Thomas v. C.I.R.

• Citation: 792 F.2d 1256
• Decision Date: 06 June 1986
• Docket Number: No. 85-1954,85-1954
• Parties: -5138, 86-1 USTC P 9465, 20 Fed. R. Evid. Serv. 1395 James P. THOMAS and Mary Lou Thomas, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 1256

792 F.2d 1256

58 A.F.T.R.2d 86-5138, 86-1 USTC P 9465,

20 Fed. R. Evid. Serv. 1395

James P. THOMAS and Mary Lou Thomas, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 85-1954.

United States Court of Appeals Fourth Circuit.

Argued Jan. 7, 1986.

Decided June 6, 1986.

Elliot I. Miller, New York City, for petitioners.

Bruce R. Ellisen, Tax Div., Dept. of Justice (Roger M. Olsen, Acting Asst. Atty. Gen., Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, Washington, D.C., on brief) for respondent.

Before ERVIN and WILKINSON, Circuit Judges, and BUTZNER, Senior Circuit Judge.

BUTZNER, Senior Circuit Judge:

The Tax Court held that the Wise County Mining Program was not organized with the primary objective of making a profit. Therefore, James P. Thomas and Mary Lou Thomas (taxpayers) could not deduct their share of the program's losses pursuant to I.R.C. Secs. 162(a) and 616(a). ^* Accordingly, the court upheld the Commissioner's assessment of a deficiency in the taxpayers' 1978 income tax return. We affirm.

I

The facts in this case are fully set forth in the Tax Court's opinion. See Thomas v. Commissioner, 84 T.C. 1244, 1245-67 (1985). They may be summarized for purposes of this appeal. The Wise County Mining Program was organized by Samuel L. Winer to sublease and mine a coal seam in Wise County, Virginia. The program entered into a contract with Shelton Coal Corporation, which undertook to mine the property for a fee. Shelton agreed to mine a minimum of 120,000 tons of coal per year for the life of the project unless its performance was excused by force majeure.

The program was financed with $912,500 in cash and $1,930,000 in nonrecourse notes furnished by investors in the program. The notes were executed in favor of Shelton and were to be paid with proceeds from the sale of coal. Shelton agreed that if it did not meet its annual mining commitments, it would pay liquidated damages to the investors sufficient to enable them to amortize the notes. The amortization of the notes and the payment of offsetting damages were accomplished through bookkeeping entries. Thus, the investors were not required to contribute any cash beyond their initial payment.

In December 1978, James P. Thomas purchased an interest in the program by paying $25,000 in cash and executing a $52,162 nonrecourse note. Pursuant to I.R.C. Sec. 761(a), Thomas and the other investors elected exclusion from the partnership provisions of Subchapter K of the Code, Secs. 701-761. This enabled the investors to avoid the "at risk" provision of I.R.C. Sec. 704(d) which would have limited their deductions to the amount of cash that they contributed.

On their 1978 return, the taxpayers reported a deduction of $73,243 as their share of the program's losses for 1978. This deduction reduced their taxes by $37,411. Thus, regardless of whether any coal was mined, Thomas was guaranteed a return of $37,411 on his $25,000 investment if the deductions were allowable.

Shelton began mining in January 1979. It encountered unmapped old mine works which created a dangerous condition in the mine. This danger prompted the Mine Safety Health Administration to order that the mine be closed in August 1979. Accordingly, Shelton suspended its operations and informed Winer that it was invoking the force majeure provision in its contract.

In October 1979, Shelton offered to develop an alternative site but the investors would not agree to pay a higher mining fee. Shelton eventually subcontracted with Triangle Mining Company to mine the original property. Triangle mined this site from October 1981 through June 1982 but was forced to halt its operations due to flooding and depressed market conditions.

The Tax Court found that a total of 57,352 raw tons of coal had been mined which produced 36,823 clean tons with gross sales of $873,543. The net proceeds to the program totalled $48,237. Thomas's share of these proceeds was $1,287.

In sustaining the Commissioner's disallowance of the 1978 deduction of $73,243, the Tax Court held that the mining venture "was not an activity engaged in with the primary and predominant objective of realizing an economic profit." 84 T.C. at 1270. The court found that the primary objective "was to secure tax benefits rather than to earn an economic profit." 84 T.C. at 1279-80. The court based its ultimate finding on the following subsidiary findings: tax considerations provided the foundation for the program's actions, the nonrecourse notes had no "valid business purpose," 84 T.C. at 1282, and were intended to provide tax deductions, preliminary investigations of the viability of the undertaking were superficial, the program's activities were not conducted in a businesslike manner, and there was scant investigation of the marketability of the coal at the projected price.

II

The taxpayers' two principal assignments of error are: (1) the Tax Court erred as a matter of law because it ignored the legal principles applicable for determining profit motive, and (2) the Tax Court erroneously applied the law in finding a lack of profit motive because every basis of its decision is legally wrong. The taxpayers emphasize that their principal objections raise issues of law, not of fact.

The Tax Court upheld the Commissioner's assessment of a deficiency on the ground that the program was not organized with the primary objective of making a profit. In this context, as the Tax Court pointed out, " 'primary' means 'of first importance' or 'principally,' and 'profit' means economic profit, independent of tax savings." 84 T.C. at 1269.

The taxpayers contend that the court should have applied the "sham transaction" test. In Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir.1985), we held that a sale and lease back transaction will be treated as a sham and any deductions will be disallowed if "the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and ... the transaction has no economic substance because no reasonable possibility of a profit exists." 752 F.2d at 91. The taxpayers contend that the program was not a sham because it had economic substance. Therefore, they say "the subjective intent of the Taxpayers is irrelevant ...."

We reject this argument. The Commissioner did not disallow the taxpayers' deductions on the ground that the program was a sham. Instead, the Commissioner asserted that the program lacked the primary objective of making a profit. These are different grounds for invalidating deductions. See Sanderson v. Commissioner, 1985 T.C.M. (P-H) p 85,477 at 2140 n. 15. If a business has the primary objective of making a profit, deductions pertaining to a specific transaction may or may not be allowed depending on whether the transaction is a sham. See, e.g., Rice's Toyota World, 752 F.2d at 91-92. The issue in this case is more fundamental. It is whether the mining venture itself has the primary objective of making a profit.

Nor can we accept the taxpayers claim that deductions attributed to mining activity should be allowed on the ground that they satisfied the requirements of Secs. 162(a) and 616(a). The major premise for the allowance of these deductions is that they arise out of a venture whose primary objective is to make a profit. See Surloff v. Commissioner, 81 T.C. 210, 232-33 (1983). Consequently, the Tax Court did not err in its analysis of the legal issues involved in this case. In order to determine whether the claimed deductions were allowable, it properly inquired whether the mining venture's primary objective was to make a profit. In Malmstedt v. Commissioner, 578 F.2d 520, 527 (4th Cir.1978), speaking of deductions claimed under Sec. 162(a), we said: "The test is whether the business was undertaken 'in good faith for the purpose of making a profit.' " There is no principled reason why the same test should not apply to determine whether mining development costs can be deducted under Sec. 616(a).

III

The Tax Court's determination that the program lacked the primary objective of making a profit is a finding of fact that ordinarily cannot be set aside unless it is clearly erroneous. Tallal v. Commissioner, 778 F.2d 275, 276 (5th Cir.1985); Faulconer v. Commissioner, 748 F.2d 890, 895 (4th Cir.1984). The taxpayers contend, however, that the court erred as a matter of law in considering much of the evidence.

The court considered the investors' decision to elect out of the partnership provisions of Secs. 701-761. This enabled them to avoid Sec. 704(d) which would have limited their deductions to the amount of their cash investment. However, as a consequence of this action, Shelton was prohibited from entering into long-term coal sales contracts on behalf of the investors. See 26 C.F.R. Sec. 1.761-2(a)(3)(iii) (1985). This prohibition was disadvantageous to the investors because mining operations were projected to last 10 years. Thus, Shelton...