Gauntt v. Comm'r of Internal Revenue, Docket Nos. 1704–81

• Decision Date: 12 January 1984
• Docket Number: 29502–81,Docket Nos. 1704–81,2275–82.,25642–81,6332–81
• Citation: 82 T.C. No. 9,82 T.C. 96
• Parties: LLOYD E. GAUNTT,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

82 T.C. 96

82 T.C. No. 9

LLOYD E. GAUNTT,1 Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 1704–81

6332–81

25642–81

29502–81

2275–82.

United States Tax Court

Filed January 12, 1984.

Ps were members of five limited partnerships which were among ten limited partnerships formed on Oct. 28, 1976. On that date, the partnerships, acting in concert, executed an agreement to execute coal subleases with BPC, subject to BPC producing proof of title. BPC was closely affiliated with J, a general partner of the partnerships. Ps joined the partnerships between Nov. 20 and Dec. 31, 1976. On Dec. 31, 1976, the five partnerships executed subleases with BPC pursuant to which they were obligated to pay advanced royalties, which were substantially less than those required in the sublease agreement. The remaining five partnerships never executed subleases nor became obligated to pay advanced royalties. The partnerships sold no coal in 1976. Held: On Oct. 29, 1976, the partnerships' obligations under the sublease agreements were illusory. Accordingly, sec. 1.612–3(b)(3), Income Tax Regs., as amended in Dec. 1977, applies, and no portion of the advanced royalties may be deducted by Ps for 1976. George Mac Vogelei and William K. Hogan, for the petitioners.

Claire Priestley-Cady, for the respondent.

OPINION

SIMPSON, Judge:

This matter is before the Court on the Commissioner's motion for partial summary judgment pursuant to Rule 121, Tax Court Rules of Practice and Procedure.² The issues raised by the motion are: (1) Whether the Commissioner properly applied the amended section 1.612–3, Income Tax Regs., to disallow certain partnership loss deductions for advanced royalties claimed by the petitioners for 1976; and (2) whether the varying interest rule of section 706(c)(2)(B) of the Internal Revenue Code of 1954³ prohibits the allocation of such losses to the petitioners.

The Commissioner determined the following deficiencies in the petitioners' Federal income taxes:

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Docket No. Petitioner TYE Dec. 31- Deficiency  
                1704-81      Lloyd E. Gauntt                        1976           $76,511
                6332-81      George C. Huff, Inc.                   1977           26,929
                25642-81     James N. Donnerstag and Linda K.       1976           71,913
                             Donnerstag
                29502-81     Richard E. Keane and Constance M.      1976           13,523
                             Keane
                2275-82      Robert Boomsliter and Jane Boomsliter  1976           15,619
                

Each of the individual petitioners had his or her legal residence in California when the petition was filed, and the corporate petitioner had its principal place of business in California when its petition was filed. All the individual petitioners filed their Federal income tax returns for 1976 with the Internal Revenue Service Center, Fresno, Calif.; and the corporate petitioner filed its return for the taxable year ended October 31, 1977, with the same service center.

Some of the facts have been stipulated for the purposes of the motion for partial summary judgment. Moreover, the Commissioner has conceded that, for the purposes of the motion, the transactions giving rise to the deductions at issue occurred as described in two affidavits submitted by one of the limited partners and in documents relating to Valley Investments, Ltd. (Valley), one of the limited partnerships involved in the present case.

Each of the petitioners was a member of a separate limited partnership. Such partnerships were among ten California limited partnerships formed on October 28, 1976. On the same day, the partnerships formed a joint venture known as Boone Powellton Coal Partners, Ltd. (the joint venture).

The general partners of the partnerships were two California corporations, Jarndyce, Ltd. (Jarndyce), and George C. Huff, Inc.⁴ All the stock of Jarndyce was owned by a trust established by Robert Kantor for the benefit of members of his family other than himself. Mr. Kantor was the president, vice president, and sole director of Jarndyce. Douglas Wolf, Mr. Kantor's law partner, owned, on behalf of himself and others; all the stock of the Boone Powellton Coal Co., a West Virginia corporation (the corporation). The law firm was the counsel for the corporation. The corporation acquired the right to mine coal from certain property located in West Virginia pursuant to a lease that it executed with the owners of the property on November 4, 1976. The lease provided that the corporation would pay the owners an advanced royalty of $2,500,000.

Acting on behalf of its constituent partnerships, the joint venture executed a contract with the corporation on October 28, 1976, providing that the corporation and the joint venture “irrevocably” agreed to execute mineral subleases of the West Virginia property under the terms and conditions contained in an unexecuted copy of a sublease attached to the agreement. Mr. Wolf was authorized by Jarndyce to execute such an agreement on behalf of Jarndyce as general partner of the limited partnerships. The sublease provided for the payment of advanced royalties of $72,000,000 to the corporation in the aggregate—$24,000,000 was to be paid in cash and $48,000,000 pursuant to an 11-year nonrecourse note. The sublease also provided that the partnerships' duties under the sublease were conditioned upon the corporation's delivery by December 24, 1976, of an opinion letter evidencing its title in the West Virginia property. The agreement provided that, on or before November 5, 1976, the partnerships would pay the corporation $225,000, whereupon the lease would be executed. The closing date was subsequently extended to December 31, 1976.

Section 1.612–3(b)(3), Income Tax Regs., as it stood prior to October 29, 1976, allowed the “payor” of “advanced royalties,” at his option, to deduct the advanced royalties in the year they were paid or accrued or in the year of the sale of the mineral product in respect of which such royalties were paid. On October 29, 1976, the IRS issued News Release IR-1687 announcing a proposed amendment of the regulation. Such proposed amendment was published in the Federal Register on November 2, 1976. 41 Fed. Reg. 48133. The amendment provided that advanced royalties could only be deducted in the year of the sale of the mineral product to which they related. Concerning the effective date of the amendment, the news release provided:

Under the proposed amendment, the treatment of advanced royalties would be revised, effective October 29, 1976, unless the advanced royalties are required to be paid pursuant to a mineral lease which (i) was binding prior to that date upon the party who in fact pays or accrues such royalties, or (ii) was required, pursuant to a written contract, to be executed by the party who in fact pays or accrues such royalties, provided that such party establishes, to the satisfaction of the Secretary or his delegate, that under all the facts and circumstances the contract was binding upon such party prior to that date. For purposes of clause (ii) above, a contract will in no event be considered to be binding upon such party if the obligations imposed on such party prior to October 29, 1976 were not substantial or were illusory.

On December 19, 1977, the amended regulation was promulgated in substantially the same form in which it had been proposed. T.D. 7523, 1978–1 C.B. 192; 42 Fed. Reg. 63640 (1977). The Treasury Decision restated the language of the news release regarding the effective date of the amendment, but added the following statement:

In the case of advanced royalties paid or accrued by a partnership the “party” who, under the preceding paragraph, must be obligated prior to October 29, 1976, with respect to the payment of the advanced royalties is the partner, not the partnership. For purposes of the preceding sentence a partner is considered obligated prior to October 29, 1976 if the partnership was obligated immediately prior to that date and then only to the extent of the partner's distributive share of the partnership's liability for such payment immediately prior to that date. * * * [T.D. 7523, 1978–1 C.B. at 194.]

On December 8, 1976, Valley issued a Confidential Memorandum, containing a copy of the lease to be executed by Valley and the corporation. Such lease provided that Valley was to pay the corporation a lump sum advanced royalty of $6,750,000; $2,250,000 was to be paid in cash, and the balance, $4,500,000, was to be paid pursuant to an 11-year nonrecourse note. The memorandum also contained the opinion of the tax counsel of the partnership regarding the Federal income tax aspects of the offering. The counsel concluded that the advanced royalty would be deductible in the year paid or accrued pursuant to section 1.612–3(b)(3), Income Tax Regs., as it stood prior to amendment. The counsel was aware that on October 29, 1976, the IRS had proposed to amend such regulation so as to deny a deduction for 1976 in the absence of a sale of coal, but the counsel concluded that the amendment would not apply to Valley since, on October 28, 1976, the joint venture of which Valley was a member had executed a contract to make a lease with the corporation. However, the counsel warned that the Commissioner might seek to apply the regulation as amended to Valley to deny the royalty deduction, specifically pointing out that the limited partners:

will have become partners after October 29, 1976, and the issue is therefore raised as to whether the admission of such parties, and the use of funds contributed by them to pay the advanced royalties, will cause the payments to have been made by a different party than the one bound in the contract.

The proposed amendment contains no explanation of the term “party” and the Service has given no indication on whether admission of new partners would result in the partnership being treated as a new “party.” There is, therefore, a risk that the Service will take an unfavorable...