# Foster v. Comm'r

> United States Tax Court · January 11, 1983 · 80 T.C. 34

URL: https://www.frixlaw.com/law-library/cases/4594633

## Case

- **Full name:** Richard H. Foster and Sara B. Foster, T. Jack Foster, Jr., and Patricia Foster, John R. Foster and Caroline Foster, and Estate of T. Jack Foster, Gladys H. Foster, and Gladys H. Foster v. Commissioner of Internal Revenue
- **Court:** United States Tax Court
- **Decided:** January 11, 1983
- **Citations:** 80 T.C. 34; 80 T.C. No. 3; 1983 U.S. Tax Ct. LEXIS 127
- **Precedential status:** Published
- **Opinion:** Opinion
- **Judges:** Dawson
- **Cited by:** 131 later opinions in the Frix Law Library

## Citator (automated)

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## How later opinions describe it (automated extraction)

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## Opinion text

Richard H. Foster and Sara B. Foster, T. Jack Foster, Jr., and Patricia Foster, John R. Foster and Caroline Foster, and Estate of T. Jack Foster, Deceased, Gladys H. Foster, Executrix and Gladys H. Foster, Petitioners v. Commissioner of Internal Revenue, Respondent
Foster v. Comm'r
Docket No. 1717-78
United States Tax Court
80 T.C. 34 ; 1983 U.S. Tax Ct. LEXIS 127 ; 80 T.C. No. 3 ;
January 11, 1983 , Filed
*127 [EDITOR'S NOTE: PART 1 OF 2. THIS DOCUMENT HAS BEEN SPLIT INTO MULTIPLE PARTS ON LEXIS TO ACCOMMODATE ITS LARGE SIZE. EACH PART CONTAINS THE SAME LEXIS CITE.]
Decision will be entered under Rule 155 .
SUBSTANTIVE ISSUES
Issues 1 and 3 : REALLOCATIONS OF INCOME UNDER SEC. 482, I.R.C. 1954 . T, J, D, and B (a father and three sons) were equal partners in FP, a general partnership. In 1958, FP began to investigate the development potential of Brewer's Island, a 2,600-acre undeveloped tract of land located about 12 miles south of San Francisco. FP determined that the tract could be transformed into a city of 35,000. In December 1959, it acquired an option for the purchase of the land; in May 1960, it secured enabling legislation from the California legislature for a municipal improvement district known as Estero; and in August 1960, it exercised its option and acquired the tract. Immediately thereafter, it began to transform Brewer's Island into Foster City.
FP played an active role in the development of Foster City. It also acted through Estero, which it controlled and dominated. Estero was used by FP in the development process both as a financing vehicle and as a vehicle by which improvements to the land were actually effected.
Foster City was developed by neighborhood. The first neighborhood to be developed was Neighborhood One. *128 In October 1962, FP deeded undivided 25-percent interests in 127 acres of land in Neighborhood One to each of four Alphabet Corporations as tenants in common. Each of these corporations was solely owned by T, J, D, or B, and the transfer of the 127 acres was tax motivated. Income derived from the sale of lots in this acreage was reported by the Alphabet Corporations; however, that income was earned by FP.
In August 1966, FP conveyed all of the single-family residential lots in Neighborhood Four to FE, a corporation which was solely owned by T, J, D, and B in equal shares. FE had a history of substantial net operating losses related to the operation of a hotel in Hawaii and the lots were conveyed in order to take advantage of those losses. Income derived from the sale of lots in 1967 was reported by FE; however, that income was earned by FP.
Held :
a. Sec. 482, I.R.C. 1954 , is not unconstitutional as an invalid delegation of legislative power. (Pp. 140-142.)
b. The Commissioner's determinations under sec. 482, I.R.C. 1954 , must be sustained unless proven unreasonable, arbitrary, or capricious. (Pp. 142-144.)
c. In order to prevent the avoidance of taxes, sec. 482, I.R.C. *129 1954 , and sec. 1.482-1(d)(5), Income Tax Regs. , may be applied to a taxable disposition of property previously acquired in a nonrecognition transaction. (Pp. 144-159.)
d. Respondent did not abuse his discretion under sec. 482, I.R.C. 1954 , in reallocating income derived from the sale of lots in Neighborhood One from the four Alphabet Corporations to FP. (Pp. 160-177.)
e. Respondent did not abuse his discretion under sec. 482, I.R.C. 1954 , in reallocating income derived from the sale of lots in Neighborhood Four from FE to FP. (Pp. 178-184.)
f. For tax purposes, FP was a partnership and not an association taxable as a corporation. Sec. 7701(a)(2) and ( 3), I.R.C. 1954 ; sec. 301.7701-1 through -3, Proced. & Admin. Regs. (Pp. 184-191.)
g. Petitioners are not entitled to affirmatively use sec. 482, I.R.C. 1954 , to effect a consolidated return of FP with all of the related corporations purportedly involved in the development of Foster City. Sec. 1.482-1(b)(3), Income Tax Regs. Respondent's failure to do so does not demonstrate any abuse of discretion on his part. (Pp. 191-195.)
Issue 2 : APPLICABILITY OF THE SUBSTANCE-OVERFORM DOCTRINE TO THE WESTWAY TRANSACTION. The terms negotiated *130 by FP for the purchase of Brewer's Island contemplated a downpayment of $ 2,500,000. However, FP was unable to fund all of that amount itself. Accordingly, it arranged with a bank with which it had an established relationship to borrow (1) $ 2 million to make the downpayment and (2) such additional amounts as were needed to satisfy the periodic installments due to the sellers of the property for the balance of the purchase price. Under the terms of the agreement, FP agreed (1) to pay interest at the prevailing market rate, (2) to pay a bonus equal to the total amount borrowed from the bank, and (3) to structure the bonus so that it would be taxed to the bank as capital gain rather than ordinary income. A complicated transaction, consisting of a series of incorporations, transfers, liquidations, and mergers, was then devised to disguise the terms of the agreement involving the 100-percent bonus. The crucial step in the transaction involved the delivery of certain promissory notes (the Westway notes) purportedly in exchange for corporate stock. The objective of the transaction from FP's point of view was to raise funds through tax savings in order to pay the bank its bonus; the *131 objective from the bank's point of view was to insure that its bonus was taxed as capital gain. In form, the transaction served to increase FP's basis in Neighborhoods Two and Three by an amount equal to approximately twice that which FP had become obligated to pay to the bank as a bonus.
Held :
a. Respondent's categorization of the Westway notes as interest is an issue which is properly before the Court and one with respect to which petitioners bear the burden of proof. (Pp. 195-197.)
b. In substance, the Westway notes represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island. (Pp. 197-211.)
c. FP is not entitled to capitalize the Westway notes under sec. 266, I.R.C. 1954 . (Pp. 211-216.)
Issue 4 : APPLICABILITY OF THE COST RECOVERY METHOD TO THE GRANT OF THE SWAY EASEMENT. In 1964, a utility company paid $ 425,000 to FP for a right-of-way immediately adjacent to an existing easement which stretched across Brewer's Island. FP characterized the payment as severance damages and reduced its basis in all of its land in Foster City by the amount received. Respondent acquiesced in that treatment. In 1967, the utility paid an additional *132 $ 72,000 for a sway easement in order to perfect the right-of-way easement which it had acquired in 1964. Held , the amount received for the grant of the sway easement should be applied against the basis of all of FP's land in Foster City rather than against only its basis in that part of its land described by the easement. Inaja Land Co. v. Commissioner , 9 T.C. 727 (1947) , applied. (Pp. 216-219.)
Issue 5 : DEDUCTIBILITY OF THE SCHOOL AND CHURCH SITES. FP conveyed three parcels of land in Foster City with respect to which it claimed deductions for charitable contributions. One parcel was conveyed to a school district for use as a school site and was in form an outright transfer; the other two parcels were conveyed to churches for use as church sites and were in form "bargain purchases." The notice of deficiency raised the issue of donative intent with respect to the deductibility of the school site but not the two church sites.
Held :
a. Given the absence of surprise or substantial disadvantage to petitioners, respondent is entitled to rely on a ground for the disallowance of a deduction which was not expressly set forth in the notice of *133 deficiency. (Pp. 220-222.)
b. FP's dominant purpose in conveying the three sites was the expectation of direct economic benefit; accordingly, the transfers are not deductible as charitable contributions under sec. 170, I.R.C. 1954 . (Pp. 222-225.)
c. FP must capitalize the cost of the school site as part of its basis in all of its remaining land in Foster City. (Pp. 225-227.)
Issue 6 : DEDUCTIBILITY OF THE PAYMENT FOR LEGAL SERVICES. FP paid $ 5,000 to an attorney for legal services. Held , the payment was a legitimate business expense and is deductible under sec. 162(a), I.R.C. 1954 . (P. 227.)
Issue 7 : ADJUSTMENTS RELATED TO THE PAYMENT OF THE FOSTERS' PERSONAL EXPENSES. Respondent disallowed certain deductions claimed by FP on the ground that the expenses were personal to T, J, D, and B. He also disallowed certain deductions claimed by three related corporations on the same ground and charged the individuals with constructive dividends.
Held :
a. Petitioners bear the burden of proof. Neither respondent's alleged delay in issuing the notice of deficiency, nor his failure to identify therein the specific partnership and corporate expenditures which were disallowed, *134 nor the alleged misconduct of his revenue agent in "scrambling" petitioners' records serves to shift the burden of proof. United States v. Janis , 428 U.S. 433 (1976) , and Weimerskirch v. Commissioner , 596 F.2d 358 (9th Cir. 1979) , revg. 67 T.C. 672 (1977) , distinguished. (Pp. 228-234.)
b. Petitioners introduced no specific evidence to establish that the expenses in question were business related rather than personal. Hence, they failed to carry their burden of proof. Evidence descriptive of the mechanics of their recordkeeping system is insufficient to discharge that burden. (Pp. 234-235.)
c. Even if expenses are disallowed at the corporate level because of the failure to comply with the recordkeeping requirements of sec. 274, I.R.C. 1954 , that fact would not necessarily preclude the taxation of the expenses as constructive dividends at the shareholder level. (Pp. 235-236.)
Issue 8 : CHARACTERIZATION OF THE PAYMENTS MADE TO GLADYS FOSTER. On her income tax returns, G reported compensation received from certain related corporations. Respondent determined that the total amount reported *135 was understated and recharacterized the revised amount as dividend income. Held , G received ordinary income in the amount determined by respondent. (Pp. 236-237.)
Issue 9 : ADDITIONS TO TAX. Respondent determined that T and G were liable for additions to tax under sec. 6653(a), I.R.C. 1954 , for each of the years before the Court. Held , the burden of proof rests with petitioners, and they have failed to carry it. (Pp. 237-238.)
EVIDENTIARY AND PROCEDURAL ISSUES
Issue A : DEPOSITION OF T. JACK FOSTER. In 1961, a utility company commenced an action in State court to condemn an additional easement for a right-of-way across Brewer's Island. T, a party herein, was named as one of the defendants in that action. In March 1962, T was called to testify as a witness by the utility at a deposition conducted by its attorney. Held , T's deposition is admissible in this proceeding, over petitioners' general hearsay objection, as an admission of a party-opponent under Rule 801(d)(2)(A), Federal Rules of Evidence. Held, further , petitioners' relevancy objection addressed and resolved. (Pp. 118-120.)
Issue B : DEPOSITION OF DEL CHAMPLIN. C, a C.P.A., was the principal *136 tax adviser for T, J, D, and B, parties herein. In June 1969, he terminated his relationship with J, D, and B. (T had died in 1968.) Shortly thereafter, he sued them in State court for, inter alia, allegedly failing to fully compensate him for services rendered. J, D, and B counterclaimed, alleging malpractice on C's part. In October and November 1969, C was called to testify as a witness by T, D, and B in a deposition conducted by their attorney. C's action against T, D, and B for breach of contract, and their counterclaim against him for malpractice, involved services which C rendered in his capacity as their tax counselor during the development of Foster City. The tax consequences of those services were at issue in the State court action, just as they are at issue in the present case. C died prior to the trial of the present case. Held , C's deposition is admissible in this proceeding, over petitioners' general hearsay objection, under the "former testimony" exception to the hearsay rule. Rule 804(b)(1), Fed. R. Evid. Held, further , petitioners' relevancy, opinion, and double hearsay objections addressed and resolved. Held, further , the fact that C was not *137 a disinterested witness does not affect the admissibility of his deposition but rather the weight to which it is entitled. (Pp. 120-128.)
Issue C : DEPOSITION OF T. JACK FOSTER, JR. In March 1971, J was called to testify as a witness by C at a deposition conducted by C's attorney. This deposition was part of the same State court action referred to in Issue B, supra. Held , J's deposition is admissible in this proceeding, over petitioners' general hearsay objection, as an admission of a party-opponent under rule 801(d)(2)(A), Fed. R. Evid. Held, further , petitioners' relevancy, opinion, and "double hearsay" objections addressed and resolved. (Pp. 128-130.)
Issue D : DEPOSITION OF REX D. JOHNSON. Prior to the commencement of the present case, petitioners filed an application with this Court under Rule 82, Tax Court Rules of Practice and Procedure , to depose W, a former vice president of the bank with which T, J, D, and B did business. After a hearing and over respondent's objection, the Court granted the application. At the deposition, W was examined by petitioners' counsel and cross-examined by respondent's counsel. However, W declined to answer questions which *138 went beyond the scope of the issue with respect to which the Rule 82 application was filed. W was alive at the time of the trial of the present case. Held , W's deposition is admissible in this proceeding, over respondent's general objection, under Rule 81(i)(3)(E), Tax Court Rules of Practice and Procedure. Held, further , respondent was not denied the right of cross-examination at the deposition. Held, further , respondent's specific objections addressed and resolved. (Pp. 131-135.)
Issue E : THE "BUSINESS PURPOSE" OBJECTION. At trial, J was asked on direct examination whether there was a business purpose for the transfer of the single-family residential lots from FP to FE in 1966. (See Issue 3, supra .) Respondent objected to this question, whereupon petitioners moved to strike the same question in J's deposition. (See Issue C, supra .) Held , the question propounded at trial is objectionable. Under rule 701, Fed. R. Evid. , opinion testimony must be "helpful" in order to be admissible, and J's expression of opinion would not have satisfied this standard. Held, further , the question propounded at the deposition is not objectionable because it elicited *139 an admission of a party-opponent which is admissible under rule 801(d)(2)(A), Fed. R. Evid. (Pp. 135-137.)
Issue F : BURDEN OF PROOF. Petitioners seek to allocate the burden of proof in respect of the three major substantive issues involved in this case (see Issues 1-3, supra ) contrary to the general rule of Rule 142(a), Tax Court Rules of Practice and Procedure. Held , respondent's determinations are not arbitrary but rather rest on a firm foundation. Held, further , the introduction of substantive evidence by respondent renders moot any issue concerning the evidentiary weight to be accorded the presumption of correctness. Weimerskirch v. Commissioner , 596 F.2d 358 (9th Cir. 1979) , revg. 67 T.C. 672 (1977) , distinguished. (Pp. 137-139.)
Valentine Brookes and Lawrence V. Brookes , for the petitioners.
Joyce E. Britt and Charlotte Mitchell , for the respondent.
Dawson , Judge .
DAWSON
*43 Respondent determined the following deficiencies in petitioners' Federal income taxes and additions to tax under sections 6651(a)(1) and 6653(a): 1 Addition
Petitioner Year Deficiency to tax
Richard H. Foster 1963 $ 108,513.06
and Sara B. Foster 1964 177,066.45
1965 277,166.65
1966 5,630.26
1967 133,246.08
701,622.50
T. Jack Foster, Jr., 1963 110,067.16
and Patricia Foster 1964 184,431.45
1965 283,634.67
1966 5,764.04
1967 137,755.12
721,652.44
John R. Foster 1963 108,997.49
and Caroline Foster 1964 176,869.03 $ 8,843.45
1965 275,674.76
1966 4,268.35
1967 129,602.81
695,412.44 2 8,843.45
Estate of T. Jack 1963 116,054.13 6,612.89
Foster and Gladys 1964 195,258.35 9,762.92
H. Foster 1965 280,017.84 14,000.89
1966 12,502.37 625.12
1967 111,748.15 5,587.41
715,580.84 3 36,589.23
*145 *44 In their petition, the petitioners claim overpayments in the following aggregate 4 amounts: Year Amount
1963 $ 30,069.78
1964 9,394.27
1965 16,386.46
1966 19,939.93
1967 29,913.76
105,704.20
Despite a number of concessions by the parties, there remains a variety of issues for us to decide. They include nine substantive issues and six preliminary issues related to certain evidentiary and procedural matters. The substantive issues are as follows:
1(a) and 3(a). Whether section 482 is unconstitutional as an invalid delegation of legislative power.
1(b) and 3(b). Whether respondent's determinations under section 482 are reviewable for an abuse of discretion or pursuant to some lesser *146 standard.
1(c) and 3(c). Whether, in order to prevent the avoidance of taxes, section 482 may be applied to a taxable disposition of property previously acquired in a nonrecognition transaction.
1(d). Whether respondent abused his discretion under section 482 in reallocating income from the sale of lots in Neighborhood One from the Alphabet Corporations to the Foster partnership.
3(e). Whether respondent abused his discretion under section 482 in reallocating income from the sale of lots in Neighborhood Four from Foster Enterprises, Ltd., to the Foster partnership.
1(f) and 3(f). In the alternative, whether the Foster partnership is an association and hence taxable as a corporation.
1(g) and 3(g). In the alternative, whether section 482 must be employed to effect a consolidation of the Foster partnership *45 with all of the Foster-controlled corporations purportedly involved in the development of Foster City.
2(a). Whether respondent's contention on brief is consistent with his ground for the adjustment set forth in the notice of deficiency, or, conversely, whether it represents a new issue.
2(b). Whether certain promissory notes, purportedly executed to reacquire corporate stock, *147 are part of the Foster partnership's basis in Neighborhoods Two and Three, or, conversely, whether they represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island.
2(c). If the notes represent an obligation to pay additional interest, whether such interest can be capitalized under section 266 as part of the Foster partnership's basis in Neighborhoods Two and Three, notwithstanding the fact that such interest was not actually paid during the taxable years in issue.
4. Whether the amount received by the Foster partnership and a related corporation for the grant of a sway easement should be applied against their bases in all of their land or conversely against their bases in only that part of their land described by the easement.
5(a). Whether respondent is entitled to rely on a ground for the disallowance of a deduction which was not expressly set forth in the notice of deficiency.
5(b). Whether the transfers of three parcels of land by the Foster partnership for school and church sites are deductible as charitable contributions under section 170.
5(c). If the transfers are not deductible, whether the partnership must capitalize the cost *148 of the school site as part of its basis in all of its remaining land in Foster City.
6. Whether a payment made by the Foster partnership pursuant to a law firm's statement for services rendered is deductible as a business expense under section 162.
7(a). Whether adjustments related to the payment of the Fosters' personal expenses were so arbitrary and excessive as to shift the burden of proof to respondent.
7(b). If petitioners bear the burden of proof, whether they can carry it through evidence that their recordkeeping system *46 was designed to differentiate between business and personal expenses.
7(c). Whether the disallowance of deductions under section 274 at the corporate level precludes the taxation of those expenses as constructive dividends at the shareholder level.
8. Whether certain amounts received by Gladys H. Foster constitute dividends or compensation for personal services.
9. Whether the Estate of T. Jack Foster and Gladys H. Foster are liable for additions to tax under section 6653(a) for negligence or intentional disregard of rules and regulations.
The preliminary issues are as follows:
A(1). Whether the deposition of T. Jack Foster, taken in connection with *149 a State court proceeding, is admissible in this proceeding as an admission of a party-opponent under Federal Rules of Evidence 801(d)(2)(A) .
A(2). If it is admissible on that basis, whether petitioners can object to any part of the deposition on grounds of relevancy.
B(1). Whether the deposition of the Fosters' former tax planner, taken in connection with a State court proceeding, is admissible in this proceeding as former testimony under Fed. R. Evid. 804(b)(1) .
B(2). If it is admissible on that basis, whether petitioners can object to any part of the deposition on grounds of relevancy, opinion, and double hearsay.
B(3). If it is admissible on that basis, whether the deponent's testimony should be completely disregarded because of bias.
C(1). Whether the deposition of T. Jack Foster, Jr., taken in connection with a State court proceeding, is admissible in this proceeding as an admission of a party-opponent under Fed. R. Evid. 801(d)(2)(A) .
C(2). If it is admissible on that basis, whether petitioners can object to any part of the deposition on grounds of relevancy, opinion, and "double hearsay."
D(1). Whether the deposition of the Fosters' former banker, taken pursuant to an application *150 filed with this Court under Rule 82 5 prior to the commencement of the present case, is admissible in this proceeding.
*47 D(2). If it is admissible under that rule, whether respondent can object to any part of the deposition on relevancy and a variety of other grounds.
E(1). Whether the Court properly sustained an objection at trial to a question calling for a conclusion by a party.
E(2). If so, whether the identical question propounded to that party at a deposition must be stricken from the record.
F. Whether the burden of proof in respect of the three major substantive issues involved in this case should be allocated contrary to the general rule of Rule 142(a) .
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
Petitioners Richard H. (Dick) Foster and Sara B. Foster, T. Jack (Jack, Jr.) Foster, Jr., and Patricia Foster, and John R. (Bob) Foster and Caroline Foster are husband *151 and wife. The three male petitioners are brothers. Together with their respective spouses, they timely filed joint Federal income tax returns for the calendar years 1963 through 1967 with the Internal Revenue Service Center at Ogden, Utah.
Petitioner Gladys H. (Gladys) Foster is the widow of T. Jack (Jack) Foster and the executrix of his estate. Jack Foster died on March 15, 1968. Together with his spouse, he also timely filed joint Federal income tax returns for 1963 through 1967 with the Ogden Service Center. Jack Foster and Gladys Foster are the parents of the three male petitioners.
At the time that they filed their petition in this case, all of the petitioners resided in the San Francisco Bay area.
Except for Gladys Foster's involvement in Issue 8, the female petitioners are parties to this action solely by virtue of having filed joint returns with their respective spouses. Accordingly, "the Fosters" will only refer to the principals involved in this case, i.e., Jack Foster, Jack Foster, Jr., Dick Foster, and Bob Foster.
During the years in issue, the Fosters were equal partners in a general partnership known as T. Jack Foster & Sons (the Foster partnership or simply the *152 partnership). Like the individuals, the Foster partnership utilized the cash method of accounting. The principal issues in this case involve substantial adjustments made by respondent to partnership items of *48 income and deduction. The adjustments, in turn, generally relate to the partnership's activities in developing a 2,600-acre tract of unimproved land known as Brewer's Island into a city of 35,000 people christened Foster City, Calif. Before discussing those activities, however, it would be helpful to briefly recount the business background of the Fosters, including the formation and organization of their partnership.
I. Facts Related to the Business Background of the Fosters Jack Foster was born in 1902. During the 1920's, he attended the law school at the University of Oklahoma and was subsequently admitted to the Oklahoma bar. He was twice elected major of Norman, Okla.; he also served one term as the city attorney.
During the depression era, Foster became interested in the real estate business. Among the first projects which he undertook was the construction of a hotel in Norman. His base of operations became Oklahoma City.
From 1946 through 1955, Foster engaged *153 in the real estate development business with an individual by the name of V. B. Likins. Likins was a successful and wealthy businessman who had connections with the Republic National Bank of Dallas (Republic or simply the bank). It was also during this period that Foster retained A. O. "Del" Champlin, an Oklahoma C.P.A., to provide financial, accounting, and tax planning services. Both Republic and Champlin later played important roles in the development of Foster City.
Foster and Likins engaged in a variety of projects during their association. Their most notable achievement was the construction of several thousand units of military housing in several States including Kansas, Texas, California, and Hawaii.
Foster and Likins did business in both corporate and partnership form. In 1952, they incorporated Likins-Foster Honolulu Corp. That corporation eventually became the parent company for most of the corporations formed during the Likins-Foster period of business activity. Likins-Foster Honolulu Corp. is involved in several of the issues presented in this case.
In February 1955, Foster and Likins terminated their *49 business relationship. They entered into an agreement *154 the relevant terms of which provided for the dissolution of their partnership and the acquisition by the Fosters, pursuant to an option, of Likins' interest in Likins-Foster Honolulu Corp. Upon the exercise of that option, Jack Foster owned 75 percent of that corporation's stock, and his sons, the remaining 25 percent, in equal shares.
FORMATION AND ORGANIZATION OF THE FOSTER PARTNERSHIP
Concurrently with the termination of his business relationship with Likins, Jack Foster entered into an agreement with his sons to form the Foster partnership for the transaction of their business. According to the partnership agreement, the purpose of the partnership was --
to own and to acquire land or interests in land, construct houses or other buildings; to rent or sell such real property or leasehold estates either in an improved or unimproved condition; to own stocks, bonds, debentures, or other evidences of indebtedness in any corporation; to buy, own, develop and operate oil and gas leasehold estates, or mineral rights or royalties; and to generally engage in the business of buying or owning property, real, personal or mixed; to act as contractors or principals or agents in any business *155 transaction; to borrow or to lend money with or without security; to act as guarantors on the contracts of others; and generally to engage in any business which the partners may agree upon among themselves.
The partnership agreement further provided that contributions to the capital of the partnership were to be made one-half by Jack Foster and one-sixth by each of his sons, and that profits and losses from its operation were to be shared in the same proportion. The agreement also designated Jack Foster as the managing partner, authorized him to make all routine decisions for the partnership, but provided that matters of policy should be determined by all of the partners. The agreement also authorized the payment of a salary to Jack Foster as managing partner.
At this point, mention should be made of the activities of Jack Foster's sons. The oldest, Jack Foster, Jr., attended the University of Oklahoma, majored in finance, and obtained a degree in business administration in 1951. He then served 2 years in the Air Force. Immediately after his discharge, he joined the Likins-Foster organization in Hawaii as a management trainee. After Foster and Likins terminated their *50 *156 business relationship in 1955, Jack, Jr., managed the Hawaiian operations of Likins-Foster Honolulu Corp. and its several subsidiaries. In November 1960, he returned to the mainland on behalf of the partnership to become the general manager of the Foster City project. (The partnership's role in the development of Foster City will be discussed later in detail.)
Dick Foster also attended the University of Oklahoma, majored in accounting, and graduated in 1957. He too became involved in the family business. In 1960, he moved to Honolulu in order to manage the Fosters' operations and thereby allow Jack, Jr., to assume his responsibilities at Foster City. While in Hawaii, he supervised the construction of several projects, including the Foster Tower Hotel, which plays a role in one of the issues involved herein. In July 1963, he left Hawaii for California in order to actively participate in the development of Foster City.
Bob Foster also attended the University of Oklahoma and graduated in 1958 with a major in geology. For approximately 2 years, he managed the family's oil and gas interests in Oklahoma. In October 1960, he too moved to California in order to take an active part *157 in the development of Foster City.
By 1959, Jack Foster's sons had all graduated from college and had assumed active and increasingly responsible roles in the family business. Accordingly, in January 1959, the Fosters amended their partnership agreement to provide for their equal participation in the profits and losses resulting from the operation of the partnership. No adjustment was made, however, in their capital accounts nor were any of the above-described provisions modified in any way except to specifically authorize the payment of salaries to all of the partners. These amendments to the partnership agreement were made at a time when the Fosters were actively assessing the feasibility of developing Foster City.
The Fosters restated their partnership agreement in August 1963. The purpose of the partnership remained unchanged, and no modifications were made to any of the provisions described above. But two new provisions were added. One authorized any two general partners to bind the partnership by any deed, contract, or other written document within the general scope of the partnership; and the other declared that *51 all stock in any corporation in which shares had *158 been equally issued to the Fosters was a partnership asset.
II. Facts Related to the Creation of Foster City While living in Pebble Beach, Calif., in 1958, Jack Foster was contacted by a fellow builder and real estate developer by the name of Richard Grant about the possibility of participating in the development of Foster City, then known as Brewer's Island. Brewer's Island was a 2,600-acre undeveloped and uninhabited tract of land located about 12 miles south of San Francisco in San Mateo County. It was separated from the city of San Mateo by a narrow estuary on its western bounds but otherwise surrounded by the waters of San Francisco Bay. The island was partially submerged, partially tideland, and partially firm land behind existing levees. It was owned by the Leslie Salt Co. (Leslie) and the Schilling Estate Co. (Schilling) and was used for agriculture and as salt ponds. Grant had been negotiating with its owners for several years but had not been successful in even obtaining an option for its purchase.
Foster had several discussions with Grant about the development potential of Brewer's Island but remained unconvinced. He agreed, however, to solicit the views of his partners. *159 Accordingly, he called his sons to California. The Fosters reviewed the preliminary feasibility study and soil test that Grant had previously commissioned. They determined that the proposed project had sufficient merit to warrant further scrutiny and agreed to finance certain additional studies. Grant and the Fosters agreed that if these studies were favorable and they decided to go forward with the project (assuming, of course, that they could purchase the land), they would do so as partners on a 50/50 basis. As for the Fosters, themselves, they proceeded in partnership form, with Jack Foster continuing to act as managing partner.
The Fosters determined that the principal engineering problem facing the proposed project was to secure an adequate supply of landfill. Acting on behalf of the partnership, Jack Foster retained Dames & Moore (D & M), a San Francisco engineering firm specializing in soil analysis, to survey the southern part of San Francisco Bay for the purpose of locating sand deposits which could be used as fill. Suitable deposits were located about 5 miles east of the San Francisco International *52 Airport at San Bruno Shoal. A dredging permit in Jack Foster's *160 name was subsequently obtained in October 1959 from the U.S. Army Corps of Engineers. During this period, various studies were also conducted on Brewer's Island, itself.
Throughout 1959, Jack Foster actively negotiated with Leslie and Schilling over the terms of the proposed purchase. Discussions were frequent, occurring about twice a week.
By the fall of 1959, the Fosters had become sufficiently enthusiastic about the proposed project to commission a major feasibility study. In November 1959, again acting on behalf of the partnership, Jack Foster retained Wilsey, Ham & Blair (W H & B), a firm of civil engineers and land planners, to prepare a proposal for the development of Brewer's Island. D & M was also retained to conduct soil studies and otherwise assist in the preparation of the engineering part of the proposal.
In December 1959, Jack Foster and Richard Grant succeeded in obtaining an option from Leslie and Schilling for the purchase of Brewer's Island for $ 12,800,000. The option was acquired for $ 200,000 and had to be exercised no later than August 19, 1960. It was acquired solely with Foster funds. Contemporaneously with its acquisition, Grant and Foster agreed for *161 the latter (acting for the partnership) to purchase the former's interest in the project for $ 3 million if the option were eventually exercised. They also agreed that the Fosters would be solely responsible for all engineering and feasibility studies.
Foster arranged to buy out Grant because he thought the property was potentially worth far more than its option price and because he preferred to proceed with only his sons as his partners if the project were undertaken. However, Grant's anticipated contributions to the project were considered so significant that the Fosters would not have undertaken it without assurance of his continued involvement. Accordingly, Foster (again acting for the partnership) also arranged to retain Grant on a full-time basis as an independent contractor at an annual fee of $ 24,000 if the project were actually undertaken.
At the time the option was acquired, the Fosters were faced with several major problems if they exercised it and committed themselves to the development of Brewer's Island. The major engineering problem related to the reclamation of the *53 land. The major financial problem related to their dependence on outside financing not *162 only to develop Brewer's Island (originally estimated by Jack Foster to require $ 55,500,000) but also to complete its purchase price.
In July 1960, WH & B submitted its proposal. The engineering plan for reclaiming Brewer's Island called for dredging a lagoon across the center of the property, installing flood gates in order to permit water draining into the lagoon to flow back into the bay, and then filling the land in the shape of a large saucer about 14 feet above sea level at the outer edge and 1 1/2 feet above sea level near the center. It was determined that the necessary fill, approximately 18 million cubic yards, could be obtained at a cost which would make the operation economically feasible.
WH & B's proposal also contemplated using municipal bonds issued by a municipal improvement district to finance the improvements to Brewer's Island. This concept actually originated with Richard Grant, who had previously discussed it with the Fosters. They were sufficiently receptive to the idea that Jack Foster, acting on behalf of the partnership, retained a San Mateo law firm specializing in municipal finance to draft proposed legislation. WH & B provided technical assistance *163 by specifying the powers that such a district would need in order to successfully undertake the contemplated development. Sometime thereafter, the Estero Municipal Improvement District Bill was introduced into the California legislature as Senate Bill No. 51 by the local State senator and State assemblyman. The former was also the Fosters' personal attorney. The bill called for the creation of a local government body which could issue bonds and impose taxes in order to raise the funds necessary to improve the land within its jurisdiction. In March 1960, San Mateo County endorsed the bill. It was subsequently passed by the legislature and approved by the Governor in May 1960. The Estero Municipal Improvement District (Estero or simply the district) played an important role in the development of Brewer's Island.
In his discussions with Leslie and Schilling, Jack Foster had negotiated a downpayment of $ 2,500,000 for the purchase of Brewer's Island. Payment of such an amount, however, was not compatible with the partnership's anticipated cash needs if the project were actually undertaken. During the spring or *54 early summer of 1960, the Fosters discussed with senior officials *164 of the Republic National Bank the possibility of financing the partnership's downpayment if the property were purchased. A $ 2 million loan was eventually arranged. However, certain of its terms are in dispute and give rise to one of the three major issues which we must decide. This matter is described later in greater detail.
By July 1960, the Fosters had expended considerable amounts assessing the development potential of Brewer's Island. For example, they had spent approximately $ 250,000 on the studies made by WH & B and D & M. In the process, however, they had determined that the project was feasible and had made the necessary arrangements for financing both the development and acquisition of Brewer's Island. Accordingly, they undertook to acquire the property.
On August 16, 1960, Jack Foster, acting on behalf of the partnership, acquired Richard Grant's interest in the option for $ 3 million as previously agreed. Foster executed a promissory note payable without interest and solely from the proceeds from the sale or use of the property subject to the option. The note was secured by an unrecorded deed of trust. On August 19, 1960, Foster, again acting on behalf of the *165 partnership, exercised the option and acquired Brewer's Island for $ 12,800,000. The $ 2,500,000 downpayment included the amount paid for the option ($ 200,000) and the amount borrowed from Republic for that purpose ($ 2 million). Foster executed promissory notes to the sellers for the balance, or $ 10,300,000. These notes were secured by a deed of trust and were payable no later than August 19, 1967.
Title to Brewer's Island was taken in the name of Jack Foster as nominee of the Foster partnership. Later, in August 1963, the partnership filed a "Statement of Partnership" with San Mateo County pursuant to the California Corporations Code. 6 At that time, Foster transferred record title (except to certain acreage, described later, which in the interim had been conveyed to certain Foster-controlled corporations) to the partnership.
With the purchase of Brewer's Island by the Foster partnership, *55 that tract of land was on its way to becoming Foster City. At *166 this point, therefore, it would be appropriate to briefly describe the contemplated development.
Foster City was envisioned as a completely planned and self-contained city consisting of nine residential neighborhoods, an industrial park, and a town center. Each neighborhood was to be built around an elementary school. Of the 2,600 acres, approximately 1,360 were to be zoned residential, 310 acres, industrial, and 150 acres, commercial. The remaining acreage was to be divided among schools, churches, parks, lagoons, streets, and municipal buildings. A population of approximately 35,000 was contemplated. The total number of housing units was estimated at 11,000, with single-family detached homes accounting for about 5,000 units and townhouses and garden and highrise apartments the remainder. Each neighborhood was to include both waterfront (lagoon and bay) and non-waterfront lots and a mix of single-family and multiple-family dwellings, as well as some commercial development.
III. Facts Related to the Sale of Lots in Neighborhood One (Issue 1) Foster City was developed neighborhood by neighborhood. As land in each neighborhood was reclaimed and the soil compacted, various improvements *167 were immediately begun with a view towards platting so that individual lots could be sold to builders. The principal income of the project was derived from the sale of such lots. Given the magnitude of the project, the Fosters lacked the financial resources to undertake the actual construction, itself. However, in several instances, they did do some building, principally commercial buildings which they intended to hold for investment purposes.
The first neighborhood to be developed was Neighborhood One. 7 Sales of lots in Neighborhood One began in June 1963 and continued for the next several years. On October 3, 1962, Jack Foster, acting on behalf of the Foster partnership, deeded undivided 25-percent interests in 127 acres of land in both *56 Units 1 and 2 of Neighborhood One to each of four corporations as tenants-in-common. (Neighborhood One was divided into two units and consisted of a total of 216 acres.) The four corporations were known as Foster J. Corp., Foster D. Corp., Foster B. Corp., and Foster T. Corp. (hereinafter referred to collectively as the Alphabet Corporations or simply the Alphabets). Each of the Alphabet Corporations was solely owned by one of the *168 Fosters: Foster J. by Jack, Jr., Foster D. by Dick, Foster B. by Bob, and Foster T. by Jack (T. Jack). In the notice of deficiency, respondent allocated to the partnership the net income reported by the Alphabets 8 from the sale of lots in Neighborhood One as follows: 1963 1964 1965 1966 1967
$ 680,459.55 $ 293,766.18 $ 134,735.03 ($ 2,521.67) $ 350.26
This allocation was made under authority of section 482 .
In order to understand the factual predicate of the Neighborhood One issue, it is necessary to describe the roles played by Estero, the Foster partnership, the Alphabets, and Del Champlin in the development of Foster City in general and Neighborhood One in particular.
A. ESTERO *169 MUNICIPAL IMPROVEMENT DISTRICT
As previously stated, the consultants retained by the Fosters recommended using municipal bonds issued by a municipal improvement district to finance the improvements to Brewer's Island. The district that was created for this purpose was Estero.
1. The Enabling Legislation
Estero was a "special act" district, i.e., it was created by special act 9 of the California legislature rather than pursuant to an existing general statute. As an independent special district, it was a public agency. However, as we shall see, Estero was designed to be subservient to the Fosters.
*57 The Estero Act recited the need for the district, prescribed its boundaries, organization, and powers, and defined the methods for its operation, management, and financing. The act described its purpose as follows:
Article 15. Need for Special *170 Act
SEC. 215. The purpose of this act is to form the Estero Municipal Improvement District in order that the area benefited may be provided with various municipal improvements. Special facts and circumstances, applicable to the general area within which the district lies and not generally, make the accomplishment of this purpose impossible under existing general laws and therefore special legislation is necessary. The special facts are as follows:
* * * *
(d) There is urgent need for the improvements which the district is empowered to construct under this act, but other municipal powers which could be exercised by a city are not required, and would result in more government than the area needs or wants.
(e) There are not existing general laws under which the area could be provided with the facilities it needs short of incorporation as a city. Therefore, the only way in which the particular needs of the area can be provided is by special act.
(f) The land in the district is not owned by residents. The owners are the ones primarily concerned with the district and the ones who will be supporting the district. The owners should therefore hold the voting power. Since no general law *171 district with the necessary powers provides for voting by owners, special legislation is necessary.
The act provided that the territorial jurisdiction of Estero was coterminous with Brewer's Island. It also restricted the right to vote to landowners and provided that voting was to be upon the basis of assessed valuation of land, with each voter to have one vote for each $ 1 in assessed valuation of land owned by him. 10
*172 The act also provided that Estero was to be governed by a *58 board of three directors elected to serve staggered, 4-year terms. Only owners or their officers or legal representatives were eligible to be directors. The officers of the district consisted of the board members, a secretary, and such other officers as the board might create. The district was entitled to employ such engineers, technical experts, and other employees as it deemed necessary. 11
*173 Estero was vested with a broad spectrum of general governmental powers. For example, it was empowered to reclaim land, make provision for street lighting, sewage, storm drainage, garbage and water service, and parks and playgrounds. It was also empowered to construct small craft harbors, provide fire and police protection, condemn land, enter into contracts, and make and enforce such regulations as were necessary and proper to the exercise of its enumerated powers. A violation of any such regulation constituted a misdemeanor. 12
*174 *59 Despite its impressive array of powers, Estero was intended to initially function as a reclamation district whose purpose was to finance the reclamation of a 2,600-acre tract of undeveloped and uninhabited land. As that tract was reclaimed, Estero was intended to function as an improvement district whose purpose was to finance the construction of general land improvements such as streets and sewers. As the land was improved, subdivided, and sold, and further improved by the construction of dwelling and other buildings, Estero was intended to function as a general governance district whose function was to provide the usual municipal-type services such as fire and police protection. 13 This functional evolution of Estero was facilitated by the comprehensive powers bestowed upon it by the enabling legislation.
In order to finance the reclamation of Brewer's Island and the construction of general *175 land improvements, the Estero Act authorized the district to issue both general obligation and revenue bonds, as well as other types of securities. Issuance of *60 these bonds required approval by the district electorate; however, a "voter" continued to be defined as a landowner. The act did not limit or restrict the amount of bonded indebtedness that could be incurred by the district. The payment of interest was expressly authorized to be funded as part of Estero's bonded indebtedness "for the period of construction and for twelve (12) months thereafter." In other words, the act authorized the face amount of a bond issue to include the interest that would have to be paid on the bonds during the specified period. 14 The significance of such capitalization of interest will be described later in greater detail.
*176 Because of a scandal during the early 1960's involving the *61 Embarcadero Municipal Improvement District in Santa Barbara, another special act district that was virtually identical to Estero in legal form, 15 the California legislature requested the State attorney general to conduct an investigation of both districts. The legislature also conducted hearings in 1962. The committee report 16 found as follows:
The Embarcadero and Estero Municipal Improvement Districts are similar public agencies with general taxing and bonding powers, specially created to aid specific land developments. The organizational requirements of these districts placed each of them under the direct control of the developers and in addition anticipated and encouraged self-dealing between the developer and the district -- all without any independent audit controls or other review procedures.
The grand theft and fraud which occurred in the Embarcadero District appear to have been facilitated by this type of district organization. The success of the Estero District, on the other hand, may be attributed to the integrity of the developer and his willingness voluntarily to secure county approval of his development *177 and to provide other public safeguards. The salient fact, however, is that the district organization itself does not appear significantly able to forestall abuses.
In June 1963, the Estero Act was amended 17 to require that one of the three directors of the board be a public member designated and appointed by the San Mateo County Board of Supervisors. 18 *178 The act was also amended to require that the finance officer be bonded for $ 250,000. 19 Finally, the exculpatory provision of section 34 of the act (quoted above in note 11) was deleted.
*62 In August 1967, the Estero Act was again amended, 20 this time because of pressure brought by the residents of Foster City. As amended, the act provided for a scheduled shift of power over a 4-year period from the landowners to the residents. Thus, the board of directors was immediately enlarged to five members, two of whom represented landowners and two of whom represented residents; the fifth member was a "public director" appointed by the county. By 1969, the fifth member was to be elected by the residents, and by 1971, all five members were to be elected by the residents. The reason for this reform will be discussed later in greater detail.
In December 1966, a resident of Foster City by the name of Cooper judicially challenged the validity of the Estero Act, *179 alleging, inter alia, that it violated the California constitution. His action was subsequently dismissed on the ground that it failed to state a cause of action. In 1969, the California Supreme Court affirmed the dismissal. 21
*180 2. Estero's Board, Officers, and Contractors
Estero was formally organized on September 8, 1960. Its first board of directors consisted of Richard Grant, who was elected president, William Innes, and George Shannon. Grant, of course, was the individual who first interested the Fosters in developing Brewer's Island and whom they arranged to retain for his help and assistance if the project were actually undertaken. Innes was a C.P.A. and former employee of Arthur Andersen & Co. He was hired by Jack Foster in 1950 and had become a trusted executive within the Foster organization. Shannon was a career city manager who had worked in Texas, California, and Alaska. He had been recommended to the Fosters by the president of the Republic National Bank and was sought out by them because of his expertise in *63 municipal government. Both Innes and Shannon served as directors through the years in issue.
In June 1961, Grant resigned from Estero's board "in order to better represent the District in an independent capacity." C. W. Olmo, a contractor, was appointed his successor and elected president. Olmo became one of the Fosters' subcontractors when they built the Wells Fargo *181 Bank Building in Foster City in 1965. He had been recommended to the Fosters by the San Mateo County Board of Supervisors. He too served as director through the years in issue.
In addition to being a director, George Shannon held a variety of other positions with Estero. At the initial organizational meeting of the board, he was appointed secretary. He also served as district tax assessor and tax collector, after those offices were created in February 1961, and became general manager (a position which consolidated his other offices and made him the chief executive officer for the district), after that position was created in August 1962. At that time, it was agreed that Shannon would be placed on the district's payroll and would no longer be employed by Likins-Foster Honolulu Corp.
Shannon served as Estero's general manager until 1969. Immediately after the residents of Foster City gained control of the board, he was terminated. Shortly thereafter he was reemployed by the Fosters.
William Innes also held several positions with Estero in addition to that of director. In March 1961, he was appointed district finance officer. In February 1964, he was appointed assistant secretary.
*182 For the first several years of its existence, Estero's offices were located within the Fosters' offices in Burlingame, a neighboring community. During this period, one or more of the Fosters customarily attended meetings of the district's board of directors. Jack Foster, Jack Foster, Jr., and Bob Foster were all present at the board's first meeting on September 8, 1960.
Estero retained many of the same contractors as the Fosters. For example, in November 1960, it retained as bond counsel the law firm that the partnership had retained to draft the Estero Act. It had previously retained that same firm as general counsel. In September 1960, Estero contracted with WH & B for the performance of engineering and surveying *64 services necessary to complete the reclamation of Foster City. In August 1961, it again contracted with WH & B for the preparation of the design, plans, and specifications for all the community facilities (e.g., sewers and drains, water mains, pavement and sidewalks, curbs and gutters, and street lights) to be constructed in Neighborhood One. At the same time, it contracted with D & M for the performance of the soil studies necessary for the construction *183 of those facilities and for other related engineering services. Other contracts were subsequently entered into with both WH & B and D & M.
Estero accepted the assignment of, and assumed the full indebtedness under, certain contracts which Jack Foster had entered into on behalf of the Foster partnership in 1959 and 1960. These contracts will be described later in greater detail. Estero also contracted with the partnership and certain of the Fosters' corporations for various services. For example, at its inception, Estero entered into an agreement with Likins-Foster Honolulu Corp. for administrative services. Other contracts will also be described later.
3. Municipal Finance
Estero entered into numerous contracts in its own name for the reclamation of land and the construction of various improvements such as levees, lagoons, roadways, water and sewer lines, and a sewage disposal plant. In order to finance this development, Estero issued long-term bonds. Estero's success in selling its bonds to the general public was due, in part, to its deliberate choice of a particular appraisal method which served to accelerate land value. On the other hand, the Fosters' success in minimizing *184 district taxes was due to the unique manner by which Estero capitalized interest. Each of these matters will be discussed in turn.
George Shannon, the district tax assessor, appraised undeveloped land within Estero on a benefit-to-be-received basis. Under this method, land was appraised as if all the bonded improvements were in place, i.e., as if the land were fully reclaimed and the streets, sewers, and other improvements completely constructed. The assessor of San Mateo County, on the other hand, appraised raw land on the basis of comparable sales of undeveloped tracts. (Both the district and the county used comparable sales to value improved real estate.) Because *65 of the basic difference between these two appraisal techniques, Estero's appraised value of undeveloped land was 3 1/2 to 6 times greater than that of the county. In the mid-1960's, after considerable development had occurred, Estero appraised the value of all the land within the district at $ 102 million whereas the county appraised it at $ 41 million.
Estero appraised undeveloped land on a benefit-to-be-received basis in order to accelerate land value. This in turn facilitated bond sales. Potential buyers *185 would have been hesitant about purchasing bonds if the district's bonded indebtedness exceeded the value of the security. Use of the benefit method allowed a comfortable margin. On the other hand, if the county's method had been used, Estero's bonded indebtedness in the mid-1960's (approximately $ 51 million) would have exceeded the aggregate land value by about $ 10 million.
By facilitating bond sales, the higher appraised value benefited the landowner. Bonds, after all, were the source of funds for the reclamation and development of the land. There was, however, a potential downside. Higher appraised value should ordinarily lead to greater taxes for the landowner. In the case of the Fosters, however, this disadvantage was minimized through the manner in which Estero capitalized interest.
"Capitalized interest" is interest which is built into the face amount of a bond. It is equal to the amount of interest which will have to be paid on the bond over some initial period of years. That period is typically the time needed to construct the particular improvement for which the bond is issued, plus some additional period such as 12 or 24 months. By capitalizing interest for this *186 period, the payment of interest is effectively postponed until the improvement can begin to pay for itself. Capitalizing interest on bonds issued to finance the construction of a toll bridge provides an illustration.
The Estero Act specifically authorized interest to be capitalized "for the period of construction and for twelve (12) months thereafter." This provision was construed, however, not to refer to the construction of the particular improvement for which the bond was issued, the usual interpretation given to such language by bond experts, but rather to the construction of Foster City, itself. This interpretation was not disclosed in *66 any prospectus published by Estero to promote bond sales. Estero thus capitalized interest not only on current bond sales but also on prior bond sales. In other words, bond proceeds were used to service prior debt, thereby reducing the current property tax impact on the landowner. Prior to the change in its board of directors in 1967, Estero was capitalizing approximately 60 percent of the interest falling due on all prior bonds, and as much as 40 to 50 percent of the total bond proceeds were being utilized to pay capitalized interest. *187 Not surprisingly, very little principal was retired during the 1960's. Between 1961 (the year of the first bond sales) and 1972, approximately $ 66 million in bonds was sold. Of this amount, about $ 64 million remained outstanding in 1972.
By the mid-1960's, the residents of Foster City had become concerned about Estero's bond practices, particularly its practice of using proceeds from the current sale of bonds to service prior debt. They realized that this practice was causing debt to pyramid and recognized that when it stopped, as it had to at some point, they would be faced with an enormous, and perhaps unmanageable, bond-related tax increase. Accordingly, they organized a homeowners association and sought to discuss their concerns with Estero. The board, however, referred them to the Fosters.
The homeowners association never succeeded in obtaining assurance from the Fosters that there would be any measure of stability in future district taxes. Some animosity developed after the association endorsed a proposal (authorizing an increase in the total amount of bonded indebtedness) in March 1967 in exchange for what it thought was the Fosters' guarantee to hold taxes to the *188 highest projected level. The Fosters, however, subsequently refused to enter into any such agreement. Accordingly, the homeowners association drafted legislation to democratize election to the Estero board. This legislation was introduced into the California legislature in April 1967 and enacted in August 1967. As described above, it programed the transfer of voting power over a 4-year period from the landowners to the residents.
During the transition period, as power was shifting, changes were made in Estero's scheme of municipal finance. There were no further bond authorizations for land reclamation or the construction of water, sewer, or street improvements. Only *67 bonds previously authorized for these purposes were sold. Bond authorizations for other purposes, such as parks and recreation, were meager in amount. Interest was not invariably capitalized, but when it was, it was limited to a maximum period of 24 months from the time of the bond sale. Moreover, interest was capitalized only in respect of a particular bond sale and not in respect of outstanding bonds as had previously been the practice. In order to compensate for such past practices, the residents voted *189 in 1968 to double their taxes, hoping to avoid an oppressive future increase.
During the transition period, the most significant change, however, was Estero's decision to finance the construction of only the major streets and major water and sewer lines. No longer was the development of the developer's private land to be financed with public funds. Rather, the developer was henceforth required to finance all on-site and local improvements (such as streets and water and sewer lines) that would be necessary to subdivide a particular tract. As a consequence, Estero was relieved of most of the expense that it would otherwise have had to incur.
By 1972, the community's finances were sound enough to permit bond sales at par. During the 1960's, bonds had been almost invariably sold at a discount.
Finally, mention should be made of the fact that during the transition period, the Fosters decided to withdraw from Foster City as developers. In 1969, negotiations were entered into with Centex Corp., an unrelated third party, and in 1970, a sale was consummated with its subsidiary, Centex West, Inc.
B. DEVELOPMENT OF NEIGHBORHOOD ONE We turn now to the development of Neighborhood One and *190 the roles played by Estero, the Foster partnership, and the Alphabet Corporations. To the extent relevant, their roles in the development of other neighborhoods will also be briefly discussed.
As the developer of Foster City, the Foster partnership played the leading role in the development of that community in general and Neighborhood One in particular. However, the partnership acted largely through Estero. The importance of the district's role, therefore, cannot be overemphasized. Accordingly, we shall begin our discussion with Estero.
*68 1. Estero
Estero was incorporated on July 7, 1960, and was formally organized at the first meeting of its board of directors on September 8, 1960.
In September 1960, Estero contracted with WH & B for the performance of the engineering and surveying services necessary to complete the reclamation of the entire 2,600-acre tract. Plans and specifications were prepared and submitted to the district in December 1960. Bids for the necessary reclamation work were immediately solicited from area contractors. A contract for the preliminary field work had been previously awarded to a local contractor.
In order to finance the reclamation *191 of Brewer's Island, Estero called a special election in December 1960 to authorize bonded indebtedness of $ 22 million. The bond issue passed by a vote of 138,025 to zero. At the election, the only authorized voter was the landowner, the Foster partnership.
At about this time, Estero resolved to commence a judicial proceeding to validate its creation and determine its right to issue bonds. Such a proceeding was expressly authorized by the Estero Act. 22 Estero thought that this action would facilitate both the awarding of contracts and the sale of its bonds. In July 1961, a judgment was rendered in an uncontested in rem proceeding in the Superior Court of San Mateo County which purported to establish the constitutionality of the act and the validity of the district's bonds.
*192 In March 1961, Estero determined that the bids received for the proposed reclamation exceeded both its engineer's estimate and the district bond authorization. Accordingly, it rejected them and determined instead to negotiate directly with qualified contractors. Estero also adopted a procedure for the payment of claims and the issuance and payment of warrants. This procedure was adopted, in part, to enable the district to pay some of the outstanding bills against it in the form of warrants. Also that month, the Planning Commission *69 of San Mateo County commenced formal review of the general plan of Foster City.
In June 1961, Estero awarded the sale of its first series of bonds (land reclamation general obligation bonds which had been authorized the previous December) to the Republic National Bank. The face amount of these bonds was $ 2,300,000, and their repayment was guaranteed by the Fosters. Estero also adopted an official map for purposes of district taxes. Later that month, the San Mateo County Board of Supervisors approved both the district's general plan and its agreement with the county for the maintenance of its drainage system.
In July 1961, Estero determined *193 that the necessary reclamation work could be performed most economically by contracting with Midwest Dredging Co. (Midwest) to furnish dredged material for landfill and another contractor for land preparation. Midwest was a corporation 90 percent of whose shares were owned by the Fosters and which was incorporated during that month. Accordingly, in August, a contract was entered into calling for Midwest to provide hydraulic fill from San Bruno Shoal at a guaranteed contract price per cubic yard. Under the contract, Midwest was to furnish all labor and supplies while Estero was to furnish the equipment under a lease-purchase agreement. It was understood that Associated Dredging Co., an unrelated third party, would serve as Midwest's subcontractor and would actually operate the equipment.
Immediately upon contracting with Midwest, Estero arranged for the purchase of the necessary dredging equipment at a cost of approximately $ 575,000. Several months were consumed in modifying this equipment. The sand barges, for example, were located on the Great Salt Lake in Utah at the time of their purchase by the district; they had to be cut into pieces and shipped by train to Oakland, where *194 they were reassembled. Thus, the actual filling operation did not begin until spring 1962.
The landfill operation was the major engineering feat in the development of Foster City. Accordingly, it would be helpful to digress for a moment in order to briefly describe it.
The first step of the operation involved dredging sand from San Bruno Shoal and pumping it into barges. The barges were *70 then moved by a tugboat to the shore of Foster City where the sand was dumped into the bay. The sand was then redredged and pumped by a 3500-horsepower engine through a large pipe to the particular area being filled. It was carried by the medium of water, which was then pumped back into the bay, leaving the sandfill. By moving the pipe, the island was filled, neighborhood by neighborhood, at the rate of approximately 4 million cubic yards per year. As each area was filled, the next stage of reclamation -- land preparation -- would begin, starting with the grading and contouring of the fill.
Estero subsequently canceled its contract with Midwest after the State attorney general questioned the arrangement as a possible conflict of interest. During the life of the contract (August 1961 *195 to December 1962), the district made payments of approximately $ 2,400,000 to Midwest for the design and mobilization of the dredging equipment, dredging operations, and various other related expenses.
After Estero canceled its contract with Midwest, it entered into a new contract with an unrelated dredging company. Under the new contract, the district agreed to furnish and retain ownership of the equipment, and the contractor agreed to perform all services and to maintain the equipment.
In August 1961, Estero also entered into a variety of other contracts. It contracted with a construction company for land reclamation work related to the digging of the lagoons and other land preparations. It contracted with WH & B for engineering services related to the design of a sewage disposal plant and the community facilities to be constructed in Neighborhood One. It also contracted with D & M for certain soil and foundation investigation services, including test borings necessary for the construction of various community facilities and again with D & M for other soil engineering services.
In October 1961, Estero contracted with a Palo Alto firm for engineering services related to aerial *196 mapping and the design of the Hillsdale-Marina Lagoon bridge. This bridge was intended to provide the principal access to Foster City. At the time, the only other access was a narrow, wooden bridge that went past the San Mateo sewer plant and garbage dump and was otherwise inadequate for the traffic. The Fosters considered the new bridge essential to their marketing plans. In May *71 1962, Estero accepted a bid from a builder for the construction of the bridge, and work began immediately. The bridge was opened to traffic in May 1963.
By October 1961, subdivision plans for Neighborhood One had been submitted to San Mateo County and a development schedule had been prepared by Estero's engineers. It was anticipated that funds would be needed in early 1962 to begin the construction of water, sewer, and street improvements, as well as to meet outstanding commitments related to the mobilization of the dredging equipment. Accordingly, Estero resolved to call a special election to authorize bonded indebtedness of $ 3 million for a water project, $ 19 million for lighting and drainage, including street improvements, $ 4 million for a sewer project, and $ 1,500,000 for parks and *197 playgrounds, as well as revenue bonds of $ 2 million for water facilities and $ 4 million for sewer facilities. Estero also resolved to call for bids on $ 10,900,000 of the general obligation land reclamation bonds that had been previously authorized as well as $ 1,700,000, $ 3,500,000, and $ 1,700,000, respectively, of general obligation water bonds, street improvement bonds, and sewer bonds.
At the special election in November 1961, each of the five bond issues passed by a vote of 7,667,010 to zero. At the election, the only authorized voters were the landowners, the Foster partnership, and a Foster-controlled corporation, Foster Bayou Corp., which was owned by the partnership and to which a small parcel of land had been previously conveyed. (Foster Bayou Corp. plays a role in Issue 2, infra .) At the same time, Estero awarded the sale of $ 2,600,000, $ 500,000, $ 800,000, and $ 600,000, respectively, of general obligation land reclamation bonds, water bonds, street improvement bonds, and sewer bonds to an underwriter; the remaining bonds were not sold at that time.
In January 1962, Estero contracted with WH & B for engineering services related to the preparation of plans *198 and specifications for the major drainage facilities to be used in the land reclamation project. Estero also approved the plans and specifications, previously submitted by WH & B, for a water supply line to connect the district with the water mains of the San Francisco Water Department in San Mateo. The waterline was to cross into Foster City, suspended from the bottom of the *72 Hillsdale-Marina Lagoon Bridge. At the same time, Estero approved a contract with San Mateo authorizing the district to install and maintain the waterline under the public streets of that city. In February 1962, a contract was awarded to an Oakland company for the actual construction of the waterline. Easements from private parties were also obtained to permit the installation and maintenance of the line.
In April 1962, Estero approved a contract for the construction of a 6,300-foot sewer outfall line. It also extended an earlier contract for additional lagoon excavation and land preparation. Another contract was awarded to an electrical contractor.
In May 1962, Estero obtained an easement from the State of California for the construction, operation, and maintenance of the sewer outfall line. *199 As previously mentioned, the district also approved a contract for the construction of the Hillsdale-Marina Lagoon Bridge. Later that month, it awarded to an underwriter the sale of $ 7 million, $ 750,000, $ 1,450,000, and $ 800,000, respectively, of general obligation land reclamation bonds, water bonds, street improvement bonds, and sewer bonds, all of which had been previously authorized.
During July 1962, Estero executed a number of additional work orders under existing contracts with several contractors. It also entered into an agreement with Pacific Gas & Electric Co. for the use of the latter's right-of-way to construct a waste water channel. Another contract was entered into with D & M for consulting services related to soil engineering.
In August 1962, Estero contracted with a consulting firm for city planning services. The contract was designed to insure that the basic features of the general plan were coordinated with the specific engineering plans for the various community facilities that were being constructed by the district. Estero also awarded a contract for the construction of the sewage disposal plant.
In September 1962, Estero awarded a contract for the construction *200 of lagoon shoreline improvements. The previous month, it had approved the plans and specifications prepared by WH & B.
From September 1961 through October 1962, Estero issued checks in the following aggregate amounts for reclamation and other development from the indicated funds: *73 Reclamation 23 Other development Total
1961 September - December $ 690,853.43
1962 January $ 501,464.79 $ 162.12 501,626.91
February 443,770.03 128,197.47 571,967.50
March 354,684.93 33,170.99 387,855.92
April 461,976.39 102,149.52 564,125.91
May
June 84,643.50 58,202.69 142,846.19
July 405,944.65 82,687.50 488,632.15
August 200,118.27 163,617.14 363,735.41
September 366,026.07 312,036.83 678,062.90
October 280,724.69 188,600.68 469,325.37
Subsequent to October 1962, Estero continued to contract for the development of Neighborhood One. Major contracts were awarded in February 1963 for the construction *201 of community facilities in unit 1 and in August 1963 for the construction of community facilities in unit 2. Landscaping contracts were awarded in January and April 1965.
Estero also continued to call special elections to approve bonded indebtedness intended to finance the overall development of Foster City. For example, in March 1964, an additional $ 26,100,000 in general obligation bonds were approved for land reclamation ($ 8,505,000) as well as the construction of street improvements ($ 3,710,000), parks and playgrounds ($ 335,000), fire stations ($ 600,000), water projects ($ 5,440,000), and sewer projects ($ 7,510,000). At this election, the bond issues again passed unanimously (10,285,000 to zero) with the landowners, principally the Foster partnership, being the only authorized voters.
Estero also continued to regulate development. For example, in July 1964, it passed a sewer ordinance.
The 216 acres of Neighborhood One had been reclaimed and were available for building no later than mid-1963. By March 1964, unit 1 had been completed with sewer and waterlines, storm drains, paved streets, street lights, and underground electric and telephone utilities. By January 1965, *202 unit 2 had been similarly completed.
It should be emphasized that the development of Foster City was a continuous, ongoing undertaking. As land in one neighborhood was being improved, land in another was being reclaimed. During the 1960's, Estero played a crucial role in *74 the reclamation and improvement of the various neighborhoods by contracting for and financing their development. Contracts which Estero awarded in respect of the other neighborhoods resembled those described above. A representative sampling of major contracts includes agreements for the construction of three additional bridges, one in February 1964 and two in April 1965; agreements for land preparation in Neighborhoods Four, Seven and Eight, and Five and Six in November 1964, September 1965, and May 1966, respectively; agreements for the paving of roadways in Neighborhoods Two, Three, and Four in October 1964, April 1965, and June 1965, respectively; and agreements for the construction of improvements in Neighborhoods Nine and Eight in June 1966 and January 1968, respectively. Certain of these contracts exceeded $ 1 million.
2. The Foster Partnership
The role played by the Foster partnership in *203 the development of Foster City prior to September 8, 1960, the date on which Estero was formally organized, has already been described. Accordingly, only its role subsequent to that date will be discussed. We start, however, with the supporting roles played by its partners.
Jack Foster was the ultimate authority among the Fosters at Foster City. He took particular interest in, and responsibility for, the financial aspects of the project. During the 1960's, he resided in Pebble Beach, Calif., approximately a 2-hour drive from Foster City. During that period, he generally spent 3 or 4 days per week in the San Mateo area working on the Foster City project. The balance of his time, he spent at home involved in other projects in California and elsewhere. In 1965, Jack Foster discovered that he had cancer. Over the next couple of years he became increasingly less active in the Foster City project. By early 1967, he was confined to bed and never returned to his office in Foster City. He died in March 1968.
Jack Foster, Jr., was general manager of the Foster City project from November 1960 until the Fosters sold their interest as developers in 1970. As general manager, he was responsible *204 for the overall development of the project and was in charge in his father's absence. With the decline in his father's health, he assumed even greater responsibility. Until *75 he moved to Foster City, he resided in a neighboring community approximately 5 minutes away. Virtually all of his time was devoted to the Foster City project.
Principally because of his training in geology, Bob Foster was assigned primary responsibility for monitoring the progress of the landfill operation. His function was to insure that the land would be suitable for home construction after the fill and grading were completed. He was also responsible for insuring that a particular earthquake-resistant foundation was installed by all builders in Foster City.
Finally, Dick Foster came to Foster City in July 1963 from Hawaii. His principal role involved supervising the construction of various commercial buildings which the Fosters intended to hold for investment purposes.
At least through 1967, the year in which the composition of Estero's board of directors began to change, the Foster partnership and the district had a very close working relationship. They were united in their goals for the reclamation *205 of the land, the sale of the lots, and the construction of improvements, and they cooperated fully in the development process. One or more of the Fosters frequently attended board meetings, especially during Estero's formative period, and were generally familiar with the agenda ahead of time. George Shannon, one of Estero's directors and its secretary, tax assessor and collector, and later its general manager when the preceding offices were consolidated, regularly attended the Fosters' weekly planning sessions. The Fosters served as judges and inspectors at the district's elections and never protested the value at which their land was appraised.
On occasion, the Fosters acted as agents for Estero. For example, in 1961 Jack Foster, Jr., negotiated the purchase for the district of land in San Mateo which was needed for the approach to the Hillsdale-Marina Lagoon Bridge. All of the Fosters, particularly Jack Foster, actively promoted the sale of Estero bonds to banks and other potential purchasers.
The Foster partnership also loaned money to Estero when the district's finances required such assistance. For example, lacking street funds, Estero obtained a $ 75,000 loan from the *206 partnership in January 1962 so that it could acquire the bridge approach which Jack Foster, Jr., had negotiated for it the previous month. Because of inadequate bond sales, Estero *76 obtained a commitment in November 1962 from the partnership to loan sufficient funds to permit land reclamation to continue. In October 1967, the district obtained a temporary loan from the partnership in the amount of $ 2,325,000 for various improvement projects.
Jack Foster assigned to Estero various permits and licenses which he had obtained on behalf of the Foster partnership and which were essential to the dredging operation. For example, no later than September 1960, Foster assigned a permit to dredge San Bruno Shoal which had been obtained in 1959 from the U.S. Army Corps of Engineers. In October 1962, he assigned a mineral lease with the California State Lands Commission permitting the extraction of sand from San Bruno Shoal.
Jack Foster also assigned to Estero various contracts which he had previously entered into on behalf of the Foster partnership. In March 1961, he assigned, and Estero assumed the full indebtedness under, an engineering contract which had been entered into with WH *207 & B in November 1959. This contract involved the preparation of the general planning and engineering guide for the reclamation of land on Brewer's Island. In March 1961, he assigned, and Estero again assumed the full indebtedness under, engineering contracts which had been entered into with D & M in March and July 1960. These contracts involved site investigation on Brewer's Island and additional sand exploration of San Bruno Shoal.
In May 1961, Estero approved the payment of claims in the amount of $ 368,809.34 to the Foster partnership for expenses incurred on behalf of the district. A significant amount of the those expenses was for services rendered by WH & B and D & M before the district was established. In November 1961, Estero approved the payment of claims in the amount of $ 66,843.28. Most of this amount related to payments made by the partnership to WH & B for engineering services. In February and April 1962, Estero again approved the payment of claims in the respective amounts of $ 75,336.71 and $ 48,916.49 for expenses incurred by the partnership on behalf of Estero.
The Foster partnership granted various interests in land to Estero. In February and July 1962, *208 easements were granted for the purpose of constructing and maintaining water supply *77 lines. In April 1965, a parcel in fee and two easements were granted in Neighborhood Three for boating and water usage. In December 1965, an easement was granted for the maintenance of the Neighborhood Four lagoons. Other easements which the partnership granted will be described hereinafter.
Estero contracted with the Foster partnership for specific services. In August 1964, for example, Estero entered into an agreement with the partnership for financial and accounting services.
The Foster partnership participated in the construction of improvements in Foster City by entering into a variety of contracts. For example, at the time that Estero awarded the contracts for the construction of community facilities in Neighborhood One, the partnership separately contracted for the necessary underground utility work. Other contracts entered into by the partnership in respect of Neighborhood One will be described hereinafter. Contracts in respect of other neighborhoods include tripartite agreements entered into by the partnership, Estero, and San Mateo County: in June 1964, for the construction *209 of improvements in Neighborhood Two; in July 1965, for the construction of community facilities in Neighborhood Three; in November 1965, for the construction of community facilities in Neighborhood Four; in February 1967, for the construction of community facilities in Neighborhood Nine; in March 1968, for the construction of improvements in Neighborhood Eight; and a bilateral agreement entered into by the partnership and Estero for the electrical work in the industrial park. The partnership entered into several of these contracts at times when acreage in several affected neighborhoods was titled in the names of other Foster entities. This matter will be discussed subsequently.
Finally, the Foster partnership held itself out and was regarded as the developer of Foster City. For example, the "Foster City Report," a promotional newsletter published by the Fosters, referred to the partnership as the developer. Estero's bond prospectuses also referred to the partnership as the developer. Correspondence between the Fosters and the Federal Housing Administration characterized the partnership as the developer of Foster City.
*78 3. The Alphabet Corporations
The Alphabet Corporations *210 were formed in September or October 1962. On October 3, 1962, they acquired their equal, undivided interests as tenants-in-common in the 127 acres of land in units 1 and 2 of Neighborhood One.
The Alphabets acted in concert through Foster T. Corp. They did not open separate bank accounts but rather maintained a single account in the name of Foster T. Corp. which was opened in June 1963 and remained active through October 1968. They had no employees or office space separate from the partnership and the other Foster entities. The Alphabets filed Federal income tax returns for the taxable years 1963 through 1969.
From July 1963 through December 1965, the Alphabets collected $ 2,023,900 from the sale of lots in Neighborhood One. These proceeds were deposited into the bank account of Foster T. Corp. During that same period, the Alphabets transferred $ 2,052,500 in stated loans to the partnership for its use in the further development of Foster City.
During the course of the development of Neighborhood One, the Alphabets entered into agreements with, and granted easements to, Estero. However, they were joined in these acts by either the Foster partnership or Jack Foster acting on *211 behalf of the partnership. For example, in January and October 1963, agreements were entered into by the Alphabets, the partnership, Estero, and San Mateo County for the construction of improvements in two tracts of Neighborhood One. In April 1963, the Alphabets and the partnership granted an easement to Estero for the maintenance and operation of lagoons in Neighborhood One.
The Alphabets also entered into agreements with other parties. Again, however, they were joined in these contracts by either the Foster partnership or Jack Foster acting on behalf of the partnership. For example, in May and December 1963, the Alphabets and the partnership entered into agreements with Pacific Gas & Electric Co. to provide gas and electric service to unit 1 of Neighborhood One.
Included within the 127 acres of land in Neighborhood One were a number of waterfront (lagoon) lots. These lots were not sold but rather leased by the Alphabets to builders who would construct and sell homes subject to 75-year ground leases. The *79 income derived by the Alphabets from this activity was not reallocated by respondent.
The involvement of the Alphabet Corporations in Foster City was not confined *212 to Neighborhood One. In January 1964, the Alphabets and the partnership contracted with Estero for the construction of improvements in part of the industrial park. In May 1967, the Alphabets purchased lots in the industrial park from Lomita Homes, a subsidiary of Likins-Foster Honolulu Corp., which had previously purchased them from the partnership in 1964 and 1965. In late 1965, the Alphabets undertook to construct the Commodore Apartments, the first section of which was completed in early 1967. These apartments were located in Neighborhood One and were built on land owned by the Foster partnership. Their construction was financed in part by bank and insurance company loans and in part by proceeds derived from the sale of lots in Neighborhood One. In 1968, the Commodore Apartments were sold to a third party in order to obtain working capital. At the time, the Foster partnership was experiencing a serious cash flow problem and the sale of the apartments was part of a program to partially liquidate investment property in order to insure the survival of the Foster City project.
C. SALE OF LOTS IN NEIGHBORHOOD ONE The Fosters originally anticipated that income from the sale of *213 lots in Neighborhood One would first be derived in 1962. However, the first block of sales was delayed primarily because the filling operation took longer than had been anticipated. By November 1962, the Fosters were projecting income by January 1963.
Negotiations between the Fosters and interested builders for the sale of lots in unit 1 of Neighborhood One began in 1962. The Fosters discovered that there were so many contractors in the Bay area who were eager to build in Foster City that it was not necessary to reduce the asking price.
In January 1963, a subdivision map of unit 1 of Neighborhood One was recorded with the county of San Mateo. The map had previously been reviewed by both the county planning commission and engineer and approved by the board of supervisors. Sales of lots were not permitted until the map was recorded. However, recordation necessitated the posting of a *80 subdivision bond by the developer to insure that all improvements would be completed to the county's satisfaction. Recordation also precipitated a reappraisal for real estate tax purposes and generally higher taxes. Accordingly, it was usually advantageous for the developer to delay recordation *214 until sales were anticipated.
Unit 1 of Neighborhood One consisted of 626 lots. Of this number, 410 were tract lots for outright sale and 216 were waterfront (lagoon) lots which were to be leased to builders who would construct and sell custom homes subject to 75-year ground leases.
The first sales were made in June 1963 to three prominent west coast builders for between $ 5,000 and $ 6,000 per lot. In August, construction began, and the first homes were completed that fall. In 1963, a total of 247 tract lots were sold and 11 waterfront lots were leased to four different builders. Additional lots were sold and leased in 1964 and 1965. The disposition of certain lots was delayed, however, because of FHA regulations regarding fill and foundation.
D. ROLE OF DEL CHAMPLIN A. O. "Del" Champlin was born in 1911. He attended the University of Oklahoma, majored in accounting, and graduated in 1932. In 1935, he became licensed to practice as a certified public accountant in Oklahoma and had offices in Oklahoma City. For most of his career, he practiced accountancy as a partner in various accounting firms which typically employed a number of staff accountants. Champlin supervised the *215 detail work involved in matters such as performing audits and preparing returns and personally provided income tax, business, and financial planning services to his clients.
Champlin met Jack Foster through V. B. Likins, for whom he had been performing accounting services, and was retained by him. Champlin serviced both Foster individually and the various Likins-Foster businesses and became one of their principal tax planners. He was frequently called upon to structure transactions in order to achieve favorable tax consequences. One of his favorite techniques was multiple incorporation and as a consequence Foster and Likins ended up with many different corporations.
After Jack Foster severed his business relationship with *81 Likins in 1955 and went into partnership with his sons, Champlin and his firm continued to perform a broad range of accounting services for the Fosters. He continued to function as one of their principal tax planners. Certain transactions which he structured during the immediate post-Likins period resulted in litigation before this Court. 24
*216 Champlin remained in Oklahoma after Jack Foster moved to California in 1958. However, as the Fosters became increasingly interested in the prospect of undertaking the Foster City project, Champlin began spending more and more time in California. At the request of Jack Foster, he moved to San Mateo in January 1961 and became licensed to practice as a C.P.A. in California. Although he continued to function as an independent contractor, the Fosters were virtually his only client and he shared their offices. The rest of his firm continued to service the Foster account from Oklahoma.
At Foster City, Champlin became the Fosters' principal tax adviser and architect of their tax planning. He was expected to minimize their taxes to the extent possible and to postpone the payment of those taxes which could not be avoided because the Foster partnership needed to retain as much cash as possible for the development of Foster City. The value of money on hand to the Fosters far exceeded any interest that might eventually have to be paid on a tax deficiency, especially when the rate of interest that the Government charged was less than that charged by commercial banks. Accordingly, a particular *217 tax strategy was not necessarily rejected merely because it might result in litigation or even ultimately fail. The more important criterion was the extent to which that strategy would promote the immediate availability of cash for the partnership's use in developing Foster City.
In order to minimize taxes, Champlin sought to shift income among multiple entities. He was responsible for the creation of numerous trusts and corporations. In 1962, Jack Foster claimed that he alone owned some 52 corporations. This multiplicity of entities frequently complicated the Fosters' operations. Champlin also sought to postpone the payment of *82 taxes by engaging in a variety of stalling tactics whenever the Commissioner undertook to audit the Fosters or one of their entities. For example, the adjustments in the case involving Likins-Foster Honolulu Corp., et al. (see note 24, supra ), took nearly 10 years to ultimately resolve.
The Fosters regarded Champlin as the "steward" of their taxes. They reposed great confidence in his tax-planning abilities and trusted him implicitly. They never challenged his recommendations but rather adopted them without critical analysis and implemented *218 them immediately. They never questioned him concerning his reasons for transferring acreage between entities or structuring a transaction in a particular manner. As a consequence, they frequently did not understand why certain measures were being taken.
Champlin's recommendations dictated the basic organizational structure within which the Fosters undertook to develop Foster City. He determined that it would be advantageous from a tax standpoint for them to begin in partnership form. Losses incurred during the early years could be utilized by the partners to reduce income on their personal returns. Later, as land was developed, acreage could be transferred to a corporation in an effort to shift income to a taxpayer subject to a lower rate of tax.
In 1962, Champlin determined that corporations should be formed for the purpose of taking title to some of the land in Neighborhood One. Accordingly, the Alphabets were incorporated, and the 127 acres were transferred to them. Champlin even designated the particular acreage that was conveyed. The Fosters did not question the transfer nor did they inquire about the reason for it. Rather, they assumed that it was for the purpose of *219 minimizing their income taxes.
E. ULTIMATE FINDINGS OF FACT Estero was controlled and dominated by the Foster partnership.
The Foster partnership used Estero as its instrument for the development of Foster City.
The Foster partnership was responsible for the development of Neighborhood One.
The Foster partnership earned the income derived from the sale of lots in Neighborhood One.
*83 The 127 acres of land in Neighborhood One were conveyed to the Alphabet Corporations in order to shift income from the Foster partnership and split it among four other taxpayers.
The 127 acres of land in Neighborhood One were conveyed to the Alphabet Corporations in order to avoid Federal income taxes.
IV. Facts Related to the Sale of Lots in Neighborhoods Two and Three (Issue 2) Neighborhoods Two and Three were the next neighborhoods to be developed. Each consisted of 215 acres. The land in Neighborhood Two was completely reclaimed and improved and available for building by mid-1965, and the land in Neighborhood Three, by mid-1966. The Foster partnership sold lots in these neighborhoods during the taxable years involved in this case and reported the income and deducted the expenses related to *220 those sales on its information returns.
In the notice of deficiency, respondent adjusted the cost claimed by the Foster partnership in respect of its sale of lots in Neighborhoods Two and Three as follows: 1963 1964 1965 1966 1967
($ 203.52) $ 1,000,842.67 $ 1,580,722.23 $ 67,473.87 ($ 164,504.72)
This adjustment was described in the notice as follows:
1.b. Cost of lot sales, neighborhoods 2 & 3
It has been determined [that] the cost of lot sales reported should be adjusted as shown in Exhibit G-3 and supporting exhibits referred to therein. The principal change is due to a disallowance of a $ 3,000,000.00 obligation incurred in the "Westway Transaction" as not being part of land basis because: (1) there is no business substance to such transaction and (2) if this is a valid business obligation, it is not a capital expenditure to be added to land basis.
Only the "Westway" component of this adjustment is in dispute.
Also in the notice of deficiency, respondent made a related adjustment in favor of the Foster partnership to gain it reported in 1964. This adjustment was described in the notice as follows:
1.e. If it is ruled by a court that there is no business *221 substance to the form of the "Westway Transaction" as specified in item (b) above, and thus should be disregarded, then it is held [that] the gain of $ 84,143.52 reported by the *84 partnership on its exchange of 500 shares of Foster California Corporation stock for 196.38 acres of land received from that corporation, will also be disregarded, such exchange being part of the "Westway Transaction."
As the above two explanatory paragraphs indicate, the factual predicate of the issue involving Neighborhoods Two and Three lies in the Westway transaction. That transaction consisted of a complicated series of steps, the crucial one of which involved the delivery of certain promissory notes which the parties refer to as the Westway notes. We must ultimately determine whether those notes were part of the partnership's basis in Neighborhoods Two and Three, as petitioners' maintain, or whether they represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island, as respondent maintains. At this time, however, we shall merely describe the Westway transaction.
A. GENESIS OF THE WESTWAY TRANSACTION As previously stated, the terms negotiated by Jack *222 Foster for the purchase of Brewer's Island contemplated a downpayment of $ 2,500,000. However, the immediate payment of that amount was not compatible with the need for cash anticipated by the partnership once the Foster City project was actually underway. Accordingly, the Fosters determined that most of the downpayment would have to be financed. At that point, they turned to the Republic National Bank.
The Fosters turned to Republic for financial assistance because they were frequent customers of that bank and enjoyed a good credit rating. Jack Foster in particular had a long and cordial business relationship with the bank that dated from the 1940's. Over the years, he had borrowed millions of dollars and had never been refused a loan. Republic had been the Fosters' major source of financing for their previous real estate transactions and had also acted as their lender for certain other of their undertakings such as oil and gas ventures. Never, however, had Republic ever assumed any role in relation to the Fosters other than that of lender.
Shortly after the enactment of the Estero Act in May 1960, the Fosters met in Dallas with senior bank officials to discuss the possibility *223 of financing the partnership's downpayment on Brewer's Island. Participants at this meeting included Fred Florence, Republic's chairman of the board; James Aston, its *85 president; and Oran Kite, a senior vice president. The Fosters recognized that it was customary for developers to furnish their own downpayment and finance only the balance of the purchase price. In order to induce Republic to advance the necessary funds, they proposed to pay not only interest at the prevailing market rate but also a bonus equal to the total amount borrowed from the bank to acquire Brewer's Island. The bonus, however, would be payable only from half the profits derived from the project in 5 years' time. As an additional inducement, the Fosters proposed to structure the bonus so that it would be taxed to the bank as capital gain rather than ordinary income. Del Champlin had conceived this part of the proposal.
At the conclusion of the Fosters' presentation, Republic's chairman patted Jack Foster on the leg and remarked, "I guess we're partners." The parties then shook hands. The terms of their agreement were not subsequently reduced to writing. As in previous dealings between the Fosters *224 and the bank, negotiations were concluded and terms agreed upon by handshake.
On August 19, 1960, Jack Foster purchased Brewer's Island on behalf of the partnership for $ 12,800,000. The $ 2,500,000 downpayment included $ 2 million which was obtained on August 16, 1960, by virtue of the agreement that had previously been negotiated with Republic. The loan documents which were executed on that date, however, reflect the involvement of the Hoblitzelle Foundation and the Howard Corp. Before proceeding further, we should briefly introduce those two entities.
The Hoblitzelle Foundation was affiliated with the Republic National Bank. It was founded by Karl Hoblitzelle, who was Republic's chairman prior to Fred Florence. James Aston, Republic's president and later its chairman, served at various times as the foundation's president and a member of its board of directors. The Howard Corp. was a corporation the stock of which was owned by trustees for the benefit of Republic's shareholders.
On August 16, 1960, the Fosters entered into a purported loan agreement with the Howard Corp. in which the latter agreed to arrange a $ 2 million loan from an unspecified lender in exchange for a $ *225 50,000 service fee. The agreement provided, *86 inter alia, that the loan proceeds were to be used for the downpayment on Brewer's Island. It also restricted the Fosters' right to sell or mortgage any part of Brewer's Island without the lender's consent. However, transfers between the Fosters and their controlled corporations were expressly exempted from this restriction.
On August 16, 1960, the Fosters also executed a $ 2 million promissory note payable to the Hoblitzelle Foundation. That note was unsecured, bore interest at the prevailing market rate (6 percent per year), was payable quarterly, and was due absolutely and in all events in 2 years. The cash advanced against that note was the source of most of the partnership's downpayment for its purchase of Brewer's Island.
Finally, on August 16, 1960, the Howard Corp. agreed with the Hoblitzelle Foundation to purchase the Fosters' note, if called upon to do so by the foundation, for an amount equal to the unpaid balance plus accrued interest at the time of such purchase. In addition, it agreed to pay the foundation an amount equal to 3 1/2 percent per year on the unpaid balance of the note during the period of the foundation's *226 ownership.
Notwithstanding the involvement of the Hoblitzelle Foundation and the Howard Corp. in making the $ 2 million loan, the Fosters at all times regarded Republic as their lender. Accordingly, the fact that their note was made payable to an entity other than the bank never led them to question whether their agreement to pay the 100-percent bonus might not apply.
As previously stated, Jack Foster executed promissory notes to the sellers (Leslie and Schilling) for the balance of the purchase price of Brewer's Island ($ 10,300,000). The payment schedule for those notes called for payments of $ 500,000 on August 19, 1961, and August 19, 1962. On each of those dates, the partnership borrowed the entire amount of the payment from Republic. Because those amounts represented part of the purchase price of Brewer's Island, they were subject to the agreement to pay the 100-percent bonus.
On August 19, 1962, the original $ 2 million loan from the Hoblitzelle Foundation was extended to August 19, 1963. On August 17, 1963, the Fosters satisfied this loan by borrowing $ 2 million from Republic.
*87 B. MECHANICS OF THE WESTWAY TRANSACTION
By August 19, 1962, the Fosters had borrowed *227 a total of $ 3 million from Republic and its affiliated foundation for the purchase of Brewer's Island. By the following year, all of this amount was owed to the bank. Under the terms of the agreement negotiated in 1960, Republic was therefore entitled to a bonus of $ 3 million payable from half the profits in 5 years' time. (The provision that the bonus be paid from half the profits was subsequently waived by the Fosters.) Republic was also entitled to the bonus on a capital gains basis. Del Champlin was assigned primary responsibility for structuring a transaction to achieve this result. What was devised was the Westway transaction. We shall defer discussion of the tax planning surrounding that transaction until after we describe the form of its several steps. Suffice it to say for now that the transaction was designed not only to insure favorable tax consequences to Republic but to the Fosters as well.
1. On August 4, 1961, Jack Foster, acting on behalf of the Foster partnership, conveyed 200.17 acres of land in Neighborhoods Eight and Nine to Foster Bayou Corp. (Foster Bayou) in exchange for 100 percent of that corporation's stock, which was titled in the name of the partnership. *228 This exchange was treated as a nontaxable transaction. Foster Bayou had been formed by the partnership on or slightly before that date. Other than the land, it had no assets. It also had no bank account and never paid any dividends. At the time of the conveyance, the 200.17 acres was dry land which had previously been leased by the Federal Aviation Administration to erect and maintain radio transmitters. (Foster City is located about 5 miles south of San Francisco International Airport and 10 miles southwest of Oakland Airport.) This lease constituted Foster Bayou's only business activity. 25 Unlike the rest of the land on Brewer's Island, the 200.17 acres had a legal description. However, being part of Neighborhoods Eight and Nine, it was not scheduled for early development. In fact, development of Neighborhood Nine was only initiated in 1967; by the end of *88 1969, Neighborhood Eight was only in a state of token development.
*229 2. On August 7, 1962, the Foster partnership transferred its stock in Foster Bayou to Westway Investment Co. (Westway) for a named consideration of $ 5,000 in cash and a non-interest-bearing note due August 7, 1967, in the amount of $ 100,000. Westway was a subsidiary of the Howard Corp. As previously stated, the sole asset of Foster Bayou was the 200.17 acres of land in Neighborhoods Eight and Nine. On the date of the transfer, this land was in essentially the same condition as when it was originally acquired by the Foster partnership. Westway did nothing to improve it during the period that it held the Foster Bayou stock (Aug. 7, 1962 -- May 4, 1964). Moreover, during that same period, Foster Bayou's expenses (such as real estate taxes) were paid by the partnership or Likins-Foster Honolulu Corp. whenever its rental income was insufficient in amount.
3. On April 23, 1963, the Esteroy Corp. (Esteroy) was formed by the Foster partnership. Other than a $ 10,000 capital contribution, Esteroy had no assets. It used as its address the same post office box as the partnership. On its Federal income tax return for the taxable year beginning April 23, 1963, and ending February 29, *230 1964, Esteroy reported no gross income and claimed deductions in the aggregate amount of $ 188.06, including amortization of organizational costs in the amount of $ 83.06 and franchise taxes of $ 105.
4. On December 3, 1963, the Foster partnership conveyed 196.638 acres of land in Neighborhoods Two and Three to Foster California Corp. (Foster California) in exchange for 500 shares, or one-half, of that corporation's authorized stock. 26 This exchange was treated as a nontaxable transaction. Foster California had been formed by the partnership on January 17, 1961, but had been dormant since its incorporation. Prior to the first meeting of its board of directors on December 3, 1963, it had not even issued stock. Prior to the conveyance of the 196.638 acres of land, it had no assets other than its initial capital contribution of $ 1,200. Foster California had no bank account, conducted no business activity, and paid no dividends.
*231 *89 5. Also on December 3, 1963, the Foster partnership transferred its 500 shares of Foster California stock to Foster Enterprises, Ltd. (Foster Enterprises). Foster Enterprises was a corporation which had been formed in 1960 to hold the Foster Tower Hotel in Honolulu and was solely owned by the Fosters in equal shares. It treated the transfer of the Foster California stock as a contribution to its capital. (Foster Enterprises also plays an important role in Issue 3, infra .)
6. In January and February 1964, Esteroy and Westway negotiated what was in form a purchase and sale of all of the Foster Bayou stock for a named consideration of $ 3,105,000, consisting of $ 5,000 to be paid in cash at the closing and non-interest-bearing promissory notes for the balance, or $ 3,100,000. This latter sum was payable in the amounts of $ 2 million on August 19, 1966, $ 100,000 on August 7, 1967, $ 500,000 on August 19, 1967, and $ 500,000 on August 19, 1968. The promissory notes for these amounts are the so-called Westway notes. Although they were executed by Esteroy, they represent the first written agreement evidencing the partnership's obligation to pay the 100-percent bonus which *232 had been negotiated in 1960. Moreover, the notes were unconditional, i.e., payment was not conditioned upon the earning of profits. Finally, they were secured by a pledge of Esteroy's stock.
Although the Westway notes were executed and delivered in February 1964, they were dated May 4, 1964. On that date, Westway transferred the Foster Bayou stock to Esteroy.
7. On June 2, 1964, Esteroy liquidated Foster Bayou and entered on its books the 200.17 acres of land in Neighborhoods Eight and Nine at a basis of $ 3,105,000. At the time that Foster Bayou had acquired that parcel, it had debited its land account in the amount of $ 1,333,648 and had credited "mortgages payable" in the amount of $ 1,142,664.
8. Three days later, on June 5, 1964, Esteroy conveyed the 200.17 acres of land that it had received from Foster Bayou to Foster California in exchange for 500 shares ($ 5,000 par value) of that corporation's stock. The 500 shares represented the remaining one-half of Foster California's authorized stock.
9. Three days later, on June 8, 1964, Esteroy was liquidated by the Foster partnership. At that time, its principal asset was the 500 shares of stock in Foster California. On its *233 final Federal income tax return for the period beginning March 1, *90 1964, and ending June 7, 1964, it reported no gross income and claimed deductions in the aggregate amount of $ 465.30, including amortization of organizational costs in the amount of $ 415.30.
At the time of its liquidation, Esteroy was indebted to Westway in the amount of $ 3,100,000. On July 24, 1964, the Fosters expressly and unconditionally assumed this indebtedness. At the time that Esteroy had pledged its shares as collateral for the purported purchase of the Foster Bayou stock, it had reserved the right to liquidate and substitute for the pledged shares the personal guarantee of the Fosters.
10. On July 31, 1964, the Foster partnership transferred to Foster California the 500 shares of stock in Foster California which it had acquired on June 8, 1964, by virtue of the liquidation of Esteroy. In exchange for its stock, Foster California transferred to the partnership on August 4, 1964, the 196.638 acres of land in Neighborhoods Two and Three which it had acquired from the partnership on December 3, 1963. This transaction was treated as a taxable exchange, and the partnership reported gain. (See the *234 adjustment in the notice of deficiency which was previously quoted.) Afterwards, Foster California was a solely owned subsidiary of Foster Enterprises.
11. In December 1965, Westway sold to Republic for $ 952,176 one-half of the $ 2 million promissory note due August 19, 1966, which Esteroy had executed in 1964 as part of the purported purchase price of the Foster Bayou stock. This left Westway with a remaining receivable of $ 2,100,000. Westway was subsequently merged into the Howard Corp., which then became the holder of that receivable.
12. By their terms, the Westway notes were due in the months of August 1966, 1967, and 1968. The Fosters were able to successfully negotiate certain renewals. However, by the end of 1968, they had become delinquent in payment. This matter will be discussed later in greater detail.
13. On June 1, 1970, Foster California (whose name had been changed to Foster C Corp.) was merged into its parent, Foster Enterprises. As we shall see, Foster Enterprises had a history of substantial net operating losses. It received the 200.17 acres in Neighborhoods Eight and Nine, less some acreage that had been previously sold, and entered the land on *91 *235 its books at $ 3,105,000. That amount represented Foster California's basis for the land and not the basis of the stock canceled.
14. In October 1970, the Fosters withdrew from Foster City as developers. The purchaser, Centex West, Inc. (Centex), agreed to assume liability for the Westway notes. In a collateral agreement, Republic and the Howard Corp. agreed to release the Fosters from personal liability in exchange for the assumption by Centex as well as other consideration which will be described subsequently. As far as the Fosters were concerned, the Westway notes were satisfied at that time.
C. TAX PLANNING The principal architect of the Westway transaction was Del Champlin, who had conceived the idea. He was assisted by Roy Lytle, an Oklahoma attorney who represented the Fosters throughout the 1950's and until his retirement in the 1960's. Republic was represented in this matter by James Laney, its attorney, as well as by senior bank officials.
The objective of the Westway transaction from Republic's point of view was to insure that the $ 3 million bonus was taxed as capital gain rather than as ordinary income. Republic sought to achieve this objective through the purported *236 purchase of Foster Bayou stock in 1962 by Westway for $ 105,000 and the subsequent sale of that stock by Westway in 1964 for $ 3,105,000.
The objective of the Westway transaction from the Fosters' point of view was to raise $ 3 million through tax savings in order to pay the bank its bonus. They sought to achieve this objective by stepping up not only the partnership's basis in the 196.638 acres of land in Neighborhoods Two and Three by $ 3,105,000, but also Foster California's basis in the 200.17 acres of land in Neighborhoods Eight and Nine by the same amount, for a total step-up in basis of $ 6,210,000. They also contemplated making Foster California a wholly owned subsidiary of Foster Enterprises. By filing consolidated returns, they hoped that the latter's net operating losses would absorb the income derived by the former from the sale of lots. As events transpired, Foster California was merged into Foster Enterprises in 1970.
The mechanics of the Westway transaction, as described *92 above, evolved over a period of time. Virtually from the time that the loan and bonus were originally negotiated, there were discussions between the parties concerning the manner in which *237 the transaction should be structured in order to achieve their respective objectives. For example, in early August 1960, Jack Foster asked Roy Lytle to attend a meeting in Dallas with James Laney and bank officials to discuss the transaction. Afterwards Lytle summarized for Foster a proposal which was discussed at that meeting and from which the Westway transaction gradually evolved:
1. Foster will pay $ 50,000.00 to Howard Corporation for its services in arranging $ 2,000,000.00 loan from Hoblitzelle Foundation * * *
2. Foundation will lend $ 2,000,000.00 to T. Jack Foster, with interest at 6%, payable quarterly, due in two years, unsecured * * *
3. There shall be organized a Delaware corporation named "Foster Laguna Corp." (which name will be used unless you pick out another one later on). This corporation shall have an authorized capital of $ 10,000.00. To this corporation shall be conveyed all of Foster's interest in a tract of land on Brewer's Island covering some 150 to 200 acres of land, it being intended to cover a part of the tract that will be first developed * * * The consideration for this conveyance will be the issuance of all of the stock of the corporation to Foster. *238 * * *
4. Foster will sell all of the stock of Laguna Corp. to Wayside (this is not the exact cor

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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/4594633. Public record. Not legal advice.