Opinion ID: 782888
Heading Depth: 2
Heading Rank: 7

Heading: Cashmere Investment Assoc.'s transactions

Text: 107 During the 1970s, Kanter was involved in a series of real estate developments with developer Sam Zell. The development properties were owned by partnerships (real estate partnerships). Kanter's interests in the real estate partnerships were held through a series of Kanter-controlled trusts, including the BWK Revocable Trust, the Everglades Trusts 1-5, and the BWK Family Trusts (referred to collectively as the grantor trusts). Each of these trusts was a grantor trust whose income was attributable to Kanter personally. A detailed breakdown of the real estate partnership interests and their associated financial attributes is provided in the Tax Court's opinion. IRA, 78 T.C.M. (CCH) at 1107-11. The interests in these real estate partnerships had, as of 1982-83, zero basis. 108 During 1982, Zell expressed his desire to purchase all of the real estate partnership interests held by the grantor trusts. Kanter was interested in selling to Zell, but was concerned that significant gains would be triggered by an unqualified sale of the real estate partnership interests held by his grantor trusts. The Tax Court found that twenty one of the real estate partnership interests held by the grantor trusts had negative capital accounts; that is, their liabilities exceeded their bases, by an amount, in total, of $476,889. IRA, 78 T.C.M. (CCH) at 1108. Therefore, the unqualified transfer of those interests would involve the assumption of liabilities in excess of the bases, and would trigger capital gains to the seller — Kanter, who was the owner by virtue of the IRC's grantor trust provisions. See 26 U.S.C. §§ 671-677. 109 In 1983, a series of transactions took place that ultimately resulted in the transfer of the real estate partnership interests from the grantor trusts to a Zell-controlled entity. The transfer took place in three stages. 110
111 Cashmere Investment Associates, Inc. (Cashmere) was an inactive shelf corporation incorporated in Delaware in 1982 and controlled by Kanter. On or about May 15, 1983, Kanter directed the grantor trusts to transfer their real estate partnership interests to Cashmere in what was intended as a nontaxable exchange under 26 U.S.C. § 351 in return for Cashmere common and preferred stock. Concurrently with the § 351 transfer, the grantor trusts also transferred to Cashmere eight promissory notes payable to, and held by, the grantor trusts with a face value, in total, of $498,500. The promissory notes were all dated May 1, 1983, and were payable on August 1, 1983. These promissory notes, according to Kanter, had a basis equal to face value and increased the total aggregate basis of the transferred property so as to eliminate the gain that would otherwise have been realized under 26 U.S.C. § 357(c) through the assumption by Cashmere of the negative capital accounts in the transfer of the real estate partnership interests. See 26 U.S.C. § 357(c). 28
112 On July 12, 1983, in the next stage of the transfers to Zell-controlled entities, Kanter directed the grantor trusts to sell their common and preferred stock in Cashmere to Waco Capital Corp. in return for promissory installment notes totaling approximately $1.5 million. The grantor trusts reported the income from this sale under the installment method of 26 U.S.C. § 453. 113 Waco was a Delaware corporation whose sole shareholder was BRT. BRT's beneficiaries were the members of Kanter's family, who were also the beneficiaries of the grantor trusts. The Tax Court found that, under 26 U.S.C. § 453(f), Waco and the grantor trusts were related persons. See 26 U.S.C. § 318(a)(2), (3). 114 On August 31, 1983, the promissory notes held by Cashmere were paid off by eight checks drawn on the Administration Co.'s Special E account. As noted, the Special E account contained the commingled funds of a variety of entities, mostly (if not entirely) Kanter entities, and the Administration Co. accounted internally for the specific source of a given disbursement. The Administration Co.'s general ledger, however, did not specify the source of the eight checks paying the notes. The checks themselves indicate, in part, what entity is the payor of the notes. Three of the promissory notes were ostensibly paid with funds from BRT, an entity that was not the maker of the notes in question, and there was no documentary evidence that BRT was advancing the funds to the makers of the promissory notes or had, in some way, assumed the obligations on the notes. IRA, 78 T.C.M. (CCH) at 1110-11. 115 As of September 1, Waco held all of the stock in Cashmere, and Cashmere's assets included the real estate partnership interests and $498,500 in cash (from the note payments).
116 Kanter subsequently negotiated the sale of Waco's Cashmere stock to Equity Financial Management Co. (Equity), an entity controlled by Zell. On September 2, 1983, Waco sold the Cashmere stock to Equity for $1,647,500 payable by check. 29 Immediately after the purchase, Zell liquidated Cashmere. 117 The Tax Court found that this convoluted series of transactions taking place within a three-and-one-half month period that ultimately resulted in the transfer of the real estate partnership interests to Zell was arranged principally to avoid immediate recognition of gain on the transfer and otherwise lacked any bona fide business purpose. IRA, 78 T.C.M. (CCH) at 1113; see 26 U.S.C. § 357(b)(1)(A), (B). Therefore, the assumption of liabilities by Cashmere was recognized as money received by Kanter (through his grantor trusts), and he was required to be taxed on his gain resulting from the transfer, up to the full amount of the liabilities. 26 U.S.C. § 357(b). Additionally, the Tax Court found that the transfer of the notes with the real estate partnership interests also lacked any bona fide business purpose and were principally intended as a means to avoid income tax. The Tax Court found that the notes represented mere transfers between and among Kanter-controlled entities, and did not represent true indebtedness. Therefore, Kanter had no basis in the notes, and the notes did not, therefore, increase the aggregate basis in the property transferred to Cashmere. Under § 357(c), the excess of liabilities over basis in the transferred property was therefore recognized as capital gain to Kanter. Because the basis in the partnership interests was zero, under both § 357(b) and (c), the full amount of the transferred liabilities was taxable to Kanter. 118 Additionally, the Tax Court found that the subsequent sale to Waco using the installment method was a dispos[ition] of property to a related person. 26 U.S.C. § 453(e)(1)(A). When Waco then subsequently transferred, within two years, the Cashmere stock to Equity, the installment method of reporting was no longer available. 26 U.S.C. § 453(e)(1), (2). The entire amount realized by Waco in the second disposition was treated as received (at the time of the second disposition) by the seller-grantor trusts in the first disposition. Id.
119 Whether the transactions involving Cashmere had economic substance for federal income tax purposes is a factual question reviewed for clear error. N. Ind. Pub. Serv. Co. v. Comm'r, 115 F.3d 506, 510 (7th Cir.1997). Similarly, whether the installment method of reporting is available is a factual question that we review for clear error. Applegate v. Comm'r, 980 F.2d 1125, 1128 (7th Cir.1992).
120 The tax-free transfer of property to a controlled corporation solely in exchange for the transferee corporation's stock is permitted under 26 U.S.C. § 351. The IRC also provides a means for preserving § 351 eligibility in circumstances where the transferee corporation assumes liabilities of the transferor together with the property transferred (an event that is economically equivalent to a transfer of money (boot) from the transferee corporation to the property transferor). 26 U.S.C. § 357. There are two limitations, however, to tax-free treatment under § 351. First, the taxpayer-transferor must prove by a preponderance of the evidence that the liabilities were not transferred for the principal purpose of tax avoidance and that the transfer had a bona fide business purpose. § 357(b). If the taxpayer fails to clear this hurdle, the assumption of the liability is treated as money received by the taxpayer, and the taxpayer recognizes any gain to the full amount of the liability. 26 U.S.C. §§ 357(b)(1), 351(b)(1)(A). Second, if the amount of the liability transferred is greater than the basis of the property transferred, then, in general, the transferor-taxpayer recognizes a capital gain on the amount by which the liability exceeds the basis of the transferred property. 26 U.S.C. § 357(c)(1). 121
122 There can be little question that the Tax Court was correct when it viewed the totality of the convoluted Cashmere transactions and found that their only purpose was the avoidance of federal income tax. Kanter's argument that § 357(b)(1) does not reach this transaction is meritless. Within a four-month period of time an inactive shelf corporation controlled by Kanter (Cashmere) had its stock transferred three times, twice between Kanter-controlled entities. Within that same time span, promissory notes, virtually equal in total value to the total negative capital account balances, were made by entities controlled by Kanter, transferred (along with the real estate partnership interests holding the negative balances) to entities controlled by Kanter and then satisfied by entities controlled by Kanter. Both Cashmere and the promissory notes completed their entire useful life-cycle within the span of the larger, intended transaction — transferring the real estate partnership interests to Zell. Yet neither the promissory notes nor Cashmere functioned to facilitate the transfer of the real estate partnership interests to Zell: the promissory notes were created, transferred, and satisfied before the consummation of the sale to Zell, and Cashmere was liquidated as soon as its stock came into Zell's possession leaving Zell with only the desired asset — the real estate partnership interests. The entire transaction was constructed to avoid the recognition of the gain realized on the assumption of the real estate partnerships' liabilities (by, ultimately, Zell). Therefore, the assumption of those liabilities by Cashmere in the initial stages of the process cannot be described as other than having as its principal purpose the avoidance of federal income tax. See 26 U.S.C. § 357(b). 123 Kanter's remaining argument with respect to § 357(b) appears to be that the intent of that statutory section was to prevent taxpayers from creating additional liabilities (like personal loans or debts) to be packaged with assets contributed in a § 351 exchange in order to extract the gains contained within the contributed property without recognition for tax purposes. This kind of intent to avoid taxes, argues Kanter, is far removed from the present case where the liabilities were a substantial aspect of the real estate partnership interests to be contributed. This argument fails as well. The fact that the liabilities being contributed were ordinary business liabilities of the partnerships does nothing to save this transaction. As noted, the entire business of contributing the partnership interests and their associated liabilities to Cashmere was a transaction whose only function was the avoidance of federal tax. Therefore, taking into consideration the nature of the liability and the circumstances in the light of which the arrangement for the assumption was made, it is clear that the principal purpose of the assumption of liabilities was the avoidance of tax. 26 U.S.C. § 357(b)(1). 124 It was not clearly erroneous for the Tax Court to have found that the assumption of the real estate partnership interests' liabilities by Cashmere had as its principal purpose the avoidance of federal income tax. 125
126 The Tax Court also found, alternatively, that § 357(c) would apply to the Cashmere transactions. 30 Section § 357(c) is triggered when the amount of the liabilities assumed exceeds the basis of the property contributed in the § 351 exchange. The taxpayer is taxed on the amount by which the liabilities exceed the basis. The Tax Court found that the contributed promissory notes did not represent genuine indebtedness and had, therefore, a basis of zero. Without any additional basis from the promissory notes, the basis of the contributed real estate partnership interests was zero, and the amount of the liabilities assumed (in the form of the oft-mentioned negative capital accounts) necessarily exceeded that zero basis. Therefore, the gain realized in the § 351 transfer must be recognized to the full extent of the assumed liabilities. 127 Kanter vigorously argues that the substance of the promissory notes should be respected and not disregarded as mere form, and the notes should be given a basis equal to their face value. For this argument Kanter relies heavily on the Ninth Circuit's determinations in Peracchi v. Comm'r, 143 F.3d 487 (9th Cir.1998), where a taxpayer made and contributed notes to his closely held corporation. The Ninth Circuit found substance in Peracchi's promises to pay himself, and increased the basis of property contributed (in a § 351 exchange) to a figure greater than the liabilities assumed by the closely-held transferee corporation. Id.; see also Lessinger v. Comm'r, 872 F.2d 519 (2d Cir.1989) (finding also that personal note had face-value basis in hands of transferee corporation). The hypothetical risk that this note might somehow become the property of a creditor (through bankruptcy of the corporation) and that a creditor might then be able to enforce the note was sufficient to make the note more than an empty promise. Peracchi, 143 F.3d at 493. The Ninth Circuit panel realized the potential for abuse of this holding, however, and cabined it. 128 We confine our holding to a case such as this where the note is contributed to an operating business which is subject to a non-trivial risk of bankruptcy or receivership. [The closely held company] is not, for example, a shell corporation or a passive investment company. 129 Id. at 493 n. 14. 130 Even if we were to accept Peracchi 's underlying premise that a taxpayer's self-made obligations to his own closely held corporation should be respected for tax purposes, in light of the language limiting Peracchi 's holding, we would not extend that premise to the present case. Cashmere was a passive investment company that, before the transactions at issue, was a shelf corporation. And after the transfer of the real estate partnership interests to Zell, Cashmere was liquidated. Cashmere was not an operating business, and, unlike Peracchi, where an insurance corporation needed more assets to meet a minimum premium-to-asset ratio for regulatory purposes, there was no underlying business purpose here for these transitory promissory notes. Nor did Cashmere face a non-trivial risk of bankruptcy. Peracchi is, therefore, quite distinguishable from the present case. The promissory notes here did not represent genuine indebtedness, and the Tax Court did not clearly err in finding that the promissory notes had no basis. Therefore, the Tax Court's conclusion that the liabilities assumed exceeded the basis of the contributed property by the full amount of the liabilities and were taxable to that extent was not clearly erroneous. 131
132 The next steps in the sale of the real estate partnership interests to Zell involved, first, the sale of the Cashmere stock from Kanter's grantor trusts to Waco and, second, the subsequent sale within two months of the Cashmere stock from Waco to Equity (the Zell-controlled entity). The grantor trusts reported their gains from the sale to Waco under the installment method allowed by 26 U.S.C. § 453. 31 But § 453(e) limits the use of the installment method in circumstances where there is a second disposition of the property within two years that is effected by a person related to the original seller. In other words, if A sells to B, and then B sells to C (within two years), A cannot report the income from its sale under the installment method if A and B are related persons under 26 U.S.C. §§ 267(b) or 318(a). The Tax Court found that the grantor trusts and Waco were related persons, and that the entire amount of income attributable to the sale of the Cashmere stock to Waco must be recognized in 1983. We affirm this finding as well. 133 Section § 453(f)(1) defines a related person for purposes of determining the reach of § 453(e): 134 (A) a person whose stock would be attributed under section 318(a) (other than paragraph (4) thereof) to the person first disposing of the property, or 135 (B) a person who bears a relationship described in section 267(b) to the person first disposing of the property. 136 26 U.S.C. § 453(f)(1). Waco's stock is owned entirely by BRT, whose beneficiaries were undisputedly the members of Kanter's family. Similarly, Kanter does not dispute that these same family members were the beneficiaries of the grantor trusts. Under 26 U.S.C. § 318(a)(2)(B)(i), the stock owned by BRT is considered owned by its beneficiaries. Therefore, the BRT beneficiaries are treated as owning the Waco stock. Similarly, those same BRT beneficiaries are also beneficiaries of the grantor trusts, and their ownership of the Waco stock is imputed upstream, under § 318(a)(3)(B)(i), to the grantor trusts. Therefore, the stock of Waco would be attributed to the grantor trusts under § 318(a), making Waco a person related to the grantor trusts under § 453(f)(1)(A). The attribution, therefore, makes the sale of the Cashmere stock to Waco ineligible for the installment method under § 453(e). 32 137 Similarly, as noted in Part III, Kanter was the substantial owner of BRT under the grantor trust provisions of 26 U.S.C. §§ 671 et seq. Therefore, there is an alternative means by which the grantor trusts and Waco are related persons. 33 Under § 318(a)(2)(B)(ii), stock owned by a grantor trust is attributed to its grantor; BRT's stock, therefore, is attributed to Kanter. That is, Kanter himself is considered to own the Waco stock owned by BRT. Following a similar statutory path as before, Kanter's status as the substantial owner of the grantor trusts means that any stock he owns personally is attributed to the grantor trusts under § 318(a)(3)(B)(ii). Therefore, Kanter's attributed ownership of the Waco stock means that the grantor trusts also own the Waco stock. Because the grantor trusts are attributed ownership of the Waco stock under § 318(a), Waco and the grantor trusts are related persons under § 453(f)(1)(A), and the sale of the Cashmere stock from the grantor trusts to Waco is ineligible for reporting under the installment method by operation of § 453(e). 138 Whether one, the other, or both methods of analysis are followed, the grantor trusts' sale of Cashmere stock to Waco was ineligible for the installment method of reporting for federal income tax purposes. The Tax Court's findings on this issue were not clearly erroneous.