1995 Decisions

Opinions of the United

States Court of Appeals

for the Third Circuit

7-24-1995

Nicholson v Commissioner IRS

Precedential or Non-Precedential:

Docket 94-7688

Follow this and additional works at: http://digitalcommons.law.villanova.edu/thirdcircuit_1995

This decision is brought to you for free and open access by the Opinions of the United States Court of Appeals for the Third Circuit at Villanova

University School of Law Digital Repository. It has been accepted for inclusion in 1995 Decisions by an authorized administrator of Villanova

University School of Law Digital Repository. For more information, please contact Benjamin.Carlson@law.villanova.edu.

Recommended Citation

"Nicholson v Commissioner IRS" (1995). 1995 Decisions. Paper 192.

http://digitalcommons.law.villanova.edu/thirdcircuit_1995/192
1 

UNITED STATES COURT OF APPEALS 

FOR THE THIRD CIRCUIT 

No. 94-7688

CHARLES E. NICHOLSON, JR. and 

MARGARET K. NICHOLSON, 

 Appellants 

v. 

COMMISSIONER OF INTERNAL REVENUE SERVICE 

On Appeal from a Decision 

of the United States Tax Court 

Tax Court No. 3343-92 

T.C. Memo 1994-280 

Argued: June 8, 1995 

Before: BECKER, NYGAARD, and ALITO, Circuit Judges

(Opinion Filed: July 24, 1995) 

____________________ 

 BARRY A. FURMAN, ESQ. 

 MARK S. HALPERN, ESQ. (Argued) 

 FURMAN & HALPERN, P.C. 

 401 City Avenue, Suite 612 

 Bala Cynwyd, PA 19004 

 Attorneys for Appellants

 LORETTA C. ARGRETT 

 Assistant Attorney General

 GARY R. ALLEN 

 RICHARD FARBER 

 THOMAS J. CLARK (Argued) 

 Tax Division 

 Department of Justice 

 Post Office Box 502 

 Washington, D. C. 20044 

 Attorneys for Appellee

____________________ 

OPINION OF THE COURT 
2 

____________________ 

ALITO, Circuit Judge: 

 The genesis of this appeal is a decision by the 

Commissioner of the Internal Revenue Service ("the Commissioner") 

to disallow certain deductions claimed by Charles and Margaret 

Nicholson on their 1983, 1984, 1985, and 1986 tax returns 

regarding computer equipment that Charles Nicholson acquired in 

1983. The Commissioner maintained that the Nicholsons were not 

entitled to take the deductions because Charles Nicholson was not 

"at risk" regarding a promissory note that he gave in partial 

payment for the equipment. Prior to a trial before the tax court 

on the propriety of these deductions, the parties settled on 

terms generally favorable to the Nicholsons. The Nicholsons 

subsequently filed a motion for litigation costs pursuant to 

I.R.C. § 7430, arguing that the Commissioner's position in the 

underlying proceedings was not "substantially justified." The 

tax court disagreed and refused to award litigation costs. We 

now reverse and remand for further proceedings. 

I.0

 

0Because the underlying case was settled, there is no stipulation 

or other formal evidence pertaining to the transactions involved 

in this case. See Nicholson v. Commissioner, T.C. Memo. 1994-280 

at 3 n.2 (1994). In this opinion, we generally rely on the tax 

court's findings of fact as they are neither challenged nor 

clearly erroneous. See Kenagy v. United States, 942 F.2d 459, 

463 (9th Cir. 1991). Where necessary, we also rely on undisputed 

evidence in the record on appeal. 
3 

 This case involves the propriety of deductions that the 

Nicholsons claimed in regard to the purchase of certain computer 

equipment. Nicholson0 acquired the equipment in 1983 from its 

original purchaser, Equipment Leasing Exchange, Inc. ("ELEX"). 

Nicholson v. Commissioner, T.C. Memo. 1994-280 at 3 (1994). ELEX 

had purchased the equipment in 1983 for $362,168. Id. In order 

to finance the purchase, ELEX obtained two nonrecourse loans from 

the Hershey Bank ("the Bank"). Id. ELEX subsequently leased the 

equipment to the Milton Hershey School ("the School") for a term 

of six years. Id. The lease provided for monthly rental income 

of $7,478. Id. As a condition of the two loans, ELEX granted 

the Bank a security interest in the computer equipment and the 

lease. Id.

 Nicholson purchased the lease and the equipment from ELEX for 

$386,798. Id. In partial payment of the purchase price, 

Nicholson executed and delivered to ELEX three promissory notes, 

in the amounts of $17,500, $20,378, and $336,195. Id. The first 

two notes were payable on March 15, 1984, and March 15, 1985, 

respectively. Id. Both notes explicitly provided ELEX a right 

of recourse against Nicholson personally in the case of default. 

Id. The third note required repayment in monthly installments of 

$7,348.80. Id. at 4. Unlike the first two notes, however, the 

third note was silent as to whether ELEX had a right of recourse 

 

0Both Charles Nicholson and his wife, Margaret Nicholson are 

parties to this action by virtue of filing joint tax returns. All 

the transactions at issue here, however, involve only Charles 

Nicholson. For convenience, "Nicholson," when used in the 

singular, refers only to Charles Nicholson. 
4 

against Nicholson. Id. All three notes were secured by the 

equipment and the lease, subject to the Bank's priority security 

interest. Id.

 In 1991, the Internal Revenue Service ("IRS") audited the 

Nicholsons' 1983, 1984, 1985, and 1986 tax returns. Initially, 

the IRS District Director took the position that deductions 

claimed by the Nicholsons with regard to the leasing activity 

should be disallowed because the leasing activity was not an 

activity entered into for profit since it had no economic or 

business purpose. Joint Appendix ("JA") at 62-65. The 

Nicholsons appealed this determination to the IRS Appeals Office. 

Id. at 65. 

 The Appeals Office agreed with the Nicholsons' argument that 

the leasing activity did have an economic purpose. Id. However, 

the Appeals Office sua sponte raised an alternative basis for 

denying the Nicholsons' deductions. The Appeals Office ruled 

that Nicholson was not "at risk" within the meaning of I.R.C. 

§465 as to the money borrowed under the third note. Id. 

Pursuant to section 465, an owner of depreciable property may 

only deduct up to the total amount of the economic investment in 

the property (i.e., the amount that is "at risk"). 

 Subsequently, on December 11, 1991, the Commissioner issued a 

Notice of Deficiency to the Nicholsons. Like the Appeals Office, 

the Commissioner asserted that the Nicholsons' deductions were 

barred by section 465's "at risk" requirement. According to the 

Commissioner, Nicholson was not "at risk" as to the third note 1) 

because it was nonrecourse; 2) because ELEX did not borrow funds 
5 

on a recourse basis from the Bank on its purchase of the 

equipment and therefore ELEX would have no motive to pursue 

Nicholson if he defaulted on the third note; and 3) because the 

lease payments from the School were sufficient to cover the 

installment payments required under the third note. Id. at 64-

65; see id. at 121-25; Nicholson, T.C. Memo. 1994-280 at 7-8 n.7. 

 The deficiencies were for income taxes for the calendar years 

1983, 1984, 1985, and 1986 in the amounts of $3,660, $25,179, 

$20,385, and $21,180 respectively. Nicholson, T.C. Memo. 1994-

280 at 2. The Commissioner also assessed an interest penalty 

against the Nicholsons under I.R.C. § 6621(c), believing that the 

underpayment was due to a tax-motivated transaction. Id.

 The Nicholsons then filed a Petition for Redetermination with 

the tax court on February 14, 1992. On February 1, 1994, the 

parties filed a Stipulation of Settled Issues ("the Settlement") 

with the Tax Court that provided: 

 The Parties hereby agree to the following 

settlement of the issues in the above-entitled case: 

 1. It is agreed for purposes of settlement that 

petitioners' claimed losses with respect to their 

activity in the Hershey transaction during the years 

1983 through 1985 shall be disallowed subject to their 

deductibility as provided below; 

 2. It is agreed for settlement purposes that 

petitioners were at risk as defined under I.R.C. 

Section 465 on the installment note in the amount of 

$336,195.00 with respect to their activity in the 

Hershey transaction beginning in 1986 and are entitled 

to suspended losses beginning in 1986; 

 3. It is agreed for purposes of settlement that 

petitioners are required to include in taxable income 

for taxable year ended December 31, 1983 the amount of 

$18,300.00 which represents the amount of Schedule E 
6 

loss disallowed on petitioners' investment in Hershey 

and Cyclops0 in 1983; 

 4. It is agreed for the settlement that 

petitioners are required to include in taxable income 

for taxable year ended December 31, 1984 the amount of 

$42,024.00 which represents the amount of Schedule E 

loss disallowed on petitioners' investment in Hershey 

and Cyclops in 1983; 

 5. It is agreed for the settlement that 

petitioners are required to include in taxable income 

for taxable year ended December 31, 1985 the amount of 

$72,341.00 which represents the amount of Schedule E 

loss disallowed on petitioners' investment in Hershey 

and Cyclops in 1983; 

 6. It is agreed for the settlement that for the 

taxable year ended December 31, 1986, petitioners are 

entitled to deduct $81,723.00 with respect to their 

investment in the Hershey transaction as a suspended 

loss under I.R.C. Section 465; 

 7. It is agreed for purposes of settlement that 

respondent concedes increased interest under I.R.C. 

Section 6621(c), formerly, 6621(d) for all issue years. 

Id. at 4-5. 

 The net effect of this Settlement was that the Nicholsons 

were not able to take the deductions claimed in 1983, 1984, and 

1985, but were able to carry these amounts forward and take them 

as a deduction in 1986.0 In addition, the Nicholsons were not 

liable for an increased interest penalty under section 6621(c). 

The Settlement was therefore quite favorable to the Nicholsons. 

 

0The "Cyclops" issue is an unrelated matter that was not 

contested by the Nicholsons. According to the tax court, the 

Commissioner conceded that it was not a significant issue. See

Nicholson, T.C. Memo. 1994-280 at 5 n.3. 

0A taxpayer does not forfeit a deduction due to the operation of 

section 465's "at risk" requirement. Rather the deduction 

becomes suspended and may be taken when the taxpayer actually 

becomes "at risk" for the amount of the deduction. See I.R.C. 

§465(a)(2). 
7 

Although the Commissioner's Notice of Deficiency alleged that 

Nicholson owed over $70,000 for the 1983-1986 period, under the 

Settlement the Nicholsons appear to have been assessed only a net 

deficiency of between $2,500 and $4,000.0 Id. at 6 & n.4. 

 The Commissioner's willingness to settle on these terms 

appears due to two significant developments. First, the 

Commissioner changed her position on whether the third note 

provided for recourse. Although the Commissioner initially 

maintained that because this note was silent as to recourse the 

underlying loan was nonrecourse, the Commissioner abandoned this 

theory because New Jersey law, which controls the terms of the 

note, clearly provides that a note is presumptively recourse. Id.

at 7-8 n.7; JA at 125; see N.J. Stat. Ann. § 12A:9-505(2). 

Second, after issuing the Notice of Deficiency, the Commissioner 

learned that ELEX in 1986 had fully repaid its loan to the Bank. 

JA at 125; Brief for the Appellee ("Comm. Br.") at 20 n.7. Thus, 

the Commissioner conceded that Nicholson was at risk as of 1986 

because ELEX would have certainly exercised its right of recourse 

against Nicholson for any default by Nicholson on the third 

note.0

 

0Although not clear from the Settlement or the record, it seems 

that the only benefit that the Commissioner received from the 

Settlement was that the Nicholsons had to pay interest (but not a 

penalty) on the deductions that they claimed for 1983, 1984, and 

1985 until they were able to take these deductions in 1986. In 

other words, because the Settlement disallowed the Nicholsons' 

deductions in 1983, 1984, and 1985, but allowed them to carry 

these deductions forward and take them in 1986, the Nicholsons 

owed interest for having use of the money for a period when they 

were not entitled to it. 

0Nicholson, however, did not concede in the Settlement that he 

was not "at risk" in 1983, 1984, and 1985. 
8 

 Following the Settlement, the Nicholsons filed a motion to 

recover their litigation costs pursuant to I.R.C. § 7430. After 

surveying the background of this litigation, the tax court began 

its analysis by observing that in order to be entitled to an 

award of costs, the Nicholsons needed to demonstrate that they 

were a "prevailing party" as defined by section 74300 and that 

they complied with that provision's procedural requirements.0

Nicholson, T.C. Memo. 1994-280 at 6. Thus, the Nicholsons needed 

to establish that: 

(1) [t]hey exhausted all administrative remedies, (2) 

they met the net worth requirement of section 

7430(c)(4)(A)(iii), (3) they ha[d] substantially 

prevailed with respect to the amount in controversy or

most significant issues, and (4) the position of the 

United States was "not substantially justified." 

 

0I.R.C. § 7430(a) provides for the award of "reasonable 

administrative costs" and "reasonable litigation costs" to a 

"prevailing party" in connection "with the determination . . . of 

any tax." I.R.C. § 7430(c)(4)(A) defines a "prevailing party" as 

a party: 

 (i) which establishes that the position of the United 

States in the proceedings was not substantially 

justified, 

 (ii) which-- 

 (I) has substantially prevailed with respect to 

the amount in controversy, or 

 (II) has substantially prevailed with respect to 

the most significant issue or set of issues 

presented, and 

 (iii) [is an individual whose net worth does not 

exceed $2,000,000 at the time the civil action was 

filed]. 

0I.R.C. § 7430(b) requires that an award of litigation costs 

"shall not be awarded . . . unless the court determines the 

prevailing party has exhausted the administrative remedies 

available to such a party within the Internal Revenue Service." 
9 

Id. (emphasis in original). 

 The tax court found that the Nicholsons had met the first two 

conditions. Id. Turning to the third condition, the tax court 

noted that the Commissioner's brief merely stated that the 

Nicholsons "may in fact be able to prove that they meet the 

alternative requirement of that condition namely the amount in 

controversy or the most significant issues." Id. Although the 

tax court appeared to indicate that the Nicholsons had satisfied 

this condition by virtue of the small net deficiency assessed 

against them under the Settlement and the Commissioner's apparent 

waiver, the court decided not to resolve this issue because it 

believed that the fourth condition was determinative. Id.

 As to the fourth condition, the tax court noted that a 

determination of whether the Commissioner's position was not 

substantially justified depends upon an 

examination of all the facts and circumstances to 

determine if that position had a reasonable basis in 

law and fact. Price v. Commissioner, [T.C. Memo. 1995-

187 at 3 (1994)]. Petitioners bear the burden of 

proof. [Tax Court] Rule 232(e); Estate of Wall v. 

Commissioner, 102 T.C. 391, 393 (1994). 

Id. at 7. The tax court therefore focused its attention on the 

arguments that each party had advanced in the underlying 

proceeding on the issue of whether Nicholson was at risk on the 

third note. As noted above, the Commissioner, after conceding 

that the third note provided ELEX with the right of recourse 

against Nicholson personally, see id. at 7-8 n.7, nevertheless 

continued to assert that Nicholson was not "at risk" because (1) 

the obligations of ELEX to the Bank were nonrecourse and (2) the 
10 

lease payments from Hershey nearly offset Nicholson's obligation 

to ELEX. In particular, the Commissioner relied on a number of 

cases in which these two elements were present and taxpayers were 

found not to be "at risk." Id. at 7. The Nicholsons, on the 

other hand, maintained that these two elements were not by 

themselves dispositive in the "at risk" analysis. Id. at 8. 

Rather, the Nicholsons argued that ELEX would have exercised its 

right of recourse on the third note if the transaction had become 

unprofitable. Id.

 The tax court found that the Commissioner's position was 

substantially justified. The tax court wrote: 

 [The Commissioner] relies on the galaxy of cases 

where the two elements relied upon by [the Nicholsons] 

were present and where the taxpayers therein were held 

not to be at risk. Those cases, as well as other cases 

cited by [the Commissioner], are analyzed in some 

detail in Thornock v. Commissioner, [94 T.C. 439, 453 

(1990)], and Wag-A-Bag Inc. v. Commissioner, [T.C. 

Memo. 1992-581 (1994)], which analyses reveal that 

those cases involved elements in addition to the 

presence of nonrecourse obligations at an earlier stage 

and offsetting payments. Thus, the message which such 

cases convey is murky at best. In any event, we are 

not prepared to say that they do not furnish some basis 

for [the Commissioner's] position on the substantive 

issue involved herein. 

Id. at 8-9. The court then concluded: 

 In short, the two elements upon which the parties 

herein have focused their arguments are not 

automatically dispositive of the "at risk" issue. Two 

non per se elements do not amount to one per se element 

either for or against [the Nicholsons]. To be sure, it 

is entirely possible that, had the instant case gone to 

decision on the substantive risk issue, we would have 

resolved that issue in favor of [the Nicholsons]. But 

that result would not have necessarily entitled 

petitioners to recover litigation costs under section 

7430. It is clearly established that the fact that the 

respondent loses a significant issue, whether by 
11 

concession or after trial, is not determinative that 

her position was reasonable. Price v. Commissioner, 

supra. 

* * * 

 The long and the short of the matter is that, 

taking into account all the facts and circumstances 

herein, we are not persuaded that [the Nicholsons] have 

carried their burden under section 7430. 

Id. at 9, 11. 

 This appeal followed. 

 

II.

 We begin with the main issue of contention between the 

litigants. In order to demonstrate that the position taken by 

the United States was not "substantially justified," the 

Nicholsons have the burden of showing that the government's 

position was not "justified to a degree that could satisfy a 

reasonable person" or had no "reasonable basis both in law and 

fact . . . ." Lennox v. Commissioner, 998 F.2d 244, 248 (5th 

Cir. 1993) (quoting Pierce v. Underwood, 487 U.S. 552, 563-565 

(1988)); see 26 C.F.R. § 301.74305-5(c); see also Rickel v. 

Commissioner, 900 F.2d 655, 666 (3d Cir. 1990) (rejecting a 

taxpayer's claim for costs award where "Commissioner's position 

could be deemed as reasonably supported in the case law"). The 

Nicholsons' burden is also increased by this court's standard of 

review: the tax court's denial of a taxpayer's motion for an 

award of costs under section 7430 is reviewed for an abuse of 

discretion. Rickel, 900 F.2d at 666; Accord Pierce, 487 U.S. 
12 

563-65 (abuse of discretion review proper for awards under the 

Equal Access to Justice Act). 

 We will structure our discussion of this issue as follows. In 

Part II.A., we will analyze I.R.C. § 465, the code provision upon 

which the Commissioner relied in assessing the deficiency against 

the Nicholsons. In Part II.B., we will examine the position 

taken by the Commissioner in the underlying litigation (i.e., the 

theory advocated by the Commissioner in support of the deficiency 

assessment). Finally, In Part II.C., we will determine whether 

the Commissioner's position was reasonable in light of the 

substantive law and consequently whether the tax court abused its 

discretion in denying the Nicholsons' motion for costs. 

 A. I.R.C. § 465 limits the ability of taxpayers to claim 

deductions resulting from the ownership of depreciable property. 

Section 465 was enacted because of the proliferation of tax 

shelters in the 1970's. Before the enactment of section 465, 

investors could take advantage of quick depreciation rules plus 

the deductibility of interest on nonrecourse debt to generate 

large "losses" in order to offset personal income.0

 

0Professor Chirelstein provides the following lucid explanation 

of the way in which these tax shelters operated: 

 In conventional form, the shelter consists of 

highly leveraged real estate in which individual 

investors participate as limited partners. The limited 

partners make initial cash payments to the shelter 

promoters which are largely absorbed by commissions, 

fees and similar charges, while the cost of the 

property itself is financed through a mortgage loan 

from a bank, insurance company or other institution. 

The loan is nonrecourse, but, under the Crane rule, the 
13 

 Section 465 attacks these practices directly. Pursuant to 

section 465, a taxpayer may only take deductions up to the amount 

"at risk" in the activity. A taxpayer is considered to be at 

risk for the amount "contributed" to the activity and for the 

amount of money "borrowed" for use in the activity. I.R.C. 

§465(b)(1). However, for purposes of section 465, an amount is 

considered borrowed only if the taxpayer is either "personally 

liable for repayment" or has pledged other personal property as 

 

limited partners are entitled to treat the borrowed 

amount as if it were a personal loan and hence, to 

include the indebtedness in basis. Rents received by 

the partnership are then expected to cover mortgage 

principal and interest requirements plus management 

fees. Sometimes, but not always, there is a small 

annual cash return to the investors. 

 [T]he combination of (a) accelerated depreciation 

and (b) deductible interest on the nonrecourse mortgage 

loan inevitably generates substantial "losses" during 

the earlier years of the enterprise. Such losses are 

of course tax artifacts. If true economic depreciation 

were substituted for accelerated depreciation, then, 

usually, the enterprise would operate at or close to a 

break-even level--there would be no deductible "loss" 

to report--and the investment from the standpoint of 

the limited partnership would have little purpose. The 

same result would arise if (while leaving accelerated 

depreciation untouched) otherwise deductible interest 

were deferred or disallowed as under Code § 265(a)(2). 

In fact, however, nether limitation was imposed. 

Instead, high-bracket taxpayers were enabled 

(encouraged) to combine tax-exempt income with taxdeductible borrowing and, by so doing, to reduce their 

taxable income to a minimum. The "loss" resulting from 

the shelter investment would be offset against income 

from other sources (chiefly personal services), even 

though the taxpayer himself would have lost little or 

nothing in economic terms. 

Marvin A. Chirelstein, Federal Income Taxation 259-60 (6th ed. 

1991). 
14 

"security for the borrowed amount (to the extent of the net fair 

market value of the taxpayer's interest in such property)." Id.

at § 465(b)(2)(A) and (B). Section 465 also contains a catch-all 

provision that provides: 

Notwithstanding any other provision of this section, a 

taxpayer will not be considered at risk with respect to 

the amounts protected against loss through nonrecourse 

financing, guarantees, stop loss agreements, or other 

similar arrangements. 

Id. at § 465(b)(4) (emphasis added). The Commissioner--conceding 

that the note that Nicholson gave to ELEX was recourse and 

moreover, that he was not protected by any guarantees or stop 

loss agreements--argued in the proceedings below that the 

peculiarities of the leasing agreement involved "other similar 

arrangements" sufficient to render him immune from any risk. 

 Although the Internal Revenue Code does not define the term 

"other similar arrangements," the meaning of this phrase has been 

addressed by several other courts of appeals. The majority of 

these courts have applied the "economic reality" test to 

determine whether a taxpayer is protected from loss by "other 

similar arrangements." Under this approach, a transaction is 

deemed not "at risk" if it is structured "to remove any realistic 

possibility that the taxpayer will suffer an economic loss if the 

transaction turns out to be unprofitable." American Principals 

Leasing Corp. v. United States, 904 F.2d 477, 483 (9th Cir. 

1990). See also Waters v. Commissioner, 978 F.2d 1310, 1315 (2d 

Cir. 1992), cert. denied, 113 S. Ct. 1814 (1993); Young v. 

Commissioner, 926 F.2d 1083, 1088 n.11 (11th Cir. 1991); Moser v. 
15 

Commissioner, 914 F.2d 1040, 1048 (8th Cir. 1990). The Sixth 

Circuit, by contrast, has employed the "worst case scenario" test 

to determine whether a taxpayer is protected from loss by an 

"other similar arrangement." Martuccio v. Commissioner, 30 F.3d 

743, 749 (6th Cir. 1994). This test is more favorable to 

taxpayers than the economic reality test, as it holds that a 

taxpayer is "at risk" unless there are no circumstances in which 

he could suffer a loss in the transaction. Id. Although this 

court has yet to address this issue, we agree with the 

Commissioner that the reasonableness of her position should be 

evaluated under the economic reality test as it has been adopted 

by the overwhelming majority of the courts to address the issue. 

Whether or not we would adopt in a case in which we were required 

to decide whether certain deductions were proper, we believe that 

if the Commissioner satisfied the economic reality test here, her 

position had a reasonable basis in law.0

 B. We now turn to the position taken by the Commissioner in 

the proceedings below.0 As noted, the Commissioner asserted that 

Nicholson was not "at risk" on the amount of the third note 

 

0We emphasize that we do not purport to adopt the economic 

reality test as the law of this circuit. 

0In this context, the "position of the United States" is the 

position taken by the Commissioner in the underlying tax court 

proceeding and, with respect to an administrative proceeding 

before the IRS, the position taken by the IRS as of the earlier 

of the date of the Notice of Deficiency or the date of receipt by 

the taxpayer of the Notice of Decision by the Appeals Office. 

I.R.C. § 7430(c)(7). Because the record does not show that the 

Nicholsons received a Notice of Decision by the Appeals Office, 

the inquiry as to the position asserted by the United States 

begins at the time that the Nicholsons receive the Notice of 

Deficiency. 
16 

because the structure of the leasing arrangement was an "other 

similar arrangement" within the meaning of section 465(b)(4). 

After abandoning the position that the third note was 

nonrecourse, the Commissioner relied on two separate aspects of 

the leasing agreement to support this argument. First, the 

Commissioner pointed to the fact that the rental payments due 

from the School on its lease were almost exactly the same amount 

as the monthly payments Nicholson owed ELEX under the terms of 

the third note. Second, the Commissioner pointed to the fact 

that the loan between the Bank and ELEX was nonrecourse and that 

the Bank had a priority security interest on the equipment. 

According to the Commissioner, these two factors were sufficient 

to demonstrate that Nicholson was not "at risk" on the third note 

for the following reasons: 

 It is evident, therefore, that the School was the 

ultimate obligor for the payments that would be used 

for the purchase of the computer equipment and that 

would be received by the Bank, as the ultimate obligee. 

In other words, at the end of the day the School owed 

rent to taxpayer, who would use those rental payments 

to satisfy his obligations on the note to ELEX, which, 

in turn, would use those payments to satisfy the 

obligations to the Bank. Taxpayer was merely the 

conduit through which payments made by the School were 

funnelled to their ultimate destination, the Bank. If 

the School, the end user, ever stopped paying rent to 

taxpayer, then the Bank would not be paid. Since 

ELEX's note to the Bank was nonrecourse, the Bank's 

sole remedy would be to foreclose on the computer 

equipment. In that event, ELEX would have suffered no 

economic loss, and therefore would have no incentive to 

pursue the taxpayer for payment on his $366,195 note. 

In these circumstances, it was reasonable to maintain, 

as the Commissioner did until the settlement of this 

case, that there was no "realistic possibility" that 

the taxpayer would suffer a loss on that note. 
17 

Comm. Br. at 17 (emphasis added). The Commissioner, however, did 

concede in the underlying proceedings that even under this theory 

that Nicholson was "at risk" on the third note after 1986, when 

ELEX paid off its loan from the Bank. Id. at 20 & n.7. 

 C. In light of this understanding of section 465 and the 

theory underlying the Commissioner's position, we now assess the 

reasonableness of her position. We find that the Commissioner's 

position is not supported in law or fact and is therefore 

unjustified. 

 We understand the Commissioner's theory as follows. Should 

the School default on the lease or refuse to meet its contractual 

obligations on account of a dispute regarding the computer 

equipment--both realistic possibilities in any business 

transaction like this one--Nicholson would be unable to pay ELEX. 

ELEX in turn might not then pay the Bank, causing the Bank to 

respond by foreclosing on the equipment itself, as it had no 

right of recourse against ELEX. With this much, we agree. 

However, the Commissioner goes on to argue that ELEX would not 

pursue Nicholson for his failure to repay the third note because 

ELEX suffered no "economic loss," as the Bank was forced to 

foreclose on the equipment rather than sue ELEX directly. We 

find no support in logic for this argument. Although ELEX could 

conceivably suffer no economic loss as a result of Nicholson's 

inability to make his payments under the third note, ELEX would 

still have incentive to sue Nicholson and obtain the outstanding 

balance of the note (which could amount to several hundred 
18 

thousand dollars).0 Thus, the Commissioner's theory does not 

provide any reason why ELEX would fail to act like an ordinary 

creditor in this situation and enforce the outstanding obligation 

owed to it by Nicholson. 

 Furthermore, the Commissioner's critical assumption that ELEX 

would suffer no "economic loss" is without foundation in the 

record. ELEX could have chosen to make larger payments than 

required under the terms of its loan from the Bank in order to 

pay-off the loan early. Indeed, this appears to have happened 

 

0At oral argument, counsel for the Commissioner asserted, for the 

first time, that ELEX would not want to enforce the terms of the 

third note in the case of a default by Hershey and Nicholson 

because this would give ELEX an unfavorable reputation in the 

community and therefore ELEX would be unable to engage in this 

type of transaction in the future. Because this argument was 

neither presented to the tax court nor in the Commissioner's 

brief, we need not consider it on appeal. See Lim v. Central 

DuPage Hosp., 871 F.2d 644, 648 (7th Cir. 1989) ("oral argument 

in this court . . . [is] too late for advancing new (or what is 

the same thing, reviving abandoned" argument)). Moreover, there 

is absolutely no support in the record for this assertion. As 

the tax court observed in Powers v. Commissioner, 100 T.C. 457, 

473 (1993), the Commissioner's position "lack[s] a reasonable 

basis in fact and law" when it has "no factual basis and [the 

Commissioner has] made no attempt to obtain information about the 

case before adopting the position." 

 We also note that counsel for the Nicholsons persuasively 

responded that ELEX would have incentive to pursue Nicholson for 

the outstanding value of the third note in the case of default. 

First, a portion of the third note represents the profits due to 

ELEX from the sale of the equipment and lease, and ELEX would 

certainly be entitled to this amount. Second, in order to 

maintain its ability to borrow on a nonrecourse basis from the 

Bank, ELEX would have incentive to act as an agent for the Bank 

and make sure that the Bank had not lost money as a result of the 

transaction. In the case of quickly obsolescent property such as 

computer equipment, the Bank's security interest in the equipment 

could easily be insufficient to cover the outstanding balance of 

its loan to ELEX. Thus, ELEX would have incentive to sue 

Nicholson for the shortfall. 
19 

here, as ELEX prepaid the loan from the Bank. In such a case, 

the proceeds from the Bank's repossession and sale of the 

equipment (minus the Bank's priority security interest) would not 

necessarily be sufficient to cover ELEX's extra payments. Thus, 

the record provided the Commissioner with no basis for presuming 

that ELEX would not suffer any economic loss should the lease 

have become unprofitable. See Lennox, 998 F.2d at 248-49 

(Commissioner's position must be supported by record evidence in 

order to be substantially justified). 

 The inadequacy of the Commissioner's position is apparently 

due to her failure to properly develop the case against the 

Nicholsons before issuing the Notice of Deficiency.0 The 

Commissioner cannot have a "reasonable basis in both fact and law 

if it does not diligently investigate a case." Powers v. 

Commissioner, 100 T.C. 457, 473 (1993); see United States v. 

Estridge, 797 F.2d 1454, 1458 (8th Cir. 1986) (award for 

litigation costs granted where Commissioner did not diligently 

investigate). When issuing the Notice of Deficiency, the 

Commissioner believed--incorrectly--that the third note between 

ELEX and Nicholson was nonrecourse because it was silent on its 

face as to recourse while the other two notes explicitly provided 

for recourse. See JA at 125. Even a cursory analysis of New 

 

0The Commissioner argues that anything that happened before the 

Notice of Deficiency is irrelevant to this case because under 

I.R.C. § 7430(c)(7), the position of the Commissioner is 

determined only after the date of the Notice of Deficiency. We 

disagree. As the Fifth Circuit explained in Lennox, 998 F.2d at 

248, the sufficiency of the position taken by the Commissioner 

after the Notice of Deficiency must be analyzed in the context of 

what caused her to take that position. 
20 

Jersey law would have revealed the deficiency in this position. 

See N.J. Stat. Ann. § 12A:9-505(2). Given the logical weakness 

of the theory eventually relied upon by the Commissioner, we are 

skeptical that the Notice would have been issued had the 

Commissioner been accurately appraised of New Jersey law. 

 Moreover, the Commissioner's position at the time of the 

Notice of Deficiency with regard to the Nicholsons' 1986 tax 

deduction was clearly not justified. In the Notice, the 

Commissioner maintained that Nicholson was not at risk in 1986. 

However, the Commissioner later conceded that because ELEX paid 

off the Bank in 1986, Nicholson was "at risk" at that time. The 

Commissioner could have discovered this fact had she adequately 

investigated the case before issuing the Notice.0 See Portillo 

v. Commissioner, 988 F.2d 27, 29 (5th Cir. 1993) (ruling that a 

Notice of Deficiency without any factual foundation is "clearly 

erroneous as a matter of law"). 

 The Commissioner seeks to overcome these deficiencies and 

justify the reasonableness of her position by citing a number of 

cases in which courts found that a taxpayer who borrowed money as 

part of a complex leasing transaction was not "at risk" for the 

borrowed amount. See Waters, 978 F.2d at 1317; Young, 926 F.2d 

at 1088 n.11 (11th Cir. 1991); Moser, 914 F.2d at 1048; American 

Principals Leasing Corp., 904 F.2d at 483; see also Thornock v. 

 

0The Commissioner can hardly blame the Nicholsons for not 

providing her with this information because the "at risk" issue 

was raised by the Appeals Office sua sponte, and no further 

investigation appears to have been conducted before the Notice 

was issued. JA at 65-66. 
21 

Commissioner, 94 T.C. 439 (1990); Wag-A-Bag, Inc. v. 

Commissioner, T.C. Memo. 1992-581 (1992). The Commissioner 

correctly notes that in these cases, the two factors eventually 

relied upon by the Commissioner were relevant to the 

determination of whether an amount was "at risk." However, the 

determinative factor in these cases was that the parties, through 

the use of nonrecourse financing and lease assignments, were able 

to create a circular web of offsetting liabilities, thereby 

effectively removing risk from the taxpayer claiming the 

deduction. See Waters, 978 F.2d at 1317 ("circular, matching 

payment obligations"); Young, 926 F.2d at 1083 ("circular 

sale/leaseback transactions"); Moser, 914 F.2d at 1049 ("circular 

nature of the arrangement" and "offsetting bookkeeping entries"); 

American Principals Leasing Corp., 904 F.2d at 483 ("circular 

obligations" and "chain of payments"); see generally Thomas A. 

Pliskin, How Circular Transactions and Certain Interests of 

Lenders Affect Amounts of Risk, 12 J. Partnership Tax. 54, 63-66 

(1995) (arguing that the courts in Moser, Young and American 

Principals Leasing correctly determined the taxpayers were not at 

risk because circular chains of payments were used to protect the 

taxpayers from loss). 

 A brief example (drawn from Moser, supra) will clarify the 

type of transaction at issue in the cases relied upon by the 

Commissioner and provide a contrast with the type at issue here. 

Assume A borrows money on a nonrecourse basis from a bank and 

uses that money to buy some equipment. A leases that equipment 

to L and the bank then takes a security interest in that 
22 

equipment and the lease. A sells the equipment to B, subject to 

the existing liens and lease and takes a promissory note from B. 

B in turn sells to taxpayer, T, for the same price that it bought 

the equipment from A. Like before, B accepts a promissory note 

from T as payment. T, in turn, leases the equipment back to A in 

exchange for payments equal to those B owes to A. 

 Under this arrangement, the payments A owes to T are 

identical to the payments T owes to B, which in turn are 

identical to the payments B owes to A. T, as the "owner" of the 

equipment, would be entitled to take deductions for depreciation 

of the property (except for the existence of section 465). Should 

any party assert a claim against another party for nonpayment, it 

could expect an equal claim asserted against it. See Pliskin, 

supra, at 62-66, 72 (diagramming this type of transaction). 

Here, by contrast, there was no circular chain of payments. 

Instead, the failure of Nicholson to meet the terms of the third 

note would trigger a demand for payment by ELEX; Nicholson, on 

the other hand, would have no corresponding claim against ELEX or 

the Bank. 

 Given this analysis, we are forced to conclude that the tax 

court abused its discretion in ruling that the Commissioner's 

position was substantially justified. As noted, the tax court 

did not seek to analyze whether Nicholson would suffer an 

economic loss if the lease became unprofitable. The court simply 

found that because two of the factors present in this case were 

also present in several of the cases finding taxpayers not "at 

risk," the Commissioner's position was substantially justified. 
23 

Thus, the court did not seek to determine why the taxpayers in 

these cases were found not "at risk." Had the court conducted 

the required economic reality test, it would have found that 

these two factors were not dispositive in this transaction 

because ELEX had incentive to sue Nicholson in the case of a 

default on the third note. 

III. 

 The only remaining issue therefore is whether to remand for a 

determination of whether the Nicholsons substantially prevailed 

in the underlying case, a necessary condition for the award of 

litigation costs under section 7430.0 The tax court, as noted, 

did not rule on this issue. We do not, however, believe such a 

remand is necessary. 

 On appeal, the Commissioner has not attempted to sustain the 

tax court's ruling on the alternative basis that the Nicholsons 

did not substantially prevail. Nor did she press this issue 

before the tax court. See supra page 9. Rather, the sole 

argument advanced before this court by the Commissioner was that 

her position was "substantially justified." Moreover, the great 

disparity between the deficiency assessed by the Commissioner and 

the Nicholsons' tax liability after the Settlement reflected in 

the record indicates that the Nicholsons have "substantially 

prevailed with respect to the amount in controversy." I.R.C. 

 

0Pursuant to section 7430(c)(4)(A)(ii), a party substantially 

prevails by either substantially prevailing "with respect to the 

amount in controversy" or "with respect to the most significant 

issue or set of issues presented." 
24 

§7430(c)(4); see Marranca v. United States, 615 F. Supp. 25, 27 

(M.D. Pa. 1985) (government conceded that taxpayers 

"substantially prevailed with respect to the amount in 

controversy" after parties reached settlement reducing initial 

assessment by nearly 75%). Thus, we conclude that the Nicholsons 

have met all the requirements of section 7430, and we therefore 

remand this case to the tax court for a determination of the 

costs and fees to which they are entitled. 

IV.

 For the foregoing reasons, the tax court's order denying the 

Nicholsons' petition for costs is reversed and remanded for 

proceedings consistent with this opinion.