Opposition — Cappuccilli v. Commissioner

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TABLE OF AUTHORITIES

B. Forman Co. v. Commissioner,

453 F. 2d 1144, cert. denied, 407 US.

tL eke eave aan cenessepeses ees 3

Bank of Coushatta v. United States,

OD ly) fp rere ree 4

Bunker v. Commissioner, Tax Ct. Mem.

Dec. (P-H) para. 79,174 ...-c+eereeercrrcees 4

Commissioner v. First Security Bank of Utah,

AOS U.S. 394 ..ccccceeccsesecneerereeeees 3,4

Corn Products Co. V. Commissioner,

950 U.S. 46 .cccccccccccivsccccccccessences 6

Delta Life Insurance Co. V. Untied States,

363 F.Supp. 410 ...-.--eeeeeereeecsrreeees 4

Dixon v. United States, 381 U.S. 68 ..+-+-+++++ 6

Fitzgerald Motor Co. Vv. Commissioner,

SOB F. 2d 1096 2.2 nec ee reece ecnmereccers 3

Kahler Corp. v. Commissioner,

YS Se) errr Teer 3

Kerry Investment Co. V Commissioner.

S00 F. 26 108 ....cncceccceeeereccssceceses 3

United States v. Basye, 410 U.S. 441 ...+--++++> 4

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Sp Sa She a aR Ra Ae ia!

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26 CER. 1.1038-1 Sige boa RL 6

In the Supreme Court of the Hnited States

OctToser Term, 1981

No. 81-1894

GRrackE CAPPUCCILLI, ET AL., PETITIONERS

Vv.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS FOR

THE SECOND CIRCUIT

MEMORANDUM FOR THE RESPONDENT IN OPPOSITION

In this federal income tax case, petitioners seek review of

the decision below upholding the Commissioner's alloca-

tion under Section 482 of the Internal Revenue Code of

intetest income from Stonehedge Development Corpora-

tion to a related partnership, which resulted in an increase

in each partner's distributive share of partnership income.

The relevant facts may be summarized as follows: Ix:

1953, Peter and Rocco Cappuccilli and Gerald Paduano

organized the Stonehedge Development Corporation (Stone-

hedge), which they owned in equal shares.' The three were

'In 1977, Peter and Rocco Cappiccilli filed bankruptcy petitions.

They are not parties to this action. The tax liabilities in dispute are those

of their wives, Grace and Dorothy Cappuccilli, who filed joint incom

tax returns with their husbands for the years in question. The tax

liabilities are based upon the business ventures of Peter and Rocco.

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also equal partners in a firm called Cappucci!li, Cappuccilli

and Paduano (CCP). The Cappuccillis and Paduano held

their interests in the two entities until 1969 when Paduano

retired from active participation in the operation of the

businesses and sold all of his stock in Stonehedge to the

Cappuccillis. Paduano thereafter remained a one-third

partner in CCP (Pet. App. 16a-18a).

During 1961-1962, CCP acquired several contiguous

parcels of undeveloped reai estate, for 2 total consideration

of $445,723. It then resold those parcels to Stonehedge in

two separate sales on February 20, 1961 ,and December 28,

1962, for a total consideration of $1 ,570,327.39—including

two promissory notes from Stonehedge to CCP. One note,

in the principal amount of $81,000, bore interest at an

annual rate of 6%. The other note, in the principal amount

of $1,075,000, bore no interest. Stonehedge held the bulk of

that land until 1972, but was unable to develop it as

planned, due to zoning problems that could not be resolved.?

In 1972, Stonehedge reconveyed the property to CCP in full

satisfaction of the balance of the two promissory notes.

During the time that Stonehedge held the land, it made

some payments on the principal balance of the two notes

but did not pay CCP any interest (Pet. App. 2a-Sa).

On audit, the Commissioner invoked his authority under

Section 482 of the Code and increased CCP’s taxable

income for 1967, 1968 and 1969 by a total of $325,718.90—

representing applicable market rate interest on the unpaid

balance of the notes. That allocation was sustained in

?The Tax Court found that the original plan of the Cappuccillis and

Paduano was to have CCP assemble a parcel of land suitable for

development and then sell it, at a substantial profit, to Stonehedge,

which would construct houses or other buildings and sell to the ultimate

purchasers (Pet. App. 17a).

3

Paduano v. Commissioner, T.C. Mem. Dec. (P-H) para.

75,069 (1975), aff'd, 538 F. 2d 312 (2d Cir.), cert. denied,

425 U.S. 992 (1976). This case involves similar allocations

for 1970, 1971 and 1972.3 In addition, the Commissioner

determined that the 1972 gain of $482,577 realized by CCP

under Section 1038 of the Code on the reacquisition of the

land from Stonehedge was taxable to the partnership as

ordinary income rather than as long-term capital gain. The

Tax Court upheld the Commissioner's determinations (Pet.

App. I4a-45a) and the court of appeals affirmed (Pet. App.

la-9a).

1. The decision correctly upheld the Commissioner's

allocation of interest income under Section 482. Here, the

device of interest free loans among related entities was used

to reduce Stonehedge’s losses (by the amount of interest it

did not pay) and to reduce CCP’s income (by the amount of

interest it did not receive). This is precisely the type of

manipulation of commonly controlled entities against

which Section 482 is directed. See B. Forman Co. v. Com-

missioner, 453 F. 2d 1144, 1150-1152(2d Cir.), cert. denied,

407 U.S. 934 (1972). See also Kahler Corp. v. Commis-

sioner, 486 F. 2d | (8th Cir. 1973); Kerry Investment Co. v.

Commissioner, 500 F. 2d 108 (9th Cir. 1974); Fitzgerald

Motor Co. v. Commissioner, 508 F.2d 1096 (Sth Cir.

1975).

Contrary to petitioners’ argument (Pet. 5-9), the decision

below does not confilct with Commissioner v. First Secur-

ity Bank of Utah, 405 U.S. 394 (1973). There, the Court held

that income could not be allocated under Section 482 to a

company which was legally prohibited from receiving the

3The Commissioner allowed Stonehedge corresponding income tax

deductions for the interest income imputed to CCP.

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income.‘ No such prohibition, however, is involved in this

case. Had the transaction here beer: at arm’s-length, CCP

could legally have charged and Stonehedge could legally

have paid interest on the loans. CCP, however, did not

charge any interest to Stonehedge. First Security Bank is

therefore distinguishable.

2. Nor does the increase in the Paduanos’ taxable income

violate their constitutional rights even though they were not

shareholders of Stonehedge, as petitioners now contend

(Pet. 11-12).5 Gerald Paduano was a one-third partner in

CCP during the years at issue. As such, he was taxable on

his distributive share of the partnership's correct taxable

income whether or not he received it. See United States v.

Basye, 410 U.S. 441, 446-448 (1973). The allocation of

interest income to CCP and then, pursuant to the rules of

partnership taxation, to the individual partners, was not

based on some supposed benefit the partners received as

shareholders of Stonehedge. Rather, the allocation was

made in order to correct distortions in income caused by

non arm’s-length dealings between the two commonly con-

trolled entities, CCP and Stonehedge. Those distortions

‘The other cases cited by petitioners (Pet. 7), viz., Delta Life Insu-

rance Co. v. United States, 363 F. Supp. 410 (E.D. La. 1973); Bunker

v. Commissioner, T.C. Mem. Dec. (P-H) para. 79,174 (1979); and

Bank of Coushatta v. United States, 650 F. 2¢ 75 (5th Cir. 1981), do

not conflict with the decision below. In Bank of Coushatta, the court

held that insurance commissions would not be taxed to a bank which

transferred its insurance sales business under a good faith belief that

receipt of insurance sales commissions by the bank would be illegal. In

Delta Life Insurance Co., supra, the court simply held that the Commis-

sioner could not, under Section 80 L of the Code, require the taxpayer to

carry for tax purposes a reserve smaller than that actually required by

state law. These cases turn on legal constraints not present in this case.

Bunker v. Commissioner, supra, involved an installment sale question

unrelated to this case and is entirely inapposite.

‘This issue was never raised by petitioners below (Pet. App. 9a).

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exist, and the Commissioner properly invoked Section 482

to correct them, whether or not the Paduanos benefited

from the distortions in income in their capacity as share-

holders of Stonehedge.

3. The decision below also correctly rejected petitioners’

claim that the partnership was entitled, in 1975, the year

prior to Stonehedge’s bankruptcy, either to a bad debt

deduction or toa business loss deduction with respect to the

allocated interest. Stonehedge never paid the interest. The

crux of this matter is that Stonehedge never had any obliga-

tion to pay the interest. There was no debt and no loss. By

failing to charge an arm’s-length interest rate on loans from

CCP to Stonehedge, the partners in CCP perhaps used the

assets of CCP to make a contribution to Stonehedge in the

amount of the interest not charged, and may be entitled to

increase their bases in the Stonehedge stock to reflect this

contribution. However, the transaction also reduced the

income of CCP and increased the income (or reduced the

losses) of Stonehedge. As the court of appeals correctly

recognized, it was precisely such a shifting of income

between related entities that Section 482 was intended to

rectify (Pet. App. 51). Allowing petitioners an income tax

deduction merely because Stonehedge did not actually pay

the imputed interest to CCP® would serve to nullify the

Commissioner’s allocation (Pet. App. 61).’

*The Tax Court found that, contrary to petitioners’ claim, Stone-

hedge probably would have been able to pay CCP a fair rate of interest

on the notes in question had it been required to do so (Pet. App.

272-28a). The court of appeals determined that this finding was not

clearly erroneous (Pet. App. 7a).

7Petitioners claim (Pet. 9-10) that this case involves an unconstitu-

tional retroactive application of the Treasury Regulations under Sec-

tion 482. But whether or not the Treasury Regulation under which the

Commissioner made his aliocation in this ca8e is broader than the

general understanding of Section 482 at the time the loans in issue were

It is therefore respectfully submitted that the petition for

a writ of certiorari should be denied.

Rex E. Lee

Solicitor Genera!

June 1982

made, it is clear that Treasury Regulations may be applied retroactively.

See Section 7805(b) of the Internal Revenue Code of 1954 (26 U.S.C.);

Dixon v. United States, 381 U.S. 68, 71, 74-75 (1965); Automobile

Club v. Commissioner, 353 U.S. 180, 184-186 (1957).

Fiually, petitioners claim (Pet. 20-22) that the gain realized by CCP

on the reacquisition of the land from Stonehedge should be taxed as

capital gain rather than ordinary income. The character of

the taxable under Section 1038 of the Code on répossession of real

property by the vendor is the same as the character of the gain realized

on the original sale. Treasury Regulations on Income Tax (1954 Code),

26 C.F.R. 1.1038-1(d). The court of appeals correctly noted (Pet. App.

at 7a-8a) that the gain on the original sale was taxed to CCP as ordinary

income, and that the record demonstrates that the gain was in fact the

“profits and losses arising from the everyday operation of a business”

rather than from investments in capital assets. See Corn Products Co.

v. Commissioner, 350 U.S. 46, 52 (1955).