81 T.C. 184 (1983), 16079-80, Rice's Toyota World, Inc. v. C.I.R.

Docket Nº:16079-80.
Citation:81 T.C. 184
Opinion Judge:GOFFE, Judge:
Party Name:RICE'S TOYOTA WORLD, INC. (FORMERLY RICE AUTO SALES, INC.) Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Attorney:William L. Tankersley, III, and Kenneth R. Keller, for the petitioner. Gary F. Walker, for the respondent.
Case Date:August 29, 1983
Court:United States Tax Court
 
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Page 184

81 T.C. 184 (1983)

RICE'S TOYOTA WORLD, INC. (FORMERLY RICE AUTO SALES, INC.) Petitioner,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 16079-80.

United States Tax Court

August 29, 1983

Petitioner entered into a purchase-and-leaseback arrangement with a computer equipment leasing corporation. Pursuant to this agreement, petitioner purchased a six-year-old computer for $1,455,227. The purchase price was paid in the form of a four-year promissory note in the amount of $250,000 and the balance in two nonrecourse notes payable over an eight-year period. Simultaneously, petitioner leased the equipment back to the equipment leasing corporation for eight years. The equipment leasing corporation's monthly rental payments to petitioner purported to amortize petitioner's nonrecourse note obligations and generate a $10,000 yearly cash flow to petitioner.

Held, petitioner had no business purpose for entering into the transaction other than tax avoidance. Held further, objective analysis of the transaction showed that petitioner could not have had a realistic hope of profit. The probable residual value of the equipment was not indicative of economic substance.

Petitioner's purchase-leaseback was lacking in economic substance and must be disregarded for Federal income tax purposes.

William L. Tankersley, III, and Kenneth R. Keller, for the petitioner.

Gary F. Walker, for the respondent.

GOFFE, Judge:

The Commissioner determined deficiencies in petitioner's Federal income tax as follows:

TYE June 30- Deficiency
1976 $104,776.32
1977 225,531.31
1978 205,347.71
Page 185 Pursuant to Rule 141(b) of the Tax Court Rules of Practice and Procedure,[1] the Court ordered a separate trial for the sole purpose of deciding one issue. That issue is whether petitioner's purchase and leaseback of used computer equipment was a tax avoidance scheme lacking in economic substance which should be disregarded for tax purposes. FINDINGS OF FACT Some of the facts have been stipulated by the parties. The stipulation of facts and the attached exhibits are incorporated herein by reference. Petitioner, Rice's Toyota World, Inc. (Rice Toyota), was a North Carolina corporation with its principal place of business in Greensboro, North Carolina, when it filed its petition in this case. Federal income tax returns for the taxable years in issue were timely filed with the Internal Revenue Service Center in Memphis, Tennessee. Rice Toyota uses the accrual method of accounting with a fiscal year ending June 30. Petitioner is primarily engaged in the sale of new and used cars. Rice Toyota was the first Toyota dealer in the Southeastern United States. Petitioner's founder, president, and sole stockholder, Garson L. Rice (Mr. Rice), began his career as a used car salesman. In the late 1950's Mr. Rice did a study of Toyota. Believing Toyota would prove to be a big winner, he contacted the Japanese manufacturers and ultimately signed a contract to represent them in the South. Today Rice Toyota is a highly successful business with annual gross sales in excess of $14 million. Entry into Transaction Although Mr. Rice did not meet with Finalco, Inc. (Finalco), representatives until June, 1976, petitioner, Rice Toyota, entered into an agreement dated February 27, 1976, with Finalco, a computer leasing corporation, to purchase a six-year- Page 186 old IBM computer. The purchase price was $1,455,227 payable in 96 monthly installments. Finalco leased back the computer equipment for the same eight years paying rent to petitioner monthly. The net difference between the monthly rentals and the monthly installment payments generated a $10,000 yearly cash flow to petitioner. Simultaneously, Finalco subleased the computer equipment to a third party for a term of five years. During the eight-year leaseback to Finalco, petitioner was not entitled to share in any revenues generated by the equipment. But, upon expiration of Finalco's lease, petitioner would be entitled to a 70-percent interest in any revenues. Finalco retained the other 30 percent and the right to remarket or sell the equipment. Mr. Rice learned about computer purchase-and-leaseback transactions through a friend who had already entered into a similar transaction. This friend was a client of Finalco. Finalco is one subsidiary of a group of companies. Its primary business is the leasing of capital equipment. It began as a lessor of computer equipment and expanded its operations to include all types of equipment. At the time of the trial, Finalco was generating leases valued in excess of $100 million a year. Mr. Rice asked petitioner's accountant, Neill M. Clegg, to telephone Finalco and request information about the types of equipment leasing transactions that were available. Clegg spoke to Stephen Eastman, then Assistant General Counsel at Finalco. The two men talked two or three times on the phone until Mr. Eastman had a general idea about the type of transaction that would appeal to Rice Toyota. In late May or early June, 1976, Finalco mailed petitioner a letter describing three representative transactions, which varied according to the size of the initial investment. Finalco later sent petitioner a placement memorandum for the transaction that petitioner had selected. This placement memorandum also contained a projected profit-and-loss statement for the entire eight-year transaction. For the taxable years in issue this statement contained the following relevant information:
TYE TYE TYE
June 30, 1976 June 30, 1977 June 30, 1978
Rental income 0 $213,101 $213,101
Nonrecourse note amortization 0 203,101 203,101
Cash flow to petitioner 0 10,000 10,000
Page 187 Total projected losses generated from accelerated depreciation and interest expense were $782,063 during the first five years of the transaction. After this time the transaction was expected to produce income. For the taxable years in issue the projected profit-and-loss sheet provided as follows:
TYE TYE TYE
June 30, 1976 June 30, 1977 June 30, 1978
Rental income 0 $213,101 $213,101
Interest expense, nonrecourse 0 (83,774) (82,514)
Depreciation expense ($218,284) (371,083) (259,758)
Net (218,284) (241,756) (129,171)
Tax savings 109,142 120,878 64,586
Petitioner would owe no cash for the transaction in the taxable year ended June 30, 1976, because the promissory note was dated July 1, 1976. For the taxable year ended June 30, 1976, petitioner claimed a depreciation deduction of $218,284 with no cash outlay. During the second two taxable years, petitioner could anticipate deductions for interest and depreciation expenses exceeding rental income by a total of $370,927. In taxable years ended June 30, 1977 and 1978 petitioner made out-of-pocket payments of $62,500 and $77,500, respectively. Petitioner's accountant, Neill Clegg, examined the proposed transaction from an economic viewpoint as well as from a tax viewpoint. He determined that the $10,000 yearly cash flow made good economic sense. In his analysis he assumed some residual value, and he also considered the possibility of re-leasing the property at the end of the lease. Mr. Rice was informed by Mr. Clegg that this transaction was not a " tax shelter" but rather a " tax deferral" whereby accelerated depreciation on the equipment in the first four years would reduce Rice Toyota's taxes during that period. He Page 188 warned Mr. Rice that the decision to enter into the transaction should be based upon a belief of substantial residual value. Mr. Eastman presented and promoted the purchase and leaseback of the equipment to Mr. Rice. On June 17, 1976, he met with Mr. Rice and petitioner's C.P.A. and tax counsel to discuss the proposed transaction. Mr. Rice and Mr. Eastman reviewed the " upside" of the transaction or its potential for profit and its " downside" or risk of loss. Mr. Eastman represented to Mr. Rice that the net economic effect of the transaction was a $10,000 per year cash flow on a $250,000 investment, equivalent to an after tax yield of 4 percent. In the worst case, Mr. Eastman said petitioner would net $80,000 of its $250,000 investment. Mr. Eastman advised Mr. Rice that the current list price for new identical IBM equipment was approximately $2,500,000. Mr. Eastman claimed that his projected residual value of 10 to 20 percent, based on that price, would return to petitioner its investment plus profit. Mr. Eastman delivered to Mr. Rice a document entitled Rules of Thumb for Pricing Used Computers[2] with an attached Stanford Research Institute (SRI) report. He pointed out that this study indicated a projected residual value at the end of the eight years of only 6 percent or about $150,000. Mr. Eastman said that Finalco was comfortable with its higher predicted residual value of 10 to 20 percent, but could not guarantee it. Mr. Eastman also mentioned the profit that might be generated through subsequent dealings and told Mr Rice that he must consider the residual value of the equipment in determining the investment's worthiness. Finalco prepared an equipment leasing memorandum that described the proposed transaction. It also prepared a set of purchase and lease documents, including purchase agreements, installment notes, security agreements, leases, and some collateral documents. The leasing memorandum stated that the transaction was " suitable only for persons anticipating substantial taxable income from other sources." The memorandum assumed no residual value in the equipment at expiration of the lease term,...

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