Opinion ID: 4538282
Heading Depth: 2
Heading Rank: 1

Heading: Validity of claimed deductions and credits

Text: The Internal Revenue Code (IRC) provides favorable tax treatment for investments in solar-energy projects and other capital expenditures. But the requirements to qualify are strict, and the government, believing that purchases of lenses for Defendants’ project did not satisfy them, filed this action in the United States District Court for the District of Utah seeking injunctive and other equitable relief against Defendants. After a 12-day bench trial in which Defendants did not call any witnesses, the district court agreed with the government. The district court concluded, as discussed in more detail below, that Defendants had engaged in conduct subject to penalty under 26 U.S.C. § 6700(a)(2)(A) by telling customers that they could claim solar-energy tax credits under 26 U.S.C. § 48 and depreciation deductions under 26 U.S.C. § 167(a), including deductions and credits in excess of both passive income, see 26 U.S.C. § 469, and the amounts at risk, see 26 U.S.C. § 465. It also concluded that Defendants engaged in conduct subject to penalty under § 6700(a)(2)(B) because they made a gross-valuation overstatement “each time they told someone the price of a lens (whether $9,000, $3,000, or $3,500).” RaPower-3, 343 F. Supp. 3d at 1191. 5 The district court determined that Defendants’ “customers were not allowed a depreciation deduction or the solar energy credit” for several reasons. Id. at 1173. To begin with, “customers were not allowed a depreciation deduction . . . because [they] were not in a ‘trade or business’ related to the solar lenses and did not hold the lenses for the production of income.” Id. The court evaluated whether customers had acquired lenses in good faith with the primary purpose of earning a profit. It relied on Tenth Circuit precedent, in particular Nickeson v. Commissioner, 962 F.2d 973 (10th Cir. 1992), which identifies factors indicating that an activity is an abusive tax scheme as opposed to a bona fide trade or business. The factors include: “marketing on the basis of projected tax benefits, grossly inflated purchase price set without bargaining, failure of taxpayers to inquire into the potential profitability of the program, taxpayers’ lack of control over activities, and use of nonrecourse indebtedness[.]” Id. at 977 (citations omitted). Defendants’ project fit the bill. The district court found (1) that the benefits of lens ownership were marketed by reference to “the tax benefits it would provide,” RaPower-3, 343 F. Supp. 3d at 1181; (2) that “no customer earned or would earn income from buying solar lenses,” id. at 1174; (3) that “customers had no control over their purported ‘lens leasing’ businesses,” id. at 1179; and (4) that “any purported obligation [of the customer] to pay is substantial—and perhaps indefinitely—deferred debt,” “[c]ustomers borrow for free,” and “the only security for the customers’ promise to pay the[] outstanding amounts is the lens itself,” id. at 1180. The district court concluded that “the solar lenses were a smokescreen for . . . unlawful ‘sales’ of tax deductions and 6 credits to customers,” id. at 1182, and that “customers’ ‘lens leasing’ businesses were not bona fide and ongoing businesses,” id. at 1183. The district court concluded that depreciation deductions were also not allowed because the lenses were not “placed in service” by the same tax year as the claimed deductions. It relied on Treasury Regulation 26 C.F.R. § 1.167(a)–10(b), which prohibits depreciation deductions unless the property for which the deduction is sought had been “placed in service” by the year that the deduction is claimed. “Property is first placed in service when first placed in a condition or state of readiness and availability for a specifically assigned function, whether in a trade or business, in the production of income, in a tax-exempt activity, or in a personal activity.” 26 C.F.R. § 1.167(a)– 11(e)(1)(i). The district court evaluated whether the lenses were “placed in service” under the framework articulated in Sealy Power, Ltd. v. Commissioner, 46 F.3d 382 (5th Cir. 1995), action on decision, AOD-1995-10 (Aug. 7, 1995), nonacq., 1995-33 I.R.B. 4, 1995-2 C.B. 1 (Aug. 14, 1995). In Sealy Power the Fifth Circuit identified five factors from Revenue Rulings for determining when the components of a power-generating system are “placed in service” within the meaning of the Treasury Regulations: 1) whether the necessary permits and licenses for operation have been obtained; 2) whether critical preoperational testing has been completed; 3) whether the taxpayer has control of the facility; 4) whether the unit has been synchronized with the transmission grid; and 5) whether daily or regular operation has begun. 7 Id. at 395. Because none of these factors was met in Defendants’ system and because “the bulk of customers’ ‘lenses’ [were] not installed on towers,” the district court concluded they were not “placed in service.” RaPower-3, 343 F. Supp. 3d at 1184. For those reasons and one additional, the district court determined that the customers were not entitled to the solar-energy credit under 26 U.S.C. § 48. Taxpayers can claim a credit for a percentage of the “basis” (generally the cost) of qualifying “energy property.” 26 U.S.C. §§ 46(2); 48(a)(1), (2)(A)(i)(II). But to qualify for the credit the property must be depreciable, see id. § 48(a)(3)(C), and placed in service during the taxable year, see id. § 48(a)(1). And, for the reasons just discussed, the lenses did not satisfy either requirement. Moreover, the lenses did not satisfy the requirement that the property be “equipment which uses solar energy to generate electricity, to heat or cool (or provide hot water for use in) a structure, or to provide solar process heat.” Id. § 48(a)(3)(A)(i). The district court found: The preponderance of the credible evidence . . . show[ed] that customers’ lenses have never been used in a system that generates electricity, that heats or cools a structure or provides hot water for use in a structure. Nearly all customer “lenses” [were] actually rectangular sheets of plastic sitting in a warehouse, uncut, unframed, and not yet installed on towers. Further, the preponderance of credible evidence show[ed] that even the lenses installed on towers do not “provide solar process heat.” RaPower-3, 343 F. Supp. 3d at 1185. Thus, there were at least three reasons why lens customers did not qualify for the solar-energy tax credit. The district court then concluded that even if lens customers were entitled to depreciation deductions and solar-energy credits, they were not allowed to claim deductions or credits in excess of their income from “passive” activities. The court 8 explained that “§ 469 generally prohibits the deduction of passive activity losses, except insofar as the losses are used to offset passive activity income,” and that “[a]ctivity that involves the rental of tangible property is” a passive activity. RaPower-3, 343 F. Supp. 3d at 1185–86. Therefore, lens customers were not allowed to use “deductions and credits from purportedly leasing out solar lenses . . . to offset active income or tax on active income.” Id. at 1185–86. Finally, the district court concluded that under § 465, lens customers were not allowed to claim deductions or credits in excess of their down payments on the lenses. It explained that losses incurred in connection with certain statutorily enumerated activities, including leasing depreciable property, see 26 U.S.C. § 465(c)(1)(C), cannot be deducted from income in excess of the amount that the taxpayer has “at risk” in the activity, id. § 465(a). The amount “at risk” is in general the amount of money (and the adjusted basis of property) the taxpayer has contributed to the activity. Id. § 465(b). The district court concluded that lens customers had no money at risk because (1) the purchase contracts “contained an explicit statement that a customer could get a refund of all amounts paid in, without penalty, if either IAS or RaPower-3 did not perform on the contract,” and (2) there was no enforceable obligation to personally repay the nonrecourse, zero-interest loan used to finance the balance of the purchase price. RaPower-3, 343 F. Supp. 3d at 1188. Therefore, lens customers “were not allowed to claim a depreciation deduction for the full purchase price or any related amount.” Id. at 1188–89. 9 In short, the district court concluded that customers were not allowed to claim the deductions or credits that Defendants advertised in connection with owning and leasing a lens.