Buhler Mortgage Co. v. Commissioner, 51 T. C. 979 (1969)

Proceeds from the sale of notes classified as securities are excluded from gross receipts for Subchapter S status if sold at a loss, even if their production required significant effort.

Summary

Buhler Mortgage Co. sold deed-of-trust notes to insurance companies, arguing that the proceeds should be included in gross receipts to maintain its Subchapter S status. The Tax Court held that these notes were securities under the Internal Revenue Code, and since they were sold at a loss, their proceeds were not part of gross receipts. This ruling led to the termination of Buhler’s Subchapter S election because its passive income exceeded 20% of its gross receipts. The decision emphasizes the statutory definition of securities over the effort involved in their production, impacting how similar entities must calculate gross receipts for tax purposes.

Facts

Buhler Mortgage Co. , a California corporation, elected to be taxed under Subchapter S. It was engaged in the mortgage business, producing deed-of-trust notes and selling them to insurance companies like Bankers Life and Acacia Mutual Life. Buhler also serviced these loans, receiving fees for this activity. During the fiscal years ending October 31, 1964, and 1965, Buhler sold the notes at a loss, warehousing them for up to a year before sale. The IRS determined deficiencies in Buhler’s federal income taxes, arguing that the proceeds from the notes’ sales should not be included in gross receipts, which would terminate Buhler’s Subchapter S election due to exceeding the 20% passive income limit.

Procedural History

The IRS determined tax deficiencies against Buhler for the fiscal years ending October 31, 1964, and 1965. Buhler conceded one issue but contested whether its Subchapter S status terminated due to the composition of its income. The case was brought before the U. S. Tax Court, which reviewed the issue of whether the proceeds from the sales of the deed-of-trust notes were part of Buhler’s gross receipts for the purpose of calculating its Subchapter S status.

Issue(s)

1. Whether the proceeds from the sales of deed-of-trust notes should be included in Buhler’s gross receipts for the purpose of maintaining its Subchapter S election?

Holding

1. No, because the deed-of-trust notes were classified as securities under the Internal Revenue Code, and since they were sold at a loss, their proceeds were not included in gross receipts.

Court’s Reasoning

The court determined that the deed-of-trust notes were securities as defined by the Internal Revenue Code and regulations. The court emphasized that the statutory definition of securities did not allow for consideration of the effort involved in producing the notes. The court rejected Buhler’s argument that the income from the notes should be treated as active income due to the effort expended in their production, stating that the test for inclusion in gross receipts is based on the plain meaning of the statutory terms. The court also noted that Treasury regulations defining securities had been consistent since their promulgation in 1959 and were valid unless clearly inconsistent with the statute. Since the notes were sold at a loss, their proceeds were not considered part of gross receipts, leading to the termination of Buhler’s Subchapter S election due to its passive income exceeding the 20% threshold. The court cited the legislative history of Subchapter S, which aimed to exclude corporations with large amounts of passive income from this tax treatment, but found that the nature of the income did not change based on the activity required to produce it.

Practical Implications

This decision has significant implications for businesses engaged in the production and sale of notes or similar financial instruments. It clarifies that the proceeds from the sale of securities, even if produced through active business efforts, are excluded from gross receipts if sold at a loss. This ruling impacts how companies calculate their gross receipts for Subchapter S eligibility, potentially affecting their tax status. Businesses must carefully assess whether their income sources could be classified as passive under the Code, as exceeding the 20% passive income limit can lead to the termination of Subchapter S status. This case also underscores the importance of adhering to statutory definitions and regulations in tax calculations, reminding practitioners to consider the legal classification of income over the nature of the business activities generating it. Subsequent cases may reference this decision when determining the tax treatment of similar financial instruments and the application of the Subchapter S rules.