Malmstedt v. Commissioner, Docket No. 4647-71

CourtUnited States Tax Court
Writing for the CourtSTERRETT
Citation1976 TC Memo 46,35 TCM (CCH) 199
PartiesMargaret E. Johnson Malmstedt, et al. v. Commissioner.
Docket NumberDocket No. 4647-71,4649-71.,4648-71
Decision Date24 February 1976

35 TCM (CCH) 199
1976 TC Memo 46

T.C. Memo. 1976-46.

Margaret E. Johnson Malmstedt, et al.1

Docket Nos. 4647-71, 4648-71, 4649-71.

United States Tax Court.

Filed February 24, 1976.

35 TCM (CCH) 200
35 TCM (CCH) 201
Sylman I. Euzent, for the petitioners. Charles B. Norris and Thomas C. Morrison, for the respondent

Memorandum Findings of Fact and Opinion


Respondent determined deficiencies in petitioners' income taxes as follows:

                 Dkt. No. Taxpayer Year Deficiency Addition
                 4647-71 Margaret E. Johnson Malmstedt 1964 $19,384.33 $4,693.78
                 1965 5,842.47
                 1966 699.07
                 4648-71 Tuscarora Realty, Inc. 19662 397.82 39.78
                 4649-71 Bertil Malmstedt 1963 20,293.79 5,073.45
                 1965 17.50 ........
                 1966 2,795.98 ........
                 2 This deficiency pertains to the fiscal year ended July 31, 1966.

Certain concessions having been made by the parties, the following issues remain for our decision:

(1) whether, in 1962, Bertil Malmstedt and Margaret Johnson Malmstedt did in fact sell the Gold Mine property to their controlled corporation, Torpet Enterprises, Inc.;

(2) whether respondent properly capitalized expenditures incurred by Bertil Malmstedt and Margaret E. Johnson Malmstedt during the years 1960 through 1963 in connection with the development of the Gold Mine property;

(3) whether petitioners Bertil Malmstedt and Margaret E. Johnson Malmsted are entitled to any net operating loss deductions as a result of the Gold Mine enterprise;

(4) whether the gain realized from the 1964 foreclosure sale of the Gold Mine property must be recognized in 1964 or 1965;

(5) whether the proceeds received from the foreclosure sale, which were applied to the payment of interest, taxes, and expenses of the sale, are deductible;

(6) whether certain income attributable to real estate transactions is includable in the gross income of Margaret E. Johnson Malmstedt rather than the gross income of her corporation, Margaret E. Johnson Associates, Inc.;

(7) whether petitioners Bertil Malmstedt and Margaret E. Johnson Malmstedt are entitled to deductions based on the worthlessness of their stock in Torpet Construction Company, Inc.;

(8) whether petitioners Bertil Malmstedt and Margaret E. Johnson Malmstedt received compensation in kind through the use of a truck owned by Tuscarora Realty, Inc. during the years 1965 and 1966;

(9) whether petitioners Bertil Malmstedt and Margaret E. Johnson Malmstedt are entitled to file joint federal income tax returns for the calendar years 1965 and 1966 after having initially filed separate returns for those years; and

(10) whether petitioner Tuscarora Realty, Inc. is entitled to a deduction for travel expenditures incurred in connection with the inspection of property it was to list for sale.

35 TCM (CCH) 202

Findings of Fact

Some of the facts have been stipulated and are so found. The stipulation of facts, together with the exhibits attached thereto, are incorporated herein by this reference.

Petitioner Margaret E. Johnson Malmstedt (hereinafter Johnson or petitioner) resided in Berkeley Springs, West Virginia, at the time she filed her petition herein. Johnson filed her federal income tax returns for the calendar years 1964, 1965 and 1966 with the district director of internal revenue, Parkersburg, West Virginia. Her 1964 income tax return was not timely filed.

Petitioner Bertil Malmstedt (hereinafter referred to as Malmstedt or petitioner) resided in Berkeley Springs, West Virginia, at the time he filed his petition herein. He filed his federal income tax returns for the calendar years 1963, 1965 and 1966 with the district director of internal revenue, Parkersburg, West Virginia. His 1963 tax return was untimely.

Petitioner Tuscarora Realty, Inc. (hereinafter Tuscarora) is a West Virginia corporation having its principal office in Berkeley Springs, West Virginia. Its corporate income tax return for its fiscal year ended July 31, 1966 was filed with the district director of internal revenue, Parkersburg, West Virginia. This return was not timely filed.

During the period 1945 through 1950, Johnson was employed by a construction firm in the capacity of bookkeeper and became acquainted with the firm's construction manager who imparted to her various facts of the construction business. Subsequently she became a real estate agent and through such activities financed her education at a school of pharmacy. In either 1956 or 1957 Johnson opened the Potomac Village Pharmacy but continued her practice as a real estate agent.

Malmstedt engaged in real estate development and building ventures from 1937 until his retirement in 1963. During the late 1950's, at which time he and Johnson became acquainted, he was transacting his business through a sole proprietorship, Torpet Construction Company (hereinafter Construction). Initially, Johnson acted in the capacity of realtor in conjunction with Construction's land acquisitions. In 1958, however, the relationship was altered when, in connection with the acquisition and development of the Beam Court project, Johnson became a partner in Construction.3

In 1958, Construction embarked upon the Beam Court project which was completed in 1959. The project involved two acres upon which several homes were constructed and several more renovated. Although Johnson was still active as a pharmacist, she scheduled her working hours in a manner that enabled her to devote approximately 8 hours per day to the project.

The next project undertaken by Construction was the development of da da Woods, a tract of land comprising approximately 30 acres. Only four homes were constructed thereon, the balance of the land being subsequently sold.

During the term of the da da Woods enterprise, Malmstedt and Johnson decided that Construction should be incorporated to formalize their operating (partnership) arrangement to limit their respective liabilities. Accordingly, in July, 1960, the assets of Construction were transferred to Torpet Construction Company, Inc. (hereinafter referred to as Construction, Inc.), the stock of which was issued in March, 1961. From March, 1961 until November, 1963, the issued and outstanding stock of Construction, Inc. was held as follows:

 No. of
                Johnson (individually) ............... 3,800
                Malmstedt (individually) ............. 3,800
                Johnson & Malmstedt (as joint tenants) 3,800

At the time the stock was issued, Johnson's basis in her shares was $81,750.20. Malmstedt's basis in his stock was $35,154.35.4 The stock of Construction, Inc. became worthless in 1964.

Subsequent to the conclusion of the da da Woods project, Johnson and Malmstedt embarked upon the development of a tract of land known as Potomac Ranch. This development, operated through the corporate vehicle, Torpet Properties, Inc.5 (hereinafter

35 TCM (CCH) 203
Properties), comprised approximately 118 acres of land. Properties, however, utilized but 10 acres in the construction of only 4 houses, the remaining land being lost in a foreclosure sale in 1963 or 1964.

On November 12, 1959, Construction entered into a contract for the purchase of certain property (hereinafter referred to as Gold Mine) from Swanson Associates, Inc. (hereinafter Swanson) for a consideration of $1,000,000. In January, 1960 Gold Mine was sold for $970,000 to Malmstedt and Johnson.6 For the sole purpose of obtaining the necessary financing, petitioners structured the transaction as follows: On January 29, 1960 Swanson executed a deed to Properties, the nominal purchaser, and the following day Properties deeded Gold Mine to Malmstedt and Johnson as tenants in common. Both deeds were recorded on February 4, 1960. To finance the acquisition $350,000 was borrowed from the Washington Mortgage and Development Company, and Properties executed a note to Swanson in the amount of $750,000, bearing interest at a rate of 6 percent,7 and a deed of trust in connection therewith.

Petitioners purchased Gold Mine for the purpose of constructing a grand-scale international hotel thereon. It was their intention to erect the hotel and lease it to an experienced hotel operator. However, various problems emerged as obstacles on their path to success, including the following:

(1) obtaining a zoning change for Gold Mine;

(2) providing Gold Mine with the necessary sewage facilities; and

(3) locating a reputable hotel operator willing to enter into a lease which provided for a guaranteed rental of $1,000,000 per annum, which was the minimum guarantee required by petitioners to obtain backing for the venture.

To facilitate the hurdling of these obstacles, petitioners leased and furnished an office in Potomac, Maryland, under the name of Torpet Enterprises, Inc. (hereinafter Enterprises), the corporation they planned to utilize as a vehicle for their operations in conjunction with the Gold Mine project.8 They subsequently expended considerable sums of money in an effort to overcome the aforenoted difficulties. Such sums included expenditures for the following:

(1) attorney's fees in connection with the zoning change application;

(2) preparation of a financial statement of Enterprises;

(3) preparation of a tax revenue study relative to Gold Mine;

(4) preparation of an economic analysis and market study of Gold Mine;

(5) preparation of a brochure illustrating the intended use of Gold Mine; and

(6) attempts through an agent, Redvers Opie, to obtain a lessee for Gold Mine. The expenditures were incurred at various times during the period 1960 through 1964.

On June 30, 1961 Johnson and Malmstedt contracted to sell Gold Mine to Enterprises. The sales price, $7,000,000,9 consisted of the following: Enterprises was to assume the first mortgage and deed of...

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