T.C. Memo. 1995-458

UNITED STATES TAX COURT

RICHARD SANTULLI AND VIRGINIA SANTULLI, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 24495-89, 16527-93. Filed September 26, 1995.

These cases involve two similar transactions: A

leasing company purchased equipment with funds borrowed

from a bank. The leasing company leased the equipment

to an end-user. Rent payments to be received from the

end-user were assigned to the bank as security for the

loan. The leasing company then sold the equipment to a

middle company, which, in turn, sold the equipment to

P. With regard to both of those sales, substantially

all of the purchase price was evidenced by a long-term

note and the equipment was acquired subject to both the

lease to the end-user and the security interest of the

bank. P then leased the equipment back to the leasing

company. Payments from the leasing company to P, from

P to the middle company, and from the middle company to

the leasing company were, with one small exception,

identical. Sec. 465, I.R.C., limits deductions for

losses from certain activities to the amount for which

the taxpayer is "at risk". Sec. 465(b)(4), I.R.C.,

provides that a taxpayer shall not be considered at

risk with respect to amounts protected against loss

through nonrecourse financing, guarantees, stop-loss

agreements, or other similar arrangements.
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1. Held: The ultimate test for determining

whether a taxpayer is at risk pursuant to sec.

465(b)(4), I.R.C., is whether there is a realistic

possibility of economic loss. Based on the facts

presented, P has not established that there was any

realistic possibility that he would be subject to

economic loss as a result of his long-term notes.

2. Held further, Ps are subject to additions to

tax under sec. 6653(a), I.R.C., for negligence.

3. Held further, Ps are subject to additions to

tax under sec. 6661, I.R.C., for substantial

understatement of income tax liability.

4. Held further, Ps are liable for the increased

rate of interest imposed under sec. 6621(c), I.R.C.,

for substantial underpayments attributable to taxmotivated transactions.

Richard S. Kestenbaum and Bernard S. Mark, for petitioners.

Theodore R. Leighton, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: These two cases have been consolidated for

trial, briefing, and opinion. Respondent has determined

deficiencies in income taxes, additions to tax, and increased

interest as follows:

 Additions to Tax 

 Sec. Sec. Sec.

 Year Deficiency 6651(a)(1) 6653(a)(1) 6653(a)(2)

 1980 $81,541.67 $16,477.20 $5,097.06 ---

 1981 35,032.19 5,254.83 4,116.46 50% of interest 

 due on $15,956

 1982 246,433.50 --- 12,321.68 50% of interest

 due on $3,195

 1983 411,000.00 --- 21,312.00 50% of interest

 due on $411,000

 
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 Additions to Tax Increased Interest

 Sec. Sec. Sec.

 Year 6659 6661 6621(c) 

 1980 --- --- Due on $81,541.67

 1981 $5,765.00 --- Due on $35,032.19

 1982 5,680.80 $56,874.38 Due on $246,443.50 

 1983 --- 102,750.00 Due on $411,000.00

For 1982 respondent determined an addition to tax under

section 6661 of $4,734 as an alternative to the addition to tax

under section 6659 shown.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

The parties have filed a stipulation of settled issues,

which is accepted by the Court. The issues remaining for

decision are: (1) Whether petitioners' deductions for losses

suffered on certain equipment leasing transactions are allowable,

(2) whether the transactions were tax-motivated transactions,

rendering petitioners liable for increased interest, and

(3) whether petitioners are liable for certain additions to tax.

FINDINGS OF FACT

Introduction

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

The stipulations of fact filed by the parties and the

accompanying exhibits are incorporated herein by this reference. 
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Petitioners Richard and Virginia Santulli are husband and wife. 

They made joint returns of Federal income tax for the calendar

years in issue. Petitioners resided in New York City at the time

they filed the petitions herein. Hereafter, all references to

petitioner shall refer to petitioner Richard Santulli.

Our remaining findings of fact are concerned with two

equipment leasing transactions entered into by petitioner. One

of those transactions involved computer equipment, and the other

involved telecommunications equipment. The parties have

characterized those transactions as the "computer equipment

activity" and the "telecommunications equipment activity",

respectively. We will adopt those characterizations.

The Computer Equipment Activity

Purchase by Sha-Li and Lease to BNY

Sha-Li Leasing Associates, Inc. (Sha-Li), is a New Jersey

corporation involved in equipment sales and leasing. During the

years in issue, petitioner was a director of Sha-Li. Sometime

prior to January 1979, Sha-Li purchased certain computer

equipment (the computer equipment), which it leased to the Bank

of New York (BNY), pursuant to eight separate leases (the BNY

leases). The dates of, terms of, and monthly rental obligations

under the BNY leases are as follows:

 Date of Lease Term Monthly Rental

 12/19/78 48 mos. $1,177

 12/19/78 48 mos. 1,188
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 12/17/78 48 mos. 1,188

 12/19/78 48 mos. 1,188

 12/19/78 48 mos. 1,188

 12/19/78 48 mos. 1,188

 12/19/78 48 mos. 1,188

 1/27/78 36 mos. 3,381

Sha-Li had purchased the computer equipment with money

borrowed from Manufacturers Hanover Leasing Corp. (MHLC). Sha-Li

borrowed the money pursuant to agreements entitled "Assignment of

Lease Without Recourse and Security Agreement" (the assignment

agreements). Among other provisions, each assignment agreement

contains the following: A statement that, as of the date of the

agreement, unpaid rent under the related BNY lease exceeded the

amount borrowed by Sha-Li pursuant to the agreement; an

assignment to MHLC of Sha-Li's rights to the proceeds

(principally rent) under the related BNY lease; a grant to MHLC

of a security interest in the computer equipment subject to the

related lease; and an agreement by MHLC to take no recourse

against Sha-Li should the lessee default in the payment of any of

its obligations as a result of the lessee's financial inability

to meet those obligations. 

Sale by Sha-Li to Proz

Proz Leasing Associates, Inc. (Proz), a New York

corporation, was organized in June 1979 to be a "middle company"

in leasing transactions. Pursuant to an agreement between Proz

and Sha-Li dated as of June 30, 1979 (the Proz computer purchase

agreement), Proz purchased the computer equipment from Sha-Li. 
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The Proz computer purchase agreement recites a purchase price of

$449,700, payable as follows:

1. $200 in cash payable to Sha-Li no later than

 December 31, 1979.

2. $1,500 by delivery to Sha-Li of a recourse note

 concurrently with execution of the Proz computer

 purchase agreement.

3. $11,500 by delivery to Sha-Li of another recourse note 

 concurrently with execution of the Proz computer 

 purchase agreement.

4. $436,500 by delivery to Sha-Li of an installment note 

 (the Proz computer installment note) concurrently with 

 execution of the Proz computer purchase agreement.

The Proz computer installment note is interest bearing and calls

for 96 monthly installment payments, each in the amount of

$6,908.79, commencing on July 1, 1979. 

In connection with Proz' purchase of the computer equipment

from Sha-Li, Proz and Sha-Li also entered into an agreement

entitled "Assumption Agreement" dated as of June 30, 1979 (the

Proz assumption agreement). The Proz assumption agreement

provides that Proz agrees to be bound by the obligations of ShaLi contained in the assignment agreements and that Proz'

ownership interest in the computer equipment shall be subordinate

to the security interest granted to MHLC by the assignment

agreements. Under the Proz assumption agreement, no recourse

shall be had against Proz or Proz' officers, directors, or

stockholders with respect to any such obligations assumed by

Proz, and, as to Proz, all such obligations are nonrecourse

obligations. 
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Sale by Proz to Petitioner

Pursuant to an agreement between petitioner and Proz dated

as of June 30, 1979 (the petitioner computer purchase agreement),

petitioner purchased the computer equipment from Proz. The

petitioner computer purchase agreement recites a purchase price

of $450,000 ($300 more than payable under the Proz computer

purchase agreement), payable as follows:

1. $500 in cash payable to Proz no later than 

 June 30, 1979.

2. $1,500 by delivery to Proz of a recourse note 

 concurrently with execution of the petitioner computer 

 purchase agreement.

3. $11,500 by delivery to Proz of another recourse note 

 concurrently with execution of the petitioner computer 

 purchase agreement.

4. $436,500 by delivery to Proz of a limited recourse 

 installment note (the petitioner computer installment 

 note) concurrently with execution of the petitioner 

 computer purchase agreement. 

The petitioner computer installment note is interest bearing and,

identically with the Proz computer installment note, it calls for

96 monthly installment payments, each in the amount of $6,908.79,

commencing on July 1, 1979. 

The petitioner computer installment note gives petitioner

the right to defer any or all note payments owed to Proz to the

extent amounts due petitioner under a lease of the computer

equipment to be entered into by petitioner with Sha-Li are not

received when due. Amounts so deferred become due and payable to

Proz when, and to the extent that, petitioner receives from Sha-
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Li or Proz amounts due petitioner under petitioner's lease with

Sha-Li. Amounts so deferred become due and payable on

February 28, 1996, whether or not petitioner has then received

from Sha-Li or Proz amounts due under petitioner's lease with

Sha-Li. No interest accrues on amounts so deferred. 

In connection with petitioner's purchase of the computer

equipment from Proz, petitioner and Proz also entered into an

agreement entitled "Assumption Agreement" dated as of June 30,

1979 (the petitioner computer assumption agreement). The

petitioner computer assumption agreement provides that petitioner

agrees to be bound by the obligations of Sha-Li contained in the

assignment agreements and that petitioner's ownership interest in

the computer equipment shall be subordinate to the security

interest granted to MHLC by the assignment agreements. Under the

petitioner computer assumption agreement, no recourse shall be

had against petitioner with respect to any such obligations

assumed by petitioner, and, as to petitioner, all such

obligations are nonrecourse obligations. 

Sha-Li, not Proz, negotiated with petitioner the terms of

the petitioner computer installment note. Any accounting records

concerning Proz' purchase and sale of the computer equipment have

at all times been maintained by Sha-Li. Proz never monitored

payments on the petitioner computer installment note. Proz

relied on Sha-Li to manage the flow of all payments between Proz,
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petitioner, and Sha-Li. Proz never monitored or questioned ShaLi's management of the payments. 

Lease by Petitioner to Sha-Li

Pursuant to an agreement of lease between petitioner and

Sha-Li dated as of June 30, 1979 (the Sha-Li lease), petitioner

leased the computer equipment to Sha-Li. The Sha-Li lease

commenced as of July 1, 1979, and had a term of 96 months. 

"Fixed rent" was set at $6,928.79 a month. Pursuant to the 

Sha-Li lease, Sha-Li was responsible during the term of the lease

for all risk of physical damage to, or loss or destruction of,

the computer equipment, unless caused by petitioner's willful

misconduct or negligence. Also pursuant to the Sha-Li lease,

Sha-Li agreed to indemnify, hold harmless, and defend petitioner

against certain losses, liabilities, claims, and other risks

arising from or in connection with, among other things, (1) any

default by Sha-Li under the Sha-Li lease and (2) any claim by

"the holders of the Lien". The term "Lien" is defined in the

Sha-Li lease to include the term "Lien" as defined in the Proz

computer purchase agreement. In the Proz computer purchase

agreement, the term "Lien" is defined as: "The security interest

in favor of * * * [MHLC], and the assignment of payments due

under the * * * [BNY leases] to * * * [MHLC] * * * ". 
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Marketing Agreement

Pursuant to a marketing agreement between petitioner and

Sha-Li dated as of June 30, 1979, petitioner appointed Sha-Li as

marketing agent for the computer equipment after the termination

or expiration of the BNY leases. 

Payment History

Until December 1982, Sha-Li's payments of rent to petitioner

pursuant to the Sha-Li lease, petitioner's payments to Proz

pursuant to the petitioner computer installment note, and Proz'

payments to Sha-Li pursuant to the Proz computer installment note

were made by check. Payments were not always timely. For

example, Sha-Li's payments due for July through September 1980

were not made until November 1980; petitioner's payments due for

July through October 1980 were not made until November 1980. 

Manufacturers and Traders Trust Co. (Manufacturers) is a

financial institution located in New York City. During 1982,

petitioner, Proz, and Sha-Li all maintained accounts at

Manufacturers. In December 1982, each of petitioner, Proz, and

Sha-Li gave instructions to Manufacturers concerning their

respective accounts. All of the instructions were effective from

November 1982 through June 1987. Sha-Li instructed Manufacturers

to charge its account on the first day of each month in the
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amount of $6,928.79 and to credit that amount to the account of

petitioner. Petitioner's and Proz' instructions were similar,

except that petitioner's account was to be charged $6,908.79,

with that amount to be credited to the account of Proz, and Proz'

account was to be charged $6,908.79, with that amount to be

credited to the account of Sha-Li.

The Telecommunications Equipment Activity

Purchase by RTS and Lease to U.S. Telephone

RTS Teleleasing Corp. (RTS) is a New York corporation

involved in equipment sales and leasing. The initials RTS in the

name "RTS Teleleasing Corporation" stand for Richard T. Santulli

(petitioner). During the years in issue, petitioner indirectly

owned 50 percent of the shares of stock of RTS. On October 1,

1982, RTS purchased certain telecommunications equipment (the

telecommunications equipment) from a corporation then known as

U.S. Telephone Communications, Inc. (U.S. Telephone). (U.S.

Telephone is now known as U.S. Sprint.) RTS purchased the

telecommunications equipment for $3,610,205. Also on October 1,

1982, RTS leased the telecommunications equipment back to U.S.

Telephone pursuant to an agreement entitled "Master Agreement of

Lease" (the U.S. Telephone lease). The term of the U.S.

Telephone lease is 60 months, commencing on October 1, 1982. 

U.S. Telephone's monthly rental obligation under the U.S.

Telephone lease is $81,420.95. 
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RTS had purchased the telecommunications equipment in part

with a loan of $3,239,620 from MHLC. RTS borrowed that sum from

MHLC pursuant to an agreement entitled "Loan and Security

Agreement" (the loan agreement). Pursuant to the loan agreement,

RTS executed a promissory note (the RTS promissory note) to MHLC.

The RTS promissory note is interest bearing and calls for 

58 monthly payments of $81,420.95, commencing on December 1,

1982. Among other provisions, the RTS promissory note contains

the following statement:

MHLC ACKNOWLEDGES AND AGREES THAT THE PERSONAL

LIABILITY OF * * * [RTS] WITH RESPECT TO PAYMENT OF

SUMS EVIDENCED BY THIS NOTE IS LIMITED AND IS SUBJECT

TO THE TERMS AND CONDITIONS CONTAINED IN THE SECURITY

AGREEMENT.

Certain pertinent provisions of the loan agreement are as

follows:

7. Payment from Amounts Due Under The Lease. MHLC and

the Borrower agree that, except as otherwise provided

in Section 15 hereof, payments due under the Note shall

be made by the Lessee's payment of the rentals and

other amounts due or to become due (including, without

limitation amounts due as Stipulated Loss Value) under

the Lease directly to MHLC; provided, however, that

nothing contained herein shall be deemed to alter or

diminish the Borrower's absolute and unconditional

obligation to make the payments to MHLC required under

the terms of the Note.

 * * * * * * *

14. Default; Remedies. In the event: (a) of a

failure of the Borrower to pay any amount owing

hereunder when due, and the continuation of such

failure for a period of 30 days after the date when

due; (b) of a failure by the Borrower to perform or
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observe any other covenant, agreement or undertaking

under this Agreement, or any covenant, agreement or

undertaking under the Lease, or under any agreement

contemplated by the second paragraph of Section 11

hereof to which Borrower is a party, or under any other

agreement or document given to evidence or secure any

of the Secured Obligations; (c) of the occurrence of an

Event of Default (as therein defined) under the Lease

or of a default by Lessee of its obligations under the

Acknowledgment and Consent to Assignment referred to in

Section 15 hereof; (d) that any representation or

warranty, made by the Borrower in connection with this

transaction, whether contained in the Lease, any

related document, in this Agreement or any certificate

or other related document delivered to MHLC in

connection herewith, or in any of the agreements

contemplated by the second paragraph of Section 11

hereof, shall prove to be incorrect or untrue in any

material respect; * * * then in any such event, MHLC

may accelerate the full amount of the then outstanding

Secured Obligations in which event such amounts will

become immediately due and payable by the Borrower

without presentment, demand, protest or other notice of

any kind, all of which are hereby expressly waived, and

MHLC may thereafter pursue all of the rights and

remedies with respect to the Collateral accruing to

MHLC hereunder or by operation of law as a secured

creditor under the Uniform Commercial Code or other

applicable law, and all such available rights and

remedies, to the full extent permitted by the law,

shall be cumulative and not exclusive.

 * * * * * * *

16. Borrower's Obligation. MHLC and the Borrower

agree that the Note and the obligations evidenced

thereby are without recourse to the Borrower and the

Borrower shall have no personal liability for the

payment of the Secured Obligations. Notwithstanding

the foregoing, however, the Borrower expressly agrees

that if at any time a Default described in either of

subsections 14(b) or (d) hereof shall have occurred and

be continuing, then in such event, the Borrower will

not be permitted to satisfy the payment of the Secured

Obligations solely or exclusively from funds generated

by MHLC's realization upon its liquidation of the

Collateral, and, in such event, MHLC shall have

unencumbered and unrestricted access to the Borrower
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and its assets for the satisfaction thereof without

proceeding initially or exclusively against the

Collateral.

Section 9 of the loan agreement provides to MHLC certain

"collateral security", including the following: An assignment to

MHLC of RTS' rights to the proceeds (principally rent) under the

U.S. Telephone lease and a grant to MHLC of a security interest

in the telecommunications equipment.

Sale by RTS to Proz

Pursuant to an agreement between Proz and RTS dated

December 30, 1982 (the Proz telecommunications purchase

agreement), Proz purchased the telecommunications equipment from

RTS. The Proz telecommunications purchase agreement recites a

purchase price of $3,605,205, payable as follows:

1. $175,510 by check or wire transfer to RTS concurrently 

 with the execution of the Proz telecommunications 

 purchase agreement.

2. $3,429,695 by delivery to RTS of an installment note

 (the Proz telecommunications installment note) 

 concurrently with the execution of the Proz 

 telecommunications purchase agreement.

The Proz' telecommunications installment note is interest

bearing. It provides for (1) an initial payment of $2,212.70 on

December 31, 1982, (2) monthly payments of $34,296.96 for the

next 24 months, and (3) monthly payments of $49,206.16 for the

next 120 months. The initial payment and the next 24 payments

are stated to be "interest only". The final 120 payments are

stated to be "principal and interest". 
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The Proz' telecommunications note additionally gives Proz

the right to defer payments on the petitioner telecommunications

installment note if Proz fails to receive payments from

petitioner under petitioner's "Limited Recourse Promissory Note -

Security Agreement". Amounts so deferred become due and payable

to RTS when, and to the extent that, Proz receives such payments

from petitioner. In any event, Proz must pay all deferred

amounts no later than December 31, 1999. No interest accrues on

amounts so deferred. 

Pursuant to the Proz telecommunications purchase agreement,

Proz acquired the telecommunications equipment subject to the

loan agreement and the U.S. Telephone lease. 

Sale by Proz to Petitioner

Pursuant to an agreement between petitioner and Proz dated

December 30, 1982 (the petitioner telecommunications purchase

agreement), petitioner purchased the telecommunications equipment

from Proz. The petitioner telecommunications purchase agreement

recites a purchase price of $3,610,205 ($5,000 more than payable

under the Proz telecommunications purchase agreement), payable as

follows:

1. $180,510 by check or wire transfer to RTS concurrently

 with the execution of the petitioner telecommunications 

 purchase agreement.

2. $3,429,695 by delivery to RTS of an installment note
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 (the petitioner telecommunications installment note) 

 concurrently with the execution of the Proz 

 telecommunications purchase agreement. 

The petitioner telecommunications installment note is captioned

"Limited Recourse Promissory Note - Security Agreement". It is

interest bearing, and petitioner's liability thereunder is

limited. Proz is accorded a security interest in the

telecommunications equipment. The note calls for payments

identical with those called for under the Proz telecommunications

note: (1) An initial payment of $2,212.70 on December 31, 1982,

(2) monthly payments of $34,296.96 for the next 24 months, and

(3) monthly payments of $49,206.16 for the next 120 months. The

initial payment and the next 24 payments are stated to be

"interest only". The final 120 payments are stated to be

"principal and interest". 

The petitioner telecommunications installment note

additionally gives petitioner the right to defer payments on that

note if petitioner fails to receive payments from RTS under

petitioner's lease of the equipment to RTS. Amounts so deferred

become due and payable to Proz when, and to the extent that,

petitioner receives such payments from RTS. In any event,

petitioner must pay all deferred amounts no later than

December 31, 1999. No interest accrues on amounts so deferred. 

Petitioner acquired the telecommunications equipment subject

to the loan agreement and the U.S. Telephone lease. 
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Any accounting records concerning Proz' purchase and sale of

the telecommunications equipment have at all times been

maintained by RTS. Proz never monitored payments on the

petitioner telecommunications installment note. Proz relied on

Sha-Li to manage the flow of all payments between Proz,

petitioner, and RTS. Proz never monitored or questioned Sha-Li's

management of the payments. 

Lease by Petitioner to RTS

Pursuant to an agreement of lease between petitioner and RTS

dated December 30, 1982 (the RTS lease), petitioner leased the

computer equipment to RTS. The RTS lease commenced on

December 30, 1982, and, subject to earlier termination, has a

term of approximately 144 months. The RTS lease calls for

payments of "Fixed Rent" identical with the payments called for

under both the Proz telecommunications installment note and the

petitioner telecommunications installment note: (1) An initial

payment of $2,212.70 on December 31, 1982, (2) monthly payments

of $34,296.96 for the next 24 months, and (3) monthly payments of

$49,206.16 for the next 120 months. Pursuant to the RTS lease,

RTS was responsible during the term of the lease for all risk of

physical damage to, or loss or destruction of, the computer

equipment, unless caused by petitioner's willful misconduct or

negligence. In addition, the RTS lease provided for

indemnification of the lessor (petitioner) as follows:
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17. Indemnification

17.1 Lessee will indemnify Lessor and protect,

defend and hold him harmless from and against any and

all loss, cost, damage, injury or expenses, including,

without limitation, reasonable attorneys' fees,

wheresoever and howsoever arising which Lessor, or any

of his agents or employees, may incur by reason of any

breach by Lessee of any of the representations by, or

obligations of, Lessee contained in this Lease or in

any way relating to or arising out of this Lease, the

Equipment or Underlying Leases; * * * 

By a reference to the petitioner telecommunications purchase

agreement, the term "Underlying Leases" is defined to be the U.S.

Telephone lease.

Marketing Agreement

Pursuant to a "Remarketing Option" between petitioner and

RTS dated December 30, 1982, RTS agreed, at petitioner's option,

to act as petitioner's agent to remarket the telecommunications

equipment as and when the RTS lease expired. 

Payment History

Until September 1983, RTS' payments of rent to petitioner

pursuant to the RTS lease, petitioner's payments to Proz pursuant

to the petitioner telecommunications installment note, and Proz'

payments to RTS pursuant to the Proz telecommunications

installment note (together the telecommunications payments) were

made by check. The telecommunications payments were not always

timely. For example, neither petitioner, Proz, nor RTS made any

payment due for January through July 1983 until December 1983. 
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In April 1983, RTS opened an account at Manufacturers. 

Beginning in September 1983, the telecommunications payments were

made by Manufacturers charging and crediting the accounts of RTS,

petitioner, and Proz. By letter dated July 23, 1983, petitioner

instructed Manufacturers to charge petitioner's account and

credit RTS' account in the following amounts: (1) $34,296.96

each month through and including December 1984 and (2) $49,206.16

each month commencing January 1985 through and including December

1994. From September 1983 to June 1990, Manufacturers complied

with those instructions. Additionally, Manufacturers (1) charged

RTS' account in like amounts and credited such amounts to Proz'

account and (2) charged Proz' account in like amounts and

credited such amounts to petitioner's account. As part of the

telecommunications equipment activity, (1) petitioner had no

obligation to make any payment to RTS, (2) RTS had no obligation

to make any payment to Proz, and (3) Proz had no obligation to

make any payment to petitioner.

Petitioners' Deductions

With regard to the computer equipment, petitioners reported

the following on their tax returns for the years is issue:

 1980 1981 1982 1983 

 Income $83,145 $83,145 $83,145 $83,145

 Deductions

 Depreciation 94,438 73,450 73,450 73,450

 Interest 45,816 41,322 41,322 56,185

 Losses 57,109 31,627 31,627 46,490
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With regard to the telecommunications equipment, petitioners 

reported the following on their tax returns for the years in 

issue: 

 1982 1983 

Income $2,213 $411,564

Deduction

 Depreciation 541,531 794,245

 Interest 2,213 411,564

Losses 541,531 794,245

OPINION

I. At-Risk Issue

A. Introduction

These cases involve two equipment leasing transactions

entered into by petitioner and characterized by the parties as

the "computer equipment activity" and the "telecommunications

equipment activity" (together, the activities). Both activities

comprised similar elements: A leasing company purchased

equipment with funds borrowed from a bank. The leasing company

leased the equipment to an end-user. Rent payments to be

received from the end-user were assigned to the bank as security

for the loan. The leasing company then sold the equipment to a

middle company, which, in turn, sold the equipment to petitioner. 

With regard to both of those sales, substantially all of the

purchase price was evidenced by a long-term note and the

equipment was acquired subject to both the lease to the end-user
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1 Respondent has proposed that we find that petitioner was not

at risk with respect to petitioner's long-term note issued with

respect to each activity (viz, the petitioner computer

installment note and the petitioner telecommunications

installment note). Respondent has not requested that we find

that petitioner lacked risk with respect to the cash and any

short-term notes issued with respect to the activities. We

assume that respondent concedes that petitioner was at risk with

respect to such cash and short-term notes as of the beginning of

the activity here in question, and we will not further address

such items.

and the security interest of the bank. Petitioner then leased

the equipment back to the leasing company.

With regard to both activities, petitioners claimed

deductions for both depreciation and interest on their Federal

income tax returns. With regard to both activities, the parties

have stipulated:

1. The activity was not a sham.

2. Petitioner had a business purpose in entering the 

 activity.

3. Petitioner's investment in the activity had substance.

 

4. Petitioner acquired the benefits and burdens of owner- 

 ship in the activity.

The parties have further stipulated that petitioners' deductions

for depreciation and interest in connection with the activities

depend on the extent to which petitioner was "at risk" for each

activity within the meaning of section 465. We thus must 

determine with respect to each activity the extent to which

petitioner was at risk.1
- 22 -

2 Additionally, respondent argues that petitioner is not at

risk because he is not personally liable on the installment notes

(see sec. 465(b)(1) and (2)) and, with respect to the computer

installment note, petitioner is indebted to a party with an

interest in the activity (Sha-Li) other than as a creditor (see

sec. 465(b)(3)). Respondent would disregard the existence of

Proz. Since we agree that petitioner was protected against loss

within the meaning of sec. 465(b)(4), we need not address

respondent's additional arguments.

B. Section 465

Section 465 limits losses allowable to an individual in

connection with certain activities, including the leasing of

depreciable property, to the amount that the individual is at

risk with respect to the activity at yearend. See sec. 465

(a)(1), (c)(1)(C). Respondent contends that, with respect to the

long-term notes issued by petitioner in connection with both the

computer equipment activity and the telecommunications equipment

activity (viz, the petitioner computer installment note and the

petitioner telecommunications installment note, respectively

(together, the installment notes)), petitioner was not at risk

because he was protected against loss within the meaning of

section 465(b)(4).2

Section 465(b)(4) provides:

Exception.--Notwithstanding any other provision of this

section, a taxpayer shall not be considered at risk

with respect to amounts protected against loss through

nonrecourse financing, guarantees, stop loss

agreements, or other similar arrangements.

In determining whether a taxpayer is protected against loss

within the meaning of section 465(b)(4), we look to see whether
- 23 -

there is any realistic possibility that the taxpayer ultimately

will be subject to economic loss on the investment at issue. 

Levien v. Commissioner, 103 T.C. 120, 126 (1994).

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

risk treatment where a transaction is structured--by

whatever method--to remove any realistic possibility

that the taxpayer will suffer an economic loss if the

transaction turns out to be unprofitable. A

theoretical possibility that the taxpayer will suffer

economic loss is insufficient to avoid the

applicability of this subsection. We must be guided by

economic reality. If at some future date the

unexpected occurs and the taxpayer does suffer a loss,

or a realistic possibility develops that the taxpayer

will suffer a loss, the taxpayer will at that time

become at risk and be able to take the deductions for

previous years that were suspended under this

subsection. I.R.C., sec. 465(a)(2)." 

Waters v. Commissioner, 978 F.2d 1310, 1315 (2d Cir. 1992)

(quoting with approval American Principals Leasing Corp. v.

United States, 904 F.2d 477, 483 (9th Cir. 1990)), affg. T.C.

Memo. 1991-462.

The question presented is one of fact, and petitioners bear

the burden of proof. Rule 142(a). With regard to leasing

activities, we scrutinize the economic reality of the

transaction, focusing in particular upon the relationships

between the parties, whether the underlying debt is nonrecourse,

the presence of offsetting payments and bookkeeping entries, the

circularity of the transaction, and the presence of any payment

guarantees or indemnities. See Waters v. Commissioner, supra at

1316-1317; Young v. Commissioner, 926 F.2d 1083, 1088 (11th Cir.

1991), affg. T.C. Memo. 1988-440; Moser v. Commissioner, 914 F.2d
- 24 -

1040, 1049-1050 (8th Cir. 1990), affg. T.C. Memo. 1989-142;

American Principals Leasing Corp. v. United States, supra; Levien

v. Commissioner, supra; Thornock v. Commissioner, 94 T.C. 439,

453 (1990). No single feature of the transaction generally will

control. E.g., Levien v. Commissioner, supra at 127.

We find no significant difference between the facts in this

case and those in the cases cited above. For example, Waters v.

Commissioner, supra, involved a similar leasing transaction

whereby the taxpayer purchased computer equipment from a middle

entity that purchased the equipment from a third party

to which the taxpayers leased the equipment. The third party had

purchased the equipment with nonrecourse bank loans and had

leased it to an end-user. The bank held a security interest in

the equipment and had received an assignment of the end-user

lease payments. The taxpayer owned the equipment subject to the

bank liens and the end-user lease. The lease payments due the

taxpayer from the third party "essentially matched" the

taxpayer's payments to the middle entity, which, in turn,

"matched" the middle entity's payments to the third party. Id.

at 1312-1313. Based on the following factors--matching payment

obligations, underlying nonrecourse debt, circular, matching

payments, and third party's promise of indemnification under the

lease from the taxpayer-- the Court of Appeals for the Second

Circuit concluded that there was no realistic possibility that

the taxpayer would suffer an economic loss if the underlying
- 25 -

transaction became unprofitable. Id. at 1317. The Court of

Appeals affirmed the holding of this Court that the taxpayer was

not at risk under section 465(b)(4). Id. at 1319. Likewise, in

Levien v. Commissioner, supra at 127-128, this Court found that

taxpayers involved in a similar computer leasing structure were

not at risk due primarily to the existence of matching, circular

payments, guarantees, and the nonrecourse nature of the

underlying debt. Accord Thornock v. Commissioner, supra.

C. Instant Cases

In the instant cases, sufficient factors are present that we

must find that there was no realistic possibility that petitioner

would suffer an economic loss on account of the installment notes

if the underlying activities became unprofitable.

1. Matching

In the computer equipment activity, Sha-Li was required to

make monthly lease payments to petitioner of $6,928.79,

petitioner was required to make monthly installment note payments

to Proz of $6,908.79, and Proz was required to make monthly

installment note payments to Sha-Li of $6,908.79. All payment

obligations were for the same term. In the telecommunications

equipment activity, all payment obligations--from RTS to

petitioner as rent, from petitioner to Proz on the Proz

telecommunications installment note, and from Proz to RTS on the

petitioner telecommunications installment note--were identical

both in amount and in term. In both activities, petitioner's
- 26 -

obligation to Proz was matched (and, in the computer equipment

activity, slightly exceeded) by the respective obligation of ShaLi and RTS to petitioner.

2. Circularity

In both activities, not only were the payments matching, but

the flow of payments was circular. It would thus appear to make

no difference whether the payments were made or not, so long as

each of the parties in the circle did the same thing. Indeed, in

the telecommunications equipment activity, virtually no scheduled

payments were made for the first 7 months. Payment lapses also

occurred in the computer equipment activity. Moreover, in the

telecommunications equipment activity, when the payments were

automated, by instructing a bank to debit and credit each

participant's account, the payments flowed the wrong way around

the circle--from petitioner to RTS to Proz to petitioner, rather

than from petitioner to Proz to RTS to petitioner--for over

7 years. Sha-Li performed bookkeeping services for Proz and RTS. 

A bookkeeper employed by Sha-Li discovered the reverse flow of

payments in 1985 or 1986. The bookkeeper did not bring the

reverse flow of payments to petitioner's attention. The parties

have stipulated the reasons she failed to do so. Among those

reasons are the following:

1. She believed that as president of RTS, petitioner had 

 more important things to be concerned with,

2. By the time the bookkeeper learned of the reverse flow 

 of payments, the payments had been circling in that 
- 27 -

 direction for several years, without any apparent 

 harm. 

No harm occurred in the sense that, since the required payments

were to be equal (virtually equal in the computer equipment

activity), it did not matter which way around the circle payments

flowed. Likewise, it would not have mattered if payments flowed

the right way around the circle but were made in only one-half

the amounts called for under the various obligations. Indeed,

from a simple balance sheet point of view, it would not have

mattered if no payments ever were made. Unless the circle was

broken, with the consequences visited on petitioner, then his

obligations to Proz imposed no realistic possibility that he 

would suffer an economic loss. As the Court of Appeals for the

Second Circuit said in Waters v. Commissioner, 978 F.2d at 1316-

1317:

if * * * [the party equivalent to Sha-Li or RTS]

stopped making payments on its lease, it could only

have expected a chain reaction resulting in * * * [the

taxpayer], and then * * * [the middle entity] ceasing

to make payments as well. Any ensuing litigation would

similarly have resulted in a chain reaction. Whether

or not a litigant would be entitled to setoff in a

particular court action, it is clear that once the dust

settled, the claims among the parties would have

cancelled each other out.

3. Nonrecourse Nature of Underlying Bank Debt

Both the petitioner computer installment note and the

petitioner telecommunications installment note are claimed by

petitioner to be "limited recourse" obligations. Assuming that

such obligations exposed petitioner to some personal liability,
- 28 -

such liability would only be theoretical for purposes of section

465(b)(4) during the years in question because of the underlying

nonrecourse nature of the debts of Sha-Li and RTS to MHLC under

the assignment agreements and the loan agreement, respectively. 

See Waters v. Commissioner, 978 F.2d at 1317.

Petitioners do not argue that the assignment agreements

imposed any personal liability on Sha-Li, and we find that they

did not. Petitioners do argue that the loan agreement (in the

telecommunications equipment activity) did impose personal

liability on RTS. The RTS promissory note states:

MHLC ACKNOWLEDGES AND AGREES THAT THE PERSONAL

LIABILITY OF * * * [RTS] WITH RESPECT TO PAYMENT OF

SUMS EVIDENCED BY THIS NOTE IS LIMITED AND IS SUBJECT

TO THE TERMS AND CONDITIONS CONTAINED IN THE SECURITY

AGREEMENT.

Under the loan agreement, MHLC had recourse against RTS

personally on the occasion of two events of default: One, the

failure of RTS to observe certain covenants and other agreements,

excluding its failure to pay amounts due, and, two, the failure

of certain representations and warranties of RTS. Under the loan

agreement, the rental payments expected from U.S. Telephone had

been assigned to MHLC as "collateral security" for RTS' repayment

of the RTS promissory note. MHLC also had a security interest in

the telecommunications equipment. RTS bore no risk of default if

U.S. Telephone failed to make those rental payments. If U.S.

Telephone had stopped making payments under the U.S. Telephone

lease, MHLC could have looked only to its "collateral security"
- 29 -

interests to recover its loss. As it affects petitioner, the RTS

promissory note was nonrecourse, and we so find.

4. Payment Deferral Provisions

Both installment notes give petitioner the right to defer

any or all note payments owed to Proz to the extent amounts due

petitioner under the Sha-Li lease or the RTS lease, respectively,

are not received when due. Thus, even if the underlying debts of

Sha-Li and RTS under the assignment agreements and the loan

agreement, respectively, were not recourse, petitioner's

obligations during the years in issue would be "theoretical", in

the words of the Court of Appeals for the Second Circuit in

Waters v. Commissioner, 987 F.2d at 1317.

5. Indemnities

In connection with the computer equipment activity, under

the Sha-Li lease, Sha-Li agreed to indemnify, hold harmless, and

defend petitioner against certain risks and any losses attendant

to those risks. Included was any claim arising in connection

with MHLC's security interest in the computer equipment or the

assignment of payments due under the BNY leases to MHLC. The

indemnification provisions of the Sha-Li lease eliminate for

petitioner any risk of default if MHLC stops receiving rent

payments from BNY.

In connection with the telecommunications equipment

activity, under the RTS lease, RTS agreed to indemnify petitioner

and protect, defend, and hold him harmless from losses in any way
- 30 -

relating to or arising out of the U.S. Telephone lease. While

not as clear as the indemnification provision in the Sha-Li

lease, we believe that the indemnification provisions of the RTS

lease eliminate for petitioner any risk of default if MHLC stops

receiving payments from U.S. Telephone.

6. Petitioners' U.C.C. Argument

Petitioners argue:

In sale leaseback transactions governed by the

Uniform Commercial Code (e.g., the transactions in the

case at bar), the institution financing the original

acquisition by the leasing company (Manufacturer's)

obtains a security interest in the middle company

(Proz) and /or investor (Petitioner) Notes because said

Notes constitute "proceeds" from the disposition of the

collateral. If the leasing company defaults (because,

for example, the underlying end-user ceases paying

rent), the original lending institution can enforce the

middle company and/or investor Notes, directly or

through the chain, to the extent that the proceeds from

foreclosure and sale of the collateral (equipment) are

insufficient to satisfy the outstanding balance of the

leasing company's debt. 

The result, petitioners argue, "is a break in the circle of

payments". 

N.Y. Uniform Commercial Code (U.C.C.) Law sec. 9-306(2)

(McKinney 1990) provides:

Except where this Article otherwise provides, a

security interest continues in collateral

notwithstanding sale, exchange or other disposition

thereof unless the disposition was authorized by the

secured party in the security agreement or otherwise,

and also continues in any identifiable proceeds

including collections received by the debtor. 

[Emphasis added.]
- 31 -

The term "proceeds" is defined to include "whatever is received

upon the sale, exchange, collection, or other disposition of

collateral". N.Y.U.C.C. Law sec. 9-306(1) (McKinney 1990).

We need not get into the fine points of the commercial law

involved. Assuming, for the sake of argument, that, upon the

default of Sha-Li or RTS to MHLC, MHLC could have moved around

the circle and ended up with petitioner being liable for any

deficiency, we do not see how that aids petitioner. First, that

did not happen during any of the years in question. We have

found that both the assignment agreements and the loan agreement

were nonrecourse debts. Sec. I.C.3., supra p. 27. The analysis

of the Court of Appeals for the Second Circuit in Waters v.

Commissioner, 978 F.2d at 1317, with regard to nonrecourse debt

is apt:

In any event, the pertinent "arrangement" to be

assessed at the close of each taxable year was the

existing nonrecourse debt, not the theoretical

possibility that its nonrecourse nature would be

disregarded by * * * [RTS] in some future contingency.

The commercial law consequences that petitioners put forth were

both theoretical and contingent during the years in question, and

do not change our analysis of the meaningless nature of the

circle of payments. Second, the payment deferral provisions

discussed above dilute even more the argument that petitioner had

any present liability. Third, the indemnification provisions

eliminate it entirely.
- 32 -

D. Conclusion

During the years in issue, petitioner was not at risk on

account of either installment note. We therefore uphold

respondent's determinations of deficiencies in tax as they relate

thereto.

II. Additions to Tax

A. Negligence

Section 6653(a) imposes one addition to tax, and, in some

cases, two additions to tax, where the taxpayer's underpayment is

due to negligence or intentional disregard of rules or

regulations (hereinafter referred to simply as negligence). 

Section 6653(a), as applicable for 1980, and section 6653(a)(1),

as applicable for 1981 through 1983, impose an addition to tax

equal to 5 percent of the entire underpayment if any portion of

such underpayment is due to negligence. Section 6653(a)(2), as

applicable for 1981 through 1983, imposes an addition to tax

equal to 50 percent of the interest payable under section 6601

with respect to the portion of the underpayment due to negligence

(the interest-sensitive addition to tax). Petitioners bear the

burden of proof. Rule 142(a).

An underpayment, for purposes of section 6653(a), is the

amount by which the tax liability exceeds the tax shown on a

timely filed return. Secs. 6653(c)(1), 6211(a). The parties

have stipulated that petitioners did not timely file their 1980

and 1981 Federal income tax returns. Therefore, for 1980 and
- 33 -

1981, inasmuch as there was no timely filed return, the amount

shown on a timely filed return is zero, and the underpayment

equals the entire tax liability. Emmons v. Commissioner, 92 T.C.

342, 348-349 (1989), affd. 898 F.2d 50 (5th Cir. 1990). When an

underpayment is caused by the taxpayer's failure to file timely

an income tax return, such underpayment is due to negligence if

the taxpayer lacks reasonable cause for such failure. See id. at

349. The parties have also stipulated that petitioners lacked

reasonable cause for failing to file timely their 1980 and 1981

Federal income tax returns. Accordingly, normally, we would find

that the entire underpayment for each of those years is due to

negligence, and we would sustain respondent's additions to tax

under section 6653(a) for 1980 and under section 6653(a)(1) and

(2) for 1981. However, the parties have additionally stipulated

that petitioners "are not liable for additions to tax pursuant to

I.R.C. §§ 6653(a)(1) and §6653(a)(2) as a result of * * *

[certain properly disallowed deductions] for their 1980, 1981, or

1982 taxable years". Also, respondent has determined the

interest-sensitive addition to tax with regard to only a portion

of the 1981 underpayment. We are at a loss to reconcile the

stipulations respondent has joined, her determination of the

interest-sensitive addition for 1981, and the rule of Emmons v.

Commissioner, supra at 348-349. We assume that respondent has

chosen not to rely on Emmons for 1980 and 1981. We will treat

respondent as having made a concession to that extent.
- 34 -

We have sustained respondent's disallowance of certain items

for each of the years in issue. For none of those years have

petitioners carried their burden of showing the absence of an

underpayment. Accordingly, we find some underpayment for each of

those years. That is not sufficient for us to determine any

addition to tax on account of negligence, however. We must

determine whether petitioners were indeed negligent. Negligence

for purposes of section 6653(a) is the lack of due care or the

failure to do what a reasonable and ordinarily prudent person

would do under the circumstances. Neely v. Commissioner, 85 T.C.

934, 947 (1985). 

Petitioners focus on the computer equipment activity and the 

telecommunications activity and argue first that they cannot be

negligent in claiming their losses therefrom because respondent

has stipulated that the activities were not a sham, that

petitioner had a business purpose, that the investments had

substance, and that petitioner acquired the benefits and burdens

of ownership. We do not agree with petitioners. The consequence

of that stipulation is to limit our inquiry with regard to the

activities to the question of whether petitioners were negligent

in taking the position that petitioner was at risk within the

meaning of section 465(a) with regard to the installment notes. 

With regard to that question, petitioners argue:
- 35 -

Petitioner, who himself was a longtime expert in

structuring leasing transactions, and who relied on the

many professionals associated with the transactions,

including but not limited to * * * [certain] major New

York law firms * * * and independent tax counsel (who

either negotiated, reviewed or drafted the documents in

issue and advised Petitioner) believed that he would be

"at risk" with respect to the Notes he signed in the

transactions. * * * 

As a general rule, the duty of filing accurate returns

cannot be avoided by placing responsibility on a tax return

preparer or other expert. See, e.g., Metra Chem Corp. v.

Commissioner, 88 T.C. 654, 662 (1987). Nevertheless, this Court

has declined to sustain additions to tax under section 6653(a) in

cases in which the taxpayer relied in good faith on the advice of

a tax expert. See, e.g., Woodbury v. Commissioner, 49 T.C. 180,

199 (1967); Brown v. Commissioner, 47 T.C. 399, 410 (1967), affd.

per curiam 398 F.2d 832 (6th Cir. 1968); Donlon I Dev. Corp. v.

Commissioner, T.C. Memo. 1993-374. However, a close examination

of these cases reveals that they raised questions as to the tax

treatment of complex transactions and that the position taken on

the returns with respect to such items had a reasonable basis.

We do not believe that petitioners have satisfied those

criteria. Petitioner is a self-proclaimed expert in structuring

leasing transactions. Therefore, for him, the activities in

question were not complex. Moreover, petitioners have not

carried their burden of showing that petitioner relied on expert

opinion that the at-risk positions in question had a reasonable

basis in law. Petitioner testified that he consulted with
- 36 -

various attorneys and others in structuring certain aspects of

the activities. Nevertheless, he has not convinced us that he

exposed the whole of each activity to a qualified expert and

obtained a reasonable opinion, or any other opinion, as to

whether petitioner was at risk within the meaning of section

465(a). For each of the years in question, we find that

petitioners were negligent in claiming the losses they did from

the activities.

Accordingly, for 1980, we uphold respondent's determination

of an addition to tax pursuant to section 6653(a) and, for 1981

through 1983, we uphold respondent's determination of an addition

to tax pursuant to section 6653(a)(1). Also for 1981 through

1983, we uphold respondent's determinations of additions to tax

pursuant to section 6653(a)(2), except to the extent that such

additions relate to the parties' stipulation that petitioners are

not liable for additions to tax pursuant to that section with

respect to certain portions of the underpayments.

B. Substantial Understatement of Income Tax Liability

Respondent has determined additions to tax under section

6661 for 1982 and 1983. Section 6661(a) provides for an addition

to the tax for any year for which there is a substantial

understatement of income tax. A substantial understatement is

defined as an understatement which exceeds the greater of

10 percent of the tax required to be shown on the return for the

year or $5,000. Sec. 6661(b)(1)(A). The amount of the addition
- 37 -

to tax is 25 percent of the underpayment attributable to a

substantial understatement. Pallottini v. Commissioner, 90 T.C.

498 (1988). The amount of the understatement, however, is

reduced by amounts attributable to items for which (1) there

existed substantial authority for the taxpayer's position, or

(2) the taxpayer disclosed relevant facts concerning the items

with his tax return. Sec. 6661(b)(2)(B).

If, however, the understatement is attributable to a tax

shelter, disclosure of the item will not enable the taxpayer to

avoid the addition, and the substantial authority test will not

apply unless the taxpayer can show that he reasonably believed

the treatment causing the understatement was more likely than not

proper. Sec. 6661(b)(2)(C)(i). The term "tax shelter" includes

"any investment plan or arrangement * * * if the principal

purpose of such * * * plan, or arrangement is the avoidance or

evasion of Federal income tax." Sec. 6661(b)(2)(C)(ii). Section

1.6661-5(b)(iii), Income Tax Regs., interprets the term "tax

shelter" as follows: 

The principal purpose of an entity, plan, or

arrangement is the avoidance or evasion of Federal

income tax if that purpose exceeds any other purpose. 

* * * Typical of tax shelters are transactions

structured with * * * nonrecourse financing * * *. The

existence of economic substance does not of itself

establish that a transaction is not a tax shelter if

the transaction includes other characteristics that

indicate it is a tax shelter.

Section 1.6661-5(a), Income Tax Regs., specifies that, to

meet the reasonable belief standard of section 6661(b)(2)(C)
- 38 -

(i)(II), the taxpayer must reasonably believe at the time the

return is filed that the tax treatment claimed is more likely

than not the proper tax treatment. Section 1.6661-5(d), Income

Tax Regs., specifies where a taxpayer will be considered

reasonably to believe that the tax treatment of an item is more

likely than not the proper tax treatment: First, if the taxpayer

himself analyzes the pertinent facts and authorities and, on the

basis thereof, reasonably concludes that there is a greater than

50-percent likelihood that the tax treatment of the item will be

upheld in litigation with the Internal Revenue Service. Second,

if the taxpayer in good faith relies on the opinion of a

professional tax adviser who makes a similar analysis and

unambiguously states a similar conclusion.

Petitioners bear the burden of proof. Rule 142(a).

The record is clear that there are substantial

understatements in tax for both 1982 and 1983 unless the amounts

that would otherwise be understatements for such years are

reduced pursuant to section 6661(b)(2)(B). Petitioners argue

that there is substantial authority supporting their position

that petitioner was at risk within the meaning of section 465(a)

with regard to both installment notes. Indeed, in Waters v.

Commissioner, T.C. Memo. 1991-462, which involved an equipment

leasing transaction, we found that the taxpayer had substantial

authority for claiming the deductions relating to his

participation in the transaction. Based on that finding, we
- 39 -

concluded that no addition to tax under section 6661 should be

imposed. We did not in Waters consider whether the transaction

constituted a tax shelter. Respondent has made that claim here,

and so we must make certain preliminary determinations before

getting to the question of substantial authority.

We find that both activities constitute tax shelters within

the meaning of section 6661(b)(2)(C)(ii). We are aware that

respondent has stipulated that neither activity was a sham, that

petitioner had a business purpose in entering each, that

petitioner's investments had substance, and that he acquired the

benefits and burdens of ownership. We have taken similar

stipulations into account in finding that a leasing transaction

was not a tax shelter. Martuccio v. Commissioner, T.C. Memo.

1992-311, revd. on other grounds 30 F.3d 743 (6th Cir. 1994);

Epsten v. Commissioner, T.C. Memo. 1991-252. Nevertheless, we

believe that here the principal purpose of both activities was

the avoidance of Federal income tax. Both activities produced

substantial tax losses for the years in question. Both involved

nonrecourse financing. The circular flow of matching payments,

combined with the nonrecourse nature of the underlying debt,

meant that any personal liability of petitioner's on the

installment notes was at best contingent and theoretical during

the years in issue. Petitioner enjoyed indemnities and deferral

provisions. If petitioner bore any risk at all with respect to

either installment note, it could only have ripened into a
- 40 -

present obligation at the end of the relevant deferral period. 

Accordingly, there was little substance to the risk of loss that

the installment notes, in form, presented. Indeed, the financial

structure of both activities was designed to give the impression,

but not to reflect the reality, of petitioner's being at risk

with respect to the installment notes. The middle company, Proz,

was inserted into each activity solely for tax reasons;

petitioner has failed to convince us that Proz was organized or

utilized for any purpose but to avoid the adverse application of

section 465. Our overall impression of both activities is that

each is inconsistent with Congress' purpose, writ large in every

aspect of section 465, to limit a taxpayer's losses to amounts

for which he is really at risk. The structure and operation of

both activities is indicative that petitioner's principal purpose

with regard to each was the avoidance of Federal income tax. See

sec. 1.6661-5(b)(2), Income Tax Regs. Moreover, petitioner has

not shown us that his business purpose in entering either

activity exceeded the obvious purposes of tax avoidance. 

Petitioner has proposed no findings that, either on a before-tax

or after-tax basis, detail his financial expectations. 

Petitioner clearly paid very little attention to the activities

once they were up and running and his risk of personal liability

had been eliminated, or at least postponed. Petitioner has

stipulated that Sha-Li's bookkeeper did not tell him about the

wrong-way flow of funds in the telecommunications equipment
- 41 -

activity because she believed that "he had more important things

to be concerned with". The parties to the two activities missed

payments for months on end. For the reasons stated, we are

convinced that both activities constitute tax shelters within the

meaning of section 6661(b)(2)(C)(ii).

Because both activities constitute tax shelters, petitioner

cannot rely on substantial authority unless, at the time the 1982

and 1983 returns were filed, he reasonably believed that the tax

treatment claimed was more likely than not the proper tax

treatment. See sec. 6661(b)(2)(C)(i)(II); sec. 1.6661-5(a),

Income Tax Regs. Petitioner testified that, in both activities,

he acquired the equipment in question through Proz in order to

satisfy his and certain of his advisers' concerns regarding

section 465. We have no doubt that petitioner and his advisers

considered the tax results to petitioner of both activities. 

Nevertheless, there is no evidence for us to find that petitioner

analyzed the pertinent facts and authorities and, in the manner

contemplated in section 1.6661-5(d)(1), Income Tax Regs.,

reasonably concluded that there was a greater than 50-percent

likelihood that the tax treatment of the claimed losses from

either the computer equipment activity or the telecommunications

activity would be upheld in litigation. Also, there is no such

unambiguous opinion from a tax adviser. See sec. 1.6661-5(d)(2),

Income Tax Regs. Accordingly, we find that petitioner did not

reasonably believe when petitioners filed the returns in question
- 42 -

that the tax treatment of the items giving rise to the losses

from either the computer equipment activity or the

telecommunications activity was more likely than not the proper

treatment.

Accordingly, petitioners cannot claim that there was

substantial authority that would allow them to reduce the amounts

of understatements on their returns. See sec. 6661(b)(2)(b)

and (c). Other than substantial authority, petitioners have set

forth no other pertinent defenses to the additions for

substantial understatement of liability. We find that

petitioners are liable for such additions as determined by

respondent.

III. Increased Interest

Respondent also seeks increased interest pursuant to section

6621(c). That section provides for an increase in the interest

rate to 120 percent of the statutory rate on underpayments of tax

if a substantial understatement is due to a tax-motivated

transaction. Certain transactions are deemed to be "tax 

motivated" by section 6621(c)(3), including any loss disallowed

under section 465(a). Sec. 6621(c)(3)(A)(ii). Since we have

concluded that the loss deductions in issue stemming from the

installment notes are disallowed under section 465(a), we also

find that the activities were tax-motivated transactions, and

respondent is entitled to additional interest on the interest 
- 43 -

accruing on the portion of the underpayments attributable to such

transactions after December 31, 1984.

Decisions will be entered

under Rule 155.