Foster, Richard H., et ux., et al. v. Comm.

Decision will be entered under Rule 155.

Valentine Brookes and Lawrence V. Brookes, for the petitioners.

Joyce E. Britt and Charlotte Mitchell, for the respondent.

C.

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APPLICATION OF SECTION 482 TO TAXABLE DISPOSITIONS OF PROPERTY PREVIOUSLY ACQUIRED IN NONRECOGNITION TRANSACTIONS

Petitioners contend that the Commissioner may not reallocate income derived from the taxable disposition of property previously acquired in a nonrecognition transaction. The nonrecognition transactions which petitioners contemplate

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include an exchange of property for stock under section 351 and a contribution of capital. We shall begin by briefly analyzing the statutory framework for their argument.

Under section 351, ⁶² a transferor does not recognize gain or loss when property is transferred to a corporation solely in exchange for its stock or securities if immediately after the exchange the transferor controls the corporation. Similarly, under section 1032, ⁶³ a corporation does not recognize gain or loss when property is transferred to it in exchange for its stock. One important consequence of this nonrecognition exchange is that under section 362(a)(1) ⁶⁴ the transferor's basis in the transferred property is carried over and becomes the transferee's basis in that property. ⁶⁵ The transferee therefore inherits the potential gain or loss which is inherent in the property at the time of its transfer. When that property is subsequently sold or otherwise disposed of in a taxable transaction, a form of income-shifting can occur, which in turn can cause some measure of distortion in both the transferor's and transferee's taxable income. Such income-shifting and distortion are unquestionably contemplated by the nonrecognition and basis provisions discussed above. The issue which

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petitioners raise is whether the Commissioner can reallocate the income to the transferor under authority of section 482.

A similar analysis applies when a shareholder merely contributes capital to a corporation. The shareholder obviously does not recognize gain or loss because income is not even realized when capital is contributed to a corporation. Similarly, under section 118 ⁶⁶ the corporation does not recognize gain or loss. Under section 362(a)(2) (see note 64, supra) the shareholder's basis in the contributed property is preserved, and the corporation inherits the potential gain or loss. As in the case of a section 351 exchange, income-shifting and some distortion occur when the property is subsequently sold in a taxable transaction. Once again, petitioners question whether the Commissioner can reverse the contemplated income-shifting and distortion by invoking section 482.

As a preliminary matter, we must decide whether petitioners have accurately characterized the transfer in question. In this regard, they characterize the October 1962 transfer by the Foster partnership of undivided 25-percent interests in 127 acres of land in Neighborhood One to each of the four Alphabet Corporations as four separate section 351 transactions. They characterize the August 1966 transfer by the partnership of 311 single-family residential lots in Neighborhood Four to Foster Enterprises as a contribution to the capital of that corporation. Respondent disputes only the former characterization, arguing that the transfers to the Alphabet Corporations were not made "in exchange for stock," and, even if they were, the partnership was not "in control" immediately after the exchange.

Although the record is not as neat and tidy as we might like, we are satisfied that the 127 acres were transferred in exchange for stock in the Alphabets. Those corporations were formed in 1962 at the behest of Del Champlin for the purpose of holding title to land in Neighborhood One. While the actual transfer of land may not have been simultaneous with the formation of the Alphabets, it was clearly part of a preconceived plan. We also think the "control" requirement was

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satisfied. The transaction can be viewed as one consisting of two steps: a distribution by the partnership of the 127 acres of land to the Fosters, followed by the transfer of their undivided interests therein to the Alphabets. In any event, this particular matter is actually moot because if that transaction is not a section 351 exchange, it would have to be viewed as a capital contribution, and the same basic analysis would apply. We shall proceed, therefore, as if it were such an exchange. We shall also focus exclusively on that transaction. The conclusions which we reach necessarily apply to the capital contribution of the residential lots in Neighborhood Four to Foster Enterprises.

Before we begin our discussion of the relationship of section 482 to the nonrecognition and basis provisions of sections 351 and 362, we should mention that those provisions do not bar the application of either section 446(b) (see Palmer v. Commissioner, 267 F.2d 434 (9th Cir. 1959), affg. 29 T.C. 154 (1957)), or such basic judicial doctrines like assignment of income (see Commissioner v. Fender Sales, Inc., 338 F.2d 924 (9th Cir. 1964), revg. a Memorandum Opinion of this Court), ⁶⁷ step transaction (substance over form) (see Hallowell v. Commissioner, 56 T.C. 600 (1971)), and tax benefit (see Hutton v. Commissioner, 53 T.C. 37 (1969), remanded 434 F.2d 1313 (6th Cir. 1971)), to taxable dispositions of property previously acquired in nonrecognition transactions. See generally Miller, "The Application of IRC Section 482 to Transfers Under Section 351: The National Securities Risk," 1976 Ariz. St. L.J. 227, 235 n. 58 (1976); Berger, Gilman & Stapleton, "Section 482 and the Nonrecognition Provisions: An Analysis of the Boundary Lines," 26 Tax Law. 523, 527 n. 17 (1973). Thus, for example, section 446(b) authorizes the Commissioner to compute taxable income by a different method of accounting if he determines that the taxpayer's method does not clearly reflect income. In Palmer v. Commissioner, supra, the Commissioner determined that the percentage-of-completion, rather than the completed-contract, method of accounting more clearly reflected the income of a partnership from a construction business for work largely completed prior to the section 351 exchange.

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The Ninth Circuit affirmed our decision sustaining his determination, concluding that the method chosen by the Commissioner was "fair and equitable." 267 F.2d at 439. Cf. Standard Paving Co. v. Commissioner, 190 F.2d 330 (10th Cir. 1951), affg. 13 T.C. 425 (1949); United States v. Lynch, 192 F.2d 718 (9th Cir. 1951).

1. Section 1.482-1(b)(1), Income Tax Regs., and the Arm's-Length Bargaining Standard

As previously stated, petitioners contend that the Commissioner may not reallocate income derived from the taxable disposition of property previously acquired in a nonrecognition transaction. Respondent, of course, contends to the contrary. The parties cite different provisions of the regulations in support of their respective positions. Petitioners rely on section 1.482-1(b)(1), Income Tax Regs. That section provides as follows:

(b) Scope and purpose. (1) The purpose of section 482 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer, by determining, according to the standard of an uncontrolled taxpayer, the true taxable income from the property and business of a controlled taxpayer. The interests controlling a group of controlled taxpayers are assumed to have complete power to cause each controlled taxpayer so to conduct its affairs that its transactions and accounting records truly reflect the taxable income from the property and business of each of the controlled taxpayers. If, however, this has not been done, and the taxable incomes are thereby understated, the district director shall intervene, and, by making such distributions, apportionments, or allocations as he may deem necessary of gross income, deductions, credits, or allowances, or of any item or element affecting taxable income, between or among the controlled taxpayers constituting the group, shall determine the true taxable income of each controlled taxpayer. The standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer.

See also secs. 1.482-1(a)(6) and 1.482-1(c), Income Tax Regs. On the other hand, respondent cites section 1.482-1(d)(5), Income Tax Regs. That section provides as follows:

(5) Section 482 may, when necessary to prevent the avoidance of taxes or to clearly reflect income, be applied in circumstances described in sections of the Code (such as section 351) providing for nonrecognition of gain or loss. See, for example, National Securities Corporation v. Commissioner of

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Internal Revenue, 137 F.2d 600 (3rd Cir. 1943), cert. denied 320 U.S. 794 (1943). ⁶⁸

Petitioners argue that the arm's-length bargaining standard adopted by section 1.482-1(b)(1), Income Tax Regs., cannot be applied to a section 351 exchange because such a transaction cannot by definition occur between unrelated parties. From this they conclude that the Commissioner may not invoke section 482 to reallocate income derived from the taxable disposition of property previously acquired in a nonrecognition transaction. However, in Northwestern Nat. Bank of Minneapolis v. United States, 556 F.2d 889 (8th Cir. 1977), the Eighth Circuit rejected a similar contention. In that case, a wholly owned subsidiary transferred 10,000 shares of stock in a third corporation as a dividend to the taxpayer, its parent corporation. Shortly thereafter, the taxpayer donated the shares to a foundation and claimed the contribution as a charitable deduction. Acting pursuant to section 482, the Commissioner reallocated the deduction to the subsidiary. In a refund action, the taxpayer argued that section 482 does not apply to a transaction which originates as a dividend distribution because such a distribution would not occur between uncontrolled taxpayers. The Court of Appeals characterized this argument as "without merit" and stated as follows:

There is nothing in the language of section 482 or its corresponding regulations that is inconsistent with applying section 482 to transactions between subsidiary corporations that might not occur in similar form between unrelated taxpayers. The purpose behind the dividend distribution was to obtain a tax advantage not available in an arm's length transaction. The transaction was made possible solely on the basis of [the taxpayer's] relationship with and control of [its subsidiary], and the end result was a distortion of the respective net incomes of both parent and subsidiary corporations. Section 482 was designed specifically to correct such distortions.

It should be noted that the distortion was not caused by the upstream dividend alone; intercorporate dividends do not automatically trigger section 482 reallocation. The dividend was simply the vehicle by which assets were moved to the parent corporation, which was in a better position to enjoy the deduction that would accrue from the previously planned contribution. Since

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such a strategy would be unavailable to an uncontrolled taxpayer, the Commissioner did not abuse his discretion in reallocating the deduction back to the subsidiary, the true donor under the standard of an uncontrolled taxpayer. See Treas. Reg. Section 1.482-1(b)(1). [556 F.2d at 891-892; emphasis added; fn. refs. and citations, generally, omitted.]

We think this reasoning is sound and applies equally to the present case because the tax strategy attendant upon a section 351 exchange would be similarly unavailable to an uncontrolled taxpayer. ⁶⁹

Petitioners ascribe controlling significance to Commissioner v. First Security Bank of Utah, 405 U.S. 394 (1972). In that case, the Commissioner reallocated under the authority of section 482, credit life reinsurance premiums from one wholly owned subsidiary, a company licensed to engage in the insurance business, to another wholly owned subsidiary, a national bank. The bank was not licensed to sell insurance; it was legally prohibited from receiving insurance-related income and, in fact, never received any such income. Nevertheless, the Commissioner allocated 40 percent of the other subsidiary's premium income to it as compensation for originating and processing the credit life insurance on its customers. The Supreme Court held that the parent holding company did not have "complete power," within the meaning of section 1.482-1(b)(1), Income Tax Regs., to shift the premium between its subsidiaries because it would have been illegal for the bank to receive that income: "The 'complete power' referred to in the regulations hardly includes the power to force a subsidiary to violate the law." 405 U.S. at 405. Because the holding company was thus barred from utilizing its control over its subsidiaries to distort their true taxable incomes, the Commissioner's determination was not sustained.

Petitioners argue that First Security Bank is significant to cases in which the events in question could only occur between commonly controlled taxpayers because the Supreme Court rested its decision disapproving the Commissioner's reallocation

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on that basis. We disagree. We think that case is inapposite to the issue before us.

In his dissenting opinion, Justice Blackmun observed that the majority's decision in First Security Bank "may not be too important, for it affects only a few taxpayers." 405 U.S. at 426. It is clear to us that petitioners are not among those few because they do not even suggest that it would have been illegal for the Foster partnership to receive the income which respondent seeks to reallocate from the Alphabet Corporations and Foster Enterprises. In our view, it was the fact that the receipt of insurance-related income would have been illegal that was determinative in First Security Bank. That case is also inapposite because it did not involve a section 351 exchange or other nonrecognition transaction.

In view of the foregoing, we think petitioners' reliance on section 1.482-1(b)(1), Income Tax Regs., is ill founded.

2. Validity of Section 1.482-1(d)(5), Income Tax Regs.

Petitioners counterattack by denying the validity of section 1.482-1(d)(5), Income Tax Regs., presumably on the basis that it is out of sync with such nonrecognition provisions as sections 351 and 362. We disagree. While our preceding discussion may perhaps be dispositive of the matter, its obvious importance demands that we address it more fully.

Section 1.482-1(d)(5), Income Tax Regs., is built upon a solid line of cases that extends back 40 years. The three leading cases in that line are National Securities Corp. v. Commissioner, 137 F.2d 600 (3d Cir. 1943), affg. 46 B.T.A. 562 (1942); Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214 (2d Cir. 1952), revg. 16 T.C. 882 (1951); and Rooney v. United States, 305 F.2d 681 (9th Cir. 1962). See also Estate of Walling v. Commissioner, 373 F.2d 190, 193-194 (3d Cir. 1967), revg. 45 T.C. 111 (1965); but see Ruddick Corp. v. United States, 226 Ct. Cl. 426, 643 F.2d 747 (1981). We will discuss each of the leading cases in turn.

The seminal case is National Securities Corp. v. Commissioner, 137 F.2d 600 (3d Cir. 1943). There, a parent corporation acquired shares of stock in an unrelated corporation (Standard) as an investment at a cost of approximately 140,000. After the market value of that stock had declined to about 8,500, the parent transferred it to the taxpayer, its wholly

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owned subsidiary, in exchange for 800 additional shares in the taxpayer, with a stated value of 8,000 and a market value of approximately 75,000. This transaction qualified as a section 351 exchange. Later that same year, the taxpayer sold the Standard stock for 7,175, and, on its income tax return, claimed a loss equal to the difference between the amount realized and its parent's cost (the taxpayer's carryover basis under section 362). Acting pursuant to section 482, the Commissioner determined that the loss ⁷⁰ should be reallocated from the taxpayer to its parent. The parent, however, was unable to use the loss because it had already claimed the maximum capital loss deduction permitted for the year in issue.

The Commissioner's determination raised two issues: Whether the nonrecognition and basis provisions of sections 351 and 362 override the Commissioner's authority under section 482 ⁷¹ to allocate; and, if not, whether the allocation in question should be sustained. Like the Board of Tax Appeals, the Court of Appeals resolved the first issue in favor of the Commissioner. It described the relationship of section 482 to sections 351 and 362 as follows:

Section [482] is directed to the correction of particular situations in which the strict application of the other provisions of the act will result in a distortion of the income of affiliated organizations. In every case in which the section is applied its application will necessarily result in an apparent conflict with the literal requirements of some other provision of the act. If this were not so Section [482] would be wholly superfluous. We accordingly conclude that the application of Section [482] may not be denied because it appears to run afoul of the literal provisions of Sections [351 and 362] if the Commissioner's action in allocating under the provisions of Section [482] the loss involved in this case was a proper exercise of the discretion conferred upon him by the section. [137 F.2d at 602.]

The Court of Appeals went on to sustain the Board's decision that the Commissioner's action in allocating the loss was neither arbitrary nor capricious. 137 F.2d at 603.

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In Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214 (2d Cir. 1952), a decision which this Court implicitly accepted in Simon J. Murphy Co. v. Commissioner, 22 T.C. 1341, 1343 (1954), revd. on other grounds 231 F.2d 639 (6th Cir. 1956), the taxpayer, a New York corporation, had been engaged for many years in the business of cultivating, processing, and selling sugar in Cuba. Except for its statutory office in New York, its land and sugar mills were located in Cuba, and its controlling shareholders were Cuban. A provision of the Cuban constitution, then only recently in force, restricted the foreign ownership of land. Fearful of expropriation, the taxpayer transferred all of its assets to a Cuban corporation pursuant to a tax-free plan of reorganization under the predecessor of section 368 in exchange for the transferee's capital stock (which was then distributed to the taxpayer's shareholders) and the assumption of its liabilities. The taxpayer had obtained an advance ruling which concluded that the transfer was not "in pursuance of a plan having as one of its principal purposes the avoidance of Federal income taxes."

The taxpayer transferred its assets, including its current unharvested and unsold sugar crop, at a time when it had incurred substantial expenses in connection with that crop but had not yet realized any income from it. On its income tax return for the reorganization year it deducted those expenses, causing it to sustain a net operating loss which it sought to carry back to a prior year. Acting under authority of the predecessor of section 482, the Commissioner reallocated the expenses to the Cuban corporation. However, we did not sustain his determination, and held, instead, that "where a sound reason not primarily related to tax saving was the motivating force of the transaction in question, the [Commissioner] should not be permitted, under the guise of section [482], to allocate certain of the expenses of the [taxpayer] to the Cuban corporation." 16 T.C. at 892-893.

On appeal, the Second Circuit reversed our decision, holding that "The Tax Court's assumption of the necessity of finding some ulterior motivation -- traditionally a thankless task in tax cases and one to be avoided if possible -- was error." 198 F.2d at 215-216. It then sustained the Commissioner's determination, observing that the purpose of section 482 is "to deny

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the power to shift income or deductions arbitrarily among controlled corporations." 198 F.2d at 216.

In Rooney v. United States, 305 F.2d 681 (9th Cir. 1962), the taxpayers, husband and wife, were hop farmers. During the middle of the year, they transferred their current unharvested, but previously contracted for crop, as well as their other farm assets, to a corporation in exchange for all of its stock. On their individual income tax returns, they claimed the expenses incurred in growing the crop prior to the date of the section 351 exchange. The corporation deducted the expenses incurred after that date and reported all of the income from the sale of the crop. As a result, the taxpayers sustained a net operating loss, which they sought to carry back to prior years. However, under authority of section 482, the Commissioner reallocated the expenses of growing the crop to the corporation.

The Ninth Circuit spared few words in disposing of the taxpayer's argument that section 482 is inapplicable in the face of section 351. It briefly quoted from National Securities Corp. v. Commissioner, supra, and then concluded that "section 482 * * * will control when it conflicts with section 351 * * * as long as the discretion of the Commissioner in reallocating is not abused." 305 F.2d at 686. Citing Central Cuba Sugar Co. v. Commissioner, supra, it then held that there was no abuse by the Commissioner in the case before it.

We fail to see how the validity of section 1.482-1(d)(5), Income Tax Regs., can be seriously questioned in light of the above cases. The regulation is neither unreasonable nor inconsistent with the statute (see Bingler v. Johnson, 394 U.S. 741, 749-751 (1969)), reflecting as it does a judicial interpretation of section 482 that has stood the test of 40 years. Moreover, as we shall now show, it harmonizes with the statute's "origin and purpose." See United States v. Vogel Fertilizer Co., 455 U.S. 16 (1982); National Muffler Dealers Ass'n, Inc. v. United States, 440 U.S. 472, 476-477 (1979).

Reference to the legislative history of section 482 sheds light on its origin and purpose. As previously stated, the section can be traced to the consolidated return provisions of section 240(d) of the Revenue Act of 1921, ch. 136, 42 Stat. 227, 260. The Senate Finance Committee report reflects congressional concern about the arbitrary shifting of profits among related businesses:

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A new subdivision is added to this section giving the Commissioner power to consolidate the accounts of related trades or businesses owned or controlled by the same interests, for the purpose only of making a correct distribution of gains, profits, income, deductions, or capital, among the related trades or businesses. This is necessary to prevent the arbitrary shifting of profits among related businesses * * *. [S. Rept. 275, 67th Cong., 1st Sess. (1921), 1939-1 C.B. (Part 2) 181, 195.]

This same concern is evident in the House Ways and Means Committee report which accompanied section 45 of the Revenue Act of 1928, ch. 852, 45 Stat. 791, 806, from which section 482 is directly derived:

The section of the new bill provides that the Commissioner may, in the case of two or more trades or businesses owned or controlled by the same interests, apportion, allocate, or distribute the income or deductions between or among them, as may be necessary in order to prevent evasion (by the shifting of profits, the making of fictitious sales, and other methods frequently adopted for the purpose of "milking"), and in order clearly to reflect their true tax liability. [H. Rept. 2, 70th Cong., 1st Sess. (1927), 1939-1 C.B. (Part 2) 384, 395.]

See also S. Rept. 960, 70th Cong., 1st Sess. (1928), 1939-1 C.B. (Part 2) 409, 426. Perhaps the best and most succinct statement of the purpose of section 482 is provided by Bittker & Eustice:

The major thrust of Section 482 is the prevention of artificial shifting, milking, or distorting of the true net incomes of commonly controlled enterprises. The regulations also warn that distortions of income may invoke application of this section even though the taxpayers act in good faith and with an absence of tax-avoidance motives. In effect, then, Section 482 seems to be an amalgam of several important themes and policies of the tax law: tax-avoidance principles, assignment-of-income notions, general deduction theories, and clear reflection of income under the parties' accounting methods. [B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders, par. 15.06, at 15-15/16 (4th ed. 1979); fn. ref. omitted.]

In our view, section 1.482-1(d)(5), Income Tax Regs., is compatible with the purpose of section 482 as expressed above and in its legislative history. It takes little imagination to envision a taxable disposition of property previously acquired in a nonrecognition transaction, such as a section 351 exchange, which results in "the artificial shifting, milking, or distorting of the true net incomes of commonly controlled enterprises." One need only recall the facts in National Securities Corp. v. Commissioner, supra. Finally, we find nothing in the origin and purpose of section

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351 that would lead us to question the validity of section 1.482-1(d)(5), Income Tax Regs. Section 351 is derived from section 202(c)(3) of the Revenue Act of 1921, ch. 136, 42 Stat. 227, 230, and is designed to facilitate changes in the form of a business by permitting an owner to incorporate without fear of adverse tax consequences. See S. Rept. 275, 67th Cong., 1st Sess. (1921), 1939-1 C.B. (Part 2) 181, 188-189; H. Rept. 350, 67th Cong., 1st Sess. (1921), 1939-1 C.B. (Part 2) 168, 175-176. As the First Circuit observed in Portland Oil Co. v. Commissioner, 109 F.2d 479, 488 (1st Cir. 1940), affg. 38 B.T.A. 757 (1938), Congress determined that it would be inappropriate to recognize gain or loss "where in a popular and economic sense there has been a mere change in the form of ownership and the taxpayer has not really 'cashed in' on the theoretical gain, or closed out a losing venture."

By creating an exception to the general rule that an exchange of property is a taxable event, section 351 in effect repealed the "incorporation tax," the burden on business readjustments which Congress sought to eliminate by the enactment of that section. Neither section 482 nor section 1.482-1(d)(5), Income Tax Regs., reinstates that tax because those sections do not apply to the nonrecognition transaction itself. Rather, they apply to the subsequent, taxable disposition of property previously acquired in the nonrecognition transaction. They do not interfere with business readjustments and thus do not violate the policy inherent in section 351. The Third Circuit reached basically this same conclusion in National Securities Corp. v. Commissioner, supra. In distinguishing the function of sections 351 and 362 from that of section 482, it stated as follows:

We think, however, that the petitioner misconceives the distinct functions of these provisions of the statute. Sections 112 [of the Revenue Act of 1936, subsec. (b)(5) of which was the predecessor of sec. 351] and 113 [subsec. (a)(8) of which was the predecessor of sec. 362] were intended to regulate the time when certain gains or losses are to be recognized for tax purposes and the cost bases to be used in determining the amounts of such gains or losses. It is true that they likewiselay down a general rule to determine which taxpayer shall take such gains or losses into account. These sections were followed in the present case by the Commissioner when he determined that no loss should be recognized upon the transfer of the Standard shares by the parent to the taxpayer and that the loss sustained by the taxpayer upon the later sale of these shares should be measured by their original cost to the parent.

Section [482] on the other hand is addressed to the wholly different

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problem of providing a more appropriate manner of allocating income and deductions when the application of the general rules of the statute will not clearly reflect the true income. [137 F.2d at 602.]

In view of the foregoing, we sustain the validity of section 1.482-1(d)(5), Income Tax Regs.

3. Section 1.482-1(d)(5), Income Tax Regs., and the Avoidance of Taxes

Having sustained the validity of section 1.482-1(d)(5), Income Tax Regs., we must now determine under what circumstances the Commissioner may reallocate income derived from a taxable disposition of property previously acquired in a nonrecognition transaction. Petitioners contend that section 482 does not authorize the Commissioner to reallocate income between commonly controlled enterprises "merely because the taxpayers' employment of nonrecognition provisions has given rise to avoidance or minimization of income tax." We disagree. Rather, we think nonrecognition provisions such as sections 351 and 362 do not bar the reallocation of income under section 482 and section 1.482-1(d)(5), Income Tax Regs., if such reallocation is necessary to prevent the avoidance of taxes.

We start with the statute. Under section 482, the Commissioner is not authorized to reallocate income unless such action "is necessary in order to prevent evasion of taxes or clearly to reflect the income" of commonly controlled taxpayers. (Emphasis added.) The statute thus contemplates alternative and independent bases for its application. Central Cuba Sugar Co. v. Commissioner, 198 F.2d at 215; Eli Lilly & Co. v. United States, 178 Ct. Cl. 666, 372 F.2d 990, 998-999 (1967); B. Bittker & J. Eustice, supra at par. 15.06, pp. 15-24. By its terms, section 1.482-1(d)(5), Income Tax Regs., only applies "when necessary to prevent the avoidance of taxes or to clearly reflect income." (Emphasis added.) Like the statute, it similarly contemplates alternative and independent bases for its application. In view of our findings of fact (see III. and V., supra), we shall address only the first ground, i.e., "to prevent the avoidance of taxes."

At first blush, the use of the term "avoidance" by the regulation may appear to be inconsistent with the use of the term "evasion" by the statute. Indeed, petitioners contend that there is a critical distinction between the terms, a proposition

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with which we cannot quarrel if criminally punishable conduct is one's focus. See sec. 7201. However, for purposes of section 482, a nonpunitive section, the terms are interchangeable. Petitioners' contention to the contrary was rejected nearly 50 years ago:

It is argued that "avoidance" connotes escape from taxation by avoidance of the receipt of income, while "evasion" connotes an effort to escape taxation by one who has received taxable income, and is conduct criminally punishable * * *. By selling to Bataafsche at cost what it might have sold to Shell Union at a profit, Asiatic avoided the receipt of income; hence, it is urged, it did not evade any tax, and section 45 is inapplicable on the basis of tax evasion. We cannot accept so narrow a construction. * * * The phrase "evasion of taxes" is broad enough to include the avoidance of the realization for taxation of such a profit * * *. That such was the meaning ascribed to it during the progress of the bill through Congress is evident from the committee reports which explain that evasion may be attempted "by the shifting of profits, the making of fictitious sales, and other methods frequently adopted for the purpose of 'milking'." [ Asiatic Petroleum Co. v. Commissioner, 79 F.2d 234, 236 (2d Cir. 1935).]

The synonymity of the terms for purposes of section 482 is reflected in section 1.482-1(c), Income Tax Regs.:

Transactions between one controlled taxpayer and another will be subjected to special scrutiny to ascertain whether the common control is being used to reduce, avoid, or escape taxes. In determining the true taxable income of a controlled taxpayer, the district director is not restricted * * * to the case of a fraudulent * * * transaction * * *

Finally, if any doubt remains, we note that synonymity is supported by both the text writers and the commentators. See B. Bittker & J. Eustice, supra at par. 15.06, pp. 15-24; Rothman, "Transfers to Controlled Corporations: Related Problems," 348 BNA Tax Mgmt. A-16/17 (1979); Miller, "The Application of IRC Section 482 to Transfers Under Section 351; The National Securities Risk," 1976 Ariz. St. L.J. 227, 232, 249-250; Adess, "The Role of Section 482 in Nonrecognition Transactions -- The Outer Edges of Its Application," 57 Taxes 946, 958, 966 (1979); Berger, Gilman & Stapleton, "Section 482 and the Nonrecognition Provisions: An Analysis of the Boundary Lines," 26 Tax Law. 523, 530-531 (1973).

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Petitioners rely heavily on Ruddick Corp. v. United States, 226 Ct. Cl. 426, 643 F.2d 747 (1981). ⁷² In that case the Court of Claims held, in its majority opinion, that absent the taint of tax avoidance, the Commissioner is not authorized to reallocate income on the ground of clear reflection of income in the face of a specific nonrecognition provision. In effect, the Court rejected that ground in the limited context of a nonrecognition transaction as an alternative and independent basis for the application of section 482; rather, it determined that any distortion arising from the sale or other disposition of property acquired in such a transaction is permissible: "Having contemplated and authorized that possible distortion, Congress is not to be frustrated by use within the Service of the general provisions of Section 482." 643 F.2d at 752.

Ruddick Corp. did not involve a section 351 exchange but rather the distribution as a dividend of highly appreciated stock in a third corporation by a profitable subsidiary to its parent who had a large net operating loss carryforward. This distribution was in effect a nonrecognition transaction as to both parties by virtue of sections 243 and 311; and under section 301, the subsidiary's basis in the stock was carried over to the parent. The Court decided the issue on the Government's motion for summary judgment, which it denied. In deciding the issue, it repeatedly cautioned that it was hypothesizing the absence of tax evasion or avoidance and the presence of a business reason (the parent's need to satisfy the net capital requirements of the SEC and the Midwest Stock Exchange) for the distribution. Because these facts were actually in dispute, the Court also denied the taxpayer's cross-motion for summary judgment and remanded the case to the Trial Division for a determination of the factual issues.

We need not express an opinion whether Ruddick Corp. was correctly decided. In our view, it is inapposite because the taint of tax avoidance is not absent in the case before us.

Based on all of the above, we hold that in order to prevent the avoidance of taxes, section 482 and section 1.482-1(d)(5), Income Tax Regs., may be applied to a taxable disposition of property previously acquired in a nonrecognition transaction.

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D. NEIGHBORHOOD ONE REALLOCATION

Having concluded that section 482 may be applied to a taxable disposition of property acquired in a nonrecognition transaction in order to prevent the evasion or avoidance of taxes, we must now decide whether the reallocation of income from the sale of lots in Neighborhood One was unreasonable, arbitrary, or capricious. See Rooney v. United States, 305 F.2d 681, 686 (9th Cir. 1962); National Securities Corp. v. Commissioner, 137 F.2d 600, 602 (3d Cir. 1943), affg. 46 B.T.A. 562 (1942). Our determination whether the Commissioner abused his discretion turns on questions of fact. Ballentine Motor Co. v. Commissioner, 321 F.2d 796, 800 (4th Cir. 1963), affg. 39 T.C. 348 (1962).

As will be recalled, the present issue arises because of the transfer by the Foster partnership of undivided 25-percent interests in 127 acres of land in Neighborhood One to each of the four Alphabet Corporations as tenants in common. This transfer occurred on October 3, 1962. The sale of lots in Neighborhood One began in June 1963 and continued for the next several years. Income derived from the 127 acres was reported by the Alphabets. Respondent, however, allocated all of the sales income to the partnership under section 482 on the theory that it was the partnership which earned it. In this regard, he contends that the partnership, acting largely through the Estero Municipal Improvement District (Estero), was solely responsible for the development of Neighborhood One and that the Alphabets were merely "corporate shells" which did nothing to improve the acreage or to sell it. He also contends that the October 1962 transfer was designed to avoid Federal income taxes. Petitioners, on the other hand, contend that respondent's section 482 allocation is erroneous in its entirety. Although they readily acknowledge the important role played by Estero in the development of Foster City, they emphasize its legitimacy and its status as a separate legal entity and maintain that it acted independently of the Fosters. They also maintain that the Alphabets had substance and actively participated in the development process. Finally, they maintain that the transfer of the 127 acres of land in Neighborhood One was business motivated rather than tax motivated. Based on our review of the record and for the reasons which

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we will discuss, we think there is substantial support for respondent's position. Accordingly, we cannot say that his section 482 allocation is unreasonable, arbitrary, or capricious.

By October 3, 1962, the date on which the Foster partnership conveyed the 127 acres of land to the Alphabet Corporations, Neighborhood One had been substantially reclaimed, i.e., filled and compacted, but not completely developed. ⁷³ A part of the income derived from the sale of lots in that neighborhood can therefore be viewed as having been earned prior to that date. That the transfer of the 127 acres shifted that part of the income from one commonly controlled enterprise to another is apparent from the fact that the partnership had been orchestrating the development of Foster City from the inception of the project, whereas the Alphabets did not even exist until the time of the transfer. ⁷⁴

Petitioners argue that Congress has given its blessing to such income shifting when it occurs in the context of an exchange to which section 351 is applicable. We have already addressed that argument at quite some length (see C., supra) and have concluded that section 482 may be applied to a taxable disposition of property previously acquired in a nonrecognition transaction (such as a section 351 exchange) in order to prevent the avoidance of taxes. Accordingly, there is no reason to consider petitioners' argument any further; however, we will address the question of tax avoidance at a later time.

Because Neighborhood One was not completely developed on October 3, 1962, a part of the income derived from the sale of lots in that neighborhood can be viewed as having been earned subsequent to that date. The question we must decide is whether the Foster partnership or the Alphabet Corporations

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earned that part of the income. The answer to this question depends primarily on one's view of Estero. In this regard, respondent maintains that Estero was the partnership's handmaiden; petitioners, by contrast, maintain that the district was an independent third party. If we accept respondent's premise, then the value added by Estero after October 1962 to the 127 acres of land which was subsequently realized upon the sale of lots is allocable to the partnership as the true earner of the income. See sec. 1.482-1(d)(1), Income Tax Regs. ⁷⁵ On the other hand, if we accept petitioners' premise, then the value added by Estero after that date was properly reported by the Alphabets as the record owners of the benefited acreage. In our opinion, Estero was controlled and dominated by the Foster partnership which used the district as its instrument for the development of Foster City. Accordingly, Estero's efforts must be viewed as the work of the partnership.

We begin with the fact that it was the Foster partnership which was responsible for the creation of Estero. In this regard, it will be recalled that in late 1959 or early 1960, the partnership retained a San Mateo law firm specializing in municipal finance to draft proposed legislation to create a municipal improvement district. The partnership also retained a firm of civil engineers and land planners to assist in the drafting of that legislation by specifying the powers that such a district would need in order to successfully undertake the contemplated development. The Estero Municipal Improvement District Bill was subsequently introduced into the California legislature by the local State senator (who was also the Fosters' personal attorney) and State assemblyman. The bill was endorsed by San Mateo County in March 1960; thereafter it was passed by the legislature and approved by the Governor in May 1960. The record gives no reason to question that the Fosters lobbied actively for the bill throughout the legislative process.

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The Foster partnership secured enabling legislation for Estero because it needed a vehicle to finance the development of Brewer's Island. Jack Foster originally estimated that the project would require 55,500,000 and would take many years to complete. Given the partnership's limited resources, outside financing on a long-term basis was a necessity. The Fosters flatly rejected the possibility of obtaining equity capital because they did not want to surrender any control over the project or share any of the anticipated profits. Although they had a long-established and cordial relationship with the Republic National Bank, a major lending institution, the amount needed was in excess of that bank's legal lending limit. It was determined, however, that the improvements to Brewer's Island could be financed through municipal bonds issued by a municipal improvement district. Because such bonds are tax exempt, they offered the added advantage of a lower rate of interest to be paid by the landowner.

The critical importance of Estero as the partnership's financing vehicle is readily apparent from the testimony of Jack Foster, Jr., at his deposition in 1971:

Q. Now, was this particular event -- the passage of this bill [i.e., the Estero bill] into law -- was that a condition before the family would go ahead with Foster City?

A. Well, it was not a formal condition written into the option [to purchase Brewer's Island], or anything like that; but I think that, had the bill not passed, then we would have been -- we would have faced the decision to proceed or to stop and lose our 200,000 option money. I think we would probably have forfeited the option money.

Q. I take it, to finance a project such as Foster City was contemplated to be was a tremendous outlay of money; isn't that right? A. It's even a lot of money to finance a small project. Q. I appreciate that. A. But tremendous there, yes.

Q. And it's of such magnitude that, without some kind of a municipal district such as Estero, it would probably not be practical and you would have abandoned it? Is that what you're saying? A. I think that's probably true.

Estero's importance to the partnership is also apparent from the testimony of Jack Foster at his deposition in 1962:

Q. Did you feel that the creation of the Estero Municipal Improvement District was a benefit to your project for developing Brewer Island into Foster City? A. I definitely felt that it was a benefit.

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Q. Can you tell me in what way you felt it would benefit the land and the project? A. Well, to assist in the financing was the principal -- Q. The main reason? A. Yes. Q. How would the district assist in the financing of the project?

A. It enabled us to sell general obligation tax-exempt bonds, tax exempt both federal and state.

So that it could serve as a financing vehicle, the Estero Act specifically authorized the district to issue both general obligation and revenue bonds, as well as other types of securities. ⁷⁶

The Fosters regarded Estero as more than the partnership's financing vehicle, however. They also regarded it as the vehicle by which the partnership would transform a 2,600-acre undeveloped and uninhabited tract of land into a completely planned and self-contained city of 35,000 people. This is why the partnership retained a firm of civil engineers and land planners to assist its attorneys in drafting legislation for a municipal improvement district. It was imperative that such a district possess all the powers needed to successfully accomplish the contemplated transformation. Accordingly, the Estero Act vested the district with a broad spectrum of general governmental powers, specifically including the power to reclaim and improve land, to enter into contracts, to employ all needed personnel, and to make and enforce such regulations as were necessary and proper to the exercise of its various powers. ⁷⁷

The role to be played by Estero in the development of Brewer's Island was too important to the ultimate success of the project for the Foster partnership not to control the district. After all, it was the partnership which was the prospective owner of Brewer's Island and which stood to benefit if the project were a financial success. Accordingly, Estero was designed to be subservient. This was accomplished by restricting the right to vote only to landowners. ⁷⁸ Each

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landowner was entitled to one vote for each dollar in assessed valuation of land owned by him. The landowners exercised control by electing the three members of the board of directors, the governing body of the district. ⁷⁹ They also exercised control by authorizing the issuance of bonds needed to finance the contemplated development. The Foster partnership, of course, was originally the only landowner; during the years in issue it was the principal landowner.

The partnership's control over Estero is reflected in the composition of the district's board of directors. Richard Grant was the individual who first interested the Fosters in developing Brewer's Island and whom they arranged to retain at a substantial fee for his help and assistance if the project were undertaken. When Grant resigned in 1961 he was replaced by C.W. Olmo, who served as director through the years in issue. Although he came to be the public member of Estero's board, ⁸⁰ he was sufficiently close to the Fosters that they retained him as one of their subcontractors when they built a major commercial building in Foster City in 1965. William Innes, one of the original directors who served through the years in issue, was a trusted executive within the Foster organization and on their payroll. George Shannon, the other original director who served through the years in issue, was affirmatively sought out by the Fosters to be on the board. Petitioners' assertion that Shannon was independent is belied by the fact that he regularly attended the Fosters' weekly planning sessions and was on the payroll of Likins-Foster Honolulu Corp. during Estero's formative period. ⁸¹

The partnership's control over Estero is also evidenced by the fact that Innes and Shannon, the directors whom the Fosters elected, were appointed by the board to important

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offices. Innes was appointed Estero's finance officer and assistant secretary. Shannon was appointed district secretary, tax assessor, and tax collector. In 1962, he was appointed general manager, a position which consolidated his other offices and made him the chief executive officer and head of the administrative branch of the district government. If Shannon was independent of the Fosters, as petitioners allege, we wonder why he was terminated as general manager immediately after the residents of Foster City gained control of the board in 1969 and why he was reemployed by the Fosters shortly thereafter.

Other facts also point to the partnership's control over Estero. For example, the district reimbursed the partnership for expenses related to the Foster City project which it incurred both before and after the district was established. Also, the major engineering obstacle facing the project involved the dredging and landfill operation. Estero originally entered into a multimillion dollar contract with a Foster-controlled corporation to perform this task. The contract was later canceled only after the State attorney general questioned the arrangement as a possible conflict of interest.

Another fact relevant to the issue of control deserves to be mentioned. The district capitalized interest on its bonds in a manner designed to shift much of the tax burden from the Fosters to the future residents of Foster City. (See pp. 64-66, supra.) When the homeowners sought to discuss their concerns about such bond practices with Estero's board of directors, the board referred them to the Fosters. Later, after the Estero Act was amended to democratize election to the board, the district's objectionable bond practices were stopped. Other fundamental changes related to finance and development were also instituted. These changes reflected community pressure to make the district responsive to the needs of the residents rather than the desires of the Fosters. (See pp. 62 and 66 to 67, supra.)

That the Estero Act gave total control of the district to the landowners has been recognized by the California Supreme Court on at least two occasions. In Cooper v. Leslie Salt Co., 70 Cal. 2d 627, 451 P.2d 406, 75 Cal. Rptr. 766 (1969), that court described the act as follows:

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The statute includes elaborate financial provisions, including authorization for the directors to issue general obligation bonds * * * and other types of securities to raise money for development of the raw land included within the district so that the owners thereof, who absolutely control the operations of the district, can cause the various improvements to be made which are necessary to make the land fit for marketing as a residential tract. [451 P.2d at 409; emphasis added; fn. ref. omitted.]

Even the dissent agreed with this assessment, stating that "the effective political and economic power rests not with the residents of the district, but with a regency." 451 P.2d at 413.

In Burrey v. Embarcadero Municipal Improvement Dist., 5 Cal. 3d 671, 488 P.2d 395, 97 Cal. Rptr. 203 (1971), the California Supreme Court had before it a question involving the statute establishing Estero's sister district. The court stated that both districts "were established by virtually identical statutes at the instance of land developers to enable them, through the use of the districts' bonding power, to raise the necessary risk capital to develop the properties as subdivisions." 488 P.2d at 396. The Court also described the voting system of the Embarcadero District, a description which applies equally to Estero in view of the "virtually identical" statutes involved:

In order to promote the development of the land, the Legislature created a system for selecting the governing board of the district which vests long-term and virtually total control of the district in the hands of the developing landowner. [488 P.2d at 397.]

The California legislature has also expressly recognized that the Estero Act gave control of the district to the landowners. In a report prepared in 1962, the Assembly Committee on Municipal and County Government described the use of a quasi-municipal type of district as a financing vehicle for the land developer.

It provides a source of public financing for streets, utilities, and other improvements, which are essential to the success of the subdivision. It does so, moreover, without tying up the developer's own capital or credit.

Speaking specifically of Estero and Embarcadero, the committee stated that "By design, the districts were planned to coordinate closely with the activities of the land developers and to be responsive to their wishes." It specifically found that "The organizational requirements of these districts placed each of them under the direct control of the developers."

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In an article written in 1965, ⁸² Thomas Willoughby, consultant to the Committee on Municipal and County Government of the California Assembly and principal draftsman of the committee report referred to in the preceding paragraph, described the use of special districts as financing vehicles for land developers:

The continuing quest of all land speculators has been the search for new sources of capital to finance their ventures. The California speculator has recently discovered that he can employ special districts and other public agencies to provide him with a significant credit subsidy. With boundary lines artfully drawn to include only the promoter's land, a special district becomes a tightly controlled operating division of the promoter's organization -- an operating division which can use its bonding powers to raise risk capital independent of the subscriber's own credit resources or capital reserve. * * * *

The current trend to subsidize development with publicly raised funds began in 1960 with the introduction of special legislation to subsidize two specific development projects. Having obtained an option to purchase 2600 acres of San Francisco Bay tidelands, one large developer [Jack Foster] had a northern California bond counsel draft special legislation to establish the Estero Municipal Improvement District. Supported actively in the Legislature by the same bond counsel, the measure passed without difficulty. The resulting district was contiguous with the developer's land holdings, was controlled by him and was authorized to issue general obligation, revenue and special assessment bonds at his discretion. * * * [38 So. Cal. L. Rev. at 72, 73; emphasis added; fn. refs. omitted.]

Petitioners maintain that the legitimacy of Estero was upheld by the California Supreme Court in Cooper v. Leslie Salt Co., supra. See also Cooper v. Estero Municipal Improvement District, 70 Cal. 2d 645, 451 P.2d 417, 75 Cal. Rptr. 777 (1969). They also maintain that after scrutiny, Estero's conduct, unlike Embarcadero's, was not censured by either the State attorney general or the Assembly Committee on Municipal and County Government. From this they conclude that "there does not appear to us to be anything for this Court to consider." We agree that Estero's legitimacy is not an issue in this case.

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Nor is the question whether the Foster partnership abused its control of Estero one for us to decide. However, we disagree with petitioners' conclusion that there is therefore nothing for us to consider. It is the question of the partnership's control over Estero which is relevant to our inquiry whether income derived from the sale of lots in Neighborhood One should be reallocated. Not only has the fact of such control been established, but the wide recognition of this fact within the California legal community has also been demonstrated.

Petitioners cite Birch Ranch & Oil Co. v. Commissioner, 13 T.C. 930 (1949), affd. 192 F.2d 924 (9th Cir. 1951), for the proposition that reclamation and improvement districts are legal entities separate and distinct from their bondholders and landowners. In that case, the taxpayer owned substantially all of the land in a California reclamation district. It also owned (along with certain related parties) substantially all of the district's bonds. In order to pay interest on the bonds, the district made assessment calls which the taxpayer paid and subsequently deducted as "taxes." The Commissioner disallowed the deduction on the basis (inter alia) that the payor and payee of the bonds were economically identical. In a Court-reviewed opinion we upheld the deduction and on appeal were affirmed.

We find Birch Ranch & Oil Co. inapposite to the issue before us. Our conclusion that the partnership controlled Estero does not conflict with the district's status as a juristic entity. As we have already observed, the California Supreme Court sustained the legitimacy of Estero while at the same time recognizing that its operations were absolutely controlled by the landowners. Cooper v. Leslie Salt Co., supra. There is no question that Estero added value to Brewer's Island. However, it never realized that value because it did not own the land or receive the proceeds from its sale. All we are deciding here is whether the value added by Estero is allocable to the Foster partnership because of the legislatively conferred control that the partnership exercised over the district. To answer that question in the affirmative does not require that we ignore Estero's legal identity as a public agency.

Before we move on we might note that petitioners do not contend that the Alphabet Corporations (rather than the Foster partnership) controlled Estero or used the district as

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their instrument for the development of the 127 acres of land in Neighborhood One. The record, however, would not permit petitioners to make such a contention. After all, such a contention would ignore the fact that it was the partnership which solved the formidable engineering and financial problems which would otherwise have precluded the Foster City project from even being undertaken. It would ignore the fact that it was the partnership which actually purchased Brewer's Island and commenced to develop it. It would ignore the fact that development of Neighborhood One was well under way before the Alphabets were even incorporated. It would ignore the fact that many of the specific improvements that were completed after their incorporation were begun before that event. ⁸³ And, as we shall see, it would ignore the passive role played by the Alphabets in the development of Neighborhood One.

We began this discussion by focusing on that part of the income derived from the sale of lots in Neighborhood One which can be viewed as having been earned subsequent to October 3, 1962, the date on which the Foster partnership transferred the 127 acres of land to the Alphabet Corporations. We asked whether the partnership or the Alphabets earned that part of the income and stated that the answer depended primarily on one's view of Estero. We have determined that the partnership controlled Estero and used the district as its instrument for the development of Foster City and that Estero's efforts must therefore be viewed as the work of the partnership. However, our inquiry is not complete until we consider the roles played by the partnership and the Alphabets independent of Estero in the development of Neighborhood One.

The role played by the Foster partnership in the development of Neighborhood One has already been described in detail (see pp. 74-77, supra) and need not be repeated here. Suffice it to say that its role was an active one. The role played by the Alphabets stands in sharp contrast. Most, if not all, of what they did was occasioned merely because they were the record owners of the 127 acres of land. It is of no consequence,

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therefore, that they executed deeds to builders and easements to Estero. The contracts entered into by the Alphabets appear to have been executed for this same reason. Moreover, the Alphabets did not act independently of the Foster partnership but rather in concert with it. Thus, for example, they were joined by the partnership as a contracting party whenever they entered into agreements with third parties. And although the Alphabets collected 2,023,900 from the sale of lots in Neighborhood One from July 1963 through December 1965, during that same period, they transferred 2,052,500 in stated loans to the partnership for its use in the further development of Foster City.

We disagree with respondent that the Alphabets were merely "corporate shells." After all, they leased waterfront lots to builders and undertook to construct an apartment complex in 1965. These activities, however, do not serve to define the Alphabets' involvement in the development of the 127 acres of land in Neighborhood One. It is only the income derived from the sale of lots in that parcel which is the subject of the section 482 allocation. We must therefore agree with respondent that the Alphabets did not earn any part of that income. The record in this case simply does not permit us to make a partial allocation. Furthermore, petitioners have never even contended in the alternative that such an allocation would be appropriate here. See Marc's Big Boy-Prospect, Inc. v. Commissioner, 52 T.C. 1073, 1105-1106 (1969), affd. sub nom. Wisconsin Big Boy Corp. v. Commissioner, 452 F.2d 137 (7th Cir. 1971).

At this point, we can readily dispose of petitioners' remaining contentions. First, they argue that respondent's section 482 allocation denies them the right to do business in corporate form. That section, however, does no such thing. Rather, it merely serves to tax income to the true earner, thereby preventing related enterprises from shifting income by legal or accounting legerdemain. Second, petitioners argue that the section 482 allocation serves to tax the Fosters, rather than the Alphabets, on the appreciation which occurred after the transfer of the 127 acres to those corporations. They fail to recognize, however, that Neighborhood One appreciated in value because of the efforts made by the partnership, rather than the Alphabets, in developing it. Finally, petitioners argue

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that the Fosters acted not as partners but as employees of two corporations, Lomita Homes, Inc., and T. Jack Foster & Sons, Inc., both of which were subsidiaries of Likins-Foster Honolulu Corp. ⁸⁴ Those corporations, however, merely performed the check-writing and bookkeeping functions for the Foster City project and did not earn any of the income derived from the sale of lots in Neighborhood One.

We turn now to the question of whether the transfer of the 127 acres of land in Neighborhood One was tax motivated. We must decide that question because income may only be allocated under section 482 if such allocation is necessary to prevent the avoidance of taxes or clearly reflect the income of commonly controlled or commonly owned enterprises. We have previously stated that these are alternative bases for the application of the section. We have also previously concluded that section 482 may be applied to a taxable disposition of property previously acquired in a nonrecognition transaction in order to prevent the avoidance of taxes. Accordingly, we will focus exclusively on the question of tax avoidance. For the reasons which we will discuss, we think the 127 acres of land were conveyed in order to avoid Federal income taxes.

Petitioners begin by arguing that the transfer of the land could not have been motivated by a desire to avoid taxes because on the basis of the "tax facts" then known, the transfer was bound to increase taxes. In this regard, they maintain that the income derived from the sale of lots was reported by the Alphabets and not offset by any losses, ⁸⁵ whereas if that income had been reported by the partnership, it would have been offset by the operating losses which the partnership claimed on its returns. We find this argument to be without merit. Petitioners conveniently overlook the aggregate theory of partnerships which predominates when it comes

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to the taxation of partnership income to the partners, see 1 W. McKee, W. Nelson & R. Whitmire, Federal Taxation of Partnerships and Partners, par. 1.02 (1977), and the implications of the rate differential which exists between individuals and corporations, see B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders, pars. 1.01-1.03 (4th ed. 1979). In other words, the tax savings to an individual realized by preserving a partnership loss may very well exceed the tax cost to his corporation incurred by reporting the income.

Next, petitioners argue that the Alphabets were incorporated and the land conveyed "because the Fosters had always, up to that time, used the corporate form for operating businesses." That statement, however, is not entirely accurate. During the Likins-Foster era, Jack Foster and V. B. Likins did business in both corporate and partnership form. When they terminated their business relationship in 1955, Foster entered into a partnership agreement with his sons. The purpose of the partnership, as defined by its agreement, was to actively transact business:

the purpose of this partnership shall be to own and to acquire land or interests in land, construct houses or other buildings; to rent or sell such real property or leasehold estates either in an improved or unimproved condition; to own stocks, bonds, debentures, or other evidences of indebtedness in any corporation; to buy, own, develop and operate oil and gas leasehold estates, or mineral rights or royalties; and to generally engage in the business of buying or owning property, real, personal or mixed; to act as contractors or principals or agents in any business transaction; to borrow or to lend money with or without security; to act as guarantors on the contracts of others; and generally to engage in any business which the partners may agree upon among themselves.

Moreover, the Fosters amended their partnership agreement in January 1959 to provide for their equal participation in the profits and losses resulting from the operation of the partnership and to authorize the payment of salaries to all of the partners rather than to just Jack Foster. The amendments were made shortly after the graduation from college and entry into the family business of Bob Foster, the youngest son, and at a time when the partnership was actively assessing the feasibility of developing Brewer's Island. In our opinion, the amendments evidence an intention to proceed as a partnership if the project were undertaken. The most potent fact, however, is that it was the partnership

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which actually committed itself to the Foster City project by solving the major engineering problem related to the reclamation of the land, by solving the major financial problem related to obtaining both long-term and short-term debt capital, by exercising the option to purchase Brewer's Island in August 1960, and thereafter by working day in and day out to effect the transformation of the land. It was not until September or October 1962, that the Alphabets were even incorporated. By that time, the partnership had succeeded in substantially reclaiming Neighborhood One.

When the Alphabets appeared on the scene, the partnership did not bow out but rather continued to act as the developer not only of Neighborhood One but also of the other neighborhoods. Petitioners describe the Foster City project as a "single unitary business." It is clear that that business was at all times conducted under the aegis, direction, and control of the partnership. Moreover, its role was no closely guarded secret. After all, the partnership held itself out and was regarded as the developer of Foster City.

We find it particularly significant that Jack Foster, Jr., the general manager of the Foster City project, was unable to say whether any business purpose was served by the incorporation of the Alphabets and the transfer of the 127 acres of land. At his deposition in 1971, he testified as follows:

Q. * * * Let me ask you the direct question: Was there any business purpose in setting up the four alphabet corporations, first, other than for purposes of tax planning? A. Well, I don't recall.

And again:

Q. Do you know of any business purpose for the setting up of the Alphabets, or was this strictly again a tax matter set up by Mr. Champlin?

A. I don't know what the business purpose was, because Mr. Champlin set it up. But I hope Mr. Champlin had some business purpose other than tax savings.

And once again:

Q. As you sit there now, do you recall any business purpose for setting up the Alphabets other than for tax reasons? A. I don't recall what it was. The basic organizational structure within which the Fosters

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undertook to develop Brewer's Island was dictated by the recommendations of Del Champlin. Jack Foster, Jr., described Champlin as "the steward of our taxes." He also testified that "Mr. Champlin was in charge of our income tax, and just whatever he said went, really. I don't recall that it was ever questioned."

Champlin determined that it would be advantageous from a tax standpoint for the Fosters to begin in partnership form. Losses incurred during the early years could be utilized by the partners to reduce income on their individual returns; later, as land was developed, acreage could be transferred to corporations in an effort to shift income and split it among taxpayers subject to a lower rate of tax. At his deposition, Foster acknowledged Champlin's grand plan:

Q. * * * Now, do I understand from what you said that Mr. Champlin said, "We'll start out with this partnership form of entity; and as time goes along, I'll set up corporations or whatever entity I think is needed and put the income into that entity at the right time," or words to that effect? Is that what he said he was going to do? A. Yes, this is the way he intended to operate it.

Jack Foster, Jr., admitted that Champlin's plan concerned him because it exposed the Fosters to personal liability through use of the partnership. He did not question the plan, however. His failure to do so is most telling:

Q. Do you recall ever being concerned about personal liability because of the use of that form of ownership? A. Yes.

Q. And when was it that you had these concerns, if there was more than one occasion? A. Oh, I think I had these concerns for quite some time. Q. Dating back how far? A. Maybe even back to the outset.

Q. But, again, to repeat, you never specifically brought it up to Mr. Champlin? A. I don't recall. My impression was -- if I could elaborate on this -- Q. Sure.

A. -- because it's coming out sounding rather foolish to be concerned about it without asking questions. I was concerned -- I don't recall that I asked questions. The impression that I was given was that the tax planning was so advantageous and so outstanding that that was just the chance we took in order to get this great tax saving.

Q. Now, this great tax advantage: this was Mr. Champlin speaking, I take it? A. It was his -- yes; right.

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Q. He said there was such a great tax advantage that it overrode all other considerations? Is that what you're saying? A. Yes.

The tax motivation for the incorporation of the Alphabets and the transfer of the 127 acres of land is further evidenced in the testimony of Jack Foster, Jr., describing the Fosters' disinterest in the particulars of those events, a disinterest which we find to be absolutely antithetical to business motivation:

Q. * * * Well, before the [Alphabet] corporations were set up, was there any discussion amongst the family and/or Mr. Champlin that this was going to be done? A. I think he told us about it. Q. Well, what did he say?

A. Well, he said that we needed these corporations to put these particular lands in. I don't recall that he gave the reasons. Q. Well, did anyone ask him why?

A. Well, no, because we trusted him implicitly. If he said to do it, we did it. He didn't have to tell us because we knew that it was done for the purpose of conserving on income taxes.

Q. Okay. Well, I take it he said, "As time goes on, we're going to form different entities," and you assumed, now, he was forming the entities he talked about? Is that what you're saying? A. Well, yes, okay.

Q. And it was all part of -- as far as you were concerned -- tax planning; is that right? A. Yes. * * * *

Q. As to the selection of what properties were put into these corporations, who participated in that? A. Mr. Champlin. Q. All by himself; is that right? A. Yes; right.

Q. Okay. He said, let's transfer in this block and that block, and everyone said, okay; is that right? A. Right. Q. Without any discussion? If there was, tell me. I wasn't there.

A. No. I'm sorry, -- I don't -- You know, as was our practice, he would make these decisions and we followed them. We did it.

The Fosters' slavish deference to their tax adviser is again evidenced in the testimony of Jack Foster, Jr.:

Q. Now, when Mr. Champlin said, let's set up these corporations and transfer some property into it, how much time elapsed from the time he made that suggestion until that was carried out, if you recall? A. Oh, usually when he came forth with these decisions, he had the

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timetable right with him. If he wanted it right then and there, it was done right then and there.

It was no accident that land in Neighborhood One was transferred to the Alphabets rather than land in some other neighborhood. Neighborhood One was the first neighborhood to be developed. The Fosters originally anticipated that it would begin to produce income in 1962. However, sales were delayed, primarily because the filling operation took longer than had been anticipated. Negotiations for the sale of lots in Neighborhood One did begin in 1962, and by November 1962, the Fosters were projecting income for the following January. Del Champlin was aware of these facts when he arranged for the incorporation of the Alphabets and the transfer of the 127 acres of land on October 3, 1962.

The Fosters' preoccupation with income taxes was attributable to a combination of two factors. First, the partnership needed to retain as much cash as possible for the development of Foster City. Second, the value of money on hand to the Fosters far exceeded any interest that might eventually have to be paid on a tax deficiency, particularly when the rate of interest charged by the Government was less than that charged by commercial banks. Champlin was therefore expected to minimize taxes to the extent possible and to postpone the payment of those taxes which could not be avoided. A particular tax strategy was not necessarily rejected merely because it might result in litigation or even ultimately fail. The more important criterion was the extent to which that strategy would promote the immediate availability of cash for the partnership's use. As Champlin testified at his deposition in 1969:

Mr. Foster's viewpoint was that the value of the money on hand far exceeded any interest that might be involved, and besides the interest could be deducted for income tax purposes anyway. * * * *

Mr. Foster felt that the availability of the cash was of very great financial benefit to him. Even if the method that was used would ultimately fail, he could make far more than any 6 percent interest by having the money.

In view of the foregoing, we are convinced that the 127 acres of land in Neighborhood One were conveyed to the Alphabet Corporations in order to avoid Federal income taxes. We therefore sustain respondent's section 482 allocation.

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E. NEIGHBORHOOD FOUR REALLOCATION

We turn now to the question whether the reallocation of income from the sale of lots in Neighborhood Four was unreasonable, arbitrary, or capricious. See Rooney v. United States, 305 F.2d 681, 686 (9th Cir. 1962); National Securities Corp. v. Commissioner, 137 F.2d 600, 602 (3d Cir. 1943), affg. 46 B.T.A. 562 (1942). As before, our determination whether the Commissioner abused his discretion turns on questions of fact. Ballentine Motor Co. v. Commissioner, 321 F.2d 796, 800 (4th Cir. 1963), affg. 39 T.C. 348 (1962).

There is no question that the transfer by the Foster partnership of the 311 single-family residential lots in Neighborhood Four to Foster Enterprises shifted income from one commonly controlled entity to another. At the time of the transfer, the neighborhood had been virtually developed by the partnership. In this regard, it should be kept in mind that the lots were conveyed on August 29, 1966; in September, the land improvements were completed. By that time, the lots had been certified and were ready and available for the construction of houses. The fact that the first sale of lots did not occur until the following February was a direct consequence of the weak housing market that existed throughout northern California during most of 1966 and had nothing to do with the status of the land improvements at the time of the transfer. It should also be kept in mind that Foster Enterprises did not undertake to complete the negligible development left to be accomplished as of the date of the transfer; that task remained the responsibility of the partnership. There is nothing in the record to indicate that Foster Enterprises even attempted to market the lots; to the contrary, it apparently relied on the partnership to advertise and sell them. Moreover, the corporation had not previously played any role in the development of Neighborhood Four. It is clear, therefore, that the income from the sale of lots in that neighborhood was not earned by Foster Enterprises but rather was completely earned by the Foster partnership. See Philipp Bros. Chemicals, Inc. (N.Y.) v. Commissioner, 435 F.2d 53 (2d Cir. 1970), affg. Philipp Bros. Chemicals, Inc. (Md.) v. Commissioner, 52 T.C. 240 (1969), where the failure to actually earn the income in question was the basis for the reallocation under section 482. There is similarly no question that the transfer of the lots in

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Neighborhood Four distorted the incomes of the Foster partnership and Foster Enterprises. First, only highly appreciated inventory pregnant with income was conveyed. Second, Foster Enterprises had no business operations in Foster City and had not played any role in its development. Third, the partnership, and not Foster Enterprises, was solely responsible for the development of Neighborhood Four.

Petitioners seek to justify the transfer on the basis that the 311 residential lots were conveyed for a business reason. In this regard, they argue that Rex Johnson, a senior vice president of the Republic National Bank who at the time was in charge of monitoring the Fosters' account, insisted that the lots be conveyed in order to improve the balance sheet of Foster Enterprises. Although there is indeed testimony in the record to that effect, we have not found it to be convincing. Rather, we think the lots were conveyed in order to avoid taxes.

In order to understand Johnson's testimony, and appreciate our skepticism, we need to briefly describe the credit relationships that existed, particularly in August 1966, among and between various Foster-controlled entities and the Republic National Bank. We start with the fact that Foster Enterprises was not indebted to Republic at any time material to this issue. However, it had borrowed money from Likins-Foster Honolulu Corp. In addition, it had borrowed from Roy Turner Associates, Ltd. (Turner Associates), a subsidiary of Likins-Foster. Turner Associates was in turn indebted to Likins-Foster. Both Likins-Foster and the Foster partnership were indebted to Republic. The balance owed by Likins-Foster in mid-August 1966 was approximately 1,100,000. This amount was secured by an assignment of sales contracts and sublease ground rentals with respect to property unrelated to Foster City, and payment was personally guaranteed by the Fosters. The balance owed by the partnership in mid-August 1966 was also approximately 1,100,000, exclusive of the Westway notes. This amount was secured, inter alia, by the Fosters' pledge of their stock in Likins-Foster.

According to Johnson, he insisted on the transfer of the lots in Neighborhood Four in order to improve the liquidity of Foster Enterprises and thereby (1) enhance the collectibility of the indebtedness of Likins-Foster to Republic, (2) improve the

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bank's security in the Likins-Foster stock, and (3) insulate the bank from the fortunes of the Foster partnership.

With regard to the first objective, Johnson testified that Likins-Foster was slow in making payment and its prospects for the future were uncertain. However, in a special audit report prepared by the bank in August 1966 concerning (inter alia) Likins-Foster Honolulu Corp., the final paragraph concluded that "The performance of the collateral [the sales contracts and sublease ground rentals], in our opinion, is good and the loans are liquidating according to arrangements approved by the bank." In any event, if Johnson was concerned about the ability of Likins-Foster to repay its loan, it would have made more sense to transfer the lots in Neighborhood Four directly to that corporation rather than to an entity that was not even indebted to Republic. Moreover, Foster Enterprises was not under any obligation to dispose of the proceeds from the sale of the lots in a manner consistent with the bank's interest in its receivable from Likins-Foster. In fact, it was understood by the parties that the sales proceeds would be used by the Foster partnership to further develop Foster City rather than by Foster Enterprise to liquidate its debts to Likins-Foster and Turner Associates. Johnson's statement that the repayment of the sales proceeds by the partnership to Foster Enterprises "would be enforceable by Enterprises as a creditor in the event should there be a bankruptcy of the Foster family partnership" may very well be true. However, we fail to comprehend how a banker avowedly concerned about his debtor's ability to repay could be so sanguine about such a daisy chain of receivables ultimately based upon a claim in bankruptcy. All of this might be more understandable if Republic had required Foster Enterprises to maintain a trust account in order to protect the bank's interest in the proceeds from the sale of lots, but this was not the case.

In contrast to the first objective, the second and third objectives relate to the partnership's indebtedness to Republic. Johnson testified that he was concerned about the financial future of the partnership, particularly because of its cash flow problem. However, the transfer of the lots obviously weakened its ability to repay its loan and certainly exacerbated its cash flow problem. Presumably, therefore, the transfer was designed to enhance the bank's position by insulating assets from

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the partnership's general creditors by placing them in corporate solution.

In our view, Republic's security in the Likins-Foster stock was only indirectly and very marginally improved by the transfer of the lots to Foster Enterprises. The stock would have provided sounder security if the transfer had been made directly to Likins-Foster. After all, it was that corporation's stock, not that of Foster Enterprises, that had been pledged as security. However, if this were not feasible, ⁸⁶ Foster Enterprises could have provided security to Republic, but did not.

We also fail to see how the transfer helped to insulate Republic from the fortunes of the Foster partnership. In 1967, Foster Enterprises sold 200 lots in Neighborhood Four for 1,516,400. During that year, it transferred approximately 1,200,000 of that amount to the partnership, which used the funds to pay its (i.e., the partnership's) operating expenses, real property taxes, and other obligations related to its ongoing development of Foster City. Although Foster Enterprises still had an asset, it was now an unsecured receivable from the partnership. Collectibility was therefore dependent upon the partnership's overall success in developing and selling land in Foster City. But this was precisely the risk against which Johnson ostensibly wanted to protect. ⁸⁷

Johnson characterized Foster Enterprises as a "key corporation" insofar as intercorporate debt was concerned and professed concern about its inadequate finances. It is remarkable, therefore, that Foster Enterprises was not even mentioned in the previously mentioned special audit report involving Likins-Foster Honolulu Corp.

One should not infer from the foregoing that we think the credit relationship between the Fosters and the Republic National Bank was without any tension. To the contrary,

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there is no question that as the years passed the Foster partnership did develop a serious cash flow problem which caused Republic such increasing concern that in 1967 it demanded, and for the first time obtained, a secured interest in the land in Foster City owned by the partnership and the related Foster corporations. Nevertheless, and unlike petitioners, we do not think Johnson was a disinterested witness whose testimony must be accepted at face value. Republic officials, including Johnson, collaborated with the Fosters in structuring the Westway transaction for their mutual benefit. ⁸⁸ Quite frankly, we think it more probable than not that Johnson applauded the transfer of the lots in Neighborhood Four as a means of improving cash flow by reducing Federal income taxes.

In view of the foregoing, as well as the curious paucity of documents surrounding the Neighborhood Four transfer, we are inclined to regard Johnson's testimony as an exercise in postmortem tax planning.

Finally, we cannot ignore the testimony of Jack Foster, Jr., given at his deposition in 1971. Foster's testimony is particularly significant because it was given at a time relatively close to the event in question and under circumstances where the consequence of his response was not so obvious as to be an incentive to reply in a self-serving manner. Moreover, as general manager of the Foster City project, Foster was in a position to know the particulars surrounding the Neighborhood Four transfer. This was especially true after his father's health began to decline in the mid-1960's, and he increasingly assumed even greater responsibilities.

In no uncertain terms, Foster testified that he was unaware of any business reason for the transfer of the lots and that they were conveyed solely on the advice and recommendation of Del Champlin:

Q. Was this transfer made, Neighborhood 4 to Foster Enterprises, solely on the advice and recommendation of Mr. Champlin? A. Yes.

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Q. And no one questioned that recommendation? A. No. Q. Did anyone ask him why he was recommending that it be done? A. No.

Q. Did he say it was for the purpose of taking advantage of a tax loss in Foster Enterprises? A. Yes. Q. Was there any business purpose in this transfer at all? A. I don't know. Q. You don't know of any? Is that what you're saying? A. Well, no.

It is apparent that the Fosters understood that the purpose of the Neighborhood Four transfer was to utilize the operating losses of Foster Enterprises. They were conscious of those losses and very anxious that they be used to reduce ordinary income. In view of its history of unprofitable operations, there was little likelihood of ever utilizing the accumulated net operating losses of that corporation without shifting income from another entity to it. The reason for specifically transferring the lots in Neighborhood Four, as opposed to lots in any other neighborhood, is clearly evident from Foster's testimony:

Q. Did he [Champlin] give any reason why he was selecting Neighborhood 4 rather than any other area in Foster City to make this particular transfer? A. Well, he saw it as the next anticipated income. Q. And you agreed with that? A. Oh, yes.

Q. Was there any other Neighborhood ready for sale at that time, or would be ready within the next year?

A. I think we had 50 lots remaining in Neighborhood 3, but I don't believe we saw any other block of lots of the single family variety that might be sold within the immediate future. Q. By that you mean within the next year? A. Right.

That the Fosters acted on Champlin's recommendation, and not at Johnson's direction, is also apparent from Foster's testimony:

Q. Now assuming that Mr. Champlin had not recommended this transfer of this particular Neighborhood 4 into Foster Enterprises, what was the plan? That you would just sell Neighborhood 4 as land then owned by the partnership, I take it?

A. Well, I would presume that Mr. Champlin would -- if that was a decision that he would make, that's what we would do. That was our pattern all along.

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Q. Are you suggesting that when land was ready or getting ready to be sold, that Mr. Champlin made the determination as to which entity would sell it? Is that what you're saying?

A. No, I'm not saying that. I have tried to say all along that this was an ongoing relationship, and he was in our office every day. He knew the status of all the land, and at any time he deemed it appropriate, for whatever tax reason he had in mind, that's when we acted.

Maybe it was years before development that he would suggest that a piece of land might be transferred to a corporation. Maybe it was at the stage where it was in the process of development. I don't know. Whenever he said, "Do it," we did it.

Based on the foregoing, we hold that the lots in Neighborhood Four were transferred in order to avoid Federal income taxes and that respondent did not abuse his discretion under section 482 in reallocating the income derived from their sale to the Foster partnership. ⁸⁹

F. STATUS OF THE FOSTER PARTNERSHIP

In the alternative, petitioners contend that the Foster partnership was an "association" within the meaning of section 7701(a)(3) and section 301.7701-2, Proced. & Admin. Regs., and hence taxable as a corporation. ⁹⁰ They recognize, however, that --

once corporate status is found, * * * all the consequences of operating in corporate form will flow from this determination; that is, the full panoply of

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tax rules relating to the treatment of corporations and shareholders will govern the organization, operation, liquidation, and reorganization of the enterprise, and the taxability of distributions to its associates. [B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders, par. 2.01, at 2-3 (4th ed. 1979); emphasis in original.]

Accordingly, they also contend that during the years in issue, the partnership made no distributions which could be regarded as taxable dividends. Finally, they contend that under section 6501(a) the 3-year period within which a deficiency against the partnership (viewed as an association) could be assessed has expired. ⁹¹ Petitioners conclude that neither they nor their partnership (again viewed as an association) is liable for any deficiency based on the three major adjustments set forth in respondent's notice of deficiency.

In our view, the major premise of petitioners' argument is faulty. In other words, we do not think the Foster partnership was an association; rather, we think it was a partnership within the meaning of section 7701(a)(2) and section 301.7701-3, Proced. & Admin. Regs. See also section 761(a) and section 1.761-1(a), Income Tax Regs. Accordingly, we do not find it necessary to address petitioners' subsidiary contentions.

At the outset, we should emphasize that for purposes of State law, the Foster partnership was exactly what it purported to be, i.e., a general partnership. For example, the written agreement entered into by the Fosters in 1955 was denominated "Partnership Agreement" and provided in part as follows: This Partnership Agreement * * * Witnesseth,

That, Whereas, the parties hereto have agreed among themselves to form a partnership for the transaction of their business, Now Therefore,

In consideration of the following convenants and agreements, It Is Stipulated by and between the parties, as follows:

1. The parties hereto do hereby form a partnership to be known as T. Jack Foster & Sons, in which partnership all of the partners are general partners;

Therefore, the only issue before us is the status of the partnership for tax purposes.

Section 7701(a)(2) defines a partnership to include "a syndicate, group, pool, joint venture, or other unincorporated

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organization, through or by means of which any business, financial operation, or venture is carried on, and which is not * * * a corporation." Section 7701(a)(3) defines a corporation to include an "association." Drawing from Morrissey v. Commissioner, 296 U.S. 344 (1935), section 301.7701-2(a)(1), Proced. & Admin. Regs., enumerates six major corporate characteristics: (1) Associates, (2) an objective to carry on business and divide the gains therefrom, (3) continuity of life, (4) centralization of management, (5) liability for corporate debts limited to corporate property, and (6) free transferability of interests. The regulation further provides that an unincorporated enterprise will be treated as an association if it more nearly resembles a corporation than, for example, a partnership, i.e. if it has more corporate characteristics than noncorporate characteristics. Secs. 301.7701-2(a)(1) and 301.7701-2(a)(3), Proced. & Admin. Regs. However, in determining the tax status of a particular enterprise, the characteristics common to the possible types of enterprises are not considered. Thus, for example, if the choice is between association or partnership status, as is the case here, the first two characteristics enumerated above are ignored because they are common to both types of enterprises, and the determination is based on the later four. ⁹² Secs. 301.7701-2(a)(2) and 301.7701-2(a)(3), Proced. & Admin. Regs. Each characteristic is accorded equal weight, and the determination is thus mechanical in approach. Larson v. Commissioner, 66 T.C. 159, 172, 185 (1976). In the absence of additional characteristics (see the previous footnote), an unincorporated enterprise such as a partnership which lacks two or more of the four determinative corporate characteristics will not be classified as an association but rather as a partnership. Sec. 301.7701-2(a)(3), Proced. & Admin. Regs.; Larson v. Commissioner, supra at 185; Zuckman v. United States, 207 Ct. Cl. 712, 524 F.2d 729, 744 (1975). This reflects the regulation's objective of limiting the ability of a partnership to qualify as a corporation for tax purposes. Larson v. Commissioner, supra at 187 (Dawson, Chief Judge, concurring).

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We turn now to the characteristics of continuity of life, centralization of management, limited liability, and free transferability of interests. Although these characteristics, or standards, are prescribed under authority of the Internal Revenue Code, local law, in this case California law, governs in determining "whether the legal relationships which have been established in the formation of an organization are such that the standards are met." Sec. 301.7701-1(c), Proced. & Admin. Regs.

(1) Continuity of life. -- Section 301.7701-2(b)(1), Proced. & Admin. Regs., provides that "if the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member will cause a dissolution of the organization, continuity of life does not exist." The regulation goes on to conclude that a general partnership subject to a statute corresponding to the Uniform Partnership Act lacks continuity of life. Sec. 301.7701-2(b)(3), Proced. & Admin. Regs. The State of California adopted the Uniform Partnership Act in 1949. Cal. Corp. Code secs. 15001-15045 (West 1977) (hereinafter cited as the California UPA). See 6 U.L.A. 1 (Supp. 1982); Baker Commodities, Inc. v. Commissioner, 415 F.2d 519, 525 n. 4 (9th Cir. 1969), affg. 48 T.C. 374 (1967). Petitioners do not dispute the fact that the Foster partnership was subject to that act. Thus, it would appear that the partnership lacked the corporate characteristic of continuity of life.

Petitioners contend, however, that the partnership agreement provided that the partnership should continue in the event of the death or withdrawal of a partner, ⁹³ and that such provision is sufficient to impart continuity of life to it. We disagree. Section 15031(5) of the California UPA provides that a partnership is dissolved by the bankruptcy of a partner.Moreover, section 301.7701-2(b)(3), Proced. & Admin. Regs., provides that notwithstanding an agreement that an enterprise is to continue for a stated period or until the completion

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of a stated transaction, the enterprise lacks continuity of life if any member has the power under local law to dissolve it. Section 15031(2) of the California UPA provides that a partnership is dissolved "In contravention of the agreement between the partners, where the circumstances do not permit a dissolution under any other provision of this section, by the express will of any partner at any time." (Emphasis added.) Although a partner who wrongfully dissolves a partnership may be answerable in damages and may forfeit his right to wind up the partnership's affairs (see secs. 15037 and 15038(2), Cal. UPA), the fact remains that such a partner has the power to dissolve the partnership. And it is the power, not the right, to dissolve which is the touchstone of the regulation. Zuckman v. United States, 524 F.2d at 737; see sec. 301.7701-2(g), examples (2) and (7), Proced. & Admin. Regs. Accordingly, we think the Foster partnership lacked the corporate characteristic of continuity of life.

(2) Centralization of management. -- Section 301.7701-2(c)(1), Proced. & Admin. Regs., provides that an enterprise has centralized management if --

any person (or any group of persons which does not include all the members) has continuing exclusive authority to make the management decisions necessary to the conduct of the business for which the organization was formed. Thus, the persons who are vested with such management authority resemble in powers and functions the directors of a statutory corporation.

The regulation goes on to provide that a general partnership subject to a statute corresponding to the Uniform Partnership Act lacks centralized management because of the mutual agency relationship between members of a general partnership. Sec. 301.7701-2(c)(4), Proced. & Admin. Regs. We have already observed that the State of California has adopted the Uniform Partnership Act and that the Foster partnership was subject to it. Section 15009(1) of the California UPA defines the mutual agency relationship as follows:

Every partner is an agent of the partnership for the purpose of its business, and the act of every partner, including the execution in the partnership name of any instrument, for apparently carrying on in the usual way the business of the partnership of which he is a member binds the partnership, unless the partner so acting has in fact no authority to act for the partnership in the particular matter, and the person with whom he is dealing has knowledge of the fact that he has no such authority.

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Although petitioners recognize the absolute language of the regulation, they nevertheless argue that the Foster partnership had a form of centralized management because of the following two paragraphs of the partnership agreement:

T. JACK FOSTER shall be the managing partner and shall be authorized to make all routine decisions for the partnership; provided, however, that any matters of policy shall be discussed and determined by all of the partners.

Any two (2) general partners are hereby authorized to bind the partnership by any deed, conveyance, contract or other written document within the general scope of the partnership.

However, the proviso of the first paragraph negates petitioners' contention. In any event, section 301.7701-2(c)(4), Proced. & Admin. Regs., provides that the partners' agreement to vest a selected few with exclusive management authority does not negate the mutual agency relationship between members of a general partnership if the agreement is ineffective as against an outsider with no notice of it. See sec. 15009(1), Cal. UPA, quoted above, and sec. 301.7701-2(g), examples (2) and (3), Proced. & Admin. Regs. Similarly, the second paragraph does not defeat the mutual agency relationship established by section 15009(1) of the California UPA. The fact that the Fosters agreed among themselves that any two could bind the partnership is not the equivalent of concentrating management authority in a particular person or particular group. Accordingly, we think the Foster partnership lacked the corporate characteristic of centralization of management.

At this point, it is apparent that the Foster partnership lacked two of the four determinative corporate characteristics and thus cannot be classified as an association. Sec. 301.7701-2(a)(3), Proced. & Admin. Regs.; Larson v. Commissioner, 66 T.C. at 185; Zuckman v. United States, 524 F.2d at 744. We could, therefore, conclude our analysis and move on. However, we think it advisable to briefly consider the remaining two corporate characteristics.

(3) Limited liability. -- Section 301.7701-2(d)(1), Proced. & Admin. Regs., provides that limited liability exists "if under local law there is no member who is personally liable for the debts of or claims against the organization." That section further provides that personal liability exists with respect to each general partner in the case of a general partnership

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subject to a statute corresponding to the Uniform Partnership Act. In this regard, see sec. 15015, Cal. UPA; Young v. Riddell, 283 F.2d 909, 910 (9th Cir. 1960). Thus, there can be no question that the Foster partnership lacked the corporate characteristic of limited liability. Petitioners do not contend to the contrary.

(4) Free transferability of interests. -- Section 301.7702-(e)(1), Proced. & Admin. Regs., equates free transferability with the power of substitution. And, "In order for this power of substitution to exist in the corporate sense, the member must be able, without the consent of other members, to confer upon his substitute all the attributes of his interest in the organization." (Emphasis added.) Although a partner can unilaterally transfer his interest in partnership profits and surplus, he cannot confer on his assignee the other attributes of membership, such as the right to participate in the management and conduct of the partnership business, without the consent of all of the partners. Secs. 15018 (c) and (g), 15026, and 15027, Cal. UPA. Accordingly, the Foster partnership lacked the corporate characteristic of free transferability of interests. Petitioners admit as much.

Our review of the four major corporate characteristics relevant to the determination of an organization's tax status indicates that the Foster partnership possessed only noncorporate characteristics and thus cannot be classified as an association. Petitioners contend, however, that if the partnership used Estero as its instrument in the development of Foster City, then Estero's characteristics should be attributed to the partnership for the purpose of determining the latter's status. In this regard, they maintain that Estero possessed the corporate characteristics of continuity of life, limited liability, and free transferability of interests. Although we agree with petitioners' premise that the partnership used Estero, we disagree with their conclusion.

First, petitioners cite no authority whatsoever in support of their rather novel theory. Second, the classification regulations (secs. 301.7701-1 through 301.7701-4, Proced. & Admin. Regs.) do not even suggest, much less expressly sanction,

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imputing corporate characteristics of one organization to another. ⁹⁴ Third, it strikes us as illogical to attribute Estero's characteristics to the partnership, as petitioners would have us do, when it was the partnership that used Estero and not the converse. In other words, it was the partnership that directed the development of Foster City; Estero was merely one of the players in the drama. The partnership was neither coincident nor coextensive with the district, which was a separate and distinct juristic entity. 1961 Cal. Stat. ch. 82, p. 459 (1st Extra Sess. 1960); Cooper v. Leslie Salt Co., 70 Cal. 2d 627, 451 P.2d 406, 75 Cal. Rptr. 766 (1969). Under these circumstances, we do not think that either the partnership's identity or its tax status should be subordinated to that of Estero.

In view of the foregoing, we hold that for tax purposes the Foster partnership was a partnership and not an association. Sec. 7701(a)(2) and (3); secs. 301.7701-1 through 301.7701-3, Proced. & Admin. Regs. G. PETITIONERS' AFFIRMATIVE USE OF SECTION 482

In the alternative, petitioners contend that if section 482 is to be applied in this case, it should be used to consolidate the Foster partnership with all of the Foster-controlled corporations (particularly Foster Enterprises) ⁹⁵ purportedly involved in the development of Foster City. Their argument is based on the fact that "there was a single unitary business being conducted." Although we agree with the factual predicate of their contention, we disagree with the contention itself.

Section 482 may not be used by taxpayers as a sword; rather, it may be invoked only by the Commissioner. 3 B. Bittker, Federal Taxation of Income, Estates and Gifts, par. 79.2, p. 79-6 (1981). In this regard, section 1.482-1(b)(3), Income Tax Regs.,

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provides that "Section 482 grants no right to a controlled taxpayer ⁹⁶ to apply its provisions at will, nor does it grant any right to compel the district director to apply such provisions." Petitioners do not attack the validity of this regulation, and that issue is therefore not before us. Nevertheless, we would like to briefly comment on what we perceive to be the firm foundation for the regulation.

As previously stated, section 482 can be traced to the consolidated return provisions of section 240(d), Revenue Act of 1921, ch. 136, 42 Stat. 227, 260. That section provided that --

in any case of two or more related trades or businesses (whether unincorporated or incorporated and whether organized in the United States or not) owned or controlled directly or indirectly by the same interests, the Commissioner may consolidate the accounts of such related trades or businesses, in any proper case, for the purpose of making an accurate distribution or apportionment of gains, profits, income, deductions, or capital between or among such related trades or businesses.

It was reenacted but amended by section 240(d), Revenue Act of 1924, ch. 234, 43 Stat. 253, 288. That section provided as follows:

In any case of two or more related trades or businesses (whether unincorporated or incorporated and whether organized in the United States or not) owned or controlled directly or indirectly by the same interests, the Commissioner may and at the request of the taxpayer shall, if necessary in order to make an accurate distribution or apportionment of gains, profits, income, deductions, or capital between or among such related trades or businesses, consolidate the accounts of such related trades or businesses. [Emphasis added.]

See. S. Rept. 398, 68th Cong., 1st Sess. (1924), 1939-1 C.B. (Part 2) 266, 286. It was reenacted without change by section 240(f), Revenue Act of 1926, ch. 27, 44 Stat. 9, 46.

In 1928, however, Congress enacted section 45, Revenue Act of 1928, ch. 852, 45 Stat. 791, 806, ⁹⁷ from which section 482 is directly derived. Although that section was based on section 240(f) of the Revenue Act of 1926, it was different in two important respects. First, it authorized the Commissioner to

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distribute, apportion, or allocate gross income or deductions between or among commonly controlled or commonly owned trades or businesses and eliminated any reference to the consolidation of accounts. ⁹⁸ Second, it eliminated the right of taxpayers to invoke the benefits of that section. Both of these significant differences have been carried forward in section 482.

Section 45 of the Revenue Act of 1928 was reenacted without change in 1932 ⁹⁹ and reenacted with a minor amendment in 1934. ¹⁰⁰ Shortly, thereafter, regulations were promulgated. Article 45-1(b), Regs. 86, provided as follows:

Section 45 grants no right to a controlled taxpayer to apply its provisions at will, nor does it grant any right to compel the Commissioner to apply such provisions. * * *

This article thus reflected the statutory changes embodied in section 45 of the Revenue Act of 1928 and is the forefather of section 1.482-1(b)(3), Income Tax Regs. That section is identical in substance and obviously rests on a firm foundation.

Petitioners cite and rely on Marc's Big Boy-Prospect, Inc. v. Commissioner, 52 T.C. 1073 (1969), affd. sub nom. Wisconsin Big Boy Corp. v. Commissioner, 452 F.2d 137 (7th Cir. 1971), and Hamburgers York Road, Inc. v. Commissioner, 41 T.C. 821 (1964), for the proposition that the Commissioner has the authority under section 482 to consolidate "the several units of a unitary business into a single one for tax purposes." However, there is nothing in these cases to suggest that the

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Commissioner must effect what is tantamount to a compulsory consolidated return, ¹⁰¹ and petitioners appear to concede the point. As previously stated, the Commissioner has broad discretion in applying section 482 and our focus is limited to determining whether under all of the facts and circumstances he acted arbitrarily, capriciously, or unreasonably in reallocating income and deductions from one enterprise to another. Marc's Big Boy-Prospect, Inc. v. Commissioner, supra at 1092-1094, 1105; Hamburgers York Road, Inc. v. Commissioner, supra at 833, 839-840.

Tenacious to the end, petitioners next contend that respondent's failure to consolidate income and deductions reflects an intent to maximize tax, "presumably on the theory [that] income is not clearly reflected unless it bears the maximum possible tax," and that this failure demonstrates an abuse of discretion sufficient to overcome his determination. The Ninth Circuit, however, had previously considered a similar "taxmaximization" argument and rejected it. Rooney v. United States, 305 F.2d 681, 686 (9th Cir. 1962). Moreover, petitioners overlook the fact that section 482 is operative to prevent the avoidance of taxes as well as to clearly reflect the income of commonly owned or commonly controlled taxpayers. We have previously found as ultimate facts that the 127 acres of land in Neighborhood One and the single-family residential lots in Neighborhood Four were conveyed by the Foster partnership for the purpose of avoiding Federal income taxes. Petitioners also overlook the fact that they, themselves, elected to do business in the various forms in which they did. Having so elected, they must accept the tax disadvantages. Higgins v. Smith, 308 U.S. 473, 477 (1940). Finally, we have previously determined that the evidence in this case affirmatively establishes the reasonableness of respondent's action in allocating both the Neighborhood One income and the Neighborhood Four income to the Foster partnership as the true earner thereof.

In view of the foregoing, we hold that petitioners are not entitled to affirmatively use section 482 to effect a consolidated

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return and that respondent's failure to do so does not demonstrate any abuse of discretion on his part. Issue 2

Applicability of the Substance-Over-Form Doctrine to the Westway Transaction

We turn now to the third of the three major substantive issues involved in this case, namely, whether certain promissory notes, i.e., the "Westway notes," are part of the Foster partnership's basis in Neighborhoods Two and Three, as petitioners contend, or conversely whether they represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island, as respondent contends. This issue requires that we decide the applicability of the substance-over-form doctrine to the "Westway transaction." Before we do so, however, we must first resolve a preliminary issue raised by petitioners. A. ADEQUACY OF THE NOTICE OF DEFICIENCY

Petitioners contend that respondent's categorization of the Westway notes as interest is not an issue properly before the Court because it was not raised by him in either the notice of deficiency or the answer. In the alternative, they contend that if the issue is before the Court, the burden of proof should be shifted to respondent under Helvering v. Taylor, 293 U.S. 507 (1935), because of the allegedly "opaque" language used in the notice to describe the adjustment. We think both contentions are without merit.

The adjustment in question is described in the notice of deficiency as follows: 1.b. Cost of lot sales, neighborhoods 2 & 3

It has been determined [that] the cost of lot sales reported should be adjusted as shown in Exhibit G-3 and supporting exhibits referred to therein. The principal change is due to a disallowance of a 3,000,000 obligation incurred in the "Westway Transaction" as not being part of land basis because: (1) there is no business substance to such transaction and (2) if this is a valid business obligation, it is not a capital expenditure to be added to land basis.

A related adjustment is described as follows:

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1.e. If it is ruled by a court that there is no business substance to the form of the "Westway Transaction" as specified in item (b) above, and thus should be disregarded, then it is held [that] the gain of 84,143.52 reported by the partnership on its exchange of 500 shares of Foster California Corporation stock for 196.38 acres of land received from that corporation, will also be disregarded, such exchange being part of the "Westway Transaction."

The above two explanatory paragraphs may not be models of clarity. However, we cannot say that when read together they fail to fairly apprise petitioners of respondent's position that the form of the Westway transaction was not in accord with its substance. ¹⁰² After all, the first paragraph expressly challenges petitioners' treatment of the Westway transaction on the ground that there was no substance to the transaction, and the second paragraph emphasizes respondent's position that the form of the transaction lacked substance. Petitioners must have comprehended the meaning of these paragraphs because in their petition they alleged that "Respondent's determination that the entire transaction was without substance is arbitrary."

In our opinion, the fact that the explanatory paragraphs of the notice of deficiency do not expressly categorize the Westway notes as interest is not of consequence. That categorization is purely derivative of respondent's position that the form of the Westway transaction was not in accord with its substance. In other words, it merely amplified his original determination by making it more specific. We are confident that petitioners realized this because the second reason given by the notice for excluding the Westway notes from basis is that those notes do not represent a capital expenditure. Moreover, in their trial memorandum, petitioners stated as follows:

Respondent has suggested previously that the Westway Notes constitute additional interest for Republic National Bank loans; to which Petitioners respond that if that is true they elected to capitalize the interest under I.R.C. Section 266, and therefore have properly capitalized it. [Emphasis added.]

Finally, in his opening statement at trial, petitioners' senior counsel stated as follows:

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They [the Fosters as partners] capitalized these Westway notes as part of their basis, that being the indebtedness that they had, which they assumed in the course of this involved transaction that I have just described. The government denied this addition to basis. It was never very explicit in anything that it wrote, thirty day letter or ninety day letter about why, but there were suggestions that it was in lieu of interest, and hence, it was an interest deduction that they should seek instead of capitalization. [Emphasis added.]

In view of the foregoing, we are satisfied that respondent's categorization of the Westway notes as interest is an issue which is properly before us.

Much of what we have already said applies equally to the question whether the burden of proof should be shifted. We have already concluded that the notice of deficiency fairly apprised petitioners of respondent's position that the form of the Westway transaction was not in accord with its substance. Accordingly, we decline their invitation to shift the burden because of the allegedly "opaque" language used therein. Cf. Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 361-362 (9th Cir. 1974), affg. a Memorandum Opinion of this Court. ¹⁰³ Moreover, the categorization of the Westway notes as interest does not constitute a "new issue" or "new matter" with respect to which respondent would bear the burden of proof. See Achiro v. Commissioner, 77 T.C. 881, 890 (1981), and cases cited therein; Rule 142(a). As previously stated, that categorization merely amplified his original determination and was perfectly consistent therewith. It did not serve to increase the amount of the deficiency nor did it require petitioners to introduce evidence different from what they would have otherwise presented. We therefore decline to shift the burden of proof to respondent. Achiro v. Commissioner, supra.

B. THE WESTWAY NOTES AS INTEREST

We must now decide whether the Westway notes are part of the Foster partnership's basis in Neighborhoods Two and Three, or conversely, whether they represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island. Respondent's determination that the notes represent interest is presumptively correct, and petitioners

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bear the burden of proving that the notes are includable in basis. Welch v. Helvering, 290 U.S. 111, 115 (1933); Majestic Securities Corp. v. Commissioner, 120 F.2d 12, 14-15 (8th Cir. 1941), affg. 42 B.T.A. 698 (1940); Rule 142(a).

The factual predicate of the present issue lies, of course, in the Westway transaction. That transaction had its origin in the financial inability of the Foster partnership to fund all of the downpayment (2,500,000) needed for the purchase of Brewer's Island and its consequent agreement with the Republic National Bank to borrow most of that amount (2 million). Under the terms of the agreement, the partnership agreed (1) to pay interest at the prevailing market rate, (2) to pay a bonus equal to the total amount borrowed, and (3) to structure the bonus so that it would be taxed to Republic as capital gain rather than ordinary income. We are concerned here with only the terms involving the 100-percent bonus. Those terms were applicable not only to the amount borrowed to make the downpayment but also to any amount subsequently borrowed in order to satisfy the periodic installments due to the sellers (Leslie and Schilling) for the balance of the purchase price (10,300,000). In August 1961, the partnership borrowed 500,000 for one such installment and the same amount a year later. Accordingly, by August 1962, it had become obligated to pay a 3 million bonus to Republic and also to insure that the bank enjoyed that bonus in the form of a capital gain.

The complexity of the Westway transaction makes summarization difficult. Nevertheless, it would be helpful to briefly review the salient features of its various steps. The mechanics of the transaction are discussed above in greater detail at pages 87-91 and 87-101.

1. On August 4, 1961, the Foster partnership conveyed 200.17 acres of land in Neighborhoods Eight and Nine to Foster Bayou Corp. (Foster Bayou) in exchange for 100 percent of that corporation's stock.

2. On August 7, 1962, the Foster partnership "sold" its stock in Foster Bayou to Westway Investment Co. (Westway) for cash in the amount of 5,000 and a non-interest-bearing note due August 7, 1967, in the amount of 100,000. As will be recalled, Westway was a subsidiary of the Howard Corp.,

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which in turn was owned by trustees for the benefit of Republic's shareholders.

3. On April 23, 1963, the Esteroy Corp. (Esteroy) was formed by the Foster partnership.

4. On December 3, 1963, the Foster partnership conveyed 196.638 acres of land in Neighborhoods Two and Three to Foster California Corp. (Foster California) in exchange for 50 percent of that corporation's authorized stock.

5. Also on December 3, 1963, the Foster partnership transferred its stock in Foster California to Foster Enterprises, Ltd. (Foster Enterprises).

6. In January and February 1964, Esteroy and Westway negotiated a "purchase and sale" of the Foster Bayou stock for 3,105,000. Of this amount, 5,000 was paid in cash, and non-interest-bearing promissory notes (the Westway notes) were executed for the balance, or 3,100,000. This sum was payable in the amounts of 2 million on August 19, 1966; 100,000 on August 7, 1967; 500,000 on August 19, 1967; and 500,000 on August 19, 1968. On May 4, 1964, Westway transferred the Foster Bayou stock to Esteroy.

7. On June 2, 1964, Esteroy liquidated Foster Bayou and entered on its books the 200.17 acres of land in Neighborhoods Eight and Nine at a basis of 3,105,000.

8. On June 5, 1964, Esteroy conveyed the 200.17 acres of land that it had received from Foster Bayou to Foster California in exchange for 50 percent of that corporation's stock.

9. On June 8, 1964, Esteroy was liquidated by the Foster partnership. On July 24, 1964, the Fosters assumed Esteroy's indebtedness to Westway in the amount of 3,100,000.

10. On July 31, 1964, the Foster partnership transferred to Foster California its stock in that corporation which it had obtained by virtue of the liquidation of Esteroy. In exchange therefor, Foster California transferred to the partnership on August 4, 1964, the 196.638 acres of land in Neighborhoods Two and Three which it had acquired from the partnership on December 3, 1963.

11. In December 1965, Westway sold to Republic one-half of the 2 million promissory note due August 19, 1966, which Esteroy had executed in 1964 as part of the "purchase price" of the Foster Bayou stock. Westway subsequently merged into

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the Howard Corp., which then became the holder of the balance of the receivable (2 million).

12. Because of financial difficulties experienced by the Foster partnership in the mid-1960's, Republic renewed the 2 million note due August 19, 1966, to August 19, 1967, and then to October 30, 1968; it also renewed the 500,000 note due August 19, 1967, to October 30, 1968. After that date, the partnership was delinquent in payment, not only with respect to those two notes but also with respect to the 500,000 note due August 19, 1968.

13. On June 1, 1970, Foster California was merged into its parent, Foster Enterprises, which entered the 200.17 acres of land in Neighborhoods Eight and Nine on its books at 3,105,000.

14. In October 1970, the Fosters withdrew from Foster City as developers. The purchaser, Centex West, Inc. (Centex), agreed to assume liability for the Westway notes. In a collateral agreement, Republic and the Howard Corp. agreed to release the Fosters from personal liability in exchange for the assumption by Centex and a release by the Fosters of any claim they might have against Republic and Howard for usury.

Emphasizing the form of the Westway transaction, petitioners contend that the Westway notes are part of the Foster partnership's basis in Neighborhoods Two and Three. Their theory assumes that the August 7, 1962, transfer of the Foster Bayou stock from the Foster partnership to Westway, and the May 4, 1964, transfer of that same stock from Westway to Esteroy were bona fide sales, and hence that the Westway notes represent the cost incurred by the Fosters in reacquiring the Foster Bayou stock.

Respondent, on the other hand, emphasizes the substance of the transaction and contends that the Westway notes represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island. He does not, therefore, quarrel with either petitioners' subchapter C (Corporate Distributions and Adjustments) or subchapter O (Gain or Loss on Disposition of Property) analysis of the transaction, but rather challenges their assumption that the August 7,

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1962, and May 4, 1964, transfers were bona fide sales, the assumption upon which their analysis depends. We agree with respondent's view.

The starting point for our analysis is the doctrine of substance over form. As early as 1921, the Supreme Court stated as follows:

We recognize the importance of regarding matters of substance and disregarding forms in applying the provisions of the Sixteenth Amendment and income tax laws enacted thereunder. In a number of cases * * * we have under varying conditions followed the rule. [ United States v. Phellis, 257 U.S. 156, 168 (1921).]

More recently, the Fifth Circuit has described the doctrine as "no schoolboy's rule" but rather "the cornerstone of sound taxation." Weinert's Estate v. Commissioner, 294 F.2d 750, 755 (5th Cir. 1961), revg. 31 T.C. 918 (1959). In our view, the substance of the Westway transaction is very different from its form. As previously stated, we think the Westway notes represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island, rather than the cost of reacquiring the Foster Bayou stock.

Interest has been defined by the Supreme Court as "compensation for the use or forbearance of money." Deputy v. du Pont, 308 U.S. 488, 498 (1940). It has also been defined as an "amount which one has contracted to pay for the use of borrowed money." Old Colony R. Co. v. Commissioner, 284 U.S. 552, 560 (1932). Accordingly, "a negotiated bonus or premium to be paid the lender as a prerequisite to obtaining borrowed capital" qualifies as interest (L-R Heat Treating Co. v. Commissioner, 28 T.C. 894, 897 (1957)), even though it might be denominated otherwise in order to conceal a usurious contract or to accomplish some other objective personal to the parties concerned (Wiggin Terminals, Inc. v. United States, 36 F.2d 893 (1st Cir. 1929); Arthur R. Jones Syndicate v. Commissioner, 23 F.2d 833 (7th Cir. 1927), revg. 5 B.T.A. 853 (1926)). ¹⁰⁴ In the present case, we think the Westway notes represent such a negotiated bonus or premium, and hence must be regarded as interest, for the following reasons:

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First, the genesis of the Westway transaction lay in the financial inability of the Foster partnership to fund all of the downpayment needed for the purchase of Brewer's Island. In order for the partnership to acquire the property and undertake the contemplated project, it had to acquire additional capital from a third party. The Fosters preferred to acquire such additional capital from a lender rather than from an equity investor. By borrowing capital, they would be able to retain complete control over the project and would more fully enjoy the financial rewards if it proved to be a success. In this regard, it should be recalled that as early as December 1959, Jack Foster arranged to buy out Richard Grant's interest in the project because he thought the property was worth far more than its option price (12,800,000) and because he preferred to proceed with his sons as his only partners.

Second, the Fosters actually sought financial assistance from only one source, the Republic National Bank, a major lending institution. They specifically turned to Republic because they were frequent customers of that bank, having borrowed millions of dollars over the years and never having been refused a loan. In fact, Republic had historically been the Fosters' major source of financing for their real estate transactions. However, Republic had never acted in any capacity other than that of the Fosters' lender.

Third, the Foster partnership succeeded in obtaining additional capital from Republic. ¹⁰⁵ It was necessary, however, to execute both a loan agreement and a promissory note. The capital obtained was repayable absolutely and in all events, and the maturity date was fixed. Moreover, interest at the prevailing market rate (6 percent per annum) was payable quarterly and unconditionally. The arrangement between the partnership and Republic was therefore indicative of a debtor-creditor relationship.

Fourth, Republic did not regard itself as anything other than the Fosters' lender. This is evident from the bank's internal correspondence (quoted above at pp. 98-100) in which the 3 million Westway obligation was consistently characterized as a "fee," a "debt," or a "fee debt." For

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example, the last paragraph of a report prepared by Republic in November 1967 in preparation for an in-house conference concerning the Foster partnership stated as follows:

5. The Fosters are being urged by us to bring in an equity partner to give stability, financial respectability and stronger management to the project. It is hoped that our debt will be substantially reduced with no more than 3,000,000 having to be carried on a term basis of five to six years. It should be noted that the latter debt [ i.e., the 3 million ] was, in fact, a fee the bank received from Foster in the early years of the project and does not represent any out-of-pocket money by either the bank or Westway, a Howard affiliate. [Emphasis added.]

Clearly, therefore, Republic considered the 3 million fee to be "a negotiated bonus or premium to be paid the lender as a prerequisite to obtaining borrowed capital." Consistent with its view of the bonus, the bank never held itself out as having any equity interest in the Foster City project.

Fifth, the Fosters did not regard Republic as anything other than their lender. This is evident from the fact that they never represented that the bank had any equity interest in the Foster City project. Instead, they consistently portrayed the partnership as the sole developer. It is also evident from the October 31, 1967, letter of Jack Foster, Jr. (quoted above at pp. 98), in which he repeatedly referred to the 3 million as the "Westway debt," and from the fact that in 1969 the Fosters directed their attorneys to review their financial relationship with Republic with a view towards possibly instituting an action against the bank for usury.

Finally, we note that at the time the Fosters withdrew from Foster City as developers, they entered into an "Agreement of Release" (quoted above at pp. 100-102) with Republic and the Howard Corp. Under the terms of that agreement, the Fosters were released from personal liability for the Westway notes, which were assumed by Centex, their buyer. In exchange therefor, the Fosters released Republic and the Howard Corp. from any claim they might have against them for usury. That those parties should have so contracted is again indicative that they viewed their relationship as one of debtor-creditor.

Our view that the Westway notes represent an obligation to pay additional interest also finds support in the transparency which characterizes the Westway transaction, particularly the two key steps involving the transfer of the Foster Bayou stock

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from the Foster partnership to Westway on August 7, 1962, for 105,000, and the transfer of that same stock from Westway to Esteroy on May 4, 1964, for 3,105,000. In our opinion, those transfers were simply the means by which the partnership attempted to satisfy its obligation to Republic (1) to pay the 3 million bonus on the money borrowed for the purchase of Brewer's Island and (2) to structure that bonus so that it would be taxed to the bank as capital gain rather than ordinary income. The artificiality of the Westway transaction becomes apparent when one examines these transfers in detail.

(1) On August 7, 1962, Westway "purchased" the Foster Bayou stock from the Foster partnership for 105,000. Of this amount, 5,000 was paid in cash and a non-interest-bearing note due August 7, 1967, was executed for the balance. This transaction raises two important questions: First, why would Westway want to purchase the Foster Bayou stock? Second, why would the Foster partnership want to sell that stock? As we shall show, the puzzling answers to these questions are incompatible with petitioners' contention that the transfer of the stock was a bona fide sale.

Because the Foster Bayou stock had little, if any, value apart from the 200.17 acres of land in Neighborhoods Eight and Nine, ¹⁰⁶ Westway's motivation in "purchasing" that stock must logically have been to acquire the land. However, there is nothing in the record to even suggest that Westway, itself, was equipped to develop the land. Indeed, during the period that it held the Foster Bayou stock (August 7, 1962 -- May 4, 1964), Westway did nothing to improve the 200.17 acres. It is also unlikely that Westway wanted to hold that particular acreage for investment purposes. Correspondence exchanged in April 1962 between Jack Foster and his attorney, Roy Lytle (quoted above at pp. 93-95 indicates that the precise acreage held by Foster Bayou in anticipation of the "sale" of its shares was of no concern to either the Fosters or Republic and that the 200.17 acres of land that were actually transferred to that corporation were selected strictly for reasons of expediency,

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i.e., because that parcel had a legal description (metes and bounds) and could therefore be more readily conveyed.

The Foster partnership's desire to sell the Foster Bayou stock must also be questioned when one considers the fact that Foster Bayou owned a significant tract of land on Brewer's Island. After all, the partnership had worked hard to acquire and plan the development of all of Brewer's Island, and by August 1962, had actually succeeded in getting the Foster City project off to a respectable start. Certainly, the need for capital could not have motivated the "sale" because the purported consideration consisted of only 5,000 in cash and a non-interest-bearing note due 5 years later.

In addition, during the period that Westway held the Foster Bayou stock, the Foster partnership and Likins-Foster Honolulu Corp. paid the expenses of Foster Bayou (such as real estate taxes) whenever the latter's rental income was insufficient. In our opinion, the fact that Westway did not assume the burdens of ownership belies petitioners' contention that the August 1962 transfer of stock constituted a bona fide sale. See Harmston v. Commissioner, 61 T.C. 216, 228-229 (1973), affd. per curiam 528 F.2d 55 (9th Cir. 1976).

(2) On May 4, 1964, Esteroy "purchased" the Foster Bayou stock from Westway for 3,105,000. Of this amount, 5,000 was paid in cash at the closing and non-interest-bearing promissory notes were executed for the balance, or 3,100,000. This sum was payable in the amounts of 2 million on August 19, 1966, 100,000 on August 7, 1967; 500,000 on August 19, 1967; and 500,000 on August 19, 1968. In this transaction, Westway recovered the 5,000 in cash that it had paid in August 1962 in order to "purchase" Foster Bayou stock; moreover, its 100,000 note due August 7, 1967, was effectively canceled by Esteroy's 100,000 note due the same date. Westway's gain on the transaction was therefore 3 million. This was precisely the amount of the bonus that the Fosters had agreed to pay under their 1960 agreement with Republic. Furthermore, the 3 million appeared on its face to be gain derived from the sale of corporate stock, i.e., capital gain. This, too, was just as the Fosters had agreed.

Petitioners argue that the 3 million gain realized by Westway in May 1964 was attributable to the appreciation of the 200.17 acres of land in Neighborhoods Eight and Nine

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during the 21 months that Westway held the Foster Bayou stock. We find this argument to be lame, however. Neighborhoods Eight and Nine were not scheduled for early development. In fact, when the Foster Bayou stock was transferred to Westway in August 1962, the 200.17 acres were in essentially the same condition as when they were originally acquired by the Foster partnership in August 1960. As previously stated, Westway did nothing to improve that acreage during the period that it held the Foster Bayou stock. Furthermore, Neighborhoods Eight and Nine were not even completely filled and ready to be improved until 1966. Under these circumstances, we think a 30-fold increase in value over 21 months was most unlikely.

Apart from the remarkable coincidence between the amount and character of Westway's gain and the Foster partnership's bonus obligation to Republic, the May 1964 transfer of the Foster Bayou stock raises two additional questions. First, why would Westway sell to Esteroy? The latter corporation had no assets other than its capital contribution (10,000). On the two Federal income tax returns which it filed during its relatively brief existence (April 23, 1963 -- June 8, 1964), Esteroy reported no gross income whatsoever. With no income and no meaningful assets, one must question whether Westway could have reasonably expected payment from Esteroy. Although Esteroy came into possession of the 200.17 acres of land by liquidating Foster Bayou shortly after acquiring its stock, it had no resources to develop that land, and Westway must certainly have been aware of that fact at the time of the "sale."

Second, because the transaction was actually with the Foster partnership, ¹⁰⁷ one must again ask why the partnership would have "sold" the Foster Bayou stock only to "buy" it back less than 2 years later for 3 million more than it originally received. This is particularly questionable because the only "advantage" in doing so was the use of 5,000 during that

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interim period. It is no answer to argue that the partnership did not anticipate reacquiring the stock at the time that it transferred it. Such a contention is flatly contradicted by the April 1962 correspondence between Jack Foster and Roy Lytle (quoted above at pp. 93-95). That correspondence, exchanged subsequent to the formation of Foster Bayou but prior to the transfer of its stock to Westway, demonstrates that the parties to the Westway transaction contemplated the "sale" and subsequent "repurchase" of corporate stock by the Fosters for the purpose of disguising the agreed-upon bonus as a capital gain.

As to the above two questions, once again the record offers no satisfactory answers which are compatible with a bona fide sale.

(3) We find it curious that the corporations which played a role in the Westway transaction generally had little in the way of income, business activity, or assets (other than the two parcels of land which were so frequently transferred). In this regard, we have already noted that Foster Bayou, the corporation whose stock was in such demand, had no assets, maintained no bank account, and never paid any dividends, and that its only business activity was a lease which it did not even manage. We have also noted that Esteroy never reported any gross income during its abbreviated existence (April 23, 1963 -- June 8, 1964). Finally, we should mention that Foster California, another key corporation in the Westway transaction, had no assets (other than its initial capital contribution of 1,200), maintained no bank account, conducted no business activity, and paid no dividends.

(4) Yet another feature of the Westway transaction which leads us to look beyond its form is its very complexity. The record suggests no justification for such a mind-boggling succession of incorporations, transfers, liquidations, and mergers other than the desire to disguise the payment of interest and to achieve favorable tax consequences. In this regard, it is clear that Republic was interested in obtaining its 3 million bonus in the form of a capital gain. As previously stated, Republic and the Fosters sought to achieve that objective by causing the Foster partnership to "sell" its stock in Foster Bayou to Westway for 105,000 in August 1962, and by causing Esteroy to "repurchase" that stock from Westway for

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3,105,000 in May 1964. It is equally clear that the Fosters were interested in raising 3 million in order to pay the bank its bonus. They attempted to do this by reducing their taxes. From their point of view, the Westway transaction was designed to step up basis in the two parcels of land previously mentioned, by 6,210,000, but at a cost of only 3 million. The vital importance to the Fosters of the tax savings inherent in the Westway transaction is strikingly evident in a letter from Del Champlin, their tax adviser and the principal architect of the Westway transaction, to Roy Lytle:

The financial effect on the Fosters * * * is a substantial reduction in income taxes because of the much higher basis. This situation affects their ability to carry out their agreements with the bank. [Emphasis added.]

Republic and the Fosters also attempted to disguise the character of the 100-percent bonus for non-tax reasons. Thus, at the time that the bonus was negotiated, interest in excess of 10 percent per year was usurious under Texas law. Tex. Const. Ann. art. 16, sec. 11 (Vernon 1955) ("All contracts for a greater rate of interest than ten percent per annum shall be deemed usurious"); Tex. Rev. Civ. Stat. Ann. art. 5071 (Vernon 1962) ("The parties to any written contract may agree to and stipulate for any rate of interest not exceeding ten per cent. per annum on the amount of the contract"). In order to circumvent State usury laws, taxpayers have long sought to disguise interest by calling it something else, and we are convinced that this was what happened here. ¹⁰⁸ However, it is clear that the Federal internal revenue laws do not abide such semantic prestidigitation. Wiggin Terminals, Inc. v. United States, 36 F.2d 893 (1st Cir. 1929); Arthur R. Jones Syndicate v. Commissioner, 23 F.2d 833 (7th Cir. 1927). ¹⁰⁹

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Petitioners spend many pages on brief emphasizing the form of the Westway transaction and the tax consequences which flow therefrom. However, we have alreadyexplained why we think it is necessary to look beyond the form of that transaction to its substance. Accordingly, we find it unnecessary to address most of their arguments. There are, however, a few which we shall briefly discuss.

First, petitioners contend that the manner in which the Commissioner handled the Westway issue during his audit of the Westway Investment Co. is "persuasive" in this case. We disagree. In our opinion, that matter is simply irrelevant.

Second, petitioners suggest that Republic and the Fosters were originally partners or joint venturers and that the bank simply liquidated its "profit sharing participation" for 3 million in 1964. Again we disagree. It is true that Republic's chairman did remark, "I guess we're partners," at the conclusion of the Dallas conference at which the Fosters sought financing for the downpayment on Brewer's Island. However, we do not think that either Republic or the Fosters ever intended to enter into a partnership or any relationship other than that of debtor-creditor. See Commissioner v. Culbertson, 337 U.S. 733, 742 (1949). In our opinion, the remark must be construed in light of the fact that the bank's bonus was originally payable only from half of the profits to be derived from the Foster City project in 5-years time. Receipt of the bonus was therefore subject to the success of the project. The fortunes of the Fosters were also hostage to the project's success. In view of this shared risk, ¹¹⁰ it is understandable that Mr. Florence spoke of Republic and the Fosters as "partners."

Moreover, the fact that the bonus was originally payable only from the project's profits does not negate a debtor-creditor relationship. Dorzback v. Collison, 195 F.2d 69 (3d Cir. 1952); Wiggin Terminals, Inc. v. United States, 36 F.2d at 896; Arthur R. Jones Syndicate v. Commissioner, supra; see 1 W. McKee, W. Nelson & R. Whitmire, Federal Taxation of Partnerships and Partners, par. 3.03[3] (1977); G. Robinson, Federal Income Taxation of Real Estate, par. 8.03, at 8-24 (3d

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ed. 1979). The presence of indicia of a debtor-creditor relationship has already been noted. Furthermore, Republic's right to share in the profits was strictly limited in amount, the bank bore no risk of loss except with respect to its loan, and it was not entitled to participate in the management of the project.

Finally, we do not ascribe any particular significance to the fact that payment of the bonus was made absolute in 1964 with the execution of the Westway notes. In this regard, the record reveals that the Fosters were unable to repay the 2 million originally borrowed for the downpayment on Brewer's Island on the scheduled due date. In order to induce Republic to extend that date, they proposed that the bonus obligation be made absolute. The bank agreed, and a few months later the "negotiations" for the "repurchase" of the Foster Bayou stock commenced. The character of the bonus as additional interest never changed; only the contingency was removed.

Third, petitioners complain that respondent fails to treat the "Texas parties," i.e., Republic, Westway, the Howard Corp., and the Hoblitzelle Foundation, ¹¹¹ as separate entities, and, instead, focuses exclusively on Republic. In our opinion, their complaint is not well founded because it ignores the substance of the Westway transaction.

As will be recalled, it was to Republic, not Westway, Howard, or the Hoblitzelle Foundation, that the Fosters turned in 1960 when they needed to borrow money, and it was with Republic, not the other entities, that they negotiated the terms for the loan, specifically including the 100-percent bonus. It was also in cooperation with Republic that they designed the Westway transaction and from Republic that they requested extensions and other modifications in their agreement. The Fosters thus acted as if all of their arrangements were with the Republic National Bank.

Moreover, the Texas parties were all related. The Hoblitzelle Foundation was affiliated with Republic and shared key

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personnel. The Howard Corp. was owned by trustees for the benefit of Republic's shareholders. ¹¹² Westway, of course, was a subsidiary of Howard.

In any event, petitioners overlook the fundamental fact that the 100-percent bonus represented compensation for the use of money. The manner in which the "Texas parties" may have agreed among themselves to make the loan and receive the bonus is therefore irrelevant.

In view of the foregoing, we hold that the Westway notes represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island. ¹¹³

C. THE WESTWAY NOTES AS CARRYING CHARGES

In the alternative, petitioners contend that if the Westway notes represent an obligation to pay additional interest, then under section 266 such interest can be capitalized at the election of the Foster partnership and treated as part of the basis of the land acquired. They contend, further, that the partnership made the requisite election. ¹¹⁴

Respondent, on the other hand, disputes that the partnership elected to capitalize the Westway notes. Even if it did, he contends that its election was invalid because it failed to capitalize other interest which it incurred with respect to the Foster City project. More fundamentally, however, he contends that petitioners are not entitled to invoke section 266 because the partnership never paid the notes during the years in issue. For reasons which we will develop, we agree with respondent.

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At the outset, we should emphasize that the present issue arises only because the Foster partnership utilized the cash method of accounting and did not pay the Westway notes during the years in issue. If it had, respondent would presumably have allowed an interest expense deduction under section 163(a). Section 266 provides as follows:

No deduction shall be allowed for amounts paid or accrued for such taxes and carrying charges as, under regulations prescribed by the Secretary or his delegate, are chargeable to capital account with respect to property, if the taxpayer elects, in accordance with such regulations, to treat such taxes or charges as so chargeable. [Emphasis added.]

Section 1.266-1(b)(1), Income Tax Regs., expands on the statute as follows:

The taxpayer may elect * * * to treat the items enumerated in this subparagraph which are otherwise expressly deductible under the provisions of subtitle A of the Code [relating to income taxes] as chargeable to capital account either as a component of original cost or other basis, for the purposes of section 1012, or as an adjustment to basis, for the purposes of section 1016(a)(1). The items thus chargeable to capital account are -- * * * *

(ii) In the case of real property, whether improved or unimproved and whether productive or unproductive:

(a) Interest on a loan (but not theoretical interest of a taxpayer using his own funds), * * * *

paid or incurred for the development of the real property * * * [Emphasis added.]

The term "paid or accrued," as used in the statute, and the term "paid or incurred," as used in the regulation, must both be construed "according to the method of accounting upon the basis of which the taxable income is computed under subtitle A." Sec. 7701(a)(25); sec. 301.7701-16, Proced. & Admin. Regs. ¹¹⁵ As we have already observed, the Foster partnership utilized the cash method of accounting in computing its

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taxable income. Under the cash method, interest is taken into account for the year in which paid rather than the year in which accrued. ¹¹⁶ Secs. 461(a), 446; secs. 1.461-1(a)(1), 1.446-1(c)(1)(i), Income Tax Regs. Accordingly, it would appear from a straightforward construction of the foregoing sections of the Code and regulations that the partnership cannot capitalize interest which it did not pay.

Our conclusion is consistent with the fact that the sole effect of section 266 is to offer a taxpayer the option of capitalizing an expense which he could otherwise deduct. Sec. 1.266-1(b)(2), Income Tax Regs.; S. Rept. 1631, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 504, 578; H. Rept. 2333, 77th Cong., 2d Sess. (1942), 1942-2 C.B. 372, 434-435. "An item not otherwise deductible may not be capitalized under section 266." Sec. 1.266-1(b)(2), Income Tax Regs. As we have already said, interest which is not paid is not deductible by a cash-basis taxpayer; therefore, such interest cannot be capitalized under section 266. ¹¹⁷ To conclude otherwise would enable a cash-basis taxpayer to derive a tax benefit from an unpaid expense, a result which is contrary to the intendment of section 266. See sec. 1.266-1(b)(3), Income Tax Regs.

Apparently in search of another theory by which to justify capitalizing the Westway notes, petitioners cite Crane v. Commissioner, 331 U.S. 1 (1947), and contend that the "doctrine of capitalization" does not depend on the item in question being paid. What petitioners overlook, however, is the fact that interest is not an element of cost for purposes of either section 263(a) or section 1012, but, rather, is an item of expense, provision for which has been expressly made by Congress in the form of a deduction. Sec. 163(a); see Chapin v. McGowan, an unreported case (W.D. N.Y. 1958, 1 AFTR 2d 1354, 58-1

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USTC par. 9469), affd. per curiam 271 F.2d 856 (2d Cir. 1959); cf. Purvis v. Commissioner, 65 T.C. 1165 (1976); Megibow v. Commissioner, 21 T.C. 197, 198-199 (1953), affd. 218 F.2d 687 (3d Cir. 1955). See also Note, "Premature Deductions for Taxes and Carrying Charges," 22 U.C.L.A. L. Rev. 1342 (1975); Sandison & Waters, "More on Tax Planning for Land Developers: Allocations, Deductions, Reporting Income," 37 J. Tax. 154, 155-157 (1972). It is only by virtue of section 266 that taxpayers can elect to treat interest as chargeable to capital account. ¹¹⁸ See 2 B. Bittker, Federal Taxation of Income, Estates and Gifts, par. 42.2, at 42-6 (1981) ("the primary function of IRC Section 266 is to authorize the Treasury to permit carrying charges to be capitalized"). And, as we have already shown, that section does not grant cash-basis taxpayers the right to capitalize interest which they have not paid.

We realize that there may be some disparity between the treatment of interest for tax purposes and the treatment of interest for purposes of financial accounting. See 1 Financial Accounting Standards Board, Accounting Standards, Current Text, sec. I67, at 26971-26979 (1982); 1 L. Seidler & D. Carmichael, Accountants' Handbook, sec. 20, at 26-28 (6th ed. 1981). However, as the Supreme Court has recognized, the prescriptions of the tax law are not, and cannot be, perfectly consonant with accounting principles. Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 538-544 (1979). Nevertheless, by affording taxpayers the option of capitalizing interest under section 266, Congress sought to harmonize the tax law's treatment of interest with "proper accounting methods." H. Rept. 2333, supra, 1942-2 C.B. at 410-411; see Purvis v. Commissioner, 65 T.C. at 1169. Of course, that option is only available to a taxpayer who brings himself within the intendment of that section and its related regulation.

In our view, the failure of the Foster partnership to pay the Westway notes during the years in issue precludes it from capitalizing that interest. Nevertheless, we would like to

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briefly address the question concerning the validity of its purported election.

Section 1.266-1(c)(1), Income Tax Regs., provides that "if expenditures for several items of the same type are incurred with respect to a single project, the election to capitalize must, if exercised, be exercised as to all items of that type." (Emphasis added.) In the case of an item such as interest which may be treated as chargeable to capital account under section 1.266-1(b)(1)(ii), Income Tax Regs., supra, the term "project" is defined as "a particular development of, or construction of an improvement to, real property." Sec. 1.266-1(c)(1), Income Tax Regs.

On its information returns for the calendar years 1963 through 1967, the Foster partnership claimed deductions for interest in the following amounts:

 Year   Amount

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In view of the foregoing, we hold that the Foster partnership is not entitled to capitalize the Westway notes under section 266. Issue 4

Applicability of the Cost Recovery Method to the Grant of the Sway Easement

In 1964, Pacific Gas & Electric Co. (PG & E) paid 425,000 to the Foster partnership for a right-of-way immediately adjacent to an existing easement which stretched across Brewer's Island. PG & E then constructed additional, and even taller, steel towers from which to suspend new, high-voltage electric transmission lines. Because these towers and lines were aesthetically objectionable and negatively affected the value of all of the land in Foster City, the partnership characterized the entire payment as severance damages and reduced its basis in all of its land by that amount.

After the towers were constructed, the Fosters discovered that under certain wind conditions, the powerlines swayed outside the scope of the easement. When this fact was brought to the attention of PG & E, the utility paid the partnership and Foster Enterprises, the record titleholders, an additional 72,000 (in 1967) for a sway easement in order to perfect the right-of-way easement which it had acquired in 1964. The partnership ¹²⁰ again characterized the entire payment as severance damages and reduced its basis in all of its land by that amount.

Under section 61(a)(3) gains derived from dealings in property constitute an item of gross income. Gain is measured by the difference between the amount realized from the sale or other disposition of property and the adjusted basis. Sec. 1001(a). Frequently, however, a taxpayer sells just part of a particular piece of property. If the property as a whole has a unitary basis, a question arises whether, and if so how, to apportion that basis to the part sold. In this regard, section 1.61-6(a), Income Tax Regs., provides as follows:

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When a part of a larger property is sold, the cost or other basis of the entire property shall be equitably apportioned among the several parts, and the gain realized or loss sustained on the part of the entire property sold is the difference between the selling price and the cost or other basis allocated to such part. The sale of each part is treated as a separate transaction and gain or loss shall be computed separately on each part. Thus, gain or loss shall be determined at the time of sale of each part and not deferred until the entire property has been disposed of.

See also Heiner v. Mellon, 304 U.S. 271, 275-276 (1938). This rule is applicable not only to the subdivision of real estate into lots but also to the grant of an easement where the grantor retains all other ownership rights with respect to the underlying property. Fasken v. Commissioner, 71 T.C. 650, 655-656 (1979).

An exception to the apportionment rule of the regulations applies if it is impossible or impracticable to rationally allocate basis to the particular interest sold. In that situation, the amount received may be applied against the taxpayer's basis in the entire property. Inaja Land Co. v. Commissioner, 9 T.C. 727, 735-736 (1947). ¹²¹ Cf. Burnet v. Logan, 283 U.S. 404 (1931).

In Inaja Land Co., the taxpayer granted a right-of-way and certain other easements to a municipality to discharge foreign waters into a river which flowed through its property. The discharge was of such quantity that it was expected to change the course of the river, and the extent of the flood was unpredictable. The easements were not described by metes and bounds. Because it was impossible to ascertain the specific portion of the property that would be adversely affected by the flooding, we held that the amount received should be treated as a return of capital and applied against the taxpayer's basis in the entire tract. 9 T.C. at 736.

On the other hand, if it is possible to rationally quantify that part of a taxpayer's acreage which is adversely affected by an easement and allocate his basis thereto, the principle of Inaja Land Co. is not applicable. ¹²²Fasken v. Commissioner, 71 T.C. 650

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(1979). ¹²³ Whether a taxpayer's basis in an entire tract can be rationally allocated to the affected and nonaffected acreage is, of course, a question of fact. Fasken v. Commissioner, supra at 657.

In the present case, only the propriety of the partnership's treatment of the 72,000 payment for the 1967 sway easement is at issue. Respondent has not challenged the cost recovery treatment of the 425,000 received for the 1964 right-of-way easement. To the contrary, he adopted that treatment in his land cost schedule in the notice of deficiency. His rationale, as stated on brief, was that "the power transmission lines built on the 1964 easement were ugly, and caused damage to all of Foster City, and that petitioners were entitled to apply the compensation received * * * to a reduction in basis."

Respondent seeks to justify the different treatment of the amount received for the 1967 sway easement on the ground that it was the erection of the towers and the suspension of the lines permitted by the 1964 right-of-way easement which caused the damage to the land in Foster City. He argues that there is no evidence that the sway easement caused any additional damage to the land in the development. Consequently, he concludes that the 72,000 should be treated as proceeds from the sale of land in the ordinary course of business and that gain should be determined by reducing said amount by the partnership's basis in the particular acreage described by the sway easement.

Respondent's position assumes that the 1967 sway easement was independent of, and unrelated to, the 1964 right-of-way easement. However, our findings of fact reflect otherwise. The 72,000 that PG & E paid for the sway easement in 1967 represented additional consideration for what it had intended to acquire in 1964. In other words, had the utility known in 1964 the actual catenary of the powerlines, it would have condemned an even wider right-of-way and would have paid a correspondingly greater amount to the partnership. Had this happened, respondent in effect concedes that he would not

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have questioned the partnership's basis adjustment. We see no reason for him to penalize the partnership now for PG & E's failure to initially condemn a sufficient easement for its purposes. Thus, we think the amounts received for the 1964 right-of-way easement and the 1967 sway easement should be treated in the same manner.

Notwithstanding the fact that the sway easement was specifically described, this approach is justified under the facts of this case. That easement was integrally related to the right-of-way easement and did not adversely affect just the land within its defined scope. Rather, it detracted from the entire Foster City development and decreased the value of all of the land therein. Accordingly, we hold for petitioners on this issue. Issue 5 Deductibility of the School and Church Sites

The Foster partnership conveyed three parcels of land in Foster City with respect to which it claimed deductions for charitable contributions on its information returns for 1964 and 1965. The first parcel, consisting of 7.4 acres in Neighborhood One, was conveyed in 1964 to the San Mateo Elementary School District for use as an elementary school site. The second parcel, consisting of 2 acres, was sold in 1964 for 40,000 to the United Church of Christ for use as a church site. The third parcel, consisting of 1.844 acres, was sold in 1965 for 36,880 to the United Church of Christ for use as a church site. The partnership valued all three parcels at 40,000 per acre. It therefore claimed a deduction for the school site in the amount of its alleged fair market value or 296,000 (7.4 acres x 40,000/acre), and deductions for the two church sites equal to the amount by which their alleged fair market value (2 acres x 40,000/acre = 80,000; 1.844 acres x 40,000/acre = 36,880) exceeded the amount received (40,000; 36,880) or 40,000 and 36,880, respectively. ¹²⁴

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A. SCOPE OF THE ISSUE

Respondent treats the deductibility of the school and church sites as a function of the Fosters' intention in conveying all three parcels. Petitioners, on the other hand, contend that the notice of deficiency does not raise the issue of intent with respect to the deductibility of the two church sites. In this regard the explanation of adjustments provides as follows:

The 296,000.00 charitable contribution claimed for a transfer of 7.4 acres of land to the San Mateo City School District during 1964 has been disallowed on the grounds that (1) the transfer was not made with donative intent but was made to benefit the remaining portions of partnership property and (2) if made with donative intent, the partnership has not established the fair market value of such property as claimed.

The 40,000.00 charitable contribution claimed for a transfer of 2 acres of land to the United Church of Christ during 1964 at a sales price of 40,000.00 has been disallowed on the grounds the partnership has not established the sales price received is less than fair market value of the 2 acres.

The 36,880.00 charitable contribution claimed for transfer of 1.844 acres of land to the United Church of Christ during 1965 at a sales price of 36,880.00 has been disallowed on the grounds the partnership has not established the sales price received is less than fair market value of the 1.844 acres.

We agree with petitioners that the notice of deficiency does not, on its face, raise the issue of intent with respect to the deductibility of the two church sites. Nevertheless, we think the issue is properly before the Court.

We have previously held that the Commissioner's determination may be sustained for a reason other than that set forth in the notice of deficiency. Estate of Horvath v. Commissioner, 59 T.C. 551, 555 (1973). On the other hand,

it is equally clear that the Court must determine whether there has been surprise and substantial disadvantage to the petitioner in the presentation of his case because of the manner in which the statutory notice and pleadings were drawn when compared to the issues raised at the trial. In this Court's opinion, it is appropriate to determine whether surprise and disadvantage are present prior to making the often esoteric finding that a particular theory advanced by the respondent has characteristics more like new "reasons" than new "issues" or "matters." This is so because once surprise and substantial detriment are found, the theory, whether a new reason or new issue, need not be heard by this Court. [ Estate of Horvath v. Commissioner, supra; citations and fn. refs. omitted.]

See also Fox Chevrolet, Inc. v. Commissioner, 76 T.C. 708, 733-736 (1981). In the absence of surprise or substantial disadvantage,

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the burden of proof remains with the taxpayer if the Commissioner merely advances a new reason; however, the burden shifts to the Commissioner if a new issue or matter is presented. Achiro v. Commissioner, 77 T.C. 881, 890 (1981); Estate of Horvath v. Commissioner, supra at 555 n. 2; see Rule 142(a).

We turn now to the question of surprise and disadvantage. Respondent maintains that petitioners were well acquainted with his position prior to the issuance of the notice of deficiency. Although he offered no testimony at trial to support this contention, other parts of the record tend to support it. For example, in their petition, the petitioners alleged as follows:

[5.](g) The partnership sold lots in Foster City to various churches for one-half of the price those lots commanded from commercial purchasers. The difference was deducted on the tax returns of the partnership as contributions to churches. In addition, the partnership made a gift to a school district of a site for a school, to be erected within Foster City, and a deduction was taken on the tax return for that gift as a gift to a political subdivision of California. Each of those transfers was made with donative intent. [Emphasis added.]

In his answer, respondent expressly denied the allegations of that subparagraph. In our view, his denial satisfied the requirements of Rule 36(b) ("The answer shall be drawn so that it will advise the petitioner and the Court fully of the nature of the defense") and Rule 31(a) ("The purpose of the pleadings is to give the parties and the Court fair notice of the matters in controversy and the basis for their respective positions").

Moreover, for reasons which will appear below, the Fosters' intent in conveying the church sites was not materially different from their intent in conveying the school site. For all practical purposes, therefore, the issue of intent has been tried and briefed as to all three parcels. Cf. Rule 41(b)(1).

Finally, petitioners have never claimed to be surprised by respondent's interpretation of the notice of deficiency. Their arguments on brief strike us as technical in nature and not based on any prejudice to their position. See Schuster's Express, Inc. v. Commissioner, 66 T.C. 588, 593-594 (1976), affd. without published opinion 562 F.2d 39 (2d Cir. 1977); Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601, 617

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(1964); cf. Graham v. Commissioner, 79 T.C. 415, 423-424 (1982).

We turn now to the question of the burden of proof. Fortunately, we need not decide whether respondent has presented a new matter or merely a new reason with respect to the issue of intent and the deductibility of the two church sites because our disposition of that issue does not depend on which party bears the burden of proof. B. CHARITABLE INTENT

As a general rule, section 170(a)(1) allows as a deduction any charitable contribution payment of which is made within the taxable year. The term "charitable contribution" is defined by section 170(c) to mean a contribution or gift to or for the use of several types of donees described therein. Neither the statute nor the regulations, however, define what is meant by "contribution or gift."

In Commissioner v. Duberstein, 363 U.S. 278 (1960), the Supreme Court, in defining the term "gift" for purposes of section 22(b)(3), I.R.C. 1939, the predecessor of section 102(a), stated as follows:

the Court has shown that the mere absence of a legal or moral obligation to make such a payment does not establish that it is a gift. * * * And, importantly, if the payment proceeds primarily from "the constraining force of any moral or legal duty," or from "the incentive of anticipated benefit" of an economic nature, * * * it is not a gift. And, conversely, "where the payment is in return for services rendered, it is irrelevant that the donor derives no economic benefit from it." * * * A gift in the statutory sense, on the other hand, proceeds from a "detached and disinterested generosity, * * * out of affection, respect, admiration, charity or like impulses." * * * And in this regard, the most critical consideration * * * is the transferor's "intention." [ Commissioner v. Duberstein, 363 U.S. at 285; fn. ref. omitted.]

Duberstein's detached and disinterested generosity test has been generally adopted by the courts as the appropriate standard by which to determine whether an individual has made a charitable contribution under section 170. See, e.g., DeJong v. Commissioner, 309 F.2d 373, 379 (9th Cir. 1962), affg. 36 T.C. 896 (1961); Fausner v. Commissioner, 55 T.C. 620, 624 (1971), affd. per curiam on another issue 472 F.2d 561 (5th Cir. 1973), and 413 U.S. 838 (1973); Wolfe v. Commissioner, 54 T.C. 1707, 1713-1714 (1970). See generally Southern Pacific Transportation

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Co. v. Commissioner, 75 T.C. 497, 602 n. 114 (1980). ¹²⁵ However, that test has been criticized as inappropriate to determine whether a business entity, such as a partnership, has made the requisite contribution or gift. See, e.g., Singer Co. v. United States, 196 Ct. Cl. 90, 449 F.2d 413 (1971); cf. Marquis v. Commissioner, 49 T.C. 695, 702 (1968). The Ninth Circuit, to which an appeal in this case would lie, has been particularly active in refining Duberstein's standard for cases involving business entities.

In United States v. Transamerica Corp., 392 F.2d 522, 524 (9th Cir. 1968), the Court of Appeals held that an indirect business benefit, "such as one incidental to the public use or to public recognition of its act of generosity," would not disqualify a transfer as a charitable contribution but that a direct economic benefit would. ¹²⁶ In Stubbs v. United States, 428 F.2d 885, 886-887 (9th Cir. 1970), it held that the expectation of a benefit need not be the sole purpose, but rather only the dominant purpose, of a transfer in order to disqualify it for purposes of section 170. See Allen v. United States, 541 F.2d 786, 787-788 (9th Cir. 1976). The Ninth Circuit has not departed from Duberstein, however, insofar as it holds that the critical consideration in determining whether a transfer qualifies as a charitable contribution is the transferor's intention. Collman v. Commissioner, 511 F.2d 1263, 1267 (9th Cir. 1975), affg. in part and revg. in part a Memorandum Opinion of this Court. ¹²⁷

In light of these Ninth Circuit cases, we will now decide whether the partnership's dominant purpose in conveying the three sites was the expectation of a direct economic benefit. This is, of course, a factual inquiry. Allen v. United States, 541 F.2d at 788; see Duberstein v. Commissioner, 363 U.S. at 289 ("Decision of the issue presented * * * must be based ultimately on the application of the fact-finding tribunal's experience with the mainsprings of human conduct to the totality of

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the facts of each case"). On the record before us, we sustain respondent because we think the partnership conveyed the sites in order to enhance the value of its remaining land in Foster City and promote its sale. ¹²⁸

The transfers of the three sites cannot be divorced from the partnership's overall plan for the development of Foster City. As detailed in our findings, Foster City was conceived, designed, and promoted as a totally planned community. Estero's prospectuses, ¹²⁹ for example, promised that "full and adequate provision" would be made for "all community facilities and services required by the resident population," and referred specifically to churches. The prospectuses also emphasized the neighborhood school plan and regularly reported the progress in school construction. These same matters were also highlighted in newspaper and magazine advertising, as well as in the promotional and public relations newsletter published by the partnership. The transfers of the sites were therefore designed to encourage the construction of facilities which "helped to make credible the 'sales pitch' of the partnership" that Foster City was a planned community. See Perlmutter v. Commissioner, 45 T.C. 311, 318 (1965).

The Fosters' "sales pitch" obviously assumed that the availability of community facilities such as schools and churches would attract buyers to Foster City and stimulate the demand for land. The transfers of the three sites were therefore also designed to enhance the value of the partnership's remaining land and promote its sale. See Stubbs v. United States, 428 F.2d at 887; Perlmutter v. Commissioner, 45 T.C. at 318; cf. Sutton v. Commissioner, 57 T.C. 239, 242-244 (1971). As previously found, the presence of schools and churches did, in fact, enhance the value of land in Foster City.

The partnership also received a quid pro quo from the local school district in return for the transfer of the school site. In

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this regard, it must be kept in mind that Foster City was expected to have an eventual population of approximately 35,000 people. San Mateo school officials were quite concerned about the obvious impact that such a population would have on their school system. Turmoil developed as Foster City continued to grow. The Fosters, however, could not afford such turmoil because they needed the cooperation of the school district if their highly publicized school plan were to succeed. In order to make peace with the district and secure its cooperation, they offered to donate the site for the first school.

The Fosters also used the school site as leverage to persuade the district to abandon its threat to cancel bus service to the school children of Foster City. The cancellation of such service would have upset the existing residents and would have made Foster City less attractive to many prospective buyers. The district agreed to continue the service only after the Fosters threatened to withdraw their offer to donate the site. C. AMORTIZATION CAPITALIZATION OF THE SCHOOL SITE

In the alternative, petitioners contend that if the transfers were not made with the requisite charitable intent, the cost of the school site ¹³⁰ should either be amortized over the period during which there was no elementary school operating in Neighborhood One or capitalized as part of the partnership's basis in only the residential acreage of that neighborhood. In the notice of deficiency, respondent capitalized the cost of that site as part of the partnership's basis in all of its remaining land in Foster City, including the other neighborhoods.

Petitioners' amortization argument assumes that the partnership conveyed the school site solely in exchange for the local school district's agreement to continue to provide bus service pending construction of the first elementary school in Foster City. In other words, petitioners view the transfer of the site as a cost of securing bus service during that period, which cost should be amortized in full over the period benefited. As

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discussed above, however, this was simply not the case. The need to make peace with the school district and secure its cooperation was the motivation for the partnership's original offer to convey the site; it was only subsequently that it expressly conditioned the transfer on continued busing. Moreover, the transfer was ultimately intended to enhance the value and promote the sale of the partnership's other land. The reasonable life of these benefits was not confined to the period during which there was no elementary school operating in Neighborhood One.

Petitioners' capitalization argument assumes that the transfer of the school site benefited only the residential land in Neighborhood One because each neighborhood was designed to have its own elementary school. Although we tend to agree that the transfer's impact was greater on the residential land in Neighborhood One, it cannot be said that the other neighborhoods were not also benefited to some degree. The transfer was the first step in implementing the partnership's neighborhood school plan. Moreover, it gave credibility to its "sales pitch" that Foster City was a planned community. Both of these factors enhanced the value and promoted the sale of land in all of the neighborhoods and not just in Neighborhood One.

For similar reasons, we think the transfer of the school site also benefited the nonresidential land in Foster City. The Fosters anticipated that business and industry would be attracted to Foster City by the ability to offer prospective employees the benefits of nearby housing and access to a comprehensive array of community facilities and services. As concluded in Estero's 1961 prospectus, "This is expected to provide added inducement to industrial development." Moreover, in a community planned to be "relatively more self sufficient than other Peninsula communities," the value of commercial land was obviously enhanced by facilities and services designed to attract a population of 35,000 people.

In view of the foregoing, we hold that respondent properly capitalized the cost of the school site as part of the partnership's basis in all of its remaining land in Foster City. See Perlmutter v. Commissioner, 45 T.C. at 319; cf. Lots, Inc. v. Commissioner, 49 T.C. 541, 550-551 (1968), affd. per curiam

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sub nom. Christie v. Commissioner, 410 F.2d 759 (5th Cir. 1969). Issue 6 Deductibility of the Payment for Legal Services

This issue involves the deductibility of a 5,000 payment made by the Foster partnership to Roy Lytle's Oklahoma City law firm "for services rendered in connection with advice on income tax matters (state and federal) relating to Brewer's Island, where the work was in conjunction with Senator Richard J. Dolwig." Respondent disallowed the deduction on the ground that the "services of Senator Dolwig [were] not shown to be for business purposes."

Based on his cross-examination of petitioners' witnesses, it appears that respondent thinks the 5,000 represents either an under-the-table payment for legislative favors or a campaign contribution. The record does not demonstrate, however, that Senator Dolwig was the ultimate recipient of the funds. Even if he were, the 5,000 would not necessarily be nondeductible because Dolwig was also a practicing attorney whom the Fosters occasionally retained to provide legal services. In any event, we have found as a fact that the partnership made the payment for legal services. Whether the services were rendered by Roy Lytle or Senator Dolwig or both is of no consequence. The payment was a legitimate business expense and is therefore deductible under section 162(a). Accordingly, we hold for petitioners on this issue. Issue 7 Adjustments Related to the Payment of the Fosters' Personal Expenses

Respondent determined that certain expenses paid by the Foster partnership were personal to the Fosters. Accordingly, he disallowed the corresponding business deductions claimed by the partnership on the ground that those expenses represent "nondeductible personal expenses of the partners." Petitioners concede the propriety of part of the disallowance. Respondent also determined that certain expenses paid by

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Likins-Foster Honolulu Corp. and two of its subsidiaries were personal to the Fosters. He characterized these payments as "informal dividends-travel" and charged the Fosters with ordinary income in an equivalent amount. Petitioners dispute that any part of these payments constitute dividends.

Petitioners challenge the adjustments made by respondent on three grounds. First, they contend that respondent bears the burden of proof on this issue and that he has not successfully discharged it. Second, they contend that even if they bear the burden of proof, they have carried it through evidence descriptive of the mechanics of their recordkeeping system. Third, they contend that the disallowance of a deduction under section 274 does not give rise to a dividend. We shall consider each of these contentions in turn. A. BURDEN OF PROOF

Petitioners recognize that "A statutory notice ordinarily carries with it a presumption of correctness that, except where provided in the Internal Revenue Code or the Tax Court Rules of Practice and Procedure, places the burden of proof and the burden of going forward with the evidence on [them]." Llorente v. Commissioner, 74 T.C. 260, 263-264 (1980), revd. in part 649 F.2d 152 (2d Cir. 1981). See Welch v. Helvering, 290 U.S. 111, 115 (1933); Rule 142(a). ¹³¹ They argue, however, that (1) respondent's "interminable delay" in issuing the notice of deficiency, (2) his failure to identify therein the specific partnership and corporate expenditures which were disallowed, and (3) the alleged misconduct of his revenue agent in "scrambling" their records serve to shift the burden of proof. ¹³² We disagree.

1. Delay

The defense of laches is a purely equitable doctrine which is generally peculiar to courts of equity. See generally 27 Am. Jur. 2d, Equity, secs. 152-176 (1966); 30A C.J.S., Equity, secs.

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112-132 (1965). Compare Pesch v. Commissioner, 78 T.C. 100, 130-131 (1982), with Southern Pacific Transportation Co. v. Commissioner, 75 T.C. 497, 840-842 (1980). It is not available where a period of time in which an action may be brought is fixed by statute. United States v. Manufacturers Hanover Trust Co., 229 F. Supp. 544, 545-546 (S.D. N.Y. 1964).

We have previously held that this Court is not at liberty to modify a fixed period prescribed by a statute of limitations in which the Commissioner is authorized to act. Saigh v. Commissioner, 36 T.C. 395, 424-425 (1961). ¹³³ In the present case, section 6501 expressly defines the period in which respondent is authorized to assess deficiencies against taxpayers. See also section 6503(a). Petitioners do not contend that the issuance of the notice was untimely under that section. ¹³⁴

2. Nonspecificity

Neither section 6212(a), which authorizes the sending of the notice of deficiency, nor any other section of the Internal Revenue Code prescribes the form of a notice or specifies the contents or information required to be included therein. Jarvis v. Commissioner, 78 T.C. 646, 655-656 (1982). The Treasury regulations are also silent. See, e.g., sec. 301.6212-1, Proced. & Admin. Regs. All that we have required is that the notice fulfill its purpose of providing formal notification that a deficiency in tax has been determined. Pietz v. Commissioner, 59 T.C. 207, 213-214 (1972); Mayerson v. Commissioner, 47 T.C. 340, 349 (1966); Standard Oil Co. v. Commissioner, 43 B.T.A. 973, 998 (1941), affd. 129 F.2d 363 (7th Cir. 1942). Accord Olsen v. Helvering, 88 F.2d 650, 651 (2d Cir. 1937), wherein Judge Learned Hand stated that "the notice is only to advise the person who is to pay the deficiency that the Commissioner means to assess him; anything that does this unequivocally is good enough." In other words, the notice must (1) fairly advise

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the taxpayer that the Commissioner has, in fact, determined a deficiency and (2) specify the year and amount. Commissioner v. Stewart, 186 F.2d 239, 242 (6th Cir. 1951), revg. on other grounds a Memorandum Opinion of this Court. ¹³⁵

Petitioners do not cite any case in support of their position that the burden of proof is shifted to respondent if he fails to identify in the notice of deficiency the specific expenditures which are disallowed. We have previously considered similar contentions and rejected them. See, e.g., Pietz v. Commissioner, 59 T.C. at 213-214; Mayerson v. Commissioner, 47 T.C. at 348; Barnes Theatre Ticket Service, Inc. v. Commissioner, T.C. Memo. 1967-250, affd. sub nom. Barnes v. Commissioner, 408 F.2d 65, 68 (7th Cir. 1969). ¹³⁶ We can see no reason to take any different position here.

We are not unsympathetic to a taxpayer's desire to simplify his burden of proof by ascertaining the specific expenditures which respondent has disallowed. ¹³⁷ In fact, our Rules provide a mechanism by which to achieve this objective. Thus, they contemplate that after the case is at issue the parties will informally confer in order to exchange necessary facts, documents, and other data with a view towards defining and narrowing the areas of dispute. Rules 38, 70(a)(1), 91(a). See Branerton Corp. v. Commissioner, 61 T.C. 691, 692 (1974). If a party is frustrated by his adversary in an effort to obtain needed information voluntarily, he may resort to discovery under Rules 70 through 72, including interrogatories under Rule 71. If his adversary unjustifiably refuses to respond he may seek an enforcement order and sanctions under Rule 104. A party may also request a pretrial conference under Rule 110. In appropriate cases, the Court will undertake to confer with the parties in order to, inter alia, narrow the issues, simplify the presentation of evidence, and otherwise assist in

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the preparation for trial. Rule 110(a). Appropriate pretrial orders may be issued in furtherance of these objectives. Rule 110(e).

3. Misconduct

We come now to petitioners' contention that the examining revenue agent "so scrambled the Fosters' files that many vouchers, payments and supporting documents are permanently disassociated, and as to them the evidence * * * is no longer available. Proof is impossible, as to some items, through Respondent's own wrongdoing."

We think it is conceivable that a revenue agent's conduct could be so reprehensible that the integrity of the judicial process would demand that we take appropriate remedial action. Such action might very well include shifting the burden of going forward with the evidence, or even shifting the burden of proof, to the Commissioner. However, we do not think that this is such a case.

Petitioners undercut their position by their previous contention that the notice of deficiency failed to identify the specific expenditures which were disallowed. By complaining of that failure they admit, in effect, that had they only known what specific expenditures were in question, they would have been able to prove that those expenditures were business-related rather than personal.

Petitioners also undercut their position by their admission that during the administrative appeal stage of their case they were able to effect a reduction in the disallowance of the expenses in question by presenting additional information to the appeals officer. ¹³⁸ Such settlement simply belies their contention that they were unable to offer proof as to this issue.

We note that petitioners do not claim that the revenue agent scrambled all of their records but only "many," so that proof as to "some" items became impossible. Nevertheless, petitioners did not introduce evidence on any of the disputed expenses. The only records which they introduced at trial were for the purpose of illustrating the mechanics of their recordkeeping

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system. (See B., infra.) Oddly enough, these records appear to be in perfect shape, despite the fact that they were selected at random.

We also note that even if petitioners' records were in such a "scrambled" state that documentary support could not be located, they were not precluded from presenting oral testimony as to the nature of the expenses. However, they offered no specific testimony whatsoever that the disallowed expenses were business related.

Finally, the revenue agent examined petitioners' records in their offices in the Foster Building in Foster City and did not remove them from the premises. Thus, the records were under their ultimate control at all times. In addition, petitioners' former office manager testified that he was aware during the examination that the agent was "disassociating" records. Apparently, however, he did not think the problem was serious enough to either restrict the agent's access to the file room or to assign an employee to oversee his treatment of the documents or to substitute copies for the original records.

In support of their effort to shift the burden of proof, petitioners rely heavily on United States v. Janis, 428 U.S. 433 (1976), and Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir. 1979), revg. 67 T.C. 672 (1977). However, we think both cases are inapposite to the issue before us.

In United States v. Janis, supra, the Commissioner assessed under section 4401 wagering excise tax against the taxpayer. The assessment was based exclusively on evidence obtained by the Los Angeles police pursuant to a search warrant, which was subsequently quashed after a hearing as to the adequacy of the supporting affidavit. The issue involved the question whether evidence illegally seized by a local law enforcement officer was admissible in a civil tax proceeding brought by or against the United States. In deciding that issue, the Supreme Court briefly discussed the presumption of correctness enjoyed by the Commissioner and the circumstances under which the burden of proof may be shifted. Citing Helvering v. Taylor, 293 U.S. 507, 514-515 (1935), the Court stated that if the illegally seized evidence could not be used as the basis for the assessment, "The determination of tax due then may be one

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'without rational foundation and excessive,' and not properly subject to the usual rule with respect to the burden of proof in tax cases." United States v. Janis, 428 U.S. at 441. It characterized such an assessment as "naked."

Janis is therefore inapposite for two reasons. First, given the nature of the present issue it cannot be said that respondent's determination was "utterly without foundation." United States v. Janis, 428 U.S. at 442. Deductions are a matter of legislative grace and it is ordinarily incumbent upon a taxpayer to prove his entitlement thereto. ¹³⁹New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Second, as we observed in Llorente v. Commissioner, 74 T.C. at 265, the Supreme Court's reference to a "naked assessment" was made in the context of illegally seized evidence. There is absolutely no suggestion in the present case that the notice of deficiency was predicated on such evidence.

In Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir. 1979), revg. 67 T.C. 672 (1977), the Commissioner determined that the taxpayer had unreported income from the sale of narcotics. He relied on the presumption of correctness and at trial called no witnesses and introduced no evidence to link the taxpayer to the alleged income-producing activity. The Court of Appeals held that "before the Commissioner can rely on this presumption of correctness, the Commissioner must offer some substantive evidence showing that the taxpayer received income from the charged activity." Weimerskirch v. Commissioner, supra at 360. The rationale for this holding was the difficulty that such a taxpayer might have in proving a negative, absent such a showing by the Commissioner.

In deduction cases, however, the taxpayer is not required to prove a negative but rather must adduce positive evidence to establish his entitlement to a particular deduction. Beck v. Commissioner, 74 T.C. 1534, 1548 (1980), affd. 678 F.2d 818 (9th Cir. 1982). ¹⁴⁰ The adjustments in question made by respondent to the partnership's returns involve the disallowance of deductions. His determination that petitioners received constructive

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dividends from Likins-Foster Honolulu Corp. and certain of its subsidiaries is predicated on his disallowance of deductions claimed by corporations owned and controlled by the Fosters. Thus, Weimerskirch is inapposite because that case involved unreported income.

B. SUFFICIENCY OF PETITIONERS' EVIDENCE

Having decided that petitioners bear the burden of proof on the present issue, we turn now to the sufficiency of their evidence. We begin by noting that they introduced no specific evidence whatsoever to establish that the expenses in question were business related rather than personal. Rather, they presented considerable evidence, principally testimony, which in their view was designed to show --

1. The existence of a system for claiming reimbursement for travel and entertainment expense devised by two certified public accountants specifically to obtain the supporting documentation required to comply with Section 274;

2. Examples selected at random of the form used to elicit supporting facts and documentation, which can be seen to be effective to satisfy Section 274;

3. Administration of the system by an executive vested with the authority to deny reimbursement where the forms did not contain sufficient substantiation to satisfy Section 274, whose authority extended alike to principals and employees;

4. That executive's impartial employment of his authority to deny many claims of reimbursement by partners or owners;

5. Preparation of the tax returns by the independent firm of auditors, who paid particular attention to compliance with Section 274 including random sampling and checking.

6. There is testimony from both [CPAs] that each made a determined effort to prevent any incomplete or inadequate claims for reimbursement from producing deductions in the tax return.

In effect, petitioners ask us to substitute their judgment for our own in deciding this issue. To do so, however, would stultify the judicial process and render nugatory our statutory mandate to redetermine deficiencies. See generally secs. 6211-6215 and 7442. This we are unwilling to do. One might ask what taxpayer would impeach his own recordkeeping system or what taxpayer would deny his entitlement to a deduction. It must be apparent that self-certification cannot be a substitute for proper proof. Accordingly, we decline petitioners' invitation to evaluate their recordkeeping system. Whatever their evidence might tend to prove about the adequacy of that

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system to accomplish its intended purpose is simply insufficient to carry their burden of proof. ¹⁴¹ Cf. Halle v. Commissioner, 7 T.C. 245, 247-248 (1946), affd. 175 F.2d 500 (2d Cir. 1949).

C. ROLE OF SECTION 274

Petitioners maintain that "Section 274 does not categorize as personal a travel or entertainment expense not supported by the technical recordkeeping requirements of Section 274." Accordingly, they argue, the disallowance of a deduction under that section should not give rise to a dividend.

Petitioners' argument misses the mark. They overlook the fact that respondent disallowed the item denominated "travel and entertainment" not because of the partnership's failure to comply with the recordkeeping requirements of section 274, but rather because he determined that the expenses in question were personal and not business-related. ¹⁴² Although the record does not include a copy of the notice of deficiency issued to Likins-Foster Honolulu Corp. and its subsidiaries, it would appear (based on the notices issued to petitioners) that respondent disallowed the corporations' deductions for the very same reason. Thus, the factual predicate for petitioners' argument is lacking.

Petitioners' argument falls short for yet another reason. Although we agree that an expenditure which is rendered nondeductible under section 274(d) is not necessarily converted into a dividend (Ashby v. Commissioner, 50 T.C. 409, 417-418 (1968)), the taxpayer is still required to present some proof that the expenditure was not made for his personal benefit (Henry Schwartz Corp. v. Commissioner, 60 T.C. 728, 743-744 (1973)). ¹⁴³ See also Erickson v. Commissioner, 598 F.2d 525, 530-531 (9th Cir. 1979), revg. and remanding on this issue a Memorandum Opinion of this Court. ¹⁴⁴ Petitioners, however,

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did not do this but rather chose to rely on evidence descriptive of the mechanics of their recordkeeping system. We have already held that such evidence is insufficient to carry their burden of proof.

Issue 8 Characterization of the Payments Made to Gladys Foster

On her 1963 through 1967 income tax returns, Gladys Foster reported compensation received from Likins-Foster Honolulu Corp. and certain of its subsidiaries in the aggregate amount of 60,000. In the notice of deficiency, respondent determined that this amount was understated by 10,761.82. He also determined that the revised amount, in its entirety, represents dividends rather than compensation. In contrast, petitioners contend that Gladys Foster rendered services as a decorator to several Foster-controlled entities and received a salary.

On brief, petitioners appear to concede this issue insofar as it relates to the amount of income. ¹⁴⁵ On the other hand, they vigorously dispute respondent's characterization of that income.

We think the income characterization issue is moot because it has no apparent impact on the computation of the deficiencies determined by respondent in Jack and Gladys Foster's income taxes for 1963 through 1967. ¹⁴⁶ See Roemer v. Commissioner, 79 T.C. 398, 410-411 (1982), on appeal (9th Cir., Nov. 15, 1982). Whether the payments are viewed as dividends or compensation, the result is additional ordinary income under section 61(a). We recognize, of course, that characterization is

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occasionally necessary in order to properly apply particular sections of the Internal Revenue Code. ¹⁴⁷ However, petitioners have not isolated, nor are we aware of, any such section relevant to this case which necessitates that we characterize the payments received by Gladys Foster. We suspect that petitioners would like us to decide this issue because the deductibility of the payments in question is an issue in a related case involving Likins-Foster Honolulu Corp. ¹⁴⁸ That case, however, has not been consolidated with the present one. Under these circumstances, we think it would be ill advised for us to decide the issue of deductibility at the corporate level in the context of this case. Accordingly, we express no opinion on the matter. Respondent's determination of additional income is sustained.

Issue 9 Additions to Tax

Respondent determined that Jack Foster and Gladys Foster are liable for additions to tax under section 6653(a) for negligence or intentional disregard of rules and regulations for the taxable years 1963 through 1967. He did not determine that any of the other petitioners are liable for that addition.

We have repeatedly held that taxpayers bear the burden of proving error in the Commissioner's determination of their liability for the addition to tax under section 6653(a). See, e.g., Bixby v. Commissioner, 58 T.C. 757, 791-792 (1972); Enoch v. Commissioner, 57 T.C. 781, 802 (1972). Although petitioners cite no cases in support of their position, they contend that respondent bears the burden of proof on this issue in the present case. In this regard, they maintain that his determination of the addition was based, in their words, on the "travel and entertainment expenses taken as deductions in the partnership return or in the returns of corporations, which the deficiency letters would treat as dividends." They then argue that a negligence penalty based on an arbitrarily determined

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substantive adjustment is itself arbitrary, and doubly so when it is asserted against just one person rather than everyone who is subject to the substantive adjustment.

Petitioners' contention is without merit because its factual predicate is faulty on two grounds. First, as we have already held (see Issue 7, supra), there was nothing arbitrary in respondent's determination related to the payment of the Fosters' personal expenses by the partnership and corporations. Second, the record does not support petitioners' assertion that the addition to tax was predicated on that particular determination. Indeed, on brief, respondent argues that we should sustain the addition because "T. Jack Foster, a lawyer himself, directed his inhouse tax advisor, A. O. Champlin to avoid Federal income tax by devising schemes to cover up the true economic substance of transactions."

Admittedly, the adjustments which respondent relies on in support of the additions to tax, i.e., the section 482 and Westway adjustments (see Issues 1 through 3, supra), are partnership adjustments which affect all of the Fosters. However, in Marcello v. Commissioner, T.C. Memo. 1964-299, affd. on this issue 380 F.2d 499, 505-507 (5th Cir. 1967), we recognized the possibility that special circumstances could justify assertion of the addition against fewer than all of the partners. In the present case, as will be recalled, Jack Foster was the ultimate authority among the Fosters. In our view, this fact provides a rational basis for respondent to only assert the addition against him. ¹⁴⁹

We think that the burden of proof rests with petitioners. In our judgment, they have failed to carry it. On brief, they confined themselves to the question of whether respondent acted arbitrarily and presented no alternative argument. Moreover, the evidence relevant to the section 482 and Westway issues, and hence to this issue, favors respondent. ¹⁵⁰ Accordingly, we sustain him on this issue. ¹⁵¹

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When we began this case, we were reminded that Lao-tzu once said "A journey of a thousand miles must begin with a single step." Having completed it, we prefer to recall Ecclesiastes 7:8, "Better is the end of a thing than the beginning thereof."

In order to give effect to the parties' concessions and our disposition of the disputed issues,

Decision will be entered under Rule 155.

Footnotes ⁶² SEC. 351. TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR.

(a) General Rule. -- No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation. For purposes of this section, stock or securities issued for services shall not be considered as issued in return for property.

An amendment made to this section by sec. 203(a), Pub. L. 89-809, 80 Stat. 1539, 1577, in 1966 is not relevant to the issue before us and is not reflected above. ⁶³ SEC. 1032. EXCHANGE OF STOCK FOR PROPERTY.

(a) Nonrecognition of Gain or Loss. -- No gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation. ⁶⁴ SEC. 362. BASIS TO CORPORATIONS.

(a) Property Acquired by Issuance of Stock or as Paid-In Surplus. -- If property was acquired on or after June 22, 1954, by a corporation --

(1) in connection with a transaction to which section 351 (relating to transfer of property to corporation controlled by transferor) applies, or (2) as paid-in surplus or as a contribution to capital,

then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain recognized to the transferor on such transfer.

See sec. 1.362-1(a), Income Tax Regs.; see also sec. 1032(b).

/65/From the transferor's point of view, his basis in the transferred property is substituted as the basis of the stock received. Sec. 358(a)(1); sec. 1.358-1(a), Income Tax Regs.

⁶⁶ SEC. 118. CONTRIBUTIONS TO THE CAPITAL OF A CORPORATION.

(a) General Rule. -- In the case of a corporation, gross income does not include any contribution to the capital of the taxpayer.

⁶⁷ T.C. Memo. 1963-119.

⁶⁸ This section was not adopted until April 1968. Assuming its validity, an issue which we shall shortly address, there is no question that it applies to all of the years before us. Sec. 7805(b); T.D. 6952, 1968-1 C.B. 218; Cayuga Service, Inc. v. Commissioner, T.C. Memo. 1975-4; see Rev. Proc. 66-33, 1966-2 C.B. 1231.

⁶⁹ See also Berger, Gilman & Stapleton, "Section 482 and the Nonrecognition Provisions: An Analysis of the Boundary Lines," 26 Tax Law. 523, 531 (1973), who maintain that the arm's-length bargaining standard "is not the test of whether or not section 482 will override an applicable nonrecognition provision [but] merely the remedy to be applied if * * * section 482 is held to override nonrecognition principles." (Emphasis in original.)

⁷⁰ The Commissioner later conceded that a small part of the loss, equal to the decline in value of the stock between the dates of the exchange and the subsequent sale, was deductible by the taxpayer.

⁷¹ The sections involved were actually the predecessors of those cited, i.e., secs. 112(b)(5), 113(a)(8), and 45, respectively, of the Revenue Act of 1936, ch. 690, 49 Stat. 1648, 1679, 1683, 1667-1668.

⁷² For recent commentary on this case, see Note, "Ruddick Corp. v. United States: Section 482 and the Nonrecognition Provisions," 2 Va. Tax Rev. 143 (1982).

⁷³ The record does not enable us to state with any degree of certainty the percent to which Neighborhood One had been completed by Oct. 3, 1962. However, it was sufficiently well along so that negotiations for the sale of lots in that neighborhood began in 1962. Moreover, by Nov. 1962 the Fosters were projecting income by January 1963.

⁷⁴ Estero's role in the development of Foster City and its relationship to the Foster partnership will be discussed in the context of our analysis of that part of the income which was earned subsequent to Oct. 3, 1962.

⁷⁵ That section provides in part as follows:

"The method of allocating, apportioning, or distributing income * * * shall be determined with reference to the substance of the particular transactions or arrangements which result in the avoidance of taxes or the failure to clearly reflect income. [Emphasis added.]"

Although sec. 1.482-1(d)(1), Income Tax Regs., was not adopted until April 1968, it applies to all of the years before us. See note 68, supra.

⁷⁶ See the sections of the Estero Act quoted above in note 14.

⁷⁷ See sec. 94 of the Estero Act quoted above in note 11 and the other sections of the act quoted in note 12.

⁷⁸ Sec. 215(f) of the Estero Act provided in part as follows:

"The land in the district is not owned by residents. The owners are the ones primarily concerned with the district and the ones who will be supporting the district. The owners should therefore hold the voting power."

See also the sections of the act quoted above in note 10.

⁷⁹ In June 1963, the Estero Act was amended to require that one of the three directors of the board be a public member designated and appointed by the Board of Supervisors of San Mateo County. The landowners still controlled the board, however. Two board members constituted a quorum for the transaction of business; the same number was required to pass an ordinance, resolution, motion, or contract.

⁸⁰ See the preceding footnote.

⁸¹ We might also mention that Shannon's name was printed on the Fosters' internal routing slips along with the names of the principals in the Foster organization.

⁸² "The Quiet Alliance," 38 So. Cal. L. Rev. 72 (1965). This article was cited by the California Supreme Court in Cooper v. Leslie Salt Co., 70 Cal. 2d 627, 451 P.2d 406, 409, and Burrey v. Embarcadero Municipal Improvement Dist., 5 Cal. 3d 671, 488 P.2d 395, 396. Its author testified at the trial in this case.

⁸³ A few examples which come to mind include the Hillsdale-Marina Lagoon Bridge, the water supply line, the sewage disposal plant, and the sewer outfall line.

⁸⁴ T. Jack Foster & Sons, Inc., was incorporated in June 1964; Lomita Homes, Inc., built homes in San Diego during the early 1950's.

⁸⁵ Petitioners claim that the carryback of operating losses subsequently incurred by the Alphabets because of the construction of the Commodore Apartments could not have been foreseen in 1962.

⁸⁶ Petitioners argue that it would have been awkward for them to transfer the lots to Likins-Foster because their stock ownership in that corporation, unlike Foster Enterprises, was unequal among themselves. However, that fact would not have been of consequence to Republic and was not even mentioned by Johnson in his testimony. In addition, the Fosters pledged their stock in Likins-Foster as security for the partnership notwithstanding their equal interests therein.

⁸⁷ Republic's practice of requiring the Fosters to personally guarantee the indebtedness of their various entities also exposed the bank to the vicissitudes of their business fortune and demonstrates that it regarded them as the ultimate source of collection.

⁸⁸ We might add at this point that we are equally skeptical of Johnson's testimony that he also insisted on the December 1963 transfer by the Foster partnership of 500 shares of stock in Foster California Corp. to Foster Enterprises in order to improve the liquidity of the latter corporation. This particular transfer was, of course, part of the Westway transaction. See Issue 2, infra.

⁸⁹ In their reply brief, petitioners appear to raise an issue concerning the amount of the income to be reallocated, presumably because in July 1966 the partnership reduced the asking price of nonwaterfront lots in Neighborhood Four from 7,800 per lot to 6,800 per lot, whereas the average sales price of the 200 lots sold in February and March 1967 was 7,582 per lot. Contrary to petitioners' contention, "this Court may allocate income under the statute [sec. 482] in a manner the evidence before us demonstrates to be correct and * * * respondent's allocation need not be approved or disapproved in toto." Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601, 617-618 (1964). See Ach v. Commissioner, 42 T.C. 114, 126-127 (1964), affd. 358 F.2d 342 (6th Cir. 1966); Bell v. Commissioner, T.C. Memo. 1982-660, slip opinion at 41-43. However, even if we were to disregard the motivation for the transfer, the obvious shifting of income, and the partnership's status as its true earner, petitioners have not convincingly demonstrated that some lesser amount should be reallocated. The fair market value of the nonwaterfront lots on the date of their transfer has not been established by appraisal or other competent evidence. Moreover, the record is silent concerning the market value of the waterfront lots. Finally, the fact that the housing market was weak in 1966, combined with the fact that the Cooper litigation, which commenced in December 1966, adversely affected the sale of lots, leads us to think that there was little, if any, potential for appreciation from August 1966 to February/March 1967.

⁹⁰ Petitioners do not contend that the Foster partnership ever elected under sec. 1361 to be taxed as a domestic corporation.

⁹¹ Petitioners appear to have overlooked the possible application of the mitigation provisions of secs. 1311 through 1314. See B. Bittker & J. Eustice, supra at par. 2.01, pp. 2-4 -- 2-5.

⁹² Characteristics other than those specifically enumerated in the regulation may be considered if helpful in resolving the classification issue. Sec. 301.7701-2(a)(1), Proced. & Admin. Regs. However, petitioners have not identified any such additional characteristics.

⁹³ In this regard the agreement, as restated in August 1963, provided as follows:

"9. This partnership shall continue for a term of twenty (20) years from the date hereof and from year to year thereafter, provided that until August 7, 1983 no partner may retire without the consent of all other partners * * *

"11. In the event any partner shall die, either within the primary term of the partnership, or thereafter, said partnership shall, for all purposes, continue despite the death of one or more of said partners * * *"

⁹⁴ We should not be understood to imply that we necessarily agree with petitioners that Estero possessed the three corporate characteristics previously mentioned. Under the view we take, it is unnecessary to determine which corporate characteristics the district may have had.

⁹⁵ As will be recalled, Foster Enterprises experienced large net operating losses during the 1960's.

⁹⁶ The term "controlled taxpayer" is defined by sec. 1.482-1(a)(4), Income Tax Regs., to mean "any one of two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests."

⁹⁷ See note 57, supra, for the full text of sec. 45, Revenue Act of 1928.

⁹⁸ In this regard, H. Rept. 2, 70th Cong., 1st Sess. (1927), 1939-1 C.B. (Part 2) 384, 395, provided as follows:

"Section 45 is based upon section 240(f) of the 1926 Act, broadened considerably in order to afford adequate protection to the Government made necessary by the elimination of the consolidated return provisions of the 1926 Act. * * *

"It has been contended that section 240(f) of the 1926 Act permits what is in effect the filing of a consolidated return by two or more trades or businesses, even though they are not affiliated within the meaning of the section. Section 45 of the bill prevents this erroneous interpretation by eliminating the phrase 'consolidate the accounts.'"

⁹⁹ Sec. 45, Revenue Act of 1932, ch. 209, 47 Stat. 169, 186.

¹⁰⁰ Sec. 45, Revenue Act of 1934, ch. 277, 48 Stat. 680, 695. The amendment consisted of the addition of the word "organizations" to the phrase "trades or businesses." See H. Rept. 704, 73d Cong., 2d Sess. (1934), 1939-1 C.B. (Part 2) 554, 572.

¹⁰¹ See also sec. 1.482-1(b)(3), Income Tax Regs., which provides that sec. 482 --

"is not intended * * * to effect in any case such a distribution, apportionment, or allocation of gross income, deductions, credits, or allowances, or any item of gross income, deductions, credits, or allowances, as would produce a result equivalent to a computation of consolidated taxable income * * *"

¹⁰² We should not be understood to imply that a notice of deficiency is invalid or otherwise legally defective if it fails to advise a taxpayer of the Commissioner's theory behind a particular adjustment. In this regard, see and compare Issue 7(a), particularly the discussion on pp. 229-231.

¹⁰³ T.C. Memo. 1971-200.

¹⁰⁴ See also Hale v. Commissioner, T.C. Memo. 1965-274, 24 T.C.M. 1497, 1506-1507, 34 P-H Memo T.C. par. 65, 274, at 65-1651.

¹⁰⁵ In form, the 2 million advance was arranged by the Howard Corp. and made by a foundation affiliated with Republic. This matter will be discussed further, infra.

¹⁰⁶ Foster Bayou had no assets other than the 200.17 acres of land which had been transferred to it by the Foster partnership at the time of its incorporation in August 1961. Moreover, it had no bank account and never paid any dividends. The corporation's only business activity was a lease to the Federal Aviation Administration. The lease, however, was managed by the partnership and Likins-Foster Honolulu Corp. for a substantial fee.

¹⁰⁷ In this regard, it should be recalled that at the time Esteroy pledged its shares as collateral for the "purchase" of the Foster Bayou stock, it reserved the right to liquidate and substitute the personal guarantee of the Fosters for the pledged shares. On June 8, 1964, Esteroy was liquidated by the Foster partnership, and on July 24, 1964, the Fosters expressly and unconditionally assumed the Westway notes. In addition, Esteroy was formed, owned, and controlled by the partnership.

¹⁰⁸ Petitioners have raised no issue concerning the effect, if any, that a usurious rate of interest may have on the status of interest. See Peterson v. United States, 344 F.2d 419, 425-427 (5th Cir. 1965); see also Russo v. Commissioner, 68 T.C. 135, 146-147 (1977); see generally 2 B. Bittker, Federal Taxation of Income, Estates and Gifts, par. 31.1.2, at 31-8/9 (1981). Accordingly we have not addressed that issue but rather have confined ourselves to the issue of substance over form.

¹⁰⁹ See also Hale v. Commissioner, T.C. Memo. 1965-274, 24 T.C.M. 1497, 1506-1507, 34 P-H Memo T.C. par. 65,274, at 65-1651. We are also reminded of Juliet's famous line: What's in a name? that which we call a rose By any other name would smell as sweet. Romeo and Juliet, Act II, sc. 2, 1.43.

¹¹⁰ We must emphasize, however, that the bank's risk only involved the 100-percent bonus; the underlying principal was payable absolutely and in all events, as was interest at the prevailing market rate.

¹¹¹ In form the original 2 million loan was arranged by the Howard Corp. and made by the Hoblitzelle Foundation. The Fosters satisfied this loan in August 1963 by borrowing 2 million from Republic. They also borrowed 1 million directly from Republic in August 1961 (500,000) and August 1962 (500,000).

¹¹² Here, the relationship was apparently so close that petitioners also stipulated that Howard was owned by the bank.

¹¹³ We might add that Bert Levit, the Fosters' attorney in the State court action involving Del Champlin (see pp. 120-121, supra), came to the same conclusion that we have reached. At the deposition of Jack Foster, Jr., in 1971, Levit stated as follows:

"It seems clear to me that, from the point of view of the Fosters, it [the 100-percent bonus] was a payment of additional interest -- although illegal interest -- for the loaning of the money and presumably would have been a cost of doing business."

¹¹⁴ Petitioners appear to assume that if we accept their alternative contention, the Westway notes will be added to the partnership's basis in Neighborhoods Two and Three, thereby eliminating that part of the deficiencies involved in this case which are attributable to the Westway issue. They overlook the fact, however, that the indebtedness which spawned the notes was incurred to acquire all of Brewer's Island and not just those two neighborhoods.

¹¹⁵ Sec. 301.7701-16, Proced. & Admin. Regs., provides that terms which are defined in sec. 7701 but not in the corresponding definitional sections of the regulations "shall, when used in this chapter, have the meanings assigned to them in sec. 7701." (Emphasis added.) The reference to "this chapter" does not contemplate ch. 79 of the Internal Revenue Code, the chapter within which sec. 7701 falls, but rather ch. 1, tit. 26 C.F.R., the chapter within which sec. 1.266-1, Income Tax Regs., falls.

¹¹⁶ However, interest which is paid is not deductible if the deduction would result in a material distortion of income. Baird v. Commissioner, 68 T.C. 115, 130-131 (1977). For the congressional solution to the issue concerning the deductibility of prepaid interest by a cash-basis taxpayer, see sec. 461(g), enacted by sec. 208(a), Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1520, 1541-1542.

¹¹⁷ Compare Parkland Place Co. v. United States, 248 F. Supp. 974, 977 (N.D. Tex. 1964), affd. per curiam 354 F.2d 916, 918 (5th Cir. 1966), in which an accural-basis taxpayer was not permitted to capitalize interest because the interest was "not otherwise deductible" within the meaning of sec. 1.266-1(b)(2), Income Tax Regs., by virtue of sec. 267(a)(2) (relating to the disallowance of deductions for unpaid expenses and interest).

¹¹⁸ Compare secs. 189 and 461(g), which compel taxpayers to capitalize interest under certain circumstances. These sections, however, were enacted subsequent to the taxable years involved herein (see secs. 201(a) and (c) and 208(a) and (b), Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1520, 1525-1527, 1541-1542) and are not otherwise applicable to the present case.

¹¹⁹ We have implicitly assumed that Foster City, itself, constitutes a "project" for purposes of sec. 1.266-1(c)(1), Income Tax Regs. However, it is possible that some unit thereof, such as a neighborhood, may constitute a project. See Sandison & Waters, "More on Tax Planning for Land Developers: Allocations, Deductions, Reporting Income," J. Tax. 154, 156 (1972). Even if that were the case, petitioners have still not carried their burden of proof.

¹²⁰ For the sake of convenience, we shall refer only to the partnership.

¹²¹ Acquiesced, 1948-1 C.B. 2. See also Rev. Rul. 77-414, 1977-2 C.B. 299, for an example of respondent's application of the cost recovery approach sanctioned by Inaja Land Co. in an analogous situation.

¹²² The principle of Inaja Land Co. is applicable, however, in that the taxpayer's basis allocable to the land affected by the easement need not be further allocated to the easement and the rest of the property rights which he retains. In other words, the question of allocating basis arises with respect to property rights, just as it does with respect to acreage, in those instances in which part, but not all, is sold.

¹²³ See also Rev. Rul. 68-291, 1968-1 C.B. 351; Rev. Rul. 59-121, 1959-1 C.B. 212.

¹²⁴ Prior to the Tax Reform Act of 1969, the amount of a deduction for a part-gift/part-sale transfer of ordinary income property was determined by the fair market value of the property at the time of the transfer, reduced by the proceeds received. Secs. 1.170-0 and 1.170-1(c)(1), Income Tax Regs.

¹²⁵ See also Dockery v. Commissioner, T.C. Memo. 1978-63.

¹²⁶ In Sutton v. Commissioner, 57 T.C. 239, 243 (1971), this Court stated that --

"Only where the anticipated or potential economic benefit, if any, to the taxpayer was not significant, or was only "incidental" to an important public-spirited, altruistic, or charitable benevolence, has the court allowed the claimed charitable contribution." ¹²⁷ T.C. Memo. 1973-93.

¹²⁸ Accordingly, we find it unnecessary to address the valuation issue.

¹²⁹ For the reasons set forth above in our discussion of Issue 1, we cannot (unlike petitioners) meaningfully distinguish between the partnership and Estero. We therefore feel comfortable in attributing representations made in the latter's prospectuses to the partnership. Moreover, the general plan ultimately prepared for Estero by Wilsey, Ham & Blair was essentially the same plan originally commissioned by the partnership. It should also be noted that Estero's 1967 prospectus specifically identified the Fosters as the developers of the district.

¹³⁰ This issue does not involve the two church sites because the partnership completely recovered its cost in the "bargain sales." See sec. 1.1001-1(e)(1), Income Tax Regs. Sec. 1.1011-2, Income Tax Regs., which requires allocation of basis in part-gift/part-sale transfers to charitable organizations, applies only to sales and exchanges made after Dec. 19, 1969. Sec. 1.1011-2(d), Income Tax Regs.

¹³¹ See also Adamson v. Commissioner, T.C. Memo. 1982-371.

¹³² We are uncertain whether petitioners advocate shifting just the burden of going forward with the evidence or the ultimate burden of persuasion. On this matter, see Helvering v. Taylor, 293 U.S. 507 (1935), and Solimene v. Commissioner, T.C. Memo. 1982-370, slip op. at 9 n. 5.

¹³³ See also Davies v. Commissioner, T.C. Memo. 1981-438, on appeal (9th Cir., Mar. 2, 1982).

¹³⁴ Apart from the above, which is dispositive of the issue, we question whether petitioners are factually positioned to assert the defense of laches. For example, they voluntarily agreed to extend the normal period within which a deficiency must be assessed. Sec. 6501(c)(4). Moreover, as discussed earlier in this opinion, delay, at least during the period that Del Champlin was their tax adviser, was part of their modus operandi in dealing with respondent.

¹³⁵ Dated Nov. 22, 1949. See also Stevenson v. Commissioner, T.C. Memo. 1982-16.

¹³⁶ See also Arlex Oil Corp. v. Commissioner, T.C. Memo. 1967-235.

¹³⁷ We must confess that in the present case our sympathy is tempered by petitioners' success in reducing the disallowance by presenting additional information regarding the expenses in question during the administrative appeal stage of their case. Our sympathy is also somewhat tempered by references in the record to a revenue agent's massive report. The entire document was not introduced as an exhibit so that we do not know exactly how much detail it may have contained. The few, selected pages which petitioners introduced in order to establish a paucity of detail appear to us, however, to be incomplete.

¹³⁸ According to petitioners' lead counsel, the revenue agent "proposed heavy adjustments in this area, which were greatly modified in the appellate division, but not eliminated." (Emphasis added.)

¹³⁹ It should be kept in mind that respondent's determination of constructive dividends was predicated on his disallowance of deductions claimed by Foster-controlled corporations.

¹⁴⁰ See also Churukian v. Commissioner, T.C. Memo. 1980-205.

¹⁴¹ Were we inclined to do so, we might question the adequacy of petitioners' recordkeeping system on the basis of their concession of the disallowance of substantial personal expenses at both the partnership and corporate levels.

¹⁴² More fundamentally, petitioners' argument is simply inapposite insofar as the consequences of the disallowance of a deduction at the partnership, rather than corporate, level are concerned. In other words, the disallowance of a deduction at the partnership level for whatever reason necessarily affects the partners.

¹⁴³ See also Halpern v. Commissioner, T.C. Memo. 1982-31. ¹⁴⁴ T.C. Memo. 1976-147.

¹⁴⁵ For example, in their proposed findings of fact, petitioners request that we find as follows:

"345. Gladys Foster's compensation for her decorating work of 15,380.16 in 1963, 14,827.68 in 1964, 15,053.63 in 1965, 21,794.07 in 1966, and 3,706.31 in 1967, was reasonable in amount, for each year, for the services rendered to the relevant Foster entities. [Emphasis added; transcript reference deleted.]"

The underscored amounts and years correspond exactly (except for a 3 cents discrepancy in the amount for 1965) with respondent's determination in the notice of deficiency.

¹⁴⁶ Characterization would, of course, affect Gladys Foster's liability for her share of FICA taxes. However, this Court does not have jurisdiction over such taxes. See generally sec. 7442; cf. Shaw v. United States, 331 F.2d 493, 494-495 (9th Cir. 1964); Wilt v. Commissioner, 60 T.C. 977, 978 (1973).

¹⁴⁷ An obvious example is sec. 116 which affords individuals a partial exclusion of certain dividends.

¹⁴⁸ See Likins-Foster Honolulu Corp. and Subsidiaries v. Commissioner, docket No. 5361-78, which is presently before this Court.

¹⁴⁹ We express no opinion whether we necessarily agree that respondent's failure to assert a foundationally sound addition to tax against all similarly situated taxpayers is itself arbitrary, requiring that the burden of proof be shifted.

¹⁵⁰ We might add that we find petitioners' arguments that they were the innocent victims of the Westway transaction and that the regulations precluded them from self-assessing the sec. 482 adjustments to be disingenuous.

¹⁵¹ See Solimene v. Commissioner, T.C. Memo. 1982-370, for an example of a recent case in which we also sustained the Commissioner on the negligence penalty where the taxpayer presented no evidence with respect to the addition and merely alleged that it must have been arbitrarily determined.