Madison Gas and Electric Company v. Commissioner, KTC 1980-17(7th Cir. 1980)
UNITED STATES COURT OF APPEALS
FOR THE SEVENTH CIRCUIT
MADISON GAS AND ELECTRIC COMPANY, Appellant v. COMMISSIONER OF INTERNAL
REVENUE, Appellee.
Docket: No. 80-1380 Filed October 27, 1980
On Appeal from the Decision of the United States Tax Court
OPINION
Before: CUMMINGS and WOOD, Circuit Judges, and CAMPBELL, Senior
District Judge. <
CUMMINGS, Circuit Judge:
This is an action under 26 U.S.C. section 7422 for the refund of
federal income taxes. The question is whether certain training and related
expenses incurred by a public utility in the expansion of its generating
capacity through the joint construction and operation of a nuclear plant
with two other utilities are deductible as ordinary and necessary expenses
in the years of payment or are non-deductible pre-operating capital
expenditures of a new partnership venture. The Tax Court in an opinion
reported at 72 T.C. 521 held that they are non-deductible capital
expenditures. We affirm.
I. All relevant facts have been stipulated by the parties (App. 8-41)
and found and set forth at length by the Tax Court. We find it necessary
to summarize them only briefly. Taxpayer Madison Gas and Electric Co.
(MGE), a Wisconsin corporation, is an operating public utility which has
been engaged since 1896 in the production, purchase, transmission and
distribution of electricity and the purchase and distribution of natural
gas. MGE is subject to the jurisdiction and regulation of the Public
Service Commission of Wisconsin (PSC) and the Nuclear Regulatory
Commission. The Federal Energy Regulatory Commission (FERC) also has or
may have jurisdiction over MGE.
MGE is required to furnish reasonably adequate service and facilities
within its service area at rates found reasonable and just by the PSC.
During 1969 and 1970, the tax years here in issue, MGE rendered service to
some 73,000 residential and commercial customers in a service area of
approximately 200 square miles in Dane County, Wisconsin. MGE also sells a
small percentage of its electrical power to other utilities in Wisconsin.
Its primary responsibility, however, is to its customers in the service
area. The number of customers within that area has grown rapidly and
continuously during the past 25 years, and the customer demand for
electricity has increased with the expansion of commercial and industrial
accounts, the substitution of electricity for other forms of energy, and
the increasing prevalence of high-energy devices such as air-conditioning
units. Thus at the time of trail MGE was servicing almost 90,000
residential, commercial and industrial customers.
MGE has over the years kept pace with the increasing demand for
electrical power and provided it at reasonable rates by expanding the
generating capacity of its facilities, contracting for the purchase and
sale of excess electrical power, interconnecting transmission facilities
with those of other Wisconsin utilities, and finally by building and
operating additional facilities in conjunction with other utilities.
Expenses incurred in connection with one of these joint ventures is the
subject of the present suit.
On February 2, 1967, MGE entered into an agreement, entitled "Joint
Power Supply Agreement" (Agreement) (App. 42-59), with Wisconsin Public
Service Corporation (WPS) and Wisconsin Power and Light Co. (WPL) under
which the three utilities agreed, inter alia, to construct and own
together a nuclear generating plant now known as the Kewaunee Nuclear
Power Plant (Plant). Under the Agreement, the Plant is owned by MGE, WPS
and WPL as tenants-in-common with undivided ownership interests of 17.8%,
41.2% and 41.0% respectively. Electricity produced by the Plant is
distributed to each of the utilities in proportion to their ownership
interests. Each utility sells or uses its share of the power as it does
power produced by its own individually owned facilities, and the profits
thereby earned by MGE contribute only to MGE's individual profits. No
portion of the power generated at the Plant is offered for sale by the
utilities collectively, and the Plant is not recognized by the relevant
regulatory bodies as a separate utility licensed to sell electricity. Each
utility also pays a portion of all expenditures for operation, maintenance
and repair of the Plant corresponding exactly to its respective share of
ownership. Under utility accounting procedures mandated by the PSC and the
FERC, these expenses are combined with and treated in the same manner by
MGE as expenses from its individually owned facilities. The ownership and
operation of the Plant by MGE, WPS and WPL is regarded by the PSC and FERC
as a tenancy-in-common. It was the intention of the utilities to create
only a co-tenancy and not a partnership and to be taxed as co-tenants and
not as partners.
In its 1969 and 1970 taxable years, MGE incurred certain expenses
relating to the nuclear training of WPS employees, the establishment of
internal procedures and guidelines for plant operation and maintenance,
employee hiring activities, nuclear field management, environmental
activities and the purchase of certain spare parts (App. 116-126). MGE had
to incur these expenses in order to carry out its Plant activities.
Pursuant to order of the PSC, MGE was required to amortize training
expenses, net of income taxes, over a 60-month period from the date of
commercial operation of the Plant, a date occurring after those in issue
here, and the other non-construction expenses associated with the Plant,
net of income taxes, over a three-year period beginning January 1, 1973,
MGE did not deduct the expenses described above on its tax returns for
1969 and 1970, but in the Tax Court claimed a deduction for them by
amendment to its refund petition in the total amounts of $33,418.45 and
$114,434.27 for 1969 and 1970 respectively.
MGE's position was, and is, that the claimed expenses were currently
deductible under Section 162(a) of the Internal Revenue Code of 1954
(Code) as ordinary and necessary business expenses. The Commissioner's
position was, and is, that the claimed expenses were nondeductible capital
expenditures. The Tax Court agreed with the Commissioner, holding that the
operation of the Plant by MGE, WPS and WPL is a partnership within the
meaning of Section 7701(a)(2) of the Code, that the expenses in question
were incurred not in the carrying out of an existing business but as part
of the start-up costs of the new partnership venture, and that the
expenses were therefore not currently deductible but must be capitalized
under Section 263(a) of the Code. MGE appeals from this judgment, arguing
that its arrangement with WPS and WPL is not a partnership within the
meaning of the Code and, alternatively, that even if it is a partnership
the expenses are currently deductible.
II. The threshold issue is whether MGE's joint venture with WPS and WPL
is a tax partnership. The Commissioner concedes that if is not, the
expenses are currently deductible under Section 162(a). <> A
partnership for federal tax purposes is defined by the Code in Section
7701(a)(2), which provides in pertinent part:
"The term 'partnership' includes a syndicate, group, pool, joint venture,
or other unincorporated organization, through or by means of which any
business, financial operation, or venture is carried on, and which is not,
within the meaning of this title, a trust estate or a corporation."
MGE's arrangement with WPS and WPL in connection with the Plant clearly
establishes an unincorporated organization carrying on a "business,
financial operation, or venture" and therefore falls within the literal
statutory definition of a partnership. The arrangement is, of course, not
taken out of this classification simply because the three utilities
intended to be taxed only as a co-tenancy and not as a partnership. While
it is well-settled that mere co-ownership of property does not create a
tax partnership, see, e.g., Estate of Appleby v. Commissioner, 41 B.T.A.
18 (1940), co-owners may also be partners if they or their agents carry on
the requisite "degree of business activities." Powell v. Commissioner, 26
T.C.M. 161 (1967); Hahn v. Commissioner, 22 T.C. 212 (1954).
MGE's argument is that a co-tenancy does not meet the business
activities test of partnership status unless the co-tenants anticipate the
earning and sharing of a single joint cash profit from their joint
activity. Because its common venture with WPS and WPL does not result in
the division of cash profits from joint marketing, MGE contends that the
venture constitutes only a co-tenancy coupled with an expense-sharing
arrangement and not a tax partnership. The Tax Court held that the Code
definition of partnership does not require joint venturers to share in a
single joint cash profit and that to the extent that a profit motive is
required by the Code it is met here by the distribution of profits in
kind. We agree.
The definition of partnership in Section 7701(a)(2) was added to the
Code by Section 1111(a) of the Revenue Act of 1932 and first appeared in
Section 3797(a)(2) of the 1939 Code. The Congressional Reports
accompanying the 1932 Act make clear, in largely identical language, that
Congress intended to broaden the definition of partnership for federal tax
purposes to include a number of arrangements, such as joint ventures,
which were not partnerships under state law. H.R. Rep. No. 708, 72d Cong.,
1st Sess., 53 (1932); S. Rep. No. 665, 72d Cong., 1st Sess., 59 (1932). In
so doing they briefly discuss the advantages of requiring a partnership
return for joint venturers rather than leaving the sole responsibility for
reporting annual gains and losses on the individual members. MGE invites
us to infer from these discussions that Congress contemplated inclusion
only of those joint ventures that are capable of producing joint cash
gains and losses. But even if we were inclined to narrow the statutory
language on the basis of such slender evidence, the subsequent legislative
history would dissuade us from reaching MGE's suggested construction.
In Bentex Oil Corp. v. Commissioner, 20 T.C. 565 (1953), the Tax Court
held that an unincorporated organization formed to extract oil under an
operating agreement which called for distribution of oil in kind was a
partnership within the meaning of Section 3797(a)(2) of the 1939 Code. The
Bentex joint venture is not distinguishable from that presented here in
any meaningful way. The co-owners there, as here, shared the expenses of
production but sold their shares of the production individually.
Following, Bentex, Congress reenacted the definition of partnership in
Section 3797(a)(2) of the 1939 Code without change as Section 7701(a)(2)
of the 1954 Code. In addition, it repeated the definition verbatim in
Section 761(a), which permits certain qualifying organizations to elect to
be excluded from application of some or all of the special Subchapter K
partnership provisions. A qualifying corporation is one which is used.
"(1) for investment purposes only and not for the active conduct of a
business, or
"(2) for the joint production, extraction, or use of property, but not
for the purpose of selling services or property produced or extracted, if
the income of the members of the organization may be adequately determined
without the computation of partnership taxable income."
In short, Section 761(a) allows unincorporated associations such as the
Bentex venture and the one in issue here, which fall within the statutory
definition of partnership, to elect out of Subchapter K. <> The
Section has generally been interpreted, in the absence of any legislative
history, as approving the Bentex decision while providing relief from
certain resulting hardships. See, e.g., Williams, Joint Operation of
Jointly Owned Natural Resources, 10 Oil and Gas Quarterly 149 (1961);
Taubman, Oil and Gas Partnerships and Section 761(a), 12 Tax L. Rev. 49
(1956). This interpretation is surely correct for, as the Tax Court
observed:
"[i]f distribution in kind of jointly produced property was enough to
avoid partnership status, we do not see how such distribution could be
used as a test for election to be excluded from the partnership provisions
of subchapter K" (72 T.C. at 563).
MGE also relies on Treasury Regulation Sections 301.7701-3 and 1.761-1(a)
(26 C.F.R.) to support its argument that joint marketing is a sine qua non
of partnership status. These Sections state in identical language that
tenants in common
"may be partners if they actively carry on a trade, business, financial
operations, or venture and divided the profits thereof"
In addition, MGE cites to us case law referring to a joint profit motive
as a characteristic of partnerships. <> See, e.g., Commissioner
v. Tower, 327 U.S. 280, 286 ("community of interest in the profits and
losses"); Ian Allison v. Commissioner, 35 T.C.M. 1069 (1976) ("an
agreement to share profits"). Neither the above-quoted Treasury Regulation
Sections nor the case law distinguish between the division of cash profits
and the division of in-kind profits, and none of the cited cases involved
in-kind profits. Moreover, while distribution of profits in-kind may be an
uncommon business arrangement, recognition of such arrangements as tax
partnerships is not novel. See e.g., Bentex, supra; Luckey v.
Commissioner, 334 F.2d 719 (9th Cir. 1965); Bryant v. Commissioner, 46
T.C. 848, affirmed, 399 F.2d 800 (5th Cir. 1968). <>
The practical reality of the venture in issue here is that jointly
produced electricity is distributed to MGE and the other two utilities in
direct proportion to their ownership interest for resale to consumers in
their service areas or to other utilities. The difference between the
market value of MGE's share of that electricity and MGE's share of the
cost of production obviously represents a profit. Just as obviously, the
three utilities joined together in the construction and operation of the
Plant with the anticipation of realizing these profits. The fact that the
profits are not realized in cash until after the electricity has been
channeled through the individual facilities of each participant does not
negate their joint profit motive nor make the venture a mere
expense-sharing arrangement. <> We hold therefore that MGE's
joint venture with WPS and WPL constitutes a partnership within the
meaning of Sections 7701(a)(2) and 761(a) of the Code.
III. On the ultimate issue in this case, the Tax Court held that the
claimed expenses were incurred as preoperational costs of the partnership
venture and therefore under settled law were non-deductible capital
expenditures. See Richmond Television Corp. v. United States, 345 F.2d 901
(4th Cir. 1965), vacated on other grounds, 382 U.S. 68. MGE argues that
this holding elevates form over substance in that even if the operating
arrangement is technically a tax partnership, the claimed expenses were in
actuality simply ordinary and necessary expenses of expanding its existing
business. MGE asks us therefore to ignore the partnership entity as
lacking economic substance.
In support of its position, MGE relies heavily on First National Bank
of South Carolina v. United States, 558 F.2d 721 (4th Cir. 1977); First
Security Bank of Idaho N.A. v. Commissioner, 63 T.C. 644 (1975); and
Colorado Springs National Bank v. United States, 505 F.2d 1185 (10th Cir.
1974). In those cases, the respective courts held that the initial costs
incurred by banks participating in non-profit associations set up as
clearinghouses for a credit card system were deductible as ordinary and
necessary business expenses because participation in a credit card system
was not a new business venture but merely a new way of conducting an old
business. These cases are not on point. Participation in the credit card
associations had no extrinsic or marketable value, created no property
right and did not entitle the participants to any distribution of profits,
either cash or in-kind. There was no suggestion in those cases whatsoever
that the banks had by participating in the association created a new
partnership venture with other banks, and the courts were not asked to
ignore partnership status. The question was whether the costs were
necessary and ordinary current expenses or capital investments in future
economic benefits.
Here MGE, WPS and WPL are engaged in the joint production of
electricity for resale, a joint venture for profit. Because they were each
already in the business of selling electricity, it can, of course, be
argued that the partnership venture itself is an extension or expansion of
their existing businesses. It does not follow from this though that we
should ignore the partnership as lacking economic substance. Such
reasoning would lead to the absurd conclusion that any partnership
established to do collectively what its participants formerly did
individually or continue to do individually outside the partnership lacks
economic substance and should not be treated as a partnership for tax
purposes.
At bottom, MGE's position is that it is not sound policy to treat the
entity here as a partnership. But we are not free to rewrite the tax laws,
whatever the merits of MGE's position. Under the Internal Revenue Code the
joint venture here is a partnership and the expenses were non-deductible,
pre-operational start-up costs of the partnership venture. Accordingly,
the judgment of the Tax Court is affirmed.
<>
*/ The Honorable William J. Campbell, Senior District Judge of the
Northern District of Illinois, is sitting by designation.
1/ The Tax Court accepted this concession for the purposes of this case
without deciding its validity (72 T.C. at 558).
2/ MGE argues that in enacting Section 761(a) Congress had in mind only
oil, gas and mineral ventures acting under operating agreements and that
therefore the Section should not be automatically construed to include an
operating agreement for the production of electricity. In support of this
position, MGE inexplicably cites Taubman, Oil and Gas Partnerships and
Section 761(a), 12 Tax L. Rev. 49 (1956), in which the author expressly
states:
"Congress thus attempted to establish a workable formula which would be
valid not only for oil and gas, but all types of operating agreements, as
well as the related and equally difficult field of investment." 12 Tax L.
Rev. 49, 67.
The three utilities here in fact did file a partnership return and
election-out of Subchapter K (App. 19, 41). The Tax Court held that the
filing of a partnership return and election-out under Section 761(a) are
not admissions of partnership status (72 T.C. at 558). MGE did not argue
below that election-out caused the organization not to be a partnership
for non-Subchapter K tax purposes, and the Tax Court declined to decide
this possible issue (72 T.C. at 559 n. 9). In its alternative position
here, however, MGE contends that the holding below is "inconsistent with
the purpose" of Section 761(a) (Br. 41). This argument is
indistinguishable from an argument that election-out under Section 761(a)
negates partnership status except where the Code explicitly provides to
the contrary. Since the issue was not raised and decided below, we do not
address it here. We note, however, that Section 7701(a)(2) explicitly
states that an organization which is a partnership as defined in that
Section is a partnership for the purposes of the entire Code, whereas
Section 761(a) provides only for election-out of Subchapter K.
3/ The Commissioner takes the position that the presence of a joint
profit motive is merely one factor to be considered in determining
partnership status, while MGE argues that it is a necessary element.
Because we find a joint profit motive here, albeit for in-kind profits, we
need not resolve this dispute.
4/ See generally, McKee, Nelson & Whitmire, Federal Taxation of
Partnerships and Partners, par. 3.02, pp. 3-8, in which the authors
conclude: "A partnership may result from a joint extraction or production
agreement among co-owners of mineral property or production facilities,
even though the co-owners separately take and sell (or reserve the right
to take and sell) their shares of production. * * * Despite the absence of
an objective to earn a joint cash profit, these ventures are generally
considered partnerships" (footnotes omitted).
5/ Treasury Regulation Sections 301.7701-3 and 1.761-1(a) (26 C.F.R.)
state that a "joint undertaking merely to share expenses is not a
partnership," and go on to give the example of neighboring landowners who
jointly construct a ditch "merely to drain surface water from their
properties." We agree with the Tax Court that the venture here is "in no
way comparable to the joint construction of a drainage ditch" (72 T.C. at
560).