Pritchett v. Commissioner

85 T.C. No. 35, 85 T.C. 580, 1985 U.S. Tax Ct. LEXIS 27, 87 Oil & Gas Rep. 195

• Court: United States Tax Court
• Decided: October 24, 1985
• Docket: Docket Nos. 14586-81, 18127-81, 18128-81, 18477-81, 27413-82
• Status: Published

Opinions

Jacobs, Judge:

In these consolidated cases, respondent determined the following deficiencies in petitioners’ Federal income taxes:

Docket No. Petitioners Taxable year Deficiency

14586-81 Jerry E. Pritchett and Patricia D. Pritchett 1977 $33,336

18127-81 Donald R. Clifford and Joyce K. Clifford 1977 3,270

18128-81 Alex Indich and Mira Indich 1977 30,492

18477-81 Arthur Knox 1977 7,175

27413-82 Richard J. Buchbinder and Voren L. Buchbinder 1976 11,583

The issue for decision is whether petitioners, as limited partners in five similar limited partnerships engaged in oil and gas drilling operations, are "at risk” within the purview of section 465² for their proportionate shares of notes given by the partnerships to a drilling company under turnkey drilling agreements. If petitioners are not at risk for their proportionate shares of these notes, then the deductions for their distributive shares of partnership losses are limited to the amounts of their cash contributions to the partnerships. If, however, petitioners are at risk for their proportionate shares of the partnership notes, then the deductions for their distributive shares of partnership losses are allowable in their entirety-

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts and attached exhibits are incorporated herein by this reference.

All petitioners resided in California when they filed their petitions. Each male petitioner³ is a limited partner in one of five similar limited partnerships (cumulatively referred to as the partnerships). The promoters and general partners of each partnership were Albert Prager and Michael Traiger. Each partnership was formed to conduct oil and gas drilling operations. One of the partnerships (t & P, ltd.) was organized under California law in December 1976; the other four were organized under Nevada law in December 1977. The partnership in which each petitioner held an interest, the year formed, the amount of each partner’s initial cash contribution

thereto, and the total partnership capitalization for each of the five limited partnerships are as follows:

Petitioner Partnership Initial cash Year contribution formed to partnership Total partnership capitalization

Jerry Pritchett Alluf, Ltd. 1977 $35,000 $412,500

Donald Clifford Altar, Ltd. 1977 5,000 645,000

Alex Indich Aaron, Ltd. 1977 35,000 705,000

Arthur Knox Akiba, Ltd. 1977 5,000 465,000

Richard Buchbinder T & P Ltd. 1976 12,500 725,000

All five partnerships engaged in drilling operations through a series of essentially identical transactions with Fairfield Drilling Corp. (Fairfield), a wholly owned subsidiary of Petroleum Development Corp. (pdc), a publicly held corporation. On December 29, 1977, Fairfield assigned to the partnerships (December 29, 1976, in the case of T & p) rights to certain oil and gas leases which it held. In exchange therefor, the partnerships agreed to pay Fairfield a royalty equal to 20 percent of the gross sales proceeds of the oil and gas extracted from the leased land, except that the royalty did not commence until the assignee-partnership received a specified amount of net profits. Concurrent with the assignment of the oil and gas leases, Fairfield and each partnership executed a turnkey drilling agreement, a completion and operation agreement, and an equipment lease agreement. As a result of these agreements, Fairfield agreed to drill and develop the leased oil and gas properties of the partnership, and to provide all necessary equipment to commercially exploit all productive wells.

Pursuant to the turnkey drilling agreement, each partnership paid cash and executed a recourse note to Fairfield in 1977 (1976 with respect to T & p) in amounts as follows:

Partnership Amount of cash Amount of note⁴ Total

Alluf $412,500 $433,125 $845,625

Altar 645,000 677.250 1.322.250

Aaron 705,000 740.250 1.445.250

Akiba 465,000 488.250 953,250

T & P 725,000 761.250 1.486.250

Each note (the Fairfield note) was non-interest-bearing and had a maturity of 15 years. Each was secured by virtually all of the maker-partnership’s assets. The principal for each Fairfield note was payable from the net cash available to the partnership as a result of its drilling operations. Only the general partners were personally liable under the Fairfield note; however, each limited partnership agreement (as well as the certificate of limited partnership) provided that in the event the Fairfield note was not paid in full at maturity, the limited partners of the maker-partnership would be personally obligated to make additional capital contributions to the maker-partnership sufficient to cover the deficiency once called upon by the general partners to do so.⁵

Each partnership elected to employ the accrual method of accounting and to deduct intangible drilling costs (i.D.c.) as an expense pursuant to section 1.612-4, Income Tax Regs. Accordingly, each partnership deducted the entire amount paid to Fairfield (the total of the cash and the note) under the turnkey drilling agreement in the initial year. As there was no income in that year, each partnership reported a loss equal to its entire I.D.C.⁶

The partnership agreement provided that all losses were to be allocated among the limited partners in proportion to their respective capital contributions.⁷ Each petitioner deducted his distributive share of the partnership loss, as set out in the following table (which also lists their cash contributions):

Petitioner Distributive loss Cash contribution

Jerry Pritchett $71,750 $35,000

Donald Clifford 10,250 5,000

Alex Indich 71,750 35,000

Arthur Knox 10,250 5,000

Richard Buchbinder 25,625 12,500

Respondent disallowed the deduction taken by each petitioner for his distributive share of the partnership loss to the extent it exceeded his cash contribution.

OPINION

The ultimate question to be resolved is whether, as a limited partner, each petitioner may deduct his entire distributive share of partnership loss for the taxable year involved, or whether the deduction is limited to petitioner’s actual cash contribution to his partnership. Resolution of this question depends upon whether each petitioner is at risk on the Fairfield note.

Generally, an individual may deduct, on his own tax return, his distributive share of losses of a partnership in which he is a member. Sec. 702(a). However, there are statutory provisions that restrict the extent to which a partner may deduct his share of partnership losses. See secs. 704(b), 704(d), and 465(a). Respondent relies upon section 465 to restrict the amount of partnership loss which can be deducted by each petitioner.⁸

Section 465 was added to the Code by the Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1531, and is applicable to taxable years beginning after December 31, 1975. It was enacted to combat a perceived abuse which allowed a taxpayer to deduct tax losses in excess of the amount of his economic investment. S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3) 49, 86.

Section 465 limits the deductibility of losses arising from certain activities, including oil and gas exploration, to the amount for which the taxpayer is at risk for such activity at the close of the taxable year. In general, a taxpayer is considered at risk for the amount of money (or basis of property) that he has contributed to the partnership, as well as amounts borrowed with respect to the activity. Sec. 465(b)(1). Section 465(b)(2) defines the term "borrowed amount” for purposes of section 465. Simply stated, as relevant to this case, a borrowed amount must both (1) be an amount borrowed for use in the oil and gas exploration, and (2) create an obligation on which the petitioner is personally liable.

A taxpayer is not considered at risk for any amount borrowed from any person with an interest in the partnership other than an interest as a creditor. Sec. 465(b)(3)(A) and (B)(i).

Respondent, contending that each petitioner was at risk only for his initial cash contribution, disallowed the deduction taken by each petitioner for his distributive share of the partnership loss to the extent it exceeded his cash contribution. Respondent first argues that neither the potential cash call nor the Fairfield notes constitute amounts borrowed within the purview of section 465. Respondent alternatively argues that, even if the Fairfield notes constitute amounts borrowed within the purview of section 465, petitioners are not at risk with regard to the Fairfield note since it represents an amount borrowed from a person⁹ (Fairfield) with an interest in the partnership other than that of a creditor.

Petitioners, on the other hand, contend that the amount for which they are at risk includes their proportionate share of the Fairfield note. The thrust of petitioners’ argument is that the cash call, coupled with the recourse nature of the Fairfield note, operates to make petitioners personally liable (through liability to their respective partnerships) to Fairfield (a person who petitioners contend is without an interest in their respective partnerships) for an amount borrowed with respect to the activity. Petitioners argue that they should be considered at risk to the extent of their proportionate shares of their respective partnerships’ liability to Fairfield under section 465(b)(1)(B) and (2)(A). We disagree.

The potential cash calls (even if they might be considered obligations on which petitioners are personally liable) are not amounts borrowed for use in the oil and gas exploration activity of the partnership. Hence, the potential cash calls do not satisfy the.first criterion set forth in section 465 (b)(2) which defines a "borrowed amount” for purposes of section 465. On the other hand, the Fairfield notes are amounts borrowed for use in the oil and gas exploration activities of the partnerships. But they are not amounts borrowed for which the petitioners are personally liable, as determinable at the close of the taxable year at issue.

State law defines the relationship among limited partners, the partnership, and creditors of the partnership. Both California and Nevada (the two States in which the partnerships involved were formed) have adopted the Uniform Limited Partnership Act (ulpa). Ordinarily, under the ulpa, a limited partner is not personally liable for partnership obligations. Cal. Corp. Code sec. 15501 (West 1977); Nev. Rev. Stat. sec. 88.020 (1979). Therefore, generally, a limited partner is not at risk for any portion of the debt of his partnership, even if the debt is recourse. Sec. 465(b)(2)(A); see sec. 1.465-24(a)(2)(i), Proposed Income Tax Regs., 44 Fed. Reg. 32242 (June 5, 1979). Only general partners ordinarily have personal exposure with respect to the debt of a limited partnership, and therefore, ordinarily only general partners are at risk.

However, there may be circumstances where a limited partner would be liable for some portion of the partnership debt. The ulpa provides that a "contributor, unless he is a general partner, is not a proper party to proceedings * * * against a partnership, except where the object is to enforce a limited partner’s * * * liability to the partnership.” (Emphasis added.) Cal. Corp. Code sec. 15526 (West 1977); Nev. Rev. Stat. sec. 88.270 (1979); see Richard Matthews, Jr., Inc. v. Vaughn, 91 Nev. 583, 540 P.2d 1062 (1975). A limited partner is liable to the partnership under the ulpa for (a) "the difference between the contribution as actually made and that stated in the certificate as having been made” and (b) "any unpaid contribution which he agreed in the certificate to make in the future at the time and on the conditions stated in the certificate.” (Emphasis added.) Cal. Corp. Code sec. 15517(l)(a) and (b) (West 1977); Nev. Rev. Stat. sec. 88.180(l)(a) and (b) (1979). Accordingly, limited partners may be named as defendants in a suit brought against the partnership by a creditor for satisfaction of a partnership debt where the limited partners are obligated to the partnership for unpaid contributions.

Petitioners posit that they are currently obligated to make future contributions to their respective partnerships. They further posit that Fairfield, as a creditor of the partnerships, could force the limited partners to satisfy this obligation to the partnership. From these premises petitioners conclude that they are personally liable to Fairfield under the Fairfield notes. The flaw in this syllogism is that petitioners are only contingently obligated to make future contributions to their respective partnerships if and when called upon by the general partner to do so. Therefore, they are not currently personally liable to Fairfield. Moreover, the cash call, as provided for in the certificates of limited partnership, is not an "unpaid contribution” which would make the limited partners personally liable under the ulpa to the partnerships in 1976 or 1977.

Each petitioner can be required to make an additional contribution to his partnership if on December 31, 1992¹⁰, there is an unpaid balance on the Fairfield note. However, by the close of each taxable year in issue (1976 or 1977), such a requirement was merely a contingency since it was not known in 1976 or 1977 (a) whether there would or would not be sufficient partnership revenues to satisfy the Fairfield note prior to or on maturity of the note, or in the event the Fairfield note was not satisfied in full on maturity, the amount of the capital contributions needed to cover the deficiency, or (b) if the general partners would in fact exercise their discretion to make the cash call if an unpaid balance on the Fairfield note were to exist on December 31, 1992.¹¹ Hence, as of the close of the taxable year in issue, petitioners had no current ascertainable liability to their partnerships for future contributions.¹²

Our holding comports with the common law contract principle that a contingent debt does not reflect a present liability. A debt is an unconditional promise to pay a sum certain in money or money’s worth on demand or on a specific date. As long as it is subject to a contingency, it is not a debt on which present liability has accrued. See Gilman v. Commissioner, 53 F.2d 47, 50 (8th Cir. 1931).

Petitioners’ brief cites Donroy, Ltd. v. United States, 301 F.2d 200 (9th Cir. 1962); Linder v. Vogue Investments, Inc., 239 Cal. App. 2d 338, 48 Cal. Rptr. 633 (1966); Indiana Mortgage & Realty Investors v. Spira-Mart of Lansing, 115 Mich. App. 141, 320 N.W.2d 320 (1982); and Robinson v. McIntosh, 3 E.D. Smith 221 (N.Y.C.P. 1854), to support their contention that "the Uniform Act has allowed creditors such as Fairfield to directly enforce the agreement of the limited partners of each Partnership to contribute their pro rata share of the unpaid balance of the Notes.” We find petitioners’ reliance upon these decisions to be misplaced.

Each of those cases involved limited partners who either withdrew their stated investment or were relieved from their obligation to make the total contribution to the partnership stated in the certificate, after debts had been incurred by the partnerships involved, thereby impairing the creditors’ rights upon default. The cases proceeded on the theory that the assets of the partnership should be available to liquidate its debt, regardless of whether those assets are in the possession of the partnership or the partners. The creditor was permitted to pursue the party in possession; he was not hindered by a collusive act aimed at defeating his claims. See Cal. Corp. Code secs. 15516, 15517(3) and (4), and 15523 (West 1977); Nev. Rev. Stat. secs. 88.170, 88.180(3) and (4), and 88.240 (1979).

Here we are faced with no such situation. Fairfield’s rights have not been impaired during the years in issue. Assuming, without deciding, that under Donroy and the other cases cited by petitioners, Fairfield might eventually have a direct path to petitioners in the event the partnership debt matured unsatisfied, our holding would not be altered. The "at risk” inquiry for purposes of section 465 is an annual one made on the basis of the facts existing at the end of each taxable year. S. Rept. 94-938,1976-3 C.B. (Vol. 3) 49, 86. Before and during the years in issue there was no collusive release of the limited partners from their obligations to make future capital contributions; we need not speculate as to what might happen in some subsequent year. Thus, as of the end of each taxable year (1976 or 1977), Fairfield had no established recourse on its notes against petitioners; therefore petitioners are not liable on those notes.

In summary, we find nothing in the ulpa, as enacted or interpreted in California and Nevada, that would saddle petitioners with liability for the Fairfield note.

Petitioners have posited still an additional theory to support their contention that they are personally liable on the Fair-field note. Specifically, they argue that Fairfield is a third party beneficiary of the contract (the limited partnership agreement) between the partnerships and the limited partners to make future contributions to satisfy any outstanding principal balance on the Fairfield note, and as such, Fairfield may proceed against the limited partners directly to enforce this obligation. Petitioners contend that this satisfies the criteria of section 1559 of the California Civil Code, which provides that "A contract, made expressly for the benefit of a third person, may be enforced by him at any time before the parties thereto rescind it” (emphasis added). The requirement for an additional contribution by the limited partners, according to petitioners, is expressly designed to protect Fairfield in the event of a shortfall in the partnership assets. Therefore, they contend, Fairfield may enforce it against the limited partners.

Accepting, arguendo, petitioners’ contention that the third party beneficiary doctrine as enacted by section 1559 in California applies in this situation, we nevertheless conclude that Fairfield has no recourse against the limited partners at the close of the taxable years at issue.

On the basis of the foregoing, we hold that petitioners are not personally liable for any portion of the partnership notes to Fairfield either under the ulpa or by the third party beneficiary doctrine at the close of the taxable years at issue.¹³

Having found that petitioners have no personal liability on the Fairfield note,¹⁴ we hold that they are at risk only for the actual cash contribution made as of the close of the taxable years at issue.¹⁵ So found, we need not address the issues involving Fairfield’s interest in the activity.

To reflect the foregoing,

Decisions will be entered for the respondent.

Reviewed by the Court.

Sterrett, Goffe, Chabot, Parker, Shields, and Clapp, JJ., agree with the majority opinion. Gerber, J., did not participate in the consideration of this case.

2 All section references are to the Internal Revenue Code of 1954 as in effect during the taxable years at issue, unless otherwise indicated.

3 The term "petitioner” and "petitioners” will exclude wives, where applicable, as only the husbands were limited partners in the partnerships involved herein.

4 The amount of each note is exactly equal to 105 percent of the amount of cash.

5 The certificates of limited partnership for each partnership and, with slight variations, the limited partnership agreement provided as follows:

"If there are not sufficient revenues to pay the entire principal amount of the recourse promissory drilling note by December 31, 1992, then the general partners will by written notice call for additional capital contributions in an amount sufficient to pay the outstanding balance of said promissory note. The total additional capital contributions shall be allocated among the limited partners in the proportion that the initial capital contribution of each limited partner bears to the initial capital contributions of all of the limited partners. Each limited partner shall be obligated to pay in cash to the partnership, on or before the specified due date set forth in the written notice from the general partners, given not less than thirty (30) days before such date, the amount set forth in such notice. * * *”

Four of the five petitioners testified that they believed that they would be unconditionally liable for future additional capital contributions to their respective partnerships if called upon to make such contributions by the general partners. The fifth petitioner did not testify. It is noteworthy that with respect to the four petitioners who testified, three failed to list as a liability on financial statements submitted in connection with loans the obligation to make additional capital contributions; the fourth never sought a loan and hence was not required to prepare a financial statement.

6 The loss of each partnership in its initial taxable year was reported as follows:

Partnership Loss tcash and note)

Alluf. $845,625 ($412,500 + $433,125)

Altar. 1,322,250 (645,000 + 677,250)

Aaron. 1,445,250 (705,000 + 740,250)

Akiba. 953,250 (465,000 + 488,250)

T&P. 1,486,250 (725,000 + 761,250)

7 The limited partners were to receive 94 percent of the profits and distributions of the partnership until such time as the full amount of their original capital contributions were returned to them; thereafter, they were to receive 70 percent of the profits and distributions. Partnership distributions were to be made at such time and in such amounts as, in the sole discretion of the general partners, the business affairs and financial circumstances of the partnership permitted, provided that no distribution would be made if such would impair the financial liquidity of the partnership or would otherwise tend to render the partnership insolvent.

8 The "at risk” rules of sec. 465 override the provisions of sec. 704(d) and related provisions, including sec. 1.752-l(e), Income Tax Regs. S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3) 49, 87.

9 Sec. 7701(a) provides:

SEC 7701(a). When used in this title, where not otherwise distinctly expressed or manifestly incompatible with the intent thereof—

(1) Person. — The term "person” shall be construed to mean and include an individual, a trust, estate, partnership, association, company, or corporation.

10 Dec. 31, 1991, for petitioner Buchbinder.

¹¹

12 The certificates of limited partnership provide for the cash call only at the stated maturity date.

13 We note sec. 1.465-22(a), Proposed Income Tax Regs., 44 Fed. Reg. 32238 (June 5,1979), which requires as an omission from the amounts considered at risk, that sum “which the partner is required under the partnership agreement to contribute until such time as the contribution is actually made.” This proposed regulation, at least as it applies to the facts with which we are here involved, comports with the general scheme of sec. 465, which is to prevent an artificial inflation of the amounts considered at risk beyond those amounts which the taxpayers actually stand to lose as of the close of the taxable year at issue.

14 It could be argued that satisfaction of the Fairfield note will ultimately be borne by petitioners, either through a reduction of distributions from their respective partnerships or by the payment of additional capital contributions. We do not accept such argument because it ignores the fact that the obligation to Fairfield is that of the partnerships (and not of the partners) and that the limited partners are entitled to receive partnership distributions only at such times and in such amounts as the general partners determine, and only if such would not impair the partnerships’ ability to satisfy their obligations.

15 Cf. Brand v. Commissioner, 81 T.C. 821 (1983), where we held that a limited partner who had guaranteed a partnership obligation was not at risk on the partnership obligation.