Beck v. Comm'r of Internal Revenue

• Decision Date: 10 October 1985
• Docket Number: Docket No. 25003-82.
• Citation: 85 T.C. No. 34,85 T.C. 557
• Parties: STANLEY BECK and HELEN BECK, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

85 T.C. 557

85 T.C. No. 34

STANLEY BECK and HELEN BECK, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 25003-82.

United States Tax Court

Filed October 10, 1985.

Petitioner purchased the rights to a book and arranged for independent parties to publish and distribute the book. HELD, based on the entire record, petitioner's activity with respect to the book did not constitute an activity engaged in for profit. GUY P. LANDER and LEONARD R. GLASS, for the petitioners.

GREGG M. WEISS and LEWIS R. MANDEL, for the respondent.

COHEN, JUDGE:

Respondent determined deficiencies in petitioners' Federal income tax of $41,293 for 1978 and $17,272 for 1979, After concessions by petitioners, the issues for decision are as follows: (1) whether petitioner Stanley Beck's activity in connection with the publication of a certain book constituted an activity engaged in for profit and (2) if so, whether a nonrecourse promissory note given as part of the consideration for rights to the book was a genuine indebtedness. ¹ The parties raised various other issues which, in view of our holding herein, we need not and do not address.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference.

Petitioners Stanley Beck (petitioner) and Helen Beck resided in Flushing, New York, at the time they filed their petition herein. They filed joint individual income tax returns for 1978 and 1979.

Since 1953 and during the years in issue, petitioner was a commercial artist and photographer whose primary clients were national television networks. Petitioner's art and photography activities did not involve any facet of the acquisition, production, or distribution of books or any other type of publication. Prior to 1978, petitioner had never purchased any book or publication for production and sale. In that year, petitioner's accountant and tax advisor, Robert M. Rosen (Rosen), suggested that petitioner acquire a book in the ‘Famous First Series‘ investment program offered by Contemporary Perspectives, Inc. (CPI).

CPI was a New York corporation engaged in the publishing and editorial development business. CPI created children's educational books and nonprint media for its own publication and for other publishers. Stephen P. Berner (Berner) and Arthur Rosenberg (Rosenberg) organized CPI in 1976 and were its principal officers and stockholders. Prior to forming CPI, Berner and Rosenberg were high-level executives with Random House, Inc. (Random House) and possessed considerable experience and expertise in educational publishing.

Soon after its formation, CPI was retained by the Baker and Taylor Company, a major book jobber, to organize a series of conferences for reading and education specialists, primarily librarians and teachers. In such conferences, which CPI conducted in various major U.S. cities, CPI presented the new educational publications of approximately 90 publishers. CPI also used the conferences to discover additional markets that it might exploit. Based upon conversations with persons attending the conferences, Berner and Rosenberg concluded that there existed a need for highly interesting yet easily readable nonfiction books to develop the skills of children with reading and language problems.

Berner and Rosenberg concluded that publishing such books would be particularly appropriate for a small company like CPI. They believed that the books would involve less risk and would provide more stable and longer-term returns than would aspiring ‘best sellers‘ and ‘blockbusters.‘

Berner and Rosenberg decided that CPI should publish the books in series, with each series centered around a particular theme. Through the assistance of education experts, CPI would control the reading difficulty of each book within a series.

After consulting various financial institutions, Berner and Rosenberg concluded that CPI would have difficulty obtaining conventional financing for development of the books. Moreover, they believed that establishing a significant presence in the market through the publication of many titles was important for a small, young company like CPI. Therefore, instead of retaining ownership of the books to be published, CPI decided to sell to investors the rights to the books in each series prior to publication and distribution of the books.

In 1977 CPI began publication of its first two series of children's books, ‘Unsolved Mysteries‘ and ‘Myths, Magic and Superstitions.‘ Based upon the initial results of these two series, CPI was optimistic about the future of its children's books series.

In late 1977 or early 1978, CPI began development of its Famous First Series. The Famous First Series consisted of 25 titles conceived by CPI's editors, including ‘America's First Football Game,‘ ‘First to the Moon,‘ ‘The First Woman in Congress: Jeanette Rankin,‘ and the book ultimately purchased by petitioner, ‘When TV Began: The First TV Shows‘ (‘When TV Began‘).

After CPI's editors created each of the 25 titles, CPI contracted with various outside authors, many of whom had experience writing for children, to write the initial manuscripts for the books. The agreement between CPI and Sally Berke (Berke), chief of the Language Arts Department of ‘Readers' Digest‘ and author of ‘When TV Began,‘ illustrates the typical arrangement CPI had with the outside authors. In the agreement, dated February 28, 1978, Berke agreed to research, write, and convey to CPI her entire interest in ‘When TV Began‘ in exchange for $500, Upon receipt of the manuscript from an author, CPI reviewed the work and, based upon that review, might have the manuscript rewritten or restructured by a second writer. Employees of CPI then edited each book for language to assure proper readability and vocabulary levels.

Contemporaneously with the development of the books, CPI began a search for a distributor for the Famous First Series. After receiving bids from several distribution companies, CPI accepted the offer of Silver Burdett Company (Silver Burdett), a subsidiary of Scott, Foresman and Company and a large, highly respected publisher of educational books.

CPI and Silver Burdett entered into a written agreement dated May 26, 1978, in which CPI granted Silver Burdett the exclusive right to the hard cover library bound English language edition of each book in the Famous First Series. Silver Burdett agreed to produce, at its own expense, not less than 5,000 copies of such edition for each book. If any title sold out, Silver Burdett undertook a similar obligation to reprint not less than 3,000 copies of the book. Silver Burdett further agreed to perform, at its own expense, all marketing services associated with the books, defined as ‘promoting, selling, advertising, billing, warehousing, fulfilling, shipping, collecting, bad debt risk, return handling, and all other appropriate customer services for distribution.‘ CPI agreed not to publish a ‘trade or book club English language edition‘ of any of the Famous First Series books within 24 months after the date of the agreement. The agreement entitled CPI to royalties equal to 27.5 percent of the net receipts (gross sales revenues less returns) from the sale of the Famous First Series books by Silver Burdett, based on a list price of not less than $7.44 per book, reduced by discounts of 25 percent for sales directly to schools and libraries and 40 percent for sales to wholesalers. Silver Burdett agreed to pay CPI an advance against the above royalties equal to $3,500 per title on January 5, 1979. The agreement was to continue through June 30, 1982, and indefinitely thereafter unless Silver Burdett breached its obligations with respect to reprints or failed to sell at least 5,000 copies of each title by June 30, 1981.

After entering into the distribution agreement with Silver Burdett, CPI attempted to sell its rights in each of the Famous First Series books (subject to the distribution agreement) to various unrelated investors. CPI ultimately sold approximately 20 or 21 of the 25 books to such investors. Only a few of the investors communicated directly with CPI. Instead, most of the investors either had previously invested in CPI books or were clients or colleagues of professionals with whom CPI did business.

Rosen was such a professional: in addition to being petitioner's accountant and tax advisor, he was the accountant for both CPI and Berner. Rosen had no expertise regarding the acquisition, production, publication, or distribution of books or other publications. He received a fee from CPI equal to approximately $1,500 for each of seven or eight investors, including petitioner, that he persuaded to purchase a book in the Famous First Series. Rosen purchased two of the books for himself.

Prior to presenting to petitioner the opportunity of investing in a Famous First Series book, Rosen examined several documents from CPI relating to the investment program. Among these was a document entitled ‘CONFIDENTIAL OFFERING MEMORANDUM‘ (the offering memorandum). ² The offering memorandum provided that the purchaser of a book would acquire all rights in the book for $130,000, $30,000 in cash ($15,000 at closing and $15,000 (plus interest at 8-/2 percent per annum) on January 15, 1979) and $100,000 by 6 percent, 10-year nonrecourse promissory note. The purchaser would be required to prepay the note to the extent of 50 percent of all sums received by the purchaser from the distribution in the United States and Canada of the hard cover library edition of the book and 70 percent of all other revenues received by the purchaser. Payments on the note would be applied first to interest and then to principal. If the purchaser's share of the revenues from the book was insufficient to pay the note on or before its maturity, CPI's only remedy would be to foreclose upon its retained security interest in the...