Opinion
Docket No. 34866.
1953-11-4
BROCKMAN BUILDING CORPORATION, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
A. Calder Mackay, Esq., and Adam Y. Bennion, Esq., for the petitioner. Charles H. Chase, Esq., for the respondent.
A. Calder Mackay, Esq., and Adam Y. Bennion, Esq., for the petitioner. Charles H. Chase, Esq., for the respondent.
Petitioner, lessee of a building, subleased a part of that building to another corporation. The subleased agreed to pay a fixed rental for its lease. By a separate agreement made with a trustee, the sublessee agreed to pay a percentage of its sales, over a certain amount, to the trustee for the benefit of certain persons and corporations, who were petitioner's stockholders and creditors. Held, the payments made to the trust by the sublessee were taxable to the petitioner as its income. United States v. Joliet & Chicago R. Co., 315 U.S. 44. Held, further, petitioner is not liable for additions to tax under sections 291(a) and 293(a), Internal Revenue Code, since it acted in good faith and with reasonable cause.
The Commissioner made the following determination:
+---------------------------------------------------------------------+ ¦ ¦ ¦ ¦ ¦25 per cent ¦5 per cent ¦ +------+-----------+----------+------------+-------------+------------¦ ¦Year ¦Liability ¦Assessed ¦Deficiency ¦penalty ¦penalty ¦ +------+-----------+----------+------------+-------------+------------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +---------------------------------------------------------------------+
EXCESS PROFITS TAX 1942 $813.92 $813.92 $203.48 $40.70 1943 33,915.26 33,915.26 8,478.82 1,695.76 1944 37,942.27 37,942.27 9,485.57 1,897.11 1945 57,065.67 57,065.67 14,266.42 2,853.28 Totals 129,737.12 129,737.12 32,434.29 6,486.85
DECLARED VALUE EXCESS-PROFITS TAX 1944 $8,493.11 $8,493.11 $424.66 1945 10,651.38 10,651.38 532.57 Totals 19,114.49 19,144.49 957.23
INCOME TAX 1944 $2,610.80 $2,610.80 $130.54 1945 2,626.41 $1,978.44 647.97 32.40 1946 36,680.61 1,533.31 35,147.30 1,757.37 1947 34,182.55 34,182.55 1,709.13 1948 34,318.35 962.00 33,356.35 1,667.82 1949 33,048.65 564.90 32,483.75 1,624.19 Totals 143,467.37 5,038.65 138,428.72 6,921.45
The principal question is whether certain amounts paid to a trust established for the benefit of petitioner's stockholders and creditors are taxable as income to the petitioner.
FINDINGS OF FACT.
Some of the facts have been stipulated by the parties. At the hearing, a number of exhibits were introduced without objection. Such exhibits, together with the stipulation, are incorporated herein by this reference.
The petitioner is a corporation organized under the laws of the State of California on July 28, 1933, with an authorized capital stock of 1,000 shares, having no par value. The petitioner filed its Federal tax returns for the periods here involved with the collector of internal revenue for the sixth district of California.
The Brockman Building (hereinafter also referred to as the building), is a 12-story structure located in Los Angeles, California. It is owned by the Security-First National Bank of Los Angeles (hereinafter also referred to as the bank) as trustee under a trust established in 1922 by John Brockman. Prior to 1933, the bank had leased the building to the Brockman Building Company (a company which is not to be confused with petitioner). In July 1933, as a result of the default of that company in its rentals and other lease requirements, the bank terminated the lease. At that time, there were outstanding certain bonds, in the amount of $92,000, which had been issued by the Brockman Building Company and which were owned by the Pacific Indemnity Company and Pioneer Securities Corporation (hereinafter also referred to together as the bondholders) in amounts of $75,000 and $17,000, respectively. All of the rents under the Brockman Building Company's subtenancies on the building had been assigned in trust as collateral security to the bondholders. When the bank, as trustee, terminated the lease, the subleases were assigned to the bank, with the consent of the bondholders.
On July 29, 1933, the bank granted to the petitioner a 28-year lease (hereinafter also referred to as the basic lease) on the Brockman Building. The lease provided for a rental consisting of all of the petitioner's gross receipts from renting the building, less certain defined operating expenses. It further provided that unless the net rentals for the period from March 1, 1933, to July 31, 1942, averaged $3,500 per month, the lease could be canceled at the option of the lessor after service of notice of default; and if the net rentals averaged at least $3,500 per month, the net rental would thereafter be fixed at that amount and petitioner could retain any excess rental which it was able to secure. The petitioner does not itself occupy the building; it subleases the space and manages the building.
At the time petitioner acquired the 1933 lease from the bank, the bank required, as a condition precedent to the delivery of the lease, that petitioner obtain a written consent to the lease from the bondholders. In order to procure such consent, petitioner entered into an agreement with the bondholders, whereby petitioner promised to purchase the bonds from them at face value. Payment for the bonds was to be made by depositing in a trust fund, established for that purpose, all income over the $3,500 net rental payable under the terms of the lease, after the rent for the building was fixed at that amount. As security for this obligation, petitioner, with the bank's consent, assigned its basic lease and petitioner's shareholders pledged all of their stock in petitioner to the bondholders.
As of January 1, 1941, petitioner was delinquent in the minimum rental payments due the bank under the basic lease in the amount of $78,549.73. On December 31, 1941, such delinquency had increased to $102,686.86; and by March 31, 1942, the delinquency was $107,435.14.
For all the years here pertinent, the basement, ground floor, and certain upper floors of the Brockman Building were subleased by petitioner to J. J. Haggarty Stores, Inc. (hereinafter referred to as Haggarty), a retail, woman's clothing store which was the building's principal tenant. Haggarty was also the lessee of a building, known as the Macdonald Building, which adjoined the Brockman Building. Openings in the walls enabled Haggarty to utilize the space in both buildings as a unit in the conduct of its business. The Haggarty sublease on the Brockman Building was due to expire, by its terms, on March 14, 1942, as was Haggarty's lease on the Macdonald Building. It was necessary, therefor, for Haggarty either to obtain renewals of those leases or to make plans for doing business elsewhere. Since it appeared likely that petitioner would be in default on its basic lease on July 31, 1942, Haggarty would accept a renewal of the sublease from petitioner only if the bank would agree to be bound thereto as lessor, in the event that the bank canceled petitioner's lease as a result of such default. Another condition to acceptance by Haggarty of a renewal was that petitioner procure the consent and agreement of the bondholders to be bound to such renewal.
Negotiations for a new sublease for Haggarty began about 2 years prior to the expiration of the existing sublease. These negotiations were carried on principally by John Shirley Ward, Chandler P. Ward, and David Blankenhorn, all officers of petitioner. At the time when he was carrying on such negotiations on behalf of petitioner, Blankenhorn was not a stockholder in petitioner. Some stockholders in petitioner had no part in the negotiations whatsoever. The bank had knowledge that such negotiations were taking place. More than one plan, whereby the petitioner could remain as the bank's lessee and Haggarty could continue to occupy the building, was considered by the parties. Petitioner was a suitable manager of the building and had obtained as much rental as was possible for the bank. Petitioner had reasonable expectations of remaining as the bank's lessee if it could obtain a satisfactory new sublease with Haggarty.
After negotiation with all the parties concerned, at the end of 1941, a proposed sublease for Haggarty was submitted to the bank of its consideration. This sublease provided for an increased fixed rental to be paid by Haggarty and contingent rentals equal to a percentage of Haggarty's gross sales over a certain amount to be paid to the petitioner, as lessor. It was contemplated that such contingent rentals were to be assigned by petitioner to John Shirley Ward or his nominees, who were intended to be petitioner's stockholders and creditors. The Haggarty sublease and any other subleases in the Brockman Building were to be assigned to the bank. The petitioner was not to benefit by any receipts from the Brockman Building other than such contingent rentals. The contingent rentals which were to be paid over to the bondholders were to be applied as payment for the bonds under the agreement entered into in 1934; no payments had been made on account of such agreement up to this time in 1941. The bank, however, would not consent to such sublease because it felt that the inclusion of the provision requiring contingent rentals in the lease together with the inclusion of the fixed rental provisions might in some way result in an undesirable conflict of interests at some later date.
As a result of the bank's reluctance to enter into an agreement which included provisions relating to the contingent rentals, a plan was formulated whereby Haggarty would enter into a new lease with petitioner providing for a fixed rental and into a separate agreement with the Title Insurance and Trust Company (hereinafter referred to as the Title Company) providing for percentage payments, such percentage payments to be determined in the same way as the contingent rentals. According to that plan, Haggarty, on March 3, 1942, entered into a lease with petitioner which provided for a fixed rental of $5,500 per month, to extend until September 30, 1961. The bank and the bondholders executed consents to the new sublease. The bank also relinquished any possible future claims to the percentage rentals. In addition, Haggarty, on March 3, 1942, agreed with the Title Company that it would pay to it, for the period beginning with the delivery to Haggarty of some newly leased premises on the third floor of the building and ending with the termination of the sublease on September 30, 1961, 4 1/2 per cent of its gross sales between $1,400,000 and $1,800,000 and 4 per cent of gross sales over $1,800,000. The agreement with the Title Company was stated to be in consideration for the efforts of petitioner's stockholders in obtaining a renewal of the lease between Haggarty and petitioner and the bank's agreement to be bound by such lease, in the event of petitioner's default, and the consent of the bondholders to the new arrangement. Haggarty assigned its lease to the Title Company as security for this agreement. Petitioner, on March 3, 1942, also entered into an amendment of its basic lease with the bank, which extended until 1956 the time for determining whether petitioner was in default in payment of its minimum rental to the bank. This amendment also provided for payment to the bank of all of petitioner's receipts from the Brockman Building for as long as Haggarty was not in default on its agreement. The fixed rental provided for in the new sublease with Haggarty was a substantial increase over the previous rental paid by Haggarty and was probably a better rental than could be obtained from any other prospective tenant.
On August 12, 1942, the Title Company executed a declaration of trust (hereinafter also referred to as the Haggarty trust). The declaration provided that the percentage payments received from Haggarty, after payment of trustee's fees, were to be held in trust for distribution to named beneficiaries. The net payments available for distribution were to be divided into two portions of 55 per cent and 45 per cent to be paid over to the bondholders and to the named stockholders of petitioner, respectively. Such portions were to be distributed as follows:
+---------------------------------------------------------------------+ ¦55 Per cent of net payments ¦45 Per cent of net payments ¦ +------------------------------------+--------------------------------¦ ¦Beneficiary ¦Proportion¦Beneficiary ¦Proportion¦ +-------------------------+----------+---------------------+----------¦ ¦Pioneer Securities Corp ¦17/92 ¦John Shirley Ward ¦85/1,000 ¦ +-------------------------+----------+---------------------+----------¦ ¦Pacific Indemnity Company¦75/92 ¦Chandler P. Ward ¦85/1,000 ¦ +-------------------------+----------+---------------------+----------¦ ¦ ¦ ¦Shirley C. Ward, Jr ¦85/1,000 ¦ +-------------------------+----------+---------------------+----------¦ ¦ ¦ ¦Robertson Ward ¦85/1,000 ¦ +-------------------------+----------+---------------------+----------¦ ¦ ¦ ¦Katherine Ward Carr ¦85/1,000 ¦ +-------------------------+----------+---------------------+----------¦ ¦ ¦ ¦Beatrice Ward Challis¦85/1,000 ¦ +-------------------------+----------+---------------------+----------¦ ¦ ¦ ¦Emma B. C. Wells ¦245/1,000 ¦ +-------------------------+----------+---------------------+----------¦ ¦ ¦ ¦Harold S. Chase ¦245/1,000 ¦ +---------------------------------------------------------------------+
The distributions to the bondholders were to be made in the proportions in which the bonds were owned. Distributions to the bondholders were to cease when they equaled $92,000, the face amount of the bonds outstanding; at that time the bonds were to be returned to petitioner, as provided for in the 1934 agreement. After that time, all distributions were to be made to the other beneficiaries in the same proportions as above. For all times pertinent to the proceeding, except as noted below, the beneficiaries, as listed above were all of the stockholders of petitioner and owned stock in the proportions as there set forth. Harold S. Chase owned 245 shares of petitioner's stock which he had acquired from one David Blankenhorn on September 24, 1936. On August 24, 1945, David Blankenhorn reacquired those shares from Harold S. Chase.
This arrangement, whereby the contingent rentals were to be paid into the trust for the benefit of petitioner's stockholders and creditors, was merely a change in form from the plan which was rejected by the bank. The activities of petitioner's officers in bringing about this new arrangement were performed on behalf of petitioner and not on behalf of the stockholders and creditors of petitioner, as such.
The new Haggarty sublease, the agreement between Haggarty and the Title Company, the Title Company's declaration of trust in favor of the bondholders and named stockholders of petitioner, the assent of the bank to the contingent payments agreement, the bondholders' assent to the new arrangement, and the bank's agreement to be bound as lessor to Haggarty in the event of petitioner's default were all executed as parts of a single plan. The Haggarty trust declaration was signed by the Title Company and the beneficiaries; petitioner was not a party thereto. The negotiations and arrangements were considered, discussed, and approved by petitioner's stockholders and directors. The agreements were all negotiated at arm's length and were not motivated by tax considerations. It was necessary for Haggarty to agree to the payment of a percentage of its sales, in order to obtain a new lease from petitioner.
The beneficial interests under the Haggarty trust were transferable in part part only with the consent of the trustee and the written acceptance of the transferee, together with his promise to pay a transfer fee. A whole interest in the trust could be transferred without such consents.
On August 24, 1945, Harold Chase assigned his undivided 245/1,000 interest in the Haggarty trust to David Blankenhorn and Harold C. Morton. On September 17, 1947, David Blankenhorn and Harold C. Morton executed assignments whereby, in effect, each received a whole interest in an undivided 122 1/2/1,000 beneficial interest in the Haggarty trust in exchange for his one-half interest in an undivided 245/1,000 interest in the trust. Morton was never a stockholder in petitioner.
By June 1, 1945, the bondholders had received full payment for the bonds in distributions from the Haggarty trust and on June 14, 1945, they reassigned petitioner's basic lease and the pledged stock, which they had held as security, and surrendered the bonds to petitioner.
In November 1946, the Haggarty trust was amended with the consent of the Title Company and all of the beneficiaries, including Morton; Haggarty, the bank, and petitioner were not parties to this agreement. In June 1947, the Brockman-Haggarty sublease was amended, in details not here relevant. Neither the Title Company nor any of the beneficiaries of the Haggarty trust were parties to such amendment. On November 30, 1948, the percentage-of-sales agreement, of March 3, 1942, between Haggarty and the Title Company was amended with the consent of all of the beneficiaries of the Haggarty trust. The petitioner and the bank were not parties to this amendment. The amendment provided that the percentage payments to the trust would thereafter be 4 per cent of gross sales between $1,800,000 and $3,800,000 and 3 per cent of sales over $3,800,000.
On April 25, 1949, Harold C. Morton filed against petitioner a complaint to quiet title, in the Superior Court of the State of California in and for the County of Los Angeles. In that suit Morton alleged that he had, since August 24, 1945, been the owner of an undivided 122 1/2/1,000 beneficial interest in the Haggarty trust, and he sought, in the prayer of the suit, that his interest therein be adjudged and determined and that the court determine that Brockman Building Corporation, Inc., is without ‘* * * any right, title or interest therein; and that plaintiff's (Morton's) interest in said trust and in and to said contract of March 3, 1942 and the benefits and avails thereof be quieted as against all possible claims, rights or demands by the defendant (Brockman Building Corporation, Inc.) * * *.‘
After having been served with a copy of the summons and complaint to quiet title, petitioner's board of directors met, on May 5, 1949, discussed the Morton suit, and passed the following resolution:
RESOLVED, that whereas Brockman Building Corporation, Inc. never had, and has never claimed to have any interest in said contract dated March 3, 1942, or the avails thereof, and never had not (sic) claimed to have any interest in Trust No. B-10543 (Haggarty Trust) of the Title Insurance and Trust Company, nor in the avails thereof, and there existing no basis in fact upon which any claim of interest by this Corporation could be supported, the officers of this Company are hereby instructed and directed, on behalf of this Company, neither to appear in, nor defend said action, with the result that, although defendant's default therein will ensue, the plaintiff will be put to proof before the Court.
On August 23, 1949, a judge of the Superior Court entered a decree quieting title in the suit which Morton had brought against petitioner.
That decree adjudged that Harold C. Morton was the owner of a 122 1/2/1,000 beneficial interest in and to the Haggarty trust, and the owner of a like interest in the percentage-of-sales contract between Haggarty and the Title Company dated March 3, 1942, and the benefits and avails thereof; and further adjudged that petitioner was without any ‘right, title or interest therein.‘ The decree also adjusted ‘ * * * That plaintiff's interest in said Trust of August 12, 1942, and in said Contract of March 3, 1942, and the benefits and avails thereof be quieted against any and all claims, rights, or demands of the defendant, and defendant is hereby perpetually enjoined and restrained from setting up or making any claim therein.‘
The following schedule sets forth the payments to and distributions from the Haggarty trust for the years 1942 to 1949, inclusive:
+-----------------------------------------------------------------------------------------------------+ ¦PAYMENTS TO ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦AND ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦DISTRIBUTION ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦FROM ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦THE HAGGARTY ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦TRUST ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦1942-1949 ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦ ¦1942 ¦1943 ¦1944 ¦1945 ¦1946 ¦1947 ¦1948 ¦1949 ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Total payment ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦by Haggarty to¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦Title ¦$6,055.01¦$43,600.85¦$66,971.24¦$92,662.53¦$97,951.92¦$98,667.32¦$94,424.03¦$92,846.80¦ ¦Co.—Haggarty ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦Trust ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Less: Expenses¦82.14 ¦200.00 ¦200.00 ¦200.00 ¦200.00 ¦200.00 ¦200.00 ¦200.00 ¦ ¦of trust ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Amount ¦ ¦.01 ¦ ¦.06 ¦ ¦.02 ¦ ¦ ¦ ¦undistributed ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Add: Prior ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦year ¦ ¦ ¦.01 ¦ ¦.05 ¦ ¦ ¦ ¦ ¦carry-over ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦ ¦5,972.87 ¦43,400.84 ¦66,771.25 ¦92,462.47 ¦97,751.97 ¦98,467.30 ¦94,224.03 ¦92,646.80 ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Distributions:¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦John Shirley ¦228.46 ¦1,660.08 ¦2,554.00 ¦5,457.40 ¦8,308.92 ¦8,369.72 ¦8,009.03 ¦7,874.99 ¦ ¦Ward ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Chandler P. ¦228.45 ¦1,660.07 ¦2,554.00 ¦5,457.40 ¦8,308.92 ¦8,369.72 ¦8,009.03 ¦7,874.98 ¦ ¦Ward ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Shirley C. ¦228.46 ¦1,660.08 ¦2,554.00 ¦5,457.40 ¦8,308.92 ¦8,369.72 ¦8,009.03 ¦7,874.99 ¦ ¦Ward, Jr ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Robertson Ward¦228.46 ¦1,660.08 ¦2,554.00 ¦5,457.40 ¦8,308.92 ¦8,369.72 ¦8,009.03 ¦7,874.99 ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Katherine Ward¦228.46 ¦1,660.08 ¦2,554.00 ¦5,457.40 ¦8,308.92 ¦8,369.72 ¦8,009.03 ¦7,874.97 ¦ ¦Carr ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Beatrice Ward ¦228.46 ¦1,660.08 ¦2,554.00 ¦5,457.40 ¦8,308.92 ¦8,369.72 ¦8,009.03 ¦7,874.97 ¦ ¦Challis ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Emma B. C. ¦658.52 ¦4,784.94 ¦7,361.52 ¦15,732.16 ¦23,949.22 ¦24,124.50 ¦23,084.91 ¦22,698.47 ¦ ¦Wells ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Harold S. ¦658.52 ¦4,784.95 ¦7,361.53 ¦5,899.29 ¦ ¦ ¦ ¦ ¦ ¦Chase ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Pacific ¦2,678.05 ¦19,459.62 ¦29,938.20 ¦23,036.22 ¦ ¦ ¦ ¦ ¦ ¦Indemnity Co ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Pioneer ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦Securities ¦607.03 ¦4,410.86 ¦6,786.00 ¦5,221.52 ¦ ¦ ¦ ¦ ¦ ¦Corp ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦David ¦ ¦ ¦ ¦ ¦ ¦6,998.66 ¦11,542.47 ¦11,349.22 ¦ ¦Blankenhorn ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Harold C. ¦ ¦ ¦ ¦ ¦ ¦6,998.66 ¦11,542.47 ¦11,349.22 ¦ ¦Morton ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦West American ¦ ¦ ¦ ¦9,830.88 ¦23,949.23 ¦10,127.16 ¦ ¦ ¦ ¦Oil Co * ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+---------+----------+----------+----------+----------+----------+----------+----------¦ ¦Total ¦5,972.87 ¦43,400.84 ¦66,771.25 ¦92,462.47 ¦97,751.97 ¦98,467.30 ¦94,224.03 ¦92,646.80 ¦ ¦distributions ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------------------------------+
FN* Certain distributions in 1945, 1946, and 1947 on account of the beneficial interests owned by David Blankenhorn and Harold C. Morton were made payable to West American Oil Company at the direction of the beneficiaries Blankenhorn and Morton. Payments into the trust were treated by Haggarty in its own records as payments of rent. Each of the individual beneficiaries reported and paid tax with respect to the amounts distributed to him. The Commissioner determined that the payments to the trust by Haggarty were income to the petitioner. He allowed petitioner the deductions for the expenses of the trust; he also allowed deductions for amortization of the cost of the petitioner's lease, based on the amount paid to the bondholders.
Petitioner executed consents extending the period of limitations, for the years 1944 and 1945, to June 30, 1952. These consents were stated to be effective only if section 275(c) of the Code was applicable to those years. In reporting its income for those years petitioner omitted amounts in excess of 25 per cent of its gross income as reported.
Petitioner's corporation income tax and declared value excess-profits tax returns for the years 1942 and 1943 had attached thereto a rider explaining briefly the transaction creating the Haggarty trust and petitioner's belief that it had no interest therein. These returns were prepared by a certified public accountant. Petitioner acted in good faith and was not negligent in failing to report the percentage payments as its income. Petitioner did not file its excess profits tax returns for the years 1942 to 1945, inclusive, until 1950. Its failure to do so was due to reasonable cause in believing that the percentage payments were not taxable as its income.
OPINION.
RAUM, Judge:
1. Petitioner is the lessee of a 12-story business building in Los Angeles known as the Brockman Building. Petitioner does not itself occupy the building. It subleases the space to a number of tenants, and, in effect, manages the property. The principal tenant for a number of years has been J. J. Haggarty Stores, Inc., a retail, woman's clothing store, which occupies the ground floor, basement, and several upper floors. In 1942, Haggarty entered into a new sublease providing for certain fixed rentals. Simultaneously, and as part of the same transaction, Haggarty also bound itself to pay a certain percentage of its gross sales, above a specified amount, to the Title Insurance and Trust Company, which, after deducting its trustee's fee, was to distribute the money thus receive partly to two corporations to discharge an obligation running from petitioner to those corporations and the remainder to the named stockholders of petitioner in proportion to their stock interests. The principal question for decision is whether the payments made by Haggarty during the tax years under the percentage-of-sales agreement constituted income to petitioner. The controversy has its roots in a rather complex factual situation, but a summary statement will suffice for a consideration of the issue.
The Brockman Building is owned by the Security-First National Bank of Los Angeles as trustee under a trust that was established many years ago. For some years prior to 1333 it leased the building to Brockman Building Company, petitioner's predecessor, which was then hopelessly in default under the lease, and which was also obligated upon bonds in the aggregate face amount of $92,000 to Pacific Indemnity Company and Pioneer Securities Corporation. All of the rents from the subleases had been assigned as security for the benefit of those bondholders. In 1933, the bank terminated the lease, and, with the consent of the bondholders, the subleases were assigned to the bank. Petitioner was incorporated on July 28, 1933, and on the following day acquired from the bank a 28-year lease upon the building.
Under petitioner's lease, the initial rentals which it was obligated to pay were to consist of all of the gross receipts received from the subleases, less operating expenses, with provision that unless by July 31, 1942, the net rentals thus paid to the bank averaged $3,500 a month, the lease could be canceled, but that if such minimum were met, the rent would thereafter be fixed at $3,500 a month. The bank required, as a condition to the delivery of the lease, that petitioner obtain the consent of its predecessor's bondholders. Such consent was given by the bondholders upon petitioner's undertaking to purchase in a specified manner the $92,000 outstanding bonds at face amount; and, with the consent of the bank, the lease was assigned to the bondholders as security for this obligation.
Although petitioner paid substantial amounts to the bank as net rent each year, such amounts were considerably less than the average minimum of $3,500 a month specified in the lease. By the beginning of 1942, petitioner's ‘delinquency‘ had reached $102,686.86, and there appeared to be no prospect that the delinquency would be cured by the critical date, July 31, 1942. Meanwhile the situation was complicated by the fact that the sublease of the principal occupant, Haggarty, was to expire in March 1942. Haggarty occupied not only its leased space in the Brockman Building, but also the space in the adjacent Macdonald Building, and by means of openings in the wall was able to operate its store as a unit in the two buildings. Its lease in the Macdonald Building was due to expire at about the same time, and it was imperative that it be assured of continued occupancy of its space in the Brockman Building if it renewed its lease in the Macdonald Building.
Negotiations looking towards the granting of a new lease to Haggarty were carried on by officers of petitioner for a period of about 2 years. Such negotiations were had with the knowledge of the bank. Although it was true that petitioner's basic lease from the bank was subject to cancellation on July 31, 1942, for failure to meet the specified minimum average monthly rental, the negotiations of petitioner's officers with Haggarty were undoubtedly on the assumption that some arrangement would be worked out with the bank to prevent cancellation and to assure Haggarty of continued occupancy under its proposed new sublease. Indeed, the evidence discloses that petitioner's officers were in touch with the bank from time to time during this period and were placing before the bank a plan or plans for petitioner to continue as primary lessee, notwithstanding the delinquency in rentals. In essence, petitioner's bargaining position with the bank was that it was obtaining on behalf of the bank as much in the way of rent from the building as was possible in the circumstances and that its managerial services in general were satisfactory. To be sure, petitioner dealt with the bank at arm's length, and the evidence shows that there was not full cooperation between them at all times. But the situation nevertheless appears to have been such that petitioner could reasonably hope to work out some arrangement with the bank to continue as primary lessee beyond July 31, 1942, provided that a satisfactory sublease were obtained from Haggarty.
In their negotiations petitioner's officers succeeded in obtaining Haggarty's assent not only to a substantial increase in fixed rentals, but also to the payment of so-called contingent rentals measured by the excess of Haggarty's annual gross sales over $1,400,000. The plan which petitioner presented to the bank contemplated that the bank would get all of the rentals from the entire building, except the contingent rentals from Haggarty. Thus, the petitioner could look only to the contingent rentals, if any, as a source of profit or compensation for its efforts and services in connection with the Brockman Building. The bank did not object to the major outline of the plan, but it was opposed, in form, to having Haggarty's obligation for the contingent rentals made part of the sublease, for fear that a conflict of interest might arise at some later time by reason of having a ‘partner‘ in the transaction. Accordingly, the proposed transaction was modified in form, whereby the contingent rentals were removed from the Haggarty sublease, but whereby Haggarty simultaneously agreed to make contingent payments, measured in identical fashion, to the Title Insurance and Trust Company, as trustee. The Title Company, in turn, was required to distribute such payments, after deducting its trustee's fee, in the following manner: 55 per cent to the bondholders in proportion to their respective interests, until the full $92,000 should be paid; and the remainder to the named stockholders of petitioner in proportion to their respective stock ownerships. The various documents, including the Haggarty sublease, the modification of the bank's lease to petitioner, Haggarty's agreement with the Title Company as to the contingent payments, the Title Company's declaration of trust in favor of the bondholders and named stockholders of petitioner, the assent of the bank to the contingent payments agreement, and the assent of the bondholders to the new arrangement, were all executed as parts of a single plan.
The payments actually made by Haggarty under its agreement with the Title Company were substantial, and in fact were sufficient to liquidate petitioner's obligation to the bondholders by June 1, 1945. The remaining amounts were distributed to the stockholders of petitioner, except that during some of the years involved, one of the stockholders had assigned his interest in the trust, so that a portion of the payments allocable to his share became payable to another person not a stockholder.
Had the transaction been carried out as originally planned, namely, with contingent rentals payable directly to petitioner in the Haggarty sublease, there could be no serious question that they would constitute income to petitioner, notwithstanding any anticipatory assignment that petitioner might have made at that time to its creditors or stockholders. Cf. United States v. Joliet & Chicago R. Co., 315 U.S. 44; Lucas v. Earl, 281 U.S. 111. And we think that the situation was not changed merely because the same transaction was cast in somewhat different form.
It is not accurate to say that Haggarty agreed to make these payments to the Title Company merely to obtain the assent of the bondholders and to compensate petitioner's stockholders for their efforts in bringing about the new sublease. The evidence before us shows not only that Haggarty, in its own records treated these payments as rentals, but that to the extent that they were distributed to the bondholders they conferred a direct benefit upon petitioner by liquidating its obligation to them.
Moreover, there is utter lack of proof that petitioner's stockholders, as individuals, were responsible for the consummation of the sublease. The evidence shows that the major burden of the negotiations was carried by John Shirley Ward and Chandler P. Ward, two officers of petitioner, whose stock interest in petitioner was only 8 1/2 per cent each. There is no evidence that the other stockholders were responsible for bringing about the transaction. And we are satisfied that John Shirley Ward and Chandler P. Ward were acting as officers of petitioner rather than as individuals or as stockholders with an 8 1/2 per cent interest each.
Decision will be entered under Rule 50. That part of the percentage payments that was paid to the bondholders was recognized by the Commissioner as a cost attributable to petitioner's basic lease, and he has allowed amortization of such amount over the life of the lease.
Certainly we cannot accept as a fact that the stockholders of petitioner, as individuals and in proportion to their stock interests, performed services for which they were to receive compensation through the contingent payment arrangement. Indeed the evidence strongly suggests that one of the largest stockholders resided in New York and that she rendered no services whatever in this connection. The truth of the situation, as we read the evidence, is that it was petitioner, acting through several of its officers, that became entitled to the contingent payments from Haggerty; and it arranged in advance to have those payments applied to discharge its obligation to the bondholders and to pay the remainder to the only other persons interested in its affairs, namely, its stockholders in proportion to their stock ownership.
There is considerable evidence in the record to support this conclusion, and we deem it unnecessary to set it forth. However, one consideration calls for special mention. If the two Wards were acting as individuals, on behalf of themselves, their position would have been antagonistic to that of petitioner in which they were officers. Indeed, at a meeting of petitioner's board of directors on July 3, 1941, when David Blankenhorn, who was not then a stockholder, resigned as president and gave notice that he might personally seek a commission from Haggarty for negotiating a new lease, both John Shirley Ward and Chandler P. Ward questioned the propriety of such action, and it was pointed out ‘that if Mr. Blankenhorn entered into an agency relation with the prospective tenant he must expect to be treated by this company in such negotiation just as it would treat any other outside agent (at arms's length)— he could not be on both sides of the same deal.‘ As to the subsequent position of the two Wards, there is no evidence whatever that either of them was acting at arm's length in relation to petitioner or was in any way violating his trust as an officer of petitioner in favor of his own private interests. To the contrary, the evidence is only too plain that each of them was vigorously and conscientiously acting as an officer of petitioner and seeking to promote its best interests.
We agree with the Commissioner that his position is in accord, in principle at least, with section 29.22(a)-19, Treasury Regulations 111,
and United States v. Joliet & Chicago R. Co., supra, which sustained the validity of an almost identical regulation.
Regulations 111:Sec. 29.22(a)-19. INCOME TO LESSOR CORPORATION FROM LEASED PROPERTY.— If a corporation has leased its property in consideration that the lessee shall pay in lieu of other rental an amount equivalent to a certain rate of dividend on the lessor's capital stock or the interest on the lessor's outstanding indebtedness, together with taxes, insurance, or other fixed charges, such payments shall be considered rental payments and shall be returned by the lessor corporation as income, notwithstanding the fact that the dividends and interest are paid by the lessee directly to the shareholders and bondholders of the lessor. The fact that a corporation has conveyed or let its property and has parted with its management and control, or has ceased to engage in the business for which it was originally organized, will not relieve it from liability to the tax. While the payments made by the lessee directly to the bondholders or shareholders of the lessor are rentals as to both the lessee and lessor (rentals paid in one cash and rentals received in the other), to the bondholders and the shareholders such amounts are interest and dividend payments received as from the lessor and as such shall be accounted for in their returns.
In the Joliet case, the taxpayer in 1864 leased all of its railroad property to another railroad, in perpetuity. In consideration for such lease, the lessee agreed to pay a 7 per cent annual dividend to the stockholders of the taxpayer. In addition the lessee agreed to pay all income taxes of the lessor which might arise on account of such dividend. As security for those promises, the lessee pledged, to the taxpayer, portions of its property. The Supreme Court, on such facts, held that the dividend payments made to the stockholders during the tax years in controversy were income to the lessor-taxpayer, regardless of the anticipatory arrangement which provided for the direct payments to the stockholders rather than to the lessor-taxpayer and the subsequent declaration of a dividend. The result thus reached was not novel; it was not predicated upon attempting to frustrate a tax avoidance scheme, the lease having been executed in 1864; and it was in accord with similar results already reached in a variety of other cases (e.g., Gold & Stock Telegraph Co. v. Commissioner, 83 F.2d 465 (C.A. 2), certiorari denied 299 U.S. 564; United States v. Northwestern Telegraph Co., 83 F.2d 468 (C.A. 2), certiorari denied 299 U.S. 565; Pacific & Atlantic Telegraph Co. v. Commissioner, 83 F.2d 469 (C.A. 2), certiorari denied 299 U.S. 564; American Telegraph & Cable Co. v. United States, 61 Ct.Cl. 326, certiorari denied 271 U.S. 660; Blalock v. Georgia Ry. & Electric Co., 246 F. 387 (C.A. 5); Rensselaer & S.R. Co. v. Irwin, 249 F. 726 (C.A. 2), certiorari denied 246 U.S. 671; Northern R. Co. of New Jersey v. Lowe, 250 F. 856 (C.A. 2); West End St. Ry. Co. v. Malley, 246 F. 625 (C.A. 1), certiorari denied 246 U.S. 671; Terre Haute Electric Co., 33 B.T.A. 975; Kansas City, St. Louis & Chicago Railroad Co., 42 B.T.A. 1163; cf. Old Colony Trust Co. v. Commissioner, 279 U.S. 716; United States v. Boston & M.R. Co., 279 U.S. 732; Raybestos-Manhattan, Inc. v. United States 296 U.S. 60).
Petitioner relies upon Denholm & McKay Realty Co. v. Commissioner, 139 F.2d 545 (C.A. 1). We do not read that decision as undertaking to lay down a rule different from the general rule applied in the Joliet case. The situation in the Denholm case was unusual, and the Court of Appeals itself at the outset commented that ‘The facts in the case are somewhat peculiar.‘ 139 F.2d at p. 546. Among other things, the taxpayer corporation and the corporation guaranteeing the dividends on the taxpayer's preferred stock were subject to control by the same person at the time the arrangement in controversy was adopted; the preferred stock was then held by the guarantor corporation; and it was then the intention of the guarantor corporation to exchange such preferred stock for its own outstanding preferred stock, thus in effect guaranteeing its own preferred stockholders a specified dividend through the medium of the taxpayer corporation's preferred. We mention these unusual aspects of the Denholm case not because any one of them is to be singled out as the crucial factor upon which the case should be regarded as resting, but rather because the peculiar situation there presented sets the case apart from the general rule applied in the Joliet case. To be sure, petitioner urges upon us a number of differences between the present case and the Joliet case. However, we have examined them carefully and do not find any of them persuasive. They are in general of a formalistic character comparable to the considerations relied upon by the Court of Appeals in the Joliet case itself (118 F.2d 174) which were rejected by the Supreme Court.
Petitioner's position as to its status was described in its 1942 and 1943 income tax returns, which referred to the new Haggarty sublease and the modification of its own basic lease from the bank on March 3, 1942, and stated:
The effect thereof was that taxpayer became a management corporation without compensation for its management, and its creditors lost any possibility of the payment of their claims, and its stockholders lost any possibility of enjoying any net income or dividends from its operations.
This was an incredible ultimate conclusion. Petitioner did arrange to receive compensation. After extensive negotiations, its compensation was to be the percentage rentals which Haggarty agreed to pay, and to which the bank did not object provided the arrangement were cast in an acceptable form. The form finally worked out made use of the Title Company as trustee, and the contingent rentals, now described merely as contingent ‘payments,‘ were to be funneled through the Title Company to discharge petitioner's obligation to the bondholders and then to be distributed to petitioner's named stockholders in proportion to their stock interest. It strains credulity to suggest that petitioner became ‘a management corporation without compensation for its management.‘
Petitioner makes much of the fact that one of the stockholders subsequently assigned his fractional interest in the trust so that one-half of the payments to be made to Harold Morton who was not a stockholder of petitioner. We think that this circumstance does not change the result. The payments were initially dedicated to petitioner's names stockholders (after provision for the bondholders) in proportion to their stock interest. The fact that one of them subsequently assigned a portion of his dividends to a stranger could not change the quality of the payments.
Petitioner also stresses the fact that in a proceeding brought by Morton against petitioner it was adjudged that as between them petitioner was without any right, title, or interest in the share of the Title Company trust that had been assigned to Morton. Wholly apart from any question that might arise from the nonadversary character of the proceeding in which such judgment was rendered (cf. Estate of Ralph Rainger, 12 T.C. 483, 495 et seq., affirmed 183 F.2d 587 (C.A. 9), certiorari denied 341 U.S. 904; Estate of Edith Wilson Paul, 16 T.C. 743, 745; Saulsbury v. United States, 199 F.2d 578, 580 (C.A. 5)), it is abundantly plain that it can have no effect on the present controversy. Of course, there is no reason to question Morton's rights in the assignment that was made to him, any more than there was reason to question the fact that the taxpayer in the Joliet case parted with all interest in the demised premises. And the decree of the California court here can have no more effect on the outcome of this case than the judgment of the Illinois court in the Joliet case. Indeed, the judgment of the Illinois court was relied upon by the Court of Appeals in that case, see 118 F.2d 174, 176, but the Supreme Court, in reversing the Court of Appeals, made it clear that ‘Such considerations do not dispose of this controversy.‘ 315 U.S. at p. 46.
2. The petitioner also raises an issue as to whether the statute of limitations has run on the tax years in controversy prior to 1946. The petitioner executed consents to extend the period of limitations for 1944 and 1946, which were expressly stipulated to be effective only if section 275(c) of the Internal Revenue Code
is applicable to those years. This issue then depends also on the resolution of the main issue.
SEC. 275. PERIOD OF LIMITATION UPON ASSESSMENT AND COLLECTION.Except as provided in section 276—(c) OMISSION FROM GROSS INCOME.— If the taxpayer omits from gross income an amount properly includible therein which is in excess of 25 per centum of the amount of gross income stated in the return, the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time within 5 years after the return was filed.
Since we have determined that the percentage payments made by Haggarty to the Title Company were income of the petitioner and were not reported by petitioner, we must only decide whether or not such payments exceeded 25 per cent of petitioner's gross income, as reported. The percentage payments made by Haggarty to the trust during 1944 and 1945 were $66,971.24 and $92,662.53, respectively. Petitioner, for the same years, reported $21,532.42 and $176,615.64, respectively, as it gross income. The unreported amounts are far in excess of the requisite 25 per cent of the reported amounts and section 275(c) therefore applies, rendering the extension of the period of limitations effective.
3. The respondent determined that, under the provisions of section 291(a) of the Code,
petitioner was liable for a 25 per cent addition to tax because of its failure to file timely excess profits tax returns, for the years 1942, 1943, 1944, and 1945. Such returns were not filed until September 29, 1950. This determination must be considered correct unless petitioner establishes that the failure to file such returns was due to reasonable cause and not to willful neglect.
SEC. 291. FAILURE TO FILE RETURN.(a) In case of any failure to make and file return required by this chapter, within the time prescribed by law or prescribed by the Commissioner in pursuance of law, unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the tax: 5 per centum if the failure is not more than thirty days with an additional 5 per centum for each additional thirty days or fraction thereof during which such failure continues, not exceeding 25 per centum in the aggregate. The amount so added to any tax shall be collected at the same time and in the same manner and as a part of the tax unless the tax has been paid before the discovery of the neglect, in which case the amount so added shall be collected in the same manner as the tax. The amount added to the tax under this section shall be in lieu of the 25 per centum addition to the tax provided in section 361(d)(1):
The Commissioner further determined that the failure of the petitioner to report the percentage payments made by Haggarty was due to negligence or intentional disregard of rules and regulations and that the petitioner was liable for the 5 per cent addition to the deficiency prescribed by section 293() of the Code.
Petitioner's liability for these proposed additional assessments turns on whether it acted in good faith in not including the percentage payments in its gross income.
SEC. 293. ADDITIONS TO THE TAX IN CASE OF DEFICIENCY.(a) NEGLIGENCE.— If any part of any deficiency is due to negligence, or intentional disregard of rules and regulations but without intent to defraud, 5 per centum of the total amount of the deficiency (in addition to such deficiency) shall be assessed, collected, and paid in the same manner as if it were a deficiency, except that the provisions of section 272(i), relating to the prorating of a deficiency, and of section 292, relating to interest on deficiencies, shall not be applicable.
We think that the Commissioner erred in determining that petitioner is liable for additions to tax under sections 291(a) and 293(a). Petitioner attached to its corporate income tax and declared value excess-profits tax returns for 1942 and 1943 a rider explaining the basic outline of the transactions involving the Haggarty trust, although it was inaccurate in one important conclusion. The returns were prepared by a certified public accountant and we think that, in view of the statement made in connection with these returns, petitioner has shown enough to establish that it acted in good faith in not reporting the percentage payments as its income. Cf. Pullman, Inc., 8 T.C. 292, 299. Similarly, we think that this bona fide belief that the payments were not taxable as its income was reasonable cause for petitioner's failure to file its excess profits tax returns according to law. Without the inclusion in income of the percentage payments, petitioner's excess profits credit was sufficient to eliminate any tax due. It would be unnecessary therefore to file a return and petitioner acted accordingly.