Decision will be entered under Rule 155.
MEMORANDUM FINDINGS OF FACT AND OPINION
WELLS, JUDGE: Respondent determined deficiencies in, and additions to, petitioners' Federal income taxes, as follows:
Increased | ||||||
Additions to Tax | Interest | |||||
Sec. | Sec. | Sec. | Sec. | Sec. | ||
Year | Deficiencies | 6653(a)(1) | 6653(a)(2) | 6659 | 6661 | 6621(c) |
1982 | $ 38,858.88 | $ 1,942.94 | 1 | $ 10,118.45 | 2 | 3 |
1983 | 26,826.77 | 1,341.34 | 8,048.03 | |||
1984 | 40,618.76 | 2,030.94 | 12,185.63 |
Respondent concedes that petitioners are not liable for additions to tax under
The issues we must decide in the instant 1999 Tax Ct. Memo LEXIS 405">*406 case are: (1) Whether Ronald Kimmich (petitioner) is "at risk" with respect to debt incurred as part of a computer leasing transaction that he entered into during 1982; and (2) whether petitioners are liable for increased interest on tax underpayments attributable to tax-motivated transactions under section 6621(c) for each of the tax years in issue.
FINDINGS OF FACT
The parties submitted the instant case fully stipulated. The parties' stipulation of facts is incorporated herein by reference and these stipulated facts are found as facts in the instant case. Petitioners resided in Gibsonia, Pennsylvania, when they filed their petition.
During the years in issue, Elmco Inc. (Elmco) was a Maryland corporation offering equipment leasing transactions to investors. Greyhound Capital Corp. (GCC), a New York corporation, was in the business of leasing and marketing computers and related equipment. On December 22, 1982, Elmco purchased computer equipment from GCC that it later sold to petitioner. A promissory note, dated December 22, 1982, required Elmco to first pay GCC $ 830 per month for 36 months, then $ 11,716.70 per month for 72 months. 2 All monthly payments accrued in arrears and were 1999 Tax Ct. Memo LEXIS 405">*407 paid quarterly on the first day of April, July, October, and January. Additionally, on December 31, 1982, Elmco was required to pay GCC $ 1,240.71, which payment constituted interest through December 31, 1982.
Also, on December 22, 1982, petitioner entered into a "Purchase Agreement" with Elmco to purchase the same computer equipment that Elmco purchased from GCC. 3 Petitioner agreed to pay $ 500,000 as follows: $ 18,500 cash; delivery of three "Equity Promissory Notes" totaling $ 82,700 bearing 12.5 percent per annum interest, and execution of a $ 398,800 long-term "Buyer Acquisition Note" bearing 14 percent per annum interest. 4 The three Equity Promissory Notes were negotiable and fully recourse. The Buyer Acquisition Note was payable as follows: $ 830.00 per month for the first 36 months, then $ 11,716.70 per month for 72 months. All monthly payments accrued in arrears and were paid quarterly on the first day of April, July, October, and January. The payment schedule mirrored exactly Elmco's payment schedule under its note to GCC. Petitioner also agreed to pay Elmco an additional $ 1,240.71 1999 Tax Ct. Memo LEXIS 405">*408 on December 31, 1982, which amount constituted interest up to that date.
The Purchase Agreement provided that petitioner would lease the computer equipment to GCC and enter a remarketing agreement with GCC as of the date of purchase. Pursuant to a December 22, 1982, "Security Agreement", petitioner granted Elmco a security interest in the computer equipment, the GCC lease, and the underlying end-user leases. The security interest, however, was subordinate to GCC's lease rights and the rights of the underlying end-user lessees. 51999 Tax Ct. Memo LEXIS 405">*409 Petitioner's purchase of the equipment was subject only to the underlying lessees' rights and Elmco's rights under the Security Agreement. Also, on December 22, 1982, Elmco, pursuant to the "Collateral Assignment", assigned its rights in petitioner's three Equity Promissory Notes and the Buyer Acquisition Note to GCC. 61999 Tax Ct. Memo LEXIS 405">*410
On December 22, 1982, pursuant to the Purchase Agreement, GCC and petitioner entered into the "Lease Agreement", whereby petitioner leased the computer equipment back to GCC with a term extending to December 31, 1991. The lease payments followed the payment schedule under petitioner's Buyer Acquisition Note. The Lease Agreement required GCC to make rental payments of $ 830 per month for the first 36 months, then $ 11,792.70 for the next 72 months. GCC also agreed to pay petitioner on December 31, 1982, an additional sum of $ 1,240.71, as a per diem rental through that date. After December 31, 1986, GCC was to pay petitioner supplemental rent equal to 85 percent of the "net rentals" until petitioner received $ 80,000. After that, GCC agreed to pay petitioner 55.25 percent of the "net rentals" through the end of the lease.
The Lease Agreement between GCC and petitioner contained a broad indemnity clause providing, in part:
Lessee hereby agrees to assume liability for, and does hereby
agree to indemnify, protect, save and keep harmless Lessor and
Lessor's successors and assigns from and against, any and all
claims, causes of action or liability (including 1999 Tax Ct. Memo LEXIS 405">*411 liability for
negligence or in strict tort), including legal fees, imposed on,
incurred by or asserted against Lessor or any of Lessor's
successors or assigns, in any way relating to or arising out of
ownership, possession, use or operation of the Equipment;
provided, however, that Lessee shall not be required to
indemnify Lessor or Lessor's successors and assigns for loss or
liability in respect of any unit of Equipment arising from acts
or events which occur after possession of such unit of Equipment
has been delivered to Lessor in accordance with Section 5, or
loss or liability resulting from the willful misconduct or
negligence of the party otherwise to be indemnified hereunder.
Lessee's obligations hereunder shall be those of primary obligor
irrespective of whether Lessor shall also be indemnified with
respect to the same matter under any other agreement by any
other person. Upon payment in full of any indemnities contained
herein by Lessee, Lessee shall be subrogated to any rights of
Lessor in respect of the matter against which indemnity has been
given.
The Lease Agreement was a net lease under which GCC's obligation to pay rent was unconditional 1999 Tax Ct. Memo LEXIS 405">*412 and not subject to set-off. As security for its obligations under the Lease Agreement, GCC granted petitioner a security interest in the underlying end-user leases. Additionally, the Lease Agreement provided that petitioner, upon GCC's default, had the right to direct the underlying lessees to make payment directly to petitioner. Finally, GCC could substitute equipment where, in GCC's opinion, a unit was uneconomical to lease, or where an end-user purchased the equipment for its fair market value or pursuant to a purchase option. 7
On December 22, 1982, GCC, Elmco, and petitioner entered into a "Depository Agreement." Pursuant to the Depository Agreement, First Interstate Bank of Arizona (First Interstate) agreed to receive, and transfer between accounts, the amounts that GCC, petitioner, and Elmco owed to each other. The Depository Agreement could not be modified, rescinded, or amplified except by a writing signed by petitioner, Elmco, and GCC. Pursuant to the Depository Agreement, payments went as follows: 1999 Tax Ct. Memo LEXIS 405">*413 (1) GCC made lease payments to First Interstate; (2) First Interstate credited petitioner's account for GCC's rental payments; (3) First Interstate then debited petitioner's account for payments to Elmco on petitioner's Buyer Acquisition Note; (4) First Interstate credited Elmco's account for petitioner's Buyer Acquisition Note payments; (5) First Interstate then debited Elmco's account for payments to GCC on its installment note; and (6) First Interstate credited GCC's account for Elmco's installment note payments. If First Interstate received any additional payments, it held those funds in petitioner's account until receipt of a written directive signed by all three parties.
On their 1982, 1983, and 1984 joint Federal income tax returns, petitioners claimed losses from petitioner's computer purchase and leaseback investment in the amounts of $ 75,000, $ 110,000, and $ 105,000 respectively. Respondent disallowed these deductions in the October 18, 1989, notice of deficiency.
OPINION
The first issue we must decide is whether petitioner is "at risk" with respect to the long-term Buyer Acquisition Note. As stated above, respondent stipulated that petitioner is at risk with respect to the 1999 Tax Ct. Memo LEXIS 405">*414 $ 18,500 cash payment and the three Equity Promissory Notes. Respondent argues, however, that, as to the long-term Buyer Acquisition Note, petitioner is not at risk because: (1) The Buyer Acquisition Note, though labeled recourse, is, in substance, nonrecourse and (2) even if the Buyer Acquisition Note is recourse, the transaction protects petitioner against loss under
Petitioners contend that we should analyze the facts of the instant case under the "worst case scenario" test articulated in
Nicholson 1999 Tax Ct. Memo LEXIS 405">*416 involved an appeal of this Court's refusal to award a taxpayer attorney's fees under section 7430. See
In its opinion, the Court of Appeals for the Third Circuit decided that the Commissioner's initial position, with respect to the propriety of the taxpayer's loss deductions, was not substantially justified. See
Although 1999 Tax Ct. Memo LEXIS 405">*417 this court has yet to address this issue, we agree with
the Commissioner that the reasonableness of her position should
be evaluated under the economic reality test as it has been
adopted by the overwhelming majority of the courts to address
the issue. Whether or not we would adopt it in a case in which
we were required to decide whether certain deductions were
proper, we believe that if the Commissioner satisfied the
economic reality test here, her position had a reasonable basis
in law. [See
Although the court considered the Commissioner's arguments under the economic reality standard, the court emphasized that "we do not purport to adopt the economic reality test as the law of this circuit."
Petitioners argue that the court's statement supports a "clear inference" that the Court of Appeals rejected the economic reality test in favor of the worst case scenario test. We believe that petitioners' contention is without merit. We read
Petitioners also argue:
In Nicholson Jr., the court placed 1999 Tax Ct. Memo LEXIS 405">*418 the burden on petitioner,
adopted arguendo the economic reality test, and required a
showing of abuse of discretion. Notwithstanding the fact that
the court drew every inference favorable to respondent, it
imposed an extraordinary sanction on the respondent and required
respondent to pay the taxpayer's fees.
Petitioner asserts that respondent's defeat on the attorney's fees issue in Nicholson means "certain defeat" for respondent in the instant case. Respondent, however, contends that petitioners fail to account, sufficiently, for the significant factual distinctions between Nicholson and the instant case. We agree with respondent.
In Nicholson, Equipment Leasing Exchange, Inc. (ELEX) purchased computer equipment from a third party and financed it through an unrelated bank. ELEX then leased the equipment to a local school. As a condition of its nonrecourse loans, ELEX granted the bank a security interest in both the equipment and the lease. Later in the year, ELEX sold the equipment and assigned the lease to the taxpayer. In exchange, the taxpayer executed two short-term notes and one long-term note. All three notes were secured by the equipment and the lease, subject to the 1999 Tax Ct. Memo LEXIS 405">*419 security interest of the bank. In addition, the monthly rent payments from the school were nearly the same as the monthly payments due on the taxpayer's long-term note to
In the instant case, there is no bank or other third party lien on the equipment. Accordingly, no third party has a stake in the transaction. Moreover, unlike Nicholson, where the initial purchase, financing, leasing, and resale of the equipment occurred through separate and distinct transactions, all components of the instant transaction were structured and set in motion simultaneously on December 22, 1982. On the other hand, the instant case involves a binding circular payment arrangement providing for offsetting payments and bookkeeping entries; i.e. the Depository Agreement. This is unlike Nicholson, where there was no payment arrangement of any kind. Moreover, Nicholson does not contain the same degree of circularity as does the instant case. In Nicholson, the school was obligated to pay the taxpayer, who was obligated to pay ELEX which, in turn, had an obligation to pay the bank. Each of the obligations in Nicholson was separate and independent of the others. There, 1999 Tax Ct. Memo LEXIS 405">*420 the court found it significant that ELEX prepaid its loans to the bank, a fact that had led the Commissioner to settle on such favorable terms. See
In short, we see no reason not to continue to adhere to our position that the economic reality of a transaction controls. See
We have previously addressed a similar argument [that the worst-
case scenario should apply] in Wag-A-Bag, Inc. v. Commissioner,
standard is used, the ultimate decision rests upon the substance
of the transaction in light of all the facts and circumstances.'
We continue to hold to the view -- expressed in Wag-A-Bag --
that, under
touchstone of the analysis. [
We 1999 Tax Ct. Memo LEXIS 405">*421 scrutinize the economic reality of leasing activities by 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
In the instant case, evidence of a sufficient number of the foregoing elements is present to lead us to conclude that petitioner is not at risk. All of the long-term monthly obligations of the parties to the transaction are nearly exactly offset by payments from another party to the transaction. 9 The GCC Lease, the Buyer Acquisition Note, and Elmco's purchase note all commence on the same date and all terminate on the same date. It is highly unlikely, due to the circular nature of the transaction, that any one of the parties to the transaction would refuse to meet its obligations. As stated in
Of course, the parties to the transaction in the instant case have no intention of fulfilling their payment obligations with a circular stream of physical transfers. Rather, the Depository Agreement provides a convenient, book-entry mechanism to facilitate the circular, offsetting payment scheme. Except for the end-user lessees, the transaction between GCC, petitioner, and Elmco is entirely closed. 101999 Tax Ct. Memo LEXIS 405">*423 The Depository Agreement binds all of the parties to the transaction and cannot be modified, rescinded, or amplified except by a signed writing by petitioner, Elmco and GCC. Consequently, none of parties to the transaction can unilaterally cease making payments.
Despite the binding nature of the Depository Agreement, petitioners argue that
It is true that the government has directed this court to no
evidence that June Partners' [partnership in which taxpayers
invested] note to Softpro [in Elmco's position] is contingent
upon Finalco [in GCC's position] discharging its obligations to
June Partners. We believe, however, that the Baldwins [in
petitioner's position] nevertheless 1999 Tax Ct. Memo LEXIS 405">*424 fall within subsection
465(b)(4). [
We reject petitioners' attempt to make the same argument in the instant case.
Petitioners' argument that Elmco would choose to enforce the Buyer Acquisition Note is not supported by the record. Although the instant case is fully stipulated, petitioners still bear the burden of proof. See
The broad indemnity agreement in the GCC Lease provides further protection from loss to petitioner. The protection provided by the broadly scripted indemnity clause can easily be read to encompass losses incurred by petitioners as a result of Elmco's enforcement of the Buyer Acquisition Note. On prior occasions, e.g.,
We conclude that the circularity of payments, the book- entry payment mechanism, and the indemnity clause in the GCC lease, when taken together, effectively immunize petitioner from any realistic possibility of suffering an economic loss. We hold that petitioner is, therefore, not at risk under
With respect to increased interest under section 6621, petitioners present no argument as to why the provision should not apply, other than contending that petitioner is at risk and, therefore, not liable for increased interest pursuant to section 6621. Because we have held that petitioner is not at risk, we also hold that the instant transaction is tax-motivated for the purpose of petitioners' 1999 Tax Ct. Memo LEXIS 405">*426 liability for increased interest under section 6621. See sec. 6621(c)(3)(A)(ii). We have considered petitioners' other arguments but find them irrelevant or unnecessary to reach. 111999 Tax Ct. Memo LEXIS 405">*427 1999 Tax Ct. Memo LEXIS 405">*428
To reflect the foregoing,
Decision will be entered under Rule 155.
1. 50 percent of the interest due on the entire deficiency.↩
2. 25 percent of the understatement of tax (determined alternatively to the additions under
3. Interest computed at 120 percent of the normal rate. ↩
1. Unless otherwise noted, 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.↩
2. Neither party introduced evidence of the recourse or nonrecourse nature of this note.↩
3. Petitioner owned of all the equipment involved in the transaction for all purposes.↩
4. The parties agree that petitioner is at risk with respect to the Equity Promissory Notes as well as the $ 18,500 cash payment.↩
5. The Lease Agreement between GCC and petitioner contained the following legend:
THIS LEASE AGREEMENT HAS BEEN ASSIGNED BY, AND IS SUBJECT TO, A
SECURITY INTEREST GRANTED BY, LESSOR [Petitioner] TO SELLER
[Elmco] PURSUANT TO A SECURITY AGREEMENT DATED AS OF DECEMBER
22, 1982, AND TO A SECURITY INTEREST GRANTED BY SELLER [Elmco]
TO LESSEE [GCC] PURSUANT TO A COLLATERAL ASSIGNMENT AGREEMENT
DATED AS OF DECEMBER 22, 1982 BETWEEN LESSEE [GCC] AND SELLER
[Elmco].↩
6. The Collateral Assignment provided that Elmco's assignment of its rights in the collateral to GCC was limited as follows:
3. SECURITY INTEREST ONLY. The rights to the Collateral
granted to the Secured Party [GCC] hereunder shall constitute a
security interest only. The Secured Party shall not proceed
against any of the Collateral, or collect the proceeds
therefrom, or exercise any other rights hereunder with respect
to the Collateral so long as the Assignor [Elmco] is not in
default hereunder. Monies received by the Assignor from the
Collateral during and attributable to any period when the
Assignor is not in default hereunder shall be received by
Assignor free and clear of the rights of the Secured Party under
this Assignment, and the Secured Party shall have no claim to
and shall not be entitled to trace such monies in the hands of
the Assignor.↩
7. If GCC replaced a unit of equipment, it would transfer title to the replacement unit to petitioner free and clear of all encumbrances, other than the rights of the end-user lessees.↩
8. See
9. The only exception, a minor one not favorable to petitioner, is that GCC's rental payments over the last 72 months of the lease ($ 11,792.70 per month) exceeded petitioner's obligations ($ 11,716.70 per month over the last 72 months) under the Buyer Acquisition Note.↩
10. GCC did not borrow to purchase the computer equipment. Accordingly, unlike many purchase and leaseback transactions, see, e.g.,
11. Petitioners assert that petitioner's liability under the Buyer Acquisition Note, because it is negotiable, potentially "runs to the world" and that this fact puts petitioner at risk with respect to the note. The court in
Petitioners additionally argue that petitioner should be considered at risk regarding the Buyer Acquisition Note under the Court of Appeals' reasoning in
Additionally, petitioners rely on