tax Ct. Memo LEXIS 392">*419 Compare Edmund F. Ball,54 T.C. 1200">54 T.C. 1200 (1970); Batten v. United States,322 F. Supp. 629 (E.D. Va. 1971). As petitioners admit and take no exception to respondent's method of determining the amount of interest to be disallowed in the event we find for respondent,

Decision will be entered for the Respondent.

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Footnotes

• 1. Petitioners concede the adjustments in the notice of deficiency increasing dividend income in the amount of $4,720 for each of the taxable years in issue and increasing interest income by $1,437 in 1973.↩

• 2. Alma is not an active participant in the partnership. Since May 1962, Bernard has held a power of attorney to sign for his wife and execute documents necessary to the conduct of their, or her affairs. During 1972 and 1973 all decisions with respect to the partnership's operations and investment portfolio were made by Bernard.↩

• 3. All the partnership's taxable securities were held in brokerage margin accounts.↩

• 4. These amounts were held in brokerage margin accounts and outside margin accounts as follows:

  ↩

  		Outside
  	On Margin	Margin	Total
  12/31/71	$1,337,392	$547,599	$1,884,991
  12/31/72	1,872,301	533,165	2,405,466
  12/31/73	1,943,691	566,271	2,509,962

• 5. All these taxable securities were held outside the brokerage margin accounts.↩

• 6. The parties have stipulated this schedule totaled $131,929; however, the notice of deficiency showed such total as $131,869 as did the partnership's U.S. partnership return of income. Bank loan interest for 1973 is stipulated to be comprised of $10,621 and $8,833, totalling $19,454 instead of $19,504 shown on said schedule.↩

• 7. Alma maintained no individual brokerage margin accounts, had no indebtedness, and incurred no individual interest expense outside of the partnership.↩

• 8. Discrepancy of $1.00 in total caused by rounding.↩

• 9. The 1975 Fact Book published by the New York Stock Exchange, shows that for the months indicated the number of brokerage margin accounts, the margin debt (debit balance), and collateral securing the margin debt of the customers of the Exchange members were as follows:

  ↩

  	Number of		Collateral
  	Accounts	Margin Debt	Securing Debt
  December 1971	675,000	$5,400,000,000	$17,660,000,000
  December 1972	750,000	7,900,000,000	22,370,000,000
  December 1973	680,000	5,050,000,000	13,390,000,000

• 10. The interest deduction on prior income taxes is not in dispute. The parties agree and recognize that the liability for income taxes and the resultant interest thereon is correctly a liability of the individual parties, rather than the partnership, but that interest is allowable in full in any event. Accordingly, disallowed partnership interest expense increases petitioners' distributive share of partnership ordinary income.↩

• 11. See fn. 6, supra. Also, although the parties stipulated this amount was the only other interest disallowed, in part, for 1972 and 1973, the notice of deficiency disallowed $812 of bank interest for 1972. This omission of $812 must be an oversight as respondent refers to that sum still being in issue on brief. In light of our opinion, infra,↩ the $812 shall be included in interest expense subject to allocation.

• 12. Interest Expense Allocation Revenue Procedure 72-18

  		B. P.	Alma
  	Total	McDough	McDough
  Year Ended 12/31/72
  Average Assets as Adjusted:
  McDonough River Co. - Exhibit A-2	$11,847,876.58	$5,923,938.29	$5,923,938.29
  B. P. McDonough - Exhibit A-3	2,796,439.95	2,796,439.95
  Alma G. McDonough - Exhibit A-3	878,189.87		878,189.87
  Totals - Average Assets	$15,522,506.40	$8,720,378.24	$6,802,128.16
  Average Investment - Tax Exempts:
  McDonough River Co. - Exhibit A-2	$ 8,431,446.39	$4,215,723.20	$4,215,723.19
  B. P. McDonough - Exhibit A-3	454,871.55	454,871.55
  Alma G. McDonough - Exhibit A-3	116,347.75		116,347.75
  Totals	$ 9,002,665.69	$4,670,594.75	$4,332,070.94
  Percent of Tax Exempt to
  Total Assets		53.5595%	63.6869%
  Year Ended 12/31/73
  Average Assets as Adjusted:
  McDonough River Co. - Exhibit A-2	$12,336,109.90	$6,168,054.95	$6,168,054.95
  B. P. McDonough - Exhibit A-3	3,491,023.41	3,491,023.41
  Alma G. McDonough - Exhibit A-3	898,377.07		898,377.07
  Total Average Assets	$16,725,510.38	$9,659,078.36	$7,066,432.02
  Average Investment - Tax Exempts:
  McDonough River Co. - Exhibit A-2	$ 9,097,699.10	$4,548,849.55	$4,548,849.55
  B. P. McDonough - Exhibit A-3	604,073.50	604,073.50
  Alma G. McDonough - Exhibit A-3	124,605.00		124,605.00
  Totals	$ 9,826,377.60	$5,152,923.05	$4,673,454.55
  Percent of Tax Exempt to
  Total Assets		53.3479%	66.1359%
  Exhibit A-2	1/1/72	12/31/72	12/31/73
  Total Assets - Line 13, Form 1065	$11,771,365.84	$11,770,617.72	$12,266,073.63
  Add: Prepaid W. Va. I.T.	30,136.80	63,463.60	62,291.
  Prepaid Federal I.T.	60,169.20		509,773.
  Total Assets as Adjusted	$11,861,671.84	$11,834,081.32	$12,838,138.
  Average Balance Average Balances represent one-half of the sum of the beginning and ending balances. *↩		$11,847,876.58	$12,336,109.
  Partners Interest
  B. P. McDonough - 50%		5,923,938.29	6,168,054.
  Alma McDonough - 50%		5,923,938.29	6,168,054.
  Investment - Tax Exempt Obligations
  Line 4(b) - Form 1065	$ 8,006,504.83	$ 8,856,387.95	$ 9,339,010.
  Average Investment *		$ 8,431,446.39	$ 9,097,699.
  Partners Interest
  B. P. McDonough - 50%		$4,215,723.20	$ 4,548,849.
  Alma McDonough - 50%		$ 4,215,723.19	$ 4,548,849.
  Exhibit A-3
  B. P. McDonough
  Total Assets per Books	$ 2,500,366.77	$ 3,202,513.12	$ 3,458,642.21
  Less: Account 199 - Pledges	60,000.00	50,000.00
  Add: A/R McDonough River Co. Acct. 260			370,891.48
  Total Assets as Adjusted	$ 2,440,366.77	$ 3,152,513.12	$ 3,829,533.69
  Average Balance *		$ 2,796,439.95	$ 3,491,023.41
  Investment - Tax Exempt Obligations	$ 442,966.80	$ 466,776.30	$ 741,370.70
  Average Investment *		$ 454,871.55	$ 604,073.50
  Alma G. McDonough
  Total Assets per Books	$ 860,897.82	$ 887,527.44	$ 880,723.21
  Add: A/R Marmac Corp. Acct. 262		7,954.47	20,549.01
  Total Assets as Adjusted	$ 860,897.82	$ 895,481.91	$ 901,272.22
  Average Balance *		$ 878,189.87	$ 898,377.07
  Investment - Tax Exempt Obligations	$ 98,727.00	$ 133,968.50	$ 115,241.50
  Average Investment *		$ 116,347.75	$ 124,605.00