Court Opinion

ID: 8980877
Source: CourtListenerOpinion
Date Created: 2022-11-27 11:20:09.526916+00
Date Added: 2024-06-11T17:10:39.539878
License: Public Domain

HUG, Circuit Judge,
dissenting:
I concur in Part I of the majority opinion but I respectfully dissent from Part II.
I.

Summary

This is not the case of a sham tax shelter arrangement. The district court found, after hearing reliable expert testimony, that the $4,863,012 purchase price for the computer equipment represented fair market *484value. The district court further found that the transaction had economic substance and that it was entered into with a reasonable expectation of profit. The Government does not contest these findings on appeal.
The June Partners’ partnership is clearly at risk. The note is a recourse note, and if the lease payments are not made, the partnership is still liable on the note. The majority erroneously interprets section 26 U.S.C. § 465(b)(4) to apply because the lease payments, if they are made, will pay off the note. Section 465(b)(4) was designed to apply to a situation where the taxpayer’s risk is eliminated by non-recourse financing, insurance, a guarantee, or some other type of collateral agreement that would preclude the taxpayer from suffering a loss. For example, if there were an agreement that .liability on the June Partners’ note would be extinguished if the lease payments were not made, then this would be the type of stop-loss agreement contemplated by section 465(b)(4). The section was not designed to apply to the normal business arrangement where a taxpayer procures a loan to buy equipment, leases it and pays off the loan with the lease payments.
II.

Detailed Analysis

We are here concerned with interpretation of 26 U.S.C. § 465 as applied to this case. Section 465(a) provides that when a taxpayer engages in an activity to which section 465 applies, any loss from such activity for a taxable year shall be allowed only to the extent of the aggregate amount that the taxpayer is “at risk” for such activity at the close of the taxable year. Section 465(b)(1) provides that a taxpayer is “at risk” for the amount of money and the adjusted basis of property contributed. Section 465(b)(2) provides that the taxpayer is also “at risk” for the amounts of money borrowed for use in the activity to the extent he is personally liable for the repayment of such amounts. There are then certain exclusions and exceptions. Section 465(b)(3)(A) excludes from the borrowed amounts considered “at risk” amounts that are borrowed from a person who has an interest in such activity, other than an interest as a creditor. Section 465(b)(4) creates an exception to the above “at risk” provisions. It provides that “[notwithstanding any other provisions of this section, a taxpayer shall not be considered at risk with respect to the amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.”
In personally assuming a $120,000 portion of June Partners’ $4,307,012 recourse long-term loan, the Baldwins are clearly at risk within the terms of section 465(b)(2) because they are personally liable for repayment. The question is whether either subsection (b)(3)(A) or (b)(4) precludes the transaction from being treated as one in which the taxpayers are “at risk.”
Because the majority relies on section 465(b)(4) in reversing the district court, I will first discuss the application of that section. Section 465(b)(4) provides for dis-allowance of “at risk” treatment for borrowed funds when the taxpayer is “protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.” It is clear that the transaction here in issue does not involve nonrecourse financing, guarantees, or stop-loss agreements. Thus, in order for this section to apply, this transaction must be determined to be an “other similar arrangement.”
The majority considers the arrangement whereby the lease payments from Finalco to June Partners are utilized to pay the Softpro note as being “similar” to protection against loss by a guarantee or stop-loss agreement, despite the fact that there is no provision that excuses performance under the note or protects against the loss if the lease payment is not made.
The lease itself is not a similar arrangement. A guarantee and a stop-loss agreement are both binding legal agreements that are directed to protect the borrower against loss on the note itself, and insure against his having to pay it. The note in issue in this case is a negotiable instrument *485with recourse against the borrower and there is no such binding agreement to protect against loss on the note. All we have here is a lease, the payments on which are sufficient to pay off the loan. There is nothing to prevent Softpro from negotiating June Partners’ note to a third party who could collect despite the nonpayment of rent. The obligations are separate. June Partners and, in turn, the Baldwins remain at risk whether the lease payment is made or not.
Suppose, for example, Softpro finds that it needs cash for some business purpose. It can legally factor the note to a third party, perhaps at a discount. Softpro would intend to continue making its payments to Finalco out of its business proceeds. The new noteholder would look to the repayment of the note from June Partners and to the personal liability of the Baldwins for the portion of the indebtedness they assumed. If for some reason Finalco cannot or does not pay the lease payments, perhaps because Softpro does not make payment on its note to Finalco, the noteholder would ultimately look to June Partners’ and the Baldwins’ personal liability.
The fact that Finalco is legally obligated to pay the rent under the lease is no guarantee that taxpayers will suffer no loss on the note. It is true that, so long as the rent payments are made, June Partners has the funds to pay Softpro. But many things can go wrong and the key is that June Partners and, in turn, the Baldwins are neither absolved on the note nor protected against loss.
We must examine what it is about this arrangement that the Government contends makes it similar to a guarantee or an agreement that the June Partners will not suffer a loss. The fact that they contracted for lease payments to cover the loan cannot be the reason. If June Partners had obtained its loan from a bank and also entered into a lease that was in an amount necessary to make those payments, no one would contend that this constituted another arrangement similar to a guarantee or stop-loss agreement. This is true even if the lessee was a solid Fortune 500 company. This would be just a simple prudent business arrangement.
Does then the fact that the credit and lease arrangement is circular disqualify this under section 465(b)(4)? There is certainly nothing in the statute or legislative history that so provides. Even assuming that Finalco lent directly to June Partners, there is no more of a guarantee, stop-loss or similar agreement than in the situation where the loan was from the bank. Now, of course, if there were an agreement that the liability on the note would be extinguished if the rent was not paid, then there would be a stop-loss type of agreement. A circular arrangement could well involve such an agreement, but the point is that in this case there was none. Indeed, there was such a binding setoff provision in the case of Klagsbrun v. Commissioner, 55 T.C.M. (CCH) 1519 (1988), relied upon by the majority but that is the crucial feature which distinguishes that case from this one.
Furthermore, in this case we do not have a true circular arrangement because Soft-pro is the lender to June Partners and June Partners receives the rent from Finalco. The district court found that Softpro is an independent business corporation. There are no organizational ties between Softpro and Finalco — Softpro is not a subsidiary; it does not have interlocking directors; it is an independent computer dealer that buys and sells equipment. It had purchased and sold $140,000,000 in computer equipment.
To have an effective stop-loss agreement in this case there would have to have been a stop-loss or setoff provision in both the June Partners’ note to Softpro and the Softpro note to Finalco. There was no such provision.
The third contention of the Government seems to be based on the method of payment. Surely it cannot be seriously contended that the fact that payment was made by offsetting bookkeeping entries rather than sending monthly checks through the mail can have any effect on the underlying legal relationships. No authority is cited for such a proposition and it *486would indeed be the paragon of form over substance to so hold.
The simple fact of the matter is that section 465(b)(4) was not designed to cover this type of arrangement at all. It was not designed to cover a situation in which the payments on a loan were going to be made from a lease of the equipment, which the loan financed. This is the normal business relationship in most circumstances. Rather, section 465(b)(4) was designed to cover the situation in which the borrower was protected by some collateral arrangement whereby he was protected by an insurance policy, a guarantee, or an agreement that insured that he would not have to pay his note or would be reinbursed if he did.
The Tax Court recognized this in Gefen v. Commissioner, 87 T.C. 1471 (1986). In that case, the taxpayer was also a limited partner who had assumed personal liability for a pro rata share of a partnership’s recourse indebtedness. The equipment financed was leased to Exxon, and the lease payments covered the loan payments. The Tax Court stated:
[The Commissioner] argues, however, that because Exxon was a strong credit risk and not likely to default on its lease obligations during the years in question, petitioner was protected against loss and was therefore not at risk within the meaning of section 465 for her pro rata share of the partnership’s recourse indebtedness. We reject this argument because we perceive nothing in section 465 or its legislative history that requires an owner of property to enter into a transaction with a party that is a poor credit risk in order to be “at risk” within the meaning of section 465.
The majority misconstrues our recent opinion in Melvin v. CIR, 894 F.2d 1072 (9th Cir.1990). In that case, a limited partner had claimed a loss for the full amount of his recourse note, but we held, in affirming the Tax Court, that he was limited to his pro rata share of the loss because California statutory provisions gave him a legally binding right of contribution against his copartners. We recognized this as a statutory collateral protection against loss and, thus, within the meaning of section 465(b)(4). We noted the legislative history of the section:
As the Senate Finance Committee explained:
A taxpayer’s capital is not ... “at risk” ... to the extent he is protected against economic loss of all or part of such capital by reason of an agreement or arrangement for compensation or reimbursement to him of any loss which he may suffer. Under this concept, an investor is not “at risk” if he arranges to receive insurance or other compensation for an economic loss after the loss is sustained, or if he is entitled to reimbursement for part or all of any loss by reason of the binding agreement between himself and another person.
S.Rep. No. 938, 94th Cong., 2d. Sess. 49 (1976) (“Senate Report”), U.S.Code Cong. & Admin.News 1976, p. 3485.
It is important to note that this explanation refers to an arrangement for protection from loss by means of insurance or other compensation “after the loss is sustained.” In our case, no loss would be sustained until after the lease payment was not made. The type of protection contemplated by Congress in section 465(b)(4) is protection that comes into play after the loss has been sustained. The statutory right of contribution among partners was such later collateral protection.
The majority acknowledges that the district court was correct in determining that the Baldwins were at risk for purposes of section 465(b)(2) because they bore the ultimate responsibility of Finalco’s financial difficulty and nonpayment of the rent. However, the majority states that for purposes of section 465(b)(4) the lease must be evaluated under a different standard and that the possibility of Finalco’s inability to pay the lease cannot be considered. The legislative history cited by the majority clearly applies, not to the basic lease transaction but to the collateral insurance against loss arrangements. If a taxpayer obtains this type of loss protection insurance, Congress did not want a collateral issue to be raised concerning the solvency of the insurer or guarantor.
*487It would make no sense to evaluate the basic lease transaction under section 465(b)(2) and then again under section 465(b)(4). In Melvin, we specifically stated that for protection against loss under section 465(b)(4) “we apply the same principles of logic as used to determine a taxpayer’s risk in a transaction,” (the section 465(b)(2) standard) at 1075.
The other case relied upon by the majority, Capek v. Commissioner, 86 T.C. 14 (1986), involved a third party in effect insuring against a loss on the notes involved. The Tax Court noted the legislative history pertaining to section 465(b)(4).
[A] taxpayer’s capital is not “at risk” in the business, even as to the equity capital which he has contributed to the extent he is protected against economic loss of all or part of such capital by reason of an agreement or arrangement for compensation or reimbursement to him of any loss which he may suffer. Under this concept, an investor is not “at risk” if he arranges to receive insurance or other compensation for an economic loss after the loss is sustained, or if he is entitled to reimbursement for part or all of any loss by reason of a binding agreement between himself and another person.
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if a taxpayer is personally liable on a mortgage but he separately obtains insurance to compensate him for any payments which he must actually make under such personal liability, the taxpayer is at risk only to the extent of the uninsured portion of the personal liability to which he is exposed_ [S.Rept. 94-938, supra, 1976-3 C.B. (Vol. 3) at 87-88; fn. refs, omitted.]
Id. at 52.
It is apparent Congress is speaking of a collateral protection against loss — insurance or compensation for loss “after the loss is sustained” or reimbursement for the loss by a binding agreement. The Tax Court noted that it is in this type of collateral agreement that reimburses for the loss after it is sustained that we do not look to the potential insolvency of the party providing the loss protection. Id.
In summary, in this case we have no collateral agreement providing reimbursement for or insurance against loss after it is sustained. We have only the lease from Finalco, which is not an arrangement similar to a guarantee or stop-loss agreement. Section 465(b)(4) does not apply.
The majority does not reach the Government’s argument that section 465(b)(3)(A) precludes “at risk” treatment and, thus, my discussion will be brief. The Government contends that Softpro was merely a strawman and, thus, ignores it in the transaction. It contends that Finalco is the real lender to June Partners and that it has a prohibited interest under that section. The district court found that Softpro was an independent computer dealer that bought the equipment and then sold it to June Partners. It had the legal responsibilities of a buyer and a seller. The Government’s argument that it operated simply as a broker is not supported by the actual legal relationships that were created. There were liabilities and responsibilities undertaken by the purchase and sale of the equipment and Softpro also stood to lose if June Partners did not pay its note. Section 465(b)(3)(A) does not apply.
I would affirm the district court.