Connor v. C.I.R., 87-1747

• Court: United States Courts of Appeals. United States Court of Appeals (1st Circuit)
• Citation: 847 F.2d 985
• Docket Number: No. 87-1747,87-1747
• Parties: -1229, 56 USLW 2703, 88-1 USTC P 9363 Eugene R. CONNOR and Mary P. Connor, Petitioners, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee. . Heard
• Decision Date: 05 January 1988

Page 985

847 F.2d 985

61 A.F.T.R.2d 88-1229, 56 USLW 2703, 88-1

USTC P 9363

Eugene R. CONNOR and Mary P. Connor, Petitioners, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee.

No. 87-1747.

United States Court of Appeals,

First Circuit.

Heard Jan. 5, 1988.

Decided May 26, 1988.

Steven A. Remsberg with whom Hinckley, Allen, Snyder & Comen, Boston, Mass., was on brief, for petitioners, appellants.

Stuart E. Horwich, Tax Div., Dept. of Justice, with whom William S. Rose, Jr., Acting Asst. Atty. Gen., Michael L. Paup and Jonathan S. Cohen, Tax Div., Dept. of Justice, Washington, D.C., were on brief, for respondent, appellee.

Before COFFIN, ALDRICH and BREYER, Circuit Judges.

BREYER, Circuit Judge.

A partnership called the Sunset Construction Co. ("Sunset") bought heavy construction equipment in 1979 and 1980 and leased it to two related companies, Connor Construction Corp. ("Connor Construction") and Catamount Construction Co. ("Catamount"). One of Sunset's partners, Eugene Connor, and his wife claimed that Sunset's purchases entitled it to an "investment tax credit," ("ITC"), 26 U.S.C. Sec. 38 (1982) (amended 1986), which they, in turn, could use to reduce their federal income taxes. The Commissioner of Internal Revenue disagreed. In his view, the law would have entitled Sunset (and the taxpayers) to take the credit but for Sunset's failure to fulfill one necessary statutory condition. That condition allows an investment tax credit to (1) a person (like Sunset) which is not a corporation, (2) which (like Sunset) buys and then leases equipment, only if

(A) the property subject to the lease has been manufactured or produced by the lessor, or

(B) the term of the lease (taking into account options to renew) is less than 50 percent of the useful life of the property [and the lessor himself spends a certain amount of money on, say, upkeep of the rental property].

26 U.S.C. Sec. 46(e)(3)(B) (1982) (amended 1986); see Appendix for full text. The Commissioner pointed out that Sunset did not satisfy (A) for it did not "manufacture[ ] or produce[ ]" the equipment in question. He also found that Sunset failed to meet (B). Although Sunset's written leases for the equipment (to Catamount and Connor Construction) specified terms of one year, the Commissioner believed it reasonably certain that the leases would last far longer. The issue in this case is whether that is so, whether, despite the short one-year written term, the leases in fact were for more than half the useful life of the property.

The tax court agreed with the Commissioner. Taking into account "all the circumstances which throw light on ... [the transaction's] nature," Highland Hills Swimming Club, Inc. v. Wiseman, 272 F.2d 176, 179 (10th Cir.1959), it found that, "at the time the lease was entered into," Hokanson v. Commissioner, 730 F.2d 1245, 1248 (9th Cir.1984), there was a " 'reasonable certainty' " that the leases would continue " 'beyond the stated period of the lease.' " G.W. Van Keppel v. Commissioner, 295 F.2d 767, 770 (8th Cir.1961) (quoting tax court memorandum decision). Indeed, it decided that the parties "realistic[ally] contemplat[ed]," Hokanson, 730 F.2d at 1248, that the leases would continue indefinitely, beyond the property's depreciation-determined half-life. At the

least, the court said, the taxpayers had not proved the contrary. Tax Court Rules of Practice and Procedure, Rule 142(a), 26 U.S.C. foll. Sec. 7453 (1982) (taxpayers bear burden of proof challenging deficiency assessed by Commissioner). The taxpayers appeal this determination. We affirm the tax court

I

We must first decide whether, in reviewing the tax court's decision, we should follow the recent Seventh Circuit case, McNamara v. Commissioner, 827 F.2d 168 (7th Cir.1987). In McNamara, the court interpreted Sec. 46(e)(3)(B) as requiring the Commissioner to accept at face value "the stated lease term in a written lease," at least where (1) the "leasing activity ... is not primarily tax motivated" and (2) "the Commissioner can[not] demonstrate that the lease is a 'sham,' i.e., that there has been a real shifting of all economic risk associated with the leased property from the lessor to the lessee." McNamara, 827 F.2d at 172. Were we to apply that test here, the taxpayer would win, for the Commissioner concedes that, although Connor and his associate created Sunset to buy and lease equipment, they did so not for tax purposes; they did so for business and labor-related reasons (to keep the building companies more 'liquid;' to keep totally separate the unionized Connor Construction and the nonunionized Catamount). Moreover, Sunset undoubtedly ran certain economic risks when it leased the equipment, e.g., that business conditions would prevent Connor Construction and Catamount from renewing their leases. We have concluded, however, that we ought not to follow the Seventh Circuit.

First, the statute's language does not require a McNamara type of test, or any other kind of test. It says only that the "term of the lease (taking into account options to renew)" must be "less than 50 percent of the useful life of the property." It leaves open the question of how the lease's "term" and how the existence of "options to renew" might be shown.

Second, the statute's purposes do not seem to call for the strong "written lease" presumption that the Seventh Circuit has erected. Congress seems to have wanted firms genuinely in the leasing business, say, truck rental companies, to receive the benefit of the investment tax credit, for that credit would encourage them to invest, like any other business. Congress, however, did not want persons not genuinely in the leasing business, say, partnerships of doctors, or lawyers, or dentists, to obtain for themselves the benefits of the ITC, say, by buying construction equipment and then leasing it to a construction company that (for various reasons, such as inadequate income) could not itself use the investment tax credit. Congress wished to reserve the ITC's benefits for "normal business transaction[s]," not "passive investment entered into for the purpose of sheltering other income." H.R.Rep. No. 533, 92d Cong., 1st Sess. 29, reprinted in 1971 U.S.Code Cong. & Admin.News 1825, 1844.

Congress tried to carry out this objective, not by asking the Commissioner or the courts to examine the motives of the lessor/purchaser or to decide whether, on all the facts, the lessor/purchaser was a legitimate business (near impossible tasks), but rather by establishing a bright line statutory test, based on "lease-life." Ridder v. Commissioner, 76 T.C. 867, 872 (1981) ("hard and fast" test adopted by Congress for determining eligibility). Where a nonmanufacturing lessor/purchaser enters into short-term leases (and pays some of the upkeep of the leased property), it is more likely (though not absolutely certain) that "the lease arrangement is an integral part of the [lessor/purchaser's] ... business and is not likely to have been entered into for the purpose of reducing tax liabilities." H.R.Rep. No. 533 at 29, 1971 U.S.Code Cong. & Admin.News at 1844 (referring to nonmanufacturing requirement). Where the lessor/purchaser enters into a long-term lease (or does not pay any upkeep), it is more likely that the lessor/purchaser is not a professional lessor but is an unrelated person (a doctor or lawyer) with income he hopes to shelter by, in effect, buying equipment for (and leasing

the equipment to) a firm that cannot itself take advantage of the ITC

Congress recognized the highly imperfect nature of this statutory test, a test that, on its face, did not seek to determine whether "all economic risk" associated with ownership had been transferred, McNamara, 827 F.2d at 172, but only whether some risks associated with 50 percent of ownership (or more) had been transferred. See H.R.Rep. No. 533 at 29, 1971 U.S.Code Cong. & Admin.News at 1844 (calling test only "quite likely" to separate out legitimate lessors). Indeed, precisely because of the approximate nature of the test, Congress provided an escape valve for legitimate professional lessors who fell on the wrong (long-term) side of the bright line; the statutory 'escape valve' permits a disqualified lessor nonetheless to pass on the ITC to the leasing firm, which can then itself use the credit. See H.R.Rep. No. 533 at 30, U.S.Code Cong. & Admin.News at 1845. Congress's statutory solution to the problem, then, focuses primarily upon the nature, not of the lessor or lessee, but of the lease. And, given this kind of statutory solution, we can find no congressional warrant for shifting the focus of the Commissioner or court away from the likely understanding of the parties in respect to the terms of the lease (including renewals), or for making near dispositive the motives of the parties in entering into the transaction.

Third, the Seventh Circuit's test seems to us too far removed from the statutory balance between "administrability" and "motive" that Congress struck. On the one hand, the effort to look into specific lessor/purchaser motives and at whether lessor/purchasers have actually shifted their economic risks (thus making their lease a "sham"), on a case-by-case basis, will prove difficult to accomplish accurately in practice. The way in which parties share particular economic risks is a function, not simply of the "time term" in a written lease, but also of many other terms read in light of the particular business circumstances. If a lessor has complete control of a lessee, the "risk" it chooses to shift is also under its control. It can draft either long-term, or short-term, leases to impose risks in a host of different ways, all without changing their duration. About the most one can say is that short-term leases may, in general, impose greater risks upon lessors; and, that is what Congress found. That fact is precisely what led Congress to write a general rule based on the...