Title: Miller v. Dept. of Rev.

State: oregon

Issuer: Oregon Supreme Court

Document:

FILED: May 21, 1998

IN THE SUPREME COURT OF THE STATE OF OREGON

PAUL MILLER and ROBIN MILLER,

		Appellants,

	v.

DEPARTMENT OF REVENUE, 
State of Oregon,

	Respondent.

KATHLEEN JOHNSTON and FRANK 
JOHNSTON

	Appellants,

       v.

DEPARTMENT OF REVENUE, 
State of Oregon,

	Respondent.

ROBERT H. LOVERIN and JANE
LOVERIN,

	Appellants,

       v.

DEPARTMENT OF REVENUE, State of
Oregon,

	Respondent.

(OTC 3763, 3764, 3768; SC S43674)

	On appeal from the Oregon Tax Court.*

	Carl N. Byers, Judge.

	Argued and submitted March 5, 1998.

	Steven W. Seymour, of Samuels, Yoelin, Kantor, Seymour &
Spinrad, LLP, Portland, argued the cause and filed the briefs for
appellants.

	Marilyn J. Harbur, Assistant Attorney General, Salem, argued
the cause for respondent.  With her on the brief were James C.
Wallace, Assistant Attorney General, and Hardy Myers, Attorney
General.

	Before Carson, Chief Justice, and Gillette, Van Hoomissen,
Durham, and Leeson, Justices.**  

	LEESON, J.

	The judgment of the Tax Court is affirmed.	

	*13 OTR 488 (1996).

	**Graber, J., resigned March 31, 1998, and did not
participate in the decision of this case.  Kulongoski, J., did
not participate in the consideration or decision of this case.

	LEESON, J.

	Taxpayers, who are the general partners and the spouses
of the general partners in three Oregon limited partnerships,
appeal from a judgment of the Oregon Tax Court that assessed
additional Oregon income taxes against them for the years 1985,
1986, 1987 and 1988.  We review for errors of law, ORS 305.445,(1)
and affirm.

FACTUAL BACKGROUND

	The Tax Court made the following findings of fact, none
of which the parties challenge:

		"In 1984, Robert Loverin and Paul Miller, who are
brothers-in-law, were employed by Rockwood Development
Corporation (Rockwood), an Oregon Corporation. 
Rockwood was owned by Miller's parents and other family
members.  Rockwood engaged in creating, purchasing, and
managing low-income housing projects, most of which
were owned by limited partnerships. * * *

		"In 1984, Loverin and Miller decided to start
their own business because Rockwood was having
financial difficulties.  They formed BP Corporation to
engage in the same kind of business as Rockwood. 
Knowing they did not have the level of management
experience in low-income housing required by the U.S.
Department of Housing and Urban Development (HUD), they
obtained the extensive experience of Rockwood through a
series of management agreements.

		"It was through Rockwood that Loverin and Miller
became aware of Edward and Fern Fischer, owners of four
low-income housing projects commonly know as Fischer
Court I, Fischer Court II, East Ninth Street (Maple
Court), and Southfair.  In May 1984, Rockwood offered
to purchase the four Fischer projects, but the Fischers
rejected the offer.  In September 1984, BP Corporation
made an offer which the Fischers accepted.  The
offering price was $3,500,000, with $650,000 down and
the balance of $2,850,000 in the form of a 15-year
nonrecourse wrap-around note bearing nine percent
simple interest. The offer acknowledged that the
properties were subject to HUD insured mortgages and
required the Fischers to pay the mortgage payments out
of the note payments they received from the buyers.

	* * * 

		"The principals of BP Corporation, Loverin and
Miller, * * * formed a limited partnership for each 

	property and thereafter sought investors for the
partnerships.  Money invested by the limited partners
would be used to make the down payments on the
apartment projects.

		"Only Fischer Court I, Fischer Court II, and East
Ninth Street Apartment Projects are involved in this
litigation, Southfair being the subject of a separate
case.  The three projects involved the same process and
types of documents.  Therefore, for purposes of
analysis, the parties and the court have focused upon
one project, Fischer Court I. 

		"* * * * *

		"On September 20, 1984, the partnership and the
Fischers executed an agreement of sale providing for
the purchase of Fischer Court I by the partnership for
$1,224,000.  In December 1984, this price was amended
to $1,185,600 with $188,914 due at closing.  The
difference between the two amounts is a 'finder's fee'
of $38,400 * * *.

		"The down payment of $188,914, due at closing, was
in the form of a nonrecourse note due January 1, 2000. 
The note, dated December 11, 1984, provided that an
'installment' of $188,914 was due on June 30, 1985, or
upon completion of syndication, whichever occurred
first.  The note bore interest at nine percent
compounded semi-annually.  The balance of the purchase
price was in the form of a [nonrecourse] 'residual
note' in the amount of $996,686.  This note wrapped
around the unpaid balance of the HUD mortgage on the
properties.  The balance of the HUD mortgage at the
time of the agreement was $363,683.  [Neither the
partnership nor its partners was liable on the
downpayment or the wraparound note.]

		"* * * * *

		"Loverin and Miller then solicited limited
partners through private placement memorandums. 
Taxpayers were unable to find a copy of the private
placement memorandum for Fischer Court I.  They did
find a copy of the private placement memorandum for
Fischer Court II and offered it into evidence as being
similar to the one for Fischer Court I.  That document
projected benefits for limited partners from November
1985 through December 1995.  It projected no cash flow
but only income tax deductions.  The projection assumed
investors in the 50 percent tax bracket and showed tax
savings exceeding the limited partners' required annual
investment (including interest) for every year except
1990.  In 1990, the limited partner would be expected
to contribute $4,760 in capital plus $583 in interest
(total $5,343) while the projected tax savings were
$5,104.  Loverin and Miller experienced some delays but
eventually obtained the limited partners necessary for
Fischer Court I.

		"Upon audit, the auditor concluded that the
property's sales price significantly exceeded the
property's fair market value.  The assessed value for
property tax purposes in 1985 was land $98,370 and
improvement $529,520, for a total of $627,890.  The
final agreed sales price was $1,185,600.  Under the
terms of the sale, the only payments to be made under
the residual note were the amounts due on the HUD
mortgage.  The rest of the principal and interest were
deferred.  When the note becomes due on January 1,
2000, the [taxpayers] will owe $2,718,010.

		"The auditor concluded that because the debt was
all nonrecourse debt and the amount of the money owing
on the property exceeded its fair market value, the
partners had no economic interest in the property. 
Moreover, the payments on the 'down payment note' were
delayed until August 1986.  Until then, the partners
had only been paying the underlying HUD mortgage and
were not acquiring any equity in the property. 
Consequently, the auditor did not believe taxpayers
were entitled to depreciation based on their cost
basis.  The auditor did recognize basis to the extent
of fair market value, and separately considered
personal property.

		"The auditor also increased the estimated life of
the property for depreciation purposes from 15 years to
30 years.  The auditor explained that the basic
Internal Revenue Service life guideline for buildings
is 45 years.  Therefore, because the subject property
was 15 years old at the time of purchase, the auditor
reasoned that there should be 30 years left.

		"Finally, on their income tax returns, the general
partners allocated 99.9 percent of the losses to
themselves up to the time the investing limited
partners were admitted.  The auditor reallocated these
losses according to the provisions in the limited
partnership agreement, allocating two percent to
general partners and 98 percent to limited partners."

Miller v. Dept. of Rev., 13 OTR 488, 490-93 (1996) (internal
footnote omitted).

		Taxpayers appealed the notices of assessment that were
issued pursuant to the audit.  After the administrative hearing,
the Department of Revenue (Department) concluded that the sales
were not arm's-length transactions and that the best indication
of the fair market value of the properties was their assessed
value on January 1, 1985.  For Fischer Court I, which is the
property selected for the purpose of analysis before the Tax
Court and this court, the assessed value was $627,890.  The
Department sustained the auditor's adjustments to depreciation
and her adjustments regarding allocation of profits and losses to
the general and limited partners.  Taxpayers appealed to the Tax
Court.

		According to the Tax Court, it was "unlikely that the
total amount due under the wrap note will ever be paid" and that
there was "no economic basis for the numbers involved except tax
benefits."  The court concluded that the purchase price of
Fischer Court I exceeded its fair market value, that taxpayers
had failed to establish that the remaining useful life of the
property was 15 years and that the limited partnership agreement
did not provide for allocation of 99.9 percent of the profits and
losses to the general partners.  Taxpayers assign error to all
three holdings.  

LEGAL STANDARDS

		Pursuant to ORS 316.007, we apply federal tax laws and
federal court interpretations of those laws in resolving the
issues raised by taxpayers.  ORS 316.007 provides, in part:

		"It is the intent of the Legislative Assembly * * * to
make the Oregon personal income tax law identical in effect
to the provisions of the federal Internal Revenue Code
relating to the measurement of taxable income of individuals
* * *; to achieve this result by application of the various
provisions of the federal Internal Revenue Code relating to
the definition of income, exceptions and exclusions
therefrom, deductions (business and personal), * * * basis,
depreciation and other pertinent provisions relating to
gross income as defined therein, modified as provided in
this chapter, resulting in a final amount called 'taxable
income' * * *."

Additionally, ORS 316.032(2) provides that, insofar as is
practicable in the administration of ORS chapter 316, "the
department shall apply and follow the administrative and judicial
interpretations of the federal income tax law."  See also Baisch
v. Dept. of Rev., 316 Or 203, 209, 850 P2d 1109 (1993) (Oregon
courts apply federal tax laws and federal court interpretations
of those laws).  

		It is well established that taxes are to be based on
the "objective economic realities of a transaction rather than  
* * * the particular form [that] the parties employed."  Frank
Lyon Co. v. United States, 435 US 561, 573, 98 S Ct 1291, 55 L Ed
2d 550 (1978).  A taxpayer seeking relief from a decision of the
Department has the burden of proving by a preponderance of the
evidence that a claimed deduction is allowable.  Reed v. Dept. of
Rev., 310 Or 260, 264, 798 P2d 235 (1990).

FAIR MARKET VALUE

		In their first assignment of error, taxpayers contend
that the Tax Court erred in holding that the purchase price of
$1,850,600 for Fischer Court I exceeded its fair market value. 
According to the Tax Court, the purchase price did not reflect
the fair market value, because it was inflated in a manner that
was acceptable both to sellers and buyers:  For tax purposes,
sellers would report only the gains they actually received on the
transaction, not the price that taxpayers paid.  Taxpayers,
through the use of nonrecourse debt, agreed to a high purchase
price in order to reap large depreciation deductions. 

		Taxpayers read Kem v. Dept. of Rev., 267 Or 111, 114,
514 P2d 1335 (1973), for the proposition that, in Oregon, "the
price paid in a voluntary, arms length transaction between a
buyer and a seller, both of whom are knowledgeable and willing"
is the most persuasive evidence in determining fair market value. 
Taxpayers contend that the evidence is "compelling" in this case
that the purchase price established the fair market value of
Fischer Court I.  The Department responds that the Tax Court did
not err in considering factors other than the purchase price in
determining the fair market value of Fischer Court I.

		A recent sale of property is "very persuasive" in
determining the property's fair market value, if the sale was a
voluntary, arm's-length transaction between a knowledgeable and
willing buyer and seller.  Id. at 114.  Whether the parties to a
sales transaction acted voluntarily, knowledgeably, willingly and
at arm's length are factual questions.  Freedom Fed. Savings and
Loan v. Dept. of Rev., 310 Or 723, 727, 801 P2d 809 (1990). 
However, purchase price "is not necessarily determinative of
market value."  Kem, 267 Or at 115.  The purchase price as
evidence of fair market value is subject to being discredited by
"special considerations."  Equity Land Res. v. Dept. of Rev., 268
Or 410, 415, 521 P2d 324 (1974); see also Durkin v. C.I.R., 872
F2d 1271, 1276 (7th Cir), cert den 493 US 824 (1989) (when debt
used to purchase an asset is unlikely to be paid by the taxpayer,
the debt does not represent a bona fide capital investment and
will be excluded from the depreciable basis of the asset).   

	 	In this case, the only disputed question of fact before
the Tax Court was whether the sales of the apartment complexes to
taxpayers were arm's-length transactions.  The Tax Court found by
a preponderance of the evidence that they were, but concluded
that "use of nonrecourse debt may produce an excessive price even
in an arm's-length transaction."  Consequently, the court
considered valuation factors other than the purchase price(2) and
concluded that the fair market value of Fischer Court I was
$730,000.  The question before this court is whether the Tax
Court erred as a matter of law when it considered valuation
factors other than purchase price in determining the fair market
value of Fischer Court I and the other properties.  For the
reasons that follow, we conclude that nonrecourse financing is a
special consideration that justifies considering factors other
than purchase price in determining fair market value.  

		The cost basis of property to a buyer includes the
amount of liabilities assumed, or taken subject to, by the buyer.
Brannen v. C.I.R., 722 F2d 695, 701 (11th Cir 1984) (citing Crane
v. Commissioner, 331 US 1, 67 S Ct 1047, 91 L Ed 1301 (1947)). 
Only genuine debt is included in the basis of property for tax
purposes, and a property's basis is its fair market value. 
Estate of Baron v. C.I.R., 798 F2d 65, 68 (2d Cir 1986).  When
the purchase price includes nonrecourse debt, the question arises
whether the debt is genuine, because if the buyer defaults, the
seller has no recourse against the buyer and must take back the
property.  Generally, if nonrecourse debt does not exceed the
value of the property that secures it, the debt is genuine,
because if the buyer defaults on the purchase, he or she will
lose an asset that is worth more than the amount of the debt. 
However, if the nonrecourse debt exceeds the value of the
securing asset, it is not genuine debt, because the buyer has no
incentive to pay it.  Bailey v. C.I.R., 993 F2d 288, 292-93 (2d
Cir 1993).  It follows that, when the purchase price of property
includes nonrecourse debt, the purchase price is not necessarily
the most persuasive evidence of the property's fair market value. 
The use of nonrecourse debt to finance a transaction justifies
consideration of factors other than purchase price in determining
the fair market value of the property.  See id. at 293 (in
deciding whether a taxpayer had an incentive to pay a nonrecourse
debt, a court must determine the value of the securing debt).

		In this case, the purchase price for, and taxpayers'
claimed basis in, Fischer Court I was $1,185,600.  The entire
debt -- the downpayment of $188,914 and the residual note of
$996,686 -- was nonrecourse.  The Tax Court did not err in
considering valuation factors other than the purchase price in
determining the fair market value of Fischer Court I.

DEPRECIATION

		Next, taxpayers contend that the Tax Court erred in
concluding that they had failed to support their claim that the
remaining useful life of Fischer Court I was 15 years.  They
frame the question on appeal as whether "the use of the 15-year
life for straight-line depreciation * * * was * * * justified by
component depreciation."  The Department responds that there is
no legal authority for any of the techniques and procedures used
by taxpayers in claiming that the remaining useful life of the
property was only 15 years.

		A taxpayer has the burden of establishing the
reasonableness of a depreciation deduction and must justify the
method used.  IRC § 167(a) (1985); Reed, 310 Or at 264.  The
method of depreciation that a taxpayer uses does not establish
the remaining useful life of the asset being depreciated. 
Regardless of the depreciation method used, the taxpayer must
establish the remaining useful life of the asset and, in doing
so, is to consider a variety of factors.  See Treas Reg §
1.167(a)-1(b) (stating the rule and identifying factors to be
considered by taxpayer in determining remaining useful life). 

		In this case, taxpayers elected to use the straight-line method of depreciation.  Under that method, the basis of
property less its salvage value is tax deductible in equal annual
amounts over the estimated useful life of the property.  Treas
Reg § 1.167(b)-1.  Taxpayers declared 15 years as the remaining
useful life of the property for purposes of calculating their
depreciation deduction under the straight-line method.(3)  The
auditor concluded that 15 years was not appropriate under any
method allowed in Oregon for establishing remaining useful life
and adjusted the remaining useful life to 30 years.  

		Taxpayers could not recall how they arrived at 15 years
as the remaining useful life of Fischer Court I.  Therefore, they
employed an accountant to justify to the Tax Court why they were
entitled to claim 15 years.  They contend that the accountant
used the component method of depreciation and that, under that
method, the remaining useful life of the properties is 15 years.

		We reject taxpayers' argument.  As noted above, a
depreciation method does not establish a property's remaining
useful life.  Even assuming that taxpayers were entitled to use
the component method of depreciation -- an assumption that the
Department disputes -- use of that method could not establish the
remaining useful life of the properties.  The Tax Court did not
err in affirming the Department's determination that the
properties have a remaining useful life of 30 years, because
taxpayers failed to establish the reasonableness of a 15-year
remaining useful life for purposes of their depreciation
deductions.  

ALLOCATION OF PROFITS AND LOSSES

		Finally, taxpayers contend that the Tax Court erred in
holding that, as to their 1985 tax returns, they were not
entitled to allocate 99.9 percent of their losses to the general
partners and one-tenth of one percent of their losses to the
initial limited partner.  The Tax Court held that the only
written agreements regarding allocations of profits and losses
unambiguously prevent such an allocation.  Taxpayers contend that
Section 8.1 of the Amended and Restated Articles of Limited
Partnership (amended articles) authorizes them to allocate
profits and losses among the general and original or substituted
limited partners as they "may agree" before admission of the
investor limited partners.  According to taxpayers, they and the
substitute limited partner agreed to the 1985 allocation.  The
Department responds that, under Section 1.5.1 A of the Articles
of Limited Partnership (articles) and amended articles, taxpayers
were entitled to claim only two percent of the profits and losses
on the 1985 tax returns.  For the reasons that follow, we
conclude that the Tax Court did not err.

		The articles, adopted on September 10, 1984, stated
that taxpayers were general partners and that Rockwood
Development Corporation (Rockwood) was the initial limited
partner.  Section 1.5.1 A of the articles allocated two percent
of the net operating profits and losses to the general partners
and 98 percent of the profits and losses to the limited partners. 
Section 8.1 of the articles provided, in part:

		"Net Operating Profits and Losses and Net Cash
Distributions from Operations (after payment of all
fees) shall be distributed to the Limited Partners (pro
rata in the relationship of the number of Units held by
each) and the General Partners (divided among them as
they agree) as stated in Section 1.5.1." (Emphasis
added.)

A statement next to the signatures of the general partners
declared that the general partnership held 100 percent of the
partnership interests.  A statement next to signature of the
initial limited partner declared that the limited partnership
held one-tenth of one percent of the limited partnership
interests.  American Properties Corporation (APC) subsequently
was substituted as a limited partner for Rockwood.  Thereafter,
taxpayers and APC signed the amended articles, under which APC
withdrew as a limited partner.  Section 1.5.1 A of the amended
articles allocates one percent of the net operating profits and
losses to the general partners and 99 percent of the profits and
losses to the limited partners.  Section 8.1 of the amended
articles provides:

		"Prior to the admission of the Investor Limited
Partners pursuant to Section 6.3, Operating Profits and
Losses shall be allocated among the General Partners
and the Original Limited Partner as they may agree."

Statements identical to those appearing next to the signatures of
the general and limited partners in the articles appeared next to
the signatures of the general and limited partners in the amended
articles.  "Schedule A," which was appended to the amended
articles, contained a list of the names of 21 new limited
partners.

		Relying on the wording in Section 8.1 of the amended
articles, taxpayers and APC agreed to allocate profits and losses
for the 1985 tax year based on the statements of ownership that
appeared next to the signature lines of the general and limited
partners.  In analyzing taxpayers' claim that Section 8.1 of the
amended articles authorized them to allocate profits and losses
as they and the limited partner "may agree" before admission of
the investor limited partners, the Tax Court noted that the
amended articles contained "no signatures for the 21 limited
partners."  The absence of the signatures of the new limited
partners is not without legal significance. 

		The formation and amendment of a limited partnership is
governed by statute.  ORS 69.180(1)(1983) describes the procedure
required for forming a limited partnership that was in effect
when taxpayers' limited partnership was formed and amended.  It
provides, in part, that when two or more persons desire to form a
limited partnership they shall "[s]ign and verify a certificate"
and shall "[f]ile one copy of such certificate in the office of
the Corporation Commissioner."  Taxpayers followed that procedure
with respect to the articles, evidence of which was introduced to
the Tax Court as an exhibit.  ORS 69.410(1)(1983) describes the
procedure required to amend a certificate of limited partnership
to change a limited partnership's composition.  That statute
provides that the writing to amend a certificate of limited
partnership shall:

 		"Be signed and verified by all partners.  An
amendment substituting a limited partner or adding a
limited or general partner shall be signed also by the
partners to be substituted or added.  When a limited
partner is to be substituted, the amendment shall also
be signed by the assigning limited partner."  ORS
69.410(1)(b).

		The only evidence regarding the amended articles that
taxpayers submitted to the Tax Court was a document signed by
taxpayers and the president of APC.  There is no evidence in this
record that the amended articles were signed by the 21 new
limited partners, as required by statute, or that the general
partners exercised a power of attorney to sign on behalf of the
investor limited partners.  See ORS 69.180(1)(a)(R) (stating
right of general partner to sign amended certificate for limited
partner if given power of attorney).  Thus, the amended articles
were not properly executed.  Consequently, taxpayers were not
entitled to rely on Section 8.1 of the amended articles for the
purposes of allocating profits and losses on their 1985 tax
returns.  The only document that conforms to the statutory
requirements and that is binding is the articles.  Section 1.5.1
A of the articles unambiguously allocates two percent of the
losses to the general partners and 98 percent of the losses to
the limited partners.  The Tax Court did not err in holding that,
with respect to their 1985 tax returns, taxpayers were not
entitled to allocate 99.9 percent of their losses to the general
partners and one-tenth of one percent of their losses to the
initial limited partner.

		The judgment of the Tax Court is affirmed.

1. 	ORS 305.445 was amended effective September 1, 1997. 
It now provides, in part:

	"The scope of the review of either a decision or order of
the tax court judge shall be limited to errors or questions
of law or lack of substantial evidence in the record to
support the tax court's decision or order."   

Before the effective date of the amendment, this court's standard
of review was de novo.  Because the case presents only issues of
law, our review is the same under either the previous or amended
version of the statute.

2. 	The valuation factors that the Tax Court took into
account were the assessed value of the property, the amount of
the other offers the sellers received, the fact that the sale was
made subject to Housing and Urban Development (HUD) regulations,
and valuation based on income, cost and sales approaches.  

3. 	The properties at issue in this appeal were in use
before Oregon adopted the federal Accelerated Cost Recovery
System (ACRS).  See OAR 150-317.368(1) (In 1984, Oregon adopted
ACRS but only for property placed into service on or after
January 1, 1985.).  Consequently, the former system, Class Life
Asset Depreciation Range system (ADR), Rev Proc 72-10, 1972-1 CB
721, was available for use by taxpayers to establish the
remaining useful life of the properties.  However, taxpayers
elected not to use the ADR system.  Consequently, they were
required to determine the remaining useful life of the properties
through consideration of the factors listed in Treas Reg §
1.167(a)-1(b).