Smith v. Comm'r of Internal Revenue
| Decision Date | 20 May 1985 |
| Docket Number | Docket No. 26787-82. |
| Citation | 84 T.C. No. 58,84 T.C. 889 |
| Parties | GEORGE F. SMITH, JR., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Petitioner and a partnership of which he was a partner executed an ‘Assumption of Liability,‘ by which petitioner purported to assume the obligation to pay principal and interest on a nonrecourse note executed by the partnership and secured by a deed of trust on property of the partnership. Thereafter, the partners exchanged their partnership interests for shares in a corporation in an exchange qualifying under sec. 351, I.R.C. 1954, the corporation assuming the partnership obligation to which the note was subordinated.
HELD: (1) Payments made by petitioner after the incorporation transaction, purporting to be interest on the note, are not deductible as interest under sec. 163(a), I.R.C. 1954, because the payments were not made on indebtedness;
(2) The ‘Assumption of Liability‘ increased the basis in petitioner's partnership interest, as petitioner thereby took on ultimate liability on the note. For purposes of sec. 357(c), I.R.C. 1954, the corporation acquired the partnership interests subject to the note, and such liability, as among the partners, was petitioner's. Gain under sec. 357(c), I.R.C. 1954, determined. KRISTINE A. ROTH and MARLENE GROSS, for the respondent.
JAMES R. MURPHY and JOHN C. SMUCK, for the petitioner.
TANNENWALD, Judge: Respondent determined the following deficiencies in and additions to petitioner's Federal income taxes:
+---------------------------------------+
¦ ¦ ¦Addition to tax¦
+------------+----------+---------------¦
¦Taxable year¦Deficiency¦sec. 6653(a)1 ¦
+------------+----------+---------------¦
¦1976 ¦$57,573.70¦$2,878.69 ¦
+------------+----------+---------------¦
¦1977 ¦95,897.50 ¦4,794.88 ¦
+------------+----------+---------------¦
¦1978 ¦373,930.89¦18,696.54 ¦
+---------------------------------------+
The issues for decision are (1) whether petitioner may deduct as interest his payments made during 1978 with respect to a promissory note and (2) whether petitioner must recognize gain on a series of transactions during 1978 culminating in the transfer of a partnership interest in exchange for stock in a controlled corporation. 2
The case was submitted fully stipulated under Rule 122. This reference incorporates the stipulation of facts and attached exhibits herein. At the time the petition was filed in this case, petitioner, a citizen of the United States, maintained his residence in Nassau, Bahamas. Petitioner timely filed Federal income tax returns for 1976, 1977, and 1978.
On July 7, 1971, petitioner and William R. Bernard (‘Bernard‘) entered into a partnership agreement establishing the Eleven Twenty Eight Sixteenth Company (the ‘partnership‘) for the purpose of purchasing and leasing the land and building located at 1128 16th Street, N.W., Washington, D.C. (the ‘DC real property‘). In relevant part, the agreement provided as follows:
1. The partnership will be a general partnership and formed and operated under the laws of the District of Columbia.
4. The profits and losses of the partnership shall be divided between the partners in accordance with the agreement of the partners.
7. No obligations shall be incurred except with consent of both the partners.
On July 28, 1971, the partnership entered into a Contract of Sale and Indemnity Agreement (the ‘purchase agreement‘) with the John H. Wilkins Co. (‘Wilkins‘) for the purchase of the DC real property. The purchase agreement provided, in relevant part, as follows:
2. The purchase price of land shall be One Hundred Thousand Dollars ($100,000.00) and the purchase price of the building thereon and the various fixtures thereto shall be Two Hundred Thousand Dollars ($200,000.00) * * * payable as follows:
One Hundred Dollars ($100.00), by check subject to collection, receipt of which is hereby acknowledged.
Two Hundred Ninety-nine Thousand Nine Hundred Dollars ($299,900.00) payable by the Purchaser, executing, acknowledging, and delivering to the Seller a negotiable promissory note satisfactory to the Seller and secured by a Deed of Trust on the properties herein sold and purchased, such note payable in one lump sum on the tenth (l0th) yearly anniversary of settlement of this agreement together with any interest remaining unpaid and accrued thereon. * * * Said note shall bear interest at the rate of six and one-half percent (6-1/2%) annually payable on the outstanding balance, interest to be paid quarterly on the last day of each calendar quarter for the quarter or portion thereof then expiring except that no interest shall accrue or be payable for the first ninety (90) days subsequent to the date of closing. Said note shall be secured solely by the premises purchased. There shall be no personal obligation upon the Purchaser for the principal of or interest upon said note beyond the value of said premises, except as hereinafter provided, and Purchaser shall not be liable for any deficiency as to either principal or interest on said note beyond the value of said premises, in the event of foreclosure, default in interest payment, default in principal payment, or similar event other than for interest accrued to date of default or to date of disavowal of its obligation by the Purchaser plus such liquidation damages as hereinafter provided.
3. The Seller agrees that up to a maximum sum of One Hundred Twenty-five Thousand Dollars ($125,000.00), which the Purchaser may borrow from time to time from other sources, the lien of the Seller's purchase money mortgage created in Paragraph 2 hereto and the obligation of the note secured thereby shall be subordinated from time to time to funds which the Purchaser may borrow from time to time from other sources over a period of not more than three years from the date of closing from any source and apply to repairs, such as painting, plastering and otherwise, capital improvements, or expend on fixtures including but not limited to carpeting, draperies, blinds and lighting fixtures which shall attach to the property and form a part thereof.
The loan of such funds may be secured by a first Deed of Trust lien upon the premises to which the Seller's purchase money Deed of Trust shall be subordinated. The Purchaser agrees that upon default of any first trust outstanding against the premises, they shall inform the Seller of such default by written notice within ten (10) days.
4. The Purchaser agrees that upon default of either the senior indebtedness permitted under Paragraph 3 or the purchase money mortgage herein created the Purchaser will pay the Seller as liquidation damages the sum of:
(a) In the event that at the time of default there is any first trust outstanding against this property then; the larger of:
(1) Fifty Thousand Dollars ($50,000.00), or
(2) Fifty percent (50%) of the then outstanding balance of the senior indebtedness on said property permitted under Paragraph 3, and
(b) Six (6) months interest on the then outstanding balance of the purchase money mortgage created herein, and
(c) Provided the lease between the parties on the adjoining premises is outstanding at that time, the sum of Four Thousand Five Hundred Dollars ($4,500.00) representing six (6) months rent on the adjoining premises known as the ‘parking lot‘ and subject to a lease-option-agreement between the parties to this contract or their assigns.
The promissory note referred to in the purchase agreement (the ‘Wilkins note ‘) was secured by a deed of trust on the DC real property dated August 23, 1971.
From the time of the purchase by the partnership until the end of April 1978, the partnership conducted the business of rental of the DC real property, and Bernard, Joanne Crothers Bernard (‘Crothers‘), and several persons and entities related to petitioner contributed property (the ‘Smith Company assets‘) to the partnership in exchange for partnership interests. During this period, petitioner was a member of a law firm that occupied portions of the building located on the DC real property. For substantial portions of this period, Bernard and Crothers, husband and wife, were members of this law firm. By December 31, 1977, the senior obligation referred to in the purchase agreement appeared on the partnership's books as a note in favor of the NS&T Bank in the amount of $87,500, and the Wilkins note appeared in the amount of $299,900. Another partnership debt to NS&T Bank, in the amount of $5,995, also appeared on the partnership's books at this time.
In early 1978, pursuant to agreements reached by petitioner, Bernard, and Crothers in partial settlement of litigation arising out of disagreements between Bernard and Crothers, on the one hand, and petitioner, on the other hand, with respect to the conduct of the business of the law firm and the partnership, the Smith Company assets were withdrawn in kind from the partnership, and steps were taken toward the incorporation of the partnership. After such withdrawal, petitioner's capital account stood at ($178,485.83), and that of Bernard and Crothers totaled ($1,711.78).
The partnership incurred an operating loss for the period January 1, 1978 through May 17, 1978 of $10,865, which petitioner claimed as a loss in 1978, and which loss respondent allowed. During the same period, petitioner made capital contributions to the partnership of $8,000.
On March 28, 1978, the parties to the litigation executed an agreement to settle the litigation whereby petitioner was to purchase the partnership interests of Bernard and Crothers for cash in the aggregate sum of $197,000, to be divided equally between Bernard and Crothers, in exchange for releases and a termination of the litigation. The payment was to be made ‘within ten (10) days of March 28, 1978, not to exceed thirty days thereafter.‘ On April 25, 1978, James R. Murphy became a...
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