Opinion
Docket Nos. 3892-68 — 3898-68.
Filed March 24, 1971.
National, a corporation whose principal business was the ownership and operation of commercial real estate, was principally owned by three families. National sold the Pantlind Hotel, a large hotel in downtown Grand Rapids, Mich., to Edith Honigman whose family owned approximately 35 percent of National's stock. The corporation reported as a loss in its tax return fled for that year, $806,888.30, the difference between the adjusted basis of the hotel and the amount paid by Edith. Within 3 months thereafter, National adopted a plan of complete liquidation, which plan qualified as a liquidation under sec. 337, allowing nonrecognition of the gains realized on National's sale of its remaining assets. Held, the fair market value of the hotel at the date of sale was $830,000, not $661,280.21, the amount paid for it; held, further, the Honigmans realized a taxable dividend in an amount equal to the difference between the fair market value of the hotel and the amount paid for it; held, further, the dividend does not qualify under sec. 346 as a distribution in partial liquidation; held, further, National is entitled to deduct as a loss realized in the year of sale, an amount equal to the difference between the adjusted basis of the hotel and its fair market value; and held, further, expenditures by National for the replacement of portions of the floor of the garage area of the First National Building and for services rendered in the course of a physical survey and recommendation of a program for further need for replacement of portions of the floor of said building are nondeductible capital expenditures.
Miles Jaffe, for the petitioners.
John H. Menzel and Robert T. Hollohan, for the respondent.
The Commissioner has determined deficiencies in petitioners' income taxes in the amounts and for the taxable years shown below:
Petitioner Docket Taxable year Amount No. ended Jason L. and Edith Honigman .... 3892-68 Dec. 31, 1963 $541,539.40 Jason Honigman, transferee ..... 3893-68} Edith Honigman, transferee ..... 3894-68} Ben L. Silberstein, transferee ................... 3895-68} {May 31, 1960 156,074.97 Gertrude Levin, transferee ..... 3896-68} {May 31, 1962 46,425.94 Harry Galperin, transferee ..... 3897-68} {May 31, 1963 260,854.10 Sarah H. Galperin, transferee .. 3898-68} The transferee petitioners in docket No. 3893-68 through 3898-68 concede their liability for any income tax deficiency of National Building Corp. Due to certain concessions made by both parties, the primary issues to be decided are: (1) Whether the transfer in May 1963 of ownership of the Pantlind Hotel property from National Building Corp. to Pantlind Hotel Co. was in part a dividend distribution to Jason and Edith Honigman to the extent of the excess, if any, of the fair market value of the hotel over the amount received by National Building Corp. from the Honigmans; (2) whether, if there was a dividend distribution, the dividend is a liquidating distribution taxable at capital gains rates or as ordinary income; (3) whether the loss of $806,888.30 which National allegedly realized on the sale of the hotel, or any part thereof, was deductible by National in that year; (4) whether expenditures by National of $87,294.27 in the fiscal year ended May 31, 1962, for the replacement of portions of the floor of the garage area of the First National Building were currently deductible as ordinary and necessary business expenses or nondeductible capital expenditures; and (5) whether expenditures of National of $10,976.44 in the fiscal year ended May 31, 1963, for services rendered in the course of a physical survey and recommendation of a program for further need for replacement of portions of the floor throughout the garage area of the First National Building were currently deductible as ordinary and necessary business expenses or nondeductible capital expenditures.FINDINGS OF FACT
Each of the petitioners in the cases designated as docket Nos. 3893-68 through 3898-68 was a stockholder and distributee of the assets of National Building Corp., hereinafter referred to as National, all of the assets of which were distributed to its stockholders, including petitioners, in the complete liquidation of National. The Federal income tax returns of National for the years in issue were filed with the district director of internal revenue at Detroit, Mich. At the time of filing the petitions herein, Jason L. and Edith Honigman and Gertrude Levin resided at Detroit, Mich., Harry and Sarah Galperin resided at Miami Beach, Fla., and Ben L. Silberstein resided at Beverly Hills, Calif.
National was formed in 1946 as a Michigan corporation with its principal office at Detroit, Mich. Its principal business was the ownership and operation of commercial real estate. From its incorporation and continuing through all relevant dates herein, the common shares of National, its sole outstanding capital stock, were owned substantially in the following proportions: Jason L. Honigman, his wife Edith, and their children and grandchildren (Honigman family), about 35 percent; Ben L. Silberstein, his former wife Gertrude Levin, and their children (Silberstein family), about 35 percent; Harry Galperin and his wife Sarah (Galperin family), about 20 percent; and the remaining 10 percent of the common stock was owned by a number of other individuals in relatively small proportions. There was no family relationship between the Honigman family and any member of either the Silberstein or Galperin families, nor were there any business relationships between the Honigman family and any members of either the Silberstein or Galperin families other than their relationship as stockholders, directors, and officers of National.
At all dates relevant herein, the following three persons were the directors of National and held the offices shown:
Ben L. Silberstein ............ President and treasurer Jason L. Honigman ............. Vice president and secretary Harry Galperin ................ Vice president
Real estate known as the First National Building was purchased by National in 1946 shortly after its incorporation.
During the year 1951, National acquired the stock of the Pantlind Hotel Co. (Delaware Pantlind), a Delaware corporation. At that time, Delaware Pantlind owned the Pantlind Hotel located in Grand Rapids, Mich. The hotel is a 10-story building with approximately 550 guestrooms and occupies an entire block located in the central business district in Grand Rapids. During the years in issue, in addition to guestrooms, the hotel had various specialty stores, four restaurants on the main floor, and a cafeteria and restaurant in the basement. A corner section of the hotel building, approximately 20 percent of the total square footage of the building, was owned by the Old Kent Bank which occupied the first floor, mezzanine, and basement areas and leased all of the upper floors to the owners of the hotel under a 99-year lease under the terms of which the tenant paid $16,500 annual rent. The lease provided the rental price was to be adjusted at the end of each 10-year period of the lease, based on changes in the fair market value of the property. The 10-year period existing during the years in issue was to expire in 1963. In 1952, the Pantlind Hotel was transferred as a dividend distribution to National by Delaware Pantlind and at the same time an agreement was entered into between National and Delaware Pantlind under the terms of which Delaware Pantlind was employed by National to operate the hotel and submit monthly financial reports and transfer to National the net income derived from the operations of the hotel. In return for these duties, Delaware Pantlind received a management fee equal to 3 percent of the entire gross income from the hotel operations. The management agreement remained in effect until National transferred the hotel on May 27, 1963.
A schedule of National's financial operations for the fiscal years ended May 31, 1959 through 1962, and for the period June 1, 1962, to May 26, 1963, is shown below:
PANTLIND HOTEL DIVISION NATIONAL BUILDING CORPORATION Statement of Operations June 1, 1962 Fiscal years ended May 31 — to May 26, 1963 1962 1961 Income: Room sales .............. $753,118 $741,028 $733,978 Food sales .............. 1,360,780 1,352,072 1,354,957 Beverage sales .......... 437,444 407,841 410,818 Telephone ............... 34,992 36,113 41,386 Barbershop .............. 16,375 18,444 19,189 Guest laundry ........... 1,400 807 793 Service charges ......... 4,329 4,689 4,469 Cigar stand concession .. 4,186 4,296 4,861 Civic auditorium concession ............ 1,748 21,462 24,272 Store rentals ........... 36,313 21,720 20,093 Other income ............ 8,904 9,961 10,150 ------------------------------------- Total income .......... 2,659,489 2,618,433 2,624,966 Costs and expenses: Rooms and unapportioned payroll ............... $444,743 $431,317 $454,547 Rooms direct and indirect expense ...... 105,313 101,472 69,496 Food payroll ............ 610,899 592,931 587,330 Beverage payroll ........ 55,193 52,684 52,198 Food cost — net of employees' meals ...... 604,440 592,561 598,001 Beverage cost ........... 152,662 137,460 143,621 Food and beverage expenses .............. 80,117 84,962 78,834 Telephone cost .......... 42,010 43,671 48,740 Barbershop payroll ...... 13,893 15,202 15,680 Civic concession expense ............... 5,099 24,792 24,627 Officers' salaries ...... 33,770 463 Administrative and general ............... 93,482 91,627 84,751 Advertising and promotion ............. 26,886 29,382 28,260 Heat, light, and power .. 122,275 125,638 122,450 Repairs and maintenance . 63,765 51,525 111,887 Taxes — local .......... 66,483 80,185 81,576 Ground rent ............. 16,500 16,500 16,500 ------------------------------------- Total costs and expenses ............ 2,537,530 2,472,372 2,518,498 ------------------------------------- Operating income .......... 121,959 146,061 106,468 ------------------------------------- Deduct: Interest ................ 41,217 37,811 39,963 Depreciation ............ 105,952 109,920 120,376 Management fees ......... 75,561 79,061 79,149 Local tax adjustment on sale .................. (78,917) Insurance adjustment on sale .................. (14,909) ------------------------------------- Net deductions ........ 128,904 226,792 239,488 Profit (or loss) per audit statements .............. (6,945) (80,731) (133,020) Fiscal years ended May 31 — 1960 1959 Income: Room sales .............. $775,747 $719,688 Food sales .............. 1,403,542 1,316,659 Beverage sales .......... 457,050 424,348 Telephone ............... 47,344 45,604 Barbershop .............. 18,358 18,735 Guest laundry ........... 961 978 Service charges ......... 4,540 3,231 Cigar stand concession .. 5,515 5,383 Civic auditorium concession ............ 24,672 Store rentals ........... 20,303 17,842 Other income ............ 10,929 9,541 ------------------------ Total income .......... 2,768,961 2,562,009 ------------------------ Costs and expenses: Rooms and unapportioned payroll ............... $436,952 $395,266 Rooms direct and indirect expense ...... 59,658 57,438 Food payroll ............ 573,885 544,085 Beverage payroll ........ 52,250 43,843 Food cost — net of employees' meals ... 612,426 583,511 Beverage cost ........... 154,098 145,062 Food and beverage expenses .............. 77,498 70,513 Telephone cost .......... 52,897 51,157 Barbershop payroll ...... 14,997 14,708 Civic concession expense ............... 19,953 Officers' salaries ...... 792 266 Administrative and general ............... 73,561 71,744 Advertising and promotion ............. 33,530 32,350 Heat, light, and power .. 115,455 110,825 Repairs and maintenance . 86,724 82,086 Taxes — local .......... 65,173 60,738 Ground rent ............. 16,500 16,500 ------------------------ Total costs and expenses ............ 2,446,349 2,280,092 ------------------------ Operating income .......... 322,612 281,917 ------------------------ Deduct: Interest ................ 47,928 54,309 Depreciation ............ 114,585 117,391 Management fees ......... 84,699 77,471 Local tax adjustment on sale .................. Insurance adjustment on sale .................. ------------------------- Net deductions ........ 247,212 249,171 Profit (or loss) per audit statements .............. 75,400 32,746 A schedule of the Pantlind Hotel's room, food, and beverage statistics for the same years is shown below: fn1 fn1 fn1 fn1 fn1 fn1 fn1 fn1 PANTLIND HOTEL DIVISION Room, Food, and Beverage Statistics June 1, 1962, Fiscal year ended May 31 — to May 26, 1963 1962 1961 Room sales: Guestrooms ........... $740,846.08 $727,380.92 $721,412.16 Public rooms ......... 12,272.35 13,647.65 12,566.15 ------------------------------------------- Total .............. 753,118.43 741,028.57 733,978.31 =========================================== Rooms in hotel ....... Rooms available ...... Rooms occupied ....... 74,574 74,579 76,639 Guests (house count) . 102,905 100,696 102,851 =========================================== Percentage of occupancy .......... 35.84 35.64 36.47 Percentage of double occupancy .......... 37.99 35.02 34.20 =========================================== Average rate per room $9.93 $9.75 $9.41 Average rate per guest 7.20 7.22 7.01 =========================================== Percentage of convention occupancy .......... 55.03 Food sales: Knife and Fork ....... $287,993.67 $284,052.60 $289,613.64 Cafeteria ............ 191,452.95 195,575.96 214,330.67 Charcoal Inn ......... 233,854.50 188,351.35 188,543.93 Pub .................. 107,417.01 109,858.85 113,010.47 Cypress Cellar ....... 151,700.50 156,368.31 164,445.10 Backroom Saloon ...... 7,020.97 Room service ......... 636.55 9,125.85 415.25 Banquets ............. 380,703.68 408,738.75 384,598.31 ------------------------------------------- Total food sales ...1,360,779.83 1,352,071.67 1,354,957.37 Beverage sales: Charcoal Inn ......... 43,436.99 39,303.10 40,751.10 Pub .................. 164,215.82 169,290.85 159,806.13 Cypress Cellar ....... 105,246.63 107,812.30 112,997.54 Backroom Saloon ...... 38,404.83 Bottle sales ......... 18,047.40 15,214.62 21,025.24 Room service ......... 13,838.27 13,927.12 14,151.72 Banquets ............. 54,253.85 62,293.40 62,086.26 Total beverage sales 437,443.79 407,841.39 410,817.99 Fiscal year ended May 31 — 1960 1959 Room sales: Guestrooms ............. $763,529.89 $790,373.87 Public rooms ........... 12,217.20 10,314.60 --------------------------- Total ................ 775,747.09 719,688.47 =========================== Rooms in hotel ......... 577 577 Rooms available ........ 211,182 210,605 Rooms occupied ......... 87,266 81,422 Guests (house count) ... 119,939 111,354 =========================== Percentage of occupancy 41.32 38.66 Percentage of double occupancy ............ 37.44 36.76 =========================== Average rate per room .. $8.75 $8.71 Average rate per guest . 6.37 6.37 =========================== Percentage of convention occupancy ............ =========================== Food sales: Knife and Fork ......... $298,016.52 $281,203.49 Cafeteria .............. 222,016.76 199,483.81 Charcoal Inn ........... 198,308.40 186,051.85 Pub .................... 133,103.95 127,104.11 Cypress Cellar ......... 177,075.55 172,511.78 Backroom Saloon ........ Room service ........... 378.00 261.55 Banquets ............... 374,642.86 350,042.60 ------------------------------ Total food sales ..... 1,403,542.04 1,316,659.19 Beverage sales: Charcoal Inn ........... 44,231.29 43,452.75 Pub .................... 178,210.41 164,213.21 Cypress Cellar ......... 125,049.08 120,541.97 Backroom Saloon ........ Bottle sales ........... 25,664.56 29,394.67 Room service ........... 18,486.98 16,561.25 Banquets ............... 65,407.58 50,183.76 Total beverage sales . 457,049.90 424,347.61 As of May 27, 1963, a downtown urban renewal development was in progress covering an area of approximately 26 acres just north and east of the Pantlind Hotel. Properties were acquired under the urban renewal program beginning on August 15, 1961.Beginning in early 1963, National entered into a series of agreements which ultimately resulted in its complete liquidation. On February 11, 1963, National entered into a preliminary agreement to sell the First National Building. On May 6, 1963, National and Pantlind Hotel Co. (hereinafter Michigan Pantlind), a newly organized Michigan corporation, all of the capital stock of which was then owned by Edith Honigman, entered into a sale agreement pursuant to which, on May 27, 1963, National delivered title to and possession of the Pantlind Hotel to Michigan Pantlind which in return paid National $661,280.21, consisting of Michigan Pantlind's assumption of the mortgage indebtedness in the hotel property of $589,754.35, assumption of $21,525.86 of unpaid current real estate and personal property taxes, plus $50,000 in cash. For the calendar year 1963, Michigan Pantlind was a subchapter S corporation, the profit or loss of which was required to be reflected in the 1963 joint income tax return of petitioners Jason and Edith Honigman. At the date of sale, National's adjusted cost basis for determining gain or loss of the hotel was $1,468,168.51. On May 29, 1963, Pantlind Hotel Co. paid National an additional $37,911.05, representing a net adjustment to the above purchase price to account for the following items:
Amounts credited to National: Food inventory ................ $29,786.93 Beverage inventory ............ 20,687.78 Insurance adjustments ......... 14,909.49 ------------ $65,384.20 Amounts credited to Michigan Pantlind: Allowance for vacation pay .... 25,000.00 Accrued interest on mortgage .. 2,473.15 ------------ 27,473.15 ----------- Net adjustment .............. 37,911.05 On August 12, 1963, National adopted a plan of liquidation which qualified as a liquidation under section 337. Pursuant to the plan of liquidation, certain assets of National, including the First National Building, were sold and the proceeds thereof, together with all of the remaining assets of National, were distributed to its stockholders on or before April 24, 1964. The liquidating distribution was $147.65 per share.At the time National entered into the preliminary agreement to sell the First National Building on February 11, 1963, the directors were aware that the Pantlind Hotel which they were desirous of selling would be sold at a loss, while the other assets would be sold at a substantial gain. They therefore decided to sell the Pantlind Hotel and then adopt and pursue a plan of complete liquidation in accordance with section 337 which would shield the corporation from the recognition of the substantial gains to be realized in the sale of the remaining assets.
Following 4 months of unsuccessful efforts to procure a purchaser, in April 1963, the directors of National held a meeting during which they further discussed the desirability of selling the hotel and at a more suitable purchase price. The previous selling efforts included contact with several hotel chain representatives and hotel owners, real estate, and hotel brokers. Most of these people were contacted by Honigman in the form of telephone or brief letter inquiries. No appraisal of the hotel was made nor was a sales brochure prepared. During the negotiations with these people, the indicated selling price of the hotel ranged from $200,000 to $250,000 above the existing mortgage on the hotel property. During the meeting, Honigman suggested selling the hotel for a "nominal" sum of $50,000 above the existing mortgage. This price had not previously been offered to outside prospective purchasers, nor was such price ever offered to them. Silberstein initially indicated an interest in purchasing the hotel for the aforementioned "nominal" sum, but declined to do so because of personal reasons. Honigman later decided to buy the hotel at the same price offered to Silberstein. The transaction was completed on May 27, 1963, at which time Michigan Pantlind purchased the hotel as outlined above.
While owned by National, the Pantlind Hotel property was encumbered by a mortgage executed in 1952 and originally bearing interest at 4 3/4 percent. The mortgage matured in 1962 at which time it was extended an additional 2 years and the interest rate was increased to 6 percent. The mortgage was payable in monthly installments of $6,462 each, inclusive of principal and interest, and the entire unpaid balance of the mortgage matured and was payable on August 31, 1964.
In October 1964, Michigan Pantlind paid the entire balance due on the mortgage encumbering the hotel property. The payment was made with the proceeds of a new $550,000 mortgage loan secured by a real estate mortgage on the hotel property plus Jason Honigman's personal guaranty of the first $175,000 payable under the loan agreement.
On November 18, 1964, Michigan Pantlind sold to three Roberts brothers 2,400 shares of its common stock out of its total capital stock of 7,500 shares then issued and outstanding. The sales price was $10 per share which was the same price per share paid therefore by Edith Honigman upon incorporation of the Michigan Pantlind in May 1963, prior to purchasing the Pantlind Hotel. All of the Roberts brothers were employees of Michigan Pantlind at the time of the sale and for many years prior thereto had been employed by Delaware Pantlind. On December 21, 1964, Michigan Pantlind purchased at a price of $137,500 from Old Kent Bank, the corner portion of the Pantlind Hotel building, the upper floors of which had for many years prior thereto been leased by the owners of the hotel from Old Kent Bank.
During its fiscal year ended May 31, 1962, National paid $87,294.27 for materials and labor for the replacement of portions of the floor of the parking garage area of the First National Building and during the year ended May 31, 1963, paid $10,976.44 for services rendered in the course of a physical survey and recommendation of a program for further need for replacement of portions of the floor throughout the parking garage area of the First National Building. National deducted these sums as current ordinary and necessary business expenses in its income tax returns for those periods.
The Pantlind Hotel's financial operations improved subsequent to its acquisition by Michigan Pantlind primarily due to better management, progress in the urban renewal program, and the addition of two profitable restaurants, the Backroom Saloon and the Upstairs Saloon.
A schedule of Pantlind Hotel Co.'s financial operations for the period May 27 to December 31, 1963, and for the years ended December 31, 1964 and 1965, is shown below:
PANTLIND HOTEL CO. Statement of Operations May 27 to 1965 1964 Dec. 31, 1963 Income: Room sales ............ $714,061 $732,728 $387,503 Food sales ............ 1,488,024 1,421,343 773,301 Beverage sales ........ 542,464 548,661 303,190 Telephone ............. 30,708 35,209 19,043 Barbershop ............ 2,394 8,768 Guest laundry and valet ............... 1,272 1,407 883 Service charges ....... 11,333 Cigar stand concession .......... 1,769 3,666 2,138 Store rentals ......... 51,181 46,944 26,432 Other income .......... 15,138 17,943 10,967 ---------------------------------------- Total income ........ 2,855,950 2,810,295 1,532,225 Costs and expenses: Rooms payroll ......... 197,343 194,666 109,581 Laundry payroll ....... 47,461 45,282 24,012 Rooms and house expenses ............ 100,262 100,801 57,106 Food payroll .......... 629,232 621,011 355,020 Food cost — employees' meals .... 606,535 582,685 315,833 Beverage payroll ...... 73,825 75,537 40,741 Beverage cost ......... 173,427 181,767 99,156 Food and beverage expense ............. 88,375 92,142 56,098 Telephone cost ........ 59,335 47,382 24,230 Telephone payroll ..... 14,241 23,505 14,142 Barbershop payroll .... 2,087 7,464 Officers salaries ..... 51,000 50,271 27,870 Administrative payroll ............. 23,216 22,178 12,050 Administrative expense ............. 105,505 106,858 68,936 Advertising and promotion ........... 18,943 20,348 14,537 Heat, light, and power ............... 102,965 105,166 64,905 Maintenance payroll ... 112,692 109,076 75,807 Maintenance expense ... 62,811 55,235 35,808 Local taxes ........... 54,369 56,755 145,340 Ground rent ........... 16,500 16,500 9,625 Payroll taxes — apportioned ......... 19,998 22,871 14,248 ---------------------------------------- Total costs and expenses ......... 2,558,035 2,532,123 1,572,509 Operating income .......... 297,915 278,172 (40,284) Deduct: Interest: Mortgage .......... 31,826 33,392 20,620 Other ............. 3,468 7,221 3,540 Depreciation .......... 81,708 83,974 39,420 ----------------------------------------- Total deductions .... 117,002 124,587 63,580 Net profit (or loss) before income taxes ..... 180,913 153,585 (103,864)A schedule of room, food, and beverage statistics for the same periods is shown below:fn1
1965 1964 May 26 to Dec. 31, 1963 Room sales: Guestrooms .......... $701,798.60 $725,435.55 $382,461.15 Public rooms ........ 12,262.50 7,292.60 5,042.00 --------------------------------------------- Total ............. 714,061.10 732,728.15 387,503.15 Rooms in hotel ........ 565 566 577 Rooms available ....... 206,222 207,156 126,940 Rooms occupied ........ 72,906 77,107 39,584 Guests (house count) .. 101,483 105,996 54,153 Percentage of occupancy 35.35% 37.22% 31.71% Double occupancy ...... 39.20% 37.47% 36.81% Average rate per room $9.63 $9.41 $9.66 Average rate per guest 6.92 6.84 7.06 Percent of convention occupancy ........... 47.84% 44.03% 39.82% Food sales: Knife and Fork ...... $294,068.41 $300,442.91 $173,253.92 Cafeteria ........... 190,883.78 185,201,44 100,602.84 Charcoal Inn ........ 235,985.74 230,000.50 137,265.60 Pub ................. 108,386.82 104,351.92 60,260.60 Cypress Cellar ...... 138,558.21 126,095.96 60,226.76 Backroom Saloon ..... 42,815.72 32,532.29 22,371.20 Upstairs Saloon ..... 9,062.45 13,336.15 Room service ........ 629.30 651.65 1,253.55 Banquets ............ 467,634.07 428,730.53 218,066.62 ----------------------------------------------- Total food sales 1,488,024.50 1,421,343.35 773,301.09 Beverage sales: Charcoal Inn ........ 40,320.90 41,085.55 25,195.20 Pub ................. 142,569.41 144,466.15 80,763.18 Cypress Cellar ...... 72,147.66 74,756.60 36,766.53 Backroom Saloon ..... 162,513.27 153,711.43 114,598.31 Upstairs Saloon ..... 37,895.56 48,633.43 Bottle sales ........ 12,065.25 12,929.72 5,257.30 Room service ........ 4,973.20 9,074.14 4,575.85 Banquets ............ 69,979.02 64,004.05 36,063.46 ----------------------------------------------- Total beverage sales ......... 542,464.27 548,661.07 303,219.83 In his notices of deficiency to petitioners Jason and Edith Honigman, respondent determined that the fair market value of the Pantlind Hotel on the date of the sale was $1,300,000, and consequently that the Honigmans received a taxable dividend equal to the difference between $1,300,000 and the amount they paid for the hotel. Respondent also asserted deficiencies against petitioners as transferees of the assets of National based upon his disallowance of both the loss deduction claimed by National on the sale of the hotel and the expense deductions claimed by National for the expenditures with respect to the garage floor areas of the First National Building.OPINION
Section 316 of the Code defines a dividend as "any distribution of property made by a corporation to its stockholders — (1) out of its earnings and profits." Property is defined in section 317 as "money, securities, and any other property."
Section 1.301-1(j), Income Tax Regs., provides in pertinent part:
If property is transferred by a corporation to a shareholder which is not a corporation for an amount less than its fair market value in a sale or exchange, such shareholder shall be treated as having received a distribution to which section 301 applies. In such case, the amount of the distribution shall be the difference between the amount paid for the property and its fair market value. * * *
This regulation has repeatedly received Court approval. See, e.g., Lester E. Dellinger, 32 T.C. 1178 (1959).
Section 301 of the Code provides in pertinent part:
(a) IN GENERAL. — Except as otherwise provided in this chapter, a distribution of property * * * made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in subsection (c).
* * * * * * *
(c) AMOUNT TAXABLE. — In the case of a distribution to which subsection (a) applies —
(1) AMOUNT CONSTITUTING DIVIDEND — That portion of the distribution which is a dividend (as defined in section 316) shall be included in gross income.
Since we have property transferred by a corporation (National) to a noncorporate shareholder, the questions for decision are: (1) Whether the hotel was transferred for an amount less than its fair market value, and, if so (2) whether the difference between the amount paid for the hotel and its fair market value is a dividend under section 316.
Although in form, the sale was to Michigan Pantlind, a corporation, the parties both at trial and on brief have treated Edith Honigman, who owned 100 percent of Michigan Pantlind's stock at all times material to this case, as the purchaser of the hotel. In his notice of deficiency to the Honigmans, respondent explained his determination that a portion of the deficiency was "the result of your indirect purchase of this property [the hotel] for less than its fair market value." (Emphasis added.)
The evidence concerning the fair market value of the hotel as of May 27, 1963, consists primarily of expert witnesses' testimony and their accompanying appraisal reports. Since no representative comparative sales were available, the experts for both parties estimated the value of the hotel by means of the capitalized earnings approach, each expert considering that the best use of the property was as an operating hotel unit. Respondent's two experts estimated the value of the hotel to be $1,300,000 and $967,000. Three experts testifying on petitioners' behalf estimated the value of the hotel to be $700,000, $659,850, and $625,000, and petitioners' fourth expert estimated the land upon which the hotel was built to be worth $220,000. For the reasons outlined below, we have determined that the fair market value of the Pantlind Hotel at the date it was purchased by the Honigmans was $830,000. The primary reasons for the different estimates of value were experts' different opinions relative to the proper factors and figures to be used in applying the capitalization-of-earnings approach After reviewing the testimony and appraisal reports, we valued the hotel applying the capitalization-of-earnings approach using an estimated 5-year average of available net earnings figure of $135,000, a 15-year remaining useful life, a 5-percent interest factor, and a capitalization rate of 9 percent.
The major difference of opinion between the witnesses concerned the correct estimate of available earnings.
Both parties argued at length concerning the correct net earnings figure to be used in applying the capitalization of earnings approach. The hotel's earnings decreased sharply during the years 1962 and 1963, and respondent contended the earnings figures for those years were not representative and should therefore be ignored in projecting the hotel's future earning capacity. Petitioners contended on the other hand that those earnings figures should weigh heavily because they were the most recent earnings figures available and were indicative of future earning capacity. We feel that in light of the many different reasons advanced by both parties to account for the large drop in earnings for the years 1962 and 1963, an average figure based upon the earnings for each of the 5 years immediately preceding the sale of the hotel is the most reasonable approximation of the estimated future earning capacity of the hotel.
As further support for what petitioners allege to be the true fair market value of the hotel, we are asked to consider the subsequent sale to the Roberts brothers of approximately a one-third interest in the hotel at the same price paid by the Honigmans and the purchase for $137,500 of the portion of the building previously owned by the Old Kent Bank. We do not consider these transactions persuasive to a determination of the fair market value of the hotel as of May 27, 1963. In our opinion and in the opinions of the experts (who used the capitalization-of-earnings approach because they could find no comparative sales), these transactions were not representative comparative sales and were of no probative value in estimating the value of the hotel.
Petitioners argue alternatively that notwithstanding a finding of fact that the price paid was less than the fair market value of the hotel, no dividend resulted because no dividend was intended. They rely heavily upon the facts that Honigman was only a minority shareholder and that National allegedly had a valid business purpose for the transaction.
Petitioners do not dispute that National had adequate earnings and profits to support finding of a dividend in the amount stated in the deficiency notice.
Respondent argues that the intent of the parties to the transaction is not controlling in determining whether the transfer resulted in a dividend and, therefore, that the sole question on the issue is whether, as a matter of fact, the fair market value of the Pantlind Hotel as of the date of sale was in excess of the price paid.
Section 316, supra, provides that a dividend is a distribution by a corporation out of its earnings and profits. Our only inquiry herein is whether National transferred to the Honigmans without cost a portion of its earnings and profits. The intent of the parties to the transaction is not controlling, nor do we consider it material that the transfer was in the form of a sale, or that no express dividend was declared. Lester E. Dellinger, supra. To the extent the fair market value exceeded the price paid, there was a distribution to the Honigmans of National's earnings and profits and consequently a taxable dividend in the same amount.
Petitioners' argument that the circumstances of the transaction, i.e., the unsuccessful efforts to find a willing "outside" purchaser, Silberstein's refusal to purchase the hotel at the same price paid by the Honigmans, and the fact that Honigman was a minority shareholder, which circumstances they contend show a bona fide sale at arm's length, are material to determining whether the transaction constituted a dividend is without merit. In our opinion, and the cases relied upon by petitioners are in agreement therewith, the surrounding circumstances may be material to a determination of the property's fair market value, but where, as here, the value of the property has already been determined, such facts are of little if any help in deciding whether a dividend resulted.
Also, petitioners' reliance upon National's alleged valid business purpose for the transaction is without merit. We are convinced that whatever National's business purpose may have been, the transaction was completed at that time primarily to entitle National to recognize the loss to be realized on the sale of the hotel. The directors had no hope of selling the hotel for more than its adjusted basis of approximately $1,400,000, and had they sold the hotel after they had adopted the liquidation plan, the loss could not have been recognized. These facts indicated the transaction was a "forced sale" and not a bona fide sale at arm's length.
The next issue is whether, as petitioners contend in the alternative, the dividend is a distribution in partial liquidation (as defined in section 346) of National and therefore is taxable as a capital gain. Secs. 331, 1221. Respondent argues that section 346 is not applicable because the transaction was not pursuant to a plan of partial liquidation, nor did the transaction include a redemption of National's stock. We agree. This Court has previously held a stock redemption to be a prerequisite to the applicability of section 346. Oscar E. Baan, 51 T.C. 1032 (1969). Petitioners failed even to contend that the transaction in issue included a redemption of stock, but in any event, it is clear that the only redemption of National's stock that occurred was pursuant to the plan of complete liquidation adopted August 12, 1963, more than 2 months after the sale of the hotel.
The next issue is whether National is entitled to deduct any loss on the sale of the Pantlind Hotel to the Honigmans. Respondent argues that since the hotel was transferred for an amount less than its fair market value that the transaction is to be treated in its entirety as a distribution to which section 301 applies. Sec. 1.301-1(j), Income Tax Regs., supra. He argues further that since under section 311 a corporation does not recognize gain or loss upon a distribution to which section 301 applies, National is not entitled to deduct any loss on the transfer of the Pantlind Hotel. Respondent's reliance upon section 1.301-1(j), Income Tax Regs., as support for his contention on this issue is misplaced because that regulation states clearly that the amount of the distribution to which section 301 is deemed to apply (and hence the amount deemed to be recognized as a dividend) is the difference between the amount paid for the property and its fair market value. In our opinion the transfer of the hotel is to be treated for tax purposes as in part a dividend in an amount equal to the difference between the fair market value of the hotel and the amount paid to acquire it and in part a sale. National realized a loss on the sale and is therefore entitled to deduct as a loss the difference between the adjusted basis and fair market value of the hotel. W. G. Maguire Co., 20 T.C. 20 (1953).
The next issue is whether certain expenditures incurred and paid by National are deductible as ordinary and necessary business expenses. In its fiscal year 1962, National expended the sum of $87,294.27 for materials and labor for replacing portions of the floor of the garage area of the First National Building and in fiscal 1963, National expended the sum of $10,976.44 for engineering services in the course of a physical survey and recommendation of a program for further need for replacing portions of the floor of the same garage area.
We will consider first the deductibility of the expenditures in 1962 for materials and labor. Petitioner contends the expenditures are ordinary and necessary business expenses in the nature of repairs. Respondent contends the expenditures are nondeductible capital expenditures because they arrested deterioration and constituted permanent betterment and improvements. Respondent relies heavily upon section 1.162-4, Income Tax Regs., which provides:
Sec. 1.162-4 Repairs.
The cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as an expense, provided the cost of acquisition or production or the gain or loss basis of the taxpayer's plant, equipment, or other property, as the case may be, is not increased by the amount of such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall either be capitalized and depreciated in accordance with section 167 or charged against the depreciation reserve if such an account is kept.
This Court has previously stated that it is necessary to consider the purpose for which an expenditure is made in order to determine whether such expenditure is capital in nature or is a current repair expense. In Illinois Merchants Trust Co., Executor, 4 B.T.A. 103 (1926), we stated:
In determining whether an expenditure is a capital one or is chargeable against operating income, it is necessary to bear in mind the purpose for which the expenditure was made. To repair is to restore to a sound state or to mend, while a replacement connotes a substitution. A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor does it appreciably prolong its life. It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired. Expenditures for that purpose are distinguishable from those for replacements, alterations, improvements or additions which prolong the life of the property, increase its value, or make if adaptable to a different use. The one is a maintenance charge, while the others are additions to capital investment which should not be applied against current earnings. * * *
The alleged repairs in this case were of two types: the replacement of entire 16 feet by 16 feet floor bay areas and the patchwork of smaller floor areas. The repair work entailed tearing up the damaged portions of the concrete floor and replacing the removed portions with new reinforced concrete. In some instances, new steel beams were either substituted for the old beams or welded alongside of them.
We hold that the expenditures related to the replacement of entire 16 feet by 16 feet floor bay areas are capital in nature and therefore nondeductible. The replacement of the floor bay areas required a substantial amount of structural work including the use of steel reinforcing rods and new steel beams. The new floor bay areas represented replacements and improvements, not merely repairs which kept the building in an ordinarily efficient operating condition. Illinois Merchants Trust Co., Executor, supra.
While we find the expenditures related to the patching of smaller floor areas to be in the nature of deductible repairs, petitioners have failed to prove what portion of the expenditures was incurred for the patchwork repairs or to give us a reasonable basis upon which to allocate a portion of the total expenditures to the patchwork. Therefore, under the principle of Cohan v. Commissioner, 39 F.2d 540 (C.A. 2, 1930), we allocate $2,500 to such repairs and hold such amount to be currently deductible.
We consider now the expenditures in fiscal 1963 for engineering services. Respondent contends this expenditure was capital in nature, but is nondeductible in any event because it was incidental to the sale of the First National Building in the section 337 liquidation. We agree that the expenditure was capital in nature at least to the extent the survey related to recommended floor replacements amounting to capital improvements. For want of proof of what portion, if any, of the survey that related to future noncapital repair work, we must assume that all of the survey expenditures related to recommended floor replacements amounting to capital improvements and consequently that all of those expenditures are capital. Accordingly, we hold that the expenditures of $10,976.44 for engineering services are nondeductible as a current expense.
Decisions will be entered under Rule 50.