SCOTUS Reports

Tag: Recourse Note

  • Follender v. Commissioner, 89 T.C. 943 (1987): Determining At-Risk Amounts Without Present Value Discounting

    Follender v. Commissioner, 89 T. C. 943, 1987 U. S. Tax Ct. LEXIS 155, 89 T. C. No. 66 (1987)

    A taxpayer’s at-risk amount for borrowed funds under section 465 is the full amount of the principal they are personally liable for, without discounting to present value.

    Summary

    In Follender v. Commissioner, the U. S. Tax Court addressed whether a limited partner’s at-risk amount should be discounted to present value when assuming the principal obligation of a recourse note without interest. David Follender assumed a portion of a $4. 6 million recourse purchase note for a motion picture investment, but not the nonrecourse interest. The court held that Follender’s at-risk amount was the full $257,058 of principal assumed, rejecting the Commissioner’s argument for discounting to present value. This decision clarified that section 465 does not require present value calculations for at-risk amounts, focusing instead on the actual liability for the borrowed amount.

    Facts

    David B. Follender and Irma R. Follender, as limited partners in Brooke Associates, invested in the motion picture “Body Heat. ” Brooke Associates purchased the film from the Ladd Company for $9,940,000, financing it with a $4,600,000 recourse purchase note due in 1991. Follender assumed primary obligation for $257,058 of the note’s principal but not the nonrecourse interest. The partnership’s offering memorandum detailed the investment structure, including the recourse note and the limited partners’ obligations.

    Procedural History

    The Commissioner of Internal Revenue determined a deficiency in the Follenders’ 1981 federal income taxes, arguing that Follender’s at-risk amount should be discounted to present value. The case was heard by the U. S. Tax Court, which issued its opinion on October 28, 1987, holding that the at-risk amount should not be discounted.

    Issue(s)

    1. Whether Follender’s at-risk amount should be increased by the full $257,058 of the recourse purchase note’s principal he assumed, without discounting to present value.
    2. Whether nonrecourse interest on the recourse purchase note should be treated as contingent interest under section 483, affecting the partnership’s basis in the motion picture.
    3. Whether Follender would be liable for increased interest under section 6621(c) if the court decided the at-risk issue in favor of the Commissioner.

    Holding

    1. Yes, because section 465 does not require discounting borrowed amounts to present value when determining at-risk amounts. Follender’s at-risk amount was the full $257,058 he assumed.
    2. No, because the nonrecourse interest was not contingent interest under section 483, as its liability and amount were determinable at the time of sale.
    3. This issue was not reached because the court held for Follender on the at-risk issue.

    Court’s Reasoning

    The court reasoned that section 465(b)(2) allows taxpayers to be considered at risk for amounts borrowed to the extent they are personally liable, without any statutory directive to discount these amounts to present value. The court rejected the Commissioner’s argument that the difference between the face value and present value of the obligation constituted an amount protected against loss under section 465(b)(4). The court also found that the nonrecourse interest on the recourse note was not contingent under section 483, as its rate and due date were fixed, and the likelihood of payment was supported by pre-release revenue estimates. The court’s decision was unanimous, with no dissenting opinions, and emphasized the legislative intent behind section 465 to limit deductions to amounts economically at risk.

    Practical Implications

    This decision provides clarity for tax practitioners and investors in structured financing arrangements, particularly those involving recourse and nonrecourse obligations. It confirms that at-risk amounts under section 465 should be calculated based on the full amount of the principal obligation, without applying present value discounting. This ruling impacts how partnerships and investors structure their financing to maximize tax benefits while ensuring compliance with at-risk rules. It also affects how the IRS assesses at-risk amounts in audits, potentially reducing disputes over valuation methods. Subsequent cases, such as Melvin v. Commissioner, have reinforced this principle, guiding practitioners in advising clients on the tax treatment of similar investment structures.

  • Andrama I Partners, Ltd. v. Commissioner, 93 T.C. 23 (1989): Establishing Ownership and Profit Motive in Tax Shelter Cases

    Andrama I Partners, Ltd. v. Commissioner, 93 T. C. 23 (1989)

    Ownership and a bona fide profit motive must be proven for a partnership to claim deductions and credits related to purchased assets in tax shelter cases.

    Summary

    Andrama I Partners, Ltd. purchased nursing training films from Andrama Films for $750,000, including a $600,000 recourse note, aiming to distribute them for profit. The IRS challenged the partnership’s claimed deductions and investment tax credits, asserting the transaction lacked a profit motive and true ownership. The Tax Court held that Andrama I Partners had acquired ownership and operated with a legitimate profit objective, thus entitling them to the deductions and credits. The court’s decision hinged on the partnership’s active management, reasonable projections of profitability, and the partners’ personal liability for the recourse note.

    Facts

    Andrama I Partners, Ltd. , a New York limited partnership formed in 1979, purchased two nursing training films, “Moving Up” and “Planning,” from Andrama Films for $750,000, which included a $150,000 cash payment and a $600,000 recourse promissory note due in 1987. The partnership licensed ABC Video Enterprises to distribute the films, expecting to receive 65% of the gross revenues. The partnership’s general partner, Herbert Kuschner, relied on the expertise of Rudolph Gartzman, the films’ producer, and conducted market research to assess the films’ potential profitability. Despite poor sales performance, Andrama I Partners sought a new distributor, the American Journal of Nursing Co. , in 1983.

    Procedural History

    The IRS determined deficiencies in the petitioners’ federal income taxes for 1979, challenging the partnership’s deductions and investment tax credits related to the film purchase. After concessions, the Tax Court addressed whether Andrama I Partners had ownership of the films, a bona fide profit motive, and if the recourse note constituted genuine indebtedness for tax purposes.

    Issue(s)

    1. Whether Andrama I Partners purchased an ownership interest in the films?
    2. Whether Andrama I Partners entered into the transaction with a bona fide objective to make a profit?
    3. Whether the recourse promissory note constituted a genuine indebtedness fully includable in determining the films’ basis for depreciation?
    4. Whether Andrama I Partners is entitled to deduct interest accrued but not paid in 1979?
    5. Whether production expenses for computing Andrama I Partners’ investment tax credit basis include amounts incurred but not paid in 1979?

    Holding

    1. Yes, because the partnership acquired all rights, title, and interest in the films, bearing the risk of loss.
    2. Yes, because the partnership’s activities were conducted in a businesslike manner with reasonable expectations of profit.
    3. Yes, because the note was a valid recourse obligation personally guaranteed by the limited partners.
    4. Yes, because the interest was accrued on a bona fide debt and likely to be paid.
    5. Yes, because the deferred production costs were guaranteed and thus properly included in the investment tax credit basis.

    Court’s Reasoning

    The court applied the substance-over-form doctrine, focusing on the economic realities of the transaction. It determined that Andrama I Partners acquired true ownership because it bore the risk of loss and had all rights transferred to it. The court found a bona fide profit motive based on the partnership’s businesslike conduct, reliance on expert advice, and reasonable projections of profitability. The recourse note was deemed genuine indebtedness due to the personal guarantees by the limited partners, which were enforceable. The court allowed the interest deduction for 1979, as the accrued interest was on a bona fide debt with a high likelihood of payment. Deferred production costs were included in the investment tax credit basis because they were guaranteed and not contingent on future profits. The court emphasized that the decision was based on the facts and circumstances at the time of the transaction, not on subsequent poor performance.

    Practical Implications

    This decision impacts how tax shelters involving asset purchases are analyzed, emphasizing the importance of proving ownership and a profit motive. Legal practitioners must ensure clients can demonstrate these elements to support deductions and credits. The ruling clarifies that recourse notes with personal guarantees can be treated as genuine indebtedness, affecting tax planning strategies. For businesses, the case highlights the need for thorough due diligence and realistic projections when entering similar ventures. Subsequent cases, such as Estate of Baron v. Commissioner, have distinguished this ruling based on different factual circumstances, particularly regarding the profit motive and enforceability of obligations.