Derr v. Commissioner
(1981)
William O. Derr and Thomasine
G. Derr, Petitioners v. Commissioner of Internal Revenue, Respondent
Docket No. 8947-77
UNITED STATES TAX COURT
77 T.C. 708
September 29, 1981, Filed
DISPOSITION: Decision will be entered under
Rule 155.
SYLLABUS: In early 1973, A decided to syndicate
the X limited partnership which would purchase and operate a certain
apartment complex. To this end, A published a prospectus offering
the sale of X partnership units to Illinois residents. The prospectus
promised substantial tax benefits in 1973 from an investment in
X and indicated that A's wholly owned corporation, Z, had already
contracted to purchase the apartment complex. Nevertheless, Z had
not contracted to purchase the apartment before the publication
of the prospectus.On June 30, 1973, Z executed the purchase agreement
for the apartment complex.On the following day, July 1, 1973, Z
entered into sales contract with X where by it agreed to sell the
apartment complex to X. A signed the sales contract on behalf of
both X, as general partner, and Z, as president. The terms of the
sales contract reflected the tax consequences promised in the prospectus.During
1973, petitioner William O. Derr was a limited partner in X and
claimed a deduction for his distributive share of the partnership
loss for 1973 on his return for that year. Held: Z's purchase and
resale of the apartment complex to X was a sham. X was the real
purchaser under the purchase agreement and did not acquire the benefits
and burdens of ownership of the apartment complex thereunder until
July 1, 1974. Held, further, during 1973, X did not have a depreciable
interest in the apartment complex, incur any indebtedness that would
allow an interest expense deduction under sec. 163, I.R.C. 1954,
or make any deductible expenditures with respect to the operation
of the apartment complex.Held, further, petitioners are not entitled
to the claimed deduction for Mr.Derr's distributive share of the
partnership loss for 1973.
COUNSEL: Clarence G. Ashby, for the petitioners.
Lewis J. Hubbard, Jr., for the respondent.
JUDGES: Wiles, Judge.
OPINION BY: WILES
OPINION: Respondent determined a $ 6,184.80
deficiency in petitioners' 1973 Federal income tax. After a concession
by respondent, the sole issue for decision is whether petitioner
William O. Derr, a limited partner in the Aragon Apartments partnership,
is entitled to deduct his distributive
share of the partnership loss for 1973. The
resolution of this issue turns on whether the partnership is entitled
to various deductions in connection with the ownership and operation
of an apartment complex in 1973.
FINDINGS OF FACT
Some of the facts have been stipulated and
are found accordingly.
William O. Derr (hereinafter petitioner) and
Thomasine G. Derr, husband and wife, resided in Jacksonville, Fla.,
when they filed their petition in this case. They filed their 1973
joint Federal income tax return with the Office of the Director,
Internal Revenue Service Center, Kansas City, Mo.
During 1973, petitioner was a limited partner
in the following partnerships: Aragon Apartments, Edens East Apartments,
and Manor Apartments. Petitioner acquired these partnership interests
as tax shelter investments.
In the early 1970's, Edward J. Reilly (hereinafter
Reilly), a registered Illinois securities dealer, was involved extensively
in the syndication of real estate limited partnerships. From 1970
through 1972, Reilly was the underwriter of record for 60 Illinois
limited partnerships, including Edens East Apartments and Manor
Apartments. During 1973, Reilly owned all the capital stock of the
following Illinois corporations: Edward J. Reilly Partnerships Inc.
(hereinafter Partnerships Inc.) and the Happiest Partner Corp. (hereinafter
HPC). Partnerships Inc. was a registered Illinois securities underwriter,
and HPC was a licensed Illinois real estate brokerage firm.
In early 1973, the construction of four brick
buildings, containing 88 total apartment units, on a parcel of real
property located in Des Plaines, Ill., was completed. The land and
buildings were known as the Foxcroft Apartments (hereinafter sometimes
referred to as the apartment complex), and were owned under an Illinois
land trust established on February 15, 1972, of which Victor
Smigel (hereinafter Smigel) was the sole beneficiary,
and the National Bank of Austin was the trustee. On December 9,
1972, the apartment complex was mortgaged in the name of the trustee
to Austin Federal Savings & LoanAssociation of Chicago (hereinafter
Austin Federal) to secure a loan in the principal amount of $ 1,280,000.
The apartment complex was subject to this
mortgage through July 1, 1974. The loan was
payable in monthly installments of $ 10,306.90, with the final payment
due on December 1, 1996. Neither Smigel nor the National Bank of
Austin was personally liable for this loan.
Sometime in early 1973, Reilly decided to
package the Foxcroft Apartments as a limited partnership, using
the name Aragon Apartments (hereinafter Aragon or the partnership).
To this end, in the spring of 1973, he caused the publication of
a prospectus offering the sale of securities
(hereinafter partnership units) in Aragon
to Illinois residents, pursuant to the Illinois Securities Law of
1953. Aragon was described as a limited partnership "being
formed to purchase and hold title to four apartment buildings containing
a total of 88 apartment units commonly known as Foxcroft, Des Plaines,
Illinois, and personal property used in the operation thereof."
The prospectus provided that Reilly would be the general partner
and portrayed him as an expert in both real estate partnership and
tax shelter investments.
Partnerships Inc. was named the underwriter-dealer
for the offering within the meaning of Illinois law. As the underwriter-dealer,
Partnerships Inc. marketed the partnership units in Aragon. The
purchase price per partnership unit was $ 1,721, payable in two
installments: (1) $ 1,000 prior to the closing on the apartment
complex in 1973, and (2) $ 721 on July 1, 1974. The minimum subscription
for any limited partner was set at 11 units for a total purchase
price of $ 18,931, with Partnerships Inc. reserving the right to
reduce the minimum subscription in the event some limited partners
subscribed to more than11 units.
According to the prospectus, the sale of partnership
units would raise $370,000, $340,400 from the limited partners for
92 percent of the total partnership units, and $ 29,600 from the
general partner, Reilly, for the remaining 8 percent. The prospectus
stated that all funds raised from the sale
of partnership units would be deposited in
an escrow account that was under the sole control of Partnerships
Inc. In this escrow account, Partnerships Inc. held the funds of
various partnerships with which it was associated.
The prospectus provided that the partnership's
objectives were "large tax shelters, income and equity growth."
With respect to Aragon's tax shelter potential, the prospectus indicated
that the partnership would have "tax deductions in 1973 in
excess of operating income and mortgage reduction as a result of
prepaid interest, prepaid management fee paid at closing, contract
financing 'points,' depreciation and personal property bonus depreciation."
According to the prospectus, HPC had entered
into a contract to purchase the Foxcroft Apartments and was prepared
to sell its contractual interest in the property to Aragon for a
total purchase price of $ 1,650,000. n1 Aragon would "receive
a credit for the mortgage balance of approximately $1,280,000"
and pay HPC the balance of $ 370,000 as follows: (1) $ 215,000 at
closing and (2)
$155,000 on July 1, 1974. With respect to
the terms of the sale to Aragon, the prospectus further provided:
THE HAPPIEST PARTNER CORPORATION is contracting
to sell its contractual interest in the subject real estate. This
purchase contract provides for 1974 interest in the amount of $
128,000 to be prepaid in 1973. THE HAPPIEST PARTNER CORPORATION,
as seller, will accept the prepaid interest as ordinary income so
that the partnership can obtain an immediate tax deduction. The
monthly cash payments to THE HAPPIEST PARTNER CORPORATION under
the purchase contract will be identical with the monthly payments
by THE HAPPIEST PARTNER CORPORATION on the mortgage. The effect
of this contract on the partnership is to pay 1973 and 1974 interest
at closing and add to the contract balance due THE HAPPIEST PARTNER
CORPORATION. Interest due for 1975 shall be paid in 1974. Approximately
one half of 1976 interest will be paid in 1975 and the balance of
the 1976 interest will be paid in 1976.
Please note that although the purchaser's
contract balance is higher (because of the addition of prepaid interest),
a lower effective interest rate is charged in the purchase contract.
However, monthly cash payments are the same, and with the lower
interest rate, there is a larger reduction of principal on the purchase
contract. It is anticipated that the partnership purchase contract
balance will be the same as the first mortgage, about October, 1976,
and THE HAPPIEST PARTNER CORPORATION will then assign the beneficial
interest in the trust to the Partnership.
While the prospectus stated that the sale
to the partnership should be closed no later than July 1, 1973,
it warned that "There is no positive assurance that the real
estate transaction will be closed and the securities actually issued."
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n1 A copy of a document entitled "Articles
of Agreement" was attached to the prospectus. This document
represented the agreement between HPC and Aragon with respect to
the sale of the apartment complex.
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The prospectus sets forth the following breakdown
of the use of the $ 370,000 to be raised from the sale of the partnership
units:
At closing 1974 (1 year later)
Purchase price $ 2,250 $ 63,000
Management fees 52,750 28,000
Contract financing points 32,000
Prepaid interest 128,000 64,000
215,000 155,000
The prospectus indicated that the management
fees, contract financing points, and prepaid interest would be fully
deductible in the year paid. It further stated that the above-described
management fees would be paid to the general partner for "general
supervision of the Partnership as well as the day-to-day operation
of the Partnership property." In addition to these payments,
the prospectus provided that the general partner would be entitled
to a management fee "equal to five percent of the gross annual
collected income from the partnership property" for his general
supervision. Finally, the prospectus stated that the above-described
contract financing points would be paid to HPC
"for its services relating to the first
mortgage financing for the partnership property."
On May 19, 1973, petitioner purchased 11 partnership
units in Aragon, thereby acquiring a 5.116-percent interest in the
partnership's profits and losses. At that time, he paid the first
installment of the purchase price by drawing a check for $ 11,309
n2 payable to the Partnerships Inc. escrow account. Petitioner received
a letter of confirmation, dated May 21, 1973, which stated
that his funds were "accepted to purchase
securities on a 'when, as, if' issued basis." On July 26, 1974,
petitioner paid the second and final installment of the purchase
price, $ 7,931, for his interest in Aragon.
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n2 Petitioner made an overpayment of the first
installment in the amount of $309 which was eventually refunded.
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Although the prospectus indicated that HPC
had entered into a contract to purchase the apartment complex, no
such contract was in effect at the time the prospectus was published.
On June 30, 1973, however, HPC, as "purchaser," and the
National Bank of Austin and Smigel, collectively referred to as
"seller," did execute a document entitled "Installment
Contract for Deed and Net Lease" (hereinafter installment contract)
agreeing to sell the apartment complex, including personal property
appurtenant to or used in the operation of the premises, to HPC.
Under the installment contract, there were two closings: (1) The
preliminary closing within 60 days after the execution of the contract,
and (2) the final closing on the first anniversary of the preliminary
closing, or such earlier date as elected by HPC. The stated purchase
price was $ 220,000 plus the actual unpaid balance of the principal
and accrued interest on the underlying mortgage to Austin Federal,
n3 which was payable as follows: (1) $ 1,000 upon signing the contract;
(2) $ 99,000 at the preliminary closing; (3) acceptance of title
to the property subject to the mortgage on the date of the final
closing; and (4) $ 120,000 at the final closing.
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n3 The installment contract stated that as
of June 30, 1973, the principal balance of the mortgage was within
1 percent of $ 1,280,000.
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On the date of the preliminary closing, the
installment contract provided that HPC would receive endorsements
to all insurance policies covering the apartment complex, naming
HPC as an additional insured. In addition, the installment contract
provided that as of the date of the preliminary closing, HPC would
be entitled to all depreciation on the apartment complex "allowed
or allowable pursuant to the provisions of the Internal Revenue
Code as amended."
With respect to the period of time between
the preliminary closing and the final closing, the installment contract
provided that the seller would retain legal title and remain in
possession and control of the premises. During that same period,
the seller would collect all rents and other income from the premises
and pay all the expenses thereof, including the payments on the
mortgage. Moreover, the installment contract specifically provided
that all rents accruing prior to the final closing were the property
of the seller and that all rents accruing after the final closing
were the property of the purchaser, HPC. For the "use and occupancy"
of the apartment complex during the interim between the preliminary
and final closing, the seller was required to pay HPC $ 1,000 per
month, with Smigel agreeing to make these payments. The installment
contract stated that the seller was retaining legal title and possession
and control of the premises solely as security for HPC's obligation
to pay the seller $ 120,000 at the final closing.
Pursuant to the installment contract, Smigel
agreed that until the final closing he would maintain the premises
and personal property in as "good condition," excepting
ordinary wear and tear, as of the date of the contract and would
make all repairs, replacements, substitutions, improvements, and
additions, structural or otherwise, necessary to keep the property
in good repair. If the replacement of any personal property transferred
under the installment contract became necessary, he agreed to replace
the property at his own expense, such replacements becoming the
property of HPC at the final closing, without any compensation to
Smigel therefor. When the need for the replacement of personal property
arose due to wear or obsolescence, Smigel was obligated to replace
the same with "new and similar" property having a value
no less than the cost of that replaced. Smigel also agreed to keep
the premises and personal property free from liens and claims for
liens and to defend, at his own expense, any action, proceeding,
or claim affecting the premises or personal property, or arising
out of the seller's operation of the premises, while holding HPC
and its assigns harmless therefrom.
In the event of a default by HPC, the installment
contract provided that the seller would retain any money paid by
HPC as liquidated damages and the contract would have "no further
force or effect," with HPC forfeiting any equitable interest
in the property. Furthermore, HPC had the option to rescind the
installment contract if all or any part of the premises was destroyed
by fire or other casualty prior to the final closing. In that case,
any money previously paid would be returned to HPC. If HPC, however,
did not elect to rescind the installment contract, the seller would
be required to assign HPC its right to any insurance proceeds at
the final closing.
On the date of the final closing, the installment
contract provided that rents, interest on the mortgage, insurance
premiums, real estate taxes, utilities, and other similar expenses
would be prorated and credited or charged, as appropriate, against
the $ 120,000 payment due from HPC. In addition, HPC and Smigel
executed an undated "rider" to the installment contract
whereby HPC agreed, notwithstanding anything to the contrary in
the installment contract, to pay the seller on the date of the final
closing an amount equal to the difference between the face amount
of the mortgage, $ 1,280,000, and the principal balance of the mortgage
on that date.
In a letter dated October 24, 1973, from HPC
to Smigel, HPC purportedly sought clarification of the installment
contract as follows:
It was our agreement that you would retain
legal title of the property solely as security [for the payment
required at the final closing] * * * and that until that payment
was made you would be operating and managing the property on our
behalf and for our benefit as owner. In other words, you would collect
all rents on our behalf and would make all required disbursements
to include real estates [sic] on our behalf.
Your compensation for operating the building
would be the net cash income of the project in excess of $ 1,000
per month. This $ 1,000 per month would be paid to us as our profit.
If the above correctly states our understanding,
please indicate by signing the enclosed copy of this letter and
return it to me.
As requested, Smigel indicated his approval
by signing the letter.
On July 1, 1973, HPC and Aragon executed a
document entitled "Articles of Agreement," whereby HPC
agreed to transfer to Aragon its beneficial interest in the land
trust under which title to the apartment complex was held. Reilly
signed the document on behalf of both HPC, as president, and Aragon,
as general partner. Aragon agreed to pay HPC a total purchase price
of $ 1,650,000, the
articles of agreement stating:
B. Apartments [Aragon] hereby covenant and
agree to pay Happiest [HPC] atotal purchase price for the real estate
and personal property thereon of One Million Six Hundred Fifty Thousand
($ 1,650,000) Dollars with interest thereon at the rate as next
set forth, in the following manner:
1. The sum of $ 2,250 on account of the principal
amount last described, concurrently with execution hereof.
2. The sum of $ 63,000 on account of the principal
amount last described on July 1, 1974.
3. The sum of $ 32,000 points at closing on
the unpaid balance.
4. The sum of $ 192,000 in payment of interest
due at the rate of 3.5% per annum on the sum of ($ 1,472,000) for
the balance of 1973 and 1974.
5. One Million Four Hundred Seventy Two Thousand
($ 1,472,000) of said principal sum and interest thereof at the
rate of 3.5% per annum for 1975 shall be paid in monthly installments
of $ 10,307 each, commencing as of August 1, 1973, and continuing
on the first day of each month thereafter until full payment of
said principal sum and interest thereon. The payments to be made
pursuant to this subscription shall be applied
during the year 1974 against interest on the principal balance as
of January 1, 1974 and 1975 and any remainder against said principal
balance; during the year 1975 against interest on the principal
balance as on January 1, 1975 for the period from January 1, 1976
through June 30, 1976 and any remainder against principal balance
as of January 1976; for the period from July 1, 1976 through December
31, 1976, and any remainder against the principal balance due hereunder.
C. Against the principal sum described in
Section B, Apartments shall be entitled to a credit in the amount
of the prorata share of the unpaid balance due on the first mortgage.
Accordingly, when the principal balance hereunder, computed as set
forth in Section B has been reduced to the then unpaid principal
balance of said mortgage, but not prior to October 1976, Happiest
shall assign its interest in the subject property to Apartments
without further payment to Happiest.
The articles of agreement recited that HPC
had contracted to purchase the apartment complex and that HPC's
"ability to convey title" was expressly conditioned upon
acquiring title from its seller. In contrast to the installment
contract, the articles of agreement provided that on the date of
its execution, possession of the apartment complex would be delivered
to Aragon and that Aragon would be entitled to the "cash flow
net operating income" therefrom. In addition, Aragon agreed
to pay all taxes and assessments levied upon the property subsequent
to that date and to make monthly escrow deposits with respect thereto.
Sometime in 1973, HPC and Aragon executed
another agreement entitled "Real Estate Management Agreement"
(hereinafter management agreement). Again, Reilly signed the document
on behalf of both HPC and Aragon. Pursuant to the management agreement,
HPC promised to manage the apartment complex in exchange for a fee
equal to 5 percent of the gross annual collected operating income
from the property. The management agreement set forth the following
limitation on the payment of this fee:
Payment of the management fee will be subordinated
to the limited partners' first receiving a minimum annual cash distribution
of 5% of said limited partners' original investment commencing 12
months after closing and continuing during the calendar years 1975
and 1976, so that Happiest [HPC] shall only receive at any time
that portion of its fee, if any, remaining after payment of such
5% to the limited partners as so provided.
In exchange for the management fee, the management
agreement provided that Aragon would receive the following:
A. Management and clerical personnel in Happiest's
[HPC's] offices to supervise all project activities as necessary.
B. Accounting services for the property and
the partnership, including monthly cash distributions, annual financial
reports and partnership tax returns.
By August 8, 1973, the sum of $ 215,000 attributable
to the payment of the first installment of the purchase price for
the Aragon partnership units, had been deposited in the Partnership
Inc. escrow account on behalf of Aragon. On or before August 8,
1973, the preliminary closing under the installment contract was
consummated, and $ 100,000 was paid to Smigel from the Aragon funds
held in the escrow account, while the remaining $ 115,000 of those
funds was paid to HPC.
On August 7, 1973, petitioner executed the
signature page of the "Aragon Apartments Limited Partnership
Agreement" (hereinafter partnership agreement), and on December
13, 1973, the partnership agreement became effective. The partnership
agreement provided that the partnership's business would be conducted
under the name of "Aragon Apartments" and named Reilly
the general partner. In addition, the partnership agreement stated
that the general partner would make a total capital contribution
of $ 29,600 to the partnership, payable in two installments: (1)
$ 17,200 at closing and (2) $ 12,400 one year thereafter. In exchange
for this contribution, the general partner received an 8-percent
interest in the partnership's profits and losses. Finally, the partnership
agreement provided that the general partner or his designated representative
would manage the partnership's business.
During 1973, Aragon neither maintained a formal
set of records nor had a bank account other than the Partnerships
Inc. escrow account. In February 1974, financial statements for
the period ending December 31, 1973, were prepared for Aragon by
a Chicago accounting firm, Kupferberg, Goldberg, Borkan & Co.
(hereinafter accountants). The accountants prepared the financial
statements from information provided to them without conducting
an audit of Aragon. Since they had not conducted an audit of Aragon,
the accountants refused to render an opinion "as to the fairness
of the financial statements" or "their conformity with
generally accepted accounting principles."
According to the "Statement of Financial
Position," Aragon had the following fixed assets as of December
31, 1973:
Land $ 132,000
Building 1,213,570
Equipment 191,680
Total 1,537,250
Less accumulated depreciation
64,058
Net fixed assets 1,473,192
All of these assets were attributable to the
apartment complex.
In addition, the "Statement of Operating
Results" asserted that Aragon had the following income and
expenses for 1973:
Statement of Operating Results
(Cash basis)
For the Period from Aug. 1, 1973
(Assigned Date of Formation) to Dec. 31, 1973
(Without audit)
Rental income $ 85,497.13
Operating expenses: n4
Advertising $ 242.32
Insurance 3,218.00
Interest on contract payable n5 22,210.66
Miscellaneous 1,517.48
Real estate taxes and
management fee 15,664.06
Scavenger 802.00
Utilities 4,173.27
Total operating expenses 47,827.79
Income before depreciation and other expense
37,669.34
Depreciation and other expense:
(Note 2) n6
Depreciation (Note 1) n6 64,058.00
Management fee 52,750.00
Contract finance fee 32,000.00
Prepaid interest 128,000.00
Total depreciation and other expense 276,808.00
Net (loss) for the period (239,138.66)
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n4 All of the operating expenses, except "Interest
on contract payable," were paid by Smigel.
n5 Although the source of this item is unclear,
we believe it is attributable to the interest portion of the monthly
payments due under the articles of agreement.
n6 Note 1 and Note 2 to the statement of operating
results stated as follows:
"Note 1 -- Allocation of real estate
acquired into the component parts of land, building and equipment
and the estimated life used for depreciation is in accordance with
the purchase contract between the partnership and 'The Happiest
Partner Corporation,' a company wholly-owned by the general partner.
"Note 2 -- No prior ruling from the Internal
Revenue Service was or will be sought with respect to this partnership
or the tax deductions as taken."
Contrary to the statement contained in Note.
1, the articles of agreement did not allocate the purchase price
among the acquired assets.
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For the period from August 1, 1973, through
December 31, 1973, Reilly timely filed a 1973 partnership return
of income n7 (Form 1065) for Aragon which had been prepared by Aragon's
accountants. Using the cash receipts and disbursements method of
accounting, the return reported rental income of $85,497.13 and
claimed the following deductions:
Item Amount
Depreciation $ 40,122.00
Additional first year depreciation 23,936.00
Interest n8 150,210.66
Contract financing fee 32,000.00
Taxes and management fee 68,414.06
Utilities 4,173.27
Insurance 3,218.00
Scavenger service 802.00
Advertising 242.32
Miscellaneous 1,517.48
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n7 The return stated that Aragon commenced
business on Aug. 1, 1973.
n8 This figure represents the sum of the amounts
set forth in the Statement of Operating Results under the headings
of "Prepaid interest" and "Interest on contract payable."
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On Schedule K (Partner's Shares of Income,
Credits, Deductions, Etc.) of the return, an ordinary loss of $
215,202.66, and additional first-year depreciation of $ 23,936 were
reported as the partnership's distributive share items. Furthermore,
the Schedule K-1 (Partner's Share of Income, Credits, Deductions,
Etc.) filed with respect to petitioner reported $ 11,967.42 of ordinary
loss and
$ 1,331.08 of additional first-year depreciation
as his share of the partnership's distributive share items. On Schedule
L (Balance Sheets) of the return, the partnership claimed total
fixed assets of $ 1,537,250, attributable to the following amounts:
(1) Buildings and other fixed depreciation
assets -- $ 1,405,250
(2) Land -- $ 132,000
By July 1, 1974, an additional $ 155,000,
attributable to thepayment of the second installment of the purchase
price for the Aragon partnership units, had been deposited in the
Partnerships Inc. escrow account on behalf of Aragon. On July 1,
1974, the final closing under the installment
contract was concluded. At that time, $ 155,000
was transferred to HPC from the Partnerships Inc. escrow account
on behalf of Aragon, and HPC paid the balance of the purchase price
due under the installment contract. Thereafter, the apartment complex
was deeded to La Salle National Bank, as trustee, pursuant to a
trust agreement dated June 24, 1974, under which Aragon was the
beneficiary.
Until July 1, 1974, Smigel operated the apartment
complex and paid all the expenses thereof, including the mortgage
payments. During 1973, the only payment made by Aragon was the transfer
of $ 215,000 from the Partnerships Inc. escrow account to Smigel
and HPC. Furthermore, Aragon never made the monthly payments to
HPC required under the articles of agreement.
On his 1973 return, petitioner claimed a deduction
of $ 13,298 for his distributive share of the partnership loss.
n9 In the notice of deficiency, respondent determined that petitioner
had failed to show that Aragon sustained any deductible loss during
1973 and disallowed the claimed deduction.
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n9 In the notice of deficiency, respondent
stated that petitioner had claimed a deduction of $ 13,344 for his
distributive share of the partnership loss. Petitioner's return,
however, shows that he only claimed a deduction of $13,298, attributable
to his distributive share of the partnership ordinary loss and additional
first-year depreciation.
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OPINION
We must decide whether petitioner is entitled
to deduct his distributive share of the alleged partnership loss
for 1973. The loss was attributable to the excess of the deductions
claimed on Aragon's 1973 return in connection with the purchase
and operation of the apartment complex over the rental income reported
thereon. The availability of those deductions and the alleged partnership
loss turns on whether HPC's sale of the apartment complex to Aragon
was a sham. In resolving this issue, we must consider:
(1) Whether the articles of agreement transferred
ownership, for tax purposes, of the apartment complex to Aragon
in 1973; and
(2) Whether the labels that the prospectus
and articles of agreement attached to the payments made by Aragon
comport with economic reality.
Respondent contends that HPC's sale of the
apartment complex to Aragon was a sham, contrived for the sole purpose
of tax avoidance. According to respondent, Aragon did not acquire
ownership, for tax purposes, of the apartment complex during 1973,
but only an option to purchase the complex. It is respondent's position
that Reilly manipulated the transaction in order to fabricate tax
deductions which would further his syndication
of Aragon. Respondent insists that the labels attached to the payments
Aragon made to HPC were a sham and that petitioner has not established
that any portion of those payments was deductible. Furthermore,
respondent asserts that during 1973 Aragon did no have a depreciable
interest in the apartment complex, incur any indebtedness
which would allow an interest expense deduction
under section 163, n10 or make any deductible expenditures with
respect to the operation of the apartment complex. Accordingly,
respondent maintains that Aragon did not sustain a deductible loss
during 1973.
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n10 All statutory references are to the Internal
Revenue Code of 1954 as amended.
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Petitioner, on the other hand, contends that
Aragon became the owner, for tax purposes, of the apartment complex
on July 1, 1973. Petitioner maintains that HPC's sale of the apartment
complex was not a sham and that Aragon was entitled to the deductions
claimed on its 1973 return. Therefore, petitioner insists that he
is entitled to the claimed deduction for his distributive share
of the partnership loss. For the reasons discussed below, we disagree
with petitioner and hold for respondent.
Although a taxpayer is entitled to reduce
the amount of his taxes by any means that the law allows, "the
question for determination is whether what was done, apart from
the tax motive, was the thing which the statute intended."
Gregory v. Helvering, 293 U.S. 465, 469 (1935). In Higgins v. Smith,
308 U.S. 473, 476-477 (1940), the Supreme Court further elaborated
as follows:
The Government urges that the principle underlying
Gregory v. Helvering finds expression in the rule calling for a
realistic approach to tax situations. As so broad and unchallenged
a principle furnishes only a general direction, it is of little
value in the solution of tax problems. If, on the other hand, the
Gregory case is viewed as a precedent for the disregard of a transfer
of assets without a business purpose but solely to reduce tax liability,
it gives support to the natural conclusion that transactions, which
do not vary control or change the flow of economic benefits, are
to be dismissed from consideration. * * *
* * * *
The Government may look at actualities and
upon determination that the form employed for doing business or
carrying out the challenged tax event is unreal or a sham may sustain
or disregard the effect of the fiction as best serves the purposes
of the tax statute. * * *
[Fn. refs. omitted. Emphasis added.]
It is now well established that the incidence
of taxation depends upon the substance of the transaction and not
the mere form, where the form is not imbued with economic reality.
Commissioner v. Court Holding Co., 324 U.S. 331 (1945). In order
to assess the form and ascertain the substance of a transaction,
we must determine (1) the purpose of the transaction, and (2) whether
it affects the taxpayer's beneficial interest apart from the tax
consequences. Knetsch v. United States, 364 U.S. 361, 366 (1960);
Decon Corp. v. Commissioner, 65 T.C. 829, 838 (1976).
Repeatedly, taxpayers have sought to obtain
advantageous tax consequences through the manipulation of controlled
entities. See, e.g., Higgins v. Smith, supra; Griffiths v. Commissioner,
308 U.S. 355 (1939); Decon Corp. v. Commissioner, supra; Palmer
v. Commissioner, 44 T.C. 92 (1965), affd. per curiam 354 F.2d 974
(1st Cir. 1965). In the instant case, Reilly was the general partner
of Aragon and owned all the capital stock of HPC. In addition, it
is clear that Reilly organized Aragon to acquire the apartment complex
and was the moving force behind the entire transaction. Since no
evidence was offered to show that Reilly lacked complete control
of either Aragon or HPC, we must conclude that such control existed.
Karme v. Commissioner, 73 T.C. 1163, 1186
(1980), on appeal (9th Cir., May 5, 1980);
Decon Corp. v. Commissioner, supra at 839; Crown Cork International
v. Commissioner, 4 T.C. 19, 25 (1944), affd. 149 F.2d 968 (3d Cir.
1945).
Although "mere control alone" will
not allow the form of a transaction to be disregarded, it indicates
that the transaction was not made at arm's length. Decon Corp. v.
Commissioner, supra at 839. See also Sun Properties v. United States,
220 F.2d 171 (5th Cir. 1955). Clearly, Reilly was
effectively dealing with himself with respect
to HPC's purported sale of the apartment complex to Aragon. He not
only controlled both Aragon and HPC, but signed the articles of
agreement on behalf of both entities. Such an absence of arm's-length
dealing requires us to consider whether the form and substance of
the transaction were the same. Sun Properties v. Commissioner, supra
at 174; Decon Corp. v. Commissioner, supra at 839.
After a painstaking analysis of the multitude
of documents and attendant circumstances in the instant case, we
conclude that HPC, under Reilly's direction and control, was acting
as Aragon's agent or nominee when it executed the installment contract.
We hold that HPC's purchase and resale of the apartment complex
to Aragon was a sham contrived by Reilly in order to create the
appearance of a completed sale in 1973 and fabricate tax deductions,
thereby furthering his promotion of Aragon as a tax shelter investment.
In determining whether the transaction involved
herein was a sham, we first consider whether the articles of agreement
transferred ownership, for tax purposes, of the apartment complex
to Aragon in 1973. Under the articles of agreement, HPC agreed to
deliver possession of the apartment complex to Aragon on the date
the agreement was executed. From that date forward, HPC also agreed
that Argon would be entitled to the cash flow net operating income
of the apartment complex. On July 1, 1973, the articles of agreement
was executed. At that time, however, under the installment contract,
HPC was not entitled to either possession of the apartment complex
or the cash flow net operating income therefrom. Moreover, we believe
that the sale under the installment contract was not completed until
the final closing thereunder on July 1, 1974, and therefore, HPC
could not have completed a sale of the apartment complex before
that time.
For purposes of Federal income taxation, a
sale occurs upon the transfer of the benefits and burdens of ownership
rather than upon the satisfaction of the technical requirements
for the passage of title under State law. Yelencsics v. Commissioner,
74 T.C. 1513, 1527 (1980); Clodfelter v. Commissioner, 48 T.C. 694,
700 (1967), affd. 426 F.2d 1391 (9th Cir. 1970). The question of
when a sale is complete for Federal tax purposes is essentially
one of fact. The applicable test is a practical one which considers
all the facts and circumstances, with no single factor controlling
the outcome. Baird v. Commissioner, 68 T.C. 115, 124 (1977); Deyoe
v. Commissioner, 66 T.C. 904, 910 (1976).
Generally, a sale of real property is complete
upon the earlier of the transfer of legal title or the practical
assumption of the benefits and burdens of ownership. Baird v. Commissioner,
supra at 124. Where, as in the instant case, the transfer of legal
title is delayed to secure payment of the purchase price, we must
determine when the parties intended to transfer the benefits and
burdens of ownership. Deyoe v. Commissioner, supra at 910; Merrill
v. Commissioner, 40 T.C. 66, 74 (1963), affd. per curiam 336 F.2d
771 (9th Cir. 1964).
The installment contract provided for both
a preliminary closing and a final closing. The preliminary closing
was scheduled to occur within 60 days after the execution of the
installment contract, and the final closing was to take place on
the first anniversary of the preliminary closing or any earlier
date chosen by HPC. The stated purchase price was $ 220,000 plus
the unpaid balance of the principal and accrued interest on the
underlying mortgage. HPC was required to pay $ 1,000 upon signing
the installment contract and $ 99,000 at the preliminary closing.
At the final closing, HPC was required to pay the balance of the
purchase price by accepting title to the apartment complex subject
to the mortgage and making a final payment of $ 120,000.
We find that under the installment contract
substantially all the benefits and burdens of ownership remained
with the seller n11 until the final closing. During the period of
time between the preliminary and final closing, the seller not only
retained legal title, but also remained in complete possession and
control of the apartment complex. Smigel bore the entire burden
of maintaining the apartment complex until the final closing, agreeing
to, among other things, maintain the premises in as "good condition,"
excepting ordinary wear and tear, as of the date of the contract.
During this period, the parties specifically agreed that the rental
income would be the property of the seller and that the seller would
pay all the expenses incurred in the operation of the apartment
complex, including the mortgage payments. Smigel also agreed to
protect HPC from any proceeding, action, or claim affecting the
apartment complex or arising from the operation thereof. Furthermore,
if any part of the
apartment complex had been destroyed by fire
or other casualty prior to the final closing, HPC had the right
to rescind the installment contract and receive a refund of the
purchase price.
- - - - - - - - - - - - - - - - - -Footnotes-
- - - - - - - - - - - - - - - - -
n11 Under the installment contract, the National
Bank of Austin and Smigel, the trustee and beneficiary, respectively,
of the Illinois land trust under which title to the apartment complex
was held, were collectively referred to as the "seller."
Under Illinois law, a land trust vests legal and equitable title
with the trustee, and the beneficiary retains a personal property
interest.
People v. Chicago Title & Trust Co., 75
Ill. 2d 479 (1979), 389 N.E.2d 540. Most of the attributes of ownership,
however, are retained by the beneficiary under the trust agreement,
and, in fact, "the only attribute of ownership ascribed to
the trustee is that relating to title." People v. Chicago Title
& Trust Co., 389 N.E.2d at 543. Moreover, under Illinois law,
actual ownership is deemed to lie with the beneficiary (People v.
Chicago Title & Trust Co., supra), and the beneficiary alone
can, in many instances, enter into a binding contract to sell the
property held in trust. Lampinen v. Hicks, 73 Ill. App. 3d 376 (1979),
391 N.E.2d 1105. With respect to the legal significance of the Illinois
land trust, the Supreme Court of Illinois stated:
"Indeed, there is not a single attribute
of ownership, except title, which does not rest in the beneficiary.
The rights of creation, modification, management, income and termination
all belong to the beneficiary. In reality the transfer to the trustee
is a formality involving a shifting of legal documents. The land
trust is, in fact, a fiction which has become entrenched in the
law of this State and accepted as a useful instrument in the handling
of real estate transactions. Outside of relationships based on legal
title, the trustees' title has little significance. * * * [People
v. Chicago Title & Trust Co., 389 N.E.2d at 545. Citations omitted.]"
Consequently, under Illinois law, Smigel possessed
most of the attributes of ownership (i.e., the benefits and burdens
of ownership) of the apartment complex prior to the execution of
the installment contract. Therefore, for the remainder of this opinion,
we shall consider Smigel the actual seller under the installment
contract.
- - - - - - - - - - - - - - - - -End Footnotes-
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In addition, pursuant to the undated rider
to the installment contract, HPC agreed to pay the seller the difference
between the face amount of the mortgage and the principal balance
thereof on the date of the final closing. Thus, HPC would not receive
any credit for the mortgage payments made prior to the final closing,
and Smigel retained the benefit of the principal amortization attributable
to those payments.
Until the final closing, the only burden assumed
by HPC was the payment of $ 100,000, and the only real benefit HPC
acquired was the right to purchase the apartment complex. Although
the installment contract also provided that on the date of the preliminary
closing HPC would be entitled to all depreciation, payments of $
1,000 per month for the seller's "use and occupancy" of
the apartment complex until the final closing, and endorsements
on all insurance policies, naming HPC as an additional insured,
these rights were, at best, insignificant.
It is well settled that a deduction for depreciation
is predicated upon an investment in property that would subject
the taxpayer to an economic loss upon the property's deterioration
through exhaustion, wear and tear, and obsolescence. Baird v. Commissioner,
supra at 123; Mayerson v. Commissioner, 47 T.C. 340, 353 (1966).
Thus, regardless of the terms of the installment contract, HPC would
not be entitled to deduct any depreciation on the apartment complex
until it had acquired an investment therein. We are convinced that
no such investment could be acquired until the final closing. Before
that time, HPC did not acquire an economic interest in the apartment
complex, but only the right to acquire such an interest upon the
completion of the sale.
HPC's right to be named as an additional insured
on all insurance policies covering the apartment complex has little
practical significance. Upon the destruction of any part of the
premises by casualty, HPC had the option to rescind the installment
contract and receive a refund of any money previously paid. If,
however, HPC chose not to exercise that option, the seller was not
required to assign its right to any insurance
proceeds to HPC until the final closing.
Finally, while the installment contract appears
to effect a net lease with the $ 1,000 monthly payments constituting
rent, this characterization fails to comport with economic reality.
First, no evidence has been offered to show that the purported rent
payable under the installment contract even approaches the fair
rental value of the apartment complex. Second, petitioner has failed
to prove that Smigel ever made the monthly payments either to HPC
or Aragon. Third, the professed net lease is part of the installment
contract and is inseparable therefrom. The extensive rights and
duties that Smigel retained under the installment contract are simply
incompatible with characterizing his operation of the apartment
complex as a net lease. See Estate of Franklin v. Commissioner,
64 T.C. 752, 769 n. 15 (1975), affd. 544 F.2d 1045 (9th Cir. 1976).
Relying on the purported letter of clarification
from HPC to Smigel, dated October 24, 1973, petitioner insists that
the installment contract, as so clarified, shifted the benefits
and burdens of ownership to HPC on July 1, 1973. The letter of clarification
stated that Smigel was retaining title solely as security and was
managing the apartment complex, collecting the rents, and paying
the expenses of the operation on HPC's behalf and for its benefit
as owner. According to that letter, the excess of the net cash income
from the operation over the $ 1,000 per month payable to HPC constituted
Smigel's compensation for managing the apartment complex.
We cannot accept the significance which petitioner
accords the purported letter of clarification. While both the installment
contract and the letter of clarification stated that title was being
retained solely as security, that statement is inconsistent with
the substance of the transaction. Moreover, the letter does not
ostensibly claim to modify the rights of the parties under the installment
contract, but rather simply professes to appropriately depict the
existing rights and duties of the parties. n12 To the extent that
the letter did represent a modification of the terms of the installment
contract, the fact remains that Smigel retained the benefits and
burdens of ownership until the final closing. There is no evidence
which indicates that the alleged compensation Smigel received for
managing the property was reasonable. It is clear, however, that
by way of this so-called compensation Smigel, in fact, retained
the benefits of ownership.
- - - - - - - - - - - - - - - - - -Footnotes-
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n12 While petitioner relies heavily on the
purported letter of clarification, he concludes that the installment
contract, as so clarified, effected a lease of the apartment complex
to Smigel for $ 1,000 per month with Smigel paying all the expenses
of operating the apartment complex on behalf of HPC, as owner. This
conclusion, however, is inconsistent with characterization set forth
in the letter of clarification. Rather, it parallels the terms of
the installment contract and indicates to us that the letter did
not modify the rights and duties of the parties under the installment
contract. Furthermore, we believe it underscores the difficulty
inherent in any attempt to characterize Smigel as operating the
apartment complex in any capacity other than as owner.
- - - - - - - - - - - - - - - - -End Footnotes-
- - - - - - - - - - - - - - - -
Although the parties undoubtedly contemplated
the eventual completion of the sale, "the intent to sell is
not synonymous with a sale." Penn-Dixie Steel Corp. v. Commissioner,
69 T.C. 837, 845 (1978). On the basis of the entire record herein
we hold that the parties to the installment contract did not intend
to transfer the accoutrements of ownership until the final closing.
n13 See Commissioner v. Stuart, 300 F.2d 872 (3d Cir. 1962), revg.
a Memorandum Opinion of this Court; Baird v. Commissioner, supra
at 128; Pacific Coast Music Jobbers, Inc. v. Commissioner, 55 T.C.
866, 877 (1971), affd. 457 F.2d 1165 (5th Cir. 1972). We are convinced
that Smigel retained ownership of the apartment complex until the
completion of the sale at the final closing. n14 Cf.
Handelman v. Commissioner, 509 F.2d 1067 (2d
Cir. 1975), revg. a Memorandum Opinion of this Court; Mittleman
v. Commissioner, 56 T.C. 171 (1971), affd. per curiam 464 F.2d 1393
(3d Cir. 1972); Lowe v. Commissioner, 44 T.C. 363 (1965); Boatman
v. Commissioner, 32 T.C. 1188 (1959).
- - - - - - - - - - - - - - - - - -Footnotes-
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n13 On brief, petitioner argued that the following
cases supported a finding that the accoutrements of ownership were
transferred on July 1, 1973: Clodfelter v. Commissioner, 426 F.2d
1391 (9th Cir. 1970), affg. 48 T.C. 694 (1967); Commissioner v.
Baertschi, 412 F.2d 494 (6th Cir. 1969), revg. 49 T.C. 289 (1967);
Deyoe v. Commissioner, 66 T.C. 904 (1976). We, however, have carefully
considered each of these cases and have found
them readily distinguishable from the instant case.
n14 Having reached this conclusion, we deem
it unnecessary to further decide whether the installment contract
constituted only an option to purchase the apartment complex as
argued by respondent. See United States Freight Co. v. United States,
190 Ct. Cl. 725, 422 F.2d 887 (1970); Estate of Franklin v. Commissioner,
64 T.C. 752 (1975), affd. 544 F.2d 1045 (9th Cir. 1976).
- - - - - - - - - - - - - - - - -End Footnotes-
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Accordingly, since the final closing was not
consummated until July 1, 1974, the articles of agreement could
not have transferred ownership, for tax purposes, of the apartment
complex to Aragon in 1973. Consequently, Aragon did not acquire
an economic interest in the apartment complex during 1973 and, therefore,
is not entitled to any depreciation deduction for that year.
Furthermore, since the operating expenses
of the apartment complex throughout 1973 were paid by the actual
owner, Smigel, Aragon was not entitled to claim any deduction therefor.
We next consider whether the labels that the
prospectus and articles of agreement attached to the payments made
by Aragon comport with economic reality. Initially, from an inspection
of the articles of agreement we are unable to ascertain any rhyme
or reason to the breakdown of the purchase price set forth therein.
Although the stated purchase price is $ 1,650,000, the total of
the amounts described as payments of principal is only $ 1,537,250.
n15 In addition, it is impossible to determine the source of validity
of the $1,472,000 indebtedness assumed by Aragon therein. Moreover,
the
$192,000 which Aragon agreed to pay as interest
on this sum for the balance of 1973 and 1974 could not be attributable
to an interest rate of only 3.5 percent. n16
- - - - - - - - - - - - - - - - - -Footnotes-
- - - - - - - - - - - - - - - - -
n15 Interestingly, the statement of financial
position prepared by Aragon's accountants stated that Aragon had
fixed assets before depreciation of $1,537,250. In addition, on
Schedule L of its 1973 return, Aragon claimed this same amount of
fixed assets.
n16 At an interest rate of 3.5 percent per
annum (simple interest), the maximum amount of interest which would
accrue on the sum of $ 1,472,000 for a period of 1 1/2 years is
$ 77,280.
- - - - - - - - - - - - - - - - -End Footnotes-
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While the prospectus also stated that the
total purchase price was $1,650,000, it provided that the purchase
price would be paid in the following manner: (1) Aragon would receive
a credit of $ 1,280,000 for the mortgage; and (2) would pay the
balance of the purchase price, $ 370,000, in two installments --
$ 215,000 at closing in 1973 and $ 155,000 on July 1, 1974. After
setting forth the essential parameters of the transaction, the prospectus
allocated the $ 370,000, which would be raised from the sale of
partnership units and eventually paid to HPC and Smigel, among the
following items:
At closing 1974 (1 year later)
Purchase price
$ 2,250 $ 63,000
Management fees
52,750 28,000
Contract financing points 32,000
Prepaid interest 128,000 64,000
215,000 155,000
According to the prospectus, the management
fees, contract financing points, and prepaid interest would be fully
deductible in the year paid.
Although the prospectus indicated that the
prepaid interest payable in 1973 was for interest which would accrue
in 1973 and 1974, and that the prepaid interest payable in 1974
was for interest which would accrue in 1975, n17 neither the interest
rate nor the principal sum that was used to calculate the amount
of interest which would accrue for those periods was stated. The
prospectus provided that the prepaid interest would be added to
the "contract balance" due to HPC. While noting that the
contract balance would be greater than the balance due on the mortgage
because of the addition of prepaid interest, the prospectus stated
that a lower interest rate would be charged in the "purchase
contract" so that the monthly cash payments due under the mortgage
and purchase contract would be the same. Thus, the $ 1,472,000 indebtedness
set forth in the articles of agreement must have been determined
by adding the balance due under the mortgage ($ 1,280,000) and the
total prepaid interest ($192,000).
- - - - - - - - - - - - - - - - - -Footnotes-
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n17 The articles of agreement, on the other
hand, provided that the entire $192,000 (128,000 + 64,000) of prepaid
interest was payable for interest accruing in 1973 and 1974. This
inconsistency is particularly astounding considering the fact that
a copy of the articles of agreement was attached to the prospectus.
- - - - - - - - - - - - - - - - -End Footnotes-
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Section 163(a) allows a deduction for "all
interest paid or accrued within the taxable year on indebtedness."
For Federal income tax purposes, "interest on indebtedness"
is generally defined as "compensation for the use or forbearance
of money." Deputy v. du Pont, 308 U.S. 488, 498 (1940). In
determining whether a payment constitutes interest on indebtedness,
economic realities, not form,
control the determination. Knetsch v. United
States, 364 U.S. 361, 366 (1960); Titcher v. Commissioner, 57 T.C.
315, 322 (1971). Amounts denominated as interest cannot be deducted
where the underlying transaction was a sham. See Collins v. Commissioner,
54 T.C. 1656, 1664 (1970).
In reality, the transaction herein under consideration
did not create a genuine indebtedness, and therefore, Aragon was
not entitled to any interest expense deduction for 1973. Significantly,
the prospectus discloses that the purported $ 1,472,000 indebtedness
was determined by adding the total prepaid interest ($ 192,000)
to the balance due under the mortgage on the apartment complex.
Nevertheless, the articles of agreement stated that the same $ 192,000
represented interest on said indebtedness. Furthermore, the prospectus
reveals that the interest rate charged under the articles of agreement
was manipulated to provide monthly payments equaling those required
under the mortgage. Moreover, we have found as a fact that Aragon
did not make the monthly payments
to HPC, and we believe that there never was
any intention that these payments would be made.
Clearly, this contrivance did not establish
a genuine indebtedness. HPC did not forbear the collection of any
money, and Aragon did not obtain the use of any of HPC's funds.
The indebtedness established under the articles of agreement was
a facade used to support the claimed interest deductions.
When Aragon became the owner of the apartment
complex, the only indebtedness was based on the underlying mortgage.
While the prospectus stated that HPC would accept the prepaid interest
as ordinary income, we consider that fact irrelevant since it was
simply an element of the facade "to clothe the payment with
the garb of interest," Collins v. Commissioner, supra at 1665.
Moreover, we believe that all of the labels
attached to the $ 370,000 paid by Aragon to HPC and Smigel lacked
economic reality. Compare LaCroix v. Commissioner, 61 T.C. 471 (1974);
Titcher v. Commissioner, supra; Collins v. Commissioner, supra.
Each label was a component in Reilly's plan to promote Aragon as
a tax shelter investment. Petitioner has not shown that Aragon was
entitled to any deduction for the claimed contract financing points.
While the prospectus stated that HPC would be paid $ 32,000 "for
its services relating to the first mortgage financing," the
record contains nothing that even suggests HPC performed such services.
n18 Moreover, since the mortgage financing was acquired by Smigel
and the National Bank of Austin in 1972, it is unlikely that HPC
performed any services in connection with the acquisition of this
financing.
- - - - - - - - - - - - - - - - - -Footnotes-
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n18 Even if HPC had performed such services,
Aragon would not have been entitled to deduct the full amount of
the payments for those services in the year paid. Payments for services
in connection with the acquisition of a loan are capital expenditures
which must be amortized over the life of the loan. Wilkerson v.
Commissioner, 70 T.C. 240, 253-257, 261-262 (1978), on appeal (9th
Cir., Oct. 1, 1979); Lay v. Commissioner,
69 T.C. 421, 437-440 (1977).
- - - - - - - - - - - - - - - - -End Footnotes-
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While the prospectus stated that Reilly would
be paid $ 52,750 in 1973 and $28,000 in 1974 for "general supervision"
of both Aragon and the day-to-day operation of the apartment complex,
no evidence has been offered to show either the nature or degree
of the supervision Reilly provided to Aragon. In fact, aside from
the prospectus, there is no other evidence that supports the
denomination of these amounts as management
fees. Significantly, the findings of fact show that the amounts
purportedly payable to Reilly as management fees were actually paid
to HPC. In addition, we have found that Aragon was not the owner
of the apartment complex during 1973, and that Smigel, not Reilly,
was in complete control of its day-to-day operation during that
year. Under these circumstances, we cannot accept the characterization
of these amounts as management fees.
On the basis of the foregoing, we conclude
that the articles of agreement was simply part of a sham manufactured
by Reilly to enhance his promotion of Aragon as a tax shelter investment.
On numerous occasions taxpayers have engaged in complex artifices
solely to lay the foundation for tax deductions, and in all instances
judicial scrutiny has struck down these devices. See, e.g., Knetsch
v. United States, supra; Barnett v. Commissioner, 44 T.C. 261 (1965),
affd. 364 F.2d 742 (2d Cir. 1966); Lynch v. Commissioner, 31 T.C.
990 (1959), affd. 273 F.2d 867 (2d Cir. 1959); Goodstein v. Commissioner,
30 T.C. 1178 (1958), affd. 267 F.2d 127 (1st Cir. 1959). In the
instant case, Reilly has used HPC as the principal component of
a facade created to support the promises contained in the prospectus.
In the prospectus, Reilly promised that an investment in Aragon
would reap substantial tax benefits in 1973. By means of his control
of HPC, Reilly fabricated a transaction that both purported to complete
the sale of the apartment complex in 1973 and establish tax deductions,
thereby lending form to the promises contained in the prospectus.
From the outset, Reilly contemplated Aragon's
eventual acquisition of the apartment complex. Nevertheless, Reilly
also sought to promote Aragon as a tax shelter investment, and he
used HPC as the vehicle to attain this goal. No legitimate business
purpose was served through HPC's participation in the acquisition
of the apartment complex. It was never intended that HPC would actually
own or operate the apartment complex, and in fact, upon the final
closing under the installment contract, the apartment complex was
deeded to the trustee under a trust agreement that named Aragon
as the beneficiary. Thus, HPC's purchase and resale of the apartment
complex was a sham. Neither the effort to complete the sale of the
apartment complex to Aragon in 1973 nor the labels fastened to $
370,000 paid by Aragon to HPC and Smigel had any substance.
The mere fact that tax planning is considered
in structuring a transaction does not require us to ignore the transaction
for tax purposes. Nevertheless, the above-described transaction
did not affect petitioner's beneficial interest other than to reduce
his taxes and, therefore, must be ignored for tax purposes. Knetsch
v. United States, supra at 366. We are convinced that HPC, under
Reilly's direction and control, was merely acting as Aragon's agent
or nominee when it executed the installment contract. n19 See Red
Carpet Car Wash, Inc. v. Commissioner, 73 T.C. 676, 685-686 (1980);
Louis Adler Realty Co. v. Commissioner, 6 T.C. 778, 786 (1946).
We hold that Aragon, not HPC, was the real purchaser under the installment
contract and made the payments required thereunder as purchaser,
with HPC simply serving as a conduit. Compare Commissioner v. Court
Holding Co., supra; Griffiths v. Commissioner, 308 U.S. 355 (1939);
Hindes v. United States, 326 F.2d 150 (5th Cir. 1964).
- - - - - - - - - - - - - - - - - -Footnotes-
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n19 We recognize the fact that ordinarily
a corporation must be respected as a separate entity for tax purposes.
Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943); New
Colonial Ice Co. v. Helvering, 292 U.S. 435, 442 (1934). Generally,
if a corporation was created or functions for some business purpose,
its separate existence may not be disregarded and its income may
not be attributed to its shareholders either on the ground that
it was merely a sham or on the ground that it was the agent of its
shareholders. Moline Properties, Inc. v. Commissioner, supra; National
Carbide Corp. v. Commissioner, 336 U.S. 422 (1949); Harrison Property
Management Co. v. United States, 201 Ct. Cl. 77, 475 F.2d 623 (1973),
cert. denied 414 U.S. 1130 (1974). In the instant case, however,
the issue is not whether HPC must be recognized as a separate taxable
entity, but rather who was the actual purchaser under the installment
contract. Cf. Red Carpet Car Wash, Inc. v. Commissioner, 73 T.C.
676, 685-686 (1980). We are not deciding who is taxable on the payments
Aragon made to HPC.
- - - - - - - - - - - - - - - - -End Footnotes-
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Aside from the payments under the installment
contract, which total $220,000, Aragon paid HPC a total of $ 150,000
which HPC retained. Petitioner, upon whom rests the burden of proof,
has failed to establish that any portion of this amount represents
a deductible expenditure. See Welch v. Helvering, 290 U.S. 111 (1933);
Rule 142(a), Tax Court Rules of Practice and Procedure. On the record
before us, we are unable to ascertain the purpose underlying the
payment of $ 150,000 to HPC. It is possible that this payment represented
a fee for the facade which HPC provided. See Knetsch v. United States,
supra at 366. We, however, believe that the $ 150,000 constitutes
payment for services performed by Reilly and HPC in connection with
organization and syndication of Aragon and the acquisition of the
apartment complex. See Estate of Boyd v. Commissioner, 76 T.C. 646
(1981). Such expenditures are nondeductible capital expenses. n20
Hilton v. Commissioner, 74 T.C. 305, 366 (1980); Kimmelman v. Commissioner,
72 T.C. 294, 304 (1979); Cagle v. Commissioner, 63 T.C. 86, 96-97
(1974), affd. 539 F.2d 409 (5th Cir. 1976).
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n20 Sec. 709(a) expressly provides that organization
and syndication expenses are not deductible, except as provided
in sec. 709(b). Sec. 709(b) allows a partnership to elect to amortize
organizational expenses over a period of not less than 60 months.
Sec. 709(b) applies only to organizational expenses paid or incurred
in taxable years beginning after Dec. 31, 1976. Sec. 213(f)(3),
Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1549, 1976-3 C.B.
(Vol. 1) 24-25.
- - - - - - - - - - - - - - - - -End Footnotes-
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In reaching our decision in this case, we
are not questioning petitioner's good faith. We are unaware of any
evidence indicating petitioner recognized or understood the dubious
character of the tax consequences set forth in the prospectus at
the time he made his investment in Aragon. Nevertheless, unless
the statute itself turns on intent, the incidence of taxation depends
upon
"objective realities" and not the
subjective good faith of the individual taxpayer. Lynch v. Commissioner,
273 F.2d 867, 872 (2d Cir. 1959), affg. 31 T.C. 990 (1959). See
also Karme v. Commissioner, 73 T.C. 1163, 1194 (1980), on appeal
(9th Cir., May 5, 1980).
Accordingly, since petitioner has failed to
prove that Aragon incurred any deductible loss for 1973, we sustain
respondent's determination.
To reflect the foregoing,Decision will be
entered under Rule 155. |
