Rice's Toyota World, Inc. v. Comm'r of Internal Revenue
| Citation | 81 T.C. No. 16,81 T.C. 184 |
| Decision Date | 29 August 1983 |
| Docket Number | Docket No. 16079–80. |
| Parties | RICE'S TOYOTA WORLD, INC. (FORMERLY RICE AUTO SALES, INC.) Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | United States Tax Court |
OPINION TEXT STARTS HERE
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.
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 ¦
+------------------------------+
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.
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.
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- 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 ¦
+-----------------------------------------------------------------------------+
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 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...
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