Patin v. Comm'r of Internal Revenue

Decision Date29 April 1987
Docket Number7434-84,Docket Nos. 31925-83,15992-84,16937-84.,9257-84
PartiesMICHAEL W. PATIN AND SANDRA H. PATIN, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
CourtU.S. Tax Court

OPINION TEXT STARTS HERE

Ps, individual investors, each purchased from O specified tonnages of ore in the form of one or more undesignated ore blocks for a price of $50 plus a fifty percent overriding royalty. Under the Purchase Agreements ore blocks were to be randomly assigned to Ps by O at an unspecified later date and from an unspecified mining property or properties. Ps then contracted with A, an affiliate of O, to perform mining development services with respect to such ore for a fee of $50 per ton. The development fee was paid one-sixth with cash and five-sixths with funds allegedly borrowed from K, evidenced by a 10 year promissory note which on its face was recourse as to principal and non-recourse as to interest. In fact, a circular flow of investors' cash from A to E, then to K, then back to A was used to create the appearance that K had funded investors' promissory notes. Ps deducted the full contract amount of the development fee as mining development expenses pursuant to section 616(a) on their 1980 Federal income tax returns. No payments were ever made on the promissory notes, and such notes were cancelled and returned to Ps during 1982 or 1983. Specific ore blocks were never assigned to investors, nor was any mining ever performed on their behalf.

HELD:

(1) The transactions herein lack economic substance, and are to be disregarded for Federal income tax purposes;

(2) such transactions are ‘tax motivated transactions‘ within the meaning of section 6621(d);

(3) Ps in docket Nos. 15992-84 and 16937-84 are liable for the addition to tax under section 6653(a) for negligence or intentional disregard of rules or regulations. David A. Aughtry, for the petitioners.

Ana G. Cummings and Bernard B. Nelson, for the respondent.

FEATHERSTON, JUDGE:

These consolidated cases were assigned to Special Trial Judge Marvin F. Peterson pursuant to section 7456(d) 2 (redesignated as section 7443A(b) by the Tax Reform Act of 1986, Pub. L. 99-514, section 1556, 100 Stat. 2755), and Rules 180, 181 and 183. 3 The Court agrees with and adopts his opinion which is set forth below.

OPINION OF THE SPECIAL TRIAL JUDGE

PETERSON, SPECIAL TRIAL JUDGE:

These consolidated cases were selected by counsel and approved by the Court to serve as test cases for resolving issues common to a much larger group of petitioners who invested during 1980 in the ‘Gold Ore Purchase and Mining Program‘ marketed by Omni Resource Development Corporation. Respondent determined deficiencies and additions to tax in Petitioners' 1980 Federal income taxes as follows:

+-----------------------------------------------------------------------------+
                ¦         ¦                                          ¦          ¦Addition to  ¦
                ¦         ¦                                          ¦          ¦tax          ¦
                +---------+------------------------------------------+----------+-------------¦
                ¦         ¦                                          ¦          ¦I.R.C. 1954, ¦
                +---------+------------------------------------------+----------+-------------¦
                ¦Docket   ¦Petitioner                                ¦Deficiency¦sec. 6653(a) ¦
                ¦No.      ¦                                          ¦          ¦             ¦
                +---------+------------------------------------------+----------+-------------¦
                ¦31925-83 ¦Michael W. Patin and Sandra Patin         ¦$49,807.92¦0            ¦
                +---------+------------------------------------------+----------+-------------¦
                ¦7434-84  ¦Gordon W. Hatheway, Jr., and Barbara S.   ¦11,729.41 ¦0            ¦
                ¦         ¦Hatheway                                  ¦          ¦             ¦
                +---------+------------------------------------------+----------+-------------¦
                ¦9257-84  ¦Arthur Espy                               ¦19,121.25 ¦0            ¦
                +---------+------------------------------------------+----------+-------------¦
                ¦15992-84 ¦Edward N. Gomberg and Helen E. Gomberg    ¦71,719.66 ¦$3,635.90    ¦
                +---------+------------------------------------------+----------+-------------¦
                ¦16937-84 ¦William S. Skeen and Alison Skeen         ¦20,000.00 ¦1,000.00     ¦
                +-----------------------------------------------------------------------------+
                

The issues for decision are (1) whether and to what extent petitioners are entitled to deductions for mining development expenditures under section 616 or, in the alternative, for mining exploration expenditures under section 617, (2) whether petitioners Gomberg (docket No. 15992-84) and Skeen (docket No. 16937-84) are liable for additions to tax under section 6653(a) as set forth above, and (3) whether petitioners are liable under section 6621(d) 4 for additional interest with respect to tax motivated transactions. This last issue was raised by respondent by amended answers in these cases.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulations of fact and exhibits attached thereto are incorporated herein by this reference. At the time their respective petitions were filed, petitioners Michael W. Patin and Sandra H. Patin resided in Houston, Texas; petitioners Gordon W. Hatheway, Jr. and Barbara S. Hatheway resided in Fairfax, Virginia; petitioner Arthur Espy resided in Dallas, Texas; petitioners Edward N. Gomberg and Helen E. Gomberg resided in Hixon, Tennessee; and petitioners William S. Skeen and Alison Skeen resided in Irvine, California.

GENERAL OVERVIEW OF GOLD PROGRAM

Omni Resource Development Corporation (Omni) was formed March 17, 1980, under the laws of the State of Delaware. American International Mining Co., Inc. (AMINTCO) was formed under Delaware law on April 14, 1980. During 1980 Dr. Phillip A. Myers (Myers) and Elwood E. Parrish (Parrish) each owned 50 percent of the capital stock of each corporation.

The deductions in dispute in these cases arise out of the participation of petitioner-husbands and petitioner Espy (hereinafter petitioners,‘ unless otherwise indicated) in Omni's ‘Gold Ore Purchase and Mining program ‘ (sometimes hereinafter referred to as the gold program). The gold program was organized and promoted through the efforts of Myers and Parrish during 1980 ostensibly to mine gold and silver ore from the ‘Shamrock‘ and ‘Encino Vivo‘ lode claims located near Silver City in southwestern New Mexico. Neither Myers nor Parrish had any previous gold mining experience at the time they organized the Omni gold program.

The gold program was promoted as providing a tax deduction equalling six times the cash invested in 1980 by prospective investors. The offering materials (hereinafter referred to as the ‘prospectus‘) petitioners received contained the following description of the gold program:

STRUCTURE OF THE PROGRAM — For a PRINCIPAL 5 who wishes to both mine gold and silver and generate a large 1980 tax loss, the program would work as follows. If the PRINCIPAL wishes, as an example, to generate a $60,000 ordinary tax loss in 1980, he would first buy 1,200 tons of gold-bearing ore from OMNI — at a total cost of $50 plus a 50% royalty of the gold and silver contents. Second, the PRINCIPAL would sign a $60,000 contract with American International Mining Co., Inc. (‘AMINTCO‘) to develop the mine site for the 1,200 tons, and to then mine and process the ore all the way to bullion. The $60,000 contract would be paid by the PRINCIPAL with $10,000 in cash, and the proceeds of a $50,000 ten year recourse note. In a typical case, part of the bullion produced would be sold to repay the note, over a five year period.

The prospectus detailed the tax benefits of the gold program in several places, including the following description in question-and- answer form:

WHAT IS THE TAX WRITE-OFF (ALSO CALLED THE REDUCTION OF ADJUSTED GROSS TAXABLE INCOME) FOR THE 1980 TAX YEAR?

The tax write-off or reduction of adjusted gross taxable income is 6 to 1.

WHAT DOES 6 to 1 MEAN?

This means that the write-off or reduction of adjusted gross taxable income is 6 times your CASH outlay.

HOW IS THIS DERIVED?

We shall use a simple example of a Principal who has $10,000 in cash, needs to shelter $60,000 in other income during 1980, and wants to make a very handsome return on his cash. This Principal would buy 1,200 tons of gold and silver bearing ore from Omni Resource Development Corporation (‘OMNI‘), which owns the Shamrock and Encino Vivo gold lodes in New Mexico. The cost to the Principal would be $50. [sic] plus 50% of the gold and silver contents processed from the ore. The Principal now owns the ore. If the Principal wishes to get the maximum tax advantage, he would next contract with American International Mining Co., Inc. (‘AMINTCO‘) to develop his mine site, and process his ore. The Principal pays AMINTCO $50.00 per ton for mine development, or $60,000 in total (1,200 tons x $50. = $60,000). OMNI has made arrangements for Kensington Financial Corporation to loan principals 5/6 of this development expense, or $50,000 in this case, at 10% simple interest, on a ten year note. The Principal will borrow this $50,000 by signing a note to Kensington, and directing Kensington to pay the money directly to AMINTCO. The $10,000 in cash plus the $50,000 borrowed equals $60,000, which gives the 6 to 1 write off. The tax code clearly states that mine development expenses (the $60,000) are deductable in full in the year in which incurred, thus the Principal can deduct the entire $60,000 in 1980.

* * *

Following are the tax savings you could expect in 1980, assuming you fully shelter your other income with this program. All figures are in dollars.

+----------------------------------------------------------+
                ¦        ¦Net           ¦       ¦      ¦       ¦Cash6      ¦
                +--------+--------------+-------+------+-------+-----------¦
                ¦        ¦taxable income¦Federal¦State ¦Total  ¦savings    ¦
...

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