Originally published on Passive Activities and Other Oxymorons on May 5th, 2011.
MORTON v. U.S., Cite as 107 AFTR 2d 2011-XXXX
I promised myself that if I got far enough ahead on my Monday, Wednesday, Friday commitment, I would start doing more posts. The MWF posts have been done on a roughly FIFO (first in, first out) basis so some of them have aged a bit. I'm going to grab from the top of the pile for any Tuesday Thursday bonus posts, so they might be a little fresher.
This is a bit of a celebrity case. Peter Morton was one of the founders of Hard Rock Cafe. His Los Angeles restaurant, Mortons, was the setting for the Julia Phillips novel "You'll Never Eat Lunch in this Town Again". He sold the Hard Rock Hotel in Las Vegas in 1995, but he continues to own the brand. The dollars involved are pretty respectable. It is a refund claim for $9,755,483. Absent all that, I would still find the case intresting. There are three issues two of them somewhat sophisticated and one fairly mundane. Ironically the taxpayer was able to get summary judgement on the sophisticated issues but the mundane one remains undecided.
The question is about the deductibity of private jets and whether a like-kind exchange of jets was blown. One aspect of the like-kind exchange issue is very straightforward:
In 1999, Plaintiff sought to exchange the G-III for the G-IV aircraft. The main reasons for this exchange were concerns about the safety and the level of noise generated by the G-III. Plaintiff entered into an agreement with a qualified intermediary for the exchange and an escrow agreement with an escrow agent. The agreement was executed on September 30, 1999, but the escrow agent accidentally and in contravention of the escrow agreement wired funds from the escrow account to RWB. Mr. Ogaz returned the funds the following day.
Ooops. Don't you hate when that happens ? The Court ruled, however, that with a properly drafted exchange facilitation agreement, an error by one of the parties will not void exchange treatment.
Defendant acknowledges that Plaintiff abided by these requirements and would have effected a valid like-kind exchange but for the accidental placement of funds into RWB's account instead of the escrow agent's account. Defendant stresses that before the funds were placed in escrow, the money was deposited into RWB's checking account; thus Defendant contends that because RWB had possession and control over the funds, Plaintiff had “actual receipt” of them.
We disagree that an accidental transfer followed by an immediate return of funds would constitute actual or constructive receipt. Significantly, Plaintiff was bound by contract not to “receive, pledge, borrow or otherwise obtain the benefits of the Exchange Value” for at least 45 days.. Legally, he could not do anything but return the funds to the proper account. If he had done anything other than return the funds, he would have been liable for conversion, or even theft.
Additionally, Plaintiff should not be penalized for another's mistake when he took every step to validly effect a deferred like-kind exchange. Plaintiff complied with all the requirements of the qualified intermediary safe harbor over which he had control; he did not have control over the mistaken actions of a third party. Because he complied with the requirement in all other aspects, we conclude that he validly effected a deferred like-kind exchange.
In many cases good documents cannot salvage poor execution. One of my earliest posts illustrates this principle in the case of family limited parnterships. Of course in the like-kind exchange area, the right documents are crucial as Ralph Crandall discovered much to his chagrin. I would say, however, that "poor execution" might be a little harsh for a mistake like depositing in the wrong account and fixing the mistake the next day. Compare it to the Estate of Sylvia Riese where the property of a terminated QPRT was not retitled for months and no rent was ever paid by the grantor. If the Tax Court can forgive that, having the money in the wrong account for a day should also be forgivealbe. Let's call it less than perfect execution.
This was also a Section 183 case, sometimes referred to as "hobby loss". but the actual title is "Activities Not Engaged in For Profit":
In the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this section.
It is not surprising that Mr. Morton owned several entities for several different purposes- ownership of different property, management, etc. He picked one of them RWB, an S corporation, to own the jet. He provided the corporation with the funds to pay related expenses. A different corporation 510 Development Corporation hired the flight team of pilot, co-pilot and flight attendant. We don't need to get into the details of the purposes of the various entities to frame the issue. RWB, all by itself, was not about to make a profit from owning the plane. So the IRS wants to disallow any expenses over and above some charter income. Mr. Morton maintains that the plane was being used for his overall enterprise - himself and all his various entities. The Court approves of the latter approach:
Case law supports Plaintiff's “unified business enterprise” theory and would allow him to take deductions for aircraft use that furthers the business purpose of entities other than RWB. This deduction may be allowed despite the fact that the aircraft is titled in RWB's name, and RWB did not use the aircraft to further its particular profit motive. As long as Plaintiff used it to further a profit motive in his overall trade or business, the deduction is allowed.
I think that both the holdings in this case are pretty important.
Mr. Morton has not, however, entirely won - at least not yet and the reason is pretty mundane:
Given that Plaintiff may impute his business activities and the business activities of one entity to his other entities, the Court must still examine whether the evidence shows that the aircraft expenses were for legitimate business purposes. The facts are in dispute. Defendant contests the purpose of many of the trips, and specifically takes issue with Plaintiff's trips to the Hamptons because his children, girlfriends, and friends of his children traveled with Plaintiff on the aircraft and stayed with Plaintiff at his vacation homes. RWB kept flight logs that identified the date and time of the trip, the number of passengers, the departure and arrival airports, the time in flight, and the pilots. However, RWB did not keep systematic records of the identity of the passengers on its flights nor the reasons why any passengers were on its flights. The lack of information about the people included on the trip makes it difficult to say at this point definitively that the flights were or were not for business purposes.
Though Plaintiff met with his accountant sometime after the trips to categorize them as “personal” or “business,” , the Court cannot definitively say that these meetings were sufficiently contemporaneous to regard these categorizations as conclusive. Plaintiff said little at oral argument to enlighten the Court about the process of determining the business or personal nature of the trips. Because the Court is unconvinced of Plaintiff's categorizations, it defers judgment on the nature of the individual trips. The Court also must defer a determination as to whether depreciation deductions are allowed because this determination is dependent on substantiating the business usage of the aircrafts.
If the Gulfstream is classified as personal use property, it would be disqualified from 1031 treatment. I will hazard a guess that 1031 would not be that imporant in that case as the plane would not have been depreciable.
Note that this is a refund case so Mr. Morton must have spent over $20,000,000 or so of after tax dollars on his jets. In case you are wondering what other perks go with being the founder of the Hard Rock Cafe, check out his super model on again off again girl friend Linda Evangelista