Lael Kovtun et al., Petitioners, v. Commissioner of Internal Revenue, Respondent, 448 F.2d 1268 (9th Cir. 1971)

The sixteen petitioning taxpayers in this case were all limited partners in S.C. Investments, Ltd., which was in turn a limited partner in Lake Murray Apartments. The other partner in Lake Murray was Sunset International Petroleum Corporation. On August 12, 1963, Lake Murray entered into a contract with Sunset under the terms of which Sunset was to construct residential buildings for a price of over $3,000,000. Sunset agreed to provide or procure financing for Lake Murray in meeting its obligations and Lake Murray agreed to pay Sunset a loan fee of $63,000 and prepaid interest in the sum of $221,812.50. S.C. agreed to (and did) lend Lake Murray $300,000, which sum was deposited in Sunset's project bank account on December 20 and 26, 1963. Later, after an Internal Revenue audit of Lake Murray began, Sunset made a journal entry transferring $284,812.50 to a prepaid interest account. Sunset never did begin construction of the residential buildings and never did provide or procure the financing for Lake Murray. Sunset's financial position deteriorated until by 1967 it was equitably insolvent.

On its partnership return for the year 1963, Lake Murray claimed an interest deduction of $284,813 paid to Sunset. The Commissioner disallowed the claimed interest deduction and, accordingly, determined deficiencies in the income taxes of petitioners for that year. The Commissioner's ruling was affirmed by the Tax Court. This review followed.

The Tax Court held that the payment made to Sunset could not be regarded as prepaid interest, since no indebtedness from Lake Murray to Sunset ever came into being. For the reasons set forth in its decision, reported at 54 T.C. 331 (1970), we agree.

Affirmed.