Sacks v. C.I.R.

Citation69 F.3d 982
Decision Date31 October 1995
Docket Number93-70724,Nos. 93-70401,s. 93-70401
Parties-7138, 64 USLW 2300, 95-2 USTC P 50,586, 95 Cal. Daily Op. Serv. 8444, 95 Daily Journal D.A.R. 14,579 Seymour SACKS; Star Sacks, Petitioners-Appellants, v. COMMISSIONER, INTERNAL REVENUE SERVICE, Respondent-Appellee. Michael R. GEYSER; Joyce Geyser, Petitioners-Appellants, v. COMMISSIONER, INTERNAL REVENUE SERVICE, Respondent-Appellee.
CourtUnited States Courts of Appeals. United States Court of Appeals (9th Circuit)

Richard C. Onsager, Jennings, Strouss & Salmon (on the briefs), Phoenix, Arizona; and Robert J. Lord, Sacks, Tierney & Kasen, (argued), Phoenix, Arizona, for petitioners-appellants.

Gary R. Allen, (on the briefs), and Thomas J. Clark, (argued), Tax Division, United States Department of Justice, Washington, D.C., for respondent-appellee.

Appeals From a Decision of the United States Tax Court.

Before: GOODWIN, O'SCANNLAIN and KLEINFELD, Circuit Judges.

KLEINFELD, Circuit Judge:

Mr. Sacks invested in solar energy devices. The Internal Revenue Service disallowed his depreciation deductions and investment tax credits on the ground that his sale and leaseback transactions were shams. The IRS prevailed in Tax Court, but we reverse.

I. FACTS

In the 1970's, after the country suffered through the Arab oil embargo and a sharp increase in the price of oil, some people thought that the world would run out of oil, or at least that prices would continue to increase. An environmental theory developed, during the 1960's and 1970's, that "the unrestrained burning of cheap fossil fuels" might also damage the earth's atmosphere. Albert Gore, Earth In the Balance 6 (1992). Many people also thought that the double digit inflation rates of the late 1970's would continue indefinitely into the future. Others disagreed, arguing that the 1980's price increases would induce investors to bring new supplies of fossil fuels onto the market and that, like most cartels, the oil cartel would collapse. People in high positions differed in their views. Many prominent politicians, journalists, and professors predicted permanent inflation and permanently rising energy prices.

Congress responded to this apprehension, and passed tax and other laws to mitigate the perceived crisis. The House Ad Hoc Committee on Energy stated that:

there is widespread agreement that a continuation of present world oil consumption trends, even with significantly higher world oil prices, will lead to a very tight world oil market in the mid-1980's. At that point, the world's oil supply will be straining to meet world demand with very serious implications for both international security and the world economy. Sudden disruptive price increases, accompanied by arbitrary curtailments of supply, will generate shocks to the national security and economic stability of each oil importing country.

H.R.Rep. No. 95-543, 95th Cong. 1st Sess., 1978 U.S.C.C.A.N. 7673, 7675 (explaining the reasons for the National Energy Act). Congress passed a package of tax and other laws to encourage people to invest in windmills, solar energy, geothermal energy, and other alternative energy sources, and to discourage "gas guzzler" automobiles and other petroleum consumption. See, e.g., 26 U.S.C. Secs. 44C, 44D, 44E, 46(a)(2)(C); S.Rep. No. 95-442, 95th Cong. 2nd Sess., 1978 U.S.C.C.A.N. pp. 7855, 7903; H.R.Rep. No. 95-543.

The State of Arizona also enacted legislation providing tax incentives for investment in alternative energy. The Arizona Solar Energy Commission published a report in 1983, submitted as an exhibit in this case. The report said that no one knew what future utility rates would be, but that it was unlikely that any future change could make solar heating an unwise investment because "electricity prices have increased nearly 200% over the last ten years" and have generally risen about 1 1/2 times as fast as inflation. Arizona Solar Energy Commission, Solar Water Heating For Arizona Homes 8 (1983). The electric utilities serving Phoenix had unsuccessfully sought a rate increase to cover construction costs for a nuclear power plant, and some people thought that once the nuclear plant went on-line, the rate base would double and dramatically increase electricity costs. Sacks v. Commissioner, 64 T.C.M. (CCH) 1003, 1004, 1992 WL 252948 (1992).

These new state and federal tax incentives worked as intended to induce Mr. Sacks, a lawyer in Phoenix, and his client and friend, Bertram Trobman, to invest in the solar heating of water. Mr. Trobman learned that affluent families had invested in solar water heating equipment, but not homeowners with less money, because the cash outlay to buy and install a solar heater was too great. He studied the market for household equipment rented to families of moderate means and learned that once they rented an appliance, they typically made monthly payments indefinitely and continued to use it as long as it lasted. He discovered that Amcor, a large Israeli company, had been selling solar devices since 1947, and had been selling solar water heating units around the world since 1965.

After studying the Amcor units at trade shows and at the factory in Israel, Mr. Trobman agreed to buy five hundred 64 gallon units for $1,080 to $1,180 each, including the necessary heating elements for cloudy days, pumps and timers. Amcor gave five year warranties on the units, and later extended the warranties to ten years. Mr. Trobman guessed that the useful life of the units on houses would be about twenty years because they were more like plumbing than anything else.

Mr. Trobman did not propose to finance this half million dollar purchase and the subsequent placement of the units on houses all by himself. He organized a corporation, BFS Solar Incorporated, and enlisted his friend and lawyer Mr. Sacks as one of the investors. BFS Solar's 1983 prospectus offered to sell each unit to investors for $4,800, and then to lease it back. The investors would get a base rent for 53 months of $1,327.80, plus a percentage of what homeowners paid to have the units on their roofs. The investor would pay $2,400 down in cash and $2,400 pursuant to a ten year, 9% note. The investor would be personally liable on the note. He would get no nonrecourse financing.

Assuming a fifteen year useful life of the solar water heaters, investors would make profits ranging from $458 based on the Tax Court's assumptions about energy inflation rates and other factors, to $7,782 based on the historical energy inflation rate of 11.5% annually. Assuming the twenty year useful life projection that BFS Solar estimated, and the 11.5% historical energy inflation rate, the investor's profit would be $34,776. All these projections were necessarily speculative, because both Amcor's technology and BFS Solar's plan for making money from it were novel for Arizona. As we all know now, the underlying assumption that the price of oil would rise rapidly into the mid-1980's was mistaken, so all these projections were mistaken. Quite possibly, the solar water heaters will not earn their cost, let alone earn profits at high, speculative rates.

One naturally wonders why investors participating in a genuine purchase of solar water heaters would pay a price of $4,800 for heaters Mr. Trobman could buy in Israel and bring to Arizona for roughly $1,100. The Tax Court found that the $4,800 price "was about the middle of the range of prices for other solar water heaters that were being sold directly to homeowners at retail prices at that time." Sacks, 64 T.C.M. (CCH) at 1008. The Tax Court found that retail prices for the water heater installed on a roof in Arizona "would range from $3,000 to $5,670," and the "very high markups" resulted from high marketing expenses to promote the new technology, high expenses, profit, and the lack of any industry standard for markups at that time. Id. at 1018. Later in the 1980's "a standard 40% markup developed." Id.

Mr. Trobman arranged for the units to be leased to middle class homeowners with houses in the $35,000 to $100,000 price range. The market had to be affluent enough to rent the units, but not so affluent that the homeowners would prefer to buy them outright. Lease revenue from the homeowners was expected to be at least $24 per month per unit, after a two year period in which no rent would be charged. The rents were to rise in tandem with the expected rise in oil prices.

Mr. Sacks learned of Mr. Trobman's plan from other people at his law firm. He had no involvement in preparing the plan. At the end of 1982, Mr. Sacks invested in ten units. He entered into a purchase agreement under which he paid $24,000 in cash and short term promissory notes, and gave BFS Solar 9% promissory notes for the rest, for a total of $48,000 plus interest. These notes were negotiable, and the holder would have full recourse against Mr. Sacks personally for the entire amount.

Mr. Sacks also entered into a 53-month net lease agreement with BFS Solar. The lease agreement had two components. First, Mr. Sacks would receive $12,029.50 base rent for BFS Solar's use of the heaters, prorated over the 53 months. The monthly rent would start at $10.20 per unit in the beginning of the lease period and increase to $33.35 per unit by the end. Second, Mr. Sacks was to receive 50 percent of the amount by which income from subleases to homeowners exceeded BFS Solar's monthly base rent obligation.

Mr. Sacks also entered into a management services agreement with BFS Corporation (as distinguished from BFS Solar). For 15% of gross rents received from homeowners, BFS was to manage the flow of rents and disbursements and provide accounting services to the investors.

Homeowners leased the units for 24 months. They paid $576 for installation, no rent for two years, and then would decide whether to continue renting the units, at a rate which Mr. Trobman expected to peg somewhat below what conventionally heated ...

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