Nicholson v. Commissioner IRS ( 1995 )

Opinions of the United
1995 Decisions States Court of Appeals
for the Third Circuit
7-24-1995
Nicholson v Commissioner IRS
Precedential or Non-Precedential:
Docket 94-7688
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UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 94-7688
CHARLES E. NICHOLSON, JR. and
MARGARET K. NICHOLSON,
Appellants
v.
COMMISSIONER OF INTERNAL REVENUE SERVICE
On Appeal from a Decision
of the United States Tax Court
Tax Court No. 3343-92
T.C. Memo 1994-280Argued: June 8, 1995
Before: BECKER, NYGAARD, and ALITO, Circuit Judges
(Opinion Filed: July 24, 1995)
____________________
BARRY A. FURMAN, ESQ.
MARK S. HALPERN, ESQ. (Argued)
FURMAN & HALPERN, P.C.
401 City Avenue, Suite 612
Bala Cynwyd, PA 19004
Attorneys for Appellants
LORETTA C. ARGRETT
Assistant Attorney General
GARY R. ALLEN
RICHARD FARBER
THOMAS J. CLARK (Argued)
Tax Division
Department of Justice
Post Office Box 502
Washington, D. C. 20044
Attorneys for Appellee
____________________
OPINION OF THE COURT
1
____________________
ALITO, Circuit Judge:
The genesis of this appeal is a decision by the
Commissioner of the Internal Revenue Service ("the Commissioner")
to disallow certain deductions claimed by Charles and Margaret
Nicholson on their 1983, 1984, 1985, and 1986 tax returns
regarding computer equipment that Charles Nicholson acquired in
1983. The Commissioner maintained that the Nicholsons were not
entitled to take the deductions because Charles Nicholson was not
"at risk" regarding a promissory note that he gave in partial
payment for the equipment. Prior to a trial before the tax court
on the propriety of these deductions, the parties settled on
terms generally favorable to the Nicholsons. The Nicholsons
subsequently filed a motion for litigation costs pursuant to
I.R.C. § 7430, arguing that the Commissioner's position in the
underlying proceedings was not "substantially justified." The
tax court disagreed and refused to award litigation costs. We
now reverse and remand for further proceedings.
I.0
0
Because the underlying case was settled, there is no stipulation
or other formal evidence pertaining to the transactions involved
in this case. See Nicholson v. Commissioner, T.C. Memo. 1994-280at 3 n.2 (1994). In this opinion, we generally rely on the tax
court's findings of fact as they are neither challenged nor
clearly erroneous. See Kenagy v. United States, 942 F.2d 459,
463 (9th Cir. 1991). Where necessary, we also rely on undisputed
evidence in the record on appeal.
2
This case involves the propriety of deductions that the
Nicholsons claimed in regard to the purchase of certain computer
equipment. Nicholson0 acquired the equipment in 1983 from its
original purchaser, Equipment Leasing Exchange, Inc. ("ELEX").
Nicholson v. Commissioner, T.C. Memo. 1994-280 at 3 (1994). ELEX
had purchased the equipment in 1983 for $362,168. Id. In order
to finance the purchase, ELEX obtained two nonrecourse loans from
the Hershey Bank ("the Bank"). Id. ELEX subsequently leased the
equipment to the Milton Hershey School ("the School") for a term
of six years. Id. The lease provided for monthly rental income
of $7,478. Id. As a condition of the two loans, ELEX granted
the Bank a security interest in the computer equipment and the
lease. Id.Nicholson purchased the lease and the equipment from ELEX for
$386,798. Id. In partial payment of the purchase price,
Nicholson executed and delivered to ELEX three promissory notes,
in the amounts of $17,500, $20,378, and $336,195. Id. The first
two notes were payable on March 15, 1984, and March 15, 1985,
respectively. Id. Both notes explicitly provided ELEX a right
of recourse against Nicholson personally in the case of default.
Id. The third note required repayment in monthly installments of
$7,348.80. Id. at 4. Unlike the first two notes, however, the
third note was silent as to whether ELEX had a right of recourse
0
Both Charles Nicholson and his wife, Margaret Nicholson are
parties to this action by virtue of filing joint tax returns. All
the transactions at issue here, however, involve only Charles
Nicholson. For convenience, "Nicholson," when used in the
singular, refers only to Charles Nicholson.
3
against Nicholson. Id. All three notes were secured by the
equipment and the lease, subject to the Bank's priority security
interest. Id.
In 1991, the Internal Revenue Service ("IRS") audited the
Nicholsons' 1983, 1984, 1985, and 1986 tax returns. Initially,
the IRS District Director took the position that deductions
claimed by the Nicholsons with regard to the leasing activity
should be disallowed because the leasing activity was not an
activity entered into for profit since it had no economic or
business purpose. Joint Appendix ("JA") at 62-65. The
Nicholsons appealed this determination to the IRS Appeals Office.
Id. at 65.
The Appeals Office agreed with the Nicholsons' argument that
the leasing activity did have an economic purpose. Id. However,
the Appeals Office sua sponte raised an alternative basis for
denying the Nicholsons' deductions. The Appeals Office ruled
that Nicholson was not "at risk" within the meaning of I.R.C.
§465 as to the money borrowed under the third note. Id.
Pursuant to section 465, an owner of depreciable property may
only deduct up to the total amount of the economic investment in
the property (i.e., the amount that is "at risk").
Subsequently, on December 11, 1991, the Commissioner issued a
Notice of Deficiency to the Nicholsons. Like the Appeals Office,
the Commissioner asserted that the Nicholsons' deductions were
barred by section 465's "at risk" requirement. According to the
Commissioner, Nicholson was not "at risk" as to the third note 1)
because it was nonrecourse; 2) because ELEX did not borrow funds
4
on a recourse basis from the Bank on its purchase of the
equipment and therefore ELEX would have no motive to pursue
Nicholson if he defaulted on the third note; and 3) because the
lease payments from the School were sufficient to cover the
installment payments required under the third note. Id. at 64-
65; see id. at 121-25; Nicholson, T.C. Memo. 1994-280 at 7-8 n.7.
The deficiencies were for income taxes for the calendar years
1983, 1984, 1985, and 1986 in the amounts of $3,660, $25,179,
$20,385, and $21,180 respectively. Nicholson, T.C. Memo. 1994-
280 at 2. The Commissioner also assessed an interest penalty
against the Nicholsons under I.R.C. § 6621(c), believing that the
underpayment was due to a tax-motivated transaction. Id.
The Nicholsons then filed a Petition for Redetermination with
the tax court on February 14, 1992. On February 1, 1994, the
parties filed a Stipulation of Settled Issues ("the Settlement")
with the Tax Court that provided:
The Parties hereby agree to the following
settlement of the issues in the above-entitled case:
1. It is agreed for purposes of settlement that
petitioners' claimed losses with respect to their
activity in the Hershey transaction during the years
1983 through 1985 shall be disallowed subject to their
deductibility as provided below;
2. It is agreed for settlement purposes that
petitioners were at risk as defined under I.R.C.
Section 465 on the installment note in the amount of
$336,195.00 with respect to their activity in the
Hershey transaction beginning in 1986 and are entitled
to suspended losses beginning in 1986;
3. It is agreed for purposes of settlement that
petitioners are required to include in taxable income
for taxable year ended December 31, 1983 the amount of
$18,300.00 which represents the amount of Schedule E
5
loss disallowed on petitioners' investment in Hershey
and Cyclops0 in 1983;
4. It is agreed for the settlement that
petitioners are required to include in taxable income
for taxable year ended December 31, 1984 the amount of
$42,024.00 which represents the amount of Schedule E
loss disallowed on petitioners' investment in Hershey
and Cyclops in 1983;
5. It is agreed for the settlement that
petitioners are required to include in taxable income
for taxable year ended December 31, 1985 the amount of
$72,341.00 which represents the amount of Schedule E
loss disallowed on petitioners' investment in Hershey
and Cyclops in 1983;
6. It is agreed for the settlement that for the
taxable year ended December 31, 1986, petitioners are
entitled to deduct $81,723.00 with respect to their
investment in the Hershey transaction as a suspended
loss under I.R.C. Section 465;
7. It is agreed for purposes of settlement that
respondent concedes increased interest under I.R.C.
Section 6621(c), formerly, 6621(d) for all issue years.
Id. at 4-5.
The net effect of this Settlement was that the Nicholsons
were not able to take the deductions claimed in 1983, 1984, and
1985, but were able to carry these amounts forward and take them
as a deduction in 1986.0 In addition, the Nicholsons were not
liable for an increased interest penalty under section 6621(c).
The Settlement was therefore quite favorable to the Nicholsons.
0
The "Cyclops" issue is an unrelated matter that was not
contested by the Nicholsons. According to the tax court, the
Commissioner conceded that it was not a significant issue. See
Nicholson, T.C. Memo. 1994-280 at 5 n.3.
0
A taxpayer does not forfeit a deduction due to the operation of
section 465's "at risk" requirement. Rather the deduction
becomes suspended and may be taken when the taxpayer actually
becomes "at risk" for the amount of the deduction. See I.R.C.
§465(a)(2).
6
Although the Commissioner's Notice of Deficiency alleged that
Nicholson owed over $70,000 for the 1983-1986 period, under the
Settlement the Nicholsons appear to have been assessed only a net
deficiency of between $2,500 and $4,000.0 Id. at 6 & n.4.
The Commissioner's willingness to settle on these terms
appears due to two significant developments. First, the
Commissioner changed her position on whether the third note
provided for recourse. Although the Commissioner initially
maintained that because this note was silent as to recourse the
underlying loan was nonrecourse, the Commissioner abandoned this
theory because New Jersey law, which controls the terms of the
note, clearly provides that a note is presumptively recourse. Id.
at 7-8 n.7; JA at 125; see N.J. Stat. Ann. § 12A:9-505(2).
Second, after issuing the Notice of Deficiency, the Commissioner
learned that ELEX in 1986 had fully repaid its loan to the Bank.
JA at 125; Brief for the Appellee ("Comm. Br.") at 20 n.7. Thus,
the Commissioner conceded that Nicholson was at risk as of 1986
because ELEX would have certainly exercised its right of recourse
against Nicholson for any default by Nicholson on the third
note.0
0
Although not clear from the Settlement or the record, it seems
that the only benefit that the Commissioner received from the
Settlement was that the Nicholsons had to pay interest (but not a
penalty) on the deductions that they claimed for 1983, 1984, and
1985 until they were able to take these deductions in 1986. In
other words, because the Settlement disallowed the Nicholsons'
deductions in 1983, 1984, and 1985, but allowed them to carry
these deductions forward and take them in 1986, the Nicholsons
owed interest for having use of the money for a period when they
were not entitled to it.
0
Nicholson, however, did not concede in the Settlement that he
was not "at risk" in 1983, 1984, and 1985.
7
Following the Settlement, the Nicholsons filed a motion to
recover their litigation costs pursuant to I.R.C. § 7430. After
surveying the background of this litigation, the tax court began
its analysis by observing that in order to be entitled to an
award of costs, the Nicholsons needed to demonstrate that they
were a "prevailing party" as defined by section 74300 and that
they complied with that provision's procedural requirements.0
Nicholson, T.C. Memo. 1994-280 at 6. Thus, the Nicholsons needed
to establish that:
(1) [t]hey exhausted all administrative remedies, (2)
they met the net worth requirement of section
7430(c)(4)(A)(iii), (3) they ha[d] substantially
prevailed with respect to the amount in controversy or
most significant issues, and (4) the position of the
United States was "not substantially justified."
0
I.R.C. § 7430(a) provides for the award of "reasonable
administrative costs" and "reasonable litigation costs" to a
"prevailing party" in connection "with the determination . . . of
any tax." I.R.C. § 7430(c)(4)(A) defines a "prevailing party" as
a party:
(i) which establishes that the position of the United
States in the proceedings was not substantially
justified,
(ii) which--
(I) has substantially prevailed with respect to
the amount in controversy, or
(II) has substantially prevailed with respect to
the most significant issue or set of issues
presented, and
(iii) [is an individual whose net worth does not
exceed $2,000,000 at the time the civil action was
filed].
0
I.R.C. § 7430(b) requires that an award of litigation costs
"shall not be awarded . . . unless the court determines the
prevailing party has exhausted the administrative remedies
available to such a party within the Internal Revenue Service."
8
Id. (emphasis in original).
The tax court found that the Nicholsons had met the first two
conditions. Id. Turning to the third condition, the tax court
noted that the Commissioner's brief merely stated that the
Nicholsons "may in fact be able to prove that they meet the
alternative requirement of that condition namely the amount in
controversy or the most significant issues." Id. Although the
tax court appeared to indicate that the Nicholsons had satisfied
this condition by virtue of the small net deficiency assessed
against them under the Settlement and the Commissioner's apparent
waiver, the court decided not to resolve this issue because it
believed that the fourth condition was determinative. Id.
As to the fourth condition, the tax court noted that a
determination of whether the Commissioner's position was not
substantially justified depends upon an
examination of all the facts and circumstances to
determine if that position had a reasonable basis in
law and fact. Price v. Commissioner, [T.C. Memo. 1995-
187 at 3 (1994)]. Petitioners bear the burden of
proof. [Tax Court] Rule 232(e); Estate of Wall v.
Commissioner, 102 T.C. 391, 393 (1994).
Id. at 7. The tax court therefore focused its attention on the
arguments that each party had advanced in the underlying
proceeding on the issue of whether Nicholson was at risk on the
third note. As noted above, the Commissioner, after conceding
that the third note provided ELEX with the right of recourse
against Nicholson personally, see id. at 7-8 n.7, nevertheless
continued to assert that Nicholson was not "at risk" because (1)
the obligations of ELEX to the Bank were nonrecourse and (2) the
9
lease payments from Hershey nearly offset Nicholson's obligation
to ELEX. In particular, the Commissioner relied on a number of
cases in which these two elements were present and taxpayers were
found not to be "at risk." Id. at 7. The Nicholsons, on the
other hand, maintained that these two elements were not by
themselves dispositive in the "at risk" analysis. Id. at 8.
Rather, the Nicholsons argued that ELEX would have exercised its
right of recourse on the third note if the transaction had become
unprofitable. Id.
The tax court found that the Commissioner's position was
substantially justified. The tax court wrote:
[The Commissioner] relies on the galaxy of cases
where the two elements relied upon by [the Nicholsons]
were present and where the taxpayers therein were held
not to be at risk. Those cases, as well as other cases
cited by [the Commissioner], are analyzed in some
detail in Thornock v. Commissioner, [94 T.C. 439, 453
(1990)], and Wag-A-Bag Inc. v. Commissioner, [T.C.
Memo. 1992-581 (1994)], which analyses reveal that
those cases involved elements in addition to the
presence of nonrecourse obligations at an earlier stage
and offsetting payments. Thus, the message which such
cases convey is murky at best. In any event, we are
not prepared to say that they do not furnish some basis
for [the Commissioner's] position on the substantive
issue involved herein.
Id. at 8-9. The court then concluded:
In short, the two elements upon which the parties
herein have focused their arguments are not
automatically dispositive of the "at risk" issue. Two
non per se elements do not amount to one per se element
either for or against [the Nicholsons]. To be sure, it
is entirely possible that, had the instant case gone to
decision on the substantive risk issue, we would have
resolved that issue in favor of [the Nicholsons]. But
that result would not have necessarily entitled
petitioners to recover litigation costs under section
7430. It is clearly established that the fact that the
respondent loses a significant issue, whether by
10
concession or after trial, is not determinative that
her position was reasonable. Price v. Commissioner,
supra.* * *
The long and the short of the matter is that,
taking into account all the facts and circumstances
herein, we are not persuaded that [the Nicholsons] have
carried their burden under section 7430.
Id. at 9, 11.
This appeal followed.
II.
We begin with the main issue of contention between the
litigants. In order to demonstrate that the position taken by
the United States was not "substantially justified," the
Nicholsons have the burden of showing that the government's
position was not "justified to a degree that could satisfy a
reasonable person" or had no "reasonable basis both in law and
fact . . . ." Lennox v. Commissioner, 998 F.2d 244, 248 (5th
Cir. 1993) (quoting Pierce v. Underwood, 487 U.S. 552, 563-565
(1988)); see 26 C.F.R. § 301.74305-5(c); see also Rickel v.
Commissioner, 900 F.2d 655, 666 (3d Cir. 1990) (rejecting a
taxpayer's claim for costs award where "Commissioner's position
could be deemed as reasonably supported in the case law"). The
Nicholsons' burden is also increased by this court's standard of
review: the tax court's denial of a taxpayer's motion for an
award of costs under section 7430 is reviewed for an abuse of
discretion. Rickel, 900 F.2d at 666; Accord Pierce, 487 U.S.
11563-65 (abuse of discretion review proper for awards under the
Equal Access to Justice Act).
We will structure our discussion of this issue as follows. In
Part II.A., we will analyze I.R.C. § 465, the code provision upon
which the Commissioner relied in assessing the deficiency against
the Nicholsons. In Part II.B., we will examine the position
taken by the Commissioner in the underlying litigation (i.e., the
theory advocated by the Commissioner in support of the deficiency
assessment). Finally, In Part II.C., we will determine whether
the Commissioner's position was reasonable in light of the
substantive law and consequently whether the tax court abused its
discretion in denying the Nicholsons' motion for costs.
A. I.R.C. § 465 limits the ability of taxpayers to claim
deductions resulting from the ownership of depreciable property.
Section 465 was enacted because of the proliferation of tax
shelters in the 1970's. Before the enactment of section 465,
investors could take advantage of quick depreciation rules plus
the deductibility of interest on nonrecourse debt to generate
large "losses" in order to offset personal income.0
0
Professor Chirelstein provides the following lucid explanation
of the way in which these tax shelters operated:
In conventional form, the shelter consists of
highly leveraged real estate in which individual
investors participate as limited partners. The limited
partners make initial cash payments to the shelter
promoters which are largely absorbed by commissions,
fees and similar charges, while the cost of the
property itself is financed through a mortgage loan
from a bank, insurance company or other institution.
The loan is nonrecourse, but, under the Crane rule, the
12
Section 465 attacks these practices directly. Pursuant to
section 465, a taxpayer may only take deductions up to the amount
"at risk" in the activity. A taxpayer is considered to be at
risk for the amount "contributed" to the activity and for the
amount of money "borrowed" for use in the activity. I.R.C.
§465(b)(1). However, for purposes of section 465, an amount is
considered borrowed only if the taxpayer is either "personally
liable for repayment" or has pledged other personal property as
limited partners are entitled to treat the borrowed
amount as if it were a personal loan and hence, to
include the indebtedness in basis. Rents received by
the partnership are then expected to cover mortgage
principal and interest requirements plus management
fees. Sometimes, but not always, there is a small
annual cash return to the investors.
[T]he combination of (a) accelerated depreciation
and (b) deductible interest on the nonrecourse mortgage
loan inevitably generates substantial "losses" during
the earlier years of the enterprise. Such losses are
of course tax artifacts. If true economic depreciation
were substituted for accelerated depreciation, then,
usually, the enterprise would operate at or close to a
break-even level--there would be no deductible "loss"
to report--and the investment from the standpoint of
the limited partnership would have little purpose. The
same result would arise if (while leaving accelerated
depreciation untouched) otherwise deductible interest
were deferred or disallowed as under Code § 265(a)(2).
In fact, however, nether limitation was imposed.
Instead, high-bracket taxpayers were enabled
(encouraged) to combine tax-exempt income with tax-
deductible borrowing and, by so doing, to reduce their
taxable income to a minimum. The "loss" resulting from
the shelter investment would be offset against income
from other sources (chiefly personal services), even
though the taxpayer himself would have lost little or
nothing in economic terms.
Marvin A. Chirelstein, Federal Income Taxation 259-60 (6th ed.
1991).
13
"security for the borrowed amount (to the extent of the net fair
market value of the taxpayer's interest in such property)." Id.
at § 465(b)(2)(A) and (B). Section 465 also contains a catch-all
provision that provides:
Notwithstanding any other provision of this section, a
taxpayer will not be considered at risk with respect to
the amounts protected against loss through nonrecourse
financing, guarantees, stop loss agreements, or other
similar arrangements.
Id. at § 465(b)(4) (emphasis added). The Commissioner--conceding
that the note that Nicholson gave to ELEX was recourse and
moreover, that he was not protected by any guarantees or stop
loss agreements--argued in the proceedings below that the
peculiarities of the leasing agreement involved "other similar
arrangements" sufficient to render him immune from any risk.
Although the Internal Revenue Code does not define the term
"other similar arrangements," the meaning of this phrase has been
addressed by several other courts of appeals. The majority of
these courts have applied the "economic reality" test to
determine whether a taxpayer is protected from loss by "other
similar arrangements." Under this approach, a transaction is
deemed not "at risk" if it is structured "to remove any realistic
possibility that the taxpayer will suffer an economic loss if the
transaction turns out to be unprofitable." American Principals
Leasing Corp. v. United States, 904 F.2d 477, 483 (9th Cir.
1990). See also Waters v. Commissioner, 978 F.2d 1310, 1315 (2d
Cir. 1992), cert. denied, 113 S. Ct. 1814 (1993); Young v.
Commissioner, 926 F.2d 1083, 1088 n.11 (11th Cir. 1991); Moser v.
14
Commissioner, 914 F.2d 1040, 1048 (8th Cir. 1990). The Sixth
Circuit, by contrast, has employed the "worst case scenario" test
to determine whether a taxpayer is protected from loss by an
"other similar arrangement." Martuccio v. Commissioner, 30 F.3d
743, 749 (6th Cir. 1994). This test is more favorable to
taxpayers than the economic reality test, as it holds that a
taxpayer is "at risk" unless there are no circumstances in which
he could suffer a loss in the transaction. Id. Although 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 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.0
B. We now turn to the position taken by the Commissioner in
the proceedings below.0 As noted, the Commissioner asserted that
Nicholson was not "at risk" on the amount of the third note
0
We emphasize that we do not purport to adopt the economic
reality test as the law of this circuit.
0
In this context, the "position of the United States" is the
position taken by the Commissioner in the underlying tax court
proceeding and, with respect to an administrative proceeding
before the IRS, the position taken by the IRS as of the earlier
of the date of the Notice of Deficiency or the date of receipt by
the taxpayer of the Notice of Decision by the Appeals Office.
I.R.C. § 7430(c)(7). Because the record does not show that the
Nicholsons received a Notice of Decision by the Appeals Office,
the inquiry as to the position asserted by the United States
begins at the time that the Nicholsons receive the Notice of
Deficiency.
15
because the structure of the leasing arrangement was an "other
similar arrangement" within the meaning of section 465(b)(4).
After abandoning the position that the third note was
nonrecourse, the Commissioner relied on two separate aspects of
the leasing agreement to support this argument. First, the
Commissioner pointed to the fact that the rental payments due
from the School on its lease were almost exactly the same amount
as the monthly payments Nicholson owed ELEX under the terms of
the third note. Second, the Commissioner pointed to the fact
that the loan between the Bank and ELEX was nonrecourse and that
the Bank had a priority security interest on the equipment.
According to the Commissioner, these two factors were sufficient
to demonstrate that Nicholson was not "at risk" on the third note
for the following reasons:
It is evident, therefore, that the School was the
ultimate obligor for the payments that would be used
for the purchase of the computer equipment and that
would be received by the Bank, as the ultimate obligee.
In other words, at the end of the day the School owed
rent to taxpayer, who would use those rental payments
to satisfy his obligations on the note to ELEX, which,
in turn, would use those payments to satisfy the
obligations to the Bank. Taxpayer was merely the
conduit through which payments made by the School were
funnelled to their ultimate destination, the Bank. If
the School, the end user, ever stopped paying rent to
taxpayer, then the Bank would not be paid. Since
ELEX's note to the Bank was nonrecourse, the Bank's
sole remedy would be to foreclose on the computer
equipment. In that event, ELEX would have suffered no
economic loss, and therefore would have no incentive to
pursue the taxpayer for payment on his $366,195 note.
In these circumstances, it was reasonable to maintain,
as the Commissioner did until the settlement of this
case, that there was no "realistic possibility" that
the taxpayer would suffer a loss on that note.
16
Comm. Br. at 17 (emphasis added). The Commissioner, however, did
concede in the underlying proceedings that even under this theory
that Nicholson was "at risk" on the third note after 1986, when
ELEX paid off its loan from the Bank. Id. at 20 & n.7.
C. In light of this understanding of section 465 and the
theory underlying the Commissioner's position, we now assess the
reasonableness of her position. We find that the Commissioner's
position is not supported in law or fact and is therefore
unjustified.
We understand the Commissioner's theory as follows. Should
the School default on the lease or refuse to meet its contractual
obligations on account of a dispute regarding the computer
equipment--both realistic possibilities in any business
transaction like this one--Nicholson would be unable to pay ELEX.
ELEX in turn might not then pay the Bank, causing the Bank to
respond by foreclosing on the equipment itself, as it had no
right of recourse against ELEX. With this much, we agree.
However, the Commissioner goes on to argue that ELEX would not
pursue Nicholson for his failure to repay the third note because
ELEX suffered no "economic loss," as the Bank was forced to
foreclose on the equipment rather than sue ELEX directly. We
find no support in logic for this argument. Although ELEX could
conceivably suffer no economic loss as a result of Nicholson's
inability to make his payments under the third note, ELEX would
still have incentive to sue Nicholson and obtain the outstanding
balance of the note (which could amount to several hundred
17
thousand dollars).0 Thus, the Commissioner's theory does not
provide any reason why ELEX would fail to act like an ordinary
creditor in this situation and enforce the outstanding obligation
owed to it by Nicholson.
Furthermore, the Commissioner's critical assumption that ELEX
would suffer no "economic loss" is without foundation in the
record. ELEX could have chosen to make larger payments than
required under the terms of its loan from the Bank in order to
pay-off the loan early. Indeed, this appears to have happened
0
At oral argument, counsel for the Commissioner asserted, for the
first time, that ELEX would not want to enforce the terms of the
third note in the case of a default by Hershey and Nicholson
because this would give ELEX an unfavorable reputation in the
community and therefore ELEX would be unable to engage in this
type of transaction in the future. Because this argument was
neither presented to the tax court nor in the Commissioner's
brief, we need not consider it on appeal. See Lim v. Central
DuPage Hosp., 871 F.2d 644, 648 (7th Cir. 1989) ("oral argument
in this court . . . [is] too late for advancing new (or what is
the same thing, reviving abandoned" argument)). Moreover, there
is absolutely no support in the record for this assertion. As
the tax court observed in Powers v. Commissioner, 100 T.C. 457,
473 (1993), the Commissioner's position "lack[s] a reasonable
basis in fact and law" when it has "no factual basis and [the
Commissioner has] made no attempt to obtain information about the
case before adopting the position."
We also note that counsel for the Nicholsons persuasively
responded that ELEX would have incentive to pursue Nicholson for
the outstanding value of the third note in the case of default.
First, a portion of the third note represents the profits due to
ELEX from the sale of the equipment and lease, and ELEX would
certainly be entitled to this amount. Second, in order to
maintain its ability to borrow on a nonrecourse basis from the
Bank, ELEX would have incentive to act as an agent for the Bank
and make sure that the Bank had not lost money as a result of the
transaction. In the case of quickly obsolescent property such as
computer equipment, the Bank's security interest in the equipment
could easily be insufficient to cover the outstanding balance of
its loan to ELEX. Thus, ELEX would have incentive to sue
Nicholson for the shortfall.
18
here, as ELEX prepaid the loan from the Bank. In such a case,
the proceeds from the Bank's repossession and sale of the
equipment (minus the Bank's priority security interest) would not
necessarily be sufficient to cover ELEX's extra payments. Thus,
the record provided the Commissioner with no basis for presuming
that ELEX would not suffer any economic loss should the lease
have become unprofitable. See Lennox, 998 F.2d at 248-49(Commissioner's position must be supported by record evidence in
order to be substantially justified).
The inadequacy of the Commissioner's position is apparently
due to her failure to properly develop the case against the
Nicholsons before issuing the Notice of Deficiency.0 The
Commissioner cannot have a "reasonable basis in both fact and law
if it does not diligently investigate a case." Powers v.
Commissioner, 100 T.C. 457, 473 (1993); see United States v.
Estridge, 797 F.2d 1454, 1458 (8th Cir. 1986) (award for
litigation costs granted where Commissioner did not diligently
investigate). When issuing the Notice of Deficiency, the
Commissioner believed--incorrectly--that the third note between
ELEX and Nicholson was nonrecourse because it was silent on its
face as to recourse while the other two notes explicitly provided
for recourse. See JA at 125. Even a cursory analysis of New
0
The Commissioner argues that anything that happened before the
Notice of Deficiency is irrelevant to this case because under
I.R.C. § 7430(c)(7), the position of the Commissioner is
determined only after the date of the Notice of Deficiency. We
disagree. As the Fifth Circuit explained in Lennox, 998 F.2d at
248, the sufficiency of the position taken by the Commissioner
after the Notice of Deficiency must be analyzed in the context of
what caused her to take that position.
19
Jersey law would have revealed the deficiency in this position.
See N.J. Stat. Ann. § 12A:9-505(2). Given the logical weakness
of the theory eventually relied upon by the Commissioner, we are
skeptical that the Notice would have been issued had the
Commissioner been accurately appraised of New Jersey law.
Moreover, the Commissioner's position at the time of the
Notice of Deficiency with regard to the Nicholsons' 1986 tax
deduction was clearly not justified. In the Notice, the
Commissioner maintained that Nicholson was not at risk in 1986.
However, the Commissioner later conceded that because ELEX paid
off the Bank in 1986, Nicholson was "at risk" at that time. The
Commissioner could have discovered this fact had she adequately
investigated the case before issuing the Notice.0 See Portillo
v. Commissioner, 988 F.2d 27, 29 (5th Cir. 1993) (ruling that a
Notice of Deficiency without any factual foundation is "clearly
erroneous as a matter of law").
The Commissioner seeks to overcome these deficiencies and
justify the reasonableness of her position by citing a number of
cases in which courts found that a taxpayer who borrowed money as
part of a complex leasing transaction was not "at risk" for the
borrowed amount. See Waters, 978 F.2d at 1317; Young, 926 F.2d
at 1088 n.11 (11th Cir. 1991); Moser, 914 F.2d at 1048; American
Principals Leasing Corp., 904 F.2d at 483; see also Thornock v.
0
The Commissioner can hardly blame the Nicholsons for not
providing her with this information because the "at risk" issue
was raised by the Appeals Office sua sponte, and no further
investigation appears to have been conducted before the Notice
was issued. JA at 65-66.
20
Commissioner, 94 T.C. 439 (1990); Wag-A-Bag, Inc. v.
Commissioner, T.C. Memo. 1992-581 (1992). The Commissioner
correctly notes that in these cases, the two factors eventually
relied upon by the Commissioner were relevant to the
determination of whether an amount was "at risk." However, the
determinative factor in these cases was that the parties, through
the use of nonrecourse financing and lease assignments, were able
to create a circular web of offsetting liabilities, thereby
effectively removing risk from the taxpayer claiming the
deduction. See Waters, 978 F.2d at 1317 ("circular, matching
payment obligations"); Young, 926 F.2d at 1083 ("circular
sale/leaseback transactions"); Moser, 914 F.2d at 1049 ("circular
nature of the arrangement" and "offsetting bookkeeping entries");
American Principals Leasing Corp., 904 F.2d at 483 ("circular
obligations" and "chain of payments"); see generally Thomas A.
Pliskin, How Circular Transactions and Certain Interests of
Lenders Affect Amounts of Risk, 12 J. Partnership Tax. 54, 63-66
(1995) (arguing that the courts in Moser, Young and American
Principals Leasing correctly determined the taxpayers were not at
risk because circular chains of payments were used to protect the
taxpayers from loss).
A brief example (drawn from Moser, supra) will clarify the
type of transaction at issue in the cases relied upon by the
Commissioner and provide a contrast with the type at issue here.
Assume A borrows money on a nonrecourse basis from a bank and
uses that money to buy some equipment. A leases that equipment
to L and the bank then takes a security interest in that
21
equipment and the lease. A sells the equipment to B, subject to
the existing liens and lease and takes a promissory note from B.
B in turn sells to taxpayer, T, for the same price that it bought
the equipment from A. Like before, B accepts a promissory note
from T as payment. T, in turn, leases the equipment back to A in
exchange for payments equal to those B owes to A.
Under this arrangement, the payments A owes to T are
identical to the payments T owes to B, which in turn are
identical to the payments B owes to A. T, as the "owner" of the
equipment, would be entitled to take deductions for depreciation
of the property (except for the existence of section 465). Should
any party assert a claim against another party for nonpayment, it
could expect an equal claim asserted against it. See Pliskin,
supra, at 62-66, 72 (diagramming this type of transaction).
Here, by contrast, there was no circular chain of payments.
Instead, the failure of Nicholson to meet the terms of the third
note would trigger a demand for payment by ELEX; Nicholson, on
the other hand, would have no corresponding claim against ELEX or
the Bank.
Given this analysis, we are forced to conclude that the tax
court abused its discretion in ruling that the Commissioner's
position was substantially justified. As noted, the tax court
did not seek to analyze whether Nicholson would suffer an
economic loss if the lease became unprofitable. The court simply
found that because two of the factors present in this case were
also present in several of the cases finding taxpayers not "at
risk," the Commissioner's position was substantially justified.
22
Thus, the court did not seek to determine why the taxpayers in
these cases were found not "at risk." Had the court conducted
the required economic reality test, it would have found that
these two factors were not dispositive in this transaction
because ELEX had incentive to sue Nicholson in the case of a
default on the third note.
III.
The only remaining issue therefore is whether to remand for a
determination of whether the Nicholsons substantially prevailed
in the underlying case, a necessary condition for the award of
litigation costs under section 7430.0 The tax court, as noted,
did not rule on this issue. We do not, however, believe such a
remand is necessary.
On appeal, the Commissioner has not attempted to sustain the
tax court's ruling on the alternative basis that the Nicholsons
did not substantially prevail. Nor did she press this issue
before the tax court. See supra page 9. Rather, the sole
argument advanced before this court by the Commissioner was that
her position was "substantially justified." Moreover, the great
disparity between the deficiency assessed by the Commissioner and
the Nicholsons' tax liability after the Settlement reflected in
the record indicates that the Nicholsons have "substantially
prevailed with respect to the amount in controversy." I.R.C.
0
Pursuant to section 7430(c)(4)(A)(ii), a party substantially
prevails by either substantially prevailing "with respect to the
amount in controversy" or "with respect to the most significant
issue or set of issues presented."
23
§7430(c)(4); see Marranca v. United States, 615 F. Supp. 25, 27
(M.D. Pa. 1985) (government conceded that taxpayers
"substantially prevailed with respect to the amount in
controversy" after parties reached settlement reducing initial
assessment by nearly 75%). Thus, we conclude that the Nicholsons
have met all the requirements of section 7430, and we therefore
remand this case to the tax court for a determination of the
costs and fees to which they are entitled.
IV.
For the foregoing reasons, the tax court's order denying the
Nicholsons' petition for costs is reversed and remanded for
proceedings consistent with this opinion.
24