James v. C.I.R., s. 87-1913

Citation899 F.2d 905
Decision Date26 March 1990
Docket Number87-1919,87-1960 and 87-1961,87-1918,Nos. 87-1913,87-1959,87-1916,s. 87-1913
Parties-1045, 90-1 USTC P 50,185 Jack S. JAMES and Carol N. James; Glen E. Michael and Sybil H. Michael; A.F. Boudreau, Jr., and Katherine F. Boudreau; David G. Ownby and Kathleen Ownby; Jeffry H. Cope and Mary E. Cope; and Robert S. Cope and Phyllis H. Cope, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
CourtUnited States Courts of Appeals. United States Court of Appeals (10th Circuit)

Tom G. Parrott (Charles N. Woodward of Lisle & Woodward, with him on the briefs), Oklahoma City, Okl., for petitioners-appellants.

Thomas R. Lamons, Atty., Tax Div. (William S. Rose, Jr., Acting Asst. Atty. Gen., Michael L. Paup and Ann Belanger Durney, Attys., Tax Div., with him on the brief), Dept. of Justice, Washington, D.C., for respondent-appellee.

Before LOGAN, MOORE and TACHA, Circuit Judges.

LOGAN, Circuit Judge.

Petitioners Jack James, Glen and Sybil Michael, A.F. Boudreau, Jr., David Ownby, Jeffrey Cope, and Robert Cope were investors, 1 either individually or through controlled entities, in joint ventures that purchased expensive computer systems already leased to large industrial corporations. These investors took deductions on their personal income tax returns for depreciation, for fees to the seller for continuing management services, and they took investment tax credits for purchases of the computer systems. The Commissioner of Internal Revenue disallowed the deductions and credits on the ground that the underlying transactions giving rise to these items were shams lacking economic substance. The United States Tax Court, in a unanimous reviewed decision, upheld the disallowances, agreeing that the transactions lacked economic substance. Jack S. James, 87 T.C. 905 (1986). 2 Because we affirm on this basis, we do not address the Tax Court's alternative holdings.

The Tax Court made detailed findings of fact which we summarize here as briefly as we can. Communication Associates, Inc., Communications Associates Leasing, Inc., and Communications Leasing International, Inc. (collectively the "Communications Group") 3 were related entities engaged in the business of purchasing computer equipment from manufacturers and leasing it to large-scale users that preferred to lease rather than buy their own equipment. In 1979 and 1980, petitioners Jack James and Glen Michael served as principal officers in certain of those companies.

On December 28, 1979, petitioners A.F. Boudreau, Jr., Glen and Sybil Michael, and Jack Jones, either individually or through controlled entities, formed a joint venture (JV# 1) for the stated purpose of investing in and leasing computer equipment. On that same date, JV# 1 and the Communications Group entered into three agreements: an agency agreement, an administrative services agreement, and a purchase agreement. In the agency agreement, JV# 1 appointed the Communications Group as its agent for purchasing computer equipment and leasing it to end users. The Communications Group was entitled to act for JV# 1 without disclosing its agency status, and JV# 1 was not liable in any manner on debt incurred by the Communications Group to finance the computer equipment purchases. The administrative services agreement stated that the Communications Group would perform various administrative tasks associated with the leasing of computer equipment purchased by JV# 1. For its services, the Group would receive annual management fees over a seven-year period starting at $72,000 and decreasing gradually to $39,600 in the fourth year.

In the purchase agreement, the Communications Group agreed to sell JV# 1 a computer system which the Group had purchased from Amdahl Corp. in June 1979 and had leased to Massey-Ferguson, Inc. The Communications Group financed the $3,211,000 purchase price by giving Amdahl an installment note payable in sixty-two monthly installments plus a balloon payment. The Group also gave Amdahl a security interest in the equipment.

The lease to Massey-Ferguson was also for a sixty-two-month term, providing for monthly rental payments commencing January 1, 1980, in an amount exactly corresponding to the Group's monthly obligations to Amdahl. The Communications Group assigned its right to receive monthly rental payments from Massey-Ferguson to Amdahl. The lease was a "net-net-net" or "triple net" lease whereby the lessee was responsible for installation, maintenance, taxes, and insurance.

JV# 1's purchase of the equipment was subject to Amdahl's security interest, Massey-Ferguson's lease, and the assignment of rental payments to Amdahl. JV# 1 paid $2 million for the equipment. Although it is not apparent from the purchase agreement itself, JV# 1's $2 million purchased only a 52.6% interest in the equipment, a markup of approximately 18.4% over 52.6% of the computer's original purchase price. The remaining interest in the computer was sold to other investors at approximately the same markup, giving the Communications Group total proceeds of $3,801,250.

JV# 1 financed this purchase by giving the Communications Group a demand note in the amount of $300,000, subsequently satisfied, and a recourse installment note for the balance of $1.7 million. JV# 1 also became obligated to pay the Communications Group a $150,000 implementation fee. In addition, the purchase agreement gave the Communications Group a "nonexclusive right to remarket" the computer equipment upon expiration or termination of the lease, under which the Group was entitled to twenty-five percent of the net proceeds of any remarketing they arranged.

The documentation surrounding JV# 1's purchase and annual statements from the Communications Group to JV# 1 described the computer equipment as serial number 70078 leased to Amdahl, while in fact, JV# 1's equipment was serial number 10055 leased to Massey-Ferguson. Both a sublease and a release of this equipment beginning in 1984 were at a monthly rental rate of less than ten percent of the monthly rental in the original lease.

In June 1982, the original administrative services agreement was cancelled and a restated administrative services agreement was executed which provided for income pooling. Under this arrangement, the Communications Group would pool all rental income from equipment it managed for JV# 1 and other investors and from its own computer equipment and then allocate the income to the various owners pursuant to a stated formula. JV# 1's share of pooled income was based on its proportionate investment in the total pool, adjusted by a "TR factor," which allegedly adjusted for equipment-specific differences such as useful life and maturity. The restated agreement also stated that the "normal rental rate" of JV# 1's equipment was equal to 21.619% of its investment. If JV# 1's share of the pooled income exceeded this rate, the Communications Group was entitled to retain the excess as a "performance fee." Further, the Group's annual management fees were revised and set at a flat rate of sixteen percent of adjusted pool rental income. The net effect of these provisions was to ensure that JV# 1's annual cash flow remained roughly at a break-even point during the term of the computer's lease, with cash inflows from rental income almost exactly (within pennies) offsetting cash outflows in satisfaction of JV# 1's various obligations to the Communications Group. In fact, in the three years before income pooling took effect the Communications Group inexplicably credited JV# 1, not for the actual rental payments made by Massey-Ferguson, but for rental income which exactly offset JV# 1's annual obligations to the Group, a discrepancy of nearly $100,000 in 1980.

On January 15, 1980, a second joint venture (JV# 2) was formed by amendment of the JV# 1 joint venture agreement, adding four new members--Robert Cope, Jeffrey Cope, David Ownby, and A.F. Boudreau, Jr., in his individual capacity. JV# 2 executed agency and administrative service agreements with the Communications Group similar to those in effect for JV# 1, except that JV# 2's administrative services agreement immediately used income pooling, normal rental rate, performance fee, and percentage management fee concepts subsequently used in JV# 1's restated administrative services agreement. The effect of these provisions was the same as for JV# 1; that is, JV# 2's annual cash flow was extremely close to breaking even.

The structure of the transactions culminating in the sale of computer equipment to JV# 2 was the same as that used with JV# 1. The Communications Group purchased three computer systems at a total cost of $3,305,284, financed through nonrecourse installment notes with different banks. The Group leased the systems to three different end users on a triple net basis for terms ranging from fifty-eight to eighty-four months and assigned the right to rental payments to the various financing banks. The Communications Group then sold the three systems, subject to the security interests, leases, and rent assignments to JV# 2 for a purchase price of $3.8 million, an approximate fifteen percent markup over the Group's purchase price. JV# 2 gave the Group an $817,000 demand note and an installment note for the balance. JV# 2 satisfied the demand note and also paid the Communications Group a $57,000 implementation fee in December 1980. The Communications Group was again entitled to a twenty-five percent remarketing fee, but rather than the "nonexclusive right to remarket" it held on JV# 1's equipment, the Group had a "right of first refusal to remarket" JV# 2's equipment.

In June 1985, one of JV# 2's lessees declared bankruptcy and the bank holding the security interest in the computer equipment repossessed the equipment. The Communications Group repurchased the equipment from the bank at a price less than the principal balance remaining on its nonrecourse note to the bank. Nevertheless, JV# 2...

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