McNamara v. C.I.R., 86-2739

CourtUnited States Courts of Appeals. United States Court of Appeals (7th Circuit)
Citation827 F.2d 168
Docket NumberNo. 86-2739,86-2739
Parties-5573, 87-2 USTC P 9481 Donald G. McNAMARA and Valerie J. McNamara, and Robert F. Christiansen and Lucille L. Christiansen, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
Decision Date19 August 1987

John F. Emanuel, Wyte & Hirschboeck, S.C., Milwaukee, Wis., for petitioners-appellants.

James S. Kimball, Appellate Section, Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellee.

Before CUMMINGS, FLAUM and EASTERBROOK, Circuit Judges.

CUMMINGS, Circuit Judge.

The Internal Revenue Code of 1954 allowed a tax credit for investment in certain depreciable property. 1 26 U.S.C. Sec. 38. Noncorporate lessors of qualifying property were permitted to claim the credit provided that the conditions set out in 26 U.S.C. Sec. 46(e)(3) were satisfied. In this case the taxpayers formed a partnership which leased certain qualifying property to a corporation which they also controlled. The taxpayers claimed investment tax credits for the property on their individual returns for the taxable years 1977, 1978, and 1979. The Commissioner disallowed the credits on the principal ground that the initial requirement of Sec. 46(e)(3)(B) had not been met in that the terms of the leases exceeded 50 percent of the useful life of the leased property. The Tax Court agreed with the Commissioner and the taxpayers appealed.


F.J.A. Christiansen Roofing Co. operated a roofing contractor business during the years here at issue. The taxpayers individually owned 83.8% of the voting stock in the company and consequently controlled its activities. In 1967 the company determined that it needed additional equipment to operate its roofing business competitively. However, it had a low net worth and limited working capital and was reluctant to incur additional indebtedness because the existence of excessive liabilities on its balance sheet would severely impede its ability to obtain bid bonds necessary to bid on construction projects. It considered leasing the equipment from another entity but found that the cost would be prohibitive. As a result, in early 1968 the taxpayers decided to form a leasing partnership, D & B Associates, which thereafter supplied the company with approximately 40 percent of its equipment needs.

In forming their partnership, the taxpayers were also motivated by a desire to acquire some assets which would be insulated from the risks and seasonal swings of the construction business. Consequently, in addition to leasing equipment to the roofing company, D & B owns real estate which it leases to another related company and has invested in stock and in partnerships involved in oil and gas activities. Despite this diversification, D & B has never leased equipment to anyone other than its related corporations.

During the three years at issue in this case, D & B purchased and leased the following items to the roofing company: a 1977 Mack truck, a 1978 Mack truck, a Toshiba copier, a 1979 25-ton Grove hydraulic truck crane, and a 1979 35-ton P & H hydraulic truck crane. The original written lease document for each of these assets provided that the lease term was to be for a period of less than 50 percent of the useful life of the respective asset and contained a fixed date of termination without an option to renew. Four of the five original leases were in fact later renewed, some at least three times. 2 The renewal leases were not negotiated simultaneously with the original leases, but rather upon expiration of each then existing lease.

On their federal income tax returns for the years 1977, 1978, and 1979, the taxpayers claimed investment tax credits for the five assets leased to the roofing company, all of which qualified as property eligible for the credit under Sec. 38. As already noted, the Commissioner disallowed the credits because in his view each of the lease terms was in reality for a period far exceeding 50 percent of the leased equipment's useful life. The Tax Court agreed with the Commissioner's determination. Although each written lease document expressly provided that the lease term was to be for less than 50 percent of the useful life of the subject property, the court found that the lease terms were actually of indefinite duration. Because the 50 percent requirement of Sec. 46(e)(3)(B) was not satisfied, it held that the taxpayers were not entitled to the credits claimed with respect to the leased equipment.


Section 46(e)(3) limits the ability of noncorporate lessors to claim investment tax credits for the property they lease. A noncorporate lessor may claim a credit for leased property 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 for the period consisting of the first 12 months after the date on which the property is transferred to the lessee the sum of the deductions with respect to such property which are allowable to the lessor solely by reason of section 162 (other than rents and reimbursed amounts with respect to such property) exceeds 15 percent of the rental income produced by such property.

Congress' intent in enacting Sec. 46(e)(3) was to prevent individuals from using investment credits to finance the acquisition and leasing of depreciable property as tax shelters. See Freesen v. Commissioner, 798 F.2d 195, 199 (7th Cir.1986); Ridder v. Commissioner, 76 T.C. 867, 872 (1981). The House Committee on Ways and Means explained that it wanted to withhold the investment credit from lessors whoses leases "represent [not] a normal business transaction of the lessor [but] rather [ ] a passive investment entered into for the purpose of sheltering other income." H.R.Rep. No. 92-533, 92d Cong., 1st Sess. 29, reprinted in 1971 U.S.Code Cong. & Admin.News 1825, 1844; see also S.Rep. No. 92-437, 92d Cong., 1st Sess. 43-44, reprinted in 1971 U.S.Code Cong. & Admin.News 1918, 1950. The lessor who manufactures the property he leases, Sec. 46(e)(3)(A), is obviously not "a conduit for a credit." Freesen, 798 F.2d at 199. Section 46(e)(3)(B) is directed at the pure lessor. The 50 percent test is designed to ensure that the lessor bears much of the economic risk of the property. As we explained in Freesen, if a lessor may not lease property for its entire useful life, then he is forced to assume "the risk that the property will depreciate faster than expected (and the concomitant risk in leasing it again--or finding itself unable to lease the item again)." Id. The 15 percent test is designed to ensure that the lessor is not a passive conduit but instead furnishes, or at least pays for, services in addition to the property itself. A lessor that pays a substantial portion of the maintenance expenses associated with the leased property is not only active but is also more likely to bear some entrepreneurial risk, which in turn provides him with an incentive to maintain the property efficiently. Id. Where the requirements of Sec. 46(e)(3) are met, "the lease arrangement is an integral part of the taxpayer's business and is not likely to have been entered into for the purpose of reducing tax liabilities." H.R.Rep. No. 92-533, 92d Cong., 1st Sess. 29, reprinted in 1971 U.S.Code Cong. & Admin.News 1825, 1844; see also S.Rep. No. 92-437, 92d Cong., 1st Sess. 43-44, reprinted in 1971 U.S.Code Cong. & Admin.News 1918, 1950-1951.

It is undisputed that each of the original written lease documents specified a fixed, definite term of less than 50 percent of the useful life of the subject property and contained no option to renew. The Commissioner nevertheless argues that the stated terms of the lease agreements should be disregarded, see G.W. Van Keppel Co. v. Commissioner, 295 F.2d 767, 770-771 (8th Cir.1961); Highland Hills Swimming Club, Inc. v. Wiseman, 272 F.2d 176, 179 (10th Cir.1959), 3 and that for purposes of Sec. 46(e)(3)(B) the true length of each lease term should be determined by reference to the "realistic contemplation" of the parties at the time the lease was entered into and the property was first put into service, see Hokanson v. Commissioner, 730 F.2d 1245, 1248 (9th Cir.1984); Ridder v. Commissioner, 76 T.C. 867, 875 (1981). 4 The Commissioner maintains that a lease term should be deemed indefinite if there is a reasonable certainty that the lessee will continue leasing the property beyond the period stated in the lease. See G.W. Van Keppel Co., 295 F.2d at 770-771.

Agreeing with the Commissioner that the "realistic contemplation" of the parties rather than the stated term of the lease document is controlling in determining whether the 50 percent test of Sec. 46(e)(3)(B) has been met, the Tax Court found that both the D & B partnership and the roofing company realistically contemplated that the leases here at issue would extend beyond their stated terms and that the actual lease terms were therefore indefinite. In support of its conclusion that the parties expected and indeed intended the leases to continue beyond their stated terms, the Tax Court pointed to a number of factors: (1) D & B purchased equipment not for its general marketability but rather to meet the specific operating needs of the roofing company; (2) the cost to the roofing company of leasing from a non-related company would undoubtedly continue to be higher than the cost of leasing from D & B; (3) there was no indication that the roofing company's financial situation would significantly change over time so that it might...

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