Wolf v. C.I.R., 91-70694

• Citation: 4 F.3d 709
• Decision Date: 27 August 1993
• Docket Number: No. 91-70694,91-70694
• Parties: -5740, 93-2 USTC P 50,501 August C. WOLF; Muriel M. Wolf, Petitioners-Appellants, v. COMMISSIONER INTERNAL REVENUE SERVICE, Respondent-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (9th Circuit)

Page 709

4 F.3d 709

72 A.F.T.R.2d 93-5740, 93-2 USTC P 50,501

August C. WOLF; Muriel M. Wolf, Petitioners-Appellants, v. COMMISSIONER INTERNAL REVENUE SERVICE, Respondent-Appellee.

No. 91-70694.

United States Court of Appeals,

Ninth Circuit.

Argued and Submitted April 8, 1993.

Decided Aug. 27, 1993.

Henry D. Nunez, Fresno, CA, for petitioners-appellants.

Joan I. Oppenheimer, Tax Div., U.S. Dept. of Justice, Washington, DC, for respondent-appellee.

Appeal from a Decision of the United States Tax Court.

Before: WALLACE, Chief Judge, O'SCANNLAIN and FERNANDEZ, Circuit Judges.

WALLACE, Chief Judge:

The Internal Revenue Service (IRS) challenged the returns of numerous taxpayers who invested in a tax shelter marketed by Encore Leasing Corporation (Encore). One of them, Wolf, appeals from a decision of the tax court upholding the IRS's disallowance of several deductions on Wolf's 1979-1982 federal income tax returns and affirming the IRS's assessment of additions to tax and penalties. The tax court exercised jurisdiction pursuant to 26 U.S.C. Secs. 6213, 6214, and 7442. We have jurisdiction over Wolf's timely appeal pursuant to 26 U.S.C. Secs. 7482(a) and 7483. We affirm.

I

Encore was incorporated on February 1, 1982, and was in the business of leasing master recordings of previously released pop and Gospel albums. Collings was its president and sole shareholder.

Encore's 32-page 1982 prospectus focused primarily on the tax advantages of investing in the Encore program. The prospectus contains only one page which discusses, in general terms, the record industry. The prospectus does not describe the specific master recordings Encore intended to lease or the nontax, economic profitability of Encore's leasing program. Encore also distributed a "Tax Opinion" prepared by attorney Nunez which advised investors to consult their "own financial, accounting, legal and tax advisors prior to any Lease of a Master Recording."

Wolf has been in the investment and insurance business since 1964. In a meeting with Ozier, a salesman for Encore with no experience in the music recording industry, Wolf was told that for a cash investment of $10,000 he would receive a $17,000 investment tax credit in 1982. On June 25, 1982, Wolf delivered a personal check for $10,000 to Collings to purchase a one-seventh share in an Olivia Newton-John master recording (master). His receipt referred only to an Olivia Newton-John master recording without identifying song titles or the name of the album.

Wolf did not consult with anyone other than Ozier prior to his investment with Encore. He did not discuss the Encore program with Collings until two or three weeks after he had made his investment. The only steps Wolf took to verify the background and experience of Collings or of Encore was to ask a fellow insurance salesman what he knew of Collings. The salesman responded that Collings was an "up front guy."

Wolf did his own tax research to conclude that master recordings could, under the proper circumstances, qualify for the investment tax credit. He also relied on Nunez's tax opinion. Wolf did not consult with anyone regarding the economic viability of the program.

Wolf has never seen the actual master recording in which he invested. He does not know where the master was produced, or the cost of its production. His only investigation into the value and marketability of the master conducted prior to investing was to ask his son's friends, none of whom had any experience in the music business, whether Olivia Newton-John was popular. Wolf did not know any of the song titles on the master prior to investing. Neither Wolf nor his spouse had any prior experience in the music recording industry.

Wolf invested in the master through a partnership promoted by Encore named O.J.N. Recording Enterprises (OJN). The OJN partnership agreement was prepared by Nunez and executed by the partners on July 29, 1982. Along with Wolf, the managing partner, there were 14 other partners in OJN. On July 29 and 30, 1982, OJN received a capital contribution from the partners; paid Encore $66,000; entered into a lease, prepared by Encore, for the master; and executed with Encore a form titled "Election to Pass Investment Tax Credit from Lessor to Lessee." As a result, Encore passed through to OJN the investment tax credit for the master based on a fair market value of $1,200,000.

The lease between OJN and Encore was not exclusive, which is unusual in the record industry. The lease merely provides that prior to the execution of the lease, Encore had not entered into a lease or otherwise encumbered its rights to the master. There is no restriction prohibiting Encore from entering into another lease for the same master subsequent to the execution of the lease between OJN and Encore.

Wolf did not have anyone review the lease prior to his signing the agreement. When he entered into the lease, Wolf was unaware of the difference between an exclusive lease and a nonexclusive lease. He also did not understand the restrictions pertaining to OJN's use of the master recording.

Wolf did not receive any appraisals regarding the master until October 8, 1982, when they were provided by Collings. The two appraisal reports Wolf received were both addressed to Encore. The Encore prospectus provides that the appraisals are not to be used to establish the value of the master for tax purposes. One appraisal was for $1,800,000; the other for $1,600,000. Neither report mentions whether the appraiser listened to the master or analyzed its quality, discusses the album's packaging, or describes the appraisal method used. Wolf accepted these appraisal reports after asking Collings about their validity. The actual fair market value of the master was $25,000 if OJN's rights to the master were exclusive. Because OJN did not have exclusive rights to the master, the actual fair market value was much lower.

The master purchase agreement between Encore and AJK Enterprises, Encore's predecessor in title, places the following restriction on Encore's use of the master:

To be manufactured and sold in set configuration as per schedule "A ONLY".

Schedule A is a list of 10 song titles. Because of this restriction, Encore would be in breach of the agreement if it altered the song configuration set forth on Schedule A, an unknown restriction in standard music industry agreements. Since Encore purchased only the right to sell the 10 songs in the order stated, AJK Enterprises could have resold those same 10 song titles, in different sequences, to millions of other investors.

To press and distribute the record, Wolf chose the Tony Lawrence Marketing & Record Distribution Agency (Agency) from a list provided by Collings, because it was the only distributor to guarantee that the master would be in production before Christmas (which the Agency failed to do). Other than interviewing Lawrence and reviewing his resume, Wolf took no steps to investigate or verify his credentials. The employment agreement between OJN and the Agency is a "vanity publishing agreement." This type of agreement, which represents 1 percent or less of the music business, is utilized if a distributor for music cannot be found and the person in possession of the recordings is willing to pay for the production of a specified number of copies. The Agency sold only 13 albums from 1982 through 1984. OJN would have to sell 122,571 records in order to realize a profit on the lease fee it paid to Encore.

Wolf reported adjusted gross income of $74,956.13 on his Federal income tax return for taxable year 1982. After deductions and credits, Wolf reported no tax liability and received a refund of $1,482.87. The tax benefits he received from OJN in 1982 alone--a loss of $6,752 and investment tax credit of $17,016--were practically double his cash investment.

Wolf filed an Application for Tentative Refund with his Federal income tax return for 1982. Because of claimed investment tax credit carrybacks, to which Wolf has conceded he is not entitled, Wolf claimed refunds for the years 1979, 1980, and 1981 in the respective amounts of $2,969, $778, and $2,411.

The Commissioner disallowed Wolf's investment tax credit deductions and assessed additions to tax, increased interest rate, and penalties. The tax court affirmed the Commissioner's actions and imposed on Wolf an additional penalty for persisting in frivolous litigation.

II

Wolf first challenges the tax court's finding that his investment in the Encore leasing program was not an activity primarily engaged in for profit pursuant to section 183 of the Internal Revenue Code (all statutory references are to the Internal Revenue Code of 1954 as amended and in effect for the involved years). This finding must be affirmed on appeal absent clear error. Independent Elec. Supply v. Commissioner, 781 F.2d 724, 727 (9th Cir.1986) (Independent Electric). We must uphold the tax court's finding unless we are "left with the definite and firm conviction that a mistake has been committed." United States v. United States Gypsum Co., 333 U.S. 364, 395, 68 S.Ct. 525, 542, 92 L.Ed. 746 (1948). Under the clearly erroneous standard, "[i]f the [tax court's] account of the evidence is plausible in light of the record viewed in its entirety, the court of appeals may not reverse it even though convinced that had it been sitting as the trier of fact, it would have weighed the evidence differently." Service Employees Int'l Union v. Fair Political Practices Comm'n, 955 F.2d 1312, 1317 n. 7 (9th Cir.), cert. denied, --- U.S. ----, 112 S.Ct. 3056, 120 L.Ed.2d 922 and cert. denied --- U.S. ----, 112 S.Ct. 3057, 120 L.Ed.2d 922 (1992), quoting Anderson v. City of Bessemer City, 470 U.S. 564, 573-74, 105 S.Ct. 1504, 1511-12, 84 L.Ed.2d 518 (1985).

Wolf contends that the tax court improperly found that he did not have a bona fide profit motive for investing in the Encore leasing program. "The burden of proving the requisite...