Petition — Battelstein v. Internal Revenue Service

tice. “Supreme Court, U.S U.S

ED

80-1468 ne

FEB 2 "

ee 7 1989

ALEXANDER

Meio STEVAS,

In THE |

Supreme Court

of the United States

Ocroser TERM, 1980 |

Barry L. BATTELSTEIN

AND JERRY FE. BATTELSTEIN,

Petitioners,

v.

INTERNAL REVENUE SERVICE,

Respondent.

On Writ or CERTIORARI To THE

Unrrep States Court oF APPEALS

For Tue Firtx Circuit

PETITION FOR CERTIORARI

Marc E. GrossBERG

Katuy A. Brea, of counsel

1415 Fannin

Houston, Texas 77002

713/654-8141

Attorneys for Petitioners

Bowne of Houston, Inc. Printed in U.S.A.

i

QUESTION PRESENTED

Whether a cash basis taxpayer who pays for a deductible

item by check is entitled to a deduction for such item in the

year the check was given.’

1 The caption of the case in this Court contains the names of all

“ods eau in the court whose judgment is sought

to i

i

TABLE OF CONTENTS

Page

rrr es ert eee e eT Soe TELE i

- SS ORR EEE ee ere e ea ree yee ii

ER uy hay ane ec kg EN a OD ii

EAI Si vane Beare ors | error yey 1

I IN 5 8 sd on baal « Vpca be miecaln che 2

a eh ek ase 1d abe age «wah ys 2

ne sah bv s ps ane gu eneate 2

Reasons for Granting the Writ ....................0ee eee. 3

Appendix Ee Le AAP ES ky kD ah Lae e ed ehieeebaweds enews A-l

TABLE OF AUTHORITIES

Statutes

ROOT eo Ser ae Pr rey 2

Cases

Burck v. Commissioner, 63 T.C. 556 (1975), affd on other

grounds, 533 F.2d 768 (2d Cir. 1976) ............ 4, 8,9, 10

Newton A. Burgess, 8 T.C. 47 (1947) ................. 8, 9, 10

Clark v. Commissioner, 253 F.2d 745 (3d Cir. 1958) ....... 5,6

Cleaver v. Commissioner, 6 T.C. 452, aff'd, 158 F.2d 342 (7th

Cir. 1946), cert. denied, 330 U.S. 849 (1947) ............ 8

Commissioner v. Bradley, 56 F.2d 728 (6th Cir. 1932). ..... 5

Estate of Spiegel v. Commissioner, 12 T.C. 524 (1949) ..... 5

Goodstein v. Commissioner, 30 T.C. 1178, = 267 F.2d 127

(1st Cir. 1959) . seek sets os

Gregory v. Helvering, | 293 U.S. 465 5 (1935) “pie AN a

Heyman v. Commissioner, 70 T.C. 482 (1978)... ....... )

Robert B. Keenan, 20 B.T.A. 498 (1930) .......... ta Fale 7

Page

Keith v. Commissioner 139 F.2d 596 (2d Cir. 1944) ........ 8

Knetsch v. United States, 364 U.S. 361 (1960) ..... ...... 8

Lee v. United States, 571 F.2d 1180 (Ct. Cl. 1978) ........ 7

Hazel B. McAdams, 15 T.C. 231 (1950), affd, 198 F.2d 54

Se rer rer errr reer Sr ere 7

Nat Harrison Associates, Inc. vy. Commissioner, 42 T.C. 601

SENS etd SO Le RG ken cp eanened heakheeeeonens \iees 8

Rubnitz v. Commissioner, 67 T.C. 621 (1977) ............ 8,9

Wilkerson v. Commissioner, 70 T.C. 240 (1978) ........ 8, 9, 10

Don E. Williams Co. v. Commissioner, 429 U.S. 569 (1977). 6

Be es Sie

In THE

Supreme Court

of the United States

Octoser TERM, 1980

Barry L. BATTELSTEIN

AND JERRY KE. BatTELsTEIN,

Petitioners,

v.

INTERNAL REVENUE SERVICE,

Respondent.

On Writ or Certiorari To THE

Unrrtep States Court or APPEALS

For Tue Firtx Crrcuir

PETITION FOR CERTIORARI

The Petitioners, Barry L. Battelstein and Jerry E. Battel-

stein, respectfully pray that a writ of certiorari issue to

review the judgment of the United States Court of Appeals

for the Fifth Circuit entered in this proceeding on Decem-

ber 3, 1980.

OPINIONS BELOW

The opinion of the United States Court of Appeals for

the Fifth Circuit on rehearing en banc, reported at 631 F.2d

1182, appears in the Appendix at p. A-1. The opinion of

2

the Court of Appeals, reported at 611 F.2d 1033, appears in

the Appendix at p. A-15. The order of the United States

District Court for the Southern District of Texas (Houston

Division), not reported, appears in the Appendix at p. A-29.

The opinion of the United States District Court for

the Southern District of Texas (Bankruptcy Division),

reported at 77-2 U.S.T.C. § 9516, appears in the Appendix

at p. A-33.

JURISDICTION

The United States Court of Appeals for the Fifth Circuit

entered its judgment on February 14, 1980 and, after grant-

ing Petitioners’ motion for rehearing en banc, vacated such

judgment and entered final judgment on December 3, 1980.

Petitioner invokes this Court’s jurisdiction under 28 U.S.C.

Sec. 1254.

STATUTORY PROVISIONS INVOLVED

26 U.S.C.A. (Internal Revenue Code) Section 163(a)

provides:

There shall be allowed as a deduction all interest paid

or accrued within the taxable year on indebtedness.

STATEMENT OF THE FACTS

Petitioners are cash-basis taxpayers. On January 27,

1971, Petitioners and two persons not parties to this action

entered into a loan agreement with Gibraltar Savings Asso-

ciation. In the loan agreement, Gibraltar agreed to lend

Petitioners the funds necessary to purchase a certain tract

of land in Houston, Texas, and to extend future loans to

Petitioners to reimburse them for the expenses required to

retain and maintain the tract until utilities became available

and development was both possible and feasible. Such

3

future loans were to be evidenced by new notes at a rate of

interest different from that of the original loan. Memoran-

dum opinion at A-35.

In 1973, 1974 and 1975 Petitioners and Gibraltar entered

into additional loans at a higher interest rate than the initial

note and with different maturity dates, each loan in an

amount equal to the amount of interest or taxes paid for

the tract. Upon notice from Gibraltar that an interest pay-

ment on the original loan was due, Petitioners would send

Gibraltar their checks for the interest payment. At the time

of each interest payment, Petitioners had assets more than

sufficient to cover the payment. Jd. at A-35, A-38, A-39.

Petitioners would request that Gibraltar lend them funds to

reimburse for the interest payments, as well as for the ad

valorem taxes, and Gibraltar would comply. Each Peti-

tioner deposited the additional loan proceeds into his

general business account at an institution other than

Gibraltar, with the result that the loan proceeds became

commingled with funds in that account. Gibraltar had no

control over the funds loaned to Petitioners. Jd. at A-35.

Gibraltar generally held Petitioners’ checks until it had

issued its check to Petitioners.

Petitioner Barry L. Battelstein filed a Chapter XI Peti-

tion under the Bankruptcy Act on November 1, 1976; Peti-

tioner Jerry E. Battelstein filed a Chapter XI Petition

under the Bankruptcy Act on April 1, 1977. This case arose

from Petitioners’ objections to claims filed by the Internal

Revenue Service. The cases were consolidated and tried

before the Bankruptcy Court of the United States District

Court for the Southern District of Texas. The bankruptcy

court found that Petitioners had paid interest on the

original loan from Gibraltar and qualified for the interest

deduction under the Internal Revenue Code of 1954. 7d. at

A-39, A-41. The court ordered that the claim against Peti-

4

tioner Barry L. Battelstein be reduced and that the claims

against Petitioner Jerry E. Battelstein be denied.

The United States District Court for the Southern Dis-

trict of Texas affirmed the bankruptcy court’s holdings on

August 29, 1977. The United States Court of Appeals for

the Fifth Circuit reversed the District Court’s decision on

February 14, 1980 and vacated its opinion upon granting

Petitioners’ request for rehearing en bane on April 11,

1980. On December 3, 1980, the United States Court of

Appeals for the Fifth Circuit reversed the decision of the

district court by a vote of 14 to 10 and remanded the cause

for determination of tax liability. Petitioners filed this peti-

tion for a writ of certiorari within ninety days from the

date of entry of judgment upon rehearing.

REASONS FOR GRANTING THE WRIT

l. The decision of the Fifth Circuit conflicts with a decision

of the Second Circuit.

In Burck v. Commissioner, 533 F.2d 768 (2d Cir. 1976),

aff’g 63 T.C. 556 (1975), the Second Circuit allowed the

taxpayer to take a deduction for interest paid under cir-

cumstances similar to those of Petitioners. The taxpayer

had placed funds borrowed from a Michigan bank into his

New York bank account and, one day later, transferred

funds to the Michigan bank as a payment of interest. The

court disallowed the portion of the claimed deduction for

interest attributable to the succeeding taxable year.

Because the trial court had found the loan to be a valid

transaction, rather than a sham, the Second Circuit upheld

the deduction for prepaid interest that accrued in the tax-

able year. Similarly, Petitioners commingled the loan pro-

ceeds with their general funds ard made interest payments

from their general accounts. In the instant case, the bank-

ruptey court, affirmed by the district court, specifically

5

found that the loan transactions were not a sham, but arose

from valid business purposes. Memorandum opinion at

A-39. Disregarding the Second Circuit’s treatment of sim-

ilar circumstances, the Fifth Circuit has responded to the

situation of interest payments from borrowed funds with

the opposite result. The Fifth Circuit’s decision has

resulted in the availability of a deduction for interest

depending on geography; taxpayers in the Second Circuit

may take one, but those in the Fifth Circuit may not. This

conflict and disparity in treatment of taxpayers justify the

grant of certiorari to review the judgment below.

2. The Fifth Circuit has decided an important question of

federal law that has not been, but should be, settled by this

Court.

The question of federal law raised by the Fifth Circuit’s

decision is important for three reasons:

(1) the decision conflicts with the principle that a

check constitutes payment for tax purposes at the

time of delivery if the check is honored upon present-

ment;

(2) the decision is contrary to a long-standing tax

law precedent and its progeny; and

(3) the decision will affect both commerce and a

substantial number of cash-basis taxpayers.

First, the decision of the Fifth Circuit is contrary to

the maxim that a check, so long as ultimately honored,

is the equivalent of cash for tax purposes. See, e.g.,

Clark v. Commissioner, 253 F.2d 745 (3d Cir. 1958) ; Com-

missioner v. Bradley, 56 F.2d 728 (6th Cir. 1932); Estate

of Spiegel v. Commissioner, 12 T.C. 524 (1949) (citing

eases). This maxim is a corollary of the general rule of

law, codified in Section 3-802 of the Uniform Commercial

Fs.

6

Code, that payment by check occurs at the time of delivery

if the check is honored upon presentment.

The federal courts usually equate the giving of a check

with payment by cash because from a practical standpoint

the consequences of the actions are the same. By writing a

check a taxpayer does not merely promise to pay.'! Such a

taxpayer has instructed his bank to transfer funds out of

his account. He has conditionally paid; his obligation to

pay becomes suspended until the drawee bank honors the

check and payment becomes final. Recognizing the common

practice of paying by check, the federal courts have there-

fore treated an ultimately honored check as the equivalent

of cash with few exceptions, such as the giving of a check

in one year with the agreement that it not be cashed until

the next. Clark v. Commissioner, 253 F.2d 745 (3rd Cir.

1958). The case of Petitioners does not present such an

exception to the general treatment of payment by check.

At the time of the interest payments, Petitioners sent

Gibraltar their checks. By executing the checks, Petitioners

instructed their banks to transfer money out of their

accounts, regardless of whether Gibraltar extended addi-

tional loans. The bankruptcy court found that in some

instances the funds on deposit in Petitioners’ accounts when

Gibraltar received the checks were already sufficient to

cover the checks. Memorandum opinion at A-35. The dis-

sent to the en bane opinion noted that in some instances

1A promise to pay does not constitute payment for tax a

See, e.g., Don E. Williams Co. v. Commissioner, 429 U.S. 569

(1977). It should be noted that the following statement in the

majority Page in the court below is incorrect: “What hap-

pened at the time of each of the exchanges, as the Battelsteins

now concede, is that the Battelsteins gave Gibraltar their note

promising to pay the amount of interest then due, plus interest

in the future.” En banc opinion at A-2. Petitioners conceded no

such thing. They promised to pay in the future an amount equal

to what they borrowed plus interest.

*%

7

the check to Gibraltar was debited before the proceeds from

the additional loan were deposited. 631 F.2d at 1188,

reprinted herein at A-13. On the occasions that the funds on

deposit were insufficient to cover the interest checks, Peti-

tioners would have been obligated to honor the checks out

of their substantial assets, in the event that Gibraltar had

declined to lend a requested amount. The trial court found

that Petitioners paid interest by checks. Memorandum

opinion at A-39. The Fifth Circuit rejected both this find-

ing and the general rule regarding payment by check. The

Fifth Cireuit’s decision calls into question the treatment of

a check as the equivalent of cash and creates a new excep-

tion to the general rule: a check honored upon presentment

does not constitute payment at the time of delivery if the

payor has deposited funds received from the payee in the

account upon which, and during the year in which, the check

is honored. The decision of the Fifth Circuit confuses a

once-clear area of the tax law for the taxpayers in the

Circuit.

Second, the Fifth Circuit’s decision conflicts with a body

of holdings by the Tax Court. The Tax Court has long held

that a deduction is not disallowable merely because the con-

tested item was paid with borrowed funds. In Hazel B.

McAdams, 15 T.C. 231 (1950), aff’d, 198 F.2d 54 (5th Cir.

1952), the Tax Court found that expenses paid with bor-

rowed funds are deductible by a cash-basis taxpayer ir the

year in which they are paid. The Tax Court followed its

reasoning in an earlier case, Robert B. Keenan, 20 B.T.A.

498 (1930). The Court of Claims recognized the irrelevance

of the source of funds for payment in Lee v. United States,

571 F. 2d 1180 (Ct. Cl. 1978), in which it noted that the mere

source of a loan should not affect the deductibility for

income tax purposes of interest paid on the loan. The Fifth

Circuit’s decision in the instant case, however, pivots on the

source of the loan.

8

By disallowing Petitioners’ deductions, the Fifth Circuit

has reached a result opposite to the response of the Tax

Court to similar situations. The Tax Court has in numerous

eases evaluated the payment of interest to a lender with

funds borrowed from such lender. When the lender, with-

out disbursing the entire loan proceeds to the taxpayer-

borrower, applies a portion of the loan to interest due on a

previous loan, the Tax Court has held that interest has not

been paid. Rubnitz v. Commissioner, 67 T.C. 621 (1977);

Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601

(1964) ; Cleaver v. Commissioner, 6 T.C. 452, aff’d, 158 F.2d

342 (7th Cir. 1946), cert. denied, 330 U.S. 849 (1947) ; Keith

v. Commissioner, 139 F.2d 596 (2d Cir. 1944). The Tax

Court has also denied the interest deduction when the

underlying transaction was a sham designed to avoid taxa-

tion. Goodstein v. Commissioner, 30 T.C. 1178, aff’d, 267

F.2d 127 (1st Cir. 1959) ; see also Knetsch v. United States,

364 U.S. 361 (1960); Gregory v. Helvering, 293 U.S. 465

(1935).2 The Tax Court has, however, consistently found

that a taxpayer did pay interest in cases similar to the

instant case: Newton A. Burgess, 8 T.C. 47 (1947); Burck

v. Commissioner, 63 T.C. 556 (1975), aff’d on other grounds,

533 F.2d 768 (2d Cir. 1976); and Wilkerson v. Commis-

sioner, 70 T.C. 240 (1978). In Burgess, the taxpayer’s

actions paralleled those of Petitioners. Having entered into

two loans with a lender, the taxpayer borrowed additional

funds from the lender nine days before making interest

payments on the previous loans. At the time of the third

loan, the taxpayer executed a new promissory note and

deposited the loan proceeds in his general unrestricted bank

account. The cash from the loan proceeds thus became

commingled with the taxpayer’s other funds and lost its

identity. The Tax Court allowed the deduction for interest.

2 The majority opinion on rehearing did not disturb the bank-

ruptcy court's finding that Petitioners’ transaction was not a sham,

but was for valid business purposes.

9

It reached the same conclusion in Burck. Refining its deei-

sion in Burgess, the Tax Court in Burck based the allowance

of the deduction primarily on tour factors: (1) the exist-

ence of valid and legitimate reasons for the second loan

other than the repayment of interest on the first loan, so

that the transaction was not a sham; (2) the commingling of

borrowed funds with the taxpayer’s general account which

destroyed the identity of the borrowed funds, so that the

interest payment could not be traced to the loan; (3) the

availability of other assets from which the interest payment

could have been made, so that the second loan was not

required for the taxpayer to pay the interest; and (4) the

lack or loss of control of the loan proceeds by the lender.

The Tax Court has reiterated the factors established in

Burck and Burgess in subsequent cases. The absence of one

or more factor led the Tax Court to find that interest was

nt paid in Rubnitz v. Commissioner, 67 T.C. 621 (1977) and

Heyman v. Commissioner, 70 T.C. 482 (1978). Because the

factors of Burgess and Burck were present, the Tax Court

held that the taxpayers had paid interest by check in

Wilkerson, even though most of the funds in the account

on which the check was drawn originated from the lender

to whom the check was given.

The bankruptcy court in the instant case found all four

factors present in Petitioners’ loans from Gibraltar. The

first factor, a valid business purpose, arose out of the need

to finance a multimillion dollar long-range venture. Memo-

randum opinion at A-39; see also the dissent to the en bane

opinion at A-11. The bankruptcy court recognized the

presence of the second factor in Petitioners’ pattern of plac-

ing proceeds from the second loans in their unrestricted

general business accounts at institutions other than

Gibraltar. Memorandum opinion at A-39. The third factor

is apparent from the bankruptcy court’s finding that at the

10

time of each challenged interest payment, Petitioners had

assets sufficient to cover the payment and, on some occa-

sions, already had enough funds on deposit to cover the

checks. Jd. at A-35, A-39. Finally, the bankruptcy court

pointed to the existence of the fourth factor in the absence

of restrictions by Gibraltar on the use of the loan proceeds.

Id. at A-35. Although the bankruptcy court in the instant

ease found all factors to be present in Petitioners’ loan

transactions, the Fifth Circuit chose to disregard the find-

ings, as well as the Tax Court’s holdings in Burgess, Burck

and Wilkerson. The conflict between this decision by the

Fifth Circuit ard the holdings of the Tax Court presents

further opportunity for inconsistent treatment of tax-

payers.

Third, the question raised by the Fifth Circuit’s decision

is important because of the effect that it will have on com-

merce and a large number of taxpayers. An analogy to con-

tract law points out the importance of the question posed

by the Fifth Circuit’s decision. Contract law has developed

to facilitate, not to hinder, commerce; to promote trade

rather than to set traps and pitfalls. This goal was accom-

plished by encouraging reliance on the sanctity of the con-

tract through consistent treatyment of similar situations.

The tax laws, of course, serve a different purpose — collect-

ing revenue for the government. Because their impact is a

factor that must be considered in most significant business

decisions, the tax laws also serve the purpose of shaping

commerce. In fulfilling these purposes, however, the tax

laws must ultimately be based on the same principles as

those that underlie contract law. The application of the tax

laws should not thwart commerce by creating uncertainty

in the tax consequences of legitimate transactions, and thus

of the taxpayer’s cash flow; such an effect could only

diminish sources of revenue. The government should apply

11

the tax laws consistently to similar types of transactions so

long as they are not a sham. Businessmen such as Peti-

tioners form their enterprises in reliance on the tax laws

and their longstanding interpretation by the courts. Peti-

tioners are cash-basis taxpayers, as are the overwhelming

majority of all U.S. taxpayers, and must therefore report

their income in the year received and take deductions for

items in the year paid. As the bankruptcy court, the trier of

fact, found, the transaction was not a sham but rather based

on the valid business purposes of acquiring and holding a

valuable piece of land until it could be developed. As land

developers, Petitioners purchased the tract not simply to

extract a tax benefit, but for the obvious purposes of devel-

oping the land and making a profit. In two of the years in

question, Petitioner Barry Battelstein did not take a deduc-

tion for interest but instead capitalized it. The Fifth Circuit

has now penalized Petitioners for their business ventures.

The position of the Internal Revenue Service and the

decision of the Fifth Circuit harms not only Petitioners but

countless other cash-basis taxpayers at all income levels.

A hypothetical similar to that posed by Judge Politz, speak-

ing for the ten dissenters in the Fifth Cireuit’s en banc

opinion at A-9, vividly demonstrates the effects. Posit a

taxpayer who has monthly home mortgage payments owed

to the same lending institution at which he keeps his

checking account. As is becoming increasingly common, the

hypothetical taxpayer has overdraft protection, an auto-

matic line of credit with his bank. Although the taxpayer

has assets he could liquidate, occasionally he may rely on

his line of credit and essentially borrow money from his

bank, the same bank to which he owes interest on his mort-

gage. Because of the possibility that funds drawn on the

line of credit may have been used, the Fifth Circuit’s deci-

sion will call into question the deductibility of the hypo-

thetical taxpayer’s mortgage payments.

12

The effect of the Fifth Circuit’s decision will be to further

complicate and discourage commerce. Taxpayers who pay

interest to a lender aud wish to take a loan in the same year

must now seek out a second lender to avail themselves of the

interest deduction. The Fifth Circuit’s decision rests solely

on the source of the second loan. If allowed to stand, the

decision below will deter knowledgable taxpayers from con-

tracting with their existing lenders and will be a trap for the

unwary. It will discourage, if not punish, those taxpayers

who borrow from a lender an amount at least equal to sums

paid to such lender in the same year. A multitude of cash-

basis taxpayers, from sophisticated entrepreneurs to home-

owners, will suffer from this decision. Those who have

financial power or a banking relationship with more than

one financial institution will be able to secure needed loans

from a second lender and thus qualify for the interest

deduction; those who do not, or who are not aware of the

peculiar distinction established by the Fifth Circuit, will

not.

The Internal Revenue Service, the Congress and the

courts have consistently recognized the right of taxpayers

who effect transactions having a significance independent

of tax consequences to utilize the benefits available under

the tax laws to reduce or postpone their tax liability. Often

these involve the timing of a deduction, as in the instant

case. Examples of such transactions are legion. Among

them are an accrual basis corporation declaring a bonus to

a cash basis employee on December 31 of one year, taking

the deduction in the year the bonus was declared and paying

the bonus on January 1 of the following year so that the

employee reports the income in the following year, the year

in which he received the payment. Another example is that

of the taxpayer who, after reviewing his income and deduc-

tions for a year, chooses to make sales of stock in the last

few days of the year, sometimes at a loss to offset gains

13

taken earlier in the year, or sometimes at a profit to offset

losses which have been taken earlier in the year. The major-

ity in the en banc opinion raised the spectre that the inde-

pendent significance of transactions will be disregarded,

for the majority in the en banc opinion, unlike the panel

majority, did not disregard the bankruptcy court’s finding

that there was no sham. Thus, they have created, as the

dissent points out, a “legal minefield”. En banc dissent, at

A-8.

CONCLUSION

For these reasons, a writ of certiorari should issue to

review the judgment and opinion of the Fifth Circuit.

Respectfully submitted,

Marc A. GrossBERG

Karny A. Brent, of counsel

1415 Fannin

Houston, Texas 77002

713/654-8141

A-l

APPENDIX A-1

Barry L. BarrEe.vsTeIn

and Jerry EK. Batrevstein,

Plaintiff s-Appellees,

v.

INTERNAL REVENUE SERVICE,

Defendant-A ppellant,

No. 77-3212.

Unrrtep Srates Court or APPEALS,

Firtx Crmovtit.

Dec. 3, 1980

Cash basis taxpayers filed Chapter XI bankruptcy peti-

tion. The bankruptcy judge denied claims filed by the

Internal Revenue Service. The United States District

Court for the Southern District of Texas, John V. Single-

ton, Jr., Chief Judge, affirmed, and the Service appealed.

The Court of Appeals, Frank M. Johnson, Jr., Circuit

Judge, 611 F.2d 1033, reversed and remanded. After

granting taxpayers’ petition for rehearing en banc, the

Court of Appeals, Frank M. Johnson, Jr., Circuit Judge,

held that cash basis taxpayers were not entitled to interest

deduction in connection with lender’s advances of interest

costs facilitated by means of exchanges of checks between

taxpayers and lender and by taxpayers executing notes

for amount of interest due.

Reversed and remanded for calculation of tax liability.

Politz, Cireuit Judge, dissented and filed opinion in

which Brown, Roney, Gee, James C. Hill, Fay, Vance,

Garza, Reavley and Randall, Circuit Judges, joined.

A-2

Internal Revenue — 518

Cash basis taxpayers were not entitled to interest

deduction in connection with lender’s advances ,of interest

costs facilitated by means of exchanges of checks between

taxpayers and lender and by taxpayers executing note for

amount of interest due. 26 U.S.C.A. § 163(a).

Appeal from the United States District Court for the

Southern District of Texas.

Before COLEMAN, Chief Judge, BROWN, AINS-

WORTH, GODBOLD, CHARLES CLARK, RONEY,

GEE, TJOFLAT, HILL, FAY, RUBIN, VANCE, KRA-

‘VITCH, FRANK M. JOHNSON, Jr., GARZA, HEN-

DERSON, REAVLEY, POLITZ, HATCHETT, ANDER-

SON, RANDALL, TATE, SAM D. JOHNSON, and

THOMAS A. CLARK, Cireuit Judges.

FRANK M. JOHNSON, Jr., Circuit Judge:

This case arose out of Chapter XI petitions in bank-

ruptcy filed by Barry L. Battelstein and Jerry E. Battel-

stein in the United States District Court for the Southern

District of Texas. In the ensuing proceedings, the Inter-

nal Revenue Service (IRS) filed proof of claims against

each. The Battelsteins objected to the claims and their

objections were consolidated for trial. The bankruptcy

judge denied the IRS claims after trial and the denial was

affirmed by the district court. In response to an appeal

filed by the IRS, a panel of this Court reversed the dis-

trict court’s decision denying the IRS claims and

remanded the case to the district court for a calculation

of tax liability. Battelstein vy. Internal Revenue Service,

611 F.2d 1033 (5th Cir. 1980). The panel’s decision was

vacated when the Court granted the Battelsteins’ petition

A-3

for rehearing en banc. Battelstein v. Internal Revenue

Service, 616 F.2d 253 (5th Cir. 1980). The case was taken

under submission by the Court en bane following addi-

tional briefing by the parties.

The facts are not in dispute. As the panel opinion

explained, the Battelsteins were land developers. Gibral-

tar Savings Association was their lender. In 1971, Gibral-

tar agreed to loan the Battelsteins more than three million

dollars to cover the purchase of a piece of property known

as Sharpstown. Gibraltar also agreed to make to the Bat-

telsteins, if desired, future advances of the interest costs

on this loan as shey became due. The Battelsteins never

paid interest except by way of these advances. Each

quarter, Gibraltar would notify the Battelsteins of the

amount of interest currently due. The Battelsteins would

then send Gibraltar a check in this amount, and, on its

receipt, Gibraltar would send the Battelsteins its check in

the identical amount.

The controversy stems from the Battelsteins’ deduction

of the amount of these checks under authority of Internal

Revenue Code §163(a), 26 U.S.C. §163(a). Section

163(a) allows cash basis taxpayers such as the Battel-

steins to take a deduction for interest paid within the tax-

able year on indebtedness. The issue in this case is

whether the Gibraltar-Battelstein check exchanges

resulted in interest being paid within the taxable year.

The bankruptcy judge and the district court decided that

the exchanges had such a result. We conclude as did the

panel, that this decision was incorrect.

It is plain that the check exchanges relied on by the

Battelsteins could not themselves extinguish the Battel-

steins’ interest obligations to Gibraltar. What happened

at the time of each of the exchanges, as the Battelsteins

now concede, is that the Battelsteins gave Gibraltar their

A-4

note promising to pay the amount of interest then due,

plus interest, in the future. It is well established, how-

ever, that such a surrender of notes does not constitute

the current payment of interest that Section 163(a)

requires. The Supreme Court has repeatedly held, as long

ago as 1931 and as recently as 1977, that payment for tax

purposes must be made in cash or its equivalent. Don E.

Williams Co. v. Commissioner, 429 U.S. 569, 577-58, 97

S.Ct. 850, 855-56, 51 L.Ed.2d 48(1977; Eckert v. Burnet,

283 U.S. 140, 141, 51 S.Ct. 373, 374, 75 L. Ed.911 (1931). See

also Battelstein v. Internal Revenue Service, 611 F.2d at

1035 n.3 (citing additional cases). The 1977 decision

explained that, “The reasoning is apparent: the note may

never be paid, and if it is not paid, ‘the taxpayer has

parted with nothing more than his promise to pay.’” Don

E. Williams Co. v. Commissioner, 429 U.S. at 578, 97 S.Ct.

at 856. The Battelsteins attempted to avoid such a char-

acterization of their interest transactions here by adding

to their surrender of notes the inconsequential exchanges

of identical amount checks.! In ignoring these ex-

changes, we merely follow a well established principle

of law, viz., that in tax cases it is axiomatic that we look

through the form in which the taxpayer has cloaked a

transaction to the substance of the transaction. See, e.g.,

Republic Petroleum Corp. v. United States, 613 F.2d 518,

524 (5th Cir.1980); Redwing Carriers, Inc. v. Tomlinson,

399 F.2d 652, 657 (5th Cir.1968) (citing cases). As the

Supreme Court stated some years ago in Minnesota Tea

Co. v. Helvering, 302 U.S. 609, 58 S.Ct. 393, 82 L.Ed. 474

(1938), “A given result at the end of a straight path is not

made a different result because reached by following a

devious path.” 302 U.S. at 613, 58 S.Ct. at 394. The check

exchanges notwithstanding, the Battelsteins satisfied their

1 The Battelsteins do not assert, nor do we find it possible to infer,

any other purpose for the check exchanges.

A-5

interest obligations to Gibraltar by giving Gibraltar notes

promising future payment. The law leaves no doubt that

such a surrender of notes does not constitute payment for

tax purposes entitling a taxpayer to a deduction.

As the panel concluded, the Battelsteins’ reliance on the

line of Tax Court cases beginning with Burgess v. Commis-

sioner, 8 T.“. 47 (1947),? is misplaced, even assuming that

the Burgess cases constitute good law. In the Burgess

cases, the Tax Court was faced with situations in which

taxpayers had obtained first one loan and then another from

the same lender, and then had attempted to claim a deduc-

tion for interest paid on the first loan, even though the inter-

est was possibly paid with funds obtained as part of the

second loan. Under the Code, a taxpayer may be entitled to

a deduction in such a situation only if the second loan was

not for the purpose of financing the interest due on the first

loan. If the second loan was for the purpose of financing

the interest due on the first loan, then the taxpayer’s inter-

est obligation on the first loan has not been paid as Section

163(a) requires; it has merely been postponed.*? In many

cases, it is not apparent what the purpose of a subsequent

loan was whether it was to finance the interest payments

on a previous loan for which deductions are being claimed,

2In addition to Burgess, see Burck v. Commissioner, 63 T.C. 556

(1975), aff'd on other grounds, 533 F.2d 768 (2d Cir. 1976), and

Wilkerson v. Commissioner, 70 T.C. 240 (1978).

3 In other words, the obligation as between the taxpayer and the

lender remains but like a note promising payment in the future,

which does not qualify for a deduction, see supra — merely in

another form. Compare the situation in which a taxpayer bor-

rows money from a certain lender, and then borrows money from

a third party in order to pay the original lender the interest. In

such a situation the interest is considered paid and deductible

because the obligation as between the taxpayer and the original

lender has not been postponed, it has been extin ed. See,

e.g., Crain v. Commissioner, 75 F.2d 962, 964 (8th Cir. 1935),

McAdams v. Commissioner, 15 T.C. 231, 235 (1950).

%

A-6

or whether it was to fulfill some other unrelated objective.

In the Burgess cases, the Tax Court attempted to establish

a formula to be used in making such a determination. The

formula has been subject to criticism for being too easy to

manipulate by taxpayers and thus as unduly inviting tax

evasion. Whether or not this criticism is valid, it is clear

that it is unnecessary to apply the formula here, or that if

applied here in light of its purpose it could yield only one

result. This is because the subsequent loans made by

Gibraltar to the Battelsteins — the checks issued by Gibral-

tar to the Battelsteins as part of the check exchanges, in

the exact amount of the Battelsteins’ currrent interest

obligations — were plainly for no purpose other than to

finance the Battelsteins’ current interest obligations to

Gibraltar. See note 1, supra. Even under Burgess, the

Battelsteins’ check exchanges cannot be said to have

resulted in the payment of interest required for a deduction

by Section 163(a).

In announcing our decision, we note that, contrary to

what has been suggested, neither the Court nor, for that

matter, the panel has considered the Battelsteins’ ‘entre-

preneurial style’ to be an issue in this case. For business

men to defer payment of interest obligations in the way

the Battelsteins have done may well be a sensible way in

which to do business. Whether it is or is not, what is rele-

vant here is that interest obligations so deferred cannot

be claimed for tax purposes as interest obligations paid.

4In Burgess and its Progeny. the Tax Court held that interest may

be considered on even though the taxpayer may have paid it

with money subsequently borrowed from the initial lender, so

long as the money subsequently borrowed actually passed into

the hands or bank account of the taxpayer, was commingled with

other funds of the taxpayer and thus became subject to the tax-

payer's unrestricted control. Burgess v. Commissioner, 8 T.C. at

49-50. See also Wilkerson v. Commissioner, 70 T.C. at 257-67;

Burck v. Commissioner, 63 T.C. at 559-60.

A-7

Under the Code, cash basis taxpayers such as the Battel-

steins are entitled to a deduction for interest paid on

indebtedness only if that interest is paid within the taxable

year. The Battelsteins simply do not qualify.

We note further that even were this Court of the opinion

that there are, as has been suggested, equitable considera-

tions in this case favoring the Battelsteins, it has long been

established that we may not allow such considerations to

play a part in our decision. As panels of this Court have

recently had occasion to reiterate, citing recent and estab-

lished Supreme Court precedent, tax deductions are matters

of legislative grace and must be narrowly construed. The

taxpayer bears the burden of proving his entitlement to a

particular deduction. Equity cannot supply a deduction

when the Code does not grant one. See, e.g., Lettie Pate

Whitehead Foundation v. United States, 606 F.2d 534; 539

(5th Cir. 1979) ; C. A. White Trucking Co. v. Commissioner,

601 F.2d 867, 869 (5th Cir. 1979).

The only question before us is whether the Battelsteins’

check exchange scheme resulted in the payment of interest

Section 163(a) requires. A review of the scheme under the

familiar standards of appraisal mandated by the Supreme

Court permits no conclusion other than that no interest

was paid, and thus that no deduction may be allowed.

REVERSED AND REMANDED FOR A CALCULA-

TION OF TAX LIABILITY.

POLITZ, Circuit Judge, with whom BROWN, RONEY,

GEE, JAMES C. HILL, FAY, VANCE, GARZA, REAV-

LEY and RANDALL, Circuit Judges, join, dissenting :

Respectfully, I dissent. The Battelstein loan arrange-

ment is precisely the type of transaction covered by the

A-8

Burgess rule. In 1971 the Battelsteins borrowed in excess

of three million dollars from the Gibraltar Savings Associ-

ation to finance the Sharpstown project. They took addi-

tional 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 equiva-

lent, were given in payment of the accrued interest on the

initial loan. But I cannot agree with the narrow characteri-

zation of this overall transaction as a paper shuffling sham

composed of surrendered notes with check exchanges fly-

ing 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 deduc-

tion 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 inter-

est 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 rejec-

tion causes the taxpayers of this circuit to run through a

legal minefield they ought not have to cross. Today’s deci-

sion 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.

1 Burgess v. Commissioner, 8 T.C. 47 (1947); as subsequent

refined, Burck v. Commissioner, 63 T.C. 556 (1975), and W

kerson v. Commissioner, 70 T.C. 240 (1978).

A-9

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 protective

line of credit, are with the same bank. Let us further sup-

pose 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 Battel-

steins 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

A-10

its immunity, because it is actuated by a desire to avoid, or,

if one chooses, 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

Treasary ; 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 sec-

ond loan other than to repay interest on the first loan, (2)

proceeds of the second loan are commingled with the tax-

payer’s other funds, (3) the taxpayer have funds or avail-

able resources to cover the interest payment, and (4) the

lending institution loses control of the proceeds of the see-

ond loan. Burgess; Burck v. Commissioner, 63 T.C. 556

(1975), aff’d on other grounds, 553 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, utili-

ties were not installed. The controversial subsequent loan

agreement was really a clause contained in the Battelstein-

Gibraltar loan accord that stated:

After execution of the agreement Gibraltar will, pur-

suant to the terms thereof, from time to time, advance

to Owners ... an additional sum or sums of money equal

A-11

to the Owners’ actual out-of-pocket costs incurred and

paid on said property subsequent to the execution of

the 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.? 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 Battelsteins 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 Gibraltar in order to give the Bat-

telsteins 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

LR.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 under-

writing 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 Gibral-

tar). Additionally, in each of the eight challenged instances

of payment (quarterly during the two-year period under

2 Interest rates and due dates on the subsequent loans differed

from those on the first loan.

ms

*%

A-12

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 approxi-

mate 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 major-

ity’s perspective, the sequencing of checks between the Bat-

telsteins and Gibraltar conclusively proved that the bank’s

control of these funds was not extinguished because an “in-

consequential 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 Battel-

steins had paid. Had Gibraltar chosen for some reason not

A-13

to loan an amount equal to the particular payment, the

Battelsteins 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 received the checks were sufficient

to cover the checks before Gibraltar made any further

loan; and in every instance, the Battelsteins 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.° Heyman v. Commis-

sioner, 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. Set-

3In 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 tax-

payer the interest deduction. The court, somewhat tically

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

waflling 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-

conceived pian 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 — 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.

-%

A-14

ting 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 en-

visioned 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

Battelsteins borrowed from Gibraltar (and other institu-

tions) 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 ban-

share-type organization? Will we not be compelled to artic-

ulate 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.

A-15

Barry L. Batre stein

and Jerry EK. Batrre.stein,

Plaintiff s-Appellees,

v.

INTERNAL REVENUE SERVICE,

Defendant-Appellant.

No. 77-3212

Unirep States Court or APPEALS,

Firrx Circuit.

February 14, 1980.

Rehearing En Banc Granted

April 11, 1980.

Cash basis taxpayers filed Chapter XI bankruptcy peti-

tion. The bankruptcy judge denied claims filed by Internal

Revenue Service. The United States District Court for

the Southern District of Texas, John V. Singleton, Jr.,

Chief Judge, affirmed, and IRS appealed. The Court of

Appeals, Frank M. Johnson, Jr., Circuit Judge, held that

where lender agreed to make to borrowers, cash basis tax-

payers, future advances of interest as it becomes due and

each quarter lender would notify borrowers of current in-

terest due, whereon borrowers would send lender a check

in such amount and, on receipt, lender would send borrower

its check in the identical amount, such exchange of checks

did not result in interest being “paid” so as to be deductible

in computing federal income tax, notwithstanding that the

indebtedness and interest opportunities apparently had

business substance.

Reversed and remanded with directions.

Politz, Circuit Judge, dissented.

Fr

A-16

1. Internal Revenue — 518

Notes which cash basis taxpayer may have given lender

for interest advances could have not have resulted in pay-

ment thereof for federal income tax purposes, as “payment”

for tax purposes must be made in cash or its equivalent, and

a note promising payment of cash in the future is not “cash”

or its equivalent. 26 U.S.C.A. (1.R.C.1954) §163(a).

See publication Words and Phrases for other judi-

cial constructions and definitions.

2. Internal Revenue — 518

Where lender agreed to make to borrowers, cash basis

taxpayer, future advances of interest as it became due and

each quarter lender would notify borrowers of current

interest due, whereon borrowers would send lender a check

in such amount and, on receipt, lender would send borrower

its check in the identical amount, such exchange of checks

did not result in interest being “paid” so as to be deductible

in computing federal income tax, notwithstanding that the

indebtedness and interest opportunities apparently had

business substance. 26 U.S.C.A. (1I.R.C.1954) §$163(a).

See publication Words and Phrases for other judi-

cial constructions and definitions.

3. Internal Revenue — 518

Where taxpayer borrows money from a third party to pay

interest due his original lender, the interest is considered

paid and deductible in computing federal income tax; in the

third-party situation, deduction is appropriate because the

obligation as between the borrower and original lender has

not been postponed, it has been extinguished, and a default

by taxpayer would not revive it. 26 U.S.C.A. (1.R.C.1954)

$163 (a).

A-17

M. Carr Ferguson, Asst. Atty. Gen., Gilbert E. Andrews,

Acting Chief, App. Section, Robert A. Bernstein, Gayle P.

Miller, William Friedlander, Attys., Tax Div., Dept. of

Justice, Washington, D.C., for defendant-appellant.

Marc E. Grossberg, David Cowan, Hugh M. Ray, Hous-

ton, Tex., for plaintiffs-appellees.

Appeal from the United States District Court for the

Southern District of Texas.

Before COLEMAN, Chief Judge, FRANK M. JOHN-

SON, Jr. and POLITZ, Circuit Judges.

FRANK M. JOHNSON, Jr., Circuit Judge:

Barry L. Battelstein in November, 1976, and Jerry E.

Battelstein in April, 1977, filed Chapter XI petitions in

bankruptcy in the United States District Court for the

Southern District of Texas. In the ensuing proceedings,

the Internal Revenue Service (IRS) filed proof of claims

against each. The Battelsteins objected to the claims and

their objections were consolidated for trial. In June, 1977,

after trial, the bankruptcy judge denied the IRS claims. In

August, 1977, the district court affirmed this denial. The

IRS filed this appeal.

The controversy stems from deductions claimed by the

Battelsteins for interest paid on indebtedness. The Battel-

steins were land developers. Gibraltar Savings Association

was their lender. In 1971, Gibraltar agreed to loan the

Battelsteins more than three million dollars to cover the

purchase of a piece of property known as Sharpstown.

Gibraltar also agreed to make to the Battelsteins, if desired,

future advances of the interest costs on this loan as they

became due.! As it happened, the Battelsteins never paid

1 In partial consideration of its entrance into the agreement Gibral-

tar was promised a 19 per cent } participation in the value

of the property when finally sol

'

re

A-18

interest except by way of these advances. Each quarter,

Gibraltar would notify the Battelsteins of current interest

due. The Battelsteins would then send Gibraltar a check

in this amovat, and, on its receipt, Gibraltar would send

the Battelsteins its check in the identical amount. Although

the 1971 agreement provided that these advances were to

be evidenced by new notes, it is unclear whether new notes

were ever executed.” The bankruptcy judge and the district

judge found that the Battelsteins were correct in deduct-

ing the amount of the interest as interest paid on indebt-

edness. This finding was clearly in error.

Under §163(a) of the Internal Revenue Code of 1954, 26

U.S.C. §163(a), cash basis taxpayers such as the Battel-

steins may take a deduction for interest paid within the

taxable year on indebtedness. The dispute in this case

turns on whether or not the Gibraltar-Battelstein arrange-

ment resulted in interest being “paid.”

[1] The Battelsteins do not contend, nor could they seri-

ously, that any of the notes they they may have given

Gibraltar for the interest advances could have resulted in

payment. As the Supreme Court recently reiterated in a

related context, payment for tax purposes must be made in

cash or its equivalent, and a note promising payment of

cash in the future is not cash or its equivalent. Don E.

Williams Co. v. Commissioner, 429 U.S. 569, 577-78, 97

S.Ct. 850, 51 L.Ed.2d 48 (1977). The Court explained

that the note may never be paid, and if it is not paid, the

2 The Battelsteins testified that they could not recall.

3In the Williams case, the Court relied on two earlier decisions

articulating the same principle; Helvering v. Price, 39 U.S. 409,

60 S.Ct. ma 84 L.Ed. B36 ( 940), and Eckert v. Burnet, 283 U.S.

140, 51 S.Ct. 373, 75 L.Ed. 911 (1931). Based on Price, Eckert,

or other precedent established on their authority, courts have

A-19

taxpayer has parted with nothing more than his promise.

Id. at 578, 97 S.Ct. 850, quoting Hart v. Commissioner, 54

F.2d 848, 852 (1st Cir. 1932).

[2] The Battelsteins strenuously argued that the ex-

change of checks with Gibraltar did result in interest being

“paid”. This argument is without merit. The Battelsteins

have asserted business reasons for putting off the interest

payments,‘ but they do not assert, nor is it possible to infer,

any purpose other than tax avoidance for the check ex-

change method employed to do so. Although there are a

great many transactions which may properly be undertaken

principally with a view of minimizing taxes, e.g., buying

tax-free municipal bonds instead of higher yielding corpo-

rate securities, or selling property at the close of one year

rather than the start of another in order to accelerate the

recognition of a loss, creating a superficial payment struc-

refused to consider “paid” and deductible interest satisfied by a

note promising future payment, Hart v. Commissioner, 54 F 2d

848, 850-52 (1st Cir. 1932); interest “withheld” by the lender from

the original loan, Parks v. United States, 434 F.Supp. 206, 211

N.D.Tex.1977); Heyman v. Commissioner, 70 T.C. 482, 485-87

1978); Rubnitz v. Commissioner, 67 T.C, 621, 628 (1977); Hop-

ns v. Commissioner, 15 T.C. 160, 181 (1950); Cleaver v. Com-

missioner, 6 T.C. 452, 454 (1946), at 158 F.2d 342, 344 (7th Cir.)

cert. denied, 330 U.S. 849, 67 S.Ct. 1093, 91 L.Ed. 1293 (1947);

interest “withheld” by the lender from a subsequent loan, Keith

v. Commissioner, 139 F.2d 596, 597 (2d Cir. 1944); Nat Harrison

Associates, Inc. v. Commissioner, 42 T.C. 601, 623-25 (1964); or

interest paid by an increase in the original principal, England v.

Commissioner, 34 T.C. 617, 621 (1960). In Williams, the Court

noted the Cleaver decision, 429 U.S. at 578 n.9, 97 S.Ct. 850, and

quoted from Hart, Id. at 578.

4 The bankruptcy judge found that the loan agreement was “clearly

no sham business deal conceived solely to render the debtors a

tax deduction,” and explained that the business purpose of the

interest advances was “to enable the owners of the harpstown

property to maintain ownership of the property for an extended

_ of time, and to make improvements, including the addition

of utilities.”

A-20

ture solely to reap the benefits of $163(a) is not one of them.

See Knetsch v. United States, 364 U.S. 361, 367 81 S.Ct. 132,

5 L.Ed.2d 128 (1960) ; Salley v. Commissioner, 464 F.2d 479,

480, 482-83 (5th Cir. 1972) ; Goldstein v. Commissioner, 364

F.2d 734, 740 (2d Cir. 1966).5 To give significance to the

check exchange would be to exalt artifice over reality and

deprive $163(a) of all serious purpose. Cf. Gregory v. Hel-

vering, 293 U.S. 465, 470, 55 S.Ct. 266, 79 L.Ed. 596 (1935).

Given its sham nature, the exchange should be ignored. See

Waterman Steamship Corp. v. Commissioner, 439 F.2d 1185,

1192 (5th Cir. 1970) ; Owens v. Commissioner, 568 F.2d 1233,

1240 (6th Cir. 1977) ; Gilbert v. Commissioner, 248 F.2d 399,

411 (2d Cir. 1957) (Hand, J., dissenting). When the ex-

change is ignored, it is obvious that the Battelsteins’ ar-

rangement resulting in nothing more than promises to pay

and not, as the Supreme Court has required, actual payment.

See Don E. Williams Co. v. Commissioner, supra, 429 U.S.

at 578, 97 S.Ct. 850. Accordingly, the deductions should not

have been allowed.

The Battelsteins’ reliance on the line of Tax Court cases

beginning with Burgess v. Commissioner, 8 T.C. 47 (1947),

is misplaced. The Burgess cases establish an exception

inapplicable to the facts of this case. In Burgess and its

progeny, the Tax Court held that interest may be con-

5 Section 163(a) is an accounting provision and, like tax accounting

provisions generally, it invites evasion. In the cases cited, tax-

payers structured elaborate loan transactions in order to create

indebtedness giving rise to interest deduction opportunities.

Finding that the transactions had no purpose other than tax

avoidance, the courts disallowed the interest deductions in full.

In this case, the indebtedness and interest Be sens corey appar-

ently had business substance; it was the check exchange m

claimed to have “paid” them that did not. The distinction is

unimportant.

6 Burgess was followed in Burck v. Commissioner, 63 T.C. 556

(1975). aff'd on other grounds, 533 F.2d (2d Cir. 1976), and again

in Wilkerson v. Commissioner, 70 T.C. 240 (1978).

A-21

sidered paid even though the taxpayer may have paid it

with money subsequently borrowed from the initial lender,

so long as the money subsequently borrowed actually passed

into the hands or bank account of the taxpayer, was com-

mingled with the other funds of the taxpayer and thus be-

came subject to the taxpayer’s unrestricted control. Bur-

gess v. Commissioner, supra, 8 T.C. at 49-50. See also Wil-

kerson v. Commissioner, 70 T.C. 240, 257-61 (1978); Burck

v. Commissioner, 63 T.C. 556, 559-60 (1975), aff’d on other

grounds, 533 F.2d 768 (2d Cir. 1976). Here the last condi-

tion was not satisfied. Because Gibraltar did not issue the

Battelsteins its check until it had their check already in

hand, it cannot be said that the interest money advanced by

Gibraltar ever became commingled with the Battelsteins’

other funds and subject to the Battelsteins’ unrestricted

control. Moreover, it should be kept in mind that the Bur-

gess conditions were apparently developed as a guide to

distinguish sham payments from legitimate payments. The

conditions notwithstanding, the Battelsteins’ check exchange

was, as noted above, obviously a sham.

[3] Even if applicable, the Burgess exception is of

doubtful validity.? The principal distinction between the

Burgess case and the Don E. Williams Co. cases® is that

in the Burgess cases the payment of interest claimed by

the taxpayer was alleged to have occurred not through a

paper transaction with the lender of the principal, such

as the giving of a note or the withholding of interest from

principal, but by an actual exchange of funds. See Bur-

gess v. Commissioner, supra, 8 T.C. at 49-50. This dis-

7 The exception has been much criticized. See Burck v. Commis-

sioner, 533 F.2d 768, 770 n.3 (2d Cir. 1976); Goodstein v. Com-

missioner, 267 F.2d 127, 131 (1st Cir. 1959); Burgess v. Commis-

sioner, supra, 8 T.C. at 50-51 (Kern, J., dissenting for himself and

five other Tax Court judges).

8 See note 3 supra.

A-22

tinction has no creditable basis. Jd. at 50-51 (Kern, J.

dissenting). The lender’s additional loan and the taxpay-

er’s ‘payment’ of interest add up to no more than a post-

ponement, not payment, of the taxpayer’s interest obliga-

gation to the lender. Cf. Minnesota Tea Co. v. Helvering,

302 U.S. 609, 613, 58 S.Ct. 393, 395, 82 L.Ed. 474 (1938)

(“A given result at the end of a straight path is not made

a different result because reached by following a devious

path.”) Contrary to the Battelsteins’ claims, the distine-

tion is not saved by analogy to the well-established rule

that, where a taxpayer borrows money from a third party

to pay interest due his original lender, the interest is con-

sidered paid and deductible. See, e.g., McAdams v. Com-

missioner, 15 T.C. 231, 235 (1950). This rule is clearly

inapposite. In the third-party situation, deduction. is

appropriate because the obligation as between the bor-

rower and the original lender has not been postponed, it

has been extinguished. A default by the taxpayer would

not revive it. Crain v. Commissioner, 75 F.2d 962, 964

(8th Cir. 1935). This is not the case where the taxpayer

‘satisfies’ his interest obligation with additional borrow-

ings from his original lender. The obligation as between

the borrower and the lender remains but, like a note

promising payment in the future, merely in another form.

Burgess provides an opportunity for tax advoidance that

§163(a) clearly did not intend. Were we to find, as did

the district court, that Burgess is here applicable, we

would decline to follow it and disallow the Battelsteins’

deductions.

A-23

REVERSED AND REMANDED FOR A

CALCULATION OF TAX LIABILITY

POLITZ, Circuit Judge, dissenting:

I respectfully dissent. The rejection of the Burgess’

“exception” is not justified. The majority opinion

ascribed undue emphasis to the source of the funds used

to make the interest payments, finding same came from

the lender of the principal loan. A single factor should

not dominate, but rather the totality of the circumstances

should control deductibility of interest payments under

26 U.S.C. § 163(a). This decision hangs an ominous ques-

tion mark over interest deductions in every instance in

which a borrower secures, from the same lender, a sub-

sequent loan equal to or greater than the interest paid

in that tax year. I recognize that there must be very care-

ful safeguards in this area or there will be abuses. But

we need not hurt hummingbirds with shotguns.

I fully endorse the rules of law collated and enunciated

by the majority to the effect that for an interest deduc-

tion to be allowed the payment must be in cash or its

equivalent, a note alone, evidencing a future obligation

is not enough, a sham exchange is to be ignored and a

superficial. payment structure created solely to reap

undue benefits under § 163(a) is not to be given force and

effect. However, the factual situation before us, as found

by the Bankruptey Judge and affirmed by the District

Court is not inconsistent with these general rules and

upon the facts so found (which are essentially not dis-

puted) the interest deductions were appropriate and

should be allowed.

My concern is heightened by the realization that if the

taxpayers had borrowed the funds needed for the inter-

1 Burgess v. Commissioner, 8 T.C. 47 (1947).

A-24

est payments from another lender the deduction would

probably not have been challenged, and if challenged,

would apparently have been approved by the majority.

For over 30 years the Burgess explication of a par-

ticular application of § 163(a) has been a part of the jur-

isprudence. As the majority notes, it has been both fol-

lowed and criticized. I believe it more worthy of support

than criticism. The rule of Burgess and its progency is

of value and ought to be available to taxpayers in this

circuit.

The material facts found by the Bankruptcy Court are

not contested. Barry Battelstein and Jerry Battelstein

entered into a loan agreement with Gibraltar Savings

Association in January 1971 in order to finance the pur-

chase and development of a piece of property. The Bat-

telsteins and other owners intended to develop the prop-

erty which, at the time of purchase, did not have

utilities. The Association agreed to make future loans

to the owners to carry the cost of the property. In return

the Association was to receive, in addition to repayment

of its loans, a 19% interest in the net proceeds of sale of

the property.

The loan agreement contained this salient language:

After execution of the agreement Gibraltar will, pur-

suant 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 agreement, including, but not being limited to

debt services, taxes...

The Association, pursuant to this provision, made sub-

sequent advances (loans) to the owners, at higher inter-

est rates than the original acquisition loan, with different

maturity dates and secured by additional liens on the

A-25

property. During 1973 and 1974 additional loa were

made to the Battelsteins for sums equal to aa ierem

taxes they paid and for debt service or interest charges

they owed the Association and timely paid. The IRS

challenged the deductibility of the interest payments and

the ad valorem tax payments on the same grounds, that

the source of the funds was the Association and thus no

deduction could be taken because no payment had been

made, The bankruptcy and district courts rejected the

challenges to deduction of both the interest payment and

the ad valorem tax payments. No appeal was taken to

the rejection of the challenge to the deduction for ad

valorem taxes. That issue leaves the case, presumptively

because the IRS concluded that challenge was not well

founded.

Jerry Battelstein claimed the interest deduction for

both tax years at issue, 1973 and 1974, Barry Battelstein

claimed the interest deduction for 1973 but capitalized

the expense in 1974 under § 266 of the Internal Revenue

Code.

These further facts were found. The Battelsteins were

not obliged to borrow the additional sums from Gibraltar.

Further, in each of the eight challenged instances of pay-

ment (quarterly during the two year period) they had

sufficient funds in their general bank accounts (maintained

with another institution, not Gibraltar) to cover the pay-

ments for interest and taxes or very ample resources from

which the taxes and interest could have been paid. 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 in 1973 and was over five million in 1974. Barry

A-26

Battelstein had substantial assets upon which to draw for

payments, for example in 1973 he had $1,300,000 in Certifi-

cates of Deposit readily available. The interest payments

during the period fluctuated between $4,991.06 and

$48,728.10, It cannot be gainsaid that the Battelstein’s had

adequate funds to pay the interest independent of the funds

received from Gibraltar.

Another cogent consideration is whether the subsequent

loans had any economic utility other than to serve as the

basis of a claimed tax deduction. The trier of fact found

that such utility existed, I fully agree, The loan agreement

was intended to keep the Battelsteins and the other owners

in a position where Gibraltar carried the full cost of

acquisition and development of the property. The money

was available. Jerry Battelstein testified that he subscribed

to the theory that money could be made with borrowed

money. This gave the Battelsteins added financial flexi-

bility. And this must be viewed in light of the fact that

Gibraltar would receive a 19% interest in the net proceeds

of sale. These subsequent loans had an obvious economic

utility.

The majority opinion assigns substantial import to the

sequencing of checks between the Battelsteins and Gibral-

tar. It is said that in each instance the Battelsteins sent

their respective checks for the quarterly interest payments

at which point Gibraltar sent the Battelsteins a like check

which the Battelsteins deposited in their general bank

accounts, I find this significant, but reach a conclusion

exactly opposite from that of the majority. When Gibraltar

received the Battelsteins’ checks there is more than simply

the Battelsteins’ promise to pay (such as would be evi-

denced by a note). They had indeed paid. The facts show

that in some instances sufficient funds were on deposit in

the Battelsteins’ accounts to fully cover these checks and

in every instance more than adequate resources existed for

A-27

payment. Gibraltar sent its checks and they were deposited

in the general bank accounts of the Battelsteins in another

institution and commingled and utilized for whatever pur-

pose. It cannot be claimed that the subsequent loans pro-

ceeds were used exclusively for payment of the quarterly

interest payments for the facts do not support that con-

clusion,

The Burgess requirements, as subsequently refined, estab-

lish adequate safeguards to avoid the very real possibilities

of abuse in dual loan transaction situations. In essence 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; Burck vy. Commissioner, 63 T.C,

556 (1975) aff’d on other grounds, 533 F.2d 768 (2nd Cir,

1976) ; Wilkerson v. Commissioner, 70 T.C, 240 (1978).

The factual grounding of many “dual loan” cases pre-

cludes the taxpayer from taking the deduction under

Burgess, however the Tax Court has consistently recognized

the rule’s applicability in proper cases, Heyman vy, Commis-

sioner, 70 T.C, 482 (1978); Alan A. Rubnite, 67 T.C, 621

(1977) ; Nat Harrison Associates, Ine, 42 T.C, 601 (1964) .*

2In Goodstein vy. C.L.R., 267 F.2d 127 (1st Cir, 1959), the First

Circuit affirmed a Tax Court holding which characterized a trans-

action within the Cleaver mold, thereby denying the taxpayer the

interest deduction, The court, somewhat cryptically “Tax-

yer cites Newton A, Burgess, . .. which would seem to hold to

e cont.ary but to use 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 rt of Appeals

determined the Goodstein transaction was devoid of economic

substance beyond the purpose of obtaining an interest deduction.

—_ —

A-28

I am convinced that all four of the above noted require-

ments are met in this case. I believe the Burgess test to be

fair and workable. I would apply it. I see a vast difference

between a carefully fashioned financial program, one inten-

tionally designed to maximize valid tax advantages, and an

artfully devised scheme to evade taxes. The latter is to be

abrogated. To reject an instance of the former is a policy

judgment only the Congress should make in the quest for

tax reform.

For these reasons I would affirm the decisions of the

bankruptcy and district courts allowing the interest deduc-

tions and I, therefore, respectfully dissent.

Indeed, the plan in that case was devised by an accountant who

contacted the IRS to test whether the pre-conceived 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 affirma-

tion for the Second Circuit, Sedge Oakes states in fn. 3 that he

disagreed with the Burgess pak 2p . Judge Oakes expressed

these reservations “for himself only”, the Burgess rule was not the

subject of review.

A-29

In Tue Unitep States District Court

For THe SoutrHern District Or Texas

Houston Division

Barry L. BATTEeLSTEIN

JERRY EK. BATTELSTEIN

Plaintiff s, Crvm Action No. H-77-1254

v.

INTERNAL REVENUE SERVICE \

ORDER

The above-styled-and-numbered cause is an appeal taken

by the Director of Internal Revenue pursuant to Bank-

ruptcy Rule 801. The Director appeals from the denial of

its claims in two Chapter XI Arrangements which were

consolidated for purposes of adjudication of such claims.

In two orders entered on June 27, 1977, the bankruptcy

court denied or reduced the Director’s claims for internal

revenue taxes in In re Jerry E. Battelsteim, Bankruptcy

No. 77-H-240, and In re Barry L. Battelstein, Bankruptcy

No. 76-H-785.

Upon careful consideration of the record on appeal and

pursuant to Bankruptcy Rule 810, this court finds that the

bankruptcy court’s findings and orders are neither clearly

erroneous nor contrary to law. Therefore, it is ORDERED,

ADJUDGED, and DECREED that the orders of the bank-

ruptcy court be, and the same hereby are, AFFIRMED.

DONE at Houston, Texas, on the 29th day of August,

1977.

United States District Judge

A-30

In Tue Unitep States District Court

For Tue Souruern District Or Texas

Hovstron Division

Barry L. BATTELSTEIN

Jerry KE. er Civ Action No. H-77-1254

INTERNAL RevENUVE SERVICE

. FINAL JUDGMENT

The Court, Hon. John V. Singleton, Jr., United States

District Judge, by Order on this Date, having AFFIRMED

the orders of the bankruptcy court,

Judgment is hereby entered in favor of the Plaintiffs and

against the Defendant.

DATED at Houston, Texas, this 5th day of December,

1977.

ENTERED NUNC PRO TUNG, effective the 29th day

of August, 1977.

V. Bamtey Tomas, Clerk

Deputy Clerk

|

A-31

In Tue Unitep States District Court

For Tue SoutrHern District Or Texas

Hovston Division

In RE: In Cuapter Xi

Barry L. BATTELSTEIN ARRANGEMENT

Debtor Bankruptcy No. 76-H-785

ORDER REDUCING CLAIM

The Objection of Barry L. Battelstein, the above named

Debtor to the allowance of the claim of the Directory of the

Internal Revenue Service, filed by the United States of

America herein being Claim No. 28, having been heard by

the Court and the Court having rendered its Memorandum

Opinion containing Findings of Fact and Conclusions of

Law, it is

ORDERED that the Claim of the Internal Revenue Serv-

ice, be and same is hereby reduced to $25,074, and allowed

at said amount,

SIGNED and ENTERED the 27th day of June, 1977.

evpuoeenanvaveece Fe Fe 8 O80. O98 £23 2 eee

Bankruptcy Judge

%

—

A-32

In Tue Unrvep Srartes District Court

For Tue SoutrHern District Or Texas

Hovston Division

In RE: In Cuaprer XI

JERRY E. BatrreLsTeIn ARRANGEMENT

Debtor Banxkervptcy No. 77-H-240

ORDER DENYING CLAIM

The Objection of Jerry E. Battelstein, the above named

Debtor to the allowance of the claim of the Director of the

Internal Revenue Service, filed by the United States of

America herein being Claim No. 15, having been heard by

the Court and the Court having rendered its Memorandum

Opinion containing Findings of Fact and Conclusions of

Law, it is

ORDERED that the Claim of the Internal Revenue Serv-

ice, be and same is hereby disallowed in its entirety.

SIGNED and ENTERED this 27th day of June, 1977.

a ee ee ee oe i me oe eo, a oe oe oe

Bankruptcy Judge

A-33

In Tue Unitep States District Court

For Tue SoutrHern District Or Texas

Hovston Division

In Tue Matter OF

Barry L. BaTTeELsTEIN

Jerry BE. BaTTELSTEIN In BANKRUPTCY

— No. 76-HS-785

Barry L, BarTreELsTEIN HS-77-240

Jerry E. BAtTrELSTEIN

Plaintiff s Apversary E

Vv. Apversary B

Drsacros Or [Filed June 13, 1977]

INTERNAL REVENUE SERVICE

Defendant ,

Marc FE. Grosssera, Esq. Huan M. Ray, Esq.

1415 Fannin 2500 Exxon Building

Houston, Texas 77002 Houston, Texas 77002

Howarp A. WEINBERGER, Esq.

Attorney, Tax Division

Department of Justice

Room 5B27, 1100 Commerce Street

Dallas, Texas 75242

MEMORANDUM OPINION ON OBJECTION TO CLAIM

WILLIAM M. SCHULTZ

UNITED STATES BANKRUPTCY JUDGE

Barry L. Battelstein filed a Chapter XI petition on

November 1, 1976, and Jerry E. Battelstein filed a Chapter

XI petition on April 1, 1977. The Internal Revenue Service

filed proofs of claim against each debtor, based upon assess-

ments made for 1973 and 1974 federal income taxes. The

claim against Barry Battelstein is in the amount of $62,484

and against Jerry Battelstein in the amount of $50,223.11.

The debtors objected to the claims on the ground that they

were entitled to certain of the deductions on which the

assessments were predicated. The assessments emanate

from the Internal Revenue Service disallowance, which the

debtors challenge, of interest and ad valorem tax deductions

in the years 1973 and 1974 by Jerry Battelstein and similar

deductions, in the year 1973, by Barry Battelstein. The

two contested matters were consolidated for trial purposes

only and a hearing on objection to the claims was held.

Each debtor also amended his objection to the claims to

include a request that the Government pay the cost of

reasonable attorney’s fees incurred in objecting to the

claims. The parties submitted post-trial briefs.

Based upon the uncontroverted testimony adduced before

the Court, I make the following findings of fact:

The debtors and others entered into an initial loan agree-

ment with Gibraltar Savings Association on January 27,

1971, to finance the purchase and development of a piece

of property known as the “Sharpstown Property.” Due to

a desire on the part of the Battelsteins and other owners to

develop the property, which at the time of purchase did not

have utilities, the Association agreed to make future loans

to the owners to carry the cost of the property until its

ultimate use was achieved.

The salient language of the agreement provided:

“After execution of the agreement Gibraltar will, pur-

suant 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 agreement, including, but not being limited to

debt services, taxes...”

A-35

Subsequent advances, hereinafter called loans, were made

to the debtors by the Association which were secured by

additional liens on the property. As partial consideration

for the Association loaning funds to the owners to defray

the carrying costs, Gibraltar received first, repayment of

all loans made and interest on those loans, plus 19% of all

remaining proceeds after deducting the expenses of any

sale of the property.

The debtors, pursuant to the loan agreement, in 1973

and 1974 borrowed funds from Gibraltar to pay current

interest and current taxes on the property. These subse-

quent loans were made by Gibraltar at a higher rate of

interest than the initial note and with different maturity

dates.

The debtors testified that they were not required to bor-

row the funds from Gibraltar. Moreover, two out of eight

times they had adequate funds in their general bank

accounts to make the payments and the other six times

they had substantial resources from which the interest and

taxes could have been paid. Furthermore, the debtors

stated that they could have borrowed the funds from

another source. Jerry Battelstein’s average monthly check-

ing account bank balances were $24,000; $75,000; and

$35,000 during 1973, 1974 and 1975; Barry Battelstein’s

average monthly balances were $36,000; $44,000; and

$40,000 during the same period.

The loan proceeds were deposited in the debtors’ regular

checking accounts and the funds commingled with the

debtors’ other funds. Gibraltar had no control over the

funds advanced to the debtors and there was no agreement

restricting the use of the funds. The debtors paid the inter-

est and tax expenses by their checks.

A-36

The two issues involved in this action are whether the

debtors, as cash basis taxpayers, have paid the interest in

in terms of § 163(a) of the Internal Revenue Code and thus

would be entitled to deduct interest paid on the loan to

purchase the “Sharpstown Property”; and, whether the

payments for ad valorem taxes on that same property were

deductible under § 164(a)(1) of the Internal Revenue Code.

The basis for the allowance of an interest deduction is

found in the Internal Revenue Code §163(a), 26 U.S.C.

§ 163(a), which provides:

“There shall be allowed as a deduction all interest paid

or accrued within the taxable year on indebtedness.”

However, a taxpayer on cash basis may deduct interest

only when actually paid. United States v. Collier, 104 F.2d

420 (5th Cir. 1939); 2 Merten’s Law of Federal Income

Taxation, § 12.58, p. 220.

Furthermore, “no deduction will be allowed unless in-

terest is paid in a transaction where some economic benefit

other than reducing taxes is calculated to inure to the tax-

payer.” 2 Mertens Law of Federal Income Taxation, $12.58

p. 221. This restriction on allowance of the deduction is

illustrated in the case of Goldstein v. Commissioner, 364

F.2d 734 (2d Cir. 1966).

“The interest deduction should be permitted whenever

it can be said that the taxpayer’s desire to secure an

interest deduction is only one of the mixed motives that

prompts the taxpayer to borrow funds; or... the

deduction is proper if there is some substance to the

loan arrangement beyond the taxpayer’s desire to

secure the deduction.” Jd. at 741.

Consequently, there must always be a court finding of

“economic utility” with regard to the transaction for the

court to allow the interest deduction.

A-37

Only two Tax Court cases have dealt with fact situations

similar to this case, and in both such cases the courts devi-

ated from the general rule and held for the taxpayers. The

cases are Burgess v. Comm’r., 8 T.C. 47 (1947) and Burck v.

Comm’r. 63 T.C. 556 (1975). The general rule abrogated by

both cases is that “when a taxpayer, on cash basis, borrows

from a creditor there has been no cash payment of inter-

est which is deductible from gross income.” Burgess v.

Comm’r., 8 T.C. at 151 (rule as stated by the dissent).

The Burgess and Burck courts based their deviation from

the general rule on the facts of the cases. In the cases the

loans were obtained to pay several bills, including interest,

and the loan funds were commingled with the funds in the

taxpayers’ regular bank accounts so as to lose their identity.

One distinction exists between the two cases. In Burgess

the court acknowledged that without the loan funds there

would have been insufficient money in the debtor’s account

to pay the interest and the other bills; whereas in the Burck

case the court took the opportunity to point out that the

loan to the taxpayer was not material because even without

the loan proceeds the debtor could have paid the interest

and his other bills. Thus, it is unclear what weight the Tax

Court gives to the inability of the debtor to pay his interest

due without additional loan proceeds.

Under existing case law it appears that employing the

proper technique in arranging transactions which result in

the interest deduction is important.

For example, it is well settled that a cash basis taxpayer

will be denied a deduction where he received the face

amount of the new loan, less the interest retained by the

lender on the old loan. Nat Harrison Associates, Inc., 42

T.C. 601 (1964); Estel L. Cheeseman, T.C. Memo par. 69,

259 (1969); Cleaver v. Comm’r., 158 F.2d 342 (7th Cir.

1946).

A-38

Nor can a taxpayer give his own note in payment of his

interest liability; the note is not the equivalent of cash so

as to entitle the taxpayer to a deduction. Helvering v. Price,

309 U.S. 409 (1940).

Also, increasing the principal of a loan by the amount of

interest owed does not constitute a “payment” for a cash

basis taxpayer. James England, 34 T.C. 617 (1960) ; Keith

v. Comm’r., 139 F.2d 596 (2d Cir. 1944).

Nevertheless, the Tax Court has carved out an exception

to the general rule against allowance of taxpayer-debtor

interest deduction when the debtor borrows a second time

from the same creditor to make interest payments on the

initial loan. That exception is the progency of the cases,

Burgess and Burck.

Turning now to the Battelsteins, the Government cites

several authorities for its position and argues that the

Battelsteins’ cases are only a variation of the loan discount

plans negated in many cases. However, the Burgess and

Burck decisions make it clear that the facts of the trans-

actions should be determinative.

The Government contends that the Burgess case holding

has been criticized. Nevertheless, that criticism has not

convinced the Tax Court to hold against a taxpayer involved

in this type of transaction. Subsequent to the dictum dis-

approval, the tax court passed up an opportunity to alter its

position when it decided the Burck case. Therefore, in the

opinion of this court, the prevailing view is that found in

Burgess and Burck.

The Government produced exhibits in an attempt to show

debtors’ inability to pay the interest and taxes plus their

other bills, but the debtors successfully rebutted this with

a showing that they had ample resources with which to pay

all their bills. The debtors testified that they had large

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checking account balances at the time the loans were made,

that they could have acquired loans through other sources

and that their other substantial assets were available to pay

the expenses if needed. Although those assets were not

always in the form of cash in their bank accounts, in the

opinion of the court, the fact that the debtors could have

paid the bills without the loan funds is a consideration

favorable to the debtors.

The Battelsteins’ transactions with Gibraltar, met the

Burgess/Burck test for allowance of the interest deduc-

tions. The Battelsteins’ commingled the loan funds with

funds in their regular bank accounts and the funds lost

their identity, the expenses were paid by check, and the

debtors had adequate resources with which to pay their

bills even without the loan funds. Therefore, the trans-

actions should be treated as cash payments.

Also, the transactions meet the Goldstein requirement

that there be “economic utility” in the transactions

beyond an attempt to acquire an interest deduction for

tax purposes. The Battelsteins and the Association ex-

plained the business purpose of the transaction was to

enable the owners of the Sharpstown property to main-

tain ownership of the Property for an extended period

of time, and to make improvements, including the addi-

tion of utilities. Under the agreement, the Association

received first, repayment for all loans made and interest

on those loans plus 19% of all remaining proceeds after

the expenses of any sale of the property. Under these

facts, there was clearly no sham business deal conceived

solely to render the debtors a tax deduction.

Based on the facts involved in this case, it is the opinion

of the court that the cases cited by the Government do

not reach the issues. The Government cites Goldstein v.

Comm’r., 267 F.2d 127 (1st Cir. 1959), in which the Cir-

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cuit Court found that there was no indebtedness. The

Goldstein court decided that whatever relationship existed

between the parties it was not debtor-creditor but was

akin to the exchange of promises of future performances

between taxpayer and lender. Jd. at 131. Furthermore, the

court found that the only purpose of the transaction in that

case was to achieve interest deductions.

In contrast, the Battelsteins clearly showed “economic

utility” in the transactions which reach beyond an inter-

est deduction, Also, there is no finding that a debtor-

creditor relationship did not exist between the Battel-

steins and the Association.

The Government also cites the case of Parks v. United

States, 77-1 U.S.T.C,, par. 9404 (N.D. Tex., April 18,

1977), which also misses the mark. The case dealt with

prepayment of interest which the court decided should

be amortized over a period of interim construction finane-

ing The arrangement in that case involved payment of

the interest out of the initial loan proceeds; whereas the

Battelsteins’ arrangement involved their reimbursement

by the Association in a series of separate new loan trans-

actions as the interest and tax expenses became due,

On the point of the ad valorem tax expenses, the basis

for that deduction is the Internal Revenue Code § 164(a)-

(1), 26 U.S.C. § 164(a)(1), which provides:

“Exept as otherwise provided in this section, the fol-

lowing taxes shall be allowed as a deduction for the

taxable year within which paid or accrued:

(1) State and local... real property taxes...”

The debtors support their deductions with a series of

cases including Hagel McAdams, 15 T.C, 235 (1950) and

Robert B. Keenan, 20 B.T.A, 998 (1930). In the opinion

of this court, these authorities entitle the debtors to their

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claimed deductions for tax expenses in the years paid

despite payment of the taxes with borrowed funds.

For all the reasons hereinabove set forth, I find that

the debtor Barry L. Battelstein is entitled to the inter-

est and tax expense deductions claimed for the year 1973

provided, however, Barry Battelstein has conceded a tax

deficiency of $25,074 consisting of $21,574 by way of an

increase in the 1974 dividend income and a disallowance

of 1973 partnership allowance, plus a $3,500 adjustment

in depreciation on apartments which was conceded at the

trial. I find that debtor Jerry E. Battelstein is entitled

to the interest and tax expense deductions claimed for

the years 1973 and 1974.

The debtors’ requests for recovery of reasonable attor-

ney’s fees incurred in prosecuting this objection to claim

is denied. In the opinion of the Court 42 U.S.C. § 1988,

on which debtors base their request, is not applicable to

the facts of these cases.

Counsel for the debtors shall submit the appropriate

order,

Winns M,Scrunrz

United States

Bankruptcy Judge