Berger v. Commissioner
Opinion
*303 Decision will be entered under Rule 155.
MEMORANDUM FINDINGS OF FACT AND OPINION
SCOTT,
Arnold Berger and Judith Berger
| Additional | Additions | ||
| Interest | to Tax | ||
| Year | Deficiency | Sec. 6621 | Sec. 6661 |
| 1980 | $ 21,321.20 | -- | -- |
| 1981 | 207,188.16 | -- | -- |
| 1982 | 259,171.45 | -- | $ 64,792.86 |
| 1983 | 21,481.00 | 1 | 5,370.00 |
| 1986 | 33,004.00 | 8,251.00 | |
| 1987 | 44,813.00 | 11,203.00 |
Irving Berger
| Additional | Additions | ||
| Interest | to Tax | ||
| Year | Deficiency | Sec. 6621 | Sec. 6661 |
| 1980 | $ 25,566.80 | -- | -- |
| 1981 | 230,601.44 | -- | -- |
| 1982 | 324,541.24 | -- | $ 81,135.31 |
Robert Kramer and Janet Kramer
| Additional | Additions | ||
| Interest | to Tax | ||
| Year | Deficiency | Sec. 6621 | Sec. 6661 |
| 1980 | $ 17,448.60 | -- | -- |
| 1981 | 237,371.80 | -- | -- |
| 1982 | 268,473.50 | -- | $ 67,118.38 |
| 1983 | 19,695.00 | 1 | -- |
| 1986 | 35,346.00 |
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*303 Decision will be entered under Rule 155.
MEMORANDUM FINDINGS OF FACT AND OPINION
SCOTT,
Arnold Berger and Judith Berger
| Additional | Additions | ||
| Interest | to Tax | ||
| Year | Deficiency | Sec. 6621 | Sec. 6661 |
| 1980 | $ 21,321.20 | -- | -- |
| 1981 | 207,188.16 | -- | -- |
| 1982 | 259,171.45 | -- | $ 64,792.86 |
| 1983 | 21,481.00 | 1 | 5,370.00 |
| 1986 | 33,004.00 | 8,251.00 | |
| 1987 | 44,813.00 | 11,203.00 |
Irving Berger
| Additional | Additions | ||
| Interest | to Tax | ||
| Year | Deficiency | Sec. 6621 | Sec. 6661 |
| 1980 | $ 25,566.80 | -- | -- |
| 1981 | 230,601.44 | -- | -- |
| 1982 | 324,541.24 | -- | $ 81,135.31 |
Robert Kramer and Janet Kramer
| Additional | Additions | ||
| Interest | to Tax | ||
| Year | Deficiency | Sec. 6621 | Sec. 6661 |
| 1980 | $ 17,448.60 | -- | -- |
| 1981 | 237,371.80 | -- | -- |
| 1982 | 268,473.50 | -- | $ 67,118.38 |
| 1983 | 19,695.00 | 1 | -- |
| 1986 | 35,346.00 | 9,336.00 | |
| 1987 | 3,971.00 | 1,915.00 |
*304 Jack Berger and Rose Berger
| Additional | Additions | ||
| Interest | to Tax | ||
| Year | Deficiency | Sec. 6621 | Sec. 6661 |
| 1981 | $ 266,292.40 | -- | -- |
| 1982 | 348,969.00 | -- | $ 87,242.25 |
Irving Berger and Estate of Rose Berger
| Additional | Additions | ||
| Interest | to Tax | ||
| Year | Deficiency | Sec. 6621 | Sec. 6661 |
| 1986 | $ 68,581 | 1 | $ 17,226 |
Rose Berger, Individually, and as Surviving Spouse of Jack Berger, and Arnold Berger, as Personal Representative of the Estate of Jack Berger, Deceased
| Additional | Additions | ||
| Interest | to Tax | ||
| Year | Deficiency | Sec. 6621 | Sec. 6661 |
| 1986 | $ 44,409 | 1 | $ 11,102 |
| 1987 | 2,105 | -- |
Respondent in her notices of final S corporation administrative adjustment sent to Echo Glen Villas, Inc., determined adjustments to the income of Echo Glen Villas, Inc., a subchapter S corporation, in the amounts and for the years as follows:
Echo Glen Villas, Inc., Jack Berger, A Person Other Than The Tax Matters Person
| Year | Total Adjustments |
| 1983 | $ 1,586,476 |
| 1984 | 1,393,730 |
| 1985 | 1,493,626 |
*305 All section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.
The issues for decision are: (1) Whether the notices of final S corporation administrative adjustment issued to Echo Glen Villas, Inc. (Echo Glen), were invalid for the years 1983 and 1984 because Echo Glen, a subchapter S corporation, had only four stockholders. Respondent in the settled issues conceded that the statute of limitations barred the sending of a notice of final S corporation administrative adjustment to Echo Glen for the year 1985 on the date the notice was sent; (2) whether petitioners were at risk within the meaning of
*306 FINDINGS OF FACT
Some of the facts have been stipulated, and these stipulated facts, including the exhibits attached to the stipulation, are found accordingly.
At all times pertinent to these consolidated cases all the individual petitioners were residents of Florida. Petitioners Arnold Berger and Judith Berger, husband and wife, filed a joint Federal income tax return with the Internal Revenue Service Center in Atlanta, Georgia, for each of the years 1980, 1981, 1982, 1983, 1986, and 1987. Petitioners Robert Kramer and Janet Kramer, husband and wife, filed their joint Federal income tax returns for the years 1980, 1981, 1982, 1983, 1986, and 1987 with the Internal Revenue Service Center in Atlanta, Georgia. Petitioners Irving Berger and Rose Berger, husband and wife, filed their joint Federal income tax returns with the Internal Revenue Service Center in Atlanta, Georgia, for the years 1980, 1981, 1982, and 1986. Petitioners Jack Berger and Rose Berger, husband and wife, filed their joint Federal income tax returns with the Internal Revenue Service Center in Atlanta, Georgia, for the years 1981, 1982, 1986, and 1987.
Echo Glen is a subchapter S Florida corporation incorporated*307 on July 30, 1981. From the date of its incorporation throughout all the period here involved it had its principal place of business in Dade or Broward County, Florida. Echo Glen maintained its books and records and filed its Forms 1120S income tax returns on an accrual method of accounting at all times here pertinent. It filed its Forms 1120S Federal income tax returns for the years 1983, 1984, and 1985 with the Internal Revenue Service Center in Atlanta, Georgia. At all times here pertinent Jack Berger, who died on July 4, 1992, Irving Berger, Robert Kramer, and Arnold Berger were the shareholders and the only shareholders of Echo Glen.
On or about September 30, 1982, Echo Glen purchased certain computer equipment from St. Joseph Equity Corp. The transaction whereby Echo Glen purchased this equipment was substantially similar to numerous other transactions entered into between St. Joseph Equity Corp. and various investors through that corporation in computer equipment. St. Joseph Equity Corp. and St. Joseph Leasing Corp. were subsidiaries of St. Joseph Lease Capital Corp., which was a holding company 51 percent of the stock of which was owned until sometime in 1984 by the *308 holding company of St. Joseph Bank & Trust Co. and 49 percent of the stock of which was owned until 1984 by Mr. Michael Jennings. In 1984, the shares of St. Joseph Lease Capital Corp. owned by the holding company of St. Joseph Bank & Trust Co. were redeemed, and thereafter Michael Jennings was the sole owner of St. Joseph Lease Capital Corp.
Transactions involving the purchase and lease of computers entered into by St. Joseph Equity Corp. (Equity) were in general arranged in the following manner. St. Joseph Leasing Corp. (Leasing) would locate and arrange to acquire computer equipment for lease to end-users. After the lessee had been identified and the purchase of the equipment arranged, Leasing would borrow, through St. Joseph Bank & Trust Co. (St. Joseph Bank) as agent, an amount to pay for the computer equipment after an agreed amount of downpayment had been made. At the time the computer equipment was bought the lease to the end-user had been arranged. A cash downpayment was made on the computer equipment, and the balance of the sales price was borrowed from various banks through St. Joseph Bank as agent. The loan for purchase of the equipment would be evidenced by a promissory*309 note that was nonrecourse as to Leasing, except that the lease which Leasing had negotiated with the end-user and the equipment would be assigned to St. Joseph Bank as agent as security for the promissory note. These notes contained a provision that the payments on the note were to be made from the rental receipts from the leases.
After Leasing had the lease in place and had arranged for the money to be borrowed, it would sell both the equipment and the lease to Equity for a stated cash downpayment, which was in excess of the cash downpayment made by Leasing, with the balance to be paid by the seller borrowing the amount upon receipt from the buyer of a reassignment to Leasing of the equipment and the lease thereon. Equity would then locate purchasers (investors) for certain specific computer equipment which was already on lease and sell the equipment to such investors, subject to the prior leases and liens thereon, and would then lease back the equipment from the purchaser for a stated monthly rental. The price for the equipment would be paid by the investor with a cash downpayment or either a partial cash downpayment and a recourse promissory note for the balance of the downpayment*310 and a nonrecourse installment note for the remaining purchase price secured by the equipment and the lease on the equipment. In most instances, after approximately 1 year an amendment would be made to the nonrecourse installment note to state that a portion of the installment note had become recourse. This would be done in an effort to meet the at-risk provisions of
There would be certain minor differences in the various transactions that Leasing and Equity arranged, but in substance they all followed the same pattern. The particular transactions here involved were with respect to certain computer equipment leased to Southern Pacific Transportation Co. (Southern Pacific) and Southern Bell Telephone & Telegraph Co. (Southern Bell) as end-users.
The transactions here involved were arranged as purchases from Equity by Echo Glen, a subchapter S corporation, of computer equipment leased to Southern Pacific and Southern Bell for a total price of $ 12 million. The Southern Pacific and Southern Bell transactions have separate agreements, but were evidenced by identical*311 agreements. Of the $ 12 million purchase price, $ 2 million was paid in cash or recourse promissory notes of Echo Glen for which, as required by Equity, substitution promissory notes of each of the four stockholders of Echo Glen totaling the amount of the recourse note of Echo Glen were accepted by Equity as substitutes for Echo Glen notes. The Echo Glen recourse promissory notes were returned to Echo Glen, and the substitute notes of the shareholders were assigned by Equity to certain banks as collateral for loans to proceed with other transactions. These substitute recourse promissory notes were paid in full by petitioners. The balances of the purchase prices were paid with nonrecourse installment notes of Echo Glen totaling $ 10 million. These notes were payable only from the rental receipts from the leases on the equipment and secured by those leases and the equipment.
When Echo Glen was incorporated, its shareholders intended for it to acquire certain land for development. However, this project fell through, and prior to the entry into the transactions here involved Echo Glen had no business operations. The total capital contributed by the stockholders at its incorporation*312 was $ 500, and no further cash contributions were made by the shareholders. The balance sheet of Echo Glen contained in its Federal income tax return for 1982, Form 1120S, showed total assets at the beginning of the year of $ 500, a shareholder's equity of $ 500, and a yearend value of assets of $ 10,244,726, consisting of $ 10,200,000 of computer equipment, which was determined by showing as the cost of the equipment $ 12 million, less depreciation of $ 1,800,000, resulting in the $ 10,200,000 value for the asset. The only other asset shown was $ 43,692 as an amount "due from affiliates". The balance sheet in its 1983 Federal income tax return showed assets at the beginning of the year the same as of the end of 1982, and for the end of the year showed assets of $ 7,560,000 for computer equipment, an amount of $ 4,440,000 of accumulated depreciation having been subtracted from the $ 12 million cost, and other assets of $ 344,793 composed of $ 317,293 as "due from affiliates" and $ 27,500 loans receivable. Capital stock was shown as $ 500 at both the beginning and end of the year 1983.
On its 1984 return the beginning assets were shown to be the same as the closing assets on the*313 1983 return, and the assets at the end of the year 1984 were shown as computer equipment of $ 5,040,000 and other assets of $ 35,810, which consisted of "due from affiliates" $ 8,310 and loans receivable of $ 27,500.
On its tax return for 1985 the balance sheet of Echo Glen showed the beginning assets the same as the assets at the end of 1984, and the assets at the end of 1985 were shown as $ 2,520,000 for computer equipment and other assets of $ 32,909, consisting of "due from affiliates" $ 5,409 and loans receivable of $ 27,500. Capital stock again was shown as $ 500.
Mr. Michael Jennings was the president of both Leasing and Equity. The computer equipment ultimately sold to Echo Glen was purchased by Leasing. A part of it was leased by Leasing to Southern Pacific Transportation Co. of San Francisco, California (Southern Pacific), by a master lease entered into on May 30, 1980, and the balance was leased to Southern Bell Telephone & Telegraph Co. of Atlanta, Georgia (Southern Bell), under a master lease entered into on March 3, 1981. Both of these master leases had attached to them various schedules of equipment that was actually to be supplied to the lessees on various dates. *314 The documents in addition to the schedules of equipment had attached thereto various special provisions such as cancellation options and renewal options. Most of these documents as well as numerous documents entered into for the remaining transactions are stipulated exhibits in the record, and their provisions will only be recited in our findings to the extent necessary to decide the issues in these consolidated cases since they have been found as facts in finding the stipulation together with the exhibits as facts in the case. The Southern Pacific lease was master lease No. 100713-1 of Leasing, and the Southern Bell lease was lease No. 100727-1 of Leasing. As either Southern Bell or Southern Pacific needed equipment from the schedule attached to the master lease to be delivered and installed, Leasing in accordance with arrangements previously made would purchase the equipment and would make a downpayment on the equipment and give to St. Joseph Bank, as agent for specific banks which were the actual lenders, a promissory note for the remainder of the price. Each of these notes contained a provision that Anything herein to the contrary notwithstanding, this Note is a non-recourse*315 obligation of the Company [Leasing] and liability of the Company to make payments of principal and interest on this Note is limited solely to payments out of the rents under the aforesaid Master Lease Agreement, Security Agreement, and the proceeds of the Equipment held as security thereunder, and no holder of this Note shall have recourse to the Company or to any assets of the Company in the event that such rents, collateral and proceeds shall not be sufficient to fully discharge the liability of the Company hereunder. Payee agrees that, notwithstanding anything to the contrary contained herein: (a) the Company's obligations contained herein and in the Agency Agreement between the Company and the Payee (hereinafter collectively referred to as the "Obligations") shall be satisfied solely out of the rentals and other sums payable under the Master Lease Agreement or any other lease of the Equipment, or any other use or sale of such collateral, and (b) the Payee shall have no right to satisfy any of the Company's Obligations out of any other property of the Company, provided that nothing shall prevent the Payee from exercising the Payee's right with respect to such collateral in the*316 event of nonpayment of the Obligations.
The purchase agreements between Equity as seller and Echo Glen as buyer for the equipment that Leasing had on lease to Southern Bell and that it had on lease to Southern Pacific were each dated September 30, 1982, and each bill of sale of the equipment was also dated September 30, 1982. Each of these purchase agreements had provisions with respect to the re-leasing or sale of the equipment by or on behalf of Echo Glen at the conclusion of the lease.
The two installment notes of Echo Glen dated September 30, 1982, totaling $ 10 million each contained among others the following provision: Seller agrees, for itself and its successors and assigns and any holder hereof, that notwithstanding anything to the contrary contained herein (a) the Buyer's Obligations shall be satisfied solely out of the rentals and other sums payable under any lease of the Equipment securing this Installment Note, or any other use or sale of the Collateral, and (b) the Seller shall have no right to satisfy any of the Buyer's Obligations out of any other property*317 of the Buyer, provided that nothing shall prevent the Seller from exercising its rights with respect to the Collateral in the event of nonpayment of the Obligations.
On the same date as the sales agreements, the promissory notes, and the installment notes were signed, Equity and Echo Glen entered into a lease agreement whereby Equity leased from Echo Glen the equipment on lease to Southern Bell and Southern Pacific. Echo Glen also signed under date of September 30, 1982, an agreement as to the sale being subject to leases, liens, encumbrances, and assignments previously made with respect to the equipment. Also a security agreement with respect to the equipment was signed by Echo Glen securing Equity. The leases with Equity as lessee and Echo Glen as lessor contained numerous provisions, among which was the following: Lessor and Lessee mutually agree for themselves, their successors and assigns, heirs, executors and administrators, that: (a) Lessee's obligations for the payment of rent or other sums under the Lease shall be satisfied solely out of the rentals and other sums payable under the present or subsequent subleasing of the Equipment; and (b) none of the Lessee's*318 obligations under the Lease shall be satisfied out of other property of the Lessee. representing the present value, utilizing a fifteen percent (15%) discount rate, of all remaining rentals and other sums due during the Original Term of the Master Lease which sum will be borrowed by the Seller, and will accordingly be deemed to be paid by the Buyer, upon receipt from the Buyer of: (i) A re-assignment to the Seller of the Master Lease; and (ii) an assignment of a senior security interest in the Equipment during the Original Term*319 of such Master Lease in order to guarantee the performance under said Master Lease by the Lessee thereunder.
During the course of negotiations between Mr. Jennings and representatives of Echo Glen, primarily Mr. Arnold Berger and Mr. Kramer and their accountant representatives, Mr. Jennings sent a document which he entitled Equipment Leasing Investment Projected Profit and Loss Statement to Echo Glen and its representatives. This statement showed the end-users as Southern Bell and Southern Pacific, the owners as Echo Glen, and the equipment as electronic data processing equipment, with a purchase price of $ 12 million, a nonrecourse installment note of $ 10 million, and equity investment of $ 2 million. It showed the rental income, which was the amount which was the stated rental to be paid by Equity in the lease from Echo Glen to Equity, interest expense, depreciation, pretax income or loss, tax savings, cash-flow, and after-tax cash flow with respect to the transactions. Various notes explained *320 the projection. Note 1 showed total rentals payable by Equity to Echo Glen of $ 185,086.83 per month for 96 months in advance commencing January 1, 1983. The explanation of the interest expense was that it was based upon a $ 10 million loan repayable in 96 equal installments of $ 178,420.16 in advance with interest at 15 percent. There were explanations of the depreciation item and other items shown in the projection. The last item under footnotes, which was note 10, stated: The at-risk rules limit a taxpayer's loss to the amount that the taxpayer has at risk and could actually lose from an activity. These rules apply to individuals, tax-option corporations and personal holding companies. Accordingly, in order to prevent the at-risk limits from applying to the losses shown, up to $ 6,750,901 of the non-recourse installment note must be converted to full recourse status in years 1983 through 1986. This full recourse portion will then fully amortize by 1990.
At the time this projection was sent by Mr. Jennings to representatives of Echo Glen, it had been Mr. Jennings' practice each year around December 15, certainly before December 31, to draw up an agreement by an investor*321 to be at recourse on the installment note to a predetermined amount, which in Mr. Jennings' opinion was sufficient to allow the investor to take full advantage of the loss deductions generated by the transaction for that year. However, by the end of 1982 the number of investors Mr. Jennings had in various computer leasing agreements had increased to such a point that it was administratively not feasible for Equity to prepare and send out to all of the investors a yearly agreement with respect to an amount of the installment note to become recourse. Therefore, starting in 1982 and continuing in 1983 Mr. Jennings drafted and sent out to investors agreements which in his opinion would cover the entire period that the individual needed to have a recourse liability on the note in order to obtain full benefit of the tax deductions. Mr. Jennings, as a representative of Equity, did not require that the amendment to the note to make a portion thereof recourse be signed and, in fact, when he had sent out yearly amendments to put a certain amount at recourse on a yearly basis, some years certain individuals had not signed the recourse amendments since for some reason in their judgment they*322 did not need the recourse liability to obtain their tax deductions. However, in Mr. Jennings' opinion the investment in the equipment sale and lease-back was a good investment only with the tax deferral aspect of the investment, and therefore he advised each investor to be sure that he had sufficient recourse amount to get the full tax deduction. In 1983 Mr. Jennings drafted an amendment to the nonrecourse installment notes of investors intended to cover the entire period during which the notes were being paid. Mr. Jennings in 1983 sent to Echo Glen an amendment to each of the installment notes, one in the Southern Bell purchase and the other in the Southern Pacific purchase, that covered all years until the installment notes were paid in full. Each of these documents was entitled "Amendment to Installment Note and Security Agreement dated as of September 30, 1982, by and between Echo Glen and Equity." The amendment in each case recited that the amendment is entered into by and between Echo Glen and Equity, referred to respectively as buyer and seller. It provided that buyer and seller agree to amend the above-referenced installment note and security agreement as follows: *323 1. The Buyer and Seller hereby agree to amend the above referenced Installment Note and Security Agreement such that the definition of the Buyer's Obligations, as such is used solely in the paragraph contained on page four of the Installment Note and Security Agreement which commences with the following phrase: "Seller agrees, for itself and its successors and assigns . . .", shall no longer mean: "all liabilities of the Buyer to the Seller arising under the Installment Note and Security Agreement", but shall instead mean: "all liabilities of the Buyer to the Seller which are in excess of the following amounts on and continuing after the specified dates: * * * " *324 2. In consideration of the Buyer entering into this Amendment and agreeing to be fully liable on a recourse basis for the Buyer's Recourse Obligation under the above referenced Installment Note and Security Agreement, the Seller and its Assignee: (i) reconfirm for the benefit of the Buyer, as regards that portion of the Buyer's Obligations which are in excess of the Buyer's Recourse Obligation, that: (a) such excess Obligations shall be satisfied solely out of the rentals and other sums payable under any lease of the Equipment securing this Installment Note, or any other use or sale of the Collateral; and (b) the Seller shall have no right to satisfy any of the Buyer's excess Obligations under the Installment Note or Security Agreement out of any other property of the Buyer, provided that nothing shall prevent the Seller from exercising its rights with respect to the Collateral in the event of nonpayment of such excess Obligations; and (ii) agree that if either: (a) the corporate bond rating of the lessee to whom the Seller is leasing the Equipment as published by Moody's Investors Service, Inc. falls below such lessee's rating as of the Commencement Date of the Original Term*325 of the Lease; or (b) the net worth of the lessee to whom the Seller is leasing the Equipment falls below such lessee's net worth as set forth in the most recent audited financial statement available as of the Commencement Date of the Original Term of the Lease, the Buyer may rescind this Amendment, in whole or in part, by tendering written notice to the Seller by registered mail, return receipt requested.
*326 The amendment is stated to be executed on December 15, 1983, on behalf of Equity and Echo Glen.
The actual method by which the accounting records were handled in connection with the transactions here involved was that Southern Bell and Southern Pacific each sent their monthly rent checks to St. Joseph Bank. The monthly rent checks were in excess of the monthly payments due on the notes of Leasing purchasing the equipment and, therefore, the rental amounts were credited in payment in full of the monthly payments due by Leasing on the purchase money notes for the equipment and the balance was sent to Equity. 3 Equity did not send any actual monthly checks or otherwise transfer money monthly to Echo Glen in payment of the rent recited as due Echo Glen under the two leases in connection with the Southern Bell and Southern Pacific transactions, nor did Echo Glen actually send a check or otherwise transfer money to Equity for the monthly payments on the notes. The accounting arrangement was that Equity would show as an indebtedness on its books to Echo Glen the $ 185,086.83 monthly rental amount and would offset that amount by the $ 178,420.16 due by Echo Glen to Equity on the installment*327 notes. The net difference of $ 6,666, which amounted to $ 40,000 every 6 months, was accumulated, and every 6 months Equity would send a remittance advice to Echo Glen with its check for the $ 40,000 excess of rental over the amount due on the installment notes. The excess rentals received by Equity from St. Joseph Bank because of the excess rental payments of Southern Pacific and Southern Bell over the amount due on Leasing's installment notes were more than the amount needed by Equity to make the $ 40,000 payments every 6 months to Echo Glen.
In late 1983 Mr. Arnold Berger and Mr. Kramer were told by their accountants that there should be some arrangement whereby the four stockholders of Echo Glen showed a greater investment or equity or basis in Echo Glen. He informed them that this was necessary in order to be entitled to tax deductions*328 from Echo Glen's computer transactions. The accountants suggested that each of the four stockholders sign a substitute promissory note comparable to the ones that they had been required to sign in connection with the recourse promissory note for the downpayment on the equipment and that they should each receive back from Echo Glen its note in the same amount thereby showing loans to Echo Glen. Someone from Echo Glen, either Mr. Berger or the accounting representatives of Echo Glen, requested Mr. Jennings to draw up notes for the stockholders for this purpose similar to those used as substitute promissory notes for Echo Glen's recourse promissory notes. At the bottom of the substitute notes signed by each stockholder under date of December 15, 1983, underneath the signature appears the following: This Promissory Note and Security Agreement is in substitution for $ 375,000 of the $ 10,000,000 Installment Notes and Security Agreements of Echo Glen Villas, Inc., executed on September 30, 1982. Accordingly, Echo Glen Villas, Inc. is hereby released from $ 375,000 of liability under the above referenced Installment Notes and Security Agreements.
When Mr. Jennings discussed by telephone with the accounting representatives of Echo Glen and with Mr. Arnold Berger and Mr. Kramer the signing on behalf of Echo Glen of the amendments to the installment notes which he was sending to them, he explained that this was to be in lieu of the yearly amendments of the installment notes so that the investors could be at risk with respect to a portion of the installment notes to enable them to get a tax deduction under the at-risk provisions of the Code without having to sign yearly amendments. They did not have a discussion of the meaning of the word "rescind". The only explanation Mr. Jennings could recall giving to either Mr. Arnold Berger, Mr. Kramer, or the accounting representatives of Echo Glen was that it would save having to sign yearly amendments to the installment notes. Neither Mr. Arnold Berger nor Mr. Kramer ever checked to see whether there had been any change in the bond rating of either Southern Bell or Southern Pacific or if their net worth had fallen below what it was at the end of December 1982. Both Mr. Arnold Berger and Mr. Kramer understood*331 Mr. Jennings to tell them, and they thought, that the provisions of the amendments would permit Echo Glen to cancel the amendments on a yearly basis, since they understood Mr. Jennings to say that the amendments were a substitution for the yearly amendments which investors in computer equipment through Equity had signed in years prior to 1983.
On January 10, 1985, Echo Glen Villas, Inc., Arnold Berger, Robert B. Kramer, Irving Berger, and Jack W. Berger, as plaintiffs, filed a suit against St. Joseph Equity Corp. and St. Joseph Bank & Trust Co. in the Marion County Superior Court of the State of Indiana in which they alleged that the plaintiffs and the defendant had entered into transactions for the sale and lease-back of certain electronic data processing equipment which involved purchase agreements, installment notes, security agreements, promissory notes and security agreements, and lease agreements, and that Arnold Berger, Robert B. Kramer, Irving Berger and Jack W. Berger executed promissory notes and security agreements in connection with this transaction. They alleged that plaintiffs were induced to enter into the agreement by specific statements, representations, and*332 assurances made by defendant's agents to plaintiffs that plaintiffs' performance pursuant to the terms under said transaction would safely allow declaration of substantial deductions for federal tax purposes which would result in substantial tax savings and benefits to the plaintiffs. Defendant made these representations intending that plaintiffs rely upon same and enter into the aforesaid agreement. Because of the falsity of the defendant's statements and the actual and potential harm occasioned thereby to the plaintiffs, the plaintiffs have refused to make any further payments to the defendant and now seek rescission*333 and cancellation of said agreement and reimbursement of plaintiffs' losses and compensation for their damages sustained to date.
The individual petitioners on their Federal income tax returns for the years 1982 through 1987 took various amounts of deductions with respect to losses of Echo Glen or investment interest*334 expense of Echo Glen. Respondent, among other adjustments which have now been disposed of by agreement of the parties, disallowed these deductions in 1982, 1986, and 1987 to each of the individual petitioners. For the years 1983 through 1985 respondent increased the income of Echo Glen by the entire amount of loss claimed in connection with the computer leasing activities and disallowed the claimed investment interest expenses shown by Echo Glen on its returns. As previously stated, respondent has conceded that the notice of final S corporation administrative adjustment for 1985 was not sent to Echo Glen within the period of limitations provided for sending such a notice.
OPINION
The first issue for decision is whether we have jurisdiction with respect to the case of Echo Glen for the years 1983 and 1984. Petitioners argue that the notices of final S corporation administrative adjustment issued to Echo Glen for the years 1983 and 1984 were invalid because Echo Glen had only four shareholders and therefore was not subject to the unified audit and litigation procedures contained in sections 6241-6245 in effect during the years 1983 and 1984. Petitioners primarily rely on On January 30, 1987, * * * the Secretary of the Treasury promulgated a temporary regulation defining S corporation for purposes of the unified litigation procedures. See The regulation unequivocally limits the exception for small S corporations "to any taxable year of an S corporation the due date of the return for which * * * is on or after January 30, 1987." * * * Consequently, all S corporations whose returns were due before January 30, *336 1987, are deemed to be S corporations subject to the requirements of the SSRA.
Both
Petitioners in their brief actually recognize that since an appeal in these cases would be to the Court of Appeals for the Eleventh Circuit, we are bound by the Court of Appeals' holding in
The second issue for decision is whether petitioners were at risk within the meaning of
Petitioners argue that they were at risk with respect to the cash downpayment made for the equipment and the recourse promissory notes to the extent of $ 2 million and were also at risk on the installment notes with respect to a sufficient amount to entitle them to the deductions claimed. In our view, the application of the at-risk issue to the $ 2 million of downpayment in cash and the recourse promissory notes is different from the at-risk issue with respect to any amounts represented by the $ 10 million installment notes. We will therefore discuss the items separately.
Echo Glen and its stockholders were at risk with respect not only to the cash downpayment made to Equity, but also with respect to the recourse*339 notes given for the remaining part of the $ 2 million under the facts we have found. Respondent's primary argument against the recourse liability with respect to the $ 2 million is a different interpretation of some of the facts in this record from the facts we have found. Respondent argues that the record is not sufficient to show that the cash downpayment was made or that the substitute notes given by the four stockholders for Echo Glen's promissory note were in fact paid. The record is unfortunately not unequivocally clear in this respect. There are some checks in the record, but not all of those checks are in payment of either the cash amount or the amounts on the stockholders' substitute notes. However, Mr. Jennings testified that the entire $ 2 million was paid and timely paid, and Mr. Arnold Berger in effect testified to the same effect, though not as clearly, and Mr. Kramer also so testified. Based on the record, we have found that the entire $ 2 million was paid. Petitioners argue that since the notes were recourse, it is immaterial whether or not payment was made. Petitioners' position is correct absent some showing that there was not an intent to make payment or*340 that the amount was protected against loss within the meaning of
The record shows that Equity required the stockholders to substitute their recourse notes for the recourse notes of Echo Glen. The reason for this requirement is not specifically stated, but as we have set forth in our findings, Echo Glen's major if not only asset other than $ 500 paid in as capital stock if that asset remained, was the computer equipment. Therefore, obviously since the promissory notes were a part of the downpayment on the equipment and were recourse, Equity wanted notes from persons able to pay the amount. The substitute notes by the shareholders, which were accepted and required by Equity, were effectively a further investment by the shareholders in Echo Glen, and therefore these amounts plus the cash payment*341 by Echo Glen represent at-risk liability of Echo Glen and the shareholders.
Respondent makes some argument here, as she also does later with respect to the installment notes, that the shareholders did not have adequate basis in Echo Glen to be entitled to deductions for the full $ 2 million for which Echo Glen was at risk when the shareholders' substitute notes are considered part of the at-risk amount. However, neither at trial nor in her trial memorandum or at any point prior to brief did respondent specifically question whether the basis of petitioners-stockholders in Echo Glen was sufficient to allow them the pass-through losses and deductions from Echo Glen, if Echo Glen actually sustained losses or had deductions which were properly pass-through losses and deductions. We, therefore, will not consider this issue since it was not properly raised.
The application of the at-risk provisions to the installment notes is much more complicated. The initial installment notes signed by Echo Glen were nonrecourse notes. Neither party denies this fact. It is petitioners' position that the amendments to the installment notes executed on behalf of Echo Glen on December 15, 1983, put*342 the amounts set forth therein at risk. Respondent contends that the amendment was ineffective for a number of reasons. First, respondent states that there was no consideration for the amendments, and, therefore, they would be unenforceable. A second reason stated by respondent for the amendment being ineffective is that Echo Glen had no assets other than the computer equipment to be at risk and, therefore, there was no substance to the claim that Echo Glen was at risk. Respondent also argues that realistically under the facts here, there was no reasonable possibility that any attempt would be made to collect any portion of the installment notes other than from rental payments by the end-users of the equipment or from a sale of the equipment which facts amount to "other similar arrangements" under
Petitioners make no contention that the amendments to Echo Glen's installment notes totaling $ 10 million were entered into for any purpose other than to permit the obtaining of tax deductions with respect to the computer equipment transactions. It is their argument that all*344 the statute requires is that Echo Glen be at risk and that the reasons for entering the transactions are immaterial. While the reasons for entering the transactions are part of the overall aspects to be considered in connection with determining whether a taxpayer is at risk, we agree with petitioners that if the taxpayer is actually at risk and personally liable with respect to an amount, the reason why he became at risk and personally liable would not be controlling. However, in our view all facts and circumstances surrounding the transactions are to be considered to determine whether realistically and substantively the taxpayer is personally liable for the borrowed amount. In
the significant tax-oriented aspects of such transactions [equipment*346 leasing] require that the availability of the tax benefits be determined by the true underlying economic substance of the transactions and not by features of the transactions that are mere window dressing and that serve no economic purpose.
In these cases there was no consideration for the amendment to the $ 10 million installment notes by Echo Glen. The recited consideration was leaving the balance of the notes nonrecourse. However, the total amount of the notes was nonrecourse prior to the amendment. In these cases we have testimony of the president of Equity, which held the notes. He in effect testified that he did not require a signing of the amendments to the nonrecourse installment notes to make them partially recourse, and in fact when amendments were made on a yearly basis, some investors did not sign some of the yearly amendments. However, he stated that he thought an investor would be foolish not to sign to make a part of the notes recourse since the investment was not a very good investment except for the tax benefits. Therefore, not only is no consideration shown for signing of the amendments, but in fact it is shown to have been a voluntary act rather than a*347 requirement of the transactions. See
Petitioners argue that the four shareholders of Echo Glen were at risk because of the substitute notes they signed each year beginning December 15, 1983, with a statement at the bottom of each substitute note that it was in replacement of a portion of the $ 10 million installment note executed by Echo Glen on September 30, 1982. Petitioners, citing such cases as This case involves an obligation on which each partner, general and limited, is directly liable to the seller of the film. The nonrecourse form of the obligation was used to avoid joint and several liability among the partners, and the "guarantee" was simply the means by which each partner agreed with the seller to be personally liable for a specific portion of the debt.
The cases relied on by petitioners as recognizing "at risk" guarantors have involved a direct obligation of a limited partner (we have found no cases involving stockholders of an S corporation) to the seller on a recourse basis. Here, there is no such situation. The substitute notes of the stockholders here, which were drawn up on behalf of the stockholders at their request, were an attempt to create a loan from the stockholders to Echo Glen to establish a further basis in Echo Glen for the stockholders. There is no showing that these substitute notes created any recourse liability on the part of the stockholders to Equity or to Echo Glen.
It is clear that the only substantial asset that Echo *351 Glen had was the computer equipment it purchased which was being paid for by the installment notes. Therefore, if some form of default occurred, there would be nothing that Echo Glen had from which any creditor could collect once the computer equipment had been used to satisfy the initial note. Realistically Echo Glen had no "at-risk" liability on the installment notes.
Finally, here there was a setup whereby, realistically, the installment notes were paid by the rental payments made by Southern Pacific and Southern Bell, similar to the situation in
Mr. Jennings testified that if the end-user lessees, Southern Pacific or Southern Bell, quit making payments, there was no obligation on Equity to make any further payments to Echo Glen. Echo Glen's installment note payments were made by being credited against the rental payments stated in the leases of the equipment to Equity by Echo Glen to be rental payments for the equipment. However, since Equity was obligated to make such payments "solely out of the rentals" paid by Southern Pacific and Southern Bell, in substance the payments of Echo Glen's installment notes were from the rental payments by Southern Pacific and Southern Bell.
Mr. Jennings in his testimony at certain points stressed the fact that the transactions between Leasing*353 and St. Joseph Bank and Leasing and Equity were separate and apart from the transactions between Equity and Echo Glen. He stressed that Echo Glen owed Equity on the installment notes and Equity owed rent to Echo Glen in a transaction separate and apart from the transactions between Leasing and St. Joseph Bank and Leasing and Equity. However, when questioned about whether there would not always be the amount of the offset of rent against the installment notes so that the installment notes would continue in that way to be paid, he called attention to the provision in the lease to Equity by Echo Glen that if the payment of the rental amount from the end-users, Southern Bell and Southern Pacific, ceased, Equity would not be required to pay Echo Glen and, therefore, there would be no rent to offset the payments due on the installment notes. In fact, he stated that except for that provision Equity would by its rental payment agreement be insuring the end-user's obligations.
Although there are more agreements here than in
Mr. Jennings testified that while he might not attempt to enforce Echo Glen's installment notes if Southern Bell and Southern Pacific quit paying rent and the equipment could not be released and was sold for less than needed to satisfy the bank loans to Leasing, that the bank might "find out" about the Echo Glen notes, even though they were not assigned to the bank, as recourse notes, and attempt to enforce them. Mr. Jennings speculated that the banks might consider the installment notes of Echo Glen to Equity to be "proceeds of the equipment held as security" under Leasing's notes. The reference to "proceeds" of the equipment in Leasing's notes to the bank appears to us to refer to a re-leasing of the equipment or a sale of the equipment by Leasing to satisfy its notes to the bank. All transactions after Leasing's placing the leases and equipment as security for the bank loans were subject to prior liens and assignments of security interests in the equipment. If the banks had considered the notes of Echo Glen to Equity as "proceeds" of the sale of the equipment, they would have required that the notes be assigned to them. *355 Furthermore, Echo Glen would have the defense to the notes of lack of consideration. Finally, any attempt to enforce the notes against Echo Glen would be futile since its only substantial asset was its interest in the computer equipment. Here, although affected by numerous agreements including assignments and reassignments of the same equipment and leases, the substance of the transactions, as in
Under the holding in
Regardless of having made a determination which in our view disposes of the issues in these cases, we consider it appropriate to discuss the so-called amendments to the installment notes in light of *356 the statements in
Respondent *357 takes the position that there is no ambiguity in the provisions of the amendments to the notes with respect to the right of Echo Glen to "rescind" the contract. It is respondent's position that under the generally accepted definitions of "rescind" the word is unambiguous. Petitioners take the position that the word "rescind" is ambiguous and that if the word as such were not ambiguous, the reference to rescind "in whole or in part" would make the rescission paragraph of the amendments to the installment notes ambiguous, since if rescind means to make void ab initio, this could be done only in whole and not in part. Black's Law Dictionary 1306 (6th ed. 1990), under "rescind", refers to rescission of contract where the first sentence states: "To abrogate, annul, avoid, or cancel a contract; particularly, nullifying a contract by the act of a party." The word "cancel", which is used as one of the meanings of "rescind" as defined in Black's Law Dictionary, is defined in that dictionary as: To obliterate; to strike or cross out. To destroy the effect of an instrument by defacing, obliterating, expunging, or erasing it. To revoke or recall; to annul or destroy, make void or invalid, *358 or set aside. To rescind; abandon; repeal; surrender; waive; terminate. * * * [
Mr. Jennings, the president of Equity, testified with respect to his discussions with petitioners' accountants and with the officers and stockholders of Echo Glen. He stated that he discussed the original papers with petitioners' accountants and that we went through the fact that we had on lease equipment to different users, other than just Southern Bell and Southern Pacific at the time. And we discussed whether or not they would like*359 to make the installment note partially recourse at inception, or whether they wanted to do the subsequent-amendment approach.
Mr. Arnold Berger and Mr. Kramer both testified with respect to conversations with Mr. Jennings about the amendment to Echo Glen's note.
The testimony of Mr. Arnold Berger and Mr. Kramer with respect to their understanding of the amendment to Echo Glen's installment note is quite confusing. However, both did insist that they thought "rescind" meant Echo Glen could cancel the notes.
From the testimony of Mr. Jennings, Mr. Arnold Berger, and Mr. Kramer, it is apparent that there was no clear understanding among these parties as to exactly what the last paragraph in the amendment to the installment note, in which the word "rescind" is used, meant. It is clear from Mr. Jennings' testimony that he was of the impression that the amendments placed no recourse liability on the individual stockholders of Echo Glen, but only on Echo Glen. From the testimony of Mr. Arnold Berger and Mr. Kramer, it appears that they were confused between the recourse liability of Echo Glen *362 and recourse liability of the stockholders individually. It is difficult to understand this confusion since they were sophisticated businessmen and had transactions with a number of S corporations which they owned. Certainly Mr. Kramer understood that unless you guaranteed or assumed the personal liability of an S corporation, you were not personally liable, even if the S corporation were liable. Neither Mr. Arnold Berger nor Mr. Kramer testified that he knew whether the "substitute" notes were intended to substitute for nonrecourse or so-called recourse liabilities of Echo Glen's notes. There is substantial confusion in the record. It finally becomes clear from Mr. Kramer's testimony that he knew he was not personally legally obligated on the installment notes of Echo Glen to Equity whether recourse or nonrecourse. It is very difficult to determine what parties to a transaction considered a word in their agreement to mean when the record as a whole so clearly shows that none of the parties involved believed that, in fact, there would ever by any personal liability of the stockholders of Echo Glen with respect to the installment notes or that any attempt would ever be made to*363 enforce those notes. The record as a whole shows that the amendments to the installment notes were executed solely in an effort to obtain tax benefits without, in fact, creating any personal liability on any of the parties.
However, on the limited issue of the meaning of the word "rescind", we conclude that there was no discussion between the parties as to the meaning of this word, but there was discussion that if one of the events listed occurred, they would be able to cancel any balance on the recourse part of Echo Glen's installment note if, in fact, there was a recourse part. Mr. Arnold Berger and Mr. Kramer each testified that he did not check to see if any of the listed events had occurred. The record shows that Southern Bell's net worth decreased at the end of 1984 and Southern Pacific's bond rating fell in 1987.
Our conclusion is that under the facts in this case there was no realistic possibility that either Echo Glen or its stockholders would ever be personally liable with respect to the installment notes, and the payment of the installment notes was entirely dependent on the rental payments by Southern Pacific and Southern Bell. In this respect this case is not distinguishable*364 from
Each year as payments on the installment notes were made, Echo Glen became "at risk" for the principal amount paid, since such payments were in effect "cash" payments which increased its equity in the computer equipment. In 1983 and each year thereafter the yearly principal payment represented an at-risk amount for that year. This record contains facts from which the amount of payment of principal on the installment notes can be computed for 1983 and each subsequent year. These amounts*365 can be computed by the parties, and to the extent of these payments each year petitioners were "at risk" and therefore entitled to a deduction to that extent of the losses or other deductions with respect to the computer equipment transactions. It appears that for the year 1982, the entire $ 2 million downpayment recourse amount would not have been absorbed, and the unabsorbed amount of recourse liability would be carried into 1983 to add to the amount of the principal payment on the notes for that year to arrive at the "at-risk" amount. Since respondent admits that 1985 is barred by the period of limitations, the amount claimed in that year would, of course, be unchanged. In 1986 the amount petitioners would be entitled to deduct would be the amount of principal paid on Echo Glen's installment notes in 1986. Since 1986 apparently was the last year that the transactions as handled by petitioners showed a loss, in 1987, petitioners would be entitled to offset against any gain, any carryover from 1983, 1984, or 1986, needed to offset the income flow in 1987.
From the many cases involving computer leasing transactions that have been decided in this Court, it is apparent that transactions comparable to the ones involved in this case were used by many taxpayers during the years involved in this case. Some cases involving the sale and leaseback of computer equipment under circumstances somewhat like those present in the instant case have been recognized as supporting the deductions claimed, and the facts have been held to show that the taxpayer was at risk. Certainly a number of cases have analyzed and considered the complicated transactions involved in computer leases of the type here involved and concluded, as we have here, that the taxpayers were not entitled to the full deductions*368 claimed because of not being at risk with respect to the amount necessary to allow such deductions under
Footnotes
1. Cases of the following petitioners are consolidated herewith: Irving Berger, docket No. 19150-90; Robert and Janet Kramer, docket No. 19157-90; Jack and Rose Berger, docket No. 19269-90; Robert and Janet Kramer, docket No. 6164-91; Arnold and Judith Berger, docket No. 6165-91; Echo Glen Villas, Inc., Jack Berger, A Person Other Than the Tax Matters Person, docket No. 18516-91; Arnold and Judith Berger, docket No. 16893-92; Irving Berger and Estate of Rose Berger, Deceased, Irving Berger, Personal Representative, docket No. 16894-92; Rose Berger, Estate of Jack Berger, Deceased, Arnold Berger, Personal Representative, and Rose Berger, Surviving Spouse, docket No. 16895-92; Robert and Janet Kramer, docket No. 16896-92.↩
1. This amount cannot be determined at this time. ↩
1. This amount cannot be determined at this time. ↩
1. This amount cannot be determined at this time.↩
1. This amount cannot be determined at this time.↩
2. The amounts shown as at recourse in the installment notes after the specified dates were as follows:
↩ As to the Southern Pacific equipment: December 15, 1983 $ 1,541,000 December 15, 1984 3,058,000 December 15, 1985 4,417,000 December 15, 1986 5,594,000 December 15, 1987 4,492,000 December 15, 1988 3,223,000 December 15, 1989 1,761,000 December 15, 1990 74,000 As to the Southern Bell equipment: December 15, 1983 $ 339,000 December 15, 1984 672,000 December 15, 1985 970,000 December 15, 1986 1,228,000 December 15, 1987 986,000 December 15, 1988 708,000 December 15, 1989 387,000 December 15, 1990 17,000 3. Mr. Jennings' testimony was that the balance was sent to Equity. However, he did not state the specific agreement that provided for these amounts being received by Equity.↩
4. There is nothing in this record to show whether this suit is still pending, has been settled, or what other action, if any, has been taken in connection therewith.↩
1994 T.C. Memo. 298 (Berger v. Commissioner) — published by Counsel Stack Legal Research, free access to 12M+ legal documents.