Wis. Cheeseman, Inc. v. United States - 388 F.2d 420 (7th Cir. 1968)

Rule:

To deny a taxpayer's deduction for interest on indebtedness while it holds tax-exempt securities, it is necessary for the Commissioner of Internal Revenue to establish a sufficiently direct relationship of the continuance of the debt for the purpose of carrying the tax-exempt bonds.

Facts:

During the three fiscal years ending July 31, 1960, 1961, and 1962, plaintiff taxpayer, engaged in a seasonal business, obtained short-term bank loans yearly to meet its needs for working capital. The borrowings were repaid out of each year's sales receipts and a part of the receipts was used to purchase municipal bonds, which were used as collateral for the bank loans. Plaintiff also took out a construction loan secured by a mortgage on the taxpayer's real estate the proceeds of which went to pay for construction, not directly to purchase municipal bonds. For these taxable fiscal years, the Commissioner of Internal Revenue disallowed taxpayer's deductions of interest on the mortgage and on some of the short-term loans. Plaintiff paid the resulting assessments and later brought the present refund suit against the United States. The District Court held that plaintiff incurred the indebtedness to carry obligations the interest on which was wholly exempt from Federal income tax within the meaning of Section 265(2) of the Internal Revenue Code. Therefore, judgment was entered for the United States. Plaintiff challenged the decision. 

Issue:

Did the plaintiff incur the indebtedness to carry obligations the interest on which was wholly exempt from Federal income tax within the meaning of Section 265(2) of the Internal Revenue Code, thereby warranting a judgment in favor of the United States? 

Answer:

Yes, with respect to interest on the short-term loans. No, with respect to the mortgage interest.

Conclusion:

On appeal, the court held that one who borrowed to buy tax-exempts and one who borrowed against tax-exempts already owned were in virtually the same economic position; I.R.C. § 265(2), which denied a deduction for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which was wholly exempt from income taxes, made no distinction between them. The court held, however, that the plaintiff did not have to liquidate the municipals instead of obtaining a real estate mortgage loan; there was an insufficient relationship between the mortgage indebtedness and the holding of the municipal bonds to justify denial of the mortgage interest deduction. I.R.C. §163(a). Accordingly, the judgment was affirmed in part and reversed in part and the cause was remanded.