Milenbach v. Commissioner of Internal RevenueMilenbach v. Commissioner of Internal Revenue
Kenneth W. Rosenberg, Department of Justice, Tax Division, Washington, D.C., for the respоndent-appellee.
TASHIMA, Circuit Judge.
The Commissioner of Internal Revenue determined deficiencies in Petitioners-Appellants Sheldon and Phyllis Milenbach‘s federal income taxes for the years 1980 through 1982. The Commissioner also issued notices of Final Partnership Administrative Adjustments determining adjustments to the income of the Los Angeles Raiders, a California Limited Partnership, for the years 1983 through 1989. Petitioners (collectively the “Raiders“) appeal from the Tax Court decisions affirming the contested determinations. See Milenbach v. Comm‘r, 106 T.C. 184 (1996).
The Raiders own a professional football team and belong to the National Football League (the “NFL“). Prior to 1980, the Raiders played their home games at the Oakland-Alameda County Coliseum (the “Oakland Coliseum“). The Raiders’ lease of the Oakland Coliseum expired at the end of the 1979 NFL season. During 1979, the Raiders negotiated with the Los Angeles Memorial Coliseum Commission (the “LAMCC“) to allow the Raiders to begin playing their home games in the Los Angeles Memorial Coliseum (the “LA Coliseum“). In 1980, the Raiders announced that they intended to leave Oakland and play their home games at the LA Coliseum. This announcement set in motion a series of events that resulted in enormous controversy for the team, including several lawsuits, and a number of business transaсtions whose tax consequences are at issue here. Specifically, the Raiders challenge the Tax Court‘s decisions regarding three discrete transactions related to the Raiders’ relocation of their team. We analyze each in turn.
I. THE LAMCC PAYMENTS
A. Background
On March 1, 1980, the Raiders entered into a Memorandum of Agreement (“MOA“) with the LAMCC providing for the relocation of the Raiders to Los Angeles beginning with the 1980 NFL season. The parties never implemented this MOA, however, because the City of Oakland (“Oakland“) filed an action in eminent domain against the Raiders, seeking to condemn for public use the Raiders’ NFL franchise, business, and рhysical assets. Both Oakland and the NFL obtained preliminary injunctions preventing the Raiders from relocating.
As a result, the Raiders played their 1980 and 1981 home games at the Oakland Coliseum. When the NFL injunction was lifted in 1982, the Raiders resumed negotiations with the LAMCC. On July 5, 1982, these negotiations produced a new Memorandum of Agreement (the “1982 MOA“). Pursuant to the 1982 MOA, in 1984, the parties executed a promissory note (the “Note“) and a lease agreement for the LA Coliseum (the “Lease“).
The 1982 MOA, the Note, and the Lease (collectively, the “LAMCC Agreement“) provided that the LAMCC would loan the Raiders $6.7 million at 10 percent interest. The Raiders were tо repay the loan from 12 percent of the net receipts from the operation of luxury suites to be constructed by the Raiders at the LA Coliseum. The repayment was to begin in the third year of suite rentals. The loan was secured by the to-be-constructed suites, with no recourse to the Raiders. The loan consisted of a $4 million cash payment to the Raiders in 1984 and credits totaling $2.7 million against rent due from the Raiders for the years 1982 through 1986.
As to the construction of the suites, the 1982 MOA provided that the Raiders “shall construct” approximately 150 private suites. The MOA went on to state that the construction “shall commence as soon as practicable as determined by [the Raiders] in [their] reasonable discretion, having in mind pending and potential litigation involving the parties hereto, or either of them, financial considerations, and other considerations reasonably deemed important or significant to the [Raiders].” The Lease further provided that the Raiders “shall use [their] best efforts to begin and complete Suite construction as soon as possible.” The LAMCC Agreement was the result of arm‘s-length bargaining between the Raiders and the LAMCC.
Actual construction began in early 1987, but was halted on February 18 of that year. On that date, the LAMCC demanded that suite construction stop because the Raiders had not obtained necessary performance bonds. The Raiders responded that they were willing and able to provide the required bonds, but stated that construction would cease because of the LAMCC‘s failure to make certain improvements to the LA Coliseum. Due to this dispute, construction never resumed and the suites were never completed.
The Raiders never made any payments on the LAMCC loan. In September 1987, the LAMCC filed a lawsuit claiming that the Raiders had breached the Lease by failing to construct the suites “as soon as practicable” and for failing to repay the $6.7 million loan. In January 1988, the Raiders answered the LAMCC‘s complaint, alleging that the LAMCC had breached a commitment to modernize and reconfigure the stadium. The lawsuit was settled on September 11, 1990.
In a Notice of Deficiency for 1982 and FPAAs for 1983 through 1986, the Commissioner disallowed the Raiders’ rent deductions because the rent was not currently payable and was part of the loan from the LAMCC. In the alternative, if the rent deductions were allowed, the Commissioner determined that the amount of the rent credits were includable in gross income as advance payment of income. The Commissioner also determined that the $4 million advance paid in 1984 was includable in the Raiders’ 1984 gross income.
The Tax Court held that the “loan” payments from the LAMCC were includable in the Raiders’ income in the years in which they were received. Milenbach, 106 T.C. at 198. It held that the obligation to construct the suites was illusory and, therefore, the LAMCC payments did not qualify as loans for tax purposes because the Raiders “controlled whether or not repayment of the $6.7 million would be triggered.” Id. at 196.
B. Analysis
We review decisions of the Tax Court under the same standards as civil bench trials in the district court. Custom Chrome, Inc. v. Comm‘r, 217 F.3d 1117, 1121 (9th Cir. 2000). Therefore, conclusions of law are reviewed de novo, and questions of fact are reviewed for clear error. Id. This court owes no special deference to the Tax Court‘s decisions on issues of state law. Harbor Bancorp & Subsidiaries v. Comm‘r, 115 F.3d 722, 727 (9th Cir. 1997). The interpretation and meaning of contract provisions are questions of law reviewed de novo. Kassbaum v. Steppenwolf Prods., Inc., 236 F.3d 487, 490 (9th Cir. 2000).
A loan is generally not taxable income because the receipt of the loan is offset by the obligation to repay the loan. Comm‘r v. Tufts, 461 U.S. 300, 307 (1983). For this rule to apply, however, the loan must be an “existing, unconditional, and legally enforceable obligation for the payment of a principal sum.” Noguchi v. Comm‘r, 992 F.2d 226, 227 (9th Cir. 1993); see also Geftman v. Comm‘r, 154 F.3d 61, 68 (3d Cir. 1998) (requiring “an unconditional obligation on the part of the transferee to repay the money, and an unconditional intention on the part of the transferor to secure repayment“) (citation and internal quotation marks omitted).
Whether a transaction is a loan for federal income tax purposes is ultimately a question of federal law. See Helvering v. Stuart, 317 U.S. 154, 162 (1942) (“Once rights are obtained by local law, whatever they may be called, these rights are subject to the federal definition of taxability.“). Initially, however, state law determines the rights and obligations of the parties to a transaction. See id. at 161-62. But once an obligation is created by local law, it is subject to the federal definition of taxability. Id. Here, the dispositive question is whether the LAMCC Agreement was sufficient, under California law, to subject the Raiders to a non-illusory and enforceable obligation to repay the LAMCC advances. If the Raiders were subject to an “existing, unconditional, and legally enforceable obligation” to repay the LAMCC advances, the advances are properly treated as loans for federal income tax purposes. Noguchi, 992 F.2d at 227.
Here, the Raiders were required to exercise their discretion reasonably and nothing in the LAMCC Agreement indicates that cоnstruction of the suites was optional. Both the 1982 MOA and the Lease state that the suites “shall be” constructed and both require the Raiders to use their “reasonable” discretion in deciding the exact timing in the construction of the suites. The Lease also required the Raiders to use their “best efforts” both to construct the suites as soon as possible and to operate them in such a way as to maximize the profits to be derived from them. At no point were the Raiders free to ignore their obligation to construct the suites. They could only delay the construction for a reasonable time and were required to usе their best efforts to complete the suites and begin repayment of the loan. These limitations on the Raiders’ discretion were sufficient to create a non-illusory obligation both to construct the suites and to repay the loan that would have been enforceable under California law. The fact that the obligations were later extinguished by the settlement of the 1987 lawsuit does not indicate that the obligation was illusory at the time the contract was made. Accordingly, we conclude that the Tax Court erred in holding that the LAMCC Agreement was illusory.
Because the Raiders had a non-illusory, unconditional obligation to repay the LAMCC loan, the payments were properly treated as loans and were excludable from income in the year in which they were received.1
II. THE OAKLAND SETTLEMENT
A. Background
The eminent domain suit filed by Oakland in 1980 was ultimately decided in favor of the Raiders. After it was decided that Oakland could not lawfully seize the Raiders’ franchise, the Raiders sought damages arising from Oakland‘s condemnation action by filing a Notice of Claim for Damages in that proceeding. The Raiders sought recovery under the California and United States Constitutions, the common law, and
Oakland objected to the Claim for Damages on procedural grounds. To avoid these procedural objections, the Raiders, at the suggestion of the Superior Court, filed a complaint of inverse condemnation against Oakland for damages arising out of the eminent domain action. The Raiders reiterated their Claim for Damages, and stated that they had suffered damages in еxcess of $26 million. The Superior Court consolidated the two actions.
In November 1988, the Raiders and Oakland settled the lawsuit. Oakland agreed to pay the Raiders $4 million in four yearly installments of $1 million plus interest. The settlement agreement stated that it was entered into for the “purpose of settling disputed claims involving the restoration of lost franchise value.”
For each of the tax years 1988 and 1989, the Commissioner determined that settlement proceeds of $600,000 ($1 million less $400,000 attorney‘s fees) received by the Raiders constituted taxable income. The Tax Court found that the Oakland settlement represented recovery of lost profits and, therefore, constituted taxable income. Milenbach, 106 T.C. at 201.
The Raiders argue that no portion of the settlement represented recovery of lost profits. They assert that the settlement represented recovery of lost value to the franchise and therefore should be treated as non-taxable return of capital. The Raiders claim that they never sought to recover lost profits in their action against Oakland, only the lost value of their franchise. They argue that their Claim for Damages can only be read as seeking recovery for lost franchise value because they based their claim on Oakland‘s denial of “the free use and enjoyment” of their franchise. The Raiders also point to the fact that the settlement agreement with Oakland provided that the payment compensated the Raiders for “lost franchise value.”
B. Analysis
The nature of a settlement payment is a question of fact reviewed for clear error. See Langer v. Comm‘r, 989 F.2d 294, 296 (8th Cir. 1993); Wolfson v. Comm‘r, 651 F.2d 1228, 1230 (6th Cir. 1981); Spangler v. Comm‘r, 323 F.2d 913, 916-17 (9th Cir. 1963); Pac. Magnesium v. Westover, 183 F.2d 584, 584 (9th Cir. 1950). When a claim is resolved by settlement, the relevant question for determining the tax treatment of a settlement award is: “In lieu of what were the damages awarded?” Getty v. Comm‘r, 913 F.2d 1486, 1490 (9th Cir. 1990); Raytheon Prod. Corp. v. Comm‘r, 144 F.2d 110, 113 (1st Cir. 1944). We take a “broad approach in determining the true nature and basis of a party‘s claim.” Getty, 913 F.2d at 1491. If the payments are in lieu of lost profits, then they are taxable income. Shakertown Corp. v. Comm‘r, 277 F.2d 625, 628 (6th Cir. 1960); Raytheon, 144 F.2d at 113. If, however, the payments are for loss of franchise value due to damage to goodwill, then the payments are nontaxable return of capital. Id. The taxpayer bears the burden of establishing that proceeds of a settlement are what the taxpayer contends them to be. Getty, 913 F.2d at 1492.
The Tax Court did not clearly err in finding that some portion of the Oakland settlement represented recovery for lost profits. The Raiders’ list of damages included several items that consistеd entirely of lost profit. Nothing in the language of the Claim for Damages or the inverse condemnation complaint suggests that the Raiders intended to limit their recovery to the reduction in value of their franchise caused by loss of goodwill. In addition, almost every item listed in the damages report would have been taxable had it been received by the Raiders. Any settlement amount meant to replace this lost income would have been “in lieu” of taxable income and would itself be taxable. Getty, 913 F.2d at 1490.
The Raiders argue that it is inherent in the nature of an inverse condemnation action that their potential recovery is limited to the damage done to the value of their franchise, and that the lost income was mentioned only as a measure of that damage. We need not decide whether an award in an inverse condemnation action represents recovery only for damage to the property, however, because the Raiders’ attempts to recover damages were not limited to an inverse condemnation action.
The Raiders also sought recovery under
Although the allocation set forth in a settlement agreement by the parties is one factor in determining the nature of a settlement payment, “[w]hen assessing the tax implications of a settlement agreement, courts should neither engage in speculation nor blind themselves to a settlement‘s realities.” Bagley v. Comm‘r, 121 F.3d 393, 395 (8th Cir. 1997). A court should take a broad approach in determining the nature of a settlement payment and is not bound by any allocation made by the parties in their settlement agreement if there is evidence that the payment represented something else. See id. at 395; Delaney v. Comm‘r, 99 F.3d 20, 23-24 (1st Cir. 1996). This is especially true in a case, such as this one, where one party (Oakland) apparently had no interest in classifying damages one way or the other. Oakland had no motive to ensure that the allocation in the settlement agreement accurately represented the nature of the settlement payments.2
Given the broad recovery allowed under section 1268.620 and the nature of the damages that the Raiders claimed to have suffered, the Tax Court did not clearly err in determining that some portion of the Oakland settlement represented taxable lost profits. Becаuse the Raiders did not meet their burden of providing some basis for allocating the settlement between taxable lost profits and non-taxable damage to franchise, the Tax Court correctly upheld the Commissioner‘s allocation of the entire amount to taxable lost profits.
III. THE CITY OF IRWINDALE LOAN
A. Background
The ongoing dispute between the Raiders and the LAMCC prompted the Raiders to enter into a Memorandum of Agreement (the “Irwindale MOA“) with the City of Irwindale (“Irwindale“) in August, 1987. The Irwindale MOA provided that the Raiders would construct a new stadium in Irwindale and play their home games in that stadium, starting in 1992, at the expiration of the Lease with the LAMCC. The Irwindale MOA alsо provided that Irwindale would loan the Raiders $115 million, to be repaid exclusively from revenue from the to-be-constructed stadium. The loan was to be secured by a deed of trust on the improvements the Raiders were obligated to build on the site provided for the proposed stadium.
Under the agreement, Irwindale advanced the Raiders $10 million of the loan. The Irwindale MOA provided that, should Irwindale fail to perform its obligations under the MOA, then all of the Raiders’ obligations under the MOA would be extinguished, including the obligation to repay the advance. The Raiders would then be entitled to keep all funds advanced to them “as consideration for the execution” of the MOA. The MOA stated that Irwindale proposed to finance the project by issuing general obligation bonds.
The Irwindale MOA made allowances for some obstacles to the performance of the MOA:
8.5 If any obstacle is imposed by third parties (such as litigation, legislation, or failure to cooperate) it is agreed that both parties pledge good faith cooperation to overcome such obstacle. However, these obstacles will not be construed as a tolling event for the project itself, nor will it be construed as a reаson to refund any exchange of monies, nor will it be construed as a forfeiture. It is further agreed, that both parties will move forward with the project and mutually work to resolving the problem ....
8.6 Any third party obstacle will not excuse either party from proceeding with the project except to the extent ordered by court, e.g. an injunction.
In September 1988, the California Legislature enacted a statute that prohibited Irwindale from using general obligation bonds to fund construction of a stadium that would be turned over to a private company, such as the Raiders. This new law made it impossible for Irwindale to finance the project in the way proposed in the Irwindale MOA.
At trial, the Commissioner argued that the Irwindale advance was not a bona fide loan and that it was taxable income in 1987, the year it was received. In the alternative, the Commissioner argued that the debt had been discharged in either 1987, 1988, or 1989.
The Tax Court held that the Irwindale advance was properly treated as a loan, rejecting the Commissioner‘s argument that it should be treated as taxable income in the year in which it was received. Milenbach, 106 T.C. at 201-02. The court also rejected the Commissioner‘s contention that the Irwindale debt was discharged in 1987. Id. at 203. Instead, the court found that the debt had been discharged in 1988, and that the Rаiders realized $10 million in taxable income as a result. Id. at 204. The court based this finding primarily on the passage of the law in September 1988 which made financing the stadium with general obligation bonds impossible.3 Id. at 203-04. The court reasoned that because the 1988 legislation prohibited the use of general obligation bonds to fund the project as proposed in the MOA, negotiations that continued beyond 1988 “were not conducted under the Irwindale MOA.” Id. at 203.
B. Analysis
The Tax Court‘s determination of the timing of a discharge of indebtedness is reviewed for clear error. Friedman v. Comm‘r, 216 F.3d 537, 542 (6th Cir. 2000). Clear error exists only when the reviewing court is left with a “definite and firm conviction that a mistake has been committed.” Gonzalez-Caballero v. Mena, 251 F.3d 789, 792 (9th Cir. 2001) (citation omitted).
The discharge of a valid debt is treated as taxable income.
Although the test for discharge of debt requires the examination of the practical probability that a debt will be repaid, the Tax Court expressly based its holding that the Raiders debt was discharged in 1988 on its conclusion that passage of the 1988 legislation “prohibited the implementation of the Irwindale MOA.” Milenbach, 106 T.C. at 203. It concluded that, under California law, the terms of the contract required Irwindale to fund the loan with general obligation bonds or forfeit the advance.
Under California law, the mutual intention of the parties at the time the contract is formed governs interpretation of the contract.
On remand, the Tax Court must determine whether the Irwindale debt was discharged in any of the challenged years. The court must perform a “practical assessment of the facts and circumstances relating to the likelihood of payment.” Friedman, 216 F.3d at 546. The court must determine when, as a practical matter, it became clear that Irwindale would not be able to fund the entire loan and that the stadium would not be built. It wаs at that point that a forfeiture resulted and the Irwindale debt was discharged.4
CONCLUSION
We affirm the Tax Court‘s decision that the Oakland settlement represented recovery of taxable lost profits. We reverse, however, the Tax Court‘s decision that the LAMCC loan payments were taxable upon receipt and that the Irwindale debt was discharged in 1988, and remand this case for further proceedings consistent with this opinion. Each party shall bear his, her, or its own costs on appeal.
AFFIRMED in part, REVERSED in part, and REMANDED.