Grodt & McKay
Realty, Inc. v. Commissioner (1981)
Grodt & McKay Realty, Inc., n1
Petitioner v. Commissioner of Internal Revenue, Respondent; Davis
Equipment Corporation, n1 Petitioner v.
Commissioner of Internal Revenue,
Respondentn1 These cases have been
consolidated for purposes of trial, briefing, and opinion.
Docket Nos. 16210-79, 4852-80
UNITED STATES TAX COURT
77 T.C. 1221
December 7, 1981, Filed
DISPOSITION:
Decisions will be entered under Rule 155.
CORE TERMS: cattle, herd, cow, breeding, animal,
purebred, warranty,
memorandum, management fees, calves, cattle-breeding,
heifer, calf, progeny, seller, born, management agreement, per head,
registration, designated, liquidation, certificate, depreciation, purchase
price, sales agreement, net proceeds, investor, birth rate, promissory,
female
SYLLABUS: Petitioners entered into sales agreements,
promissory notes, security agreements, and management agreements with
Cattle Co. Pursuant to these agreements, petitioners purportedly purchased
units of cattle, consisting of five breeding cows per unit, at $ 30,000
per unit. The purchase price was paid $ 1,000 to $ 1,500 cash on execution
of the sales agreement, and the balance in the form of nonrecourse
promissory notes. Petitioners also made cash payments in the first 3 years
which were designated interest and management fees. The fair market value
of the cattle was approximately $ 600 per cow. Petitioners did not acquire
the right to possession, control, or dominion over the cattle. Held:
Petitioners' transactions with Cattle Co. were not sales for Federal tax
purposes. Petitioners' only real expectation of profit from the
transactions with Cattle Co. rested on hoped-for tax benefits. Held,
further, the transactions do not have sufficient substance, apart from tax
manipulation, to be recognized for tax purposes.
COUNSEL: William S. Smith, William B. Serangeli, and
Charles H. Liebold, for the petitioners.
Genelle F. Schlichting, for the respondent.
JUDGES: Hall, Judge. *
* This opinion was prepared by Judge Hall during her
tenure of office.
OPINIONBY: HALL
OPINION: Respondent determined the following
deficiencies in petitioners' income taxes: Petitioner Docket No. Year
Deficiency Grodt & McKay Realty, Inc 16210-79 1976 $ 6,885.24
The issues for decision are:
(1) Whether transactions in which petitioners
purportedly purchased cattle were bona fide sales or sham transactions;
(2) In the alternative, whether petitioners'
cattle-breeding activities were activities engaged in for profit;
(3) In the alternative (a) whether nonrecourse
purchase-money notes used to purchase the cattle were so contingent as to
(1) prohibit their inclusion in petitioners' bases for depreciation and
investment tax credit purposes, and (2) prohibit deductions for interest
payments thereon; and (b) whether petitioners are entitled to deduct
management fees in excess of the amounts allowed by respondent.
FINDINGS OF FACT
Some of the facts have been stipulated and are found
accordingly.
Grodt & McKay Realty, Inc. (Grodt & McKay),
and Davis Equipment Corp. (Davis Equipment) each had its principal place
of business in Des Moines, Iowa, when it filed its petition. Both Grodt
& McKay and Davis Equipment keep their books and file their income tax
returns using the accrual method of accounting and the calendar year.
During all relevant times, both corporations were taxed as regular
corporations.
Grodt & McKay is an Iowa corporation primarily
engaged in the sale of real estate. During 1976, Paul O. Grodt was the
president and sole shareholder of Grodt & McKay. During 1977, Grodt
owned 80 percent of Grodt & McKay's outstanding stock, and the
remaining 20 percent was owned by a trust established by Grodt for the
benefit of his heirs.
Davis Equipment is an Iowa corporation primarily
engaged in the retail sales and servicing of fertilizer application
equipment. During all relevant times, Roger L. Davis was the president and
sole shareholder of Davis Equipment.
On December 8, 1976, T. R. Land & Cattle Co., Inc.
(Cattle Co.), issued a private placement memorandum describing a private
offering of an investment opportunity in a cattle-breeding program. The
memorandum detailed Cattle Co.'s intention to establish a large-scale
cattle-breeding program by selling 35 "units" of cattle at $
30,000 per unit, with each unit consisting of five breeding cows. Cattle
Co. proposed to retain all management responsibility for the cattle, n2
and it offered to finance up to $ 28,500 of the purchase price with a
promissory note payable out of the profits from the cattle-breeding
operations. A "Sales Agreement," a "Management
Agreement," a "Promissory Note," and a "Security
Agreement" made up the basic instruments embodying the arrangement
between purchasers and Cattle Co. n3
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n2 The memorandum specifically states that Cattle
Co.'s management services are optional. However, the management services
were considered an integral element of the arrangement between Cattle Co.
and purchasers of the units, and the memorandum and the proposed
agreements fully contemplate that the management services will be part of
the overall undertaking.
n3 The specifics of the cattle-breeding program as
explained in the memorandum (including the sample documents attached
thereto) are materially different from some of the provisions of the
program found in the actual documents executed by petitioners. For this
reason, the text of our findings of fact will rely on the actual documents
executed.
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On December 9, 1976, Grodt & McKay executed
documents pursuant to which it purchased n4 two units of cattle in Cattle
Co.'s program for $ 30,000 per unit. On December 11, 1976, Davis Equipment
purchased one unit of cattle for $ 30,000.
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n4 Use of such terms as "purchase,"
"sale," "own," "petitioners' herds,"
"interest," "principal," "price," "downpayment"
and "management fee," should not be construed as carrying any
conclusion as to the legal effect of the documents or transactions
involved.
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Under the provisions of the sales agreements,
petitioners' units of breeding cattle n5 consisted of five purebred Angus
cows (the basic herd). Cattle Co. agreed to promptly replace any
nonbreeder n6 in the basic herd with a cow of comparable quality.
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n5 The sales agreements contain no definition of
"breeding cattle." The memorandum, on the other hand, states
that "Each animal in the basic herd will be between 1 and 12 years of
age at the time of sale and will be mature for breeding." Black Angus
heifers generally reach breeding age between 18 and 20 months.
n6 The sales agreements define a nonbreeder as a cow
or heifer which does not become pregnant after six consecutive breeding
attempts or within 6 months of the date of the sales agreement, whichever
occurs first. An agreement to replace a nonbreeder is standard practice in
the industry.
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Grodt & McKay's purchase price of $ 60,000 was
payable as follows: $ 2,000 cash on execution of the sales agreements and
the balance ($ 58,000) in the form of a nonrecourse promissory note. Davis
Equipment agreed to pay $ 1,500 cash on execution of the sales agreement
and the balance of the $ 30,000 purchase price ($ 28,500) in the form of a
nonrecourse promissory note. Petitioners remained liable on the promissory
notes whether or not Cattle Co. performed under the management agreement.
Pursuant to the sales agreements, Cattle Co. agreed
that it would, whenever possible, artificially inseminate each cow in the
basic herd with semen from a quality bull that would hopefully improve the
calf crop of the basic herds. The sales agreements contained the following
warranties and guaranties, and the following provisions regarding early
termination of the management agreements:
2. The animals in the Basic Herd are represented and
warranted to be breeders capable of being registered with the Black Angus
Association. The Herd will remain registered with the Black Angus
Association under the name of the Seller or its nominee for the benefit of
the Buyer. n7
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n7 The American Angus Association issues registration
certificates for purebred Angus cattle and records such certificates in
the American
Aberdeen-Angus Herd Book. These certificates contain
information on the registered cow, including its name and registration
number, the name of its record owner, and provisions for subsequent
transfer of its registration on the records of the American Angus
Association. The registration certificates for the purebred cattle
designated as part of petitioners' basic herds all indicate Cattle Co. as
the record owner. All of the registration certificates for the purebred
progeny of the basic herds list Cattle Co. as the first owner and do not
reflect any subsequent owners. None of the certificates indicate that
Cattle Co. held title in a fiduciary or other capacity for the benefit of
petitioners.
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9. Seller [Cattle Co.] agrees that, commencing with
the fiscal year (January 1 to December 31) starting on the first January 1
to follow the execution of this Agreement, if for any reason whatsoever,
the Basic Herd shall have less than an 80% annual live calf birth rate and
if such deficiency shall not have been offset by calves born from the date
of entry into a Program in excess of the 80% minimum for that year, then
Seller shall promptly transfer to Buyer and add to Buyer's Herd a
sufficient number of animals of a quality comparable to the progeny of
other Basic Herds managed by Seller to the extent necessary to make up
such net deficiency. The animals so transferred to make up any deficiency
shall be approximately 50% heifer calves and 50% bull calves.
10. Seller agrees to forthwith replace any animal in
the Basic Herd which shall, prior to its tenth (10th) birthday, die or be
lost by theft or disappearance. The aforesaid obligation to substitute
animals shall apply not only to the animals in the Basic Herd but also to
any animal substituted therefor in accordance herewith. All substitutions
shall be of comparable quality to the animal for which they are
substituted.
11. In the event Buyer desires to remove his or its
Herd from Seller's care and management, Buyer agrees to release Seller of
all obligations under the Sales Agreement and Management Agreement. Seller
agrees to release the Herd on the terms set forth below. Seller agrees
that upon written notice from the Buyer to remove his or its Herd from
Seller's management together with full
payment of the Purchase Price (Note and accrued
interest, where applicable), payment of 50% of the Progeny or Herd value
determined as set forth below and payment of Management Agreement fees
prorated to the date of Herd removal, Seller shall arrange, within 30
days, for the Herd to be prepared for shipment and delivery. If the
Program is terminated within 30 days of the date of entry therein, no
management fees will be paid by the Herd Owner. Buyer will pay all costs
of preparation and shipment. If Buyer exercises his or its right under
this Section, Seller agrees to reduce the Purchase Price and/or the
outstanding principal balance of the Note, if applicable, in the following
manner:
(a) If Buyer takes delivery of the Herd in 1977, such
reduction shall equal Twenty Thousand Dollars ($ 20,000.00).
(b) If Buyer takes delivery of the Herd in 1978, such
reduction shall equal Fifteen Thousand Dollars ($ 15,000.00).
(c) If Buyer takes delivery of the Herd in 1979, such
reduction shall equal Seven Thousand Five Hundred Dollars ($ 7,500.00).
In the event Buyer terminates this Agreement during
the first three calendar years of a Program, he will be required to pay
the Company [Cattle Co.] 50% of the Progeny value as additional management
fees. Thereafter, the Buyer will be required to pay the Company 50% of the
Herd value as additional management fees. Both values will be determined
by an independent third party selected by the Company. In the event that
both this and the Management Agreement are terminated within 30 days of
their execution, all sums paid by the Herd Owner will be refunded.
The Company will defend one test case at its own
expense if its cattle breeding programs are challenged by the IRS. If such
case is lost and if a Herd Owner thus loses his tax benefits the Company
will, if the Herd Owner so elects, buy the Herd from the Herd Owner. That
is, the Company will refund any principal or interest payments, or
management fees (all of which shall be net of tax savings from which the
Herd Owner has benefited, based on the assumption he is in a 50% tax
bracket). In exchange therefor the Herd Owner will transfer his entire
Herd to the Company, and the Sales Agreement, Management Agreement and
Note will be mutually terminated. If the Herd Owner elects to thus resell
his Herd he may recapture certain depreciation and investment credit
deductions. (See "Recapture" above). The ability of the Company
to buy back the Herd will be dependent on its financial viability. (See
"Risk Factors-1. Financial Condition of the Company.") n8
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n8 These last two paragraphs were taken directly from
the memorandum. Whether the references to portions of the memorandum
incorporate them in the sales agreements is not an issue in this case.
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Finally, each sales agreement provides that it, the
management agreement, the security agreement, and the promissory note
constitute the entire understanding between petitioners and Cattle Co. and
cannot be amended or terminated, orally, and shall be interpreted under
the law of Iowa.
The promissory notes executed by petitioners call for
the payment to Cattle Co. of $ 58,000 by Grodt & McKay and $ 28,500 by
Davis Equipment, together with interest at the rate of 7 percent per
annum. The promissory note executed by Davis Equipment provided for the
payment of principal and interest as follows:
WITH RESPECT TO PRINCIPAL * * *
An amount equal to seventy-five percent (75%) of the
total net proceeds (gross sales less commissions, sales costs and
brokerage fees), resulting from the sale or other income derived from the
animals in the Maker's Herd (as such term is defined in the certain Sales
Agreement and Management Agreement between the Maker and the Company) in
accordance with the Sales Agreement and Management Agreement will be
applied first towards the payment of interest and then toward the
reduction of principal until the principal balance of this Note has been
paid in full.
The Maker has no personal liability of any kind
whatsoever for the principal amount referred to above and in the event of
default in payment of the amount, the Company will look only to the
collateral (as that term is defined in the Security Agreement) and the
Maker will have no personal liability for any deficiency. n9
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n9 The memorandum specifically states that the notes
will be recourse and the herd owner will be personally liable for the
entire unpaid balance thereof upon maturity. It may be that the notes were
made nonrecourse for petitioners because they were corporations, and,
during 1976, corporations such as petitioners were not subject to the
at-risk provisions of sec. 465. Testimony in this case also indicates
that, in 1978, Davis Equipment and Cattle Co. amended Davis Equipment's
note to conform with changes made to sec. 465.
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WITH RESPECT TO INTEREST:
The Maker will pay a total of $ 3,990 in 24 equal
monthly interest payments commencing one year from the date of this
Promissory Note. All other interest will be paid to the Company from the
remainder, after payment of management fees in accordance with the
Management Agreement, of the Maker's share of the proceeds realized from
the sale or other income derived from the animals in the Maker's Herd. In
the event such proceeds shall be insufficient to pay such accumulated
interest, any deficiency will be carried forward and charged against the
remainder of the Maker's share of the proceeds realized from future sales.
Interest will be paid by the Maker in an amount sufficient to cover the
estimated interest payable as of the end of the calendar year in which
cattle income is realized. [Fn. ref. omitted.]
The Maker has no personal liability of any kind
whatsoever for the interest payments referred to above and in the event of
a default in the payment of such interest the Company will look only to
the collateral (as that term is defined in the Security Agreement) and the
Maker has no personal liability for any deficiency in interest payments.
n10
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n10 See note 9 supra.
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WITH RESPECT TO PRINCIPAL AND INTEREST:
Any unpaid balance of principal and interest will be
due twenty (20) years from the date hereof.
Grodt & McKay executed an identical promissory
note for $ 58,000 except for the first sentence of the first paragraph
under the "With Respect to Interest" section, which provided:
The Maker will pay $ 2,030.00 commencing six months
after January 1 of the year following the date of this Promissory Note;
and every six months thereafter until four interest payments of like
amount have been received by holder of the note.
The security agreements provide for assignments from
petitioners to Cattle Co. of their interests in their herds to secure
petitioners' payment and performance of all obligations to Cattle Co.
required under the sales agreements, the promissory notes, and the
management agreements.
The final agreements rounding out Cattle Co.'s planned
cattle-breeding program were management agreements. In these agreements,
Cattle Co. agreed to "breed, care for, manage, feed, transport and
provide whatever is necessary, including, without limitation, medical
services and facilities to the" herds. Cattle Co. also agreed to cull
the herds periodically, and to sell most breeding cows by their 10th
birthday. The management agreement also provided the following guaranty
regarding the live-calf birth rate of cows in Cattle Co.'s charge:
5. The Company agrees that, commencing with the fiscal
year (January 1 to December 31) starting on the first January 1 to follow
the signing of this Agreement, if for any reason whatsoever the Breeding
Herd shall have less than an 80% annual live calf birth rate and if such
deficiency shall not have been offset by calves born from the date of
entry into a Program in excess of the 80% minimum for all previous fiscal
years, then the Company shall promptly transfer to Owner and add to
Owner's Herd a sufficient number of animals comparable to the progeny of
other herds managed by the Company necessary to make up such net
deficiency. The animals so transferred to make up any deficiency shall be
approximately 50% heifer calves and 50% bull calves. Progeny in excess of
80% shall be retained by the Company.
6. Beginning with the 1977 calf crop (i.e. calves born
during the fiscal year commencing January 1, 1977), the Company may retain
from each fiscal year's calf crop sufficient heifer calves to be
ultimately added as replacements to the Breeding Herd. The Breeding Herd
will consist of not less than five animals at all times, except during
liquidation.
The management agreements, like the sales agreements,
recite that Cattle Co. will artificially inseminate the cows in the
breeding herds at no additional cost to petitioners.
Petitioners agreed to pay Cattle Co. $ 3,000 per year
per unit for its services during the first 3 years the management
agreements are in effect. After that time, and until the interest and
principal due under the promissory notes is paid, Cattle Co. is to receive
as management fees an amount equal to "25 percent of all net proceeds
(gross sales price less commissions, sales costs and brokerage fees)
derived from" petitioners' herds. The remaining 75 percent of the net
proceeds is to be applied against the outstanding interest and principal
due on the notes. Once all interest and principal is paid, Cattle Co. is
to receive as management fees 75 percent of all net proceeds from
petitioners' herds, and petitioners will receive 25
percent of the net proceeds.
Under the management agreements, Cattle Co. has full
control over all sales of animals for which full payment is received in
less than 24 months. On sales extending credit for 24 months or more,
Cattle Co. must obtain petitioners' consent, which consent cannot be
unreasonably withheld. Cattle Co. has the obligation to transmit
semiannual accounting reports to petitioners and semiannual reports
providing the following information regarding each animal in petitioners'
herds: ear tatoo and ear tag numbers, name, sex, date of birth,
registration number, breeding, calving, and progeny information. Cattle
Co. further agreed to keep extensive herd records at their offices which
would be available to petitioners. These records were to include Black
Angus
registration certificates on all herd animals, sales
and breeding information, and other records related to the cattle-breeding
program.
Other pertinent provisions of the management
agreements provided:
14. The Company agrees to forthwith replace any animal
in the Breeding Herd which shall, prior to its tenth (10th) birthday, die
or be lost by theft or disappearance. All substitutions shall be of
comparable quality for the animal for which they are substituted.
15. Subject to the express provisions contained herein
and as long as either this Agreement is in effect or the Note remains
unpaid, the Company shall have full control of the matters set forth in
Section 7 hereof [relating to the sale of animals and prices therefor, the
retention of progeny, the incorporation of progeny in the breeding
program, and the selling, culling or replacing of animals in the herd] and
the location, maintenance, expansion, breeding and culling of the Herd
which constitutes the collateral security for such Note. The Company will
also retain the right to determine the most opportune time for sales from
the Herd and the right to make such sales. Upon any default by the Company
pursuant to the provisions of Section 19 below [relating to federal
bankruptcy and reorganization, assignment for the benefit of creditors,
and voluntary receivership, liquidation or reorganization under state law]
and the termination of this Agreement pursuant thereto, or upon payment of
the Note in full, Owner shall have the right to enter into any management
agreement with respect to the Herd which Owner, in his sole judgment or
discretion, may decide.
16. Either the Company or the Owner shall have the
option to cause the liquidation of the Herd by giving written notice to
the other at any time after the unpaid principal balance due on the Note
has been reduced to $ 13,125 or less; provided, however, that the Company
shall have such option to cause the liquidation of the Herd at any time
before the principal balance of the Note has been reduced to $ 13,125
provided that the net proceeds of such liquidation shall at least equal
three times the then remaining principal
balance due on the note.
17. This Agreement shall terminate when the
liquidation of the Herd has been completed and all net proceeds therefrom
have been distributed as provided herein; provided, however, that the
Company shall have the option to sooner terminate this Agreement by giving
written notice to Owner at any time after the Note has been paid in full
or after failure to cure any default in the payment thereof within 30 days
after written notice of such default. The Company also has the right to
terminate this Agreement upon Owner's default in payment of the management
fees provided for in Section 8 hereof.
18. In the event of termination by the Company, the
Company will give the Owner notice of such termination and the Owner will
then have 10 days to advise the Company of his or its desire that the
Company not liquidate the Herd. The Owner must then, at his or its own
expense and within 30 days of the date of the Company's notice, remove his
or its Herd and pay the Company the percentage of the Herd value as
determined in accordance with Section 11 of the Sales Agreement, together
with any unpaid management fees and unpaid principal and interest due on
the Note calculated to the date of payment or, in the event a Note is not
executed, payment in full of the purchase price and interest to date.
19. In the event the Company shall file a voluntary
petition in bankruptcy, whether federal or state, or petition for any form
of reorganization under the Bankruptcy Act of the United States or of any
state, or make an assignment for the benefit of creditors, or voluntarily
submit to any procedure for receivership, liquidation or reorganization
under state law, or be the subject of an involuntary petition of
bankruptcy which is not discharged within 90 days after being filed, Owner
shall have the option to (1) remove the Herd from the Company's care,
possession and control, and all further obligations of Owner to the
Company under this Management Agreement shall promptly terminate or (2) in
full satisfaction of all of his remaining obligations to the Company, he
may assign all of his right, title and interest in the cattle to the
Company. n11
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n11 In addition to the agreements already described,
both petitioners also executed subscription agreements on Dec. 9, 1976, in
which they acknowledged that they had either a net worth of at least $
50,000 and taxable income subject to an income tax rate of at least 40
percent, or a net worth of at least $ 100,000.
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The memorandum also included an extensive explanation
of expected tax consequences concluding, but not guaranteeing, that an
investor qualified for an investment credit and depreciation on the herd
using a basis of $ 30,000. In addition, the memorandum indicated that
investors could deduct the management fees and interest expenses, and that
the profits realized from the sale of cattle would be taxed as capital
gains (subject to the recapture provisions of section 1245). The
memorandum advised potential investors that substantial expenses in excess
of income were expected in the early years of the investment and that they
should be prepared to retain their herds for at least 10 to 15 years. The
memorandum further notified petitioners that Cattle Co. might
enter into sales transactions with its officers and
principals. Finally, the memorandum, as well as several of the agreements,
warned investors that the offerings were not registered and that Federal
and State securities regulations prohibited the transfer of an investor's
rights unless registered or unless an exemption was available. n12
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n12 The memorandum indicated that the expected cost of
each cow in each investor's herd was between $ 1,000 and $ 1,500, that the
value of the warranties which went with the cows was $ 15,000, and that a
portion of the balance represented profit to Cattle Co.
The memorandum also describes the purchase price to
investors as including the "raising, breeding and maintaining the
animals prior to sale, investigation and inspection of cattle in order to
obtain quality animals, sales commissions, transportation and insurance
for purchased animals, veterinarian fees, costs of this offering,
financing expenses, overhead charges for supervisory and management staffs
and recordation of registration fees of animals with the appropriate
breeding associations."
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Cattle Co. was incorporated on December 30, 1976, n13
and has its principal place of business in Des Moines, Iowa. Alfred T.
Zimmerman is a director, chairman of the board, vice president, and
secretary-treasurer of Cattle Co. John R. Hunter is a director and
president of Cattle Co. n14 As of December 30, 1976, Zimmerman and Hunter
each owned 50 percent of the outstanding stock of Cattle Co. n15 Hunter
transferred approximately 50 Angus and Maine Anjou commercial cattle to
Cattle Co. as his capital contribution. Cattle Co.'s unaudited balance
sheet dated December 30, 1976, lists the following:
BALANCE SHEET
Assets
Cash $ 2,000 Cattle (approximate market value) 50,000
Total assets 52,000 Liabilities and equity
Liabilities 0 Capital stock -- Shares
outstanding Amount
Issued for cash 10 $ 1
Issued for cattle 190 19
Additional paid-in capital 51,980 52,000 Total
liabilities and equity n16 52,000
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n13 Cattle Co.'s incorporation on Dec. 30, 1976,
directly conflicts with representations made in the memorandum and
agreements implying that Cattle Co. was already in existence on Dec. 8,
1976 -- the date of the memorandum. In addition, both petitioners believed
that Cattle Co. existed at the time they executed the documents described
above.
n14 Both Grodt and Davis knew Zimmerman prior to their
transactions with Cattle Co. Grodt has known Zimmerman for roughly 25
years and they are associates in Centurion Financial Management, an
apparently unrelated business. Zimmerman had been an adviser to Davis on
pension and profit-sharing plans. Grodt also knew Hunter personally and
professionally prior to his investment with Cattle Co. There were,
however, no familial or significant personal relationships between
petitioners' principals and Cattle Co.'s principals.
n15 The record contains no evidence concerning the
stock ownership of Cattle Co. subsequent to the date of its incorporation.
n16 There is no explanation of how the contributed
cattle was valued, whether the 50 head of cattle contributed by Hunter
constituted the total number of cows contributed, or who paid the initial
$ 2,000 to Cattle Co.
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Grodt & McKay's check for $ 2,000 and Davis
Equipment's check for $ 1,500 as their downpayments on the units were
dated December 30, 1976. Cattle Co. owned no purebred Angus cows on either
December 9 or 11, 1976 (the dates petitioners executed the agreements), or
December 30, 1976 (the date on petitioners' checks for the downpayments).
Cattle Co. deposited petitioners' checks in its account on January 4,
1977.
On February 3, 1977, Cattle Co. purchased nine
purebred Angus heifers and one bull for $ 5,600 (an average price of $ 560
per head). On February 9, 1977, Cattle Co. purchased four purebred Angus
heifers for $ 1,820 (an average price of $ 455 per head). And on March 18,
1977, Cattle Co. purchased one heifer and one cow (both purebred) from
Hunter for $ 1,235.
Cattle Co.'s records indicate that the nine cows
purchased on February 3, 1977, were originally designated as part of the
Grodt & McKay basic herd. At some later time, Cattle Co. changed this
designation so that only six of the cows purchased on February 3, 1977,
were part of the Grodt & McKay basic herd. Cattle Co. then designated
three of the cows purchased on February 9, 1977, as part of the Grodt
& McKay basic herd. The 10th cow designated as part of the Grodt &
McKay basic herd was born on April 9, 1977, and was not a registered
purebred. Of the cattle eventually designated as the Grodt & McKay
basic herd, only five were of breeding age when purchased by Cattle Co. in
February 1977, four became of breeding age during 1977, and one became of
breeding age in 1978.
In 1977, three female calves and one male calf were
born to the Grodt & McKay basic herd, of which the three females were
purebreds. In 1978, three female calves and five male calves were born to
the Grodt & McKay basic herd, of which all of the females and one of
the males were purebreds. In 1979, five male calves and one female calf
were born to the Grodt & McKay basic herd, none of which were
purebreds. In 1979, there were also two female calves born to the Grodt
& McKay herd, exclusive of the basic herd, both of which were
purebreds. In May or June 1980, one of the cows in the Grodt & McKay
basic herd died, but it had not been replaced by the time of the trial in
this case (October 1980). One of the cows in the Grodt & McKay basic
herd has never borne a calf.
Cattle Co.'s records indicate that three of the cattle
purchased on February 3, 1977, and originally designated as part of the
Grodt & McKay basic herd were eventually designated as part of the
Davis Equipment basic herd. One of the cattle purchased on February 9,
1977, and one of the cows purchased from Hunter on March 18, 1977, were
designated as the remainder of the Davis Equipment basic herd. None of the
cattle designated as the Davis Equipment basic herd were of breeding age
when purchased by Cattle Co. in February and March 1977.
There were no calves born to the Davis Equipment basic
herd in 1977. In 1978, three female calves were born to the Davis
Equipment basic herd, two of which were purebreds. n17 In 1979, three
female calves and one male calf were born to the Davis Equipment basic
herd, two of which were purebreds.
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n17 One of these purebred calves was transferred to
the Grodt & McKay herd.
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The cattle comprising petitioners' herds had an
average value as of January 1, 1977, of less than $ 600 per head. The
average sales price for purebred Black Angus cows between October 1, 1975,
and September 30, 1976, was $ 537; between October 1, 1976, and September
30, 1977, it was $ 542; between October 1, 1977, and September 30, 1978,
it was $ 703; and between October 1, 1978, and September 30, 1979, it was
$ 1,096.
Petitioners made the following payments to Cattle Co.
under the terms of the agreements:
Payment Grodt & McKay Davis Equipment
Downpayment $ 2,000 $ 1,500
Management fees
1977 6,000 3,000
1978 6,000 3,000
1979 6,000 3,000
Interest
1977 4,060 1,995
1978 4,060 1,995
Total 28,120 14,490
Cattle Co. issued various reports (in the form of
letters from Zimmerman to petitioners) purporting to comply with its
obligations under the management agreements. These reports were
inaccurate, inconsistent from one year to the next, and varied from the
information found in Cattle Co.'s books and records. Neither petitioner
sufficiently examined these reports to determine whether Cattle Co. was
complying with its warranties. At the time of trial, petitioners' herds
were no better than average commercial herds. Over the years Cattle Co.
has sold some cattle from each petitioner's herd, but it did not submit
records from these sales to petitioners as required by the agreements. The
net profits from these sales have been used to reduce petitioners'
indebtedness to Cattle Co.
When petitioners entered the agreements with Cattle
Co., they were both fully aware that Cattle Co.'s cost of the cows to be
placed in their herds would be significantly less than the $
6,000-per-head price they were paying. Petitioners attributed the
difference to Cattle Co.'s warranties and management services. Both
petitioners were in financial positions to seek
investment opportunities, but they failed to establish
that they had any reasonable purpose for entering into the cattle-breeding
activities other than the tax benefits they anticipated.
Petitioners did not supervise their investments with
Cattle Co. in a prudent business manner. Neither petitioner has requested
that Cattle Co. make any transfers to its herd to meet the requirements of
the various warranties, and there is no evidence that any such transfers
(other than the transfer mentioned in note 17 supra) have been made. Grodt
saw the herd record sheets, but he did not check to see whether any of the
cows in the Grodt & McKay basic herd were nonbreeders. In addition,
Grodt did not know that one of the cows in the Grodt & McKay basic
herd was not a purebred and that one was not born until April 7, 1977.
Davis, on the other hand, never physically inspected the Davis Equipment
herd until the spring of 1978. Davis has never inspected the herd record
sheets and has never seen complete records of the sales from the Davis
Equipment herd.
During 1977 and 1978, Hunter managed petitioners'
herds. In 1979 and 1980, Cattle Co. contracted with Dennis Ory on an
annual basis to feed and care for all of the cattle in petitioners' herds.
Ory does the recordkeeping, furnishes labor, selects cattle for Cattle
Co., manages the breeding, and pays for all direct maintenance expense of
the cattle such as feed and veterinarian costs. Ory was compensated for
these services in the amount of $ 250 per head in 1979, and $ 260 per head
in 1980. Cattle Co. paid for semen and the certificate attesting to the
donor-bull's quality whenever cattle were artificially inseminated. Such
semen costs, including certification, were between $ 100 and $ 150 per
insemination. Cattle Co. also furnished some of the necessary summer
pasture land.
On its 1976 Federal income tax return, Grodt &
McKay claimed a $ 786.68 investment tax credit based on its purchase of
the two units of cattle for $ 60,000. On its 1977 income tax return, Grodt
& McKay took deductions for depreciation of $ 7,500, management fees
of $ 6,000, and interest of $ 4,060, all attributable to its herd of
cattle. Davis Equipment claimed a depreciation deduction of $ 357.14 on
its 1976 tax return, based on its herd of cattle. On its 1977 tax return,
Davis Equipment claimed deductions for depreciation of $ 4,286, management
fees of $ 3,000, interest of $ 1,995, and fees to the Angus Association of
$ 20, all attributable to its herd of cattle. n18
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n18 In his notice of deficiency, respondent made
adjustments in Davis Equipment's claimed investment tax credit. It is not
clear, however, whether any part of the adjustments is attributable to an
investment tax credit claimed on the cattle. To the extent that it is, our
decision regarding Grodt & McKay's investment tax credit also applies
to Davis Equipment.
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Respondent disallowed all of petitioners' investment
tax credits and depreciation deductions on the primary basis that the
benefits and burdens of ownership of the cattle had not been transferred
to petitioners. Alternatively, respondent determined that petitioners were
not entitled to the depreciation deductions because they had failed to
establish that they used the cattle in a trade or business or in the
production of income, or that the cattle-breeding activity was entered
into for profit. As a second alternative, respondent limited petitioners'
depreciation deductions to amounts calculated using a fair market value
for the cattle of $ 800 per head.
Respondent disallowed petitioners' management fees
deduction on the primary ground that petitioners did not establish that
the fees were ordinary and necessary expenses incurred in business or for
the production of income, or that they were incurred in connection with an
activity entered into for profit. Alternatively, respondent determined
that the management fees should be limited to a reasonable amount -- $ 500
per head per year for Grodt & McKay's herd, and $ 250 per head per
year for Davis Equipment's herd.
Respondent disallowed petitioners' interest expense
deductions on the primary ground that it had not been shown that the
assets purchased had a fair market value equal to or exceeding the face
amount of the note. Alternatively, respondent disallowed the interest
deductions on the ground that the note was not a bona fide indebtedness.
Finally, respondent disallowed Davis Equipment's $ 20
Angus Association fee because it was not an ordinary and necessary
business expense.
Prior to trial, the parties distilled respondent's
determinations and produced the agreed-upon issues listed at the beginning
of this opinion. Resolution of these issues will resolve all of the above
disallowances.
OPINION
The first issue for decision is whether petitioners'
transactions with Cattle Co. were bona fide arm's-length sales for Federal
income tax purposes, or whether they lacked the commercial, legal, and
economic substance of sales. Respondent contends that the transactions
were shams devoid of commercial, legal, and economic substance.
Petitioners, on the other hand, assert that the transactions were bona
fide cattle sales and should be treated accordingly. We agree with
respondent that the transactions do not have the economic substance of
sales.
A taxpayer's use of a device to form an illusion of
reality and thereby create or inflate tax benefits is not a novel problem.
It is well settled that the economic substance of transactions, rather
than their form, governs for tax purposes. Gregory v. Helvering, 293 U.S.
465 (1935). Recently, in Frank Lyon Co. v. United States, 435 U.S. 561
(1978), the Supreme Court summarized the principles underlying this
doctrine:
This Court, almost 50 years ago, observed that
"taxation is not so much concerned with the refinements of title as
it is with actual command over the property taxed -- the actual benefit
for which the tax is paid." Corliss v. Bowers, 281 U.S. 376, 378, 50
S.Ct. 336, 74 L.Ed. 916 (1930). In a number of cases, the Court has
refused to permit the transfer of formal legal title to shift the
incidence of taxation attributable to ownership of property where the
transferor continues to retain significant control over the property
transferred. E.g., Commissioner of Internal Revenue v. Sunnen, 333 U.S.
591, 68 S.Ct. 715, 92 L.Ed. 989 (1948); Helvering v. Clifford, 309 U.S.
331, 60 S.Ct. 554, 84 L.Ed. 788 (1940). In applying this doctrine of
substance over form, the Court has looked to the objective economic
realities of a transaction rather than to the particular form the parties
employed. The Court has never regarded "the simple expedient of
drawing up papers," Commissioner of Internal Revenue v. Tower, 327
U.S. 280, 291, 66 S.Ct. 532, 538, 90 L.Ed. 670 (1946), as controlling for
tax purposes when the objective economic realities are to the contrary.
"In the field of taxation, administrators of the laws and the courts
are concerned with substance and realities, and formal written documents
are not rigidly binding." Helvering v. Lazarus & Co., 308 U.S.,
at 255, 60 S.Ct., at 210. See also Commissioner of Internal Revenue v. P.
G. Lake, Inc., 356 U.S. 260, 266-267, 78 S.Ct. 691, 2 L.Ed.2d 743 (1958);
Commissioner of Internal Revenue v. Court Holding Co., 324 U.S. 331, 334,
65 S.Ct. 707, 89 L.Ed. 981 (1945). Nor is the parties' desire to achieve a
particular tax result necessarily relevant. Commissioner of Internal
Revenue v. Duberstein, 363 U.S. 278, 286, 80 S.Ct. 1190, 4 L.Ed.2d 1218
(1960). [435 U.S. at 573.]
However, under the circumstances in Frank Lyon Co.,
the Supreme Court found that the substance of the challenged transactions
were as structured, noting that where --
there is a genuine multiple-party transaction with
economic substance which is compelled or encouraged by business or
regulatory realities, is imbued with tax-independent considerations, and
is not shaped solely by tax-avoidance features that have meaningless
labels attached, the Government should honor the allocation of rights and
duties effectuated by the parties. [435 U.S. at 583-584.]
Bearing these fundamental precepts in mind, we now
must examine the transactions before us to determine whether they amount
to sales of cattle.
The term "sale" is given its ordinary
meaning for Federal income tax purposes and is generally defined as a
transfer of property for money or a promise to pay money. Commissioner v.
Brown, 380 U.S. 563, 570-571 (1965). The key to deciding whether
petitioners' transactions with Cattle Co. are sales is to determine
whether the benefits and burdens of ownership have passed from Cattle Co.
to petitioners. This is a question of fact which must be ascertained from
the intention of the parties as evidenced by the written agreements read
in light of the attending facts and circumstances. Haggard v.
Commissioner, 24 T.C. 1124, 1129 (1955), affd. 241 F.2d 288 (9th Cir.
1956). n19 Some of the factors which have been considered by courts in
making this determination are: (1) Whether legal title passes
(Commissioner v. Segall, 114 F.2d 706, 709 (6th Cir. 1940), cert. denied
313 U.S. 562 (1941); Oesterreich v. Commissioner, 226 F.2d 798, 802 (9th
Cir. 1955)); (2) how the parties treat the transaction (Oesterreich v.
Commissioner, supra at 803); (3) whether an equity was acquired in the
property (Haggard v. Commissioner, 241 F.2d 288, 289 (9th Cir. 1956);
Oesterreich v. Commissioner, supra at 803; see Mathews v.
Commissioner, 61 T.C. 12, 21-23 (1973), revd. 520 F.2d
323 (5th Cir. 1975), cert. denied 424 U.S. 967 (1976)); (4) whether the
contract creates a present obligation on the seller to execute and deliver
a deed and a present obligation on the purchaser to make payments (Wiseman
v. Scruggs, 281 F.2d 900, 902 (10th Cir. 1960)); (5) whether the right of
possession is vested in the purchaser (Wiseman v. Scruggs, supra at 902;
Commissioner v. Segall, supra at 709); (6) which party pays the property
taxes (Harmston v. Commissioner, 61 T.C. 216, 229 (1973), affd. 528 F.2d
55 (9th Cir. 1976)); (7) which party bears the risk of loss or damage to
the property (Harmston v. Commissioner, supra at 230); and (8) which party
receives the profits from the operation and sale of the property (Harmston
v. Commissioner, supra at 230). See generally Estate of
Franklin v. Commissioner, 64 T.C. 752 (1975), affd. on
other grounds 544 F.2d 1045 (9th Cir. 1976). Using the above criteria as
guideposts, we conclude that Cattle Co. did not sell the cattle to
petitioners.
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n19 See also Midwest Metal Stamping Co. v.
Commissioner, T.C. Memo. 1965-279.
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Unfortunately, the record in the present case is
inadequate to determine whether petitioners or Cattle Co. held legal title
to the cattle in petitioners' herds. The evidence does establish, however,
that petitioners allowed Cattle Co. to represent itself as record owner of
the cattle in their herds with the American Angus Association, even though
the sales agreements call for the registration of the cows in the name of
Cattle Co. for the benefit of petitioners. In fairness, it should be noted
that the herd record sheets maintained by Cattle Co. do list petitioners
as the owners of the cattle in their herds. The record does not disclose,
however, whether the registration certificates are readily available to
the public or relied on in the industry as a means of ascertaining legal
ownership. Under the terms of the agreements, petitioners had the right to
inspect Cattle Co.'s records and the registration certificates (which were
kept as a part of Cattle Co.'s records). Although Grodt inspected the
records on behalf of Grodt & McKay, he apparently made no demand on
Cattle Co. to correct the registration certificates to show that Cattle
Co. held title for the benefit of Grodt & McKay. Davis, on the other
hand, did not even bother to inspect the records for Davis Equipment. We
find that petitioners treated Cattle Co. as the record owner and consented
to its representation of that status to third parties.
Petitioners did not acquire an equity in the cattle
either at the time they purportedly purchased the cattle, or subsequently
when Cattle Co. actually acquired the cattle finally designated as part of
petitioners' basic herds. Petitioners ostensibly paid $ 6,000 per head for
cows they knew were worth far less and which we find had a fair market
value not in excess of $ 600 per head. Petitioners explained that they
were purchasing far more than just the cows. They contend that they were
also purchasing warranties and guaranties which went along with the cows,
the expertise and assistance of Cattle Co. in their cattle-breeding
endeavors, and the various management services rendered by Cattle Co.
Petitioners introduced extensive evidence from purported experts to urge
the conclusion that the fair market value of each cow in light of these
additional considerations was approximately equal to the ostensible
purchase price of $ 6,000 per head. We found this evidence and
petitioners' explanation unsatisfactory.
Petitioners maintain that in determining a fair market
value for the cattle we cannot look at the various agreements in
isolation, but rather must view them in toto as constituting the entire
purchase. We agree with petitioners that any analysis of the transactions
in this case must consider all of the agreements together. When we do so,
petitioners' cause is hardly advanced.
Based on the actual prices paid by Cattle Co. for the
cows in petitioners' herds, and on the average sales prices of similar
cows during the period when Cattle Co. made these purchases, we have found
that the fair market value of the cattle was $ 600 per head. In addition,
since the standard practice in the industry when selling breeding cattle
is to include a nonbreeder warranty, that warranty adds nothing to the
established fair market value of petitioners' cattle. In the same fashion,
the warranty that the cows are purebreds does not add any value to the
cattle since the average prices relied upon were also for purebred cattle.
To the extent petitioners contend that the fair market
value of the cattle should include the costs of management services,
artificial insemination, and insurance against all risks of death or other
loss of the cows, we cannot agree. These expenses are the period expenses
of maintaining, using, and protecting the cattle. Under the circumstances
of this case, there is no reason to include the cost of these items as a
component of the cost of the cattle. n20
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n20 Assuming the transactions should be treated as
structured by petitioners, these types of costs are more properly
characterized as management expenses which were more than amply paid for
under the management agreements. Moreover, if petitioners did view the $
6,000 price per cow as including these costs, it was incumbent on
petitioners to establish what portion of the price is so allocable to
these items. Petitioners made no attempt to make an allocation.
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There remains for consideration only the 80-percent
live calf birth rate warranty. n21 We need not here decide whether a
warranty of this type is a proper component of cost, since this warranty,
plus the initial $ 600 fair market value for each cow, does not begin to
equal $ 6,000.
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n21 Our analysis here will not focus on the fact that
Cattle Co. failed to live up to most of its warranties and promises.
Rather, we find that at the time petitioners executed the agreements, they
reasonably expected Cattle Co. to meet its obligations.
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On the evidence introduced in this case, it is very
difficult to determine whether the 80-percent live calf birth rate
warranty had any substantial value. Respondent introduced evidence tending
to establish that an 80-percent live calf birth rate is the industry
average, whereas petitioners introduced evidence that the average is only
70 percent. Rather than rely on questionable evidence from both sides to
determine what the industry average actually is, we will assume the
industry average is 70 percent. Petitioners bear the burden of proving
that, based on an industry average of 70 percent, the value per cow of the
80-percent live calf birth rate is equal to $ 5,400 ($ 6,000 less $ 600).
Petitioners made numerous calculations attempting to establish this, but
these calculations were not persuasive. n22 We therefore hold that this
warranty had only minimal value.
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n22 The agreements, themselves, provide Cattle Co.
with a convenient method of greatly reducing, if not entirely eliminating,
any risks it has under the 80-percent live calf birth rate warranty. The
warranty covers all cows in the breeding herds. A heifer born into the
herds is not considered a part of the breeding herds until she reaches the
age of 24 months. However, an Angus heifer reaches breeding age between 18
and 20 months. Thus, Cattle Co. has between 4 and 6 months to attempt to
breed the heifer before that heifer is covered by the warranty. If it is
apparent to Cattle Co. that the heifer will not breed, or has a low
tendency to breed, Cattle Co. can cull the heifer from the herd before it
joins the breeding herds and thus reduce its present and future
obligations under the warranty.
Cattle Co. has the unfettered discretion to cull the
herds periodically. If a cow which is part of the breeding herds fails to
become impregnated, there is only one limitation on Cattle Co.'s ability
to cull that cow from the breeding herds, namely, that each breeding herd
never consist of fewer than five animals. Thus, Cattle Co.'s promise,
albeit on the surface a somewhat valuable warranty, is worth little. Even
if Cattle Co.'s ability to cull cows from the herds is subject to an
implied reasonableness standard, it is difficult to imagine how the
culling of a nonbreeder from breeding herds of cattle is anything but
reasonable.
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Petitioners have failed to establish that the fair
market value of the cattle was at least approximately equal to the
purchase price. Since a normal attribute of a true arm's-length sale is a
purchase price at least approximately equal to fair market value, the
totally disproportionate purchase price in this instance strongly
militates against petitioners' contention that a true sale has taken
place. Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976),
affg. on different grounds 64 T.C. 752 (1976). n23
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n23 In Narver v. Commissioner, 75 T.C. 53, 98 (1980),
on appeal (9th Cir., Jan. 15, 1981), we adopted the analysis of Estate of
Franklin v. Commissioner, 544 F.2d 1045, affg. on different grounds 64
T.C. 752 (1975).
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Additionally, the agreements are clear that
petitioners have no right to possess the cattle or to exercise any real
control or dominion over them. Cattle Co. has complete control over the
sale of animals, the sales price, n24 retention of progeny, the
incorporation of progeny into the breeding herds, the culling and
replacing of herd animals, and the location, maintenance, expansion, and
breeding (including artificial insemination) of the herds. Petitioners'
only rights with respect to the possession, control, or dominion of the
herds are extremely limited and, as a practical matter, valueless.
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n24 The one exception to this is that Cattle Co. must
obtain petitioners' consents for any sales for which it is extending
credit for 24 months or more. Petitioners' consents, however, may not be
unreasonably withheld.
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Petitioners have the right to terminate the management
agreements on 30 days' notice, to cause the liquidation of the herds when
the note balances are $ 13,125 or less, and, under certain circumstances,
n25 to remove their herds from Cattle Co.'s "care, possession and
control" n26 or to assign all their interests in the cattle back to
Cattle Co. To acquire actual possession of the cattle, however,
petitioners must fully pay off their notes and they must release Cattle
Co. from all obligations under the agreements. Petitioners must also pay
additional management fees equal to one-half the value of their progeny or
the herds. If, however, petitioners exercise the right to take possession
of their cattle during 1977, 1978, or 1979, the purchase price is reduced
$ 20,000, $ 15,000, or $ 7,500 per unit, respectively.
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n25 E.g., Cattle Co.'s liquidation, bankruptcy,
receivership, etc.
n26 These words are taken directly from par. 19 of the
management agreements.
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These provisions, while ostensibly giving petitioners
rights to the possession, control, and dominion over their cattle, are
mere facades without any substance. For example, during 1977 each
petitioner could obtain possession of each unit of cattle by paying $
10,000, less the downpayment, and by agreeing to release Cattle Co. from
all of its obligations. Assuming the cattle did not have any progeny at
the time petitioners exercised this right, they would be paying a total of
$ 10,000 for cattle with a maximum fair market value of $ 3,000 ($ 600 for
each of five cows). A purported right to possession, control, and
dominion, when burdened by a cumbersome cost which no reasonable person
would pay is a hollow right indeed. n27 A true sale for tax purposes must
provide the purchaser with more.
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n27 This situation continues at least until the value
of petitioners' herds are equal to twice the outstanding balances on their
notes -- a point in time almost entirely controlled by Cattle Co. because
it has full control over sales and sales prices. Once this point is
reached, it is to the advantage of Cattle Co.'s principals to liquidate
the herd by having Cattle Co. sell it to themselves. Since this will
produce no possessory interest in petitioners, it is highly unlikely that
the notes will be paid off prior to a decision by Cattle Co. to liquidate
the herds.
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Continuing our analysis, we find that under the terms
of the agreements, Cattle Co. assumed all of these risks with respect to
the cattle in petitioners' herds. Petitioners' risks in this regard are
only that Cattle Co. might not make good on its promises to assume these
risks. This is not the risk normally associated with ownership for tax
purposes.
Finally, we must examine the allocation of the profits
from sales. Here, Cattle Co. and petitioners have used labels to create
the appearance that petitioners are receiving a benefit from the net
profits from sales of cattle. In fact, until the amount of net proceeds
from each petitioner's herd is equal to 133 percent n28 of the amount of
each petitioner's promissory note plus interest, 100 percent of the
profits go to Cattle Co. These funds are labeled as management fees and
principal and interest payments on the promissory notes. The labels,
however, are not controlling. Only after the principal amount of the note
is retired will petitioners ever receive any cash, and even then they will
be entitled to only 25 percent of the net proceeds. This is merely a not
very realistic chance to acquire a profits interest in the future if the
value of the herds greatly increases. We conclude that this allocation of
speculative future profits is inadequate to support a sale for Federal tax
purposes.
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n28 Since the net proceeds from sales will be
allocated one-quarter to management fees and three-quarters to principal,
plus interest, sales must produce 133 percent of the total principal, plus
interest, to retire the note.
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In short, when the various agreements are probed
beneath their labels and are considered in the context of the surrounding
facts and circumstances, it strains credulity and offends logic to find
that a true sale, to be recognized for tax purposes, had taken place. We
must conclude the contrary.
The next question for decision is how should the
transactions be treated for Federal income tax purposes. Respondent
maintains that since the transactions are not sales it follows, ipso
facto, that the transactions are shams having no economic, legal, or
commercial effect and should be disregarded for Federal tax purposes. n29
While we disagree with respondent's premise that any transaction which
purports to be a sale, but which is not, is necessarily a sham (see Estate
of Franklin v. Commissioner, 64 T.C. 752 (1975), affd. on different
grounds 544 F. 2d 1045 (9th Cir. 1976) (purported sales were not sales but
options)), n30 we do find that under the circumstances of this case the
transactions between petitioners and Cattle Co. should be entirely
disregarded for tax purposes.
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n29 Some support for this result can be found in the
language of Narver v. Commissioner, supra, and the Ninth Circuit's opinion
in Estate of Franklin v. Commissioner, supra. See Hager v. Commissioner,
76 T.C. 759, 775 n. 8 (1981).
n30 See also 1 B. Bittker, Federal Taxation of Income,
Estates and Gifts, par. 4.4, at 4-56 (1981).
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The courts have, in appropriate circumstances,
disregarded for Federal tax purposes transactions entered into without any
economic, commercial, or legal purpose other than the hoped-for favorable
tax consequences flowing therefrom. Knetsch v. United States, 364 U.S. 361
(1960); Gregory v.
Helvering, 293 U.S. 465 (1935); Estate of Franklin v.
Commissioner, supra; Goldstein v. Commissioner, 364 F.2d 734 (2d Cir.
1966), cert. denied 385 U.S. 1005 (1967); Diggs v. Commissioner, 281 F.2d
326 (2d Cir. 1960), cert. denied 364 U.S. 908 (1960); Derr v.
Commissioner, 77 T.C. 707 (1981); Hager v. Commissioner, 76 T.C. 759
(1981); Narver v. Commissioner, 75 T.C. 53 (1980), on appeal (9th Cir.,
Jan. 15, 1981); Beck v. Commissioner, 74 T.C. 1534 (1980); Millbrew v.
Commissioner, T.C. Memo. 1981-610. n31 While we do not here propose to
draw precise lines of demarcation between valid and invalid tax shelters,
the facts of this case are so far over the line that it is appropriate to
disregard the transactions for tax purposes.
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n31 These cases represent merely a sampling of the
enormous number of cases in which courts have concluded that the facts do
not support the tax
consequences requested by taxpayers.
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Analysis of the transactions involved reveals only
attempted tax benefits, not any realistic possibility of economic reward.
The agreements make clear that none of the profits from the
cattle-breeding activities will actually flow to petitioners until such
time as the principal amounts of the notes are paid in full. Prior to this
time, if the transactions are treated as structured and given the tax
consequences explained in the memorandum and anticipated by petitioners,
the only benefits petitioners can expect from the transactions are tax
benefits. Petitioners hoped to be entitled to investment tax credits and
depreciation deductions based on a cost of $ 30,000 per unit. They also
hoped to deduct the amounts designated as management fees and interest
which were paid during the first 3 years to Cattle Co. During the time
prior to complete payment of the note, they hoped that the net proceeds
from sales of cattle would be taxed as capital gains.
This tax treatment is not basically different from the
tax benefits which might be available under valid tax shelter arrangements
(e.g., depreciable real estate). Favorable tax consequences alone are no
reason to ignore transactions for tax purposes. However, where there is no
substance to the transactions aside from the hoped-for tax consequences, a
different question is presented.
Grodt and Davis gave extensive testimony regarding
their alleged profit motives for executing the agreements. They contend
they sought the profits which might arise from a successful
cattle-breeding activity, and they relied entirely on Cattle Company and
its officers to carry on the venture.
Petitioners also testified that they anticipated that
the notes would be paid in full. Despite the testimony of Grodt and Davis,
we do not believe petitioners ever expected any economic gain from the
cattle-breeding activities.
While investors may leave the conduct of business to
others, the behavior of Grodt and Davis in this instance is indicative of
the lack of business substance to this transaction. Both Grodt and Davis
were experienced businessmen. Yet, neither ever carefully reviewed any of
Cattle Co.'s books and records or the "reports" sent to them by
Cattle Co. Neither sought to have Cattle Co. meet its obligations under
the agreements. In sum, petitioners appeared completely indifferent to the
success or failure of the venture.
Petitioners have also not convinced us that the notes
will ever be fully retired. On brief, petitioners made elaborate
calculations of increases in the value of their herds. These calculations,
however, were unpersuasive. Moreover, under the terms of the agreements,
themselves, there is little realistic hope that the notes will ever be
fully paid prior to a decision by Cattle Co. to liquidate the herd. Any
liquidation of the herd prior to the time the values of the herds are
equal to twice the outstanding balance of the notes will give 100 percent
of the proceeds to Cattle Co. After that, Cattle Co. will have to share
any proceeds with petitioners until theoretically petitioners reach a
maximum share of 25 percent. However, the memorandum specifically warned
petitioners that Cattle Co. might enter into sales transactions with its
officers (Zimmerman and Hunter). Thus, if the cattle-breeding activity
were successful, Cattle Co. could liquidate the herds by selling them to
Zimmerman and Hunter when the value of the cattle exceeded twice the
outstanding balance of the notes. n32 If, as should be expected, the
liquidations take the shape of a sale to Cattle Co.'s principals, they
will effectively eliminate any prospect for profit to petitioners and
maximize the profits to Cattle Co. and its principals. In light of this
very real probability, petitioners, who were experienced businessmen,
could not have harbored any serious expectation of profit.
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n32 While Cattle Co. is somewhat restricted in its
power to liquidate before the notes are reduced to $ 13,125, the company's
power to control the culling of the herd and sale of the cattle does not
present it with any inseparable obstacle to the shift of any gains to
itself and its owners and away from its purported investor.
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In summary, we hold that, under the factual
circumstances of this case, where petitioners have gone to great lengths
to clothe in "sales" garb transactions which are not sales, and
where petitioners' only real expectations of profit rest on the hoped-for
tax benefits, the transactions do not have sufficient substance apart from
tax manipulation to be recognized for tax purposes.
Decisions will be entered under Rule 155.
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