At-risk rules flow through loss limitations.

Generally, a taxpayer's deductions from an activity are limited to amounts at risk. A taxpayer is considered at risk for an activity for the amount of money and adjusted basis of other property contributed to the activity and for amounts borrowed to use in the activity to the extent that he is personally liable for the repayment of such amounts or has pledged property as security for such borrowed amount (Sec. 465(b)).

Legislative history provides many tax shelter cases in which taxpayers were found not to be "at risk," when involved in circular, computer equipment sale-leaseback schemes. The courts have found that the offsetting payment structure in a true circular transaction has meant that a default by one party would lead each of the others to default in turn, making it unlikely that any of the parties within the circular transaction (even those with recourse rights) would disrupt the payment chain.

In Robert L. Whitmire (5/28/99), the Ninth Circuit affirmed the Tax Court, 109 TC 266 (1997), which found that the risk in a complex computer equipment leasing transaction was so layered with protections that the investment crossed the line into an exception to Sec. 465, which excludes deductions despite the existence of a risk (i.e., when loss protections remove any realistic possibility that a taxpayer will suffer a loss).

Sec. 465(b)(4) Exception

Sec. 465 provides that a taxpayer may take a deduction from leasing depreciable property only to the extent that he is at risk in the leasing activity. A limited partner is not considered to be at risk for partnership debt obligations associated with a computer leasing transaction; however, a taxpayer is personally liable if he would legally be responsible for his debt under a worst-case scenario (American Principals Leasing Corp., 904 F2d 477 (9th Cir. 1990)).

Facts

Petunia, a New York limited partnership, purchased from the Venture Company computer equipment that had been involved in four prior sales transactions, subject to a user lease, a recourse loan and a security agreement. Petunia gave Venture a limited recourse installment promissory note (Petunia-Venture note). The limited partner liability on the Petunia-Venture note was 434.75% of the partner's contributions. Petunia leased the equipment to F/S Computer Corporation; the lease provided that F/S would indemnify Petunia for any losses resulting from F/S's failure to meet the lease's terms. FSC (F/S's and Venture's grandparent company) unconditionally (and on a full recourse basis) guaranteed F/S's full performance of the lease. FSC guaranteed F/S's obligation to Petunia under the commitment agreement that Venture had assigned to Petunia.

Worst-Case Scenario vs. Economic Reality

Whitmire had funded his limited partnership interest in Petunia with cash and a recourse promissory note, and he claimed a deduction based on his investment in Petunia, the risk of which hinged on Petunia's inability to make payments on the Petunia-Venture note.

In the Ninth Circuit's opinion, the worst-case scenario would have occurred if no fewer than 11 events (including several remote contingencies) took place; if every party to the transaction breached all their commitments (i.e., the default and involvency of every party to the transaction), the financing corporation would call on the limited partners to make contributions to the extent of their personal liability on the Petunia-Venture note.

Thus, although the transactions left Whitmire "at risk" in a technical sense, the numerous contingencies placed between a potentially unprofitable transaction and any real chance he would ever suffer a loss was reflected by the number of events that would have to take place prior to his realizing financial harm.

Economic Reality

In the court's opinion, numerous guarantees protected Whitmire against loss. Whitmire argued that a rent guarantee should not be considered protection against loss, as there was risk in using lease proceeds to make debt payments (because the lessee might default). However, Petunia's lease was guaranteed by another party in the circular transaction.

FSC's guarantee also effectively protected Whitmire from risk. Because it removed the risk in the use of lease proceeds by Petunia to make debt payments, the FSC guarantee placed Whitmire within the Sec. 465 (b)(4) exception. Despite Whitmire's "worst-case scenario" to establish personal liability, he was not entitled to a deduction.

According to American Principals Leasing Corp., the purpose of Sec. 465 (b) (4) is "to suspend at risk treatment where a transaction is structured--by whatever method--to remove any realistic possibility that the taxpayer v,511 suffer an economic loss if the transaction turns out to be unprofitable." Worst-case scenarios are not appropriate when determining whether a Sec. 465(b) (4) arrangement exists; rather, "economic: reality" is the guide and a "theoretical possibility" that a taxpayer will suffer loss is insufficient to avoid the exception.

A chain of recourse notes can be established between a taxpayer and a creditor outside of the circular transaction; the creditor has no disincentive to calling the loan in the event of default, theoretically establishing "at risk." The court concluded that, despite the existence of "risk" in the circular transaction, the existence of the FSC guarantee and the theoretical nature of the taxpayer's scenario for risk were the determining factors in establishing that he was not at-risk within the meaning of Sec. 465.

FROM SARAH AVERY, CPA, EHRENKRANTZ STERLING & CO., LIVINGSTON NJ

Philip E. Moore, CPA, MBA Brown, Dakes & Wannall, P.C. DFK International Fairfax, VA