Denholm & McKay Co. v. Commissioner

DENHOLM AND MCKAY CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Denholm & McKay Co. v. Commissioner Docket No. 89606. United States Board of Tax Appeals 39 B.T.A. 767; 1939 BTA LEXIS 984; April 14, 1939, Promulgated *984 Petitioner, as lessee, entered into a lease with the lessor corporation, providing for a cash rental and guaranteeing the payment of interest on preferred stock of lessor and the redemption of such stock upon liquidation. In 1934 the terms of the cash payment were modified by an agreement that the lessee should pay as rental all taxes and expenses of the Realty Co., "together with an amount equal to 7 percent on the preferred capital stock of the Realty Co. now issued and outstanding." Held, that the dividends and taxes paid and accrued by the petitioner are deductible as items of rent. Howe P. Cochran, Esq., for the petitioner. Harold Allen, Esq., for the respondent. VAN FOSSAN *767 This proceeding was brought to redetermine a deficiency in the income tax of the petitioner for the fiscal year ended January 31, 1935, in the sum of $6,628.67. The issues are as follows: (1) The deductibility of $36,150.50 representing payments made by the petitioner pursuant to its guarantee of the payment of dividends on the preferred stock of the Denholm & McKay Realty Co., made as a consideration of a lease between the petitioner and that company. *985 (2) The taxability of $7,429.57 received from certain insurance companies and representing overpayments made on premiums. (3) The deductibility of $56,222.08 representing city taxes assessed on January 1, 1935, payable one-half on July 1, 1935, and one-half on October 1, 1935. *768 FINDINGS OF FACT. The facts were stipulated substantially as follows: The petitioner is a corporation. It was incorporated in the year 1891 under the laws of the State of Massachusetts and has its principal place of business in Worcester, Massachusetts. The petitioner is a retail department store and its place of business is a store building owned by the Denholm & McKay Realty Co., hereinafter called the Realty Co. Its capital stock outstanding in the fiscal year ending January 31, 1935, was 5,000 shares of $100 par common and 5,083 shares of $100 par preferred stock. The petitioner keeps its books upon the accrual basis. Its fiscal year ends January 31. The Realty Co. was incorporated in 1916, its officers at organization being the same as those of the petitioner. It was organized by three individuals with 500 shares of common capital stock, which shares were issued to those*986 three individuals in consideration of services rendered. The facts concerning the early history of these companies as found by the Board in , are to be taken as true in so far as material to any issue here involved. During the petitioner's taxable year the Denholm & McKay Realty Co. had outstanding 500 shares of $100 par common and 7,138 shares of $100 par preferred stock. Its common stock was all held by the petitioner. The petitioner held 252 shares of its preferred stock, which was without voting rights except in case the dividend on it was passed, in which event it had voting rights identical with the common stock until arrears in preferred stock dividends were paid. The dividend on the preferred stock was to be 7 percent, payable quarterly on March 1, June 1, September 1, and December 1. The petitioner is the sole tenant of the Realty Co. and the cash and other considerations paid by the petitioner are the sole source of income of that company. During the taxable year the petitioner agreed to pay in rental to the Realty Co. an amount of rent to be composed of the following items: All taxes assessed on the said property, *987 either assessed to the Realty Co. or to the petitioner, including city, state and Federal taxes; premiums on insurance placed on the property; the costs of all repairs; the amount of interest required or paid by the Realty Co. on all its outstanding indebtedness, both secured and unsecured, together with an amount equal to 7 percent on the preferred capital stock of the Realty Co. now issued and outstanding; the salaries of its (the Realty Co.'s) officers, and all other expenses of the Realty Co. The Realty Co. passed similar resolutions, thus establishing the amount of the rent, and the parties agreed that the payment of accrued charges should be made as the several obligations occurred, *769 became payable, or at such times as might by the mutual agreement of the officers of the companies be determined. The taxes "assessed on siad property" by the city of Worcester during the year which began on February 1, 1934, and ended January 31, 1935, were in two amounts - one amount assessed April 1, 1934, of $56,112.40 and the other assessed January 1, 1935, in the amount of $56,222.08. The taxes assessed on April 1, 1934, were payable on or before October 27, 1934, and the taxes*988 assessed on January 1, 1935, were payable one-half on July 1, 1935, and one-half on October 1, 1935. In making its tax return, the petitioner included among its deductions $56,112.40 taxes assessed on April 1, 1934, but did not include among its deductions the $56,222.08 taxes assessed on January 1, 1935. The petitioner now claims as a deduction for its fiscal year ending January 31, 1935, the $56,222.08 assessed on January 1, 1935. The petitioner received during the year ended January 31, 1935, $7,429.37 from the certain insurance companies representing overpayments on premiums paid. This amount stood upon the books of the petitioner as an account receivable at the beginning of the taxable year in question, and had been accrued as such by income adjustments. It had been reflected in "insurance reserve", a surplus reserve, increases in which had theretofore been reported as income. The Realty Co. purchased the building belonging to the Denholm & McKay Co., hereinafter referred to as the store. The building was at that time, and is now, occupied by the store. The purchase was made in 1916 and the consideration paid for the property was 10,000 shares of Realty Co. preferred*989 stock of a par value of $100 per share. Thereupon, the Realty Co. rented the building to the store at an agreed rental of $264,000 per annum, for a period of 21 years from 1916, and in further consideration of this lease, the store agreed to guarantee "the payment of dividends at the rate of 7% per annum, payable quarterly upon the outstanding preferred capital stock" of the Realty Co. and agreed to guarantee to redeem this stock upon liquidation of the Realty Co. at $110 per share, with any accrued and unpaid dividends thereon. Thereafter the store offered to its stockholders to exchange the Realty Co. preferred stock, which it then owned, for its own then outstanding standing preferred stock. Whereupon, approximately one-half of the holders of preferred stock of the store agreed to such exchange, and it was duly made with them. Thereafter the Realty Co. borrowed $300,000 from various bankers upon notes endorsed by the store. The purpose of this loan, and the reason for the endorsement by the store, was to enable the Realty Co. to purchase 3,000 shares of its own preferred stock from the store. This it did and the $300,000 purchase money was used by the store to apply against*990 its own indebtedness. *770 Thereafter the store entered into negotiations with the owners of the common stock of the Realty Co. and purchased all of the common stock of the Realty Co., paying therefor 1,430 shares of the Realty Co. preferred stock then owned by it and the Realty Co. and the store agreed to cancel the lease then existing between the parties and to enter into a new lease more favorable to the store. At January 1, 1934, the Realty Co.'s sole tangible asset was the building of which the store is tenant. The realty Co.'s balance sheet as of January 1, 1934, included a valuation of $1,503,800 for the land and building, upon which basis the balance sheet showed a deficit of $948,812.41. The valuation of the property by the Treasury Department, based upon cost of $600,000 for the building, would show the Realty Co. had a deficit of $1,148,812.41 on a capital structure of $763,000. In the year 1933 the Realty Co. defaulted in its dividend on the preferred stock which was due June 1, 1933, and again defaulted on the dividends of September 1, 1933, December 1, 1933, and March 1, 1934. After this default, the preferred stockholders of the Realty Co. exercised*991 their right to vote as provided in the preferred stock certificate as follows: The Preferred Stock is entitled to receive a dividend of seven per cent (7%) per annum to be paid in quarterly installments the first days of March, June, September and December; said preferred stock not to participate in any voting power unless a dividend is passed, in which case it is to have full voting power with the common stock until such time as all dividends in arrears are paid. In the year 1934 the Realty Co. used the rent money paid by the store to reduce its bank loans, to the extent of approximately $50,000, the banks having brought pressure to bear for payment. Having used the money for this purpose, the Realty Co. continued to default on its dividends. The preferred stockholders continued to exercise their right to vote throughout the years 1934, 1935, and 1936 and thereafter. During the year 1934 various preferred stockholders demanded that dividends be paid by the store upon its guarantee of the Realty Co. stock. Because of these demands the store sought advice of counsel as to its liability under the guarantee agreement and was advised that it could not escape liability. Thereupon*992 it did in the taxable year in question pay dividends upon the preferred stock of the Realty Co. in the amount of $36,150.50. Dividends in the total amount of $36,150.50 paid by the petitioner in its fiscal year ended January 31, 1935, on preferred stock of the Realty Co. represented dividends of 7 percent applicable to the three quarterly periods June 1, September 1, and December 1, 1934, on 6,886 shares held by others than petitioner; i.e., on the 7,138 shares *771 outstanding less the 252 shares held by the petitioner. There was no agreement or understanding between the petitioner and the Realty Co. that the $36,150.50 paid by the petitioner as dividends on the Realty Co.'s preferred stock would be returned to the petitioner in whole or in part at any time by the Realty Co. The amount was immediately charged off on the petitioner's books to profit and loss. The petitioner's income tax return for the fiscal year ended January 31, 1935, reflected net taxable income of $5,973.62 and income tax liability of $821.37, which was paid. Two of the items in dispute, $36,150.50 paid by the petitioner as dividends on preferred stock of the Realty Co. and $7,429.37 representing*993 the return of certain deposits made by the petitioner with insurance companies, were not included in net income in the return. The deduction of $56,222.08 claimed on account of the taxes assessed January 1, 1935, was not claimed on the return. At the time these dividends were paid, the defaulted 1933 dividends were still unpaid. OPINION. VAN FOSSAN: The first issue involves the deductibility of payments of the preferred dividends of the Realty Co. made by the petitioner under the guarantee contained in its lease agreement with that company. The petitioner contends that the payment of such dividends was in performance of its promise incurred in 1916 as a part of the rent consideration and was the primary obligation of the petitioner, with no right of subrogation against anyone. The respondent's position is that the expenditure was in the nature of a capital investment enhancing the value of the petitioner's stock and thus not deductible. The Realty Co. was organized in 1916 to hold and operate the real estate in which the petitioner's store was situated. The lease from the Realty Co. to the petitioner contained a clause providing that the petitioner would guarantee*994 the payments of dividends on the preferred stock of the Realty Co. and would redeem such stock upon the liquidation of the Realty Co. It is clear on examination of the stipulated facts that article 24-2 of Regulations 86 1 (restating the same principle contained in prior regulations), cited by the respondent, does not apply. Petitioner was not a holding company and did not guarantee the dividends for *772 the purposes stated in the article. In fact, the respondent does not attempt to bring the relationship within the language of the regulation. He assumes to make the principle therein set forth generally applicable, regardless of the fact that the petitioner was not a holding company. This position is wholly unwarranted. The guarantee provision was incorporated in*995 the lease to secure more favorable terms for the petitioner. These was no agreement that the petitioner could have recourse on the Realty Co. for reimbursement if the former paid the dividends. It was an outright promise to pay, not made for the purpose of increasing the value of the petitioner's stock or of securing new capital. The terms of the 1916 lease were modified by the lease agreement covering the taxable year, but the dividend guarantee provision was retained and such dividends, amounting to $36,150.50, were paid by the petitioner. That sum was specifically made a part of the petitioner's rent and was charged off on the petitioner's books. The respondent cites several cases to support his theory, but all of those cases contain such vital differences in facts that it would serve no purpose to discuss them. However, his following quotation from , is pertinent to the case at bar: There is no general rule that a payment by a shareholder to his corporation or to one of its obligees to relieve it of an existing obligation is per se a contribution by him to its capital which augments the cost of his shares. *996 The question is controlled by the circumstances in which the payment is made. If there is intent that the payment shall enlarge the stock investment, the shareholder may not for tax purposes treat it otherwise to support a loss or a bad debt deduction. Whether there is such intent, actual or to be implied, is determinable upon evidence which may vary in different cases. Cf. ; . The following excerpt from the same case is equally apt: The evidence here is clear. When petitioner made his payments, both on his endorsements and his guarantees, he had no illusions about the condition of the corporation and no intention to invest more capital. He paid only because he was legally obligated to do so, and the obligation was not an incident of his being a shareholder but was incurred with the intention of creating a potential debtor and creditor relation. To attribute to him an intention to invest more money in the corporation's shares is contrary to the express evidence and not a fair inference from the circumstances. And it is equally clear that there was no intention to make a gift. *997 The petitioner's obligation to pay the preferred dividends of the Realty Co. was originally incurred and continued to exist in 1934 only as a part of its rental. There is nothing in the record that justifies the inference that the guarantee was made for capital purposes. In , the petitioner paid the interest and taxes chargeable to the lessor under his lease of an apartment. *773 Such expenditures were specifically designated "not as rent." He sought to deduct them under section 23(b) and (c) of the Revenue Act of 1928, but there we said: * * * we think no argument or citation of authority is necessary to support the elemental proposition that, if the circumstances of the case establish that the payments of interest and taxes were made as part of the consideration for the lease of the apartment, then they constituted additional rent, and such fact is not changed and can not be disregarded because of a contrary statement contained in the lease contract between the petitioner and his lessor. However, notwithstanding said statement in the lease contract, we think a fair construction of the provisions of that contract clearly*998 indicates that the interest and taxes paid by the petitioner constituted nothing more nor less than additional rental. * * * In that case the petitioner did not attempt to show that the payments were deductible as a business expense or "otherwise than interest and taxes." Here, however, the petitioner does claim that they are deductible as rent and, hence, are an allowable business expense. We agree with the petitioner's contention and allow the deduction. The second issue has been settled by stipulation. The sum of $7,429.57, representing insurance premium overpayments, is not taxable to the petitioner. The third issue relates to the deductibility of property taxes, amounting to $56,222.08, assessed to the Realty Co. on January 1, 1935, and payable one-half on July 1, 1935, and one-half on October 1, 1935. The respondent concedes that taxes of this character accrue when assessed (). He states that ordinarily the petitioner, on an accrual basis, would be entitled to deduct the total amount of accrued taxes but places such accrual in the same category as the payment of the guaranteed dividends. He insists that the taxes so paid*999 should be added to the cost of the petitioner's stock and that the deduction should be denied. The same reasons for allowing the deduction under the first issue are applicable to the allowance of accrued taxes. Article 23(a)-10 of Regulations 86 contains the following rule: * * * Taxes paid by a tenant to or for a landlord for business property are additional rent and constitute a deductible item to the tenant and taxable income to the landlord, the amount of the tax being deductible by the latter. * * * According to the stipulated facts the taxes were paid as a portion of the rental and the taxes assessed on April 1, 1934, were included in the petitioner's deductions on its return. No objection was made by the respondent to the deduction of the taxes assessed on April 1, 1934, and, therefore, such taxes have been allowed by the respondent. These stipulated facts are inconsistent with the respondent's present position. *774 The respondent's contention can not be sustained. Otherwise, we would be lead to the untenable situation in which the cost of the petitioner's stock in the Realty Co. would be increased as each successive installment of taxes and other rental*1000 equivalent might be paid. The item of $56,222.08, representing taxes accrued on January 1, 1935, is deductible from the petitioner's gross income. Decision will be entered under Rule 50. Footnotes 1. * * * A holding company which guarantees dividends at a specified rate on the stock of a subsidiary corporation for the purpose of securing new capital for the subsidiary and increasing the value of its stock holdings in the subsidiary may not deduct amounts paid in carrying out this guaranty in computing its net income, but such payments may be added to the cost of its stock in the subsidiary. ↩