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District Court Decision Highlights Split in Circuits on At-Risk Provision.
(Parker Tax Publishing June 11, 2014)

A taxpayer was at risk with respect to his guarantee through an LLC on a loan to purchase a jet that was then leased out at a large loss; since the average customer use of the jet was less than seven days, a court held that the taxpayer's lease activity was not a rental activity and was thus excepted from the passive loss rules that would have limited the amount of deductible loss. Moreno v. U.S., 2014 PTC 241 (W.D. La. 5/19/14).

Michel and Tiffany Moreno filed for a tax refund as a result of suffering a loss of almost $4.8 million that arose out of their acquiring and leasing a Learjet aircraft in 2005. The aircraft was owned and operated through Aerodynamic, LLC, a limited liability company owned solely by Michel. Aerodynamic was a disregarded entity for tax purposes, and Aerodynamic's operations were reported on Michel and Tiffany's Schedule C. The aircraft purchase was financed by a loan from General Electric Capital Corporation (GE) to Aerodynamic in the amount of the purchase price. The loan was secured by a security interest granted to GE in the aircraft, the corporate guaranty of Dynamic Industries, Inc., and an individual personal guaranty by Michel. Dynamic Industries, Inc. was owned by Moreno Energy, Inc., which was 98 percent owned by Michel. Once acquired, Aerodynamic leased the aircraft to various lessees throughout the remainder of 2005.

Aerodynamic suffered losses in 2005 and, as a result, Michel deducted the losses on his and Tiffany's personal return and sought a refund of approximately $667,000 in taxes plus interest. The IRS denied the refund request, arguing that Michel was not at risk under Code Sec. 465 with respect to the aircraft leasing activity, and that the aircraft leasing activity constituted a rental activity, subject to the passive activity loss rules of Code Sec. 469. Michel countered that he was at risk with respect to the leasing activity and that the activity was not a rental activity by reason of the exception in Reg. Sec. 1.469-1T(e)(3)(ii)(A). That exception excludes from rental activity the lease of tangible property where the average period of customer use is less than seven days. According to Michel, he was at risk on the loan because he personally guaranteed its repayment. If the loan defaulted and the sale of the aircraft was not sufficient to pay off the debt, he argued, GE could pursue him and/or Dynamic.

Under Code Sec. 465(b)(1)(B) and Code Sec. 465(b)(2)(A), a taxpayer is considered at risk for an activity for amounts borrowed with respect to such activity provided the taxpayer is personally liable for the repayment of such amounts. However, under Code Sec. 465(b)(4), a taxpayer is not considered at risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop-loss agreements, or other similar arrangements. While the IRS agreed that Michel personally guaranteed the repayment of the GE loan to Aerodynamic and thus satisfied Code Sec. 465(b)(2)(A), it said that the substance and economic realities of the transaction protected Michel from ever being required to satisfy his obligation and, therefore, the transaction fell within the exception from at-risk treatment provided by Code Sec. 465(b)(4). The IRS did not argue that Michel was protected against loss arising out of his personal guaranty through nonrecourse financing, guarantees, or stop loss agreement. The issue was whether, under Code Sec. 465(b)(4), Michel was protected against loss through other similar arrangements and the IRS argued that he was.

The IRS also objected to Michel's contention that he was not involved in a rental activity because he fit within the exception of Reg. Sec. 1.469-1T(e)(3)(ii)(A), which excludes activities involving the use of tangible property where the average use of such property is seven days or less. The argument centered on how the average period of customer use is calculated. According to the IRS, each lease agreement constituted a contract with a definite term the life of the aircraft with a reservation of right to terminate. Because none of the agreements were terminated in 2005, each lessee had a continuous and recurring right to use the aircraft from the time each agreement was entered into, through the end of 2005. Thus, the average period of customer use of the aircraft was 85 days.

According to Michel, the lease agreement was a contract without a definitive term. The agreement, Michel noted, did not provide the lessee with a continuous or recurring right to use the aircraft because (1) the agreement could be terminated at the will of the parties at any time the aircraft was in the possession of the owner, and (2) each use of the aircraft by the lessee was subject to the owner's approval.

The statute does not define or explain the phrase other similar arrangements in Code Sec. 465(b)(4). The Second, Eighth, Ninth, and Eleventh Circuits apply an economic realities test to determine whether a borrowed amount is protected against loss under Code Sec. 465(b)(4). Under this test, whether a taxpayer is personally liable for repayment of borrowed amounts is determined by analyzing whether the taxpayer is ultimately liable for repayment of the borrowed amounts in a worst-case scenario. Whether the taxpayer has engaged in a loss-limiting arrangement prohibited by Code Sec. 465(b)(4) is determined by whether a transaction is structured by whatever method to remove any realistic possibility that the taxpayer will suffer an economic loss if the transaction turns out to be unprofitable. Under the economic realities test, a theoretical possibility that the taxpayer will suffer an economic loss is insufficient to avoid the application of Code Sec. 465(b)(4).

By contrast, the Sixth Circuit applies a payor of last resort test to determine whether a borrowed amount is protected against loss. This test asks whether, under both Code Sec. 465(b)(2) and Code Sec. 465(b)(4), in a worst-case scenario, the individual taxpayer will suffer any personal, out-of-pocket expenses. The Tax Court has said that whichever standard is used, the ultimate decision rests on the substance of the transaction in light of all the facts and circumstances. The Fifth Circuit, the circuit to which this case is appealable, has not addressed the standard to be applied.

The district court held that Michel was at risk with respect to the Aerodynamic loan. The court said that while it tended to agree with the Sixth Circuit's interpretation of Code Sec. 465(b)(4) and its application of the payor of last resort test, Michel was considered at-risk under either test. The court noted that the cases cited by the IRS all involved a complicated web of circular sale/leaseback transactions that did not exist in Michel's case. Additionally, the court said, in many of the cited cases, the investor's personal liability did not run through to an independent third-party lender as it did in Michel's case, but rather to the investment creator, thus leading the courts to find the taxpayers in those cases were protected against loss.

The district court also agreed with Michel's argument that he was not involved in a rental activity because the average period of customer use was seven days or less; thus, his aircraft leasing was not subject to the passive activity loss rules. The court concluded that each flight by a lessee was a separate rental or lease and, as a result, the average period of customer use in 2005 was less than two days.

OBSERVATION: It's not always clear what the average number of days of customer use is for purposes of determining if an activity is excepted from the definition of a rental activity. On occasion, what seems like a short-term rental may, in fact, be much longer. Typically, this happens with related parties, where the lease is for a short period, but there is a renewal option. Reg. Sec. 1.469-1(e)(3)(iii)(D) explicitly provides that the period of customer use is each period during which the customer has a recurring right to use the property, whether or not there is a lease. If someone has the right to use the property all year long, there is one single period of customer use for the year, even if the person or entity uses the property only sporadically for a few hours or days at a time.

For a discussion of when a borrower is considered personally liable on a loan and not otherwise protected from loss, see Parker Tax ¶247,520. For a discussion of the rule excepting an activity from the definition of rental activity where customer use is seven days or less, see Parker Tax ¶247,140. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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