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Saviano v. Commissioner of Internal Revenue

June 18, 1985


Appeal from the Decision of the United States Tax Court, No. 15926-81, Perry Shields, Judge.

Author: Campbell

Before CUMMINGS, Chief Judge, COFFEY, Circuit Judge, and CAMPBELL, Senior District Judge.*fn*

CAMPBELL, Senior District Judge.

"Gold for Tax Dollars," certainly an alluring phrase, is the title of a tax shelter that has enticed thousands of taxpayers with dreams of large deductions. The plan contemplated the taxpayer investing in a gold mine in Panama (for taxable year 1978) or French Guiana (for taxable year 1979) and obtaining thereby a tax deduction equivalent to four times the actual investment. However, the Commissioner of Internal Revenue Service, concluding that the shelter resulted in precious few tax dollars and precious little gold, has disallowed certain of the deductions claimed pursuant to the plan.*fn1 Appellant,*fn2 who participated in both the 1978 and 1979 tax shelters, filed this suit challenging the Commissioner's deficiency determinations. The Tax Court denied Saviano relief as to both years and he filed this appeal under the jurisdiction of 26 U.S.C. § 7482.

Prior to our analysis of the transactions we need to address a preliminary dispute between the parties. For purposes of the cross-motions for summary judgment, the IRS agreed that the Tax Court should assume that the transactions occurred as described in the promotional literature for the tax shelters. The appellant contends that the Commissioner violated this agreement by making certain arguments and that the Tax Court in approving those arguments ignored that agreement.

The parties to a lawsuit are free to stipulate to factual matters. However, the parties may not stipulate to the legal conclusions to be reached by the court. For example, in this case it is undisputed that the International Monetary Exchange (IME) and Saviano executed a "Loan Agreement." Appellant then states in his brief, as a fact, the IME loaned him $30,000 which he then paid for mining expenses. However, neither the nomenclature of the "Loan Agreement" nor the agreement with the Commissioner binds this court as to the appropriate characterization of that transaction for tax purposes. That determination involves a conclusion of law, see Ortmayer v. Commissioner, 265 F.2d 848, 854 (7th Cir. 1959). Thus, while the parties are free to stipulate to the factual elements of the transactions, the court is not bound by the legal conclusions implied by the terminology utilized.

Since the "Gold for Tax Dollars" shelters for 1978 and 1979 were structured differently, they will be described and discussed separately.

THE 1978 Transaction

Facts. The 1978 plan provided that the IME would obtain for the taxpayer a mineral lease on certain gold-bearing land from Diversiones Internationales, S.A. (Diversiones). The taxpayer determined the volume of land covered by the lease by dividing the amount of the desired tax deduction by 1.60. In this case, Saviano sought a deduction of $40,000. Therefore, he obtained a lease on 25,000 cubic meters of auriferous gravel. IME did not charge the taxpayer any fee of auriferous gravel. IME did not charge the taxpayer any fee for its services in obtaining the lease nor did the taxpayer have to pay anything for the lease itself.*fn3 Under the lease, Diversiones was to receive 50% of the extracted gold after deduction of the development costs and government taxes. However, the lease did not require that Saviano ever extract any gold. But Diversiones could terminate the lease if Saviano discontinued or abandoned the mining operation. Even in the absence of such action, the lease would terminate in April of 1990 when the goldmining concession granted to Diversiones by the Panamanian government would expire.

The taxpayer was required to invest one quarter of the amount of the desired tax deduction which was then used to pay mining development expenses. In this case, Saviano paid the $10,000 through IME to Tuquesa Amalgamated, S.A. (Tuquesa) to perform certain development work. Appellant deducted that payment from his income taxes in 1978 as a mining expense under 26 U.S.C. § 616(a). That deduction is not at issue in this appeal.

The controversial aspect of this transaction involves the additional deduction of $30,000 claimed by the taxpayer as a mining expense. That amount was also paid to Tuquesa by IME on Saviano's behalf. However, that money did not come out of appellant's pocket. IME provided the $30,000 and Saviano claims it is attributable to him by virtue of a "Loan Agreement" between them. That contract provided that the money was lent to appellant on a non-recourse basis which meant that Saviano was not personally liable for its repayment. The "Loan Agreement" required that the $30,000 "be remitted to an approved contractor for development costs" related to Saviano's gold mine. IME's sole security was a general lien on appellant's mineral lease and the only source of repayment would be the proceeds from the gold mine. The "loan" was to bear interest at 10% per annum payable annually. However, any interest unpaid when due was to be treated as a new advance under the loan agreement. In addition to the interest, IME was to receive a 2% commission on the net amount of all gold sales. The loan agreement included a provision that if the accrued advances equaled the estimated market value of the gold, IME was permitted to extract and liquidate sufficient gold to reduce the "indebtedness" to an amount equivalent to 75% of the estimated market value. No other form of self-help was available to IME prior to termination of the agreement.

By claiming the $30,000 payment as his own, Saviano deducted a total of $40,000 as mining expenses on his 1978 income tax return. As a result, he claimed and received a tax refund of $15,865 for that year. However, the Commissioner disallowed the deduction for the mining expense. The taxpayer challenged that determination before the Tax Court. The only issue presented to the Tax Court on the cross-motions for summary judgment was the deductibility of the $30,000 payment which originated from IME. The Tax Court concluded that the liability of the taxpayer under the "Loan Agreement" was too contingent to be treated as a bona fide debt for tax purposes. We agree with that conclusion but utilize a slightly different analysis to reach it.

Legal Analysis. Appellant contends that the appropriate construction of the 1978 transaction is as follows: IME loaned him $30,000 and he paid that money through IME to Tuquesa as mining expense. Therefore, he argues that as a cash basis taxpayer he is entitled to deduct the mining expense in the year he paid it rather than in the year that he repays the debt, see Crain v. Commissioner, 75 F.2d 962 (8th Cir. 1935); McAdams v. Commissioner, 198 F.2d 54 (5th Cir. 1952). However, as noted previously, the question of whether appellant's arrangement with IME constituted a loan for tax purposes involves a legal conclusion and, therefore, we cannot accept his construction of the transaction without an independent analysis.

Initially, we note a few generalities regarding loans in the context of tax cases. It has been said that "in a true lending transaction, there exists the reasonable likelihood that the lender will be repaid in the light of all reasonably foreseeable risks," Gibson Products Company v. United States, 637 F.2d 1041, 1047 (5th Cir. 1981). The degree of risk involved in a typical loan is minimized by the lender's reliance on either the value of the personal commitment to repay or adequate security pledged to ensure repayment, see Brountas v. Commissioner, 692 F.2d 152, 157 (1st Cir. 1982). A capital contribution, on the other hand, is not secured by a promise of repayment but rather is invested at the risk of the business. Normally a capital contributor is entitled to a greater potential return than a lender and that possibility justifies the acceptance of a greater risk.

Nonrecourse loans eliminate the personal commitment of the borrower to repay the debt. In a commercial context such transactions are normally of limited risk because the lender relies on the value of the property securing the debt. As long as the value of the encumbered property exceeds the amount of the liability a reasonable businessman will treat the debt as a personal obligation since, otherwise, he risks losing his equity in the property, see Note, Federal Income Tax Treatment of Nonrecourse Debt, 82 Colum.L.Rev. 1498, 1514 (1982). The recent use of nonrecourse loans which are secured by speculative collateral has created a need for close scrutiny of these transactions.

If a financing arrangement is structured under which funds are advanced by an ostensible lender to an operator as ostensible borrower, who is to conduct exploration and development activities on an unexplored and unproven oil and gas prospect and in which recourse for repayment of the loan is limited to the oil and gas prospect as the burdened property, the transaction may be so lacking in the essential characteristics, economic realities, and financial expectations of a true lending transaction as to call for reclassification of the transaction as one other than a loan and ascribing to it consequences for tax purposes other than those growing out of a true loan. Fielder, "Drilling Funds and Nonrecourse Loans -- Some Tax Questions," 24th Southwestern Legal Foundation Institute on Oil and Gas Taxation 527, 528 (1973), quoted in Gibson Products, supra, 637 F.2d at 1041.

In Gibson Products, supra, and Brountas, supra, the courts analyzed those types of nonrecourse loans and concluded that they should not be treated as true loans for tax purposes. Both of those cases involved limited partnership tax shelters which were engaged in oil and gas exploration. The tax shelters were leveraged through the use of nonrecourse loans to the partnerships which were to be repaid solely from the proceeds of the oil and gas wells. The partners deducted from their income taxes as drilling expenses an amount greater than their actual investment because they attributed to themselves their pro rata share of the expenses which were paid through the nonrecourse loan. In both cases the courts concluded that the leveraged portion of the drilling expenses was not a proper deduction for the partners.

In Brountas the court analyzed the loan transaction and concluded:

The obligations here, unlike recourse notes, represented (as a practical matter) a promise to pay only if oil was found. They seem less like the repayment obligation that typically accompanies a recourse loan than like a device for sharing business risks -- the risks that accompany oil explorations. 692 F.2d at 158.

The court determined that nonrecourse loans were too contingent to be classified as a liability of the partnership for purposes of 26 U.S.C. § 752. Thus, the taxpayers' deductions were limited to that portion represented by their actual contributions to the partnership.

In Gibson Products, the court also analyzed the allocation of risks inherent in the nonrecourse loan transaction. After noting the significant risks assumed by the lender, the court stated:

The single most important factor dictating our conclusion that the transaction between Galaxy and McNeil/Midwest was not a true loan is the fact that the total combined assets of both joint venturers were not sufficient to pay the note on or before the maturity date, even if McNeil/Midwest was so inclined, absent production from any of the leases. 637 F.2d at 1047.

In that case the terms for the nonrecourse loan permitted the lender at its option to enter into a joint venture with the borrower with regard to any particular producing well and to obtain a 20% participating interest in it. The court noted that this provision deviated from the normal lender/borrower relationship:

Another characteristic of a true loan is that the "borrower, exclusively, is entitled to all of the entrepreneurial rewards and gains from the application and investment of the loan proceeds and the lender is entitled to none of them as such." Fielder, supra at 535 . . . . Here, instead of the borrower (McNeil/Midwest) being exclusively entitled to all of the entrepreneurial rewards and gains from application and investment of the loan proceeds, the ...

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