                                                                                                                           Opinions of the United
1995 Decisions                                                                                                             States Court of Appeals
                                                                                                                              for the Third Circuit


7-24-1995

Nicholson v Commissioner IRS
Precedential or Non-Precedential:

Docket 94-7688




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                  UNITED STATES COURT OF APPEALS
                      FOR THE THIRD CIRCUIT

                           No. 94-7688

                   CHARLES E. NICHOLSON, JR. and
                      MARGARET K. NICHOLSON,
                                         Appellants
                                v.
             COMMISSIONER OF INTERNAL REVENUE SERVICE

                     On Appeal from a Decision
                  of the United States Tax Court
                       Tax Court No. 3343-92
                         T.C. Memo 1994-280


                       Argued: June 8, 1995
Before:   BECKER, NYGAARD, and ALITO, Circuit Judges

                 (Opinion Filed:       July 24, 1995)

                       ____________________

                    BARRY A. FURMAN, ESQ.
                    MARK S. HALPERN, ESQ. (Argued)
                    FURMAN & HALPERN, P.C.
                    401 City Avenue, Suite 612
                    Bala Cynwyd, PA    19004

                    Attorneys for Appellants

                    LORETTA C. ARGRETT
                    Assistant Attorney General
                    GARY R. ALLEN
                    RICHARD FARBER
                    THOMAS J. CLARK (Argued)
                    Tax Division
                    Department of Justice
                    Post Office Box 502
                    Washington, D. C. 20044

                    Attorneys for Appellee




                       ____________________

                       OPINION OF THE COURT


                                   1
                        ____________________



ALITO, Circuit Judge:


    The genesis of this appeal is a decision by the

Commissioner of the Internal Revenue Service ("the Commissioner")

to disallow certain deductions claimed by Charles and Margaret

Nicholson on their 1983, 1984, 1985, and 1986 tax returns

regarding computer equipment that Charles Nicholson acquired in

1983.   The Commissioner maintained that the Nicholsons were not

entitled to take the deductions because Charles Nicholson was not

"at risk" regarding a promissory note that he gave in partial

payment for the equipment.   Prior to a trial before the tax court

on the propriety of these deductions, the parties settled on

terms generally favorable to the Nicholsons.   The Nicholsons

subsequently filed a motion for litigation costs pursuant to

I.R.C. § 7430, arguing that the Commissioner's position in the

underlying proceedings was not "substantially justified."    The

tax court disagreed and refused to award litigation costs.   We

now reverse and remand for further proceedings.


                                I.0


0
 Because the underlying case was settled, there is no stipulation
 or other formal evidence pertaining to the transactions involved
in this case. See Nicholson v. Commissioner, T.C. Memo. 1994-280
 at 3 n.2 (1994). In this opinion, we generally rely on the tax
    court's findings of fact as they are neither challenged nor
  clearly erroneous. See Kenagy v. United States, 942 F.2d 459,
463 (9th Cir. 1991). Where necessary, we also rely on undisputed
                 evidence in the record on appeal.


                                 2
      This case involves the propriety of deductions that the

Nicholsons claimed in regard to the purchase of certain computer

equipment.      Nicholson0 acquired the equipment in 1983 from its

original purchaser, Equipment Leasing Exchange, Inc. ("ELEX").

Nicholson v. Commissioner, T.C. Memo. 1994-280 at 3 (1994).          ELEX

had purchased the equipment in 1983 for $362,168.         Id.   In order

to finance the purchase, ELEX obtained two nonrecourse loans from

the Hershey Bank ("the Bank").         Id.   ELEX subsequently leased the

equipment to the Milton Hershey School ("the School") for a term

of six years.         Id.   The lease provided for monthly rental income

of $7,478.      Id.     As a condition of the two loans, ELEX granted

the Bank a security interest in the computer equipment and the

lease.    Id.

      Nicholson purchased the lease and the equipment from ELEX for

$386,798.    Id.       In partial payment of the purchase price,

Nicholson executed and delivered to ELEX three promissory notes,

in the amounts of $17,500, $20,378, and $336,195.         Id.   The first

two notes were payable on March 15, 1984, and March 15, 1985,

respectively.         Id.    Both notes explicitly provided ELEX a right

of recourse against Nicholson personally in the case of default.

Id.    The third note required repayment in monthly installments of

$7,348.80.      Id. at 4.     Unlike the first two notes, however, the

third note was silent as to whether ELEX had a right of recourse


0
Both Charles Nicholson and his wife, Margaret Nicholson are
parties to this action by virtue of filing joint tax returns. All
the transactions at issue here, however, involve only Charles
Nicholson. For convenience, "Nicholson," when used in the
singular, refers only to Charles Nicholson.

                                       3
against Nicholson.    Id.   All three notes were secured by the

equipment and the lease, subject to the Bank's priority security

interest.    Id.

    In 1991, the Internal Revenue Service ("IRS") audited the

Nicholsons' 1983, 1984, 1985, and 1986 tax returns.     Initially,

the IRS District Director took the position that deductions

claimed by the Nicholsons with regard to the leasing activity

should be disallowed because the leasing activity was not an

activity entered into for profit since it had no economic or

business purpose.    Joint Appendix ("JA") at 62-65.   The

Nicholsons appealed this determination to the IRS Appeals Office.

Id. at 65.

    The Appeals Office agreed with the Nicholsons' argument that

the leasing activity did have an economic purpose.     Id.    However,

the Appeals Office sua sponte raised an alternative basis for

denying the Nicholsons' deductions.    The Appeals Office ruled

that Nicholson was not "at risk" within the meaning of I.R.C.

§465 as to the money borrowed under the third note.     Id.

Pursuant to section 465, an owner of depreciable property may

only deduct up to the total amount of the economic investment in

the property (i.e., the amount that is "at risk").
    Subsequently, on December 11, 1991, the Commissioner issued a

Notice of Deficiency to the Nicholsons.    Like the Appeals Office,

the Commissioner asserted that the Nicholsons' deductions were

barred by section 465's "at risk" requirement.    According to the

Commissioner, Nicholson was not "at risk" as to the third note 1)

because it was nonrecourse; 2) because ELEX did not borrow funds


                                  4
on a recourse basis from the Bank on its purchase of the

equipment and therefore ELEX would have no motive to pursue

Nicholson if he defaulted on the third note; and 3) because the

lease payments from the School were sufficient to cover the

installment payments required under the third note.    Id. at 64-

65; see id. at 121-25; Nicholson, T.C. Memo. 1994-280 at 7-8 n.7.

    The deficiencies were for income taxes for the calendar years

1983, 1984, 1985, and 1986 in the amounts of $3,660, $25,179,

$20,385, and $21,180 respectively.    Nicholson, T.C. Memo. 1994-

280 at 2.   The Commissioner also assessed an interest penalty

against the Nicholsons under I.R.C. § 6621(c), believing that the

underpayment was due to a tax-motivated transaction.    Id.

    The Nicholsons then filed a Petition for Redetermination with

the tax court on February 14, 1992.    On February 1, 1994, the

parties filed a Stipulation of Settled Issues ("the Settlement")

with the Tax Court that provided:
          The Parties hereby agree to the following
     settlement of the issues in the above-entitled case:

          1. It is agreed for purposes of settlement that
     petitioners' claimed losses with respect to their
     activity in the Hershey transaction during the years
     1983 through 1985 shall be disallowed subject to their
     deductibility as provided below;

          2. It is agreed for settlement purposes that
     petitioners were at risk as defined under I.R.C.
     Section 465 on the installment note in the amount of
     $336,195.00 with respect to their activity in the
     Hershey transaction beginning in 1986 and are entitled
     to suspended losses beginning in 1986;

          3. It is agreed for purposes of settlement that
     petitioners are required to include in taxable income
     for taxable year ended December 31, 1983 the amount of
     $18,300.00 which represents the amount of Schedule E


                                5
     loss disallowed on petitioners' investment in Hershey
     and Cyclops0 in 1983;

          4. It is agreed for the settlement that
     petitioners are required to include in taxable income
     for taxable year ended December 31, 1984 the amount of
     $42,024.00 which represents the amount of Schedule E
     loss disallowed on petitioners' investment in Hershey
     and Cyclops in 1983;

          5. It is agreed for the settlement that
     petitioners are required to include in taxable income
     for taxable year ended December 31, 1985 the amount of
     $72,341.00 which represents the amount of Schedule E
     loss disallowed on petitioners' investment in Hershey
     and Cyclops in 1983;

          6. It is agreed for the settlement that for the
     taxable year ended December 31, 1986, petitioners are
     entitled to deduct $81,723.00 with respect to their
     investment in the Hershey transaction as a suspended
     loss under I.R.C. Section 465;

          7. It is agreed for purposes of settlement that
     respondent concedes increased interest under I.R.C.
     Section 6621(c), formerly, 6621(d) for all issue years.


Id. at 4-5.

    The net effect of this Settlement was that the Nicholsons

were not able to take the deductions claimed in 1983, 1984, and

1985, but were able to carry these amounts forward and take them

as a deduction in 1986.0   In addition, the Nicholsons were not

liable for an increased interest penalty under section 6621(c).

The Settlement was therefore quite favorable to the Nicholsons.

0
 The "Cyclops" issue is an unrelated matter that was not
contested by the Nicholsons. According to the tax court, the
Commissioner conceded that it was not a significant issue. See
Nicholson, T.C. Memo. 1994-280 at 5 n.3.
0
 A taxpayer does not forfeit a deduction due to the operation of
section 465's "at risk" requirement. Rather the deduction
becomes suspended and may be taken when the taxpayer actually
becomes "at risk" for the amount of the deduction. See I.R.C.
§465(a)(2).


                                 6
Although the Commissioner's Notice of Deficiency alleged that

Nicholson owed over $70,000 for the 1983-1986 period, under the

Settlement the Nicholsons appear to have been assessed only a net

deficiency of between $2,500 and $4,000.0   Id. at 6 & n.4.

    The Commissioner's willingness to settle on these terms

appears due to two significant developments.   First, the

Commissioner changed her position on whether the third note

provided for recourse.   Although the Commissioner initially

maintained that because this note was silent as to recourse the

underlying loan was nonrecourse, the Commissioner abandoned this

theory because New Jersey law, which controls the terms of the

note, clearly provides that a note is presumptively recourse. Id.

at 7-8 n.7; JA at 125; see N.J. Stat. Ann. § 12A:9-505(2).

Second, after issuing the Notice of Deficiency, the Commissioner

learned that ELEX in 1986 had fully repaid its loan to the Bank.

JA at 125; Brief for the Appellee ("Comm. Br.") at 20 n.7.     Thus,

the Commissioner conceded that Nicholson was at risk as of 1986

because ELEX would have certainly exercised its right of recourse

against Nicholson for any default by Nicholson on the third

note.0

0
 Although not clear from the Settlement or the record, it seems
that the only benefit that the Commissioner received from the
Settlement was that the Nicholsons had to pay interest (but not a
penalty) on the deductions that they claimed for 1983, 1984, and
1985 until they were able to take these deductions in 1986. In
other words, because the Settlement disallowed the Nicholsons'
deductions in 1983, 1984, and 1985, but allowed them to carry
these deductions forward and take them in 1986, the Nicholsons
owed interest for having use of the money for a period when they
were not entitled to it.
0
 Nicholson, however, did not concede in the Settlement that he
was not "at risk" in 1983, 1984, and 1985.

                                7
    Following the Settlement, the Nicholsons filed a motion to

recover their litigation costs pursuant to I.R.C. § 7430.     After

surveying the background of this litigation, the tax court began

its analysis by observing that in order to be entitled to an

award of costs, the Nicholsons needed to demonstrate that they

were a "prevailing party" as defined by section 74300 and that

they complied with that provision's procedural requirements.0

Nicholson, T.C. Memo. 1994-280 at 6.   Thus, the Nicholsons needed

to establish that:
     (1) [t]hey exhausted all administrative remedies, (2)
     they met the net worth requirement of section
     7430(c)(4)(A)(iii), (3) they ha[d] substantially
     prevailed with respect to the amount in controversy or
     most significant issues, and (4) the position of the
     United States was "not substantially justified."

0
I.R.C. § 7430(a) provides for the award of "reasonable
administrative costs" and "reasonable litigation costs" to a
"prevailing party" in connection "with the determination . . . of
any tax." I.R.C. § 7430(c)(4)(A) defines a "prevailing party" as
a party:

       (i) which establishes that the position of the United
     States in the proceedings was not substantially
     justified,

       (ii) which--

            (I) has substantially prevailed with respect to
          the amount in controversy, or

            (II) has substantially prevailed with respect to
          the most significant issue or set of issues
          presented, and

        (iii) [is an individual whose net worth does not
      exceed $2,000,000 at the time the civil action was
      filed].
0
 I.R.C. § 7430(b) requires that an award of litigation costs
"shall not be awarded . . . unless the court determines the
prevailing party has exhausted the administrative remedies
available to such a party within the Internal Revenue Service."

                                8
Id. (emphasis in original).

    The tax court found that the Nicholsons had met the first two

conditions.    Id.   Turning to the third condition, the tax court

noted that the Commissioner's brief merely stated that the

Nicholsons "may in fact be able to prove that they meet the

alternative requirement of that condition namely the amount in

controversy or the most significant issues."     Id.   Although the

tax court appeared to indicate that the Nicholsons had satisfied

this condition by virtue of the small net deficiency assessed

against them under the Settlement and the Commissioner's apparent

waiver, the court decided not to resolve this issue because it

believed that the fourth condition was determinative.     Id.

    As to the fourth condition, the tax court noted that a

determination of whether the Commissioner's position was not

substantially justified depends upon an
     examination of all the facts and circumstances to
     determine if that position had a reasonable basis in
     law and fact. Price v. Commissioner, [T.C. Memo. 1995-
     187 at 3 (1994)]. Petitioners bear the burden of
     proof. [Tax Court] Rule 232(e); Estate of Wall v.
     Commissioner, 102 T.C. 391, 393 (1994).


Id. at 7.     The tax court therefore focused its attention on the

arguments that each party had advanced in the underlying

proceeding on the issue of whether Nicholson was at risk on the

third note.    As noted above, the Commissioner, after conceding

that the third note provided ELEX with the right of recourse

against Nicholson personally, see id. at 7-8 n.7, nevertheless

continued to assert that Nicholson was not "at risk" because (1)

the obligations of ELEX to the Bank were nonrecourse and (2) the


                                  9
lease payments from Hershey nearly offset Nicholson's obligation

to ELEX.   In particular, the Commissioner relied on a number of

cases in which these two elements were present and taxpayers were

found not to be "at risk."   Id. at 7.   The Nicholsons, on the

other hand, maintained that these two elements were not by

themselves dispositive in the "at risk" analysis.    Id. at 8.

Rather, the Nicholsons argued that ELEX would have exercised its

right of recourse on the third note if the transaction had become

unprofitable.   Id.

    The tax court found that the Commissioner's position was

substantially justified. The tax court wrote:
          [The Commissioner] relies on the galaxy of cases
     where the two elements relied upon by [the Nicholsons]
     were present and where the taxpayers therein were held
     not to be at risk. Those cases, as well as other cases
     cited by [the Commissioner], are analyzed in some
     detail in Thornock v. Commissioner, [94 T.C. 439, 453
     (1990)], and Wag-A-Bag Inc. v. Commissioner, [T.C.
     Memo. 1992-581 (1994)], which analyses reveal that
     those cases involved elements in addition to the
     presence of nonrecourse obligations at an earlier stage
     and offsetting payments. Thus, the message which such
     cases convey is murky at best. In any event, we are
     not prepared to say that they do not furnish some basis
     for [the Commissioner's] position on the substantive
     issue involved herein.


Id. at 8-9. The court then concluded:
          In short, the two elements upon which the parties
     herein have focused their arguments are not
     automatically dispositive of the "at risk" issue. Two
     non per se elements do not amount to one per se element
     either for or against [the Nicholsons]. To be sure, it
     is entirely possible that, had the instant case gone to
     decision on the substantive risk issue, we would have
     resolved that issue in favor of [the Nicholsons]. But
     that result would not have necessarily entitled
     petitioners to recover litigation costs under section
     7430. It is clearly established that the fact that the
     respondent loses a significant issue, whether by


                                10
     concession or after trial, is not determinative that
     her position was reasonable. Price v. Commissioner,
     supra.

                                * * *

          The long and the short of the matter is that,
     taking into account all the facts and circumstances
     herein, we are not persuaded that [the Nicholsons] have
     carried their burden under section 7430.


Id. at 9, 11.

    This appeal followed.


                                 II.

    We begin with the main issue of contention between the

litigants.    In order to demonstrate that the position taken by

the United States was not "substantially justified," the

Nicholsons have the burden of showing that the government's

position was not "justified to a degree that could satisfy a

reasonable person" or had no "reasonable basis both in law and

fact . . . ."    Lennox v. Commissioner, 998 F.2d 244, 248 (5th

Cir. 1993) (quoting Pierce v. Underwood, 487 U.S. 552, 563-565

(1988)); see 26 C.F.R. § 301.74305-5(c); see also Rickel v.

Commissioner, 900 F.2d    655, 666 (3d Cir. 1990) (rejecting a

taxpayer's claim for costs award where "Commissioner's position

could be deemed as reasonably supported in the case law").       The

Nicholsons' burden is also increased by this court's standard of

review:   the tax court's denial of a taxpayer's motion for an

award of costs under section 7430 is reviewed for an abuse of

discretion.     Rickel, 900 F.2d at 666; Accord Pierce, 487 U.S.




                                  11
563-65 (abuse of discretion review proper for awards under the

Equal Access to Justice Act).

    We will structure our discussion of this issue as follows. In

Part II.A., we will analyze I.R.C. § 465, the code provision upon

which the Commissioner relied in assessing the deficiency against

the Nicholsons.   In Part II.B., we will examine the position

taken by the Commissioner in the underlying litigation (i.e., the

theory advocated by the Commissioner in support of the deficiency

assessment).   Finally, In Part II.C., we will determine whether

the Commissioner's position was reasonable in light of the

substantive law and consequently whether the tax court abused its

discretion in denying the Nicholsons' motion for costs.



    A.   I.R.C. § 465 limits the ability of taxpayers to claim

deductions resulting from the ownership of depreciable property.

Section 465 was enacted because of the proliferation of tax

shelters in the 1970's.   Before the enactment of section 465,

investors could take advantage of quick depreciation rules plus

the deductibility of interest on nonrecourse debt to generate

large "losses" in order to offset personal income.0

0
Professor Chirelstein provides the following lucid explanation
of the way in which these tax shelters operated:

          In conventional form, the shelter consists of
     highly leveraged real estate in which individual
     investors participate as limited partners. The limited
     partners make initial cash payments to the shelter
     promoters which are largely absorbed by commissions,
     fees and similar charges, while the cost of the
     property itself is financed through a mortgage loan
     from a bank, insurance company or other institution.
     The loan is nonrecourse, but, under the Crane rule, the


                                12
    Section 465 attacks these practices directly.     Pursuant to

section 465, a taxpayer may only take deductions up to the amount

"at risk" in the activity.   A taxpayer is considered to be at

risk for the amount "contributed" to the activity and for the

amount of money "borrowed" for use in the activity.    I.R.C.

§465(b)(1).   However, for purposes of section 465, an amount is

considered borrowed only if the taxpayer is either "personally

liable for repayment" or has pledged other personal property as


     limited partners are entitled to treat the borrowed
     amount as if it were a personal loan and hence, to
     include the indebtedness in basis. Rents received by
     the partnership are then expected to cover mortgage
     principal and interest requirements plus management
     fees. Sometimes, but not always, there is a small
     annual cash return to the investors.

          [T]he combination of (a) accelerated depreciation
     and (b) deductible interest on the nonrecourse mortgage
     loan inevitably generates substantial "losses" during
     the earlier years of the enterprise. Such losses are
     of course tax artifacts. If true economic depreciation
     were substituted for accelerated depreciation, then,
     usually, the enterprise would operate at or close to a
     break-even level--there would be no deductible "loss"
     to report--and the investment from the standpoint of
     the limited partnership would have little purpose. The
     same result would arise if (while leaving accelerated
     depreciation untouched) otherwise deductible interest
     were deferred or disallowed as under Code § 265(a)(2).
     In fact, however, nether limitation was imposed.
     Instead, high-bracket taxpayers were enabled
     (encouraged) to combine tax-exempt income with tax-
     deductible borrowing and, by so doing, to reduce their
     taxable income to a minimum. The "loss" resulting from
     the shelter investment would be offset against income
     from other sources (chiefly personal services), even
     though the taxpayer himself would have lost little or
     nothing in economic terms.

Marvin A. Chirelstein, Federal Income Taxation 259-60 (6th ed.
1991).


                                13
"security for the borrowed amount (to the extent of the net fair

market value of the taxpayer's interest in such property)."    Id.

at § 465(b)(2)(A) and (B).   Section 465 also contains a catch-all

provision that provides:
     Notwithstanding any other provision of this section, a
     taxpayer will not be considered at risk with respect to
     the amounts protected against loss through nonrecourse
     financing, guarantees, stop loss agreements, or other
     similar arrangements.


Id. at § 465(b)(4) (emphasis added).   The Commissioner--conceding

that the note that Nicholson gave to ELEX was recourse and

moreover, that he was not protected by any guarantees or stop

loss agreements--argued in the proceedings below that the

peculiarities of the leasing agreement involved "other similar

arrangements" sufficient to render him immune from any risk.

    Although the Internal Revenue Code does not define the term

"other similar arrangements," the meaning of this phrase has been

addressed by several other courts of appeals.   The majority of

these courts have applied the "economic reality" test to

determine whether a taxpayer is protected from loss by "other

similar arrangements."   Under this approach, a transaction is

deemed not "at risk" if it is structured "to remove any realistic

possibility that the taxpayer will suffer an economic loss if the

transaction turns out to be unprofitable."   American Principals

Leasing Corp. v. United States, 904 F.2d 477, 483 (9th Cir.

1990).   See also Waters v. Commissioner, 978 F.2d 1310, 1315 (2d

Cir. 1992), cert. denied, 113 S. Ct. 1814 (1993); Young v.
Commissioner, 926 F.2d 1083, 1088 n.11 (11th Cir. 1991); Moser v.



                                14
Commissioner, 914 F.2d 1040, 1048 (8th Cir. 1990).   The Sixth

Circuit, by contrast, has employed the "worst case scenario" test

to determine whether a taxpayer is protected from loss by an

"other similar arrangement."   Martuccio v. Commissioner, 30 F.3d

743, 749 (6th Cir. 1994).   This test is more favorable to

taxpayers than the economic reality test, as it holds that a

taxpayer is "at risk" unless there are no circumstances in which

he could suffer a loss in the transaction.   Id.   Although this

court has yet to address this issue, we agree with the

Commissioner that the reasonableness of her position should be

evaluated under the economic reality test as it has been adopted

by the overwhelming majority of the courts to address the issue.

Whether or not we would adopt in a case in which we were required

to decide whether certain deductions were proper, we believe that

if the Commissioner satisfied the economic reality test here, her

position had a reasonable basis in law.0

    B.   We now turn to the position taken by the Commissioner in

the proceedings below.0   As noted, the Commissioner asserted that

Nicholson was not "at risk" on the amount of the third note
0
 We emphasize that we do not purport to adopt the economic
reality test as the law of this circuit.
0
 In this context, the "position of the United States" is the
position taken by the Commissioner in the underlying tax court
proceeding and, with respect to an administrative proceeding
before the IRS, the position taken by the IRS as of the earlier
of the date of the Notice of Deficiency or the date of receipt by
the taxpayer of the Notice of Decision by the Appeals Office.
I.R.C. § 7430(c)(7). Because the record does not show that the
Nicholsons received a Notice of Decision by the Appeals Office,
the inquiry as to the position asserted by the United States
begins at the time that the Nicholsons receive the Notice of
Deficiency.



                                 15
because the structure of the leasing arrangement was an "other

similar arrangement" within the meaning of section 465(b)(4).

After abandoning the position that the third note was

nonrecourse, the Commissioner relied on two separate aspects of

the leasing agreement to support this argument.   First, the

Commissioner pointed to the fact that the rental payments due

from the School on its lease were almost exactly the same amount

as the monthly payments Nicholson owed ELEX under the terms of

the third note.   Second, the Commissioner pointed to the fact

that the loan between the Bank and ELEX was nonrecourse and that

the Bank had a priority security interest on the equipment.

According to the Commissioner, these two factors were sufficient

to demonstrate that Nicholson was not "at risk" on the third note

for the following reasons:
          It is evident, therefore, that the School was the
     ultimate obligor for the payments that would be used
     for the purchase of the computer equipment and that
     would be received by the Bank, as the ultimate obligee.
     In other words, at the end of the day the School owed
     rent to taxpayer, who would use those rental payments
     to satisfy his obligations on the note to ELEX, which,
     in turn, would use those payments to satisfy the
     obligations to the Bank. Taxpayer was merely the
     conduit through which payments made by the School were
     funnelled to their ultimate destination, the Bank. If
     the School, the end user, ever stopped paying rent to
     taxpayer, then the Bank would not be paid. Since
     ELEX's note to the Bank was nonrecourse, the Bank's
     sole remedy would be to foreclose on the computer
     equipment. In that event, ELEX would have suffered no
     economic loss, and therefore would have no incentive to
     pursue the taxpayer for payment on his $366,195 note.
     In these circumstances, it was reasonable to maintain,
     as the Commissioner did until the settlement of this
     case, that there was no "realistic possibility" that
     the taxpayer would suffer a loss on that note.




                                16
Comm. Br. at 17 (emphasis added).      The Commissioner, however, did

concede in the underlying proceedings that even under this theory

that Nicholson was "at risk" on the third note after 1986, when

ELEX paid off its loan from the Bank.      Id. at 20 & n.7.



    C.   In light of this understanding of section 465 and the

theory underlying the Commissioner's position, we now assess the

reasonableness of her position.    We find that the Commissioner's

position is not supported in law or fact and is therefore

unjustified.

    We understand the Commissioner's theory as follows.       Should

the School default on the lease or refuse to meet its contractual

obligations on account of a dispute regarding the computer

equipment--both realistic possibilities in any business

transaction like this one--Nicholson would be unable to pay ELEX.

ELEX in turn might not then pay the Bank, causing the Bank to

respond by foreclosing on the equipment itself, as it had no

right of recourse against ELEX.    With this much, we agree.

However, the Commissioner goes on to argue that ELEX would not

pursue Nicholson for his failure to repay the third note because

ELEX suffered no "economic loss," as the Bank was forced to

foreclose on the equipment rather than sue ELEX directly.      We

find no support in logic for this argument.      Although ELEX could

conceivably suffer no economic loss as a result of Nicholson's

inability to make his payments under the third note, ELEX would

still have incentive to sue Nicholson and obtain the outstanding

balance of the note (which could amount to several hundred


                                  17
thousand dollars).0   Thus, the Commissioner's theory does not

provide any reason why ELEX would fail to act like an ordinary

creditor in this situation and enforce the outstanding obligation

owed to it by Nicholson.

    Furthermore, the Commissioner's critical assumption that ELEX

would suffer no "economic loss" is without foundation in the

record.   ELEX could have chosen to make larger payments than

required under the terms of its loan from the Bank in order to

pay-off the loan early.    Indeed, this appears to have happened

0
At oral argument, counsel for the Commissioner asserted, for the
first time, that ELEX would not want to enforce the terms of the
third note in the case of a default by Hershey and Nicholson
because this would give ELEX an unfavorable reputation in the
community and therefore ELEX would be unable to engage in this
type of transaction in the future. Because this argument was
neither presented to the tax court nor in the Commissioner's
brief, we need not consider it on appeal. See Lim v. Central
DuPage Hosp., 871 F.2d 644, 648 (7th Cir. 1989) ("oral argument
in this court . . . [is] too late for advancing new (or what is
the same thing, reviving abandoned" argument)). Moreover, there
is absolutely no support in the record for this assertion. As
the tax court observed in Powers v. Commissioner, 100 T.C. 457,
473 (1993), the Commissioner's position "lack[s] a reasonable
basis in fact and law" when it has "no factual basis and [the
Commissioner has] made no attempt to obtain information about the
case before adopting the position."

    We also note that counsel for the Nicholsons persuasively
responded that ELEX would have incentive to pursue Nicholson for
the outstanding value of the third note in the case of default.
First, a portion of the third note represents the profits due to
ELEX from the sale of the equipment and lease, and ELEX would
certainly be entitled to this amount. Second, in order to
maintain its ability to borrow on a nonrecourse basis from the
Bank, ELEX would have incentive to act as an agent for the Bank
and make sure that the Bank had not lost money as a result of the
transaction. In the case of quickly obsolescent property such as
computer equipment, the Bank's security interest in the equipment
could easily be insufficient to cover the outstanding balance of
its loan to ELEX. Thus, ELEX would have incentive to sue
Nicholson for the shortfall.


                                 18
here, as ELEX prepaid the loan from the Bank.    In such a case,

the proceeds from the Bank's repossession and sale of the

equipment (minus the Bank's priority security interest) would not

necessarily be sufficient to cover ELEX's extra payments.     Thus,

the record provided the Commissioner with no basis for presuming

that ELEX would not suffer any economic loss should the lease

have become unprofitable.   See Lennox, 998 F.2d at 248-49

(Commissioner's position must be supported by record evidence in

order to be substantially justified).

    The inadequacy of the Commissioner's position is apparently

due to her failure to properly develop the case against the

Nicholsons before issuing the Notice of Deficiency.0   The

Commissioner cannot have a "reasonable basis in both fact and law

if it does not diligently investigate a case."    Powers v.

Commissioner, 100 T.C. 457, 473 (1993); see United States v.

Estridge, 797 F.2d 1454, 1458 (8th Cir. 1986) (award for

litigation costs granted where Commissioner did not diligently

investigate).   When issuing the Notice of Deficiency, the

Commissioner believed--incorrectly--that the third note between

ELEX and Nicholson was nonrecourse because it was silent on its

face as to recourse while the other two notes explicitly provided

for recourse.   See JA at 125.   Even a cursory analysis of New

0
The Commissioner argues that anything that happened before the
Notice of Deficiency is irrelevant to this case because under
I.R.C. § 7430(c)(7), the position of the Commissioner is
determined only after the date of the Notice of Deficiency. We
disagree. As the Fifth Circuit explained in Lennox, 998 F.2d at
248, the sufficiency of the position taken by the Commissioner
after the Notice of Deficiency must be analyzed in the context of
what caused her to take that position.


                                 19
Jersey law would have revealed the deficiency in this position.

See N.J. Stat. Ann. § 12A:9-505(2).    Given the logical weakness

of the theory eventually relied upon by the Commissioner, we are

skeptical that the Notice would have been issued had the

Commissioner been accurately appraised of New Jersey law.

    Moreover, the Commissioner's position at the time of the

Notice of Deficiency with regard to the Nicholsons' 1986 tax

deduction was clearly not justified.   In the Notice, the

Commissioner maintained that Nicholson was not at risk in 1986.

However, the Commissioner later conceded that because ELEX paid

off the Bank in 1986, Nicholson was "at risk" at that time.    The

Commissioner could have discovered this fact had she adequately

investigated the case before issuing the Notice.0   See Portillo

v. Commissioner, 988 F.2d 27, 29 (5th Cir. 1993) (ruling that a

Notice of Deficiency without any factual foundation is "clearly

erroneous as a matter of law").

    The Commissioner seeks to overcome these deficiencies and

justify the reasonableness of her position by citing a number of

cases in which courts found that a taxpayer who borrowed money as

part of a complex leasing transaction was not "at risk" for the

borrowed amount.   See Waters, 978 F.2d at 1317; Young, 926 F.2d
at 1088 n.11 (11th Cir. 1991); Moser, 914 F.2d at 1048; American

Principals Leasing Corp., 904 F.2d at 483; see also Thornock v.


0
The Commissioner can hardly blame the Nicholsons for not
providing her with this information because the "at risk" issue
was raised by the Appeals Office sua sponte, and no further
investigation appears to have been conducted before the Notice
was issued. JA at 65-66.


                                  20
Commissioner, 94 T.C. 439 (1990); Wag-A-Bag, Inc. v.

Commissioner, T.C. Memo. 1992-581 (1992).   The Commissioner

correctly notes that in these cases, the two factors eventually

relied upon by the Commissioner were relevant to the

determination of whether an amount was "at risk."   However, the

determinative factor in these cases was that the parties, through

the use of nonrecourse financing and lease assignments, were able

to create a circular web of offsetting liabilities, thereby

effectively removing risk from the taxpayer claiming the

deduction.   See Waters, 978 F.2d at 1317 ("circular, matching

payment obligations"); Young, 926 F.2d at 1083 ("circular

sale/leaseback transactions"); Moser, 914 F.2d at 1049 ("circular

nature of the arrangement" and "offsetting bookkeeping entries");

American Principals Leasing Corp., 904 F.2d at 483 ("circular

obligations" and "chain of payments"); see generally Thomas A.

Pliskin, How Circular Transactions and Certain Interests of

Lenders Affect Amounts of Risk, 12 J. Partnership Tax. 54, 63-66

(1995) (arguing that the courts in Moser, Young and American

Principals Leasing correctly determined the taxpayers were not at

risk because circular chains of payments were used to protect the

taxpayers from loss).

    A brief example (drawn from Moser, supra) will clarify the
type of transaction at issue in the cases relied upon by the

Commissioner and provide a contrast with the type at issue here.

Assume A borrows money on a nonrecourse basis from a bank and

uses that money to buy some equipment.   A leases that equipment

to L and the bank then takes a security interest in that


                                21
equipment and the lease.   A sells the equipment to B, subject to

the existing liens and lease and takes a promissory note from B.

B in turn sells to taxpayer, T, for the same price that it bought

the equipment from A.   Like before, B accepts a promissory note

from T as payment.   T, in turn, leases the equipment back to A in

exchange for payments equal to those B owes to A.

    Under this arrangement, the payments A owes to T are

identical to the payments T owes to B, which in turn are

identical to the payments B owes to A.    T, as the "owner" of the

equipment, would be entitled to take deductions for depreciation

of the property (except for the existence of section 465). Should

any party assert a claim against another party for nonpayment, it

could expect an equal claim asserted against it. See Pliskin,

supra, at 62-66, 72 (diagramming this type of transaction).

Here, by contrast, there was no circular chain of payments.

Instead, the failure of Nicholson to meet the terms of the third

note would trigger a demand for payment by ELEX; Nicholson, on

the other hand, would have no corresponding claim against ELEX or

the Bank.

    Given this analysis, we are forced to conclude that the tax

court abused its discretion in ruling that the Commissioner's

position was substantially justified.    As noted, the tax court

did not seek to analyze whether Nicholson would suffer an

economic loss if the lease became unprofitable.    The court simply

found that because two of the factors present in this case were

also present in several of the cases finding taxpayers not "at

risk," the Commissioner's position was substantially justified.


                                22
Thus, the court did not seek to determine why the taxpayers in

these cases were found not "at risk."   Had the court conducted

the required economic reality test, it would have found that

these two factors were not dispositive in this transaction

because ELEX had incentive to sue Nicholson in the case of a

default on the third note.


                                 III.

    The only remaining issue therefore is whether to remand for a

determination of whether the Nicholsons substantially prevailed

in the underlying case, a necessary condition for the award of

litigation costs under section 7430.0   The tax court, as noted,

did not rule on this issue.   We do not, however, believe such a

remand is necessary.

    On appeal, the Commissioner has not attempted to sustain the

tax court's ruling on the alternative basis that the Nicholsons

did not substantially prevail.    Nor did she press this issue

before the tax court.   See supra page 9.   Rather, the sole

argument advanced before this court by the Commissioner was that

her position was "substantially justified."    Moreover, the great

disparity between the deficiency assessed by the Commissioner and

the Nicholsons' tax liability after the Settlement reflected in

the record indicates that the Nicholsons have "substantially

prevailed with respect to the amount in controversy."    I.R.C.

0
Pursuant to section 7430(c)(4)(A)(ii), a party substantially
prevails by either substantially prevailing "with respect to the
amount in controversy" or "with respect to the most significant
issue or set of issues presented."


                                 23
§7430(c)(4); see Marranca v. United States, 615 F. Supp. 25, 27

(M.D. Pa. 1985) (government conceded that taxpayers

"substantially prevailed with respect to the amount in

controversy" after parties reached settlement reducing initial

assessment by nearly 75%).   Thus, we conclude that the Nicholsons

have met all the requirements of section 7430, and we therefore

remand this case to the tax court for a determination of the

costs and fees to which they are entitled.


                               IV.

    For the foregoing reasons, the tax court's order denying the

Nicholsons' petition for costs is reversed and remanded for

proceedings consistent with this opinion.




                                24
