department of the treasury internal_revenue_service washington d c number release date tl-n-5204-98 cc dom fs p si uilc date internal_revenue_service national_office field_service_advice memorandum for north -south carolina district_counsel cc ser ncs gbo from subject assistant chief_counsel field service cc dom fs leveraged_lease transaction this field_service_advice responds to your memorandum dated date field_service_advice is not binding on examination or appeals and is not a final case determination this document is not to be cited as precedent legend taxpayer b c d e f g h i j period period period period period period period period period period date date date year v year w amount amount amount amount amount amount amount amount amount amount amount amount amount amount amount amount amount amount amount amount amount amount amount amount amount percentage percentage dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure percentage percentage percentage percentage percentage country note sec_1 note sec_2 number number number this field_service_advice responds to your request for coordination dated date field_service_advice is not binding on examination or appeals and is not a final case determination this document is not to be cited as precedent issues whether the leveraged_lease transaction is a transaction lacking business_purpose and economic_substance whether the purported sale_and_leaseback are properly characterized for federal_income_tax purposes whether the indebtedness incurred by the taxpayer to purchase the rail cars should be respected for federal_income_tax purposes whether sec_482 should not be applied to this sale leaseback_transaction to reallocate the ownership attributes between taxpayer and d because we do not believe the control requirement of sec_482 has been met conclusions we believe a strong argument could be made that the sale lease-back transaction lacks economic_substance and should not be respected according to its form moreover even if the transaction were found to have some substance it should not be respected according to its form because taxpayer did not acquire the benefits_and_burdens_of_ownership of the rail cars and therefore should not be considered the owner of the rail cars for federal tax purposes additional factual development is necessary before we can determine whether the service should apply this theory we conclude that the transaction should not be respected as a sale and a lease-back for federal_income_tax purposes the transaction may be viewed at best as a financing the taxpayer’s claim of depreciation_deductions may be totally disallowed additional factual development is required to support these conclusions the indebtedness incurred by the taxpayer does not appear to be either genuine or to have economic_substance the indebtedness may be disregarded for federal_income_tax purposes and can be disregarded for determining the taxpayer’s basis in the rail cars any interest deductions taken pursuant to this indebtedness may be denied additionally the taxpayer may only take depreciation_deductions to the extent of its basis in the rail cars as discussed below we conclude that sec_482 should not be applied to this sale leaseback_transaction to reallocate the ownership attributes between taxpayer and d because we do not believe the control requirement of sec_482 has been met further we do not recommend that the acting in concert doctrine that has been applied to lease_stripping transactions should be pursued in this case because the parties in this transaction are unrelated and did not shift deductions separately from income in a manner that would raise a presumption of control by one party over the other facts b through its subsidiary taxpayer entered into a type of transaction known as a leveraged_lease transaction in year v on date c acting as the owner trustee agreed to purchase and hold number rail cars from d for the benefit of taxpayer for a purchase_price of dollar_figureamount pursuant to the terms of the participation_agreement d acquired number cars manufactured by e during period and initially placed the rail cars into service during period d initially acquired and placed into service number rail cars manufactured by f during period d purchased each of these cars for dollar_figureamount the purchase_price of the rail equipment was comprised of the following amounts the taxpayer paid dollar_figureamount in cash to c g a country bank made a secured loan to c in the amount of dollar_figureamount to pay d for the equipment and in exchange c issued the note sec_1 to g and d made a purchase money loan to c in dollar_figureamount and in exchange c issued the note sec_2 to d taxpayer agreed to make a capital_contribution to h equal to a certain percentage of c’s purchase_price although c was the promisor on the note sec_1 and note sec_2 c was acting for the benefit of taxpayer the note sec_1 and note sec_2 bear interest at an annual rate of percentage with respect to the note sec_2 no cash was exchanged rather the annual rent payments equaled the interest payments made by the taxpayer pursuant to the note sec_2 d stated that the p roceeds for the note sec_2 are an internal accounting circle since d holds these notes questions concerning taxpayer transactions pincite the dollar_figureamount loan principal that was disbursed by g to c on behalf of d was used to purchase a certificate of deposit cd in that same amount with interest accruing at a rate of percentage annually c purchased the cd on behalf of d from i i then purchased a cd in the same amount from j we understand that the cd with i has since been eliminated and d has deposited the cash with j in an interest bearing account questions concerning taxpayer transactions pincite taxpayer disbursed dollar_figureamount in cash to c and c disbursed the money as follows dollar_figureamount to d dollar_figureamount was put into an investment account and used to purchase u s government securities dollar_figureamount to i a subsidiary of b as a deposit fee and dollar_figureamount as a fee to promoter on date c acting as trustee under the owner trust agreement leased the equipment back to d for a year lease_term pursuant to the terms of the lease agreement d has agreed to pay approximately dollar_figureamount in total rent over this year period each rent payment is to be in no event less than the installment of principal and interest due and payable on the note sec_1 notes on such rent payment_date pursuant to the lease agreement upon an event of default which includes failure to pay rent or to carry insurance on the rail cars c has the right to demand payment of liquidated_damages from d or d will have to deliver the rail cars to c lease agreement b in the event that c repossesses the rail cars or d otherwise sells the cars the parties are required to comply with all requirements imposed on the sale by the federal transit authority fta lease agreement the lease is a net_lease and d is expected to maintain liability and loss value casualty insurance on the rail cars the money placed into the investment account was pledged to c to provide collateral security to c for d’s obligations under the lease the parties purchased one u s treasury bill and two u s treasury strips with a total face_amount upon maturity of dollar_figureamount and accruing a total amount of original_issue_discount oid of approximately amount over a twenty year period c had a first priority perfected security_interest in the treasury bill and strips pursuant to the terms of the investment account agreement and the lease agreement f the oid will accrue to d however d is obligated to use the funds in the investment account including the oid to pay its rent for the rail cars to c d will have the choice of exercising either a termination option upon the expiration of the lease on date or a purchase option on date prior to the expiration of the lease if d chooses to exercise the termination option d will pay c dollar_figureamount the termination option payment is percentage and percentage of the purchase_price of the e and f cars pursuant to the terms of lease supplement number upon d’s exercise of the termination option c as the lessor of the equipment will be obligated to sell the equipment to the highest bidder and then pay a fraction of the amount received to d in the sale as a reimbursement for the termination option payment lease agreement the taxpayer will be able to receive a refund equal to the lesser_of either an amount equal to the discounted_present_value of the net_proceeds of the equipment that exceeds percentage of the taxpayer’s purchase_price or the termination option payment plus interest if d exercises the purchase option d will pay a total amount of dollar_figureamount stated to be percentage of the purchase_price of the rail cars pursuant to the terms of lease supplement number the purchase option amount that d is supposed to pay equals dollar_figureamount for the residual_value of the cars and the outstanding interest and principal on the note sec_1 and note sec_2 the purchase option is less than the termination option payment because it must be exercised one year earlier than the termination option payment c granted d a security_interest in the leased rail cars and in the proceeds from the equipment and bill of sale pursuant to the terms of the lessee security_agreement dated date excluded from the collateral of the security_interest is any right title and interest of c in any lease with d which includes any rent payments profits or indemnity payments d granted c a security_interest in the f safe_harbor equipment that is a percentage interest in the f cars pursuant to the terms of the lessor security_agreement dated date g granted taxpayer a continuing security_interest in the note sec_1 pursuant to the terms of the reimbursement and security_agreement taxpayer has this security_interest to secure g’s obligation to reimburse taxpayer for any payments that it is required to make that are not already funded by j reimbursement and security_agreement the parties calculated the residual_value of the rail cars upon the expiration of the d lease in year w to be percentage of the purchase_price that taxpayer paid in year v or dollar_figureamount taxpayer is expected to receive from d either the termination option payment in the total amount of dollar_figureamount or the purchase option payment in the total amount of dollar_figureamount the taxpayer is expected to repay about dollar_figureamount of indebtedness on the note sec_1 and depending on whether d exercises either the purchase option or the termination option taxpayer expects to receive over dollar_figureamount if d exercises the purchase option for a return of approximately dollar_figureamount in excess of its cash payment of dollar_figureamount the facts indicate that taxpayer may receive less if d exercises the termination option if taxpayer does not receive significant salvage proceeds upon the sale of the rail cars taxpayer is expected to take dollar_figureamount in annual depreciation_deductions over a period life pursuant to sec_167 for a total of approximately dollar_figureamount to dollar_figureamount it is also expected that taxpayer will take interest deductions in the amount of the interest_paid on the note sec_1 and note sec_2 pursuant to sec_163 but the exact amount is not clear from the facts if taxpayer loses or is denied its interest deductions depreciation_deductions and amortization deductions or if the taxpayer is required to recapture the depreciation_deductions then taxpayer shall be entitled to an indemnification payment amount pursuant to the terms of the tax indemnity agreement at this indemnification amount is the make whole amount and is equal to the economic return to which the taxpayer would otherwise be entitled taking into account any additional taxes required to be paid on additional income_tax indemnity agreement at this type of domestic sale-leaseback transaction is discussed in chapter of a publication entitled published by the this publication provides guidance on how a transit system can meet the legal requirements that the receive a proportional return of the value on disposal of transit assets ie rail cars this publication states that since the transit system retains effective continuing control of the assets for transit service regards this situation as meeting the requirements of the law the concludes in this publication that the requirement for effective continuing control does not require more than physical possession and the unquestioned right to use the asset in transit service as agreed in the grant documents that enabled the asset’s initial purchase additionally if the transit system defaults then the lessor or owner of the assets has the right to take possession and resell the assets however the transit system has signed an agreement with pledging to maintain effective continuing control of the assets the lessor would thus be in direct competition with the u s government for control of the transit assets involved this publication notes that the defeasance features of these leases tend to mitigate the risk associated with such defaults because the transit authority banks most of the proceeds of the sale of the assets there is ample cushion from which to make the lease payments we note that the endorsement and opinion as to the tax consequences are irrelevant to the analysis of this field_service_advice issue - economic_substance whether the lease transactions at issue lack business_purpose and economic_substance conclusion we believe a strong argument could be made that the sale lease-back transaction lacks economic_substance and should not be respected according to its form moreover even if the transaction were found to have some substance it should not be respected according to its form because taxpayer did not acquire the benefits_and_burdens_of_ownership of the rail cars and therefore should not be considered the owner of the rail cars for federal tax purposes additional factual development is necessary before we can determine whether the service should apply this theory discussion where there is a genuine transaction with economic_substance which is compelled or encouraged by business or regulatory realities is imbued with tax-independent considerations and is not shaped solely by tax-avoidance features that have meaningless labels attached the transaction is valid and the service should honor the allocation of rights and duties effectuated by the parties to provide guidance in determining whether a transaction is for valid tax purposes courts have looked to whether the taxpayer had a business purposes for engaging in the transaction other than tax_avoidance and whether the transaction had economic_substance beyond the creation of tax benefits thus both the taxpayer’s subjective business motivation and the objective economic_substance of the transactions are examined a transaction that is entered into solely for the purpose of tax reduction and that has no economic or commercial objective to support it is not valid and is without effect for federal_income_tax purposes estate of franklin v commissioner t c 752_f2d_89 4th cir 435_us_561 when a transaction is treated as invalid the form of the transaction is disregarded in determining the proper tax treatment of the parties to the transaction in 157_f3d_231 3d cir cert_denied 119_sct_1251 u s the service argued that the purchase and sale of debt instruments were prearranged and predetermined devoid of economic_substance and lacking in economic reality see also compaq computer v commissioner 113_tc_17 in its opinion the tax_court said that the taxpayer desired to take advantage of a loss that was not economically inherent in the object of the sale but which the taxpayer created artificially through the manipulation and abuse of the tax laws the tax_court also stated that the tax law requires that the intended transactions have economic_substance separate and distinct from economic benefit achieved solely by tax reduction it held that the transaction lacked economic_substance and therefore the taxpayer was not entitled to the claimed deductions the opinion demonstrates that the tax_court will disregard a series of otherwise legitimate transactions where the service is able to show that the facts when viewed as a whole have no economic_substance if the transaction is valid in this case it would disallow income expenses and deductions from the sale-leaseback the transaction at issue in this case involves a sale-leaseback that when taken as a whole have no business_purpose independent of tax considerations as in acm partnership the taxpayer entered into the transaction for the sole purposes of avoiding taxes the united_states supreme court addressed the issue of whether a sale leaseback_transaction should be respected according to its form in frank lyon in that case the taxpayer used third party financing to purchase a building from a bank and leased the building back to the bank the court sustained the taxpayer’s position that it was the true owner of the building and therefore entitled to the corresponding tax benefits according to the court the transaction was a genuine multi-party transaction with economic_substance the court noted that the taxpayer was liable for the recourse_debt used to acquire the property and bore a risk of loss in the event it could not re-lease the property at the end of the lease_term and the property was not repurchased pursuant to an option given to the bank additionally the frank lyon court emphasized that the transaction did not create deductions that would not otherwise exist respecting the transaction simply shifted those deductions from the bank to the taxpayer the present case differs significantly from that in frank lyon here taxpayer lacks any real liability for the transaction financing repayment of the financing from the is assured because of various deposits investments and satisfaction of the seller financing from d appears to be assured because of d’s offsetting rent and end-of-year-lease term obligations to taxpayer there may be some possibility that if the rail cars fail to retain any residual_value taxpayer will lose some portion of its dollar_figureamount investment but this appears unlikely if district counsel’s factual conclusions are correct and moreover any such loss would appear to be nominal in relation to the size of the transaction thus the taxpayer in frank lyon bore a burden of ownership risk of loss from decline in market_value that taxpayer does not bear in this case a further basis for distinguishing frank lyon is that this transaction if respected according to its form does result in the creation of otherwise nonexistent deductions because d is unable to use the depreciation and other deductions available to the owner of the rail cars the lower courts in numerous cases have disallowed the tax benefits accompanying ownership of property when the transaction purporting to transfer ownership lacks economic_substance in rice’s toyota world inc the court held that a sale leaseback_transaction did not have significant economic_effect on the taxpayer insofar as risk of loss was negated by the use of nonrecourse_financing and the opportunity for pre-tax profit was remote given that the leased property lacked any expected residual_value as already noted this transaction is structured to substantially eliminate taxpayer’s risk of loss from depreciation of the rail cars taxpayer’s opportunity to profit meanwhile is capped because d has the option of purchasing the rail cars at the end of the lease_term and will exercise this option if the rail cars have a value of at least percentage of their purchase_price even if d fails to exercise the option makes the termination_payment and transfers the rail cars to taxpayer any excess of the residual_value of the rail cars over percentage of their purchase_price inures to d’s benefit because taxpayer must sell the rail cars and pay d such excess the limitations on taxpayer’s risk of loss and opportunity to profit deprive this transaction of meaningful economic_substance district_counsel employs a present_value analysis in concluding that the transaction fails to afford taxpayer any opportunity for profit although there is some authority for not using the present_value concept in evaluating the substance of a sale leaseback_transaction we agree that the better view is to take into account the fact that the net payment expected to be received by taxpayer will not be paid until period after taxpayer makes its equity_investment this was the approach adopted in acm partnership other cases have taken into account the time_value_of_money in 912_f2d_736 4th cir the court concluded that a sale_and_leaseback of computer equipment was invalid given that there was no reasonable expectation of profit apart from the tax benefits of the transaction there is contrary authority 84_tc_412 n but in determining whether a transaction has more than a de_minimis economic_effect on a taxpayer ignoring the present_value concept flies in the face of reality finally regardless of whether this transaction is found to be valid an argument can be made that taxpayer is not entitled to depreciation and other deductions reserved to the owner of property because it never received the benefits_and_burdens_of_ownership of the rail cars see 91_tc_838 77_tc_1221 a very important fact in determining whether a taxpayer is the tax owner of property is whether that taxpayer has the potential to realize a profit or loss from the sale or re- lease of the property in this case taxpayer’s ability to either profit or lose as a result of the residual_value of the rail cars is circumscribed it knows that it will receive a certain sum as a termination_payment even if the rail cars lack any residual_value and d fails to exercise its purchase option it also knows that if the residual_value of the rail cars exceeds percentage of their original cost this excess will inure to d’s benefit either because d will exercise d will exercise its purchase option or because taxpayer will have to sell the rail cars after they are transferred to it and remit the excess to d taxpayer lacks either the upside or downside that an owner of property normally possesses thus even if the transaction were found to have substance as an investment by taxpayer or otherwise it should not be respected as a valid sale_and_leaseback case development hazards and other considerations issue genuine debt whether the purported sale_and_leaseback are properly characterized for federal_income_tax purposes conclusion we conclude that the transaction should not be respected as a sale and a leaseback for federal_income_tax purposes the transaction may be viewed at best as a financing the taxpayer’s claim of depreciation_deductions may be totally disallowed additional factual development is required to support these conclusions discussion whether the characterization of a sale_and_leaseback of the same asset should be respected for federal_income_tax purposes depends upon the substance of the transaction 91_tc_838 a transaction may be considered a sale for federal_income_tax purposes if the benefits_and_burdens_of_ownership passed to the purchaser of the assets levy t c pincite the petitioner in levy entered into sale-leaseback transactions involving computer equipment in determining that the petitioner’s purchase of the equipment should be respected for federal_income_tax purposes the court stated that the factors relevant to this determination are the purchaser’s equity_interest in the computer equipment as a percentage of the purchase_price a useful_life of the property that extends beyond the lease_term lease renewal or purchase options at the end of the lease_term based on fair_market_value of the equipment at that time whether the projected residual_value of the equipment plus the cash_flow generated by the rental of the equipment allows the investors to recoup at least their initial cash investment whether a turnaround point is reached at some point whereby depreciation and interest_deduction are less than income received from the lease whether the net tax savings for the investors are less than their initial cash investment and the potential for realizing a profit or loss on the sale or release of the equipment levy t c pincite see also 89_tc_1229 aff’d in part rev’d in part 909_f2d_1360 9th cir determining that most of taxpayer’s computer leasing sale_and_leaseback transactions were not motivated by a business_purpose were devoid of economic_substance and were disregarded for federal_income_tax purposes but also determined that taxpayer acquired the benefits_and_burdens_of_ownership additional factors to consider include whether an equity_interest was acquired in the property whether the contract created a present obligation on the seller to execute and deliver a deed and on the purchaser to make payments and whether the right of possession is vested in the purchaser 77_tc_1221 factors that the tax_court in larsen deemed to be neutral in determining whether a taxpayer should be respected as the owner of the equipment include the following the existence of a net_lease the absence of significant positive net_cash_flow during the leaseback term or rent geared to interest and mortgage amortization and the use of nonrecourse_liability larsen t c pincite citing 84_tc_412 see also 435_us_561 revrul_55_540 1955_2_cb_39 established a guide for determining the federal_income_tax treatment of leases of equipment the service stated in this revenue_ruling that in deciding whether a taxpayer is entitled to a deduction for any payments claimed to represent rentals under the provisions of the code it is necessary to determine whether by virtue of the agreement the lessee has acquired or will acquire title to or an equity in the property the determination of that question with respect to agreements of the type here involved will ordinarily depend upon whether the particular agreement should be treated in reality as a lease or a conditional sale contract a transaction will not be treated as a lease or rental agreement if one or more of the following conditions is present portions of the periodic_payments are made specifically applicable to an equity to be acquired by the lessee the lessee will acquire title upon payment of the required amount of rentals the total amount which the lessee is required to pay for a relatively short_period of use constitutes an inordinately large proportion of the total sum required to be paid to secure the transfer of title see truman 12_tc_446 the rental payments materially exceed the current fair rental value as an indiction that the rental payments include an element other than compensation_for the use of property the property may be acquired under a purchase option at a price which is nominal in relation to the value of the property at the time when the option may be exercised or is relatively small when compared with the total payments made or some portion of the payments is designated as interest or recognizable as interest revrul_55_541 1955_2_cb_19 sets forth the proper treatment for federal_income_tax purposes of a lease of equipment the service determined that the purported lessee of the equipment m was transferred equitable ownership of the equipment and not a leasehold interest because m enjoy ed all of the benefits of ownership for substantially the entire useful_life of the property in 556_f2d_1107 ct_cl the court upheld the trial court’s determination that the assignment of future revenues by the plaintiff was not a bona_fide sale but was rather a loan-type of investment secured_by the right to future revenue a nonrecourse secured loan the court looked to the fact that the assignee had the right to repayment and this certainty was characteristic of a loan mapco f 2d pincite additionally the court determined that amounts deposited in the bank by the plaintiff indirectly guaranteed repayment also characteristic of a loan if the transaction was not a sale but rather a financing_arrangement then any amount that d received from taxpayer would not be included in d’s gross_income 499_us_573 1991_2_cb_30 furthermore if the transaction is not a sale and a leaseback the rental income to the taxpayer would then be properly characterized as repayment of principal and would not be taxable as income upon the application of the factors set forth in levy and grodt mckay to the facts of this case this sale_and_leaseback should not be respected for federal_income_tax purposes in the case at hand taxpayer paid dollar_figureamount in cash which represented percentage of the dollar_figureamount purchase_price of the rail cars of the cash amount_paid by the taxpayer dollar_figureamount was paid to d and amount was paid for other expenses the remaining dollar_figureamount was placed in an investment account and was used to purchase u s treasury securities the investment account was created to provide collateral security to c in substance to the taxpayer for d’s rental obligations under the lease although the money in the investment account is in form the property of d d is not to receive the money unless all of its obligations to c under the lease have been discharged upon satisfaction of its obligations d will be entitled to the proceeds of the dollar_figureamount purchase_price paid_by the taxpayer dollar_figureamount was financed by d as a purchase money loan d has indicated that the note sec_2 are an internal accounting circle since d holds the notes they do not contemplate any future obligations to infuse any cash since at the close of the transaction the funds owed to d on the j deposit the note sec_2 and the investment account should pay off all obligations of d questions concerning taxpayer transaction pincite thus it appears that d never intended to contribute this amount of cash to the transaction and the amount can be subtracted from the original purchase_price of the rail cars if the total amount of the note sec_2 is subtracted from the purchase_price of the rail cars then the purchase_price of the rail cars was dollar_figureamount and the cash paid_by taxpayer represents an equity_investment of approximately percentage of the purchase_price this fact when viewed alone is neutral from the facts known by us it is likely but not certain that the useful_life of the property will extend beyond the period lease_term both the e cars and the f cars may have a useful_life of an additional period however it appears to be likely that d will purchase and will continue to use the cars after the expiration of the leases under the terms of the documents if d elects the termination option then d will have to acquire rail cars from another source this will be beneficial to d if the residual_value of these cars is inflated and if d can acquire rail cars more cheaply from another source additionally if d elects the termination option and loses control and custody of the rail cars then d will be required to repay the a fraction of the proceeds as d has agreed to do when it sells the rail cars or loses custody and control_over the rail cars d will be economically compelled to purchase the cars that it has leased if the cost to acquire cars from the marketplace is more expensive than keeping the cars that it has leased d will be able to use the proceeds from the investment account to finance its acquisition of the rail cars thereby avoiding any out-of-pocket expenses therefore it appears that the purchase option will be economically beneficial to d upon d’s exercise of the purchase option d will then have been using the rail cars for their entire economic life which would support the recharacterization as a financing_transaction we do not know the whether the purchase_price of the residuals in the purchase option reflects fair_market_value of the rail cars we recommend additional factual development on this issue the taxpayer has projected its income in excess of its expenses to be approximately dollar_figureamount if d exercises its purchase option and can recoup at least their initial cash investment it appears likely that d will exercise its purchase option the taxpayer has also projected that it may lose money on the transaction if d exercises the termination option but this is not as likely to occur the fact that the taxpayer is indirectly guaranteed to recover its costs is indicative of a financing and as discussed below indicative of a lack of economic_substance it does not appear that there will be a turnaround point when the deductions will be less than the income because the depreciation and interest deductions will exceed the taxpayer’s rental income the rental income is matched with the interest deductions on the note sec_1 and note sec_2 notes indicating if the transaction is to be respected at all that it is a financing the taxpayer’s initial cash investment of dollar_figureamount of which it will recover dollar_figureamount plus accrued oid is significantly less than the overall tax savings of dollar_figureamount in depreciation_deductions plus its additional interest deductions under the form of the transaction if d exercises the purchase option then taxpayer will receive dollar_figureamount from d which will include the dollar_figureamount residual_value of the equipment the payment of the interest and principal due on the note sec_1 and note sec_2 thus the dollar_figureamount that d will pay taxpayer will be in excess of both taxpayer’s total cash payment dollar_figureamount and net cash payment of dollar_figureamount dollar_figureamount to d and dollar_figureamount and dollar_figureamount in other fees because d expects to pay the residual_value of the rail cars from the accrued oid on the u s government securities that it holds the amount is predictable it appears from the facts of this case that d will exercise the purchase option therefore taxpayer’s potential for realizing a profit income in excess of its expenses is locked in and a fixed amount which is indicative of a financing_transaction if the form of the transaction is respected taxpayer could lose money on the transaction if d exercises the termination option if d exercises the termination option taxpayer will be forced to sell the rail cars on the open market the sale of the rail cars will expose the taxpayer to the possibility that it will not recover its initial investment in the rail cars as discussed previously it appears unlikely that d will exercise the termination option we recommend that you develop this issue as discussed below under the documents the beneficial_ownership in the rail cars will not be vested in taxpayer at any time during this transaction although taxpayer will have the right to repossess the rail cars from d in the event that d defaults on its rental obligations this is unlikely to happen because d has stated that the rents have already been provided for and that it is fully defeased questions concerning taxpayer transactions pincite taxpayer may possess the rail cars if d elects the termination obligation but as indicated above this is also not likely to happen thus these facts support characterizing the transaction as a financing upon the application of revrul_55_540 and revrul_55_541 to this case it appears that d was not a lessee of the rail cars because d has retained an equity_interest in the rail cars first upon d’s exercise of the purchase option and upon d’s payment of the rents d can acquire title to the rail cars without paying additional money d will receive the accrued oid from the investment account upon its fulfillment of its obligation to pay rent d has stated that it is fully defeased because it expects to use the dollar_figureamount of accrued oid and the funds deposited in the cd with j to fund the purchase option without incurring any out-of-pocket expenses additionally we note that if d does not exercise its purchase option but rather exercises the termination option and loses control_over the rail cars d will be obligated to pay the a certain fraction of the value of the rail cars the is required to receive a portion of the value of the rail cars upon the disposal of the rail cars pursuant to the legal requirements for the assistance that taxpayer received second because d may reacquire the rail cars upon its exercise and payment of the purchase option which requires no out-of-pocket payments by d d will effectively acquire title to the rail cars upon its payment of all rent d expects to pay for the residual_value of the equipment from the oid that has accrued in the investment account to its benefit thus d expects to pay none of its own funds to purchase the rail cars an amount which is nominal in relation to the value of the equipment third it appears that d will enjoy the benefits of ownership for substantially the entire useful_life of the property as of date when the parties entered into this transaction d had been using the e cars since period but d purchased the cars between period although we do not know the age of the cars at the time that d put them in service we do know that the e cars will have been used for between period upon the expiration of d’s lease d had been using the f cars since period although we do not know the age of the cars at the time that d put them in service the f cars will have been used for between period upon the expiration of d’s lease at best some of the cars will be within period of their estimated period life it appears likely that d will exercise its purchase option and will retain possession and control_over the cars because of their continuous economic investment in the rail cars furthermore in the published by the the requires rail systems like d to retain effective continuing control_over the rail cars the has stated that it will accept the purported sale-leaseback transaction general background information on d leases pincite conversely it appears that taxpayer will never exercise physical control_over the rail cars these facts indicate that d has retained its equity_interest in the rail cars which supports characterizing the transaction as other than a lease fourth the total rental payments may materially exceed the total fair rental value of the rail cars however d’s actual annual rental payments will be far less than the annual fair rental value because the annual rental payments will equal the annual interest payments on the note sec_1 and note sec_2 and d will make one large balloon payment at the end of the lease this will require an independent valuation of the fair_market_value of the rail cars and their rents we recommend that you develop additional facts to support this argument as discussed below fifth d was granted a security_interest in the leased rail cars by c the grantor pursuant to the lessee security_agreement this security_interest may be viewed as an equity_interest in the leased equipment although d’s security_interest in the rail cars is consistent with d’s status as the seller of the rail cars and lender to the taxpayer it is inconsistent with d’s status as a lessee of the rail cars because under service position a lessee may not have an equity_interest in the equipment in the event that c the grantor defaults upon its obligations d the secured party may enforce its rights including foreclosure of the rail cars in the event of default by c acting as the lessor of the equipment d as the lessee of the rail cars would then have the right to terminate the lease this leads to an absurd result because it would constitute a default by c acting as the grantor and d would retain its rights as a secured party could terminate the lease and could nevertheless foreclose upon the rail cars which have never left its possession because d has retained its equity_interest in the rail cars the transaction should not be respected as a sale_and_leaseback upon the application of the factors set forth in mapco and assuming that the debt is bona_fide it appears that this transaction is a secured financing by d and not a sale_and_leaseback of the rail cars thus the funds dollar_figureamount and dollar_figureamount that d will receive is simply a loan that it must repay we exclude from this loan amount the taxpayer’s cash payment to d of dollar_figureamount which d is not required to repay and d’s own purchase money loan of dollar_figureamount because it is a loan to itself d implicitly guaranteed repayment of the loan because d is to pay either the purchase option or the termination option with the amounts received on the loan from g the accrued oid in the investment account and the purchase money loan that d made to taxpayer essentially repaying itself upon recharacterizing this transaction as a financing we must determine the ownership of the funds contributed to the investment account income is taxable to the recipient pursuant to sec_61 when a taxpayer acquires funds has control_over the property and derives readily realizable economic value from it the taxpayer is regarded as having received income and is liable for tax on the income 366_us_213 a loan or an advance is not taxable_income to the borrower sattelmaier v commissioner tcmemo_1991_597 in determining whether a loan is a bona_fide loan the tax_court will consider the following factors whether a note or other evidence_of_indebtedness exists whether there is any written loan agreement whether there is a fixed schedule for repayment whether any security or collateral is requested whether interest is charged whether a demand for repayment has been made whether the records reflect the transaction as a loan whether any repayments have been made and whether the borrower was solvent at the time of the loan id the tax_court stated in reed v commissioner tcmemo_1994_611 that in determining whether a purported loan is bona_fide the ultimate issue is the intent of the borrower to repay and the intent of the lender to enforce repayment in this case taxpayer purportedly paid d dollar_figureamount as part of the purchase_price of the rail cars when it contributed dollar_figureamount to c to contribute to the investment account in d’s name in the event that d fails to pay rent for the rail cars the funds in the investment account may be applied towards rent pursuant to the terms of the investment account agreement c acting as trustee has the first priority perfected security_interest in the funds in the investment account when asked how the securities in the investment account are going to be applied by d d responded that these securities that it holds are restricted and that it believes that d cannot touch these securities questions concerning taxpayer transactions pincite d has said that it expects that it will not infuse any of its own cash into the transaction because it is fully defeased and the funds owed to d on the j deposit the note sec_2 and the investment account should pay off all obligations of d questions concerning taxpayer transactions pincite furthermore the parties specifically contemplated a situation in the tax indemnity agreement where taxpayer could receive additional income possibly indicating that taxpayer may be viewed as the owner of the investment account and the interest and oid accruals these facts indicate that d intends to repay the money to taxpayer which supports characterization as a loan reed tcmemo_1994_611 it appears that d has not had and will not have the control required to be considered to be the owner of the funds in the investment account for federal_income_tax purposes 366_us_213 although not all of the indicia of bona_fide indebtedness are present in this case the most significant element of a loan intent to repay is present it appears that the transaction resembles a loan accordingly the interest and oid that will accrue in the investment account may be attributed to taxpayer issue - genuine debt whether the indebtedness incurred by the taxpayer to purchase the rail cars should be respected for federal_income_tax purposes will depend on whether the debt is genuine and whether it has economic_substance if the debt used to purchase an asset is not genuine indebtedness the debt is not properly included in the basis of the asset 83_tc_56 conclusion the indebtedness incurred by taxpayer does not appear to be either genuine or to have economic_substance the indebtedness may be disregarded for federal_income_tax purposes and can be disregarded for determining the taxpayer’s basis in the rail cars any interest deductions taken pursuant to this indebtedness may be denied additionally taxpayer may only take depreciation_deductions to the extent of its basis in the rail cars as discussed below discussion debt will not be recognized as genuine indebtedness if the purchaser acquires no equity in the property by making payments and has no economic incentive to pay off the note 544_f2d_1045 9th cir in estate of franklin twenty-fourth property associates the purchasers agreed to purchase real_estate for dollar_figure the sellers then leased back the property the purchasers paid dollar_figure in prepaid_interest issued a nonrecourse obligation to the sellers with a balloon payment in the final year of dollar_figure and agreed to pay dollar_figure in monthly principal and interest installments the monthly principal and interest installments were designed to approximate the monthly lease payments the appeals court determined that the taxpayers failed to demonstrate that the purchase_price was at least approximately equivalent to the fair_market_value of the property estate of franklin f 2d pincite the court stated that p ayments on the principal of the purchase_price yield no equity so long as the unpaid balance of the purchase_price exceeds the then existing fair_market_value under these circumstances the purchaser by abandoning the transaction can lose no more than a mere chance to acquire an equity in the future should the value of the acquired property increase estate of franklin f 2d pincite the court in estate of franklin determined that the taxpayers did not acquire an equity_interest in the property because the purchase_price did not approximate the fair_market_value the taxpayer in the case at hand also did not acquire an equity_interest in the rail cars that it purportedly purchased although for reasons that are different from the taxpayers in estate of franklin the taxpayer in the case at hand did not acquire an equity_interest because d retained its equity_interest in the rail cars as discussed above in addition the purported debt was not used by the taxpayer and was secured_by its own generation of interest therefore the indebtedness incurred is not genuine the purported purchaser the taxpayer can therefore lose no more than a chance to acquire an equity in the rail cars in the future under estate of franklin the indebtedness will not be included in the taxpayer’s basis in the rail cars the existence of debt will also be disregarded if the overall transaction is not valid and therefore devoid of economic_substance 909_f2d_1360 9th cir 157_f3d_231 3d cir the taxpayer paid dollar_figureamount in cash and financed the purported purchase of the rail cars by borrowing dollar_figureamount from g through c acting as trustee and by borrowing dollar_figureamount from d upon close scrutiny of the loan from g and the loan from d neither of these two loans possess any economic_substance first the loan from g for dollar_figureamount for which the note sec_1 were issued has no economic_substance because the money was deposited in a cd later deposited in an interest bearing account ostensibly for the benefit of d however d has indicated that the funds held in the cd will be used to fund its future obligations to pay either the termination option or the purchase option to the taxpayer questions concerning taxpayer transactions pincite the dollar_figureamount will be moving in a circle without any economic_substance second d’s loan to c of dollar_figureamount has no substance either because d has acknowledged that these funds for which d received the note sec_2 are an internal accounting circle and for which cash was never going to be exchanged both of these two loans therefore can be excluded from taxpayer’s basis in the rail cars the funds deposited in the investment account may also be excluded from taxpayer’s basis because it appears that the funds in the investment account in substance belong to the taxpayer and not to d interest payments are not deductible under sec_163 if they arise from transactions that have no purpose substance or utility apart from their anticipated tax consequences 155_f3d_584 2d cir revrul_99_14 i r b the loans made pursuant to the note sec_1 and note sec_2 appear to have no purpose and substance apart from their tax consequences accordingly taxpayer’s interest deductions taken pursuant to sec_163 for interest_paid on the note sec_1 and note sec_2 may be denied in summary d has neither sold nor leased back its rail cars from taxpayer taxpayer has no rights under the purported loan from g of dollar_figureamount and under the purported loan from d amount of dollar_figureamount because these purported loans are circular and possess no economic_substance if taxpayer defaults on its obligations it means that d failed to meet its obligation to pay rent if taxpayer fails to meet its obligation to pay rent then d will have the right to repossess the rail cars thus taxpayer cannot at any time be the beneficial_owner of the rail cars because d has retained its equity_interest in the rail cars case development hazards and other considerations the facts in this case support a recharacterization of the sale-leaseback and the economic_substance argument although we are confident of our conclusion we recommend that you develop additional facts in support of the recharacterization such additional facts include the following issue - international issues whether sec_482 should not be applied to this sale leaseback_transaction to reallocate the ownership attributes between taxpayer and d because we do not believe the control requirement of sec_482 has been met conclusion we conclude that sec_482 should not be applied to this sale leaseback_transaction to reallocate the ownership attributes between taxpayer and d because we do not believe the control requirement of sec_482 has been met further we do not recommend that the acting in concert doctrine that has been applied to lease_stripping transactions should be pursued in this case because the parties in this transaction are unrelated and did not shift deductions separately from income in a manner that would raise a presumption of control by one party over the other if you have any further questions please call the branch telephone number deborah a butler by william c sabin jr senior technician reviewer passthroughs and special industries branch field service division


t c memo united_states tax_court tom and nancy miller petitioners v commissioner of internal revenue respondent docket no filed date michael j low for petitioners john m wall for respondent memorandum findings_of_fact and opinion kroupa judge respondent determined deficiencies in petitioners’ federal income taxes of dollar_figure and dollar_figure for and years at issue respectively and dollar_figure and dollar_figure accuracy-related_penalties under sec_6662 for those years with respect to petitioners dispute the entire deficiency and penalty except for dollar_figure of disallowed_interest_expense and a dollar_figure rental_activity loss from a property at avenida monteflora in desert hot springs california with respect to petitioners dispute the entire deficiency and penalty except for an dollar_figure rental_activity loss from the property at avenida monteflora we are asked to decide two issues the first issue is whether petitioners’ rental real_estate losses for the years at issue were passive_activity_losses subject_to the limitation under sec_469 we hold that petitioners’ losses were not passive_activity_losses for two of their rental properties but were passive_activity_losses for the remaining four properties the second issue is whether petitioners are liable for the accuracy-related_penalty under sec_6662 we hold that they are not findings_of_fact some of the facts have been stipulated and are so found the stipulations of facts and accompanying exhibits are 1the parties stipulated that petitioners failed to report dollar_figure of interest_income for and that they did not materially participate in the rental real_estate activity reported for the property at avenida monteflora in desert hot springs california during the years at issue 2all 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 unless otherwise indicated incorporated by this reference petitioners resided in petaluma california at the time they filed the petition tom miller mr miller the older child of german immigrants had an interest in building drafting and architecture growing up he pursued his interest in boats however after his father met an instructor at the california maritime academy mr miller graduated from the california maritime academy in with a bachelor of science degree in nautical industrial technology he quickly left his first job which required him to spend months at sea because it kept him away from nancy miller mrs miller he took a job with a tugboat company that allowed him to be nearer to mrs miller who is now his wife of years and to return to the san francisco bay area petitioners have two daughters at the age of mr miller became a partner in the san francisco bar pilots association sfbpa and began piloting commercial seagoing vessels for sfbpa during the years at issue mr miller piloted client vessels for the sfbpa including large container ships passenger cruise ships and large military 3mrs miller is a bookkeeper by training 4the sfbpa is a partnership for federal_income_tax purposes during the years at issue sfbpa was limited by statute to pilots all sfbpa pilots were equal partners of the sfbpa and received equal distributions ships he piloted these client vessels from miles at sea outside the san francisco bay channel throughout the san francisco san pablo and suisun bays including the sacramento and san joaquin rivers mr miller’s schedule as an sfbpa pilot requires that he work seven days and then have seven days off mr miller generally is not required to actually work for all of his seven days on his schedule is also somewhat flexible and predictable sfbpa pilots know roughly when they will have to work during their on time and can trade turns in the pilot rotation subject_to limitations despite his piloting work mr miller did not lose his interest in building and drafting he acquired a class b general contractor’s license in which he held during the years at issue he provided construction services for clients in including kitchen remodeling replacing home siding building decks building fences and replacing windows he also drafted and worked on approximately a dozen building plans for houses including during the years at issue petitioners owned six rental real_estate properties during and seven during petitioners conceded that they did not materially participate in the rental real_estate activity with respect to a property at avenida monteflora and therefore the losses from that property are passive_activity_losses petitioners argue however that the losses from their remaining rental properties are not passive_activity_losses for each of the rental properties at issue petitioners found tenants by placing ads and pictures on craigslist mrs miller prepared the written leases for the properties which petitioners both reviewed and signed petitioners collected the rents petitioners also spent substantial time researching and bidding on various rental real_estate properties including during the years at issue mr miller created contemporaneous timesheets detailing time spent on his rental_real_estate_activities and construction business the parties provided to 5craigslist is a network of online communities featuring online classified advertisements for housing jobs goods services romance local activities advice and more craigslist sites found at http craigslist org serve hundreds of cities across the united_states and in dozens of countries attracting millions of visitors every month 6mrs miller described some of the time-consuming process and challenges of researching country homes in addition to online research petitioners would travel to the locations research zoning laws and meet with the health inspector regarding water wells and septic systems on the basis of their research petitioners sometimes chose not to bid on the properties they researched when petitioners did make an offer they did not always acquire the property for example when there was a higher bidder 7as with his piloting logs mr miller did not record administrative time spent on his rental_real_estate_activities mr miller’s real_estate administrative work included planning construction and repair jobs amending timelines and ordering materials the court a number of other timesheets and summaries of petitioners’ time allocation as well petitioners’ first rental property was on pepper road in petaluma california petitioners bought five acres of land surrounded by dairy ranches in and mr miller built two homes on the land mrs miller assisted her husband with the interior design of the homes petitioners resided in one of the homes and continued to reside in that home at the time of trial petitioners leased the second home pepper road property mr miller performs maintenance work for the pepper road property including maintenance of the well septic system and all or most of the yard mr miller also performed repair work on the pepper road property including repairs to the fence washing machine garbage disposal and back door petitioners and martin miller mr miller’s brother owned and leased a single-family home on morning glory drive in petaluma california from through the years at issue morning glory property petitioners held an 85-percent interest in the morning glory property until date when they acquired martin miller’ sec_15 percent interest martin miller resided next door to the morning glory property during the years 8the court notes that petitioners’ timesheets had some inaccuracies and were imperfect nevertheless the timesheets provided useful guidance when coupled with petitioners’ testimony at issue he would occasionally mow the lawn at the morning glory property although the tenants would usually maintain the property and mow the lawn martin miller had a new carpet installed at the morning glory property in mr miller and martin miller along with an associate of mr miller installed a fence on one side of the morning glory property in martin miller hired a fence company to build a fence on the other side of the morning glory property in and mr miller reimbursed martin miller for some of the costs petitioners purchased a single-family home on lind avenue in clovis california in date lind property the lind property is in a community governed by a homeowner’s association homeowners in this community pay monthly homeowner’s association fees for maintenance of common areas and mowing and maintenance of the front yards of homes within the community petitioners rented the lind property during the years at issue petitioners purchased a single-family home on n price avenue in fresno california in date price property petitioners hired a landscaper to provide weekly mowing and gardening services for the price property for dollar_figure per month petitioners rented the price property in petitioners and martin miller purchased a single-family home on e emerald avenue in fresno california in date emerald property petitioners and martin miller held equal interests in the emerald property petitioners hired and paid an individual to provide bi-monthly mowing and gardening services for the emerald property petitioners rented the emerald property during the years at issue petitioners purchased a single-family home on bennett valley road in santa rosa california in date bennett valley property mr miller and his subcontractor delmont bogart mr bogart made a number of improvements to the bennett valley property the improvements included building a retaining wall replacing decks remodeling a bathroom installing new gutters replacing the plumbing and repairing the furnace mr bogart described mr miller as a workaholic who worked on the home after his piloting job and performed manual labor alongside him for each project on the property petitioners leased the bennett valley property in addition to mr bogart other witnesses described mr miller’s work ethic as extraordinary a friend pilot and partner of mr miller’s at sfbpa testified to his one in a million work ethic saying that he did not know anyone who worked harder mrs miller testified that she had to go to mr miller’s construction sites to see her husband mrs miller prepared petitioners’ joint returns for the years at issue petitioners did not make an election to treat all their interests in rental real_estate as one activity under sec_469 before or during the years at issue respondent issued the deficiency_notice to petitioners disallowing the schedule e rental real_estate losses for the years at issue and determining the deficiencies and accuracy- related penalties for those years petitioners timely filed a petition opinion we must decide whether a pilot of commercial seagoing vessels spent more time on his construction and rental_real_estate_activities than on piloting and whether he and his wife materially participated in certain rental_real_estate_activities so that they may deduct rental real_estate losses for the years at issue we begin with the burden_of_proof determinations of the commissioner in a deficiency_notice are presumed correct and taxpayers bear the burden of proving otherwise rule a 290_us_111 deductions are generally a matter of legislative grace and taxpayers bear the burden of proving entitlement to claimed deductions 503_us_79 292_us_435 the burden to disprove a claimed deduction may shift to the commissioner if the taxpayers prove that they have satisfied certain conditions sec_7491 snyder v commissioner tcmemo_2001_255 citing h conf rept pincite 1998_3_cb_747 petitioners have neither claimed nor shown that they complied with the substantiation requirements of sec_7491 the burden_of_proof therefore remains on petitioners see rule a petitioners claimed losses of dollar_figure and dollar_figure from their rental_real_estate_activities for the years at issue the deduction of passive_activity_losses is generally suspended sec_469 a passive_activity_loss is the excess of the aggregate losses from all passive activities for the taxable_year over the aggregate income from all passive activities sec_469 a passive_activity includes the conduct of any trade_or_business in which the taxpayer does not materially participate sec_469 a rental_activity generally is treated as a per se passive_activity sec_469 a taxpayer may however avoid having his or her real_estate activity classified as a per se passive_activity if the taxpayer is a qualifying real_estate_professional and satisfies the material_participation requirements of sec_469 a taxpayer will qualify as a real_estate_professional if i more than one-half of the personal services performed in trades_or_businesses by the taxpayer during the taxable_year are performed in real_property trades_or_businesses in which the taxpayer materially participates and ii such taxpayer performs more than hours_of_service during the taxable_year in real_property trades_or_businesses in which the taxpayer materially participates sec_469 a taxpayer may establish his or her participation in an activity by any reasonable means sec_1_469-5t temporary income_tax regs fed reg date this court has acknowledged that reasonable means is interpreted broadly and that the temporary regulations may not provide precise guidance goshorn v commissioner tcmemo_1993_578 nevertheless a postevent ballpark guesstimate will not suffice see lee v commissioner tcmemo_2006_193 goshorn v commissioner supra where as here a joint_return has been made the foregoing real_estate_professional requirements are satisfied if either spouse separately satisfies those requirements sec_469 thus if mr miller meets the foregoing requirements petitioners’ rental activities are not per se passive and the normal passive_activity_loss rules of sec_469 will apply we now consider whether mr miller qualifies as a real_estate_professional on the basis of the record and testimony provided at trial we find that mr miller has established that he spent more than hours performing significant construction work as a contractor and on his rental_real_estate_activities we find that mr miller spent more time on his construction work and rental properties than he did piloting vessels in the years at issue respondent highlights that mr miller was a partner in the sfbpa respondent also notes that mr miller occasionally spent additional time on sfbpa-related activities outside of piloting nevertheless we find petitioners’ testimony and evidence compelling mr miller completed a number of significant construction projects both as a contractor and as a landlord in the years at issue he also performed a number of additional real_estate tasks including researching properties bidding on properties finding tenants collecting rent and performing maintenance work at rental properties mr miller presented contemporaneous work logs for his construction and rental activities and provided compelling testimony and witnesses thus we find that mr miller is a qualified_real_estate_professional within the meaning of sec_469 having found that mr miller is a qualified_real_estate_professional we now consider whether petitioners materially participated in their rental activities for this purpose each interest in rental real_estate is treated as a separate rental real_estate activity unless the qualifying taxpayer makes an election to treat all interests as a single activity see sec_469 petitioners did not make such an election also for this purpose we must consider both spouses’ efforts sec_469 sec_1_469-9 income_tax regs thus we consider whether petitioners’ joint efforts amount to material_participation with respect to each rental real_estate activity material_participation is defined generally as regular continuous and substantial involvement in the business operations sec_469 a taxpayer can establish material_participation by satisfying any one of the seven tests provided in the regulations sec_1_469-5t temporary income_tax regs fed reg date see akers v commissioner tcmemo_2010_85 two tests are particularly relevant here a taxpayer is treated as materially participating in an activity if his or her participation in that activity during the taxable_year constitutes substantially_all of the participation9 in the activity for that year sec_1_469-5t temporary income_tax regs supra a taxpayer is also treated as having materially participated if the taxpayer participates in the activity for more than hours during the taxable_year and the taxpayer’s participation in the activity for the taxable_year is not less than the participation of any other individual sec participation generally means any work done in an activity by an individual who owns an interest in the activity sec_1_469-5 income_tax regs 469-5t a temporary income_tax regs fed reg date we are satisfied that petitioners participated in the rental_real_estate_activities at the pepper road property and the bennett valley property for over hours per year for the relevant yearsdollar_figure we are also satisfied that their participation was not less than the participation of any other individual for those years it follows and we hold that petitioners materially participated in the rental_real_estate_activities at the pepper road property and the bennett valley property in the relevant years and the deductions attributable to those activities are not subject_to limitation under sec_469 petitioners have not shown however that they participated in the rental_real_estate_activities at the morning glory property the lind property the price property or the emerald property for over hours per year for the relevant years they also have not carried their burden of proving that their participation in the rental_real_estate_activities at each of these four properties constitutes substantially_all of the participation for those properties in the years at issue we particularly note martin miller’s participation at the morning glory property which is adjacent to his home we sustain 10as aforementioned petitioners did not own the bennett valley property in respondent’s disallowance of losses with respect to the real_estate activities at the morning glory property the lind property the price property and the emerald property for the years at issue we now address whether petitioners are liable for the accuracy-related_penalty for a substantial_understatement_of_income_tax for each year at issue a taxpayer may be liable for a penalty of percent on the portion of an underpayment_of_tax attributable to among other things a substantial_understatement_of_income_tax sec_6662 b there is a substantial_understatement_of_income_tax if the amount of the understatement exceeds the greater of percent of the tax required to be shown on the return or dollar_figure sec_6662 sec_1 b income_tax regs we find that respondent has met his burden of production if rule_155_computations show petitioners have a substantial_understatement_of_income_tax see 116_tc_438 jarman v commissioner tcmemo_2010_285 a taxpayer is not liable for an accuracy-related_penalty however if the taxpayer acted with reasonable_cause and in good_faith with respect to any portion of the underpayment sec_6664 the determination of whether the taxpayer acted with reasonable_cause and in good_faith is made on a case-by-case basis taking into account all pertinent facts and circumstances including the taxpayer’s efforts to assess his or her proper tax_liability sec_6664 sec_1_6664-4 income_tax regs circumstances that may indicate reasonable_cause and good_faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances sec_1_6664-4 income_tax regs petitioners state in their petition that they acted with reasonable_cause and in good_faith and we so find petitioners prevailed on the threshold question of whether mr miller qualifies as a real_estate_professional they also prevailed on the question of whether they materially participated with respect to two of their rental properties as for the remaining properties petitioners provided evidence and gave credible testimony but simply failed to meet their burden_of_proof nevertheless petitioners provided extensive records of their rental_real_estate_activities including contemporaneous timesheets we find that petitioners acted with reasonable_cause and in good_faith in claiming rental real_estate losses for the years at issue accordingly we decline to impose a penalty upon petitioners we have considered all arguments made in reaching our decision and to the extent not mentioned we conclude that they are moot irrelevant or without merit to reflect the foregoing decision will be entered under rule


t c memo united_states tax_court christopher schorse petitioner and cynthia palabrica commissioner of internal revenue respondent intervenor v docket no filed date christopher schorse pro_se cynthia palabrica pro_se richard c grosenick for respondent memorandum findings_of_fact and opinion paris judge pursuant to sec_6015 petitioner seeks review of respondent’s determination that he is not entitled to relief from joint_and_several_liability under sec_6015 c or f for and with respect to federal_income_tax returns that he jointly filed with intervenor his former spouse the liability has been paid in full and petitioner is not seeking a refund of any payments made toward the liability for that year respondent and intervenor concede that petitioner is entitled to relief under sec_6015 for the remaining issues to be decided are whether petitioner is entitled to relief from joint_and_several_liability under sec_6015 c or f for and findings_of_fact some of the facts have been stipulated and are so found the first stipulation of facts between petitioner and respondent the first amended first 1unless otherwise indicated all section references are to the internal_revenue_code in effect at all relevant times and all rule references are to the tax_court rules_of_practice and procedure 2because and are not in controversy they will not be discussed further except to provide background information stipulation of facts between intervenor and respondent and the exhibits are incorporated herein by this reference petitioner resided in wisconsin when he timely filed his petition intervenor resided in wisconsin when she intervened in this case background petitioner and intervenor were married in they were legally_separated in and their divorce became final in during their marriage they had three children born in and petitioner holds a bachelor of science degree in computer science and has no formal education in business finance or accounting for the years in issue petitioner had his own business crs enterprises inc an s_corporation intervenor was an obstetrician-gynecologist ob-gyn and the shareholder of hls medical services s c hls an s_corporation petitioner and intervenor managed their personal and business finances separately and neither controlled the other’s spending they had separate bank accounts and a personal joint bank account used to pay the mortgage_insurance and utility expenses for their family home historically and for the years in issue 3the first stipulation of facts between petitioner and respondent with attached exhibits contains identical stipulations and exhibits to the first amended first stipulation of facts between intervenor and respondent intervenor earned to of the household_income she paid most of the family_expenses and all of the childrens’ expenses including dollar_figure a month for private elementary_school for one child and dollar_figure a month for a full-time nanny for the other two children petitioner was aware that significant funds were spent on childcare and the cost of private school tax returns for and intervenor provided petitioner with her tax information including her hls schedules k-1 partner’s share of income deductions credits etc intervenor’s hls schedules k-1 reflected losses for and petitioner asked intervenor and her business accountant about the losses they informed him that intervenor did not have a sufficient basis in hls to deduct the losses for those years for each year in issue petitioner calculated their tax_liability both with and without the loss claimed for each year in issue petitioner then instructed his business accountant to prepare and file a joint_return that claimed the loss deduction petitioner thought that the information on intervenor’s hls schedules k-1 was similar to the information he would have reported on his business’ schedules k-1 and that the profits and losses reported on intervenor’s hls schedules k-1 were the amounts to be used on the joint returns for they reported adjusted_gross_income agi of dollar_figure claimed a loss deduction of dollar_figure and received refunds totaling dollar_figure for they reported agi of dollar_figure claimed a loss deduction of dollar_figure and received a refund of dollar_figure for they reported agi of dollar_figure claimed an at-risk carryover deduction of dollar_figure and received a refund of dollar_figure during the years in issue they significantly renovated their family home with their tax refunds in or respondent examined petitioner and intervenor’ sec_2002 and joint returns for respondent assessed additional tax of dollar_figure and an accuracy-related_penalty of dollar_figure for respondent assessed additional tax of dollar_figure and an accuracy-related_penalty of dollar_figure for respondent assessed additional tax of dollar_figure and an accuracy-related_penalty of dollar_figure on date petitioner and intervenor entered into an installment_agreement to pay dollar_figure a month on the and tax_liabilities within four months their installment_agreement for and was canceled because they defaulted on their payments petitioner and intervenor 4petitioner and intervenor were issued a dollar_figure refund on date and a dollar_figure refund on date there is no explanation in the record as to why petitioner and intervenor were issued two refunds for legally_separated on date intervenor continued to make payments on the liability and it was paid in full on date petitioner and intervenor’s divorce was finalized on date petitioner’s request for administrative relief on date before their divorce was final petitioner submitted to the internal_revenue_service form_8857 request for innocent spouse relief seeking relief from joint_and_several_liability for and under the explanation for involvement with finances and preparing returns petitioner checked the boxes for gathered receipts and cancelled checks gave tax documents to the person who prepared the returns and reviewed the returns before they were signed petitioner further explained that he was provided intervenor’s tax information and assumed it was correct but he did not verify whether it was correct under their marital settlement agreement intervenor agreed to be responsible for their tax_liabilities for the years in issue through on date respondent made a preliminary determination that petitioner was entitled to full relief for and under sec_6015 and partial relief for under sec_6015 on date intervenor 5on date petitioner submitted a separate form_8857 for submitted to respondent a letter appealing the preliminary determination on date respondent’s office of appeals appeals informed petitioner that it was reconsidering petitioner’s request on date petitioner provided appeals the marital settlement agreement on date appeals made a final_determination that petitioner was ineligible for relief for and under sec_6015 c or f on form_8857 petitioner reported total monthly income of dollar_figure and total monthly expenses of dollar_figure at the time appeals made its final_determination petitioner’s monthly income had increased to dollar_figure at the time of trial petitioner’s financial situation was substantially the same opinion generally married taxpayers may elect to file joint federal_income_tax returns sec_6013 sec_6013 provides that if a joint_return is filed each spouse is jointly and severally liable for the entire tax due for that year a requesting spouse may be relieved from joint_and_several_liability under sec_6015 however if certain conditions are met except as otherwise provided in sec_6015 the requesting spouse generally bears the burden_of_proof rule a 119_tc_306 aff’d 101_fedappx_34 6th cir sec_6015 provides three potential avenues to relief under subsections b c and f a requesting spouse who satisfies the conditions of subsection b may be relieved from liability for an understatement_of_tax attributable to the other spouse similarly a requesting spouse who satisfies the conditions of subsection c may have his or her liability for a deficiency limited to the portion of the deficiency allocated to him or her under subsection d finally the requesting spouse may be granted relief under subsection f from any unpaid tax or any deficiency if relief is not available under subsection b or c and it would be inequitable to hold the requesting spouse liable the court will determine whether petitioner is entitled to relief under subsection b c or f for and see sec_6015 i relief under sec_6015 sec_6015 provides that a requesting spouse shall be relieved of joint_and_several_liability for a particular year if each of the following requirements is met a a joint_return was filed for the year in issue b the return contains an understatement attributable to an erroneous item of the nonrequesting spouse c the requesting spouse establishes that in signing the return he or she did not know and had no reason to know of the understatement 6as stated supra p and are no longer in issue d it is inequitable to hold the requesting spouse liable for the deficiency attributable to the understatement and e the requesting spouse’s claim for relief is timely failure to meet one of these requirements precludes relief under sec_6015 alt v commissioner t c pincite respondent argues that petitioner has not satisfied the subparagraph c requirement of sec_6015 to qualify for sec_6015 relief a requesting spouse cannot have had actual knowledge or a reason to know of the understatement at the time he signed the joint_return sec_6015 generally a requesting spouse has reason to know of the understatement if he has reason to know of the transaction that gave rise to the understatement 118_tc_106 aff’d 353_f3d_1181 10th cir the u s court_of_appeals for the seventh circuit to which this case is appealable absent an agreement between the parties see sec_7482 has adopted a more lenient approach in cases where the understatement results from improper deductions versus cases involving unreported income see 74_f3d_1528 7th cir rev’g and remanding tcmemo_1994_241 see also 54_tc_742 aff’d 445_f2d_985 10th cir the court_of_appeals has stated that the requesting spouse must establish that he did not know or have reason to know that the erroneous deduction would give rise to an understatement resser v commissioner f 3d pincite6 quoting 887_f2d_959 9th cir the court applies a reasonably prudent person standard to evaluate the requesting spouse’s knowledge in cases involving both unreported income and erroneous deductions 121_tc_73 regarding improper deductions 114_tc_276 regarding unreported income a spouse knew or had reason to know of an understatement if a reasonably prudent person in his position would have known that the return contained an understatement when he signed it resser v commissioner f 3d pincite6 butler v commissioner t c pincite the reasonably prudent person standard also imposes a duty_of inquiry on the requesting spouse resser v commissioner f 3d pincite hopkins v commissioner t c pincite butler v commissioner t c pincite for understatements resulting from improper deductions the requesting spouse had reason to know if he had sufficient knowledge of the facts underlying the deductions such that a reasonably prudent person in his position would seriously have questioned whether the deductions were erroneous resser v commissioner f 3d pincite quoting 872_f2d_1499 11th cir aff’g t c memo in applying the reasonably prudent person standard the court considers four factors the requesting spouse’s level of education the requesting spouse’s involvement in the family’s financial and business activities any substantial unexplained increase in the family’s standard of living and the nonrequesting spouse’s evasiveness or deceitfulness about the family’s finances resser v commissioner f 3d pincite no single factor is controlling each of these four factors weighs against petitioner petitioner has a bachelor of science degree in computer science and owned and operated his own business even though petitioner does not have a degree in business accounting or finance his experience owning and operating his s_corporation provided him with at least a cursory understanding of the appropriate tax treatment of profits and losses petitioner testified that he reported profits and losses from his business on schedule_k-1 each year and understood intervenor’s schedules k-1 to include the same type of information for the years in issue petitioner was involved in the family’s financial activities and was aware of intervenor’s financial and tax situation because he was provided that information the court finds his claims to the contrary are self- serving and not credible see 87_tc_74 finding that the court is not required to accept uncorroborated or self-serving testimony as reliable and true while petitioner was not involved in intervenor’s ob-gyn practice he was given all of intervenor’s tax documents and was involved in preparing the joint returns petitioner calculated their tax_liability for each year in issue before taking their tax information to his business accountant when he inquired about the losses reflected on intervenor’s hls schedules k-1 intervenor and her business accountant told him intervenor could not deduct the losses for and he was aware that claiming the losses would result in refunds because he compared their and tax_liabilities with and without the losses before instructing his business accountant to deduct them petitioner and intervenor maintained a high standard of living during the years in issue their high standard of living included paying dollar_figure a month for one of their children to attend a private elementary_school and paying dollar_figure a month for a full-time nanny for their other children in addition to their high standard of living during the years in issue they used their tax refunds to renovate the family home petitioner testified that he had no control_over how intervenor spent her income or the refunds petitioner was aware however that the joint income was being spent on high-cost items and that there was a substantial increase in funds used to renovate the family home he benefited from the high standard of living and the renovations finally nothing in the record indicates that intervenor tried to deceive or hide anything from petitioner while petitioner and intervenor maintained separate bank accounts they also had a joint bank account to pay the mortgage and other household costs petitioner was provided all of intervenor’s tax information to prepare the joint returns when he asked about the losses reported on intervenor’s schedules k-1 he was given an answer by intervenor and her business accountant petitioner provided all of his and intervenor’s tax information to his business accountant to prepare the joint returns and instructed his accountant to include the losses on the joint returns in consideration of the four enumerated factors the court finds that a reasonably prudent person in petitioner’s position at the time he signed the joint returns could be expected to know that the joint returns contained understatements and that petitioner actually knew the and joint returns each contained an understatement thus petitioner failed to satisfy his burden to establish that he did not know or have reason to know that the loss deductions would result in understatements of tax for and and is not entitled to relief under sec_6015 failing any condition of subsection b precludes relief under that subsection as the court has found that petitioner failed the knowledge requirement he is not entitled to relief under sec_6015 for or ii relief under sec_6015 an election under sec_6015 is ineffective with respect to any portion of a deficiency if the commissioner proves by a preponderance_of_the_evidence that the requesting spouse had actual knowledge when signing the return of an item giving rise to a deficiency that is otherwise allocable to the nonrequesting spouse sec_6015 hopkins v commissioner t c pincite in cases involving erroneous deductions a spouse is deemed to have actual knowledge of an item giving rise to a deficiency if he had actual knowledge of the factual circumstances that made the deduction unallowable 116_tc_198 actual knowledge of the tax laws or legal consequences of the operative facts is not required id 115_tc_183 aff’d 282_f3d_326 5th cir as the court found supra pp petitioner had actual knowledge of the items allocable to intervenor giving rise to the understatements when he signed the joint returns therefore petitioner is not entitled to relief under sec_6015 for or iii relief under sec_6015 sec_6015 grants the commissioner discretion to relieve an individual from joint liability where relief is not available under sec_6015 or c if taking into account all the facts and circumstances it is inequitable to hold the individual liable for any unpaid tax or deficiency when the court reviews a determination by the commissioner denying relief under sec_6015 both the standard and scope of review are de novo 132_tc_203 as directed by sec_6015 the commissioner has prescribed procedures to determine whether a requesting spouse is entitled to equitable relief from joint_and_several_liability those procedures are set forth in revproc_2013_34 sec_4 2013_43_irb_397 although the court considers those procedures when reviewing the commissioner’s determination the court is not bound by them 136_tc_432 rogers v commissioner tcmemo_2018_53 at the court’s determination ultimately rests on an evaluation of all the facts and circumstances porter v commissioner t c pincite pursuant to revproc_2013_34 sec_4 the commissioner conducts a multistep analysis when determining whether a requesting spouse is entitled to equitable relief under sec_6015 the requirements for relief under revproc_2013_34 supra are categorized as threshold or mandatory requirements streamlined elements and equitable factors a requesting spouse must satisfy each threshold requirement to be considered for relief see revproc_2013_34 sec_4 i r b pincite if the requesting spouse meets the threshold requirements the commissioner will grant equitable relief if the requesting spouse meets each streamlined element see id sec_4 i r b pincite otherwise the commissioner will determine whether equitable relief is appropriate by evaluating the equitable factors see id sec_4 i r b pincite a threshold requirements the requesting spouse must meet seven threshold requirements to be considered for relief under sec_6015 revproc_2013_34 sec_4 the parties agree and the court finds that petitioner meets the threshold requirements b streamlined elements if the threshold requirements are satisfied revproc_2013_34 sec_4 describes circumstances in which the commissioner will make a streamlined determination granting equitable relief under sec_6015 to be eligible for a streamlined determination the requesting spouse among other things must establish under guidelines provided in revproc_2013_34 sec_4 a that he d id not know or have reason to know that there was an understatement or deficiency on the joint income_tax return id sec_4 c i i r b pincite as found supra pp petitioner had knowledge of the understate- ments on the joint returns for the years in issue therefore petitioner is ineligible for a streamlined determination in accordance with revproc_2013_34 sec_4 c equitable factors revproc_2013_34 sec_4 applies to a requesting spouse who requests relief under sec_6015 and who satisfies the threshold conditions of sec_4 but does not qualify for streamlined determinations granting relief under sec_4 id sec_4 revproc_2013_34 sec_4 lists the following seven nonexclusive factors to be considered in determining whether taking into account all the facts and circumstances equitable relief under sec_6015 should be granted the current marital status of the spouses whether the requesting spouse would suffer any economic hardship if relief were not granted whether the requesting spouse knew or had reason to know of the item giving rise to the understatement whether either spouse has a legal_obligation to pay the outstanding federal_income_tax liability whether the requesting spouse significantly benefited from the understatement whether the requesting spouse has made a good_faith effort to comply with the income_tax laws in the years following the years for which relief is sought and whether the requesting spouse was in poor mental or physical health at the time the returns in issue were filed at the time the request for relief was made or at the time of trial in making a determination under sec_6015 the court considers the enumerated factors as well as any other_relevant_factors no single factor is dispositive and t he degree of importance of each factor varies depending on the requesting spouse’s facts and circumstances revproc_2013_34 sec_4 see pullins v commissioner t c pincite hall v commissioner tcmemo_2014_171 at marital status if the requesting spouse is no longer married to the nonrequesting spouse this factor will weigh in favor of granting relief see revproc_2013_34 sec_4 a if the requesting spouse is still married to the nonrequesting spouse this factor is neutral id as petitioner and intervenor were divorced before respondent’s final_determination this factor favors petitioner economic hardship economic hardship exists if satisfaction of the tax_liability in whole or in part would result in the requesting spouse’s being unable to meet his or her reasonable basic living_expenses id sec_403 i r b pincite where the requesting spouse’s income exceed sec_250 of the federal poverty guidelines this factor favors relief if monthly income exceeds reasonable basic living_expenses by dollar_figure or less id if denying relief from joint_and_several_liability will not cause the requesting spouse to suffer economic hardship this factor will be neutral id at the time of trial petitioner’s monthly income was approximately dollar_figure which exceed sec_250 of the federal poverty guidelines petitioner did not provide the court with evidence of his monthly expenses therefore petitioner has not established that he will suffer economic hardship if the court denies him relief this factor is neutral knowledge knowledge exists when the requesting spouse knew or had reason to know of the item giving rise to the understatement or deficiency as of the date the joint_return was filed or the date the requesting spouse reasonably believed the joint_return was filed id sec_4 c i a if the requesting spouse did not know and had no reason to know of the item giving rise to the understatement this factor will weigh in favor of relief id if the requesting spouse knew or had reason to know of the item giving rise to the understatement this factor will weigh against relief id as previously discussed petitioner knew of the items giving rise to the understatements on the joint returns for the years in issue see supra pp this factor weighs against granting relief legal_obligation this factor favors relief where the nonrequesting spouse has the sole obligation to pay an outstanding federal tax_liability under a binding divorce decree or other legally binding agreement revproc_2013_34 sec_4 d i r b pincite this factor is neutral where both spouses have an obligation to pay the outstanding liability under a binding divorce decree or other legally binding agreement id petitioner and intervenor’s divorce decree states that intervenor is solely responsible for the and federal_income_tax liabilities accordingly this factor favors petitioner significant benefit under this factor the court considers whether the requesting spouse received a significant benefit beyond normal support from the understatement id sec_4 e normal support is measured by the circumstances of the particular party porter v commissioner t c pincite guidance under sec_6015 states that benefits in excess of normal support are mitigated however where the nonrequesting spouse controlled the household or business finances making this factor neutral revproc_2013_34 sec_4 e this factor will weigh in favor of granting relief if the nonrequesting spouse significantly benefited from the unpaid tax or understatement and the requesting spouse had little or no benefit or the nonrequesting spouse enjoyed the benefit to the requesting spouse’s detriment id as discussed above petitioner and intervenor had a high standard of living which included private school and a nanny for their children additionally during the years in issue they significantly renovated the family home with their tax refunds petitioner benefited significantly from the understatements of tax for and petitioner argues he had no control_over how intervenor spent her income or the refunds intervenor however had contributed to of the household_income and had paid most of the household expenses out of their joint bank account the record reflects that petitioner was aware and enjoyed the benefit of the renovations the private school and the nanny additionally petitioner controlled the preparation of the joint returns for the years in issue and decided to deduct hls’ losses petitioner’s argument fails to take into account that his income_tax liabilities were also reduced by the erroneous deductions claimed on their returns because petitioner significantly benefited from the understatements this factor weighs against him compliance the parties agree that petitioner is currently in compliance with his federal_income_tax obligations therefore this factor favors petitioner health this factor may weigh in favor of relief if the requesting spouse was in poor mental or physical health at the time the returns in issue were filed at the time the request for relief was made or at the time of trial id sec_4 g i r b pincite see also pullins v commissioner t c pincite if the requesting spouse was in neither poor physical nor poor mental health this factor is neutral revproc_2013_34 sec_4 g the parties agree that petitioner was not in poor mental or poor physical health at any of those times thus this factor is neutral d conclusion on sec_6015 relief although many of the factors for equitable relief either favor petitioner or are neutral petitioner’s actual knowledge of the losses deducted on the joint returns his involvement in preparing those returns and the significant benefit he received from the understatements weigh too heavily against him to allow relief weighing all the facts and circumstances the court finds that petitioner is not entitled to relief from joint_and_several_liability under sec_6015 for or iv conclusion the court finds that petitioner is not entitled to relief from joint_and_several_liability under sec_6015 c or f for and the court has considered all the other arguments of the parties and to the extent not discussed above finds those arguments to be irrelevant moot or without merit to reflect the foregoing an appropriate decision will be entered