Estate of Baron v. C.I.R.

• Decision Date: 12 August 1986
• Docket Number: No. 623,D,623
• Parties: -5688, 86-2 USTC P 9622 ESTATE of Sydney S. BARON, Sylvia S. Baron, Administratrix, and Sylvia S. Baron, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. ocket 85-4072.
• Court: U.S. Court of Appeals — Second Circuit

Page 65

798 F.2d 65

58 A.F.T.R.2d 86-5688, 86-2 USTC P 9622

ESTATE of Sydney S. BARON, Sylvia S. Baron, Administratrix,

and Sylvia S. Baron, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 623, Docket 85-4072.

United States Court of Appeals, Second Circuit.

Argued Jan. 21, 1986.

Decided Aug. 12, 1986.

Marvin E. Frankel, New York City (Steven C. Todrys, Alvin D. Knott, New York City, Kramer, Levin, Nessen, Kamin & Frankel, of counsel), for petitioners-appellants.

Glenn L. Archer, Jr., Asst. Atty. Gen., Washington, D.C. (Michael L. Paup, Ann Belanger Durney, Michael J. Roach, Attys., Tax Div., U.S. Dept. of Justice, Washington, D.C., of counsel), for respondent-appellee.

Leon C. Baker, White Plains, as amicus curiae.

Before LUMBARD, MESKILL and PIERCE, Circuit Judges.

PIERCE, Circuit Judge:

This is an appeal from a judgment of the United States Tax Court, Tannenwald, Judge, holding that taxpayers Sydney S. Baron ("Baron"), now deceased, and his wife improperly claimed certain deductions on their joint personal income tax return for the tax years 1977 and 1978 and must therefore pay $230,031 and $82,525 for those years, respectively, pursuant to a notice of deficiency issued by the Commissioner of Internal Revenue ("Commissioner"). The claimed deductions reflected alleged losses relating to certain rights in a master recording of the soundtrack to a movie. Baron had purchased those rights in 1977 for $90,000 in cash and $560,000 in two nonrecourse notes bearing face amounts of $460,000 and $100,000, respectively, and payable solely out of the record sale proceeds. The master recording having generated only slight revenues, the Barons claimed depreciation deductions in 1977 and 1978 based upon the $90,000 cash outlay and the $460,000 nonrecourse note. The Tax Court denied the deductions and held that: (1) the obligation represented by the nonrecourse note was "too contingent" to be included in basis under Internal Revenue Code ("I.R.C.") Sec. 167, 26 U.S.C. Sec. 167, irrespective of the existence of some market value of the master recording rights; and (2) petitioners did not sustain their burden of proving the requisite profit objective under I.R.C. Sec. 183, 26 U.S.C. Sec. 183. Estate of Baron v. Commissioner, 83 T.C. 542 (1984).

Appellants argue principally that the Tax Court erred: (1) in excluding the $460,000 note from Baron's deductible basis in the rights without specifically making a finding as to the value of the rights at the time of purchase; and (2) in finding that Baron's purchase of the recording rights constituted an activity "not engaged in for profit" under I.R.C. Sec. 183.

Appellee argues principally that: (1) the Tax Court's exclusion of the $460,000 nonrecourse note from Baron's deductible basis in the rights was proper because the Court found that the fair market value of the master recording securing the note was not reasonably equivalent to the face amount of the note; and (2) the Tax Court correctly found that Baron's purchase of the rights was not an activity "engaged in for profit" under section 183, and that his deductions were thus limited at most to the gross income derived from that activity.

For the reasons stated below, we affirm the judgment of the Tax Court.

BACKGROUND

Baron was a public relations executive whose gross income was approximately $515,000 for the tax year 1977 and $345,000 for the tax year 1978. In the spring of 1977, Richard Baron, Sydney Baron's son (and a tax lawyer), called Richard Talmadge, an entertainment lawyer to whom he had been referred, and asked whether Talmadge knew of any good entertainment properties in which Richard Baron's family might invest.

Talmadge contacted his friend, Richard Trugman, who was vice-chairman, secretary and treasurer of Casablanca Record and Filmworks, Inc. ("Casablanca"), which was then a young, successful and aggressive film company. Although Trugman at first responded that Casablanca had nothing to sell, he later informed Talmadge that Casablanca would be willing to sell the United States and Canadian rights in the master recording of the soundtrack to "The Deep," a movie that Casablanca was then producing with Columbia Pictures, Inc., based on a novel by Peter Benchley and perceived as a sequal to the movie, Jaws. The recording was of fine technical quality and included compositions by John Barry, a well-known composer. Side One of the recording contained Parts I and II of a song entitled "Return to the Sea." On Side Two were two vocal versions--one fast and one slow--of "Theme From the Deep (Deep, Deep Inside)," sung by Donna Summer, a well-known vocalist. Side Two also featured a third version, this one instrumental, of the same song, and a song called "Disco Calypso" by a little known group named "Beckett." In January, 1977, Neil Bogart, Casablanca's president, estimated to Trugman in a memorandum that he believed that Casablanca would sell not less than 100,000 long playing ("LP") record albums, "with a potential of 500,000." Judge Tannenwald found that "the major purpose of the album was to promote the movie." 83 T.C. at 546.

Talmadge informed Richard Baron of the recording. Neither Richard Baron nor his father had had any business experience in the record industry. Judge Tannenwald found, and appellants do not contest, that Baron failed to adduce evidence that he had obtained an appraisal of the value of the United States and Canadian rights in the recording prior to purchasing it in May 1977. Nonetheless, Baron purchased the rights in a three-step transaction.

First, on May 18, 1977, Casablanca sold the rights to "Whittier," a shell corporation wholly owned by Martin Engels, a commercial lawyer with whom Richard Baron shared office space. Whittier in return gave to Casablanca $90,000 in cash and a nonrecourse note in the face amount of $460,000 due in seven years at 7% per annum payable out of fifty percent of the royalties from the master recording. All parties understood that Baron would immediately purchase the rights from Whittier. Second, on May 28, 1977, Whittier sold the rights to Baron for $90,000 cash, the assumption of Whittier's obligation to Casablanca on the $460,000 note, and the issuance from Baron to Whittier of a separate $100,000 nonrecourse note, at 6% annual interest, to be paid out of ten percent of Baron's royalties from the recording. In fact, Engels never received any payments under the $100,000 note, notwithstanding Baron's realization of $32,672 in total royalty receipts in 1977, 1978 and 1979. Moreover, Engels agreed to cancel the $100,000 note on March 1, 1978 when it became clear that record sales were and would continue to be hopelessly low. In the third part of the transaction, Baron sold to Casablanca on May 27, 1977 the sole distribution rights to the master recording. In return, Baron would receive $.80 for each LP album or tape sold in the United States, $.04 for each 45 rpm record sold in the United States, $.40 for each LP or tape sold in Canada, and $.02 for each 45 rpm record sold in Canada. Half of Baron's royalties, however, would be retained by Casablanca as payment on the $460,000 note.

Although Casablanca vigorously promoted the recording, and thereby the film, which itself was a success, record sales

                were dismally low.  Under the terms of the agreements, it would appear from the Commissioner's analysis of the evidence adduced at trial that approximately 1,150,000 records would have to have been sold for Baron to pay off the $460,000 note and recoup his cash outlay. 1   Instead, Baron's total royalty receipts for three years, net of withholdings by Casablanca pursuant to the distribution agreement, was $32,672.  Baron declared $550,000 as his basis in the recording and, under the income forecast method of depreciation, deducted 72.98 percent of that amount ($401,390) on his 1977 joint tax return and the other 27.02 percent ($148,610) on his 1978 joint tax return.  The Commissioner issued a notice of tax deficiency for those years, which was the subject of an unsuccessful petition by the Barons before the Tax Court.  This appeal followed
                

DISCUSSION

This case requires us to consider whether the Tax Court properly disallowed Baron's depreciation deductions based on the face amount of the $460,000 nonrecourse note and the $90,000 cash outlay in the purchase of a recording that, by all accounts, was a financial failure. ² The case thus entails analysis of two discrete legal questions arising from a common set of facts attendant to the three-step transaction by which Baron acquired the rights to the recording. These issues are (1) whether, under I.R.C. Sec. 167, the Tax Court properly excluded the $460,000 note from Baron's basis in the recording as "too contingent" an investment, given the uncertain value of the underlying collateral and (2) whether, under I.R.C. Sec. 183, the Tax Court properly concluded that the purchase of the recording did not constitute an activity "engaged in for profit."

1. Exclusion of the $460,000 Nonrecourse Note.

It is well settled that nonrecourse debt may constitute part of a taxpayer's basis in property under I.R.C. Sec. 167 ³ as long as the fair market value of the property securing the debt reasonably approximates the principal amount of the debt. See, e.g., Brannen v. Commissioner, 722 F.2d 695, 701 (11th Cir.1984); Estate of Franklin v. Commissioner, 544 F.2d 1045, 1048-49 (9th Cir.1976). Conversely, a taxpayer may not include in his basis a liability that, for any economic reason, does not constitute a "genuine debt[ ]," Deegan v. Commissioner, 787 F.2d 825, 827 (2d Cir.1986) (per curiam), since it would be manifestly unfair to permit a taxpayer to enjoy the benefits of deducting as losses an alleged indebtedness for which there had been no economic incentive or expectation Baron argues that the Tax Court erred in applying the contingency principle to the present case rather than...