The Tenth Circuit upheld a Tax Court decision that a taxpayer did not have a profit motive in his purchase and leases of solar lenses intended to generate electricity and sustained the IRS’s disallowance of deductions for depreciation under Sec. 167 and credits for solar energy under Sec. 48.
Facts: Preston Olsen, the taxpayer, entered a lens-sale-and-leaseback arrangement with Neldon Johnson. The lenses were to be used in a new system that would generate electricity by heating a liquid to generate steam and drive a turbine. Nine years after Olsen’s initial investment, of the 19 towers that had been planned to be built to hold the lenses, only one tower was completed with lenses installed.
Olsen initially bought the lenses from International Automated Systems (IAS) in 2009 and later from RaPower3 LLC (2011–2014), both owned by Johnson, making a down payment of 30% of the lens price with the remaining amount due in installments five years after the system began producing revenue. Through his own company, PFO Solar LLC, Olsen then leased the lenses to LTB, another company owned by Johnson, who would, Olsen was told, place the lenses in service and operate them. Once the system began producing revenue, PFO Solar would receive $150 in income per year from LTB for each of the lenses. However, during PFO Solar’s lease arrangement with LTB, the system never earned any income or produced any commercially viable amount of electricity.
Even though the lease arrangement did not earn income, Olsen, through PFO Solar, claimed depreciation deductions (Sec. 167(a)) and solar energy credits (Sec. 48(a)(3)) for tax years 2009 through 2014, which offset his ordinary wage income and led to almost no tax liability on his individual income tax returns for those years. The amounts claimed for these benefits were based on the full purchase price of the lenses and not the 30% down payment that was actually paid.
The IRS issued a notice of deficiency to Olsen disallowing the depreciation deductions and solar energy credits claimed for tax years 2010 through 2014. Olsen petitioned the Tax Court, which noted that Olsen’s was one of more than 200 cases involving Johnson’s investors, that Johnson’s operation had been investigated by the IRS as a tax shelter, and that the Department of Justice had obtained an injunction against it (Olsen, T.C. Memo. 2021-41). The court also noted that in his promotional materials to investors, Johnson suggested they could “zero out” their federal tax liability and that he referred Olsen and others to tax preparers who helped them do so.
The Tax Court held that Olsen was not entitled to the deductions and credits because he was not engaged in a trade or business or a rental activity with respect to the lenses. Neither was he able to claim a deduction for the production of income under Sec. 212, the Tax Court held, since he did not demonstrate a profit motive. In addition, the Tax Court held, Olsen’s losses were passive, against which he had no passive income to offset (Olsen, slip op. at 42).
Olsen appealed the Tax Court’s decision to the Tenth Circuit.
Issues: For a taxpayer to claim a depreciation deduction, property placed in service during the year needs to be used in a trade or business or for the production of income (Secs. 167(a)(1) and (2)). The taxpayer must also show a profit-seeking motive behind the deduction (see Wiles, 312 F.2d 574 (10th Cir. 1962)). The motive, though, needs to be more than incidental (see Cannon, 949 F.2d 345 (10th Cir. 1991)). Olsen needed to show that profit was the dominant or primary objective of the venture. Intent surrounding profit motive is based on the objective facts surrounding the case and not on the taxpayer’s subjective intent (see Nickeson, 962 F.2d 973 (10th Cir. 1992)).
The Tax Court had used the nine nonexclusive factors of Regs. Sec. 1.183-2(b) to analyze whether Olsen had a profit motive. The Tenth Circuit also applied the Nickeson test, under which it analyzed Olsen’s claimed profit motive using five characteristics the Tenth Circuit identified in Nickeson that demonstrate when a taxpayer’s activity lacks a profit motive.
The nine nonexclusive factors of Regs. Sec. 1.183-2(b) are: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer’s history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, that are earned; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation.
In applying these factors, the Tax Court had held that Olsen lacked a profit motive. First, he lacked sufficient business records (i.e., bank account, business plan, marketing strategy, etc.) to carry on PFO Solar as a profit-seeking entity. Furthermore, Olsen kept buying lenses even though he stated that the items “always look[ed] a little like junk.”
The Tax Court also determined that Olsen lacked the requisite expertise in the field and had not consulted experts in the field. Although he claimed he visited the site quarterly, he submitted no travel logs or documentation that he did so. Olsen conceded that his business activities were limited to “writing annual checks to buy lenses, renewing the limited liability company each year, maintaining copies of the agreements, and deciding annually how many lenses to buy.”
As Olsen testified, he did not expect the lenses to appreciate, stating that they were essentially “worthless” and that it was “very unlikely” the lenses would produce electricity at a commercial rate. The court also rejected Olsen’s claim that IAS was profitable, thereby creating a profit motive for PFO Solar, because IAS’s profits came from selling lenses to taxpayers like Olsen. Therefore, even if IAS was profitable, PFO Solar would earn only $150 per lens, assuming LTB generated revenue. The court further noted that even though a “commercially usable volume of electricity” was never produced, Olsen continued to buy more lenses even after the seller breached its promise to place the lenses in service.
In addition, weighing against a finding of profit motive was the fact Olsen had substantial income from other sources and used the losses from solar activity to offset them. The court also stated that although Olsen had no personal or recreational motive for engaging in the solar activity, this did not undermine the Tax Court’s conclusion that he had a tax-avoidance motive for the activity. After looking at all the evidence, the Tenth Circuit concluded that the Tax Court did not clearly err in applying the nine regulatory factors.
The Tenth Circuit then applied the Nickeson test. Under this test, the five common characteristics of activities suggesting the absence of a profit motive are: (1) the marketing materials focus on expected tax benefits; (2) the taxpayer buys the item for a grossly inflated price without negotiating; (3) the taxpayer does not ask the seller about potential profitability; (4) the taxpayer lacks control over activities; and (5) the taxpayer uses nonrecourse debt. The Tenth Circuit focused its Nickeson analysis on the lenses’ marketing materials, the price Olsen paid for them, and his lack of control over the business.
The court noted that the seller’s brochures claimed that purchasing the lens would “zero out your taxes” and that Olsen paid a grossly inflated purchase price for them without negotiating. Lastly, Olsen lacked control over the activities surrounding the business, even admitting that he did not “fully understand the project.” Thus, the court concluded that the transaction was simply “the naked sale of tax benefits.”
Holding: The Tenth Circuit affirmed the Tax Court’s decision, stating that it did not err in applying Regs. Sec. 1.183-2(b) to find that Olsen lacked a profit motive and that the Nickeson test similarly showed a lack of profit motive. Since he lacked a profit motive in investing in the lenses, Olsen could not claim any depreciation deductions or solar energy credits for the tax years in question, the court held.
■ Olsen, No. 21-9005 (10th Cir. 11/4/22)
— John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation within the SC Johnson College of Business at Cornell University. Matthew Geiszler, Ph.D., is a lecturer in accounting within the College of Human Ecology at Cornell University. To comment on this column, contact Paul Bonner, the JofA’s tax editor.