74 T.C. 111 (1980), 4446-74, Perrett v. C.I.R.

Docket Nº:4446-74, 5900-76.
Citation:74 T.C. 111
Opinion Judge:FEATHERSTON, Judge:
Attorney:Harry Margolis and Richard Gladstein, for the petitioners. Robert E. Casey, for the respondent.
Judge Panel:AARONS, Special Trial Judge:
Case Date:April 24, 1980
Court:United States Tax Court

Page 111

74 T.C. 111 (1980)




Nos. 4446-74, 5900-76.

United States Tax Court

April 24, 1980

         Held, on the facts, petitioners did not suffer a deductible loss in 1970 on the disposition on Dec. 30 of stock which they had acquired in early December of that year because the stock purchase and sale transaction lacked significant economic substance. Held, further, on the facts, the amounts paid by petitioner's partnership to certain trusts were not deductible as interest under sec. 163(a), I.R.C. 1954, because the transactions between the trusts and the partnership were not loans, in substance, and the trusts were mere conduits of the funds which were the subject of the purported loans.

          Harry Margolis and Richard Gladstein, for the petitioners.

         Robert E. Casey, for the respondent.

          FEATHERSTON, Judge:

         This case was tried before Special Trial Judge Lehman C. Aarons pursuant to Rule 180, Tax Court Rules of Practice and Procedure. His report was served on the parties. Petitioners filed exceptions, and respondent filed a brief in response to petitioners' exceptions. After careful consideration, the Special Trial Judge's report, which is set forth below, is adopted with minor modifications.


         AARONS, Special Trial Judge:

         Respondent determined deficiencies in the amounts of $9,172 and $45,065, respectively, in

Page 112

petitioners' Federal income tax for 1970 and 1972, together with negligence penalties under section 6653(a)[1] of $459 and $2,253, respectively. Two of the issues to be decided depend on determinations of the proper amounts of income, in 2 different years, of a partnership in which petitioner-husband was a partner. (An adjustment to partnership income will change the size of the portion of that income includable on petitioners' return.) After concessions by respondent, these issues are whether the partnership correctly deducted, in 1970, a loss on the sale of section 1244 stock, and whether the partnership is entitled to an interest deduction for certain payments in 1972. The third issue, although originally raised separately, has now been conceded by respondent to be an alternative to the stock loss issue. If we find that the partnership properly deducted an amount for loss on the sale of stock, we must consider whether petitioners realized income in 1972 from cancellation of indebtedness. Finally, we must determine whether petitioners are liable for additions to tax under section 6653(a).

         A constitutional objection raised by petitioners is no longer an issue before this Court. This matter was disposed of when the Court granted respondent's motion to strike amendments to the petitions herein, for reasons set forth in a memorandum sur order dated October 27, 1978. This memorandum sur order is a part of the record in this case and fully sets forth the positions of the parties with respect to the constitutional issue as well as the Court's disposition of the matter.[2]


         Although Rule 91 of this Court's Rules of Practice and Procedure requires that the parties stipulate all matters to the fullest extent possible (and although an oral stipulation of

Page 113

documents was made), no written stipulation of facts was filed in this case. This failure has compounded the Court's difficulties in synthesizing and making an orderly and understandable presentation of the extremely complex facts in this case. We believe all of the facts set forth below--obfuscating as they appear to be--are necessary for an understanding of the issues herein.

         Petitioners resided in Ventura, Calif., at the time the petitions herein were filed. Their Federal income tax returns for 1970 and 1972 were filed with the Internal Revenue Service Centers in Ogden, Utah, and Fresno, Calif., respectively.

         Michael F. Perrett (hereinafter petitioner) was an attorney during the years involved herein in the firm Hathaway, Clabaugh & Perrett (HCP). In 1970, the law firm was operating as a partnership (the partnership). At that time, two of the partners were active in the business of the firm. Hathaway had retired almost completely from the practice of law and owned a nominal share of the partnership, if any. In mid-1971, the law practice was incorporated, although the partnership continued in existence as a vehicle for managing other interests of the partners. During this period, Clabaugh concentrated, for the most part, on administrative law problems and trials. Petitioner, generally responsible for overseeing the business affairs of the firm, was certified as a specialist in the law of taxation by the State Bar of California.

         In 1970, prompted by concern for financing his children's education, petitioner decided to establish some kind of trust or other fund for their use. Petitioner discussed this matter with Harry Margolis (Margolis), an attorney whom he had met a few years earlier through a former business associate. Together they agreed on a plan, detailed below, which provided for trusts for petitioner's children, a series of loans, and the purchase by the partnership of stock in Jowycar Music Corp. (Jowycar).[3]

         By execution of three trust agreements dated October 23, 1970, petitioners created a trust for each of their three minor children. The agreements named as trustees John Webster and Robert Soares (two former business associates of petitioner), and

Page 114

Patrick Perrett (petitioner's brother). At some later point, Webster and Patrick Perrett resigned and David Schmutte, petitioner's accountant, was substituted. The initial corpus of each trust was $10.

         Signing a note dated December 2, 1970, petitioner borrowed $100,000 from Anglo Dutch Capital Co. (Anglo Dutch). Anglo Dutch, during this period, was a California corporation engaged in the business of lending money. Petitioner's loan was negotiated on behalf of Anglo Dutch by Margolis, who was president of the company and owned one-half of the stock. (An accountant associated with Margolis' law firm owned the other half.) The note, bearing a maturity date of December 1, 1971, required the payment of quarterly interest installments at the rate of 10 percent annually. The loan was unsecured.

         The next step in the plan was the loan by petitioner of the $100,000 to his children's trusts. Soares, as trustee, signed an agreement to borrow money, dated December 6, 1970, and a promissory note, dated December 7, 1970, on behalf of each of the three trusts. Two of the notes were in the amount of $33,333.33. The third was for $33,333.34. Each note promised payment of principal on demand and provided for annual interest payments at 3 percent, with the first payment due January 31, 1972.

         On December 10, 1970, loan agreements and promissory notes were executed for the loan of $100,000 by the Perrett children's trusts to the HCP partnership. The terms of these documents provided that the partnership would pay principal to the trusts on demand and 6-percent interest annually on or before December 31 of each year, beginning in 1971. At approximately the same time, the partnership borrowed $100,000 from two trusts created for Clabaugh's children. This money had been borrowed by the trusts from Clabaugh, who had also originally borrowed it from Anglo Dutch. After the three sets of loans had been completed, the partnership had $200,000 with which to purchase stock in Jowycar.

         In early October 1970, Jowycar was essentially an inactive corporation. Associated Arts, N.V., was its sole shareholder; the corporation's officers were Ben Margolis, brother of Harry Margolis; John McTernan; and Elaine Fischel, an attorney and associate of Margolis.

         In late October, Jowycar was revived so that it might be used

Page 115

as a vehicle for investment by the partnership and others. Associated Arts had agreed to be redeemed out of the corporation to make way for the new investors. Before the redemption, new officers were elected: Robert Dunnett, an attorney employed by Margolis; Dr. Alexander Ellenberg, a prospective purchaser of Jowycar stock; and Marjorie Trover, an employee of Margolis. Jowycar's business address was the same as that of Margolis' law firm.

         It was planned to use the proceeds of the new issue of Jowycar stock to help finance a real estate venture of Bonaire Development Co. (Bonaire), a California corporation. In return, Jowycar was to receive from Bonaire a right to receive certain payments, specifically a one-half interest in a secured obligation which was referred to as " the pledge." The affairs of Bonaire were controlled by Margolis or his delegates. Bonaire's relationship with Jowycar involved three different tracts of real estate. The first of these was a parcel of 206 acres located in San Diego, Calif. (the 206 acres).

         Under the terms of an agreement of sale dated June 1, 1970, Bonaire agreed to purchase the 206 acres from Universal Decoration Leasing Co.[4] The purchase price was set at $1,907,536, and the agreement recited that Bonaire's note for $100,000 of the amount was attached. As payment of the balance, Bonaire contracted to assume two obligations of the seller, Universal Decoration Leasing Co., i.e., a note to World Minerals, N.V., in the amount of $1,656,286, and a note to M.A.C. Joint Venture in the amount of $150,000 plus $1,250 interest. This 206-acre parcel was subject to two deeds of trust. The first of these, in order of priority, was referred to as the " Jacobs-Forbes" deed of trust. The second, referred to as the " Greater West" deed of trust, dated May 27, 1966, was executed...

To continue reading