Nicholson v. Commissioner IRS

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Precedential or Non-Precedential: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 1994-280

Argued: 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. 1994-280

at 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.

11

563-65 (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