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

Heading: tax-law implications

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.
The district court construed § 6700(a)(2)(A) to permit the imposition of a penalty against any “person who 1) organizes or sells any plan or arrangement involving taxes and 2) makes or furnishes, or causes another to make or furnish, a statement connecting the allowability of a tax benefit with participating in the plan or arrangement, which statement the person knows or has reason to know is false or fraudulent as to any material matter.” Id. at 1170. Penalties can also be recovered from one who sells a service or product at a grossly inflated price (more than twice the correct value, see 26 U.S.C. § 6700(b)(1)(A)), so that customers can claim excessive tax benefits. See id. § 6700(a)(2)(B); United States v. Campbell, 897 F.2d 1317, 1322 (5th Cir. 1990) (explaining that tax shelters based on gross overvaluations “eliminate the buyer’s incentive to pay no more than the investment’s value because the financing mechanism allows the buyer to save more in tax benefits than is paid for the investment. That economic incentive pushes the price above the value”); see also Autrey v. United States, 889 F.2d 973, 981 (11th Cir. 1989) (“[A] promoter is in essence strictly liable for grossly overstating the value of property or services based upon which an investor will attempt to take a deduction or credit.”). The district court determined that Defendants’ “solar energy scheme [was] a ‘plan’ under § 6700 because the key component of the scheme was its promoted connection to 10 the federal tax benefits of a depreciation deduction and a solar energy tax credit.” RaPower-3, 343 F. Supp. 3d at 1170. And it found that all the Defendants “organized, or assisted in organizing the scheme, and sold the scheme to customers either directly or through other people.” Id. The district court further determined that Defendants made false or fraudulent statements about material matters by asserting that customers could claim deductions and credits in connection with their lens purchases. It explained that these statements were material because they “‘would have a substantial impact on the decision-making process of a reasonably prudent investor and include matters relevant to the availability of a tax benefit.’” Id. at 1171 (quoting Campbell, 897 F.2d at1320). And finally, the district court concluded that the scienter element of § 6700(a)(2)(A) was met because Defendants knew or had reason to know that their statements were false or fraudulent. It applied the following test: A court may conclude that a promoter had reason to know his statements are false or fraudulent based on what a reasonable person in the defendant’s subjective position would have discovered. The trier of fact may impute knowledge to a promoter, so long as it is commensurate with the level of comprehension required by his role in the transaction. A person selling a plan would ordinarily be deemed to have knowledge of the facts revealed in the sales materials furnished to him by the promoter. A person who holds himself out as an authority on a tax topic has reason to know whether his statements about that topic are true or false. The test . . . is satisfied if the defendant had reason to know his statements were false or fraudulent, regardless of what he actually knew or believed. Id. at 1173 (brackets, emphasis, citations, and internal quotation marks omitted). Under this test, Defendants knew all the facts indicating that lens customers were not entitled to claim the promoted deductions or credits. Further, their defense that they relied on the 11 advice of counsel that their customers were entitled to all of the promoted tax benefits was unavailing because “[i]f anything, the circumstances surrounding the writings [of the attorneys on whom they purportedly relied], and the attorneys’ outraged response to learning that Defendants were using their writings to promote the solar energy scheme, bolster Defendants’ reason to know that their statements were false or fraudulent.” Id. at 1190. The district court also concluded that Defendants had violated § 6700(a)(2)(B) by making gross overstatements as to the value of the lenses. It determined that each sheet of plastic from which lenses were to be cut cost Defendants between $52 and $70, and that “[b]ased on the available and credible evidence, . . . the correct valuation of any ‘lens’ is close to its raw cost, and does not exceed $100.” Id. at 1191. Defendants were selling each lens for $3,500, so the court held that they “engaged in conduct subject to penalty under § 6700(a)(2)(B) and made or furnished a gross valuation overstatement each time they told someone the price of a lens[.]” Id.
The district court ruled that injunctive and other equitable relief was appropriate under 26 U.S.C. § 7408 (which authorizes the government to seek injunctive relief to prevent ongoing conduct subject to penalty under § 6700 and other specified sections of the Tax Code) and § 7402(a) (which grants district courts jurisdiction to issue injunctions and other equitable relief to enforce the Tax Code), because Defendants had engaged in the scheme for many years; they knew that their statements about tax benefits were false or fraudulent; the scheme had caused great harm, including harm to the federal treasury; 12 and Mr. Johnson’s and Mr. Shepard’s lack of remorse and continuation of the scheme after the IRS began investigating their scheme indicated that they were very likely to continue promoting their abusive tax scheme unless enjoined from doing so. It issued an injunction to prohibit Defendants from continuing to engage in the conduct that was subject to penalty under § 6700. For the same reasons that an injunction was appropriate, the district court ordered Defendants to disgorge their gross receipts from lens sales. Defendants appeal, raising a number of issues, to which we now turn.