107 T.C. No. 15

UNITED STATES TAX COURT

SCOTT C. AND SHERRY L. RUSSON, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 23686-94. Filed November 6, 1996.

P, a funeral director, is a full-time employee of

Russon Brothers Mortuary, a C corporation, all the

stock of which was owned by his father and two uncles. 

In 1985, P, his brother, and two cousins (all funeral

director employees of Russon Brothers) agreed to

purchase all the stock from their fathers so that the

sons could conduct the mortuary business and earn a

living continuing the business founded and developed by

their fathers. P incurred indebtedness in order to

purchase his share of the stock. At issue is whether

interest paid on that indebtedness is deductible as

business interest or whether deductibility is subject

to the investment interest limitations of sec. 163(d),

I.R.C., as modified by the Revenue Act of 1986, Pub. L.

99-514, 100 Stat. 2085.

Pursuant to sec. 163(d)(1), I.R.C., the amount

allowable as a deduction for "investment interest" may

not exceed the taxpayer's "investment income",

sometimes known as portfolio income. "Investment
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interest" is defined in sec. 163(d)(3), I.R.C., as

interest paid on indebtedness properly allocable to

"property held for investment," a term that is defined

in sec. 163(d)(5)(A)(i), I.R.C., to include "property

which produces income of a type described in sec.

469(e)(1)," i.e., portfolio income such as dividends,

interest, etc.

Held: Since stock is the type of property that

normally pays dividends, it is covered by sec.

163(d)(5), I.R.C., as "property which produces income"

of a type described in sec. 469(e)(1), I.R.C.,

notwithstanding that in this case no dividends have in

fact been paid in the past on Russon Brothers stock. 

Accordingly, interest paid by P on indebtedness

incurred to purchase the stock is subject to the

limitations of sec. 163(d)(1), I.R.C.

J. Michael Gottfredson, for petitioners.

James B. Ausenbaugh and Mark H. Howard, for respondent.

OPINION

RAUM, Judge: The Commissioner determined deficiencies in

petitioners' Federal income taxes of $4,220.50, $4,231.92, and

$3,967.60 for the taxable years 1990, 1991, and 1992,

respectively. Petitioner husband (petitioner or Scott) together

with his brother and two cousins, all employed full time as

funeral directors in a mortuary operated by a C corporation,

purchased all the stock of that corporation from its owners,

their fathers, so that they could conduct the mortuary business

full time and "earn a living." At issue is whether interest paid

on an indebtedness incurred by petitioner to purchase his share

of the stock is deductible as business interest or is subject to
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the investment interest limitations of section 163(d) as modified

by the Revenue Act of 1986, Pub. L. 99-514, 100 Stat. 2085. 

Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the tax years involved. 

Petitioners resided in Centerville, Utah, when the petition

in this case was filed. Petitioner is an employee of Russon

Brothers Mortuary (Russon Brothers), a Utah corporation that was

organized as a "C" corporation in 1969 and continues as such to

the present. Petitioner began full-time employment with Russon

Brothers in September 1979 as a funeral director and has

continued full time with Russon Brothers to the present. 

On December 23, 1985, Scott, his brother Brent C. Russon,

and two cousins, Robert L. Russon and D. Gary Russon, agreed to

buy all the stock in Russon Brothers from Scott and Brent's

father, Milton W. Russon, Robert's father, Leo W. Russon, and

Gary's father, Dale L. Russon. Milton, Leo, and Dale are

brothers, each of whom owned one-third of the stock of Russon

Brothers. Scott, Brent, Robert, and Gary agreed to pay their

fathers $999,000 for the stock in Russon Brothers, each son to

pay one-fourth (1/4) of the purchase price, payable ten percent

(10%) down and the balance payable in 180 equal monthly payments

with interest at nine percent (9%) on the remaining balance. The

Agreement gave the four buyers the "right to exercise the

ownership rights * * * [which] shall include * * * the right to

all the dividends from the stock," except as limited by the
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Agreement. One of the limitations provided that until the full

purchase price was paid, the buyers could not "declare or pay any

dividends or make any distributions" relating to the stock

without written permission of the sellers, the fathers. 

Scott, Brent, Robert, and Gary all were funeral directors at

the time of the purchase. They were trained and taught the

mortuary business at Russon Brothers. They qualified themselves

to operate the mortuary business through schooling and while

working at Russon Brothers. On December 23, 1985, Russon

Brothers, as the Company, Scott, Brent, Robert, and Gary, as

Buying Shareholders, and Milton, Leo and Dale, as Selling

Shareholders, entered into a Stock Purchase Agreement. On

December 23, 1985, Milton, Leo, Dale, Brent, and Gary were

elected directors of Russon Brothers. The new directors then

elected Robert as president, Brent as vice president, and Scott

as secretary-treasurer of Russon Brothers. 

At the time the stock was purchased Milton and Leo retired

from Russon Brothers. Dale continued as a full-time employee for

a few months in order "to receive his maximum Social Security

benefits allowable to him for retirement at age 62". Scott,

Brent, Robert, and Gary purchased the Russon Brothers stock from

their fathers so that they could manage, operate, conduct, and

participate full time in the mortuary business and earn a living

continuing a business started and developed by their fathers. 

Scott did not have a substantial investment motive when he
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purchased the stock. Milton, Dale, and Leo sold the Russon

Brothers stock to Scott, Brent, Robert, and Gary so the four sons

of the three fathers could actively continue the mortuary

business. 

All the assets of Russon Brothers, except for a mutual fund

acquired by the company in 1989 for $12,000 with a 1995 value of

$20,000, are used actively in the mortuary business. The

checking account of Russon Brothers has an average balance of

$70,000 with cash available of $30,000 and is all actively used

in the mortuary business. 

Russon Brothers has never paid interest, dividends,

annuities, or royalties to any of its shareholders during its

existence of 26 years. Beginning before December 23, 1985, and

continuing through all years involved in the tax matter before

the Court, Scott, Brent, Robert, and Gary actively and materially

participated in Russon Brothers as an active mortuary business on

a regular, continuous, and substantial basis in excess of 40

hours per week. Scott, Brent, Robert, and Gary have never been

engaged in the trading or dealing of stocks or securities. 

Section 163(a) allows "as a deduction all interest paid or

accrued within the taxable year on indebtedness." However,

section 163(d)(1) provides that "In the case of a taxpayer other

than a corporation, the amount allowed as a deduction under this

chapter for investment interest for any taxable year shall not

exceed the net investment income of the taxpayer for the taxable
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year." Section 163(d)(3) defines "investment interest" as "any

interest allowable as a deduction under this chapter * * * which

is paid * * * on indebtedness properly allocable to property held

for investment." Section 163(d)(5) defines "property held for

investment" as follows:

(A) In general. The term "property held for investment"

shall include--

(i) any property which produces income of a type

described in section 469(e)(1), and 

(ii) any interest held by a taxpayer in an

activity involving the conduct of a trade or

business--

(I) which is not a passive activity, and

(II) with respect to which the taxpayer

does not materially participate.

* * * * * * *

(C) Terms.--For purposes of this paragraph, the terms

"activity", "passive activity", and "materially

participate" have the meanings given such terms by

section 469.

The income described in section 469(e)(1) includes "interest,

dividends, annuities, or royalties not derived in the ordinary

course of a trade or business", sometimes known as portfolio

income.

The dispute in this case revolves around whether the Russon

Brothers stock is "property held for investment". Respondent has

stipulated that petitioner materially participates in Russon

Brothers, and concedes that section 163(d)(5)(A)(ii) does not
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1 The 1985 version of section 163(d)(1) provides:

(1) In general.--In the case of a taxpayer other than

a corporation, the amount of investment interest * * *

otherwise allowable as a deduction under this chapter

shall be limited, in the following order, to--

(A) $10,000 ($5,000, in the case of a separate

return by a married individual), plus

(B) the amount of the net investment income * * *

by which the deductions allowable under this

apply to petitioner. However, since stock is generally

productive of dividends, the Commissioner contends that the stock

here is covered by section 163(d)(5)(A)(i), notwithstanding that

the Russon Brothers stock has, in fact, never paid a dividend. 

Accordingly, the argument continues, the Russon Brothers stock is

"property held for investment", and, as such, petitioners'

deduction for the interest is limited to their investment income. 

If this case were to be decided under the Code as it existed

prior to enactment of the Tax Reform Act of 1986, Pub. L. 99-514,

100 Stat. 2085, petitioners might be entitled to prevail. Under

prior law, the term "investment interest" was defined as

"interest paid or accrued on indebtedness incurred or continued

to purchase or carry property held for investment." Sec.

163(d)(3)(D). At that time, the phrase "property held for

investment" had not been defined in the Code or the regulations. 

Recklitis v. Commissioner, 91 T.C. 874, 907 (1988). To determine

whether interest should be subject to the limitations of then

section 163(d)(1)1, the Tax Court looked to whether the taxpayer
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section * * * and sections 162, 164(a)(1) or (2),

or 212 attributable to property of the taxpayer

subject to a net lease exceeds the rental income

produced by such property for the taxable year.

In the case of a trust, the $10,000 amount specified in

subparagraph (A) shall be zero.

had a substantial investment intent. Miller v. Commissioner, 70

T.C. 448, 455 (1978). Whether the taxpayer had the requisite

intent was a question of fact. Id. at 455-456. The parties in

this case stipulated that petitioner did not have a substantial

investment motive when he purchased the stock. Prior to the Tax

Reform Act of 1986, he would likely have prevailed.

The Tax Reform Act of 1986 broadened the definition of

investment interest. Section 511(a) of the 1986 Act defines

"property held for investment" to include "any property which

produces income of a type described in section 469(e)(1)." 100

Stat. 2245. The definition applies uniformly to every taxpayer;

his mindset is irrelevant. As a result, the reach of the

definition under the 1986 Act is more inclusive.

Petitioners contend that the phrase "property which produces

income" in section 163(d)(5)(A)(i) is limited to property which

has actually produced one of the types of income described in

section 469(e)(1)(A). However, the Government's position here is

supported by the legislative history. In the report of the

Senate Finance Committee accompanying section 469, portfolio

income includes "gain or loss attributable to disposition of (1)
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property that is held for investment (and that is not a passive

activity) and (2) property that normally produces interest,

dividend, or royalty income." S. Rept. 99-313 at 728 (1986),

1986-3 C.B. (Vol. 3). (Emphasis added.) This committee report

runs counter to petitioners' assertions as set forth in their

brief that stock must produce a dividend before it is "property

held for investment". The report indicates that Congress did not

require the payment of interest, dividends, etc. Section

163(d)(5)(A)(i) refers to section 469(e)(1) for one definition of

"property held for investment". Inasmuch as portfolio income

under section 469(e)(1) includes property that "normally

produces" interest, dividends, etc., it follows that the

reference to section 469(e)(1) in section 163(d)(5) would also

include property which "normally produces" dividends. Certainly,

stock is the kind of property that "normally produces" dividends. 

Would petitioners' position be different here if the corporation

had paid only a very small dividend over the years?

Moreover, on the record in this case, the possibility of

dividends being paid was clearly contemplated by the buyers and

sellers of the stock. Indeed, the agreement of sale of the stock

explicitly recognized that the purchasers would be entitled to

"all of the dividends from the stock", subject only to the

written consent of the sellers prior to the payment in full of

the purchase price. That condition is not at all to be regarded

as uncommon where there is a sale of all the stock of a
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corporation. Further, it should be remembered that, although the

sale may be treated as having been made at arm's length,

nevertheless the sellers were the fathers of the purchasers, and

at least in some circumstances it would seem more likely that

their consent would not be withheld than in the case of

strangers.

Petitioners contend that the purpose of the new 1986

provisions supports the allowance of the claimed deduction in

their case. To be sure, the legislative history of the 1986 Act

does disclose that Congress was concerned with plugging a

loophole that had permitted taxpayers to take deductions against

their earned income by reason of interest, expenses, losses,

etc., attributable to tax shelters and other arrangements not

related to the taxpayer's trade or business. See H. Rept. 99-426

at 299-300 (1985), 1986-3 C.B. (Vol. 2). And petitioners' rely

upon a statement of the staff of the Joint Committee on Taxation

explaining the reason for the new provisions, as follows:

Under prior law, leveraged investment property was

subject to an interest limitation, for the purpose of

preventing taxpayers from sheltering or reducing tax on

other, non-investment income by means of the unrelated

interest deduction. Congress concluded that the

interest limitation should be strengthened so as to

reduce the mismeasurement of income which can result

from the deduction of investment interest expense in

excess of current investment income, and from deduction

of current investment expenses with respect to

investment property on which appreciation has not been

recognized. [Staff of Joint Comm. on Taxation, General

Explanation of the Tax Reform Act of 1986 at 263 (J.

Comm. Print 1987); emphasis added.]
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Petitioners call attention to the fact that in this case there

would be no "mismeasurement of income which can result from the

deduction of investment interest expense in excess of current

investment income." However, there are at least several answers

to petitioners' point. In the first place, as has been stressed

earlier in this opinion, the statutory language was intended by

Congress, as shown in the report of the Senate Finance Committee,

to cover "property that normally produces interest, dividends or

royalty income." S. Rept. 99-313, supra, 1986-3 C.B. (Vol. 3) at

728. (Emphasis added.) And in this case the property involved,

stock, is of a type that "normally" produces dividends. In the

second place, as pointed out by Judge Friendly in Commissioner v.

Pepsi Cola Niagara Bottling Corp., 399 F.2d 390, 392 (2d Cir.

1968), "a legislature seeking to catch a particular abuse may

find it necessary to cast a wider net." 

Further, petitioners fail to consider the fact that Russon

Brothers is a C corporation. If Russon Brothers were an S

corporation or a partnership, it appears that Scott, as an active

manager, would be entitled to deduct the interest, without

limitation, on the debt incurred to purchase the stock as a

direct owner of the business. However, as a C corporation,

Russon Brothers is a separate taxpaying entity, distinguishable

from its owners. Cf., e.g., Moline Properties, Inc. v.

Commissioner, 319 U.S. 436 (1943). Russon Brothers owns the

mortuary business, not Scott and his fellow stockholders. Scott
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is an employee of the mortuary business. As a result, he is not

entitled to deduct the interest on the debt incurred to purchase

the Russon Brothers stock as trade or business interest.

The result that we reach is in accord with Rev. Rul. 93-68,

1993-2 C.B. 72, which considers a case virtually identical with

this case. The revenue ruling explained its reasoning as

follows:

Because stock generally produces dividend income,

it is property held for investment within the meaning

of sections 163(d)(5)(A) and 469(e)(1)(A) of the Code,

unless the dividends are derived in the ordinary course

of a trade or business. In this case, any dividends

paid by X [a C corporation] would not be derived by A

[an employee and purchaser of stock in X] in the course

of a trade or business because A is neither a dealer

nor a trader in stock or securities. Thus, the X stock

purchased by A is property held for investment pursuant

to section 163(d)(5)(A), regardless of A's motives for

purchasing or holding that stock. * * * [Emphasis

added.]

Rev. Rul. 93-68, 1993-2 C.B. at 73. Although we are by no means

bound by the revenue ruling, we think its reasoning is correct,

and we have independently reached the same result here. 

Section 163(d)(5)(A) contains two objective tests for

"property held for investment." We have concluded that

petitioner's stock in Russon Brothers satisfies the first test

under section 163(d)(5)(A)(i). It is therefore unnecessary to

consider the second test in subparagraph (A)(ii), although it

would seem, and the Government concedes, that the second test

does not apply here.
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Decision will be entered

for respondent.