Looney v. Commissioner
This text of 1988 T.C. Memo. 332 (Looney v. Commissioner) is published on Counsel Stack Legal Research, covering United States Tax Court primary law. Counsel Stack provides free access to over 12 million legal documents including statutes, case law, regulations, and constitutions.
Opinion
Ps leased children's master recordings from J in transactions that can be characterized as "generic tax shelters".
(2) Ps are liable for the addition to tax pursuant to
(3) Ps, in docket numbers 6850-86, 8688-86, 8689-86, and 8690-86 are liable for additions to tax under
(4) Ps are liable for the increased rate of interest provided in
(5) R is not awarded damages under
MEMORANDUM FINDINGS OF FACT AND OPINION
SCOTT,
OPINION OF THE SPECIAL TRIAL JUDGE
VANDERVORT,
| Petitioner | Year | Deficiency | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Gerald L. Looney | 1979 | $ 1,553.00 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 6850-86 | 1982 | 13,571.50 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1983 | 1,853.00 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Gordon Hall | 1979 | 7,553.06 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 8688-86 | 1980 | 8,562.19 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1981 | 10,065.75 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1982 | 11,815.00 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1983 | 7,452.00 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| George M. and Gloria | 1980 | 39,305.00 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| E. Wolfe 8689-86 | 1983 | 16,797.00 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Howard V. and Amy H. | 1979 | 8,522.00 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| West 8690-86 | 1980 | 12,645.00 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1981 | 4,789.00 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1982 | 26,419.00 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| John W. and Gina Y. | 1980 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Petitioner | Year | Deficiency |
| Gerald L. Looney | 1979 | $ 1,553.00 |
| 6850-86 | 1982 | 13,571.50 |
| 1983 | 1,853.00 | |
| Gordon Hall | 1979 | 7,553.06 |
| 8688-86 | 1980 | 8,562.19 |
| 1981 | 10,065.75 | |
| 1982 | 11,815.00 | |
| 1983 | 7,452.00 | |
| George M. and Gloria | 1980 | 39,305.00 |
| E. Wolfe 8689-86 | 1983 | 16,797.00 |
| Howard V. and Amy H. | 1979 | 8,522.00 |
| West 8690-86 | 1980 | 12,645.00 |
| 1981 | 4,789.00 | |
| 1982 | 26,419.00 | |
| John W. and Gina Y. | 1980 | 2,521.00 |
| Powers 19873-86 | 1981 | 4,838.00 |
| 1983 | 3,535.00 |
| Additions to Tax | |||
| Section | Section | Section | |
| Petitioner | 6653(a)(1) | 6653(a)(2) | 6659(a) |
| Gerald L. Looney | $ 77.65 | * | $ 465.90 |
| 6850-86 | 678.55 | 4,071.30 | |
| 92.65 | 555.90 | ||
| Gordon Hall | 377.65 | 2,265.91 | |
| 8688-86 | 428.10 | 2,568.65 | |
| 503.28 | 3,019.72 | ||
| 590.75 | 3,544.50 | ||
| 372.60 | 2,235.60 | ||
| George M. and Gloria | 1,965.25 | 11,791.50 | |
| E. Wolfe 8689-86 | 839.85 | 5,039.10 | |
| Howard V. and Amy H. | 426.10 | 2,556.60 | |
| West 8690-86 | 632.25 | 3,793.50 | |
| 239.45 | 1,436.70 | ||
| 1,320.95 | 7,925.70 | ||
| John W. and Gina Y. | 126.05 | 756.30 | |
| Powers 19873-86 | -- | -- | 1,451.40 |
| 176.75 | 1,060.50 | ||
Respondent also determined that all underpayments in tax for each year in issue are substantial underpayments attributable to tax-motivated transactions under the provisions of
In Amendments to Answer, respondent asserted additions to tax under the provisions of
Petitioners leased children's master sound recordings from Jarelco, Inc. (Jarelco). The issues for decision 5*364 *363 are:
(A) Whether the Jarelco master recording lease venture is a generic tax shelter subject to the unified objective analysis formulated in
(B) Whether the venture lacked economic substance and should consequently be disregarded for tax purposes;
(C) Whether petitioners are liable for additions to tax for negligence pursuant to
(D) Whether petitioners are liable for additions to tax under
(E) Whether petitioners are liable for additions to tax under
(F) Whether petitioners are liable for the increased rate of interest provided in
(G) Whether damages should be awarded to respondent under
FINDINGS OF FACT
Some of the facts have been stipulated. This reference incorporates the stipulation of facts and attached exhibits.
Jarelco, Inc. (Jarelco) purchased children's master recordings (the masters) from Oriolo Educational Publications, Inc. (OEP), which produced the masters. 6 Jarelco then leased the masters to petitioners to package, market, and distribute.
The purchase of the masters created investment tax credits which Jarelco passed to the petitioners bases upon a value of not less than $ 195,000 per master. In addition, petitioners amortized lease expenses and deducted distribution costs and miscellaneous expenses, claiming that they were in the business of selling the master recordings.
The master audio recordings are various children's stories presented through dialogues of fictitious, cartoon characters and are approximately fifteen minutes in length. Joseph Oriolo and his son, Donald Oriolo, created and developed the characters. Coloring posters *365 depicting one or more of the animated characters were to accompany the recordings.
Joseph Oriolo had over 50 years experience in the animation industry. Donald Oriolo's experience includes performing as a studio musician and writing, producing, arranging, recording, and publishing musical compositions.
James A. Rumpf was president, sole director, and sole shareholder of James A. Rumpf and Associates, Inc., a Texas corporation in the business of tax advantaged investments. On August 13, 1982, Joseph Oriolo and Donald Oriolo met with Mr. Rumpf and agreed to produce the children's master recordings. It was agreed that Donald Oriolo would form OEP and sell the master recordings to Jarelco, a company which Mr. Rumpf would form.
At the meeting, they orally agreed to a uniform purchase price for each master and the structure of payments. 7 The purchase price for each master recording was $ 195,000; Jarelco paid OEP a $ 3,000 cash downpayment, issued a promissory note for $ 192,000, and put a lien on the corresponding master as security for the purchase. The promissory note was payable from 50 percent of the gross revenues that the respective master generated, and was due ten years from *366 the date the note was executed.
In last August 1982, Jarelco was incorporated with Mr. Rumpf as its president, sole director, and sole shareholder. OEP was formed in September 1982, with Donald Oriolo as chief executive officer and president.
On August 23, 1982, Mr. Rumpf, as president of Jarelco, drafted and signed a letter that memorialized the oral agreement. Donald Oriolo, as chief executive officer of OEP, and Joseph Oriolo, as president of OEP, signed the letter on August 27, 1982.
The letter states that the promissory note for each master would be paid out of 50 percent of revenues from commercial exploitation of each master. The letter also states that the promissory note would be nonnegotiable, nonassignable, and nontransferable in nature and could not be used as security. Initial funding of Jarelco was stated to be between $ 10,000 and $ 50,000.
The documents for purchase and sale of each individual master included these samples: (a) a purchase agreement between OEP (seller) and Jarelco (purchaser); (b) a promissory note between OEP (payee) and Jarelco (maker); (c) a security agreement between *367 OEP (secured party) and Jarelco (debtor). These documents were included in the information memorandum distributed to investors.
Each promissory note from Jarelco (maker) to OEP (payee) provides for security for payment to OEP. The security was stated to be a lien upon the masters. Jarelco promised to insure the masters against loss from fire, theft, or other destruction.
The promotional materials that petitioners received emphasized the expected tax benefits from leasing children's master recordings. The beginning of the promotional materials stated the following:
NOTICE
* * *
* * * the lessee must have knowledge and experience in financial and business matters, or utilize a financial advisor with such knowledge and experience,
The materials included a one-page worksheet so that prospective investors could figure their Federal income tax savings. A "tax consideration" section projected tax write-offs of at least 3.8 to 1, and, in 1982, stated that a $ 10,000 purchase would result in a write-off of $ 41,667.
The *368 materials contained a tax opinion which warned prospective investors of the "* * * substantial likelihood that the [Internal Revenue] Service will label this transaction as an abusive tax shelter * * *." The tax opinion also warned that a lessee might be required to prove affirmatively the fair market value of the master or the intent to make a profit.
Blanket appraisals of the masters were included in the material. Jarelco provided a suggested check list to each appraiser which outlined the items to be covered and included in each of the standardized appraisals.
The Jarelco master recording leasing program was promoted nationally. Petitioners leased their master recording interests from Jarelco through Balanced Financial Services, Inc. (BFM) which received a commission from Jarelco for each master recording interest leased. 8Managed Accounting Services, Inc. (MAS), 9*369 a related accounting service company which BFM formed, performed the accounting, statistical, and tax preparation services for BFM, its clients, and its agents.
Petitioners had no experience or expertise in the master recording industry. Before investing in the Jarelco program, none of the petitioners listened to the master recordings they leased or examined appraisals for the master recordings. Further they did not seek independent appraisals for those masters or obtain expert advice about the economic viability of the Jarelco promotion or the merits of leasing master sound recordings.
Maria Mutschler, one of a group who BFM retained to promote the Jarelco program on a commission basis, 10 introduced petitioner Gerald L. Looney (Looney), a physician, to Jarelco. Looney attended a Jarelco promotional seminar, reviewed a copy of the promotional materials, and, relying on Maria Mutschler's advice, invested in Jarelco in 1982. Without any subsequent investigation, he also invested in 1983.
In 1982, petitioner Howard V. West (West), a CPA, attended a number of Jarelco promotional events. West invested in 1982 *370 and subsequently became a commissioned salesman for the program.
In 1982, petitioner West introduced petitioner Gordon Hall (Hall), an accountant, to Jarelco. Hall attended several Jarelco seminars held at BFM's offices, reviewed the promotional materials, and contacted a MAS representative about the promotion. After discussing the tax benefits from the program with his accountant, Hall invested in 1982 and, without any further investigation, again in 1983.
At the time of his investment in Jarelco in 1983, petitioner George M. Wolfe was a Divisional Manager for Data Design Laboratories. 11
Petitioner John W. Powers (Powers) was an oil field technician in 1983 when he attended a Jarelco promotional seminar. After subsequent conversations with Maria Mutschler, Powers decided to invest in Jarelco in 1983.
After investing in the Jarelco program, the petitioners determined the particular master recordings to be leased. However, the investors did not listen to the selected masters prior to leasing them.
Those who leased a partial interest in the Jarelco masters, less than 100 percent, were given *371 a master chosen to match the percentage interests purchased with interests available from other partial leases. Consequently, at the time of their investment, partial interest holders in Jarelco masters did not know the identity of the remaining interest holders in those same masters.
Jarelco leased 576 master recordings in 1982 and 1,272 master recordings in 1983. The following chart indicates the master titles and the percentage interest which petitioners leased in 1982 and 1983:
| Petitioner | Year | Title of master leased | % leased |
| Looney | 1982 | George Washington Bridge | 62.5 |
| 1983 | Penny Pitching | 50.0 | |
| Hall | 1982 | Big Brass | 37.5 |
| 1982 | Water Roads | 100.0 | |
| 1983 | Puppy Love | 60.0 | |
| Wolfe | 1983 | Teaching Was Supposed To Be Easy | 100.0 |
| 1983 | The Big Build Up | 100.0 | |
| West | 1982 | Dewey Or Don't We | 100.0 |
| 1982 | Big Foot and Little Inch | 100.0 | |
| 1982 | Weigh Out | 100.0 | |
| Powers | 1983 | George Mikan, The Once Big Man | 40.0 |
To lease a master recording interest from Jarelco, each petitioner signed a lease agreement which was not negotiated. The lease agreements conveyed the right to commercially exploit the corresponding master recordings for six years. 12 Petitioners were required to pay Jarelco both a fixed amount at the beginning of each lease ($ 10,000 in 1982 and $ *372 12,000 in 1983), plus 80% of all gross revenues that the masters generated. From the remaining 20% of gross revenues, petitioners were required to pay the costs to manufacture and distribute.
In exchange, Jarelco elected to pass any investment tax credit relating to the masters to petitioners. Petitioners participating in the 1982 program claimed investment tax credits based on a value of $ 220,000, and 1983 participants claimed credits based on a value of $ 260,000.
Petitioners who leased Jarelco masters through BFM signed powers of attorney that authorized MAS to manage their Jarelco investments. However, MAS had never produced, manufactured, or distributed master recordings. Nevertheless, petitioners relied exclusively on MAS to manage the Jarelco masters and did not actively monitor their interests.
MAS chose Teleproducts Distributing, Inc. (Teleproducts) from a list which Jarelco provided to distribute the Jarelco masters. MAS did *373 not contact or consider distributors other than those which Jarelco suggested. Neither the investors nor MAS negotiated the terms of distribution. Each petitioner signed distribution agreements for their respective interests in the masters.
Teleproducts attempted to distribute the Jarelco master recordings leased in 1982 and 1983, a task which it could not manage. Packaging, production, and distribution of the masters was delayed because the inventory and derived products were not in a central location. Additionally, original packaging was so poorly done that the price of the product was drastically reduced 13 and new packaging was designed.
Due to the large volume of master recordings, delays in production, and poor packaging, the product failed to attract retailers to sell the Jarelco line of tapes. Consequently, sales were low, Teleproducts' efforts to distribute were unsuccessful, and none of petitioners reported any income from their master recording activities.
In 1985, petitioner Hall told MAS that he no longer wanted to retain its services. However, no replacement *374 was hired to manage or distribute his Jarelco investments.
In the summer of 1985, Sanders Career School through a subsidiary, SCS Consumer Products (SCS) acquired Teleproducts and purchased its inventory at significantly reduced prices. Without investigating SCS or considering other potential distributors, petitioners Looney, West, and Powers retained SCS to distribute their masters. 14
SCS than tried to distribute the masters. SCS, however, did not keep books or records of the tapes that were shipped or the income received from an individual title. In addition, the income earned from a shipment of tapes was divided equally among all lessees whose titles were shipped, regardless of actual sales.
Mr. Rumpf retained several appraisers to value the masters. Sherwin Raiken submitted a blanket appraisal which purported to set the average fair market value of all Jarelco masters. Mr. Raiken did not value any of the master recordings individually, and the blanket appraisal did not refer to any particular master. Rather, Mr. Raiken simply apprised *375 the master recordings as a group, alleging the value of each master to be at least $ 495,000.
Ralph Stein, David A. Gordon, S. Lawrence Sikora, and Jerry Dougherty prepared "secondary" appraisals for the master recordings. One secondary appraisal was submitted for each individual master recording. Each secondary appraiser prepared a form appraisal letter on which the appraiser entered the title or catalog number of the corresponding master.
In the appraisal letters, Mr. Stein states the fair market value to be $ 320,000 per master recording. Mr. Gordon states a fair market value of "between $ 375,000 to $ 450,000" per master recording. Mr. Sikora arrived at a fair market value of "not less than $ 495,000" per master. Mr. Dougherty claimed a value of "not less than $ 500,000" per master.
The Jarelco promotional materials referred to the blanket and secondary appraisals, and the 1983 promotional materials contained copies of the blanket appraisal letter and the various secondary appraisal letters.
Petitioners claimed tax credits and losses, amortized lease expenses, and deducted distribution costs and miscellaneous expenses. With separate *376 deficiency notices, respondent disallowed the claims and determined additions to tax for negligence under
Respondent filed Amendments to Answers and claims damages in these cases pursuant to
OPINION
Jarelco purchased children's master recordings with both cash and promissory notes. Jarelco then leased the masters to petitioners to package, distribute, and sell. Jarelco passed the investment tax credits to the lessees who also claimed deductions for the amortization of lease expense, distribution costs, and miscellaneous expenses. It is the judgment of this Court that:
(A) The Jarelco master recording venture is a generic tax shelter;
(B) The venture, tested under the unified objective analysis formulated in
(C) Petitioners are liable for additions to tax for negligence pursuant to
(D) Petitioners are [Text Deleted by Court Emendation] liable for additions to tax under
(E) Petitioners, in docket numbers 6850-86, 8688-86, 8689-86, and 8690-86 are liable for additions to tax under
(F) Petitioners are liable for the increased rate of interest provided in
(G) Respondent is not entitled to damages under
Ordinary and necessary expenses paid or incurred may be deducted if the venture is carrying on a trade or business or, in the case of an individual, if the activity is carried on for the production of income.
To be a trade or business, the taxpayer must engage in the activity with the objective to realize a profit.
The expectation of making a profit need not be reasonable but the taxpayer must have entered into the activity, or continued it, with the objective of making a profit.
A transaction has no valid business purpose where there exists little reason, apart from the significant tax benefits, for entering into the transaction.
Whether a transaction is entered to make a profit is a question of fact to be determined from the manner in which the activity *380 is pursued.
To analyze whether petitioners are entitled to deduct claimed business expenses, regulations promulgated under
This Court, however, has recently formulated a separate analysis that emphasized objective factors. See
A. GENERIC TAX SHELTER
A "generic tax shelter" 17 is a venture possessing some or all of the following characteristics:
(1) tax benefits are the focus of the materials used to promote the program;
(2) the investors accepted the price and terms of the leases without negotiation;
(3) the assets in question consist of packages of purported rights, difficult to value in the abstract, and substantially overvalued in relation to the tangible property included as part of the packages;
(4) the *382 tangible assets were acquired or created at relatively small cost shortly prior to the transactions in question; and
(5) the bulk of the consideration was deferred by promissory notes, nonrecourse in form or in substance.
In cases having these characteristics, tax motivation is apparent and they are identified as generic tax shelters. See
BFM representatives first introduced petitioners to the Jarelco master recording lease program. BFM emphasized the tax benefits which petitioners could receive by claiming the investment tax credits.
The promotional material for both the 1982 Jarelco program and the 1983 program emphasized the tax benefits, rather than economic potential. Although it is not clear whether all petitioners received the promotional material, the information they did receive focused almost exclusively on the tax aspects of investing in the Jarelco program.
Furthermore, petitioners did not negotiate the terms of either the leases *383 or the sales agency agreements. The masters were overvalued and the bulk of the consideration paid for the masters was deferred through the use of promissory notes.
Tax savings clearly motivated petitioners to invest in the leases. Accordingly, the Jarelco master recording leases are considered a generic tax shelter subject to the unified objective analysis. See
B. ECONOMIC SUBSTANCE AND BUSINESS PURPOSE
The unified objective analysis seeks to determine whether a generic tax shelter lacks economic substance. See
(1) petitioners' investment activities;
(2) the relationship between fair market value and price;
(3) the structure of the financing; and
(4) perceived Congressional intent.
1.
Prior to leasing the Jarelco masters, petitioners had no expertise or knowledge of children's audio tape distribution. Petitioners *384 did not independently investigate the economics of the distribution activity. No effort was made to confirm the projected sales or costs contained in the promotional materials. No expert in the children's recording industry was contacted to study the economic viability of the program. In fact, petitioners did not listen to the masters before leasing them.
MAS entered into distribution agreements with Teleproducts, Inc. to distribute recordings made from the Jarelco masters. The evidence shows that sales were not sufficient to produce income for petitioners. No evidence was presented on the number of recordings produced from the masters.
Petitioners did not ask MAS or Teleproducts why the master recordings were not a commercial success. After Teleproducts' efforts failed, petitioners undertook no independent distribution effort until SCS contacted them. Some petitioners made no attempt to retain SCS as their distributor until the eve of trial.
Additionally, there is no evidence that petitioners asked to see the books and records of Teleproducts, SCS, or MAS to review the distribution of the tapes. They did not request an accurate sales history of the tapes derived from their *385 respective masters. Petitioners did not have insurance on the masters and did not require Teleproducts or SCS to carry any insurance.
Petitioners spent little time and effort to distribute the masters. The only effort was to sign the lease agreements and distribution agreement and to receive mail from MAS, BFM, Teleproducts, and SCS.
Avdik B. Poladian, a certified public accountant, testified as an expert for petitioners. He testified that his firm would charge $ 2,000 to $ 5,000 to review the promotional materials to determine the tax consequences.
Mr. Poladian also stated that his firm would not give an opinion of the economic potential. He would advise a potential investor to hire an expert in children's recordings to conduct an economic feasibility study. Based on the amount of money being invested, he stated that it would be unreasonable to expect petitioners to pay for both a tax review and a study of economic potential.
Petitioners, however, made no effort to investigate the tax consequences or economic viability. Petitioners clearly should have made some investigation prior to leasing the masters. See
2.
Jarelco purchased each of the masters from OEP for a purchase price of $ 195,000 with a cash downpayment of $ 3,000 and a promissory note for $ 192,000. The 1983 Jarelco promotional materials contained letters stating the values of the masters to be from $ 320,000 to $ 500,000. Petitioners claimed investment tax credits based on purported values of $ 220,000 in 1982 and $ 260,000 in 1983.
At trial, David Gordon, who the promoters of Jarelco hired to make secondary appraisals, testified for petitioners. In the Jarelco promotional materials his stated value for the masters ranged from $ 375,000 to $ 450,000.
At trial, however, he testified that the leased masters had value only in the educational market. He placed a value of $ 30,800 for each master if a teacher's guide accompanied the recordings. His opinion was that the masters had no value without a teacher's guide.
No teacher's guide, however, was developed. In fact, petitioners and the distributor never planned to develop such guides. Further, petitioners never attempted to market the Jarelco recordings to teachers or educational institutions.
Arthur Denish, a sales manager for Teleproducts, *387 testified that Teleproducts had to "beg" retailers to take the product. Further, he testified that Jarelco overproduced the masters and tried to sell in a saturated market.
Respondent's experts, Shelley Miles and Steven Schwartz, examined the market potential of the Jarelco masters. They both noted that the children's recording industry is extremely competitive and has limited avenues of distribution. They determined that the tapes could generate only minimal income and that the cost to produce, package, and distribute the recordings made the venture uneconomic.
Mr. Schwartz testified that the stories were not creative and that the quality of the tapes was mediocre. In addition, the Jarelco recordings do not have name recognition or any other attributes which would encourage retailers to stock the recordings and consumers to buy them. Consequently, he valued the replacement cost of the masters at between $ 500 and $ 3,000.
In the expert opinion of Ms. Miles, the replacement value of the masters is from $ 1,500 to $ 5,000. According to Ms. Miles, petitioners could not reasonably expect significant sales, regardless of the marketing efforts that might have been made.
The opinions *388 of experts are admissible and relevant to the issue of value, but the opinions are weighed according to the expert's qualifications and other relevant evidence. See
Respondent's experts were thorough and professional. Their appraisals were performed with adequate care and are reasonably accurate.
The fair market values of the Jarelco masters bear no relationship to the values which petitioners claimed for the investment tax credits. Nor do the values of the leases of the masters bear reasonable relationships to the costs of the leases.
3. Structure of the Financing
Deferred debt that is in substance or in fact not likely to be paid lacks economic substance.
Although no notes were created at the investor level, Jarelco calculated the investment tax credits based on the inflated purchase price. Jarelco subsequently elected to pass the investment credit to petitioners.
The purchase price for each master that Jarelco paid to OEP was $ 195,000, with a $ 3,000 cash payment and a ten year recourse note for $ 192,000. The total face value of the promissory notes signed on behalf of Jarelco for the purchase of the masters is approximately $ 355,000,000 with simple interest at nine percent per annum. Interest of approximately $ 320,000,000 is stated to be due and owing in 1992 and 1993 for a total purported debt of approximately $ 675,000,000.
Although OEP apparently had full recourse against Jarelco under the terms of the notes, the only notable assets were the masters themselves. When the notes were executed, Jarelco was newly incorporated with initial capital of between $ 10,000 and $ 50,000.
The lease agreements provided that payments on the notes were to be made to OEP from fifty percent of the gross profits. There is no evidence that any payments were made on behalf of the petitioners under the terms *390 of the notes and lease agreements. It is clear that the ten year notes would not be paid and that Jarelco or OEP never contemplated payment.
The promissory notes in these cases lack economic substance. The masters were negotiated solely to inflate investment tax credits and Jarelco could not have intended to repay those notes. Under such circumstances, the notes are nonrecourse in substance, if not in form. See
4.
Petitioners made no showing that Congress intended to encourage investment in the type of activities and transactions involved in these master recordings. See
Tested with the unified objective analysis, petitioners' master recording activity lacks economic substance and is disregarded for Federal income tax purposes.
Petitioners have failed to prove that they had a bona fide intent to make a profit. They only invested in the tax shelter to claim the tax benefits which were in no way related to the fair market value of the leased masters. See
Petitioners leased the master sound recordings based on inflated values and *391 were immediately placed at a tremendous disadvantage. To make a profit, the masters had to generate revenues far in excess of what they feasibly could produce. See
Accordingly, petitioners are not entitled to claim deductions, losses, or investment tax credits. The deduction disallowance extends to the cash payments, including lease payments. Such payments merely represent a fee which petitioners paid to purchase tax benefits and, consequently, may not be deducted.
C.
An addition to tax equal to 5 percent of the underpayment is imposed if any part of an underpayment of tax is due to negligence or intentional disregard of rules and regulations.
Negligence is the lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances.
While petitioners claimed to have engaged in the commercial development of master recordings, they had no experience in the industry and paid little attention to their investment. They did not seek advice about the propriety or financial merit of leasing the master sound recordings. Petitioners did not listen to any of the masters prior to leasing them nor did they seek independent appraisals of the masters. Further, there is no objective support for the valuation amounts which they claimed.
Petitioners' actions did not remotely approach the actions which reasonable and ordinarily prudent persons would have taken under the circumstances. See
The deficiencies resulting from the master recordings are due to negligence and intentional disregard of the rules and regulations. Accordingly, petitioners are liable for the additions *393 to tax under
A graduated addition to tax is imposed when an individual has an underpayment of tax which equals or exceeds $ 1,000 and is attributable to a valuation overstatement.
Jarelco purchased each of the masters from OEP for a purchase price of $ 195,000 with a cash downpayment of $ 3,000 and a promissory note for $ 192,000. Petitioners claimed investment tax credits based on purported values of $ 220,000 in 1982 and $ 260,000 in 1983.
It has already been determined that the fair market values of the Jarelco masters bear no relationship to the values which petitioners claimed for the investment tax credits and that the transactions lacked economic substance. Where a transaction lacks economic substance, the taxpayer takes a zero basis in the asset and a valuation overstatement automatically *395 follows. 20
Respondent, in Amendments to Answer, raised additions to tax under
The taxpayer is considered to believe that the treatment of an item is more likely than not the proper treatment if the taxpayer analyzes the pertinent facts and authorities and, in reliance upon that analysis, reasonably concludes that there is a greater than 50 percent likelihood that the tax treatment of the item will be upheld.
A substantial understatement is an understatement of tax on a return that exceeds the greater of ten percent of the tax required to be shown on the return or $ 5,000.
It is clear that petitioners in these docket numbers had substantial understatements of tax as defined in
Accordingly, petitioners in these docket numbers are liable for additions to the tax under
Tax-motivated transactions include valuation overstatements and deductions disallowed from activities not entered into for profit.
Congress specifically amended
The Jarelco master recording venture is one lacking economic substance and is thus a tax motivated transaction under the provisions of
Accordingly, the sanction of
Petitioners exchanged a small cash amount for large tax deductions from a nonrecourse transaction that lacked underlying economic substance or entrepreneurial risk. See
Damages, however, will not be awarded under
Footnotes
1. The following cases are consolidated: Gordon Hall, docket No. 8688-86; George M. and Gloria E. Wolfe, docket No. 8689-86; Howard V. and Amy H. West, docket No. 8690-86; and John W. and Gina Y. Powers, docket No. 19873-86. ↩
2. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954, as amended and in effect during the years in issue. All Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise noted. ↩
3. Counsel selected these petitioners with the approval of the Court to be a consolidated test case. This test case will serve to resolve numerous issues common to a much larger group of individuals who invested in the Jarelco master sound recording leasing program.↩
*. Amount to be determined (i.e., 50 percent of the interest due on the portion of the underpayment attributable to negligence) under
section 6653(a)(2)↩ .4. Subsection (d) of
section 6621↩ was redesignated subsection (c) and amended by the Tax Reform Act of 1986, Pub. L. 99-514, section 1511(c)(1)(A)-(C), 100 Stat. 2744. The reference to the Internal Revenue Code as redesignated and amended will be used.5. Petitioners argued for the first time at trial that respondent improperly failed to extend the same settlement offer to petitioners that was extended to other Jarelco investors. Petitioners did not address this issue in either their original briefs or their reply briefs. Since petitioners failed to properly plead this issue and subsequently abandoned it, it will not be considered. Rule 151(e);
Camp Wolters Enterprises, Inc. v. Commissioner, 22 T.C. 737 (1954)230 F.2d 555 (5th Cir.), cert. denied352 U.S. 826↩ (1956) .6. Masters are used to manufacture audio products such as records and cassette tapes. Only a master can exactly duplicate an audio program. ↩
7. OEP did not begin producing the Jarelco masters until September 1982. ↩
8. James A. Rumpf & Associates, Inc. was also used to locate investors. ↩
9. MAS was incorporated in 1983, and operated under the name of Protech Accounting Corporation after mid-1984. References to this organization will be to MAS.
10. BFM also retained Maria Mutschler to prepare Federal income tax returns and amended returns for some of its clients who invested in Jarelco. ↩
11. Petitioner Wolfe did not testify at trial. ↩
12. The 1982 Jarelco promotion promised the right to distribute products derived from the masters throughout the United States and Canada only, while the 1983 Jarelco promotion promised worldwide distribution rights. ↩
13. Some accounts originally offering Jarelco cassette tapes at $ 4.98 later lowered the price to 99". ↩
14. The record does not show whether petitioner Wolfe also signed a distribution agreement with SCS. ↩
15.
Section 183(a) provides the general rule that, in the case of an activity not engaged in for profit, no deduction attributable to such activity shall be allowed except as provided insection 183(b) .Section 183(b)(1) provides that there shall be allowed those deductions that would be allowable without regard to whether the activity is engaged in for profit.Section 183(b)(2) provides that deductions that would be allowable if the activity were engaged in for profit shall be allowed only to the extent that the gross income derived from the activity exceeds the deductions allowable undersection 183(b)(1) .Section 183(c) defines the term "activity not engaged in for profit" as "any activity other than one with respect to which deductions are allowable for the taxable year undersection 162 or under paragraph (1) or (2) ofsection 212↩ ."16.
Section 1.183-2(b), Income Tax Regs. , lists the following factors to be considered, in addition to all of the facts and circumstances surrounding the activity, in this determination: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his or her advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits earned, if any; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation involved in the activity.17. Generic tax shelters may involve a variety of assets such as books, master recordings, lithographic materials, innovations/inventions, mining ventures, and films.
Rose v. Commissioner, 88 T.C. 386↩ (1987)18.
Section 6653(a)(2)↩ is to be computed with reference to the total underpayment.19.
Section 6659 does not apply to underpayments of tax which are not "attributable to" valuation overstatements. SeeTodd v. Commissioner, 89 T.C. 912 (1987)Todd v. Commissioner, supra. We decline to accept this concession. Petitioners had ample opportunity to concede this issue at trial and failed to do so. In addition, the record is inconclusive with respect to the placing in service of the master recordings. Their invitation to concede on brief is an attempt to avoid the obvious overvaluation. ↩
20. This is in contrast to a fraudulent transaction where the assets are not placed in service during the years before the Court because the assets do not exist and the valuation question is not reached.
Chellappan v. Commissioner, T.C. Memo. 1988-208Chellappan v. Commissioner, supra.↩ 21.
Section 6621 provides:(c) Interest on Substantial Underpayments Attributable to Tax Motivated Transactions. --
(3) TAX MOTIVATED TRANSACTIONS. --
(A) IN GENERAL. -- For purposes of this subsection, the term "tax motivated transaction" means --
(i) any valuation overstatement (within the meaning of
section 6659(c) ),(ii) any loss disallowed by reason of section 465(a) and any credit disallowed under section 46(c)(8),
(iii) any straddle (as defined in section 1092(c) without regard to subsections (d) and (e) of section 1092),
(iv) any use of an accounting period specified in regulations prescribed by the Secretary as a use which may result in a substantial distortion of income for any period, and
(v) any sham or fraudulent transaction. ↩
22. Pub. L. 99-514, sec. 1535(a), 100 Stat. 2085, 2750. This amendment is effective for interest accruing after December 31, 1984, the original effective date of
section 6621(d) , nowsection 6621(c)↩ .
Related
Cite This Page — Counsel Stack
1988 T.C. Memo. 332, 55 T.C.M. 1376, 1988 Tax Ct. Memo LEXIS 360, Counsel Stack Legal Research, https://law.counselstack.com/opinion/looney-v-commissioner-tax-1988.