61 T.C.M. (CCH) 2897
NORMAN E. SMOOT AND TOMMI L. SMOOT, Petitioners
COMMISSIONER OF INTERNAL REVENUE, Respondent
United States Tax Court
June 11, 1991
Donald W. Muir, Jr., and Irwin D. Zucker, for the petitioners.
Bruce w. Kent, for the respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined deficiencies in and additions to petitioners' Federal income tax as follows:
|| Additions to Tax and Increased Interest-Secs.
The issue presented is whether petitioners are entitled to deductions for depreciation and interest arising from the purchase and leaseback of certain peripheral computer equipment. FINDINGS OF FACT The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference. Petitioners Norman E. Smoot and Tommi L. Smoot, husband and wife, resided in San Antonio, Texas, at the time their petition in this case was filed. Petitioners filed a timely joint U.S. Individual Federal Income Tax Return for 1983 with the Internal Revenue Service in Austin, Texas. Petitioners' joint return for the taxable year 1984 was filed on October 15, 1985. On October 28, 1986, petitioners executed a Special Consent to Extend the Time to Assess Tax (Form 872-A) for the period ended December 31, 1983. Respondent mailed a notice of deficiency to petitioners on July 13, 1987. This case involves a leveraged lease transaction entered into by petitioner 
in December 1983. The parties to the transaction were as follows: (1) The end-user, Chase Manhattan Bank (Chase), which had use of the equipment for a period of time as specified in its lease; (2) the leasing company, Thomas Nationwide Computer Corporation (Thomas), which purchased the equipment, placed it with the end-user, and served as the remarketing agent for the equipment; (3) an intermediary entity, Intercontinental Investors Group, Inc. (IIG), which purchased the equipment from Thomas and provided administrative services during the life of the lease; and (4) petitioner, who purchased the equipment from IIG, simultaneously leased it to Thomas, accrued tax benefits associated with ownership, and sought to realize any potential profits from sharing in both lease rental income and sale proceeds on the equipment. STRUCTURE OF PETITIONER'S SALE AND LEASEBACK TRANSACTION A. PURCHASE AND LEASE BY THOMAS In the fall of 1983, Chase desired to lease certain IBM computer equipment. Thomas was selected by Chase as the third-party leasing company for a lease transaction. Undertaking the Chase lease was part of Thomas' efforts to establish an equipment-leasing division. Previously, Thomas had been involved in the purchase, restoration, and resale of used equipment. In November 1983, Thomas purchased $900,453 of peripheral equipment 
from IBM consisting of the following:
|| Machine Type
|| Communication Control Unit
|| Communication Control Unit
|| Control Unit/Display Station
|| Control Unit/Display Station
|| Display Station
|| Display Station
The $900,453 purchase price included $70,463.80 in discounts from IBM. Thomas subsequently leased this equipment to Chase pursuant to a master equipment lease executed by the parties on November 29, 1983. The lease was a net lease. It also provided that Thomas retained the right to depreciation, interest deductions, and the investment tax credit. Chase's initial lease term varied depending on the equipment, which was leased in groups to various Chase branch offices. Of these groups, 9 equipment groups had a lease term of 3 years, 1 group had a lease term of 2-1/2 years, and 14 lease groups had a lease term of only 2 years. Total monthly rent due from Chase for the 2-year period November 30, 1983 - November 30, 1985, was $32,635. Total monthly rent due for the period December 1, 1985 - November 30, 1986, was $1,619. The lease did not grant Chase options to terminate, renew, or purchase. However, Chase, on its own initiative could re-lease the equipment if it chose to do so. B. SALE BY THOMAS TO IIG On December 16, 1983, Thomas sold the peripheral equipment to IIG for approximately $900,000. In return for the equipment, IIG paid 12 to 14 percent of the cost to Thomas in cash and also executed a promissory note/security agreement in the face amount of $783,394 at a rate of 10.30 percent. The purchase agreement stated that IIG acquired the equipment subject to the lease between Thomas and Chase, and subject to Thomas' security interest in the equipment and any proceeds from its sale, insurance, or rental. On December 16, 1983, Thomas and IIG also executed a remarketing agreement. The agreement appointed Thomas as IIG's agent to remarket the equipment, by sale or re-lease, upon termination of any lease between Thomas and any party to whom IIG sold the equipment. As compensation for these services, Thomas was to receive 10 percent of any net sale or lease proceeds (net remarketing proceeds). The remarketing agreement recognized that the equipment would be sold by IIG to petitioner and subsequently released to Thomas. C. IIG'S SALE TO PETITIONER On December 15, 1983, 
petitioner executed a written agreement to purchase the peripheral equipment from IIG for a specified purchase price of $900,453. This was payable in $38,539 cash down and four recourse promissory notes in the aggregate sum of $141,551 payable as follows:
| Note due 3/15/84 at 15 percent
| Note due 6/30/84 at 15 percent
| Note due 1/31/85 at 15 percent
| Note due 1/31/86 at 15 percent
The balance of the purchase price was payable pursuant to a long-term nonrecourse note commencing in July 1984 as follows:
| 7-year installment note
| (14 semi-annual payments)
| of $79,971.42 at 13 percent)
The amount and timing of petitioner's payments to IIG on the long- term note mirrored IIG's payments on its debt to Thomas. Petitioner paid the cash downpayment and the short-term notes with interest as they came due. Including interest, these payments totaled $205,649.03. Including interest, petitioner's debt service on the long-term note was $1,118,843.80. Including interest, petitioner's total cash outlay for the purchase of the IBM computer equipment was $1,324,492.80. The purchase agreement also appointed IIG as petitioner's agent to administrate the collection of rents due from Thomas as lessee. IIG could offset such monies against payments due from petitioner, and IIG was to receive a fee for such collection service equal to any interest earned on rents in excess of debt service. At the time of trial, IIG was charging a 10-percent managerial fee on gross additional rents collected. The purchase agreement required petitioner to warrant that in making his investment decision, he relied solely upon an independent investigation made by him or his duly appointed or qualified representative. He also had to warrant that he understood that no Federal agency had yet made any finding or determination as to the fairness of the equipment investment. The purchase agreement between petitioner and IIG specified that the equipment purchase was subject to the lease between Thomas and Chase and Thomas' security interest in the equipment arising out of the note between IIG and Thomas. Additionally, petitioner executed a security agreement giving IIG a security interest in the equipment and its proceeds and noting that IIG's interest was subordinate to Thomas' security interest in the same equipment. Despite this subordinated position, no provision was made for recovery against petitioner individually in the event the equipment or its proceeds were insufficient to satisfy petitioner's debt to IIG. In fact, the agreement also included the following deferral clause, which indicated that repayment of the note was contingent upon receipt of rental income and that IIG looked only to the equipment for repayment: 3.2 DEFERRAL In the event the Lease [between petitioner and Thomas] is terminated prior to the expiration of the Lease Term on account of an Event of Default as defined thereunder, then, notwithstanding anything herein to the contrary, the entire unpaid principal amount of this Note, together with all interest accrued hereunder, shall be deferred without further accrual of interest during the period of such deferral and shall not be due and payable until August 31, 1997, at which time all such unpaid principal and accrued interest shall become due and payable; provided, however that, notwithstanding such deferral, to the extent the Payor shall receive any proceeds from the Equipment following a termination of the Lease as aforesaid, it shall be obligated to pay such proceeds to Payee on account of the indebtedness evidenced by this Note (and such payments shall be deemed to be prepayments under this Note). According to IIG, this provision was inserted to protect petitioner in the event that Thomas, a company new to leasing, went into bankruptcy or otherwise defaulted on its payments to petitioner. IIG's president, Howard Straus (Straus), testified that in either event, the deferral clause was intended to provide the parties with a period of time to find a substitute for Thomas and to continue the transaction. As part of the December 15, 1983, sale, IIG also assigned its rights under the remarketing agreement to...