Lael Kovtun v. Commissioner of Internal Revenue

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…