Foster v. Comm'r of Internal Revenue

• Decision Date: 11 January 1983
• Docket Number: Docket No. 1717-78.
• Parties: RICHARD H. FOSTER and SARA B. FOSTER, T. JACK FOSTER, JR., and PATRICIA FOSTER, JOHN R. FOSTER and CAROLINE FOSTER, and ESTATE of T. JACK FOSTER, DECEASED, GLADYS H. FOSTER, EXECUTRIX and GLADYS H. FOSTER, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

80 T.C. 34

RICHARD H. FOSTER and SARA B. FOSTER, T. JACK FOSTER, JR., and PATRICIA FOSTER, JOHN R. FOSTER and CAROLINE FOSTER, and ESTATE of T. JACK FOSTER, DECEASED, GLADYS H. FOSTER, EXECUTRIX and GLADYS H. FOSTER, PETITIONERS
v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 1717-78.

United States Tax Court

Filed January 11, 1983.

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                ¦CONTENTS ¦
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 Page
                Headnote 37
                Introduction and Statement of Issues 43
                Findings of Fact 47
                

I. Facts Related to the Business Background
                of the Fosters 48
                

Formation and Organization of the Foster
                Partnership 49
                II. Facts Related to the Creation of Foster City 51
                

III. Facts Related to the Sale of Lots
                in Neighborhood One (Issue 1) 55
                A. Estero Municipal Improvement District 56
                1. The Enabling Legislation 56
                2. Estero's Board, Officers, and Contractors 62
                3. Municipal Finance 64
                B. Development of Neighborhood One 67
                1. Estero 68
                2. The Foster Partnership 74
                3. The Alphabet Corporations 78
                C. Sale of Lots in Neighborhood One 79
                D. Role of Del Champlin 80
                E. Ultimate Findings of Fact 82
                

IV. Facts Related to the Sale of Lots
                in Neighborhoods Two and Three (Issue 2) 83
                A. Genesis of the Westway Transaction 84
                B. Mechanics of the Westway Transaction 87
                C. Tax Planning 91
                D. Post-Maturity Developments 97
                E. Ultimate Findings of Fact 101
                

V. Facts Related to the Sale of Lots
                in Neighborhood Four (Issue 3) 102
                A. Development of Neighborhood Four 102
                B. Involvement of Foster Enterprises 103
                C. Role Played by Del Champlin 104
                D. Ultimate Findings of Fact 105
                

VI. Facts Related to the Grant of the Sway
                Easement (Issue 4) 105
                Ultimate Findings of Fact 106
                

VII. Facts Related to the Transfers of the
                School and Church Sites (Issue 5) 107
                A. Motivation for the Transfers 108
                B. Ultimate Finding of Fact 111
                

VIII. Facts Related to the $5,000 Payment for
                Legal Services (Issue 6) 111
                Ultimate Finding of Fact 112
                

IX. Facts Related to the Payment of the Fosters'
                Personal Expenses (Issue 7) 112
                A. Nature of the Underlying Adjustments 113
                B. Ultimate Findings of Fact 116
                

X. Facts Related to the Payments Made
                to Gladys Foster (Issue 8) 116
                Ultimate Findings of Fact 117
                Opinion 117
                

Preliminary Issues Related to Certain
                Evidentiary and Procedural Matters 117
                A. Deposition of Jack Foster 118
                1. Petitioners' General Hearsay Objection 119
                2. Petitioners' Relevancy Objection 120
                B. Deposition of Del Champlin 120
                1. Petitioners' General Hearsay Objection 125
                2. Petitioners' Remaining Objections 127
                3. Petitioners' Complaint of Bias, etc 128
                C. Deposition of Jack Foster, Jr 128
                D. Deposition of Rex D. Johnson 130
                1. Respondent's General Objections 132
                2. Respondent's Specific Objections 133
                E. The “Business Purpose” Objection 135
                1. Objection to Question Calling for a Conclusion 136
                2. Motion To Strike 136
                F. Burden of Proof 137
                

Issues 1 and 3: Reallocations of Income Under
                Section 482 139
                A. Constitutionality of Section 482 140
                B. Standard for Review and Burden of Proof 142
                

C. Application of Section 482 to Taxable
                Dispositions of Property Previously Acquired
                in Nonrecognition Transactions 144
                

1. Section 1.482-1(b)(1), Income Tax Regs
                and the Arm's-Length Bargaining
                Standard 148
                

2. Validity of Section 1.482-1(d)(5), Income
                Tax Regs 151
                

3. Section 1.482-1(d)(5), Income Tax Regs
                and the Avoidance of Taxes 157
                D. Neighborhood One Reallocation 160
                E. Neighborhood Four Reallocation 178
                F. Status of the Foster Partnership 184
                G. Petitioners' Affirmative Use of Section 482 191
                

Issue 2: Applicability of the Substance-Over-Form
                Doctrine to the Westway Transaction 195
                A. Adequacy of the Notice of Deficiency 195
                B. The Westway Notes as Interest 197
                C. The Westway Notes as Carrying Charges 211
                

Issue 4: Applicability of the Cost Recovery
                Method to the Grant of the Swat Easement 216
                

Issue 5: Deductibility of the School and Church
                Sites 219
                A. Scope of the Issue 220
                B. Charitable Intent 222
                C. Amortization/Capitalization of the School Site 225
                

Issue 6: Deductibility of the Payment for Legal Services 227
                

Issue 7: Adjustments Related to the Payment
                of the Fosters' Personal Expenses 227
                A. Burden of Proof 228
                1. Delay 228
                2. Nonspecificity 229
                3. Misconduct 231
                B. Sufficiency of Petitioners' Evidence 234
                C. Role of Section 274 235
                

Issue 8: Characterization of the Payments Made
                to Gladys Foster 236
                Issue 9: Additions to Tax 237
                

[80 T.C. 37]

SUBSTANTIVE ISSUES

Issues 1 and 3: REALLOCATIONS OF INCOME UNDER SEC. 482, I.R.C. 1954. T, J, D, and B (a father and three sons) were equal partners in FP, a general partnership. In 1958, FP began to investigate the development potential of Brewer's Island, a 2,600-acre undeveloped tract of land located about 12 miles south of San Francisco. FP determined that the tract could be transformed into a city of 35,000. In December 1959, it acquired an option for the purchase of the land; in May 1960, it secured enabling legislation from the California legislature for a municipal improvement district known as Estero; and in August 1960, it exercised its option and acquired the tract. Immediately thereafter, it began to transform Brewer's Island into Foster City.

FP played an active role in the development of Foster City. It also acted through Estero, which it controlled and dominated. Estero was used by FP in the development process both as a financing vehicle and as a vehicle by which improvements to the land were actually effected.

Foster City was developed by neighborhood. The first neighborhood to be developed was Neighborhood One. In October 1962, FP deeded undivided 25-percent interests in 127 acres of land in Neighborhood One to each of four Alphabet Corporations as tenants in common. Each of these corporations was solely owned by T, J, D, or B, and the transfer of the 127 acres was tax motivated. Income derived from the sale of lots in this acreage was reported by the Alphabet Corporations; however, that income was earned by FP.

In August 1966, FP conveyed all of the single-family residential lots in Neighborhood Four to FE, a corporation which was solely owned by T, J, D, and B in equal shares. FE had a history of substantial net operating losses related to the operation of a hotel in Hawaii and the lots were conveyed in order to take advantage of those losses. Income derived from the sale of lots in 1967 was reported by FE; however, that income was earned by FP.

Held:

a. Sec. 482, I.R.C. 1954, is not unconstitutional as an invalid delegation of legislative power. (Pp. 140-142.)

b. The Commissioner's determinations under sec. 482, I.R.C. 1954, must be sustained unless proven unreasonable, arbitrary, or capricious. (Pp. 142-144.)

c. In order to prevent the avoidance of taxes, sec. 482, I.R.C. 1954, and sec. 1.482-1(d)(5), Income Tax Regs., may be applied to a taxable disposition of property previously acquired in a nonrecognition transaction. (Pp. 144-159.)

d. Respondent did not abuse his discretion under sec. 482, I.R.C. 1954, in reallocating income derived from the sale of lots in Neighborhood One from the four Alphabet Corporations to FP. (Pp. 160-177.)

e. Respondent did not abuse his discretion under sec. 482, I.R.C. 1954, in reallocating income derived from the sale of lots in Neighborhood Four from FE to FP. (Pp. 178-184.)

f. For tax purposes, FP was a partnership and not an association taxable as a corporation. Sec. 7701(a)(2) and (3), I.R.C. 1954; sec. 301.7701-1 through - 3, Proced. & Admin. Regs. (Pp. 184-191.)

g. Petitioners are not entitled to affirmatively use sec. 482, I.R.C. 1954, to effect a consolidated return of FP with all of the related corporations purportedly involved in the development of Foster City. Sec. 1.482-1(b)(3), Income Tax Regs. Respondent's failure to do so does not demonstrate any abuse of discretion on his part. (Pp. 191-195.)

Issue 2: APPLICABILITY OF THE SUBSTANCE-OVER-FORM DOCTRINE TO THE WESTWAY TRANSACTION. The terms negotiated by FP for the purchase of Brewer's Island contemplated a downpayment of $2,500,000. However, FP was unable to fund all of that amount itself. Accordingly, it arranged with a bank with which it had an established relationship to borrow (1) $2 million to make the downpayment and (2) such additional amounts as were needed to satisfy the periodic installments due to the sellers of the property for the balance of the purchase price. Under the terms of the agreement, FP agreed (1) to pay interest at the prevailing market rate, (2) to pay a bonus equal to the total amount borrowed from the bank, and (3) to structure the bonus so that it would be taxed to the bank as capital gain rather than ordinary income. A complicated transaction, consisting of a series of incorporations, transfers, liquidations, and mergers, was then devised to disguise the terms of the agreement involving the 100-percent bonus. The crucial step in the transaction involved the delivery of certain promissory notes (the Westway notes) purportedly in exchange for corporate stock. The objective of the transaction from FP's point of view was to raise funds through tax savings in order to pay the bank its bonus; the objective from the bank's point of view was to insure that its bonus was taxed as capital gain. In form, the transaction served to increase FP's basis in Neighborhoods Two and Three by an amount equal to approximately twice that which FP had become obligated to pay to the bank as a bonus.

Held:

a. Respondent's categorization of the Westway notes as interest is an issue which is properly before the Court and one with respect to which petitioners bear the burden of proof. (Pp. 195-197.)

b. In substance, the Westway notes represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island. (Pp. 197-211.)

c. FP is not entitled to capitalize the Westway notes under sec. 266, I.R.C. 1954. (Pp. 211-216.)

Issue 4: APPLICABILITY OF THE COST RECOVERY METHOD TO THE GRANT OF THE SWAY EASEMENT. In 1964, a utility company paid $425,000 to FP for a right-of-way immediately adjacent to an existing...