Howard v. More v. Commissioner , 115 T.C. No. 9 ( 2000 )

115 T.C. No. 9UNITED STATES TAX COURT
HOWARD V. MORE, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 4455-99. Filed August 15, 2000.
P is an individual underwriter for Lloyd’s of
London (Lloyd’s). As an underwriter, P is required to
demonstrate that he can cover potential losses on the
policies that he underwrites, a.k.a., show means. In
order to show means, P posted a letter of credit issued
by Bank Julius Baer (BJB) with Lloyd’s. The letter of
credit was secured by P’s preexisting stock portfolio.
The policies that P underwrote for the taxable
years 1992 and 1993 incurred losses. As a result of
the losses, BJB sold P’s stock at a substantial gain
during those years.
P reported the losses from his underwriting
activities as passive losses on his 1992 and 1993
Federal income tax returns. Additionally, P reported
the gain from the sale of stock by BJB as passive
income. P then offset the gain with the passive
losses. R contends that the gain recognized on the
sale of stock is portfolio income, and portfolio income
cannot be offset by P’s passive losses.
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Held: The gain from the sale of stock is
portfolio income pursuant to sec. 469(e)(1)(A), I.R.C.,
and sec. 1.469-2T(c)(3), Temporary Income Tax Regs., 53
Fed. Reg. 5686, 5713 (Feb. 25, 1988), and cannot be
offset by P’s passive losses.
Martha A. Roof, for petitioner.
Louis B. Jack, for respondent.
OPINION
VASQUEZ, Judge: In the notice of deficiency, respondent
determined deficiencies of $38,145 and $79,812 in petitioner’s
Federal income taxes for 1992 and 1993, respectively. After
concessions, the issue for decision is whether gain from the sale
of stock pledged as collateral for a letter of credit which
guaranteed petitioner’s underwriting activities is portfolio
income.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
Background
The parties submitted this case fully stipulated. The
stipulation of facts and the attached exhibits are incorporated
herein by this reference. At the time the petition was filed,
petitioner resided in Pasadena, California.
General Background on Underwriting for Lloyd’s
Lloyd’s of London’s (Lloyd’s) business consists of insuring
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and reinsuring worldwide risks.1 Like insurance companies,
Lloyd’s generates income from the underwriting of insurance risks
and from the investment of premiums received on the insurance
policies underwritten. Generally, the underwriting component
generates losses, while the investment component generates
profits.
Lloyd’s is organized into numerous entities referred to as
syndicates. Syndicates are composed of individual and corporate
members (Names) and controlled by managing agents. Names provide
the financial backing behind Lloyd’s policies. From the mid-
1970's until the years in issue, petitioner was a Name for
Lloyd’s.
The managing agents of the syndicates select policies to
underwrite from the Lloyd’s trading floor in the same fashion as
a mutual fund manager acquires stock for a mutual fund. A
managing agent may decide to underwrite any percentage of the
risk of any Lloyd’s policy that he/she wishes. For example, a
managing agent may choose to underwrite 10 percent of the risk on
an aviation policy and leave the other 90 percent of the risk to
be underwritten by other syndicates.
Each year, Names choose the syndicates in which they wish to
participate. To limit their risk, Names usually participate in
1
Lloyd’s is not an insurance company but a competitive
market where risks are undertaken by syndicates and their
members.
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many syndicates. Names agree to accept a predetermined
percentage of all risks underwritten on behalf of the syndicates.
Where total insurance claims are less than the premiums collected
plus investment income, Names make a profit commensurate with the
percentage that they agreed to underwrite. However, where claims
exceed premiums collected plus investment income, Names must
cover their percentage of the loss.
Names have a certain capacity of premiums that they can
underwrite for a given year. A Name’s usual capacity is from
£200,000 to £2 million. In order to be accepted by Lloyd’s, a
Name must demonstrate his/her ability to cover potential losses,
a.k.a., “show means”. A Name generally may show means by posting
cash, assets, or a letter of credit equal to at least 30 percent
of his/her underwriting capacity with Lloyd’s.
Petitioner’s Underwriting Activities
Beginning in the 1960's, petitioner invested in stock. In
1988, to secure a letter of credit, petitioner transferred his
stock portfolio (pledged stock) to a brokerage account at Bank
Julius Baer (BJB), a London-based bank.
During 1992 and 1993, petitioner underwrote £500,000 of
Lloyd’s premiums which were secured by a letter of credit from
BJB in the amount of £150,000.
During those years, a number of the syndicates in which
petitioner participated incurred losses. In order to cover those
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losses, BJB sold petitioner’s pledged stock.2 From these sales
of the pledged stock, he realized substantial gains during 1992
and 1993.
Lloyd’s Closing Agreement and Filing Procedure
In 1990, in an effort to provide uniform tax treatment to
United States and non-United States underwriters of Lloyd’s, the
underwriters, Lloyd’s, and the IRS entered into a closing
agreement. The closing agreement bound all United States Names,
including petitioner, to report all underwriting profits and
losses and all investment income from Lloyd’s activities as
income or loss from a passive activity. Thus, pursuant to the
closing agreement, petitioner treated the losses incurred by the
syndicates in which he participated as passive losses. The
closing agreement did not address the tax treatment of gains or
losses realized on the disposition of assets held as security for
a letter of credit provided for the underwriting activities.
Discussion
On his 1992 and 1993 tax returns, petitioner reported the
gain from the sale of the pledged stock as passive income and
offset the gain by the passive losses from his underwriting
activities. Respondent disagrees with this treatment and argues
that the gain is portfolio income which cannot be offset by
2
We assume that Lloyd’s drew upon petitioner’s letter of
credit thereby precipitating the sale of petitioner’s pledged
stock by BJB.
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passive losses.
General Background on the Passive Loss Rules
The section 469 passive loss rules were enacted as part of
the Tax Reform Act of 1986 (TRA '86), Pub. L. 99-514, 100 Stat.
2085, in response to the Congressional belief that “decisive
action * * * [was] needed to curb the expansion of tax
sheltering”. S. Rept. 99-313 (1986), 1986-3 C.B. (Vol. 3) 713,
714. Those rules were specifically designed to prevent a
taxpayer from using losses from a passive activity to offset
unrelated income generated in a nonpassive activity. See Hillman
v. Commissioner, 114 T.C. 103, 107 (2000).
A passive activity is defined as a trade or business in
which the taxpayer does not materially participate. See sec.
469(c)(1). Section 469 generally disallows a taxpayer’s passive
activity loss or credit. See sec. 469(a). A taxpayer’s passive
activity loss is the amount by which the aggregate losses from
all passive activities for the taxable year exceed the aggregate
gains from all passive activities for such year. See sec.
469(d)(1).
Income from passive activities, i.e., passive activity gross
income, includes an item of gross income if and only if such
income is from a passive activity. See sec. 1.469-2T(c)(1),
Temporary Income Tax Regs., 53 Fed. Reg. 5686, 5711 (Feb. 25,
1988). In determining how to treat the gain from the disposition
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of property used in an activity, the regulations generally
provide that (1) the gain is treated as gross income from such
activity; (2) if the activity is a passive activity of the
taxpayer for the year of the disposition, the gain is treated as
passive activity gross income; and (3) if the activity is not a
passive activity of the taxpayer for the year of the disposition,
the gain is treated as not from a passive activity. See sec.
1.469-2T(c)(2)(i), Temporary Income Tax Regs., 53 Fed. Reg. 5686,
5711-5712 (Feb. 25, 1988).
The Secretary promulgated a separate rule for substantially
appreciated property.3 Where property used in an activity is
substantially appreciated at the time of its disposition, any
gain from the disposition will be treated as not from a passive
activity unless the property was used in a passive activity for
either (1) 20 percent of the period during which the taxpayer
held the property or (2) the entire 24-month period ending on the
date of the disposition. See sec. 1.469-2(c)(2)(iii)(A), Income
Tax Regs.4 The Secretary added this rule to dissuade taxpayers
3
Substantially appreciated property is defined as property
with a fair market value which exceeds 120 percent of the
property’s adjusted basis. See sec. 1.469-2(c)(2)(iii)(C),
Income Tax Regs.
4
We note that sec. 1.469-2(c)(2)(iii), Income Tax Regs.,
was first introduced in temporary form in 1988 as sec. 1.469-
2T(c)(2)(iii), Temporary Income Tax Regs., 53 Fed. Reg. 5686,
5711-5712 (Feb. 25, 1988). In 1989, the Secretary amended
slightly the temporary regulation. See sec. 1.469-2T(c)(2)(iii),
(continued...)
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from structuring dispositions in a manner that would generate
passive activity gross income in inappropriate situations. See
T.D. 8175, 1988-1 C.B. 191, 196. Without this exception, a
taxpayer could transfer substantially appreciated property used
in a nonpassive activity to a passive activity just prior to
disposition, thereby converting nonpassive gain into passive gain
to be offset by passive losses.
Section 469(e)(1)(A) and the applicable regulations
thereunder provide that certain income will not be treated as
income from a passive activity including (1) any gross income
from interest, dividends, annuities, or royalties not derived in
the ordinary course of a trade or business, and (2) any gain or
loss not derived in the ordinary course of a trade or business
which is attributable to the disposition of property producing
income of a type described in (1) or property held for investment
(the portfolio income exception). The temporary regulations
refer to this type of income as portfolio income. See sec.
1.469-2T(c)(3)(i), Temporary Income Tax Regs., 53 Fed. Reg. 5686,
5713 (Feb. 25, 1988); see also Schaefer v. Commissioner, 105 T.C.
227, 230 (1995).
The legislative history sheds some light on why Congress
4
(...continued)
Temporary Income Tax Regs., 54 Fed. Reg. 20527, 20538 (May 12,
1989). In 1992, the temporary regulation was finalized without
change. See sec. 1.469-2(c)(2)(iii), Income Tax Regs., 57 Fed.
Reg. 20747, 20754 (May 15, 1992); T.D. 8417, 1992-1 C.B. 173,
181-183.
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excluded portfolio income from the passive loss rules:
Portfolio investments ordinarily give rise to positive
income, and are not likely to generate losses which
could be applied to shelter other income. Therefore,
for purposes of the passive loss rule, portfolio income
generally is not treated as derived from a passive
activity, but rather is treated like other positive
income sources such as salary. To permit portfolio
income to be offset by passive losses or credits would
create the inequitable result of restricting sheltering
by individuals dependent for support on wages or active
business income, while permitting sheltering by those
whose income is derived from an investment portfolio.
[S. Rept. 99-313, supra, 1986-3 C.B. (Vol. 3) at 728.]
Income of a type generally regarded as portfolio income
which is derived in the ordinary course of a trade or business
does not fall within the definition of portfolio income. See
sec. 469(e)(1)(A); sec. 1.469-2T(c)(3)(i), Temporary Income Tax
Regs., 53 Fed. Reg. 5686, 5713 (Feb. 25, 1988). Congress and the
Secretary reasoned that “the rationale for treating portfolio-
type income as not from the passive activity does not apply [in
these instances], since deriving such income is what the business
activity actually, in whole or in part, involves.” S. Rept. 99-
313, supra, 1986-3 C.B. (Vol. 3) at 729. For example, banks
derive a large majority of their business income from interest.
See id. Under this rule, the bank would not treat the interest
as portfolio income. See id.
Parties’ Arguments
Petitioner claims that his gain is attributable to the
disposition of substantially appreciated property used in a
passive activity (his underwriting activity) for more than 20
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percent of the period during which he held the interest in the
property. Petitioner therefore argues that the gain is passive
income under section 1.469-2T(c)(2)(i), Temporary Income Tax
Regs., 53 Fed. Reg. 5686, 5711-5712 (Feb. 25, 1988), and section
1.469-2(c)(2)(iii), Income Tax Regs.
Respondent argues that petitioner’s gain is attributable to
the disposition of dividend-producing property which was not
derived in the ordinary course of a trade or business.
Respondent therefore contends that the gain on the sale of the
pledged stock is portfolio income under section 469(e)(1)(A) and
section 1.469-2T(c)(3)(i)(C), Temporary Income Tax Regs., 53 Fed.
Reg. 5686, 5713 (Feb. 25, 1988).
Which Rule Applies?
In order to understand how the rules relied on by the
parties interrelate and decide which rule controls in the present
case, we look at the general structure of section 469 and the
applicable regulations thereunder. The regulation relied on by
petitioner, i.e., section 1.469-2(c)(2)(iii), Income Tax Regs.,
is part of the general rules defining passive activity gross
income under section 469. The Internal Revenue Code section and
regulation relied on by respondent, i.e., section 469(e)(1)(A)
and section 1.469-2T(c)(3)(i)(C), Temporary Income Tax Regs., 53
Fed. Reg. 5686, 5713 (Feb. 25, 1988), except from those general
rules a disposition of property of a type that produces portfolio
income.
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We find that the specific exception for a disposition of
property that produces portfolio income takes precedence over the
more general rule regarding the treatment of gain from the
disposition of property used in an activity. See HCSC-Laundry v.
United States, 450 U.S. 1, 6, 8 (1981) (holding that a specific
provision takes precedence over a general one). When a
disposition is of property that generates portfolio-type income,
the more specific provisions regarding the disposition of such
property should apply in accordance with the Congressional aim
behind the portfolio income exception. We therefore apply
section 469(e)(1)(A) and section 1.469-2T(c)(3), Temporary Income
Tax Regs., 53 Fed. Reg. 5686, 5713 (Feb. 25, 1988), to the
present case.
Application of Section 469(e)(1)(A) and Section 1.469-2T(c)(3)
As noted earlier, passive activity gross income does not
include portfolio income. See sec. 469(e)(1)(A); sec. 1.469-
2T(c)(3)(i), Temporary Income Tax Regs., 53 Fed. Reg. 5686, 5713
(Feb. 25, 1988). Portfolio income includes: (1) Any gross
income from interest, dividends, annuities, or royalties not
derived in the ordinary course of a trade or business, and (2)
any gain or loss not derived in the ordinary course of a trade or
business which is attributable to the disposition of property
producing income of a type described in (1) or property held for
investment. See id.The regulations provide for this purpose a narrow definition
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of “gross income derived in the ordinary course of a trade or
business”. Sec. 1.469-2T(c)(3)(ii), Temporary Income Tax Regs.,
53 Fed. Reg. 5686, 5713 (Feb. 25, 1988). The regulations provide
an exhaustive list of seven sources of income that satisfy the
definition and, as a result, will not be considered portfolio
income.5 See id. The source pertinent to our discussion is
5
Sec. 1.469-2T(c)(3)(ii), Temporary Income Tax Regs., 53
Fed. Reg. 5686, 5713 (Feb. 25, 1988), provides, in pertinent
part:
gross income derived in the ordinary course of a trade
or business includes only--
(A) Interest income on loans and investments made
in the ordinary course of a trade or business of
lending money;
(B) Interest on accounts receivable arising from
the performance of services or the sale of property in
the ordinary course of a trade or business of
performing such services or selling such property, but
only if credit is customarily offered to customers of
the business;
(C) Income from investments made in the ordinary
course of a trade or business of furnishing insurance
or annuity contracts or reinsuring risks underwritten
by insurance companies;
(D) Income or gain derived in the ordinary course
of an activity of trading or dealing in any property if
such activity constitutes a trade or business * * *;
(E) Royalties derived by the taxpayer in the
ordinary course of a trade or business of licensing
intangible property * * *;
(F) Amounts included in the gross income of a
patron of a cooperative * * * by reason of any payment
or allocation to the patron based on patronage
occurring with respect to a trade or business of the
(continued...)
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“Income from investments made in the ordinary course of a trade
or business of furnishing insurance or annuity contracts or
reinsuring risks underwritten by insurance companies” found in
subdivision (ii)(C) of section 1.469-2T(c)(3), Temporary Income
Tax Regs., 53 Fed. Reg. 5686, 5713 (Feb. 25, 1988), (subdivision
(ii)(C)).
Respondent contends that petitioner’s gain was not derived
in the ordinary course of a trade or business within the meaning
of subdivision (ii)(C). On brief, petitioner does not address
the application of this regulation.
In light of the restrictive nature of subdivision (ii)(C),
we read it narrowly. We look closely at the language contained
in the regulation and interpret it according to its ordinary and
plain meaning. See FDIC v. Meyer, 510 U.S. 471, 476 (1994);
Borregard v. National Transp. Safety Bd., 46 F.3d 944, 945-946
(9th Cir. 1995); ICI Pension Fund v. Commissioner, 112 T.C. 83,
87 (1999).
Subdivision (ii)(C) provides that income from investments
made in the ordinary course of a trade or business of reinsuring
risks underwritten by insurance companies constitutes “gross
5
(...continued)
patron; and
(G) Other income identified by the Commissioner as
income derived by the taxpayer in the ordinary course
of a trade or business.
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income derived in the ordinary course of a trade or business” and
is, thus, not portfolio income. According to its plain meaning,
we believe that the phrase “made in the ordinary course of a
trade or business” contemplates not only that the investment
occur at a time when the taxpayer is conducting a trade or
business of reinsuring risks but also contemplates that the
investment be an ordinary and necessary part of the business of
reinsuring risks.
Additionally, we interpret subdivision (ii)(C) in light of
the workings of the insurance industry. Like insurance
companies, Lloyd’s generates income from the underwriting of
insurance risks and from the investment of premiums received on
the insurance policies underwritten. The underwriting component
generally generates losses, while the investment component
generates profits. While the income generated by the investment
component of a reinsurance business would otherwise be considered
portfolio income, we believe that under subdivision (ii)(C), if
this income is derived in the ordinary course of a trade or
business of reinsuring risks, it is excluded from the definition
of portfolio income. Insofar as this income is considered to be
part and parcel of the business activity of reinsuring risks, the
income is not characterized as portfolio income.
It is unclear from the record whether petitioner acquired
all of the pledged stock before his underwriting activities
began. We note that at least some of the pledged stock was
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acquired as early as 1960, and petitioner did not begin
underwriting until the mid-1970's. Petitioner has not shown that
acquisition of any of the pledged stock was an ordinary and
necessary part of his underwriting activities. The evidence
indicates instead that petitioner acquired the pledged stock as
an investment. He merely pledged this investment asset to secure
the letter of credit that he needed for his underwriting
activities. The pledging of the stock did not convert
petitioner’s investment asset to an asset used in a trade or
business of underwriting. We do not find that petitioner’s
acquisition of the pledged stock was “made in the ordinary course
of a trade or business” as contemplated by subdivision (ii)(C).
Further, we believe petitioner’s gain is not the typical
type of income recognized by insurance companies or reinsurers on
their investment of insurance premiums. There is no evidence
that petitioner acquired the pledged stock with the premiums of
the policies underwritten. Nor does the record show that the
gain from the disposition of the pledged stock was committed to
his underwriting activities and not spent for personal purposes
such as living expenses. Consequently, we do not believe that
subdivision (ii)(C) was meant to encompass petitioner’s gain.
We also draw an analogy between petitioner’s gain and the
interest earned on the investment of working capital. Section
469(e)(1)(B) provides that any income, gain, or loss which is
attributable to an investment of working capital shall be treated
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as not derived in the ordinary course of a trade or business,
i.e., it will be treated as portfolio income. In regard to this
section, the report of the Senate Committee on Finance stated:
“Although setting aside such amounts may be necessary to the
trade or business, earning portfolio income with respect to such
amounts is investment-related and not a part of the trade or
business itself.” S. Rept. 99-313 (1986), 1986-3 C.B. (Vol. 3)
713, 729-730. We believe that petitioner’s gain is no more
closely connected to his underwriting activities than would be
interest earned on the investment of working capital, and, thus,
it should be treated as not derived in the ordinary course of a
trade or business.
We conclude that petitioner’s gain is portfolio income and
that he cannot utilize his passive losses to offset this gain.
Decision will be entered
under Rule 155.