Nowland Realty Co. v. Commissioner

NOWLAND REALTY CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Nowland Realty Co. v. Commissioner Docket No. 34298. United States Board of Tax Appeals 18 B.T.A. 405; 1929 BTA LEXIS 2056; November 30, 1929, Promulgated *2056 1. Held that certain amounts constructively received as rental by the petitioner as lessor from its president as lessee pursuant to the terms of a written lease entered into between them constituted rent to the petitioner. 2. Upon the facts, the accounts of two businesses should not be consolidated. Frank C. Olive, Esq., for the petitioner. A. H. Fast, Esq., for the respondent. TRAMMELL *405 This is a proceeding for the redetermination of deficiencies in income taxes of $878.38 and $929.05 for 1924 and 1925, respectively. The matters in controversy are the respondent's action (1) in including in gross income for each of the years 1924 and 1925 the amount of $7,000 constructively received by the petitioner as lessor from its president as lessee to provide for retirement of portions of the petitioner's preferred stock and, as an alternative contention, (2) in refusing to consolidate the income of the petitioner with that of its president under the provisions of section 240(d) of the Revenue Act of 1924 and section 240(f) of the Revenue Act of 1926. FINDINGS OF FACT. About 1923 Lorenz Schmidt was the owner of certain real estate*2057 in the City of Indianapolis. Being desirous of obtaining a loan of $70,000 on this property, he, through his son, approached J. L. Rodabaugh, an official of the Bankers Investment Co. of Indianapolis, with respect to obtaining the loan from that company. After investigating the property and having it appraised, Rodabaugh advised that the Bankers Investment Co., hereinafter referred to as the investment company, would loan the desired amount of money on certain terms and conditions and that the loan would take the form of a preferred stock issue, which for many years had been the customary form of loans of this character in Indianapolis. Thereafter and on June 20, 1923, the petitioner was incorporated under the laws of Indiana, with its principal place of business at Indianapolis. The petitioner's authorized capital stock was $105,000, consisting of 1,050 shares of a par value of $100 each. Of the capital stock, $35,000 par value was common stock and $70,000 par value was 6 per cent cumulative preferred stock. All of the stock was issued immediately after incorporation. All of the common stock was issued to Schmidt as part consideration for certain real estate transferred by*2058 him to the petitioner. *406 The articles of association provide that "the business to be done by the corporation shall be to acquire, own, improve, manage, rent and lease" certain real estate and personal property described therein. They also provide that such property may be conveyed with the written consent of and on the terms approved by the investment company and that without such consent the property shall not be transferred, conveyed or encumbered without the consent in writing of the holders of three-fourths of the preferred stock of the petitioner. The articles further provide that the common stock shall be sold at not less than $80 per share and the preferred stock at $92.50 per share. They also provide that the length of the life of the corporation is from the date of its incorporation to and including the first day of January, 1931, and such term shall not be extended without the consent of the holders of three-fourths of the preferred stock. The minutes of the meeting of the board of directors of the petitioner held on June 20, 1923, are in part as follows: There was discussed the acquisition of the property referred to in the Company's Articles, and the*2059 financing of the purchase price thereof. A proposed contract with Bankers Investment Company, touching the sale of the Company's preferred stock, was read and submitted to the meeting. The following proposition was also read and submitted: INDIANAPOLIS, INDIANA, June 20, 1923. NOWLAND REALTY COMPANY, Indianapolis, Indiana. The following is proposed to you by the undersigned: 1. To convey and assign to you, by good and sufficient warranty deed and instrument of assignment, respectively, the real estate and securities described in your Articles of Association, free of all encumbrance other than current taxes and municipal assessments not delinquent. 2. To execute and deliver the proxy and transfer the three shares of your common stock, referred to in the proposed contract with Bankers Investment Company just submitted to you. 3. To guarantee in a form approved by said Bankers Investment Company the performance by you of your obligations to your preferred stockholders. 4. To join as lessees in the execution of the lease contemplated by said contract with Bankers Investment Company, in the form submitted herewith as a part hereof. All in consideration*2060 that you issue to your incorporators the shares of your common stock by them subscribed, and to the undersigned, all of your remaining authorized common stock; such stock to be issued as fully paid and non-assessable, and that you cause to be paid, in the manner set forth in said contract with Bankers Investment Company, all of the proceeds of the sale of your preferred stock. LORENZ SCHMIDT Accepted this 20 day of June, 1923. NOWLAND REALTY COMPANY By LORENZ SCHMIDT, President. *407 It was moved and seconded that the foregoing proposition be accepted, and that said proposed contract with Bankers Investment Company and said lease be approved and executed, and that the President be directed to endorse this Company's acceptance of said proposition at the foot thereof, and join, on behalf of this company, in the execution of said contract and said lease. Which motion being placed upon its passage, was unanimously adopted. Under date of June 20, 1923, the petitioner and the investment company executed an instrument which, after reciting that the petitioner, designated the first party, intended to acquire certain real estate in the City of Indianapolis and*2061 certain personal property therein described having a total appraised value of $152,383, and that the petitioner desired the assistance of the investment company, designated the second party, in financing the cost of purchasing such property, provided as follows: 1. The first party shall cause to be issued its duly authorized capital stock in the amount of $105,000, of which 350 shares shall be common stock and 700 shares shall be preferred stock. Said preferred stock shall bear cumulative dividends at the rate of six per cent per annum from June 20, 1923, payable October 1, 1923, and quarterly thereafter. Said preferred stock shall be redeemed as follows: $7,000 on the first day of January of each of the years 1925 to 1928, both inclusive; $9,000 on the first day of January 1929 and 1930; and $24,000 on the first day of January, 1931. Said preferred stock shall carry an optional right of redemption at any dividend paying date on or after January 1st, 1924, at 102 per cent of par plus all accrued dividends, on the giving of thirty days prior written notice to the holders of the shares selected for redemption; Provided that if less than the whole shall be so redeemed, such*2062 redemption shall be by impartial lot from the shares of latest maturity outstanding. The certificate evidencing such preferred stock shall be in substantially the form of Exhibit "A" hereto attached. 2. Said Realty Company shall issue its common stock, excepting necessary qualifying shares, to Lorenz Schmidt, who, in partial consideration thereof, shall cause said real estate and securities to be conveyed and assigned to said Realty Company, free of all encumbrance other than current taxes and assessments not delinquent, by good and sufficient warranty deed, and assignment. 3. The first party shall cause said Lorenz Schmidt to execute and deliver unto nominees of the second party, a proxy irrevocable so long as any of said preferred stock shall remain outstanding, authorizing them to vote a majority of the common stock of said Realty Company whenever and so long as said Realty Company shall be in default in the performance of any of its obligations to its preferred stockholders; and shall cause to be transferred to nominees of the second party three shares of said common stock to the end that there shall be available qualifying shares for new directors in case the second party, *2063 its nominees, assigns or any representative of the preferred stockholders shall desire to exercise said proxy in the event of such default. 4. As a further consideration for the issuance to him of said common stock, the first party shall procure said Lorenz Schmidt to execute and deliver, in a form approved by the second party, his guaranty of the performance by first party of all of its obligations to its preferred stockholders. *408 5. The first party shall enter into a lease of said real estate to said Lorenz Schmidt for the period commencing June 20, 1923, and ending with January 1, 1931, at a rental at least sufficient to take care of the dividends on said preferred stock and the retirement of the principal thereof coming due for retirement within the demised term, and all taxes, insurance and all other costs, charges and expenses of said Realty Company to the end that said Realty Company, at all times within said demised term, shall have net revenues ample to meet all of its obligations to its preferred stockholders. Said lease shall be in a form approved by the second party. 6. The first party shall cooperate with the second party in taking all steps necessary*2064 to qualify said preferred stock with the Indiana Securities Commission, and pay all expenses thereof. 7. First party agrees to pay all expenses in connection with its organization, the issuance of said preferred stock, and the reasonable compensation of counsel of the second party in connection with all steps taken in carrying out the provisions of this agreement. 8. So long as any of said preferred stock shall remain outstanding, said Realty Company shall: (a) Pay no salaries to its officers and no dividends on its common stock. (b) Pay all taxes before delinquent and protect its property against all other liens of every kind. (c) Carry insurance against loss by fire on the improvements on said property to at least the full insurable value thereof, tornado insurance to at least fifty per cent of the amount of such fire insurance, and other insurance in such forms and amounts as are usually carried on similar properties. (d) Not transfer, convey or encumber said property; Provided, that any or all of said property may be sold upon the payment to the order of second party of three-fourths (3/4) of the appraised value of each item sold, using the appraised values*2065 hereinbefore set forth; such funds to be used for the sole purpose of redeeming said preferred stock of latest maturity outstanding. (e) Employ the second party as Registrar of its preferred and common stock, and pay it for such service the sum of $50.00 per year. (f) Cause a representative of the second party to be maintained on its Board of Directors, if requested by the second party. (g) Not incur any floating indebtedness in excess of $2,000, other than for current taxes and municipal assessments not delinquent. 9. Subject to the performance of all the terms and provisions of this agreement to be performed by others, the second party agrees to purchase, and first party agrees to sell to the second party all of said preferred stock of the par value of $70,000 at ninety-two and one-half (92 1/2) per cent of the par value thereof; the resulting proceeds to be paid as follows: $25,000 on or before July 1, 1923; $20,000 on or before August 1, 1923; and the balance on or before August 15, 1923. Such payments shall be applied first to the payment of all mortgages, liens and encumbrances on said property or any thereof, other than current taxes and municipal assessments*2066 not delinquent, and the remaining balance to be paid to Lorenz Schmidt as a further consideration for the conveyance and assignment of said property to first party. On all undrawn balances of such purchase price the first party shall be allowed interest at the rate of four per cent per annum from June 20th, 1923. Under date of June 20, 1923, Schmidt, who was president of the petitioner, executed in his personal capacity a lease agreement with *409 the petitioner for its property for the period commencing June 20, 1923, and ending January 1, 1931. The instrument provides in part as follows: IN CONSIDERATION WHEREOF, and as rental for said demised premises the Lessee [Schmidt] agrees: (a) To pay on or before ten days prior to the first day of January, April, July and October throughout said demised term, commencing ten days prior to October 1, 1923, all sums fixed for payment on the first day of the next succeeding month, as dividends on the preferred stock of the lessor. There being $70,000 par value of such stock presently to be issued bearing 6% cumulative dividends from June 20th, 1923. (b) To pay on or before the 21st day of December of each year, commencing*2067 with December 1924, the amount of lessor's preferred stock fixed for redemption on the next succeeding January 1st. Said stock is to be redeemed as follows: $70,000 on the first day of January of each of the years 1925 to 1928, both inclusive. $9,000 on the first day of January 1929 and 1930; and $24,000 on the first day of January, 1931. (c) To pay throughout said demised term all expenses and obligations of the Lessor for taxes, by whatever authority assessed or imposed on Lessor or its property; all insurance premiums on policies issued on account of fire, tornado and such other casualties as Lessor shall elect and in such amounts as Lessor shall require; and all public assessments and all other costs incident to the ownership and upkeep of the demised premises. To the end that, at all times during the demised term, the Lessor shall have available net revenues ample to enable it to meet its obligations to its preferred stockholders. * * * The Lessee shall protect and save harmless the Lessor from any and all loss or liability of any kind at any time arising out of accidents or injuries occurring or received upon or about the demised premises during the term hereof, *2068 and shall pay all expenses connected with the defense of any and all claims resulting therefrom. The Lessee shall keep said leased premises in good repair, after completion thereof by the lessor, shall commit no waste thereon, and shall take all reasonable steps to protect said premises from danger by fire or other casualty. * * * It is expressly agreed that this lease shall not be terminated or modified, nor shall the rights of the Lessee hereunder be abridged or diminished without the written consent of Bankers Investment Company, representing the preferred stockholders of the lessor. Under date of June 20, 1923, Schmidt executed a proxy to J. L. Rodabaugh and R. R. Rodabaugh or either of them to vote 176 shares of the common stock of the petitioner standing in his name. The proxy provided that it should not be exercised except in the event and so long as the petitioner shall be in default in the performance of any of its obligations to its preferred stockholders. The proxy further provided that so long as any of the preferred stock is outstanding, the proxy should be in full force and effect as against any successive holder of any of the 176 shares of common *410 *2069 stock and due reference to the existence of the proxy should be made on the face of any and all stock certificates representing any such shares. In consideration of the purchase by the investment company of the preferred stock of the petitioner of the par value of $70,000 and as one of the considerations for the issuance to him of common stock of the petitioner Schmidt by an instrument dated June 20, 1923, assigned and transferred to the Continental National Bank of Indianapolis 204 1/3 shares of the common stock of the Old Town Co. and 52 1/2 shares of the common stock of Polar Ice & Fuel Co., subject to certain terms and conditions. Included among such terms or conditions were the following: 1. So long as any of the preferred stock of said Realty Company (petitioner) remains outstanding, said bank shall hold said stock certificates for the use and benefit of said Realty Company and of its preferred stockholders. 2. Whenever and so often as said Realty Company shall be in default in the payment of any dividend upon any of its shares of preferred stock, or in the redemption of any instalment of the principal thereof, at any of the times fixed therefor, then and in that event*2070 said bank shall on request either of said Realty Company, or of Bankers Investment Company representing said preferred stockholders, sell any or all of said shares of stock hereby assigned and apply the proceeds of such sale to the making good of any such existing default and shall retain any balance of such proceeds and any unsold remainder of such stock so hereby assigned to be used for the same purpose in case of any subsequent default. * * * * * * 3. This instrument shall be deemed a fullfilment and discharge of the obligations of the first party under the terms of an agreement of even date herewith with said Realty Company to assign said above described stock to said Realty Company as one of the considerations toward the issue to first party of the common stock of said Realty Company and the payment to first party of part of the proceeds of sale of the preferred stock of said Realty Company. The instrument also contained provisions relating to the return to Schmidt of the stocks transferred by the payment by him of certain amounts or by the petitioner fulfilling all the terms of its agreement with respect to the redemption of its preferred stock. Under date of June 20, 1923, Schmidt*2071 executed an instrument wherein he agreed that if the dividends on the preferred stock of the petitioner were not paid at the times provided therefor he would on request of any holder of any of the preferred stock pay the amount of any such dividend and that on failure of the petitioner to pay, at the time fixed for redemption thereof any installment of the principal of the preferred stock, he would on request of any holder thereof take over and purchase the preferred stock which had not been so redeemed at the time fixed therefor and would pay therefor to any such holder the par value thereof, plus *411 all accrued dividends and that he would assert no claim against the petitioner by reason of any such sale until all of such preferred stock should have been redeemed. It was provided that the agreement should continue in full force and effect for the benefit of the holders of preferred stock until all of such stock shall have been redeemed at the times and in the manner provided therefor. The form of the petitioner's preferred stock certificate is as follows: No. NOWLAND REALTY COMPANY Shares Indianapolis, Indiana. COMMON STOCK, $35,000 PREFERRED STOCK, $70,000 *2072 THIS CERTIFIES THAT is the holder of fully paid and non-assessable shares of the par value of one hundred dollars ($100) each of the preferred stock of Nowland Realty Company, transferable only on the books of the company by the holder hereof or his duly authorized attorney, on the surrender and cancellation of this certificate properly endorsed. The holder hereof shall be entitled to receive dividends at the rate of six per cent (6%) per annum on the shares of stock represented hereby, payable in equal quarterly installments of one and one-half per cent (1 1/2%) on the first day of January, April, July and October of each year (the first dividend being payable October 1st, 1923, at the rate of six per cent (6%) per annum from June 20th, 1923), before any sum whatever is paid to or set aside for the benefit of the common stockholders, which dividends shall be cumulative. In event of liquidation of the company, the preferred stockholders shall be entitled to receive the par value of their shares of stock, plus all accrued dividends, before anything shall be paid to the holders of the common stock. The company agrees to redeem the shares of stock represented hereby at their*2073 par value, plus accrued dividends on the first day of January 19 , and it reserves the right to redeem any of its shares of preferred stock at one hundred and two per cent (102%) of par, plus accrued dividends, on January first, 1924, or on any dividend date thereafter on giving thirty (30) days prior written notice to the holders of the shares selected for redemption. The company may convey any of its property with the written consent of and upon the terms and conditions approved by Bankers Investment Company of Indianapolis, upon the payment to the order of said Bankers Investment Company of at least seventy-five per cent (75%) of the present appraised value thereof, which sum shall be used solely for the redemption of such preferred stock of latest maturity outstanding, in the manner hereinbefore provided; but without such consent it shall not convey or encumber its property except with the written consent of the holders of 75% of its outstanding preferred stock. It agrees that it will maintain insurance against loss by fire on the improvements on such property to the amount of the insurable value thereof; that it will not become indebted in excess of two thousand dollars ($2,000) *2074 other than for taxes not delinquent. The Company shall pay no dividends on its common stock nor any salaries to its officers until the preferred stock is all redeemed. The exclusive voting rights shall be in the common stock excepting in case the company shall be in default in the performance of any of its obligations to its preferred stockholders, in which event, and so long as such default shall *412 continue, the preferred stockholders shall have voting rights in all respects equal, share for share, with the common stockholders. Upon failure of the company to comply with all the obligations and agreements herein contained, the holders of three fourths in amount of the preferred stock then outstanding may require the liquidation of the company and the application of its assets to the payment of its creditors and stockholders in the order provided by law. This certificate shall not be valid until registered by Bankers Investment Company, as registrar. IN WITNESS WHEREOF, the said Nowland Realty Company has caused this certificate to be executed by its duly authorized officers and its corporate seal to be hereunto affixed, this day of . [19] President *2075 ATTEST: Secretary Treasurer (Seal) In determining the deficiencies here involved the respondent included in the petitioner's gross income for each of the years 1924 and 1925 the amount of $7,000 representing the amount constructively received in those years by the petitioner as lessor from Schmidt, as lessee to retire the amounts of preferred stock that were to be retired on January 1, 1925, and January 1, 1926. During 1923, 1924, and 1925 Schmidt was engaged in the general real estate and insurance business and after the conveyance by him to the petitioner of certain real property he still retained in his name a considerable amount of real estate and personal property, which he continued to rent, manage and lease during the years here in controversy. In determining the deficiencies here involved the respondent refused to accede to the petitioner's request that he consolidate the accounts of the petitioner with those of Schmidt. OPINION. TRAMMELL: The petitioner contends that the respondent erred in including in its gross income for each of the years 1924 and 1925 the amount of $7,000 constructively received by it as lessor from Schmidt as lessee to provide*2076 for the retirement of portions of its preferred stock. The evidence indicates that it has been the custom in Indiana for a number of years to make practically all large loans on real estate in the form of a preferred stock issue instead of a bond issue secured by a mortgage. The reason for the custom as shown by the evidence is that the bonds are subject to property tax whereas the preferred stock is free from tax in the hands of the holders. By circumscribing the rights of the corporation and of the common stockholders the *413 preferred stockholders have substantially the same protection as under a bond issue and, by a proxy for the voting of the common stock being held by some one for them, their desires can be carried out more expeditiously than under a bond issue. The petitioner urges that Schmidt's sole object in forming the petitioner corporation was to obtain a loan of $70,000 and that the payments of $7,000 in 1924 and 1925 constitute contributions to the capital of the petitioner and represent an additional price paid by Schmidt for his common stock. It is not disputed that the petitioner was legally organized or that its existence has never been questioned*2077 by the State of Indiana, or that the various proceedings, agreements, leases, etc., are legal and are what they purport to be, or that the agreements have not been or are not being carried out. Nor is it denied that the petitioner constructively received the amounts in controversy. The question, therefore, is, Did the amounts constitute income to the petitioner, or were they capital contributions by Schmidt? The evidence indicates that at the formation of the petitioner Schmidt turned in to it certain real and personal property having a total appraised value of $152,383, for which he received $35,000 par value common stock of the petitioner and the proceeds from the sale to the investment company of the $70,000 par value of the preferred stock. Schmidt leased from the petitioner certain of the property so turned in to it and as "rental" for the property agreed, among other things, to pay the amounts here in controversy. Although at the time of organization Schmidt paid in to the petitioner assets of an appraised value of approximately $50,000 in excess of the par value of the common stock and the proceeds from the sale of the preferred stock received by him, the petitioner urges*2078 that he was still making payments thereon at the rate of $7,000 per year during 1924 and 1925 and to 1928, after which time larger payments are to be made. Throughout the various instruments placed in evidence Schmidt is referred to as "lessee" and the amounts to be paid by him as such lessee are referred to as "rental." There is no evidence, documentary or otherwise, to indicate that the parties at the time of entering into the various agreements considered or intended that the amounts here involved were to be additional payments by Schmidt for the common stock that he received. From a thorough consideration of the facts in the case, we are unable to find anything that would justify the conclusion that the amounts represented anything else than what the parties have denominated them. Accordingly, the action of the respondent is sustained. *414 As an alternative contention, the petitioner urges that its accounts and those of Schmidt be consolidated in accordance with the provisions of section 240(d) of the Revenue Act of 1924 and section 240(f) of the Revenue Act of 1926. These sections, which are identical, provide as follows: In any case of two or more related trades*2079 or businesses (whether unincor porated or incorporated and whether organized in the United States or not) owned or controlled directly or indirectly by the same interests, the Commissioner may and at the request of the taxpayer shall, if necessary in order to make an accurate distribution or apportionment of gains, profits, income, deductions or capital between or among such related trades or businesses, consolidate the accounts of such related trades or businesses. It was stipulated at the hearing that during the years here involved Schmidt was engaged in the general real estate and insurance business and that he held a considerable amount of real estate and personal property which he rented, managed and leased. The petitioner accordingly contends that its business and that of Schmidt were not only related and similar but were entirely controlled by a single interest; that had both businesses been conducted as corporations, consolidated returns would have been filed and that since such returns are precluded, the above quoted provision of the 1924 and 1926 Acts should be applied. Granting, for the sake of argument, that the foregoing contention is correctly premised, the statute*2080 specifically provides that the consolidation of the accounts as provided for therein shall be made "if necessary in order to make an accurate distribution or apportionment of gains, profits, income, deductions or capital between or among such related trades or businesses." This requirement must be met in order for accounts to be consolidated. We are not convinced that this requirement has been met. The only transactions relied on by the petitioner involving the petitioner and the business of Schmidt are the rental payments made under the lease entered into between them in June, 1923. In our opinion these do not constitute such an intermingling of the accounts or the shifting of the profits of the two businesses in question as would necessitate the consolidation of the accounts in order to make the accurate distribution or apportionment contemplated by the statute. See . We think this contention of the petitioner must be denied. Reviewed by the Board. Judgment will be entered for the respondent. LANSDON, SMITH, TRUSSELL, and PHILLIPS dissent.