Carol W. Hilton v. Commissioner of Internal Revenue

In 1964 Broadway-Hale Stores, Inc. (Broadway) entered into a sale-leaseback agreement with Fourth Cavendish Properties, Inc. (Fourth) to build a department store (the property) in Bakersfield, California. In January 1967, construction of the property was completed. On December 20, 1967, Fourth sold the notes to the lenders, turned the proceeds over to Broadway, and transferred the property back to Broadway under a net lease for a 30-year term, with the option to extend. Rent was calculated based on the amount needed to satisfy principal and interest payments when due. The rent went from Broadway to Fourth’s lenders and would be reduced once financing was paid off. In December 1967, when the agreement was effectuated, Fourth transferred 51 percent of its interest to Medway Associates (Medway), inclusive of partner Roderick Cushman, and 49 percent to Fourteenth Property Associates (14th PA), inclusive of partner Jack R. Young & Associates (JRYA). Cushman and JRYA performed substantial services in the creation of the leaseback agreement. After the transfer to Medway, there was an acquisition of interests in Medway by tier partnerships, including Thirty-Seventh Property Associates (37th PA). Possession of the property was never transferred to Fourth or their partnerships. Members of the 14th PA and 37th PA (collectively, the members) (plaintiffs) claimed deductions for partnership losses resulting from interest and depreciation over rental income and payments they made to JRYA and Cushman. The commissioner of the Internal Revenue Service (IRS) (defendant) did not allow these deductions. The members filed suit against the IRS. The IRS provided an expert, C. Everett Steichen, who determined that there was no economic foundation for the investments of the limited partners in 14th PA and 37th PA. The members’ expert, Robert J. Lichter, determined that the transaction was economic and reasonable.