Foster v. C.I.R.

• Decision Date: 03 April 1985
• Docket Number: No. 83-7745,83-7745
• Citation: 756 F.2d 1430
• Parties: -1285, 85-1 USTC P 9300 Richard H. FOSTER and Sara B. Foster, T. Jack Foster, Jr. and Patricia Foster, Jack R. Foster and Caroline Foster, and Estate of T. Jack Foster, Deceased, Gladys H. Foster, Executrix, and Gladys H. Foster, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 1430

756 F.2d 1430

55 A.F.T.R.2d 85-1285, 85-1 USTC P 9300

Richard H. FOSTER and Sara B. Foster, T. Jack Foster, Jr. and Patricia Foster, Jack R. Foster and Caroline Foster, and Estate of T. Jack Foster, Deceased, Gladys H. Foster Executrix, and Gladys H. Foster, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 83-7745.

United States Court of Appeals Ninth Circuit.

Argued and Submitted Nov. 16, 1984.

Decided April 3, 1985.

Valentine Brookes, Brookes & Brookes, San Francisco, Cal., for petitioners-appellants.

R. Pomerance, Washington, D.C., for respondent-appellee.

Appeal from the Decision of the United States Tax Court.

Before DUNIWAY, KENNEDY, and ANDERSON, Circuit Judges.

J. BLAINE ANDERSON, Circuit Judge:

In 1955, Jack Foster and his three sons formed a partnership, T. Jack Foster and Sons (Partnership), for the general purpose of dealing in property, with Jack as the managing partner. In 1958, the Partnership began to investigate the reclamation potential of Brewer's Island, a 2,600 acre undeveloped and partially submerged tract of land located about 12 miles south of San Francisco. After commissioning engineering studies, the Partnership determined that the tract could be transformed into a self-contained city (Foster City) of 35,000.

In December, 1959, the Partnership acquired an option to purchase the property for $12.8 million; in May, 1960, it secured enabling legislation from the California legislature for a municipal improvement district known as Estero, which was coterminus with Brewer's Island; and, in August, 1960, it exercised its option to purchase the tract. Thereafter, the Partnership and Estero began developing the property by neighborhood.

The Commissioner of Internal Revenue issued notices of deficiency to the Fosters for the years 1963-67 concerning their role in the development of Foster City. The Fosters appeal the United States Tax Court's affirmance of the Commissioner's determination. We affirm in part and vacate in part.

I. Section 482

The Internal Revenue Code of 1954, Sec. 482, 26 U.S.C. Sec. 482 (1976), authorizes the Commissioner to reallocate income or deductions among commonly controlled businesses "if he determines that such ... allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such ... businesses."

A. Standard of Review

In Sec. 482 cases, this court has held that "[t]he Commissioner has broad discretion under section 482, and neither we nor the Tax Court will countermand his decision unless the taxpayer shows it to be unreasonable, arbitrary or capricious." Erickson v. Commissioner, 598 F.2d 525, 528 (9th Cir.1979).

The Fosters argue that this standard was diluted in Commissioner v. First Security Bank of Utah, 405 U.S. 394, 92 S.Ct. 1085, 31 L.Ed.2d 318 (1972), in which the Court concluded that "[t]he Commissioner's exercise of his Sec. 482 authority was therefore unwarranted in this case." 405 U.S. at 407, 92 S.Ct. at 1093. We do not believe the Court, by employing the term "unwarranted," was signaling a change in the standard of review. The issue before the Court was not the appropriate standard of review. Moreover, the Court was affirming the determination of the Tenth Circuit, which had employed the arbitrary and capricious standard in reaching its decision. See First Security Bank of Utah, N.A. v. Commissioner, 436 F.2d 1192, 1198 (10th Cir.1971).

B. The "Avoidance" of Taxes

Section 482 refers to the "evasion of taxes," whereas the Tax Court based its decision on the Fosters' "avoidance of taxes." We have noted the "sometimes elusive" distinction between the two terms, Stewart v. Commissioner, 714 F.2d 977, 987 (9th Cir.1983), and agree with the Tax Court's finding that "for purposes of section 482, a non-punitive section, the terms are interchangeable." Foster v. Commissioner, 80 T.C. 34, 158 (1983).

The regulations support the Tax Court's holding. ¹ Additionally, this court, in discussing the application of Sec. 482, has stated that "Congress enacted the predecessor of section 482 to prevent the evasion of taxes through such means as 'shifting of profits, the making of fictitious sales and other methods frequently adopted for the purpose of "milking." ' " Stewart, 714 F.2d at 987 (citations omitted). Put another way, the taxpayer must establish that he did not "cash in" on the gain. Id. at 989. In a civil case, a thorough analysis of the facts in light of the above criteria is more important than whether the Tax Court labeled its ultimate conclusion tax avoidance or evasion.

Our conclusion is not altered by Commissioner v. First Security Bank of Utah, 405 U.S. 394, 92 S.Ct. 1085, 31 L.Ed.2d 318 (1972), in which the Court reiterated the long-standing shibboleth that a taxpayer is free to arrange his affairs in the manner calculated to minimize his tax liability. 405 U.S. at 398 n. 4, 92 S.Ct. at 1089 n. 4. In First Security, the Court disapproved the Commissioner's reallocation under Sec. 482. First Security, however, did not, as in this case, involve a nonrecognition transaction. Also, the determinative factor in disallowing the reallocation was that it would have been illegal for the entity to receive the income, id. at 401-402, 92 S.Ct. at 1090-1091, which is not the situation here.

C. Application of Sec. 482 to the Disposition of Property Acquired in a Nonrecognition Transaction

The first of the nine neighborhoods to be developed was Neighborhood One. In October, 1962, before any sales to builders were consummated, the Partnership transferred an undivided one-quarter interest in 127 acres of Neighborhood One to each of four newly formed corporations as tenants in common. Each of the four corporations, referred to collectively by the Tax Court as the Alphabets, was solely owned by one of the Fosters.

In August, 1966, the Partnership transferred 311 lots in Neighborhood Four, which had been improved to a lesser extent than Neighborhood One, to Foster Enterprises, a corporation owned by the Fosters in equal shares. Foster Enterprises, which was incorporated in 1960 to take title to a hotel in Hawaii, had accumulated a net operating loss of $1.2 million.

The Neighborhood One transaction was an exchange of property for stock under Sec. 351. The Neighborhood Four transaction was a contribution to capital under Sec. 1032. Under both sections, neither the transferor nor the transferee recognize gain or loss on the transfer, and the basis of the property does not change. The transferee therefore inherits the potential gain or loss inherent in the property at the time of its transfer.

The Tax Court was correct in its determination that the Commissioner may employ Sec. 482 to reallocate income derived from the disposition of property previously acquired in a nonrecognition transaction. Rooney v. United States, 305 F.2d 681, 686 (9th Cir.1962) (Section 482 will control when it conflicts with Sec. 351 as long as the discretion of the Commissioner in reallocating is not abused.); Treas.Reg. Sec. 1.482-1(d)(5) (1984); see also Stewart v. Commissioner, 714 F.2d 977, 989 (9th Cir.1983).

D. Section 482 Reallocation

The Tax Court, pursuant to Sec. 482, reallocated all the income from the sale of the lots in Neighborhood One and Neighborhood Four from the Alphabets and Foster Enterprises to the Partnership. The income reallocated was divided into two parts, income due to appreciation in value before the transfers and income due to appreciation after the transfers.

1. Pre-transfer Appreciation

The Tax Court reallocated the income attributable to appreciation before the transfers on the ground that the purpose of the transfers was to avoid taxes. It found that A.O. Champlin, the Fosters' long-time tax advisor, decided it was advantageous from a tax standpoint for the Fosters to undertake the development of Foster City in a partnership form. Losses incurred during the early years could then be used by the partners to reduce income on their personal tax returns. Later, as the land was developed, certain lots were transferred from the Partnership to its controlled entities in an effort to shift income. As noted by the Tax Court, "only highly appreciated inventory pregnant with income was conveyed." Foster, 80 T.C. at 179. Moreover, according to the testimony of Champlin, the value of money on hand to the Fosters far exceeded any interest that might eventually have to be paid on a tax deficiency, particularly when the rate of interest charged by the Government was less than that charged by commercial banks.

In the case of the Alphabets, which were formed within a month of the transfer, the Tax Court determined that the object was to shift from the Partnership the income from the sale of the lots and split it among taxpayers subject to a lower rate of tax. The Fosters argue that the transfer could not have been tax motivated because it would have increased taxes; the income reported by the Alphabets was not offset by any losses, whereas if the income had been reported by the Partnership, it would have been offset by the operating losses which the Partnership claimed on its returns. The Tax Court, however, found that "the tax savings to an individual realized by preserving a partnership loss may very well exceed the tax cost to his corporation incurred by reporting the income." Id., 80 T.C. at 173.

The Fosters contend that although the Neighborhood Four transfer may have resulted in a tax saving, it was made for a business purpose. There was evidence that Rex Johnson, a senior vice president of Republic National Bank who was in charge of monitoring the Fosters' account, insisted that the lots be conveyed to Foster Enterprises as a condition to Republic's renewing the Partnership's loans. The Tax Court discounted this as the motivation behind the transfer, and we find its reasoning persuasive.

Foster Enterprises was not indebted to Republic. It had borrowed...