Colonnade Condominium, Inc. v. Commissioner

*794 Respondent determined the following deficiencies in petitioner's corporate income tax: ¹

In the statutory notice of *135 deficiency, respondent determined that petitioner distributed a partnership interest to its shareholders resulting in a gain taxable to petitioner under section 311(c). ²*136 On January 18, 1985, respondent filed a motion for leave to file amendment to answer wherein he *795 asserted as his primary theory that the transaction in issue was a sale of a partnership interest. Petitioner filed an objection to respondent's motion and requested that respondent's motion be denied or alternatively, that respondent bear the burden of proof with respect to the matters contained in his amended answer. On February 19, 1985, a hearing was held on respondent's motion to amend his answer and petitioner's motion for continuance, at which time we took the matter under advisement. By order dated February 27, 1985, we agreed with petitioner that respondent's amended answer presented new matters under Rule 142(a), and we granted respondent's motion and ordered that the burden of proof be borne by respondent. ³

After concessions by petitioner ⁴ and in light of respondent's amended answer, the primary issue for decision is whether petitioner's transfer to its three shareholders of a portion of a general partnership interest in a limited partnership, subject to nonrecourse and recourse liabilities in excess of basis, constitutes a taxable sale pursuant to sections 741 and 1001, ⁵ or whether*137 the transaction, which occurred pursuant to an amendment of the partnership agreement, was an admission of new partners, a nontaxable event.

*138 *796 FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation and attached exhibits are incorporated herein by this reference.

Colonnade Condominium, Inc.

Colonnade Condominium, Inc. (petitioner or Colonnade), is a corporation organized in June 1974 under the laws of the District of Columbia. Petitioner's principal place of business was Washington, D.C., when its petition was filed. Colonnade filed its Federal corporate income tax returns (Forms 1120) on the accrual basis of accounting with a fiscal year ending January 31.

The three shareholders of Colonnade were, and continue to be, Stewart Bernstein (Bernstein), Myer Feldman (Feldman), and John Mason (Mason). Bernstein and Mason are real estate developers, and Mason is also a banker with NS&T Bank. Feldman is a partner in the District of Columbia law firm of Ginsburg, Feldman & Bress. The three shareholders each own 30 shares of common stock and constitute the board of directors. During the years in issue, Bernstein was the president and treasurer; Feldman was the executive vice president; and Mason was a vice president and secretary. Corporate decisions were made by the three shareholders, *139 who were aware of the policy and direction of the corporation as it related to real estate development and were somewhat aware of the accounting procedures used by its accounting firm.

In 1974, Colonnade embarked on the conversion of an apartment complex in Washington, D.C., known as the Colonnade, into condominiums for sale to the public. Beginning in 1976, Colonnade also developed a second condominium project known as Foxhall East. These two financially successful conversions were Colonnade's major projects. By the end of fiscal year ended January 31, 1979, all of the Colonnade and Foxhall East units had been sold. Due to economic conditions, Colonnade made no new investments for the period 1979 to 1981, although it did look for other real estate ventures.

Colonnade's gross income from sales and rent (gross receipts less costs of goods sold) from January 1976 *797 through January 1981 was approximately $ 5 million. During these years of operation, Colonnade also reported a partnership loss from Georgia King Associates, a limited partnership in which Colonnade held a majority general partnership interest. ⁶

*140 These partnership losses, combined with other operating expense deductions, resulted in claimed net operating losses. ⁷ Due to these net operating losses, Colonnade did not have any taxable income for fiscal years ending January 31, 1976, through January 31, 1981.

Colonnade's reported tax picture for these years, as it pertains to the losses claimed from its investment in Georgia King Associates, is summarized as follows:

The net operating losses for fiscal years ending January 31, 1976, 1979, and 1980, *141 were carried back and forward to reduce to zero taxable income for fiscal years ending January 31, 1977, 1978, and 1981.

Colonnade declared no dividends and made no distributions to its three shareholders for fiscal years ending January 31, 1975, through January 31, 1980. For fiscal years ending January 31, 1976 through January 31, 1981, Colonnade's books included accounts receivable and notes receivable from its three shareholders, Bernstein, Feldman, and Mason. Initially, only the accounts receivable were posted on the books of Colonnade. In June 1978, approximately 70 percent of the accounts receivable were converted to notes receivable from the respective shareholders in the *798 following amounts: Bernstein in the amount of $ 333,000; Feldman in the amount of $ 475,500; and Mason in the amount of $ 333,000. The cumulative total of the accounts receivable and notes receivable carried on the books of Colonnade is summarized as follows:

*142 These accounts and loans receivable for the period January 1976 to January 1981 resulted from numerous transactions including the issuance of checks; the values assigned to apartments and improvements to apartments received by Feldman and Bernstein and their relatives; cash proceeds from the sale of an apartment; and transfers of amounts receivable and notes receivable from Colonnade Ltd. (a Bernstein, Feldman, and Mason partnership), and the 2801 partnership.

As of December 17, 1980, the outstanding notes receivable and accounts receivable from Mason, Feldman, and Bernstein carried on Colonnade's books totaled $ 1,860,263. By corporate resolution on that same date signed by Bernstein, Feldman, and Mason as shareholders and directors, Colonnade made a $ 1,860,263 distribution to its shareholders of the notes and accounts receivable as follows:

Colonnade reported that, prior to the distribution, its unappropriated retained earnings for fiscal year ending January 31, 1981, was ($ 303,700). On their *143 1980 income tax returns, the shareholders claimed long-term capital gain with respect to the $ 1.8 million distribution.

Georgia King Associates (Georgia King or the partnership) is a limited partnership formed under the laws of New *799 Jersey for the purpose of constructing, developing, owning, maintaining, and operating low-income public housing projects pursuant to the Limited Dividend Non-Profit Housing Corporation Law of New Jersey, and the New Jersey Housing Finance Agency Law of 1976. Georgia King was formed to complete the development of Georgia King Village (the Village or the project), a 422-unit public housing project located in Newark, New Jersey. ⁸ Since its formation, Georgia King's sole project has been the Village, which it continues to own.

*144 On August 2, 1976, a certificate of limited partnership (the certificate) was executed by the authorized representatives of To-Sault Renewal & Redevelopment Corp. (To-Sault), C.R.H.C., Inc. (CRHC), Colonnade, the general partners, and by Capital Housing Partners-XX (CHP-XX), the limited partner. ⁹ Pursuant to this certificate, which created the Georgia King Associates Limited Partnership, the percentages of profits, losses, and net cash-flow were initially allocated and distributed and capital contributions were required as follows:

In addition to the above-stated contributions, Colonnade was to make additional contributions from time to time, and agreed to provide a $ 500,000 letter of credit on behalf of Georgia King in favor of the New Jersey Housing Finance Agency (NJHFA).

*145 Among the stated partnership powers was the following provision:

g. To borrow money and to issue evidence of indebtedness, and to secure the same by mortgage, deed of trust, pledge or other lien, in furtherance of any or all of the objects of its business in connection with *800 said project provided that neither the Partnership nor any of its Partners shall be personally liable for the repayment of any such indebtedness.

To-Sault, a nonprofit corporation was the original owner of the Village and the mortgagor with NJHFA on a 100-percent, 48-year term mortgage in the amount of $ 18,250,000, which was acquired in August 1974. As of August 1974, the estimated development costs and capital requirements totaled $ 18,250,000, the amount of the mortgage. Included in these costs were such items as professional services, selling and renting expenses, and 2-year carrying and finance charges. In May 1976, the estimated development costs and capital requirements were revised for a total project cost of $ 20,278,000. ¹⁰ The $ 18,250,000 mortgage loan then constituted 89.9 percent of the total cost, resulting in a 10-percent equity requirement of $ 2,028,000.

*146 On August 2, 1976, To-Sault agreed to convey its interest in the Village to Georgia King, subject to certain conditions. ¹¹ To-Sault was to receive fees (acquisition, incentive management, and development) totaling $ 1,085,000 over a 9-year period. The fees were to be pledged by To-Sault to NJHFA on behalf of Georgia King in order to meet the 10-percent equity requirement of NJHFA in connection with the conversion of the project from a nonprofit organization (To-Sault) to a limited dividend organization (Georgia King). Under the offer and agreement to purchase (the purchase agreement), NJHFA would continue its financing in the amount of $ 18,250,000. The purchase agreement also designated To-Sault as the managing general partner and provided that To-Sault was to have the right of first refusal in the event the partnership received a bona fide offer from a third party to purchase the Village.

*147 As a condition for its approval of the transfer of the Village from To-Sault to the partnership, NJHFA required that Georgia King agree to establish a development-cost *801 escrow account (DCE account) totaling $ 965,000, to meet the equity requirement. ¹² The agreement regarding development-cost escrow provided for a schedule of payments from Georgia King into the interest-bearing account on a yearly basis through 1984 as follows:

On August 3, 1976, To-Sault deeded the Village to Georgia King.

On August 17, 1976, To-Sault and Georgia King entered into an assignment and assumption agreement with respect to the original mortgage, mortgage note, and related *802 agreements (the original financing agreements). Under the assignment and assumption agreement, To-Sault assigned the August 7, 1974, original financing agreement to Georgia King. Georgia King assumed all of To-Sault's rights and obligations to pay principal and interest on the $ 18,250,000 indebtedness to NJHFA. The agreement provided that "for the purpose of establishing and continuing the existence of the indebtedness * * * it is a condition * * * that*149 neither the Assignee [Georgia King] nor any general partner or limited partner thereof shall assume any personal liability with respect thereto."

On October 20, 1976, the general partners and limited partner of Georgia King (the Georgia King partners) amended certain terms and provisions of the August 2, 1976, certificate. ¹⁵ Pursuant to sections 5.01 and 10.01(a) of the agreement and first amended certificate of limited partnership (the October 20, 1976, agreement), the percentage of profits, losses, and net cash-flow available for distribution and capital contributions were allocated as follows:

Under the October 20, 1976, agreement, Colonnade's *150 $ 2,164,600 capital contribution was payable in nine yearly installments through June 1984. In addition to its originally stated $ 100 capital contribution, CHP-XX was to contribute $ 62,000 in June 1984. Except for the first 2 years of scheduled payments, the payment schedule for Colonnade's capital contributions (and including that of CHP-XX in 1984) corresponded to the combined total of the DCE and development *803 costs payable on an annual basis through August 1984. ¹⁶

Section 5.01(c) of the October 20, 1976, agreement also provided for a reallocation of capital contributions between Colonnade*151 and CHP-XX:

Colonnade and CHP-XX may, at their sole election, hereafter agree upon a reallocation of the amount of capital contribution to be made by each of them, provided however in no event shall the total be less than $ 2,226,600. In the event of such an agreement the Interests of Colonnade and CHP-XX shall be increased or decreased, as appropriate to reflect such reallocation of their obligation to make Capital Contributions.

Under article II, "contribution" was defined as follows:

"Capital Contribution" means the total amount of money or other property contributed or agreed to be contributed, as the context requires, to the Partnership by each Partner pursuant to the terms of this Agreement. Any reference to the Capital Contribution of a Partner shall include the Capital Contribution made by a predecessor holder of the Interest of such Partner.

The October 20, 1976, agreement also provided that subject to any reallocation pursuant to section 5.01(c), certain defined gains (section 10.03(a) gains) recognized by the partnership upon the sale, exchange, or other disposition of the Village were to be allocated according to the percentage interest of the partners for profits*152 and losses. Gains in excess of defined gains and losses on the sale of the Village (section 10.03(c) gains and losses), were to be allocated as follows: *804

Likewise, section 10.05(a) provided for the distribution of proceeds from the sale or refinancing of the project, with any remaining proceeds, after payoff of liabilities and return of contributions, going to the partners, pursuant to section 10.05(a)(vi), in the same percentage as excess recognized gains reflected in section 10.03(c).

With respect to the lack of personal liability for mortgage financing, the October 20, 1976, agreement slightly altered the original wording of the certificate, but restated that the partnership and the partners shall have no "personal liability for the payment of a Mortgage or other such indebtedness, but that the sole recourse of any lender shall be to the property securing the Mortgage or other such indebtedness."

The October 20, 1976, agreement stated:

In determining the Federal tax basis of their Interest in the Partnership, the Partners may take into account their allocable *153 share of any nonrecourse mortgage indebtedness incurred by the Partnership (to the extent of the fair market value of the properties secured) in the same proportion as they share in the profits and losses of the Partnership.

Under section 6.01, none of the general partners were entitled to withdraw from the partnership, or to sell or assign their interests without the prior consent of NJHFA and CHP-XX. Section 6.02 of the October 20, 1976, agreement set forth the following terms and conditions for the "admission of a successor or additional general partner:"

(a) the admission of such Person shall have been Consented to by CRHC, Colonnade, To-Sault and NJHFA;

(b) the successor Person shall have accepted and agreed to be bound by all the terms and provisions of this Agreement, by executing a counterpart thereof, * * * and such other documents or instruments as may be required or appropriate in order to effect the admission of such Person as a General Partner; and this Agreement evidencing the admission of such Person as a General Partner shall have been filed for recordation * * *

* * * *

*805 (d) counsel for the Partnership shall have rendered an opinion that the admission of *154 the successor Person is in conformity with the Uniform Limited Partnership Act of the State of New Jersey and that none of the actions taken in connection with the admission of the successor Person will cause the termination of dissolution of the Partnership or will cause it to be classified other than a partnership for Federal income tax purposes.

Section 6.03 which set forth the effect of bankruptcy, death, withdrawal, dissolution, or incompetence of a general partner, provided, in part, that the "dissolution of Colonnade, the effect of which is the transfer of its interest to Myer Feldman, John J. Mason, Stewart A. Bernstein, or any of them, shall not cause the termination" of the partnership.

Under section 7.01 of the October 20, 1976, agreement, To-Sault was designated as the managing general partner.

Section 7.08(a) provided that the corporation was to maintain such net worth "necessary to assure that the Partnership is classified as a partnership for Federal income tax purposes," ¹⁷ and per section 7.08(c) it was understood and agreed that Colonnade could nominate Bernstein, Feldman, and Mason or any one of them to become a substitute general partner for the purpose of meeting*155 the requirements of section 7.08(a).

Georgia King, which filed its partnership returns on the accrual method of accounting for the calendar year, claimed a total tax loss for 1976 in the amount of $ 1,119,432. As a 97.98-percent general partner, Colonnade's portion of the loss was $ 1,096,819, which it claimed on its corporate return for fiscal year ending January 31, 1977. Colonnade also claimed its portion of loss attributable to its interest in CHP-XX in the amount of $ 67,229. ¹⁸

Colonnade's reported adjusted basis at the *156 end of the 1976 partnership year was $ 19,293,340. Colonnade's basis included its share of the nonrecourse partnership mortgage on the Village, plus the $ 2,164,400 total capital contribution required. Colonnade's initial total adjusted basis of $ 20,390,159 was then reduced by $ 1,096,819, the amount of *806 the claimed partnership loss, to arrive at the reported adjusted basis of $ 19,293,340.

Throughout the course of its investment in Georgia King and CHP-XX, Colonnade received draft projections of anticipated taxable income and losses. For example, in a letter dated November 22, 1976, from Martin Schwartzberg (Schwartzberg) ¹⁹ to Feldman, Schwartzberg discussed a contemplated amendment to the October 20, 1976, agreement to provide for a reallocation of the profits, losses, and cash-flow between Colonnade and CHP-XX. Enclosed with the letter were projections of tax losses resulting from Colonnade's investment in Georgia King and CHP-XX. According to Schwartzberg, units of CHP-XX were to be sold in 1977, and Schwartzberg advised Feldman that "in divesting [Colonnade] of its obligations commencing in 1977 and its percentage of interest in [Georgia King], a variety of alternatives*157 are available." There were no references to any reorganization of the partnership affecting any partner's interest other than with respect to Colonnade and CHP-XX.

On July 8, 1977, Schwartzberg wrote to Feldman again and enclosed various exhibits pertaining to the allocation of projected tax losses and investments in Georgia King. Exhibit A to the letter was a 1977 revision of the allocations projected in 1976. The 1976 projections were based on the assumption of a "sale of 49 percent to CHP-XX in 1977 by Georgia King Associates" and a "sale of 25 percent to Georgia King Associates I in 1978 by Georgia King Associates." In 1977, the 1976 projections were "revised to reflect payments by Colonnade assuming no further sale of its interest in Georgia King Associates." ²⁰

On January 19, 1977, the Georgia King partners executed an amendment to agreement and first amended certificate of limited partnership. A revised amendment to agreement and *807 revised first amended certificate of limited partnership (technical corrections) was signed as of January 19, 1977, on March 29, 1977 (the January 19, 1977, revised amendment). Both amendments were filed with the State of New Jersey.

As a result of the January 19, 1977, revised amendment, the percentage of profits, losses, and net cash-flow available for distribution as defined in section 10.01(a), and the section 10.03(a) gains were reallocated between Colonnade and CHP-XX as follows:

Correspondingly, the section 10.03(c) gains and losses and the section 10.05(a)(vi) distributions were reallocated as follows:

*159 The aggregate capital contributions of Colonnade and CHP-XX were reallocated as follows:

Under the January 19, 1977, revised amendment, Colonnade's capital contribution became payable in seven yearly installments (with one installment previously paid) through 1982, and Colonnade was entitled to receive refunds in the amounts of $ 24,000 and $ 45,000, in 1983 and 1984, respectively. CHP-XX's obligation to contribute was payable in eight installments through 1984.

*808 At the time the partners executed the January 19, 1977, revised amendment (which increased CHP-XX's limited partnership*160 interest to 49 percent), the syndication of the CHP-XX partnership took place simultaneously. Prior to the January 19, 1977, revised amendment, Colonnade had an 80-percent interest in CHP-XX. As a result of the syndication of CHP-XX, Colonnade's interest in CHP-XX was reduced to 0.0247 percent. The limited partners that acquired interests pursuant to the syndication, totaling 95.07 percent, were unrelated to Colonnade.

Georgia King claimed a total tax loss of $ 1,635,090 for the 1977 tax year. Colonnade's portion of that loss was $ 970,949, which it claimed on its corporate return for fiscal year ending January 31, 1978. The $ 970,949 loss was calculated on the basis of Colonnade's retained 50.98-percent interest in Georgia King for the entire year and its allocable interest in CHP-XX as reduced pursuant to the syndication. ²²

*161 Colonnade's partnership interest in Georgia King was reported to have dropped from 97.98 percent to 50.98 percent, a decrease of 47-percentage points, while CHP-XX partnership's interest rose from 2 percent to 49 percent, or a gain of 47-percentage points. ²³ Similarly, Colonnade's share of partnership nonrecourse liabilities was reduced to reflect the reduction of its partnership interest to 50.98 percent.

Colonnade's beginning capital account was reported on*162 the 1977 Schedule K-1 as $ 1,067,781. With respect to its obligation to contribute $ 834,300 ²⁴ in the future (which was assumed by CHP-XX), Colonnade treated the reduction of its amount of future capital contributions as a negative contribution of $ 764,700. The $ 69,000 to be refunded in 1983 and *809 1984 pursuant to the January 19, 1977, revised amendment was not included in this reduction. After taking into consideration the $ 970,949 loss, Colonnade's yearend capital account was reported as ($ 670,854).

The April 1, 1978, Third Amendment to Agreement and First Amended Certificate of Limited Partnership ²⁵

*163 On April 1, 1978, the Georgia King partners executed a third amendment to agreement and first amended certificate of limited partnership. A revised version of this