Lead Opinion
Respondent determined deficiencies in petitioners’ 1977 Federal income taxes as follows:
Petitioner Deficiency
Herbert Gershkowitz. $8,888
Anthony D. Famighetti and Estate of Helen M. Famighetti, deceased. 8,158
Martin Greenberg and Thelma Greenberg. 1,669
Charles Druck and Roslyn Druck. 8,978
Wallace Kandell and Phyllis Kandell. 7,162
Ernest Malbin and Dorothy Malbin. 15,649
Raymond Tracht and Josephine Tracht. 16,637
Arthur A. Friedberg and Esther H. Friedberg_ 7,106
James V. Dowler, Jr., and Patricia Dowler. 28,542
The issues for consideration are (1) whether the cancellation of certain nonrecourse debts of limited partnerships in which petitioners
FINDINGS OF FACT
The facts have been stipulated and are so found. The stipulation of facts and attached exhibits are incorporated herein by this reference.
At the time the petitions herein were filed, petitioner Herbert Gershkowitz (Gershkowitz) resided in Chappaqua, New York. Petitioner Anthony D. Famighetti, who is one of
The Digitax Partnerships
Digitax of New England, Digitax of Michigan, Digitax Southeast, and Digitax of Pennsylvania (hereinafter collectively referred to as the Digitax partnerships) were all limited partnerships organized in 1972 for the purpose of engaging in the business of the computerized preparation of tax returns. Tax Management Corp. (now known as and hereinafter referred to as Vanguard Ventures, Inc.) was the sole general partner of each of the Digitax partnerships. During the years 1972 through 1977, Carl G. Paffendorf was the principal owner of Vanguard Ventures, Inc. During 1976 and 1977, Mr. Paffendorf was the chairman of the board and secretary of Vanguard Ventures, Inc.
Each of the petitioners in the instant case was a limited partner during the year 1977 and had made total capital contributions through 1977 to the partnership(s) as follows:
Petitioner Limited partnership Amount
Herbert Gershkowitz Digitax Southeast $10,000
Helen Famighetti1 Digitax of New England 10,000
Greenberg and Kandell2 Digitax of Michigan 10,000
Charles Druck Digitax of Michigan 10,000
Wallace Kandell, nominee3 Digitax of Michigan 10,000
Petitioner Limited partnership Amount
Ernest Malbin Digitax Southeast $10,000
Ernest Malbin 10,000 Digitax of New England
Raymond Tracht 10,000 Digitax of New England
Raymond Tracht 10,000 Digitax of Michigan
Arthur Friedberg 10,000 Digitax of New England
James Dowler 50,000 Digitax of Pennsylvania
For the years 1972 through 1977, each of the Digitax partnerships used the cash method of accounting to compute its taxable income.
Each of the Digitax partnerships was organized in New York and was to remain in existence through December 31, 1992, unless it was terminated prior to that date.
When the partnerships were formed, the general partner, Vanguard Ventures, Inc., contributed 38,000 shares of the common stock (1 cent par value) of COAP Systems, Inc. (hereinafter COAP), in exchange for a 19-percent interest in each partnership. The initial limited partner of each partnership contributed 2,000 shares of the common stock of COAP in exchange for a 1-percent interest in the partnership. Under the partnership agreement, all net income and losses of the partnership, including gains or losses realized on the sale, exchange or involuntary conversion of partnership property were to be allocated to the partners according to the ratios that their capital contributions bore to the total capital contributions of all the partners. However, until each limited partner had received distributions from the partnership which were equal to his initial capital contribution, all net income and net losses of the partnership were to be credited or charged, respectively, 95 percent to the accounts of the limited partners in the same proportion as their
Digitax Associates Transaction
On November 8, 1972, each of the Digitax partnerships purchased computerized income tax preparation systems and programs from Digitax Associates for a total purchase price of $200,000. Digitax Associates was a limited partnership which was wholly owned by Digitax, Inc., and COAP. Digitax, Inc., was a wholly owned subsidiary of COAP. Each partnership was restricted in the use of these programs to a specified geographical territory within the United States. For example, the specified geographical territory for Digitax of Michigan was the State of Michigan and the specified geographical territory for Digitax of Pennsylvania was the State of Pennsylvania.
Of the total purchase price of $200,000, $6,667 was paid in cash and the balance of $193,333 was payable by a nonrecourse note dated November 8, 1972. The nonrecourse note was payable in five annual installments, with payments of $40,000 due on April 30, 1973, 1974, 1975, and 1976, and a final payment of $33,333 due on April 30, 1977. Interest on the note was payable at the rate of IVz percent per year on the outstanding amount. The note was secured only by the Digitax computer program, and under the terms of the note, in the event of default, Digitax Associates could proceed to sell the collateral and keep the proceeds thereof, but in no event could it proceed against each Digitax partnership, its general partner, its limited partners or their assets. Each Digitax partnership granted Digitax Associates a security interest in the purchased computerized programs.
Digitax Associates provided a warranty, under the terms of the contract of sale, that the program could be used to process Federal and State income tax returns and that the program would be free of design defects for a 5-year period. Digitax Associates agreed to maintain the program until December 31, 1977. The fees charged for such maintenance were $80,000 each year for 1972, 1973, and 1974, $40,000 for 1975, and $20,000 for 1976 and each year thereafter.
The sales quotas contained in the agreement were not met for the years 1973, 1974, 1975, and 1976. Digitax, Inc., then parent of Digitax Associates, therefore elected to allocate to each partnership the processing of returns from other geographic territories, thereby increasing each partnership’s income. The total sales allocated to the partnerships were as follows:
Year Amount
1973 . $30,349
1974 . 151,311
1975 . 249,899
1976 . 346,237
COAP and its subsidiaries received revenue from the partnerships as follows:
FYE Apr. 30— Amount
1973. $900,663
1974. 859,088
1975. 670,492
1976. 615,745
On April 15, 1975, Digitax, Inc., advised the general partner of each partnership that it agreed to modify the payment terms of the sales agreement entered into between each partnership and Digitax Associates by reducing the purchase price installments due on April 30 of each year from $40,000 to $30,000, until the balance was paid, with the last payment to be $23,333.
COAP Planning Transaction
On April 15, 1973, each Digitax partnership purchased from COAP Computer Programming, Inc. (now known as and hereinafter referred to as COAP Planning, Inc.), three
COAP Planning, Inc., agreed to provide any improvements or enhancements to the estate and financial planning programs to each Digitax partnership for a fee of $5,000 per year payable in advance of April 15 of each year for the period from April 15, 1973, through April 15, 1978. COAP Planning, Inc., also agreed to assist each partnership in the marketing of services within its specific territory for an additional fee of $5,000 per year.
Finally, under the purchase agreement, the Digitax partnerships were entitled to cancel the purchase agreement with COAP Planning, Inc., if their gross sales from the services connected with this purchase were less than $25,000 for the 12-month period ending April 30, 1974. If the partnerships elected to cancel the agreement, they would forfeit all prior payments made to COAP Planning, Inc.
For the fiscal period ending on April 30, 1974, each of the partnerships had less than $25,000 in gross sales but did not exercise their right to cancel the sales contract.
COAP Planning, Inc., gave a warranty to each partnership that the systems and programs would be free from design defects for a period of 5 years.
On April 15, 1975, COAP Planning, Inc., advised the general partners of each Digitax partnership that it agreed to defer the payment of interest as well as purchase price
The computer systems and programs purchased by each Digitax Partnership from Digitax Associates and COAP Planning, Inc., were used in the business of the Digitax partnerships.
COAP Management Agreement
COAP Systems, Inc. (COAP), on November 8, 1972, agreed to perform on behalf of Vanguard Ventures, Inc., and each Digitax partnership, the management and administrative responsibilities of Vanguard Ventures, Inc., as set forth in a limited partnership agreement. The management agreement between COAP and the Digitax partnerships was amended as set forth in a letter dated December 17, 1973, whereby the obligation of COAP in respect of the management and administrative responsibilities of Vanguard Ventures, Inc., was terminated effective January' 1, 1974. The initial term of the management agreement was 5 years, and COAP was to be compensated $10,000 per year by Vanguard Ventures, Inc., plus a sum equal to 2 percent of the gross sales of each Digitax partnership. In addition, COAP was to receive up to $25,000 from Vanguard Ventures, Inc., for its accountable expenses which were incurred in the operation of the business of the Digitax partnerships during the first year. Under the agreement, COAP, in its discretion, could place the employees of the partnerships on its own payroll and pay other normal, necessary, and reasonable expenses on behalf of the partnerships. The agreement also provided that if the number of tax returns processed by or on behalf of the Digitax partnerships was less than 1,000 in 1972, 5,000 in 1973, 8,000 in 1974, 12,000 in 1975, and/or 17,000 in 1976, COAP would defer its annual compensation until the tax year in which the minimum number of returns was processed or until September 30, 1977, whichever came first. Further, the management agreement provided that COAP was obligated to lend or arrange for a loan of up to $200,000 to each partnership, in increments of no less than $25,000, within 30 days of a written request from Vanguard
Each Digitax partnership entered into an agreement with COAP which granted COAP the option of purchasing, at a fixed price, the assets of each partnership at any time after December 31, 1978. The option agreement was dated November 8, 1972. COAP could not exercise the option as long as the partnership had any outstanding loans due to COAP or any affiliates of COAP.
COAP Systems, Inc.
From 1972 through 1977, COAP wholly owned several subsidiaries including Digitax, Inc., and COAP Planning, Inc. COAP, along with Digitax, Inc., also wholly owned the limited partnership Digitax Associates. Carl G. Paffendorf owned 16 percent of the common stock of COAP. Prentice-Hall, Inc., owned 15 percent of the common stock of COAP plus 49 percent of the preferred stock. Digitax, Inc., and Digitax Associates had a marketing agreement in 1972 whereby Digitax, Inc., was to do all the selling and marketing of the products of Digitax Associates. In 1975, Digitax Associates became wholly owned by Digitax, Inc., and was absorbed into it. During 1976, COAP Computer Programming Inc., changed its corporate name to COAP Planning, Inc. Paffendorf was the president and director of COAP during the years 1972 through 1977. In addition to the stock he held, other shares of COAP common stock were owned by members of his family and by Vanguard Ventures.
The $570,000 note was secured by the computer programs used for the preparation of income tax returns and estate planning (CS101) which were prepared by Digitax Associates and COAP Planning, respectively. In addition to this security interest, COAP was restricted from entering into any contract or commitment in excess of $50,000 without Prentice-Hall’s consent as long as $150,000 of the $570,000 note remained outstanding. In July of 1974, COAP paid $300,000 of the $570,000 note leaving a balance due of $270,000. In November 1974, Prentice-Hall loaned COAP an additional $300,000 at an interest rate equal to the prime rate. This loan was unsecured.
During 1973 and 1974, approximately 55 percent and 46 percent, respectively, of COAP’s gross revenues were the result of sales to the Digitax partnerships.
In June of 1972, the Institute for Business Planning (IBP) a wholly owned subsidiary of Prentice-Hall, entered into an agreement with COAP to sell its Digitax income tax preparation service. This agreement was terminated on June 27, 1973, and a similar agreement was entered into between COAP and Prentice-Hall. During the fiscal year which ended July 31, 1975, Prentice-Hall received commissions from COAP of approximately $192,000 as a result of being the sales agent for the Digitax income tax preparation service. The agreement for Prentice-Hall to serve as the marketing and sales agent of the Digitax income tax preparation service was terminated by COAP in 1976.
Prentice-Hall gave its consent to COAP to permit Digitax Associates to sell the income tax preparation program to
Prentice-Hall Loans
On November 8, 1972, Prentice-Hall, Inc., loaned $50,000 to each of the Digitax partnerships on a nonrecourse basis. Each loan was due on November 30, 1977, with interest payable annually at the rate of 7 percent. The loan was secured by 40,000 shares of the common stock of COAP Systems, Inc., which was owned by each Digitax partnership. Each partnership also provided Prentice-Hall with a security interest in the computer programs, systems, and documentations for the income tax preparation service prepared by Digitax Associates. However, this security interest was subordinate to the security interest of Digitax Associates. Prentice-Hall was also given the option to acquire the 40,000 COAP common shares from each Digitax partnership at a purchase price of $1.25 per share.
On June 30, 1973, Prentice-Hall loaned $100,000 to each of the Digitax partnerships on a nonrecourse basis. This loan was due on June 30, 1978. Interest on the June 30, 1973, loan was payable annually at the rate of 7 percent. This loan was secured by a security interest in the computer programs, systems, and documentations for the preparation o,f estate planning and financial analysis reports. However, this security interest was subordinate to that of COAP Planning.
On July 1, 1974, Prentice-Hall loaned another $100,000 to each of the Digitax partnerships on a nonrecourse basis. This loan was payable on June 30, 1979, and interest thereon was payable annually at the rate of 8 percent. This loan was to be secured by the accounts receivable of each Digitax partnership, beginning on May 1, 1979. On the same date, each partnership agreed to give Prentice-Hall, as additional security for the $50,000 loan of November 8,
The stated consideration providing for the release of COAP from its guarantee of the $50,000 loans was COAP’s agreement to waive the condition which required that a prepayment of $100,000 on COAP’s $570,000 debt to Prentice-Hall had to be made only if COAP received the sum of $500,000 from the Digitax partnerships in any year. The stated consideration for the release of COAP from its guarantee of the $100,000 loans was COAP’s promise to pay $500,000 to Prentice-Hall on or before May 1, 1975, and partial satisfaction of the $570,000 note which was due June 30, 1977.
COAP Loans
On various dates in 1975 and 1976, COAP loaned funds to each Digitax Partnership on a nonrecourse basis. These loans were payable on demand and secured by the Digitax computer program, the COAP Planning computer program, the accounts receivable of the partnerships, and the 40,000 shares of common stock of COAP owned by each partnership. The security interests granted to COAP by each partnership were subordinate to the security interests of Digitax, Inc., COAP Planning, Inc., and Prentice-Hall, Inc. The nonrecourse loans made by COAP to each Digitax partnership were as follows:
(a) Digitax of Pennsylvania
Date of loan Amount
Dec. 16, 1976. $112,000
Dec. 29, 1976. 20,000
Nov. 28, 1975. 18,620
Dec. 26, 1975. 16,000
Total. 166,620
(b) Digitax of New England
Date of loan Amount
Nov. 28, 1975. $42,400
Dec. 29, 1975. 18,500
Oct. 30, 1975 . 11,957
Oct. 26, 1976 . 95,000
Dec. 29, 1976 .. .. 20,000
Total. 187,857
(c) Digitax of Michigan
Date of loan Amount
Nov. 28, 1975.'. $42,217
Dec. 23, 1975. 18,000
Dec. 16, 1976..'...V.:. 115,500
Dec. 29, 1976..'. 20,000
Total.•. 195,717
(d) Digitax Southeast
Date of loan Amount
Nov. 28, 1975. $18,034
Dec. 23, 1975. 20,000
Dec. 7, 1976 .i. 118,500
Dec. 29, 1976. 20,000
Total.'.. 176,534
Vanguard Ventures Loans
Vanguard Ventures, Inc., loaned funds to each Digitax partnership on a nonrecourse basis at various times prior to January 1, 1977. These loans, repayable on demand, were as follows:
Amount Borrower
$8,500 .Digitax of Pennsylvania
2.500 .Digitax of New England
10,500.Digitax of Michigan
7.500 .Digitax Southeast
Liquidation
The assets and liabilities of each of the Digitax partnerships as reflected on their books and records as of January 1, 1977, are as follows:
(a) Digitax of Pennsylvania
Assets Amount
Cash. $254
Digitax computer program:
Cost. $200,000
Less depreciation. 166,667 33,333
CS 101/201/301 computer program:
Cost. 100,000
Less depreciation. 75,000 25,000
COAP Systems, Inc., stock (40,000 common shares). 50,000
Total assets. 108,587
Liabilities
Prentice-Hall, Inc., due 11/30/77 . 50,000
Prentice-Hall, Inc., due 6/30/78 . 100,000
Prentice-Hall, Inc., due 6/30/79 . 100,000
Digitax, Inc., due in installments of $30,000 and $23,333 on Apr. 30, 1977, and Apr. 30, 1978, respectively. 53,333
COAP Planning, Inc., due $20,000 per annum on 4/15/77 through 4/15/79. 60,000
COAP Systems, Inc., due on demand, nonrecourse loans
Date of loan
Dec. 16, 1976 . 112,000
Dec. 29, 1976 ..'. 20,000
Nov. 28, 1975. 18,620
Dec. 26, 1975 . 16,000 166,620
Digitax, Inc., due on demand, nonrecourse loan. 2,750
Vanguard Ventures, Inc., due on demand, nonrecourse loans. 8,500
Total liabilities. 541,203
(b) Digitax of New England
Assets Amount
Cash. $141
Digitax computer program:
Cost. $200,000
Less depreciation. 166,667 33,333
CS 101/201/301 computer program:
Cost. 100,000
Less depreciation. 75,000 25,000
COAP Systems, Inc., stock (40,000 common shares)_ 50,000
Total assets. 108,474
Liabilities
Prentice-Hall, Inc., due 11/30/77 50,000
Prentice-Hall, Inc., due 6/30/78 . 100,000
Prentice-Hall, Inc., due 6/30/79 . 100,000
Digitax, Inc., due in installments of $30,000 and $23,333 on Apr. 30, 1977, and April 30, 1978, respectively. $53,333
COAP Planning, Inc., due $20,000 per annum on 4/15/77 through 4/15/79. 60,000
COAP Systems, Inc., due on demand, nonrecourse loans
Date of loan
Nov. 28, 1975. $42,400
Dec. 29, 1975 . 18,500
Oct. 30, 1975 . 11,957
Oct. 26, 1976 . 95,000
Dec. 29, 1976 . 20,000 187,857
Vanguard Ventures, Inc., due on demand, nonrecourse loans. 2,500
Total liabilities. 553,690
(c) Digitax of Michigan-.
Assets Amount
Cash. $255
Digitax computer program:
Cost. $200,000
Less depreciation. 166,667 33,333
CS 101/201/301 computer program:
Cost.•. 100,000
Less depreciation. 75,000 25,000
COAP Systems Inc.,stock (40,000 common shares). 50,000
Total assets. 108,588
Liabilities
Prentice-Hall, Inc., due 11/30/77 . 50,000
Prentice-Hall, Inc., due 6/30/78 . 100,000
Prentice-Hall, Inc., due 6/30/79 . 100,000
Digitax, Inc., due in installments of $30,000 and $23,333 on Apr. 30, 1977, and Apr. 30, 1978, respectively. 53,333
COAP Planning, Inc., due $20,000 per annum on 4/15/77 through 4/15/79. 60,000
COAP Systems, Inc., due on demand, nonrecourse loans
Date of loan
Nov. 28, 1975. 42,217
Dec. 23, 1975 . 18,000
Dec. 16, 1976 . 115,500
Dec. 29, 1976 . 20,000 $195,717
Vanguard Ventures, Inc., due on demand, nonrecourse loans. 10,500
Total liabilities. 569,550
(d) Digitax Southeast:
Assets Amount
Cash. $430
Digitax computer program Cost. $200,000
Less depreciation. 166,667 33,333
CS 101/201/301 computer program Cost. 100,000
Less depreciation. 75,000 25,000
COAP Systems, Inc., stock (40,000 common shares). 50,000
Total assets. 108,763
Liabilities
Prentice-Hall, Inc., due 11/30/77 . 50,000
Prentice-Hall, Inc., due 6/30/78 .... 100,000
Prentice-Hall, Inc., due 6/30/79 . 100,000
Digitax,Inc., due in installments of $30,000 and $23,333 on Apr. 30, 1977, and Apr. 30, 1978, respectively. 53,333
COAP Planning, Inc., due $20,000 per annum on 4/15/77 through 4/15/79. 60,000
COAP Systems, Inc., due on demand, nonrecourse loans
Date of loan
Dec. 23, 1975 . 20,000
Nov. 28, 1975. 18,034
Dec. 7, 1976 . 18,500
Dec. 29, 1976 . 20,000 176,534
Vanguard Ventures, Inc., due on demand, nonrecourse loans. 7,500
Total liabilities. 547,367
The fair market value of the Digitax computer programs and the COAP Planning computer programs owned by each partnership was $30,000 at all times throughout 1977. The fair market value of the 40,000 shares of restricted COAP common stock owned by each Digitax partnership was $2,500 at all times during 1977.
In a letter dated October 20, 1976, Prentice-Hall, Inc., COAP, and the Digitax partnerships agreed to terminate their relationship. The time period for the termination of this relationship was extended to June 20, 1977, by a letter dated December 22, 1976, from Prentice-Hall. On June 20, 1977, a cross-receipt and settlement agreement was entered into between Prentice-Hall and each of the Digitax partnerships whereby Prentice-Hall received $40,000 in cash and extinguished the $250,000 nonrecourse debt owed by each
The agreement provided that, upon receipt of $350,000 from COAP and $40,000 from each Digitax partnership, Prentice-Hall would:
(i) Contribute to COAP Systems Inc. (“COAP”) the following COAP securities: 310,373 shares of COAP Common Stock, $.01 value; 75,000 shares of COAP Preferred Stock, $8.00 par value, and the Warrant to purchase 456,000 shares of COAP Common Stock;
(ii) Cancel the principal amount and all interest due and hereafter accruing on all indebtedness owed to P-H from COAP (and subsidiaries) including the following: $270,000 Promissory Note due June 30, 1977, $300,000 Promissory Note due May 31, 1977 and all other current indebtedness due May 31, 1977 aggregating $443,051 as of September 30, 1976;
(iii) Cancel the principal amount and all interest due and hereafter accruing on all indebtedness due P-H from the five Digitax Partnerships, including Promissory Notes in the total amount of $1,250,000 due in installments commencing November, 1977;
(iv) Release and cancel all security agreements and option rights relating to the foregoing and any and all other agreements relating to COAP (or subsidiaries), and the five Digitax Partnerships and P-H’s option rights relating to an aggregate of 250,000 shares of COAP Common Stock owned by Mr. Carl G. Paffendorf.
On August 29, 1977, COAP, COAP Planning, Inc., and Digitax, Inc., entered into an agreement with each Digitax partnership. Under this agreement, each Digitax partnership conveyed and transferred to COAP Planning, Inc., and Digitax, Inc., all of the computer programs, systems, and technology which such partnership had originally purchased from COAP Planning, Inc., and Digitax, Inc.; and COAP, COAP Planning, Inc., and Digitax, Inc., extinguished all debts due to them from each Digitax partnership and terminated the security interests which collateralized such indebtedness. Also under this agreement, each Digitax partnership acknowledged receipt of the $40,000 nonrecourse loan received from COAP and used to pay Prentice-Hall. Such loan was secured by a security interest in the computer income tax programs and estate planning
Partnership Amount
Digitax of Pennsylvania. $322,703
Digitax of Michigan. 349,050
Digitax of New England. 341,190
Digitax Southeast. 329,867
Also on August 29, 1977, Vanguard Ventures and each Digitax partnership entered into an agreement whereby each partnership returned to Vanguard Ventures the 40,000 shares of COAP common stock which had a basis of $50,000 to each partnership. At that time, the stock was not subject to any liabilities. Vanguard Ventures did not assume any liabilities of the Digitax partnerships in connection with the receipt of such stock. In exchange for this stock, Vanguard Ventures extinguished the nonrecourse debt of each Digitax partnership as follows:
Partnership Amount
Digitax of Pennsylvania. $11,223
Digitax of Michigan. 13,223
Digitax of New England. 4,025
Digitax Southeast. 7,500
The agreement also provided for the termination of any and all security interests collateralizing such debt. Each of the limited partners of the Digitax partnerships executed a consent and general release which, among other things, released COAP and its subsidiaries Digitax, Inc., and COAP Planning, Inc., Prentice-Hall, and Vanguard Ventures and their respective officers and directors from any and all
On December 26, 1977, an amendment to the limited partnership agreement for each of the Digitax partnerships was executed. The amendment provided as follows:
Whereas, the parties hereto entered into a Limited Partnership Agreement dated as of the 8th day of November, 1972; and
Whereas, the parties have authorized the liquidation of said Partnership and the filing of a Certificate of Cancellation of the Certificate of Limited Partnership; and
Whereas, the parties hereto wish to authorize, ratify, approve and confirm the allocation of net profits and losses from capital transactions and related matters;
NOW, THEREFORE, the parties hereto agree
1. Article XIV (D) (4) is hereby amended in its entirety to be and read as follows: “The net profits and losses from capital transactions shall first be allocated among the partners pro-rata to eliminate any deficits in their respective capital accounts; thereafter net profits and losses from capital transactions shall be allocated in accordance with the profit and loss sharing ratio set forth in ARTICLE VI without regard to the last sentence thereof.”
2. This Amendment shall be effective for all transactions occurring within the fiscal year of the partnership commencing January 1, 1977 through the effective date of the filing of the Certificate of Cancellation of the Certificate of Limited Partnership referred to above.
Article VI of the limited partnership agreement of each Digitax partnership read as follows:
All net income, and all net losses of the Partnership, computed in accordance with generally accepted accounting principles consistently applied, including gains or losses realized upon the sale, exchange or involuntary conversion of Partnership property, shall be allocated to the respective accounts of all partners, in the ratios that their capital contributions bear to the total capital contributions of all partners; provided, however, that until each limited partner shall have received distributions from the Partnership equal to his initial capital contribution, all net income and all net losses of the Partnership shall be credited or charged, as the case may be, as follows: 95 percent to the accounts of the limited partners in the same proportion as their capital contributions; and 5 percent' to the account of the general partner. Any distribution of assets under Article XIV, paragraph (D) shall be made without reference to the above 95 percent - 5 percent proviso.
The intention of each partnership in making the 1977 amendment to the limited partnership agreement was (1) to
On December 28, 1977, each of the Digitax partnerships executed a certificate of cancellation of the certificate of limited partnership, and the partnerships were terminated. Each of the Digitax partnerships conducted no business during the year 1977 except as required to terminate its operations and liquidate the partnership. Prior to January 1, 1977, none of the Digitax partnerships had earned a profit in any taxable year. On January 1, 1977, and at all times thereafter, each Digitax partnership was insolvent. Each of the petitioners herein was solvent during the entire calendar year 1977.
The partnerships paid or incurred the following ordinary and necessary business expenses in 1977:
Partnership Amount
Digitax of Pennsylvania. $2,882
Digitax of Michigan. 2,884
Digitax of New England. 1,584
Digitax Southeast. 284
As of January 1, 1977, and prior to the liquidation of each partnership, the adjusted basis, capital account and percent of each partners’ interest in the Digitax partnerships is as follows:
Percent Capital Adjusted interest Petitioner Digitax partnership account 1 basis in partnership
H. Gershkowitz Digitax Southeast ($19,155) $1,437 3.762%
H. Famighetti Digitax of New England (19,740) 1,090 3.762
M. Greenberg2 Digitax of Michigan (5,119) 238 0.940
C. Druck Digitax of Michigan (20,474) 962 3.762
W. Kandell3 Digitax of Michigan (17,915) 833 3.292
E. Malbin Digitax Southeast (19,154) 1,438 3.762
E. Malbin Digitax of New England (19,739) 1,091 3.762
R. Tracht Digitax of Michigan (20,474) 952 3.762
R. Tracht Digitax of New England (19,739) 1,091 3.762
A. Friedberg Digitax of New England (14,951) 5,879 3.762
J. Dowler Digitax of Pennsylvania (78,780) 22,503 18.810
The transactions entered into between each of the Digitax partnerships and Prentice-Hall, Inc., COAP and its subsidiaries, Digitax Associates and Vanguard Ventures, Inc., are the same except for the outstanding amounts which were owed by each partnership to COAP, its subsidiaries, Digitax Associates, and Vanguard Ventures, Inc.
OPINION
1. Prentice-Hall Transactions
The first issue for consideration is whether petitioners must recognize a gain on the Prentice-Hall transaction. Each partnership received loans in the aggregate amount of $250,000 from Prentice-Hall. These loans were nonrecourse, and were secured by the 40,000 shares of COAP common stock owned by each partnership and by the accounts receivable of each partnership. Prentice-Hall also had a subordinate security interest in the computer programs purchased by each partnership from Digitax Associates and COAP Planning, Inc. On June 20, 1977, Prentice-Hall released its security interest in the COAP stock, the computer
In determining whether petitioners in the instant case must recognize a gain on the discharge of the Prentice-Hall indebtedness, two sets of rules must be considered. First, the general provisions of section 61(a)(12) dealing with income from discharge of indebtedness, and secondly the distribution provision of section 752(b) relating to a decrease in partnership liabilities.
In general, gross income includes income from the discharge of indebtedness. Sec. 61(a)(12); United States v. Kirby Lumber Co.,
Under section 752(a), at the time a partnership assumes a liability, an individual partner’s share of such liability is treated as a contribution of money by the partner to the partnership and increases the partner’s basis in his partnership interest. Sec. 722. Conversely, any decrease in the partner’s share of the partnership liabilities is treated as a distribution of money by the partnership to the partner under section 752(b) and results in the recognition of gain by the partner to the extent that such a distribution exceeds his adjusted basis in his partnership interest. Sec. 731(a)(1). The gain recognized is characterized as gain from the sale or exchange by the partner of his partnership interest, and is taken into income under section 61(a)(3) (gains derived from dealings in property).
Petitioners maintain that the opinion in Stackhouse stands for the proposition that income from the discharge of indebtedness should be recognized at the partnership, rather than the partner, level, and that the insolvency exception to the discharge of indebtedness doctrine applies,
Petitioners allege that their interpretation of Stackhouse is supported by the legislative history of the Bankruptcy Tax Act of 1980 (Pub. L. 96-589, December 24, 1980) (the act). Section 2(a) of the act amended section 108 of the Code to provide that the application of the code section providing for nonrecognition of discharge of indebtedness income when the taxpayer is insolvent should take place at the partner, rather than the partnership, level. Specifically, the legislative history states:
The bill provides that the rules of exclusion from gross income and reduction of tax attributes in section 108 of the Code (as amended by the bill) are to be applied at the partner level and not at the partnership level.26
Based on this footnote, petitioners argue that Congress perceived that, prior to the act, the insolvency exception to the recognition of discharge of indebtedness income was to be applied at the partnership level. Other than Stackhouse, however, petitioners cite no authority in support of this proposition, nor have we found any. As stated above, this issue was not addressed in Stackhouse. Further, by requiring recognition at the partner level, Congress provided for the inclusion of discharge of indebtedness income as a
Even if we were to assume, however, that petitioners’ analysis of the legislative history of the act was correct, we would still decline to follow the opinion of the Fifth Circuit in Stackhouse.
For the above-stated reasons, petitioners’ reliance on Stackhouse is misplaced. The application of the insolvency exception to the discharge of indebtedness income should be made at the partner, not the partnership, level. Because each petitioner herein was solvent at the time the debts were discharged, each must recognize ordinary income with respect to his share of the partnership’s income under section 702(a)(8). This income will provide each partner with an increase in basis under section 705(a)(1)(A). At the same time, each partner will receive a distribution from the partnership in an amount equal to his share of the partnership indebtedness. Sec. 752(b). This distribution will offset each partner’s basis under section 733(1). Thus, the increase in basis under section 705, coupled with the distribution and decrease in basis under sections 752 and 733 result in a net change of zero in each partner’s basis. The optional adjustments to basis enacted by the Bankruptcy Tax Act of 1980 were intended to change this result. S. Rept. 96-1035, at 21 (1980).
Respondent argues, on brief, that the partners should not be entitled to a basis increase under section 705(a)(1)(A) because of the realization of discharge of indebtedness income. Respondent asserts that the basis increase would provide an opportunity for limited partners to bail out of crossover tax shelter partnerships without the recognition of the “phantom gain” inherent in their partnership interests, citing W. McKee, W. Nelson & R. Whitmire, Federal Taxation of Partnerships and Partners, par. 9.06[3] n. 144 (1977). We agree with respondent that, if the insolvency exception were to apply at the partnership level, such a step-up in basis would be abusive. In the instant case, however, we have determined that this exception must be applied at the partner level. When the loan proceeds were received by the partnerships, each partner increased his basis in his partnership interest by his distributive share of the liability. Sec. 722. This basis increase allowed the partners to deduct their distributive shares of partnership losses and deductions prior to the discharge of the loans. If
Having concluded that each partner must recognize ordinary income from the discharge of indebtedness as a result of the Prentice-Hall transaction, we must now consider the amount of that income. Petitioners allege that each partnership realized income of $210,000 (liability of $250,000 less payment of $40,000), but that none of this amount must be recognized. Respondent, on the other hand, argues that each partnership has income of $2,500 under the doctrine developed by United States v. Kirby Lumber Co.,
Although the statutory notices of deficiency issued in the instant case determined that each partner recognized income in 1977 to the extent of his distributive share of the amount of indebtedness that was discharged, less the amount of money paid to Prentice-Hall by each partnership,
Respondent acknowledges that the rationale of the Kirby Lumber doctrine has been somewhat eroded by the Supreme Court’s opinion in Commissioner v. Tufts,
We are not presented with and do not decide the contours of the cancellation-of-indebtedness doctrine. We note only that our approach does not fall within certain prior interpretations of that doctrine. In one view, the doctrine rests on the same initial premise as our analysis here— an obligation to repay — but the doctrine relies on a freeing-of-assets theory to attribute ordinary income to the debtor upon cancellation. See Commissioner v. Jacobson,336 U.S. 28 , 38-40 (1949); United States v. Kirby Lumber Co.,284 U.S. 1 , 3 (1931). According to that view, when nonrecourse debt is forgiven, the debtor’s basis in the securing property is reduced by the amount of debt canceled, and realization of income is deferred until the sale of the property. See Fulton Gold Corp. v. Commissioner,31 B.T.A. 519 , 520 (1934). Because that interpretation attributes income only when assets are freed, however, an insolvent debtor realizes income just to the extent his assets exceed his liabilities after the cancellation. Lakeland Grocery Co. v. Commissioner,36 B.T.A. , 292 (1937). Similarly, if the nonrecourse indebtedness exceeds the value of the securing property, the taxpayer never realizes the full amount of the obligation canceled because the tax law has not recognized negative basis. [289 461 U.S. 300 , 311 n. 11.]
The Court held that the amount realized on the sale of property included the full amount of nonrecourse debt to which the property was subject even when the value of the property was less than the outstanding amount of the obligation. Similar results had been reached by this Court in Millar v. Commissioner,
This finding is totally in keeping with the spirit and reasoning of Crane. While not personally liable upon the loan from Jamison, the taxpayers utilized those funds to increase the basis of their stock, which then permitted them to claim sizable deductions calculated against that basis. See 26 U.S.C. secs. 163, 1374(a), (b). Having substantially reduced the adjusted basis of their stock in this manner and thereafter surrendering their devalued stock in exchange for the cancellation of their indebtedness, the taxpayers clearly realized taxable gain equal to the value of the cancelled obligation, less the adjusted basis of their surrendered stock. A finding that the taxpayers did not realize gain as a result of this exchange, after having realized the full economic benefit of this transaction, would entitle them to the type of double deductions of which the Supreme Court so clearly disapproved in Crane. [Millar v. Commissioner,577 F.2d 212 , 215 (3d Cir. 1978).]
If, as respondent urges, we restrict the amount realized by petitioners in the instant case to the fair market value of their stock at the time the indebtedness was canceled, petitioners in this case will achieve the result that the appellate court sought to avoid in Millar. Petitioners will have received the benefit of increased basis, which permitted them to take deductions based on the partnership’s
The general partner of the limited partnerships involved herein was Vanguard Ventures, Inc. At the time the partnerships were formed, Carl Paffendorf was the sole shareholder of Vanguard Ventures, Inc., and as such has been involved in several tax shelter promotions. See Hagler v. Commissioner,
Petitioners attempted to avoid the Millar result by using cash to close the Prentice-Hall transaction. We cannot allow petitioners to accomplish indirectly what they were unable to do directly: that is, to avoid the recognition of gain on the discharge of the loan. We therefore hold that although petitioners transferred cash, rather than the stock which secured the loan, to Prentice-Hall in exchange for the discharge of the partnerships’ debts, they must recognize gain to the extent that the amount of debt discharged exceeded the cash transferred. Further, the restrictions of the Kirby Lumber doctrine are not applicable in the instant case to permit the partnerships to avoid recognition of the full amount of indebtedness which was discharged. Accordingly, each partner must recognize gain under section 702 to the extent of his distributive share of $210,000.
The next issue for consideration is the amount and character of the gain which petitioners must recognize on the discharge of the loans from COAP, COAP Planning, Inc., and Digitax, Inc. Each partnership entered into an agreement with COAP, COAP Planning, Inc., and Digitak, Inc., on August 29, 1977, under which the partnership debts to each entity were discharged. In exchange, each partnership transferred to COAP Planning, Inc., and Digitax, Inc., all computer programs, systems, and technology which were originally purchases by the partnerships from COAP Planning, Inc., and Digitax, Inc. Respondent urges that the discharge of indebtedness under the agreement be treated as a single transaction. Petitioners argue, however, that there are three separate transactions involved and that each must be separately addressed. We agree with petitioners.
By arguing that the agreement results in one transaction between the partnerships and COAP, COAP Planning, Inc., and Digitax, Inc., respondent is seeking sale or exchange treatment for the entire amount of indebtedness discharged under the agreement. Such an analysis enables respondent to adopt the position that petitioners must recognize the full amount realized, less their basis in the property reconveyed to COAP Planning, Inc., and Digitax, Inc., without confronting the Kirby Lumber problem discussed above with respect to the loans from COAP Systems, Inc. Because of our holding with respect to the Prentice-Hall transaction, however, we do not need to adopt respondent’s analysis in order to require the recognition of income by petitioners on the discharge of the COAP Systems, Inc., loans.
Further, although we recognize that there is a close relationship between all parties to the transactions in the instant case, we cannot ignore the independent corporate identities of COAP Planning, Inc., and Digitax, Inc. The corporate entity may be disregarded only when the court finds that it is a sham or unreal. Moline Properties, Inc. v. Commissioner,
The discharge of partnership debt by COAP Planning, Inc., and Digitax, Inc., is treated as a sale or exchange because the partnerships surrendered the security for the indebtedness to their creditors. Estate of Delman v. Commissioner, supra. These transactions are, therefore, governed by the rules of section 1001 and not by the discharge of indebtedness doctrine. Income realized as a result of these transactions is reported under section 61(a)(3) rather than section 61(a)(12). Therefore, the discharge of indebtedness doctrine does not apply, and the solvency of the individual partners or of the partnerships is irrelevant. Estate of Delman v. Commissioner, supra.
The amount realized by each partnership on the reconveyance of the property to COAP Planning, Inc., and Digitax, Inc., includes the amount of indebtedness to which the property is subject. Commissioner v. Tufts, supra. Each partnership must recognize gain to the extent that the amount of the outstanding indebtedness exceeds the partnership’s basis in the reconveyed property. Sec. 1001(a); sec. 1.1001-2(a)(l), Income Tax Regs. Each partner must recognize gain to the extent of his distributive share of such income. Sec. 702(a)(8). This recognition will increase the partners’ bases in their partnership interests under section 705(a)(1)(A). At the same time, each partner will receive a section 752(b) distribution as a result of the discharge of partnership liabilities which will reduce his basis under section 733(1).
Gain realized on the disposition of personal property used in a taxpayer’s trade or business is characterized under section 1231. However, any depreciation taken by the taxpayer must be recaptured at the time the property is disposed of and reported as ordinary income. Sec. 1245(a)(1). Therefore, each partner has ordinary income to the extent of
3. Vanguard Ventures, Inc., Transactions
The next issue for consideration is the determination of the amount and character of any loss realized by the partnerships as a result of the agreement with Vanguard Ventures, Inc. On August 29, 1977, each partnership entered into an agreement with Vanguard Ventures, Inc. Under the agreements, each partnership transferred 40,000 shares of restricted COAP common stock to Vanguard Ventures, Inc. Vanguard Ventures, Inc., in exchange, extinguished the debts owed to it by each partnership. As discussed above, with respect to the COAP Planning, Inc., and Digitax, Inc., transactions, this transaction is governed by the principles of section 1001 and is treated as a sale or exchange. Because each partnership had a basis in its stock of $50,000, which exceeded the amount of the debt owed by each partnership to Vanguard Ventures, Inc., each partner realized a loss on the transaction to the extent of his distributive share of the partnerships’ loss. This loss will decrease the partners’ bases in their partnership interests under section 705(a)(2)(A). At the same time, each partner will receive a section 752(b) distribution in the amount of his distributive share of the indebtedness which was discharged and a corresponding basis reduction under section 733(1). The loss realized by the partnerships on the exchange of the stock is a capital loss. Sec. 702(b).
4. Amendment to Partnership Agreement
The final issue for consideration is whether the amendment to the partnership agreement has substantial economic effect. The partnership agreement originally provided that all items of partnership income and loss would be allocated to the partners in accordance with their capital contributions; however, until each limited partner recovered his capital contribution, all items of income and loss would be allocated 95 percent to the accounts of limited partners, in proportion to their capital contributions, and 5 percent to
Petitioners maintain that the agreement should be respected because it was designed to leave each partner with a capital account balance of zero which, according to petitioners, reflects the economic status of the partnerships at the time of liquidation. Respondent asserts, however, that the agreement lacks substantial economic effect because its sole purpose was to limit the tax liability of the partners. Neither party cites any authority for its position.
In general, a partner’s share of items of income and loss Eire determined by the partnership agreement and will be respected for Federal income tax purposes. Sec. 704(a). However, if the allocations provided for in the partnership agreement do not have substantial economic effect, they will be disregarded. Sec. 704(b)(2). Section 704 was amended by the Tax Reform Act of 1976 (Pub. L. 94-455). The amendment is effective for partnership years beginning after December 31, 1975. The joint committee’s explanation of the amendments to section 704 indicated that, in determining whether partnership allocations had substantial economic effect, the partners’ rights to distribution of capital on liquidation were to be considered. Joint Comm, on Taxation, General Explanation of the Tax Reform Act of 1976, 1976-3 C.B. (Vol. 2) 107 n. 6. The purpose underlying the amendments was to permit partnerships to use special
The regulations under section 704 provide that a partnership agreement which provides for special allocation of items of income and loss will be considered to have substantial economic effect if, on liquidation of the partnership, partners with positive capital accounts will receive distributions in accordance with the balance in those capital accounts and partners with negative capital accounts will be required to restore the amount of the deficit balance in those accounts to the partnership. Sec. 1.704-l(b)(2)(ii)(b)(2) and (5), Income Tax Regs. The effect of the amendment to the partnership agreement in the instant case is to defeat the requirement that liquidating distributions be made in accordance with capital accounts.
Because the amendment to the partnership agreement does not have substantial economic effect, the amount of gain or loss to each partner for taxable year 1977 must be determined in accordance with the provisions of the original partnership agreement.
To reflect the foregoing,
Decisions will be entered under Rule 155.
Reviewed by the Court.
Notes
OnIy one petitioner in each docket was a limited partner. For convenience, we will sometimes refer to the limited partners as petitioners and in the masculine gender.
All section references are to the Internal Revenue Code of 1954 as amended and in effect during the years here in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.
Helen Famighetti died on Nov. 14, 1977, and the executors of her estate are Anthony Famighetti and the First National Bank of Long Island.
Petitioners Martin Greenberg and Wallace Kandell and a third party who is not a petitioner to this case were partners in the Greenberg and Kandell partnership which owned a limited partnership interest in Digitax of Michigan. Greenberg owned a 25-percent interest, representing a $2,500 capital contribution, and Kandell owned a 37.5-percent interest, representing a $3,750 capital contribution in the partnership.
Petitioner Wallace Kandell owned 50 percent of the partnership interest listed in his name, representing a $5,000 capital contribution, as a nominee for a third party who is not a petitioner in this case.
The amounts here indicated are the sum of the debts of each partnership’s debts to COAP, Digitax, Inc., and COAP Planning, as indicated on the balance sheets, supra> and the $40,000 nonrecourse loan used to pay Prentice-Hall.
The capital accounts are all deficits.
Greenberg owned a 25-percent interest in the Kandell and Greenberg partnership which in turn owned a 3.762-percent interest in Digitax of Michigan.
Kandell owned a 37.5-percent interest in the Kandell and Greenberg partnership which in turn owned a 3.762-percent interest in Digitax of Michigan. Kandell also owned a 50-percent interest in Digitax of Michigan. His total interest therefore was 3.292 percent.
The effect of these provisions of the bill is to overturn the decision in Stackhouse v. U.S.,
[S. Rept. 96-1035, at 21 (1980).]
We note that appeal in the instant case, if taken, will lie in the Second Circuit. Therefore, we are not bound by the Fifth Circuit’s opinion in Stackhouse v. Commissioner,
The notices of deficiency issued to petitioners in the instant case determined deficiencies in the amount of each petitioner’s distributive share of the full amount of the debts discharged, less the amount of money transferred. Petitioners bear the burden of proving that these deficiencies are in error. Rule 142(a); Welch v. Helvering,
The final regulations promulgated under sec. 704(b) were filed on Dec. 24, 1985, and published on Dec. 81, 1985. T.D. 8065, 50 Fed. Reg. 53420 (1985), 1986-
However, for partnership taxable years beginning after Dec. 31, 1975, but before May 1, 1986 (or before Jan. 1, 1987, with respect to special allocations of nonrecourse debts), a special allocation that does not satisfy their requirements nonetheless will be respected for purposes of the final regulations if such allocation has substantial economic effect as interpreted under the relevant case law and the legislative history of the Tax Reform Act of 1976, and the provisions of this paragraph in effect for partnership taxable years beginning before May 1, 1986. Sec. 1.704-l(b)(l)(ii), Income Tax Regs. Here, applying the relevant case law, the legislative history of the Tax Reform Act of 1976, and the prior regulations, the special allocation lacks economic effect under such criteria and is not to be respected.