Appeals from the United States Tax Court, No. 25477-82 -- Joel Gerber, Judge. Nos. 16209-81, 24559-83 -- Stephen J. Swift, Judge.
William J. Bauer, Chief Judge, Kenneth F. Ripple, Circuit Judge, and Hubert L. Will, Senior District Judge.*fn*
Kenneth F. RIPPLE, Circuit Judge.
These appeals present two separate questions of tax law, and require us to review two different decisions of the United States Tax Court.*fn1 The first issue is whether early withdrawal penalties received by banking institutions from depositors constitute discharge of indebtedness income to the institutions under section 108 of the Internal Revenue Code of 1954 (the Code). The second issue is whether shareholders of the Chicago Federal Home Loan Bank recognized income upon the receipt of stock dividends in 1978 and 1979, under section 305 of the Code, when none of the shareholders had a legal right to receive cash in lieu of stock, but the Chicago Federal Home Loan Bank had never refused any of its shareholders' redemption requests after a stock dividend.
In an opinion filed November 26, 1985, the Tax Court ruled that early withdrawal penalties constitute regular income to banking institutions and not discharge of indebtedness income. Colonial Sav. Ass'n v. Commissioner, 85 T.C. 855 (1985). In an opinion filed September 24, 1986, the Tax Court ruled that no shareholder of the Chicago Federal Home Loan Bank had an election to receive cash in lieu of stock, and that therefore the shareholders did not realize income upon the receipt of stock dividends. Frontier Sav. & Loan Ass'n v. Commissioner, 87 T.C. 665 (1986). We shall analyze each issue separately. For the reasons set forth in the following opinion, we affirm both decisions of the Tax Court.
Early Withdrawal Penalties
The facts of this case have been stipulated. The appellant is Colonial Savings Association (Colonial), a Wisconsin savings and loan association. Colonial filed a timely corporation income tax return for its taxable year ended June 30, 1980, with the Internal Revenue Service (the IRS). On July 29, 1982, the IRS issued Colonial a notice of deficiency. On October 19, 1982, Colonial filed a timely petition with the United States Tax Court. One of the subjects of dispute between Colonial and the IRS was Colonial's treatment of early withdrawal penalties that it had received from depositors who prematurely had withdrawn amounts from their accounts. The IRS contended that these penalties were regular income to Colonial. Colonial submitted that these penalties were discharge of indebtedness income, and therefore were subject to favorable tax treatment as existed under section 108 of the Code at that time.*fn2
During its taxable year ended June 30, 1980, Colonial had various types of savings accounts outstanding, differing from each other in term, interest rate and other particulars. Interest on all of the accounts in question was computed on a daily basis and added each day to the depositors' accounts. The parties agree that a bona fide indebtedness existed between Colonial and its depositors on any given day equal to the amount of principal and accrued interest on each account. Although Colonial used the cash method of accounting for tax purposes, Colonial deducted under section 591 of the Code the year's aggregate of interest that had been credited to its depositors ' accounts.
When a depositor withdrew the principal balance in any of the accounts in question prior to the account's maturity date, the depositor was required by federal regulation to pay a penalty to Colonial. See 12 C.F.R. § 526.7(a) (1979) & 12 C.F.R. § 526.7(a) (1980). The amount of this penalty was prescribed by the same federal regulations.*fn3 Under terms of the account between the depositor and Colonial, the penalty was paid by reducing the amount that Colonial gave the depositor upon withdrawal.
During the tax year at issue, Colonial received $600,744.88 in early withdrawal penalties. The parties agree that at least 90 percent of the early withdrawals were motivated by rapidly increasing interest rates. That is, because of an increase in interest rates, depositors determined that they were better off paying the penalty rather than leaving their money in an account that paid below-market interest rates.
The Tax Court determined that early withdrawal penalties were regular income and not discharge of indebtedness income. The court acknowledged that a debtor does not have income from the discharge of indebtedness "if the debt forgiveness is simply the method by which a creditor makes a payment to a debtor." Colonial Sav. Ass'n v. Commissioner, 85 T.C. 855, 866 (1985). The court then said that the facts and circumstances of early withdrawal penalties did "not give rise to cancellation or discharge of the debt." Id. Rather, the court believed that the "penalty or forfeiture was an obligation of the depositor, which petitioner and depositor agreed, in advanced, could be satisfied from interest credited or principal deposited in the account." Id. at 867.
The court also noted that Colonial had no need for relief from discharge of indebtedness income. The court said that Colonial had had the use of depositors' funds, and had received a tax deduction for interest credited to the depositors' account, even though no interest actually had been paid. Thus, there was no hardship to Colonial from having to recognize income immediately.
C. Contentions of the Parties
Colonial argues that early withdrawal penalties represent a reduction in the debt that Colonial owes the depositor. Colonial points out that both parties agree that a debtor-creditor relationship exists between Colonial and the depositor, and that savings accounts represent a bona fide indebtedness. Thus, when a depositor withdraws his account prematurely, the withdrawal penalty represents a reduction in the amount Colonial owes the depositor. Colonial therefore submits that the early withdrawal penalty is not a separate and distinct obligation from the indebtedness, but is simply a reduction in the amount that the depositor owes Colonial.
The IRS submits that the early withdrawal penalty represents a separate obligation from the depositor to Colonial. The IRS argues that, in effect, a depositor receives from Colonial the full amount of his account, but then pays back to Colonial a portion of that amount as a penalty. According to this theory, the discharge of indebtedness is merely the medium of payment of the penalty, and the early withdrawal penalty is regular income to Colonial.
In essence, the parties ask that we choose between two characterizations of withdrawal penalty income. The taxpayer submits that such income is income from the discharge of indebtedness, the Commissioner submits that it is regular income.*fn4 Determining which of these characterizations is most appropriate involves a two-step inquiry. First, we must examine the statutory scheme. While it hardly provides us with a definitive answer, this legislative framework is indispensible because our task is to give effect to the congressional intent, however obscure its expression. Second, we must analyze this particular banking transaction in light of the statutory framework and decide upon a characterization that seems most in harmony with the congressional intent.
1. The Statutory Framework
Section 61(a) of the Code provides that gross income means all income, from whatever source derived, including "[i]ncome from discharge of indebtedness." 26 U.S.C. § 61(a)(12). As a general rule, a taxpayer may realize income from the discharge of indebtedness when the taxpayer's debt is forgiven, cancelled, or otherwise discharged for less than the face amount of the debt. United States v. Kirby Lumber Co., 284 U.S. 1, 76 L. Ed. 131, 52 S. Ct. 4 (1931). This general proposition is subject to several exceptions. For the tax year in question here, section 108 of the Code provided in pertinent part:
No amount shall be included in gross income by reason of the discharge, in whole or in part, within the taxable year, of any indebtedness for which the taxpayer is liable, or subject to which the taxpayer holds property, if --
(1) the indebtedness was incurred or assumed --
(B) by an individual in connection with property used in his trade ...