Vandenhoff v. Commissioner, Docket No. 11786-82

• Decision Date: 26 February 1987
• Docket Number: 11789-82.,11787-82,Docket No. 11786-82
• Citation: 1987 TC Memo 116,53 TCM (CCH) 271
• Parties: George E. and Grace L. Vandenhoff, et al. v. Commissioner.
• Court: U.S. Tax Court

53 T.C.M. (CCH) 271 (1987)

T.C. Memo. 1987-116.

George E. and Grace L. Vandenhoff, et al.¹ v. Commissioner.

Docket Nos. 11786-82, 11787-82, 11789-82.

United States Tax Court.

Filed February 26, 1987.

Jerome R. Rosenberg, 50 Park Ave., New York, N.Y., for the petitioners. Paulette Segal and Alice Fitzpatrick, for the respondent.

Memorandum Findings of Fact and Opinion

HAMBLEN, Judge:

In these consolidated cases, respondent determined deficiencies in petitioners² Federal income taxes for the year 1978 as follows:

                Petitioners Docket No. Deficiency
                George E. Vandenhoff
                  ("Vandenhoff") and
                  Grace L. Vandenhoff   11786-82      $40,130.00
                Sun Y. Wong ("Wong")
                  and Janet L. Wong...  11787-82      $39,473.87
                David Pasant
                  ("Pasant") and
                  Christine Pasant ...  11789-82      $41,408.00
                

The deficiencies in dispute arise from petitioners' involvement in Laurel Associates ("Laurel") limited partnership. Laurel is a New York limited partnership organized to purchase and exploit feature motion pictures. The issues for decision are (1) whether petitioners, as limited partners of Laurel, are entitled to deductions for their distributive shares of loss reported by Laurel and, if so, in what amounts; and (2) whether petitioners are entitled to investment tax credits.

Findings of Fact

Some of the facts have been stipulated and are incorporated herein by this reference.

At the time the petitions herein were filed, each petitioner maintained a legal residence within the state of California.

Laurel was organized under the laws of the state of New York as a limited partnership on June 1, 1978. Daniel Glass ("Glass") and Stephen Sharmat ("Sharmat") were the general partners of Laurel. Twenty-eight investors became limited partners in Laurel. Glass and Sharmat each had prior experience in the negotiation of distribution agreements with major motion picture distributors.

Glass has been a practicing attorney with a specialization in the entertainment field for several years and is a partner in the law firm of Migdal, Tenney, Glass & Pollak. Glass has served as general counsel to Screen Gems, the television subsidiary of Columbia Pictures, where he also served as business affairs manager responsible for the negotiation of various industry related agreements. Glass has specific experience as an entertainment law specialist concerning the negotiation of employment contracts, distribution agreements, financing agreements, and production budgets. Glass has been an organizer or general partner of other motion picture limited partnerships.

Sharmat has had extensive experience in the production and financing of motion picture and television projects. Sharmat has experience financing such opportunities within the United States, England, Germany, Australia, and Japan. He has also conducted seminars and lectures on financing motion pictures. Sharmat has been associated as an organizer or general partner of other motion picture partnerships.

As general partners of Laurel, Glass and Sharmat negotiated with Warner Brothers, Inc. ("Warner"), to purchase the motion picture "Bloodbrothers" (sometimes hereinafter referred to as "the film"). The film focuses upon the intrafamily conflicts of a working class Italian family in New York, New York. The cast of the film included Paul Sorvino, Tony LoBianco, and Richard Gere, who in later years became a major box office attraction. The producer of the film was Stephen Friedman. Robert Mulligan directed the film. The screenplay was written by Walter Newman.

Sidney Kiwitt ("Kiwitt") served as a vice-president to Warner during the year in issue. Kiwitt's responsibilities to Warner included the location of risk capital. Risk capital is the amount of cash advanced to finance production costs. Warner sought outside risk capital to finance approximately twenty-five percent (25%) of the actual production costs including overhead of the motion pictures it produced. The total production costs of "Bloodbrothers" was $5,120,499.01. Kiwitt represented Warner in the negotiation of the transactions at issue and had negotiated prior motion picture agreements with Glass and Sharmat regarding the location of risk capital in his capacity as a vice-president of Warner. It was Kiwitt's experience that, generally, one out of five motion pictures was successful.

Everett Rosenthal ("Rosenthal") was the sole shareholder and principal officer of Cincoa Funding, Inc. ("Cincoa"). Cincoa was formed some years prior to the transaction at issue to raise funds in conjunction with Rosenthal's capacity as president of FRP Productions ("FRP"). The principal business purpose of FRP was to service the motion picture industry concerning production services in the New York City area and to finance completion guarantees. Production services included providing stage props and studio rentals. Completion guarantees within the motion picture industry are agreements to provide additional funding in instances where a producer or studio had exceeded production budget agreements and required additional capital investment to complete the production. Cincoa was formed to assist FRP in the location of completion guarantee capital. However, Cincoa was an inactive company during the year in issue. Rosenthal had become acquainted with Glass in prior years through the completion guarantee aspect of FRP's business. Glass had represented Rosenthal as legal counsel in an unrelated motion picture distribution dispute.

Glass approached Rosenthal to involve Cincoa in the transactions at issue. Rosenthal did not negotiate with Warner regarding the film proposal. Glass and Sharmat negotiated all arrangements with Warner. As to the role of Cincoa, the terms of the film proposal were fait accompli upon presentation to Rosenthal.

On June 1, 1978, the simultaneous transactions at issue were executed. Pursuant to terms negotiated between Warner and the general partners of Laurel, Warner executed with Cincoa a document titled "Purchase Agreement" ("Warner-Cincoa Agreement"). The Warner-Cincoa Agreement provided for the transfer of the copyright to the film to Cincoa. Cincoa agreed to pay Warner $5,000,000.00 for the worldwide rights to the film except any interest whatsoever in and to:

(a) Any of the literary and/or dramatic material contained in the Picture or upon which the Picture is based and the copyright and any renewals and extensions thereof (all said literary, and/or dramatic material being hereinafter collectively called the "Property"), except to the extent necessary to allow Purchaser to distribute the Picture throughout the world or license the manufacture and sale of musical phonograph records, tapes, cartridges, cassettes, whether in album or single record form or otherwise, throughout the world;

(b) Any right to use, exercise, employ and exploit all of the characters, situations, objects, properties, wardrobe designs, equipment or events depicted, described or portrayed in the Picture.

(c) Any right to perform on radio and/or television any number of programs based upon the Picture or any part thereof.

Pursuant to the Warner-Cincoa Agreement, Cincoa paid Warner $1,125,000.00 in cash. The debt portion of the Warner-Cincoa Agreement in the amount of $3,875,000.00 together with interest of eight and one half percent (8½%) per annum from September 30, 1978, was to be satisfied no later than September 30, 1985. Cincoa's debt portion of the purchase price was a nonrecourse obligation payable solely from the "Net Producer's Share of Gross Receipts" from the film as defined within "Paragraph 20 of that certain Distribution Agreement contemplated to be entered into concurrently herewith between Seller Warner and Laurel Associates ***."³ The Warner-Cincoa Agreement warranted that Warner's books would reflect a total production cost in the film of not less than $5,000,000.00. On August 3, 1978, Warner notified MGM Laboratories, who held possession of the film, that Warner had sold the film and the copyright to Cincoa with retention of a security interest in the film.

Laurel executed a document titled "Purchase Agreement" with Cincoa ("Laurel-Cincoa Agreement") also on June 1, 1978, as part of the simultaneous and integrated transactions at issue. The terms of the Laurel-Cincoa Agreement provided that Laurel pay Cincoa the amount of $4,985,000.00 for Cincoa's entire rights to the film acquired under the Warner-Cincoa Agreement except "television syndication rights (as that term is understood in the motion picture and television industries); as distinguished from other television rights such as cable television *** or any other ancillary rights and/or albeit rights (including, without limitation, theatrical stage rights) in or to the Picture or the Property." Cincoa has not sold television syndication rights to the film as such rights are defined within the industry. The cash portion of the Laurel-Cincoa Agreement in the amount of $1,125,000.00 was paid by Laurel to Cincoa upon delivery of the film. Cincoa paid Warner all cash received from Laurel as part of the Warner-Cincoa Agreement. The debt portion of the Laurel-Cincoa Agreement in the amount of $3,860,000.00 provided for interest at eight and one half percent (8½%) per annum calculated from August 31, 1978, until such debt portion of the agreement is satisfied, which shall not be later than September 30, 1982. The debt portion of the Laurel-Cincoa Agreement was evidenced by a non-negotiable, contingent nonrecourse promissory note labeled as a "full recourse" promissory note dated June 1, 1978 ("the June Promissory Note") executed between Laurel and Cincoa. The June Promissory Note incorporated the terms of the Laurel-Cincoa Agreement and was made pursuant to and subject to such agreement.⁴

The Laurel-Cincoa Agreement provided that each partner of Laurel separately execute and deliver to Cincoa a document entitled "Guarantee" pursuant to which each limited partner assumed liability for such...