1985 U.S. Tax Ct. LEXIS 13">*13
P, a savings and loan association, was entitled to receive penalties from depositors because of premature withdrawals from their accounts. P generally credited depositors' accounts with compound interest on a daily basis. Depositors were entitled to withdraw the interest, but incurred a penalty if principal was withdrawn before maturity of the certificate. P contends that the penalties are income from discharge of indebtedness within the meaning of
85 T.C. 855">*856 Respondent determined a deficiency of $ 5,000 in petitioners' taxable year ended June 30, 1980. Due to an agreement of the parties, 1 the sole1985 U.S. Tax Ct. LEXIS 13">*16 issue for our consideration is whether income received by financial institutions as penalties for premature withdrawal is to be treated as income from discharge of indebtedness within the meaning of
FINDINGS OF FACT
All of the facts1985 U.S. Tax Ct. LEXIS 13">*17 have been stipulated and are found accordingly. The stipulation of facts and attached exhibits are incorporated by this reference. The factual pattern in this case is essentially the same as that presented in
1985 U.S. Tax Ct. LEXIS 13">*18 Colonial Savings Association (petitioner), a Wisconsin savings and loan associations organized on August 26, 1892, was owned by approximately 17,000 depositors as of June 30, 1980. Petitioner has two wholly owned subsidiaries: Brown County Service Corp., incorporated in 1975, and Colonial Financial Services, Inc., incorporated in 1976. References to petitioner in the singular will be to Colonial Savings Association. Petitioner's principal corporate office is in Green Bay, Wisconsin. Branch savings and loan offices are also maintained at several locations in Green Bay and Appleton, Wisconsin.
Petitioner, a cash basis taxpayer, timely filed a consolidated corporate income tax return (Form 1120) with the Internal Revenue Service Center, Kansas City, Missouri, for its taxable year ended June 30, 1980.
When a depositor opened an account, petitioner provided the depositor with a certificate describing the account. If the depositor renewed the account, a new certificate was not issued, but petitioner sent a notice informing the depositor of any changes in the terms of the account. The parties have agreed that the certificates and notices of changes included terms that complied with1985 U.S. Tax Ct. LEXIS 13">*19 all laws and regulations applicable to savings accounts at the time of issuance.
Petitioner's accounts included certificates with terms ranging from 3 months to 8 years. 4 Interest was compounded on 85 T.C. 855">*858 these accounts on a daily basis with petitioner adding, on its computer records, the daily interest each day to the depositor's account. 5 With respect to petitioner's 6-month certificates, petitioner computed and added the interest to a depositor's account on a daily basis in the same manner as the other accounts, except that the interest was not compounded.
Some of the depositors' accounts were opened during petitioner's taxable year ended1985 U.S. Tax Ct. LEXIS 13">*20 June 30, 1980. The remainder of the accounts were opened in prior years, and either the initial term had extended into or through petitioner's 1980 taxable year, or the initial term had expired on prior years, but the depositor had renewed the account at least once for a term extending into or through petitioner's 1980 taxable year. Petitioner's total deposits were $ 106,383,872 at the beginning of its 1980 taxable year, and $ 123,617,503 on June 30, 1980, at the end of its taxable year.
On any given day, a depositor could withdraw the principal balance in his account, plus the interest shown on petitioner's computer records as earned through such date, less any accrued interest that the depositor had already withdrawn. If a depositor requested the withdrawal of the principal in any account prior to maturity, the depositor was required, both pursuant to the terms of the certificates and Federal regulation, 61985 U.S. Tax Ct. LEXIS 13">*22 to forfeit an amount as a penalty for withdrawal of the funds before the certificates reached maturity. 7 When a penalty for premature withdrawal was incurred, the depositor 85 T.C. 855">*859 received a netted amount, composed of the principal on deposit plus interest payable to1985 U.S. Tax Ct. LEXIS 13">*21 the date of withdrawal, less the penalty for premature withdrawal. The mandatory forfeitures were therefore "paid" by reducing the amounts payable to the depositor by the amount that the depositor had agree to pay and was required to forfeit. In no event did a depositor "pay" the forfeiture after first receiving the full amount due on a certificate.
Petitioner's books, for the period beginning July 1 to September 4, 1979, reflected the deduction of a net amount under section 591, comprised of gross interest accrued, less the amount of premature withdrawal forfeitures. Thus, petitioner treated the forfeitures during that period (in the amount of $ 8,024.04) as a reduction of its total interest deduction for that period. For the period beginning September 4, 1979, petitioner deducted the total amount of each day's interest as and when such interest was shown on petitioner's computer records. Petitioner treated the premature withdrawal forfeitures during this period as income from the discharge of indebtedness under section 61(a)(12) and excluded that amount from its gross income under
The total amount1985 U.S. Tax Ct. LEXIS 13">*23 petitioner deducted during the taxable year ended June 30, 1980, after the offsets for early withdrawal forfeitures described above, was $ 10,372,635.95. The total amount forfeited by depositors due to early withdrawals from accounts on deposit was $ 600,744.88.
Petitioner contends that its method of handling the forfeitures prior to September 4, 1979, was incorrect. Petitioner believes that such method was incorrect because the forfeitures should always have been treated as income from the discharge of indebtedness. 8
OPINION
It is well settled that gross income means gross income from whatever source derived. Sec. 61(a). Gross income includes 85 T.C. 855">*860 income from discharge of indebtedness. Sec. 61(a)(12). A taxpayer may realize income by 1985 U.S. Tax Ct. LEXIS 13">*24 paying an obligation at less than its face value.
1985 U.S. Tax Ct. LEXIS 13">*25 This is the first instance where a court has been asked to determine whether the receipt of premature withdrawal penalties is income from discharge of indebtedness within the meaning of
In addition, respondent argues that, pursuant to the contractual agreement between petitioner and depositors, petitioner was to be compensated if the funds were demanded early. The value of giving up the right to use the funds until maturity1985 U.S. Tax Ct. LEXIS 13">*26 presumably equals the amount of the penalty and there was no cancellation of indebtedness because the financial institution 85 T.C. 855">*861 received value equal in amount to the withdrawal penalty thus satisfying the debt in full. Petitioner counters that there was no payment and therefore there should not be any two-step analysis as respondent asserts. The statutes (sections 61(a)(12) and 108) are stark and undetailed. They cryptically provide that income from discharge of indebtedness is includable in gross income unless the taxpayer files a consent to defer the income pursuant to
Prior to 1931, the Government was singularly unsuccessful in promoting the concept that income could be realized due to the discharge of indebtedness. 10
1985 U.S. Tax Ct. LEXIS 13">*28 In 1931, however, the Government's position that income could be realized due to discharge of indebtedness met with 85 T.C. 855">*862 success in
1985 U.S. Tax Ct. LEXIS 13">*29 The Government has managed to protect its
1985 U.S. Tax Ct. LEXIS 13">*30 Another line of cases provides an exception to
Another exception to
Where the value of the asset falls below the balance of the debt it secures and the parties agree upon a reduction in the debt, another exception to
It is helpful to understand1985 U.S. Tax Ct. LEXIS 13">*32 the legislative background that preceded congressional enactment of
Petitioner contends that the forfeiture, in the form of an "early withdrawal penalty," results in "income by reason of the discharge of indebtedness" under
Respondent's position, as set forth in
if an employer lends $ 50 to an employee with the understanding that the debt will be deducted from the employee's next paycheck, the debt is paid in full on payday even though no cash changes hands and the transaction is formally termed a1985 U.S. Tax Ct. LEXIS 13">*36 "cancellation." The employee must report $ 50 as income, not because the debt has been cancelled for less than its face amount within the meaning of
Petitioner contends that it had "pure" and not "spurious" cancellation of indebtedness because no consideration passed from petitioner to the depositors for the discharge (forfeiture) as it had from the employee to the employer in the above-cited example. The parties 17 have focused their attention on whether there was one or two transactions between petitioner and each depositor. Ostensibly, the parties must believe that it is necessary to have two separate transactions or events to fall within the "spurious" cancellation area, i.e., indebtedness and separate consideration1985 U.S. Tax Ct. LEXIS 13">*37 for its reduction, rather than discharge. Petitioner argues that its relationship with the depositors was solely that of debtor and creditor and the "forfeiture" constituted a discharge of the sole object of the relationship -- the debt. Respondent, on the other hand, has ruled 18 that the depositor's liability for the penalty is contractual and also required by DIDC 19 regulations. Respondent's contention is that the forfeiture is "in the nature of agreed-upon fees or liquidated damages intended both as consideration for the early withdrawal privilege, and as compensation to the taxpayer for loss of the use of the deposited funds for the full term of the certificate."
1985 U.S. Tax Ct. LEXIS 13">*38 85 T.C. 855">*866 We agree with both parties that the net effect of or the "forfeiture" itself causes the realization of income to petitioner. We disagree with petitioner, however, that this income is from the discharge of indebtedness.
In this case petitioner and each depositor agreed, in substance, as follows: Petitioner agreed to pay interest at a fixed rate and on certain dates if the depositor agreed to deposit an amount of money for a fixed period. The depositor agreed to be subject to a penalty 201985 U.S. Tax Ct. LEXIS 13">*40 if withdrawals, below a minimum balance requirement, occurred at certain times prior to maturity of the certificate or account. Petitioner, pursuant to section 591, deducted the entire amount of interest accrued in each depositor's account, without reduction for1985 U.S. Tax Ct. LEXIS 13">*39 the penalties or forfeitures. 21 This factual pattern does not give rise to cancellation or discharge of the debt. The debt (interest) was credited to the depositor's account and (subsequent to September 4, 1979) deducted in full by petitioner. 22 The depositor was subject to a penalty, depending upon the extent of prematurity of withdrawal, which would either reduce or completely eliminate the interest credited. Further, the depositor may have the principal subjected to the penalty depending upon the prematurity of withdrawal and/or the amount of interest withdrawn from the account. In sum and substance, the debt (which includes both interest and principal) 23 has not been 85 T.C. 855">*867 discharged, canceled, or forgiven. The penalty or forfeiture was an obligation of the depositor, which petitioner and depositor agreed, in advance, could be satisfied from interest credited or principal deposited in the account.
Respondent has treated consistently the subject of premature withdrawal in regulations and rulings. The obligation to supply depositors with annual information returns, Forms 1096 and 1099-INT, was published in 1973 and required institutions to reflect1985 U.S. Tax Ct. LEXIS 13">*41 the full or gross amount of interest credited or paid, unreduced by any penalty or forfeiture for premature withdrawal.
The need for relief from (deferral of) income from discharge of indebtedness, congressionally considered in the enactment of
85 T.C. 855">*868 Petitioner cites three cases in support of its position. One of these cases has a factual pattern with some similarities to this1985 U.S. Tax Ct. LEXIS 13">*43 case. In
We understand and do not disapprove of petitioner's attempt herein to arrange its tax matters efficiently and seek deferral of the income from the depositors' penalties. We find, however, that the facts herein do not support the result petitioner seeks.
In view of the foregoing,
1. Respondent determined several adjustments to the amounts reported by petitioners. For purposes of this opinion, however, the only issue for our consideration deals with cancellation of indebtedness. With respect to another pending issue, the parties in this case have agreed to be bound by the final decision in
2. All statutory references are to the Internal Revenue Code of 1954 as amended and in effect for the taxable year at issue.↩
3. In pertinent part, the facts of
FACTS
The taxpayer is a financial institution that issues savings certificates with terms of maturity varying from 6 months to 10 years. Federal regulations pertaining to these certificates require a holder to forfeit an amount as a penalty for withdrawal of the funds before the stated term of maturity. The amount of this premature withdrawal penalty is prescribed by the Depository Institutions Deregulation Committee (DIDC), which was established by the Depository Institutions Deregulation Act of 1980, section 203,
* * * *
The regulation provides a premature withdrawal penalty that may cause, in effect, a forfeiture of principal, as well as interest. If the deposited funds are withdrawn before the specified amount of interest is earned, or before it could have been earned, then a portion of the principal must be forfeited to pay the prescribed penalty.
Under the taxpayer's contracts with its savings certificate holders, interest at a fixed rate is paid or credited to accounts of the holder either monthly or quarterly at the holder's option. The interest is withdrawable on demand and without penalty. The taxpayer's contracts also contain the terms of the penalties required by the above DIDC regulation for premature withdrawal. Should a holder incur a premature withdrawal penalty after withdrawing interest earned, a corresponding reduction is made in principal returned to the holder.
The taxpayer reported on its federal income tax return its income attributable to premature withdrawal penalties as income from the discharge of indebtedness under
4. Petitioner had the following types of accounts based on their maturities: 3-month, 6-month, 1-year, 2-year, 2 1/2-year, 3-year, 4-year, 6-year, and 8-year certificates.↩
5. The amount of daily interest was computed by applying the applicable annual interest rate to the amount on deposit (including previously compounded interest) and then dividing the result by 360.↩
6. The amount of the premature withdrawal penalty has been prescribed by the Depository Institutions Deregulation Committee (DIDC) since July 31, 1980. Prior to that time, the Federal Home Loan Bank promulgated the regulations. For accounts opened or renewed after June 30, 1979, and before June 2, 1980, the regulations required the depositor to forfeit 3 months' interest on accounts with terms of 1 year or less and required the depositor to forfeit 6 months' interest for accounts with terms exceeding 1 year. If the account was open for less than the 3-month or 6-month minimum penalty period, whichever was applicable, the depositor was required to forfeit all the interest.
For accounts opened or renewed after June 1, 1980, the depositor was required to forfeit all the interest which could have been earned, whether earned or not, for accounts with terms of less than 3 months. For accounts with terms from 3 months to 1 year, the depositor was required to forfeit 3 months' interest, whether earned or not. And for accounts with terms of more than 1 year, the depositor was required to forfeit 6 months' interest, whether earned or not.
7. The penalty for premature withdrawal may cause a forfeiture of principal as well as interest. Classification of whether interest or principal is being forfeited does not change the outcome of this case.↩
8. Petitioner does concede, however, that it made certain errors in calculating the amount to be excluded and that, if the early withdrawal forfeitures do constitute income from discharge of indebtedness, the amount that should be excluded under
9. The Bankruptcy Tax Act of 1980, Pub. L. 96-589, sec. 2(a), 94 Stat. 3389, amended
10. In attempting to develop a historical perspective of this area of the tax law, we were confronted by a confusing line of precedent. A noted commentator has also called it "One of the murkiest pools of obscurity in the tax law * * *" and suggested that "logic has taken an extended vacation in the debt cancellation area." Eustice, "Cancellation of Indebtedness and the Federal Income Tax: A Problem of Creeping Confusion,"
11.
12. A relatively recent law review article provides a categorization and analysis of the exceptions to the
13. S. Rept. 1631, 77th Cong., 2d Sess. (1942),
14. The parties have agreed (1) that petitioner has realized income, (2) that both the principal and interest reflected in depositors' accounts were "legally binding indebtedness," and (3) that petitioner has made a proper election. The sole dispute is whether the penalty or "forfeiture" constitutes discharge (cancellation or forgiveness) of indebtedness.↩
15. Petitioner's attempt to bring the facts of this case within the original purposes and requirements for the predecessor of
16. See Bittker & Thompson, "Income From the Discharge of Indebtedness: The Progeny of
17. By an order dated Nov. 8, 1984, the United States League of Savings Institutions was granted leave to file briefs as amicus curiae. Its briefs have been considered regarding this and other aspects of this case. The briefs of the "League" solely support petitioner's position.↩
18.
19. DIDC (Depository Institutions Deregulation Committee) was established by the Depository Institutions Deregulation Act of 1980, sec. 203,
20. The certificates issued by petitioner contained "Penalty Clause [Sectionss]" and the text of these sections referred to a "penalty," whereas the DIDC regulations refer to a "forfeiture." The parties have used the terms "penalty" and "forfeiture" interchangeably in their stipulation of facts and briefs and we have not placed any significance upon the use of these particular terms.↩
21. Up until Sept. 4, 1979, and for all prior years, petitioner reduced the gross amount of interest shown in depositors' accounts by the amount of penalties or forfeitures for the same period. Following Sept. 4, 1979, through the conclusion of its taxable year ended June 30, 1980, petitioner did not reduce the gross amount of interest reflected in depositors' accounts by the amount of forfeitures for that same period. This change in approach by petitioner coincides with the change in the regulations, to some extent, as reflected in note 6,
22. See note 16,
23. The parties agree that both interest and principal in the accounts are the basis for a debtor-creditor relationship between the petitioner and depositors.↩
24. Because a certificate may not mature prior to the end of petitioner's taxable year, petitioner may have enjoyed some deferral without
25. The "unsound financial condition" requirement was removed in 1942.↩