Lead Opinion
Respondent determined deficiencies in. petitioners’ Federal income tax as follows:
Year Deficiency
1970.$50,531.75
1971.21,618.10
The issues remaining for our decision are: (1) Whether
GENERAL FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly. The stipulations of facts, together with the exhibits attached thereto, are incorporated herein by this reference.
Herbert A. Dunn and Georgia E. Dunn (Herbert, Georgia, or petitioners) resided in Liverpool, N. Y., at the time of filing the petition herein. Petitioners filed joint Federal income tax returns for 1970 and 1971 with the North-Atlantic Service Center, Andover, Mass. Herbert was born in 1893 and Georgia was born in 1897.
FINDINGS OF FACT
Trade or Business Issue
Herbert has been interested in horses since at least 1940. Prior to 1968, he owned various horses, which were stabled at his home and ridden by himself and his children for pleasure. He entered his horses in amateur exhibitions and horse shows to compete for ribbons.
He later became interested in harness racing. In 1968, Herbert owned “Little Pumpkin” and “Crowning Glory.” “Little Pumpkin” was entered in two races at Pompano Beach, Fla., and won a total of $104. The combined winnings of the first place winners in these two races was $800. On his 1968 Federal income tax returns, Herbert disclosed a net loss of $8,967.65 from the operations of his racing stable, including wagering. Petitioner took no deduction for this loss because, during 1968, Herbert considered himself an amateur and his racing activities as not being carried on for profit.
In 1969, Herbert informed his lawyer that he contemplated retiring from the automobile business (see p. 721 infra) and that he wanted his harness horse racing and breeding to be his future
In 1969,' Herbert continued to own “Crowning Glory” and he acquired “Miss Linda Sharp” and “Straight Shot.” He did not enter any horses'in races in 1969.
In 1970, Herbert continued to own “Crowning Glory” and acquired “Henry Knauf.” “Miss Linda Sharp” and “Straight Shot” were sold at losses of $1,680.23 and $2,182.28, respectively, which petitioners deducted as losses from the sale of section 1231 property. Prior to his sale, “Straight Shot” was entered in 11 races at Saratoga Springs, N. Y., winning a total of $734. The combined winnings of first place horses in these races was $4,200. “Straight Shot” was also entered in a “New York Sire Race” at Buffalo, N. Y., where he finished fourth and won $627.35. The winner of this race won $3,921. None of Herbert’s other horses were entered in races in 1970.
In 1971, Herbert continued to own “Henry Knauf” and “Crowning Glory.” For the first time, he took a deduction for depreciation with respect to “Crowning Glory.” “Henry Knauf” was entered in two races at VerjnonDowns, Vernon, N. Y., where he won $93.75 for fifth place in one race and nothing in the other. The winner in the former race won $937.50. “Crowning Glory” was not entered in any races in 1971.
Herbert continued to own “Crowning Glory” throughout 1972. “Henry Knauf” was sold at a loss in that year. Prior to his sale, he was entered in four races at Pompano Beach, where he won a total of $219, and was entered in eight races at Saratoga Springs, where he won a total of $240. The combined first place winnings in all these races was $11,570. “Crowning Glory” was not entered in any races in 1972.
Subsequent to 1972, Herbert began winding down his horse racing 'and breeding activities and did not enter any more races. In each of the years 1973 and 1974, he sold a foal. He continued to own “Crowning Glory” until 1975.
Herbert conducted his harness racing and breeding activities in both New York State and Florida. In 1970 and 1971, petitioners spent the winter in Florida.
On their tax returns for 1969 through 1975, petitioners reported on Schedule C (Profit/or Loss from Business or Profession) all income from Herbert’s breeding and harness
The financial aspects of Herbert’s horse racing and breeding activities may be summarized as follows:
Year Gross receipts1 Deductions Profit (loss)
19682 .$5,032.35 $14,000.00 ($8,967.65)
1969. 4,263.50 9,677.66 (6,096.65)
1970. 1,230.35 20,860.85 (19,630.50)
1971.93.00 14,015.55 (13,922.55)
1972. 1,796.00 13,140.96 (11,344.96)
1973. 1,400.00 4,219.21 (2,819.21)
1974. 4,250.00 3,795.92 504.08
1975. 1,500.00 1,144.00 356.00
Petitioners’ reported taxable income for the years 1968 through 1974 was as follows:
Year Taxable income Year Taxable income
1968.$18,847.80 1972 .$24,315.56
1969.44,706.86 1973.34,181.34
1970.38,440.77 1974.57,123.40
1971.31,317.74
On October 31,1972, Herbert, but not Georgia, signed a letter electing, pursuant to section 183(e), to defer the determination of whether the presumption in section 183(d) applies until the close of calendar year 1976.
ULTIMATE FINDING OF FACT
Herbert did not carry on a trade or business or engage in an activity for profit during the taxable years 1970 and 1971.
OPINION
The question before us is whether Herbert’s harness horse racing and breeding activities constitute a trade or business, as petitioners contend, or an activity not engaged in for profit, as respondent contends. Petitioners’ entitlement to deductions for net operating losses and for ordinary losses incurred in the sale
Section 183(d) provides that, if for any 2 of 7 consecutive taxable years (in the case of an activity which consists in major part of the breeding, training, showing, or racing of horses) the gross income derived from such activity exceeds the deductions, the activity shall be presumed to be engaged in for profit unless the Commissioner establishes to the contrary. If the taxpayer so elects under section 183(e), the applicability of the presumption shall not be determined before the close of the sixth taxable year following the year in which the taxpayer first engages in the activity. For this purpose, a taxpayer is treated as not engaged in any activity in a year beginning before January 1,1970. In the event of such an election, the presumption shall apply to each taxable year in the 7-year period beginning with the first year in which the taxpayer engages in the activity, subject to certain conditions.
The Commissioner contends that Herbert’s purported election is invalid because not signed by Georgia. See section 12.9, Income Tax Regs., adopted as temporary regulations under section 183(e) by T.D. 7308, 1974-
An activity not engaged in for profit under section 183 is the other side of the coin of a trade or business under section 162. Section 183(c) defines an “activity not engaged in for profit” as “any activity other than one with respect to which deductions are allowable for the taxable year under section 162 or under paragraph (1) or (2) of section 212.” The legislative history indicates that Congress intended to codify the distinction between a business and a hobby drawn by case law. H. Rept. 91-413
The test of whether an individual is carrying on a trade or business for purposes of section 162 depends upon his primary or dominant motive, i.e., is it to make a profit. Godfrey v. Commissioner,
Whether Herbert had the requisite profit motive is a question of fact to be determined on the basis of the entire record. Jasionowski v. Commissioner, supra at 319. The regulations set forth the relevant factors, derived from prior case law, which are to be considered in determining the applicability of section 183. Jasionowski v. Commissioner, supra at 320; Benz v. Commissioner, supra. The regulations further provide that no one factor is conclusive and, thus, we do not reach our decision herein by merely counting the factors which support each party’s position. Sec. 1.183-2(b), Income Tax Regs.
Because of health constraints, Herbert was unable to testify and we must reach our decision on the basis of objective factors contained in the record. Analysis of these factors convinces us that Herbert had no bona fide expectation of profit. We recognize, as petitioners point out, that it takes time to develop a successful breeding and horse racing business. However, on the facts of the record herein, we are convinced that Herbert’s activities were not potentially profitable. Compare Bessenyey v. Commissioner,
We are further influenced by the fact that Herbert was 76 years old in 1969, an advanced age for embarking on any new business and particularly one that takes time to develop. Moreover, the fact that Herbert had always been interested in horses and had actively pursued this interest in other ways strongly indicates that his activities were a hobby, rather than a business. Sec. 1.183-2(b)(9), Income Tax Regs. See Benz v. Commissioner, supra at 385; Bessenyey v. Commissioner, supra at 274-275.
We are unimpressed by the few outward manifestations of a business (hired trainers, an accountant to prepare the appropriate schedule for their tax return) upon which petitioners base their position. In short, we are convinced that Herbert’s activities were not operated on a basis which supports the conclusion of good faith expectation of profitability and there is no evidence of a plan of development that would change this situation. See sec. 1.183-2(b)(6). Nor is there any other evidence that persuades us that Herbert’s profit motive, while unreasonable, was nevertheless bona fide. Compare Mercer v. Commissioner, supra.
Redemption Issue
Bresee Chevrolet Co., Inc. (Bresee or the company), is a car dealership franchised by General Motors (GM) and located in Syracuse, N. Y. Georgia acquired all of the stock of the company through inheritance from her parents and purchase from others in 1936. Until about 1951, Herbert was president of the company. Thereafter, her son William B. Dunn served as president. Herbert continued as an employee until he retired in 1973.
Beginning in 1951, Georgia made gifts of stock to her children
Relationship Number
Stockholder to Georgia of shares
Georgia.249
Jane D. Harris.daughter.51
Patricia Bowen.daughter.51
William B. Dunn.son.149
On June 1, 1970, Bresee redeemed all of Georgia’s remaining shares. GM had been pressing her for some time to dispose of her stock because they wanted her son, who was the president of the company, to own a majority of the stock. Georgia desired to dispose of her stock because she was advised that it created liquidity problems from an estate planning point of view and because she and her husband wanted additional income as they advanced in age, and Bresee, with one exception, had not in the past paid dividends. She also wished to spend most of her time in Florida and did not want to have any business responsibilities.
Georgia and the company were represented by separate counsel in negotiations regarding a stock redemption. The parties reached an agreement whereby Bresee would redeem Georgia’s shares, which provided for payment of $335,154 as follows:
a. The sum of ONE HUNDRED THOUSAND DOLLARS ($100,000.00) on June 1,1970.
b. The balance amounting to TWO HUNDRED THIRTY-FIVE THOUSAND ONE HUNDRED FIFTY-FOUR DOLLARS ($235,154.00) by the Purchaser executing and delivering a promissory note made payable to the Seller, in said amount of $235,154.00, bearing interest to be computed at the rate of Five Percent (5%) per annum, and made payable as follows:
“The sum of FIFTY-FIVE THOUSAND ONE HUNDRED FIFTY-FOUR DOLLARS ($55,154.00) of principal, together with interest computed on said principal indebtedness of $235,154.00 from June 1, 1970 at the rate of 5% per annum, shall be due and payable on June 1,1971.
Thereafter commencing with June 1, 1972, and continuing for a period of ten (10) years, regular annual payments covering principal and interest computed at the above rate in the constant amount of $23,311.80 each shall be due and payable on the 1st day of June of each year until June 1,1981. Each of said annual payments of $23,311.80 shall be first applied in payment of interest computed at the rate of 5% per annum on the respective unpaid principal balances, and the balance of each payment shall then be applied in the reduction of the principal indebtedness then remaining unpaid.”
The agreement further provided that Bresee would not take any action such as excessive purchases, declaring or paying dividends, increases in officers’ salaries, or abnormal increases in indebtedness which would affect its ability to make timely payments to Georgia. Bresee further agreed that it would borrow against life insurance policies on Georgia’s life owned by it in order to make the first two payments.
On November 1, 1970, Bresee entered into a new Minimum Capital Standard Agreement with GM, whereby it agreed to increase its “minimum owned net working capital” from $329,569 to $732,266 by October 31,1971, and to retain 75 percent of its net profits after taxes until such time as it had increased its working capital as required.
GM approved the agreement.
Payments of principal and interest were made as follows:
Date due Principal due Date paid
June 1, 1972 $14,311.80 June 18, 1973
June 1, 1973 15,027.39 May 29, 1974
June 1, 1974 16,567.70 Oct. 15, 1975
June 1, 1975 17,396.08 July 27, 1976
Date due Interest due Date paid
June 1, 1972 $11,757.70 June 13, 1972
June 1, 1973 9,000.00 June 18, 1973
June 1, 1974 8,284.41 May 29, 1974
June 1, 1975 6,744.10 Oct. 15, 1975
June 1, 1976 5,915.72 July 27, 1976
Each time a payment was made, Bresee was in violation of its Minimum Capital Standard Agreement, although its net working capital was increasing each year. GM was not specifically informed of the payments, but did receive monthly balance sheets and profit and loss statements. GM never objected to the payments made by Bresee to Georgia.
Bresee was the largest Chevrolet dealer between Buffalo and Albany.
Following the redemption of her stock, Georgia was not an officer, director, or employee of Bresee. At the time of trial, she had not acquired any stock in Bresee. Georgia filed the agreement required by section 302(c)(2)(iii) with her 1970 tax return.
OPINION
This issue is whether amounts received by Georgia in redemption of her Bresee stock are ordinary income, as respondent contends, or capital gain, as petitioners contend.
Section 302(a) provides that a distribution of property to a shareholder by a corporation in redemption of stock will be treated as a sale or exchange of the stock if the redemption falls into one of four categories enumerated in section 302(b). Under section 302(d), all redemptions which do not meet a specific statutory exception are treated as distributions under section 301 (i.e., a dividend to the extent the corporation has earnings and profits and the balance as a return of capital).
Under section 302(b)(3), a shareholder is entitled to exchange treatment if all the stock owned by that shareholder is redeemed. Georgia is treated as the owner of her children’s stock
Georgia filed the required agreement and did not remain as an officer, director, or employee of Bresee. Thus, the focal point of the dispute herein is whether Georgia retained an interest “other than an interest as a creditor.”
At the outset, we think it important to establish certain guidelines for our analysis of the issue thus posed.
First, we do not have a situation where the attribution rules clearly apply and the question is whether such application can be avoided by considerations of business purpose. United States v. Davis,
Second, the determination of whether a taxpayer has “an interest other than as a creditor” concededly requires consideration of the plethora of cases in the debt-equity arena. Most of these cases involve situations where the taxpayer retained a stock interest and sought a dual status — as a creditor as well as a shareholder — a factor which is not present herein. Moreover, analysis of those cases has been described as “distinguishing the indistinguishable” (see W. Plumb, “The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal,” 26 Tax L. Rev. 369, 640 (1971)), and, in any event, the relative weight to be given the various considerations which enter into the decisional process in that arena is not necessarily the same in every context. Such variable contextual application finds support in section 385, enacted by section 415(a) of the Tax Reform Act of 1969, Pub. L. 91-172, 83 Stat. 487, which authorized the Secretary of the Treasury to prescribe regulations
Third, we note that there is not the slightest suggestion in the record that the transaction herein was not bona fide and that the interposition of conditions of payment relating to the requirements of GM was contrived so as to give colorable support to a transaction which otherwise would be suspect as a scheme for tax avoidance. See Lewis v. Commissioner,
With the foregoing guidelines in mind, we proceed to analyze the facts herein in light of section 1.302-4(d), Income Tax Regs., which provides:
(d) For the purpose of section 302(c)(2)(A)(i), a person will be considered to be a creditor only if the rights of such person with respect to the corporation are not greater or broader in scope than necessary for the enforcement of his claim. Such claim must not in any sense be proprietary and must not be subordinate to the claims of general creditors. An obligation in the form of a debt may thus constitute a proprietary interest. For example, if under the terms of the instrument the corporation may discharge the principal amount of its obligation to a person by payments, the amount or certainty of which are dependent upon the earnings of the corporation, such a person is not a creditor of the corporation. Furthermore, if under the terms of the instrument the rate of purported interest is dependent upon earnings, the holder of such instrument may not, in some cases, be a creditor.
Respondent, relying on a literal interpretation of his regulation, asserts that any indicia of a proprietary interest is fatal, that there are several such indicia in the instant case, and that consequently Georgia fails to meet the requirement that her claim “must not in any sense be proprietary.” (Emphasis added.) Recognizing that in interpreting a regulation “the courts should if possible avoid a construction which will bring into question” its validity (see Steen v. Commissioner,
Respondent argues that Georgia’s claim was voluntarily subordinated to the claims of general creditors because some payments were deferred. He assumes that Bresee was paying all
Respondent attempts further to support his position that Georgia retained “an interest other than as a creditor” by arguing that Bresee did not have a good record of timely compliance with its obligations to make payments to her. See Piedmont Corp. v. Commissioner,
In the next breath, respondent seizes upon the fact that the incorporation of the restrictions imposed by GM into the agreement between Georgia and Bresee produced a situation where the payments to Georgia were dependent upon earnings and (at least in theory) could by postponed indefinitely. He goes on to argue that this caused Georgia to have a proprietary interest (cf. Curry v. Commissioner, supra; Duerr v. Commissioner,
For example, if under the terms of the instrument the corporation may discharge the principal amount of its obligation to a person by payments, the amount or certainty of which are dependent upon the earnings of the corporation, such a person is not a creditor of the corporation.
We think respondent pushes his regulation beyond its intended meaning. Perhaps if the parties to an agreement inter sese voluntarily construct such an arrangement, it could be said to fall within the example as being “under the terms of the instrument.” But, we think this portion of the regulation (which, after all, is only an example) should not be elevated into a rule of law which would automatically include restrictions derived from conditions which are in fact imposed, as is the case herein, by a third party in order to accomplish that person’s legitimate business objectives, and where there is no evidence that it served
It is clear from the record that Georgia wanted to terminate her interest in Bresee so that she could have income and more liquid assets and could spend more time in Florida without concern for business affairs in New York. The company wanted to redeem her interest because of pressure to do so from GM. Under the circumstances of this case, the redemption of Georgia’s stock constituted a bona fide severance of her interest in Bresee within the intended purpose of section 302(c)(2). H. Rept. 1337, 83d Cong., 2d Sess. 35 (1954); S. Rept. 1622, 83d Cong., 2d Sess. 45 (1954). The factors relied upon by respondent, applied within the appropriate boundaries of interpretation of section 1.302-4(d), Income Tax Regs., do not mandate a contrary conclusion. Accordingly, Georgia is entitled to capital gain treatment with respect to the proceeds of the redemption. Sec. 302(a).
Decision will be entered under Rule 155.
Notes
Unless otherwise indicated, all section references are to the Internal Revenue. Code of 1954, as amended and in effect during the taxable years in issue. *
Gross receipts exceed the amounts received from harness racing, but the record does not contain the source of the excess.
Figures for 1968 include income and losses from wagering.
“Owned net working capital" was defined to mean the amount of net working capital which should be supplied by investment and earnings.
There is no specific evidence that General Motors approved the redemption agreement, but such approval can clearly be inferred from the record.
The stock redemption agreement provided that this payment would be made with proceeds from a loan against life insurance policies on Georgia’s life. The record contains no explanation for Bresee’s failure to make payment by the agreed means.
Respondent does not argue that Georgia’s claim was subordinated pursuant to the terms of the agreement. Subordination may be considered implicit in the fact that her right to payment is dependent on earnings because of the GM restrictions. Respondent’s argument with respect to these restrictions is discussed at pp. 728-729 infra.
We note that the stock redemption agreement provided that the 1970 and 1971 payments could be made without affecting or decreasing the “present ‘Owned Net Working Capital.’” However, the parties stipulated that the June 1,1971, payment would have violated the Minimum Capital Standard Agreement dated November 1,1970. The change in the effect of the payment is apparently due to the fact that a new Minimum Capital Standard Agreement was executed subsequent to the redemption agreement.
In this connection, we note that it can clearly be inferred from the record that, absent GM’s insistence, Georgia and Bresee would not have included such restrictions in the agreement.
Cf. also Lisle v. Commissioner,