Summary
In Holladay, this court affirmed the Tax Court's decision to disallow half of certain tax benefits that an agreement between two joint venturers allocated to only one of the venturers.
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No. 80-5274.
July 9, 1981.
Kenneth G. Anderson, Jacksonville, Fla., for petitioners-appellants.
M. Carr Ferguson, Asst. Atty. Gen., Gilbert E. Andrews, Act. Chief, Appellate Section, Tax Div., Dept. of Justice, N. Jerold Cohen, Chief Counsel, Internal Revenue Service, Michael L. Paup, Jonathan S. Cohen, Daniel F. Ross, Tax Division, Dept. of Justice, Washington, D.C., for respondent-appellee.
Appeal From the Tax Court of the United States.
Durand A. Holladay petitioned the United States Tax Court for a review of the federal income tax deficiencies totalling $589,396 assessed against him by the Commissioner of Internal Revenue for calendar years 1971 through 1973. Holladay appeals from the Tax Court's decision in favor of the Commissioner under 26 U.S.C.A. § 7482. This case was consolidated for oral argument with Boynton v. Commissioner, 649 F.2d 1168 (5th Cir. 1981), and should be read in conjunction with it.
Mrs. Blanche F. Holladay is a party to this appeal solely because she filed joint returns with her husband for the years involved.
We agree with Holladay that the Tax Court erred by considering tax year 1970 for substantive tax purposes; accordingly the only tax years at issue in this appeal are 1971, 1972 and 1973 as the refunds claimed by Holladay for tax years 1968-1970 were based on the net operating loss carrybacks from the tax years 1971-1973.
I. Facts
The factual situation involved is essentially undisputed. In 1970, Charles I. Babcock, Jr., a developer and housing builder, approached Durand A. Holladay with a proposed joint venture to develop a 600-unit apartment project named the Kings Creek Apartments, which would be located in Dade County, Florida. In October 1968, Babcock had purchased 17.5 acres of undeveloped land for the apartments; 90% of the $599,000 purchase price was financed by Babcock with mortgages and promissory notes. After further financing (through Babcock Company, his personal investment company), Babcock acquired the land for $631,533.55. Babcock needed additional capital for the long term costs of the project so he approached Holladay, who had training as an engineer and a lawyer and who was a successful investor and mortgage company executive with an annual income exceeding $1,000,000.
At the end of the trial, Holladay made several unsuccessful post trial motions; one motion was for further findings of fact. However, he does not assign as error the Tax Court's denial of those motions.
The joint venture agreement basically provided that Babcock Company would contribute the land, plans, and construction of the project and in exchange Holladay would contribute an equity capital contribution of $750,000, a subordinated loan up to $1,000,000 and his expertise at obtaining additional institutional financing; thus Babcock would supply the construction services and Holladay would provide the long term financing for the project. The joint venture agreement was signed on July 1, 1970, and later amended on April 15, 1971. When the agreement became effective on July 1, 1970, each joint venturer obtained a 50% interest in the assets of the project, that is, Babcock became one-half owner of the $750,000 equity and Holladay became one-half owner of the land.
Holladay did not send the original agreement to his attorney for review until December 1970. Subsequent to that review, the original agreement was amended on April 15, 1971.
The original agreement provided that the first available funds for distribution would repay the joint venture's obligations to Babcock and Holladay, including Holladay's subordinated loan; thereafter all funds would be divided evenly between them. The amended agreement, which is the agreement at issue, modified several provisions including the distribution provisions such that (1) every year the first $100,000 available for distribution would be divided equally, (2) Babcock Company would receive a one-time payment of $150,000 out of one-half of the balance available for distribution, (3) Holladay's subordinated loan would be repaid after three years over a five-year period, (4) other outstanding loans from the venturers would be paid, and (5) any remaining balance would be equally divided (e.g., funds from apartment rentals, sale of any jointly owned assets, etc.). One feature that was significantly modified by the amended agreement was Section 4 which provided that, prior to 1975, all profits and losses of the venture were to be allocated to Holladay, exclusive of any gains or losses from the sale of property or other disposition; any profits or losses not allocable to Holladay prior to 1975 were to be shared equally; and after January 1, 1975, all profits and losses were to be shared equally.
The Tax Court found that the modifications of the original agreement did not significantly affect the import of pertinent provisions. One of the main reasons the agreement was amended was to include the cash flow provisions that granted Babcock priority return of his capital investment. The amended agreement established priority rights of distribution; thus Holladay's subordinated loan would not be repaid until after Babcock's $150,000 priority cash flow payment and construction fees were satisfied. All of these distributions were subordinated to the $100,000 cash flow that was to be equally divided between Babcock and Holladay.
All of the venture's losses "as finally determined for income tax purposes" were allocated to Holladay because the adjusted basis of the property contributed by Babcock differed "substantially from the fair market value of said property at the time of its contribution." See Appendix A, Original Agreement § IV(A). However, this statement was eliminated when the agreement was amended to provide that Holladay would bear all profits and losses of the venture prior to 1975. See Appendix B, Amended Agreement § 4(A).
Holladay contributed $750,000 equity to the project during the summer of 1970. Over the next 13-month period he advanced loans totalling $875,000 under the subordinated $1,000,000 loan provision. Thus his total investment was $1,625,000; these funds were used by the venture to reimburse Babcock Company for its pre-venture expenses such as mortgages on the project's property and various project improvements. Holladay was also instrumental in obtaining institutional financing for the project through three loans totalling $9,970,000; Holladay and Babcock (and Babcock Company) were liable for these loans as they had agreed to share equally the burden of any additional financing required after Holladay's subordinated loan was exhausted.
The joint venture's losses for tax years 1970 through 1973 were $372,412, $971,221, $617,212 and $379,364 for total losses of $2,340,209 which were all reported on Holladay's individual income tax returns for the same period. Babcock did not claim any losses for the period 1970 to 1973. A net operating loss of $267,758 was claimed for tax year 1971, which was carried back to tax years 1968 to 1970, resulting in tentative refunds of $38,914, $97,519 and $11,043 or a total of $147,476 for those years. Because the Commissioner allowed Holladay to claim only 50% of the reported $2,340,209 losses, a $589,396 deficiency was assessed against Holladay, which included the carryback years.
II. Interpretation of Holladay's Loss Allocation Under IRC § 704(a)
The sole issue decided by the Tax Court was whether the allocation of all of the joint venture's losses to Holladay was bona fide within the meaning of Section 704 of the Internal Revenue Code of 1954, as amended, 26 U.S.C.A. § 704. See Boynton v. Commissioner, supra, 649 F.2d at 1171, n. 7. The Tax Court held that the 100% allocation of losses to Holladay lacked economic substance because the allocation failed to reflect the actual agreement between Holladay and Babcock regarding their respective share of the profits and losses. The court interpreted the amended agreement as providing for a nearly equal division of economic benefits given that the proceeds of the joint venture were to be distributed regardless of the amount or deficit in the capital accounts of the joint venturers. Holladay's argument that the allocation was bona fide since both joint venturers agreed to the allocation and consistently followed it was rejected by the Tax Court.
The joint venture was properly treated as a partnership for tax purposes. Treas. Reg. § 1.761-1(a) (1954). The problem in this case is again essentially one of the proper statutory construction of IRC § 704. Holladay argues that, since the tax avoidance standard of Section 704(b)(2) concededly does not apply, the Tax Court erred in imposing a general tax avoidance standard. Moreover, he contends that, because the amended agreement here reflected a true arm's length bargain and was not a sham, Kresser v. Commissioner, 54 T.C. 1621 (1970) and Frank G. Sellers T.C. Memo 1970-70, aff'd other issues, 592 F.2d 227 (4th Cir. 1979), which were sham cases, do not serve as precedent. The Commissioner responds by stating that the allocation was a sham, as the only business purpose for the loss allocations to Holladay was the tax benefits Holladay would receive as a result of claiming losses he did not personally incur; Holladay conceded that those benefits induced him to join the venture. Further, the Commissioner contends that Section 704 does not exalt form over substance by allowing an allocation of profits and losses without regard to which venturer actually received the benefits or bore the losses.
Terms defined.
(a) Partnership. The term "partnership" includes a syndicate, group, pool, joint venture, or other incorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not a corporation or a trust or estate within the meaning of the Code. The term "partnership" is broader in scope than the common law meaning of partnership, and may include groups not commonly called partnerships. See Section 7701(a)(2). . . .
Superficially, it would appear that Holladay was entitled to a 100% loss allocation since (a) Section 4(a) of the amended agreement provided that Holladay would receive all of the profits and losses for the first five years of the venture and (b) the first $1,625,000 utilized by the venture consisted of Holladay's equity contribution ($750,000) and his subordinated loan ($875,000). As we noted in Boynton, the allocation of all losses to a sole contributing partner is proper if that partner bears the entire economic burden of any loss. Boynton v. Commissioner, supra, 649 F.2d 1168. Moreover, the existence of a tax benefit resulting from a transaction does not automatically make it a sham as long as the transaction is imbued with tax-independent considerations. See Frank G. Lyon Co. v. United States, 435 U.S. 561, 583-84, 98 S.Ct. 1291, 1303, 55 L.Ed.2d 550 (1978); see also Holladay v. Commissioner, 72 T.C. 571, 594 (Fay, J., dissenting). However, there are several reasons why the Tax Court correctly disallowed the 100% loss allocation to Holladay.
First of all, Holladay was not the "sole contributing partner" as Babcock put up his property (and the improvements undertaken prior to the formation of the venture), plans, contracts and expertise in exchange for Holladay's capital. Once the original joint venture agreement became effective, the joint venturers became one-half owners of the assets of the venture. Thus, if the venture had failed after the agreement's execution, each venturer would have borne 50% of the loss. Moreover, as Holladay chose to characterize his $875,000 cash advance as a subordinated loan rather than a capital contribution, he is bound by the tax consequences of that characterization. See Boynton v. Commissioner, supra, 649 F.2d 1168. As of December 31, 1973, only $270,000 of Holladay's $875,000 subordinated loan was repaid, leaving a balance of $605,000. Holladay argues that, since this amount (plus his initial equity) was at risk during the tax years at issue and the equal sharing provisions would not become effective until after Holladay's subordinated debt was repaid (which would not occur until after certain other priorities were satisfied), the total loss allocation to him was justified. But Holladay's $875,000 advance was a loan, not a capital contribution; thus Holladay stood as any other lender with respect to those funds.
If the debt became worthless, Holladay could claim a deduction under the IRC's bad debt provision.
Secondly, the Tax Court's factual finding that the joint venture agreement as amended provided for a nearly equal division of economic benefits is supported by the record. For example, Babcock was equally liable for any additional financing required after Holladay's initial funds were expended. Furthermore, the cash distribution provision which had first priority, was to be implemented regardless of the status of the joint venturers' capital accounts. In other words, the allocation of losses to Holladay did not affect the amount of money either he or Babcock put in or took out of the venture, thus the allocation lacked economic effect. Compare Harris v. Commissioner, 61 T.C. 770, 786 (1974) with Orrisch v. Commissioner, 55 T.C. 395, 403 (1970). In Harris the Tax Court allowed a loss allocation under IRC § 704(a) because the loss allocated to the petitioner was applied to reduce proportionately his capital account and his share of future proceeds in the event of liquidation. Here, the loss allocation had no effect on Holladay's capital account or upon his share in the event of dissolution. See Appendix C.
Finally, the loss allocation provision must be considered within the context of the entire transaction. Section 4(a) of the amended agreement provided that Holladay would receive all of the profits and losses during the early years of the venture. Yet as Holladay's counsel conceded at oral argument, during the early years of a venture such as the one involved, the depreciation charges are so high that profits are extremely unlikely. As of 1971, the economic realities of Section 4(a) in the context of a 600-unit apartment complex were such that Holladay would receive the tax benefits of the venture's losses which were virtually certain during its early years of operation; subsequent to 1974, the time when the project would be more likely to show a profit, the joint venturers would thereafter equally divide the profits and losses. Consequently, we find that the allocation of all of the venture's losses to Holladay lacked economic substance and was clearly a sham under IRC § 704(a). See Knetsch v. United States, 364 U.S. 361, 81 S.Ct. 132, 5 L.Ed.2d 128 (1960); Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935); Boynton v. Commissioner, supra; Kresser v. Commissioner, supra; see also Thompson v. Commissioner, 631 F.2d 642, 646 (9th Cir. 1980). Since the statutory tax avoidance test under IRC § 704(b)(2) was clearly inapplicable to this case, the Tax Court did not err in relying on the Kresser rationale. See Boynton v. Commissioner, supra, 649 F.2d at 1173, n. 13. In view of the entire transaction, the joint venturers' agreement to allocate the tax benefits of certain losses to Holladay, who was not the sole contributor of the venture, lacks a valid business purpose and is ineffective for federal tax purposes. Accordingly, the Tax Court's decision that Holladay could claim only 50% of the losses for tax years 1971-1974 is AFFIRMED. However, because the basis upon which the Tax Court determined the deficiency due for tax year 1970 is unclear from the record, we REMAND solely for a recomputation of the taxes due.
As many of the commentators on the 1976 amendment of IRC § 704(b) have noted, Congress wanted specifically to include the substantial economic effect test as stated in Kresser as the proper test for a bottom line allocation such as the one involved in this case. See, e. g., McKee, Nelson Whitmire, Federal Taxation of Partnerships and Partners § 10.01[2] (1977).