Source: https://casetext.com/case/gilman-v-cir
Timestamp: 2018-12-17 11:02:18
Document Index: 681815111

Matched Legal Cases: ['§ 465', 'art, 752', '§ 1', '§ 7721', '§ 6662', '§ 6662']

Gilman v. C.I.R, 933 F.2d 143 | Casetext
Gilman v. C.I.R
933 F.2d 143 (2d Cir. 1991)
United States Court of Appeals, Second CircuitMay 14, 1991
Long Term Capital Holdings v. U.S.
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Bank of N.Y. Mellon Corp. v. Comm&apos;r
…Applicable Law In determining whether a transaction lacks “economic substance,” we consider: 1) whether the…
holding that a transaction disregarded for lack of economic substance—a non-valuation-related ground—nevertheless may be subject to a valuation misstatement penalty because “ transaction that lacks economic substance generally reflects an arrangement in which the basis of the property was misvalued in the context of the transaction” and that Congress “intended to penalize” such transactions
recognizing that a transaction that lacks economic substance "generally reflects an arrangement in which the basis of the property was misvalued in the context of the transaction."
asking whether a prudent investor would have found that a "realistic potential for economic profit" existed
R. Donald Turlington, New York City (James A. Gouwar, Bennett I. Deutsch, Stuart B. Katz, Brown Wood, New York City, on the brief), for petitioner-appellant.
Before NEWMAN and ALTIMARI, Circuit Judges, and CONBOY, District Judge.
The Honorable Kenneth Conboy of the District Court for the Southern District of New York, sitting by designation.
On December 30, 1980, Equilease purchased the computer equipment from Disko for $2,740,808, subject to the end-user leases and Dresdner Bank's security interest. Equilease leased the equipment back to Disko for a term of nine years. On December 31, 1980, Equilease sold the equipment to Aardan for $2,992,500, subject to Disko's lease, the end-user leases, and Dresdner Bank's security interest. The same day, Aardan sold the equipment to the taxpayer, Gilman, for $3 million. Gilman then leased the equipment to Equilease for a term of nine years.
According to Mallin's testimony, Aardan was inserted into the transaction as a "middle company" in an effort to comply with the "at risk" provisions of 26 U.S.C. § 465 (1976). Aardan was incorporated on December 29, 1980, two days before it purchased the computer equipment.
On his 1980 and 1981 tax returns, Gilman reported this computer transaction as a $3 million purchase, took deductions for depreciation and interest, and included as income the rent received from Equilease. The Commissioner disallowed these tax deductions, excluded the rental income, and issued Gilman a notice of deficiency for the tax years 1980 and 1981 in the amounts of $171,680 and $329,555, respectively. The Commissioner classified the 1981 underpayment as due to a valuation overstatement and assessed a section 6659 penalty tax of $98,867. In addition, the Commissioner viewed both years' underpayments as the result of a tax-motivated transaction and applied the section 6621(c) penalty rate of interest. Gilman filed a petition with the Tax Court.
The section 6659 penalty tax was not assessed against the 1980 tax return because the provision became effective only for returns filed after December 31, 1981.
The subsection was redesignated from (d) to (c) by section 1511(c)(1)(A) of the Tax Reform Act of 1986, Pub.L. No. 99-514, 100 Stat. 2744. The provision will be cited hereafter as section 6621(c).
"the entry into the transaction was motivated by business purpose to justify the form of the transaction, and that the transaction was supported by economic substance. Rice's Toyota World, Inc. v. Commissioner, 81 T.C. [184] at 201-203 [(1983)]. In Rice's Toyota World, Inc., we stated that the tests developed under the sham transaction doctrine are applied to determine whether a threshold level of business purpose or economic substance is present. Rice's Toyota World, Inc. v. Commissioner, 81 T.C. at 196."
Gilman v. Commissioner, 58 T.C.M. (CCH) 1075, 1078 (1989) (quoting Larsen v. Commissioner, 89 T.C. 1229, 1251-52 (1987), aff'd in relevant part, rev'd in part sub nom. Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir. 1990)). The Tax Court further stated that "[t]he presence of business purpose does not entitle a transaction to be recognized for Federal tax purposes where objective indicia of economic substance indicating a realistic potential for economic profit are not manifest." Id. (quoting Larsen, 89 T.C. at 1252 (1987)).
In determining whether the sale/leaseback transaction was a sham, the Court also considered whether the transaction had economic substance, noting that a transaction "`has economic substance and will be recognized for tax purposes if the transaction offers a reasonable opportunity for economic profit, that is, profit exclusive of tax benefits.'" Id. (quoting Gefen v. Commissioner, 87 T.C. 1471, 1490 (1986)). The Court approached the analysis from the standpoint of the prudent investor. See Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184, 209 (1983), aff'd in part, rev'd in part, 752 F.2d 89 (4th Cir. 1985) (affirming the finding that transaction was a sham and the disallowance of depreciation and interest deductions on nonrecourse debt). The Court, however, gave some consideration to the taxpayer's subjective statement as to his non-tax motive. See Cherin v. Commissioner, 89 T.C. 986, 992 (1987).
Gilman would earn a non-tax based profit on this transaction only if the residual value exceeded $437,774, or 14.6 percent of the original purchase price. Therefore, Gilman was required to demonstrate that "a prudent investor could have concluded that there was a realistic opportunity that the residual value of the equipment at the end of the lease would have exceeded 14.6 percent of the original purchase price." Gilman, 58 T.C.M. at 1080. Gilman and the Commissioner presented experts to testify as to what were reasonable expectations, at the time of the transaction, of the residual value. Because Gilman's experts presented contradictory, incomplete, and unsupported conclusions regarding useful life, scrap value, price decline, and the effect of innovation and development in the computer industry, the Court found "the appraisals of [the Commissioner's] experts to be sufficiently more convincing than those of [Gilman's] experts and conclude[d] that in December 1980 a prudent investor would have concluded that the equipment would have only a nominal residual value in December 1989." Id. at 1083.
This calculation is based on Gilman's net investment of $393,997 (the $469,597 cash investment minus the income of $8,400 per year for nine years from Equilease) and the fact that Equilease was entitled to retain 10 percent of the residual value of the equipment.
On appeal, the taxpayer first argues that the Tax Court applied the wrong legal standard in determining whether his transaction was a sham. Gilman claims that the Court erred in applying the two-pronged legal standard of Rice's Toyota (business purpose and economic substance). Relying on our recent decision in Jacobson v. Commissioner, 915 F.2d 832 (2d Cir. 1990), Gilman contends that the relevant standard for determining economic substance is "whether the transaction may cause any change in the economic positions of the parties (other than tax savings)," and "that the `profit motive/business purpose' inquiry should be based on the criteria in the regulations under section 183." Brief for Appellant at 15.
Gilman's argument is premised on an incorrect reading of Jacobson. In that case we rejected the Tax Court's finding that a film transaction was a sham, where the Tax Court had relied on its subjective opinion of the film. However, we explicitly supported the business purpose/economic effect analysis of sham transactions: "`A transaction is a sham if it is fictitious or if it has no business purpose or economic effect other than the creation of tax deductions.'" Jacobson, 915 F.2d at 837 (quoting DeMartino v. Commissioner, 862 F.2d 400, 406 (2d Cir. 1988)). We also noted that a court could either inquire whether there were any non-tax economic effects or use the analysis under section 183. Id. at 837-38. Whether the terminology used was that of "economic substance, sham, or section 183 profit motivation" was not critical; what was important was reliance on objective factors in making the analysis. Id. at 838.
In the present case, the Tax Court did not demand that the taxpayer demonstrate both business purpose and economic substance. Rather, the Court examined each prong separately and concluded that Gilman lacked a business purpose and that the transaction lacked economic substance. The Tax Court applied the sham analysis consistent with the guidelines of this Circuit and others, indicating the flexible nature of the analysis. See Jacobson, 915 F.2d at 837-38; Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990); Sochin v. Commissioner, 843 F.2d 351, 354 (9th Cir.), cert. denied, 488 U.S. 824, 109 S.Ct. 72, 102 L.Ed.2d 49 (1988); see also Zmuda v. Commissioner, 731 F.2d 1417, 1420 (9th Cir. 1984).
The taxpayer relies on Rosenfeld v. Commissioner, 706 F.2d 1277 (2d Cir. 1983), and Commissioner v. Brown, 380 U.S. 563, 85 S.Ct. 1162, 14 L.Ed.2d 75 (1965), to argue that where a transaction changes the beneficial and economic rights of the parties it cannot be a sham. But the Commissioner does not contend that Gilman does not own the computer equipment. Instead, the concern is that his entry into the transaction was motivated by tax consequences and not by business or economic concerns.
The taxpayer argues that the Tax Court erred in requiring a reasonable possibility of profit because the regulation under section 183 states that "a reasonable expectation of profit is not required." Treas. Reg. § 1.183-2(a) (1972). However, Gilman's assertion of error is incorrect on two grounds. First, even according to Gilman's own analysis, section 183 applies after a transaction has been determined to have economic substance. The Tax Court concluded that Gilman's transaction lacked economic substance. Second, both the regulation and Jacobson refer to the expectation of profit in the context of risky business ventures, typified by the wildcat oil well, not the residual value in equipment at the end of a nine-year lease. See also Bryant v. Commissioner, 928 F.2d 745 (6th Cir. 1991) (risky nature of gold mine venture does not render it a sham). Additionally, the Tax Court in the present case made reference to the expectation of profit in an effort to identify the kind of information a businessman would seek before entering into this transaction.
The Tax Court calculated a deficiency of $329,555 on the 1981 return, based on the disallowance of the deductions for depreciation and interest and the exclusion of rental income. Then the Court concluded that the correct adjusted basis of the computer equipment was zero, and not the $3 million claimed by the taxpayer. With the basis at zero, the percent of overvaluation was infinite; the Court therefore applied the maximum penalty percentage rate, 30 percent, since the property was overvalued by more than 250 percent. Section 6659(b). A penalty of $98,867 (30 percent of the underpayment attributable to the overvaluation, i.e., $329,555) was added to Gilman's 1981 taxes.
This figure is from the Tax Court's original opinion, prior to the adjustment for the deduction of interest paid on the short-term notes. The difference is not relevant to the arguments regarding application of section 6659.
Application of the overvaluation penalty in the context of tax shelter transactions challenged as lacking economic substance appears to have developed from a series of cases involving cattle breeding. The sequence begins with Grodt McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981). The taxpayer used a small amount of cash and substantial nonrecourse loans ostensibly to acquire interests in cattle. The Commissioner primarily contend that in reality no sale had occurred and that all depreciation deductions should be disallowed. Alternatively, he argued that only limited depreciation deductions should be allowed based on a fair market value far below the taxpayer's alleged purchase price. The Tax Court ruled that the claimed sale price far exceeded fair market value, that a sale had not occurred, and that the transaction lacked economic substance. Depreciation deductions were disallowed entirely.
On similar facts in Zirker v. Commissioner, 87 T.C. 970 (1986), similar conclusions were reached. In Zirker, however, the Court cited Grodt McKay Realty for the proposition that since no sale had occurred, "it follows that petitioner's `correct' adjusted basis in the cattle is zero." 87 T.C. at 978. The Court then concluded that an overvaluation penalty would be imposed under section 6659 and fixed the penalty percentage at 30 percent, viewing the overvaluation as having exceeded 250 percent. Zirker was relied on by the Eighth Circuit to impose an overvaluation penalty in still another case involving a claimed purchase of breeding cattle, Massengill v. Commissioner, 876 F.2d 616 (8th Cir. 1989).
It is fairly questionable whether what occurred in these cases was a "valuation overstatement." What indisputably happened is that the Tax Court ruled that no sale had occurred. In one sense, the taxpayers had "overvalued" by claiming a high value for an asset that the Tax Court ruled they had not bought at all. Yet, in another sense, these were not cases of taxpayers selecting an unduly high value; rather, the taxpayers were rebuffed in their claims that any purchase at all had occurred. To say that a taxpayer has a zero basis in an asset he is found not to have acquired seems strained. Yet the appropriateness of the penalty seems more justified if one considers the alternative arguments of the Commissioner in Grodt McKay Realty, arguments typically made in tax shelter disputes. Had the Commissioner been confined to his fallback position that the taxpayer's basis for depreciation was fair market value, a value far below his claimed purchase price, it would have been entirely sound to say that the asset had been "overvalued" and to impose the section 6659 penalty. If the Commissioner is more successful and persuades the Court to disregard not only the nonrecourse notes but the entirety of the purchase price, thereby lowering the "price" down not only to fair market value but all the way to zero, should the Commissioner's success have the perverse effect of sparing the taxpayer the overvaluation penalty?
We are inclined to accept the view of the Tax Court in this and the prior cases and of the Eighth Circuit in Massengill and deem the penalty applicable. Indeed, ours is a stronger case for the penalty than the cattle cases, because, while the Commissioner disputes that the computer transaction has sufficient economic substance to warrant deductions for depreciation and interest, he does not contend that Gilman did not make a purchase. We acknowledge that applying the penalty somewhat strains the natural reading of the statutory phrase "valuation overstatement." And where the taxpayer's basis has been reduced to zero, it is somewhat odd to apply a provision that scales the penalty rates to the percentage of overvaluation. The percent of "overvaluation" above zero is infinite, which is literally more than 250 percent, the level at which the 30 percent penalty rate begins to apply. But arguably the overvaluation in a sham transaction is different in kind, not merely degree. On the other hand, application of the section 6659 penalty surely reenforces the Congressional objective of lessening tax shelter abuse. Moreover, we note that when Congress recodified and somewhat simplified penalty provisions in 1989 by creating a general "accuracy-related penalty," Pub.L. 101-239, § 7721(a), 103 Stat. 2395, 2395-97 (1989), to be codified at 26 U.S.C. § 6662, see 26 U.S.C.A. § 6662 (Supp. 1991), it retained the concept of a "valuation overstatement" as an example of a circumstance warranting the revised penalty, see subsections 6662(b)(3), (e), and made no change to preclude application of the penalty to tax shelter transactions like Gilman's where an alleged purchase price is totally disregarded as a basis for depreciation deductions.
Gilman further argues that even if there was a valuation overstatement, the tax deficiency was not "attributable" to it, as required by section 6659(a). Gilman relies primarily on Todd v. Commissioner, 862 F.2d 540 (5th Cir. 1988), in which the taxpayers took depreciation deductions on property with a highly inflated basis. They failed, however, to put the property into service in the tax year for which they were claiming the deductions. The deductions were denied, creating an underpayment of tax. The Court concluded that there should be no section 6659 penalty because the underpayment was not attributable to the valuation overstatement, but rather to the taxpayer's failure to comply with the depreciation regulations requiring the property to be placed into service. See also Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990) (imposition of section 6659 penalty reversed, based on Todd). Applying this interpretation of section 6659 to his case, Gilman argues that where the underpayment derives from the disallowance of the transaction ( i.e., non-recognition of the transaction for tax purposes), then the underpayment is not attributable to an overvaluation.