Douglas Hotel Co. v. Commissioner

Douglas Hotel Company, a Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent Douglas Hotel Co. v. Commissioner Docket Nos. 4252, 20242 United States Tax Court 14 T.C. 1136; 1950 U.S. Tax Ct. LEXIS 174; June 13, 1950, Promulgated *174 Decisions will be entered under Rule 50. 1. Equity Invested Capital -- Donated Property. -- Value of real estate deeded to a corporation as a gift by a citizen of Omaha, Nebraska, as a site for a first-class hotel development in that city held includible in donee corporation's equity invested capital at fair market value thereof at the time acquired. Brown Shoe Co. v. Commissioner, 339 U.S. 583. 2. Equity Invested Capital -- Distribution of Depreciation Reserves. -- Distribution to sole stockholder of cash depreciation reserves set up in prior years against hotel properties held "not out of accumulated earnings and profits" within the meaning of section 718 (b) (1), I. R. C. Equity invested capital reduced by such distributions. 3. Excess Profits Taxes -- Exempt Corporations. -- A corporation having no income from sources outside the United Statesheld not entitled to exemption from excess profits taxes under section 727 (g), I. R. C. William J. Hotz, Esq., for the petitioner. Frank M. Cavanaugh, Esq., for the respondent. LeMire, Judge. LeMIRE *1136 The respondent has determined deficiencies in petitioner's excess profits taxes for 1942 and 1943 in the amounts of $ 4,895.44 and $ 11,777.33, respectively. Separate proceedings were brought for each year and by agreement of the parties the proceedings were consolidated for hearing. The issues involved in these proceedings are as follows (1) whether in determining petitioner's equity invested capital there should be included the value of land donated to petitioner for a hotel site in the city of Omaha, Nebraska, by a resident of that city; (2) if so, the*176 value of the real estate at the time of its acquisition by petitioner; (3) whether invested capital should be reduced by the amount of $ 448,438.67 representing depreciation reserves accumulated in prior years and withdrawn by sole stockholder in 1924 and subsequent years; and (4) whether petitioner is exempt from excess profits taxes under section 727 (g), Internal Revenue Code. The respondent in his deficiency notices included the land referred to in issue 1 above in invested capital at a valuation of $ 125,000. By an amendment to his answer in each proceeding the respondent pleads affirmatively that this was error and that the land is not includible in invested capital at any valuation. FINDINGS OF FACT. Petitioner is a corporation, with its principal office at Omaha, Nebraska. Its returns for 1942 and 1943 were filed with the collector of internal revenue for the district of Nebraska. *1137 Petitioner was organized in 1913 by a group of Omaha businessmen for the purpose of promoting and building a first-class hotel in that city. This movement was started somewhat as a civic enterprise in 1912. A prominent businessman and real estate owner of Omaha, Arthur D. Brandeis, *177 offered to donate the building site for a hotel in the heart of the business district of Omaha, provided other citizens would subscribe for sufficient stock to put the plan in operation. Committees were formed and much of the promotional work was done before 1913. Petitioner was incorporated January 2, 1913. Brandeis conveyed the building site to petitioner by deed dated January 6, 1913. It consisted of two lots described as lots 7 and 8, block 109, located on the northwestern corner of Eighteenth and Douglas Streets. The Omaha newspapers gave considerable prominence to the venture as a civic enterprise and commented upon Brandeis' public-spirited donation of the land for the hotel building. Petitioner was capitalized at $ 1,000,000, divided into 10,000 shares of a par value of $ 100 each. There were 5,000 shares of common and 5,000 shares of 6 per cent cumulative preferred stock which had equal voting rights with the common. Article IV of the articles of incorporation provided as follows: The amount of the capital stock authorized is One Million Dollars ($ 1,000,000.00), divided into ten thousand shares of One Hundred Dollars each. Five Hundred Thousand Dollars thereof shall*178 be preferred stock, and Five Hundred Thousand Dollars common stock. Three Hundred Thousand Dollars or more of the preferred stock shall be subscribed, before the contract is let for the construction of the hotel. The capital stock may be paid for with money, or property necessary for corporate use, and when issued it shall be deemed and held to be fully paid up and non-assessable. The holders of preferred and common stock shall have equal rights to vote their stock at all stockholders' meetings, each share being entitled to one vote. Dividends shall be declared and paid on the preferred stock at the rate of six per cent per annum, payable semi-annually, January first and July first, and all expenses of maintenance, interest, insurance, taxes and other charges against the property shall be paid, before dividends are declared or paid on the common stock. The dividends on the preferred stock are to be cumulative, and should there be a deficiency at any time it shall be paid out of the income and profits of the succeeding year or years prior, to the declaration of dividends on the common stock. The preferred stock is to be preferred, not only as to dividends, but also in the distribution*179 of the assets and property of the corporation. Two Hundred Thousand Dollars of the common stock shall be issued to represent the value of the hotel site donated to the corporation, and it shall be distributed and donated with the Four Hundred Thousand Dollars of the preferred stock first subscribed, one share of common stock being given with two shares of preferred stock. The remaining Three Hundred Thousand Dollars of the common stock, or any part thereof, shall be issued at such times and under such terms and conditions as the board of directors may prescribe. The first meeting of petitioner's stockholders was held January 2, 1913. Prior to that date $ 300,000 of its preferred stock had been subscribed and under its articles of incorporation petitioner was then qualified to let the contract for construction of the hotel. *1138 Arthur D. Brandeis was elected a vice president of petitioner and a director at the stockholders' meeting on January 2, 1913, although he was not present at that meeting. He was reelected an officer and director at several successive meetings during his lifetime. He died June 10, 1916. Listed among the assets of his estate were 300 shares of the*180 preferred stock of the petitioner, together with 150 shares of its common stock. Petitioner's ledger shows that J. L. Brandeis & Sons, a corporation, subscribed for 50 shares of petitioner's stock in January, 1913, and 250 additional shares in December of that year, for which it paid par value of $ 100 per share in cash. On March 29, 1917, certificates for those shares were endorsed by J. L. Brandeis & Sons to the trustees of the estate of Arthur D. Brandeis, then deceased, and on the same date new certificates representing those shares were issued in the names of the trustees of the estate. Arthur D. Brandeis is shown to have owned 1,332 1/3 shares of the capital stock of J. L. Brandeis & Sons (the total amount of that company's outstanding stock is not shown) and to have had a credit with the company of $ 266,254.74 at the time of his death. His total estate was inventoried at a value of $ 1,460,430.64. Petitioner did not acquire the above described real estate from Brandeis in exchange for shares of its common stock. It acquired it as a donation. The deed conveying lots 7 and 8 to petitioner was delivered to petitioner and recorded March 11, 1913. A contract was let by petitioner*181 for construction of the hotel building during January, 1913. In April, 1913, Brandeis deeded to petitioner on the same basis as lots 7 and 8 an adjoining 22-foot strip of land, a part of lot 6, block 109. Petitioner assumed an outstanding mortgage on that property in the amount of $ 15,000, which it later paid. Petitioner issued $ 46,275 of common stock against this additional tract on the same basis as the $ 200,000 of common shares issued against lots 7 and 8. All of the stock ever issued by petitioner was issued in 1913 during its formative period. This consisted altogether of $ 494,550 par value of preferred, which was issued for cash, and $ 246,275 par value of common issued therewith. Lots 7 and 8, as well as lots 5 and 6, were purchased by Brandeis in November, 1912, for a total consideration of $ 160,000. In acquiring this property Brandeis represented to the sellers that it was to be used as a site for a new first-class hotel and that he was making a gift of the land for that purpose. The fair market value of lots 7 and 8 at the time of their acquisition by the petitioner was not in excess of $ 125,000. The hotel was given the name Hotel Fontenelle. It was completed*182 and opened for business February 27, 1915. It was leased beginning *1139 March 1, 1915, to the Interstate Hotel Co. at an annual rental of $ 70,200. It has been operated continuously by that lessee up to the present time. The cost of constructing the hotel building was $ 928,636.38. The land has been carried in petitioner's books at all times at a total figure of $ 262,661.08. That amount consists of $ 246,275 against which the common stock was issued, plus the $ 15,000 mortgage assumed in the acquisition of a part of lot 5, plus $ 1,386.08 of special improvement taxes thereon which petitioner paid. The petitioner obtained a mortgage loan of $ 400,000 from Metropolitan Life Insurance Co. January 6, 1915. The petitioner itself has never operated the hotel as an active business. Its income from the hotel property has consisted at all times of the rentals which it received from its lessee. Each year after payment of principal and interest on its mortgage indebtedness and other incidental expenses it distributed its remaining income to the stockholders. It paid regular dividends for the period 1915 to 1948, inclusive, in the total amount of $ 620,565.23. Petitioner's mortgage*183 indebtedness had been reduced to $ 235,397 in 1942 and $ 224,794.52 in 1943. In its income tax return for 1916 petitioner reported paid-up preferred stock of $ 494,150 and no paid-up common stock. All of petitioner's outstanding capital stock was purchased by Rome Miller, now deceased, in December, 1923, for $ 1,100,000. At that time the mortgage on the property with Metropolitan Life Insurance Co. was $ 350,000. The property was leased under an agreement entered into on January 2, 1924, for a period of 30 years at an annual rental of $ 80,000. After his acquisition of petitioner's stock in 1924, Miller withdrew each year all of petitioner's income after payment of mortgage principal and interest and current expenses and also withdrew the idle depreciation reserves. These withdrawals included large amounts in addition to the regularly declared dividends. A ledger account in the name of Rome Miller was set up in petitioner's books in 1924, in which all of these withdrawals were entered, and which was intended to reflect both his capital withdrawals and depreciation reserves. This account was continued after Miller had transferred a large portion of petitioner's stock to his children*184 in 1932. It was determined by this Court in Douglas Hotel Co., Docket Nos. 83750 and 94251 (memorandum opinion, May 13, 1939), that Douglas Hotel Co. did not constructively receive interest on the Rome Miller account during the taxable years 1931 to 1934, inclusive. We found in that proceeding that Miller had withdrawn the funds in question as his own by reason of his ownership of all of the petitioner's stock and without any agreement to pay interest to petitioner, or any intention *1140 of repaying the funds. We did not determine, however, because it was not necessary for us to do so, whether the withdrawals by Miller were of capital, as the petitioner then contended, or withdrawals of corporate earnings, as the Commissioner was contending. OPINION. Our first question is whether the land which Brandeis deeded to petitioner as a site for the hotel is includible in petitioner's invested capital. This question is controlled by the recent decision of the United States Supreme Court in Brown Shoe Co. v. Commissioner, 339 U.S. 583. It was there held that property donated to a corporation by nonstockholders was includible in equity invested*185 capital as a contribution to capital. On authority of that case we hold that the land deeded to petitioner by Brandeis for the hotel site in 1913 is includible in petitioner's equity invested capital as a contribution to capital under section 718 (a) (2), Internal Revenue Code. Under section 718 (a) (2), Internal Revenue Code, property acquired by a corporation as a contribution to capital is to be included in equity invested capital "in an amount equal to its basis (unadjusted) for determining loss upon sale or exchange." Under section 113 (a), Internal Revenue Code, the basis for determining gain or loss is cost, with certain exceptions, among which is that if the property was acquired by gift on or before December 31, 1920, the basis for gain or loss shall be the fair market value of such property at the time of acquisition. The Commissioner's excess profits tax regulations (Regulations 112, sec. 35.718-1) provide that if the property was acquired prior to January 1, 1921, as paid-in surplus or as a contribution to capital, then "the basis is the fair market value of the property at the time it was paid in." The respondent contends that the value at which the property is to be*186 included, if at all, is not more than $ 125,000, the value which he determined for it in his notice of deficiency, while petitioner contends that it is not less than $ 246,275. The value contended for by petitioner is the amount at which the property was set up in its opening books. This book value represented the par value of the shares of common stock which petitioner claims it issued for the property. Petitioner's theory is that it acquired the property in exchange for its common stock, which at all times has had a value of par or greater. The petitioner and the respondent seem to be in agreement that the property in question is to be included in petitioner's invested capital, if at all, at its fair market value when acquired by the petitioner. They disagree, however, as to when petitioner acquired the property. Petitioner contends that the date of acquisition was March 11, 1913, *1141 when the deed was delivered to it and recorded, while respondent claims that it was about January 6, 1913, the date the deed was executed. We do not deem it necessary here to decide that question. The evidence is that the value of the property was about the same in March that it was in*187 January and that there was no increase in value over that period, except as may have resulted from petitioner's intended use of it. We think that the best evidence before us as to the value of the property in either January or March, 1913, is the price which Brandeis paid for it in an arm's length transaction in November, 1912. He paid $ 160,000 for the whole southern half of block 109, including lots 5 and 6, comprising the southwest corner of the block, and lots 7 and 8, comprising the southeast corner. The real estate agent who handled the transaction testified in this proceeding that the price of $ 160,000 represented the fair market value of the land at that time and that there was no appreciable change in its value up to the time petitioner acquired it, aside from its usage in connection with the proposed hotel. In the absence of any evidence to the contrary, we may assume that lots 7 and 8 had about the same value as lots 5 and 6. Petitioner argues that the value which we must determine is the value of the land after the transfer and as a site for the hotel, taking into consideration the rental income to be derived from the lease of the entire property to Interstate Hotel*188 Co. This lease had been entered into prior to March 11, 1913. The fair market value at a given date is what the property would bring in a free and open sale. The prospective return from the usage of the property by the petitioner might have a bearing on the market value of petitioner's stock, but that question is not before us here. We have found above that the property was not acquired in exchange for stock, but was a donation and contribution to capital. Therefore, the value of the stock, whatever that may have been, is no measure of the value of the property. We do not think that the petitioner's use of the property and the expected income from the lease are factors to be taken into consideration in determining its value at the time petitioner acquired it. We think, and have so found above, that the value of the property at the time of its acquisition by petitioner was not in excess of $ 125,000, the amount at which the respondent included it in petitioner's invested capital in his notice of deficiency. The next issue relates to respondent's reduction of petitioner's invested capital by the amount of $ 448,438.67, representing the cash withdrawals made by petitioner's president*189 and sole stockholder after he acquired all of petitioner's stock in 1924. Respondent determined that these withdrawals were "not out of accumulated earnings and profits" within the meaning of section 718 (b) (1), Internal Revenue *1142 Code, and that they therefore reduced petitioner's equity invested capital, as defined in section 718 (a). Both parties base their arguments on this question on the assumption that all of the withdrawals in dispute were taken from a cash depreciation reserve which petitioner had established in prior years. In its 1942 excess profits tax return the petitioner voluntarily reduced its invested capital by the amount of $ 448,438.67, said to represent withdrawals from capital. Petitioner now claims, however, and has so alleged in its petition, that this was error and that the item should be restored to invested capital. Depreciation or depletion reserves are generally regarded as partaking of the nature of capital, since they represent a portion of the cost of the assets used in the business. Therefore, distributions from such reserves have been held to constitute distributions of capital rather than of income. See Creamette Co., 37 B. T. A. 216;*190 Ida I. McKinney, 32 B. T. A. 450; affd., 87 Fed. (2d) 811; John K. Beretta, 1 T. C. 86; affd., 141 Fed. (2d) 452; certiorari denied, 323 U.S. 720. In the last named case we said that: It is true, of course, that a distribution by a corporation to its stockholders of its depreciation reserve is not a taxable dividend and would be applied to a reduction in the cost basis of the stock. This is true because a depreciation reserve represents a return of capital. However, it must be borne in mind that under section 115 (b), supra, for the purposes of taxation effect, a corporation can not distribute to its stockholders its depreciation reserve as long as it has earnings and profits accumulated after February 28, 1913, sufficient to cover the distribution in question. We conclude from the evidence before us that petitioner had no earnings and profits accumulated after February 28, 1913, out of which the distributions in question could have been made. It is shown that petitioner regularly distributed all of its earnings and profits by way of*191 dividends. For all that the evidence shows, the depreciation reserves were properly claimed and allowed as deductions against petitioner's income of prior years and represented the actual exhaustion of petitioner's capital assets. There was never any claim by petitioner that the reserves were excessive or that any portion of them should have been restored to income either in the years when set up or in the years when distributed. See Peabody Coal Co., 18 B. T. A. 1081; affd., 55 Fed. (2d) 7; G. M. Standifer Construction Corporation, 30 B. T. A. 184; Creamette Co., supra. Section 29.115-6 of Regulations 111 provides in part as follows: Sec. 29.115-6. Distributions From Depletion or Depreciation Reserves. -- A reserve set up out of gross income by a corporation and maintained for the purpose of making good any loss of capital assets on account of depletion or depreciation is not a part of surplus out of which ordinary dividends may be paid. A distribution made from a depletion or a depreciation reserve based upon the cost or other basis of the property will not*192 be considered as having been *1143 paid out of earnings or profits, but the amount thereof shall be applied against and reduce the cost or other basis of the stock upon which declared. If such a distribution is in excess of the basis, the excess shall be taxed as a gain from the sale or other disposition of property as provided in section 29.111-1. * * * This or similar provisions have been carried in the Commissioner's regulations since 1918. See Regulations 45, art. 1549 (Revenue Act of 1918). We think that the respondent correctly reduced petitioner's equity invested capital by the amount distributed from its depreciation reserves. Finally, petitioner contends that it is exempt from excess profits tax under the provisions of section 727 (g) (2), Internal Revenue Code. Section 727 provides in part as follows: SEC. 727. EXEMPT CORPORATIONS. The following corporations, except a member of an affiliated group of corporations filing consolidated returns under section 141, shall be exempt from the tax imposed by this subchapter: * * * * (g) Domestic corporations satisfying the following conditions: (1) If 95 per centum or more of the gross income of such domestic corporation*193 for the three-year period immediately preceding the close of the taxable year (or for such part of such period during which the corporation was in existence) was derived from sources other than sources within the United States; and (2) If 50 per centum or more of its gross income for such period or such part thereof was derived from the active conduct of a trade or business. Petitioner's position on this issue is wholly inexplicable. Although the statutory exemption is plainly based on the condition that 50 per cent or more of the gross income be derived from the active conduct of a trade or business, petitioner argues in its brief that it was not engaged in the active conduct of a business, but was merely collecting its rentals. We quote paragraphs 2 and 3 from page 55 of petitioner's opening brief: 2. The Douglas Hotel Company was not engaged in the active conduct of trade or business in 1942 or 1943. Whatever income it had was derived from a lease executed on January 2, 1924. The corporation did nothing else, according to the testimony of the witness Reed, from the beginning, and the witness Rothery, from 1924 to date, as heretofore explained. This point was properly raised*194 in the pleadings and presented at the trial. 3. The petitioner submits that the applicable law exempts domestic corporations, such as the petitioner, from the excess profits tax as defined by Sec. 727 (g) (2), which states, "If 50 per centum or more of its gross income for such period or such part thereof was derived from the active conduct of a trade or business." As to whether petitioner was or was not actively engaged in a trade or business during 1942 and 1943, we venture no opinion. However that may be, it is the plain meaning of section 727 (g) that both of the conditions prescribed under subsections (1) and (2) must be met; *1144 that is, 95 per cent or more of the income for the preceding three years must have been derived from sources outside the United States. Petitioner had no income other than from sources within the United States. It, therefore, has no possible claim to the exemption. Decisions will be entered under Rule 50.