Opposition Brief — Paduano v. Commissioner

Iu the Supreme Court of the United States

OcTOBER TERM, 1975

No. 75-1381

GERALD F. PADUANO, ET AL., PETITIONERS

Vv.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS FOR

THE SECOND CIRCUIT

MEMORANDUM FOR THE RESPONDENT IN OPPOSITION

The question in this federal income tax case is whether

the court of appeals correctly upheld the Commissioner's

allocation of income and deductions among a group of

related taxpayers, pursuant to his authority under Section

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

That provision permits the Commissioner to allocate gross

income, deductions, credits, or allowances among organ-

izations, trades, or businesses owned or controlled by the

same interests, if he determines that such allocation is

necessary to prevent evasion of taxes or clearly to reflect

the income of any of such organizations, trades, or

businesses.

(1)

2

The pertinent facts are as follows: Gerald Paduano,

Rocco Cappuccilli and Peter Cappuccilli! were equal

partners in a firm that sold and rented real estate. Each

partner also owned one third of the stock of three corpora-

tions—Stonehedge Development Corporation, Seneca

Sewerage Corporation, and Cappy’s Real Estate, Inc.

(Pet. App. A 6).

During 1962, the partnership advanced $1,075,000 to

Stonehedge in an _ interest-free mortgage loan. The

partnership also loaned an additional $106,000 to

Stonehedge and Seneca in mortgage loans at six percent

interest, but no interest was paid on these loans. However,

Stonehedge and Seneca in mortgage loans at six-percent

during this period. Finally, the partnership advanced

additional funds to Stonehedge and Cappy’s to enable them

to continue in operation, but interest was neither charged

nor paid on these advances (Pet. App. A 7-A 8; Pet. 3).

Pursuant to his authority under Section 482, the

Commissioner allocated interest income to the partnership

at the rate of five percent per annum on these loans.

Correlative interest deductions were allowed to Stone-

hedge, Seneca, and Cappy’s (Pet. App. A 10). Deficiencies

were thereby determined against each partner on his

distributive share of the additional partnership interest

income. The Tax Court sustained the Commissioner's

allocation (Pet. App. A 9-A 12), and the court of appeals

affirmed by order (Pet. App. A 12-A 13).

It is well established that when one member of a

commonly controlled group of taxpayers advances funds to

‘Caroline Paduano, Dorothy Cappuccilli, and Grace Cappuccilli

were parties to this action only because they filed joint income tax

returns with their husbands.

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another member, but fails to charge an arm’s-length rate

of interest, the Commissioner may allocate interest to

the creditor under Section 482, without regard to accrual

accounting principles.? See, e.g., B. Forman Co. v. Com-

missioner, 453 F.2d 1144, 1156 (C.A. 2), certiorari denied,

407 U.S. 934; Kahler Corp. v. Commissioner, 486 F.2d

1, 4-5 (C.A. 8); Kerry Investment Co. v. Commissioner,

500 F.2d 108, 109 (C.A. 9); Fitzgerald Motor Co. v. Com-

missioner, 508 F.2d 1096, 1100-1101 (C.A. §). For if the

Commissioner could not allocate interest income in such

circumstances, interest-free loans could be used by a

controlled group as a means of shifting income from its

profitable members to those which have experienced

losses, thereby reducing the total tax liability of the group.

Thus, the allocation of income in this case is in accord with

this Court’s observation that “§ 482 is designed to prevent

‘artificial shifting, milking, or distorting of the true net

incomes of commonly controlled enterprises.” Com-

missioner v. First Security Bank of Utah, 405 U.S. 394. 400.

Petitioners acknowledge (Pet. 6) that the courts of

appeals have consistently upheld the Commissioner’s

authority under Section 482 to allocate interest income in

these circumstances. But they argue that the allocation was

improper on the facts of this case because the debtor

corporations had experienced financial difficulties so that

their payment of interest could not reasonably be expected.

The record indicates, however, that at least two of the three

"Thus, the accrual accounting cases relied upor. by petitioner

(Pet. 14-15) are not pertinent authority.

3The rejection of the Commissioner's Section 482 allocation in

Commissioner v. First Security Bank of Utah, supra, and in L. E.

Shunk Latex Products, Inc. v. Commissioner, 18 T.C. 940, arose in

distinguishable situations (see Pet. 17, 20). In both of those cases.

the taxpayers were legally prohibited from receiving the income

allocated to them.

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corporations (Stonehedge and Seneca) paid interest to other

third-party creditors during the period in question. Thus,

there is no factual support for petitioners’ hypothesis that

their debtor corporations could not have paid interest to the

partnership.

At all events, there is no legal basis to petitioners’

argument. If the financial inability of a member of a

controlled group to pay interest could defeat the Com-

missioner’s Section 482 allocation, it would be a relatively

simple matter to arrange such inability in advance of an

interest-free loan. The objective standard of Section 482

requires the allocation of interest income when interest-free

loans are made among members of a controlled group.‘

It is therefore respectfully submitted that the petition fora

writ of certiorari should be denied.

RosBerT H. Bork,

Solicitor General.

May 1976.

4Although petitioners (Pet. 15) point to a concession made by

the Commissioner in Pitchford’s, Inc. v. Commissioner, 34 T.C.M.

384. that interest would not be allocated where the debtor was in

poor financial condition, that concession was improvident. As we

pointed out in our brief in the court of appeals in this case (pp. 15-16),

that concession does not represent the views of the Commissioner,

and does not bind the Commissioner in any other case.

DOJ-1976-05

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