Appeal from a decision by the Tax Court holding that a mortgage "seller-servicer," required to purchase Federal National Mortgage Association stock as a seller and to retain it for an average period of fifteen years as a servicer, was entitled to consider the restriction on sale in determining the stock's fair market value and, therefore, to deduct seventy-five percent of the price paid for the stock as a business expense pursuant to section 162(d) of the Internal Revenue Code. Judgment reversed.
Before Feinberg, Chief Judge, Oakes, Circuit Judge, and Neaher, District Judge.*fn*
This appeal by the Commissioner from an adverse ruling of the Tax Court presents the somewhat abstruse question whether a "seller-servicer" of mortgages required to buy Federal National Mortgage Association (FNMA) stock as a seller, and to retain it as a servicer, is entitled to deduct as a business expense a portion of the price it paid for the FNMA stock by virtue of section 162(d) of the Internal Revenue Code. The Tax Court, Richard C. Wilbur, Judge, held that the statutory reference in section 162(d) to "fair market value" mandates that the ownership requirement on the servicer be taken into account so as to reduce the present value of the FNMA stock and thereby permit a business expense deduction. The Commissioner argues on appeal that section 162(d) does not apply in this case to permit such a deduction because the quoted market price of FNMA stock was at all times greater than the issuance price paid by appellee Eastern Service Corporation as a seller of mortgages to FNMA. The Commissioner contends that the application of section 162(d) was erroneous because it was premised on treating Eastern's stock as if it were a "restricted" stock for purposes of determining "fair market value" when, in fact, the stock was freely alienable and could be sold at any time. Indeed, it is the Commissioner's position that the FNMA stock was a capital asset necessary to Eastern's business and that the acquisition cost of the stock is nondeductible. We agree with the Commissioner and, therefore, reverse the decision of the Tax Court.
Appellee Eastern was a mortgage seller-servicer during 1969, the tax year in issue. In its business, Eastern originated mortgage loans on residential properties and sold the loans to permanent institutional investors, including FNMA. After the sales Eastern serviced the accounts of the institutional investors, collecting the monthly payments under the mortgages and remitting the funds to the investor, to taxing authorities, and to insurance companies.*fn1 For performing these duties, Eastern received a servicing fee amounting to about one-half of one percent of the mortgage principal.
Eastern preferred to sell mortgages to institutional investors other than FNMA because FNMA exacted a nonrefundable commitment fee and had certain stock purchase and stock retention requirements. But in periods of tight credit, Eastern and other mortgage sellers turned increasingly to FNMA, which could gather funds for the mortgage market because of its size and its preferred borrowing status as a federally-sponsored credit agency. In fact, during 1968 and thereafter FNMA was the principal purchaser of mortgages originated by Eastern. These mortgages typically have a twenty-five to thirty-year term, but if the home is sold, the owner refinances, or the mortgage is prepaid, then the life of the mortgage will be shorter. The average life of the FNMA mortgages serviced by Eastern during 1969, the tax year in question, was approximately fifteen years.DP1 Under the FNMA Charter Act, when mortgage sellers such as Eastern sell mortgages to FNMA, they must make nonrefundable capital contributions to FNMA as measured by a percentage of the unpaid mortgage principal. 12 U.S.C. § 1718(b).*fn2 In return for these capital contributions mortgage sellers are issued shares of FNMA's common stock. Prior to September 1968, sellers to FNMA, who made the capital contribution and received FNMA stock, could resell the stock without any restriction. In 1968, however, Congress amended section 303(c) of the FNMA Charter Act, 12 U.S.C. § 1718(c), to require each FNMA mortgage servicer to own a minimum amount of FNMA stock.*fn3
In 1969, Eastern originated first mortgage loans totalling $56,300,000 of which some $33,000,000 worth were sold to FNMA. Pursuant to the stock purchase requirements, Eastern retained the minimum amount of FNMA stock required of it as a servicer, which, allowing for subsequent stock splits, came to some 59,216 shares and which had an aggregate purchase price of $498,513. In its 1969 federal income tax return Eastern reduced its otherwise taxable income by this $498,513. Eastern believed that the requirement that it retain ownership of a specified amount of FNMA stock for the life of the mortgages it was servicing for FNMA made the fair market value of the stock far less than the price paid for it and, thus, justified the deduction. But the Commissioner took exception to Eastern's treatment and determined a deficiency of $281,639 in Eastern's income tax. The Tax Court heard the case and adopted in large part Eastern's position, ruling that the fair market value of the FNMA stock was only twenty-five percent of its market price and, accordingly, that under section 162(d) of the Internal Revenue Code,*fn4 Eastern was entitled to deduct seventy-five percent of the price of its FNMA stock on its 1969 tax return. Eastern Service Corp. v. Commissioner, 73 T.C. 833 (1980). From the Tax Court's decision, the Commissioner now appeals.
1 Although this is a case of first impression, the tax treatment of FNMA stock purchases has long been of concern to mortgage companies, the Internal Revenue Service, the Tax Court, and the Congress. It is helpful, therefore, in order to reach a solution to the instant case to review briefly the history of this problem.
1 During the period from 1954 to September 1968, when FNMA operated as a quasi-governmental corporation, FNMA raised private capital from the financial institutions that sold mortgages to it by requiring them to make nonrefundable capital contributions equal to a specified percentage of the outstanding mortgage principal. In exchange for these payments, FNMA issued shares of its non-voting, $100 par value common stock to the mortgage sellers. The problem, however, was that the mortgage sellers had to purchase the prescribed amounts of FNMA stock at the par value of $100, while the price of the stock on the open market was appreciably less. Although commentators generally felt that the difference between par and market value should be regarded as a business expense, deductible in the year of issue, e. g., Mertens, Law of Federal Income Taxation, Code Commentary § 162(d), at 278 (1979), the Commissioner initially took the position that the entire purchase price must be capitalized, with no allowance for business expense deductions, Rev.Rul. 58-41, 1958-1 C.B. 86.*fn5
1 Congress, viewing the Commissioner's ruling as unfair to mortgage sellers, effectively overruled the Commissioner's position when in 1960 it enacted section 162(d) of the Internal Revenue Code,*fn6 explicitly allowing a business deduction for mortgage sellers whenever the amount of capital contributions for the FNMA stock exceeded the fair market value of that stock on the date of issuance.*fn7 After Congress enacted section 162(d), the Tax Court decided Ancel Greene & Co. v. Commissioner, 38 T.C. 125 (1962), involving a tax year prior to the effective date of section 162(d). The court followed in principle section 162(d), holding that only the fair market value of the FNMA stock rather than the entire purchase price was includable in the taxpayer's gross income.*fn8 The Commissioner subsequently acquiesced in the Ancel Greene decision by revoking the prior revenue ruling, but the Commissioner nonetheless ruled that Ancel Greene had no application to transactions after the effective date of section 162(d). Rev.Rul. 63-44, 1963-1 C.B. 11.
1 Then in 1968 the rules governing private shareholder transactions with FNMA changed and it is from this change that the problem in the case at bar arises. Prior to September 1, 1968, there were no restrictions on the resale of stock acquired by a mortgage seller-servicer that sold mortgages to FNMA. But the 1968 amendment to section 303(c) of the FNMA Charter Act, 12 U.S.C. § 1718(c), converted FNMA into a privately-owned corporation and required a mortgage servicer to hold a specified minimum amount of FNMA stock for the life of each mortgage it serviced for FNMA. Regulations promulgated by FNMA under section 303(c) of the FNMA Charter Act and incorporated into its mortgage servicing contracts, also required that prescribed amounts of FNMA stock be owned as a condition of servicing home mortgages purchased by FNMA.
For the purposes of this case, the parties have stipulated that the mean bid and asked price of the FNMA stock in the over-the-counter market at all relevant times was not less than the issue price of the FNMA stock purchased by Eastern. This means that the capital contributions Eastern was required to make for the FNMA stock were not in excess of the price that the stock was selling for on the open market; but with the retention requirements Eastern could not sell the stock so long as it serviced the outstanding mortgages. What we must decide, then, is the applicability of section 162(d) of the Internal Revenue Code, and its ...