86 T.C. 1009 (1986), 10835-82, Tolwinsky v. C.I.R.

Docket Nº:10835-82, 2326-83.
Citation:86 T.C. 1009
Opinion Judge:SIMPSON, JUDGE:
Attorney:Melvin E. Pearl, Rex A. Guest, and Glenn A. Nadell, for the petitioner. Bryan R. Sullivan and Thomas J. Kane, for the respondent.
Case Date:May 28, 1986
Court:United States Tax Court

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86 T.C. 1009 (1986)




Nos. 10835-82, 2326-83.

United States Tax Court

May 28, 1986

P was a limited partner in H, a partnership formed in 1978. In 1977 and 1978, EMI produced a major motion picture film in accordance with the terms of a production-financing-distribution agreement. Under such agreement, U, a major motion picture distributor, advanced a portion of the production funds in return for the exclusive and perpetual right to distribute the film in the United States and Canada. EMI and U were to share equally in the proceeds from the distribution of the film after U recouped its advance, distribution fee, and expenses. In 1978, EMI assigned all its rights under such agreement to a related company, BL. Immediately thereafter, through a series of transactions involving two ‘ strawman‘ entities, H purportedly purchased from EMI all rights (excepting television syndication, television series, remake and sequel rights) to the film in the United States and Canada and licensed BL to distribute the film in such territory. U distributed the fiLm, and it was highly successful at the box office. H made an economic profit on its investment.

Held: (1) H did not acquire a depreciable interest in the film. H purchased, in substance, only a contractual right to payments contingent on the success of the film.

(2) H is entitled to depreciate its basis in such contract right, and its depreciable basis is determined.

(3) A purchase money note given by H did not represent a genuine indebtedness. Consequently, H may not include the face amount of the note in its depreciable basis, and it may not deduct purported interest payments made with respect to the note.

(4) H is not entitled to deduct guaranteed payments made to its general partner and certain unspecified miscellaneous expenses, and its claimed deductions for amortization of an organization fee are allowed only to the extent substantiated.

(5) H was engaged in an activity for profit.

(6) P is not entitled to an investment tax credit with respect to the film because the partnership did not acquire an ‘ ownership interest‘ in the film within the meaning of sec. 48(k)(1), I.R.C. 1954.

Melvin E. Pearl, Rex A. Guest, and Glenn A. Nadell, for the petitioner.

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Bryan R. Sullivan and Thomas J. Kane, for the respondent.


The Commissioner determined deficiencies in the petitioner's Federal income taxes of $23,999 for 1978 and $39,011 for 1979. The issues for decision are: (1) Whether the petitioner, as a limited partner in a partnership purportedly engaged in the purchase and distribution of a motion picture, is entitled to deductions for a distributive share of losses reported by the partnership and, if so, in what amounts; and (2) whether the petitioner is entitled to an investment tax credit.


Some of the facts have been stipulated, and those facts are so found.

The petitioner, Nathan Tolwinsky, maintained his legal residence in Waukegan, Ill., at the time he filed his petitions in these cases. Dr. Tolwinsky filed his Federal income tax returns for 1978 and 1979 with the Internal Revenue Service.

EMI Limited (EMI Ltd.), headquartered in London, was the parent company of British Lion, Inc. (British Lion), and of EMI Films, Inc. (EMI). The subsidiaries maintained separate bank accounts, but their funds were commingled in and drawn from a single concentration account. The subsidiaries filed consolidated tax returns. The offices of British Lion and EMI were located in Beverly Hills, Cal.

In 1977, EMI possessed an option to acquire ‘ all motion picture and certain allied rights‘ in an original screenplay entitled ‘ The Man Who Came to Play. ‘ The original screenplay, written by Louis Garfinkle and Quinn Redeker, had been revised and rewritten by Michael Cimino and Deric Washburn and renamed ‘ The Deer Hunter.‘

On or about May 23, 1977, EMI entered into an agreement with Universal Pictures (Universal) for the production, financing, and distribution of the film ‘ The Deer Hunter‘ (the production-financing- distribution agreement). Under that agreement, EMI agreed to exercise its option to acquire the motion picture and allied rights in the literary material and to produce the film. The final screenplay, final budget,

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and production schedule were subject to Universal's approval. After the director and EMI exercised their rights to cut and edit the motion picture, Universal had the right to cut, edit, alter, delete, add to, or otherwise change the motion picture. Both parties were to contribute to the production costs: Universal agreed to reimburse EMI, on a weekly basis, for one-half of the total direct cost of the motion picture, plus an amount equal to 16 percent of such one-half of the direct cost, but in no event, was Universal obligated to reimburse EMI for more than $4,220,000; EMI agreed to furnish all funds necessary to produce the motion picture in excess of Universal's commitment.

The production-financing-distribution agreement further provided that EMI granted to Universal exclusive and perpetual distribution rights to the motion picture ‘ in all media by any manner and means now known or later developed, ‘ including television, in the ‘ Distribution Territory.‘ However, EMI expressly retained music publishing rights, the right to make commercial phonograph records or tapes of the sound track, publishing rights (with the exception that Universal was entitled to publish, for advertising purposes only, synopsis, novelizations, and other adaptations based on the motion picture or its underlying literary material), and the right to use or license the use of remake, sequel, special or television series rights in the motion picture or in its underlying literary material. The ‘ Distribution Territory‘ was defined as the United States and its territories and possessions, Canada, and ships, planes, and armed forces installations, flying the flag of the United States or Canada. [1] The ‘ net profits,‘ if any, derived by Universal from the distribution of ‘ The Deer Hunter‘ were to be divided equally between EMI and Universal, with the exception that Universal was entitled to retain for its own account the first $250,000 of net profits in excess of the first $2 million of net profits. ‘ Net profits‘ were defined essentially as Universal's ‘ accountable gross‘ (i.e., Universal's receipts, including net sums received by Universal from the settlement of or as a judgment in litigation resulting from any claims for infringement of the film) less

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Universal's distribution fee (30 percent, except 15 percent for ‘ outright sales‘ ) and distribution expenses, and less an amount, to be retained by Universal, equal to the amount contributed by Universal toward the production cost of the film.

The production-financing-distribution agreement granted Universal exclusive control over the distribution, exploitation, marketing, reissuing, and sale or other disposition of the film in the distribution territory, but under a supplemental agreement dated July 5, 1977, Universal agreed, among other things, not to sell the film outright in connection with its theatrical release so long as Universal had its own releasing organizations in the distribution territory. Universal could assign the production-financing- distribution agreement to its parent company (Universal City Studios, Inc.) or to any company with or into which Universal might be merged or consolidated or to any company controlling, controlled by, or under the common control of Universal. EMI's right to assign the contract was limited to a right to assign its percentage share of the motion picture's net profits.

EMI commenced filming ‘ The Deer Hunter‘ sometime in the spring or summer of 1977 and completed filming by the end of 1977. EMI budgeted the direct production costs of the motion picture at $6,845,251, but the final direct production costs actually amounted to approximately $11,900,000. Pursuant to the production-financing- distribution agreement, Universal advanced $4,220,000 to EMI.

EMI delivered the completed motion picture and synchronized sound negative to the laboratory of Technicolor, Inc. (Technicolor), in Los Angeles. The negative could not be removed from Technicolor without the approval of Universal. Both EMI and Universal had the right to obtain positive prints of the film and duplicating material from Technicolor.

In the early months of 1978, EMI came under increasing financial pressure because its film program had gone over budget. To raise cash and to reduce its financial exposure on its investment in the film program, EMI and its parent company, EMI Ltd., engaged in negotiations with several representatives of tax shelter investment groups. EMI Ltd. rejected the proposals of such representatives as unfavorable

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to it and to EMI. Subsequently, in May 1978, Michael Deeley, the president of EMI, attended the Cannes Film Festival and there met a prior acquaintance, Peter Strauss. Mr. Deeley was aware that Mr. Strauss, as an executive vice president of Allied Artists Pictures Corporation, had previously been involved in the arrangement of post-production ‘ tax shelter deals‘ for motion pictures. Mr. Deeley asked Mr. Strauss if he knew of anyone who would be able to enter into an agreement with EMI for the purchase [2] of three movies (‘ The Deer Hunter,‘ ‘ Death on the Nile,‘ and ‘ Convoy‘ ) on short notice and on terms more favorable to EMI than those proposed earlier by tax shelter representatives. Mr. Strauss mentioned the name of Melvin Pearl and agreed to contact him.

Melvin Pearl, an attorney, was a partner in...

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