90 T.C. 1154 (1988), 8679-86, Ferrell v. C.I.R.

Docket Nº:Dkt. 8679-86, 8742-86, 7283-87.
Citation:90 T.C. 1154
Opinion Judge:FEATHERSTON, JUDGE:
Party Name:WILLIAM L. FERRELL, ET AL., Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Attorney:Michael J. Christianson, for the petitioners. William H. Quealy, Jr., and Jeffrey A. Hatfield, for the respondent.
Case Date:June 16, 1988
Court:United States Tax Court
 
FREE EXCERPT

Page 1154

90 T.C. 1154 (1988)

WILLIAM L. FERRELL, ET AL., Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Dkt. Nos. 8679-86, 8742-86, 7283-87.

United States Tax Court

June 16, 1988

         Petitioners purchased limited partnership interests in Western Reserve Oil and Gas Company (Western Reserve) and claimed deductions for their distributive shares of losses and other deductions reported by Western Reserve for 1981 and 1982.

         Held: Western Reserve did not incur the disputed losses and expenditures in carrying on a ‘ trade or business‘ within the meaning of sec. 162(a) or sec. 167(a), I.R.C. 1954; therefore, the claimed deductions are not allowable.

         Held, further: The purported obligations on which the interest deductions were allegedly accrued were not genuine indebtedness within the meaning of sec. 163(a), I.R.C. 1954; therefore, the interest deductions reported by Western Reserve are not allowable.

         HELD, FURTHER: Petitioners have not shown that any oil and gas leases for which abandonment losses were claimed under sec. 165, I.R.C. 1954, became worthless in 1982 or that Western Reserve had a basis in such leases; therefore, the claimed deductions are not allowable.

         HELD, FURTHER: Petitioners are liable for additions to tax under secs. 6653(a)(1) and (2), and 6661, I.R.C. 1954, and additional interest under sec. 6621(c) (formerly sec. 6621(d), I.R.C. 1954; petitioners are not liable for the addition to tax under sec. 6659, I.R.C. 1954.

          Michael J. Christianson, for the petitioners.

         William H. Quealy, Jr., and Jeffrey A. Hatfield, for the respondent.

         FEATHERSTON, JUDGE:

         These consolidated actions are test cases which were selected for trial to attempt to resolve approximately 200 other cases (many with multiple petitioners) docketed in this Court as well as other similar cases pending administratively in the Internal Revenue Service (IRS). In the cases before the Court, respondent determined the following deficiencies for 1981 and 1982:

William L. Ferrell
Docket No. 8679-86
Addition
Sec. 6653(a)(1), Sec. 6653(a)(2), Sec. 6659,
Year Deficiency I.R.C. 1954 I.R.C. 1954 I.R.C. 1954
1982 $21,797 $1,090 50% of interest $6,540
due on $21,797
Robert Crowder
Docket No. 8742-86
Addition
Sec. 6653(a)(1), Sec. 6653(a)(2), Sec. 6659,
Year Deficiency I.R.C. 1954 I.R.C. 1954 I.R.C. 1954
1981 $38,978 $1,948.90 50% of interest $11,693.40
due on $38,978
Robert A. and Barbara J. Woltman
Docket No. 7283-87
Addition
Sec. 6653(a)(1), Sec. 6653(a)(2), Sec. 6659,
Year Deficiency I.R.C. 1954 I.R.C. 1954 I.R.C. 1954
1981 $7,357 $368 50% of interest $2,207
due on $7,357
1982 8,620 431 50% of interest 2,586
due on $8,620
Page 1155           The issues for decision arise from respondent's disallowance of losses and deductions attributable to Western Reserve Oil and Gas Company, Ltd. (hereinafter Western Reserve), a limited partnership in which petitioners were members. The issues to be decided are as follows:          1. Whether petitioners are entitled to deductions for their distributive shares of Western Reserve's losses and other deductions for 1981 and 1982. The answer to that question depends mainly on whether Western Reserve was engaged in a ‘ trade or business‘ within the meaning of sections 162(a)[2] and 167(a).          2. Whether the promissory notes with respect to which Western Reserve accrued interest for 1982 under section 163(a) were genuine indebtedness.          3. Whether petitioners have shown that Western Reserve is entitled to abandonment losses for 1982 with respect to certain oil and gas leases. Page 1156           4. Whether any part of petitioners' underpayment of tax for 1981 and 1982 was attributable to negligence or intentional disregard of the rules and regulations within the meaning of section 6653(a)(1) and (2).          5. Whether petitioners' underpayment of tax, if any, for 1981 or 1982 or both is attributable to a valuation overstatement within the meaning of section 6659.          6. Whether petitioners had a substantial understatement of tax for 1982 within the meaning of section 6661(a).          7. Whether petitioners are liable for additional interest under section 6621(c)[3] for 1981 and 1982.          FINDINGS OF FACT          1. BACKGROUND FACTS          Petitioners were residents of California when they filed their petitions. They filed Federal income tax returns for 1981 and 1982 on which they claimed deductions and investment tax credits with respect to Western Reserve, a limited partnership organized under the laws of California.          Western Reserve was organized by Trevor Phillips (Phillips) on December 2, 1981, as a vehicle for a tax shelter program. Under a Certificate and Agreement of Limited Partnership of Western Reserve Oil and Gas Company, Ltd. (partnership agreement), filed December 2, 1981, the general partner was Phillips International Marketing Co., Inc. (Pimco), a California corporation formed in 1981. Phillips was Pimco's sole shareholder and chief executive officer. The stated purpose of Western Reserve was to acquire and develop oil and gas properties anywhere in the United States. During 1981, 1982, and at least part of 1983, Phillips was Western Reserve's general manager. Under the partnership agreement as amended on March 10, 1982, he was added as a general partner; the agreement was again amended on January 31, 1983. Prior to this oil and gas venture, Phillips had worked in sales, advertising, and communications; he had no prior oil and gas business experience. Page 1157           As a participant in the program, Magna Energy Corporation (Magna) was organized on October 5, 1981, under the laws of Louisiana by Terry Mabile (Mabile) and William V. Brannan (Brannan). Brannan owned 5 percent of the stock and was president of the corporation. Mabile owned 95 percent of the stock and was the corporation's secretary-treasurer.          Mabile was a former revenue agent who marketed interests in Western Reserve and other tax shelters through an organization which used a card bearing the legend ‘ Mabile & Associates, Tax Shelters Assembled by Former Revenue Agents. ‘ Handling all of Magna's dealings with Western Reserve, he was the principal promoter of sales of interests in Western Reserve. His associates, salesmen, or tax advisors who sold Western Reserve limited partnership interests included Garry Gorman, Erroll Davidson, Jack Alexander, and Clark Lilly.          Brannan was the only one connected with Magna or Western Reserve who had any oil and gas business background. He had studied geology and for 25 years prior to his association with Magna had owned a land title and oil and gas leasing business. His work consisted mainly of determining the ownership of drill sites, pipelines, and the like for oil companies.          Magna's only employees were Brannan, his secretary, and, for a short period of time, a landman. Magna paid Brannan a salary of approximately $60,000 per year. For 1981, Magna received approximately $60,000 from Western Reserve to cover Brannan's salary and expenses and for 1982 and 1983 Magna received $100,000 each year, designated as advance minimum royalties, to cover his salary and expenses.          2. PROMOTIONAL ACTIVITY          Western Reserve distributed lengthy confidential private placement memoranda (sometimes herein offering memoranda or memoranda) for 1981 and 1982 to individuals interested in making investments. The memoranda stated that units of interest in Western Reserve would be offered and sold in a private offering and that the units had not been registered with the Securities and Exchange Commission Page 1158 or any State regulatory agency. The memoranda explained that, because the investments involved a high degree of risk, the units were being offered to a limited number of sophisticated investors in the 50-percent income tax bracket who had sufficient knowledge or professional advice to evaluate the partnership as an investment. Investors were required to satisfy the corporate general partner that they had a net worth (exclusive of home, furnishings, and automobile) exceeding $250,000 if residents of California, and $500,000 if nonresidents of that State. The offering memoranda included a lengthy tax opinion by an attorney, John H. Sibbison, discussing a long list of tax issues that might be raised by the program.          Numerous seminars and promotional meetings were held to sell shares in Western Reserve and a great deal of promotional material, in addition to the offering memorandum, was distributed to promote sales. Those materials placed heavy emphasis on the tax benefits to be derived from the program and stressed that Mabile and his sales associates were former revenue agents.          The promotional material used by Mabile and his salesmen outlined a program in which investors would make a minimum cash investment of $10,000 and sign short-term and long-term notes, described below, totalling $140,000; Western Reserve would acquire interests in oil and gas leases from Magna, and Western Reserve would give Magna long-term notes, which would be assumed proportionately by the investors, in amounts equal to the investors' notes to Western Reserve; Western Reserve would accrue the amounts of the notes to Magna as advance minimum royalty deductions, and deductions for those royalties plus other credits and expenses would be passed through the Western Reserve partnership to the investors-limited partners. One piece of promotional material described the tax benefits as follows: [4]          This...

To continue reading

FREE SIGN UP