FENIX RESTAURANT, INC. - DETERMINATION - 11/16/98. In the Matter of FENIX RESTAURANT, INC. TAT(H) (GC) - DETERMINATION

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1 FENIX RESTAURANT, INC. - DETERMINATION - 11/16/98 In the Matter of FENIX RESTAURANT, INC. TAT(H) (GC) - DETERMINATION NEW YORK CITY TAX APPEALS TRIBUNAL ADMINISTRATIVE LAW JUDGE DIVISION GENERAL CORPORATION TAX - NO DEDUCTION WAS ALLOWED TO A TAXPAYER CORPORATION WITH RESPECT TO ITS TRANSFERS OF FUNDS TO A SECOND CORPORATION BECAUSE THE TAXPAYER CORPORATION FAILED TO ESTABLISH THAT THE TRANSFERS WERE DEDUCTIBLE AS EXPENSES INCURRED AS A MEMBER OF A JOINT VENTURE WITH THE SECOND CORPORATION OR SOME OTHER APPROPRIATE BASIS OF DEDUCTION. NOVEMBER 16, 1998

2 NEW YORK CITY TAX APPEALS TRIBUNAL ADMINISTRATIVE LAW JUDGE DIVISION : In the Matter of the Petition : DETERMINATION : of : TAT(H) (GC) : FENIX RESTAURANT, INC. : : Schwartz, A.L.J.: Petitioner, Fenix Restaurant, Inc., 2328 Broadway, New York, New York, 10024, filed a Petition with the New York City Tax Appeals Tribunal ("Tribunal") requesting a redetermination of deficiencies of New York City ("City") General Corporation Tax ("GCT") under Chapter 6 of Title 11 of the City Administrative Code ("Code") for the calendar years 1986 through 1989 (the "Tax Years"). A Hearing was held before the undersigned on August 27, 1997 at which testimony was taken and various documents, including a stipulation of facts, were entered into the record. On October 13, 1998, an additional stipulation was submitted to the Tribunal and admitted as part of the record in this case. Petitioner submitted a post-hearing brief on December 10, The Commissioner of Finance (the "Commissioner" or "Respondent") filed his post-hearing brief on January 30, Petitioner filed its reply brief on March 27, Respondent filed his reply brief on April 6, Petitioner filed its sur-reply brief on April 29, Respondent filed his sur-reply brief on May 15, Petitioner was represented by George Stone, Esq. of Burke & Stone. At the Hearing, Respondent was represented by Robert J. Firestone, Esq. and David M. Steiner, Esq., Assistant Corporation Counsels. Frances J. Henn, Esq., Assistant Corporation Counsel, also participated on the briefs.

3 ISSUE Whether the Commissioner properly disallowed a deduction for certain payments made by Petitioner to a related corporation. FINDINGS OF FACT 1. Petitioner is a closely-held corporation which owns a restaurant located at 1063 First Avenue at East 58th Street in Manhattan Broadway Restaurant Operators, Inc. ("Broadway") is a closely-held corporation which owns a restaurant on Broadway at West 85th Street in Manhattan. 3. During the Tax Years, Nikos Pharasles was the president, a director, and a shareholder of both Petitioner and Broadway. 4. During the Tax Years, Daniel Hickey was the secretary, a director, and a shareholder of both Petitioner and Broadway. 5. Petitioner's remaining officers and directors were Doug Griebel, George Harpootlian, and Robert Valente, all of whom were shareholders of both Petitioner and Broadway Petitioner, Broadway and five other closely held corporations (the "Five Corporations"), each of which owned a restaurant, have at all times handled all of their accounting, bookkeeping, and payment functions for their respective restaurants, from the same office located at 2328 Broadway in Manhattan. 1 The record does not indicate whether these individuals were also officers and/or directors of Broadway. 2

4 7. The books of Petitioner, Broadway, and the Five Corporations were kept by the same comptroller, a corporation owned by Mr. Pharasles. 8. There was cross-ownership by the shareholders in all seven corporations. For example, on December 31, 1986, individuals who were shareholders of both Petitioner and Broadway held in the aggregate percent of the shares of Petitioner and percent of the shares in Broadway. 9. Peter Cosmas, CPA, a shareholder of both Petitioner and Broadway, served as accountant for both corporations throughout the Tax Years and in that capacity prepared the corporations' tax returns. Mr. Cosmas also represented Petitioner during the audit of this matter and the pre-hearing portion of these proceedings. 10. Petitioner began operating its restaurant, Rosa Mexicano, in Rosa Mexicano served haute Mexican cuisine. Josephina Howard, its executive chef, was very well known. Mr. Pharasles characterized Rosa Mexicano as "a popular destination restaurant." TR. p In 1986, Rosa Mexicano had gross sales of $1.9 million and Petitioner reported ordinary income of $25,698 on its Form 1120S, U.S. Income Tax Return for an S Corporation. 12. Broadway began operating its restaurant in Its restaurant was originally called Ancora Ristorante ("Ancora") and sold nouveau Italian cuisine. 13. At Petitioner's Board of Directors Meeting of July 17, 1986, a resolution was adopted authorizing Josephina Howard to be retained as a consultant to Broadway. 3

5 14. In 1986, Broadway had financial difficulties. The record is not entirely clear regarding the reasons for these financial difficulties. According to a memo dated August 27, 1986 from Mr. Pharasles to the Broadway shareholders (the "Pharasles Memo," Taxpayer's Ex. 1) while Ancora's "[k]ey operating margins in food, beverages and labor [were] all in line with industry norms," it did not do the volume of business needed to cover certain extraordinary expenses. The Pharasles Memo noted that "non-operating expenses, primarily legal, have created a precarious cash flow condition...." The Pharasles Memo further noted that "[r]egarding litigation, a settlement, aggregating $400,000 ($250,000 down with $150,000 in 10% notes over four years commencing March 2, 1987) was agreed upon." The record does not indicate the nature of these legal difficulties. The Pharasles Memo noted that Ancora had averaged net sales of $40,000 per week since January 1, The Pharasles Memo suggested three alternative approaches to resolving Broadway's difficulties: (1) continuing to operate in its present format in the hopes that net sales would increase to $60,000 per week; (2) looking for a buyer; or (3) converting the restaurant operation to Las Delicias de Rosa Mexicano ("Las Delicias"). Broadway's management recommended the third approach. In support of its recommendation, the Pharasles Memo noted:... Las Delicias... makes business sense for the Shareholders of both Rosa and Ancora and for the immediate use of the creative talents of Josephina Howard, Executive Chef at Rosa Mexicano. Rosa Mexicano has been a commercial success. Rosa's net sales for its first fiscal year, 12/31/85, were $1,600,000 upon which it generated $249,000 in working capital from operations... After depreciation and amortization of $87,000, Rosa had net income of $162,000. The Pharasles Memo did not describe how the conversion of Ancora to Las Delicias would benefit Petitioner, nor did it explain what Petitioner's role in the conversion would be. 4

6 16. Mr. Pharasles testified that he expected Las Delicias to average gross sales of $50,000 to $55,000 per week, or $2.5 million per year. TR. p Broadway's restaurant was, thereafter, converted to a new format along the lines of what was successfully done by Petitioner at Rosa Mexicano. Its name was changed to Las Delicias de Rosa Mexicano. The conversion and operation of this new restaurant is referred to as the "Las Delicias Project." 18. Las Delicias opened in early or mid-december of TR. p. 29; City's Ex. C. It was not successful. Its weekly net sales never exceeded the high $30,000s. Following a mediocre review of the new restaurant, sales dropped to the low $20,000s. Las Delicias closed in mid-april, Approximately two months after Las Delicias closed, Broadway's restaurant reopened, under another concept, as Patsos. Patsos had a less expensive menu that was mainly Italian style but also included more generic items such as hamburgers. At the time of the Hearing, Broadway was still in business, operating a restaurant known as Nova Restaurant at the same location. 20. Between November 24, 1986 and March 3, 1987, Petitioner transferred, in the aggregate, $454,000 (the "$454,000 Transfer") to Broadway at the following times: Date of Transfer Amount 11/24/86 $50,000 11/28/86 20,000 12/3/86 70,000 12/8/86 70,000 12/10/86 30,000 12/12/86 50,000 12/31/86 40,000 Total 1986 Transfers $330,000 5

7 1/7/87 15,000 1/21/87 4,000 2/13/87 50,000 2/23/87 50,000 3/3/87 5,000 Total 1987 Transfers 124,000 Total Amount Transferred $454,000 It is not disputed that Petitioner received none of this money back. What is disputed is the deductibility of the $454,000 Transfer. 21. During the audit and at the Hearing, Petitioner characterized the relationship between itself and Broadway with respect to the Las Delicias Project as a joint venture. However, there are inconsistencies in the record regarding the relationship between Petitioner and Broadway and the proper characterization for tax purposes of the $454,000 Transfer. 22. No separate books were maintained for the Las Delicias Project. The individuals who worked at the Las Delicias restaurant were treated as employees of Broadway. The Las Delicias Project did not obtain a separate taxpayer identification number, nor did it file Form 1065, U.S. Partnership Return of Income for any of the Tax Years. Neither did it file Form NYC-204, City Unincorporated Business Tax("UBT") Return for Partnerships, for any of the Tax Years. Instead, the income and expenses of the project were reflected solely on Broadway's books. Mr. Cosmas stated that he was aware that for federal tax purposes, "a joint venture [may exist]... even though there is no formal partnership agreement, [as] technically, in the eyes of the IRS it's considered a partnership...." TR. p

8 Mr. Cosmas further stated "[t]hat's what it is, except in this particular case. It was a joint venture that was kept under one roof...." TR. pp Mr. Cosmas stated "[s]o we just did not do the 1065 but everything was reported on the New York City [NYC-3L] and the 1120 return. It was an 1120 return." TR. p Mr. Cosmas stated that setting up a partnership is: more bookwork, you got to pay an accountant and you got to do this, do that. In a joint venture, we didn't do that, okay? We didn't do a formal thing but it was treated, it was going to be treated as a joint venture. TR. p During the course of the audit in this matter, Mr. Cosmas, who was then acting as Petitioner's representative, provided the auditor with a document dated August 27, 1986 (the "Purported Agreement") that Petitioner asserts represents the agreement between itself and Broadway regarding the conversion of Broadway's restaurant. 24. The Purported Agreement stated as follows: It is heretofore agreed between the parties, [Broadway] and [Petitioner] to: a) Convert [Broadway's] restaurant (Ancora Ristorante) to a Mexican type restaurant (Las Delicias de Rosa Mexicano) in order to maximize the 180 seats of Ancora. b) [Petitioner] will receive 60% of the profits of the operation and be responsible to finance any losses. c) [Broadway] will receive 40% of the profits, but guaranteed [$]150,000 per year for the first two years of operation. d) [Petitioner] will advance to [Broadway] $350,000 to pay old liabilities incurred by the Ancora operation. e) Josephina Howard will enter into a consulting agreement with [Broadway] and will receive the following incentives: 7

9 at a weekly net sale of: Fee Opening $ $40, ,000+ 1, Maximum cap 1, This document has signature lines for both Petitioner and Broadway. However, the copy of the Purported Agreement provided to the auditor is unsigned. The auditor requested either the original or a signed copy of the Purported Agreement. Neither was provided. 25. At Petitioner's Board of Directors Meeting of September 10, 1986, the Board of Directors enacted resolutions enabling Petitioner to enter into a credit line loan facility with Marine Midland Bank in the amount of $350,000 (the "Credit Line"). Petitioner was also empowered to open a bank account at Marine Midland on which Messrs. Pharasles, Hickey, and Griebel were signatories. In the Minutes of this Board of Directors Meeting only the establishment of the Credit Line and the bank account were discussed. The Minutes do not indicate why Petitioner wished to open the Credit Line. Neither the relationship, if any, between Petitioner and Broadway, nor the nature of any assistance Petitioner was to provide to Broadway, was described. 26. The Credit Line was guaranteed by all but three of Petitioner's shareholders. Ultimately, Petitioner drew down 2 $450,000 from the Credit Line at Marine Midland Bank, all of which it paid over to Broadway. $454,000 Transfer. This is the source of most of the 27. The minutes of Petitioner's Board of Directors Meeting of September 10, 1986 state that the actions taken were approved by Petitioner's shareholders at the Annual Shareholders Meeting held 2 Presumably, the Credit Line was increased. 8

10 on September 9, The record contains a notice of Petitioner's Annual Shareholders Meeting to be held on September 9, This notice is signed by Mr. Hickey. However, no minutes of this meeting were provided by Petitioner. 28. A notice of Broadway's Annual Shareholders Meeting to be held on September 9, 1986, also signed by Mr. Hickey as secretary, is in the record. However, no minutes of that meeting were provided by Petitioner. 29. Mr. Hickey testified that at the Annual Meeting of the Shareholders of Broadway a plan was presented to: put together somewhat of an offshoot of a concept that we were running at Rosa Mexicano on the east side and to bring a slightly changed concept of the Rosa concept to the west side of Manhattan. TR. p. 81. Mr. Hickey testified that Broadway was: to contribute a very attractive leasehold. We also had a very relatively new physical plant and equipment and that was to be contributed to whatever changes we might make.... TR. p. 82. Mr. Hickey testified that in return for that contribution: [Broadway] was to receive a percentage of the profits from whatever business we put together with Rosa Mexicano. TR. p. 82. Mr. Hickey testified that the Annual Meeting of the Broadway shareholders was held on September 9, 1986 and: the proposal of this joint venture was made to the shareholders and it was approved at that meeting by the majority of the shareholders. TR. p Mr. Cosmas testified that at Petitioner's Annual Shareholders Meeting the issue of a joint venture was discussed. 9

11 He stated that a resolution was adopted, the substance of which was that Petitioner and Broadway: would operate a joint venture at the premises of... Broadway called Delicias Mexicano,... to operate there.... [Petitioner] was to supply Josephina Howard as being the head chef and was to supply, because through its balance sheet a line of credit to be able to have a working capital and construction costs to change the atmosphere into a Mexican restaurant. TR. pp Mr. Cosmas also testified that he attended a Broadway Shareholders Meeting at which a resolution was approved, the substance of which was: That at 2330 Broadway, the premises, it would no longer operate Ancora, the Italian restaurant, but we'd transform it into a Mexican Restaurant along the lines of Rosa Mexicano. TR. p. 94. Mr. Cosmas testified that Petitioner "was supposed to get 60 percent of the profits and [Broadway] 40 percent of the profits." TR. p During cross examination of Mr. Pharasles, in connection with the contributions that Petitioner was making to the Las Delicias Project, the following colloquy took place: Q. You were provided a lot of capital and a lot of know how, is that correct? A. No, it's not correctly stated because we facilitated the capital in the form of a loan but this was not an equity infusion of funds, okay. TR. p The record is not clear regarding how the funds transferred from Petitioner to Broadway were used. Mr. Cosmas 10

12 testified that a portion of the $454,000 Transfer went to pay Broadway's old debts including rent arrears. TR. pp. 103, 126. Mr. Cosmas also testified that Broadway needed $150,000 per year to pay off its bank loan from a prior obligation and that was why the Purported Agreement provided that Broadway was to receive a minimum of $150,000 per year. TR. p. 97. Mr. Pharasles testified that he originally expected to spend between $150,000 and $200,000 to convert Ancora to Las Delicias. These expenditures were to include renovation costs such as specially made decorative Mexican tiles that would create a decor suitable for a Mexican restaurant. Also included would be fixed expenses such as rent and utilities that would be incurred while the restaurant was closed. Although Mr. Pharasles expected the restaurant to be closed for four weeks, it actually took ten weeks. TR. pp Mr. Pharasles attributed the additional costs to cost overruns resulting in actual construction costs of approximately $250,000 and to "variable and fixed expenses of operating space and also working capital to fund the growth of a new business." TR. p Respondent's representative made repeated requests for detailed information about the loss on the Las Delicias Project. In response, Petitioner provided Respondent with trial balances and workpapers for Broadway dealing with all of Broadway's operations for each of calendar years 1986 through 1988 and also for the fourmonth period January 1 through April 30, The trial balance and workpapers for 1986 include Broadway's revenues and expenditures for the entire year including the portion of the year when Broadway operated Ancora, the period when the restaurant was closed during renovations, and the period in December when Las Delicias opened. The 1987 workpapers include Broadway's revenues and expenditures for all of 1987 including the period in early 1987 when Las Delicias was in operation, and the 11

13 period after April, 1987 when Las Delicias closed and Broadway operated Patsos. The 1988 workpapers related solely to the period after the Las Delicias Project ended. There were no entries on these workpapers or trial balances that were specifically identified as being part of the Las Delicias Project. Mr. Cosmas testified that the losses attributable to the Las Delicias Project were "blended in." In order to ascertain the amount of that loss he would have to "break out" the relevant items. TR. p Despite repeated requests from Respondent that it do so, Petitioner has not provided Respondent with those "broken out" items. The workpapers for the four month period January 1, through April 30, 1987 show a loss of $146,369. However, even here, it cannot be determined if any of the expenses shown relate to the period in late April after Las Delicias closed and Patsos was being readied. It is not disputed that Petitioner transferred $454,000 to Broadway during 1986 and However it cannot be determined from the record how much of those funds were used to pay Broadway's old debts unrelated to the Las Delicias Project, how much represented capital expenditures for renovating the restaurant, and how much represented losses on a current basis from the operation of the Las Delicias Project. 35. The $454,000 Transfer was treated initially on Broadway's books as a loan payable to Petitioner. Over the three year period from 1986 through 1988, Broadway charged off this loan and treated it as "management fee income." The amounts charged off and treated as management fee income in each of the three years are as follows: 12

14 1986 $179, , ,000 Total $454, Petitioner filed Forms 1120S, U.S. Income Tax Return for an S Corporation, for the Tax Years. Petitioner also filed Forms NYC-3L, General Corporation Tax Returns, for the Tax Years. Petitioner deducted the following amounts as "management contract expense:" 1986 $179, , ,000 Total $454, Mr. Cosmas testified that he would have deducted the $454,000 as "management contract expense" whether or not the Las Delicias Project made money. TR. p Mr. Cosmas testified that Petitioner's "loss" on the Las Delicias Project was a "clear loss" in 1987 once Las Delicias closed. He stated that he did not deduct the balance of the "loss" in that year because: we had maybe a little hope that they would pay maybe $100,000 back but they didn't. There was never anything paid back because [Broadway] did not fare well. TR. p The record contains no other explanation why Petitioner deducted the $454,000 in 1986 through 1988 as indicated above when it transferred the $454,000 over two years: $330,000 in 1986 and $124,00 in

15 40. To Mr. Cosmas's knowledge, Petitioner and Broadway engaged in no activities together after Las Delicias closed. TR. p Broadway continued on its own operating Patsos. Patsos was in the same location, under the same lease, and using the same plant and equipment that had been used for Las Delicias, although it abandoned certain items of decor used at Las Delicias, such as the Mexican tile. 41. In 1988, some, but not all, of the shareholders of Broadway made additional contributions to Broadway's capital in exchange for additional shares. The relationship between the amount contributed and the number of shares received is not constant. Messrs. Pharasles and Griebel each contributed $50,000 and received shares, which would result in a price per share of $ Mr. Hickey contributed $25,000 and received shares, resulting in a price per share of $ Certain other shareholders, who were also shareholders of Petitioner, paid anywhere from $1, per share to $1, per share. The Broadway shareholders who were not also shareholders of Petitioner paid between $1, and $2, per share. 42. Mr. Cosmas testified that Messrs. Pharasles, Hickey, and Griebel received a disproportionately high number of shares because they had waived management fees to which they were entitled in the amount of $118,000. TR. p Mr. Pharasles testified that certain shareholders of Petitioner who did not guarantee the Credit Line were "penalized" in the recapitalization of Broadway. TR. p Mr. Pharasles could not explain some of the other apparent price per share differences. TR. p On March 5, 1993, the City Department of Finance (the "Department") issued a Notice of Determination to Petitioner 14

16 asserting the following proposed GCT deficiencies for the Tax Years: 3 Tax Year Principal Interest Total Deficiency 1986 $15, $11, $26, , , , , , , Total $37, $24, $61, The basis for the proposed deficiencies was the disallowance of the deductions in 1986 through 1988 for "management contract expense" which the auditor disallowed under the theory that the $454,000 Transfer was actually a contribution to capital from Petitioner's shareholders to Broadway. The proposed deficiency for 1989 is caused by a reduction of a net operating loss carryforward that occurred because of the management contract expense disallowances for 1986 through Following a proceeding before the Department's Conciliation Bureau, a Conciliation Decision and Order was issued on May 24, 1995 discontinuing those proceedings because Petitioner or its duly authorized representative did not agree to the Conciliation Bureau's proposed resolution of the matter. 47. Petitioner filed a Petition with the Tribunal on August 21, 1995 requesting a redetermination of the deficiencies asserted by the Commissioner in the Notice of Determination of March 5, STATEMENTS OF POSITIONS Petitioner claims that it entered into a joint venture with Broadway with respect to the Las Delicias Project. It contends 3 Computed to 3/15/93. 15

17 that the entire $454,000 was deductible by Petitioner as a business expense to promote the joint venture. Petitioner dismisses as "an untimely procedural argument," Respondent's objection to Petitioner's attempt to recharacterize the transaction. Petitioner further asserts that the $454,000 Transfer was not a contribution to Broadway's capital that was intended to bail out Broadway's shareholders. Finally, Petitioner states that the issue of the deductibility of the $454,000 Transfer under either Internal Revenue Code ("IRC") 162 or IRC 166 is not relevant to this case. Respondent claims that since Petitioner deducted the $454,000 Transfer as a management contract expense on its tax returns, it cannot now recharacterize the transaction as an expense attendant to a joint venture. Respondent also contends that even if Petitioner were permitted to recharacterize the transaction, the substance of the transaction is not a joint venture. Respondent asserts that the transaction was actually an investment in Broadway by Petitioner's shareholders. Finally, the Commissioner contends that the Petition should be dismissed because throughout the proceedings Petitioner flouted the rules of discovery. CONCLUSIONS OF LAW The starting point for the computation of the GCT is entire net income ("ENI"), which generally is taxable income for federal income tax purposes with certain modifications not relevant here. Code , The taxable income Petitioner reported for federal purposes was computed by deducting $454,000 transferred to Broadway as a management fee expense over three years: $179,000 in 1986, $150,000 in 1987, and $125,000 in These deductions were disallowed by Respondent and are at issue here. A taxpayer may, under IRC 162, deduct the ordinary and necessary expenses of conducting its trade or business. However, despite the representation on its tax returns that Petitioner was 16

18 paying a "management contract expense," Petitioner never claimed, and the facts do not indicate, that it paid Broadway for Broadway to provide it with management services. To the contrary, Petitioner made its employee, Josephina Howard, available to Broadway without reimbursement for her services, and transferred funds to Broadway, thus enabling Broadway to pay Broadway's bills and run its restaurant. It appears, therefore, that Petitioner transferred funds to Broadway so that Broadway could manage Broadway's own business. Indeed, initially, Broadway treated the proceeds from Petitioner as a loan, and Mr. Cosmas did not deduct the entire remaining portion of the purported loss in 1987 after Las Delicias closed, because, as he put it, "we had maybe a little hope they would pay maybe $100,000 back." Finding of Fact Thus, on the facts presented, the $454,000 Transfer is not deductible as management expenses as was reported on Petitioner's returns. Petitioner does not dispute this conclusion apparently recognizing that a taxpayer may not deduct the expenses of the 5 trade or business of another taxpayer. Instead, Petitioner supports the deductions by claiming that it was engaged in a joint venture with Broadway with respect to the Las Delicias Project. Petitioner asserts that the $454,000 is deductible as an expense to promote that joint venture and/or as a loss on that joint venture. The thrust of Petitioner's argument appears to be that since it transferred the money to Broadway and never got any of the money 4 If the $454,000 had been lent by Petitioner to Broadway, it is not at all clear that such amount would be deductible as a bad debt. To be deductible under IRC 166 a debt must be worthless. Broadway is still in business and there is no indication in the record that the debt is worthless. In any event, since Petitioner concedes that the $454,000 Transfer is not deductible under IRC 166, this question is moot. 5 Dietrick v. Commissioner, 881 F.2d 336 (6th Cir., 1989). 17

19 back, it should be entitled to a deduction. Representative stated it: As Petitioner's The manner in which the loss was taken from an accounting position may in hindsight not have been perfect and the bookkeeping could possible have been better but these failings do not change the ultimate and irrefutable conclusion that this was a legitimate business loss entitled to be deducted. While I am sympathetic to Petitioner's position, the law is well settled that deductions are a matter of legislative grace and that "a taxpayer seeking a deduction must be able to point to an applicable statute and show that he comes within its terms." Grace v. N.Y.S. Tax Commission, 37 N.Y.2d 193, 197 (1975), quoting New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934). Accordingly, Petitioner must establish that it falls within a provision that allow the deductions it claims. A member of a joint venture may deduct its distributive share of the losses or deductions of a joint venture in accordance with 6 the provisions of Subchapter K of the IRC. A member of a joint venture may also deduct the loss on the disposition of its interest 7 in the venture or on the termination of the venture. However, in order for these deductions to be allowed, the joint venture must be a partnership as that term is understood under the tax law. Under the Internal Revenue Code, a partnership includes "a syndicate, group, pool, joint venture or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on,..." IRC 761(a). A partnership exists where: 6 7 IRC 704. IRC 165, 731, 741, 752(b). 18

20 considering all the facts -- the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent -- the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise. Commissioner v. Culbertson, 337 U.S. 733, 742 (1949). Whether a partnership existed depends in the first instance on the intent of the parties. Here, the intent of the parties is difficult to discern. Each of Petitioner's witnesses: its president, its secretary, and its accountant, each of whom is a shareholder of both Petitioner and Broadway, testified that the Las Delicias Project was a "joint venture" between Petitioner and Broadway. However, the actions of the parties are inconsistent with this characterization. No partnership formalities were complied with. No separate books were maintained for the Las Delicias Project. No taxpayer identification number was obtained for the Las Delicias Project as required by IRC Neither did it file federal partnership returns as required by IRC 6031(a). The Las Delicias Project did not file City UBT returns as required by Code nor did it pay UBT for the Tax Years. Instead, for all purposes, Las Delicias operated under the corporate umbrella of Broadway and the income and expenses of the Las Delicias Project apparently were included on Broadway's federal and City corporate income tax returns. Accordingly, the record reveals no clear intention to form a joint venture. Next, in determining whether a partnership exists, the nature of the agreement between the parties and their conduct in execution of that agreement must be considered. Here, the provisions of the purported partnership agreement are not at all clear. There is neither a signed partnership agreement in the record, nor testimony 19

21 that the Purported Agreement was ever executed. The record contains no Minutes of the Annual Shareholders Meetings of September 9, 1986 of either Petitioner or Broadway. While there is testimony that a "joint venture" between Petitioner and Broadway was discussed and approved at those meetings, there is nothing in the record that would indicate the precise nature of the relationship that the shareholders of both corporations apparently approved. The Minutes of Petitioner's Board of Directors Meeting of September 10, 1986 do not refer at all to a joint venture with Broadway. Those Minutes simply address the Credit Line and the related bank account to be set up. It cannot be determined from these Minutes whether, for example, Petitioner intended to lend the funds to Broadway, rather than entering into a joint venture. While Petitioner contends that the Purported Agreement was indeed the agreement of the parties, it is highly unlikely that the parties ever intended to follow its terms. According to the Purported Agreement, Petitioner agreed to advance Broadway only $350,000 to cover Broadway's old liabilities. However, according to the evidence, Broadway needed more money than that. According to the Pharasles Memo, Broadway needed $250,000 to make the initial payment it was required to make under the settlement of its litigation. Mr. Cosmas testified that funds were also needed by Broadway to pay rent arrears. In addition, Mr. Pharasles testified that before unexpected cost overruns, he anticipated spending $150,000 to $200,000 to convert the restaurant. Finding of Fact 33. It is difficult to understand how Petitioner and Broadway expected $350,000 to cover the immediate litigation settlement costs, the back rent, and the costs of converting the restaurant, when the amount of such expenses were expected to exceed $400,000 assuming all went well. It is not surprising that Petitioner wound up advancing an additional $100,

22 Mr. Hickey testified that Broadway's contribution to the Las Delicias Project was its leasehold, plant and equipment. Finding of Fact 29. However, after Las Delicias closed, Broadway continued to use the favorable leasehold, plant and equipment that it purported to have contributed to the joint venture in its new restaurant. Finding of Fact 40. According to Mr. Cosmas, Petitioner had no interest in the profits, if any, from any new venture of Broadway's once Las Delicias closed. Yet, Petitioner has provided no explanation why it did not claim a continuing interest in the assets of the "joint venture" or of Broadway. Thus, neither the parties' intentions, nor their conduct under the Purported Agreement demonstrates the existence of a joint venture. Accordingly, I find that no partnership, within the meaning of the federal income tax law was created. Furthermore, even if the Las Delicias Project were a partnership, Petitioner still would not be entitled to the losses it claimed. First, under the partnership provisions of the Internal Revenue Code, income and expenses from the operation of the partnership are computed at the partnership level and flow 8 through to the partner's income tax returns. In order to determine whether a partner is entitled to a deduction for the operating expenses of a partnership, it is therefore necessary to know what the income and expenses of the partnership itself are for each relevant year. Because the revenues and expenditures related to Las Delicias are, in Mr. Cosmas's words, "blended in" with Broadway's other financial information, and no breakdown was provided, it is impossible to determine from the record before me what expenses would properly flow through to Petitioner under IRC 704 and be deductible on Petitioner's income tax returns had a partnership been created. 8 IRC

23 Second, a partner is permitted to deduct what loss it may have in its partnership interest when it ceases being a partner. amount of that loss depends, among other things, upon the amount of that partner's investment in the partnership and the partnership's losses that flowed through to the departing partner. Whether that loss is ordinary or capital depends on certain highly technical 10 rules. Here, because of the lack of records for the purported partnership, it would also be impossible to determine the amount or character of any loss to which Petitioner might be entitled. 9 The There is certainly some support in the record for Respondent's contention that the transaction was, in substance, a contribution to the capital of Broadway to bail out Broadway's shareholders, many of whom were also shareholders of Petitioner. While additional shares in Broadway were not issued directly in exchange for the $454,000 Transfer, Respondent points to the disparities in purchase prices of the Broadway shares during the 1988 recapitalization and asserts that certain of Petitioner's shareholders effectively received more equity than their capital contributions warranted. See, Finding of Fact 41. Although there are certain flaws in Respondent's assertion, they do not alter the results in this case. Petitioner, who can best provide the facts, bears the burden of proof in this proceeding and has not established that Respondent's characterization is incorrect, let alone that its classification is correct. ACCORDINGLY, IT IS CONCLUDED THAT the Commissioner properly disallowed a deduction for the payments Petitioner made to Broadway that were designated on its tax returns as "management contract expenses." 9 10 See, footnote 7, supra. See, e.g., Rev. Rul , C.B

24 The Notice of Determination dated March 5, 1993 is sustained in full and the Petition filed on August 21, 1995 is denied. DATED: November 16, 1998 New York, New York MARLENE F. SCHWARTZ Administrative Law Judge 23