United States District Court, Northern District of Illinois, E.D
December 23, 1982
RONALD ATLAS AND ELLEN ATLAS, PLAINTIFFS,
UNITED STATES OF AMERICA, DEFENDANT.
The opinion of the court was delivered by: William T. Hart, District Judge.
MEMORANDUM OPINION AND ORDER
This is a civil tax refund action pursuant to
28 U.S.C. § 1346(a)(1). The matter is currently before the Court on the
United States' ("defendant") motion for partial summary
judgment. The plaintiff*fn1 Ronald Atlas ("Atlas") is one of
21 limited partners in an Illinois limited partnership, Fostman
Venture No. 4 ("Fostman 4"). Sometime in 1975, Fostman 4
became, in exchange for a capital contribution of $650,000.00,
a limited partner in an Oklahoma limited partnership Villa
Fontana Associates ("Villa Fontana"). Villa Fontana's sole
asset is a Tulsa apartment complex, Villa Fontana Apartments.
Pursuant to written agreement, 99 percent of Villa Fontana's
losses were to be allocated to Fostman 4 in 1975. Villa Fontana
claimed 1975 losses in the amount of $1,592,484.00. On his 1975
tax return, Atlas claimed $19,984.00 as his percentage share of
that loss. Most of Atlas' claim was disallowed by the Internal
The defendant argues that the primary reason*fn2 for the
disallowance to Atlas is that Fostman 4 did not become a
limited partner until December 30, 1975. It asserts that for
tax purposes a partnership is created only when capital and
services have been contributed with the intent to create a
partnership and where the requirements of state law have been
met. Neither capital nor services were contributed by Fostman
4 to Villa Fontana before December 30. Also several
prerequisites to closing the transaction, including
statutorily required filings, were not accomplished until that
The defendant further states that the "varying interest"
rule provided for in section 706(c)(2) of the Internal Revenue
Code of 1954 (26 U.S.C.) ("Code")*fn3 prevents the
retroactive allocation of losses to persons not partners when
the losses occurred. In the alternative, the defendant claims
that the federal policy prohibiting the assignment of unearned
income or losses prevents Atlas from claiming more than his
percentage share of the losses incurred before December 30,
1975. Accordingly, the defendant requests the Court to
(1) That the partnership of Fostman Venture No.
4, for federal income tax purposes, was not
entitled to a retroactive allocation of 99% of
the net loss of the partnership of Villa Fontana
Associates for the period from January 1, 1975
until the date in 1975 on which Fostman Venture
No. 4 became a partner in Villa Fontana
(2) That Fostman Venture No. 4 was not a
partner in Villa Fontana Associates prior to
December 30, 1975.
Atlas raises a number of arguments in opposition. First, he
claims that the 1975 tax laws permitted losses incurred from
the first day of the relevant tax year to be allocated to new
partners admitted up to and including the last day of the
partnership's tax year. Atlas alleges that he may claim,
pursuant to section 704(a) of the Code, whatever portion of
gain or loss is specified in the partnership agreement. Under
this view, the exact day in 1975 when Fostman 4 became a
limited partner in Villa Fontana is irrelevant. In the
alternative, Atlas claims that Fostman 4 became a limited
partner at least by December 1, 1975 and that he is entitled
to claim his distributive share of 100 percent*fn4
losses suffered by Villa Fontana from December 1 until the end
of December, 1975.
Second, Atlas argues that the Court cannot grant summary
judgment on the issue of when Fostman 4 became a limited
partner in Villa Fontana because facts material to the
determination are in dispute. See Fed.R.Civ.P. 56(c). He says
that for purposes of federal taxation the creation of a
partnership is determined from the intent of the parties —
not, as the government says, from the contribution of capital
and services or from compliance with a state's partnership law.
Atlas also claims that when intent is at issue, summary
judgment is an improper remedy. See, e.g., Staren v. American
National Bank and Trust Co. of Chicago, 529 F.2d 1257 (7th Cir.
1976); Cedillo v. International Association of Bridge and
Structural Iron Workers, 603 F.2d 7 (7th Cir. 1979). Atlas
submits the affidavit of Jerald F. Richman, a general partner
of Fostman and Associates, indicating Richman's intent to
become a limited partner in Villa Fontana as of November 29,
1975 and to form Fostman 4 on the same day.
Finally, Atlas argues that partial summary Judgment is not
permitted where fewer than all parts of a single claim are
presented for disposition. Atlas claims that he is entitled to
either a share of 99 percent of all the losses incurred by
Villa Fontana in 1975 or 100 percent of the losses incurred
from December 1 through December 31, 1975. The defendant
allegedly seeks summary judgment only as to part of this claim
— whether retroactive allocation of 99 percent of the losses
is lawful irrespective of the date on which Fostman 4 became a
limited partner of Villa Fontana. Thus the portion of Atlas'
claim which proposes that he may deduct his share of 100
percent of the December 1975 losses allegedly has not been
presented for disposition.*fn5
The disposition of this motion requires a determination of
exactly when Fostman 4 became a limited partner of Villa
Fontana. As of November 27, 1982, neither limited partnership,
Fostman 4 nor Villa Fontana, was in existence. On November 28,
1975, Fostman and Associates, the general partner of Fostman
4, executed a Memorandum of Agreement with the general partner
of Villa Fontana. The Memorandum's purpose was to set the
ground rules for acquisition of a limited partnership interest
in the Villa Fontana Apartments. Fostman 4 was to be formed by
Fostman and Associates and designated as its assignee in a
limited partnership to be formed and known as Villa Fontana
Associates. The Memorandum also specified that a portion of
Fostman 4's capital contribution would be used to fund Villa
Fontana's 1975 cash requirements, including some obligations
incurred by Villa Fontana prior to December 1, 1975. Closing
of the transaction was to occur "no
later than December 12, 1975." The closing was contingent on,
among other things, the preparation of a limited partnership
agreement, the filing of a certificate of limited partnership,
financial, profit and loss and cash flow statements and
evidence that the general partner of Villa Fontana was a
person of general substance.
On December 28, 1975, Atlas executed a Fostman 4
subscription agreement, having tendered an application to be
a limited partner six days before. On December 30, 1975, the
Agreement of Limited Partnership and Certificate for Fostman
4 were executed and filed in Illinois. Also on December 30,
Fostman 4 paid Villa Fontana the sum of $650,000.00. Finally,
on December 31, 1975, a Limited Partnership Agreement and
Certificate on behalf of Villa Fontana was filed in Oklahoma.
The Court first concludes that, as a matter of law, Fostman
4 did not become for federal tax purposes a limited partner in
Villa Fontana until December 30, 1975. For federal tax
purposes, the standards governing the existence of a
partnership are federal. Evans v. Commissioner, 447 F.2d 547
(7th Cir. 1971); Internal Revenue Code § 7701; Treasury
Regulations on Procedure § 301.7701-1. Thus, in one respect
Atlas is correct, i.e., whether the would-be partners complied
with the specificity of Oklahoma's or Illinois' partnership
laws by executing partnership agreements and certificates
before doing business is irrelevant to the determination of
when Fostman 4 was created for federal taxation.
Turning to the federal regulations, section 704(e)(1)
provides that "[a] person shall be recognized as a
partner . . . if he owns a capital interest in a partnership
in which capital is a material income producing factor."
Although section 704(e) applies to family partnerships, its
scope encompasses all partnerships for purposes of tax law.
Evans v. Commissioner, supra, at 550.
The controlling law on the formation of partnerships is
Commissioner v. Culbertson, 337 U.S. 733, 69 S.Ct. 1210, 93
L.Ed. 1659 (1949). There the Court considered the question
"whether an intention to contribute capital or services
sometime in the future is sufficient to satisfy ordinary
concepts of partnership" as required by federal law. Id. at
738-39, 69 S.Ct. at 1212. The Court concluded that
[A] partnership is, in other words, an
organization for the production of income to
which each partner contributes one or both of the
ingredients of income — capital or services. The
intent to provide money, goods, labor, or skill
sometime in the future cannot meet the
demands . . . of the code that he who presently
earns the income through his own labor and skill
and the utilization of his own capital be taxed
therefor. The vagaries of human experience preclude
reliance upon even good faith intent as to future
conduct as a basis for the present taxation of
Atlas argues that Culbertson does not hold that the existence
of a partnership turns first on the contribution of either
capital or services. Rather he says that contributions of
capital or services are but factors to be considered. In his
view, regardless of a person's contribution of either capital
or services, the primary resolution of whether a partnership is
created turns on the partners' intention to form a partnership.
Atlas misreads Culbertson.
The Culbertson case, and all but one of the cases cited by
Atlas, deal with family partnerships. A close reading of those
cases indicates that there was always an allegation of some
contribution of capital or services by the purported
partner/family member. The issue was whether the amount,
quality or origin of the capital or services was sufficient to
indicate an intent to establish a partnership. This is because
family partnerships, unlike the instant arm's length
transaction, were attacked as "created" only to evade the
payment of taxes. Thus, the statement in Culbertson: "[e]ven
though it was admitted in the
[Commissioner v.] Tower [327 U.S. 280, 66 S.Ct. 532, 90 L.Ed.
670 (1946)] case that the wife contributed no original
capital . . . or services, this Court did not say as a matter
of law that there was no valid partnership." (Emphasis added).
The Court was saying that where no original capital is
contributed, as where the donee of an intrafamily gift seeks to
become a partner through investment of the gift in the family
partnership, the true intentions of the parties must be
scrutinized to determine if the goal is merely tax avoidance
rather than operation of a "real" partnership. But the
Culbertson case clearly establishes that there first must be
some contribution of capital or services before a person can be
taxed as a partner. Then if his intentions are in doubt, the
case merits a further look.
Despite the passage of 33 years, Culbertson is still good
law. Evans v. Commissioner, supra, at 550-51; Pflugradt v.
U.S., 310 F.2d 412, 415 (7th Cir. 1962). This is so although
the Code's present section 704(e)(1) replaced the
"good-faith/business purpose" test in force in 1949 with the
"ownership of a capital interest" test. On December 30, 1975,
Fostman 4 contributed capital to Villa Fontana. There is no
allegation that it ever contributed services. Thus Fostman 4
owned no capital interest in Villa Fontana until December 30,
1975. In fact, Fostman 4 was not even created until that date.
The good faith intentions of the affiant Jerold Richman to
become a limited partner of Villa Fontana on December 1 is
immaterial. Arguably, Fostman and Associates was not even bound
by the Memorandum of Agreement to contribute capital or to form
Fostman 4 since the agreement recites that if all contingencies
were not satisfied [before December 12, 1975], the agreement
would expire and each party would hold the other harmless.
Thus, no genuine issue of fact material to deciding when
Fostman 4 became a limited partner of Villa Fontana remains
since, as a matter of law, Fostman 4 did not become a limited
partner until December 30, 1975.
Second, the Court finds that the Code does not permit any
portion of the losses incurred by Villa Fontana prior to
December 30, 1975 to be retroactively allocated to Fostman 4
or deducted by Atlas on his 1975 return. Subchapter K of the
Code, §§ 701 et seq., controls the taxation of partnership
income. Individual partners, not the partnership, pay tax on
partnership income or deduct its losses according to their
distributive share of income or loss. Where a partnership
agreement is in effect, that agreement generally governs
allocation of a partner's distributive share. Code § 704(a).
There are, however, several exceptions. Only one — the
varying interest rule — is relevant here. In 1975, section
706(c)(2)(B) provided that when a partner "sells or exchanges
less than his entire interest in the partnership or with
respect to a partner whose interest is reduced . . . [his
distributive share of partnership losses] shall be determined
by taking into account his varying interests in the partnership
during the taxable year." This section has been consistently
interpreted to prohibit the arrangement that Atlas seeks to
validate here. Williams v. U.S., 680 F.2d 382 (5th Cir. 1982);
Snell v. U.S., 680 F.2d 545 (8th Cir. 1982), Mahoney v. U.S.,
No. 497-77 (Ct.Cl. Nov. 6, 1981); Rodman v. Commissioner,
542 F.2d 845 (2d Cir. 1976); Richardson v. Commissioner, 76 T.C. 512
(1981); Marriott v. Commissioner, 73 T.C. 1129 (1980);
Moore v. Commissioner, 70 T.C. 1024 (1978).
Moore v. Commissioner, supra, at 1032, held that the
distributive share of a partner who is a transferee of less
than the entire interest of the transferor partner is
determined in the identical way as that of the transferor
partner's distributive share. Losses incurred by a partnership
before partnership interests are altered, e.g., reduced, are
deductible by the transferor according to his then existing
partnership interest. Losses incurred after a shift in
partnership interest are deductible by the transferor and
transferee in accordance with their newly created interests in
the partnership. Atlas has not directed the Court to any case
that, based on the preceding
interpretation of section 706(c)(2)(B), has held that a member
of a partnership for only a part of the tax year can deduct
losses incurred for the other part. Since the statute would
prevent an original partner from sharing disproportionately in
the partnership's losses after admission of a new partner, the
statute similarly bars a new partner from sharing
disproportionately in losses which accrued prior to his
The varying interest rule is consistent with the long
standing ban against the assignment of unearned income or
losses. See Helvering v. Horst, 311 U.S. 112, 116, 61 S.Ct.
144, 146, 85 L.Ed. 75 (1940); Lucas V. Earl, 281 U.S. 111, 115,
50 S.Ct. 241, 74 L.Ed. 731 (1930); Williams v. U.S., supra.
Moore v. Commissioner, supra. Accordingly, the courts "have
recognized that partnership agreements allocating to a new
partner a portion of partnership profit or losses attributable
to the period prior to the partner's entry into the partnership
violate the assignment of income doctrine." Williams v. U.S.,
supra, at 385, and the cases cited therein. This Court is
persuaded to make an identical finding.
Nonetheless, Atlas argues that many of the cited cases are
either factually distinguishable or are legally insupportable.
He states that section 706(c)(2)(B) is inapplicable to a
situation where, as here, a new partner obtains his interest
by making a capital investment instead of by purchasing
existing shares. Cf. Marriott v. Commission, supra, and Moore
v. Commissioner, supra. Atlas argues that the word "reduced" in
the 1975 version of section 706(c)(2)(B) did not apply to him
because by adding capital to Villa Fontana, the partnership's
assets were increased. Thus, he says, the old partners'
percentage shares, despite additional interested partners, were
somehow not reduced. This so-called "size of the pie" theory is
illogical. The Court can find no decision in which the theory
was accepted. The 1982 decisions of the Fifth, Williams v.
U.S., supra, and Eighth, Snell v. U.S., supra, Circuits also
reject the theory Atlas advances here. Furthermore, the leading
commentator on partnership taxation rejects the proposition
that no reduction of the interests of the existing partners
occurs where the pie is increased sufficiently to offset a
reduction in proportionate interest. A. Willis, Partnership
Taxation 286 (2d ed. 1976). Thus, to the extent that Atlas
seeks to distinguish this case from the cases where an interest
is purchased outright rather than gotten by capital
contribution, he poses a distinction without a difference.
Atlas tries to make his argument credible by comparing the
1975 version of section 706(c)(2)(B) with its 1976
counterpart. The Tax Reform Act of 1976 amended that sec-tion
and inserted after the phrase "a part-ner whose interest is
reduced" the paren-thetical phrase "(whether by entry of a new
partner, partial liquidation of a partner's interest, gift or
otherwise)." Both parties agree that the 1976 amendment
clearly pro-hibits retroactive allocation of losses to a
person in advance of his status of partner, whether a
partnership occurred by capital contribution or outright sale.
Atlas, however, argues that the absence in 1975 of the
parenthetical addition means that retroactive allocation for
new partners joined by capital contributions was permitted in
A review of the legislative history and interpretative case
law is to the contrary. The purpose of the amendment appears
to be to clarify the law as it existed, and not to change it.
The Report of the Joint Committee on Taxation recognized as
ambiguous the pre-1976 law:
Under prior law, it was unclear whether . . .
[§ 706(c)(2)(B)] pertained to the situation where a
partner's proportionate interest in the partnership
was reduced as the result of the purchase of an
interest directly from the partnership.
Consequently, it was unclear whether an incoming
partner, who purchased his interest directly from
the partnership, would be subject to the rule of
including partnership income and loss according to
his varying interests during the years.
Staff of Joint Commission on Taxation, 94th Cong., 2d Sess.,
General Explanation of the Tax Reform Act of 1976, p. 92
Therefore, the purpose of the 1976 amendment was —
to make it clear that the varying interests rule of
this provision is to apply to any partner whose
interest in a partnership is reduced, whether by
entry of a new partner who purchased his interest
directly from the partnership, partial liquidation
of a partner's interest, gift, or otherwise.
Correspondingly, the provision is to apply to the
incoming partner so as to take into account his
varying interests during the year. In addition,
regulations are to apply the same alternative
methods of computing allocations of income and loss
to situations falling under section 706(c)(2)(B) as
those now applicable to section 706(c)(2)(A)
situations (sale or liquidation of an entire
Id., at pp. 93-94. Accord Williams v. U.S., supra; Richardson
v. Commissioner. Thus, the varying interest rule in effect in
1975 prohibited Atlas from deducting any percentage of losses
incurred by Villa Fontana prior to December 30, 1975,
notwithstanding the terms of the agreement between the parties.
Atlas' insistence that this case is governed by Smith v.
Commissioner, 331 F.2d 298 (7th Cir. 1964), also is to no
avail. In Smith, the Seventh Circuit upheld an agreement
providing that one partner was to be allocated 100 percent of
the partnership's tax year gain. Unlike the instant case,
however, Smith involved a reallocation of income among members
of an ongoing partnership. Each member had been a partner for
the entire tax year. Furthermore, the Smith case did not even
discuss the varying interest rule but focused only on whether
the partnership agreement was an attempt to evade the payment
of taxes. Smith is not controlling here.
The Court recognizes that summary judgment is a drastic
remedy and that it should not be granted without excellent
reasons or where intent is critical to ascertain. Poller v.
Columbia Broadcasting System, Inc., 368 U.S. 464, 82 S.Ct. 486,
7 L.Ed.2d 458 (1967). At a minimum, it must be established that
"no genuine issue as to any material fact" remains for trial.
Fed.R.Civ.P. 56(c). However, as no fact material to this motion
can be disputed as a matter of law, no genuine issue as to any
material fact remains: Retroactive allocation to incoming
partners of preexisting partnership losses is forbidden and,
notwithstanding the good faith intentions of its originators,
Fostman 4 was not formed for federal tax purposes until
December 30, 1975.
Accordingly, the defendant's motion for partial summary
judgment is granted. The issues of whether the IRS properly
disallowed 1) certain deductions claimed by Villa Fontana
Associates on its 1975 partnership tax return and 2) certain
deductions claimed by Fostman 4 on its 1975 partnership tax
return, disallowances which, in turn, reduced the amount of
partnership losses ultimately claimable by Atlas, remain for
trial. A status hearing to set a date for the submission of a
pretrial order will be held on January 19, 1983 at 9:30 a.m.