Court Opinion

ID: 4483396
Source: CourtListenerOpinion
Date Created: 2020-01-16 21:16:04.780607+00
Date Added: 2024-06-11T15:04:31.277848
License: Public Domain

Tannenwald, J., dissenting in part: I share the majority’s concern over the attempt by Condiotti to spread the tax liability resulting from his business operation among petitioner and the numerous trusts established for the benefit of his family members. However, I cannot agree with the technique chosen by the majority to attack the effect of the partnership agreement and thereby allocate the entire income of the partnership to petitioner. Under my approach, part of the partnership income, albeit a small portion, would be allocated to the trusts, and it is for this reason that I record my dissent rather than concurrence. Section 704 (e)(1) provides that “A person shall be recognized as a partner” if two conditions are satisfied: first, the individual must own a capital interest in the partnership; second, capital must be a material income-producing factor in the partnership. The majority reasons that the interests of the trusts should not be recognized because the second requirement has not been satisfied. Its rationale is that capital was not a material income-producing factor in Sonoma’s business because substantially all of the capital employed in the business was borrowed and the partnership was .able to borrow such funds only because Condiotti, who was not a partner, guaranteed the loans. I cannot agree with this rationale. Section 752(a) and the regulations thereunder make clear that liabilities resulting from funds borrowed by a partnership are treated as a contribution of capital by the partners and enter into the calculation of the partners’ bases of their partnership interests. This is true of a limited partner in a situation where none of the partners has any personal liability, i.e., a nonrecourse borrowing by the partnership. It is also true, to a lesser extent, where there is personal liability on the part of another partner and the limited partner has not made the full capital contribution for which he is obligated. See sec. 1.752-l(e), Income Tax Regs. See also Kingbay v. Commissioner, 46 T.C. 147, 152-153 (1966). This treatment is consistent with section 1.704-l(e)(l)(iv), Income Tax Regs., which deals with capital as a material income-producing factor. The regulation does not consider “borrowed” capital at all. Instead, it pinpoints “employment of capital in the business conducted by the partnership” and distinguishes businesses which require substantial inventories or a substantial investment in plant, machinery, or other equipment from businesses which derive their income primarily as compensation for services. What is determinative for such purposes is the function capital serves for the business, not the source from which it is obtained. See Hartman v. Commissioner, 43 T.C. 105, 112, 118-119 (1964). What clearly emerges from the facts herein is that the partnership was in the business of purchasing land and constructing houses for sale on subdivided lots. Such transactions required the infusion of substantial sums of money. I perceive no valid reason why the fact that such funds were obtained from borrowings on the strength of Condiotti’s credit should per se preclude a finding that capital was a material income-producing factor in the business of the partnership within the meaning of section 704(e)(1). Indeed, the majority’s reasoning to the contrary, if carried to its logical conclusion, could cast doubt on the propriety of the allocation of income among partners in an ordinary limited real estate partnership with only one general partner, an approach which is fraught with substantial, if not insuperable, difficulties. As I see it, capital was clearly a material income-producing factor in the business of Sonoma and the only issue herein is the impact, if any, of the borrowed funds upon the allocation of the partnership income among the petitioner and the trusts. Under section 704(e)(1), aside from the element of capital as a material income-producing factor, the question is whether the trusts’ partnership status, and therefore the partnership, should be considered sham. While many aspects of the instant situation lend support for the basic thrust of respondent’s argument that the partnership and the trusts’ interests therein lacked economic reality and therefore should not be recognized, the fact of the matter is that the trusts did contribute capital, albeit in very small amounts. Perhaps these small capital contributions were not realistically required in the business of the partnership, but they were made and I am not prepared to say that, at least to the extent thereof, the trusts’ partnership interests should not be recognized.1 But there is still the further question as to the applicability of section 704(e)(2), which provides: In the case of any partnership interest created by gift, the distributive share of the donee under the partnership agreement shall be includible in his gross income, except to the extent that such share is determined without allowance of reasonable compensation for services rendered to the partnership by the donor, and except to the extent that the portion of such share attributable to donated, capital is proportionately greater than the share of the donor attributable to the donor’s capital. * * * [Emphasis added.] Under this provision, each trust’s share of income cannot exceed that amount justified by its share of the capital of the partnership. Petitioner argues that this provision is inapplicable because the partnership interests were purchased with trust assets. This argument is answered by section 1.704-l(e)(4), Income Tax Regs., which provides that a purported purchase of a capital interest in a partnership will have to meet the same requirements as an interest created by gift, unless the purchase is recognized as bona fide under section 1.704-l(e)(4)(ii), Income Tax Regs.2  I can think of few cases where the bona fides of the so-called purchases of the partnership interests by the trusts could be more open to question. The trusts herein were established and the partnership interests were acquired on the same day. The trusts were funded simply with a transfer of $1,000 to each trust and that entire amount was simultaneously invested in the partnership. While these elements standing alone might not be sufficient to justify ignoring the form of purchase, I think they are relevant when considered in the context of the allocation of partnership income in the instant case. The share of partnership income attributable to each trust, while proportionate to the initial capital investments by each partner, was grossly disproportionate when the role of Condiotti, and particularly the use of his credit standing, is taken into account. Nor is there any indication that investments by the trusts were intended to promote the success of the partnership’s business either through the participation of the trusts or the use of their credit. In short, I think it more than appropriate to treat the trusts’ partnership interests as having been acquired by gift within the meaning of section 704(e)(2). There remains the question of how the partnership income should be allocated to reflect the exception of section 704(e)(2) in a situation where “the portion of such share attributable to donated capital is proportionately greater than the share of the donor attributable to the donor’s capital.” In this connection, the following provision of section 1.704-l(e)(3)(ii)(c), Income Tax Regs., is pertinent: In the case of a limited partnership * * * consideration shall be given to the fact that a general partner, unlike a limited partner, risks his credit in the partnership business. Given the limited participation by the trusts, the status of petitioner as the sole general partner with the concomitant full risk of loss thereby imposed upon it, and the pervasive role of petitioner’s sole shareholder (Condiotti), including his assumption of the ultimate full risk of loss via his guaranty, it is clear to me that the capital represented by the borrowed funds should be considered as petitioner’s capital.3 Once that is done and the petitioner’s capital thus determined, I would allocate the partnership income in accordance with the respective capital interests of the petitioner and the trusts. Drennen, Fay, Hall, and Wilbur, JJ., agree with this dissenting opinion. Hall, J., dissenting: I join in Judge Tannenwald’s dissenting opinion. I also share Judge Goffe’s concern expressed in his concurring opinion that the majority’s rationale does violence to the previously well-understood meaning of “capital as a material income-producing factor.” All too frequently, the understandable desire to strike out at an abusive situation tempts judges to the shortcut of distorting the meaning of well-understood words. But (because we tinker with a complex mechanism) such distortion can open the door to new abuses elsewhere. This case provides an example. If we establish the hitherto undreamed-of principle that borrowed capital cannot be considered in determining whether capital is a material income-producing factor, tax planners will have a colorable excuse for new avoidance plans. For example, a proprietor (simply by borrowing all. the needed capital on his own credit) could possibly report the entire profit of a manufacturing business — instead of only 30 percent— as “earned income” subject to the 50-percent maximum tax. See sections 1348(b)(1)(A) and 911 (b). As Judge Tannenwald has demonstrated, Congress has provided us with statutory tools aplenty to handle abusive cases like this, without trying to make statutory phrases do more than they were designed for. Drennen and Wilbur, JJ.,agree with this dissenting opinion.  None of the cases relied upon by respondent to support his argument of lack of economic reality involved situations where the trusts made any payment. Respondent also argues that the trustee “was not in a position to act as an independent fiduciary.” One of the tests in determining “sham” is whether a trustee-partner is “amenable to the will of the grantor.” See sec. 1.704-l(eX2Xvii), Income Tax Regs. Such amenability should not be inferred from the mere fact that the trustee involved herein was also Condiotti’s accountant. Cf. Estate of Gilman v. Commissioner, 65 T.C. 296 (1975), affd. per curiam 547 F.2d 32 (2d Cir. 1976).   Sec. 1.704-l(e)(4Xii), Income Tax Regs., provides: (ii) Tests as to reality of purchased interest. A purchase of a capital interest in a partnership, either directly or by means of a loan or credit extended by a member of the family, will be recognized as bona fide if: (a) It can be shown that the purchase has the usual characteristics of an arm’s-length transaction, considering all relevant factors, including the terms of the purchase agreement (as to price, due date of payment, rate of interest, and security, if any) and the terms of any loan or credit arrangement collateral to the purchase agreement; the credit standing of the purchaser (apart from relationship to the seller) and the capacity of the purchaser to incur a legally binding obligation; or (b) It can be shown, in the absence of characteristics of an arm’s-length transaction, that the purchase was genuinely intended to promote the success of the business by securing participation of the purchaser in the business or by adding his credit to that of the other participants. However, if the alleged purchase price or loan has not been paid or the obligation otherwise discharged, the factors indicated in (a) and (b) of this subdivision shall be taken into account only as an aid in determining whether a bona fide purchase or loan obligation existed.   petitioner appears to argue that, if respondent is not correct in his contention that the partnership should be considered a sham, then none of the income of Sonoma should be attributable to petitioner, because all of the activities of Sonoma were “earned” by Condiotti, who “ran the whole show.” I would reject this argument to the extent that it can be construed as seeking to avoid the deficiency herein by claiming that the proper taxpayer is Condiotti (who is not before the Court) for two reasons: (1) Since I do not think the partnership should be ignored, petitioner’s argument falls by the wayside, and (2) in any event, I would have serious doubts as to whether, under the circumstances herein, petitioner could ignore the form of the transaction adopted by the parties. Cf. Strong v. Commissioner, 66 T.C. 12 (1976), affd. without opinion 553 F.2d 94 (2d Cir. 1977). Compare Larson v. Commissioner, 66 T.C. 159 (1976), on appeal (9th Cir., Sept. 14, 1976).