Opposition Brief — Levien v. Commissioner

No. 95-1677

In the Supreme Court of the G

OCTOBER TERM, 1995

FRANCIS LEVIEN AND JANICE LEVIEN, PETITIONERS

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE ELEVENTH CIRCUIT

BRIEF FOR THE RESPONDENT IN OPPOSITION

DREW S. DAYS, II]

Solicitor General

LORETTA C. ARGRETT

Assistant Attorne Y¥ Gt nera

BRUCE R. ELLISEN

CAROL BARTHEL

Attorneys

Department of Justice

Washington, D.C. 20530

(202) 514-2217

QUESTION PRESENTED

Whether petitioner is “at risk” with respect to a

long-term note that he executed in a circular sale-

leaseback of computer equipment and is therefore

allowed to take deductions in excess of his cash in-

vestment under Section 465 of the Internal Revenue

Code, 26 U.S.C. 465.

TABLE OF CONTENTS

Page

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TABLE OF AUTHORITIES

Cases:

American Principals Leasing Corp. v. United

States, 904 F.2d 477 (9th Cir. 1990) ..........0000000... 7-8, 10.

Emershaw v. Commissioner, 949 F.2d 841 (6th Cir.

SPE cattails itincbidiakictbessikaivthesstbaesedeoresssevises easbinee 5, 8-9

Martuccio v. Commissioner, 30 F.3d 743 (6th Cir.

ER RR VE aA RAR Rae Pe EO es fa I 5,9

Moser v. Commissioner, 914 F.2d 1040 (8th Cir.

SES cocchsiguduhinvckiaiesas EE, SE OS aS Oe eR ee 8. 10

Thornock v. Commissioner, 94 T.C. 439 (1990) ....... ~

Waters v. Commissioner, 978 F.2d 1310 (2d Cir.

1992), cert. denied, 507 U.S. 1018 (1993) .............. 8, 9, 10

Waters v. Commissioner, cert. denied, 507 U.S.

a sabe adncsbonebaes 11

Young v. Commissioner, 926 F.2d 1083 (11th Cir.

a dsc ic scbadaunseeedannesoe 8, 10

Statutes and regulation:

Internal Revenue Code (26 U.S.C.):

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(III)

IV

Statutes and regulation—Continued: Page

aR a a a I NS ete tec oie et ea PERE 5

Tax Reform Act of 1976, Pub. L. No. 94-455, § 204(a),

ee a WE accdicccasaivcbdancinnscstducseioecushaiiadesciesalaced cine. 6

Tax Reform Act of 1986, Pub. L. No. 99-514, § 501(a),

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Be Cpa lie AE IEEE nde chéndereicemieceved ictbesncacbiicanias 1]

Miscellaneous:

H.R. Rep. No. 1445, 95th Cong., 2d Sess. (1978) ........ 6

S. Rep. No. 313, 99th Cong., 2d Sess. (1986) ............... 10

S. Rep. No. 938, 94th Cong., 2d Sess. (1976) ...... 6, 7, 9, 10

Staff of Joint Comm. on Taxation, 100th Cong.,

Ist Sess., General Explanation of the Tax Reform

Act Of 1966 (COMM. PINE TFET) ccvccecrcecccscccccessccssices 1]

In the Supreme Court of the Gnited States

OCTOBER TERM, 1995

No. 95-1677

FRANCIS LEVIEN AND JANICE LEVIEN, PETITIONERS

v.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE ELEVENTH CIRCUIT

BRIEF FOR THE RESPONDENT IN OPPOSITION

OPINIONS BELOW

The opinion of the court of appeals (Pet. App. la-2a)

is unofficially reported at 77 A.F.T.R.2d (RIA) 96-1009

and is noted at 77 F.3d 497 (Table). The opinion of the

Tax Court (Pet. App. 3a-27a) is reported at 103 T.C.

120.

JURISDICTION

The judgment of the court of appeals was entered on

January 22,1996. The petition for a writ of certiorari

was filed on April 16, 1996. The jurisdiction of this

Court is invoked under 28 U.S.C. 1254(1).

(1)

ho

STATEMENT

1. In December 1983, Aardan Leasing Corporation

acquired certain computer equipment in two transac-

tions. Aardan acquired some of the equipment from

Equilease Associates III Limited Partnership (Asso-

ciates) and the remainder of the computer equipment

from Equilease Equipment Brokerage C.V. (C.V.). In

each transaction, Aardan paid part of the purchase

price in cash and delivered a note for the balance.

Aardan acquired the equipment subject to (i) the

liens created when Associates and C.V. purchased the

equipment and (ii) the leases of the equipment that

had been entered into with end-users. Pet. App. 6a-7a.

The computer equipment originally had been pur-

chased with nonrecourse financing. Jd. at 12a.

Simultaneously with these transactions, petitioner

Francis Levien purchased an interest in the comput-

er equipment from Aardan for a total consideration of

$543,750.’ Petitioner paid cash of $11,250 and executed

two short-term notes in the amount of $21,875 each

and one long-term note in the amount of $488,750.

Petitioner’s personal liability under the long-term

note was limited to $325,000. Pet. App. 5a-6a. At the

same time, petitioner (together with the other owners

of interests in the equipment) leased the equipment

back to Associates and C.V. The lease agreements

provided fixed monthly rental payments for the terms

of the leases and provided that Associates and C.V.

would indemnify petitioner from any loss. Jd. at 7a-8a,

Lda.

Simultaneously with these transactions, petitioner

entered into an agreement with Aardan to secure

| Petitioner Janice Levien is a party because she filed joint

income tax returns with her husband for the years in issue.

payment on his notes to Aardan. Petitioner gave

security interests to Aardan in his interest in the

computer equipment and his rights under the lease

agreements with Associates and C.V. This included

the right to collect the rent due under those agree-

ments. The obligations of Associates and C.V. to pay

rent to petitioner were secured by assignments of

their rights to collect rent from their own sublessees.

Pet. App. 8a.

Simultaneously with these transactions, petitioner

and Equilease Corp., an affiliate of Associates and

C.V., entered into two “Capitalization Agreements”

under which Equilease agreed “to make all necessary

loans, advances or capital contributions to C.V. and

Associates, respectively, to ensure the payment by

C.V. and Associates” of rents to petitioner. Pet. App.

8a. The monthly rental payments due to petitioner

from Associates and C.V. precisely equalled the

obligation of petitioner to pay Aardan for the comput-

er equipment. That sum also equalled Aardan’s

monthly obligations to pay Associates and C.V. for

petitioner’s interest in the equipment. Similarly, the

monthly rental payments due to petitioner from C.V.

and Associates equalled the monthly payments that

he was obligated to make to Aardan on the long-term

note. Jd. at Ya.

2. Petitioner claimed deductions from the equip-

ment leasing transactions on his income tax returns

for 1983 and 1984. The Commissioner determined that

petitioner’s deductions were limited by Section 465 of

the Internal Revenue Code, which generally provides

that a taxpayer may deduct a loss from an activity

only to the extent that he is “at risk” for that ac-

tivity. Section 465(d) defines “loss,” for purposes of

the Section, as the excess of allowable deductions

allocable to an activity over the income from such

activity.

3. Petitioner sought review of the resulting

deficiencies in the Tax Court. The Tax Court, in a

reviewed opinion with no dissent, concluded that peti-

tioner was not “at risk” (within the meaning of Sec-

tion 465) with respect to the long-term note to Aardan

because that obligation was “protected against loss

through nonrecourse financing, guarantees, stop loss

agreements, or other similar arrangements.” 26

U.S.C. 465(b)(4). The Tax Court stated that, in deter-

mining whether a taxpayer is protected against loss

within the meaning of Section 465(b)(4), “we look to

see whether there is any realistic possibility that the

taxpayer ultimately will be subject to economic loss

on the investment at issue.” Pet. App. 10a. The

Tax Court rejected petitioner’s contention that the

“worst-case scenario,” rather than economic reality,

must be considered in applying Section 465(b)(4). Pet.

App. 18a-14a.

The Tax Court determined that the nonrecourse

underlying debt, the circular, matching debt vcbliga-

tions, and the indemnification provided to petitioner,

constituted an “arrangemert” under Section 465(b)(4)

of the Code by which petitioner was effectively pro-

tected against loss in connection with his debt. The

Tax Court noted that all monthly obligations were

exactly offset (including the rental obligations of

Associates and C.V. to petitioner and the other own-

ers, petitioner’s obligations to Aardan, and Aardan’s

obligations to Associates and C.V.) and that the pay-

ments were mutually extinguished by offsetting

bookkeeping entries. Pet. App. 12a. The court

observed that the transaction was circular, with a

middle entity (Aardan) connecting petitioner and the

third-party lessees (Associates and C.V.). Ibid. The

court concluded that it was “highly unlikely that any

one of the parties would refuse to meet an obligation”

since, “if one party failed to ‘pay’, he could only

expect a chain reaction resulting in his obligor’s

ceasing ‘payment’ as well.” Jbid. The court noted

that the rental payments of Associates and C.V. were

guaranteed by an affiliate, Equilease, and the under-

lying financing used by the companies from whom

Associates and C.V. purchased the computer equip-

ment was nonrecourse. /bid. Because petitioner was

“effectively immunized from any realistic possibility

of suffering an economic loss even though the under-

lying transaction was not profitable,” the Tax Court

concluded that petitioner was “protected against loss

within the meaning of section 465(b)(4).” Pet. App.

14a.”

4. The court of appeals affirmed (Pet. App. la-2a).

The court of appeals found itself in agreement with

the reasoning of the Tax Court and affirmed the Tax

Court’s judgment “for substantially the reasons set

out in its opinion.” Id. at 2a.

ARGUMENT

The decision of the court of appeals is correct. Al-

though the Sixth Circuit reached contrary decisions

in Emershaw v. Commissioner, 949 F.2d 841 (6th Cir.

1991), and Martuccio v. Commissioner, 30 F.3d 743

(6th Cir. 1994), there is no need for this conflict to be

resolved because the importance of “at risk” analysis

“ The Tax Court also determined that the leasing trans-

action was tax-motivated and that an increased rate of interest

on the underpayment was therefore required by 26 U.S.C.

6621(c). Pet. App. 14a-15a.

6

under Section 465 has been substantially diminished

by subsequent congressional enactment.

1. In 1976, Congress added Section 465 to the In-

ternal Revenue Code to combat increasing abuse of

tax benefits derived from the use of nonrecourse

financing. See Tax Reform Act of 1976, Pub. L. No.

94-455, § 204(a), 90 Stat. 1531; S. Rep. No. 938, 94th

Cong., 2d Sess. 45-51 (1976). Congress determined

that the use of nonrecourse financing and other risk-

limiting devices presented significant tax abuses, for

they permitted taxpayers to deduct amounts in excess

of their bona fide investment at risk in the

transaction. See id. at 47.

In order to prevent taxpayers engaged in. certain

activities from deducting losses in excess of their

actual economic investment in the activity, Section

465(a)(1) provides that a taxpayer engaged in an

activity to which Section 465 applies may deduct a

loss from that activity “only to the extent of the

aggregate amount with respect to which the taxpayer

is at risk * * * for such activity at the close of the

taxable year.” 26 U.S.C. 465(a)(1). A taxpayer's

amount “at risk” with respect to an activity is

generally the amount that he “could actually lose

from th[e] activity.” H.R. Rep. No. 1445, 95th Cong.,

2d Sess. 67 (1978). A taxpayer is generally considered

“at risk” to the extent of the cash and the adjusted

basis of property contributed to the activity (26

U.S.C. 465(b)(1)(A)), as well as any amounts borrowed

for use in the activity to the extent that the taxpayer

‘is personally liable for the repayment of such

amounts.” 26 U.S.C. 465(b)(2)(A). See S. Rep. No. 938,

supra, at 49. Under Section 465(b)(4) of the Code,

however, a taxpayer is not considered at risk with

respect to “amounts protected against loss through

nonrecourse financing, guarantees, stop loss agree-

ments, or other similar arrangements.” 26 U.S.C.

465(b)(4). See S. Rep. No. 938, supra, at 49-50.

The Tax Court (Pet. App. 10a-14a) and the court of

appeals (id. at la-2a) correctly determined in this case

that Section 465(b)(4) applies to any mechanism or

arrangement that has the effect of immunizing the

taxpayer from economic losses from the venture.

Because of the circular, offsetting sales and leases in

the present case—under which Associates and C.V.

were both the initial obligees (on the notes from

Aardan) and the ultimate obligors (on the lease from

petitioner and other interest owners)—the financial

viability of the transaction was not in any manner

dependent on Associates’ and C.V.’s rental payments

to petitioner. Indeed, because of Associates’ and

C.V.’s dual roles—which resulted from a series of

interrelated transactions that occurred on the same

day—Associates, C.V., Aardan, and petitioner could

continue to satisfy their circular monthly obligations

through offsetting bookkeeping entries. Because

no cash needed to change hands, Associates, C.V.,

Aardan, and petitioner could continue to satisfy their

respective monthly obligations by means of these

offsetting obligations even if the underlying leases to

end-users of the equipment were defaulted. The

circular, offsetting nature of these obligations, Asso-

ciates’ and C.V.’s agreement to indemnify petitioner,

Equilease’s guarantee of the rent payments due

petitioner, and the nonrecourse nature of the under-

lying debt, all effectively removed any realistic

possibility that petitioner would suffer an economic

loss from the transaction. Pet. App. 10a-14a.

Three other courts of appeals—the Ninth Circuit

in American Principals Leasing Corp. v. United

States, 904 F.2d 477 (9th Cir. 1990), the Eighth Circuit

in Moser v. Commissioner, 914 F.2d 1040 (8th Cir.

1990), and the Second Circuit in Waters v. Commis-

sioner, 978 F.2d 1310 (2d Cir. 1992), cert. denied, 507

U.S. 1018 (1993)—have reached the same conclusion

reached by the Eleventh Circuit in this case and in

Young v. Commissioner, 926 F.2d 1083 (11th Cir.

1991). Those courts have also held that Section

465(b)(4) applies to any arrangement that effectively

immunizes the taxpayer from incurring loss. In

those cases, the courts were faced with three-party

circular sales and leasebacks of computer equipment

that were essentially the same as the transaction

involved in the present case. All of these courts

concluded that the taxpayers involved were not “at

risk” because there was no realistic possibility that

the taxpayers would be required to satisfy their

notes. In reaching this conclusion, each of the courts

emphasized that the circular, offsetting nature of the

obligations ensured that the taxpayers would never be

required to satisfy personally their respective obli-

gations. See Waters v. Commissioner, 978 F.2d at

1317; Young v. Commissioner, 926 F.2d at 1089;

Moser v. Commissioner, 914 F.2d at 1049; American

Principals Leasing Corp. v. United States, 904 F.2d

at 483. See also Thornock v. Commissioner, 94 T.C.

439 (1990).

2. Petitioners correctly note (Pet. 5-6) that in

Emershaw v. Commissioner, 949 F.2d 841 (6th Cir.

1991), the Sixth Circuit interpreted Section 465(b)(4)

to deny “at risk” treatment for a transaction only

when a “collateral agreement” has been made with a

third party who is a stranger to the transaction that

protects the taxpayer from loss after the losses have

occurred. See Emershaw v. Commissioner, 949 F.2d

at 849. In Martuccio v. Commissioner, 30 F.3d 743

(6th Cir. 1994), the Sixth Circuit followed Emershaw

in another situation involving similar facts. As the

Second Circuit concluded in Waters v. Commis-

sioner, 978 F.2d at 1316, the Sixth Circuit’s interpre-

tation of Section 465(b)(4) is contradicted by the plain

language of the statute, which refers to “nonrecourse

financing” and “other similar arrangements” (26

U.S.C. 465(b)(4)). As the court stated in Waters,

“nonrecourse financing” is “ordinarily a prearrange-

ment to protect against loss.” 978 F.2d at 1316.

The Sixth Circuit’s interpretation of the statute is

also contrary to the fundamental premise of Section

465, which is that a taxpayer’s deductions should be

limited to the investment for which he is “at risk” (26

U.S.C. 465(a)). The object of the statute is “[t]o

prevent a situation where the taxpayer may deduct a

loss in excess of his economic investment.” S. Rep.

No. 938, supra, at 48. The Sixth Circuit erred in

Emershaw by placing emphasis on the statement in

the Senate Report that “an investor is not ‘at risk’ if

he arranges to receive insurance or other compen-

sation for an economic loss after the loss is sustained,

or if he is entitled to reimbursement for part or all of

any loss by reason of a binding agreement between

himself and another person” (S. Rep. No. 938, supra,

at 49). See 949 F.2d at 848-849. As the Second Circuit

stated in Waters, “[wJhile the Senate Report outlines

some arrangements that fall within § 465(b)(4), it does

not directly address the language of that provision or

purport to provide an exhaustive description of its

coverage.” 978 F 2d at 1316.

Petitioners contend (Pet. 6-7) that the court of

appeals erred in disregarding the “worst-case sce-

nario” test articulated by the Sixth Circuit in Emer-

10

shaw, i.e., the potential insolvency or bankruptcy of

Associates and C.V. The Senate Report, however,

indicates that the possibility that the party protec-

ting the taxpayer against loss “will fail to carry out

the agreement (because of factors such as insolvency

or other financial difficulty) is not to be material

unless and until” the time such event occurs. S. Rep.

No. 938, supra, at 50 n.6. For this reason, courts have

correctly rejected the suggestion that the “worst-

case scenario,” instead of economic reality, should be

the guide in determining whether the taxpayer is “at

risk” for purposes of Section 465. See Waters v.

Commissioner, 978 F.2d at 1317; Young v. Comm-

issioner, 926 F.2d at 1089; Moser v. Commissioner,

914 F.2d at 1049; American Principals Leasing Corp.

v. United States, 904 F.2d at 482.

3. The importance of the question presented in

this case has been substantially diminished by subse-

quent legislation. In 1986, Congress added Section

469 to the Internal Revenue Code to eliminate the

benefits of many traditional tax shelters. See Tax

Reform Act of 1986, Pub. L. No. 99-514, § 501(a), 100

Stat. 2233; S. Rep. No. 313, 99th Cong., 2d Sess. 713-

718 (1986). Effective for tax years beginning after De-

cember 31, 1986, Section 469 generally provides that

losses from a “passive” trade or business activity are

deductible only against income from that or another

passive activity, and cannot be deducted against other

income, such as salary, interest, dividends, and active

business income. See S. Rep. No. 313, supra, at 718-

719, 722; 26 U.S.C. 469(a). A “passive activity” is an

activity “in which the taxpayer does not materially

participate” and which involves the conduct of a trade

or business. 26 U.S.C. 469(c)(1). While Section 465

was designed te combat one of the significant features

1]

of the traditional tax shelter, the passive-loss limita-

tions of Section 469 respond directly to the sheltering

of income and prevent a taxpayer from reducing taxes

on income from one source with losses and excess

credits from another source.

The Section 469 passive-loss limitations are broad-

er in scope than those of Section 465 and have

effectively displaced analysis under that Section.

Even if a taxpayer is considered to be “at risk” with

respect to an investment, a loss may be claimed only

to the extent. that it is allowed by Section 469. See

Staff of Joint Comm. on Taxation, 100th Cong., Ist

Sess., General Explanation of the Tax Reform Act of

1986, at 223 & n.17 (Comm. Print 1987); 26 C.F.R.

1.469-2T(d)(6). For tax years beginning after 1986,

the passive-loss limitations thus bar deductions of the

type involved in the present case regardless of

whether the taxpayer is “at risk.” The question

addressed in this case, and in Emershaw, would thus

be inconsequential with respect to an identical

transaction entered into after December 31, 1986.*

* We note that the Court accordingly denied certiorari in

Waters v. Commissioner, 507 U.S. 1018 (1993), notwithstanding

the conflict between that decision and Emershaw.

12

CONCLUSION

The petition for a writ of certiorari should be

denied.

Respectfully submitted.

DREW S. DAYS, III

Solicitor General

LORETTA C. ARGRETT

Assistant Attorney General

BRUCE R. ELLISEN

CAROL BARTHEL

Attorneys

MAY i996