90 T.C. 558 (1988), 10193-78, Bailey v. C.I.R.

Docket Nº:10193-78, 12885-80, 21771-81, 4505-82, 3781-85, 18288-85, 18721-85, 18790-85, 18966-85, 19016-85.
Citation:90 T.C. 558
Opinion Judge:SCOTT, JUDGE:
Party Name:GUY B. BAILEY, JR. AND LOIS M. BAILEY, ET AL.,[1] Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Attorney:Richard H. Levine, Carlton M. Smith, and Albert Rosenblum, for the petitioners. Gerald A. Thorpe, for the respondent.
Judge Panel:PAJAK, SPECIAL TRIAL JUDGE:
Case Date:March 31, 1988
Court:United States Tax Court
 
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Page 558

90 T.C. 558 (1988)

GUY B. BAILEY, JR. AND LOIS M. BAILEY, ET AL., [1] Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Nos. 10193-78, 12885-80, 21771-81, 4505-82, 3781-85, 18288-85, 18721-85, 18790-85, 18966-85, 19016-85.

United States Tax Court

March 31, 1988

Petitioner-husbands claimed deductions and investment tax credits in connection with motion pictures through their interests as limited partners in either of two partnerships. HELD:

1. The partnerships did not acquire depreciable interests in the motion pictures but purchased contractual rights to payments contingent on the success of the respective motion picture. Durkin v. Commissioner, 87 T.C. 1329 (1986), and Tolwinsky v. Commissioner, 86 T.C. 1009 (1986), followed.

2. The partnerships are entitled to depreciate their bases in the contractual rights and their bases are determined.

3. The partnerships were engaged in their motion picture activities for profit.

4. The partnerships' nonrecourse purchase money notes must be disregarded for tax purposes since the debts had no substance and thus are not includable in depreciable bases.

5. The partnerships are not entitled to interest deductions on payments made with respect to the purchase money notes.

6. The partnerships are entitled to use the income forecast method based on their earnings from their contract rights.

7. The retroactive application of section 48(k) and section 804 of the Tax Reform Act of 1976 is not unconstitutional. Petitioners-husbands are entitled to investment tax credits as lenders or guarantors with respect to the motion pictures under the regulations promulgated pursuant to section 48(k).

8. Determinations are made as to substantial underpayments of tax due to tax motivated transactions within the meaning of section 6621(c).

Page 559

Richard H. Levine, Carlton M. Smith, and Albert Rosenblum, for the petitioners.

Gerald A. Thorpe, for the respondent.

OPINION

SCOTT, JUDGE:

These cases were assigned to and heard by Special Trial Judge John J. Pajak, pursuant to the provisions of section 7456 (redesignated as section 7443A(b) by the Tax Reform Act of 1986, Pub. L. 99-514, section 1556, 100 Stat. 2755) of the Code and Rule 180 et seq. [2] The Court agrees with and adopts the Special Trial Judge's opinion which is set forth below.

OPINION OF THE SPECIAL TRIAL JUDGE

PAJAK, SPECIAL TRIAL JUDGE:

In these consolidated cases, [3] Respondent determined deficiencies in Federal income taxes due from petitioners as follows:

Petitioners Docket No. Taxable year Deficiency
Bernard B. Neuman 3781-85 1973 $7,534.40
and Miriam Neuman 1974 3,451.00
1975 1,365.85
1976 1,119.50
1977 30.81
Guy B. Bailey, Jr., 10193-78 1974 18,342.50
and Lois M. Bailey 4505-82 1975 222,565.42
1976 75,325.75
Norman B. Levy 12885-80 1974 14,096.00
and Helene Levy 1975 25,277.00
1976 46,815.00
Henry Milgram 21771-81 1971 2,059.00
and Toby Milgram 1972 2,059.00
1974 38,153.00
19016-85 1975 2,447.00
1976 90,419.00
1977 1,212.00
Henry Milgram 18966-85 1978 5,754.00
and Carol Milgram 1979 1,210.00
William Milgram 18721-85 1971 4,975.00
and Harriet Milgram 1974 25,887.00
1975 77,872.00
1976 160,000.00
1977 2,177.00
William Milgram 18790-85 1978 7,522.00
1979 3,146.00
William Milgram 18288-85 1980 83,823.00
and Joyce Milgram
Page 560 Respondent also determined an addition to tax under section 6651(a)(1) in the amount of $1,834.25 for the year 1974 in docket No. 10193-78. Certain issues in these cases were severed and consolidated for the purposes of trial, briefing, and opinion. These issues arise out of activities of two partnerships, Persky-Bright Associates (Persky- Bright) and Vista Company (Vista). After concessions, the issues for decision are: (1) whether the partnerships purchased interests in motion pictures, and, if so, the nature of their purchases; (2) whether the partnerships constituted activities not engaged in for profit within the meaning of section 183; (3) whether the nonrecourse notes should be included in the basis of the partnerships' interests in the motion pictures, and, if not, the determination of the basis of the partnerships' interests; (4) whether the partnerships may deduct interest on the Page 561 nonrecourse notes; (5) whether the partnerships are entitled to depreciation deductions under the income forecast method; (6) whether each petitioner is entitled to an investment credit; and (7) whether petitioners are subject to an increased rate of interest under section 6621(d) (now section 6621(c)) [4] for substantial underpayments attributable to tax motivated transactions. FINDINGS OF FACT Some of the facts have been stipulated. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference. Petitioners Guy B. Bailey, Jr. and Lois H. Bailey resided in Coral Gables, Florida, when their petition was filed. Petitioners Norman B. Levy and Helene Levy resided in Woodland Hills, California, at the time their petition was filed. Petitioners Bernard B. Neuman and Miriam Neuman resided in Skokie, Illinois, when their petition was filed. Petitioners Henry Milgram and Toby Milgram resided in Penn Valley, Pennsylvania, and Bala Cynwyd, Pennsylvania, respectively, at the time their petition was filed. Petitioners Henry Milgram and Carol Milgram resided in Penn Valley, Pennsylvania, at the time their petition was filed. Petitioners William Milgram and Harriet Milgram resided in Boca Raton, Florida, and Elkins Park, Pennsylvania, respectively, at the time their petition was filed. Petitioner William Milgram resided in Boca Raton, Florida, when his petition was filed. Petitioners William Milgram and Joyce Milgram resided in Boca Raton, Florida, when their petition was filed. On their pertinent Federal income tax returns, petitioner- husbands as partners in Persky-Bright and Vista claimed deductions and investment tax credits. Respondent disallowed the claimed deductions and investment credits on a variety of grounds. Page 562 BACKGROUND Persky-Bright and Vista are two of a number of film partnerships organized by Lester Persky (Persky) and Richard Bright (Bright). Persky, after an advertising and public relations career, was involved with the production of several motion pictures in the late 1960s. Bright was experienced in the fields of taxation and cash management and was a financial advisor who specialized in agricultural and real estate investments before joining forces with Persky. They met in 1971 when Persky was attempting to find an American distributor for two foreign films. They became the general partners of a limited partnership which purchased the two films. Persky and Bright were not satisfied with the independent distributor of those films. In 1973, Columbia pictures, Inc. (Columbia), a major distributor, was in desperate financial condition, nearing bankruptcy. It had experienced operating losses in excess of $100 million during the prior three years and had an approximate net worth of only $8 million. Columbia was over $250 million in debt and the banks refused to extend any further credit. The banks insisted on a change of management. Burton Marcus (Marcus), a tax lawyer, became the vice-president and general counsel of Columbia. He and several other new operating officers determined that Columbia's most potent source of cash was through the distribution of films and that they would not give up the right to distribute their films. They estimated that approximately $40 million was needed to produce the films they wanted to distribute. Columbia had $25 million at the time. To raise part of the difference Columbia sold its corporate headquarters building at a bargain price of $11,000,000, its television stations in Salt Lake City, New Orleans, and Puerto Rico, and its Learning Corporation. To raise additional funds, Marcus decided to develop a program to sell films. [5] After doing a cost analysis, Marcus decided that he would price the films at warranted cost plus at least a 25 percent markup. Page 563 The first film Columbia decided to sell was ‘ Summer Wishes, Winter Dreams.‘ Marcus learned that Persky and Bright wanted to buy the film. In late 1973, Marcus met with Persky and Bright to arrange the sale of ‘ Summer Wishes, Winter Dreams‘ to Persky-Bright. Persky and Bright did not have any independent projections of profit made before contracting for the film. In 1974, Marcus met with Persky and Bright to arrange the sale of a package of four films to Vista, the other partnership involved in this case. Again, Persky and Bright did not have any independent projections of profit made before contracting to buy the film package. Ultimately, Columbia sold 10 to 15 films to partnerships organized by Persky and Bright. I PERSKY-BRIGHT Persky-Bright is a New York limited partnership formed on October 15, 1973. Persky and Bright are the general partners, each owning a 2.5 percent interest in the profits and losses and a 0.5 percent interest in the investment tax credit and 2.5 percent interest in the cash flow of the partnership. Persky and Bright prepared an informal offering memorandum for prospective partners. The memorandum was similar to the offering memorandum prepared in connection with the formation of the Vista partnership. During the years in issue, the limited partners held in aggregate a 95 percent interest in the...

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