1432 BROADWAY CORP. v. COMMR. OF INTERNAL REVENUE, 4 T.C. 1158 (1945)
Docket No. 1828.United States Tax Court.
Promulgated April 20, 1945.
Amounts accrued by a corporation as interest on debentures issued to its shareholders with shares at the time of incorporation, held, under the circumstances, not deductible as interest.
A. Loeb Salkin, Esq., and David Boyd Chase, Esq., for the petitioner.
Sidney B. Gambill, Esq., and Laurence F. Casey, Esq., for the respondent.
The Commissioner determined deficiencies as follows:
Of several adjustments, petitioner assails the disallowance of a deduction taken as interest.
FINDINGS OF FACT.
The taxpayer, a New York corporation, was incorporated May 23, 1932. Its books were kept and its returns were made on an accrual and a calendar year basis. Its returns were filed in the third district of New York.Page 1159
Al Hayman, a resident of New York, died February 10, 1917, and by his will he bequeathed the residue of his estate in trust, the income to be paid to his wife, Minnie Hayman, during life and the remainder, after retaining in trust $250,000 and payment of specific bequests, to be divided equally among the surviving children of his sisters, Rose Hochstadter, Blanche Meyer, and Ella Bernheimer. Minnie Hayman died April 16, 1928. Five children each of Ella Bernheimer and Rose Hochstadter and four children of Blanche Meyer survived testator, and in 1931 they resided in various places in the United States. The property to be divided among the surviving children included real property and improvements at 1428-1432 Broadway and 116-132 West 40th Street, New York City. By a lease dated January 28, 1920, made by the executors with Famous Players-Lasky Corporation, the part of the above premises known as the Empire Theatre Buildings was leased for a term beginning May 1, 1922, and ending April 30, 1943, at an annual rental of $50,000. By a lease dated May 1, 1920, made with the New York Gekco Co., the remaining part of the premises was leased for a similar term at an annual rental of $35,000. The lessees were required to pay maintenance and operation expenses, alterations and repairs, taxes, assessments, water rents, and insurance.
At the incorporation of taxpayer the depreciated inheritance tax valuation of the real property as of the date of Al Hayman’s death was:
Upon petition of Sanford J. Bernheimer, one of the children of Ella Bernheimer, the Surrogate’s Court of New York, on August 17, 1931, ordered the sale of the above property at public auction for cash at any date after October 1, 1931, but not later than November 15, 1931. The other parties in interest wanted to avoid such a sale. Several plans were submitted to Bernheimer and were rejected. By order of the court the sale was postponed to December 10, 1931. An agreement was made December 5, 1931, by Bernheimer, as first party, and the others, as second parties, for the sale to them of Bernheimer’s one-fourteenth interest for $85,714.28, payable $25,000 on December 30, 1931, and $60,714.28 on June 30, 1932, plus 6 percent interest from December 30, 1931, but subject to the deduction of one-fourteenth of all expenses incurred by the trustee of the residuary estate on or before December 30, 1931, for advertising the sale, auctioneers’ fees, title examination, and trustee’s commissions.Page 1160
After further negotiations, the parties, other than Bernheimer, made a “Syndicate Agreement” on January 29, 1932, wherein Joseph Milner, Lionel Straus, and Lester Meyer were designated as “Managers” and the parties in interest “Syndicate Members,” and whereby, after reciting, inter alia, that:
the Syndicate Members are desirous of combining their several interests as beneficiaries under the said last will and testament, for the purpose of acquiring, in the manner hereinafter set forth, and operating and holding the said property,
the syndicate members formed a syndicate:
To acquire the said real and personal property, and to provide the finances required for the maintenance and operation thereof; and in order to facilitate their accomplishment of said purposes, said Syndicate Members do hereby designate and appoint Joseph Milner, Lionel Straus, and Lester Meyer, their Managers, and do hereby confer upon them the powers and authority hereinafter set forth.
To provide funds for the purchase of the Bernheimer interest, the syndicate members agreed to authorize the trustee of the Hayman residuary estate to pay $25,000 to Bernheimer without making similar payment to each of the syndicate members, and the managers were authorized at any time in their discretion to borrow on first mortgage maturing not less than three years thereafter covering the real estate, and to use the amount borrowed to pay the balance due Bernheimer and certain enumerated expenses. The balance, less $75,000, was to be distributed among the syndicate members “for their own use and benefit, pro rata, according to their respective distributive shares of said real property.” The managers were authorized to form a corporation “to hold and operate real and * * * personal property,” to convey to the corporation the real estate and $75,000 or any lesser sum retained by them from the borrowed funds, and to cause the corporation to issue to them jointly in full payment all its capital stock and debentures, the capital stock to be assigned by the managers to themselves as voting trustees. It was provided that the voting trustees should not vote in favor of the sale of the real property unless the sales price be $1,200,000 or more, and:
That so long as the amount of cash or its equivalent in the form of liquid investments to the credit of the Reserve Fund for Contingencies of said corporation shall be not less than Seventy five thousand ($75,000) Dollars, said Voting Trustees shall, so far as they prudently may, cause said corporation to distribute quarter-annually to its Debenture holders and/or Stock holders, all surplus income of said corporation.
The primary purpose of the syndicate agreement was to provide for the ownership and operation of the property by a corporation until it could be sold and in the meantime to distribute all surplus earnings and profits, except for the reserve for contingencies, to the syndicate members.Page 1161
At the time the syndicate agreement was executed, the thirteen parties in interest conveyed the property to the managers. The managers on June 3, 1932, borrowed $300,000 from the Bank for Savings in the city of New York, for a term of five years at 5 1/2 percent interest, payable semiannually, with the right to pay multiples of $10,000 of principal on any interest date, and as collateral security for the payment of the indebtedness a mortgage upon the property maturing June 3, 1937, was given to the bank. Out of such funds approximately $60,000, the balance due Bernheimer, was paid to him, and he conveyed his undivided one-fourteenth interest to the managers. Also out of such funds the managers paid to the members $195,000 and some miscellaneous expenses, leaving $40,000 in their hands.
Pursuant to the syndicate agreement, the taxpayer corporation was organized May 23, 1932, with a capital stock of 390 no par shares, consisting of 120 class A, 120 class B, and 150 class C. Holders of class A shares were entitled as a class to elect the class A director, and the holders of class B and class C were similarly entitled to elect the class B and the class C directors, respectively. The three class directors were not required to be shareholders. The duration of the corporation was to be perpetual and its purposes were, among other things, to acquire 1428-1432 Broadway and 116-132 West 40th Street; to maintain, operate, and develop such property, and any property for which it might be exchanged; to borrow money; and to issue its own shares and debentures for the acquisition of such real property.
At the first meeting of the corporation, May 23, 1932, the syndicate managers offered to transfer and convey to the corporation $40,000 and the real property upon the condition that the corporation issue all its authorized capital stock to voting trustees as designated and “Ten Year 7% Debenture Bonds” to the syndicate members in the amounts set opposite their names aggregating $1,170,000. This proposal was accepted.
On June 3, 1932, the syndicate managers made a voting trust agreement and assigned to themselves as voting trustees all the capital stock, to be held by them subject to the trust agreement. The voting trustees were to issue voting trust certificates to the syndicate members. Joseph Milner was designated as the class A voting trustee, Lester Meyer as the class B voting trustee, and Lionel F. Straus as the class C voting trustee. The agreement, among other things, provided:
Without the affirmative vote first duly had and obtained, of the holders of voting trust certificates representing not less than two-thirds of all outstanding stock of said Company, the Voting Trustees shall not vote in favor of any sale of the real property owned by the Company, known as 1428-1432 Broadway and 116-132 West 40th Street, in the Borough of Manhattan, City and State of NewPage 1162
York, unless the sale price shall be the sum of One Million Two hundred thousand Dollars ($1,200,000), or more, but this provision shall not be deemed as in any way limiting the absolute discretion of the said Voting Trustees in the determination of the terms and conditions upon which any sale of said real property may be effected by the Company, including the proportion of the purchase price which is to be paid in cash and the proportion thereof, if any, to be secured by purchase money mortgage covering said real property, and the terms and conditions of such purchase money mortgage, if any.
So long as the amount of cash or its equivalent in the form of liquid investments to the credit of the Reserve Funds for Contingencies of said Company shall be more than Seventy-five thousand Dollars ($75,000.), the Voting Trustees shall, if in their uncontrolled discretion they deem it wise and prudent so to do, cause said Company to distribute quarter-annually all surplus income of said Company, either by way of dividends on its outstanding capital stock or by way of payment in liquidation of the principal of its Debentures or by way of payment of interest thereon.
On June 3, 1932, the syndicate managers conveyed the real property, subject to the $300,000 mortgage, and the $40,000 to the taxpayer and it issued to the voting trustees 120 class A, 120 class B, and 150 class C shares. On the same day the voting trustees issued voting trust certificates and the taxpayer issued its “Ten Year 7% Debentures” maturing March 11, 1942, to the syndicate members as follows:
Since taxpayer’s incorporation there have been several transfers by inheritance of its debentures and voting trust certificates, but the above transfers by Milner are the only transfers of debentures without a corresponding pro rata transfer of voting trust certificates. The provisions on the face of the debentures were as follows:
1432 BROADWAY CORPORATION, a Corporation, * * * for value received, hereby promises to pay to __________ the sum of __________ Dollars onPage 1163
March 11, 1942, at the office of Corporation in the City of New York, with interest from March 11, 1932, at the rate of seven per cent per annum payable quarter-annually or otherwise, as hereinafter provided, at the office as aforesaid, or by mail to the registered address of the owner hereof.
This Debenture is one of a duly authorized issue of debentures of the corporation of like date, tenor and effect evidencing an aggregate indebtedness of One Million five hundred thousand ($1,500,000.) Dollars and the following is a statement of the rights of the holder of this Debenture and the conditions to which this Debenture is subject, to all of which provisions the holder hereof, by the acceptance of this Debenture, assents:
1. All Debentures of this issue rank equally and ratably without priority over one another.
2. The right title and interest of the holder hereof in and to said principal sum or any part thereof and the interest due and to grow due thereon, is and shall remain subject and subordinate to the claims of all contract creditors of the Corporation, and upon dissolution or liquidation of the Corporation no payment shall be due or payable upon this Debenture unless and until all other contract creditors of the Corporation shall have been paid in full.
3. Interest on all Debentures of this issue may at the option of the Corporation (a) be deferred or suspended without limit of time, or (b) be paid in whole or in part in cash or in interest bearing Debentures of the Corporation, but such suspension of payment shall in no wise relieve the Corporation of the obligation to pay accrued interest thereon at some future time, not later than March 11, 1942.
4. No holder of Debentures of this issue shall institute any suit, action, or proceeding for the enforcement of the payment of principal and/or interest unless the holders of seventy five (75%) per cent in amount of all outstanding Debentures of this issue, join in such suit, action, or proceeding.
5. The Corporation may at any time at its own option, prepay in whole or in part the principal sum of all outstanding Debentures of this issue, on thirty days written notice served by registered mail to the registered address of the owners of all outstanding Debentures of this issue.
6. This Debenture is transferable only upon the books of the Corporation by the holder hereof in person or by duly authorized attorney at the office of the Corporation in the City of New York on surrender of this Debenture properly endorsed.
7. The Corporation may deem and treat the person whose name appears above as the absolute owner hereof for the purpose of receiving payment of or on account of the principal and/or interest due hereon and for all other purposes.
8. This Debenture is the corporate obligation of the Corporation only, and no recourse shall be had for the payment thereof or the interest thereon against any stockholder, officer or director of the Corporation either directly or through the Corporation by virtue of any Statute for the enforcement of any assessment or otherwise; all such liability of stockholders, directors and officers as such being released by the holder hereof by the acceptance of this Debenture.
* * * * * * *
Payments on account of Principal of this Debenture are noted on the Reverse side hereof.
Prior to the maturity date of the debentures, March 11, 1942, taxpayer procured from each holder a written consent that the maturity of the unpaid principal and accrued interest be extended to March 1, 1947, and this was endorsed on the debentures.Page 1164
All the outstanding debentures have been recorded on the books as “Ten Year Seven Per Cent. Debenture Bonds, due March 11, 1942,” distinct from outstanding capital stock.
On taxpayer’s books the value of the land and buildings was set up as $1,430,390, of which $41,362.59 was charged to buildings.
In each year between 1932 and 1941 taxpayer recorded on its books the aggregate amount of interest accrued on its outstanding debentures. No part of such interest has been paid except $1,248.74 which was paid in 1933. On June 21, 1932, and at various times thereafter to September 24, 1941, the taxpayer set aside from its surplus funds various amounts to be applied pro rata in reduction of principal of debentures. Such payments were made and so noted on the reverse side of debentures. From 1932 to 1941 the accrued debenture interest, reported income or loss, and amounts paid on account of principal were:
In its 1939, 1940, and 1941 returns taxpayer reported rents of $85,393.84, $214,222.10, and $173,930.88. Its balance sheets as of December 31, 1939, 1940, and 1941, showed deficits of $283,140.16, $219,669.22, and $192,569.22.
On December 31, 1941, the principal of the mortgage of $300,000 had been reduced to $140,000.
1. The Commissioner disallowed the deduction taken by the taxpayer of the “interest” accrued upon the outstanding debentures, and the taxpayer undertakes to establish that the debentures are evidences of indebtedness, that the accrued amounts are interest thereon, and that, since the method of its accounts is an accrual method, such amounts are deductible by it in the year of accrual. Sec. 23 (b), I. R. C. The evidence and argument follow a familiar pattern to show that the debentures have attributes of indebtedness. Cf. Charles L.Huisking Co., 4 T.C. 595. The debenturesPage 1165
are in approved legal form, and, if their legal attributes alone were determinative of the character of the interest accruals, there would be little room for doubt that they were the indebtedness they purport to be. Cf. Clyde Bacon, Inc.,4 T.C. 1107. But, for tax purposes, their conformity to legal forms is not conclusive. Although a taxpayer has the right to cast his transactions in such form as he chooses, and the form he chooses will generally be respected, the Government is not required to acquiesce in the taxpayer’s election of form as necessarily indicating the character of the transaction upon which his tax is to be determined. “The Government may look at actualities and upon determination that the form employed for doing business or carrying out the challenged tax event is unreal or a sham may sustain or disregard the effect of the fiction as best serves the purposes of the tax statute.”Higgins v. Smith, 308 U.S. 473. See also Commissioner v.Court Holding Co., 324 U.S. 331. The Government is not bound to recognize as the substance or character of a transaction a technically elegant arrangement which a lawyer’s ingenuity has devised. Griffiths v. Commissioner, 308 U.S. 355.
We therefore bypass the examination of the legalistic craftsmanship of the debentures which the taxpayer invites and go directly to the circumstances to determine whether, notwithstanding their form, the substance of the transaction which they purport to evidence was in actuality a loan or indebtedness and whether the substance of the accrual sought to be deducted is in reality interest. The corporation was formed as a means of holding a piece of productive real property in New York City which had been left by a decedent to fourteen individuals scattered about the country, one of whom was discontented and wanted the property sold and his interest converted into cash. A plan was devised whereby the others would buy him out. This corporation was the result, and to it the property was transferred. No loan was made to the corporation by the owners, either of property or of money. The property was worth at least $1,200,000 (maybe more) and was yielding $85,000 rent; a mortgage was given for $300,000, and the equity plus $40,000 was contributed by the owners to the new corporation for all of its 390 shares and the debentures, aggregating $1,170,000, entirely unsecured. The corporation in the tax years had substantial deficits. In these circumstances, there is no identification of the portion of the contribution contributed for the shares and the portion contributed for the debentures, and the latter was no less at the risk of the business than the former. The entire contribution was a capital contribution rather than a loan, but by the form adopted the corporation was in a position to feign that its rent income was used as a means of discharging its debenture obligation, giving it a tax deduction, and not as a distributionPage 1166
of dividends, which would not be deductible. Cf. Edward G.Janeway, 2 T.C. 197; 147 F.2d 602; Commissioner v. KelleyCo., 146 F.2d 466 (C.C.A., 7th Cir., Dec. 21, 1944);Talbot Mills v. Commissioner, 146 F.2d 809. The distribution of the rent income, whether called interest or principal on debentures or dividends on shares, would go to the same persons in the same proportions, since each had the same proportionate number of both, and it would matter not to them whether the distribution was called dividends or interest. But to the corporation on the accrual method it mattered materially whether the distribution was called interest, thus being deductible in computing its taxable net income, even though not actually paid, or dividend, which would be without a favorable tax effect. The agreements show that the voting trustees could in their discretion elect to cause the corporation to distribute surplus either as dividends or as interest or principal. Such an election of form by the taxpayer, although permissible for its own purposes, is not one in which the Government is required to acquiesce, but is one which for the purpose of the tax statute it may disregard as a fiction. Since we are of opinion that the evidence does not show that the debentures were, or were intended to be, evidences of indebtedness, and the Commissioner has determined that the amounts accrued by the corporation as interest were not such, we think that under the decisions of the Supreme Court the determination must be sustained.
As in Charles L. Huisking Co., supra, in which a similar plan was devised and defended by the same lawyer (cf.Commissioner v. O. P. P. Holding Co., 76 F.2d 11), these securities are more nearly like preferred stock than indebtedness. The debentures are unsecured and are subordinated to the claims of all creditors, and, although interest is in form absolute, none (except $1,248.74 in 1933) has been paid and payment could be deferred by the corporation entirely until 1942 and longer (as in fact it was), and the debtor was immune from suit unless 75 percent of the holders joined. It is idle to argue that the debentures were transferable and must therefore be judged separately from the shares, for they were issued to the same persons as held the shares, and in the same proportions, and they were not in fact transferred. No significance can be given to the fact that Milner transferred $15,000 of his debentures to his wife and $15,000 to Bauman in trust, or that once, in 1933, $1,248.74 was actually paid and treated as interest on the debentures. Interest is payment for the use of another’s money which has been borrowed, but it can not be applied to this corporation’s payment or accruals, since no principal amount had been borrowed from the debenture holders and it was not paying for the use of money.
The Commissioner’s determination disallowing the deduction taken for interest on the debentures is sustained.Page 1167
2. An issue under Internal Revenue Code, section 734, is cloudily presented in respect of an inconsistent position taken by the taxpayer as to its excess profits credit based on invested capital. In its excess profits tax returns for 1940 and 1941 the taxpayer included the value of its property in its invested capital as property “paid in for stock.” This was inconsistent with its position in its earlier income tax returns, the correction of which is now prevented by operation of law, that the debentures represented an indebtedness. This inconsistent position was, however, one from which, by the Commissioner’s regulations (Regulations 112, sec. 35.734-2), it was permitted to withdraw. The taxpayer did by a timely letter withdraw from its inconsistent position and at the hearing expressly waived it. The Commissioner has also taken a similar inconsistent position, for, while he disallowed the deduction of interest on the debentures, he nevertheless treated the debentures as “borrowed capital” for the purpose of computing the excess profits tax credit. Hence, no adjustment of the income taxes for 1932, 1935, 1936, and 1937, under section 734, is to be made. The earlier years of such deductions are not within the limitation period and the allowance therefore is not subject to correction. The present decision is therefore confined to the approval of the determination for the years in issue disallowing the deduction for interest, and requires the inclusion in equity invested capital of the value of the property paid in for the pseudo debentures as if such payment had been in form as well as substance paid in for preferred shares.
Decision will be entered under Rule 50.