Opinion
Docket No. 10284.
1947-10-31
SWOBY CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Daniel B. Priest, Esq., for the petitioner. Harold D. Thomas, Esq., for the respondent.
1. 99-year 8 per cent ‘income debenture‘ of $250,000, issued with petitioner's stock of $200 total par value in exchange for property of sole stockholder upon petitioner's incorporation, held to represent invested rather than borrowed capital, requiring disallowance of deductions for ‘interest.‘
2. Payment by petitioner's lessee in return for petitioner's permission to cancel sublease, held not to entitle petitioner to relief under Internal Revenue Code, section 721(a)(E), in absence of showing that transaction was abnormal. Daniel B. Priest, Esq., for the petitioner. Harold D. Thomas, Esq., for the respondent.
This proceeding involves the following proposed deficiencies:
+-------------------------------------------------+ ¦ ¦ ¦Declared ¦ ¦ +-------------+----------+------------+-----------¦ ¦Year ended— ¦Income tax¦value excess¦Excess ¦ +-------------+----------+------------+-----------¦ ¦ ¦ ¦profits tax ¦profits tax¦ +-------------+----------+------------+-----------¦ ¦Mar. 31, 1942¦$3,888.22 ¦$56.23 ¦$2,277.49 ¦ +-------------+----------+------------+-----------¦ ¦Mar. 31, 1943¦ ¦1,218.63 ¦23,544.35 ¦ +-------------------------------------------------+
Four issues are presented:
(1) Whether petitioner is entitled to deduct amounts paid and designated by it as interest on a 99-year income debenture;
(2) Whether, in determining invested capital for excess profits tax purposes, the so-called debenture represents borrowed capital;
(3) Whether petitioner is entitled to deductions for depreciation based on cost, as stipulated, on its building which had been leased for a term of 99 years, and, if so, the proper rate therefor;
(4) Whether, in determining excess profits net income for the fiscal year 1943, petitioner is entitled to exclude as abnormal income under Internal Revenue Code, section 721(a)(2)(E), the amount of $15,873.21, a payment which it received from its lessee in consideration of petitioner's consent to the cancellation of a sublease, in the absence of which such sublease could not have been canceled.
FINDINGS OF FACT.
Petitioner, a New York corporation, filed its returns, prepared on a cash and fiscal year (ending March 31) basis, with the collector for the second district of New York.
It was incorporated under the laws of the State of New York on March 18, 1939, for the purpose, inter alia, of acquiring title to real property, improved with an office building, located at the corner of Court and Livingston Streets, Brooklyn, New York. All of its outstanding securities, consisting of 200 shares of capital stock of the par value of $1 per share, and a single 99-year ‘Income Debenture‘ of the face amount of $250,000 are owned by Madeleine D. Wolfe.
She acquired these securities by conveying to petitioner her fee interest in certain realty in Brooklyn, consisting of 90 feet on Court Street and 22 feet on Livingston Street, on which part of the aforementioned building was erected. This property was devised to her in trust under the will of her grandfather, who died in 1900, and was ultimately transferred to her, free of the trust, in 1911. At the time of her grandfather's death, the property was improved with a 5-story building, and had a fair market value of $52,500.
The building was occupied by the district attorney's office at a rental of $12,000 annually, which was increased in 1925 to $17,000 annually. Shortly thereafter, as the offices of the district attorney were to be moved, Mrs. Wolfe entered into a lease with Isaac Allen, calling for an annual rental of $29,000. Early in 1926, Allen's leasehold interest was acquired by Jacob Adelman, who planned to buy the property to the rear of that owned by Mrs. Wolfe and to erect a large building covering both parcels of ground. Mrs. Wolfe thereupon entered into a new lease with Adelman, dated April 30, 1926, providing for a rental of $35,000 per year.
In order to secure funds to erect the office building, Adelman formed the 66 Court Street Corporation, which became lessee under a new lease in 1926 from Mrs. Wolfe, and raised $2,000,000 through the public sale of first mortgage bonds. A 32-story office building was thereupon erected.
The rental under the 1926 lease was regularly paid through 1937, although the original tenant had defaulted on its bonds, and a group of its bondholders had combined and bought in the property subject to the lease and took title thereto in the name of a new corporation, Court-Livingston Corporation.
In 1938, at the instance of Court-Livingston, Mrs. Wolfe consented to reduce the rental to $20,000 a year from June 1, 1938, to May 31, 1939.
During the year while this reduced rental was in force, it became evident that the tenant would not be able to resume the rental at the full amount, and Mrs. Wolfe was unwilling to continue the reduced rental. Negotiations were then commenced, resulting in a decision on the part of Mrs. Wolfe to purchase the interest of the tenant, Court-Livingston, consisting of the title to the parcel adjoining her land and the building extending over both parcels and the tenant's interest in the lease.
After considering various methods of taking over the entire property, she decided to form a corporation to acquire title to the plot and building, the reasons for favoring the corporate form being, among others, the desire to avoid personal liability on the bond which would have to be given in connection with new financing and also to provide for more efficient management in view of the fact that her home was in Pittsburgh.
As a result, she caused petitioner corporation to be formed for the purpose of acquiring all the property. The details of incorporation and forms of capitalization were handled by her attorney, W. R. Brewster, who is her brother.
Since Mrs. Wolfe had no other substantial income than the derived from the property, and since she desired some assurance of steady income, consideration was given to the form of securities that could best meet these standards. At Brewster's suggestion, a 99-year ‘income debenture,‘ in the amount of $250,000, and bearing ‘interest‘ at 8 per cent per annum and 200 shares of $1 par value stock were issued by petitioner and delivered to Mrs. Wolfe in exchange for her property, on April 21, 1939. The property so conveyed had a value of at least $250,200.
At the same time, petitioner purchased from Court-Livingston its title to the parcel of realty adjoining Wolfe's property to the rear, its interest in the building covering both parcels and its leasehold, for the sum of $250,000. The purchase was financed by placing a 4 1/2 per cent mortgage of $285,000 on the entire property.
The land turned over to petitioner by Mrs. Wolfe comprised approximately one-fourth of the total land area of the two parcels, and a somewhat smaller proportion of the building rested on this parcel. The value of the two parcels was about equal, in that the Wolfe parcel, although smaller in area, had the better frontage. Petitioner carried the land and buildings on its books at approximately $511,000.
Also on April 21, 1939, petitioner leased the entire property to Court-Chambers Corporation for a term of 99 years and 10 days.
The material provisions of the income debenture were the following:
(1) Petitioner's obligation to pay Mrs. Wolfe or her transferee $250,000, on April 1, 2038;
(2) ‘Interest‘ from April 1939 at a rate not to exceed 8 per cent, payable quarterly, if and to the extent there are ‘net earnings‘ available for the payment of interest, as determined by the directors.
(3) Net earnings defined as ‘the balance remaining, after deducting from the Company's (petitioner's) gross income from all sources (excluding therefrom the proceeds realized from the sale of property other than current assets) for such fiscal period, all operating and non-operating expenses, charges and other items which shall have been paid or accrued as expenses properly incurred in the operation or management of the property of the Company, excluding, however, losses sustained from the sale of capital assets, but including among the deductions allowable as aforesaid all such reserves as the Board of Directors of the Company, in their absolute discretion, may determine to be necessary or advisable to provide for the future operations of the Company and proper charges for depreciation and for maintenance, repairs, replacements and renewals, provision for notes and accounts receivable considered doubtful of collection, amounts paid or reserved for taxes, insurance, tenant changes, management fees, wages and salaries and principal of and interest on all indebtedness of the Company to the payment of which the Debentures may from time to time be subordinate as hereinafter provided.‘
(4) ‘interest‘ cumulative, but accumulated interest was not to bear interest;
(5) Obligation to pay ‘interest‘ and principal subordinate to any mortgage debt or other indebtedness incurred by petitioner at any time;
(6) Debenture subject to redemption at petitioner's election, in whole or in part, subject to the condition that no cumulative interest remained unpaid;
(7) Right of registered owner to declare principal and interest forthwith due and payable in case any of the described ‘events of default‘ occur;
(8) Debenture transferable either in whole or in part.
Petitioner's directors, who included Mrs. Wolfe, who was vice president; her husband, who was president; her brother, who was secretary and treasurer; Malcolm MacArthur, and Vaughn Blaxter, met, as required, to determine what reserves should be provided for and the amount of earnings available for the payment of ‘interest‘ on the debenture.
From the date of incorporation, through the period ended February 28, 1943, payments, denominated as interest on the debenture, were made, the deficiency (or excess) of amount due being in the following amounts, nothing having been paid on account of reduction of the principal of the debenture:
+-------------------------------------+ ¦Period ended—¦Amount paid¦Deficiency ¦ +-------------+-----------+-----------¦ ¦ ¦ ¦(or excess)¦ +-------------+-----------+-----------¦ ¦2/29/40 ¦$16,041.67 ¦$2,291.66 ¦ +-------------+-----------+-----------¦ ¦2/28/41 ¦18,437.50 ¦1,562.50 ¦ +-------------+-----------+-----------¦ ¦2/28/42 ¦19,500.00 ¦500.00 ¦ +-------------+-----------+-----------¦ ¦2/28/43 ¦22,000.00 ¦(2,000.00) ¦ +-------------+-----------+-----------¦ ¦Total ¦75,979.17 ¦2,354.16 ¦ +-------------------------------------+
Since incorporation, petitioner has had no gross income, except rents under the lease to Court-Chambers.
This lease provided for a minimum annual rental of $20,000 for the first 3 years and 10 days, $25,000 for each year thereafter until April 30, 1960, and thereafter at such rate as the parties might mutually agree upon, or as further provided in the lease, an amount which would be 6 per cent of the valuation of the property at the beginning of each successive 20 year period, but in no event less than $20,000 annually. In addition to the minimum rental, petitioner was entitled to receive a further rental if 20 per cent of the lesses's net earnings exceeded the minimum rental. Real estate taxes and interest on the mortgage were to be paid by the tenant, as were amounts due on account of amortization, but petitioner treated all of these items for income tax purposes as constructively received by it.
Petitioner's receipts exceeded disbursements, even including in disbursements the aforementioned payments on the debenture, and the following transfers were made to surplus:
+------------------------+ ¦Mar. 31, 1940 ¦$2,694.31¦ +--------------+---------¦ ¦Mar. 31, 1941 ¦2,279.14 ¦ +--------------+---------¦ ¦Mar. 31, 1942 ¦956.17 ¦ +--------------+---------¦ ¦Mar. 31, 1943 ¦18,166.87¦ +------------------------+
In the statement attached to the notice of deficiency respondent determined:
(a) It is held that you are not entitled to the deductions claimed as interest on debenture bonds during the fiscal years ended March 31, 1942 and 1943, in the respective amounts of $19,500.00 and $22,000.00, under the provisions of Section 23(b) of the Internal Revenue Code.
(b) It is held that in the determination of your invested capital the debenture bonds do not constitute indebtedness within the meaning of Section 719(a) of the Internal Revenue Code.
Accordingly, averaged (sic) borrowed invested capital is reduced $125,000.00 (50% of $250,000.00).
He allowed, in the determination of equity invested capital, the inclusion of $52,300 for property paid in, such amount being determined to be the basis to Mrs. Wolfe of property turned over by her for securities issued to her by petitioner.
Although petitioner in neither year claimed as a deduction depreciation on the building it owned and leased to Court-Chambers, in its petition it has assigned as error respondent's failure to allow depreciation. The parties have stipulated the basis for depreciation, if any is allowable, as being $163,471.17.
Respondent now concedes that some depreciation is allowable, but contests petitioner's right to use the rate of 2 1/2 per cent, based upon a 40-year life. His view is that the deduction for depreciation on the building should be limited to 1/99 of the basis therefor.
The structure, a store and office building of 32 stories in height, with basement and two subbasements, erected in 1926, is constructed of steel and concrete, with brick and terra cotta facing, having concrete floors. It has Otis elevators and Fitzgibbon locomotive boilers.
The lease with Court-Chambers, of which Frederick A. Purdy was president, provided, in part:
The Lessee (Court-Chambers) covenants and agrees that during the term of this lease the Lessee shall, at all times, keep in good order and repair, inside and out, all buildings and structures now or hereafter constructed on or appurtenant to the demised premises, including any and all equipment which may be therein contained, and shall from time to time make renewals and replacements of such equipment, so that at all times said buildings, structures and equipment shall be in thoroughly good order, condition and repair.
That no building which is or shall be erected upon said demised premises under the provisions of this lease, shall be removed or torn down or any alterations made therein which will diminish the value thereof, or which shall exceed in reasonable cost $7,500 without the consent in writing of said Lessor, (petitioner) which consent, however, shall not be unreasonably withheld. * * *
In case of loss or damage to the building, this lease shall not terminate, and the Lessee's liability for the rent herein provided shall continue without any abatement.
Purdy, who engaged in the real estate business and had some experience in appraising New York City real estate, was of the opinion that the building had a probable useful life of 40 years from completion in 1926, considering both physical depreciation and obsolescence.
The building is located on Court Street, an important business street of the borough of Brooklyn. Buildings have been erected along it that are representative of the advanced construction of the borough, and petitioner's building rates favorably with them.
The useful life of the building was 50 years from the date of its erection.
The lease between petitioner and Court-Chambers contains a clause requiring petitioner's consent for cancellation of subleases, providing as follows:
NINETEENTH.
THE LESSEE (COURT-CHAMBERS) agrees that without in each case the Lessor's (petitioner) prior written consent the Lessee will not accept the surrender of any present or future lease of store or office space in the building or enter into any modification of any such lease in which the rent reserved during any year of such lease is at the rate of $2,500 or more.
During the fiscal year ended March 31, 1943, Melville Shoe Co., a tenant of one of the stores in the building, under a lease from Court-Chambers running to about 1948, and providing for an annual rental of approximately $12,000, made an offer to Court-Chambers to pay a lump sum in cancellation of its lease, as it could not afford to pay the required rental and as Court-Chambers would not reduce it. Court-Chambers expressed its willingness to accept a lump-sum settlement, finally determined in the amount of $57,500, if it could secure petitioner's consent, under article nineteenth of its lease with petitioner.
In the early part of 1943, petitioner consented, but insisted that $15,837.21 of the $57,500 be paid by Court-Chambers to the escrow agent under petitioner's mortgage to be applied in reduction of the mortgage debt. This amount was so paid on March 31, 1943.
In denying petitioner's claim of abnormality under section 721(a)(2)(E), referring ‘In the case of a lessor of real property (to) income included in gross income for the taxable year by reason of the termination of the lease, ‘ respondent recited in the statement attached to the notice of deficiency:
It is held that no part of the amount of $15,837.21 received from the Court-Chambers Corporation during the fiscal year ended March 31, 1943 and reported as ordinary income in the return filed for that year constitutes abnormal income within the meaning of Section 721(a)(2)(E) of the Internal Revenue Code.
OPINION.
OPPER, Judge:
While the specified factual distinction
between John Kelley Co. v. Commissioner and Talbot Mills v. Commissioner, 326 U.S. 521, furnishes little assistance in determining whether the ‘debenture‘ in issue represents an indebtedness and the interest carried by it is hence deductible, two other factors not present in those cases but alluded to by the Supreme Court in the same opinion seem to indicate that it is not.
‘Although the obligations of the two taxpayers had only one striking difference, the noncumulative in one and the cumulative quality in the other of the payments reserved under the characterization of interest, the Tax Court * * * held that the payments under the former, Kelly Company, case, were interest and under the Talbot Mills were dividends.‘ (326 U.S. 521, 523.)
That Court takes occasion to issue what we can not but view as a warning when it notes that ‘As material amounts of capital were invested in stock, we need not consider the effect of extreme situations such as nominal stock investments and an obviously excessive debt structure.‘ (321 U.S. at 526). The necessity excluded there we can not now avoid. Dealing with property having a stipulated value of ‘at least $250,200,‘ the financing selected was to create a clearly ‘nominal‘ figure of $200 in the common stock and ‘an obviously excessive debt structure‘ of $250,000 in the debenture. This evokes a factor evidently regarded as significant by the Supreme Court, which, unlike either the Talbot Mills or Kelley Co. cases, tends to justify the respondent's treatment.
The maturity date of the present debenture also constitutes an element distinguishing it from Kelley Co. The latter is characterized in the Supreme Court opinion as ‘a definite maturity date in the reasonable future. ‘ (321 U.S. at p. 526.) But we are dealing here with a 99-year obligation issued by a corporation whose principal asset is urged by petitioner, in a different connection, as having an anticipated life at the time of acquisition of less than a third of that span. It must be seriously doubtful, to say the least, whether such a maturity date, definite though it may be, can be thought of as falling ‘in the reasonable future.‘
But there is, in addition, a compelling reason why this security should be treated as comparable to stock rather than indebtedness. Subsequent to its decisions in the Talbot Mills and Kelly Co. cases, this Court decided 1432 Broadway Corporation, 4 T.C. 1158, which was, after the final affirmance of those cases, itself affirmed (C.C.A., 2d Cir.), 160 Fed(2d) 885. We think it necessary to treat the 1432 Broadway Corporation case, in many respect comparable to this one, as controlling. As in that case:
* * * No loan was made to the corporation by the owners, either of property or of money * * * . The entire contribution was a capital contribution rather than a loan * * * . The distribution of the rent income, whether called interest or principal on debentures or dividends on shares, would go to the same persons * * * .
* * * these securities are more nearly like preferred stock than indebtedness * * * . It is idle to argue that the debentures were transferable and must therefore be judged separately from the shares, for they were issued to the same persons as held the shares, and in the same proportions, and they were not in fact transferred * * * . Interest is payment for the use of another's money which has been borrowed, but it cannot be applied to this corporation's payment or accruals, since no principal amount had been borrowed from the debenture holders and it was not paying for the use of money. (pp. 1165, 1166.)
Except taxwise, every advantage said to have been sought from the security in the proceeding at bar could have been attained through an equivalent issue of preferred stock. See Ticker Publishing Co., 46 B.T.A. 399. In all but name this was redeemable preferred stock and nomenclature is not controlling. Charles L. Huisking & Co., 4 T.C. 595. It was unsecured and subordinate to all creditors. Commissioner v. Schmoll Fils Associated, Inc. (C.C.A., 2d Cir.), 110 Fed.(2d) 611. It was callable by petitioner, but, due to the extreme length of its term, not collectible by the holder in effect, until dissolution, if at all. See Golden Belt Lumber Co., 1 T.C. 741. Its payment as to both current and accumulated interest depended not only on available profits, but in reality on the decision of the directors not to create preferential reserves. Cf. Ticker Publishing Co., supra. In fact, this decision by the directors as to payment of interest was virtually comparable to that made in declaring a dividend on preferred stock. No creditor dealing at arm's length, except in the last extremity of obvious uncollectibility, would have consented to accept such a means of payment. In a prosperous and solvent corporation like petitioner, the instrument in question was in every material respect the equivalent of an equity security, not the evidence of a debt. Mullin Building Corporation, 9 T.C. 350. We can not escape the compulsion of the cases mentioned to characterize these payments as the distribution of profits, rather than interest on indebtedness. On this issue the deficiency is upheld.
On the second issue, respondent is now ‘willing to concede * * * that some depreciation is allowable. Charles Bertram Currier, et ux. (1946), 7 T.C. 980 * * * .‘ The parties being in agreement as to basis, the dispute is as to the rate. We are not satisfied that useful life was as short as estimated by petitioner's witness, but, as appears from our findings, we regard a 50-year life, or 2 per cent rate, as appropriate. Bureau of Internal Revenue, Bulletin F. To this extent, the deficiency is disapproved.
The third issue involves the abnormality for excess profits tax purposes of a payment received by petitioner upon cancellation by its tenant of a lease with a subtenant. Petitioner's consent was required and the payment in question was the price of that consent. The precise question is the applicability of section 721(a)(2)(E), referring to ‘abnormal income‘ of the ‘class‘: ‘In the case of a lessor of real property, income included in gross income for the taxable year by reason of the termination of the lease.‘
The insuperable objection to allowance of this claim seems to us to be petitioner's failure to show either that ‘it is abnormal for the taxpayer to derive income of that class‘ or that the amount received in the tax year was abnormally high. One or the other is necessary. See Rochester Button Co., 7 T.C. 529. For all that appears, payments for cancellation of subleases in the 32-story office building may have been a fairly regular occurrence, and the amount currently received may not have been abnormally high. On this issue respondent is sustained.
It is finally, insisted by petitioner that borrowed capital may be increased to include the ‘debenture‘ discussed under the first issue. What we said there disposes of that contention, the issues being comparable, as is virtually conceded by petitioner. But, although not so presented by either party, it seems to us that equity invested capital may be correspondingly increased. In 1432 Broadway Corporation, cited supra, first issue, it was ruled that:
* * * The present decision * * * requires the inclusion in equity invested capital of the value of the property paid in for the pseudo debentures as if such payment had been in form as well as substance paid in for preferred shares. And respondent, in his deficiency notice, increased this amount from $200 to $52,500, apparently fixing that amount as the figure because ‘you have not established a value in excess of $52,500.00 for the property * * * .‘ Since the parties now agree that the equity turned in to the corporation for the issuance of its securities had a value of ‘at least $250,200,‘,”’ it seems that an appropriate further adjustment should be made.
Reviewed by the Court.
Decision will be entered under Rule 50.