Resnik v. Comm'r of Internal Revenue

• Decision Date: 12 April 1976
• Docket Number: Docket No. 8610-73.
• Citation: 66 T.C. 74
• Parties: BERNARD RESNIK AND BEVERLY RESNIK, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

66 T.C. 74

BERNARD RESNIK AND BEVERLY RESNIK, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 8610-73.

United States Tax Court

Filed April 12, 1976.

Lawrence M. Schulner, for the petitioners.

Robert E. Casey, for the respondent.

A limited partnership, of which petitioner-husband was a limited partner, on the beginning and ending day of its initial taxable year (being a 1-day taxable years) prepaid interest for 4 years and 3 months hence. The partnership reported no income and no other deductions for such 1-day taxable year. Petitioner-husband's share of the partnership loss created by the prepaid interest deduction was claimed by petitioners on their joint return which the Commissioner disallowed under sec. 446(b), I.R.C. 1954, on the grounds that the prepaid interest deduction materially distorted the income of the partnership. Held: The Commissioner did not abuse the authority granted to him in sec. 446(b) by disallowing the deduction for prepaid interest claimed by the partnership in order to clearly reflect income of the partnership. Andrew A. Sandor, 62 T.C. 469 (1974), followed. Disallowance of the prepaid interest deduction claimed by the partnership eliminates the partnership loss and the share thereof claimed by petitioners. Because of the distortion of partnership income caused by the prepaid interest deduction, it is not necessary to decide whether, under different circumstances, a determination should be made as to whether the prepaid interest claimed by the partnership results in a distortion of the income of one or more of the partners.

OPINION

GOFFE, Judge:

The Commissioner determined a deficiency in the Federal income tax of petitioners for the taxable year 1969 in the amount of $15,135.30. The sole issue for decision is whether petitioners are entitled to deduct their claimed distributive share of a partnership loss produced by the prepayment of interest by the partnership for a period in excess of 4 years.

All of the facts have been stipulated. The stipulation of facts and exhibits attached thereto are incorporated herein and adopted as our findings. The case has been submitted under Rule 122 of the Tax Court's Rules of Practice and Procedure.

Petitioners Bernard and Beverly Resnik, husband and wife, resided in Chicago, Ill., at the time of the filing of their petition. They filed a joint Federal income tax return for the taxable year 1969 with the Internal Revenue Service.

During the taxable year 1969, petitioner, Bernard Resnik (hereinafter referred to as petitioner) was a limited partner in the San Jose Co., an Illinois limited partnership. The San Jose Co. was one of 30 related limited partnerships associated with Capital Concepts Corp., a California corporation, in a 1969 real estate transaction. At all times material herein, Lawrence M. Schulner, Alvin B. Glatt, and N. C. Van Berkel were, respectively, president, vice president, and manager of Canadian Operations of Capital Concepts. The San Jose Co. and 29 related partnerships were formed on December 31, 1969, in either Illinois (16), California (13), or Canada (1). Schulner was the general partner of the 13 partnerships formed in California, Glatt was the general partner of the 16 partnerships formed in illinois, including the San Jose Co., Van Berkel was the general partner for the partnership formed in Canada.

During 1969 Capital Concepts entered into certain purchase agreements with the owners of improved real properties situated in Texas. The Texas properties consisted of eight apartment complexes containing a total of 892 units. These real estate transactions involved the sale of the Texas properties to Capital Concepts and then, simultaneously therewith, the sale of all or substantially all of the same Texas properties from Capital Concepts to the 30 related partnerships. The escrow ‘closing date’ for these simultaneous sales was on December 31, 1969. The simultaneous transactions between Capital Concepts and each of the 30 related partnerships were identical in most material respects.

In accordance with the terms of the several sales agreements, all or substantially all of the money that was paid by the 30 related partnerships to Capital Concepts on December 31, 1969, was characterized and treated as ‘prepaid interest’ and totaled the sum of approximately $3,257,330. The San Jose Co. purchased a 3.333 percent undivided interest in the Texas properties from Capital Concepts for a total consideration of $296,080. The terms of the sale required, inter alia, payment by the San Jose Co. to Capital Concepts as follows:

(a) $10,000 downpayment (to be applied to principal);

(b) The execution of a promissory note, secured by a deed of trust, in the amount of $286,080 and bearing interest at the rate of 9.62 percent per annum, with payments of $2,083.34 per month until paid in full; and,

(c) A $115,000 payment of prepaid interest, representing interest for a period of approximately 4 years and 3 months.

The San Jose Co. was formed with one general partner and nine limited partners. The total capital contribution of the nine limited partners was $125,000. The general partner made no capital contribution. The petitioner's capital contribution was $40,000, which represented a 32-percent interest in the San Jose Co. Pursuant to the agreement of sale of an undivided interest in the Texas properties from Capital Concepts to the San Jose Co., the San Jose Co. paid to Capital Concepts $115,000 as a prepaid interest payment for an approximate period of 4 years and 3 months. This $115,000 payment was made on December 31, 1969, which was the day the partnership commenced business and was the first and last day of its initial taxable year. The interest was paid solely out of the capital contributed by the limited partners.

On the partnership return of income (For 1065) filed for the initial taxable year, beginning and ending on December 31, 1969, the San Jose Co. reported an ordinary loss of $115,00 . The ordinary loss consisted entirely of the prepaid interest expense deduction claimed on the same return. This was the only expense incurred or paid by the San Jose Co. for its initial taxable year beginning and ending on December 31, 1969. The interest expense deduction of $115,000 represented the December 31, 1969, payment of the San Jose Co. to Capital Concepts of prepaid interest for an approximate period of 4 years and 3 months.

The San Jose Co. employed the cash receipts and disbursements method of accounting in the computation of its taxable income and in maintaining its books and records.

On the 1969 joint Federal income tax return of petitioners they claimed a $36,800 deduction representing petitioner's distributive share of the $115,000 partnership loss of the San Jose Co. for the taxable year ended December 31, 1969. Petitioners' capital investment in the partnership was $40,000. On their joint Federal income tax return for 1969, petitioners reported $20,836 adjusted gross income and $10,426 taxable income. The Commissioner, in his statutory notice of deficiency, disallowed the loss of $36,8 0 and determined--

that the prepaid interest deducted by the San Jose Co. partnership for the year ended Dec. 31, 1969, represented interest for a period extending more than 12 months beyond the taxable year of payment, therefore, materially distorting income. The deduction taken by the San Jose Co. partnership has been disallowed. On your return for year ended Dec. 31, 1969 you deducted $36,800.00 as your share of the loss from San Jose Co. partnership. Since the prepaid interest deducted by that partnership has been disallowed and the partnership loss is eliminated, the deduction taken by you is disallowed.

Petitioners assert that they are entitled to deduct their entire distributive share of the San Jose Co. partnership loss. The loss is due solely to the prepayment of interest for 4 years and 3 months, paid on the only day of the partnership's initial taxable year which began and ended on December 31, 1969. Petitioner's assertion is based on three alternative grounds: (1) The San Jose Co. partnership's taxable income was not materially distorted by the interest payment; (2) even if the partnership's taxable income was materially distorted, petitioner's income was not materially distorted; and (3) disallowance of the interest expense and resulting loss would result in an inaccurate reflection of petitioners' income because they report their income and claim their deductions on the cash receipts and disbursements method of accounting. Petitioners rely on John D. Fackler, 39 B.T.A. 395 (1939); Court Holding Co., 2 T.C. 531 (1943), revd. and remanded 143 F.2d 823 (5th Cir. 1944), revd. 324 U.S. 331 (1945); L. Lee Stanton, 34 T.C. 1 (1960), to support their contention that prepaid interest is deductible and that a denial of the deduction would improperly place taxpayer on the accrual method of accounting as to that item on their return while leaving them on the cash method of accounting as to the other items on the return. Respondent contends that the prepaid interest should be disallowed because it results in a material distortion of both the partnership income and petitioners' taxable income.

Section 163(a) provides that ‘There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.’ The $115,000 payment is concededly interest and respondent has not challenged the characterization of the payments as being anything other than interest. Compare Kenneth D. LaCroix, 61 T.C. 471 (1974); Norman Titcher, 57 T.C. 315 (1971). Section 446(b) vests broad discretion in the Commissioner to insure that petitioner's method of accounting and ‘computation of taxable income shall be made under such method as, in the opinion of the Secretary or his delegate, does clearly reflect income.’ Commissioner v. Hansen, 360 U.S. 446 (1959); Fort Howard Paper Co., 49 T.C. 275 (1967); ...