Harris-Emery Co. v. Commissioner , 37 B.T.A. 958 ( 1938 )

HARRIS-EMERY COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Harris-Emery Co. v. Commissioner

Docket No. 86060.

United States Board of Tax Appeals

37 B.T.A. 958; 1938 BTA LEXIS 955;

June 1, 1938, Promulgated

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The unamortized value of leases in existence on March 1, 1913, which were later extended, should be prorated over the terms of the leases as extended.

Arnold F. Schaetzle, Esq., for the petitioner.

Paul E. Waring, Esq., for the respondent.

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SMITH

This proceeding involves deficiencies in petitioner's income and excess profits tax as follows:

	Deficiency
Fiscal year ended	Income tax	Excess profit tax
January 31, 1933	$1,172.78
January 31, 1934	1,015.84	$56.37

The petition alleges that "The respondent erred in prorating allowable depreciation on leasehold and leasehold improvements over a period ending March 31, 1953."

FINDINGS OF FACT.

The petitioner is an Iowa corporation, with its principal place of business at Des Moines.

For many years prior to January 15, 1927, the petitioner conducted and operated a large retail department store in the City of Des Moines at the corner of Seventh and Walnut Streets. The department store business was conducted in a seven story building which was erected on leased ground. The petitioner did not erect the building. The ground upon which the building was erected consisted of three separate parcels, each parcel being owned in fee simple by separate parties in interest. The west 66 feet along Walnut Street and extending 132 feet on Seventh Street was owned in fee simple by the Rothwell estate; the next 22 feet adjoining on the east was owned in fee simple by the Estate of Charles Weitz, Inc.; the next adjoining 44 feet on the east, hereinafter referred to as the east 44 feet, was owned in fee simple by four persons, hereinafter referred to as the Frankel interests.

Certain improvements to the store building occupied by the petitioner prior to January 15, 1927, were made and paid for by the petitioner. The store building is one continuous building covering the entire 132 feet along Walnut Street.

The original store building was erected about 1898 and covered only the ground owned by the Rothwell estate and the Estate of Charles Weitz, Inc., i.e., the west 88 feet. The petitioner's occupancy of the above described premises commenced in April 1900. In the first instance the tenancy expired on March 3, 1910; later the term was extended to March 31, 1915, and in June 1908, by appropriate instruments of lease, was further extended to March 31, 1925. The Weitz lease in effect on March 1, 1913, provided that the petitioner should pay $3,275 annual rental to March 31, 1913; an annual rental of $3,521.25 from April 1, 1913, to March 31, 1918; an annual rental of $3,783.46 from April 1, 1918, to March 31, 1923; and an annual rental of $4,065.35 from April 1, 1923, to March 31, 1925. The Rothwell lease in effect on March 1, 1913, provided for an annual rental of $13,319.20 to March 31, 1915; for an annual rental of $1j,618 from April 1, 1915, to March 31, 1920; and an annual rental of $16,118 from April 1, 1920, to March 31, 1925. In 1914 the petitioner requested the lessors to add two or three stories to the building so as to make a seven story building, which was done. In the month of March 1914, by appropriate instruments of lease, each of the above mentioned lease agreements was merged into a new lease agreement extending the tenancy of the respective premises to March 31, 1940. Under the new lease agreement, the petitioner paid additional rentals for at least a part of the term. The rental reserved in the Weitz lease from April 1, 1925, to March 31, 1930, was $5,000; for the succeeding five years $5,375; and for the last five years ending March 31, 1940, $5,778.13. There was a provision that the rental for the last named term might be increased, as a result of an appraisement, to an amount in excess of $5,778.13 per annum. The petitioner was obligated under the new lease agreement with the Rothwell estate to pay an annual rental of $1,,033.92 for the period April 1, 1925, to March 31, 1930; $19,833.92 for the period April 1, 1930, to March 31, 1935; and $19,833.92, plus certain additions, for the period April 1, 1935, to March 31, 1940.

About 1915, A. Frankel, Jr., M. Frankel, N. Frankel, and M. Rosenfield, all substantial stockholders in the petitioner corporation, purchased outright the east 44 feet. These four parties then erected thereon an addition to the building covering the west 88 feet owned by the Rothwell estate and the Estate of Charles Weitz, Inc., respectively. The floor levels of the addition on the east 44 feet were matched with the floor levels of the old building and the style of architecture was made to conform to the old building, so that when the additions were completed there was one continuous building covering the entire premises. On June 1, 1918, the entire east 44 feet was conveyed by the four above named parties to the petitioner in fee simple in exchange for certain of its capital stock and the assumption of the mortgage on the property. In 1922 the petitioner reconveyed this tract to the four above named parties in fee simple, the stock previously issued therefor was canceled, and the petitioner was released from the obligation under the mortgage. The petitioner then leased the east 44 feet from the four named individuals under date of April 29, 1922. This lease provided for an annual rental of $29,200 to March 31, 1926; $30,200 from that date to March 31, 1936; and $31,200 from that date to March 31, 1940, upon which latter date the lease terminates. This lease was acquired by the petitioner without cost.

On December 13, 1924, the petitioner made a new lease with the Estate of Charles Weitz, Inc., under the terms of which the middle 22 feet was leased for a term expiring December 31, 2023. This renewal of the lease was not before the Board and was not considered by the Board in its opinion recorded at 10 B.T.A. i97. The rental for the Weitz tract was stipulated to be $8,500 per annum until March 31, 1940, and $1i,000 per annum thereafter until the termination of the lease.

In the fall of 1926 the petitioner began negotiations with Younker Bros., Inc., a corporation likewise conducting a retail department store on Walnut Street in Des Moines, with a view to effecting a merger and consolidation of the respective merchandising businesses of the two corporations. Younker Bros., Inc., occupied a large store building covering an entire block between Seventh and Eighth Streets on the north side of Walnut Street. A merger and consolidation of the two stores was possible only if and when the petitioner could procure a tenant for its store building, the plan of merger contemplating that all of petitioner's stock of merchandise, equipment, and records would be moved into the building occupied by Younker Bros., Inc. On January 10, 1927, the consolidation agreement was executed, effective as of January 15, 1927. All the assets of the petitioner, except leasehold and leasehold improvements, were transferred to Younker Bros., Inc., for $1,200,000 of its $100 par value preferred stock. Such stock was then distributed to the stockholders of the petitioner so that after the merger the petitioner's only remaining assets were leaseholds, leasehold improvements, and an account receivable from Younker Bros., Inc., for $119,381.66, representing the excess value of assets transferred over the $1,200,000 of stock issued. At the commencement of negotiations for this merger petitioner had three leases covering the premises in which its store was located, i.e.:

(a) The Rothwell estate lease which had been extended in March, 1914, to expire March 31, 1940, covering the west 66 feet.

(b) A lease with the Estate of Charles Weitz, Inc., expiring December 31, 2023, and covering the middle 22 feet.

(c) The lease with the Frankel interests expiring March 31, 1940, and covering the east 44 feet.

In order to make the contemplated merger with Younker Bros., Inc., possible the petitioner sought and procured as a tenant for the building S. Davidson & Bros., Inc., a corporation operating a largee retail furniture store in Des Moines, S. Davidson & Bros., Inc., was unwilling to enter into any sublease contracts with petitioner for any term expiring March 31, 1940. Accordingly, it was necessary for the petitioner so to arrange its affairs that it would be possible for S. Davidson & Bros., Inc., to obtain lease agreements that would not expire until March 31, 1953.

The Weitz lease for the middle 22 feet would not expire until 2023; hence, it was not necessary for petitioner to procure any further extension of this lease. The Rothwell lease and the lease with the Frankel interest would expire March 31, 1940.

An agreement was entered into on December 1, 1926, between the Rothwell estate and the petitioner under which the term of the Rothwell lease was extended to March 31, 1953, with the provision that after March 31, 1940, the annual rental would be:

* * * an amount equal to the total annual rental (with all additions thereto) actually payable on the leased premises under the provisions hereof for the year ending March 31, 1940, plus such sum as the Trustees and the Company may mutually agree in writing, or appraisers may decide as hereinafter provided, should be added to said total rental payable for the year ending March 31, 1940, to make the annual rental for each of said six years a fair and proper rental; * * *

On December 31, 1926, a leasehold agreement was entered into between the petitioner and the Frankel interests as joint lessors, parties of the first part, and S. Davidson & Bros., Inc., lessee, party of the second part. This agreement of December 31, 1926, provides in part as follows:

In consideration whereof, lessee does hereby covenant and agreed to pay to the lessors, as rent for said premises, at the office of the lessors in the city of Des Moines, Iowa (or at such other place or places in Des Moines as the lessors may in writing designate), as follows:

From the beginning of this lease as above provided, and ending on the 31st day of March, 1935, the lessee shall pay to the lessors, the sum of eighty-four thousand ($84,000.00) dollars per year.

For the period beginning March 31st, 1935, and ending on the 31st day of March, 1940, the lessee shall pay to the lessors, the sum of Eighty-four Thousand ($84,000.00) dollars per year plus such further sum or sums, if any, as shall be added to the rents to be paid by Harris-Emery Company, one of the lessors herein, to the Trustees of the James Rothwel Estate, under the lease and the several extensions thereof, covering said period, made between Harris-Emery Company and said Trustees of the James Rothwell Estate, said lease being dated May 26th, 1900, recorded in Book 405, page 220, records of the office of the Recorder of Polk County, Iowa, and said extensions dated December 2nd, 1903, June 8th, 1908, March 9th, 1914 and December 1st, 1926, all of which are hereinbefore referred to.

For the period beginning on the 31st day of March, 1940, and ending on the 31st day of March, 1953, the lessee shall pay to the lessors, rent for said premises as follows: forty-eight thousand ($48,000.00) dollars for the east sixty-six (E. 66) feet of said demised premises, plus all such further sums for the west sixty-six (W. 66) feet of said premises, as shall be required to be paid by Harris-Emery Company for said period to the Trustees of the James Rothwell Estate, under the lease and extensions thereof, made between Harris-Emery Company and said Trustees hereinabove referred to.

The rentals to be paid the Trustees of the James Rothwell Estate, under their lease and extensions, for the period beginning March 31st, 1935, and ending March 31, 1940, and the rentals so to be paid for the period beginning March 31st, 1940 and ending March 31st, 1953, are to be fixed either by an agreement between the lessee under said lease and the Rothwell Trustees, or by appraisement, as provided in said lease and extensions, and it is agreed between the parties hereto in relation thereto, that in fixing said rentals for said periods, the lessee hereunder, S. Davidson & Bros. Incorporated, may act and are hereby granted power and authority to act for the lessee under said Rothwell lease and extensions, in negotiating with said Trustees in fixing the rentals for said periods, or in making the said appraisements, and the lessors, Harris-Emery Company, shall in any of said negotiations or appraisements, fully cooperate with the lessee, S. Davidson & Bros. Incorporated.

As between the Harris-Emery Co., the petitioner herein, and the Frankel interests there was no separate agreement entered into covering the east 44 feet (Frankel lease), whereby that lease was extended beyond March 31, 1940. However, the Frankel interests, together with the petitioner, as first parties, lessors, executed the leasehold agreement dated December 31, 1926, with S. Davidson & Bros., Inc., as second party, lessee, covering the entire premises.

The petitioner filed an appeal, Docket No. 113, with this Board on September 4, 1924, with respect to its income tax liability for the fiscal period ended January 31, 1918. In its petition the petitioner alleged error on the part of the respondent in failing to allow as a deduction from income an aliquot part of the value of leaseholds as of March 1, 1913, on the Rothwell and Weitz leases due to the exhaustion hereof. This proceeding did not involve the Frankel lease, which was not acquired by the petitioner until April 29, 1922.

On January 27, 1928, this Board promulgated its opinion with respect to the issues raised in the petition referred to above, . The Board found as a fact that the Bothwell lease and the Weitz lease had a combined or merged value of $60,000 as of March 1, 1913. The Board further found and decided that the petitioner was entitled to an exhaustion deduction for the period under review in that case which should be computed upon the basis that from March 1, 1913, to March 31, 1914, a deduction had been allowed on the basis of a period of 12 years and 1 month and that thereafter and during the period under review (fiscal period ended January 30, 1818), the deduction should be based upon the unexhausted value on April 1, 1914, prorated over a period ending March 31, 1940. The Rothwell lease extension dated December 1, 1926, was not before the Board nor considered by it in Docket No. 113, covering the fiscal period ended January 31, 1918.

For the fiscal years under review (ended January 31, 1933, and January 31, 1934), the petitioner deducted from gross income in its tax return for each of those years $2,100.80 for the exhaustion of the March 1, 1913, value of the Rothwell and Weitz leases. This deduction is the same aliquot part of the leasehold value totaling $60,000 as was determined and allowed by the Board in computing taxable net income for the fiscal period ending January 31, 1918, in its opinion promulgated January 27, 1928, in the case referred to above. This amortization of leasehold value is predicated upon a period expiring March 31, 1940, and does not take into consideration the extension dated December 1, 1926, of the Rothwell lease to March 31, 1953. The respondent for the years under review has accepted the March 1, 1913, value of the Rothwell and Weitz leases and has determined an amortization deduction for each year in the amount of $1,015.63 for the leasehold values predicated upon a period ending March 31, 1953. No amortization deduction was allowed by the respondent for the Frankel lease, since this lease had no cost or March 1, 1913, value.

During the year ended January 31, 1926, the petitioner made certain improvements, at an aggregate cost of $121,495.84, for the purpose of joining the basement of its store building with the basement of the "News Building", which was across the alley south of the building occupied by the petitioner. Such improvements extended over the entire 132 feet of the building occupied by the petitioner and improved the entire building. One-half of the cost, or $60,747.92, was allocated to the News Building and no depreciation on that one-half is claimed by the petitioner. The undepreciated cost of improvements as of February 1, 1928, was $91,784.12. No allocation of that underpreciated cost can be made with respect to the separate leaseholds of the petitioner, except on an arbitrary basis.

The depreciation allowances on the improvements for the years here under review have been computed by the petitioner over the period from February 1, 1928, to March 31, 1940. The respondent has determined that the undepreciated cost of such improvements should be amortized over the period February 1, 1928, to March 31, 1953.

OPINION.

SMITH: The first question for the consideration of the Board in this proceeding is the proper allowance for each of the taxable years ended January 31, 1933, and January 31, 1934, for the unamortized March 1, 1913, value of the Rothwell and Weitz leases. Both parties are in agreement that the March 1, 1913, value was $60,000 and that up to the beginning of the first taxable year a certain portion of that cost had been or should have been recovered through amortization allowances. The petitioner contends that such unamortized value should be spread over the period ending March 31, 1940, as determined by the Board in its opinion published at , while the respondent contends that the spread should be made over the period ending March 31, 1953.

In our opinion at , we said:

The leases existing on March 1, 1913, expired on March 31, 1925, but in June, 1914, these leases were merged into a longer term expiring March 31, 1940. We are, therefore, of the opinion that the petitioner is entitled to an exhaustion deduction for the period here under review which should be computed upon the basis that from March 1, 1913, to March 31, 1914, a deduction had been allowed on the basis of a period of 12 years and one month, and that thereafter and during the period here under review the deduction should be based upon the unexhausted value on April 1, 1914, prorated over the years and periods ending March 31, 1940. * * *

The petitioner argues that, since in our prior opinion we determined that for 1918 the unamortized value on April 1, 1914, should be prorated over the period ending March 31, 1940, the rule should apply equally in the determination of the amortization allowance for each of the tax years 1933 and 1934. It argues that the question of the rate of the exhaustion of these leaseholds is res adjudicata. It is to be noted, however, that both the Rothwell and the Weitz leases have been renewed or extended since the taxable year which the Board had under consideration in the prior proceeding. The facts in the instant case, therefore, being different from those previously considered by the Board for the prior taxable year, the determination in that proceeding is not binding in this one.

The petitioner further argues that it will have no net income for the fiscal years ending after March 31, 1940, since after that date all of the rental income received by the petitioner from S. Davidson & Bros., Inc., will be paid over to the lessors. The stipulated facts do not show, however, that the petitioner will have no net income from the rentals after March 31, 1940. They do not show what portion of the rentals received will beling to the Frankel interests. Neither is it made clear that all of the amounts not paid to the Frankel interests will be paid to the lessors of the Rothwell and Weitz tracts.

In , the question before the Board was whether the March 1, 1913, value of certain franchises enjoyed by that company should be exhausted over the term of the original franchise or over the term of that franchise as extended. In our opinion we stated:

It is generally recognized that a franchise is the subject of contract between the state and the grantee and a contract thus created has the same status as any other contract recognized by the law. (Cf. .) In so far as the grantee is concerned, it has a right not unlike that which a lessee under a lease contract acquires. Petitioner contends that such an analogy exists and that the method of determining the amount of the amortization under its franchise and the various extensions or renewals, should be the same as that frequently approved by the courts and by this Board in cases involving leases. A typical illustration of this method is found in , a decision in which the Commissioner acquiesced. Therein the taxpayer acquired a lease in 1920 for $50,000. It was due to run for a period of 10 years, but in 1923, by the payment of an additional $1,000, the taxpayer secured a 10-year extension, viz., until 1940. This Board held that petitioner was entitled to a deduction as amortization during the fiscal year ending June 30, 1924, of one-seventeenth of the unexhausted cost of the lease as extended. To the same effect see also ; ; ; ; certiorari denied, . * * *

Upon the authority of the cases referred to above, and cases cited therein, the Board is of the opinion that the unamortized value of the Rothwell and Weitz leases should be spread over the period ending March 31, 1953, as contended by the respondent.

The only remaining question for decision is whether the cost of improvements of $91,784.12, as shown by the petitioner's books of account on February 1, 1928, should be spread over the period ending March 31, 1940, or over the period ending March 31, 1953. The respondent has determined depreciation allowances upon the basis that the spread should be over the longer period. The stipulated facts do not show that such improvements will be exhausted prior to March 31, 1953, except so far as they relate to improvements upon the Frankel tract. The Frankel lease will expire on March 31, 1940. All of the improvements relate to the store building extending 132 feet on Walnut Street. It is stipulated that no allocation of these improvements to the different tracts can be made except upon an arbitrary basis. Since one-third of the store building is upon the Frankel tract, we are of the opinion that a fair allocation of the improvement to the Frankel tract is one-third of the total. We are, therefore, of the opinion that one-third of the undepreciated cost of the improvements should be spread over the period ending March 31, 1940. The balance of the undepreciated cost of improvements should be allocated to the Rothwell and Weitz tracts and spread over the period February, 1, 1928, to March 31, 1953.

Reviewed by the Board.

Judgment will be entered under Rule 50.