Barry L. Battelstein and Jerry E. Battelstein v. Internal Revenue Service

POLITZ, Circuit Judge,

with whom BROWN, RONEY, GEE, JAMES C. HILL, FAY, VANCE, GARZA, REAVLEY and RANDALL, Circuit Judges, join, dissenting:

Respectfully, I dissent. The Battelstein loan arrangement is precisely the type of transaction covered by the Burgess rule. 1 In 1971 the Battelsteins borrowed in excess of three million dollars from the Gibraltar Savings Association to finance the Sharps-town project. They took additional loans from Gibraltar in 1973 and 1974. It is beyond dispute that a § 163(a) deduction, is not available to the Battelsteins if notes alone, rather than cash' or its equivalent, were given in payment of the accrued interest on the initial loan. But I cannot agree with the narrow characterization of this overall transaction as a paper shuffling sham composed of surrendered notes with check exchanges flying CAP. By declining to apply and raising the spectre of criticism of Burgess, the majority registers its objection to a 33 year old tax law precedent which is both logical and meritorious. I believe this rejection unjustified.

There is no question but that the § 163(a) interest deduction may be claimed in instances in which the interest is paid with the proceeds of a loan. If the Battelsteins had borrowed the money to pay the interest to Gibraltar from a different lender, no challenge would apparently be made to the interest deduction. It is only because the Battelsteins secured additional loans from Gibraltar, equal to the interest paid, that they forfeit the deduction. It is this dimension of the majority opinion with which we take issue, and for which the Burgess rule is particularly appropos. Its rejection causes the taxpayers of this circuit to run through *1186 a legal minefield they ought not have to cross. Today’s decision portends the day when the § 163(a) deduction is put in jeopardy whenever a taxpayer borrows from a lender a sum at least equal to the interest paid that same lender that tax year.

It is not difficult to envision completely unacceptable consequences of the rule of this case. Let us suppose that a homeowner/taxpayer has a $30,000 mortgage required $300 monthly payments of principal and interest. Let us also suppose that he has an automatic $1,000 line of credit available if he should overdraw his personal account. The mortgage loan and the checking account, with the the protective line of credit, are with the same bank. Let us further suppose that at various times during the year our hypothetical taxpayer either owes up to $1,000 or has several thousands of dollars on demand deposit, depending on transitory seasonal fluctuations. Throughout the entire, year his assets exceed $100,000 which, for his own reasons, he chooses not to liquidate during the “deficit” periods but opts to rely on borrowing in order to maintain financial flexibility. Under today’s decision the deductibility of the mortgage interest is endangered because funds drawn on the line of credit may have been used to make the monthly mortgage payments. The risk is created simply because both loans came from the same lender. Proper application of the Burgess rule would assure this taxpayer safe passage.

The only credible distinction between the Battelsteins’ predicament and that of our hypothetical taxpayer is that the former is structured and the latter is not. The Bat-telsteins appear to have designed their transaction to conform with existing case law and regulatory precedents. Our hypothetical taxpayer is in a quite common situation very probably affecting a substantial number of taxpayers. I am compelled to the conclusion that the Battelsteins are being penalized for trying to carefully fashion a tax-oriented transaction designed to maximize tax advantages. Surely this effort is not proscribed. As was cogently observed by the eminent jurist Judge Learned Hand, “a transaction otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one choose, to evade, taxation. Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best, pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), affirmed 293 U.S. 465 , 55 S.Ct. 266 , 79 L.Ed. 596 (1935).

The Burgess formulation, which I believe should govern disposition of this case, is a time tested amalgamation of various factors that aid courts in determining whether a taxpayer is perpetrating a dual loan transaction sham or is legitimately entitled to the interest deduction. To qualify for the tax deduction under the Burgess test it is necessary that: (1) there be valid and legitimate reasons for the second loan other than to repay interest on the first loan, (2) proceeds of the second loan are commingled with the taxpayer’s other funds, (3) the taxpayer have funds or available resources to cover the interest payment, and (4) the lending institution loses control of the proceeds of the second loan. Burgess; Burek v. Commissioner, 63 T.C. 556 (1975), aff’d. on other grounds, 533 F.2d 768 (2d Cir. 1976); Wilkerson v. Commissioner, 70 T.C. 240 (1978).

Factor one is satisfied because valid reasons existed for the subsequent loans, other than merely making interest payments on the first loan. Funds were required to finance development of the Sharpstown project which was a multi-million dollar long-range venture; roads were not in, utilities were not installed. The controversial subsequent loan agreement was really a clause contained in the Battelstein-Gibral-tar loan accord that stated:

After execution of the agreement Gibraltar will, pursuant to the terms thereof, from time to time, advance to Owners ... an additional sum or sums of money equal to the Owners’actual out-of-pocket costs incurred and paid on said property subsequent to the execution of the *1187 agreement, including, but not being limited to debt services, taxes . . .

In return for this long-term financing clause, Gibraltar was to be repaid the loans plus interest and receive a 19% interest in the net proceeds when the land was sold. 2 Jerry Battelstein was eager to obtain this type of financing because it did not tie up his own liquid assets; he testified that he firmly believed an astute businessman could make money with borrowed money. Advances were in fact made to the Battel-steins in 1973 and 1974 for sums equal to the ad valorem taxes paid on the land and for debt service or interest owed to Gibraltar on the initial loan.

It is clear that the subsequent loans were intended to place the full cost of acquisition and development of the Sharpstown property on Gilbraltar in order to give the Battel-steins added financial flexibility. The majority’s position focuses, in isolation, on the funds borrowed to pay interest charges on the first loan. No mention is made of the funds borrowed to pay the ad valorem taxes, the payment of which had been originally rejected as a deduction by the I.R.S. for the same reason, i.e., the funds used for payment had been borrowed from Gibraltar. This focusing obscures the business purpose of the subsequent loans, the underwriting of all “out-of-pocket” expenses associated with the Sharpstown parcel.

Factors (2) and (3) of Burgess are met. Proceeds of the second loan were commingled with personal Battelstein funds in their bank accounts (which were not with Gibraltar). Additionally, in each of the eight challenged instances of payment (quarterly during the two-year period under scrutiny) the Battelsteins had ample assets to cover taxes and interest payments independent of the subsequent loan proceeds. During the years 1973, 1974 and 1975, Jerry Battelstein’s average monthly checking account balances were $24,000, $75,000 and $35,000 respectively. Barry Battelstein’s monthly averages during those years were $36,000, $44,000 and $40,000. Jerry Battelstein’s approximate net worth exceeded four million dollars in 1973 and was over five million in 1974. Similarly, Barry Battelstein had substantial assets upon which to draw for payments. For example, in 1973 he had $1,300,000 worth of Certificates of Deposit that could have been liquidated to pay accruing ad valorem taxes and interest charges on the first loan. During the years in question accruing interest paid with funds borrowed under the second loan accord fluctuated between $4,991.06 and $48,728.10. It cannot be' disputed that the Battelsteins had more than adequate funds to pay the quarterly interest, independent of any monies received on later advances from Gibraltar.

Finally, Burgess requires that Gibraltar relinquish total control of the questioned loan proceeds. From the majority’s perspective, the sequencing of checks between the Battelsteins and Gibraltar conclusively proved that the bank’s control of these funds was not extinguished because an “inconsequential exchange of surrendered notes” occurred rather than a cash payment of interest. Emphasis is placed on the fact that the Battelsteins first sent their checks for the quarterly interest payments at which time Gibraltar sent the Battelsteins a like check which they deposited in their general bank accounts. I find this significant, but reach a conclusion exactly opposite from that of the majority. Upon receipt of the Battelsteins’ check, Gibraltar had made more than a mere promise to pay (such as would be evidenced by a note). When Gibraltar received the checks the Battelsteins had paid. Had Gibraltar chosen for some reason not to loan an amount equal to the particular payment, the Battel-steins would have been obliged to see that the check was honored out of their own substantial personal funds. Sending those checks was the equivalent of sending cash. The record reflects that in some instances the funds on deposit when Gibraltar re- *1188 eeived the checks were sufficient to cover the checks before Gibraltar made any further loan; and in every instance, the Bat-telsteins had more than adequate resources available. The record also reflects that in some instances the check to Gibraltar was debited before the proceeds from the Gibraltar check were deposited.

It is apparent that in many, if not most “dual loan” cases the Burgess requirements would preclude the taxpayer from taking the interest deduction. That is all the more reason to support the application of Burgess in a proper case. I view this as just such a case. The Tax Court continues to support the rule in appropriate cases. 3 Heyman v. Commissioner, 70 T.C. 482 (1978); Alan A. Rubnitz, 67 T.C. 621 (1977); Nat Harrison Associates, Inc., 42 T.C. 601 (1964).

The majority opinion occasions further comments which perhaps might best be stated in the form of inquiries. Setting aside for the moment the permutation of cash versus accrual basis and date of crediting in determining taxable income we inquire, in general terms, about the tax posture of Gibraltar. What may we safely assume to be the position of the I.R.S. as respects the Battelsteins’ interest payments? Was that reportable income to Gibraltar? When did it become so? May Gibraltar insist that it did not receive the interest payments due on the initial loan because it made other loans at different rates of interest and with different due dates?

Viewing the total transaction from the standpoint of the Battelsteins we must also inquire. The development envisioned the sale of the property, presumably at a handsome profit. One would assume that was the early expectation. What would have been the position of the I.R.S. had the Bat-telsteins borrowed from Gibraltar (and other institutions) all sums necessary to make the quarterly interest payments over a several year period, and timed or extended the subsequent loans so that all came due in the year of the sale, to be used in a lump sum against the profit realized? One need hardly doubt the reception that program would have gotten.

The essential predicate for the majority opinion is that the subsequent loans came from the same lender. How far do we extend the “sameness”? What about a loan from a subsidiary or affiliated lending institution or from a sibling bank which happens to be a member of the growing bancs-hare-type organization? Will we not be compelled to articulate a Burgess type rubric?

I am convinced beyond peradventure that the Burgess test is applicable to this case and should be endorsed. I would affirm the decisions of the bankruptcy court and the district court allowing the interest deduction. I therefore respectfully DISSENT.

. Burgess v. Commissioner, 8 T.C. 47 (1947); as subsequently refined, Burck v. Commissioner, 63 T.C. 556 (1975), and Wilkerson v. Commissioner, 70 T.C. 240 (1978).

. Interest rates and due dates on the subsequent loans differed from those on the first loan.

. In Goodstein v. C.I.R., 267 F.2d 127 (1st Cir. 1959), the First Circuit affirmed a Tax Court holding which characterized a transaction within the Cleaver mold, thereby denying the taxpayer the interest deduction. The court, somewhat cryptically said, “Taxpayer cites Newton A. Burgess, ... which would seem to hold to the contrary but to us the reasoning of the dissenting members of the court is more persuasive.” Goodstein at 131 . This waffling rejection of Burgess should be scrutinized in light of the facts before the court. Both the Tax Court and the Court of Appeals determined the Goodstein transaction was devoid of economic substance beyond the purpose of obtaining an interest deduction. Indeed, the plan in that case was devised by an accountant who contacted the IRS to test whether the pre-con-ceived plan would result in a tax deduction. Goodstein is, therefore, distinguishable from the present case; it ignores the first noted test in the Burgess exception, perhaps because the transaction in that case was undeserving of the exception. In writing the Burck affirmance for the Second . Circuit, Judge Oakes expressed these reservations “for himself only;” the Burgess rule was not the subject of review.