A district court has determined that a taxpayer was at risk with respect to the aircraft leasing activity of his wholly owned limited liability company (LLC), but was only at risk with respect to 50% of a loan taken out by the LLC on which he was a co-guarantor. The court further concluded that the LLC’s leasing activity wasn’t a rental activity and that the taxpayer therefore wasn’t subject to the passive activity loss (PAL) limitations.
Facts: On Sept. 30, 2005, Aerodynamic, LLC, which was solely owned by Michel Moreno, acquired a Learjet aircraft for $7.9 million. The 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. (Dynamic), which was 100% owned by Moreno Energy, which in turn was 98% owned by Mr. Moreno. The loan was also secured by an individual personal guaranty by Mr. Moreno. Once acquired, Aerodynamic leased the aircraft to various lessees throughout the remainder of 2005.
Mr. Moreno (on a joint return filed with his wife) claimed a $4.8 million loss for the 2005 tax year, which he claimed arose out of the acquisition and leasing of the aircraft. IRS disallowed the loss, and Mr. Moreno sought to recover a refund of $667,299 plus interest.
Parties’ arguments. Mr. Moreno argued that (1) he was at risk within the meaning of Code Sec. 465 with respect to the aircraft leasing activity in which Aerodynamic engaged in 2005, and (2) Aerodynamic’s leasing activity fell within Reg. § 1.469-1T(e)(3)(ii)(A)’s exception from rental activities because the average period of customer use of the aircraft was less than seven days.
IRS, on the other hand, asserted that Mr. Moreno was not at risk under Code Sec. 465 with respect to the aircraft leasing activity because he engaged in a loss-limiting arrangement that effectively removed any realistic possibility that he would suffer an economic loss if Aerodynamic defaulted on its loan. Additionally, IRS claimed that the leasing activity constituted a rental activity subject to Code Sec. 469’s passive activity loss rules. Both parties motioned for partial summary judgment.
Background—at-risk rules. The Code Sec. 465 at-risk rules are designed to ensure that a taxpayer deducts losses only to the extent he is economically or actually at risk for the investment. A taxpayer’s amount at risk includes cash contributions and certain amounts borrowed with respect to the activity for which the taxpayer is personally liable for repayment or for which the taxpayer has pledged property, other than property used in the activity, as security for the borrowed amounts. However, a taxpayer isn’t considered at-risk with respect to any amount protected against loss by nonrecourse financing, guarantees, stop loss agreements, or other “similar arrangements.”
The term “other similar arrangements” isn’t defined or explained in the statute. 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 that test, whether a taxpayer is personally liable for repayment of borrowed amounts under Code Sec. 465(b)(2) is determined by analyzing whether the taxpayer is ultimately liable for repayment of the borrowed amounts in a worse-case scenario; but whether a 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.
The Sixth Circuit applies a “payor of last resort” test to determine whether a borrowed amount is protected against loss. This test simply 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 Fifth Circuit (the relevant Court of Appeal) has not addressed the applicable standard.
Taxpayer was at risk. The district court concluded that Aerodynamic’s failing to meet the terms of its loan agreement would trigger a demand for payment by GE against Dynamic and/or Mr. Moreno, and that there was no arrangement in place that would excuse performance under the note or that protected against loss if the note payments weren’t made. The court found that its determination was the same regardless of whether it used the economic realities test or the payor of last resort test—either way, Mr. Moreno was at risk with respect to the Aerodynamic loan. The court readily distinguished the cases cited by IRS as involving a “complicated web of circular sale/leaseback transactions,” which it noted weren’t present in this case.
The court then addressed, and rejected, each of IRS’s specific arguments, as follows:
- Insufficient liquidity. IRS argued GE’s internal loan documents show that, from the time it made the loan in September of 2005 until the end of that year, despite showing a net worth of approximately $27 million, Mr. Moreno didn’t have sufficient liquidity to pay the GE Loan if Aerodynamic had defaulted on the loan. The court found that Mr. Moreno’s liquidity was a question of fact, but not a material question of fact since there is no requirement that a guarantor have sufficient cash on hand to satisfy a claim under guaranty in order to be at risk.
- GE relied on Dynamic as security. IRS claimed that, in approving the loan, GE relied primarily on Dynamic’s strong financial position and not on Mr. Moreno’s guarantee. The court again found that this was a question of fact, but not a material one since the government cited no legal authority supporting its position that, where a lender’s internal loan documents purportedly show the lender is relying on the financial strength of one surety over another, that the latter should be denied at-risk treatment.
- Upon default, Dynamic would have paid. IRS asserted that, since Mr. Moreno was the controlling shareholder of Moreno Energy, he had the ability to ensure that Dynamic would have paid any loss resulting from Aerodynamic’s default and that his personal assets would be protected. The court again found that to be a question of fact, but a not material one, since the bank could have called upon Dynamic, Mr. Moreno, or both to satisfy the obligation in the event of a default.
- Indemnity provision. IRS argued that, since Mr. Moreno was indemnified under a provision in his employment agreement with Moreno Energy, he was protected against loss. However, the court found that the indemnity provision wasn’t sufficiently broad in scope to necessarily apply to a personal guaranty, and that there was no evidence that the guaranty was executed in Mr. Moreno’s capacity as a director, employee, agent, etc. of Moreno Energy.
The court then turned to Mr. Moreno’s arguments that he was entitled to at-risk treatment because: (i) in the event that either he or Dynamic satisfied the obligation on behalf of Aerodynamic, the paying surety would have a state law right of contribution against the non-paying surety for 50% of the amount paid; and (ii) if Dynamic were to pay the obligation, Dynamic would have a right to reimbursement from him and/or a claim against him for unjust enrichment. IRS, in response, argued that any right of contribution or reimbursement would be effectively negated by the indemnification provisions in Mr. Moreno’s employment agreement. The court, however, found that the indemnity provision was inapplicable to the facts and hand and thus didn’t constitute a loss-limiting arrangement.
With respect to rights of contribution and reimbursement, the court cited various IRS guidance for the proposition that where a member of an LLC guarantees a liability of the entity, he is at risk except to the extent he has a right of contribution or reimbursement from the other guarantor(s). (See, e.g., Field Service Advice 2000-25-018) Here, all parties acknowledged that if either Dynamic or Mr. Moreno were to pay Aerodynamic’s obligation, the paying entity would have a state law right of contribution against the other for half the amount it paid.
However, the court found that Mr. Moreno failed to carry his burden of proof that Dynamic would have a right of reimbursement or a claim of unjust enrichment against him for the remaining 50% paid on behalf of Aerodynamic. Accordingly, the court found that he was at risk with respect to the Aerodynamic loan, except to the extent that he had a right of contribution against Dynamic—i.e., he was at risk for 50% of the amount guaranteed.
Background—passive activity losses. Code Sec. 469 generally disallows passive activity losses incurred by individual taxpayers for the tax year. A passive activity loss is the amount by which the aggregate losses from all passive activities for the tax year exceed the aggregate income from such activities for the year. (Code Sec. 469(d)(1)) Generally, a passive activity is a trade or business in which a taxpayer does not materially participate. (Code Sec. 469(c)(1)) The term “passive activity” includes any rental activity, regardless of whether the taxpayer materially participates.
However, as an exception to the above rule, an activity involving the use of tangible property isn’t a rental activity if the “average period of customer use” is seven days or less. (Reg. § 1.469-1T(e)(3)(i)) The average period of customer use is determined by dividing the aggregate number of days in all periods of customer use for the property during the tax year by the number of periods of customer use.
Activity wasn’t “rental activity.” The court then concluded that Aerodynamic’s leasing activity wasn’t a rental activity and thus the losses incurred by Mr. Moreno weren’t subject to the passive activity loss limitations. The core of the disagreement between the parties was on the calculation of “periods of customer use,” with Mr. Moreno arguing that each period was determined by the distinct time a lessee was in actual possession of the aircraft, and with IRS arguing that the period was continuous starting from when a contract of lease is signed and continuing until the contract is terminated.
The court, looking at the terms of the non-exclusive lease agreement between Aerodynamic and the lessees, found that, until the owner approved a flight scheduling request, there was no binding contract for lease. The lease thus commenced upon delivery of the aircraft to the lessee on the date requested (and approved) and concluded with return of the aircraft. The court found that, because the agreement clearly stated a potential lessee’s request could be granted or denied in the owner’s sole discretion, there was no “continuous or recurring right” to use the aircraft. Accordingly, the court concluded that the activity wasn’t a “rental activity” and that the losses incurred by Mr. Moreno in his aircraft leasing business during 2005 weren’t subject to the passive activity loss rules.
© 2014 Douglas Rutherford, CPA, CGMA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.
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