                        T.C. Memo. 2012-25



                      UNITED STATES TAX COURT



       ROBERT JAY AND ELIZABETH T. BROOKS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 3430-09.                Filed January 26, 2012.



     Thomas Edward Brever, for petitioners.

     David L. Zoss, for respondent.



                        MEMORANDUM OPINION


     HOLMES, Judge:   Robert Brooks received a loan from his

employer, Dain Rauscher, Inc. in 1998.    Dain promised to forgive

the entire loan--including accrued interest--if Brooks stayed

employed for the full five-year term of the loan.    Brooks kept

his word and stayed employed by Dain.    Dain kept its word and

forgave the loan.   Brooks and his wife included the forgiven loan
                                 - 2 -

principal and accrued interest as income on their 2003 joint

return.   The parties agree that the forgiven principal was

income, but Brooks now claims that the forgiven interest was not.

                            Background

     Dain recruited Brooks as a stockbroker in March 1998.    As

part of his compensation, Dain lent him more than $500,000.

Brooks promised in return to repay Dain the principal amount of

the loan plus interest on the unpaid balance.   The written loan

agreement and promissory note required Brooks to repay the loan

in five annual installments of slightly more than $100,000 at the

end of March in each year from 1999 through 2003.   Dain, however,

promised to forgive the installment of principal and any accrued

interest due each year if Brooks remained a Dain employee.

     The deal worked in some peculiar ways.   An internal Dain

memorandum from March 1998 said that before each year’s payment

became due, Dain would issue Brooks a check for the amount of the

upcoming installment of principal plus accrued interest and minus

tax withholding.   In turn, Brooks was to write a check to Dain

for the installment amount and accrued interest.    The memorandum

also said that the amount of the check Brooks would write to Dain

would be larger than the one he received from Dain because of tax

withholding.   It also said that the check from Dain “is

considered income by the IRS.”    Despite what the memorandum said,

and despite the fact that Brooks undeniably remained a Dain
                                 - 3 -

employee throughout the five-year term of the loan, there is no

evidence in the record that the parties exchanged checks or that

Dain withheld any tax upon forgiving part of the loan each year.1

        The parties instead stipulated that in 2003 Dain forgave the

entire loan and included $650,342.352 (the sum of $506,300 in

principal and $144,042.35 of accrued interest) on Brooks’s March

14, 2003 pay statement.3    Dain also included the canceled debt as

wages on Brooks’s Form W-2 for 2003.     Brooks reported all of the

wages on this Form W-2 on his 2003 return, which he filed in May

2006.

     Since Brooks reported the income from the forgivable note

agreement on his 2003 return, that wasn’t the reason the

Commissioner audited his return.    The notice of deficiency

instead focused on receipts that Brooks reported and losses that

he claimed on numerous stock sales, and on his assertion that he



        1
       This may be why Brooks never reported any income from the
forgivable note agreement before tax year 2003.
        2
       There was a typo in the stipulation: Brooks’s March 14,
2003 pay statement says $650,342.35, not $650,352.35. Since the
stipulation is clearly contrary to the facts disclosed by the
record on this tiny point, we are not bound by it. See Svoboda
v. Commissioner, T.C. Memo. 2006-235.
        3
       The pay statement listed federal withholding of
$175,592.43 for the pay period and $192,294.88 for the year to
date, but Brooks’s 2003 return listed federal income tax withheld
of only $20,694. There is no other evidence in the stipulated
facts that Dain actually withheld any federal tax from the
$650,342.35 in forgiven debt, and we specifically find that it
did not do so.
                                - 4 -

should be taxed on these sales as a trader and not as an

investor.    See King v. Commissioner, 89 T.C. 445, 458-59 (1987)

(explaining difference between trader and investor for tax

purposes).    The parties have since settled all those issues, and

the only question left for us to answer is the proper tax

treatment of the forgiven interest on the forgiven loan.    Brooks

claims he didn’t have to report this substantial amount--

$144,042.35--as income.

     He and his wife were Minnesota residents when they filed

their petition.    The parties submitted the case for decision

under Rule 122.4

                             Discussion

I.   Taxability of Forgiven Loan in 2003

     The parties both assume that figuring out whether Brooks’s

forgiven interest is taxable income is an issue only for the 2003

tax year.    But that’s not so clear to us.   Before we decide the

taxability of forgiven interest, we normally look first at the

character and timing of the forgiven loan to make sure that we

have the proper tax year at issue.      See OKC Corp. v.

Commissioner, 82 T.C. 638, 647-49 (1984) (court must determine




     4
       All Rule references are to the Tax Court Rules of Practice
and Procedure. All section references are to the Internal
Revenue Code in effect for the relevant tax year, unless
otherwise indicated.
                                - 5 -

whether discharge of indebtedness results in “pure” income or

indirect payment for services, property, or something else).

     This case seems quite similar to Winter v. Commissioner,

T.C. Memo. 2010-287.    In Winter, we held that the bonus advance

that Winter received from his employer was compensation for

services rather than a loan.    We reasoned that the bonus advance

was not a loan because its primary purpose was to induce Winter

to provide personal services, and his obligation to repay the

advance was conditional--he had to repay it only if he quit or

was fired for cause within five years.    See id.   Because we found

that the advance was income and not a loan, we held that it was

taxable to Winter in the year he received it.    See id. (citing

section 451(a) and section 1.451-1(a), Income Tax Regs.).

     In form, the agreement between Brooks and Dain appears to be

a loan:    There is a note evidencing indebtedness and a stated

interest rate.    See, e.g., Gales v. Commissioner, T.C. Memo.

1999-27.    In substance, however, the up-front payment looks a lot

like the advance in Winter--one that we held was compensation for

personal services subject to a conditional obligation to repay.

Brooks received the payment from Dain as part of his compensation

arrangement and only had to repay it--on a pro rata basis--if he

didn’t stay employed.

     This is a potential problem for the Commissioner.    If

Brooks’s “loan” was compensation for personal services subject to
                                - 6 -

a conditional obligation to repay, then Brooks should have

reported the income from the forgivable note agreement in 1998--

the year he received the money--and not 2003.    And 1998 is not

the tax year before us.

      There are limits to what parties can stipulate, and pure

statements of law that are just plain wrong may well be out of

bounds.   But we read the stipulation in this case as an agreement

that Brooks received at least $506,300--the principal of the

loan--as income in 2003.   Because neither party has argued that

the stipulation on this mixed question of fact and law doesn’t

bind us, we deem this issue waived.5    See Buchsbaum v.

Commissioner, T.C. Memo. 2002-138; see also Bartel v.

Commissioner, 54 T.C. 25 (1970) (applying “duty of consistency”

in similar circumstances even without stipulation).

      We will therefore, like the parties, avert our eyes from

this problem, and turn to the proper treatment of the forgiven

interest.

II.   Deductibility of Forgiven Interest

      The Code generally treats the discharge of indebtedness as

income.   See sec. 61(a)(12).   The reason for the rule is this:   A

borrower who doesn’t have to pay back a loan gets an economic

benefit that is an accession to wealth.    See, e.g., United States


      5
       For the same reason, we also need not decide whether
Brooks should have reported discharge-of-indebtedness income each
year that part of the loan was forgiven.
                               - 7 -

v. Kirby Lumber Co., 284 U.S. 1, 3 (1931); Toberman v.

Commissioner, 294 F.3d 985, 988 (8th Cir. 2002), affg. in part

and revg. in part T.C. Memo. 2000-221.     Discharge-of-indebtedness

income includes both forgiven loan principal and interest.     See

Jelle v. Commissioner, 116 T.C. 63, 66, 69-70 (2001).

     The general rule has exceptions, and section 108(e)(2) is

one of them:   It tells us that a debtor will not realize

discharge-of-indebtedness income to the extent payment of the

liability would’ve given rise to a deduction.     It follows that a

cash-basis taxpayer will not realize discharge-of-indebtedness

income upon the cancellation of accrued interest that--had it

been paid--would’ve been deductible.     See Owens v. Commissioner,

T.C. Memo. 2002-253 n.4, affd. in part, revd. in part and

remanded on other grounds 67 Fed. Appx. 253 (5th Cir. 2003).

     Our task, then, is to determine whether Brooks would’ve been

able to deduct the accrued interest on the loan had he repaid it.

Brooks has the burden of proof here, see Rule 142(a), which means

he must have records sufficient to verify his claims, see sec.

6001; sec. 1.6001-1(a), Income Tax Regs.

     That turns out to be quite important here, because Brooks

argues that the interest that Dain forgave in his case would’ve

been deductible under section 212.     This section allows

individuals to deduct all the ordinary and necessary expenses

paid or incurred for the production of income.     (Note that he
                               - 8 -

doesn’t argue that the interest would’ve been deductible under

section 162 as a trade or business expense.)    He says the loan’s

purpose was to give him a stake to showcase his skills as a

stockbroker to produce income for himself and his wife.    His 2003

return does show a large number of stock trades, and he points to

them as proof that he used the loan to buy a portfolio of stocks.

He argues that this is enough to prove that the forgiven interest

would’ve been deductible as an expense for the production of

income.

     The Commissioner has two counterarguments.    The first is

that Brooks hasn’t even tried to trace the flow of money from the

loan to his investments.   Without evidence showing use of the

loan proceeds to buy stocks or securities, the Commissioner

argues Brooks hasn’t proven he would’ve been entitled to a

deduction under section 212.

     The Commissioner is correct.    We generally allocate interest

expense to the associated debt.    See Kudo v. Commissioner, T.C.

Memo. 1998-404, affd. 11 Fed. Appx. 864 (9th Cir. 2001).    And we

allocate debt by tracing disbursements of the loan proceeds to

specific expenditures.   See id.    We therefore have to look at how

Brooks used his loan proceeds to decide whether the interest

related to that debt would’ve been deductible.    See Hahn v.

Commissioner, T.C. Memo. 2007-75; sec. 1.163-8T(c)(1), Temporary

Income Tax Regs., 52 Fed. Reg. 25000 (July 2, 1987).
                               - 9 -

     Brooks hasn’t given us enough.    The only proof he points to

is the long list of stock transactions that he attached to his

2003 return.   From this he asks us to find that he must have used

the money that Dain lent him in 1998 to assemble a stock

portfolio.   This is quite a stretch, especially considering that

the record is devoid of any bank-account records, brokerage-

account records, or other evidence supporting his claim.    See

sec. 1.163-8T(c)(3) through (5), Temporary Income Tax Regs., 52

Fed. Reg. 25001 (July 2, 1987).   We therefore agree with the

Commissioner that Brooks has not proven he would’ve been entitled

to a deduction under section 212.

     The Commissioner contends as an additional ground that even

if Brooks had shown he used the loan proceeds to buy stock, he

still isn’t entitled to a deduction because of section 163(d)(1).

Section 163 generally allows a deduction for “all interest paid

or accrued within the taxable year on indebtedness.”    Sec.

163(a).   Section 163(a) has its own exceptions, and one of them,

section 163(h), says that an individual taxpayer may not deduct

personal interest.   See sec. 163(h)(1).   The exception has its

own exception, and excludes from the definition of personal

interest “investment interest.”   See sec. 163(h)(2)(B).

     This is an important exclusion, because section 163(d)

limits the deduction of investment interest to a taxpayer’s net

investment income--the excess of investment income over
                               - 10 -

investment expenses--for his tax year.6     This limitation

overrides not only section 163, but all of chapter 1 (which

includes section 212).    See sec. 163(d)(1) (“the amount allowed

as a deduction under this chapter for investment interest for any

taxable year shall not exceed the net investment income of the

taxpayer for the taxable year”); Robinson v. Commissioner, 119

T.C. 44, 48-49 (2002).    This means that even if Brooks had been

entitled to an interest deduction under section 212, section

163(d) would’ve limited it.7

     Section 163(d)(3)(A) defines investment interest as interest

on indebtedness that is properly allocable to property held for

investment.   Property is held for investment if it produces

income in the form of interest, dividends, annuities, or

royalties not derived in the ordinary course of a trade or

business (i.e., portfolio income).      See secs. 163(d)(5)(A),

469(e)(1).    Because stock is a type of property that normally

pays dividends, it is property held for investment.      See Russon

v. Commissioner, 107 T.C. 263, 270-71 (1996).




     6
       And there is even an exception to that exclusion--a
taxpayer unable to deduct investment interest in one year may
carry it forward to later years. See sec. 163(d)(2).
     7
       As we recognized in Malone v. Commissioner, T.C. Memo.
1996-408: “The limits of section 163(d) would be undermined if
taxpayers could deduct under section 212 interest which is not
deductible under section 163(d).”
                                - 11 -

     If Brooks used the loan to buy a stock portfolio--as he

claims he did--then the interest on the loan would be

attributable to the stock.    See sec. 1.163-8T(c)(1), Temporary

Income Tax Regs., supra.     That would make interest on the loan

investment interest subject to section 163(d)(1)’s limitation.

     But if interest on the loan was investment interest, Brooks

would’ve been entitled to a deduction for that interest only to

the extent his investment income exceeded his investment interest

and other investment expenses for 2003.    Brooks has not, however,

shown or argued that his investment income exceeded his

investment expenses for 2003.    His 2003 return reports that he

had net investment income of only $25 and makes no mention of the

forgiven interest.   We therefore agree with the Commissioner that

if Brooks had used the proceeds of the loan to purchase stocks or

securities, he still wouldn’t have been entitled to deduct the

interest for 2003.

     Since Brooks has not shown that the $144,042.35 in forgiven

interest would’ve been deductible interest, he may not reduce his

2003 discharge-of-indebtedness income by that amount.    The

parties’ having settled the other issues in the case,


                                           Decision will be entered

                                      under Rule 155.
