Appendix — Cappuccilli v. Commissioner

APPENDIX A | .

OPINION OF U.S. COURT OF APPEALS

FOR THE SECOND CIRCUIT

UNITED STATES COURT OF APPEALS

For the Second Circuit

No. 101—August Term, 1981

(Argued: September 28, 1981 Decided: December 29, 1981)

Docket No. 80-4244

GRACE CAPPUCCILLI, ET AL.,

Petitioners-Appellants,

—against—

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

Before:

LUMBARD and VAN GRAAFEILAND, Circuit Judges

and BONSAL, District Judge.*

Grace Cappuccilli, Dorothy Cappuccilli, Gerald Paduano

and Caroline Paduano appeal from a decision in the United

States Tax Court, Tannenwald, J., upholding the Com-

missioner’s determinations that (1) petitioners’ partnership

recognized ordinary income, rot capital gain, from the sale of

real property; (2) income should be allocated from petitioners’

corporations to their partnership for the years 1970-72; (3) a

*Honorable Dudley B. Bonsal, United States District Judge for the Southern

District of New York, sitting by designation.

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APPENDIX A

tea of U.S. Court of Appeals for the Second Circuit

deduction should be denied for income allocated to but never

collected by the partnership for 1967-69.

Affirmed.

VICTOR CHINI, ESQ., Syracuse, New York (Stanley

R. Germain, Esq., Syracuse, New York, of

counsel), for Petitioners-Appellants.

R. RUSSELL MATHER, Attorney, Tax Division,

Department of Justice, Washington, D.C.

(John F. Murray, Acting Assistant Attorney

General, Michael L. Paup, Daniel F. Ross,

Attorneys, Tax Division, Department of Jus-

tice, Washington, D.C., of counsel), for Appel-

lee.

LUMBARD, Circuit Judge:

Dorothy Cappuccilli, Grace Cappuccilli, Gerald Paduano

and Caroline Paduano appeal from a decision of the Tax

Court, Tannenwald, J., sustaining income tax deficiencies

asserted by the Commissioner for 1970-72, and denying a

refund sought by the taxpayers for 1967-69.' Some of the

deficiencies were based on income from the sale of land by the

taxpayers’ partnership Cappuccilli, Cappuccilli and Paduano

(CCP), which the taxpayers reported as a capital gain and the

Commissioner taxed as ordinary income. Other deficiencies

IThe Commissioner assessed deficiencies of $7,140.13 for 1970, $7,089.58

for 1971, and $69,974.26 for 1972 against Grace Cappuccilli; $7,422.54,

$7,467.60 and $71,077.22 for those years against Dorothy Cappuccilli; and

$7,590.10, $6,486.68 and $59,895.65 for those years against Gerald and

Caroline Paduano. The three taxpayers sought a refund for 1967-09

totalling $201 ,633.73.

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APPENDIX A

Opinion of U.S. Court of Appeals for the Second Circuit

were based on allocation of income under § 482 of the Internal

Revenue Code to the partnership from corporations controlled

by the partners. The corporations never made case payments to

CCP corresponding to the income allocated by the Com-

missioner. The taxpayers claim that it was improper to allocate

corporate income to the partnership in 1970-72, and that, in

any event, the partnership should have an offsetting deduction.

The taxpayers further claim a refund for 1967-69 on similar

grounds: that corporate income allocated to the partnership in

those years was never paid. We affirm the judgment of the Tax

Court and sustain the Commissioner, although not entirely for

the reasons enunciated by Judge Tannenwald.

The facts were stipulated by the parties or found at trial by

Judge Tannenwald, and taxpayers dispute few of those findings

on appeal. Brothers Peter and Rocco Cappuccilli and Gerald

Paduano each own one third of the partnership bearing their

names. (All filed joint tax returns, but as Peter and Rocco filed

bankruptcy petitions in 1977, the deficiencies were assessed

against their wive.) Their partnership, CCP, bought un-

developed land in the Syracuse, New York area, and sold it on

credit, at a paper profit, to Stonehedge Development Cor-

poration, which in turn contracted for development work with

Seneca Sewerage Corporation. Each CCP partner owned one

third of these corporations until 1969, when Paduano retired

and sold his shares to the Cappuccilli brothers. CCP and Stone-

hedge operated out of the same offices. CCP, Stonehedge,

Seneca and the individual partners all used the same lawyer.

Starting in 1955, Stonehedge developed the Seneca Knolls

Community in the town of Van Buren, New York. From 1961

to 1962, CCP purchased land adjoining Seneca Knolls —

hereinafter the Seneca Farms — for a total of $445,723 and

resold it to Stonehedge for a total of $1,570,327.39 — con-

sisting of assumption of mortgages, cash and two promissory

—

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APPENDIX A =

Opinion of U.S. Court of Appeals for the Second Circuit

notes, one for $81,000 yielding six percent interest, and one

non-interest bearing note for $1,075,000. On Amil 15, 1961,

CCP purchased a different plot of land from Stonehedge — the

Preston Farm — for $25,000, and resold it the next day to

Seneca for $40,000 — which included a $25,000 promissory

note intended to yield six percent. The corporations -nade

payments of principal, but no payments of interest. The

Commissioner concluded that the lack of interest recognized by

CCP on the notes to the controlled corporations understated

the true income of the partnership. Interest income of

$325,718.90 was allocated to CCP for 1967-69. At the same

time, the Commissioner credited the affiliated corporations

with a deduction for interest paid to CCP. The allocation was

upheld in Paduano v. Commissioner, 34 T.C.M. (CCH) 368

(1975), aff'd mem., 538 F.2d 312 (2d Cir.), cert. denied, 425

U.S. 992 (1976).

Zoning problems prevented Stonehedge from developing the

land. From 1970 to 1975, Stonehedge was insolvent. In 1970,

Stonehedge borrowed $500,000 from Merchants Nationa! 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. Stonehedge’s debt to CCP for these ad-

vances 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 CCP and

CCP forecloued on the remainder, in full satisfaction of Stone-

hedge’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 1.R.C.

§ 1038. CCP reported this gain as capital gain.

—.

Sa

APPENDIX A

Opinion of U.S. Court of Appeals for the Second Circuit

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 as CTI’s

predecessor to CCP, but the bankruptcy court, McGuire, /.,

(W.D.N.Y.), held that under New York law, the Com-

missioner’s allocation. imposed no obligation on CTI to pay

interest to CCP.?

The Cappuccillis and Paduanos sought a bad debt deduction

corresponding to the 1967-69 allocated interest, and therefore

claimed a refund. The Commissioner denied the 1967-69

deduction and the refund, and allocated $132,088.70 in interest

income from the controlled corporations to CCP for 1970-72.

The Commissioner again credited the controlled corporations

with a deduction for interest allocated to CCP. The Com-

missioner further asserted that CCP’s gain on repossession of

land from Stonehedge was ordinary income, not capital gain.

The Tax Court sustained the Commissioner’s determinaticns,

and this appeal followed.

The taxpayer’s claim for either a bad debt deduction or an

ordinary loss deduction is unprecedented, and, we think,

unwarranted. Section 482 empowers the Commissioner to

allocate income among mutually controlled organizations to

reflect their true income. Interest free loans are often used to

shift income from. organizations with high tax liabilities to

those with low tax liabilities. Latham Park Manor, Inv. v.

Commissioner, 69 T.C. 199, 212 (1977), aff’d mem., 618 F.2d

100 (4th Cir. 1980). The Commissioner here merely determined

that CCP’s income was understated, and that, as a result, the

income of Stonehedge or Seneca was overstated. He placed no

2CTI emerged from bankruptcy court in 1977, when a plan of arrangement

was approved providing for 100 percent payment of unsecured claims over

seven years, and for the subordination of individual Cappuccilli claims.

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APPENDIX A

Opinion of U.S. Court of Appeals for the Second Circuit

obligation on the corporations to pay the partnership. Had

CCP wished to receive payments from the corporations

reflecting the allocation of income, the partnership could have

done so only upon application to the Commissioner and only if

the Commissioner determined the interest free loans were not

intended to avoid taxes. Rev. Proc. 65-17, §§ 3.02, 4.02, 1965-1

C.B. 833. To allow CCP a deduction now would retroactively

cancel the Commissioner’s determination of CCP’s true tax

status in 1967-72..Granting such a deduction could also give

taxpayers a windfall. Allocation of income under § 482 is

properly offset by the creation of a deduction for the

organization from which income was allocated. B. Forman Co.

v. Commissioner, 453 F.2d 1144, 1156 (2d Cir.), cert. denied,

407 U.S. 934 (1972); Treas. Reg. § 1.482-1(d)(2). Such a

deduction was granted by the Commissioner to Seneca and

Stonehedge.? Thus taxpayers seek double deductions for § 482

allocations. Neither the law nor common sense supports such

an outcome.

3The offsetting deductions granted under Treas. Reg. §1.482-1(d)(2) to

Seneca and Stonehedge may be unused if the corporations’ successor, CTI,

fails to earn income against which the deduction can be applied. But the

fact that a §1.482-1(d)(2) deduction is worthless or unavailable does not

preclude allocation of income under §482, Continental Equities, Inc. v.

Commissioner, 551 F.2d 74, 78-82 (Sth Cir. 1977), and therefore is no

reason to void such allocation retroactively by granting CCP a deduction.

4judge Tannenwald ruled that any ‘‘bad debt’’ corresponding to a $482

allocation existed only after the Supreme Court had denied certiorari in

1976 — and therefore the taxpayers’ assertion of a 1976 deduction was not

timely for offsetting taxes paid 1967-69. Given our analysis of the “‘bad

debt” deduction, we need not reach the issue of timeliness. We would note,

however, that the analysis of the tax court would preclude direct appeal of

taxpayers’ claim for a “‘bad debt’’ deduction for 1970-72. The Supreme

Court would have to deny certiorari on the decision herein on the §482

allocation for 1970-72 before we could consider any offsetting “‘bad debt”’

deduction based on that allocation. The tax court did not consider tax-

payers’ claims for a bad debt deduction for 1970-72.

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APPENDIX A

Opinion of U.S. Court of Appeals for the Second Circuit

The taxpayers argue that the allocation of income to CCP for

1970-72 was improper, either because CCP had no reasonable

expectation of receiving interest from the corporations or

be:ause Gerald Paduano’s sale of stock in the corporations

dissolved the common cuntrol of CCP and the corporations. In

both instances, taxpayers challenge findings of fact by the tax

court. In neither instance are the findings clearly erroneous.

Sudge Tannenwald’s finding that CCP did have a reasonable

expectation of receiving interest was based on Stonehedge’s

receipt of a $500,000 loan from Merchants National Bank &

Trust Co., on Stonehedge’s sale of land to a third party for

$233,756, and on Stonehedge’s ability to repay CCP for its cash

advances. Judge Tannenwald further found that common

control of CCP and the corporations existed in 1970-72 because

the interest-free notes represented a common control method of

income shifting that. predated Paduano’s retirement and

continued afterwards. This finding comports with the rule in

this circuit that the realities of control, rather than record

ownership, determine the application of } 482. B. Forman Co.,

supra, 453 F.2d at 1153-4. If the owners of one organization

differ from the owners of another, the two may still be held to

be under common control if they are in fact run by the same

people. Collins Electiiral Co., Inc. v. Commissioner, 67 T.C.

911, 918-19 (1977) Clearly, the Cappuccilli brothers ran CCP,

There remains the question of whether CCP’s gain on

repossession of Stonehedge’s land was capital gain or ordinary

income. The character of gain un repossession under § 1038 is

determined by the character of the original sale. Treas. Reg.

§ 1.1038-1(d). Therefore the question is whether CCP in 1962

sold land in the ordinary course of business. I.R.C. § 1221(1).

Two decades ago, the IRS taxed CCP’s gain from the sale of

land in 1957-58 as the sale of ordinary assets yielding ordinary

income. CCP did not challenge the IRS. Now the Com-

APPENDIX A

Opinion of U.S. Court of Appeals for the Second Circuit

missioner again asserts that CCP was, during 1961-62, in the

business of buying and selling real estate. CCP assembled the

- Seneca Farms in purchases from February 22, 1961 through

January 3, 1962. CCP drew up papers for resale of the land in

late 1961 and early 1962. The closing was to occur on January

10, 1962, only a week after the last of the farms had been

purchased. The closing was delayed until December 28, 1962

only because the partners became concerned about rezoning the

land for development. The gains from this turnover of real

estate were clearly ‘‘ ‘the profits and losses arising from the

everyday operation of a business’ ’’ rather than ‘‘ ‘the

realization of appeciation in value accrued over a substantial

period of time,’ ’’ Malat v. Riddell, 383 U.S. 569, 572 (1966).

Petitioners’ only evidence to the contrary was the assertion by

Peter Cappuccilli that CCP purchased the land for either

speculation or investment. On this record, such an assertion is

insufficient to carry petitioners’ burden of proof in challenging

the Commissioner’s determination that CCP’s gain was or-

dinary income.°

Affirmed.

VAN GRAAFEILAND, Circuit Judge, Concurring:

Because appellants’ attorneys have proceeded in this matter

as if their clients’ interests were identical, I concur in the result

reached by my colleagues. Had counsel seen fit to distinguish

the merits of the Paduamo claim from those of the other ap-

pellants, I would find affirmance of that claim more

S judge Tannenwald found that the inverrelationships between CCP, Stone-

hedge and their owners created a ‘“‘joint venture”’ of sorts. As taxpayers

conceded that Stonchedge was in the business of buying and selling real -

estate, Judge Tannenwald ruled that CCP as a joint venturer was, through

Stonehedse, also in the business of buying and selling real estate. Given our

analysis of CCP’s business, we need not consider the joint venture theory

enunciated by the tax court.

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APPENDIX A

Gpinion of U.S. Court of Appeals for the Second Circuit

In May 1969, Mr. Paduano relinquished all of his interest in

Stonehedge Development Corporation and Seneca Sewerage

Corporation. The only evidence presented ii: *e Tax Court

indicated that, although Paduano remained a nominal p.urtner

in CCP, he in fact retired from active participation in that

partnership. Despite these undisputed facts, Mr. and Mrs.

Paduano have been held liable to pay a tax on non-existent

income allocated from the corporations to the partnership and

which, of course, the Paduanos never received.

When actual partnership income is involved, the law is clear

that each partner must pay a tax on his distributive portion of

that income. United States v. 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.’’ Hoeper v. Tax

Commissioner, 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. Com-

missioner v. 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 corporations

during the taxable years in question and derived no benefit

whatever from the interest-free loans to those entities, the

allocation of income from the corporations to the Paduanos

has constitutional implications which are bothersome.

Although courts look 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).

Because this issue has beer neither briefed nor argued, i

discuss it only to indicate my belief that the Commissioner’s

power of allocation under section 482 is not without con-.

stitutional limitations.

~

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APPENDIX A

Opinion of U.S. Court of Appeals for the Second Circuit

UNITED STATES COURT OF APPEALS

Second Circuit

United States Court House

Foley Square

New York 10007

A. DANIEL FUSARO

Clerk

Grace Cappuccilli, et al. v.C.1.R. August Term, 1981

Docket No. 80-4244 | Decided December 19, 1981

-_——-

Page 612, line 26 — delete ‘‘case payments’’ and insert “‘cash

payments’’ in place thereof.

Page 614, line 3— delete “‘affiliated’’.

Page 614, lines 28 and 29 and 30 — delete entirely and insert

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

allocated by the Commissioner from Stonehedge to CPP, but

the bankruptcy court, McGuire, B.J.,” ip place thereof.

Page 614, liz » 32 — delete ‘ton CTI’’ and insert ‘‘on Seneca or

its successor CTI”’ in place thcreot.

A. DANIEL FUSARO, Clerk

ADF/hjd :

_ APPENDIX B

ORDER OF U.S. COURT OF APPEALS FOR THE

SECOND CIRCUIT DENYING REHEARING

UNITED STATES COURT OF APPEALS

Second Circuit

At a Stated Term of the United States Court of Appeals, in

and for the Second Circuit, held at the United States Court

House, in the City of New York, on the 27th day of January,

one thousand nine hundred and eighty-two.

Present: HON. J. EDWARD LUMBARD, HON.

ELLSWORTH A. VanGRAAFEILAND, Circuit Judges,

HON. DUDLEY B. BONSAL, District Judge.

GRACE CAPPUCCILLI, DOROTHY CAPPUCCILLI,

GERALD F. PADUANO and CAROLINE PADUANO,

Petitioners-Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

Docket No. 80-4244

A petition for a rehearing having been filed herein by counsel

for the petitioners-appellants, Grace Cappuccilli, et al.,

Upon consideration thereof, it is

Ordered that said petition be and hereby is denied.

A. DANIEL FUSARO

Clerk

by: /s/ FRANCIS X. GINDHART

Francis X. Gindhart

Chief Deputy Clerk

UNITED STATES COURT OF APPEALS

SECOND CIRCUIT

FILED

JAN 27 1982

_ A. DANIEL FUSARO, Clerk

a

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| APPENDIX C

JUDGMENT OF U.S, COURT OF APPEALS

FOR THE SECOND CIRCUIT

UNITED STATES COURT OF APPEALS

For The Second Circuit

At a stated Term of the United States Court of Appeals for

the Second Circuit, held at the United States Courthouse in the

City of New York, on the twenty-ninth day of December one

thousand nine hundred and eighty-one.

Present:

HON. J. EDWARD LUMBARD,

HON. ELLSWORTH A. VAN GRAAFEILAND

Circuit Judges

HON. DUDLEY B. BONSAL,

District Judge

GRACE CAPPUCCILLI, et al.,

Petitioners-Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

Docket No. 80-4244

Appeal from the United States Tax Court

This cause came on to be heard on the transcript of record

from the United States Tax Court and was argued by counsel.

ON CONSIDERATION WHEREOF, it is now hereby

ordered, adjudged, and decreed that the decision of said United

States Tax Court be and it hereby.is affirmed in accordance

—e.

; Bs

{

,

*

den

13a

APPENDIX C

Judgment of U.S. Court of Appeals for the Second Circuit

with the opinion of this court with costs to be taxed against the

appellant.

A. DANIEL FUSARO

Clerk

by /s/ EDWARD J. GUARDARO,

Edward J. Guardaro,

Deputy Clerk

UNITED STATES COURT OF APPEALS

SECOND CIRCUIT

FILED

DEC 29 1981

A. DANIEL FUSARO, CLERK

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APPENDIX D

OPINION OF UNITED STATES TAX COURT

T. C. Memo. 1980-347

UNITED STATES TAX COURT

GRACE CAPPUCCILLI, ET AL.,' Petitioners v. COMMIS-

SIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 2095-77, 2097-77, 2207-77, 2208-77, 5255-77,

5801-77.

Filed August 28, 1980.

SERVED AUG 28 1980

Victor Chini, for the petitioners.

Kenneth Bersani and John D. Steele, Jr., for the respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

TANNENWALD, Judge: In these consolidated cases,

respondent has determined deficiencies against petitioners for

the taxable years 1970, 1971. and 1972 as follows:

Petitioner Docket No. Year Deficiency

Grace Cappuccilli 2095-77 1970 $ 7,140.13

1971 7,089.58

2208-77 1972 69,974.26

Dorothy Cappuccilli 2097-77 1970 7,422.54

1971 7,467.60

2207-77 1972 71,077.22

Gerald F. and

Caroline Paduano 5801-77 1970 7,590.10

1971 6,486.68

$255-77 1972 59,895.65

1Cases of the following petitioners are consolidated herewith: Dorothy

Cappuccilli, docket Nos. 2097-77 and 2207-77; Grace Cappuccilli, docket

No. 2208-77; and Gerald F. and Caroline Paduano, docket Nos. 5255-77,

$801-77.

bing

Sa

APPENDIX D

Opinion of United States Tax Court

The tax year 1975 is also involved for all of the petitioners

because of, and to the extent of, a disputed bad debt deduction

which resulted in a claimed loss carryback to 1972.?

The issues presented in these cases are: (1) whether

respondent properly allocated interest for the years 1970, 1971,

and 1972 under section 4823 to the partnership of Cappuccilli,

Cappuccilli, & Paduano (CCP or the partnership) from two

related corporations on account of mortgage notes held and

cash ioans made by CCP; (2) whether intercst income properly

allocated to CCP under section 482 on account of the above-

mentioned mortgages and cash loans in 1967, 1968, and 1969

(see Paduano v. Commissioner, T.C. Memo. 1975-69, affd.

mem. 538 F.2d 312 (2d Cir. 1976), cert. denied 425 U.S. 992

(1976)), may be the subject of a bad debt deduction in either

1972 or 1975; (3) whether the gain which CCP realized pursuant

to section 1038, because of its foreclosure of a mortgage in

1972, is ordinary or capital in nature, and, if capital, whether it

is long or short term.

FINDINGS OF FACT

Some of the facts were stipulated. The stipulations of facts

and stipulated exhibits are incorporated herein by this

reference.

At the time the petitions herein were filed, Grace Cappuccilli

(Grace) and Dorothy Cappuccilli (Dorothy) resided in

2in his preliminary statement on brief, respondent states that these con-

solidated cases are also for the redetermination of an overpayment of

income tax of the petitioners for 1975 in the following amounts: Grace

Cappuccilli, $1,460; Dorothy Cappuccilli, $2,815; and Gerald F. and

Caroline Paduano, $1,072.

3All section references, unless otherwise indicated, are to the Internal

Revenue Code of 1954, as amended and in effect during the taxable years at

issue.

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APPENDIX D

Opinion of United States Tax Court

Syracuse, New York, and Gerald F. Paduano (Paduano) and

Caroline Paduano resided in Sarasota, Florida. Grace, with her

husband Peter L. Cappuccilli (Peter), who is not a party to

these cases, timely filed joint income tax returns with the North

Atlantic Service Center, Andover, Massachusetts, for the

taxable years 1970, 1971, and 1972, as did Dorothy and her

husband Rocco M. Cappuccilli (Rocco), who is also not a party

to these cases, and the Paduanos.

On May 6, 1976, Peter and Rocco each filed separate

petitions with the United States District Court for the Northern

District of Mew York, pursuant to Chapter XII of the

Bankruptcy Act. Pursuant to section 6871, the District Director

of Internal Revenue, Buffalo, New York, assessed income tax

deficiencies for the taxable years 1970, 1971, and 1972 against

both Peter and Rocco. The deficiencies which were assessed

against them are the deficiencies which are the subject of their

wives’ petitions herein.

In 1954, Peter, Rocco, and Paduano (hereinafter collectively

referred to as the developers) formed CCP. Each had a one-

third interest in the partnership. CCP was principally engaged

in the real estate business in the Syracuse, New York, area.

Stonehedge Development Corporation (Stonehedge) was

organized on April 8, 1953. The stock of Stonehedge was

owned equally by Peter, Rocco, and Paduano from its

organization through May 26, 1969. Seneca Sewerage Cor-

poration (Seneca) was organized on April 1, 1961, for the

purpose of operating a sanitary sewage treatment plant. The

stock of Seneca was owned equally by Peter, Rocco, and

Paduano through May 26, 1969. On May 27, 1969, Paduano

retired from active participation and ownership in all the

corporate and business ventures they had undertaken together,

except with respect to the partnership. Subsequently, in 1969,

and in all of 1970, 1971, and 1972, the stock of Stonehedge was

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APPENDIX D

Opinion of United States Tax Court

owned equally by Peter and Rocco, as was the stock of Seneca.

The partnership ownership interests remained the same,

although Paduano did not take an active part in the operations

of CCP.

The general plan of the developers was to have CCP acquire

options and purchase individual properties until it had put

together a parcel of land which could be developed; CCP would

make no efforts to improve or subdivide the parcel but would

subsequently sell it, at a profit, to Stonehedge, which would

make the necessary improvements, obtain new zoning (if

necessary), subdivide the lots, and construct and sell houses or

other buildings. The proceeds from these sales would provide

Stonehedge with the necessary funds to discharge the

obligations which it incurred in acquiring the land from CCP.

CCP also owned other properties for investment purposes,

such as a bowling alley, an office building, and other rental

properties.

Between 1955 and 1962, Stonehedge developed a community

known as Seneca Knolls in the Town of Van Buren, New York.

Henderson farm, lying adjacent to Seneca Knolls, was pur-

chased by CCP on March 8, 1960, for $125,460. The farm was

sold to Stonéhedge on February 20, 1961, in consideration of a

cash payment of $28,122.25, the assumption of mortgage

obligations totaling $107,605.14, and a note in the amount of

$81,000, bearing interest at six percent per annum, secured by a

purchase money mortgage, and providing for payment of

principal to be made in equal installments plus interest on the

first and second anniversaries of the sale.

“During the period February 22, 1961, through January 3,

1962, CCP acquired five contiguous farms (hereinafter the

APPENDIX D

Opinion of United States Tax Court

Seneca Knolls farms) at a total cost of $320,083.* The Seneca

Knolls farms lay between two previously completed sections of

the Seneca Knolls community. CCP anticipated that the Seneca

Knolls farms would be sold to Stonehedge (or another

developer) who wou!'d then subdivide them into lots for in-

dividual sale.

Prior to purchasing the Seneca Knolls farms, however,

Stonehedge wanted to be relatively certain that the Town of

Van Buren would rezone the land for residential lots of the size

they desired. Peter and Rocco had contacts with various town

officials and were given conflicting signals regarding the zoning

request. Nonetheless, in late 1961 and early 1962, their lawyer,

James M. Cerio,5 drafted the necessary documents for the

Seneca Knolls farms to be transferred to Stonehedge. Cerio

brought these documents — a closing statement, mortgage

note, mortgage, and the deed — with him to a meeting at the

developers’ offices on January 10, 1962. At that meeting, Peter

signed the closing statement, note, mortgage, and deed as

president of Stonehedge; Peter, Rocco, and Paduano all signed

the deed. During the meeting, while signing the documents, the

parties realized that there was a serious question whether the

zoning request, with negotiated modifications, would be ap-

‘ Dateof Purchase _ Existing Interest

Farm Purchase Price Mortgage per annum

Walter 2/22/61 $ 64,065 $54,000 4 percent

Commane 10/20/61 71,830 51,830 5 percent

Green 10/26/61 34,788 24,690 5% percent

Patterson 11/24/61 22,400 18,650 0 percent

Higgins 1/ 3/62 127,000 84,000 S percent

42,000 5 percent (Hunt)

SCerio was the attorney for CCP, Stonehedge, and Seneca, as well as Peter,

Rocco, and Paduano.

nae

ve.

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APPENDIX D

Opinion of United States Tax Court

proved. Cons:quently, the individuals held up signing the

closing statenent and concluding the sale until they were

reasonably satisfied that the zoning problem would be resolved.

Cerio left and Peter placed the documents in the CCP files in

the office.6 CCP paid the real estate tax on the properties for

1962.

On December 28, 1962, another meeting was held to close the

sale. Checks were written to cover transfer and recording fees,

legal fees, and the cash balance due CCP according to the

closing statement. Cerio recorded the deed later that day; when

the deed was returned after the recording, it was placed in the

Stonehedge file. Stonehedge made no payments on the pur-

chase between January 10 and December 28, 1962. The total

purchase price for the farms was $1,353,600. Stonehedge was

to assume mortgages on the land (from CCP’s purchases)

totaling $275,170. In addition, it gave CCP a mortgage and

non-interest bearing note for $1,075,000 to be paid $75,000 on

January 10, 1964, and $100,000 on each successive January 10

until the balance was paid in full. The deed, note, and mortgage

retained the January 10, 1962, date reflected in the documents

Originally prepared for the sale.

After the January 10, 1962, meeting, Stonehedge continued

its attempts to get the zoning change. In an application to the

Planning Board of the Town of Van Buren in June 1962, Stone-

hedge stated that the land was ‘‘now owned by deed or contract

by Stonehedge,’’and that ‘‘[p]rior tc development, compiete

title by deed will be held by the Corporation.’’ Its petition to

the Town Board merely made the former statement as did Cerio

in his appearance for Stonehedge at an August 16, 1962,

hearing on the application.’ Cerio’s presentation, as well as the

6CCP and Stonehedge were both operated out of the same office, as were

various other enterprises of the Cappucillis and Paduano.

7No separate contract of sale of the farms to Stonehedge is in evidence.

ae

20a

APPENDIX D

Opinion of United States Tax Court

petition to the board, explained that the development planned

on the parcel was ‘‘in conformity with the developer’s master

plan of development conceived and laid out prior to the enact-

ment of the present zoning ordinances [in 1961].”’

The Town Board refused Stonehedge’s request, so Stone-

hedge brought an action to compel approval of the rezoning

request in August 1963. In its complaint, Stonehedge stated

that it ‘‘is and at all times hereinafter mentioned was the owner

of [the Seneca Knoils farms];’’ that period included the summer

of 1962, during which time the rezoning applications were

pending.

During all of the taxable years 1970 and 1971, and during the

pericd from January | until March 13, 1972, CCP carried two

mortgage receivables on its books and records due from Stone-

hedge. These mortgages resulted from the sale of the Hen-

derson farm and the Seneca Knolls farms by CCP to Stone-

hedge. The outstanding balances on these two mortgages on

various relevant dates were as follows:

Date Henderson Farm Seneca Knolls Farms

Date of purchase $81,000 $1,075,000

1/ 1/70 70,000 1,052,850

12/31/70 70,000 1,052,850

1/ 1/71 70,000 1,052,850

12/31/71 706,000 1,052,850

1/ 1/72 ak 1,010,9729

3/12/72 = 1,010,972

During the taxable years 1970, 1971, and 1972, CCP carried

a mortgage receivable on its books and records due from

8These figures are not available in the record.

9 There is no explanation in the record as to how the mortgage balance went

from $1,052,850 on 12/31/71 to $1,010,972 on 1/1/72, only one day later.

2la

APPENDIX D

Opinion of United States Tax Court

Seneca in the amount of $25,000. This mortgage resulted

from the sale of half the Preston farm (20 acres) by CCP to

Seneca on April 16, 1961. The Preston Farm was purchased on

April 15, 1961, by CCP from Stonchedge.

Neither Stonehedge nor Seneca paid CCP any interest on

theix respective mortgages during the taxabi« vears 1970, 1971,

or 1972. Due to Stonehedge’s development probiems, Seneca

was unz ble to realize revenue from anticipated tap-ins.

During the taxable years 1970, 1971, and 1972, CCP had

loans due from Stonehedge (in addition to the mortgage loans ~

discussed supra) on which no interest was charged or paid in the

following amounts:

1970

Balance

Balance 1/1/70 $120,000

Balance 12/31/70 (repaid 10/29/70) ~« 0

1971

Balance 1/1/71 0

Advance 6/21/71 $6,000 $ 6,000

Advance 7/20/71 6,000 12,000

Advance 8/10/71 4,000 16,000

Advance 10/23/71 4,000 20,000

Advance 11/24/71 3,000 23,000

Balance 12/31/71 23,000

1972 Baiance

Balance 1/1/72 $23,000

Balance 12/31/72 23,000

10{: is not clear from the record whether this note bore interest, or at what

rate, because the exhibit which the parties stipulated to be the note is, in

fact, the mortgage note from Stonehedge to CCP on the Henderson farm.

Petitioners’ brief indicates the note called for six percent interest, as does

the testimony.

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APPENDIX D

Opinion of United States Tax Court

These loans resulted from advances to Stonehedge in order to

keep the corporation going and to meet priority obligations on

first mortgages.

On or about November 12, 1968, the State of New York

acquired by eminent domain a portion of the Seneca Knolls

farms property. Stonehedge rejected the state’s offer of

$52,300 for the property (on which a partial payment had been

made in 1969). The condemned property had a cost basis of

$130,183. On January 26, 1970, Stonehedge filed a claim

against the State of New York for $2,000,000; $1,000,000 in

direct damages and $1,000,000 consequential damages. It

expected to realize $600,000 to $700,000 on this claim. By

judgment entered May 16, 1973, the Court of Claims of the

State of New York determined that Stonehedge was entitled to

$245,399 for the parcel taken by the State. The total amount

paid Stonehedge, including interest, was $294,032.91, of which

$39,225 had been received as a partial payment in 1969.

In 1970, Stonehedge assigned its anticipated award from the

State as security for a $500,000 loan to be used to develop land

in Van Buren from the Merchants National Bank and Trust

Company of Syracuse (Merchants Bank). The loan was also

secured by mortgages on two farms and the personal

guarantees of Peter and Rocco, which Merchants had con-

sidered insufficient collateral without the assignment of the

claim against the State. Interest was payable at 1-1/2 percent

over the prime rate. Merchants Bank made this loan, in part, in

anticipation of receiving mortgage applications from the

purchasers of units from Stonehedge and its affiliated cor-

porations. Had it known, however, that only $254,807.91

would be received from the State for the assigned claim, it

probably would not have made the loan. ,

Prior to .he pledge of Stonehedge’s potential claim against

the State to Merchants Bank, it was not otherwise pledged,

assigned, or made the subject of a security interest.

23a

APPENDIX D

Opinion of United States Tax Court

On March 14, 1972, Stonehedge sold approximately 115

acres of land in the Seneca Knolls farms tract and paid CCP the

$223,756 proceeds of the sale.'' This money was used to reduce

the principal of CCP’s mortgage on the property (the partial

release of which was a precondition to the sale), after which

$889,094 of mortgage principal remained outstanding.

On or about March 14, 1972, Stonehedge gave CCP a deed in

lieu of foreclosure of the CCP nortgages for the Henderson

farm and the remainder of the Seneca Knolls tract. CCP took

ownership of the properties in full satisfaction of its mortgages.

CCP realized a gain of $482,577 on :.s reacquisition of the

properties from Stonehedge.

Stonehédge’s balance sheets for the years ending December

31, 1970, 1971, and 1972 reflected the following:

11 The two purchasers, PRG Enterprises, Inc., and the Village Green of Van

Buren, Inc., were corporations related to Stonehedge and CCP. The date of

March 14, 1972, is stipulated by the parties, although the foreclosure

document states that these two entities were conveyed land in deeds dated

December 30, 1971.

tS

1970 1971 1972 1973 1974

ASSETS

Current assets $ 303.8362 $ 16,230 $ 13,285 $ $

Equipment (less

depreciation) 4,995 3,496 26,145

Lan“ (at cost) 1,338,654 1,338,797 200,175

Due from Seneca 71,950 68,950 69,350

Seneca mortgage 10,000 10,000 10,000

Total Assets $1,729,435 $1,437,473 $318,955 $4,819 $5,118

—SEE ————___—______4 = ed

STOCKHOLDERS’ EQUITY =.

Current liabilities $ 90,174 $ 116,348 $174,500 “

Mortgages payable 1,146,152 1,142,101 9,249 sy

Merchants’ Bank loan 496,00013 472,000!4 306,000 Sie

Other liabilities 57,416 66,385 90,397 15,908 15,847 = 2

Common stock!5 8,35715 8,35715 835715 - 835715 8.35715 & S

Retained earnings (68,664) (367,718) (269,548) _(19,446) _(19,086) & S

Total Liabilities and g =

Stockholders’ Equity $1,729,435 $1,437,473 $318,955 $4,819 $5,118

.————___— 4 ————————— ————_—_—_—_ SS aa g

12 This includes $250,000 due from two affiliated companies, Stevemark Realty Corp. and Cappy’s of Syracuse, Inc., of Q

which $240,324 was written off as uncollectible in 1971. q

130f this amount, $104,000 was due withi:, one year.

» 14Of this amount, $24,000 was due within one year.

_ 15Stonehedge originally issued at par 120 out of 200 authorized shares of $100 par value common stock. Paduano’s shares

were purchased by the corporation in 1969 for $9,643.22 and held as treasury stock. It is the net of these figures, $8,357,

which is reflected as shareholders’ equity in common stock.

« . ' , . ‘ .

ER oon to ae [<= f a . pea ‘ 3 iat, oe to . by Ue .

erz

25a

APPENDIX D

Opinion of United States Tax Court

The fol)awing table shows Stonehedge’s earnings during the

taxable years indicated as shown on its financial statements

and/or tax returns:'6

Net earnings (or less)

Gross profit or Other after

Year oss from sales Income for taxes

1967 $40,341.95 $ 4,216 $ 3,285

1968 (26,683.23) 6,269 (54,687)

1969 Nosales listed 6,113 (35,948)

1970 Nosales listed 1,175 (43,645)

1971 Nosales listed 2,321 (299,054)

1972 Nosales listed 1,245 (39,563)!7

1973 Nosales listed 254,708!8 9,779

1974 Nosales listed 86 (125)

The notes to the 1970 and 1971 financial statements’ schedules

of land and mortgages payable, referring to the Seneca Knolls

farms, state: ‘‘It is the opinion of management that the market

value of the land exceeds the stated amount of each mortgage.”’

For the taxable years 1967, 1968, and 1969, the District

Director of Internal Revenue, Buffalo, New York, allocated

interest on the mortgages given CCP by Stonehedge and

Seneca, and on advances made by CCP to Stonehedge and to

Cappy’s Real Estate, Inc., another related corporation, pur-

suant to section 482. In 1975, this Court sustained respondent’s

allocation of interest, and its effect on the distributable part-

16For 1973, the financial statement covers only the five-month period ending

May 31, whereas the tax return covers the entire year.

17The statement of earnings reflects a capital gain of $137,733.16,

presumably from the foreclosure, which, under the circumstances,

represents no cash receip.s.

18includes $48,634 in interest in respect of the condemnation award and

$204,224 reported as long-term gain, the source of which was not iden-

tified.

26a

APPENDIX D

Opinion of United States Tax Court

nership income of each of the partners, for those three taxable

years. Our decision was affirmed by the United States Court of

Appeals for the Second Circuit, and the Supreme Court denied

certiorari. Paduana v. Commissioner, T.C. Memo. 1975-69,

affd. mem. $38 F.2d 312 (2d Cir. 1976), cert. denied 425 U.S.

992 (1976). The amounts of interest allocated for the taxable

years 1967, 1968, and 1969 were $69,428.49, $68,134.93, and

$64,070.31, respectively.

In its amended partnership return for 1975, signed August

13, 1976, after the Supreme Court denied certiorari, CCP

claimed a bad debt deduction for the interest allocated for

1967, 1968, and 1969. The taxpayers then filed amended

returns for 1975 and refund claims to carryback the net

operating loss to the taxable year 1972.

On June 13, 1975, the boards of directors of Stonehedge and

Community Technology, Inc. (CTI), and their shareholders,!9

approved the merger of their corporations, together with PRG

Enterprises, Inc., another related corporation, which owned all

the shares of Village Green of Van Buren, Inc., into CTI. The

purpose of this merger was to reduce costs by simplifying their

operations. As originally planned, each entity was to serve a

particular function, but in practice they began overlapping,

complicating both their internal and external dealings.

On or about May 13, 1976, CTI filed a petition in the United

States District Court for the Northern District of New York

pursuant to Chapter XI of the Bankruptcy Act, coincident with

Peter’s and Rocco’s filing under Chapter XII of the

Bankruptcy Act. The primary purpose of filing all three

PONS SNe Ho ERMC OED HERENNT SHRCNRENAES OF FEM,

Rocco, and CTI.

191n addition to Peter and Rocco, one Alfred Cappuccilli was also a share-

~ holder and director of CTI.

27a

APPENDIX D

Opinion of United States Tax Court

In its Statement of Affairs filed with the Bankruptcy Court

on June 11, 1976, CTI listed total property in the amount of

$7,048,737.25, and total debts of $8,970,466.79. These debts,

however, included one liability of $1,979,127 which was a

mortgage debt against a project which had been conveyed

subject to the mortgages, so the value of this property,

$2,400,000, was not included as an asset of CTI. Another debt

for $1,500,000 included on CTI’s debt schedule was secured by

certain phases of a project owned by Peter and Rocco, which

had a market value in excess of $5,000,000 and was not

otherwise encumbered; it, too, was not reflected in CTI’s asset

schedule.

The secured indebtedness was successfully renegotiated. On

or about October 6, 1977, the Bankruptcy Court approved a

Plan of Arrangement with the unsecured creditors providing

for 100-percent payment of their claims by June 10, 1984. li:

addition, Peter and Rocco agreed to a subordination of their

individual claims against CTI.

In the course of the bankruptcy proceeding, CCP filed a

proof of claim in the sum of $325,718.90 for interest allocated

by respondent pursuant to section 482 for the period 1967 until

March 1972. The Bankruptcy Court disallowed this claim

because under New York law, no interest liability by CTI to

CCP existed. The United States filed an amicus curiae brief in

the Bankruptcy Court opposing CCP’s claim on these grounds.

ULTIMATE FINDINGS OF FACT

CCP had a reasonable expectation that, if it had charged

interest to Seneca during the taxable years at issue, such interest

could have been paid during such years or within a reasonable

time thereafter.

CCP had a reasonable expectation that, if it had charged

interest to Stonehedge during the taxable years at issue, such

‘

*

28a

APPENDIX D

Opinion of United States Tax Court

interest could have been paid during such years or within a

reasonable time thereafter.

At the time of the sale to Stonehedge, CCP held the Seneca

Knolls and Henderson farms properties primarily for sale to its

customers in the ordinary course of its trade or business. The

sale to Stonehedge took place on December 28, 1962.

OPINION

The parties have presented us with three issues to be resolved.

Whether: (1) respondent’s allocations of interest to CCP

pursuant to section 482”° for the taxable years 1970, 1971, and

1972 should be upheld;?! (2) CCP may deduct as a bad debt in

either 1972 or 1975 the interest properly allocated to it for the

years 1967, 1968, and 1969; and (3) the character of the gain to

CCP upon its foeclosure of the mortgages on the Henderson

and Seneca Knolls farms.

Petitioners do not dispute the principle that where one

member of a group of commonly controlled entities becomes

indebted to another but is charged no interest, respondent may

20The interest was allocated in respect of the Stonehedge and Seneca mort-

gages under section 482 rather than section 483 because the sale to Stone-

hedge occurred prior to July 1, 1963. With respect to the Seneca mortgage.

even if it bore interest at six percent (see footnote 10, supra) such interest

was not paid (nor does the record reveal that CCP reported any such in-

terest on its tax returns for the years at issue) and, in any event, petitioners

make.no separate argument with respect to respondent’s use of a five-

percent rate in making his allocation. Cf. Liberty Loan Cofporation v.

United States, 498 F.2d 225, 231-232 (8th Cir. 1974).

21 Petitioners concede that if interest is properly allocable to CCP under the

circumstances herein, the rate utilized by ‘respondent is appropriate.

Respondent has allowed Stonehedge and Seneca additional interest

_ deductions for the years in issue in amounts equal to the interest income

which he has allocated to CCP under section ‘*2. Section 1.482-1(d\(2),

Income Tax Regs. ’

29a

APPENDIX D

Opinion of United States Tax Court

allocate interest to the creditor under section 482, if interest

would have been charged under like circumstances in an arm’s-

length transaction. B. Forman Company v. Commissioner, 453

F.2d 1144 (2d Cir. 1972), affg. in part and revg. in part 54 T.C.

912 (1970). Petitioners acknowledge that no interest was

charged during the years in issue, but argue that (a) the cor-

porations and partnership were not commonly controlled, and

(b) since interest would not have been accrued under the cir-

cumstances by unrelated entities, respondent cannot allocate it

under section 4f2.

We find petitioners’ argument that the necessary control

(under section 482) did not exist to be frivolous. They contend

that when Paduano relinquished his stock int =rests in 1969, the

common control also disappeared. Section 482 and regulations

thereunder”? clearly state that common control, direct or in-

direct, not common ownership, is all that is necessary. Charles

Town, Inc. v. Commissioner, 372 F.2d 415, 419-420 (4th Cir.

1967), affg. a Memorandum Opinion of this Court. The

language is broad and sweeping, and is ample to cover the

present case. Cf. Ach v. Commissioner, 42 T.C. 114, 125

(1964), affd. 358 F.2d 342 (6th Cir. 1966).

We are to apply a realistic approach to the control question.

B. Forman Company v. Commissioner, 453 F.2d at 1153.7

Though there may have been a potential conflict of interest be-

tween Paduana and the Cappuccillis, because of the former’s

continued ownership of a one-third interest in the partnership,

22Section 1.482-1(a\3).

23Since the business entities involved herein are Stonehedge and Seneca, on

the one hand, and the CCP partnership on the other, we are not required to

decide whether we will accept the full import of the reversal of our holding

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

affg. in part and revg. in part $4 T.C. 912 (1970).

ey ee

po

.

30a

APPENDIX D

Opinion of United States Tax Court

petitioners have demonstrated no actual conflict. In fact, the

only evidence presented indicates that Paduano had retired

from active participation in CCP, thereby manifesting common

direct control in Peter and Rocco over the entities. Even if the

evidence had indicated a continuing active role for Paduano in

CCP, we would find the necessary control. In failing to collect

interest from Stonehedge and Seneca, CCP was merely con-

tinuing its practice established while Paduano was involved in

the corporations. We have no evidence that Paduano attempted

to change such practice, despite his new status solely as a

creditor of the corporations via the partnership, rather than as

a shareholder, thereby indicating an acquiescence in the

management decisions by Rocco and Peter. Petitioners have

failed to convince us that the actual control of the partnership

and the corporations was not exercised by the latter ¢wo in-

dividuals at all times during the taxable years 1970, 1971, and

1972. We, therefore, find the requisite control by the same

interests. See also Grenada Industries, Inc. v. Commissioner,

17 T.C. 231, 253-254 (1951), affd. 202 F.2d 873 (Sth Cir. 1953).

In Dallas Ceramic Co. v. United States, 598 F .2d 1382 (Sth Cir.

1979), Brittingham v. Commissioner, 66 T.C. 373, 395-400

(1976), affd. per curiam 598 F.2d 1375 (Sth Cir. 1979), and

Cedar Valley Distillery, Inc. v. Commissioner, 16 T.C. 870

(1951), relied upon by petitioners, the ownership involved was

24Petitioners’ argument that ‘‘it should be obvious that Paduano was looking

forward to having CCP collect its mortgage obligations, including interest,

from Stonehedge and Seneca,”’ is ludicrous. CCP had no enforceable right

to collect interest from Stonehedge on its mortgage loan under New York

law. New York State Thruway Authority v. Hurd, 25 NY 2d 150, 158, 303

N.Y.S. 2d 51, 56 (1969). Moreover, he was well aware that CCP had not

been collecting interest from either corporation. Paduano’s explained

absence from the trial means, at most, that his failure to testify will not be

held against petitioners (see Snyder v. Commissioner, T.C. Memo. 1969-

173), not that they may speculate as to what such testimony might have

been.

2 alg

3la

APPENDIX D

Opinion of United States Tax Court

so disparate that the necessary common control under section

482 was found not to exist. These cases are clearly

distinguishable.

It is clear that respondent may allocate interest to CCP in

respect of its loans to the corporations even if the corporations

did not realize income from the loans during the year. B.

Forman Company v. Commissioner, supra; Latham Park

Manor, Inc. v. Commissioner, 69 T.C. 199 (1977). He is to

make such allocation —

in order to prevent ‘‘evasion of taxes or clearly to reflect

the income.’’ The legislative history of section 482 in-

dicates that it was designed to prevent evasion of taxes

by the arbitrary shifting of profits, the making of fic-

titious sales, and other such methods used to “‘milk’’ a

taxable entity. The Commissioner has considerable

discretion in applying this section and his deter-

minations must be sustained unless he has abused his

discretion. We may reverse his determinations only

where the taxpayer proves them to be unreasonable,

arbitrary, or capricious. * * * Ach v. Commissioner, 42

TC at 125-126. [Citations omitted.]

Petitioners argue that the financial status of Stonehedge and

Seneca was such that, even if an adequate rate of interest had

been charged (as presumably an unrelated third party would

have done) such interest would not have been accruable,

because there was no reasonable expectation of collection

during the taxable years at issue, and that, therefore,

respondent was without power to allocate interest income to

CCP in respect of those years. Respondent argues that be may

apply section 482 to allocate interest income regardless of the

debtor’s ability to pay (see section 1.482-1(d) (4), Income Tax

Regs.) and, in any case, that the financial condition of Stone-

hedge and Seneca were such that CCP had a reasonable ex-

pectation of collecting interest and, therefore, if an adequate

interest had been charged, it would have been accruable.

_

32a

APPENDIX D

Opinion of United States Tax Court

We deal first with the question as to whether an unrelated

taxpayer or CCP (had it charged an adequate rate of interest)

would have been required to report for tax purposes interest

income during any of the taxable years at issue. Under the

accrual method of accounting, income is includable in gross

income when all the events have occurred which fix the right to

receive such income and the amount can be determined with

reasonable accuracy. Section 1.451-1(a), Income Tax Regs.

Where, however, income is of doubtful collectibility or it is

reasonably certain that it will not be collected within a

reasonable time after the taxable year, i.e., in the absence of

**reasonable expectancy of its receipt,’’ a taxpayer is justified in

not accruing the item. Corn Exchange Bank v. United States,

37 F.2d 34 (2d Cir. 1930). The mere financial difficulty of the

debtor or postponement of making payment does not constitute .

the requisite absence of reasonable expectancy of receipt.

Harmont Plaza, Inc. v. Commissioner, 64 T.C. 632, 650

(1975), affd. by order 549 F.2d 414 (6th Cir. 1977). The

determination of whether CCP would have had a “‘reasonable

expectancy’”’ of collecting interest from Seneca and Stonehedge

is a question of fact. Chicago & North Western Railway Co. v.

Commissioner, 29 T.C. 989, 996 (1958). In approaching the

question of “‘reasonable expectancy,’’ we recognize that this

involves an exception to the general rule of accruability and

that it should be applied narrowly in order that the exception

does not swallow up the rule itself. Cf. Georgia School-Book

Depository, Inc. v. Commissioner, 1 T.C. 463, 469 (1943).

Furthermore, we recognize the problem in examining cash flow

in the context of leveraged real estate transactions such as

Stonehedge engaged in (see Harmont Plaza, Inc. v. Comi-

missioner, 64 T.C. at 650), a problem which is accentuated

where related corporations and the consequent opportunity for

manipulation are involved.

25See also IDI Management, Inc. v. Commissioner, T.C. Memo. 1977-369.

a

33a

APPENDIX D

Opinion of United States Tax Court

We note initially that, as to Seneca, we have only Peter’s self-

serving and unsubstantiated testimony that it could not pay

interest. Though petitioners filled the record with Stonehedge’s

tax returns and audited financial statements, the only

documentation relati-° to Seneca was its corporate income tax

returns for use fiscal years ending Jitue 30, 1968, and 1969,

years not invo'ved herein. These returns sliow that, although

Seneca operate:| at a loss during those years, it had substantial

gross receipts, and there is no evidence that such flow of

receipts did not continue during the taxabie years 1970, 1971,

and 1972 and that interest could not have been paid

therefrom.” Petitioners have totally failed to carry their

burden of proof (Welch v. Helvering, 290 U.S. 111 (1933); Rule

142(a), Tax Court Rules of Practice and Procedure). Ac-

cordingly, we uphold respondent’s determination that CCP

should have accrued interest income due from Seneca during

the years in issue. Cf. Bryan v. Commissioner, 281 F.2d 238,

243 (4th Cir. 1960), affg. in part and remanding 32 T.C. 104

(1959).

The issue of ‘‘reasonable-expectancy’”’ as to Stonehedge is not

as clear-cut. Throughout the taxable years 1970, 1971, and

1972, Stonehedge’s real estate holdings were heavily leveraged.

Based upon its tax returns and financial statements during such

years, its liabilities far exceeded its assets,”’ it was unprofitable,

and it had cash flow problems. But, Stonehedge received

substantial amounts of cash during those years which, for

aught that appears in the record herein, could have been used to

pay interest had it been charged — some $496,000 by way of

26See Merit Tank and Body, Inc. v. Commissioner, T.C. Memo. 1980-175.

270n its balance sheet of December 31, 1970, current assets exceeded current

« liabilities. The current as.ets, however, included $250,000 in accounts

receivable from related corporations, of which $240,324 was written off as

uncollectible in 1971. See footnote 12. supra.

a’

34a

APPENDIX D

Opinion of United States Tax Court

loan from Merchants Bank and $223,756 from the sale of

acreage to a third party.

Petitioners’ arguments that the proceeds of the Merchants

Bank loan could not have been used to pay interest had it been

charged are not persuasive. We were not favored with any

written evidence as to the terms of the $500,000 loan which

would have revealed the restrictions, if any, on the use of funds

advanced by the bank thereunder. Nor did the oral testimony of

Gschwender (the loan officer of Merchants Bank involved with

the loan to Stonehedge) enlighten us on this score. He merely

testified that Merchants Bank would have loaned funds for the

purpose of paying interest to CCP only on a subordinated basis

and did not testify as to the conditions imposed by the bank on

the loan actually made. We do not think that the evidence of

record as to the collateral and guaranties which Merchants

Bank required is sufficient to indicate whether any such

restrictions existed, or the nature thereof. Nor were we favored

with any evidence as to how the funds received from Merchants

Bank were in fact used, altho: - we presume they were used to

pay operating expenses which, according to the financial

statements, with minor exceptions, did not involve any con-

struction or other direct costs of developing Stonehedge’s land.

Similarly, no evidence was submitted to show the source of

funds with which repayments were made to Merchants Bank.”*

In this connection, we note that in 1971 and 1972 the loan

balance was reduced. Thus, we are not satisfied that the funds

advanced by Merchants Bank could not have been used to pay

interest to CCP during the taxable years at issue.

Our position is reinforced by the fact that during 1970 Stone-

hedge repaid $120,000 of advances by CCP. Since Stonehedge

had only a miniscule amount of income during th-: year, such

28The loans from Merchants Bank aggregated $472,000 at the end of 1971

and $306,000 at the end of 1972. ,

PY pee Sh

35a

APP. -NDIX D

Opinion of United States Tax Court

repayment presumably was made from funds received from

Merchants Bank on the theory that such advances were for the

purpose of facilitating the development of Stonehedge’s

properties. The use of such advances to pay interest on CCP’s

mortgage (had it been charged) could presumably have been

supported on the same basis, since the mortgages represented

the proceeds of sales of land to Stonehedge for purposes of

development.

As far as the $223,756 is concerned, it appears that such

payment was necessary to release CCP’s mortgage in order that

the property in question could be sold. The funds were applied

to the discharge of the principal of the mortgage; in fact, there

was no reason for it to have been applied otherwise, since at the

time of application, Paduano v. Commissioner, T.C. Memo.

1975-69, affd. mem. 538 F.2d 312 (2d Cir. 1976), cert. denied

425 U.S. 992 (1976), had not been decided to say nothing of the

fact that the deficiency notices which gave rise to the Paduano

case had not even been issued (they were issued in June 1972).

Moreover, under New York law, such application would have

been recognized as binding between the parties. Cf. Foss v.

Riordan, 84 N.Y.S. 2d 224, 233-234 (West. Cty. 1947), affd.

273 App. Div. 982, 79 N.Y.S. 2d 515 (2d Dept. 1948), and cases

cited thereat. See New England Waterworks Co. v. Farmers’ L.

& T. Co., 54 App. Div. 309, 66 N.Y.S. 811, 815 (ist Dept.

1900); Laney v. Whitaker, 91 Misc. 2d 949, 398 N.Y.S. 2d 839,

840 (Monroe Cty. 1977), citing Bank of Caiifornia v. Webb, 94

N.Y. 467, 472 (1884). Moreover, respondent’s own regulations

seem to recognize that payments are applied first to principal

(at least in the absence of a contrary application by the parties)

in outlining the method by which the time periods for com-

puting allocated interest are determined. See section 1.482-

2(a) (3), Incorae Tax Regs. Under these circumstances, we

incline to the view that the $223,756 should not be considered as

being available for the payment of the interest allocated in

respect of the taxable years at issue.

Ss CU

36a

APPENDIX D

Opinion of United States Tax Court

However, as we see it, there was still another source of funds

which could have been available to pay interest had it been

charged. CCP received $404,422 in October 1973 as proceeds

from the sale of land. The record does not clearly reveal what

land was sold. A part of it ($254,399) apparently was the

principal proceeds of the State condemnation award, which for

the reasons hereinafter stated (see p. 37, infra) we do not

believe should be taken into account. The balance of the

proceeds ($159,023) apparently came from other land which

presumably was available for sale by Stonehedge at an earlier

date. Stonehedge’s 1973 return shows a cost of tae land not

involved in the condemnation award as $70,015 which indicates

that of the total gain of $204,224 reported — a figure as to

which we have been unable to construct a reconciliation on the

basis of the record before us — $89,008 ($159,023 less $70,015)

was available to pay interest had it been charged.”9

Based on the foregoing, Stonehedge would appear to have

had at least $589,008 available (and possibly more, see footnote

2%, supra) available cash funds during the taxable years at issue

or within a reasonable time thereafter. Granted that it was

reasonable to expect that some of these funds were needed for

operations (although, as we have pointed out, no hard evidence

on this score was forthcoming), there would still seem to have

been enough which could have been used to pay interest had it

been charged. The amounts of allocated interest to CCP from

Stonehedge for the three years at issue herein aggregated only

$129,339 (1970 — $61,111; 1971 — $56,564; 1972 — $11,664).

If we were to take into account the $196,380 of interest

allocated to CCP from Stonehedge fas 1967, 1968, and 1969,3°

29For aught that appears in the record, this land may well have beer, aeld free

of encumbrances by Stonehedge so that the full $159,663 proceeds from its

sale could have been sc available.

30The remaining $5,254 ($201,634 less $196,380) allocated for these years

involved other entities and need not be considered.

37a

APPENDIX D

Opinion of United States Tax Court

we would reach the same conclusion; the aggregate allocated

interest for all six years (some $325,719) was still substantially

less than the funds which appear to have been available, even

after making some allowance for expenditures to cover

operating costs.

In sum, petitioners have simply not carried their burden of

proof (Welch v. Helvering, supra; Rule 142(a), supra) that

there was not a “‘reasonable expectancy”’ that, had such interest

been charged Stonehedge by CCP, it could not hav: been

paid.3!

Petitioners’ argument that we should not take allocated

interest into account because it was not clear, at least until

Paduano v. Commissioner, supra, was decided by this Court in

1975, that there was any liability for such interest is beside the

point. The test we have applied is, not whether there was a

‘reasonable expectancy”’ of collectibility of allocated interest,

but whether, if a third party (or CCP) had in fact charged in-

terest in the amounts allocated by the respondent, such interest

could have been reasonably expected to have been collected.

See pp. 27-28, supra.

Because we have concluded that respondent’s allocation of

interest to CCP for the taxable years at issue should be

sustained for the reasons stated above, we do not reach

respondent’s arguments that we should hold that there was a

‘reasonable expectancy”’ of collectibility because Stonehedge

had available unrealized appreciation in its real estate®? and

31We reach this conclusion on the basis of a “‘preponderance of the

evidence”’ standard of proof and, therefore, do not reach the question

whether, because section 482 is involved, a higher standard of proof, i.c.,

that respondent’s determination was art -.rary, is required of petitioners on

the subsidiary issue of reasonable expectancy.

321 trial, because of the manner in which the evidence was developed, the

Court stated that, in any event, it was not disposed to deal with this issue.

‘

38a

APPENDIX D

Opinion of United States Tax Court

because of the availability, prior to its assignment to Merchants

Bank, of the State condemnation award.” Similarly, we do not

reach the issue as to whether, even if there was no reasonable

expectancy of collectibility, respondent nevertheless had the

power to allocate interest by analogy to the “‘creation of in-

come”’ cases. See Latham Park Manor, Inc. v. Commissioner,

69 T.C. at 214-216, and cases collected thereat; section 1.482-

1(d) (4), Income Tax Regs. In this latter connection, we observe

that the ‘‘creation of income’’ cases involved the question

whether it was material to the existence of respondent’s power

to allocate income under section 482 that funds represented by

non-interest-bearing loans were used to produce income (in

which context, the Court of Appeals in B. Forman Company v.

Commissioner, supra, rejected the standard of correctness

‘from a pure accounting standpoint”’ and held that section 482

could be utilized, see 453 F.2d at 1156), whereas, in the instant

case, had we found no reasonable expectancy of collectibility,

our analysis would have started from the premise that

respondent had the power to “‘create’’ income under section

482 and would then have proceeded to deal with the question

whether the interest income so created should have been in-

cluded in CCP’s income even though an independent third

party (or CCP) would not have been required to report such

interest had it been charged, a question not faced in the

33We note that this argument has an aura of incongruity, since the amount, if

any, which Stonehedge would receive beyond the $13,075 excess over what

the State had paid in 1969 was highly speculative; the final award of

$245,399 was not made until May 16, 1973, well after the close of the last

taxable year involved herein.

34Sce Pitchford’s, Inc. v. Commissioner, T.C. Memo. 1975-75, where

respondent conceded solely for the purposes of that case that section 482

should not be applied under such circumstances — a conclusion which he

now. characterizes as “‘inopportune.”’ Section 1.482-1(b)(1), Income Tax

Regs., provides: :

Footnote continued on next page—

APPENDIX D

Opinion of United States Tax Court

**creation of income’’ cases.35

The next issue to be resolved is whether petitioners are en-

titled to a bad debt deduction in either 1972 or 1975 for the

interest respondent successfully allocated .o CCP under section

482 for the years 1967, 1968, wg 2 aie apa ay

Commissioner, supra.)

Petitioners argue that the ‘‘debt’’ became worthless in either

1972 or 1975. Their 1972 claim is based upon B. Forman

Company v. Commissioner, supra, the first case upholding

respondent in his allocation of interest on non-interest-bearing

loans under section 482, being decided in that year, including

—Footnote continued from preceding page

(b) Scope and purpose. (1) The purpose of section 482 is to place a

controlled taxpayer on a tax parity with an uncontrolled toxpayer, by

determining according to the standard of an uncontrolled taxpayer, the

true taxable income from the property and business of a controlled tax-

payer. The interests controlling a group of controlled taxpayers are

assumed to have complete power to cause each controlled taxpayer so to

conduct its affairs that its transactions and accounting records truly reflect

the taxable income from the property and business of each of the controlled

taxpayers. If, however, this has not been done, and the taxable incomes are

thereby understated, the district director shall intervene, and, by making

such distributions, apportionments, or allocations as he may deem

necessary of gross income, deductions, credits, or allowances, or of any

item or element affecting taxable income, between or among the controlled

taxpayers constituting the group, shall determine the true taxable income of

each controlled taxpayer. The standard to be applied in every case is that of

an uncontrolled taxpayer dealing at arm’s length with another uncontrolled

taxpayer. [Emphasis added.)

35Respondent’s reliance on Hennessey v. Commissioner, T.C. Memo. 1977-

122, is also misplaced. In that case, we found that Hennessey had a

reasonable expectation of collecting interest payments and, therefore, did

not have to face this issue. Our passing reference to the fact that the

question of reasonable expectation of cullectibility is ‘not entirely distinct

from their creation of income argument”’ is too thin a reed to support

respondent's contention.

40a

APPENDIX D

pinion of United States Tax Court

the denial of a petition for certiorari (407 U.S. 934 (1972)) and

a rehearing thereon (409 U.S. 899 (1972)) and their receipt in

that year of the deficiency notices for 1967, 1968, and 1969.

Their alternative claim for 1975 rests on the fact that in that

year, we decided Paduano v. Commissioner, supra, upholding

respondent’s allocation of interest from Stonehedge and

Seneca. For the reasons which follow, we hold that if a ‘‘debt’’

was created, it dic not come into existence until 1976.

It is well-settled that a debt does not exist for purposes of

section 166 where the obligation to repay is subject to a con-

tingency which has not occurred. Lieberfarb v. Commissioner,

60 T.C. 350, 354 (1973); Ewing v. Commissioner, 20 T.C. 216,

229 (1953). The obligation of the petitioners’ in Paduano vy.

Commissioner, supra, to pay the tax on the allocated interest

was contingent on both our decision and its affirmance on

appeal. Blake v. Commissioner, 67 T.C. 7, 18-20 (1976), and

cases discussed thereat, affd. as to this issue 615 F.2d 731, 736

(6th Cir. 1980); North American Coal Corporation v. Com-

missioner, 28 B.T.A. 807, 851 (1933). Cf. United States v.

Consolidated Edison Co., 366 U.S. 380 (1961); Lucas v.

American Code Co., 280 U.S. 445 (1930). See sections 6215 and

7485. See generally, 2 Mertens, Law of Federal Income

Taxation (Malone Rev. 1974) sec. 12.66, pp. 267-269.

Petitioners argue that the requirements of section 7485 and

Rule 192, Tax Court Rules of Practice and Procedure, that the

filing of a notice of appeal does not stay assessment or

collection of the deficiency determined by this Court unless a

bond is filed with this Court, remove the contingency. We

disagree. We think it a fair assumption that their appeal of the

Paduano decision was in good faith and not a dilatory tactic.

See section 7482 (c) (4). Thus, we will not now hear petitioners

argue that they did not believe their tax liability was in dispute

and subject to a real contingency in 1975. Similarly, since the

tax liability was contingent until 1976, a debt for it could not

4la

APPENDIX D

Opinion of United States Tax Court

have been in existence in 1972. Petitioners’ argument that the

debt arose in that year because the deficiency notice was

“‘presumptively correct,’’ is clearly without merit .>°

Thus far, the discussion has centered on the petitioners’ tax

liability in Paduano v. Commissioner, supra, whereas we are

concerned herein with the underlying interest liability. That

interest obligation, however, was the alter ego of the tax

liability; the allocation of interest was contingent on our tax

decision. Had we, or an appellate court, decided in favor of the

petitioners in Paduano, there would have been no allocation of

interest, nor any question as to whether it was a valid and

enforceable obligation. Until the decisions were final,

therefore, the interest liability (if it ever were to legally arise)

was subject to a contingency which had not yet occurred. It is

analogous to the situation in which the tax liability is con-

tingent on when the underlying claim is finally resoived. E.g.,

Dixie Pine Co. v. Commissioner, 320 U.S. 516 (1944) (all

events have not occurred where liability is contingent and is

contested by taxpayer).>’

We turn now to the final issue, i.e., the character of the gain

recognized by CCP pursuant to section 1038 (b) (1), upon the

foreclosure of the mortgages on the Seneca Knolls and Hen-

36The effect of the deficiency notice 1s to place the burden of proof on the

issues raised therein on the petitioners. Many petitioners are able to carry

this burden, although the petitioners in Paduano v. Commissioner, T.C.

Memo. 1975-69, affd. mem. 538 F.2d 312 (2d Cir. 1976), cert. denied 425

U.S. 992 (1976), were not. See generally, Liorente v. Commissioner, 74

T.C. ___ (May 13, 1980) (Tannenwaid, J., concurring).

371f a debt was not created, petitioners may be entitled to a loss. See Tharp v.

Commissioner, T.C. Memo. 1972-10. See also Corn Exchange Bank v.

United States, 37 F.2d 34, 35 (2d Cir. 1930). Our findings regarding the

proper taxable year apply to this issue, as well. Section 1.165-1(d)(1),

Income Tax Regs.

ee

42a

APPENDIX D

Opinion of United States Tax Court

derson farms in 1972.58 The characterization of the gain as

ordinary or capital is controlled by the circumstances of the

original sale. Section 1.1038-1 (d), Income Tax Regs. Thus, we

must decide whether the Seneca Knolls and Henderson farms

were capital assets within the meaning of section 1221 in CCP’s

hands, when originally sold to Stonehedge.

Section 1221 (1) denies capital gain treatment to gains arising

from the sale of ‘‘property held by the taxpayer primarily for

sale to customers in the ordinary course of his trade or

business.’’ The purpose of this provision “‘is to differentiate be-

tween ‘the profits and losses arising from the everyday

operation of a business’ on the one hand *** and ‘the

realization of appreciation in value accrued over a substantial

period of time’ on the other, * * *.’’ Malat v. Riddell, 383 U.S.

569, 572 (1966).

The ultimate determination is a factual one, to be based on

all the surrounding circumstances. Adam v. Commissioner, 60

T.C. 996, 999 (1973). Rather than list the factors deemed

relevant by the courts (see e.g., Gault v. Commissioner, 332

F.2d 94, 96 (2d Cir. 1964), affg. a Memorandum Opinion of

this Court; Adam v. Commissioner, supra), we shall only

discuss those relevant to our decision herein. The relationship

among the factors and their mutual interaction changes in each

case depending on the facts. Biedenharn Realty Co. v. United

States, $26 r.2d 409, 415 (Sth: Cir. 1976). The focus of the

factual inquiry is the statutory tests, i.e., (1) what was CCP’s

trade or business? (2) was CCV’ holding the property primarily

for sale in the ordina: + <>u.«se of its trade or business and (3)

was Stonehedge a customer of CCP in that trade or business?

Cf. Suburban Realty Co. v. United States, 61! F.2d 171, 178

(Sth Cir. 1980).

38Petitioners concede that the amount of said gain is $482,577.

43a

APPENDIX D

Opinion of United States Tax Court

Petitioners argue that CCP and Stonehedge were separate

taxable entities, as were the partner/shareholders, so that the

activities of each should not be attributed to the others. See

Gordy v. Commissioner, 36 T.C. 855 (1961). They then argue

that CCP merely acquired the individual farms as a speculative

investment, assembling enough contiguous parcels to make it

worthwhile for a purchaser to seek a zoning change. They claim

that CCP undertook no other activity to rezone, subdivide, or

otherwise improve the land, nor any sales activities. In ad-

dition, they deny that CCP was in the trade or business of

selling land, claiming that its real estate transactions were few

and isolated .59

The developers were careful, on paper, to separate their

activities and those of Stonehedge from the partnership’s, but

that is where the separation ended. CCP cannot 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.

Bauschard v. Commissioner, 31 T.C. 910, 916-917 (1959), affd.

279 F.2d 115, 118 (6th Cir. 1960). Cf. Pointer v. Com-

missioner, 48 T.C. 906, 917 (1967), affd. 419 F.2d 213, 216 (9th

Cir. 1969). Peter explained the role each entity played in their

development plan. The jointness of the venture may be seen

from how the land sales were structured — no interest was

actually charged on cither the Henderson or Seneca Knolls

mortgages, repayment was scheduled over several years as the

land was expected to be developed and resold, delivery of the

deed was held up until the principals believed (incorrectly) that

39Petitioners do not question that Stonehedge was holding property for sale

to customers in theordinary course of its trade or business.

40Sce and compare Bush v. Commissioner, T.C. Memo. 1977-75, affd. 610

F.2d 426 (6th Cir. 1979).

44a

APPENDIX D

Opinion of United States Tax Court

the zoning would be approved, and essentially all of the risk of

non-development fell on CCP, which apparently expected no

payment until the buildout had proceeded and did not foreclose

until it had abandoned its development plan, at least with

respect to the use of Stonehedge.*! In this context, we hold that

CCP was in the trade or business of land development and sales

at the time the Seneca Knolls properties were sold.

From the record, it is clear that CCP acquired and held the

farms intending to resell them to Stonehedge.*? These con-

tiguous parcels lay between the already completed sections of

Seneca Knolls and were included in Stonehedge’s master plan

of development which had been previously filed with the Town

of Van Buren. Furthermore, we have found that the

developers’ method of operation was to have CCP acquire the

land and Stonchedge develop it. The fact that the sale here was

to one customer does not prevent characterization of the gain as

ordinary income. Pointer v. Commissioner, 48 T.C. at 917.%

Thus, the sale was of land primarily held for sale to a customer

in the ordinary course of CCP’s trade or business. The gain

41 While Merchants Bank anticipated repayment from the ‘‘buildout,”’ it also

required a minimum payment schedule and did not offer this entire

package of benefits.

42Even with our finding that certain of the properties were not sold to Stone-

hedge until December 28, 1962 (see footnote 43, infra), the sales of the

parcels involved herein to Stonehedge by CCP took place within » short

period of time after their acquisition by the latter — the longest period

CCP held any such parcel was from February 2, 1961 to December 28,

1962, less than two years.

43Qur ultimate finding of fact as to the date of the sale by CCP to Stonehedge

(see p.21, supra) has been included solely in the interests of completeness.

In light of our conclusion, the ioiding period of CCP has no effect on the

character of the gain therefrom. Moreover, also in the interest of complete-

ness, we note that we have taken into account, in making our finding of

fact, certain admissions against interest revealed in the record.

APPENDIX D

Opinion of United States Tax Court

reported by CCP on the foreclosure of the mortgages is,

therefore, taxable to CCP and through it to petitioners as

ordinary income.“

Decisions will be entered for the respondent.

44See also Bush v. Commissioner, supra, footnote 40.

46a

APPENDIX E

DECISION AND ORDER OF

U.S. DISTRICT COURT OF NEW YORK

UNITED STATES DISTRICT COURT

FOR THE WESTERN DISTRICT OF NEW YORK

IN THE MATTER

OF

COMMUNITY TECHNOLOGY, INC.

Debtor

NO. 76-BK-1130

Decision and Order

HON. BERYL E. McGUIRE

Bankruptcy Judge

UNITED STATES DISTRICT COURT

FOR THE NORTHERN DISTRICT OF NEW YORK

IN THE MATTER

OF

COMMUNITY TECHNOLOGY, INC.

Debtor

76-BK-1130

Menter, Rudin and Trivelpiece, P. C. (A. Solomon

Menter, Esq., of counsel), Syracuse, New York, At-

torneys for Community Technology, Inc.

«

47a

APPENDIX E

Decision and Order of U.S. District Court Of New York

Bond, Schoeneck & King (James E. Walsh, Esq., of

counsel), Syracuse, New York, Attorneys for Official

Creditors’ Committee

Victor Chini, Esq., Syracuse, New York, Attorney for

Cappuccilli, Cappuccilli & Paduano

McGuire, BJ*

On May 6, 1976, Community Technology, Inc. (hereinafter

referred to as CTI) filed a petition under the provisions of

Chapter XI of the Bankruptcy Act. A plan of arrangement has

been submitted to and accepted by creditors. The plan was

confirmed on October 6, 1977.

In the course of this proceeding, Cappuccilli, Cappuccilli and

Paduano, a partnership (hereinafter referred to as CCP), filed

a proof of claim in the sum of $325,718.90. The proof of claim

describes the indebtedness due the partnership as follows:

**Interest on a note and purchase money mortgage and

on cash advances for the years 1967 — March 1972 due

and owing from Stonehedge Development Corporation

which was merged into Debtor on July 1, 1975’’,

and further as ‘‘being deficiency assessments for interest in-

come by the Internal Revenue Service.”’

The debtor, CTI, joined by the official creditors’ committee.

has objected to the allowance of the claim on the ground that

the note secured by a mortgage between Stonehedge

Development Corporation (since merged into CTI) and CCP

expressly and, under New York Law, legally provided for no

interest. CCP has appeared in opposition to the debtor’s

motion.

a ee U.S.C.

7i(c)j.

—

48a

APPENDIX E

Decision and Order of U.S. District Court Of New York

The matter has been submitted upon a stipulated set of facts;

the contents of which are hereby incorporated by reference.

During the years in question, Gerald Paduano, Rocco

Cappuccilli and Peter Cappuccilli were equal partners in CCP.

They also were equal shareholders in Stonehedge Development

Corporation. Relative to the non interest bearing real estate

and mortgage transaction hereinbefore referred to, the

Commissioner of Internal Revenue, pursuant to § 482 of the

Internal Revenue Code, imputed interest income of

$196,330.19 to the partnership for the years 1967, 1968 and

1969.

Disputing that ruling, the three partners and their wives

petitioned the Tax Court. That Court upheld the Commissioner

as did the 2nd Circuit Court of Appeals, and certiorari to the

United States Supreme Court was denied.!

II

Because CCP’s argument in opposition to CTI’s and the

creditors’ committee’s objection suggested that disallowance of

its claim at least in part would create a conflict in decision as

between this Court and the Tax Court and the Second Circuit

Court of Appeals, this Court called for the briefs to those

Courts and, in addition, invited the Government to file an

Amicus brief on the point. The Government, with little

dispatch, filed its brief at Utica on February 16, 1978.

See Paduano v. C.1.R. TCM 1975-69 (TC 1975), aff'd. w/o opinion, 538

F2d 312 (2nd Cir. 1976), cert. den., 96 S. Ct. 2204 (1976).

49a

APPENDIX E

Decision and Order of U.S. District Court Of New York

In substance, the Government agrees with CTI and its

creditors’ committee that New York Law controls and that

under New York Law and the facts of this case no interest

liability by CTI to CCP would exist.? It points out that, under

§ 482, the respective rights and liabilities of parties for tax

purposes only may be viewed quite differently from those

under state law.

Extended discussion of the Government’s views on the

subject is not necessary. From its review, the Court now is

satisfied that New York Law controls, that under New York

Law CCP has no valid claim against the debtor for interest, and

that neither the decision of the Tax Court nor Second Circuit

Court of Appeals suggests a contrary view.

Accordingly, the objections of CTI and its creditors’

committee are sustained, and claim number 135 is disallowed.

So Ordered.

Dated: February 22, 1978

ȴ BERYL E. McGUIRE

Bankruptcy Judge

RECEIVED

AND

FILED

FEB 23 1978

OFFICE OF BANKRUPTCY JUDGE

UTICA, N.Y.

2See Woerz v. Schumacher, 161 NY 530 (1900); New York State Thruway

Authority v. Hurd, 25 NY2nd 150 (1969).

, in) -_ * ‘a: nail

‘“ we :

~

UNITED STATES CONSTITUTION —

FIFTH AMENDMENT

_ No person shail be held to answer for a capital, or otherwise

infamous crime, unless on a presentment or indictment of a

grand jury, except in cases arising in the land or naval forces, or

in the militia, when in actual service in time of war or public

danger; nor shall any person be subject for the same offense to

be twice put in jeopardy of life or limb; nor shall be compelled

in any criminal case, to be a witness against himself; nor be

deprived of life, liberty, or property, without, due process of

law; nor shall private property be taken for public use, without

just compensation.

Sla

APPENDIX F

STATUTES AND REGULATIONS

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

SEC. 165. LOSSES.

(a) General Rule. — There shall be allowed as a deduction

any loss sustained during the taxable year and not com-

pensated for b; insurance or otherwise.

(b) Amount of Deduction. — For purposes of subsection

(a), the basis for determining the amount of the deduction

for any loss shall be the adjusted basis provided in section

1011 for determining the loss from the sale or other

disposition of property.

* * >

SEC. 166. BAD DEBTS

(a) General Rule. —

(1) Wholly worthless debts — There shall be allowed

as 2 deduction any devt which becomes worthless within

the taxable year.

(2) Partially worthless debts. — When satisfied that a

debt is recoverable only in part, the Secretary or his

delegate may allow such debt, in an amount not in excess

of the part charged off within the taxable year, as a

(b) Amount of deduction. — for purposes of subsection (a),

the basis for determining the amount of the deduction for

any bad debt shail be the adjusted basis provided in section

1011 for determining the loss from the sale or other

disposition of property.

Ro Oe he ee ee Es IR RS oS ON ae: SA Free Ie

“-s

APPENDIX F

Statutes and Regulations

SEC. 482 ALLOCATION OF INCOME AND DEDUC-

TIONS AMONG TAXPAYERS.

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

businesses (whether or not incorporated, whether or not

organized in the United Stetes, and whether or not affiliated)

owned or controlled directiy or indirectly by the same in-

terests, the Secretary or his delegate may distribute, ap-

portion, or allocate gross income, deductions, credits, or

allowances between or among such organizations, irades, or

businesses, if he determines that such distribution, ap-

portionment, 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.

Sec. 1221 [1954 Code]. For purposes of this subtitle, the term

*‘capital asset’’ means property held by the taxpayer (whether

or not connected with his trade or business), but does not in-

clude—

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

kind which would properly be included in the inventory 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;

(2) property, used in his trade or business, of a character

which is subject to the allowance for depreciation provided in

section 167, or real property used in his trade or business;

(3) a copyright, a literary, musical, or artistic com-

position, a letter or memorandum, or similar property, held

by—

(A) a taxpayer whose personal efforts created such

property,

53a

APPENDIX F

Statutes and Regulations

(B) in the case of a letter, memorandum, or similar

property, a taxpayer for whom such property was

prepared or produced, or

(C) a taxpayer in whose hands the basis of such

property is determined, for purposes of determining

gain from a sale or exchange, in whole or part by

reference to the basis of such property in the hands of a

taxpayer described in subparagraph (A) or (B);

(4) accounts or notes receivable acquired in the ordinary

course of trade or business for services rendered or from the

sale of property described in paragraph (1);

* * *

Sec. 6601 [1954 Code]. (a) General Rule. — If any amount of

tax imposed by this title (whether required to be shown on a

return, or to be paid by stamp or by some other method) is not

paid on or before the last date prescribed for payment, interest

on such amount at an annual rate established under section

6621 shall be paid for the period from such last date to the date

paid.

Treasury Regulations on Income Tax (1954 Code) (26 C.F.R.):

§1.166-1. Bad debts.

(a) Allowance of deduction. Section 166 provides that, in

computing taxable income under section 63, a deduction

shall be allowed in respect of bad debts owed to the taxpayer.

For this purpose, bad debts shall, subject to the provisions of

section 166 and the regulations therecnder, be taken into

account either as—

(1) A deduction in respect of debts which become worth-

less in whole or in part; or as

_——

wath

S4a

APPENDIX F

Statutes and Regulations

(2) A deduction for a reasonable addition to a reserve for

(c) Bona fide debt required. Only a bona fide debt

qualifies for purposes of section 166. A bona fide debt is a

debt which arises from a debtor-creditor relationship based

upon a valid and enforceable obligation to pay a fixed or

determinable sum of money. A gift or contribution to capital

shall not be considered a debt for purposes of section 166.

The fact that a bad debt is not due at the time of deduction

shall not of itself prevent its allowance under section 166. For

the disallowance of deductions for bad debts owed by a

political party, see § 1.271.1.

§ 1.482-1 Allocation of income and deductions among tax-

payers.

(a) Definitions. When used in this section and in § 1.482-

, we

(3) The term ‘‘controlled”’ includes any kind of control,

direct or indirect, whether legally enforceable, and however

exercisable or exercised. It is the reality of the control which

is decisive, not its form or the mode of its exercise. A

presumption of control arises if income or deductions have

been arbitrarily shifted.

* oF ae '¢

(6) The term ‘‘true taxable income’’ means, in the case of

a controlled taxpayer, the taxable income (or, as the case

may be, any item or element affecting taxable income) which

would have resulted to the controlled taxpayer, had it in the

a

SSa

APPENDIX F

Statutes and Regulations

conduct of its affairs (or, as the case may be, in the particular

contract, transaction, arrangement, or other act) dealt with

the other member or members of the group at arm’s length.

It does not mean the income, the deductions, the credits, the

allowances, or the item or element of income, deductions,

credits, or allowances, resulting to the controlled taxpayer by

reason of the particular contract, transaction, or arrange-

ment, the controlled taxpayer, or the interests controlling it,

chose to make (even though such contract, transaction, or

arrangement be legally binding upon the parties thereto).

(b) Scope and purpose. (1) The purpose of section 482 is to

place a controlled taxpayer on a tax parity with an un-

controlled taxpayer, by determining, according to the

standard of an uncontrolled taxpayer, the true taxable in-

come from the property and business of a controlled tax-

payer. The interests conirolling a group of controlled tax-

payers are assumed to have complete power to cause each

controlled taxpayer so to conduct its affairs that its trans-

actions and accounting records truly reflect the taxrble in-

come from the property and business of each of the con-

trolled taxpayers. If, however, this has not been done, and

the taxable incomes are thereby understated, the district

director shall intervene, and, by making such distributions,

apportionments, or allocations as he may deem necessary of

gross income, deductions, credits, or allowances, or of any

item or element affecting taxable income, between or among

the controlled taxpayers constituting the group, shall

determine the true taxable income of each controlled tax-

payer. The standard to be applied in every case is that of an

uncontrolled taxpayer dealing at arm’s length with another

uncontrolled taxpayer.

°

_

56a

APPENDIX F

Statutes and Regulations

(3) 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. It is not

intended (except in the case of the computation of con-

solidated taxable income under a consolidated return) to

effect in any case such a distribution, apportionment, or

allocation of gross income, deductions, credits, or

allowances, or any item of gross income, deductions, credits,

or allowances, as would produce a result equivalent to a

computation of consolidated taxable income under sub-

chapter A, chapter 6 of the Code.

(d) Method of allocation. (1) The method of allocating,

apportioning, or distributing income, deductions, credits,

and allowances to be used by the district director in any case,

including the form of the ad,ustments and the character and

source of amounts allocated, shall be determined with

reference to the substance of the particular transactions or

arrangements which result in the avoidance of taxes or the

failure to clearly reflect incorhe. The appropriate ad-

justments may take the form of an increase or decrease in

gross income, increase or decrease in deductions (including

depreciaiion), increase or decrease in basis of assets (in-

cluding inventory), or any other adjustment which may be

appropriate under the circumstances. See § 1.482-2 for

specific rules relating to methods of allocation in the case of

several types of business transactions.

(2) Whenever the district director makes adjustments to

the income of one member of a group of controlled taxpayers

(such adjustments being referred to in this paragraph as

“primary” adjustments) he shall also make appropriate

correlative adjustments to the income of any other member

of the. group involved in the allocation. The correlative

adjustment shall actually be made if the U. S. incor< ‘ax

57a

APPENDIX F

liability of the other member would be affected for any pend-

ing taxable year. Thus, if the district director makes an

allocation of income, he shall not only increase the income of

one member of the group, but shall decrease the income of

the other member is such adjustment would have an effect on

the U. S. income tax liability of the other member for any

pending taxable year. For the purposes of this subparagraph,

a ‘‘pending taxable year’’ is any taxable year with respect to

which the U. S. income tax return of the other member has

been filed by the time the allocation is made, and with respect

to which a credit or refund is not barred by the operation of

any law or rule of law. If a correlative adjustment is not

actually made because it would have no effect on the U. S.

income tax liability of the other member involved in the

allocation for any pending taxable year, such adjustment

shall nevertheless be deemed to have been made for the

purpose of determining the U. S. income tax liability of such

member for a later taxable year, or for the purposes of

determining the U. S. income tax liability of any person for

any taxable year. The district director shall furnish to the

taxpayer with respect to which the primary adjustment is

made a written statement of the amount and nature of the

correlative adjustment which is deemed to have been made.

For purposes of this subparagraph, a primary adjustment

shall not be considered to have been made (and therefore a

correlative adjustment is not required to be made) until the

first occurring of the following events with respect to the

primary adjustinent:

§ 1.482-2. Determination of taxable income in specific

Situations.

(a) Loans or advances — (1) In general.

ae

APPENDIX F

Statutes and Regulations

Where one member of a group of controlled entities makes

a loan or advance directly or indirectly to, or otherwise

becomes a creditor of, another member of such group, and

charges no interest, or charges interest at a rate which is not

equal to an arm’s length rate as defined in subparagraph (2)

of this paragraph, the district director may make appropriate

allocations to reflect an arm’s length interest rate for the use

of such loan or advance.

an

59a

APPENDIX F

REVENUE PROCEDURE 65-17, 1965-1CB 833

Technical position and procedure governing the adjustment

of accounts and the transfer of amounts as the result of

allocations of income or deductions made pursuant to section

482 of the Internal Revenue Code of 1954 (section 45 of the

Internal Revenue Code of 1939).

SECTION |. SCOPE.

This Revenue Procedure prescribes the position of the In-

ternal Revenue Service and the procedures to be followed in

cases in which a United States taxpayer, whose taxable income

has been increased for a taxable year by reason of an allocation

under section 482 of the Internal Revenue Code of 1954 (section

45 of the Internal Revenue Code of 1939), requests permission

to receive payment from the entity from, or to, which the

allocation of income, or deductions, was made of an amount

equal to a part or all of the amount allocated, without further

Federal income tax consequences.

SECTION 2. BACKGROUND AND PURPOSES.

Section 482 of the Code gives the Internal Revenue Service

authority to ‘“‘distribute, apportion or allocate gross income,

deductions, credits, or allowances’’ among certain related

organizations, trades or businesses if it ‘‘determines that such

distribution, apportionment, or allocation is necessary in order

to prevent evasion of taxes or clearly to reflect the income’’ of

any such entity. In applying section 482, the Service will, in

appropriate cases and pursuant tc a closing agreement, permit

taxpayers whose income has been increased by the Service

under section 482 of the Code to make certain adjustments to

conform their accounts to reflect the section 482 allocations.

The cases in which such adjustments will be permitted are

outlined in section 3, below. The types of adjustment permitted

are described in section 4 and the prescribed procedures are set

forth in section 5. Any reference in this Revenue Procedure to

APPENDIX F

Revenue Procedure 65-17, 1965-1CB 833

an increase in taxable income shall also be deemed a reference,

in an appropriate case, to a reduction in a taxpayer’s loss.

SECTION 3. CASES IN WHICH ADJUSTMENT OF AC-

COUNTS WILL BE PERMITTED.

A United States taxpayer shall qualify for the treatment

provided in this Revenue Procedure: _

.01 If for a taxable year beginning prior to January 1, 1963,

the taxable income of such taxpayer is increased by the Internal

Revenue Service under section 482 of the Code, or

.02 If for a taxable year beginning after December 31, 1962,

the taxable income of such taxpayer is increased by the Internal

Revenue Service under section 482 of the Code and it is

determined by the Service that the arrangements or trans-

actions, or the terms thereof, giving rise to the section 482

allocation did not have as one of their principal purposes the

avoidance of Federal income tax. The determination as to

whether one of the principal purposes was avoidance of Federal

income tax will be based upon all the facts and circumstances of

the case. Among the factors which will be considered are the

dividends received from the corporation with which the trans-

action or arrangement giving rise to the section 482 allocation

was consummated, whether the taxpayer attempted in good

faith to comply with the regulations theretofore promulgated

under section 482 of the Code, the extent to which the

arrangement contravened such regulations, and the amount of

income tax, including any income tax levied by a foreign

country, which resulted from the transaction. The relative

weight to be given any one factor will depend on the facts of

each case. The fact that the other party to the transaction or

arrangement giving rise to the section 482 allocation is a foreign

corporation or a Western Hemisphere trade corporation shall

not in and of itself be a basis for a finding that one of the

6la

APPENDIX F

Revenue Procedure 65-17, 1965-1CB 833

principal purposes of the transaction or arrangement was

avoidance of Federal income tax.

.03 A taxpayer shall not qualify under section 3.01 or 3.02,

above, for the treatment provided in this Revenue Procedure if

any part of any underpayment of tax by such taxpayer for the

taxable year involved in the allocation is due to fraud.

SECTION 4. ADJUSTMENTS TO BE MADE OR

ALLOWED.

.01 If a taxpayer qualifying under section 3 above complies

with the requirements of section 5 below, such taxpayer shall be

permitted to exclude from his gross income all or part of ary

dividend which

(1) was received from the corporation (as defined in section

7701(a) (3) of the Code) with which it engaged in the trans-

action Or arrangement giving rise to the section 482

allocation (the ‘‘other corporation’’) and

(2) was included in the gross income of the taxpayer as 2

dividend (within the meaning of section 316 of the Code} for

the year for which the allocation is made,

provided that the amount so excluded shall not exceed the

amount of the increase in the taxable income of such taxpayer

resulting from the section 482 allocation from the other cor-

poration less the amount of any offset whicll is allowed to the

taxpayer under, section 3 of the Revenue Procedure 64-54, 1964-

2 CB 1008, with respect to such section 42 allocation. To the

extent that a dividend is excluded from income pursuant to this

paragraph, it shail cease to qualify as a dividend under section

316 of the Code or a distribution under section 963 of the Code

or as a dividend for any Federal income tax purpose; for in-

stance, no foreign tax shall be deemed te have been paid with

respect thereto under section 902 of the Code for the purpose of

ae et une aie Pa ine Py Tue n wt =| a =

APPENDIX F

Revenue Procedure 65-17, 1965-1CB 833

the credit allowed under section 901 of the Code and no

dividend received deduction shall be allowed with respect

thereto under sections 241 through 247 of the Cude. An amount

includable in income under sections 551 or 951 of the Code

shall not be considered a dividend for purposes of this

paragraph.

02 If a taxpayer qualifying under section 3, above, complies

with the requirement of section 5, below, such taxpayer shall be

entitled to establish an accourt receivable from the entity with

which it engaged in the transaction or arrangement giving rise

to the section 482 allocation (the ‘‘other entity’’). Such account

receivable shall not exceed

(1) The amount of the increase in the taxable income of

such taxpayer resulting from the section 482 allocation from

the other entity, less

(2) The amount of any offset which is allowed to the

taxpayer under section 3 of Revenue Procedure 64-54 with

respect to such section 482 allocation, and less

(3) Any amount excluded by the taxpayer pursuant to

section 4.01, above, and plus

(4) The interest accrued on such eccount receivable and

included in taxable income pwrsuant to section 4.03, below.

Except as provided in section 4.03, below, the account

receivable may be established and paid without tax con-

sequences, provided that such account receivable is paid within

90 days after the date of the closing agreement required by

section 5.013, below. Payment must be in the form of money, a

. written debt obligation payable at a fixed date and bearing

at an arm’s length rate determined in the manner

provided in section 1.482-2(aX2) of the Income Tax

Regulations (or the proposed regulations if such -egulations are

not yet in force), or an accounting entrv offsetting such account

:

bat ~ i ~~

oe Jen ae ae

63a

APPENDIX F

Revenue Procedure 65-17, 1965-1CB 833

Se ee ee Ome

other entity.

.03 The account receivable established in accordance with

section 4.02, above, (except for the accrued interest) shall be

deemed to have been created as of the last day of the taxpayer’s

taxable year for which the allocation under section 482 of the

Code is made. Such account receivable shall bear interest at an

arm’s length rate, computed in the manner provided in section

1.482-2(a)(2) of the Income Tax Regulations (or the proposed

regulations if such regulations are not yet in force), from the

day after the date the account is deemed to have been created or

from the first day of the taxpayer’s first taxable year beginning

after December 31, 1962, whichever is later, to the date of

payment. The interest so computed shall be accrued and in-

cluded in the taxpayer’s taxable income for each taxable year

during which the account receivable is deemed outstanding.

.04 A taxpayer’s election to avail itself of the provisions of

this Revenue Procedure shall in no way affect the allocation

made by the Service under section 482 of the Code. Such

election shall, however, affect the taxpayer’s taxable income

and credits to the extent indicated by sections 4.02 and 4.03,

above.

TO

PURCHASES BY PARTNERSHIP STONEHEDGE

(1, (2) (3) (4) (5) 7)

Farm Owner Option Total Date of Selling Price

Price Purchase

Henderson Easter 12/07/59 $125,460 3/08/60 **Henderson Farm’”’ $ 216,500

Patterson Patterson 9/01/60 22,400 11/24/61)

)

Commane Commane 11/19/58 71,830 10/20/61)

)

Walter Walter 2/07/58 64,065 2/22/61) **Seneca Knolls 1,353,600

) Property”’

Green Green 3/15/60 34,788 10/26/61)

)

Higgins Hunt 10/13/58 127,000 1/03/62)

S6l LIQIHXa LNIOf