Marine v. Comm'r of Internal Revenue

• Decision Date: 11 May 1989
• Docket Number: Docket No. 8077-85.
• Citation: 92 T.C. 958,92 T.C. No. 61
• Parties: JAMES B. MARINE AND VERA L. MARINE, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

92 T.C. 958

92 T.C. No. 61

JAMES B. MARINE AND VERA L. MARINE, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 8077-85.

United States Tax Court

Filed May 11, 1989.

S, the promoter and general partner of numerous limited partnerships, represented that limited partners in S partnerships would be entitled to claim first-year interest deductions in an amount equal to their cash contributions. P- husband and Ps' trust acquired interests in two S limited partnerships. The first-year interest deductions were based on circular transfers of funds, rather than loans, and no interest was paid. By nonrecourse financing, each limited partnership acquired legal title to certain real estate at prices controlled by S and substantially in excess of the sellers' acquisition prices at the same time or a few months earlier. HELD: (1) Ps are not entitled to theft loss deductions on their cash contributions; (2) the transactions and nonrecourse notes lack economic substance and are not to be recognized for Federal income tax purposes; (3) the limited partnerships did not enter into the transactions with a profit objective; and (4) additions to tax under sections 6653(a) and 6661 and additional interest under section 6621(c) are sustained. Arthur A. Armstrong, for the petitioners.

James M. Kamman, Benjamin Duncan, and Jolynn L. Ricks, for the respondent.

OPINION

COHEN, JUDGE:

Respondent determined deficiencies of $29,851.66, $22,034.00, $9,215.95, and $9,578.00 in petitioners, Federal income tax for 1979, 1980, 1981, and 1982, respectively, and an addition to tax under section 6661 of $957.80 for 1982. The issues for decision are (1) whether petitioners have deductible theft losses on their initial cash contributions to certain limited partnerships; (2) whether petitioners are entitled to claim losses in connection with the real estate activities of the limited partnerships; and (3) whether petitioners are liable for additions to tax under sections 6653(a) and 6661 and additional interest under section 6621(c).

All section references are to the Internal Revenue Code as amended and in effect for the years in issue, except as otherwise noted.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated facts are incorporated in our findings by this reference.

Petitioners resided in Arcadia, California, when the petition was filed.

PETITIONERS' TRANSACTIONS

In 1979, James B. Marine (petitioner), a partner in an advertising firm, contributed $60,000 in cash for a limited partnership interest in Clark, Ltd. The Clark, Ltd. offering memorandum stated that the partnership had entered into negotiations to acquire the United States Post Office land and building in Jeffersonville, Indiana (the Jeffersonville post office), for $545,000, payable by a long-term loan at a maximum interest rate of 4 percent per annum with terms assuring that monthly payments would not exceed monthly partnership income. According to the offering memorandum, the property was leased to the United States Government under ‘a non-cancellable 20 year lease with six 5 year options.‘ Under the lease, the United States Government was liable for all utility and housekeeping expenses and taxes. The general partner would be responsible for maintenance and insurance.

The Clark, Ltd. offering memorandum described the method of purchase as follows:

The capital to be contributed by the partners to the partnership is $165,000. The general partner will be allocated $1,650 and the limited partners will be allocated $163,350.

On December 5, 1978 the partnership borrowed $1,388,000 for a 13 month term. This sum has been placed in a non-interest bearing deposit with a long term lending institution which has undertaken to guarantee to the partnership the availability of the sum of $545,000 which is required to complete the purchase referred to above. When the $1,388,000 deposit is returned to the partnership the borrowed $1,388,000 will be repaid to the lender.

* * *

All partners, limited or general, who occupy that position at the time the interest is paid on the $1,388,000 loan, will be entitled to their pro rata share of the interest payment made thereon.

Therefore, the partnership has a cash requirement consisting of the interest which is paid on the $1,388,000 loan. The interest expense to the partnership for the year 1979 would be approximately $165,000.

In regard to ‘Tax Benefits,‘ the limited partnership was a self- described ‘tax shelter.‘ The Clark, Ltd. offering memorandum discussed and projected the tax advantages of the investment, namely the first-year interest deduction in an amount at least equal to the limited partners' cash contributions. Specifically, it stated that ‘Terms of the purchase are such that all dollars in the one time investment are written off either because they are shielded by depreciation or interest. The 20 year non-cancellable lease with the United States Government will assure that the investment will perform as shown to provide depreciation write-off and tax shelter.‘ It further stated that the general partner would pay for partnership tax returns, audits and legal representation at no cost to the partnership.

In 1980 petitioners, through their revocable living trust, contributed $36,000 for a limited partnership interest in Trout, Ltd. According to the Trout, Ltd. offering memorandum, Trout, Ltd. had entered into negotiations to acquire the Sedalia, Missouri, post office, both land and building (the Sedalia post office), for $1,185,000, payable by a long-term low-interest loan. The Trout, Ltd. offering memorandum indicated that the property was leased to the United States Government under terms similar to those described in the Clark, Ltd. offering memorandum. The Trout, Ltd. offering memorandum further stated that the limited partners would contribute a total of $360,000 of capital, of which 1 percent would be allocated to the general partner; that on November 16, 1979, the partnership borrowed $2,856,000 for 13-1/2 months, which sum was deposited interest-free with a lending institution to arrange the $1,185,000 of long-term financing; and that the partnership would use the $360,000 cash to pay interest on the $2,856,000 borrowing. The Trout, Ltd. offering memorandum was in all other material respects identical to the Clark, Ltd. offering memorandum.

Neither offering memorandum contained an appraisal of the property to be acquired or projections of appreciation or economic profit. Petitioners did not examine a copy of either lease described in the offering memoranda before investing in the partnerships. In deciding to invest in the partnerships, petitioners relied exclusively on the offering memoranda and the advice of a seller of the partnership interests, the treasurer/office accountant of petitioner's advertising firm, and one of the partners in his firm.

The Clark, Ltd. and Trout, Ltd. limited partnership agreements, according to their terms, were to be interpreted under California law.

THE SCHULMAN PARTNERSHIPS

Clark, Ltd. and Trout, Ltd. are two of some 600 similarly structured limited partnerships organized, promoted, and syndicated by Gerald L. Schulman (Schulman). Schulman was the general partner of each limited partnership. The Schulman partnerships were generally formed for the expressed purpose of acquiring buildings, particularly post offices, under lease to Government entities or utility companies. Schulman promoted the limited partnerships by representing, inter alia, that the partnership would claim an interest deduction in its first year substantially equal to the partners' cash capital contributions. Each first year interest deduction was actually based upon a circular transfer of funds, more fully described below. Although minor variations existed from year to year, the interest was purportedly paid on an unsecured loan (short- term loan) to the partnerships from a Netherlands or Netherlands Antilles corporation, which amount was purportedly reloaned by the partnership, unsecured and interest free, to a Panamanian corporation. In return for the ‘interest free deposit,‘ the Panamanian entity would locate a post office or other building to sell to the partnership and provide the partnership with favorable long-term financing (hereinafter long-term notes) usually consisting of no down payment and a 4-percent note for 30 years or more.

Schulman was a client and business associate of Harry Margolis (Margolis), an attorney, from late 1973 to sometime in 1980 or 1981. Margolis and his office were involved in structuring and implementing the circular transfers of funds for Schulman. Margolis structured the transactions through the use of various domestic and foreign entities that he controlled known as the ‘System.‘ The System entities included, among others, Hexagram, a Netherlands Antilles corporation, and Parallax, S.A. of Panama. Generally, Margolis would deposit at a bank a given sum of money (a ‘collected fund‘); by ‘spinning‘ the deposit on a single day through multiple accounts in the names of System entities, he would effect a succession of offsetting banking entries. The entries were reflected in bank records that on their face indicated amounts of transactions far exceeding the collected fund. The bank records would later be used in an attempt to substantiate nonexistent transactions.

Schulman used the Margolis System to conduct ostensible transactions in an attempt to create records of nonexistent large short-term borrowings and payment of interest thereon for the Schulman partnerships. On October 31, 1978, a total of $95,225,000 moved around a circle as follows: Banco de Iberoamerica (Banco) of Panama lent the sum to Hexagram for 1 year at 9.75-percent interest; Hexagram then made 1-year loans aggregating the same sum at the same interest rate to 55 Schulman partnerships; said partnerships then lent the same aggregate sum to Parallax for 1 year interest free;...