Burwell v. C.I.R., 120285 FEDTAX, 6493-82

Docket Nº:6493-82.
Attorney:IRENE SCOTT CARROLL, for the respondent. PHILLIP K. FIFE, for the petitioners.
Case Date:December 02, 1985
Court:United States Tax Court

51 T.C.M. (CCH) 6




No. 6493-82.

United States Tax Court

December 2, 1985

Petitioner was a partner in a general partnership, which incorporated in 1976. Petitioner intended that the successor- corporation would not assume the partnership's ending liabilities. The corporation did not execute any agreement to assume these liabilities, nor did the partnership's creditors release their claims against the partnership or its partners. Petitioner remained personally liable on the partnership's outstanding obligations. In 1976, the corporation paid certain debts on behalf of petitioner, which had been incurred by the partnership. HELD, respondent is not estopped from determining a deficiency in petitioner's income tax, based on respondent's initial examination of the partnership's tax return. HELD FURTHER, that upon the incorporation of the partnership business, the corporation did not assume the partnership's ending liabilities and petitioner does not have gain to be recognized pursuant to sections 351 and 357(c), I.R.C. 1954. HELD FURTHER, the corporation's payments of petitioner's personal obligations constitute constructive distributions to petitioner as a shareholder, pursuant to section 301.

IRENE SCOTT CARROLL, for the respondent.

PHILLIP K. FIFE, for the petitioners.



By notice of deficiency dated December 23, 1981, respondent determined a deficiency in petitioners' Federal income tax for the taxable year ended December 31, 1976 in the amount of $20,133. The issues before us are: (1) whether respondent is estopped from determining a deficiency in petitioners' 1976 tax, and, if not, (2) whether petitioners recognized gain due to the assumption of the partnership's liabilities or, alternatively, as constructive distributions by the corporation.


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

Petitioners, Clifton J. Burwell and Ginette A. Burwell, were husband and wife during 1976 and resided in Northridge, California at the time they filed their petition in this case. They timely filed their joint Federal income tax return for the 1976 taxable year with the Internal Revenue Service Center in Fresno, California. Petitioner Ginette A. Burwell is a party in this case solely because she filed a joint tax return with her husband for the year in issue. All references to petitioner in the singular refer to petitioner Clifton J. Burwell.

Petitioner, Oded E. Sturman (Sturman), and Benjamin Grill (Grill) were the three partners of Rain Brain Manufacturing Company (Rain Brain or the partnership), a general partnership. The partnership was formed as of May 1, 1975 without a written partnership agreement. The partnership elected the cash method of accounting. Petitioner owned a 25-percent interest in the partnership and was allocated 90 percent of the partnership profits or losses; Sturman and Grill each owned a 37.5-percent interest and each was allocated 5 percent of the partnership profits or losses. The purpose of the partnership was to develop, manufacture and market battery-operated lawn sprinkler controls. Various patents were obtained with respect to the partnership's operations. They were held by the partners Sturman and Grill individually and were not transferred to the partnership.

Partnership operating funds were provided in part by loans from the partners. In 1975 and 1976 petitioner made seven loans to the partnership, totaling $80,373. In 1975 Sturman and Grill jointly made three loans to the partnership, totaling $30,800. All such loans were evidenced by written promissory notes of the partnership, also executed jointly by the three individuals in their capacities as partners. The notes were not secured by partnership assets nor by personal assets of the nonlender partner(s).

The partnership ceased operating as of April 8, 1976, with ending liabilities of approximately $182,708, as follows:

Debt Amount
Bank account overdraft $ 15,006
Accounts payable (vendors and suppliers) 41,270
Unpaid consulting fees to Sturman and Grill 14,000
Unpaid rent 1,259
Loans outstanding (listed above) 111,173
Total $182,708
Respondent issued a letter, dated January 24, 1980, to the three partners which stated that the 1976 final partnership return for the short taxable year ended April 30, 1976 was ‘ accepted as filed‘ and that ‘ no change‘ was required. On March 11, 1976 the three partners formed Aqua Brain Manufacturing Corporation (Aqua Brain or the corporation). The partnership assets were transferred to the corporation and the corporation continued to carry on the business of the partnership. Aqua Brain was incorporated pursuant to section 25102(h) of the California Corporations Code and section 351, I.R.C. 1954; [1] there was no election of ‘ small business corporation‘ status under section 1372. Section 25102(h) of the California Corporations Code provides as follows: The consideration to be received by the issuer for the stock to be issued shall consist of (i) only assets (which may include cash) of an existing business enterprise transferred to the issuer upon its initial organization, of which all of the persons who are to receive the stock to be issued pursuant to this exemption were owners during, and such enterprise was operated for, a period of not less than one year immediately preceding the proposed issuance, and the ownership of such enterprise immediately prior to such proposed issuance was in the same proportions as the shares of stock are to be issued, or (ii) only cash or cancellation of indebtedness for money borrowed or both upon the initial organization of the issuer, provided all such stock is issued for the same price per share, or (iii) only cash, provided the sale is approved in writing by each of the existing shareholders and the purchaser or purchasers are existing shareholders, or (iv), in a case where after the proposed issuance there will be only one owner of the stock of the issuer, any legal consideration. (Paragraph (3) of section 25102(h), Cal. Corp. Code (West 1977).) Petitioner, Sturman and Grill were equal shareholders of the corporation and received 333 shares of stock each, in exchange for $333 in cash, and each was elected a corporate director. No additional shares of stock were issued at any time. Aqua Brain was incorporated by the partnership's legal counsel. In a letter dated February 23, 1976, petitioner was advised originally by his attorney that- The proposed capitalization will consist of the transfer of the assets of the prior partnership to the Company, and it will be necessary to prepare appropriate promissory notes for advances made by you or your other companies which will be obligations of the Company after the date of its organization. In a subsequent letter, dated April 9, 1976, the same counsel wrote to the three partners as follows: You have received this date various documents in connection with the organization of (Aqua Brain Manufacturing Corporation). I have discussed many of these documents with you in the office, but would like to further amplify the thoughts behind the initial capitalization of the corporation. I have had conversations with both Dale Prince of Seidman & Seidman and Roger Blakely, Esq. regarding the tax ramifications of the initial organization. Since all of you deducted the losses of Rain Brain Manufacturing Company, a partnership, it was thought inadvisable by Dale and myself that we have the corporation assume the obligations of the partnership to the individual partners. If the corporation assumed the debt, it would create ordinary income for each of you in the amount of the obligation thus assumed. Since (as is discussed below) you decided not to transfer any licenses to the corporation, the initial capital contribution from each of you to the corporation will be $333 cash. Of course, we would like to see a more substantial capitalization of the corporation, but at this point in time, given the fact that you don't have a...

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