Lawrence & Alice O'Toole v. Commissioner of Revenue (October 17, 2000)

COMMONWEALTH OF MASSACHUSETTS

APPELLATE TAX BOARD


LAWRENCE & ALICE O'TOOLE 		v.	COMMISSIONER OF REVENUE
				

Docket No. F205390          		Promulgated:
		                   		October 17, 2000


	This is an appeal under the formal procedure pursuant to G.L. c. 62C, § 39, from the refusal of the Commissioner of Revenue ("Commissioner") to abate personal income tax assessed against Lawrence and Alice O'Toole ("O'Tooles") under G.L. c. 62, § 2, for the tax year ended December 31, 1990.
	Commissioner Lomans heard the appeal and was joined by Chairman Burns, former Chairman Gurge, and Commissioner Gorton in a decision for the appellant.  
These findings of fact and report are promulgated at the request of the appellant, pursuant to G.L. c. 58A, § 13, and 831 CMR 1.32. 
 	Stephen M. Politi, Esq. for the appellant.

Frances M. Donovan, Esq. for the appellee.

FINDINGS OF FACT AND REPORT
This appeal raises the issue of whether the O'Tooles may deduct, on their 1990 Massachusetts Resident Income Tax Return, the interest expense incurred in a debt-financed acquisition of stock in a Subchapter S corporation.  Based on the testimony and exhibits offered at the hearing of this appeal, the Appellate Tax Board ("Board") made the following findings of fact.
	On May 19, 1992, the O'Tooles filed an amended 1990 Massachusetts Resident Income Tax Return ("amended return") which reflected a deduction of $90,000 for interest expenses incurred during 1990 and not previously deducted on their original 1990 Massachusetts return.  The Commissioner treated the amended return as an application for abatement of $5,355 in personal income tax.  By notice dated December 18, 1992, the Commissioner denied the O'Tooles' application for abatement.  On January 11, 1993, the O'Tooles filed their appeal with the Board.  On this basis, the Board found that it had jurisdiction over this appeal.
	Lawrence O'Toole, a Massachusetts resident, was employed by Collins Pipe & Supply Company, Incorporated, ("Collins") starting in July of 1985.  At all material times, Collins was a Massachusetts Subchapter S corporation.  From 1987 through 1992, Mr. O'Toole worked full-time as vice president and general manager of Collins.  Mr. O'Toole testified that Collins held business assets exclusively, and held no passive investments. 
On January 2, 1990, Mr. O'Toole purchased seventeen shares of Collins stock from his father for a stated consideration of $900,000.  The seventeen shares of stock represented a one-third interest in the company.  No cash was exchanged in the transaction, as Mr. O'Toole executed a promissory note in favor of his father in the amount of the $900,000 plus interest.  O'Toole pledged his shares of stock as security for repayment of the obligation.  Pursuant to the stock purchase agreement and promissory note executed January 2, 1990, Mr. O'Toole made a $90,000 payment to his father consisting entirely of interest for the 1990 tax year.
	For 1990, the O'Tooles filed a federal Individual Income Tax Return Form 1040, including Schedule E.  The $90,000 interest payment relating to the debt-financed acquisition of seventeen shares of Collins stock was reported on Part II of the 1990 Schedule E as a non-passive loss, and was claimed on line 18 on the Form 1040 as an "above the line" deduction from gross income. No evidence in the record contradicts Mr. O'Toole's testimony that the Internal Revenue Service made no adjustments to the O'Tooles' federal taxable income for the tax year at issue.  
The O'Tooles attached the federal Schedule E for 1990 to their Massachusetts return together with an explanation.  On their original 1990 Massachusetts return, the $90,000 interest payment was reported as a Massachusetts difference to Schedule E, and the O'Tooles did not claim a deduction for the interest payment.  On May 19, 1992, the O'Tooles filed an amended 1990 Massachusetts return by which they claimed a deduction for the interest payment of $90,000 as an expense incurred in connection with the conduct of a trade or business.  Accordingly, they requested a state income tax abatement in the amount of $5,355.  The Commissioner of Revenue refused to abate the tax, even though he had granted an abatement of $5,355 to another taxpayer who purchased a one-third interest in Collins under identical and contemporaneous circumstances.
On this basis, and for the reasons discussed in its opinion, the Board determined that the 1990 interest payment relating to the debt-financed acquisition of shares of Collins stock was interest paid in connection with the conduct of a trade or business deductible from Massachusetts Part B income.  Accordingly, the Board issued a decision for the O'Tooles and granted an abatement of personal income tax in the amount of $5,355. 

OPINION
The issue presented in this appeal is whether the O'Tooles' payment of interest relating to the debt-financed purchase of shares in a Massachusetts S Corporation was deductible as an interest expense paid on indebtedness incurred in connection with the conduct of trade or business.
Under G.L. c. 62, § 2, the definition of Massachusetts gross income is federal gross income as defined under the Internal Revenue Code ("Code") with certain modifications which are not relevant to this appeal. For the relevant tax year, Massachusetts gross income was divided into two classes: Part A gross income, consisting of interest, dividends, and net capital gain included in Massachusetts gross income; and Part B income, consisting of the remainder of Massachusetts gross income.  G.L. c. 62, § 2(b).  Part B adjusted gross income is calculated by subtracting from Part B gross income "the deductions allowable under section[s] sixty-two . . . of the Code."  G.L. c. 62, § 2(d).  Section 62 of the Code defines federal adjusted gross income as gross income minus specific deductions.  Code § 62.  A deduction is allowed for expenses "attributable to a trade or business carried on by the taxpayer . . ."  Code § 62(a)(1).  Accordingly, if the O'Tooles' interest expense is "attributable to a trade or business carried on by" Mr. O'Toole, the expense would be deductible under Code § 62, and therefore, under G.L. c. 62, § 2(d).  If, however, the interest incurred in the debt-financed acquisition of the Collins stock is "personal interest," no deduction is allowable under Code § 62 or G.L. c. 62, § 2(d).  See Code § 163(h)(2).  Pursuant to Code § 163(h)(2)(A), "personal interest" does not include "interest paid or accrued on indebtedness properly allocable to a trade or business (other than the trade or business of performing services as an employee)." Code § 163(h)(2)(A). 
The Supreme Judicial Court has recognized that "Massachusetts tax statutes and the Internal Revenue Code are inextricably interwoven" and that interpreting Massachusetts tax statutes often "requires balancing the State's independent development of its individual tax code against the Legislature's consistent references to, and incorporation of, Federal tax provisions."  Commissioner of Revenue v. Franchi, 423 Mass. 817, 819, 822 (1996). See also Grady v. Commissioner of Revenue, 421 Mass. 374 (1995); Commissioner of Revenue v. Shafner, 392 Mass. 256 (1984); Salhanick v. Commissioner of Revenue, 392 Mass. 256 (1984); Dow Chemical Co. v. Commissioner of Revenue, 378 Mass. 254 (1979); B.W. Co. v. State Tax Commission, 370 Mass. 18 (1976); Forte Investment Fund v. State Tax Commission, 369 Mass. 786 (1976).
In Franchi, the court held that a Temporary Treasury Regulation and other administrative materials promulgated by the Internal Revenue Service ("IRS"), which changed the federal tax treatment of certain income from interest income to passive activity income, must be followed in determining whether the income constituted "interest" for purposes of G.L. c. 62, § 1(i), where no contrary legislative intent was apparent.  "'If the State income tax law has incorporated Federal income tax provisions, those provisions should be interpreted as they are interpreted for Federal income tax purposes.'"  Franchi, 423 Mass. at 823, quoting B.W. Co., 370 Mass. at 22-23.  
In the present appeal, G.L. c. 62, § 2(d) specifically refers to deductions allowable under Code § 62 which include deductions for trade or business expenses.  Accordingly, under Franchi and the cases cited above, and in the absence of a contrary legislative intent, IRS promulgations regarding the federal treatment of interest incurred in the debt-financed acquisition of stock in a pass-through entity are relevant to the determination of whether the interest is a trade or business expense and therefore properly deductible for Massachusetts tax purposes.
The IRS has promulgated regulations and notices interpreting Code § 163(h) to determine whether interest is properly allocable to a trade or business.  26 C.F.R. 1.163-8T provides that in determining the amount of deductible interest expense, the taxpayer must "allocate" the interest expense among the following types of expense:  trade or business expense; passive activity expenditure; investment expenditure; personal expenditure; and portfolio expenditure.  See 26 C.F.R. 1.163-8T(a)(4)(i).  The characterization of the interest expense determines whether it is fully, partially or non-deductible.  If fully or partially deductible, the federal return schedule on which the deduction is reported depends upon the characterization of the interest expense.
The regulation regarding allocation of debt proceeds states that "[d]ebt is allocated to expenditures in accordance with the use of the debt proceeds." 26 C.F.R. 1.163-8T(c)(1).  Further, the regulation states that the "interest expense on a debt is allocated in the same manner as the debt to which the interest expense relates is allocated."  26 C.F.R. 1.163-8T(a)(3). 
Following the promulgation of this regulation, the IRS published three Notices specifically addressing the treatment of interest expense paid in connection with debt-financed acquisitions of interests in pass-through entities.  These Notices provide guidance in determining the proper result in the instant case because, as Notice 88-20 states: "[s]ection 1.163-8T does not address the treatment of debt allocated to expenditures for interests in pass-through entities." Notice 88-20 (IRB No. 1988-9, 2/10/1988).    
Notice 88-20, applicable to tax years ending on or before December 31, 1987, provides guidance specifically regarding "allocation of interest expenses in connection with certain partnerships and S corporations ('pass-through' entities)."  Id.  The pertinent language of this Notice states: "[i]n the case of debt proceeds allocated under 1.163-8T to the purchase of an interest in a pass-through entity (other than the purchase of an interest in which the entity receives proceeds from the purchase), the debt proceeds and the associated interest expense shall be allocated  among   the  assets  of  the  entity  using  any 
reasonable method." Id.  Reasonable methods include allocating the debt among the assets of the corporation or tracing the debt proceeds to the entity's expenditures. Id.  The O'Tooles made a debt-financed acquisition of an interest in a pass-through entity, for which the entity did not receive the proceeds from the purchase.  The O'Tooles seek to allocate the debt and the interest associated with the debt to the assets of the pass-through entity.  The O'Tooles assert that the debt is allocated to assets used exclusively in the entity's trade or business.    
Notice 88-37 (IRB No. 1988-15, 4/11/88), applicable to tax years on or after December 31, 1986, instructs taxpayers to report interest expenses paid in connection with debt-financed acquisitions of S Corporations on either Schedule E or Schedule A of Form 1040, depending on the allocation of the interest expense.  Under Notice 87-37, if the interest is allocated to an expense that is characterized as other than a trade or business expense, then  it   should   be   reported  on  Schedule  A 
under many circumstances.  However, if the interest expense is allocated as a trade or business interest, it is reported on Schedule E.  Id.  See also Notice 89-35 (IRB No. 1989-13 3/27/89).
 Notice 88-37, applicable to tax years beginning on or after December 31, 1986, specifically references the allocation guidance found in CFR 1.163-8T and Notice 88-20.  Therefore, even though Notice 88-20 applies to tax years ending on or before December 31, 1987, the specific reference in 88-37 to Notice 88-20's allocation provisions makes the allocation guidance found in Notice 88-20 applicable post-1987.  See Notice 88-37 (IRB No. 1988-15, § IV.A.1., 4/11/88).   Notice 88-37 states that "interest expenses allocated under the rules of Notice 88-20 to assets used in an activity shall be treated for purposes of this section [of Notice 88-37] in the same manner as interest expense allocated to an expenditure for such assets would be treated."  Notice 89-35 (IRB No 1989-13, 3/27/89), applicable to tax years ending after December 31, 1987, reiterates the guidance of Notices 88-20 and 88-37, stating:  "in the case of debt proceeds allocated under section 1.163-8T to the purchase of an interest in a pass-through entity, (other than by way of contribution of capital to such entity), the debt proceeds and the associated interest expense shall be allocated among all of the assets of the entity using any reasonable method."
Applying the allocation methods approved in the foregoing Notices, the O'Tooles' interest expense is properly characterized as a trade or business expense.  Through a debt-financed acquisition, Mr. O'Toole purchased an interest in a pass-through entity.  The entity possessed no investment or passive assets.  Under the Notices, the IRS has sanctioned the use of "any reasonable method" of allocating the debt proceeds.  Collins held trade or business assets exclusively, and held no passive investments.  Accordingly, under the Notices, the interest expense is properly allocable to trade or business assets. Thus, the interest expense is characterized properly as interest paid in connection with the conduct of a trade or business and, therefore, deductible under Code § 62 and G.L. c. 62, § 2(d).  Pursuant to Notice 88-37, the interest expense is reported properly on Schedule E, Section II as non-passive loss, and carries through to the Massachusetts return as a deduction from the O'Tooles' Part B income. 
The Commissioner asserted that the O'Tooles' interest expense is investment interest and cannot be characterized as business interest.  In support of his assertion, the Commissioner advanced four arguments.  First, the Commissioner argued that the taxpayer did not follow the analysis required by 26 CFR 1.163-8T (allocation regulation) and Notice 88-20.  However, the Commissioner failed to apply Notice 88-37 and Notice 89-35 to the facts of this case.  As discussed previously, the two notices neglected by the Commissioner's analysis specifically clarify and instruct the taxpayer regarding allocating and reporting interest expense relating to debt financed purchases of interests in a pass-through entity.  Because his argument incorporates only 26 C.F.R. 1.163-8T and Notice 88-20, it is incomplete and unreliable.  
Second, the Commissioner cites Malone v. Commissioner of Internal Revenue, 72 T.C.M. (CCH) 594 (1996), as persuasive due to factual similarity.  However, the case contains a crucial factual difference in that there is no indication in the decision that the corporation in Malone was a pass-through entity.  Thus, the case is inapposite given its factual dissonance coupled with the specific IRS instructions regarding allocating and reporting interest expenses for debt-financed acquisition of interests in pass-through entities.  
Third, the Commissioner asserted that a standard "trade or business" expense analysis is appropriate for this appeal.  Regardless of the merits of this argument, it is inapplicable in this appeal because the IRS has issued specific instructions regarding the treatment of interest payments made in connection with the debt-financed purchase of shares in a pass-through entity.  The Massachusetts deduction under G.L. c. 62, § 2(d), specifically refers to deductions allowable under Code § 62.  Accordingly, the federal treatment of the subject interest expense as a trade or business expense deduction under Code § 62 is relevant and instructive.  See Franchi, 423 Mass. at 823.
Finally, the Commissioner cites Department of Revenue Directive 86-23 (DOR-D 86-23, 20 August 1986), as precedent for barring the deduction of the interest expense in this case.  This DOR Directive was published prior to the IRS Notices that dealt specifically with debt-financed acquisitions of pass-through entities.  Accordingly, the DOR Directive is of little value in the present appeal.
A taxpayer seeking a deduction must point to a specific statutory provision that authorizes the deduction.  See Commissioner of Corporations and Taxation v. Charles F. Adams, Jr., et. al., 316 Mass. 484, 487 (1944).  For the reasons stated above, the Board determined that the O'Tooles met their burden.  Pursuant to G.L. c. 62, § 2(d), Code §§ 62 and 163(h) and corresponding regulations and notices, the O'Tooles correctly treated the $90,000 interest payment as an interest expense paid on indebtedness incurred in connection with the conduct of a trade or business.  Thus, the interest expense is fully deductible "above the line" on the O'Tooles' 1990 Massachusetts Resident Income Tax Return.  Accordingly, the Board issued a decision for the appellants in this appeal. 

					     APPELLATE TAX BOARD

					By:						
					   Abigail A. Burns, Chairman





A true copy,


Attest:________________________
         Clerk of the Board

 	

 Some exclusions from Part A income exist but are not relevant to this appeal.  See G.L. c. 62, § 2(b).
 For the tax year at issue, references to the Internal Revenue Code refer to the Code as amended and in effect for 1988.  G.L. c. 62, § 1(c) as amended by St. 1988, c. 106, § 1.
 To purchase the Collins stock, Mr. O'Toole executed a promissory note secured by a stock purchase agreement.  The stock purchase agreement authorized the seller, Mr. O'Toole's father, to hold the stock as security for the repayment of the obligation.  Thus, Collins did not receive any proceeds from the purchase of the stock.
 Notice 88-37 specifically references the allocation guidance of Notice 88-20 as that which the taxpayer should use in determining appropriate allocations.
   Pursuant to Notice 87-37, the deductible amount of interest expense allocated to trade or business expenses should be reported on Schedule E, the deductible amount of the interest expense allocated to passive activity expenditures should be reported on Schedule E, the deductible amount of interest expense allotted to investment expenditure should be reported on Schedule E or A according to the instructions on Form 4952, and the interest expense allocated to personal expenditure should be reported on Schedule A.

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ATB 2000 - 858