                       T.C. Memo. 1998-116



                     UNITED STATES TAX COURT



          GERALD P. AND ABBE L. KEANE, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 23705-95.                    Filed March 23, 1998.



     Fred Alan Jones, for petitioners.

     Laurel M. Robinson, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     DEAN, Special Trial Judge:   This case was heard pursuant to

section 7443A(b)(3) and Rules 180, 181, and 182.1




     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue. All
Rule references are to the Tax Court Rules of Practice and
Procedure.
                               - 2 -


     Respondent determined deficiencies in petitioners' Federal

income taxes in the following amounts:



               Year            Deficiency
               1991              $2,676
               1992                 855
               1993               2,446


     After concessions by both parties,2 the remaining issue for

decision is whether interest payments made on a promissory note

executed pursuant to a settlement agreement with the U.S.

Department of Health and Human Services qualify as deductible

expenses.

     At the time their petition was filed, petitioners resided in

Hillsborough, California.   Some of the facts have been stipulated

and are so found.   The stipulation of facts and the accompanying

exhibits are incorporated herein by reference.

                         FINDINGS OF FACT

     Petitioner Gerald P. Keane is a physician, and petitioner

Abbe L. Goll-Keane is a registered nurse.   Hereinafter references

to "petitioner" refer to petitioner Gerald P. Keane.




     2
      Petitioners concede Schedule C interest deductions for
1991, 1992, and 1993 to Academic Financial Services of $592,
$479, and $317, respectively, and to the University of Rhode
Island of $38, $29, and $16, respectively. Respondent concedes
Schedule C interest paid by petitioners to First Interstate Bank
in 1993 of $1,938.
                               - 3 -


     Petitioner graduated from Brown University Medical School

(Brown) in June 1982.   While he was a student from 1978 through

1982, he received yearly tuition scholarships totaling $45,805

from the Department of Health, Education and Welfare (now called

the Department of Health and Human Services (DHHS)), as part of

the National Health Service Corps (NHSC) scholarship program.    As

a condition of receiving this award, petitioner was obligated

upon graduation to serve as a Public Health Service commissioned

officer or a civilian member of the National Health Service Corps

in a designated area for a number of years equivalent to the term

of the award.

     After graduating from Brown in June 1982, petitioner began

his internship and residency at Stanford University Medical

Center (Stanford) in the physical medicine and rehabilitation

program.   Petitioner's service requirement with NHSC was

scheduled to begin upon his graduation from Brown, but petitioner

expected to receive a deferment of his obligation until he

completed the graduate training program at Stanford.

     DHHS agreed to the deferment of his service obligation the

first year it was requested, which was until July 1, 1983, but

when petitioner reapplied for the remaining years, DHHS refused

to grant subsequent deferments based on policy changes in the

program.   On July 1, 1983, when petitioner was denied deferment

for his second year of the Stanford graduate training program, he
                                - 4 -


made the decision not to leave Stanford to fulfill his service

obligation because he believed to do so would affect his standing

in the program.    DHHS thereafter regarded him as in default and

liable to the United States for repayment of the scholarship

money plus damages pursuant to a treble damages clause in the

contract.    Health Professional Educational Assistance Act of

1976, Pub. L. 94-484, sec. 408(b)(1), 90 Stat. 2243, 2286, 42

U.S.C. sec. 254o(b)(1) (Supp. IV, 1981).

     Petitioner, believing he was not in default, filed a civil

suit in the United States District Court for the District of

Columbia against the Secretary of DHHS in Keane v. Bowen, Civil

Action No. 86-02574-SS.

     In October 1987, petitioner reached a settlement with DHHS,

and the case was dismissed.    Under the terms of the agreement, a

promissory note was executed whereby petitioner agreed to pay

$125,000 to DHHS representing the $45,805 in original principal

and $79,195 in previously accrued interest.    Additional interest

on the unpaid balance was also due at the rate of 7.22 percent

per annum.

     In taxable years 1991, 1992, and 1993, petitioners claimed

Schedule C business deductions for the interest paid on the

promissory note in the amounts of $7,249, $5,220, and $5,409,

respectively.   Respondent disallowed these deductions on the
                               - 5 -


grounds that they were neither business expenses under section

162 nor deductible interest expenses under section 163.

                              OPINION

     Respondent contends that the interest payments on the

promissory note are nondeductible personal expenses.   The

interest accrued on funds that were characterized in the

promissory note as petitioner's "medical school tuition and

expenses".3   Therefore, respondent argues that these payments are

of a personal nature and do not qualify as either section 162

business expenses or section 163 interest expenses.

     Petitioner's position is that the interest payments are

deductible business expense because settlement of his claim with

DHHS allowed petitioner to avoid his medical service obligation

thereby enabling him to devote more time to his medical practice.


     3
      The Settlement Agreement and Mutual Release signed on
behalf of the Secretary and the petitioner states:

          1. Dr. Keane shall pay to the Secretary the principal
     sum of one hundred twenty-five thousand dollars
     ($125,000.00), (representing forty-five thousand eight
     hundred and five dollars ($45,805.00) in original principal
     (i.e., the monies expended on Dr. Keane's behalf for his
     medical school tuition and expenses), plus previously
     accrued interest totaling seventy-nine thousand one hundred
     ninety-five dollars ($79,195.00) claimed by the Secretary
     under 42 U.S.C. Section 254o(b)(1)), plus additional
     interest on the unpaid balance compounded at the rate of
     seven and twenty-two one-hundreths [sic] percent (7.22%) per
     annum, in a single lump-sum payment plus quarterly
     installments as set forth in the Promissory Note which is
     appended to this Agreement as Attachment 1. [Emphasis
     added.]
                                - 6 -


Pursuit of his medical practice is a profit generating business

activity which generates taxable income, and this, petitioner

argues, should entitle him to deductions under sections 162 or

163.    The interest incurred is not related to the repayment of

medical school tuition and expenses, petitioner argues; rather,

the agreement is an entirely new contract and should be examined

independently from the original scholarship agreement with DHHS.

       Even if the payments under the agreement do not constitute

repayment of student loans, respondent argues they are repayments

of a qualified scholarship under section 117, meaning that

interest payments incurred during repayment are not deductible

because they are directly related to the production of tax-exempt

income and are subject to the nondeductibility limitations of

section 265.

       The issue for decision is whether petitioner may deduct the

interest portion of the payments he made pursuant to the

settlement agreement with DHHS in 1987.    Deductions are strictly

a matter of legislative grace, and petitioner must prove his

entitlement to any deductions claimed.    Rule 142(a); INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice

Co. v. Helvering, 292 U.S. 435, 440 (1934).    If petitioner can

prove the interest payments were an expense incurred in carrying

on his trade or business, he may be entitled to business expense

deductions under section 162.    Alternatively, if petitioner can
                                 - 7 -


prove that his interest payments are not of a personal nature, he

may qualify for interest deductions under section 163.

 Section 162 - Trade or Business Expense

     A deduction shall be allowed for all ordinary and necessary

expenses paid during the taxable year in carrying on a taxpayer's

trade or business.     Sec. 162; sec. 1.162-1, Income Tax Regs.      An

expense is ordinary if it arises out of the normal operations of

the business.   Deputy v. du Pont, 308 U.S. 488 (1940).      An

expense is necessary if it is appropriate and helpful to the

taxpayer's business.     Welch v. Helvering, 290 U.S. 111, 114

(1933).   Interest payments on a settlement may be deducted if the

payments have a business origin and are proximately related to

the taxpayer's trade or business.        United States v. Gilmore, 372

U.S. 39, 49 (1963); Deputy v. du Pont, supra at 493-494; Harden

v. Commissioner, T.C. Memo. 1991-454.

     Business origin is described as the "character of the claim

with respect to which an expense was incurred".       United States v.

Gilmore, supra at 49.     It is not the consequence of the

litigation on the taxpayer's trade or business; it is the origin

of the underlying claim which is determinative.       United States v.

Gilmore, supra.   The question to be answered is, out of what kind

of transaction did petitioner's interest expenses arise.          Boagni

v. Commissioner, 59 T.C. 708, 713 (1973).
                                - 8 -


     In this case, petitioner's interest expenses arose out of

the settlement of his lawsuit with DHHS.    The settlement

agreement was entered into to determine the respective rights of

the parties as a result of petitioner's declaratory judgment

lawsuit.4   Petitioner correctly points out that the 1987

settlement agreement is a completely new contract between

petitioner and DHHS.    But the fact that a new contract has been

entered does not affect the nature of the claim.    We must look

behind this new agreement to the underlying claim which brought

about the settlement.    The lawsuit itself was the reason for the

settlement and subsequent interest payments, so we must examine

the underlying nature of the lawsuit to determine whether it has

a business origin.

     The underlying claim of the lawsuit between petitioner and

DHHS relates to the NHSC scholarship contract.    Therefore, the

interest payments were made pursuant to the settlement of this

contract dispute.    The NHSC contract provided that petitioner

would receive scholarship tuition from DHHS in exchange for his

promise to serve as an employee of DHHS for a term of years

following graduation.    Generally, education expenditures are


     4
      Petitioner argues that his primary motive in settling the
lawsuit with DHHS was to eliminate the chance that he would have
to interrupt his medical practice to perform services for DHHS.
The record, however, indicates that this was not a realistic
possibility. DHHS sought from petitioner money damages, not
specific performance.
                                - 9 -


deductible only if they are incurred to maintain or improve the

taxpayer's employment or to meet the express requirements of the

job.    Sec. 1.162-5(a), Income Tax Regs.

       Educational expenses incurred to allow the taxpayer to meet

the minimum educational requirements for his job qualification

are considered personal expenses and are not deductible.      Taubman

v. Commissioner, 60 T.C. 814, 819 (1973) (law school expenses not

deductible when legal education prepared taxpayer for new

career); sec. 1.162-5(b), Income Tax Regs.    In this case,

petitioner is repaying money he received as a tuition scholarship

while studying for his medical degree at Brown.     A medical degree

is a necessary step to practice medicine as a doctor.     Repayment

of these funds under the NHSC contract is therefore a personal

expense because the funds were originally expended to enable him

to enter into a new profession.    Petitioner's interest payments

are personal expenditures and not incurred in carrying on a trade

or business.    Deductions for them are disallowed under section

162.

Section 163 - Interest Deduction

       Petitioner alternatively argues that his interest payments

are deductible under section 163.    Generally, section 163

provides that interest on indebtedness is deductible by the

taxpayer in the year it is paid.    Sec. 163(a).   However,

substantial limitations are placed on this general rule which may
                             - 10 -


limit or prohibit the taxpayer from deducting indebtedness

interest at all.

     Section 163(h) provides that for an individual taxpayer,

personal interest is nondeductible.   Personal interest is defined

in section 163(h)(2) as the residual of what remains after

considering five enumerated exceptions.   These exceptions are:

          (A) interest paid or accrued on indebtedness
     properly allocable to a trade or business (other than
     the trade or business of performing services as an
     employee),

          (B) any investment interest (within the meaning
     of subsection (d)),

          (C) any interest which is taken into account
     under section 469 in computing income or loss from a
     passive activity of the taxpayer,

          (D) any qualified residence interest (within the
     meaning of paragraph (3)), and

          (E) any interest payable under section 6601 on
     any unpaid portion of the tax imposed by section 2001
     for the period during which an extension of time for
     payment of such tax is in effect under section 6163 or
     6166 or under section 6166A (as in effect before its
     repeal by the Economic Recovery Tax Act of 1981).


Section 163(h)(2).

     The first exception relating to interest paid on a trade or

business expense is the only exception that potentially relates
                               - 11 -


to petitioner's case.5   Petitioner maintains that the settlement

of his claim with DHHS was a decision made out of concern for his

private medical practice, and thus payments made pursuant to the

agreement are in pursuit of his trade or business.   This is

essentially the same argument he makes in support of

deductibility under section 162.

     Similar to our section 162 analysis, interest on

indebtedness must be allocated in the same manner as its

underlying debt.   Sec. 1.163-8T, Temporary Income Tax Regs., 52

Fed. Reg. 24999 (July 2, 1987).    Underlying debt is allocated by

tracing specific disbursements of the proceeds to specific

expenditures.   Sec. 1.163-8T, Temporary Income Tax Regs., 52 Fed.

Reg. 24999 (July 2, 1987).    If the underlying debt is incurred as

a personal expenditure, the interest on that debt may not be

deducted under section 163.   Sec. 1.163-8T(a)(4)(ii), Ex. 1,

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

     Personal expenditures are defined in the Temporary Income

Tax Regs., section 1.163-8T(b)(5), 52 Fed. Reg. 25000 (July 2,

1987), as any expenditure that is not a trade or business

expenditure, a passive activity expenditure, or an investment


     5
      The record is devoid of facts or argument which suggests
that petitioner's indebtedness interest is allocable to property
held for investment, sec. 163(h)(2)(B), passive activity, sec.
163(h)(2)(C), a qualified residence, sec. 163(h)(2)(D), or
interest on any unpaid portion of tax imposed by sec. 2001, sec.
163(h)(2)(E).
                              - 12 -


expenditure.   We have already concluded that the payments do not

constitute trade or business expenditures, and petitioner has

offered nothing to show that his interest payments relate to

either passive activity or investment expenditures.   We therefore

hold petitioner may not deduct his interest payments under

section 163.

Section 265 - Tax Exempt Income

     Respondent argues that section 265 also prevents petitioner

from deducting the interest expenses here at issue.   Because the

Court concludes that petitioner's interest payments are not

deductible under either section 162 or 163, we decline to examine

the implications of section 265 on petitioner's scholarship

repayment.

     For the foregoing reasons, we sustain respondent's

determination that petitioner is liable for the deficiency

relating to the deduction of his interest payments for 1991,

1992, and 1993.

     To reflect the foregoing,

                                         Decision will be entered

                                    under Rule 155.
