Summary
In Standard Envelope Mfg. Co. v. Commissioner, 15 T.C. at 48, we held that a leasehold interest with a term of 1 year and an option to renew for a term of 24 years was not equivalent to a fee interest, and we have held that options to renew are included in determining whether a leasehold interest is equivalent to a fee interest.
Summary of this case from VIP's Indus. Inc. v. Comm'rOpinion
Docket No. 22112.
1950-07-31
THE STANDARD ENVELOPE MANUFACTURING COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
William A. Polster, Esq., and David A. Gaskill, Esq., for the petitioner. C. E. Price, Esq., for the respondent.
Where petitioner made an irrevocable conveyance of property which it owned, to an independent purchaser in a bona fide arm's length sale, and as part of the sales agreement retained the right to lease back the property for a 25-year term upon the payment of a reasonable rent, held, petitioner is entitled, under section 23(f), to deduct as a loss the excess of the basis of the property sold over the amount realized from the sale. William A. Polster, Esq., and David A. Gaskill, Esq., for the petitioner. C. E. Price, Esq., for the respondent.
The respondent has determined that there is deficiency in excess profits tax for 1944 in the amount of $99,135.77. The determination results from disallowance of four items deducted by the petitioner. Two of the adjustments are not contested by the petitioner. The items remaining in dispute are disallowance of an alleged loss of $120,065.47 upon the sale of real property, and of expenses of $2,852 incident to the sale, or a total of $122,917.47. The petitioner now contends that the total amount of its claimed deduction is only $122,378.84.
Petitioner filed its corporation income and excess profits tax returns for 1944 with the collector for the eighteenth district of Ohio.
The record consists of a stipulation of certain facts, testimony, and various exhibits.
FINDINGS OF FACT.
The facts stipulated are found as stipulated, and are incorporated herein by this reference.
The petitioner is a corporation organized under the laws of Ohio. For the year 1944, it kept its books and made its returns on the accrual basis of accounting. The business of the petitioner is, primarily, the manufacture and sale of paper enveloped. At the beginning of 1944, petitioner occupied, as its offices and manufacturing plant, the land and two buildings thereon located at the northwest corner of Payne Avenue and East 30th Street in Cleveland, Ohio. The area of the land is 70,607 square feet, with a frontage of 177.5 feet on the north side of Payne Avenue, and 451 feet on the west side of East 30th Street.
The petitioner occupied the land under a lease from The Cleveland Trust Company, which was executed on June 1, 1922, for a term of 99 years, renewable at petitioner's option for a further term of 99 years, and renewable for like periods subject to the same terms, in perpetuity. Under the lease petitioner was obligated, in 1944, to pay annual ground rent of $7,500, for the balance of the lease, plus all taxes, assessments, and insurance.
Under the lease, petitioner had an option, exercisable for a period of ten years from June 1, 1937, to purchase the land for $125,000. The sum of $125,000 was arrived at by capitalizing the annual ground rent of $7,500 at six per cent. The lease was not otherwise cancellable by either party.
Under the lease, petitioner was required to construct a building, at its own expense, on the leased land. Petitioner carried out this requirement and occupied the building which it caused to be built. In 1922 petitioner completed the first portion of the building, and in 1929 an addition to the building was constructed. The two buildings were one story in height and formed a single unit having a floor area of approximately 46,000 square feet. The buildings were in good repair and modern in all respects in December 1944. They had been constructed to meet petitioner's specific needs. Also, they were built so that additional facilities could be added if needed.
The original cost of the buildings and of improvements was approximately $145,000. They had an adjusted basis as of December 28, 1944, of $64,526.84.
In computing the loss, which was taken on the return, from the sale of the property in question, the petitioner considered the adjusted basis of the buildings to be $65,665.47. Petitioner now concedes error in this respect, and has stipulated that the adjusted basis is $64,526.84. Therefore, the total amount of the claimed deduction in this proceeding is $122,378.84.
At some time in 1944, the petitioner found that the buildings which it occupied on the leased premises on Payne Avenue and East 30th Street had become too small for its increased business production and operations. Consideration was given to building an addition onto the buildings, and estimates showed that the cost would be about $100,000. Consideration was given, also, to the alternative of moving the business to a larger plant in a more desirable location. With respect to the alternative solution, the petitioner was advised by real estate brokers and its counsel that, if it could and decided to move its plant, it might have difficulties in disposing of the existing buildings which it occupied and of its interest in The Cleveland Trust Company lease because of the terms of the lease relating to the ground rent and the amount of the option price. Petitioner was advised that the leasehold ground rental was too high, if not excessive.
Petitioner proceeded to look about for a new plant and in August 1944 engaged L. E. Lang of Cragin, Lang & Co., real estate brokers, to look for a new location which would provide from seventy to eighty thousand square feet of floor pace in a one story building constructed to sustain substantial floor loads and have additional land area about the building and railroad facilities. Lang was unable to find a location which satisfied all of the requirements, but he advised petitioner that space might become available after the war was ended. Lang continued, unsuccessfully, the search for a new plant location until June 1945.
Petitioner had been dissatisfied with the terms of The Cleveland Trust Company lease for several years. On three occasions, between September 1940 and November 1943, petitioner had carried on extensive negotiations with the Trust Company to obtain reduction of the ground rent and in the latter part of 1943, had attempted to secure some reduction in the amount of the option purchase price of the land. All of these efforts to obtain some modification of the terms of the lease were unsuccessful. Petitioner considered the lease to be burdensome and unsatisfactory because it believed that the amount of the leasehold rent was too high, and, furthermore, the leasehold term was very long, ending in the year 2021. Petitioner did not want to make the expenditures for additions to the buildings under the terms of a burdensome lease. Its only alternative to continuing to pay the required rent was to purchase the land. The option to purchase would expire in June 1947. Petitioner, in 1944, when it was unable to locate another plant, turned its considerations to the matter of exercising the option to purchase the property.
Petitioner was advised by its counsel and an independent tax consultant that if it exercised the option to purchase the land and resold the property, and a loss was sustained, the loss would probably be deductible as a business loss.
On October 16, 1944, petitioner gave written notice to The Cleveland Trust Company that it elected to exercise its option to purchase the property. On December 16, 1944, petitioner delivered a certified check for $125,000 in full payment of the purchase price, and on December 18, 1944, the Trust Company delivered a deed to the petitioner conveying the fee simple title to the land free and clear of the lease.
Petitioner's election to exercise its option to purchase the land was primarily to obtain relief and release from a burdensome lease. Shortly after purchasing the property, the petitioner asked R. T. Cragin of Cragin, Lang & Co. to prepare an appraisal of the price for which the property which the petitioner then owned could be sold. Cragin advised the petitioner that the land and buildings thereon could be sold for about $60,000. Petitioner also obtained an appraisal from W. E. Malm, real estate broker and appraiser, who appraised the entire property, as of November 1, 1944, at $68,000.
Petitioner authorized Cragin, Lang & Co. to offer the property, land and buildings, for $75,000, with the condition that the petitioner be allowed to remain in occupancy of the premises until it could move to another location. Cragin, Lang & Co. discussed the offer of sale with twenty or twenty-five persons who were interested in making investments in real estate. They offered the property for $75,000 but with the provision that the buyer would lease the property to the petitioner for a term of 3 years, with the right in the petitioner to cancel the lease within that period if it located a suitable place to which it would move.
One of the persons approached by Cragin, Lang & Co. was Edward J. Meisel, who was known to be interested in real estate investments. Meisel had formerly owned a business which had been one of petitioner's customers and was acquainted with several of the officers of petitioner. He was not related to petitioner or any of its officers, directors, or stockholders. Meisel was interested in the property but did not feel that it was worth $75,000. He was also dissatisfied with the proposed terms of the proposed lease to the petitioner and believed that if he purchased the property, he could secure a tenant who would be willing to execute a lease for a longer term.
On December 23, 1944, after extended negotiations with Meisel, which resulted in changes in the proposition initially made, petitioner entered into an agreement with Meisel to sell to him for a cash consideration of $70,000 petitioner's then existing plant, including both the land and the buildings, and Meisel agreed to allow petitioner to continue in occupancy as a tenant at an annual rent of $6,000, plus all expenses, repairs, heat, utilities, insurance and taxes for a period of one year, with an option, exercisable on or before July 1, 1945, to enter into a lease for a term of 24 years beginning on January 1, 1946.
On December 28, 1944, Meisel paid petitioner $70,000, and petitioner gave him a deed irrevocably conveying to him title to the land and the buildings situated thereon. Petitioner incurred expenses of $2,852 for broker's fees, appraisal fees, and title search in connection with the sale. Petitioner realized a net amount of $67,148 from the sale of the property.
After December 28, 1944, petitioner actively tried to secure other and more suitable quarters. As stated heretofore, Lang continued to look for a new location until June of 1945. When it became evident that a new location which would meet petitioner's requirements could not be found, petitioner, on June 27, 1945, exercised its option to lease the premises it then occupied from Meisel, and Meisel executed a lease of the premises to petitioner for 24 years at an annual rental of $6,000. The lease provided that petitioner, the lessee, would pay, in addition, for heat, utilities, insurance, repairs, and taxes. The annual rent called for by the lease was a reasonable rental for the property which petitioner leased from Meisel. The petitioner had no right or option under the lease to renew the lease upon the expiration of the 24 year term or to repurchase the land or buildings at any time, and there was no other agreement or understanding with Meisel which granted to the petitioner any such right or option. The lease provided further for the financing of any improvements of or additions to the existing buildings, as follows:
If the lessee, at any time during the first ten years of the lease required additional facilities and space, it was agreed that the parties to the lease should pay the costs up to but not exceeding $100,000, of which the lessee agreed to pay 50 per cent of the cost and the lessor agreed to pay 50 per cent of the cost. Also, upon the making of such improvements, the lessee agreed to pay, as additional rent, computed on an annual basis, but payable in advance monthly, 8 1/2 per cent of the lessor's share of the cost of the improvements.
Since the execution of the lease on June 27, 1945, additions to the existing buildings have been made at a total cost of $119,000, of which Meisel paid $50,000, and petitioner's annual rent has been increased $4,250 per year, on the basis of the agreed rate of 8 1/2 per cent of the sum advanced by the lessor.
Petitioner exercises no control over Meisel and his transactions, and Meisel is not related in any way to the petitioner but is an independent investor. Petitioner's sale of its land and buildings to Meisel on December 28, 1944, was an arm's length, bona fide sale and resulted in an irrevocable conveyance of the property to Meisel.
The petitioner deducted in its 1944 return $120,065.47, as a loss from the sale of real estate, and $2,852, expenses of the sale. The respondent disallowed both deductions, giving the following explanations for his determinations:
(c) Under Item 12(b) of your income tax return, Form 1120, for the year ended December 31, 1944, you claimed a deduction of $120,110.88, representing the net loss from sale or exchange of property other than capital assets. Included in said deduction is an alleged loss of $120,065.47 from the sale of land and buildings to Edward J. Meisel. It is held that the loss of $120,065.47, as claimed, is not an allowable deduction under the provisions of Section 23(f), or any other section of the Internal Revenue Code.
(d) The following-named selling expenses totaling $2,852.00 incurred in the sale of real estate and claimed as deductions in your income tax return have been disallowed since they are applicable to the selling price:
Petitioner incurred expenses in connection with the sale of the land and buildings during 1944 of $2,852 for broker's fees, title search, and appraisal.
Petitioner's sale of the land and buildings to Meisel in 1944 was a bona fide arm's length transaction. Petitioner, in good faith, believed that the price for which it sold the land and buildings represented the fair market price of the property.
OPINION.
HARRON, Judge:
The principal issue in this proceeding is whether petitioner is entitled, under section 23(f), to deduct from income a loss allegedly suffered by it from the sale of land and buildings which were used in its trade or business. Respondent has also disallowed certain expenses incurred by petitioner incident to the sale. The deductibility of these expenses from the gross sales price is admitted by both parties to be dependent upon the decision of the primary issue. It is respondent's position that the sale of the property was not a bona fide arm's length transaction, but, instead, that it was a ‘pure sham‘ conceived solely for the purpose of effecting a tax saving. Examination of the evidence in this proceeding, however, fails to sustain respondent's contention.
Petitioner also argues, in the alternative, that it is entitled to a part of the deduction in question as an ordinary and necessary business expense under section 23(a)(1)(A) by reason of the purchase of the land from The Cleveland Trust Company which it alleges was made in order to relieve itself of a burdensome lease, and that it is entitled to the balance of the deduction as a loss from the sale of property used in its trade or business other than a capital asset. In view of our decision upholding petitioner's principal argument it is not necessary to decide the alternative contention.
Much of the record in this proceeding is made up of expert testimony as to the fair market value as of the date of sale of the land and buildings sold by petitioner. But, it is not necessary to our decision to determine the fair market value of the property. As respondent says in his brief, the valuation of the land and buildings is important only to the extent that a showing of the fair market value may reveal the unreality of the sale. We are convinced, from an examination of all the evidence, however, that petitioner in good faith believed that the price at which it sold the land and buildings represented a fair valuation of the property. But the reason for the calling of the expert witnesses should be pointed out. Petitioner sought expert advice prior to entering into the transaction and desired to present to the Court testimony of the two independent real estate brokers and appraisers which it had consulted prior to selling the property. The first of these, William E. Malm, appraised the fair market value of the land and buildings to be $68,000, based on the income potentialities which a study of the rental values of comparable properties indicated joint use of the land and the improvements thereon might be expected to produce. The other appraiser, Raymond T. Cragin, informed petitioner that the estimated fair market value of the property as of the time of sale was $60,000, based on a study of the selling price of comparable properties in Cleveland. Respondent called expert witnesses to demonstrate his theory that the sale to Meisel was not a bona fide arm's length transaction, to rebut, if not impeach, the expert witnesses whom petitioner relied upon prior to the transaction and who testified in the proceeding.
Careful consideration has been given to the opinions expressed by all the expert witnesses and the factors which each took into consideration. The testimony of the chief expert witness called by respondent, who appraised the fair market value of the property to be $132,750, was impressive, and much consideration has been given to it. We think, however, that there is a reason for the discrepancy between the testimony of petitioner's experts and respondent's experts as to the estimated fair market value of the property. The different experts did not consider the same comparable properties and transactions in arriving at fair rental and sales value. We believe that the sounder choice of comparable properties was made by petitioner's experts. Petitioner's witnesses also used as their basis for comparison properties with which, for the most part, they had actually dealt. On the other hand, respondent's experts, for the most part, had no personal acquaintance with the properties upon which they relied; they used as a basis for comparison transactions which they secured from examination of courthouse records, rather than properties with which they had actually dealt.
However, we are not called upon and to not make a finding of fact as to the fair market value of the subject property on the date of sale. The issue in this proceeding is limited to whether petitioner sustained a loss upon the resale of the land and buildings to Meisel. Respondent determined that there was no loss and attacked the whole transaction as a sham. But after careful consideration of the testimony of all the witnesses and of the facts before us and in particular the terms of the sale and lease-back with Meisel, we conclude that the sale was a bona fide business transaction. There is no evidence that any relationship or agreement between petitioner and Meisel existed, other than that of buyer and seller. Meisel had no connection with petitioner. The transaction was entered into at arm's length and resulted in the absolute transfer of the fee in the property to Meisel. He was secured as a purchaser by the independent real estate brokers who had been hired by petitioner to effect a sale of the property, and the sale was made only after extensive negotiations between Meisel and petitioner.
Although we think it necessary to regard the sale to Meisel and the lease-back as one interrelated transaction, it is only reasonable to believe that the provisions of the lease which provided for the investment by the purchaser of the property of up to $50,000 in improving the property was an important factor in arriving at the consideration to be paid by the purchaser. The lease-back provisions of the sales agreement provided also for retention of possession by petitioner for one year at a rental of $500 per month. And petitioner was granted the right, exercisable within six months, to lease the premises for a term of 24 years at an annual rental of $6,000, plus certain expenses. But there was neither a repurchase option nor a renewal option present in the agreement. The lease was for a term of less than 30 years, and, therefore, was not the equivalent of a fee under the terms of section 29.112(b)(1)-1 of Regulations 111. It cannot be said that petitioner retained substantially all the rights it had in the property before the transaction was consummated. Any loss which it suffered in the sale of the land and buildings, therefore, is deductible from its income.
Respondent, however, contends that petitioner suffered no actual loss from the sale of the property. In support of this argument, respondent cites Shoenberg v. Commissioner, 77 Fed.(2d) 446, affirming 30 B.T.A. 659, and Chicago Title & Trust Company, Executor, 32 B.T.A. 249. Both of those cases, however, involved transactions between the taxpayer and corporations dominated by the taxpayer or her husband, in which securities were sold at a loss and then substantially similar securities were purchased from one of the dominated corporations. In those cases the claimed loss was disallowed on the ground that there had been no change in the taxpayer's position, that he was no poorer after the transactions than before. But those cases are not analogous to the instant proceeding. Petitioner had no control over Meisel, and petitioner materially changed its position as a result of the transaction. Before the sale, it was the owner in fee simple of the land and the buildings. After the sale, Meisel was the owner of the property, and petitioner was entitled merely to temporary possession of the property for one year, with the option to lease the premises for a 24-year term, in exchange for a rental of $500 per month plus certain expenses.
Respondent stresses the fact that petitioner's cash position is benefited by the sale if a deduction for the claimed loss is allowed because a reduction of its tax liability serves to conserve its cash. This argument has been considered. Petitioner, admittedly, considered the tax consequences of the transaction. However, a taxpayer may give consideration to the tax consequences of transactions. See United States v. Cumberland Public Service Co., 338 U.S. 451, and Commissioner v. Hale, 67 Fed.(2d) 561. It has been found as a fact that the sale was a bona fide one, consummated at arm's length. In addition, petitioner has shown that it had other business purposes in making the sale. It was desirous of expanding its physical facilities, either by moving to a larger plant, or, if no suitable property could be found, by building an addition to the plant which it was occupying. As part of the sale agreement, the purchaser agreed that if petitioner decided to exercise its option to lease the property it would pay one-half the cost of any additions made by petitioner up to an expenditure of $50,000 by it. If such improvements were made, petitioner agreed to pay as additional rent a sum equal to 8 1/2 per cent of the cost borne by the lessor. Petitioner actively tried to secure other and more suitable quarters after the sale. When this search proved unsuccessful, petitioner exercised its option to lease back the property which it had sold, at an annual net rental of $6,000 plus certain expenses, for 24 years.
The petitioner has proved, in our opinion, that the rental agreed upon was a fair rental for the property.
It is held that petitioner is entitled to deduct from income the difference between the amount which it realized on the sale and the basis of the property sold. Also, petitioner is entitled to deduct $2,852, the expenses of the sale, from the gross selling price in computing the net amount realized from the sale.
Decision will be entered under Rule 50.