Carriage Square, Inc. v. Commissioner

*119 Respondent has determined the following deficiencies in petitioner's Federal income taxes:

There are two issues for our decision: (1) Whether the consent agreement (Treasury Form 872-A) duly executed on behalf of *120 petitioner validly extended the statute of limitations for the years in question pursuant to section 6501(c)(4); ¹ and (2) whether all of the income earned by*37 a purported partnership of which petitioner was the only general partner should be included in petitioner's gross income pursuant to section 61.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

Petitioner Carriage Square, Inc., is a corporation formed under the laws of California and having its principal office at Santa Rosa, Calif., at the time the petition was filed herein. Petitioner's Federal income tax returns for the years ended November 30, 1969, November 30, 1970, and November 30, 1971, were filed with the Western Service Center in Ogden, Utah.

Arthur Condiotti (Condiotti) engaged individually in the business of acquiring and subdividing land in northern California during the years 1967 through 1971. Additionally, during the period in question, Condiotti was president of petitioner and owned 79.5 percent of its outstanding shares of stock. The remaining 20.5 percent was owned by William*38 P. Barlow (Barlow). Condiotti was also the president and majority shareholder of the following corporations during the taxable years ended November 30, 1969, through November 30, 1971:

Barlow, as trustee, and Suzie Condiotti, as grantor, signed five agreements purportedly establishing trusts as of February 14, 1969, to be known as the A. Condiotti Trust One, the E.M. Condiotti Trust One, the Daniel Condiotti Trust One, the Debra Condiotti Trust One, and the Mark Condiotti Trust One (hereinafter collectively referred to as the trusts). Each trust was *121 named according to its principal beneficiary. A. Condiotti is Arthur Condiotti, E.M. Condiotti is his wife, and Daniel, Debra, and Mark are their children born in 1958, 1953, and 1950, respectively. Suzie Condiotti, the purported grantor of the trusts, is Condiotti's mother. Barlow received five checks for $ 1,000 each signed by Suzie Condiotti and payable to*39 him as trustee.

Barlow has handled Condiotti's tax affairs since 1964 and, during the relevant period, his accounting firm prepared the tax returns of Condiotti and the corporations which he controlled. Barlow advised Condiotti to have the trusts set up and he was compensated for such advice.

On February 14, 1969, the trusts, as limited partners, and petitioner, as general partner, entered into a "Limited Partnership Agreement." Barlow signed such agreement on behalf of petitioner as its assistant secretary as well as on behalf of the trusts, as trustee of each. The purpose of such partnership was "to carry on the business to acquire and develop residential property," and it was to do business under the name of "Sonoma Development Company" (Sonoma). Petitioner contributed $ 556 to its capital and each of the trusts contributed $ 1,000. Each trust was entitled to an 18-percent share of Sonoma's profits whereas petitioner was entitled to a 10-percent share. The trusts were not obligated to contribute any additional capital and they were liable for the debts of Sonoma only to the extent of their capital contribution plus their share of any retained profits. Petitioner was liable*40 for the debts of Sonoma to the same extent as partners in a general partnership, but it was not obligated, in the event of a loss, to make up the capital contributions of the limited partners. The partnership agreement also contained the following provisions:

7. Management Duties and Restrictions

* * * *

The general partner shall devote only such time to the affairs and business of the partnership as may be required for the conduct thereof. It is specifically understood that the partnership is a side line for the general partner and that such partner shall be free to engage in any other business or occupation without the consent of any other partner, save and except in competing businesses.

* * * *

8. Dissolution of Partnership

Upon agreement of the partners, the partnership may be dissolved and the assets liquidated forthwith. This partnership shall also dissolve upon the dissolution, bankruptcy or insolvency of the general partner or at the option of *122 the limited partners, upon its failure to devote its time to the affairs of the partnership as may be required for the conduct thereof for a period of 120 continuous days. * * *

* * * *

In the event of dissolution of*41 the partnership the general partner or limited partners, and each of them, may purchase the business and assets of the partnership by payment to those partners not desiring to continue the business, the amount of said partner's capital account and drawing account as of the date of dissolution.

* * * *

11. Assignability

If a limited partner shall be desirous of selling his interest in the partnership, he shall first offer to sell such interest to the other partners at a price to be fixed and determined by the selling partner, and if the other partners shall not accept such offer within 30 days after tender, then the selling partner shall be at liberty to sell his interest to any other person at the same or a higher price, but the selling partner shall not sell his interest at a lesser price to any other person or persons unless and until such offer shall have been submitted to the other partners at such lower price, and said last mentioned offer shall not have been accepted within 30 days.

Sonoma filed a certificate of limited partnership in Sonoma County, Calif. At the time the partnership was formed, it was possible to borrow from a bank all of the money necessary to finance a*42 real estate development and construction project.

Sonoma engaged in the business of arranging to have homes built and sold. Sonoma purchased all of the lots in the Elizabeth Manor I subdivision (Elizabeth Manor) from Condiotti and his wife. The Condiottis had purchased the undeveloped property for Elizabeth Manor I from W. Garfield (Garfield) on December 31, 1968, by paying $ 6,000 down, assuming existing deeds of trust for amounts totaling $ 16,702, and obtaining a secured loan of $ 16,628.51 from Garfield. The Condiottis then borrowed $ 145,000 from the Crocker Citizens National Bank (Crocker) to develop the land by subdividing and installing offsite improvements such as streets, sewers, and utility connections. With the proceeds of such loan, the Condiottis paid the loan fee, paid off the deeds of trusts which they had assumed when purchasing the Elizabeth Manor I property, and expended approximately $ 127,000 on improvements. Garfield agreed to subordinate his secured interest to that of Crocker.

Sonoma did not purchase all of the lots in Elizabeth Manor I at the same time, but it purchased several at a time from the Condiottis with funds advanced by Crocker. Sonoma then*43 *123 obtained a construction loan from Crocker, and from its proceeds Sonoma repaid Crocker the funds advanced by it to enable Sonoma to purchase the land. The remainder of the loan proceeds was retained by Crocker in a construction loan account to be disbursed in accordance with the construction loan agreement as construction of the houses progressed. As soon as Sonoma sold five or six houses it went back to Crocker and requested another loan to build more houses until it had gotten sufficient loans to build the entire subdivision.

Sonoma was able to finance the construction and sale of houses in its subdivisions with no funds by obtaining loans for larger amounts than those needed for construction and by getting the owner of the undeveloped land to subordinate his deed of trust to the deed of trust given to the lender of the construction loan.

Sonoma also constructed and sold houses in the Rincon View II subdivision. The Rincon View II subdivision was handled in a manner similar to Elizabeth Manor I. The Condiottis bought undeveloped land on which they installed offsite improvements using borrowed money. Once the majority of the improvements were installed on the land, *44 the subdivided lots were transferred to Sonoma and construction of the houses began.

The $ 5,556 contributed to the partnership by the trusts and petitioner was used as seed money. The money to purchase the property was obtained by construction loans. Sonoma hired Condiotti Enterprises, Inc., another corporation owned by Condiotti, to construct houses on the lots that it purchased.

Condiotti and his wife gave a continuing guarantee to Crocker for the liabilities of their corporations when they began borrowing funds from Crocker because Crocker would not lend money on a subdivision without such guarantee. A continuing guarantee for $ 4 million, which was dated November 14, 1969, and signed by Condiotti and his wife, covered any liabilities to Crocker by Condiotti Enterprises, Inc., Sonoma Development Co., petitioner, and five other corporations. A continuing guarantee dated March 19, 1970, for $ 3 million was signed by "Sonoma Development Company by: Carriage Square, Inc., A. Condiotti, Pres." and covered any liabilities owed to Crocker by the Condiottis, Condiotti Enterprises, Inc., petitioner, and four other corporations.

Sonoma filed U.S. partnership income tax returns (Forms*45 1065) for the period from February 14, 1969, through December *124 31, 1969, and for the calendar years 1970 and 1971 reporting income for such periods in the following amounts: $ 2,600 in 1969; $ 142,600 in 1970; and $ 177,742 in 1971.

Petitioner's U.S. corporation income tax returns for the taxable years ended November 30, 1969, November 30, 1970, and November 30, 1971, were received by the Internal Revenue Service on February 12, 1970, February 16, 1971, and March 21, 1972, respectively. Forms 872 were signed by Condiotti on behalf of petitioner on May 2, 1972, and December 7, 1972, so that the period of limitations upon assessment for the taxable year ended November 30, 1969, was extended to December 31, 1974. A Form 872 consent was signed by Condiotti on behalf of petitioner on December 19, 1973, extending the period of limitations upon assessment for the taxable year ended November 30, 1970, to December 31, 1974.

A Special Consent Fixing Period of Limitation Upon Assessment of Income Tax (Form 872-A) was signed by Condiotti on behalf of petitioner on November 21, 1974, providing that the amounts of any Federal income tax due under any of petitioner's returns for its taxable*46 years ended November 30, 1969, November 30, 1970, and November 30, 1971 --

under existing or prior revenue acts, may be assessed at any time on or before the 90th day after (1) mailing by the Internal Revenue Service of written notification to the taxpayer(s) of termination of Appellate Division consideration, or (2) receipt by the Regional Appellate Division branch office considering the case of written notification from the taxpayer(s) of election to terminate this agreement, except that if in either event a statutory notice of deficiency in tax for any such year is sent to the taxpayer(s) the running of the time for making any assessment shall be suspended for the period during which the making of an assessment is prohibited and for 60 days thereafter. If such statutory notice is sent to the taxpayer(s) and neither of the conditions enumerated (1) and (2) in the preceding sentence have occurred, the time for making such assessment will expire 60 days after the period during which the making of an assessment is prohibited. However, this agreement will not reduce the period of time otherwise provided by law for making such assessment.

In his statutory notice, dated September *47 26, 1975, respondent allocated all of Sonoma's income to petitioner and thereby increased petitioner's income for the taxable years ended November 30, 1969, November 30, 1970, and November 30, 1971, by $ 2,340, $ 130,713, and $ 160,558, respectively. Since Sonoma filed its return on a calendar year basis and petitioner used a fiscal year ending November 30, it was necessary for respondent *125 to recompute Sonoma's income using a fiscal year ending November 30. ² At trial, petitioner objected to respondent's method of computing Sonoma's income on petitioner's fiscal year basis.

*48 OPINION

Petitioner argues that section 6501(c)(4) ³ authorizes extending *126 the period of limitation upon assessment of income tax for a definite period only so that Treasury Form 872-A, which purports extension of such period for an indefinite period, is invalid. Of course, if the Form 872-A consent agreement is invalid, then assessment of a deficiency in petitioner's taxes for the years in question is barred and respondent's deficiency notice is erroneous. Sec. 6501(a),(b), and (c).

*49 In McManus v. Commissioner, 65 T.C. 197, 207 (1975), on appeal (9th Cir. 1976), we held that since section 6501(c)(4) contained "no requirement that the statute of limitations can only be extended for a definite period of time," the Form 872-A agreement was valid to extend the period of limitations for a reasonable time. In the instant case, the Form 872-A consent agreement was signed by Condiotti on behalf of petitioner on November 21, 1974, and the deficiency notice is dated only approximately 10 months later, on September 26, 1975. There is no evidence whatsoever that petitioner notified respondent of its desire to terminate the agreement or complained of the delay. Since we believe that McManus was correctly decided for the reasons there given, and believe respondent has reasonably used the Form 872-A agreement in the case at bar, we hold such agreement valid.

Respondent argues that he has properly allocated the income of Sonoma to petitioner, its sole general partner, for the years in question because such income was earned solely by the services performed and the financial risks assumed by petitioner.

Section 704(e)(1)⁴ provides:

Sec. *50 704(e)(1). Recognition of interest created by purchase or gift. -- A person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person.

Section 1.704-1(e)(1)(iv), Income Tax Regs., provides the following amplification of section 704(e)(1):

Sec. 1. 704-1(e)(1)(iv). Capital as a material income-producing factor. For purposes of section 704(e)(1), the determination as to whether capital is a material income-producing factor must be made by reference to all the facts of each case. *51 Capital is a material income-producing factor if a substantial portion *127 of the gross income of the business is attributable to the employment of capital in the business conducted by the partnership. In general, capital is not a material income-producing factor where the income of the business consists principally of fees, commissions, or other compensation for personal services performed by members or employees of the partnership. On the other hand, capital is ordinarily a material income-producing factor if the operation of the business requires substantial inventories or a substantial investment in plant, machinery, or other equipment.

After carefully reviewing the record in the instant case, we hold that capital was not a material income-producing factor in Sonoma's business. We note at the outset that, with a total initial capital contribution of only $ 5,556, Sonoma earned $ 322,942 during its first 3 years. ⁵

*52 Sonoma did employ large amounts of borrowed capital in constructing houses on the lots which it purchased from the Condiottis. While borrowed capital, under other circumstances, may be "capital" for section 704(e)(1) purposes, we hold that it is not in this instance. Petitioner, as Sonoma's only general partner, was the only partner in Sonoma whose liability for repayment of such borrowed capital was not substantially limited. Furthermore, Crocker would not have loaned such capital to Sonoma secured by partnership assets (or the general partner's assets) alone, but would loan such capital to Sonoma only after a continuing guarantee had been executed making the Condiottis liable for Sonoma's debts to Crocker in the event that Sonoma did not pay them.

Since Sonoma made a large profit with a very small total capital contribution from its partners and was able to borrow, and did borrow, substantially all of the capital which it employed in its business upon the condition that such loans were guaranteed by nonpartners, we think that section 1.704-1(e)(1)(i), ⁶ Income Tax Regs., prohibits the borrowed capital in the instant case from being considered as a "material income-producing*53 factor." The regulation requires that such capital be "contributed by the partners." This view is supported by Bateman v. United States, 490 F.2d 549, 553 (9th Cir. 1973):

*128 had the good will been personal to the Batemans, the transfers of interest to the trusts would not have received tax recognition. Under those circumstances, without the very substantial good will owned by BBC, the partnership would not have been one in which capital was a material income-producing factor. * * *

*54 We hold, therefore, that Sonoma was not a partnership in which capital was a material income-producing factor and consequently section 704(e)(1) is inapplicable. However, the trusts must still be recognized as partners unless it appears that the parties did not in good faith and acting with a business purpose intend to join together as partners. Commissioner v. Culbertson, 337 U.S. 733 (1949); Poggetto v. United States, 306 F.2d 76 (9th Cir. 1962).

We are unable to find that the parties acted with a business purpose because the trusts received a 90-percent share of Sonoma's profits even though they made no material contribution to the business. Their capital contribution was not material since Sonoma could borrow substantially all the money necessary to conduct its business as long as the Condiottis guaranteed its debts (which they did). The trusts provided no services and their liability was limited to the amount of their contributed capital plus their share of retained earnings. Furthermore, we cannot find that the parties in good faith intended to join together as partners where petitioner provided all the services*55 necessary for the conduct of a partnership business, assumed substantially all risk of loss, and utilized its business contacts in obtaining the large loans required by the partnership business, but nevertheless was given only a share of the partnership profits which was exactly equal to its share of the capital contributions. Accordingly, we hold that the trusts were not bona fide partners of Sonoma so that respondent correctly allocated the income earned by Sonoma to petitioner. ⁷

*56 In its petition, petitioner asserted errors in respondent's *129 partial disallowance of its surtax exemption for the taxable year ended November 30, 1969, under section 1561(a), ⁸*57 and in respondent's determination that petitioner was liable for an additional tax for the taxable years ended November 30, 1970, and November 30, 1971, under section 1562(b). ⁹

*58 Petitioner apparently has abandoned these issues since it presented no evidence at trial and does not urge them on brief. In any event, petitioner has failed to prove that it was not a member of a controlled group of corporations for the years in *130 issue. It follows that respondent's determinations as to these issues are sustained.

Decision will be entered for the respondent.

Goffe, J., concurring: I concur in the result that the trusts should not be recognized as limited partners but I cannot agree with the approach used by the majority. The majority holds that borrowed capital was not a material income-producing factor in the Sonoma limited partnership. There is an attempt to limit such holding to the facts of this case; nevertheless it places a qualification on the concept of "capital as a material income-producing factor" which concept is found in other areas of the tax law; i.e., e.g., definition of earned income from sources without the United States (sec. 911); income subject to the 50-percent maximum rate on personal service income (sec. 1348); earned income for self-employment tax purposes ( sec. 1.1402(a)-2(a), Income Tax Regs.); election as *59 to treatment of income subject to foreign community property laws (sec. 981); and the qualification of retirement plans covering self-employed individuals ( sec. 1.401-10, Income Tax Regs.). The opinion of the majority is also out of touch with reality. Borrowed capital is almost invariably involved (usually to the maximum extent possible) in real estate developments. Moreover, the rationale adopted by the majority is gratuitous; it was not presented by respondent and, therefore, not argued by the parties in their briefs.

The majority emphasizes the unlimited liability of the general partner (petitioner) as distinguished from the limited liability of the limited partners (trusts). Such distinction is meaningless because the degree of liability between general partners and limited partners is not only customary, it is definitional. Indeed, the regulations recognize this truism. Sec. 1.704-1 (e)(3)(ii)(c), Income Tax Regs.

All of the members of the Court recognize that the tax avoidance scheme of Arthur Condiotti and his accountant-tax adviser, William P. Barlow, cannot be allowed to stand. It is an obvious attempt, and a somewhat crude attempt, lacking *131 legitimate business*60 purposes, to spread large anticipated sums of ordinary income among several taxpayer trusts to achieve a low rate of tax on such income. The tax-planning technique of splitting anticipated ordinary income among several taxpayers created by the taxpayer who generates the income is a well known method of attempting to minimize the rate of tax on such income; i.e., e.g., multiple corporations, multiple trusts, family partnerships. The only disagreement among the members of the Court is how best to set aside the tax avoidance scheme. I view the majority opinion as a strained approach to the problem and, therefore, reason for an alternative which is less dangerous, supported completely by the regulations and in harmony with the congressional intent of section 704. It would seem to me that the majority should examine the facts in light of the regulations promulgated under section 704(e) as the Court did in Krause v. Commissioner, 57 T.C. 890 (1972), affd. 497 F.2d 1109 (6th Cir. 1974), cert. denied 419 U.S. 1108 (1975).

Arthur Condiotti and his tax adviser Barlow owned all of the issued and outstanding*61 stock of petitioner. Condiotti, using his mother as grantor, established five trusts, naming Barlow as trustee of each. The trusts were for the benefit of Condiotti, his wife, and his three children. They were funded by cash contributions of $ 1,000 each which Condiotti gave to his mother. On the same day that the trust agreements were executed, Barlow, as trustee of the five trusts, acquired limited partnership interests for each of the trusts, using the entire corpus of each trust. The limited partnership consisted of the five trusts and petitioner, the general partner, which contributed only $ 556 to the capital of the partnership. Under the limited partnership agreement, each limited partner (trust) received an 18-percent share of the profits and assets upon dissolution and the general partner (petitioner) received only a 10-percent share of the profits and assets upon dissolution. The substantial sums of money used by Sonoma to generate its ordinary income came almost exclusively from loans assumed by petitioner or borrowed by petitioner and guaranteed by Condiotti and his wife.

The obvious starting point for the examination of the Condiotti-Barlow scheme must be section*62 704(e), ¹ entitled "Family *132 Partnership." The predecessors of section 704(e) were sections 191 and 3797(a)(2) of the Internal Revenue Code of 1939. Those identical sections were added by the Revenue Act of 1951. The committee reports covering the enactment of sections 191 and 3797(a)(2) clearly declare the intent of Congress. H. Rept. 586, 82d Cong., 1st Sess. (1951), 1951-2 C.B. 357, 380; S. Rept. 781,82d Cong., 1st Sess. (1951), 1951-2 C.B. 458, 485. After the Supreme Court decided Commissioner v. Tower, 327 U.S. 280 (1946), and Commissioner v. Culbertson, 337 U.S. 733 (1949), numerous cases arose involving transfers of capital among family members in the organization of family partnerships. Such family partnerships were frequently held to be invalid based upon such concepts as "intention," "business purpose," "reality," and "control." Congress enacted the predecessor of section 704(e) to --

harmonize the rules governing interests in the so-called family partnership with those generally applicable to other forms of property or business. Two principles*63 governing attribution of income have long been accepted as basic: (1) income from property is attributable to the owner of the property; (2) income from personal services is attributable to the person rendering the services. There is no reason for applying different principles to partnership income. * * * [H.Rept. 586, supra, 1951-2 C.B. at 380; S. Rept. 781, supra, 1951-2 C.B. at 485.]

*64 Section 1.704-1(e), Income Tax Regs., reflects the intent of Congress in enacting the predecessor of section 704(e). Petitioner does not challenge the validity of the regulations.

The facts of this case should be examined under the tests specified by the various portions of section 1.704-1(e), Income Tax Regs., entitled "Family Partnerships." The income of any *133 partnership must be taxed to the person whose labor and skills earn the income and/or to the person whose own capital is utilized to produce the income. Sec. 1.704-1(e)(1), Income Tax Regs. Under section 752(a) of the Code, the increases in petitioner's liabilities as a result of being a partner and the liabilities of the partnership assumed by petitioner are deemed to be contributions of money to the partnership, yet the profits of the partnership were allocated among the partners in the ratio of their initial contributions which were nominal in comparison to the tremendous liabilities assumed by petitioner. Even under this broad principle, it is readily apparent that the income of the partnership was not taxed to the partner who provided the capital. In the usual limited partnership, the limited partners contribute*65 substantial sums needed to earn the income and the general partner performs services.

In general, a person will be recognized as a partner for income tax purposes if he owns a capital interest in such partnership whether or not such interest is derived by purchase or gift from any other person. Sec. 1.704-1(e)(1)(ii), Income Tax Regs. However, in either the case of a purchase or a gift, the general rule is qualified as follows:

A donee or purchaser of a capital interest in a partnership is not recognized as a partner under the principles of section 704(e)(1)unless such interest is acquired in a bona fide transaction, not a mere sham for tax avoidance or evasion purposes, and the donee or purchaser is the real owner of such interest. To be recognized, a transfer must vest dominion and control of the partnership interest in the transferee. The existence of such dominion and control in the donee is to be determined from all the facts and circumstances. A transfer is not recognized if the transferor retains such incidents of ownership that the transferee has not acquired full and complete ownership of the partnership interest. Transactions between members of a family*66 will be closely scrutinized, and the circumstances, not only at the time of the purported transfer but also during the periods preceding and following it, will be taken i