Kovtun v. Commissioner

Lael Kovtun, et al., 1 Petitioners v. Commissioner of Internal Revenue, Respondent Kovtun v. Commissioner Docket Nos. 3390-67, 3400-67 -- 3412-67, 3424-67, 3510-67 United States Tax Court 54 T.C. 331; 1970 U.S. Tax Ct. LEXIS 206; February 24, 1970, Filed *206 Decisions will be entered for the respondent. The petitioners in all of these consolidated cases were limited partners in S.C., a partnership that was in turn a partner in Lake Murray partnership. The latter partnership reported the payment of prepaid interest to the Sunset Corp. in its information return. The partners in S. C. each took the ratable portion of said interest expense as a deduction in his individual return. Held: Respondent was right in disallowing said deductions for there was no existing "indebtedness" ( sec. 163, I.R.C. 1954) owed by the Lake Murray partnership to Sunset to support the interest payment. The required indebtedness was not evidenced by a contract whereby Sunset agreed to provide and/or procure financing for the Lake Murray partnership, in exchange for the partnership payment of a loan fee and prepaid interest, when the evidence shows Sunset failed to perform its obligation to provide and/or procure the financing for the partnership. Bruce I. Hochman, for the petitioners. Sheldon M. Sisson, for the respondent. Mulroney, Judge. MULRONEY *332 Respondent determined deficiencies in the 1963 income tax of petitioners in these consolidated cases, as follows: Docket No. Petitioner 1963 deficiency 3390-67 Lael Kovtun $ 4,595.40 3400-67 Sawyer A. Tuller and Ethel S. Tuller 216.36 3401-67 Martin Gang and Josephine T. Gang 1,976.36 3402-67 Milton A. Rudin and Elizabeth Rudin 1,407.49 3403-67 Louis M. Brown and Hermione K. Brown 781.24 3404-67 Bruce I. Hochman and Harriet B. Hochman 10,631.38 3405-67 David Goldberg and Lillian Goldberg 220.73 3406-67 Norman R. Tyre and Margery C. Tyre 1,675.41 3407-67 Frank G. Wells and Luanne C. Wells 268.62 3408-67 Julius Kovtun 4,575.68 3409-67 Payson Wolff and Helen Wolff 618.68 3410-67 Milton Zeman and Mitzi Zeman 210.04 3411-67 Eli Boyer 245.66 3412-67 Sheldon I. Silver and Joan Silver 1,346.00 3424-67 Ronald R. Levy and Esther Levy 23,610.26 3510-67 Stanley L. Keller and Wilma D. Keller 610.52 *208 These 16 petitioners (referring to husbands in joint returns) were limited partners in a partnership called S. C. Investments, Ltd. 2 The deficiencies result from respondent's adjustment that disallowed $ 284,813 claimed by the partnership to be interest expense. This adjustment resulted in respondent's disallowance of the individual partner's ratable portion of the interest expense that had been reported on the partnership information return. FINDINGS OF FACT Some of the facts have been stipulated and they will be found accordingly. All of the petitioners named above in these consolidated cases resided in California at the time the petitions were filed. They all filed their income tax returns for 1963 with the district director of internal revenue at Los Angeles, Calif. In 1963 Sunset International Petroleum Corp. (Sunset) was a publicly held corporation. *209 Its securities were traded on the American Stock Exchange. Sunset engaged both in the development of oil and *333 gas properties and the development of real estate projects. Sunset's real estate ventures were scattered throughout California and located in areas such as San Francisco, Marin County, Los Angeles, La Jolla, San Diego, and Beverly Hills. Sunset owned land in the San Carlos section of San Diego, Calif. Prior to August 1963, Sunset had constructed a shopping center (Navajo Shopping Center) and a medical center (Navajo Medical Center) in this area. All of the properties are located at the intersection of Navajo and Lake Murray Boulevards in San Diego. Sunset owned undeveloped real estate across the street from the Navajo Shopping Center. Negotiations with Sunset about the purchase of the undeveloped property at Navajo and Lake Murray Boulevards began in early 1963 by Marvin Strin, an accountant. Rough grading of the property had taken place prior to August 1963. Approximately $ 140,000 had been spent by Sunset prior to August 1963 on plans and rough grading. The initial development plans called for a senior citizens' project with about 300 units. S.C. Investments, *210 Ltd. (S.C.), was a limited partnership. It was formed in August 1963. Its purpose was to purchase, develop, and operate Sunset's undeveloped property mentioned above. The accounting firm of Strin, Silver and Pecora was the general partner of S.C. Investments, Ltd. Thirty-nine individuals or entities acting as limited partners made investments in S.C. totaling $ 600,000. The general partner invested $ 1,000. Each limited partner's contribution was to be paid: 50 percent upon execution of the partnership agreement and 50 percent by December 1, 1963. Some of the limited partners of S.C. were also investors in the Navajo Medical Center. Around August 12, 1963, S.C. purchased the vacant property located at the intersection of Navajo and Lake Murray Boulevards from Sunset for $ 625,000. $ 175,000 was paid on the purchase price and $ 126,000 was prepaid as interest on the encumbrance of $ 450,000. Also in August 1963, a partnership known as Lake Murray Apartments (Lake Murray) was formed. It was composed of Sunset as the general partner and S.C. as the limited partner. Lake Murray was formed to construct multifamily residential dwelling units on the undeveloped real property located*211 at Navajo and Lake Murray Boulevards. Sunset, as the general partner, was to make no cash contribution to Lake Murray. It was to provide construction supervision. S.C. contributed subject to encumbrances the property it had purchased from Sunset to the Lake Murray partnership. On August 12, 1963, Sunset and Lake Murray entered into a "Financing and Construction Agreement" which provided: This Agreement, made this 12th day of August 1963, by and between SUNSET INTERNATIONAL PETROLEUM CORPORATION, a Delaware corporation, *334 (hereinafter called "Sunset") and LAKE MURRAY APARTMENTS, a limited partnership, (hereinafter called "Murray"). WITNESSETH: Whereas, as Murray desires to build certain multi-family residential buildings and related improvements and facilities on that certain unimproved real property situated in the County of San Diego, State of California, more particularly described in Exhibit "A" attached hereto, hereinafter referred to as "said real property"; and Whereas, Murray desires to contract with Sunset and Sunset desires to contract with Buyer for the construction on said real property of said multi-family residential buildings and related improvements and facilities, *212 hereinafter referred to collectively as "said improvements"; Now, Therefore, the parties agree as follows: 1. CONSTRUCTION OF IMPROVEMENTS: (a) Sunset shall construct on said real property all of said improvements for Murray substantially in accordance with certain preliminary plans for said improvements. Said preliminary plans have been read and approved by Murray. (b) In consideration for the construction of said improvements pursuant to said plans, Murray agrees to pay to Sunset the sum of Three Million One Hundred Sixty Thousand Dollars ($ 3,160,000.00) plus interim construction loan fees, charges, and prepaid interest, as provided for in Section 2 hereof. 2. INTERIM FINANCING: (a) Sunset agrees to provide and/or procure for Murray the required interim construction financing in the amount of Three Million One Hundred Fifty Thousand Dollars ($ 3,150,000.00) during the construction period of said multi-family residential buildings and improvements until such time as the permanent financing hereinafter provided for is consummated. (b) Said interim financing may be provided in all or in part by Sunset and/or in all or in part through financing from a financial institution or institutions*213 selected by Sunset. (c) In consideration of the obtaining and/or providing of said interim financing, Murray agrees to pay to Sunset a loan fee in the amount of Sixty Three Thousand Dollars ($ 63,000.00), said sum to be paid to Sunset by Murray on or before December 1, 1963. (d) Murray further agrees to pay to Sunset as interest on said interim financing the sum of Two Hundred Twenty One Thousand Eight Hundred Twelve Dollars and Fifty Cents ($ 221,812.50), said interest to be prepaid in full to Sunset by Murray on or before December 1, 1963. Said interest on said interim financing is based upon six percent (6%) per annum on said total interim financing, for an estimated construction time of approximately thirteen (13) months. (e) Said interim financing shall be in addition to that certain Three Hundred Thousand Dollars ($ 300,000.00) loan being obtained by Murray from S.C. INVESTMENTS, LTD., a limited partnership, pursuant to a loan agreement being executed simultaneously herewith. (f) Said interest and said interim financing loan fee shall not be adjusted in any way as a result of Sunset's being able by the use of its financial credit to obtain all or a portion of said interim financing*214 at a rate of interest below said rate of interest of six and one-half percent (6 1/2%) per annum, or for a time in excess of said estimated time of construction of approximately eight (8) months or at a loan fee below the basis of said fee set forth above. *335 3. PERMANENT FINANCING: (a) Sunset expressly agrees that it will procure and/or provide permanent financing in a total sum of at least Three Million One Hundred Fifty Thousand Dollars ($ 3,150,000.00) upon the best terms available on said real property. (b) Said permanent financing shall consist of a loan or loans in the aggregate principal amount of Three Million One Hundred Fifty Thousand Dollars ($ 3,150,000.00) secured by a trust deed or trust deeds on said real property. (c) Said permanent financing shall be provided directly in all or in part by Sunset and/or procured by Sunset in all or in part from a financial institution or institutions or other parties. (d) Said permanent financing shall be upon such terms and conditions as Sunset shall designate except as follows: (1) Said permanent financing shall be over a period of not less than twenty-five (25) years, providing for equal payments covering interest and amortization*215 of principal. (2) Said permanent financing or portion thereof obtained by Sunset from financial institutions or other parties shall provide for the usual and prevailing prepayment penalty and other customary clauses required by such financial institution or institutions making said loan or loans, or if such loan or loans are made by other parties not financial institutions, said permanent financing shall provide for the usual and prevailing prepayment penalty and other customary clauses required by financial institutions in making loans of a similar type and nature. (3) The average interest rate on all of said financing shall not exceed six and one-half percent (6 1/2%) per annum on the aggregate principal balance due. (4) To the extent that Sunset directly provides all or a portion of said financing, by holding all or a portion of said loan or loans, there shall be no prepayment penalty payable to Sunset by Murray. (5) Said permanent financing shall be prior in right and additional in amount to said Deed of Trust in the amount of Four Hundred Fifty Thousand Dollars ($ 450,000.00) covering said real property executed by S. C. INVESTMENTS, LTD., a limited partnership, in favor of Sunset*216 as beneficiary. (6) Said permanent financing shall be in addition to that certain Three Hundred Thousand Dollar ($ 300,000.00) unsecured loan being obtained by Murray from S. C. INVESTMENT, LTD., a limited partnership, pursuant to a Loan Agreement being executed simultaneously herewith. (7) Murray shall not be responsible for the payment of any permanent financing loan fees, if any, in connection with said permanent financing. 4. ADDITIONAL DOCUMENTS: Murray and Sunset agree to execute any and all additional documents which may be reasonably required in order to carry out the terms and provisions of this Agreement. 5. COMMENCEMENT OF CONSTRUCTION: Sunset agrees that construction of said improvements shall be commenced on or before December 10, 1963 and shall be completed within a reasonable time thereafter. 6. FORCE MAJEURE: It is agreed that in the event Sunset is delayed in the performance of any of its obligations hereunder as a result of strikes, lockouts, wars, unavailability of material, floods, unusual weather conditions, government regulations and acts, or other causes beyond Sunset's reasonable control, then the time for the performance of any such obligation so delayed shall*217 be extended for the period of such delay. *336 7. BINDING AGREEMENT: This Agreement shall be binding upon and inure to the benefit of the successors and assigns of the parties hereto. In Witness Whereof, the parties hereto have executed this Agreement as of the day and year first hereinabove written. S. C. agreed to lend Lake Murray $ 300,000 for a period of 10 years with annual interest at 10 percent. On December 19, 1963, Strin, Silver and Pecora, the general partner of S. C. sent a check for $ 292,000 to Sunset. On December 24, 1963, Strin, Silver and Pecora sent a check for $ 8,000 to Sunset. After Sunset received the $ 300,000 the money was deposited in Sunset's San Carlos Project bank account on December 20 and 26, 1963. The sum received was credited to the Lake Murray Apartments inter-company account on the San Carlos Project books. After the Internal Revenue Service audit of Lake Murray began, Sunset made a journal entry transferring $ 284,812.50 from the intercompany account to the prepaid interest account. The individuals comprising S. C. sought to invest their funds in a real estate venture. At the same time, they wished to limit their personal liability. Sunset*218 sought a profit on the sale and subsequent development of its land. The original contractual obligations required Sunset to begin construction no later than December 10, 1963, and to proceed with reasonable speed. Sunset was unable due to lack of funds to proceed with the development of the property. In 1963 and 1964 negotiations for takeout loans were entered into with San Diego Federal Savings & Loan Association. No loans were obtained. Sunset also submitted an application for financing to the Prudential Insurance Co. during 1964. On August 21, 1964, the Prudential Insurance Co. issued a commitment for permanent financing on the project. The commitment expired on August 18, 1966. On August 23, 1966, Prudential issued a recommitment. The second commitment expired on August 16, 1968, and Prudential did not make the loan. After 1963 there were other unsuccessful attempts to arrange financing for the San Carlos project. Between 1963 and 1967 no construction took place. There was some grading and new plans were drawn. The amount spent by Sunset on grading and plans in 1964 was $ 237,000. After 1963 there was a change in the corporate hierarchy at Sunset. In late 1964 or *219 early 1965 the senior citizens project was dropped and a general apartment house complex was proposed. Before the revised project started the Prudential financing commitment had expired. Sunset's financial position continued to deteriorate and by 1967 it was equitably insolvent. *337 On the 1963 Lake Murray Form 1065 balance sheet its accountants showed an asset of $ 3,016,266 called "Construction Funds Available" and a liability of $ 3,160,000 called "Construction Contracts Payable." The difference, $ 143,734, was called an asset and labeled "Construction in Progress." "Construction in Progress" was Sunset's accumulated cost for plans and grading incurred before the Lake Murray partnership was formed. The information needed to prepare the Lake Murray return came from the accountants at Sunset. On its partnership return for the year 1963 Lake Murray claimed an interest deduction of $ 284,813 paid to Sunset. The components of the deduction were a "loan fee" of $ 63,000 and "prepaid interest" of $ 221,812.50. Sunset initially reported none of the $ 284,812.50 claimed as a deduction by Lake Murray as income. After the Internal Revenue Service commenced the audit of S. C. and *220 Lake Murray and questioned Lake Murray's deduction of the $ 284,812.50, Sunset filed an amended return including the questioned amount as income. Sunset, however, had a net operating loss deduction available to it in excess of the amount included in income. The apartments were not constructed. Respondent's determination of deficiency in each case increased taxable income of S. C.'s partners to reflect his adjustment to the Murray partnership return disallowing the claimed interest deduction of $ 284,813. OPINION Petitioners, who were limited partners, deducted their ratable portions of the so-called loan fee and prepaid interest shown on the partnership return in the total amount of $ 284,813, on their individual income tax returns for 1963 under section 163, I.R.C. 1954. 3That section provides, in part: "There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." *221 It is respondent's position that there was no existing indebtedness in relation to which any interest was paid in 1963. Respondent states on brief that "petitioners' right to deduct prepaid interest in 1963, provided there is an indebtedness, is not challenged." 4 Petitioners argue that the indebtedness requirement of the statute was satisfied by the existence of a binding obligation on the part of Sunset to provide and/or procure the interim financing. They state on brief that each tax year must be considered "in the light of facts known at year end." The argument seems to be that at December 31, 1963, *338 Sunset was unequivocally obligated to either provide or procure the interim financing of $ 3,150,000 in exchange for the loan fee of $ 63,000 and the prepaid interest in the sum of $ 221,812.50. And, petitioners argue, the fact that Sunset did not perform its obligation to provide and/or procure *222 the interim financing is immaterial. We said in First National Co., 32 T.C. 798, 807, that the word "indebtedness" in the interest deduction statute "means an existing, unconditional, and legally enforcible obligation for the payment of money." 5 The Financing and Construction Agreement of August 12, 1963, which was not complied with by Sunset, does not evidence a valid, unconditional indebtedness on the part of Lake Murray. The record is clear that in the year 1963 Sunset did not provide or procure any financing. Under the agreement Sunset was to begin construction of the building by December 10, 1963. It did not begin construction in 1963 and the building has never been constructed. Under*223 the agreement Sunset was to obtain permanent financing and it has never done so. Sunset's bookkeeping manueuvers with its entry to a prepaid interest account and its belated amended return reporting the receipt of prepaid interest income, both made after the deductions in issue were questioned by the revenue agent, are in no way persuasive -- especially since Sunset had a 1963 loss greater than the reported prepaid interest income. We agree with respondent. There was no valid existing indebtedness owed by the partnership to Sunset in the year 1963. The so-called interest payment was correctly disallowed. Our holding renders it unnecessary to consider respondent's alternative contention that the loan fee portion of the $ 284,813 ($ 63,000) would be a capital expenditure. Petitioners state on brief that if the payments herein are not deductible as interest they should be classified as "commitment fees" or "carrying charges" and deductible as ordinary and necessary business expenses. There is nothing in the petitions to indicate that such a question was in issue in this case nor was there evidence introduced at the time of trial with respect to an issue of ordinary and necessary *224 business expense. In any event, there is no merit to this theory of petitioners. The record, which fails to show the existence of an indebtedness to support an interest deduction, will not sanction calling the payment an ordinary and necessary business expense. Decisions will be entered for the respondent. Footnotes 1. Cases of the following petitioners are consolidated herewith: Sawyer A. Tuller and Ethel S. Tuller, docket No. 3400-67; Martin Gang and Josephine T. Gang, docket No. 3401-67; Milton A. Rudin and Elizabeth Rudin, docket No. 3402-67; Louis M. Brown and Hermione K. Brown, docket No. 3403-67; Bruce I. Hochman and Harriet B. Hochman, docket No. 3404-67; David Goldberg and Lillian Goldberg, docket No 3405-67; Norman R. Tyre and Margery C. Tyre, docket No. 3406-67; Frank G. Wells and Luanne C. Wells, docket No. 3407-67; Julius Kovtun, docket No. 3408-67; Payson Wolff and Helen Wolff, docket No. 3409-67; Milton Zeman and Mitzi Zeman, docket No. 3410-67; Eli Boyer, docket No. 3411-67; Sheldon I. Silver and Joan R. Silver, docket No. 3412-67; Ronald R. Levy and Esther Levy, docket No. 3424-67; and Stanley L. Keller and Wilma D. Keller, docket No. 3510-67.↩ 2. There were 39 partners in S. C. Investments, Ltd., and we are told the returns of the remaining 23 partners are with the Appellate staff in a protest stage.↩ 3. All section references are to the Internal Revenue Code of 1954, as amended, unless otherwise noted.↩ 4. This transaction arose before Rev. Rul. 68-643, 1968-2 C.B. 76↩. 5. Although this case was reversed on appeal on another issue, the Court of Appeals for the Sixth Circuit specifically approved our definition of the term "indebtedness" in the interest deduction statute. First National Co. v. Commissioner, 289 F. 2d 861, 865↩.