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Estate of Sydney S. Baron, Sylvia S. Baron, Administratrix, and Sylvia S. Baron, Petitioners v. Commissioner of Internal Revenue, RespondentEstate of Baron v. CommissionerDocket No. 14759-81
United States Tax Court September 26, 1984. September 26, 1984, Filed1984 U.S. Tax Ct. LEXIS 26">*26
Decision will be entered under Rule 155 .B purchased certain rights in a master recording in exchange for $ 90,000 cash and $ 560,000 in two nonrecourse notes payable solely out of the record sales proceeds. B claimed depreciation deductions based on the $ 90,000 cash and a $ 460,000 nonrecourse note, the second note having been canceled prior to the filing of the tax returns.
Held , the obligation represented by the nonrecourse note was too contingent to be included in basis irrespective of the existence of some value which might be considered fair market value.Held, further , petitioners have not carried their burden of proving that B had the requisite profit objective.Thomas S. Carles , Richard BaronAlice M. Carles , for the petitioners.Martha Sullivan , for the respondent.Tannenwald,Judge .TANNENWALD83 T.C. 542">*542 Respondent determined the following deficiencies in petitioners' Federal income tax for 1977 and 1978:
Year Deficiency 1977 $ 230,031 1978 82,525 After concessions, we must determine whether petitioners are entitled to various deductions and credits claimed in connection with Sydney Baron's purchase of the U.S. and Canadian rights in the master recording of the soundtrack of the motion picture "The Deep" (sometimes hereafter referred to as purchase of the master recording).
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
Petitioners' legal address at the time the petition herein1984 U.S. Tax Ct. LEXIS 26">*29 was filed was in Scarsdale, NY. Sydney S. Baron (sometimes Baron), petitioner Sylvia S. Baron's husband, died in 1981, prior to the filing of the petition.
83 T.C. 542">*543 In the spring of 1977, Richard Baron, Sydney Baron's son (and a tax lawyer), called Richard Talmadge (Talmadge), an entertainment lawyer, and asked Talmadge whether he knew of any good entertainment properties in which Richard Baron's family could invest. 1984 U.S. Tax Ct. LEXIS 26">*30 Talmadge then contacted Richard Trugman (Trugman), an old friend, who was vice chairman, secretary, and treasurer of Casablanca Record & Filmworks, Inc. (Casablanca). At first, Trugman told Talmadge that Casablanca had nothing to sell. In a subsequent conversation, Trugman told Talmadge that Casablanca would be willing to sell the U.S. and Canadian rights in the master recording of the soundtrack of "The Deep," a movie they were working on at the time. 1984 U.S. Tax Ct. LEXIS 26">*31 7-percent-per-annum interest), payable solely out of royalties 83 T.C. 542">*544 from Casablanca's sale of records in respect of the master recording in the United States and Canada. 1984 U.S. Tax Ct. LEXIS 26">*32 The note was due on May 27, 1984 (7 years later). The $ 90,000 cash which Whittier used to purchase the rights in the master recording was received from Sydney Baron. At all times pertinent herein, it was understood by Casablanca, Whittier, and the Barons that Sydney Baron would be the ultimate purchaser of the rights in the master recording. 1984 U.S. Tax Ct. LEXIS 26">*33 entitled to retain as payment on the $ 460,000 note.
Pursuant to a distribution agreement entered into between Casablanca and Sydney Baron, also on May 27, 1977, 83 T.C. 542">*545 soundtrack 1984 U.S. Tax Ct. LEXIS 26">*34 for albums and singles sold in Canada. Half of the royalties to be received by Sydney Baron were to be kept by Casablanca as partial payment of interest and principal on the $ 460,000 nonrecourse note.
The motion picture "The Deep" was based on a novel by Peter Benchley, the author of "Jaws." The movie "Jaws" had been extremely successful and "The Deep" was perceived as the equally successful "Jaws" sequel. The "Jaws" soundtrack album was not nearly as successful as the movie; the1984 U.S. Tax Ct. LEXIS 26">*35 album did not go "gold."
1984 U.S. Tax Ct. LEXIS 26">*36 Due to Casablanca's position in the record industry and its relationship to "The Deep" film, Casablanca wanted to produce the soundtrack album. Columbia finally decided to grant Casablanca rather than Arista Records, Columbia's subsidiary, that right. Several months before Casablanca officially received the right from Columbia to produce the soundtrack records, Casablanca was focusing on the expected album and its uses to promote the film. John Barry, the well-known arranger and composer of soundtracks for motion pictures and television specials, including "Born Free," "Midnight Cowboy," "The Lion in Winter," and several James Bond movies, had already been selected by Columbia to arrange and compose 83 T.C. 542">*546 the music for "The Deep" movie.
1984 U.S. Tax Ct. LEXIS 26">*37 Casablanca soon began considering the possibility of having Donna Summer, one of their "stars" (see note 12
supra ) sing the title song in the film and on the soundtrack album. Casablanca's European licensees were very interested in such a soundtrack album, since Donna Summer had spent several years singing in Europe and was quite a sensation there. Casablanca projected that the album would sell better with Donna Summer on it. Columbia and John Barry agreed in April to have Donna Summer on the album recording. After the album was put together and the promotional activities planned, Casablanca hoped to sell, at a minimum, approximately half a million albums (i.e., go "gold").Side 1 of the album recording contains an instrumental "ballet" by John Barry based on the score from the movie. On side 2, Donna Summer sings one song, "Theme From The Deep (Down, Deep Inside)"
1984 U.S. Tax Ct. LEXIS 26">*38 Casablanca vigorously sought to promote the movie and the album. Radio station contests with numerous prizes, including bikes, radios, cameras, Casablanca cassette libraries, and trips to Bermuda were held in over 50 cities. 83 T.C. 542">*547 approximately 10 cents per poster). Casablanca spent $ 250,000 to advertise the album, and thereby the movie as well, in the United States. 1984 U.S. Tax Ct. LEXIS 26">*39 was of major importance to Casablanca. "The Deep" movie's net film rental for 1977 was $ 31 million.
"The Deep" album was, notwithstanding Casablanca's vigorous efforts, a flop.
Rev. Rul. 60-358, 1960-2 C.B. 68, Rev. Rul. 64-273, 1964-2 C.B. 62 ,1984 U.S. Tax Ct. LEXIS 26">*40 andRev. Rul. 79-285, 1979-2 C.B. 91 , using the income forecast method of depreciation. They deducted depreciation on the master recording of $ 401,390 (72.98 percent of $ 550,000) 1984 U.S. Tax Ct. LEXIS 26">*41 Thus, the rights in the master recording were fully depreciated over 83 T.C. 542">*548 2 years. 1984 U.S. Tax Ct. LEXIS 26">*42 principal issues which we must resolve 1984 U.S. Tax Ct. LEXIS 26">*43 are whether: (1) The $ 460,000 nonrecourse note should be taken into account in determining Sydney Baron's basis for the master recording rights he acquired, and (2) in entering into the transaction for the acquisition of those rights, Sydney Baron's bona fide objective was to make a profit from the royalties aside from the tax benefits by way of large deductions. 83 T.C. 542">*549 payment of the nonrecourse note, and (2) the obligation on the note is in any event too contingent. Petitioner, of course, contends that the fair market 1984 U.S. Tax Ct. LEXIS 26">*44 value of the rights was at least as great as, if not greater than, the purchase price (and, a fortiori, the amount of the note) and that the obligation on the note is not too contingent because there was a reasonable certainty at the time Sydney Baron acquired the rights that the note would be paid in full. We find it unnecessary to engage in an evaluation of the opinions of the experts herein as to the fair market value of Sydney Baron's rights in the master recording, because we conclude that, irrespective of the existence of some value which might be considered the fair market value, the obligation represented by the nonrecourse note was too contingent at the time Sydney Baron entered into the transaction to permit its inclusion in basis.1984 U.S. Tax Ct. LEXIS 26">*45 We start from the recognized principle that, in appropriate circumstances, obligations have been found to be too contingent to permit their inclusion in basis and that this principle has been utilized in recent cases dealing with tax shelters. See, e.g.,
CRC Corp. v. Commissioner , 693 F.2d 281">693 F.2d 281Brountas v. Commissioner , 73 T.C. 491">73 T.C. 491Brountas v. Commissioner , 692 F.2d 152">692 F.2d 15273 T.C. 491">73 T.C. 491 (1979) (same);Gibson Products Co. v. United States , 637 F.2d 1041">637 F.2d 1041Fox v. Commissioner , 80 T.C. 972">80 T.C. 972Barnard v. Commissioner , 731 F.2d 230">731 F.2d 230Hook v. Commissioner, Kratsa v. Commissioner, Leffel v. Commissioner, Rosenblatt v. Commissioner, Zemel v. Commissioner , 734 F.2d 9">734 F.2d 9Saviano v. Commissioner , 80 T.C. 955">80 T.C. 955Graf v. Commissioner , 80 T.C. 944">80 T.C. 944Denver & Rio Grande Western R.R. Co. v. United States , 205 Ct. Cl. 597">205 Ct. Cl. 597Lemery v. Commissioner , 52 T.C. 367">52 T.C. 367451 F.2d 173">451 F.2d 173 (9th Cir. 1971) (obligation contingent upon business sold showing net profit);Columbus & Greenville Railway Co. v. Commissioner , 42 T.C. 834">42 T.C. 834358 F.2d 294">358 F.2d 294 (5th cir. 1966), cert. denied385 U.S. 827">385 U.S. 827 (1966) (obligation to pay based on mileage of railroad lines);Albany Car Wheel Co. v. Commissioner , 40 T.C. 831">40 T.C. 831333 F.2d 653">333 F.2d 653 (2d Cir. 1966) (obligation for severance pay -- incurred as part of acquisition of assets of predecessor corporation -- contingent upon failure to give employees notice prior to closing plant).Applying the contingency principle, we think it clear that the $ 460,000 nonrecourse note was too contingent to be includable in Sydney Baron's basis. The nonrecourse note specifically provided that payments were to be made "solely out of the gross receipts" from the use of the rights in respect to the master recording. See note 32
infra . Thus, it seems clear that the parties contemplated that the rights had no value apart from the income stream which might be generated. More importantly, in the instant case, the income stream was totally dependent upon public acceptance of, not only the movie "The Deep," but the album and other recordings as well. While thefailure of the movie might well hinder the album and other recordings, thesuccess of the movie would not create any viable degree of assurance that the album and other recordings would be accepted by the public. Every witness at the trial herein testified that the1984 U.S. Tax Ct. LEXIS 26">*48 record industry is a highly speculative business and that it is extremely difficult to predict the success of a particular record in advance of its release and the resulting indication of public acceptance. Here, at the time Sydney Baron entered into the transaction and acquired the rights subject to the $ 460,000 nonrecourse note, neither the movie, the album, nor any other recording had been released for sale to the public. To be sure, there were high hopes for both because of the involvement of Donna Summer (a rising star vocalist at that point), John Barry (a well-known arranger and composer), Peter Guber (a recognized movie producer who had recently produced "Jaws"), Peter Benchley (who had written the book "The Deep," his first after the record-breaking book and movie "Jaws"), and Casablanca (a well-known 83 T.C. 542">*551 record producer and distributor) and because of the extensive advance promotion efforts, most of which, however, were of the film rather than of the recordings. But these pluses are not, in our opinion, sufficient to provide a basis for a meaningful measurement of the possibility of a successful release of the music contained in the master recording.The situation1984 U.S. Tax Ct. LEXIS 26">*49 herein is to be sharply distinguished from those cases where the courts have valued movie rights and the potential income to be derived therefrom after the movie had been released. See, e.g.,
Grill v. United States , 157 Ct. Cl. 804">157 Ct. Cl. 804O'Brien v. Commissioner , 25 T.C. 376">25 T.C. 376Herbert v. Riddell , 103 F. Supp. 369">103 F. Supp. 369637 F.2d 1041"> ;Gibson Products Co. v. United States, supra at 1048-1049Siegel v. Commissioner , 78 T.C. 659">78 T.C. 659692 F.2d 152"> .Brountas v. Commissioner, supra at 157Mayerson v. Commissioner , 47 T.C. 340">47 T.C. 340 (1966)1984 U.S. Tax Ct. LEXIS 26">*53 The long and short of the matter is that, in the case before us, the value of the rights in the master recording lay solely in the anticipated income stream derived from direct and total public acceptance and that Sydney Baron was liable on the nonrecourse note only out of his receipts from that income stream. If there were no receipts, there was no obligation to pay. 1984 U.S. Tax Ct. LEXIS 26">*54 Under these circumstances, there was no incentive for Sydney Baron to pay the note out of his other funds in order to preserve valuable property -- an element which the courts have found compelling in other cases involving nonrecourse obligations. See
Brannen v. Commissioner , 78 T.C. 471">78 T.C. 471722 F.2d 695">722 F.2d 695 (11th Cir. 1984);78 T.C. 659"> . Under these circumstances, the amount of $ 460,000 represented by the nonrecourse note may not be 83 T.C. 542">*553 included in Sydney Baron's basis.Siegel v. Commissioner, supra at 689section 183 , 1984 U.S. Tax Ct. LEXIS 26">*56 an "activity not engaged in for profit."Dreicer v. Commissioner , 78 T.C. 642">78 T.C. 642, 78 T.C. 642">643-645 (1982)702 F.2d 1205">702 F.2d 1205 (D.C. Cir. 1983);Engdahl v. Commissioner , 72 T.C. 659">72 T.C. 659Golanty v. Commissioner , 72 T.C. 411">72 T.C. 411647 F.2d 170">647 F.2d 170 (9th Cir. 1981). Baron's objective is a question of fact to be determined from all the facts and circumstances.Allen v. Commissioner , 72 T.C. 28">72 T.C. 28Surloff v. Commissioner , 81 T.C. 210">81 T.C. 210The regulations under
section 183 list the following nine relevant factors which should normally be taken into account in determining whether an activity is engaged in for profit: (1) The manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer1984 U.S. Tax Ct. LEXIS 26">*57 or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financing status of the taxpayer; (9) the elements of personal pleasure or recreation.Sec. 1.183-2, Income Tax Regs. We see no need to dissect the record herein separately with respect to each of the foregoing factors, particularly since many of these factors are hard to fit to shelter activity of the type involved herein. Rather, we will deal with the totality of the circumstances revealed by that record in the context of the elements which the parties assert in favor of their positions.Petitioners contend that Baron consulted with industry experts before purchasing the master recording, that there was every indication, when Baron purchased the master recording, that "The Deep" album would be a success, that Casablanca made every effort to make "The Deep" album a success, and1984 U.S. Tax Ct. LEXIS 26">*58 that Baron reasonably relied on Casablanca, whose interests were similar to his own, to distribute the album in such a manner as to achieve maximum sales.
Respondent argues that tax profit, rather than economic profit, motivated Baron in his acquisition of the master recording. Numerous examples of Baron's alleged "unbusinesslike manner" in this transaction have been provided by respondent to illustrate what respondent believes was Baron's lack of concern with making a profit on his investment.
The bulk of petitioners' argument on profit motive revolves around Casablanca's promotion of the record and Baron's allegedly justifiable reliance thereon. We agree with petitioner that, from Casablanca's perspective, "The Deep" record was a legitimate business venture and that Casablanca went all out to promote "The Deep" project, although we note that Casablanca's 83 T.C. 542">*555 main interest was in the success of the movie, with the promotion of the records an instrument to achieving that main objective. However, that does not end our inquiry, for we still must determine
Baron's objective.Petitioners rely heavily on Baron's "consultation" with industry experts before purchasing his rights1984 U.S. Tax Ct. LEXIS 26">*59 in the master recording. However, it is clear from the record that Baron's "consultation" was mere window dressing to conceal tax motives. It was Richard Baron who initiated the entire chain of events by calling Talmadge, an entertainment lawyer he had never met, and asking Talmadge whether any good entertainment properties were available for investment. The record contains no evidence that either Sydney or Richard Baron knew the first thing about entertainment properties. Prior to his interest in "The Deep," Baron had never invested in, purchased, or sold master recordings or audiotapes for production or sale. Similarly, although Richard Baron apparently knew so little about commercial law that he asked Engels, another lawyer, to review the purchase documents, as a tax lawyer, Richard Baron did know a great deal about the tax consequences of his parents' half-million-dollar annual income. See note 38
infra . On May 12, 1977, when Talmadge mailed Richard Baron the original draft agreement for the purchase, Richard Baron was aware of who was involved in "The Deep" project and had been given certain sales projections (in the half-million-unit range) by Casablanca. See note1984 U.S. Tax Ct. LEXIS 26">*60 42infra . All of the details were settled by May 18, 1977, the date of the agreement between Whittier and Casablanca. Each party to the transaction knew that Engels via Whittier was merely acting on behalf of the ultimate purchaser, Baron. Of the two appraisals Baron received of his rights in the master recording, one was dated May 24, 1977 (6 daysafter the transaction was, in effect, consummated), and one was undated. See note 7supra . The record contains no evidence that either of those appraisals was available, either orally or in writing, prior to May 18, 1977. 1984 U.S. Tax Ct. LEXIS 26">*61 Thus, as far as the record herein shows, the only information that Baron had regarding his purchase prior to his entering the deal was given him by 83 T.C. 542">*556 the seller via his son, Richard.Surloff v. Commissioner , 81 T.C. 210">81 T.C. 237Fox v. Commissioner , 80 T.C. 972">80 T.C. 10151984 U.S. Tax Ct. LEXIS 26">*62 Respondent places great emphasis on Baron's use of nonrecourse financing, both in acquiring his master recording rights and in compensating Engels for reviewing the sales arrangement, as illustrating Baron's tax, rather than economic, profit objective. We agree. While the use of large nonrecourse financing vis-a-vis cash invested is not necessarily fatal to establishing a profit objective (see
Wildman v. Commissioner , 78 T.C. 943">78 T.C. 943Barnard v. Commissioner , 731 F.2d 230">731 F.2d 230Fox v. Commissioner , 80 T.C. 972">80 T.C. 972Fuchs v. Commissioner , 83 T.C. 79">83 T.C. 79Dean v. Commissioner , 83 T.C. 56">83 T.C. 56Baron's $ 650,000 purchase price for the master recording rights would have produced (assuming a 70-percent tax bracket) 1984 U.S. Tax Ct. LEXIS 26">*65 a tax benefit of $ 455,000 from the depreciation he expected to be able to claim (or $ 365,000 above his $ 90,000 cash investment). Cf.
731 F.2d 230"> .1984 U.S. Tax Ct. LEXIS 26">*63 Even if Baron were eventually required to recapture his excess depreciation deductions under section 1245, 83 T.C. 542">*557 in pocketBarnard v. Commissioner, supra at 231after taxes and after deducting his $ 90,000 cash investment, over $ 109,000. 1984 U.S. Tax Ct. LEXIS 26">*66 In contrast, Baron would not have even recovered his $ 90,000 in before-tax dollars until 281,250 albums were sold, supra. If the album went "gold," i.e., sold 500,000 copies, which was the projection given Baron by Casablanca, 1984 U.S. Tax Ct. LEXIS 26">*67 Baron would have received in before-tax dollars $ 70,000 above his $ 90,000 investment.section 183 . If such a standard were the sole criterion, we would have the ridiculous situation that the lower the amount 83 T.C. 542">*558 of the cash investment and the higher the amount of1984 U.S. Tax Ct. LEXIS 26">*64 nonrecourse financing, the more likely would be the existence of a profit objective.Wildman v. Commissioner , 78 T.C. 943">78 T.C. 943, 78 T.C. 943">954 (1982)Bizub v. Commissioner , T.C. Memo. 1983-280In our view, the comparison should be made between the $ 70,000 and the $ 365,000 net benefits from the deduction for depreciation. In adopting this comparison, we are not suggesting that there must always be a dollar-for-dollar matching which would, in this case, necessitate a prediction of well over 2,300,000 albums, 1984 U.S. Tax Ct. LEXIS 26">*70 a figure clearly beyond anyone's wildest imagination (see note 42
supra ). Instead, we conclude that an intermediate position will usually be in order, namely, that the disparity between before-tax profit and tax benefits be weighed in the context of all the factors involved in determining the existence of the requisite profit objective, 1984 U.S. Tax Ct. LEXIS 26">*68 objective test for the tax benefits. Cf.81 T.C. 210"> See alsoSurloff v. Commissioner, supra .Lemmen v. Commissioner , 77 T.C. 1326">77 T.C. 132659 Taxes 985 (1981) ) and may appear to leave the ultimate weight to be accorded the comparison to intuitive judicial judgment. 1984 U.S. Tax Ct. LEXIS 26">*69 would not, in those areas where Congress has singled out particular transactions for favorable treatment via tax-benefit subsidies. SeeFox v. Commissioner , 82 T.C. 1001">82 T.C. 1001supra . Applying the foregoing analysis and the other elements revealed by the record herein, we conclude that the presence of a potential $ 70,000 profit on Baron's cash investment is not sufficient to cause us to conclude that Baron had a profit objective aside from the net tax benefits of $ 365,000 which he anticipated being able to obtain.Respondent argues that no business person concerned with making an economic profit would impose upon himself or herself a $ 100,000 nonrecourse note for legal fees which would presumably have been, at most, a few thousand dollars and that Baron's $ 100,000 note to Whittier further exhibits his concern with tax, rather than economic, profit. Petitioners argue, however, that the $ 100,000 Whittier note is irrelevant, since Baron did not include it in his basis in his rights on the 1977 tax return. Whatever Baron's thinking 1984 U.S. Tax Ct. LEXIS 26">*71 may have been in 1978, it is clear that in 1977, when he entered this transaction, he contemplated a purchase price of $ 650,000 ($ 90,000 cash plus the Casablanca and Whittier notes) and this higher purchase price was expected to enable him to realize greater tax benefit. Consequently, in determining Baron's objective in entering the transaction, the Whittier note must be considered and, in the context of this case, respondent's argument is persuasive.
83 T.C. 542">*560 Similarly, there is no evidence in the record that Baron
ever checked with Casablanca regarding the progress of the album. complete absence of contact with Casablanca can only be attributed to Baron's lack of concern with an economic profit.1984 U.S. Tax Ct. LEXIS 26">*72 The long and the short of the matter is that, based on the record herein, we simply cannot find that Sydney Baron was even the least bit concerned with making an economic profit. Baron lacked the knowledge to value the rights he was purchasing and yet did not consult with any outside expert until
after he had already committed himself to the venture. We think it more than reasonable to infer, from the record herein, that Baron was quite aware of the anticipated tax benefits to be derived from the transaction and, as a result, increased his purchase price by an additional $ 100,000 nonrecourse note in an attempt further to increase those benefits. The most that can be said is that Baron "was completely indifferent to the success or failure" of the sale of records from "The Deep" soundtrack. SeeGrodt & McKay Realty, Inc. v. Commissioner , 77 T.C. 1221">77 T.C. 1221We hold that Sydney Baron's acquisition1984 U.S. Tax Ct. LEXIS 26">*73 constituted an activity "not engaged in for profit," as defined in
section 183(c) . However, petitioners are entitled to deductions to the extent of the gross income derived from that activity. SeeBrannen v. Commissioner , 722 F.2d 695">722 F.2d at 702-703Decision will be entered under Rule 155 .Footnotes
1. Richard Baron did not, at that time, know Talmadge; Richard Baron learned of Talmadge through a mutual friend.↩
2. Until then, Casablanca had never sold the rights in any of its master recordings.↩
3. Columbia Pictures Industries, Inc. (Columbia), formally granted Casablanca all rights to "The Deep" master recording by agreement dated June 17, 1977. However, negotiations to effect the sale began in April. Prior to May 18, 1977, Casablanca had acquired a sufficient interest in the master recording to sell the above-mentioned rights to Whittier.↩
4. The rights in many master recordings of motion picture soundtracks are sold for recording costs plus re-use fees (payments to unions). Here, the $ 90,000 cash payment approximated recording costs plus re-use fees. A record company's other expenses (advertising, pressing, and fabrication of albums, etc.) are recoupable from the proceeds of record sales. Here, Casablanca's other expenses (which approximated the nonrecourse note) were likewise recoupable from the proceeds of record sales as well as from one-half of the purchaser's royalty.↩
5. Prior to his involvement in "The Deep," Sydney Baron had never invested in, purchased, or sold master recordings or audio tapes for production or sale.↩
6. Whether a payment of Engels' fee or an increase in the purchase price, the $ 100,000 note would be considered an acquisition cost as against an expense item.↩
7. Sydney Baron received two appraisals of the master recording, an undated appraisal from Irwin Rawitz, vice president of Dynamo Records, and one dated May 24, 1977, from George Lee, vice president of MCA records; each appraisal said there was a "real potential" that enough income would accumulate from Baron's share of the proceeds to repay the nonrecourse note and, therefore, that the fair market value of the U.S. and Canadian rights in the master recording was in excess of $ 650,000. Each appraisal was based on the premise that Baron would receive 80 cents for each album sold.↩
8. Apparently, no distribution agreement was entered into between Casablanca and Whittier because all the parties knew that Sydney Baron was the ultimate purchaser of the master recording rights.↩
9. Casablanca agreed to manufacture and put into distribution a minimum of 50,000 albums and 10,000 singles no later than June 15, 1977. Casablanca also agreed to release a Donna Summer single from the soundtrack album by May 27, 1978. Casablanca released all the records it was obligated to release, including the Donna Summer 7-inch single.↩
10. Prior to 1975, an album was certified "gold" through a formula based on dollars of sales. In 1975, a second requirement, 500,000 units sold, was added. In 1976, the "platinum" classification was added for albums that met a dollar formula and sold 1 million units.↩
11. Columbia was the financing party (budget of approximately $ 5 million), but Casablanca supervised the day-to-day activities in the movie's physical production.↩
12. In 1976, Casablanca had produced 20 albums, of which 9 went "gold" and 3 went "platinum." Casablanca's biggest stars in 1977 included Donna Summer and the rock group "Kiss."↩
13. Notwithstanding John Barry's status as an excellent soundtrack composer and conductor (76 feature films and television shows), only one of his soundtrack albums (Midnight Cowboy) went "gold."↩
14. The Donna Summer song is sung over the closing credits and for 14 seconds, at a very reduced volume, during a dance scene involving Nick Nolte and Jacqueline Bissett.↩
15. If Casablanca had had to purchase the free air time it got as a result of the radio promotion, the cost would have been over half a million dollars.↩
16. Columbia spent approximately $ 4 million to promote the film.↩
17. Casablanca was late in requesting "Record of the Month" status for June because many details of the album had not been settled by the critical date.↩
18. The best hindsight explanation for the failure of the album to capture the ephemeral taste of the record-buying public was offered by Bruce Bird, Casablanca's vice president of promotion in 1977, who stated that the album, quite simply, "wasn't in the grooves."
The album did, however, spend 7 weeks on Billboard Magazine's "Top 100" charts. The album's best position, 70th, was reached during week 4.↩
19. The Barons limited their basis in the master recording to $ 550,000 because the $ 100,000 nonrecourse note to Whittier was canceled prior to the filing of the 1977 return.↩
20. The Barons' accountant did not include the 50 percent of Sydney Baron's royalty being kept by Casablanca as partial payment on the nonrecourse note when he determined the numerator and denominator of the income forecast formula. The full royalty should have been included in the calculation.↩
21. The Barons' accountant, Joel Rosen (sometimes Rosen), called Talmadge prior to determining the allowable depreciation. Early in 1978, Talmadge told Rosen what royalties the album had produced in 1977 and up to that point in 1978. Talmadge also stated that, since the record did not appear to be selling, he did not know if there would be any additional income at all. When Rosen spoke with Talmadge in 1979, royalty information for 1978 was given along with Talmadge's estimate of no future income. In fact, Baron earned an additional $ 4,419.90 in royalties, half of which was paid to Baron in 1979.↩
22. There is no indication in the record what recording costs were incurred by Baron. One $ 750 check was made to Dynamo Records, whose vice president, Irwin Rawitz, had given an appraisal of "The Deep" album for Sydney Baron. The second $ 750 check payment was made to Dune Road, whose identity is unexplained. George Lee, who rendered the second appraisal, was vice president of MCA records.↩
23. There is no indication in the record as to what travel expenses were incurred.↩
24. Presumably because of Baron's anticipated quick recovery of cost through depreciation, no investment credit was claimed on the 1977 return. Nor was it claimed in this proceeding until petitioners' brief was filed. Because of our disposition of the principal issues in the case and because petitioners did not prove a useful life of 3 years or more for the master recording (Sydney Baron and Sylvia Baron, in fact, used a 2-year life on their joint returns), petitioners would not be entitled to any such investment credit. In any event, the claim for such credit was made too late.
Rollert Residuary Trust v. Commissioner , 80 T.C. 619">80 T.C. 61925. Master recordings were not covered by the at-risk provisions of sec. 465 until the enactment of the Revenue Act of 1978, Pub. L. 95-600, sec. 201, 92 Stat. 2814. H. Rept. 95-1445, at 68 (1978), 1978-3 C.B. (Vol. 1) 181, 242; H. Rept. 95-1800, at 219 (Conf.) (1978), 1978-3 C.B. (Vol. 1) 521, 553. The 1978 amendments to sec. 465 were made effective for taxable years commencing after Dec. 31, 1978. See Pub. L. 95-600, sec. 204, 92 Stat. 2817. Since the taxable years 1977 and 1978 are involved herein, sec. 465 is not applicable.↩
26. See
Brannen v. Commissioner , 722 F.2d 695">722 F.2d 69578 T.C. 471">78 T.C. 471 (1982), particularly the concurrence of Chabot, J., 78 T.C. 513. Like the Eleventh Circuit Court of Appeals, we find it unnecessary to resolve whether the fair market value of the rights should be measured against the purchase price or the amount of the note. See alsoFuchs v. Commissioner , 83 T.C. 79">83 T.C. 7927. Cf.
Fox v. Commissioner , 80 T.C. 972">80 T.C. 972Barnard v. Commissioner , 731 F.2d 230">731 F.2d 230Kratsa v. Commissioner, Hook v. Commissioner, Rosenblatt v. Commissioner, Leffel v. Commissioner, Zemel v. Commissioner , 734 F.2d 9">734 F.2d 9Bizub v. Commissioner , T.C. Memo. 1983-280↩28. At this point, we should note that in situations, such as estate tax valuations, where the issue is the value of rights which are keyed solely to the income stream, the courts have no alternative but to determine such value irrespective of the existence of data as to actual experience. See
Dorsey v. Commissioner , 49 T.C. 606">49 T.C. 60629. While Donna Summer's status in the industry might have been sufficient to reasonably expect an album on which she was the sole performer to become a hit, such cannot be said for an album on which she only sang one song twice at different speeds, especially when that song was available on a single. Similarly, while John Barry was extremely well regarded within the industry, his inability to sell albums is evidenced by the fact that only one soundtrack album he composed has gone gold.↩
30. We note that the acquisition of patent rights involves the right of
use↩ thereof, which is an element independent of the income stream to be realized from licensing. In the case of a copyright, however, i.e., a book, the value would appear to rest solely on the income stream derived from selling the copyrighted article. Conceivably, a design copyright might fall in a different category.31. This type of property, i.e., real estate, was involved in
Commissioner v. Tufts , 461 U.S. 300">461 U.S. 300Crane v. Commissioner , 331 U.S. 1">331 U.S. 1Fuchs v. Commissioner , 83 T.C. 79">83 T.C. 7932. While Casablanca had the right to foreclose on Baron's rights in the master recording in the event that the note was not paid at maturity, if the master recording had not generated significant income, it presumably would have had little, if any, value, and consequently Casablanca would probably not have had an economic incentive to seek foreclosure.↩
33. Nothing herein should be taken as an indication that actual payments on the note should not be included in basis. See
Siegel v. Commissioner , 78 T.C. 659">78 T.C. 659infra↩ .34. Unless otherwise indicated, all statutory references are to the Internal Revenue Code of 1954 as amended and in effect during the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
35.
Sec. 183(a) provides that "if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this section."Sec. 183(b)(1) allows those deductions which would be allowable without regard to whether or not such activity is engaged in for profit.Sec. 183(b)(2) provides that deductions which would be allowable only if such activity is engaged in for profit shall be allowed "but only to the extent that the gross income derived from such activity for the taxable year exceeds the deductions allowable by reason of paragraph (1)."Sec. 183(c)↩ defines an "activity not engaged in for profit" as "any activity other than one with respect to which deductions are allowable for the taxable year under section 162 or under paragraph (1) or (2) of section 212."36. Indeed, there is no evidence in the record that either appraisal was received prior to May 27, 1977, the date of the contract between Baron and Whittier.↩
37. We find no need to speculate as to exactly how many albums Casablanca really expected to sell. At trial, Casablanca's officers and employees all testified that they believed the album would be a hit. While those witnesses were quite forthright, we find it difficult to believe that, if Casablanca really expected the album to be a hit, it would have sold certain rights in the master recording in May 1977 for $ 90,000 cash plus the right to receive a percentage of Baron's royalty until the note was paid off (at which time Baron would be entitled to the entire royalty) when the sale of a mere 225,001 albums in the United States would have produced more income for Casablanca if it kept rather than sold those rights. This conclusion derives from the following analysis: (a) The sale of 225,000 albums and the application of an 80-cent royalty rate produces $ 180,000; (b) if Casablanca had not entered into the deal with Baron, it would have been entitled to the $ 180,000; (c) by virtue of the deal with Baron, Casablanca received $ 90,000 in cash and was entitled to half of the $ 180,000, or an additional $ 90,000; (d) hence, 225,000 albums represented the break-even point.↩
38. In 1977, Sydney and Sylvia Baron's taxable income (without considering the income and deductions relating to the master recording) was approximately $ 515,000; in 1978, their taxable income (without considering the master recording items) was approximately $ 345,000. During the years in issue, a 70-percent tax rate applied to all taxable income on joint returns in excess of $ 203,200, and a 60-percent tax rate applied to the amounts over $ 91,200 but not over $ 103,200. We have not taken into account any tax benefit from an investment credit (see note 24
supra↩ ), although we think it highly likely that Baron envisaged the availability of such credit at the time he acquired his rights.39. The Casablanca note was due on May 27, 1984. Unless Baron had already paid off the note, Casablanca could have foreclosed on it at that point. Although the Whittier note as such had no due date, the security agreement indicates that the due date was also May 27, 1984. In this connection, we recognize that, even if the right of foreclosure was not exercised, an argument could be made that an abandonment might be deemed to have taken place at the time the right of foreclosure could have been exercised. We express no opinion as to the validity of any such argument. See Fass, "Motion Pictures as a Tax Shelter: A Current Analysis of the Technique and the Problems,"
40 J. Tax. 154, 156↩ (1974) .40. In calculating this figure, we have assumed that (1) all income and deductions relating to the master recording rights would have been subject to the 70-percent tax rate, (2) Baron would have depreciated his investment over 2 years (which he, in fact, did and which was the period petitioners' expert Brandon Phillips testified was the anticipated span over which the bulk of the recordings would be sold), (3) Baron's basis in his investment was $ 650,00, (4) he would have invested his tax savings in 5-percent tax-exempt bonds (U.S. Department of Commerce, Statistical Abstract of the United States - 1978, Table No. 893), and (5) any tax on recaptured depreciation would have been due in April 1985 (the Casablanca note was due in 1984). If Baron invested his $ 455,000 in tax savings in 5-percent tax-exempt bonds, in the 6 years between when all the tax savings would have occurred and when any tax on recaptured depreciation would have been due, Baron would have earned interest (non-compounded) of $ 136,500. Thus, Baron would have had $ 591,500 with which to pay the tax on recaptured depreciation of $ 392,000 (assuming no reduction in the principal amounts of the notes). This would have left Baron with $ 199,500, which, after subtracting his cash investment of $ 90,000, would have produced a "profit" of $ 109,500 solely from tax benefits.↩
41. Baron was entitled to keep 32 of the 80 cents in royalties for each album sold in the United States until the notes were paid off; Casablanca was entitled to 40 cents per album and Whittier was entitled to 8 cents per album.↩
42. John Weidenmann, respondent's valuation expert, testified that before "The Deep" album was released, he would have estimated that it would have sold between 200,000 and 300,000 copies. Brandon Phillips, petitioners' valuation expert, testified that he would have estimated that the album would have sold 600,000 copies if it was
not↩ a "hit" and 1 million to 1.5 million copies if it were a phenomenal "hit." Phillips also testified, however, that selling 500,000 albums, i.e., going "gold," is very difficult to do. Prior to Donna Summer's involvement in the album, Neil Bogart, Casablanca's president, estimated that the album would sell between 100,000 and 300,000 copies. After Donna Summer's involvement, Trugman estimated that the album would sell in the half-million-unit range. While we need not determine how many albums a prudent investor would have expected to sell, we would note that practically all of these estimates would generate before-tax cash to Baron far below his after-tax benefit from depreciation deductions.43. Neither of these cash recovery calculations considers the impact of
any↩ tax, including recapture of excess depreciation deductions.44. To illustrate the ultimate in ridiculousness, a mere $ 1 cash investment and a $ 1 profit, i.e., 100 percent of investment, would be determinative.↩
45. If depreciation recapture were not taken into account, Baron's tax benefit from depreciation alone would have been $ 455,000 ($ 650,000 X 0.70). Without taking into account the time value of money, if 2,300,000 albums were sold, Baron would have been entitled to receive $ 1,840,000 (80 cents per album). Under our assumptions (and not taking into account interest payments and deductions therefor), he would have been able to take $ 650,000 in depreciation, leaving him with taxable income of $ 1,190,000, on which the tax would have been $ 833,000. He would thus have been left with $ 1,007,000 after taxes. Out of this, he would have had to pay $ 560,000 on the promissory notes. This would have left him with $ 447,000 less his $ 90,000 cash investment or $ 357,000 ($ 8,000 less than he would receive from tax benefits alone).↩
46. In certain situations, the matching standard will require the conclusion that the requisite profit objective is not present.
Fox v. Commissioner , 82 T.C. 1001">82 T.C. 1001↩47. Compare Justice Stewart's concurring opinion in
Jacobellis v. Ohio , 378 U.S. 184">378 U.S. 18448. The only contacts that Baron or his agents ever apparently had with Casablanca were when royalty checks were received and when Baron's accountant, Joel Rosen, requested sales projections so he could calculate depreciation under the income forecast method.↩
49. In any event, petitioners have presented no evidence on these two deductions other than testimony by Joel Rosen, the accountant, that Sydney Baron told him he spent the money for the purposes indicated, and consequently have failed to carry their burden of proof with respect to these items.↩
50. Petitioners have not claimed that Sydney and Sylvia Baron are entitled to any deductions for the portion of the actual payments as "interest" under sec. 163. Any such portion of the payments by Baron to Casablanca which might be labeled "interest" is less than the income Baron received and therefore would merely lower the amount of other deductions to be claimed against the income. See
sec. 183(b) . In any event, no interest deduction would appear to be allowable, since no valid indebtedness existed herein for the purposes of sec. 163. See, e.g.,Fox v. Commissioner , 80 T.C. 972">80 T.C. 972Siegel v. Commissioner , 78 T.C. 659">78 T.C. 659
Document Info
Docket Number： Docket No. 14759-81
Citation Numbers： 83 T.C. 542, 1984 U.S. Tax Ct. LEXIS 26, 83 T.C. No. 28
Judges： Tannenwald
Filed Date： 9/26/1984
Precedential Status： Precedential
Modified Date： 10/19/2024