New 2/21/04

In Oren v. Comm., ___ F3d. ___, 2002 WL 1587216, (8th Cir. 2004), the 8th Circuit agreed with the Tax Court that Oren’s loans to HL and HS had no economic substance and, thus, were not real economic outlays, even though Oren and his corporations observed all of the formalities necessary to create legal obligations.

The Oren family owned three S corporations that performed various functions within the family’s trucking business. Dart Transit Company (“Dart”) a motor carrier that provided “truckload” service throughout the lower 48 states, contracted with independent drivers, who leased or owned their tractors, many of whom “leased-to-purchase” their tractors from a second family corporation, Highway Sales (“HS”). Dart used trailers leased from a third family corporation, Highway Leasing (“HL”). HL and HS had significant ordinary tax losses generated by the accelerated depreciation of their equipment, while simultaneously enjoying significant operating profits during the years in question.

Oren attempted to restructure his investment, and entered into a series of loan transactions Dart, HL, and HS whereby Dart loaned, over 3 years, approximately $15 million to Oren, who, in turn, made loans totaling the same amount to HL and HS, both of which, over time, loaned the same amount back to Dart. Each loan transaction within a cycle occurred on the same day or within a few days of each other. The loan terms of the loans, including interest rate (7% annually) and repayment conditions (on demand plus 375 days), were the same in each transaction. Dart, Oren, HL, and HS paid all interest due under the loan agreements by check. Each of the parties to the transactions paid off their obligations when the Commissioner notified the Orens of the deficiencies for 1993, 1994, and 1995.

The 8th Circuit noted that in determining whether a loan is an investment,it had adopted the tax court’s formulation of the “actual economic outlay” doctrine, which states that, for basis to increase, a loan from a shareholder to an S corporation must be an actual economic outlay of money by the shareholder. This actual economic outlay must leave the taxpayer “poorer in a material sense.”

The Court found that even if the very slight possibility of HL or HS suffering a catastrophic judgment occurred (as suggested by taxpayer to justify economic effect), such an event would have a direct impact only on Dart as the recipient of the loans from HL and HS. Dart would have to choose to enforce Oren’s obligation to it to have a direct effect on Oren, a decision that would have to be made by Oren, who controlled all voting shares in Dart. This required assuming the occurrence of a great number of unlikely facts as a postulate to a circumstance in which Oren would suffer personal economic loss as a result of the lending transactions.

The Court then found that even if the Orens’ basis in HL and HS increased under § 1366(d),the Orens must establish that the loans satisfy the at risk requirement of § 465 to be entitled to the claimed deductions. Section 465 provides that a taxpayer involved in an equipment-leasing business may deduct a loss from that activity “only to the extent of the aggregate amount with respect to which the taxpayer is at risk … for such activity at the close of the taxable year.” For borrowed money to be at risk the taxpayer must be “personally liable for the repayment of such amounts … . ” § 465(b)(2). Borrowed money is not at risk if it is “borrowed from any person who has an interest in such activity or from a related person … . ” § 465(b)(3). Similarly, such funds are not at risk if the taxpayer is “protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.” § 465(b)(4). The provision responds to the use of nonrecourse financing and other loss-limiting devices to increase basis but limit risk. The at risk analysis is very similar to the actual economic outlay analysis discussed by the Court, and Court looked to the economic reality of the situation to determine whether there was a realistic chance that Oren might lose the money he loaned to HL and HS, or, rather, whether the funds were protected from loss by the arrangement of the transactions. The “theoretical possibility that the taxpayer will suffer economic loss is insufficient to avoid the applicability of § 465.