Peat Oil & Gas Assocs. v. Commissioner

Swift, J., concurring: Neither of the two U.S. Courts of Appeals that have already analyzed the precise investment herein, nor any of the other Courts of Appeals, have adopted and applied the “unified” generic tax shelter test of Rose v. Commissioner, 88 T.C. 386 (1987), affd. 868 F.2d 851 (6th Cir. 1989). 1 Even the majority’s opinion in this case indicates that “in the future”, majority op. p. 276, the Tax Court may decide not to follow the unified generic tax shelter test of Rose.

I would make that decision now. I would no longer follow Rose, and I would conclude that the test that should be utilized to evaluate the profit-objective element of passive tax-sheltered investments is the “actual and honest” profit-objective test reflected in so many of our recent opinions. As discussed below, I believe a “primary” profit-objective test, as suggested by Judge Ruwe in his concurring opinion — that is not found in the relevant statutory or regulatory scheme, that is in my opinion contrary to commercial and financial reality, and that has been utilized by the Supreme Court only in the context of evaluating whether an activity is in the nature of a hobby activity as distinguished from a trade or business activity — is too strict.

Over the years, in the context of analyzing passive, tax-sheltered investments, the courts have not been consistent in the language used to describe the quantity or level of profit objective that must be established: (1) Under section 183; (2) under the profit-objective aspect of the sham-transaction doctrine; and (3) under the profit-objective aspect of the economic-substance doctrine. The inconsistent profit-objective language that has been used has included, among other language, the following: “Basic”, “dominant”, “primary”, “predominant”, “substantial”, “reasonable”, “bona fide”, and “actual and honest”. As one court commented, we have been “glutted with tests. Many such tests proliferate because they give the comforting illusion of consistency and precision. They often obscure rather than clarify.” Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988), affg. Dister v. Commissioner, T.C. Memo. 1987-217 .

Some courts have used different, inconsistent language in the same opinion. For example, one recent opinion suggested that investors have to establish that they had a “dominant” profit objective, but also that “the determination crucial to the instant case [was] whether the taxpayers had an actual and honest profit objective.” Nickeson v. Commissioner, 962 F.2d 973, 976 (10th Cir. 1992), affg. Brock v. Commissioner, T.C. Memo. 1989-641 . Another opinion suggested that investors must show a “primary” profit objective, but then suggested that the test for sham-transaction purposes was whether “the transaction has any practicable economic effects other than” tax benefits. Bryant v. Commissioner, 928 F.2d 745, 748 (6th Cir. 1991) (emphasis added), affg. in part, revg. in part and remanding T.C. Memo. 1989-527 .

The Tax Court, however, in the last 5 years and with few exceptions — in evaluating passive, tax-sheltered investments and in an attempt to bring some uniformity to the language and the analysis associated with the determination of profit objective — has consistently stated the test relating to profit objective to be whether the investors had an “actual and honest” profit objective (or whether the investors had a “bona fide”, “good faith”, or “any” profit objective — language, in my opinion, synonymous with “actual and honest”). Generally, no particular attempt has been made by the Tax Court to quantify the amount of profit objective required (i.e., to disallow claimed tax benefits where the investors’ profit objective was actual and honest but not primary).

According to my research, in over 123 of the 131 Tax Court division and memorandum opinions issued since 1987 in which profit objective was at issue in the context of passive, tax-sheltered investments, we applied the “actual and honest” profit-objective test, or a synonymous test, in evaluating whether passive investors had the requisite profit objective. See, e.g., Krause v. Commissioner, 99 T.C. 132 (1992); Marine v. Commissioner, 92 T.C. 958 (1989), affd. without published opinion 921 F.2d 280 (9th Cir. 1991); McCrary v. Commissioner, 92 T.C. 827 (1989); Levy v. Commissioner, 91 T.C. 838 (1988); Antonides v. Commissioner, 91 T.C. 686 (1988), affd. 893 F.2d 656 (4th Cir. 1990); Soriano v. Commissioner, 90 T.C. 44 (1988); Fielding v. Commissioner, T.C. Memo. 1992-553 ; Universal Research and Dev. Partnership No. 1 v. Commissioner, T.C. Memo. 1991-437 ; Schwartz v. Commissioner, T.C. Memo. 1991-380 ; Berry v. Commissioner, T.C. Memo. 1991-145 ; Charlton v. Commissioner, T.C. Memo. 1990-402 ; Bukove v. Commissioner, T.C. Memo. 1989-588 ; Golden v. Commissioner, T.C. Memo. 1989-514 ; Keenan v. Commissioner, T.C. Memo. 1989-300 ; Brown v. Commissioner, T.C. Memo. 1988-527 .

The U.S. Courts of Appeals have been less consistent. Nearly every circuit, however, in at least one opinion, has utilized the “actual and honest” profit objective test (or a synonymous nonquantitative test) without any reference to a “primary” or “dominant” profit objective requirement. See, for example—

1st Circuit:

Estate of Power v. Commissioner, 736 F.2d 826 (1st Cir. 1984), affg. T.C. Memo. 1983-552

2d Circuit:

Schley v. Commissioner, 375 F.2d 747 (2d Cir. 1967), affg. T.C. Memo. 1965-111

3d Circuit:

Weir v. Commissioner, 109 F.2d 996 (3d Cir. 1940), affg. in part and revg. in part 39 B.T.A. 400 (1939)

4th Circuit:

Faulconer v. Commissioner, 748 F.2d 890 (4th Cir. 1984), revg. and remanding T.C. Memo. 1983-165 ; Malmstedt v. Commissioner, 578 F.2d 520, 527 (4th Cir. 1978), revg. T.C. Memo. 1976-46

6th Circuit:

Smith v. Commissioner, 937 F.2d 1089 (6th Cir. 1991), revg. 91 T.C. 733 (1988); Campbell v. Commissioner, 868 F.2d 833 (6th Cir. 1989), affg. in part, revg. in part and remanding T.C. Memo. 1986-569

7th Circuit:

Burger v. Commissioner, 809 F.2d 355 (7th Cir. 1987), affg. T.C. Memo. 1985-523 ; Glimco v. Commissioner, 397 F.2d 537, 540 (7th Cir. 1968), affg. T.C. Memo. 1967-119

8th Circuit:

Evans v. Commissioner, 908 F.2d 369 (8th Cir. 1990), revg. T.C. Memo. 1988-468

9th Circuit:

Hillendahl v. Commissioner, 976 F.2d 737 (9th Cir. 1992), affg. without published opinion Noonan v. Commissioner, T.C. Memo. 1986-449 ; Sochin v. Commissioner, 843 F.2d 351 (9th Cir. 1988), affg. Brown v. Commissioner, 85 T.C. 968 (1985)

10th Circuit:

Clark v. Commissioner, 951 F.2d 1258 (10th Cir. 1991), affg. without published opinion T.C. Memo. 1989-598

D.C. Circuit:

Cornfeld v. Commissioner, 797 F.2d 1049 (D.C. Cir. 1986), revg. and remanding T.C. Memo. 1984-105 ; Dreicer v. Commissioner, 665 F.2d 1292 (D.C. Cir. 1981), revg. and remanding T.C. Memo. 1979-395

I submit that the “primary” profit-objective test suggested by Judge Ruwe ignores the commercial and business reality that the tax laws affect the shape of most business transactions. Frank Lyon Co. v. United States, 435 U.S. 561, 580 (1978). The underlying activity on which a passive, tax-sheltered investment is typically structured generally constitutes an activity that carries with it (assuming it is not a sham) significant tax benefits. The availability of the tax benefits, or tax shelter, is often the reason the particular activity (e.g., equipment leasing) is selected in preference to an activity that does not carry with it significant tax benefits (e.g., undeveloped land). The presence, therefore, of significant tax benefits (that may even represent the investor’s primary objective for entering into the transaction) should not result in the loss of the associated tax benefits if the investor, in fact, has an actual and honest profit objective apart from the tax benefits (and assuming the transaction is not a sham).

We have expressly recognized the above proposition in a number of situations where Congress has made available particular tax benefits with the specific intent of providing investors special incentives to enter into investments that they might not otherwise enter into. See, e.g., Levy v. Commissioner, 91 T.C. 838, 853, 871-872 (1988); Friendship Dairies, Inc. v. Commissioner, 90 T.C. 1054, 1064 (1988); Estate of Thomas v. Commissioner, 84 T.C. 412, 432 (1985); Fox v. Commissioner, 82 T.C. 1001, 1021 (1984).

Respondent’s own “bible” on leveraged equipment-leasing transactions recognizes this proposition and requires only a nominal profit objective. See Rev. Proc. 75-21, 1975- 1 C.B. 715 , 716; see also Macan & Umbrecht, “Tax Aspects of Equipment Leasing”, in Equipment Leasing-Leveraged Leasing 313, 430-436 (Fritch et al. eds., 3d ed. 1988).

Similarly, in the instant case, which involves research and development activities, by enactment of section 174 and by making available certain tax benefits thereunder, Congress sought to “stimulate the search for new products and new inventions upon which the future economic and military strength of our Nation depends.” Snow v. Commissioner, 416 U.S. 500, 503 (1974). In reversing our opinion in Smith v. Commissioner, 937 F.2d 1089 (6th Cir. 1991), the Court of Appeals for the Sixth Circuit explicitly recognized that the exact same investment activity as the activity at issue in the instant case is a tax-favored investment under section 174, as follows:

Snow made it clear that “[s]ection 174 was enacted in 1954 to dilute some of the conception of ‘ordinary and necessary’ business expenses under section 162(a).” * * * We deem the kind of enterprise to develop the Koppelman process and K-Fuel reactors as a type of “small” and “upcoming” partnership enterprise encouraged in Snow. [Smith v. Commissioner, 937 F.2d 1089, 1097-1098 (6th Cir. 1991); citations omitted.]

See also Diamond v. Commissioner, 930 F.2d 372, 374 (4th Cir. 1991), affg. 92 T.C. 423 (1989); Green v. Commissioner, 83 T.C. 667, 686 (1984).

Judge Ruwe’s concurring opinion cites the Supreme Court’s opinion in Commissioner v. Groetzinger, 480 U.S. 23 (1987), as support for his suggestion that we should require taxpayers to prove a “primary” profit objective in analyzing the allowability of tax benefits associated with passive, tax-sheltered investments. In Commissioner v. Groetzinger, supra at 35 , the Supreme Court utilized a “primary” profit-objective test to ascertain whether a taxpayer was engaged in the active conduct of a gambling trade or business activity or whether the taxpayer’s gambling activity was merely a hobby. As stated by the Supreme Court, “the taxpayer’s primary purpose for engaging in the activity must be for income or for profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.” Id. 2

The hobby-loss issue in Groetzinger is distinguishable from issues arising in the context of tax-sheltered investments, and as suggested in Snyder v. United States, 674 F.2d 1359, 1363 (10th Cir. 1982), the primary profit-objective test should only apply when distinguishing between a hobby and a trade or business activity. See also Carkhuff v. Commissioner, 425 F.2d 1400, 1404 (6th Cir. 1970), affg. T.C. Memo. 1969-66 ; Schley v. Commissioner, supra at 750. As noted in Johnson v. United States, 11 Cl. Ct. 17, 27 (1986), “the predominant profit motive cases under section 162 have importance only in the ‘hobby loss’ context, and do not control in a business situation” and a primary profit-objective test is not supported by relevant statutory language or legislative history.

Continuing, the Claims Court explained—

Economic and tax motives regularly operate side by side to influence business transactions, and it would be unfair and contrary to the realities of the marketplace to apply a “primary or dominant” test to them. * * *

[Johnson v. United States, 11 Cl.Ct. at 27 .]

As observed by the Court of Appeals for the Fourth Circuit in Faulconer v. Commissioner, 748 F.2d 890 , 895-896 n.10 (4th Cir. 1984), neither section 183 nor the regulations thereunder require a “primary” or “dominant” profit objective. All that is required is “a profit” objective.

In summary, in my opinion, Judge Ruwe’s suggested “primary” profit-objective test should not apply in this case (involving tax benefits claimed under section 174), and such a test should not apply generally to typical passive, tax-sheltered investments that are structured largely on the basis of the extensive tax benefits that Congress has made available.

If a tax-sheltered investment is a sham, if it has no economic substance, if the investor had no actual and honest profit objective, or so negligible a profit objective that it should be ignored, let the courts so find, and let the courts reject the claimed tax benefits. But I would spare us, other courts, the IRS, and the tax bar, the task of evaluating whether, for example, a $5,000 before-tax profit when compared to $20,000 of tax benefits provides a sufficient nontax profit for one investor but not for another.

Wells and Whalen, JJ., agree with this concurring opinion. See Nickeson v. Commissioner, 962 F.2d 973, 976 (10th Cir. 1992), affg. Brock v. Commissioner; T.C. Memo. 1989-641 ; Hunt v. Commissioner, 938 F.2d 466 , 471 n.5 (4th Cir. 1991), affg. T.C. Memo. 1989-660 ; Smith v. Commissioner, 937 F.2d 1089 (6th Cir. 1991); revg. 91 T.C. 733 (1988); Karr v. Commissioner, 924 F.2d 1018, 1023 (11th Cir. 1991), affg. Smith v. Commissioner, 91 T.C. 733 (1988); Rose v. Commissioner, 868 F.2d 851, 853 (6th Cir. 1989), affg. 88 T.C. 386 (1987) (Court reviewed); Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988), affg. Dister v. Commissioner, T.C. Memo. 1987-217 .

It has been noted that “The primary standard first appeared as a judicial gloss on the statutory language of section 165(c)(2) in Helvering v. National Grocery Co., 304 U.S. 282 (1938), * * * [a] case unrelated to section 165(c)(2) and the reference to section 23(e) (predecessor to section 165(c)(2)) was made in order to support the proposition that ‘The instances are many in which purpose or state of mind determines the incidence of an income tax’.” Fox v. Commissioner, 82 T.C. 1001, 1018 (1984) (citations omitted); see also Dewees v. Commissioner, 870 F.2d 21, 33 (1st Cir. 1989), affg. Glass v. Commissioner, 87 T.C. 1087 (1986); Miller v. Commissioner, 84 T.C. 827, 851-852 (1985) (Simpson, J., dissenting), revd. 836 F.2d 1274 (10th Cir. 1988); Thurner v. Commissioner, T.C. Memo. 1990-529 .