On April 6, 2021, the Tax Court issued a Memorandum Opinion in the case of Olsen v. Commissioner (T.C. Memo. 2021-41). The primary issues presented in Olsen were whether the petitioners were entitled to depreciation deductions reported on Schedules C (Profit or Loss from Business) and whether they were entitled to energy tax credits reported on Forms 3800 (General Business Credit) for deductions and credits related to a solar energy tax shelter. Held: Hells no.
Initial Point of Clarification
Petitioners are not related (as far as I could tell) to the Full House Olsen twins.
Blinded by the Light
This case (and more than 200 others just like it) involve investors in a solar power tax shelter scheme. The promoters of the scheme sold the petitioners light-concentrating lenses that were supposedly going to be used as components of a system to generate electricity. The promoters told the petitioners that they could zero out their Federal tax liability by claiming energy tax credits and depreciation deductions on the lenses. The solar power project never got past the research and development (R&D) stage, and the lenses were never placed in service to produce energy.
The petitioners claimed substantial depreciation deductions and tax credits attributable to the lenses on their Federal income tax returns for 2010-2014. For each year, the petitioners reduced their taxable income to zero (or close to it) and claimed substantial refunds. They used the refunds to purchase more lenses, for which they claimed more deductions and credits to generate more refunds. This process continued until the U.S. Department of Justice sought, and eventually secured, an injunction to shut down the tax shelter. See United States v. RaPower-3, LLC, 343 F. Supp. 3d 1115 (D. Utah 2018), aff’d, 960 F.3d 1240 (10th Cir. 2020).
The Petitioner-Husband, a Tax Attorney
The petitioner-husband has a B.A. in economics and a J.D. from the University of Chicago. He is a tax attorney.
It should be noted that Tax Court opinions that begin the background of the case by observing that the petitioner is an attorney, or worse—a tax attorney, rarely end well for said attorney, and it does not end well in this case, either.
The promoter urged the petitioner to “[b]uy our solar units with your tax money instead of giving it away to the IRS.” Although these tax benefits were alluring, the petitioner expressed some skepticism, noting that aspects of the deal “seem[ed] too good to be true.” You don’t have to be a tax attorney to understand that the arrangement does not pass the smell test.
Avoiding Passive Treatment
The petitioner also expressed concern that his purchase of lenses would “be viewed as a passive investment,” leading the IRS to deny deductions and credits under the passive loss rules of IRC § 469. The promoter suggested that this problem could be obviated by creating an LLC and designating the promoter as the LLC’s representative. As long as the “representative” logged enough hours, petitioner was supposedly “free to work as little as he would like in his solar business.” Sure. Sounds right.
The petitioner testified that he occasionally read email updates from the promoter to stay apprised of progress (or the lack of it) at the Delta site. He admitted that he did “not [do] much” with the LLC that nominally held and leased the lenses. The LLC did not maintain any business records, hire any employees or contractors, or have its own bank account. The petitioner characterized his administrative responsibilities as “renewing the LLC each year,” “maintaining PDF copies of the documents,” and “just trying to determine how many lenses to purchase” to maximize his tax benefits.
Claiming Deductions and Credits
Although the petitioner never technically saw his lenses in operation, he claimed deductions and credits annually on the basis of letters he received from the promoter. Those letters asserted that his lenses were “put into service,” thereby qualifying him for a “solar energy tax credit.”
The petitioner used a CPA suggested by the promoter, who had prepared returns for other investors. On the returns, they reported wages, but the total tax was zero, because of the deductions and credits. On Schedule C, they identified the LLC as a “solar energy” business and claimed $30,600 in depreciation expense on the lenses. They reported no income and no other expenses on the Schedule C. They attached a Form 3800 claiming an energy credit of $18,000, computed as 30% of the lenses’ nominal purchase price ($60,000). They characterized the lenses as “property using solar energy placed in service during the tax year” and as eligible for the credit for that reason. They went through this exercise in 2009, 2010, and 2011. The CPA declined to prepare the petitioners’ return for 2012, “evidently because IRS audit activity had begun to heat up.” Fear not, though, as the promoter had another CPA willing to prepare the petitioners’ return for 2012, and yet another, who prepared their 2013 and 2014 returns.
Placed into Service
For each year the petitioners reported their lens-related deductions and credits on the basis of “placed in service” letters received from the promoter. These letters stated that the lenses had been “put into service” in December of each year, thereby qualifying the petitioners for depreciation deductions and energy credits. The petitioner did not question the accuracy of these letters even though he had never actually seen one of his lenses on a tower.
The IRS’s Expert
At trial respondent presented testimony from Dr. Thomas Mancini, whom the Tax Court recognized as an expert in concentrated solar power. See, e.g., RaPower-3, LLC, 343 F. Supp. 3d 1115. Dr. Mancini visited the promoter’s facility twice to evaluate the promoter’s technology and determine whether it could produce electricity. He met with the promoter and reviewed materials he supplied. Those materials, Dr. Mancini discovered, contained “no tests, no test reports, [and] no documentation of any type.” Dr. Mancini found “no information that even indicated that all the components have been assembled into a system to produce electricity.” Dr. Mancini was puzzled that, after 17 years, the promoter still “didn’t know what they were developing.”
Following examination of all the evidence, Dr. Mancini opined that the technology (and he used that term lightly) “does not produce electricity or other useable energy from the sun.” Further, he concluded that the technology was not and would never be “a commercial-grade dish solar system.”
The Petitioners’ Expert
The petitioners’ “expert” opined that the promoter’s system was “technically viable to generate electricity,” but he acknowledged that he did not actually observe any electricity being produced. He testified that the promoter “activated the system” for a 30-minute period, but the system “wasn’t connected to anything” and “wasn’t putting anything on the [electric] grid.” However, he said he was impressed by Mr. Johnson’s “creativity.” Wow.
IRC § 48 allows an “energy credit” equal to 30% of the taxpayer’s basis in certain “energy property,” defined to include “equipment which uses solar energy to generate electricity.” IRC § 48(a)(1), (2)(A)(i), (3)(A)(i). However, property qualifies as “energy property” only if (among other things) it is property “with respect to which depreciation (or amortization in lieu of depreciation) is allowable.” IRC § 48(a)(3)(C). If no depreciation is allowable during the year in question, the property cannot constitute “energy property.”
“The period for depreciation of an asset shall begin when the asset is placed in service.” Treas. Reg. § 1.167(a)-10(b). The energy credit is likewise available only with respect to “energy property placed in service during such taxable year.” IRC § 48(a)(1). Thus, assuming that the taxpayer uses property in his trade or business or holds it for production of income, the property qualifies for depreciation deductions and energy credits only if it has been “placed in service.”
Not Operating Trade or Business
To be conducting a trade or business “the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987). “Profit” means economic profit, independent of tax savings. Surloff v. Commissioner, 81 T.C. 210, 233 (1983). The Tax Court appropriately found that the petitioner’s primary purpose in purchasing lenses was to benefit from tax savings, not to derive profit from the conduct of a genuine business enterprise.
Not Placed in Service
An asset is “placed in service” when “placed in a condition or state of readiness and availability for a specifically assigned function.” Treas. Reg. § 1.167(a)-11(e)(1)(i); see Treas. Reg. § 1.46-3(d)(1)(ii) (using the same definition of “placed in service” for energy credit purposes). If the asset is “an individual component that is designed to operate as a part of a larger system [but] is incapable of contributing to the system in isolation,” the asset “is not regarded as placed in service until the entire system reaches a condition of readiness and availability for its specifically assigned function.” Green Gas Del. Statutory Tr. v. Commissioner, 147 T.C. 1, 52 (2016), aff’d, 903 F.3d 138 (D.C. Cir. 2018). Individual components, therefore, “are not to be considered placed in service separately from the system of which they are an essential part.” Sealy Power, Ltd. v. Commissioner, 46 F.3d 382, 390 (5th Cir. 1995), aff’g in part, rev’g in part on other grounds T.C. Memo. 1992-168; see Pub. Serv. Co. v. United States, 431 F.2d 980, 984 (10th Cir. 1970) (holding that individual components of a power plant could not be considered separately because no component “would serve any useful purpose” on its own).
In the case of Cooper v. Commissioner, 88 T.C. 84, 113-114 (1987), although the solar water-heating systems were “not in actual use during the year in issue,” they were “nevertheless devoted to the business of the taxpayer and ready for use.” Id. (quoting Clemente, Inc. v. Commissioner, T.C. Memo. 1985-367). Before Cooper, the Tax Court had held that “property which is held for leasing to others in a profit-motivated leasing venture is placed in service when it is first held out for lease.” Id. at 114 (citing Waddell v. Commissioner, 86 T.C. 848 (1986), aff’d, 841 F.2d 264 (9th Cir. 1988)). Following these precedents, the Tax Court held in Cooper that the water-heating systems “were placed in service as of the date of purchase” because the systems were then available for use in the taxpayers’ profit-motivated leasing venture. Id.
Such was not the case with the solar lenses for three reasons. First, Cooper involved “genuine multiple party transactions,” whereas the petitioners’ case involves a sale-and-leaseback transaction between a tax shelter investor and the tax shelter promoter. Second, the property in Cooper consisted of integrated water-heating systems that were ready for installation to discharge their designated function. Petitioners’ lenses were mere components of a system, and (as far as the evidence shows) they remained unwrapped on pallets at the promoter’s facility. Third, the equipment in Cooper was available for use in the taxpayers’ profit-motivated leasing venture. Cooper, 88 T.C. at 114. The petitioner, however, was not engaged in a leasing business and his venture was certainly not “profit-motivated.”
Passive Activity Losses
Finally, even if petitioners had met all of the foregoing requirements and had placed the lenses in service during 2010-2014, the Code disallows losses and credits connected to a “passive activity.” IRC § 469. The petitioner’s purported lens-leasing activity was a passive activity because it consisted of “rental activity” that did not involve a “real property business.” IRC § 469(c)(2), (7). In any event his lens-related activity was passive because he did not “materially participate” in it by devoting effort that was “regular,” “continuous,” and “substantial.” IRC § 469(h)(1).
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