Levien v. Commissioner

103 T.C. No. 9, 103 T.C. 120, 1994 U.S. Tax Ct. LEXIS 55

• Court: United States Tax Court
• Decided: August 2, 1994
• Docket: Docket No. 9006-90
• Status: Published

Opinions

OPINION

Ruwe, Judge:

Respondent determined deficiencies, additions to tax, and additional interest against petitioners as follows:

Year Deficiency Additions to tax sec. 6659 Additional interest sec. 6621(c)

1983 $89,609 $26,883 120% of the interest due on $89,609

1984 68,210 20,463 120% of the interest due on $68,210

Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the taxable years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

Respondent has conceded the additions to tax, and the parties have stipulated the outcome of certain issues. Only two issues remain for us to decide. Those issues arise in connection with losses claimed by petitioners from an investment by petitioner husband (hereafter petitioner) in a computer leasing activity (sometimes, the activity). We must decide whether such losses are disallowed pursuant to section 465 and whether petitioners are liable for additional interest.

Background

The parties have submitted this case fully stipulated, pursuant to Rule 122(a). The stipulation of facts entered into by the parties and exhibits attached thereto are incorporated herein by this reference. Petitioners resided in Palm Beach, Florida, at the time they filed the petition herein. During the years in issue, petitioners, who were calendar year taxpayers, filed joint income tax returns. Following is a summary of certain relevant facts.

I. Petitioner’s Transactions

On December 20, 1983, petitioner entered into an agreement to purchase five units of interest in certain computer equipment for a total purchase price of $543,750.¹ The seller of those units was a Delaware corporation, Aardan Leasing Corp. (Aardan). Petitioner paid for his units by delivering to Aardan both cash and notes. Petitioner paid cash of $11,250. He also executed two short-term notes (the short-term notes) and one long-term note (the long-term note) in favor of Aardan. The short-term notes were each in the principal amount of $21,875, with one due in April 1984 and the other due in January 1985. Petitioner’s liability was not limited under either short-term note. The long-term note was in the principal amount of $488,750. Principal and interest on the long-term note were due and payable on December 31, 1998. Prepayment was mandatory, however, to the extent of certain proceeds received by petitioner in connection with his interest in the computer equipment (principally, rental payments received from a lease of the equipment). Petitioner’s personal liability under the long-term note was limited to $325,000. The five units of interest petitioner purchased in the computer equipment gave him an approximately one-fortieth interest (2.665560 percent) in the equipment. Subsequent to agreeing to purchase his interest in the computer equipment, petitioner entered into a lease of that interest, as described below. On their 1983 and 1984 Federal income tax returns, petitioners claimed losses of $83,333 and $161,727, respectively, on account of such transactions.

II. Preceding Sales

The computer equipment in which petitioner acquired an interest from Aardan was acquired by Aardan in two transactions. In the first, on December 31, 1983, Aardan acquired computer equipment from a partnership, Equilease Associates III Ltd. Partnership (Associates), a Connecticut limited partnership. The purchase price of that equipment (the Associates equipment) to Aardan was $1,013,548. Aardan paid $22,805 in cash and delivered its note, in the principal amount of $990,743, for the balance. That note called for an immediate payment of $68,414, applicable to the first 2 years’ interest, and mandatory prepayments, out of certain proceeds, with any balance of interest and principal due on December 31, 2003. The Associates equipment was acquired by Aardan subject to (1) certain liens created when Associates acquired that equipment, and (2) certain leases of the equipment to users thereof. On or before the day that Associates sold the Associates equipment to Aardan, Associates purchased that equipment from a corporation, Equilease Marketing Corp. At that time, the Associates equipment was under lease and sublease to Chemco Leasing GmbH and Hessischer Rundfunk, respectively (foreign business organizations).

The second transaction by which Aardan acquired the computer equipment in question also occurred on December 31, 1983. Aardan acquired computer equipment from Equilease Equipment Brokerage C.V. (C.V.) (also a foreign business organization). The purchase price of that equipment (the C.V. equipment) to Aardan was $17,744,237. Aardan paid $399,245 in cash and delivered its installment note in the principal amount of $17,344,992 for the balance. That note called for an immediate payment of $1,197,736, applicable to the first 2 years’ interest, mandatory prepayments, out of certain proceeds, with any balance of interest and principal due on December 31, 2003. As with the Associates equipment, the C.V. equipment was acquired by Aardan subject to (1) certain liens created when C.V. acquired that equipment, and (2) certain leases of the equipment to users thereof. On or before the day that C.V. sold the C.V. equipment to Aardan, C.V. purchased that equipment from various leasing companies in Europe. The C.V. equipment was already under lease when purchased by C.V.

III. Lease by Petitioner

On December 31, 1983, petitioner, along with the other owners of interests in the Associates and C.V. equipment (collectively, the tenants in common) retained an agent, Equitable Leasing Co., Inc. (Equitable), to act on their behalf in connection with certain contemplated leasing activities. On that same date, the tenants in common, through Equitable, leased both the Associates equipment and the C.V. equipment to Associates and C.V., respectively. The rental term in each case was from December 31, 1983, through June 30, 1991. The total rental due under the lease to C.V. was $25,457,997.54, with monthly payments of $94,303.18, from January 31, 1984, through December 31, 1985, and of $351,435.17, beginning January 31, 1986, and continuing for the next 65 months. The total rental due under the lease to Associates was $1,454,158.08, with monthly payments of $5,386.64 from January 31, 1984, through December 31, 1985, and of $20,073.92, beginning January 31, 1986, and continuing for the next 65 months.

IV. Related Agreements

On December 31, 1983, Aardan and petitioner, by petitioner’s agent, Equitable, entered into an agreement to secure petitioner’s obligations to pay its notes to Aardan. Petitioner accorded to Aardan security interests in (1) his fractional interests in the computer equipment purchased from Aardan, and (2) his rights under the agreements to lease that equipment to Associates and C.V. Aardan had the right to collect the rent due petitioner under those agreements. Associates’ and C.V.’s obligations to pay rent to the tenants in common (including petitioner) were secured by assignments of their rights to collect rent from their own lessees, respectively.

On December 31, 1983, petitioner, by petitioner’s agent, Equitable, and a corporation named Equilease Corp. (Equilease) entered into two separate agreements, one with respect to the lease to Associates and one with respect to the lease to C.V. Under those agreements, styled “Capitalization Agreement”, Equilease agreed “to make all necessary loans, advances or capital contributions to C.V. and Associates, respectively, to ensure the payment by C.V. and Associates” of rents to the tenants in common. Equilease’s obligations were contingent on Aardan’s continuing to make payments on its notes to Associates and C.V. for purchase of the Associates and C.V. equipment, respectively.

Equilease is stipulated to be an “affiliate” of both C.V. and Associates.²

V. Coincidence of Payments

Monthly payments received pursuant to the rental obligations of Associates and C.V. by the tenants in common (including petitioner) equal the monthly obligation of the tenants in common to pay Aardan for the computer equipment, which sum also equals the monthly obligations of Aardan to pay Associates and C.V. for such equipment. Similarly, petitioner’s percentage of the rental payments received from C.V. and Associates equals the prepayment that he was obliged to make to Aardan on the long-term note.

Discussion

At Risk

Section 465 limits losses allowable to an individual in connection with certain activities to the amount that the individual is “at risk” with regard to the activity at yearend. The activity here in question is one to which section 465 applies.³ Sec. 465(c)(1)(C). Respondent agrees that petitioner was at risk with regard to (1) the cash he contributed to the activity, and (2) payments he made on the short-term notes.⁴ Respondent contends, however, that, with respect to the long-term note, petitioner was not at risk because he was protected against loss within the meaning of section 465(b)(4).

Section 465(b)(4) provides:

(4) Exception. — Notwithstanding any other provision of this section, a taxpayer shall not be considered at risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.

In determining whether a taxpayer is protected against loss within the meaning of section 465(b)(4), we look to see whether there is any realistic possibility that the taxpayer ultimately will be subject to economic loss on the investment at issue. Thornock v. Commissioner, 94 T.C. 439, 453 (1990).

[T]he purpose of subsection 465(b)(4) is to suspend at risk treatment where a transaction is structured — by whatever method — to remove any realistic possibility that the taxpayer will suffer an economic loss if the transaction turns out to be unprofitable. A theoretical possibility that the taxpayer will suffer economic loss is insufficient to avoid the applicability of this subsection. We must be guided by economic reality. * * * [Waters v. Commissioner, 978 F.2d 1310, 1315 (2d Cir. 1992), affg. T.C. Memo. 1991-462 (quoting with approval American Principals Leasing Corp. v. United States, 904 F.2d 477, 483 (9th Cir. 1990)).]

The question presented is one of fact, and petitioners bear the burden of proof. Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933).⁵ With regard to leasing activities, we scrutinize the economic reality of the transaction, focusing in particular upon the relationships between the parties, whether the underlying debt is nonrecourse, the presence of offsetting payments and bookkeeping entries, the circularity of the transaction, and the presence of any payment guarantees or indemnities. See Waters v. Commissioner, 978 F.2d 1310, 1316-1317 (2d Cir. 1992), affg. T.C. Memo. 1991-462; Young v. Commissioner, 926 F.2d 1083, 1088 (11th Cir. 1991), affg. T.C. Memo. 1988-440; Moser v. Commissioner, 914 F.2d 1040, 1049-1050 (8th Cir. 1990), affg. T.C. Memo. 1989-142; American Principals Leasing Corp. v. United States, 904 F.2d 477, 483 (9th Cir. 1990); Thornock v. Commissioner, supra at 453. No single feature of the transaction generally will control. Thornock v. Commissioner, supra at 449.

We find no significant difference between the facts in this case and those in the cases cited above. For example, Young v. Commissioner, supra, involved similar sale/leaseback transactions, whereby the taxpayers purchased computer equipment from a middle entity that purchased the equipment from third parties to which the taxpayers leased the equipment. The rental payments in Young were equal to or in excess of the payments required under the taxpayers’ purchase agreements to the middle entity. Based on these factors, the Court of Appeals for the Eleventh Circuit held that the taxpayers were not at risk under section 465(b)(4).⁶ As stated by the Court of Appeals, “The chain of ‘payments’ could either continue as bookkeeping entries or cease, and there would be no actual circumstance upon which a demand for a payment would be made. See American Principals Leasing Corp. v. United States, 904 F.2d 477, 483 (9th Cir. 1990)”. Id. at 1088. Likewise, in Thornock v. Commissioner, supra at 451, this Court found that taxpayers involved in a similar computer leasing structure were not at risk due primarily to the existence of guarantees, the offsetting nature of lease and note payments, and the nonrecourse nature of the underlying debt.

In the instant case, all the important elements relied upon in the previously cited cases are present. All monthly obligations were exactly offset, including the rental obligations of C.V. and Associates to the tenants in common (including petitioner), petitioner’s obligations to Aardan, and Aardan’s obligations to C.V. and Associates. The payments simply self-extinguished via offsetting bookkeeping entries. The master leases (evidencing rental payments due from C.V. and Associates), the long-term notes (evidencing installment obligations to Aardan from the tenants in common), and the purchaser notes (evidencing Aardan’s obligations to C.V. and Associates) commenced on the same date and were to terminate on the same date. As in the previous cases, the transaction was circular, with a middle entity (Aardan) connecting the taxpayer and third-party lessees (C.V. and Associates). Thus, it was highly unlikely that any one of the parties would refuse to meet an obligation. As stated in American Principals Leasing Corp. v. United States, supra at 483, “if one party failed to ‘pay’, he could only expect a chain reaction resulting in his obligor’s ceasing ‘payment’ as well.” In addition, the rental payments of C.V. and Associates were guaranteed by an affiliate, Equilease.

Finally, as in both Young and Thornock, petitioners on brief concede that the underlying financing used by the original leasing companies, from whom C.V. and Associates purchased the computer equipment, was nonrecourse. See also Moser v. Commissioner, supra at 1050.

The relationships among the parties to the transaction, as evidenced by the master leases, the purchaser notes, and the long-term notes, show that great pains were taken to ensure that no economic loss would be sustained by the tenants in common as a result of their execution of the long-term note. In paragraph 18 of the master lease agreements, Associates and C.V. agreed to indemnify the tenants in common against any and all as losses incurred for, or by reason of the leasing of, the equipment.⁷ The tenants in common were explicitly provided with all the usual legal remedies in the event that one of the other parties defaulted on its obligations, including the ability to sue Aardan for breach of warranty and C.V. and Associates for nonpayment.

Petitioners request that we analyze the facts herein based on the “worst case scenario” test that was articulated by the court in Emershaw v. Commissioner, 949 F.2d 841 (6th Cir. 1991), affg. T.C. Memo. 1990-246. They contend that, based upon this test — as opposed to the “realistic possibility of economic loss” analysis upon which we base our decision— petitioner’s transaction did not constitute a loss-protection scheme or a prohibited “other similar arrangement”. We previously addressed a similar argument in Wag-A-Bag, Inc. v. Commissioner, T.C. Memo. 1992-581, in which we determined that “whichever standard is used, the ultimate decision rests upon the substance of the transaction in light of all the facts and circumstances.” ⁸ We continue to hold to the view — expressed in Wag-A-Bag — that, under section 465(b)(4), economic reality should be the touchstone of the analysis.⁹

Petitioners do not deny that the individual factors discussed above were present in petitioner’s leasing transactions. However, petitioners attempt to obscure what appears to be the economic reality of the transactions by arguing that each piece of the transactions, standing alone, did not protect the tenants in common against loss. Petitioners also attempt to distinguish the numerous cases with similar facts and unfavorable conclusions on the basis of factors present or not present in those other cases. We reject these arguments. We adhere to our position that it is the substance of the transaction, rather than the form, which is controlling and that substance is determined by looking at all the material facts. Thornock v. Commissioner, supra at 449. As stated above, we discern no material difference between the facts of this case and those in the numerous cases cited above.

In Porreca v. Commissioner, 86 T.C. 821, 838 (1986), we observed that while the legislative history of section 465 does not define what is meant by “other similar arrangements”, the phrase “[evidences] concern with situations in which taxpayers are effectively immunized from any realistic possibility of suffering an economic loss even though the underlying transaction was not profitable.” We find this an apt description of petitioner’s transactions. After consideration of all the elements described above, petitioners have failed to convince us that petitioner was not protected against loss within the meaning of section 465(b)(4).

Section 6621(c)

Respondent also seeks increased interest pursuant to section 6621(c). That section provides for an increase in the interest rate to 120 percent of the statutory rate on underpayments of tax if a substantial understatement is due to a tax-motivated transaction. Certain transactions are deemed to be “tax motivated” by section 6621(c)(3), including any loss disallowed under section 465(a). Sec. 6621(c)(3)(A)(ii). Since we have concluded that the loss deductions in issue stemming from petitioner’s long-term note to Aardan are disallowed under section 465(a), we also find that this was a tax-motivated transaction, and respondent is entitled to additional interest on the interest accruing on the portion of the underpayment attributable to such transaction after December 31, 1984.

Decision will be entered under Rule 155.

Reviewed by the Court.

Hamblen, Parker, Cohen, Swift, Gerber, Wright, Parr, Wells, Colvin, Beghe, Chiechi, and Laro, JJ., agree with this majority opinion.

1 Exhibit 11-K is entitled “Equipment Purchase Agreement”. Exhibit A to that agreement states the purchase price of the equipment to be $500,000, yet calls for cash and notes equaling a stated 108.75 percent of that amount, or $543,750. Exhibit 23-W is entitled “Security Agreement”. Sec. 1 thereof describes two short-term notes (described herein, infra, in the total amount of $43,750) that represent interest payments on a long-term note (also described infra). The parties have stipulated that petitioner paid $543,750 in cash and notes for the purchase of his interest in the computer equipment in question. We have found that petitioner agreed to pay $543,750 for that interest. We have based our finding on stipulation 20, notwithstanding the contradictory evidence in the stipulated exhibits.

2 On brief, petitioners state that C.V. is a shell subsidiary of Equilease and that Associates is an “affiliate” of Equilease.

3 The parties agree that petitioner’s computer sale and leaseback transaction had economic substance and that petitioner reasonably expected to make an economic profit from the transaction exclusive of tax benefits. In addition, the parties agree that petitioner shared the benefits and burdens of ownership of the computer equipment.

4 In their briefs, the parties have proposed various findings of fact. With regard to the short-term notes, there appears to be a conflict concerning the timing of petitioner’s becoming at risk with regard to those notes. Respondent asks that we find that petitioner’s amounts at risk include “payments made” on the short-term notes. We assume that respondent is asking us to find that petitioner became at risk with regard to the short-term notes only as, and to the extent that, he made payments on those notes. Petitioners simply request a finding that petitioner was at risk with regard to the short-term notes. We interpret petitioners’ request to be a request for a finding that petitioner became at risk with regard to the short-term notes at the time he executed those notes. Neither respondent’s notice of deficiency nor the pleadings address this timing issue. Respondent’s notice simply states that “gains or losses are limited to your [petitioner’s] amount at risk”, while the petition equally simply says that respondent has made an erroneous determination, and that petitioner’s amount at risk is not limited to his initial cash contribution. On brief, respondent sets forth as the only question presented with regard to the at-risk issue, whether the long-term note is part of petitioner’s at-risk amount. The stipulation of facts entered into by the parties leads us to believe that the short-term notes were paid in full, the first in 1984 and the second in 1985. We interpret respondent’s failure to state any question with regard to the timing issue concerning the two short-term notes as a concession of any issue raised by the seeming conflict in the proposed findings of fact. We have found the short-term notes to have been part of the purchase price petitioner agreed to pay for his interest in the computer equipment. We will treat petitioner as becoming at risk with regard to the two short-term notes as of the date he executed them, Dec. 20, 1983.

5 Petitioners’ burden of proof remains unchanged despite the fact that this case was fully stipulated. Rule 122(b); Borchers v. Commissioner, 95 T.C. 82 (1990), affd. on other issues 943 F.2d 22 (8th Cir. 1991).

6 Appeal in the instant case lies to the Court of Appeals for the Eleventh Circuit. See Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971).

7 Indeed, according to the promotional letter for the transaction, Equilease went so far as to agree to repurchase the equipment at the price paid by the tenants in common plus a reasonable interest factor if certain potential tax law changes retroactively rendered the transaction unprofitable.

8 But see Martuccio v. Commissioner, 30 F.3d 743 (6th Cir. 1994), revg. and remanding T.C. Memo. 1992-311.

9 While our opinion in Wag-A-Bag, Inc. v. Commissioner, T.C. Memo. 1992-581, downplays the differences between application of the “worst case scenario” and “realistic possibility of economic loss” tests, other courts have viewed the distinctions between the two as more fundamental and have rejected the application of the “worst case scenario” for purposes of sec. 465(b)(4). See Waters v. Commissioner, 978 F.2d 1310, 1315-1316 (2d Cir. 1992), affg. T.C. Memo. 1991-462; Young v. Commissioner, 926 F.2d 1083, 1089 n.14 (11th Cir. 1991), affg. T.C. Memo. 1988-440; Moser v. Commissioner, 914 F.2d 1040, 1049-1050 (8th Cir. 1990), affg. T.C. Memo. 1989-142; American Principals Leasing Corp. v. United States, 904 F.2d 477, 482 (9th Cir. 1990).