UNITED 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.
                               - 2 -

          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
                                - 3 -

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.
                                 - 4 -

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
                                - 5 -

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.
                                - 6 -

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, 

, 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
                               - 7 -

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...)
                              - 8 -

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, 

, 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.
                                 - 9 -

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. 

, 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-

, 1986-3 C.B. (Vol. 3) at 729.   For example, banks

derive a large majority of their business income from interest.

See 

rule, the bank would not treat the interest

as portfolio income.   See 

     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
                              - 10 -

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.
                              - 11 -

     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, 

, 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 

provide for this purpose a narrow definition
                               - 12 -

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 

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...)
                              - 13 -

“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, 

, 476 (1994);

Borregard v. National Transp. Safety Bd., 

, 945-946

(9th Cir. 1995); ICI Pension Fund v. Commissioner, 

,

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.
                              - 14 -

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
                               - 15 -

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
                               - 16 -

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.