ON APPEAL FROM THE UNITED STATES TAX COURT
Before: ADAMS, VAN DUSEN, and WEIS, Circuit Judges
In this appeal from a decision by the Tax Court in favor of the Commission of Internal Revenue, the appellants, Thomas and Louise Ferrill, claim that the Tax Court erred in disallowing a deduction of prepaid interest and in permitting an amended answer by the Commissioner. Because we conclude that the Tax Court neither committed an error of law nor abused its discretion, we affirm.
The Ferrills were cash basis taxpayers who filed a joint return for the calendar year 1972. Earlier in that year, they investigated the possibility of establishing a restaurant franchise, in the hope of obtaining income tax deductions for interest and depreciation. The Ferrills visited Missouri to learn more about the restaurant business and subsequently attempted to locate and purchase a site in the Tampa Bay, Florida, area for construction of their own restaurant.While the taxpayers were searching for a favorable restaurant site, they kept more than $150,000 in their personal checking and savings accounts with Industrial Valley Bank and Trust Company (IVB) in Jenkintown. After finding a suitable location in Florida, the Ferrills made an unsuccessful offer to the owners.
Upon determining that their efforts to commit funds during 1972 to the restaurant project would not succeed, the Ferrills explored other ventures which might yield tax deductions while still permitting them to pursue their restaurant project the following year. The taxpayers eventually settled on a loan transaction which they believed would offer them the greatest tax advantages. They decided to borrow $2,537,720.79 from IVB late in the calendar year 1972, with the loan to be paid in full by December 21, 1973. The amount of the loan was credited to the Ferrills' IVB checking account on December 27, 1972. On the same day, their account was debited by the full amount of the loan in order to cover the cost of purchasing United States Treasury bonds. The bonds, along with other securities owned by the taxpayers, were pledged as collateral to secure the loan.
In accordance with an agreement made with the bank, on December 27, 1972, the Ferrills prepaid $145,513.62 in interest for the term of the loan. By taking this action, the rate of interest on the loan became fixed. On their 1972 income tax return the Ferrills showed an adjusted gross income of $279,905.75, which included $252,185.32 from Mr. Ferrill's law practice. They claimed the $145,513.62 paid to IVB on December 27, 1972, as an interest expense deduction.
Relying initially on section 163(d) of the Internal Revenue Code, 26 U.S.C.§ 163(d), which establishes limitations on the amount of allowable interest expense, the Commissioner issued a notice of deficiency to the Ferrills and disallowed $35,938 of the claimed interest expense deduction. The Ferrills thereupon filed suit in the Tax Court protesting this disallowance and contending that the Commissioner had abused his discretion.During pretrial proceedings, after the taxpayers had furnished answers to certain interrogatories, the Commissioner moved to amend its deficiency assessment from $35,938 to $75,718. This latter figure represented the disallowance of the entire interest claimed by the taxpayers in 1972, and was justified, according to the Commissioner, because, by claiming a deduction for all of the prepaid interest in 1972, the Ferrills "materially distorted" their 1972 income.*fn1
The Tax Court agreed with the Commissioner that the prepaid interest deduction claimed by the Ferrills resulted in material distortion of income from 1972. Consequently, the Tax Court held that the Commissioner had not abused his discretion, and disallowed all but 4/360 of the interest deduction in 1972.*fn2 In this appeal, the taxpayers argue that the Tax Court erred as a matter of law and that the Commissioner abused his discretion in preventing them from deducting the prepaid interest from their 1972 adjusted gross income.
Although section 163(a) of the Code authorizes a deduction for "all interest paid or accrued within the taxable year on indebtedness," the timing of this deduction depends upon the "method of accounting used in computing taxable income," 26 U.S.C. § 461(a). The Code provides that a taxpayer may determine how his taxable income is to be computed under the method of accounting regularly used by the taxpayer. The taxpayer's determination nevertheless is reviewable by the Commissioner, who, acting pursuant to section 446(b), 26 U.S.C. § 446 (b), may reject a taxpayer's method of accounting if it "does not clearly reflect income." Under these circumstances, the Commissoner may instead compute the taxpayer's income "under such method as, in the opinion of the Secretary or his deliegate, does clearly reflect income."
The Commissioner has broad discretion in determining whether a taxpayer's method of accounting clearly reflects his income. Commissioner v. Hansen, 360 U.S. 446, 3 L. Ed. 2d 1360, 79 S. Ct. 1270 (1959); Fort Howard Paper Co. v. Commissioner, 49 T.C. 275 (1967). As a result, a taxpayer ordinarily has a heavy burden in overcoming any such determination by the Commissioner. Fort Howard Paper Co., supra; Photo-Sonics Inc. v. Commissioner, 42 T.C. 926(1964), aff'd, 357 F.2d 656 (9th Cir. 1966). Even if the accounting method used by a taxpayer is consistent with generally accepted accounting principles, the Commissioner may reject that method if it fails to represent accurately the taxpayer's income. American Automobile Association v. United States, 367 U.S. 687, 6 L. Ed. 2d 1109, 81 S. Ct. 1727 (1961); Fort Howard Paper Co., supra; Sandor v. Commissioner, 62 T.C. 469 (1974), aff'd, 536 F.2d 874 (9th Cir. 1976). With this general principle as a guide, we turn to the disallowance at issue here.
Prior to 1968, the Internal Revenue Service permitted a cash basis taxpayer to deduct up to five years of prepaid interest from income. In 1968, however, the Service issued Revenue Ruling 68-643, 1968-2 C.B. 76, which restricted the deductibility of prepaid interest. Pursuant to this ruling, prepayment of interest for periods exceeding twelve months beyond the end of the current taxable year ordinarily will be disallowed as a material distortion of income. Instead, the Commissioner will require the interest deduction to be spread over the years involved. See e.g., Cole v. Commissioner, 64 T.C. 1091 (1975), aff'd, 586 F.2d 747 (9th Cir. 1978). In situations where prepayment of interest is made on indebtedness extending over a period of time shorter than twelve months, the Commissioners is to determine whether the deduction materially distorts income on a case-by-case basis. In making determinations of this type, the Commissioner may consider the following factors: the ...