On Appeal from a Decision of the United States Tax Court -- Washington, D.C., Tax Court No. 8389-87.
Gibbons, Chief Judge, Hutchinson, Circuit Judge and Wolin, District Judge*fn*
Bruce and Marianne Prabel appeal from an adverse decision by the United States Tax Court. The Prabels owned an interest in a partnership which had calculated its interest expense for a long-term loan using the Rule of 78 method. The Commissioner of Internal Revenue determined that this method did not clearly reflect the actual interest expense. The Commissioner required that the interest expense be calculated under the economic accrual method and issued a notice of deficiency. The Tax Court found that the Commissioner did not abuse his discretion under 26 U.S.C. § 446(b) and upheld the deficiency. We will affirm the Tax Court decision.
Bruce and Marianne Prabel, residents of Chadds Ford, Pennsylvania, are cash basis taxpayers who timely filed joint federal income tax returns for 1981 and 1982. On or about October 20, 1980, Bruce Prabel became a limited partner in Quincy Associates, Ltd., acquiring a 3.7485 percent share. In late 1980, Quincy Associates purchased a shopping center from First Delaware Equity Corp. (FDEC) for $2,471,000. The shopping center was located in Quincy, Florida. The purchase price was payable by a cash downpayment of $192,000 and the balance of $2,279,000 by a nonrecourse, 23-year, 20-month purchase-money note. The note was issued in the total amount of $7,268,249, reflecting the $2,279,000 deferred purchase price and $4,989,249 of stated, precomputed interest. In effect, the note is issued at a discount. The discount substitutes for or is the equivalent of interest. According to the terms of the note, the discount is written off, or interest accrues, in accordance with the Rule of 78's method. The note matures on December 31, 2003, and is secured by a mortgage and security agreement issued by Quincy Associates.
The terms of the transaction including the terms of the note were the result of dealings between related entities and were not the result of arms-length negotiations.
The payment schedule for the note is set forth infra and includes a comparison to economic accrual of the interest expense. During the first 13 years, interest expense under the Rule of 78's amortization substantially exceeds actual cash payments. This is negative amortization. The accrued but unpaid interest is carried over to subsequent years. However, interest does not accrue on unpaid interest owed. There is no compounding of interest for the entire term of the loan.
Pursuant to the terms of the note, Quincy Associates had the right, at its discretion, to prepay in whole or in part the outstanding principal of the note. In the event of a prepayment, Quincy was required to pay all unpaid and accrued interest thereon. The note provides:
Regular monthly payments will be allocated first to the Interest Element and then to the Principal Element in accordance with the "Rule of 78."
Mortgagor shall have the right to prepay this Note in whole, at any time that First Mortgage or Subsequent First Mortgage may be prepaid, by paying to mortgagee the sum of: (i) the then outstanding principal balance of this Note; (ii) all unpaid and accrued interest on this Note; (iii) and the amount of any prepayment charge or penalty due on the First Mortgage and/or Subsequent First Mortgage.
On prepayment of this Note in whole, the Mortgagor will receive a credit for the unearned portion of the Interest Element determined in accordance with the "Rule of 78."
For federal income tax purposes, Quincy Associates reports its income on an accrual basis. Quincy Associates determined its annual interest expense for this loan by taking the total precomputed interest (discount) and allocating it to annual accounting periods according to the Rule of 78.
Following an examination of Quincy Associates' tax returns for 1980, 1981 and 1982, the Commissioner determined that the Rule of 78 method of computing interest expense did not clearly reflect income and that Quincy Associates must recompute interest under the economic accrual method.*fn1 See 26 U.S.C. § 446(b). The partnership's alleged excessive accrual for 1980 was adjusted by way of a section 481 adjustment reflected in deficiencies issued with respect to 1981.
As a result of these adjustments, the Commissioner determined deficiencies in the Prabel's tax liabilities for 1981 and 1982 based on their distributive share of the partnership loss claimed on their tax returns. For 1981, the Commissioner determined a deficiency in the amount of $2,986.00 and for 1982, he determined a deficiency of $1,870.28.
The Prabels filed a petition with the Tax Court. Both parties moved for summary judgment. The Tax Court held that the Rule of 78 method used to compute interest expense distorted partnership income and that it was within the Secretary's discretion under § 446(b) to require recomputation of interest pursuant to the economic accrual method. We shall affirm the tax court's decision.
The Internal Revenue Code, 26 U.S.C. § 446(b), gives the Commissioner the power to disallow any accounting method which does not clearly reflect income and requires that the taxpayer's income be computed under such method which in the opinion of the Commissioner does clearly reflect income.*fn2 In the present case, the Commissioner determined that Quincy Associates' use of the Rule of 78 to compute interest expense distorted the partnerships' reported income and that its income must instead be computed by economic accrual. The Commissioner has broad discretion both to determine whether an accounting method clearly reflects income and to choose an accounting method which does clearly reflect income. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-33 , 58 L. Ed. 2d 785 , 99 S. Ct. 773 (1979); Commissioner v. Hansen, 360 U.S. 446, 467 , 3 L. Ed. 2d 1360 , 79 S. Ct. 1270 (1959); Ferrill v. Commissioner, 684 F.2d 261, 264 (3d Cir. 1982). In the present context, we hold that the Commissioner has not committed an abuse of discretion. Furthermore, we reject taxpayer's argument that entry of summary judgment was improper. There is no material issue of fact precluding summary judgment.
The economic accrual method of calculating interest expense is set forth inRevenue Ruling 83-84, 1983-1 C.B. 97. It is merely a traditional present value analysis of the cost of borrowing. See W. Meigs & R. Meigs, Financial Accounting 488-91 (4th ed. 1983); T. Maness, Introduction to Corporate Finance 154-56 (1988). The concept of present value, like interest, is based upon the time value of money. If a debt instrument is issued at face amount, has a stated interest rate, and requires periodic payments which cover accrued interest, the cost of borrowing is fairly easy to determine. For example a one-year note for $1,000, for which $1,000 was received, which pays 12% annual interest has an effective cost of borrowing of 12%. At the end of the one-year term, the borrower will be required to repay $1,120. The cost of borrowing or effective interest rate equals the stated interest rate.
However, suppose the one-year $1,000 note has no stated interest rate. The note merely pays $1,000 at the end of the one-year term. Assuming a sale, the purchaser will not pay $1,000 today for the note. The note will be purchased for less than $1,000. The difference between the face amount and the purchase price is an original issue discount. Assuming that the note is acquired for $909, the borrower will effectively receive $91 in interest when the note is paid off, or approximately a 10% return. Another way of stating this is that assuming an implicit rate of return of 10%, $909 is the present value of a debt instrument paying $1,000 in one year. If we had only been told that the note had been acquired for $909 and that it would pay $1,000 in one year, we could have used present value analysis to determine that the implicit interest rate is approximately 10%.
In the previous two examples, determining the cost of borrowing is fairly simple. However, when notes have below market stated interest rate, issue at a discount and provide that interest is not compounded on interest owed but not paid, then the determination of the cost of borrowing becomes more complex. At a certain discount factor, the present value of cash outlays equals the present value of cash receipts. See Introduction to Corporate Finance at 129-32. The interest rate corresponding ...