Foster v. Commissioner of Internal Revenue
756 F.2d 1430, 1985 U.S. App. LEXIS 29909, 55 A.F.T.R.2d (RIA) 1285 (1985)
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Rule of Law:
Under Section 482 of the Internal Revenue Code, the Commissioner may reallocate income from the disposition of property between commonly controlled entities to prevent tax evasion or to clearly reflect income, even when the property was previously transferred in a nonrecognition transaction, if the primary purpose of the transfer was tax avoidance.
Facts:
- In 1955, Jack Foster and his sons formed a partnership, T. Jack Foster and Sons (Partnership), for the purpose of dealing in property.
- In 1958, the Partnership began developing a 2,600-acre tract of land into a self-contained city known as Foster City, acquiring the land in 1960.
- In October 1962, after significant development work had increased the land's value, the Partnership transferred a portion of the developed land in 'Neighborhood One' to four newly created corporations (the 'Alphabets'), each wholly owned by one of the Fosters.
- In August 1966, the Partnership transferred 311 developed lots in 'Neighborhood Four' to Foster Enterprises, a corporation also owned by the Fosters, which had accumulated substantial net operating losses from unrelated business ventures.
- The Alphabets and Foster Enterprises subsequently sold the lots they received from the Partnership to third-party builders.
- Separately, the Partnership engaged in a series of complex transactions involving a subsidiary, Westway Investment Co., to structure a $3 million loan bonus from a bank as a capital gain rather than ordinary income.
- The Partnership also conveyed parcels of land for a school and two churches, claiming the difference between the sale price and fair market value as charitable deductions.
Procedural Posture:
- The Commissioner of Internal Revenue issued notices of deficiency to Richard H. Foster and other members of the Foster family for tax years 1963-1967.
- The Fosters, as petitioners, challenged the deficiencies in the United States Tax Court.
- The Tax Court largely affirmed the Commissioner's determinations, finding that the income from the property sales was properly reallocated to the Partnership.
- The Fosters, as petitioners-appellants, appealed the decision of the Tax Court to the United States Court of Appeals for the Ninth Circuit, with the Commissioner as the respondent-appellee.
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Issue:
Does the Commissioner of Internal Revenue abuse his discretion under Section 482 by reallocating income from corporations back to a commonly controlled partnership, when the partnership transferred appreciated property to the corporations in non-recognition transactions primarily for tax avoidance purposes?
Opinions:
Majority - J. Blaine Anderson
No. The Commissioner does not abuse his discretion under Section 482 by reallocating income from the corporations back to the partnership because the transfers were motivated by tax avoidance rather than a valid business purpose. The court found that the Commissioner has broad authority to reallocate income among commonly controlled businesses to prevent tax evasion or to clearly reflect income. This power extends to situations involving non-recognition transactions, such as the Section 351 transfer to the Alphabets, when they conflict with the purpose of Section 482. The evidence showed that the Partnership transferred 'highly appreciated inventory pregnant with income' to the Alphabets to split the income among lower tax brackets and to Foster Enterprises to absorb the income with its net operating losses. The court rejected the proffered business purpose for the Foster Enterprises transfer—that a bank insisted on it—as illogical and unsupported by the transaction's economic reality. The court also affirmed the reallocation of post-transfer appreciation, reasoning that the development work was performed by a municipal district (Estero) that was the 'creature' of the Partnership, meaning any value it added would have accrued to the Partnership if not for the tax-motivated transfers. The court further held that a series of transactions involving the 'Westway Notes' was a sham designed to disguise interest payments as capital gains, and disallowed charitable deductions for land transfers because the dominant motive was to enhance the value of the Partnership's remaining property, not charity. The court vacated the negligence penalty, however, finding the legal issues were complex and the Fosters' positions were reasonably debatable.
Analysis:
This case solidifies the Commissioner's broad authority under Section 482 to police transactions between controlled entities, establishing that the substance of a transaction will prevail over its form. It confirms that Section 482 can override non-recognition provisions like Section 351 when the transfer's primary purpose is tax avoidance. The decision serves as a significant precedent against income-shifting strategies, particularly in real estate development, where developers might be tempted to transfer appreciated property to related entities to shelter gains. Furthermore, the court's willingness to attribute the developmental activities of a public municipal district to the controlling private developer for tax purposes demonstrates the expansive reach of the 'control' concept within Section 482.
