Opinion
Docket No. 63473.
1959-05-15
STATE-ADAMS CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
H. Gilmer Wells, Esq., and Albert C. Petite, Esq., for the petitioner. William T. Holloran, Esq., and Paul D. Barker, Esq., for the respondent.
H. Gilmer Wells, Esq., and Albert C. Petite, Esq., for the petitioner. William T. Holloran, Esq., and Paul D. Barker, Esq., for the respondent.
In order to obviate anticipated difficulties with regard to the devolution of title to a valuable piece of Chicago real estate leased on a long-term ‘net lease’ to a department store, petitioner corporation was organized to hold title to such real estate (and lease). It was not intended that petitioner would exercise any substantial business function with regard to this property or otherwise, and petitioner did not actually engage in business after its organization. Its only activities were the holding of title to such real estate, the taking of steps necessary to continue its own corporate life, and the substantial continuation of those methods by which the income from the property was remitted to the beneficial owners thereof. Held, income from such property not taxable to petitioner. John A. Mulligan, 16 T.C. 1489, followed.
Respondent determined a deficiency in petitioner's Federal income and excess profits tax for the year 1951 in the sum of $88,558.18. Respondent explained this determination as follows:
It is held that the lease of property located at State and Adams Streets, Chicago, Illinois, under which, The Fair, an Illinois corporation, is the lessee, which was transferred to you by your stockholder in 1933 for a note of $2,700,000.00 with interest at 5% per annum, represents a contribution to capital and the alleged interest payments of $139,015.68 thereon are not deductible under the provisions of Section 23(b) of the Internal Revenue Code of 1939.
Petitioner alleged in its petition that respondent erred in his determination that the interest payments were not deductible under section 23(b) of the Internal Revenue Code of 1939, and, in the alternative, that respondent ‘erred in failing and refusing to determine that the Petitioner is, and was during the period herein involved, a mere conduit or agency formed and utilized for the sole purpose of holding title to real estate and therefore is not to be regarded as a separate taxable entity distinct from its stockholders.’
Petitioner also alleged error in that respondent refused ‘to determine that the Petitioner was entitled to compute its 1951 excess profits credit by the method prescribed by Section 435 or 436 of the Internal Revenue Code of 1939.’ No mention was made of this alleged error at the trial herein or on brief and we assume that it has been waived by petitioner.
The testimony adduced by petitioner at the trial herein related only ‘to disregarding the petitioner as a separate taxable entity’ and petitioner's argument on brief was confined to its contention that ‘petitioner is not a taxable entity separate and distinct from its stockholders.’
FINDINGS OF FACT.
Most of the relevant facts herein were the subject of a stipulation by the parties. All facts so stipulated and the exhibits attached thereto are made a part of our findings by this reference.
Petitioner State-Adams Corporation, hereinafter sometimes referred to as petitioner, was incorporated under the laws of Illinois on September 26, 1933. At all times relevant to this proceeding, with exceptions to be noted hereinafter, petitioner was and is so incorporated. Its address is c/o John N. Penick, 30 Broad Street, New York 4, New York. It filed a corporation income tax return for the taxable year 1951 with the collector of internal revenue for the second district of New York, listing its principal business activity as ‘REAL ESTATE HOLDING.’ In this return it reported the receipt of rent in the sum of $140,000, deducted therefrom the sums of $139,015.68 in ‘interest’ and $984.32 as ‘Legal services and collection charges,‘ and reported its net income as ‘none.’ In Schedule E the return stated: ‘The Corporation owns title to property on the corner of State and Adams Streets, Chicago. It receives rent of $140,000 annually, and disburses the same, less legal fees and collection charges to the holders of the corporation promissory notes in payment of interest on the notes.’ In Schedule M the return stated: ‘THIS CORPORATION HAS NO NET INCOME, NO EARNED SURPLUS AND NO UNDIVIDED PROFITS.’
A consent, Form No. 872, extending to June 30, 1956, the period of limitation for assessment of income taxes with respect to petitioner's taxable year 1951 was executed on February 24, 1955, on behalf of petitioner and respondent.
Edwin H. Sheldon died testate a resident of Delaware County, New York, on December 18, 1890, leaving a will dated May 27, 1887, which was duly admitted to probate by the Surrogate's Court of Delaware County, New York, on January 10, 1891. Letters testamentary were duly issued to Edwin B. Sheldon and Frances Sheldon Whitehouse, the surviving son and daughter, respectively, of Edwin H. Sheldon. By his will, Edwin H. Sheldon devised and bequeathed his residuary estate in trust, hereinafter referred to as the Sheldon Trust, naming Edwin B. Sheldon and Frances Sheldon Whitehouse as trustees. The terms of the Sheldon Trust provided that after the payment of certain annuities the net income therefrom was to be divided equally between Edwin B. Sheldon and Frances Sheldon Whitehouse during their joint lives. Upon the death of either, his or her share was to pass to his or her descendants, per stirpes, and in default of such descendants, the survivor of Edwin B. Sheldon or Frances Sheldon Whitehouse was to receive the entire trust income for life and upon his or her death the entire trust property was to be transferred and paid over in fee to his or her descendants, per stirpes.
The assets in the Sheldon Trust included a parcel of real property located at the corner of State and Adams Streets, Chicago, Illinois, hereinafter sometimes referred to as ‘State-Adams property.’ Under date of May 1, 1915, this State-Adams property was leased by Edwin B. Sheldon and Frances Sheldon Whitehouse, in their capacity as trustees of the Sheldon Trust, to a Chicago department store known as and hereinafter referred to as The Fair. The Fair lease was for a term of 79 years, commencing May 1, 1915, and ending April 30, 1994, and provided for lease rentals in the following amounts:
+----------------------------------------------+ ¦ ¦Annual ¦Monthly ¦ +--------------------------+--------+----------¦ ¦May 1, 1915 to May 1, 1920¦$125,000¦$10,416.67¦ +--------------------------+--------+----------¦ ¦To May 1, 1925 ¦130,000 ¦10,833.34 ¦ +--------------------------+--------+----------¦ ¦To May 1, 1930 ¦132,500 ¦11,041.67 ¦ +--------------------------+--------+----------¦ ¦To May 1, 1950 ¦135,000 ¦11,250.00 ¦ +--------------------------+--------+----------¦ ¦To May 1, 1994 ¦140,000 ¦11,666.67 ¦ +----------------------------------------------+
This lease still is in full force and effect and has not been the subject of modification in any respect since its execution on May 1, 1915.
The lease to The Fair of the State-Adams property was a ‘net lease.’ Pursuant to its terms all of the usual duties of ownership and management with respect to the property and any improvements thereon were imposed upon The Fair as lessee. The lessee had the duties of paying all water rates, taxes, general and special assessments, and all other impositions of every kind or nature levied or assessed upon the premises or upon any buildings or improvements at any time situated thereon. The lessee was required to see that the premises and improvements thereon were devoted to lawful uses, to maintain the premises and the improvements, and to keep them adequately insured. As a result of these provisions of the lease, Edwin B. Sheldon and Frances Sheldon Whitehouse, the owners of the fee as trustees, were relieved of all managerial duties and the normal burdens of ownership with respect to the State-Adams property.
In 1923 Edwin B. Sheldon died without descendants, leaving Frances Sheldon Whitehouse as the sole trustee and sole income beneficiary of the Sheldon Trust. At this time Frances Sheldon Whitehouse had six children, namely, Henry J., William FitzHugh, Sheldon, Norman O., Frances Ramsay, and Lily Coventry.
Between 1923 and 1933 two of Frances Sheldon Whitehouse's children, Frances Ramsay and Lily Coventry, married nonresident aliens and each relinquished her American citizenship. These daughters and three of Frances Sheldon Whitehouse's sons, Henry, William, and Sheldon, all had children of their own. By 1933 Frances Sheldon Whitehouse was 81 years of age. Several of her grandchildren were then minors. Had she died at such time the Sheldon Trust automatically would have terminated and its assets, including the State-Adams property together with The Far lease, would have been distributed in fee to Frances Sheldon Whitehouse's six children, including the two who were nonresident aliens. If one of her children had predeceased her leaving minor issue, an undivided interest in the State-Adams property would have vested in such minor issue on Frances Sheldon Whitehouse's subsequent death.
By 1933 Frances Sheldon Whitehouse had become concerned about the devolution of ownership of the State-Adams property upon the termination of the Sheldon Trust at her death. This concern was particularly acute in view of the fact that the laws of the State of Illinois (section 2 of the Illinois Session Laws of 1897) then in force prohibited the ownership of Illinois real estate by aliens for a period in excess of 6 years and, as matters then stood, Frances Sheldon Whitehouse's two daughters, Frances Ramsay and Lily Coventry, both aliens, would have received title to undivided interests in the State-adams property upon the death of Frances Sheldon Whitehouse. A further cause for concern was the probability that difficulties might arise in connection with title in the event that part of the ownership of the State-Adams property vested in minor beneficiaries upon the termination of the Sheldon Trust.
Early in 1933 Frances Sheldon Whitehouse's attorney in New York, Charles F. Smith, was consulted concerning these problems and requested to devise a solution. On May 24, 1933, Smith wrote Russell F. Locke, a Chicago attorney, outlining his problem as follows:
It is possible that in the not-distant-future I shall be confronted with the problem of holding title to a piece of Chicago real estate for the benefit of half a dozen individuals who will be the actual owners. By reason of the fact that all of these individuals are married, most have children, and several are nonresidents of the United States, you can readily see the desirability of having the legal title elsewhere than in all six jointly.
In our enlightened State this problem would be readily solved by the use of a real estate holding corporation, but in the sovereign State of Illinois (where, I understand, trial by battle and ordeal by fire still are practiced), I am informed that real estate holding companies are not permitted.
Without devoting any time to the question, I wonder if you would give me your idea of what might be done. I suppose title might be conveyed to a bank and held by it under a deed of trust. Perhaps your ingenious mind has devised some other scheme for avoiding title difficulties in a case of this sort, without interfering with the beneficial interest of the various individuals.
Subsequently Smith and Locke developed a plan whereunder Frances Sheldon Whitehouse, as trustee and life beneficiary of the Sheldon Trust, would convey the title to the State-Adams property and The Far lease to an Illinois corporation in exchange for its securities so that upon her death the remaindermen of the trust would receive securities of the corporation. On June 10, 1933, Smith again wrote Locke confirming this plan, this letter reading in pertinent part as follows:
As I have stated in my previous letters, the plan is to have Mrs. Whitehouse, as Trustee and life beneficiary, to convey the title to an Illinois corporation, and upon her death the remaindermen, those of her children who survive her, would receive securities of the corporation without the title to the property being in any way affected.
You will see from the foregoing that the arrangement is really one of convenience and form only, and in no way prejudices the interests of the remaindermen in the trust property.
All of the subscribers named in the certificate of incorporation of petitioner were associates in Locke's law office in Chicago, and Locke was named as the registered agent of the corporation. The purpose for which the petitioner was organized, as set forth in its certificate of incorporation, was to ‘purchase, own, hold title to and sell real estate in the State of Illinois.’ At all times since its incorporation and relevant hereto the only assets of petitioner consisted of the State-Adams property and the long-term lease thereof to The Fair.
On September 29, 1933, Smith wrote Frances Sheldon Whitehouse, who was then in Paris, France, advising her of the formation of the State-Adams Corporation and requesting that she execute a deed to the State-Adams property and an assignment of The Fair lease, both running to petitioner. Smith informed Frances Sheldon Whitehouse that the deed would be delivered to petitioner in return for all of its capital stock and that the assignment of the lease would be delivered to it in return for its promissory note payable to Frances Sheldon Whitehouse as trustee, the interest on which note would ‘be equivalent to the amount of the rent received from The Fair.’ Smith also advised Frances Sheldon Whitehouse that the ‘new arrangement’ would in no way affect the present crediting of her account ‘with a sum equal to the total rent from the property.’
At the first organizational meeting of stockholders and directors, held in Smith's offices in New York City, on October 27, 1933, the State-Adams real property was conveyed to petitioner by Frances Sheldon Whitehouse, as trustee, in exchange for all of petitioner's capital stock, namely, 100 shares of the par value of $100 each. At the same board of directors meeting Frances Sheldon Whitehouse, as trustee, assigned to the petitioner the leasehold agreement dated May 1, 1915, whereunder the State-Adams property was leased to The Fair until April 30, 1994.
At the time of the assignment to petitioner of the lease petitioner made and delivered to Frances Sheldon Whitehouse, as trustee, its promissory note dated November 1, 1933, in the amount of $2,700,000 bearing interest at the rate of 5 per cent per annum, payable monthly in advance. The 5 per cent interest rate would yield $135,000 per annum, the exact amount of the annual rental then being received under The Fair lease. The note dated November 1, 1933, was payable 3 years after date. No cash was paid into the petitioner upon its organization.
At the time of incorporation of petitioner, Frances Sheldon Whitehouse, her son William FitzHugh Whitehouse, Smith, and Locke were elected as directors. Frances Sheldon Whitehouse was elected president, William FitzHugh Whitehouse vice president and treasurer, and Smith secretary. The Bank of Montreal, Chicago branch, was selected as the Illinois statutory office, and the petitioner's mailing address was designated as ‘care of Mr. Charles F. Smith, of New York City, N.Y.’ Smith was also attorney for Frances Sheldon Whitehouse. Upon Smith's death in 1950, petitioner's mailing address was changed to ‘care of one of Mr. Smith's law partners, Mr. John N. Penick, who after Smith's death became the attorney for the Whitehouse family.
At the initial meeting of petitioner's subscribers held in Smith's office on October 27, 1933, and attended only by Smith and William FitzHugh Whitehouse, petitioner's bylaws, consisting of 2 1/4 typewritten pages, were adopted. The bylaws provided that petitioner's board of directors should consist of four directors, only two of which would be necessary to constitute a quorum.
Before the organization of petitioner, the rental income from the State-Adams property receivable by Frances Sheldon Whitehouse, as trustee, from The Fair was forwarded directly by The Fair to Ogden, Sheldon & Co., a Chicago real estate concern, which, after deducting a commission of 1 per cent, transmitted the proceeds to the Bank of Montreal, New York, which credited the funds to the ‘Income Account of the Estate of Edwin H. Sheldon, deceased (Mrs. Frances S. Whitehouse, Trustee).’
The Bank of Montreal has always been the bank used by the Whitehouse family. Immediately after the organization of the petitioner, The Fair was instructed by petitioner, acting according to corporate resolutions, to deliver the rental checks to the Bank of Montreal, Chicago, Illinois. The Chicago branch of the Bank of Montreal in turn cleared the checks and was instructed to remit the funds received from The Fair to the ‘Agents, Bank of Montreal, New York, for the credit of Frances Sheldon Whitehouse, as surviving trustee of the E. H. Sheldon Estate.’ At no time after the organization of petitioner were any rental payments made directly to it. All rental payments were made by The Fair directed to the Bank of Montreal by checks payable to petitioner. Petitioner never maintained a bank account and no check was ever drawn in its name on any account.
In January of 1938 Lock and Smith discovered that approximate 2 1/2 years earlier petitioner, at the instance of the secretary of state of Illinois, had been dissolved on July 2, 1935, by order of the Superior Court of Cook County, Illinois, as a result of its failure to file Illinois franchise tax returns and to pay such taxes. In March of 1938 petitioner's delinquent Illinois franchise taxes were paid by Smith and an order was then entered vacating the 1935 decree of dissolution.
The note dated November 1, 1933, which was due on November 1, 1936, was not paid by petitioner in 1936 nor was it presented for payment. However, ‘interest’ continued to be paid thereon. In April of 1940 a new note dated April 1, 1940, payable April 1, 1943, for $2,700,000 with interest at 5 per cent was issued.
Frances Sheldon Whitehouse died on March 7, 1944, and, pursuant to its terms, the Sheldon Trust terminated. The trust principal, including the stock and promissory note of petitioner, thereupon vested in the remaindermen who then were Frances Sheldon Whitehouse's four surviving sons, her daughter Lily Coventry, and the two children of Frances Ramsay, Frances Sheldon Whitehouse's deceased daughter who had died in 1935. At this time Lily Coventry and the two surviving children of Frances Ramsay were nonresident aliens of the United States. Each of Frances Sheldon Whitehouse's five surviving children was entitled to a one-sixth interest and the two grandchildren each to a one-twelfth interest in the trust estate. Accordingly, the 100 shares of petitioner's stock theretofore held by the Sheldon Trust were distributed and transferred as follows:
+-----------------------------------------------------------+ ¦ ¦Number of ¦Remainder ¦ +-----------------------------------+-----------+-----------¦ ¦Children of Frances S. Whitehouse ¦shares ¦interest ¦ +-----------------------------------+-----------+-----------¦ ¦ ¦ ¦ ¦ +-----------------------------------+-----------+-----------¦ ¦Henry J. Whitehouse ¦16 2/3 ¦1/6 ¦ +-----------------------------------+-----------+-----------¦ ¦William F. Whitehouse ¦16 2/3 ¦1/6 ¦ +-----------------------------------+-----------+-----------¦ ¦Sheldon Whitehouse ¦16 2/3 ¦1/6 ¦ +-----------------------------------+-----------+-----------¦ ¦Norman O. Whitehouse ¦16 2/3 ¦1/6 ¦ +-----------------------------------+-----------+-----------¦ ¦Lily Coventry ¦16 2/3 ¦1/6 ¦ +-----------------------------------+-----------+-----------¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------+
Grandchildren of Frances S. Whitehouse Veronica Armfelt (now Ward) 8 1/3 1/12 Constantine A. F. Ramsay 8 1/3 1/12
To effect this distribution the certificate for 100 shares of petitioner's stock formerly held by the Sheldon Trust was canceled and new certificates issued to the children and grandchildren of Frances Sheldon Whitehouse as indicated above.
The distribution and transfer of petitioner's stock to the remaindermen of the Sheldon Trust were effected at a meeting of the directors of petitioner held in Smith's office in New York on March 17, 1944, shortly after Frances Sheldon Whitehouse's death. At this meeting Smith recommended that petitioner's promissory note in the amount of $2,700,000, formerly held by the Sheldon Trust and vested in the trust remaindermen since Frances Sheldon Whitehouse's death, be written down to the amount of $1,682,500 which would more closely approximate the then fair market value of the State-Adams property. Smith pointed out that inasmuch as the same persons owned petitioner's stock and its note in exactly the same proportions, revision of the amount of the note would therefore make no change in the actual total value of the stock and note to any of the holders. The amount of petitioner's promissory note was accordingly adjusted to $1,682,500. The 5 per cent promissory note in the principal amount of $2,700,000, formerly held by the Sheldon Trust, was surrendered for cancellation and new notes aggregating $1,682,499.96, dated April 1, 1944, and bearing interest at the rate of 8 per cent per annum ‘or an amount equal to 1/6
of the maker's net earnings, whichever is lower,‘ were issued to the trust remaindermen as follows:
This fraction was 1/12 in the case of the notes issued to the grandchildren.
+----------------------------------------------------------------+ ¦ ¦Face amount of ¦Remainder ¦ +-----------------------------------+----------------+-----------¦ ¦Children of Frances S. Whitehouse ¦note ¦interest ¦ +-----------------------------------+----------------+-----------¦ ¦ ¦ ¦ ¦ +-----------------------------------+----------------+-----------¦ ¦Henry J. Whitehouse ¦$280,416.66 ¦1/6 ¦ +-----------------------------------+----------------+-----------¦ ¦William F. Whitehouse ¦280,416.66 ¦1/6 ¦ +-----------------------------------+----------------+-----------¦ ¦Sheldon Whitehouse ¦280,416.66 ¦1/6 ¦ +-----------------------------------+----------------+-----------¦ ¦Norman O. Whitehouse ¦280,416.66 ¦1/6 ¦ +-----------------------------------+----------------+-----------¦ ¦Lily Coventry ¦280,416.66 ¦1/6 ¦ +-----------------------------------+----------------+-----------¦ ¦ ¦ ¦ ¦ +----------------------------------------------------------------+
Grandchildren of Frances S. Whitehouse Veronica Armfelt (now Ward) 140,208.33 1/12 Constantine A. F. Ramsay 140,208.33 1/12
Immediately after the death of Frances Sheldon Whitehouse in March of 1944, the Bank of Montreal in Chicago was instructed by petitioner, acting according to corporate resolutions, to continue to receive the rental checks from The Fair and to transmit the funds direct to the Bank of Montreal in New York City. The Bank of Montreal in New York City was in turn directed to deposit each remainderman's pro rata share of the rental directly to his or her personal account. It was agreed that as compensation for its services in this connection the Bank of Montreal would be entitled to withhold from the rental payments received by it a service fee of one-half of 1 per cent thereof before allocating the rental payments among the remaindermen of the Sheldon Trust. (These fees were deducted by petitioner each year in its income tax return.) From the time of petitioner's organization in 1933 until the closing of the Chicago branch of the Bank of Montreal in 1952, all rental payments made by The Fair under the lease of May 1, 1915, were paid by The Fair directly to the Chicago branch of the Bank of Montreal by checks payable to petitioner; after the closing of the Bank of Montreal's Chicago branch in 1952, all such payments were made by The Fair to the First National Bank of Chicago, Chicago correspondent for the Bank of Montreal, which credited such funds to the account of the Bank of Montreal, New York agency. After deducting its service fee therefrom the Bank of Montreal in New York credited each remainderman's pro rata share of such amounts directly to his or her personal account.
In April 1944, shortly after the death of Frances Sheldon Whitehouse, the Bank of Montreal in New York wrote Smith pointing out that since Frances Sheldon Whitehouse had died and as a result thereof the remaindermen of the Sheldon Trust had come into possession of the petitioner's stock and notes representing beneficial ownership and control of the State-Adams property, it felt ‘that for the sake of regularity of procedure’ it should be furnished with a directive signed by all of the remaindermen, having ‘beneficial ownership and control of the Illinois realty,‘ which would authorize the Bank of Montreal thereafter to continue to collect and dispose of the rentals as it had done in the past. The requested directive, signed by the remaindermen, was furnished the Bank of Montreal shortly thereafter.
In April 1946, Illinois counsel for The Fair wrote Smith advising him that they questioned petitioner's title to the State-Adams property and the validity of the 1933 assignment to petitioner by Frances Sheldon Whitehouse as trustee of The Fair lease. Accordingly, they requested quitclaim deeds and a ratification of The Fair lease from all of the remaindermen of the Sheldon Trust. The quitclaim deeds so requested were obtained by Smith and delivered to the representatives of The Fair in May and June 1946. The ratification of the lease was effected at a special meeting of petitioner's stockholders, called for this particular purpose, held in Smith's office on January 28, 1947.
It was the intention of the organizers of petitioner and subsequently of all remaindermen of the Sheldon Trust, who became the petitioner's stockholders and noteholders upon Frances Sheldon Whitehouse's death, to distribute pro rata among the beneficial owners of the State-Adams property the entire net rentals from the property irrespective of the interest rate prescribed by petitioner's promissory notes. Thus, upon several occasions the amount distributed to petitioner's noteholders actually exceeded the amount which would have been payable pursuant to the interest rate prescribed by petitioner's notes. In the taxable year 1951, $139,000 was distributed to petitioner's noteholders as ‘interest’ while the amount required to be distributed by the 8 per cent interest rate prescribed in the notes would have been approximately $134,600.
Throughout the entire history of petitioner the rate of interest applicable to its promissory notes intentionally was fixed and adjusted so as to exhaust the aggregate net rental payments receivable from The Fair and thus to pass such rentals on to the beneficial owners of the property (or their heirs) as such ownership existed prior to October 27, 1933. In 1954, by which time the rentals from The Fair had increased to $140,000 per annum, the interest rate on petitioner's notes was changed from 8 per cent per annum to the lower of 8 1/2 per cent per annum or the company's net earnings. This last interest adjustment was effected at a special meeting of petitioner's board of directors held in its New York attorney's office on April 12, 1954. At this meeting it was pointed out that the adjustment in the prevailing interest rate was necessary sine ‘in view of the present increased rental from The Fair, the 8% interest rate formerly charged did not exhaust all of the net earnings of the Corporation.’
At no time since its organization has petitioner maintained an office (other than the required Illinois statutory office) for the transaction of business. Its mailing address at all times has been in care of Smith or John N. Penick, attorneys for the Whitehouse family.
The only expenses which petitioner sustained throughout the period of its existence consisted of the service fee charged by the Bank of Montreal, small legal fees payable to Smith's and Penick's law firm, and Illinois franchise taxes. These expenses were not paid directly by petitioner but were paid by Smith's and Penick's law firm which received reimbursement therefor from the Bank of Montreal, the Bank of Montreal deducting such expenses from the next rental check received by it from The Fair before effecting pro rata distribution of the net proceeds among the beneficial owners.
None of the officers or directors of petitioner, all of whom were either members of the Whitehouse family or their counsel, received any compensation from petitioner in their capacity as officers or directors. Article III-3 of petitioner's bylaws, which was never amended in this respect, expressly provided that no compensation should be paid to the directors or officers of petitioner for any services rendered to petitioner in such capacities. In its Federal income tax returns for the years 1934 through 1943, deductions in amounts ranging from $350 to $610 were claimed under the heading of ‘Compensation to Officers.’ Such amounts actually represented Smith's compensation as attorney and the various charges and franchise taxes referred to above, and were deducted as follows:
+----------------------------------------------------------------------+ ¦Year ¦Amount ¦ ¦ +------+---------+-----------------------------------------------------¦ ¦1933 ¦$2,250.00¦Legal services for incorporation. ¦ +------+---------+-----------------------------------------------------¦ ¦1934 ¦357.00 ¦Compensating of officers (name not given), including ¦ +------+---------+-----------------------------------------------------¦ ¦ ¦ ¦$7.00 capital stock tax. ¦ +------+---------+-----------------------------------------------------¦ ¦1935 ¦350.00 ¦Compensation of officers (name not given). ¦ +------+---------+-----------------------------------------------------¦ ¦1936 ¦350.00 ¦Compensation of officer, C. F. Smith, Secretary, with¦ +------+---------+-----------------------------------------------------¦ ¦ ¦ ¦the following note: “Compensation covers general ¦ +------+---------+-----------------------------------------------------¦ ¦ ¦ ¦legal and secretarial work for the Company.” ¦ +------+---------+-----------------------------------------------------¦ ¦1937 ¦350.00 ¦Compensation of officer, C. F. Smith, Secretary, with¦ +------+---------+-----------------------------------------------------¦ ¦ ¦ ¦the following note: “Compensation covers general ¦ +------+---------+-----------------------------------------------------¦ ¦ ¦ ¦legal and secretarial work for the Company.” ¦ +------+---------+-----------------------------------------------------¦ ¦1938 ¦450.00 ¦Compensation of C. F. Smith. ¦ +------+---------+-----------------------------------------------------¦ ¦1939 ¦413.87 ¦Compensation of C. F. Smith “and disbursements.” ¦ +------+---------+-----------------------------------------------------¦ ¦1940 ¦410.00 ¦Compensation of C. F. Smith “and disbursements.” ¦ +------+---------+-----------------------------------------------------¦ ¦1941 ¦410.00 ¦Compensation of C. F. Smith “and disbursements.” ¦ +------+---------+-----------------------------------------------------¦ ¦1942 ¦610.00 ¦Compensation of C. F. Smith “and disbursements.” ¦ +------+---------+-----------------------------------------------------¦ ¦1943 ¦410.00 ¦Compensation of C. F. Smith “and disbursements.” ¦ +------+---------+-----------------------------------------------------¦ ¦1944 ¦2,569.77 ¦“Legal service and collection charges.” ¦ +------+---------+-----------------------------------------------------¦ ¦1945 ¦2,158.25 ¦“Legal service and collection charges.” ¦ +------+---------+-----------------------------------------------------¦ ¦1946 ¦2,000.00 ¦“Legal service and collection charges.” ¦ +------+---------+-----------------------------------------------------¦ ¦1947 ¦2,000.00 ¦“Legal service and collection charges.” ¦ +------+---------+-----------------------------------------------------¦ ¦1948 ¦1,000.00 ¦“Legal service and collection charges.” ¦ +------+---------+-----------------------------------------------------¦ ¦1949) ¦N. A. ¦ ¦ +------+---------+-----------------------------------------------------¦ ¦1950) ¦ ¦ ¦ +------+---------+-----------------------------------------------------¦ ¦1951 ¦984.32 ¦“Legal service and collection charges.” ¦ +----------------------------------------------------------------------+
From the time of its organization to the present date only two meetings of petitioner's stockholders have been held. The first, held on October 27, 1933, was a meeting of the original subscribes which was necessary in order to comply with the legal requirements of corporate formation. The only other stockholders meeting was held on January 28, 1947, for the sole purpose of ratifying The Fair lease, as requested by The Fair. Over the period from 1933 to the date of the trial herein 10 directors' meetings of petitioner have been held. All of these meetings were held in Smith's or Penick's office. The directors meetings, as recorded in the minute books of petitioner, were held on the following dates:
October 27, 1933
November 17, 1933
April 19, 1940
March 17, 1944
December 21, 1945
March 15, 1946
January 21, 1949
July 15, 1949
May 15, 1950
April 12, 1954
In each of its Federal income tax returns from the date of its organization to the present date, petitioner consistently has reported the rental payments from The Fair as its sole income and has deducted the expenses set out above and interest payments, said rental income and interest payments being as follows:
+------------------------+ ¦ ¦ ¦Deduction ¦ +----+-------+-----------¦ ¦Year¦Rental ¦entitled ¦ +----+-------+-----------¦ ¦ ¦income ¦“Interest ¦ +----+-------+-----------¦ ¦ ¦ ¦expense” ¦ +----+-------+-----------¦ ¦1933¦$11,250¦$11,250.00 ¦ +----+-------+-----------¦ ¦1934¦135,000¦135,000.00 ¦ +----+-------+-----------¦ ¦1935¦135,000¦135,000.00 ¦ +----+-------+-----------¦ ¦1936¦135,000¦135,000.00 ¦ +----+-------+-----------¦ ¦1937¦135,000¦135,000.00 ¦ +----+-------+-----------¦ ¦1938¦135,000¦135,000.00 ¦ +----+-------+-----------¦ ¦1939¦135,000¦134,586.13 ¦ +----+-------+-----------¦ ¦1940¦135,000¦134,590.00 ¦ +----+-------+-----------¦ ¦1941¦135,000¦134,590.00 ¦ +----+-------+-----------¦ ¦1942¦135,000¦134,390.00 ¦ +----+-------+-----------¦ ¦1943¦135,000¦134,590.00 ¦ +----+-------+-----------¦ ¦1944¦135,000¦132,430.23 ¦ +----+-------+-----------¦ ¦1945¦135,000¦132,841.75 ¦ +----+-------+-----------¦ ¦1946¦135,000¦133,000.00 ¦ +----+-------+-----------¦ ¦1947¦135,000¦133,000.00 ¦ +----+-------+-----------¦ ¦1948¦135,000¦134,000.00 ¦ +----+-------+-----------¦ ¦1951¦140,000¦139,015.68 ¦ +------------------------+
In no instance has it reported any net taxable income or paid any Federal income taxes.
OPINION.
KERN, Judge:
The deficiency involved in this case results from the respondent's determination that the so-called interest payments here involved, although in form the payments of interest called for by promissory notes, were, as a matter of economic reality and for Federal income tax purposes, the distributions of income to the investors of equity capital, and were therefore not deductible as interest under section 23(b) of the Internal Revenue Code of 1939. The petitioner on brief does not contend that these payments constituted deductible payments of interest. Its argument is that respondent has not gone far enough in applying the doctrine that in Federal tax matters substance shall prevail over form, and that under the peculiar facts of this case that doctrine requires that the corporate entity of petitioner separate and apart from its shareholders be ignored and that the income which is in form that of the corporate petitioner should be considered as being, in reality and for Federal tax purposes, the income of its shareholders taxable to them and not to petitioner.
Upon the question of when and under what circumstances the corporate entity may be disregarded for Federal tax purposes, the law has been succinctly stated by the United States Court of Appeals for the Second Circuit in Jackson v. Commissioner, 233 F.2d 289, 290, affirming 24 T.C. 1, as follows:
A corporation may not be disregarded in respect of taxation, if, inter alia, a bona fide intention in creating it was that the corporation itself should have some real substantial business function, or if it actually engages in business; on the other hand, the corporation may be disregarded, in the absence of such an intention or activity. The intended or actual business functioning of the corporation itself, not the taxpayer's aim to be accomplished via the corporation, is the test.
A natural person may be used to receive income which in fact is another's. So, too, a corporation, although for other purposes a jural entity distinct from its stockholders, may be used as a mere dummy to receive income which in fact is the income of the stockholders or of someone else; in such circumstances, the company will be disregarded.
See also Landon L. Skarda, 27 T.C. 137, 145, affd. 250 F.2d 429.
Examples of fact situations in which ‘a corporation may not be disregarded in respect of taxation’ are found in Estate of L. B. Whitfield, 14 0t.c. 776; Langdon L. Skarda, supra; Harry F. Shannon, 29 T.C. 702; and Given v. Commissioner, 238 F.2d 579 (affirming a Memorandum Opinion of this Court). Examples of fact situations in which a corporation may be so disregarded are found in Paymer v. Commissioner, 150 F.2d 334, and John A. Mulligan, 16 T.C. 1489. See also Bartell Hotel Co., 32 T.C. 311. Such fact situations in which the general rule (that a corporation should be considered for tax purposes as an entity separate and distinct from its stockholders) is not applicable are, in the examples given, where for the convenience of owners of real property
title to such property is transferred to and held by a corporation which thereafter does not itself engage in any business activity with regard thereto, such as mortgaging such property, executing leases, collecting rentals, making improvements, maintaining a bank account, or negotiating sales.
Including long-term leases. See Lewis Eugene Grigsby Trust, 5 T.C. 51.
The facts in the instant case more closely resemble those present in John A. Mulligan, supra, than those of any other case brought to our attention by the voluminous briefs filed by the parties. The only reason for the creation of petitioner corporation and the transfer to it of the real property (including the lease) was to convenience the owners of the property with regard to matters incident to the holding of title thereto. It was never intended that the corporation should, and the corporation did not perform any real substantial business function or engage in a business activity with regard to the property. It executed no leases, mortgages, or sales. It made no improvements or repairs, and paid no taxes on the property. It maintained no bank account and had no working capital. The rentals were collected by the same persons who collected them before the formation of petitioner and were credited to the checking accounts of the person (or their heirs) owning the property prior to the passing of title to petitioner. The only things done by petitioner were to take steps necessary for the channeling of the income from the property to those owners (without itself receiving and depositing such income) and to take steps necessary for the preservation of its corporate life (and even this was in jeopardy for a period because of the carelessness of its officers with regard to its affairs). Petitioner did not exercise a substantial business function or actually engage in business after its creation by reason of acquiring the lease in return for the execution of its promissory notes. Respondent himself characterizes this transaction, and rightly so, as a contribution of capital with the notes evidencing equity ownership and a right to income rather than a debt.
Under the peculiar facts of this case we conclude that the corporate entity of petitioner should be disregarded for Federal tax purposes and that the income which is in form the income of petitioner is in reality the income of its stockholders and should be taxable to them rather than to petitioner.
Decision will be entered under Rule 50.