Coleman v. Comm'r of Internal Revenue

• Decision Date: 24 October 1985
• Docket Number: Docket No. 7216-83.
• Citation: 85 T.C. 622,85 T.C. No. 37
• Parties: RONALD COLEMAN AND NANCY COLEMAN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

85 T.C. 622

85 T.C. No. 37

RONALD COLEMAN AND NANCY COLEMAN, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7216-83.

United States Tax Court

Filed October 24, 1985.

Petitioners purchased an interest in certain computer equipment from C, which had purchased such interest from E, which had purchased an interest in the equipment from A. Petitioners then leased their interest back to C. HELD, petitioners did not own a depreciable present interest in the equipment in the years in issue. HELD FURTHER, petitioners, acquisition constitutes an activity not engaged in for profit, within the meaning of sec. 183, I.R.C. 1954. HELD FURTHER, interest payments on petitioners' nonrecourse note, which does not constitute genuine indebtedness, are not deductible. HELD FURTHER, interest payments on a recourse note are deductible. MATTHEW H. ROSS and LEON C. BAKER, for the petitioners.

SUSAN G. LEWIS and PATRICIA H. DELZOTTI, for the respondent.

TANNENWALD, JUDGE:

Respondent determined deficiencies in petitioners' Federal income taxes for taxable years 1979 and 1980 of $2,189 and $2,442, respectively, relating to petitioner Nancy Coleman's 1 percent interest in a computer leasing transaction. In his amended answer, respondent alleged additional deficiencies for taxable years 1979 and 1980 of $31,840 and $64,700, respectively, relating to petitioner Ronald Coleman's interest in the same transaction. The issues for decision are whether petitioners' deductions for depreciation and interest expenses were properly disallowed.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. This reference incorporates the stipulations of facts and attached exhibits. At the time they filed their petition in this case, petitioners resided in Oradell, New Jersey. Petitioners timely filed joint Federal income tax returns for 1979 and 1980.

During the years 1979 and 1980, petitioner Ronald Coleman was a one-third partner in Majestic Construction Co. (‘Majestic‘), a New Jersey general partnership. The other partners were Ronald Coleman's brothers, Harvey and William Coleman. Majestic's business was constructing rental income properties for its own account. During 1979 William Coleman and Leon C. Baker, a first cousin of the Colemans' and an attorney who had been involved with equipment leasing since 1972, discussed Majestic's need for a tax shelter and the economic and tax aspects of computer leasing. Baker approached Nigel Leopard, a representative of Carena (Computers) B.V. (‘Carena‘), a Netherlands corporation, to develop a deal for the Colemans. Baker had dealt with Leopard for about seven years, the latter generally acting as an intermediary between European leasing companies and American brokers who, in turn, sought investors for equipment leasing transactions. Baker sought from Leopard an equipment transaction that gave the Colemans an ‘inside price,‘ i.e., a higher percentage of leverage than that featured in typical equipment deals.

Leopard contacted Vernon Davies, co-founder and, at that time, president of Atlantic Computer Leasing p.1.c. (‘Atlantic‘). Atlantic, a United Kingdom (U.K.) corporation, was a large, reputable supplier of configured computer systems consisting of IBM central processors, IBM operating systems, and IBM and IBM-compatible peripherals. Atlantic supplied such equipment mainly through ‘arranged leases,‘ i.e., transactions in which Atlantic arranged financing for its customers by transferring title to the equipment to financial institutions or corporate leasing subsidiaries and arranging leases between these parties as lessors and the customer-users as lessees. To a lesser extent, Atlantic utilized direct leases and outright sales to its customers. Leopard had known Davies for approximately 2 years, and had done several deals with him, by the time of their meeting regarding the Colemans' transaction. Their negotiations centered on certain computer equipment (the ‘Equipment ‘) financed through leases ‘arranged‘ between seven lessors (the ‘Lenders‘) and six end users and having the following terms:¹

In each of these ‘arranged-lease‘ transactions, Atlantic had purchased the Equipment, transferred title thereto to the Lender, and arranged the initial lease between the Lender and the user-lessee. Atlantic generally transfers title to lenders in order to get lower financing rates from them, and thus to be competitive in the user market; because U.K. tax law provides for first-year expensing of equipment costs by the title holder,⁵ and lenders offer better rates in exchange for title to the equipment. In each case, the Lender provided Atlantic with an amount based upon the discounted value of the stream of rents receivable under the leases being arranged. Such amount included the value-added tax (VAT) imposed by the United Kingdom on consumption.⁶ In each lease agreement, the Lender covenants to the user-lessee that it is ‘the lawful owner of the Machines leased hereunder.‘ Additionally, each of the leases contains an automatic renewal provision that is to take effect if the lessee does not terminate its lease in writing within three months after completion of the initial term. Atlantic bears no recourse credit risk with respect to the arranged leases; upon default by a lessee, the Lender, as lessor, is entitled under its lease agreement to take immediate possession of the subject equipment, and would look to Atlantic for help in arranging a new lease in order to recoup its losses. Atlantic has no legal obligation to provide such help.

Concurrently, Atlantic and the Lenders entered into residual agreements whereby Atlantic retained or still retains options to repurchase the Equipment for nominal consideration upon completion of the leases' initial terms, ‘subject to the receipt of all monies due thereunder or the receipt of an agreed early termination settlement.‘⁷ Atlantic generally looks to the residual value of equipment to make a profit on its ‘arranged-lease‘ transactions. This is so because the combination of intense competition in the user market, forcing low rentals and thus lower payments from lenders, the necessity of giving the lenders title to the equipment during the initial lease terms, and the costs associated with arranging the lease transactions and purchasing the equipment frequently drains the initial leases of any profit potential for Atlantic. Atlantic carried its residual interests in the Equipment on its balance sheet at a discount from the IBM list price in effect at the time of valuation, less the cost of repurchase under the residual agreements and estimated remarketing costs. A valuation committee meets regularly to calculate the appropriate discount factors for the various equipment in which Atlantic has residual interests, and takes into account factors such as the equipment type, the initial lease terms, money market rates, and IBM product announcements; with regard to the last factor, the committee, based on past experience with the accuracy of such announcements, exercises a degree of skepticism, and does not accept such announcements at face value. Remarketing costs include the expenses necessary to refurbish the equipment to the engineering and cosmetic specifications of the new user-lessees after the completion of the initial leases. These expenses total up to 15 percent of the cost of the equipment being refurbished. Maintenance and repair expenses necessary to bring the equipment as configured to peak performance are not included in the remarketing costs, as user- lessees are required to arrange with IBM for such maintenance. The user-lessees are also required to carry insurance on the Equipment. The financial information with respect to the Equipment is as follows:⁸

Leopard negotiated with Davies a deal known to Atlantic as a ‘forward sale,‘ whereby Atlantic sells to an investor its residual interest in leased equipment.¹⁶ Their intense negotiations centered on the amount of cash that would flow from the Colemans to Atlantic, and the degree to which the Colemans would share in the residual value of the Equipment. Upon the conclusion of these negotiations, Baker, apparently after ironing out the details with Leopard, wrote the following letter, dated October 16, 1979, to William Coleman proposing the equipment leasing deal:

Dear Bill:

Enclosed are two schedules on an equipment leasing deal which I believe would be suitable for your purposes. The first schedule provides for no minimum net cash flow and the second provides for a small minimum. Naturally, the cash investment is higher in the second case. In either case, there would be contingent rent payable commencing in the fifth year.

The equipment would be data processing or other office equipment with a six year depreciation life for tax purposes. The cash investment would be approximately 7-1/2% of cost without minimum cash flow and approximately 8.55% of cost with minimum cash flow. The investment can be paid in three installments over a period spaced over three fiscal years, with interest on the unpaid portion of the investment of 12% per annum.

As in all tax shelters, the key is leverage. You invest 7.5 or 8.55 cents and you depreciate $1.00.

The good news is that you could generate tax losses, per $1,000,000 of equipment, of $90,000 in 1979 and $146,695 in 1980, which could be carried back to 1979. Actually, since there are four of you, you could get $16,000 of first year depreciation in 1979, if you have not taken this amount on other property, and $40,000 of accelerated depreciation in each year without paying minimum tax. This would bring the total for the two years to over $400,000 so you could solve your entire 1979 problem with two $1,020.000 (sic) units.

By 1981 your new project should be generating substantial ordinary income so you could use the additional deductions generated in 1981 through 1984.

The bad news, of course, is that in 1985 the deal turns...