Justice Stevens Announces Retirement (4/9/10)

The papers announce today Justice John Paul Stevens' long expected retirement. He is a great judge and will be missed on the Supreme Court and throughout the country. 

I had first encountered Judge Stevens in arguments in the 7th Circuit Court of Appeals long ago.  I found him exceptionally sharp and willing to mix it up intellectually.  I eschew war stories here, however interesting they may be to me.  Being a tax lawyer and being concerned about the development of the tax law for the good of society as a whole, I can point to one particular matter in which his voice, spoken in dissent, should have been heeded.  That was in Frank Lyon Co. v. United States, 435 U.S. 561 (1978), a case that, in my opinion (I am not alone) was wrongly decided by the majority and has had disastrous consequences to the orderly development of the tax law over the years.  Therefore, I quote Judge Stevens' dissent in Frank Lyon in its entirety.  Although it would help to have read the majority opinion to knew the target he is shooting at, it is not critical.  If you have been more than casually involved in or observing the tax shelter industry over the years, you will understand why he is right:  The doctrine of economic substance developed on the shoulders of his dissent would have been a lot more coherent.

[*584]

DISSENT: MR. JUSTICE STEVENS, dissenting.

In my judgment the controlling issue in this case is the economic relationship between Worthen and petitioner, and matters such as the number of parties, their reasons for structuring the transaction in a particular way, and the tax benefits which may result, are largely irrelevant. The question whether a leasehold has been created should be answered by examining the character and value of the purported lessor's reversionary estate.

For a 25-year period Worthen has the power to acquire full ownership of the bank building by simply repaying the [*585] amounts, plus interest, advanced by the New York Life Insurance Company and petitioner. During that period, the economic relationship among the parties parallels exactly the normal relationship between an owner and two lenders, one secured by a first mortgage and the other by a second mortgage. n1 If Worthen repays both loans, it will have unencumbered ownership of the property. What the character of this relationship suggests is confirmed by the economic value that the parties themselves have placed on the reversionary interest.

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   n1 "[Where] a fixed price, as in Frank Lyon Company, is designed merely to provide the lessor with a predetermined fixed return, the substantive bargain is more akin to the relationship between a debtor and creditor than between a lessor and lessee." Rosenberg & Weinstein, Sale-leasebacks: An analysis of these transactions after the Lyon decision, 45 J. Tax. 146, 149 (1976).
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All rental payments made during the original 25-year term are credited against the option repurchase price, which is exactly equal to the unamortized cost of the financing. The value of the repurchase option is thus limited to the cost of the financing, and Worthen's power to exercise the option is cost free. Conversely, petitioner, the nominal owner of the reversionary estate, is not entitled to receive any value for the surrender of its supposed rights of ownership. n2 Nor does [*586] it have any power to control Worthen's exercise of the option. n3

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   n2 It is worth noting that the proposals submitted by two other potential investors in the building, see ante, at 564, did contemplate that Worthen would pay a price above the financing costs for acquisition of the leasehold interest. For instance, Goldman, Sachs & Company proposed that, at the end of the lease's primary term, Worthen would have the option to repurchase the property for either its fair market value or 20% of its original cost, whichever was the greater. See Brief for United States 8 n. 7. A repurchase option based on fair market value, since it acknowledges the lessor's equity interest in the property, is consistent with a lessor-lessee relationship. See Breece Veneer & Panel Co. v. Commissioner, 232 F.2d 319 (CA7 1956); LTV Corp. v. Commissioner, 63 T. C. 39, 50 (1974); see generally Comment, Sale and Leaseback Transactions, 52 N. Y. U. L. Rev. 672, 688-689, n. 117 (1977).
   n3 The situation in this case is thus analogous to that in Corliss v. Bowers, 281 U.S. 376, where the Court held that the grantor of a trust who retains an unrestricted cost-free power of revocation remains the owner of the trust assets for tax purposes. Worthen's power to exercise its repurchase option is similar; the only restraints upon it are those normally associated with the repayment of a loan, such as limitations on the timing of repayment and the amount due at the stated intervals.
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"It is fundamental that 'depreciation is not predicated upon ownership of property but rather upon an investment in property.' No such investment exists when payments of the purchase price in accordance with the design of the parties yield no equity to the purchaser." Estate of Franklin v. Commissioner, 544 F.2d 1045, 1049 (CA9 1976) (citations omitted; emphasis in original). Here, the petitioner has, in effect, been guaranteed that it will receive its original $500,000 plus accrued interest. But that is all. It incurs neither the risk of depreciation, n4 nor the benefit of possible appreciation. Under the terms of the sale-leaseback, it will stand in no better or worse position after the 11th year of the lease -- when Worthen can first exercise its option to repurchase -- whether the property has appreciated or depreciated. n5 And this remains true throughout the rest of the 25-year period.

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  n4 Petitioner argues that it bears the risk of depreciation during the primary term of the lease, because the option price decreases over time. Brief for Petitioner 29-30. This is clearly incorrect. Petitioner will receive $500,000 plus interest, and no more or less, whether the option is exercised as soon as possible or only at the end of 25 years. Worthen, on the other hand, does bear the risk of depreciation, since its opportunity to make a profit from the exercise of its repurchase option hinges on the value of the building at the time.
  n5 After the 11th year of the lease, there are three ways that the lease might be terminated. The property might be condemned, the building might be destroyed by act of God, or Worthen might exercise its option to purchase. In any such event, if the property had increased in value, the entire benefit would be received by Worthen and petitioner would receive only its $500,000 plus interest. See Reply Brief for Petitioner 8-9, n. 2.
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[*587]

Petitioner has assumed only two significant risks. First, like any other lender, it assumed the risk of Worthen's insolvency. Second, it assumed the risk that Worthen might not exercise its option to purchase at or before the end of the original 25-year term. n6 If Worthen should exercise that right not to repay, perhaps it would then be appropriate to characterize petitioner as the owner and Worthen as the lessee. But speculation as to what might happen in 25 years cannot justify the present characterization of petitioner as the owner of the building. Until Worthen has made a commitment either to exercise or not to exercise its option, n7 I think the Government is correct in its view that petitioner is not the owner of the building for tax purposes. At present, since Worthen has [*588] the unrestricted right to control the residual value of the property for a price which does not exceed the cost of its unamortized financing, I would hold, as a matter of law, that it is the owner.

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   n6 The possibility that Worthen might not exercise its option is a risk for petitioner because in that event petitioner's advance would be amortized during the ensuing renewal lease terms, totaling 40 years. Yet there is a possibility that Worthen would choose not to renew for the full 40 years or that the burdens of owning a building and paying a ground rental of $10,000 during the years 2034 through 2044 would exceed the benefits of ownership. Ante, at 579.
   n7 In this case, the lessee is not "economically compelled" to exercise its option. See American Realty Trust v. United States, 498 F.2d 1194 (CA4 1974). Indeed, it may be more advantageous for Worthen to let its option lapse since the present value of the renewal leases is somewhat less than the price of the option to repurchase. See Brief for United States 40 n. 26. But whether or not Worthen is likely to exercise the option, as long as it retains its unrestricted cost-free power to do so, it must be considered the owner of the building. See Sun Oil Co. v. Commissioner, 562 F.2d 258, 267 (CA3 1977) (repurchase option enabling lessee to acquire leased premises by repaying financing costs indicative of lessee's equity interest in those premises).
   In effect, Worthen has an option to "put" the building to petitioner if it drops in value below $500,000 plus interest. Even if the "put" appears likely because of bargain lease rates after the primary terms, that would not justify the present characterization of petitioner as the owner of the building.
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I therefore respectfully dissent.