McCrary v. Comm'r of Internal Revenue

• Decision Date: 17 April 1989
• Docket Number: Docket No. 2979-86
• Citation: 92 T.C. No. 50,92 T.C. 827
• Parties: RONALD W. McCRARY AND DIANE E. McCRARY, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

92 T.C. 827

92 T.C. No. 50

RONALD W. McCRARY AND DIANE E. McCRARY, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 2979-86

United States Tax Court

Filed April 17, 1989

Ps entered into a purported ‘lease‘ of a master recording produced by American Educational Leasing. Shortly prior to trial, they conceded that they were not entitled to the investment tax credit claimed on their tax returns because the agreement was not a lease. They continued to claim deductions for lease payments and other expenses, however. HELD, Ps were not entitled to the deductions claimed. HELD FURTHER, no part of the underpayment of Ps' taxes was attributable to a valuation overstatement, and they are not liable for additions to tax under sec. 6659, I.R.C. Todd v. Commissioner, 89 T.C. 912 (1987), affd. 862 F.2d 540 (5th Cir. 1988), followed. HELD FURTHER, Ps are liable for additions to tax under secs. 6653(a) and 6661 on the full amount of the underpayment. They are liable for additional interest under sec. 6621(c) on the portion of the underpayment attributable to the disallowed deductions but not the portion attributable to the concession that the agreement was not a lease. Gary R. DeFrang, Joseph Wetzel, and Russell A. Sandor, for the petitioners.

Kathleen O. Lier and Mary Beth V. Calkins, for the respondent.

COHEN, JUDGE:

Respondent determined deficiencies in and additions to petitioners' Federal income taxes for 1982 and 1983 as follows:

+--------------------------------------------------------------------------+
                ¦    ¦          ¦Additions to tax                                          ¦
                +----+----------+----------------------------------------------------------¦
                ¦Year¦Deficiency¦Sec. 6653(a)(1) 1  ¦Sec. 6653(a)(2)¦Sec. 6621(d)¦Sec. 6659¦
                +----+----------+-------------------+---------------+------------+---------¦
                ¦1982¦$19,758.43¦$987.92            ¦*              ¦***         ¦$5,550   ¦
                +----+----------+-------------------+---------------+------------+---------¦
                ¦1983¦597.08    ¦1,119.88           ¦**             ¦---         ¦---      ¦
                +----+----------+-------------------+---------------+------------+---------¦
                ¦    ¦          ¦                   ¦               ¦            ¦         ¦
                +----+----------+-------------------+---------------+------------+---------¦
                ¦    ¦          ¦                   ¦               ¦            ¦         ¦
                +--------------------------------------------------------------------------+
                

On their joint Form 1040, U.S. Individual Income Tax Return, for 1982, petitioners claimed a loss on Schedule C of $2,857, consisting of $1,357 (1/7 of the $9,500 lease fee) as ‘rent on business property‘ and $1,500 ‘distributing fees.‘ They claimed $185,000 as ‘qualified investment‘ based on a claimed fair market value of $185,000 for the master recording. They claimed a ‘tentative regular investment credit‘ of $18,500, reducing their reported income tax liability from $24,550 to $6,050, resulting in a claimed refund of income tax withheld of $15,088.47.

On their 1983 Form 1040, petitioners claimed on Schedule C a loss of $1,357 as ‘rent on business property‘ (1/7 of the $9,500 lease fee).

In the statutory notice of deficiency, respondent disallowed the investment tax credit and deductions claimed and determined the additions to tax set forth above. The Explanation of Adjustments for 1982 included the following:

SCHEDULE C AND INVESTMENT TAX CREDIT

It is determined that the alleged losses and investment tax credits claimed on your income tax return with respect to Music Recordings are not allowed because you have not established that the transactions were bona fide arm's-length transactions at fair market value or that such transactions had any economic substance other than the avoidance of taxes. It is further determined that the losses and investment tax credits are not allowed because you have not established that the transactions were incurred in a trade or business entered into for profit.

If the determinations set forth above are not sustained, then it is determined that:

1. The losses are not allowed because you have not established that your method of accounting clearly reflects income or that any amounts deducted were paid or incurred, were ordinary and necessary business expenses, or were anything other than a capital expense.

2. The investment tax credits are not allowed because you have not established: (a) that you qualify for investment tax credit pass-through from the alleged asset's lessor, (b) that the fair market value of basis of the alleged asset is other than zero, (c) that the alleged asset was placed in service in the year claimed, (d) that the alleged asset is tangible property, or (e) that the alleged asset is anything other than a license or non-exclusive right.

It is further determined that if any loss or credit is allowable, such loss or credit is limited to the amount that you and/or the alleged asset's lessor are at risk within the meaning of I.R.C. sections 46(c) (8) and 465.

In the petition filed January 31, 1986, petitioners alleged in part:

4. The determinations of tax and additions to tax, set forth in the notice of deficiency, are based upon the following errors:

* * *

(b) Respondent erred in determining that petitioners are not entitled to claim an investment tax credit for a master educational recording leased by petitioner Ronald W. McCrary in the taxable year 1982.

* * *

5. The facts upon which petitioners rely, as the basis for their case, are as follows:

(a) In 1982, petitioner Ronald W. McCrary leased a master educational recording (‘educational recording‘) from American Educational Leasing (‘AEL ‘) for a term of 85 months. As consideration for use of the educational recording, he was required to make rental payments to AEL. All payments required by the lease agreement have been made.

(b) Under the lease agreement referred to in the preceding subparagraph, AEL, in accordance with I.R.C. sec. 48(d) and applicable Treasury Regulations, elected to treat Mr. McCrary as having acquired the educational recording, which was new tangible property, for its fair market value. On the date leased, the educational recording had a fair market value of not less than $185,000.

In an amendment to petition filed June 8, 1988, a little over a mo nth prior to trial, petitioners alleged in part:

Petitioners amend their petition for this case as follows:

(1) Subparagraph (b) of paragraph 4 is deleted.

(2) Addition of the following subparagraph to paragraph 4:

(g) If respondent correctly determined that there are tax underpayments attributable to a valuation overstatement, negligence or substantial understatement of tax, he erred and abused his discretion in not waiving imposition of these additions to tax.

(3) Addition of the following to subparagraph (a) of paragraph 5.

As initially executed by Mr. McCrary and AEL, the lease was nonexclusive and Mr. McCrary was granted the domestic distribution rights for the educational recording. In 1984 the lease agreement was modified to provide that Mr. McCrary was granted the exclusive right to use the educational recording for the lease term.

(4) Deletion of the phrase ‘in accordance with I.R.C. sec. 48(d) and applicable Treasury Regulations,‘ from the second and third lines of subparagraph (b) of paragraph 5.

(5) Addition of the following subparagraphs to paragraph 5.

(i) There was a reasonable basis for the valuation, if any, attributed to the educational recording on petitioners' return for the taxable year 1982 and such valuation, if any, was made in good faith.

(j) Respondent abused his discretion in not waiving the additions to tax proposed against petitioners as he has waived such additions to tax in cases involving similarly situated taxpayers.

OPINION

This case is a test case for numerous taxpayers who invested in the AEL master recording lease program. For reasons discussed below, we reject petitioner's argument that his intent in entering into the master recording transaction distinguishes him from those taxpayers who failed to sustain claimed deductions and investment tax credits in Apperson v. Commissioner, T.C. Memo. 1987-571, on appeal (7th Cir., Mar. 9, 1988), and in every other case decided by this Court involving the lease or sale of a master recording. See, e.g., Estate of Baron v. Commissioner, 83 T.C. 542 (1984), affd. 798 F.2d 65 (2d Cir. 1986); Morrow v. Commissioner, T.C. Memo. 1988-372; Avers v. Commissioner, T.C. Memo. 1988-176; Lowenbach v. Commissioner, T.C. Memo. 1987-496; Hawkins v. Commissioner, T.C. Memo. 1987-233; and cases cited in Secoy v. Commissioner, T.C. Memo. 1987-286, n. 8, on appeal (9th Cir., Dec. 7, 1987). Respondent moved for damages under section 6673 because of the similarity of this case and those cited.

Petitioners have been candid, however, in explaining that trial of this case was necessitated by the cumulation of various additions to tax determined by respondent. They summarize the situation as follows:

Excluding the alternative determination under I.R.C. sec. 6661, the proposed deficiencies, additions to tax (sometimes referred to as penalties in this brief) and damages total $42,536.40. Twenty-two thousand one hundred eighty dollars and ninety-seven cents ($22,180.97) of this amount, represents penalty and damage liabilities and reflects a determination by respondent that petitioners should pay about $1.09 in penalties and damages for each dollar of tax which is due. Excluding both the I.R.C. sec. 6661 alternative determination and the claim for damages, tax deficiencies of $20,355.42 and penalty liabilities of $17,180.97 have been proposed with a resulting ratio of about eighty-five cents of proposed penalties for each dollar of tax liability asserted.

Petitioners agree that the investment tax credit in the amount of $18,500.00 claimed on their 1982 return is not allowable, leaving in dispute proposed tax deficiencies totaling $1,855.43 and proposed...