Nicholson v. C.I.R.

• Decision Date: 24 July 1995
• Docket Number: No. 94-7688,94-7688
• Parties: -5701, 95-2 USTC P 50,403 Charles E. NICHOLSON, Jr. and Margaret K. Nicholson, Appellants v. COMMISSIONER OF INTERNAL REVENUE SERVICE.
• Court: U.S. Court of Appeals — Third Circuit

Page 1020

60 F.3d 1020

76 A.F.T.R.2d 95-5701, 95-2 USTC P 50,403

Charles E. NICHOLSON, Jr. and Margaret K. Nicholson, Appellants v. COMMISSIONER OF INTERNAL REVENUE SERVICE.

No. 94-7688.

United States Court of Appeals Third Circuit.

Argued June 8, 1995.

Decided July 24, 1995.

Barry A. Furman and Mark S. Halpern (argued), Furman & Halpern, P.C., Bala Cynwyd, PA, for appellants.

Loretta C. Argrett, Asst. Atty. Gen., Gary R. Allen, Richard Farber, and Thomas J Clark (argued), Tax Div., Dept. of Justice, Washington, DC, for appellee.

Before: BECKER, NYGAARD, and ALITO, Circuit Judges.

OPINION OF THE COURT

ALITO, Circuit Judge:

The genesis of this appeal is a decision by the Commissioner of the Internal Revenue Service ("the Commissioner") to disallow certain deductions claimed by Charles and Margaret Nicholson on their 1983, 1984, 1985, and 1986 tax returns regarding computer equipment that Charles Nicholson acquired in 1983. The Commissioner maintained that the Nicholsons were not entitled to take the deductions because Charles Nicholson was not "at risk" regarding a promissory note that he gave in partial payment for the equipment. Prior to a trial before the tax court on the propriety of these deductions, the parties settled on terms generally favorable to the Nicholsons. The Nicholsons subsequently filed a motion for litigation costs pursuant to I.R.C. Sec. 7430, arguing that the Commissioner's position in the underlying proceedings was not "substantially justified." The tax court disagreed and refused to award litigation costs. We now reverse and remand for further proceedings.

I. ¹

This case involves the propriety of deductions that the Nicholsons claimed in regard to the purchase of certain computer equipment. Nicholson ² acquired the equipment in 1983 from its original purchaser, Equipment Leasing Exchange, Inc. ("ELEX"). Nicholson v. Commissioner, T.C. Memo.1994-280 at 3, 1994 WL 269018 (1994). ELEX had purchased the equipment in 1983 for $362,168. Id. In order to finance the purchase, ELEX obtained two nonrecourse loans from the Hershey Bank ("the Bank"). Id. ELEX subsequently leased the equipment to the Milton Hershey School ("the School") for a term of six years. Id. The lease provided for monthly rental income of $7,478. Id. As a condition of the two loans, ELEX granted the Bank a security interest in the computer equipment and the lease. Id.

Nicholson purchased the lease and the equipment from ELEX for $386,798. Id. In partial payment of the purchase price, Nicholson executed and delivered to ELEX three promissory notes, in the amounts of $17,500, $20,378, and $336,195. Id. The first two notes were payable on March 15, 1984, and March 15, 1985, respectively. Id. Both notes explicitly provided ELEX a right of recourse against Nicholson personally in the case of default. Id. The third note required repayment in monthly installments of $7,348.80. Id. at 4. Unlike the first two notes, however, the third note was silent as to whether ELEX had a right of recourse against Nicholson. Id. All three notes were secured by the equipment and the lease, subject to the Bank's priority security interest. Id.

In 1991, the Internal Revenue Service ("IRS") audited the Nicholsons' 1983, 1984, 1985, and 1986 tax returns. Initially, the IRS District Director took the position that deductions claimed by the Nicholsons with regard to the leasing activity should be disallowed because the leasing activity was not an activity entered into for profit since it had no economic or business purpose. Joint Appendix ("JA") at 62-65. The Nicholsons appealed this determination to the IRS Appeals Office. Id. at 65.

The Appeals Office agreed with the Nicholsons' argument that the leasing activity did have an economic purpose. Id. However, the Appeals Office sua sponte raised an alternative basis for denying the Nicholsons' deductions. The Appeals Office ruled that Nicholson was not "at risk" within the meaning of I.R.C. Sec. 465 as to the money borrowed under the third note. Id. Pursuant to section 465, an owner of depreciable property may only deduct up to the total amount of the economic investment in the property (i.e., the amount that is "at risk").

Subsequently, on December 11, 1991, the Commissioner issued a Notice of Deficiency to the Nicholsons. Like the Appeals Office, the Commissioner asserted that the Nicholsons' deductions were barred by section 465's "at risk" requirement. According to the Commissioner, Nicholson was not "at risk" as to the third note 1) because it was nonrecourse; 2) because ELEX did not borrow funds on a recourse basis from the Bank on its purchase of the equipment and therefore ELEX would have no motive to pursue Nicholson if he defaulted on the third note; and 3) because the lease payments from the School were sufficient to cover the installment payments required under the third note. Id. at 64-65; see id. at 121-25; Nicholson, T.C. Memo.1994-280 at 7-8 n. 7.

The deficiencies were for income taxes for the calendar years 1983, 1984, 1985, and 1986 in the amounts of $3,660, $25,179, $20,385, and $21,180 respectively. Nicholson, T.C. Memo. 1994-280 at 2. The Commissioner also assessed an interest penalty against the Nicholsons under I.R.C. Sec. 6621(c), believing that the underpayment was due to a tax-motivated transaction. Id.

The Nicholsons then filed a Petition for Redetermination with the tax court on February 14, 1992. On February 1, 1994, the parties filed a Stipulation of Settled Issues ("the Settlement") with the Tax Court that provided:

The Parties hereby agree to the following settlement of the issues in the above-entitled case:

1. It is agreed for purposes of settlement that petitioners' claimed losses with respect to their activity in the Hershey transaction during the years 1983 through 1985 shall be disallowed subject to their deductibility as provided below;

2. It is agreed for settlement purposes that petitioners were at risk as defined under I.R.C. Section 465 on the installment note in the amount of $336,195.00 with respect to their activity in the Hershey transaction beginning in 1986 and are entitled to suspended losses beginning in 1986;

3. It is agreed for purposes of settlement that petitioners are required to include in taxable income for taxable year ended December 31, 1983 the amount of $18,300.00 which represents the amount of Schedule E loss disallowed on petitioners' investment in Hershey and Cyclops ³ in 1983;

4. It is agreed for the settlement that petitioners are required to include in taxable income for taxable year ended December 31, 1984 the amount of $42,024.00 which represents the amount of Schedule E loss disallowed on petitioners' investment in Hershey and Cyclops in 1984;

5. It is agreed for the settlement that petitioners are required to include in taxable income for taxable year ended December 31, 1985 the amount of $72,341.00 which represents the amount of Schedule E loss disallowed on petitioners' investment in Hershey and Cyclops in 1985;

6. It is agreed for the settlement that for the taxable year ended December 31, 1986, petitioners are entitled to deduct $81,723.00 with respect to their investment in the Hershey transaction as a suspended loss under I.R.C. Section 465;

7. It is agreed for purposes of settlement that respondent concedes increased interest under I.R.C. Section 6621(c), formerly, 6621(d) for all issue years.

Id. at 4-5.

The net effect of this Settlement was that the Nicholsons were not able to take the deductions claimed in 1983, 1984, and 1985, but were able to carry these amounts forward and take them as a deduction in 1986. ⁴ In addition, the Nicholsons were not liable for an increased interest penalty under section 6621(c). The Settlement was therefore quite favorable to the Nicholsons. Although the Commissioner's Notice of Deficiency alleged that Nicholson owed over $70,000 for the 1983-1986 period, under the Settlement the Nicholsons appear to have been assessed only a net deficiency of between $2,500 and $4,000. ⁵ Id. at 6 & n. 4.

The Commissioner's willingness to settle on these terms appears due to two significant developments. First, the Commissioner changed her position on whether the third note provided for recourse. Although the Commissioner initially maintained that because this note was silent as to recourse the underlying loan was nonrecourse, the Commissioner abandoned this theory because New Jersey law, which controls the terms of the note, clearly provides that a note is presumptively recourse. Id. at 7-8 n. 7; JA at 125; see N.J.Stat.Ann. Sec. 12A:9-505(2). Second, after issuing the Notice of Deficiency, the Commissioner learned that ELEX in 1986 had fully repaid its loan to the Bank. JA at 125; Brief for the Appellee ("Comm.Br.") at 20 n. 7. Thus, the Commissioner conceded that Nicholson was at risk as of 1986 because ELEX would have certainly exercised its right of recourse against Nicholson for any default by Nicholson on the third note. ⁶

Following the Settlement, the Nicholsons filed a motion to recover their litigation costs pursuant to I.R.C. Sec. 7430. After surveying the background of this litigation, the tax court began its analysis by observing that in order to be entitled to an award of costs, the Nicholsons needed to demonstrate that they were a "prevailing party" as defined by section 7430 ⁷ and that they complied with that provision's procedural requirements. ⁸ Nicholson, T.C. Memo.1994-280 at 6. Thus, the Nicholsons needed to establish that:

(1) [t]hey exhausted all administrative remedies, (2) they met the net worth requirement of section 7430(c)(4)(A)(iii), (3) they ha[d] substantially prevailed with respect to the amount in controversy or most significant issues, and (4) the position of the United States was "not substantially justified."

Id. (emphasis in original).

The tax court found that the Nicholsons had met the first two conditions. Id. Turning to the third...