COMMISSIONER OF INTERNAL REVENUE, PETITIONER V. GEORGE PRUSSIN AND
SHARON PRUSSIN

   No. 88-2133

   In the Supreme Court of the United States

   October Term, 1989

   On Petition For A Writ Of Certiorari To The United States Court Of
Appeals For The Third Circuit

   Reply Brief For The Petitioner

   1. In our petition, we urge that certiorari is warranted because
the court of appeals has erroneously decided a recurring issue of
importance to the administration of the tax laws in a manner that
conflicts with decisions of three other courts of appeals.
Specifically, we argue that the decision below conflicts with Estate
of Isaacson v. Commissioner, 860 F.2d 55 (2d Cir. 1988);  Odend'hal v.
Commissioner, 748 F.2d 908 (4th Cir. 1984), cert. denied, 471 U.S.
1143 (1985);  and Estate of Franklin v. Commissioner, 544 F.2d 1045
(9th Cir. 1976).

   Respondents do not, and cannot, dispute that the decision below
conflicts with the Second Circuit's decision in Estate of Isaacson
(see Br. in Opp. 4-5).  As we explain in our petition (at 14-15), that
case involved another investor in the same tax shelter at issue here,
and the cases were consolidated in the Tax Court.  That investor was
represented by the same counsel as respondents and made the same
arguments to the court of appeals.  The Second Circuit affirmed the
judgment below in its entirety for the reasons stated by the Tax Court
(see 860 F.2d at 56-57), which had rejected the investors' argument
that they should be allowed deductions based on the fair market value
of the property (Pet. App. 58a-59a).  The reality and
authoritativeness of the Second Circuit's decision are not diminished
by respondents' cavil (Br. in Opp. 5) that these courts, in rejecting
an argument that was flatly inconsistent with the results in other
court of appeals decisions and that had never been accepted by any
other court, did not sufficiently explain their reasoning.
Conversely, the court below, on identical facts, reversed the decision
of the Tax Court in part and remanded the case for the allowance of
such deductions.  Thus, as the court of appeals below acknowledged
(Pet. App. 3a n.2), the results of the two decisions are
irreconcilable.  The existence of this square conflict between the
Third and Second Circuits is alone sufficient reason for this Court to
grant certiorari on this important issue.

   Moreover, respondents' efforts to distinguish the other two court
of appeals decisions cited in our petition are unavailing.  As we
explain in our petition (at 16-17), the Fourth Circuit in Odend'hal
held that the taxpayers could not take interest and depreciation
deductions based upon nonrecourse obligations that substantially
exceeded the fair market value of the collateral because they were not
genuine indebtedness.  The court clearly did not allow the taxpayers
to take deductions for the portion of the nonrecourse obligation that
did not exceed fair market value;  the passages quoted by respondents
(Br. in Opp. 5-6), read in context, do not seek to justify such
deductions but rather explain why greatly inflated levels of
nonrecourse debt are not genuine indebtedness -- namely, because the
disparity between the amount of the obligation and the fair market
value of the collateral eliminates any economic incentive for the
debtor to pay.  Nor can Odend'hal be reconciled with the decision
below by virtue of the allowance there of deductions up to the amount
of the income from the property (see Br. in Opp. 5).  Allowing
deductions against actual income is an entirely different matter from
the substantial tax shelter that respondents seek here on the basis of
a hypothetical obligation in the amount of the fair market value of
the property;  indeed, the Commissioner did not contest the right to
take deductions up to the amount of income from the property either in
Odend'hal or in this case.

   The Ninth Circuit in Estate of Franklin also clearly held that no
deductions may be taken for nonrecourse obligations that substantially
exceed the fair market value of the collateral.  The court concluded
(544 F.2d at 1049):  "For debt to exist, the purchaser, in the absence
of personal liability, must confront a situation in which it is
presently reasonable from an economic point of view for him to make a
capital investment in the amount of the unpaid purchase price." This
rule leaves no room for the partial deduction approach espoused by the
court below.  While, as respondents note (Br. in Opp. 8), the court in
Estate of Franklin stated that the taxpayer had failed to prove the
fair market value of the property, the decision to deny all deductions
in that case plainly was not premised on an (almost certainly false)
assumption that the property had no value.  Rather, the court of
appeals was quite specific in identifying the fatal failure of proof
-- namely, failure to demonstrate that "the purchase price was at
least approximately equivalent to the fair market value of the
property" (544 F.2d at 1048;  see also id. at 1048 n.4).  The holding
of Estate of Franklin is that, in the absence of such approximate
equivalence, the taxpayer cannot take deductions based on the
nonrecourse obligation.  That holding is inconsistent with that of the
court of appeals here.

   2. Nor are respondents correct in contending (Br. in Opp. 6 n.4)
that Section 1274(b)(3) of the Internal Revenue Code (26 U.S.C.), and
the regulations thereunder, support the approach of the court below.
That Section is addressed to an entirely different situation from that
presented here and in no way suggests that a taxpayer should be
entitled to take deductions based on a nonrecourse obligation that
greatly exceeds the fair market value of the collateral.  Section
1274, which was added by Section 41(a) of the Deficit Reduction Act of
1984, Pub. L. No. 98-369, 98 Stat. 538-539, was designed to prevent
taxpayers from obtaining unwarranted tax advantages by characterizing
what is actually interest in a deferred payment transaction as
principal.  See H.R. Rep. No. 432, 98th Cong., 2d Sess. Pt. 2, at
1244-1245 (1984).  The "potentially abusive situation" (Section
1274(b)(3)) addressed by the new statute includes a case where the
purchaser pays a total consideration on a deferred basis that conforms
to the fair market value of the property (discounted to present
value), but where the transaction is structured (by stating a below
market interest rate) so that the stated purchase price of the
property exceeds its current fair market value.  See H.R. Rep. No.
432, supra, at 1244 n.10.

   In sum, the issue in this case concerns the tax treatment of a
nonrecourse obligation that is inflated well beyond fair market value
and hence reflects neither genuine indebtedness nor real consideration
that is truly intended to be paid for the property.  Section 1274,
conversely, is addressed to the situation where the debt instrument
does reflect consideration that is actually being paid for the
property, in conformity with its fair market value, but where the
instrument has made an unrealistic allocation of that consideration
between interest and principal.  Section 1274 operates to allocate
those two components correctly.  This is clearly illustrated by the
simple example given in the House Report.  H.R. Rep. No. 432, supra,
at 1244 n.10.  /*/ Thus, Section 1274 addresses situations where the
purchaser does have an economic incentive to live up to the terms of
his bargain, and hence it provides no support for the decision below.
Indeed, the Joint Committee's explanation of Section 1274 specifically
notes that Congress did not intend to endorse partial recognition of
the nonrecourse debt issued in abusive tax shelter schemes such as the
one in this case.  The Joint Committee explained:

         The limitations on principal amount imposed by these
      provisions do not override prior case law dealing with
      overstatement of basis and other abuses in transactions
      involving nonrecourse debt.  As under prior law, an obligation
      must represent a bona fide indebtedness of the purchaser-issuer
      to be respected for purposes of the (original issue discount)
      rules and other provisions of the Code.  Thus, if a nonrecourse
      obligation is given in exchange for property having a value less
      than the principal amount of the purported debt obligation * * *
      , the obligation may be disregarded in whole or in part under
      general principles of tax law and basis, interest deductions,
      and other tax benefits may be denied.  See, e.g. Estate of
      Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976);
      Odend'hal v. Commissioner, 80 T.C. 588 (1983);  Rev. Rul. 78-29,
      1978-1 C.B. 62;  and Rev. Rul. 82-224, 1982-2 C.B. 5.

   Staff of the Joint Comm. on Taxation, 98th Cong., 2d Sess., General
Explanation of the Revenue Provisions of the Deficit Reduction Act of
1984, at 119 (Joint Comm. Print 1984).

   3. Respondents' suggestion (Br. in Opp. 13) that this case
potentially presents a constitutional question is entirely without
merit.  It is well settled that tax deductions are a matter of
legislative grace.  See, e.g., Deputy v. du Pont, 308 U.S. 488, 493
(1940);  New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
Thus, if the Internal Revenue Code does not permit respondents to take
a deduction based upon nonrecourse debt that greatly exceeds the fair
market value of the collateral, that is the end of the matter;  there
surely is no "taking without due process" (Br. in Opp. 13).  Moreover,
as we explain in our petition, the denial of all depreciation and
interest deductions attributable to such inflated nonrecourse
indebtedness is not a penalty, but rather reflects the absence of any
financial incentive on the part of the borrower, who is not personally
liable, to pay.  Thus, respondents' nonrecourse obligation was not
genuine indebtedness and did not represent a true investment in the
property;  therefore, neither common sense, the Internal Revenue Code,
nor any constitutional principle suggests that they should be entitled
to base interest and depreciation deductions upon that nonrecourse
obligation.

   For the foregoing reasons, and those stated in our petition, the
petition for a writ of certiorari should be granted.

   Respectfully submitted.

   KENNETH W. STARR

      Solicitor General

   SEPTEMBER 1989

   /*/ The more complicated examples cited by respondent from proposed
regulations under Section 1274 (proposed on April 8, 1986, 51 Fed.
Reg. 12,022, but not yet adopted in final form) similarly reflect this
basic distinction.  For instance, in Example (3) of Section
1.1274-3(c)(2) (see 51 Fed. Reg. 12,068 (1986)), there is no
suggestion that the total consideration reflected in the debt
instrument exceeds the fair market value of the property.  In order
for this example to illustrate the general rule of Section
1.1274-3(c)(1) for determining whether a debt instrument provides for
adequately stated interest, it must contemplate that, in purchasing
property worth $7 million for consideration of $1 million in cash and
a debt instrument with a stated principal amount of $7 million, the
purchaser has not overpaid for the property -- i.e., that the total
consideration (discounted to present value) is equivalent to the
current fair market value of the property, but that the stated
principal amount of the note has been inflated by understating the
true interest rate.  Accordingly, Section 1274 comes into play to
restructure the note to provide for a $6 million principal amount at a
market interest rate.