Opinion
Docket No. 91178.
1964-02-28
FORESUN, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Richard Katcher, for the petitioner. Eugene S. Linett, for the respondent.
Richard Katcher, for the petitioner. Eugene S. Linett, for the respondent.
Held: Transactions between petitioner and certain individuals resulted in contributions to petitioner's capital, rather than a sale and loans, so that respondent properly disallowed interest deductions. Petitioner's basis in the contributed property is that of its transferor, section 113 (a)(8)(B),I.R.C. 1939, not the ‘sale’ price.
TRAIN, Judge:
Respondent determined deficiencies in the statutory notice and asserted increased deficiencies in an amended answer to the petition in the income tax liability of petitioner for the years and in the amounts as follows:
+--------------------------------------+ ¦Fiscal year ending¦Statutory¦Amended ¦ +------------------+---------+---------¦ ¦ ¦notice ¦answer ¦ +------------------+---------+---------¦ ¦Oct. 31— ¦ ¦ ¦ +------------------+---------+---------¦ ¦1956 ¦$6,099.28¦$9,863.26¦ +------------------+---------+---------¦ ¦1957 ¦4,386.97 ¦8,399.98 ¦ +------------------+---------+---------¦ ¦1958 ¦4,421.65 ¦8,434.67 ¦ +--------------------------------------+
The issues for decision are:
(1) Whether petitioner is entitled to an interest deduction for amounts paid to Ada Osborn in each of the fiscal years ending October 31, 1956, 1957, and 1958;
(2) Whether petitioner is entitled to an interest deduction for amounts paid to one of petitioner's shareholders and the wives of three others for the years in question; and
(3) Whether petitioner is entitled to use $218,025 as the basis for depreciating certain property acquired from Ada Osborn in 1949.
FINDINGS OF FACT
Some of the facts have been stipulated and are hereby found as stipulated.
The petitioner, Foresun, Inc. (sometimes hereinafter referred to as petitioner), is an Ohio corporation with its principal place of business at 165 Harriman, Bedford, Ohio. Petitioner was organized on September 2, 1949, and has, at all times material herein, been engaged in the business of owning and renting real estate. Petitioner's corporation income tax returns for the taxable years ending October 31, 1956, 1957, and 1958 were filed with the district director of internal revenue, Cleveland, Ohio. During each of the fiscal years in question petitioner employed an accrual method of accounting.
At all material times, the outstanding stock of petitioner was owned as follows:
+----------------------------------------------------------+ ¦ ¦Number of¦Subscription¦ ¦ +-------------------+---------+------------+---------------¦ ¦Shareholder ¦shares ¦price ¦Office ¦ +-------------------+---------+------------+---------------¦ ¦ ¦ ¦(per share) ¦ ¦ +-------------------+---------+------------+---------------¦ ¦Edwin H. Osborn ¦5 ¦$100 ¦President. ¦ +-------------------+---------+------------+---------------¦ ¦William P. Lindauer¦5 ¦100 ¦Vice president.¦ +-------------------+---------+------------+---------------¦ ¦Frank K. Byers, Jr ¦5 ¦100 ¦Secretary. ¦ +-------------------+---------+------------+---------------¦ ¦Arnold W. MacAlonan¦5 ¦100 ¦Treasurer. ¦ +----------------------------------------------------------+
The Stalwart Rubber Co. (hereinafter sometimes referred to as Stalwart) is an Ohio corporation organized on June 5, 1937. At all material times, it has been engaged in the manufacture of industrial rubber products. The outstanding common stock of Stalwart was owned, at the dates indicated, as follows:
+---------------------------------------------------+ ¦ ¦Number of shares ¦ +----------------------+----------------------------¦ ¦Shareholder ¦ ¦ ¦ +----------------------+--------------+-------------¦ ¦ ¦Sept. 10, 1949¦Dec. 31, 1958¦ +----------------------+--------------+-------------¦ ¦Herman W. Osborn ¦8,489 ¦5,449 ¦ +----------------------+--------------+-------------¦ ¦Edwin H. Osborn ¦939 ¦1,384 ¦ +----------------------+--------------+-------------¦ ¦Elizabeth J. MacAlonan¦939 ¦1,384 ¦ +----------------------+--------------+-------------¦ ¦Ellen E. Byers ¦939 ¦1,384 ¦ +----------------------+--------------+-------------¦ ¦Margaret M. Lindauer ¦939 ¦1,384 ¦ +----------------------+--------------+-------------¦ ¦Ada Osborn ¦160 ¦380 ¦ +----------------------+--------------+-------------¦ ¦William P. Lindauer ¦ ¦260 ¦ +----------------------+--------------+-------------¦ ¦Frank K. Byers, Jr ¦ ¦260 ¦ +----------------------+--------------+-------------¦ ¦Lois Osborn ¦ ¦260 ¦ +----------------------+--------------+-------------¦ ¦Arnold W. MacAlonan ¦45 ¦305 ¦ +----------------------+--------------+-------------¦ ¦R. H. Tyrell ¦50 ¦50 ¦ +----------------------+--------------+-------------¦ ¦Total ¦12,500 ¦12,500 ¦ +---------------------------------------------------+
Herman W. Osborn (hereinafter sometimes referred to as Herman) and Ada Osborn (hereinafter sometimes referred to as Ada) were husband and wife. Herman died March 10, 1961. Their children and their children's spouses are as follows:
+------------------------------------------+ ¦Children ¦Spouse ¦ +----------------------+-------------------¦ ¦Edwin H. Osborn ¦Lois Osborn ¦ +----------------------+-------------------¦ ¦Elizabeth J. MacAlonan¦Arnold W. MacAlonan¦ +----------------------+-------------------¦ ¦Ellen E. Byers ¦Frank K. Byers, Jr.¦ +----------------------+-------------------¦ ¦Margaret M. Lindauer ¦William P. Lindauer¦ +------------------------------------------+
R. H. Tyrell, now deceased, was not related in any way to the Osborn family.
On July 7, 1944, Ada's preferred stock in Stalwart was redeemed in exchange for an unimproved lot and adjacent improved real property occupied by Stalwart in the conduct of its business. From July 7, 1944, to September 30, 1949, Stalwart leased this improved realty from Ada at an annual rental of $20,400. A business expense deduction of $7,000 per year for such rental was allowed by the Commissioner for the years 1944 to 1948, inclusive and was agreed to by Stalwart.
Petitioner was incorporated on September 2, 1949, for the purpose of acquiring from Ada the improved property rented by Stalwart, together with the adjacent unimproved lot. Pursuant to such purpose, petitioner on September 10, 1949, made an ‘Offer to Purchase’ (hereinafter referred to as the offer) that property (hereinafter referred to as the property) from Ada for $225,000, which she accepted on the same date.
Under the terms of that offer, petitioner agreed to pay $225,000 for the property, consisting of $25,000 in cash and a second mortgage in the amount of $200,000, which mortgage was to be second in priority only to a first mortgage for $25,000. No payments on principal were to be made on the second mortgage until the first mortgage was paid in full, after which monthly payments of not less than $625 were to be paid on the second mortgage. Interest at the rate of 6 percent per annum was payable quarterly on the balance due on said mortgage, the first of such payments to be due 3 months after September 30, 1949.
Petitioner's board of directors, at a meeting held on September 10, 1949, authorized the purchase of the property for $225,000 on the terms and conditions set forth in the offer.
In order to purchase the property from Ada, petitioner borrowed $25,000 from the National City Bank of Cleveland (hereinafter referred to as National City Bank), Cleveland, Ohio. To evidence its obligation to National City Bank, petitioner executed and delivered its promissory note to the bank for $25,000, dated September 19, 1949, payable 5 years from date in quarterly installments of $1,200 each, with interest at the rate of 4 percent per annum. This note was secured by a first mortgage on the property, which mortgage was recorded in the county recorder's office of Cuyahoga County, Ohio.
Prior to making the $25,000 loan to petitioner, National City Bank had appraised the property at $201,000, of which $18,000 represented the value of the land and $183,000 the value of the buildings.
West Brothers, Inc., on March 15, 1949, appraised the land at $7,560 and the replacement and sound values of the buildings at $398,114.99 and $282,243.14, respectively. This appraisal was the basis upon which petitioner relied in its offer to purchase the property from Ada for $225,000.
Petitioner consummated the purchase by paying Ada $25,000 in cash and executing and delivering to her its cognovit installment note, dated September 30, 1949, in the amount of $200,000. This note provided for payments of not less than $625 per month, with interest at the rate of 6 percent per annum, payable quarterly, principal payments not to commence until the first mortgage to National City Bank had been paid in full. The note was secured by a second mortgage on the property, dated September 30, 1949, which mortgage was recorded in the Cuyahoga County, Ohio, records on October 14, 1949, the same date on which the first mortgage to National City Bank was recorded.
Pursuant to the offer to purchase, Ada executed a warranty deed to petitioner as grantee. This warranty deed, which was recorded in the Cuyahoga County, Ohio, records, had affixed to it U.S. internal revenue documentary stamps reflecting a total consideration of $225,000 for the transfer of the property to petitioner.
After the above transactions petitioner's capital structure was composed of the $2,000 paid-in capital, the $25,000 indebtedness to National City Bank, and its obligation of $200,000 to Ada.
The purpose of the above-described transaction was to secure for Ada a regular source of income during her lifetime and, in view of her ill health, to relieve her of the burdens of managing the property. At the time when Ada transferred the property to petitioner on September 10, 1949, she was 55 years old. The adjusted basis of said property in her hands was $27,500.
On her Federal income tax return for 1949, Ada reported the transaction whereby she transferred the property to petitioner as an installment sale under the provisions of section 44 of the Internal Revenue Code of 1939.
Subsequent to its acquisition by petitioner, the property was leased by petitioner to Stalwart at the following annual rentals:
+-----------------------------+ ¦Fiscal year Oct. 31— ¦Rent ¦ +---------------------+-------¦ ¦1950 (12 1/2 months) ¦$25,000¦ +---------------------+-------¦ ¦1951 ¦24,000 ¦ +---------------------+-------¦ ¦1952 ¦24,000 ¦ +---------------------+-------¦ ¦1953 ¦24,000 ¦ +---------------------+-------¦ ¦1954 ¦46,000 ¦ +---------------------+-------¦ ¦1955 ¦59,400 ¦ +---------------------+-------¦ ¦1956 ¦65,000 ¦ +---------------------+-------¦ ¦1957 ¦54,000 ¦ +---------------------+-------¦ ¦1958 ¦54,000 ¦ +-----------------------------+
For Federal income tax purposes, stalwart has been allowed to deduct the entire amounts of the above rents.
After World War II, Stalwart's business increased to such an extent that it required additional space for the conduct of its operations. To take care of its needs in this regard in the period between 1950 and 1952 Stalwart made leasehold improvements at a cost to it of $196,027.27. These included the construction of a new office building and the installation of a sprinkler system on the property which it leased from petitioner.
In 1952 and 1953, due to the business conditions then prevailing, Stalwart was in need of working capital. Its efforts to obtain financing from its regular source of funds, National City Bank, proved unsuccessful. Stalwart then offered to sell the leasehold improvements to petitioner at Stalwart's cost and to pay additional rental for the property leased from petitioner. Petitioner accepted this proposal.
To finance the purchase of these leasehold improvements, petitioner negotiated a $150,000 loan from Country Life Insurance Co. hereinafter referred to as Country Life), Chicago, Ill. On August 11, 1953, Country Life agreed to lend petitioner $150,000, payable in 120 monthly installments of $1,250 each, with interest at the rate of 6 percent per annum, secured by a first mortgage; provided petitioner, among other things, assigned to Country Life the lease between petitioner and Stalwart providing for an annual rental of $48,000. This condition was accepted by petitioner on August 18, 1953.
As of April 15, 1953, West Brothers, Inc., appraised the property owned by petitioner, and the leasehold improvements then owned by Stalwart and the subject of the proposed purchase by petitioner, as follows:
+-------------------------------------------------------------------+ ¦ ¦Replacement value¦Sound value ¦ +---------------------------------+-----------------+---------------¦ ¦Foresun: ¦ ¦ ¦ ¦ ¦ +---------------------------------+--------+--------+-------+-------¦ ¦Land ¦ ¦$10,080 ¦ ¦$10,080¦ +---------------------------------+--------+--------+-------+-------¦ ¦Buildings: ¦ ¦ ¦ ¦ ¦ +---------------------------------+--------+--------+-------+-------¦ ¦Below ground ¦$40,243 ¦ ¦$26,123¦ ¦ +---------------------------------+--------+--------+-------+-------¦ ¦Above ground ¦340.587 ¦380,830 ¦217,677¦243,800¦ +---------------------------------+--------+--------+-------+-------¦ ¦Total ¦ ¦390,910 ¦ ¦253,880¦ +---------------------------------+--------+--------+-------+-------¦ ¦Stalwart: Leasehold improvements:¦ ¦ ¦ ¦ ¦ +---------------------------------+--------+--------+-------+-------¦ ¦Below ground ¦36,503 ¦ ¦35,580 ¦ ¦ +---------------------------------+--------+--------+-------+-------¦ ¦Above ground ¦269,628 ¦306,131 ¦252,106¦287,686¦ +---------------------------------+--------+--------+-------+-------¦ ¦Total ¦ ¦697,041 ¦ ¦541,566¦ +-------------------------------------------------------------------+
On November 27, 1953, petitioner executed its cognovit note in the amount of $150,000 to Country Life, payable in 120 equal monthly installments of $1,250 each, with interest at the rate of 6 percent per annum. This note was secured by a mortgage deed, dated November 27, 1953, which was recorded on December 15, 1953.
As part of the transaction whereby petitioner borrowed $150,000 from Country Life, Arnold W. MacAlonan, an officer and shareholder of petitioner, approached Ada with a view to having her take a new $200,000 note and mortgage in substitution for the existing mortgage in order to help petitioner consummate its purchase of the leasehold improvements from Stalwart. Ada agreed to take a secondary position to Country Life's loan of $150,000.
Pursuant to her agreement, Ada surrendered to petitioner its cognovit installment note, dated September 30, 1949, payable to her, and on March 22, 1954, canceled of record the second mortgage securing said note.
Upon surrender to it of this $200,000 note, petitioner executed and delivered to Ada a new cognovit installment note, dated December 5, 1953, in the amount of $100,000. This note contained the same terms and conditions set forth in its original note except that it was subject to the first mortgage of $150,000 to Country Life. This note was secured by a second mortgage on the property dated December 5, 1953. The second mortgage was not recorded as one of the conditions of the loan from Country Life.
On December 10, 1953, petitioner purchased the leasehold improvements from Stalwart at the latter's cost and, in payment therefor, executed and delivered to Stalwart two promissory notes dated December 10, 1953, in the amounts of $140,027.27 and $56,000. With respect to the $140,027.27 note, petitioner paid to Stalwart $16,000 on March 8, 1954, and paid in balance of $124,027.27 on March 22, 1954. The $56,000 note was paid by petitioner on February 19, 1954.
As part of the transaction whereby petitioner purchased the leasehold improvements from Stalwart, Edwin Osborn, Ellen Byers, Margaret Lindauer, and Elizabeth MacAlonan (hereinafter sometimes referred to as the individual note holders) each advanced to petitioner the sum of $9,500. Petitioner executed and delivered to each its unsecured ‘promissory demand note’ in the face amount of $9,500. The amounts which the individual note holders advanced to petitioner were borrowed by them from National City Bank, which load was evidenced by a note secured by four insurance policies on the life of Herman in the amount of $40,000 each. Also, Herman advanced $8,500 to petitioner which he borrowed from National City Bank. The National City Bank note in the amount of $38,000 was paid on April 13, 1961.
Petitioner used the funds it obtained from Country Life, from the individual note holders, and from Herman, to pay the balance due on its $25,000 note, dated September 30, 1949, to National City Bank. The mortgage securing the National City Bank's $25,000 note was canceled of record on March 22, 1954.
In June 1953, Stalwart purchased all of the outstanding shares of Jasper Rubber Co., a Georgia corporation located in Jasper, Ga. On September 30, 1955, petitioner purchased the land and buildings owned by Jasper Rubber Co. for $152,047.85. The purchase price was paid by petitioner by executing and delivering to Jasper Rubber Co. its promissory note in the amount of $10,800, and assuming a first mortgage on the property in the amount of $141,247.85, with interest at 5 percent per annum. Petitioner paid the $10,800 note by making payments of $5,400 each in December 1957 and February 1960.
The second mortgages which petitioner executed in favor of Ada required that policies of insurance on the property acquired from her in the event of loss be made payable to her ‘as her interest may appear.’ Pursuant to the provisions of the mortgages, at all times material hereto petitioner's insurance policies on the acquired property contained a standard mortgage clause stating that the proceeds in the event of loss or damage were payable to National City Bank as first mortgagee and Ada as second mortgagee, or Country Life as first mortgagee and Ada as second mortgagee, as the case might be.
In a safe located in her home, Ada has kept possession of the $200,000 cognovit installment note and the second mortgage securing the note which had been executed and delivered by petitioner to her as evidence of its obligation arising out of the 1949 transfer of property to petitioner.
As of October 31, 1958, petitioner had reduced its note obligation to Country Life from $150,000 to $78,750. As of September 1962, the balance of that note was $20,000.
At all times material hereto, the books of petitioner have reflected an obligation of $200,000 to Ada with respect to the transaction which took place in 1949, and petitioner has paid annually to Ada an amount equal to 6 percent of the face amount shown on its $200,000 note. Petitioner has never made any payments of principal to Ada on the note.
The sources of funds available to petitioner from which to make payments on its obligation to Ada are rental income from the property leased to Stalwart and from the property located in Jasper, Ga.
There was no understanding, written or otherwise, between Ada and petitioner that, if for any reason petitioner did not pay the interest or principal it was obligated to pay pursuant to the terms of the $200,000 cognovit installment note, Ada would not enforce the rights which she has under the notes and the mortgages securing them.
Ada has never been an officer or director of petitioner and has never taken part in the conduct of its business.
Petitioner's books and records have at all times material hereto reflected as a liability its $38,000 obligation to the individual noteholders.
Petitioner has not made any payment of principal on the notes totaling $38,000 to the individual noteholders.
At all times material hereto, petitioner has paid annually to the individual noteholders an amount equal to 5 percent of the face amount shown on the notes executed and delivered by it to them.
There is no agreement between petitioner and the individual noteholders that they will not enforce collection of the notes.
The transactions between petitioner and Ada and the individual noteholders constituted contributions to petitioner's capital.
OPINION
Issue 1
The issue is whether petitioner is entitled to deduct the annual payments of $12,000 made to Ada as interest. The answer to this question depends upon whether the transaction whereby Ada transferred the property to petitioner was a sale as contended by petitioner or was a contribution to capital as contended by respondent.
There is no question here with respect to the form of the instruments involved. Respondent recognizes that the conveyance by Ada to petitioner was in the form of a sale of the property to petitioner and that the note and mortgage given by petitioner to Ada were in form an ordinary promissory note and mortgage. The record also shows that the transaction was recorded on the books of petitioner and Ada as a sale of property in return for a note and mortgage. Cf. Gooding Amusement Co., 23 T.C. 408, 418 (1954), affd. 236 F.2d 159 (C.A. 6, 1956).
It is respondent's position that in spite of the clear form that the substance of the transaction was not a sale but was rather a contribution by Ada to petitioner's capital. Respondent contends that Ada did not intend to create a bona fide debt as between herself and petitioner, but intended to embark upon petitioner's corporate adventure, taking the attendant risks of loss.
There is no one factor which is determinative in resolving the question here presented; each case must be determined by weighing the facts peculiar to it. John Kelley Co. v. Commissioner, 326 U.S. 521 (1946). There have been numerous decided cases involving whether purported sales of property or loans were in fact contributions to capital and various criteria have been pointed out as guidelines in determining whether the transaction is in substance what it purports in form to be. The name given to the instrument is not conclusive but is to be considered along with other facts. Presence or absence of a maturity date for the indebtedness, the right of the creditor to enforce the payment of principal and interest, participation in management, whether the creditor subordinates his debt to those of the other corporate creditors, whether the corporation is adequately capitalized, identity of interest between creditor and stockholders, whether the advance was at the time of the organization of the corporation, and the ability of the corporation to obtain loans from outside lending institutions, are all among the factors to be considered in determining the ultimate fact. O. H. Kruse Grain & Milling v. Commissioner, 279 F.2d 123 (C.A. 9, 1960), affirming a Memorandum Opinion of this Court; Wilbur Security Co., 31 T.C. 938 (1959), affd. 279 F.2d 657 (C.A. 9, 1960); and Clyde Bacon, Inc., 4 T.C. 1107 (1945). In the application of these criteria, it is the intent of the parties which is determinative, but this intent must be gleaned from consideration of all pertinent factors in the case. Isidor Dobkin, 15 T.C. 31, 33 (1950), affd. 192 F.2d 392 (C.A. 2, 1951).
Upon consideration of all the facts in the instant case, we conclude that the purported sale by Ada to petitioner was in substance nothing more than a contribution to capital. Petitioner states, ‘the only conceivable factor missing from this transaction is that petitioner has not made any principal payments on the note.’ However, on the facts of this case, we consider this failure to make principal payments to be very significant. Despite the testimony of Ada and her son-in-law, Arnold W. MacAlonan, we do not believe that there was ever any intention to make any payments on the principal of the purported note. From the facts of this case, it seems apparent that the shifting of property and papers was nothing more than a transparent tax savings device to generate interest deductions and a stepped-up basis for the petitioner. The purported transactions give off an unmistakably hollow sound when tapped.
In 1944, Ada acquired the property from Stalwart, a corporation controlled by her husband and other family members. For the period July 7, 1944, to September 10, 1949, Stalwart paid Ada a yearly rental of $20,400 per year. Petitioner asserts that in 1949 Ada ‘was desirous of selling the Osborn property to secure herself a regular source of income during her lifetime and, because of her ill health, to relieve herself of the burdens of managing the property,‘ so that Ada sold the property to petitioner.
There are a number of infirmities in the argument petitioner seeks to base on the foregoing assertion. It is difficult to understand what managerial problems could be involved in leasing property to a corporation controlled by Ada's family in view of the close working relationships she had with them, and there is no evidence of such difficulties. But even assuming this claim to be true, we fail to see how Ada could be relieved of any financial problems by selling the property. If petitioner had really intended to repay the principal amount to her, any repayments would have required her to reinvest in something else that would also give her the secure income she purportedly sought. We also find it difficult to see how Ada could have had any more security than by leasing the property to Stalwart. It would appear that Ada's secure income could only be maintained under the purported sale if no payments were made on the principal of the note and only ‘interest’ payments were made.
The downpayment of $25,000 gave some semblance of bona fides to the transaction; however, we think this payment was mere ‘window dressing.’ Petitioner had to borrow the money and give a first mortgage on the property, thus delaying any principal payments to Ada for 5 years, by means of which her ‘secure income’ was preserved for an additional length of time. Furthermore, the presence of consideration need not preclude a contribution to capital. Cf. Commissioner v. McKay Products Corp., 178 F.2d 639 (C.A. 3, 1949), reversing 9 C.T. 1082 (1947).
As for Stalwart's sudden need for working capital in 1953 being the person for subrogating Ada's mortgage a second time, we think this was again one of those transactions with a distinctly hollow ring, done primarily to further postpone the principal payments on Ada's ‘note.’ Stalwart began putting these improvements on the property shortly after the purposed sale in 1949, establishing a plausible reason for trying to get the property out of Ada's estate. With the improvements, the property might have a value of as much as $500,000 in Ada's estate. Under the purported sale, Ada would only be holding, at most, a $200,000 note. In addition, if no ‘principal payments' were made, Ada would get her ‘secure income.’
It seems more than coincidental that Stalwart would need working capital at just about the same time as Foresun's $25,000 note to National City Bank was almost paid off. The purported sale of the leasehold assets to petitioner appears to be nothing more than a cog in the overall plan.
The 1953 transaction could have done nothing but prejudice Ada's position. Petitioner argues that she had increased security because of the leasehold improvements. However, since these were presumably fixtures, they were already security. Teaff v. Hewitt, 1 Ohio St. 511 (1853); Roseville Pottery v. County Board of Revisions, 149 Ohio St. 89, 77 N.E.2d 608 (1948). This is but another indication that Ada was willing to, and in fact testified that she would, go through the same subordination if necessary, to help petitioner and/or Stalwart.
When asked why she was confident that the security for her second mortgage was adequate, she replies:Well, knowing the company as they were, I felt I would be sure that I would get it (the principal amount) * * *Well, it was just my trust i guess.
Petitioner has made much of the fact that Ada was not a shareholder. Petitioner argues that the cases relied on by respondent all involved closely held corporations where shareholder made advances to a controlled corporation. This argument has been decided adversely to petitioner in another context. In Brown Shoe Co. v. Commissioner, 339 U.S. 583 (1950), the Supreme Court decided that persons other than stockholders could make contributions to capital, a principle now codified in section 362(c) of the 1954 Code. See also Edwards v. Cuba Railroad, 268 U.S. 628 (1925); Liberty Mirror Works, 3 T.C. 1018, 1025 (1944); Commissioner v. McKay Products Corp., supra; Zephyr Mills, Inc. v. Commissioner , 279 F.2d 494 (C.A. 3, 1960), affirming per curiam a Memorandum Opinion of this Court; Veterans Foundation, 38 T.C. 66 (1962), affd. 317 F.2d 456 (C.A. 10, 1963). In the instant situation, Ada's dealings with petitioner indirectly benefited her in the same manner as the ‘contributors' derived benefits in the above-cited cases. Her testimony clearly indicates that she placed the business interests of petitioner and Stalwart foremost as long as she received her steady income.
If we look solely at the ‘note’ and nothing else, it appears that the ‘note’ has a reasonably certain maturity date. However, we do not believe that petitioner had any real intention of making any ‘principal payments,‘ as evidenced by the subsequent extensions granted to petitioner by Ada. The high ratio of debt to equity lends additional support to respondent's contention that the transactions in question were contributions to capital rather than bona fide loans. Petitioner argues that cases involving ‘thin capitalization’ are not in point because Ada was not a shareholder. Again we point out that this is not a necessary requirement. Petitioner would have us treat Ada as an unrelated third party acting in her own best interest. While it is true that transactions are not to be disregarded merely because of a family relationship, such relationship is a potent reason for giving close scrutiny to the transaction. Sun Properties v. United States, 220 F.2d 171 (C.A. 5, 1955). The real question is whether the transaction was what it purported to be, regardless of the identity of the parties.
Petitioner argues that subordination alone is not sufficient to convert debt into capital. With this proposition we agree. However, it is a factor to be considered. It is true that there was no subordination to general creditors, but this does not tell the entire story. Under petitioner's operation, in which it was little more than a rent collector, there were no general creditors of any significance. Thus, petitioner's day-to-day operations could be carried on without fear of reprisal by general creditors. Petitioner's only expenses aside from ‘interest’ and depreciation, were taxes, insurance, and office expense, the total of which did not exceed $8,000 in any year before us. Thus, Ada was really in the position of being a preferred shareholder, not a creditor. See United States v. Title Guarantee & Trust Co., 133 F.2d 990, 993 (C.A. 6, 1943). Before receiving the property from Stalwart in 1944, she was a preferred shareholder of Stalwart; now she is in effect a preferred shareholder of petitioner, receiving a steady income from her ‘sale’ of the property to petitioner. If petitioner were dissolved and there were any assets left after the first mortgage was paid, Ada would receive the remainder, up to the amount of her investment. She was also assured of a yearly payment on her investment. There is no question that under the ‘mortgage’ and ‘note’ Ada could have enforces her ‘debt,‘ but we do not believe she ever would have done so. The potential beneficiaries of her estate were the same persons who would benefit from her ‘loan’ to petitioner, and we accord little weight to Ada's testimony that she intended to have her estate enforce this ‘debt,‘ especially if this would be to the detriment of the persons or corporations involved here. Cf. Gooding Amusement Co., supra at 418-419.
Petitioner's reliance on our decision in Warren H. Brown, 27 T.C. 27 (1956), is misplaces. The factors which distinguished that case from Gooding Amusement Co., supra, are not present here. In Brown all installments due had been paid, an underlying independent business purpose was present, and there was a low debt to equity ratio.
After a consideration of all the facts, we are led inescapably to the conclusion that Ada did not ‘sell anything to petitioner but in fact made a contribution to capital.
Issue 2
Petitioner contends that it is entitled to deduct as interest the amounts paid to the individual noteholders. Petitioner's argument is substantially the same as in Issue 1: that three of the individual noteholders were not shareholders and that the ‘loans' were evidenced by demand notes. Respondent contends that the ‘loans' were in fact contributions to capital.
Petitioner could not borrow any more money from lending institutions and consequently had to rely on the family members for additional capital. After almost 10 years no payments have been made on these notes other than purported ‘interest’ payments. These notes are payable on demand, not at a fixed maturity date. Essentially, the daughters knew nothing about the ‘loans' other than that they were made on the advice of their husband-stockholders. Their testimony was that they would not enforce their obligation if it would be detrimental to the company. Again, we note that the fact the three daughters were not denominated ‘shareholders' is not controlling.
While it is true that there is no rule which permits the Commissioner to dictate what portion of a corporationS operations shall be provided for by equity financing rather than by debt, it is equally true that what was intended is a question to be decided from all the facts. Based upon the record, we hold that the advances by the individual noteholders were in fact contributions to capital. Accordingly, respondent's determination on this issue is sustained.
Issue 3
In an amended answer, respondent claimed that petitioner's basis in the property for depreciation purposes should be Ada's basis of $27,500 rather than the $218,025 ‘sale’ price used by petitioner. Having found that Ada made a contribution to capital rather than a sale, we agree with respondent. Secs. 114(a), 113(a)(8)(B), and (b), I.R.C. 1939.
SEC. 114. BASIS FOR DEPRECIATION AND DEPLETION.(a) BASIS FOR DEPRECIATION.— The basis upon which exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property shall be the adjusted basis provided in section 113(b) for the purpose of determing the gain upon the sale or other disposition of such property.SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.(a) BASIS (UNADJUSTED) OF PROPERTY.— The basis of property shall be the cost of such property; except that—(8) PROPERTY ACQUIRED BY ISSUANCE OF STOCK OR AS PAID-IN SURPLUS.— If the property was acquired after December 31, 1920, by a corporation—(B) as paid-in surplus or as a contribution to capital, then the basis shall be the same as it would be in the hands of the transferor * * *(b) ADJUSTED BASIS.— The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis determined under subsection(a), adjusted as hereinafter provided.
Decision will be entered under Rule 50.