Hoffman v. Commissioner
| Citation | 57 TCM(CCH) 51,1989 TC Memo 154 |
| Decision Date | 10 April 1989 |
| Docket Number | Docket No. 26345-83,16898-85. |
| Parties | Gary Hoffman and Sonia Hoffman v. Commissioner. Albert Landry and Bonnie Landry v. Commissioner. |
| Court | United States Tax Court |
Frederick R. Schumacher and A. Clifton Hodges, for the petitioners. Jeffrey Wong, for the respondent.
Memorandum Findings of Fact and Opinion
By notice of deficiency dated March 11, 1985, respondent determined a deficiency in petitioners Albert and Bonnie Landry's Federal income tax in the amount of $1,163,544 and an addition to tax under section 6653(a)1 in the amount of $58,177 for taxable year 1979. By notice of deficiency dated June 14, 1983, respondent determined a deficiency in petitioners Gary and Sonia Hoffman's Federal income tax in the amount of $1,134,048 for taxable year 1979.
After concessions, the issues for our consideration in these consolidated cases are: (1) whether petitioners, as shareholders of Snomark, Inc., a Subchapter S corporation, are required to include in income their proportionate shares of three short-term negotiable notes and three long-term non-negotiable notes received by Snomark, Inc., during taxable year 1979; (2) whether petitioners were entitled to claim deductions for their proportionate shares of "commission expenses" paid by Snomark, Inc., during taxable year 1979; (3) whether petitioners Albert and Bonnie Landry properly claimed deductions with respect to their investment in Federal Investments Partnership, a limited partnership; and (4) whether petitioners Albert and Bonnie Landry are liable for an addition to tax pursuant to section 6653(a).
Some of the facts have been stipulated and are so found. The stipulated facts and attached exhibits are incorporated herein by this reference.
Petitioners were all residents of California when they timely filed their petitions herein. Albert Landry (Landry), Gary Hoffman (Hoffman) and James S. Jones (Jones) were equal shareholders in Snomark, Inc. (Snomark), a California corporation formed in the spring of 1979. Jones was the motivating force behind the formation of the corporation. Snomark properly elected Subchapter S treatment.
Snomark was organized for the limited purpose of purchasing and reselling security devices to protect skis and skiing equipment from theft. Snomark purchased locking stations, in which skiers could secure their skis while not in use, and locker openings, in which skiers could secure other skiing equipment, from the manufacturer, Ski B, Inc. (Ski B), a California corporation. In July 1979, Snomark purchased 15,062 new and used locking stations for $611,893.75 and 5,105 new and used locker openings for $306,300. In November of 1979, Snomark purchased an additional 20,640 locking stations and 8,875 locker openings for $838,500 and $532,500, respectively. In 1979, Snomark also purchased 520 "Hot Foot" devices (boot warmers), which blow hot air into a skier's boots to warm them, for $260,000.
Prior to Snomark's purchase of the lockers and the locker openings, Jones organized and was sole general partner of two limited partnerships, Mountain Security, Ltd. (Mountain Security) and Winter-Lock, Ltd. (Winter-Lock) formed to purchase the lockers and locker openings from Snomark. In 1980, Jones left these limited partnerships and was replaced as general partner by National Management Services (National Management). Neither Hoffman nor Landry were partners in Mountain Security and Winter-Lock. Snomark and Jones received $468,500 and $216,500, respectively, as commissions in connection with the organization, syndication, and solicitation of investors for Winter-Lock and Mountain Security.
In 1979, Snomark sold all the equipment purchased from Ski B to the partnerships and to Clifford and Donna Losh (the Loshes), individual investors. Winter-Lock purchased 15,062 locking stations and 5,105 locker openings at $2,118,093.70 and $781,065, respectively. Winter-Lock paid $1,013,159 in cash and executed a negotiable promissory note due February 15, 1980, for $150,000 (the short-term note) and a non-negotiable 20-year promissory note for $1,736,000 (the long-term note). In 1979 Snomark sold Mountain Security 20,640 locking stations and 8875 locker openings for $4,349,125. Mountain Security paid $1,723,000 in cash and executed a negotiable promissory note due February 15, 1980, for $208,250 (the short-term note) and a non-negotiable 20-year promissory note for $2,417,875 (the long-term note). In addition, Snomark sold 52 of the 520 boot warmers to the Loshes for $102,700. The Loshes paid $36,500 in cash and executed a negotiable promissory note due February 15, 1980, for $9,000 (the short-term note) and a non-negotiable 20-year promissory note for $57,200 (the long-term note). Snomark received all the proceeds from the short-term negotiable promissory notes, when payment was due.
The non-negotiable 20-year notes (the long-term notes) executed by the limited partners in Winter-Lock and Mountain Security were identical. Payment was due on February 15, 1999, and interest on the principal amount was to accrue at 7 percent per annum for the first 4 years and at 10 percent per annum thereafter. Although the notes were full recourse as to principal, the holder of the note was required to foreclose on the collateral, upon default, before approaching the limited partners. The limited partners would not be personally liable for a default in the payment of interest. The 13 limited partners in Winter-Lock and the 30 limited partners in Mountain Security each executed an assumption agreement making him or her personally liable for a proportionate share of any unpaid partnership liabilities owed to Snomark.
The terms of the Snomark's sales to Winter-Lock, Mountain Security and the Loshes provided that the purchased equipment would be placed in service at various ski resorts in the United States and Canada. Snomark never took physical possession of the equipment. Ski B was hired to install, service and maintain the purchased equipment. By 1982 it became clear that the equipment sold by Snomark to Winter-Lock and Mountain Security was of poor quality. Furthermore, the partnerships were dissatisfied with Ski B's management services. None of the partners in Winter-Lock or Mountain Security received any income from the lockers or the locking stations during the year in issue, although the Loshes did receive income from the rental of the boot warmers. In 1981 and 1982, the limited partners in Winter-Lock and Mountain Security loaned an additional $66,000 to their respective partnerships to fund the repair of the equipment purchased from Snomark. The schedule of income and losses for both partnerships during the years 1980 through 1986 is:
Partnership Partnership
Fiscal Year Receipts Income2
1980/1981 $204,954.48 $204,954.48
1981/1982 269,036.50 294,384.53
1982/1983 275,413.41 294,921.79
1983/1984 320,774.60 363,521.25
1984/1985 354,932.66 385,047.45
1985/1986 355,694.12 346,536.57
The individual partners each sustained profits and losses during those years in the following amounts: a loss of $21,418.63 in 1980/1981, a loss of $85,560.03 in 1981/1982, a loss of $79,285.32 in 1982/1983, a loss of $10,586.96 in 1983/1984, a profit of $61,483.20 in 1984/1985 and a profit of $91,174.55 in 1985/1986.
In 1982, the California Franchise Tax Board, the State's income taxing authority, commenced an audit of Winter-Lock and Mountain Security. One of the issues considered was whether the long-term notes executed by Winter-Lock and Mountain Security to Snomark should be included in the limited partners' basis. To assist in that audit, Hoffman and Landry submitted affidavits swearing that they intended to enforce the notes and for Snomark to be paid in full for the value of the long-term notes.
In its Federal income tax return filed for tax year 1979, Snomark, using the cash basis method of accounting, included in gross income only the cash payments received from Winter-Lock, Mountain Security and the Loshes, and not the value of any of the promissory notes. On that same return Snomark claimed deductions for the "commissions paid" in connection with the organization of Winter-Lock and Mountain Security. Although Snomark continued in business until 1982, it failed to file tax returns after 1979.
OpinionThe first issue for our consideration is whether petitioners, as shareholders in Snomark, are required to use the accrual method of reporting and to include in income for taxable year 1979 the face value of the short-term promissory notes and the long-term promissory notes which Snomark received from Mountain Security, Winter-Lock and the Loshes. Section 446 provides that taxable income is to be computed under the taxpayer's normal method of accounting unless that method does not clearly reflect income, in which event taxable income is to be computed under such method as, in the opinion of the Commissioner, does clearly reflect income. Sec. 446(a) and (b). Section 1.446-1(c)(2), Income Tax Regs., states that where "it is necessary to use an inventory the accrual method of accounting must be used with regard to purchases and sales." This principle has been consistently upheld by this Court. See Niles Bement Pond Co. v. United States 2 USTC ¶ 518, 281 U.S. 357, 360 (1930); Estate of Iverson v. Commissioner 58-1 USTC ¶ 9518, 255 F.2d 1, 2-5 (8th Cir. 1958), affg. Dec. 22,255 27 T.C. 786 (1957), cert. denied 358 U.S. 893 (1958); Caldwell v. Commissioner 53-1 USTC ¶ 9218, 202 F.2d 112, 114 (2d Cir. 1953), affg. a Memorandum Opinion of this Court Dec. 18,422(M).
Section 1.471-1, Income Tax Regs., states that "In order to reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is...
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