Opinion
Docket No. 8374-71.
1973-11-14
GORDON J. HARMSTON AND ALICE C. HARMSTON, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
William P. Irwin and George F. Belyea, for the petitioners. Joyce E. Britt and James Booher, for the respondent.
William P. Irwin and George F. Belyea, for the petitioners. Joyce E. Britt and James Booher, for the respondent.
T, as buyer, entered into two contracts for the purchase of two orange groves. The groves were newly planted, and required 4 years of maintenance and care in order to become mature or established. The contract price was $4,500 an acre, payable at the rate of $1,125 per acre per year over a 4-year period. During the 4-year period the seller remained in possession and assumed full responsibility in the contracts to provide maintenance and care. The seller also retained legal title, paid the real estate taxes, and in general retained most of the burdens and benefits of ownership. Held, the payments made by T under the contracts represented his nondeductible cost of the established groves, no part of which may properly be allocated to deductible expenses for maintenance and care of the groves.
The Commissioner determined deficiencies in petitioners' income tax in the amounts of $11,530.44, $23,501, and $16,040 for the calendar years 1967, 1968, and 1969, respectively. Petitioner acquired two orange groves, paying $4,500 per acre in respect of each of them over a period of approximately 4 years each. The principal question is whether portions of such amounts may be allocated to services for ‘management and care’ of the grove performed by the seller and thus treated as deductible from gross income under section 162, I.R.C. 1954, and section 1.162-12(a), Income Tax Regs., or whether the entire amounts paid by petitioner (at $4,500 per acre) represent simply his nondeductible capital investment in the groves. If the foregoing question should be decided in petitioner's favor, a further question presented is whether the particular allocation claimed by him was incorrect, thus requiring a different allocation of the amounts involved.
FINDINGS OF FACT
The parties have filed a stipulation of facts which, together with accompanying exhibits, is incorporated herein by this reference.
Gordon J. and Alice C. Harmston are husband and wife. They filed joint Federal income tax returns with the district director of internal revenue at San Francisco, Calif., for 1967, and with the Internal Revenue Service Center for the western region, at Ogden, Utah, for 1968 and 1969. At the time their petition herein was filed they resided in Fresno, Calif.
Gordon J. Harmston (petitioner) is a physician specializing in radiology. He has been practicing medicine in Fresno, Calif., since sometime prior to 1967. During the period 1961 through 1965 Dr. Harmston purchased various ‘farm’ properties. These purchases are reflected in the following table:
+----+ ¦¦¦¦¦¦ +----+
Year Number purchased of Location Description of use acres 1961 3 Fresno “proper” 15 walnut, 12 olive, and various citrus trees. 1963 60 Shaw and McCall Barley. Avenues in Clovis, Calif. { 500 Auberry, Calif Grazing and open land. 1964 { 70 Clovis, Calif Grazing and dog training land. 1965 240 Meadow Lakes, Pasture and grazing land Calif with an active apple orchard.
This property is ‘leased out’ by Dr. Harmston.
The 3 acres in Fresno and the 60 acres in Clovis, Calif., were owned by Dr. Harmston alone, the other properties were owned by him in conjunction with others. In addition, Dr. Harmston was a partner in a 28,000-acre cattle ranch located in Mendocino County, Calif. Some alfalfa was raised on this property, and it had a hunting lodge which was sometimes used as a dude ranch. On their Federal income tax returns for 1967, 1968, and 1969 petitioners reported income and claimed deductions for real estate taxes paid with respect to certain of these properties
in various amounts, as is indicated in the following table:
It is not clear from the record whether certain other amounts claimed as deductions for real estate taxes paid in 1967, 1968, and 1969 might relate in whole or in part to the 3 acres in Fresno or the 70 acres in Clovis, Calif.
+----+ ¦¦¦¦¦¦ +----+
1967 1968 1969 Income (loss): Mendocino Ranch ($836) ($1,428) ($1,205) Auberry Property 225 120 Meadow Lakes Property 68 124 44 Shaw and McCall Property 372 Deductions for real estate taxes: Auberry Property 154 3 176 Meadow Lakes Property 82 88 95 Shaw and McCall Property 576 615 680
A grazing fee of $112 and a real estate tax of $164 were reported in petitioners' 1968 return and described as relating to ‘Sierra High’ which was not otherwise identified and may conceivably have been intended to refer to the Auberry Property.
Sometime in 1964 or 1965 petitioner became interested in citrus ‘farming.’ After some preliminary discussions in May 1967, with William P. Irwin, president of Jon-Win Farms (Jon-Win), a California corporation, petitioner and Jon-Win on June 1, 1967, entered into the first of two contracts, hereinafter described. Petitioner's accountant had referred him to Irwin. Irwin is a lawyer, and is petitioner's trial counsel in this case. He is a stockholder, director, and president of Jon-Win, and he appears to be the dominant figure in its affairs. Jon-Win had approximately 10 stockholders, it was a cash basis taxpayer with a fiscal year ended September 30, and it qualified as a ‘subchapter S' corporation.
Jon-Win owned two separate ranches in the Fresno area, known as the Academy Ranch and the Elk Ranch, both of which it was developing primarily into citrus groves. Although each has been referred to from time to time as a 400-acre ranch, the Academy Ranch consisted of about 374 acres and the Elk Ranch of about 385 acres. Jon-Win acquired the Academy Ranch in five separate parcels during the period 1961-66 and the Elk Ranch in 1966. As of September 30, 1967, there were 227 acres on the Academy Ranch which were planted with citrus trees, 35 acres which were vacant and ready to have citrus trees planted, and 85 acres
which were planted with vines which had been on the property when it was purchased. There were also a small number of walnut trees, comprising roughly 1 or 2 acres on the ranch. At the time the Elk Ranch was purchased 212 of its acres were planted with Emperor vines and approximately 141 of its acres
The remaining acreage of the Academy Ranch, 25 acres, was used for roads, the homes of employees and others who lived on the ranch, and various service buildings and machine sheds.
were cleared. In the fall of 1966 Jon-Win began to prepare a portion (81 acres) of this cleared land for planting with citrus trees— principally orange trees. The two contracts involved herein related to two parcels that were carved out of those 81 acres of the Elk Ranch, and by June 1, 1967, the date of the first contract, they had already been planted or were being planted with orange trees. Such planting appears to have been completed during ‘the spring of 1967.’
The remaining acreage on the Elk Ranch, 32 acres, was used for roads. and building and home sites.
Orange tree seedlings are approximately the size of a pencil when they are first planted in the nursery. During their first year of growth they develop a fibrous network of roots which expands outward from the base of the tree. After the tree has been growing for approximately 1 year, these roots are cut back to within approximately an 8-inch diameter circle surrounding the base of the tree, and to a depth of approximately 14 inches. The top portion of the tree is also partially removed to balance the tree after the loss of a portion of its roots. This entire process is known as ‘balling’ the tree, and after it is done the mass of roots and dirt on the bottom of the tree is wrapped in burlap and the tree is ready to be replanted in properly prepared soil. Once the tree is replanted it will begin to develop its taproot. This root should grow to a depth of approximately 4 feet; if the growth of the taproot is inhibited the tree will develop an inadequate, shallow root system unable to draw moisture from the damp soil several feet below the surface, and it will be a weaker, less productive tree.
The soil in the Fresno area has developed what is known as a ‘hard pan payer,’ between 1 1/2 and 3 feet below the surface of the soil, which is composed of natural salts and calcium which have been ‘leached’ to that depth by the action of rain. This layer can be extremely hard and it must be broken up before the trees are planted to allow the taproot of an orange tree to penetrate to its proper depth, i.e., about 4 feet. The process of breaking up the ‘hard pan layer’ is known as ‘ripping’ the land; it involves the use of large tractors which draw a device over the land that penetrates to a depth of approximately 4 1/2 feet and ‘moves' the soil. After the land has been ‘ripped’ it is leveled and some means of irrigation is provided. It is then ready to be planted with 1-year-old orange trees. Assuming that the trees grow normally after they are planted. they will not yield any crop during their first 2 years in the grove, and the crop during their third and fourth years will be small. After 4 years the grove is sometimes referred to as an established or mature grove; and the crop yield is expected to be more substantial at that time.
There are numerous problems which must be dealt with by the manager of the grove after the trees are planted. During the first year the trees must be watered in a proper manner and for a long enough period of time to make sure that there is a settling of the dirt around and beneath the ‘ball’ of the tree. This prevents an air pocket from developing under the ‘ball’ of the tree which would block the proper growth of the taproot. In subsequent years overwatering can be a problem, since it may cause the roots of the tree to begin to rot. Both of these problems can prevent the proper growth and development of the tree, causing it to be less productive in future years. There are also numerous diseases, such as ‘scaly bark,’ ‘tristeza,‘ and ‘exocortis,‘ which can attack the trees and affect their future productivity. In addition the wrong kind of soil, or water containing certain harmful chemicals, can have an adverse effect on the grove. Proper management of the grove is important to avoid these problems or deal with them when they arise. Finally, problems such as cold weather (a freeze) or hail can affect both the orange crop and the trees themselves. While it is common to insure the annual crop. there is no insurance against damage to the trees. Once a tree is damaged to the point where it must be removed, regardless of its age it is usually replaced by a 1-year-old tree; while it might be physically possible to replace damaged trees with older trees, it is not economically feasible to do so.
The costs of management and care of a newly planted orange grove during its first 2 years are greater than those incurred thereafter. Such costs in later years may nevertheless be substantial.
On June 1, 1967, petitioner (as ‘Buyer’) and Jon-Win (as ‘Seller’) entered into the first of the two contracts here in issue. It was captioned ‘Contract of Sale of Real Property,‘ and dealt with a parcel of 17.31 acres that had been carved out of the 81-acre portion of the Elk Ranch that was mentioned above. This 17.31-acre parcel was along Belmont Avenue, a main thoroughfare, some 3 miles from the city of Sanger, Fresno County. By June 1, 1967, the 17.31-acre parcel had already been ripped and leveled, and the necessary pipeline and hydrants had already been installed; also, it had by then been planted (or was being planted) with 1-year-old orange trees. The contract provided, in part, as follows:
Seller, in consideration of the payments to be made by Buyer and the conditions and covenants to be kept and performed by Buyer as hereinafter set forth, agrees to sell, and Buyer agrees to buy, 17.31 acres out of Seller's real property described in Exhibit A. * * *
The real property purchased by Buyer shall be improved and planted prior to July 15, 1967, to a navel orange grove at Seller's sole cost and expense. * * * Seller, at its own cost and expense, has improved said real property by deep ripping and leveling same and the installation of the necessary pipeline and hydrants for the water systems.
I
Purchase Price
The purchase price for said orange grove shall be $4500 per acre, or a total purchase price of $77,895.00 for 17.31 acres, payable at the rate of $1125 per acre per year over a four-year period from date of this contract.
Buyer and Seller agree that, since the cost of the land acquisition and the land development cost and the expense of the operation of the grove for the four-year period of this contract is to be borne by Seller and to be at Seller's risk, the purchase price paid by Buyer to Seller over the four-year period of the contract shall be allocated each year and payable in the following manner:
+-----------------------------------------------------------------+ ¦1st year—for management and care at $1125 per acre ¦$19,473.75¦ +------------------------------------------------------+----------¦ ¦2nd year—for management and care at $1125 per acre ¦19,473.75 ¦ +------------------------------------------------------+----------¦ ¦3rd year—for management and care at $435 per acre ¦7,529.85 ¦ +------------------------------------------------------+----------¦ ¦3rd year—for trees and care at $690 per acre ¦11,943.90 ¦ +------------------------------------------------------+----------¦ ¦4th year—for trees and care at $25 per acre ¦432.75 ¦ +------------------------------------------------------+----------¦ ¦4th year—for pipeline at $100 per acre ¦1,731.00 ¦ +------------------------------------------------------+----------¦ ¦4th year—for land at $1000 per acre ¦17,310.00 ¦ +------------------------------------------------------+----------¦ ¦Total four-year payments allocated over four-year term¦77,895.00 ¦ +-----------------------------------------------------------------¦ ¦($4,500.00 per acre) ¦ +-----------------------------------------------------------------+
(Provision was then made for payment of the annual amount of $19,473.75 in four substantially equal installments. For 1967, these installments were payable on execution of the contract, and on September 1, December 1, and December 31. For the remaining 3 years, the installments were due on March 1, June 1, September 1, and December 1 of each year.)
II
Seller's Obligation for Management and Care
Seller agrees at its own cost and expense to properly maintain and care for said orange grove purchased by Buyer hereunder and to farm the same in a good and farmerlike manner * * * . The management and care obligation at Seller's sole cost and expense to continue for the four-year crop period (navel oranges being harvested largely in the months of November, December and January of each year) of 1967-68, 1968-69, 1969-70 and 1970-71.
Seller's obligation for management and care for the four-year crop period of this contract shall include deep ripping and leveling the land, installation of the necessary pipeline and irrigation system for the delivery of water to the grove, payment of all real property taxes and irrigation district taxes, payment of all utility bills for power, payment for all fertilizer, insecticide and labor bills in connection with the operation of the grove, together with all payroll taxes and workmen's compensation insurance, payment for all of the orange trees to be planted, together with the survey work and planting labor in connection therewith. In addition, Seller shall provide frost protection at its own cost and expense as deemed necessary and advisable in Seller's discretion. Seller shall provide at its own cost and expense the management and supervision necessary to successfully manage and operate said grove during the four-year period. Seller carries public liability insurance for bodily injury in the amount of $1,000,000 and property damage insurance in the amount of $100,000. Seller will indemnify and hold Buyer harmless from any liability for public liability or property damage during the four-year contract period. In addition, Seller shall supply at its own cost and expense all equipment and supplies necessary to properly care for, maintain and cultivate said grove in a good and farmerlike manner. Any trees that either die or are not healthy in the judgment of Seller or any trees that may be damaged by frost or from any other cause other than acts of God during the term of this contract shall be replaced with a new tree at Seller's own cost and expense.
It is the intention of the parties that all costs of whatsoever kind and nature necessary and incidental to the preparation, planting and operation of an orange grove be paid for by Seller during the four-year term of this contract and that Buyer shall not be called upon to pay any of said expenses with the exception of the yearly payments due Seller from Buyer under the terms of this contract.
III
Crop
The orange crop shall belong to Seller for the four-year crop period of this contract, being 1967-68, 1968-69, 1969-70 and 1970-71. All subsequent crops shall belong to Buyer.
IV
Depreciation and Investment Credit
Buyer shall be entitled to claim credit for all depreciation available on the assets purchased and all investment credit available on all assets purchased.
V
Warranty of Seller
Seller represents and warrants to Buyer that it has already paid for all of the trees to be planted on Buyer's property and all of the ripping and leveling expense and all of the pipeline on said property; that it has legal title to the real property and is lawfully seized in fee simple and that it will deliver to Buyer upon payment in full of the contract price a grant deed to said real property, free and clear of all encumbrances except easements, covenants, restrictions and rights of way of record. This contract shall remain unrecorded until payment is received in full, at which time a deed to said property will be recorded in Buyer's name. Upon payment of the contract price, Seller shall deliver to Buyer a policy of title insurance insuring Buyer's title in an amount of not less than the contract price. Seller further warrants that it shall make no transfer, sale or assignment of any interest in the property purchased by Buyer hereunder at any time during the term of this contract.
IX
Default
Time is of the essence of this contract. Should Buyer default in any of the payments to be made under this contract or fail to comply with any of the terms and conditions on his part to be performed under this contract, then at the option of Seller the whole balance of principal and interest provided for herein shall immediately fall due and become payable; or, Seller may, at its option, consider this contract immediately terminated and may thereupon take possession of said property and retain all sums of money theretofore paid * * *
X
Assignment of Rights of Buyer and Seller and Right of First Refusal
Seller consents to Buyer's right to assign Buyer's interest in this contract at any time during the contract period, providing, however, that Buyer remains financially responsible on said contract for its entire term. * * * Seller will relieve Buyer from further liability on this contract * * * only in the event Buyer submits or has his assignee submit to Seller evidence satisfactory to Seller of said assignee's ability to meet the remaining portion of the contract balance. Seller shall have the right of first refusal to match any offer made to Buyer for said property of Buyer and upon the same terms and conditions at any time during this contract period or thereafter in the event Buyer elects to sell the property purchased hereunder. * * * any sale or assignment shall be subject to the provisions relating to assignment as set forth above.
Seller shall have the right to assign its interest in this contract, but shall remain financially responsible on this contract to Buyer for the entire term of this contract and, in addition, Seller shall not, in any event, be relieved of its duty to be personally responsible for the management, care and supervision of Buyer's orange grove property for the entire term of this contract.
XI
Seller's Reports and Buyer's Inspection
Buyer is free to consult with Seller and enter upon and inspect the property at any reasonable time during the four-year term of this contract.
XIII
Maintenance of Property by Seller
Seller agrees to develop and farm said property in a good and farmerlike manner and to maintain said property in a clean condition and to maintain the improvements on said property in good condition at all times during the term of this contract.
XIV
Option in Buyer to Assume Seller's Financing
In lieu of a cash payment to Seller for the fourth year payment due Seller under the terms of this contract, Buyer shall have the option to assume the pro rata part of Seller's trust deed financing existing on the 400-acre Elk Ranch as it relates to the acreage purchased by Buyer hereunder. * * *
Buyer shall in any event have the right to call for a deed to said property, free and clear of all encumbrances except easements, covenants, restrictions and rights of way of record by placing his fourth year payment; when due, in an escrow at Security Title Insurance Company, * * * with instructions to deliver same to Seller when Seller is in a position to deliver a deed free and clear of all encumbrances except easements, covenants, restrictions and rights of way of record.
On July 26, 1967, Jon-Win, as trustor, executed a deed of trust in favor of Connecticut General Life Insurance Co. (Connecticut General) for the purpose of securing payment of $540,000 owed by it on a loan obtained by Jon-Win from Connecticut General and evidenced by a promissory note payable to Connecticut General also dated July 26, 1967. The security covered by the deed of trust consisted of the Elk Ranch and included the 17.31 acres that were the subject of the foregoing contract of June 1, 1967, between petitioner and Jon-Win. Moreover, at the time of the execution of the June 1, 1967, contract there were two other deeds of trust or mortgages wherein the Elk Ranch property was used to secure indebtedness to others in the amounts of $225,000 and $205,000. The record is not clear as to what extent the loan from Connecticut General may have superseded one of these other two loans.
Notwithstanding that the contract of June 1, 1967, provided that it should ‘remain unrecorded until payment is received in full, at which time a deed to said property will be recorded in Buyer's name,‘ a document entitled ‘Memorandum of Contract of Sale,‘ which had been executed on September 6, 1967, was recorded on September 19, 1967, in the official records of Fresno County, and provided in principal part as follows:
The purpose of this Agreement is to record the ownership interest of GORDON J. HARMSTON as purchaser under a Contract of Sale executed by the Seller and Buyer dated June 1, 1967. This Contract of Sale is junior and subordinate to a first trust deed on the real property in favor of Connecticut General Life Insurance Company and any advancements made thereunder, which trust deed is in the principal sum of.$540,000.00 and was dated July 26, 1967, and recorded on August 14, 1967, in Book 5469, page 599, official records, Fresno County. Said trust deed covers the property described in the Contract of Sale and other surrounding real property of Seller.
On November 1, 1968, petitioner (as ‘Buyer’) and Jon-Win (as ‘Seller’) entered into the second of the two contracts here in issue, which was similarly captioned ‘Contract of Sale of Real Property.’ It, too, related to a portion (17.26 acres) of the Elk Ranch, which was not only contiguous to the 17.31 acres that were the subject of the first contract, but was also included within the 81 acres that were developed into orange groves during the period from the fall of 1966 through the spring of 1967. Under this second contract, which to a considerable extent contained provisions that were identical to those in the first contract, petitioner agreed to purchase the 17.26 acres for $4,500 an acre, or a total purchase price of $77,670, payable at the rate of $19,417.50 per year over a stated period of 4 years. This land had been ripped, leveled, and planted with 1-year-old orange trees at approximately the same time in 1966 and 1967 as the land which was the subject of the first contract. The 17.26 acres of the second contract thus represented an orange grove that was nearly a year and a half old at the time of its execution on November 1, 1968. This contract, following the language of the earlier contract, nevertheless treated the grove as though it had been newly planted, and undertook to make allocations in respect of the purchase price as follows:
Buyer and Seller agree that, since the cost of the land acquisition and the land development cost and the expense of the operation of the grove for the four-year period of this contract is to be borne by Seller and to be at Seller's risk, the purchase price paid by Buyer to Seller over the four-year period of the contract shall be allocated each year and payable in the following manner:
+------------------------------------------------------------------------+ ¦1st year—for management and care at $1125 per acre ¦$19,417.50¦ +-------------------------------------------------------------+----------¦ ¦2nd year—for management and care at $1125 per acre ¦19,417.50 ¦ +-------------------------------------------------------------+----------¦ ¦3rd year —for management and care at $435 per acre ¦7,508.10 ¦ +-------------------------------------------------------------+----------¦ ¦3rd year—for trees at $621 per acre ¦10,718.46 ¦ +-------------------------------------------------------------+----------¦ ¦4th year 6 —for trees at $25 per acre ¦431.50 ¦ +-------------------------------------------------------------+----------¦ ¦4th year—for pipeline at $100 per acre ¦1,726.00 ¦ +-------------------------------------------------------------+----------¦ ¦4th year—for interest on capital items at 4% at $230 per acre¦3,969.80 ¦ +-------------------------------------------------------------+----------¦ ¦4th year—for land at $839 per acre ¦14,481.14 ¦ +-------------------------------------------------------------+----------¦ ¦Total four-year payments allocated over four-year term ¦77,670.00 ¦ +------------------------------------------------------------------------¦ ¦($4,500.00 per acre) ¦ +------------------------------------------------------------------------+
Although this contract stated, as did the June 1, 1967, contract, that the purchase price was to be ‘payable at the rate of $1125 per year over a four-year period,‘ the payments for the third year are only $1,056 per acre, while those for the fourth year are $1,194 per acre. The average of the third and fourth year payments, however is $1,125 per acre per year.
The terms of this contract were generally identical or similar to those in the earlier contract; however, certain changes are described in the margin which may perhaps be regarded as noteworthy.
Unless otherwise indicated, the basic provisions of the first contract which were quoted extensively above were either incorporated in substantially identical language in the second contract or were adapted without significant change therein.
Such changes include the following: (1) An ‘interest’ charge on ‘capital items' was included in the purchase price, by changing the allocation of the payment for the fourth year; (2) the requirement that the buyer take out a life insurance policy on his life irrevocably naming the seller as a beneficiary to insure payment of the full contract price in the event of the buyer's death was removed; and (5) a new provision was added to the contract setting out the rights of the seller in the event the buyer should default on any of his payments or otherwise fall to comply with the terms of the contract, which superseded and replaced the provision in the earlier contract in that respect, and which provided that upon 60 days' written notice to the buyer after such default or failure the seller would have the right to declare the whole balance of the principal and interest under the contract immediately due and payable.
On December 17, 1908, a ‘Memorandum of Contract of Sale,‘ which had been executed by petitioner and Jon-Win on November 1, 1968, was recorded in the official records of Fresno County. Except for the particular property involved, the dates, and an unexplained increase in the amount of the trust deed of July 26, 1967, to $549,000, this document was in all important respects identical to the ‘Memorandum of Contract of Sale’ filed on September 19, 1967, in connection with the first contract.
As of June 1, 1967, and November 1, 1968, the dates of the two contracts, the fair market value of the bare, unripped, unleveled land involved therein was $1,050 per acre. As of each of those dates, the fair market value of newly planted orange groves on such land (which had been ripped, leveled, and provided with pipeline for irrigation) was $2,400 per acre. As of each of those dates, the fair market value of a contract right to obtain established 4-year-old orange groves on such land at the expiration of such period (with allowance for normal loss of trees during that period and their replacement with 1-year-old trees) was in the range of $4.200 to $4,500 per acre.
Jon-Win and petitioner carried out their respective obligations under the two contracts. Record title remained in Jon-Win during the contract periods, and petitioner received a deed to each parcel upon making final payment in respect thereof at the end of the respective 4-year periods.
In a case in which a contract of sale had been executed with respect to certain property, it was the practice of the Fresno County Assessor to send the notice of assessed value and the tax bill to the seller of the property until a deed was recorded in the buyer's name. Throughout the period that the Harmston contracts were in effect the Fresno County Assessor sent the notices of assessed value and the tax bills with respect to the property which was the subject of the two Harmston contracts to Jon-Win. These parcels were separately assessed and taxed, as was the practice with respect to other parcels owned by Jon-Win. However, Jon-Win paid the real estate taxes imposed upon all its real estate including the two parcels that were subject to the Harmston contracts during the respective 4-year periods covered by such contracts, and it took deductions therefor on its Federal income tax returns. During these periods Jon-Win did not keep separate accounting records for the property that was subject to these contracts. No deductions were claimed by petitioners for real estate taxes in respect of these properties during the 4-year periods. After petitioner received a deed to each of the properties he received and paid the tax bills in respect of each of them for subsequent years.
During the 4-year periods, any increases in real estate taxes or in any management and care expenses were to be borne by Jon-Win, not by petitioner. Jon-Win assumed the financial risks of managing the groves during the 4-year contract periods. After expiration of the contracts, Jon-Win by special arrangement has continued to manage the groves for $300 per acre per year.
When the two contracts were executed Jon-Win was operating at a net loss, and it was anticipated that it would continue to do so for some time. Although Jon-Win reported the ‘management and care’ items on petitioner's contracts as income on its own returns, such income was offset by its net losses.
The two contracts in issue were executory and did not transfer ownership of the respective properties to petitioner at the time the contracts were entered into.
Petitioners claimed deductions for farm expenses on their 1967, 1968, and 1969 Federal income tax returns in the amounts of $19,474, $38,892, and $26,948, respectively. This deduction was characterized on their 1967 return as ‘Management and Care Expense, 17.31 acres Jon-Win Farms— $19,474,‘ on their 1968 return as ‘Jon-Win Farms, Management and Care Expenses, 17.31 acres— $7,530, 17.79
acres— $19,418.’ In his deficiency notice to petitioners the Commissioner disallowed the entire amount of these claimed deductions, for the reasons that ‘(1) * * * Such payments do not represent deductible farm expenses, but instead constitute a part of the purchase price of citrus orchards (and) (2) The claimed expenses were not incurred in carrying on a trade or business during the years in question.’
Although it seems clear that this deduction was claimed in respect of the payments made under the second contract, which involved a parcel of land that covered 17.26 acres, the figure of 17.79 acres in petitioners' return is unexplained.
OPINION
RAUM, Judge:
Petitioner entered into two contracts with Jon-Win, in each of which he undertook to purchase from it an orange grove of approximately 17 acres at $4,500 an acre. Each contract was stated to run for a period of 4 years. Both groves were newly planted in the spring of 1967, and it appears to be recognized that it takes 4 years for an orange grove to mature or become established. Under each contract petitioner was required to pay one-fourth of the purchase price ($1,125 per acre) each year, and upon payment of the last installment he was to be entitled to a deed to the property. Meanwhile, under each contract the seller remained in complete control of the property and obligated itself to render services of management and care of the groves during the 4-year period, assuming all responsibility in respect thereof. Such services were extensive, particularly during the first 2 years. The primary question for decision is whether allocable portions of the annual amounts paid by petitioner to the seller may be treated by him as deductible expenses, rather than as installment payments made to acquire established groves as of the end of the contract periods. If petitioner in fact acquired ownership of the groves immediately upon entering into the contracts, there does not seem to be any serious dispute between the parties that he would be entitled to deductions in respect of those portions of the payments that might fairly be allocable to management and care.
However, if, as the Government contends, the contracts were in fact executory and petitioner did not become the owner of the groves until the termination of the contracts, the payments made by him would in fact represent nothing more than the nondeductible purchase price for established groves, and the effort to characterize a portion thereof as something else (i.e., fees for management and care) would be of no avail. The real question before us therefore is to determine whether the contracts were executory and whether petitioner in fact paid any management and care fees notwithstanding the effort in the contracts to describe a portion of the purchase price as consisting of such fees. In our view of the record, the contracts were executory, petitioner did not become the owner of each grove until he made the final payment, and all the installments paid by him were merely nondeductible costs of acquiring two groves which had been brought to maturity after 4 years of management and care.
Thus, to the extent that his payments might be allocable to management and care of his own citrus groves he would be regarded as having paid ‘cultural costs? which he could elect to deduct pursuant to sec. 1.162-12(a), Income Tax Regs. See Estate of Richard R. Wilbur, 43 T.C. 322, 324, 328. Although such deductions had been allowed administratively for many years, they were regarded as an ‘abuse,‘ and were outlawed by sec. 216 of the Tax Reform Act of 1969, Pub.L. 91-172, 83 Stat. 573, which added sec. 278 to the Code. See H. Rept. No. 91-413, 91st Cong., 1st Sess., pp. 62-63; S.Rept.No. 91-552, 91st Cong., 1st Sess., pp. 95-96; Conf.Rept.No. 91-782, 91st Cong., 1st Sess., p. 299; 115 Cong.Rec. S15954, S15955 (daily ed. Dec. 6, 1969) (remarks of Senator Holland); Staff of the Joint Committee on Internal Revenue Taxation, 91st Cong., 2d Sess., General Explanation of the Tax Reform Act of 1969, p. 97 (Dec. 3, 1970). However, these new provisions do not apply here, because they are specifically made inapplicable to citrus groves planted prior to their enactment.
An issue raised in the deficiency notice challenging the deduction on the ground that it is not available to petitioner because ‘The claimed expenses were not incurred in carrying on a trade or business'—i.e., because he was allegedly not a ‘farmer’ within the meaning of the regulations— does not seem to be pressed by the Government on brief, independently of its position that petitioner was ‘merely a party to a contract for the purchase of a developed citrus grove’ and therefore was not a ‘farmer’ in respect of such grove under sec. 1.162-12 of the regulations prior to the expiration of the applicable 4-year period. Accordingly, our disposition of the principal issue makes unnecessary any separate consideration of this point. Similarly, our holding on the principal issue makes it unnecessary for us to reach the question whether the particular allocation claimed by petitioner should be modified.
The question as to when a sale is consummated for tax purposes is a practical one, which must be decided by weighing all of the various factors present in each case. As was stated in Commissioner v. Segall, 114 F.2d 706, 709-710 (C.A. 6), reversing on other grounds 38 B.T.A. 43, certiorari denied 313 U.S. 562:
There are no hard and fast rules of thumb that can be used in determining, for taxation purposes, when a sale was consummated, and no single factor is controlling; the transaction must be viewed as a whole and in the light of realism and practicality. Passage of title it perhaps the most conclusive circumstance. Brown Lumber Co. v. Commissioner, 59 App.D.C. 110, 35 F.2d 880. Transfer of possession is also significant. Helvering v. Nibley-Mimnaugh Lumber Co., 63 App.D.C. 181, 70 F.2d 843; Commissioner v. Union Pac. R. Co., 2 Cir., 86 F.2d 637; Brunton v. Commissioner, 9 Cir., 42 F.2d 81. A factor often considered is whether there has been such substantial performance of conditions precedent as imposes upon the purchaser an unconditional duty to pay. Commissioner v. North Jersey Title Ins. Co., 3 Cir., 79 F.2d 492; Brunton v. Commissioner, supra; Case v. Commissioner, 9 Cir., 103 F.2d 283; United States v. Utah-Idaho Sugar Co., 10 Cir., 96 F.2d 756. See Options and Sale Contracts in Taxation, 46 Yale Law Jour. 272, 279.
See also Clodfelter v. Commissioner, 426 F.2d 1391, 1393-1394 (C.A. 9), affirming 48 T.C. 694; Morco Corp. v. Commissioner, 300 F.2d 245-246 (C.A. 2), affirming a Memorandum Opinion of this Court; Commissioner v. Baertschi, 412 F.2d 494, 498 (C.A. 6), reversing 49 T.C. 289. The test has also been stated in terms of when the ‘benefits and burdens' of ownership have passed from the seller to the buyer. See Dettmers v. Commissioner, 430 F.2d 1019, 1023 (C.A. 6), affirming 51 T.C. 290; Ted F. Merrill, 40 T.C. 66, 74, affirmed per curiam 336 F.2d 771 (C.A. 9); 2 Lexington Avenue Corp., 26 T.C. 816, 822, 824-825. Taking such criteria into account, it is our best judgment that the ‘ownership’ of the properties in question did not pass to petitioner when he signed the respective ‘Contract(s) of Sale of Real Property,‘ and that what he got in substance was merely a contract right to acquire ownership upon the expiration of the 4-year periods, provided that he had complied with his contractual obligations.
Although passage of title is not the single determinative factor in deciding when ‘ownership’ has passed under a contract of sale, it is certainly an important consideration. In this case, legal title to each of the properties remained in Jon-Win (seller) during the period of each contract. The contracts specifically provided that they were to remain unrecorded until full payment was received, and that petitioner (buyer) did not have a right to call for a deed until his fourth year payment, when due, had been placed in escrow. Thus, under the terms of the contracts petitioner had to wait 4 years before he could demand a deed for the property. Although a ‘Memorandum of Contract of Sale’ was recorded with respect to each contract, which stated that its purpose was ‘to record the ownership interest of Gordon J. Harmston as purchaser,’ petitioner still did not have a deed of the contract periods. Moreover, neither ‘Memorandum’ makes clear precisely what petitioner's ‘ownership interest’ was, and it would seem to identify only his contractual rights with respect to the groves. Thus, the real property taxes on both parcels were assessed to, and paid by, Jon-Win, and only Jon-Win claimed deductions for real estate taxes paid with respect thereto, notwithstanding that it was petitioner's practice to claim deductions for real estate taxes paid with respect to his other ‘farm’ properties. Finally, there was no indication on any of the tax bills introduced into evidence by petitioner that Jon-Win was being assessed for the tax on behalf of petitioner in a representative capacity, although California law specifically provides for such indication. Cal. Rev. & Tax. Code sec. 612 (West 1970).
Sec. 612. Representative designationWhen a person is assessed as agent, trustee, bailee, guardian, executor, or administrator, his representative designation shall be added to his name, and the assessment entered separately from his individual assessment.
Possession of the two properties, for all practical purposes, also remained in Jon-Win. While it may sometimes be difficult to determine the precise point at which possession of an orange grove passes from the seller to the buyer, the facts of this case indicate quite clearly that Jon-Win retained possession. Petitioner did not have the right to enter either of the properties at any time he wished. Rather, he was only given the right to inspect the properties ‘at any reasonable time during the 4-year term of’ the contracts (emphasis added). The contracts also provided that during their 4-year periods the crop from the groves was to belong to Jon-Win. To be sure, a newly planted grove does not produce any fruit during the first 2 years and the crop is small during the third and fourth years; however, the fact that Jon-Win was entitled to whatever was produced is a matter of more than minimal significance. Moreover, as to the second contract, the grove had already been planted about a year and a half when the contract was entered into, and the fourth year under that contract included the fifth year of that grove's life, when it was reasonable to expect a more substantial crop. Petitioner's right to ‘sell’ the groves amounted to little more than a qualified right to sell his interest in the contracts, and not the absolute right of an owner of property. Thus, even if petitioner sold his interest, he would remain ‘financially responsible’ on the contracts, and could only be relieved of this responsibility upon the submission to Jon-Win of ‘evidence satisfactory to (Jon-Win) of said (purchaser's) ability to meet the remaining portion of the contract balance.’
Other ‘burdens of ownership’ were also borne by Jon-Win. Thus, Jon-Win took the risk of any of the trees dying or otherwise showing themselves to be unhealthy during the period of the contracts. In the event that this should happen Jon-Win was obligated to replace the dead or unhealthy trees with new ones at its own expense. Moreover, although petitioner took the risk of damage to the trees by ‘acts of God,‘ the most common ‘act of God’ likely to damage the trees, frost, was specifically made the responsibility of Jon-Win, and any tree which was damaged by frost was to be replaced by Jon-Win at its own expense. Indeed, Jon-Win was generally responsible for all damage to the trees from whatever cause, other than ‘acts of God.’ It would also seem that Jon-Win bore the risk of condemnation by a governmental authority. Cal. Civ. Code sec. 1662(a) (West 1970) provides with respect to any contract for the purchase or sale of real property, that ‘unless the contract expressly provides otherwise,’ if neither legal title nor possession has passed to the purchaser, and a material part of the property is taken by eminent domain, the contract cannot be enforced against the purchaser, who has a right to recover whatever portion of the purchase price he has paid. Since neither of the contracts in issue deals with the rights of the parties in the event of condemnation, the foregoing provisions of the California statute appear to be controlling, and we give but little weight to statements appearing in Jon-Win's minutes that were introduced into evidence suggesting a different burden in the event of condemnation.
It is clear to us that the two contracts were executory and that ‘ownership’ of each grove did not pass to petitioner until the end of the 4-year period relating to it. During such periods, virtually all of the important ‘benefits and burdens' of ownership— certainly most of them— remained with Jon-Win. Cf. Herbert D. Wiener, 58 T.C. 81, 92-94. Accordingly, the payments made by petitioner must be regarded simply as his cost of acquiring the groves and cannot be treated in any part as representing expenditures made by him for management and care of the groves. In the circumstances, we do not reach the question whether the allocation spelled out in the contracts and claimed by petitioner correctly reflected such expenses, although we do note that they appear to be unrealistic and tend to emphasize the spurious nature of petitioner's principal contention.
In support of their position, petitioners have argued vigorously that Jon-Win retained legal title simply as a security device, akin to a mortgage, and that the contracts actually transferred ownership to petitioner when they were executed. Reliance is placed upon California law that ownership may thus be transferred even though legal title is retained by the seller as a security device until the buyer has paid the full purchase price. See, e.g., Venable v. Harmon, 233 Cal.2d 297, 43 Cal.Rptr. 490. Of course, we fully agree that where the purchaser takes possession, pays the real estate taxes, and assumes the burdens and benefits of ownership, such a contract can operate merely as a security device and the purchaser will be regarded as the owner, notwithstanding that legal title remains in the seller. But where, as here, nearly all the important burdens and benefits of ownership remain with the seller, there is presented an entirely different picture. Here, Jon-Win remained in control of the properties and petitioner was given the right to enter thereon merely for inspection and only at ‘reasonable’ times. Furthermore, Jon-Win assumed the farming risks and burdens of the venture, including all fertilizer, insecticide, and labor costs (together with payroll taxes and workmen's compensation costs), utility bills, water supply, frost protection, planting and replacement of trees (damaged by frost or any other cause other than ‘acts of God’), liability insurance, real estate taxes, and the obligation to provide the necessary management and supervision so that a mature or established grove could be turned over to petitioner at the end of the respective 4-year periods of the contracts. At the same time Jon-Win retained such benefits of ownership as the right to the crops. which, although perhaps of minor financial importance in the case of the first contract, could have been substantial in the case of the second contract, and was nevertheless significant. On the facts before us, it is plain that the contracts were no mere security devices. They were executory; ownership remained with Jon-Win until petitioner paid for the groves in full; and the payments in issue consisted merely of his nondeductible expenditures to acquire mature or established groves at the end of the contract periods. No part of those payments represented any deductible amount paid by petitioner for management and care.
Decision will be entered for the respondent.