Schiff v. U.S., 90-5677

• Decision Date: 01 October 1991
• Docket Number: No. 90-5677,90-5677
• Parties: -5364, 60 USLW 2152, 91-2 USTC P 50,423 Peter SCHIFF, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 348

942 F.2d 348

68 A.F.T.R.2d 91-5364, 60 USLW 2152,

91-2 USTC P 50,423

Peter SCHIFF, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 90-5677.

United States Court of Appeals Sixth Circuit.

Argued May 3, 1991.

Decided Aug. 15, 1991.

Rehearing and Rehearing En Banc

Denied Oct. 1, 1991.

Eugene Jared, Madewell & Jared, Cookeville, Tenn., John W. Nelley, Jr. (argued), Lesa H. Skoney (argued), Charles C. Allen, Nashville, Tenn., for plaintiff-appellant.

Joe B. Brown, U.S. Atty., Nashville, Tenn., Gary R. Allen, Acting Chief, Richard Farber, Sally Schornstheimer, Jordan L. Glickstein (argued), U.S. Dept. of Justice, Appellate Section Tax Div., Carl Q. Carter, U.S. Dept. of Justice, Tax Div., Washington, D.C., for defendant-appellee.

Before KRUPANSKY and BOGGS, Circuit Judges; and COHN, District Judge. ^*

I.

COHN, District Judge.

This is an income tax case. Plaintiff, Peter Schiff (Schiff), appeals from a judgment which effectively denied him an investment tax credit (ITC) under § 46(e)(3)(B) of the Internal Revenue Code (Code), 26 U.S.C. § 46(e)(3)(B), on an aircraft which he leased to his 90% owned corporation. For the reasons which follow, we AFFIRM the judgment of the District Court.

A.

In 1981, Schiff purchased a Gulfstream aircraft (the Gulfstream) that he simultaneously leased to SMEC, Inc. (SMEC), a corporation in which he owned 90% of the stock. Schiff timely filed his individual federal income tax return for the 1981 calendar year and, based on his purchase of the Gulfstream, claimed an ITC. Upon audit, the government disallowed the ITC. The ITC amounted to $184,810.48, which meant Schiff's income taxes due the government for the year 1981 were increased by that amount.

Defendant, the United States (the government), then said, as it does now, that Schiff failed to meet the requirements of § 46(e)(3)(B) and therefore was not entitled to the ITC. In particular, the government said: (1) a noncorporate lessor may not receive an ITC under § 46(e)(3)(B) unless the "term" of the lease is for a period of less than 50 percent of the useful life of the leased property, (2) in the case of a lease between an individual and a corporation he or she controls, the "term" is not the stated period in the lease but, rather, is the period of time the parties to the lease "realistically contemplated" that the lease would remain in effect, and (3) Schiff and SMEC realistically contemplated that the lease would cover more than 50 percent of the useful life of the Gulfstream.

Schiff appealed the disallowance administratively and was unsuccessful. Schiff then paid the additional income taxes due because of the loss of the ITC and followed up with a claim for a refund, which was also denied. Thereafter Schiff filed a claim for a refund, which was summarily denied by the IRS on June 17, 1988. Schiff then filed suit in the United States District Court for the Middle District of Tennessee for the amount of the claimed refund. The district court upheld the disallowance of Schiff's claimed ITC stating that: (1) the IRS properly applied a realistic contemplation test to § 46(e)(3)(b), and (2) Schiff and SMEC realistically contemplated that the lease of the Gulfstream would extend beyond 50 percent of its useful life. See Owen v. Commissioner, Internal Revenue Service, 881 F.2d 832 (9th Cir.1989); Connor v. Commissioner, Internal Revenue Service, 847 F.2d 985 (1st Cir.1988).

B.

Schiff says we should shun the realistic contemplation test and follow McNamara v. Commissioner, 827 F.2d 168 (7th Cir.1987). In McNamara, 827 F.2d at 172, the Court of Appeals for the Seventh Circuit held that in a case involving leasing activity that is not primarily tax motivated, a noncorporate lessor is entitled to an ITC if the actual language of the written lease states a term that is less than 50 percent of the property's useful life--unless the government demonstrates the lease is a sham.

As explained infra, we decline the invitation to follow McNamara. The district court correctly held that the realistic contemplation test applies to situations like this one, in which a noncorporate lessor leases property to a controlled corporation and then seeks an ITC under § 46(e)(3)(B). Moreover, the district court's finding that Schiff and SMEC realistically contemplated that the lease of the Gulfstream would extend beyond 50 percent of the Gulfstream's useful life was not clearly erroneous.

II.

Schiff is the inventor of a heart pump machine. At all relevant times, Schiff served as the president and owned 90% of the stock of SMEC, which developed, manufactured, serviced and sold the heart pump machine and other cardiac assistance equipment. At its peak, SMEC had about 250 heart pump machines in use throughout the country and internationally. The machines were sold primarily to hospitals who used them for bypass open heart surgery, resuscitation, kidney transplants, and in stabilizing patients before and after heart attacks.

SMEC guaranteed service or replacement of a machine in 24 hours. As a result, it was necessary for Schiff to respond to a call from anywhere in the country within a few hours. In order to support this service guarantee, SMEC bought an aircraft in 1974. As the demands of the business increased, the use and needs of the aircraft increased, and SMEC traded in and upgraded the aircraft for better models in 1974, 1975, 1977, and 1979.

In 1981, however, Schiff purchased the Gulfstream personally and then leased it to SMEC. Importantly, SMEC signed as guarantor on the purchase of the Gulfstream. ¹ At the time when Schiff purchased the Gulfstream, he had been negotiating the sale of SMEC. The negotiations eventually fell through. In fact, Schiff had been trying to sell SMEC since 1976 but all his efforts proved unsuccessful until an eventual sale of SMEC in 1985.

The Gulfstream had a useful life of five years. The lease between Schiff and SMEC and Schiff provided for a two year term with a defined termination date and no option to renew.

Upon the termination of the lease, SMEC and Schiff entered into a second two year lease. The provisions of the second lease were virtually identical to those in the first lease.

III.

A.

The issue is one of first impression in this circuit. During 1981, the year in question, the Code, as a general rule, allowed a credit against income tax for qualified investments in certain depreciable property. In providing a credit to a taxpayer who purchased qualifying depreciable property, Congress imposed certain limitations on noncorporate taxpayers who leased property to other parties. Section 46(e)(3) of the Code provided in this regard as follows:

(e) LIMITATIONS WITH RESPECT TO CERTAIN PERSONS.

* * * * * *

(3) Noncorporate lessors.--A credit shall be allowed ... to a person which is not a corporation with respect to property of which such a person is a lessor 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 total of the deduction with respect to such property ... exceeds 15 percent of the rental income produced by such property.

Schiff and the government stipulated at trial that the latter of the two conditions contained in subparagraph (B) is not in issue, namely that the expense associated with the Gulfstream amounted to at least 15 percent of the rental income produced by it. Thus, the sole issue at trial was whether Schiff had established that the term of the lease, taking into considerations options to renew, was less than 50 percent of the Gulfstream's useful life.

B.

The lease states, on its face, it was for a two year term; and there is no option to renew. Two years was clearly less than 50 percent of the Gulfstream's five year useful life. The government did not dispute that the literal term of the lease covered less than half of the Gulfstream's useful life. However, the government argued for the realistic contemplation test to determine whether the lease was in actuality for an indefinite term. This test provides that, under § 46(e)(3)(B), the true term of a lease should be determined by reference to whether the parties realistically contemplated that the lease would last longer than 50 percent of the property's useful life. Owen, 881 F.2d at 834 (citing Hokanson v. Commissioner, 730 F.2d 1245, 1249 (9th Cir.1984)).

The origin of the realistic contemplation test, as applied to § 46(e)(3)(B), can be traced to the Tax Court decision in Ridder v. Commissioner, 76 T.C. 867 (1981) in which an employee leased a tractor-truck to his employer. The lease was open-ended and did not have a fixed termination date. The Tax Court denied the employee an ITC under § 46(e)(3)(B) in part because he made no evidentiary showing that he and the employer realistically contemplated the lease would terminate within three years, that is, 50 percent of the tractor-truck's six year useful life. Ridder, 76 T.C. at 875. ² Since Ridder, the realistic contemplation test has been applied by many courts. Peterson v. Commissioner, 44 T.C.M. (CCH) 1215 (1984); Hokanson, 730 F.2d at 1248; Sanders v. Commissioner, 48 T.C.M. (CCH) 1215, 1219-20 (1984), aff'd without opinion, 770 F.2d 174 (11th Cir.1984); Harvey v. Commissioner, 52 T.C.M. (CCH) 207, 209 (1986); Connor, supra; McEachron v. Commissioner, 873 F.2d 176, 177 (8th Cir.1988); Owen, 881 F.2d at 834; Borchers v. Commissioner, 95 T.C. 82 (1990).

The facts in Connor, supra, most closely parallel those at issue here. In Connor, 847 F.2d at 987-89, the Court of Appeals for the First Circuit applied the realistic contemplation test where, as here: (1) the lease was executed by controlling stockholder and his controlled corporation, (2) the...