54 T.C. 1621">*1622 The Commissioner determined deficiencies in the petitioners' Federal income tax for the taxable year 1965 in the following amounts:

The above consolidated cases present a common issue: Whether the petitioners are taxable on distributive shares of the 1965 ordinary income of two partnerships in which they held interests where a purported reallocation of all the 1965 income of those partnerships was made to another partner, one W. H. Appleton, to permit him to take advantage of a net operating loss deduction which would have expired at the end of 1965.

FINDINGS OF FACT

Some of the facts have been stipulated and are incorporated herein by this reference.

The petitioners in each of the three consolidated cases, Jean V. and Blanche Kresser, Gino and Augusta Granucci, and William A. and Elaine M. Lange, are husband and wife. Each couple filed its joint Federal1970 U.S. Tax Ct. LEXIS 79">*82 income tax return for the taxable year 1965 on the cash basis of accounting with the district director of internal revenue, San Francisco, Calif. At all times relevant, including the times the petitions herein were filed, the legal residence of each petitioner was in San Francisco, Calif.

William H. Appleton (Appleton), a resident of Cotati, Calif., was "interested" in certain tracts of unimproved land in the area of Sonoma County, Calif. He became the organizer, promoter, and dominant figure in a number of enterprises, at least some of which were concerned with the development and subdivision of unimproved land and sale of lots from such subdivisions. Two of such enterprises, conducted as partnerships, are involved herein, namely, Canon Manor and Westview Meadows No. 289 (Westview Meadows).

In order to provide capital for the acquisition and development of unimproved land of these enterprises, Appleton persuaded a number of people to invest various amounts of capital in either or both of the Canon Manor and Westview Meadows partnerships. Thus, in the case of Canon Manor, there were 21 partners; Appleton's interest was 22 1/2 percent, and the interests of the remaining partners1970 U.S. Tax Ct. LEXIS 79">*83 ranged from 1/3 percent to 17 1/2 percent. In the case of Westview Meadows, there were 33 partners; Appleton's interest was 17 percent, the interests of Alan Appleton and W. H. Appleton, Jr. (otherwise unidentified), were 4 percent and 2 percent, respectively, and the interests of the remaining 30 partners ranged from 1/2 percent to 17 percent.

During the calendar year 1965 and at all times relevant to the matters 54 T.C. 1621">*1623 at issue, the following petitioners had partnership interests in the partnerships as set forth below:

In addition to these three petitioners and Appleton there were eight other partners that had interests in both Canon Manor and Westview Meadows.

Canon Manor was formed on or about March 12, 1956, and Westview Meadows was formed at some undisclosed time prior to 1965. No written partnership agreement was executed for either Canon Manor or Westview Meadows. Appleton devoted a substantial amount of time to the operation of the partnerships during 1965 and the periods relevant1970 U.S. Tax Ct. LEXIS 79">*84 to the issues presented here. He supervised the overall operations of the partnerships including the sale of property. He also fixed the prices at which partnership property was to be sold.

All property sales were transacted through the Sonoma County Abstract Bureau, Santa Rosa, Calif., a title insurance company (sometimes hereinafter referred to as the Abstract Bureau) in which title to the unsold realty of the partnerships was vested pursuant to written "holding" agreements. The parties to the agreements were the Abstract Bureau and Appleton. Under the terms of the agreements the Abstract Bureau was directed to take instructions from Appleton or any other person designated in writing by him. In the absence of instructions by Appleton or a person designated by him in writing for a 60-day period, the Abstract Bureau was directed to take instructions from the persons listed in the holding agreements who were appointed by Appleton to a "Board of Governors," hereinafter described.

All payments in respect of sales of real property by the partnerships were made directly to the Abstract Bureau. All expenses of the partnerships were handled by the Abstract Bureau. As expenses become1970 U.S. Tax Ct. LEXIS 79">*85 due the Abstract was notified and a check was mailed directly to the payee.

There was a "Board of Governors," known at times as "The Board of Governors of the W. H. Appleton Developments" or "Board of Governors of W. H. Appleton Interests," and referred to sometimes herein as the board, which played some part in the affairs of the various Appleton enterprises including Canon Manor and Westview Meadows. It consisted of Appleton and some four or five other persons who held interests in Canon Manor, Westview Meadows, or other Appleton enterprises. Members of the board were selected by Appleton. 54 T.C. 1621">*1624 The board considered matters affecting the partnerships, and it voted on resolutions in respect of the affairs of all the partnerships even though all the members did not have interests in every partnership involved. Appleton was chairman of the board and he ordinarily introduced the matters to be considered by it. Under the procedures followed by the board, decisions were made by majority vote. However, the record does not disclose the source of the board's authority or of Appleton's authority in appointing members of the board, or whether the board had authority to take action1970 U.S. Tax Ct. LEXIS 79">*86 that would bind the partnerships or affect the rights of the partners without their consent. The board usually considered the business affairs of each partnership separately and when the board finished considering the affairs of one partnership it proceeded to consider the affairs of the other partnerships. Among the Appleton enterprises in addition to Canon Manor and Westview Meadows with which the board concerned itself were the following: "Johnnie's Drive-In," "Happy Acres," "Cypress," "Thorobred," and "Greenvue." The record does not disclose the precise nature of these additional enterprises. Appleton appointed petitioner Jean V. Kresser (Kresser) to the board in 1960 and Kresser was a member of the board during 1965 and at all other relevant times.

There were no regular meeting dates for the board and there was no regular or established practice of recording and distributing minutes of the board meetings. For some years, including 1965, Marjorie A. Avellar, an employee of the Abstract Bureau, served as secretary to the board.

Up to and including the year 1965 there were no general meetings of the partners of any of the partnerships engaged in the real estate ventures initiated1970 U.S. Tax Ct. LEXIS 79">*87 by Appleton, including Canon Manor and Westview Meadows.

Commencing in 1958, and continuing until the time of the trial here, Charles A. Mayer (Mayer), a certified public accountant, prepared the partnership tax returns for Canon Manor and Westview Meadows. Mayer was the accountant for Appleton and his wife since 1953.

In the taxable years 1956 through 1964 for Canon Manor and the taxable years 1963 and 1964 for Westview Meadows, ordinary income from the business operations of each partnership was generally allocated to the partners in accordance with their percentage partnership interests. Also during these years for each of the partnerships, cash withdrawals or distributions when made to partners were generally made in accordance with their respective partnership interests.

Appleton and his wife, Alice, had available for their calendar year 1965 an unused net operating loss carryover from the years 1959 and 54 T.C. 1621">*1625 1960 in the total amount of $ 419,001.53. Mayer, the Appletons' accountant, became aware that the Appletons' 1959 and 1960 unused net operating loss carryover would be lost on December 31, 1965, if not utilized in that year.

A meeting of the board of governors was1970 U.S. Tax Ct. LEXIS 79">*88 held on December 2, 1965, at which Appleton introduced Mayer to the members of the board. At the meeting, Mayer advised the Appletons and the board, some of whom were partners of Canon Manor and Westview Meadows, that if there was an agreed-upon modification of the partnership agreements, the Appletons could report all of the partnership income on their 1965 return without liability for income tax thereon (as a consequence of their net operating loss carryover) while the remaining partners would have none of the partnership income allocated to them, and would not be required to report any distributable income for the year 1965. The members of the board were given to understand that the partners would not be disadvantaged by allocating all of their 1965 partnership ordinary income to Appleton because the amounts to which they would otherwise have been entitled and which were to be assigned or allocated to Appleton would be restored to them in subsequent years. It thus became the understanding of the members of the board that in return for the allocation of all the ordinary income of Canon Manor and Westview Meadows to Appleton for 1965, the ordinary income of the partnerships in1970 U.S. Tax Ct. LEXIS 79">*89 years subsequent to 1965 would be allocated to all the partners except Appleton until such time as the amounts of partnership income allocated to Appleton had been restored to the other partners.

In accordance with Mayer's recommendation the board voted favorably on a motion to allocate to Appleton all of Canon Manor and Westview Meadows' ordinary income for 1965. The minutes of the December 2, 1965, meeting reported the action of the board with respect to the allocation of income. Several unidentified handwritten insertions appear on those minutes. The record does not establish who made such insertions, when they were made, or whether they were in fact part of the minutes. These additions are set forth in italics in the following quotation from the minutes:

MINUTES OF BOARD OF GOVERNOR'S OF W. H. APPLETON INTERESTS

held

December 2, 1965 writen [sic] December 17, 1965

The Fall meeting of the Board of Governor's of the W. H. Appleton Interests was called to order by Mr. W. H. Appleton on December 2, 1965, at 1:45 P.M., after a delicious luncheon, the meeting being held at the Olympic Club in San Francisco.

All members of the Board of Governors were present.

54 T.C. 1621">*1626 1970 U.S. Tax Ct. LEXIS 79">*90 A copy of the minutes of the last meeting was presented to each member of the Board and they were read and approved during the luncheon.

* * * *

Mr. Appleton then introduced Mr. Charles P. Mayer, Accountant, to discuss a tax question which would be settled at a later date.

A motion was made by Mr. Jean Kresser, and seconded by Mr. Bill Lange that all Governors agree to Mr. Mayer's recommendation, to give to W. H. Appleton income for 1965, subject to rescission by December 15, 1965. (No one phoned Marjorie Avellar before December 15, 1965, as agreed.) The recommendation was with regard to income tax on Westvue Meadows Tract 289, and Canon Manor, was passed unanimously. Mr. Appleton thanked all the Governors for their cooperation, for passing motion.

There being no further business to come before the Board, upon motion, the meeting was adjourned at 4:45 P.M.

Respectfully submitted,

(S) Marjorie A. Avellar,

Marjorie A. Avellar,

It was contemplated that the various partners would be sent notifications of the foregoing action of the board on December 2, 1965, allocating all of the 1965 income of Canon Manor and Westview Meadows to Appleton, 1970 U.S. Tax Ct. LEXIS 79">*91 so that the partners might indicate their approval or disapproval of such allocation by December 15, 1965. However, the record does not establish that such notifications were actually sent to all of the partners, and it affirmatively appears that at least one of the partners of Westview Meadows, Donald P. Donahue, who held a 1-percent interest therein, did not in fact receive any such notification. Donahue did not even become aware of the December 2, 1965, meeting until December of 1966, although he was informed by Mayer sometime in April 1966 that he did not have to report any income from Westview Meadows on his 1965 Federal income tax return, and he accordingly did not report any such income on his 1965 return.

The record does not establish whether any partners other than the members of the board consented to the allocation of all the partnership 1965 income of Westview Meadows and Canon Manor to Appleton prior to April 15, 1966, the time provided by law for the filing of the partnership 1965 returns.

In accordance with the decision reached at the December 2, 1965, meeting the ordinary income of Canon Manor for its calendar year in the amount of $ 190,957.23 and the ordinary income1970 U.S. Tax Ct. LEXIS 79">*92 of Westview Meadows for its calendar year 1965 in the amount of $ 65,353.97 were allocated solely to Appleton and these allocations were reflected on the partnership returns for 1965.

Appleton and his wife, Alice, reported all of the 1965 ordinary income of Canon Manor and Westview Meadows on their joint 1965 54 T.C. 1621">*1627 Federal income tax return. After taking into account any necessary adjustments and all reported income, the Appletons still showed a net loss of $ 48,376 on their 1965 Federal income tax return.

During the calendar year 1965, Canon Manor made cash distributions to or allowed withdrawals by all its partners in the total amount of $ 92,399.88, generally in accordance with their respective percentage partnership interests. These cash distributions or withdrawals were charged against the respective partner's capital account as reflected in each partner's capital account balance as of December 31, 1965. Accordingly, even though Appleton was allocated all of Canon Manor's ordinary income for 1965, $ 190,957.23, his withdrawals during that year amounted to only $ 18,900.

During the calendar year 1965, Westview Meadows made cash distributions to or allowed withdrawals by1970 U.S. Tax Ct. LEXIS 79">*93 all of its partners in the total amount of $ 26,400, generally in accordance with their respective partnership interests. Accordingly, even though Appleton was allocated all of Westview Meadows' ordinary income for 1965, $ 65,353.97, his withdrawals during that year amounted to only $ 6,480.

The sources of the funds for the foregoing cash withdrawals and the cash distributions to the respective partners of Canon Manor and Westview Meadows were the capital contributions of the respective partners or undistributed partnership income derived from operations of the partnership in years prior to the tax year 1965, reported on prior partnership tax returns, and which income had been included in the income tax returns of the respective partners for such prior years.

The petitioning partners of Canon Manor and Westview Meadows did not report any earned distributable income for either of those partnerships as taxable income for 1965 and also did not report their cash withdrawals as taxable income, but treated such withdrawals as a reduction of their respective partnership capital accounts.

Pursuant to the understanding of the board members at the December 2, 1965, meeting Appleton's shares1970 U.S. Tax Ct. LEXIS 79">*94 of Canon Manor and Westview Meadows partnership ordinary income in years subsequent to 1965 were yielded by him to restore to the other partners what would have been their shares of partnership income for 1965. Such restoration to the other partners was accomplished (1) by reducing if not eliminating Appleton's percentage interests in the distributable ordinary income of the partnership in subsequent years, and (2) by charging all net losses to Appleton in any subsequent year in which there was no net ordinary income. Thus, Appleton had no percentage interest in the ordinary income of Westview Meadows for its taxable year 1966 and was charged with all the net losses sustained in 1967 and 1968. 54 T.C. 1621">*1628 With regard to Canon Manor for its taxable years 1966 through 1968, Appleton's percentage interest in the ordinary net income was reduced from 22 I/2 percent in prior years to 1.29 percent.

In determining the deficiencies against the petitioners for 1965 the Commissioner included in their gross income their respective distributive shares of the ordinary income of Canon Manor and Westview Meadows in accordance with their percentage interests in the partnerships.

OPINION

The Commissioner1970 U.S. Tax Ct. LEXIS 79">*95 determined that the so-called allocation of all of the 1965 income of the Canon Manor and Westview Meadows partnerships to W. H. Appleton did not relieve the petitioner-partners of their obligation to account for their distributive shares of such income computed in accordance with their percentage interests in those enterprises. Petitioners, on the other hand, contend that the partnership agreements were modified as a result of the decision reached at the December 2, 1965, meeting of the "Board of Governors of the W. H. Appleton Developments," and that, as thus modified, their distributive share of income was zero for 1965. We hold that the Commissioner's determination must be sustained for either of at least two reasons.

1. Section 702(a), I.R.C. 1954, requires a partner to take into account his distributive share of partnership income in determining his personal income tax. Section 704(a) provides that a partner's distributive share of partnership income is determined, except as otherwise provided by section 704, by the partnership agreement. Section 761(c) ² states that the partnership agreement "includes any modifications of the partnership agreement" made in accordance with1970 U.S. Tax Ct. LEXIS 79">*96 specified conditions. Such modifications relate back to the beginning of the partnership year. See David A. Foxman, 41 T.C. 535">41 T.C. 535, 41 T.C. 535">554, affirmed 352 F.2d 466 (C.A. 3). The partnership agreement, as well as any modifications thereto may be oral or written. Income Tax Regs., sec. 1.761-1(c).

During the year in issue, and at all other relevant times, Canon Manor and Westview Meadows operated under oral agreements. Prior to 1965 the distributive shares of the ordinary income of Canon Manor and Westview Meadows were allocated 1970 U.S. Tax Ct. LEXIS 79">*97 to the partners in accordance with their percentage interests in the partnerships. Since the allocation 54 T.C. 1621">*1629 of all the partnerships' 1965 income to Appleton purported to change this arrangement, such allocation was in effect a modification of the partnership agreements and therefore was required to satisfy the conditions of section 761(c), namely, that the modification be agreed to "by all the partners" prior to or at the time prescribed by law for the filing of the partnership return, or that it be "adopted in such other manner as may be provided by the partnership agreement." The burden of proof is, of course, upon petitioners, and, in our judgment, petitioners have failed to prove that there was a modification that complied with either of these conditions.

(a) The record is particularly unsatisfactory in respect of the required agreement of all the partners to the reallocation of income to Appleton. To be sure, there is evidence that the partners were to be notified that the board had voted on such reallocation at its December 2, 1965, meeting, that the partners were to have the opportunity to indicate their disapproval thereof by December 15, 1965, and that the minutes1970 U.S. Tax Ct. LEXIS 79">*98 contained the following parenthetical statement: "(No one phoned Marjorie Avellar before December 15, 1965, as agreed.)" But we had no confidence whatever in the inferences that petitioners would have us draw from such evidence. The affairs of the partnerships appear to have been conducted in a very loose manner. The minutes were crudely written, Marjorie Avellar was not a witness before us (nor does it appear that any effort was made to take her deposition), and the testimony that we did hear left us with too many troubling doubts. We had no convincing evidence that all the partners were actually sent notifications of the board's action, and there was persuasive affirmative evidence that at least one of the partners, Donald P. Donahue, not only failed to receive any such notification but that he learned for the first time in December 1966 of the board's December 2, 1965, meeting. While it is true that Donahue was told by Mayer, Appleton's accountant, on some unspecified day in April 1966 that he would not be required to report any share of the partnership's 1965 income, the precise nature of what he was told, on what day he was told (whether before or after April 15), ³ and 1970 U.S. Tax Ct. LEXIS 79">*99 whether he in fact agreed to the reallocation of income to Appleton or merely proceeded upon the assumption that it was a fait accompli -- these are matters in respect of which the record is either murky or uninformative. Moreover, no solid evidence was presented in respect 54 T.C. 1621">*1630 of the necessary agreement by the other partners. Taking into account the fact that the burden was on the petitioners, we cannot find on this state of the record that the first condition of section 761(c) has been satisfied.

1970 U.S. Tax Ct. LEXIS 79">*100 (b) Nor can we find, as urged by petitioners, that the modifications of the partnership agreements were "adopted in such other manner as may be provided by the partnership [agreements]." In essence, it is the petitioners' contention that the modifications were adopted by the board of governors, and that the partnership agreements gave the board authority to make such modifications. Again, taking into account the fact that the burden of proof was upon the petitioners, we cannot make any such finding on this record.

The partnership agreements themselves were oral and the record is singularly uninformative as to the nature or content of those agreements. Appleton, who was probably better informed than anyone else as to the nature of the oral agreements, was not called as a witness, nor was there any other evidence of substance that established the extent of the authority of the board (in particular, whether it had authority to modify the distributive shares of partnership income), or whether such "authority" as it may have had stemmed from the partnership agreements rather than from Appleton himself, who appeared to dominate the affairs of these enterprises. The evidence before us1970 U.S. Tax Ct. LEXIS 79">*101 was loose and vague. Certainly, we cannot assume that the necessary clarifying evidence which petitioners did not present would have been in their favor; the burden was upon them and they must bear the consequences. Cf. Samuel Pollack, 47 T.C. 92">47 T.C. 92, 47 T.C. 92">108, affirmed 392 F.2d 409 (C.A. 5). On this state of the record we hold that petitioners have failed to establish that the alleged modifications were adopted in a manner "provided by the partnership [agreements]."

2. Wholly apart from the failure of petitioners to prove that there was compliance with the conditions of section 761(c), the record further fails to establish that there was in fact any bona fide modification of the partnership agreements which actually changed the distributive shares of the partners.

It is quite true, as petitioners contend, that partners may readjust their respective partnership shares of income and that, apart from the provisions of section 704(b)(2), ⁴1970 U.S. Tax Ct. LEXIS 79">*103 effect will be given to the partners' 54 T.C. 1621">*1631 agreement and their modifications thereof. ⁵ See David A. Foxman, 41 T.C. 535">41 T.C. 554. Moreover, while one of the purposes1970 U.S. Tax Ct. LEXIS 79">*102 of the statute was to provide flexibility to a certain extent (e.g., in respect of payments for goodwill) that would enable the partners to shift their tax burdens inter sese, cf. 41 T.C. 535">David A. Foxman, supra;Commissioner v. Jackson Investment Co., 346 F.2d 187 (C.A. 9), reversing 41 T.C. 675">41 T.C. 675, the modifications contemplated must at least be bona fide. Thus, although the partners are to be permitted to readjust their distributive shares inter sese, such readjustments must be real, and we are therefore faced with the threshold question on this issue as to whether there was any genuine readjustment of the partners' distributive shares. In our view of the record the evidence indicates the contrary and certainly does not establish that there was any such bona fide reallocation.

1970 U.S. Tax Ct. LEXIS 79">*104 As we appraise the evidence, the purported reallocation of income to Appleton did not in reality shift the 1965 income from the other partners to him. Under the arrangement it appears that at the very least the so-called allocation was made on the understanding that Appleton would restore to the other partners in later years the amounts allocated to him in 1965. Thus, to the extent that the partnerships had income in the years following 1965 Appleton yielded either all or the major portion of such income to the other partners, and to the extent that a net loss was sustained in any year Appleton absorbed it in its entirety. Presumably, this course of action was to continue until the entire amounts of the so-called allocations of 1965 income were restored to the other partners. The record does not disclose the full nature of Appleton's undertaking in this respect -- e.g., whether Appleton personally guaranteed that the amounts allocated to him would be restored to the other partners regardless of the success or failure of the enterprises. It would seem at least doubtful whether all of the other partners would have agreed to give up their 1965 income without any such undertaking1970 U.S. Tax Ct. LEXIS 79">*105 by Appleton. But here again, the vagueness of the record and the failure to present a clear picture of what in fact occurred leaves us with the definite impression that the 1965 transaction may have amounted to little more than something in the nature 54 T.C. 1621">*1632 of a loan to Appleton which was to be repaid in later years. Indeed, it may even have been something less than a loan, for the actual cash withdrawals by Appleton were far less than the amount of distributive income allocated to him. Thus, on this issue as well, the fact that petitioners did not produce Appleton as a witness at the trial to clarify the situation and thereby left much to conjecture is hardly a circumstance that can operate in their favor when it is kept in mind that the burden of proof was upon them. We cannot find that the so-called allocation of 1965 income to Appleton was in fact anything more than a paper transaction having no consequences of substance, and did not represent a true modification or readjustment of the partners' distributive shares of income. What was said by the Supreme Court in a somewhat different context is equally applicable here (Commissioner v. Court Holding Co., 324 U.S. 331">324 U.S. 331, 324 U.S. 331">334):

1970 U.S. Tax Ct. LEXIS 79">*106 To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress.

We hold that petitioners have failed to prove that there was a bona fide modification of the partnership agreements which in fact readjusted the distributive shares of partnership income.

Decisions will be entered for the respondent.