# Petition for Writ of Certiorari — Foster v. Commissioner > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385018_0793%3A1 ## Record - **Collection:** Supreme Court brief - **Document type:** Petition for Writ of Certiorari - **Published:** January 1, 1986 - **Citation:** 474 U.S. 1055 ## Text 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 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 Sie: sje mens fein LADS. a t. 2; bee. Sa MER, pee. ey i 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 * R ‘wolnd Ar Sees , met HE bo f3% Kan? tenes ie ee AnOdD pr & Beith Sacrsesogace: e = ; a we cee Se | ¢ te .. ; Ehecae 7HQ. SAS NFL SS eos seu ot - : sinc) ot ba pese seas nd bowed eos: ben betas tae . : a | e - gslge -aeyoR oS eas oaabulond 2 ditnots283 eas 5I04 Soe tobivibdes ts whitest #a322-OnF abna nfOstBROGICO ICT. p24: SSGG Lae koma? - : sead +4 ak BPGL- Etec: 3 etre sus #igns. att: bevencifs ee iat Bird Seal esl alll a Bok se an sada tt oll ARLE. ROE! A CASIO DR ee nied NAC AR 008 TE We TR ta AE th, td 6 OR ae A i ita ata J erent ’ 12 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 oe oe " 7+ d %) “ ‘ | m4 ¥ ’ * b ¥ to 4 - : 4 i 4 : - é ct ar “ 7% an 4 a > ph 2 -—~ . 4 > . . a 5 rs. ‘= bed J bee j ‘ a . er - v - a . « > ¥ oe soneTeS Santee 2 cepaeehs feng sere SAT eee W/o FBT ew - ste - 13 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. ry 1 oF q » r 2 ‘ab -« ¢ as ‘eo * x r va « A) ’ le Fae : é 5 ~ p =e —- ae | “ rs co af % 4 ; - - Es yt ‘ ni 5 ‘ da ~ r iy $ y ‘ : ig f r . 3 | - p 2 ¥ bs ; : : s ; 7 cS : ; , ‘ 4 acs SS Rie ‘ . i a@ = 5 " 2 a f e bi» > -_--- Se Paros 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 . ~ oh cd a 7, f 2. s : « ‘ a : _ a@'noantol xee “4 a 4 i: 3@e * Si o& ed g ¥ ie » ‘ . ‘ . 4 el Ly ee ne eee : . > siggy ee ane oa ae Sear eer mae a> oe a ana ne eet em ae ee ae, ae be See a = ee ne ee . oo Ri 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, at ieee, Ss eo oe as Coat t Face Bs ee : ‘Aodase iid: so Pere ass: agate. monde per. sen iaek sike Fagness bre: cee a Lat gee OOS PONS ace. Raed NS. priabesia. see. epbebe bel siastS Bra’ agienee eee, tod: : Mey &aeeliood- opses sew ssteogeb | et iia we whe Santee hat perute” akiganm: ; ; \eaess Ce ats te ee os et. a sol tenimeke sent. Of a2 BEER? earetis auto. bee ITH bay AOS® Lacayeh: ai be - SO . ofl es u kee ree eae ww wheds 4 pepied 2 stsase ose soe MG RBRR ies edo 36 - an ae Fs ene: bateiac:. bake: nadeeges: Much) «gl gud _esrebive oot nckateoged. ot oi3- kere oR aa ela : o> 4) Bee oreo 22442 oi 8 ey eogiue ae ee at nobstisogeb Siioces. & noldee? Sree FOer gh st ionaisoge griboe iit, tore les ritlQgesa = 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 ‘ & 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. > ~~ = J: Pe 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 ; + »* Ded sce =. L iw » . , Ste} ofmhe. BOY Sa vemedon. Be. st v7 84 sebBe ~~ ToReRot ome : a | y , a 4 ce vA eve t r+ a ae ee eee ae - ¥ ae . > « ie nie j & y 7 + m= a ae ete 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 $i:iave” Oe t 2 ‘(Gn 2 1f55 5m + I 2 - & 4 Pils J saors WSS Bis Tate seVemreEs at. te es At Sfont «sy then » C7Sat etede beddethe- dsr a vain o-ebloiche bkeekiet “en acon es nos seaininim®. 462 eas Ses vane IS POled eas eLanioiy eiayt Wad oi “(92 02 -O938196) @10ace 13g Saat Pid: BRA -hyU gOS Bet 838. Pest a ee le eR NY 41 386 (1935), and the separation of powers doctrine recently applied by this Court in I. N. & S. v. Chadha, U.S. , 77 L.Ed.2d 317 (1983). Unlike the Court of Appeals, the Tax Court did consider and reply to this con- tention to its satisfaction, by stating in reliance on a law review article and a dissenting opinion by a member of this Court that the first two of those cases had been overruled by the passage of time. We suggest that awareness by this Court of the existence of this problem is suggested by the fact that in its opinion in Commissioner v. First Security Bank of Utah, supra, 405 U.S. 394 (1972), this Court referred to the statutory word "evasion", and never once referred to it as “avoidance." The question is important and under- lies every use of Section 482 to negate a 4 i ee e i Py Wes os f * i %, ee es . a ‘A: : oa 7 Bt . . be ef * ae a CERRES OIE BEL bce weT afta -,sieeqGge 2h 344. BA) aFisne ori t 38 8. WA eg O2 SOR LS tS D C74 05 So - DAA Sidi tsa 5ives.- PS. 6 “ia une lies os (gdqer 2 YO nei Age pnisraasd site 24S eS SE Oe vceeityoe = 3 Tr 4) tanks 5 {BWA BON + ¥ aa > ie ay ee ae : , aie ae 3 * aU LP a F Gyo by . ‘ As "ee us { i + ets be eee seamen. ine Mbgheat aes Be ae, ae Sees 4 ie = Fy > a ei? BAA SVSSs 279. we eer Ee aan : ‘- ‘ , : ¢ = eo). -o cit et 9 & Fa; oe Sa #0 3 pact 135 ii as Fy ra “ cal ete y ee 34 ¥ he - m ¢ ; -Frptes past woeiso$ 3. eh “ x M 2 ; mt st w-3 ¥ 3% eee 12 aS ‘ Fe? a ers - d ‘ a io ; ~ a ee Se Seen oe P| vig mid add of seetsie see 205 YC Reva my NG as aes ot, ej entton.2k ko tbut ste2 2% “poidepil | ast 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 ayia Sits Yo Sao Oe, Seat ~taekiovee py eit? Bia at. . yIeee oS cr he ts ey Bee . iz Bi tem | by Legge ¢ oe . ks : tw. af ¥s * orbs Bovis sat. mot a wens ; IOs fz ee’ SO) 23 BO * ae rcem 2 _ ‘ o be & ~ } err , ame Oe a) } L20i Dut 12 ed # baa BOGS A ¢ ‘ . * bal . “a ~ : ea aa Se o> Gs : 7 Wik w . st z Ss , _- rah F ro ~™+ta = if 35 oe. Li. f , it : oy ; 2 de rvs ~~ “ § i x 4 & ; yv 2 . : ‘ ; % x ge ra ~s a % Fi = - C4 * 7 i } ay : , ; * 55 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. Fe a aie atay AEE no kaacnnnersg - $6 (feden 2 309. Oheeiet See Sipate nent , * a4 oa Stenop od Sivow sae soi pagel ict sot 7 4 ft le oe on 4 be lxe wears i) 2g ": bi =e | Sd «MOSS ‘er i> Ante” Tey +09 -etntie Seg tis in.- me | 23 _ 1 ty , say hes gnoos grits PAINE ~ab vie ome. Bor ihe SOG ROL Sag. Re we HOF -— ee ony esses leltad. en #20} oe ROS ihe on rf } - fs! — , ; {do wbeetaen3 ¢ 26 85560 si &: anag 88. es SC oet Bil SAOReS 63 pith? Bey ni nergraoges eff" (sparen ac as bo iaal b . 5 &taz S307 Yi seg. 2 i ‘ (AAO . 3 See rid) cit? tae C ieEteg Ge : prych GAS: sactad +). atpsorg OF a=. eed baceer B05 shee “8 KS2G ; M * > S ; § § \ = 3 e * is a ES ae bs ? \ =- i i : : 56 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 tg SIRE BAT ee ~ ~~ d . ss sarre Z &- ; * C A? -% 2 *¢ ~4 ae ; +> ‘ : a ee as Z boa x 4 | aliases oe tat ; S25 ‘ Ete . ra ’ + A734 . - - . S . 7 ~- Hp fi os i. : 4 NRCBOD Se PESOS SERA: Se aGe : a . * Se _ SP) amagetinet aware ore > i925 ae a eng ate te A 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 ee, pat a a “ey #23 -OF nok sev0R - i] sae é : ye - ied on : ia pale ae el Lisubtw? bak aresao8 ate ine - Feitnshbantig f4engeeriv 9308 ger oe ~~ » cs nt aoneblvects: Maw eae: aaa + heritit etetett ers Jen. Diocese ers o 4 = 4 P e tet LS ' ‘ a . a he 7 . : ‘ 3 P. > 4eq~reer se i¢ Si@e een = Be “5 rg SEE ER a ere: get oe es Sot : , mh : x t i F é - ec =f 4 + os A. ” . : . ++ ery ‘ ‘ a 3 . “ > 4 i> i > * ad ~ bee ‘ ’ m : ‘. at. & mm + “2 » = * y ~ = a ra et ~o ey eee i 42 wt a a ae 4 ‘ rs > te awit im £4 p. * - 4 rk ; \ 13 oO : é . & eas) 9 1 * imo BS 2 4 a % . a \- = : i 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 | . -_ 1 enyes & ‘ .4\45 , . ¢ i ow A * 3 , ‘ 4 - om Ps ats . prereset se bad iad - : y i cea 4 ee nels Py eh - ; a a - ~~ oo a Si 4 * ? . ce 7 P ' —. - . : x 4 hl es ? PFne es 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 | 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. --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385018_0793%3A1. Public record. Not legal advice.