Petition for Writ of Certiorari — Waters v. Commissioner

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No. nm 7 1993

IN THE

Supreme Court of the United States

OCTOBER TERM, 1992

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JOHN J. WATERS and JEANNE M. WATERS,

Petitioners,

—Yy.—

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

STEPHEN D. GARDNER

Counsel of Record

ANN-ELIZABETH PURINTUN

PETER L. ENTE

KRONISH, LIEB, WEINER & HELLMAN

Attorneys for Petitioners

1345 Avenue of the Americas

New York, New York 10105-0202

(212) 841-6000

QUESTION PRESENTED

Whether the Court of Appeals erred when it failed to con-

sider the potential insolvency or bankruptcy of the taxpayer's

lessee in determining whether the taxpayer was “protected

against loss” within the meaning of section 465(b)(4) of the

Internal Revenue Code with respect to the negotiable recourse

promissory note he executed to purchase the computer equip-

ment that he leased to the lessee.

TABLE OF CONTENTS

PAGE

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2. ‘Tee Deceit Bw kines ee 6

REASONS FOR GRANTING THE WRIT ................ 7

1. The Court of Appeals Misinterpreted Section

465(b)(4) and Its Legislative History........... 7

2. There Is a Conflict Among the Circuits Which

This Court Showld ROSIE... ......cccsunacesseces 13

CAPRA AP IU, 6a 50 i knw cdg daedacase be ces eee ane eee 16

APPENDIX

Opinion of the Court of Appeals..................... la

Opinion of the United States Tax Court.............. 20a

Judgment of the Court of Appeals ................... 40a

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TABLE OF AUTHORITIES

Cases PAGE

American Principals Leasing Corp. v. United States,

ee cee SEF CPR AE, TIPU) cc cceseecccccess 10, 13, t4

Brady v. Commissioner, T.C. Memo. 1990-626,

a 15

Emershaw v. Commissioner, T.C. Memo. 1990-246,

59 T.C.M. (CCH) 621, aff’ d, 949 F.2d 841

ee ie ae ee aa eaasae cassie ere e 15

Emershaw v. Commissioner, 949 F.2d 841

Tee dak S hea Aaae ned eraviacs 7,14

Moser v. Commissioner, 914 F.2d 1040 (8th Cir. 1990)... 14

Thornock v. Commissioner, 94 T.C. 439 (1990)........... 15

Van Roekel v. Commissioner, T.C. Memo. 1989-74,

WE occ ack cenesdaccnsaKasasesws's 15

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

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Statutes

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

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PAGE

Legislative History

S. Rep. No. 938 (Part 1), 94th Cong., 2d Sess. (1976),

[reprinted in 1976 U.S.C.C.A.N. 3439] ............ 8, 11

Miscellaneous

Isadore Barmash, Bankruptcy Petition is Filed by O.P.M..,

ee ae ee eee 9

Creditors Accept Itel Reorganization, N.Y. Times, May

als a OE MS is oe deck cae CRS RARER SORA ERVILS 9

James J. White & Robert S. Summers, Uniform Commer-

CE Ge Re PE ea sxca ce Ricks hws ac euterccees 10

Melinda Wilson, CM/ Corp. Owner Files for Chapter 11,

Crains Detroit Business, January 23, 1989, at3 ..... 9

No.

IN THE

Supreme Court of the Hnited States

‘ OCTOBER TERM, 1992

JOHN J. WATERS and JEANNE M. WATERS,

Petitioners,

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITES STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

John J. Waters and Jeanne M. Waters respectfully petition for

a writ of certiorari to review the decision of the United States

Court of Appeals for the Second Circuit in this case.

OPINIONS BELOW

The opinion of the Court of Appeals (App. 1a-19a),

___ ~ F.2d ____, is unofficially reported at 1992-2 U.S.T.C.

(CCH) ¥ 50,547. The opinion of the United States Tax Court

(App. 20a-39a), T.C. Memo. 1991-462, is unofficially reported

at 62 T.C.M. (CCH) 778.

JURISDICTION

The judgment of the Court of Appeals (App. 40a) was

entered on October 21, 1992. The jurisdiction of this Court is

invoked under 28 U.S.C. § 1254(1).

STATUTE INVOLVED

A conflict among the Circuits exists with respect to the

meaning of section 465(b)(4) of the Internal Revenue Code,

26 U.S.C. § 465(b)(4). Section 465 provides in pertinent part:

§ 465. Deductions limited to amount at risk

(a) Limitation to amount at risk.—

(1) In general.—In the case of—

(A) an individual

~ * *

engaged in an activity tc which this section applies, any

loss from such activity for the taxable year shall be

allowed only to the extent of the aggregate amount with

respect to which the taxpayer is at risk (within the mean-

ing of subsection (b)) for such activity at the close of the

taxable year.

* * *

(b) Amounts considered at risk. —

(1) In general.—-For purposes of this section, a tax-

payer shall be considered at risk for an activity with

respect to amounts including—

(A) the amount of money and the adjusted basis

of other property contributed by the taxpayer to the

activity, and

(B) amounts borrowed with respect to such activ-

ity (as determined under paragraph (2)).

(2) Borrowed amounts.—For purposes of this section,

a taxpayer shall be considered at risk with respect to

amounts borrowed for use in an activity to the extent that

he—

(A) is personally liable for the repayment of such

amounts, or

(B) has pledged property, other than property used

in such activity, aS security for such borrowed

amount (to the extent of the net fair market value of

the taxpayer’s interest in such property).

No property shall be taken into account as security if such

property is directly or indirectly financed by indebtedness

which is secured by property described in paragraph (1).

* * *

(4) Exception.—Notwithstanding any other provision

of this section, a taxpayer shall not be considered at risk

with respect to amounts protected against loss through

nonrecourse financing, guarantees, stop loss agreements,

or other similar arrangements.

* ” *

STATEMENT OF THE CASE

By this petition, the petitioners seek a determination by this

Court of the legal test for whether a taxpayer is “at risk” for

federal income tax purposes with respect to a negotiable

recourse promissory note issued by the taxpayer to purchase

equipment that the taxpayer then leases to an affiliate of the

payee of the note. The Court of Appeals below applied its own

business judgment to evaluate the business risks of the tax-

payer’s equipment leasing transaction instead of analyzing the

rights and obligations of the parties to the transaction to deter-

mine whether the taxpayer would have been exposed to eco-

nomic loss if the transaction had gone sour. The petitioners

contend that if a taxpayer is unconditionally liable on a note

and does not have the benefit of any protective arrangement

that will insulate him from loss if his lessee becomes insolvent

or bankrupt, the taxpayer is “at risk.”” The fact that the taxpayer

will not suffer any economic loss if the lessee remains solvent

and makes all rent payments is not a basis for holding that the

taxpayer is not “at risk.”

This Court should resolve a conflict among the Circuits on

this issue so that taxpayers are subject to consistent legal stan-

dards instead of the vagaries of the courts’ business judgment.

1. Material Facts. Mr. and Mrs. Waters, husband and wife,

filed joint federal income tax returns for 1982, 1983, 1984 and

1985. On those returns they claimed losses attributable to Mr.

Waters’ leasing of peripheral computer equipment to Equitable

Financial Management, Inc. (“Equitable”). (App. 4a, 28a)

Equitable, a general equipment leasing co; ~=ny, had orig-

inally purchased the equipment from the if/ sufacturer, ITT-

Courier Terminal Systems, Inc., for ©2°8,775. Equitable

financed its purchase of the equipment by ®urrowing, on a non-

recourse basis, from a bank. The bank loan was collateralized

by a security interest in the equipment and by an assignment of

the lease payments due under all end-user leases of the equip-

ment. (App. 4a, 21a-22a)

Equitable leased the equipment to Duquesne Light Company

(“Duquesne”) for an initial term of five years and seven

months. The lease payments essentially matched Equitable’s

payments on the bank loan. (App. 5a, 23a)

Equitable subsequently sold the equipment, subject to the

Duquesne lease and the bank lien, to an affiliate, Cooper Leas-

ing Corp. (“Cooper Leasing”), for $298,000. The purchase

price was paid with a cash payment of $1,000 and a recourse

promissory note in the amount of $297,000. In addition to

monthly payments for eight yeas and four months, the note

called for cash payments (designated as interest payments) in

the amounts of $10,000 upon execution, $26,643 six months

later, and $27,720 one year after that. (App. 5a, 23a-24a)

Simultaneously with the sale of the equipment by Equitable

to Cooper Leasing, Mi. Waters and Geraid A. Moffatt each pur-

chased a fifty percent undivided interest in the equipment, sub-

ject to the Duquesne lease and the bank lien, from Cooper

Leasing for $150,000. Each made a cash payment of $1,500

and executed a negotiable recourse promissory note in the

amount of $148,500. (App. 6a, 25a)

Contemporaneously with their purchase of the equipment,

Messrs. Waters and Moffatt leased the equipment to Equitable

for a term of eight years and four months. The monthly rental

payments due from Equitable under the lease essentially

matched the monthly note payments due from Messrs. Waters

and Moffatt to Cooper Leasing (and the monthly note payments

due from Cooper Leasing to Equitable). In addition to monthly

payments for eight years and four months, Messrs. Waters’ and

Moffatt’s notes each called for cash payments (designated as

intesest payments) in the amounts of $5,000 upon execution,

$13,322 six months later, and $13,860 one year after that.

There were no rental payments under the lease corresponding

to these interest payments. (App. 6a-7a, 25a-26a) Mr. Waters

made all payments called for by his note. (App. 28a)

The following diagram outlines the structure of the trans-

action in which Mr. Waters participated:

Loan Sale of

Bank Equipment Cooper

> Leasing

: I

User

Lease Note

Rent

Sale of 1 I

Equipment ee Note | | Sale of

ITT-Courier [74 -— 4 Equipment

Loan '

Proceeds a

Rent H

< »

D ‘

uquesne | User Lease Lease of Waters/

: Moffatt

Equipment

The Commissioner of Internal Revenue (the “Commis-

sioner”) disallowed the losses attributable to Mr. Waters’ com-

puter equipment leasing activity. Mr. and Mrs. Waters

petitioned the United States Tax Court for review of the Com-

missioner’s disallowance.

2. The Decisions Below. The Tax Court held that, contrary

to the Commissioner’s determinations, (i) Mr. Waters’ purchase

and lease of the computer equipment “was not a sham trans-

action lacking in economic substance” (App. 37a); (ii) Mr.

Waters had “an actual and honest profit objective for entering

into the transaction” (/d.); and (iii) Mr. Waters “acquired own-

ership of the computer equipment” (App. 38a).

The Tax Court also concluded that Mr. Waters was not “at

risk” with respect to the negotiable recourse promissory note

he executed in connection with his purchase of the computer

equipment because he was “protected against loss” within the

meaning of section 465(b)(4) of the Internal Revenue Code.

(App.30a) Mr. and Mrs. Waters appealed the “at risk” issue to

the Court of Appeals. The Commissioner did not appeal the

Tax Court’s determinations in Mr. Waters’ favor.

The Court of Appeals affirmed the decision of the Tax Court,

ruling that for purposes of determining whether a taxpayer is

“protected against loss,” only “year-end economic realities” are

to be considered. (App. 18a) Applying that standard, the Court

of Appeals concluded that at the close of the tax years in issue,

based on the cumulative effect of the underlying nonrecourse

bank debt, the matching lease and note payment obligations,

and a standard lessee indemnity contained in the Equitable

lease, Mr. Waters “did not face any realistic possibility of loss

from his Equipment-leasing activity” and therefore “was not ‘at

risk’ in those years. . . with respect to his promissory note to

Cooper Leasing.” (App. 18a-19a)

The Court of Appeals acknowledged that the Sixth Circuit

uses a different analysis to determine whether a taxpayer is

protected against loss within the meaning of section 465(b)(4).

(App. 13a) The Sixth Circuit examines the taxpayer’s economic

exposure under the “worst-case scenario”: Could the taxpayer

suffer a loss if his lessee becomes insolvent or bankrupt and

ceases to pay rent? If the answer is yes, the taxpayer is not pro-

tected against loss and is therefore “at risk.” See Emershaw v.

Commissioner, 949 F.2d 841, 845 (6th Cir. 1991).

REASONS FOR GRANTING THE WRIT

1. The Court of Appeals Misinterpreted Section 465(b)(4)

and Its Legislative History. Section 465 of the Internal Revenue

Code is designed to prevent taxpayers engaged in certain activ-

ities, including equipment leasing, from deducting tax losses in

excess of their potential economic losses from the activity.

S. Rep. No. 938 (Part I), 94th Cong., 2d Sess. 48 (1976),

reprinted in 1976 U.S.C.C.A.N. 3439, 3483. For any given tax

year, deductible losses are limited to the amount for which the

taxpayer is “at risk”—and which the taxpayer could actually

lose—in connection with the activity. 26 U.S.C. § 465(a)(1).

Generally, a taxpayer is at risk to the extent of cash invested

in the activity, plus borrowed amounts for which the taxpayer

is personally liable. 26 U.S.C. §§ 465(b)(1), (2). Section

465(b)(4) provides, however, that notwithstanding the general

rule, a taxpayer shall not be considered at risk with respect to

“amounts protected against loss through nonrecourse financing,

guarantees, stop loss agreements, or other similar arrange-

ments.” Thus, section 465(b)(4) is concerned with distin-

guishing between taxpayers who have insulated themselves

from economic exposure and those who have not.

In this case, Mr. Waters’ negotiable purchase money note

was fully recourse. Mr. Waters’ obligation to pay the note was

unconditional, whether or not he received rent payments from

Equitable, his lessee. Nevertheless, the Court of Appeals ruled

that the cumulative effect of certain features of the transaction

in which Mr. Waters participated constituted an “other similar

arrangement” that protected him against loss. Essentially, the

Court of Appeals concluded that the protection against loss

resulted from the “circular” payment obligations of Messrs.

Waters and Moffatt, Cooper Leasing and Equitable. (App. 15a-

16a)

The Court of Appeals reasoned:

The payments on Waters’ nominally recourse notes were

essentially identical to the payments Waters was entitled

to receive from Equitable on its lease. . . .

. Although it is theoretically possible that one of

the parties might have broken the chain of payments, there

appears to have been no reason for this to occur.

. . . [I]f Equitable stopped making payments on its

lease, it could only have expected a chain reaction result-

ing in Waters and Moffatt, and then Cooper Leasing, ceas-

ing to make payments as well. Any ensuing litigation

would similarly have resulted in a chain reaction. Whether

Or not a litigant would be entitled to setoff in a particular

court action, it is clear that once the dust settled, the

claims among the parties would have cancelled each other

out.

The analysis of the Court of Appeals is flawed. In deter-

mining whether Mr. Waters was protected against loss, the

Court of Appeals disregarded the potential insolvency or

bankruptcy of Equitable. If Equitable had stopped making pay-

ments on its lease because it was unable to make the payments,

it is far from clear that “once the dust settled, the claims among

the parties would have cancelled each other out.” On the con-

trary, once the dust settled Mr. Waters would have paid his note

to Cooper Leasing, but he might have been unable to collect

anything on his claim against an insolvent Equitable.

The unfortunate reality is that, since the early 1980’s, many

equipment leasing companies have filed for bankruptcy pro-

tection. See, e.g., Isadore Barmash, Bankruptcy Petition is

Filed by O.P.M., N.Y. Times, March 12, 1981, at D1; Creditors

Accept Itel Reorganization, N.Y. Times, May 25, 1982, at D4;

Melinda Wilson, CM/ Corp. Owner Files for Chapter 11,

Crains Detroit Business, January 23, 1989, at 3. If Equitable

had been in bankruptcy, it could have rejected the lease of the

equipment from Messrs. Waters and Moffatt pursuant to section

365 of the Bankruptcy Code, 11 U.S.C. § 365. Payment of rent

would have ceased after rejection, but rejection would not have

absolved Mr. Waters of his recourse liability to Cooper Leas-

ing. Rejection of the lease wouid have broken the circle of pay-

ments, leaving Mr. Waters fully exposed on his note. Equitable

would have been required to enforce Cooper Leasing’s note for

the benefit of its creditors, and Cooper Leasing would have

enforced Mr. Waters’ note. Mr. Waters would have had only a

pre-petition general claim against Equitable for breach of the

lease. See 11 U.S.C. § 365(g). That claim might have yielded

little or nothing.

Moreover, Mr. Waters’ purchase money note was fully nego-

tiable. If Cooper Leasing had negotiated Mr. Waters’ note to a

holder in due course, the circle of payment obligations would

have been broken, the relationship between Cooper Leasing

and Equitable would have been irrelevant, and any purported

protection against loss would have vanished. See James J.

White & Robert S. Summers, Uniform Commercial Code

§ 14-9 (3d ed. 1988). Mr. Waters would have had to make pay-

ments on his note without regard to what he received from

Equitable.

The lease of the equipment to Equitable provided Mr. Waters

with a source of payments with which to Satisfy his obligations

on his purchase money note. The “protection” provided by the

lease would last just as long as the stream of rental payments

continued. If the rental income stream dried up, there was no

“arrangement” protecting Mr. Waters against loss on his fully

recourse note.

The Court of Appeals held that section 465(b)(4) “operates

‘to suspend at risk treatment where a transaction is struc-

tured—by whatever method—to remove any realistic possi-

bility that the taxpayer will suffer an economic loss if the

transaction turns out to be unprofitable.’ (App. 15a (quoting

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

477, 483 (9th Cir. 1990); other citations omitted) (emphasis

added)) But, in fact, the Court of Appeals never analyzed what

would have happened if the transaction in which Mi. Waters

participated had tumed out to be unprofitable because Equi-

table was unable to pay rent.

The Court of Appeals correctly concluded that, as long as the

transaction did not tum sour, it was unlikely Mr. Waters would

be called on to pay his note from his personal resources. But

instead of recognizing what would have happened if the trans-

action had gone sour, the Court of Appeals, in effect, required

Mr. Waters to demonstrate a “realistic possibility” that the

transaction would go sour. That is not the correct construction

of section 465(b)(4). Section 465 does not require a taxpayer

to make a bad investment in order to be at risk. The taxpayer

need only be exposed to economic loss if the investment turns

Out to be bad. Whether Mr. Waters was at risk does not depend

on the degree of probability of a default by Equitable in pay-

ment of rent. It depends on whether, if there was a rent default,

Mr. Waters was protected against loss on his note. Mr. Waters

had no such protection in the event the rent was not paid.

The single most significant risk to a lessor of equipment is

the risk of the lessee’s default. Generally speaking, lessees do

not default on a whim. They default because they are in finan-

cial difficulty. Nevertheless, the Court of Appeals mistakenly

believed that the legislative history of section 465 precluded

any consideration of Equitable’s potential insolvency in eval-

uating whether Mr. Waters was protected against loss.

The Court of Appeals relied on a single footnote in the leg-

islative history. That footnote states:

For purposes of [section 465(b)(4)], it will be assumed

that a loss-protection guarantee, repurchase agreement or

insurance policy will be fully honored and that the

amounts due thereunder will be fully paid to the taxpayer.

The possibility that the party making the guarantee to the

taxpayer, or that a partnership which agrees to repurchase

a partner's interest at an agreed price, 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 when the taxpayer becomes unconditionally

entitled to payment and, at that time, demonstrates that he

cannot recover under the agreement.

S. Rep. No. 938 (Part I), 94th Cong., 2d Sess. 50 n.6 (1976),

reprinted in 1976 U.S.C.C.A.N. 3439, 3486 n.6.

The footnote mentions three different “collateral” arrange-

ments (a guarantee, a repurchase agreement and an insurance

policy) that can protect a taxpayer against loss if a transaction

turns out to be unprofitable. There is only one reasonable way

to read the footnote: In determining whether the taxpayer is

protected against loss, it must be assumed that such a collateral

loss-limiting arrangement will be honored if the transaction

itself goes sour.

Section 465(b)(4) is intended to distinguish between tax-

payers who have protected themselves by entering into loss-

limiting arrangements and those who have not. The risk that a

collateral loss-limiting arrangement will not be honored always

exists. If that possibility were sufficient to preclude protection

against loss, section 465(b)(4) would never have any applica-

tion. A taxpayer could never be protected against loss.

The case is very different where it is the structure of the tax-

payer’s transaction itself that purportedly provides protection

against loss. Congress cannot have intended the language in its

footnote to preclude consideration of the potential insolvency

or bankruptcy of a party on which the financial viability of the

taxpayer’s transaction depends. To read the footnote in that

way is to impute to Congress a logical inconsistency: A tax-

payer is at risk if he will bear the economic loss should the

transaction go sour; but in determining whether the taxpayer is

at risk, the possibility that the transaction will go sour cannot

be considered.

No taxpayer will lose economically if the transaction in

which he participates turns out well. The at-risk analysis is

concerned with the taxpayer’s economic exposure if the trans-

action tums out badly. In evaluating whether a taxpayer is at

risk, therefore, the potential insolvency or bankruptcy of a key

participant in the transaction (in this case, Equitable, the lessee

of the equipment from Mr. Waters) must be considered.

By failing to take into account the potential insolvency or

bankruptcy of Equitable, the Court of Appeals adopted an

approach that is not only logically flawed but also adminis-

tratively unworkable. The “realistic possibility” and “year-end

economic realities” touchstones adopted by the Court of

Appeals demand an annual economic analysis of the likelihood

that the transaction will go sour. Neither taxpayers nor the

Internal Revenue Service can reasonably be expected to under-

take such analyses. The courts cannot be expected to review

them. By contrast, the analysis required by the footnote in the

legislative history of section 465(b)(4) is modest indeed. Only

when the basic transaction has in fact gone sour and the tax-

payer becomes unconditionally entitled to payment under a col-

lateral loss-limiting arrangement does the taxpayer’s inability

to collect become relevant.

It is not the function of the courts to apply their own busi-

ness judgment to evaluate the business risks of a taxpayer’s

transaction. That the courts are ill-equipped to do so is amply

demonstrated by the opinion of the Court of Appeals, which is

replete with a priori judgments about the degree of risk to

which Mr. Waters was exposed. See, e.g., App. 15a (“there was

no realistic possibility that Waters would suffer an economic

loss”; “the virtual identity of the composition and control of

Equitable and Cooper Leasing . . . belies any likelihood that

Equitable would have stopped making lease payments”;

“{ajlthough it is theoretically possible that one of the parties

might have broken the chain of payments, there appears to have

been no reason for this to occur”); App. 16a (“the possibility

that Cooper Leasing would negotiate Waters’ note [was] more

theoretical than realistic’’). The opinion of the Court of Appeals

does not reveal any empirical basis for these judgments.

2. There Is a Conflict Among the Circuits Which This Court

Should Resolve. The decision of the Court of Appeals below,

and the decisions in American Principals Leasing Corp. v.

United States, 904 F.2d 477 (9th Cir. 1990), and Young v. Com-

missioner, 926 F.2d 1083 (11th Cir. 1991), cannot be reconciled

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

1991).*

The majority opinion in Emershaw (like the dissenting opin-

ion in American Principals) considers the “worst-case scenario”

in determining whether a taxpayer is protected against loss

within the meaning of section 465(b)(4). It analyzes who has the

ultimate financial exposure if the transaction goes sour. It rec-

Ognizes that economic exposure is created by commercial law

and that the determination of whether a taxpayer has limited his

economic exposure requires consideration of the rights and obli-

gations created by local law and by federal bankruptcy law.

In contrast, the decision below, the majority opinion in

American Principals, and the decision in Young frame the ques-

tion differently: Is there a realistic possibility that the taxpayer

will suffer an economic loss if the transaction turns out to be

unprofitable? These decisions purport to evaluate the degree of

the taxpayer’s economic exposure. But they focus so exclu-

sively on the notion of “realistic possibility” that they forget

the other part of the question—“‘if the transaction turns out to

be unprofitable.” In misguided reliance on a Congressional

footnote dealing with loss-limiting arrangements collateral to

the taxpayer’s transaction, they refuse to consider the possi-

bility that the transaction itself will go sour.

Moreover, litigation in the Tax Court involving the appli-

cation of section 465(b)(4) has become a “crap shoot.” On facts

” The Eighth Circuit's decision in Moser v. Commissioner, 914 F.2d

1040 (8th Cir. 1990), is factually distinguishable from the present case

and from American Principals, Young and Emershaw, although the Court

of Appeals did not recognize the distinction. In Moser, Finalco sold com-

puter equipment, subject to an end-user lease, to Lease Pro for cash and

Lease Pro’s obligation to deliver promissory notes. Lease Pro sold the

computer equipment, subject to the end-user lease, to the taxpayers, who

leased the computer equipment to Finalco. Finalco released Lease Pro

from its obligation to deliver its own promissory notes in exchange for

delivery to Finalco of the taxpayers’ notes. That release extinguished the

three-party nature of the transaction and gave the taxpayers a direct right

of setoff in the event Finalco defaulted on its rental obligations under its

lease of the equipment.

that are not materially distinguishable, decisions have been

anything but consistent. Compare, e.g., Brady v. Commissioner,

T.C. Memo. 1990-626, 60 T.C.M. (CCH) 1415, 1419-21, and

Emershaw v. Commissioner, T.C. Memo. 1990-246, 59 T.C.M.

(CCH) 621, 630-31, aff'd, 949 F.2d 841 (6th Cir. 1991), with

Thornock v. Commissioner, 94 T.C. 439, 449-54 (1990), and

Van Roekel v. Commissioner, T.C. Memo. 1989-74, 56 T.C.M.

(CCH) 1297, 1307-08. In each of these cases the underlying

debt was nonrecourse, the transaction was structured to provide

for circular payments and there was some sort of guarantee by

a participant (or a party related to a participant) of the rent due

under the taxpayer's lease of the equipment. The court’s “anal-

ysis” in Brady consisted of a comparison of the facts of that

case with those of Emershaw and Van Roekel. Without expla-

nation, concluding that the facts were closer to those in Emer-

shaw than to those in Van Roekei, the court in Brady found that

the taxpayer was not protected against loss. 60 T.C.M. at 1421.

Emershaw explicitly considered the potential bankruptcy of the

lessee of the equipment in determining whether the taxpayer

was protected against loss. 59 T.C.M. at 631. Consideration of

the lessees’ potential bankruptcy was explicitly rejected by the

court in both Thornock, 94 T.C. at 454, and Van Roekel, 56

T.C.M. at 1308.

Unless the conflict is resolved by this Court, section

465(b)(4) will be applied in such a way as to cause disparate

tax treatment based upon the happenstance of a taxpayer’s geo-

graphic location, and chaos will continue to reign in the Tax

Court.

CONCLUSION

For the foregoing reasons, the petition for a writ of certiorari

should be granted.

Respectfully submitted,

/s/ STEPHEN D. GARDNER

STEPHEN D. GARDNER

Counsel of Record

ANN-ELIZABETH PURINTUN

PETER L. ENTE

KRONISH, LIEB, WEINER & HELLMAN

Attorneys for Petitioners

1345 Avenue of the Americas

New York, NY 10105-0202

(212) 841-6000

January 6, 1993

APPENDIX

eae CN Ae ee ee

or oe

UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

No. 1512—August Term, 1991

(Argued: May 5, 1992 Decided: October 21, 1992)

Docket No. 92-4023

JOHN J. WATERS and JEANNE M. WATERS,

Petitioners-Appellants,

—_VvV.—

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

Before:

PRATT, MAHONEY, and MCLAUGHLIN,

Circuit Judges.

Appeal from a decision of the United States Tax Court,

Stephen J. Swift, Judge, which held that a taxpayer was

not “at risk” within the meaning of § 465 of the Internal

Revenue Code of 1954 with respect to a note executed in

connection with an investment in computer equipment.

We affirm.

STEPHEN D. GARDNER, New York, New York

(Ann-Elizabeth Purintun, Peter L. Ente,

Kronish, Lieb, Weiner & Hellman, New

York, New York, of counsel), for Peti-

tioners-Appellants.

BRUCE R. ELLISEN, Attorney, Tax Division,

Department of Justice, Washington, D.C.

(James A. Bruton, Acting Assistant

Attorney General, Gary R. Allen, William

J. Patton, Attorneys, Tax Division,

Department of Justice, Washington,

D.C.), for Respondent-Appellee.

MAHONEY, Circuit Judge:

John J. and Jeanne M. Waters appeal from a decision of

the United States Tax Court, Stephen J. Swift, Judge,

which ruled, inter alia, that John Waters (“Waters”) was

protected against loss, and therefore not “at risk” within

the meaning of § 465 of the Internal Revenue Code of

1954,' with respect to a nominally recourse note executed

1 All statutory references herein are to the Internal Revenue Code of

1954 (26 U.S.C.) as amended and in effect during the years at issue. The

Code has since been redesignated as the Internal Revenue Code of 1986.

See Tax Reform Act of 1986, Pub. L. No. 99-514, § 2, 100 Stat. 2085,

2095.

As pertinent herein, § 465 provides:

DEDUCTIONS LIMITED TO AMOUNT AT RISK.

(a) Limitation to Amount at Risk.

(1) Jn General.—tin the case of —

(A) an individual,. .. .

engaged in an activity to which this section applies, any loss from such

activity for the taxable year shall be allowed only to the extent of the

aggregate amount with respect to which the taxpayer is at risk (within

the meaning of subsection (b)) for such activity at the close of the tax-

able year. (footnote continued)

in connection with his investment in the purchase and

lease of peripheral computer equipment. Waters v. Com-

missioner, 62 T.C.M. (CCH) 778 (1991).

(2) Deduction in succeeding year.—Any loss from an activity to

which this section applies not allowed under this section for the taxable

year shall be treated as a deduction allocable to such activity in the first

succeeding taxable year.

(b) Amounts Considered at Risk.

(1) In General.—For purposes of this section, a taxpayer shall be

considered at risk for an activity with respect to amounts including —

(A) the amount of money and the adjusted basis of other

property contributed by the taxpayer to the activity, and

(B) amounts borrowed with respect to such activity (as

determined under paragraph (2)).

(2) Borrowed amounts.—For purposes of this section, a taxpayer

shall be considered at risk with respect to amounts borrowed for use in

an activity to the extent that he—

(A) is personally liable for the repayment of such amounts. . . .

(4) Exception.—Notwithstanding any other provision of this section,

a taxpayer shall not be considered at risk with respect to amounts

protected against loss through nonrecourse financing, guarantees, stop

loss agreements, or other similar arrangements.

(5) Amounts at risk in subsequent years.—If in any taxable year the

taxpayer has a loss from an activity to which subsection (a) applies, the

amount with respect to which a taxpayer is considered to be at risk

(within the meaning of subsection (b)) in subsequent taxable years with

respect to that activity shall be reduced by that portion of the loss which

(after the application of subsection (a)) is allowable as a deduction.

(1) Types of activities.—This section applies to any taxpayer

engaged in the activity of—

1245(a)(3)).

(d) Definition of Loss.

For purposes of this section, the term “loss” means the excess of the

deductions allowable under this chapter for the taxable year (determined

(footnote continued)

We affirm.

Background

John J. and Jeanne M. Waters, husband and wife, filed

joint federal income tax returns for the years 1982

through 1985. They claimed on those returns losses

attributable to Waters’ computer leasing activity, which

we now describe.

On March 26, 1981, Equitable Financial Management,

Inc. (“Equitable”), an equipment leasing company, con-

tracted to purchase a large quantity of new peripheral

computer equipment (the “Equipment”’) from ITT Courier,

Inc. (“ITT”) for $278,775, reflecting a seven to ten per-

cent quantity discount. The equipment was to be delivered

in stages throughout 1981 and 1982.

During the years at issue, Charles L. Dixon, president

of Equitable, and Fred E. Cooper, its secretary, each

owned fifty percent of the voting and nonvoting stock of

Equitable, with the exception of a small minority stock

interest held by another individual.

Equitable financed approximately the full purchase

price of the Equipment by borrowing, on a nonrecourse

basis, from the First National Bank of Allentown (“Allen-

town’). Equitable granted Allentown a security interest in

the Equipment and assigned to Allentown the lease pay-

ments due under all end-user leases of the Equipment.

Some or all of this loan was subsequently refinanced with

another bank.

without regard to the first sentence of subsection (a)) and allocable to an

activity to which this section applies over the income received or accrue by

the taxpayer during the taxable year from such activity. . . .

On April 6, 1981, Equitable leased the Equipment to

Duquesne Light Company (“Duquesne”) for an initial

term of five years and seven months (from the date of

installation of each particular piece of equipment) running

through March 16, 1988. The lease terms were “net,” with

all costs and obligations relating to the Equipment to be

borne by Duquesne. The lease payments effectively

matched Equitable’s payments on the bank loan.

On August 31, 1982, Equitable sold the Equipment,

subject to the end-user lease and bank liens, to Cooper

Leasing Corp. (“Cooper Leasing”) for $298,000. The pur-

chase price was paid with a cash payment of $1,000 and

a recourse promissory note in the amount of $297,000.

Interest was set at twelve percent per annum, and pay-

ments designated as prepaid interest, deferred interest, or

interest were to be made as follows: $10,000 on August

31, 1982; $26,643 on February 28, 1983; $27,720 on

February 28, 1984; $934.25 per month from September

1982 through December 1984. Payments of $5,806.42 per

month for principal and interest were to be made from

January 1985 to December 1990. Cooper Leasing pro-

vided Equitable with a security interest in the Equipment

and end-user lease to secure performance of the note obli-

gations.

Cooper Leasing was in the business of equipment and

real estate leasing. In 1982, however, it was in the process

of winding down its business activities and thereafter

served as an intermediary between Equitable and third-

party investors with respect to leasing transactions.

Cooper was Cooper Leasing’s president and Dixon was its

secretary. Cooper and Dixon each owned fifty percent of

Cooper Leasing’s stock. Thus, the ownership and officers

of Cooper Leasing were substantially the same as those of

Equitable.

Also on August 31, 1982, simultaneously with the sale

of the Equipment by Equitable to Cooper Leasing, Waters

and Gerald A. Moffatt each purchased a fifty percent

undivided interest in the Equipment, subject to the end-

user lease and bank liens, from Cooper Leasing for a

stated purchase price of $300,000. Waters and Moffatt

each made a cash payment of $1,500 and provided a

recourse promissory note in the amount of $148,500.

Interest was set at twelve percent per annum, and princi-

pal and interest payments were to be made at times and in

amounts (when aggregated) that matched the payment

obligations of Cooper Leasing under its promissory note

to Equitable. Waters and Moffatt each provided Cooper

Leasing with a security interest in the Equipment and end-

user lease to secure performance of their note obligations.

Contemporaneously with their purchase of the Equip-

ment, Waters and Moffatt leased the Equipment to Equi-

table for an eight-year and four-month fixed term,

coterminous with their promissory notes to Cooper Leas-

ing and Cooper Leasing’s promissory note to Equitable.

Equitable was to make monthly rental payments that

essentially matched the monthly note payments due from

Waters and Moffatt to Cooper Leasing and the monthly

note payments due from Cooper Leasing to Equitable.

Additionally, the lease included the following indemni-

fication provision:

[Equitable] will indemnify [Waters and Moffatt] and

protect defend and hold [them] harmless from and

against any and all loss, cost, damage, injury or

expense, including, without limitation, reasonable

attorneys’ fees, wheresoever and howsoever arising

which [they] may incur by reason of any breach by

[Equitable] of any of the representations by, or obli-

gations of, [Equitable] contained in this Lease, the

Equipment, claims of Senior Lienholders, Underly-

ing Lessee, or the leasing, subleasing, use, operation

or maintenance of the Equipment.

There were no rental payments that corresponded with

the nonmonthly interest payments under the Cooper Leas-

ing, Waters, and Moffatt notes due August 31, 1982,

February 28, 1983, and February 28, 1984. Approximately

half of these payments, which flowed through to Equi-

table in an aggregate amount of $64,363, was apparently

intended to fund payments on those dates to Parkside

Associates, a leasing consultant retained by agreement

dated August 31, 1982 (the “Management Agreement’) to

act as the administrator or manager of the various con-

tracts between Waters, Moffatt, Equitable, and Cooper

Leasing. In any event, Waters concedes in his appeal brief

that: “The obligations of Messrs. Waters and Moffatt on

their Notes to Cooper Leasing essentially matched Cooper

Leasing’s obligations on its note to Equitable, which

essentially matched Equitable’s rent payment obligations

under the Equitable Lease.” Further, as will appear, the

Tax Court allowed Waters to deduct interest actually paid

on his note obligations in the year of payment.

The Management Agreement also provided that Cooper

Leasing was to collect Equitable’s monthly rental pay-

ments on behalf of Waters and Moffatt and apply the

rental payments (1) to discharge the monthly note pay-

ments due from Waters and Moffatt on their notes to

Cooper Leasing, and then (2) to discharge Cooper Leas-

ing’s monthly obligations on its note to Equitable. Cooper

Leasing was to retain a ten dollar monthly fee for these

services.

In summary, the resulting lease and ownership arrange-

ments were as follows:

¢ Waters and Moffatt owned the Equipment, subject

to the bank liens and end-user lease.

¢ The banks retained a security interest in the Equip-

ment and were assigned the end-user lease pay-

ments.

¢ Waters and Moffatt leased the Equipment to Equi-

table.

¢ Equitable leased the Equipment to Duquesne.

The resulting payments were structured as follows:

¢ Equitable was obligated, on a nonrecourse basis, to

make payments to the banks pursuant to the financ-

ing of the initial purchase of the Equipment from

é ge A

¢ Duquesne made monthly rental payments pursuant

to the end-user lease to the banks that effectively

matched Equitable’s obligations on the bank loan.

Equitable made monthly rental payments to Waters

and Moffatt on its lease of the Equipment.

Waters and Moffatt made corresponding monthly

note payments to Cooper Leasing on their purchase

of the Equipment, which were satisfied by Cooper

Leasing’s collection of the monthly rental pay-

ments from Equitable on behalf of Waters and

Moffatt.

Cooper Leasing made corresponding monthly pay-

ments On its note to Equitable.

As a result of depreciation, interest, and management

fees stemming from his investment in the Equipment,

Waters claimed deductions for losses on his Federal

income tax returns for 1982 through 1985 as follows:

$30,822 for 1982, $44,115 for 1983, $42,665 for 1984,

and $12,213.59 for 1985. The Commissioner disallowed

the losses, which resulted in asserted (1) income tax defi-

ciencies for each year; (2) increased interest for each year

because of a substantial underpayment of income taxes

attributable to tax motivated transactions, pursuant to

§ 6621(c); and (3) as to all years except 1985, a twenty-

five percent addition to the assessed deficiency for sub-

stantial understatement of income tax, pursuant to § 6661.

The disallowances were based primarily upon the Com-

missioner’s determinations that: (1) Waters did not have

the benefits and burdens of ownership of the Equipment;

(2) his Equipment transactions were not conducted for

profit; (3) his Equipment transactions were sham or

lacked economic substance; and/or (4) the loss deductions

were limited by § 465. Waters filed a petition with the

United States Tax Court seeking a redetermination of the

asserted deficiencies, and a trial was held.

The Tax Court determined that: (1) “the transaction

before [it] in this case was not a sham transaction lacking

in economic substance and [Waters] had an actual and

honest profit objective for entering into the transaction,”

62 T.C.M. at 786; and that Waters “acquired ownership of

the computer equipment and that the interest actually paid

by [Waters] on his written debt obligations associated

with the transaction is deductible in the year paid.” /d.

(citing Rice’s Toyota World, Inc. v. Commissioner, 752

F.2d 89 (4th Cir. 1985); Rose v. Commissioner, 88 T.C.

386, 423-24 (1987), aff'd, 868 F.2d 851 (6th Cir. 1989)).

The court also ruled, however, that Waters was not at

risk with respect to his debt obligation to Cooper Leasing

within the meaning of § 465(a)(1)(A) and § 465(b)

because that obligation was “protected against loss

through nonrecourse financing, guarantees, stop loss

10a

agreements, or other similar arrangements” within the

meaning of § 465(b)(4). 62 T.C.M. at 782-84. Specifi-

cally, the court determined that the nonrecourse nature of

the underlying bank debt, the circular, matching payment

obligations, and the Equitable indemnification agreement

establish that there was no realistic possibility that

[Waters] would suffer an economic loss in connection

with the transactions in issue. The cumulative effect

of these provisions constitutes a prohibited ‘other

similar arrangement’ under section 465(b)(4) that

effectively immunize[d] [Waters] from any economic

loss with respect to [his] debt obligations under [his]

nominally recourse purchase money promissory

note[ ] in favor of Cooper Leasing.

Id. at 783.

As aresult of these rulings, the Tax Court reduced the

income tax deficiencies assessed by the Commissioner for

the years 1982-1984, and determined that Waters had

made an overpayment for 1985. The court also determined

that Waters had substantial authority for claiming the

Equipment-related deductions, thus eliminating the

§ 6661 addition to tax, id. at 786, but that penalty interest

should be imposed pursuant to § 6621(c). /d. at 787.

Waters appeals, challenging the Tax Court’s ruling as to

§ 465. The Commissioner does not contest the Tax Court

determinations in Waters’ favor.

Discussion

ae 6

As a preliminary matter, we note that “ ‘(oJur usual

standards of review .. . apply. The Tax Court’s legal con-

clusions will receive plenary review. Factual findings will

be reversed only if “clearly erroneous.” ’ ” Bausch &

lla

Lomb Inc. v. Commissioner, 933 F.2d 1084, 1088 (2d Cir.

1991) (quoting Eli Lilly & Co. v. Commissioner, 856 F.2d

855, 861 (7th Cir. 1988) (quoting Anderson v. City of

Bessemer City, 470 U.S. 564, 573 (1985))). Specifically,

the Tax Court’s application of the at-risk rules of section

465 is a legal issue which we review de novo. See Moser

v. Commissioner, 914 F.2d 1040, 1044 n.11 (8th Cir.

1990); Casebeer v. Commissioner, 909 F.2d 1360, 1368

(9th Cir. 1990).

The Tax Court determined that (1) the nonrecourse

underlying bank debt, (2) the circular, matching payment

obligations, and (3) the indemnification provided by Equi-

table to Waters cumulatively constituted an “other simi-

lar arrangement” under section 465(b)(4) by which Waters

was effectively protected against loss in connection with

his debt. 62 T.C.M. at 782-84. Waters contends, however,

that he was not protected against potential economic loss

by this arrangement, and therefore should be considered

at risk with respect to his recourse purchase money note

to Cooper Leasing.

In order to prevent taxpayers engaged in certain activ-

ities from deducting losses in excess of their actual eco-

nomic investment therein, § 465(a)(1) provides that a

taxpayer engaged in an activity to which § 465 applies

may deduct “any loss from such activity for the taxable

year... only to the extent of the aggregate amount with

respect to which the taxpayer is at risk . . . for such activ-

ity at the close of the taxable year.” The general rule is

that a taxpayer is at risk for the amount of cash invested

in the activity and for amounts borrowed for which the

taxpayer is personally liable. § 465(b)(1), (2). Section

465(b)(4) provides, however, that a taxpayer “shall! not be

considered at risk with respect to amounts protected

against loss through nonrecourse financing, guarantees,

12a

stop loss agreements, or other similar arrangements

[emphasis added].”

Any loss disallowed under section 465 for a given tax-

able year “shall be treated as a [§ 465] deduction alloca-

ble to such activity in the first succeeding taxable year,”

§ 465(a)(2), and thus may be carried forward and claimed

in a later year in which a risk materializes that was not

Operative at the close of any prior taxable year. See

Moser, 914 F.2d at 1049 (§ 465 deduction not allowed

unless and until risk-precipitating event occurs or a real-

istic possibility develops that it might); American Prin-

cipals Leasing Corp. v. United States, 904 F.2d 477, 483

(9th Cir. 1990) (same); S. Rep. No. 938, 94th Cong., 2d

Sess. 48 (1976), reprinted in 1976 U.S.C.C.A.N. 2897,

3484 (“Losses .. . are suspended under this provision’’).

Although we have not previously addressed the impact

of § 465 upon an equipment leasing transaction of the

Structure presented by this appeal, other circuits have

done so, and with one exception have sided with the posi-

tion taken by the Commissioner in this case. The leading

case is American Principals, in which the Ninth Circuit

observed that § 465 “nowhere explains the phrase ‘other

similar arrangements,’ ” 904 F.2d at 482, but noted that

“subsection 454(b)(4)’s use of the term ‘arrangement’

rather than ‘agreement’ indicates that a binding contract

is not necessary for this subsection to be applicable,” id.

at 482-83, and concluded:

[T]he purpose of subsection 465(b)(4) is to suspend

at risk treatment where a transaction is structured—

by whatever method—to remove any realistic possi-

bility that the taxpayer will suffer an economic loss

if the transaction turns out to be unprofitable. A the-

oretical possibility that the taxpayer will suffer eco-

13a

nomic loss is insufficieut to avoid the applicability of

this subsection. We must be guided by economic real-

ity. If at some future date the unexpected occurs and

the taxpayer does suffer a loss, or a realistic possi-

bility develops that the taxpayer will suffer a loss, the

taxpayer will at that time become at risk and be able

to take the deductions for previous years that were

suspended under this subsection. I.R.C. § 465(a)(2).

Id. at 483 (citations omitted).

The Eleventh and Eighth Circuits have adopted this

rule. See Young v. Commissioner, 926 F.2d 1083, 1088-89

(11th Cir. 1991); Moser, 914 F.2d at 1048. The Sixth Cir-

Cuit takes a contrary view, however, agreeing with the

view of the dissent in American Principals that the leg-

islative history of § 465 “indicate[s] that a loss-limiting

arrangement within the meaning of § 465(b)(4) is a col-

lateral agreement protecting a taxpayer from loss after

the losses have occurred, either by excusing him from his

obligation to make good on the losses or by compensating

him for losses he has sustained.” Emershaw v. Commis-

sioner, 949 F.2d 841, 849 (6th Cir. 1991) (citing American

Principals, 904 F.2d at 487 (Hug, J., dissenting)).

The legislative history upon which Emershaw relies,

see 949 F.2d at 848-49, is primarily the following excerpt

from the Senate report accompanying the initial enact-

ment of § 465 in 1976:

[A] taxpayer’s capital is not “at risk” in the business,

even as to the equity capital which he has con-

tributed[,] to the extent he is protected against eco-

nomic loss of all or part of such capital by reason of

an agreement or arrangement for compensation or

reimbursement to him of any loss which he may suf-

fer. Under this concept, an investor is not “at risk” if

l4a

he arranges to receive insurance or other compensa-

tion 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 at 49, reprinted in 1976 U.S.C.C.A.N. at

3485 (emphasis added, paralleling Emershaw).

We do not regard this statement as dispositive with

respect to the meaning of “other similar arrangements” in

§ 465(b)(4). While 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.

“c ‘

In any event, [w]here ... the resolution of a ques-

tion of federal law turns on a statute and the intention of

Congress, we look first to the statutory language and then

to the legislative history if the statutory language is

unclear.’ ” Toibb v. Radloff, 111 S. Ct. 2197, 2200 (1991)

(quoting Blum v. Stenson, 465 U.S. 886, 896 (1984)).

Accordingly, our primary focus must be upon the lan-

guage of § 465(b)(4). That language prompts disagree-

ment with Emershaw’s conclusion that the term “similar

arrangements” under § 465(b)(4) encompasses only “col-

lateral agreement/s] protecting a taxpayer from loss after

the losses have occurred.” Emershaw, 949 F.2d at 849. As

American Principals points out, the statutory phrase is

“similar arrangements,” not “agreements.” 904 F.2d at

482-83. Moreover, the “arrangements” may be “similar”

not only to “guarantees” and “stop loss agreements,” but

also to “nonrecourse financing,” ordinarily a prearrange-

ment to protect against loss.?

2 ~_Inany event, so far as the outcome of this appeal is concerned, Equi-

table provided Waters with an indemnification that constitutes a col-

lateral agreement to protect Waters against loss after it occurred.

1Sa

We join the Eighth, Ninth, and Eleventh Circuits in

holding that § 465(b)(4) operates “to suspend at risk treat-

ment where a transaction is structured—by whatever

method—to remove any realistic possibility that the tax-

payer will suffer an economic loss if the transaction turns

Out to be unprofitable.” American Principals, 904 F.2d at

483; see also Young, 926 F.2d at 1089; Moser, 914 F.2d at

1048-49; S. Rep. No. 1263, 95th Cong., 2d Sess. 67

(1978), reprinted in 1978 U.S.C.C.A.N. 6761, 7103

(§ 465 limits “at risk” treatment to “the amount the tax-

payer has placed at risk and could actually lose from the

activity” (emphasis added)). Economic reality is the

touchstone of the required analysis. See Young, 926 F.2d

at 1088 & n.11; Moser, 914 F.2d at 1048 & n.21: Ameri-

can Principals, 904 F.2d at 483.

In this case, there was no realistic possibility that

Waters would suffer an economic loss if the underlying

transaction became unprofitable. First, the circular nature

of the arrangement between Waters and Moffatt, Cooper

Leasing, and Equitable effectively immunized Waters

from economic loss. Equitable was both the initial obligee

and final obligor. The payments on Waters’ nominally

recourse notes were essentially identical to the payments

Waters was entitled to receive from Equitable on its lease.

The only obligation outside the circle of transactions was

a nonrecourse bank debt.

Second, the virtual identity of the composition and con-

trol of Equitable and Cooper Leasing, the only entities

transferring funds, belies any likelihood that Equitable

would have stopped making lease payments. Although it

is theoretically possible that one of the parties might have

broken the chain of payments, there appears to have been

no reason for this to occur.

16a

Third, if Equitable stopped making payments on its

lease, it could only have expected a chain reaction result-

ing in Waters and Moffatt, and then Cooper Leasing, ceas-

ing to make payments as well. Any ensuing litigation

would similarly have resulted in a chain reaction. Whether

Or not a litigant would be entitled to setoff in a particular

court action, it is clear that once the dust settled, the

claims among the parties would have cancelled each other

Out.

~ Fourth, if Duquesne stopped making lease payments,

the banks could have only looked to the Equipment to

recover their funds. Although Dixon testified that he “per-

sonally regarded Equitable as fully liable on a recourse

basis on the bank loan and that [in the event of a default]

Equitable would have insisted on full payment by Cooper

Leasing and by [Waters] and Moffatt of their debt obli-

gations under their ‘recourse’ promissory notes,” 62

T.C.M. at 783, the Tax Court was not clearly erroneous in

rejecting this testimony. In any event, the pertinent

“arrangement” to be assessed at the close of each taxable

year was the existing nonrecourse debt, not the theoreti-

cal possibility that its nonrecourse nature would be dis-

regarded by Equitable in some future contingency.

_ Waters contends that even if the nonrecourse nature of

‘the underlying bank debt would ordinarily protect him

against loss, he was not so protected in this case because

his recourse note was fully negotiable. We reject this

argument. The structure of the transaction and parties at

issue in this case, as well as the Management Agreement

between the parties, made the possibility that Cooper

Leasing would negotiate Waters’ note more theoretical

than realistic. If at some future date the unexpected

occurred and the note was negotiated to a third party,

Waters might at that juncture become at risk and be able

17a

to take deductions unavailable in prior years. See

§ 465(a)(2). As discussed earlier, the operation of § 465

is to suspend and defer, rather than completely deny,

other-wise available deductions.

Waters also contends that the matching payment obli-

gations did not immunize Waters against loss, citing

numerous Tax Court opinions, as well as Emershaw, in

Support of that view. We agree that the existence of a

source of rental payments to cover a taxpayer’s note obli-

gations does not in and of itself eliminate risk, as some of

the cases cited by Waters make clear. See, e.g., Rubin v.

Commissioner, 58 T.C.M. (CCH) 25, 38 (1989) (mere fact

that taxpayer would receive sufficient rent from third

party to cover note payments did not result in § 465 expo-

Sure) (citing Gefen v. Commissioner, 87 T.C. 1471

(1986)); B & A Distrib. Co. v. Commissioner, 56 T.C.M.

(CCH) 958, 969 (1988) (same) (citing Gefen). However,

the additional factors presented here—the underlying non-

recourse debt, the circular, matching payment obligations,

and the Equitable indemnification—take this case well

beyond an unadorned availability of rental payments to

cover note obligations.

Waters’ essential argument, invoking Emershaw, 949

F.2d at 845, is that the “worst-case scenario” must be con-

sidered in applying § 465(b)(4) rather than year-end eco-

nomic realities. We disagree. Rather, as stated in Moser:

While it may be appropriate to examine the worst-

Case scenario in determining whether a taxpayer is

personally liable for amounts that he has borrowed

for use in an activity when applying § 465(b)(2), see

Krause [v. Commissioner, 92 T.C. 1003, 1017

(1989)), such an analysis is not proper when deter-

mining whether the “taxpayer has engaged in a loss-

18a

limiting arrangement prohibited by subsection

465(b)(4).” [American Leasing], 904 F.2d at 482.

Moser, 914 F.2d at 1048.

Moser drew support for this analysis from the pertinent

Senate report, which states:

For purposes of [subsection 465(b)(4)], it will be

assumed that a loss-protection guarantee, repurchase

agreement or insurance policy will be fully honored

and that the amounts due thereunder will be fully

paid to the taxpayer. The possibility that the party

making the guarantee to the taxpayer, or that a part-

nership which agrees to repurchase a partner’s inter-

est at an agreed price, 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 when the taxpayer becomes uncon-

ditionally entitled to payment and, at that time,

demonstrates that he cannot recover under the agree-

ment.

S. Rep. No. 938 at 50 n.6, reprinted in 1976 U.S.C.C.A.N.

at 3486 n.6; see also American Principals, 904 F.2d at

482 (quoting above passage from S. Rep. No. 938).

Finally, the language of § 465(b)(4), which is addressed

to arrangements that “protect[{ ] against loss,” taken

together with the overall structure of § 465, which defers

rather than permanently disallows losses, encourages an

interpretation of this statute which looks to year-end eco-

nomic realities rather than worst-case scenarios. Because

at the close of the tax years at issue Waters did not face

any realistic possibility of loss from his Equipment-leas-

ing activity, the Tax Court properly concluded that he was

19a

not “at risk” in those years within the meaning of § 465

with respect to his promissory note to Cooper Leasing.

Conclusion

The decision of the Tax Court is affirmed.

20a

T. C. Memo. 1991-462

UNITED STATES TAX COURT

John J. Waters and Jeanne M. Waters, Petitioners v.

Commissioner of Internal Revnue, Respondent.

Docket No. 9938-88. Filed September 23, 1991.

Stephen D. Gardner and Michael G. Lefkowitz, for the peti-

tioners.

Jody Tancer and Laurie B. Kazenoff, for the respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

SWIFT, Judge: Respondent determined deficiencies in peti-

iioners’ Federal income taxes and additions to tax as follows:

Sec. 6661

Year Deficiency Addition to Tax'

PORE ikkckxctineevcieeee $14,361 $3,590

BRR ckwinrktoraec uses 20,258 5,065

io MRR Gen aMS Ly fs 18,700 4,675

EE TET Oe 2,443 —

Increased interest under section 6621(c) also was determined

for each year.

The primary issues for decision are: (1) Whether petitioner

John J. Waters (petitioner) was at risk within the meaning of

section 465 with respect to debt obligations incurred in con-

nection with an investment in peripheral computer equipment;

(2) whether petitioner’s investment was a sham transaction

devoid of economic substance; and (3) whether petitioner’s

investment constituted an activity entered into for profit within

the meaning of section 183.

1 Unless otherwise indicated, ail section references are to the Internal

Revenue Code of 1954 as in effect for the years in issue.

21a

Findings of Fact

Some of the facts have been stipulated and are so found.

Petitioners are husband and wife and resided in Huntington,

New York, at the time their petition was filed.

During the years in issue, petitioner was a certified public

accountant. In early 1982, petitioner and Gerald A. Moffatt

(Moffatt), one of petitioner’s partners at the public accounting

firm at which petitioner worked, sought advice from Michael

Gorin (Gorin) concerning possible investments in computer

equipment leasing transactions. Gorin was a certified public

accountant and had performed accounting and financial ser-

vices for computer equipment leasing companies, and Gorin

had given advice to other investors concerning investments in

computer equipment leasing transactions. Further, Gorin had

experience purchasing computer equipment for a prior

employer.

On August 31, 1982, after considering and discussing for a

number of months with Gorin and other colleagues various

investment opportunities, including computer equipment leas-

ing transactions, and after investigating the credit standing of

the prospective end user of the equipment, petitioner and

Moffatt entered into the transactions with respect to certain

peripheral computer equipment described below.

Original Purchase Transaction and End-User Lease

On March 26, 1981, Equitable Financial Management, Inc.

(Equitable), a general equipment leasing company, entered into

a master purchase agreement to purchase a large quantity of

new peripheral computer equipment from ITT Courier, Inc.

(ITT), the manufacturer of the equipment. Equitable’s purchase

price for the particular computer equipment that is at issue in

this case (and that was purchased from ITT under the referred-

to master purchase agreement) was $278,775. The equipment

included display terminals, keyboards, printers, printer inter-

faces, and remote terminal controllers. The equipment was to

be delivered in stages throughout 1981 and 1982.

22a

ITT peripheral computer equipment was highly regarded in

the computer industry. The particular controllers purchased by

Equitable had a redundancy feature that made them particularly

attractive to financial institutions, utility companies, and other

end users whose business necessitated computer equipment

with backup capability.”

Charles L. Dixon (Dixon) was the president of Equitable.

Fred E. Cooper (Cooper) was the corporate secretary. During

the years in issue, Dixon and Cooper each owned 50 percent of

the voting and nonvoting stock of Equitable, with the exception

of a small minority stock interest held by another individual.

In connection with its purchase of the computer equipment,

Equitable borrowed on a nonrecourse basis from The First

National Bank of Allentown approximately the full stated pur-

chase price of the equipment. The proceeds from the non-

recourse bank loan were used by Equitable to pay ITT the

purchase price of the computer equipment. The loan was sub-

sequently refinanced on a nonrecourse basis by another bank.

As collateral for the bank loan, Equitable gave the bank

security interests in the computer equipment and in the lease

payments due under all end-user leases of the equipment.

Neither the term of, nor the interest rate due, on Equitable’s

bank loan is established in the record.

The $278,775 purchase price (for the computer equipment

that is in issue in this case and that was purchased by Equitable

from ITT) reflected a 7- to 10-percent discount from ITT’s list

price for the equipment because the purchase was part of a pur-

2 The particular computer equipment at issue in this case and thal was pur-

chased by Equitable from ITT under the master purchase agreement and the listed

prices associated with the different types of equipment are indicated below:

No. of Price Total

Units Model Per Unit Price

3 PERE is sas badcae ce eeneNeeaaweaben $14,490 $43,470

3 ER bicabaiecancheveenkndeksehanes 20,700 62,100

] MU cickdcasshoendvsrveehournyenss 990 990

14 OUI sn:schncauseedadavacesubneewet 1,665 23,310

35 BRE bai ever cavindusiibenenewets 2,300 80,500

17 PU aceite skecicek pcuricawessakeeksan 3,915 66,555

| RUN Gui SedNKKA CEES RATAN eu enea ees 1,850 1,850

PE OD eco cri vancicdacdcscweedashneeawun $278,775

23a

chase by Equitable from ITT under the master purchase agree-

ment of a much larger quantity of computer equipment.

On April 6, 1981, Equitable entered into a master end-user

lease agreement with Duquesne Light Co. (Duquesne Light), a

public utility company located in Pittsburgh, Pennsylvania,

with respect to the peripheral computer equipment purchased

from ITT. The initial terms of the various end-user leases with

Duquesne Light began on either March 16, 1982, May 27,

1982, or August 16, 1982, and had terms of 5 years and 7

months, running (depending on the installation date at

Duquesne Light of the various pieces of equipment) through

March 16, 1988.

During the initial 5-year 7-month lease terms, total monthly

end-user lease payments in the amount of $6,953 were due

from Duquesne Light with respect to the equipment. The

monthly end-user lease payments effectively matched the pay-

ments due on Equitable’s purchase money promissory note to

the bank. Under lease renewal provisions, if Duquesne Light

chose to renew the leases, Duquesne Light would pay the fair

market rental rates at the time of renewal up to a maximum of

40-51 percent of the original lease rental rates.

The end-user leases with Duquesne Light were net leases

under which Duquesne Light was liable for all costs and

expenses of maintaining the computer equipment. In order to

fulfill its obligation in that regard, Duquesne Light entered into

an equipment maintenance agreement with ITT with respect to

the computer equipment, under which ITT (for a fee to be paid

by Duquesne Light) was obligated to provide remedial and pre-

ventive maintenance throughout the term of the end-user

leases. Under the end-user lease agreements, Duquesne Light

also was required to and did maintain casualty insurance on the

computer equipment during the term of the end-user leases.

Sale of Computer Equipment to Cooper Leasing and to

Petitioner

On August 31, 1982, 17 months after the initial master pur-

chase agreement for the purchase of computer equipment was

entered into between Equitable and ITT, two additional and

24a

simultaneous transactions occurred (involving the particular

computer equipment in issue in this case) with the objective of

transferring ownership of the equipment and assignment of the

end-user leases with respect to the equipment (subject to the

security interests therein of the bank) to petitioner and to

Moffatt.

The first transaction was a sale of the computer equipment

and assignment of the end-user leases by Equitable to Cooper

Leasing Corporation, Inc. (Cooper Leasing), followed by the

immediate resale of the computer equipment and reassignment

of the end-user leases by Cooper Leasing to petitioner and to

Moffatt. Both transactions were subject to the prior security

interests of the bank in the equipment and in the end-user lease

payments.

The total stated price for the purchase of the computer equip-

ment by Cooper Leasing from Equitable was $298,000 (reflect-

ing, among other things, the fact that ITT peripheral computer

equipment had appreciated in value from March of 1981 to

August of 1982). The total purchase price was to be paid with

a cash downpayment of $1,000 and by the execution by Cooper

Leasing in favor of Equitable of a purportedly recourse promis-

sory note in the amount of $297,000.

Interest was to accrue on the promissory note at 12 percent

per year, and payments designated as-prepaid interest, deferred

interest or interest were to be made as follows: $10,000 on

August 31, 1982; $26,643 on February 28, 1983; $27,720 on

February 28, 1984; $934 monthly from September of 1982

through December of 1984. Payments of principal and interest

were to be made as follows: $5,806 monthly from January of

1985 through December of 1990.

Cooper Leasing was in the general business of equipment

and real estate leasing. The officers and ownership of Cooper

Leasing were the same as the officers and ownership of

Equitable, except that Fred E. Cooper was president of Cooper

Leasing, and Charles L. Dixon was the corporate secretary.

Cooper and Dixon each owned 50 percent of the stock of

Cooper Leasing.

25a

On August 31, 1982, simultaneously with the above trans-

action between Equitable and Cooper Leasing, Cooper Leasing

sold the computer equipment to petitioner and to Moffatt as

joint tenants for a stated purchase price of $300,000, repre-

sented by cash downpayments by petitioner and by Moffatt of

$1,500 each and by the execution of separate 8-year and 4-

month purchase money promissory notes by petitioner and by

Moffatt cach in the amount of $148,500, reflecting a total pur-

chase money debt reflected by the promissory notes of

$297,000. Petitioner’s and Moffatt’s debt obligations to Cooper

Leasing under the promissory notes were secured by security

interests in the equipment executed and filed in favor of

Cooper Leasing.

Interest was to accrue on petitioner’s and Moffatt’s promis-

sory notes in favor of Cooper Leasing at 12 percent a year, and

payments of prepaid interest, deferred interest, accrued inter-

est, and principal with respect to each of the promissory notes

were to be made in total amounts that matched the payment

obligations of Cooper Leasing under its promissory note to

Equitable.

S_parate promissory notes in favor of Cooper Leasing were

executed by petitioner and Moffatt reflecting their obligations

lo pay interest to Cooper Leasing of $26,643 oi February 28,

1983, and $27,720 on February 28, 1984.

In their separate written $148,500 purchase money promis-

sory notes and in their promissory notes regarding the interest

payments due on February 28, 1983, and February 28, 1984,

petitioner and Moffatt are stated to be personally liable, on a

fully recourse basis, for the full amount of the principal and

interest due thereon.

Leaseback of the Computer Equipment to Equitable

On August 31, 1982, simultaneously with the above two

transactions, petitioner and Moffatt entered into an agreement

leasing back the computer equipment to Equitable for a fixed

term of 8 years and 4 months. Under the leaseback agreement,

Equitable agreed to make monthly lease payments to petitioner

and to Moffatt that essentially matched the monthly payments

26a

due from petitioner and from Moffatt under their promissory

notes in favor of Cooper Leasing and the monthly payments

due from Cooper Leasing under its promissory notes in favor

of Equitable.

Under a management agreement between petitioner, Moffatt,

and Cooper Leasing, Cooper Leasing was to collect directly

from Equitable the monthly lease payments due from Equitable

under the leaseback agreement with petitioner and Moffatt.

From those payments, Cooper Leasing would credit petitioner’s

and Moffatt’s monthly debt obligations to Cooper Leasing

under their promissory notes to Cooper Leasing, and Cooper

Leasing in turn would transfer the payments back to Equitable

in payment of its (Cooper Leasing’s) debt obligations to

Equitable. For its services in handling the payments and the

bookkeeping, Cooper Leasing was to retain a fee of $10 a

month.

In 1982, 1983, and 1984, as a result of the essentially off-

setting lease and debt payment obligations, petitioner and

Moffatt were to earn no net rental proceeds. In 1985 through

1988, petitioner and Moffatt would each earn $250 a year in net

rental proceeds. In 1989 and later years, petitioner and Moffatt

also would be entitled to additional nei rental proceeds from

Equitable based on a percentage of the net end-user rental pro-

ceeds Equitable realized from any re-lease of the equipment, as

follows: 15 percent for 1989; 20 percent for 1990; and 50 per-

cent for 1991 and later years.

On August 31, 1982, petitioner, Moffatt, and Equitable

entered into a nonexclusive remarketing agreement under

which Equitable, upon expiration of the lease agreement, could

attempt to sell the used computer equipment. Under the agree-

ment, Equitable would receive 25 percent of any net sales pro-

ceeds, and petitioner and Moffatt would receive the balance. A

sale of the equipment had to be approved by petitioner and

Moffatt.

The leaseback agreement between petitioner, Moffatt, and

Equitable provided an indemnification provision in favor of

petitioner and Moffatt, as follows:

27a

[Equitable] will indemnify [petitioner and Moffatt] and

protect defend and hold [petitioner and Moffatt] harmless

from and against any and all loss, cost, damage, injury or

expense, including, without limitation, reasonable attor-

ney’s fees, wheresoever and howsoever arising which

[petitioner and Moffatt] may incur by reason of any

breach by [Equitable] of any of the representations by, or

obligations of, [Equitable] contained in this Lease, the

Equipment, claims of Senior Lienholders, Underlying

Lessee, or the leasing, subleasing, use, Operation or main-

tenance of the Equipment.

The leaseback agreement also contained a typical provision

obligating Equitable to maintain Casualty, property, and lia-

bility insurance coverage on the equipment.

On August 31, 1982, petitioner, Moffatt, Equitable, Cooper

Leasing, and Parkside Associates (Parkside) entered into an

agreement under which Parkside was to act as the manager or

administrator of the various agreements between petitioner,

Moffatt, Equitable, and Cooper Leasing. For its management

services, Parkside was to be paid by Equitable $5,100 in

August of 1982, $19,400 on February 28, 1983, and $8,000 on

February 28, 1984.

Parkside was in the business of providing consulting services

to those engaged in the equipment leasing business and to

investors in equipment leases. In 1984, the business of Parkside

was taken over by Linwood Associates. Michael Gorin was the

president and sole owner of Parkside and of Linwood.

All aspects of the above sale and leaseback transactions were

documented and recorded. Records were properly maintained

of the income and expenses relating to the equipment.

Under the various debt and lease obligations of the parties,

total annual pretax cash flow available to petitioner and to

Moffatt relating to the above transactions would be as follows:

During 1982 through 1984, $0; during each of 1985, 1986,

1987, and 1988, $500 ($250 to petitioner and $250 to Moffatt);

during each of 1989, 1990, and 1991 and subsequent years, 15,

28a

20, and 50 percent, respectively, of any net end-user lease pro-

ceeds received from Equitable (one half of which would be

paid to petitioner and one half of which would be paid to

Moffatt).

A written financial analysis of the above transactions that

was provided to petitioner and to Moffatt in August of 1982

with respect to their participation in the above transactions

noted the tax benefits and reflected the limited net cash flow

available to petitioner and to Moffatt in the early years of the

investment.

As of the time of trial, all lease payments due from

Duquesne Light have been made, the equipment has been con-

tinuously and properly maintained and upgraded under the

maintenance agreement with ITT, the end-user leases have

been renewed by Duquesne Light at the maximuni lease rental

rates allowed (i.e., at 40-51 percent of the original rates), and

all of the peripheral computer equipment was still on lease to

Duquesne Light. Further, the bank loan Equitable obtained to

finance the purchase of the computer equipment from ITT has

been fully paid. Also, amounts due Equitable from Cooper

Leasing under Cooper Leasing’s promissory note and amounts

due Cooper Leasing under petitioner's and Moffatt’s promis-

sory notes have been paid.

Petitioners’ Federal income tax returns for 1982 through

1985 were filed with respondent using the cash method of

accounting. Petitioners claimed thereon losses relating to the

above equipment leasing transaction of $30,822 for 1982,

$44,115 for 1983, $42,665 for 1984, and $12,213 for 1985. On

petitioners’ 1987 and subsequent years’ Federal income tax

returns, due to the “turnaround” of the financial aspects of the

investment, petitioner reported the positive taxable income

arising from the lease rentals received from Equitable in excess

of depreciation and interest deductions claimed.

On audit, respondent disallowed the net losses claimed for

1982, 1983, 1984, and 1985.

29a

Opinion

At-Risk Issue

This and other courts have recently discussed at some length

the at-risk limitations of section 465(b)(4) as they apply to

multiparty equipment leasing transactions. See, e.g., Moser v.

Commissioner, 914 F.2d 1040, 1047-1050 (8th Cir. 1990), affg.

a Memorandum Opinion of this Court; Casebeer vy.

Commissioner, 909 F.2d 1360, 1368-1370 (9th Cir. 1990), affg.

on this issue, revg. in part, and remanding Larsen vy.

Commissioner, 89 T.C. 1229 (1987), and three memorandum

opinions of this Court; American Principals Leasing Corp v.

United States, 904 F.2d 477, 482-483 (9th Cir. 1990); Thornock

v. Commissioner, 94 T.C. 439, 447-454 (1990); Levy v.

Commissioner, 91 T.C. 838, 862-865 (1988); Follender v.

Commissioner, 89 T.C. 943, 949-950 (1987); Porreca vy.

Commissioner, 86 T.C. 821, 835-843 (1986). See also Raphan

v. United States, 759 F.2d 879, 885 (Fed. Cir. 1985). It is not

necessary to reiterate that discussion.

It suffices herein to note that the nonrecourse nature of the

underlying third-party bank debt, the offsetting payment obli-

gations, and the indemnification agreement that in Thornock v.

Commissioner, supra at 447-454, were held to immunize

investors against any realistic economic risk of loss (with

regard to their nominally recourse purchase money debt obli-

gations) are very similar to the nonrecourse third-party bank

debt, the offsetting payment obligations, and the indemnifi-

cation agreement that are presented to us this case.

Thornock v. Commissioner, supra, controls the resolution of

the at-risk issue in this case. Paraphrasing our conclusions in

that opinion (94 T.C. at 447-450), The First Nationa! Bank of

Allentown and the bank that refinanced Equitable's purchase of

the equipment from ITT on a nonrecourse basis looked only to

the computer equipment and to the end-user lease payments as

collateral. Neither Equitable, Cooper Leasing, Parkside, nor

petitioner or Moffatt, had any liability or legal responsibility

to see that the banks were repaid on the loan, except the

responsibility to act in good faith with regard to other aspects

30a

of the transactions. Other than their rights with regard to the

end-user lease payments and the collateral, the banks had no

legal right to require any participant in the transactions to pro-

vide funds to pay off the nonrecourse bank loan.

Dixon, the president of Equitable, testified that he personally

regarded Equitable as fully liable on a recourse basis on the

bank loan and that Equitable would have insisted on full pay-

ment by Cooper Leasing and by petitioner and Moffatt of their

debt obligations under their “recourse” promissory notes in

order to insure that Equitable had the funds to pay the nonre-

course bank loan and thereby to protect Equitable’s credit

standing. Under the at-risk provisions of section 465, however,

we are dealing primarily with the reality of the legal relation-

ships and debt obligations under the agreements and written

obligations as entered into and documented by the parties. The

fact that particular individuals or representatives of debtors on

nonrecourse debt obligations personally may believe that their

company should or would voluntarily treat particular debt obli-

gations as recourse is, in our opinion, essentially meaningless.

As the transactions before us were structured, the banks had

no recourse to Equitable, and Equitable had no personal lia-

bility on its promissory note to the banks. That fact and the

other features and provisions of the transactions we have men-

tioned (particularly the indemnity agreement) establish that

there was no realistic possibility that petitioner and Moffatt

would suffer an economic loss in connection with the trans-

actions in issue. The cumulative effect of these provisions con-

Stitutes a prohibited “other similar arrangement” under section

465(b)(4) that effectively immunizes petitioner and Moffatt

from any economic loss with respect to their debt obligations

under their nominally recourse purchase money promissory

notes in favor of Cooper Leasing. See also Moser v.

Commissioner, supra at 1049; Casebeer v. Commissioner, supra

at 1369.

Petitioner argues that in spite of the protections built into the

transactions, the bankruptcy of one of the parties to the trans-

actions might result in an economic loss to petitioner. For

example, petitioner argues that if the equipment became worth-

3la

less in the fourth year of the end-user lease with Duquesne

Light, Duquesne Light might stop making lease payments due

Equitable, Equitable might stop making lease payments due

petitioner and Moffatt, and petitioner and Moffatt might stop

making payments due under their promissory notes to Cooper

Leasing. Petitioner speculates that Cooper Leasing and/or

Equitable might then assign or negotiate petitioner's and

Moffatt’s “recourse” promissory notes to the bank, and that the

bank might then enforce against petitioner and Moffatt the

assigned “recourse” promissory notes, even though the bank

originally had no recourse on its loan to Equitable.

As we have previously explained, the “worst-case” analysis

that is reflected in our opinions stops short of anticipating the

potential bankruptcy or other financial adjustments that might

occur if any of the participants providing the particular “pro-

tections-against-loss” get into financial difficulty. As stated in

Thornock v. Commissioner, supra at 454, quoting from the leg-

islative history of section 465—

the potential bankruptcy of entities providing guarantees

Or loss protection to investors is not a consideration in

determining the application of section 465(b)(4) unless

and until the bankruptcy actually occurs. Capek v.

Commissioner, 86 T.C. 14, 52 (1986). In this regard, the

report of the Senate Finance Committee with respect to

section 465 states as follows:

For purposes of this rule [i.e., section 465(b)(4)], it will

be assumed that a loss-protection guarantee, repurchase

agreement or insurance policy will be fully honored and

that the amounts due thereunder will be fully paid to the

taxpayer. The possibility that the party making the guar-

antee to the taxpayer, or that a partnership which agrees to

repurchase a partner’s interest at an agreed price, will fail

to Carry Out the agreement (because of factors such as

insolvency or other financial difficulty) is not to be mate-

rial unless and until the time when the taxpayer becomes

unconditionally entiiled to payment and, at that time,

demonstrates that he cannot recover under the agreement.

32a

[S. Rept. 94-938 at 50 n.6 (1976), 1976-3 C.B. (Vol. 3)

49, 88. Fn. ref. omitted; emphasis added. ]}

See also in this regard, American Principals Leasing Corp. v.

United States, 904 F.2d 477, 482 (9th Cir. 1990).

Petitioner also argues that in 1982, when he first entered into

the transactions, he should be considered to be at risk under

section 465(b)(1) with respect to his debt obligations on the

interest-only promissory notes due on February 28, 1983, and

February 28, 1984, in the respective amounts of $26,643 and

$27,720. We disagree. Under section 465(b)(1), a taxpayer is

to be regarded as at risk only with respect to: (1) Amounts of

money and the adjusted basis of property actually contributed

to the activity; and (2) amounts borrowed with respect to or for

use in the activity. An obligation to pay interest in the future

does not so qualify. Such an obligation does not constitute a

contribution of money or property to the activity, nor does it

constitute the borrowing of money. If money has been bor-

rowed and is used in the activity, such money or loan proceeds

may qualify under the at-risk rules, but interest on the associ-

ated debt does not qualify until it is paid.

Porreca v. Commissioner, 86 T.C. 821 (1986), and

Lansburgh v. Commissioner, T.C. Memo. 1987-164, are not to

the contrary. In Porreca v. Commissioner, supra at 847, we sim-

ply treated interest actually paid as part of the taxpayer’s cap-

ital cost of the investment. Porreca is not authority for the

proposition that an obligation to pay interest in the future is to

be regarded as an amount with respect to which a taxpayer is at

risk under section 465.

In Lansburgh v. Commissioner, supra, a taxpayer was con-

sidered at risk with respect to an obligation to pay interest not

because the obligation reflected an obligation to pay interest,

but because the obligation also constituted part of the price to

convert the underlying debt obligations to nonrecourse obli-

gations. Lansburgh v. Commissioner, supra, is distinguishable

from the instant case on that basis.

Petitioner is to be regarded as at risk with regard to the inter-

est-only promissory notes only in the years petitioner's obli-

33a

gations thereunder were actually paid (namely, in 1983 and

1984).

In light of the above resolution of the at-risk issues under

section 465, it is not necessary to address respondent’s alter-

native argument that under the remarketing agreement between

petitioner, Moffatt, and Equitable, Equitable had fixed and def-

inite rights in conflict with its creditor status that constituted

a prohibited other interest under section 465(b)(3).

Sham Transaction, Economic Substance, and Profit Objective

When analyzing the substance and form of business trans-

actions, the reality that the tax laws affect the shape of most

business transactions cannot be ignored. Frank Lyon Co. v.

United States, 435 U.S. 561, 576-580 (1978). This principle is

particularly appropriate where significant tax benefits are made

available for the specific purpose of promoting and stimulating

the precise type of investments in issue. Levy v. Commissioner,

91 T.C. 838, 853 (1988); Estate of Thomas v. Commissioner, 84

T.C. 412, 432 (1985). In general, equipment leasing transac-

tions would appear to qualify as a type of Significantly tax-

motivated transaction that Congress intended to encourage.

Levy v. Commissioner, supra at 871-872; Fox v. Commissioner,

82 T.C. 1001, 1021 (1984).

It also is well established, however, that to be recognized for

Federal income tax purposes, transactions must have a business

purpose and economic substance apart from anticipated tax

consequences. Knetsch v. United States, 364 U.S. 361, 366

(1960); Goldstein v. Commissioner, 364 F.2d 734, 740 (2d Cir.

1966), affg. 44 T.C. 284 (1965); Hulter v. Commissioner, 91

T.C. 371, 388 (1988). Where taxpayers resort to “the expedient

of drawing up papers to characterize transactions contrary to

objective economic realities and which have no economic Sig-

nificance beyond expected tax benefits,” the tax benefits claimed

will be denied on the basis that the transactions were shams.

Cooper v. Commissioner, 88 T.C. 84, 103 (1987); Falsetti v.

Commissioner, 85 T.C. 332, 335 (1985).

Examinations into the business purpose and economic substance

of transactions are inherently factual. Levy v. Commissioner, supra

34a

at 854. It is often difficult to distinguish clearly between valid and

invalid transactions. Rice’s Toyota World, Inc. v. Commissioner, 81

T.C. 184, 197 (1983), affd. on this issue 752 F.2d 89 (4th Cir.

1985).

The business purpose inquiry tends to be an inquiry into the tax-

payer's subjective purpose for entering into the transactions in

issue. Levy v. Commissioner, supra at 854; Packard vy.

Commissioner, 85 T.C. 397, 417 (1985). The economic substance

inquiry tends to be an analysis of objective factors indicating

whether the transactions had a reasonable possibility of producing

a profit. Levy v. Commissioner, supra at 854; Packard vy.

Commissioner, supra at 417. See also Casebeer v. Commissioner,

909 F.2d 1360, 1363 (9th Cir. 1990), affg. on this issue, revg. in

part, and remanding Larsen v. Commissioner, 89 T.C. 1229 (1987),

and three memorandum opinions of this Court; James v.

Commissioner, 899 F.2d 905, 908-909 (10th Cir. 1990), affg. 87

T.C. 905 (1986); Friedman v. Commissioner, 869 F.2d 785, 792

(4th Cir. 1989), affg. Glass v. Commissioner, 87 T.C. 1087 (1986);

Rose v. Commissioner, 868 F.2d 851, 854 (6th Cir. 1989), affg. 88

T.C. 386 (1987).

In order to satisfy the profit-objective test and thereby to be

entitled to claim the losses at issue in this case independently of

the limitations of section 183, petitioner must also have entered

into the investments with an actual and honest objective of mak-

ing a profit. Cooper v. Commissioner, 88 T.C. 84, 108 (1987);

Fuchs v. Commissioner, 83 T.C. 79, 98 (1984); Dreicer v.

Commissioner, 78 T.C. 642, 646 (1982), affd. without opinion 702

F.2d 1205 (D.C. Cir. 1983). The expectation of profit need not

have been reasonable, but the taxpayer must have entered into the

activity with the objective of making a profit. Sec. 1.183-2(a),

Income Tax Regs.; Engda&l v. Commissioner, 72 T.C. 659, 666

(1979); Golanty v. Commissioner, 72 T.C. 411, 425-426 (1979),

affd. without published opinion 647 F.2d 170 (9th Cir. 1981).

Various factors set forth in the regulations under section 183

have been used in the analysis of whether the requisite profit

objective exists. No one factor, however, is determinative. See sec.

1.183-2(b), Income Tax Regs. The resolution of whether a profit

Objective exists is to be made on the basis of all of the facts and

35a

circumstances. Elliott v. Commissioner, 84 T.C. 227, 236 (1985),

affd. without published opinion 782 F.2d 1027 (3d Cir. 1986);

Golanty v. Commissioner, supra at 426. More weight is to be given

to objective facts than to self-serving statements of intention. Beck

v. Commissioner, 85 T.C. 557, 570 (1985); Siegel v. Commissioner,

78 T.C. 659, 699 (1982).

We do not believe that the transactions before us constitute

sham transactions lacking in economic substance. The equipment

existed. It was essentially new, state of the art peripheral computer

equipment that was highly regarded in the computer industry and

that because of its special features had a particular niche in the

market place. Most significantly, the stated purchase price for the

equipment was not inflated. It reflected recent market price adjust-

ments in ITT computer equipment, and the fair market value of the

equipment was reflected at each level of the various transactions.

The evidence is persuasive that the ITT peripheral computer

equipment involved in this case was not as subject to technolog-

ical obsolescence as was mainframe computer equipment and that

the list price of such equipment tended to reflect the technologi-

cal obsolescence that may have existed at the time of the sale. See

also Mukerji v. Commissioner, 87 T.C. 926, 943 (1986).

The equipment was already delivered, installed, and on lease

with Duquesne Light under the existing end-user lease agreement,

circumstances often justifying, as they do in this case, a lease pre-

mium in the valuation of the equipment. Mukerji v. Commissioner,

supra at 965.

The equipment has been maintained and upgraded under the

maintenance agreement with ITT. The equipment has been re-

leased to Duquesne Light at the maximum lease renewal rates

allowed under the lease renewal provisions and it remains on lease

through the time of trial.

Petitioner’s first expert witness began his valuation of the

equipment with the nondiscounted list price of the peripheral com-

puter equipment of ITT that is involved in this case and discounted

that figure 10 percent for the unavailability of the investment tax

credit. He factored into his valuation a 15-percent lease premium

in light of the end-user lease with Duquesne Light, a 10-percent

premium in light of the maintenance agreement, and a 5-percent

36a

premium in light of the insurance carried on the equipment by

Duquesne Light.

Petitioner’s second expert witness based his valuation largely on

a report he authored in 1981 under contract with the U.S.

Government. That report evaluated and projected the future of the

computer and data processing industry, and it projected future

costs in 1990 and 1995 of specific types of computer equipment

including terminal display equipment. The conclusions set forth in

petitioner’s second expert’s 1981 report and his report prepared for

this case generally support a finding that the ITT peripheral com-

puter equipment purchased by petitioner and Moffatt for $300,000

was purchased at or below its fair market value.

Respondent’s expert witness began his valuation with pricing

information relating to IBM and Telex peripheral computer equip-

ment that was only generally compatible with the ITT equipment

involved in this case and which information was not available until

after petitioner and Moffatt entered into the transactions in issue.

Respondent’s expert discounted the sales price that ITT charged

Equitable by 20 percent for the unavailability of the investment tax

credits. Respondent’s expert offered no explanation as to why the

discount would be 20 percent, twice the amount of the credit

Respondent’s expert did not factor in any premiums for the exist-

ing end-user lease, for the maintenance agreement, for the insur-

ance on the equipment carried by Duquesne Light, nor did he take

into account the fact that the price Equitable paid ITT reflected a

quantity discount not available to petitioner or Moffatt individu-

ally. Respondent’s expert also ignored the fact that ITT increased

the price of its peripheral computer equipment in November of

1981. Lastly, respondent’s expert did not properly account for the

differences between the ITT terminal displays involved in this

case and IBM terminal displays (particularly the redundancy fea-

ture of the ITT equipment).

We summarize generally the opinions of Petitioner’s first expert

witness, but we use a 5-percent factor for the lease premium, and

of respondent’s expert witness as follows:

37a

Petitioner's Respondent's

Ist Expert Expert

2. Santee aah ale $300,000 $278,775

Less Discount For:

WO Ee aes Ceaxvcas as csaks 10% 20%

Plus Premiums For:

Existing Lease........... 5% 0%

Maintenance............. 10% 0%

re 5% 0%

Fair Market Value:

August 31, 1982.......... $329,870 $225,411

1982 Estimate of Residuai

Value in 1992............ 33% —0-

1982 Estimate of Useful Life... 14-16 yrs 4-6 yrs

We agree generally with the analysis and estimates utilized by

petitioner’s experts, and adopt the figures in the above summary

reflecting the opinion generally of petitioner’s first expert witness.

With regard to whether petitioner had an actual and honest

profit objective for entering into the transactions in issue, many of

the above factors are relevant. Additionally, we note that begin-

ning in 1985, the fixed lease payments to be paid by Equitable to

petitioner exceed the note payments due by petitioner to Cooper

Leasing. Also, petitioner had the expectation that he would share

in significant additional rentals on release of the equipment and

that the equipment would have a significant residual value that

would be realized on a resale of equipment. The fair market pur-

chase price paid for the equipment, the features of the equipment,

the existing lease with Duquesne Light, the historical performance

of the equipment, and the subsequent renewal of the lease by

Duquesne Light, among other things, establish and corroborate

petitioner’s profit objective.

We hold that the transaction before us in this case was not a

sham transaction lacking in economic substance and that petitioner

had an actual and honest profit objective for entering into the

transaction.

38a

Other Issues

Based primarily on the arguments he made concerning the issue

of sham transaction and profit objective, respondent argues that

petitioner and Moffatt did not acquire the benefits and burdens of

ownership of the computer equipment, and that the underlying

debt obligations were not genuine and therefore that interest actu-

ally paid on the debt obligations should not be deductible.

Essentially for the same reasons we ruled in favor of petitioner on

the sham transaction and the profit objective issues, we conclude

that petitioner and Moffat acquired ownership of the computer

equipment and that the interest actually paid by petitioner on his

written debt obligations associated with this transaction is

deductible in the year paid. See Rice’s Toyota World, Inc. v.

Commissioner, 752 F.2d 89 (4th Cir. 1985), revg. on this issue 81

T.C. 184 (1983); Rose v. Commissioner, 88 T.C. 386, 423-424

(1987), affd., 868 F.2d 851 (6th Cir. 1989).

Respondent contends that additions to tax under section 6661

should be imposed because there was no substantial authority sup-

porting the claimed treatment of the disallowed items. Sec.

6661(b)(2)(B)(i) and (ii). Petitioner argues that he had substantial

authority for the deductions taken.

In this case, resolution of the only substantive issue decided

against petitioner (namely, the at-risk issue) is based primarily on

a conclusion drawn from very complex and interrelated contrac-

tual documents. Epstea v. Commissioner, T.C. Memo. 1991-252.

The underlying facts of this case are somewhat similar to the facts

of a number of other published opinions of this Court in which

equipment leasing transactions have been found to be valid invest-

ments. See, among others, Levy v. Commissioner, 91 T.C. 838

(1988); Gefen v. Commissioner, 87 T.C. 1471 (1986); Pearlstein

v. Commissioner, T.C. Memo. 1989-621. With regard to the at-risk

issue, we Cannot say that petitioner did not have substantial

authority. See Levy v. Commissioner, supra; Gefen v.

Commissioner, supra; Emershaw v. Commissioner, T.C. Memo.

1990-246, on appeal (6th Cir., Sept. 21, 1990); Rubin v.

Commissioner, T.C. Memo. 1989-484; Moser v. Commissioner,

T.C. Memo. 1989-142, affd., 914 F.2d 1040 (8th Cir. 1990);

B & A Distributing Co. v. Commissioner, T.C. Memo. 1988-589.

39a

On the facts of this case, we conclude that petitioner had sub-

Stantial authority for claiming the deductions relating to his par-

ticipation in the equipment leasing transaction and that the

addition to tax under section 6661 should not be imposed.

Section 6621(c) provides for an increased rate of interest for

substantial underpayments attributable to tax-motivated transac-

tions. A substantial underpayment is an underpayment in excess of

$1,000. Among the types of transactions considered to be tax

motivated are losses disallowed as a result of the limitations of

section 465(a).

We have previously determined that petitioner’s losses are lim-

ited by section 465(a). Petitioner is therefore liable for increased

interest under section 6621(c).

Decision will be entered under Rule 15S.

40a

UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

Docket No. 92-4023

Filed Oct. 21, 1992

At a stated Term of the United States Court of Appeals for

the Second Circuit, held at the United States Courthouse in the

City of New York, on the 21st day of October, one thousand

nine hundred and ninety-two.

Present: HON. GEORGE C. PRATT, HON. J. DANIEL

MAHONEY, HON. JOSEPH M. MCLAUGHLIN,

Circuit Judges.

JOHN J. WATERS and JEANNE M. WATERS,

Petitioners-Appellants,

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

Appeal from the United States Tax Court.

This cause came on to be heard on the transcript of record

from the United States Tax Court, and was argued by counsel.

ON CONSIDERATION WHEREOF, it is now hereby ordered,

adjudged and decreed that the judgment of said Tax Court be

and it hereby is affirmed in accordance with the opinion of this

Court with costs to be taxed against the appellants.

ELAINE B. GOLDSMITH, Clerk

By: /s/ EDWARD J. GUARDARO,

Edward J. Guardaro

Staff Attorney

a>)

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