Robert H. & Joyce L. Sturdy v. Commissioner of Revenue (October 1, 2003)

COMMONWEALTH OF MASSACHUSETTS
APPELLATE TAX BOARD
  
ROBERT H. & JOYCE L. STURDY	v.	COMMISSIONER OF REVENUE 

Docket No. C260289	Promulgated:             October 1, 2003
							
This is an appeal filed under the formal procedure pursuant to G.L. c. 62C, § 39, from the refusal of the Commissioner of Revenue ("Commissioner") to abate personal income taxes for the calendar years 1996 and 1997.
Commissioner Scharaffa heard the appeal and was joined in the decision for the appellee by Chairman Burns and Commissioners Gorton, Egan and Rose. 
These findings of fact and report are made at the request of the appellants pursuant to G.L. c. 58A, § 13 and 831 CMR 1.32.

Robert Sturdy, pro se, for the appellants.
Andrew M. Zaikis, Esq., for the appellee.
 

FINDINGS OF FACT AND REPORT

Based on testimony and exhibits offered into evidence at the hearing of this appeal, the Appellate Tax Board ("Board") made the following findings of fact.
During calendar years 1996 and 1997 ("the years at issue"), Robert and Joyce Sturdy (collectively "the appellants") were residents of the Commonwealth of Massachusetts.  For both tax years, the appellants filed Form-1 Resident income tax returns that included a Schedule C, profit or loss from a business.  The appellants maintained that they were in the "money lending" business.  The appellants reported no business income for either year but did claim a substantial mortgage interest expense, which resulted in a "net" loss for both years.  The business losses were then used to offset the appellants' other income for 1996 and 1997 and, therefore, reduced their tax liability for both years.  
On or about September 29, 1999, the Desk Audit Division of the Department of Revenue began an examination of the appellants' tax returns.  Upon review, the Audit Division concluded that the appellants were not entitled to the interest expense deduction taken on their 1996 and 1997 Schedule C, and, on November 5, 1999, issued a Notice of Intention to Assess additional income taxes.  The appellants requested a pre-assessment hearing before the Appeal and Review Bureau ("A & R"), held on February 23, 2000.  On July 10, 2000, A & R upheld the Audit Division's determination, and, on July 25, 2000, the Commissioner issued a Notice of Assessment of additional income taxes.  On October 19, 2000, the appellants timely filed an application for abatement.  The Commissioner denied the application on April 12, 2001.  On June 11, 2001, the appellants seasonably filed an appeal with this Board.  Based on these facts, the Board found that it had jurisdiction over the subject appeal.
On October 31, 1985, the appellants purchased the assets of Inconix Corporation, in their entirety.  Using these assets, Mrs. Sturdy formed, and subsequently incorporated under Massachusetts law, Hancock Electronics ("the Company").  The Company was formed to engage in the design and production of electronic equipment for use in mass transit systems.  During the years at issue, Joyce Sturdy was the sole shareholder and only corporate officer of the Company.  Mr. Sturdy testified that the business was structured this way so that the appellants could take advantage of the benefits offered to women in business.  For services rendered, in 1996 Joyce Sturdy received compensation totaling $66,300, and in 1997 she received compensation totaling $68,600.  
Initially, the Company financed its operations through a $250,000 line of credit secured from Fleet Bank.  This line of credit, with a maturity date of May 31, 1993, was personally guaranteed by the appellants who provided collateral in the form of a first mortgage against their personal real estate.  Monthly statements reporting the amount of principal, and accrued interest due and payable, were mailed to, and paid by, the Company.  
In June of 1994, the Company was the low-bidder on a $5,000,000 contract with the Washington D.C. Transit Authority.  To be awarded the contract, however, the Company was required to secure a $500,000 line of credit.  Mrs. Sturdy attempted to secure the funding in the Company's name, but no commercial lender was willing to issue the line of credit based solely on the Company's assets.  However, Hingham Savings indicated to the appellants that it would be willing to provide a $500,000 line of credit in the name of Joyce Sturdy who, in turn, could loan the proceeds to the Company.  Subsequently, Mrs. Sturdy applied to the Hingham Institute for Savings for a $500,000 line of credit in her own name.  As with the Company's previous line of credit, Hingham Savings required that the appellants personally guarantee the loan and provide collateral in the form of a first mortgage on their personal real estate.
In July 1994, Hingham Savings granted the loan to the appellants, personally, with a stated interest rate of "Prime rate plus 1½%," a ten-year maturity date, and secured by the appellants' personal real estate.  Pursuant to the loan documents, monthly principal payments in the amount of $2,000 were required, in addition to payments of accumulated interest.  During the term of the loan, monthly statements of principal and accumulated interest were mailed to, and paid by, the appellants.  
After securing the personal line of credit from Hingham Savings, Joyce Sturdy extended to the Company a similar line of credit with essentially the same terms as her loan, including a stated interest rate of Prime rate plus 1½% and providing for monthly payments equal to $2,000 of principal plus accrued interest.  The loan was evidenced by a $500,000 promissory note from the Company to Joyce Sturdy, and also a Security Agreement.  As purported security for the line of credit, the Company granted and assigned to the appellants the Company's rights and interests in all assets, tangible and intangible, and all legal rights.
In the following years, the appellants obtained additional funds from Hingham Savings and State Street Bank, which were also personally guaranteed by the appellants, and provided collateral in the form of a mortgage on their personal real estate.  These additional funds were also made available to the Company, through an increase in the line of credit, to finance its operations.  During the term of the loans, monthly statements of accumulated interest were mailed to, and paid by, the appellants.  
In total, the Company now had available to it, through the appellants, a line of credit totaling $1,000,000.  Although the existing promissory note from the Company to Joyce Sturdy was amended to reflect the increased line of credit, no additional collateral was provided.
Although the promissory note signed by Joyce Sturdy on behalf of the Company, provided that monthly interest payments be made to Joyce Sturdy, the Company failed to make any such payments for more than five years.  During this time, the appellants were required to and did make interest payments to the financial institutions from which they had borrowed money.  Despite the Company's failure to pay, the appellants did not make demand upon or default the Company.  To the contrary, the appellants allowed the Company to continue to draw upon the line of credit.  Further, although the Company failed to make the requisite interest payments to Joyce Sturdy, it did continue to pay her yearly salary.
Based on these facts, the Board found that the appellants were not engaged in the trade or business of lending money.  The appellants original intent was for the Company to secure its own financing.  Since no commercial lender was willing to extend the line of credit, the appellants secured the funding personally and then "lent" the money to the Company.  During the years, the appellants had no other borrowers, nor did they seek any.  
Also, although Mr. Sturdy suggested that the Company was paying an interest rate of Prime plus 2%, the promissory note specifically provided for interest of Prime plus 1½%.  This rate was the exact interest rate that the lending institutions charged the appellantes.   In addition, even though the promissory note required the Company to make monthly payments to the appellants, equal to $2,000 of principal plus accrued interest, no such payments were made for more than five years.  Throughout this time, however, the appellants continued to make the required payments to Hingham Savings.  Further, during this time of delinquency, the appellants chose not to enforce their rights of demand for payment or default, but continued to make available the line of credit.
Accordingly, the Board found and ruled that the appellants were not seeking a fair return or profit on their "investment." Consequently, the Board found and ruled that the appellants were not engaged in the business of lending money and, therefore, were not entitled to deduct the interest paid to Hingham Savings.  The Board entered a decision for the appellee.

OPINION
Part B adjusted gross income is defined as "Part B gross income less the following deductions:-  (1) [t]he deductions allowable under section sixty-two  . . . of the Code."  G.L. c. 62, § 2(d).  Section 62 of the Code allows deductions for expenses which are "attributable to a trade or business carried on by a taxpayer, as long as such trade or business does not consist of the performance of services by the taxpayer as an employee."  I.R.C.  § 62(a)(1).  One allowable deduction is interest paid on indebtedness.  I.R.C. § 163(a).
In the present appeal the appellants contend that they were in the business of lending money and, therefore, that the interest that they paid on the borrowed money, and subsequently lent to the Company, was a deductible trade or business expense.  The Board, however, disagreed.
Although used throughout the Code, the phrase "engaged in a trade or business" is not defined.  See generally Groetzinger v. Commissioner of Internal Revenue, 480 U.S. 23, 27 (1987).  Instead, whether a taxpayer is engaged in a trade or business "'requires an examination of the facts in each case.'"  Id. at 36, (quoting Higgins v. Commissioner of Internal Revenue, 312 U.S. 212, 217 (1941)).  One useful test that the Court has set forth is that to qualify as engaged in a trade or business the taxpayer "must be involved in the activity with continuity and regularity and that the taxpayer's primary purpose for engaging in the activity must be for income and profit."  Id. at 35.
The appellants maintained that they entered into the new money lending business solely for the purpose of making a profit and that the monthly transactions over the years satisfy the continuity requirement.  Therefore, the appellants argued, they were entitled to the business expense deduction for the interest paid to Hingham Savings.  The Board disagreed.
Investing, although the primary purpose for which is to generate a profit, does not constitute a trade or business.  U.S. v. Henderson, 375 F.2d 36, 41 (1967).  Generally speaking, "'a loan from a shareholder to a corporation for the purpose of protecting or enhancing the shareholder's investment in the corporation is nonbusiness.'"  Rosse v. Commissioner of Revenue, 430 Mass. 431, 435 (1999) (quoting Bell v. Commissioner of Internal Revenue, T.C. Memo. 1998-136 (1998)).
To qualify as being engaged in a money lending business, the taxpayer must demonstrate that the primary motive for making the loan was to generate a fair return of profit.  Henderson at 42.  Further, the taxpayer must present other indicia that a genuine loan business exists, including, advertising and holding one's self out to be in the loan business; maintenance of a business office; devotion of a significant amount of time to making loans; and, involvement in a continuous course of conduct of making loans.  Id.  In Henderson, the Tax Court ultimately found and ruled that where:  (1) the taxpayer received no compensation for her risk, charging the same rate of interest as she was charged; (2) no interest was ever paid to the taxpayer; and, (3) the taxpayer did not insist on her rights as a creditor; the taxpayer's motives "were clearly not those of an investor seeking the return of profit in connection with a money lending business."  Id.
Based on the facts presented and using the indicia set forth in Henderson, the Board found that the appellants were not engaged in a money lending business.  First, the loan between the appellants and the Company bore the exact same rate of interest as the loans that the appellants received from the lending institutions.  Consequently, the only profit that the appellants would derive was the profit from the overall success of the Company, not the loans themselves.  Accordingly, the income received was compensation for her services rendered to the Company not interest income from a money lending business.  Also, for more than five years the Company failed to pay to the appellants the accrued interest, yet, the appellants chose not to enforce their rights as creditors.
In addition, at no time did the appellants advertise or hold themselves out as being in the money lending business.  To the contrary, the appellants conceded that the only reason they had to borrow money from the financial institutions was to provide funding to the Company.  Lastly, the appellants argued that they maintained a "continuous course of conduct" of making loans and that this conduct was evidenced by the monthly principle payments that were made to the appellants.  The evidence showed, however, that there were only three actual loans and that the multitude of payments were just that, payments in accordance with the loan terms.
Based on these findings the Board found and ruled that the appellants were not engaged in the trade or business of money lending.  Although the appellants' intent was to make a profit, it was the profit from the Company's business activities not from the loans themselves.
Accordingly, the Board found and ruled that the subject assessment was proper and issued a decision for the appellee in this appeal.


							APPELLATE TAX BOARD

						By:												   Abigail A. Burns, Chairman


A true copy,


Attest:					
        Clerk of the Board

ATB 2003-591