Segal v. C.I.R., s. 94-1214

• Decision Date: 27 December 1994
• Docket Number: 94-1215,94-1216 and 94-1217,Nos. 94-1214,s. 94-1214
• Citation: 41 F.3d 1144
• Parties: -310, 94-2 USTC P 50,621, 25 UCC Rep.Serv.2d 95 Alan F. SEGAL and Kathleen W. Segal, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1144

41 F.3d 1144

75 A.F.T.R.2d 95-310, 94-2 USTC P 50,621,

25 UCC Rep.Serv.2d 95

Alan F. SEGAL and Kathleen W. Segal, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nos. 94-1214, 94-1215, 94-1216 and 94-1217.

United States Court of Appeals Seventh Circuit.

Argued Sept. 20, 1994.

Decided Dec. 2, 1994.

Rehearing Denied Dec. 27, 1994.

Theodore A. Sinars (argued), Madden, Jiganti, Moore & Sinars, Chicago, IL, for petitioners-appellants.

Richard Farber, Gary R. Allen, Thomas J. Clark (argued), Dept. of Justice, Tax Div., Appellate Section, Washington, DC, for respondent-appellee.

Before ESCHBACH, RIPPLE and ROVNER, Circuit Judges.

ESCHBACH, Circuit Judge.

Alan F. Segal and his wife ("Segal") claimed deductions on their joint income tax returns during the years 1979 through 1982 flowing from Alan Segal's share in a general partnership which purchased rights in a motion picture. The Commissioner of Internal Revenue ("Commissioner") disallowed these deductions and issued a notice of deficiency. Segal petitioned the United States Tax Court for relief pursuant to 26 U.S.C. Secs. 6213 and 7442 and the Tax Court issued decisions favorable to the Commissioner. For the reasons below, we affirm.

I.

In 1977 and 1978, Calvin Eisenberg ("Eisenberg"), a tax attorney, organized a number of partnerships for the purpose of investing in one or more movies produced by Paramount Corporation ("Paramount"). Some of these transactions were the subject of this court's opinion in Durkin v. Commissioner, 872 F.2d 1271 (7th Cir.), cert. denied, 493 U.S. 824, 110 S.Ct. 84, 107 L.Ed.2d 50 (1989). Generally, the pattern of these deals was for Paramount to sell a group of films to Film Writers Corporation ("Film Writers"), who turned around and resold individual films to the partnerships formed by Eisenberg. ¹

On May 26, 1979, Paramount sold Film Writers a package of seven films for an aggregate price of $114,787,400. For each of the seven films sold, the price included a combination of cash, short-term recourse notes, long-term recourse notes, and long-term nonrecourse notes. In addition, Film Writers paid a $350,000 fee to Walter E. Heller & Company ("Heller") to guarantee the seven long-term recourse promissory notes executed by Film Writers to Paramount, which totaled $34,436,220. The amount guaranteed by Heller would be reduced dollar for dollar by the total television revenues earned by the seven movies. At the time of the sale, Paramount had already negotiated an agreement with the American Broadcasting Company, Inc. ("ABC") to license five of the seven films sold to Film Writers. These five licenses totalled in excess of $38 million. Thus, less than a year later, when the television revenues had actually been collected, Heller's obligation under the guarantee expired.

Out of the aggregate purchase price for the seven films, $11,569,500 was for the film "North Dallas Forty." This price included $634,683 in cash during 1979; $1,735,000 in a short-term recourse note payable March 15, 1980; $3,471,000 in a long-term recourse note payable July 15, 1987; and $5,728,817 in a long-term nonrecourse note payable July 15, 1987.

On the same day as the sale from Paramount, Film Writers turned around and resold "North Dallas Forty" to a partnership named Regina Associates ("Regina"). Regina was formed among Eisenberg's fellow law partners, including Segal, at the firm of Levenfeld & Kanter. Regina paid $11,770,000 for the film, payable $2,570,183 in cash with the balance of $9,199,817 represented by a recourse promissory note which would convert to non-recourse upon the happening of one of two events: (1) the film realized $20,000,000 in worldwide gross receipts of which $10,000,000 came from foreign markets; or (2) the film realized $7,000,000 in non-theatrical gross receipts. "North Dallas Forty" was one of the two films not to have a network license agreement in place prior to sale, and in fact, Paramount did not commence negotiations with its eventual licensee, the National Broadcasting Company, Inc. ("NBC"), until after the film was sold to Regina. Finally, Regina was also required to pay interest of $122,317 in 1979 on its note to Film Writers. Regina's obligations under the agreement were partially fulfilled through Paramount's retention of a certain amount of the fees it owed Regina under the distribution agreement, which granted Paramount worldwide rights to the distribution, exhibition, exploitation and marketing of "North Dallas Forty." Each of the partners of Regina personally guaranteed that part of the note corresponding to that partner's interest in the partnership, up to 97% of the note.

Paramount and Film Writers both warranted under the terms of their respective agreements that "North Dallas Forty" would come with appropriate "cover," or alternate scenes of a movie when the scenes as originally shot contain too much vulgarity, nudity or profanity, so that the film could be broadcast by the networks in conformity with standards of the National Association of Broadcasters. ² However, no such cover was provided in this case. "North Dallas Forty" was a movie about the seamier side of professional football, and the director complained that producing alternate shots would have virtually required the production of another movie.

Despite the failure to produce appropriate cover, Paramount did succeed in licensing the film to NBC for $7,000,000 on June 18, 1980, approximately ten months after the film was released in the theatre. ³ NBC still retained the right to reject the film if further editing failed to satisfy NBC's broadcast standards. However, "North Dallas Forty" was eventually approved by NBC and shown on network television. As a result of the agreement, Regina met the non-theatrical income conversion test and its recourse note converted to nonrecourse when the television revenues were collected. ⁴ This nonrecourse note was never paid in its entirety. However, the $3,471,000 recourse note due Paramount was paid in full.

Regina reported substantial net losses in each of the years 1979 through 1982, a major portion of which came from depreciation deductions and investment tax credits from the film "North Dallas Forty." These losses were passed through to its partners, including Segal. Regina's depreciation deductions were calculated using a basis equal to the stated purchase price, $11,770,000, at which it acquired interest in the movie. The Commissioner disallowed these claimed deductions and Segal petitioned the Tax Court for review of the Commissioner's actions. After a full trial, the Tax Court allowed Regina's cash contribution in the amount of $3,092,500 included in its basis, but denied the amount in excess of the cash contribution, claiming its convertible note did not constitute a bona fide indebtedness. As a result, it held that Segal had income tax deficiencies for the years 1979 through 1982.

II.

Initially, we note the basic principle that the Tax Court's findings of fact may not be disturbed on appeal unless they are clearly erroneous. Commissioner v. Duberstein, 363 U.S. 278, 291, 80 S.Ct. 1190, 1200, 4 L.Ed.2d 1218 (1960); Durkin, 872 F.2d at 1275. The Tax Court's conclusions of mixed questions of fact and law, or the application of legal principles to a specific factual pattern, are also reviewed under the clearly erroneous standard. Williams v. Commissioner, 1 F.3d 502, 505 (7th Cir.1993).

Segal limits his argument on appeal to the claim that the Tax Court should have included, in addition to the cash contributed by Regina, an amount equal to the $3,471,000 recourse note executed by Film Writers to Paramount in Regina's basis in the film "North Dallas Forty." ⁵ He argues that the note was a bona fide indebtedness and should be included in the partnership's basis for the movie under the "at risk" rules in Sec. 465 of the Internal Revenue Code.

In Durkin, which involved the acquisition of several movies by two partnerships, we addressed an issue almost identical to the one presented in this case. 872 F.2d at 1276. Depreciation deductions are allowed to investors who have placed capital at risk through the purchase of an asset used in trade or business or held for the production of income. I.R.C. Sec. 167. However, when the debt used to purchase an asset is unlikely to be paid by the taxpayer, or is otherwise contingent, that debt does not represent a bona fide capital investment by the taxpayer and will be excluded from the depreciable basis of the asset. Goulding v. United States, 957 F.2d 1420, 1429 (7th Cir.1992); Durkin, 872 F.2d at 1276 (citing Estate of Baron v. Commissioner, 83 T.C. 542, 550-553, 1984 WL 15617 (1984), aff'd, 798 F.2d 65 (2d Cir.1986)). We characterize debt as contingent in this manner when "the principal is to be paid solely out of exploitation proceeds, the loan is nonrecourse, shielding the taxpayer from personal liability, and the purchase price of the asset unreasonably exceeds its fair market value." Durkin, 872 F.2d at 1276 (citing Towlinsky v. Commissioner, 86 T.C. 1009, 1053-59, 1986 WL 22132 (1986)); Upham v. Commissioner, 923 F.2d 1328, 1335 (8th Cir.1991). Since it is axiomatic that substance controls over form for federal tax purposes, Commissioner v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708, 89 L.Ed. 981 (1945), we examine the expectation of the parties and the structure of the transactions in determining whether the debt represents a bona fide capital investment. Durkin, 872 F.2d at 1277.

The Tax Court in Durkin found, as in this case, that the principal was to be paid solely out of exploitation proceeds and the purchase price of the asset unreasonably exceeded its fair market value. Thus, the critical question was whether the initial recourse nature of the convertible long-term notes should require the Commissioner to include the debt in Durkin's depreciable basis. We affirmed the finding of the Tax C...