Opinion
Docket No. 28000.
1951-06-29
D. G. HALEY AND ANNE M. HALEY, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Henry Ravenel, Esq., and Lawrence A. Baker, Esq., for the petitioners. Percy C. Young, Esq., for the respondent.
Henry Ravenel, Esq., and Lawrence A. Baker, Esq., for the petitioners. Percy C. Young, Esq., for the respondent.
1. DEDUCTION— OPERATING LOSSES— CASH BASIS— NO PAYMENTS.— A taxpayer using the cash receipts and disbursements basis has no right to deduct on his return an operating loss of a business, even though he managed that business, where an associate advanced all of the money lost in the unsuccessful operation of the business and the taxpayer gave his notes to his associate for one-half of the money advanced but never made any payment on the notes.
2. GAIN OR LOSS— EXCHANGE— PROPERTY FOR STOCK AND NOTES.— The incorporation of a business did not result in any gain to the petitioner who received stock of the corporation which was worthless and a note of the corporation which was worthless and a note of the corporation which he was required under the plan to endorse and deliver with his stock to another party to the transaction.
The Commissioner determined deficiencies in income tax against the petitioners as follows:
+----------------+ ¦1944¦$18,357.73 ¦ +----+-----------¦ ¦1945¦15,314.55 ¦ +----+-----------¦ ¦1946¦55,107.49 ¦ +----------------+
The issues for decision are:
(1) What parts, if any, of the operating losses of Terra Ceia Bay Farms for the fiscal years ended June 30, 1944 and 1945 and for the last six months of 1945 are deductible by the petitioner;
(2) Did the Commissioner err in holding that the petitioner realized a capital gain of $54,263 in connection with the incorporation in 1946 of the aforesaid business under the name of Terra Ceia Bay Farms, Inc.; and
(3) What is the amount of the deduction to which the petitioners are entitled representing depreciation for 1946 on a rented house.
FINDINGS OF FACT.
The petitioners are husband and wife. They filed joint returns for the taxable years with the collector of internal revenue for the district of Florida. Those returns were filed on the cash receipts and disbursements basis. The husband, referred to herein as the petitioner, has been engaged in the practice of law in Florida since 1912 and has also devoted a large part of his time since 1936 to the production and sale of gladioli spikes.
The petitioner agreed with William M. Greve, in March 1943 to endeavor to purchase lands and develop them for the production and sale of gladioli spikes. Lands were purchased and developed prior to October 1943. Title was taken in the name of River Farm and Nurseries, Inc., hereafter called River, a corporation owned by Greve. The petitioner did not supply any of the money for the purchase or development of the land.
River called ‘lessor‘ and the petitioner called ‘lessee‘ entered into a ‘Lease Agreement‘ on October 21, 1943, covering lands at Terra Ceia, Florida, for the period July 1, 1943, to June 30, 1948. The agreement is incorporated herein by this reference. The parties state that they do not intend to enter into a partnership relation or a joint venture. Neither party was to be liable for any debts or obligations incurred by the other. The petitioner was to grow gladioli on the lands during the period specified and to do all of the things incident thereto. He was to consult with and keep River advised of the operation of the property. The petitioner was to retain 25 per cent of the net income from the operation and was to pay the remaining 75 per cent to River. River was to have 75 per cent of all personal property acquired by the petitioner in connection with the operation of the property at the end of the period. The petitioner was not to expend any money in operating the property under the agreement ‘except when and to the extent either that moneys therefor are advanced to Lessee by Lessor, pursuant to an agreement of even date executed and delivered by Lessor and Lessee, or that moneys therefor are available to Lessee from the operation of the business on said premises.‘
The other agreement dated October 21, 1943, just referred to, was between the same parties but River was called ‘seller‘ and the petitioner was called ‘purchaser.‘ That agreement is incorporated herein by this reference. It records that the petitioner desired to acquire an undivided one-half interest in the property owned by River, River was to advance funds for the development and operation of the lands, and the petitioner was to repay to River one-half of the cost of the lands and one-half of the advances with interest. The property was the same property described in the other agreement of the same date. The stated cost of the lands was $30,264. River agreed to advance to the petitioner all funds necessary for the purchase of machinery and equipment required in the operation and for the payment of wages, but the total advances, including the cost of the land, would not exceed $175,000. No advances were to be required after December 31, 1944. All advances were to be against written requisitions made by the petitioner after he and River had agreed upon the necessity and advisability of the purchase of the items requisitioned. River was to make the advances against the delivery to River by the petitioner of his negotiable promissory notes for 50 per cent of the cost of the land. The notes were all to be payable on or before June 30, 1948, with interest at 4 per cent payable annually. The petitioner was not to receive any compensation for his services in operating the property. River agreed to apply in partial payment of the notes of the petitioner 50 per cent of the 75 per cent of the profits received by it from the operation of the properties. River was to give the petitioner a deed for a 50 per cent undivided interest in the real estate as a joint tenant when all of the petitioner's promissory notes had been paid. The parties stated that they did not intend to enter into a partnership or a joint venture but their sole purpose was to become joint tenants without rights of survivorship in the lands, each having a 50 per cent undivided interest in the whole. Neither party was to be liable for any debts incurred by the other.
The parties started to carry out the agreements. River advanced a total of $189,052.49. The last advance was made in February 1944. The petitioner delivered to River his promissory notes all due June 30, 1948, bearing interest at 4 per cent. The total principal amount of the notes was $94,526. The money advanced by River was used by the petitioner solely in the operation of the properties.
The petitioner, on one occasion, filed a suit in his own name ‘Doing business as Terra Ceia Bay Farms‘ against a supplier of bulbs, and on two occasions, after River had made its final advance, borrowed money for the purchase of additional bulbs. The loans were repaid with moneys derived from the operation of the properties. The petitioner was known to bulb suppliers and others, and made credit arrangements with them. All bills for purchases came to the petitioner in the name of Terra Ceia Bay Farms. The petitioner devoted about 50 per cent of his time to the management of the business conducted on the properties. Greve visited the properties once a year and discussed operations with the petitioner, but otherwise the only activity of the other contracting party was to send the required advances.
The petitioner maintained books of account for the operation on the basis of a fiscal year ending June 30 and he filed returns for the fiscal years ended June 30, 1944 and June 30, 1945, and for the last 6 months of 1945 on Form 1065, entitled ‘Partnership Return of Income.‘ The name of the taxpayer given on the returns was Terra Ceia Bay Farms.
The operations of the property resulted in losses as follows:
+---------------------------------------+ ¦Fiscal year 1944 ¦$57,139.24 ¦ +---------------------------+-----------¦ ¦Fiscal year 1945 ¦19,603.21 ¦ +---------------------------+-----------¦ ¦July 1 to December 31, 1945¦32,052.09 ¦ +---------------------------+-----------¦ ¦Total ¦$108,794.54¦ +---------------------------------------+
The operation of the properties would have shown net income of about $23,000 for the calendar year 1945 if the books had been kept on that basis.
The original return of Terra Ceia Bay Farms for 1944 showed that the loss of $57,139.24 was to be shared equally by River and the petitioner, and the petitioners on their original return for 1944 claimed that same amount as a loss in computing their income. An amended return was filed for Terra Ceia Bay Farms on Form 1065 showing that the entire loss was that of the petitioner. The petitioners filed an amended return for 1944 claiming the entire loss. The returns of Terra Ceia Bay Farms for the fiscal year 1945 and for the last 6 months of 1945 show the entire loss as that of the petitioner. The petitioners on their return for 1945 claimed those entire losses and on their return for 1946 claimed a net loss carry-over.
The Commissioner, in determining the deficiencies, restored the losses claimed on the 1944 and 1945 returns to income, with the explanation that they are not allowable, and disallowed an operating loss carry-over to 1946, with the explanation that no operating loss deduction is allowable.
The petitioner did not receive compensation of any kind for services performed by him through 1945 under the agreements above mentioned.
Greve decided in the latter part of 1945 that a corporation should be used to own and operate the properties and the petitioner made no objection to the change. Terra Ceia Bay Farms, Inc., hereafter called the corporation, an empty shell of an existing corporation, was used for the purpose.
The petitioner and River entered into an agreement dated November 6, 1945, which is incorporated herein by this reference. It provided that the notes of the petitioner in the amount of $94,526 held by River were to be cancelled; the corporation was to deliver its note for the same amount dated January 1, 1946, to the petitioner, and the petitioner was to endorse that note with recourse to River; the petitioner was also to pledge with River, as security for his endorsement, 25 shares of the stock of the corporation; the petitioner was to pay River the interest on his notes up to January 1, 1946; and the two agreements dated October 21, 1943, were to be cancelled.
The petitioner, River, and the corporation entered into an agreement dated November 14, 1945, which is incorporated herein by this reference. River and the petitioner agreed to transfer to the corporation as of the close of business on December 31, 1945, all of their interests in the lands formerly covered by the agreements of October 21, 1943, together with all of the personal property used in connection with the operation of those lands. The corporation agreed to issue its negotiable promissory notes dated January 1, 1946, due June 30, 1948, with interest at 4 per cent— one in the amount of $94,526.49 to River and the other in the amount of $94,526 to the petitioner. It also agreed to issue 25 shares of its stock to River and 25 to the petitioner, being all of its stock.
The agreement of November 1945 were carried out in accordance with their terms.
Anne M. Haley, a petitioner, and River entered into an agreement with the corporation dated November 14, 1945, which is incorporated herein by this reference, in which they agreed to transfer to the corporation as of the close of business on December 31, 1945, all of their interest in a property known as ‘Suburban Holdings,‘ for which the corporation was to issue to each its negotiable promissory note for $15,000 dated January 1, 1946, due June 30, 1948, with interest at 4 per cent.
The cost to Anne of her one-half interest in Suburban Holdings was $1,702.
The book value of the properties conveyed by River and Haley to the corporation at the close of business on December 31, 1945, was $80,107.46, consisting of $6,116.32 in cash, land at its cost of $35,148.36, wells at their cost of $2,950.18, a laboratory at its cost of $2,661.72, and equipment at its cost less depreciation. The properties were not appraised or valued at that time. The fair market value of those properties, plus the fair market value of the property obtained by the corporation from River and Anne M. Haley, was not in excess of $125,000.
The Commissioner, in determining the deficiency for 1946, held that the transfer of ‘interest in real and personal property of the unincorporated gladioli growing venture to Terra Ceia Bay Farms, Inc., is a taxable exchange resulting in taxable capital gain of $54,263.‘
The 25 shares of stock of the corporation received by the petitioner in 1946 had no fair market value at the time received. The petitioner realized no gain or profit from the transfer of his interest in the unincorporated gladioli growing venture to the corporation.
The note of the corporation in the amount of $15,000 received by Anne in 1946 had a fair market value at the time received of $10,000.
Anne M. Haley, a petitioner, was the owner of a cottage during 1946. It was rented on January 1, 1946, and she received and reported $255 as rent for the cottage for that year. The petitioners claimed on their return for that year a deduction of $450 representing depreciation on the cottage for 1946. The Commissioner, in determining the deficiency, disallowed the entire amount of the deduction. A reasonable allowance for depreciation on the cottage for 1946 is $255.
OPINION.
MURDOCK, Judge:
The petitioner claims that he is entitled, as sole proprietor of the business of Terra Ceia Bay Farms, to claim the entire amount of its losses in computing income on his joint returns and in carrying forward or carrying back the resulting net operating losses, and even if the operation is to be regarded as a joint venture, still he is entitled to use half of those losses for the same purposes. He does not contend that he was a partner with River in the business and their agreements expressly disavow any such relationship. The parties are agreed on the net results of the operation of the Terra Ceia Bay Farms business from July 1, 1943, through December 31, 1945. It is important to remember that the petitioners reported their income on the basis of cash receipts and disbursements, the petitioner put no cash or property into the business, the only money put into the venture was furnished by River, and the petitioner under no circumstances ever obligated to reimburse River for more than one-half of the money advanced. The losses used up a part of the money furnished by River. Thus, under no circumstances would be petitioner have the right to claim, in computing his income, more than the share which he stood to lose in the venture, that is, one-half. Furthermore, no theory advanced by the petitioner would justify the Court in allowing him to deduct any part of the operating losses of Terra Ceia Bay Farms in computing his income for the taxable years.
It is obvious that both River and the petitioner were involved in the operation of the business, regardless of what the operation is called. The operation was to continue until June 30, 1948. River advanced the money to buy the properties and to operate them. It was to share in the profits and it sustained all of the losses until such time as the petitioner made payments on its notes, although the agreements do not contain any express provisions in regard to losses. The petitioner was not to spend any money except that put up by River or that derived from the operation. The petitioner was to have a one-half interest in the land, equipment, and business at June 30, 1948, if the venture proved successful and if he paid off his notes to River. He gave his promissory notes in the amount of $94,526 to evidence the fact that he owed his associate, River, that much money under the agreements. However, he never put his potential share of the losses on a cash and closed basis by paying a part of the principal of those notes and at the end of 1945 they were cancelled. He had suffered no out-of-pocket losses in connection with the operation of the business up to that time. The transaction did not terminate at that point, however, although the original arrangement was changed. The business was then incorporated. The petitioner received at that time one-half of the stock of the corporation and a note of the corporation in the amount of $94,526. He immediately endorsed the note to River and pledged the stock with River as collateral for his endorsement of the note. Clearly, those events did not change his situation so that he suffered any loss. He never paid anything on the note of the corporation up to the time of the hearing. Indeed, the only money which ever came out of his pocket during the entire transaction was the interest on his own notes from the date of their issuance up to January 1, 1946, which amount is not here in dispute, probably because he claimed and was allowed deductions on his returns for the payment of that interest. A taxpayer, using the cash receipts and disbursements basis, has no right to deduct on his own return an operating loss of a business under such circumstances until he is actually out of pocket by making payments on the notes which he gave to his associate in the business to evidence his promise to reimburse that associate for one-half of the money advanced and lost in the unsuccessful operation of the business. Max Gross, 36 B.T.A. 759; Page v. Rhode Island Hospital Trust Co., 88 F.2d 192.
The Commissioner has held and contends that the petitioner realized a capital gain of $54,263 as a result of his transfer of his interest in the business to the corporation in exchange for one-half of the stock of the corporation and its note for $94,526. The record does not show how the Commissioner computed that gain, but his counsel states that it is one-half of a long term capital gain of $108,526. He does not explain how he computes the gain of $108,526. The evidence shows, however, that the petitioner realized no gain in that transaction. The corporation received all of the assets of the business having a book value at that time of about $80,000 and a fair market value of less than $100,000. It also received another property worth $30,000. It immediately issued its notes for over $219,000. There were no free assets at that time to give its stock any value. Furthermore, as one of the inseparable steps of the entire transaction, the petitioner was required to pledge his stock as collateral with River. The petitioner's note for $94,526 was held by River prior to the transaction and at the conclusion of the transaction River held the note of the corporation, endorsed by the petitioner, for the same amount of money secured by the pledge of the petitioner's stock. It thus appears that River let go of nothing by the transaction and the petitioner gained nothing. Incidentally, he never thereafter gained possession of the stock or the note. His liability as endorser on the note of the corporation was not sufficiently different from his former primary liability on his own note to give rise to any gain. The Commissioner erred in adding the $54,263 to the petitioner's income for 1946.
The petitioners, not knowing how the alleged gain of $54,263 was computed, pleaded and introduced evidence in connection with the transfer by Anne to the corporation of her one-half undivided interest in Suburban Holdings. Although the Commissioner contends that the entire gain of $108,526 was realized by the husband, nevertheless, he also claims that Anne realized a long term capital gain of $13,298 as a result of the sale of her property. There is no direct testimony as to the value of the note but no interest or principal has ever been paid on it. The petitioners argue that it could not have had a value in excess of the cash which the corporation had on January 1, 1946. The total notes which the corporation had outstanding on January 1, 1946, were almost double the value of its assets. There is some indication that the business began to improve in 1945, but there is no evidence to show what the situation was in 1946. The Court, on the basis of the meager evidence before it, has determined that the value of the note at the time it was received by Anne was $10,000. A long term capital gain of $8,298 results.
The petitioners claimed a deduction for depreciation on a cottage owned by Anne during 1946. She reported income of $255 from rent and claimed a deduction of $450 for depreciation on the cottage for 1946. The Commissioner disallowed the entire deduction. His action was obviously wrong because the property had some remaining basis and it was rented during the year. The petitioners are entitled to some deduction for depreciation. They were unable to prove the cost of the cottage or what its basis was at the beginning of 1946. They proved, however, that the basis was at least $4,500 and they do not claim a basis in excess of $7,500. Here again the Court is required to make some kind of a decision and has concluded that a reasonable allowance for depreciation for 1946 is $255. Cf. Cohan v. Commissioner, 39 F.2d 540.
The Commissioner has conceded a number of other adjustments which will be made under Rule 50.
Decision will be entered under Rule 50.