Opposition Brief — Foster v. Commissioner

——-

Supreme Court, U.S.

(3) : FILED

No. 85-512 NOV 27 1985

JOSEPH B. SPANIOL, JR.

| Ou the Supreme Court of the Hnited States

OCTOBER TERM, 19°75

ae

RICHARD H. FOsTER, ET AL., PETITIONERS

V.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS FOR

THE NINTH CIRCUIT

MEMORANDUM FOR THE RESPONDENT IN OPPOSITION

CHARLES FRIED

Solicitor General

Department of Justice

Washington, D.C. 20530

(202) 633-2217

TABLE OF AUTHORITIES

Page

Cases:

Commissioner v. First Security Bank,

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Crane v. Commissioner, 331 U.S. 1 ............ 7

Keller v. Commissioner,

pk eS ey eR Oe | Er 7

National Securities Corp. v. Comniissioner,

137 F.2d 600, cert. denied, 320 U.S.

BM SS RR oe ee 5,6

Old Colony R.R. v. Commissioner,

SR BE aa re ee 4,8

Rooney v. United States, 305 F.2d 681 ......... 5

Stewart v. Commissioner, 714 F.2d 977 ........ 6

United States v. Basye, 410 U.S. 441 ........... 7

United States v. Mississippi Chemical

PE 1 oko 2 Wan as es caseccccssee 8

Statute and regulation:

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

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I ee se ae 2

aa ay cade bas sos ckkeig 04 cA 2, 3,5, 6,7

RR ee ee 3

_ERRSENR ei anne se Meine COCR ap 3

ee Se 7

II

Page

Statute and regulation—Continued:

Treas. Reg. :

2.5 (()) 0) coe 5

8.925 | () oor 5

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Miscellaneous:

H.R. Rep. 2, 70th Cong., Ist Sess.

(1927) oc cccccccccccccsccccccvcccccccececes 5

In the Supreme Court of the Hnited States

OCTOBER TERM, 1985

No. 85-512

RICHARD H. FOstsr, ET AL., PETITIONERS

A

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS FOR

THE NINTH CIRCUIT

MEMORANDUM FOR THE RESPONDENT IN OPPOSITION

This income tax case concerns the tax ramifications of

petitioners’ development of Foster City, California. The

many issues raised in the petition turn on the facts and

circumstances involved, and were correctly decided in the

Commissioner’s favor by the courts below. There is no

conflict among the circuits or other consideration warrant-

ing this Court’s review.

1. Jack Foster and his three sons did business as a part-

nership (Pet. App. II, at 1-2).! The partnership purchased a

barren and partially submerged tract of 2,600 acres in the

San Francisco Bay area, reclaimed and developed it with

‘Petitioners’ wives are parties to this case solely by virtue of having

filed joint income tax returns with their husbands for the relevant tax

years. Jack Foster died after the period in suit and his estate has been

substituted as a party.

(1)

2

the aid of a quasi-public improvement agency that the

partnership controlled, and marketed the improved lots for

residential and commercial uses (Pet. App. II, at 1-3, 15-17; -

Pet. App. III, at 74-77). The area is known as Foster City

and has 35,000 residents. Petitioners’ role in the creation of

Foster City gave rise to the two principal issues in this case.

a. After improving certain of the lots in “Neighbor-

hoods” One and Four of Foster City, the partnership trans-

ferred them to five corporations that petitioners controlled

(Pet. App. II, at 7-8). Four of the corporations, known

collectively as “the Alphabets,” were newly formed to take

title to the properties; the fifth, Foster Enterprises, had been

incorporated several years earlier and had an accumulated

net operating loss of more than $1 million (ibid.). The

transfers of land to these corporations were “nonrecogni-

tion” transactions, i.e., neither the partnership nor the

transferees recognized gain (or loss), and the partnership’s

original cost basis in the lots, which were highly appre-

ciated, carried over to the transferees. See Sections 351 and

362.2 The Alphabets and Foster Enterprises sold the tracts

to third parties, and reported the income from the sales on

their tax returns (Pet. App. III, at 56, 102). Foster Euter-

prises used its preexisting net operating loss to offset its gain

from the sales (id. at 104-105).

Section 482 of the Code authorizes the Commissioner to

“allocate gross income, [or] deductions” between or among

businesses that are controlled by the same interests, “if he

determines that such * * * allocation is necessary in order

to prevent evasion of taxes or clearly to reflect the income of

any of such * * * businesses.” Pursuant to Section 482, the

Commissioner determined that the sales income reported

2Unless otherwise noted, all references to the Code are to the Internal

Revenue Code of 1954 (26 U.S.C.), as in effect for the tax periods in

issue.

3

by the Alphabets and Foster Enterprises should be reallo-

cated to petitioners’ partnership (Pet. App. III, at 56, 102).

That adjustment led to an increase in petitioners’ gross

income, since the income of a partnership flows through to

its partners in accord with their respective distributive

shares. Sections 701, 702. By reason of that adjustment, the

Commissioner asserted deficiencies in petitioners’ income

taxes.

b. The partnership borrowed $3 million from a bank to

finance the development of Foster City (Pet. App. II, at

21-22). Because the project was considered risky, the part-

nership agreed to pay the bank a bonus of $3 million for

making the loan (ibid.). Through a convoluted series of

transactions «the Westway transactions), the partnership

endeavored to make its obligation to pay the bonus appear

to produce a $3 million step-up in its basis in Neighbor-

hoods Two and Three of Foster City (Pet. App. II, at 21-23;

Pet. App. III, at 84-97). The gist of the transactions was that

the partnership purported to sell 200 acres in Foster City to

the bank for $105,000, and to buy them back, less than two

years later, for $5,000 in cash plus $3.1 million in notes

(ibid.). When the partnership thereafter sold the properties

in Neighborhocds Two and Three to builders, it applied the

claimed increase in basis to reduce the gain it reported on its

tax returns (Pet. App. III, at 83). The Commissioner disal-

lowed the accession to basis and determined income tax

deficiencies, finding that the Westway transactions had “no

business substance” (ibid.).

2. The Tax Court upheld the Commissioner’s determina-

tions on beth counts. To begin with, the court found that

the Commissioner’s allocation of sales income to the part-

nership was within his discretion under Section 482 (Pet.

App. III, at 172-184). The court found that tie partnership

conveyed the lots to the controlled corporations solely to

avoid federal income taxes, not for any business reason

4

(ibid.). According to the Tax Court, the partnership was the

“true earner” of the income, having “work{ed] day in and

day out to effect the transformation of the land” (id. at 174),

whereas petitioners’ corporations “had not played any role

in [Foster City’s] development” (id. at 179). In the court’s

view, the transfers of “highly appreciated inventory preg-

nant with income” unquestionably “distorted the income ]

of the Foster partnership” (ibid.).

Second, the Tax Court agreed with the Commissioner

that “the substance of the Westway transaction [was] very

different from its form” (Pet. App. III, at 201). The court

found that the bonus owed by the partnership reflected

additional interest on borrowed money, and was not part of

the partnership’s basis or investment in any property that it

owned (id. at 200-211).

The court of appeals affirmed those holdings. First, the

court agreed with the Tax Court that “{t]he transfers

[among the controlled entities] had no business function;

their purpose was tax avoidance” (Pet. App. II, at 21). The

purpose of the transfers, the Ninth Circuit pointed ou’. was

“to reduce income on [the partners’ ] personal tax returns”

(id. at 10), and “to shift [the income] to Foster Enterprises

* * * so that it could be absorbed by that corporation's

losses” (id. at 14).

Like the Tax Court, the court of appeals also rejected

petitioners’ claim to a step-up in basis (Pet. App. II, at

21-29). The Westway transactions, the Ninth Circuit

observed, were carried out “for the purpose of disguising

the agreed upon bonus” as a capital transaction (id. at 26).

Adopting the Tax Court's findings, the court of appeals

concluded that the bonus constituted interest, i.e., “ ‘the

amount [the debtor] contracted to pay for the use of bor-

rowed money’ ” (id. at 27, quoting Old Colony R.R. v.

Commissioner, 284 U.S. 552, 560 (1932)).

5

3. The decision below is correct. The disposition of the

fact-bound issues in this case by both courts below presents

nothing that merits further review.

a. Its legislative history shows that Section 482 is

designed to prevent distortion of the “true tax liability” of

commonly controlled enterprises by “the shifting of profits,

the making of fictitious sales, and other methods frequently

adopted for the purpose of ‘milking’ ” (H.R. Rep. 2, 70th

Cong., Ist Sess. 16-17 (1927)). Long-standing Treasury

Regulation provides that “[t}ransactions between one con-

trolled taxpayer and another will be subjected to special

scrutiny to ascertain whether the common control is being

used to reduce, avoid, or escape taxes” (Treas. Reg. $ 1.482-

1(c)). Under the Regulation, “{t]he standard to be applied in

every case is that of an uncontrolled taxpayer dealing at

arm’s length with another uncontrolled taxpayer” (Treas.

Reg. $ 1.482-1(b)(i)).

Section 482 is intended, moreover, to “provid[e] a more

appropriate manner of allocating income and deductions

when the application of the general rules of the statute will

not clearly reflect the true income.” National Securities

Corp. v. Commissioner, 137 F.2d 600, 602 (3d Cir.), cert.

denied, 320 U.S. 794 (1943). Thus, the Regulation specifies

that “Section 482 may, when necessary to prevent the avoi-

dance of taxes or to clearly reflect income, be applied in

circumstances described in sections of the Code (such as

section 351) providing for nonrecognition of gain or loss”

(Treas. Reg. $ 1.482-1(d)(5)).

The courts of appeals have regularly sustained the Com-

missioner’s authority to apply Section 482 in the context of

nonrecognition transactions. In Rooney v. United States,

305 F.2d 681 (9th Cir. 1962), a sole proprietor conveyed his

farm to a corporation in exchange for all the stock (a

Section 351 transaction), not long before the crops were

6

harvested. The court of appeals approved the Commis-

sioner’s allocation of the crop expenses to the corporation

formed “in midstream,” so that the deductions of the busi-

ness would be matched with its income. In National Securi-

ties Corp. v. Commissioner, supra, a parent transferred to

its subsidiary, in exchange for the latter’s stock, a portfolio

of securities that “had become well nigh valueless” (137

F.2d at 602). The court of appeals found that “[{t}he shifting

of the loss to the subsidiary gf ave] an artificial picture of its

true income and one which it was unnecessary for the

Commissioner to accept” (id. at 603). Accord, Stewart v.

Commissioner, 714 F.2d 977, 989 (9th © +. 1983).

b. The Commissioner’s exercise of his authority here was

equally “necessary in order to prevent evasion of taxes or

clearly to reflect the income” (Section 482). The courts

below agreed that the transfers among petitioners’ con-

trolled entities “had no business function” (Pet. App. II, at

21). Rather, “their purpose was tax avoidance” (ibid.). The

property conveyed, the trial court found, was “highly

appreciated inventory pregnant with income,” income that

“was not earned by Foster Enterprises [or by the Alphabets]

but rather was completely earned by the Foster partner-

ship” (Pet. App. III, at 178-179). Whereas the partnership

“solv[ed] the major engineering problem related to the re-

clamation of the land,” and “work[ed] day in and day out to

effect the transformation of the land” (id. at 174), the con-

trolled corporations performed nothing of substance to

develop the properties (id. at 171-172, 173-174, 178-179).

Thus, the scheme, pursuant to which the Alphabets and

Foster Enterprises purportedly realized the income incident

to sale of the lots, as the Tax Court concluded, “distorted

the income{ ] of the Foster partnership” (id. at 179).

c. Contrary to petitioners’ contention (Pet. 30-35), more-

over, the decision below does not conflict with Commis-

sioner v. First Security Bank, 405 U.S. 394 (1972). As this

;

Court later explained, “[w]e held there that the Commis-

sioner could not properly allocate income to one of a con-

trolled group of corporations under 26 U.S.C. § 482 where

that corporation could not have received that income as a

matter of law.” United States v. Basye, 410 U.S. 441, 453

n.13 (1973). That is not the situation here, for petitioners’

partnership could have, if it chose, retained title to the

properties, sold them itself, and received the income, all

without legal impediment.

Nor is there any conflict between the decision below and

Keller v. Commissioner, 723 F.2d 58 (10th Cir. 1983), aff’g

77 T.C. 1014 (1981). That case involved a physician who

assigned his earnings to his wholly-owned professional cor-

poration. The Tax Court there rejected the Commissioner's

use of Section 482 to tax the doctor on his corporation’s

receipts, finding that he dealt with his corporation at arm’s

length and that the amount of his compensation from the

corporation (in the form of salary, pension, and other

benefits) was essentially equivalent to the amount of income

that he assigned to the corporation. 77 T.C. at 1025-1028.

The Keller case has little to do with the instant case, where

the partnership “divert{ed] what would normally be [its]

income” to the controlled corporations (Pet. App. II, at

19-20) without receiving any commensurate financial

return.

4. a. Under Crane v. Commissioner, 331 U.S. 1 (1947),

when a taxpayer takes out a loan and applies the proceeds

to buy property, he can, of course, generally include the

amount of the loan in computing his basis in the property.

The loan, in those circumstances, ordinarily forms part of

“the cost of such property” within the meaning of Code

Section 1012. The interest on the loan, however, is not so

includible in basis. The interest simply reflects “the amount

[the debtor] contracted to pay for the use of borrowed

8

money”(Old Colony R.R. v. Commissioner, 284 U.S. 552,

560 (1932)).

b. The courts below correctly applied these weil-settled

principles to the facts of the Westway transactioas. Looking

through the form of those transactions to their substance,

the court of appeals agreed with the Tax Court that the $3

million bonus “represented an obligation by the Partner-

ship to pay interest on the money borrowed” (Pet. App. II,

at 23). Like the Tax Court, the court of appeals found that

the Westway transactions were not made at arm’s length,

and were contrived and executed “for the purpose of dis-

guising the agreed upon bonus” as capital gain (Pet. App.

II, at 24, 26). In affirming the denial of petitioners’ claim to

a stepped-up basis, the court of appeals concluded that the

bonus was not “part of the cost of tne property” but rather

part of “the cost of the loan” (id. at 29).

c. Contrary to petitioners’ argument (Pet. 42), there is no

conflict between the decision below and United States v.

Mississippi Chemical Corp., 405 U.S. 298 (1972). In that

case, a borrower was required to buy stock in a bank as a

condition of securing a loan. This Court held that, since the

stock was a capital asset with long-term value, the amounts

the borrower paid for the stock did not constitute interest.

The situation in the instant case is materially different. In

return for the bonus, petitioners received nothing from the

bank besides a loan.

It is therefore respectfully submitted that the petition for

a writ of certiorari should be denied.

CHARLES FRIED

Solicitor General

NOVEMBER 1985

DOJ-1985-11