Hunt v. C.I.R., s. 90-1022

• Decision Date: 05 August 1991
• Docket Number: Nos. 90-1022,s. 90-1022
• Citation: 938 F.2d 466
• Parties: -5152, 91-2 USTC P 50,337 C.D. HUNT, Jr., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Jackie ROBINSON; Carolyn K. Robinson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Christine M. POWELL, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Larry T. SUITT; Gwendolyn C. Suitt, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Wilbert Joseph HAMILTON; Geneva A. Hamilton, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Alfonzo HAMILTON, Jr.; Beatrice G. Hamilton, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. David REID, III; Gloria J. Reid, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Lee JOHNSON, Jr.; Veronica B. Johnson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Ronald Eric JOHNSON; Rosetta B. Johnson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Exter G. GILMORE, Jr.; Olivia G. Gilmore, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Ronald DAYE; Bobbie Daye, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Ronald DAYE; Bobbie Daye, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Thelma B. BROWN, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. to 90-1034.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 466

938 F.2d 466

68 A.F.T.R.2d 91-5152, 91-2 USTC P 50,337

C.D. HUNT, Jr., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Jackie ROBINSON; Carolyn K. Robinson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Christine M. POWELL, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Larry T. SUITT; Gwendolyn C. Suitt, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Wilbert Joseph HAMILTON; Geneva A. Hamilton, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Alfonzo HAMILTON, Jr.; Beatrice G. Hamilton, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

David REID, III; Gloria J. Reid, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Lee JOHNSON, Jr.; Veronica B. Johnson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Ronald Eric JOHNSON; Rosetta B. Johnson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Exter G. GILMORE, Jr.; Olivia G. Gilmore, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Ronald DAYE; Bobbie Daye, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Ronald DAYE; Bobbie Daye, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Thelma B. BROWN, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nos. 90-1022 to 90-1034.

United States Court of Appeals Fourth Circuit.

Argued Feb. 6, 1991.

Decided July 1, 1991.

As Amended Aug. 5, 1991.

Henry Donnell Gamble, Durham, N.C., for petitioners-appellants.

David I. Pincus, argued (Shirley D. Peterson, Asst. Atty. Gen., Gary R. Allen, Howard M. Solomon, Laura Conley O'Hanlon, Tax Div., U.S. Depart. of Justice, Washington, D.C., on brief), for respondent-appellee.

Before PHILLIPS and WILKINSON, Circuit Judges, and SMITH, United States District Judge for the Eastern District of Virginia, sitting by designation.

OPINION

REBECCA BEACH SMITH, District Judge:

Appellants challenge on appeal three aspects of the Tax Court's decision: 1) the finding that appellants did not enter the master recording lease program with a profit motive; 2) the reliance upon certain expert testimony to establish the fair market values of the master sound recordings; and 3) the imposition of additional interest pursuant to section 6621(c) of the Internal Revenue Code ("I.R.C."). ¹ For the reasons stated below, we affirm the decision of the Tax Court.

I.

Alfred Masters and John Olive formed Music Masters, Ltd. ("Music Masters") in March, 1982, for the purpose of purchasing master sound recordings ("master recordings") and then leasing the master recordings to investors. Master recordings are permanent tapes of musical performances used to make records and tapes for mass distribution and sale. During 1982 and 1983, Music Masters purchased approximately 135 master recordings at prices purportedly ranging from $250,000 for a single recording to $2,000,000 for an album. Sales of the master recordings were structured so that Music Masters made only a small cash down payment and paid the balance through a purported recourse promissory note, which typically equaled between ninety-eight and ninety-nine percent of the purchase price. Each promissory note had a life of twelve years and, prior to its due date, the only payment obligation on a note was for Music Masters to pay a percentage of the profits generated from the sale of records. Furthermore, each note was secured only by the master recording for which it was issued and whatever assets Music Masters might have at the end of the twelve-year period.

In 1982, Music Masters began promoting the Master Sound Recording Lease Program ("lease program") by distributing promotional material at seminars and other meetings with potential investors. Each master recording owned by Music Masters was divided into twenty-five leasehold units. Music Masters leased these units to investors for a period of ninety months during which time the lessee was given the right to exploit the master recording commercially. By executing a lease, the lessee committed only to pay the first fifteen months minimum lease payment, which, at the lessee's election, could be paid in cash or by a deferred payment plan. All other future lease payments were to come from a share of the profits earned on the sale of recordings. Upon executing a lease, the lessee also entered into an agreement with a distributor to manufacture and market recordings produced from the master. The lessee chose the distributor from a list provided by Music Masters, and paid the distributor a "start-up" fee ranging from $200 to $800 to cover the start-up costs for distribution. ²

A principal focus of the multi-page promotional brochure was introducing the potential investor to the attendant tax benefits that could be realized by investing in the lease program. In particular, the brochure emphasized that pursuant to I.R.C. Sec. 48(d) lessees were eligible to claim an investment tax credit based on the amount that Music Masters purportedly paid for the master recording. This investment tax credit, the brochure explained, could, if the lessee enjoyed an excess of credit in that tax year, be used as a carryback for a period of three years or used as a carryover for a period up to fifteen years. In addition to the investment tax credit benefits, the brochure informed prospective investors that lessees were entitled to deduct as business expenses under I.R.C. Sec. 162 the lease payments and distribution costs incurred and, furthermore, that a legal assistance fund had been established to assist investors in subsequent litigation with a government agency--the Internal Revenue Service.

Appellants invested in the lease program in 1982 and 1983. In accordance with the promotional brochure, appellants claimed investment tax credits based on the "purchase price" of the master recordings and claimed business deductions for the "start-up" fees and other expenditures. Appellants subsequently were served with notices of deficiency arising from their investment in master recordings, and were assessed various additions to tax under the I.R.C., including sections 6661 (repealed 1989), ³ 6621(c) (repealed 1989), 6653(a) (amended 1989), and 6659 (repealed 1989). ⁴ Appellants, in turn, petitioned the Tax Court for a redetermination of their tax liability.

Appellants' cases were consolidated for trial by the Tax Court on the issues of whether appellants were entitled to the credits and deductions claimed with respect to their investments in master recordings, and whether appellants were liable for the additions to tax asserted against them. Applying the "generic tax shelter" test, ⁵ the Tax Court found that appellants' investments in master recordings were sham transactions. Accordingly, the Tax Court sustained the Commissioner's deficiency determinations and additions to tax. This appeal followed.

II.

The Internal Revenue Service may ignore for tax purposes sham transactions. Hines v. United States, 912 F.2d 736, 739 (4th Cir.1990). A sham transaction is one designed to create tax benefits rather than to serve a legitimate business purpose. Id. (citing Frank Lyon Co. v. United States, 435 U.S. 561, 573, 98 S.Ct. 1291, 1298, 55 L.Ed.2d 550 (1978)). This circuit has adopted a two-pronged test for analyzing whether a transaction is a sham:

To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of a profit exists.

Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir.1985) (citing Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184, 209 (1983)). The purpose of this test is to ascertain both the subjective motivations of the taxpayer and the objective reasonableness of the investment to determine whether the transaction contained economic substance aside from the tax benefits. Hines, 912 F.2d at 739.

As stated earlier, the Tax Court applied the "generic tax shelter" test to analyze appellants' investment activities. Although this test, in form, is not identical to the two-pronged test employed by this court since Rice's Toyota, both tests are premised on considering the relevant facts and circumstances to determine the presence or absence of a profit motive and to evaluate the economic substance of the venture at issue. ⁶ Accordingly, the Tax Court's findings in applying the "generic tax shelter" test support a holding that, under the Rice's Toyota test, appellants' leasing activities constituted sham transactions.

The first prong of the Rice's Toyota test--the business purpose inquiry--concerns the motives of the taxpayer in entering the transaction in question. 752 F.2d at 92. The Tax Court in the present case determined appellants' subjective motive by examining the objective evidence before it. See Hunt v. Commissioner, 58 T.C.M. (CCH) 965, 970-72 (1989). It is proper to draw from objective facts inferences regarding a subjective intent to profit. Friedman v. Commissioner, 869 F.2d 785, 792 (4th Cir.1989); Faulconer v. Commissioner, 748 F.2d 890, 894 (4th Cir.1984).

The objective evidence contained in the record supports the Tax Court's conclusion that appellants did not engage in the leasing activities with a profit motive. Of particular significance in determining intent in this case is the focus of the promotional material distributed to prospective investors. ⁷ See Friedman, 869 F.2d at 793. As the Tax Court recognized, the obvious focus of the promotional brochure distributed to appellants was on the tax benefits of the lease program. See Hunt, 58 T.C.M. (CCH) at 971.

...