Downey S&L Assoc v. Comdisco Inc

Citation: Not availableDocket: 05-1697

Court: Court of Appeals for the Seventh Circuit; January 16, 2006; Federal Appellate Court

Original Court Document: View Document

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In the case before the Seventh Circuit, Downey Savings and Loan Association appealed a bankruptcy court's ruling that Comdisco, Inc. did not breach their contract related to a sale and leaseback arrangement. Downey, seeking tax benefits from its loss carryforwards, purchased $46 million worth of IBM computers from Comdisco and leased them back for five years. This arrangement allowed Downey to report the sale proceeds as taxable income while using its loss carryforwards to offset the resulting tax liability. The leaseback was also intended to generate depreciation deductions to offset future taxable income.

For the tax benefits to be legitimate and not deemed a sham by the IRS, the transaction required a valid business purpose beyond tax avoidance. Key requirements included that Downey could not purchase the computers for more than their market value and must have a reasonable prospect of profit beyond tax savings. If the transaction's structure indicated no real profit potential, it would be classified as a tax evasion scheme. The court highlighted precedents stressing the importance of substance over form in tax-related transactions.

Downey's potential profit from a transaction with Comdisco does not automatically indicate a corresponding loss for Comdisco, as the transaction's commercial viability depends on the present value of the lease being less than the purchase price. If this condition is met, Comdisco effectively receives a net cash payment, making the sale and leaseback arrangement defensible as a nonrecourse loan, where repayment depends solely on the collateral (the computers). The transaction may primarily serve to create tax savings for Downey, which Downey shares with Comdisco to encourage participation. Downey's risk lies in the potential market fluctuations of the computers, despite Comdisco's expertise in the computer business. Although Downey's transaction motives could be questioned, a valid nontax business rationale could defend the arrangement. The IRS is focused on ensuring that the forecast of the residual value of leased equipment at the lease's end is not overly optimistic, as an inflated forecast could indicate a sham transaction. For instance, if the purchase price is $100 and the projected residual value is $30, the transaction can be viewed as a legitimate financing method, allowing Downey to retain funds for operations.

If the expected residual value of leased equipment drops from $30 million to $5 million, the transaction may be perceived as a sham, prompting IRS scrutiny. The IRS mandates that the forecasted residual value must be at least 20% of the purchase price for taxpayers seeking transaction clearance. In a 1990 deal involving Comdisco and Downey, valuation firm Marshall Stevens predicted a residual value of $9 million, slightly under the IRS threshold but deemed reasonable enough to avoid challenge. After the lease expired in 1995, the actual market value was only $200,000, leading the IRS to deem the transaction largely a sham and deny approximately half of Downey's claimed tax benefits, resulting in a $7.8 million tax liability. 

Downey acknowledges this tax liability but seeks reimbursement from Comdisco, claiming Comdisco's responsibility for the allegedly negligent appraisal. Despite the lack of a direct contractual relationship with Marshall Stevens, Downey could argue third-party beneficiary status or a tort duty of care. However, Downey has not pursued claims against the appraisal firm, focusing solely on Comdisco. A provision in the lease states that inaccuracies in representations by Comdisco constitute a breach, but the appraisal report itself contains no warranties or representations from Comdisco. Including such representations could jeopardize the tax benefits of the transaction, as the IRS favors independent valuations. While contractual language can sometimes be interpreted flexibly to avoid unreasonable outcomes, in this case, a literal interpretation appears reasonable.

A tax-shelter promoter, identified as Comdisco, is not liable for errors made by an independent appraiser due to the inherent unpredictability of a computer's future value. Downey's claim seeks to hold Comdisco legally accountable for negligence rather than mere erroneous forecasts. Imposing such a liability would necessitate Comdisco's involvement in the appraisal process, compromising the appraiser's independence and jeopardizing the transaction's tax benefits. Additionally, it would increase the risk of lawsuits from dissatisfied taxpayers looking to recover tax benefits. The court ruled that the case should not have proceeded to trial, as Illinois law stipulates that contract interpretation should be based on the contract's language to avoid unnecessary litigation. In this instance, the contract did not hold Comdisco responsible for the appraiser’s errors, and no surrounding circumstances warranted altering this interpretation. The decision was affirmed.