Brannen v. Comm'r of Internal Revenue

• Decision Date: 30 March 1982
• Docket Number: Docket No. 9669-79.
• Parties: E. A. BRANNEN and FRANCES K. BRANNEN, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

78 T.C. 471

E. A. BRANNEN and FRANCES K. BRANNEN, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 9669-79.

United States Tax Court

Filed March 30, 1982.

Petitioner purchased a 4.95-percent limited partnership interest in early 1974. Thereafter, the general partner, on behalf of the limited partnership, purchased a movie for $330,000 cash plus a 4-percent nonrecourse note in the amount of $1,400,000, secured only by the movie. The partnership reported large losses during its first 4 years due to the claimed depreciation deductions and the fact that the movie was a box office failure. Held: The partnership did not have any actual investment in the movie to the extent of the $1,400,000 nonrecourse note, as the stated purchase price of the property securing the note unreasonably exceeded its fair market value. Therefore, the partnership may not include the face amount of the note in the depreciable basis of the movie. Held, further, the purchase and exploitation of the movie by the partnership was an “activity not engaged in for profit” and its claimed deductions are allowable only to the extent provided in sec. 183(b), I.R.C. 1954. John E. James, for the petitioners.

David D. Aughtry, for the respondent.

SCOTT , Judge:

Respondent determined a deficiency in the joint Federal income tax of Frances K. and E. A. Brannen (petitioner) in the amount of $7,001 for the calendar year 1975. The issue for decision is whether petitioner, as a limited partner of Britton Properties, is entitled to deduct his distributive share of the losses from the partnership, which owned a movie as its principal asset.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

Petitioners E. A. and Frances K. Brannen, husband and wife, who resided in Macon, Ga., at the time of filing their petition in this case, filed a joint Federal income tax return for the calendar year 1975 with the Internal Revenue Service Center in Chamblee, Ga.

Dr. Brannen is a medical doctor by profession. He has been engaged in the private practice of medicine for more than 32 years, specializing in obstetric-gynecology. He received his undergraduate degree in journalism and his medical degree from Emory University. Out of the proceeds of his medical practice, petitioner has made a number of investments in real estate but has never engaged in any activity related to the movie industry. Petitioner sold one of his real estate investments, a parking lot adjacent to his office building, on April 5, 1974, to the Charter Medical Co. His total gain on the sale amounted to $164,316.23, and he reported the sale on the installment method. He received payments in 1974 in the amount of $45,143.64, with a gain of $41,117.73. On December 27, 1974, petitioner sold his former office building, including the land on which it was situated, for a total amount of $53,812.85, with a gain of $38,818.68. The sale of the parking lot was negotiated about 3 or 4 months prior to the date of its sale, and the sale of the office building had been under negotiation for more than a year before the date of its sale.

Petitioner had been a long-time friend of Dr. Sweeney Sykes, who was a psychiatrist in Macon, Ga. Upon learning that petitioner would, during 1974, have a substantial amount of cash to invest, Dr. Sykes and his wife recommended a movie investment to petitioner similar to the one they had made through a close friend of theirs, Dr. W. L. Ryder. In late February or early March 1974, when Dr. Ryder was in Macon, petitioner was among those invited to Dr. Sykes' house for a presentation. Dr. Ryder had practiced psychiatry in Atlanta, Ga., and subsequently practiced psychiatry in Shreveport, La. However, at the meeting, Dr. Ryder represented himself as an investment counselor and proceeded to give a presentation regarding the purchase of partnership interests in a New York limited partnership named “Britton Properties.” About six or seven local businessmen and doctors attended the presentation.

Dr. Ryder explained that the limited partnership was to purchase a movie called “Beyond the Law.” He presented the financial and tax aspects of the investment through the use of a flip chart. During the presentation, Dr. Ryder discussed the plot of the movie and explained the details of limited partnerships, nonrecourse loans, the income forecast method of depreciation, and the hypothetical financial projections prepared by Hecht, Brayer & Grill, certified public accountants. Petitioner received a number of documents at the meeting and made notations on many of them.

These documents included an opinion letter written by Mr. Robert M. Fink of the law firm of Troutman, Sanders, Lockerman & Ashmore of Atlanta, Ga. Petitioner regarded this letter as a very important document as it was an opinion of an independent law firm concerning the legal status of the entire investment. The letter was discussed during the presentation by Dr. Ryder. Petitioner reviewed the letter after he returned home and underscored some of the sentences which he considered to be of key importance. He also sent the letter to his personal lawyer, but only for a confirmation of whether or not this was a “good” law firm and whether Mr. Fink was qualified to write such an opinion. The opinion letter stated, among other things, that the partnership would be respected for Federal income tax purposes, that each limited partner's adjusted basis in the partnership would include his share of the nonrecourse partnership liabilities since the debt was a bona fide debt obligation, and that the seller of the film, Cinema Shares International, Ltd. (CSIL), was not related to the general partner or any of the limited partners of the partnership.

Another document distributed at the presentation was a statement from Sancrosiap, S.p.A. (Sancrosiap), the producer of the movie. This document listed the official production costs, with the explanation of each item in Italian, and the actual costs in lire, with an asterisk by the total converting it to $1,453,448.37 in American dollars. It was represented at the presentation that this was the production cost of the movie. In addition, there was a certificate from Mr. Francis Schertenleib, president of Pictures & Movies Establishment, the seller of the movie to CSIL, which stated that the gross earnings of the movie in American dollars was $2,700,000 in Italy and $4 million in the rest of the world, excluding the United States and Canada. Dr. Ryder stated that usually the films that are well received abroad are better received in the United States, since the United States is a larger movie market.

The maximum permissible depreciation was discussed at the presentation, and petitioner made a notation on one of the documents distributed at the meeting that of the total amount of permissible depreciation, 96 percent would be deductible in the first 2 years of ownership—-85 percent in the first year and 11 percent in the second year. This notation was made on a letter from Mr. Eli J. Warach, who was a vice president-managing editor of Prentice-Hall, Inc. Petitioner regarded this letter as a key factor in his decision to make this investment. The letter, dated January 29, 1974, stated that it was the author's conclusion that Britton Properties was “based upon sound and realistic economic practices and principles” and that “this program is built upon a solid economic and tax foundation.”

As he followed along with Dr. Ryder's presentation, while he was utilizing the flip chart as a visual aide, petitioner copied down an entire example from the flip chart on a blank sheet of paper. There were two columns representing the years 1974 and 1975, both of which assumed taxable income of $80,000 and, after subtracting the deductions attributable to the investment, the “tax saving” was listed as $31,360 in 1974 and $10,130 for 1975, the second year of the investment. The next line stated that the tax savings in excess of the cost of investment of $20,000 were $11,360 in the first year and $10,120 in the second year. Below these two columns, petitioner had written a note explaining that if the tax deduction from the investment could not be utilized in the first few years of the investment, a taxpayer was allowed to carry back a loss 3 years and forward 5 years.

On a separate sheet of paper, petitioner also copied a bar graph chart as presented by Dr. Ryder. The chart showed an initial investment of $20,000 and then 3 years of tax savings of $30,490, $8,695, and $4,345, respectively. The next bar above the line on the chart was an illustration made by Dr. Ryder showing that if an investor were to invest the $43,530 in tax savings realized after 3 years in 5-percent tax-exempt bonds, their yield would be $31,900 over the next 9 years. At the end of 12 years, assuming that the picture was unsuccessful, each investor would be subject to recapture in the amount of $33,200. After netting this recapture tax with the tax-exempt income, the chart represented that each investor would make $22,000 on his investment of $20,000, which petitioner regarded as probably less than he could make with $20,000 invested in something else. Thus, it was represented that if an investor were to invest his tax savings in municipal bonds, it was possible for him to come out ahead even if the movie investment was subject to recapture. At the bottom of the page, petitioner wrote that although the life of the movie was indeterminate, the Government would accept a 12-year life, and if the movie made enough to pay off the mortgage, the entire amount, plus or minus $45,000, would be sheltered.

On a cover letter from Hecht, Brayer & Grill, certified public accountants, stating that they had prepared financial projections of the proposed motion picture limited partnerships, petitioner wrote that the typical distribution agreement was as follows: on income of $0 to $500,000, the distributor...