Petition — Cappuccilli v. Commissioner

October Term, 1982

GRACE CAPPUCCILLI, DOROTHY CAPPUCCILLIi,

GERALD F. PADUANO and CAROLINE PADUANO,

Petitioners,

vs.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION FOR WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

VICTOR CHINI, ESQ.

Attorney for Petitioners

Office and Post Office Address

915 State Tower Building

Syracuse, New York 13202

Telephone: (315) 422-7771

Of Counsel:

STANLEY R. GERMAIN

314 East Fayette Street

Syracuse, New York 13202

Telephone: (315) 422-4163

on

QUESTION PRESENTED — ISSUE ONE

Section 482! of the Internal Revenue Code of 1954 (26USC)

and the Treasury Regulations thereunder authorizes the Com-

missioner to impute interest income on loans between con-

trolled parties where a reasonable rate of interest has not been

charged.

The question presented is whether the Commissioner may,

under Section 482, impute interest income to CCP for the years

1970-1971-1972 on interest free loans and mortgage which it

made to Stonehedge, a controlled related party, where CCP,

received no imputed interest payment and where the payment

of said interest to CCP from Stonehedge was prohibited by

legal disability. The Second Circuit Court of Appeals affirmed

the U.S. Tax Court in upholding the Commissioner’s deter-

ruination.

QUESTION PRESENTED — ISSUE TWO

The Second Circuit Court of Appeals in a landmark case

upheld the Commissioner’s right under Section 482 to impute

interest income on interest free loans between related parties. B.

Forman Co. v. Commissioner, 453 F.2d 1144 (2d Cir. 1972),

cert. denied, 407 U.S. 934 (1972), rehearing denied, 409 U.S.

899 (1972).

ITitle 26 USCS Section 482 provides: —

“In any case of two or more organizations, trades, or businesses

(whether or not incorporated, whether or not organized in the

United States, and whether or not affiliated) owned or controlled

directly or indirectly by the same interests, the Secretary or his

tions, trades, or businesses, if he determines that such distribution,

apportionment, or allocation is necessary in order to prevent

evasion of taxes or clearly to reflect the income of any of such

- organizations, trades, or businesses.’’

ii

The question presented is whether the Commissioner’s ten

year retroactive application of Section 482 for the years 1970-

71-72 to an interest free mortgage (of $1,075,000) executed in

1962 by CCP and Stonehedge is so arbitrary and oppressive as

to violate the Petitioners’ Fifth Amendment rights under the

constitution.

QUESTION PRESENTED — ISSUE THREE

If the Court holds for the Commissioner on Issues One and

Two, then: the question presented is whether the Commis-

sioner’s imputation of interest income to Paduano a partner of

CCP (having three equal partners) at a time when CCP had

interest free loans and mortgage due from Stonehedge and

Seneca corporations which were totally owned by the other two

partners, violates the Fifth Amendment rights of Paduano who

has no interest in the corporate obligors.

QUESTION PRESENTED — ISSUE FOUR

The Petitioners who were assessed income taxes on imputed

interest income (under Section 482) for the years 1967-1972,

attempted to take a tax deduction in 1975 when the imputed

interest income was deemed to be uncollectible.

The Tax Court denied Petitioners’ deduction on the theory

that any such deduction should be taken in 1976, (App. D,

infra, 40a, 41a) a year not before the Tax Court. Affirming the

denial of the dedtiction on entirely different grounds, the

Second Circuit Court of Appeals held that Petitioners were

seeking a double deduction. (App. A., infra, 6a).

The question presented is whether the denial of a tax

deduction to Petitioners on uncollected and uncollectible

imputed interest income on which taxes were assessed (and

paid) constituted a violation of Petitioners’ Fifth Amendment

rights.

oe!

7

ae i aes

iii

_ QUESTION PRESENTED — ISSUE FIVE

For purposes relevant to this issue, Section 1221 defines

“‘capital asset’’ as

“property held by the taxpayer (whether or not

connected with his trade or business), but does not

include — ;

(1) stock in trade of the taxpayer or other property

of a kind which would properly be included in the in-

ventory of the taxpayer if on hand at the close of the

taxable year, or property held by the taxpayer primarily

for sale to customers in the ordinary course of his trade

or business’”’ ‘

Section 1221(1)

The United States Tax Court held that CCP recognized

ordinary income and not capital gain on the sale of vacant land

to Stonehedge in 1962 because CCP was a developer. This hold-

ing was based not on CCP’s activities but on an erroneous

principle of law, a joint venture theory, in which the Tax Court

attributed Stonehedge’s development activities to CCP. The

Second Circuit Court of Appeals which did not embrace the

Tax Court’s joint venture theory, nevertheless, on an entirely

different theory affirmed.

The question presented is whether the Second Circuit Court

was justified in making a finding that CCP sold the subject

property in the ordinary course of its trade or business under

Section 1221(1) where the Tax Court’s findings of CCP’s lack

of development activity were not clearly erroneous.

Reason for Granting Certiorari on Issue Une.........

Reason for Granting Certiorari on Issue Two ........

Reason for Granting Certiorari on Issue Three .......

Reason for Granting Certiorari on Issue Four ........

Reason for Granting Certiorari on Issue Five.........

APPENDICES

ties Second Circuit ooo eis pc cls cdc ccaveccvecs

APPENDIX B — Order of U.S. Court of Appeals for

the Second Circuit Denying Rehearing............

APPENDIX C — Judgment of U.S. Court of Appeals

for the Second Circuit .......--++sesseeeeeeees

APPENDIX D — Opinion of United States Tax Court .

APPENDIX E — Decision and Order of U.S. District

Cee OF eee Fe ie SE vig be kPa awccc cic eVeiebs

Py

2

«

v

TABLE OF AUTHORITIES

Page

United States Constitution

SEE EPE PPT ee Es tee oP Ee 10, 13, 19

Cases:

B. Forman Co. v. Comm., 453 F2d 1144 (2d Cir. 1972)

cert. den. 407 U.S. 934 (1972)... 2... cece eee eenes 6, 9, 16

Bank of Coushatta v. United States, 650 F2d 75 (Sth Cir.

DEE 6 xin Sind Ge bee es EONS PORES bts vs 7

Bunker, Owen W., §79,174 P-H Mem. T.C. Memo

SME TREITEN sf abcchadi cpdbes soc opnie ews a’ 7

Burnet v. Clark, 287 U.S. 410 (1932) ..........5-- 13, 16, 21

Cohan v. Commissioner, 39 F2d 540 (2d Cir. 1930)... . 10

Commissioner v. First Security Bank of Utah, 405 U.S.

394 31 L.Ed. 2d 318, 92 S.Ct. 1085 (1973) ..... 5,7, 8,9, 11

Corn Exchange Bank v. United States, 37 F2d 34,35 (2d

ees eo ee 7,13

Delta Life Insurance Company v. U.S., 73-2 USTC

§9663, D.C. E.D. La. 363 F. Supp. 410(1973)...... 7

Gault v. Commissioner, 332 F2d 94 (2d Cir. 1964). .... 20

Gordy v. Commissioner, 36 T.C. 855 (1961) ....... 13, 16, 21

Heiner v. Donnan, 285 U.S. 312, 326 (1932) ......... 10, 13

Hennessey v. Commissioner, T.C. Memo 1977-122.... 15

Jarvis v. Commissioner, 32 T.C. 173 (1959) ....... 13, 16, 21

Moline Properties, Inc. v. U.S., 319 U.S. 436 (1943) ... 13, 16

Moritz v. Comm., 469 F2d 466(10 Cir. 1972) ........ 18

* m . < . :

e

a

tant

ag a. 4,

*

vi

, Page

Morton-Norwich Products, Inv. v. U.S., 602 F2d 270

SE a: COT As orcaviccetee canae Ms taes of 14

Nichols v. Coolidge, 274 U.S. 531, 542 (1927) ...... 10, 13, 19

Paduano v. Commissioner, $38 F2d 312 (2d Cir. 1975)

cert. den. 425 U.S; 992 (1976)... . oe ee ee ee 4

Pitchford v. Commissioner, T.C. Memo 1975-75. ..... 14

Reisman v. Caplin, 375 U.S. 440 (1964). ............ 12, 20

Taxation with Representation of Washington v. Regan,

82-IUSTC 49272, p. 8361 (D.C. Cir. 1982)........ 19

Tharp v. Commissioner, T.C. Memo 1972-10 ........ 13

U.S. v. Basye, 410 U.S. 441 (1973). ... 0. 6. eee eee 8

U.S. vy. Darusmont, 449 U.S. 292 (1981) reversing and

remanding District Court 80-2 USTC § 9671, p. 85208

Soe ib, a's Bias vig Sh cb ebb ooo ohare wees kh aaede's 10

U.S. v. Stapf, 375 U.S. 118 (1963) rehearing denied 375

WN MD eiele a 5 os Vika odo eee ah ameed ot ce kunens 13

U.S. v. Vogel Fertilizer Co., 82-1 USTC §9134 (S.Ct.

SORT OGIO Gin a Badin ova cig < HEP o Leb ds 9 bes 12,19

Statutes and Regulations:

Internal Revenue Code of 1954: (26 U.S.C.)

I ED 6. alec 4a he Wie 6 a%' so ete weeks 2, 15, 17, 19

Ne. oes ais. ii eee iS a 2, 15, 17, 19

he 6

she a ae bef Pa

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: vii

‘ Page

Section 1221... .. wikia s wus CORRS Lae e's.» tgs 20

NN REE Re RT een 2,14

sisiaie hadchics iliac allo (26. F.R.)

Section 1.482-1(b)(3) ........ Git, mw ncaescecdis 2, 18

Sectiont TAMA-MANID 5 Eas ccc sccis ei ecees 2, 13,14

DONOR 3 hs xx 6-0 626402 FRE KA A Rs oe ig 18

SARIN wok neta bess chcenecaned 2,9

Section 1 AOD-MANMD: Ti iS oes ca iGo cweee 9

Miscellaneous:

Mertens Law of Federal Income Taxation Volume 7,

OURS 6.55 c4 oF ocknn Neck bas Chaedna coeds 6

Rev. Procedure 65-17 Se.3.02, Séc. 4.02 1965 -1 C.B.

$33.0... Nios $:0as RDP TTS Ieee re tes 2, 13,14

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f 2) - * *

—_—.P

In The

Supreme Court of the Batted States

October Term, 1982

No.

GRACE CAPPHUCCILLI, DOROTHY CAPPUCCILLI,

GERALD F. PADUANO and CAROLINE PADUANO,

Petitioners,

vs.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

= = —————SS

(PETITION FOR WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

Victor Chini, attorney at law, on behalf of Grace Cap-

puccilli, Dorothy Cappuccilli, Gerald F. Paduano and Caroline

Paduano, petitions for a writ of certiorari to review the

judgment of the United States Second Circuit Court of Appeals

in this case.

OPINIONS BELOW

The opinion of the Second Circuit Court of Appeals (App.

A, infra, 1a-10a) affirming the United States Tax Court is

reported at 668 F2d 138 (2d Cir. 1981), 82-1 USTC §9118,

p. 83059. The United States Tax Court opinion (App. D, infra,

14a-45a) is reported at T.C. Memo 1980-347; 40 TCM 1084.

oA ial

‘The opinion of the Second Circuit Court of Appeals was filed

on Deceinber 29, 1981. The judgment of the Second Circuit

Court of Appeals was also entered on December 29, 1981 (App.

C, infre, 12a, 13a). The order denying rehearing en banc was

entered on January 27, 1982 (App. B, infra, ila). The

jurisdiction of this Court is invoked under 28 U.S.C. 1254.

STATUTE AND REGULATIONS

The relevant provisions of Sections 165, 166, 482, 6601 of the

Internal Revenue Code of 1954 (26 U.S.C.), and of Treasury

Regulations, Sections 1.166-1(a)({1) and (2), 1.166-1(c), 1.482-

i(aX(3), 1.482-1(aX(6), 1.482-1(b){1), 1.482-1(b)(3), 1.482-

1(dX{1) and (2), 1.482-2(a)(1) (26 C.F.R.), and Revenue

Procedure 65-17, Section 3.02, 4.02 1965-1 C.B. 833, are set

forth at App. D., infra, 50a-66a.

STATEMENT

1. In 1954, brothers Peter and Rocco Cappuccilli formed a

partnership with Gerald Paduano hereafter referred to as CCP.

Each partner had a one-third interest in the partnership. (App.

A, infra, 3a). The ‘wee partners had organized the Stonehedge

Development Corporation (Stonehedge) in April of 1953 and

subsequently organized the Seneca Sewerage Corporation

(Seneca) in April of 1961. The stock of Stonehedge and Seneca

was owned equally by the Cappuccilli brothers and Paduano

until May 26, 1969 when Paduano retired his stock in the

corporations and the Cappuccillix brothers became 100%

owners of both corporations. Paduano remained a partner in

CCP throughout all of the years in question. (App. A, in/ra,

3a)., '

All parties filed joint tax returns but, as the Cappuccilli’s

filed bankruptcy petitions in 1977, the deficiencies were

assessed against their wives. (App. A, infra, 3a).

‘2. In February of 1958 the partnership, CCP, began to

acquire options to buy farm lands adjoining a tract of land

developed by Stonehedge in 1955. (Jt. Ex. 19-S; R. 3) (App.,

infra, 64a)

In 1960-1962, CCP exercised the options that it had acquired

and purchased a number of individual parcels at a cost of

$445,723.00 to assemble a tract known as Seneca Knolls farms.

CCP made no attempt.to improve or subdivide the tract and .

subsequently (after a holding period in excess of six months)”

sold the tract to Stonehedge for a sales price of $1,570,327.39 —

consisting of assumption of mortgages, cash and two

promissory notes, one for $81,000.00 at six percent interest and

one noninterest bearing mortgage note of $1,075,000.00. (App.

A., infra, 3a, 4a; App. D, infra, 17a-19a).

On April 15, 1961, CCP purchased a different parcel of land,

the Preston Farm, from Stonehedge for $25,000.00 and resold

it the next day to Seneca for $40,000.00 which included a

promissory note for $25,000.00 at six percent interest. (App.

A., infra, 4a).

3. Neither Sconehedge nor Seneca paid CCP any interest on

their respective mortgages. (App. D, infra, 21a).

Zoning problems prevented Stonehedge from

developing the land. From 1970 to 1975, Stonehedge

borrowed $500,000.00 from the Merchants National

Bank & Trust Co., on the security of a pending eminent

domain claim against New York State, and in 1972 the

corporation sold land for $223,756, paying the proceeds

to CCP. But from 1970 to 1972, CCP had to advance

cash to Stonehedge to keep the corporation going.

’s debt to CCP for these advances once

totalled $120,000. Stonehedge managed to repay these

advances, but never paid any interest on them. In 1972,

Stonehedge reconveyed part of the Seneca Farms to

2Including the option periods (since 1958) CCP had effective control on all

farms for an average of 43 months. (Jt. Ex. 19-S; R. 3) (App. , infra, 64a)

* CCP and CCP foreclosed on the femainder, in full satis-

faction of Stonehedge’s obligations to the partnership.

Because CCP had received payments on the notes while

Stonehedge was in possession of the land, CCP

recognized gain to the extent of those payments —

$482,577 — upon repossession under I1.R.C. Sec. 1038.

CCP reported this gain as capital gain.

(App. A, infra, 4a).

* 4. The Commissioner concluded that the lack of interest

recognized by CCP on the mortgages to Stonehedge and Seneca

understated the true income of the partnership and, pursuant to

Section 482 of the Internal Revenue Code, allocated some

$325,718.90 in ‘‘interest income”’ to"CCP for 1967-1969. The

Commissioner simultaneously credited the corporations with

an interest deduction in the same amount and the allocation

was upheld in Paduano v. Commissioner, 538 F .2d 312 (2d Cir.

1975), cert. den., 425 U.S. 992 (1976). (App. A., infra, 4a).

In 1975, Stonehedge merged with Community Technology,

Inc. (CTI), which filed a Chapter XI bankruptcy petition in

1976. CCP filed a claim for $325,718.90 in interest income

from Stonehedge as allocated by the Commissioner for the

years 1967-1972. In February 1978 the Bankruptcy Court

denied the claim, holding that the Commissioner’s allocation

imposed no obligation under New York law, on CTI te pay

interest to CCP. (App. A.., infra, 5a).

In its amended partnership return for 1975, signed August

13, 1976, CCP claimed a bad debt deduction for the interest

allocated for 1967-1969. and subsequently filed amended

returns for 1975 and refund claims to carry back the net

operating loss'to the taxable year 1972. (App. A, infra, Sa).

5. The Commissioner denied the 1967-1969 deduction and

refund and allocated another $132,088.70 in interest income

from Stonehedge and Seneca for 1970-1972. The Commissioner

also determined that CCP’s gain on the foreclosure and

5

repossession of land from Stonehedge was ordinary income and

not capital gain. (App. A, infra, Sa).

6. The Tax Court sustained the Commissioner’s determina-

tions and the Second Circuit Court of Appeals affirmed the

decision of the Tax Court, under different theories holding:

a) For the years 1967-69; no bad debt deduction was

allowed to CCP on interest income of $196,380 whicl: was

imputed from Stonehedge and upon which CCP had paid a tax,

and which interest it could not collect.

b) For the years 1970-72; the Commissioner could impute

interest income of $129,329 to CCP from Stonehedge; also

CCP could not claim a bad debt loss for that emount even

though said interest was uncollectible.

c) CCP’s gain on repossession of land from Stonehedge

was Ordinary income, not capital gain. (App. A, infra. 3a).

REASON FOR GRANTING CERTIORARI

ON ISSUE ONE

The ko® ‘ings of the Courts below in imputing interest income

where a legal disability exists as to collection appear to be in

direct conflictto the holding of this Court in Commissioner v.

First Security. Bank of Utah, 405 U.S. 394, (1973) which held

that:

Since the taxpayers (banks) received no premium in-

surance income, and were legally prohibited by law from

receiving any such income, the Commissioner’s

allocation to the taxpayers under Sec. 482 was not

warranted.

As Justice Powell of this Court said:

**We know of no decision of this Court wherein a

person has been found to have taxable income that he

did not receive and that he was prohibited from

has been assumed that the person to whom the income

was attributed could have received it. The underlying

assumption always has been that in order to be taxed for

income, a taxpayer must have complete dominion over

it.””

405 U.S. 394, 403.

In the instant case, the sale by CCP to Stonehedge providing

for an interest free mortgage took place ten years prior to the

Second Circuit Court’s decision in, B. Forman Co. v. Comm.,

453 F.2d 1144 (2d Cir. 1972), cert. den. 407 U.S. 934 (1972),

which upheld the Commissioner’s authority to impute interest

on loans between related parties. Prior to the Forman case,

(supra), and at the time of the transactions relevant to the case

at bar, a long series of cases held that the Commissioner could

not ‘‘create’’ income that was not actually or constructively

received.

In fact, prior to the Forman case in 1972, there was neither

legal nor theoretical justification for the payment of interest on

a non-interest bearing loan between related parties. Mertens,

Law of Federal Income Taxation Vol. 7 Sec. 38.63 at p. 160;

See also: Forman, (supra) 453 F.2d at 1144, 1155-1156.

In 1978 CCP filed a claim in the Bankruptcy Court in an

attempt to recover the interest that had been imputed by the

Commissioner from Stonehedge in the amount of $325,718.90

for the years 1967-1972. The Bankruptcy Court denied CCP’s

claim on the ground that no liability existed under New York

law and held that CCP was prohibited, by law, from collecting

the imputed interest. (App. E, infra, 46a-49a).

Since the Commissioner argued in the Bankruptcy Proceed-

ings (of CTI) that no valid obligation was created by the income

allocation under Section 482, it is.clear that the imputation of

interest income under Section 482 creates an uncollectible debt

and results in a tax on proceeds that would not, and could not,

have been paid.

In Corn Exchange Bank v. U.S., 37 F.2d 34 (2d Cir. 1930),

(involving an accrual basis taxpayer), the Court said at page 34:

**When a tax is lawfully imposed on income not

actually received, it is upon the basis of a reasonable

expectancy of its receipt, but a taxpayer should not be

required to pay a tax when it is reasonably certain that

such alleged accrued income will not be received and

when in point of fact it never was received.”’

In Commissioner v. First Security Bank of Utah, supra, this

Court held that the Commissioner could not allocate insurance

commissic? invome under Section 482 to banks which had not

received the income and were prohibited by federal banking law

from receiving said commissions. This same principle has been

extended by other courts and applied to cases where, as here,

taxpayers werc precluded from collecting imputed or

**phantom”’ income due to prohibitions in state laws.

In Delta Life Insurance Company v. U.S., 363 F. Supp. 410

(1973) the court held that where a life insurance company was

required to maintain certain reserves under Louisiana law, the

IRS is precluded from imposing a smaller reserve which would

result in higher taxes. The Delta court cited First Security Bank

of Utah, supra, stating:

**The bank simply lacked the ‘requisite power to

receive the income. Likewise, Delta lacked the power

under state law to maintain a smaller reserve.’’ (363

F. Supp. at 415)

In Owen W. Bunker, T.C. Memo 1979-174 (1979), the Com-

missioner attempted to tax a bank on a certain stock gain,

on an argument that the bank was the real owner of the

stock. The Tax Court held that since the state banking law

prohibited the bank from owning the stock in question, the

Commissioner could not tax the bank on the stock gain.

In Bank of Coushatta v. U.S., 650 F.24.75 (Sth Cir. 1981),

the Fifth Circuit held that, where a bank transferred its credit

insurance operation to individual agents based on its good faith

belief that it would have been illegal for the bank to continue to

earn and receive insurance commission income, the Com-

missioner could not allocate commission income to the bank

under Section 482 because the bank did not actually, or con-

structively receive the income. The Court responded to the

government’s argument that the reasoning in the First Security

Bank of Utah case (supra) was limited to cases where it would

he illegal for the taxpayer to receive the income stating:

**The ‘Supreme »Court clearly did not hoid that a

showing that it would be illegal to receive commissions is

essential for a plaintiff to prevail in a similar situation.

Rather, the fact that the banks could not legally have

received the commissions was cited as proof that the

funds were not diverted away from them by the holding

company. The issue in this case is whether Coushatta

received the commission actually or constructively as

income.”’

650 F.2d 75, 77.

in U.S. v. Basye, 410 U.S. 441 (1973) this Court held that the

reasoning in First Security Bank of Utah, supra, does not appiy

where taxpayers were contracting p»rties that agreed to deflect

their income to a retirement trust for their benefit.

The critical factor distinguishing the Basye case, (supra),

from the case at bar is that while the taxpayers in Basye at-

tempted to defer the taxation of their earnings, the taxpayers in

the instant case had no real income to deflect or defer. The

alleged income in the case at bar is comprised solely of

phantom interest created by the Commissioner and then

allocated to CCP. Also, prior to Forman, supra, the taxpayers

were conducting business within the legal framework of state

law and federal tax laws.

‘As Justice Powell of this Court stated in the First Security

Bank of Utah, supra:

**The ‘complete power’ referred to in the regulations

hardly includes the power to force a subsidiary to violate

the law.”’

405 U.S. at 405

This is precisely what the Commissioner is requiring of .

Stonehedge. If prior to Forman (1972) supra, Stonehedge had

» deducted interest on its tax réturns for those years, Stonehedge

and its officers would have violated not only state law — but

also the Federal Income Tax Laws — because its returns would

have been fraudulent.

It is clear from the foregoing that the holding of the Courts

below directly conflicts with the principle enunciated by this

Court in Commissioner v. First Security Bank of Utah, (supra).

The extent of the Commiissioner’s ability to create, allocate and

then tax income that was uncollected and uncollectible raises

numerous questions of far-reaching consequences and should

be addressed and clarified by this Court so that this area of the

income tax law may be administered more fairly, uniformly

ar equitably.

REASON FOR GRANTING CERTIORARI

ON ISSUE TWO

The treasury regulations authorizing the Commissioner to

allocate interest income based on loans between related parties

were not proposed until four years after the sale by CCP (1962)

to Stonehedge and were not adopted until 1968, some six years

after the transaction in issue. Treas. Regs. Section 1.482-

2(a)(1); Section 1.482-2(a)(2). 7

_ Even after the adoption of the aforementioned regulations in

1968 it was another four years before the Second Circuit

Court’s decision in B. Forman Co. v. Comm., (supra), in 1972

upheld the Commissioner’s authority to impute interest on

loans between related parties where no interest rate had been

_ expressly stated.

10

This Court in several cases has upheld the retroactive ap-

plication of the income tax laws involving periods of twelve

months or less, as not violating the due process clause of the

Fifth Amendment. See U.S. v. Darusmont, 449 U.S. 292 (1981)

reversing and remanding District Court 80-2 USTC wnt.

p.85208, and cases cited therein.

In that case this Court stated:

**This ‘retroactive’ application apparently has been

confined to short and limited periods required by the

practicalities of producing nationai legislation. We may

safely say that it is a customary congressional practice.”’

However, petitioners are of the opinion that their situation is

analogus to that of the individual referred to by Judge Hand,

who ‘“‘has no reason to suppose that any transactions of this

sort will be taxed at all’’. Cohan v. Commissioner, 39 F.2d 540,

545 (2d Cir. 1930). :

It is clear from the facts in this case however, that unlike tise

taxpayers in Cohan (supra), the taxpayers herein had no reason

to suppose thai the transactions entered into in 1961-1962

would, or could, be taxed. It was not until after Formen, supra,

some ten years after the transactions, that the novel idea that

the Commissioner could create and impute interest income not

actually charged by related parties was accepted.

The Commissioner’s retroactive application of Section 482 in

this case constitutes such an unduly harsh, oppressive and

arbitrary assessment of the taxpayers as to amount to a con-

fiscation in violation of their rights to due process under the

Fifth Amendment. Heiner v. Donnan, 285 U.S. 312 (1932);

Nichols v. Coolidge, 274 U.S. 531 (1927).

+

.

ll

REASON FOR GRANTING CERTIORARI

ON ISSUE THREE

Section 482 was designed to prevent tax avoidance between

related business entities and to treat related parties as non-

related parties in similar business transactions. With respect to

the time period involved (1970-71-72) it cannot be said that

Paduano was related in any way to the corporate obligors

(Stonehedge and Seneca).

There is no language in that statute, the regulations or the

legislative history of Section 482 to warrant the holding that a

_ party who derived ne economic benefit on an interest free loan,

must nevertheless, because of his status as a partner, at the time

that the loan was made, be charged with income taxes.

As Justice Powell of this Court stated:

“We know of no decision of this Court wherein a

person has been found to have a taxable income that he

did not receive . . . In cases dealing with the concept of

income it has been assumed that the person to whom thc

income was attributed could have received it. Commis-

sioner vy. First Security Bank of Utah, 405 U.S. 394 at

403 (1972).

in his concurring opinion in the Court below, Judge

VanGraafeiland raised the constitutionality of charging income

tax to Paduano, stating:

**In May 1969, Mr. Paduano relinquished all of his

interest in Stonehedge Development.Corporation and

Seneca Sewerage Corporation. The only evidence

presented in the Tax Court indicated that, although

Paduano remained a inal partner in CCP, he in fact

retired from active ia that partnership.

Despite these undisputed facts, Mr. und Mrs. Paduano

have been held liable to pay a tax on nonexistent income

allocated from the corporations to the partnership and

which, of course, the Paduanos never received.

12

When actual partnership incotne is involved, the law is

‘Clear that each partner must pay a tax on his distributive

portion of that income. United States vy. Basye, 410 U.S.

441, 448 (1973). However, ‘‘(t)hat which is not in fact

‘the taxpayer’s income cannot be made such by calling it

income." Hoepe: v. Tax Commission, 284 U.S. 206,

215 (1931). Taxable income contemplates the existence

of an economic benefit which is subject to the dominion

and control of the taxpayer. Commissioner vy. Kowalski,

434 U.S. 77, 83 (1977); Commissioner v. First Security

Bank, 405 U.S. 394, 403 (1972). Because the Paduanos

had no interest in or control over the

during the taxable years in question and derived ao

benefit whatever from the interest-free loans tu those

entities, the allocations of income from the corporations

to the Paduanos has constitutional implications which

are ‘bothersome. Although courts lock upon tax

legislation with an indulgent eye, a levy which is so

arbitrary and capricious as to amount to confiscation

may be held to violate the Fifth Amendment. Heiner v.

Donnan, 285 U.S. 312, 326 (1932); Nichols v. Coolidge,

274 U.S. 531, 542 (1927).

(App. A, infra, 8a, 9a)

’ The application of Section 482 in this instance constitutes an

unwarranted and unreasonable interpretation of that statute,

and a violation of Mr. Paduano’s constitutional rights under

the Fifth Amendment. Cf. U.S. v. Vogel Fertilizer Co., 82-1

USTC §9134, p.83116 (S.Ct. 1982).

REASON FOR GRANTING CERTIORARI

ON ISSUE FOUR

The Courts !elow disallowed the taxpayers the right to take a

deduction for the imputed interest income that was neither

collected nor collectible and this Court should grant certiorari

to review this finding for the following reasons:

1) The Second Circuit Court of Appeals affirmed ‘on a

different theory than the Tax Court. Reisman v. Caplin, 375

U.S. 440, (1964).

13

2) The Second Circuit Court applied an incorrect principle

of law (its double deduction theory) in. that it ignored the

separate entities of Petitioners (CCP) and Stonehedge. This

Court recognized that a corporation is a separate taxable entity.

Moline Properties, Inc. v. U.S., 319 U.S. 436 (1943). It is well

settled that in determining the irade or business of a taxpayer,

the business activities of a closely held corporation will not be

attributed to the taxpayer absent a showing of exceptional

circumstances. See, Burnet v. Clark, 287 U.S. 410 (1932);

Jarvis v. Commissioner, 32 T.C. 173 (1959); Gordy v. Com-

missioner, 36 T.C. 855 (1961).

2} The Second Circuit Court’s analysis of Section 482

ignores the intent of Treas. Regs. Section 1.482-1(d)(2) and

Rev. Proc, 65-17 Sections 3.02, 4.02, 1965-1 CB. 833 as to

reciprocal entries required under a Section 482 allocation.

4) The denial of a tax deduction in this instance constitutes

an arbitrary, unwarranted, and discriminatory application of

the Commissioner’s authority under Section 482 and violates

Petitioners’ inion. agg Fieine? V. Donnan, supra;

Nichols v. Coolidge, supra

5) IR 0s ACETAL es CM

missioner of Section 482, and because the question of a tax

deduction after the application of Section 482 has never been

decided by this Court, the resolution of this issue is necessary

for the proper administration of the tax laws. U.S. v. Stapf,

375 U.SS. 118, (1963) rehearing denied, 375 U.S. 981.

TAX COURT’S THEORY

The Tax Court rejected CCP’s bad debt claim for either 1972

or 1975 on the theory that if a debt arose (from a Section 482

allocation) it did not come about until 1976 (App. D, infra,

40a). However, the court noted that even if there was no debt

that may be entitled to a loss, for 1976 (citing Tharp

v. Comm vy, T.C. Memo 1972-10; Corn Exchange Bank,

supra) (App. D, infra, 41a, Fn. 37).

14

In denying the deduction the Tax Court reasoned that the

underlying tax liability as well as the interest obligation was

contingent until a final decision in the Paduano case. (App. D,

infra, 41a). Under the Court’s reasoning, no interest should be

charged by the Commissioner for the years 1967-69 except from

the date the tax liability became final, in 1976; but this is not

the case. Interest on an income tax liability or deficiency runs

from the due date of the income tax returns for the years in

issue. Section 6601; Morton-Norwich Products, Irc. v. U.S.,

602 F.2d 270 (Ct. Cl.1979). The ‘‘contingent liability’’ cases

cited by the Court are inapposite since they do not support the

position that an income tax liability becomes a fixed liability

when a final decision has been rendered, although the under-

lying adjustments relate back to the tax years in issue.

A consistent and logical theory would hold that in Section

482 cases, the imputed interest income, interest expense, and

the income tax consequences take effect simultaneously and

retroactively (from the date of the final determination). The

Commissioner apparently recognizes that the interest

obligation arises at the same time that the interest income is

imputed, because under Revenue Procedure 65-17, Section 4.02

1965-1 C.B. 833, he permits the taxpayer to issue promissory

notes in payment of the interest obligation (which results from

a Section 482 allocation) in order to avoid a double tax effect in

certain situations. Also under Treasury Regs. Section 1.482- —

1(d){(2) correlative adjustments are required as to the related

parties at the time interest is imputed.

In Pitchford v. Commissioner, T.C. Memo 1975-75, the

Commissioner conceded, (solely for purposes of that case), that

a Section 482 allocation should not be made in situations where

the financial condition of the related party obligor was such

that an accrual of such interest income would not have been

justified on interest bearing loans involving non-related parties.

By this concession, the Commissioner recognized that the

15

interest debt exists simultaneously with the imputation of

interest.

Subsequent to the Pitchford case, the Tax Court, in Hen-

nessey v. Commissioner, T.C. Memo 1977-122, again con-

sidered the collectibility of an interest obligation, and again did

so for the same years in which the Commissioner imputed the

interest income. The Hennessy court thus recognized that the

interest income and the related interest obligation should be

considered during and for the tax years in issue.

Peiitioners argued in the Tax Court and on appeal that in-

terest should not be imputed if there is no reasonable ex-

pectation of collection. The Tax Court found and the Second

Circuit agreed that there was a reasonable expectation of

collection. (App. A, infra, 7a). This holding necessarily implies

that there was a pre-existing (or a simultaneous) debt which was

in fact collectible.

Accordingly, it should necessarily follow that if there was an

interest debt due (under Seciion 482) and if that interest is not

collected and a tax was previously assessed, then a tax

deduction should be permitted either under Section 165 (loss) or

Section 166 (bad debt).

DOUBLE DEDUCTION THEORY

Notwithstanding, the Tax Couct’s implied admission of some

tax relief to CCP for paying income tax on funds which CCP

could not receive, the Second Circuit Court under a theory

which was not briefed or argued by the government, and on an

entirely new and unprecedented theory, held that no deduction

at all was permissible to CCP. That Court reasoned that

petitioners were attempting to take a double deduction because

the Commissioner had already allowed an interest deduction to

Stonehedge and Seneca who are not the taxpayers in this case.

(App. A, infra, 6a) This “‘double deduction”’ theory is incorrect

as a matter of law.

16

Either Stonehedge. and CCP (and Seneca and CCP) are

separate entities for tax purposes or they are not. if they are,

and the lower Courts held so for imputing interest income, then

consistency and fairness requires that they be treated as such

for all tax consequences.

In denying a deduction for bad debt or business loss to CCP,

the Second Circuit Court had these remarks:

**Such a deduction was granted by the Commissioner

to Seneca and Stonehedge. Thus /axrvayers seek double

deductions for Sec. 482 allocations. “Jeither the law nor

common sense supports such an outcome.’’ (emphasis

added) (App. A, infra, 6a)

The appellants’ position is that the Court’s feasoning con-

cerning a ‘‘double deduction’’ or ‘‘windfali’’ profits theory

clearly and unfairly ignores the fact that Stonehedge and CCP

and Seneca and CCP are separate entities.

Although the corporations oltained a deduction for interest

expenses, CCP received no deauction. Stonehedge and Seneca

are not the taxpayers in this case; the taxpayers before the

Court are the partners (and their wives) of CCP. Consequently

for the Second Circuit Court to allege a double deduction to the

taxpayers, it must, of necessity, group all the corporate entities

and CCP as one taxable entity. Under this reasoning, however,

there would have been no Section 482 allocation made in the

first place.

This Court recognized that a corporation is a separate

taxable entity. Moline Properties, Inc. v. U.S., supra. Also}it

is well settled that in determining the trade or business of a

taxpayer, the business activities of a closely held corporation

will not be attributed to the taxpayer absent a showing of ex-

ceptional circumstances. See, Burnet v. Clark, supra; Jarvis v.

Commissioner, supra; Gordy v. Commissioner, supra.

The Second Circuit Court in this case as well as in its Forman

decision (supra, 1972) recognized that the lender and borrower

17

were separate viable entities for purposes of a Section 482

imputation of interest, but when the lender attempts to claim a

tax deduction on the uncollected imputed interest that court in

denying the deductions inconsistently holds they are not

separate entities.

Nor ¢2n it be argued that the subsequent events which allow

CCP (under the tax law) to take a deduction for uncollected

interest, frustrate the tax law or result in any sort of windfall or

double deduction because the same principle also applies to

taxpayers having net operating losses (Section 172) or capital

losses (Section 1212) which are allowed to be carried back to

earlier years.

The tax law also allows bad debt losses (Section 166 of the

Code) and ordinary business losses. (Section 165 of the Code).

These tax relief measures are allowed to non-related parties and

should be allowed to related party transactions in this instance.

An example to point out the inconsistency of the double

deduction theory follows:

_ Suppose that CCP had been’on an accrual accounting basis

and that it had charged interest income on the Stonehedge

mortgage. At year end, CCP would have accrued interest in-

come, and the partners would have paid income taxes on the

accrued interest income. Suppose at a later date Stonehedge

never having paid the accrued interest to CCP. went bankrupt.

Under the tax law CCP would have been entitled to take a

business bad debit deduction under Section 166 of the Code.

Why should the fact that the Commissioner imputed interest

income (which effectively puts CCP on an accrual basis for that

purpose), to CCP under Section 482 change that result.

Concerning collection of the imputed intetest, the Second

Circuit Court stated:

‘Had CCP wished to receive payment from the

corporations reflecting the allocation of income, the

%

— i OF >

iv

18

partnership could have done so only upon application to

the Commissioner and only if the Commissioner deter-

mined the interest free loans were not intended to avoid

taxes. Rev. Proc. 65-17 Sections 3.02, 4.02, 1965-1

C.B.833.”’ (App.A, infra, 6a)

The facts of this case make it clear, however, the Petitioners

did not structure the transactions in question to avoid taxes.

Most of the imputed interest involved here arose from a non-

interest bearing mortgage which was transacted in 1962. This

was cight years prior to the adoption of Treasury Regs. Section

1.482-2 (concerning interest fiee loans) and ten years prior to

the Forman decision which upheld the Commissioner’s Section

482 allocation in related party interest free loans. Before

Forman, the law was to the contrary and no such allocation

could have been made.

In fact, ‘‘Section 482 grants no right to a controlled taxpayer

to apply its provisions at will, nor does it grant any right to

compel the District Director to apply such provisions’’. Treas.

Regs. Section 1 .482-1(b)(3).

Thus assuming that Stonehedge had been in a higher tax

bracket than the partners of CCP, if Stonehedge had taken an

imputed interest deduction, (prior to Forman, supra) on the

interest free mortgage (in order to reduce the overall taxes),

Stonehedge and its officers would be filing fraudulent income

tax returns.

_ It is submitted, based on the foregoing that the ‘“‘double

deduction” theory is Mogical end contrary to. established

principlesoflaw. ~«

Compare Mortiz v. Comm., 469 F.2d 466, (10 Cir. 1972)

which held that an income tax deduction based on sex classi-

tigation ‘‘is subject to scrutiny under equal protection prin-

ciples . . . as part of due process under the Fifth Amendment.’’

(In that case spinsters were allowed deductions for dependent

care but not bachelors).

a

we,

19

= Compare also, a recent case decided by the United

Circuit Court of Appeals for the District of Columbia in

that Court stfuck down a law granting tax exempt status to

vetecan’s groups but denied exemption to “‘other charitable aad

‘educational groups who conduct lobbying activities”. That

Court stated:

“Congress has violated the equal protection

guarantees of the Constitution’’ by granting different

tax treatment to these “groups. Taxation with

Representation of Washington v. Regan, 82-I[USTC

49272, p. 83611 (D.C. Cir. 1982) .

Neither the Commissioner nor the Second Circuit Court cited

any authority to suggest that Congress intended that related

parties (under Section 482 transactions) should be, penalized

and treated more harshly than non-related parties in similar

transactions. The Second Circuit’s holding in this instance is an

unwarranted and unreasonable interpreiation of the ap-

plication of Section 422. cf. U.S. v. Vogel Fertilizer Co., supra.

Also, the denial f a deduction to CCP amounts to a con-

fiscation cf. Heiner v. Donnon, supra, and is an obvious gross

injustice. Nichols v. Coolidge, supra.

Based on the foregoing, it is clear that CCP was entitled to a

deduction for.either a business bad debt (Section 166) or an

ordinary loss (Section 165) equal to the adjusted basis of the

uncollected imputed interest, (Section 166(b)).

The denial of a deduction would constitute a violation of

Petitioners’ se wtnamer hea nacelles Bier feo

Clause.

REASONS FOR GRANTING CERTIORARI

ON ISSUE FIVE

In denying capital gains treatment to Petitioners on their sale

(through CCP) in 1962 of vacant land to Stonehedge Cor-

poration, a related entity, the Second Circuit Court of Appeals

relied on a different theory than the United States Tax Court.

(App. A, infra, 3a, 7a, 8a) Reisman v. Caplin, supra

The Tax Court did not enumerate in its findings the various

factors set forth in Gault v. Commissioner, 332 F2 94 (2d Cir.

1964) for determining whether CCP sold the subject property to

Stonehedge in the ordinary course of its business, under Section

1221(1) which are:

’ **(1) the frequency, number and continuity of sales; (2)

Subdivision, plotting, and other improvements or

developments tending to make the property more

marketable; (3) the extent to which the taxpayer is

engaged in sales activity; (4) the length of time the

property has been held; (5) the substantiality of the

income derived from the sales, and what percentage that

is of the taxpayer’s total income; (6) the nature of the

taxpayer’s business; (7) the taxpayer’s purpose in

acquiring and holding the property; (8) the extent of the

sales promotional activities such as advertising; (9) the

listing of property directly through brokers.’’

332 F.2d 94 at 96.

On the contrary Judge Tannenwaid of the Tax Court found

that:

“CCP would make no efforts to improve or subdivide

the parcel but would subsequently sell it, at a profit, to

Stonehedge, which (would then develop the

property)’. (App. D, infra, 17a) emphasis supplied.

The Tax Court conceded that CCP and Stonehedge were

separate taxable entities and that CCP’s acquisition, holding

and subsequent sale of the subject property was separate from

21

the development activities later undertaken by Stonehedge.

Nevertheless, the Tax Court held, that:

**CCP can not be permitted to insulate itself from the

acts of an entity (Stonehedge) whose efforts are so

closely related to its own; the supplier of developable

land may be regarded as a joint participant with the

builder in an integrated real estate development

business.’’ (Citations omitted). (App. D, infra, 43a)

The Tax Court concluded that CCP and Stonehedge were

**joint participants’ in a real estate development venture and

that CCP was, therefore, ‘‘in the trade or business of land

development and sales at the time the Seneca Knolls properties

were sold.”’ (App. D, infra, 44a).

It is well settled that in determining the trade or business of a

taxpayer, the business activities of a closely held corporation

will not be attribut<u te the taxpayer «.sent a showing of ex-

ceptional circumsiances. See, Burnet v. Clark, supra; Jarvis v.

Commissioner, supra; Gordy v. Commissioner, supra.

In Gordy, (supra), the Tax Court considered facts similar to

those in the case at bar and held that the taxpayer’s gain on the

sale of land to a controlled corporation in (< real estate

development business.constituted capital gain and not ordinary

income. The Tax Court in Gordy stated:

**Respondent recognizes no distinction between a

taxpayer holding property for sale to his customers and

a taxpayer holding property for sale to his controlled

corporation engaged in selling such property to its

36 T.C. 855 at 859-860. The Gordy Court, citing Burnet v.

Clark, (supra), held, that the taxpayer’s business and the

business of the real estate development corporation were

separate and distinct and that, as long as the corporation was a

viable entity and could not be regarded as the taxpayer’s alter

ego or agent, the corporation’s development‘activities could.not :

be attributed to the taxpayer.

It is undisputed that throughout the years in question Ston’

hedge was a viable business entity and in no sense the alter ego

of CCP. The primary point of contention here thus concerns

the Tax Court’s finding that Stonehedge’s activities could be

imputed to CCP because the entities wereengaged in a joint

venture. The cases cited by the Tax Court in support of this

finding are clearly distinguishable from the case at bar both in

principle and on the facts. This is supported by the fact that

neither the government in its argument to the Second Circuit

Court, nor that Court itself, relied on the Tax Court’s joint

venture theory. (App. A, infra, 8a).

If the Tax Court on the facts presented could have found

CCP a developer based on CCP’s own activities (and not the

activities of Stonehedge), it would seem unreasonable and

unwarranted for that Court also to rely on the joint venture

theory. Since the trial Judge did not, on the facts pertaining to

CCP alone, hold that CCP was a developer, and since the facts

pertaining to the lack of CCP’s development activity and lack

of significant sales activity were not clearly in dispute, it is

submitted that the Second Circuit Court’s holding was not

justified by the facts and is erroneous.

CONCLUSION

The petition for writ of certiorari should be granted.

VICTOR CHINI, ESQ.

Attorney for Petitioners

Stanley Germain, Jr., Esq.

of Counsel

Dated: April 1982