Hokanson v. C.I.R., 82-7768

Citation730 F.2d 1245
Decision Date07 February 1984
Docket NumberNo. 82-7768,82-7768
Parties84-1 USTC P 9217 Ragnar V. HOKANSON and Marilyn L. Hokanson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
CourtUnited States Courts of Appeals. United States Court of Appeals (9th Circuit)

Robert G. Burt, Burt & Hagen, P.C., Portland, Or., for petitioners-appellants.

William Wong, Asst. Atty. Gen., Washington, D.C., for respondent-appellee.

Appeal from the Decision of the United States Tax Court.

Before FLETCHER and ALARCON, Circuit Judges, and JAMESON, * District Judge.

FLETCHER, Circuit Judge:

This is an appeal from a decision of the tax court that the Hokansons were not entitled to an investment tax credit on tractor-trailer trucks they purchased for lease to a farm cooperative during 1977 and 1978. We affirm.


The Hokansons leased the trucks in question to North Pacific Canners and Packers, Inc. (Nor-Pac), an Oregon farm cooperative engaged in the food distribution business. In 1970, Nor-Pac had become dissatisfied with the commercial trucking companies it had been using to transport its food products to distribution points throughout the country and decided to set up its own transportation department. Because of a shortage of capital, Nor-Pac decided not to purchase its own fleet of trucks but rather to enter into a lease-employment relationship with the Hokansons.

In 1970, Ragnar Hokanson joined Nor-Pac as transportation director, in charge of managing the shipping division. The Hokansons also agreed to lease tractor-trailer trucks to Nor-Pac pursuant to a master lease agreement, which became effective on January 1, 1971.

Under the leasing arrangement, the Hokansons were to purchase on their own credit trucks needed by Nor-Pac. The master lease served as the governing instrument for all trucks acquired and leased to Nor-Pac. Schedules describing the trucks subject to the lease were periodically attached and incorporated into the master lease.

According to the terms of the master lease, each party had the right to cancel the lease each January by giving 30 days written notice, but neither party had an option to renew. Without any action on the part of either party to cancel, the lease would continue indefinitely.

At the time the parties first entered into the lease, neither was willing to make an irrevocable commitment. The Hokansons leased only three trucks to Nor-Pac in the first year, and the Nor-Pac board of directors wanted to be free to cancel the lease if the new arrangement did not prove In 1977 and 1978, the tax years at issue, the Hokansons purchased and then leased to Nor-Pac 18 tractor and trailer units that the parties stipulated were "new section 38 property." Nor-Pac made no loans or loan guarantees to assist the Hokansons in purchasing the trucks.

to be an improvement over the old. After the first year and each January thereafter, Hokanson reviewed the lease rates and occasionally proposed new ones. The Nor-Pac board then also reviewed the lease and determined whether to continue or modify the leasing agreement. The parties periodically amended the lease to incorporate higher lease rates. Neither party exercised the right to cancel until March of 1980, when Hokanson terminated the leasing arrangement largely because of his bad health.

On their 1977 and 1978 federal income tax returns, the Hokansons claimed investment credits based on the units purchased and put into service in those years. The Commissioner disallowed taxpayers' investment credit claims and issued a notice of deficiency, determining that the terms of the leases for the trucks at issue were open-ended and were not realistically contemplated to last for less than 50 percent of the stipulated 8-year useful life of the trucks.

The Tax Court agreed with the Commissioner and denied the credits, ruling that the taxpayers failed to meet their burden of demonstrating that the parties realistically contemplated that the leases would terminate prior to the expiration of one-half of the useful life of the trucks. The tax court found that "the parties intended this equipment to be leased for its entire useful life" and that the annual reviews were but "periodic examinations of a continuing and indefinite lease."


The Hokansons argue they are entitled to an investment credit under section 38 of the Internal Revenue Code. Section 38 allows a credit against tax for investments in certain depreciable property. 26 U.S.C. Sec. 38 (1976). Section 46(e)(3) provides:

A credit shall be allowed by section 38 to a person which is not a corporation with respect to property of which such person is the lessor 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, ...

26 U.S.C. Sec. 46(e)(3).

As the tax court explained in Ridder v. Commissioner, 76 T.C. 867, 872 (1981), "[s]ection 46(e)(3) is a fairly technical provision which can best be understood in terms of its purpose. In general, Congress was concerned that individuals might be tempted to use investment credits to finance the acquisition and leasing of depreciable property as tax shelters," citing S.Rep. 437, 92d Cong., 1st Sess. 43-44 reprinted in 1971 U.S.Code Cong. & Admin.News, p. 1825. Congress established limitations on the availability of the investment credit so as to benefit only those noncorporate lessors actually using section 38 property in an active business. Ridder, 76 T.C. at 872. See also Carlson v. Commissioner, 712 F.2d 1314, 1316, (9th Cir.1983). These lessors were determined to be persons who either had themselves produced the property or had leased the property on a short term basis. Ridder, 76 T.C. at 872. On the other hand, Congress wanted to deny credits to purchaser-lessors who were involved merely in financing arrangements. Id. To exclude these lessors, section 46(e)(3)(B) denies the credit to noncorporate lessors where the lease term exceeds 50 percent of the useful life of the property. Id.

In this case, the availability of a tax credit depends solely on whether the terms of the leases by which the 18 trucks were placed into service were of less than 4 years duration. The taxpayers contend that the tax court improperly denied the credits because (a) the leases did in fact

terminate in less than 4 years; (b) the tax court's conclusion that the parties did not realistically contemplate termination of the leases in less than 4 years was clearly erroneous; (c) Congress did not intend these leases to be disqualified under section 46(e)(3)(B). None of these arguments has merit.


The taxpayers argue first that, regardless of how long the parties expected the 18 leases to continue, the tax credits should be allowed here because the leases in fact terminated in 1980. The Commissioner asserts that, for purposes of applying section 46(e)(3)(B), the term of a lease is to be calculated on the basis of the realistic expectations of the parties at the time the lease was entered into, regardless of what eventually happened in subsequent years.

Neither the Code nor its legislative history explains whether the length of the term of a lease is to be calculated by reference to the realistic expectations of the parties or to the actual length of the subject lease. In at least two cases, the tax court has rejected the contention that the actual duration of the lease is determinative. Ridder v. Commissioner, 76 T.C. 867, 875 (1981) (no credit where truck with 6-year useful life leased on indefinite basis is demolished in less than 3 years); Bloomberg v. Commissioner, 74 T.C. 1368, 1371 (1980) (no credit where 5-year lease of property with 7-year useful life is cancelled in third year). We agree that the "realistic contemplation" of the parties is the correct test for calculating the length of a lease term for purposes of section 46(e)(3)(B).

To make the availability of the credit contingent on the actual duration of a lease would hamper the administrative processes and enforcement mechanisms of the Internal Revenue Service. Even though taxpayers would, as they must, take the credit in the first year property is placed into service, 1 the IRS would not be certain as to the validity of any given credit until the lease had actually terminated or 50 percent of the property's useful life had run. This problem would be especially burdensome on the IRS because the "useful life" of section 38 property can be as long as several decades.

Several of the other significant factors upon which availability of the investment tax credit depends relate solely to the facts and circumstances in existence in the first year the property is put in service. Congress explicitly provided, for example, that the credit is available to short-term noncorporate lessors only if the depreciation deductions for "the first 12 months after the date on which the property is transferred to the lessee" exceed 15 percent of the rental income of the property. 26 U.S.C. Sec. 46(e)(3)(B). Similarly, Congress provided that the base to which the term of the lease is to be compared is the "useful life of the property." Id. The regulations make quite clear that this "useful life" is to be determined hypothetically at the time the property is first put into service and not later when the useful life has expired. See Treas.Reg. Sec. 1.48-1(a) (1977) (section 38 property is "property ... which has an estimated useful life of 3 years or more (determined as of the time such property is placed in service)"). The focus on determination in respect to all these factors in the first year the property is in service supports the view that the term of the lease likewise be determined by reference to the realistic contemplation of the parties at the time the property is first put into service. 2

The taxpayers further argue that, even if...

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