Tax law is full of lessons where taxpayers exalt form over substance, then get caught. Last week’s lesson---where a charity in name was a business in substance---was one of those. We can think of those as “dog bites man” lessons, because they are common.
This week’s lesson is more of the “man bites dog” variety. In William C. Lipnick and Dale A. Lipnick v. Commissioner, 153 T.C. No. 1 (Aug. 28, 2019) (Judge Lauber), it was the IRS that relied on form and the taxpayer who argued substance. Mr. Lipnick had received real estate partnership shares from his Dad by gift and bequest. The partnership passed through interest expenses on real estate loans. Mr. and Ms. Lipnick deducted those expenses on their Schedule E. The IRS insisted the Lipnicks treat the expenses as investment interest (deducted on Schedule A) because Dad had so treated them. In his usual no-nonsense clear and direct style, Judge Lauber explains why the IRS position was incorrect: its reasons were formalist and ignored how the substance of the interest payments had changed once the partnership shares passed from father to son. Details below the fold.
Law: Interest Deductions
I teach only the very basics of §163. It’s tricky section. If readers think of a better way I can introduce it in an intro tax course I would love to hear about it.
Most sections of the Tax Code start with a single general rule, but I teach §163 as having two different general rules. The first one is for corporate taxpayers. You find that one in §163(a) and it permits deductions for any expense paid or incurred on debt. The second general rule is for taxpayers other than corporations. As to those taxpayers §163(h)(1) and (2) combine to give a general rule that disallows deductions for “any interest allowable as a deduction...other than” one of the six categories listed in 163(h)(2).
Thus, I teach students to think of §163 as creating buckets of permitted deductions. Section 163(a) creates a single bucket for corporations. Section §163(h)(2) creates six different buckets for non-corporate taxpayers. Once you identify your bucket, then the rest of §163 gives details about the scope and limits on the bucket you find yourself in. Yes, I know that oversimplifies the section, but since I am focusing students on individual income taxation, I think it's a reasonable approach.
Today’s lesson involves a non-corporate taxpayer. The two buckets relevant to today’s lesson are the §163(h)(2)(A) bucket for interest payments attributable to a non-corporate taxpayer’s trade or business and the §163(h)(2)(B) bucket for “any investment interest."
To decide what bucket a particular interest payment falls into, Treas. Reg. 1.163-8T(a)(3) sets up a general tracing regime whereby “interest expense on a debt is allocated in the same manner as the debt to which such interest expense relates is allocated.” For example, if a taxpayer uses debt proceeds to make an investment expenditure, that is an investment loan and the resulting interest payments fall into the §163(h)(2)(B) bucket of investment interest. But if the debt proceeds are used in the taxpayer’s trade or business then the interest expenses fall into the §163(h)(2)(A) bucket of trade or business interest.
Three legal wrinkles also apply to today’s lesson. First, the IRS uses a substance-over-form approach to apply the general tracing concept contained in Treas. Reg. 1.163-8T to partnership distributions. In Notice 89-35 (guidance that came out about 2 years after the temp reg), the IRS decided that if a partnership incurs debt and then simply distributes debt proceeds to the partners, it would apply the tracing rules to each partner’s use of the debt proceeds. Thus, a partner who received an allocation of a partnership’s debt proceeds and then used those proceeds to buy investments would be eligible to bucket future partnership allocations of interest payments as investment interest. If the partner used the proceeds to buy a yacht, then future allocations of interest payments would be a non-deductible personal expense.... unless the yacht was used in a trade or business. But remember: Yachts are pigs.
The second wrinkle has to do with how the taxpayer accounts for the discharge from non-recourse debt when the taxpayer sells or disposes of property encumbered by non-recourse debt. In the seminal case of Commissioner v. Tufts, 461 U.S. 300 (1983), the Supreme Court held that a taxpayer had to report as amount realized the loan balance of a non-recourse loan, even when the fair market value of the property disposed of was less than the non-recourse loan balance. The Court there said, “when the obligation is cancelled, the [taxpayer] is relieved of his responsibility to repay the sum he originally received and thus realizes value to that extent...” The idea in Tufts forms part of the regulatory treatment of how taxpayers must account for discharge of non-recourse indebetedness when they sell or otherwise dispose of property encumbered by that kind of debt. Treas. Reg. 1001-2(a)(1).
For a fuller explanation, see my 2018 lesson The Phantom of the Tax Code.
The third wrinkle is the interplay of §163 with §62. Some buckets ‘o interest deductions are allowed above the line and others are allowed below the line. Specifically, deductions for interest allocable to a trade or business can be taken above the line, either on Schedule C or E. §62(a)(1), (4). But investment interest must be taken below the line, as an itemized deduction, albeit not one subject to a 2% floor (§67(b)(1)) and, hence, not one sucked into oblivion by the §67(g) vortex.
That is basically the fight in today’s case: whether the taxpayer properly took interest expense deductions above the line. The IRS said no. Judge Lauber said yes.
Mr. Lipnick’s dad was a partner in some big-deal partnerships in the Washington D.C. area that owned and operated rental real estate. In 2009 three of those partnerships borrowed money and distributed the loan proceeds to the partners, with over $22 million going to Dad. The loans were non-recourse. Dad used those proceeds to buy investments. Each year thereafter the partnership distributed the interest payments on the loans to the partners. Each year Dad properly obeyed the tracing rules and deducted the interest on Schedule A as an itemized deduction, following the rules for deduction of investment interest.
Dad also owned interest in one other, smaller, real estate partnership. This smaller partnership did the same drill. It borrowed money (non-recourse) and distributed the proceeds to Dad. Dad invested the money. Dad then deducted the resulting partnership interest passed through on Schedule A.
In 2011 Dad gifted half of his ownership interests in the three big partnerships to Mr. Lipnick. The transfer did not make Mr. Lipnick personally liable on the partnership loans. Following the rule in Tufts and in Treas.Reg. 1.1001-2, Dad properly reported the amount of the non-recourse liabilities attributable to the transferred partnership interest as an “amount realized” on the gift. Accordingly, Dad reported and paid tax on a significant amount of capital gain on his 2011 return.
In 2013 Dad died and left most of his interest in the small partnership to Mr. Lipnick.
For 2013 and 2014 Mr. Lipnick received Schedule K-1’s that reported his share of the partnerships’ interest expenses. Mr. Lipnick treated the interest as related to the business of the partnerships in owning and renting real estate and, therefore, fully deductible on Schedule E against the income distributed by the partnerships.
The IRS audited and disallowed the deductions on Schedule E. The IRS said that because the original loan proceeds had been used to buy investments and because Mr. Lipnick stepped into the shoes of his father for both the inter vivos gift and the bequest, Mr. Lipnick should have treated the interest payments as “investment interest” and taken deductions on Schedule A.
That was bad news for Mr. Lipnick because §163(d) allows a deduction for investment interest only to the extent that a taxpayer has net investment income. In 2013 and 2014 Mr. and Mrs. Lipnick had no net investment income.
So the Lipnicks really wanted the Schedule E deduction. They petitioned the Tax Court to get it.
Lesson: The Son is Not The Dad
Judge Lauber says that the IRS elevated form over substance by focusing on the original use of the loan proceeds and disregarding the subsequent events. Although the loans were still on the books of the partnerships, using that formality to characterize Mr. Lipnick’s share of the resulting interest expense as investment interest had “no support...in the statute, the regulations or the decided cases,” Judge Lauber declared.
Judge Lauber said the proper way to analyze these facts is to remember the son is not the dad. The partnership tracing rules in Notice 89-35 focus on the use of the distributed loan proceeds by the taxpayer, not by the partnership. So even though the partnership remained the same, the taxpayers were different. Unlike Dad, Mr. Lipnick “did not receive, directly or indirectly, any portion of the debt-financed distributions that the partnerships made to [Dad].... Nor did [Mr. Lipnick] use distributions from those partnerships to make investment expenditures.” (citations and internal quotes omitted).
Judge Lauber pointed out that Treas. Reg. 1.163-8T (c)(3)(ii) says when a taxpayer acquires property in part by assuming debt, then “the debt is treated for purposes of this section as if the taxpayer used an amount of the debt proceeds equal to the balance of the debt outstanding...to make an expenditure for such property.” In other words, the regulations tell us to treat the non-recourse debt associated with the purchased property as acquisition debt, or a cost (at least so long as none of the debt proceeds are distributed to the buyer).
As applied to partnership interest, Judge Lauber tells us that Notice 89-95 applies that rule to acquisitions of partnership interests. It “refers to this scenario as debt-financed acquisition, as opposed to a debt-financed distribution.” In other words, Judge Lauber says, “it seems obvious that [Mr. Lipnick] would have no investment interest if he had acquired his ownership interests in the four partnerships from a third party for cash.”
The fact that Mr. Lipnick acquired the property by gift and bequest and not by purchase did not matter. Either way, the relationship between the taxpayer and loan changed: the transferee did not have the same relationship to the partnership loan as the transferor because no part of the loan proceeds were distributed to the transferee. Notice that whether property is disposed of by gift or sale also makes no difference to the rules governing how the taxpayer disposing of the property must report gain. Either way, Dad had to report getting rid of the non-recourse debt as an amount realized, resulting in a capital gain. Treas. Reg. 1.1002-2(b). Similarly, Judge Lauber found that whether Mr. Lipnick acquired the partnership interest by purchase or gift, the resulting change in ownership changed the substance of the relationship between the taxpayer and loan such that Mr. Lipnick was entitled to treat the partnership interest payments differently than had Dad. As to Mr. Lipnick, the non-recourse debt that the partnership continued to service was allocable to the real estate assets held by the partnerships, the assets that secured the loans. It was simply not traceable to any investments made by Mr. Lipnick.
Thus, we have another substance over form lesson, only this time with a result adverse to the IRS.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.