Jacobson v. C.I.R.

• Decision Date: 05 October 1990
• Docket Number: D,No. 155,155
• Citation: 915 F.2d 832
• Parties: -5685, 90-2 USTC P 50,532 Harvey JACOBSON and Marcia Jacobson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Defendant-Appellee. ocket 89-4057.
• Court: U.S. Court of Appeals — Second Circuit

Page 832

915 F.2d 832

66 A.F.T.R.2d 90-5685, 90-2 USTC P 50,532

Harvey JACOBSON and Marcia Jacobson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Defendant-Appellee.

No. 155, Docket 89-4057.

United States Court of Appeals, Second Circuit.

Argued Oct. 6, 1989.

Decided Oct. 5, 1990.

Walter J. Rockler, Washington, D.C. (Richard L. Hubbard, Arnold & Porter, Washington, D.C., of counsel), for petitioners-appellants.

Charles Bricken, Atty., Tax Div., Dept. of Justice, Washington, D.C. (Shirley D. Peterson, Asst. Atty. Gen., Gary R. Allen, David English Carmack, Attys., Tax Div., Dept. of Justice, Washington, D.C., of counsel), for defendant-appellee.

Before NEWMAN, PRATT and MAHONEY, Circuit Judges.

MAHONEY, Circuit Judge:

Harvey and Marcia Jacobson ¹ appeal from an order and decision of the United States Tax Court, B. John Williams, Jr., Judge, entered February 2, 1989 that determined (1) a federal income tax deficiency for 1979 in the amount of $29,444, and (2) that the entire deficiency constituted a substantial underpayment attributable to a tax-motivated transaction for purposes of computing the interest payable with respect to the deficiency, pursuant to 26 U.S.C. Sec. 6621(c) (1988), formerly Sec. 6621(d). ² The memorandum opinion of the Tax Court is reported as Jacobson v. Commissioner, 55 T.C.M. (CCH) 1437 (1988).

The Tax Court, substantially upholding an assessment by the Commissioner of Internal Revenue (the "Commissioner"), ³ found that the acquisition of the motion picture Promises in the Dark ("Promises ") by Triad Associates ("Triad"), a limited partnership, was devoid of economic substance and should be ignored for federal income tax purposes. The court accordingly disallowed a loss of $57,125 shown on Jacobson's 1979 tax return as his distributive share of Triad's 1979 tax loss, and an investment tax credit of $3,198 attributable to Jacobson's interest in Triad.

We reverse and remand.

Background

In October 1979, Jacobson acquired one-third of a unit of Triad, representing a 1.58333 percent interest in the profits and losses of Triad. The purchase price was $37,334.45. $9,733.63 was paid in cash, and the remainder was in the form of two promissory notes, one in the amount of $20,755.16 due March 15, 1980 and one in the amount of $6,845.66 due January 15, 1981, both secured by an irrevocable letter of credit dated October 31, 1979.

Triad was a New York limited partnership formed on August 13, 1979 to acquire, own and exploit motion pictures. Promises was the only film acquired, although it was originally intended that Triad acquire two additional films, Heartbeat and Ten. Triad's two general partners were Daniel Glass and Seymour Malamed, both of whom had significant experience in the motion picture industry and in organizing limited partnerships to acquire and distribute films.

Glass was an attorney who had practiced for over thirty years in the entertainment industry, particularly in motion pictures and television. He had been general counsel and business manager of Screen Gems, Inc., a subsidiary of Columbia Pictures, and was responsible for negotiating movie distribution and purchase agreements. Malamed had been a consultant to the movie industry since 1975, and for twenty years prior thereto was an officer of Columbia Pictures, where his positions included the following: executive vice president-administration, 1973-1975; vice president-finance, treasurer, and chief administrative officer, 1971-1973; vice president, treasurer, and chief financial officer, 1963-1971. In the five years preceding the transaction at issue herein, both had acted as general partners of other partnerships which had financed the production of, or purchased, numerous motion pictures, many of which had been commercially successful.

Orion Pictures Company ("Orion") owned Promises, a completed motion picture. Promises featured actress Marsha Mason, whose starring role in The Goodbye Girl resulted in an Academy Award nomination. Promises was directed by a successful producer, Jerome Hellman, and the screenplay was written by Loring Mandel, a well known script writer who had won an Emmy Award. The film was described in one of Triad's offering documents as follows:

The picture is set in a middle sized town in Connecticut and depicts the effect on a young doctor (Marsha Mason) of the terminal illness of a teenage girl patient and the relationship of the doctor with her hospital colleagues as well as the relationship of both doctor and patient with the girl's family and friends, involving all of the emotional conflicts and moral dilemmas in such a situation.

Glass and Malamed viewed Promises, and decided that Triad would purchase the film from Orion.

Triad simultaneously entered into two agreements with Orion, a Purchase Agreement and a Distribution Agreement, as of October 1, 1979. In the Purchase Agreement, Orion sold Promises to Triad, retaining certain rights, ⁴ for $6,130,000. The purchase price was based upon the actual production costs of the film, which were warranted by Warner Brothers, Inc. ("Warner Brothers"), successor to Orion as distributor of the film, and Orion to be $6,284,842. Of this amount, Triad was to pay $380,000 at closing, with the balance in the form of two nonnegotiable promissory notes: a full recourse note in the amount of $2,650,000 (the "Recourse Note") and a nonrecourse note in the amount of $3,100,000 (the "Nonrecourse Note"). Both notes were payable on September 30, 1986, bore interest at 6% per annum, and were secured by a lien on Promises.

Interest on both notes, and the principal amount of the Nonrecourse Note, were to be paid solely out of receipts resulting from the distribution of Promises. Each limited partner of Triad assumed primary liability for that partner's pro rata share of the principal of the Recourse Note.

The Distribution Agreement conveyed from Triad back to Orion "all advertising, distribution, exhibition and exploitation rights and licenses" in Promises. Triad undertook to advance to Orion the first $1,800,000 of advertising costs for the film, and to pay Orion a marketing strategy fee in the amount of $1,200,000. These amounts were to be recouped from the proceeds of the distribution of Promises, in accordance with a complicated formula set forth in Exhibit A to the Distribution Agreement.

Exhibit A to the Distribution Agreement also provided that Triad would be entitled to be paid from Promises' television receipts "an amount equal to the unpaid principal amount of the Recourse note when due (whether upon maturity or by way of acceleration) after application of all other proceeds remitted or remittable to [Triad] and applied in reduction of the principal amount of said Recourse Note." The television receipts payable to Triad were those remaining after payment of Orion's distribution fee, which was contractually defined as twenty-five percent for a sale or license for free television reception on a national network, subject to downward and upward adjustments depending upon the timing of the fee in relation to total gross receipts generated by Promises. ⁵

In order to finance the $1,800,000 advertising advance and $1,200,000 marketing strategy fee, respectively, Triad obtained a "Marketing Loan" in the amount of $1,850,000 and an "Additional Financing Loan" in the amount of $1,656,080 from Chemical Bank. The Marketing Loan was a nonrecourse obligation, with principal and interest to be satisfied solely out of Triad's right to receipts from the commercial exploitation of Promises. If those receipts were inadequate to meet any interest payment, Orion was to advance the difference to Chemical Bank, and was entitled to recoup any such advance from future receipts generated by Promises.

The Additional Financing Loan, on the other hand, was a recourse obligation as to which each limited partner of Triad was personally obligated for his proportionate share of the principal amount. As security for payment, Triad pledged to Chemical Bank the letters of credit and certificates of deposit that Triad had received as security for payment of the limited partners' capital contributions.

Since Triad would recoup its investment and realize profits from the commercial exploitation of Promises only after the payment of (1) Orion's distribution fees and expenses, (2) the principal and interest of various indebtedness, and (3) profit participations to such third parties as Marsha Mason and Jerome Hellman, it was, according to Triad's private offering memorandum, "anticipated that the [limited partners of Triad] will not recoup their investment in [Triad] unless and until Gross Receipts [from the commercial exploitation of Promises ] equal at least $27,000,000."

Promises, which was released on November 2, 1979, was not commercially successful, although it was accorded some favorable critical reviews; its receipts totaled only $6,273,383 as of June 30, 1987. Ultimately, Triad sold Promises back to Orion in 1987 for $225,000 and cancellation of the unpaid balance of the Recourse and Nonrecourse Notes. ⁶

On its 1979 federal income tax return, Triad reported income in the amount of $4,959 and deductions in the amount of $3,612,856, resulting in an ordinary loss of $3,607,897. Jacobson deducted a distributive share of this loss, $57,125, on the 1979 federal income tax return at issue in this litigation. He also took an investment tax credit in the amount of $3,198 as his distributive share of Triad's 1979 investment tax credit of $202,000.

In a statutory notice of deficiency dated May 30, 1985, the Commissioner disallowed the deduction and credit, asserting that the acquisition of Promises was not an activity entered into for profit under section 183(a). The Commissioner also disallowed, duplicatively, certain components of the partnership loss: i.e., deductions for depreciation, tax advice, advertising--marketing, distribution fees, interest expense and...