Abramson v. Commissioner

*360 This consolidated case includes 10 different petitioners, one of which is a fiscal year corporation. Appendix A sets forth the petitioners by name and docket numbers, the tax years involved, the deficiencies for each year, the places of residence of each individual petitioner, and the principal place of business of the corporate petitioner when each petition was filed. Each of the petitions includes, among other issues, the common *361 issue of the tax consequences of the investment by the individual general partner and by all of the limited partners in a New Jersey limited partnership known as Surhill Co. (Surhill). In the statutory notice, respondent disallowed each partner's share of the partnership losses, which included current expense and depreciation deductions. Issues related to this matter were severed and consolidated for the purposes of trial, briefing, and opinion. The issues arise out of the acquisition in 1976 and the exploitation of a movie originally*147 entitled "Scandal" or "Scandello" and retitled "Submission" (Submission).

The issues as framed by respondent may be summarized as:

(1) Whether Surhill was organized with an intention to make a profit; and

(2) if issue (1) is decided in favor of petitioners,

(i) whether petitioners may include in basis the amount of a nonrecourse note evidencing the unpaid portion of the purchase price due the seller of Submission;

(ii) whether Surhill is entitled to an allowance for depreciation under the income forecast method for the tax year 1977;

(iii) whether the depreciation deductions claimed by Surhill for the years 1977 and 1978 were properly computed in accordance with the income forecast method; and

(iv) whether petitioners were at risk under section 465²*148 for the amount of the nonnegotiable promissory note element in the purchase price by reason of a written guarantee (sometimes referred to as so-called guarantee) by the limited partners running to the seller of Submission. ³

*149 *362 FINDINGS OF FACT

Some of the facts have been stipulated and are so found. At the time of filing of the petitions, the residences of the several petitioners were as set forth in Appendix A. To the extent material with respect to the years involving the severed issues, the petitioners filed timely income tax returns, and respondent issued timely statutory notices. ⁴

Surhill was formed as a limited partnership under the laws of the State of New Jersey on December 10, 1976, by Edwin D. Abramson (Abramson). He and his wholly owned corporation, *150 Creative Film Enterprises, Inc. (Creative), were the general partners of Surhill. The remaining petitioners were limited partners, but not all of the limited partners have filed petitions with this Court with respect to the Surhill issue. Surhill was organized for the purpose of purchasing the U.S. rights to Submission. Creative was incorporated under the laws of the State of New Jersey by Abramson for the purpose of locating movies for acquisition by limited partnerships similar to Surhill and to become a general partner in such limited partnerships. The general partners together contributed $ 3,333 to Surhill and are entitled to 1 percent of the profit or loss. The limited partners together contributed the sum of $ 330,000 and are entitled to 99 percent of the profit or loss. Surhill elected to use the accrual method of accounting and files its returns on the calendar-year basis.

Abramson is a certified public accountant with offices in West Orange, New Jersey. ⁵ He has specialized in doing *363 accounting work for businesses in the entertainment field and for entertainers. For many years, he has represented entertainers and authors in connection with film production*151 and distribution matters, has assisted in the production of a film, and many years ago had himself worked as a professional musician. In connection with the matters involved, Abramson was assisted by his legal adviser, Felix Ziffer (Ziffer), who is an attorney, practicing in New York City and specializing in "leisure time activities" which includes the motion picture industry. From time to time, Ziffer has represented several of the major film producers and distributors and many businesses and individuals in business matters pertaining to the production and distribution of films. On occasion, he and Abramson have represented the same client in specific matters and Ziffer has also represented Abramson, personally, from time to time, in motion picture matters. Ziffer, at some point in the past, also acquired and produced films for his own account.

*152 Submission is a color, feature-length (96 minutes) motion picture made in Europe in the English language and post-synchronized. ⁶ The principal actor, Franco Nero, in 1976 had played roles in other movies successfully distributed in the United States, with some United States name recognition. The lead female, Lisa Gastoni, also had some recognition in this country. Submission is well photographed and directed and is of a quality quite acceptable to U.S. audiences. It has an MPAA rating of R. In content, Submission is similar to "Emanuelle" and "Story of O," which were X-rated films distributed shortly prior to 1976. Submission is similar to the film "Swept Away" which also had a successful box office reception in the United States.

*153 In early 1976, Submission was brought to the attention of Joseph Brenner (Brenner), the principal officer of Joseph Brenner Associates, Inc. (Associates), a small, independent distribution company which had been in that business since 1954. From 1954 to the date of trial, Associates has *364 acquired the distribution rights to 40 to 50 films. Brenner was interested in Submission and arranged to screen it with his son and other associates. Based on the screening, he concluded that the film would appeal to all types of audiences and would play in top theaters. In his judgment, it was of good quality, had superb acting, and excellent music. He negotiated with Walter Bedogni, an officer of Rizzoli Co., S.P.A., the owner of the film, which led to a proposal to contract with Associates for the distribution rights for an advance payment of $ 150,000 in cash plus a percentage of distributor film rentals. Negotiations ceased because the cash payment was more than Associates could afford to pay.

Thereafter, the film was presented to Abramson and Ziffer, with the information that Associates was interested in the distribution rights. At this time (the latter part of 1976), Abramson*154 was looking for films to present to investors using the criteria that the film must be commercially feasible and viable and well produced with name actors. Prior to screening Submission, they had screened five to eight other films. The film was screened by Abramson and Ziffer twice during the month of November 1976. Negotiations went forward somewhat simultaneously with Bedogni with respect to the acquisition of the film and with Associates with respect to distribution of the film. One of the factors which influenced Abramson to negotiate for acquisition of the film was Brenner's excitement about its prospects and his (Brenner's) conclusion that Submission could generate several million dollars worth of distributor film rentals. Abramson and Ziffer were both aware of the substantial success of the films "Story of O," "Emanuelle," and "Swept Away," which had generated $ 3 to $ 6 million in film rentals. On that basis, Abramson estimated that his prospective investor group would do very well. During the course of negotiations with the seller's agent, Abramson and Ziffer were informed that "Submission," under the name "Scandello" had been shown in foreign markets and generated*155 approximately $ 340,000 of revenues. They were also informed that the production cost was approximately $ 2 million.

*365 The initial asking price for Submission was $ 1 million in cash plus a percentage of film rentals. The agreed upon price for the right to exploit Submission in the United States was $ 1,750,000, payable $ 225,000 in cash and $ 1,525,000 evidenced by a nonnegotiable, nonrecourse promissory note with interest. The note was due in 10 years, but was also payable out of one-half of the revenues received by Surhill from the film's distribution. As discussed below, payment of the purchase price was guaranteed by the partners. The deferral of a substantial portion of purchase price was valuable to Abramson's prospective investors.

Abramson and Ziffer also negotiated a distribution contract with Associates. The agreement required payment by Associates to Surhill of a percentage of net distributor film rentals, that is the excess of Associates' receipts over its expenses, but modified in that advertising expenses in one location could not be offset against revenues from another location. ⁷ This agreement called for a payment by Associates of $ 50,000 as an advance*156 against Surhill's share of film rentals. The sum of $ 25,000 was payable as soon as the film was delivered to Associates. The balance was in the form of a guarantee that Surhill would receive as its share of film rentals not less than the additional sum of $ 12,500 by September 15, 1977, and the further sum of $ 12,500 by December 15, 1977. This advance was to be repaid out of Surhill's share of revenues. It was unusual in this time period for Associates to make an advance to the owner of a film.

The distribution agreement covered the United States of America, its Territories and Possessions, all U.S. ships at sea and airplanes, bases*157 of the Armed Forces, the Red Cross, the Veteran's Administration, and other governmental agencies. The term of the agreement is 15 years. Associates was required to exhibit "Submission" in at least two theaters in the United States prior to December 31, 1976, and in not less than 25 theaters during the year 1977.

Acquisition of the U.S. rights to Submission was consummated *366 in Switzerland on December 21, 1976 ⁸ and the distribution agreement with Associates was executed on December 22, 1976. All of the limited partners in Surhill were either clients of Abramson or of another certified public accountant who was compensated for his services in securing investors. Abramson, for his services, received the sum of $ 3,000, and Creative, the sum of $ 66,000 out of the initial capitalization of Surhill.

The closing documents*158 consisted of the purchase agreement between Surhill and the seller of Submission, the promissory note, a copy of which was attached to the purchase agreement, a security agreement, a copy of which was attached to the promissory note, and the guarantee agreements referred to in, and a copy attached to, the promissory note. ⁹ Surhill filed a Form UCC-1 financing statement pursuant to New Jersey law to protect the seller's security interest in Submission.

The most critical document in this case is the so-called guarantee agreement ¹⁰ entered into by each of the limited partners and by the general partners. This document, as well as the partnership agreement and the promissory note, was drafted by Gerald Rubin, a New Jersey attorney who specialized*159 in corporate, tax, and commercial matters. The documents were drafted so as to respond to the requirements of the seller of the film that each partner would have personal liability for payment of a pro rata share of the note when due, but to provide the limited partners with the *367 benefit of limited partner status under New Jersey law and to preclude any partner, limited or general, from acquiring joint liability, that is, from being responsible to the seller of Submission for more than that partner's pro rata share of the promissory note. The pertinent part of the guarantee agreement reads as follows:

GUARANTEE AGREEMENT

The undersigned hereby guarantees and promises to pay to Transcontinental Films Anstalt that percentage of the unpaid balance due Transcontinental Films Anstalt pursuant to a certain Promissory Note of even date in the principal sum of $ 1,525,000 issued to it by Surhill Company, a New Jersey Limited Partnership, in the event of a default by Surhill Company in payment of such note, set forth opposite his name below.

* * * *

Under no circumstances shall any of the undersigned persons have any liability under this guarantee or the Promissory Note issued to*160 Transcontinental Films Anstalt in any amount greater than the percentage set forth opposite the undersigned's name above, multiplied by the outstanding balance due under the Promissory Note issued by Surhill Company to Transcontinental Films Anstalt at the time of default thereunder, after reduction for any amounts payable to Transcontinental Films Anstalt pursuant to the exercise of its rights under a certain Security Agreement of even date.

Pertinent extracts from the subscription agreement, the promissory note, and the private placement memorandum are set forth in Appendix B attached hereto.

*161 Although it is clear from the facts that Surhill was formed solely to acquire and exploit Submission, the partnership agreement is very general, merely reflecting that the property to be acquired by the partnership is a motion picture film. On the other hand, the private placement memorandum fully summarizes the transaction, including the required execution of the guarantee agreement, a copy of which is attached, together with copies of the other agreements requiring execution by the limited partners. The subscription agreement also emphasizes the personal liability to be assumed under the guarantee agreement. While the acquisition agreement describes the note as a "nonnegotiable, recourse promissory note," the note is actually a nonrecourse note in that it expressly provides that neither the general partners nor the limited partners will have any personal liability of any kind or nature on the note except *368 as provided in the guarantee agreement. The so-called guarantee agreement, executed by each partner (general and limited) in his capacity as a partner, obligates each person to pay to the seller that percentage of the unpaid balance due the seller in the event of a*162 default which is equal to the partner's percentage interest. A default occurs upon nonpayment of the balance due on the $ 1,525,000 on December 20, 1986. At that point, the seller must foreclose on the film and it may then look to each partner for that partner's share of the unpaid balance of the indebtedness.

Submission was initially shown in December 1976 in a theater in San Antonio, Texas, with very poor results. That did not, however, lessen Associates' enthusiasm for the film. However, later test showings were also disappointing. Development of advertising programs as well as screenings by representatives of theater chains and other prospects for exploitation continued during 1977 and thereafter. Nero made a special trailer ¹¹ at substantial expense. Submission was also screened for cable television and home video. Associates expended more than $ 100,000 of its moneys (in addition to the $ 50,000 advance) in preparation for distribution of the film. This is a larger sum than Associates has spent promoting any other film. At least in part because of the money spent by Associates and the delay in release of Submission, during 1977 Brenner requested that the scheduled*163 payments in that year be delayed. Ultimately, Abramson agreed and the second $ 25,000 was not paid until 1978.

Representatives of several of the major theater chains expressed an interest in acquiring rights to show Submission, and Associates also engaged in negotiations with Revlon for some sort of joint exploitation which would be coupled with the issuance of a perfume under the name "Submission." However, Submission was not released for general distribution in 1977. One problem with release in that year was the distribution at that time of a hard- core pornographic film under the title 'Nights of Submission," which Brenner thought might damage the public acceptance of Submission. Eventually all negotiations for distribution *369 of the film ceased, with the idea of eventually changing Submission's name and releasing it again as a new film. Submission won an award at the Virgin Island*164 Film Festival in 1977 or 1978.

During the period 1975-78, the movie industry was undergoing a change in that interest in drive-in theaters was diminishing, with many being closed down. In their place, many small indoor theaters were being constructed, often several at one location. Associates had been very successful in the distribution of films for drive-in theaters but recognized that it would have to change its direction. Brenner thought that Submission was an ideal vehicle to use to break into distribution to better theaters. As a rule of thumb, 1 film out of 10 is successful, although Associates' success rate in films it had distributed prior to 1976 was between 85 and 90 percent, its success rate dropping to approximately 50 percent in 1976 and 1977.

During the years in issue, none of the persons involved in these matters (including the partners of Surhill) had any financial or other ownership interest in any other person. Negotiations with the seller of Submission and with Associates were conducted by Abramson and his advisers in a business-like fashion. Surhill maintained normal books and records. Abramson as general partner of Surhill acted reasonably in keeping abreast*165 of Associates' efforts to exploit Submission.

ULTIMATE FINDINGS OF FACT

Surhill and its general partners acquired Submission with a predominant profit objective at a purchase price and upon terms determined after arm's-length bargaining between unrelated parties. The value of Submission on the date of acquisition was its purchase price -- the sum of $ 1,750,000, payable $ 225,000 in cash, with the balance payable out of revenues and due in all events at the end of 10 years.

OPINION

The first issue for decision is whether the partnership's business was an activity engaged in for profit for the *370 purposes of section 162. ¹²The burden of proof is upon petitioners to demonstrate the necessary profit objective. Golanty v. Commissioner, 72 T.C. 411 (1979), affd. without opinion 647 F.2d 170 (9th Cir. 1981); Rule 142(a). In order to constitute a trade or business for purposes of section 162, the activity must be carried on in good faith, with the dominant hope and intent of making a profit. Siegel v. Commissioner, 78 T.C. 659, 698 (1982). Determination of the *166 profit objective is based upon all of the facts and circumstances. Dunn v. Commissioner, 70 T.C. 715, 720 (1978), affd. 615 F.2d 578 (2d Cir. 1980). In the case of a partnership, the profit issue is determined at the partnership level on the basis of the activities of the partnership and of the general partners. Brannen v. Commissioner, 78 T.C. 471 (1982), affd. 722 F.2d 695 (11th Cir. 1984).

This does not mean, however, that our inquiry is confined solely to the activities of the partnership, for those parties possessing resources sufficient to acquire and exploit investment property are not always blessed with corresponding expertise. In such case, a partnership can rely upon the expertise of third parties * * *. The scope of the relevant inquiry therefore expands to encompass the entirety of such multilayered transactions. [Flowers v. Commissioner, 80 T.C. 914, 932 (1983).]

See also Fox v. Commissioner, 80 T.C. 972, 1008 (1983), affd. by order 742 F.2d 1441 (2d Cir. 1984),*167 affd. sub nom. Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984), affd. in unpublished orders sub nom. Hook v. Commissioner, Kratsa v. Commissioner, Leffel v. Commissioner, Rosenblatt v. Commissioner, Zemel v. Commissioner, 734 F.2d 5-9 (3d Cir. 1984). On this issue, our decision is conclusively for petitioners.

*168 As we have found, in 1976 Associates was a small but established and nationally recognized producer and distributor of films, with established expertise. In arm's-length bargaining, Abramson and Ziffer negotiated with an agent *371 of an unrelated foreign producer terms for the purchase of Submission, and similarly negotiated with Associates for distribution ofthe film. While the aggregate of the cash and deferred portions of the price, $ 1,750,000, is in excess of the original cash asking price of $ 1 million, that asking price also included a percentage of revenues generated by Submission. There is nothing in this record to suggest that Abramson could have negotiated a better bargain. Neither is there anything improper or even suspicious in taking into account, as Abramson did, the fact that deferral of a portion of the purchase price for 10 years was valuable to the Surhill partners, all of whom were reasonably wealthy. Abramson did not consciously or unconsciously inflate the purchase price. As we have found, Submission was worth exactly what Surhill agreed to pay -- $ 225,000 in cash and a fixed deferred obligation payable with interest in 10 years in the amount of*169 $ 1,525,000. ¹³

Also the distributor was reputable, well established, and nationally recognized. The distribution agreement was in fact more favorable to Surhill than was customary, and the $ 50,000 advance was the largest made up to that time by Associates. This was clearly not a typical abusive tax shelter scenario.

A profit objective may be analyzed in relation to the nine factors set out in respondent's section 183 regulations, ¹⁴ but those factors are not applicable or appropriate for every case. The facts and circumstances of the case in issue remain the primary test. Golanty v. Commissioner, supra;Dunn v. Commissioner, supra at 720. The initial profit projections furnished by Associates to Abramson*170 and made by Abramson and Ziffer based on their own knowledge of comparable films were reasonable and were based upon the experience of knowledgeable persons. Abramson and Ziffer at this time had considerable experience in the movie industry.

The deferral in 1977 of exploitation of Submission was explained satisfactorily. We found Brenner to be a credible witness. While he may have been overly optimistic as to *372 Submission's prospects of success, he held sincere beliefs and acted according to his best judgment and in good faith, expending a substantial sum of money in the process. Abramson and Ziffer also acted as reasonable businessmen. Petitioners have conclusively established the good-faith profit objective of the general partner, Abramson (and thus of Creative), and of the partnership and all limited partners.

Respondent argues that a profit motive is negated by the fact that the price of the Film so far exceeded its fair market value as to preclude petitioners from*171 making a profit, relying on our opinion in Brannen v. Commissioner, 78 T.C. 471 (1982), affd. 722 F.2d 695 (11th Cir. 1984). But respondent fails to recognize that, when a property is purchased as a result of good-faith arm's-length bargaining between unrelated parties, with neither buyer nor seller being under any compulsion and there being no special circumstances present, the purchase price will in general reflect the value of the article purchased at the time of purchase. As we have found in this case, the value of the film was its purchase price. ¹⁵ On this record, it is at least open to question whether appraisal testimony has any relevance. ¹⁶

*172 On issue (1) we hold for petitioners. Having found for petitioners on the profit objective issue, we automatically conclude that petitioners are entitled to the business expense deductions claimed on the Surhill returns.

Extended analysis of the partnership and/or transaction documents is not required. New Jersey law is applicable and, unfortunately, neither party has favored us with a discussion of applicable law, except that Gerald Rubin, the New Jersey attorney responsible for drafting the documents, testified that this arrangement of an apparently *373 nonrecourse promissory note qualified by a limited recourse agreement is common practice in New Jersey in connection with acquisition of real estate by partnerships. He stated that to his knowledge no New Jersey court had construed such a series of documents but, in his opinion, the partnership agreement would be interpreted as creating a limited partnership. Mr. Rubin further expressed the opinion, and we agree, that each partner incurred an 'absolute obligation' to pay his share of the unpaid balance, which sum would be determinable after disposition of the film pursuant to the security*173 agreement.

Without any question, the partnership documents include not only the partnership agreement but also the private placement memorandum and the subscription agreement. They also incorporate by reference the promissory note and the so-called guarantee agreement, both of which were exhibits to the private placement memorandum. These documents are all "inseparably linked." Zappo v. Commissioner, 81 T.C. 77, 85 (1983). Thus, we conclude that the partner's obligations as guarantors were undertaken pursuant to the partnership agreement. ¹⁷ See also Raphan v. United States, 759 F.2d 879 (Fed. Cir. 1985). The partners in this case entered into the guarantee agreement in their respective capacities as limited and general partners, and in so doing, they incurred liability for payment of the balance due on the $ 1,525,000 note when it matures.

The next issue for decision is whether the petitioners may increase their bases in Surhill as a result of their guaranteeing the note given by Surhill to the seller of the film.

Section 752(a)provides that "Any increase in a partner's share of the liabilities of a partnership, or any increase in a partner's individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership." Pursuant to section 722, a contribution of money by a partner to the partnership increases the partner's basis in the partnership.

*374 As a result of the direct obligation undertaken by each petitioner qua partner to pay to the seller a portion of Surhill's debt pursuant to the so-called guarantee, each partner in Surhill increased his share of Surhill's liabilities. Thus, pursuant to sections 752(a) and 722, each partner's basis in Surhill is increased as a result of this additional personal obligation as to which each partner is ultimately liable. See Smith v. Commissioner, 84 T.C. 889, 908 (1985). ¹⁸

*175 The guarantee of an otherwise nonrecourse note places each guaranteeing partner in an economic position indistinguishable from that of a general partner, with liability under a recourse note -- except that the guaranteeing partner's liability is limited to the amount guaranteed. While recognizing that under State law there may be differences between the obligations of a general partner and those of a limited partner guarantor, such differences should not be controlling for Federal tax purposes. Each is obligated to use his personal assets to satisfy, pro rata, the partnership liability. In effect, the limited partners are the equivalent of general partners to the extent of their pro rata guarantees especially since, as to this obligation, the liability of the general partners is limited. Economic reality dictates that they be treated equally, and we so hold. Consequently, both general and limited partners will be entitled to include such liabilities in their basis to the extent of their pro rata guarantees. The $ 1,525,000 liability is apportioned to them in accordance with their loss ratios under the partnership agreement.

This holding is consistent with, and foretold by, our*176 decision in Smith v. Commissioner, supra.In the Smith case, one of the partners executed and contributed to the partnership an assumption agreement as to a nonrecourse partnership liability. We held that the partner's basis was increased by the amount of the debt assumed, saying:

Where, as here, the partner becomes ultimately liable to pay the debt, it is irrelevant for purposes of section 752(a) that the partnership or its property remains liable to the mortgagee. * * * By taking on ultimate and unconditional liability, petitioner constructively contributed the *375 amount of the indebtedness to the partnership, and was thus entitled to increase his basis * * * [Smith v. Commissioner, 84 T.C. at 980.]

Our facts are different, in that the property, i.e., Submission, was still liable for the indebtedness, and Surhill was obligated to pay the seller of the film one-half of its film rentals. We do not believe that these differences alter the result. In this partnership transaction, each partner is directly and ultimately liable for a pro rata portion of the obligation. The fact that the obligation might *177 be paid in part by applicat