80 T.C. 34 (1983), 1717-78, Foster v. C.I.R.

Docket Nº:1717-78
Citation:80 T.C. 34
Party Name:RICHARD H. FOSTER and SARA B. FOSTER, T. JACK FOSTER, JR., and PATRICIA FOSTER, JOHN R. FOSTER and CAROLINE FOSTER, and ESTATE of T. JACK FOSTER, DECEASED, GLADYS H. FOSTER, EXECUTRIX and GLADYS H. FOSTER, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
Attorney:Valentine Brookes and Lawrence V. Brookes, for the petitioners. Joyce E. Britt and Charlotte Mitchell, for the respondent.
Case Date:January 11, 1983
Court:United States Tax Court
 
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Page 34

80 T.C. 34 (1983)

RICHARD H. FOSTER and SARA B. FOSTER, T. JACK FOSTER, JR., and PATRICIA FOSTER, JOHN R. FOSTER and CAROLINE FOSTER, and ESTATE of T. JACK FOSTER, DECEASED, GLADYS H. FOSTER, EXECUTRIX and GLADYS H. FOSTER, PETITIONERS

v.

COMMISSIONER of INTERNAL REVENUE, RESPONDENT

No. 1717-78.

United States Tax Court

January 11, 1983

Issues 1 and 3 : REALLOCATIONS OF INCOME UNDER SEC. 482, I.R.C. 1954. T, J, D, and B (a father and three sons) were equal partners in FP, a general partnership. In 1958, FP began to investigate the development potential of Brewer's Island, a 2,600-acre undeveloped tract of land located about 12 miles south of San Francisco. FP determined that the tract could be transformed into a city of 35,000. In December 1959, it acquired an option for the purchase of the land; in May 1960, it secured enabling legislation from the California legislature for a municipal improvement district known as Estero; and in August 1960, it exercised its option and acquired the tract. Immediately thereafter, it began to transform Brewer's Island into Foster City.

FP played an active role in the development of Foster City. It also acted through Estero, which it controlled and dominated. Estero was used by FP in the development process both as a financing vehicle and as a vehicle by which improvements to the land were actually effected.

Foster City was developed by neighborhood. The first neighborhood to be developed was Neighborhood One. In October 1962, FP deeded undivided 25-percent interests in 127 acres of land in Neighborhood One to each of four Alphabet Corporations as tenants in common. Each of these corporations was solely owned by T, J, D, or B, and the transfer of the 127 acres was tax motivated. Income derived from the sale of lots in this acreage was reported by the Alphabet Corporations; however, that income was earned by FP.

In August 1966, FP conveyed all of the single-family residential lots in Neighborhood Four to FE, a corporation which was solely owned by T, J, D, and B in equal shares. FE had a history of substantial net operating losses related to the operation of a hotel in Hawaii and the lots were conveyed in order to take advantage of those losses. Income derived from the sale of lots in 1967 was reported by FE; however, that income was earned by FP.

Held :

a. Sec. 482, I.R.C. 1954, is not unconstitutional as an invalid delegation of legislative power. (Pp. 140-142.)

b. The Commissioner's determinations under sec. 482, I.R.C. 1954, must be sustained unless proven unreasonable, arbitrary, or capricious. (Pp. 142-144.)

c. In order to prevent the avoidance of taxes, sec. 482, I.R.C. 1954, and sec. 1.482-1(d)(5), Income Tax Regs., may be applied to a taxable disposition of property previously acquired in a nonrecognition transaction. (Pp. 144-159.)

d. Respondent did not abuse his discretion under sec. 482, I.R.C. 1954, in reallocating income derived from the sale of lots in Neighborhood One from the four Alphabet Corporations to FP. (Pp. 160-177.)

e. Respondent did not abuse his discretion under sec. 482, I.R.C. 1954, in reallocating income derived from the sale of lots in Neighborhood Four from FE to FP. (Pp. 178-184.)

f. For tax purposes, FP was a partnership and not an association taxable as a corporation. Sec. 7701(a)(2) and (3), I.R.C. 1954; sec. 301.7701-1 through - 3, Proced. & Admin. Regs. (Pp. 184-191.)

g. Petitioners are not entitled to affirmatively use sec. 482, I.R.C. 1954, to effect a consolidated return of FP with all of the related corporations purportedly involved in the development of Foster City. Sec. 1.482-1(b)(3), Income Tax Regs. Respondent's failure to do so does not demonstrate any abuse of discretion on his part. (Pp. 191-195.)

Issue 2 : APPLICABILITY OF THE SUBSTANCE-OVER-FORM DOCTRINE TO THE WESTWAY TRANSACTION. The terms negotiated by FP for the purchase of Brewer's Island contemplated a downpayment of $2,500,000. However, FP was unable to fund all of that amount itself. Accordingly, it arranged with a bank with which it had an established relationship to borrow (1) $2 million to make the downpayment and (2) such additional amounts as were needed to satisfy the periodic installments due to the sellers of the property for the balance of the purchase price. Under the terms of the agreement, FP agreed (1) to pay interest at the prevailing market rate, (2) to pay a bonus equal to the total amount borrowed from the bank, and (3) to structure the bonus so that it would be taxed to the bank as capital gain rather than ordinary income. A complicated transaction, consisting of a series of incorporations, transfers, liquidations, and mergers, was then devised to disguise the terms of the agreement involving the 100-percent bonus. The crucial step in the transaction involved the delivery of certain promissory notes (the Westway notes) purportedly in exchange for corporate stock. The objective of the transaction from FP's point of view was to raise funds through tax savings in order to pay the bank its bonus; the objective from the bank's point of view was to insure that its bonus was taxed as capital gain. In form, the transaction served to increase FP's basis in Neighborhoods Two and Three by an amount equal to approximately twice that which FP had become obligated to pay to the bank as a bonus.

Held :

a. Respondent's categorization of the Westway notes as interest is an issue which is properly before the Court and one with respect to which petitioners bear the burden of proof. (Pp. 195-197.)

b. In substance, the Westway notes represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island. (Pp. 197-211.)

c. FP is not entitled to capitalize the Westway notes under sec. 266, I.R.C. 1954. (Pp. 211-216.)

Issue 4 : APPLICABILITY OF THE COST RECOVERY METHOD TO THE GRANT OF THE SWAY EASEMENT. In 1964, a utility company paid $425,000 to FP for a right-of-way immediately adjacent to an existing easement which stretched across Brewer's Island. FP characterized the payment as severance damages and reduced its basis in all of its land in Foster City by the amount received. Respondent acquiesced in that treatment. In 1967, the utility paid an additional $72,000 for a sway easement in order to perfect the right-of-way easement which it had acquired in 1964. Held, the amount received for the grant of the sway easement should be applied against the basis of all of FP's land in Foster City rather than against only its basis in that part of its land described by the easement. Inaja Land Co. v. Commissioner, 9 T.C. 727 (1947), applied. (Pp. 216-219.)

Issue 5 : DEDUCTIBILITY OF THE SCHOOL AND CHURCH SITES. FP conveyed three parcels of land in Foster City with respect to which it claimed deductions for charitable contributions. One parcel was conveyed to a school district for use as a school site and was in form an outright transfer; the other two parcels were conveyed to churches for use as church sites and were in form " bargain purchases." The notice of deficiency raised the issue of donative intent with respect to the deductibility of the school site but not the two church sites.

Held :

a. Given the absence of surprise or substantial disadvantage to petitioners, respondent is entitled to rely on a ground for the disallowance of a deduction which was not expressly set forth in the notice of deficiency. (Pp. 220-222.)

b. FP's dominant purpose in conveying the three sites was the expectation of direct economic benefit; accordingly, the transfers are not deductible as charitable contributions under sec. 170, I.R.C. 1954. (Pp. 222-225.)

c. FP must capitalize the cost of the school site as part of its basis in all of its remaining land in Foster City. (Pp. 225-227.)

Issue 6 : DEDUCTIBILITY OF THE PAYMENT FOR LEGAL SERVICES. FP paid $5,000 to an attorney for legal services. Held, the payment was a legitimate business expense and is deductible under sec. 162(a), I.R.C. 1954. (P. 227.)

Issue 7 : ADJUSTMENTS RELATED TO THE PAYMENT OF THE FOSTERS' PERSONAL EXPENSES. Respondent disallowed certain deductions claimed by FP on the ground that the expenses were personal to T, J, D, and B. He also disallowed certain deductions claimed by three related corporations on the same ground and charged the individuals with constructive dividends.

Held :

a. Petitioners bear the burden of proof. Neither respondent's alleged delay in issuing the notice of deficiency, nor his failure to identify therein the specific partnership and corporate expenditures which were disallowed, nor the alleged misconduct of his revenue agent in " scrambling" petitioners' records serves to shift the burden of proof. United States v. Janis, 428 U.S. 433 (1976), and Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir. 1979), revg. 67 T.C. 672 (1977), distinguished. (Pp. 228-234.)

b. Petitioners introduced no specific evidence to establish that the expenses in question were business related rather than personal. Hence, they failed to carry their burden of proof. Evidence descriptive of the mechanics of their recordkeeping system is insufficient to discharge that burden. (Pp. 234-235.)

c. Even if expenses are disallowed at the corporate level because of the failure to comply with the recordkeeping requirements of sec. 274, I.R.C. 1954, that fact would not necessarily preclude the taxation of the expenses as constructive dividends at the shareholder level. (Pp. 235-236.)

Issue 8 : CHARACTERIZATION OF THE PAYMENTS MADE TO GLADYS FOSTER. On her income tax returns, G reported compensation received from certain related corporations. Respondent determined that the total...

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