Levy v. Comm'r of Internal Revenue
| Decision Date | 02 November 1988 |
| Docket Number | 1133-85,1134-85,Docket Nos. 1132-85 |
| Citation | 91 T.C. No. 54,91 T.C. 838 |
| Parties | FRANK L. LEVY, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Petitioners participated in a multiple-party equipment leasing transaction involving IBM computer equipment. Petitioners purchased the equipment and leased it back to the seller who previously had leased the equipment to an end-user. HELD: (1) The transaction had a business purpose and economic substance; (2) ownership of the equipment was transferred to petitioners; (3) petitioners were at risk within the meaning of sec. 465, I.R.C. 1954, with respect to debt obligations associated with the transaction; and (4) petitioners' investment constituted an activity entered into for profit under sec. 183, I.R.C. 1954. Graham Stafford and Steven I. Klein, for the petitioners.
Gary F. Walker, for the respondent.
In timely statutory notices of deficiency dated October 12, 1984, respondent determined the following deficiencies in petitioners' 1980 and 1981 Federal income taxes:
+---------------------------------------------+
¦Petitioner ¦Docket No.¦Year¦Deficiency¦
+------------------+----------+----+----------¦
¦Frank L. Levy ¦1132-85 ¦1980¦$31,682 ¦
+------------------+----------+----+----------¦
¦ ¦ ¦1981¦79,237 ¦
+------------------+----------+----+----------¦
¦Lee & Leon Oil Co.¦1133-85 ¦1980¦69,173 ¦
+------------------+----------+----+----------¦
¦ ¦ ¦1981¦179,807 ¦
+------------------+----------+----+----------¦
¦Samuel A. Levy ¦1134-85 ¦1980¦32,223 ¦
+------------------+----------+----+----------¦
¦ ¦ ¦1981¦78,979 ¦
+---------------------------------------------+
After concessions, the issues for consideration are: (1) Whether petitioners' investment in computer equipment was a sham transaction devoid of economic substance; (2) whether ownership of the computer equipment was transferred to petitioners; (3) whether petitioners were at risk within the meaning of section 465 2 with respect to debt obligations they incurred in connection with the transaction; and (4) whether petitioners' investment constituted an activity entered into for profit within the meaning of section 183.
Some of the facts have been stipulated and are so found. Petitioner Lee and Leon Oil Co., Inc. (Lee and Leon Oil) was incorporated under the laws of Louisiana on January 1, 1959. Lee and Leon Oil was engaged in the business of selling and distributing equipment and supplies relating to offshore oil and gas drilling. It sold to such companies as Exxon, Texaco, Mobil, and Amoco, and was one of the largest Shell jobbers in the country. Lee and Leon Oil maintained its principal business office in Metairie, Louisiana, and it used the accrual method of accounting for tax purposes during the years in issue.
Petitioners Frank L. Levy and Samuel A. Levy are brothers and are, respectively, president and vice president of Lee and Leon Oil. Each owned 50 percent of the common stock. Frank Levy resided in New Orleans, Louisiana and Samuel Levy resided in Lacombe, Louisiana at the time their petitions were filed. Frank and Samuel Levy each used the cash method of accounting for tax purposes during the years in issue. All petitioners timely filed Federal income tax returns for 1980 and 1981.
In 1979, because of concerns over the cyclical nature of the oil business, Frank and Samuel Levy decided to diversify their company and their personal investments by means of a long-term investment outside the oil industry. In early 1980, they asked their financial adviser, David Kushner, to investigate investment alternatives. After evaluating numerous types of investments, Mr. Kushner advised Frank and Samuel Levy that equipment leasing represented a viable investment alternative. After considering specific investment recommendations of Mr. Kushner, Frank and Samuel Levy, and Lee and Leon Oil purchased certain IBM computer equipment on December 23, 1980. On that day they also leased the equipment back to an unrelated company.
The controversy in these consolidated cases arises out of respondent's disallowance of deductions claimed on petitioners' Federal income tax returns for the years in issue with respect to this investment. Respondent disallowed depreciation and interest expenses and decreased rental income relating to petitioners' investment as follows:
EQUIPMENT PURCHASED
Petitioners' purchased an IBM model 3033-N8 central processor and peripheral equipment consisting of a 3036-1 console and a 3037-1 power and coolant unit. The 3033 line of IBM mainframe computers was first announced in March of 1977. The 3033-N8 model was first announced in November of 1979 and became commercially available in 1980. At that time, it was regarded as IBM's latest, top-of-the-line mainframe computer and represented an evolutionary improvement in IBM mainframe computers. Because of high demand, purchasers had a minimum waiting period of 90 days for delivery of new 3033-N8 computers.
In late 1981 or early 1982, IBM announced the 3083 H-series of mainframe computers and discontinued further production of new 3033- N8 central processors. By late 1982 or early 1983, IBM discontinued marketing new 3033-N8 models.
In 1984, IBM announced the 3090 model of mainframe computers. The 3090 model represented the first revolutionary change in IBM mainframe computers from the IBM 370 series. The announcement and subsequent production of the 3090 model caused a drastic and unexpected reduction in the then-current fair market value, the residual value, and the useful life of IBM 3033-N8 mainframe computers.
The mainframe computers IBM had developed in the 1960's and 1970's (referred to generically as the 360 and 370 series) generally had experienced economic useful lives of approximately 15 and 10 years, respectively. 3
The independent leasing company involved in the transaction at issue in this case is DPF, Inc. DPF began purchasing and leasing equipment in 1964. Through 1980, DPF had leased to end-users equipment with a total value of $750 million. In 1980, DPF was a publicly owned company listed on the New York stock exchange. It had gross revenues in that year in excess of $600 million, of which $45 million was related to its leasing activities. It owned $320 million in assets of which $150 million was equipment leased to end-users.
Initially, DPF's leasing business involved traditional third- party leasing. DPF purchased new equipment from manufacturers, retained ownership of the equipment and leased it to other companies. In 1977, however, DPF purchased a baking business for $42 million in cash which reduced its available cash to support its leasing activities. In order to recover a portion of the capital invested in its leasing business, DPF investigated entering into multiple-party sale-leaseback transactions, in lieu of direct third-party leasing. In a multiple-party sale-leaseback transaction, DPF would sell to investors its equity position in equipment it had purchased and leased to end-users. The investors would immediately lease the equipment back to DPF which would continue leasing the equipment to end-users.
Multiple-party sale-leaseback transactions appeared attractive to DPF in 1980 because in such transactions DPF would recapture quickly its capital investment in the leasing-related equipment it purchased. DPF also had the potential to earn a profit through remarketing the equipment to subsequent end-users, and DPF would maintain its customer base through continued direct contact with end-users even though it no longer owned the equipment. DPF decided to pursue multiple-party sale-leaseback transactions with a company by the name of AARK Enterprises (AARK).
AARK was formed in 1977 by Raymond Kenard as a joint venture of two existing corporations. AARK was formed for the purpose of arranging sale-leaseback transactions of equipment owned by leasing companies and already on lease to end-users. Generally, AARK would purchase the equipment from leasing companies, resell the equipment to corporate or individual investors, and assign its rights in the existing end-user leases of the equipment to the investors. After arranging such transactions, AARK did not remarket, re-lease, or repurchase the equipment. Its continuing role in the transactions was to pay off its debt obligations to the leasing companies and to collect payments from the investors on their debt obligations to AARK. From 1977 to 1980, AARK's participation in such multiple-party sale-leaseback transactions produced approximately $200 million in income.
In May of 1980, DPF purchased from IBM a model 3033-N8 IBM mainframe computer and peripheral equipment and leased it to Bristol- Myers Co. DPF paid $2,005,000 for the computer equipment. DPF made a cash downpayment and borrowed $1,777,918 from Manufacturers Hanover Leasing Corporation (MHLC) in order to finance the purchase of the computer equipment from IBM.
The $1,777,918 loan MHLC made to DPF was...
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