Note sale: does it accelerate related-party interest deductions?
Ronald Moran Cadillac (RMC) was a car dealer franchise operating in California. Prior to 1994 it had borrowed $2,339,929 from its 100% shareholder. The amount of the loans and all accrued interest were recorded on a note on January 1, 1994. The pre-1994 interest of $787,994 had not been deducted by the taxpayer due to the restrictions of IRC section 267(a)(2). On September 20, 1994, the shareholder sold the note and all accrued but unpaid interest to an unrelated third party, resulting in a capital loss of $500,000. On its 1994 federal income tax return, RMC deducted interest of $1,049,657, creating an $810,267 net operating loss (NOL). The IRS disallowed the pre-1994 interest of $787,994, thereby eliminating the NOL. RMC filed a claim for a refund with the U.S. District Court of California, arguing that once the note was sold by its shareholder to an unrelated third party, the restrictions of section 267(a)(2) were no longer in effect. Therefore, it now could deduct the previously disallowed interest of $787,994.
The IRS argued that once section 267(a)(2) disallowed a deduction for an accrued expense for a given tax year, the expense could not be deducted until it was paid. The replacement of the former creditor who was a related party with a new creditor who was not did not accelerate the deduction of the previously disallowed accrued interest. The district court agreed, saying the IRS's interpretation was supported by the language of the statute, Treasury regulations and congressional intent. RMC appealed the decision to the 9th Circuit Court of Appeals.
Result. For the IRS. The 9th Circuit agreed section 267(a)(2) disallowed a deduction by an accrual basis payor until the tax year in which the payee included the amount as income. RMC acknowledged it had not paid any of the pre-1994 interest of $787,994 to the new creditor; the court ruled RMC, therefore, could deduct that interest only in the year it was paid. RMC argued the IRS had taken an inconsistent position since, in 1994, it had allowed the franchise to deduct the accrued interest for the first eight months of that year when the 100% shareholder held the note, but it had not allowed RMC to deduct the accrued interest for pre-1994 years. The court rejected this argument as well, saying section 267(a)(2) required determination of related-party status be made at the end of the tax year. Since RMC and the new creditor were not related parties at the end of 1994, section 267(a)(2) did not apply to any interest for that year. However, because RMC and its 100% shareholder were related parties at the end of the tax years prior to 1994, section 267(a)(2) did control when the interest for those years should be deducted.
RMC further argued that the sale of the note by its 100% shareholder to the unrelated third party converted the accrued interest prior to 1994 into a new liability, thus permitting the taxpayer to accrue and deduct the entire amount in 1994. The court also rejected this argument. It said once the restrictions of section 267 applied to an accrued expense, they continued to apply until the expense was paid. Therefore, no deduction was allowed until the interest was actually paid. Any acceleration of the deductions of the interest due to the sale of the note would have been contrary to the purpose of section 267.
* Ronald Moran Cadillac, Inc. v. United States 385 F3d 1230 (CA-9).
Prepared by Charles J. Reichert, CPA, MS, professor of accounting, University of Wisconsin, Superior.
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|Title Annotation:||Ronald Moran Cadillac, Inc. v. United States|
|Author:||Reichert, Charles J.|
|Publication:||Journal of Accountancy|
|Date:||Mar 1, 2005|
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