Milenbach v. Commissioner - 318 F.3d 924 (9th Cir. 2003)

Rule:

Under California law, an obligation under a contract is not illusory if the obligated party's discretion must be exercised with reasonableness or good faith. Where the contract specifies performance the fact that one party reserves the power to vary it is not fatal if the exercise of the power is subject to prescribed or implied limitations such as the duty to exercise it in good faith and in accordance with fair dealings. 

Facts:

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 physical assets. Both Oakland and the NFL obtained preliminary injunctions preventing the Raiders from relocating. When the NFL injunction was lifted, negotiations went underway again which produced a new MOA in 1982. Pursuant to the 1982 MOA, the parties in 1984 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 to 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. 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." Plans to construct the suites prior to the 1984 Summer Olympics were abandoned after the Los Angeles Olympic Committee voiced concerns over the timing of the construction. The Raiders worked with architects and contractors on the planning of the suites throughout 1985 and 1986. 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 fromthe 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, as the obligation to construct the suites was illusory and therefore the payments did not qualify as loans for tax purposes.

Issue:

Are the LAMCC loan payments excludable from income in the year in which they were received?

Answer:

Yes.

Conclusion:

Contrary to the Tax Court's conclusion, the Raiders' broad discretion in the timing of the construction of the suites did not make the contract illusory. Here, the Raiders were required to exercise their discretion reasonably and nothing in the LAMCC Agreement indicates that construction 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 use 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.