Wednesday, November 9, 2011

Frank Lyon Co. v. United States Case Brief (435 U.S. 561)

Frank Lyon Co. v. United States
FACTS
  • Lyon is a closely held AR corporation engaged in distribution of home furnishings, Frank Lyon was the majority shareholder; also served on Worthen’s board.  Worthen was an AR chartered bank and had begun planning a new bank in Little Rock.   
  • Union, Worthen’s competitor also was planning a new bank, both were to be built on adjacent sites.  There was a competition to see what bank would be built first. 
  • Worthen planned to finance build and own the proposed facility at a cost of $9M.  He abandoned the plan because he could not legally pay interest on any debentures that it might issue, and he would have to get permission from the federal reserve system, which he was told he would not be likely to get. 
  • Worthen had to find an alternative: a sale-and-leaseback arrangement, Worthen was required to possess an option to repurchase the leased property at the end of the 15th year at a set price, and the building had to be owned by an independent third party. 
  • Worthen obtained a commitment from NY Life to provide $7,140,000 in mortgage financing, conditioned upon approval of titleholder.  Lyon also made a proposal and was ultimately selected. 
  • 9/15, worthen begun construction (before Lyon was selected) 
  • Building was old by Worthen to Lyon as it was constructed, Worthen leased building back from Lyon.  Under the sales agreement, Worthen agreed to sell building to Lyon, Lyon agreed to buy it, piece by piece as it was constructed, for a total price not to exceed $7,640,000.  Lyon leased the building back to Worthen for a primary term of 25 years (with options to extend). 
  • The building lease was a “net lease”, Worthen was responsible for all expenses usually associated with the maintenance/repairs/taxes, etc.  Worthen also had option to repurchase.   
  • Construction financing agreement stated that City Bank agreed to lend Lyon $7M for construction, secured by a mortgage.  NY life agreed to purchase the note, security to be first deed of trust and Lyon’s assignment of interests in the lease. 
  • 12/69, building completed, Worthen took possession.  Lyon received permanent loan from NY Life and discharged interim loan from City Bank.  Actual cost of construction (excluding cost of land) exceeded $10M. 
  • Lyon filed federal income tax on accrual and calendar year basis.  On 1969 return, accrued rent from Worthen for December, asserted deductions one month’s interest to NY Life, 1 month’s depreciation on building, interest on construction loan from City Bank, and sums for legal/other expenses. 
  • Audit of 1969 return:  Commissioner determined that Lyon was not owner for tax purposes of any portion of the building and ruled “income and expenses are not allowable for Federal income tax purposes.” 
  • Commissioner also determined that sale and leaseback arrangement was a financing transaction in which Lyon loaned Worthen $500,000 and acted as a conduit for the transmission of principal and interest from Worthen to NY Life.
PROCEDURAL HISTORY
-District Court held that Lyon’s claimed deductions were allowable.  
-Court of Appeals reversed, determined that Lyon was not the true owner and therefore was not entitled to the claimed deductions.  Said benefits to Lyon were too unsubstantial to establish a claim to the status of owner for tax purposes.
The court of appeals looks at the agreement as an elaborate financing scheme designed to provide economic benefits to Worthen and a guaranteed return to Lyon.
ISSUE
Is Lyons the true owner and therefore entitled to the claimed deductions?
HOLDING

Yes.  So long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction that is adopted by the parties governs for tax purposes.
ANALYSIS
-Court looks at Helvering v. Lazarus & Co., stated that transaction between the taxpayer and the bank was in reality a mortgage loan and allowed the taxpayer depreciation on buildings transferred to a trustee and leased back to the taxpayer.
-Distinguishes it as involving only 2 parties (here there are 3).
-If anything went wrong in the later years of the lease, Lyon was primarily liable.  The obligation of the notes was Lyon’s, and he exposed his businesses well-being to this risk.
-To the extent that Lyon used its capital in this transaction, the less able he was to obtain financing for other needs.
-The fact that favorable tax consequences were taken into account by Lyon upon entering into the transaction is no reason to disallow those consequences.  
Tax laws affect the shape of nearly every business transaction.
-Appeals court urged that Worthen should be treated as the owner, speculated that options would be exercised.  Can not speculate.  
CONCLUSION
It is Lyon’s capital that is invested in the building according to the agreement of the parties, and it is Lyon who is entitled to depreciation deductions under 167.
---
DISSENT
The dissent looks at the economic relationship between Worthen and Lyons.  Says to look at the character and value of the lessor’s reversionary estate.

-Lyons has made only two significant risks, risk of Worthen’s insolvency, and risk that Worthen might not exercise option to purchase at or before the end of the 25 year term.
-Until Worthen has made a commitment either to exercise or not exercise his option, the Government is correct in the view that Lyons is not the owner for tax purposes.
-Since Worthen has unrestricted right to control the residual value of the property for a price which does not exceed the cost of its unamortized financing, he should be held to be the owner.

Class: Federal Income Taxation
Topic: Deductions and Losses

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