Cma Consolidated, Inc. v. Commissioner, Dkt. No. 12746-01.

• Decision Date: 31 January 2005
• Docket Number: Dkt. No. 12746-01.
• Citation: 89 T.C.M. 701
• Parties: CMA Consolidated, Inc. & Subsidiaries, Inc. v. Commissioner.
• Court: U.S. Tax Court

89 T.C.M. 701

T.C. Memo. 2005-16

CMA Consolidated, Inc. & Subsidiaries, Inc. v. Commissioner.

Dkt. No. 12746-01.

United States Tax Court.

January 31, 2005.

George W. Connelly, Jr., Linda S. Paine, and William O. Grimsinger, for petitioners.

Mary E. Wynne and Caroline Tso Chen, for respondent.

                                             CONTENTS
                Introduction and Statement of Issues Findings of Fact
                    I. The Two Lease Strip Deals
                       A. Background
                       B. First Lease Strip Deal
                       C. Second Lease Strip Deal
                       D. Other Aspects of Petitioner's Claimed
                       Losses and Deductions With Respect to
                       the Second Lease Strip Deal
                  II. Petitioner's 1995 Through 1997 Advances to
                      Cap Corp. and the December 2, 1996, Debt
                      Conversion Transaction
                         A. Cap Corp. and Its Business
                         B. Petitioner's 1995 and 1996 Advances to
                         Cap Corp
                         C. The December 2, 1996, Debt Conversion
                         Transaction
                         D. Petitioner's 1997 Advances to Cap Corp
                         E. Petitioner's 1997 Ordinary Loss and
                         Bad Debt Deduction; Petitioner's 1998
                         AeroCentury Stock Transaction
                           1. The $2 Million Consulting Fee
                           2. Petitioner's Advances to Koehler
                Opinion
                  I. Petitioner's Second Lease Strip Deal
                     A. Did the Underlying Transactions Have
                     Economic Substance
                       1. Generally
                       2. Background and Recapitulation of the
                       Two Lease Strip Transactions
                       3. Petitioner's Rental Expense Deductions
                       and Note Disposition Losses
                

                       4. Did Petitioner Have a Nontax Business
                       Purpose for Entering Into the Second
                       Lease Strip Transaction
                       5. Whether Petitioner's Lease Strip Deal
                       Had Economic Profit Potential Aside
                       From the Tax Benefits
                         a. The Experts' Opinions
                             i. Petitioner's Expert
                                (a) Svoboda's Opinions as to
                                the Fair Market Values and Estimated
                                Residual Values
                                (b) Svoboda's Fair Market
                                Value for the Over Lease
                                Residual Interests
                            ii. Respondent's Expert
                         b. Evaluation and Comparison of the
                         Experts
                         c. Petitioner's Lease Strip Deal's Economic
                         Profit Potential
                      6. Conclusion as to the Economic Substance
                         of Petitioner's Lease Strip Deal
                    B. Petitioner's Entitlement to Its Claimed
                    Deductions
                II. Petitioner's $2,052,900 Ordinary Loss and
                    $1,859,135 Bad Debt Deduction
                    A. Petitioner's Claimed Deductions—the
                    Debt vs. Equity Issue
                    B. Application of the 11-Factor Test
                       1. Names Given to the Documents
                       2. Presence or Absence of a Fixed Maturity
                       Date
                       3. Source of the Repayment
                       4. The Right To Enforce the Payments
                       5. Participation in Management
                       6. Status Relative to Other Creditors
                       7. Intent of the Parties
                       8. Thin or Adequate Capitalization
                       9. Identity of Interest
                      10. Payment of Interest Only Out of
                      Dividends
                      11. Ability To Obtain Loans From
                      Outside Lending Institutions
                   C. Conclusion and Holdings
                III. The $2 Million Fee
                   A. The Assignment of Income Doctrine
                   B. The Parties' Arguments
                      1. Petitioner's Arguments
                      2. Respondent's Arguments
                   C. Analysis and Holding
                      1. Petitioner's Agreement With NSI
                      2. CKH's and Petitioner's Purported Fee-Splitting
                      Agreement
                      3. Petitioner's Entitlement to a Business
                      Deduction
                IV. Petitioner's Advances to Koehler
                V. Is Petitioner Liable for Penalties Under Section
                   6662
                Appendixes
                Appendix A—Flow Chart Reflecting the Basic Elements
                of the Transactions in the Two Lease Strip
                Deals
                Appendix B—Summary of Appendix A
                Appendix C—Existing End User Equipment Rental
                Monthly Payments That HCA Purchased
                

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Chief Judge.

Respondent determined income tax deficiencies, an addition to tax, and penalties with respect to petitioner's¹ taxable years ended November 30, 1996 and 1997, as follows:

                Addition to Tax and Penalties
                        TYE        Deficiency       Sec. 6651(a)(1)       Sec. 6662(a)
                    11/30/96        $320,375         $16,019                 $90,609
                    11/30/97       1,729,294            --                   176,383
                

All section references are to the Internal Revenue Code, as amended and in effect for the years in issue. Rule references are to the Tax Court Rules of Practice and Procedure.

After concessions by the parties, the primary issues remaining for our consideration are: (1) Whether petitioner is entitled to approximately $2.7 million of deductions claimed for its taxable years ended November 30, 1996 and 1997, from a lease strip deal; (2) whether petitioner's lease strip deal has economic substance and is to be respected for Federal income tax purposes; (3) whether petitioner's claimed rental expense deductions arising from the lease strip deal are deductible as ordinary and necessary business expenses; (4) whether petitioner is entitled to claim note disposition losses from the lease strip deal; (5) whether the $2,259,900 that petitioner advanced to CMA Capital Corp. is to be treated as an investment (equity) or debt; (6) whether for its taxable year ended November 30, 1997, petitioner is entitled to a deduction for a $2,052,900 ordinary loss from a debt conversion transaction; (7) whether petitioner is entitled to claim a $1,859,135 bad debt deduction for its taxable year ended November 30, 1997, with respect to loans petitioner purportedly made to CMA Capital Corp.; (8) whether petitioner should include in its income the $2 million portion of a consulting fee that petitioner paid to Crispin Koehler Holding Corp. in early 1997; (9) if the $2 million is includable in petitioner's income for its taxable year ended November 30, 1997, whether petitioner is entitled to deduct its payment of $2 million to Crispin Koehler Holding Corp. as a business expense; (10) whether petitioner is entitled to a $76,705 bad debt deduction for its taxable year ended November 30, 1996, with respect to its advances to Richard Koehler; and (11) whether petitioner is liable for penalties under section 6662 for its taxable years ended November 30, 1996 and 1997, with respect to portions of its underpayments for those years attributable to its claimed lease strip deal deductions.

FINDINGS OF FACT²

Petitioner is a California corporation. At the time the petition was filed, petitioner maintained its office and principal place of business in Burlingame, California. At all pertinent times, Neal Crispin (Crispin) owned 98 percent of CMA's outstanding stock and has been petitioner's ultimate decision maker.

Since its May 1992 incorporation, CMA Capital Management, Inc. (CMACM), has been a wholly owned subsidiary of petitioner and a member of petitioner's consolidated group. Since its August 1983 incorporation, Capital Management Associates (CM Associates) has been a wholly owned subsidiary of petitioner and a member of petitioner's consolidated group.

I. The Two Lease Strip Deals

A. Background

Petitioner was generally involved in equipment leasing transactions and the structuring of equipment financing. During the early 1990s, petitioner began to arrange deals designed to separate equipment rental income from the related rental expenses. In those deals, which were called "lease strips" and/or "rent strips", the rental income was allocated to a tax-indifferent or tax-neutral party in order to allow another party to claim a greatly disproportionate share of the related tax benefits. Generally, a "tax-indifferent" or "tax-neutral" party is one that does not incur a Federal income tax liability on its income because of its status or its circumstances. Examples would include a party that was not a U.S. taxpayer or a party that was a U.S. taxpayer but had large net operating losses available to offset income.

One such tax-indifferent party petitioner employed was the Iowa Tribe of Oklahoma (Iowa Tribe). Because of its status as an Indian tribe recognized by the Bureau of Indian Affairs of the U.S. Department of the Interior, the Iowa Tribe was not subject to Federal income tax on income allocated to it from lease strip deals.³ The Iowa Tribe participated in approximately eight different partnerships during the mid-1990s and received fees for its participation as a limited partner in those partnerships. In exchange for its "modest investment" and agreement to be the 99-percent limited partner in a partnership, the Iowa Tribe received a fee ranging from $17,000 to $40,000 at the closing of each deal. The fee represented a percentage of the total commissions received by CMA in connection with the lease strip deal. The Iowa Tribe had no active role in the partnership and realized that its participation allowed others to exploit its tax-exempt status. A wholly owned CMA subsidiary and/or Crispin (CMA's 98-percent shareholder and ultimate decision maker) often served as a 1-percent or less general partner of the partnership.

The two lease strip deals involve computer and photo processing equipment subject to two existing end-user leases. One end-user lease agreement, dated October 26, 1989 (hereinafter for convenience referred to as the K-Mart end-user lease or K-Mart lease), involved the lease of existing and after-acquired photo processing equipment by Varilease Corp. (Varilease) to K-Mart Corp. (K-Mart). On January 22, 1992, Computer Leasing, Inc. (CLI), purchased the equipment subject to the K-Mart lease along with Varilease's rights and obligations under the lease. On May 18, 1994, additional equipment was added to the K-Mart end-user lease. The other end-user lease agreement dated July 1, 1993 (hereinafter for convenience referred to as the Shared end-user lease or Shared lease), involved the lease of computer equipment by CLI to Shared Medical System Corp. (Shared).

Starting with the K-Mart and Shared end-user leases...