Elliston v. Commissioner

82 T.C. No. 59, 82 T.C. 747, 1984 U.S. Tax Ct. LEXIS 71

• Court: United States Tax Court
• Decided: May 23, 1984
• Docket: Docket No. 27000-81
• Status: Published

Opinions

OPINION

Cohen, Judge:

Respondent determined the following deficiencies in petitioners’ Federal income taxes:

Year Deficiency

1975. $2,823.78

1976 . 6,682.94

1977. 24,304.34

1978 . 6,637.72

After concessions by petitioners, the issue remaining for decision in this fully stipulated case is whether section 465(c)(2)¹ permits the gains of certain limited partnerships (the second-tier partnerships) to be netted against the losses of other second-tier partnerships in determining petitioner Daniel G. Elliston’s net distributive gain or loss from his interest in a general partnership (the first-tier partnership) that was the limited partner in each of the second-tier partnerships.

Petitioners were husband and wife and resided in Dallas, Tex., when they filed their petition herein. All future references to "petitioner” will be to Daniel G. Elliston.

During all relevant times, petitioner owned a 30.69-percent interest in the capital and profits and losses of a general partnership formed under Texas law on April 29, 1976, and known as Dallas Associates (or the partnership).² Joe B. Dorman, I. E. Barlow, and Richard R. Wadsworth, Jr., were petitioner’s partners in Dallas Associates. The business purpose of the partnership was to hold and maintain interests in various limited partnerships and to provide a single entity through which all interests in the transactions of the limited partnerships could be collected, summarized, and distributed.

Petitioner and his partners also incorporated Intercap Corp. (Intercap) and were its sole shareholders. In 1976 and 1977, Intercap and Dallas Associates formed five limited partnerships, identified as:

Limited Date of commencement partnership of business

Intercap Leasing, Ltd.

(hereinafter ICL). May 4, 1976

Intercap Leasing, Ltd. 001

(hereinafter ICL 001). May 28, 1976

Intercap Leasing, Ltd. 0021

(hereinafter ICL 0021). September 1976

Intercap Leasing, Ltd. 7761

(hereinafter ICL 7761). June 1, 1977

Intercap Leasing, Ltd. 7771

(hereinafter ICL 7771). August 1977

Intercap, as the general partner, and Dallas Associates, as the limited partner, owned 1 percent and 99 percent, respectively, of the capital and profits and losses of each of the limited partnerships, with the exception of ICL 7761, which had two limited partners, Dallas Associates (59 percent) and Alamo Associates (40 percent). The limited partnerships and Dallas Associates filed partnership tax returns on a calendar year basis.

Each of the limited partnerships obtained nonrecourse financing from unrelated financial institutions in order to engage in the business of leasing personal property to unrelated entities. The use of separate partnerships to conduct the leasing activities was a condition imposed by the makers of the nonrecourse loans. (The record does not explain the reason for this condition.)

On their joint Federal income tax returns for 1976, 1977, and 1978, petitioners did not report any income, gain, or loss from their partnership interest in Dallas Associates. Upon audit, respondent made certain adjustments W) income and loss of the limited partnerships and to Dallas Associates’ distributive share from each partnership. Those adjustments are not now disputed by petitioners. Dallas Associates’ distributive share of the ordinary income (loss) from the activity of each limited partnership for the years 1976, 1977, and 1978 was determined to be:

Taxable period ending Dec. 31-

Partnership 1976 1977 1978

ICL $47,697.00 $154,512.11 $170,353

ICL 001 (97,343.68) 4,830.08 7,848

ICL 0021 (4,353.69) 4,283.84 19,762

ICL 7761 (128,205.00) (785,366)

ICL 7771 (9,062.00) (73,181)

Total (54,000.37) 26,359.03 (660,584)

In addition to the foregoing amounts, ICL 001 realized a 1977 gain under sec. 1231; Dallas Associates’ distributive share of that gain was $4,460.94.

During the years 1976, 1977, and 1978, Dallas Associates had no items of income, deductions, or credits other than its distributive share of those items arising from its interest in the five limited partnerships.

Respondent also determined that under the at-risk rules of section 465, the proper computation of petitioner’s distributive share of gain and loss from Dallas Associates is as follows:

1976

Partnership 1976 gains and losses Gains and losses after application of Code sec. 465 Unused losses carried to subsequent year

ICL $47,697.00 $47,697.00 0

ICL 001 (97,343.68) 0 ($97,343.68)

ICL 0021 (4,353.69) 0 (4,353.69)

Dallas Associates’ distributive share Petitioner’s interest 47,697.00 X 30.69%

Petitioner’s distributive share 14,638.21

1977

Partnership 1977 gains and losses 1977 gains and losses plus 1976, carryovers 1977 capital gains Gains and losses after application of Code sec. 465

ICL $154,512.11 $154,512.11 0 $154,512.11

ICL 001 4,830.38 (92,513.30) $4,460.94 (4,460.94)

ICL 0021 4,283.84 (69.85) 0 0

1977

Partnership 1977 gains and losses 1977 gains and losses plus 1976 carryovers 1977 capital gains Gains and losses after application of Code sec. 465

ICL 7761 ($128,205.00) ($128,205.00) 0 0

ICL 7771 (9,062.00) (9,062.00) 0 0

Dallas Associates’ distributive share Petitioner’s interest $4,460.94 $150,051.71 X 30.69% X 30.69%

Petitioner’s distributive share 1,369.05 46,050.70

As a result of the foregoing computation, respondent computed that petitioner had unused losses to carry to 1978 as follows:

Partnership Amount

ICL. 0

ICL 001. ($88,052.36)

ICL 0021... (69.85)

ICL 7761... (128,205.00)

ICL 7771... (9,062.00)

1978

Partnership 1978 gains and losses 1978 gains and losses plus 1976 and 1977 carryovers Gains and losses after application of Code sec. 465

ICL $170,353 $170,353.00 $170,353.00

ICL 001 7,848 (80,204.36) 0

ICL 0021 19,762 19,692.15 19,692.15

ICL 7761 (785,366) (913,571.00) 0

ICL 7771 (73,181) (82,243.00) 0

Dallas Associates’ distributive share Petitioner’s interest 190,045.15 X 30.69%

Petitioner’s distributive share 58,325.00

In the notices of deficiency, respondent increased petitioner’s taxable income for 1976, 1977, and 1978 to reflect his distributive share of income from Dallas Associates as determined under section 465. A loss carryback from 1978 claimed by petitioner was disallowed, and petitioner’s 1975 taxes were increased by the amount previously refunded to him on a refund application for that year.

On October 4, 1976, after the formation of Dallas Associates and ICL, ICL 001, and ICL 0021, Congress enacted section 465³ to combat perceived taxpayer abuse of the benefits stemming from the use of nonrecourse financing following the Supreme Court’s decision in Crane v. Commissioner, 331 U.S. 1 (1947). S. Rept. 94-938, at 46-47 (1976), 1976-3 C.B. (Vol. 3) 49, 83-84. The Supreme Court held in Crane that an owner’s adjusted basis in a parcel of real property included the amount of a nonrecourse mortgage on the property, under which the mortgagee-lender could seek recovery of its loan only from the property. The Crane rule, that the adjusted basis of property includes borrowed amounts paid for the property, permitted taxpayers to generate tax deductible losses in activities in which they personally assumed little or no financial risk. In stating its reasons for proposing section 465, the Senate Finance Committee report of June 10, 1976, noted:

When an investor is solicited for a tax shelter activity, it has become common practice to promise the prospective investor substantial tax losses which can be used to decrease the tax on his income from other sources. The committee believes that it is not equitable to allow these individual investors to defer tax on income from other sources through losses generated by tax sheltering activities, to the extent the losses exceed the amount of actual investment the taxpayer has placed at risk in the transaction. [S. Rept. 94-938, at 47 (1976), 1976-3 C.B. (Vol. 3) 49, 85.]

Section 465 was thus intended to effectuate Congress’ goal of preventing tax shelter abuse by limiting the amount of loss adjustments from a taxpayer’s interest in the activities listed in the statute ("at risk” activities) that he may use to reduce his taxable income to the amount of actual economic risk incurred by him in connection with each such activity. When calculating his losses allowable under section 465(a), a taxpayer must separately determine his amount at risk under section 465(b) and his at-risk loss under section 465(d) for each separate at-risk activity in which he is engaged.

Congress provided, however, that if the taxpayer engages in at-risk activities through a partnership, his interest in the partnership is a single activity for the purpose of calculating loss under section 465. Sec. 465(c)(2). In determining a partnership’s loss under section 703 from its interest in at-risk activities, "all of the [at-risk] activities in the same category (;i.e., all motion picture films and video tapes) are to be treated as one activity. * * * the loss from the activity for any partner is that partner’s loss from the partnership.” S. Rept. 94-938, supra, 1976-3 C.B. (Vol. 3) at 89. Thus, the partnership nets the losses and gains from the at-risk activities that are of the same type when determining each partner’s distributive share of tax incidents under section 702.⁴

Respondent agrees with petitioner’s argument that if Dallas Associates were conducting the five equipment leasing activities itself, petitioner would be entitled to have Dallas Associates offset the gains from some of its leasing activities against the losses from the other leasing activities and distribute to its partners their shares of that net amount. Respondent contends, however, that aggregating activities at the partnership level under section 465(c)(2) is a benefit accorded by section 465 only to partnerships actively conducting at-risk activities; because Dallas Associates functions as a mere investing partnership, it should be disregarded for purposes of applying section 465 in this case. Consequently, respondent concludes, petitioner has an interest in each of the five limited partnerships and thus has five at-risk activities, some of which incurred losses that petitioner may not currently deduct under section 465 and some of which had gains that petitioner must report as income.

Neither section 465 as written nor the legislative history supports respondent’s position that Dallas Associates is not a "partnership” within the meaning of section 465(c)(2). Subsections 465(a) and 465(c) refer to taxpayers and partnerships "engaged in” at-risk activities without distinguishing between taxpayers or partnerships that actively conduct the at-risk activity and those that merely invest in an at-risk activity.⁵ The language of the Senate report quoted by respondent to support his argument that a partnership must be actively conducting business to be able to aggregate same-category activities, viz, "partners in a partnership which conducts an activity described in this provision,” was used by the Senate Finance Committee to describe the taxpayers limited by the provisions of section 465(a)⁶ and not to exclude investing partnerships from section 465(c)(2). The Senate Finance Committee reported 465(c)(2). The Senate Finance Committee reported that "the limitation [of section 465] applies to all taxpayers (other than corporations which are not subchapter S corporations) including * * * partners in a partnership which conducts an activity described in this provision.” S. Rept. 94-938, supra, 1976-3 C.B. (Vol. 3) at 86. If we were to interpret that language as excluding investing partnerships, as respondent requests, we would remove petitioners from the category of persons affected by section 465. Such interpretation would indeed be contrary to that intended and enacted by Congress.

Similarly, respondent has not cited and we have not found any statute or case that would justify ignoring the existence of Dallas Associates for tax purposes under the facts in this case. The question of when a partnership will be recognized for tax purposes was considered by the Supreme Court in Commissioner v. Culbertson, 337 U.S. 733 (1949), in which the Court held that a partnership exists for Federal income tax purposes when "the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.” 337 U.S. at 742. Since Culbertson, various courts, including this Court and the Court of Appeals for the Fifth Circuit, to which this case is appealable, háve recognized the viability for tax purposes of a first-tier partnership that served as a holding arrangement for interests in second-tier partnerships actively conducting business where there was no improper assignment of income. See Klein v. Commissioner, 18 T.C. 804 (1952); United States v. Atkins, 191 F.2d 146 (5th Cir. 1951).⁷ Such is the case here.

Nonetheless, respondent argues that to permit Dallas Associates to net the gains and losses from the limited partnerships’ activities defeats the intent of Congress in enacting section 465. The section, however, was enacted to prevent individual investors from deferring "tax on income from other sources through losses generated by the sheltering activities.” S. Rept. 94-938, supra, 1976-3 C.B. (Vol. 3) at 85. Petitioners herein did not attempt to use the losses from their interest in Dallas Associates to reduce their taxable income from other sources; none of their distributive share of loss from Dallas Associates was reported on their returns. The express language of the statute permits a partner’s investment in a partnership to be treated as a single activity to the extent of the partnership’s interests in at-risk activities of the same type, and that exception is not limited as respondent here seeks to limit it.

Accordingly, under section 465, Dallas Associates may net the gains and losses from its interests in second-tier partnerships in determining petitioners’ distributive share of gain or loss from Dallas Associates, and petitioner may treat his interest in Dallas Associates as a single' activity.

To reflect petitioners’ concessions,

Decision will be entered under Rule 155.

Reviewed by the Court.

Simpson, Sterrett, Goffe, Wiles, Chabot, Shields, Clapp, and Swift, JJ., agree with this opinion. Jacobs, J, did not participate in the consideration of this case.

1 Unless otherwise indicated, all statutory references are to the Internal Revenue Code of 1954 as amended and in effect during the years in issue.

2 The parties have so stipulated. The written partnership agreement indicates that petitioner’s interest in Dallas Associates was actually held for him in trust until Dec. 31, 1976. This does not affect the outcome of the case, however, so we will accept the parties’ stipulation.

3 Sec. 465 was added to the Code by Pub. L. 94-455, 90 Stat. 1531, the Tax Reform Act of 1976, and for years 1976, 1977, and 1978, provided:

SEC. 465. DEDUCTIONS LIMITED TO AMOUNT AT RISK IN CASE OF CERTAIN ACTIVITIES.

(a) General Rule. — In the case of a taxpayer (other than a corporation which is neither an electing small business corporation (as defined in section 1371(b)) nor a personal holding company (as defined in section 542)) engaged in an activity to which this section applies, any loss from such activity for the taxable year shall be allowed only to the extent of the aggregate amount with respect to which the taxpayer is at risk (within the meaning of subsection (b)) for such activity at the close of the taxable year. Any loss from such activity not allowed under this section for the taxable year shall be treated as a deduction allocable to such activity in the first succeeding taxable year.

(b) Amounts Considered at Risk.—

(1) In general. — For purposes of this section, a taxpayer shall be considered at risk for an activity with respect to amounts including—

(A) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity, and

(B) amounts borrowed with respect to such activity (as determined under paragraph (2)).

(2) Borrowed amounts. — For purposes of this section, a taxpayer shall be considered at risk with respect to amounts borrowed for use in an activity to the extent that he—

(A) is personally liable for the repayment of such amounts, or

(B) has pledged property, other than property used in such activity, as security for such borrowed amount (to the extent of the net fair market value of the taxpayer’s interest for such property).

No property shall be taken into account as security if such property is directly or indirectly financed by indebtedness which is secured by property described in paragraph (1).

(3) Certain borrowed amounts excluded. — For purposes of paragraph (1XB), amounts borrowed shall not be considered to be at risk with respect to an activity if such amounts are borrowed from any person who—

(A) has an interest (other than an interest as a creditor) in such activity, or

(B) has a relationship to the taxpayer specified within any one of the paragraphs of section 267(b).

(4) Exception. — Notwithstanding any other provision of this section, a taxpayer shall not be considered at risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar agreements.

(5) Amounts at risk in subsequent years. — If in any taxable year the taxpayer has a loss from an activity to which this section applies, the amount with respect to which a taxpayer is considered to be at risk (within the meaning of subsection (b)) is subsequent taxable years with respect to that activity shall be reduced by that portion of the loss which (after the application of subsection (a)) is allowable as a deduction.

(c) AcnviTiES to Which Section Applies.—

(1) Types op activities. — This section applies to any taxpayer engaged in the activity of—

(A) holding, producing, or distributing motion picture films or video tapes,

(B) farming (as defined in section 464(e)),

(C) leasing any section 1245 property (as defined in section 1245(aX3)), or

(D) exploring for, or exploiting, oil and gas resources as a trade or business or for the protection of income.

(2) Separate activities. — For purposes of this section, a taxpayer’s activity with respect to each—

(A) film or video tape,

(B) section 1245 property which is leased or held for leasing,

(C) farm, or

(D) oil and gas property (as defined under section 614),

shall be treated as a separate activity. A partner’s interest in a partnership or a shareholder’s interest in an electing small business corporation shall be treated as a single activity to the extent that the partnership or an electing small business corporation is engaged in activities described in any subparagraph of this paragraph.

(d) Definition of Loss. — For purposes of this section, the term "loss” means the excess of the deductions allowable under this chapter for the taxable year (determined without regard to this section) and allocable to an activity to which this section applies over the income received or accrued by the taxpayer during the taxable year from such activity.

4 We do not here address the situation of a partnership’s gain or loss from the conduct of different types of at-risk activities. The language of sec. 465(c)(2) permits aggregation of activities "described in any subparagraph of this paragraph,” i.e., subpar. (A), (B), (C), or (D). The legislative history documents the intent of Congress to allow aggregation only of like-kind at-risk activities, as the following language indicates:

" All equipment leasing activities engaged in through a partnership or subch. S corporation will be treated as one activity under this provision. However, if the partnership or corporation engages in more than one type of activity covered by the the at risk rule, then each type of activity is treated as a separate activity. [Staff of Joint Comm, on Taxation, 94th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1976, 1976-3 C.B. (Vol. 2) 93.]”

6 By contrasts, pars. 465(cX3) and 465(cX4), which were added by Pub. L. 95-600,92 Stat. 2814, the Revenue Act of 1978, specifically use the term "actively” to create a distinction between active conduct and passive investment in at-risk activities.

5 Because Dallas Associates is not a taxpayer, the counting of activities must occur at petitioner’s level, and he has an interest in only one partnership.

7 The Internal Revenue Service has also recognized the viability for tax purposes of a first-tier partnership that functioned exclusively as a holding company. See Rev. Rul. 78-2,1978-1 C.B. 202.