Clearview Apartment Co. v. Commissioner

Clearview Apartment Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Clearview Apartment Co. v. Commissioner Docket No. 52030 United States Tax Court 25 T.C. 246; 1955 U.S. Tax Ct. LEXIS 50; November 4, 1955, Filed *50 Decision will be entered under Rule 50. Petitioner in March 1951 borrowed $ 900,000 from the Metropolitan Life Insurance Company, and used $ 300,000 of the proceeds of the loan to pay the unpaid portion of a prior loan which was due on that date. Held, the $ 600,000 additional indebtedness was not incurred by petitioner in good faith for the purposes of its business and was not, therefore, "borrowed capital" within the meaning of section 439 (b) (1) of the Internal Revenue Code of 1939 for the purpose of computing its invested capital and excess profits credit. David P. Brown, Jr., Esq., for the petitioner. Edward Pesin, Esq., for the respondent. Raum, Judge. RAUM *246 The respondent determined deficiencies in the income tax of petitioner in the amount of $ 6,368.47 for the year 1950 and $ 6,706.54 for the *51 year 1951. The parties have settled several issues by agreement. The only issue for decision is whether all or only a portion of amounts totaling $ 900,000, which the petitioner borrowed from an insurance company in 1951, should be considered as borrowed capital in the computation of its excess profits credit for that year, based upon invested capital. At the trial the Court granted the respondent's unopposed motion to file an amendment to his answer claiming an increased deficiency for the year 1951. FINDINGS OF FACT. The facts stipulated by the parties are adopted as part of our findings and incorporated herein by this reference. Petitioner, Clearview Apartment Company, is a corporation incorporated under the laws of the Commonwealth of Pennsylvania on January 9, 1930, and having its principal office and place of business at Philadelphia, Pennsylvania. Petitioner, whose books of account were maintained on an accrual basis, for calendar years, filed its income and excess profits tax returns *247 for the calendar years 1950 and 1951 with the then collector of internal revenue for the first district of Pennsylvania. Petitioner was organized with an authorized capital consisting*52 of 5,000 shares of $ 50-par-value preferred stock and 500 shares of no-par-value common stock having a stated value of $ 100 per share. Upon petitioner's organization, all of its stock was issued to John Loughran's Sons, Inc., solely in exchange for a tract of vacant land situate on both sides of Clearview Street, between Broad and Fifteenth Streets, Philadelphia, Pennsylvania. Petitioner recorded the property on its books at a cost of $ 300,000. The adjusted and unadjusted basis of the property to petitioner for determining gain or loss upon its sale or exchange is $ 56,771.70, and such amount is includible in petitioner's invested capital for purposes of computing its excess profits credit for the taxable years 1950 and 1951. Petitioner elected to compute its invested capital for the year 1950 under section 437 of the Internal Revenue Code of 1939, and for the year 1951 under section 458 of the Internal Revenue Code of 1939. After the acquisition of the real property, petitioner erected thereon two apartment buildings, known as Norfolk Manor and Suffolk Manor. It owned and operated these apartment buildings from the date of their construction -- in 1930 -- until the present, *53 including the taxable years 1950 and 1951. For purposes of interim financing of construction of the apartment buildings petitioner, on January 28, 1930, executed to the Market Street Title and Trust Company, Philadelphia, Pennsylvania, two certain bonds and mortgages, secured by the tract of vacant land and the buildings and improvements to be erected thereon, in the total amount of $ 900,000. Each bond and mortgage was in the amount of $ 450,000. By assignment from Market Street Title and Trust Company the Metropolitan Life Insurance Company (hereinafter referred to as Metropolitan) acquired ownership of the bonds and mortgages for the permanent financing. By successive agreements the due date of the obligations was extended until March 1, 1951. On February 25, 1951, the outstanding balance due by petitioner to Metropolitan on the obligations was $ 300,000. Petitioner was personally liable on the bonds accompanying the mortgages. The rate of interest on the original obligations executed on January 28, 1930, was 6 per cent. From January 28, 1930, through December 24, 1930, the principal of the obligations of $ 900,000 was reduced to $ 800,000. On December 24, 1930, the due *54 date for the balance of $ 800,000 was extended to March 1, 1941. During the period of the extension the principal of the obligations was reduced to $ 650,000, and the interest rate payable was 6 per cent. On April 18, 1941, the due date for the balance of $ 650,000 of the obligations was extended to March 1, 1951. The interest rate payable under the terms of the *248 latter extension was 4 1/2 per cent on the remaining balance of $ 650,000 until such balance was reduced to $ 500,000, at which time the interest rate was to be reduced to 4 1/4 per cent, and remain in effect until such balance was reduced to $ 250,000, at which time the interest rate was to be reduced to 4 per cent. On February 25, 1951, the effective interest rate in force on the then unpaid balance of $ 300,000 was 4 1/4 per cent. At a meeting of the board of directors of petitioner on March 24, 1950, a resolution was adopted directing its treasurer to negotiate with Metropolitan for an extension of the old loan or for a new loan. On November 16, 1950, Metropolitan issued to petitioner two "commitment letters," in which it agreed that it would grant new mortgage loans on the Norfolk Manor and Suffolk Manor *55 apartments in the amount of $ 450,000 each; that the rate of interest on the new loans be 3 3/4 per cent; that the rate of interest of 4 1/4 per cent on the then unpaid balance of the outstanding loans should continue to be effective until March 1, 1951; that the loans should run for 10 years, from March 1, 1951, to March 1, 1961; that the remaining balance of $ 150,000 of each of the then outstanding unpaid loans be paid out of the new loan proceeds at settlement; that on each new loan of $ 450,000, semiannual principal payments of $ 6,750 were required to be made on March 1 and September 1 of each year beginning September 1, 1951, but that petitioner should have the privilege of paying a total amount of $ 45,000 of principal per year on each new loan, and, finally, that on any interest date (March 1 and September 1) on and after March 1, 1956, petitioner might, upon 60 days prior written notice to mortgagee, pay the entire unpaid balance on each loan at the cost of a surrender charge equal to 2 per cent of the unpaid principal. At a meeting of the board of directors of petitioner held on December 1, 1950, its treasurer reported that negotiations with Metropolitan had been concluded*56 and informed them of the terms of the proposed new loans. By appropriate resolution, its officers were authorized to execute such mortgages and other documents to obtain the funds referred to in the "commitment letters" dated November 16, 1950. By appropriate resolution, at a meeting held on January 26, 1951, its board of directors, after inspecting the proposed new loan documents, authorized the submission to its stockholders, for their approval, of the proposed increase of its indebtedness by the execution of the documents to obtain new mortgage loans of $ 900,000. At a special meeting held on January 27, 1951, petitioner's stockholders, after inspecting these documents authorized petitioner's officers to execute them. On February 28, 1951 (one day before the due date for payment of the obligations of $ 300,000 extended to March 1, 1951), petitioner's liquid assets, including cash, amounted to $ 23,122.38. *249 On February 26, 1951, petitioner's president and secretary executed two bonds and mortgages to Metropolitan in the total amount of $ 900,000. Each bond and mortgage was in the amount of $ 450,000, and was applicable to the apartment buildings known as Norfolk Manor*57 and Suffolk Manor, respectively. Out of the proceeds petitioner, on March 1, 1951, paid the then outstanding balance of $ 300,000 due on the bonds and mortgages executed January 28, 1930. Each of the new bonds expressly provided, as the original bonds did not, that -- All liability under any judgment obtained or taken by virtue of this Bond and any judgment obtained on any renewal or revival thereof is restricted to the premises described in the Mortgage securing the Bond. No other property of the said Obligor, real or personal, is to be taken in execution or sold except the premises described in the Mortgage securing this Bond. Petitioner, on or about March 1, 1951, received $ 600,000 net proceeds of the new loans from Metropolitan. In addition to the indebtedness due to Metropolitan, the only loans outstanding during the year 1951 were those which had been made to petitioner by the Loughran Trusts, of which Edward P. Loughran, the treasurer of the petitioner, was trustee. The Loughran Trusts consisted of 10 different trusts whose beneficiaries were adult members of the family of Edward P. Loughran and owners of stock of petitioner. All of the officers of petitioner during the*58 year 1951 were members of this family. When the petitioner needed cash from time to time, the Loughran Trusts advanced to it the moneys required. On February 6, 1951, petitioner's indebtedness to the Loughran Trusts amounted to $ 297,283.68. This indebtedness was incurred on the following dates: Notes payable Loans payable Incurred $ 124,822.94 Mar. 10, 1942 109,460.74 Jan. 1, 1942 $ 63,000 July 1, 1950 The $ 63,000 indebtedness was reduced by a payment to the Loughran Trusts of $ 10,000 on February 7, 1951, and a payment of $ 24,000 on December 6, 1951. On December 1, 1951, the petitioner borrowed an additional $ 6,500 from these trusts. At the end of the year 1951 the petitioner was still indebted to the Loughran Trusts in the total amount of $ 269,783.68. At the time the new loan of $ 900,000 was negotiated, petitioner was not being pressed by Edward P. Loughran, as trustee of the Loughran Trusts, for repayment of any of its indebtedness to the trusts, although at that time the payment of the $ 63,000 debt was overdue, and the balance was due in about a year. Extensions of time for payment had theretofore been granted by the trusts to petitioner. *250 *59 At the time petitioner borrowed the $ 900,000 from Metropolitan, its representatives did not contemplate the investment of the $ 600,000 net proceeds of the loan in securities, and it was not the purpose of the loan to obtain funds to make such investments. Immediately after receiving the net proceeds of $ 600,000, $ 400,000 was invested in Government bonds, and before the end of March 1951, the remaining balance of $ 200,000 was invested in marketable securities. The purchases of securities made by petitioner with funds obtained from Metropolitan on March 1, 1951, the cost of securities sold during the years 1951 through 1954, and the year-end balances of securities on hand, were as follows: Balance January 1, 1951 Purchases, 1951 $ 619,737.17 Cost of securities sold in 1951 66,875.07 Balance December 31, 1951 $ 552,862.10 Purchases, 1952 352,879.69 Cost of securities sold in 1952 425,426.64 Net decrease, 1952 ($ 72,546.95) Balance December 31, 1952 $ 480,315.15 Purchases, 1953 117,733.58 Cost of securities sold in 1953 216,652.75 Net decrease, 1953 ($ 98,919.17) Balance, December 31, 1953 $ 381,395.98 Purchases, 1954 219,494.89 Cost of securities sold in 1954 254,005.62 Net decrease, 1954 ($ 34,510.73) Balance, December 31, 1954 $ 346,885.25 *60 Income from investment securities and gains on sales of such securities were realized, by petitioner, during the years 1951 through 1954, as follows: Dividend Interest Capital Totals Year income income gains [1951] $ 6,554.03 $ 1,477.90 $ 7,878.11 $ 15,910.04 [1952] 15,216.30 8,037.03 3,541.65 26,794.98 [1953] 13,821.44 5,985.28 (2,586.94) 17,219.78 [1954] 13,161.85 2,642.62 30,458.56 46,263.03 The interest charge to petitioner during the years 1951 through 1954 on the additional $ 600,000 borrowed from Metropolitan on the bonds and mortgages executed on February 26, 1951, was as follows: *251 [1951] $ 18,500 [1952] 20,875 [1953] 19,375 [1954] 17,875 Total $ 76,625 Petitioner paid $ 45,000 on August 28, 1951, and $ 90,000 in each of the taxable years 1952, 1953, and 1954 -- exclusive of interest -- in reduction of the bond and mortgage obligations executed February 26, 1951. Of the 1951 payment $ 25,000 was allocable to the principal amount of $ 300,000, the amount of the old loan, and $ 20,000 was allocable to the $ 600,000 balance in excess of the amount of the old loan. In its corporate income tax return for the year 1950, the petitioner*61 reported net income of $ 38,122.61, and in its return for 1951 net income of $ 31,308.24. Its net income for those years, as adjusted by respondent, after eliminating an item of officers' salaries which the respondent admits was erroneously disallowed as a deduction, amounted to approximately $ 46,000 for the year 1950 and approximately $ 39,000 for the year 1951. In its return for 1951 petitioner reported interest on Treasury notes of $ 1,477.90 and taxable capital gains from sales of stock of $ 7,878.11. The petitioner until 1951 was engaged exclusively in owning and operating the Norfolk Manor and Suffolk Manor apartment buildings. Rent controls, which affected the maximum rent it could receive from apartments, were in effect both prior and subsequent to 1951. Its policy as of March 24, 1950, was to make as few repairs and replacements in the apartment buildings as possible. In 1948 approximately $ 35,000 was expended by petitioner for refrigerators and $ 4,000 for a new roof; and in another year prior to 1950 copper pipe was installed at a cost of $ 9,000. At a meeting of the directors of petitioner on March 24, 1950, they received a report from its president that it looked*62 as though Congress would pass an act extending rent controls, and they concluded that the policy of the company of making as few repairs and replacements as possible would have to be continued in effect. Petitioner's major repair and replacement items were included, on its books, in three accounts, designated "Elevators, Gas Ranges and Servels"; "Plumbing, Heating and Roofing"; and "Paper Hanging, Painting and Floors." During the years 1951 (after the loan funds had been received from Metropolitan) through 1954, petitioner made expenditures for major repairs and replacements as follows: Account [1954] Elevators, gas ranges, and Servels $ 684.33 $ 1,019.81 1 $ 24,681.68 $ 1,739.84 Plumbing, heating, and roofing 4,118.91 8,477.64 6,713.79 8,175.07 Paper hanging, painting, and floors 6,614.89 1,844.32 1,729.69 10,471.10 $ 11,418.13 $ 11,341.77 $ 33,125.16 $ 20,386.01 *252 Petitioner also has on its books an account designated "Hardware, Glass, Lumber and Electrical Expenses" to which were charged smaller and recurring items of everyday maintenance, repair, and replacement. All of the above-mentioned*63 accounts were closed out to profit and loss at the end of each year. An application filed by petitioner for increase in its rentals under the Rent Control Law was approved in 1953, and in 1954 it received increased rentals in the amount of $ 18,130.39. Its rental income for 1953 was $ 235,033.94 and for 1954 $ 253,164.33. Petitioner received a written offer to purchase the two apartment properties on or about April 1, 1949, for the price of $ 1,500,000 and also several oral offers, but the petitioner was not trying to sell the properties and it determined not to sell, declining all offers made. In its return for 1951 petitioner included in its daily borrowed capital $ 300,000 as due to Metropolitan from January 1, 1951, to February 28, 1951, and $ 900,000 from March 1, 1951, through August 27, 1951, thus including the additional principal amount of $ 600,000 as well as the principal amount of $ 300,000, the amount of the original loan. For the period from August 28, 1951, through December 31, 1951, petitioner included in its daily borrowed capital the amount of $ 855,000, the remaining principal balance due Metropolitan after crediting the repayment of $ 45,000 made on August 28, *64 1951. Respondent's position is based upon (1) a determination that there was properly included in petitioner's daily borrowed capital for the period from January 1, 1951, through August 27, 1951, the principal amount of $ 300,000, and for the period from August 28, 1951, through December 31, 1951, the principal amount of $ 275,000, $ 25,000 of the repayment of $ 45,000 on August 28, 1951, being allocable to the principal amount of $ 300,000; and (2) the consequent disallowance of any excess over these amounts in computing petitioner's daily borrowed capital for these periods. To the extent of $ 600,000, the indebtedness incurred by the petitioner to Metropolitan on or about February 26, 1951, was not "incurred in good faith for the purposes of the business" within section 439 (b) (1) of the 1939 Code, and therefore did not constitute allowable daily borrowed capital in computing its historical invested capital under section 458 for the purpose of determining its excess profits credit for 1951. The amount of the outstanding indebtedness due from the petitioner to Metropolitan during the year 1951 allowable in computing its daily borrowed capital for the purpose of determining its excess*65 profits credit for that year was $ 300,000 during the period from January 1, 1951, through August 27, 1951, and $ 275,000 for the period from August 28, 1951, through December 31, 1951. *253 OPINION. The petitioner elected to use the "historical" invested capital method in the computation of its taxable adjusted excess profits net income for the year 1951. Having made this election, it became entitled to a credit based on invested capital under the applicable provisions of the Internal Revenue Code of 1939 (secs. 430, 431, 434, 436, 437, 439, and 458). One of the factors entering into the determination of the amount of this credit is "daily borrowed capital." That term is defined in section 439 (b) (1) to include the following: The amount of the outstanding indebtedness (not including interest) of the taxpayer, incurred in good faith for the purposes of the business, which is evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, deed of trust, bank loan agreement, or conditional sales contract. In the case of property of the taxpayer subject to a mortgage or other lien, the amount of indebtedness secured by such mortgage or lien*66 shall be considered as an indebtedness of the taxpayer whether or not the taxpayer assumed or agreed to pay such indebtedness, * * * [Italics supplied.] Treasury Regulations 130, sec. 40.439-1 (d), provide as follows: In order for any indebtedness to be included in borrowed capital it must be incurred in good faith for the purposes of the business and not merely to increase the excess profits credit. Similar language was contained in Treasury Regulations 112, section 35.719-1, relating to World War II excess profits tax in effect during the years 1940 to 1945, inclusive, and these regulations were held to be reasonable and valid. Hart-Bartlett-Sturtevant Grain Co., 12 T. C. 760, 769, affirmed 182 F. 2d 153, 158 (C. A. 8); Mahoney Motor Co. v. Commissioner, 192 F. 2d 508, 512 (C. A. 8); Globe Mortgage Co., 14 T. C. 192, 197. The question before us whether $ 600,000 of the $ 900,000 borrowed by petitioner from Metropolitan represented an obligation "incurred in good faith for the purposes of the business." The Commissioner determined that it did not, and the*67 burden of proving error in this determination is on the petitioner. Petitioner's principal witness was its treasurer, Edward P. Loughran, who was also trustee of the Loughran Trusts. He undertook to detail a number of business reasons for the loan. However, we are satisfied from an appraisal of his testimony in the light of the record as a whole that these alleged reasons did not in fact motivate petitioner in borrowing any part of the $ 900,000 from Metropolitan in excess of $ 300,000. The reasons outlined and discussed by him impressed us as being nothing more than a lawyer's attempt to marshal possible business objectives that might conceivably have motivated the loan, notwithstanding that they in fact played no part in the transaction. We do not believe his testimony that the obligation was incurred for the reasons which he spelled out. *254 For example, one of the reasons said to have induced the making of the loan was the possibility that petitioner would have to repay an aggregate indebtedness to the Loughran Trusts of some $ 297,000, of which $ 63,000 was then overdue. We cannot take this seriously. The $ 600,000 made available to petitioner by Metropolitan was *68 promptly invested in securities, without at that time paying to the Loughran Trusts any part of the $ 63,000 then overdue. The only payment on that indebtedness during 1951 was made many months later, in December, and was only in the amount of $ 24,000. Also, petitioner had meanwhile borrowed an additional $ 6,500 from the Loughran Trusts. The evidence is all too plain to us that the Loughran Trusts had been financing petitioner's operations over a period of years, that there was no pressure for repayment of its loans, and that the borrowing from Metropolitan was wholly unrelated to petitioner's loans from the Loughran Trusts. Another alleged reason for the loan was the need to make major repairs and replacements in the buildings. The amount of the actual expenditures made by petitioner for these purposes during the years immediately following the loan and petitioner's express policy of making "as few repairs and replacements as possible" as long as rent controls were in effect make incredible to us Loughran's testimony that this alleged reason played any part in the transaction. Another alleged reason was that the larger loan would make the property more salable. However, the*69 evidence discloses that petitioner had rejected several offers to sell its property and that it was not interested in selling. We cannot believe, in these circumstances, that petitioner borrowed an additional $ 600,000 to make its property more salable. We think that petitioner has not carried its burden of proof and that the various business reasons suggested were spurious. We must therefore conclude that the Commissioner did not err in his determination that the obligation with respect to $ 600,000 of the $ 900,000 borrowed from Metropolitan in 1951 was not incurred in good faith for the purposes of petitioner's business. Decision will be entered under Rule 50. Footnotes 1. Includes the cost of 275 gas ranges.↩