section 6694 and business purpose"

The following IRS Private Ruling Letter concludes that there was no "substantial authority" because a sale/leaseback transaction lacked a business propose. It appeared to the IRS that the complex transactions were solely motivated by tax savings. The IRS used substance over form principles (i.e., economic substance rationale) to reach its conclusion. What is striking about the IRS analysis is that they did not take into account or consider Taxpayer authority and analysis under Reg. section 1.6662-4(d)(3) which governs the "substantial authority" analysis. Now that "substantial authority" is the standard of conduct for section 6694(a)(2)(A) positions (under the Emergency Stabilizagion Act), IRS precedent for this term under section 6662 is directly relevant to the IRS mandate under the proposed 6694 regulations. In this ruling, the IRS did not even bother to mention the Taxpayer's argument under the law under Reg. 1.6662-4(d)(3), thereby ignoring its own regulations. The IRS is likely to do this when they sense tax motivated transactions.

Nevertheless, lessions can be learned from this PLR:

1. Beware of complex trancations because the IRS will analze them, not by their form, but by their economic substance.
2. Beware of tax motivated transactions. The IRS, as it should, treats "business purpose" as the dominant factor in its analysis. The IRS based its conclusion solely on its conclusion about "business purpose."
3. Tax return preparers will be at a high risk for the 6694 penalty by preparing tax returns that reflect a series of complex interrelated transactions.
4. If section 6694 were an issue in this case, it would be likely that the IRS examiners would shoot for the $5,000 per position penalty.
5. Tax return preparers will be well advised to avoid preparing tax returns that reflect any type of aggressive tax position.
6. Get the guidance of a tax expert for a reliable technical opinion on the facts and the law before you even think of preparing a tax return that reflects complex interrelated transactions.


Chief Counsel Advice 200338009, August 8, 2001

LTR Report Number 1386, September 24, 2003

IRS REF: Symbol: CC:PSI:B01-POSTF-149350-01


Uniform Issue List Information:


UIL No. 0061.43-01



Gross income v. not gross income; Form v. substance; Lease of property.



UIL No. 9214.03-00



Leasing shelter; Railroad car leasing.


[ Code Secs. 61 and 9214]




MEMORANDUM FOR ASSOCIATE AREA COUNSEL, CC:LM:CTM:LA2



FROM: Associate Chief Counsel, Passthroughs & Special Industries



SUBJECT: Leasing Transaction



This Chief Counsel Advice responds to your memorandum dated April 10, 2002. In accordance with section 6110(k)(3) of the Internal Revenue Code, this Chief Counsel Advice should not be cited as precedent.




ISSUES


With respect to the transactions described below:



1. Whether the transactions lack economic substance.



2. Alternatively, whether the transactions should be recharacterized as a financing, rather than a sale-leaseback.



3. Whether A received original issue discount income as a result of the transactions.



4. Whether A is liable for negligence penalties, pursuant to section 6662, for entering into the transactions.




CONCLUSIONS


1. The facts set forth below suggest that the transactions lack economic substance and should not be respected.



2. Alternatively, the transactions described below should be recharacterized as a financing, rather than a sale-leaseback.



3. If the transaction can be described as a sale-leaseback, A received original issue discount income as a result of the transactions.



4. A is liable for negligence penalties, pursuant to section 6662, for entering into the transactions.




FACTS


Pursuant to a Participation Agreement dated Date 1, A, B, Lender, and Trust 1 , entered into a purported sale-leaseback transaction. A is a U.S. corporation. B's core business is C and is wholly-owned by the government of Country C.



On Date 1, B sold the Equipment to Trust and simultaneously leased the Equipment back pursuant to the Lease and Lease Agreement. The initial term of the Lease comprises an interim term of Z months followed by a Base Term. The Base Term commences on Date I and ends on Date 4. The Replacement Term of the Lease commences on Date 4 and extends for X years thereafter.



A invested in the transaction by providing $1 (Equity Contribution), which was J percent of the cost of the Equipment, to Trust and by paying the expenses in connection with the transaction. Trust borrowed from Lender the balance of the purchase price, $2, which was D percent of the cost of the Equipment. Also, on Date 1, the parties entered into a Loan Agreement, Lease Agreement, Lease Supplement, Swap Agreement, Custodial Agreement and additional agreements 2 to effectuate the Participation Agreement. To finance the purported purchase of the Equipment, A entered into a Loan Agreement with Lender and Trust. The Loan and Security Agreement is dated Date 7. Under the Loan and Security Agreement, Trust issued loan certificates to Lender and pledged the Loan Estate 3 as security for the loan certificates. The proceeds of the loan certificates were to be used by Trust to pay for a portion of the cost of the Equipment. Pursuant to the Loan Agreement, Lender agreed to lend to Trust D percent of the cost of the Equipment subject to the Lease, which was equal to $2. Payments on the loan certificates were to be made solely from the Loan Estate.



B sold the Equipment to Trust pursuant to a Deed of Conveyance. Trust pledged the Equipment and the Lease to Lender as collateral for Trust's loan from Lender. Trust agreed to pay all of the transaction costs. Trust and Lender agreed that they would not take any action that would increase the interest rate in the Loan Agreement which would, in turn, affect B's rent obligation under the lease. The parties further agreed that they could not exit from the agreement and could not transfer any of the property and/or leases and/or loans involved in the agreement unless the transferee agreed to undertake the transferor's obligations under the Participation Agreement.



The Lease sets forth a formula for calculating the rent due each month. Nonetheless, the Lease Agreement provides that the amount of rent due will, at a minimum, be sufficient to pay the principal installment and accrued principal due on all the loan certificates outstanding under the Loan Agreement. No lease payments were due during the interim term. Generally, lease payments were due biannually from Date 2 to Date 4. Additionally, no lease payment was due on Date 4.



The Lease is a net lease and B is liable for all costs and expenses in connection with the Equipment for construction, delivery, ownership, use, possession, registration, control, subleasing, operation, maintenance, repair, insurance, improvement and return of the Equipment.



According to the Appraisal, the Equipment has a useful life of approximately W years, which exceeds the Base Term by V years. Even if the term of a New Lease is aggregated with the Lease to B, the combined lease term is U years, which is T years less than the Equipment's useful life. In accordance with the Lease, B will cause each piece of Equipment to be serviced, repaired, maintained, overhauled and tested during the term of the Lease, which should allow the Equipment to reach or exceed the estimated useful life.



According to the Loan Agreement, the Lease specifies that B pay, directly to Lender, B's rent obligations to Trust, at the address specified by Lender. Pursuant to the Loan Agreement, Trust agreed that when Trust received money that was part of the Loan Estate, Trust would transfer such funds to Lender.



Lender and B entered into a currency swap transaction ("Swap") purportedly to protect B from the currency exchange risk involved in making its Lease obligation payments in U.S. dollars rather than Currency A. Pursuant to the Swap Agreement, fixed interest payment obligations were swapped for floating rate payment obligations. B gave Lender an amount equivalent to $2. Additionally, Lender was obligated to pay B a stream of payments in U.S. dollars. The termination date for the stream of payments for the Swap Agreement is Date 4. The Swap Agreement payments from Lender to B were due biannually each year from Date 2 through Date 4. On Date 4, the amount due under the Swap Agreement would be $3.



As a result of all of the above, the stream of payments due on the Loan Agreement, Lease Agreement and Swap Agreement are equivalent in amount and are due and payable on the same dates, except that on the first payment date, the Lease payment exceeds the Loan and Swap payments.



B and A entered into a Tax Indemnity Agreement on Date 7. Pursuant to the Tax Indemnity Agreement, B and A agreed to the following:



A will be treated as the owner of the Trust Estate and will be required to take into account in computing its taxable income all items of income, gain, loss and deduction flowing from the Trust Estate;



The Lease will be treated as a true lease by Trust as owner and lessor to B and the obligations on the Loan will constitute indebtedness of the Lessor; and



A, as the beneficial owner of the Equipment, will be treated as the purchaser, owner and lessor of each Piece of Equipment and will be entitled to depreciation deductions for the Equipment, interest deductions on the Loan and amortization of transaction expenses related to the Lease.



Significantly, at the end of the Base Term, the Lease Agreement requires B to exercise one of the three following options:



1. to purchase the Equipment pursuant to a "Purchase Option";



2. to cause a New Lessee to enter into a new lease pursuant to a "New Lease Option"; or



3. to return the Equipment to Trust pursuant to the "Return Option."



(1) The Purchase Option.



Assuming all rents due were paid and the loans were not defaulted, on Date 4, B could purchase the Equipment from Trust for a price equal to E percent of the cost of the Equipment, or $4. Additionally, B would pay all the unpaid rent due and payable as of Date 4. When B paid these amounts, rent would stop accruing, the term of the lease would terminate, and title to the Equipment would be conveyed to B. Additionally, Trust would request that upon payment of all amounts due under the Loan Agreement and upon termination of the Loan Agreement, Lender would release Trust from its liabilities under the Loan Agreement and related pledge agreements. At B's expense, Trust would execute and deliver to B the appropriate documents conveying Trust's right, title and interest in and to the Equipment to B or B's designee.



B entered into an agreement with Foundation, purportedly to protect itself from currency fluctuation risk by providing a source of U.S. dollars to pay the Purchase Option price if B chooses to exercise the Purchase Option on Date 4. B transferred funds from the Equity Contribution to the Foundation. Foundation used the funds to purchase two treasury strips. The first strip matured in an amount equal to the Net Rent amount due on Date 3. The Net Rent equals the amount by which a Lease payment exceeds a Loan payment. The second strip matured on Date 4 in an amount equal to the Net Purchase Option price. The Net Purchase Option price is the extent to which the Purchase Option price would exceed the principal and interest scheduled to be paid on the Loan certificates on Date 4. On Date 4, the Purchase Option price will exceed the principal and interest scheduled to be paid on the Loan certificates, in an amount equal to the amount that the second treasury strip will mature to.



(2) The New Lease Option.



To exercise the New Lease Option, B would have to find a new replacement lessee ("New Lessee") who would 1) use the Equipment in its business; 2) lease the Equipment to another business; 3) sublease the Equipment to another entity; or 4) enter into subleases for terms of less than three years with sublessees that are tax exempt entities. The new lease would begin on Date 4 and would extend for a period of X years or less. B could compensate the New Lessee to induce it to enter into the new lease. The rental payments on the new lease must preserve Trust's net economic return so that Trust's net economic return is the same as it was under the original lease. The Equipment must be delivered in Country C at the commencement of the new lease. If 30 days prior to the expiration date of the Base Term of the lease, Trust and the New Lessee have not entered into a new lease, then, no later than 25 days before the expiration date of the Base Term of the lease, B will give irrevocable notice to Trust of its election to exercise the Return Option or the Purchase Option. If either B gives notice that it is electing the New Lease option or Trust and New Lessee have not agreed to a new lease at least 30 days prior to the expiration date of the Base Term of the Lease, Trust may unilaterally make a preemptive election to require the return of the Equipment on the expiration date of the Base Term of the lease. In its notice of making a preemptive election, B must agree to pay Lender all amounts due and payable on Date 4 under the Loan Agreement. If Trust exercises this preemptive election, B will have to return the Equipment.



(3) The Return Option



If B exercises the Return Option, then B must return the Equipment to Trust on Date 4. On Date 4, B will have to pay Trust all the rent due and payable on that date and a Lump Sum Payment. 4 Trust would use commercially reasonable efforts to sell and dispose of the Equipment to the highest bidder at auction. If the loan certificates have been repaid in full, then the proceeds of the sale in excess of F percent of the Equipment's cost will be paid to B up to the amount of the Lump Sum Payment. However, if at Trust's option, Trust retained the Equipment and the entire principal amount and accrued interest of the loan certificates has been paid or the interest rate has been reset or the loan certificates have been purchased at par plus accrued interest through Date 4, then Trust will pay B an amount equal to the fair market value of the Equipment in excess of F percent of the Equipment's cost, up to the amount of the Lump Sum Payment.



According to the Appraisal of the Equipment obtained by A from Appraiser, B will not be under any economic compulsion to exercise any particular option. Thus, it was not possible for the appraisal to conclude which option A would be most likely to exercise at the end of the Lease Term.




LAW AND ANALYSIS


I. Whether The Sale-Leaseback Transaction Lacks Economic Substance



In order to be respected, a transaction must have economic substance separate and distinct from the economic benefit achieved solely by tax reduction. If a taxpayer seeks to claim tax benefits, which were not intended by Congress, by means of transactions that serve no economic purpose other than tax savings, the doctrine of economic substance is applicable. United States v. Wexler, 31 F.3d 117, 122, 124 (3d Cir. 1994) [ 94-2 USTC ¶50,361]; Yosha v. Commissioner, 861 F.2d 494, 498-99 (7\th/ Cir. 1988) [ 88-2 USTC ¶9589], aff'g, Glass v. Commissioner, 87 T.C. 1087 (1986) [CCH Dec. 43,495]; Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966) [ 66-2 USTC ¶9561], aff'g 44 T.C. 284 (1965) [CCH Dec. 27,415]; ACM Partnership v. Commissioner, T.C. Memo. 1997-115 [CCH Dec. 51,922(M)], aff'd in part and rev'd in part 157 F.3d 231 (3d Cir. 1998) [ 98-2 USTC ¶50,790].



Whether a transaction has economic substance is a factual determination. United States v. Cumberland Pub. Serv. Co., 338 U.S. 451, 456 (1950) [ 50-1 USTC ¶9129]. This determination turns on whether the transaction is rationally related to a useful nontax purpose that is plausible in light of the taxpayer's conduct and useful in light of the taxpayer's economic situation and intentions. The utility of the stated purpose and the rationality of the means chosen to effectuate it must be evaluated in accordance with commercial practices in the relevant industry. Cherin v. Commissioner, 89 T.C. 986, 993-94 (1987) [CCH Dec. 44,333]; ACM Partnership, supra. A rational relationship between purpose and means ordinarily will not be found unless there was a reasonable expectation that the nontax benefits would be at least commensurate with the transaction costs. Yosha, supra; ACM Partnership, supra.



In determining if a transaction has economic substance, both the objective economic substance of the transaction and the subjective business motivation of the taxpayer must be determined. ACM Partnership, 157 F.3d at 247 [ 98-2 USTC ¶50,790]; Horn v. Commissioner, 968 F.2d 1229, 1237 (D.C. Cir. 1992) [ 92-2 USTC ¶50,328]; Casebeer v. Commissioner, 909 F.2d 1360, 1363 ((9\th/ Cir. 1990) [ 90-2 USTC ¶50,435]. The two inquiries are not separate prongs, but are interrelated factors used to analyze whether the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes. ACM Partnership, 157 F.3d at 247 [ 98-2 USTC ¶50,790]; Casebeer, 909 F.2d at 1363 [ 90-2 USTC ¶50,435]. Consequently, in considering whether a sale-leaseback case has economic substance, the Tax Court in Levy v. Commissioner, 91 T.C. 838, 856 (1988) [CCH Dec. 45,152], found the following factors to be "particularly significant":



The presence or absence of arm's-length price negotiations, Helba v. Commissioner, 87 T.C. 983, 1005-1007 (1986) [CCH Dec.43,474], affd. 860 F.2d 1075 (3d Cir. 1988); see also Karme v. Commissioner, 73 T.C. 1163, 1186 (1980) [CCH Dec. 36,843], affd. 673 F.2d 1062 (9\th/ Cir. 1982) [ 82-1 USTC ¶9316]; the relationship between the sales price and fair market value, Zirker v. Commissioner, 87 T.C. 970, 976 (1986) [CCH Dec. 43,473]; Helba v. Commissioner, supra at 1005-1007, 1009-1011; the structure of the financing, Helba v. Commissioner, supra at 1007-1011; the degree of adherence to contractual terms, Helba v. Commissioner, supra at 1011; and the reasonableness of the income and residual value projections, Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184, 204-207 [CCH Dec. 40,410].



Accordingly, an equipment sale-leaseback will be considered a sham if it (1) was not motivated by any economic purpose outside of tax considerations, and (2) was without any real potential for profit. See Rice's Toyota World v. Commissioner, 752 F.2d 89 (4\th/ Cir. 1985) [ 85-1 USTC ¶9123].



Courts recognize that offsetting legal obligations, or circular cash flows may effectively eliminate any real economic significance of the transaction. For instance, in Knetsch v. United States, 364 U.S. 361 (1960) [ 60-2 USTC ¶9785], the taxpayer repeatedly borrowed against increases in the cash value of a bond. Since the bond and the taxpayer's borrowings constituted offsetting obligations, the taxpayer could never derive any significant benefit from the bond. The Supreme Court found the transaction to be a sham because it would produce no significant economic effect and had been structured only to provide the taxpayer with interest deductions.



Subsequently, the Court of Appeals for the Second Circuit applied an economic substance analysis in Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966) [ 66-2 USTC ¶9561], affg. 44 T.C. 284 (1965) [CCH Dec. 27,415]. In that case, the taxpayer won the Irish Sweepstakes. In an attempt to shelter her winnings from tax, she borrowed from two banks and invested the loan proceeds in Treasury notes. The loans required her to pay interest at 4 percent, while some Treasury notes yielded one-half percent and others yielded 1-1/2 percent. Her financial advisers estimated that these transactions would produce a pretax loss of $18,500 but a substantial after-tax gain. The court disallowed the interest deductions because it found that the taxpayer's purpose in entering into the loan transactions "'was not to derive economic gain or to improve here [sic] beneficial interest; but was solely an attempt to obtain an interest deduction as an offset to her sweepstakes winnings." Id. at 738. The court stated further that the loan arrangements did not "have purpose, substance, or utility apart from their anticipated tax consequences," and that the transactions had no "realistic expectation of economic profit." Id. at 740.



Goldstein is significant because unlike many purported tax shelters, the tax-motivated transactions in that case were not fictitious. Goldstein v. Commissioner, supra at 737- 738. They were real and conducted at arm's length. The taxpayer's indebtedness was enforceable with full recourse and her investments were exposed to market risk. Yet, the strategy was not consistent with rational economic behavior in the absence of the expected tax benefits.



Other courts have applied the teaching of Goldstein in varied settings. For example, in Sheldon v. Commissioner, 94 T.C. 738 (1990) [CCH Dec. 46,602], the Tax Court denied the taxpayer the tax benefits of a series of Treasury bill sale-repurchase transactions because they lacked economic substance. In the transactions, the taxpayer bought Treasury bills that matured shortly after the end of the tax year and funded the purchase by borrowing against the Treasury bills. The taxpayer accrued the majority of its interest deduction on the borrowings in the first year while deferring the inclusion of its economically offsetting interest income from the Treasury bills until the second year. The transactions lacked economic substance because the economic consequence of holding the Treasury bills was largely offset by the economic cost of the borrowings. The taxpayer was denied the tax benefit of the transactions because the real economic impact of the transactions was "infinitesimally nominal and vastly insignificant when considered in comparison with the claimed deductions." Sheldon, 94 T.C. at 769 [CCH Dec. 46,602].



Even in cases in which a circular flow of funds was not the predominant feature, courts have indicated that a minimal profit should not be conclusive in finding economic substance or practical economic effects. Minimal or no profit has been held to be acceptable in highly risky circumstances, where a chance for large profits also existed. See Bryant v. Commissioner, 928 F.2d 745 (6\th/ Cir. 1991) [ 91-1 USTC ¶50,157]; Jacobson v. Commissioner, 915 F.2d 832 (2d Cir. 1990) [ 90-2 USTC ¶50,532]. Conversely, a minimal profit should be less acceptable when a ceiling on profits from a transaction is all but certain. Thus, if tax considerations predominate, the courts will find that an equipment leasing transaction is a sham even if it holds out the promise of minimal profit. See Hines v. Commissioner, 912 F.2d 736 (4\th/ Cir. 1990) [ 90-2 USTC ¶50,477]; Prager v. Commissioner, T.C. Memo. 1993-452 [CCH Dec. 49,309(M)]. The fact that the taxpayer is willing to accept minimal returns in a transaction with little additional profit potential is evidence that the transaction was tax motivated.



In ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998) [ 98-2 USTC ¶50,790], the taxpayer entered into a near-simultaneous purchase and sale of debt instruments. Taken together, the purchase and sale "had only nominal, incidental effects on [the taxpayer's] net economic position." ACM Partnership, 157 F.3d at 250 [ 98-2 USTC ¶50,790]. The taxpayer claimed that, despite the minimal net economic effect, the transaction had economic substance. The Third Circuit Court of Appeals held that transactions that do not "appreciably" affect a taxpayer's beneficial interest, except to reduce tax, are devoid of substance and are not respected for tax purposes. ACM Partnership, 157 F.3d at 248 [ 98-2 USTC ¶50,790]. The court denied the taxpayer the purported tax benefits of the transaction because the transaction lacked any significant economic consequences other than the creation of tax benefits. In addition, the court specifically affirmed the Tax Court's adjustment of future income to net present value to determine the profit potential of a transaction under the judicially created economic substance doctrine. The court rejected the argument that there is no statutory basis for using present values, and cited several cases sustaining the use of present value computations to determine the true profit potential of a transaction.



In United Parcel Service of America, Inc., 254 F.3d 1014 (11\th/ Cir. 2001) [ 2001-2 USTC ¶50,475] the Eleventh Circuit recently reversed the Tax Court on the issue of economic substance finding that UPS' restructuring of its excess-value business had both real economic effects and a business purpose. The Court reasoned that setting up a transaction (that otherwise has economic substance) with tax planning in mind is permissible as long as it figures in a bona fide, profit-seeking business purpose. We do not believe that this opinion will have a negative effect on the instant case because, for the reasons articulated below, we do not believe that the transactions had a bona fide profit-seeking business purpose. Also, unlike UPS, A is not in C in business. Moreover, the Eleventh Circuit recently affirmed the Tax Court's determination that a transaction entered into by the taxpayer was a substantive sham. Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313 (11\th/ Cir. 2001) [ 2001-2 USTC ¶50,495].



In Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5\th/ Cir. 2001) [ 2002-1 USTC ¶50,144], the Fifth Circuit found that Compaq made a pretax profit and had a non-tax business purpose on Royal Dutch ADR transactions. See also, IES Indus. v. United States, 253 F.3d 350 (8\th/ Cir. 2001) [ 2001-2 USTC ¶50,471]. While these cases have not changed our analysis in the instant case, we recommend that you carefully scrutinize any claim of pretax return and determine if it is insubstantial when compared to the post-tax returns.



A. The Circular Flows of Funds Involved in the Sale-Leaseback Transaction Entered into by A, Trust, B, and Lender Illustrates that A had no subjective profit motive and the transactions had no objective economic substance



On the funding date, the sale, leaseback, loan and swap transactions all commenced, creating two complete circular flows of funds yielding a net cash flow of zero. According to the Documents, the following three transfers of $2 took place on the funding date: (1) Lender lent $2 to Trust; (2) Trust contributed the $2 together with the Equity Contribution from A to B for the purchase of the Equipment; and (3) B transferred $2 to Lender pursuant to the Swap Agreement. Accordingly, $2 ended where it started, with Lender. Additionally, according to the Documents, the following three streams of payments were agreed to and initiated as of the funding date: (1) Pursuant to the Lease Agreement, B would pay lease payments to Trust for use of the Equipment; (2) Pursuant to the Loan Agreement, Trust would make loan payments to Lender for principal and interest owed on the purported $2 loan from Lender to Trust and the Loan Agreement also provided that B would pay the lease payments it owed Trust directly to Lender; and (3) Lender would make payments to B pursuant to the Swap Agreement. The amounts of all of the payments were equivalent and the payments were all due on the same date. However, the Lease payment made on Date 3 exceeded the amount of the Loan payments and Swap payments due on Date 4. Except for the payment made on Date 3, the three streams of payments yielded a net cash flow of zero. Thus, A does not appear to have an expectation of profit from the rental payments independent of tax benefits.



The Custodial Agreement entered into by B and the Foundation completed the circular flow of funds. B transferred funds from the Equity Contribution to the Foundation. The Foundation used the funds from the Equity Contribution to purchase two Treasury strips. One strip matured to the Net Rent due on the first Lease payment. The second strip matured to the Net Purchase Option price in the amount of $8. The remaining portion of the Purchase Option Price, $3 is part of another circular flow of funds. On Date 4, the amount due from A to Lender outstanding on the loan certificates is $3 and the amount due from Lender to B on the Swap Agreement also equals $3. On Date 4, the $3 makes a complete circle between the three parties to the transaction with no net outflow of cash from any of the parties. Accordingly, the amount of the matured treasury strip provided B with sufficient cash to exercise the Purchase Option price without any further outlay of cash by B. Thus, A has no risk that B would have insufficient funds to exercise the Purchase Option on Date 4.



Additionally, B has business motives to reacquire the Equipment. The acquisition of the Equipment was part of B's modernization program. Furthermore, B is in the business of C in Country C and is the likely party to wish to operate the Equipment. Since A had no opportunity to earn a profit on the deal during the Lease Term, the only opportunity for A to earn a profit was on Date 4. However, the following analysis of the three options shows that A would not earn a profit on Date 4, either.




1. The Purchase Option


The Purchase Option is the most economically preferable option. By drawing on the funds held by Foundation, by Date 4, B would have the funds necessary to exercise the Purchase Option without any additional costs. If the Equipment appreciated to a fair market value greater than the Purchase Option price, B, acting rationally, would exercise the Purchase Option to take advantage of the bargain price. If the Equipment depreciated to a fair market value lower than the Purchase Option price, B, acting rationally, would still exercise the Purchase Option because, as will be illustrated in the following discussion, the Purchase Option is still the most economically advantageous option. Additionally, B has a business motive to exercise the Purchase Option and retain the Equipment.



If B exercises the Purchase Option on Date 4, A receives a very small profit on its Equity Contribution. The Purchase Option Price is $4. However, A will owe Lender $3 leaving A a net return of $8 which is the Net Purchase Option Price. On Date 4, Lender will owe B $3 pursuant to the Swap Agreement. Accordingly, the $3 goes in a complete circle and ends where it started, with B. B can take the funds from the treasury strip that matures on Date 4 to $8 to pay the Net Purchase Option price. Accordingly, B has no additional outlay of costs to exercise the Purchase Option.




2. The New Lease Option


It also appears that exercising the New Lease Option would put B in a worse position, economically, than exercising the Purchase Option. Under the New Lease Option, the Lease payments were predetermined as of the funding date. Thus, if B were to find a New Lessee, the parties would not be able to renegotiate the New Lease payments so that they would be in accord with the then fair market value. If B wished to find a New Lessee and the Equipment appreciated in value so that the New Lease payments were less than fair market value, B, acting rationally, would exercise the Purchase Option and then lease the Equipment, itself, to take advantage of the appreciation in value. If the Equipment depreciated in value so that the New Lease payments would be a higher price than the market would otherwise bear, B would have to pay an inducement to the New Lessee. In this circumstance, B would have to pay the inducement and not have the Equipment. Acting rationally, we believe that B would exercise the Purchase Option and then lease the Equipment, itself. In doing so, B would be able to find another entity to lease and operate the Equipment but would not have any further costs with respect to the sale-leaseback transaction with Trust.



However, there are significant litigation hazards unless it can demonstrate that the New Lease Option is purely illusory. The New Lease Option could be viewed as a negotiated protection inserted into the Lease Agreement. For the Trust and Lender, the New Lease Option offers the protection of a long term, fixed rate of return based on a lease term of as many as X years for the Equipment in the event B does not exercise its Purchase Option. For B, the New Lease Option offers protection against being forced to either buy the Equipment or walk away with a large expenditure and no Equipment. Nonetheless, we believe that the rational choice is the Purchase Option.




3. The Return Option


Exercising the Return Option would put B in a worse position, economically than exercising the Purchase Option. If B exercises the Return Option, then B will be required to pay A the Lump Sum Payment equal to H percent of the original Equipment cost which is $5 and A will sell the Equipment at auction. A will pay B proceeds from A's sale of the Equipment greater than F percent of the Equipment Cost and up to the amount of the Lump Sum Payment. If B exercised the Return Option, B would have funds available in the Foundation to pay the Lump Sum; however, B would not have any Equipment. Pursuant to the terms of the Return Option, B would get some of A's Equipment sale proceeds. However, B would not be able to receive the first $7 5 of A's Equipment sales proceeds and would not be able to receive more than the Lump Sum amount. B would not be able to recoup a sufficient amount to purchase the same or alternative Equipment. Thus, B would be in a worse economic position if it exercised the Return Option than if it exercised the Purchase Option. Since it is the economically rational choice to select the Purchase Option, regardless, of whether the property appreciates or depreciates in value, A has no opportunity to profit from appreciation in the property, nor to suffer a loss from depreciation in the property.



A's only net return on the transaction is the Net Rent paid on Date 3 and the Net Purchase Option price paid on Date 4. Those amounts are very small compared to the tax benefits that A enjoys during the Lease Term. A minimal profit should not be conclusive in finding economic substance or practical economic effects. Minimal or no profit has been held to be acceptable in highly risky circumstances, where a chance for large profits also existed. See Bryant v. Commissioner, 928 F.2d 745 (6th Cir. 1991) [ 91-1 USTC ¶50,157]; Jacobson v. Commissioner, 915 F.2d 832 (2d Cir. 1990) [ 90-2 USTC ¶50,532]. However, a minimal profit should conversely be less acceptable when a ceiling on profits from a transaction is all but certain. A's willingness to accept minimal returns in a transaction with a limitation on profit potential demonstrates that the transaction was tax motivated. Thus, a minimal profit in an equipment leasing transaction will not prevent the finding of a sham if tax considerations predominate. See Hines v. Commissioner, 912 F.2d 736 (4th Cir. 1990) [ 90-2 USTC ¶50,477]; Prager v. Commissioner, T.C. Memo. 1993-452 [CCH Dec. 49,309(M)].



Arguably, the only motivation for this transaction was A's desire to "purchase" tax benefits. This transaction could reasonably be viewed as a "sale" of tax benefits by an entity which cannot use them to a taxable entity which can. In exchange for its equity investment, A received a substantially greater amount of tax benefits by claiming depreciation, amortization and interest expenses each year over the life of the transaction. Because it appears likely that Trust will exercise the Purchase Option, and all amounts have been pre-funded, this transaction shares many factual similarities with other cases decided under economic substance principles. See Knetsch supra (offsetting legal obligations).



In form, this transaction was a sale/leaseback between A and B financed by a loan from Lender, with an embedded currency swap with the purported purpose of protecting B from currency exchange risk. In the instant case, a currency swap was used to complete a circular flow of funds. A currency swap agreement is two offsetting loans in two different currencies. By substituting a currency swap between Lender and B for a loan from B to Lender, the transaction embeds what is in substance a loan from Lender to B in what would otherwise be a sham transaction involving a circular flow of funds.



All the cash flows were circular and yielded net proceeds of zero, thus, A had no economic risk in undertaking the transaction; and A has a cap on the possibility of earning a profit from this transaction or bearing any significant costs either during or at the expiration of the Lease Term, this series of transactions lacked the potential for any significant economic consequences and therefore lacked economic substance and had no business purpose. See, e.g., Rice's Toyota World; Nicole Rose; Levy. For this reason we believe economic substance principles may be applied in this case.



Accordingly, A is not entitled to deduct the depreciation deductions claimed for the Equipment purportedly purchased by A pursuant to the transaction. Further, the interest deductions at issue in the instant case stem directly from the Loan taken by A through Trust. The loan cannot be separated from the purported sale transaction whose sole purpose was for A to obtain tax benefits. As such, the Loan was an integral part of the transaction and a deduction for the interest on the Loan is not allowable under section 163.



II. Whether The Transaction Should Be Treated As a Financing Rather Than As a Sale-Leaseback



Alternatively, the transaction should be treated as a financing. Whether a sale-leaseback is respected for federal income tax purposes is not determined by the labels of the parties. In Helvering v. F. & R. Lazarus & Co., 308 U.S. 252 (1939) [ 39-2 USTC ¶9793], the Supreme Court stated that, "taxation ... [is] concerned with substance and realities, and formal written documents are not rigidly binding." 308 U.S. at 255. In Lazarus, the taxpayer conveyed property to a bank and then leased the property back for a term of ninety-nine years. The Court concluded that the transaction, though structured in the form of a sale-leaseback, was in substance a loan secured by the property. It held that the taxpayer was the party who bears the burden of exhaustion of capital investment in the property and thus, is entitled to deduct depreciation regardless of the fact that the taxpayer had by agreement designated another party as the legal owner. Lazarus stands for the proposition that, in the sale-leaseback area, the substance of the transaction rather than its form is controlling for federal tax purposes.



In Frank Lyon Co. v. United States, 435 U.S. 561 (1978) [ 78-1 USTC ¶9370], the Supreme Court set forth standards for determining when a sale-leaseback may not be ignored as a sham, holding that "so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes." Id. at 584. In Frank Lyon, the Frank Lyon Company's (Company) majority shareholder and board chairman also served on the board of Worthen Bank (Bank). The Company invested $500,000 of its own funds to acquire a new office building from the Bank and lease it back to the Bank for an initial term of 25 years. The Company financed the remainder of the building with a full recourse loan of $7,140,000 obtained from an unrelated insurance company. The rent for the first 25 years equaled the principal and interest payments that would amortize this loan. The Company also leased the land under the building from the Bank for 76 years. The Bank had the right to renew its lease of the building for eight additional 5-year intervals at a fixed rent making its total potential leasehold 65 years long. The Bank had the option to purchase the building at 11 years and at other points in the lease for the Company's investment with compound interest at 6 percent plus repayment of the loan balance. The Bank also had the option to purchase the building at fair market value under certain conditions involving a transfer of the Company's interest. Under applicable federal and state law, the Bank was precluded from financing an office building of that magnitude for its own use. However, the state and federal regulators approved the sale and leaseback so long as the Bank had an option to purchase the property after 15 years at a fixed price where another party owned the building.



The Government argued that the sale leaseback should be disregarded as a sham, because the Company was only acting as a conduit to forward rent payments to pay the mortgage and was doing so for a guaranteed return. In rejecting the sham argument, the Court distinguished Lazarus because it involved two rather than three parties. The third party (the lender) was necessary to the transaction in Frank Lyon because of the restrictions on borrowing imposed on the Bank. The Court found it significant that the Bank could not legally own and finance its own building. The Court emphasized that the Company had assumed recourse liability in the debt, and thus it had exposure to real and substantial risk. Moreover, the Court rejected the contention that the purchase options allowed the Bank to accumulate equity in the property over time because the Bank was free to walk away without further obligation without exercising any lease extension and, alternatively, the option prices represented fair estimates of market value on applicable dates. The Court also noted that the Company would be free to do with the building as it chose if the lease were not extended, but would remain liable for the ground rent. The Court concluded, at 583-84, that:



Where ... there is a genuine multi-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties. Expressed another way, so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes. What those attributes are in any particular case will necessarily depend upon its facts.



The decision in Frank Lyon rested strongly upon the risks incurred by the Company, including the recourse debt, the ground rent, and the possibility the lease would not be extended (significantly, without any compensation to the Company), and the rewards of the use of the property if the Bank did not extend the lease. Such risks gave the Company the significant attributes of a lessor. No similar risks were incurred in the present case. Here, the Loan is subject to satisfaction and the risks as well as the potential gains from the transaction have been carefully collared to limit both potential loss and profit by A. While it is true that Frank Lyon suggests rental payments in a lease may match up to the amount of principal and interest necessary to amortize a loan, that case involved the construction of a building that, implicitly at least, could be used by any lessee. That the payments match up, therefore, is not significant unless it reinforces the view that the lessor's risks and rewards indicate the lessor is not the owner of the property. Significantly, therefore, the below analysis will show that the risks and the potential gains from the transaction to A have been carefully collared to limit both potential loss and profit to A.



Moreover, in Frank Lyon the Bank was precluded by federal and state regulations from financing and constructing the building itself. No such restrictions are present in this case because B owned the Equipment prior to the effective date of the transaction here. Accordingly, although the legal principles of Frank Lyon (that is, focusing on the substance of the transaction) are appropriate to an analysis of this transaction, that case is factually distinguishable from the present case.



Despite the government's inability to demonstrate, on the facts in Frank Lyon, that the Company was simply financing the Bank's building purchase, many courts have addressed whether a sale-leaseback was, in substance, a financing, that is, whether the purported owner/lessor simply lent money to the purported seller/lessee. A particularly instructive example is Pacific Gamble Robinson and Affiliated Companies v. Commissioner, 54 T.C. Memo. 915 (1987) [CCH Dec. 44,281(M)]. There, petitioner (PER) sold its Yakima Apple Facility to Third Birkenhead Properties Inc. for $500,000; $490,000 of which was financed with a nonrecourse note payable to Minnesota Mutual Life Insurance Company. At the same time, the facility was leased back to PER for a 25-year primary term and six 5-year renewal terms. During the primary lease term, the rental payments equaled the payments due from Third Birkenhead to Minnesota Mutual on the note. Third Birkenhead had the right to require PER to buy the facility at the end of the basic lease term under a predetermined price schedule for a stated purchase price nearly equal to the then outstanding balance owed on the note. This lease provision was amended to require PER to offer to buy the facility at the end of the primary term for the greater of its then fair market value or the outstanding balance owed on the note. It was unlikely that the fair market value of the facility would exceed the outstanding balance on the note. New notes were later issued that provided that the lenders would look solely to the facility and to the sums due from PER under the lease for repayment on the notes. Under the new notes, PER agreed to pay the installments when they became due.



The Tax Court disregarded the form of the transaction as a sale-leaseback as inconsistent with its economic substance. It held that PER was in substance the "owner" of the facility for federal tax purposes. The court cited several factors to support its holding: (1) As a matter of economic reality, PER (the "lessee"), not the lessor, was principally liable on the debt; (2) PER, not the lessor, retained the primary benefits and burdens of ownership associated with the facility; and (3) the lessor had no reasonable opportunity for economic profit from the transaction absent tax benefits.



Similarly, in situations involving the characterization of sale-leaseback transactions, the Service consistently has held that the substance of a transaction is controlling for federal tax purposes. For instance, Rev. Rul. 72-543, 1972-2 C.B. 87, concluded that a transaction in the form of a "sale-leaseback" is in fact a financing where under the terms of the leaseback, the taxpayer-lessee never actually parted with the benefits and burdens of ownership to the property for federal income tax purposes. In that ruling, the taxpayer, a shipping company financed reconstruction of a vessel by "selling" title to the vessel to the subsidiary of a bank for the vessel's then fair market value. The subsidiary borrowed the cost of the acquisition and reconstruction from a group of lenders under a "charter party," an agreement whereby the subsidiary leases the vessel to the taxpayer for use in its transportation business. At the same time, the subsidiary assigned all of its rights, title and interest to the monies due under the charter party to the lenders. Under the agreement, the subsidiary chartered the vessel to the taxpayer for a 21-year term at a rental rate sufficient to pay the total costs of acquiring and reconstructing the vessel plus interest over the 21-year period. The 21-year term exceeded the vessel's useful life. The taxpayer was at risk for the vessel at all times during this term and had to maintain insurance. The charter gave the taxpayer the right to buy the vessel on the 9th anniversary of delivery for a predetermined price equal to the unamortized principal amount of the loan on that date.



Rev. Rul. 72-543 concluded that the taxpayer held the benefits and burdens of ownership to the vessel since (I) it was obliged to repay the costs of acquisition and reconstruction plus interest in the form of rentals; (ii) it had to pay the vessel's operating and insurance costs; (iii) it had an option to purchase the vessel for the unamortized principal amount of the loan at a specific anniversary date; and (iv) the parties intended for legal title to pass to taxpayer. Although cast in the form of a sale-leaseback, the ruling held that the transaction, when viewed in its entirety, was a financing arrangement with ownership of the vessel in the taxpayer.



Thus, whether a transaction is a sale, a lease, or a financing arrangement is a question of fact, which must be ascertained from the intent of the parties as evidenced by the written agreements read in light of the attending facts and circumstances. Haggard v. Commissioner, 24 T.C. 1124, 1129 (1955) [CCH Dec. 21,249], aff'd, 241 F.2d 288 (9\th/ Cir. 1956) [ 57-1 USTC ¶9230]. The judicial test for determining if a transaction is a sale, as opposed to a lease or a financing arrangement, is whether the benefits and burdens of ownership have passed to the purported purchaser. Larsen v. Commissioner, 89 T.C. 1229 (1987) [CCH Dec. 44,401]. For this purpose, the "refinements of title" are not dispositive. Corliss v. Bowers, 281 U.S. 376, 378 (1930). In fact, even if the vesting of title in someone other than taxpayer created a prima facie case that the taxpayer was not the owner of certain equipment for depreciation purposes, the Tax Court, in Coleman v. Commissioner, 87 T.C. 178, 202 n. 18 (1986) [CCH Dec. 43,193], aff'd, 833 F.2d 303 (3d Cir. 1987), acknowledged that the location of title did not mean that it was holding that taxpayer was not the owner. Instead, the location of title meant only that the taxpayer had the burden of producing "strong proof" that the other benefits and burdens of ownership were held by the taxpayer. 87 T.C. at 203-04 [CCH Dec. 43,193]. The court's opinion in Coleman analyzed the benefits and burdens of ownership of the equipment and concluded that the taxpayers failed to demonstrate that it held the incidents of ownership to the equipment.



The Tax Court analyzes the following factors to determine if the benefits and burdens of ownership pass in a transaction: (1) whether legal title passed; (2) whether the parties treated the transaction as a sale; (3) whether the purchaser acquired an equity interest in the property; (4) whether the sale contract obligated the seller to execute and deliver a deed and obligated the purchaser to make payments; (5) whether the purchaser is vested with the right of possession; (6) whether the purchaser pays property taxes after the transaction; (7) whether the purchaser bears the risk of economic loss or physical damage to the property; and (8) whether the purchaser receives the profit from the property's operation, retention and sale. Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237-38 (1981) [CCH Dec. 38,472]. Although the potential for gain and amount of risk have been deemed the pivotal factors, the overall concentration should lie on the economic substance of the transaction. Mapco, Inc. v. United States, 556 F.2d 1107, 1111 (Ct. Cl. 1977) [ 77-2 USTC ¶9476].



The Tax Court has also considered the following factors as being relevant to determining whether a sale has occurred (that is, whether to respect a sale-leaseback): (1) the existence of a useful life of the property in excess of the leaseback term; (2) the existence of a purchase option at fair market value; (3) renewal rental at the end of the leaseback term set at fair market rent; and (4) the reasonable possibility that the purported owner of the property can recoup his investment in the property from the income producing potential and residual value of the property. Torres v. Commissioner, 88 T.C. 702, 721 (1987) [CCH Dec. 43,809] citing Estate of Thomas v. Commissioner, 84 T.C. 412, 436 (1985) [CCH Dec. 41,943]; Mukerji v. Commissioner, 87 T.C. 926 (1986) [CCH Dec. 43,469]. The Tax Court in Torres has found the taxpayer's equity interest as a percent of the purchase price to be significant, and it further noted that a sale-leaseback involving a net lease has certain specific characteristics, 88 T.C. at 721 [CCH Dec. 43,809]:



[B]ecause net leases are common in commercial settings, it is less relevant that petitioner was not responsible for the payment of property taxes or that petitioner bears less of a risk of loss or damage to the property because the lessee is required to maintain insurance on the property. Similarly, a lessor is normally not vested with the right to possession during the term of the lease and, therefore, the relevant consideration in this regard is whether the useful life of the property extends beyond the term of the lease so as to give the purchaser a meaningful possessory right to the property. Also, in a leaseback transaction it is normal for the lessee to receive profits from the operation of the property while the lessor's receipt of payments is less dependent upon the operation of the property.



Since no one factor is dispositive of the issue of whether a sale has occurred, the facts and circumstances determine the importance of each factor. For example, whether the buyer has acquired an equity interest in the property may be considered substantive evidence of a sale. See Estate of Franklin v. Commissioner, 544 F.2d 1045, 1048 (9th Cir. 1976) [ 76-2 USTC ¶9773]. However, a taxpayer who acquires no equity interest in the property has no depreciable interest in the property, but instead will be viewed as having attempted to acquire mere tax benefits. Houchins v. Commissioner, 79 T.C. 570, 602 (1982) [CCH Dec. 39,387]. In this context, equity consists of a positive differential between the fair market value of the property and the balance of any loans owed on the property.



Equity may also be viewed as the amount of the purchaser's funds at risk in the property. Thus, a true owner has potential for gain or loss from increase or decrease in the market value of the property. In contrast, a mortgagee's economic return, consisting of interest payments and return of principal, is generally fixed at the time of the initial transaction, irrespective of fluctuations in market value of the property.



Given these overlapping lists of factors, we proceed first to examine the factors set out in Grodt & McKay and then analyze the factors set out in Torres to determine if the benefits and burdens of ownership pass in a transaction and whether a sale has occurred. This analysis will then determine whether A is entitled to the depreciation deductions A claimed for the Equipment purportedly purchased pursuant to the sale-leaseback transaction.




A. Grodt & McKay Factors



1. Whether Legal Title Passed


Pursuant to the Participation Agreement and Deed of Conveyance, B sold, assigned and transferred to Trust all of B's right, title, and interest in the Equipment. The Participation Agreement further provided that if B elects to exercise the Purchase Option on Date 4, Trust "shall execute and deliver to B appropriate instruments conveying Trust's right, title and interest in and to the Equipment to B or its designee." Even though title passed from B to Trust at the outset of the transaction, the facts also suggest the likelihood that B will exercise the Purchase Option to regain all right, title and interest to the Equipment on Date 4. Additionally, the purchase of the Equipment is part of B's modernization program giving B a business incentive to retain the Equipment. If B exercises the Purchase Option on Date 4, this feature indicates that title is only held temporarily by Trust in a form more akin to holding it as security. As such, the Sale-Leaseback Transaction looks more like a secured financing than a sale. See Rev. Rul. 72-543.




2. Whether the Parties Treated the Transaction as a Sale of Equipment


The Documents were prepared in the form of a sale. Moreover, A reported this transaction for federal income tax purposes as a sale and claimed United States tax ownership of the Equipment. A is deducting depreciation expenses for the Base Term and A treated the transaction on its books as an asset purchase. Pursuant to the Tax Indemnity Agreement, B agreed not to claim ownership of the Equipment for United States tax purposes which is consistent with treating the transaction as a sale. This factor appears to favor sale-leaseback treatment.




3. Whether A Acquired an Equity Interest in the Equipment


The Documents are drafted to indicate that A made a J percent equity contribution to the purchase of the Equipment. If "equity" is defined as the difference between the Equipment's fair market value and the amount of the Loan, 6 and assuming the sale price represents fair market value, then A has an equity interest equal to J percent of the Equipment. An owner's equity interest in property is distinguished from a mortgagee's security interest in property by the potential for appreciation or depreciation in the value of the property, the potential to profit from use of the property at the expiration of the lease term, and the nature of its risk of loss.



Here, A's funds are more in the nature of principal on a secured financing than an equity interest in the Equipment since, as a result of the nature of the three options held by B at the end of the Base Term, it appears that A has capped its right to potential appreciation in the Equipment at the difference between the Purchase Option price and the amount necessary to repay Lender. If the value of the Equipment at the end of the Base Term exceeds this differential, B, acting rationally in its economic interest, will exercise the Purchase Option and reacquired title to the Equipment. As discussed above, the Purchase Option is the most economically advantageous option for B to exercise. Acting rationally, B would exercise the Purchase Option regardless of whether the Equipment had appreciated or depreciated in value compared to the projected fair market value set forth in the appraisal. Given B's exercise of the Purchase Option, A is prevented from obtaining a profit from potential appreciation in the fair market value and A is protected from suffering a loss due to depreciation in fair market value. Accordingly, A's position is more in the nature of a secured mortgagee rather than as an equity owner. See Lazarus.




4. Whether the Sale Contract Obligated B to Execute and Deliver a Deed and Obligated A to Make Payments


B transferred to Trust all of B's right, title and interest in the Equipment. Additionally, according to the Documents, A must make semiannual payments to Lender on the Loan. However, pursuant to the Loan Agreement, those payments were to be paid to Lender by B in the form of B depositing its lease payments to Trust directly to Lender. Moreover, since the most economically realistic option for B to exercise on Date 4 is the Purchase Option, which will return title to the Equipment to B, it appears that the documents created a circular delivery of the deed. That is, it appears that A only has a "loan" of the deed or bill of sale during the Base Term, after which the title to the Equipment returns to B. Such circular delivery, or "loan," of the deed is more consistent with treating A as holding a security interest in the Equipment. See Lazarus.



This view is supported by the flow of funds concerning A, which is, with the exception of the first Lease payment, offset by the remaining Loan payments with rental income it receives from B. This point is further illustrated by the fact that pursuant to the Loan Agreement, B was to deposit its lease payments directly to Lender. In each instance, the amount of the rental income equals the amount of the Loan payment and the rent and loan payments are due and payable on the same date. If B exercises the Purchase Option, B is essentially "lending" title of the Equipment to Trust for A for the Base Term. In substance the deed transfer may only be temporary since it is more than reasonable to contemplate the return of the Equipment to B.




5. Whether the Purchaser Is Vested with the Right of Possession


The right of possession factor favors a financing since there is no indication that the parties ever manifested an intent for Trust or A to actually "possess" the Equipment. Generally a sale-leaseback contemplates that the buyer-lessor wants possession of the property at the end of the lease term. In a financing, however, the mortgagee typically does not want use or possession of the property. When A acquired the Equipment pursuant to the Documents, A, through Trust, had no right to sell the Equipment to anyone other than B or even hold it out for lease to the highest bidder prior to its leaseback to B. In fact, B already had possession of the Equipment at the time the transaction was entered into. All of Trust's activities thus were circumscribed so as to keep the Equipment under the possession and control of B at all times. B also controls whether A will possess the Equipment on Date 4 by unilaterally determining which option it will exercise. Arguably, such limitations on possession are inconsistent with the benefits and burdens of ownership. A does not have control to determine if it will ever obtain possession of the Equipment.



In addition, the Lease prevents Trust, acting for A, from taking possession of the Equipment unless necessary to protect its rights, as in the event of default. These conditions are essentially the same as the conditions in which a secured creditor would take possession of the secured property. See Rev. Rul. 72-543. However, while the Documents appear to make possession by A a possibility, this possibility is unlikely since B is most likely to exercise the Purchase Option on Date 4. Consequently, when this transaction is taken as a whole, A has not shown any intent to possess the Equipment. This factor favors financing treatment.




6. Whether the Purchaser Pays Property Taxes after the Transaction


B is responsible for all property taxes. Under the Participation Agreement, B is responsible for all applicable customs duties and stamp taxes and all other taxes in respect of the Equipment. However, this factor is neutral since this is common to net leases. See Torres, 88 T.C. at 721 [CCH Dec. 43,809].




7. Whether the Purchaser Bears the Risk of Economic Loss or Physical Damage


As discussed above, if the Equipment declines in value such that its fair market value on Date 4 is lower or higher than the fair market value projected in the Appraisal, then B, acting rationally, will still exercise the Purchase Option. This factor insulates A from suffering a loss due to depreciation in the market place. Rather, the loss would be suffered by B since B would reacquire its Equipment at a lesser value. Thus, B is the party that ultimately is affected by market decline.



The Lease requires B to maintain insurance on the Equipment and to replace or repair the Equipment in the event of damage or destruction. These requirements are typical in a net lease situation, nonetheless they do insulate A from obligations in the event of physical loss of the property. As noted above regarding the risk of loss of value of the Equipment, the Purchase Option price amount and the rental stream for any New Lease apparently were determined by reference to the amount necessary to repay the Loan and guarantee that A would receive a certain rate of return on the transaction. These provisions essentially insulate A from any risk of physical loss of the property. Further, these conditions essentially shift the risks to B. B's risk of loss is more like that of an owner/mortgagor, while A's fixed return and entitlement to payment without regard to damage to the collateral are consistent with the risks of a mortgagee. See, e.g., Helvering v. F. & R. Lazarus & Co.




8. Whether the Purchaser Receives the Profit from the Property's Operation


Courts have consistently found that the potential for profit or loss on the sale or release of the property is a crucial benefit or burden of owning property. Gefen v. Commissioner, 87 T. C. 1471, 1492 (1986) [CCH Dec. 43,600]. At all times after the transaction is initiated, B operates the Equipment and receives the profit, if any, therefrom. This is consistent with a lessee's right to operate property under a valid lease. In this case, however, as previously discussed, the amount B must pay under the Purchase Option, the Return Option, or the New Lease Option, results in either a ceiling on A's potential for profit or a floor under its potential for loss. For example, if the Equipment appreciates to a fair market greater than that projected by the Appraisal, B will exercise the Purchase Option. As such, A's potential profit from the Sale-Leaseback Transaction is capped at the difference between the Purchase Option price and the amount owed by Trust to Lender on Date 4. Since the Purchase Option price is preset as of the funding date, A is not able to profit from appreciation in fair market value. Rather, B, having exercised the Purchase Option, will be able to benefit from appreciation in the fair market value. This factor indicates that the transaction has the character of a financial arrangement.




B. Torres Factors



1. The Existence of a Useful Life of Property in Excess of the Leaseback Term


According to the Appraisal, the Equipment has a useful life of approximately W years, which exceeds the Base Term by V years. Even if the term of a New Lease is aggregated with the Lease to B, the combined lease term is U years, which is T years less than the Equipment's useful life. In accordance with the Lease, B will cause each piece of Equipment to be serviced, repaired, maintained, overhauled and tested during the term of the Lease, which should allow the Equipment to reach or exceed the estimated useful life. However, since B is expected to exercise the Purchase Option at the end of the Base Term, the additional useful life may not benefit A. Because control of whether to exercise the Purchase Option rests with B and because the Purchase Option is the most likely to be exercised by B, this factor does not strongly support sale-leaseback treatment.




2. The Existence of a Purchase Option at Fair Market Value


The Appraisal provides that the fair market value at the end of the Base Term is estimated to be I percent of the cost of the Equipment. Under the Lease, the Purchase Option Price is set at E percent of the cost of the Equipment. Thus, the Purchase Option price exceeds fair market value by a small amount. Nevertheless, because the appreciation potential of the Equipment is capped by this amount, this factor arguably favors treatment as a financing arrangement.




3. Renewal Rental at the End of the Leaseback Term Set at Fair Market Value


The rental schedules appear to have been determined by reference to the amount required to repay the loan and Equity Contribution and to guarantee A's return on investment. This coupled with the fact that B may have to pay an inducement in order to acquire a New Lessee, indicates that the renewal rent is not set at fair market value.



Moreover, assuming rental rates increase, under the Documents, Trust has the right to reject the New Lessee chosen by B and recover the Equipment. This feature would seem to indicate that Trust has some appreciation potential in that it can find its own lessee to rent the Equipment at a higher rental rate. However, if the Equipment appreciates in value, B could simply exercise the Purchase Option, recover title to the Equipment, and either use it, or release it at the higher rental rate reflected by the Equipment's then fair market value. This factor actually indicates that the risks of a decline, or the rewards of an increase, in the then fair market rental value of the Equipment have shifted to B. This shift is inconsistent with the risks and rewards to a lessor associated with the requirement that any renewal or release of property be set at fair market value. Therefore, this factor supports treatment of the transaction as a financing arrangement.




4. The Reasonable Possibility That the Purported Owner of the Property Can Recoup its Investment in the Property Based on its Income-Generating Potential and Residual Value of the Property


Under the structure of the transaction, A actually received very little net income stream during the Base Term since, except for the first Lease payment, all Lease payments made by B equal all Loan payments made by Trust for principal and interest. Consequently, since the rental stream essentially equals the debt service, there is very little income-generating gene rating potential to A during the Base Term. Accordingly, A can only look to either the payment received upon exercise of the Purchase Option or the Return Option, or to payments under an extension of the Lease under the New Lease Option, for the recoupment of, and a return on, its investment.



In the event the Purchase Option is exercised, A would only recover its investment out of the Purchase Option payment and thus its profit is capped at the difference between the Purchase Option option price and the amount owed to Lender on Date 4. If the New Lease Option were exercised, A would see a positive cash flow during the New Lease Term. Superficially, this factor favors the treatment of the transaction as a sale-leaseback since A would receive a profit on the New Lease. However, as the above analysis indicates, the terms of the transaction have shifted the risks and rewards of ownership essentially to B from Trust and A. Only if the transaction continues through the end of the New Lease term and the Equipment then returns to Trust, would A have an uncollared risk of loss and opportunity for appreciation. This will likely never occur because it is economically more advantageous for B to exercise the Purchase Option. Therefore, although A will recoup its investment, the specified rate of return and collared risk and reward indicate that it is in the position of a mortgagee, not a bona fide owner.



Since the above factors indicate that A stands more in the position of a mortgagee than a bona fide owner, the benefits and burdens of ownership did not pass to A as a result of this transaction. Accordingly, the transaction should be treated as a financing rather than as a sale-leaseback. As such, A is not treated as the owner of the Equipment and therefore is not entitled to the depreciation deductions A claimed on the Equipment.



III. Whether A Received Oriqinal Original Issue Discount Income as a Result of this Purported Sale-Leaseback Transaction.



If (1) the Sale-Leaseback transaction lacks economic substance and (2) the purchase price option will be exercised, A may be required to accrue income on a deemed loan from A to Lender. Section 1273(a)(1) provides "[t]he term 'original issue discount' means the excess (if any) of (A) the stated redemption price at maturity, over (B) the issue price." To impute OlD income in a sale-leaseback transaction, there must be an unconditional obligation to return the principal sum. A "substantial likelihood" is not enough to characterize the Purchase Option as an unconditional obligation. Original issue discount (OID) is imputed on a constant yield basis. See section 1.1272-1(b).



Indebtedness is defined, for federal income tax purposes, as an unconditional obligation to pay a sum certain at a fixed maturity date. Gilbert v. Commissioner, 248 F.2d 399, 402 (2\nd/ Cir. 1957) [ 57-2 USTC ¶9929]. If we successfully argue that the purchase price will always be exercised, A's equity payment might be appropriately viewed as a loan with the unconditional obligation to repay a principal sum being both the net rent payment due on Date 3 and the net Purchase Option payment due on Date 4. It is represented that the net rent payment and the net Purchase Option payment constitute the return on A's equity investment. The amount by which the net rent payment and the net Purchase Option payment exceed the equity payment could be asserted to be OlD includable in A's income. If we are unable to prove that A will receive a fixed amount of cash at the end of the transaction, we will not be able to deem a loan between A and Lender.



Thus, we should also be able to argue that A's equity payment is a loan if we demonstrate that either the Purchase Option or the Return Option will be exercised. Whether the Purchase Option or the Return Option is exercised, A will be receiving an amount that exceeds its equity payment. The OlD calculation is slightly more complicated if we deem the equity payment a loan with repayment being either the amount of the Purchase Option (and net rent payment) or the Return Option (and net rent payment). As a loan with alternative payment schedules, the rules of section 1.1272-1(c) of the Income Tax Regulations would apply to determine the amount of OlD includable in A's income.



A accrues interest based on the ownership of the Treasury strips only if it can be shown that A has control over and derives readily realizable economic value from the Treasury strips. See James v. United States, 366 U.S. 213, 219 (1961) [ 61-1 USTC ¶9449]. The issue price of the strips is the amount at which the Treasury strips were issued. As owner of the Treasury Strips, A would include in income the OlD on the Treasury strips.



If the Sale-Leaseback transaction is viewed as a financing between A and Lender, we believe that A should properly include OlD income from the deemed financing. The amount of OlD income from the deemed financing would be calculated in the same manner as described above under the economic substance argument.



IV Whether A Is Liable for Penalties, Pursuant to Section 6662 as a Result of this Transaction.



Section 6662 imposes an accuracy-related penalty equal to twenty percent of the portion of the underpayment attributable to, among other things, negligence or disregard of rules or regulations, and any substantial understatement of income tax. Section 1.6662-2(c) provides that there is no stacking of the accuracy-related penalty components and, thus, the maximum accuracy-related penalty imposed on any portion of an underpayment is twenty percent. The accuracy-related penalty does not apply to any portion of an underpayment with respect to which it is shown that there was reasonable cause and that A acted in good faith. Section 6664(c)(1).




A. Negligence


Pursuant to section 6662(c) and section 1.6662-3(b)(1) of the Income Tax Regulations, negligence includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code or to exercise ordinary and reasonable care in the preparation of the tax return. Negligence has been defined as the failure to do what a reasonable and ordinary prudent person would do under the circumstances. Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967) [ 67-2 USTC ¶9516]; Neely v. Commissioner, 85 T.C. 934, 947 (1985) [CCH Dec. 42,540]. Section 1.6662-3(b)(1)(ii) provides that negligence is strongly indicated where a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit, or exclusion on a return that would seem to a reasonable person to be "too good to be true" under the circumstances. Where the taxpayer is sophisticated, the court may still find liable even though highly paid professionals were involved. In Nicole Rose v. Commissioner, 117 T.C. No. 27, 2001 [CCH Dec. 54,578] TNT 251-11 ¶64, the Tax Court found the taxpayer was liable for an accuracy related penalty pursuant to section 6662 for entering into a series of transactions lacking in business purpose and economic substance and stating that "[t]he participation of highly paid professionals provides petitioner no protection, excuse, justification, or immunity from the penalties in issue. Petitioner participated in a clear and obvious scheme to reap the benefits of claimed ordinary business expense deductions that had no business purpose and no economic substance. The facts and circumstance of this case reflect no reasonable cause and no good faith for petitioner's participation in the transactions before us."



The Tax Court likewise sustained the application of the negligence penalty in Sheldon v. Commissioner, 94 T.C. 738 (1990) [CCH Dec. 46,602], stating that the taxpayer intentionally entered into loss-producing repurchase agreements to generate and claim tax benefits.




B. Substantial Understatement


Pursuant to section 6662(d)(1), a substantial understatement of income tax exists for a taxable year if the amount of the understatement exceeds the greater of ten percent of the tax required to be shown on the return or $5,000 ($10,0000 in the case of corporations other than S corporations or personal holding companies). Section 6662(d)(2)(B) provides that understatements are generally reduced by the portion of the understatement attributable to: 1) the tax treatment of items for which there was substantial authority for such treatment, and 2) any item if the relevant facts affecting the item's tax treatment were adequately disclosed in the return or a statement attached to the return, and there is a reasonable basis for the taxpayer's tax treatment of the item. These exceptions, however, do not apply to tax shelter items of corporate taxpayers. Section 6662(d)(2)(C)(ii). Thus, if a corporate taxpayer has a substantial understatement attributable to a tax shelter item, the accuracy-related penalty applies to the understatement unless the reasonable cause exception applies. Treas. Reg. §1.6664-4(e), discussed below contains special rules relating to the definition of reasonable cause in the case of a tax shelter item of a corporation. However, section 6662(d)(2)(C)(iii) which is applicable to the years at issue, defines a tax shelter, among other things, as a plan or arrangement the principal purpose of which is tax avoidance or evasion.




C. Reasonable Cause


Section 1.6664-4(b)(1) provides that the determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, generally taking into account all pertinent facts and circumstances. The most important factor is generally the extent of the taxpayer's effort to assess its proper tax liability. Reliance on professional advice may constitute reasonable cause and good faith if, under all the circumstances, such reliance was reasonable. See United States v. Boyle, 469 U.S. 241 (1985) [ 85-1 USTC ¶13,602]. The advice must also be based upon all pertinent facts and circumstances and the law relating to those facts and circumstances. For example, the advice must take into account the taxpayer's purpose and the relative weight of such purpose for entering into a transaction and for structuring a transaction in a particular manner.



With respect to reasonable cause for the substantial understatement penalty attributable to a corporation's tax shelter items, a corporation is deemed to have acted with reasonable cause and in good faith if the corporation had substantial authority, as that term is defined in section 1.6662-4(d), for its treatment of the tax shelter item, and if at the time of filing the return, the corporation reasonably believed such treatment was more likely than not the proper treatment. Treas. Reg. §1.6664-4(e)(2)(I).



The "more likely than not" standard can be met by the corporation's good faith and reasonable reliance upon the opinion of a tax advisor if the opinion is based on the advisor's analysis of the pertinent facts and authorities in the manner described in Section 1.6662-4(d)(3)(ii), and the opinion unambiguously states the advisor's conclusion that there is a greater than fifty percent likelihood the tax treatment of the item will withstand a challenge by the Service. Section 1.6664-4(e)(2)(I)(B)(2). A cannot hide behind an appraisal for a transaction lacking in economic substance and claim that it had reasonable cause for entering into the transaction. Nicole Rose.



The circular cash flows and the lack of a valid business purpose evidence that A's involvement in the sale-leaseback transaction was solely due or primarily motivated by the tax benefits, and thus is totally devoid of economic substance. Moreover, if the transaction lacked economic substance and/or A did not truly acquire the benefits and burdens of ownership of the Equipment, then A cannot, in good faith, claim depreciation and interest deductions flowing from the transaction. Therefore, based on the facts presented, assertion of the section 6662 accuracy-related penalty is appropriate in this case.



CASE DEVELOPMENTS, HAZARDS AND OTHER CONSIDERATIONS



In our view, there are several aspects of this case which must be further developed.



First, to support the view that B is compelled to exercise its Purchase Option to acquire the Equipment upon termination of the Basic Lease term, the Field must develop firm evidence that B has effected either a legal or economic defeasance of its obligations. Although it is possible to hypothesize that B purchased stripped bonds in order to meet any of the three options provided for at the end of the Lease, the term, "defeasance" is used as if it were a fact. In a true defeasance situation the lessee is either required by the documents (or informal agreement by the parties) to deposit into an escrow account an amount (in absolute terms or net present value terms) (economic defeasance), or it gives legal notice at the initiation of the lease (or shortly thereafter) of its intent to exercise its Purchase Option at the end of the lease term and reacquire the property (legal defeasance). We did not find either in the facts provided. Accordingly, to make this argument, the Field needs to develop facts that demonstrate a true defeasance.



In light of the hazards with the New Lease Option, we recommend that you develop additional facts to show that the New Lease Option is truly illusory. Such facts would include those that demonstrate that the Equipment is "limited use" property. See Rev. Proc. 2001-28, 19 I.R.B. 1156 (May 7, 2001). That is, if the facts developed show that the Equipment has little value to operators other than those in Country C, the ownership rights claimed by Trust become easier to challenge because its ability to release the Equipment to any lessee or operator other than B or to operate the Equipment itself would be severely limited. Development of such facts may require outside engineers and other experts. If such facts demonstrate that no one but B may have any commercially reasonable use for the Equipment, then exercise of the New Lease Option would be impracticable.



In addition, the Field should verify, that if Country C privatizes the B's business and restricts B's ability to own or acquire the Equipment, the only viable option for B may be the New Lease Option. Also, helpful facts include those that would demonstrate that it is highly unlikely that Country C will decide to acquire even more modern Equipment at the end of the Base Term.



Examination of any presentations to the Trust concerning this transaction may provide insight into whether its participation is primarily tax motivated. It is also recommended that the Field investigate any prearrangement aspects of the transaction. Persuasive evidence of prearrangement includes any additional evidence that the parties understood that B would exercise the Purchase Option.



Moreover, we note that this transaction is dissimilar to the lease-in, lease-out transaction described in Rev. Rul. 99-14, 1999-1 C.B. 835. In that revenue ruling, the taxpayer retained the power to require the lessee to continue with the lease of the property for an additional period of time by virtue of a put renewal option in the agreements. In this case, however, the facts as presently developed indicate that B, not A, has the sole power to determine which option will be exercised at the end of the Base Term. Thus, this feature of the transaction makes it important to develop facts which will demonstrate that the New Lease is not a viable option for B and, therefore, the transaction has little probability of continuing beyond the Base Term. Consequently, such facts will indicate if the return of the Equipment to B at that time is a foregone conclusion.



We recommend that you carefully scrutinize the pretax return and determine if it is insubstantial when compared to the post-tax returns. This analysis should be made using both constant dollars and relevant present value assumptions. The Field should compare its facts to those in other economic substance cases or in Rev. Rul. 99-14, in which the taxpayer's profit pretax in constant dollars was insignificant compared to the amount invested. In furtherance of this strategy, case development should include the employment of independent appraisers, economists and financial consultants, whose analyses could affect the results of these calculations.



With respect to the OlD issue, a "substantial likelihood" is not enough to characterize the net Purchase Option as an unconditional obligation, and thus is a high hazard in this case.



If, upon further development, the facts do not indicate that the transactions lack economic substance or constitute a financing arrangement, we recommend you contact CC:ITA to develop whether A's depreciation deductions are based on a lease term that includes the period of the New Lease. In that case, the tax-exempt use property rules could apply to limit the availability of the deductions. I.R.C. Section 168(g)(3)(A) and Treas. Reg. Section 1.168(i) -2. We encourage you to raise this argument as early as possible in order to preserve it in case the transaction is determined to neither lack economic substance nor constitute a financing. 7



This writing may contain privileged information. Any unauthorized disclosure of this writing may have an adverse effect on privileges, such as the attorney client privilege. If disclosure becomes necessary, please contact this office for our views.



Please call if you have any further questions.



William P. O'Shea, Acting Associate Chief Counsel, Passthroughs and Special Industries, Carolyn H. Gray, Senior Legal Counsel, Branch 2, Office of the Associate Chief Counsel, Passthroughs and Special Industries.


1 A entered into a trust agreement with Trust on Date I authorizing Trust to execute all documents and rights and perform all of A's duties with respect to this transaction.

2 These agreements will be collectively referred to as the "Documents."

3 The Loan Estate consists of the following:

Trust's rights and interests in the Equipment, the documents involved in the sale-leaseback transaction, all amounts of rent due under the Lease, any moneys arising out of the documents that are required to be deposited on Trust's account and any other property or rights of Trust arising out of the documents involved in the sale-leaseback transaction.

4 The Lump Sum Payment is equal to the Appraisal's projected Fair Market Value of the Equipment over F percent of the Equipment Cost, where the Equipment Cost equals Equipment Cost. The Appraisal projects that the Fair Market Value of the Equipment on Date 4 will be I percent of Equipment Cost. I percent of the Equipment Cost equals $6. The Lump Sum Payment is equal to H percent of Equipment Cost which equals $5.

5 F percent of the Equipment Cost is $7.

6 Crane v. Commissioner, 331 U.S. 1, 7 (1947) [ 47-1 USTC ¶9217].

7 The enactment of the extended lease period in section 168 was not designed to supplant the traditional arguments challenging sale-leaseback transactions. The Conference Committee Report of the Deficit Reduction Act of 1984 provides "the primary objective of the conferees is that there be no relaxation of administrative rules and practices that would result in lease treatment for financing transactions in which the purported lessor does not have a significant ownership interest in the property." H.R. Rep. No. 98-861, 98th Congress, 2nd Sess. at 772.


Assuming the 6694 penalty is an issue in the following Rosenblatt case decided yesterday, the conclusion is reached that a tax motivated transaction will not automatically result in a taxpayer negligence penalty under 6662. However, the 6694 penalty would still be applied under the position taken without technical support. My view is that if 6694 would have been an issue in the following case, the 6694 penalty would be applied. There are two standards: 1) return preparer negligence or lack of technical support and 2) client negligence. Sometimes the two issues are interrelated. The Rosenblatt case is a client negligence case. However, the case suggsest that if the 6694 penalty were an issue in the case, the fact that the client was tax motivated would not necessarily impact on the 6694 analysis. I would still expect that tax return preparers have a duty to penetrate these transactions. The standards of the proposed regulations are quite simple: the return preparer can either provide support for the position (whether or not disclosed) or not have analysis and technical support. I do not think there would be technical support under the facts of Rosenblatt.

Ronald and Susan Rosenblatt v. Commissioner.Docket No. 17002-06S .

Filed October 30, 2008.





Respondent determined deficiencies in petitioners' Federal income taxes of $33,583 and $20,684 and section 6662 accuracy-related penalties of $6,716.60 and $4,136.80 for the taxable years 2002 and 2003, respectively. The issues for decision are: 2 (1) Whether petitioners' aircraft activity during 2002 and 2003 was engaged in for profit within the meaning of section 183; (2) whether petitioners are entitled to deductions for worthless stock and bad debts incurred in 2002; and (3) whether petitioners are liable for section 6662 accuracy-related penalties for 2002 and 2003. 3





Background



Some facts have been stipulated and are so found. The stipulation of facts and the attached exhibits are incorporated by this reference. At the time of filing the petition, petitioners resided in Iowa.



Ronald Rosenblatt (petitioner) is a graduate of Columbia University with a bachelor's degree in art history, a minor in economics, and a master's of art. Petitioner also holds a Ph.D. in economics from the University of Idaho. Petitioner worked as a professor and taught economics for 7 years after he received his Ph.D.



In 2002, petitioner was employed by Principal Residential Mortgage, Inc. (PRM), a subsidiary of Principal Financial Group. Petitioner directly managed six or seven people. Indirectly, he managed approximately 500 people. Petitioner worked approximately 50 hours per week in 2002, and he spent most of his work week in the offices of PRM in downtown Des Moines. Most of petitioner's income in 2002 came from his position at PRM.



Between 2002 and 2003, PRM sold the division that petitioner managed to American Home Mortgage (AHM). In 2003, petitioner was employed by AHM as an executive vice president of sales support and development. Petitioner's work hours and responsibilities did not change very much between 2002 and 2003. Petitioner Susan Rosenblatt (Mrs. Rosenblatt) is an anchor reporter for the local FOX news network in Des Moines, Iowa. Petitioners reported wages on their Federal income tax returns in excess of $593,000 for 2002 and $742,000 for 2003.



Petitioner always had an interest in flying. Petitioner had been interested in being a pilot since his youth. In 1965, when petitioner graduated from high school, he had an appointment to the Air Force Academy, and he intended to become an Air Force pilot. However, petitioner did not attend the Air Force Academy because his eyesight did not meet the requirements for him to train as a pilot.



Petitioners' daughter Katie received flight instruction from Executive One Aviation (EOA), beginning in 2001. In the fall of 2001, petitioner also began taking flight training lessons from EOA. On June 6, 2002, petitioner formed KAR RRR Aviation Leasing, LLC (KAR RRR). Mrs. Rosenblatt purchased a one-half interest in KAR RRR on September 30, 2002. Before Mrs. Rosenblatt became a member of KAR RRR, petitioner was the sole member, and they were the only two members thereafter. 4 Aside from petitioners, KAR RRR had no employees.



In June 2002, KAR RRR purchased a Cessna 172 R (N3529D) aircraft (Cessna) from EOA. Petitioner has never been a licensed pilot. Before the Cessna was purchased, petitioner had no experience in the aviation industry other than being a "frequent flyer". Petitioner described his decision to purchase the Cessna "as a way of having a good new plane upon which to learn, and as a way of starting a new business with the plane."



KAR RRR financed the Cessna with Cessna Finance Corp. (CFC). Petitioners paid 10 percent of the purchase price for the Cessna as a down payment, and KAR RRR financed $144,350, the balance of the purchase price for the Cessna, through CFC. Petitioner personally guaranteed the loan from CFC to KAR RRR. The Cessna was hangared at Ankeny Regional Airport in Ankeny, Iowa.



On May 6, 2002, before petitioner purchased the Cessna, EOA provided a written projection of net income to petitioners related to a purchase and leaseback of a Cessna. EOA projected that if the Cessna was rented out for 700 hours per year at $95 per Hobbs hour, 5 it could potentially generate $66,500 in gross receipts. 6 After subtracting expenses for insurance, hangar, fuel, maintenance, engine reserve, and management fees totaling $44,725, EOA projected a net income of $21,775 on a leaseback by EOA of the Cessna. Petitioner did not produce any other formal business plan for KAR RRR. 7



EOA's projection did not include finance expenses, commissions, legal and professional services expenses, or depreciation. Reported expenses for petitioners' 2002 and 2003 aircraft activity were as follows:



2002 Expenses





Deductions Schedule C Schedule E Total

Repairs and maintenance $1,210 $2,146 $3,356

Interest 1,777 1,777 3,554

Depreciation (and
sec. 179) 73,447 5,924 79,371

Commissions (and fees) 1,595 1,160 2,755

Fuel 3,513 2,385 5,898

Hangar 375 375 750

Insurance 2,495 2,709 5,204

Miscellaneous -- 39 39

Legal and professional
services 3,100 -- 3,100

Management fees 2,087 -- 2,087

Total 89,599 16,515 106,114





2003 Expenses





Deductions Schedule E

Repairs and maintenance $8,739

Interest 5,942

Depreciation (and
sec. 179) 35,882

Commissions (and fees) 4,282

Fuel 6,203

Hangar 1,500

Insurance 10,762

Miscellaneous 906

Legal and professional
services 1,500

Instruction 591

Total 76,307





On June 14, 2002, KAR RRR, CFC, and EOA entered into a "Consent to Lease Agreement" (lease agreement), related to the Cessna. CFC required the lease agreement as a condition precedent to obtaining financing on the Cessna because the Cessna would be rented out to the general public. Under the lease agreement, KAR RRR was designated the "Lessor" and EOA was designated the "Lessee". The lease agreement stated in pertinent part: "Neither Lessor [KAR RRR] nor Lessee [EOA] shall further lease the * * * [Cessna] or assign the Lease without first obtaining the prior written consent of CFC, which consent may be withheld at the sole discretion of CFC."



KAR RRR and EOA also entered into an "Aircraft Marketing Agreement" (marketing agreement), drafted by Advocate Consulting, which stated as follows:



AIRCRAFT MARKETING AGREEMENT



This agreement, made on this 14th day of June, 2002 by and between KAR RRR Aviation Leasing, LLC., hereinafter referred to as the Owner, and * * * [EOA], hereinafter referred to as the Agent.



WITNESSETH



WHEREAS, Owner is the owner of one (1) Cessna 172R, Registration Number N3529D;



WHEREAS, Agent in the ordinary course of business develops relationships with prospective customers for owner seeking to rent aircraft;



WHEREAS, Agent is willing to serve as marketing and compliance agent on a non-exclusive basis upon the terms and conditions herein set forth.



NOW, THEREFORE, in consideration of the mutual covenants and agreements herein contained, the parties hereto do hereby agree as follows;



1) Aircraft: Owner hereby authorizes Agent to serve as a nonexclusive marketer for the aircraft outlined on Exhibit A.



2) Terms of Agreement: The term of this agreement shall be for a period of seven (7) days commencing on the date hereof, and automatically renew each seven (7) days thereafter. This agreement shall be subject to termination by either the Owner or Agent for any reason whatsoever upon five (5) days advance written notice given to the other party.



3) The aircraft will be based at the Ankeny Airport, and the owner will assume all responsibility for storage fees in the amount of $125.- per month for heated, community hangar space.



4) Owner has had the aircraft inspected by * * * [EOA], verifying that the aircraft meets the standards required by the Federal Aviation Regulations and that a valid Airworthiness Certificate exists in respect thereto, and that all other requirements and paperwork are in good order and effect.



5) The fees payable by Owner to Agent for the rental of said aircraft shall be calculated at the rate of 15% of the gross Hobbs rental charge. At the start of this agreement, said hourly rate shall be $90.00, and may be adjusted with approval of both parties. The rent shall be paid within ten days after the end of each calendar month, based upon the hours rented during each prior month. Agent agrees to waive charges for the use of the aircraft by Owner. Owner agrees to follow scheduling procedures established by Agent for the reservations of aircraft and to return aircraft with full fuel to the Agent.



6) Owner shall maintain the aircraft to satisfactorily retain its airworthiness certificate thereby meeting the requirements of the Federal Aviation Administration.



7) Owner shall furnish at their own expense all fuel, oil, lubricants and other materials necessary for the operation of said aircraft. Fuel shall be priced by Agent to Owner at the leaseback rate of twenty (20) cents below the then current retail rate. In addition all shop labor shall be priced at $5 per hour below current list and parts shall be charged at 15% above cost, plus freight or other added charges. All required & routine maintenance may be performed by the * * * [EOA] maintenance facility without prior notice to Owner.



8) Renters shall be required at a minimum to have 12 hours total time plus a sign-off from an FAA Approved Current Flight Instructor in order to solo this aircraft. Other than for maintenance down time, this aircraft shall be available for scheduled rent at all times.



9) Owner shall provide and keep insurance in full force and effect, at their own expense. Such insurance shall be written by an underwriter satisfactory to all parties and naming the Owner, Agent and Current Lienholder as insured, and shall protect the interests of the Owner, Agent and Current Lienholder. If the risk is covered by the insurance policy of the Agent, the Owner shall prepay Agent the amount of such insurance at the first of each calendar month and Agent shall provide Owner evidence of such Insurance coverage in force and satisfactory to the Owner and Current Lien holder. Agent shall be responsible for deductible if the aircraft is damaged while hangared at * * * [EOA], if such damage is caused by an * * * [EOA] employee or by a customer renting the aircraft through * * * [EOA].



10) The term of this agreement shall be 5 years, commencing on the below mentioned execution date. Owner may terminate this agreement for any reason upon thirty (30) days written notice to Agent.



Petitioner provided documents (logs) indicating his involvement with KAR RRR during 2002 and 2003. These logs show that petitioner spent approximately 197.05 8 and 208.25 hours on KAR RRR activities in 2002 and 2003, respectively. 9 Petitioner prepared these logs himself, though he admits they are incomplete. Much of the time reflected in petitioner's logs represents time during which he participated in flight instruction, ground school, and test flights.



Petitioners relied on the services of EOA for taking reservations for the Cessna, providing storage for the Cessna, and providing licensed flight instructors to fly the Cessna. The customers who rented the Cessna did not enter into written lease agreements, but they did sign a document ensuring that the people who flew the Cessna were licensed pilots. These agreements were maintained by EOA. The people who flew the Cessna included both flight instruction students and private pilots. KAR RRR's Cessna was one of three or four aircraft available to rent at the Ankeny Regional Airport in 2002 and 2003.



Benefit Technologies, Inc. (BTI), is a research and development business specializing in full flexible benefit plans for small to midsize companies. Andrew Hyman (Mr. Hyman) was the founder of BTI and is still actively involved with BTI. BTI filed for chapter 7 bankruptcy protection in February 2001, shortly after BTI defaulted on a $250,000 interest payment to a venture capital firm on January 15, 2001. Sometime after filing for bankruptcy, BTI's bankruptcy proceedings were converted from chapter 7 to chapter 11.



Petitioner owned BTI stock, lent money to BTI, and served on BTI's board of directors, but petitioner was not an employee of BTI. Petitioner was never actively involved in BTI, other than having attended occasional board meetings. Petitioners claimed losses of $432,346 in 2002 relating to the alleged worthlessness of their BTI stock and loans that petitioner made to BTI.





Discussion



Generally, the Commissioner's determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving that the determinations are incorrect. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).




I. Claimed Losses From Aircraft Activity


Pursuant to section 183(b), deductions with respect to an activity "not engaged in for profit" generally are limited to the amount of gross income derived from such activity. Section 183(c) defines an activity not engaged in for profit as "any activity other than one with respect to which deductions are allowable for the taxable year under section 162 or under paragraph (1) or (2) of section 212."



Deductions are allowed under section 162 for the ordinary and necessary expenses of carrying on an activity which constitutes the taxpayer's trade or business. Deductions are allowed under section 212 for expenses paid or incurred in connection with an activity engaged in for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income. With respect to either section, however, the taxpayer must demonstrate a profit objective for the activities in order to deduct associated expenses. Dreicer v. Commissioner, 78 T.C. 642, 644-645 (1982), affd. without published opinion 702 F.2d 1205 (D.C. Cir. 1983); Warden v. Commissioner, T.C. Memo. 1995-176, affd. without published opinion 111 F.3d 139 (9th Cir. 1997); sec. 1.183-2(a), Income Tax Regs. In order to meet the required profit objective, "the taxpayer's primary purpose for engaging in the activity must be for income or profit." Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987); Bot v. Commissioner, 353 F.3d 595, 599 (8th Cir. 2003), affg. 118 T.C. 138 (2002); Am. Acad. of Family Physicians v. United States, 91 F.3d 1155, 1157-1158 (8th Cir. 1996).



Section 1.183-2(b), Income Tax Regs., provides factors to be considered when determining whether an activity is engaged in for profit as follows:



(b). Relevant factors. --In determining whether an activity is engaged in for profit, all facts and circumstances with respect to the activity are to be taken into account. No one factor is determinative in making this determination. In addition, it is not intended that only the factors described in this paragraph are to be taken into account in making the determination, or that a determination is to be made on the basis that the number of factors (whether or not listed in this paragraph) indicating a lack of profit objective exceeds the number of factors indicating a profit objective, or vice versa. * * *



Nine nonexclusive factors are set forth in the regulations which are to be considered when determining profit intent. Those factors are: (1) The manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation exist. Id. Not all of the factors are applicable in every case, and no one factor is controlling. See Abramson v. Commissioner, 86 T.C. 360, 371 (1986); sec. 1.183-2(b), Income Tax Regs. We begin by applying each of these factors to the facts relating to petitioners' aircraft activity.



The fact that a taxpayer carries on an activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity was engaged in for profit. See Engdahl v. Commissioner, 72 T.C. 659, 666 (1979); sec. 1.183-2(b)(1), Income Tax Regs. During the years at issue, petitioner kept logs noting his involvement with KAR RRR, but he admitted that those logs were incomplete. The logs were not made contemporaneously with the activities petitioner noted therein. Much of the time memorialized in the logs is attributable to travel time and time that petitioner spent on his own flight training activities and classes.



Petitioner failed to develop a formal business plan. Although petitioner testified that he used a "pro forma", it was not produced at trial. EOA's financial projections overestimated the profitability of renting the Cessna, and the projected expenses did not include finance expenses, sales tax, or registration fees and did not take into account actual depreciation of the Cessna.



Petitioner testified that he was active in advertising the Cessna throughout the community, but he failed to adequately corroborate that testimony with evidence of such marketing activities. Petitioner also did bookkeeping for KAR RRR, including the establishment and maintenance of the company bank account. However, petitioners relied on the services of EOA for the day-to-day rental of the Cessna, including taking reservations for the Cessna, providing storage for the Cessna, and providing licensed flight instructors to fly the Cessna. Moreover, the maintenance, rental of the aircraft, and collection of rental receipts were performed by either EOA or the flight instructors associated with the rental flights. Petitioner explained at trial that student pilots and renters would pay EOA directly for the use of the Cessna at the end of the rental period. EOA would then credit the account of KAR RRR for the fee generated. At the end of the month, EOA would deduct their commission and other expenses, such as fuel and maintenance. Petitioner was not qualified to perform the maintenance on the Cessna necessary to keep it airworthy. Petitioner reviewed some of these activities but did not perform them himself and otherwise had limited involvement in the day-to-day activities involving the Cessna. Consequently, consideration of the first factor weighs against the finding of a profit objective.



A taxpayer's expertise or that of his advisers is a factor in determining profitability. Sec. 1.183-2(b)(2), Income Tax Regs. Before his purchase of the Cessna, petitioner had no relevant experience in the aircraft industry. Petitioner spent time "going on the FAA's website" to understand what rules and regulations governed private aviation. He also researched Cessna's advisories about his type of aircraft to determine "whether there were recalls or anything like that."



Petitioner sought advice in selecting the appropriate aircraft for the activity, relying in part on the knowledge of local flight instructors. Otherwise, petitioner relied on EOA, the seller of the Cessna, and Advocate Consulting. Before the purchase of the Cessna, petitioner was informed by EOA's president that the Cessna could be rapidly depreciated for tax purposes. At the same time, employees of EOA informed petitioner that Advocate Consulting could structure the purchase of the Cessna in a tax-advantageous manner. Petitioner's independent research on Advocate Consulting entailed going online and trying "to get a little background on the * * * company." Petitioner did not know anyone else who was referred to Advocate Consulting. Petitioner testified that Advocate Consulting agreed to represent petitioners before the IRS as part of their agreement with KAR RRR.



Petitioners retained the services of Advocate Consulting on a yearly basis. Petitioners sought the advice of Advocate Consulting because aircraft leasing "was a field that * * * [petitioner] really didn't know in terms of legal or tax issues." When asked at trial if he ever thought that the tax advice he received was too good to be true, petitioner responded that if he's "paying for their advice and their counsel tells me that this is the way it is, then * * * I believe them."



As we have already noted, EOA provided a written projection of net income that did not include finance expenses, commissions, legal and professional services expenses, or tax depreciation expenses related to the Cessna. Given petitioner's educational background in economics and his discussions with employees of EOA and Advocate Consulting about structuring the purchase of the Cessna in a tax-advantageous manner, it is reasonable to assume that petitioner recognized the significant distortions these omissions would create between the projected profits and the profits or losses from the aircraft activity that petitioners would report on their tax returns. In preparing for an activity, a taxpayer need not make a formal market study, but might be expected to undertake a basic investigation of the factors that would affect profit. Westbrook v. Commissioner, T.C. Memo. 1993-634, affd. 68 F.3d 868 (5th Cir. 1995). Yet petitioner failed to seek an objective opinion about the profit potential of such an undertaking and relied heavily on parties with their own subjective interest in the transaction. Under the circumstances, petitioner's independent research of profitability of the aircraft activity was insufficient. Consequently, the second factor weighs against a finding of a profit objective.



The fact that a taxpayer devotes much of his personal time and effort to carrying on an activity, particularly if there are no substantial personal or recreational elements, may indicate a profit motive. Sec. 1.183-2(b)(3), Income Tax Regs. Much of the time that petitioner spent on the aircraft activity involved his own flying lessons. Petitioner and his daughter had decided to learn how to fly, and petitioner purchased the Cessna as a way to do that. Petitioner had long wanted to learn to fly airplanes, having attempted to join the Air Force when he was younger. Petitioner created logs documenting his activities related to the Cessna. The logs, though incomplete, indicate that petitioner spent approximately 197.05 and 208.25 hours on KAR RRR activities in 2002 and 2003, respectively. Much of that time represents petitioner's own flying instruction. While the logs petitioner kept indicate some activity that could be construed as business related, it could also be construed as a genuine interest in a recreational activity. Regardless, the relatively small amount of time spent on this activity that was substantiated in the record does not outweigh the evidence indicating that petitioner had a significant interest in the recreational elements of the activity. Consequently, the third factor does not support a finding of a profit objective.



An expectation that the assets used in the activity will appreciate in value might indicate a profit objective. Sec. 1.183-2(b)(4), Income Tax Regs. It is unlikely that petitioner expected the Cessna, the only asset owned by KAR RRR, to appreciate in value. Additionally, absent extenuating circumstances, none of which were established in this case, the regular wear and tear on a Cessna would likely cause economic depreciation. Accordingly, the fourth factor weighs against finding a profit objective.



The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable. Sec. 1.183-2(b)(5), Income Tax Regs. Petitioner had no previous experience in the aircraft industry, and provided no evidence that he had engaged in any similar activities for profit. Consequently, the fifth factor is neutral.



A series of losses during the initial or startup stage of an activity may not necessarily be an indication that the activity is not engaged in for profit. Sec. 1.183-2(b)(6), Income Tax Regs. However, where losses continue to be sustained beyond the period that customarily is necessary to bring the operation to profitable status, such continued losses, if not explainable as due to customary business risks or reverses, may be indicative that the activity is not being engaged in for profit. Id. Ultimately, a taxpayer must demonstrate an ability to make a profit in the long term to offset any startup losses. See Bessenyey v. Commissioner, 45 T.C. 261 (1965), affd. 379 F.2d 252 (2d Cir. 1967).



There was no prior history of either profits or losses from petitioner's aircraft activity because the years at issue were the first 2 years in which petitioner's aircraft activity existed. In neither 2002 nor 2003 did the aircraft activity generate a profit. 10 Petitioner testified and submitted evidence indicating that in the years following the years at issue, several flight instructors who had used petitioner's Cessna to give lessons decided to start their own flight instruction business using petitioner's Cessna at Des Moines International Airport. Petitioner explained that he became very involved in the marketing and organization of this new business and had plans to merge his aircraft activity with the flight instructors' business. However, petitioner failed to submit evidence regarding the profitability of the aircraft activity in the years after 2003. Without any proof of profitability in later years, the sixth factor is neutral.



The amount of occasional profits earned in relation to the amount of losses incurred may provide useful criteria in determining the taxpayer's intent. Sec. 1.183-2(b)(7), Income Tax Regs. As we have established, there is no history of the aircraft activity's being profitable. Consequently, the seventh factor is neutral.



Substantial income from sources other than the activity may indicate that the activity is not engaged in for profit, especially if there are personal or recreational elements involved. Sec. 1.183-2(b)(8), Income Tax Regs. Petitioner worked approximately 50 hours per week in 2002, and he spent most of his work week in the offices of PRM in downtown Des Moines. Most of petitioner's income came from his position at PRM. Petitioner's hours and responsibilities did not change very much between 2002 and 2003. Petitioners reported salaries in excess of $593,000 in 2002 and $742,000 in 2003. The losses created by the aircraft activity, if found to be deductible, would offset some of petitioners' substantial salaries and generate a significant tax savings in the years at issue. Consequently, the eighth factor weighs against a profit objective.



Finally, the presence of personal motives in carrying on an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved. Sec. 1.183-2(b)(9), Income Tax Regs. Petitioners' daughter Katie received flight instruction from EOA beginning in 2001. In the fall of 2001, petitioner also began taking flight training lessons from EOA. Before taking flying lessons, petitioner always had an interest in flying. Being a pilot had been a long-term interest of petitioner since his youth. Petitioner acknowledges the purchase of the Cessna as "a way of having a good new plane upon which to learn". Consequently, the ninth factor weighs against a finding of a profit objective.



When considering whether a taxpayer engaged in an activity for profit, greater weight must be given to the objective facts than to a taxpayer's mere statement of intent. Beck v. Commissioner, 85 T.C. 557, 570 (1985). While some of petitioner's efforts could support an argument in favor of a profit objective, they could also be construed as a genuine interest in and an effort to contribute to an activity that provided personal pleasure in the form of a hobby. Regardless, petitioner's testimony and the evidence on record in favor of petitioners' argument are insufficient to overcome the weight of the objective facts indicating that petitioners were not engaging in the activity primarily for profit. 11 Accordingly, we will sustain respondent's determination with regard to the disallowance of losses created by the aircraft activity.




II. Claimed Loss from Worthless Stock and Loans


On their 2002 Federal income tax return, petitioners claimed losses of $432,346 relating to the alleged worthlessness of their BTI stock and loans petitioner made to BTI. On petitioners' 2002 Schedule D, Capital Gains and Losses, they reported a short-term capital loss of $332,346 related to BTI, which contributed to a total net short-term loss of $412,033 reported for that year. Petitioners also reported a $100,000 long-term capital loss related to BTI on their Schedule D for 2002, which contributed to a total net long-term capital loss of $26,245. Petitioners were limited by section 1211(b)(1) to a recognized capital loss of $3,000 on their 2002 Federal income tax return. Petitioners carried forward a short-term capital loss of $409,033 and a long-term capital loss of $26,245 to 2003.



Respondent disallowed petitioners' claimed capital losses relating to BTI. However, respondent concedes that after application of the section 1211(b)(1) capital loss limitation in 2002, petitioners' Federal income tax return for 2002 reflected the appropriate amount of capital losses (i.e., capital loss of $3,000). Accordingly, the disallowance of the reported loss with respect to BTI affects only petitioners' taxable income for 2003.



Petitioners argue that the BTI stock became worthless and that their loans to BTI became nonbusiness bad debt when BTI "ran out of opportunities to sell the company" in 2002. Respondent argues that neither the stock nor the loans became worthless in 2002.



In order for a taxpayer to claim a loss for worthless securities in a taxable year, the security must become worthless in that taxable year. Sec. 165(g)(1). A loss shall be treated as sustained during the taxable year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year. Sec. 1.165-1(d)(1), Income Tax Regs. Total worthlessness of the security is required for the deduction. Sec. 1.165-4, Income Tax Regs. No loss deduction is allowed for partial worthlessness or for mere decline in value. Sec. 1.165-5, Income Tax Regs. Stock becomes worthless and the loss is sustained only when the stock has no liquidating value and there is no reasonable hope and expectation that at some future point in time it will become valuable. Duncan v. Commissioner, T.C. Memo. 1986-122. The burden is on the taxpayer to establish the worthlessness of the stock and the year in which it became worthless. Id. (citing Boehm v. Commissioner, 326 U.S. 287, 292 (1945)). The loss can be established satisfactorily only by some "identifiable event" in the corporation's life which extinguishes all hope and expectation of revitalization, such as bankruptcy, cessation of business operations, liquidation of the corporation, or appointment of a receiver for it. Morton v. Commissioner, 38 B.T.A. 1270, 1279 (1938), affd. 112 F.2d 320 (7th Cir. 1940).



In the case of a taxpayer other than a corporation, where any nonbusiness debt becomes worthless within the taxable year, the loss resulting therefrom shall be considered a loss from the sale or exchange, during the taxable year, of a capital asset held for not more than 1 year. Sec. 166(d)(1)(B). A loss on a nonbusiness debt is treated as sustained only if and when the debt has become totally worthless. Sec. 1.166-5(a)(2), Income Tax Regs. The burden is on the taxpayer to establish the worthlessness of the debt and the year in which it became worthless. Crown v. Commissioner, 77 T.C. 582, 598 (1981). It is generally accepted that the year of worthlessness is to be fixed by identifiable events which form the basis of reasonable grounds for abandoning hope of recovery. Id.



Whether petitioner's loans made to BTI should be evaluated for fitting the definition of worthless securities or nonbusiness bad debt depends on whether the debt is evidenced by a security as defined in section 165(g)(2)(C). 12 Sec. 166(e). However, each of these alternatives requires petitioners to show that, at the end of 2002, there was no reasonable prospect for recovery. See Boulafendis v. Commissioner, T.C. Memo. 1984-321 (citing Boehm v. Commissioner, supra at 291-292; Crown v. Commissioner, supra at 598). Accordingly, we begin our analysis by addressing this issue.



Mr. Hyman testified that BTI owned furniture, fixtures, and a patent on the use of linear programming at the time it filed for bankruptcy in 2001. He testified that BTI had substantial value at that time. Almost immediately after the bankruptcy filing, the venture capital firm on whose interest payment BTI defaulted and another company submitted separate bids to purchase the assets of BTI for $2 million. Mr. Hyman testified that if a sale had occurred in 2001, BTI shareholders would have benefited. However, Mr. Hyman believed that BTI could be sold for, and the assets were worth, significantly more than $2 million. According to Mr. Hyman, that is the reason that BTI's bankruptcy trustee turned down both of the $2 million offers.



Mr. Hyman testified that it was reasonable for petitioner to believe that he could get something for his investment in BTI at the end of 2001, even after it filed for bankruptcy. At that time, Mr. Hyman was hopeful that a sale was going to occur. Mr. Hyman testified that, when no sale occurred, the company was "put into cold storage" with the goal of trying to raise money. BTI's bankruptcy proceeding was later converted from chapter 7 to chapter 11. BTI is presently operating as a business in chapter II, and Mr. Hyman testified that "there's activity now starting to try to raise capital within the chapter 11 environment to be able to, to bring the company potentially out of chapter 11 and operate * * * the company."



The evidence presented at trial, combined with Mr. Hyman's testimony, indicates that BTI had value at all times in 2002 and still has value. Petitioners have failed to carry their burden of proof to show that there was no reasonable prospect of recovery for their stock and loans in 2002. Accordingly, we hold that petitioners are not entitled to deductions for worthless securities or nonbusiness bad debt.




III. Accuracy-Related Penalty


With respect to the accuracy-related penalty under section 6662(a), the Commissioner has the burden of production. Sec. 7491(c). To prevail, the Commissioner must produce sufficient evidence that it is appropriate to apply the penalty to the taxpayer. Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner meets his burden of production, the taxpayer bears the burden of supplying sufficient evidence to persuade the Court that the Commissioner's determination is incorrect. Id. at 447.



Section 6662(a) and (b)(1) provides accuracy-related penalties equal to 20 percent of the underpayment of tax required to be shown on a return if the underpayment is due to negligence or disregard of rules or regulations. 13 For purposes of section 6662, the term "negligence" includes "any failure to make a reasonable attempt to comply with the provisions of * * * [the Code], and the term 'disregard' includes any careless, reckless, or intentional disregard." Sec. 6662(c). "Negligence" also includes any failure by a taxpayer to keep adequate books and records or to substantiate items properly. Sec. 1.6662-3(b)(1), Income Tax Regs.



An accuracy-related penalty is not imposed with respect to any portion of the underpayment as to which the taxpayer acted with reasonable cause and in good faith. Sec. 6664(c)(1); see Higbee v. Commissioner, supra at 448. This determination is made based on all the relevant facts and circumstances. Higbee v. Commissioner, supra at 448; sec. 1.6664-4(b)(1), Income Tax Regs. Relevant factors include the taxpayer's efforts to assess his proper tax liability.



While we have held that petitioners did not have profit as their primary objective for entering into the aircraft activity, we believe that they had both personal and profit objectives in the sense that they actually hoped that their activity might produce a profit. See Warden v. Commissioner, T.C. Memo. 1995-176. Sometimes it is difficult to determine which of two motives for engaging in an activity is primary. That is one of the basic reasons for using objective facts to determine subjective intent. But a finding that profit was not the primary motive does not automatically result in a conclusion that petitioners were negligent or intentionally disregarded the rules and regulations. See Bernardo v. Commissioner, T.C. Memo. 2004-199; Sherman v. Commissioner, T.C. Memo. 1989-269. On the basis of the previously stated facts, we find that petitioners' reporting of their aircraft activity was not due to negligence and that they are not liable for the penalties with respect to the portions of the underpayments due to their aircraft activity. Likewise, we find that petitioners are not liable for the penalty on the portion of the 2003 underpayment due to their claimed losses from worthless stock and loans. The determination of worthlessness in the situation described in this case is not without some doubt, and while we have found that petitioners have not proven worthlessness, we believe that they honestly believed that their stock and loans were worthless in 2002. 14 We therefore hold that petitioners are not liable for the section 6662 penalties.



To reflect the foregoing,



Decision will be entered for respondent as to the deficiencies and for petitioners as to the accuracy-related penalties.


1 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

2 Before trial, petitioners' counsel submitted to the Court a document entitled "Petitioners' Consolidated Pre-Trial Motion", which the Court treated as petitioners' pretrial memorandum. At trial, petitioners' counsel requested that the Court treat part of their pretrial memorandum as a motion for partial summary judgment (motion). The Court obliged the request but denied the motion and declined to rule on petitioners' counsel's request to shift the burden of proof. Petitioners failed to pursue some of the arguments made in their motion at trial or in their post-trial briefs. Accordingly, we deem those arguments to have been abandoned and will decide only the issues that petitioners' counsel disputed in their posttrial briefs. See Nicklaus v. Commissioner, 117 T.C. 117, 120 n.4 (2001).

3 Respondent also determined that petitioners' itemized deductions should be decreased by $2,534 in 2002 and $2,052 in 2003. These are computational adjustments that depend on our disposition of the other issues in this case.

4 Petitioners apparently accounted for the aircraft activity as a sole proprietorship on a Schedule C, Profit or Loss From Business, until Mrs. Rosenblatt became a member of KAR RRR in 2002. Thereafter, petitioners accounted for the aircraft activity as a partnership on a Schedule E, Supplemental Income and Loss.

5 A Hobbs meter is a device used to measure the amount of time an aircraft is in operation.

6 Petitioners had actual gross receipts from the aircraft activity of $21,645 in 2002 and $31,865 in 2003.

7 Petitioner testified that he "worked off * * * [a] pro forma and * * * [his] own notes about marketing and so on" and that those materials indicated that, "given a certain number of hours per month of * * * lease that it would be profitable." Petitioner's "pro forma" and marketing notes were not offered into evidence.

8 The total time on petitioner's log for 2002 is listed as 191.3 hours but actually adds up to 197.05 hours.

9 The logs separate petitioner's "Business Time" and "Travel Time" spent on KAR RRR. In 2002, petitioner's log reflects 52.75 hours of travel time and 144.3 hours of business time. In 2003, petitioner's log reflects 41 hours of travel time and 167.25 hours of business time.

10 The aircraft activity generated losses of $84,469 for 2002 and $44,442 for 2003.

11 Because we find that petitioners' aircraft activity was not engaged in with the required profit objective, we need not decide whether petitioners' losses were nondeductible passive activity losses subject to the limitations imposed under sec. 469.

12 Sec. 165(g)(2)(C) defines a "security" as "a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form."

13 Sec. 6662 can also apply when there is a substantial understatement of tax. See sec. 6662(b)(2). However, since the only reason given in the notice of deficiency for imposing the penalty was negligence or intentional disregard of rules and regulations, and respondent did not raise sec. 6662(b)(2) until after trial, we will only consider the issue raised in the notice of deficiency.

14 In petitioners' posttrial brief, they requested the following finding of fact:

62. Dr. Rosenblatt believes his investments in Benefit Technologies became worthless in 2002 because during that year the bankruptcy trustee ran out of opportunities to the [sic] sell the company.

In his answering brief, respondent had no objection to this proposed finding of fact.