Petition for Writ of Certiorari — Foster v. Commissioner
Supreme Court brief1986
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95-512 | |
No. 85-
In the Supreme Court
Of The United States
OCTOBER TERM, 1985
RICHARD H. FOSTER AND SARA B,
FOSTER, T. JACK FOSTER, JR.,
AND PATRICIA FOSTER, JOHN R.
FOSTER AND CAROLINE FOSTER, AND
ESTATE OF T. JACK FOSTER,
DECEASED, GLADYS H. FOSTER,
EXECUTRIX, AND GLADYS H.
FOSTER,
Petitioners,
V.
COMMISSIONER OF INTERNAL
REVENUE.
PETITION FOR WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
+ $+ + + + + + + + + + + + | | | + + + } | | + +} + +} +} +} + + + +} + + + + +} + ~-
VALENTINE BROOKES
Counsel of Record
LAWRENCE V. BROOKES
BROOKES AND BROOKES
601 California St., #1902
San Francisco, CA 94108
(415) 981-7630
Attorneys for Petitioners
pS SD
OF
QUESTIONS PRESENTED
lea. Whether the Commissioner of
Internal Revenue is empowered by Internal
Revenue Code Section 482 to deny the tax
incidents of property transfers to viable
controlled corporations which Congress
provided in Sections 351 and 358, and in
the provisions taxing corporate income
and losses differently from those of
individuals, merely becauee the taxpayers
selected the corporate form of operation
in order to obtain those favorable tax
incidents.
b. As an alternate statement of
this issue, does the Section 482 grant of
discretionary power in the Commissioner
to "allocate" income and deductions in
order to "prevent evasion of taxes" mean
the same as discretion to allocate to
"prevent avoidance of ore with the
consequence that he can allocate to deny
ii
any taxpayer's deliberate invocation of a
statutory tax minimization if the
taxpayer knew it would "avoid" otherwise
higher taxes.
2. If the answer to the first
question is affirmative, whether the
authority can be conferred on an
administrative official to decide in his
discretion, without statutory guidelines,
when tax incentives and favorable tax
incidents for which Congress has provided
should be denied, without violating the
separation of powers principle, or, if it
be different, the prohibition against
delegation of powers.
3.a. Whether notes representing the
purchase price of stock of a corporation
owning 200 acres of land in the area
being developed for subdivision could be
in substance interest, where the obligee
had not loaned any money and the notes
were, as to it, principal; where the
iii
actual lenders were not the obligees of
the notes, but did receive market-rate
interest on the loans they made; and
there was no stock relationship between
the obligee of the notes and the actual
lenders which would permit the lenders
ever to profit from the notes.
b. Whether Internal Revenue Code
Section 266 denies taxpayers the right to
elect to capitalize the notes even if
they were interest, because they were on
the cash basis of accounting instead of
the accrual basis.
4.a. Whether, in view of Rule 301
of the new Rules of Evidence, a trial
court in an income tax case, can properly
hold that the presumption that the
Commissioner's position is correct
survives the presentation by the taxpayer
of a normally prima facie case where no
evidence is presented by the
Commissioner, merely because the issue
iv
invelves a deduction instead of gross
income.
b. Whether, in the foregoing
question,the extent of the prima facie
case is enhanced by uncontradicted
evidence that the particular expenditures
which were disallowed for lack of the
required substantiating documentation
were not identified by the Commissioner
in his deficiency letter, in his pleading
in the Tax Court, or at trial, and the
taxpayers’ evidence established that the
revenue agent had left their records so
scrambled that the taxpayers could not
tell from them what was disallowed, that
the agent's work papers were
unintelligible, and the taxpayers’
evidence proved that they had established
a system specifically designed to satisfy
the statutory requirements and the opera-
tional system should not have permitted
any improper deductions to slip throuch
5. Whether in a case involving an
allocation by the Commissioner under
Section 482, the burden is on the
taxpayer to prove that administrative
action was arbitrary and unreascnable, or
merely that it was unwarranted,
particularly in the light of newly
adopted Rule of Evidence 301 and its
legislative history.
6. Whether the Court of Appeals
erred in refusing to take judicial notice
under Rule of Evidence 201 of a
deposition subpoenaed by respondent from
the possession of the California Superior
Court, in spite of the mandatory duty to
do so declared in Rule 201(d), and in
treating the offer of the deposition
under Rule 201 as a motion to augment the
record and then denying it, where
respondent had subpoenaed the deposition
but withheld it from evidence on the
wn dite oe
vi
representation to the trial court that it
was merely cumulative of a prior
deposition on which the trial judge
subsequently relied but which in fact it
contradicted, thus producing the result
that the trial court relied on statements
in a deposition which were contradicted
by the same person in the second,
suppressed, deposition.
7. Whether Estero Municipal
Improvement District, a public agency of
the State of California created by
special act of the Lewislature with the
power to borrow money by issuing tax
exempt bonds, to levy and collect taxes,
and to employ staff and independent
contractors, and with the function of
converting semi-submerged land into a
city, can be held to be the mere alter
ego of these taxpayers, so that the
increased land values created by that
conversion can be treated as allocable to
vii
them under I.R.C. Section 482, and not to
the actual corporate owners.
8. Whether, if the court below
correctly held that the activities of
Estero in improving the area through the
work of its officers, employees and
independent contractors financed by the
sale to the public of tax exempt bonds,
are the activities of the individuals
here, and the activities of a private
corporation owned by these individuals in
employing them and others to perform the
developers activities are also activities
of these individuals and not corporate
activities, these individuals clothed
themselves in the corporate form of one
public corporation and one private
corporation, and thereby operated as an
association taxable as a corporation?
9. Whether a trial judge may
properly refuse to permit a witness to
correct testimony given in a deposition
viii
which had been admitted into eviuence by
using the precise phrase which he had
used in the deposition testimony.
10. Whether under rule of Evidence
804(b)(1) and (5) a discovery deposition
taken of the plaintiff by the defendants
in a state court action involving parties
and issues different from those in this
case, without cross-examination and
without any motive to test the
credibility of the testimony in the
deposition, is admissible in this tax
case.
PARTIES TO THE PROCEEDING
The caption of the petition contains
the names of all parties to the case.
a en Eee
PR 8 Oe rw me
hes
Stith it Rt De I cee RI, “lp llth ra Saale ae ii SS BEN ACL IE EAL PELE Sn
ix
TABLE OF CONTENTS
Page
Questions PFESENted..cceeeeeserccees 1
Parties to the proceeding........... viii
Opinions DeELOW .eceeeeeeeeereersccees 2
PUBRBGECEIOR bos odd cbdicccisccsicves 2
Statutes and regulations involved .. 3
Statement of the caSe....ceeeesecees 3
Reasons for granting the writ....... 21
Conclusion PECESCEBHESEBESO CERO CSC OE 65
Appendix 1
Appendix 2
Appendix 3 (Separately bound)
x
TABLE OF AUTHORITIES CITED
Cases
Page
Bert v. Helvering, 92 F.2d 391,
Esl Cir. 1937) eeee7n85+eo7#7e85een ee@eee8eeeeee 64
Commissioner v. Birch Ranch &
Oil Co., 192 F.2d 924 (9th Cir.,
1951) eeeeeveevoeee veer vreeeeeeeeeeee eee 61
Commissioner v. First Security
National Bank of Utah, 405 U.S.
394 (1972) eeeeoeeveeveeeeeeveeee 30, 33, 4l,
KS Sees cSCEECS USS HEEEOEESé SOE TER,S 46, 48
Cooper v. Estero Municipal
ereroenns District, 70 Cal.2d
645, 75-Cal.Rptr. 777 (1969) ..cccee 60
Cooper v. Leslie Salt Co., 70
(1969) eeeeeveveeeeeeeeeeveeeeeeeevn ee ee ee 60
Deputy v. duPont, 308 U.S. 488,
497-498 (1940) be 66696666640 0ERO 44, 47
Eli Lilly and Co. v. Commissioner,
84 Zatce 996 (1985) eeeeevnv0neeeeeeeeee 28
Frank Lyon Co. v. United States,
435 U.S. 561 (1978) cccccccccccccee 35
Giglio v. United States, 405 U.S.
150 CIDT2S) cov ees es eS esas eesesssesere 56
Gregory v. Helvering, 293 U.S.
465, CIDSS) ccccoesesceceeseeceseesese 35
Helvering v. Taylor, 293 U.S.
507 Bo) pe ee er es ee 52
Te N. & S. Ve Chadha, U.S. ’
xi
77 L.Ed.2d 317 $ 9: FR Ree eres 41
: Keller v. Commissioner, 723 F.2d
2S CAGGR Civ.» BOER céscccccdae 23¢ 24,
tke osha bane heinous 26, 27, 35
Klein v. Board of Supervisors, 283
U.S. 19 (1930) ccccccccccccccsccsere 60
: Moline Properties, Inc. v.
Commissioner, 319 U.S. 436 (1943).. 60
}
Morrissey v. Commissioner, 296 U.S.
344 (1938S) cccccccceceeeerseseeeeees 65
Napue v. Illinois, 360 U.S. 264
(1959) cccccccccccccccccecesscecsces 57
Pacific Refining Co. v. Ryan, 293
U8. 386 (1938) wccccccccccccececece 40
|
| Parratt v. Taylor, 451 U.S. 527
(1981) eeeeeeeeeeeeeeeeeeeeeeeeeeee 57
Rooney v. Commissioner, 305 F.2d 681
' (1962) cccccccccccccceceesscscscccces 28
Rutland v. Tomlinson, 327 F.2d 668
(5th 4 OK 1964) ccocccccscseseeceeesse 61
Schechter v. United States 295 U.S.
495 (19s) ccccccceesceeceecececoses 40
United States v. Janis, 438 U.S. 433
Oly, } PPPerrererrrerrrrrrerreriser 52
United States v. Mississippi Chemical
Corp., 405 U.S. 298 (1972).....42, 44, 46
Rules
Rules of Evidence 201.....++e+e+e+2l, 53, 55
SURG) 0006000606006 53
BGbciccceccecesesSDs 50
ee ee
sli iein initiate
xii
. 804(b)(1) and
| (S)....19, 49, 53
Statutes
Internal Revenue Code,
BOGSEIOR BEGicacccssecsscceces 3o 42, 48
dence eee eeeGeosesrens 26
StGcccescseser Be LS, 16, 17, $i
| TTT eee Te
SEE OE6 O00 646 00:6.00:6:060.0-0 0068 3
RE, OS a PS lO
340 Soe S360 Ble 38
41, 46, 59, 62
FERRER eo ceeerceeoeeeoeeseote 6S
FPROLEDLS) ccececwececceesceese = 3
United States Code, Title 28,
BOCEION LTZSGcccccceccoccecscoscccseces 2
Treas. Reg. Section
DeSOScdocecccececceceeecese 3
L.4BQ—Lecccccccccvecccccece 3
301.7701-2(a) (2)... ceeeeeedy 64
fee eRe ec ceeseeccoocesessees G4
64 Bk) aes
PRED e cakes ecocccsccess «6G
PP CR Seeseeesectoecestscece | 6
12 ol olt< 7.7312 eeeeeeoeeooeveooeneoe eed 45
Constitutional Provisions
United States Constitution,
Article I, Section 8,
Clauses 1 and LBcccccccccccccecccce
to
3
3
$
3
In the Supreme Court
Of The United States
OCTOBER TERM, 1985
RICHARD H. FOSTER AND SARA B.
FOSTER, T. JACK FOSTER, JR.,
AND PATRICIA FOSTER, JOHN R.
FOSTER AND CAROLINE FOSTER, AND
ESTATE OF T. JACK FOSTER,
DECEASED, GLADYS H. FOSTER,
EXECUTRIX, AND GLADYS H.
FOSTER,
Petitioners,
Vv.
COMMISSIONER OF INTERNAL
REVENUE.
PETITION FOR WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
Richard H. Foster and Sara B.
Foster, T. Jack Foster, Jr., and Patricia
Foster, John R. Foster and Caroline
Foster, and Estate of T. J. Jack Foster,
Deceased, Gladys H. Foster, Executrix,
end Gladys H. Foster petition for a Writ
2
4
of Certiorari to the United States Court
of Appeals for the Ninth Circuit, to
review its decision rendered in this case
April 3, 1985, petition for rehearing
denied May 30, 1985.
OPINIONS BELOW
The opinion of the Court of Appeals
is reported in 756 F.2d 1430, and is re-
produced in the Appendix. The opinion of
the Tax Court is reported in &0 T.C. 34.
JURISDICTION
The jurisdiction of this Court is
invoked under Section 1254 of Title 28,
United States Code and Section 7482(a) of
the Internal Revenue Code. Jurisdiction
of the United States Court of Appeals for
the Ninth Circuit lay under Section 7482
of the Internal Revenue Code. It filed
its decision on April 3, 1985; petition
for rehearing was filed on April 17,
1985, and denied on May 30, 1985. The
opinion of the United States Tax Court
wile! ip Lien 3 bod
3
was filed January 11, 1983. Its judgment
was entered on August 8, 1983, and the
appeal to the Court of Appeals was filed
on September 30, 1983. The Court of
Appeals did not question its jurisdiction
and decided the case on substantive
grounds, as had the Tax Court.
STATUTES AND REGULATIONS INVOLVED
The statutes involved are Internal
Revenue Code 88 266, 274, 351, 358, 482,
and 7701(a)(3), which are reproduced in
the Appendix. The regulations involved
are Treas. Regs. 88S 1.266-1,301.7701(2)-
(a)(1) and (2) and 1.482-1, also repro-
duced in the Appendix. The constitu-
tional issue is not based on a specific
provision but on implications drawn f1 om
the entire Articles I and II, particu-
larly Article I, Section 8, clauses 1 and
18, which are set forth in the Appendix.
STATEMENT OF CASE
1. This is an income tax case. Pe-
ee er ee
a Se eT
+
titioners appealed from an adverse deci-
sion the United States Tax Court reported
in 80 T.C. 34. The Court of Appeals
affirmed the Tax Court on all issues but
one. The bulk of the original deficiency
of $2,870,857 remains in issue.
2. Petitioners, referred to herein-
after either as "the Fosters" or as "the
taxpayers", are husbands and wives who
filed joint returns, except in one case
where the husband died after the years
involved and the petitioners are the
estate of the decedent husband and the
surviving wife. The four men were
partners in T. Jack Foster & Sons and
were the shareholders in several corpora-
tions which are not parties but are
involved in the facts presented.
3. The facts found by the Tax Court
and accepted below can be summarized as
follows: Underlying the issues is the
history of the development of Foster
5
City, a California city, from Brewer's
Island, a 2600 acre partially submerged
and barren area of San Francisco Bay in
San Mateo County. The Foster part-
nership bought the land in that condition
in August 1960, and evolved plans for its
development into Foster City. In May,
1960 the California Legislature created
Estero Municipal Improvement District as
a political subdivision of the State,
with authority and responsibility to
issue tax-exempt bonds and impose prop-
erty taxes, and with that financing to
drain and fill Brewer's Island, to
develop and. improve it with the necessary
facilities for a city, and to provide
government for it. Estero was run by a
board of directors, the members of whom
were elected by the landowners, and a
general manager it employed, who was
unrelated to the Fosters. Initially the
Fosters were the only landowners, but
6
from 1962, parts of Brewer's Island
passed into other hands, taking those
voting rights along.
4. The Foster partnership purchased
Brewer's Island by making a $2,000,000
down payment and giving notes for the
balance of the purchase price. The
Fosters borrowed the down payment from
the Republic National Bank of Dallas,
Texas. To induce the bank to make the
loan, they had offered the bank, in
addition to interest, 50% of the profits
when securely earned, in amount equal to
the principal of the loans it would make
Or arrange. The offer and its acceptance
were oral and never reduced to writing.
The parties negotiated about the form
profit-sharing would take, the bank in-
sisting that its profit be taxable as
Capital gain.
The® $2,000,000 loan to the
Fosters was made by The Hoblitzelle
a —— es
>
Foundation, at 6% interest, with one
year maturity. The notes were renewed
annually to August, 1963, when they were
paid in full by proceeds from a loan from
the Republic National Bank. Hoblitzelle
Foundation was a charitable foundation
organized by a former chairman of the
board of the Republic Bank. In 1961 and
1962 the Fosters made installment pay-
ments totalling $1,000,000 to the
previous landowners from other Republic
Bank loans to them at 6% interest. By
August, 1963 the Fosters owed Republic
Bank $3,000,000 in interest-bearing
notes.
The Fosters transferred 200
acres on Brewer's Island to a wholly-
owned corporation, Foster Bayou Corp.
("Bayou"), on August 4, 1961. On August
7, 1962, the stock of Bayou was sold to
Westway Investment Corp., ("Westway") for
$105,000.00, of which $100,000 was
Pe nO ne Oe ee ee eininninal Sat OLAS SEIN edi ‘.
8
by promissory note. Westway was wholly
owned by the Howard Corporation
("Howard") which in turn was owned by
trustees for the shareholders of Republic
National Bank. In January 1964 Westway
wrote the Fosters, offering to sell he
stock of Bayou for $3,105,000.00, with
payment to be deferred. Esteroy
Corporation ("“Esteroy"), owned by the
Fosters, accepted the offer. In May 1964
Esteroy signed notes in that amount and
without interest, maturing serially in
1966 and 1967, and exchanged them with
Westway for the Bayou stock.
Through transfers within the
Foster group, the 200 acres became the
property of Foster California Corporation
in exchange for another Foster City tract
of 196 acres and the Fosters assumed the
$3,105,000 note. In their income tax
returns reporting gains from the sale of
lots in the 196-acre parcel, the Fosters
PAA. DP Geshe
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Sa MER, pee.
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9
elected to capitalize the indebtedness as
part of the cost of the 196 acres. The
Commissioner disallowed that addition to
basis. The propriety of his doing so is
one of the major issues in this case.
5. Meanwhile, Estero had organized
itself into a functioning municipal
corporation. It employed a general
manager who employed subordinates; it had
a board of directors which met regularly,
took necessary action, and kept minutes.
The Fosters as landowners were free to
elect directors of their own choosing,
but to insure the independence of Estero
they elected one Board member to repre-
sent them, the second was Estero's
professional general manager, and the
third was chosen by the San Mateo County
Board of Supervisors. In 1962 Estero
issued and sold the first of several
series of tax-exempt bonds, pursuant to
the enabling Act. It engaged an outside
10
- engineering consultant, and adopted plans
for municipal development. It hired third
persons to drain, fill and level the
acreage sequentially and to develop roads
to the island, sidewalks, sewers,
electricity and other utilities. It
hired others to construct those improve-
ments and an access bridge to the island,
and a network of streets on the island,
and a sewage plant, outfall line, and
collection network. By October 3, 1962,
some of these improvements were underway
but none had been completed. Water had
not been brought to the island, nor had
the sewage disposal plant been built.
6. On October 3, 1962, 127 acres of
Foster City land were conveyed by the
partnership to four personal corpora-
tions, each owned by a partner; the names
of each were derived from its sharehold-
er's first name; @.g., Foster D Corpora-
tion for Richard H. (Dick) Foster. They
11
were referred to below as "the Alphabet
corporations". In January 1963 these
corporations filed a proposed subdivision
map, together with the partnership, which
had retained some land in the area to be
subdivided. It was designated
Neighborhood One ("N. One").
By May 1963, Estero'’s contrac-
tors had completed the access bridge, the
water line, and the sewage outfall line.
In July 1963, the sewage plant became
operative, streets and sidewalks, and
water, sewage, and gas systems, were
completed in a portion of N. One,
including the 127 acres which were
subdivided into lots. In that month the
four corporations made the first sale of
lots in N. One. The Commissioner has
allocated the entire proceeds from ail
sales of lots in the 127 acres to the
Fosters under I.R.C. Section 482, and
both the Tax Court and the court below
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sustained this allocation "to prevent
avoidance of income taxes." Both courts
stated that the acts of Estero and its
contractors to improve the lots should be
attributed to the individual Fosters.
This presents one of the major issues in
this appeal.
7. Neighborhoods Two and Three ("N.
Two and N. Three") were next completed,
and they were sold by the partnership,
beginning in late 1964 and continuing
through the taxable years. The propriety
of the inclusion of the Westway notes in
the Fosters’ basis for the property in
Ns. Two and Three is an issue explained
previously.
8. On August 29, 1966, the Foster
family partnership transferred 311 lots
in Neighborhood Four (N. 4) to Foster
Enterprises, Ltd., ("Enterprises") a
corporation owned by the partnership,
which owned a subsidiary with 200 acres
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in Foster City, and which also owned a
Honolulu hotel which had incurred tax
losses. The 311 acres were not salable
when conveyed to Enterprises because they
were not completely developed and im-
proved; sales of fully improved lots in
older areas in Foster City had come to a
standstill; and Estero was unable to sell
bonds due to pending litigation and was
compelled to suspend operations at the
end of 1966. Enterprises sold the first
of the lots in February 1967.
The Commissioner allocated the
entire proceeds from the sale of those
lots to the Fosters individually. The
Commissioner stated that the allocation
of these proceeds from the sales of lots
in N. One and N. Four was made “to
prevent avoidance of income taxes,"
citing Section 482. The Tax Court and
the court below both sustained his action
for the reason he gave.
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14
9. The Tax Court found that the
transfers of the N. 1 lots were made to
obtain the presumably lower corporate tax
rate, although the partnership tax
returns showed losses. The Tax Court
also found that the transferee
corporations were viable, that they held
some of the transferred acreage for
investment and leased it out, built
apartment houses, and operated them. The
Tax Court affirmatively held that they
were not mere shells or sham.
Tax Court found that the
transfer to Foster Enterprises was made
to offset its tax losses from hotel op-
erations, and rejected as untrustworthy
the testimony of the Republic Bank offi-
cer then in charge of the account that he
had demanded the transfer be made as the
price of renewing the loans which came
due in August 1966, and renewed the loans
only when assured the transfer would be
made.
The Court of Appeals affirmed
on both issues.
10. The Fosters each incurred
business travel and entertainment
expenses. In 1962 their office manager
and their independent accountant jointly
established a system to maintain and
verify records to satisfy the require-
ments of newly enacted IRC Section 274,
The system was administered by the office
manager, Chase, who reviewed the records
and prepared the tax returns in
conformity to those records. The Revenue
Agent in examining them disassembled the
associated records and left them in that
condition, so that the supporting bills
and vouchers were detached and scrambled.
He then asserted deficiencies based on
disallowing some of the reimbursed ex-
penses under Section 274. Neither Chase
nor the outside accountant, Moak, could
16
reassemble the records. The agent's
report did not identify which reimburse-
ments were being disallowed as deductions
and treated as income, and neither does
the deficiency letter or the answer. [It
was impossible for anyone to discern the
expenses disallowed.
At the trial, both Chase and
Moak so testified. Chase also testified
that he believed the system worked, that
he returned claims unpaid which would not
qualify under Section 274, whether made
by a partner or by an employee, and that
he approved on for inclusion in the tax
returns only those which would be al-
lowed. Moak testified that he made an
independent sampling of the travel and
entertainment account to be certain that
it was operating as it should, and that
it was he who prepared the tax returns
and the deductions of travel and enter-
tainment expenses from Chase's work
17
papers, only after satisfying himself in
this manner that they were proper. He
too stated that he considered that the
system he helped install and reviewed
should satisfy the requirements of Sec-
tion 274, and the ee determined
that it was being administered in the
intended manner. Moak also testified
that during the conferences with the IRS
Appellate Conferee he was given a copy of
the agent's work papers pertaining to
this issue, and that neither he nor the
Conferee was able to comprehend them. A
copy is in the record. Neither the trial
judge nor respondent's counsel claimed to
understand them. Respondent offered no
testimony or other evidence to contradict
Or meet the thrust of the foregoing tes-
timony. Nevertheless the trial court
held that the Fosters had not carried
their burden of proof because they had
not identified the disallowed items and
18
showed that they were improperly disai-
lowed, and the court below affirmed,
stating the burden of proof in deduction
cases was stronger than in gross income
cases.
ll. There are also two issues of
evidence and procedure raised in the
petition, in addition to the one
concerning the propriety of discrediting
Johnson's testimony, which we have
described earlier. One such ruling
prevented Jack Foster, Jr.'s testifying
that at the time of trial he knew what
the “business purpose" of the transfer to
Enterprise was, the court stating that
the existence of "business purpose" was
the ultimate issue. Foster testified
that when he gave a discovery deposition
in 1971, which deposition the court had
admitted into evidence, he had not known
what the “business purpose" was and so
testified, but that was before reading
19
Rex Johnson's testimony. He was not
permitted to state whether he now knew of
a business purpose. The result of the
ruling coupled with the denial of our
motion to strike his 1971 testimony was
that Mr. Foster's testimony given in 1971
that he was ignorant of the business
purpose of the transaction was in the
record and was relied on by the Tax
Court, and his explanation given at the
trial, using the same terminology, has
been excluded. The Court of Appeals did
not discuss this issue, although we
raised it in our briefs.
12. The final evidentiary point
raised below is the ruling of the Tax
Court that a pre-trial discovery
deposition taken in a state court pro-
ceeding in 1969 is admissible under Fed.
Rules of Evid., Rul. 804(b)(1), (5).
This deposi- tion was given by Del
Champlin, the since deceased financial
a .
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20
and tax adviser of the Fosters, who broke
with them after the death of the senior
Mr. Foster and brouc::+ suit against the
surviving Fosters for $1,000,000 as a fee
for tax advice and financial advice. The
deposition was taken to learn what
Champlin thought he had done to justify
the fee. It was taken by the Fosters’
attorney, there was no cross-examination,
and the deposition was never used in the
case, which was settled before trial. We
appealed and briefed the admission of the
deposition into evidence, but the court
below did not discuss the issue.
13. Respondent obtained that depo-
sition from the California Superior Court
by subpoena, and also obtained in the
same fashion a second deposition in a
related proceeding by Champlin in 1971.
In that deposition Champlin told an en-
tirely different story in the two re-
spects in which what he said is relevant,
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21
and confirmed the testimony of the bank
officer. Because we were taken by sur-
prise by the suppression of the second
deposition, and because we were concerned
that our objection to admission of the
first depositon would be waived if we
offered a similar deposition into evi-
dence ourselves, we did not do so. We
lodged it with the Clerk of the Court of
Anpeals with the request that that court
take judicial notice of the deposition
under Rule of Evidence 201(b) and of the
fact that in his second deposition
Champlin testified inconsistently with
what the Tax Court thought he said in the
first one. The Court of Appeals refused.
22
REASONS FOR GRANTING THE WRIT
l.(a) In holding that Section 482
empowers the Internal Revenue Service to
deny favorable tax incidents Congress has
provided for, merely because the business
structure taxpayers have adopted was
chosen because of those tax incidents,
the decision below is in conflict with
the decision of the United States Court
of Appeals for the Tenth Circuit in
Keller v. Commissioner, 723 F.2d 58.
That decision was addressed to the court
below in our briefs and discussed at
length as major point of reliance in our
argument. The court below did not
attempt to distinguish the Keller case
but simply ignored it.
The principle involved in Keller is
that involved here: Does Section 482
confer on the Internal Revenue Service
the power to deny tax benefits Congress
‘<ged eae “ioebion
me oitt eis
ie
ras dots ee : re
aioe a
5 4c. >
&
has deliberately written into the tax
code to effectuate its policies, merely
because the taxpayer organized his
affairs so as to obtain those benefits.
In Keller, the taxpayer, a physician,
formed a wholly owned professional cor-
poration with which he contracted for his
services, and it became the partner in
the medical partnership in which he had
theretofore practiced individually. He
caused his corporation to establish a
retirement fund and a medical insurance
plan, which costs were deductible from
the corporate net income but not taxable
to him. If he had continued his practice
in the partnership as an individual, he
would have been restricted in the amount
he could deduct from income for his re-
tirement plan, and would have been tax-
able on the premiums paid for the medical
insurance plan. Transforming his prac-
tice into corporate form therefor re-
24
duced taxes, which the Tax Court acknow-
: ledged he had intended. It held,
nevertheless, that the tax code has
consistently recognized the difference
between corporations and individuals, and
has consistently provided a different
taxing structure for corporations than
for individuals, always with a difference
Jin rates. The Tax Court saw that Con-
Noress had deliberately invited what the
) physician had done and concluded that
that amounted to a legislative mandate
which the Commissioner could not ignore
Sunder the guise of allocation of income
Junder Section 482. The Tax Court deci-
sion was reviewed by the entire court,
with a majority opinion and numerous
Jdissents. The Court of Appeals affirmed
the Tax Court decision for the reasons
B set forth in the majority opinion. The
) reasoning of the two Keller courts is
ythat found in the majority opinion of the
25
Tax Court, summarized above.
The issue in the instant case is the
same in substance. As held in Keller,
4 Congress has consistently provided for
separate taxation of corporations and
their individual stockholders, and the
corporate income is taxed to the corpora-
tion instead of to the individual, at a
different rate. The court below sus-
tained the Tax Court decision that the
transfer of proparty to corporations
owned by the transf rs, with knowledge
which the Tax Court held the individuals
had that the transfer, tax free under
permissive Code sections, would serve to
reduce taxes by having the income taxed
to the corporations instead of to the
individuals, was sufficient reason to
allocate income to the transferors under
Section 482 on the ground that the allo-
cation served to prevent what that
section describes as "evasion of taxes".
26
The decision below is thus in irrecon-
cilable conflict with the Keller
decision, unless the transferee corpora-
tions lacked substance or were shams.
However, Tax Court found here as it
had in Keller that the transferee cor-
porations had substance and did business.
Here the corporations filed the subdivi-
sion map, they made numerous contracts
for the development of the land occurring
after the transfer of the land to them,
and they made the sales to developers.
The corporations ultimately invested the
proceeds in apartments which they built
and operated for several years, and they
retained and leased out some of the land.
In the last of the series of years in-
volved the corporations owned and oper-
ated the apartment houses referred to.
Though not identical factually, the cases
are indistinguishable.
This conflict can have important
27
consequences if not corrected. By
deciding the Keller case as a reviewed
decision, the Tax Court meant to estab-
lish it as a rule of principle governing
its future decisions. The decision in
the Tax Court here was rendered after
Keller, by a judge who had dissented in
Keller. The affirmance of Keller after
the Tax Court decision here has undoubt-
edly led the Tax Court to believe that
the Keller decision was correct.
The inconsistent decision here is
not only certain to confuse courts in
future cases, but represents a true re-
volution in thinking. This is the first
case in the long history of Section 482
to decide that an “evasion of tax" which
the Commissioner can deny altogether
flows from the necessary implication of
Section 351, which is that the corporate
tax rate applies to the income derived
from the sale of property with the
28
carryover basis resulting from Section
351 transactions.1/ Although the court
below cited one of its former decisions
(Rooney v. Commissioner, 305 F.2d 681
(1962)) as representing pre- existing
precedent supporting that -esult, that
case did not deny the berefits of Section
351 to the income from the transferred
property, and, contrary to the instant
case, did tax it to the corporate
taxpayer instead of the individual
shareholders. What it did was to sustain
an allocation to the corpora- tion of the
costs incurred to create the income of
the corporation, so that the income and
the cost of producing it would be taxed
to the same taxpayer. The prior
1/ Quite recently the Tax Court refused
to sustain a Section 482 allocation to a
parent in disregard of Section 35l,
saying: "It is well establilshed that
taking advantage of tax benefits made
available by Congress does not constitute
tax evasion." Eli Lilly and Co., 84 TC
996, 1120 (1985). Here, though, both the
Tax Court and the Court of Appeals held
to the exact contrary.
29
decision is thus not precedent for what
the court below did here, because neither
it, nor the Tax Court, nor the Commis-
sioner, assigned to the Fosters the costs
incurred in improving the land to the
point where it became saleable, and
income productive. The instant decision
is thus one without precedent.
The decision below must leave in
doubt the tax status of every transaction
complying with Section 351, since the
conditions relied on by the'Tax Court and
by the Court of Appeals will be found in
virtually every such transfer. Section
351 presupposes the transfer of appreci-
ated property, and it requires that the
transfer not change the beneficial con-
trol because it requires that the former
owners of the property control the trans-
feree corporation. Those are the very
conditions the court below found trig-
gered Section 482 in this case. If it
30
will do so in this case, it can trigger a
reallocation under Section 482 in every
case in which the Code imposes a lower
tax on controlled corporations than on
individuals.
(Db) The decision below, in
holding tthat taxpayers’ deliberateiy
taking adivantage of tax reduction provi-
sions is sufficient to authorize the
Commissioner to invoke Section 482 to
deny thatt tax reduction, is also in
direct conflict with the decision of this
Court in Commissioner v. First Security
National Bank of Utah, 405 U.S. 394
(1972). That case is the only case this
Court has decided which considered the
applicat:ion of Section 482. [In his peti-
tion for certiorari there (Pet. Cert. No.
70-305, Oct. Terms 1970, 1971, p. 8), the
Solicitor General asserted that in the
restructuring which the Commissioner had
attacked, "controlled corporate groups
31
sought to achieve considerable tax sav-
ings" through invoking the lower tax
rates applicable to "the income of their
life insurance subsidiaries.2/ The bank
in question believed it could not legally
S receive referral income from insurance it
originated for insurance companies. The
, restructuring it carried out created a
) reinsurance carrier affiliated with the
bank which could legally receive premium
; income from the reinsurance of risks re-
_ferred by the bank to insurance compan-
Jies. The Commissioner allocated a por-
tion of the reinsurance premiums to the
} bank for its services. In its opinion,
this Court pointed out that the restruc-
turing did indeed reduce taxes. (405
U.S. 394, 399.) It also added Footnote 4
to page 398 of the opinion, which has
§2/ In his brief on the merits (pp. 7,
27, 34), the Solicitor General also
referred to the tax reduction consequent
§on the restructuring.
32
every earmark of being seriously in-
tended, a quotation from Judge Learned
Hand that the payment of taxes is an
enforced exaction, not a voluntary
contribution, and added its own words
that “Taxpayers are .. . free to
@ structure their business affairs ... to
wminimize taxes." Since the Court was
speaking in the context of Section 482,
and addressing itself to a challenge the
Solicitor Ge :eral had made to the
restructuring on the ground that it had
been done to reduce taxes, the conclusion
that the court meant what it said is
irresistible. The lower court, however,
referred to the language in the footnote
fas “shibboleth", and gave it no sub-
stance. Moreover it said, mistakenly,
that the bank restructuring was not a
"nonrecognition transaction." Even if
that were true, it would not increase the
Commissioner's power under Section 482,
ra
>
~
33
unless the court meant that the Commis-
sioner has more power to overturn Con-
gressionally mandated "nonrecognition
transactions" than transactions not
governed by explicit tax deferral or
J minimization statutes.
The lower court's interpretation of
this Court's decision in First Security
| Bank is erroneous and the error appears
to us to be self-evident: There was no
purpose for the Commissioner to apply
Section 482 in that case unless by doing
so he increased taxes by allocating in-
come from a low bracket taxpayer to a
high bracket taxpayer. hace he had to
contend that he was preventing the eva-
@sion of taxes through a restructuring
B which taxed some of the income at the
!lower insurance corporation rate. The
questions whether the form of operation
before the corporate restructuring was a
violation of banking laws, and whether
34
that violation was cured by the restruc-
turing, were not reached if the taxpay-
er's adoption of a restructuring which
reduced taxes was sufficient to support a
reallocation under Section 482 to "“pre-
vent evasion of taxes". This Court
admitted that the effect of the readjust-
ment was to reduce taxes (405 U.S. 394,
399) but in its Footnote 4 said that to
reduce taxes by “lawful structuring" was
every taxpayer's right. Only then did it
need to question whether the Commission-
er's allocation was proper under Section
482 “clearly to reflect the income," and
it was in that context that the Court
considered the banking law aspect of the
case.
The Court of Appeals has entirely
misread this Court's decision in First
Security Bank, and has reduced its seri-
ously meant remarks about taxpayers’
right "to structure their business af-
35
fairs" to reduce their taxes, to a mere
"shibboleth", by which the court evi-
dently meant a slogan, and not a binding
' statement of principle.’ Failure
properly to apply the only decision this
} court has rendered involving Section 482
is a ground for granting the writ, and
when coupled with the inconsistency be-
tween the decision below and that of the
Court of Appeal for the Tenth Circuit in
the Keller case, represents two important
: reasons for granting the writ. As we
stated above, the importance of the issue
in future administration of Section 482
is difficult to exaggerate.
3/ This Court subsequently applied the
same principle to reject an attack ona
sale and leaseback, Frank Lyon Co. v.
United States, 435 U.S. 561 (1978). It
had also declared that principle
‘@ previously, i ee v. Helvering, 293
fU.S. 465,469 (1: :
36
The foregoing is an important
question of federal law4/ which has not
been but should be settled by this Court.
2. Ar important question of federal
law which has not been, but should be,
settled by this Court, is whether the
authority to allocate income or deduc-
tions between controlled business
Bentities "in order to prevent evasion of
e
&
4 4/ The question is presented both by the
transfers to the four corporations of
lots in N. One, and the later transfers
' of 311 lots nearing the final stage of
development for sale in N. Four to Foster
Enterprises, a corporation owned by the
individuals in equal shares. The ground
offered to support the reallocations of
both Nl and N4 lots was the same: the
transfer was made to avoid or minimize
taxes, and both courts sustained the
4 reallocation on that basis. In so doing,
they extended Section 482 to attain a
result Congress stopped short of
authorizing when it enacted Section 269.
37
taxes" extends also to allocations "to
prevent avoidance of taxes." The Court
below held that it did, without consid-
ering the constitutional limitation such
a construction raises, although our
briefs presented this point>/
The regulations, and both the Tax
Court and the Court of Appeals in the
instant case, have construed the language
of Section 482 ("to prevent evasion of
taxes") to have the same meaning as "to
prevent avoidance of taxes." The
Internal Revenue Code is replete with
provisions carefully adopted by Congress
ameliorate or reduce the burden of taxes
on particular persons, on particular
corporations, or on particular trans-
5/7 The Commissioner's brief was silent
on the point, a silence matched by the
Court of Appeals.
5 ies SAAS Fa :
oo Heater aA. >
~~
=
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38
actions. Virtually every one of those
provisions becomes applicable only when
the taxpayer acts, such as to form a cor-
poration, which brings it into operation.
Each act avoids taxes which would other-
wise be imposed. Thus virtually every
tax reduction or minimization provision
Congress has placed in the Internal
Revenue Code has the effect of "avoidance
of taxes", so if the interpretation of
the statutory term "to prevent evasion of
taxes" means what the court below held it
did, then everything done deliberately to
take advantage of a tax minimization fea-
ture Congress has enacted will constitute
"avoidance of taxes" within Section 482.
Section 482 becomes operative only
when... “the Secretary .. . deter-
mines that such .. . allocation is
necessary in order to prevent evasion of
taxes or clearly to reflect the income of
any of such organizations ...." It is
hg
LSOAL Sa te
te oe
Gh,
39
thus dependent upon administrative dis-
cretion. However, under the interpreta-
tion below every tax minimization will
evade taxes and may be denied by the
Secretary, at his unfettered option.
Congress could not have intended to
grant the Commissioner (the delegate of
the Secretary) uncontrolled power to
allocate income and deductions so as to
tax income to corporations instead of
individuals to produce greater taxes, or
to individuals instead of corporations
where that will, but the court below, and
the regulations themselves, have so held.
This represents an invalid delegation of
power, but this so little disturbed the
court below that it entirely failed to
address our argument.
If the Commissioner has discretion
to apply this axe to prune off all tax
advantages Congress has enacted, he must
be given guidelines for the exercise of
;
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40
that discretion. If the statute means
what it says, those guidelines will flow
from the understandable difference
between “evasion” and “avoidance.” The
flaw in the reasoning below (and in the
regulations) is the equation of "evasion"
and “avoidance.” This is more than a
matter of improper statutory interpreta-
tion. If the statute may be applied
wherever what the taxpayer has done is to
avoid taxes, and the Commissioner can
invoke the statute as he sees fit,
Congress has delegated to him the power
to deny every tax rate minimization
feature in the Internal Revenue Code
which it adopted, where there are the
controlled or related entities or parties
many of the tax minimization sections
require. This violates the delegation of
powers principle declared in Schechter v.
United States, 295 U.S. 495 (1935), ance
Pacific Refining Co. v. Ryan, 293 U.S.
i a, eh
$i:iave” Oe
t 2 ‘(Gn 2 1f55 5m
+ I 2 - & 4 Pils J saors
WSS Bis Tate seVemreEs
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41
386 (1935), and the separation of powers
doctrine recently applied by this Court
in I. N. & S. v. Chadha, U.S. , 77
L.Ed.2d 317 (1983).
Unlike the Court of Appeals, the Tax
Court did consider and reply to this con-
tention to its satisfaction, by stating
in reliance on a law review article and a
dissenting opinion by a member of this
Court that the first two of those cases
had been overruled by the passage of
time.
We suggest that awareness by this
Court of the existence of this problem is
suggested by the fact that in its opinion
in Commissioner v. First Security Bank of
Utah, supra, 405 U.S. 394 (1972), this
Court referred to the statutory word
"evasion", and never once referred to it
as “avoidance."
The question is important and under-
lies every use of Section 482 to negate
a 4
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42
Congressionally enacted tax avoidance
measures. |
3. In holding that the principal of
the Westway notes constituted interest,
the Court of Appeals has decidec another
federal question in a way to conflict
with this Court's decision in Deputy v.
duPont, 308 U.S. 488 (1940). Its
decision also conflicts with this Court's
decision in United States v. Mississippi
Chemical Corp., 405 U.S. 288 (1972), and
with its decision of the second aspect of
Commissioner v. First Security Bank of
Utah, supra, 405 U.S. 394 (1972).
The status of the notes as
interest or principal would not matter if
the taxpayers were permitted to
capitalize them under Internal Revenue
Code Section 266, as they elected to do.
Both lower courts held that that section
was unavailable to a cash basis taxpayer.
The language of the statute does not com-
43
pel that discrimination, and the legisla-
tive history, which we analyzed in our -
brief below, refutes the suggestion.
If the "Westway Notes” consti-
tuted interest, (1) they were usurious
and hence violated the law of Texas,
where the obligee did business, (2) they
were interest on a liability to repay
funds the obligee had never advanced or
loaned, and (3) were never payable to the
entities which did lend funds. The funds
were loaned by the Hoblitzelle Founda-
tion, a charitable foundé:ion, and after
three years were repaid with funds bor-
| rowed from the Republic National Bank.
q Westway, to which the $3,000,000 of notes
were payable, was neither parent nor
subsidiary of the Republic National Bank,
although the Bank and Westway'’s parent
had common shareholders. For an interest
obligation to exist, as this Court has
@ defined the rule, there must be a princ:-
2
*
Lay BT yates
44
pal obligation to repay a2 debt to the one
to whom interest is payable, and to repay
it in cash. Deputy v. duPont, supra, 308
U.S. 488. 497-498. This essential
felement was missing. This is a question
of law, not fact. United States v.
Mississippi Chemical Corp., supra. More-
over, the concept of "interest" approved
sbelow is indeed “esoteric” and not one
based on the “usual, ordinary and every-
day meaning of the term," as Deputy v.
duPont requires, supra, 308 U.S. at 497.
The genesis of the obligation was an
oral agreement between the Fosters and
the Republic National Bank to give the
bank a 50% interest in the profits up to
an amount equal to the funds the bank
either loaned or persuaded someone else
to lend to the Fosters, This is a form of
inducement known in business as a "piece
of the action." The regulations of the
omptroller of the Currency permit a
45
national bank to take such an inducement,
either in lieu of interest or in addition
to it. 12 C.F.R. 7.7312. The loans made
by the Hoblitzelle Foundation and later
by the bank bore interest at the rate of
6%, which was the going rate of interest
at the time. Hence the inducement was in
addition to interest, not in lieu of it.
By letter ruling, the Comptroller of
the Currency has ruled that the amount,
if in lieu of interest, cannot be large
enough to make the transaction usurious.
Since the additional amount was 100% of
the loan, if it was interest it was
: obviously usurious, and the Tax Court
acknowledged the fact in its opinion.
Once again two courts have approved the
Commissioner's action in distorting a
transaction from a legal form into an
illegal one, in order to increase taxes.
This interpretation of the Commissioner's
powers was disapproved by this court in
46
i Commissioner v. First Security Bank of
Utah, supra, 405 U.S. 394, in the context
of Section 482. On this issue, the
Commissioner has not used Section 482.
Instead, he has relied on his interpreta-
tion of the substance of the transaction,
which was sustained by the courts below
i as if it were a question of fact. How-
ever, the rule that the Commissioner
should not distort legal transactions
into illegal ones in order to produce a
} larger tax is a rule of law.
As we stated above, the court below
decided the issue in a manner which
conflicts with the decision of this Court
in United States v. Mississippi Chemical
Corp., supra, 405 U.S. 298, where, in
reversing two lower courts which had
treated as one of fact the question
whether certain payments were interest so
as to be deductible, this Court held that
the amounts in question were not inter-
bee? S282.
as
u
G
) ;
oe
~
47
est. In the course of its opinion the
Court stated that where the form of a
transaction was carefully and deliber-
ately adopted for reasons of the parties,
the form should not be lightly disre-
garded and amounts treated as interest
contrary to the parties’ contract, parti-
cularly when the payments are not
interest in the ordinary sense of the
word, relying on Deputy v. duPont, supra.
We submit that the Court of Appeals,
as did the Tax Court, has gone to unrea-
sonable lengths to disregard the form of
the transaction, and even identity of the
parties. No principal sum was ever owed
to Westway, except the notes themselves,
and the principal of the notes could not
possibly be interest, under the rules of
this Court as discussed above, and if the
transaction is related to its inception
and the negotiations of the parties which
produced it, and the amounts are treated
aed cobp ion “ai 30 sewed ede or. om
-
| Py 4 i. be preg
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48
as interest, they amount to 100% of the
loan and hence are usurious and unlawful,
with the result that the transaction has
been distorted by the court below and the
Commissioner into an illegal form, con-
trary to this Court’s decision in First
Security Bank of Utah decision.
The question of what is interest is
always important in tax administration
and in denying that the thousands of cash
basis taxpayers who must have elected to
capitalize under Section 266 did so prop-
erly, the court velow has opened a
Pandora's box which represents an impor-
tant question of federal law, appropriate
for review here.
4. The court below has so far
departed from the accepted and usual
course of judicial proceedings as to call
for an exercise of this Court's power of
supervision.
(a) The court below disregarded the
as NOUR RL RANSON SD IOI GERI.
49
existence of three sections of the new
Rules of Evidence, which were adopted in
1978 and therefore applied to this case.
All three were discussed 2° length in our
briefs, though not all of them were
discussed in appellee's brief. These are
Rule 301, governing the survival of
presumptions; Rule 804(b)(1) and (5),
dealing with the admissibility of
discovery depositions taken in a state
court proceeding between private parties
involving different issues; and Rule 201
dealing with the mandatory requirement
that the court take judicial notice of
proper items for judicial notice when
called to the court's attention. Not
one of the three was discussed by the
4 Court of Appeals, but statements or
| actions in conflict with them were made.
Rule 301 provides that presump-
tions disappear when evidence making a
prima facie case has been introduced. It
50
does not distinguish between the many
presumptions of official regularity, and
presumptions between private parties; it
does not distinguish between presumptions
in a tax case where the issue is a deduc-
tion, and where the issue is over gross
income. Nevertheless, the court below,
citing a previous decision of its own
antedating the adoption of the Males of
Evidence, and without discussing either
the relevant section of those rules, or
this Court's decision in Helvering v.
Taylor, 293 U.S. 507 (1935), held that
the presumption continued in effect after |
a prima facie case was made by the tax-
payers because the issue was the propri-
ety of a deduction, and an especially
heavy burden is on the taxpayer to
establish his right to deductions. That
distinction is not made by Rule 30l.
The underlying issue was whether
petitioners had complied with Section
tT) =
StS Se
SEF
128 255
58 a
o
“asi st
- = 5
2 se ee
are
LOR ag GP ee RE GRR AI Sn STENT feet CSE HN EONS gh He WS! ‘
A AYRE MI OES POPE EARLE | SORE AGAR MEME Shera SebAN a hat gay a erg Le of earth Ug eet
51
274, which requires certain types of
documentary support for travel and
entertainment deductions. The deficiency
letter merely disallowed a lump sum,
without specification. The examining
Revenue Agent had scrambled petitioner's
records so that it was impossible for
anyone to determine which items were dis-
allowed. His work papers were undeci-
pherable, as the trial judge noted during
the trial. Petitioners’ uncontroverted
evidence showed that the system provided
the necessary documentary support, in-
cluding random examples taken from their
files. These examples met the Section
274 standard (which neither court
denied), making a prima facie case, and
the Commissioner should have been re-
quired to produce evidence showing which
deductions were disallowed, and why. He
stood mute. Under the new Rule there was
no remaining presumption in his favor and
.
a ee ae a eae ~~. te. o Sc me bo
eo bn Me TS Lie Sel ree. Meee:
—_
z 2 iz
- es
= 4 Sg
aa ae Mey eo Ee ; oy 3,
reer eysant bioeds rene! ragimmcd’ @e
52
judgment on this issue should have been
for petitioners, but both lower courts
held, the Tax Court with an opinion ex-
plaining its views but disregarding the
Rule, and the Court of Appeals without
discussing the new rule, that the pre-
sumpcion survived. On this point the
decision below is contrary not only to
Rule 301 but to the decision of this
Court in Helvering v. Taylor, 293 U.S.
507 (1935), where the issue was the
proper calculation of basis to be de-
ducted from sales price. It appears also
to be an attempt to limit United States
v. Janis, 428 U.S. 433 (1976), where
nothine said by this Court suggests ey
distinction between gross income cases
and deduction cases.
The next omission by the court below
from accepted and usual course of judi-
cial proceedings was its refusal to dis-
cuss and decide whether a pre-trial dis-
tele ca A ae de le tial el a ene
53
cnsdey -Cunee itton taken in a state court
proceeding between different parties was
admissible in evidence as an exception to
the hearsay rule under Rule of Evidence
804(b)(1) and (5). The Tax Court had
admitted it over our objections. This
point was thoroughly discussed in our
briefs but the court below did not re-
spond to our argument either by rejecting
it or agreeing with it, though the effect
of its affirmance is to leave the trial
court unreversed for having admitted the
discovery deposition in evidence and
having relied on it extensively.
Allied to this objectionable silence
is the court's silence about its reason
not to follow the mandate of Rule 201 and
take judicial notice of a second and
conflicting pre-trial discovery deposi-
tion given by the same witness in the
Same court. Rule 201(d) states that the
obligation to take judicial notice is
: ie tele tee Rie Bao x
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ove ae co <p Balk Rae pa ap ee eh ae
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54
mandatory at any stage in the case, if
the offered material satisfies the re-
quirements for judicial notice and is
made available to the court by the offer-
ing party. We did this. This particular
deposition was subpoenaed by the Commis-
sioner from the files of the Superior —
Court of California for San Mateo County,
was made returnable to the Tax Court in
San Francisco, was presented to the Tax
Court, but was not offered in evidence by
the Commissioner, whose attorney told the
Tax Court that it was cumulative of the
first deposition. We offered the second
deposition for judicial notice in the
Court of Appeals to prove that the wit-
ness had testified differently in the
second deposition, on a point the Tax
Court had extracted from the first depo-
sition and on which it had placed much
emphasis. We argued both that the incon-
sistency of the two depositions demon-
- ee
ve
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strates the inherent unreliability of
discovery depositions, and that if the
depositions are admissible, the Commis-
sioner should not profit from his sup-
pression of the second deposition on a
misrepresentation to the trial court, and
there should be a remand for a trial at
which both depositions would be consid-
ered. The Court of Appeals was silent on
all these points, not even demonstrating
that it had considered them, or
understood them. °/
(b) The Court of Appeals also
departed from the accepted and usual
course of judicial proceedings in refus-
ing to remand for a new trial where the
67 The Court of Appeals treated our
motion to take judicial notice as a
motion to augment the record, and as such
denied it, saying: "The deposition is
not properly before this court, ..."
Footnote 2 to opinion, Appendix infra p.
i. We brought it before the court
exactly as Rule 201 prescribes.
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suppressed evidence could be considered.
In his briefs in the Tax Court, Commis-
ioner asked that court to make findings
which were contradicted by the suppressed
evidence, although his counsel had repre-
sented it was merely cumulative. That
court made those findings, over our
objections that the deposition was
hearsay and not made admissible by Rule
804(b)(1), and did not say what was
argued. We would have waived the first
objection had we offered the second
deposition because it was not admissible
if the first one was not. In both our
briefs and our petition for rehearing in
the Court of Appeals we cited decisions
from this Court holding that a new trial
must occur under the compulsion of the
due process clause where at the first the
Government suppressed evidence (Giglio v.
United States, 405 U.S. 150 (1972)), or
knowingly introduced perjured testimony
57
(Napue v. Illinois, 360 U.S. 264 (1959)).
We pointed out that the due process
clause is a guaranty to property as well
as liberty so it applies to civil cases
as well as criminal (Parratt v. Taylor,
451 U.S. 527, 537, $38, (1981)).
We also pointed out that we had
not waived objections to the suppression
of the deposition because we were
contending that such depositions were
inadmissible.
Not only did the Court of
Appeals not remand for a new trial but it
neglected to explain why or discuss the
issue at all. This is a departure from
settled judicial procedure producing an
unconstitutional result, and hence is
particularly worthy of the exercise of
this Court's supervisory powers.
(c) Another argument the court
below ignored was that the trial court
erred in refusing to permit one of the
58
parties to testify that he now knew what
the business purpose was for the transfer
of N. 4 to Foster Enterprises. In a de-
position in a prior case in the state
courts, admitted by the Tax Court, he had
testified to ignorance of the business
purpose. The Tax Court refused to permit
him to correct his testimony by using the
same phrase, business purpose, he had
used in the prior testimony. Obviously,
if he could not use the term he used be-
fore, his correction would not be any
correction at all. The error was so
clear respondent did not even argue to
justify it in his brief below, but the
court below did not reverse. on that
account; it ignored the point. This too
is a departure from the accepted and
usual course of judicial proceedings.
(d) The court below departed
from established law by improperly treat-
ing the activities of Estero Municipal
splot Mp R Oat, A OO pe
Fe a a Ne ean ee ae i kik a aa: ale
Vetiay ahaa | PRR eM ELAR SPANNER AEN REANIM SE MRE NGA al IR I DRA UI Re le IS
59
Improvement District, a public agency of
the State of California, created by the
State Legislature, as those of the tax-
payers, and improperly held that in-
creases in land values due to improve-
ments made by Estero's employees and
independent contractors and financed by
public funds should be treated as made by
these taxpayers. In addition, the court
held that the taxpayers’ corporations
that employed them and paid them salaries
for their services should be disregarded
as well, and all the taxpayers’ activi-
ties should be treated as if conducted by
them as individuals in order to increase
the value of the property held by vazvious
of their corporations, and not as corpor-
ate employees. In this fashion the court
sought to justify the application of Sec-
tion 482 to tax the individuals on the
increment in value of land before the
corporations sold it because of the im-
60
provement of the land by the State of
California's agency, Estero.
To sweep aside corporate entities in
this manner is such a departure from the
accepted and usual legal standards as to
call for the exercise of this Court's
power of supervision. This court has
repeatedly held that the corporate fic-
tion is created by law and is meant to be
recognized, in tax matters as elsewhere
(Klein v. Board of Supervisors, 283 U.S.
19 (1930); Moline Properties, Inc., v.
Commissioner, 319 U.S. 436 (1943), unless
abused. No abuse was found here, or
existed. Estero did exactly what the
California legislature created it to do,
and in a proper manner. The California
Supreme Court so held. Cooper v. Estero
Municipal Improvement District, 70 Cal.2d
645, 75 Cal.Rptr. 777 (1969), cert. den.
396 U.S. 821; Cooper v. Leslie Salt Co.,
70 Cal.2d 627, 75 Cal.Rptr. 766 (1969).
BR re
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61
To attribute its activities to the
Fosters is to disregard the legal
separateness of the state agency, even
though the court below thought it could
successfully deny that analysis. It
distinguished its prior decision in
Commissioner v. Birch Ranch & Oil Co.,
192 F.2d 924 (9th Cir., 1951), although
the distinction appears empty. It could
overrule that decision without presenting
a conflict between the circuits, but if
it did that there would remain a conflict
between this case and that in Rutland v.
Tomlinson, 327 F.2d 668 (5th Cir. 1964),
which followed the Birch decision. To
the Fifth Circuit it must appear that
there is a conflict.
The disregard by the court below of
the existence of the controlled private
corporation T. Jack Foster and Sons,
Inc., so it could attribute the activi-
ties of the Fosters (and others) as
is
yonene SAS R- 8a te
tm.
f
ee ee mR AR ye
b a ‘jgmae o7keT9s sobsioniseth a
i wwoette molkioebd edd sarees
es 5iitaes..6 niga ites eigats sad bib
hes oes 2S
a ee ere : (¢444 Se or no BEG
= 3 tats saegeEs sens, ti ‘guowl ant es
i ze aa tenes & ah exes
cpalea
62
employees of that corporation to the
Fosters individually is also startling,
and has more widespread precedential
impact. There was no evidence in the
record that the Fosters abused or dis-
regarded the corporate identity. The
record showed the corporation was one of
substance which owned several buildings
in Foster City. The Commissioner did not
allocate income or deductions to or from
it under Section 482, he allocated em-
ployees from it, and the court below
sustained him on the ground the Fosters
used the corporation in their business.
That is the classic reason closely held
corporations are formed, and if their
identity can be disregarded on that
ground as the court below did, the deci-
sion below is revolutionary, contrary to
ee ae
established concepts of law, and should
tah
not be allowed to stand.
The decision presents an important
EERO POL LEAI GERD AP IO IOAN ES
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question of federal law which apparently
has been left open by prior decisions of
this Court. That question should now be
settled by this Court.
(e) The Court of Appeals also
failed to follow the accepted course of
judicial procedure by not addressing
petitioners’ alternative argument that if
they, as taxpayers, were chargeable with
the activities of the staff of Estero
Municipal Improvement District, and with
borrowing funds in its name, contracting
in its name, placing improvements on
Brewer's Island in its name, then they
were engaged in business as an associa-
tion taxable as a corporation. Estero
was a corporation; it differed from the
typical in that voting power was in
landowners and not shareholders, and
petitioners had the majority of votes;
this is the hook on which the court hung
its conclusion that petitioners used
64
Estero's employees and taxing power and
borrowing power to construct the im-
provements on Brewer's Island which im-
proved and increased the value of their
land. It follows from the court's
analysis that petitioners did business as
an association, because they utilized all
of the corporate characteristics of
Estero, as well as those of the private
corporation, T. Jack Foster & Sons, Inc.,
which was their employer. Thus petition-
ers surrounded themselves with corporate
characteristics and used them in their
activities.
This scenario creates the
classic association, under the
Regulations (Treas. Reg. Section
301.7701-2(a)(2), last sentence, ibid,
subdivision (b)(1), (c)(1) and (3),
(d)(1) and (e)(1)), under Bert v.
) Helvering, 92 F.2d 391, (D.C. Cir. 1937),
and under this Court’s decision in
old sree es ed os
Pe Bie fees oS ae
od
.
tabs FX
eo wk |
c* tof
65
Morrissey v. Commissioner, 296 U.S. 344
(1935), and a number of similar cases
decided the same day as Morrissey. This
position, if sound, would have won the
entire case for petitioners, because it
would have meant that the assessments
made against petitioners should have been
made against the association, against
which the statute of limitations has ap-
parently run.
The Court of Appeals should be
instructed to consider and decide this
and the other issues it ignored.
CONCLUSION
The writ of certiorari should be
granted.
Respectfully submitted,
Valentine Brookes
Counsel of Record
Lawrence V. Brookes
BROOKES AND BROOKES
Attorneys for Petitioners
(Appendices follow)
In the Supreme Court
OF THE
United States
OCTOBER TERM, 1985
RICHARD H. FOSTER AND SARA B.
FOSTER, T. JACK FOSTER, JR.,
AND PATRICIA FOSTER, JOHN R.
FOSTER AND CAROLINE FOSTER, AND
ESTATE OF T. JACK FOSTER,
DECEASED, GLADYS H. FOSTER,
EXECUTRIX, AND GLADYS H.
FOSTER,
Petitioners,
Vv.
COMMISSIONER OF INTERNAL
REVENUE.
i ee ee ee eee
ee 1.
Appendix I
Constitutional provisions,
statutes, and regulations
involved
“ype ec Saas
ek ae hw mS
eth a ie ee
Appendix
A-1
United States Constitution,
Article I,
Sec. 8.[Powers of Congress.]
{[l.] The Congress shall have power to lay
and collect Taxes, Duties, Imposts and
Excises, to pay the Debts and provide for
the common Defence and general Welfare of the
United States; but all Duties, Imposts and
Excises shall be uniform throughout the
United States.
[18.] To make all Laws which shall be
necessary and proper for carrying into Execu-
tion the foregoing Powers, and all other
Powers vested by this Constitution in the
Government of the United States, or in any
Department or Officer thereof.
PAS ae ett ee Pe eee
| .
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.
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ow A
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prereset se bad iad
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7 ai ts> * as es de ‘
hare OR Ce? Ny RE GEE LRP APSR AME LEAT ERE AT
eas fe AARNE NN AR ENB BARE! OEE SSP ARIELLE AD TM RAS te 3 SMO RASC on Merny
A-2
SEC. 266. CARRYING CHARGES.
No deduction shall be aiiw << for amounts paid or ac-
crued for such taxes and carrying charges as, under regu-
lations prescribed by the Secretary, are chargeable to capi-
tal account with respect to property, if the taxpayer elects,
in accordance with such regulations, to treat such taxes or
charges as so chargeable.
SEC. 351. TRANSER TO CORPORATION CON-
TROLLED BY TRANSFEROR.
(a) General Rule.—No gain or loss shall be recognized
if property is transferred to a corporation by one or more
persons solely in exchange for stock or securities in such
corporation and immediately after the exchange such per-
son or persons are in control (as defined in section 368(c) )
of the corporation.
(b) Receipt of Property.—If subsection (a) would apply
to an exchange but for the fact that there is received, in
addition to the stock or securities permitted to be received
under subsection (a), other property or money, then—
(1) gain (if any) to such recipient shall be recognized,
but not in excess of—
(A) the amount of money received, plus
(B) the fair market value of such other property
received, and
(2) no loss to such recipient shall be recognized.
(c) Special Rule.—In determining control, for purposes
of this section, the fact that any corporate transferor dis-
tributes part or all of the stock which it receives in the
exchange to its shareholders shall not be taken into account.
(a) General Rule.—In the case of an exchange to which
section 351, 354, 355, 356, 361, 371(b), or 374 applies—
(1) Nonrecognition Property.—The basis of the prop-
erty permitted to be received under such section without
A-3
the recognition of gcin or loss shall be the same as that of
the property exchanged—
{A) decreased by—
(i) the fair market value of any other property
(except money) received by the taxpayer,
(ii) the amount of any money received by the tax-
payer, and
(iii) the amount of loss to the taxpayer which was
recognized on such exchange, and
(B) increased by—
(i) the amount which was treated as a dividend, and
(ii) the amount of gain to the taxpayer which was
recognized on such exchange (not including any por-
tion of such gain which was treated as a dividend).
(2) Other Property—The basis of any other property
(except money) received by the taxpayer shall be its fair
market value.
(b) Allocation of Basis—
(1) In general—Under regulations prescribed by the
Secretary, the basis determined under. subsection (a) (1)
shall be allocated among the properties permitted to be
received without the recognition of gain or loss.
SEC. 482. ALLOCATION OF INCOME AND DEDUC-
TIONS AMONG TAXPAYERS.
In any case of two or more organizations, trades, or
basinesses (whether or not incorporated, whether or not
organized in the United States, and whether or not affili-
ated) owned or controlled directly or indirectly by the same
interests, the Secretary may distribute, apportion, or allo-
cate gross income, deductions, credits, or allowances
between or among such organizations, trades, or busi-
A-4
nesses, if he determines that such distribution, apportion-
ment, 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.
TREASURY REGULATIONS
§ 1.266-1. Taxes and carrying charges chargeable to
capital account and treated as capital items.
(a) In general. In accordance with section 266, items
enumerated in paragraph (b) (1) of this section may be
capitalized at the election of the taxpayer. Thus, taxes and
carrying charges with respect to property of the type de-
scribed in this section are chargeable to capital account at
the election of the taxpayer, notwithstanding that they are
otherwise expressly deductible ander provisions of subtitle
A of the Code. No deduction is allowable for any items so
treated.
(b) Taxes and carrying charges. (1) The taxpayer
may elect, as provided in paragraph (c) of this section, to
treat the items enumerated in this subparagraph which are
otherwise expressly deductible under the provisions of sub-
title A of the Code as chargeable to capital account either
as a component of original cost or other basis, for the pur
poses of section 1012, or as an adjustment to basis, for the
purposes of section 1016(a)(1). The items thus chargeable
to capital account are—
(i) In the case of unimproved and unproductive
real property: Annual taxes, interest on a mortgage,
and other carrying charges.
(ii) In the case of real property, whether improved or
unimproved and whether productive or unproductive:
(a) Interest on a loan (but not theoretical interest
of a taxpayer using his own funds),
(b) Taxes of the owner of such real property meas-
ured by compensation paid to his employees,
A-5
§ 1.482-1. Allocation of income and deductions among
taxpayers.
(a) Definitions. When used in this section and in
§ 1.482-2—
(1) The term “organization” includes any organization
of any kind, whether it be a sole proprietorship, a partner-
ship, a trust, an estate, an association, or a corporation (as
each is defined or understood in the Internal Revenue Code
or the regulations thereunder), irrespective of the place
where organized, where operated, or where its trade or
business is conducted, and regardless of whether domestic
or foreign, whether exempt, whether affiliated, or whether
a party to a consolidated return.
(2) The term “trade” or “business” includes any trade
or business activity of any kind, regardless of whether or
where organized, whether owned individually or otherwise,
and regardless of the place where carried on.
(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-G
A presumption of control arises if income or deductions
have been arbitrarily shifted.
(4) The term “controlled taxpayer” means any one of
two or more organizations, trades, or businesses owned or
controlled directly or indirectly by the same interests.
(5) The terms “group” and “group of controlled tax-
payers” mean the organizations, trades, or businesses
owned or controlled by the same interests.
(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 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 deduc-
tions, 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 arrangement, the controlled taxpayer, or
the interests controlling it, chose to make (even though
such contract, transaction, or arrangement be legally bind-
ing 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
uncontrolled taxpayer, 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 tax-
able income from the property and business of each of the
controlled taxpayers. If, however, this has not been done,
A-7
and the taxable incomes are thereby understated, the dis-
trict director shall.intervene, and, by making such distri-
butions, apportionments, or allocations as he may deem
necessary of gross income, deductions, credits, or allow-
ances, 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.
(2) Section 482 and this section apply to the case of any
controlled taxpayer, whether such taxpayer makes a sepa-
rate or a consolidated return. If a controljed taxpayer
makes a separate return, the determination is of its true
separate taxable income. If a controlled taxpayer is a party
to a consolidated return, the true consolidated taxable
income of the affiliated group and the true separate taxable
income of the controlled taxpayer are determined consist-
ently with the principles of a consolidated return.”
(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
consolidated taxable income under a consolidated return)
to effect in any case such a distribution, apportionment, or
allocation of gross income, deductions, credits, or allow-
ances, or any item of gross income, deductions, credits, or
allowances, as would produce a result equivalent to a com-
putation of consolidated taxable income under subchapter
A, chapter 6 of the Code.
(c) Application. Transactions between one controlled
taxpayer and another will be subjected to special scrutiny
to ascertain whether the common control is being used to
reduce, avoid, or escape taxes. In determining the true tax-
able income of a controlled taxpayer, the district director
A-8
is not restricted to the case of improper accounting, to the
case of a fraudulent, colorable, or sham transaction, or to
the case of a device designed to reduce or avoid tax by
shifting or distorting income, deductions, credits, or allow-
ances. The authority to determine true taxable income ex-
tends to any case in which either by inadvertence or design
the taxable income, in whole or in part, of a controlled tax-
payer, is other than it would have been had the taxpayer
in the conduct of his affairs been an uncontrolled taxpayer
dealing at arm’s length with another uncontrolled tax-
payer.
(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 adjustments and the charac-
ter and source of amounts allocated, shall be determined
with reference to the substance of the particular transac-
tions or arrangements which result in the avoidance of
taxes or the failure to clearly reflect income. The appropri-
ate adjustments may take the form of an increase or de-
crease in gross income, increase or decrease in deductions
(including depreciation), increase or decrease in basis of
assets (including 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 tax-
payers (such adjustments being referred to in this para-
graph as “primary” adjustments) he shall also make ap-
propriate 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 United
States income tax liability of the other member would be
affected for any pending taxable year. Thus, if the district
director makes an allocation of income, he shall not only
A-9
increase the income of one member of the group, but shail
decrease the income of the other member if such adjust-
ment would have an effect on the United States 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 United
States 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 United
States income tax liability of the other member involved
in the allocation for any pending taxable year, such adjust-
ment shall nevertheless be deemed to have been made for
the purpose of determining the United States income tax
liability of such member for a later taxable year, or for the
purposes of determining the Uni'ed States income tax lia-
bility 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 sub-
paragraph, 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 adjustment:
(4) If the members of a group of controlled taxpayers
engage in transactions with one another, the district direc-
tor may distribute, apportion, or allocate income, deduc-
tions, credits, or allowances to reflect the true taxable
income of the individual members under the standards set
forth in this section and in § 1.482-2 notwithstanding the
fact that the ultimate income anticipated from a series of
transactions may not be realized or is realized during a
later period. For example, if one member of a controlled
A-10
group sells a product at less than an arm’s length price to
a second member of the group in one taxable year and the
second member resells the product to an unrelated party in
the next taxable year, the district director may make an
appropriate allocation to reflect an arm’s length price for
the sale of the product in the first taxable year, notwith-
standing that the second member of the group had not
realized any gross income from the resale of the product in
the first year. Similarly, if one member of a group lends
money to a second member of the group in a taxable year,
the district director may make an appropriate allocation
to reflect an arm’s length charge for interest during such
taxable year even if the second member does not realize
income during such year. The provisions of this subpara-
graph apply even if the gross income contemplated from a
series of transactions is never, in fact, realized by the other
members.
(5) Section 482 may, when necessary to prevent the
avoidance of taxes or to clearly reflect income, be applied
in circumstances described in sections of the Code (such as
section 351) providing for non-recognition of gain or loss.
See, for example, National Securities Corporation v. Com-
missioner of Internal Revenue, (43-2 USTC { 9560] 137 F.
2d 600 (3rd Cir. 1943), cert. denied 320 U. S. 794 (1943).
§ 1.482-2 Determination of taxable income in specific
situations.
§7701. DEFINITIONS
(a) When used in this title, where not
otherwise distinctly expressed or mani-
festly incompatible with the intent
thereof--
(3) CORPORATION--The term "corporation"
includes associations, joint-stock con-
ovanies, and insurance companies.
In the Supreme Court
OF THE
United States
OCTOBER TERM, 1985
RICHARD H. FOSTER AND SARA B.
FOSTER, T. JACK FOSTER, JR.,
AND PATRICIA FOSTER, JOHN R.
FOSTER AND CAROLINE FOSTER, AND
ESTATE OF T. JACK FOSTER,
DECEASED, GLADYS H. FOSTER,
EXECUTRIX, AND GLADYS H.
FOSTER,
Petitioners,
Vv.
COMMISSIONER OF INTERNAL
REVENUE.
ee
_ .
Appendix II
Opinion of Court of Appeals
for the Ninth Circuit, and
Order denying rehearing
A-II-1
rt is @
APR 3 1985
PHILLIP B. WINBERRY
CLERK, U. S. COURT
OF APPEALS
IN THE UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
RICHARD H. FOSTER AND )
SARA B. FOsTER, T. JACK )
FOSTER, JR. and PATRICIA )
FOSTER, JACK R. FOSTER and )
CAROLINE FOSTER, and Estate )No.
of T. JACK FOSTER, Deceased, ) 83-7745
GLADYS H. FOSTER, Executrix, )Tax No.
and GLADYS H. FOSTER, ) 1717-78
)
Petitioneers-Appellants, )OPINION
vs.
COMMISSIONER OF INTERNAL
REVENUE,
Respondent-Appellee.
ee eee eee eee ee ee
Appeal from the Decision of the
United States Tax Court
Argued and submitted November 16, 1984
Before: DUNIWAY, KENNEDY, and ANDERSON,
Circuit Judges.
J. BLAINE ANDERSON, Circuit Judge:
In 1955, Jack Foster and his three
sons formed a partnership, T. Jack Foscer
A-II-2
and Sons (Partnership), for the general
purpose of dealing in property, with Jack
as the managing partner. In 1958, the
Partnership began to investigate the
reclamation potential of Brewer's Island,
a 2,600 acre undeveloped and; artially
submerged tract of land located about 12
miles south of San Francisco. After
commissioning engineering studies, the
Partnership determined that the tract
could be transformed into a self-
contained city (Foster City) of 35,000.
In December, 1959, the Partnership
acquired an option to purchase the
property for $12.8 million; in May, 1960,
it secured enabling legislation from the
California legislature for a municipal
improvement district known as Estero,
which was coterminus with Brewer's
Island; and, in August, 1960, it
exercised its option to purchase the
tract. Thereafter, the Partnership and
Estero began developing the property by
A-II-3
neighborhood.
The Commissioner of Internal Revenue
issued notices of deficiency to the
Fosters for the years 1963-67 concerning
their role in the development of Foster
City. The Fosters appeal the United
States Tax Court’s affirmance of the
Commissioner's determination. We affirm
in part and vacate in part.
I. Section 482
The Internal Revenue Code of 1954,
8482, 26 U.S.C. 8482 (1976), authorizes
the Commissioner to reallocate income or
deductions among commonly controlled
businesses "if he determines that such .
- « Allocation is necessary in order to
prevent evasion of taxes or clearly to
reflect the income of any of such...
businesses."
A. Standard of Review
In 8482 cases, this court has held
that "[{t]he Commissioner has broad
A-II-4
discretion under section 482, and neither
we nor the Tax Court will countermand his
decision unless the taxpayers shows it to
be unreasonable, arbitrary or
capricious.” Erickson v. Commissioner,
598 F.2d 525, 528 (9th Cir. 1979).
The Fosters argue that this standard
was Giluted in Commissioner v. First
Security Bank of Utah, 405 U.S. 394
(1972), in which the Court concluded that
"[t]he Commissioner's exercise of his 8
482 authority was therefore unwarranted
in this case." 405 U.S. at 407. We do
not believe the Court, by employing the
term “unwarranted," was signaling a
change in the standard of review. The
issue before the Court was not the
appropriate standard of review.
Moreover, the Court was affirming the
determination of the Tenth Circuit, which
had employed the arbitrary and capricious
Standard in reaching its decision. See
First Security Bank of Utah, N.A. v.
A-II-5
Commissioner, 436 F.2d 1192, 1198 (10th
Cir. 1971).
B. The “Avoidance” of Taxes
Section 482 refers to the "evasion of
Taxes," whereas the Tax Court based its
decision on the Fosters' “avoidance of
taxes." We have noted the "sometimes
elusive" distinction between the two
terms, Stewart v. Commissioner, 714 F.2d
977, 9876 (9th Cir. 1983), and agree with
the Tax Court's finding that “for
purposes of Section 482, a non-punitive
section, the terms are interchangeable."
Foster v. Commissioner, 80 T.C. 34, 158
(1983).
The regulations support the Tax
1 Additionally, this
Court's holding.
court, in discussing the application of 8
482, has stated that "Congress enacted
the predecessor of section 482 to prevent
the evasion of taxes through such means
as ‘shifting of profits, the making of
fictitious sales and other methods
A-II-6
frequendtly adopted for the purpose of
"milking."'" Stewart, 714 F.2d at 987
(citations omitted). Put another way,
the taxpayer must establish that he did
not “cash in" on the gain. Id. at 989.
In a civil case, a thorough analysis of
the facts in light of the above criteria
is more important than whether the Tax
Court labeled its i1ltimate conclusion tax
avoidance or evasion.
Our conclusion is not altered by
Commissioner v. First Security Bank of
Utah, 405 U.S. 394 (1972), in which the
Court reiterated the long-standing
shibboleth that a taxpayer is free to
arrange his affairs in the manner
calculated to minimize his tax liability.
405 U.S. at 398 n.4. In First Security,
the Court disapproved the Commissioner's
reallocation under 8 482. First
Security, however, did not, as in this
case, involve a nonrecognition
transaction. Also, the determinative
A-II-7
factor in disallowing the reallocation
was that it would have been illegal for
the entity to receive the income, id. at
401-402, which is not the situation here.
C. Application of 8 482 to the
Disposition of Property Acquired ina
Nonrecognition Transaction
The first of the nine neighborhoods
to be developed was Neighborhood One. In
Cctober, 1962, before any sales to
builders were consummated, the
Partnership transferred an undivided
one-quarter interest in 127 acres of
Neighborhood One to each of four newly
formed corporations as tenants in common.
Fach of the four corporations, referred
to collectively by the Tax Court as the
Alphabets, was solely owned by one of the
Fosters.
In August, 1966, the Partnership
transferred 311 lots in Neighborhood
Four, which had been improved to a lesser
extent than Neighborhood One, to Foster
A-II-8
Enterprises, a corporation owned by the
Fosters in equal shares. Foster
Enterprises, which was incorporated in
1960 to take title to a hotel in Hawaii,
had accumulated a net operating loss of
$1.2 millions.
The Neighborhood One transaction was
an exchange of property for stock under
8351. The Neighborhood Four transaction
was a contribution to capital under 8s
1032. Under both sections, neither the
tranferor nor the transferee recognize
gain or loss on the transfer, and the
basis of the property does not change.
The transferee therefore inherits the
potential gain or loss inherent in the
property at the time of its transfer.
The Tax Court was correct in its
determination that the Commissioner may
employ 8482 to reallocate income derived
from the disposition of property
previously acquired in a nonrecognition
transaction. Rooney v. United States,
A-II-9
305 F.2d 681, 686 (9th Cir. 1962)
(Section 482 will control when it
conflicts with 8 35l as long as the
discretion of the Commissioner in
reallocating is not abused.); Treas. Reg.
8 1.482-1(d)(5) (1984); see also Stewart
v. Commissioner, 714 F.2d 977, 989 (9th
Cir. 1983).
D. Section 482 Reallocation
The Tax Court, pursuant to 8 482,
reallocated all the income from the sale
of the lots in Neighborhood One and
Neighborhood Four from the Alphabets and
Foster Enterprises to the Partnership.
The income reallocated was divided into
two parts, income due to appreciation in
value before the transfers and income due
to appreciation after the transfers.
l. Pre-tr.‘sfer Appreciation
The Tax Cou:t reallocated the
income attributable to appreciation
before the transfers on the ground that
the purpose of the transfers was to avoid
~ . . - oper = noe rere
Se ee ee ee .
A-II-10
taxes. It found that A.O. Champlin, the
Fosters' long-time tax advisor, decided
it was advantageous from a tax standpoint
for the Fosters to undertake the
development of Foster City in a
partnership form. Losses incurred during
the early years could then be used by the
partners to reduce income on their
personal tax returns. Later, as the land
was developed, certain lots were
transferred from the Partnership to its
controlled entities in an effort to shift
income. As noted by the Tax Court, "only
highly appreciated inventory pregnant
with income was conveyed." Foster, 80
T.C. at 179. Moreover, according to the
testimony of Champlin, the value of money
on hand to the Fosters far exceeded any
interest that might eventually have to be
paid on a tax deficiency, particularly
when the rate of interest charged by the
Government was less than that charged by
commercial banks.
A-II-11
In the case of the Alphabets,
which were formed within a month of the
transfer, the Tax Court determined that
the object was to shift from the
Partnership the income from the sale of
the lots and split it among taxpayers
subject to a lower rate of tax. The
Fosters argue that the transfer could not
have been tax motivated because it would
have increased taxes; the income reported
by the Alphabets was not offset by any
losses, whereas if the income had been
reported by the Partnership, it would
have been offset by the operating losses
which the Partnership claimed on its
returns. The Tax Court, however, found
that "the tax savings to an individual
realized by preserving a partnership loss
may very well exceed the tax cost to his
corporation incurred by reporting the
income." Id., 80 T.C. at 173.
The Fosters contend that
although the Neighborhood Four transfer
A-II-12
may have resulted in a tax saving, it was
made for a business purpose. There was
evidence that Rex Johnson, a senior vice
president of Republic National Bank who
was in charge of monitoring the Foster's
account, insisted that the lots be
conveyed to Foster Enterprises as a
condition to Republic’s renewing the
Partnership's loans. The Tax Court
discounted this as the motivation behind
the transfer, and we find its reasoning
persuasive.
Foster Enterprises was not
indebted to Republic. It had borrowed
money from Likins-Foster Honolulu
Corporation and Roy Turner Associates,
Ltd., a subsidiary of Likins-Foster.
Both Likins-Foster and the Partnership
were indebted to Republic.
According to Johnson, the
transfer was necessary to improve the
liquidity of Foster Enterprises and
thereby (1) enhance the collectibility of
A-II-13
the indebtedness of Likins-Foster to
Republic, (2) improve the bank's security
in the Likins-Foster stock, and (3)
insulate the bank from the fortunes of
the Foster partnership. The Tax Court,
however, found that a special audit
report prepared by the bank stated that
the Likins-Foster loans were being paid
according to schedule. Moreover, if
Johnson were concerned about the ability
of Likins-Foster to repay its loan, it
would have made more sense to transfer
the lots directly to that corporation
because it was the Likins-Foster stock
that had been pledged as security. The
transfer of the lots obviously weakened
the Partnership's ability to repay its
loan to Republic, noted the Tax Court,
and certainly exacerbated its cash flow
problem.
The sales proceeds were not used
by Foster Enterprises to liquidate its
debts to Likins-Foster and Turner
A-II-14
Associates. Rather, they were loaned to
the Partnership to further develop Foster
City. Although Foster Enterprises still
had an asset, it was now, continued the
Tax Court, an unsecured receivable from
the Partnership. Collectibility was
therefore dependent upon the
Partnership's overall success with the
Foster City undertaking, precisely the
risk against which Johnson ostensibly
wanted to protect.
The Tax Court found that the
purpose of the Neighborhood Four
transaction was to shift to Foster
Enterprises the income earned from the
sale of the lots so that it could be
absorbed by that corporation's losses.
The record contains ample evidence to
Support the Tax Court's conclusions
concerning both the Neighborhood Four and
2
the Neighborhood One transactions. We
therefore find that the Commissioner did
not abuse his discretion in reallocating
A-II-15
to the Partnership that portion of the
sales income due to appreciation before
the date of transfer. See Rooney v.
United States, 305 F.2d 681, 684-85 (9th
Cir. 1962).
2. Post-transfer Appreciation
Because Neighborhoods One and
Four were both further developed after
the transfers, a part of the income
derived from the sale of lots was created
after the transfer date. The Tax Court
concluded that Estero was controlled by
the Partnership, and was used by it as
its instrument for the development of
Foster City. Thus Estero’s efforts were
te be viewed as those of the Partnership,
and the gain was to be attributed to it.
Estero, a Municipal Improvement
District, was created in 1960 by a
special act of the California
legislature. It was authorized to tax
and to issue tax-exempt bonds to finance
its activities in reclaiming and
A-II-16
improving Brewer's Island. It was also
vested with a broad array of general
governmental powers. As enumerated by
the Tax Court:
It was empowered to reclaim
land, make provision for street
lighting, sewage, storm
drainage, garbage and water
service, and parks and
playgrounds. It was also
empowered to construct small
craft harbors, provide fire and
police protection, condemn land,
enter into contracts, and make
and enforce such regulations as
were necessary and proper to the
exercise of its enumerated
powers. A violation of such
regulation constituted a
misdemeanor.
Foster, 80 T.C.. at 58.
We agree with the Tax Court that
during the years in issue, the Fosters,
as the principal landowners and
developers, controlled Estero. Indeed,
the California Supreme Court has
recognized that the Estero Act was
designed by the California legislature to
Place control of the district in the
landowner/developer. Cooper v. Leslie
.
eect neta optimal a aT a oan tetova borer Meniivten
wee
iad
sestin Se
A-II-17
Salt Co., 70 Cal.2d 627, 451 P.2d 406,
408-409, 75 Cal.Rptr. 766, cert. denied,
396 U.S. 821 (1969). The Tax Court
stated:
There is no question that
Estero added value to Brewer's
Island. However, it never
realized that value because it
did not own the land or
receive the proceeds from its
sale. All we are deciding here
is whether the value added by
Estero is allocable to the
Foster partnership because of
the legislatively conferred
control that the partnership
exercised over the district. To
answer that question in the
affirmative does not require
that we ignore Estero'’s legal
identity as a public agency.
Foster, 80 T.C. at 169. Estero was the
Partnership's creature, used by it to
improve the land and thus increase its
value. That is what it was designed to
be and do. Because it is a public body,
validly created, its own income, if any,
belongs to it, and would not be allocable
to some other entity.
Commissioner v. Birch Ranch &
Oil Co., 192 F.2d 924 (9th Cir. 1951),0n
A-II-18
which the Partnership relies, is quite
different from our case. There, the
taxpayer owned substantially all the land
in a California reclamation district,
and, along with certain related parties,
substantially all of the district's
bonds. In order to pay interest on the
bonds, the District made assessment calls
which the taxpatyer paid and later
deducted as taxes. The Commissioner
denied the deduction on the ground that
the payor and the payee were economically
identical. We upheld the deduction,
stating:
Since the district met the
requirements of California law,
its status as a district
entity, not to be confused with
the owners of the ranch, or the
taxpayer-corporation, cannot
be questioned regardless of the
fact that the district served
but a single ranch, (plus one
240 acre parcel). The western
states have long considered
that the reclamation, even of a
Single parcel of land in single
ownership, may justify the
exercise of sovereign powers.
192 F.2d at 928. The case dealt with the
—
A-II-19
validity, as a tax deduction by the owner
of the property in the district, of an
assessment levied by the district against
the landowners and actually paid by the
owners to the district. Nothing
comparable is involved in our case.
The Tax Court stated that its
finding that the Partnership controlled
Estero did not conflict with the
district's status as a "juristic entity,"
and therefore, Birch Ranch & Oil was
inapposite. 80 T.C. at 169. We agree.
The primary question here is not whether
Estero is an independent entity. The
primary question is whether the
Commissioner can allocate to the
Partnership the income arising from value
created by Estero that would have gore to
the Partnership but for the transfers to
the Alphabets and Foster Enterprises.
The Alphabets' and Foster Enterprises’
function was to divert what would
normally be the income of the Partnership
-
*
et
7
>|
a aly . 2
hem wy!
ia fe
A-II-20
away from it and to the Alphabets and
Foster Enterprises. If the transfers had
not been made, the income in question
would not have been Estero’s; it would
have been that of the Partnership. The
relationship between the Partnership and
its creatures, the Alphabets and Foster
Enterprises, was precisely the same,
whether the appreciation in value
occurred before the transfers or after
them. Under section 482, the
Commissioner may allocate income earned
subsequent to the income evading event
or transfer. The fact that some of it is
attributable to a time following the
transfers makes no difference. Because
Estero did not own the land, the gain in
value would never accrue to Estero, but
would have accrued to the Partnership,
the landowner, but for the transfers. By
the transfers, the Partnership shifted
that income away from itself and to the
Alphabets, which had nothing, and to
A-II-21
Foster Enterprises, which had large
losses from unrelated ventures. By that
device, the Partnership sought to get out
from under large tax liabilities and yet
retain control of Foster City. Under 8
482, the Commissioner could reallocate to
the Partnership the income that the
Partnership had shifted to the Alphabets
and Foster Enterprises. The transfers
had no business function; their purpose
was tax avoidance. The Tax Court properly
upheld the Commissioner's reallocation.
II. The Westway Notes
A. Form Over Substance Doctrine
As of August, 1962, the Partnership
had borrowed $3 million from Republic for
the development of Foster City. As an
inducement for the loan, the Fosters
agreed that, in addition to interest,
they would pay a bonus equal to the
amount borrowed. Republic desired that
the bonus be structured as capital gain
A-II-22
rather than ordinary income. The
advantage to the Partnership wouldw be a
stepped-up basis in the land.
Thus began a complex succession of
incorporations, transfers, liquidations,
and mergers. See Foster, 80 T.C. at
198-200. At the core of this arrangement
was the conveyance and reconveyance of
stock in Foster Bayou, a corporation
organized by the Fosters and capitalized
with 200 acres of land in Foster City.
In August, 1962, the Partnership sold its
stock in Foster Bayou to Westway
Investment Co. for $5,000 cash and a
$100,000 non-interest bearing note.
Westway was a subsidiary of Howard
Corporation, which in turn was owned by
trustees for the benefit of Republic's
shareholders. In May, 1964, Esteroy, a
corporation organized by the Fosters the
previous year and capitalized with
$10,000, bought the stock from Westway
for $5,000 cash p’us $3.1 million in
A-II=-23
non-interest bearing notes (Westway
Notes). Both Foster Bayou and Esteroy
were later liquidated so that the
Partnership eventually assumed the notes.
The Tax Court, relying on the
well-established doctrine of form over
substance, see Stewart, 714 F.2d at
987-88, found that the notes represented
an obligation by the Partnership to pay
interest on the money borrowed from
Republic, rather than the cost of
reacquiring the Foster Bayou stock.
Consequently, the Tax Court disallowed
the Fosters the $3 million stepup in the
basis of two of the Foster City
neighborhoods. On review, the Tax
Court's determination that the Westway
transaction was lacking in economic
substance will not be set aside unless
Clearly erroneous. Thompson v.
|' Commissioner, 631 F.2d 642, 646 (9th Cir.
1980), cert. deniec, 452 U.S. 961 (1981).
Contrary to the Fosters' assertion
A-II-24
that the notes were indicative of the
profit-sharing aspect of a partnership,
the Tax Court cites overwhelming evidence
that the relationship between the Fosters
and Republic was always one of debtor-
creditor. Foster, 80 T.C. at 202-203.
Additionally, Republic’s right to share
in the profits was strictly limited in
amount, The bank bore no risk of loss
except with respect to its loan, and it
was not entitled to participate in the
management of the project.
The Fosters contend that $3.1 million
($15,500/acre) was a realistic price, not
because of evidence that that was the
value of the land, but because of the
property's alleged investment potential.
Their argument that the transaction was
‘made at arm's length, however, is belied
by the fact that although the Fosters had
Originally paid approximately $4500 per
acre for the land, Foster Bayou, in
selling the stock to Westway for
A-II-25
$105,000, sold it for about $500 per
acre. The Tax Court noted that Westway
was not equipped to develop the land, nor
did it improve the land during its
ownership. Moreover, the record
contained evidence (correspondence
between Jack Foster and his attorney)
that that particular parcel was chosen
only because it could be expediently
transferred. Id. at 94-95.
In any event, the result of this
complex series of transactions was that
when Esteroy purchased the Foster Bayou
stock from Westway, it recovered the
$5,000 in cash that it originally paid to
purchase the stock; its $100,000
non-interest-bearing note, both of which
were due on the same date; Westway'’s gain
on the transaction was therefore $3
million, the amount of the bonus that the
Fosters had agreed to pay under their
agreement with Republic. Furthermore,
the $3 million was structured as capital
A-II-26
gain (gain derived from the sale of
corporate stock), which was also part of
the agreement. Finally, that the
Partnership anticipated the “sale" and -
"repurchase" of the stock by the Fosters
for the purpose of disguising the agreed
upon bonus as capital gain was evidenced
by correspondence between Jack Foster and
his attorney. Foster, T.C. at 94.
United States v. Mississippi Chemical
Corporation, 405 U.S. 298 (1972), is
distinguishable. In that case,
cooperative associations under the
Agricultural Marketing Act were required
to purchase stock in a member bank as a
condition for securing a loan. The Court
held that the stock was a capital asset
having long-term value. Its cost,
therefore, was not deductible as an
interest expense. Here, although the
Fosters were required to pay a sum in
addition to the stated interest rate,
they received nothing in return other
A-II-27
than the amount borrowed. An additional
reason noted by the Court in Mississippi
Chemical for disallowing the interest
deduction was that Congress had intended
to provide loans to farmers at low
interest rates; it therefore would have
been “odd" for Congress to have provided
a hidden interest charge in the
legislation. 405 U.S. at 310. No such
considerations of legislative intent
apply in this case.
We find that the Westway Notes
represented "the amount [the debtor]
contracted to pay for the use of borrowed
money." Old Colony Railroad Company v.
Commissioner, 284 U.S. 552, 560 (1932).
Thus, the Commissioner was not clearly
erroneous in characterizing them as
interest.
B. Capitalization of Interest
The Fosters contend that if the
Westway Notes represent an obligation to
pay additional interest, then under 26
A-II-28
U.S.C. 8S 266 (1976), such interest may be
capitalized at the election of the
Partnership and added to the basis of the
land. Section 266 provides:
No deduction shall be allowed
for amounts paid or accrued for
such taxes and carrying charges
as, under the regulations
prescribed by the Secretary,
are chargeable to capital
account with respect to
property, if the taxpayer
elects, in accordance with such
regulations, to treat such taxes
or charges as so chargeable.
The Tax Court, relying on the
language of 8266, legislative history,
and the regulations, found that an item
not otherwise deductible may not be
Capitalized under 8 266. Foster, 80 T.
Cc. 212-213. The Partnership used the
cash, rather than the accrual, method of
j accounting. Under the cash method,
interest may not be deducted until it is
paid. 26 U.S.C. 8S 461 (1976); Treas.
Regs. 88 1.461-l(a)(1), 1.446-1(c)(1)(1i)
(1984).
We agree with the Tax Court's
A-II-2$
analysis and therefore find that the
Partnership may. not capitalize interest
that it did not pay. The Fosters do not
dispute that the Partnership paid no
portion of the Westway Notes during the
year in issue. Thus, the option of
Capitalizing the Westway Notes was not
available.
Crane v. Commissioner, 331 U.S. l
(1947), does not change this result.
Under Crane, a taxpayer may include the
amount of a loan in computing the basis
in the property against which the loan is
taken. The loan, however, is a part of
the cost of the property, whereas
interest is the cost of the loan.
Congress has expressly provided for
interest in the form of a deduction. 26
U.S.C. 8 163(a) (1976).
C. Charitable Deductions
The Partnership conveyed three
parcels of land in Foster City for which
it claimed charitable deductions: a
A-II-30
school site, by gift deed, and two church
sites for $20,000 per acre. On its tax
returns, the Partnership valued the sites
at $40,000 per acre, deducting the
difference as a charitable contribution.
A business will not be allowed a
charitable deduction if the dominant
motive behind the transfer was the
expectation of economic benefit. Allan
v. United States, 541 F.2d 786, 788 (9th
Cir. 1976). Contrary to the Fosters’
assertion, this standard was employed by
the Tax Court. Foster, 80 T.C. at 223.
The Tax Court's determination that the
Fosters were not entitled to a charitable
deduction will not be overturned unless
it was clearly erroneous. Allan, 541
F.2d at 788.
The Tax Court found that, as
demonstrated by Estero's prospectus and
the Partnership's promotional
publications, Foster City was designed to
be a self-sufficient community with
A-II-31
provision for all services required by
the resident population, including
schools and churches. The Tax Court
determined that the transfer of the three
sites was therefore designed to enhance
the value of the Partnership’s remaining
land and to promote its sale. See Stubbs
v. United States, 428 F.2d 885, 886-87
(9th Cir. 1970), cert. denied, 400 U.S.
1009 (1971). Additionally, concluded the
Tax Court, the transfer of the school
site was made to secure the cooperation
of the school district and to persuade
the district to abandon its threat to
cancel school bus service to Foster City.
The Fosters object to the Tax Court's
attributing the representations in
Estero’'s prospectuses to the Partnership.
Given our holding that the activities of
Estero may not be attributed to the
Partnership, we agree with the Fosters’
contention. The Fosters, however, do not
A-II-32
the same benefits were touted in the
Partnership’s publications. Thus, even
without attributing the Estero
prospectuses to the Partnership, the Tax
Court’s finding, that there was
sufficient motivation of ‘econcnte benefit
to disallow the deductions, was not
clearly erroneous.
The Fosters argue that if the
transfers are disallowed, the cost of the
school site should be capitalized as part
of the Partnership’s basis in only the
residential acreage of the neighborhood
the future school would serve
(Neighborhood One), rather than the
Commissioner's capitalization of the cost
as part of the Partnership’s basis in all
of its remaining land in Foster City.
The Fosters state that the only benefit
to flow from the transfer was the
continued bus service, which was of
benefit only to Neighborhood One. We,
rT PS Me att at tee Dh poet itt ao tia Paw
A-II-33
Court was clearly erroneous in finding
that, “{t]he transfer was the first step
in implementing the partnership's
neighborhood school plan. Moreover, it
gave credibility to its ‘sales pitch’
that Foster City was a planned community.
Both of the factors enhanced the value
and promoted the sale of land in all the
neighborhoods and not just in
Neighborhood One." Foster, 80 T.C. at
226.
D. Business Deductions
The Tax Court affirmed the
Commissioner's determination that a
portion of the Fosters’ travel and
entertainment expenses were personal to
the Fosters and therefore not deductible
as business expenses. The deficiency
notice did not itemize the particular
deductions disallowed, but instead gave
the total disallowance for each taxpayer.
We note initially that the deficiency
notice was not defective. Abatti v.
A-II-34
Commissioner, 644 F.2d 1385, 1389-90 (9th
Cir. 1981).
The Commissioner;s deficiency
determination carries a presumption of
correctness. Rockwell v. Commissioner,
512 F.2d 882, 885 (9th Cir. 1975), cert.
denied, 423 U.S. 1015 (1975). The
Fosters’ reliance on Weimerskirch v.
Commissioner, 598 F.2d 358 (9th Cir.
1979), and United States v. Janis, as
indicating "that the Commissioner must
_ offer some foundational support for the
deficiency d-cermination before the
presumption of correctness attaches to
it.” 596 F.2d at 361. In both
Weimerskirch and Janis, however, the
Commissioner had determined that the
taxpayer had unreported income. As a
rationale for its decision, the
Weimerskirch court observed that absent a
showing by the Commissioner, the
taxpayer, in a case of unreported income,
would have the difficult task of proving
Rakin eh, Beciged
A-II-35
a negative. Id. Such is not the case
with a deduction.
"The presumption in favor of the
Commissioner is a procedural device which
requires the taxpayer to come forward
with enough evidence to support a finding
contrary to the Commissioner's
determination." Rockwell, 512 F.2d at
885. The evidence offered by the Fosters
to rebut the presumption was testimony
that their record-keeping system was
accurate and that the examining revenue
agent so scrambled their records that
they could not be reassembled to prove
the legitimacy of the claimed deductions.
The Fosters do not dispute the
Commissioner's assertion that they agreed
with several of the Commissioner's
adjustments, thus undermining their
argument that their record-keeping system
was fail-safe. In any event, we agree
with the Tax Court that the Fosters’
self-certification of their record-
A-II-36
keeping system is not a substitute for
proof of their deductions. Deductions
are a matter of legislative grace with
the taxpayer bearing the burden of their
substantiation. Rockwell, 512 F.2d at
886. We cannot say that the Tax Court's
decision that the Fosters did not carry
this burden was clearly erroneous. See
Zmuda v. Commissioner, 731 F.2d 1417,
1421 (9th Cir. 1984).
E. Penalty
The Tax Court affirmed the
Commissioner's assessment of a penalty
against Jack and Gladys Foster for
negligent or intentional disregard of
income tax rules and regulations. 26
U.S.C. 3 6653(a) (1976). We vacate the
assessment. This is a case of first
impression with no clear authority to
guide the decision makers as to the major
and complex issues. The positions taken
by the Fosters were reasonably debatable.
Under all of the circumstances, we do not
A-II-37
believe it can be fairly said that the
Fosters acted negligently or
intentionally in disregard of the law.
AFFIRMED in part, VACATED in part.
FOOT RH OT 6S
l. "Transactions between one
controlled taxpayer and another will
be subject to special scrutiny to
ascertain whether the common control
is being used to reduce, avoid, or
escape taxes .... In determining
the true taxable income of a
controlled taxpayer, the district
director is not restricted ... to
the case of a device designed to
reduce or avoid tax by shifting or
distorting income ...." Treas.
Reg. $8 1.482-l(c) (1984) (emphasis
added). "Section 482 may, when
necessary to prevent the avoidance of
taxes or to clearly reflect income,
be applied. ..." id. at 8
1.482-1(d)(5) (1984) (emphasis
added).
2. The Fosters move to augment the
record with an additional depositon
of A.O. Champlin. The deposition is
not properly before this court; the
motion is therefore denied. Karmun
v. Commissioner, 749 F.2d 567, 570
(9th Cir. 1984).
mie
A-II-38
FILED
MAY 30 1985
PHILLIP B. WINBERRY
Clerk, U.S. COURT
OF APPEALS
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
RICHARD H. FOSTER and SARA
B. FOSTER, T. JACK FOSTER, Jr.
and PATRICIA FOSTER, JACK R.
FOSTER and CAROLINE FOSTER,
and ESTATE OF T. JACK FOSTER, No. 83-
Deceased, GLADYS H. FOSTER, 7745
Executrix, and GLADYS H.
FOSTER, TAX NO.
1717-78
Petitioners-Appellants,
ORDER
Ve
COMMISSIONER OF INTERNAL
REVENUE,
Respondent-Appellee.
me ee et ee ee ee ee ee ee See?
Before: DUNIWAY, KENNEDY, and ANDERSON,
Circuit Judges.
The panel as constituted in the
above case has voted to deny the petition
for rehearing and to reject the
suggestion for a rehearing en banc.
i
A-II-39
The full court has been advised
of the suggestion for en banc rehearing,
and no judge of the court has requested a
vote on the suggestion for rehearing en
banc. Fed. R. App. P. 35(b).
The petition for rehearing is
denied and the suggestion for a rehearing
en bank is rejected.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.