Pearlstein v. Commissioner
| Decision Date | 16 November 1989 |
| Docket Number | 5552-81.,Docket No. 5551-81 |
| Parties | Irving Pearlstein and Flora Pearlstein v. Commissioner. Allan H. Pearlstein v. Commissioner. |
| Court | U.S. Tax Court |
Stephen D. Gardner, John Hartje and Robert Lord, 1345 Avenue of the Americas, New York, N.Y., for the petitioner. Theodore J. Kletnick, Jo-Ann Fox and Susan Grossman, for the respondent.
Memorandum Findings of Fact and Opinion
In timely statutory notices of deficiency, respondent determined the following deficiencies in petitioners, 1974 Federal income taxes:
Petitioners Docket No. Deficiency
Irving and Flora Pearlstein .......... 5551-81 $95,518.60
Allan H. Pearlstein .................. 5552-81 93,710.00
At trial, respondent was allowed to amend his answer to claim additional interest under section 6621(c).1
These consolidated cases involve investments by a partnership in two equipment-leasing, sale-leaseback transactions. The investments are unusual in that, apart from tax benefits, they earned a profit for the partnership of approximately $2 million on the partners' total combined cash investment of $2 million (a 100-percent profit).
The deductions at issue relate to investments of a limited partnership by the name of Wyatt Associates ("Wyatt"). The primary issues for decision are: (1) Whether the equipment-leasing and sale-leaseback transactions lacked economic substance; (2) whether ownership of the equipment was transferred to Wyatt and whether Wyatt's nonrecourse debt obligations associated with the transactions reflect genuine indebtedness; (3) whether the transactions were entered into for profit within the meaning of section 183; (4) whether Wyatt is entitled to claim a full year of depreciation on equipment purchased in June of 1974; (5) whether certain prepaid interest was deductible in 1974; and (6) whether allocations of income and losses among the partners of Wyatt should be recognized for Federal income tax purposes.
Many facts have been stipulated and are so found. Petitioners Irving and Flora Pearlstein are husband and wife and resided in Palm Beach, Florida, when they filed their petition. Petitioner Allan H. Pearlstein resided in Baltimore, Maryland when he filed his petition. All petitioners timely filed Federal income tax returns for 1974 and used the cash method of accounting.
Throughout the 1960's and 1970's, petitioners with other members of their families owned a shoe-manufacturing business managed by petitioners Irving and Allan Pearlstein. Petitioners had invested most of their assets in this business. In 1972, petitioners decided to diversify their investments. They asked their certified public accountant to investigate investments outside the shoe industry and the stock market. After analyzing several investments over the course of two years, the certified public accountant recommended that petitioners invest in the Wyatt equipment leasing limited partnership.
On or about June 12, 1974, petitioners Irving and Flora Pearlstein jointly invested $50,000 in Wyatt and petitioner Allan Pearlstein invested $50,000.
The Wyatt partnership was nominally established on January 30, 1973, as a Washington, D.C. limited partnership for the purpose of engaging in the equipment-leasing business. At the time of trial, the principal place of business of Wyatt was in New York City. Wyatt did not own any property nor did it engage in business until June 28, 1974.
In the spring of 1974, offering memoranda soliciting investments in Wyatt were circulated. The offering memoranda described the organization of Wyatt, disclosed the significant economic risks associated with equipment-leasing transactions, and described anticipated terms of the contemplated transactions. The offering memoranda also made projections of cash flow, profits, and tax benefits of the contemplated equipment-leasing transactions.
Thirty investors (generally referred to herein as "the contributing partners") agreed to invest in Wyatt as limited partners. The contributing partners in the aggregate made total capital contributions to Wyatt of $2,021,717. Investments by the various contributing partners ranged from $28,409 to $160,000.
Wyatt's limited partnership agreement specified how losses, net income, net investment proceeds, and residual proceeds of the partnership were to be allocated and distributed among the partners. Losses of Wyatt were to be allocated annually — 100 percent to the contributing partners. Net income was to be allocated annually 30 percent to the contributing partners and 70 percent to the general partners.
In June of 1974, Wyatt entered into a master purchase agreement with Castle Group, Inc. ("Castle") to purchase from Castle equipment having an aggregate purchase price of not less than $12,750,000 and not more than $25,000,000. The equipment to be purchased was to be already on lease to end users with credit ratings acceptable to Wyatt.
Wyatt was to pay Castle a price for the equipment equal to not more than 95 percent of the appraised fair market value of the equipment, with a cash down payment of 1.5 percent of the total purchase price and the balance to be reflected by a five-year nonrecourse promissory note, bearing 12-percent interest per year secured by the equipment. At closing, Wyatt also was to prepay interest on the nonrecourse note attributable to the last 15 months of the five-year note.
Under the terms of the master purchase agreement, on June 28, 1974, Wyatt purchased2 from Castle computer equipment manufactured by a number of companies including International Business Machines ("IBM"), General Electric Corporation ("GE"), and Basic Four. Included in the equipment purchased were the following types of computer equipment listed by company:
Additional computer equipment manufactured by Texas Instruments, Digital Equipment Company, Microdata Corporation, Olivetti Corporation of America, and Phillips Business Systems was included in the computer equipment Wyatt purchased from Castle. All of the equipment was on lease to end users on a net-lease basis.
In addition to the above computer equipment, on June 28, 1974, Wyatt purchased from Castle a DC-9-31 airplane manufactured by McDonnell Douglas. McDonnell Douglas first introduced DC-9 model airplanes in 1965. Since then, McDonnell Douglas has improved the DC-9 airplane and has manufactured series 10 through 40 of the DC-9 airplane. As of the time of trial, most DC-9 airplanes in service and on order were from the DC-9-30 series, few had been sold or traded in the used airplane market, and the new price of airplanes in the DC-9-30 series had increased 33 percent from the new-1969 sales price.
The particular DC-9-31 airplane purchased by Wyatt in 1974 was manufactured in 1969 and was being maintained by Eastern Airlines ("EAL"). At the time Wyatt purchased the airplane, the airplane was in good condition, and EAL recently had performed a major overhaul on the airplane.
The total purchase price Wyatt agreed to pay for the computer equipment and the DC-9-31 airplane was $17,183,746. Wyatt made a cash down payment to Castle of $262,809, and Wyatt gave Castle two nonrecourse five-year promissory notes in the total amount of $16,920,937. Consistent with the terms of the master purchase agreement, at closing Wyatt also paid Castle $1,758,808 in prepaid interest, representing interest due on the Wyatt promissory notes for the last 15 months of the five-year notes.
Immediately prior to the sale to Wyatt, Castle had purchased much of the computer equipment (including the IBM equipment) and the DC-9-31 airplane from NRG, Inc. ("NRG"), a general equipment leasing company. Wyatt's promissory note in favor of Castle that related to the computer equipment and the DC-9-31 airplane purchased by Castle from NRG (the "Wyatt-Castle-NRG" promissory note) was in the amount of $13,450,258. The schedule of note payments due on the Wyatt-Castle-NRG promissory note was as follows:
MonthlyPaymentPayment ofDateof InterestPrincipal
6/28/74 .................... $1,398,056 prepayment
7/01/74 — 12/1/74 .......... $ 44,850 per month --
1/01/75 — 3/1/78............ * $ 267,090*
4/01/78 — 6/1/79............ -- $ 197,459 to
$ 224,675**
6/30/79........................... $4,017,401 balloon
* Monthly payments of $267,090 included interest computed at 12 percent per year
** Monthly payments of principal increased approximately $2,000 each month
The computer equipment sold to Wyatt that had not been purchased by Castle from NRG was purchased by Castle (also just prior to its sale to Wyatt) from O.P.M. Leasing Services, Inc. ("OPM"), another general equipment-leasing company. Wyatt's promissory note attributable to the computer equipment purchased by Castle from OPM (the "Wyatt-Castle-OPM" promissory note) was in the amount of $3,470,679. Payments due on this promissory note were as follows:
Monthly
Payment Payment of
Date of Interest Principal
6/28/74 .................... $ 360,752 prepayment --
7/01/74—12/1/74 .......... $ 11,573 per month --
1/01/75—3/1/78............ * $ 68,920
4/01/78—6/1/79............ -- $ 50,436 to
$ 57,975 **
6/30/79..................... -- $1,036,643 balloon
* Payments of $68,920 included interest computed at 12 percent per year.
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