Appendix — Foster v. Commissioner
Supreme Court brief1986
Ask Donna
What actually matters in this document.
Text
——
(y) Supreme Court, U.S.
Y FiLED
AUG 27 1985
JOSEPH F. SPANIOL, JR.
82-21
—
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.
Appendix III
(Separately bound)
Opinion of United States
Tax Court reproduced from
official report (80 T.C. 34 et seq.)
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 FosTEeR, DECEASED, GLADYS
H. Foster, EXEcuTRIX AND GLapys H. Foster, PETITIONERS
v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Docket No. 1717-78. Filed January 11, 1983.
CONTENTS
Page
a i a RRA 5 SEIT INL RITE IEE oe 37
Introduction and Statement of Issues ......................6. 43
Under the Subchapter S Revision Act of 1982 (1982 Act), Pub. L. 97-354, 96 Stat. 1669,
signed by the President on Oct. 19, 1982, and generally effective for tax years beginning
after Dec. 31, 1982, the tax treatment of subch. S corporations underwent a major overhaul.
Under prior law, a subch. S corporation was not treated as a conduit. Generally, the only
item that retained its character in the hands of the shareholders was the excess of net long-
term capital gain over net short-term capital loss. Under the 1982 Act, an S corporation
(officially designated as such by the 1982 Act), is treated as a conduit much like a
partnership. Items of income, deduction, or credit, and their character are now passed
through to the shareholders. See sec. 2 of the 1982 Act, new sec. 1366 of the Internal
Revenue Code of 1954. Thus, under the 1982 Act, operating income of the S corporation
would retain its character in the hands of the shareholders and, presumably, would not
qualify as investment income for sec. 163d) purposes. Congressional action, owever, taken
in 1982 does not change the result of this case.
Since a special provision was no longer needed to attribute the character of investment
iteme of a subch. S corporation to its shareholders, sec. 163(dX4XC) was repealed by the 1982
Act. See sec. aX 18), 96 Stat. 1693.
“Our holding applies to both actual distributions and undistributed amounts which are
treated as dividends. No part of the included amounts at issue constitutes salary or
compensation to petitioners.
«eee woeuaeellll
(34)
FOSTER v. COMMISSIONER 35
Pe ah oe hai s hA vai cba tone Wetsieesscc devcivecens 47
a
VIII.
. Facts Related to the Sale of Lots
. Facts Related to the Grant of the Sway
. Facts Related to the Transfers of the
Facts Related to the Business Background
I I 5 kN sian ccnnc Maceihbs cegnmnesobsticcaces. 48
Formation and Organization of the Foster
PT Sp Fak b Vibs Gis aa tears cobs cceselWabescivecsvccess 49
. Facts Related to the Creation of Foster City .... 51
III.
Facts Related to the Sale of Lots
in Neighborhood One (Issue 1) ...................005 55
A. Estero Municipal Improvement District ........ 56
1. The Enabling Legislation ....................... 56
2. Estero’s Board, Officers, and
EE EET cosets. obeutisacdasst cecccdcccscees 62
ie TEN Sache odds ndiedacsnseires cocdseees 64
B. Development of Neighborhood One .............. 67
Be ee ede iL cs Ledsckcistccsveccceccvcsses 68
2. Eee Pemeer PALtNerenip «...............00..c0000 74
3. The Alphabet Corporations .................... 78
C. Sale of Lots in Neighborhood One ............... 79
DD, Fe IIE, ovis csecesccccccccscccccsccnes 80
E. Ultimate Findings of Fact ......................000. 82
. Facts Related to the Sale of Lots
in Neighborhoods Two and Three (Issue 2) ..... 83
A. Genesis of the Westway Transaction ............
B. Mechanics of the Westway Transaction
ee a cciciccukbicevesccsecsscess
D. Post-Maturity Developments ....................66.
E. Ultimate Findings of Fact .......................06.
in Neighborhood Four (Issue 3) ..................++.
A. Development of Neighborhood Four .............
B. Involvement of Foster Enterprises ...............
C. Role Played by Del Champlin .....................
D. Ultimate Findings of Fact .....................0008:
Nees Sis vensvacecccsccecvccveses
UOPeeD PREIS OF PACE oo cisiis so cece. ens cccccccscees
School and Church Sites (Issue 5) ..................
A. Motivation for the Transfers ......................
pe |. Se
Facts Related to the $5,000 Payment for
Eemek Bervices (eM GS) .......ccercccecccccvccsevccsees
DIRE NE OE. OG. osc cnc svcic cnasencncasesseccnes
ELE
36 80 UNITED STATES TAX COURT REPORTS (34)
Page
IX. Facts Related to the Payment of the Fosters’
Personal Expenses (Issue 7) ..............:..eeceeeeees 112
A. Nature of the Underlying Adjustments ........ 113
B. Ultimate Findings of Fact ......................0005 116
X. Facts Related to the Payments Made
to Gladys Foster (Issue 8) ..............:.cceeeeeeeeees 116
LIGUMUOED MIEN GE UES cctcccvccconsccesscdscccecuaes 117
CERAM oo siceinnsssuhcveliedsdancGdlee ceeds calticehepdichank<cietiannae 117
reliminary Issues Related to Certain
Evidentiary and Procedural Matters ...................... 117
A. Deposition of Jack Foster ....................eceeeee 118
1. Petitioners’ General Hearsay Objection ....119
2. Petitioners’ Relevancy Objection ............. 120
B. Deposition of Del Champlin ........................ 120
1. Petitioners’ General Hearsay Objection ....125
2. Petitioners’ Remaining Objections ........... 127
3. Petitioners’ Complaint of Bias, etc .......... 128
_C. Deposition of Jack Foster, Jr ..................... 128
D. Deposition of Rex D. Johnson ..................... 130
1. Respondent’s General Objections ............. 132
2. Respondent’s Specific Objections ............. 133
E. The “Business Purpose” Objection ............... 135
1. Objection to Question Calling
ee als ead ce caedhdxsesesonncess 136
DE SEES peck anaescnsnaeskavenacesssceqvess 136
FP EE i III paths ns choc ra danpaciencenmsavanvensateesss 137
Issues 1 and 3: Reallocations of Income Under
arte GIs siscannccholh tncdth MEA leach ssesesee 139
A. Constitutionality of Section 482 ................... 140
B. Standard for Review and Burden of Proof ....142
C. Application of Section 482 to Taxable
Dispositions of Property Previously Acquired
in Nonrecognition Transactions ................ 144
1. Section 1.482-1(bX1), Income Tax Regs.,
and the Arm’s-Length Bargaining
SANA «oi cies. ccncsokeboaravennsceecessesse ses 148
pe a a a ee) ee 151
3. Section 1.482-1(dX5), Income Tax Regs.,
and the Avoidance of Taxes ................. 157
D. Neighborhood One Reallocation ................... 160
E. Neighborhood Four Reallocation .................. 178
F. Status of the Foster Partnership ................. 184
G. Petitioners’ Affirmative Use of Section 482 ..191
Issue 2: Applicability of the Substance-Over-Form
Doctrine to the Westway Transaction .................... 195
A. Adequacy of the Notice of Deficiency .......... 195
B. The Westway Notes as Interest .................. 197
C. The Westway Notes as Carrying Charges ..... 211
(34) FOSTER v. COMMISSIONER 37
Page
, Issue 4: Applicability of the Cost Recovery
Method to the Grant of the Sway Easement .......... 216
Issue 5: Deductibilicy of the School and Church
SION delist tae UM Aree ti Me Bivite iab and bpphihcnens éuoxsvanesion'ewes 219
Pi CI A ND Bai lh is den ccvicnc cnc sscncvocesneses 220
i ian, sky ciupas ophanasticerb ies 222
C. Amortization/Capitalization
eg ee iyi iiven bi desnicanstvedepac 225
Issue 6: Deductibility of the Payment for Legal
Se aia, te Ps ire was cand cease ceneee dé ann deseies 227
Issue 7: Adjustments Related to the Payment
of the Fosters’ Personal Expenses .....................000: 227
ii TE io saci on cs ak chpaenceneeeineesatokes 228
ares cs vvsnnn ts tenia anh uocaaeeibenss 228
et ET 5 05, bs an pecpentahsaceicanctsondhnses 229
Be. I ie sai cANURG cl ial b bak on abo bwnddesaa¥an’ 231
B. Sufficiency of Petitioners’ Evidence ............. 234
Se EF IEEE S2e0 cis cdetui bees cctstdeusccecdanes 235
Issue 8: Characterization of the Payments Made
eh I ire ened ececccchdopeddensabeccesckseweaces 236
Beatie: Fe ee TN. ca as sos ckine shes tanec envi. 237
SUBSTANTIVE ISSUES
Issues 1 and 3: REALLOCATIONS OF INCOME UNDER SEC.
482, I.R.C. 1954. T, J, D, and B (a father and three sons) were
equal partners in FP, a general partnership. In 1958, FP began
to investigate the development potential of Brewer’s Island, a
2,600-acre undeveloped tract of land located about 12 miles
south of San Francisco. FP determined that the tract could be
transformed into a city of 35,000. In December 1959, it acquired
an option for the purchase of the land; in May 1960, it secured
enabling legislation from the California legislature for a munici-
pal improvement district known as Estero; and in August 1960,
it exercised its option and acquired the tract. Immediately
thereafter, it began to transform Brewer’s Island into Foster
City.
FP played an active role in the development of Foster City. It
also acted through Estero, which it controlled and dominated.
Estero was used by FP in the development process both as a
financing vehicle and as a vehicle by which improvements to the
land were actually effected.
Foster City was developed by neighborhood. The first neigh-
borhood to be developed was Neighborhood One. In October
38 80 UNITED STATES TAX COURT REPORTS (34)
1962, FP deeded undivided 25-percent interests in 127 acres of
land in Neighborhood One to each of four Alphabet Corpora-
tions as tenants in common. Each of these corporations was
solely owned by T, J, D, or B, and the transfer of the 127 acres
was tax motivated. Income derived from the sale of lots in this
acreage was reported by the alphabet corporations; however,
that income was earned by FP.
In August 1966, FP conveyed all of the single-family residen-
tial lots in Neighborhood Four to FE, a corporation which was
solely owned by T, J, D, and B in equal shares. FE had a history
of substantial net operating losses related to the operation of a
hotel in Hawaii and the lots were conveyed in order to take
advantage of those losses. Income derived from the sale of lots in
1967 was reported by FE; however, that income was earned by
FP.
Held:
a. Sec. 482, I.R.C. 1954, is not unconstitutional as an invalid
delegation of legislative power. (Pp. 140-142.)
b. The Commissioner’s determinations under sec. 482, I.R.C.
1954, must be sustained unless proven unreasonable, arbitrary,
or capricious. (Pp. 142-144.)
c. In order to prevent the avoidance of taxes, sec. 482, I.R.C.
1954, and sec. 1.482-1(dX5), Income Tax Regs., may be applied to
a taxable disposition of property previously acquired in a
nonrecognition transaction. (Pp. 144-159.)
d. Respondent did not abuse his discretion under sec. 482,
LR.C. 1954, in reallocating income derived from the sale of lots
in Neighborhood One from the four Alphabet Corporations to
FP. (Pp. 160-177.)
e. Respondent did not abuse his discretion under sec. 482,
LR.C, 1954, in reallocating income derived from the sale of lots
in Neighborhood Four from FE to FP. (Pp. 178-184.)
f. For tax purposes, FP was a partnership and not an
association taxable as a corporation. Sec. 7701(aX2) and (3),
I.R.C. 1954; sec. 301.7701-1 through -3, Proced. & Admin. Regs.
(Pp. 184-191.)
g. Petitioners are not entitled to affirmatively use sec. 482,
I.R.C. 1954, to effect a consolidated return of FP with all of the
related corporations purportedly involved in the development of
Foster City. Sec. 1.482-1(bX3), Income Tax Regs. Respondent’s
failure to do so does not demonstrate any abuse of discretion on
his part. (Pp. 191-195.)
Issue 2: APPLICABILITY OF THE SUBSTANCE-OVER-
FORM DOCTRINE TO THE WESTWAY TRANSACTION. The
terms negotiated by FP for the purchase of Brewer’s Island
contemplated a downpayment of $2,500,000. However, FP was
unable to fund all of that amount itself. Accordingly, it arranged
with a bank with which it had an established relationship to
(34) FOSTER v. COMMISSIONER 39
borrow (1) $2 million to make the downpayment and (2) such
additional amounts as were needed to satisfy the periodic
installments due to the sellers of the property for the balance of
the purchase price. Under the terms of the agreement, FP
agreed (1) to pay interest at the prevailing market rate, (2) to
pay a bonus equal to the total amount borrowed from the bank,
and (3) to structure the bonus so that it would be taxed to the
bank as capital gain rather than ordinary income. A complicat-
ed transaction, consisting of a series of incorporations, transfers,
liquidations, and mergers, was then devised to disguise the
terms of the agreement involving the 100-percent bonus. The
crucial step in the transaction involved the delivery of certain
promissory notes (the Westway notes) purportedly in exchange
for corporate stock. The objective of the transaction from FP’s
point of view was to raise funds through tax savings in order to
pay the bank its bonus; the objective from the bank’s point of
view was to insure that © “onus was taxed as capital gain. In
form, the transaction serve?)to increase FP’s basis in Neighbor-
hoods Two and Three by an amount equal to approximately
twice that which FP had become obligated to pay to the bank as
a bonus.
Held:
a. Respondent’s categorization of the Westway notes as inter-
est is an issue which is properly before the Court and one with
respect to which petitioners bear the burden of proof. (Pp.
195-197.)
b. In substance, the Westway notes represent an obligation to
pay additional interest on money borrowed for the purchase of
Brewer’s Island. (Pp. 197-211.)
c. FP is not entitled to capitalize the Westway notes under
sec, 266, I.R.C. 1954. (Pp. 211-216.)
Issue 4: APPLICABILITY OF THE COST RECOVERY
METHOD TO THE GRANT OF THE SWAY EASEMENT. In
1964, a utility company paid $425,000 to FP for a right-of-way
immediately adjacent to an existing easement which stretched
across Brewer's Island. FP characterized the payment as sever-
ance damages and reduced its basis in all of its land in Foster
City by the amount received. Respondent acquicsced in that
treatment. In 1967, the utility paid an additional $72,000 for a
sway easement in order to perfect the right-of-way easement
which it had acquired in 1964. Held, the amount received for the
grant of the sway easement should be applied against the basis
of all of FP’s land in Foster City rather than against only its
basis in that part of its land described by the easement. Jnaja
Land Co. v. Commissioner, 9 T.C. 727 (1947), applied. (Pp.
216-219.)
Issue 5: DEDUCTIBILITY OF THE SCHCOL AND CHURCH
SITES. FP conveyed three parcels of land in Foster City with
respect to which it claimed deductions for charitable contribu-
40 80 UNITED STATES TAX COURT REPORTS (34)
tions. One parcel was conveyed to a school district for use as a
school site and was in form an outright transfer; the other two
parcels were conveyed to churches for use as church sites and
were in form “bargain purchases.” The notice of deficiency
raised the issue of donative intent with respect to the deductibil-
ity of the school site but not the two church sites.
Held:
a. Given the absence of surprise or substantial disadvantage
to petitioners, respondent is entitled to rely on a ground for the
disa!lowance of a deduction which was not expressly set forth in
the notice of deficiency. (Pp. 220-222.)
b. FP’s dominant purpose in conveying the three sites was the
expectation of direct economic benefit; accordingly, the trans-
fers are not deductible as charitable contributions under sec.
170, I.R.C. 1954. (Pp. 222-225.)
c. FP must capitalize the cost of the school site as part of its
basis in all of its remaining land in Foster City. (Pp. 225-227.)
Issue 6: DEDUCTIBILITY OF THE PAYMENT FOR LEGAL
SERVICES. FP paid $5,000 to an attorney for legal services.
Held, the payment was a legitimate business expense and is
deductible under sec. 162(a), I.R.C. 1954. (P. 227.)
Issue 7: ADJUSTMENTS RELATED TO THE PAYMENT OF
THE FOSTERS’ PERSONAL EXPENSES. Respondent disal-
lowed certain deductions claimed by FP on the ground that the
expenses were personal to T, J, D, and B. He also disallowed
certain deductions claimed by three related corporations on the
same ground and charged the individuals with constructive
dividends.
Held:
a. Petitioners bear the burden of proof. Neither respondent’s
alleged delay in issuing the notice of deficiency, nor his failure
to identify therein the specific partnership and corporate
expenditures which were disallowed, nor the alleged misconduct
of his revenue agent in “scrambling” petitioners’ records serves
to shift the burden of proof. United States v. Janis, 428 U.S. 433
(1976), and Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir.
1979), revg. 67 T.C. 672 (1977), distinguished. (Pp. 228-234.)
b. Petitioners introduced no specific evidence to establish that
the expenses in question were business related rather than
personal. Hence, they failed to carry their burden of proof.
Evidence descriptive of the mechanics of their recordkeeping
system is insufficient to discharge that burden. (Pp. 234-235.)
c. Even if expenses are disallowed at the corporate level
because of the failure to comply with the recordkeeping require-
ments of sec. 274, I.R.C. 1954, that fact would not necessarily
preclude the taxation of the expenses as constructive dividends
at the shareholder level. (Pp. 235-236.)
eT
(34) FOSTER v. COMMISSIONER 41
Issue 8: CHARACTERIZATION OF THE PAYMENTS MADE
TO GLADYS FOSTER. On her income tax returns, G reported
compensation received from certain related corporations. Re-
spondent determined that the total amount reported was
understated and recharacterized the revised amount as dividend
income. Held, G received ordinary income in the amount
determined by respondent. (Pp. 236-237.)
Issue 9: ADDITIONS TO TAX. Respondent determined that T
and G were liable for additions to tax under sec. 6653(a), I.R.C.
1954, for each of the years before the Court. Held, the burden of
proof rests with petitioners, and they have failed tocarry it. >.
237-238.)
EVIDENTIARY AND PROCEDURAL ISSUES
Issue A: DEPOSITION OF T. JACK FOSTER. In 1961, a
utility company commenced an action in State court to condemn
an additional easement for a right-of-way across Brewer's
Island. T, a party herein, was named as one of the defendants in
that action. In March 1962, T was called to testify as a witness
by the utility at a deposition conducted by its attorney. Held, T’s
deposition is admissible in this proceeding, over petitioners’
general hearsay objection, as an admission of a party-opponent
under Rule 801(dX2XA), Federal Rules of Evidence. Held,
further, petitioners’ relevancy objection addressed and resolved.
(Pp. 118-120.)
Issue B: DEPOSITION OF DEL CHAMPLIN. C, a C.P.A., was
the principal tax adviser for T, J, D, and B, parties herein. In
June 1969, he terminated his relationship with J, D, and B. (T
had died in 1968.) Shortly thereafter, he sued them in State
court for, inter alia, allegedly failing to fully compensate him for
services rendered. J, D, and B counterclaimed, alleging malprac-
tice on C’s part. In October and November 1969, C was called to
testify as a vritness by T, D, and B in a deposition conducted by
their attorney. C’s action against T, D, and B for breach of
contract, and their counterclaim against him for malpractice,
involved services which C rendered in his capacity as their tax
counselor during the development of Foster City. The tax
consequences of those services were at iseue in the State court
action, just as they are at issue in the present case. C died prior
to the trial of the present case. Held, C’s deposition is admissible
in this proceeding, over petitioners’ general hearsay objection,
under the “former testimony” exception to the hearsay rule.
Rule 804(bX1), Fed. R. Evid. Held, further, petitioners’ relevan-
cy, opinion, and double hearsay objections addressed and
resolved. Held, further, the fact that C was not a disinterested
witness does not affect the admissibility of his deposition but
rather the weight to which it is entitled. (Pp. 120-128.)
a
42
80 UNITED STATES TAX COURT REPORTS
Issue C: DEPOSITION OF T. JACK FOSTER, JR. In March
1971, J was called to testify as a witness by C at a deposition
conducted by C’s attorney. This deposition was part of the same
State court action referred to in Issue B, supra. Held, J’s
deposition is admissible in this proceeding, over petitioners’
general hearsay objection, as an admission of a party-opponent
under rule 801(dX2XA), Fed. R. Evid. Held, further, petitioners’
relevancy, opinion, and “double hearsay” objections addressed
and resolved. (Pp. 128-130.)
Issue D: DEPOSITION OF REX D. JOHNSON. Prior to the
commencement of the present case, petitioners filed an applica-
tion with this Court under Rule 32, Tax Court Rules of Practice
and Procedure, to depose W, a former vice president of the bank
with which T, J, D, and B did business. After a hearing and over
respondent’s objection, the Court granted the application. At the
deposition, W was examined by petitioners’ counsel and cross-
examined by respondent’s counsel. However, W declined to
answer questions which went beyond the scope of the issue with
respect to which the Rule 82 application was filed. W was alive
at the time of the trial of the present case. Held, W’s deposition
is admissible in this proceeding, over respondent’s general
objection, under Rule 81(iX3XE), Tax Court Rules of Practice and
Procedure. Held, further, respondent was not denied the right of
cross-examination at the deposition. Held, further, respondent’s
specific objections addressed and resolved. (Pp. 131-135.)
Issue E: THE “BUSINESS PURPOSE” OBJECTION. At trial,
J was asked on direct examination whether there was a business
purpose for the transfer of the single-family residential lots
from FP to FE in 1966. (See Issue 3, supra.) Respondent objected
to this question, whereupon petitioners moved to strike the
same question in J’s deposition. (See Issue C, supra.) Held, the
question propounded at trial is objectionable. Under rule 701,
Fed. R. Evid., opinion testimony must be “helpful” in order to be
admissible, and J’s expression of opinion would not have
satisfied this standard. Held, further, the question propounded
at the deposition is not objectionable because it elicited an
admission of a party-opponent which is admissible under rule
801(dX 2A), Fed. R. Evid. (Pp. 135-137.)
Issue F: BURDEN OF PROOF. Petitioners seek to allocate the
burden of proof in respect of the three major substantive issues
involved in this case (see Issues 1-3, supra) contrary to the
general rule of Rule 142(a), Tax Court Rules of Practice and
Procedure. Held, respondent’s determinations are not arbitrary
but rather rest on a firm foundation. Held, further, the
introduction of substantive evidence by respondent renders
moot any issue concerning the evidentiary weight to be accorded
the presumption of correctness. Weimerskirch v. Commissioner,
596 F.2d 358 (9th Cir. 1979), revg. 67 T.C. 672 (1977), distin-
guished. (Pp. 137-139.)
(34)
ih asin Seni ial nei
inate se sins
(34) FOSTER v. COMMISSIONER
Valentine Brookes and Lawrence
petitioners.
43
V. Brookes, for the
Joyce E. Britt and Charlotte Mitchell, for the respondent.
Dawson, Judge: Respondent determined the following defi-
ciencies in petitioners’ Federal income taxes and additions to
tax under sections 6651(aX1) and 6653(a): '
Petitioner
Richard H. Foster
and Sara B. Foster
T. Jack Foster, Jr.,
and Patricia Foster
John R. Foster
and Caroline Foster
Estate of T. Jack
Foster and Gladys
H. Foster
Year
1963
1964
1965
1966
1967
1963
1964
1965
1966
1967
1963
1964
1965
1966
1967
1963
1964
1965
1966
1967
Deficiency
$108,513.06
177,066.45
277,166.65
5,630.26
133,246.08
701,622.50
110,067.16
184,431.45
283,654.67
5,764.04
137,755.12
721,652.44
108,997.49
176,869.03
275,674.76
4,268.35
129,602.81
Addition
to tax
695,412.44
116,054.13
195,258.35
280,017.84
12,502.37
111,748.15
28,843.45
6,612.89
9,762.92
14,000.89
625.12
5,587.41
715,580.84
336,589.23
‘Unless otherwise indicated, all section references are to the Internal Revenue Code of
1954 as amended and in effect during the taxable years in issue.
Sec. 6651(aX1).
Sec. 6653 a).
44 80 UNITED STATES TAX COURT REPORTS (34)
In their petition, the petitioners claim overpayments in the
following aggregate* amounts:
Year Amount
ee dae $30,069.78
St ear 9,394.27
a eee 16,386.46
0 19,939.93
SEL, sin wosanabsosaa 29,913.76
105,704.20
Despite a number of concessions by the parties, there
remains a variety of issues for us to decide. They include nine
substantive issues and six preliminary issues related to certain
evidentiary and procedural matters. The substantive issues
are as follows:
1(a) and 3(a). Whether section 482 is unconstitutional as an
invalid delegation of legislative power.
l(b) and 3(b). Whether respondent’s determinations under
section 482 are reviewable for an abuse of discretion or
pursuant to some lesser standard.
l(c) and 3(c). Whether, in order to prevent the avoidance of
taxes, section 482 may be applied to a taxable disposition of
property previously acquired in a nonrecognition transaction.
1(d). Whether respondent abused his discretion under sec-
tion 482 in reallocating income from the sale of lots in
Neighborhood One from the Alphabet Corporations to the
Foster partnership.
3(e). Whether respondent abused his discretion under sec-
tion 482 in reallocating income from the sale of lots in
Neighborhood Four from Foster Enterprises, Ltd., to the
Foster partnership.
1(f) and 3(f). In the alternative, whether the Foster partner-
ship is an association and hence taxable as a corporation.
1(g) and 3(g). In the alternative, whether section 482 must be
employed to effect a consolidation of the Foster partnership
‘Petitioners do not allege the amount of overpayment claimed for each specific set of
petitioners.
fasta
(34) FOSTER v. COMMISSIONER 45
with all of the Foster-controlled corporations purportedly
involved in the development of Foster City.
2(a). Whether respondent’s contention on brief is consistent
with his ground for the adjustment set forth in the notice of
deficiency, or, conversely, whether it represents a new issue.
2(b). Whether certain promissory notes, purportedly execut-
ed to reacquire corporate stock, are part of the Foster
partnership’s basis in Neighborhoods Two and Three, or,
conversely, whether they represent an obligation to pay
additional interest on money borrowed for the purchase of
Brewer’s Island.
2c). If the notes represent an obligation to pay additiona!
interest, whether such interest can be capitalized under
section 266 as part of the Foster partnership’s basis in
Neighborhoods Two and Three, notwithstanding the fact that
such interest was not actually paid during the taxable years in
issue.
4. Whether the amount received by the Foster partnership
and a related corporation for the grant of a sway easement
should be applied against their bases in all of their land or
conversely against their bases in only that part of their land
described by the easement.
5(a). Whether respondent is entitled to rely on a ground for
the disallowance of a deduction which was not expressly set
forth in the notice of deficiency.
5(b). Whether the transfers of three parcels of land by the
Foster partnership for school and church sites are deductible
as charitable contributions under section 170.
5(c). If the transfers are not deductible, whether the partner-
ship must capitalize the cost of the school site as part of its
basis in all of its remaining land in Foster City.
6. Whether a payment made by the Foster partnership
pursuant to a law firm’s statement for services rendered is
deductible as a business expense under section 162.
7(a). Whether adjustments related to the payment of the
Fosters’ personal expenses were so arbitrary and excessive as
to shift the burden of proof to respondent.
7(b). If petitioners bear the burden of proof, whether they
can carry it through evidence that their recordkeeping system
46 80 UNITED STATES TAX COURT REPORTS (34)
was designed to differentiate between business and personal
expenses.
7(c). Whether the disallowance of deductions under section
274 at the corporate level precludes the taxation of those
expenses as constructive dividends at the shareholder level.
8. Whether certain amounts received by Gladys H. Foster
constitute dividends or compensation for personal services.
9. Whether the Estate of T. Jack Foster and Gladys H.
Foster are liable for additions to tax under section 6653(a) for
negligence or intentional disregard of rules and regulations.
The preliminary issues are as follows:
A(1). Whether the deposition of T. Jack Foster, taken in
connection with a State court proceeding, is admissible in this
proceeding as an admission of a party-opponent under Federal
Rules Evidence 801(d2)XA).
A(2). If it is admissible on that basis, whether petitioners
can object to any part of the deposition on grounds of
relevancy. ;
B(1). Whether the deposition of the Fosters’ former tax
planner, taken in connection with a State court proceeding, is
admissible in this proceeding as former testimony under Fed.
R. Evid. 804(b\1).
B(2). If it is admissible on that basis, whether petitioners can
object to any part of the deposition on grounds of relevancy,
opinion, and double hearsay.
B(3). If it is admissible on that basis, whether the deponent’s
testimony should be completely disregarded because of bias.
C(1). Whether the deposition of T. Jack Foster, Jr., taken in
connection with a State court proceeding, is admissible in this
proceeding as an admission of a party-opponent under Fed. R.
Evid. 801(d)(2)A).
C(2). If it is admissible on that basis, whether petitioners can
object to any part of the deposition on grounds of relevancy,
opinion, and “double hearsay.”
D(1). Whether the deposition of the Fosters’ former banker,
taken pursuant to an application filed with this Court under
Rule 82° prior to the commencement of the present case, is
admissible in this proceeding.
5Unless otherwise indicated, all Rulé references are to the Tax Court Rules of Practice and
Procedure.
1 hneinee imeem
(34) FOSTER v. COMMISSIONER 47
1DX(2). If it is admissible under that rule, whether respondent
can object to any part of the deposition on relevancy and a
variety of other grounds.
E(1). Whether the Court properly sustained an objection at
trial to a question calling for a conclusion by a party.
E(2). If so, whether the identical question propounded to
that party at a deposition must be stricken from the record.
F. Whether the burden of proof in respect of the three major
substantive issues involved in this case should be allocated
contrary to the general rule of Rule 142(a).
FINDINGS OF FACT
Some of the facts have been stipulated and are found
accordingly.
Petitioners Richard H. (Dick) Foster and Sara B. Foster, T.
Jack (Jack, Jr.) Foster, Jr., and Patricia Foster, and John R.
(Bob) Foster and Caroline Foster are husband and wife. The
three male petitioners are brothers. Together with their
respective spouses, they timely filed joint Federal income tax
returns for the calendar years 1963 through 1967 with the
Internal Revenue Service Center at Ogden, Utah.
Petitioner Gladys H. (Gladys) Foster is the widow of T. Jack
(Jack) Foster and the executrix of his estate. Jack Foster died
on March 15, 1968. Together with his spouse, he also timely
filed joint Federal income tax returns for 1963 through 1967
with the Ogden Service Center. Jack Foster and Gladys Foster
are the parents of the three male petitioners.
At the time that they filed their petition in this case, all of
the petitioners resided in the San Francisco Bay area.
Except for Gladys Foster’s involvement in Issue 8, the
female petitioners are parties to this action solely by virtue of
having filed joint returns with their respective spouses.
Accordingly, “the Fosters’ will only refer to the principals
involved in this case, i.e., Jack Foster, Jack Foster, Jr., Dick
Foster, and Bob Foster.
During the years in issue, the Fosters were equal partners in
a general partnership known as T. Jack Foster & Sons (the
Foster partnership or simply the partnership). Like the
individuals, the Foster partnership utilized the cash method of
accounting. The principal issues in this case involve substan-
tial adjustments made by respondent to partnership items of
48 80 UNITED STATES TAX COURT REPORTS (34)
income and deduction. The adjustments, in turn, generally
relate to the partnership’s activities in developing a 2,600-acre
tract of unimproved land known as Brewer's Island into a city
of 35,000 people christened Foster City, Calif. Before discuss-
ing those activities, however, it would be helpful to briefly
recount the business background of the Fosters, including the
formation and organization of their partnership.
I. Facts RELATED TO THE BusINESS BACKGROUND
OF THE FOSTERS
Jack Foster was born in 1902. During the 1920’s, he
attended the law school at the University of Oklahoma and
was subsequently admitted to the Oklahoma bar. He was twice
elected mayor of Norman, Okla.; he also served one term as
the city attorney.
During the depression era, Foster became interested in the
real estate business. Among the first projects which he
undertook was the construction of a hotel in Norman. His base
of operations became Oklahoma City.
From 1946 through 1955, Foster engaged in the real estate
development business with an individual by the name of V. B.
Likins. Likins was a successful and wealthy businessman who
had connections with the Republic National Bank of Dallas
(Republic or simply the bank). It was also during this period
that Foster retained A. O. “Del” Champlin, an Oklahoma
C.P.A., to provide financial, accounting, and tax planning
services. Both Republic and Champlin later played important
roles in the development of Foster City.
Foster and Likins engaged in a variety of projects during
their association. Their most notable achievement was the
construction of several thousand units of military housing in
several States including Kansas, Texas, California, and Ha-
waii.
Foster and Likins did business in both corporate and
partnership form. In 1952, they incorporated Likins-Foster
Honolulu Corp. That corporation eventually became the
parent company for most of the corporations formed during
the Likins-Foster period of business activity. Likins-Foster
Honolulu Corp. is involved in several of the issues presented in
this case.
In February 1955, Foster and Likins terminated their
(34) FOSTER v. COMMISSIONER 49
business relationship. They entered into an agreement the
relevant terms of which provided for the dissolution of their
partnership and the acquisition by the Fosters, pursuant to an
option, of Likins’ interest in Likins-Foster Honolulu Corp.
Upon the exercise of that option, Jack Foster owned 75 percent
of that corporation’s stock, and his sons, the remaining 25
percent, in equal shares.
FORMATION AND ORGANIZATION OF THE FOSTER PARTNERSHIP
Concurrently with the termination of his business relation-
ship with Likins, Jack Foster entered into an agreement with
his sons to form the Foster partnership for the transaction of
their business. According to the partnership agreement, the
purpose of the partnership was—
to own and to acquire land or interests in land, construct houses or other
buildings; to rent or sell such real property or leasehold estates either in an
improved or unimproved condition; to own stocks, bonds, debentures, or
other evidences of indebtedness in any corpore’ »n; to buy, own, develop and
operate oil and gas leasehold estates, or min.. ° rights or royalties; and to
generally engage in the business of buyir.g or owning property, real,
personal or mixed; to act as contractors or principals or agents in any
business transaction; to borrow or to lend money with or without security; to
act as guarantors on the contracts of others; and generally to engage in any
business which the partners may agree upon among themselves.
The partnership agreement further provided that contribu-
tions to the capital of the partnership were to be made one-half
by Jack Foster and one-sixth by each of his sons, and that
profits and losses from its operation were to be shared in the
same proportion. The agreement also designated Jack Foster
as the managing partner, authorized him to make all routine
decisions for the partnership, but provided that matters of
policy should be determined by all of the partners. The
agreement also authorized the payment of a salary to Jack
Foster as managing partner.
At this point, mention should be made of the activities of
Jack Foster’s sons. The oldest, Jack Foster, Jr., attended the
University of Oklahoma, majored in finance, and obtained a
degree in business administration in 1951. He then served 2
years in the Air Force. Immediately after his discharge, he
joined the Likins-Foster organization in Hawaii as a manage-
ment trainee. After Foster and Likins terminated their
50 80 UNITED STATES TAX COURT REPORTS (34)
business relationship in 1955, Jack, Jr., managed the Hawai-
ian operations of Likins-Foster Honolulu Corp. and its several
subsidiaries. In November 1960, he returned to the mainland
on behalf of the partnership to become the general manager of
the Foster City project. (The partnership’s role in the develop-
ment of Foster City will be discussed later in detail.)
Dick Foster also attended the University of Oklahoma,
majored in accounting, and graduated in 1957. He too became
involved in the family business. In 1960, he moved to Honolulu
in order to manage the Fosters’ operations and thereby allow
Jack, Jr., to assume his responsibilities at Foster City. While
in Hawaii, he supervised the construction of several projects,
including the Foster Tower Hotel, which plays a role in one of
the issues involved herein. In July 1963, he left Hawaii for
California in order to actively participate in the development
of Foster City.
Bob. Foster also attended the University of Oklahoma an4
graduated in 1958 with a major in geology. For approximately
2 years, he managed the family’s oil and gas interests in
Oklahoma. In October 1960, he too moved to California in
order to take an active part in the development of Foster City.
By 1959, Jack Foster’s sons had all graduated from college
and had assumed active and increasingly responsible roles in
the family business. Accordingly, in January 1959, the Fosters
amended their partnership agreement to provide for their
equal participation in the profits and losses resulting from the
operation of the partnership. No adjustment was made,
however, in their capital accounts nor were any of the above-
described provisions modified in any way except to specifically
authorize the payment of salaries to all of the partners. These
amendments to the partnership agreement were made at a
time when the Fosters were actively assessing the feasibility of
developing Foster City.
The Fosters restated their partnership agreement in August
1963. The purpose of the partnership remained unchanged,
and no modifications were made to any of the provisions
described above. But two new provisions were added. One
authorized any two general partners to bind the partnership
by any deed, contract, or other written document within the
general scope of the partnership; and the other declared that
(34) FOSTER v. COMMISSIONER 51
all stock in any corporation in which shares had been equally
issued to the Fosters was a partnership asset.
II. Facts RELATED TO THE CREATION OF FOSTER CITY
While living in Pebble Beach, Calif., in 1958, Jack Foster was
contacted by a fellow builder and real estate developer by the
name of Richard Grant about the possibility of participating in
the development of Foster City, then known as Brewer’s
Island. Brewer’s Island was a 2,600-acre undeveloped and
uninhabited tract of land located about 12 miles south of San
Francisco in San Mateo County. It was separated from the city
of San Mateo by a narrow estuary on its western bounds but
otherwise surrounded by the waters of San Francisco Bay. The
island was partially submerged, partially tideland, and par-
tially firm land behind existing levees. It was owned by the
Leslie Salt Co. (Leslie) and the Schilling Estate Co. (Schilling)
and was used for agriculture and as salt ponds. Grant had been
negotiating with its owners for several years but had not been
successful in even obtaining an option for its purchase.
Foster had several discussions with Grant about the develop-
ment potential of Brewer’s Island but remained unconvinced.
- He agreed, however, to solicit the views of his partners.
Accordingly, he called his sons to California. The Fosters
reviewed the preliminary feasibility study and soil test that
Grant had previously commissioned. They determined that the
proposed project had sufficient merit to warrant further
scrutiny and agreed to finance certain additional studies.
Grant and the Fosters agreed that if these studies were
favorable and they decided to go forward with the project
(assuming, of course, that they could purchase the land), they
would do so as partners on a 50/50 basis. As for the Fosters,
themselves, they proceeded in partnership form, with Jack
Foster continuing to act as managing partner.
The Fosters determined that the principal engineering
problem facing the proposed project was to secure an adequate
supply of landfill. Acting on behalf of the partnership, Jack
Foster retained Dames & Moore (D & M), a San Francisco
engineering firm specializing in soil analysis, to survey the
southern part of San Francisco Bay for the purpose of locating
sand deposits which could be used as fill. Suitable deposits
were located about 5 miles east of the San Francisco Interna-
* Le RT ONE Te
52 80 UNITED STATES TAX COURT REPORTS (34)
tional Airport at San Bruno Shoal. A dredging permit in Jack
Foster’s name was subsequently obtained in October 1959
from the U.S. Army Corps of Engineers. During this period,
various studies were also conducted on Brewer’s Island, itself.
Throughout 1959, Jack Foster actively negotiated with
Leslie and Schilling over the terms of the proposed purchase.
Discussions were frequent, occurring about twice a week.
By the fall of 1959, the Fosters had become sufficientiy
enthusiastic about the proposed project to commission a major
feasibility study. In November 1959, again acting on behalf of
the partnership, Jack Foster retained Wilsey, Ham & Blair (W
H & B), a firm of civil engineers and land planners, to prepare
a proposal for the development of Brewer’s Island. D & M was
also retained to conduct soil studies and otherwise assist in the
preparation of the engirsering part of the proposal.
In December 1959, Jack Foster and Richard Grant succeed-
ed in obtaining an option from Leslie and Schilling for the
purchase of Brewer’s Island for $12,800,000. The option was
acquired for $200,000 and had to be exercised no later than
August 19, 1960. It was acquired solely with Foster funds.
Contemporaneously with its acquisition, Grant and Foster
agreed for the latter (acting for the partnership) to purchase
the former’s interest in the project for $3 million if the option
were eventually exercised. They also agreed that the Fosters
would be solely responsible for all engineering and feasibility
studies.
Foster arranged to buy out Grant because he thought the
property was potentially worth far more than its option price
and because he preferred to proceed with only his sons as his
partners if the project were undertaken. However. Grant’s
anticipated contributions to the project were considered so
significant that the Fosters would not have undertaken it
without assurance of his continued involvement. Accordingly,
Foster (again acting for the partnership) also arranged to
retain Grant on a full-time basis as an independent contractor
at an annual fee of $24,000 if the project were actually
undertaken.
At the time the option was acquired, the Fosters were faced
with several major problems if they exercised it and commit-
ted themselves to the development of Brewer’s Island. The
major engineering problem related to the raclamation of the
(34) FOSTER v. COMMISSIONER 53
land. The major financial problem related to their dependence
on outside financing not only to develop Brewer’s Island
(originally estimated by Jack Foster to require $55,500,000)
but also to complete its purchase price.
In July 1960, WH & B submitted its proposal. The engineer-
ing plan for reclaiming Brewer’s Island called for dredging a
lagoon across the center of the property, installing flood gates
in order to permit water draining into the lagoon to flow back
into the bay, and then filling the land in the shape of a large
saucer about 14 feet above sea level at the outer edge and 1%
feet above sea level near the center. It was determined that the
necessary fill, approximately 18 million cubic yards, could be
obtained at a cost which would make the operation economi-
cally feasible.
WH & B’s proposal also contemplated using municipal bonds
issued by a municipal improvement district to finance the
improvements to Brewer’s Island. This concept actually origi-
nated with Richard Grant, who had previously discussed it
with the Fosters. They were sufficiently receptive to the idea
that Jack Foster, actifg on behalf of the partnership, retained
a San Mateo law firm specializing in municipal finance to
draft proposed legislation. WH & B provided technical assis-
tance by specifying the powers that such a district would need
in order to successfully undertake the contemplated develop-
ment. Sometime thereafter, the Estero Municipal Improve-
ment District Bill was introduced into the California legisla-
ture as Senate Bill No. 51 by the local State senator and State
assemblyman. The former was also the Fosters’ personal
attorney. The bill called for the creation of a local government
body which could issue bonds and impose taxes in order to
raise the funds necessary to improve the land within its
jurisdiction. In March 1960, San Mateo County endorsed the
bill. It was subsequently passed by the legislature and ap-
proved by the Governor in May 1960. The Estero Municipal
Improvement District (Estero or simply the district) played an
important role in the development of Brewer’s Island.
In his discussions with Leslie and Schilling, Jack Foster had
negotiated a downpayment of $2,500,000 for the purchase of
Brewer’s Island. Payment of such an amount, however, was
not compatible with the partnership’s anticipated cash needs
if the project were actually undertaken. During the spring or
54 80 UNITED STATES TAX COURT REPORTS (34)
early summer of 1960, the Fosters discussed with senior
officials of the Republic National Bank the possibility of
financing the partnership’s downpayment if the property were
purchased. A $2 million loan was eventually arranged. How-
ever, certain of its terms are in dispute and give rise to one of
the three major issues which we must decide. This matter is
described later in greater detail.
By July 1960, the Fosters had expended considerable
amounts assessing the development potential of Brewer’s
Island. For example, they had spent approximately $250,000
on the studies made by WH & B and D & M. In the process,
however, they had devermined that the project was feasible
and had made the necessary arrangements for financing both
the development and acquisition of Brewer’s Island. Accord-
ingly, they undertook to acquire the property.
On August 16, 1960, Jack Foster, acting on behalf of the
partnership, acquired Richard Grant’s interest in the option
for $3 million as previously agreed. Foster executed a promis-
sory note payable without interest and solely from the
proceeds from the sale or use of the property subject to the
option. The note was secured by an unrecorded deed of trust.
On August 19, 1960, Foster, again acting on behalf of the
partnership, exercised the option and acquired Brewer’s Island
for $12,800,000. The $2,500,000 downpayment included the
amount paid for the option ($200,000) and the amount bor.
rowed from Republic for that purpose ($2 million). Foster
executed promissory notes to the sellers for the balance, or
$10,300,000. These notes were secured by a deed of trust and
were payable nc later than August 19, 1967.
Title to Brewer’s Island was taken in the name of Jack
Foster as nominee of the Foster partnership. Later, in August
1963, the partnership filed a “Statement of Partnership” with
San Mateo County pursuant to the California Corporations
Code.* At that time, Foster transferred record title (except to
certain acreage, described later, which in the interim had been
conveyed to certain Foster-controlled corporations) to the
partnership.
With the purchase of Brewer’s Island by the Foster partner-
®See Cal. Corp. Code sec. 15010.5 (West 1977).
(34) FOSTER v. COMMISSIONER 55
ship, that tract of land was on its way to becoming Foster City.
At this point, therefore, it would be appropriate to briefly
describe the contemplated development.
Foster City was envisioned as a completely planned and self-
contained city consisting of nine residential neighborhoods, an
industrial park, and a town center. Each neighborhood was to
be built around an elementary school. Of the 2,600 acres,
approximately 1,360 were to be zoned residential, 310 acres,
industrial, and 150 acres, commercial. The remaining acreage
was to be divided among schools, churches, parks, lagoons,
streets, and municipal buildings. A population of approximate-
ly 35,000 was contemplated. The total number of housing units
was estimated at 11,000, with single-family detached homes
accounting for about 5,000 units and townhouses and garden
and highrise apartments the remainder. Each neighborhood
was to include both waterfront (lagoon and bay) and non-
waterfront lots and a mix of single-family and multiple-family
dwellings, as well as some commercial development.
Ill. Facts RELATED TO THE SALE oF LoTs
IN NEIGHBORHOOD ONE (ISSUE 1)
Foster City was developed neighborhood by neighborhood.
As land in each neighborhood was reclaimed and the soil
compacted, various improvements were immediately begun
with a view towards platting so that individual lots could be
sold to builders. The principal income of the project was
derived from the sale of such lots. Given the magnitude of the
project, the Fosters lacked the financial resources to under-
take the actual construction, itself. However, in several
instances, they did do some building, principally commercial
buildings which they intended to hold for investment pur-
poses.
The first neighborhocd to be developed was Neighborhood
One.’ Sales of lots in Neighborhood Or- hegan in June 1963
and continued for the next several yea. © sn October 3, 1962,
Jack Foster, acting on behalf of the Fostei partnership, deeded
undivided 25-percent interests in 127 acres of land in both
7During the period when the Fosters were the developers of Foster City, neighborhoods
were developed in the numerical sequence of One, Two, Three, Four, Nine, Eight, and Six.
56 80 UNITED STATES TAX COURT REPORTS (34)
Units 1 and 2 of Neighborhood One to each of four corpora-
tions as tenants-in-common. (Neighborhood One was divided
into two units and consisted of a total of 216 acres.) The four
corporations were known as Foster J. Corp., Foster D. Corp.,
Foster B. Corp., and Foster T. Corp. (hereinafter referred to
collectively as the Alphabet Corporations or simply the
Alphabets). Each of the Alphabet Corporations was solely
owned by one of the Fosters: Foster J. by Jack, Jr., Foster D. by
Dick, Foster B. by Bob, and Foster T. by Jack (T. Jack). In the
notice of deficiency, respondent allocated to the partnership
the net income reported by the Alphabets? from the sale of lots
in Neighborhood One as follows:
1963 1964 1965 1966 1967
$680,459.55 $293,766.18 $134,735.03 ($2,521.67) $350.26
This allocation was made under authority of section 482.
In order to understand the factual predicate of the Neigh-
borhood One issue, it is necessary to describe the roles played
by Estero, the Foster partnership, the Alphabets, and Del
Champlin in the development of Foster City in general and
Neighborhood One in particular.
A. ESTERO MUNICIPAL IMPROVEMENT DISTRICT
As previously stated, the consultants retained by the Fosters
recommended using municipal bonds issued by a municipal
improvement district to finance the improvements to Brewer’s
Island. The district that was created for this purpose was
Estero.
1. The Enabling Legislation
Estero was a “special act” district, i.e., it was created by
special act? of the California legislature rather than pursuant
to an existing general statute. As an independent special
district, it was a public agency. However, as we shall see,
Estero was designed to be subservient to the Fosters.
®Any adjustments that respondent may have made to the net income reported by the
Alphabets from the sale of these lots is not in issue.
%Estero Municipal Improvement District Act, 1961 Cal. Stat. 1st Extra Sess. 1960, ch. 82, p.
459, hereinafter referred to as “the Estero Act” or simply “the act.”
(34) FOSTER v. COMMISSIONER 57
The Estero Act recited the need for the district, prescribeu
its boundaries, organization, and powers, and defined the
methods for its operation, management, and financing. The
act described its purpose as follows:
Article 15. Need for Special Act
SEC. 2'5. The purpose of this act is to form the Estero Municipal
Improvement District in order that the area benefited may be provided \: ith
various municipal improvements. Special facts and circumstances, applica-
ble to the general area within which the district lies and not generally, make
the accomplishment of this purpose impossible under existing general laws
and therefore special legislation is necessary. The special facts are as follows:
* * * * * * *
(d) There is urgent need for the improvements which the district is
empowered to construct under this act, but other municipal powers which
could be exercised by a city are not required, and would result in more
government than the area needs or wants.
(e) There are not existing general laws under which the area could be
provided with the facilities it needs short of incorporation as a city.
Therefore, the only way in which the particular needs of the area can be
provided is by special act.
(f) The land in the district is not owned by residents. The owners are the
ones primarily concerned with the district and the ones who will be
supporting the district. The owners should therefore hold the voting power.
Since no general law district with the necessary powers provides for voting
by owners, special legislation is necessary.
The act provided that the territorial jurisdiction of Estero
was coterminous with Brewer’s Island. It also restricted the
right to vote to landowners and provided that voting was to be
upon the basis of assessed valuation of land, with each voter to
have one vote for each $1 in assessed valuation of land owned
by him.?°
The act also provided that Estero was to be governed by a
10[n this regard, the act provided as follows:
SEC. 17. “Land” means land in the district and does not include improvements or
personal or utility property.
SEC. 19. “Owner” means the owner of land as shown on the last equalized county
assessment roll.
SEC. 20. “Voter” means an owner, or the officer appointed therefor by the board of
directors of a corporation owner, or the legal representative of the owner.
SEC. 64. Each voter shall have one vote for each one dollar ($1) in assessed valuation of
land owned by him as shown by the last equalized assessment roll.
SEC. 65. A majority of the votes cast shall be required to elect a director or approve a
58 80 UNITED STATES TAX COURT REPORTS (34)
board of three directors elected to serve staggered, 4-year
terms. Only owners or their officers or legal representatives
were eligible to be directors. The officers of the district
consisted of the board members, a secretary, and such other
officers as the board might create. The district was entitled to
employ such engineers, technical experts, and other employees
as it deemed necessary.!!
Estero was vested with a broad spectrum of general govern-
mental powers. For example, it was empowered to reclaim
land, make provision for street lighting, sewage, storm drain-
age, 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
any such regulation constituted a misdemeanor.!”
proposition. a
See also sec. 215(f) of art. 15 quoted above in the text.
The provisions described above were expressed in the act as follows:
SEC. 26. The board is the governing body of the district and shall consist of three (3)
members, one of whom shall be president. The officurs of the district are the three members
of the board and a secretary. The district may have a finance officer, and other officers as
the board may from time to time create. An owner may nominate an officer or a legai
representative for each office to be filled by election or appointment.
SEC. 27. The first district board shall be elected at an election conducted by the [San
Mateo County] board of supervisors immediately following the formation of the district. The
first district board shall classify itself by lot so that one director will hold office for two years
and two directors will hold office for four years following the district formation or until their
successors have been elected or appointed and qualified.
SEC. 28. The directors shall be owners, or officers or legal representatives of owners.
SEC. 29. The term of each director, after the first board, shall be four years, or until the
election or appointment, and qualification of his successor.
SEC. 32. Once each year, the board shall elect one of its members to serve as president,
shal! appoint a secretary and shall fill anv other offices as it may from time to time create.
SEC. 34. The board shall! act only by ordinance, resolution, motion or contract. No
question of interest shall affect the legality of any contract or the right of any officer to act.
SEC. 35. A majority of the board shall constitute a quorum for the transaction of business.
SEC. 36. No ordinance, resolution, motion or contract shall be passed or become effective
without the affirmative vote of at least the majority of the members of the board.
SEC. 94. The district may appoint, employ and fix the compensation of engineers,
attorneys, assistants and other employees as it deems proper.
'2The powers described above were expressed in the act as follows:
SEC. 77. The district may acquire, construct, reconstruct, alter, enlarge, lay, renew,
replace, maintain and operate, street and highway lighting facilities; facilities for the
Asari! i
FMEA Pe WO G8 ig ST IT tes ch
(34) FOSTER v. COMMISSIONER 59
Despite its impressive array of powers, Estero was intended
to initially function as a reclamation district whose purpose
was to finance the reclamation of a 2,600-acre tract of
undeveloped and uninhabited land. As that iract was re-
ciaimed, Estero was intended to function as an improvement
district whose purpose was to finance the construction of
general land improvements such as streets and sewers. As the
land was improved, subdivided, and sold, and further improved
by the construction of dwelling and other buildings, Estero was
intended to function as a general governance district whose
function was to provide the usual munic. val-ty pe services such
as fire and police protection.'' This functional evolution of
Estero was facilitated by the comprehensive powers bestowed
upon it by the enabling legislation.
In order to finance the reclamation of Brewer’s Island and
the construction of general land improvements, the Estero Act
authorized the district to issue both general obligation and
revenue bonds, as well as other types of securities. Issuance of
collection, treatment and disposal of sewage, industrial wastes, storm waters, garbage and
refuse; the production, storage, treatment and distribution of water for public and private
purposes; parks, playgrounds and works to provide for the drainage of roads, streets, and
public places, including, but not limited to curbs, gutters, sidewalks and grading and
pavement; and the reclamation of submerged or other land by watering or dewatering.
SEC. 78. The district may acquire or construct the reclamation of land for private small
craft harbor purposes * * *
SEC. 79. The district may acquire, construct, maintain and operate facilities for providing
fire protection to the district and its occupants or inhabitants, including buildings, engines,
hose, hose carts, or carriages, and other appliances and supplies for the full equipment of
fire companies or departments and a police department, to protect and safeguard life and
property.
SEC. 80. The district may take, acquire, hold, use, lease and dispose of property of every
kind within or without the district, necessary, expedient or advantageous to the full exercise
and economic enjoyment of its purposes and powers.
SEC. 81. The district may exercise the right of eminent domain for the condemnation of
private property for public use within but not without the district.* * *
SEC. 83. The district may make and accept contracts, deeds, releases and documents that,
in the judgment of the board, are necessary or proper in the exercise of any of the powers of
the district.
SEC. 97. The district may make and enforce all necessary and proper regulations, not in
conflict with the laws of this State, for the removal! of garbage and refuse and the supplying
of sewage, light, water, storm water and fire and police protection service. A violation of a
regulation of the district is a misdemeanor punishable as such.* * *
\3Estero ceased to function in this latter capacity in April 1971 when Foster City was
incorporated as a city.
60 80 UNITED STATES TAX COURT REPORTS (34)
these bonds required approval by the district electorate;
however, a “voter” continued to be defined as a landowner.
The act did not limit or restrict the amount of bonded
indebtedness that could be incurred by the district. The
payment of interest was expressly authorized to be funded as
part of Estero’s bonded indebtedness “for the period of
construction and for twelve (12) months thereafter.” In other
words, the act authorized the face amount of a bond issue to
include the interest that would have to be paid on the bonds
during the specified period. The significance of such capital-
ization of interest will be described later in greater detail.
Because of a scandal during the early 1960’s involving the
\«The financial powers described above were expressed in the act as follows:
SEC. 87. The district may incur bonded indebtedness and issue bonds in the manner
herein provided.
SEC. 90. Any bonds issued by the district organized under the provisions of this act are
given the same force, value and use as bonds issued by any municipality and shall be exempt
from all taxation within the State.
Article 6. General Obligation Bonds
SEC. 105. The district may issue bonds as provided in this article for any of the purposes
stated in Sections 77, 78, 79 and 80. [See note 12 supra.]
SEC. 106. By resolution, when in its judgment it is advisable, the board may call an
election and submit to the voters of the district the question of whether bonds shall be
issued.
SEC. 112. If, at the election, two-thirds of the votes cast are in favor of the issuance of
bonds, the board may issue and dispose of the bonds.
Article 8. Revenue Bonds
SEC. 135. The district may create revenue bond indebtedness for the acquisition and
construction, or acquisition or construction of any improvements or property or facilities
contained within its powers.
SEC. 136. Proceedings for the authorization, issuance, sale, security, and payment of
revenue bonds shall be had, the board shall have the powers ed duties, and the bondholders
shall have the rights and remedies, all in substantial accor !ance with and with like legal
effect as provided in the Revenue Bond Law of 1941 * * * ; provided, hcwever, that qualified
voters at the election therein provided shall be voters as defined in this act, and the method
of voting shall be as herein provided.* * *
Article 12. Funds
SEC. 178. The bond moneys may also be used for interest and working capital for the
period of construction and for twelve (12) months thereafter, and also to pay the costs of
their authorization and issuance including fees for legal, engineering, fiscal, economic or
other service.
nCaded:
De Si | ne ee es ee
OME AE IA hy Bld She”
(34) FOSTER v. COMMISSIONER 61
Embarcadero Municipal Improvement District in Santa Bar-
bara, another special act district that was virtually identical to
Estero in legal form,'' the California legislature requested the
State attorney general to conduct an investigation of both
districts. The legislature also conducted hearings in 1962. The
committee report!¢ found as follows:
The Embarcadero and Estero Municipal Improvement Districts are
similar public agencies with general taxing and bonding powers, specially
created to aid specific land developments. The organizational requirements
of these districts placed each of them under the direct control of the
developers and in addition anticipated and encouraged sei‘-dealing between
the developer and the district—all without any independent audit controls
or other review procedures.
The grand theft and fraud which occurred in the Embarcadero District
appear to have been facilitated by this type of district organization. The
success of the Estero District, on the other hand, may be attributed to the
integrity of the developer and his willingness voluntarily to secure county
approval of his development and to provide other public safeguards. The
salient fact, however, is that the district organization itself does not appear
significantly able to forestall abuses.
In June 1963, the Estero Act was amended!’ to require that
one of the three directors of the board be a public member
designated and appointed by the San Mateo County Board of
Supervisors.'* The act was also amended to require that the
finance officer be bonded for $250,000.'9 Finally, the exculpato-
ry provision of section 34 of the act (quoted above in note 11)
was deleted.
‘sCompare 1961 Cal. Stat. ch. 81, p. 441 (1st Extra Sess. 1960) (Embarcadero) with ch. 82, p.
459 (Estero).
‘eThe report, prepared by the Assembly Committee on Municipal and County Govern-
ment, focused generally on the uses of special assessment procedures and independent
special districts to aid land development.
171963 Cal. Stat. ch. 995, jo. 2257.
'8Sec. 28 of the act, quoted above in note 11, was amended to read as follows:
SEC. 28. Two directors shall be owners, or officers or legal representatives of owners and
shall be nominated and elected or appointed in accordance with Article 4 [“Elections”).
Commencing in the year 1964 and each four years thereafter one of the expiring terms of
director shall be filled by a public member designated and appointed by the county board of
supervisors.
As will be seen, the Fosters had anticipated this amendment and had provided for a public
member of Estero’s board since June 1961.
'8The Fosters also anticipated this amendment although Estero’s finance officer was
originally bonded for only $25,000.
62 80 UNITED STATES TAX COURT REPORTS (34)
In August 1967, the Estero Act was again amended,” this
time because of pressure brought by the residents of Foster
City. As amended, the act provided for a scheduled shift of
power over a 4-year period from the landowners to the
residents. Thus, the board of directors was immediately
enlarged to five members, two of whom represented landown-
ers and iwo of whom represented residents; the fifth member
was a “public director” appointed by the county. By 1969, the
fifth member was to be elected by the residents, and by 1971,
all five members were to be elected by the residents. The
reason for this reform will be discussed later in greater detail.
In December 1966, a resident of Foster City by the name of
Cooper judicially challenged the validity of the Estero Act,
alleging, inter alia, that it violated the California constitution.
His action was subsequently dism ssed on the ground that it
failed to state a cause of action. In 1969, the California
Supreme Court affirmed the dismissal.
2. Estero’s Board, Officers, and Contractors
Estero was formally organized on September 8, 1960. Its first
board of directors consisted of Richard Grant, who was elected
president, William Innes, and George Shannon. Grant, of-
course, was the individual who first interested the Fosters in
developing Brewer’s Island and whom they arranged to retain
for his help and assistance if the project were actually
undertaken. Innes was a C.P.A. and former employee of
Arthur Andersen & Co. He was hired by Jack Foster in 1950
and had become a trusted executive within the Foster organi-
zation. Shannon was a career city manager who had worked in
Texas, California, and Alaska. He had been recommended to
the Fosters by the president of the Republic National Bank
and was sought out by them because of his expertise in
201967 Cal. Stat. ch. 1511, p. 3593.
21Cooper v. Leslie Salt Co., 70 Cal. 2d 627, 451 P.2d 406, 75 Cal. Rptr. 766 (1969). See also
Cooper v. Estero Municipal Improvement District, 70 Cal. 2d 645, 451 P.2d 417, 75 Cal. Rptr.
777 (1969), for related litigation. Compare Justice Mosk’'s concurring and dissenting opinion
in Cooper v. Leslie Salt Co., supra, and Burrey v. Embarcadero Municipal Improvement Dist.,
5 Cal. 3d 671, 488 P.2d 395, 97 Cal. Rptr. 203 (1971), a case involving Estero’s sister district
in which the California Supreme Court held unconstitutional a provision under which the
right to vote was limited to landowners.
Bs HO Ne OP 1 ASI 2
as ohetiE WALD" Goth, 2
ea VOR SS teat BAR elie do. Pa Sint nth
(34) FOSTER v. COMMISSIONER 63
municipal government. Both Innes and Shannon served as
directors through the years in issue.
In June 1961, Grant resigned from Estero’s board “in order
to better represent the District in an independent capacity.” C.
W. Olmo, a contractor, was appointed his successor and elected
president. Olmo became one of the Fosters’ subcontractors
when they built the Wells Fargo Bank Building in Foster City
in 1965. He had been recommended to the Fosters by the San
Mateo County Board of Supervisors. He too served as director
through the years in issue.
In addition to being a director, George Shannon held a
variety of other positions with Estero. At the initial organiza-
tional meeting of the board, he was appointed secretary. He
also served as district tax assessor and tax collector, after
those offices were created in February 1961, and became
general manager (a position which consolidated his other
offices and made him the chief executive officer for the
district), after that position was created in August 1962. At
that time, it was agreed that Shannon would be placed on the
district’s payroll and would no longer be employed by Likins-
Foster Honolulu Corp.
Shannon served as Estero’s general manager until 1969.
Immediately after the residents of Foster City gained control
of the board, he was terminated. Shortly thereafter he was
reemployed by the Fosters.
William Innes also held several positions with Estero in
addition to that of director. In March 1961, he was appointed
district finance officer. In February 1964, he was appointed
assistant secretary.
For the first several years of its existence, Estero’s offices
were located within the Fosters’ offices in Burlingame, a
neighboring community. During this period, one or more of the
Fosters customarily attended meetings of the district’s board
of directors. Jack Foster, Jack Foster, Jr., and Bob Foster were
ail present at the board’s first meeting on September 8, 1960.
Estero retained many of the same contractors as the Fosters.
For example, in November 1960, it retained as bond counsel
the law firm that the partnership had retained to draft the
Estero Act. It had previously retained that same firm as
general counsel. In September 1960, Estero contracted with
WH & B for the performance of engineering and surveying
O4 80 UNITED STATES TAX COURT REPORTS (34)
services necessary to complete the reclamation of Foster City.
In August 1961, it again contracted with WH & B for the
preparation of the design, plans, and specifications for all the
community facilities (e.g., sewers and drains, water mains,
pavement and sidewalks, curbs and gutters, and street lights)
to be constructed in Neighborhood One. At the same time, it
contracted with D & M for the performance of the soil studies
necessary for the construction of those facilities and for other
related engineering services. Other contracts were subsequent-
ly entered into with both WH & B and D & M.
Estero accepted the assignment of, and assumed the full
indebtedness under, certain contracts which Jack Foster had
entered inte on behalf of the foster partnership in 1959 and
1960. These contracts will be described later in greater detail.
Estero also contracted with the partnership and certain of the
Fosters’ corporations for various services. For example, at its
inception, Estero entered into an agreement with Likins-
Foster Honolulu Corp. for administrative services. Other
contracts will also be described later.
3. Municipal Finance
Estero entered into numerous contracts in its own name for
the reclamation of land and the construction of various
improvements such as levees, lagoons, roadways, water and
sewer lines, and a sewage disposal plant. In order to finance
this development, Estero issued long-term bonds. Estero’s
success in selling its bonds to the general public was due, in
part, to its deliberate choice of a particular appraisal method
which served to accelerate land value. On the other hand, the
Fosters’ success in minimizing district taxes was due. to the
unique manner by which Estero capitalized interest. Each of
these matters will be discussed in turn.
George Shannon, the district tax assessor, appraised unde-
veloped land within Estero on a benefit-to-be-received basis.
Under this method, land was appraised as if all the bonded
improvements were in place, i.e., as if the land were fully
reclaimed and the streets, sewers, and other improvements
completely constructed. The assessor of San Mateo County, on
the other hand, appraised raw land on the basis of comparable
sales of undeveloped tracts. (Both the district and the county
used comparable sales to value improved real estate.) Because
Scena dat a AR Nh Roig tiiait Bs ahs hal Sibir tid
DN fh AAR Tei Ne SC Ae Sioned . ied.
(34) FOSTER v. COMMISSIONER 65
of the basic difference between these two appraisal techniques,
Estero’s appraised value of undeveloped land was 3% to 6
times greater than that of the county. In the mid—1960’s, after
considerable development had occurred, Estero appraised the
value of all the land within the district at $102 million
whereas the county appraised it at $41 million.
Estero appraised undeveloped land on a benefit-to-be-re-
ceived basis in order to accelerate land value. This in turn
facilitated bond sales. Potential buyers would have been
hesitant about purchasing bonds if the district’s bonded
indebtedness exceeded the value of the security. Use of the
benefit method allowed a comfortable margin. On the other
hand, if the county’s method had been used, Estero’s bonded
indebtedness in the mid-1960’s (approximately $51 million)
would have exceeded the aggregate land value by about $10
million.
By facilitating bond sales, the higher appraised value
benefited the landowner. Bonds, after all, were the source of
funds for the reclamation and development of the land. There
was, however, a potential downside. Higher appraised value
should ordinarily lead to greater taxes for the landowner. In
the case of the Fosters, however, this disadvantage was
minimized through the manner in which Estero capitalized
interest.
“Capitalized interest” is interest which is built into the face
amount of a bond. It is equal to the amount of interest which
will have to be paid on the bond over some initial period of
years. That period is typically the time needed to construct the
particular improvement for which the bond is issued, plus
some additional period such as 12 or 24 months. By capitaliz-
ing interest for this period, the payment of interest is
effectively postponed until the improvement can begin to pay
for itself. Capitalizing interest on bonds issued to finance the
construction of a toll bridge provides an illustration.
The Estero Act specifically authorized interest to be capital-
ized “for the period of construction and for twelve (12) months
thereafter.” This provision was construed, however, not to
refer to the construction of the particular improvement for
which the bond was issued, the usual interpretation given to
such language by bond experts, but rather to the construction
of Foster City, itself. This interpretation was not disclosed in
66 80 UNITED STATES TAX COURT REPORTS (34)
any prospectus published by Estero to promote bond sales.
Estero thus capitalized interest not only on current bond sales
but also on prior bond sales. In other words, bond proceeds
were used to service prior debt, thereby reducing the current
property tax impact on the landowner. Prior to the change in
its board of directors in 1967, Estero was capitalizing approxi-
mately 60 percent of the interest falling due on all prior bonds,
and as much as 40 to 50 percent of the total bond proceeds
were being utilized to pay capitalized interest. Not surprising-
ly, very little principal was retired during the 1960’s. Between
1961 (the year of the first bond sales) and 1972, approximately
$66 million in bonds was sold. Of this amount, about $64
million remained outstanding in 1972.
By the mid-1960’s, the residents of Foster City had become
concerned about Estero’s bond practices, particularly its
practice of using proceeds from the current sale of bonds to
service prior debt. They realized that this practice was causing
debt to pyramid and recognized that when it stopped, as it had
to at some point, they would be faced with an enormous, and
perhaps unmanageable, bond-related tax increase. Accurding-
ly, they organized a homeowners association and sought to
discuss their concerns with Esterc. The board, however,
referred them to the Fosters.
The homeowners association never succeeded i» obtaining
assurance from the Fosters that there would be any measure
of stability in future district taxes. Some animosity developed
after the association endorsed a proposal (authorizing an
increase in the total amount of bonded indebtedness) in March
1967 in exchange for what it thought was the Fosters’
guarantee to hold taxes to the highest projected level. The
Fosters, however, subsequently refused to enter into any such
agreement. Accordingly, the homeowners association drafted
legislation to democratize election te the Estero board. This
legislation was introduced into the California legislature in
April 1967 and enacted in August 1967. As described above, it
programed the transfer of voting power over a 4-year period
from the landowners to the residents.
During the transition period, as power was shifting, changes
were made in Estero’s scheme of municipal finance. There
were no further bond authorizations for land reclamation or
the construction of water, sewer, or street improvements. Only
ee ee ee ed
Pcie ch o
ee ee
ee ee ee Pe ae Ee ee ee a ee ee ere ee
(34) FOSTER v. COMMISSIONER 67
bonds previously authorized for these purposes were sold.
Bond authorizations for other purposes, such as parks and
recreation, were meager in amount. Interest was not invari-
ably capitalized, but when it was, it was limited to a maximum
period of 24 months from the time of the bond sale. Moreover,
interest was capitalized only in respect of a particular bond
sale and not in respect of outstanding bonds as had previously
been the practice. In order to compensate for such past
practices, the residents voted in 1968 to double their taxes,
hoping to avoid an oppressive future increase.
During the transition period, the most significant change,
however, was Estero’s decision to finance the construction of
only the major streets and major water and sewer lines. No
longer was the development of the developer’s private land to
be financed with public funds. Rather, the developer was
henceforth required to finance ali on-site and local improve-
ments (such as streets and water and sewer lines) that would
be necessary to subdivide a particular tract. As a consequence,
Estero was relieved of most of the expense that it would
otherwise have had to incur.
By 1972, the community’s finances were sound enough to
permit bond sales at par. During the 1960’s, bonds had been
almost invariably sold at a discount.
Finally, mention should be made of the fact that during the
transition period, the Fosters decided to withdraw from Foster
City as developers. In 1969, negotiations were entered into
with Centex Corp., an unrelated third party, and in 1970, a
sale was consummated with its subsidiary, Centex West, Inc.
B. DEVELOPMENT OF NEIGHBORHOOD ONE
We turn now to the development of Neighborhood One and
the roles played by Estero, the Foster partnership, and the
Alphabet Corporations. To the extent relevant, their roles in
the development of other neighborhoods will also be briefly
discussed.
As the developer of Foster City, the Foster partnership
played the leading role in the development of that community
in general and Neighborhood One in particular. However, the
partnership acted largely through Estero. The importance of
the district’s rele, therefore, cannot be overemphasized. Ac-
cordingly, we shall begin our discussion with Estero.
68 80 UNITED STATES TAX COURT REPORTS (34)
1. Estero
Estero was incorporated on July 7, 1960, and was formally
organized at the first meeting of its board of directors on
September 8, 1960.
In September 1960, Estero contracted with WH & B for the
performance of the engineering and surveying services neces-
sary to complete the reclamation of the entire 2,600-acre tract.
Plans and specifications were prepared and submitted to the
district in December 1960. Bids for the necessary reclamation
work were immediately solicited from area contractors. A
contract for the preliminary field work had been previously
awarded to a local contractor.
In order to finance the reclamai«™ of Brewer’s Island,
Estero called a special election in December 1960 to authorize
bonded indebtedness of $22 million. The bond issue passed by a
vote of 138,025 to zero. At the election, the only authorized
voter was the landowner, the Foster partnership.
At about this time, Estero resolved to commence a judicial
proceeding to validate its creation and determine its right to
issue bonds. Such a proceeding was expressly authorized by
the Estero Act. Estero thought that this action would
facilitate both the awarding of contracts and the sale of its
bonds. In July 1961, a judgment was rendered in an uncontest-
ed in rem proceeding in the Superior Court of San Mateo
County which purported to establish the constitutionality of
the act and the validity of the district’s bonds.
In March 1961, Estero determined that the bids received for
the proposed reclamation exceeded both its engineer’s esti-
mate and the district bond authorization. Accordingly, it
rejected them and determined instead to negotiate directly
with qualified contractors. Estero also adopted a procedure for
the payment of claims and the issuance and payment of
warrants. This procedure was adcpted, in part, to enable the
district to pay some of the outstanding bills against it in the
form of warrants. Also that month, the Planning Commission
SEC. 121. The board may, in its discretion. before or after issuance, commence in the
superior court of the county, a snecial proceeding to determine its right to issue the bonds
and their validity * * * The board may use the same procedure to validate the creation of
(34) FOSTER v. COMMISSIONER 69
of San Mateo County commenced formal review of the general
plan of Foster City.
In June 1961, Estero awarded the sale of its first series of
bonds (land reclarmation general obligation bonds which had
been authorized the previous December) to the Republic
National Bank. The face amount of these bonds was
$2,300,000, and their repayment was guaranteed by the
Fosters. Estero also adopted an official map for purvoses of
district taxes. Later that month, the San Mateo County Board
of Supervisors approved both the district’s general plan and its
agreement with the county for the maintenance of its drainage
system.
In July 1961, Estero determined that the necessary reclama-
tion work could be performed most economically by contract-
ing with Midwest Dredging Co. (Midwest) to furnish dredged
material for landfill and another contractor for land prepara-
tion. Midwest was a corporation 90 percent of whose shares
were owned by the Fosters and which was incorporated during
that month. Accordingly, in August, a contract was entered
into calling for Midwest to provide hydraulic fill from San
Bruno Shoal at a guaranteed contract price per cubic yard.
Under the contract, Midwest was to furnish all labor and
supplies while Estero was to furnish the equipment under a
lease-purchase agreement. It was understood that Associated
Dredging Co., an unrelated third party, would serve as
Midwest’s subcontractor and would actually operate the
equipment.
Immediately upon contracting with Midwest, Estero ar-
ranged for the purchase of the necessary dredging equipment
at a cost of approximately $575,000. Several months were
consumed in modifying this equipment. The sand barges, for
example, were located on the Great Salt Lake in Utah at the
time of their purchase by the district; they had to be cut into
pieces and shipped by train to Oakland, where they were
reassembled. Thus, the actual filling operation did not begin
until spring 1962.
The landfill operation was the major engineering feat in the
development of Foster City. Accordingly, it would be helpful to
digress for a moment in order to briefly describe it.
The first step of the operation involved dredging sand from
San Bruno Shoal and pumping it into barges. The barges were
70 80 UNITED STATES TAX COURT REPORTS (34)
then moved by a tugboat to the shore of Foster City where the
sand was dumped into the bay. The sand was then redredged
and pumped by a 3500-horsepower engine through a large pipe
to the particular area being filled. It was carried by the
medium of water, which was then pumped back into the bay,
leaving the sandfill. By moving the pipe, the island was filled,
neighborhood by neighborhood, at the rate of approximately 4
million cubic yards per year. As each area was filled, the next
stage of reclamation—land preparaticn—would begin, starting
with the grading and contouring of the fill.
Estero subsequently canceled its contract with Midwest
after the State attorney general questioned the arrangement
as a possible conflict of interest. During the life of the contract
(August 1961 to December 1962), the cistrict made payments
of approximately $2,400,000 to Midwest for the design and
mobilization of the dredging equipment, dredging operations,
and various other related expenses.
After Estero canceled its contract with Midwest, it entered.
into a new contract with an unrelated dredging company.
Under the new contract, the district agreed to furnish and
retain ownership of the equipment, and the contractor agreed
to perform all services and to maintain the equipment.
In August 1961, Estero also entered into a variety of other
contracts. It contracted with a construction company for land
reclamation work related to the digging of the lagoons and
other land preparations. It contracted with WH & B for
engineering services related to the design of a sewage disposal
plant and the community facilities to be constructed in
Neighborhood One. It also contracted with D & M for certain
soil and foundation investigation services, including test
borings necessary for the construction of various community
facilities and again with D & M for other soil engineering
services. '
In October 1961, Estero contracted with a Palo Alto firm for
engineering services related to aerial mapping and the design
of the Hillsdale-Marina Lagoon bridge. This bridge was
intended to provide the principal access te Foster City. At the
time, the only other access was a narrow, wooden bridge that
went past the San Mateo sewer plant and garbage dump and
was otherwise inadequate for the traffic. The Fosters consid-
ered the new bridge essential to their marketing plans. In May
a ehea alia cables) crate) EA ATA ie
Fee RT I Hee Re WERE
See sia WANE bench ER I ribet BM Perla
me ABSTD
pore
(34) FOSTER v. COMMISSIONER 71
1962, Estero accepted a bid from a builder for the construction
of the bridge, and work began immediately. The bridge was
opened to traffic in May 1963.
By October 1961, subdivision plans for Neighborhood One
had been submitted to San Mateo County and a development
schedule had been prepared by Estero’s engineers. It was
anticipated that funds would be needed in early 1962 to begin
the construction of water, sewer, and street improvements, as
well as to meet outstanding commitments related to the
mobilization of the dredging equipment. Accordingly, Estero
resolved to call a special election to authorize bonded indebt-
edness of $3 million for a water project, $19 million for
lighting and drainage, including street improvements, $4
million for a sewer project, and $1,500,000 for parks and
playgrounds, as well as revenue bonds of $2 million for water
facilities and $4 million for sewer facilities. Estero also
resolved to call for bids on $10,900,000 of the general obliga-
tion land reclamation bonds that had been previously author-
ized as well as $1,700,000, $3,500,000, and $1,700,000, respec-
tively, of general obligation water bonds, street improvement
bonds, and sewer bonds.
At the special election in November 1961, each of the five
bond issues passed by a vote of 7,667,010 to zero. At the
election, the only authorized voters were the landowners, the
Foster partnership, and a Foster-controlled corporation, Fos-
ter Bayou Corp., which was owned by the partnership and to
which a small parcel of land had been previously conveyed.
(Foster Bayou Corp. plays a role in Issue 2, infra.) At the same
time, Estero awarded the sale of $2,600,000, $500,000,
$800,000, and $600,000, respectively, of general obligation land
reclamation bonds, water bonds, street improvement bonds,
and sewer bonds to an underwriter; the remaining bonds were
not sold at that time.
In January 1962, Estero contracted with WH & B for
engineering services related to the preparation of plans and
specifications for the major drainage facilities to be used in the
land reclamation project. Estero also approved the plans and
specifications, previously submitted by WH & B, for a water
supply line to connect the district with the water mains of the
San Francisco Water Department in San Mateo. The waterline
was to cross into Foster City, suspended from the bottom of the
72 80 UNITED STATES TAX COURT REPORTS (34)
Hillsdale-Marina Lagoon Bridge. At the same time, Estero
approved a contract with San Mateo authorizing the district to
install and maintain the waterline under the public streets of
that city. In February 1962, a contract was awarded to an
Oakland company for the actual construction of the waterline.
Easements from private parties were also obtained to permit
the installation and maintenance of the line.
In April 1962, Estero approved a contract for the construc-
tion of a 6,300-foot sewer outfall line. It also extended an
earlier contract for additional lagoon excavation and land
preparation. Another contract was awarded to an electrical
contractor.
In May 1962, Estero obtained an easement from the State of
California for the construction, operation, and maintenance of
the sewer outfall line. As previously mentioned, the district
also approved a contract for the construction of the Hillsdale-
Marina Lagoon Bridge. Later that month, it awarded to an
underwriter the sale of $7 million, $750,000, $1,450,000, and
$800,000, respectively, of general obligation land reclamation
bonds, water bonds, street improvement bonds, and sewer
bonds, all of which had been previously authorized.
During July 1962, Estero executed a number of additional
work orders under existing contracts with several contractors.
It also entered into an agreement with Pacific Gas & Electric
Co. for the use of the latter’s right-of-way to construct a waste
water channel. Another contract was entered into with D & M
for consulting services related to soil engineering.
In August 1962, Estero contracted with a consulting firm for
city planning services. The contract was designed to insure
that the basic features of the general plan were coordinated
with the specific engineering plans for the various community
facilities that were being constructed by the district. Estero
also awarded a contract for the construction of the sewage
disposal plant.
In September 1962, Estero awarded a contract for the
construction of lagoon shoreline improvements. The previous
month, it had approved the plans and specifications prepared
by WH &B.
From September 1961 through October 1962, Estero issued
checks in the following aggregate amounts for reclamation
and other development from the indicated funds:
Se ee
(34) FOSTE =. COMMISSIONER 73
Reclamation Other development® Total
1961 September - December --- --- $690,853.43
1962 January $501,464.79 $162.12 501,626.91
February 443,770.03 128,197.47 571,967.50
March 354,684.93 33,170.99 387,855.92
April 461,976.39 102,149.52 564,125.91
May s*- ---
June 84 643. 50 58,202.69 142,846.19
July 405,944.65 82,687.50 488,632.15
August 200,118.27 163,617.14 363,735.41
September 366,026.07 312,036.83 678,062.90
October 280,724.69 188,600.68 469,325.37
Subsequent to October 1962, Estero continued to contract for
the development of Neighborhood One. Major contracts were
awarded in February 1963 for the construction of community
facilities in unit 1 and in August 1963 for the construction of
community facilities in unit 2. Landscaping contracts were
awarded in January and April 1965.
Estero also continued to call special elections to approve
bonded indebtedness intended to finance the overall develop-
ment oi: Foster City. For example, in March 1964, an addition-
al $26,100,000 in general obligation bonds were approved for
land reclamation ($8,505,000) as well as the construction of
street improvements ($3,710,000), parks and playgrounds
($335,000), fire stations ($600,000), water projects ($5,440,000),
and sewer projects ($7,510,000). At this election, the bond
issues again passed unanimously (10,285,000 to zero) with the
landowners, principally the Foster partnership, being the only
authorized voters.
Estero also continued to regulate development. For example,
in July 1964, it passed a sewer ordinance.
The 216 acres of Neighborhood One had been reclaimed and
were available for building no later than mid-1963. By March
1964, unit 1 had been completed with sewer and waterlines,
storm drains, paved streets, street lights, and underground
electric and telephone utilities. By January 1965, unit 2 had
been similarly completed.
It should be emphasized that the development of Foster City
was a continuous, ongoing undertaking. As land in one
neighborhood was being improved, land in another was being
reclaimed. During the 1960’s, Estero played a crucial role in
2General fund, water fund, sewage fund, and street improvement fund.
74 80 UNITED STATES TAX COURT REPORTS (34)
the reclamation and improvement of the various neighbor-
hoods by contracting for and financing their development.
Contracts which Estero awarded in respect of the other
neighborhoods resembled those described above. A representa-
tive sampling of major contracts includes agreements for the
construction of three additional bridges, one in February 1964
and two in April 1965; agreements for land preparation in
Neighborhoods Four, Seven and Eight, and Five and Six in
November 1964, September 1965, and May 1966, respectively;
agreements for the paving of roadways in Neighborhoods Two,
Three, and Four in October 1964, April 1965, and June 1965,
respectively; and agreements for the construction of improve-
ments in Neighborhoods Nine and Eight in June 1966 and
January 1968, respectively. Certain of these contracts exceed-
ed $1 million.
2. The Foster Partnership
The role played by the Foster partnership in the develop-
ment of Foster City prior to September 8, 1960, the date on
which Estero was formally organized, has already been
described. Accordingly, only its role subsequent to that date
will be discussed. We start, however, with the supporting roles
played by its partners.
Jack Foster was the ultimate authority among the Fosters
at Foster City. He took particular interest in, and responsibili-
ty for, the financial aspects of the project. During the 1960’s,
he resided in Pebble Beach, Calif., approximately a 2-hour
drive from Foster City. During that period, he generally spent
3 or 4 days per week in the San Mateo area working on the
Foster City project. The balance of his time, he spent at home
involved in other projects in California and elsewhere. In 1965,
Jack Foster discovered that he had cancer. Over the next
couple of years he became increasingly less active in the Foster
City project. By early 1967, he was confined to bed and never
returned to his office in Foster City. He died in March 1968.
Jack Foster, Jr., was general manager of the Foster City
project from November 1960 until the Fosters sold their
interest as developers in 1970. As general manager, he was
responsible for the overall development of the project and was
in charge in his father’s absence. With the decline in his
father’s health, he assumed even greater responsibility. Until
ord
Ce ey We eee Cae Pe ee Tree og me
(34) FOSTER v. COMMISSIONER 75
he moved to Foster City, he resided in a neighboring communi-
ty approximately 5 minutes away. Virtually all of his time was
devoted to the Foster City project.
Principally because of his training in geology, Bob Foster
was assigned primary responsibility for monitoring the prog-
ress of the landfill operation. His function was to insure that
the land would be suitable for home construction after the fill
and grading were completed. He was also responsible for
insuring that a particular earthquake-resistant foundation
was installed by all builders in Foster City.
Finally, Dick Foster came to Foster City in July 1963 from
Hawaii. His principal role involved supervising the construc-
tion of various commercial buildings which the Fosters intend-
ed to hold for investment purposes.
At least through 1967, the year in which the composition of
Estero’s board of directors began to change, the Foster
partnership and the district had a very close working relation-
ship. They were united in their goals for the reclamation of the
land, the sale of the lots, and the construction of improve-
ments, and they cooperated fully in the development process.
One or more of the Fosters frequently attended board meet-
ings, especially during Estero’s formative period, and were
generally familiar with the agenda ahead of time. George
Shannon, one of Estero’s directors and its secretary, tax
assessor and collector, and later its general manager when the
preceding offices were consolidated, regularly attended the
Fosters’ weekly planning sessions. The Fosters served as
judges and inspectors at the district’s elections and never
protested the value at which their land was appraised.
On occasion, the Fosters acied as agents for Estero. For
example, in 1961 Jack Foster, Jr., negotiated the purchase for
the district of land in San Mateo which was needed for the
approach to the Hillsdale-Marina Lagoon Bridge. All of the
Fosters, particularly Jack Foster, actively promoted the sale of
Estero bonds to banks and other potential purchasers.
The Foster partnership also loaned money to Estero when
the district’s finances required such assistance. For example,
lacking street funds, Estero obtained a $75,000 loan from the
partnership in January 1962 so that it could acquire the bridge
approach which Zack Foster, Jr., had negotiated for it the
previous month. Because of inadequate bond sales, Estero
76 80 UNITED STATES TAX COURT REPORTS (34)
obtained a commitment in November 1962 from the partner-
ship to loan sufficient funds to permit land reclamation to
continue. In October 1967, the district obtained a temporary
loan from the partnership in the amount of $2,325,000 for
various improvement projects.
Jack Foster assigned tu. Estero various permits and licenses
which he had obtained on behalf of the Foster partnership and
which were essential to the dredging operation. For example,
no later than September 1960, Foster assigned a permit to
_ dredge San Bruno Shoal which had been obtained in 1959 from
the U.S. Army Corps of Engineers. In October 1962, he
assigned a mineral lease with the California State Lands
Commission permitting the extraction of sand from San Bruno
Shoal.
Jack Foster also assigned to Estero various contracts which
he had previously entered into on behalf of the Foster
partnership. In March 1961, he assigned, and Estero assumed
the full indebtedness under, an engineering contract which
had been entered into with WH & B in November 1959. This
contract involved the preparation of the general planning and
engineering guide for the reclamation of land on Brewer’s
Island. In March 1961, he assigned, and Estero again assumed
the full indebtedness under, engineering contracts which had
been entered into with D & M in March and July 1960. These
contracts involved site investigation on Brewer’s Island and
additional sand exploration of San Bruno Shoal.
In May 1961, Estero approved the payment of claims in the
amount of $368,809.34 to the Foster partnership for expenses
incurred on behalf of the district. A significant amount of the
those expenses was for services rendered by WH & B and D &
M before the district was established. In November 1961,
Estero approved the payment of claims in the amount of
$66,843.28. Most of this amount related to payments made by
the partnership to WH & B for engineering services. In
February and April 1962, Estero again approved the payment
of claims in the respective amounts of ©75,336.71 and
$48,916.49 for expenses incurred by the partnership on behalf
of Estero.
The Foster partnership granted various interests in land to
Estero. In February and July 1962, easements were granted
for the purpose of constructing and maintaining water supply
(34) FOSTER v. COMMISSIONER 77
lines. In April 1965, a parcel in fee and two easements were
granted in Neighborhood Three for boating and water usage.
In December 1965, an easement was granted for the mainte-
nance of the Neighborhood Four lagoons. Other easements
which the partnership granted will be described hereinafter.
Estero contracted with the Foster partnership for specific
services. In August 1964, for example, Estero entered into an
agreement with the partnership for financial and accounting
services.
The Foster partnership participated in the construction of
improvements in Foster City by entering into a variety of
contracts. For example, at the time that Estero awarded the
contracts for the construction of community facilities in
Neighborhood One, the partnership separately contracted for
the necessary underground utility work. Other contracts
entered into by the partnership in respect of Neighborhood
One will be described hereinafter. Contracts in respect of other
neighborhoods include tripartite agreements entered into by
the partnership, Estero, and San Mateo County: in June 1964,
for the construction of improvements in Neighborhood Two; in
July 1965, for the construction of community facilities in
Neighborhood Three; in November 1965, for the construction
of community facilities in Neighborhood Four; in February
1967, for the construction of community facilities in Neighbor-
hood Nine; in March 1968, for the construction of improve-
ments in Neighborhood Eight; and a bilateral agreement
entered into by the partnership and Estero for the electrical
work in the industrial park. The partnership entered into
several of these contracts at times when acreage in several
affected neighborhoods was titled in the names of other Foster
entities. This matter will be discussed subsequently.
Finally, the Foster partnership held itself out and was
regarded as the developer of Foster City. For example, the
“Foster City Report,” a promotional newsletter published by
the Fosters, referred to the partnership as the developer.
Estero’s bond prospectuses also referred to the partnership as
the developer. Correspondence between the Fosters and the
Federal Housing Administration characterized the partner-
ship as the developer of Foster City.
78 80 UNITED STATES TAX COURT REPORTS (34)
3. The Alphabet Corporations
The Alphabet Corporations were formed in September or
October 1962. On October 3, 1962, they acquired their equal,
undivided interests as tenants-in-common in the 127 acres of
land in units 1 and 2 of Neighborhood One.
The Alphabets acted in concert through Foster T. Corp.
They did not open separate bank accounts but rather main-
tained a single account in the name of Foster T. Corp. which
was opened in June 1963 and remained active through October
1968. They had no employees or office space separate from the
partnership and the other Foster entities. The Alphabets filed
Federal income tax returns for the taxable years 1963 through
1969.
From July 1963 through December 1965, the Alphabets
collected $2,023,900 from the sale of lots in Neighborhood One.
These proceeds were deposited into the bank account of Foster
T. Corp. During that same period, the Alphabets transferred
$2,052,500 in stated loans to the partnership for its use in the
further development of Foster City.
During the course of the development of Neighborhood One,
the Alphabets entered into agreements with, and granted
easements to, Estero. However, they were joined in these acts
by either the Foster partnership or Jack Foster acting on
behalf of the partnership. For example, in January and
October 1963, agreements were entered into by the Alphabets,
the partnership, Estero, and San Mateo County for the
construction of improvements in two tracts of Neighborhood
One. In April 1963, the A‘phabets and the partnership granted
an easement to Estere fer the maintenance and operation of
lagoons in Neighborhood One.
The Alphabets also entered into agreements with other
parties. Again, however, they were joined in these contracts by
either the Foster partnership or Jack Foster acting on behalf
of the partnership. For example, in May and December 1963,
the Alphabets and the partnership entered into agreements
with Pacific Gas & Electric Co. to provide gas and electric
service to unit 1 of Neighborhood One.
Included within the 127 acres of land in Neighborhood One
were a number of waterfront (lagoon) lots. These lots were not
sold but rather leased by the Alphabets to builders who would
construct and sell homes subject to 75-year ground leases. The
AN ti ia ica ihe
. ae tie ae hilt a ae
(34) FOSTER v. COMMISSIONER 79
income derived by the Alphabets from this activity was not
reallocated by respondent.
The involvement of the Alphabet Corporations in Foster
City was not confined to Neighborhood One. In January 1964,
the Alphabets and the partnership contracted with Estero for
the construction of improvements in part of the industrial
park. In May 1967, the Alphabets purchased lots in the
industrial park from Lomita Homes, a subsidiary of Likins-
Foster Honolulu Corp., which had previously purchased them
from the partnership in 1964 and 1965. In late 1965, the
Alphabets undertook to construct the Commodore Apart-
ments, the first section of which was completed in early 1967.
These apartments were located in Neighborhood One and were
built on land owned by the Foster partnership. Their construc-
tion was financed in part by bank and insurance company
loans and in part by proceeds derived from the sale of lots in
Neighborhood One. In 1968, the Commodore Apartments were
sold to a third party in order to obtain working capital. At the
time, the Foster partnership was experiencing a serious cash
flow problem and the sale of the apartments was part of a
program to partially liquidate investment property in order to
insure the survival of the Foster City project.
C. SALE OF LOTS IN NEIGHBORHOOD ONE
The Fosters originally anticipated that income from the sale
of lots in Neighborhood One would first be derived in 1962.
However, the first block of sales was delayed primarily
because the filling operation took longer than had been
anticipated. By November 1962, the Fosters were projecting
income by January 1963.
Negotiations between the Fosters and interested builders for
the sale of lots in unit 1 of Neighborhood One began in 1962.
The Fosters discovered that there were so many contractors-in
the Bay area who were eager to build in Foster City that it was
not necessary to reduce the asking price.
In January 1963, a subdivision map of unit 1 of Neighbor-
hood One was recorded with the county of San Mateo. The map
had previously been reviewed by both the county planning
commission and engineer and approved by the board of
supervisors. Sales of lots were not permitted until the map was
recorded. However, recordation necessitated the posting of a
80 80 UNITED STATES TAX COURT REPORTS (34)
subdivision bond by the developer to insure that all improve-
ments would be completed to the county’s satisfaction. Recor-
dation also precipitated a reappraisal for real estate tax
purposes and generally higher taxes. Accordingly, it was
usually advantageous for the developer to delay recordation
until sales were anticipated.
Unit 1 of Neighborhood One consisted of 626 lots. Of this
number, 410 were tract lots for outright sale and 216 were
waterfront (lagoon) lots which were to be leased to builders
who would construct and sell custom homes subject to 75-year
ground leases.
The first sales were made in June 1963 to three prominent
west coast builders for between $5,000 and $6,000 per lot. In
August, construction began, and the first homes were com-
pleted that fall. In 1963, a total of 247 tract lots were sold and
11 waterfront lots were leased to four different builders.
Additional lots were sold and leased in 1964 and 1965. The
disposition of certain lots was delayed, however, because of
FHA regulations regarding fill and foundation.
D. ROLE OF DEL CHAMPLIN
A. O. “Del” Champlin was born in 1911. He attended the
University of Oklahoma, majored in accounting, and gradu-
ated in 1932. In 1935, he became licensed to practice as a
certified public accountant in Oklahoma and had offices in
Oklahoma City. For most of his career, he practiced account-
ancy as a partner in various accounting firms which typically
employed a number of staff accountants. Champlin supervised
the detail work involved in matters such as performing audits
and preparing returns and personally provided income tax,
business, and financial planning services to his clients.
Champlin met Jack Foster through V. B. Likins, for whom
he had been performing accounting services, and was retained
by him. Champlin serviced both Foster individually and the
various Likins-Foster businesses and became one of their
principal tax planners. He was frequently called upon to
structure transactions in order to achieve favorable tax
consequences. One of his favorite techniques was multiple
incorporation and as a consequence Foster and Likins ended
up with many different corporations.
After Jack Foster severed his business relationship with
(34) FOSTER v. COMMISSIONER 81
Likins in 1955 and went into partnership with his sons,
Champlin and his firm continued to perform a broad range of
accounting services for the Fosters. He continued to function
as one of their principai tax planners. Certain transactions
which he structured during the immediate post-Likins period
resulted in litigation before this Court.”
Champlin remained in Oklahoma after Jack Foster moved
to California in. 1958. However, as the Fosters became increas-
ingly interested in the prospect of undertaking the Foster City
‘project, Champlin began spending more and more time in
California. At the request of Jack Foster, he moved to San
Mateo in January 1961 and became licensed to practice as a
C.P.A. in California. Although he continued to function as an
independent contractor, the Fosters were virtually his only
client and he shared their offices. The rest of his firm
continued to service the Foster account from Oklahoma.
At Foster City, Champlin became the Fosters’ principal tax
adviser and architect of their tax planning. He was expected to
minimize their taxes to the extent possible and to postpone the
payment of those taxes which could not be avoided because the
Foster partnership needed to retain as much cash as possible
for the evelopment of Foster City. The value of money on
hand to the Fosters far exceeded any interest that might
eventually have to be paid on a tax deficiency, especially when
the rate of interest that the Government charged was less than
that charged by commercial banks. Accordingly, a particular
tax strategy was not necessarily rejected merely because it
might result in litigation or even ultimately fail. The more
important criterion was the extent to which that strategy
would promote the immediate availability of cash for the
partnership’s use in developing Foster City.
In order to minimize taxes, Champlin sought to shift income
among multiple entities. He was responsible for the creation of
numerous trusts and corporations. In 1962, Jack Foster
claimed that he alone owned some 52 corporations. This
multiplicity of entities frequently complicated the Fosters’
operations. Champlin also sought to postpone the payment of
™* Foster v. Commissioner, T.C. Memo. 1966-273, and T.C. Memo. 1967-207, modified and
remanded sub nom. Likins-Foster Honolulu Corp. v. Commissioner, 417 F.2d 285 (10th Cir.
1969).
82 80 UNITED STATES TAX COURT REPORTS {34)
taxes by engaging in a variety of stalling tactics whenever the
Commissioner undertook to audit the Fosters or one of their
entities. For example, the adjustments in the case involving
Likins-Foster Honolulu Corp., et al. (see note 24, supra), took
nearly 10 years to ultimately resolve.
The Fosters regarded Champlin as the “steward” of their
taxes. They reposed great confidence in his tax-planning
abilities and trusted him implicitly. They never challenged his
recommendations but rather adopted them without critical
analysis and implemented them immediately. They never
questioned him concerning his reasons for transferring acre-
age between entities or structuring a transaction in a particu-
lar manner. As a consequence, they frecuently did not
understand why certain measures were being taken.
Champlin’s recommendations dictated the basic organiza-
tional structure within which the Fosters undertook to develop
Foster City. He determined that it would be advantageous
from a tax standpoint for them to begin in partnership form.
Losses incurred during the early years could be utilized by the
partners to reduce income on their personal returns. Later, as
land was developed, acreage could be transferred to a corpora-
tion in an effort to shift income to a taxpayer subject to a lower
rate of tax.
In 1962, Champlin determined that corporations should be
formed for the purpose of taking title to some of the land in
Neighborhood One. Accordingly, the Alphabets were incorpo-
rated, and the 127 acres were transferred to them. Champlin
even designated the particular acreage that was conveyed. The
Fosters did not question the transfer nor did they inquire
about the reason for it. Rather, they assumed that it was for
the purpose of minimizing their income taxes.
E. ULTIMATE FINDINGS OF FACT
Estero was controlled and dominated by the Foster partner-
ship.
The Foster partnership used Estero as its instrument for the
development of Foster City.
The Foster partnership was responsible for the development
of ':eighborhood One.
The Foster partnership earned the income derived from the
sale of lots in Neighborhood One.
(34) FOSTER v. COMMISSIONER 83
The 127 acres of land in Neighborhood One were conveyed to
the Alphabet Corporations in order to shift income from the
Foster partnership and split it among four other taxpayers.
The 127 acres of land in Neighborhood One were conveyed to
the Alphabet Corporations in order to avoid Federal income
taxes.
IV. Facts RELATED TO THE SALE oF Lots
IN NEIGHBORHOODS Two AND THREE (Issue 2)
Neighborhoods Two and Three were the next neighborhoods
to be developed. Each consisted of 215 acres. The land in
Neighborhood Two was completely reclaimed and improved
and available for building by mid--1965, and the land in
Neighborhood Three, by mid-1966. The Foster partnership
sold lots in these neighborhoods during the taxable years
involved in this case and reported the income and deducted the
expenses related to those sales on its information returns.
In the notice of deficiency, respondent adjusted the cost
claimed by the Foster partnership in respect of its sale of lots
in Neighborhoods Two and Three as follows:
1963 1964 1965 1966 1967
($203.52) $1,000,842.67 $1,580,722.23 $67,473.87 ($164,504.72)
This adjustment was described in the notice as follows:
1.b. Cost of lot sales, neighborhoods 2 & 3
It has been determined [that] the cost of lot sales reported should be
adjusted as shown in Exhibit G-3 and supporting exhibits referred to
therein. The principal change is due to a disallowance of a $3,000,000.00
obligation incurred in the “Westway Transaction” as not being part of land
basis because: (1) there is no business substance to such transaction and (2) if
this is a valid business obligation, it is not a capital expenditure to be added
to land basis.
Only the “Westway” component of this adjustment is in
dispute.
Also in the notice of deficiency, respondent made a related
adjustment in favor of the Foster partnership to gain it
reported in 1964. This adjustment was described in the notice
as follows:
1.e. If it is ruled by a court that there is no business substance to the form
of the “Westway Transaction” as specified in item (b) above, and thus should
be disregarded, then it is held [that] the gain of $84,143.52 reported by the
me
a4 80 UNITED STATES TAX COURT REPORTS (34)
partnership on its exchange of 500 shares of Foster California Corporation
stock for 196.38 acres of land received from that corporation, will also be
disregarded, such exchange being part of the “Westway Transaction.”
As the above two explanatory paragraphs indicate, the
factual predicate of the issue involving Neighborhoods Two
and Three lies in the Westway transaction. That transaction
consisted of a complicated series of steps, the crucial one of
which involved the delivery of certain promissory notes which
the parties refer to as the Westway notes. We must ultimately
determine whether those notes were part of the partnership’s
basis in Neighborhoods Two and Three, as petitioners’ main- ,
tain, or whether they represent an obligation to pay additional
interest on money borrowed for the purchase of Brewer’s
Island, as respondent maintains. At this time, however, we
shall merely describe the Westway transaction.
A. GENESIS OF THE WESTWAY TRANSACTION .
As previously stated, the terms negotiated by Jack Foster .
for the purchase of Brewer’s Island contemplated a downpay-
ment of $2,500,000. However, the immediate payment of that
amount was not compatible with the need for cash anticipated
by the partnership once the Foster City project was actually
underway. Accordingly, the Fosters determined that most of
the downpayment would have to be financed. At that point,
they turned to the Republic National Bank.
The Fosters turned to Republic for financial assistance
because they were frequent customers of that bank and
enjoyed a good credit rating. Jack Foster in particular had a
long and cordial business relationship with the bank that
dated from the 1940’s. Over the years, he had borrowed
millions of dollars and had never been refused a loan. Republic
had been the Fosters’ major source of financing for their
previous real estate transactions and had also acted as their
lender for certain other of their undertakings such as oil and
gas ventures Never, however, had Republic ever assumed any
role in relation to the Fosters other than that of lender.
Shortly after the enactment of the Estero Act in May 1960,
the Fosters met in Dallas with senior bank officials to discuss
the possibility of financing the partnership’s downpayment on
Brewer’s Island. Participants at this meeting included Fred
Florence, Republic’s chairman of the board; James Aston, its
ee eee ey Wiis ote eo
(34) FOSTER v. COMMISSIONER 85
president; and Oran Kite, a senior vice president. The Fosters
recognized that it was customary for developers to furnish
their own downpayment and finance only the balance of the
purchase price. In order to induce Republic to advance the
necessary funds, they proposed to pay not only interest at the
prevailing market rate but also a bonus equal to the total
amount borrowed from the bank to acquire Brewer’s Island.
The bonus, however, would be payable only from half the
profits derived from the project in 5 years’ time. As an
additional inducement, the Fosters proposed to structure the
bonus so that it would be taxed to the bank as capital gain
rather than ordinary income. Del Champlin had conceived this
part of the proposal.
At the conclusion of the Fosters’ presentation, Republic’s
chairman patted Jack Foster on the leg and remarked, “I
guess we’re partners.” The parties then shook hands. The
terms of their agreement were not subsequently reduced to
writing. As in previous dealings between the Fosters and the
bank, negotiations were concluded and terms agreed upon by
handshake.
On August 19, 1960, Jack Foster purchased Brewer’s Island
on behalf of the partnership for $12,800,000. The $2,500,000
downpayment included $2 million which was obtained on
August 16, 1960, by virtue of the agreement that had previous-
ly been negotiated with Republic. The loan documents which
were executed on that date, however, reflect the involvement
of the Hoblitzelle Foundation and the Howard Corp. Before
proceeding further, we should briefly introduce those two
entities.
The Hoblitzelle Foundation was affiliated with the Republic
National Bank. It was founded by Karl Hoblitzelle, who was
Republic’s chairman prior to Fred Florence. James Aston,
Republic’s president and later its chairman, served at various
times as the foundation’s president and a mernber of its board
of directors. The Howard Corp. was a corporation t..2 stock of
which was owned by trustees for the benefit of Republic’s
shareholders.
On August 16, 1960, the Fosters entered into a purported
loan agreement with the Howard Corp. in which the latter
agreed to arrange a $2 million loan from an unspecified lender
in exchange for a $50,000 service fee. The agreement provided,
86 80 UNITED STATES TAX COURT REPORTS (34)
jater alia, that the loan proceeds were to be used for the
downpayment on Brewer’s Island. It also restricted the Fos-
ters’ right to sell or mortgage any part of Brewer’s Island
without the lender’s consent. However, transfers between the
Fosters and their controlled corporations were expressly
exempted from this restriction.
On August 16, 1960, the Fosters also executed a $2 million
promissory note payable to the Hoblitzelle Foundation. That
note was unsecured, bore interest at the prevailing market
rate (6 percent per year), was payable quarterly, and was due
absolutely and in all events in 2 years. The cash advanced
against that note was the source of most of the partnership’s
downpayment for its purchase of Brewer’s Island.
Finally, on August 16, 1960, the Howard Corp. agreed with
the Hoblitzelle Foundation to purchase the Fosters’ note, if
called upon to do so by the foundation, for an amount equal to
the unpaid balance plus accrued interest at the time of such
purchase. In addition, it agreed to pay the foundation an
amount equal to 3% percent per year on the unpaid balance of
the note during the period of the foundation’s ownership.
Notwithstanding the involvement of the Hoblitzelle Founda-
tion and the Howard Corp. in making the $2 million loan, the
Fosters at all times regarded Republic as their lender. Accord-
ingly, the fact that their note was made payable to an entity
other than the bank never led them to question whether their
agreement to pay the 100-percent bonus might not apply.
As previously stated, Jack Foster executed promissory notes
to the sellers (Leslie and Schilling) for the balance of the
purchase price of Brewer’s Island ($10,300,000). The payment
schedule for those notes called for payments of $500,000 on
August 19, 1961, and August 19, 1962. On each of those dates,
the partnership borrowed the entire amount of the payment
from Republic. Because those amounts represented part of the
purchase price of Brewer’s Island, they were subject to the
agreement to pay the 100-percent bonus.
On August 19, 1962, the original $2 million loan from the -
Hoblitzelle Foundation was extended to August 19, 1963. On
August 17, 1903, the Fosters satisfied this loan by borrowing
$2 million from Republic.
(34) FOSTER v. COMMISSIONER 87
B. MECHANICS OF THE WESTWAY TRANSACTION
By August 19, 1962, the Fosters had borrowed a total of $3
million from Republic and its affiliated foundation for the
purchase of Brewer’s Island. By the following year, all of this
amount was owed to the bank. Under the terms of the
agreement negotiated in 1960, Republic was therefore entitled
to a bonus of $3 million payable from half the profits in 5
years’ time. (The provision that the bonus be paid from half
the profits was subsequently waived by the Fosters.) Republic
was also entitled to the bonus on a capital gains basis. Del
Champlin was assigned primary responsibility for structuring
a transaction to achieve this result. What was devised was the
Westway transaction. We shall defer discussion of the tax
planning surrounding that transaction until after we describe
the form of its several steps. Suffice it to say for now that the
transaction was designed not only to insure favorable tax
consequences to Republic but to the Fosters as well.
1. On August 4, 1961, Jack Foster, acting on behalf of the
Foster partnership, conveyed 200.17 acres of land in Neighbor-
hoods Eight and Nine to Foster Bayou Corp. (Foster Bayou) in
exchange for 100 percent of that corporation’s stock, which
was titled in the name of the partnership. This exchange was
treated as a nontaxable transaction. Foster Bayou had been
formed by the partnership on or slightly before that date.
Other than the land, it had no assets. It also had no bank
account and never paid any dividends. At the time of the
conveyance, the 200.17 acres was dry land which had previous-
ly been leased by the Federal Aviation Administration to erect
and maintain radio transmitters. (Foster City is located about
5 miles south of San Francisco International Airport and 10
miles southwest of Oakland Airport.) This lease constituted
Foster Bayou’s only business activity.> Unlike the rest of the
land on Brewer’s Island, the 200.17 acres had a legal descrip-
tion. However, being part of Neighborhoods Eight and Nine, it
was not scheduled for early development. In fact, development
of Neighborhood Nine was only initiated in 1967; by the end of
2The lease was actually managed by the Foster partnership or Likins-Foster Honolulu
Corp. for which service a substantial management fee was charged.
88 80 UNITED STATES TAX COURT REPORTS (34)
1969, Neighborhood Eight was only in a state of token
development.
2. On August 7, 1962, the Foster partnership transferred its
stock in Foster Bayou to Westway Investment Co. (Westway)
for a named consideration of $5,000 in cash and a non-interest-
bearing note due August 7, 1967, in the amount of $100,000.
Westway was a subsidiary of the Howard Corp. As previously
stated, the sole asset of Foster Bayou was the 200.17 acres of
land in Neighborhoods Eight and Nine. On the date of the
transfer, this land was in essentially the same condition as
when it was originally acquired by the Foster partnership.
Westway did nothing to improve it during the period that it
held the Foster Bayou stock (Aug. 7, 1962—May 4, 1964).
Moreover, during that same period, Foster Bayou’s expenses
(such as real estate taxes) were paid by the partnership or
Likins-Foster Honolulu Corp. whenever its rental income was
insufficient in amount.
3. On April 23, 1963, the Esteroy Corp. (Esteroy) was formed
by the Foster partnership. Other than a $10,000 capital
contribution, Esteroy had no assets. It used as its address the
same post office box as the partnership. On its Federal income
tax return for the taxable year beginning April 23, 1963, and
ending February 29, 1964, Esteroy reported no gross income
and claimed deductions in the aggregate amount of $188.06,
including amortization of organizational costs in the amount
of $83.06 and franchise taxes of $105.
4. On December 3, 1963, the Foster partnership conveyed
196.638 acres of land in Neighborhoods Two and Three to
Foster California Corp. (Foster California) in exchange for 500
shares, or one-half, of that corporation’s authorized stock.”
This exchange was treated as a nontaxable transaction. Foster
California had been formed by the partnership on January 17,
1961, but had been dormant since its incorporation. Prior to
the first meeting of its board of directors on December 3, 1963,
it had not even issued stock. Prior to the conveyance of the
196.638 acres of land, it had no assets other than its initial
capital contribution of $1,200. Foster California had no bank
account, conducted no business activity, and paid no dividends.
The remaining 500 shares of Foster California’s stock was not issued until June 5, 1964.
See par. 8, infra.
(34) FOSTER v. COMMISSIONER 89
5. Also on December 3, 1963, the Foster partnership trans-
ferred its 500 shares of Foster California stock to Foster
Enterprises, Ltd. (Foster Enterprises). Foster Enterprises was
a corporation which had been formed in 1960 to hold the
Fosver Tower Hotel in Honolulu and was solely owned by the
Fosters in equal shares. It treated the transfer of the Foster
California stock as a contribution to its capital. (Foster
Enterprises also plays an important role in Issue 3, infra.)
6. In January and February 1964, Esteroy and Westway
negotiated what was in form a purchase and sale of all of the
Foster Bayou stock for a named consideration of $3,105,000,
consisting of $5,000 to be paid in cash at the closing and non-
interest-bearing promissory notes for the balance, or
$3,100,000. This latter sum was payable in the amounts of $2
million on August 19, 1966, $100,000 on August 7, 1967,
$500,000 on August 19, 1967, and $500,000 on August 19, 1968.
The promissory notes for these amounts are the so-called
Westway notes. Although they were executed by Esteroy, they
represent the first written agreement evidencing the partner-
ship’s obligation to pay the 100-percent bonus which had been
negotiated in 1960. Moreover, the notes were unconditional,
i.e., payment was not conditioned upon the earning of profits.
Finally, they were secured by a pledge of Esteroy’s stock.
Although the Westway notes were executed and delivered in
February 1964, they were dated May 4, 1964. On that date,
Westway transferred the Foster Bayou stock to Esteroy.
7. On June 2, 1964, Esteroy liquidated Foster Bayou and
entered on its books the 200.17 acres of land ii: Neighborhoods
Eight and Nine at a basis of $3,105,000. At the time that
Foster Bayou had acquired that parcel, it had debited its land
account in the amount of $1,333,648 and .iad credited “mort-
gages payable” in the amount of $1,142,664.
8. Three days later, on June 5, 1964, Esteroy conveyed the
200.17 acres of land that it had received from Foster Bayou to
Foster California in exchange for 500 shares ($5,000 par value)
of that corporation’s stock. The 500 shares represented the
remaining one-half of Foster California’s authorized stock.
9. Three days later, on June 8, 1964, Esteroy was liquidated
by the Foster partnership. At that time, its principal asset was
the 500 shares of stock in Foster California. On its final
Federal income tax return for the period beginning March 1,
90 80 UNITED STATES TAX COURT REPORTS (34)
1964, and ending June 7, 1964, it reported no gross income and
claimed deductions in the aggregate amount of $465.30,
including amortization of organizational costs in the amount
of $415.30.
At the time of its liquidation, Esteroy was indebted to
Westway in the amount of $3,100,000. On July 24, 1964, the
Fosters expressly and unconditionally assumed this indebt-
edness. At the time that Esteroy had pledged its shares as
collateral for the purported purchase of the Foster Bayou
stock, it had reserved the right to liquidate and substitute for
the pledged shares the personal guarantee of the Fosters.
10. On July 31, 1964, the Foster partnership transferred to
Foster California the 500 shares of stock in Foster California
which it had acquired on June 8, 1964, by virtue of the
liquidation of Esteroy. In exchange for its stock, Foster
California transferred to the partnership on August 4, 1964,
the 196.638 acres of land in Neighborhoods Two and Three
which it had acquired from the partnership on December 3,
1963. This transaction was treated as a taxable exchange, and
the partnership reported gain. (See the adjustment in the
notice of deficiency which was previously quoted.) Afterwards,
Foster California was a solely owned subsidiary of Foster
Enterprises.
11.In December 1965, Westway sold to Republic for
$952,176 one-half of the $2 million promissory note due
August 19, 1966, which Esteroy had executed in 1964 as part of
the pur; orted purchase price of the Foster Bayou stock. This
left Westway with a remaining receivable of $2,100,000.
Westway was subsequently merged into the Howard Corp.,
which then became the holder of that receivable.
12. By their terms, the Westway notes were due in the
months of August 1966, 1967, and 1968. The Fosters were able
to successfully negotiate certain renewals. However, by the
end of 1968, they had become delinquent in payment. This
matter will be discussed later in greater detail.
13. On June 1, 1970, Foster California (whose name had
been changed to Foster C Corp.) was merged into its parent,
Foster Enterprises. As we shall see, Foster Enterprises had a
history of substantial net operating losses. It received the
200.17 acres in Neighborhoods Eight and Nine, less some
acreage that had been previously sold, and entered the land on
(34) FOSTER v. COMMISSIONER 91
its books at $3,105,000. That amount represented Foster
California’s basis for the land and not the basis of the stock
canceied.
14. In October 1970, the Fosters withdrew from Foster City
as developers. The purchaser, Centex West, Inc. (Centex),
agreed to assume liability for the Westway notes In a
collateral agreement, Republic and the Howard Corp. agreed
to release the Fosters from personal liability in exchange for
the assumption by Centex as well as other consideration which
will be described subsequently. As far as the Fosters were
concerned, the Westway notes were satisfied at that time.
C. TAX PLANNING
The principal architect of the Westway transaction was Del
Champlin, who had conceived the idea. He was assisted by Roy
Lytle, an Oklahoma attorney who represented the Fosters
throughout the 1950’s and until his retirement in the 1960’s.
Republic was represented in this matter by James Laney, its
attorney, as well as by senior bank officials.
The objective of the Westway transaction from Republic’s
point of view was to insure that the $3 million bonus was taxed
as capital gain rather than as ordinary income. Republic
sought to achieve this objective through the purported pur-
chase of Foster Bayou stock in 1962 by Westway for $105,000
and the subsequent sale of that stock by Westway in 1964 for
$3,105,000.
The objective of the Westway transaction from the Fosters’
point of view was to raise $3 million through tax savings in
order to pay the bank its bonus. They sought to achieve this
objective by stepping up not only the partnership’s basis in the
196.638 acres of land in Neighborhoods Two and Three by
$3,105,000, but also Foster California’s basis in the 200.17
acres of land in Neighborhoods Eight and Nine by the same
amount, for a total step-up in basis of $6,210,000. They also
contemplated making Foster California a wholly owned sub-
sidiary of Foster Enterprises. By filing consolidated returns,
they hoped that the latter’s net operating losses would absorb
the income derived by the former from the sale of lots. As
events transpired, Foster California was pees oa into Foster
Enterprises in 1970.
The mechanics of the Westway transaction, as described
92 80 UNITED STATES TAX COURT REPORTS (34)
above, evolved over a period of time. Virtually from the time
that the loan and bonus were originally negotiated, there were
discussions between the parties concerning the manner in
which the transaction should be structured in order to achieve
their respective objectives. For example, in early August 1960,
Jack Foster asked Roy Lytle to attend a meeting in Dallas with
James Laney and bank officials to discuss the transaction.
Afterwards Lytle summarized for Foster a proposal which was
discussed at that meeting and from which the Westway
transaction gradually evolved: :
1. Foster will pay $50,000.00 to Howard Corporation for its services in
arranging $2,000,000.00 loan from Hoblitzelle Foundation * * *
2. Foundation will lend $2,000,000.00 to T. Jack Foster, with interest at
6%, payable quarterly, due in two years, unsecured * * *
3. There shall be organized a Delaware corporation named “Foster
. Laguna Corp.” (which name will be used unless you pick out another one
later on). This corporation shall have an authorized capital of $10,000.00. To
this corporation shall be conveyed all of Foster’s interest in a tract of land on
Brewer’s Island covering some 150 to 200 acres of land, it being intended to
cover a part of the tract that will be first developed * * * The consideration
for this conveyance will be the issuance of all of the stock of the corporation
to Foster.* * *
4. Foster will sell all of the stock of Laguna Corp. to Wayside (this is not
the exact corporate name, but it is an inactive subsidiary of Howard
Corporation which, at the present time, has no assets and no liabilities) for a
consideration of either $25,000.00 or $125,000.00 of which $5,000.00 will be
paid in cash by Wayside and the remainder of the purchase price will be
evidenced by a promissory note of Wayside running in favor of Foster due
five years hence and without interest.
5. There shall be incorporated in Delaware, but not necessarily qualified
in California, a corporation known as “Foster Bayou Corp.” having an
authorized capital of $1,000.00. Foster will pay $1,000.00 to the corporation
and receive in exchange all of the stock of this corporation.
6. Foster wii} contribute to Likins-Foster Honolulu Corg. all of the stock
of Foster Bayou Corp. so that it is a 100% owned subsidia:y of Likins-Foster
Honolulu Corp.
7. The stockholders of Wayside will give Bayou Corp. an option to
purchase all of the stock of Wayside for $5,000.00 ia cash and a note for
$2,000,000.00 due five years from the present date, withcut interest.* * * In
some way the note of Wayside to Foster is to be canceiled or we will
eliminate any reference to the note of $20,000.00 or $120,000.00, as the case
may )e, it being intended that the owners of Wayside will get the $5,000.00
in cash to pay to Foster and that the stockholders and Wayside will get back
their $5,00°.00 in cash and end up with a $2,000,000.00 note * * *
8. If any ad valorem taxes become due against the land owned by Foster
(34) FOSTER v. COMMISSIONER 93
Laguna Corp. while the stock of such corporation is held by Wayside, Foster
is to pay those taxes.*.* *
9. Foster, individually, joined with his sons and wife, shall guarantee to
the stockholders of Wayside Corp. the note of Bayou Corp., limiting the
guarantee, however, to 50% of the net profits before taxes made by the
guarantors and their corporations on the entire Brewer’s Island Project.
* * * Just how you will handle the payment of the $2,000,000.00 on your
books is up to Del [Champlin] to decide.
10. As soon as you obtain the Wayside stock you will then liquidate
Laguna Corp. into Wayside, Wayside into Bayou, and Bayou into Honolulu
Corp. In the last liquidation the $2,000,000.00 note of Bayou will not be
assumed. Immediately after the liquidation of these corporations, Laguna
Corp. will convey to Honolulu Corp. the land owned by it* * *
11. At the same time that all of the other documents are prepared some
subsidiary of Howard Corporation, or it may be Howard Corporation, will
commit itself, without commitment fee, to make available to you $500,000.00
on August 19, 1961 and $500,000.00 on August 19, 1962, each of which notes
would be for a period of one year at 6%, with interest payable quarterly.
12. For these two loans, if you took them, you would be expected to make
available $500,000.00 of capital gains. You would form other corporations
which «vould take title to the land involved, the stock would be sold to other
subsidiaries of Howard Corporation, a new corporation would issue a note for
$500,000.00, which you would guarantee to the extent of one-half of the
profits in the Brewer’s Island venture, excluding, of course, the first
$4,000,000.00 of profit, one-half of which you would be obligated to pay on
the first deal.
13. No mention was made at the conference of any obligation on your part
to borrow from the Texas lenders either of the $500,000.00 loans which
might be necessary to pay off Schilling. So far as any conversation was
carried out, you would be free to borrow that where you pleased. I got a great
speech on how much the Republic Bank loved you and how much they were
sure that you loved the Republic Bank and that if any of the papers prepared
didn’t work out satisfactorily they could always be shifted and they knew
that if you made a tremendous profit on the transaction you would be happy
to share it with the Republic Bank group. I think Mr. Florence really
believes this, but I would sure hate to see you owe them money that you
couldn’t pay. You are also correct in saying that the $2,000,000.00 capital
gain carrot was one that the Texas rabbits [i.e., the Republic bankers] wanted
very badly and they wanted it as soon as possible * * * \2"\ {Emphasis added.]
In April 1962, subsequent to the formation of Foster Bayou
but prior to the transfer of its stock to Westway, Jack Foster
27As will be recalled, the remaining $1 million of the ultimate $3 million “capital gain
carrot” did not sprout until Aug. 19, 1961, and Aug. 19, 1962, at which times the partnership
borrowed from Republic the $500,000 installments which it owed to the sellers of Brewer's
Island.
—
94 80 UNITED STATES TAX COURT REPORTS (34)
asked Roy Lytie about the 200.17 acres of land in Neighhor-
hoods Eight and Nine that had been conveyed by the partner-
ship to Foster Bayou:
In reviewing the Republic National Bank’s memorandum regarding our
transaction out here with the Howard Corporation, we agreed that we would
transfer to a corporate entity some 200 or 300 acres, which would be the first
lots to be developed and sold. Instead, we transferred to them the 200 acres
consisting of the site where the F.A.A. station is located, and that will be one
of the later or last areas developed.
I do not think this actually makes any difference because we plan to buy
back all from the corporate entity, giving them a capital gain. I am sure that
Del [Champlin] felt it would give them a greater protection for their capital
gain if they took this land that was transferred to them.
Do you recall whether you discussed this with the Bank and cleared this
particular point? Mr. Jim Cumby, Senior Vice President of the Bank, will be
here on the 10th and I would like to have a clarification on this point before
he arrives.
[Emphasis added. ]}
Later that month Lytle responded to Foster’s inquiry in the
following manner:
I have your letter * * * in which you inquired as to my discussions with
the Republic National Bank concerning the exact location of the land which
was to be conveyed to the corporation which was purchased by a bank
subsidiary. * * * At the time that I left you in California you did not know
what land would be conveyed to your corporation. We left the acreage in
round figures and it was suggested that the land would be among that that
was first filled. Later on, because we had no surveys, we took the F.A.A. lease
survey. No point has been raised that I know of as to the location of the land
owned by Foster Bayou Corp. and, frankly, I doubt if Mr. Laney or Mr. Aston
have any recollection of the discussion except by virtue of the memorandum.
Incidentally, when I got the Foster Bayou Corp. deed on record and
everything else fixed up I sent the stock certificates and all of the other
books and papers pertaining to the Foster Bayou Corp. to Mr. Laney and
said, in effect, “Here it is; you can send us the agreed purchase price (which I
think was $5,000.00) at your convenience.” I heard nothing from him for a
month and finally I wrote him and asked him if he got the papers. He
immediately answered and acknowledged receipt of them, but that was all. I
did not, in sending the papers to Laney, call attention to where the land was
located and I doubt if he knows to this date. I am reasonably sure that Mr.
Cumby will have no recollection of it because I never met him. J don’t think
it actually makes a bit of difference, but should the point be raised, I think
you can merely say that that was the only description we had that covered the
desired acreage and that it probably doesn’t make any difference anyway,
because you are going to buy back from The Howard Corporation all of the
(34) FOSTER v. COMMISSIONER 95
stock in their subsidiary company [i.e., Westway} which has no assets except
the siock in Foster Bay »u Corp.'*| [Emphasis added. ]
Subsequent to the transfer of the Foster Bayou stock to
Westway in August 1962, the Fosters and Republic continued
to discuss the manner in which the transaction should be
structured in order to achieve their respective objectives.
In early August 1963, Roy Lytie corresponded with Rex
Johnson, a senior vice president of Republic in charge of the
Foster account, concerning the renewal of the $2 million note
to the Hoblitzelle Foundation which was due later that month:
After I talked with you last week I advised Mr. Foster of your suggestions
in regard to the replacement of the Hoblitzelle Foundation $2,000,000.00
note which comes due August 19, 1963. * * * Mr. Foster and his sons have
mulled over this matter for about a week, and they say that the terms that
you have set forth are impossible to meet because the land will bring in
money just so fast and no faster. They have countered with the following
suggestions which they said they can and will meet.
4. On the bonus money he is willing to give the Howard Corporation in
exchange for the Bayou Corp. stock, notes aggregating $3,000,000.00. These
notes would be unsecured notes and would provide for payment of
$2,000,000.00 on August 19, 1966, $500,000.00 on August 19, 1967, and
$500,000.00 on August 19, 1968. These notes would bear no interest until
maturity, but would bear interest at 6% after maturity. He feels that he is
making a very substantial concession in giving an unconditional promise to
pay, because he is waiving the provision that these notes are payable only out
of and from profit. I think that we all agree that it will be extremely difficult
to draw a contract which defines profit.
. *. * bal > . *
Jack asked me to emphasize the fact that it will be impossible to give
security on Brewer's Island property. As you know, it is subject to a deed of
trust in favor of Schilling-Leslie, together with an obligation in favor of
Richard H. Grant. He said that any mortgage or deed of trust put on the
developed property would make it impossible to sell.
When we were discussing the bonus money arrangements in Mr. Laney's
office he wanted the purchase price of Westway, which owns Bayou, to be
$2,000,000.00, and he wanted a new corporation formed to hold title to some
land which, in turn, would be sold back for $100,000.00. We, of course, are
At this point in time, the parties to the Westway transaction contemplated that the
Fosters would “purchase” all of Westway's stock in order to reacquire the Foster Bayou
stock which the partnership had previously “sold” to Westway. See par. 7 of the Lytle
memorandum quoted above in the text; note that Westway is referred to as “Wayside” in
that memorandum. As events transpired, the Fosters achieved their objective by simply
“purchasing” the Foster Bayou stock from Westway.
96 80 UNITED STATES TAX COURT REPORTS (34)
willing to do this, but in view of the amendments proposed to regulations
under Code Section 61 and 421, I am afraid that you could not get capital
gains since the proposed regulations refer to options granted after July 11,
1963. It would be simpler and, in my opinion, much safer if you simply sold
the Westway stock for the $3,000,000.00 in notes which are due without
interest in 1966, 1967 and 1968, as set forth above.
{Emphasis added. }
During the fall of 1963, the Fosters continued to discuss
ways by which to structure the Westway transaction that
would not only be acceptable to Republic but compatible with
their own interests. Correspondence from Champlin to Lytle in
September 1963 reflects the Fosters’ objective of financing the
100-percent bonus through tax savings:
One of the essential reasons for concluding the transaction at this time is
the fact that the Fosters, in their financial agreements with the bank, took
the fact that this transaction would be concluded now into consideration.
The financial effect on the Fosters * * * is a substantial reduction in income
taxes because of the much higher basis. This situation affects their ability to
carry out their agreements with the bank. [Emphasis added. ]}
In January 1964, correspondence commenced concerning
the proported sale of the Foster Bayou stock. The initial
“offer” came from Westway and was addressed to the Foster
partnership:
As you know, Westway Investment Corporation is the sole owner of Foster
Bayou Corporation, which owns certain lands located on what was known at
the time of their acquisition as Brewer's Island. At the present time, our
situation is such that we would consider a sale of this interest.
Therefore, this shall constitute an offer to sell to you 100% of the capital
stock of Foster Bayou Corporation for a consideration of $3,105,000.00 to be
paid to Westway Investment Corporation. This offer shali remain open until
January 31, 1964, and unless accepted prior thereto will automatically
terminate on same date.
Ten days later, Esteroy responded as follows:
We have given consideration to your offer to sell 100% of the capital stock
of the Foster Bayou Corp. as contained in your letter of January 13, 1964. We
would propose to buy this stock on the following terms and conditions:
The sum of $5,000 to be paid in cash upon c.osing and the sum of $100,000
on August 7, 1967; $2,000,000 on August 1Y, 1966; $500,000 on August 19,
1967 and $500,000 on August 19, 1968. Notes will be given for the different
amounts and said notes will be non-interest bearing prior to maturity. The
notes will be secured by pledge of all of the stock of the Esteroy Corporation
owned by T. Jack Foster & Sons.
| think we should advise you that we contemplate the liquidation of Foster
(34) FOSTER v. COMMISSIONER 97
Bayou Corp. if Esteroy shouid acquire that stock. It probably makes no
difference to you, but we wanted you to understand what we planned to do.
The Westway notes were delivered in February 1964.
Shortly thereafter, a pledge agreement was executed. Under
its terms, Esteroy agreed not to permit its own liquidation
unless and until the Fosters, individually and unconditionally,
agreed to guarantee payment of the Westway notes. However,
Esteroy was liquidated in June 1964 and it was not until the
following month that the Fosters notified Republic of that fact.
At that time, they expressly assumed liability for the Westway
notes.
D. POST-MATURITY DEVELOPMENTS
By their terms, the Westway notes were due as follows:
Amount Due Holder®
$2,000,000 8/19/66 Westway ($1 million);
Republic ($1 million)
3 100,000 8/ 7/67 Westway
500,000 8/19/67 Westway
500,000 8/19/68 Westway
3,100,000
By mid-1966, the Foster partnership was experiencing
financial difficulty principally related to cash flow. Although
Republic was no longer eager to loan additional amounts, it
did agree to renew the $2 million note to August 19, 1967. By
that time, however, the partnership’s financial position had
deteriorated further and Republic was becoming increasingly
concerned. Nevertheless, in October 1967, Republic again
agreed to renew the $2 million note and the first $500,000 note
(originally due Aug. 19, 1967) to October 30, 1968. In exchange,
however, it demanded interest at the rate of 1 percent above
As will be recalled, Westway was the named payee of all of the notes but transferred $1
million of the $2 million note to Republic in December 1965. Subsequentl;, it merged into
the Howard Corp. For the sake of convenience, however, Westway will be referred to as the
holder of the indicated notes.
“This note was offset by Westway's $100,000 note which was also due on Aug. 7, 1967. As
will be recalled, Westway’s note represented all but $5,000 of the stated consideration for its
“purchase” of the Foster Bayou stock in 1962. Because of the offset, neither the Fosters nor
Republic considered this note as part of the “Westway notes” for purposes of the
negotiatioris which will be described above.
98 80 UNITED STATES TAX COURT REPORTS (34)
prime, a mortgage on all of the real property in Foster City
owned by the partnership and the related Foster corporations,
and the Fosters’ individual guarantees.
Immediately after the second renewal in October 1967, the
Fosters began to seek additional time within which to satisfy
the Westway notes. By letter dated October 31, 1967, Jack
Foster, Jr., wrote to John Stuart, a vice president of Republic
who at that time was responsible for the Foster account:
For purposes of financial planning with particular emphasis on aiding us
in the retiring of our obligations to the Republic National Bank, it is
important that we have some idea as to the position of the Republic National
Bank regarding the $3,000,000 Westway debt. (I shall refer to this as the
Westway debt even though I realize a portion of it is now in the Republic
National Bank.)
We will be materially aided in attaining ovr goals of meeting these
obligations, as well as to put our financial house in order, if the Bank will
agree to handling this Westway debt as follows:
Subject to the payment of all debt now owing the Republic National Bank
by the Foster partnership and all related corporations, except the Westway
debt, and
Subject to securing an investor who will provide new capital in the form of
a loan
This text is long and has been trimmed here. Open the source document for the complete record.
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.