Harry E. Peaden, Jr. v. Commissioner

113 T.C. No. 6

UNITED STATES TAX COURT

HARRY E. PEADEN, JR. AND CINDY D. PEADEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 14837-97. Filed August 9, 1999.

C, P's wholly owned S corporation,
leased trucks under master lease agreements
(master leases). For each truck, C and the
lessor agreed to a base rent dependent on the
lessor's cost of the truck. The master
leases contain a terminal rental adjustment
clause (TRAC), as defined in sec. 7701(h)(3),
I.R.C., providing that the lessor, at the
conclusion of the lease term, must sell the
truck and remit to C any sale proceeds that
exceed the remaining base rent plus the
lessor's cost of arranging the sale. R does
not argue that the lease agreements are not
"qualified motor vehicle operating
agreements" within the meaning of sec.
7701(h)(2), I.R.C., but instead argues that
the TRAC may be taken into account in
determining whether the transactions entered
into pursuant to the master leases (lease
transactions) should be treated as leases.
Held: Pursuant to sec. 7701(h)(1),
I.R.C., the TRAC contained in the master
 - 2 -

leases will not be taken into consideration
in deciding whether the lease transactions
are entitled to lease treatment. Held,
further, the lease transactions are entitled
to be treated as leases.

David D. Aughtry and Vivian D. Hoard, for petitioners.

Mark S. Mesler, for respondent.

WELLS, Judge: Respondent determined a deficiency in

petitioners' 1993 Federal income taxes of $977,267 and a section

6662 accuracy-related penalty of $195,453.

Unless otherwise indicated all section references are to the

Internal Revenue Code in effect for the year in issue, and all

Rule references are to the Tax Court Rules of Practice and

Procedure.

The issues we must decide in the instant case are: (1)

Whether section 7701(h)(1) precludes consideration of a "terminal

rental adjustment clause" (TRAC)1 contained in certain agreements

1
Sec. 7701(h)(3) provides:

(3) Terminal rental adjustment clause
defined.--

(A) In general.--For purposes of this
subsection, the term "terminal rental adjustment
clause" means a provision of an agreement which
permits or requires the rental price to be
adjusted upward or downward by reference to the
amount realized by the lessor under the agreement

(continued...)
 - 3 -

covering transactions entered into by Country-Fed Meat Co., Inc.

(Country-Fed), a subchapter S corporation wholly owned by

petitioner Harry E. Peaden, Jr. (petitioner) and (2) whether such

agreements should be treated as leases or purchases of trucks.

FINDINGS OF FACT

Some of the facts and certain exhibits have been stipulated

for trial pursuant to Rule 91. The parties' stipulations of fact

are incorporated into this Opinion by reference and, accordingly,

are found as facts in the instant case.

At the time they filed the petition, petitioners resided in

Fayetteville, Georgia. Petitioner is the sole shareholder of

Country-Fed, a corporation that was incorporated under the laws

of the State of Georgia. Petitioner elected, before 1993, to

have Country-Fed taxed as a small business corporation pursuant

to section 1362(a).

Country-Fed is in the business of selling meat, chicken, and

seafood products through direct sellers. Country-Fed's direct

sellers distribute Country-Fed's products in approximately 20

States.

1
(...continued)
upon sale or other disposition of such property.
 - 4 -

During 1993, Country-Fed entered into separate agreements

(collectively, master leases)2 with World Omni Leasing, Inc.

(World Omni), McCullagh Leasing, Inc. (McCullagh), and Automotive

Rentals, Inc. (ARI) (collectively, the lessors) covering

approximately 565 trucks, with attached refrigeration units,

(trucks) for the following duration: 9 trucks for 50 months, 1

truck for 40 months, 10 trucks for 36 months, 321 trucks for 30

months, 72 trucks for 24 months, 114 trucks for 18 months, and 38

trucks for 12 months (collectively, lease transactions). Each of

the trucks has a useful life that extends beyond its respective

lease term. Country-Fed provides the trucks to direct sellers

who use the trucks daily to distribute Country-Fed's products.

The master leases were negotiated at arm's length and

contain the general provisions for individual lease transactions

covering each of the trucks. Country-Fed and the lessors adhered

to the contractual terms of their respective master lease

agreements. Country-Fed is not required to make a downpayment in

conjunction with any of the lease transactions.

The lessors realized a more than de minimis pretax economic

benefit from each of the lease transactions. As a part of each

2
The master leases are similar to one another in both form
and substance. To the extent that there are any important
differences in the master leases, we will refer to the master
leases separately.
 - 5 -

lease transaction, Country-Fed executed the certification

required by section 7701(h)(2)(C).3 In each lease transaction,

3
Sec. 7701(h)(2) provides:

(2) Qualified motor vehicle operating agreement
defined.--For purposes of this subsection--
(A) In general.--The term "qualified
motor vehicle operating agreement" means any
agreement with respect to a motor vehicle
(including a trailer) which meets the
requirements of subparagraphs (B), (C), and
(D) of this paragraph.

(B) Minimum liability of the lessor.--An
agreement meets the requirements of this subparagraph
if under such agreement the sum of--

(i) the amount the lessor is
personally liable to repay, and

(ii) the net fair market value of the
lessor's interest in any property pledged as
security for property subject to the agreement,

equals or exceeds all amounts borrowed to finance
the acquisition of property subject to the
agreement. There shall not be taken into account
under clause (ii) any property pledged which is
property subject to the agreement or property
directly or indirectly financed by indebtedness
secured by property subject to the agreement.

(C) Certification by lessee; notice of tax
ownership.--An agreement meets the requirements of
this subparagraph if such agreement contains a
separate written statement separately signed by
the lessee--

(i) under which the lessee certifies,
under penalty of perjury, that it intends that
more than 50 percent of the use of the property
subject to such agreement is to be in a
trade or business of the lessee, and
(continued...)
 - 6 -

the lessor's rental income over the period of the lease exceeded

the sum of the lessor's depreciation and cost of financing its

purchase of the trucks.

A typical lease transaction takes place as follows:

Country-Fed first identifies the type of truck it wishes to

lease. The lessor then obtains the truck that Country-Fed has

identified. Often, Country-Fed negotiates with dealers regarding

the price for which the lessor could acquire the truck. After

identifying a truck which Country-Fed wishes to lease, Country-

Fed and the lessor execute a "New Vehicle Order"4 which is

subject to the terms of the master lease and contains the

3
(...continued)
(ii) which clearly and legibly states that
the lessee has been advised that it will not be
treated as the owner of the property subject to
the agreement for Federal income tax purposes.

(D) Lessor must have no knowledge that
certification is false.--An agreement meets the
requirements of this subparagraph if the lessor
does not know that the certification described in
subparagraph (C)(i) is false.

As to each truck, Country-Fed executed the certification required
by sec. 7701(h)(2)(C) and used the truck in its business. There
is no evidence in the record regarding how the lessors financed
their acquisition of the trucks.
4
This is the term used by the McCullagh master lease. The
ARI master lease refers to this agreement as a "Motor Vehicle
Lease Agreement". The World Omni master lease refers to this
agreement as the "Leased Unit Quotation". Despite the difference
in terminology, the information contained in each document is
essentially the same.
 - 7 -

following additional information as to the particular truck:

(1) The term of the lease; (2) the base rent;5 and (3) the

monthly rental charge.

The base rent represents the sum of all of the monthly rent

due throughout the lease transaction for the particular truck.

The base rent is dependent on the lessor's cost of obtaining the

truck and refitting it to petitioner's specifications, which

could include the purchase and attachment of the refrigeration

units. Over the lease term, a fixed portion of the monthly rent

is applied to reduce the base rent. The amount of the reduction

is calculated to be equal to an amount that, at the end of the

lease term, effectively reduces the base rent to zero.6 The

remaining portion of the monthly rent is a service and

administrative charge that is not applied to reduce the base

rent.7

5
The ARI master lease refers to this figure as the
Capitalized Value.
6
The ARI master lease reaches the same result by providing
that, upon the termination of the lease period, the Capitalized
Value is reduced by the "total depreciation reserve". The "total
depreciation reserve" is determined by multiplying: (1) The
number of months a vehicle is billed in service and paid by the
Lessee, times (2) the Capitalized Value, times (3) the monthly
depreciation percentage, which is determined at the outset of the
lease. The monthly depreciation percentage is calculated to be
equal to an amount that, at the end of the lease term,
effectively reduces the Capitalized Value of the truck to zero.
7
Under the ARI master lease this is the portion of the
(continued...)
 - 8 -

In addition to the monthly rent, Country-Fed must pay all

registration and compliance fees not included in the base rent.

Country-Fed also must pay any taxes that accrue with respect to

the use or possession of the particular trucks during the term of

its lease transaction.

Country-Fed must repair any damage to the trucks. If a

truck is damaged beyond repair, Country-Fed must pay the lessor

the remaining base rent.8

The master lease provides that title to the leased truck

remains with the lessor throughout the term of the lease. At the

end of the lease term for a particular truck, Country-Fed is

responsible to return that truck to the lessor. If the truck

remains in Country-Fed's possession beyond the term of the

respective lease, Country-Fed is required to continue paying the

lessor the monthly service and administrative fees.

Upon return of the truck, the lessor is obligated to sell

the truck. If the proceeds of the sale obtained by the lessor

exceed any remaining base rent, plus the cost to the lessor of

7
(...continued)
monthly rent not included in the depreciation reserve. The ARI
master lease also provides that Country-Fed may continue to use
the truck at the end of the lease term as long as it continues to
pay the "administrative" portion of the monthly rent.
8
Under the ARI master lease, if a truck was damaged beyond
repair, Country-Fed can elect to terminate the lease.
Termination of the lease effectively results in Country-Fed's
paying the lessor the remaining base rent. See infra.
 - 9 -

arranging the sale, the lessor is required to remit the excess to

Country-Fed. If the proceeds of the sale obtained by the lessor

are less than any remaining base rent, plus the cost to the

lessor of arranging the sale, Country-Fed is required to pay the

lessor the difference.

The McCullagh master lease contains an option for Country-

Fed to buy the respective truck at the end of its lease term for

the truck's fair market value. The ARI master lease specifically

provides that Country-Fed has no option to purchase the

respective truck at any time. The World Omni master lease does

not provide an option for Country-Fed to buy the respective truck

but provides that Country-Fed may purchase the truck if it is

being sold at a public sale. Country-Fed did, however, acquire

title to most of the trucks at the end of the respective lease

transactions.

On or about April 9, 1997, respondent issued a notice of

deficiency that determined a deficiency in petitioners' Federal

income tax in the amount of $977,267 for their 1993 taxable year.

Respondent increased petitioners' Schedule E income by

$2,304,296. In calculating the increase, respondent determined

that petitioners were not entitled to: (1) A rental deduction of

$2,946,224 for the lease of trucks and related equipment by

Country-Fed; (2) an employee business relations/entertainment

deduction of $222,425; and (3) other deductions of $350,365.
 - 10 -

Respondent allowed petitioners additional Schedule E deductions

of $1,092,804 for depreciation and $121,914 for fringe benefits

paid to employees. Additionally, respondent increased

petitioners' adjusted gross income by $91,672 for fringe benefits

received and disallowed $71,879 in itemized deductions.

Respondent further determined that petitioners were liable for an

accuracy-related penalty pursuant to section 6662 of $195,453.

The parties have settled all of the issues determined in the

notice of deficiency except the disallowed Schedule E rental

deduction for the trucks and related equipment leased by Country-

Fed and the allowable depreciation deduction if the rental

deduction is disallowed.

OPINION

We must decide whether section 7701(h)(1) precludes

consideration of the TRAC contained in the master leases covering

the lease transactions and whether the lease transactions should

be treated as leases or as purchases of trucks. Neither party

disputes that the provisions of the master leases that require

either the lessor to remit to Country-Fed the amount by which the

sale proceeds of the truck exceed the remaining base price plus

the cost of the sale, or, conversely, require Country-Fed to

remit to the lessor the amount by which the remaining base rent

plus the cost of the sale exceeds the proceeds, are a "terminal

rental adjustment clause" within the meaning of section
 - 11 -

7701(h)(3). Respondent contends that the lease transactions are

conditional purchases of trucks because, as to any particular

lease transaction, the remaining base rent is always lower than

the fair market value of the respective truck at the end of its

lease term. Respondent points to the TRAC contained in each of

the master leases and argues that, because the amounts that the

lessors receive on the sale of the trucks always exceed the

remaining base rent, Country-Fed could, and for the most part

did, acquire the trucks at the end of the lease term for a

nominal price. Accordingly, respondent argues, the substance of

the lease transactions is the purchase of a truck.

Petitioners argue that, in deciding whether the lease

transactions should be treated as leases, section 7701(h)(1)

precludes consideration of the TRAC upon which respondent relies.

Petitioners argue that, but for the TRAC, the substance of the

lease transaction is a lease and therefore the lease transactions

should be treated as leases.

Section 7701(h)(1) provides:

SEC. 7701 (h). Motor Vehicle Operating Leases.--

(1) In general.--For purposes of this title, in
the case of a qualified motor vehicle operating
agreement which contains a terminal rental adjustment
clause--

(A) such agreement shall be treated as a
lease if (but for such terminal rental adjustment
clause) such agreement would be treated as a lease
under this title, and
 - 12 -

(B) the lessee shall not be treated as the
owner of the property subject to an agreement
during any period such agreement is in effect.

Respondent does not contend that the master leases are not

"qualified motor vehicle operating agreements".9 Rather,

respondent argues that the TRAC may be considered in deciding

whether the substance of the lease transactions is the purchase

of a truck. We disagree. "The plain meaning of legislation

should be conclusive, except in the 'rare cases [in which] the

literal application of a statute will produce a result

demonstrably at odds with the intentions of its drafters.'"

United States v. Ron Pair Enters., Inc., 489 U.S. 235, 242 (1989)

(quoting Griffin v. Oceanic Contractors, Inc., 458 U.S. 564, 571

(1982)).

Section 7701(h) was enacted after our decision in Swift

Dodge v. Commissioner, 76 T.C. 547 (1981), revd. 692 F.2d 651

(9th Cir. 1982). In Swift Dodge, the taxpayer, a leasing

company, entered into various lease transactions. Under the

terms of each lease, part of the lessee's monthly payments was to

be applied to the cost of the vehicle ("capitalized cost")

resulting in the "depreciated value". The lease further provided

that, if at the end of the lease term the actual wholesale value

of the car exceeded its "depreciated value", the lessor would

9
See the statutory definition of "qualified motor vehicle
operating agreement" set forth supra note 3.
 - 13 -

remit the excess to the lessee. Conversely, if the "depreciated

value" of the car exceeded its actual wholesale value, the lessee

would pay the difference to the lessor. We held that the

agreement in question was a lease, noting that the depreciated

value was calculated on the basis of expected depreciation of the

vehicle over the course of the lease. See id. at 569, 570. We

explained that "the inclusion of a contract provision that shifts

the depreciable loss to the extent of wholesale value away from

the taxpayer in an attempt to minimize business risks does not

control for purposes of determining whether the agreement is a

lease or conditional sales contract." Id. at 569. We further

stated that "this is not a case in which the total rental

payments paid all but a nominal amount of the cost of the leased

property." Id. at 572.

After our decision in Swift Dodge v. Commissioner, supra,

Congress enacted the Tax Equity and Fiscal Responsibility Act of

1982 (TEFRA), Pub. L. 97-248, 96 Stat. 324. TEFRA section 210,

96 Stat. 447, precluded the Commissioner from considering TRAC

provisions in determining whether an agreement was a lease until

a statute is enacted or regulations are issued. See Leslie

Leasing Co. v. Commissioner, 80 T.C. 411 (1983). After the

enactment of TEFRA, the Court of Appeals for the Ninth Circuit

reversed our decision in Swift Dodge v. Commissioner, 692 F.2d at

651. The Court of Appeals held that the agreement in question
 - 14 -

was closer to a conditional sales agreement than to a lease. See

id. at 654. The Court did not consider the effect of TEFRA

section 210. After the decision of the Court of Appeals in Swift

Dodge, the Commissioner proposed regulations which would have

prevented leases containing TRAC provisions from being treated as

leases. See sec. 1.168(f)(8)-12, Proposed Income Tax Regs., 47

Fed. Reg. 52730 (Nov. 23, 1982).

During 1984 Congress enacted section 168(f)(13) as part of

the Deficit Reduction Act of 1984 (DEFRA), Pub. L. 98-369, sec.

32, 98 Stat. 494, 530. DEFRA section 32 is virtually identical

to current section 7701(h), which was enacted during 1986 as part

of the Tax Reform Act of 1986 (TRA 1986), Pub. L. 99-514, sec.

201(c), 100 Stat. 2085, 2138. The legislative history of DEFRA

section 32 specifically refers to: (1) Our decision in Swift

Dodge, (2) the decision of the Court of Appeals for the Ninth

Circuit in Swift Dodge, and (3) the proposed regulations. See H.

Rept. 98-432, at 1615 (1984); S. Rept. 98-169, at 865 (1984); H.

Conf. Rept. 98-861, at 801 (1984), 1984-3 C.B. (Vol. 2) 1, 55.

By those references, we know that, when DEFRA section 32 was

enacted, Congress was aware of our holding and the Court of

Appeals' holding in Swift Dodge, as well as the proposed

regulations. Consequently, when the DEFRA section 32 was enacted

and when the current, identical section 7701(h) was enacted as

part of TRA 1986, Congress, being well aware of those holdings
 - 15 -

and regulations, could have specifically denied the protection

provided by section 7701(h) to lease transactions such as those

in issue in the instant case where "the total rental payments

paid all but a nominal amount of the cost of the leased

property." Swift Dodge v. Commissioner, 76 T.C. at 572.

Congress, however, did not elect to place such limitations in

section 7701, and it is not within our province to do what

Congress failed to do or elected not to do. See Hanover Bank v.

Commissioner, 369 U.S. 672, 688 (1962).

Consequently, we will adhere to the plain language of

section 7701(h). As required by that section, we will analyze

the lease transactions without the TRAC; that is, we will look at

the lease transactions as if the lessors received possession of

the trucks at the end of the lease term without any obligation to

sell them and remit to Country-Fed any proceeds which exceed the

base price plus the cost of arranging the sale. Moreover, as a

result of our disregarding the TRAC, we regard any sale of the

trucks to Country-Fed under the provisions of the McCullagh or

World Omni master leases10 as sales at fair market value as

required by the master leases.11

10
The ARI master lease specifically provides that Country-Fed
has no option to purchase the truck at the end of the lease term.
11
That Country-Fed in fact paid only a nominal price for the
purchase of the trucks at the end of the lease term is a direct
(continued...)
 - 16 -

Once the TRAC is disregarded, the master leases contain

standard equipment lease provisions that do not preclude

treatment of the lease transactions as leases. See, e.g., Torres

v. Commissioner, 88 T.C. 702, 721 (1987) ("because net leases are

common in commercial settings, it is less relevant that * * *

[the lessor] was not responsible for the payment of property

taxes or that * * * [the lessor] bears less of a risk of loss or

damage to the property because the lessee is required to maintain

insurance on the property."); Gefen v. Commissioner, 87 T.C.

1471, 1493 (1986) ("we have long rejected any notion that a net

lease * * * shifts the burden of ownership from the lessor to the

lessee."); Northwest Acceptance Corp. v. Commissioner, 58 T.C.

836, 847-848 (1972) (finding that even a generous purchase option

is not fatal to lease determination), affd. per curiam 500 F.2d

1222 (9th Cir. 1974). Accordingly, in the instant case, we

conclude that the lease transactions should be treated as leases.

Finally, the form of a transaction, if imbued with tax-

independent considerations, has economic substance and will be

11
(...continued)
result of the TRAC. Because Country-Fed was entitled to the
proceeds of the sale above any remaining base price plus the
costs to the lessor of arranging the sale, when Country-Fed
purchased the trucks, it was not required to pay the lessor
anything above the base price plus the costs to the lessor of
arranging the sale. Moreover, because the base price was
effectively reduced to zero at the end of the lease term,
Country-Fed would be required to pay only a nominal amount to
purchase the vehicle at the end of the lease term.
 - 17 -

respected for Federal income tax purposes. See Frank Lyon Co. v.

United States, 435 U.S. 561, 584-585 (1978); Hulter v.

Commissioner, 91 T.C. 371, 388 (1988). Country-Fed chose to

lease the trucks instead of purchasing them outright because the

lessors did not require a downpayment on leased trucks. Not

having to make a downpayment on the trucks allowed Country-Fed to

use its capital elsewhere in its expanding business. Of course,

leasing the trucks apparently12 resulted in additional tax

benefits to Country-Fed in the form of accelerated deductions.

That a transaction is shaped in part, however, by tax

considerations is not a sufficient reason for disregarding its

form. See Frank Lyon Co. v. United States, supra at 581.

We have considered the parties' remaining arguments and find

them irrelevant or unnecessary to reach. To reflect the

foregoing and the concessions of the parties,

Decision will be entered

under Rule 155.

12
Petitioner has moved to shift the burden of proof arguing
that the amounts in the notice of deficiency relating to allowed
depreciation deductions were arbitrary. Because we hold that
petitioner is entitled to rental deductions and not depreciation
deductions, with respect to the trucks, petitioner's motion to
shift the burden of proof is moot.