Foster v. Comm'r , 80 T.C. 34 ( 1983 )

Richard H. Foster and Sara B. Foster, T. Jack Foster, Jr., and Patricia Foster, John R. Foster and Caroline Foster, and Estate of T. Jack Foster, Deceased, Gladys H. Foster, Executrix and Gladys H. Foster, Petitioners v. Commissioner of Internal Revenue, Respondent

Foster v. Comm'r

Docket No. 1717-78

United States Tax Court

80 T.C. 34; 1983 U.S. Tax Ct. LEXIS 127; 80 T.C. No. 3;

January 11, 1983, Filed

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[EDITOR'S NOTE: PART 1 OF 2. THIS DOCUMENT HAS BEEN SPLIT INTO MULTIPLE PARTS ON LEXIS TO ACCOMMODATE ITS LARGE SIZE. EACH PART CONTAINS THE SAME LEXIS CITE.]

Decision will be entered under Rule 155.

SUBSTANTIVE ISSUES

Issues 1 and 3: REALLOCATIONS OF INCOME UNDER SEC. 482, I.R.C. 1954. T, J, D, and B (a father and three sons) were equal partners in FP, a general partnership. In 1958, FP began to investigate the development potential of Brewer's Island, a 2,600-acre undeveloped tract of land located about 12 miles south of San Francisco. FP determined that the tract could be transformed into a city of 35,000. In December 1959, it acquired an option for the purchase of the land; in May 1960, it secured enabling legislation from the California legislature for a municipal improvement district known as Estero; and in August 1960, it exercised its option and acquired the tract. Immediately thereafter, it began to transform Brewer's Island into Foster City.

FP played an active role in the development of Foster City. It also acted through Estero, which it controlled and dominated. Estero was used by FP in the development process both as a financing vehicle and as a vehicle by which improvements to the land were actually effected.

Foster City was developed by neighborhood. The first neighborhood to be developed was Neighborhood One. In October 1962, FP deeded undivided 25-percent interests in 127 acres of land in Neighborhood One to each of four Alphabet Corporations as tenants in common. Each of these corporations was solely owned by T, J, D, or B, and the transfer of the 127 acres was tax motivated. Income derived from the sale of lots in this acreage was reported by the Alphabet Corporations; however, that income was earned by FP.

In August 1966, FP conveyed all of the single-family residential lots in Neighborhood Four to FE, a corporation which was solely owned by T, J, D, and B in equal shares. FE had a history of substantial net operating losses related to the operation of a hotel in Hawaii and the lots were conveyed in order to take advantage of those losses. Income derived from the sale of lots in 1967 was reported by FE; however, that income was earned by FP.

Held:

a. Sec. 482, I.R.C. 1954, is not unconstitutional as an invalid delegation of legislative power. (Pp. 140-142.)

b. The Commissioner's determinations under sec. 482, I.R.C. 1954, must be sustained unless proven unreasonable, arbitrary, or capricious. (Pp. 142-144.)

c. In order to prevent the avoidance of taxes, sec. 482, I.R.C. 1954, and sec. 1.482-1(d)(5), Income Tax Regs., may be applied to a taxable disposition of property previously acquired in a nonrecognition transaction. (Pp. 144-159.)

d. Respondent did not abuse his discretion under sec. 482, I.R.C. 1954, in reallocating income derived from the sale of lots in Neighborhood One from the four Alphabet Corporations to FP. (Pp. 160-177.)

e. Respondent did not abuse his discretion under sec. 482, I.R.C. 1954, in reallocating income derived from the sale of lots in Neighborhood Four from FE to FP. (Pp. 178-184.)

f. For tax purposes, FP was a partnership and not an association taxable as a corporation. Sec. 7701(a)(2) and ( 3), I.R.C. 1954; sec. 301.7701-1 through -3, Proced. & Admin. Regs. (Pp. 184-191.)

g. Petitioners are not entitled to affirmatively use sec. 482, I.R.C. 1954, to effect a consolidated return of FP with all of the related corporations purportedly involved in the development of Foster City. Sec. 1.482-1(b)(3), Income Tax Regs. Respondent's failure to do so does not demonstrate any abuse of discretion on his part. (Pp. 191-195.)

Issue 2: APPLICABILITY OF THE SUBSTANCE-OVERFORM DOCTRINE TO THE WESTWAY TRANSACTION. The terms negotiated by FP for the purchase of Brewer's Island contemplated a downpayment of $ 2,500,000. However, FP was unable to fund all of that amount itself. Accordingly, it arranged with a bank with which it had an established relationship to borrow (1) $ 2 million to make the downpayment and (2) such additional amounts as were needed to satisfy the periodic installments due to the sellers of the property for the balance of the purchase price. Under the terms of the agreement, FP agreed (1) to pay interest at the prevailing market rate, (2) to pay a bonus equal to the total amount borrowed from the bank, and (3) to structure the bonus so that it would be taxed to the bank as capital gain rather than ordinary income. A complicated transaction, consisting of a series of incorporations, transfers, liquidations, and mergers, was then devised to disguise the terms of the agreement involving the 100-percent bonus. The crucial step in the transaction involved the delivery of certain promissory notes (the Westway notes) purportedly in exchange for corporate stock. The objective of the transaction from FP's point of view was to raise funds through tax savings in order to pay the bank its bonus; the objective from the bank's point of view was to insure that its bonus was taxed as capital gain. In form, the transaction served to increase FP's basis in Neighborhoods Two and Three by an amount equal to approximately twice that which FP had become obligated to pay to the bank as a bonus.

Held:

a. Respondent's categorization of the Westway notes as interest is an issue which is properly before the Court and one with respect to which petitioners bear the burden of proof. (Pp. 195-197.)

b. In substance, the Westway notes represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island. (Pp. 197-211.)

c. FP is not entitled to capitalize the Westway notes under sec. 266, I.R.C. 1954. (Pp. 211-216.)

Issue 4: APPLICABILITY OF THE COST RECOVERY METHOD TO THE GRANT OF THE SWAY EASEMENT. In 1964, a utility company paid $ 425,000 to FP for a right-of-way immediately adjacent to an existing easement which stretched across Brewer's Island. FP characterized the payment as severance damages and reduced its basis in all of its land in Foster City by the amount received. Respondent acquiesced in that treatment. In 1967, the utility paid an additional $ 72,000 for a sway easement in order to perfect the right-of-way easement which it had acquired in 1964. Held, the amount received for the grant of the sway easement should be applied against the basis of all of FP's land in Foster City rather than against only its basis in that part of its land described by the easement. Inaja Land Co. v. Commissioner, 9 T.C. 727">9 T.C. 727 (1947), applied. (Pp. 216-219.)

Issue 5: DEDUCTIBILITY OF THE SCHOOL AND CHURCH SITES. FP conveyed three parcels of land in Foster City with respect to which it claimed deductions for charitable contributions. One parcel was conveyed to a school district for use as a school site and was in form an outright transfer; the other two parcels were conveyed to churches for use as church sites and were in form "bargain purchases." The notice of deficiency raised the issue of donative intent with respect to the deductibility of the school site but not the two church sites.

Held:

a. Given the absence of surprise or substantial disadvantage to petitioners, respondent is entitled to rely on a ground for the disallowance of a deduction which was not expressly set forth in the notice of deficiency. (Pp. 220-222.)

b. FP's dominant purpose in conveying the three sites was the expectation of direct economic benefit; accordingly, the transfers are not deductible as charitable contributions under sec. 170, I.R.C. 1954. (Pp. 222-225.)

c. FP must capitalize the cost of the school site as part of its basis in all of its remaining land in Foster City. (Pp. 225-227.)

Issue 6: DEDUCTIBILITY OF THE PAYMENT FOR LEGAL SERVICES. FP paid $ 5,000 to an attorney for legal services. Held, the payment was a legitimate business expense and is deductible under sec. 162(a), I.R.C. 1954. (P. 227.)

Issue 7: ADJUSTMENTS RELATED TO THE PAYMENT OF THE FOSTERS' PERSONAL EXPENSES. Respondent disallowed certain deductions claimed by FP on the ground that the expenses were personal to T, J, D, and B. He also disallowed certain deductions claimed by three related corporations on the same ground and charged the individuals with constructive dividends.

Held:

a. Petitioners bear the burden of proof. Neither respondent's alleged delay in issuing the notice of deficiency, nor his failure to identify therein the specific partnership and corporate expenditures which were disallowed, nor the alleged misconduct of his revenue agent in "scrambling" petitioners' records serves to shift the burden of proof. United States v. Janis, 428 U.S. 433">428 U.S. 433 (1976), and Weimerskirch v. Commissioner, 596 F.2d 358">596 F.2d 358 (9th Cir. 1979), revg. 67 T.C. 672">67 T.C. 672 (1977), distinguished. (Pp. 228-234.)

b. Petitioners introduced no specific evidence to establish that the expenses in question were business related rather than personal. Hence, they failed to carry their burden of proof. Evidence descriptive of the mechanics of their recordkeeping system is insufficient to discharge that burden. (Pp. 234-235.)

c. Even if expenses are disallowed at the corporate level because of the failure to comply with the recordkeeping requirements of sec. 274, I.R.C. 1954, that fact would not necessarily preclude the taxation of the expenses as constructive dividends at the shareholder level. (Pp. 235-236.)

Issue 8: CHARACTERIZATION OF THE PAYMENTS MADE TO GLADYS FOSTER. On her income tax returns, G reported compensation received from certain related corporations. Respondent determined that the total amount reported was understated and recharacterized the revised amount as dividend income. Held, G received ordinary income in the amount determined by respondent. (Pp. 236-237.)

Issue 9: ADDITIONS TO TAX. Respondent determined that T and G were liable for additions to tax under sec. 6653(a), I.R.C. 1954, for each of the years before the Court. Held, the burden of proof rests with petitioners, and they have failed to carry it. (Pp. 237-238.)

EVIDENTIARY AND PROCEDURAL ISSUES

Issue A: DEPOSITION OF T. JACK FOSTER. In 1961, a utility company commenced an action in State court to condemn an additional easement for a right-of-way across Brewer's Island. T, a party herein, was named as one of the defendants in that action. In March 1962, T was called to testify as a witness by the utility at a deposition conducted by its attorney. Held, T's deposition is admissible in this proceeding, over petitioners' general hearsay objection, as an admission of a party-opponent under Rule 801(d)(2)(A), Federal Rules of Evidence.Held, further, petitioners' relevancy objection addressed and resolved. (Pp. 118-120.)

Issue B: DEPOSITION OF DEL CHAMPLIN. C, a C.P.A., was the principal tax adviser for T, J, D, and B, parties herein. In June 1969, he terminated his relationship with J, D, and B. (T had died in 1968.) Shortly thereafter, he sued them in State court for, inter alia, allegedly failing to fully compensate him for services rendered. J, D, and B counterclaimed, alleging malpractice on C's part. In October and November 1969, C was called to testify as a witness by T, D, and B in a deposition conducted by their attorney. C's action against T, D, and B for breach of contract, and their counterclaim against him for malpractice, involved services which C rendered in his capacity as their tax counselor during the development of Foster City. The tax consequences of those services were at issue in the State court action, just as they are at issue in the present case. C died prior to the trial of the present case. Held, C's deposition is admissible in this proceeding, over petitioners' general hearsay objection, under the "former testimony" exception to the hearsay rule. Rule 804(b)(1), Fed. R. Evid.Held, further, petitioners' relevancy, opinion, and double hearsay objections addressed and resolved. Held, further, the fact that C was not a disinterested witness does not affect the admissibility of his deposition but rather the weight to which it is entitled. (Pp. 120-128.)

Issue C: DEPOSITION OF T. JACK FOSTER, JR. In March 1971, J was called to testify as a witness by C at a deposition conducted by C's attorney. This deposition was part of the same State court action referred to in Issue B, supra. Held, J's deposition is admissible in this proceeding, over petitioners' general hearsay objection, as an admission of a party-opponent under rule 801(d)(2)(A), Fed. R. Evid.Held, further, petitioners' relevancy, opinion, and "double hearsay" objections addressed and resolved. (Pp. 128-130.)

Issue D: DEPOSITION OF REX D. JOHNSON. Prior to the commencement of the present case, petitioners filed an application with this Court under Rule 82, Tax Court Rules of Practice and Procedure, to depose W, a former vice president of the bank with which T, J, D, and B did business. After a hearing and over respondent's objection, the Court granted the application. At the deposition, W was examined by petitioners' counsel and cross-examined by respondent's counsel. However, W declined to answer questions which went beyond the scope of the issue with respect to which the Rule 82 application was filed. W was alive at the time of the trial of the present case. Held, W's deposition is admissible in this proceeding, over respondent's general objection, under Rule 81(i)(3)(E), Tax Court Rules of Practice and Procedure.Held, further, respondent was not denied the right of cross-examination at the deposition. Held, further, respondent's specific objections addressed and resolved. (Pp. 131-135.)

Issue E: THE "BUSINESS PURPOSE" OBJECTION. At trial, J was asked on direct examination whether there was a business purpose for the transfer of the single-family residential lots from FP to FE in 1966. (See Issue 3, supra.) Respondent objected to this question, whereupon petitioners moved to strike the same question in J's deposition. (See Issue C, supra.) Held, the question propounded at trial is objectionable. Under rule 701, Fed. R. Evid., opinion testimony must be "helpful" in order to be admissible, and J's expression of opinion would not have satisfied this standard. Held, further, the question propounded at the deposition is not objectionable because it elicited an admission of a party-opponent which is admissible under rule 801(d)(2)(A), Fed. R. Evid. (Pp. 135-137.)

Issue F: BURDEN OF PROOF. Petitioners seek to allocate the burden of proof in respect of the three major substantive issues involved in this case (see Issues 1-3, supra) contrary to the general rule of Rule 142(a), Tax Court Rules of Practice and Procedure.Held, respondent's determinations are not arbitrary but rather rest on a firm foundation. Held, further, the introduction of substantive evidence by respondent renders moot any issue concerning the evidentiary weight to be accorded the presumption of correctness. Weimerskirch v. Commissioner, 596 F.2d 358">596 F.2d 358 (9th Cir. 1979), revg. 67 T.C. 672">67 T.C. 672 (1977), distinguished. (Pp. 137-139.)

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

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

Dawson, Judge.

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DAWSON

Respondent determined the following deficiencies in petitioners' Federal income taxes and additions to tax under sections 6651(a)(1) and 6653(a): ^{AdditionPetitionerYearDeficiencyto taxRichard H. Foster1963$ 108,513.06and Sara B. Foster 1964177,066.451965277,166.6519665,630.261967133,246.08701,622.50T. Jack Foster, Jr.,1963110,067.16and Patricia Foster 1964184,431.451965283,634.6719665,764.041967137,755.12721,652.44John R. Foster1963108,997.49and Caroline Foster 1964176,869.03$ 8,843.451965275,674.7619664,268.351967129,602.81695,412.44Estate of T. Jack1963116,054.136,612.89Foster and Gladys 1964195,258.359,762.92H. Foster  1965280,017.8414,000.89196612,502.37625.121967111,748.155,587.41715,580.84*145 In their petition, the petitioners claim overpayments in the following aggregate YearAmount1963$ 30,069.7819649,394.27196516,386.46196619,939.93196729,913.76105,704.20}

Despite a number of concessions by the parties, there remains a variety of issues for us to decide. They include nine substantive issues and six preliminary issues related to certain evidentiary and procedural matters. The substantive issues are as follows:

1(a) and 3(a). Whether section 482 is unconstitutional as an invalid delegation of legislative power.

1(b) and 3(b). Whether respondent's determinations under section 482 are reviewable for an abuse of discretion or pursuant to some lesser standard.

1(c) and 3(c). Whether, in order to prevent the avoidance of taxes, section 482 may be applied to a taxable disposition of property previously acquired in a nonrecognition transaction.

1(d). Whether respondent abused his discretion under section 482 in reallocating income from the sale of lots in Neighborhood One from the Alphabet Corporations to the Foster partnership.

3(e). Whether respondent abused his discretion under section 482 in reallocating income from the sale of lots in Neighborhood Four from Foster Enterprises, Ltd., to the Foster partnership.

1(f) and 3(f). In the alternative, whether the Foster partnership is an association and hence taxable as a corporation.

1(g) and 3(g). In the alternative, whether section 482 must be employed to effect a consolidation of the Foster partnership with all of the Foster-controlled corporations purportedly involved in the development of Foster City.

2(a). Whether respondent's contention on brief is consistent with his ground for the adjustment set forth in the notice of deficiency, or, conversely, whether it represents a new issue.

2(b). Whether certain promissory notes, purportedly executed to reacquire corporate stock, 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.

2(c). If the notes represent an obligation to pay additional interest, whether such interest can be capitalized under section 266 as part of the Foster partnership's basis in Neighborhoods Two and Three, notwithstanding the fact that such interest was not actually paid during the taxable years in issue.

4. Whether the amount received by the Foster partnership and a related corporation for the grant of a sway easement should be applied against their bases in all of their land or conversely against their bases in only that part of their land described by the easement.

5(a). Whether respondent is entitled to rely on a ground for the disallowance of a deduction which was not expressly set forth in the notice of deficiency.

5(b). Whether the transfers of three parcels of land by the Foster partnership for school and church sites are deductible as charitable contributions under section 170.

5(c). If the transfers are not deductible, whether the partnership must capitalize the cost of the school site as part of its basis in all of its remaining land in Foster City.

6. Whether a payment made by the Foster partnership pursuant to a law firm's statement for services rendered is deductible as a business expense under section 162.

7(a). Whether adjustments related to the payment of the Fosters' personal expenses were so arbitrary and excessive as to shift the burden of proof to respondent.

7(b). If petitioners bear the burden of proof, whether they can carry it through evidence that their recordkeeping system was designed to differentiate between business and personal expenses.

7(c). Whether the disallowance of deductions under section 274 at the corporate level precludes the taxation of those expenses as constructive dividends at the shareholder level.

8. Whether certain amounts received by Gladys H. Foster constitute dividends or compensation for personal services.

9. Whether the Estate of T. Jack Foster and Gladys H. Foster are liable for additions to tax under section 6653(a) for negligence or intentional disregard of rules and regulations.

The preliminary issues are as follows:

A(1). Whether the deposition of T. Jack Foster, taken in connection with a State court proceeding, is admissible in this proceeding as an admission of a party-opponent under Federal Rules of Evidence 801(d)(2)(A).

A(2). If it is admissible on that basis, whether petitioners can object to any part of the deposition on grounds of relevancy.

B(1). Whether the deposition of the Fosters' former tax planner, taken in connection with a State court proceeding, is admissible in this proceeding as former testimony under Fed. R. Evid. 804(b)(1).

B(2). If it is admissible on that basis, whether petitioners can object to any part of the deposition on grounds of relevancy, opinion, and double hearsay.

B(3). If it is admissible on that basis, whether the deponent's testimony should be completely disregarded because of bias.

C(1). Whether the deposition of T. Jack Foster, Jr., taken in connection with a State court proceeding, is admissible in this proceeding as an admission of a party-opponent under Fed. R. Evid. 801(d)(2)(A).

C(2). If it is admissible on that basis, whether petitioners can object to any part of the deposition on grounds of relevancy, opinion, and "double hearsay."

D(1). Whether the deposition of the Fosters' former banker, taken pursuant to an application filed with this Court under Rule 82*47 D(2). If it is admissible under that rule, whether respondent can object to any part of the deposition on relevancy and a variety of other grounds.

E(1). Whether the Court properly sustained an objection at trial to a question calling for a conclusion by a party.

E(2). If so, whether the identical question propounded to that party at a deposition must be stricken from the record.

F. Whether the burden of proof in respect of the three major substantive issues involved in this case should be allocated contrary to the general rule of Rule 142(a).

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

Petitioners Richard H. (Dick) Foster and Sara B. Foster, T. Jack (Jack, Jr.) Foster, Jr., and Patricia Foster, and John R. (Bob) Foster and Caroline Foster are husband and wife. The three male petitioners are brothers. Together with their respective spouses, they timely filed joint Federal income tax returns for the calendar years 1963 through 1967 with the Internal Revenue Service Center at Ogden, Utah.

Petitioner Gladys H. (Gladys) Foster is the widow of T. Jack (Jack) Foster and the executrix of his estate. Jack Foster died on March 15, 1968. Together with his spouse, he also timely filed joint Federal income tax returns for 1963 through 1967 with the Ogden Service Center. Jack Foster and Gladys Foster are the parents of the three male petitioners.

At the time that they filed their petition in this case, all of the petitioners resided in the San Francisco Bay area.

Except for Gladys Foster's involvement in Issue 8, the female petitioners are parties to this action solely by virtue of having filed joint returns with their respective spouses. Accordingly, "the Fosters" will only refer to the principals involved in this case, i.e., Jack Foster, Jack Foster, Jr., Dick Foster, and Bob Foster.

During the years in issue, the Fosters were equal partners in a general partnership known as T. Jack Foster & Sons (the Foster partnership or simply the partnership). Like the individuals, the Foster partnership utilized the cash method of accounting. The principal issues in this case involve substantial adjustments made by respondent to partnership items of income and deduction. The adjustments, in turn, generally relate to the partnership's activities in developing a 2,600-acre tract of unimproved land known as Brewer's Island into a city of 35,000 people christened Foster City, Calif. Before discussing those activities, however, it would be helpful to briefly recount the business background of the Fosters, including the formation and organization of their partnership.

I. Facts Related to the Business Background of the Fosters

Jack Foster was born in 1902. During the 1920's, he attended the law school at the University of Oklahoma and was subsequently admitted to the Oklahoma bar. He was twice elected major of Norman, Okla.; he also served one term as the city attorney.

During the depression era, Foster became interested in the real estate business. Among the first projects which he undertook was the construction of a hotel in Norman. His base of operations became Oklahoma City.

From 1946 through 1955, Foster engaged in the real estate development business with an individual by the name of V. B. Likins. Likins was a successful and wealthy businessman who had connections with the Republic National Bank of Dallas (Republic or simply the bank). It was also during this period that Foster retained A. O. "Del" Champlin, an Oklahoma C.P.A., to provide financial, accounting, and tax planning services. Both Republic and Champlin later played important roles in the development of Foster City.

Foster and Likins engaged in a variety of projects during their association. Their most notable achievement was the construction of several thousand units of military housing in several States including Kansas, Texas, California, and Hawaii.

Foster and Likins did business in both corporate and partnership form. In 1952, they incorporated Likins-Foster Honolulu Corp. That corporation eventually became the parent company for most of the corporations formed during the Likins-Foster period of business activity. Likins-Foster Honolulu Corp. is involved in several of the issues presented in this case.

In February 1955, Foster and Likins terminated their business relationship. They entered into an agreement the relevant terms of which provided for the dissolution of their partnership and the acquisition by the Fosters, pursuant to an option, of Likins' interest in Likins-Foster Honolulu Corp. Upon the exercise of that option, Jack Foster owned 75 percent of that corporation's stock, and his sons, the remaining 25 percent, in equal shares.

FORMATION AND ORGANIZATION OF THE FOSTER PARTNERSHIP

Concurrently with the termination of his business relationship with Likins, Jack Foster entered into an agreement with his sons to form the Foster partnership for the transaction of their business. According to the partnership agreement, the purpose of the partnership was --

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.

The partnership agreement further provided that contributions to the capital of the partnership were to be made one-half by Jack Foster and one-sixth by each of his sons, and that profits and losses from its operation were to be shared in the same proportion. The agreement also designated Jack Foster as the managing partner, authorized him to make all routine decisions for the partnership, but provided that matters of policy should be determined by all of the partners. The agreement also authorized the payment of a salary to Jack Foster as managing partner.

At this point, mention should be made of the activities of Jack Foster's sons. The oldest, Jack Foster, Jr., attended the University of Oklahoma, majored in finance, and obtained a degree in business administration in 1951. He then served 2 years in the Air Force. Immediately after his discharge, he joined the Likins-Foster organization in Hawaii as a management trainee. After Foster and Likins terminated their business relationship in 1955, Jack, Jr., managed the Hawaiian operations of Likins-Foster Honolulu Corp. and its several subsidiaries. In November 1960, he returned to the mainland on behalf of the partnership to become the general manager of the Foster City project. (The partnership's role in the development of Foster City will be discussed later in detail.)

Dick Foster also attended the University of Oklahoma, majored in accounting, and graduated in 1957. He too became involved in the family business. In 1960, he moved to Honolulu in order to manage the Fosters' operations and thereby allow Jack, Jr., to assume his responsibilities at Foster City. While in Hawaii, he supervised the construction of several projects, including the Foster Tower Hotel, which plays a role in one of the issues involved herein. In July 1963, he left Hawaii for California in order to actively participate in the development of Foster City.

Bob Foster also attended the University of Oklahoma and graduated in 1958 with a major in geology. For approximately 2 years, he managed the family's oil and gas interests in Oklahoma. In October 1960, he too moved to California in order to take an active part in the development of Foster City.

By 1959, Jack Foster's sons had all graduated from college and had assumed active and increasingly responsible roles in the family business. Accordingly, in January 1959, the Fosters amended their partnership agreement to provide for their equal participation in the profits and losses resulting from the operation of the partnership. No adjustment was made, however, in their capital accounts nor were any of the above-described provisions modified in any way except to specifically authorize the payment of salaries to all of the partners. These amendments to the partnership agreement were made at a time when the Fosters were actively assessing the feasibility of developing Foster City.

The Fosters restated their partnership agreement in August 1963. The purpose of the partnership remained unchanged, and no modifications were made to any of the provisions described above. But two new provisions were added. One authorized any two general partners to bind the partnership by any deed, contract, or other written document within the general scope of the partnership; and the other declared that all stock in any corporation in which shares had been equally issued to the Fosters was a partnership asset.

II. Facts Related to the Creation of Foster City

While living in Pebble Beach, Calif., in 1958, Jack Foster was contacted by a fellow builder and real estate developer by the name of Richard Grant about the possibility of participating in the development of Foster City, then known as Brewer's Island. Brewer's Island was a 2,600-acre undeveloped and uninhabited tract of land located about 12 miles south of San Francisco in San Mateo County. It was separated from the city of San Mateo by a narrow estuary on its western bounds but otherwise surrounded by the waters of San Francisco Bay. The island was partially submerged, partially tideland, and partially firm land behind existing levees. It was owned by the Leslie Salt Co. (Leslie) and the Schilling Estate Co. (Schilling) and was used for agriculture and as salt ponds. Grant had been negotiating with its owners for several years but had not been successful in even obtaining an option for its purchase.

Foster had several discussions with Grant about the development potential of Brewer's Island but remained unconvinced. He agreed, however, to solicit the views of his partners. Accordingly, he called his sons to California. The Fosters reviewed the preliminary feasibility study and soil test that Grant had previously commissioned. They determined that the proposed project had sufficient merit to warrant further scrutiny and agreed to finance certain additional studies. Grant and the Fosters agreed that if these studies were favorable and they decided to go forward with the project (assuming, of course, that they could purchase the land), they would do so as partners on a 50/50 basis. As for the Fosters, themselves, they proceeded in partnership form, with Jack Foster continuing to act as managing partner.

The Fosters determined that the principal engineering problem facing the proposed project was to secure an adequate supply of landfill. Acting on behalf of the partnership, Jack Foster retained Dames & Moore (D & M), a San Francisco engineering firm specializing in soil analysis, to survey the southern part of San Francisco Bay for the purpose of locating sand deposits which could be used as fill. Suitable deposits were located about 5 miles east of the San Francisco International Airport at San Bruno Shoal. A dredging permit in Jack Foster's name was subsequently obtained in October 1959 from the U.S. Army Corps of Engineers. During this period, various studies were also conducted on Brewer's Island, itself.

Throughout 1959, Jack Foster actively negotiated with Leslie and Schilling over the terms of the proposed purchase. Discussions were frequent, occurring about twice a week.

By the fall of 1959, the Fosters had become sufficiently enthusiastic about the proposed project to commission a major feasibility study. In November 1959, again acting on behalf of the partnership, Jack Foster retained Wilsey, Ham & Blair (W H & B), a firm of civil engineers and land planners, to prepare a proposal for the development of Brewer's Island. D & M was also retained to conduct soil studies and otherwise assist in the preparation of the engineering part of the proposal.

In December 1959, Jack Foster and Richard Grant succeeded in obtaining an option from Leslie and Schilling for the purchase of Brewer's Island for $ 12,800,000. The option was acquired for $ 200,000 and had to be exercised no later than August 19, 1960. It was acquired solely with Foster funds. Contemporaneously with its acquisition, Grant and Foster agreed for the latter (acting for the partnership) to purchase the former's interest in the project for $ 3 million if the option were eventually exercised. They also agreed that the Fosters would be solely responsible for all engineering and feasibility studies.

Foster arranged to buy out Grant because he thought the property was potentially worth far more than its option price and because he preferred to proceed with only his sons as his partners if the project were undertaken. However, Grant's anticipated contributions to the project were considered so significant that the Fosters would not have undertaken it without assurance of his continued involvement. Accordingly, Foster (again acting for the partnership) also arranged to retain Grant on a full-time basis as an independent contractor at an annual fee of $ 24,000 if the project were actually undertaken.

At the time the option was acquired, the Fosters were faced with several major problems if they exercised it and committed themselves to the development of Brewer's Island. The major engineering problem related to the reclamation of the land. The major financial problem related to their dependence on outside financing not only to develop Brewer's Island (originally estimated by Jack Foster to require $ 55,500,000) but also to complete its purchase price.

In July 1960, WH & B submitted its proposal. The engineering plan for reclaiming Brewer's Island called for dredging a lagoon across the center of the property, installing flood gates in order to permit water draining into the lagoon to flow back into the bay, and then filling the land in the shape of a large saucer about 14 feet above sea level at the outer edge and 1 1/2 feet above sea level near the center. It was determined that the necessary fill, approximately 18 million cubic yards, could be obtained at a cost which would make the operation economically feasible.

WH & B's proposal also contemplated using municipal bonds issued by a municipal improvement district to finance the improvements to Brewer's Island. This concept actually originated with Richard Grant, who had previously discussed it with the Fosters. They were sufficiently receptive to the idea that Jack Foster, acting on behalf of the partnership, retained a San Mateo law firm specializing in municipal finance to draft proposed legislation. WH & B provided technical assistance by specifying the powers that such a district would need in order to successfully undertake the contemplated development. Sometime thereafter, the Estero Municipal Improvement District Bill was introduced into the California legislature as Senate Bill No. 51 by the local State senator and State assemblyman. The former was also the Fosters' personal attorney. The bill called for the creation of a local government body which could issue bonds and impose taxes in order to raise the funds necessary to improve the land within its jurisdiction. In March 1960, San Mateo County endorsed the bill. It was subsequently passed by the legislature and approved by the Governor in May 1960. The Estero Municipal Improvement District (Estero or simply the district) played an important role in the development of Brewer's Island.

In his discussions with Leslie and Schilling, Jack Foster had negotiated a downpayment of $ 2,500,000 for the purchase of Brewer's Island. Payment of such an amount, however, was not compatible with the partnership's anticipated cash needs if the project were actually undertaken. During the spring or early summer of 1960, the Fosters discussed with senior officials of the Republic National Bank the possibility of financing the partnership's downpayment if the property were purchased. A $ 2 million loan was eventually arranged. However, certain of its terms are in dispute and give rise to one of the three major issues which we must decide. This matter is described later in greater detail.

By July 1960, the Fosters had expended considerable amounts assessing the development potential of Brewer's Island. For example, they had spent approximately $ 250,000 on the studies made by WH & B and D & M. In the process, however, they had determined that the project was feasible and had made the necessary arrangements for financing both the development and acquisition of Brewer's Island. Accordingly, they undertook to acquire the property.

On August 16, 1960, Jack Foster, acting on behalf of the partnership, acquired Richard Grant's interest in the option for $ 3 million as previously agreed. Foster executed a promissory note payable without interest and solely from the proceeds from the sale or use of the property subject to the option. The note was secured by an unrecorded deed of trust. On August 19, 1960, Foster, again acting on behalf of the partnership, exercised the option and acquired Brewer's Island for $ 12,800,000. The $ 2,500,000 downpayment included the amount paid for the option ($ 200,000) and the amount borrowed from Republic for that purpose ($ 2 million). Foster executed promissory notes to the sellers for the balance, or $ 10,300,000. These notes were secured by a deed of trust and were payable no later than August 19, 1967.

Title to Brewer's Island was taken in the name of Jack Foster as nominee of the Foster partnership. Later, in August 1963, the partnership filed a "Statement of Partnership" with San Mateo County pursuant to the California Corporations Code. *55 that tract of land was on its way to becoming Foster City. At this point, therefore, it would be appropriate to briefly describe the contemplated development.

Foster City was envisioned as a completely planned and self-contained city consisting of nine residential neighborhoods, an industrial park, and a town center. Each neighborhood was to be built around an elementary school. Of the 2,600 acres, approximately 1,360 were to be zoned residential, 310 acres, industrial, and 150 acres, commercial. The remaining acreage was to be divided among schools, churches, parks, lagoons, streets, and municipal buildings. A population of approximately 35,000 was contemplated. The total number of housing units was estimated at 11,000, with single-family detached homes accounting for about 5,000 units and townhouses and garden and highrise apartments the remainder. Each neighborhood was to include both waterfront (lagoon and bay) and non-waterfront lots and a mix of single-family and multiple-family dwellings, as well as some commercial development.

III. Facts Related to the Sale of Lots in Neighborhood One (Issue 1)

Foster City was developed neighborhood by neighborhood. As land in each neighborhood was reclaimed and the soil compacted, various improvements were immediately begun with a view towards platting so that individual lots could be sold to builders. The principal income of the project was derived from the sale of such lots. Given the magnitude of the project, the Fosters lacked the financial resources to undertake the actual construction, itself. However, in several instances, they did do some building, principally commercial buildings which they intended to hold for investment purposes.

The first neighborhood to be developed was Neighborhood One. *56 Units 1 and 2 of Neighborhood One to each of four corporations as tenants-in-common. (Neighborhood One was divided into two units and consisted of a total of 216 acres.) The four corporations were known as Foster J. Corp., Foster D. Corp., Foster B. Corp., and Foster T. Corp. (hereinafter referred to collectively as the Alphabet Corporations or simply the Alphabets). Each of the Alphabet Corporations was solely owned by one of the Fosters: Foster J. by Jack, Jr., Foster D. by Dick, Foster B. by Bob, and Foster T. by Jack (T. Jack). In the notice of deficiency, respondent allocated to the partnership the net income reported by the Alphabets 19631964196519661967$ 680,459.55$ 293,766.18$ 134,735.03($ 2,521.67)$ 350.26

This allocation was made under authority of section 482.

In order to understand the factual predicate of the Neighborhood One issue, it is necessary to describe the roles played by Estero, the Foster partnership, the Alphabets, and Del Champlin in the development of Foster City in general and Neighborhood One in particular.

A. ESTERO MUNICIPAL IMPROVEMENT DISTRICT

As previously stated, the consultants retained by the Fosters recommended using municipal bonds issued by a municipal improvement district to finance the improvements to Brewer's Island. The district that was created for this purpose was Estero.

1. The Enabling Legislation

Estero was a "special act" district, i.e., it was created by special act *57 The Estero Act recited the need for the district, prescribed its boundaries, organization, and powers, and defined the methods for its operation, management, and financing. The act described its purpose as follows:

Article 15. Need for Special Act

SEC. 215. The purpose of this act is to form the Estero Municipal Improvement District in order that the area benefited may be provided with various municipal improvements. Special facts and circumstances, applicable to the general area within which the district lies and not generally, make the accomplishment of this purpose impossible under existing general laws and therefore special legislation is necessary. The special facts are as follows:

* * * *

(d) There is urgent need for the improvements which the district is empowered to construct under this act, but other municipal powers which could be exercised by a city are not required, and would result in more government than the area needs or wants.

(e) There are not existing general laws under which the area could be provided with the facilities it needs short of incorporation as a city. Therefore, the only way in which the particular needs of the area can be provided is by special act.

(f) 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. Since no general law district with the necessary powers provides for voting by owners, special legislation is necessary.

The act provided that the territorial jurisdiction of Estero was coterminous with Brewer's Island. It also restricted the right to vote to landowners and provided that voting was to be upon the basis of assessed valuation of land, with each voter to have one vote for each $ 1 in assessed valuation of land owned by him. *172 The act also provided that Estero was to be governed by a board of three directors elected to serve staggered, 4-year terms. Only owners or their officers or legal representatives were eligible to be directors. The officers of the district consisted of the board members, a secretary, and such other officers as the board might create. The district was entitled to employ such engineers, technical experts, and other employees as it deemed necessary. *173 Estero was vested with a broad spectrum of general governmental powers. For example, it was empowered to reclaim land, make provision for street lighting, sewage, storm drainage, garbage and water service, and parks and playgrounds. It was also empowered to construct small craft harbors, provide fire and police protection, condemn land, enter into contracts, and make and enforce such regulations as were necessary and proper to the exercise of its enumerated powers. A violation of any such regulation constituted a misdemeanor. *174 Despite its impressive array of powers, Estero was intended to initially function as a reclamation district whose purpose was to finance the reclamation of a 2,600-acre tract of undeveloped and uninhabited land. As that tract was reclaimed, Estero was intended to function as an improvement district whose purpose was to finance the construction of general land improvements such as streets and sewers. As the land was improved, subdivided, and sold, and further improved by the construction of dwelling and other buildings, Estero was intended to function as a general governance district whose function was to provide the usual municipal-type services such as fire and police protection. *175 land improvements, the Estero Act authorized the district to issue both general obligation and revenue bonds, as well as other types of securities. Issuance of these bonds required approval by the district electorate; however, a "voter" continued to be defined as a landowner. The act did not limit or restrict the amount of bonded indebtedness that could be incurred by the district. The payment of interest was expressly authorized to be funded as part of Estero's bonded indebtedness "for the period of construction and for twelve (12) months thereafter." In other words, the act authorized the face amount of a bond issue to include the interest that would have to be paid on the bonds during the specified period. *176 Because of a scandal during the early 1960's involving the Embarcadero Municipal Improvement District in Santa Barbara, another special act district that was virtually identical to Estero in legal form, *177 and to provide other public safeguards. The salient fact, however, is that the district organization itself does not appear significantly able to forestall abuses.

In June 1963, the Estero Act was amended *178 The act was also amended to require that the finance officer be bonded for $ 250,000. *62 In August 1967, the Estero Act was again amended,

In December 1966, a resident of Foster City by the name of Cooper judicially challenged the validity of the Estero Act, alleging, inter alia, that it violated the California constitution. His action was subsequently dismissed on the ground that it failed to state a cause of action. In 1969, the California Supreme Court affirmed the dismissal. *180 2. Estero's Board, Officers, and Contractors

Estero was formally organized on September 8, 1960. Its first board of directors consisted of Richard Grant, who was elected president, William Innes, and George Shannon. Grant, of course, was the individual who first interested the Fosters in developing Brewer's Island and whom they arranged to retain for his help and assistance if the project were actually undertaken. Innes was a C.P.A. and former employee of Arthur Andersen & Co. He was hired by Jack Foster in 1950 and had become a trusted executive within the Foster organization. Shannon was a career city manager who had worked in Texas, California, and Alaska. He had been recommended to the Fosters by the president of the Republic National Bank and was sought out by them because of his expertise in municipal government. Both Innes and Shannon served as directors through the years in issue.

In June 1961, Grant resigned from Estero's board "in order to better represent the District in an independent capacity." C. W. Olmo, a contractor, was appointed his successor and elected president. Olmo became one of the Fosters' subcontractors when they built the Wells Fargo Bank Building in Foster City in 1965. He had been recommended to the Fosters by the San Mateo County Board of Supervisors. He too served as director through the years in issue.

In addition to being a director, George Shannon held a variety of other positions with Estero. At the initial organizational meeting of the board, he was appointed secretary. He also served as district tax assessor and tax collector, after those offices were created in February 1961, and became general manager (a position which consolidated his other offices and made him the chief executive officer for the district), after that position was created in August 1962. At that time, it was agreed that Shannon would be placed on the district's payroll and would no longer be employed by Likins-Foster Honolulu Corp.

Shannon served as Estero's general manager until 1969. Immediately after the residents of Foster City gained control of the board, he was terminated. Shortly thereafter he was reemployed by the Fosters.

William Innes also held several positions with Estero in addition to that of director. In March 1961, he was appointed district finance officer. In February 1964, he was appointed assistant secretary.

For the first several years of its existence, Estero's offices were located within the Fosters' offices in Burlingame, a neighboring community. During this period, one or more of the Fosters customarily attended meetings of the district's board of directors. Jack Foster, Jack Foster, Jr., and Bob Foster were all present at the board's first meeting on September 8, 1960.

Estero retained many of the same contractors as the Fosters. For example, in November 1960, it retained as bond counsel the law firm that the partnership had retained to draft the Estero Act. It had previously retained that same firm as general counsel. In September 1960, Estero contracted with WH & B for the performance of engineering and surveying services necessary to complete the reclamation of Foster City. In August 1961, it again contracted with WH & B for the preparation of the design, plans, and specifications for all the community facilities (e.g., sewers and drains, water mains, pavement and sidewalks, curbs and gutters, and street lights) to be constructed in Neighborhood One. At the same time, it contracted with D & M for the performance of the soil studies necessary for the construction of those facilities and for other related engineering services. Other contracts were subsequently entered into with both WH & B and D & M.

Estero accepted the assignment of, and assumed the full indebtedness under, certain contracts which Jack Foster had entered into on behalf of the Foster partnership in 1959 and 1960. These contracts will be described later in greater detail. Estero also contracted with the partnership and certain of the Fosters' corporations for various services. For example, at its inception, Estero entered into an agreement with Likins-Foster Honolulu Corp. for administrative services. Other contracts will also be described later.

3. Municipal Finance

Estero entered into numerous contracts in its own name for the reclamation of land and the construction of various improvements such as levees, lagoons, roadways, water and sewer lines, and a sewage disposal plant. In order to finance this development, Estero issued long-term bonds. Estero's success in selling its bonds to the general public was due, in part, to its deliberate choice of a particular appraisal method which served to accelerate land value. On the other hand, the Fosters' success in minimizing district taxes was due to the unique manner by which Estero capitalized interest. Each of these matters will be discussed in turn.

George Shannon, the district tax assessor, appraised undeveloped land within Estero on a benefit-to-be-received basis. Under this method, land was appraised as if all the bonded improvements were in place, i.e., as if the land were fully reclaimed and the streets, sewers, and other improvements completely constructed. The assessor of San Mateo County, on the other hand, appraised raw land on the basis of comparable sales of undeveloped tracts. (Both the district and the county used comparable sales to value improved real estate.) Because of the basic difference between these two appraisal techniques, Estero's appraised value of undeveloped land was 3 1/2 to 6 times greater than that of the county. In the mid-1960's, after considerable development had occurred, Estero appraised the value of all the land within the district at $ 102 million whereas the county appraised it at $ 41 million.

Estero appraised undeveloped land on a benefit-to-be-received basis in order to accelerate land value. This in turn facilitated bond sales. Potential buyers would have been hesitant about purchasing bonds if the district's bonded indebtedness exceeded the value of the security. Use of the benefit method allowed a comfortable margin. On the other hand, if the county's method had been used, Estero's bonded indebtedness in the mid-1960's (approximately $ 51 million) would have exceeded the aggregate land value by about $ 10 million.

By facilitating bond sales, the higher appraised value benefited the landowner. Bonds, after all, were the source of funds for the reclamation and development of the land. There was, however, a potential downside. Higher appraised value should ordinarily lead to greater taxes for the landowner. In the case of the Fosters, however, this disadvantage was minimized through the manner in which Estero capitalized interest.

"Capitalized interest" is interest which is built into the face amount of a bond. It is equal to the amount of interest which will have to be paid on the bond over some initial period of years. That period is typically the time needed to construct the particular improvement for which the bond is issued, plus some additional period such as 12 or 24 months. By capitalizing interest for this period, the payment of interest is effectively postponed until the improvement can begin to pay for itself. Capitalizing interest on bonds issued to finance the construction of a toll bridge provides an illustration.

The Estero Act specifically authorized interest to be capitalized "for the period of construction and for twelve (12) months thereafter." This provision was construed, however, not to refer to the construction of the particular improvement for which the bond was issued, the usual interpretation given to such language by bond experts, but rather to the construction of Foster City, itself. This interpretation was not disclosed in any prospectus published by Estero to promote bond sales. Estero thus capitalized interest not only on current bond sales but also on prior bond sales. In other words, bond proceeds were used to service prior debt, thereby reducing the current property tax impact on the landowner. Prior to the change in its board of directors in 1967, Estero was capitalizing approximately 60 percent of the interest falling due on all prior bonds, and as much as 40 to 50 percent of the total bond proceeds were being utilized to pay capitalized interest. Not surprisingly, very little principal was retired during the 1960's. Between 1961 (the year of the first bond sales) and 1972, approximately $ 66 million in bonds was sold. Of this amount, about $ 64 million remained outstanding in 1972.

By the mid-1960's, the residents of Foster City had become concerned about Estero's bond practices, particularly its practice of using proceeds from the current sale of bonds to service prior debt. They realized that this practice was causing debt to pyramid and recognized that when it stopped, as it had to at some point, they would be faced with an enormous, and perhaps unmanageable, bond-related tax increase. Accordingly, they organized a homeowners association and sought to discuss their concerns with Estero. The board, however, referred them to the Fosters.

The homeowners association never succeeded in obtaining assurance from the Fosters that there would be any measure of stability in future district taxes. Some animosity developed after the association endorsed a proposal (authorizing an increase in the total amount of bonded indebtedness) in March 1967 in exchange for what it thought was the Fosters' guarantee to hold taxes to the highest projected level. The Fosters, however, subsequently refused to enter into any such agreement. Accordingly, the homeowners association drafted legislation to democratize election to the Estero board. This legislation was introduced into the California legislature in April 1967 and enacted in August 1967. As described above, it programed the transfer of voting power over a 4-year period from the landowners to the residents.

During the transition period, as power was shifting, changes were made in Estero's scheme of municipal finance. There were no further bond authorizations for land reclamation or the construction of water, sewer, or street improvements. Only bonds previously authorized for these purposes were sold. Bond authorizations for other purposes, such as parks and recreation, were meager in amount. Interest was not invariably capitalized, but when it was, it was limited to a maximum period of 24 months from the time of the bond sale. Moreover, interest was capitalized only in respect of a particular bond sale and not in respect of outstanding bonds as had previously been the practice. In order to compensate for such past practices, the residents voted in 1968 to double their taxes, hoping to avoid an oppressive future increase.

During the transition period, the most significant change, however, was Estero's decision to finance the construction of only the major streets and major water and sewer lines. No longer was the development of the developer's private land to be financed with public funds. Rather, the developer was henceforth required to finance all on-site and local improvements (such as streets and water and sewer lines) that would be necessary to subdivide a particular tract. As a consequence, Estero was relieved of most of the expense that it would otherwise have had to incur.

By 1972, the community's finances were sound enough to permit bond sales at par. During the 1960's, bonds had been almost invariably sold at a discount.

Finally, mention should be made of the fact that during the transition period, the Fosters decided to withdraw from Foster City as developers. In 1969, negotiations were entered into with Centex Corp., an unrelated third party, and in 1970, a sale was consummated with its subsidiary, Centex West, Inc.

B. DEVELOPMENT OF NEIGHBORHOOD ONE

We turn now to the development of Neighborhood One and the roles played by Estero, the Foster partnership, and the Alphabet Corporations. To the extent relevant, their roles in the development of other neighborhoods will also be briefly discussed.

As the developer of Foster City, the Foster partnership played the leading role in the development of that community in general and Neighborhood One in particular. However, the partnership acted largely through Estero. The importance of the district's role, therefore, cannot be overemphasized. Accordingly, we shall begin our discussion with Estero.

1. Estero

Estero was incorporated on July 7, 1960, and was formally organized at the first meeting of its board of directors on September 8, 1960.

In September 1960, Estero contracted with WH & B for the performance of the engineering and surveying services necessary to complete the reclamation of the entire 2,600-acre tract. Plans and specifications were prepared and submitted to the district in December 1960. Bids for the necessary reclamation work were immediately solicited from area contractors. A contract for the preliminary field work had been previously awarded to a local contractor.

In order to finance the reclamation of Brewer's Island, Estero called a special election in December 1960 to authorize bonded indebtedness of $ 22 million. The bond issue passed by a vote of 138,025 to zero. At the election, the only authorized voter was the landowner, the Foster partnership.

At about this time, Estero resolved to commence a judicial proceeding to validate its creation and determine its right to issue bonds. Such a proceeding was expressly authorized by the Estero Act. *192 In March 1961, Estero determined that the bids received for the proposed reclamation exceeded both its engineer's estimate and the district bond authorization. Accordingly, it rejected them and determined instead to negotiate directly with qualified contractors. Estero also adopted a procedure for the payment of claims and the issuance and payment of warrants. This procedure was adopted, in part, to enable the district to pay some of the outstanding bills against it in the form of warrants. Also that month, the Planning Commission of San Mateo County commenced formal review of the general plan of Foster City.

In June 1961, Estero awarded the sale of its first series of bonds (land reclamation general obligation bonds which had been authorized the previous December) to the Republic National Bank. The face amount of these bonds was $ 2,300,000, and their repayment was guaranteed by the Fosters. Estero also adopted an official map for purposes of district taxes. Later that month, the San Mateo County Board of Supervisors approved both the district's general plan and its agreement with the county for the maintenance of its drainage system.

In July 1961, Estero determined that the necessary reclamation work could be performed most economically by contracting with Midwest Dredging Co. (Midwest) to furnish dredged material for landfill and another contractor for land preparation. Midwest was a corporation 90 percent of whose shares were owned by the Fosters and which was incorporated during that month. Accordingly, in August, a contract was entered into calling for Midwest to provide hydraulic fill from San Bruno Shoal at a guaranteed contract price per cubic yard. Under the contract, Midwest was to furnish all labor and supplies while Estero was to furnish the equipment under a lease-purchase agreement. It was understood that Associated Dredging Co., an unrelated third party, would serve as Midwest's subcontractor and would actually operate the equipment.

Immediately upon contracting with Midwest, Estero arranged for the purchase of the necessary dredging equipment at a cost of approximately $ 575,000. Several months were consumed in modifying this equipment. The sand barges, for example, were located on the Great Salt Lake in Utah at the time of their purchase by the district; they had to be cut into pieces and shipped by train to Oakland, where they were reassembled. Thus, the actual filling operation did not begin until spring 1962.

The landfill operation was the major engineering feat in the development of Foster City. Accordingly, it would be helpful to digress for a moment in order to briefly describe it.

The first step of the operation involved dredging sand from San Bruno Shoal and pumping it into barges. The barges were then moved by a tugboat to the shore of Foster City where the sand was dumped into the bay. The sand was then redredged and pumped by a 3500-horsepower engine through a large pipe to the particular area being filled. It was carried by the medium of water, which was then pumped back into the bay, leaving the sandfill. By moving the pipe, the island was filled, neighborhood by neighborhood, at the rate of approximately 4 million cubic yards per year. As each area was filled, the next stage of reclamation -- land preparation -- would begin, starting with the grading and contouring of the fill.

Estero subsequently canceled its contract with Midwest after the State attorney general questioned the arrangement as a possible conflict of interest. During the life of the contract (August 1961 to December 1962), the district made payments of approximately $ 2,400,000 to Midwest for the design and mobilization of the dredging equipment, dredging operations, and various other related expenses.

After Estero canceled its contract with Midwest, it entered into a new contract with an unrelated dredging company. Under the new contract, the district agreed to furnish and retain ownership of the equipment, and the contractor agreed to perform all services and to maintain the equipment.

In August 1961, Estero also entered into a variety of other contracts. It contracted with a construction company for land reclamation work related to the digging of the lagoons and other land preparations. It contracted with WH & B for engineering services related to the design of a sewage disposal plant and the community facilities to be constructed in Neighborhood One. It also contracted with D & M for certain soil and foundation investigation services, including test borings necessary for the construction of various community facilities and again with D & M for other soil engineering services.

In October 1961, Estero contracted with a Palo Alto firm for engineering services related to aerial mapping and the design of the Hillsdale-Marina Lagoon bridge. This bridge was intended to provide the principal access to Foster City. At the time, the only other access was a narrow, wooden bridge that went past the San Mateo sewer plant and garbage dump and was otherwise inadequate for the traffic. The Fosters considered the new bridge essential to their marketing plans. In May 1962, Estero accepted a bid from a builder for the construction of the bridge, and work began immediately. The bridge was opened to traffic in May 1963.

By October 1961, subdivision plans for Neighborhood One had been submitted to San Mateo County and a development schedule had been prepared by Estero's engineers. It was anticipated that funds would be needed in early 1962 to begin the construction of water, sewer, and street improvements, as well as to meet outstanding commitments related to the mobilization of the dredging equipment. Accordingly, Estero resolved to call a special election to authorize bonded indebtedness of $ 3 million for a water project, $ 19 million for lighting and drainage, including street improvements, $ 4 million for a sewer project, and $ 1,500,000 for parks and playgrounds, as well as revenue bonds of $ 2 million for water facilities and $ 4 million for sewer facilities. Estero also resolved to call for bids on $ 10,900,000 of the general obligation land reclamation bonds that had been previously authorized as well as $ 1,700,000, $ 3,500,000, and $ 1,700,000, respectively, of general obligation water bonds, street improvement bonds, and sewer bonds.

At the special election in November 1961, each of the five bond issues passed by a vote of 7,667,010 to zero. At the election, the only authorized voters were the landowners, the Foster partnership, and a Foster-controlled corporation, Foster Bayou Corp., which was owned by the partnership and to which a small parcel of land had been previously conveyed. (Foster Bayou Corp. plays a role in Issue 2, infra.) At the same time, Estero awarded the sale of $ 2,600,000, $ 500,000, $ 800,000, and $ 600,000, respectively, of general obligation land reclamation bonds, water bonds, street improvement bonds, and sewer bonds to an underwriter; the remaining bonds were not sold at that time.

In January 1962, Estero contracted with WH & B for engineering services related to the preparation of plans and specifications for the major drainage facilities to be used in the land reclamation project. Estero also approved the plans and specifications, previously submitted by WH & B, for a water supply line to connect the district with the water mains of the San Francisco Water Department in San Mateo. The waterline was to cross into Foster City, suspended from the bottom of the Hillsdale-Marina Lagoon Bridge. At the same time, Estero approved a contract with San Mateo authorizing the district to install and maintain the waterline under the public streets of that city. In February 1962, a contract was awarded to an Oakland company for the actual construction of the waterline. Easements from private parties were also obtained to permit the installation and maintenance of the line.

In April 1962, Estero approved a contract for the construction of a 6,300-foot sewer outfall line. It also extended an earlier contract for additional lagoon excavation and land preparation. Another contract was awarded to an electrical contractor.

In May 1962, Estero obtained an easement from the State of California for the construction, operation, and maintenance of the sewer outfall line. As previously mentioned, the district also approved a contract for the construction of the Hillsdale-Marina Lagoon Bridge. Later that month, it awarded to an underwriter the sale of $ 7 million, $ 750,000, $ 1,450,000, and $ 800,000, respectively, of general obligation land reclamation bonds, water bonds, street improvement bonds, and sewer bonds, all of which had been previously authorized.

During July 1962, Estero executed a number of additional work orders under existing contracts with several contractors. It also entered into an agreement with Pacific Gas & Electric Co. for the use of the latter's right-of-way to construct a waste water channel. Another contract was entered into with D & M for consulting services related to soil engineering.

In August 1962, Estero contracted with a consulting firm for city planning services. The contract was designed to insure that the basic features of the general plan were coordinated with the specific engineering plans for the various community facilities that were being constructed by the district. Estero also awarded a contract for the construction of the sewage disposal plant.

In September 1962, Estero awarded a contract for the construction of lagoon shoreline improvements. The previous month, it had approved the plans and specifications prepared by WH & B.

From September 1961 through October 1962, Estero issued checks in the following aggregate amounts for reclamation and other development from the indicated funds:

		Reclamation	Total
1961	September - December			$ 690,853.43
1962	January	$ 501,464.79	$ 162.12	501,626.91
	February	443,770.03	128,197.47	571,967.50
	March	354,684.93	33,170.99	387,855.92
	April	461,976.39	102,149.52	564,125.91
	May
	June	84,643.50	58,202.69	142,846.19
	July	405,944.65	82,687.50	488,632.15
	August	200,118.27	163,617.14	363,735.41
	September	366,026.07	312,036.83	678,062.90
	October	280,724.69	188,600.68	469,325.37

Subsequent to October 1962, Estero continued to contract for the development of Neighborhood One. Major contracts were awarded in February 1963 for the construction of community facilities in unit 1 and in August 1963 for the construction of community facilities in unit 2. Landscaping contracts were awarded in January and April 1965.

Estero also continued to call special elections to approve bonded indebtedness intended to finance the overall development of Foster City. For example, in March 1964, an additional $ 26,100,000 in general obligation bonds were approved for land reclamation ($ 8,505,000) as well as the construction of street improvements ($ 3,710,000), parks and playgrounds ($ 335,000), fire stations ($ 600,000), water projects ($ 5,440,000), and sewer projects ($ 7,510,000). At this election, the bond issues again passed unanimously (10,285,000 to zero) with the landowners, principally the Foster partnership, being the only authorized voters.

Estero also continued to regulate development. For example, in July 1964, it passed a sewer ordinance.

The 216 acres of Neighborhood One had been reclaimed and were available for building no later than mid-1963. By March 1964, unit 1 had been completed with sewer and waterlines, storm drains, paved streets, street lights, and underground electric and telephone utilities. By January 1965, unit 2 had been similarly completed.

It should be emphasized that the development of Foster City was a continuous, ongoing undertaking. As land in one neighborhood was being improved, land in another was being reclaimed. During the 1960's, Estero played a crucial role in the reclamation and improvement of the various neighborhoods by contracting for and financing their development. Contracts which Estero awarded in respect of the other neighborhoods resembled those described above. A representative sampling of major contracts includes agreements for the construction of three additional bridges, one in February 1964 and two in April 1965; agreements for land preparation in Neighborhoods Four, Seven and Eight, and Five and Six in November 1964, September 1965, and May 1966, respectively; agreements for the paving of roadways in Neighborhoods Two, Three, and Four in October 1964, April 1965, and June 1965, respectively; and agreements for the construction of improvements in Neighborhoods Nine and Eight in June 1966 and January 1968, respectively. Certain of these contracts exceeded $ 1 million.

2. The Foster Partnership

The role played by the Foster partnership in the development of Foster City prior to September 8, 1960, the date on which Estero was formally organized, has already been described. Accordingly, only its role subsequent to that date will be discussed. We start, however, with the supporting roles played by its partners.

Jack Foster was the ultimate authority among the Fosters at Foster City. He took particular interest in, and responsibility for, the financial aspects of the project. During the 1960's, he resided in Pebble Beach, Calif., approximately a 2-hour drive from Foster City. During that period, he generally spent 3 or 4 days per week in the San Mateo area working on the Foster City project. The balance of his time, he spent at home involved in other projects in California and elsewhere. In 1965, Jack Foster discovered that he had cancer. Over the next couple of years he became increasingly less active in the Foster City project. By early 1967, he was confined to bed and never returned to his office in Foster City. He died in March 1968.

Jack Foster, Jr., was general manager of the Foster City project from November 1960 until the Fosters sold their interest as developers in 1970. As general manager, he was responsible for the overall development of the project and was in charge in his father's absence. With the decline in his father's health, he assumed even greater responsibility. Until he moved to Foster City, he resided in a neighboring community approximately 5 minutes away. Virtually all of his time was devoted to the Foster City project.

Principally because of his training in geology, Bob Foster was assigned primary responsibility for monitoring the progress of the landfill operation. His function was to insure that the land would be suitable for home construction after the fill and grading were completed. He was also responsible for insuring that a particular earthquake-resistant foundation was installed by all builders in Foster City.

Finally, Dick Foster came to Foster City in July 1963 from Hawaii. His principal role involved supervising the construction of various commercial buildings which the Fosters intended to hold for investment purposes.

At least through 1967, the year in which the composition of Estero's board of directors began to change, the Foster partnership and the district had a very close working relationship. They were united in their goals for the reclamation of the land, the sale of the lots, and the construction of improvements, and they cooperated fully in the development process. One or more of the Fosters frequently attended board meetings, especially during Estero's formative period, and were generally familiar with the agenda ahead of time. George Shannon, one of Estero's directors and its secretary, tax assessor and collector, and later its general manager when the preceding offices were consolidated, regularly attended the Fosters' weekly planning sessions. The Fosters served as judges and inspectors at the district's elections and never protested the value at which their land was appraised.

On occasion, the Fosters acted as agents for Estero. For example, in 1961 Jack Foster, Jr., negotiated the purchase for the district of land in San Mateo which was needed for the approach to the Hillsdale-Marina Lagoon Bridge. All of the Fosters, particularly Jack Foster, actively promoted the sale of Estero bonds to banks and other potential purchasers.

The Foster partnership also loaned money to Estero when the district's finances required such assistance. For example, lacking street funds, Estero obtained a $ 75,000 loan from the partnership in January 1962 so that it could acquire the bridge approach which Jack Foster, Jr., had negotiated for it the previous month. Because of inadequate bond sales, Estero obtained a commitment in November 1962 from the partnership to loan sufficient funds to permit land reclamation to continue. In October 1967, the district obtained a temporary loan from the partnership in the amount of $ 2,325,000 for various improvement projects.

Jack Foster assigned to Estero various permits and licenses which he had obtained on behalf of the Foster partnership and which were essential to the dredging operation. For example, no later than September 1960, Foster assigned a permit to dredge San Bruno Shoal which had been obtained in 1959 from the U.S. Army Corps of Engineers. In October 1962, he assigned a mineral lease with the California State Lands Commission permitting the extraction of sand from San Bruno Shoal.

Jack Foster also assigned to Estero various contracts which he had previously entered into on behalf of the Foster partnership. In March 1961, he assigned, and Estero assumed the full indebtedness under, an engineering contract which had been entered into with WH & B in November 1959. This contract involved the preparation of the general planning and engineering guide for the reclamation of land on Brewer's Island. In March 1961, he assigned, and Estero again assumed the full indebtedness under, engineering contracts which had been entered into with D & M in March and July 1960. These contracts involved site investigation on Brewer's Island and additional sand exploration of San Bruno Shoal.

In May 1961, Estero approved the payment of claims in the amount of $ 368,809.34 to the Foster partnership for expenses incurred on behalf of the district. A significant amount of the those expenses was for services rendered by WH & B and D & M before the district was established. In November 1961, Estero approved the payment of claims in the amount of $ 66,843.28. Most of this amount related to payments made by the partnership to WH & B for engineering services. In February and April 1962, Estero again approved the payment of claims in the respective amounts of $ 75,336.71 and $ 48,916.49 for expenses incurred by the partnership on behalf of Estero.

The Foster partnership granted various interests in land to Estero. In February and July 1962, easements were granted for the purpose of constructing and maintaining water supply lines. In April 1965, a parcel in fee and two easements were granted in Neighborhood Three for boating and water usage. In December 1965, an easement was granted for the maintenance of the Neighborhood Four lagoons. Other easements which the partnership granted will be described hereinafter.

Estero contracted with the Foster partnership for specific services. In August 1964, for example, Estero entered into an agreement with the partnership for financial and accounting services.

The Foster partnership participated in the construction of improvements in Foster City by entering into a variety of contracts. For example, at the time that Estero awarded the contracts for the construction of community facilities in Neighborhood One, the partnership separately contracted for the necessary underground utility work. Other contracts entered into by the partnership in respect of Neighborhood One will be described hereinafter. Contracts in respect of other neighborhoods include tripartite agreements entered into by the partnership, Estero, and San Mateo County: in June 1964, for the construction of improvements in Neighborhood Two; in July 1965, for the construction of community facilities in Neighborhood Three; in November 1965, for the construction of community facilities in Neighborhood Four; in February 1967, for the construction of community facilities in Neighborhood Nine; in March 1968, for the construction of improvements in Neighborhood Eight; and a bilateral agreement entered into by the partnership and Estero for the electrical work in the industrial park. The partnership entered into several of these contracts at times when acreage in several affected neighborhoods was titled in the names of other Foster entities. This matter will be discussed subsequently.

Finally, the Foster partnership held itself out and was regarded as the developer of Foster City. For example, the "Foster City Report," a promotional newsletter published by the Fosters, referred to the partnership as the developer. Estero's bond prospectuses also referred to the partnership as the developer. Correspondence between the Fosters and the Federal Housing Administration characterized the partnership as the developer of Foster City.

3. The Alphabet Corporations

The Alphabet Corporations were formed in September or October 1962. On October 3, 1962, they acquired their equal, undivided interests as tenants-in-common in the 127 acres of land in units 1 and 2 of Neighborhood One.

The Alphabets acted in concert through Foster T. Corp. They did not open separate bank accounts but rather maintained a single account in the name of Foster T. Corp. which was opened in June 1963 and remained active through October 1968. They had no employees or office space separate from the partnership and the other Foster entities. The Alphabets filed Federal income tax returns for the taxable years 1963 through 1969.

From July 1963 through December 1965, the Alphabets collected $ 2,023,900 from the sale of lots in Neighborhood One. These proceeds were deposited into the bank account of Foster T. Corp. During that same period, the Alphabets transferred $ 2,052,500 in stated loans to the partnership for its use in the further development of Foster City.

During the course of the development of Neighborhood One, the Alphabets entered into agreements with, and granted easements to, Estero. However, they were joined in these acts by either the Foster partnership or Jack Foster acting on behalf of the partnership. For example, in January and October 1963, agreements were entered into by the Alphabets, the partnership, Estero, and San Mateo County for the construction of improvements in two tracts of Neighborhood One. In April 1963, the Alphabets and the partnership granted an easement to Estero for the maintenance and operation of lagoons in Neighborhood One.

The Alphabets also entered into agreements with other parties. Again, however, they were joined in these contracts by either the Foster partnership or Jack Foster acting on behalf of the partnership. For example, in May and December 1963, the Alphabets and the partnership entered into agreements with Pacific Gas & Electric Co. to provide gas and electric service to unit 1 of Neighborhood One.

Included within the 127 acres of land in Neighborhood One were a number of waterfront (lagoon) lots. These lots were not sold but rather leased by the Alphabets to builders who would construct and sell homes subject to 75-year ground leases. The income derived by the Alphabets from this activity was not reallocated by respondent.

The involvement of the Alphabet Corporations in Foster City was not confined to Neighborhood One. In January 1964, the Alphabets and the partnership contracted with Estero for the construction of improvements in part of the industrial park. In May 1967, the Alphabets purchased lots in the industrial park from Lomita Homes, a subsidiary of Likins-Foster Honolulu Corp., which had previously purchased them from the partnership in 1964 and 1965. In late 1965, the Alphabets undertook to construct the Commodore Apartments, the first section of which was completed in early 1967. These apartments were located in Neighborhood One and were built on land owned by the Foster partnership. Their construction was financed in part by bank and insurance company loans and in part by proceeds derived from the sale of lots in Neighborhood One. In 1968, the Commodore Apartments were sold to a third party in order to obtain working capital. At the time, the Foster partnership was experiencing a serious cash flow problem and the sale of the apartments was part of a program to partially liquidate investment property in order to insure the survival of the Foster City project.

C. SALE OF LOTS IN NEIGHBORHOOD ONE

The Fosters originally anticipated that income from the sale of lots in Neighborhood One would first be derived in 1962. However, the first block of sales was delayed primarily because the filling operation took longer than had been anticipated. By November 1962, the Fosters were projecting income by January 1963.

Negotiations between the Fosters and interested builders for the sale of lots in unit 1 of Neighborhood One began in 1962. The Fosters discovered that there were so many contractors in the Bay area who were eager to build in Foster City that it was not necessary to reduce the asking price.

In January 1963, a subdivision map of unit 1 of Neighborhood One was recorded with the county of San Mateo. The map had previously been reviewed by both the county planning commission and engineer and approved by the board of supervisors. Sales of lots were not permitted until the map was recorded. However, recordation necessitated the posting of a subdivision bond by the developer to insure that all improvements would be completed to the county's satisfaction. Recordation also precipitated a reappraisal for real estate tax purposes and generally higher taxes. Accordingly, it was usually advantageous for the developer to delay recordation until sales were anticipated.

Unit 1 of Neighborhood One consisted of 626 lots. Of this number, 410 were tract lots for outright sale and 216 were waterfront (lagoon) lots which were to be leased to builders who would construct and sell custom homes subject to 75-year ground leases.

The first sales were made in June 1963 to three prominent west coast builders for between $ 5,000 and $ 6,000 per lot. In August, construction began, and the first homes were completed that fall. In 1963, a total of 247 tract lots were sold and 11 waterfront lots were leased to four different builders. Additional lots were sold and leased in 1964 and 1965. The disposition of certain lots was delayed, however, because of FHA regulations regarding fill and foundation.

D. ROLE OF DEL CHAMPLIN

A. O. "Del" Champlin was born in 1911. He attended the University of Oklahoma, majored in accounting, and graduated in 1932. In 1935, he became licensed to practice as a certified public accountant in Oklahoma and had offices in Oklahoma City. For most of his career, he practiced accountancy as a partner in various accounting firms which typically employed a number of staff accountants. Champlin supervised the detail work involved in matters such as performing audits and preparing returns and personally provided income tax, business, and financial planning services to his clients.

Champlin met Jack Foster through V. B. Likins, for whom he had been performing accounting services, and was retained by him. Champlin serviced both Foster individually and the various Likins-Foster businesses and became one of their principal tax planners. He was frequently called upon to structure transactions in order to achieve favorable tax consequences. One of his favorite techniques was multiple incorporation and as a consequence Foster and Likins ended up with many different corporations.

After Jack Foster severed his business relationship with Likins in 1955 and went into partnership with his sons, Champlin and his firm continued to perform a broad range of accounting services for the Fosters. He continued to function as one of their principal tax planners. Certain transactions which he structured during the immediate post-Likins period resulted in litigation before this Court. *216 Champlin remained in Oklahoma after Jack Foster moved to California in 1958. However, as the Fosters became increasingly interested in the prospect of undertaking the Foster City project, Champlin began spending more and more time in California. At the request of Jack Foster, he moved to San Mateo in January 1961 and became licensed to practice as a C.P.A. in California. Although he continued to function as an independent contractor, the Fosters were virtually his only client and he shared their offices. The rest of his firm continued to service the Foster account from Oklahoma.

At Foster City, Champlin became the Fosters' principal tax adviser and architect of their tax planning. He was expected to minimize their taxes to the extent possible and to postpone the payment of those taxes which could not be avoided because the Foster partnership needed to retain as much cash as possible for the development of Foster City. The value of money on hand to the Fosters far exceeded any interest that might eventually have to be paid on a tax deficiency, especially when the rate of interest that the Government charged was less than that charged by commercial banks. Accordingly, 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 in developing Foster City.

In order to minimize taxes, Champlin sought to shift income among multiple entities. He was responsible for the creation of numerous trusts and corporations. In 1962, Jack Foster claimed that he alone owned some 52 corporations. This multiplicity of entities frequently complicated the Fosters' operations. Champlin also sought to postpone the payment of taxes by engaging in a variety of stalling tactics whenever the Commissioner undertook to audit the Fosters or one of their entities. For example, the adjustments in the case involving Likins-Foster Honolulu Corp., et al. (see note 24, supra), took nearly 10 years to ultimately resolve.

The Fosters regarded Champlin as the "steward" of their taxes. They reposed great confidence in his tax-planning abilities and trusted him implicitly. They never challenged his recommendations but rather adopted them without critical analysis and implemented them immediately. They never questioned him concerning his reasons for transferring acreage between entities or structuring a transaction in a particular manner. As a consequence, they frequently did not understand why certain measures were being taken.

Champlin's recommendations dictated the basic organizational structure within which the Fosters undertook to develop Foster City. He determined that it would be advantageous from a tax standpoint for them to begin in partnership form. Losses incurred during the early years could be utilized by the partners to reduce income on their personal returns. Later, as land was developed, acreage could be transferred to a corporation in an effort to shift income to a taxpayer subject to a lower rate of tax.

In 1962, Champlin determined that corporations should be formed for the purpose of taking title to some of the land in Neighborhood One. Accordingly, the Alphabets were incorporated, and the 127 acres were transferred to them. Champlin even designated the particular acreage that was conveyed. The Fosters did not question the transfer nor did they inquire about the reason for it. Rather, they assumed that it was for the purpose of minimizing their income taxes.

E. ULTIMATE FINDINGS OF FACT

Estero was controlled and dominated by the Foster partnership.

The Foster partnership used Estero as its instrument for the development of Foster City.

The Foster partnership was responsible for the development of Neighborhood One.

The Foster partnership earned the income derived from the sale of lots in Neighborhood One.

The 127 acres of land in Neighborhood One were conveyed to the Alphabet Corporations in order to shift income from the Foster partnership and split it among four other taxpayers.

The 127 acres of land in Neighborhood One were conveyed to the Alphabet Corporations in order to avoid Federal income taxes.

IV. Facts Related to the Sale of Lots in Neighborhoods Two and Three (Issue 2)

Neighborhoods Two and Three were the next neighborhoods to be developed. Each consisted of 215 acres. The land in Neighborhood Two was completely reclaimed and improved and available for building by mid-1965, and the land in Neighborhood Three, by mid-1966. The Foster partnership sold lots in these neighborhoods during the taxable years involved in this case and reported the income and deducted the expenses related to those sales on its information returns.

In the notice of deficiency, respondent adjusted the cost claimed by the Foster partnership in respect of its sale of lots in Neighborhoods Two and Three as follows:

1963	1964	1965	1966	1967
($ 203.52)	$ 1,000,842.67	$ 1,580,722.23	$ 67,473.87	($ 164,504.72)

This adjustment was described in the notice 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 $ 3,000,000.00 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.

Only the "Westway" component of this adjustment is in dispute.

Also in the notice of deficiency, respondent made a related adjustment in favor of the Foster partnership to gain it reported in 1964. This adjustment was described in the notice as follows:

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."

As the above two explanatory paragraphs indicate, the factual predicate of the issue involving Neighborhoods Two and Three lies in the Westway transaction. That transaction consisted of a complicated series of steps, the crucial one of which involved the delivery of certain promissory notes which the parties refer to as the Westway notes. We must ultimately determine whether those notes were part of the partnership's basis in Neighborhoods Two and Three, as petitioners' maintain, or whether they represent an obligation to pay additional interest on money borrowed for the purchase of Brewer's Island, as respondent maintains. At this time, however, we shall merely describe the Westway transaction.

A. GENESIS OF THE WESTWAY TRANSACTION

As previously stated, the terms negotiated by Jack Foster for the purchase of Brewer's Island contemplated a downpayment of $ 2,500,000. However, the immediate payment of that amount was not compatible with the need for cash anticipated by the partnership once the Foster City project was actually underway. Accordingly, the Fosters determined that most of the downpayment would have to be financed. At that point, they turned to the Republic National Bank.

The Fosters turned to Republic for financial assistance because they were frequent customers of that bank and enjoyed a good credit rating. Jack Foster in particular had a long and cordial business relationship with the bank that dated from the 1940's. Over the years, he had borrowed millions of dollars and had never been refused a loan. Republic had been the Fosters' major source of financing for their previous real estate transactions and had also acted as their lender for certain other of their undertakings such as oil and gas ventures. Never, however, had Republic ever assumed any role in relation to the Fosters other than that of lender.

Shortly after the enactment of the Estero Act in May 1960, the Fosters met in Dallas with senior bank officials to discuss the possibility of financing the partnership's downpayment on Brewer's Island. Participants at this meeting included Fred Florence, Republic's chairman of the board; James Aston, its president; and Oran Kite, a senior vice president. The Fosters recognized that it was customary for developers to furnish their own downpayment and finance only the balance of the purchase price. In order to induce Republic to advance the necessary funds, they proposed to pay not only interest at the prevailing market rate but also a bonus equal to the total amount borrowed from the bank to acquire Brewer's Island. The bonus, however, would be payable only from half the profits derived from the project in 5 years' time. As an additional inducement, the Fosters proposed to structure the bonus so that it would be taxed to the bank as capital gain rather than ordinary income. Del Champlin had conceived this part of the proposal.

At the conclusion of the Fosters' presentation, Republic's chairman patted Jack Foster on the leg and remarked, "I guess we're partners." The parties then shook hands. The terms of their agreement were not subsequently reduced to writing. As in previous dealings between the Fosters and the bank, negotiations were concluded and terms agreed upon by handshake.

On August 19, 1960, Jack Foster purchased Brewer's Island on behalf of the partnership for $ 12,800,000. The $ 2,500,000 downpayment included $ 2 million which was obtained on August 16, 1960, by virtue of the agreement that had previously been negotiated with Republic. The loan documents which were executed on that date, however, reflect the involvement of the Hoblitzelle Foundation and the Howard Corp. Before proceeding further, we should briefly introduce those two entities.

The Hoblitzelle Foundation was affiliated with the Republic National Bank. It was founded by Karl Hoblitzelle, who was Republic's chairman prior to Fred Florence. James Aston, Republic's president and later its chairman, served at various times as the foundation's president and a member of its board of directors. The Howard Corp. was a corporation the stock of which was owned by trustees for the benefit of Republic's shareholders.

On August 16, 1960, the Fosters entered into a purported loan agreement with the Howard Corp. in which the latter agreed to arrange a $ 2 million loan from an unspecified lender in exchange for a $ 50,000 service fee. The agreement provided, inter alia, that the loan proceeds were to be used for the downpayment on Brewer's Island. It also restricted the Fosters' right to sell or mortgage any part of Brewer's Island without the lender's consent. However, transfers between the Fosters and their controlled corporations were expressly exempted from this restriction.

On August 16, 1960, the Fosters also executed a $ 2 million promissory note payable to the Hoblitzelle Foundation. That note was unsecured, bore interest at the prevailing market rate (6 percent per year), was payable quarterly, and was due absolutely and in all events in 2 years. The cash advanced against that note was the source of most of the partnership's downpayment for its purchase of Brewer's Island.

Finally, on August 16, 1960, the Howard Corp. agreed with the Hoblitzelle Foundation to purchase the Fosters' note, if called upon to do so by the foundation, for an amount equal to the unpaid balance plus accrued interest at the time of such purchase. In addition, it agreed to pay the foundation an amount equal to 3 1/2 percent per year on the unpaid balance of the note during the period of the foundation's ownership.

Notwithstanding the involvement of the Hoblitzelle Foundation and the Howard Corp. in making the $ 2 million loan, the Fosters at all times regarded Republic as their lender. Accordingly, the fact that their note was made payable to an entity other than the bank never led them to question whether their agreement to pay the 100-percent bonus might not apply.

As previously stated, Jack Foster executed promissory notes to the sellers (Leslie and Schilling) for the balance of the purchase price of Brewer's Island ($ 10,300,000). The payment schedule for those notes called for payments of $ 500,000 on August 19, 1961, and August 19, 1962. On each of those dates, the partnership borrowed the entire amount of the payment from Republic. Because those amounts represented part of the purchase price of Brewer's Island, they were subject to the agreement to pay the 100-percent bonus.

On August 19, 1962, the original $ 2 million loan from the Hoblitzelle Foundation was extended to August 19, 1963. On August 17, 1963, the Fosters satisfied this loan by borrowing $ 2 million from Republic.

B. MECHANICS OF THE WESTWAY TRANSACTION

By August 19, 1962, the Fosters had borrowed a total of $ 3 million from Republic and its affiliated foundation for the purchase of Brewer's Island. By the following year, all of this amount was owed to the bank. Under the terms of the agreement negotiated in 1960, Republic was therefore entitled to a bonus of $ 3 million payable from half the profits in 5 years' time. (The provision that the bonus be paid from half the profits was subsequently waived by the Fosters.) Republic was also entitled to the bonus on a capital gains basis. Del Champlin was assigned primary responsibility for structuring a transaction to achieve this result. What was devised was the Westway transaction. We shall defer discussion of the tax planning surrounding that transaction until after we describe the form of its several steps. Suffice it to say for now that the transaction was designed not only to insure favorable tax consequences to Republic but to the Fosters as well.

1. On August 4, 1961, Jack Foster, acting on behalf of 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, which was titled in the name of the partnership. This exchange was treated as a nontaxable transaction. Foster Bayou had been formed by the partnership on or slightly before that date. Other than the land, it had no assets. It also had no bank account and never paid any dividends. At the time of the conveyance, the 200.17 acres was dry land which had previously been leased by the Federal Aviation Administration to erect and maintain radio transmitters. (Foster City is located about 5 miles south of San Francisco International Airport and 10 miles southwest of Oakland Airport.) This lease constituted Foster Bayou's only business activity. *88 1969, Neighborhood Eight was only in a state of token development.

2. On August 7, 1962, the Foster partnership transferred its stock in Foster Bayou to Westway Investment Co. (Westway) for a named consideration of $ 5,000 in cash and a non-interest-bearing note due August 7, 1967, in the amount of $ 100,000. Westway was a subsidiary of the Howard Corp. As previously stated, the sole asset of Foster Bayou was the 200.17 acres of land in Neighborhoods Eight and Nine. On the date of the transfer, this land was in essentially the same condition as when it was originally acquired by the Foster partnership. Westway did nothing to improve it during the period that it held the Foster Bayou stock (Aug. 7, 1962 -- May 4, 1964). Moreover, during that same period, Foster Bayou's expenses (such as real estate taxes) were paid by the partnership or Likins-Foster Honolulu Corp. whenever its rental income was insufficient in amount.

3. On April 23, 1963, the Esteroy Corp. (Esteroy) was formed by the Foster partnership. Other than a $ 10,000 capital contribution, Esteroy had no assets. It used as its address the same post office box as the partnership. On its Federal income tax return for the taxable year beginning April 23, 1963, and ending February 29, 1964, Esteroy reported no gross income and claimed deductions in the aggregate amount of $ 188.06, including amortization of organizational costs in the amount of $ 83.06 and franchise taxes of $ 105.

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 500 shares, or one-half, of that corporation's authorized stock. *231 5. Also on December 3, 1963, the Foster partnership transferred its 500 shares of Foster California stock to Foster Enterprises, Ltd. (Foster Enterprises). Foster Enterprises was a corporation which had been formed in 1960 to hold the Foster Tower Hotel in Honolulu and was solely owned by the Fosters in equal shares. It treated the transfer of the Foster California stock as a contribution to its capital. (Foster Enterprises also plays an important role in Issue 3, infra.)

6. In January and February 1964, Esteroy and Westway negotiated what was in form a purchase and sale of all of the Foster Bayou stock for a named consideration of $ 3,105,000, consisting of $ 5,000 to be paid in cash at the closing and non-interest-bearing promissory notes for the balance, or $ 3,100,000. This latter 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. The promissory notes for these amounts are the so-called Westway notes. Although they were executed by Esteroy, they represent the first written agreement evidencing the partnership's obligation to pay the 100-percent bonus which had been negotiated in 1960. Moreover, the notes were unconditional, i.e., payment was not conditioned upon the earning of profits. Finally, they were secured by a pledge of Esteroy's stock.

Although the Westway notes were executed and delivered in February 1964, they were dated May 4, 1964. On that date, 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. At the time that Foster Bayou had acquired that parcel, it had debited its land account in the amount of $ 1,333,648 and had credited "mortgages payable" in the amount of $ 1,142,664.

8. Three days later, 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 500 shares ($ 5,000 par value) of that corporation's stock. The 500 shares represented the remaining one-half of Foster California's authorized stock.

9. Three days later, on June 8, 1964, Esteroy was liquidated by the Foster partnership. At that time, its principal asset was the 500 shares of stock in Foster California. On its final Federal income tax return for the period beginning March 1, 1964, and ending June 7, 1964, it reported no gross income and claimed deductions in the aggregate amount of $ 465.30, including amortization of organizational costs in the amount of $ 415.30.

At the time of its liquidation, Esteroy was indebted to Westway in the amount of $ 3,100,000. On July 24, 1964, the Fosters expressly and unconditionally assumed this indebtedness. At the time that Esteroy had pledged its shares as collateral for the purported purchase of the Foster Bayou stock, it had reserved the right to liquidate and substitute for the pledged shares the personal guarantee of the Fosters.

10. On July 31, 1964, the Foster partnership transferred to Foster California the 500 shares of stock in Foster California which it had acquired on June 8, 1964, by virtue of the liquidation of Esteroy. In exchange for its stock, 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. This transaction was treated as a taxable exchange, and the partnership reported gain. (See the adjustment in the notice of deficiency which was previously quoted.) Afterwards, Foster California was a solely owned subsidiary of Foster Enterprises.

11. In December 1965, Westway sold to Republic for $ 952,176 one-half of the $ 2 million promissory note due August 19, 1966, which Esteroy had executed in 1964 as part of the purported purchase price of the Foster Bayou stock. This left Westway with a remaining receivable of $ 2,100,000. Westway was subsequently merged into the Howard Corp., which then became the holder of that receivable.

12. By their terms, the Westway notes were due in the months of August 1966, 1967, and 1968. The Fosters were able to successfully negotiate certain renewals. However, by the end of 1968, they had become delinquent in payment. This matter will be discussed later in greater detail.

13. On June 1, 1970, Foster California (whose name had been changed to Foster C Corp.) was merged into its parent, Foster Enterprises. As we shall see, Foster Enterprises had a history of substantial net operating losses. It received the 200.17 acres in Neighborhoods Eight and Nine, less some acreage that had been previously sold, and entered the land on its books at $ 3,105,000. That amount represented Foster California's basis for the land and not the basis of the stock canceled.

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 as well as other consideration which will be described subsequently. As far as the Fosters were concerned, the Westway notes were satisfied at that time.

C. TAX PLANNING

The principal architect of the Westway transaction was Del Champlin, who had conceived the idea. He was assisted by Roy Lytle, an Oklahoma attorney who represented the Fosters throughout the 1950's and until his retirement in the 1960's. Republic was represented in this matter by James Laney, its attorney, as well as by senior bank officials.

The objective of the Westway transaction from Republic's point of view was to insure that the $ 3 million bonus was taxed as capital gain rather than as ordinary income. Republic sought to achieve this objective through the purported purchase of Foster Bayou stock in 1962 by Westway for $ 105,000 and the subsequent sale of that stock by Westway in 1964 for $ 3,105,000.

The objective of the Westway transaction from the Fosters' point of view was to raise $ 3 million through tax savings in order to pay the bank its bonus. They sought to achieve this objective by stepping up not only the partnership's basis in the 196.638 acres of land in Neighborhoods Two and Three by $ 3,105,000, but also Foster California's basis in the 200.17 acres of land in Neighborhoods Eight and Nine by the same amount, for a total step-up in basis of $ 6,210,000. They also contemplated making Foster California a wholly owned subsidiary of Foster Enterprises. By filing consolidated returns, they hoped that the latter's net operating losses would absorb the income derived by the former from the sale of lots. As events transpired, Foster California was merged into Foster Enterprises in 1970.

The mechanics of the Westway transaction, as described above, evolved over a period of time. Virtually from the time that the loan and bonus were originally negotiated, there were discussions between the parties concerning the manner in which the transaction should be structured in order to achieve their respective objectives. For example, in early August 1960, Jack Foster asked Roy Lytle to attend a meeting in Dallas with James Laney and bank officials to discuss the transaction. Afterwards Lytle summarized for Foster a proposal which was discussed at that meeting and from which the Westway transaction gradually evolved:

1. Foster will pay $ 50,000.00 to Howard Corporation for its services in arranging $ 2,000,000.00 loan from Hoblitzelle Foundation * * *

2. Foundation will lend $ 2,000,000.00 to T. Jack Foster, with interest at 6%, payable quarterly, due in two years, unsecured * * *

3. There shall be organized a Delaware corporation named "Foster Laguna Corp." (which name will be used unless you pick out another one later on). This corporation shall have an authorized capital of $ 10,000.00. To this corporation shall be conveyed all of Foster's interest in a tract of land on Brewer's Island covering some 150 to 200 acres of land, it being intended to cover a part of the tract that will be first developed * * * The consideration for this conveyance will be the issuance of all of the stock of the corporation to Foster. * * *

4. Foster will sell all of the stock of Laguna Corp. to Wayside (this is not the exact corporate name, but it is an inactive subsidiary of Howard Corporation which, at the present time, has no assets and no liabilities) for a consideration of either $ 25,000.00 or $ 125,000.00 of which $ 5,000.00 will be paid in cash by Wayside and the remainder of the purchase price will be evidenced by a promissory note of Wayside running in favor of Foster due five years hence and without interest.

5. There shall be incorporated in Delaware, but not necessarily qualified in California, a corporation known as "Foster Bayou Corp." having an authorized capital of $ 1,000.00. Foster will pay $ 1,000.00 to the corporation and receive in exchange all of the stock of this corporation.

6. Foster will contribute to Likins-Foster Honolulu Corp. all of the stock of Foster Bayou Corp. so that it is a 100% owned subsidiary of Likins-Foster Honolulu Corp.

7. The stockholders of Wayside will give Bayou Corp. an option to purchase all of the stock of Wayside for $ 5,000.00 in cash and a note for $ 2,000,000.00 due five years from the present date, without interest. * * * In some way the note of Wayside to Foster is to be cancelled or we will eliminate any reference to the note of $ 20,000.00 or $ 120,000.00, as the case may be, it being intended that the owners of Wayside will get the $ 5,000.00 in cash to pay to Foster and that the stockholders and Wayside will get back their $ 5,000.00 in cash and end up with a $ 2,000,000.00 note * * *

8. If any ad valorem taxes become due against the land owned by Foster Laguna Corp. while the stock of such corporation is held by Wayside, Foster is to pay those taxes. * * *

9. Foster, individually, joined with his sons and wife, shall guarantee to the stockholders of Wayside Corp. the note of Bayou Corp., limiting the guarantee, however, to 50% of the net profits before taxes made by the guarantors and their corporations on the entire Brewer's Island Project. * * * Just how you will handle the payment of the $ 2,000,000.00 on your books is up to Del [Champlin] to decide.

10. As soon as you obtain the Wayside stock you will then liquidate Laguna Corp. into Wayside, Wayside into Bayou, and Bayou into Honolulu Corp. In the last liquidation the $ 2,000,000.00 note of Bayou will not be assumed. Immediately after the liquidation of these corporations, Laguna Corp. will convey to Honolulu Corp. the land owned by it * * *

11. At the same time that all of the other documents are prepared some subsidiary of Howard Corporation, or it may be Howard Corporation, will commit itself, without commitment fee, to make available to you $ 500,000.00 on August 19, 1961 and $ 500,000.00 on August 19, 1962, each of which notes would be for a period of one year at 6%, with interest payable quarterly. * * *

12. For these two loans, if you took them, you would be expected to make available $ 500,000.00 of capital gains. You would form other corporations which would take title to the land involved, the stock would be sold to other subsidiaries of Howard Corporation, a new corporation would issue a note for $ 500,000.00, which you would guarantee to the extent of one-half of the profits in the Brewer's Island venture, excluding, of course, the first $ 4,000,000.00 of profit, one-half of which you would be obligated to pay on the first deal.

13. No mention was made at the conference of any obligation on your part to borrow from the Texas lenders either of the $ 500,000.00 loans which might be necessary to pay off Schilling. So far as any conversation was carried out, you would be free to borrow that where you pleased. I got a great speech on how much the Republic Bank loved you and how much they were sure that you loved the Republic Bank and that if any of the papers prepared didn't work out satisfactorily they could always be shifted and they knew that if you made a tremendous profit on the transaction you would be happy to share it with the Republic Bank group. I think Mr. Florence really believes this, but I would sure hate to see you owe them money that you couldn't pay. You are also correct in saying that the $ 2,000,000.00 capital gain carrot was one that the Texas rabbits [i.e., the Republic bankers] wanted very badly and they wanted it as soon as possible * * * *242 In April 1962, subsequent to the formation of Foster Bayou but prior to the transfer of its stock to Westway, Jack Foster asked Roy Lytle about the 200.17 acres of land in Neighborhoods Eight and Nine that had been conveyed by the partnership to Foster Bayou:

In reviewing the Republic National Bank's memorandum regarding our transaction out here with the Howard Corporation, we agreed that we would transfer to a corporate entity some 200 or 300 acres, which would be the first lots to be developed and sold. Instead, we transferred to them the 200 acres consisting of the site where the F.A.A. station is located, and that will be one of the later or last areas developed.

I do not think this actually makes any difference because we plan to buy back all from the corporate entity, giving them a capital gain. I am sure that Del [Champlin] felt it would give them a greater protection for their capital gain if they took this land that was transferred to them.

Do you recall whether you discussed this with the Bank and cleared this particular point? Mr. Jim Cumby, Senior Vice President of the Bank, will be here on the 10th and I would like to have a clarification on this point before he arrives.

[Emphasis added.]

Later that month Lytle responded to Foster's inquiry in the following manner:

I have your letter * * * in which you inquired as to my discussions with the Republic National Bank concerning the exact location of the land which was to be conveyed to the corporation which was purchased by a bank subsidiary. * * * At the time that I left you in California you did not know what land would be conveyed to your corporation. We left the acreage in round figures and it was suggested that the land would be among that that was first filled. Later on, because we had no surveys, we took the F.A.A. lease survey. No point has been raised that I know of as to the location of the land owned by Foster Bayou Corp. and, frankly, I doubt if Mr. Laney or Mr. Aston have any recollection of the discussion except by virtue of the memorandum.

Incidentally, when I got the Foster Bayou Corp. deed on record and everything else fixed up I sent the stock certificates and all of the other books and papers pertaining to the Foster Bayou Corp. to Mr. Laney and said, in effect, "Here it is; you can send us the agreed purchase price (which I think was $ 5,000.00) at your convenience." I heard nothing from him for a month and finally I wrote him and asked him if he got the papers. He immediately answered and acknowledged receipt of them, but that was all. I did not, in sending the papers to Laney, call attention to where the land was located and I doubt if he knows to this date. I am reasonably sure that Mr. Cumby will have no recollection of it because I never met him. I don't think it actually makes a bit of difference, but should the point be raised, I think you can merely say that that was the only description we had that covered the desired acreage and that it probably doesn't make any difference anyway, because you are going to buy back from The Howard Corporation all of the stock in their subsidiary company [i.e., Westway], which has no assets except the stock in Foster Bayou Corp. *245 Subsequent to the transfer of the Foster Bayou stock to Westway in August 1962, the Fosters and Republic continued to discuss the manner in which the transaction should be structured in order to achieve their respective objectives.

In early August 1963, Roy Lytle corresponded with Rex Johnson, a senior vice president of Republic in charge of the Foster account, concerning the renewal of the $ 2 million note to the Hoblitzelle Foundation which was due later that month:

After I talked with you last week I advised Mr. Foster of your suggestions in regard to the replacement of the Hoblitzelle Foundation $ 2,000,000.00 note which comes due August 19, 1963. * * * Mr. Foster and his sons have mulled over this matter for about a week, and they say that the terms that you have set forth are impossible to meet because the land will bring in money just so fast and no faster. They have countered with the following suggestions which they said they can and will meet.

* * * *

4. On the bonus money he is willing to give the Howard Corporation in exchange for the Bayou Corp. stock, notes aggregating $ 3,000,000.00. These notes would be unsecured notes and would provide for payment of $ 2,000,000.00 on August 19, 1966, $ 500,000.00 on August 19, 1967, and $ 500,000.00 on August 19, 1968. These notes would bear no interest until maturity, but would bear interest at 6% after maturity. He feels that he is making a very substantial concession in giving an unconditional promise to pay, because he is waiving the provision that these notes are payable only out of and from profit. I think that we all agree that it will be extremely difficult to draw a contract which defines profit.

* * * *

Jack asked me to emphasize the fact that it will be impossible to give security on Brewer's Island property. As you know, it is subject to a deed of trust in favor of Schilling-Leslie, together with an obligation in favor of Richard H. Grant. He said that any mortgage or deed of trust put on the developed property would make it impossible to sell.

When we were discussing the bonus money arrangements in Mr. Laney's office he wanted the purchase price of Westway, which owns Bayou, to be $ 2,000,000.00, and he wanted a new corporation formed to hold title to some land which, in turn, would be sold back for $ 100,000.00. We, of course, are willing to do this, but in view of the amendments proposed to regulations under Code Section 61 and 421, I am afraid that you could not get capital gains since the proposed regulations refer to options granted after July 11, 1963. It would be simpler and, in my opinion, much safer if you simply sold the Westway stock for the $ 3,000,000.00 in notes which are due without interest in 1966, 1967 and 1968, as set forth above.

[Emphasis added.]

During the fall of 1963, the Fosters continued to discuss ways by which to structure the Westway transaction that would not only be acceptable to Republic but compatible with their own interests. Correspondence from Champlin to Lytle in September 1963 reflects the Fosters' objective of financing the 100-percent bonus through tax savings:

One of the essential reasons for concluding the transaction at this time is the fact that the Fosters, in their financial agreements with the bank, took the fact that this transaction would be concluded now into consideration. 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.]

In January 1964, correspondence commenced concerning the proported sale of the Foster Bayou stock. The initial "offer" came from Westway and was addressed to the Foster partnership:

As you know, Westway Investment Corporation is the sole owner of Foster Bayou Corporation, which owns certain lands located on what was known at the time of their acquisition as Brewer's Island. At the present time, our situation is such that we would consider a sale of this interest.

Therefore, this shall constitute an offer to sell to you 100% of the capital stock of Foster Bayou Corporation for a consideration of $ 3,105,000.00 to be paid to Westway Investment Corporation. This offer shall remain open until January 31, 1964, and unless accepted prior thereto will automatically terminate on same date.

Ten days later, Esteroy responded as follows:

We have given consideration to your offer to sell 100% of the capital stock of the Foster Bayou Corp. as contained in your letter of January 13, 1964. We would propose to buy this stock on the following terms and conditions:

The sum of $ 5,000 to be paid in cash upon closing and the sum of $ 100,000 on August 7, 1967; $ 2,000,000 on August 19, 1966; $ 500,000 on August 19, 1967 and $ 500,000 on August 19, 1968. Notes will be given for the different amounts and said notes will be non-interest bearing prior to maturity. The notes will be secured by pledge of all of the stock of the Esteroy Corporation owned by T. Jack Foster & Sons.

I think we should advise you that we contemplate the liquidation of Foster Bayou Corp. if Esteroy should acquire that stock. It probably makes no difference to you, but we wanted you to understand what we planned to do.

The Westway notes were delivered in February 1964. Shortly thereafter, a pledge agreement was executed. Under its terms, Esteroy agreed not to permit its own liquidation unless and until the Fosters, individually and unconditionally, agreed to guarantee payment of the Westway notes. However, Esteroy was liquidated in June 1964 and it was not until the following month that the Fosters notified Republic of that fact. At that time, they expressly assumed liability for the Westway notes.

D. POST-MATURITY DEVELOPMENTS

By their terms, the Westway notes were due as follows:

Amount	Due	$ 2,000,000	8/19/66	Westway ($ 1 million);
		Republic ($ 1 million)
8/ 7/67	Westway
500,000	8/19/67	Westway
500,000	8/19/68	Westway
3,100,000

By mid-1966, the Foster partnership was experiencing financial difficulty principally related to cash flow. Although Republic was no longer eager to loan additional amounts, it did agree to renew the $ 2 million note to August 19, 1967. By that time, however, the partnership's financial position had deteriorated further and Republic was becoming increasingly concerned. Nevertheless, in October 1967, Republic again agreed to renew the $ 2 million note and the first $ 500,000 note (originally due Aug. 19, 1967) to October 30, 1968. In exchange, however, it demanded interest at the rate of 1 percent above prime, a mortgage on all of the real property in Foster City owned by the partnership and the related Foster corporations, and the Fosters' individual guarantees.

Immediately after the second renewal in October 1967, the Fosters began to seek additional time within which to satisfy the Westway notes. By letter dated October 31, 1967, Jack Foster, Jr., wrote to John Stuart, a vice president of Republic who at that time was responsible for the Foster account:

For purposes of financial planning with particular emphasis on aiding us in the retiring of our obligations to the Republic National Bank, it is important that we have some idea as to the position of the Republic National Bank regarding the $ 3,000,000 Westway debt. (I shall refer to this as the Westway debt even though I realize a portion of it is now in the Republic National Bank.)

We will be materially aided in attaining our goals of meeting these obligations, as well as to put our financial house in order, if the Bank will agree to handling this Westway debt as follows:

Subject to the payment of all debt now owing the Republic National Bank by the Foster partnership and all related corporations, except the Westway debt, and

Subject to securing an investor who will provide new capital in the form of a loan or otherwise * * *, and subject to the approval by the Republic National Bank of the financial strength of such partner, then, in that event:

1. The Westway debt will be amortized over a period of six years at the rate of $ 500,000 per year, starting 1969;

2. The Westway debt will be secured by land in Foster City at the ratio of 100% of security to outstanding indebtedness, reserving the right of substitution of other land in Foster City, and;

3. All collateral except that securing the Westway debt and all guarantees will be returned to Foster.

In preparation for an in-house conference, a report was prepared by Republic in November 1967 concerning the Foster partnership. The last paragraph of that report read 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 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.]

In December 1967, John Stuart wrote James Aston a memorandum commenting on the Fosters' proposal. The first and last paragraph of that letter provided as follows:

The Fosters are, as I previously informed you, reportedly trying to get a suitable equity partner for the Foster City project. To assist them in negotiations, Jack Foster, Jr., feels it would be most advantageous to have the indication from us that we would be willing to receive the $ 3,000,000 of our debt repayable $ 500,000 a year plus interest. This is the portion of the overall debt which Mr. Florence received as a fee at the inception of the project. As it stands now, $ 1,000,000 of this is owing the bank and $ 2,000,000 is owing Westway.

I feel that * * * we can prepare such a letter [accepting the Fosters' proposal] which will be very general in context but will be within the spirit of what we hope the Fosters are trying to accomplish and what we need to have done in regard to all our debt. In summary, we would have all of our debt cleaned up with the exception of the fee debt which would be paid back in installments of $ 500,000. There are some tax advantages to receiving smaller payments * * * that can be more easily offset by depletion, etc., rather than a lump sum payment since this is ordinary interest to Westway.

[Emphasis added.]

In 1968, the financial condition of the Foster City project became so precarious that the Fosters consulted their attorneys about the possibility of filing a chapter proceeding under the Bankruptcy Act. Moreover, as the Westway notes approached term, the Fosters had not yet obtained an investor nor had they definitively resolved the situation with Republic.

During the latter half of 1968, there were frequent discussions between Republic and the Fosters concerning the latter's indebtedness to the bank. John Stuart participated in those discussions and prepared memoranda to the file summarizing them. Excerpts from four such memoranda follow.

(1) Memorandum dated August 2, 1968:

Jack [Foster, Jr.] told us that he thought under the right restructuring of debt they would be able to handle the Leslie-Schilling debt, the $ 1,500,000 owing Republic, with the balance owing Republic of approximately $ 4,500,000 being handled on a separate basis. This would entail the $ 3,000,000 fee debt that came out of Westway being paid at the tail end of the project or some other extended date, with the remaining $ 1,500,000 continued to be reduced on a monthly basis from cash flow from leases and contracts pledged (this runoff is at the rate of approximately $ 15,000 to $ 20,000 a month, including interest).

(2) Memorandum dated August 27, 1968:

I talked to Dick Foster on 8/25/68 regarding the bank's contemplated work on a creditor's program for the Foster City problem. Dick told me that they are now working on a plan to liquidate select properties to, hopefully, raise enough to pay approximately $ 3,100,000 to Republic National Bank and $ 986,000 to Wells Fargo. This would thereby reduce their debt to the original $ 3,000,000 that was taken in by Westway (now Howard) in connection with a fee that Mr. Florence worked out with Mr. Foster, Sr. The Fosters then think we should work along with them on this remaining portion due to the origination of the "indebtedness."

(3) Memorandum dated October 11, 1968:

Mr. Lytle asked if we would take $ 3,100,000 on their debt and continue to carry the balance on some type of amortized basis. Of course we agreed to this, subject to Mr. Aston's approval since our position would change very little if this were accomplished. This would then repay actual dollars that the bank has invested in the project with the "fee debt" to come at a later date.

To summarize, the Fosters have reached the "moment of truth" and are following anticipated courses of action that we thought they probably would. They appear to feel a strong responsibility to our bank for the actual funds borrowed, but not for the fee money.

(4) Memorandum dated December 10, 1968:

Before concluding the meeting, Jack [Foster, Jr.] pressed Aston on their obligation to pay the $ 3,000,000 "fee debt" of which Howard is owed $ 2,000,000 and RNB $ 1,000,000. Aston stated that it was an obligation of the Fosters' and we anticipated full payment. Jack questioned the validity of the debt and insisted on playing a tape recording they had of a telephone conversation between Foster, Sr., Aston and Mr. Florence. (It was recorded without the bank's knowledge.)

The Foster position is that the debt was originally to be repaid from a split of profits if any. Aston acknowledged this point, but clearly explained to Jack that subsequent units [sic] and conditions changed this. It is now an obligation owing for which we expect full payment.

In 1969, the Fosters directed their attorneys to review their financial relationship with Republic. They were particularly interested in the possibility of an action against the bank for usury. Although no action was commenced, Republic was aware of their claims.

In October 1970, the Fosters withdrew from Foster City as developers by selling to Centex. At the same time, they entered into an "Agreement of Release" 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. In exchange therefor, the Fosters released Republic and the Howard Corp. from any claim they might have against them for usury. In this regard, the agreement provided as follows:

Recitals:

E. Certain of the parties included in the Foster Group are asserting claims against Bank and Howard for payments made or agreed to be made by one or more of the Foster Group to Bank or to Howard, or to their affiliated corporations, arising out of the aforementioned transactions between certain of the Foster Group, on the one hand, and Bank and/or Howard, on the other hand, subsequent to January 1, 1960, allegedly in violation of applicable usury statutes. Bank and Howard deny the validity of any such claim or claims.

* * * *

G. The Foster Group, on the one hand, and the Bank and Howard, on the other hand, have agreed to settle and compromise all controversies between and among them and to mutually release each other from any and all claims, demands and liabilities, including without limitation the claim of the Foster Group against Bank and Howard for alleged violation of usury laws as aforesaid.

Now, Therefore, in consideration of the mutual covenants and agreements herein contained, It is Agreed as Follows:

* * * *

3. The Foster Group and each of them hereby waive, relinquish, release and discharge Bank and Howard, and each of them, of and from any claims, demands, controversies, actions, causes of action, costs, expenses, attorneys' fees, damages, compensation, obligations and liabilities of any nature whatsoever, whether known or unknown, suspected or claimed, matured or unmatured or whether contingent or noncontingent (including specifically, but without limiting the generality of this release, the claims of the Foster Group referred to in Recital E above), which they and each of them, or their successors in interest, had, now have or may have or claim to have against Bank and Howard, or either of them, by reason of any matter, cause or thing whatsoever in any way arising out of or in connection with acts or transactions prior to this Agreement.

* * * *

6. The Foster Group, and each of them, convenants and agrees to indemnify and hold Bank and Howard harmless against all loss, cost, damage and expense, including attorneys' fees, which Bank and Howard, or either thereof, may suffer or incur by reason of the institution or assertion by the Foster Group, their successors in interest (exclusive of Centex West, Inc., its successors and assigns), or any thereof, of any claim, suit, legal action or proceeding against Bank or Howard based upon any claim or demand released or purported to be released by this Agreement.

E. ULTIMATE FINDINGS OF FACT

The $ 3 million bonus represented compensation for the use of money.

The Westway notes were executed in consideration of money loaned and not for the purchase of corporate stock.

The Westway notes were not paid during the years in issue.

V. Facts Related to the Sale of Lots in Neighborhood Four (Issue 3)

Neighborhood Four was the next neighborhood to be developed. It consisted of 311 single-family residential lots, nearly 56 acres of multifamily land, and about 12 acres of commercial land. All together, the neighborhood contained 157 acres.

On August 29, 1966, the Foster partnership conveyed all of the single-family residential lots in Neighborhood Four to Foster Enterprises, a corporation that was owned solely by the Fosters in equal shares. It treated the transfer of the lots as a contribution to its capital.

During 1967, approximately two-thirds of the single-family residential lots in Neighborhood Four were sold to builders. On its 1967 income tax return, Foster Enterprises reported net income from the sale of those lots in the amount of $ 936,379.01. Respondent determined that such income was overstated by approximately $ 16,000. In the notice of deficiency, he allocated the revised amount, or $ 920,462.25, to the Foster partnership. This allocation was made under authority of section 482.

In order to understand the factual predicate of the Neighborhood Four issue, it is necessary to describe the development of Neighborhood Four, the involvement of Foster Enterprises, and the role played by Del Champlin in causing the transfer of the 311 residential lots.

A. DEVELOPMENT OF NEIGHBORHOOD FOUR

Neighborhood Four was not developed by unit, as were the other neighborhoods, but rather as an integrated whole. The progress of its development can be traced by the following:

In November 1964, Estero awarded a ground preparation contract. In April 1965, the San Mateo County Planning Commission approved the subdivision map. Later that month, Estero entered into an agreement with WH & B for engineering services related to, inter alia, the high school site.

In May 1965, the fill for Neighborhood Four was completed.

In June 1965, Estero awarded a contract for rough grading. That contract was completed ahead of schedule in September 1965. In that month, Estero awarded a contract for the construction of community facilities such as curbs, gutters and sidewalks, street lights, storm and sewer pipes, and water mains and hydrants. Completion of the contract was scheduled for August 1966. Sixty-five percent of the contract was completed by the end of March 1966.

In November 1965, Estero also entered into an agreement for the construction of community facilities with the Foster partnership and San Mateo County. Later that month, the subdivision map was recorded with the county.

In December 1965, the Foster partnership granted an easement to Estero for the maintenance of the lagoons in Neighborhood Four.

In June 1966, Estero awarded "extension contracts" for the construction of additional improvements such as the paving of roadways.

In September 1966, the Neighborhood Four improvements were completed. By that time, the 311 single-family residential lots had been certified and were ready and available for house construction.

B. INVOLVEMENT OF FOSTER ENTERPRISES

The Foster partnership conveyed the 311 single-family residential lots to Foster Enterprises on August 29, 1966. At that time, Neighborhood Four was virtually developed. Foster Enterprises did not participate in completing the improvements, nor had it previously played any role in the development of that neighborhood. Rather, Neighborhood Four was completely developed by the partnership, which used Estero as its instrument in the development process.

Although Neighborhood Four was completely developed by September 1966, Foster Enterprises was unable to sell any lots until February 1967. This delay was caused by the weak housing market that existed throughout northern California during most of 1966. In fact, the market was so weak that one major builder withdrew entirely from Foster City, a second went into bankruptcy, and a third stopped purchasing lots because of its large, unsold inventory. Another factor which adversely affected the sale of lots was the Cooper litigation which commenced in December 1966. *104 During February and March 1967, Foster Enterprises sold 200 of the 311 single-family residential lots in Neighborhood Four to three builders for a total of $ 1,516,400. *265 income was derived solely from the operation of Foster Tower.

Foster Enterprises had no payroll from the date of its incorporation until 1967. It paid a management fee for the operation of Foster Tower to Kuhio Beach Hotel, Ltd. (Kuhio). Kuhio was a Hawaiian corporation which was also solely owned by the Fosters in equal shares. It owned the ground lease on the land under the hotel as well as the commercial space on the first floor.

At the same time that Foster Enterprises was incorporated, it was expected that the operation of the Foster Tower Hotel would generate considerable tax deductions through depreciation. From 1962 through 1966, Foster Enterprises never had a profitable year and incurred a cumulative net operating loss of $ 1,268,835. Most of this loss ($ 928,825) was generated by accelerated depreciation. The decision to claim accelerated depreciation had previously been made on the advice and recommendation of Del Champlin.

The decision to transfer the 311 residential lots in Neighborhood Four to Foster Enterprises was also made on the advice and recommendation of Del Champlin. The Fosters did not question his recommendation nor did they inquire about his reasons for it. They understood that the transfer was for the purpose of utilizing the net operating loss carryovers of Foster Enterprises. They were very conscious of these carryovers and anxious to insure that they were used to reduce ordinary income. Champlin specifically selected the lots in Neighborhood Four because both he and the Fosters anticipated that they would be the next major source of income in Foster City.

Foster Enterprises derived net income of approximately $ 920,000 in 1967 from the sale of lots in Neighborhood Four. This income was completely absorbed by a combination of a 1967 net operating loss in excess of $ 200,000 (exclusive of the aforementioned net income) and the NOL carryovers from prior years.

D. ULTIMATE FINDINGS OF FACT

The income from the sale of the single-family residential lots in Neighborhood Four was earned by the Foster partnership.

The lots in Neighborhood Four were conveyed to Foster Enterprises so that the income from their sale would be absorbed by that corporation's losses, particularly its net operating loss carryovers.

The lots in Neighborhood Four were conveyed to Foster Enterprises for the purpose of avoiding Federal income taxes.

VI. Facts Related to the Grant of the Sway Easement (Issue 4)

At the time that the Foster partnership acquired Brewer's Island in 1960, the Pacific Gas & Electric Co. (PG & E) owned an easement for a right-of-way across the island. In 1961, PG & E sought to widen that easement in order to construct new, high-voltage electric transmission lines. The Fosters opposed that action because they preferred to have both the contemplated and existing lines rerouted. PG & E refused to accede to this request and commenced an action to condemn an additional easement immediately adjacent to the existing one. In 1964, it succeeded in obtaining the easement and paid the partnership $ 425,000 for it.

The electric transmission towers which PG & E constructed after condemning the additional easement were in a triple row and taller than the preexisting ones. They were aesthetically objectionable and negatively affected the value of all of the land in Foster City. Consequently, the partnership characterized the entire $ 425,000 payment as severance damages and reduced its basis in all of its land by said amount. Respondent never challenged this treatment and in fact adopted it in his land cost schedule in the notice of deficiency.

After the new towers were constructed, the partnership's electrical engineer discovered that the catenary of the power lines was greater than had been anticipated. This meant that under certain wind conditions, the lines would sway outside the easement which PG & E had just condemned. The Fosters, through their attorney, brought this matter to the attention of PG & E, which thereupon undertook to acquire a "sway easement" in order to perfect the right-of-way easement which it had condemned in 1964. A sway easement is an easement which permits powerlines to sway over a portion of the land which is beyond the scope of the existing easement. Because of the sway of the lines, the outer boundary of such an easement defines an arc which can be described by metes and bounds.

The land described by the sway easement was zoned for single-family, multiple-family, and commercial use. The easement precluded the construction of homes or other buildings under the sway area. However, backyards and parking areas could extend under it and trees could be planted, provided they did not interfere with the sway of the powerlines.

PG & E paid $ 72,000 for the sway easement in 1967. Of this amount, $ 63,717 was paid to the partnership, and $ 8,243 to Foster Enterprises as the record title holders. Both the partnership and Foster Enterprises characterized the entire amount received as severance damages and reduced their bases in their respective land holdings by said amount.

In the notice of deficiency, respondent determined that the amount received for the sway easement constituted proceeds from the sale of land in the ordinary course of business and not severance damages. He then determined the amount of the gain and allocated all of it to the Foster partnership.

ULTIMATE FINDINGS OF FACT

The powerlines and towers which PG & E constructed after condemning the additional easement in 1964 detracted from the entire Foster City development and decreased the value of all of the land therein.

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.

The 1967 sway easement was not independent of and unrelated to the 1964 right-of-way easement but rather was an indispensable part thereof.

VII. Facts Related to the Transfers of the School and Church Sites (Issue 5)

During 1964 and 1965, 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 those years:

1. In 1964, the partnership conveyed 7.4 acres of land in Neighborhood One to the San Mateo City Elementary School District

3. In 1965, the partnership sold 1.844 acres of land for $ 36,880 ($ 20,000 per acre) to the United Church of Christ for use as a church site. It also valued this land at $ 40,000 per acre. Accordingly, it again characterized the transfer as a "bargain sale" and claimed a deduction for a charitable contribution in the amount of $ 36,880 ($ 73,760-$ 36,880).

In the notice of deficiency, respondent disallowed all three deductions in their entirety. The deduction for the transfer of the school site was disallowed because --

(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.

In his land cost schedule, respondent added the cost of this parcel to the partnership's basis in all of its remaining land in Foster City. The deduction for the transfers of the church sites was disallowed because "the partnership has not established the sales price received is less than fair market value of the 2 [or 1.844] acres." No part of the cost of either of these two parcels was capitalized by respondent because their cost was completely recovered in the "bargain sales."

A. MOTIVATION FOR THE TRANSFERS

Foster City was conceived, designed, and promoted as a totally planned city which would offer its residents a complete array of community facilities and services including schools and churches. Estero's July 1961 bond prospectus described the general plan for the creation of the city as follows:

The firm of Wilsey, Ham and Blair, Consulting Engineers and Planners was employed to prepare a General Plan, comprising the 2,600 acres in the District. The objective for the engagement was to develop a complete plan for a balanced community providing for a proportionate share of the land to be used for industry, business, and residential purposes, and to use the natural characteristics of the land to provide for high amenities for the residents of the community. The Plan was to encompass and provide for all community facilities and services that would be required of a city. The result of the plan represents a logical breakthrough on a scale from shopping centers, industrial parks, and housing projects which have been popular in recent decades and has created an integral union of all these elements. It is the first attempt in the West to create a city "in toto", which will provide various classes of residential areas, completely planned neighborhoods, school sites -- all in keeping with practical application of the most recent advancements and techniques of city planning. * * *

The prospectus went on to enumerate specific design criteria and objective goals of the general plan:

2. Since it [Foster City] will be developed as a whole, in accordance with modern planning principles and unity of control, it shall be designed to be relatively more self sufficient than other [San Francisco] Peninsula communities.

3. Since surrounding communities have failed to provide themselves with adequate employment area, Foster City will offer a closer balance between work space and residential area.

4. Full and adequate provision will be made for all community facilities and services required by the resident population, including parks, playgrounds, clinics and sanitariums, churches, libraries, swimming pools, community center, communications, shopping facilities, exhibits, parking and maintenance and operating facilities.

* * * *

8. A unique and outstanding Town Center will be developed, comprising a designed composition of stores, offices, public buildings, churches, cultural facilities, recreation and amusement services, hotels, service establishments, banks, restaurants, theater, malls, squares, landscaping, parking structures, and a water front promenade.

9. In order to maximize efficient location and reduce commuting, houses and places of employment will be developed concurrently, so that a newcomer finding a job may also find a vacant and available dwelling at the same time, and so prospective industries can be offered housing for their employees. This is expected to provide added inducement to industrial development, reduce private and public commuting costs, and foster social stability and civic pride.

* * * *

11. All elementary schools will be located at the center of neighborhoods. With arterial streets generally bounding neighborhoods, and with moderately higher population density, all youngsters will be within 2,000 feet of their school and neighborhood playground and may reach them without crossing major traffic thereby eliminating need for an expensive bus system.

12. The land owner [Jack Foster, on behalf of the Foster partnership] will make all the planned school sites available to the School District at his cost. The Estero District will be reimbursed for all improvement costs of providing for land reclamation and all the community facilities, to relieve the District's tax-payers from paying for improvements on land that will have tax-free usage. Tax payments will therefore be kept in their proper category.

The 1961 prospectus also set forth the general plan's "acreage distribution of land use requirements for a balanced community." In this regard, the plan called for 182 acres of land for schools and 40 acres for churches and institutions. *276 In language substantially identical to that in its 1961 prospectus, Estero's July 1965 prospectus emphasized Foster City's neighborhood school concept. Moreover, it specifically called attention to the fact that the community's first elementary school (the site for which had been conveyed the previous year by the Foster partnership) had been completed and was already in use by the San Mateo Elementary School District.

Estero's 1966 and 1967 prospectuses also highlighted the progress of schools in Foster City. For example, the 1967 prospectus stated that the San Mateo Elementary School District had been operating a 600-pupil elementary school in Neighborhood One since 1965 and that it presently had under construction a 750-pupil elementary school in Neighborhood Two and a 1,000-pupil junior high school in Neighborhood Three.

The Fosters also advertised the planned community concept in newspapers and magazines and in the "Foster City Report," the promotional and public relations newsletter published by the partnership. For example, the August 1963 edition of the "Report" contained a photograph of a 42-square-foot scale model of Foster City complete with the neighborhood schools, churches, and other public facilities. The newsletter reported that similar scale models were on public display in important public places throughout San Mateo County, including at the Fair where "the model attracted more than 100,000 visitors."

In the fall-winter 1965 edition of the "Foster City Report," the headline announced that the San Mateo Union High School District had acquired a 56-acre site in Foster City for the construction of a high school designed to accommodate 3,000 to 3,500 students. The newsletter also reported that the San Mateo Elementary School District was discussing plans for a junior high school in Foster City, and that enrollment in the first elementary school had topped 300 pupils.

In order to provide adequately for schools in Foster City, the Fosters commenced discussions with San Mateo school officials as early as the summer of 1960. There was a great deal of concern on the part of those officials about the impact that Foster City would have on the local school system. That concern grew as development continued and the first residents began moving in. Eventually, the partnership, in order to settle the turmoil that had arisen, offered to donate the site for the first school.

At the time of the partnership's offer, the San Mateo Elementary School District had been providing bus service to the school children of Foster City. The school district, however, threatened to cancel that service. In addition to alarming the residents, this threat, if carried out, would have made Foster City less attractive to prospective buyers with school-age children. At that point, the Fosters announced that they would withdraw their offer to donate the school site if the bus service were canceled. The district continued the service, whereupon the Fosters conveyed the site.

In order to provide for churches in Foster City, the Fosters developed a "church plan" with the assistance of the California-Nevada Council of Churches. The objective of the plan was to insure that Foster City would offer the proper variety and number of churches. The Council was given the responsibility of designating which churches should be given the first opportunity to purchase sites in Foster City.

The presence of schools and churches in Foster City enhanced the value of all of the land therein.

B. ULTIMATE FINDING OF FACTS

The Foster partnership's dominant reason for conveying the school and church sites was the expectation of direct economic benefit.

VIII. Facts Related to the $ 5,000 Payment for Legal Services (Issue 6)

In January 1965, the Foster partnership received a statement for services rendered in the amount of $ 5,000 from the Oklahoma City law firm of Lytle, Soule & Emery. The statement was sent by Roy Lytle, a partner in that firm and the attorney whom the Fosters had continued to retain notwithstanding their relocation to California. The statement reads as follows:

T. Jack Foster & Sons -- General

To fee 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.

The partnership paid the $ 5,000 in January 1965 and claimed a deduction for legal fees in that amount on its information return for 1965. In the notice of deficiency, respondent disallowed the deduction in its entirety on the ground that the "services of Senator Dolwig [were] not shown to be for business purposes."

Senator Richard Dolwig was a California State senator. He cosponsored the Estero Municipal Improvement District Act in the California legislature in 1960. Subsequent to the passage of that act, however, he did not engage in any legislative activity on behalf of the partnership.

Senator Dolwig was also a practicing attorney. He performed legal services for the Fosters in connection with the 1961 PG & E condemnation action (discussed supra in VI).

It was not the Fosters' practice to make campaign contributions as great as $ 5,000.

Roy Lytle performed substantial legal services for the Fosters during the 1950's and until his retirement in the 1960's. Unlike Del Champlin, he did not move to California when the Fosters undertook the Foster City project. Like Champlin, however, the Fosters trusted him and reposed great confidence in his professional ability. Accordingly, he was frequently called upon to render legal services from Oklahoma City. For example, he drafted their partnership agreements as well as many of their contracts, agreements, and other legal documents. He was usually the individual responsible for formally incorporating and dissolving their corporations. From 1960 through 1964, he was particularly active on their behalf in the Westway transaction.

ULTIMATE FINDING OF FACT

The $ 5,000 payment made by the Foster partnership to Roy Lytle in 1965 was made for legal services and was a business expense.

IX. Facts Related to the Payment of the Fosters' Personal Expenses (Issue 7)

This issue involves certain deductions claimed by the Foster partnership which respondent disallowed on the basis that they were personal expenses of the Fosters. It also involves certain expenses paid by Likins-Foster Honolulu Corp. and two of its subsidiaries which respondent also determined were personal to the Fosters. *282 expenses of the partners":

1963	1964	1965	1966	1967
$ 12,863.07	$ 8,676.73	$ 13,737.12	$ 8,504.77	$ 5,550

Respondent scheduled these amounts as follows in table I on page 115. As the schedule indicates, only the item denominated "travel and entertainment" *283 301 and 316. *114 dividend income because he determined that their corporations paid their personal expenses.

B. ULTIMATE FINDINGS OF FACT

The Foster partnership paid personal expenses of the Fosters in the amounts of $ 12,863.07 in 1963, $ 8,676.73 in 1964, $ 13,737.12 in 1965, $ 8,504.77 in 1966, and $ 5,500 in 1967.

Likins-Foster Honolulu Corp. and certain of its subsidiaries paid personal expenses of the Fosters in the aggregate amounts of $ 18,057.59 in 1963, $ 10,726.98 in 1964, $ 7,072.62 in 1965, $ 3,631 in 1966, and $ 845 in 1967.

X. Facts Related to the Payments Made to Gladys Foster (Issue 8)

On her 1963 through 1967 joint income tax returns, Gladys Foster, the wife of Jack Foster, described her occupation as that of decorator, and reported the receipt of compensation as follows:

Year	Amount	Payor
1963	$ 12,000	Likins-Foster Honolulu Corp.
1964	12,000	Do.
1965	12,000	Do.
1966	12,000	Do.
1966	9,000	Cardiff Homes, Inc.
1967	Lomita Homes, Inc.
	60,000

Both Cardiff Homes, Inc., and Lomita Homes, Inc., were subsidiaries of Likins-Foster Honolulu Corp.

In the notice of deficiency, respondent determined that Gladys Foster's "compensation" for 1963 through 1967 was actually $ 70,761.82, allocable as follows:

1963	1964	1965	1966	1967
$ 15,380.16	$ 14,827.68	$ 15,053.60	$ 21,794.07	$ 3,706.31

Respondent also determined that these amounts constitute dividends *115

TABLE I
	1963	1964	1965
Unagreed issues:
Travel and entertainment --
T. Jack Foster	$ 6,000.00	$ 2,000.00	$ 1,950.00
Advertising	83.20	605.73	5,633.55
Total unagreed issues	6,083.20	2,605.73	7,583.55
Previously agreed issues:
Boat expense	654.87	435.00	578.57
Richard Foster, personal	2,000.00	2,000.00	2,000.00
John R. Foster, personal	1,400.00	1,400.00	1,400.00
T. Jack Foster, Jr.	2,000.00	2,000.00	2,000.00
Telephone -- T. Jack Foster	100.00
Dues and subscriptions	625.00		175.00
Charitable contributions		236.00'
Total previously agreed
issues	6,779.87	6,071.00	6,153.57
Total personal expenses
disallowed	12,863.07	8,676.73	13,737.12

TABLE I
	1966	1967	Nature of item disallowed
Unagreed issues:
Travel and entertainment --
T. Jack Foster	$ 892.76		Personal expenses
Advertising	1,526.68		Personal expenses
Total unagreed issues	2,419.44
Previously agreed issues:
Boat expense	351.83		Personal use of boat
Richard Foster, personal	2,000.00	$ 2,000	Personal use of automobile
John R. Foster, personal	1,400.00	1,400	Personal use of automobile
T. Jack Foster, Jr.	2,000.00	2,000	Personal use of automobile
Telephone -- T. Jack Foster
Dues and subscriptions	333.50
Charitable contributions		150
Total previously agreed
issues	6,085.33	5,550
Total personal expenses
disallowed	8,504.77	5,550

TABLE II
Dick Foster	1963	1964	1965	1966	1967
Travel and entertainment:
Likins-Foster Honolulu Corp.	$ 122.36
Lomita Homes, Inc.	2,427.43	$ 623.68
	852.83	$ 1,546.33	$ 200	$ 75
Total	2,549.79	1,476.51	1,546.33	200	75
Bob Foster
4,332.34	894.35	850.00	200	75
Jack Foster, Jr.
Travel and entertainment
Likins-Foster Honolulu Corp.	122.37
Lomita Homes, Inc.	2,218.66	408.02
T. Jack Foster & Sons, Inc.		1,676.45	1,119.53	300	100
Total	2,341.03	2,084.47	1,119.53	300	100
Jack Foster
Travel and entertainment
Likins-Foster Honolulu
Corp.: travel	1,561.38
Lomita Homes, Inc.:
Travel and telephone	7,273.05	4,035.86
T. Jack Foster & Sons, Inc.:
Travel and telephone		2,235.79	3,156.76	2,931	595
Photos			400.00
Total	8,834.43	6,271.65	3,556.76	2,931	595
Grand total	18,057.59	10,726.98	7,072.62	3,631	845

ULTIMATE FINDING OF FACT

During 1963 through 1967, Gladys Foster received payments in the aggregate amount of $ 70,761.82, allocable to those years as determined by respondent, which are taxable as ordinary income to her and Jack Foster.

OPINION

By this point, it is probably apparent that this case involves some measure of complexity. That complexity is reflected in the sheer magnitude of the record and is exacerbated by the contentiousness of the parties. Not surprisingly, our task of finding the facts has been laborious and frequently frustrating. We have plodded through nearly 2,000 pages of testimony and examined more than 200 exhibits. The record is replete with factual inconsistencies and contradictions which the parties exploit to their own advantage in almost 1,000 pages of briefs. Nevertheless, we have done our best to reconcile the conflicting portions of the record. In all too many instances, however, we have reluctantly concluded that perfect harmony is simply not attainable.

Before turning to the substantive issues involved in this case, we need to address a number of preliminary issues related to certain evidentiary and procedural matters. The most important of these relate to the admissibility of several depositions. We have devoted considerable attention to these issues because of the importance of the content of the depositions to the parties' respective positions.

Preliminary Issues Related to Certain Evidentiary and Procedural Matters

During the course of this case, four depositions were admitted into evidence. The admissibility of each of those depositions has been challenged. Moreover, a ruling made by the Court at trial sustaining an objection to a question calling for a conclusion by a witness has been questioned. Finally, an issue concerning the proper locus of the burden of proof in respect of the three major substantive issues has been raised. We shall begin with the depositions and discuss each in the chronological order in which it was taken.

A. DEPOSITION OF JACK FOSTER

In 1961, the Pacific Gas & Electric Co. (PG & E) commenced an action to condemn an additional easement for a right-of-way across Brewer's Island. The action was brought in the Superior Court of the State of California for the County of San Mateo. Jack Foster was named as one of the parties defendant.

In March 1962, Foster was called to testify as a witness by PG & E at a deposition conducted by its attorney before a notary public and court reporter. At the deposition, Foster was represented by counsel. He was put under oath and examined by PG & E's attorney. His own attorney actively participated in the deposition by objecting to questions and occasionally instructing him not to answer and by briefly examining him. The examination included a history of the Fosters' involvement in Brewer's Island, a discussion of public and private financing for the project, and a review of the first 2 years of operation.

The deposition transcript was not executed by Foster. However, it was stipulated that if he did not sign it prior to trial, it could be used at that time with the same force and effect as though he had signed it. *119 Foster's deposition into evidence, subject to petitioners' relevancy objection.

1. Petitioners' General Hearsay Objection

Rule 801(c) of the Federal Rules of Evidence*291 and offered later at trial to prove the truth of the matter asserted would seem to fall within that definition. If so, such statements are inadmissible under Fed. R. Evid. 802 unless an exception to the hearsay rule is applicable. See Fed. R. Evid. 803 and 804. However, Fed. R. Evid. 801(d)(2)(A) provides that a statement is not hearsay if it constitutes an admission by a party-opponent, i.e., "the statement is offered against a party and is his own statement, in either his individual or a representative capacity."

The rationale for excluding admissions from the definition of hearsay is set forth in the Advisory Committee's Note to Fed. R. Evid. 801:

Admissions by a party-opponent are excluded from the category of hearsay on the theory that their admissibility in evidence is the result of the adversary system rather than satisfaction of the conditions of the hearsay rule. No guarantee of trustworthiness is required in the case of an admission. The freedom which admissions have enjoyed from technical demands of searching for an assurance of trustworthiness in some against-interest circumstance, and from the restrictive influences of the opinion rule and the rule requiring firsthand knowledge, when taken with the apparently prevalent satisfaction with the results, calls for generous treatment of this avenue to admissibility. [Citations omitted.]

See also 4 J. Wigmore, Evidence, sec. 1048 (J. Chadbourn rev. 1972); D. McCormick, Evidence, sec. 262 (2d ed. 1972). As Wigmore explains:

The theory of the hearsay rule is that an extrajudicial assertion is excluded unless there has been sufficient opportunity to test the grounds of assertion and the credit of the witness, by cross-examination by the party against whom it is offered * * *; e.g., if Jones had said out of court, "The party-opponent Smith borrowed this fifty dollars, "Smith is entitled to cross-examine Jones upon that assertion. But if it is Smith himself who said out of court, "I borrowed this fifty dollars," certainly Smith cannot complain of lack of opportunity to cross-examine himself before his assertion is admitted against him. Such a request would be absurd. Hence the objection of the hearsay rule falls away, because the very basis of the rule is lacking, viz., the need and prudence of affording an opportunity of cross-examination. [4 J. Wigmore, supra at sec. 1048, pp. 4-5.]

An admission by a party-opponent is thus admissible as substantive evidence of the fact stated. 4 J. Weinstein & M. Berger, Weinstein's Evidence, par. 801(d)(2)[01] (1981). Jack Foster's deposition constitutes a series of admissions (see 2 B. Jones, Evidence, sec. 13:54 (6th ed. 1972)), which are admissible as such. *294 2. Petitioners' Relevancy Objection

Petitioners also raise a relevancy objection. We agree that an admission must be relevant to be admissible. Fed. R. Evid. 402; see Fed. R. Evid. 403. However, to the extent that their objection speaks to the deposition as a whole, it is without merit because Foster's examination touched on a number of matters which are relevant to many of the issues before us. To the extent that their objection relates to specific passages, suffice it to say that in finding the facts we were mindful of the definition of "relevant evidence" set forth in Fed. R. Evid. 401, *295 B. DEPOSITION OF DEL CHAMPLIN

In June 1969, A. O. "Del" Champlin terminated his relationship with the Fosters. His rapport with the three sons had gradually deteriorated, particularly after Jack Foster's death in 1968. In July 1969, Champlin commenced an action against Jack Foster, Jr., Dick Foster, and Bob Foster in the Superior Court of the State of California for the County of San Mateo. The complaint was styled as one "for wrongful interference with advantageous relationship, compensatory and punitive damages." It alleged that they caused the dissolution of Champlin's accounting firm by inducing his partners to continue rendering accounting services notwithstanding the termination of his relationship with the Fosters.

Shortly thereafter, Champlin also sued the three Foster sons for breach of contract in a separate action. His complaint alleged three causes of action, namely, that the Fosters failed to (1) fully compensate him for services related to his agreement to (a) relocate to California and (b) "perform and provide for defendant's ordinary day to day advisory services and certified public accountant services in matters of finances, taxes and business advice during the planned eight (8) year development by defendants of Foster City;" (2) compensate him for "extraordinary tax consultation services" related to, inter alia, Foster Bayou Corp., Esteroy Corp., Foster Enterprises, Ltd., and Foster California Corp.; and (3) reimburse him for certain expenses incurred in respect of the foregoing. Judgment in the amount of $ 1,500,000 was prayed for on the first two causes of action.

In the breach of contract action, the Fosters counterclaimed, alleging malpractice on Champlin's part and damage "by reason of tax deficiencies, and by reason of tax deductions lost to defendants which substantially increased the income taxes paid by defendants in excess of those otherwise payable." Judgment in the amount of $ 2 million (plus interest and penalties), was prayed for in the counterclaim. In answers to interrogatories served by Champlin, the Fosters outlined the grounds for their malpractice counterclaim, including the following:

I. Failure to recommend or cause incorporation of Foster City development project.

The pending audit by the Internal Revenue Service of the Foster tax returns for the period 1959-1967 discloses proposed assessments of tax deficiencies based on attribution of additional taxable income to the partners of the partnership known as T. Jack Foster & Sons in an amount in excess of $ 5.9 million. If the claims of the Service are sustained, the resulting taxes will be imposed on the individual members of the partnership at rates which exceed corporate tax rates by an average of 50%. At corporate tax rates, the proposed assessment would result in tax deficiencies of approximately $ 2.95 million (applying an average corporate tax rate of approximately 50%). At individual tax rates, however, the proposed assessment could result in imposition of taxes on the individual partners aggregating approximately $ 4 million, or approximately $ 1.1 million more than would have been the case if the Foster City development project had been placed in a corporate structure at the outset.

Plaintiff was or should have been aware that it is the custom and practice in the development industry to perform land development under a corporate form of organization, particularly where, as in the instant case, sales projections (in the making of which plaintiff participated) showed prospects of very large profits and the retaining and reinvesting in the project of very large sums for continued development.

If the proposed deficiency is sustained, the amount of deficiency will bear interest at the rate of 6% per year; based on an average projected period of 7 years, the aggregate loss resulting solely from this one item is approximately $ 1.5 million ($ 1.1 million, plus 6% interest for 7 years).

II. Creation of and failure to use losses generated in Foster Enterprises, Ltd.

Foster Enterprises, Ltd. was a corporation which owned the Foster Towers apartment-hotel building in Honolulu. From the completion of the structure, plaintiff elected to take accelerated depreciation for tax purposes, rather than taking depreciation on a straight line basis. The result was to increase substantially operating losses generated by Foster Enterprises, Ltd.

Plaintiff utterly failed to do anything about the substantial losses that were being generated in Enterprises until 1966, at which time some of the earlier loss carryforwards would have expired. In 1966, plaintiff recommended and caused the transfer to Enterprises of a substantial amount of real property located in Neighborhood 4 in the Foster City project in San Mateo County, which property was owned by the partnership of T. Jack Foster & Sons. The said property was sold shortly after such transfer, and the losses of Enterprises were set off against the profits on the sales. It is the position of the Internal Revenue Service that the property at the time of transfer was fully developed and ready for sale; that the transfer of the property to Enterprises was sham, and that the profit on the sales should properly be charged to the partnership. If the Internal Revenue Service is sustained in its position, approximately $ 980,000 in taxable income will be attributed to the partners for the year 1967, which will result in tax liabilities of approximately $ 650,000, plus interest at 6% per year. In addition, the bulk of the losses generated in Enterprises as aforesaid will be of no use to any taxpayer, the time for such use having expired. The effect of the use of accelerated depreciation has been to decrease the basis of the hotel building by approximately $ 530,000 and the taxable gain on sale will be increased by an equivalent amount. Assuming that the building is sold by a corporation (sales negotiations are currently pending), the result will be an unnecessary increased tax liability of approximately $ 265,000 on the sale resulting from the use of accelerated depreciation.

Plaintiff was negligent in connection with the foregoing transactions in the following particulars:

(a) Plaintiff elected to take accelerated depreciation on the hotel building, and failed to discontinue the same when it was apparent that Enterprises would not, of itself, generate profits, and plaintiff neither formulated nor executed reasonable plans for use of the operating losses of Enterprises.

(b) Plaintiff failed to cause the property transferred to Enterprises to be transferred at a timely date, i.e., failed to cause such transfer to occur when the property was clearly undeveloped and not ready for sale.

III. Creation of, and transfer of properties to, the "Alphabet Corporations".

(a) Failure to effect timely transfer.

As land in Neighborhood 1 of the Foster City project was being developed, plaintiff caused the formation of 4 separate "alphabet" corporations; namely, Foster T, Foster J, Foster B, and Foster D Corporations, each of which was wholly owned by one of the partners of T. Jack Foster & Sons, the then owner of the land. Neighborhood 1 land was transferred to the 4 corporations as tenants in common in or about 1963. The bulk of the land was then sold during the period 1963-1965 at a substantial profit, most of such profit being realized in 1963 and 1964.

It is the position of the Internal Revenue Service that the formation of the alphabet corporations, and the transfer of land to them, had no business purpose other than the avoidance of taxes; that the land transferred was fully developed and ready for sale at the time of transfer; and that the entire series of transactions was therefore a sham which should be disregarded, with all profit on the sales of land by the alphabet corporations in Neighborhood 1 to be attributed to the partnership, T. Jack Foster & Sons. The total profit proposed to be attributed by the Internal Revenue Service to the partnership on the said land sales is $ 1,225,238.56. Because the partners' tax brackets were substantially higher than those of the corporations, the effect of the attribution will be to increase taxes payable by the individuals to the Federal Government by more than $ 750,000.

* * * *

Plaintiff was negligent and unprofessional in his conduct and advice in connection with the foregoing transactions as follows:

(a) Plaintiff failed to cause the property transferred to the alphabet corporations to be transferred at a timely date, i.e., failed to cause such transfer to occur when the property was clearly undeveloped and not ready for sale;

* * * *

VII. Negligence in preparing tax returns in relation to personal, as opposed to business, expenses.

Plaintiff had primary responsibility for preparation of the tax returns of the Fosters. The Internal Revenue Service has taken the position that the returns covered by its pending audit were so far overreaching in their claims of business expense deductions for items which the Service regards as personal that a 5% negligence penalty is proposed on the income of the taxpayers involved for the years covered by the returns. It is not possible at this time to state the amount of such penalty if it is imposed, other than to state that it would not be less than $ 50,000 and could be substantially greater than that amount. If the Internal Revenue Service is sustained in its position, it will be because of plaintiff's negligence in preparing the returns in question.

* * * *

IX. General and Miscellaneous Items.

* * * *

Further, and throughout the periods covered in these interrogatories, plaintiff purported to act as tax counsellor and consultant to defendants. In the course of so doing, plaintiff gave legal advice, prepared instruments beyond his professional competence, and engaged in the practice of law without a license.

All of these answers to interrogatories were verified by Bob Foster under penalties of perjury.

In October and November 1969, Del Champlin was called to testify as a witness by the Fosters in a deposition conducted by their attorney before a notary public and court reporter. At the deposition, Champlin was represented by counsel. He was put under oath and examined by the Fosters' attorney over a 5-day period. His own attorney participated in the deposition only to a limited extent. The examination included Champlin's background, his association with the Fosters, and his involvement in the Foster City project.

The deposition transcript was not executed by Champlin. However, he reviewed it and a number of corrections were made. The parties stipulated that it could be used at trial. *304 filed with the State court. However, the underlying actions were ultimately settled prior to trial.

Del Champlin died prior to the trial of the present case.

Over petitioners' general hearsay objection, the Court granted respondent's motion to admit specified parts of the Champlin deposition into evidence, subject to petitioners' relevancy, opinion, and double hearsay objections. Petitioners then moved to admit portions of the balance of the deposition for the limited purpose of establishing alleged "bias or untruthfulness or inconsistencies" on Champlin's part. Respondent offered no objection and their motion was granted.

1. Petitioners' General Hearsay Objection

There is no question that Champlin's deposition constitutes hearsay as defined in Fed. R. Evid. 801(c). It is therefore inadmissable under Fed. R. Evid. 802 unless an exception to the hearsay rule is available. We thinkFed. R. Evid. 804(b)(1) provides such an exception. That rule states as follows:

(b) Hearsay exceptions. -- The following are not excluded by the hearsay rule if the declarant is unavailable as a witness:

(1) Former testimony. -- Testimony given as a witness * * * in a deposition taken in compliance with law in the course of the same or another proceeding, if the party against whom the testimony is now offered * * * had an opportunity and similar motive to develop the testimony by direct, cross, or redirect examination.

Champlin, as the declarant, is "unavailable as a witness" within the meaning of that phrase as defined in Fed. R. Evid. 804(a)(4). Petitioners concede that his deposition was "taken in compliance with law" and that they had the opportunity to develop his testimony by direct examination. They contend, however, that they did not have a "similar motive" to develop his testimony because it was taken in the context of a discovery deposition. In this regard, they maintain that their motive "was not to tie Mr. Champlin down to a consistent and truthful statement of facts" that would be admissible in court but rather to achieve "wide-range" discovery objectives, principally including the production of "raw information" and the identification of the "outer limits" of their adversary's position.

We recognize that the focus of a party's examination of a witness at trial will generally be narrower than in a discovery deposition. However, we reject any suggestion that we adopt a rule of law that a party's motive in examining the witness is not similar in the two proceedings. See 4 J. Weinstein & M. Berger, supra at par. 804(b)(1)[02], pp. 804-61/62, 804-62 ("Rule 804(b)(1) should not be interpreted as requiring a blanket exclusion of all depositions taken for purposes of discovery"). Rather, we think the question of similarity of motive is factual and is best resolved by comparing "the similarity of the issues and the context in which the opportunity for examination previously arose." S. Saltzburg & K. Redden, Fed. R. Evid. Manual 652 (3d ed. 1982). See 4 J. Weinstein & M. Berger, supra at par. 804(b)(1)[04].

Champlin's action against the Fosters for breach of contract, and their counterclaim against him for malpractice, involved services which he rendered in his capacity as their tax counselor during the development of Foster City. The tax consequences of those services give rise to the issues presently before us. It is readily apparent from a perusal of the Fosters' answers to Champlin's interrogatories that the tax consequences of those services were also at issue in the State court action. For example, they faulted him for failing to recommend or cause the incorporation of the Foster City project, and for failure to effect a timely transfer of land to the Alphabet Corporations. As we shall see, these matters relate to the Neighborhood One issue, discussed infra in Issue 1. They also faulted him for creating, and then failing to use, losses generated by Foster Enterprises. As we shall also see, this matter relates to the Neighborhood Four issue, discussed infra in Issue 3. Moreover, they alleged in their answers that Champlin had "primary responsibility" for not only preparing their tax returns but also establishing their books of account and those of their corporations. *308 Furthermore, in another deposition (discussed infra in C.), Jack Foster, Jr., described Del Champlin as the "steward" of the Fosters' taxes. Champlin was unquestionably the architect of their tax strategy. The soundness of that strategy was a major issue before the Superior Court and the central issue before this Court. Similarly, the extent to which Champlin may have played a role other than that of tax consultant was, and continues to be insofar as the parties are concerned, an important related issue. The Fosters probed these issues over a 5-day period in 1969. Their efforts are reflected in a transcript which runs 435 pages. For these reasons, we are satisfied that petitioners had a similar motive to develop Champlin's testimony, and hence that his deposition is admissible in this proceeding under the "former testimony" exception to the hearsay rule.

2. Petitioners' Remaining Objections

We turn now to petitioners' relevancy, opinion, and double hearsay objections.

We agree that petitioners are entitled to raise relevancy objections at this time. See D. McCormick, supra at sec. 259. However, if the objection is to the Champlin deposition as a whole, it is without merit. Even given the most hurried and superficial reading, the relevance of that deposition is readily apparent. On the other hand, if the objection is to isolated passages, we refer to our comments set forth above in A.2., which are equally applicable here.

It is less certain whether petitioners are entitled to raise opinion objections at this time. See D. McCormick, supra at sec. 259. However, we need not decide that issue because the trial court has considerable latitude under Fed. R. Evid. 701 in admitting opinion testimony by lay witnesses. See 3 J. Weinstein & M. Berger, supra at par. 701[02]. 4 J. Weinstein & M. Berger, supra at par 801(d)(2)(A)[01], p. 801-140 n. 7. That rule, which rejects a rigid and liberal application of the opinion rule, provides as follows:

If the witness is not testifying as an expert, his testimony in the form of opinions or inferences is limited to those opinions or inferences which are (a) rationally based on the perception of the witness and (b) helpful to a clear understanding of his testimony or the determination of a fact in issue.

We find little, if indeed anything, objectionable in Champlin's testimony under this rule. His testimony is certainly helpful in determining many of the facts in issue. We also think it rests on a firm foundation. After all, Champlin had a long history with the Fosters. He began by performing accounting services for them during the Likins-Foster era and continued to do so after Likins and Foster terminated their business relationship in 1955. At their request, he moved to San Mateo in January 1961. From that time until June 1969, the Fosters were virtually his only clients and he devoted most of his time to their affairs. He even shared their offices and was never excluded from one of their meetings regardless of the subject matter. As their tax adviser they trusted him implicitly and reposed great confidence in his professional ability. And, most importantly, he played a central role in arranging the transactions challenged here by respondent. However, we agree with petitioners that Champlin's comments concerning the management ability and integrity of each of the Fosters, as well as similar expressions of opinion, are objectionable, but on grounds of relevance and not opinion. Thus, we have disregarded those comments.

Finally, we agree that petitioners are entitled to raise double hearsay objections at this time. However, their objections are generally not well founded for several reasons. First, Fed. R. Evid. 805 does not exclude hearsay within hearsay "if each part of the combined statements conforms with an exception to the hearsay rule provided in these rules." Second, as previously discussed (see A.1., supra), a party's admissions do not constitute hearsay and are admissible as substantive evidence of the fact stated. See Fed. R. Evid. 801(d)(2)(A). Most of petitioners' specific objections to Champlin's testimony involve admissions by the Fosters. Thus, double hearsay is not even present. Third, to be objectionable, hearsay must be evident in the testimony, itself. We will not sustain an objection premised on a party's inference drawn from other parts of the record that the deponent's testimony must have been hearsay because he could not possibly have had firsthand knowledge of the underlying facts.

3. Petitioners' Complaint of Bias, etc.

Petitioners urge that we reject the Champlin deposition in its entirety because the deponent was allegedly biased, inconsistent, and not truthful in his testimony. In our view, this complaint does not affect the admissibility of the deposition but rather the weight to which it is entitled. See Fed. R. Evid. 607 and 608; see generally D. McCormick, supra at sec. 40; cf. Fed. R. Evid. 403. No protracted analysis is therefore necessary. We shall simply state that Champlin was not a disinterested witness, just as the Fosters were not at the trial of this case, and that we considered that fact in evaluating his testimony.

C. DEPOSITION OF JACK FOSTER, JR.

In March 1971, Jack Foster, Jr., was called to testify as a witness by Del Champlin at a deposition conducted by Champlin's attorney before a notary public and court reporter. The deposition was part of Champlin's action against the Fosters for breach of contract and their counterclaim against him for malpractice. (See B., supra.) At the deposition, Foster was represented by counsel. He was put under oath and examined by Champlin's attorney over a 4-day period. His own attorney participated in the deposition only to a limited extent. The examination revolved around the development of Foster City as well as Champlin's relationship to the Fosters and his involvement in the project.

The deposition transcript was reviewed, corrected, and executed by Jack Foster, Jr., and was apparently filed with the State court. *314 Petitioners' hearsay and relevancy objections are without merit for the reasons previously discussed. See A., supra. This leaves for consideration their opinion and "double hearsay" objections.

Contrary to petitioners' contention, an admission is not objectionable merely because it is not based on personal knowledge or is in the form of an opinion. 4 J. Weinstein & M. Berger, supra at par. 801(d)(2)[01], p. 801-136, and par. 801(d)(2)(A)[01], p. 801-140; 4 J. Wigmore, supra at sec. 1053; D. McCormick, supra at secs. 263 and 264; see Owens v. Atchison, Topeka & Santa Fe Railway Co., 393 F.2d 77">393 F.2d 77, 79 (5th Cir. 1968) ("it is well settled that the opinion rule does not apply to a party's admissions"); cf. Fed. R. Evid. 602; S. Saltzburg & K. Redden, supra at 305-306. Such an admission may be entitled to less weight, but it is clearly not inadmissible. We might also add that, as previously discussed, Fed. R. Evid. 701 eschews a rigid and literal application of the opinion rule in favor of a liberal formulation which gives the trial court considerable latitude in admitting opinion testimony by lay witnesses. See B.2., supra . In any event, we fail to see much potential for opinion testimony on the part of Jack Foster, Jr. After all, Foster was not a "sidewalk superintendent" idly gazing into the construction pit and casually observing the development of Foster City. Rather, from November 1960 until 1970, he was the project's general manager, a position that consumed virtually all of his time. Moreover, he was an equal partner in the Foster family partnership and a shareholder and officer in most of the Foster-dominated corporations.

We turn now to petitioners' "double hearsay" objection. Although Fed. R. Evid. 805 does not technically apply because admissions do not constitute hearsay statements under Fed. R. Evid. 801(d)(2) (see S. Saltzburg & K. Redden, supra at 686), we agree that hearsay within an admission is subject to objection, unless, of course, an exception to the hearsay rule applies. See Cedeck v. Hamiltonian Fed. Sav. & L. Ass'n, 551 F.2d 1136">551 F.2d 1136 (8th Cir. 1977); S. Saltzburg & K. Redden, supra at 686. However, we think their specific hearsay objections are without merit because petitioners have confused hearsay with lack of personal knowledge. In other words, there is a difference between offering as an admission a party's out-of-court statement that "A said that x is a fact" for the purpose of proving that x is a fact, and offering as an admission a party's out-of-court statement that "x is a fact" for that same purpose. As stated above, a party's lack of personal knowledge that x is a fact does not render inadmissible his statement to that effect. Returning to our example, even though a party's out-of-court statement that "x is a fact" is based on A's having told him that fact rather than on his personal knowledge, the statement is still admissible as an admission. Of course, a party is entitled to try to lessen the weight of an admission by introducing evidence that it was not based on personal knowledge. D. McCormick, supra at sec. 263. Admissibility of the admission, however, is a completely different matter.

D. DEPOSITION OF REX D. JOHNSON ^{*317 In December 1977, immediately prior to the issuance of the first of the four notices of deficiency involved in this case, petitioners filed with this Court an "Application to Take Deposition to Perpetuate Testimony of Rex D. Johnson Before Commencement of Case." See Rules 82, 80(a). Attached to their application was a copy of a letter dated August 12, 1974, from Johnson to their present counsel which purported to outline "the various steps taken or initiated in 1966 to improve the credit support or security which the Republic National Bank had for the various loans it had made to the Foster interests." Petitioners stated that they desired to perpetuate Johnson's testimony concerning the content of his letter, indicating that it related to the Neighborhood Four issue. (See Issue 3, infra.)}

Respondent filed a notice of objection to petitioners' application and a hearing was held in San Francisco in January 1978. After considering the arguments of counsel, the Court granted the application. The last paragraph of our order stated that if the applicants should file a petition in this Court, the deposition could only be used in accordance with Rule 81(i).

In February 1978, Rex Johnson was called to testify as a witness by petitioners in a deposition conducted by their counsel before a notary public and court reporter. Johnson was not represented by counsel at the deposition. He was put under oath and examined by petitioners' counsel and then cross-examined by respondent's counsel. Petitioners' counsel objected to, and the witness declined to answer, questions propounded by respondent's counsel which they thought went beyond the scope of the August 1974 letter, and, hence, the direct examination, particularly questions addressed to the Westway transaction. (See Issue 2, infra.)

The deposition transcript was reviewed, corrected, and executed by the witness.

Rex Johnson was not present at the trial of this case. At that time he was alive and well and living in Dallas.

Pursuant to petitioners' motion and over respondent's general objections, the Court admitted the Johnson deposition into evidence (see Rule 143(c)), subject to a number of specific objections by respondent.

1. Respondent's General Objections

Respondent objects to the Johnson deposition in its entirety on two grounds. First, he contends that the deposition does not satisfy any of the conditions for its use at trial set forth in Rule 81(i). Second, he contends that he was denied the right of cross-examination at the deposition. We think both contentions lack merit.

Rule 82 governs depositions to perpetuate evidence taken in anticipation of commencing a case in this Court. The last sentence of that rule provides that if such a deposition is taken and a case is thereafter commenced, the deposition may only be used in conformity with Rule 81(i). That Rule provides in part as follows:

At the trial * * * any part or all of a deposition, so far as admissible under the rules of evidence applied as though the witness were then present and testifying, may be used against any party who was present or represented at the taking of the deposition * * * in accordance with any of the following provisions:

* * * *

(3) The deposition may be used for any purpose if the Court finds: * * * (E) that such exceptional circumstances exist, in regard to the absence of the witness at the trial, as to make it desirable in the interests of justice, to allow the deposition to be used.

We think that such exceptional circumstances exist that the interests of justice allow the use of the Johnson deposition and did not demand that the witness be present at trial. Respondent is not prejudiced. He had reasonable notice of the deposition and was represented by counsel of his choice. He had the opportunity to, and did, in fact, cross-examine the witness. Moreover, use of the deposition at trial conserved time, helped to shorten an already protracted proceeding, and minimized expense and inconvenience. See Rule 1(b). Finally, the witness is not a party and resides a considerable distance from where the trial was held. The deposition was conducted in Dallas at the Republic National Bank where he was given the opportunity to review bank records in an effort to refresh his recollection about events which occurred during the mid-1960's.

Respondent's other general objection involves his complaint that he was denied the opportunity to cross-examine Johnson at the deposition. However, the deposition transcript indicates to the contrary. The witness only declined to answer questions when respondent sought to examine him on matters unrelated to his August 1974 letter. Petitioners' original application clearly stated that they desired to depose Johnson only with respect to the content of that letter, indicating that it related to the Neighborhood Four issue. At the deposition, the witness repeatedly stated his understanding that his examination was to be so limited and explained that he prepared himself accordingly. He indicated that because of the passage of time, he was reluctant to testify further, for fear of being inaccurate and unfair, without first refreshing his recollection by reviewing pertinent bank records. As he stated: "the only way I can be fair in these matters is to be accurate. And I just cannot expound on items that old without some opportunity to prepare myself."

We are satisfied that respondent was not denied the opportunity to cross-examine Rex Johnson at the deposition. If his testimony on the Westway transaction was sufficiently important, respondent had the opportunity to subpoena him at trial (see Rule 147), or to take his deposition (see Rules 74, 81). His failure to do either reinforces our view that his contention is without merit. *322 2. Respondent's Specific Objections

Respondent also objects to parts of the Johnson deposition. Certain of his objections were raised at the deposition while others were raised at trial. See Rule 85(c); cf. Rule 81(f)(2).

Respondent objects to a substantial part (and arguably all) of the Johnson deposition on the ground of relevancy. He contends that as a matter of law, petitioners cannot frustrate his application of section 482 by claiming that the Neighborhood Four lots were transferred for a business purpose, and that, for that reason, Johnson's testimony is largely irrelevant. The objection, therefore, goes to the heart of the substantive issue. Accordingly, it would be inappropriate to consider it at this time. See instead Issue 3, infra.

Respondent also objects, on hearsay and "best evidence" grounds, that the records which Johnson reviewed in preparing to testify at the deposition were not made available to him for inspection. The deposition transcript, however, suggests the contrary. For example, it refers to the presence of two cardboard boxes allegedly containing the records which Johnson reviewed. Nothing in the transcript indicates that respondent's counsel was precluded from inspecting the contents of those boxes or that he even requested to do so. Moreover, we simply cannot comprehend a hearsay basis for this objection. Respondent's additional reliance on the best evidence rule is likewise ill founded. That rule requires the production of the original in order to prove the contents of a writing. Fed. R. Evid. 1002; see D. McCormick, supra at sec. 230. However,

If the contents are not sought to be proved, this particular Rule need not be complied with. The fact that a writing is made to describe or record an event or a condition does not prevent testimony by knowledgeable witnesses as to the same event or condition. [S. Saltzburg & K. Redden, supra at 732.]

Johnson's testimony concerning Republic's interest in the transfer of the Neighborhood Four lots is thus outside the scope of the best evidence rule.

Contending that they constitute more than mere corrections, respondent also objects to changes made by Johnson to the deposition transcript before he executed it. However, Rule 81(h)(1) provides that "Any changes in form or substance, which the witness desires to make, shall be entered upon the deposition by the officer with a statement of the reasons given by the witness for making them." (Emphasis added.) Although Rule 81 governs depositions in a pending case, we can see no reason why the quoted provision should not also apply to depositions under Rule 82. Cf. Rule 143(c).

Finally, respondent objects on hearsay grounds to three exhibits introduced by petitioners at the deposition. One of the exhibits is the August 1974 letter from Rex Johnson to petitioners' present counsel which was written in anticipation of this litigation. It is a classic hearsay statement (see Fed. R. Evid. 801(c)), and is inadmissible under Fed. R. Evid. 802. Fed. R. Evid. 803(6).

E. THE "BUSINESS PURPOSE" OBJECTION

At his deposition in March 1971, Jack Foster, Jr., testified as follows:

Q. At the time Neighborhood 4 was transferred into Foster Enterprises, did you actually have some sales pending for those lots, or not?

A. I would say -- let's see. The transfer was in '66?

Q. Yes.

A. Well, no, I don't think we did have any sales for those lots in '66.

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

A. Yes.

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? [Emphasis added.]

A. I don't know.

Q. You don't know of any? Is that what you're saying?

A. Well, no.

At trial, Foster was again questioned about the transfer of the Neighborhood Four lots to Foster Enterprises. On direct examination he testified as follows:

Q. * * * Have you had the opportunity of reviewing the deposition of Rex Johnson?

A. Yes.

Q. And have you looked at the exhibits which are attached to that deposition?

A. Yes.

Q. With that information, would you say there was -- would you now state whether or not there was a business purpose to that transfer? [Emphasis added.]

At this point, respondent objected on the grounds that the question "calls for a conclusion on the witness * * * And it was an observation made precisely for the trial." The Court sustained the objection but reserved judgment on petitioners' motion to strike the same question in Foster's deposition.

1. Objection to Question Calling for a Conclusion

On brief, petitioners invite us to reverse our ruling on respondent's objection at trial, an invitation which we decline. Assuming that their business purpose question is relevant, it is clear that the abolition of the ultimate issue rule in Fed. R. Evid. 704Fed. R. Evid. 701. See the Advisory Committee's Note to Fed. R. Evid. 704; 3 J. Weinstein & M. Berger, supra at par. 704[02], pp. 704-9/10; S. Saltzburg & K. Redden, supra at 478. In our judgment, Foster's opinion would not have satisfied this standard. It would have been based solely on his reading of the Johnson deposition, formulated only for purposes of the present case, and expressed nearly 15 years after the transfer in question. We have previously ruled that the Johnson deposition is admissible. See D., supra. If we determine that business purpose is relevant to the Neighborhood Four issue (see Issue 3, infra), we will therefore have available for our consideration the exact same raw information upon which Foster would have based his opinion. Under these circumstances, we fail to see how his expression of opinion would have been helpful.

2. Motion To Strike

We turn now to petitioners' motion to strike. We think that motion must be denied because the business purpose question asked at the deposition elicited an admission of a party-opponent which is admissible under Fed. R. Evid. 801(d)(2)(A). See A.1. and C., supra. As D. McCormick states:

this [opinion] rule, designed to promote the concreteness of answers on the stand, is grotesquely misapplied to out-of-court statements, such as admissions, where the declarant's statements are made without thought of the form of courtroom testimony and where it can only be applied by excluding the statement, whereas in the courtroom if the opinion objection is sustained, counsel may reframe his question in the preferred form. [D. McCormick, supra at sec. 264, p. 632.]

Although not necessary to support either our ruling at trial or our disposition of petitioners' motion to strike, we think Foster's answer to the business-purpose question at the deposition was given under circumstances which would make it far more trustworthy than an answer to that question at trial. The deposition was conducted in 1971, ten years before the trial of the present case. Moreover, Foster's incentive to respond at trial in a self-serving manner would obviously have been greater than at his deposition.

F. BURDEN OF PROOF

Petitioners begin their brief with a lengthy discussion of the "bursting bubble" theory of presumptions. They maintain that the presumption of correctness enjoyed by respondent does not constitute evidence and disappears from the case when contrary evidence is introduced. They then attempt to relate that discussion to the manner in which the burden of proof should be allocated. They also invoke the burden-shifting principles of Helvering v. Taylor, 293 U.S. 507">293 U.S. 507 (1935), and Weimerskirch v. Commissioner, 596 F.2d 358">596 F.2d 358 (9th Cir. 1979), revg. 67 T.C. 672">67 T.C. 672 (1977). Although the issues which they raise are intriguing (see Llorente v. Commissioner, 74 T.C. 260">74 T.C. 260, 272-280 (1980) (Tannenwald, J., concurring), revd. in part 649 F.2d 152">649 F.2d 152 (2d Cir. 1981)), we think they are largely academic here because the requisite factual foundation is lacking. Nevertheless, we shall briefly address them so that there is no question about our approach to the three major substantive issues involved in this case. ^{*138 (See Issues 1 and 3, infra.) We shall also address them further, later in this opinion, as the need arises.}

Petitioners' preoccupation with the question of whether a presumption, particularly the presumption of correctness, constitutes evidence would be more understandable if respondent had simply sat back and passively relied on that presumption with respect to his determinations. That, however, was not what happened. Rather, respondent played a very active role in the trial of this case. He subpoenaed and examined witnesses. He offered depositions. He introduced exhibits. He stipulated facts and documents in support of his determinations. In fact, respondent may have even introduced a greater quantum of evidence than petitioners. In any event, what we have done to decide the issues is evaluate the quality of the evidence introduced by petitioners and the quality of the evidence introduced by respondent. We have then weighed the evidence, keeping in mind the general rule that it is petitioners who bear the ultimate burden of proof. Rule 142(a); Welch v. Helvering, 290 U.S. 111">290 U.S. 111, 115 (1933). We hasten to emphasize that in weighing the evidence we have assigned not even a gram to the presumption of correctness.

From what we have just said, it should be readily apparent that petitioners' reliance on Weimerskirch v. Commissioner, 596 F.2d 358">596 F.2d 358 (9th Cir. 1979), is ill founded. In that case the Commissioner determined that the taxpayer had unreported income from the sale of narcotics. At trial, however, he called no witnesses and introduced no evidence in support of his determination. In reversing our decision, the Court of Appeals held that the Commissioner was not entitled to rely exclusively on the presumption of correctness in an unreported income case, particularly where he alleges that the taxpayer is engaged in an illegal income-producing activity. In the present case, however, we have placed upon the evidentiary scales, not the presumption of correctness, but rather only the proof adduced by respondent in support of his determinations. Weimerskirch, therefore, is inapposite. See Basic Bible Church v. Commissioner, 74 T.C. 846">74 T.C. 846, 854 (1980); Perrett v. Commissioner, 74 T.C. 111">74 T.C. 111, 135-136 (1980), affd. without published opinion 679 F.2d 900">679 F.2d 900 (9th Cir. 1982); Karme v. Commissioner, 73 T.C. 1163">73 T.C. 1163, 1195-1196 (1980), affd. 673 F.2d 1062">673 F.2d 1062 (9th Cir. 1982).

Petitioners' reliance on Helvering v. Taylor, 293 U.S. 507">293 U.S. 507 (1935), is also misplaced. Contrary to their assertion, respondent's determinations are simply not arbitrary. The basis for this conclusion will become apparent when we address the merits of the first three issues. Suffice it to say for the present, that we think respondent's determinations rest on a rational foundation. ^{*333 Issues 1 and 3}

Reallocations of Income Under Section 482

Two of the three major substantive issues in this case involve reallocations of income made by respondent under the authority of section 482. That section provides as follows:

SEC. 482. ALLOCATION OF INCOME AND DEDUCTIONS AMONG TAXPAYERS.

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary or his delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

The genesis of the first section 482 issue lies in 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. In the notice of deficiency, respondent allocated to the partnership the net income *140 governed by the nonrecognition and basis provisions of sections 351, 1032, and 362, rather than by section 482.

The genesis of the second 482 issue lies in the August 1966 transfer by the Foster partnership of 311 single-family residential lots in Neighborhood Four to Foster Enterprises. In the notice of deficiency, respondent allocated to the partnership the corrected net income reported by that corporation from the sale of those lots. Again, petitioners contend, inter alia, that the issue is governed by the nonrecognition and basis provisions of sections 118 and 362, rather than by section 482.

Before delving into the complexities of section 482, we need to resolve two preliminary issues raised by petitioners involving that section. First, they question the constitutionality of section 482. Second, they also question the heretofore acknowledged standard for review of the Commissioner's determinations under that section. We will deal with the constitutional issue first because of its obvious threshold importance.

A. CONSTITUTIONALITY OF SECTION 482

Section 482 is directly derived from section 45 of the Revenue Act of 1928, ch. 852, 45 Stat. 791, 806. It can be traced, however, to the consolidated return provisions of section 240(d) of the Revenue Act of 1921, ch. 136, 42 Stat. 227, 260, and ultimately to articles 77 and 78 of Regulations 41, which were promulgated under the War Revenue Act of 1917, ch. 63, 40 Stat. 300. Despite this long history, section 482 has rarely been the subject of constitutional challenge. In fact, the only previous constitutional challenge we are aware of was raised in Asiatic Petroleum Co. v. Commissioner, 79 F.2d 234 (2d Cir. 1935), affg. 31 B.T.A. 1152">31 B.T.A. 1152 (1935). There, the taxpayer argued that section 45 of the Revenue Act of 1928 ^{*141 due process of law. The Court of Appeals rejected this contention and stated that the section --}

does not measure the tax of one person by the income of another * * *; rather, it looks through form to reality * * *. Even without such a statute as section 45, many cases have gone very far in disregarding formal transfers introduced into corporate transactions for the purpose of escaping taxation. If anticipatory arrangements intended to circumvent taxes may be disregarded by the courts without the aid of statutory authority, a statute authorizing the Commissioner to disregard them under similar circumstances cannot be unconstitutional. It is true, as the Supreme Court recently stated in Gregory v. Helvering * * * that a taxpayer is privileged "to decrease the amount of what would otherwise be his taxes, or altogether avoid them, by means which the law permits." But there is no suggestion in that opinion, or in the authorities upon which it relies, that a statute would be unconstitutional which took away this privilege. At least under the conditions specified in section 45 we are satisfied that it may be taken away. [79 F.2d at 238; citations omitted.]

Presumably, petitioners do not quarrel with Asiatic Petroleum Co. because they attack the constitutionality of section 482 on other than due process grounds. Rather, they invoke the nondelegation doctrine and, of course, the two stalwarts of that doctrine, Panama Refining Co. v. Ryan, 293 U.S. 388 (1935), and Schechter Corp v. United States, 295 U.S. 495 (1935).

In its pristine form, the nondelegation doctrine held that Congress could not lawfully delegate its legislative power to an administrative agency. See United States v. Shreveport Grain & El. Co., 287 U.S. 77">287 U.S. 77, 85 (1932) ("That the legislative power of Congress cannot be delegated is, of course, clear"). The doctrine was later narrowed to hold that legislation which does not provide a meaningful standard to guide the exercise of an agency's discretion constitutes an unlawful delegation of legislative power. Panama Refining Co. v. Ryan, supra;Schechter Corp. v. United States, supra.Petitioners contend that section 482 is unconstitutional because it purports to vest in the Commissioner the discretion to disregard the statutory structure established by Congress for the taxation of corporations without setting forth a meaningful standard to guide him in the exercise of that discretion. We disagree. We think petitioners' contention is infirm for at least two reasons.

First, contrary to petitioners' apparent belief, section 482 does not delegate authority to respondent to reallocate income at his whim. Rather, he may do so only if he first determines that such reallocation is "necessary in order to prevent evasion of taxes or clearly to reflect the income" of two or more commonly owned or commonly controlled organizations, trades, or businesses. We think this is a meaningful standard. Moreover, respondent's exercise of his authority under section 482 is judicially reviewable. ^{*340 Second, the very doctrine on which petitioners rely has been described by Justice Marshall as "moribund." National Cable Television Assn. v. United States, 415 U.S. 336">415 U.S. 336, 353 (1974) (dissenting opinion). Professor Davis is even more direct: "Since 1935 the nondelegation doctrine has had no reality in the holdings, although remnants of the doctrine persist in judicial verbiage." 1 K. Davis, Administrative Law Treatise, sec. 3:1, at 150 (2d ed. 1978). His comments on Panama Refining Co. v. Ryan, supra, and Schechter Corp. v. United States, supra, the only two cases in which the Supreme Court has ever held congressional delegations to governmental authorities to be invalid, deserve to be quoted:}

Despite the futility, counsel often cite the two cases in briefs, but the courts uniformly uphold the delegations. E.g., United States v. Davis, 564 F.2d 840">564 F.2d 840, 844 (9th Cir. 1977), cert. denied 434 U.S. 1015">434 U.S. 1015 (1978); United States Postal Service v. Brennan, 574 F.2d 712">574 F.2d 712, 716 (2d Cir. 1978), cert. denied 439 U.S. 1115">439 U.S. 1115 (1979). Such briefs waste the client's money and waste the courts' time. The current law is not in the Panama and Schecter opinions, the attitude of those cases "has been virtually abandoned by the Court for all practical purposes." National Cable Television Ass'n v. United States, 415 U.S. 336">415 U.S. 336, 352-53 (1974). [K. Davis, supra at sec. 3:8 (Supp. 1982).]

In view of the foregoing, we hold that section 482 is not unconstitutional as an invalid delegation of legislative power.

B. STANDARD FOR REVIEW AND BURDEN OF PROOF

The Commissioner enjoys broad discretion under section 482. Spicer Theatre, Inc. v. Commissioner, 346 F.2d 704">346 F.2d 704, 706 (6th Cir. 1965), affg. 44 T.C. 198">44 T.C. 198 (1964); Edwards v. Commissioner, 67 T.C. 224">67 T.C. 224, 230 (1976); E. I. du Pont de Nemours & Co. , 221 Ct. Cl. 333">221 Ct. Cl. 333, 608 F.2d 445">608 F.2d 445, 455 (1979). In applying that section, his determinations must be sustained absent an abuse of discretion. We may reverse only where the taxpayer proves that those determinations are unreasonable, arbitrary, or capricious. ^{Ach v. Commissioner, 42 T.C. 114">42 T.C. 114, 125-126 (1964), affd. 358 F.2d 342">358 F.2d 342 (6th Cir. 1966); Philipp Bros. Chemicals, Inc. (N.Y.) v. Commissioner, 435 F.2d 53">435 F.2d 53, 57 (2d Cir. 1970), affg. Philipp Bros. Chemicals, Inc. (Md.) v. Commissioner, 52 T.C. 240">52 T.C. 240 (1969); Charles Town, Inc. v. Commissioner, 372 F.2d 415">372 F.2d 415, 422 (4th Cir. 1967), affg. a Memorandum Opinion of this Court. section 482 in support of his determination. Young & Rubicam, Inc. v. United States, 187 Ct. Cl. 635">187 Ct. Cl. 635, 410 F.2d 1233">410 F.2d 1233, 1245 (1969); see Commissioner v. Transport Mfg. & Equip. Co., 478 F.2d 731">478 F.2d 731, 734-736 (8th Cir. 1973), affg. Riss v. Commissioner, 56 T.C. 388">56 T.C. 388 (1971), and 57 T.C. 469">57 T.C. 469 (1971) (supplemental opinion); Achiro v. Commissioner, 77 T.C. 881">77 T.C. 881, 890-891 (1981).}

In the present case, petitioners do not contend that they were unaware that respondent reallocated income under authority of section 482. The notice of deficiency expressly so provides. Rather, they contend that in Commissioner v. First Security Bank of Utah, 405 U.S. 394 (1972), the Supreme Court announced a new, and presumably less strict, standard for review. In this regard, they seize upon the penultimate sentence of that Court's opinion: "The Commissioner's exercise of his § 482 authority was therefore unwarranted in this case." 405 U.S. at 407; emphasis added. In their view, the use of the word "unwarranted" constitutes an implied rejection of the "unreasonable, arbitrary, or capricious" standard. We disagree.

A careful reading of First Security Bank reveals that the Supreme Court did not have before it any issue involving the appropriate standard for review of the Commissioner's determinations under section 482. That no such issue was presented is also apparent from the fact that it was the Commissioner who petitioned for certiorari (405 U.S. at 395), after losing in the Tenth Circuit. The Court of Appeals, whose judgment was affirmed by the Supreme Court, stated as follows:

We recognize the established rules that substance prevails over form, that the Commissioner has a wide discretion which we may not upset unless it is used arbitrarily or capriciously, and that the burden of persuasion lies on the taxpayers. These do not change the result. * * * We believe that the § 482 allocations made by the Commissioner are arbitrary and capricious and inconsonant with the basic concepts of federal income taxation. [First Security Bank of Utah, N.A. v. Commissioner, 436 F.2d 1192">436 F.2d 1192, 1198 (10th Cir. 1971); emphasis added.]

The absence of any discussion of the established standard in First Security Bank confirms our opinion that the Supreme Court did not intend the use of the word "unwarranted" to signal any departure from, or dilution of, that standard. We also note that since 1972, this Court and the various Courts of Appeals, have continued to apply the unreasonable, arbitrary, or capricious standard in reviewing the Commissioner's determinations under section 482. See, e.g., Erickson v. Commissioner, 598 F.2d 525">598 F.2d 525, 528 (9th Cir. 1979), revg. on other grounds a Memorandum Opinion of this Court; ^{Wilson v. United States, 530 F.2d 772">530 F.2d 772, 776 (8th Cir. 1976); Pacella v. Commissioner, 78 T.C. 604">78 T.C. 604, 618 (1982); Keller v. Commissioner, 77 T.C. 1014">77 T.C. 1014, 1021-1022 (1981), on appeal (10th Cir., Apr. 2, 1982).}

For these reasons, we therefore hold that the Commissioner's determinations under section 482 must be sustained unless proven unreasonable, arbitrary, or capricious.

---

Footnotes

• 1. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954 as amended and in effect during the taxable years in issue.↩

• 2. Sec. 6651(a)(1).↩

• 3. Sec. 6653(a).↩

• 4. Petitioners do not allege the amount of overpayment claimed for each specific set of petitioners.↩

• 5. Unless otherwise indicated, all Rule references are to the Tax Court Rules of Practice and Procedure.↩

• 6. See Cal. Corp. Code sec. 15010.5↩ (West 1977).

• 7. During the period when the Fosters were the developers of Foster City, neighborhoods were developed in the numerical sequence of One, Two, Three, Four, Nine, Eight, and Six.↩

• 8. Any adjustments that respondent may have made to the net income reported by the Alphabets from the sale of these lots is not in issue.↩

• 9. Estero Municipal Improvement District Act, 1961 Cal. Stat. 1st Extra Sess. 1960, ch. 82, p. 459, hereinafter referred to as "the Estero Act" or simply "the act."↩

• 10. In this regard, the act provided as follows:

  SEC. 17. "Land" means land in the district and does not include improvements or personal or utility property.

  * * * *

  SEC. 19. "Owner" means the owner of land as shown on the last equalized county assessment roll.

  SEC. 20. "Voter" means an owner, or the officer appointed therefor by the board of directors of a corporation owner, or the legal representative of the owner.

  * * * *

  SEC. 64. Each voter shall have one vote for each one dollar ($ 1) in assessed valuation of land owned by him as shown by the last equalized assessment roll.

  SEC. 65. A majority of the votes cast shall be required to elect a director or approve a proposition.

  See also sec. 215(f) of art. 15 quoted above in the text.↩

• 11. The provisions described above were expressed in the act as follows:

  SEC. 26. The board is the governing body of the district and shall consist of three (3) members, one of whom shall be president. The officers of the district are the three members of the board and a secretary. The district may have a finance officer, and other officers as the board may from time to time create. An owner may nominate an officer or a legal representative for each office to be filled by election or appointment.

  SEC. 27. The first district board shall be elected at an election conducted by the [San Mateo County] board of supervisors immediately following the formation of the district. The first district board shall classify itself by lot so that one director will hold office for two years and two directors will hold office for four years following the district formation or until their successors have been elected or appointed and qualified.

  SEC. 28. The directors shall be owners, or officers or legal representatives of owners.

  SEC. 29. The term of each director, after the first board, shall be four years, or until the election or appointment, and qualification of his successor.

  * * * *

  SEC. 32. Once each year, the board shall elect one of its members to serve as president, shall appoint a secretary and shall fill any other offices as it may from time to time create.

  * * * *

  SEC. 34. The board shall act only by ordinance, resolution, motion or contract. No question of interest shall affect the legality of any contract or the right of any officer to act.

  SEC. 35. A majority of the board shall constitute a quorum for the transaction of business.

  SEC. 36. No ordinance, resolution, motion or contract shall be passed or become effective without the affirmative vote of at least the majority of the members of the board.

  * * * *

  SEC. 94. The district may appoint, employ and fix the compensation of engineers, attorneys, assistants and other employees as it deems proper.↩

• 12. The powers described above were expressed in the act as follows:

  SEC. 77. The district may acquire, construct, reconstruct, alter, enlarge, lay, renew, replace, maintain and operate, street and highway lighting facilities; facilities for the collection, treatment and disposal of sewage, industrial wastes, storm waters, garbage and refuse; the production, storage, treatment and distribution of water for public and private purposes; parks, playgrounds and works to provide for the drainage of roads, streets, and public places, including, but not limited to curbs, gutters, sidewalks and grading and pavement; and the reclamation of submerged or other land by watering or dewatering.

  SEC. 78. The district may acquire or construct the reclamation of land for private small craft harbor purposes * * *

  SEC. 79. The district may acquire, construct, maintain and operate facilities for providing fire protection to the district and its occupants or inhabitants, including buildings, engines, hose, hose carts, or carriages, and other appliances and supplies for the full equipment of fire companies or departments and a police department, to protect and safeguard life and property.

  SEC. 80. The district may take, acquire, hold, use, lease and dispose of property of every kind within or without the district, necessary, expedient or advantageous to the full exercise and economic enjoyment of its purposes and powers.

  SEC. 81. The district may exercise the right of eminent domain for the condemnation of private property for public use within but not without the district. * * *

  * * * *

  SEC. 83. The district may make and accept contracts, deeds, releases and documents that, in the judgment of the board, are necessary or proper in the exercise of any of the powers of the district.

  * * * *

  SEC. 97. The district may make and enforce all necessary and proper regulations, not in conflict with the laws of this State, for the removal of garbage and refuse and the supplying of sewage, light, water, storm water and fire and police protection service. A violation of a regulation of the district is a misdemeanor punishable as such. * * *↩

• 13. Estero ceased to function in this latter capacity in April 1971 when Foster City was incorporated as a city.↩

• 14. The financial powers described above were expressed in the act as follows:

  SEC. 87. The district may incur bonded indebtedness and issue bonds in the manner herein provided.

  * * * *

  SEC. 90. Any bonds issued by the district organized under the provisions of this act are given the same force, value and use as bonds issued by any municipality and shall be exempt from all taxation within the State.

  Article 6. General Obligation Bonds

  SEC. 105. The district may issue bonds as provided in this article for any of the purposes stated in Sections 77, 78, 79 and 80. [See note 12 supra.]

  SEC. 106. By resolution, when in its judgment it is advisable, the board may call an election and submit to the voters of the district the question of whether bonds shall be issued.

  * * * *

  SEC. 112. If, at the election, two-thirds of the votes cast are in favor of the issuance of bonds, the board may issue and dispose of the bonds.

  Article 8. Revenue Bonds

  SEC. 135. The district may create revenue bond indebtedness for the acquisition and construction, or acquisition or construction of any improvements or property or facilities contained within its powers.

  SEC. 136. Proceedings for the authorization, issuance, sale, security, and payment of revenue bonds shall be had, the board shall have the powers and duties, and the bondholders shall have the rights and remedies, all in substantial accordance with and with like legal effect as provided in the Revenue Bond Law of 1941 * * *; provided, however, that qualified voters at the election therein provided shall be voters as defined in this act, and the method of voting shall be as herein provided. * * *

  Article 12. Funds

  SEC. 178. The bond moneys may also be used for interest and working capital for the period of construction and for twelve (12) months thereafter, and also to pay the costs of their authorization and issuance including fees for legal, engineering, fiscal, economic or other service.↩

• 15. Compare 1961 Cal. Stat. ch. 81, p. 441 (1st Extra Sess. 1960) (Embarcadero) with ch. 82, p. 459 (Estero).↩

• 16. The report, prepared by the Assembly Committee on Municipal and County Government, focused generally on the uses of special assessment procedures and independent special districts to aid land development.↩

• 17. 1963 Cal. Stat. ch. 995, p. 2257.↩

• 18. Sec. 28 of the act, quoted above in note 11, was amended to read as follows:

  SEC. 28. Two directors shall be owners, or officers or legal representatives of owners and shall be nominated and elected or appointed in accordance with Article 4 ["Elections"]. Commencing in the year 1964 and each four years thereafter one of the expiring terms of director shall be filled by a public member designated and appointed by the county board of supervisors.

  As will be seen, the Fosters had anticipated this amendment and had provided for a public member of Estero's board since June 1961.↩

• 19. The Fosters also anticipated this amendment although Estero's finance officer was originally bonded for only $ 25,000.↩

• 20. 1967 Cal. Stat. ch. 1511, p. 3593.↩

• 21. Cooper v. Leslie Salt Co., 70 Cal. 2d 627">70 Cal. 2d 627, 451 P.2d 406">451 P.2d 406, 75 Cal. Rptr. 766">75 Cal. Rptr. 766 (1969). See also Cooper v. Estero Municipal Improvement District, 70 Cal. 2d 645">70 Cal. 2d 645, 451 P.2d 417">451 P.2d 417, 75 Cal. Rptr. 777">75 Cal. Rptr. 777 (1969), for related litigation. Compare Justice Mosk's concurring and dissenting opinion in Cooper v. Leslie Salt Co., supra, and Burrey v. Embarcadero Municipal Improvement Dist., 5 Cal. 3d 671">5 Cal. 3d 671, 488 P.2d 395">488 P.2d 395, 97 Cal. Rptr. 203">97 Cal. Rptr. 203↩ (1971), a case involving Estero's sister district in which the California Supreme Court held unconstitutional a provision under which the right to vote was limited to landowners.

• 22. SEC. 121. The board may, in its discretion, before or after issuance, commence in the superior court of the county, a special proceeding to determine its right to issue the bonds and their validity * * * The board may use the same procedure to validate the creation of the district and any annexations thereto.↩

• 23. General fund, water fund, sewage fund, and street improvement fund.↩

• 24. Foster v. Commissioner, T.C. Memo. 1966-273, and T.C. Memo. 1967-207, modified and remanded sub nom. Likins-Foster Honolulu Corp. v. Commissioner, 417 F.2d 285↩ (10th Cir. 1969).

• 25. The lease was actually managed by the Foster partnership or Likins-Foster Honolulu Corp. for which service a substantial management fee was charged.↩

• 26. The remaining 500 shares of Foster California's stock was not issued until June 5, 1964. See par. 8, infra↩.

• 27. As will be recalled, the remaining $ 1 million of the ultimate $ 3 million "capital gain carrot" did not sprout until Aug. 19, 1961, and Aug. 19, 1962, at which times the partnership borrowed from Republic the $ 500,000 installments which it owed to the sellers of Brewer's Island.↩

• 28. At this point in time, the parties to the Westway transaction contemplated that the Fosters would "purchase" all of Westway's stock in order to reacquire the Foster Bayou stock which the partnership had previously "sold" to Westway. See par. 7 of the Lytle memorandum quoted above in the text; note that Westway is referred to as "Wayside" in that memorandum. As events transpired, the Fosters achieved their objective by simply "purchasing" the Foster Bayou stock from Westway.↩

• 29. As will be recalled, Westway was the named payee of all of the notes but transferred $ 1 million of the $ 2 million note to Republic in December 1965. Subsequently, it merged into the Howard Corp. For the sake of convenience, however, Westway will be referred to as the holder of the indicated notes.↩

• 30. This note was offset by Westway's $ 100,000 note which was also due on Aug. 7, 1967. As will be recalled, Westway's note represented all but $ 5,000 of the stated consideration for its "purchase" of the Foster Bayou stock in 1962. Because of the offset, neither the Fosters nor Republic considered this note as part of the "Westway notes" for purposes of the negotiations which will be described above.↩

• 31. See note 21 supra↩, and the accompanying text.

• 32. During that same period, an additional 41 lots were sold, subject to certain FHA restrictions, to one of the builders. The restrictions were not removed until 1968, at which time the sale was finalized.↩

• 33. Although Foster City was not within the city of San Mateo, it was at that time within that city's elementary school district.↩

• 34. In a self-prepared schedule which was attached as an exhibit to his March 1962 deposition (see pages 118 to 119, infra↩), Jack Foster set forth six classes of land use for Foster City. According to this schedule, 352 acres were to be devoted to "Schools, churches, etc."

• 35. The deductibility of these expenses by the corporations is an issue in Likins-Foster Honolulu Corp. and Subsidiaries v. Commissioner of Internal Revenue↩, docket No. 5361-78, a related but unconsolidated case which is presently pending before this Court.

• 36. On its information returns for 1963 through 1967, the partnership claimed deductions for travel and entertainment. Respondent did not disallow those deductions in toto but rather only in part. It is difficult to compare the amounts disallowed with the amounts allowed because it would appear that some travel and entertainment expense was deducted as "advertising."↩

• 37. In Jack Foster's case, respondent determined other constructive dividends in the form of the payment of personal legal fees and the personal use of a company car. These dividends, which aggregate $ 21,250, have been conceded by petitioners.↩

• 38. As stated in the preceding footnote, the record does not include a complete copy of the notice of deficiency issued to Bob Foster so that we do not know how the relevant exhibit may have described the dividends charged to him.↩

• 39. The 1967 return indicates that this amount was salary of Jack Foster. The parties, however, appear to agree that it is actually salary of Gladys Foster.↩

• 40. As will be recalled, Jack Foster owned 75 percent of the stock of Likins-Foster Honolulu Corp., and his three sons, the remaining 25 percent in equal shares. Presumably because Jack and Gladys Foster filed joint returns for 1963 through 1967, respondent did not specifically attribute the dividends to either spouse in the notice of deficiency. On brief, however, he inexplicably attributed them to Gladys Foster despite her lack of stock ownership. If the amounts in question are dividends, they should, of course, be attributed to Jack Foster.↩

• 1. This corporation should not be confused with the Foster partnership. It was incorporated in June 1964 and performed the check-writing and bookkeeping functions for the Foster City project, functions which had previously been performed by Lomita Homes, Inc.↩

• 2. The record does not include a complete copy of the notice of deficiency issued to Bob Foster so that we do not know how the relevant exhibit allocated these amounts among the payor corporations.↩

• 41. It was also stipulated that all objections to questions, except those related to form, were reserved by the parties.↩

• 42. This Court is, of course, bound by the Federal Rules of Evidence. Sec. 7453; Rule 143(a); Fed. R. Evid. 101, 1101(a)↩.

• 43. In the present proceeding, the party-opponent is technically the Estate of Jack Foster and not Jack Foster, individually. However, the relationship between the two is such that Foster's statements constitute admissions. 4 J. Wigmore, Evidence, sec. 1081.↩

• 44. Moreover, their objection is without factual foundation because Foster's attorney did, in fact, question him after he was examined by PG & E's counsel.↩

• 45. "Relevant evidence" is defined by that rule as --

  "evidence having any tendency to make the existence of any fact↩ that is of consequence to the determination of the action more probable or less probable than it would be without the evidence. [Emphasis added.]"

• 46. It was also stipulated that all objections to questions, except those related to form, were reserved by the parties.↩

• 47. The latter responsibility is alleged in a portion of their answers which was not reproduced above.↩

• 48. It appears that the parties to that proceeding stipulated that the transcript could be used at trial. They also stipulated that all objections to questions, except those related to form, were reserved by the parties.↩

• 49. In the context of this issue, the phrase "double hearsay," or "hearsay within hearsay," is technically a misnomer because admissions do not constitute hearsay under Fed. R. Evid. 801(d)(2)↩.

• 50. As will be recalled, Rex D. Johnson was at one time a senior vice president of the Republic National Bank with responsibility for the Foster account.↩

• 51. In his reply brief, for the first time, respondent objects to the admissibility of the Johnson deposition on the specific ground that the deponent was not "unavailable as a witness" within the meaning of Fed. R. Evid. 804(b)(1). See also Fed. R. Evid. 804(a). However, we think the objection on this particular ground comes too late. See Rule 85(c); Fed. R. Evid. 103(a)(1)↩.

• 52. We find petitioners' contention that this letter is not hearsay but that if it is, it constitutes "recorded recollection" and hence is admissible under an exception to the hearsay rule, i.e., Fed. R. Evid. 803(5)↩, to be so disingenuous as not to warrant further comment.

• 53. The rule provides as follows:

  "Testimony in the form of an opinion or inference otherwise admissible is not objectionable because it embraces an ultimate issue to be decided by the trier of fact."↩

• 54. We have confined our comments to this context because petitioners have generally focused on just those substantive issues.↩

• 55. We defer, for now, consideration of petitioners' additional argument that the doctrine of laches is incorporated into the burden-shifting principles set forth in Helvering v. Taylor, 293 U.S. 507">293 U.S. 507 (1935), and Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir. 1979). See instead Issue 7, infra↩.

• 56. Although sec. 482 authorizes the Commissioner to allocate "gross income," it is generally recognized that he may also allocate "net income." Hamburgers York Road, Inc. v. Commissioner, 41 T.C. 821">41 T.C. 821, 834 (1964); see B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders, par. 15.06, at 15-17 (4th ed. 1979); Fuller, "Section 482 Revisited," 31 Tax L. Rev. 475">31 Tax L. Rev. 475, 517↩ n. 176 (1976).

• 57. SEC. 45. ALLOCATION OF INCOME AND DEDUCTIONS.

  In any case of two or more trades or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Commissioner is authorized to distribute, apportion, or allocate gross income or deductions between or among such trades or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such trades or businesses.↩

• 58. In Schechter Corp. v. United States, 295 U.S. 495">295 U.S. 495, 532-533↩ (1935), the Supreme Court was influenced in its decision to invalidate sec. 3 of the National Industrial Recovery Act, ch. 90, 48 Stat. 195, 196-197, by the fact that judicial review was not to be provided for in "codes of fair competition" approved or prescribed by the President pursuant to that section.

• 59. The fact that some cases express this standard in the conjunctive rather than the disjunctive (see, e.g., Pacella v. Commissioner, 78 T.C. 604">78 T.C. 604, 618 (1982)), is of no consequence because the terms utilized by the standard are synonymous. Wilson v. United States, 530 F.2d 772">530 F.2d 772, 779↩ n.1 (8th Cir. 1976) (concurring opinion).

• 60. T.C. Memo. 1966-15↩.

• 61. T.C. Memo. 1976-147↩.