T.C. Memo. 2005-16
UNITED STATES TAX COURT
CMA CONSOLIDATED, INC. & SUBSIDIARIES, INC., Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12746-01. Filed January 31, 2005.
George W. Connelly, Jr., Linda S. Paine, and William O.
Grimsinger, for petitioners.
Mary E. Wynne and Caroline Tso Chen, for respondent.
CONTENTS
Page
Introduction and Statement of Issues........................ 3
Findings of Fact............................................ 5
I. The Two Lease Strip Deals.............................. 6
A. Background......................................... 6
B. First Lease Strip Deal............................. 11
C. Second Lease Strip Deal............................ 19
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D. Other Aspects of Petitioner’s Claimed Losses and
Deductions With Respect to the Second Lease Strip
Deal............................................... 29
II. Petitioner’s 1995 Through 1997 Advances to Cap Corp.
and the December 2, 1996, Debt Conversion Transaction.. 32
A. Cap Corp. and Its Business......................... 32
B. Petitioner’s 1995 and 1996 Advances to Cap Corp.... 35
C. The December 2, 1996, Debt Conversion Transaction.. 38
D. Petitioner’s 1997 Advances to Cap Corp............. 40
E. Petitioner’s 1997 Ordinary Loss and Bad Debt
Deduction; Petitioner’s 1998 AeroCentury Stock
Transaction........................................ 41
1. The $2 Million Consulting Fee.................. 43
2. Petitioner’s Advances to Koehler .............. 50
Opinion..................................................... 52
I. Petitioner’s Second Lease Strip Deal................... 53
A. Did the Underlying Transactions Have Economic
Substance?......................................... 54
1. Generally...................................... 54
2. Background and Recapitulation of the Two Lease
Strip Transactions............................. 57
3. Petitioner’s Rental Expense Deductions and Note
Disposition Losses............................. 62
4. Did Petitioner Have a Nontax Business Purpose
for Entering Into the Second Lease Strip
Transaction?................................... 64
5. Whether Petitioner’s Lease Strip Deal Had
Economic Profit Potential Aside From the Tax
Benefits....................................... 70
a. The Experts’ Opinions...................... 74
i. Petitioner’s Expert.................... 75
(a) Svoboda’s Opinions as to the Fair
Market Values and Estimated Residual
Values................................. 76
(b) Svoboda’s Fair Market Value for
the Over Lease Residual Interests...... 77
ii. Respondent’s Expert.................... 79
b. Evaluation and Comparison of the Experts... 82
c. Petitioner’s Lease Strip Deal’s Economic
Profit Potential........................... 85
6. Conclusion as to the Economic Substance of
Petitioner’s Lease Strip Deal.................. 86
B. Petitioner’s Entitlement to Its Claimed Deductions. 90
II. Petitioner’s $2,052,900 Ordinary Loss and $1,859,135
Bad Debt Deduction..................................... 91
A. Petitioner’s Claimed Deductions--the Debt vs.
Equity Issue....................................... 91
B. Application of the 11-Factor Test.................. 94
1. Names Given to the Documents................... 94
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2. Presence or Absence of a Fixed Maturity Date... 95
3. Source of the Repayment........................ 97
4. The Right To Enforce the Payments.............. 98
5. Participation in Management.................... 99
6. Status Relative to Other Creditors............. 100
7. Intent of the Parties.......................... 101
8. Thin or Adequate Capitalization................ 102
9. Identity of Interest........................... 104
10. Payment of Interest Only Out of Dividends...... 105
11. Ability To Obtain Loans From Outside Lending
Institutions................................... 106
C. Conclusion and Holdings............................ 107
III. The $2 Million Fee..................................... 110
A. The Assignment of Income Doctrine.................. 110
B. The Parties’ Arguments............................. 112
1. Petitioner’s Arguments......................... 112
2. Respondent’s Arguments......................... 113
C. Analysis and Holding............................... 114
1. Petitioner’s Agreement With NSI................ 114
2. CKH’s and Petitioner’s Purported Fee-Splitting
Agreement...................................... 114
3. Petitioner’s Entitlement to a Business
Deduction...................................... 118
IV. Petitioner’s Advances to Koehler....................... 119
V. Is Petitioner Liable for Penalties Under Section 6662?. 122
Appendixes
Appendix A--Flow Chart Reflecting the Basic Elements of
the Transactions in the Two Lease Strip Deals. 129
Appendix B--Summary of Appendix A......................... 132
Appendix C--Existing End User Equipment Rental MonthlY
Payments That HCA Purchased................... 133
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Chief Judge: Respondent determined income tax
deficiencies, an addition to tax, and penalties with respect to
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petitioner’s1 taxable years ended November 30, 1996 and 1997, as
follows:
Addition to Tax and Penalties
TYE Deficiency Sec. 6651(a)(1) Sec. 6662(a)
11/30/96 $320,375 $16,019 $90,609
11/30/97 1,729,294 -- 176,383
All section references are to the Internal Revenue Code, as
amended and in effect for the years in issue. Rule references
are to the Tax Court Rules of Practice and Procedure.
After concessions by the parties, the primary issues
remaining for our consideration are: (1) Whether petitioner is
entitled to approximately $2.7 million of deductions claimed for
its taxable years ended November 30, 1996 and 1997, from a lease
strip deal; (2) whether petitioner’s lease strip deal has
economic substance and is to be respected for Federal income tax
purposes; (3) whether petitioner’s claimed rental expense
deductions arising from the lease strip deal are deductible as
ordinary and necessary business expenses; (4) whether petitioner
is entitled to claim note disposition losses from the lease strip
deal; (5) whether the $2,259,900 that petitioner advanced to CMA
Capital Corp. is to be treated as an investment (equity) or debt;
(6) whether for its taxable year ended November 30, 1997,
1
Petitioners make up an affiliated group of corporations
that filed consolidated income tax returns for the years in
issue. CMA Consolidated, Inc. (CMA), is the common parent
corporation of that group. For convenience, we use “petitioner”
to refer to that affiliated group of corporations.
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petitioner is entitled to a deduction for a $2,052,900 ordinary
loss from a debt conversion transaction; (7) whether petitioner
is entitled to claim a $1,859,135 bad debt deduction for its
taxable year ended November 30, 1997, with respect to loans
petitioner purportedly made to CMA Capital Corp.; (8) whether
petitioner should include in its income the $2 million portion of
a consulting fee that petitioner paid to Crispin Koehler Holding
Corp. in early 1997; (9) if the $2 million is includable in
petitioner’s income for its taxable year ended November 30, 1997,
whether petitioner is entitled to deduct its payment of $2
million to Crispin Koehler Holding Corp. as a business expense;
(10) whether petitioner is entitled to a $76,705 bad debt
deduction for its taxable year ended November 30, 1996, with
respect to its advances to Richard Koehler; and (11) whether
petitioner is liable for penalties under section 6662 for its
taxable years ended November 30, 1996 and 1997, with respect to
portions of its underpayments for those years attributable to its
claimed lease strip deal deductions.
FINDINGS OF FACT2
Petitioner is a California corporation. At the time the
petition was filed, petitioner maintained its office and
principal place of business in Burlingame, California. At all
2
The parties’ stipulations of fact and the exhibits attached
thereto are incorporated herein by this reference.
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pertinent times, Neal Crispin (Crispin) owned 98 percent of CMA’s
outstanding stock and has been petitioner’s ultimate decision
maker.
Since its May 1992 incorporation, CMA Capital Management,
Inc. (CMACM), has been a wholly owned subsidiary of petitioner
and a member of petitioner’s consolidated group. Since its
August 1983 incorporation, Capital Management Associates (CM
Associates) has been a wholly owned subsidiary of petitioner and
a member of petitioner’s consolidated group.
I. The Two Lease Strip Deals
A. Background
Petitioner was generally involved in equipment leasing
transactions and the structuring of equipment financing. During
the early 1990s, petitioner began to arrange deals designed to
separate equipment rental income from the related rental
expenses. In those deals, which were called “lease strips”
and/or “rent strips”, the rental income was allocated to a
tax-indifferent or tax-neutral party in order to allow another
party to claim a greatly disproportionate share of the related
tax benefits. Generally, a “tax-indifferent” or “tax-neutral”
party is one that does not incur a Federal income tax liability
on its income because of its status or its circumstances.
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Examples would include a party that was not a U.S. taxpayer or a
party that was a U.S. taxpayer but had large net operating losses
available to offset income.
One such tax-indifferent party petitioner employed was the
Iowa Tribe of Oklahoma (Iowa Tribe). Because of its status as an
Indian tribe recognized by the Bureau of Indian Affairs of the
U.S. Department of the Interior, the Iowa Tribe was not subject
to Federal income tax on income allocated to it from lease strip
deals.3 The Iowa Tribe participated in approximately eight
different partnerships during the mid-1990s and received fees for
its participation as a limited partner in those partnerships. In
exchange for its “modest investment” and agreement to be the 99-
percent limited partner in a partnership, the Iowa Tribe received
a fee ranging from $17,000 to $40,000 at the closing of each
deal. The fee represented a percentage of the total commissions
received by CMA in connection with the lease strip deal. The
Iowa Tribe had no active role in the partnership and realized
that its participation allowed others to exploit its tax-exempt
status. A wholly owned CMA subsidiary and/or Crispin (CMA’s 98-
3
The parties disagree over whether two lease strip deals
involving petitioner that are discussed more fully infra had
economic substance and should be respected for tax purposes. The
terms “sale”, “sold”, “lease”, “purchase”, “income”, “interest”,
“invest”, “note”, “obligation”, “lien”, and other similar terms
are used herein for convenience and are not intended as ultimate
findings or conclusions concerning the validity for tax purposes
of the deals and/or underlying transactions in dispute.
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percent shareholder and ultimate decision maker) often served as
a 1-percent or less general partner of the partnership.
The two lease strip deals involve computer and photo
processing equipment subject to two existing end-user leases.
One end-user lease agreement, dated October 26, 1989 (hereinafter
for convenience referred to as the K-Mart end-user lease or K-
Mart lease), involved the lease of existing and after-acquired
photo processing equipment by Varilease Corp. (Varilease) to K-
Mart Corp. (K-Mart). On January 22, 1992, Computer Leasing, Inc.
(CLI), purchased the equipment subject to the K-Mart lease along
with Varilease’s rights and obligations under the lease. On May
18, 1994, additional equipment was added to the K-Mart end-user
lease. The other end-user lease agreement dated July 1, 1993
(hereinafter for convenience referred to as the Shared end-user
lease or Shared lease), involved the lease of computer equipment
by CLI to Shared Medical System Corp. (Shared).
Starting with the K-Mart and Shared end-user leases and
certain other equipment leases with three other end users, a
series of preconceived transactions was arranged with respect to
that equipment. The transactions were intended to create
residual lease periods beginning after the conclusion of the
existing end-user leases with K-Mart, Shared, and the other end
users. The transactions served as a foundation for two lease
strip deals under which the rental income streams from the
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equipment and the related deductions were bifurcated and
allocated to different entities. Virtually all of the remaining
rental income under the existing end-user leases with K-Mart,
Shared, and other end users was stripped out and allocated to the
Iowa Tribe (a tax-indifferent party not subject to Federal income
tax). A wraparound equipment lease position (encompassing the
existing end-user leases and the residual lease periods) and an
equipment purchase installment note and/or payment rights thereto
(previously issued in “taxable sale”-leaseback transactions
either to the Iowa Tribe’s partnership or another partnership in
which the Iowa Tribe’s partnership held an interest) were
transferred to the respective lease strip deal’s ultimate
beneficiary/customer in a purported section 351 transaction. The
principal and interest payments due under the equipment purchase
installment note equaled, coincided with, and fully offset the
rental payments due under the wraparound lease.
As structured, the two lease strip deals were intended to
generate substantial potential tax benefits for each deal’s
ultimate beneficiary/customer in amounts grossly disproportionate
to the beneficiary’s economic investment in that deal. For
instance, the first lease strip deal’s ultimate beneficiary/
customer would claim equipment rental deductions over the
wraparound lease’s entire life, even though (1) substantially all
of the related rental income from the equipment had been stripped
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out and (2) the rental payments that the beneficiary deducted
were fully offset by the payments due the beneficiary under the
equipment purchase installment note. The ultimate beneficiary/
customer’s potential net tax benefits in the first lease strip
deal equaled the total rental payments due under the wraparound
lease less the interest portion of the installment note payments.
According to a tax opinion issued to CFX Corp. (CFX) (the first
lease strip deal’s ultimate beneficiary/ customer), while the
economic cost of the deal to CFX would be approximately $2.9
million, the deal would generate approximately $13.8 million in
potential net tax deductions for CFX over the life of the
wraparound lease.
In each of the two lease strip deals, the ultimate
beneficiary/customer’s only prospect of realizing a pretax
economic profit on the deal essentially depended upon whether the
rental income produced during the wraparound lease residual
periods would exceed the economic investment in the deal. In
addition, although a series of complex multiparty transactions
(which are discussed in more detail infra) was required to
implement each of these two lease strip deals, typically, the
beneficiary/customer infused the only noncircuitous cash paid to
participants, brokers, lawyers, and others involved in setting up
that deal.
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B. First Lease Strip Deal4
As to the first lease strip deal, the following complex
multiparty equipment purchase, lease, and related transactions
were entered into on November 1, 1994, November 30, 1994,
December 2, 1994, and January 3, 1995.
1. On November 1, 1994, CLI sold, subject to the existing
end-user leases, the equipment leased to K-Mart and Shared, along
with some equipment leased to others, to Equity Resource
Acquisition II (ERA), a limited partnership, for $13,919,451.
ERA was a special-purpose entity created and controlled by CLI
for the express purpose of accomplishing the purchase and sale of
the leased equipment. In exchange for the leased equipment
package, ERA assumed the debt incurred by CLI to finance the
equipment purchase. ERA also issued a $2,307,500 secured
recourse promissory note to CLI, payable within 60 days, with
accrued interest at 10 percent.
2. In turn, on November 1, 1994, ERA sold the leased
equipment for $15.05 million, subject to the existing end-user
leases, to Capital Finance Partners (CFP), a limited partnership.
The partners of CFP were: The Iowa Tribe--a 99-percent limited
partner; CMACM--a .05-percent managing general partner; Crispin--
4
Although petitioner’s subject deductions were derived from
the second lease strip deal, we detail the first deal for
purposes of clarity and to provide a background for discussion of
the second deal.
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a .05-percent individual general partner; and Mithril Corp.--a
.9-percent corporate general partner. In exchange for the leased
equipment, CFP issued its $15.05 million recourse promissory note
bearing 8 percent interest, payable within 60 days to ERA. The
$15.05 million CFP promissory note was executed on behalf of
CMACM (as CFP’s general partner) by Gregory W. Johnson (Johnson),
a vice president of petitioner. After the respective sales to
ERA and CFP in steps 1 and 2, the leased equipment remained
subject to the debt incurred by CLI to purchase the equipment,
and liens that CLI had placed on the equipment and rents due
under the existing end-user leases. In addition, following ERA’s
sale of the equipment to CFP, ERA placed liens on the equipment
to secure payment of CFP’s $15.05 million note to ERA.
3. Also on November 1, 1994, CFP sold the leased equipment
for $14,872,910 to EQ Corp. (EQ), subject to the existing end-
user leases to K-Mart, Shared, and others. ERA consented to the
sale of the leased equipment from CFP to EQ. Joel Mallin
(Mallin), a lawyer in New York, held a major and/or controlling
interest in EQ and its vice president was Joel Klein (Klein), who
rented office space from Mallin. EQ paid for the leased
equipment by issuing to CFP a “$14.125 million Secured Limited
Recourse Installment Note” and a “$747,910 Secured Recourse
Promissory Note”, both of which had a 12-percent interest rate.
The $14.125 million installment note was payable:
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(i) in eleven (11) equal consecutive semi-annual
installments of $1,446,718 on April 30th and October
31st of each year, and (ii) thereafter in five (5)
equal consecutive semi-annual installments of $501,782
on April 30th and October 31st of each year, commencing
April 30, 1995, through and including October 31, 2002.
The $747,910 short-term promissory note was payable 60 days after
November 1, 1994. CFP also placed liens on the equipment to
secure EQ’s note obligations to CFP.
4. On November 1, 1994, after CFP’s sale of the equipment
to EQ in step 3 above, CFP leased the equipment back from EQ
under a wraparound lease encompassing the existing end-user
equipment leases (master lease). The existing Shared and K-Mart
end-user leases expired no later than March 29 and July 31, 1997,
respectively. The master lease expired on April 30, 2000, for
the Shared equipment, and on October 31, 2002, for the K-Mart
equipment, respectively.5 The master lease, among other things,
provided that CFP’s master lease residual interests in the K-Mart
and Shared end-user lease equipment consisted of residual periods
5
The master lease also covered: (1) Computer equipment
subject to an existing end-user lease with the Health Ins. Plan
of Greater N.Y. (HIP NY), (2) computer equipment subject to an
existing end-user lease with Martin Marietta Corp. (Martin
Marietta), and (3) satellite dish equipment subject to an
existing end-user lease with Amoco Corp. (Amoco). The HIP NY
end-user lease expired on Dec. 31, 1997; the Martin Marietta end-
user lease expired on May 31, 1997; and the Amoco end-user lease
expired on Mar. 31, 2000. As to this foregoing equipment, the
master lease ran: (1) From Nov. 1, 1994, through Apr. 30, 2000,
in the case of the HIP NY equipment; (2) from Nov. 1, 1994,
through Apr. 30, 2000, in the case of the Martin Marietta
equipment; and (3) from Nov. 1, 1994, through Oct. 31, 2002, in
the case of the Amoco equipment.
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between March 29, 1997, and April 30, 2000, and July 31, 1997,
and October 31, 2002, respectively, all of which followed the
existing leases. It also provided that CFP had the right to
receive rents on the K-Mart and Shared equipment during its
master lease residual periods. The master lease rental payments
due from CFP to EQ were equal to, coincided with, and were fully
offset by the installments owed to CFP by EQ under the $14.125
million equipment purchase note.
5. On November 1, 1994, Johnson executed, on behalf of
CMACM in its capacity as managing partner of CFP, a remarketing
agreement with CLI (master remarketing agreement) providing that
CLI would be the exclusive remarketing agent for the leased
equipment for the period between the expiration of the K-Mart and
Shared end-user leases and the expiration of the master lease.
The master remarketing agreement provided that revenue and
proceeds from the lease, sale, or disposition of the leased
equipment would be applied in the following order: (1) Senior
financing; (2) reimbursement of CLI’s expenses; (3) reimbursement
of CFP’s (sublessor’s) expenses; (4) payment of a 5-percent fee
to CLI; and (5) payment of any remainder to CFP (sublessor). The
master remarketing agreement also provided that the sublessor
(CFP) could terminate the agreement if, among other events, CLI
ceased its remarketing activities, filed for bankruptcy, or
failed to perform its obligations under the agreement. In
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addition, CFP would be entitled to terminate CLI’s exclusive
remarketing agency if an item of equipment was not leased for
more than 120 days and CLI had not presented a remarketing
opportunity within that 120-day period.
6. Also on November 1, 1994, EQ and CLI entered into a
remarketing agreement (owner remarketing agreement) providing
that CLI would be responsible for the remarketing of the leased
equipment after the master lease’s term expired. The owner
remarketing agreement, with respect to the application of rent
proceeds, had identical terms to those contained in the above-
described master remarketing agreement between CFP and CLI.
7. On November 30, 1994, CFP sold for $11,773,040 to
Hitachi Credit America Corp. (HCA) its right to the rental income
from the existing end-user leases on the K-Mart, Shared, and
other equipment in a transaction described as a “rent strip
sale”. CFP, in turn, paid the $11,773,040 to ERA in satisfaction
of the senior debt that encumbered the leased equipment.
Simultaneously with the rent strip sale to HCA, CLI, ERA, and CFP
agreed to release their liens against the rents to become due
under the K-Mart, Shared, and other end user leases. CLI and
ERA, but not CFP, subordinated their claims against the leased
equipment to the rights of HCA. Thereafter, K-Mart, Shared, and
other end users were also instructed to pay the rent due from
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them under their end-user leases on the equipment directly to
HCA. CFP allocated 99 percent of its income from the rent strip
sale with HCA to the Iowa Tribe.
The net effect of the series of November 1994 transactions
described above in steps 1 through 7 was for virtually all rental
income realized from the rent strip sale to HCA to be attributed
to a nontaxable entity (the Iowa Tribe), with the rental payments
due thereafter under the existing end-user leases on the
equipment to be paid to HCA.
8. About 2 days later, on December 2, 1994, CFP sold for
$450,000 to Asset Residco, Inc. (Residco), CFP’s interests as to
(1) the first 2 years of the master lease residual period with
respect to the K-Mart end-user lease equipment and (2) the first
6 months of the master lease residual period with respect to the
Amoco end-user lease satellite dish equipment. Residco, a
Delaware corporation, was wholly owned by Klein (vice president
of EQ and managing partner of Capital Asset Partners). CFP
allocated 99 percent of the income from its sale of these
residual interests to CFP’s 99-percent limited partner, the Iowa
Tribe. Residco paid the $450,000 sale price for these residual
interests by issuing its $450,000 secured promissory note due
January 1, 1995. Residco’s note was secured by the rental
payments Residco would be entitled to receive under its master
lease residual interests with respect to the K-Mart and Amoco
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equipment. CFP used the $450,000 Residco note to reduce its
promissory note obligation to ERA (that was incurred above in
step 2).
9. On January 3, 1995, in a purported section 351
nonrecognition transaction, CFP transferred to CFX Financial
Services, Inc. (CFX Financial), a subsidiary of CFX: (1) CFP’s
remaining master lease residual interests with respect to the K-
Mart, Shared, and other equipment (i.e., its master lease
residual interests in that equipment, less the first 2 years of
the master lease residual interest in the K-Mart equipment and
the first 6 months of the master lease residual interest in the
Amoco equipment that were sold to Residco as described above in
step 8); (2) CFP’s master lease rental payment obligation to EQ;
(3) the right to receive offsetting payments from EQ under the
$14.125 million EQ equipment purchase installment note; and (4)
the $747,910 EQ short-term promissory note. In exchange for
CFP’s transfer, it received 75,000 shares of CFX Financial $1 par
value preferred stock. On that same date, CFX contributed $2.8
million to CFX Financial and received 280 shares of CFX Financial
common stock. (The assignment and assumption agreement between
CFP and CFX Financial dated January 3, 1995, notes that the
master lease equipment was subject to CLI’s lien under the
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$2,307,500 ERA note and ERA’s lien under the $15.05 million CFP
note, and that $2,782,700 was the remaining balance owed on the
$15.05 million CFP note as of January 4, 1995.)6
After the January 3, 1995, transaction, CFX Financial made
master lease rental payments to EQ in amounts equal to EQ’s
installment payments to CFX Financial under the $14.125 million
EQ installment note. Pursuant to the January 3, 1995,
transaction, CFX claimed substantial tax benefits far greater
than its economic investment in the first lease strip deal.
Specifically, CFX Financial (which joined in consolidated income
tax returns filed by CFX and its other affiliates, including CFX
Bank) was in a position over the life of the master lease to (1)
receive fully offsetting payments under the EQ installment note
equal to CFX Financial’s master lease rental payments and only
recognizing for tax purposes the relatively smaller installment
note interest income, but (2) claiming substantially larger
deductions for all its master lease rental payments.
All of the transactions described in steps 1 through 8 above
were structured and undertaken to benefit CFX as the first lease
strip deal’s ultimate customer. CMACM received a $611,665 fee
for providing advice relating to the above-described
6
As noted above in steps 1 and 2, both the $2,307,500 Equity
Resource Acquisition II (ERA) note to Computer Leasing, Inc.
(CLI), and the $15.05 million Capital Finance Partners (CFP) note
to ERA were payable within 60 days of Nov. 1, 1994.
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transactions. On April 28, 2000, CFX Financial redeemed its
preferred stock held by CFP for $94,950.82, consisting of $75,000
for the shares and $19,950.82 in dividends thereon.
C. Second Lease Strip Deal
Sometime before August 1995, Crispin asked Klein and certain
parties and/or entities involved in the first lease strip deal to
create another position out of the equipment package involved in
that first deal. Although petitioner and Crispin were planning
to market this second lease strip deal to a customer, they
changed their plans following the Internal Revenue Service’s
(IRS) issuance of Notice 95-53, 1995-2 C.B. 334, on October 30,
1995. In Notice 95-53, supra, the IRS warned it would challenge
and disallow potential tax benefits that taxpayers claimed under
lease strip deals. Due to the issuance of Notice 95-53, supra,
petitioner and Crispin concluded that it would not be possible to
sell the second lease strip deal to third parties. Because the
transactions for the contemplated deal had already been
consummated, petitioner and Crispin instead decided to complete
the second lease strip deal with petitioner as the “customer” or
ultimate beneficiary.
The wraparound lease (over lease) in the second lease strip
deal involved the K-Mart and Shared end-user lease equipment and
encompassed the existing K-Mart and Shared end-user leases.
However, the express lease term for the K-Mart and Shared over
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lease agreement provided for no actual over lease residual
interests in that equipment. The over lease agreement set forth
a lease term for the K-Mart and Shared equipment that expired on
the same dates as the master lease respecting that equipment.7
Unlike the ultimate beneficiary in the first lease strip
deal, petitioner did not retain its lease position throughout the
life of the over lease in the second lease strip deal. Instead,
petitioner disposed of its lease position and/or the associated
equipment installment note in three transactions with other
entities over a 21-month period running from November 27, 1995,
through September 1, 1997.
As to the second lease strip deal, the following complex
series of multiparty equipment purchase, lease, and other
transactions took place on August 31, September 1, September 28,
and November 27, 1995; and on October 31, 1996, and September 1,
1997.
7
As discussed supra, the master lease ran: (1) From Nov. 1,
1994, through Oct. 31, 2002, in the case of the K-Mart Corp. (K-
Mart) end-user lease equipment, and (2) from Nov. 1, 1994,
through Apr. 30, 2000, in the case of the Shared Medical System
Corp. (Shared) end-user lease equipment. As discussed more fully
infra, the Aug. 31, 1995, over lease agreement provided that the
over lease ran: (1) From Aug. 31, 1995, through Oct. 31, 2002,
in the case of the K-Mart end-user lease equipment, and (2) from
Aug. 31, 1995, through Apr. 30, 2000, in the case of the Shared
end-user lease equipment. Accordingly, petitioner had no
residual lease interests in that equipment.
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1. On August 31, 1995, EQ sold to Capital Asset Partners
(CAP), a Nevada limited partnership, the K-Mart and Shared end-
user lease equipment and the right to receive master lease rents
upon that equipment. CAP assumed EQ’s obligation to make related
installment payments to CFX Financial under the EQ equipment
purchase installment note (which EQ had issued in connection with
step 3 of the first lease strip deal). Conversely, EQ assigned
to CAP the right to receive from CFX Financial the master lease
rental payments relating to the K-Mart and Shared end-user lease
equipment. Those rental payments equaled and coincided with the
installments due under the EQ installment note. As a part of the
foregoing sale of the K-Mart and Shared equipment, Klein (CAP’s
1-percent managing general partner) executed and issued to EQ on
August 31, 1995, CAP’s $750,000 secured promissory note, due
November 29, 1995.
Kanawha Enterprises, LP (Kanawha), a Nevada limited
partnership, was CAP’s 99-percent limited partner. The Iowa
Tribe was the 99-percent limited partner of Kanawha, and a
company named Pending One was the .9-percent managing general
partner of Kanawha, with the remaining .1-percent interest in
Kanawha held by Z-Kelp, LP, a limited partnership. Mallin was
Pending One’s president. For purposes of the second lease strip
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deal, the Iowa Tribe had the same role, involvement, and
participation in Kanawha as the Iowa Tribe had in CFP for
purposes of the first lease strip deal.
2. On August 31, 1995, CAP transferred ownership of the K-
Mart and Shared end-user lease equipment, along with the right to
receive master lease rental payments upon that equipment, to
Jenrich Corp. (Jenrich) in exchange for two notes.8 One Jenrich
note was a $4,056,220 long-term nonrecourse secured installment
note with 8 percent interest payable in:
(i) thirteen (13) semi-annual installments of principal
and interest, each in the amount of $371,301 payable on
February 28th and August 30th of each year, commencing
on February 28, 1996 through and including February 28,
2002, and (ii) four (4) semi-annual installments of
principal and interest, each in the amount of $159,876
payable on August 30th and February 28th of each year,
commencing August 30, 2002, through and including
February 28, 2004.
The other Jenrich note was a $215,000 short-term note due
November 29, 1995. Both notes were signed by Marlene Freedman
(Freedman), Jenrich’s sole shareholder and president.
8
For its taxable years ended Mar. 31, 1995 and 1996, Jenrich
Corp. (Jenrich) claimed losses of $4,879,471 and $16,203,523,
respectively. From its 1995 through 1997 fiscal years, Jenrich’s
deficit in retained earnings for financial accounting purposes
also increased dramatically: For its year ended Mar. 31, 1995,
Jenrich’s deficit in retained earnings increased from $24,806 to
$137,303,245; for its year ended Mar. 31, 1996, Jenrich’s deficit
in retained earnings increased from $137,303,245 to $153,506,768;
and for its year ended Mar. 31, 1997, Jenrich’s deficit in
retained earnings increased from $153,506,768 to $155,502,577.
- 23 -
Freedman was a longtime employee of Mallin and performed
administrative and office work for Mallin. During 1980, acting
upon Mallin’s advice, Freedman invested $2,500 to acquire
Jenrich. Mallin was instrumental in bringing about Jenrich’s and
Freedman’s involvement in the foregoing transaction. Mallin
advised Freedman to cause Jenrich to enter into that transaction
and the equipment leaseback from CAP (described below in step 3).
Mallin negotiated those transactions for Freedman with Jenrich
and CAP. Freedman discussed those transactions with Mallin, but
not with Klein, the managing general partner of CAP who rented
space in Mallin’s office. Freedman eventually disposed of her
interest in Jenrich for $5,000 during 2000 when she sold her
Jenrich stock to an associate of Mallin. Freedman received
$40,000 in compensation as an officer of Jenrich from 1993
through 2003.
3. Also on August 31, 1995, CAP leased back from Jenrich
the Shared and K-Mart equipment pursuant to the over lease
wraparound lease covering the existing K-Mart and Shared end-user
leases and the master lease for the K-Mart and Shared end-user
lease equipment. In exchange, CAP received the right to CFX
Financial’s master lease rental payments on that equipment. The
over lease agreement provided for lease periods of the K-Mart and
Shared end-user lease equipment that coincided with and ended at
the same times as the master lease for the K-Mart and Shared
- 24 -
equipment. With those lease periods specified by the
over lease agreement, CAP would have no actual over lease
residual interests in the K-Mart and Shared equipment. See
supra note 7.
The right to the master lease rental payments owed by CFX
Financial for the K-Mart and Shared equipment was separate from
the over lease rental payments that CAP owed to Jenrich. Under
the over lease, CAP was obligated to apply those CFX Financial
master lease rental payments to pay off the EQ installment note
held by CFX Financial. As to CAP’s over lease rental payments
due to Jenrich, they equaled and coincided with the installments
that Jenrich was required to make to CAP under Jenrich’s
$4,056,220 equipment purchase installment note (which had been
issued in connection with the above CAP-Jenrich transaction in
step 2).
4. On the next day, September 1, 1995, CAP sold to Aardan
Leasing Corp. (Aardan), a Delaware corporation, the rights to the
master lease rental payments due from CFX Financial relating to
the K-Mart and Shared equipment. The September 1, 1995,
agreement between CAP and Aardan provided that Aardan assume
CAP’s obligation (described above in step 1) to CFX Financial
under the EQ installment note.
- 25 -
Virtually all of CAP’s income from the sale to Aardan was
allocated to Kanawha (CAP’s 99-percent limited partner) and in
turn to the Iowa Tribe. Although not directly a partner of CAP,
the Iowa Tribe was the 99-percent limited partner of Kanawha.
Aardan was organized by Mallin before 1995. Roland
Hennessey (Hennessey), who was also an officer of Jenrich, signed
the September 1, 1995, sales agreement on behalf of Aardan. At
Mallin’s request, Hennessey, beginning in 1986 or 1987, served as
an officer of several corporations (including Aardan and Jenrich)
and at some unspecified point, eventually was designated as
Aardan’s owner. Hennessey had retired as a police officer before
his involvement in these transactions. In exchange for
Hennessey’s serving as an officer and/or owner of these various
corporations, Mallin paid Hennessey $1,000 per month.
Hennessey’s role in these corporations was that of a nominee who
signed documents. Hennessey had no involvement in negotiations,
decisionmaking, or business activities of the corporate entities.
5. Pursuant to a September 28, 1995, document, CAP, in
exchange for 10 shares of CMACM common stock in a purported
section 351 transaction, transferred, among other things, the
following to CMACM: (1) CAP’s rights under the over lease; (2)
the $4,056,220 Jenrich equipment purchase installment note; (3)
CAP’s over lease rental payment obligation to Jenrich; and (4)
$215,000 of CAP’s obligation to EQ under the $750,000 CAP
- 26 -
equipment purchase note. On that same date, CMA contributed
$68,000 to CMACM in exchange for 68,000 shares of CMACM common
stock.
For tax purposes, CMACM claimed a $4,081,319 carryover basis
in the Jenrich note, consisting of the note’s $4,056,220 face
value and accrued interest of $25,099. By means of a March 25,
1996, letter agreement, CMACM and Jenrich agreed to offset
CMACM’s over lease rental payment liability and Jenrich’s
installment note liability against one another so that no cash
payments would have to be made by CMACM or Jenrich.
6. On November 27, 1995, CMACM transferred all of its
interests and obligations under various agreements relating to
the K-Mart end-user lease equipment to Okoma Enterprises, LP
(Okoma), a Delaware limited partnership. Among other things,
CMACM transferred the following to Okoma: (1) CMACM’s over lease
rights in the K-Mart equipment, and (2) a portion of the Jenrich
note in the amount of $1,982,185. In exchange, Okoma assumed
CMACM’s over lease obligations concerning the K-Mart end-user
lease equipment and also CMACM’s obligations on the CAP note in
the amount of $235,000. Okoma’s 99-percent limited partner was
the Iowa Tribe and Okoma’s 1-percent managing general partner was
MBP Administration, Inc., a Nevada corporation. On its 1995
Federal return, petitioner characterized CMACM’s partial
disposition of the Jenrich note as a “rental expense” of
- 27 -
$1,982,825. The $1,982,825 rental deduction, in conjunction with
other items on petitioner’s 1995 Federal return, resulted in a
$404,000 net operating loss (NOL) carryover from the 1995 to the
1996 tax year. Respondent, in the notice of deficiency,
disallowed the $404,000 NOL carryover.
7. On October 31, 1996, CMACM transferred 25 percent of its
interests and obligations in the Shared end-user lease to First
Lexington Leasing, Inc. (Lexington). From 1998 to the time of
trial Lexington was owned by Asset Leasing Partners I, LP, with
Crispin and CMACM as managing general partners and the Iowa Tribe
as a limited partner. Among other things, CMACM transferred:
(1) Twenty-five percent of CMACM’s rights in the Shared
equipment, and (2) 25 percent of that portion of the Jenrich note
attributable to the Shared equipment. In exchange for CMACM’s
transfer, Lexington issued a $10,000 unsecured promissory note to
CMACM and assumed 25 percent of that portion of CMACM’s over
lease rental payment obligation to Jenrich attributable to the
Shared equipment. The promissory note had an 8-percent interest
rate and was due on December 31, 2002.
Lexington was incorporated in California during 1995 and was
wholly owned by Richard Koehler (Koehler), a friend and longtime
business associate of Crispin. Before and after the CMACM-
Lexington transaction, Koehler depended on petitioner and Crispin
for funds to keep CMA Capital Corp. operating.
- 28 -
For 1996, CMACM claimed a $469,221 cost basis in its 25-
percent portion of the Jenrich note transferred to Lexington. In
addition, CMACM claimed a $459,221 loss from its partial
disposition of that note. CMACM also deducted $414,041 for the
over lease rental payments that it reported as being paid to
Jenrich during 1996. The $414,041 amount equaled the amount due
CMACM from Jenrich under the Jenrich installment note.
8. On September 1, 1997, CMACM transferred to Lexington the
remaining 75 percent of its interests and obligations under
various agreements concerning the Shared end-user lease
equipment. Among other things, CMACM transferred: (1) The
remaining 75 percent of CMACM’s over lease rights in the Shared
equipment, and (2) 75 percent of that portion of the Jenrich note
attributable to the Shared equipment. In exchange for CMACM’s
transfer, Lexington issued its $1,000 unsecured promissory note
to CMACM and assumed 75 percent of that portion of CMACM’s over
lease rental payment obligation to Jenrich attributable to the
Shared equipment. Pursuant to the terms of the unsecured note,
Lexington promised to pay CMACM $1,000, plus 8 percent interest
on December 31, 2002.
For 1997, CMACM claimed a $1,179,013 basis in the 75-percent
portion of the Jenrich note it transferred to Lexington and a
$1,178,013 loss from the partial disposition of the note. CMACM
- 29 -
also deducted $237,853 (which was equal to the amount due CMACM
from Jenrich under the Jenrich installment note) as over lease
rental payments that it claimed to have paid to Jenrich during
1997.
D. Other Aspects of Petitioner’s Claimed Losses and
Deductions With Respect to the Second Lease Strip Deal
As a result of the second lease strip deal and CMACM’s
partial dispositions of the Jenrich note over a 21-month period,
petitioner claimed more than $4.2 million of deductions for
1995, 1996, and 1997. Petitioner did not report any income from
Okoma’s and Lexington’s assumptions of CMACM’s over lease rental
payment obligations to Jenrich. In addition to $3,620,059 of
losses claimed for dispositions of the Jenrich note, petitioner
claimed deductions of $414,041 (1996) and $237,853 (1997) for
over lease rental payments to Jenrich. In almost all of the
above-described second lease strip deal transactions, petitioner
either received or was entitled to receive an offsetting payment
equal to the amount it was obligated to pay and deducted. In
only one instance, involving the purported section 351 transfer,
did petitioner assume $215,000 of the $750,000 CAP note owed to
EQ, without receiving or being entitled to receive an equivalent
offsetting amount.
- 30 -
On July 20, 1998, CMACM redeemed the 10 shares of CMACM
common stock held by CAP for $500. On its return for its taxable
year ended November 30, 1998, petitioner wrote off and deducted
the $10,000 and $1,000 Lexington notes issued to CMACM in the
CMACM-Lexington transactions.
In the second lease strip deal, the over lease residual
interests in the K-Mart and Shared equipment were the sole source
of possible cashflow and pretax profit to petitioner. About 2
months after CMACM obtained the over lease residual interests
from CAP, CMACM transferred the over lease residual interest in
the K-Mart equipment to Okoma. On October 31, 1996, CMACM
transferred 25 percent of its over lease residual interest in the
Shared equipment to Lexington. As previously noted, upon
termination of the Shared end-user lease (March 29, 1997), the
Shared equipment was to be returned to CLI. On September 1,
1997, CMACM transferred the remaining 75 percent of its over
lease residual interest in the Shared equipment to Lexington.
For 1998, petitioner wrote off the $10,000 and $1,000 Lexington
notes that CMACM earlier received in exchange for CMACM’s
residual lease interest in the Shared equipment. Christopher
Hughes (Hughes), petitioner’s manager for tax and accounting,
concluded, among other things, that Lexington’s lease position in
the Shared equipment was worthless.
- 31 -
In connection with its involvement in the second lease strip
deal, petitioner did not obtain an outside appraisal as to the
value of the over lease residual interests in the K-Mart and
Shared equipment or tax advice regarding that deal from an
independent, qualified tax adviser. Crispin and Hughes analyzed
the second lease strip deal, and Hughes prepared an analysis of
the value of the over lease residual interests before CMACM’s
entering into its transaction with CAP. Hughes, in valuing the
over lease residual interests, considered an earlier appraisal
report (the Marshall & Stevens appraisal) on the master lease
residual interests in the K-Mart, Shared, and other equipment
that was done by Ralph Page of the firm of Marshall & Stevens and
furnished it to CFX.
Late in 1994 and in early 1995, petitioner, Crispin, and
others obtained and used the following items in the marketing of
the first lease strip deal to CFX: (1) The Marshall & Stevens
appraisal; (2) another similar appraisal report on the master
lease residual interests done by the firm of Murray, Devine & Co.
that was also furnished to CFX (the Murray, Devine appraisal);
and (3) the tax opinion issued to CFX by the law firm Thacher
Proffitt & Wood, as CFP’s counsel (the Thacher Proffitt tax
opinion). Petitioner and Crispin were familiar with the IRS’s
October 30, 1995, issuance of Notice 95-53, 1995-2 C.B. 334,
warning that the Commissioner would challenge and disallow on
- 32 -
various grounds the tax benefits that taxpayers claimed under
lease strip deals. Until the issuance of Notice 95-53, supra,
petitioner and Crispin were contemplating the marketing of the
second lease strip deal. Following Notice 95-53, supra, Crispin
concluded it would not be possible to sell that second deal to a
third party, and instead decided to have petitioner become the
customer/user of the tax benefits from the second deal.
II. Petitioner’s 1995 Through 1997 Advances to Cap Corp. and
the December 2, 1996, Debt Conversion Transaction
A. Cap Corp. and Its Business
CMA Capital Corp. (Cap Corp.) was organized in 1989, and
until August 1995, Crispin and Koehler were each 50-percent
shareholders. During August 1995, Crispin reduced his stock
ownership from 50 percent to 9 percent, and Koehler
correspondingly increased his stock ownership interest in Cap
Corp. from 50 percent to 91 percent.
Through December 2, 1996, Koehler was in charge of Cap
Corp.’s day-to-day operations, and he would, at least weekly,
consult with Crispin about Cap Corp. After December 2, 1996,
Crispin took over Cap Corp.’s day-to-day operations. Sometime
during the middle of 1997, Koehler formally resigned his
positions as a director and a manager of Cap Corp. and
transferred some of his Cap Corp. stock to Crispin, making
Crispin Cap Corp.’s majority shareholder.
- 33 -
From its inception in 1989, CMA Capital Group (Cap Group)
was a wholly owned subsidiary of Cap Corp. From its inception
until December 2, 1996, Crispin Koehler Securities (CKS), a
securities broker-dealer, was also a wholly owned subsidiary of
Cap Corp.
In 1989, Crispin and Koehler formed JetFleet Aircraft, LP
(JetFleet I), a California limited partnership that invested in
leased aircraft and related equipment. Crispin, Koehler, and Cap
Group were general partners of JetFleet I. In 1991, Crispin and
Koehler formed JetFleet Aircraft II, LP (JetFleet II), another
California limited partnership that invested in leased aircraft
and related equipment. Crispin, Koehler, Cap Group, and CMA
Capital Group LP were general partners of JetFleet II. CMA
Capital Group LP9 was a California limited partnership that was
formed in 1992. Crispin and Koehler were general partners of CMA
Capital Group LP and PSC Aircraft Leasing was a limited partner
of CMA Capital Group LP. CMA Capital Group LP was dissolved on
May 31, 1994.
The main business location and/or the administrative and
support functions of Cap Corp., Cap Group, CKS, and the JetFleet
I and JetFleet II partnerships were at petitioner’s office in
Burlingame, California. Cap Corp. and its two subsidiaries, Cap
9
Not to be confused with CMA Capital Group (Cap Group), the
CMA Capital Corp. (Cap Corp.) subsidiary formed in 1989.
- 34 -
Group and CKS, derived substantial fees and other income in
connection with the JetFleet I and JetFleet II partnerships. Cap
Group’s original business goal was to arrange for the syndication
and marketing to investors of the JetFleet I and JetFleet II
partnerships. Cap Group was to act as sponsor and managing
general partner of the JetFleet I and JetFleet II partnerships.
It leased and managed the aircraft equipment on behalf of each
partnership and its investor-partners. In exchange for Cap
Group’s services it was to receive fees and a percentage of each
partnership’s cashflow. Up until approximately 1994, CKS
marketed interests in the JetFleet I and JetFleet II partnerships
to investors.
From approximately 1994 through 1997, the JetFleet I and
JetFleet II partnerships were not being marketed while Crispin
and others considered plans and undertook steps for consolidating
those two partnerships into a publicly held corporation. As of
December 1996, Cap Corp. and the management of the JetFleet I and
JetFleet II partnerships were making progress towards obtaining
consents from over 90 percent of the investor-partners in each
partnership to effect the consolidation of those two partnerships
into a new publicly traded corporation. At that time, however,
ultimate approval of the proposed consolidation of those two
partnerships was by no means certain. It was not until November
1997 that the votes respecting the proposed consolidation were
- 35 -
tallied and the consolidation was approved by the requisite
percentage of the investor-partners in each partnership. Shortly
thereafter, the two partnerships were consolidated into a company
named AeroCentury. As a result of the consolidation, Cap Corp.
received 44,119 shares of AeroCentury stock. On January 1, 1998,
it transferred the 44,119 AeroCentury shares to petitioner in
part payment of its outstanding debts to petitioner.
During 1995, Cap Corp. and CKS began marketing to investors
JetFleet III, a third aircraft equipment leasing partnership.
From 1995 through 1997, Cap Corp. was insolvent. Crispin
dissolved Cap Corp. during 1999. Cap Corp. would have failed
long before 1999 without the advances it received from petitioner
during the period 1995 through 1997.
B. Petitioner’s 1995 and 1996 Advances to Cap Corp.
During petitioner’s taxable years ended November 30, 1996
and 1997, Cap Corp. was unable to pay its expenses from its
revenues and the revenues of Cap Group and CKS, its two wholly
owned subsidiaries. Earlier, Cap Corp. raised capital by issuing
more than $4 million of its notes to third parties. During 1996,
approximately $2.5 million of these notes remained outstanding.
Although the principal payments were not due until December 1997
or December 1998, Cap Corp. was obligated to make interest
payments. Cap Corp. also had obligations to pay its expenses and
those of its subsidiaries. Among other things, CKS (the
- 36 -
securities dealer) incurred considerable monthly overhead and
marketing expenses. From 1994 through 1996, CKS had 10 to 15
branch offices around the country and over 150 employees,
including a large sales staff. In addition to marketing the
JetFleet I, JetFleet II, JetFleet III, and other securities
products, CKS’s business also included the marketing of bonds.
Crispin was aware of Cap Corp.’s inability to pay its
expenses and Cap Corp.’s need for advances to pay those expenses.
Koehler asked Crispin to supply operating capital for Cap Corp.
Crispin arranged for petitioner to advance funds to Cap Corp. to
pay its day-to-day operating expenses. Through January 1, 1995,
petitioner advanced $858,991 to Cap Corp.10 On April 30, June
30, and August 31, 1995, Cap Corp. made payments to petitioner
totaling $593,834, leaving a $515,825 balance as of August 31,
1995. From September 1995 through November 30, 1996, petitioner
advanced an additional $2,060,425 to Cap Corp. without
considering accrued interest. As of November 30, 1996, Cap Corp.
owed petitioner $2,759,903.
Cap Corp. issued a January 1, 1995, promissory note to
petitioner concerning the January 1, 1995, through November 30,
1996, advances. This promissory note in pertinent part stated:
10
Except as where otherwise indicated, for convenience these
amounts in controversy that petitioner advanced have been rounded
to the nearest $1.
- 37 -
FOR VALUE RECEIVED, * * * [Cap Corp.], hereby
promises to pay on or before November 30, 1996 to the
order of * * * [petitioner] all principal and interest
outstanding according to the attached Schedule A under
this note.
1. This note (the “Note”) shall bear interest from
the date hereof on the principal amount of the Note
outstanding from time to time, at the rate per annum
(on the basis of a 365-day year for the actual number
of days involved) of 10%.
2. This Note shall be governed by and constructed
in accordance with the laws of the State of California.
Sometime on or after November 30, 1996, Koehler signed a
document entitled “Schedule A” acknowledging that petitioner had
transferred funds to Cap Corp. that it was to repay. The
Schedule A contained the following:
Interest Principal Interest Total
Date Loans Accrued Balance Balance Balance
1-1-95 -- -- $858,990.87 -- $858,990.87
1-31-95 -- $7,295.54 858,990.87 $7,295.54 866,286.41
2-28-95 -- 6,824.86 858.990.87 14,120.40 873,111.27
3-31-95 -- 7,530.88 858,990.87 21,651.28 880,642.15
4-30-95 ($360,000.00) 7,295.54 498,990.87 28,946.82 527,937.69
5-31-95 196,425.65 4,374.71 695,416.52 33,321.53 728,738.05
6-30-95 (136,412.00) 5,906.28 559,004.52 39,227.81 598,232.33
7-31-95 5,168.00 4,900.86 564,172.52 44,128.67 608,301.19
8-31-95 (97,422.00) 4,946.17 466,750.52 49,074.84 515,825.36
9-30-95 174,405.00 3,964.18 641,155.52 53,039.02 694,194.54
10-31-95 150,000.00 5,621.09 791,155.52 58,660.11 849,815.63
11-30-95 289,436.76 6,719.40 1,080,592.28 65,379.51 1,145,971.79
12-31-95 40,000.00 9,473.69 1,120,592.28 74,853.20 1,195,445.48
1-31-96 135,000.00 9,824.37 1,255,592.28 84,677.57 1,340,269.85
2-29-96 86,000.00 10,319.94 1,341,592.28 94,977.51 1,436,589.79
3-31-96 40,000.00 11,761.90 1,381,592.28 106,759.41 1,488,351.69
4-30-96 169,000.00 11,734.07 1,550,592.28 118,493.48 1,669,085.76
5-31-96 72,000.00 13,594.23 1,622,592.28 132,087.72 1,754,680.00
6-30-96 141,100.00 13,780.92 1,763,692.28 145,868.64 1,909,560.92
7-31-96 181,000.00 15,462.51 1,944.692.28 161,331.15 2,106,023.43
8-31-96 -- 17,049.36 1,944,692.28 178,380.50 2,123,072.78
9-30-96 138,926.00 16,516.56 2,083,618.28 194,897.07 2,278,515.35
10-31-96 208,000.00 18,267.34 2,291,618.28 213,164.41 2,504,782.69
11-30-96 235,657.46 19,463.06 2,527,275.74 232,627.46 2,759,903.20
- 38 -
C. The December 2, 1996, Debt Conversion Transaction
By October 1996, Crispin and Koehler realized that Cap Corp.
was insolvent with obligations that were several multiples of its
assets. They also realized that Cap Corp.’s poor financial
condition was negatively affecting CKS’s operations. Hence, they
formulated a debt conversion transaction whereby: (1) Crispin
and Koehler would establish a new corporation; (2) that new
corporation would assume substantially all of Cap Corp.’s
outstanding debt to petitioner, in exchange for receiving Cap
Corp.’s 100-percent stock ownership interest in CKS; and (3)
petitioner would cancel all but $100,000 of the Cap Corp. debt
assumed by the new corporation, in exchange for a preferred stock
in the new corporation.
On or about October 22, 1996, Crispin and Koehler
incorporated Crispin Koehler Holding Corp. (CKH), a California
corporation. Crispin’s and Koehler’s respective stock ownership
interests in CKH were the same as their then-respective stock
ownership interests in Cap Corp.--9 percent for Crispin and 91
percent for Koehler. CKH’s place of business was the same as
petitioner’s.
On December 2, 1996, Cap Corp., CKH, CKS, and petitioner
effected a debt conversion transaction relieving Cap Corp. of
$2.259 million of its debt to petitioner. This debt relief for
Cap Corp. was accomplished through the following two steps: (1)
- 39 -
Cap Corp. (through Koehler), CKH (through Koehler), CKS (through
Koehler), and petitioner (through Crispin) executed a December 2,
1996, stock purchase agreement under which CKH assumed $2.259
million Cap Corp. debt in exchange for 100 percent of the
outstanding stock of CKS (503,820 shares); and (2) CKH (through
Koehler) and petitioner (through Crispin) entered into a December
2, 1996, “Debt Conversion Agreement”, under which they agreed
that CKH would issue to petitioner 215,990 shares of CKH $10
preferred stock in exchange for petitioner’s cancellation of all
but $100,000 of the $2.259 million Cap Corp. debt assumed by CKH.
CKH paid the $100,000 of the Cap Corp. debt by offsetting it
against a $100,000 receivable due to CKH from petitioner.
CKS (which CKH was acquiring from Cap Corp.) was worth far
less than $2.259 million as of December 2, 1996. Crispin and
Koehler estimated that CKH’s net asset value (excluding CKS’s
indeterminate and highly speculative value) did not exceed
$100,000 after the debt conversion transaction.11
11
As will be discussed more fully infra in connection with
the National Service Industries (NSI) consulting fee issue, at
the time Crispin Koehler Holding Corp. (CKH) was created in
October 1996, NSI was negotiating with petitioner for
petitioner’s help in arranging an NSI subsidiary’s divestment of
a “tax benefit transfer lease” without adverse tax consequences.
To effect such a divestment, it would be necessary for petitioner
to use a securities broker-dealer like Crispin Koehler Securities
(CKS). On Dec. 1, 1996, NSI and petitioner executed a consulting
agreement whereby petitioner would be paid a $2.5 million
consulting fee for its services in arranging such a divestment.
Petitioner contends that it and CKH had previously reached an
(continued...)
- 40 -
After the debt conversion, Cap Corp. remained liable to
petitioner for $500,000 of the original $2.7599 million debt. On
its 1996 Federal return, Cap Corp. did not report cancellation of
indebtedness income from the debt conversion transaction.
D. Petitioner’s 1997 Advances to Cap Corp.
After December 2, 1996, Crispin took over the management of
Cap Corp., Cap Group (Cap Corp.’s subsidiary), and the
consolidation activity with respect to the JetFleet I and
JetFleet II partnerships. Shortly after the December 2, 1996,
debt conversion transaction, Koehler no longer managed Cap Corp.
Koehler continued to manage CKS, Cap Corp.’s former subsidiary
that became a wholly owned subsidiary of CKH in the debt
conversion. Sometime during the summer of 1997, Koehler formally
resigned his positions as a director and manager of Cap Corp.,
and he transferred some of his Cap Corp. stock to Crispin, making
Crispin the majority shareholder of Cap Corp.
Although Crispin knew that Cap Corp. continued to be
insolvent after the debt conversion transaction, he caused
petitioner to transfer additional funds to Cap Corp. during 1997.
11
(...continued)
oral agreement that CKH would receive a $2 million portion of any
NSI consulting fee. Petitioner further maintains that, as of the
Dec. 2, 1996, date of the debt conversion, consummation of the
desired divestment (and NSI’s payment of a consulting fee to
petitioner) was still uncertain and could have fallen through.
Petitioner argues that, at that time, petitioner’s receipt of an
NSI consulting fee was not even a “bird in the bush”.
- 41 -
The financial statement that was part of Cap Corp.’s 1996 Federal
return reflects that Cap Corp.’s assets were just under $151,000
and its liabilities were well over $4 million. Cap Corp.’s 1996
return also reflected a net loss of $641,600 for Cap Corp. and
its subsidiaries. As of November 30, 1997, Cap Corp. owed
petitioner $1,859,135, consisting of the $500,000 outstanding
debt along with $1.257 million of additional advances made during
1997, plus interest. During 1997, petitioner made advances to
Cap Corp. of $55,000 on January 31, 1997; $50,000 on April 30,
1997; and $1.152 million on July 31, 1997.
Cap Corp. (through Koehler) issued petitioner a December 1,
1996, promissory note to cover the above debt. Among other
things, Cap Corp. promised to pay on or before November 30, 1997,
all outstanding principal and 10 percent interest to petitioner.
E. Petitioner’s 1997 Ordinary Loss and Bad Debt Deduction;
Petitioner’s 1998 AeroCentury Stock Transaction
On its 1997 return, petitioner claimed a $1,859,135 bad debt
deduction consisting of: (1) The $500,000 Cap Corp. debt not
assumed by CKH in the debt conversion transaction; (2) the
$1,257,000 of advances to Cap Corp. during 1997; and (3) $102,135
of interest owed petitioner by Cap Corp. Petitioner did not
claim a deduction with respect to CKH’s $2.259 million assumption
of Cap Corp.’s debt or the conversion of the Cap Corp. debt into
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CKH preferred stock. On its 1998 return, petitioner reported
$441,190 of miscellaneous income in connection with its receipt
of 44,119 shares of AeroCentury stock from Cap Corp.
On February 15, 2001, during respondent’s examination of the
1997 tax return, petitioner submitted an informal claim asserting
that it was entitled to an additional ordinary loss deduction in
an amount exceeding $2 million in connection with the debt
conversion transaction. In its informal claim, petitioner
asserted: (1) CKH’s only valuable asset was CKS; and (2) since
CKS’s filing for bankruptcy under chapter 7 of the Bankruptcy
Code in 1998, CKS has been in the process of liquidation.
Petitioner also maintained that ignoring the speculative goodwill
attributable to CKS, CKH had a net worth of approximately
$120,000 after the debt conversion transaction.
In the notice of deficiency for 1997, respondent disallowed
the additional ordinary loss informally claimed and the
$1,859,135 bad debt deduction. Among other things, respondent
determined: (1) The claimed ordinary loss and bad debt deduction
were not allowable because they represented capital expenditures;
and (2) it had not been established that petitioner’s reported
$1,859,135 bad debt became worthless during 1997.
In its petition, petitioner claimed a $2,052,900 ordinary
loss regarding CKH’s assumption of Cap Corp.’s $2.259 million
debt to petitioner and/or petitioner’s cancellation of that debt
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in exchange for CKH preferred stock. Petitioner contended that
the value of the CKH preferred stock would not have exceeded
$207,000 at the time of the exchange.
1. The $2 Million Consulting Fee
Before the creation of CKH in October 1996, petitioner was
negotiating with National Service Industries, Inc. (NSI), to
provide certain services. The services involved assisting NSI to
dispose of a safe harbor lease under former section 168(f)(8)
without adverse tax consequences. The safe harbor lease was on
the verge of producing approximately $87 million of ordinary
income (the tax benefit lease). Although NSI, if it remained the
holder of the tax benefit lease, would not receive or be enriched
by $87 million from an economic standpoint, NSI, for tax
purposes, would be obligated to report $87 million of ordinary
income with respect to the tax benefit lease. A consulting
agreement was executed between NSI Enterprises (an NSI
subsidiary) and petitioner on December 1, 1996, 1 day before Cap
Corp.’s, CKH’s, and petitioner’s execution of the stock purchase
and debt conversion agreements, discussed in II. C. above, under
which among other things, CKH acquired a 100-percent stock
ownership in CKS.
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NSI intended to divest itself of the lease without adverse
tax consequences. To that end, in August 1996 NSI entered into a
presumably tax-free, nonrecognition transaction involving
preferred stock in a company called RD Leasing (RD).12 The RD
stock had a value of approximately $700,000. Significantly, the
prior owner of the RD stock ostensibly had a high tax basis
(approximately $87 million) in the stock.13 By acquiring the RD
stock in a presumably tax-free transaction, NSI sought to obtain
an $87 million carryover basis and a potential built-in loss of
nearly $87 million to offset $87 million of ordinary income from
the tax benefit lease. NSI’s plan was to transfer the tax
benefit lease and the RD stock to an NSI affiliate in a series of
tax-free transactions. NSI would then sell, to an unrelated
entity, all outstanding shares of stock in the NSI affiliate with
the offsetting income and loss. The unrelated entity could sell
the RD stock to trigger the $87 million built-in loss. To be
entitled to offset and to claim an ordinary loss with respect to
12
The bona fides and proper attendant tax consequences of
the divestment and/or any of the divestment’s steps to NSI and/or
other participants are not in issue in this case.
13
This prior owner’s earlier acquisition of the RD Leasing
(RD) preferred stock was discussed in Andantech L.L.C. v.
Commissioner, T.C. Memo. 2002-97, affd. on some issues and
remanded for further proceedings on other issues 331 F.3d 972
(D.C. Cir. 2003).
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the sale of the RD stock, the unrelated entity, however, would
have to be a securities dealer in whose hands the preferred stock
would be “inventory” rather than a capital asset.14
NSI paid a $2.5 million fee to petitioner in late January
1997 for services in helping to arrange the divestment. Melissa
Meder (Meder), NSI’s vice president for tax, was involved in
planning and effecting NSI’s divestment of the tax benefit lease.
On August 31, 1996, NSI, through a subsidiary, acquired the RD
stock15 in exchange for 7,302 shares of NSI Enterprises preferred
stock. The RD stock had a $100 per share liquidation preference
value, was entitled to a dividend of 6.878 percent per annum, and
had a “put” feature allowing the preferred stockholder to request
redemption and to have that stock redeemed on or after January 1,
1999. While the preferred stock remained outstanding, RD was
required to maintain investments in governmental instruments or
“A”-rated bonds having a value equal to the preferred stock’s
liquidation preference and accrued but unpaid dividends.
On August 31, 1996, NSI transferred to NSI Enterprises the
tax benefit lease and certain real estate in Decatur, Georgia
(the Decatur realty). On the same date, NSI Enterprises
transferred to Corisma, Inc. (Corisma), a wholly owned subsidiary
14
See sec. 1221(1); see also sec. 1211(a), which prohibits a
corporate taxpayer’s deduction of a capital loss against its
ordinary income.
15
RD was a second-tier subsidiary of Norwest Bank (Norwest).
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of NSI Enterprises, the tax benefit lease, the RD stock, and the
Decatur realty. Before August 31, 1996, Corisma had been an
inactive subsidiary of NSI Enterprises. Concurrently with the
conveyance of the Decatur realty to Corisma on August 31, 1996,
NSI leased back the Decatur realty from Corisma under a net lease
agreement for use by NSI’s Lithonia division.
Beginning in the fall of 1996 through December 1, 1996,
Meder (on NSI’s behalf) sought petitioner’s services in finding a
buyer for Corisma and helping NSI to consummate a sale of
Corisma’s shares to that buyer. On December 1, 1996, petitioner
and NSI Enterprises executed a consulting agreement pursuant to
which petitioner ostensibly would provide consulting services to
NSI Enterprises and its corporate affiliates for a 3-year period
ending November 30, 1999, in exchange for the $2.5 million fee,
payable “in advance” (December 1, 1996) at the inception of the
NSI Enterprises-petitioner consulting agreement.
As of the conclusion of the December 2, 1996, debt
conversion transaction, aside from CKH’s 100-percent stock
ownership interest in CKS, CKH did not have any significant
assets. Koehler held 91 percent of CKH’s outstanding common
stock and Crispin held the remaining 9 percent. Petitioner held
a large preferred stock interest in CKH. Koehler estimated that
petitioner’s CKH preferred stock represented 98 percent of the
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total equity in CKH. Among other things, petitioner’s ownership
of the CKH preferred stock gave petitioner a liquidation
preference upon CKH’s liquidation.
After December 1, 1996, petitioner offered CKH as a
prospective buyer for Corisma and negotiated with NSI the terms
of CKH’s purchase of Corisma. Immediately before selling Corisma
to CKH, NSI changed Corisma’s name to LLDEC, Inc. (LLDEC). CKH
employees did not participate in the negotiations for purchase of
LLDEC (Corisma); petitioner alone conducted the negotiations.
Meder was unaware that CKH was to be LLDEC’s buyer until the
final stages of the transaction. Meder learned that CKH would be
the prospective buyer probably no earlier than January 29, 1997,
when Koehler issued a document authorizing CKH to purchase
LLDEC’s stock from NSI Enterprises.
On January 30, 1997, Earl Lester (Lester) on CKH’s behalf
executed the closing documents for purchase from NSI of the LLDEC
stock and LLDEC’s sale of the Decatur realty to Wachovia Capital
Markets, Inc. (Wachovia). Lester worked as a salesman for CKS in
Lexington, Kentucky, primarily selling Jet Fleet partnership
interests. Koehler asked Lester to travel to Atlanta to sign the
closing documents. Lester was appointed an officer of CKH on the
same day that he executed these documents for CKH. Lester was
not a knowledgeable participant in the transactions and was under
the impression that he was in Atlanta to sign documents for
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Crispin in a “tax deal”. Upon his return from Atlanta, Lester
was paid about $7,500 for his services in traveling to and
participating in the closing.
Although Koehler did not attend the Atlanta closing, Koehler
was elected sole director, president, secretary, and treasurer of
LLDEC in documents dated January 30, 1997. On January 30, 1997,
Lester was elected senior vice president of LLDEC. Also by means
of a January 30, 1997, document, Koehler (as LLDEC’s sole
director) authorized LLDEC’s sale of the Decatur realty to
Wachovia for $7,577,657, which was accomplished by means of a
January 30, 1997, agreement between LLDEC and Wachovia. The sale
of the Decatur realty to Wachovia was negotiated by employees of
NSI. In a January 30, 1997, document entitled “Guaranty of
Lease”, NSI guaranteed fulfillment of the obligations in the
prior net lease agreement (to which the Decatur realty was
subject) between NSI and Corisma. Finally, on January 30, 1997,
NSI sold all of LLDEC’s stock to CKH for $7,053,000 derived from
LLDEC’s sale of the Decatur realty. LLDEC paid petitioner
$524,657 (which represented the difference between the $7,577,657
selling price for the Decatur realty and the $7,053,000 selling
price for the LLDEC stock), purportedly as an investment banking
fee for petitioner’s arranging the sale of the Decatur realty.
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On January 30, 1997, NSI paid petitioner the $2.5 million
fee mentioned in the December 1, 1996, consulting agreement.
Although the December 1, 1996, consulting agreement stated that
petitioner was to provide “consulting services” for a 3-year
period ending November 30, 1999, after January 30, 1997,
petitioner was not required to render any further services.
On February 1, 1997, CKS and petitioner executed an
investment banking services agreement, pursuant to which
petitioner agreed to provide consulting services to CKS with
respect to CKS’s disposition of the RD stock and the tax benefit
lease. Upon CKS’s disposition of the RD stock, petitioner was to
receive the net proceeds, less $132,000. Upon CKS’s disposition
of the tax benefit lease, petitioner was to receive 75 percent of
the net proceeds.
On February 4, 1997, LLDEC (now also a CKH subsidiary)
transferred the tax benefit lease and the RD stock to CKS. On
February 13, 1997, petitioner transferred $2 million to CKH. On
May 5, 1997, Norwest (through its subsidiary Norwest Equipment)
redeemed the RD stock and paid CKS $758,123.64 representing the
liquidation value of the RD stock, plus accrued dividends. CKS,
in turn, transferred $624,123.64 of the $758,123.64 to
petitioner, leaving CKS with $134,000.16
16
As indicated above, the investment banking services
agreement between CKS and petitioner provided that $132,000 was
(continued...)
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On its return for the tax year ended November 30, 1997,
petitioner reported only $500,000 of the $2.5 million NSI fee
received on January 30, 1997. Petitioner did not report the $2
million portion of the NSI fee as income.
On the CKH and CKH’s affiliates consolidated income tax
return filed for the short tax year October 22, 1996, through
March 31, 1997, CKH reported the $2 million portion of the NSI
fee transferred by petitioner. The $2 million of income was
offset by CKS’s $2,079,706 reported loss for that year and a
$1,739,488 NOL carryover from prior years.
In the notice of deficiency for the taxable year ended
November 30, 1997, respondent determined that the $2 million
portion of the NSI consulting fee was includable in petitioner’s
income. Petitioner alternatively alleged in the petition that,
in the event this $2 million portion of the NSI fee was held to
be taxable to petitioner, petitioner should be entitled to deduct
the $2 million payment to CKH as a business expense.
2. Petitioner’s Advances to Koehler
On August 31, 1994, Koehler executed a demand promissory
note to petitioner for $31,705 for advances that petitioner had
made to Koehler over a period extending back to the 1980s.
16
(...continued)
to be retained by CKS. The parties, however, stipulated that
$134,000 was the amount that CKS actually retained. The record
does not disclose the reason for this $2,000 discrepancy.
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Before August 31, 1994, there was no note evidencing the $31,705.
The demand promissory note also covered additional principal
amounts advanced by petitioner to Koehler that were to be added
to the $31,705 shown on a schedule attached to the note.
Interest, at the rate of 5 percent, was provided for from the
date of each principal disbursement.
Beginning on August 31, 1994, through December 30, 1994,
petitioner advanced an additional $45,000 to Koehler, in nine
semimonthly payments of $5,000 each on the 15th and the last day
of each month. Before the $5,000 semimonthly payments, Koehler
had been receiving monthly compensation from Cap Corp. Koehler
suggested that petitioner label the $5,000 payments to Koehler as
loans, as opposed to compensation, because Koehler’s former wife
was then seeking increased alimony payments.
Koehler had experienced financial difficulties since his
divorce in 1987 or 1988 and was paying $4,000 in monthly alimony.
From at least 1992 through 1996, Koehler’s financial condition
was poor, and he was unable to repay the advances received from
petitioner. By August 31, 1994, when petitioner began making its
nine $5,000 semimonthly payments to Koehler, Crispin knew that
Koehler was insolvent.
Beginning on August 31, 1994, through December 1, 1995,
$4,555 in interest accrued on the August 31, 1994, demand
promissory note. During that same period, Koehler paid
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petitioner accrued monthly note interest in varying monthly
amounts totaling $4,555.
As of December 31, 1994, Koehler owed petitioner $76,705
under the August 31, 1994, demand promissory note. Koehler did
not make principal payments on the $76,705 note. Petitioner has
not sought repayment of the $76,705 advanced to Koehler.
On its return for the taxable year ended November 30, 1996,
petitioner deducted as a miscellaneous expense the $76,705
advanced to Koehler. In the notice of deficiency, respondent
disallowed the deduction. Respondent determined that it had not
been established that this $76,705 (1) was an ordinary and
necessary business expense and (2) had been expended for the
purpose stated.
OPINION
The factual circumstances in this case consist of a
Byzantine labyrinth of complex transactions. Most of the
transactions were generated to achieve a tax effect. We must
decide whether these transactions should be respected. Some of
the transactions we consider present less sophisticated questions
such as when and by whom income should be reported or whether
certain deductions should be allowed. The specific issues we
consider involve: (1) Petitioner’s entitlement to more than $2.7
million of deductions from the second lease strip deal for its
taxable years ended November 30, 1996 and 1997; (2) petitioner’s
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entitlement to a $2,052,900 ordinary loss and a $1,859,135
business bad debt deduction for 1997 with respect to advances to
Cap Corp.; (3) $2 million of the NSI consulting fee and (a)
whether it is includable in petitioner’s 1997 income, and (b) if
it is includable in income, whether petitioner is entitled to a
$2 million business deduction for 1997; (4) petitioner’s
entitlement to a $76,705 business bad debt deduction for 1996
concerning loans to Koehler; and (5) whether petitioner is liable
for penalties under section 6662.
I. Petitioner’s Second Lease Strip Deal
Petitioner arranged lease strip deals using tax-indifferent
parties and series of complex multiparty transactions to secure
substantial tax benefits exponentially larger than taxpayers’
economic investments in the deals. The parties’ arguments
concerning these deals involve questions of substance versus
form. Petitioner relies on the form of the transactions, and
respondent relies on the substance. Specifically, respondent
contends that petitioner’s second lease strip deal lacks economic
substance and should not be respected for tax purposes.
Alternatively, respondent contends that petitioner’s claimed
rental expenses and note disposition losses are neither ordinary
and necessary business expenses under section 162 nor otherwise
deductible losses under section 165.
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A. Did the Underlying Transactions Have Economic
Substance?
1. Generally
If a transaction is found not to have economic substance,
the form of the transaction may be disregarded in determining the
proper tax treatment to be accorded that transaction. Numerous
courts have held that a transaction that is entered into
primarily to reduce tax and which otherwise has minimal or no
supporting economic or commercial objective, has no effect for
Federal tax purposes. Frank Lyon Co. v. United States, 435 U.S.
561 (1978); Gregory v. Helvering, 293 U.S. 465 (1935); ACM Pship.
v. Commissioner, 157 F.3d 231, 246-247 (3d Cir. 1998), affg. in
part and revg. in part T.C. Memo. 1997-115; United States v.
Wexler, 31 F.3d 117, 122, 124 (3d Cir. 1994); Yosha v.
Commissioner, 861 F.2d 494, 498-499 (7th Cir. 1988), affg. Glass
v. Commissioner, 87 T.C. 1087 (1986); Goldstein v. Commissioner,
364 F.2d 734, 740-741 (2d Cir. 1966), affg. 44 T.C. 284 (1965);
Nicole Rose Corp. v. Commissioner, 117 T.C. 328, 336 (2001),
affd. 320 F.3d 282 (2d Cir. 2002).
The determination of whether a transaction lacks economic
substance requires a consideration of the facts and circumstances
surrounding the transaction, with no single factor being
determinative. United States v. Cumberland Pub. Serv. Co., 338
- 55 -
U.S. 451, 456 (1950). Whether a taxpayer’s characterization of a
transaction should be respected depends upon whether there is a
bona fide transaction with economic substance, compelled or
encouraged by business or regulatory realties, imbued with tax-
independent considerations, and not shaped primarily by tax
avoidance features that have meaningless labels attached. See
ACM Pship. v. Commissioner, supra; Casebeer v. Commissioner, 909
F.2d 1360 (9th Cir. 1990), affg. Sturm v. Commissioner, T.C.
Memo. 1987-625; Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C.
254 (1999), affd. 254 F.3d 1313 (11th Cir. 2001).
In deciding whether a transaction or series of transactions
lacks economic substance, courts have used a two-pronged inquiry:
(1) A subjective inquiry as to whether the transaction(s) was
carried out for a valid business purpose; and (2) an objective
inquiry concerning the economic effect of the transaction(s).
ACM Pship. v. Commissioner, supra at 247-248; Casebeer v.
Commissioner, supra at 1363; Kirchman v. Commissioner, 862 F.2d
1486, 1490-1491 (11th Cir. 1989), affg. Glass v. Commissioner, 87
T.C. 1087 (1986); Nicole Rose Corp. v. Commissioner, supra. We
note that the two tests have much in common and are not
necessarily discrete prongs of a “rigid two-step analysis”.
Casebeer v. Commissioner, supra at 1363.
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The consideration of whether there is a valid business
purpose has been described as an inquiry into whether the
transaction is motivated by profit or economic advantage so as
not to be considered a “sham for purposes of analysis under
I.R.C. § 165(c)(2).” Kirchman v. Commissioner, supra at 1491.
That inquiry has been similarly described as one where the court
considers whether the transaction is “rationally related to a
useful nontax purpose that is plausible in light of the
taxpayer’s conduct and * * * economic situation”. ACM Pship. v.
Commissioner, T.C. Memo. 1997-115. This evaluation of the
practicability or utility of the stated nontax purpose and the
rationality of the means used to achieve that nontax purpose are
to be evaluated in accordance with commercial practices in the
relevant industry. Cherin v. Commissioner, 89 T.C. 986, 993-994
(1987).
Consideration of the economic effect of the transaction(s)
in question involves an objective inquiry concerning whether the
transaction appreciably affected the taxpayer’s beneficial
economic interest, absent tax benefits. Knetsch v. United
States, 364 U.S. 361, 366 (1960); ACM Pship. v. Commissioner, 157
F.3d at 248. For example, where offsetting legal obligations or
circular cashflows effectively eliminated any real economic
profit from the transaction, the transaction was considered to be
without economic effect. Knetsch v. United States, supra at 366;
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Hines v. United States, 912 F.2d 736, 741 (4th Cir. 1990). De
minimis or inconsequential pretax profits relative to a
taxpayer’s artificially and grossly inflated claim of potential
tax benefits may be insufficient to imbue an otherwise
economically questionable transaction with economic substance.
ACM Pship. v. Commissioner, 157 F.3d at 257; Sheldon v.
Commissioner, 94 T.C. 738, 767-768 (1990).
2. Background and Recapitulation of the Two Lease
Strip Transactions
Petitioner is a privately held corporation owned and
controlled by Crispin, its 98-percent shareholder and ultimate
decision maker. Petitioner was generally involved in equipment
leasing transactions and helping to structure the financing of
equipment, including the arranging of lease strip deals. Through
the maneuvering of certain equipment and existing leases through
a preconceived series of transactions using several entities,
rental income and related rental expenses are bifurcated and
reallocated to different parties. Virtually all of the rental
income is stripped out and allocated to a tax-indifferent party
in order to provide a disproportionately large share of tax
benefits (deductions) to a taxpayer. In addition, the character
of the income may be changed; i.e., capital gains are converted
to ordinary income or vice versa. By late 1994, petitioner had
extensive experience in arranging lease strip deals.
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Before November 1994, CLI (an entity unrelated to
petitioner) owned certain computer, photo processing, and
satellite dish equipment that was leased to various entities
unrelated to petitioner. Most of these existing leases were
scheduled to end during the spring, summer, or winter of 1997.
In late 1994 and early 1995, petitioner arranged a first
lease strip deal for CFX. According to a tax opinion, CFX, in
exchange for a cost of approximately $2.9 million, would receive
approximately $13.8 million in deductions. The $2.9 million to
be paid by CFX was divided among the participants and others who
arranged the deal, including CLI and petitioner. Petitioner
earned $611,655 for its services in arranging the first lease
strip deal for CFX.
A second lease strip deal involving some of the same
equipment was initiated approximately 9 months later. In the
first and second lease strip deals there were at least 17
interrelated transactions with respect to the same equipment.
Under the second lease strip deal, petitioner claimed over $4.2
million in deductions for 1995, 1996, and 1997. Petitioner’s
out-of-pocket cost for the “investment” in its second lease strip
deal approximated 1 percent of the claimed deductions or slightly
more than $40,000.
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The first lease strip deal (for CFX) and the second lease
strip deal (for petitioner) involved equipment already subject to
the following leases: (1) A lease of photo processing equipment
to K-Mart (a large retailer), and (2) a lease of computer
equipment to Shared (a medical services provider). Late in 1994,
the K-Mart and Shared leases each had only a few years left to
run.
The transactions used to effect the first lease strip deal
included: (1) The purchase of computer, photo processing, and
satellite dish equipment already subject to existing end-user
leases with K-Mart, Shared, and others; (2) “taxable sale”-
leaseback transactions of that equipment by CFP, a partnership
and a tax-indifferent partner under the sale-leaseback
partnership, (a) where CFP was issued an equipment purchase
installment note with the installments equal to and offset by the
rental payments due under the wraparound lease entered into by
CFP, and (b) CFP’s leaseback of that equipment under a wraparound
lease encompassing those existing end-user leases; (3) a lease
strip sale by CFP whereby virtually all of the rental income with
respect to those existing end-user leases was stripped out and
allocated to the Iowa Tribe, a tax-indifferent party and 99-
percent limited partner of CFP; and (4) the transfer in a
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purported section 351 transaction by CFP to CFX Financial (a
subsidiary of CFX) of (a) the wraparound lease position and (b)
the equipment purchase installment note or payment rights.
In the second lease strip deal, in which petitioner was the
customer/taxpayer, similar transactions were employed including
“taxable sale”-leaseback transactions and a rent strip sale
involving the Iowa Tribe, a tax-indifferent party, to generate
deductions disproportionately larger than petitioner’s economic
investment in that deal. Unlike the beneficiary of the first
lease strip deal, petitioner did not retain the over lease
wraparound lease position for the entire life of the lease.
Instead, petitioner disposed of its over lease position and the
accompanying equipment installment note in a series of three
transactions during a 21-month period from November 27, 1995,
through September 1, 1997.
Normally, in lease strip deals structured by petitioner, the
tax benefits customer was wholly unrelated to petitioner. In the
second deal, however, petitioner was the tax benefits customer
that claimed the deductions from the lease strip deal with
respect to the same K-Mart and Shared equipment. After arranging
the first lease strip deal for CFX, petitioner reconfigured,
refined, and reused the ownership of the K-Mart and Shared
equipment, the K-Mart and Shared end-user leases, and the master
lease to create a second lease strip deal and the over lease
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wraparound lease involving the same equipment. Originally,
petitioner planned to market the second lease strip deal to an
unrelated customer. Petitioner, however, decided to claim over
$4.2 million in deductions itself.
Petitioner contends that it was forced to become involved in
the second lease strip deal because of the IRS’s October 30,
1995, issuance of Notice 95-53, 1995-2 C.B. 334. The purpose of
that notice was to discourage such lease strip deals. In Notice
95-53, 1995-2 C.B. at 334-335, the IRS (1) described a lease
strip deal which, in all material respects, was substantially
similar to the first and second lease strip deals we consider
here, and (2) warned that the IRS would challenge and, on various
grounds, disallow the claimed tax benefits under such lease strip
deals. Notwithstanding the IRS’s warning in Notice 95-53, supra,
petitioner deducted more than $4.2 million for 1995, 1996, and
1997 from its involvement in the second lease strip deal.
In the first lease strip deal, involving CFX, the complex
multiparty equipment purchase, lease, and other transactions were
entered into on November 1 and 30, 1994, December 2, 1994, and
January 3, 1995. In petitioner’s second lease strip deal the
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complex multiparty transactions were entered into on August 31,
September 1, September 28, and November 27, 1995; and on October
31, 1996, and September 1, 1997.17
3. Petitioner’s Rental Expense Deductions and Note
Disposition Losses
On its 1995 tax return, petitioner claimed CMACM’s purported
$1,982,825 loss from partial disposition of the $4,056,220
Jenrich note to Okoma, resulting in petitioner’s $404,000 NOL for
1996. On its 1996 tax return, petitioner reported that CMACM had
a $469,221 cost basis for the portion of the $4,056,220 note
transferred to Lexington for an unsecured $10,000 promissory note
on October 31, 1996. On the basis of that, petitioner claimed
CMACM’s $459,221 loss on the partial disposition of the Jenrich
note. Petitioner also claimed $414,041 as rental expenses on its
1996 tax return attributable to CMACM’s 1996 purported over lease
rental payments. CMACM’s claimed rental expenses equaled, and
were completely offset by, the amounts due petitioner under
Jenrich’s equipment purchase installment note.
17
Attached to this opinion as app. A is a 3-page, 17-step
flow chart reflecting the basic elements of the transactions.
Attached as app. B is a single-page summary of app. A. Apps. A
and B were prepared by respondent and used during the trial as an
aid to understanding the various steps in the questioned
transactions. The appendixes were not received in evidence, but
were marked for purposes of identification. These charts are
included solely to aid in better understanding the complex fact
pattern in this case.
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On its 1997 tax return, petitioner reported that CMACM had a
$1,179,013 cost basis for the remaining portion of the $4,056,220
Jenrich note that CMACM transferred to Lexington for Lexington’s
$1,000 unsecured promissory note. On the basis of that,
petitioner claimed a $1,178,013 loss on the partial disposition
of the Jenrich note to Lexington. Petitioner also claimed
$237,853 of rental expenses on its 1997 tax return attributable
to CMACM’s purported over lease rental payments during 1997. The
rental expenses claimed by CMACM equaled, and were completely
offset by, the amounts due to CMACM under Jenrich’s equipment
purchase installment note.
Finally, on its 1998 tax return, petitioner claimed
deductions for the worthlessness of Lexington’s $10,000 and
$1,000 unsecured promissory notes.
In sum, on the basis of its $10 investment in stock and
assumption of a purported $215,000 obligation owed by CAP to EQ,
petitioner claimed over $4.2 million in deductions from the
second lease strip deal transactions. ($1,982,825 + $459,221 +
$414,041 + $1,178,013 + $237,853 + $10,000 + $1,000 =
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$4,282,953.18) As of September 1, 1997, petitioner’s actual out-
of-pocket cost was approximately $40,000.
4. Did Petitioner Have a Nontax Business Purpose for
Entering Into the Second Lease Strip Transaction?
The second lease strip deal was designed to provide
substantial tax benefits for petitioner. Petitioner acknowledges
that its only possibility for realizing an economic profit from
the over lease position depended upon rental income being
produced from the residual lease interests with respect to the K-
Mart and Shared equipment. The lease term in petitioner’s over
lease agreement, however, provided for no actual residual
interests in the K-Mart and Shared equipment. The over lease
agreement specified a lease term for the K-Mart and Shared
equipment that expired on the same dates as the master lease
respecting that equipment. Although acknowledging that the over
lease agreement provided respective termination dates of October
31, 2002, and April 30, 2000, with respect to the K-Mart and
Shared equipment, petitioner and Crispin assert that the over
lease termination dates are a “drafting error”. Petitioner and
Crispin maintain that the over lease was meant to run: (1) From
August 31, 1995, through February 28, 2004, in the case of the K-
18
The $10 stock investment and the $215,000 obligation
represented petitioner’s only actual out-of-pocket expenditures.
As of the years under consideration, however, petitioner had paid
only $40,000 of the $215,000 obligation. All other purported
obligations were part of circular flows so that petitioner was
not required to make any out-of-pocket expenditures.
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Mart equipment, and (2) from August 31, 1995, through February
28, 2002, in the case of the Shared equipment.
Petitioner did not offer a reasonable explanation as to why
it was necessary for CMACM (petitioner’s subsidiary and
affiliate) to acquire petitioner’s purported over lease residual
interests in the K-Mart and Shared equipment, and for CMACM,
pursuant to the purported section 351 transfer from CAP, to
acquire and/or assume (1) the rental payment obligation for the
entire life of the over lease and (2) the Jenrich equipment
purchase installment note. In that regard, there appears to have
been no concern on petitioner’s part in structuring this second
lease strip deal about Jenrich’s questionable financial condition
and ability to make payments on the installment note.
Ultimately, any note installments paid by Jenrich and over lease
rental payments by CMACM would be completely offset so that no
cash payments would have to be made by CMACM or by Jenrich.
In the first lease strip deal for CFX, petitioner had a
business purpose and profit motive; viz, obtaining a fee of more
than $611,000 for arranging the lease strip deal for CFX.
Petitioner, however, has not shown any credible business purpose
for its involvement in the second lease strip deal other than its
intent to claim $4.2 million in tax benefits. The second lease
strip deal was structured to strip out the equipment rental
income and reallocate it to the tax-indifferent Iowa Tribe in
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order to leave petitioner with deductions of more than $4.2
million. Petitioner sought to claim these tax benefits because
it was unable to sell the deal to others because of the IRS’s
October 30, 1995, issuance of Notice 95-53, 1995-2 C.B. 334,
warning of the IRS’s intention to challenge and disallow tax
benefits claimed under lease strip deals.
Petitioner contends that this case is “fact driven, and this
Court must ultimately decide whose version of the facts is
correct.” Petitioner argues that it was in the business of
structuring leasing transactions and that the two lease strip
deals under consideration did not differ from and were typical of
contemporaneous lease strip deals. Finally, petitioner argues
that it was genuinely motivated to seek a pretax economic profit.
In effect, petitioner asks this Court to accept its version
of the facts, including the premise that the second lease strip
deal employs the same form as similar lease strip deals being
conducted at that time. It is well settled that the mere
execution of documents assigning labels to aspects of a
transaction does not automatically result in their being
respected for tax purposes. Similarly agreements which, on their
face, formally comply with the requirements of a statute do not
give substance to a transaction which in reality has no economic
substance. See Gregory v. Helvering, 293 U.S. at 468. We must
decide whether what was done, apart from the tax motive, was what
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the statute intended. Id. at 469; see also Knetsch v. United
States, 364 U.S. at 365. Even if we accepted petitioner’s
premise that the second lease strip deal was a typical deal,
petitioner’s approach focused solely on form with no regard for
the substance. The lease strip deals we consider in this case
are mere tax-avoidance devices or subterfuges mimicking a leasing
transaction. The obvious purpose was to obtain unwarranted and
substantial tax benefits.
We first consider whether petitioner subjectively had a
valid, nontax business purpose for entering into the second lease
strip deal. See ACM Pship. v. Commissioner, 157 F.3d at 247-248;
Casebeer v. Commissioner, 909 F.2d at 1363.
Petitioner claims to have entered the lease strip deal to
hold the over lease residual interests in the K-Mart and Shared
equipment because it expected to earn a pretax profit from the
equipment rental income or the income produced from disposition
of the residual interests. The over lease agreement, however,
provides for a lease term under which petitioner would have no
residual interests in the equipment because the agreement
specifies a lease term that expires on the same date as the
master lease respecting the same equipment. Thus the operative
legal document governing petitioner’s rights contains a
fundamental flaw and does not support petitioner’s over lease
position. Significantly, petitioner’s failure to discover and/or
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remedy this fundamental flaw undercuts petitioner’s contention
that it had a genuine pretax profit motive and a valid nontax
business purpose for entering into the lease strip deal. Indeed,
the flaw in the agreement escaped petitioner’s notice and that of
others representing Okoma and Lexington, the two entities to
which CMACM disposed of part of CMACM’s over lease position in a
series of three transactions from November 28, 1995, through
September 1, 1997.
Petitioner attempts to counter the effect of what it terms
an “ambiguity” by contending that “Crispin, CMA [petitioner], and
its personnel would not have entered into a transaction for any
consideration [where that transaction] * * * did not give them
the residual period they thought they were buying, mainly because
no customer would have even considered buying a nonexistent
position from CMA.” We are skeptical of petitioner’s argument.
Petitioner and CMACM had extensive experience in arranging lease
strip deals. If petitioner and Crispin were unsophisticated or
relied on others, their argument might be more colorable. But
here, the “experts” bought their own “product” with a major
drafting flaw and fundamental defect. Under these circumstances,
we conclude that the substantive rights were of no import to
these “experts” and that they viewed the transactions with
indifference. For petitioner the transactions were solely a
means for securing a tax advantage. If petitioner and Crispin
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had been genuinely concerned about the pretax profit potential,
they would have carefully reviewed the over lease agreement to
ensure that the residual lease periods were properly defined.
Petitioner’s lack of interest or concern is inconsistent
with a genuine pretax profit motive for entering into the second
lease strip deal. Other than self-serving testimony, petitioner
offered no preinvolvement documents reflecting the value of the
lease transaction rights. Notwithstanding petitioner’s claimed
pretax profit motive, it did not hold the over lease position for
very long. Petitioner caused CMACM to dispose of its position to
Okoma and Lexington in a series of three transactions from
November 27, 1995, through September 1, 1997. In the
consummation of the three transactions, Crispin and petitioner’s
personnel failed a second time to discover the fact that there
was no over lease term. We note that Crispin, as CMACM’s
president, personally executed each assignment and assumption
agreement by which CMACM disposed of a portion of its over lease
position to either Okoma or Lexington.
On or about March 25, 1996, when CMACM and Jenrich agreed to
offset CMACM’s over lease rental payment liability and Jenrich’s
installment note liability against one another, petitioner and
its personnel on a third occasion failed to discover the overlap
of the lease terms.
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On the basis of the foregoing, we hold that petitioner did
not have a pretax profit motive. We also hold that petitioner
had no valid nontax business purpose for entering into the second
lease strip deal. See Casebeer v. Commissioner, 909 F.2d at
1363-1364; Nicole Rose Corp. v. Commissioner, 117 T.C. at 336-
338; ACM Pship. v. Commissioner, T.C. Memo. 1997-115.
5. Whether Petitioner’s Lease Strip Deal Had Economic
Profit Potential Aside From the Tax Benefits
We now turn to the second prong of our inquiry involving an
objective inquiry into the economic effect of the series of
transactions and whether it appreciably affected petitioner’s
beneficial economic interest, aside from potential tax benefits.
See ACM Pship. v. Commissioner, 157 F.3d at 246-248; Casebeer v.
Commissioner, supra at 1363.
In this inquiry, we examine the potential for economic
profit from petitioner’s over lease residual interests in the
K-Mart and Shared equipment. As discussed above, there were no
over lease residual interests because the over lease agreement
expired on the same date as the master lease. Even assuming that
petitioner had acquired some over lease residual interests in
that equipment, those interests had no residual value and/or
little if any potential for rental income. A September 28, 1995,
forecast respecting the residual interests would have revealed
that, by the time the residual interest periods began, there
would have been: (1) No residual value for that equipment and/or
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(2) no projected equipment rental income to be earned from that
equipment. Respondent’s expert Peter Daley opined that, as of
September 28, 1995, with one de minimis exception, the K-Mart and
Shared equipment would have no estimated residual value by the
critical date, May 1, 2000. The exception concerned photo
equipment with a nominal value of $194.
We emphasize, however, that petitioner did not obtain a pre-
September 28, 1995, outside appraisal of its residual interests.
Instead, Hughes (petitioner’s tax and accounting manager),
sometime before September 28, 1995, prepared a valuation analysis
of those over lease residual interests. Crispin and Hughes both
testified that this valuation analysis was based upon extending
the 10- to 12-year equipment “yield decline curve” that had been
used in the Marshall & Stevens appraisal to value CFX’s first
lease strip deal residual interests in the K-Mart, Shared, and
other existing lease equipment. We note that petitioner did not
offer into evidence any document containing the details of
Hughes’s pre-September 28, 1985, valuation analysis.
In addition, the Marshall & Stevens appraisal was not
received in evidence for purposes of establishing the probative
value of the conclusions therein or as opinion because no expert
testimony was offered. Respondent also points out that this
Court, in other cases, has rejected the valuation methodology of
Marshall & Stevens appraisals in cases involving computer
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equipment. See Nicole Rose Corp. v. Commissioner, 117 T.C. at
338; Coleman v. Commissioner, 87 T.C. 178, 199 (1986), affd.
without published opinion 833 F.2d 303 (3d Cir. 1987); Smoot v.
Commissioner, T.C. Memo. 1991-268. Marshall & Stevens applied a
10-year “yield decline curve” to computer equipment that was
assumed to have a life of 10 years. The 10-year assumption was
used even though the equipment under consideration had been
introduced into the market place a number of years before the
transaction.
The right to the equipment rental income for the remaining
terms of the underlying leases had considerable value, as each
lessee was highly creditworthy and in all events, the lessee was
required to make the scheduled rental payments. In the first
lease strip deal on November 30, 1994, HCA paid $11.763 million
to acquire the equipment rental stream due from K-Mart, Shared,
and other end users under the existing end-user leases.19 By
contrast, the rental stream under the over lease residual
interests had a substantially lower potential for value.
The following factors reflect that there was little
potential for value or rental income from the over lease residual
interests: (1) The original leases were entered into before
January 3 and September 28, 1995; (2) the equipment subject to
19
Attached to this opinion as app. C is a schedule detailing
the monthly rental payments that Hitachi Credit America Corp.
(HCA) purchased in the Nov. 30, 1994, rent strip sale.
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each existing lease had been declining in value since the lease
was entered into; (3) the equipment could only be expected to
continue to decline in value; (4) the existing end-user leases
each had a few years to run before CFX’s master lease residual
interest periods and then petitioner’s purported over lease
residual interest periods with respect to that equipment would
have begun;20 (5) the first 2 years of the master lease residual
interest in the K-Mart end-user lease equipment and the first 6
months of the master lease residual interest in the Amoco end-
user lease equipment were “sold” to Residco; and (6) no lease
arrangement with a potential user was in place for the period
following the termination of the existing leases. Any such lease
arrangements would have to be negotiated at some future point
either with the equipment’s current end user or with another
possible user.
In that regard, one of petitioner’s experts acknowledged
that the projected future monthly rental income to be earned
under (1) the master lease residual interests and (2) the over
lease residual interests would be substantially less than the
monthly rental income due under the existing end-user leases on
that equipment.
20
The existing Shared and K-Mart end-user leases expired no
later than Mar. 29 and Jul. 31, 1997, respectively. The existing
HIP NY end-user lease expired on Dec. 31, 1997; the existing
Martin Marietta end-user lease expired on May 31, 1997; and the
existing Amoco end-user lease expired on Mar. 31, 2000.
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a. The Experts’ Opinions
Respondent’s expert, Peter Daley (Daley), opined that, as of
September 28, 1995, the K-Mart and Shared end-user lease
equipment would: (1) Have almost no estimated residual value
when petitioner’s purported over lease residual interest periods
began; and (2) not generate rental income during the over lease
residual interest periods. Obviously, if the over lease residual
interests had minimal or no value when acquired, petitioner would
not pass the second prong of the economic substance test.
Petitioner’s expert, Robert S. Svoboda (Svoboda), opined
that the over lease residual interests had a fair market value of
$122,000 to $263,000 as of September 28, 1995. Petitioner
contends that it should succeed if it establishes that there was
a projected rental income above $215,00021 as of September 28,
1995. In other words, petitioner argues that the economic
substance test is met if it shows that as of September 28, 1995,
some potential existed for petitioner’s earning a pretax profit.
In that regard, petitioner also argues that its projected future
over lease residual interest rental income need not be discounted
to its present value as of September 28, 1995.
21
This amount would have been petitioner’s maximum out-of-
pocket cost if the note obligation had been fully paid. We note,
however, that petitioner had paid only $40,000 of the $215,000 as
of the time under consideration.
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Conversely, respondent argues that any projected future over
lease residual rental income must be discounted to its present
value as of September 28, 1995. Respondent also argues that the
value of the residual interests must be commensurate with or in
some way reasonably proportionate to petitioner’s claimed
potential tax benefits from the second lease strip deal.
In our consideration of the experts’ opinions we may accept
or reject expert testimony, in whole or in part. Helvering v.
Natl. Grocery Co., 304 U.S. 282, 295 (1938); Silverman v.
Commissioner, 538 F.2d 927, 933 (2d Cir. 1976) (and cases cited
thereat), affg. T.C. Memo. 1974-285.
i. Petitioner’s Expert
Svoboda was asked to provide an opinion as to the fair
market values, as of September 28, 1995, of the underlying K-Mart
photo processing and Shared computer equipment. He also
estimated the future residual values for the K-Mart and Shared
equipment when (1) the existing or prior lease of that equipment
terminated, and (2) the over lease residual interest periods
began. Svoboda also determined the fair market value, as of
September 28, 1995, of petitioner’s over lease residual interests
in the K-Mart and Shared equipment. For purposes of his
appraisal, Svoboda added to the classical definition of “fair
market value” the assumption that the buyer and seller
contemplate the retention of the properties by the current end-
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user lessees.22 Although Svoboda has over 25 years of appraisal
experience, he had relatively little experience valuing residual
interests in equipment with useful lives of 10 years or less.
(a) Svoboda’s Opinions as to the Fair Market
Values and Estimated Residual Values
Svoboda concluded that, as of September 28, 1995, the K-Mart
and Shared equipment had the following fair market values and
estimated future residual values:
Estimated Future Residual Value On:
Equipment Fair Market Value 2-24-97 3-13-97 6-30-97 7-31-97 5-1-00 11-1-02
K-Mart
No. 32 $116,844 –- -- -- $50,076 -- $8,346
No. 33 473,452 –- -- -- 295,908 -- 29,591
No. 34 1,215,504 –- -- $759,690 -– -- 151,938
Shared
No. 5 567,521 –- $133,471 -- –- -0- --
No. 6 143,052 $30,654 -– -- –- -0- –-
Svoboda primarily used the sales comparison approach to
value the Shared computer equipment. His opinion was based on
published market data on this equipment, including reports
published by respondent’s expert, Daley. Svoboda concluded that
the Shared computer equipment would have no residual value by May
1, 2000, the date when petitioner’s over lease residual interest
in that equipment began.
22
Svoboda also assumed that petitioner was contractually
entitled to income from the over lease residual interest periods,
a fact that is not supported by the operative documents.
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In valuing the K-Mart photo processing equipment, however,
Svoboda was unable to find published market data. Accordingly,
he relied on (1) discussions with equipment brokers and used
equipment dealers and (2) information on that equipment from the
market at the time he prepared his report. His research
uncovered very little information regarding the equipment during
the mid-1990s. Although the manufacturers’ representatives for
the K-Mart equipment indicated that the K-Mart equipment might
have either a 5- to 7-year life or an 8- to 10-year life, Svoboda
determined that the K-Mart equipment had a 10-year useful life.
He set a 5- or 10-percent “floor” or selling price for the K-Mart
equipment at the end of its useful life and developed a
depreciation curve to reach the K-Mart equipment’s fair market
values and future residual values.
(b) Svoboda’s Fair Market Value for
the Over Lease Residual Interests
Svoboda opined that the residual interests in the K-Mart and
Shared equipment had a fair market value ranging from $122,000 to
$263,000. He considered the three traditional approaches (i.e.,
sales, income, and cost) for valuing equipment and chose the
income approach, explaining that “the cost approach was not
applicable and comparable sales were not available.”
Svoboda chose the income approach because “Ultimately the
value of the over lease residual * * * [interests] equates to the
present worth of future benefits”. His “goal was to quantify the
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future benefits and convert them to present value using a
discount rate commensurate with the risk associated with
obtaining those benefits”. He considered three variables
including: (1) Quantifying the future benefits; (2) determining
the appropriate discount rate; and (3) determining the time
required to achieve those benefits and quantifying the risks
associated with achieving those benefits.
In order to quantify the future benefits of the residual
interests, Svoboda used the same monthly rental income generated
during the preceding leases. Recognizing that those monthly
rates were too high, he used an “anticipated realization factor”
to project the future rental income. This adjustment, according
to Svoboda, would take into account (1) the likelihood that the
equipment would be leased during petitioner’s over lease residual
interest periods, and (2) the anticipated decline in monthly
rents for the equipment over time. Relying heavily upon his
conversations with Paul Raynault (Raynault), CLI’s chairman and
50-percent shareholder, concerning the likelihood that K-Mart and
Shared would continue to rent after the existing leases expired,
Svoboda determined that his anticipated realization factors
should be 25 to 50 percent for the K-Mart photo processing
equipment and 1 to 5 percent for the Shared computer equipment.
With respect to the Shared computer equipment, Svoboda recognized
that technology was changing rapidly and that there would be
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increased pressure on the lessees to replace computer equipment.
Additionally, by the mid-1990s computer equipment manufacturers
were inclined to offer significant financial incentives to
potential customers. Svoboda applied a 10-percent discount
factor to account for those factors. Svoboda’s fair market value
opinion concerning the over lease residual interests is
summarized as follows:
Present Value of
Anticipated Realization Projected Future
Factor Percentage Range Rental Income1
Equipment Low High Low High
K-Mart 25 percent 50 percent $116,292 $232,585
Shared 1 percent 5 percent 6,036 30,182
Total and FMV2 122,000 263,000
1
Determined by applying a discount factor of 10
percent.
2
Rounded to nearest $1,000.
ii. Respondent’s Expert
Daley concluded that, as of September 28, 1995, the K-Mart
photo processing and Shared computer equipment would: (1) Have
an inconsequential estimated residual value at the beginning of
the residual lease periods, and (2) generate no future rental
income during those residual lease periods. He also concluded
that the K-Mart and Shared equipment would have a total combined
estimated value of $499,406 at the end of the original leases.
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Daley is president of Daley Marketing Corp. (DMC), a company
that prepares and publishes market and residual value reports for
computer equipment. DMC collects and maintains a data base of
information concerning the market and residual values of computer
equipment. The sources of the data are brokers, dealers, and
lessors, and the reports have been published quarterly since
1985. DMC reports are used as a reference by many companies,
including Fortune 500 companies, to ascertain computer equipment
values. Petitioner subscribed to these reports during 1995.
Daley also considered the three traditional approaches
(i.e., sales, income, and cost) to valuing equipment and selected
the market approach because of the availability of actual sales
and offering prices for the same or similar equipment. He
reasoned that an actual market for equipment presents a more
direct and reliable indicator of fair market value.
The methodology used to convert raw equipment information
obtained from brokers, dealers, and lessors into DMC residual
value reports includes the adding of a gross margin to arrive at
an “end user” fair market value. In addition, the forecasting of
future value includes the development of a depreciation curve to
adjust for new technology, supply and demand, continued viability
of the manufacturer, competition, and other market factors. On
the basis of that methodology, Daley’s judgment is that the
equipment we consider here reaches a salvage value of 2 percent
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of list price. In Daley’s judgment, the value of the equipment
reaches “salvage value” when the equipment is “scrapped or sold
off to third party maintenance companies” for spare parts.
Daley concluded that by May 1, 2000, with one exception, the
K-Mart and Shared equipment would have no estimated residual
value. The one exception was a piece of photo processing
equipment that Daley estimated would have a nominal residual
value of $194.
Daley used DMC’s compiled computer equipment reports to
determine the residual values for the Shared computer equipment.
With respect to the K-Mart photo processing equipment, Daley
compiled information from a similar data base on photo processing
equipment. Using a similar methodology as he used for computer
equipment, Daley arrived at the conclusion that the K-Mart
equipment would have no residual value.
On the basis of that analysis and using a 10-percent
interest or discount rate, Daley projected the future rental
income the K-Mart and Shared equipment would produce during the
master lease and over lease periods. He projected that the K-
Mart and Shared equipment would produce no rental income during
the purported over lease.
Daley opined that the underlying K-Mart and Shared end-user
lease equipment had the following fair market values as of the
dates specified below:
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Fair Market Value
Equipment Nov. 1, 1994 Aug. 31, 1995 Sept. 28, 1995
K-Mart $1,651,272 $1,093,247 $1,041,105
Shared 2,396,764 1,394,450 1,188,847
Daley further opined that, as of September 28, 1995, the K-
Mart and Shared equipment would have the following estimated
residual values on the dates shown below and could be expected to
produce no rental income during the purported over lease residual
interest periods, as follows:
Estimated Residual Value
3-1-97 7-1-97
or or Over Lease Int. Pds.1
Equipment 4-1-97 8-1-97 5-1-00 Proj. Rental Income
K-Mart -- $378,486 $194 -0-
Shared $120,920 -- -0- -0-
1
The over lease periods are: (1) From Nov. 1, 2002, through
Feb. 28, 2004, in the case of the K-Mart equipment, and (2) from
May 1, 2000, through Feb. 28, 2002, in the case of the Shared
equipment.
b. Evaluation and Comparison of the Experts
In many respects, the experts’ reports were terse and
lacking in adequate detail and explanation. In particular,
Svoboda’s opinions as to fair market value and projected future
rental income were premised on questionable and purely
speculative judgments. We found Daley’s report to be short on
some details, but more objective and less speculative.
Although Svoboda agreed with Daley that the Shared computer
equipment would have no value by the start of the residual lease
period, Svoboda claimed “it would be reasonable” to expect that
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petitioner would earn some future rental income from leasing it.
He based this claim upon 1994 and 1995 discussions with Raynault.
Raynault stated that during the early 1990s there had been some
experience of continued use for a few years following the end of
an initial lease term. As a result, Svoboda concluded that
petitioner’s prospect of realizing equipment rental income from
the Shared equipment during the residual lease period was
“speculative” but possible. We agree that Svoboda’s conclusion
is speculative and without support in the record. We note that
Shared had no commitment to use the equipment beyond the end of
the existing lease (March 29, 1997), and no other prospective
lessee had been identified. Significantly, Svoboda’s opinion
that there was potential for rental income is contradictory to
his recognition that the equipment would then have exceeded its
commercial useful life and be technologically obsolete.
Svoboda’s conclusion is inconsistent with traditional
definitions of “fair market value”. Under traditional willing-
buyer-willing-seller tests, lack of value and relatively minimal
utility are relevant facts in valuation. Svoboda’s valuation did
not take into account these highly relevant factors. In that
regard, the record reveals that technology changes for this type
of equipment can render it obsolete.
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Regarding the K-Mart photo processing equipment, Svoboda’s
level of experience and expertise in valuing equipment with a 10-
year or less useful life is inferior to that of Daley.
Accordingly, we give less weight to Svoboda’s conclusions
regarding (1) the fair market values of the K-Mart photo
processing equipment and the Shared computer equipment, (2) the
estimated residual value of the K-Mart equipment, and (3) the
fair market value of petitioner’s over lease residual interests
in the K-Mart and Shared equipment.
Although Daley’s opinion was also lacking in detail, we have
more confidence in Daley’s valuation and find his approach and
assumptions to be more reasonable. His fair market and residual
value opinions were based on objective market data.
Consequently, we rely on Daley’s conclusions with respect to
(1) the fair market values of the K-Mart and Shared equipment,
(2) the residual values of the K-Mart and Shared equipment, and
(3) petitioner’s projected equipment rental income from its over
lease residual interests.
We find as an ultimate fact that as of September 28, 1995,
the K-Mart photo processing and Shared computer equipment had no
residual value. We further find as an ultimate fact that as of
September 28, 1995, petitioner’s prospect for realizing equipment
rental income and/or other income from the over lease residual
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interests was de minimis or nonexistent. We hold that, as of
September 28, 1995, petitioner’s residual lease interests had
minimal or no fair market value.
c. Petitioner’s Lease Strip Deal’s Economic Profit
Potential
As of September 28, 1995, the K-Mart and Shared equipment
would have had no estimated residual value, and the fair market
value of the residual lease interests was nominal or zero. In
addition, the second lease strip deal, aside from potential tax
benefits, lacked any demonstrable objective, practical, economic
profit potential. Accordingly, we hold that petitioner’s second
lease strip deal fails to meet the second prong of our inquiry
into its economic substance. See ACM Pship. v. Commissioner, 157
F.3d at 246-248; Casebeer v. Commissioner, 909 F.2d at 1363.
Because of our holding, it is unnecessary to address
petitioner’s argument that rental income should not be discounted
to present value in valuing the lease strip deal profit
potential. See ACM Pship. v. Commissioner, 157 F.3d at 259-260
(agreeing on this point with T.C. Memo. 1997-115). In addition,
there is no need to address respondent’s argument that modest or
inconsequential profits relative to petitioner’s claimed
substantial potential tax benefits are insufficient to imbue an
otherwise questionable second lease strip deal with economic
substance. See id. at 258; Sheldon v. Commissioner, 94 T.C. at
767-768.
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6. Conclusion as to the Economic Substance of
Petitioner’s Lease Strip Deal
Petitioner did not have a valid nontax business purpose for
entering into the second lease strip deal. Aside from potential
tax benefits, the second lease strip deal did not have any
objectively demonstrable, practical economic profit potential for
petitioner. The transactions for the second lease strip deal
were effected through various participating and pass-through
entities, a number of which either were related to petitioner or
were owned and/or controlled by others who regularly cooperated
with petitioner and/or Crispin in lease strip deals and/or other
types of transactions. The other participants involved in the
first and second lease strip deals, in most instances, were not
acting at arm’s length and shared a common interest in inflating
the values of the underlying equipment and the values of the
leases and residual interests to generate substantial potential
tax benefits for the ultimate beneficiaries/customers. As
Raynault testified, CFX put up the only meaningful amount of
capital to be derived by the participants and others involved in
setting up the first deal.
Much of the purported debt and other payment obligations
incurred in lease strip deals were to be offset by circuitous
cashflows among the participants. For example, the supposedly
high-basis $14.125 million EQ and $4,056,220 Jenrich equipment
purchase installment notes played key roles in the plan to
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produce substantial potential tax benefits in the lease strip
deals. CFX was to claim approximately $13.8 million in net
rental expense deductions during the master lease. Petitioner
sought to claim deductions in the $3 to $4 million range for net
rental payments during the over lease. Yet the respective master
lease and over lease purported rental payments would equal,
coincide with, and be completely offset by the purported
equipment installment note payments CFX and petitioner were to
receive.
In deciding the extent to which a nonrecourse note may be
accorded economic substance, a number of courts have relied
heavily on whether the fair market value of the underlying
property was within a reasonable range of its stated purchase
price. E.g., Estate of Franklin v. Commissioner, 544 F.2d 1045,
1048 (9th Cir. 1976), affg. 64 T.C. 752 (1975); Hager v.
Commissioner, 76 T.C. 759 (1981); see Hilton v. Commissioner, 74
T.C. 305, 363 (1980), affd. 671 F.2d 316 (9th Cir. 1982); cf.
Frank Lyon Co. v. United States, 435 U.S. 561 (1978) (where,
among other things, the buyer-lessor in a sale-leaseback
transaction was personally liable on the mortgage).
In addition, the mere labeling of a note as recourse is not
controlling. A note’s recourse label does not preclude inquiry
into the adequacy of the collateral securing an alleged purchase
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money debt. Waddell v. Commissioner, 86 T.C. 848, 901-903
(1986), affd. 841 F.2d 264 (9th Cir. 1988). We have held that
recourse notes were not to be treated as bona fide debt for tax
purposes where the possibility that the notes would be paid was
illusory and no actual intent existed to pay them. Ferrell v.
Commissioner, 90 T.C. 1154, 1186-1190 (1988); Durham Farms #1,
J.V. v. Commissioner, T.C. Memo. 2000-159, affd. 59 Fed. Appx.
952 (9th Cir. 2003).
The purported debt issued in connection with the first and
second lease strip deals is not valid indebtedness. With respect
to the $4,056,220 Jenrich equipment installment note and the
$10,000 and $1,000 Lexington notes issued to CMACM, there was no
bona fide intent to pay or to enforce those purported debt
obligations on the part of the issuers and holders of the notes.
Mallin (who advised Jenrich and was instrumental in bringing
about Jenrich’s involvement in the second lease strip deal
transactions) and Koehler (Lexington’s sole shareholder)
essentially viewed Jenrich’s and Lexington’s participation in
those second lease strip deal transactions as an accommodation to
petitioner and Crispin.
It is also highly questionable whether Jenrich and Lexington
possessed sufficient financial resources to meet their respective
“debt obligations”. In any event, the Jenrich “note payments”
equaled, coincided with, and were completely offset by the
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purported over lease rental payments that would be “owed” Jenrich
by CMACM (petitioner’s wholly owned subsidiary). Also, the
$4,056,220 Jenrich note was expressly stated to be a nonrecourse
obligation. “Payment” of the $4,056,220 note was stated to be
“secured” by the equipment and the “Lessor Rights” thereto. With
respect to the $10,000 and $1,000 Lexington notes, those notes
were unsecured notes, and Lexington appeared to possess minimal,
if any, financial resources.
Significantly, the over lease agreement (which Jenrich
signed as lessor) involves a lease term that provided CAP and
later petitioner, Okoma, and Lexington with no actual over lease
residual interests in the K-Mart and Shared equipment. As
previously indicated, this so-called over lease agreement
ambiguity escaped not only the notice of petitioner, CAP, Okoma,
and Lexington, but also that of others (including Crispin,
petitioner’s personnel, and Koehler) representing them in their
second lease strip deal transactions. Moreover, the fact that
there was no residual lease period was not corrected. This
apparent inattention and lack of due care upon the part of
Crispin, petitioner’s personnel, and Koehler confirms, among
other things, that no bona fide intent existed to have Jenrich
and Lexington pay their respective purported debt obligations.
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In actuality, Crispin, Koehler, Mallin, petitioner, and
others viewed the $4,056,220 Jenrich note and the $10,000 and
$1,000 Lexington notes as having no practical economic effect.
Their actions evidence that they themselves viewed the notes as
merely being part of the paper facade needed to support
substantial tax benefits for petitioner. Accordingly, the
$4,056,220 Jenrich note and the $10,000 and $1,000 Lexington
notes are not considered valid indebtedness for tax purposes.
On the basis of the foregoing, we hold that the second lease
strip deal lacks economic substance and is not to be respected
for tax purposes. See Frank Lyon Co. v. United States, supra;
Knetsch v. United States, 364 U.S. at 366; Gregory v. Helvering,
293 U.S. 465 (1935); ACM Pship. v. Commissioner, 157 F.3d at 231;
Casebeer v. Commissioner, 909 F.2d at 1363; Nicole Rose Corp. v.
Commissioner, 117 T.C. at 336. Clearly, the combination of steps
and transactions in the second lease strip deal had no meaningful
purpose other than to generate tax benefits.
B. Petitioner’s Entitlement to Its Claimed Deductions
Because we have held that the second lease strip deal lacked
economic substance, it follows that petitioner is not entitled to
its claimed rental expense deductions of $414,041 and $237,853
for its taxable years ended November 30, 1996 and 1997,
respectively.
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Similarly, the $4,056,220 Jenrich note disposition also
lacked economic substance. Among other things, the $4,056,220
Jenrich note did not represent valid indebtedness. We
accordingly hold that petitioner is not entitled to its claimed
note disposition losses of $459,221 and $1,178,012 for its
taxable years ended November 30, 1996 and 1997, respectively.
Finally, on the basis of all of the foregoing, we hold that
petitioner is not entitled to its claimed $404,000 NOL carryover
deduction to its taxable year ended November 30, 1996. That
$404,000 NOL resulted from petitioner’s claiming a $1,982,825
second lease strip deal “rental expense” deduction for its 1995
taxable year.
II. Petitioner’s $2,052,900 Ordinary Loss and $1,859,135 Bad
Debt Deduction
A. Petitioner’s Claimed Deductions--the Debt vs. Equity
Issue
For its taxable year ended November 30, 1997, petitioner
claimed a $2,052,900 ordinary loss and a $1,859,135 bad debt
deduction. These deductions are based upon advances by
petitioner to Cap Corp. through 1997.
Generally, section 165(a) allows a deduction for losses
sustained during the taxable year that are not compensated for by
insurance or otherwise. If stock in a corporation becomes
worthless during a taxable year, the taxpayer’s loss will be
treated as a capital loss. Sec. 165(g)(1). As relevant to this
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case, the term “security” includes shares of stock in a
corporation, unless those shares are in a corporation affiliated
with a taxpayer that is a domestic corporation.23 Sec.
165(g)(2)(A) and (3).
Absent the applicability of a specific statutory provision
prescribing ordinary loss treatment, losses from the sale or
exchange of a capital asset are treated as capital losses. Secs.
65, 1222(2), (4). Section 1221 broadly defines a “capital asset”
as “property held by the taxpayer (whether or not connected with
his trade or business),” subject to enumerated exceptions for
certain kinds of property. Specifically, with respect to stock
in a corporation, unless the taxpayer is a securities dealer
within the meaning of section 1221(1), the stock is deemed to be
capital and the taxpayer’s other business motive for holding that
stock is irrelevant. Sec. 1221; Ark. Best Corp. v. Commissioner,
485 U.S. 212, 215-218, 221-223 (1988). In the case of a
corporate taxpayer, a capital loss may not be deducted against
that taxpayer’s ordinary income. Secs. 165(f), 1211(a).
23
Cap Corp. and petitioner were not affiliated corporations.
Further, if held to be debt for tax purposes, the advances from
petitioner in controversy would not be “securities” for purposes
of sec. 165(g), as the Cap Corp. promissory notes evidencing
those advances did not have interest coupons and were not issued
in registered form. See sec. 165(g)(2)(C).
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Section 166(a)(1), on the other hand, generally allows a
deduction for a debt that becomes worthless during a taxable
year. In the case of a corporate taxpayer, section 166(a) allows
an ordinary deduction for a worthless debt, regardless of whether
the debt is a business or nonbusiness debt. Sec. 1.166-1(a),
Income Tax Regs.; cf. sec. 166(d)(1); sec. 1.166-5(a), Income Tax
Regs.
Sections 165 and 166 are mutually exclusive. In situations
where both sections might otherwise be applicable, section 166--
the specific statute--controls over section 165--the general
statute. Spring City Foundry Co. v. Commissioner, 292 U.S. 182,
189 (1934).
The parties disagree about whether the advances by
petitioner to Cap Corp. are to be treated as equity as opposed to
debt. The Court of Appeals for the Ninth Circuit, which barring
an agreement otherwise would be the venue for appeal in this
case, has identified the following 11 factors to be considered in
making this determination: (1) The names given to the documents
evidencing the indebtedness; (2) the presence or absence of a
maturity date; (3) the source of the payments; (4) the right to
enforce the payments of principal and interest; (5) participation
in management; (6) a status equal to or inferior to that of
regular corporate creditors; (7) the intent of the parties; (8)
“thin” or adequate capitalization; (9) identity of interest
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between creditor and stockholder; (10) payment of interest only
out of “dividend” money; and (11) the ability of the corporation
to obtain loans from outside lending institutions. Bauer v.
Commissioner, 748 F.2d 1365, 1368 (9th Cir. 1984), revg. T.C.
Memo. 1983-120; A.R. Lantz Co. v. United States, 424 F.2d 1330,
1333 (9th Cir. 1970); O.H. Kruse Grain & Milling v. Commissioner,
279 F.2d 123, 125-126 (9th Cir. 1960), affg. T.C. Memo. 1959-110;
Anchor Natl. Life Ins. Co. v. Commissioner, 93 T.C. 382, 400
(1989). No one factor is controlling or decisive, and the court
must look to the particular circumstances of each case. Bauer v.
Commissioner, supra at 1368. Analysis of these factors,
including objective evidence of the intent of the parties, is a
guide to the resolution of the ultimate issue of whether the
parties intended the advances to create debt or equity. Id. at
1367-1368; A.R. Lantz Co. v. United States, supra at 1333-1334;
Anchor Natl. Life Ins. Co. v. Commissioner, supra at 401.
B. Application of the 11-Factor Test
1. Names Given to the Documents
The issuance of a stock certificate indicates an equity
contribution. In contrast, the issuance of a bond, debenture, or
note is indicative of indebtedness. Estate of Mixon v. United
States, 464 F.2d 394, 403 (5th Cir. 1972); Anchor Natl. Life Ins.
Co. v. Commissioner, supra at 404.
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Cap Corp. issued promissory notes as evidence of the 1995
through 1997 advances. The record also reveals that Crispin and
Koehler effectively were the parties to all documents and
transactions. All of Cap Corp.’s outstanding shares were held by
Crispin and Koehler. Crispin and Koehler were also close,
longtime business associates and friends. Crispin was CMA’s 98-
percent shareholder and ultimate decision maker. Where, as here,
the corporate “debtor” is closely held and related to its
“creditor”, the form of the transaction and the labels used by
the parties may lessen the probative quality of evidence. In the
setting we consider, Crispin and Koehler were able to manipulate
the transactions and create whatever appearance would be of
benefit to them or the structured activities. See Fin Hay Realty
Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968); Anchor
Natl. Life Ins. Co. v. Commissioner, supra at 406-407. Moreover,
by 1995, Cap Corp. had serious insolvency problems and an abiding
need for operating funds from petitioner.
Although the documents were cast as notes, the form is
largely offset by the lack of arm’s-length parties and Cap
Corp.’s apparent inability to repay the advances.
2. Presence or Absence of a Fixed Maturity Date
“The presence of a fixed maturity date indicates a fixed
obligation to repay, a characteristic of a debt obligation. The
absence of the same on the other hand would indicate that
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repayment was in some way tied to the fortunes of the business,
indicative of an equity advance.” Estate of Mixon v. United
States, supra at 404; Anchor Natl. Life Ins. Co. v. Commissioner,
supra at 405.
The January 1, 1995, and December 1, 1996, promissory notes
specified November 30, 1996 and 1997, respective payment dates.
Sometime before October 1996, however, Crispin and Koehler
realized that Cap Corp. was insolvent and would not be able to
repay the outstanding advances. They thus began the planning of
a debt conversion transaction to relieve Cap Corp. of
substantially all of its outstanding obligations to petitioner.
Under the plan, petitioner was to be repaid only a small
portion of the total outstanding advances. Notwithstanding the
uncertainty of repayment, petitioner advanced an additional
$443,657 to Cap Corp. between October 31 and November 30, 1996.
On December 2, 1996, in the conversion transaction, Cap Corp. was
relieved of the obligation to repay $2.259 million. The
remaining $500,000 was rolled over into the December 1, 1996,
promissory note. Cap Corp. remained insolvent even after the
December 2, 1996, debt conversion transaction, and its potential
for earnings was greatly reduced after it parted with the CKS
stock. In spite of these circumstances, petitioner advanced an
additional $1.257 million to Cap Corp. during 1997.
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Although there were fixed dates for repayment, a factor that
favors petitioner’s position, any advantage to petitioner is
largely undercut by Crispin’s, Koehler’s, and petitioner’s
conduct. The circumstances and their actions show that they did
not believe, or could not have reasonably believed, the advances
would be repaid by the specified note maturity dates. See Fin
Hay Realty Co. v. United States, supra at 698 (noting that
although a purported corporate debtor issued demand notes for the
advances, the actual economic reality was that those notes would
not be repaid until some distant time in the future); Cuyuna
Realty Co. v. United States, 382 F.2d 298, 301-302 (1967)
(reasoning that an advance, though qualifying at the time made as
a valid debt for tax purposes, may later lose that status for
subsequent taxable years when the purported creditor ceases to
act like a reasonable creditor).
3. Source of the Repayment
If repayment is contingent upon earnings or is to come from
a restricted source, such as a judgment recovery, dividends, or
profits, an equity interest is indicated. Estate of Mixon v.
United States, supra at 405; Calumet Indus., Inc. v.
Commissioner, 95 T.C. 257, 287-288 (1990). In such a case, the
lender acts “‘as a classic capital investor hoping to make a
profit, not as a creditor expecting to be repaid regardless of
the company’s success or failure.’” Calumet Indus., Inc. v.
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Commissioner, supra at 287-288 (quoting In re Larson, 862 F.2d
112, 117 (7th Cir. 1988)). Likewise when circumstances make it
impossible to estimate when an advance will be repaid because
repayment is contingent upon future profits, or repayment is
subject to a condition precedent, or where a condition may
terminate or suspend the obligation to repay, an equity
investment is indicated. Affiliated Research, Inc. v. United
States, 173 Ct. Cl. 338, 351 F.2d 646, 648 (1965).
At trial, Koehler was questioned about petitioner’s 1995 and
1996 advances to Cap Corp. He indicated that, by causing
petitioner to make the advances, Crispin was “rolling the dice”
because repayment depended on Cap Corp.’s making sales,
especially through CKS, its subsidiary. After the debt
conversion, Cap Corp.’s serious financial problems continued and
its earnings capacity also dramatically declined because CKS was
no longer a source of earnings.
Accordingly, as to the source of repayment, this factor
favors respondent.
4. The Right To Enforce the Payments
The right to enforce the repayment residing in the entity
making the advance is indicative of bona fide debt. Estate of
Mixon v. United States, 464 F.2d at 405.
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Technically, petitioner had a right to enforce payment
pursuant to the terms set forth in the January 1, 1995, and
December 1, 1996, promissory notes. In actuality, as discussed
above in connection with the prior three factors, payment of the
note principal and interest depended wholly on Cap Corp.’s
success.
This factor supports petitioner but is outweighed by other
attendant circumstances making uncertain Cap Corp.’s actual
payment of the note principal and interest to petitioner.
5. Participation in Management
The right to participate in the management of a business by
the entity advancing funds demonstrates that the advance may not
have been bona fide debt and instead was intended as an equity
investment. Am. Offshore, Inc. v. Commissioner, 97 T.C. 579, 603
(1991).
From 1995 through December 2, 1996, Crispin and Koehler
continued to manage Cap Corp. in the same manner as before 1995.
Koehler was in charge of Cap Corp.’s day-to-day operations, but
he would consult with Crispin at least weekly. After the
December 2, 1996, debt conversion, Crispin took over Cap Corp.’s
day-to-day operations.
This factor is neutral with respect to petitioner’s advances
during 1995 and 1996. It favors respondent with respect to
petitioner’s advances during 1997.
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6. Status Relative to Other Creditors
Whether an advance is subordinated to obligations to other
creditors bears on whether the taxpayer advancing funds was
acting as a creditor or an investor. Estate of Mixon v. United
States, 464 F.2d at 406. In addition, “Failure to demand timely
repayment effectively subordinates the intercompany debt to the
rights of other creditors who receive payment in the interim.”
Am. Offshore, Inc. v. Commissioner, supra at 603 (citing
Inductotherm Indus., Inc. v. Commissioner, T.C. Memo. 1984-281,
affd. without published opinion 770 F.2d 1071 (3d Cir. 1985)).
Petitioner acknowledges that Cap Corp. used a large portion
of petitioner’s advances to make interest payments to Cap Corp.’s
third-party creditors. Effectively, petitioner subordinated its
Cap Corp. advances for the benefit of these third-party creditors
in three ways. First, petitioner advanced $443,657 to Cap Corp.
on October 31 and November 30, 1996, and then on December 2,
1996, participated in the debt conversion transaction relieving
Cap Corp. of $2.259 million in advances. Second, petitioner
agreed to have the remaining $500,000 of advances rolled over
into the December 1, 1996, promissory note. Finally, petitioner
advanced an additional $1.257 million to Cap Corp. during 1997,
knowing that (1) after December 2, 1996, Cap Corp. remained
insolvent, (2) a significant portion of the funds furnished in
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1997 would be used to pay Cap Corp.’s third-party creditors, and
(3) it was highly unlikely that Cap Corp. would be able to repay
petitioner by the November 30, 1997, maturity date.
This factor favors respondent.
7. Intent of the Parties
“[T]he inquiry of a court in resolving the debt-equity issue
is primarily directed at ascertaining the intent of the parties”.
A.R. Lantz Co. v. United States, 424 F.2d at 1333 (citing Taft v.
Commissioner, 314 F.2d 620 (9th Cir. 1963), affg. in part and
revg. in part T.C. Memo. 1961-230). The objective and subjective
expressions of intent, as well as the other 10 enumerated
factors, must be examined. Id. at 1333-1334. The resolution of
a debt versus equity question involves consideration of the
substance and reality and not merely the form. Form used as a
subterfuge to shield the real essence of a transaction should not
control. Id. at 1334.
Cap Corp. and petitioner treated the advances in controversy
as debt in that Cap Corp. issued petitioner the January 1, 1995,
and December 1, 1996, promissory notes documenting the advances
and accrued interest. The advances were recorded as debt by Cap
Corp. and assets by petitioner on their respective financial
statements.
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Although the advances were treated as debt on the books,
neither Cap Corp. nor petitioner intended, or reasonably could
have intended, the advances to be bona fide debt. Petitioner
made the advances to keep Cap Corp. from defaulting upon its
promissory notes to third-party creditors and to pay Cap Corp.’s
operating expenses. During 1995 through most of 1996, petitioner
made the advances knowing they were risky. During late 1996 and
1997, petitioner knew that it would not recover most, if any, of
the funds advanced to Cap Corp., but it continued to inject funds
into Cap Corp. Petitioner knew its repayment prospects with
respect to these later advances were highly uncertain. We
conclude that neither petitioner nor Cap Corp. genuinely intended
the advances to be bona fide debt or reasonably intended the
advances to be repaid. See id. at 1333-1334.
This factor favors respondent.
8. Thin or Adequate Capitalization
The purpose of examining the debt-to-equity ratio in
characterizing an advance is to determine whether a corporation
is so thinly capitalized that it would be unable to repay an
advance. Such an advance would be indicative of venture capital
rather than a loan. Bauer v. Commissioner, 748 F.2d at 1369.
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Cap Corp.’s 1995 financial statement reflects total assets
of $755,731 and total liabilities of more than $5 million. The
1996 financial statement reflects total assets of $150,958 and
total liabilities of almost $4.6 million.
Respondent contends that from January 1, 1995, through
December 1, 1996, Cap Corp. was thinly capitalized. Respondent
points out that Cap Corp.’s financial statements reflect a debt-
to-equity ratio of at least 5 to 1 from 1995 through December 2,
1996. Following the December 2, 1996, debt conversion of $2.259
million, Cap Corp. remained insolvent and unable to benefit from
CKS’s future profitability.
Petitioner argues that thin capitalization is not decisive
by itself and that a loan to a seemingly insolvent entity may
nonetheless be treated as debt if repayment was reasonably
expected. Petitioner acknowledges, however, that Cap Corp.
lacked tangible assets to serve as security or a repayment source
for the advances.
We agree with respondent that up until December 2, 1996, Cap
Corp. was thinly capitalized and that, even after the December 2,
1996, debt conversion, Cap Corp.’s earnings base was insufficient
to meet its obligations to third-party creditors and petitioner
under the December 1, 1996, promissory note. As discussed above,
the December 1, 1996, promissory note was reduced to $500,000 as
of November 30, 1996, and petitioner continued to make advances
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of $1.257 million during 1997. Cap Corp. also owed approximately
$2.5 million on outstanding notes issued to third-party
creditors. With respect to the $2.5 million, Cap Corp. was
obligated to make interest payments and pay off the note
principal during December 1997 or December 1998. See Cuyuna
Realty Co. v. Commissioner, 382 F.2d at 302 (noting that although
the taxpayer-parent’s later concession that some of its purported
loans to its subsidiary were equity might significantly improve
the debt-to-equity ratio of its subsidiary, the subsidiary still
would lack a sufficient earnings base to carry the remaining
outstanding indebtedness).
This factor favors respondent.
9. Identity of Interest
Advances made by a sole shareholder are more likely to be
committed to the risk of the business than are advances made by
creditors who are not shareholders. Ga. Pac. Corp. v.
Commissioner, 63 T.C. 790, 797 (1975). The sole shareholder is
also less likely to be concerned than a third party would be with
the safeguards normally used to protect such advances. Id.
At all times relevant, Crispin and Koehler were Cap Corp.’s
only shareholders. Petitioner itself held no formal stock
interest in Cap Corp. However, Crispin was CMA’s 98-percent
shareholder and ultimate decision maker.
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Crispin’s and Koehler’s stock ownership in Cap Corp. and
petitioner’s lack of a direct stock interest in Cap Corp. are of
less import because of Cap Corp.’s serious insolvency problems
and need for funds from Crispin and/or petitioner. At all times
relevant, little, if any, shareholder equity existed in Cap Corp.
The financial statements reflect no shareholder equity during
1996, with Cap Corp.’s liabilities exceeding assets by several
multiples. At all relevant times, Crispin effectively controlled
and directed Cap Corp. In this connection, Koehler testified
that, during 1995 and 1996, he would contact Crispin whenever Cap
Corp. lacked funds to cover its required interest payments to
third-party creditors and its other operating expenses. There is
an identity of interest between petitioner’s role as purported
creditor and Crispin’s role as Cap Corp.’s controlling
shareholder.
This factor favors respondent.
10. Payment of Interest Only Out of Dividends
This factor is essentially the same as the third factor;
i.e., source of the payments. Hardman v. United States, 827 F.2d
1409, 1414 (9th Cir. 1987). It focuses, however, on how the
parties treated interest. In that regard, “A true lender is
concerned with interest.” Am. Offshore, Inc. v. Commissioner, 97
T.C. at 605 (citing Estate of Mixon v. United States, 464 F.2d at
409). The failure to insist on interest payments may indicate
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that a purported lender expects to be paid out of future earnings
or through an increased market value of its equity interest. Id.
at 605 (citing Curry v. United States, 396 F.2d 630, 634 (5th
Cir. 1968)).
Although the Cap Corp. promissory notes provided that
accruals of interest be added to the outstanding balance, Cap
Corp. did not make and was not financially capable of making
interest payments after August 1995. Payment of accrued interest
depended entirely on profits that Cap Corp. did not have and was
not likely to earn in the future.
This factor favors respondent.
11. Ability To Obtain Loans From Outside Lending
Institutions
“[T]he touchstone of economic reality is whether an outside
lender would have made the payments in the same form and on the
same terms.” Segel v. Commissioner, 89 T.C. 816, 828 (1987)
(citing Scriptomatic, Inc. v. United States, 555 F.2d 364, 367
(3d Cir. 1977)). A corporation’s ability to borrow from outside
lending institutions gives the transaction the appearance of a
bona fide debt and indicates that the purported creditor acted in
the same manner toward the corporation as ordinary reasonable
creditors would have acted. Hardman v. United States, supra
(citing Estate of Mixon v. United States, supra at 410).
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Cap Corp. would not have been able to obtain similar loans
from an outside lending institution. Petitioner acknowledges
that: (1) Cap Corp. was insolvent from 1995 through 1997 and
needed funds from petitioner to pay its operating expenses and
those of its subsidiaries, including substantial interest
payments due Cap Corp.’s third-party creditors; (2) Cap Corp.
would have failed long before 1999 without the advances in
controversy; and (3) Cap Corp., during 1995 and 1996, lacked
tangible assets to serve as security and/or a repayment source
for loans. By October 1996 Crispin and Koehler realized Cap
Corp. was bankrupt, with liabilities exceeding assets by several
multiples. Even after the December 2, 1996, debt conversion, Cap
Corp.’s insolvency problems continued and its potential earnings
base declined dramatically.
This factor favors respondent.
C. Conclusion and Holdings
After considering the above factors, we hold that
petitioner’s advances to Cap Corp. are not to be treated as bona
fide debt for tax purposes. Those advances, instead, constituted
equity in Cap Corp.
On brief, however, petitioner argues that it is entitled to
ordinary deductions irrespective of whether the advances are
classified as debt or equity. Petitioner argues that, under
certain circumstances, courts have allowed taxpayers an ordinary
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loss upon the disposition of their stock or upon its becoming
worthless even though they were not securities dealers. See,
e.g., Irwin v. United States, 558 F.2d 249, 252 (5th Cir. 1977)
(holding that for a taxpayer to be entitled to an ordinary
deduction upon his stock’s becoming worthless, the taxpayer was
required to show (1) the purchase of that stock was necessary for
the taxpayer’s business, and (2) his motive for the purchase was
to promote his business purpose and investment was not a
predominant motive); W.W. Windle Co. v. Commissioner, 65 T.C.
694, 713 (1976) (holding that where a substantial investment
motive exists in a predominantly business-motivated acquisition
of corporate stock, the stock is a capital asset). Petitioner
asserts that it made the advances in controversy to protect or
promote its own business.
The cases petitioner relies on, however, predate the Supreme
Court’s holding in Ark. Best Corp. v. Commissioner, 485 U.S. 212
(1988). These pre-Ark. Best Corp. cases were decided under a
doctrine that had evolved from the case of Corn Prods. Refining
Co. v. United States, 350 U.S. 46 (1955), in which the Supreme
Court recognized a nonstatutory exception to the definition of
capital asset. In that case the exception concerned whether
certain futures contracts that were acquired and held for a
business purpose qualified for ordinary loss as a noncapital
asset.
- 109 -
In Ark. Best Corp. v. Commissioner, supra at 223, however,
the Supreme Court clarified these earlier cases by holding that a
taxpayer’s motivation in purchasing an asset is irrelevant to the
question of whether the asset comes within the general definition
of a capital asset in section 1221. Petitioner does not argue,
and the facts do not indicate, that its equity interest meets any
section 1221 exclusion from the general definition of a capital
asset. Hence, under the authority of the Ark. Best Corp. case,
petitioner’s advances in controversy (which we have held to
constitute a stock/equity interest rather than debt for tax
purposes) cannot result in an ordinary deduction upon either the
disposition of that stock/equity interest or its becoming
worthless. See Azar Nut Co. v. Commissioner, 94 T.C. 455 (1990)
(rejecting, on the basis of the Ark. Best Corp. case, the
business-connection-business-motivation rationale used in certain
pre-Ark. Best Corp. cases), affd. 931 F.2d 314 (5th Cir. 1991);
Sellers v. Commissioner, T.C. Memo. 2000-235; see also Maginnis
v. United States, 356 F.3d 1179, 1185 (9th Cir. 2004) (noting,
among other things, that the Supreme Court’s decision in the Ark.
Best Corp. case rejected the “motive” test).
On the basis of the foregoing, we hold that petitioner is
not entitled to ordinary deductions in connection with the
$2,052,900 and $1,859,135 amounts claimed for its taxable year
ended November 30, 1997.
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III. The $2 Million Fee
Petitioner did not include as income for its taxable year
ended November 30, 1997, a $2 million portion of the $2.5 million
fee from NSI. Petitioner paid the $2 million to CKH, and CKH
reported the $2 million in income for its short taxable year
ended March 31, 1997. The transfer to CKH was to match the
income with $2 million in losses that was already available to
CKH in order to eliminate the incidence of tax on the $2 million
of income earned by petitioner.
A. The Assignment of Income Doctrine
In United States v. Newell, 239 F.3d 917 (7th Cir. 2001),
the Court of Appeals for the Seventh Circuit held that a 50-
percent S corporation shareholder was required to include in
income payments for services rendered by the S corporation, even
though the payments were made to an offshore Bermuda corporation.
In United States v. Newell, supra at 919-920, the Court of
Appeals reviewed various leading cases under the assignment of
income doctrine and explained:
To shift the tax liability, the assignor must
relinquish his control over the activity that generates
the income; the income must be the fruit of the
contract or the property itself, and not of his ongoing
income-producing activity. See Blair v. Commissioner,
300 U.S. 5, * * * (1937); Greene v. United States, 13
F.3d 577, 582-83 (2d Cir. 1994). This means, in the
case of a contract, that in order to shift the tax
liability to the assignee the assignor either must
assign the duty to perform along with the right to be
paid or must have completed performance before he
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assigned the contract;[24] otherwise it is he, not the
contract, or the assignee, that is producing the
contractual income--it is his income, and he is just
shifting it to someone else in order to avoid paying
income tax on it. To state the point differently, an
anticipatory assignment of income, that is, an
assignment of income not yet generated, as distinct
from the assignment of an income-generating contract or
property right, does not shift the tax liability from
the assignor’s shoulders, Helvering v. Horst, 311 U.S.
112, * * * (1940); Boris I. Bittker et al., Federal
Income Taxation of Corporations and Shareholders ¶ 7.07
(4th ed. 1979), unless, as we said, the duty to produce
the income is assigned also, so that the assignor is
out of the income-producing picture. In Lucas v. Earl,
[281 U.S. 111 (1930)] where the taxpayer had assigned
an interest in his future income to his wife, the
[Supreme] Court held that when the income came in, it
was his income, because it was generated by his
efforts, including his decisions about what to charge
for his services and what expenses to incur. See also
Commissioner v. Sunnen, 333 U.S. 591, 608-10, * * *
(1948); Greene v. United States, supra, 13 F.3d at 582.
Similarly, the income on the contract with ADIA [the S
corporation’s client] was generated by the exertions of
Inc. [the S corporation], not of Ltd. [ the Bermuda
offshore corporation]
The Court of Appeals also explained that the taxpayer’s position
in that case was weak because, among other things, the Bermuda
offshore corporation was the taxpayer’s alter ego and it was
doubtful whether there ever was any assignment of the contract to
the Bermuda offshore corporation. Id. at 920.
24
Income the assignor had already earned would be recognized
by and taxed to the assignor under the assignment of income
doctrine. Helvering v. Eubank, 311 U.S. 122 (1940); Schneer v.
Commissioner, 97 T.C. 643, 648 (1991).
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B. The Parties’ Arguments
1. Petitioner’s Arguments
Petitioner contends that the assignment of income doctrine
should not be applied with respect to the $2 million portion of
the NSI consulting fee paid over to CKH. In support of its
argument, petitioner relies heavily on Crispin’s and Koehler’s
testimony concerning an alleged oral fee-splitting agreement.
Crispin and Koehler testified that it was necessary for
petitioner to involve CKH because petitioner, unlike CKS (a
securities dealer), would not be able to claim the $87 million
ordinary loss from the sale of the RD stock. Their testimony is
that, shortly after NSI retained petitioner, Crispin and Koehler
orally agreed that petitioner would split the fee and pay $2
million to CKH. Petitioner asserts that this alleged oral
agreement created something in the nature of a joint venture with
petitioner and CKH as partners working together to earn and,
ultimately, to share the fee.
Petitioner also relies on Crispin’s testimony that, during
its 1997 taxable year, petitioner entered into similar fee-
splitting agreements with third parties that assisted petitioner
in performing services for petitioner’s clients. Petitioner
contends that respondent did not dispute the validity of other
fee-splitting agreements. Petitioner also argues that respondent
would not have disputed its alleged fee-splitting agreement if,
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instead, petitioner had reported the full $2.5 million fee and
claimed a $2 million business deduction with respect to the
portion paid to CKH.
Alternatively, petitioner argues that if the $2 million is
includable in its income, then petitioner is entitled to a $2
million deduction for the payment to CKH.
2. Respondent’s Arguments
Respondent argues that the assignment of income doctrine
applies and that the entire $2.5 million NSI fee is includable in
petitioner’s taxable income for 1997. Respondent asserts that
petitioner earned the $2.5 million fee. As to the alleged fee-
splitting agreement, respondent maintains that Crispin’s and
Koehler’s testimony is self-serving and not credible. Respondent
also contends that the failure to execute a contemporaneous
written document memorializing a $2 million fee-splitting
agreement is suspect.
Although acknowledging that petitioner was arranging the
sale of the RD stock by a securities dealer like CKS, respondent
maintains that petitioner has failed to show that any portion of
its $2 million payment to CKH is deductible as a business
expense.
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C. Analysis and Holding
1. Petitioner’s Agreement With NSI
The December 1, 1996, consulting agreement executed by NSI
and petitioner required that petitioner provide consulting
services to NSI Enterprises and its affiliates for a 3-year
period ending November 30, 1999, in exchange for a $2.5 million
fee, payable in full on the December 1, 1996, contract date. The
consulting agreement contained no mention of NSI’s plan to divest
itself of its tax benefit lease. As we have found, NSI’s and
petitioner’s actual agreement was that petitioner would find a
buyer for Corisma (the NSI affiliate holding the tax benefit
lease and the RD stock) and assist NSI in consummating a sale of
Corisma’s shares. As we understand that agreement, petitioner in
return for its services would earn and receive a $2.5 million fee
from NSI. Upon concluding the sale of LLDEC’s (Corisma’s) shares
to CKH on January 30, 1997, NSI paid the agreed $2.5 million fee
to petitioner. See Greene v. United States, 13 F.3d 577, 581 (2d
Cir. 1994); Ferguson v. Commissioner, 108 T.C. 244, 259 (1997),
affd. 174 F.3d 997 (9th Cir. 1999).
2. CKH’s and Petitioner’s Purported Fee-Splitting
Agreement
Crispin testified that he had estimated that $4 million
would be earned from the NSI tax deal and that he had proposed to
Koehler that CKH and petitioner share this $4 million equally.
In his testimony, Crispin also asserted that a securities dealer
would have demanded as much as 90 percent of the fee in question.
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Koehler testified that he agreed to $2 million of the $4 million
for CKH because of his experiences on other deals with Crispin
where fees were split 50-50.
We find Crispin’s and Koehler’s testimony on this matter to
lack credibility. Their testimony contained significant
discrepancies, inconsistencies, and lapses regarding the
purported oral agreement. For example, under the alleged fee-
splitting agreement, petitioner agreed to pay to CKH $2 million
or 80 percent of the NSI fee. Considering the large amount of
documentation used for related transactions, we find it
incredible that petitioner and CKH would not memorialize an
agreement to pay $2 million. Crispin and Koehler were
experienced businessmen whose transactions were based on written
documentation, yet they maintained that it was unnecessary for
CKH and petitioner to execute a $2 million fee-splitting
agreement because they “trusted” one another. Similarly, Crispin
claimed that CKH did not issue a bill for the $2 million payment
because it was transferred in accordance with the oral agreement.
During the trial, Crispin was asked about another
transaction between petitioner and CKS that had been documented
(the Investment Banking Services Agreement on February 1, 1997).
Crispin explained that a written agreement was needed because
Koehler and CKS had numerous creditors and petitioner’s rights to
the money had to be established or memorialized.
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Crispin also maintained that Koehler was in the “driver’s
seat” because petitioner needed to have CKS, a securities dealer,
in the transaction. Contrary to Crispin’s and petitioner’s
claim, the record reflects that Crispin and/or petitioner had
practical control of CKH and Koehler. As discussed earlier, Cap
Corp. was insolvent and could not continue operating without
capital from petitioner. As of September 30, 1996, Cap Corp.
purportedly owed petitioner approximately $2.287 million. By the
time Crispin and Koehler formed CKH on October 22, 1996, they
realized that Cap Corp. was insolvent. In the December 2, 1996,
debt conversion transaction petitioner permitted CKH to acquire
CKS from Cap Corp. by means of petitioner’s cancellation of
$2.1599 million of Cap Corp.’s obligation regarding the advances.
Even after the debt conversion, CKH and Koehler were at the mercy
of Crispin and/or petitioner for funds, as CKS continued to incur
considerable monthly expenses and suffer substantial operating
losses.
In addition to effective control over CKH and Koehler,
petitioner held a large preferred stock interest in CKH. Koehler
estimated that petitioner’s preferred stock represented 98
percent of the equity in CKH. We conclude that CKH and
petitioner did not enter into a fee-splitting agreement regarding
the NSI fee.
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In the same manner as the lease strip deal, Crispin and
petitioner contrived the $2 million fee-splitting agreement to
shift petitioner’s income to CKH to be offset and sheltered by
CKH’s losses. We conclude that the principal reason petitioner
transferred $2 million of income to CKH was to avoid the
incidence of tax on $2 million in earned fee income. There was
no business purpose for this transfer.
We also note that LLDEC, which was CKH’s wholly owned
subsidiary, deducted the $524,657 paid to petitioner for
arranging the Decatur realty sale and denominated it an
“investment banking fee”. We find it anomalous that CKH and
LLDEC would have been charged an “investment banking fee” by
petitioner--if CKH and petitioner were joint venturers as
contended.
On the record presented in this case, there is no credible
evidence supporting a fee-splitting agreement or a joint venture
or partnership agreement between petitioner and CKH. No
partnership return was filed and no partnership income reported.
See Bagley v. Commissioner, 105 T.C. 396, 419 (1995), affd. on
other issues 121 F.3d 393 (8th Cir. 1997).
We accordingly hold that petitioner failed to report $2
million of the $2.5 million fee in income for 1997. See United
States v. Newell, 239 F.3d at 919-920.
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3. Petitioner’s Entitlement to a Business Deduction
Petitioner makes the alternative argument that it is
entitled to a business deduction for the $2 million paid to CKS.
Petitioner bears the burden of establishing its entitlement to
business deductions. See Rule 142(a). Petitioner paid $2
million to CKH, and CKH’s wholly owned subsidiary CKS received
$134,000 following the redemption of the RD stock by CKS.
No probative evidence has been offered regarding the
appropriate fee for participation in a transaction like the NSI
tax deal. Crispin’s testimony that a securities dealer might
have required up to 90 percent of the income is self-serving and
unreliable. We are also skeptical about Crispin’s claims with
respect to the purported risks CKH and/or CKH’s subsidiaries
undertook in “acquiring” and disposing of the Decatur realty, the
RD stock, and the tax benefit lease.
Nonetheless, CKH did enter into the transactions on January
30, 1997, pursuant to which NSI consummated its sale of LLDEC’s
(Corisma’s) shares to CKH. Following these January 30, 1997,
transactions, CKH transferred the RD stock and the tax benefit
lease from LLDEC (now a wholly owned subsidiary of CKH) to CKS
(CKH’s other wholly owned subsidiary). CKS engaged in additional
transactions to dispose of the RD stock and the tax benefit
lease. An independent securities dealer would have charged
petitioner for involvement and participation in the NSI tax deal.
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Bearing heavily against petitioner because of the ambiguity
and inexactitude of the proof it offered, we hold that petitioner
is entitled to a $500,000 deduction for 1997 with respect to
CKS’s participation in the NSI tax deal. See Cohan v.
Commissioner, 39 F.2d 540, 544 (2d Cir. 1930).
IV. Petitioner’s Advances to Koehler
Petitioner advanced $76,705 to Koehler before 1996.
Petitioner acknowledges that it mistakenly deducted this $76,705
as a miscellaneous expense on its 1996 taxable year return.
Petitioner now asserts it is entitled to deduct the $76,705 as a
business bad debt.
Section 166(a) permits a deduction for debts that become
worthless during a taxable year. Petitioner contends that its
advances to Koehler became wholly worthless during petitioner’s
1996 taxable year, and that it is entitled to deduct those
advances as wholly worthless debts under section 166(a)(1).25
A bad debt is deductible only for the year in which it
becomes worthless. Sec. 166(a)(1); Dustin v. Commissioner, 53
T.C. 491, 501 (1969), affd. 467 F.2d 47, 48 (9th Cir. 1972). For
purposes of section 166, the debt must be a bona fide debt; i.e.,
one which arises under a debtor-creditor relationship and is
based on a valid and enforceable obligation to pay a fixed and
25
Petitioner has not claimed that it is entitled to deduct
those advances as partially worthless debts under sec. 166(a)(2).
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determinable sum of money. A gift or contribution to capital is
not considered to be a debt for purposes of section 166. In re
Uneco, Inc., 532 F.2d 1204, 1207 (8th Cir. 1976); Zimmerman v.
United States, 318 F.2d 611, 612 (9th Cir. 1963); sec. 1.166-
1(c), Income Tax Regs.
The existence of a bona fide debtor-creditor relationship is
a question of fact to be determined on the basis of the facts and
circumstances in each case. Kean v. Commissioner, 91 T.C. 575,
594 (1988); Fisher v. Commissioner, 54 T.C. 905, 909 (1970). An
essential element of a bona fide debtor-creditor relationship is
the existence of a good faith intent on the part of the recipient
to repay and a good faith intent on the part of the person
advancing the funds to enforce repayment. Fisher v.
Commissioner, supra at 909-910. In determining the debtor’s and
creditor’s subjective intent, we consider whether there was a
reasonable expectation of repayment in light of the economic
realities of the situation. Id. at 910.
Petitioner contends that the $76,705 in advances to Koehler
represents bona fide debt. Respondent, on the other hand,
contends that the advances were made without reasonable
expectation of repayment. We conclude that these advances were
not bona fide debt.
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Koehler’s August 31, 1994, demand promissory agreement did
not have a fixed maturity date or a repayment schedule. See
Boatner v. Commissioner, T.C. Memo. 1997-379 (wherein the notes
in question, among other things, had no fixed maturity dates or
repayment schedules), affd. without published opinion 164 F.3d
629 (9th Cir. 1998).
The record reveals that, at the time the advances of $76,705
were made, petitioner could not have had a reasonable expectation
of repayment. Koehler had been experiencing financial
difficulties since his divorce in 1987 or 1988. From at least
1992 through 1996, Koehler’s financial condition was extremely
poor and he did not have the capability to repay the advances.
Koehler testified that, if petitioner or any of his other
creditors had pressed him for payment during 1993, he would have
filed for bankruptcy. Yet from August 31 through December 30,
1994, petitioner advanced $45,000 to Koehler.26 See Fisher v.
26
We essentially consider window dressing Richard Koehler’s
(Koehler) execution of the Aug. 31, 1994, demand promissory
agreement. Until Aug. 31, 1994, no note existed evidencing and
covering the earlier $31,705 that petitioner advanced Koehler,
possibly as far back as the 1980s. The record further does not
reflect whether Koehler paid petitioner any “interest” with
respect to the $31,705 in advances before Aug. 31, 1994.
Similarly, we also consider window dressing Koehler’s monthly
“interest” payments totaling $4,555 to petitioner from Aug. 31,
1994, through Dec. 1, 1995. That $4,555 represented less than
one of the nine $5,000 semimonthly payments that petitioner made
to Koehler from Aug. 31 through Dec. 30, 1994.
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Commissioner, supra at 910-911; see also Zimmerman v. United
States, 318 F.2d at 613.
The $76,705 in advances appears to be something other than
loans. Essentially petitioner expected Koehler to repay these
advances “when he could”. Koehler did not furnish security, and
petitioner did not seek repayment of the advances. On the basis
of the record, we conclude that Crispin arranged the advances
from petitioner to help his friend and business associate,
Koehler, who was in financial need. See McCain v. Commissioner,
T.C. Memo. 1987-285, affd. per order (9th Cir., Apr. 11, 1989);
see also Boatner v. Commissioner, supra.
On the basis of the foregoing, we hold that petitioner is
not entitled to deduct a $76,705 bad debt for its taxable year
ended November 30, 1996.
V. Is Petitioner Liable for Penalties Under Section 6662?27
Respondent determined that petitioner was liable for
penalties under section 6662 for its taxable years ended November
30, 1996 and 1997, with respect to underpayments attributable to
the lease strip deal deductions. In particular, respondent
determined that petitioner was liable for a 20-percent penalty on
the portions of the underpayments attributable to rental expense
deductions as being due to petitioner’s negligence, disregard of
27
Although respondent disallowed petitioner’s $404,000 net
operating loss (NOL) carryover deduction for 1996, respondent did
not determine that petitioner was liable for an accuracy-related
penalty on the portion of its underpayment attributable to the
$404,000 NOL.
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rules or regulations, or substantial understatement of income
tax. Respondent also determined that petitioner was liable for a
40-percent gross valuation overstatement penalty on the portions
of the underpayments attributable to petitioner’s claimed note
disposition losses. Alternatively, with respect to the note
disposition losses, respondent determined that petitioner was
liable for a 20-percent penalty under section 6662 due to
petitioner’s negligence, disregard of rules or regulations,
substantial understatement of income tax, or substantial
valuation misstatement.
Section 6662 imposes a 20-percent accuracy-related penalty
on the portion of an underpayment attributable to (1) negligence
or disregard of rules or regulations, (2) substantial
understatement of income tax, or (3) substantial valuation
misstatement under chapter 1 of the Internal Revenue Code. Sec.
6662(a), (b)(1), (2), and (3). In general, where a gross
valuation misstatement is involved, an accuracy-related penalty
under section 6662(a) is imposed in an amount equal to 40 percent
of the portion of an underpayment attributable to a gross
valuation misstatement. Sec. 6662(h)(1).
Negligence includes any failure to make a reasonable attempt
to comply with the provisions of the Internal Revenue Code or to
exercise ordinary and reasonable care in the preparation of a tax
return. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs.
Negligence may be indicated where a taxpayer fails to make a
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reasonable attempt to ascertain the correctness of a deduction
that would seem to a reasonable and prudent person “too good to
be true” under the circumstances. Sec. 1.6662-3(b)(1)(ii),
Income Tax Regs. Disregard of the rules or regulations “includes
the provisions of the Internal Revenue Code, temporary or final
Treasury regulations * * * and revenue rulings or notices * * *
issued by the Internal Revenue Service and published in the
Internal Revenue Bulletin.” Sec. 1.6662-3(b)(2), Income Tax
Regs.
A substantial valuation misstatement generally constitutes a
“gross valuation misstatement” if the value or adjusted basis of
any property claimed on a return is 400 percent or more of the
amount determined to be the correct value or adjusted basis.
Sec. 6662(h)(2).
The accuracy-related penalty under section 6662(a) will not
apply to any part of a taxpayer’s underpayment of tax if, with
regard to that part, the taxpayer establishes reasonable cause
and that the taxpayer acted in good faith. Sec. 6664(c).
Petitioner arranged its own lease strip deal and claimed
over $4.2 million in tax benefits for 1995, 1996, and 1997. As
we have held, petitioner did not have a valid nontax business
purpose for entering into the lease strip deal. In seeking
substantial deductions vastly greater than economic outlay,
petitioner was indifferent to the deal’s lack of economic
substance and economic profit potential. This is plainly shown
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by petitioner’s casual attitude toward the bona fides of the
transactions. Crispin and petitioner failed to notice or correct
the fact that the over lease agreement did not provide petitioner
with any residual interests in the K-Mart photo processing and
Shared computer equipment. Petitioner prepared its own in-house
analysis and valuation of the over lease residual rights before
entering into the September 28, 1995, transaction with CAP.
Presumably, a reasonable review and/or appraisal would have
uncovered this fundamental flaw. Petitioner also entered into a
series of transactions over a 21-month period from November 27,
1995, through September 1, 1997, to dispose of its “lease
position” without recognizing or correcting this flaw.
Petitioner through Crispin and other employees who were also
experienced in leasing transactions cannot hide behind the
professionals who were involved in the first lease strip deal.
Petitioner engaged in a blatant scheme to obtain deductions
greatly disproportionate to its economic investment in
transactions that lacked economic substance or a business
purpose. The facts and circumstances of this case reflect that
petitioner did not have reasonable cause and lacked good faith in
entering into the transactions and claiming the deductions
regarding the lease strip deal. Petitioner’s reliance upon the
Marshall & Stevens appraisal, the Murray Devine appraisal, and
the Thacher Proffitt tax opinion (all of which had been issued to
CFX concerning the first lease strip deal and the master lease
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residual interests) was not reasonable, as that advice, among
other things, had not been furnished by disinterested, objective
advisers but by advisers involved in marketing the first lease
strip deal to CFX. See Rybak v. Commissioner, 91 T.C. 524, 565
(1988); see also Neonatology Associates, P.A. v. Commissioner,
299 F.3d 221, 233-234 (3d Cir. 2002) (holding that the reliance
“must be objectively reasonable”), affg. 115 T.C. 43 (2000).
Indeed, given petitioner’s experience and expertise arranging
lease strip deals and its awareness of Notice 95-53, 1995-2 C.B.
334, petitioner was aware and forewarned but chose to proceed
with the transactions and claim the deductions. See Freytag v.
Commissioner, 89 T.C. 849, 889 (1987), affd. 904 F.2d 1011 (5th
Cir. 1990), affd. 501 U.S. 868 (1991).
We further reject petitioner’s argument that it qualifies
under the reasonable cause and good faith exception of section
6664(c). In that regard, petitioner claimed that it relied upon
and followed the advice of a national accounting firm that
reviewed petitioner’s proposed 1996 return. As previously
discussed, the second lease strip deal had no economic substance
and the $4,056,220 Jenrich note was not a valid indebtedness.
Among other things, it has not been shown that: (1) The
accounting firm’s advice was based upon all pertinent facts and
circumstances and the law as it relates to those facts and
circumstances; (2) petitioner had disclosed all relevant facts to
the accounting firm; and (3) the accounting firm’s advice was
- 127 -
based on reasonable factual or legal assumptions. Sec. 1.6664-
4(c), Income Tax Regs.; see Collins v. Commissioner, 857 F.2d
1383, 1386 (9th Cir. 1988), affg. T.C. Memo. 1987-217.
Petitioner was negligent and/or disregarded rules or
regulations as to the portions of its underpayments attributable
to its claimed lease strip deal rental expense deductions. We
hold that petitioner is liable for the 20-percent section 6662(a)
penalties for its taxable years ended November 30, 1996 and 1997,
equal to 20 percent of those portions of its underpayments
attributable to its claimed lease strip deal rental expense
deductions.
The portions of petitioner’s underpayments attributable to
its claimed note disposition losses constitute gross valuation
misstatements under section 6662(h). As we have held, the second
lease strip deal lacked economic substance and the $4,056,220
Jenrich note was not a valid indebtedness; i.e., had no value.
Petitioner claimed an adjusted basis in the Jenrich note in an
amount exceeding $4 million, an amount that was immensely greater
than the correct adjusted basis of zero. See sec. 1.6662-5(g),
Income Tax Regs. We hold that petitioner is liable for the 40-
percent accuracy-related penalties under section 6662(h) for its
taxable years ended November 30, 1996 and 1997, on those portions
of its underpayments attributable to its claimed note disposition
losses. See Gilman v. Commissioner, 933 F.2d 143, 149-152 (2d
Cir. 1991), affg. T.C. Memo. 1989-684.
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Because we have found that the subject transactions are
without substance or business purpose and that petitioner and its
officers were fully aware of the lack of bona fides of the
factual underpinnings for the transactions, there could be no
substantial authority or reasonable belief or cause on
petitioner’s part that would allow it to avoid the application of
the section 6662 penalties in this case.
In light of the foregoing and to reflect concessions by the
parties,
Decision will be entered
under Rule 155.
[REPORTER’S NOTE: This opinion was amended by Order dated
February 14, 2005.]
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APPENDIX A
- 130 -
- 131 -
- 132 -
APPENDIX B
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APPENDIX C
Existing End User Equipment Rental
Monthly Payments That HCA Purchased
Martin
Date K-Mart Shared Amoco HIP NY Marietta
12-1-94 $61,236 $46,657 -- $130,000 $40,914
1-1-95 61,236 46,657 -- 130,000 40,914
2-1-95 61,236 46,657 $70,300 130,000 40,914
3-1-95 61,236 46,657 70,300 130,000 40,914
4-1-95 61,236 46,657 70,300 130,000 40,914
5-1-95 61,236 46,657 70,300 130,000 40,914
6-1-95 61,236 46,657 70,300 130,000 40,914
7-1-95 61,236 46,657 70,300 130,000 40,914
8-1-95 61,236 46,657 70,300 130,000 40,914
9-1-95 61,236 46,657 70,300 130,000 40,914
10-1-95 61,236 46,657 70,300 130,000 40,914
11-1-95 61,236 46,657 70,300 130,000 40,914
12-1-95 61,236 46,657 70,300 130,000 40,914
1-1-96 61,236 46,657 70,300 130,000 40,914
2-1-96 61,236 46,657 70,300 130,000 40,914
3-1-96 61,236 46,657 70,300 130,000 40,914
4-1-96 61,236 46,657 70,300 130,000 40,914
5-1-96 61,236 46,657 70,300 130,000 40,914
6-1-96 61,236 46,657 70,300 130,000 40,914
7-1-96 61,236 46,657 70,300 130,000 40,914
8-1-96 61,236 46,657 70,300 130,000 40,914
9-1-96 61,236 46,657 70,300 130,000 40,914
10-1-96 61,236 46,657 70,300 130,000 40,914
11-1-96 61,236 46,657 70,300 130,000 40,914
12-1-96 61,236 46,657 70,300 130,000 40,914
1-1-97 61,236 46,657 70,300 130,000 40,914
2-1-97 61,236 46,657 70,300 130,000 40,914
3-1-97 61,236 36,267 70,300 130,000 40,914
4-1-97 61,236 -- 70,300 130,000 40,914
5-1-97 61,236 -- 70,300 130,000 40,914
6-1-97 61,236 -- 70,300 130,000 --
7-1-97 20,395 -- 70,300 130,000 --
8-1-97 -- -- 70,300 130,000 --
9-1-97 -- -- 70,300 130,000 --
10-1-97 -- -- 70,300 130,000 --
11-1-97 -- -- 70,300 130,000 --
12-1-97 -- –- 70,300 130,000 --
1-1-98 -- -- 70,300 -- --
2-1-98 -- -- 70,300 -- --
3-1-98 -- -- 70,300 -- --
1
4-1-98 -- –- 70,300 –- –-
1
The Amoco payments continue at $70,300 per month through
Jan. 1, 2000.