Winter Realty & Constr. Co. v. Commissioner , 2 T.C. 38 ( 1943 )

Winter Realty & Construction Co., Petitioner, v. Commissioner of Internal Revenue, Respondent

Winter Realty & Constr. Co. v. Commissioner

Docket No. 107310

United States Tax Court

2 T.C. 38; 1943 U.S. Tax Ct. LEXIS 144;

June 9, 1943, Promulgated

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Decision will be entered under Rule 50.

1. Prior to the taxable years here involved portions of certain properties owned by petitioner were condemned and taken for street widening. The compensation for the taking was paid to petitioner in the taxable years 1932, 1935, and 1936. Held, under section 112 (f) of the Revenue Acts of 1932, 1934, and 1936, petitioner did not expend any of the award money in the establishment of a replacement fund but did expend part thereof forthwith in good faith in the acquisition of other property similar or related in service or use to the property taken; held, further, in determining the amount of the gain to be recognized under the last sentence of section 112 (f), the amount of "money which is not so expended" is the gross award less commission fees, special assessments levied against the remaining properties, and the amount expended in the acquisition of other property similar or related in service or use to the property taken.

2. During the taxable years 1935 and 1936 petitioner received in addition to the above awards certain amounts designated as interest. Held, the amounts so designated were not a part of the awards but were compensation for delay in payments, Kieselbach et al. v. Commissioner, 317 U.S. 399">317 U.S. 399; held, further, the amounts so designated did not accrue as income until 1935 and 1936, when the final court decrees were entered, Patrick McGuirl, Inc. v. Commissioner, 74 Fed. (2d) 729, followed; held, further, the difference between the amounts so received and the amounts so reported in 1935 and 1936, was correctly added to income in those years by the respondent.

3. Upon the record, held, petitioner has not shown that its officers actually rendered any personal services that would call for a reasonable allowance for salaries or other compensation of an amount in excess of that determined and allowed by the respondent for the taxable years 1935 to 1938, inclusive.

William Cogger, Esq., and Philip F. Biggins, Esq., for the petitioner.

Thomas H. Lewis, Jr., Esq., for the respondent.

Black, Judge.

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BLACK

This proceeding involves the determination by the respondent of deficiencies in income and excess profits taxes against petitioner in amounts and for taxable years as follows:

Year	Income tax	Excess profit
		tax
1932	$ 2,609.82
1935	21,333.59	$ 7,326.42
1936	25,878.65	13,240.82
1937	2,006.30
1938	127.90

Petitioner has assigned eight errors as follows:

(a) For the year 1932 the Respondent erred in adding to Petitioner's income alleged capital gain of $ 23,527.98.

(b) For the year 1935 the Respondent erred in adding to Petitioner's income alleged capital gain of $ 125,735.57.

(c) For the year 1936 the Respondent erred in adding to Petitioner's income alleged capital gain of $ 101,116.10.

(d) For the year 1932 the Respondent erred by adding to Petitioner's income interest disallowed as a deduction, amounting to $ 3,415.67.

(e) For the year 1932 the Respondent erred by disallowing as a deduction taxes amounting to $ 9,600.33.

(f) For the year 1935 the Respondent erred by disallowing an interest deduction of $ 24,537.59.

(g) For the year 1935 the Respondent erred in disallowing officers' salaries of $ 8,400; and for the years 1936, 1937, and 1938 the Respondent erred in disallowing in each year, as officers' salaries, $ 19,200.00.

(h) For the year 1936 the Respondent erred by disallowing as an interest deduction $ 7,287.98.

In addition to the above adjustments to net income made by the respondent which petitioner has assigned as error, the respondent made adjustments to net income for the years 1932, 1935, 1937, and 1938 on account of depreciation which have been accepted by petitioner.

FINDINGS OF FACT.

Petitioner is a corporation, with its principal office in Flushing, New York. Its returns for the periods here involved were filed with the collector of internal revenue at Brooklyn, New York. The returns were made on the accrual basis.

Issues (a), (b), and (c). -- The respondent, in adjusting petitioner's net income for the years 1932, 1935, and 1936, added thereto as capital gain the amounts of $ 23,527.98, $ 125,735.57, and $ 101,116.10, respectively. In a statement attached to the deficiency notice he explained the adjustment for 1932 as follows:

(a) It is held that the profit realized from the condemnation of property by the City of New York constitutes taxable income since the proceeds of the awards were not forthwith expended in the acquisition of other property similar or related in service, or use to the property condemned; nor in the acquisition of control of a corporation owning such property; nor in the establishment of a replacement fund, in accordance with the provisions of section 112 (f) of the applicable Revenue Acts.

[Here follows a computation resulting in a determination of profit of $ 23,527.98 from the condemnation of property for the year 1932.]

The respondent's explanation of the adjustments for 1935 and 1936 was the same as for 1932, except for the computation of the respective capital gains of $ 125,735.57 and $ 101,116.10.

At some time prior to November 4, 1931, the city of New York commenced proceedings for the condemnation and taking of property necessary to widen a public thoroughfare known as the Northern Boulevard in Flushing, New York. Title to the property taken passed to the city of New York on November 4, 1931. A part of the property taken was at the time of the taking owned by petitioner and consisted of five parcels designated as parcels 2, 14, 29, 36a, and 31.

Petitioner was paid for this taking by the city of New York on dates and in amounts ¹ as follows:

		Designated as	Designated as
Date	Parcel No.	award	interest	Total
May 12, 1932	2, 14, 29, 36a	$ 107,978.40		$ 107,978.40
May 12, 1932	31	61,486.20		61,486.20
August 1932		200.00		200.00
Nov. 7, 1935	2, 14, 29, 36a	142,021.60	$ 39,025.75	181,047.35
May4, 1936	31	118,513.80	35,066.19	153,579.99
June 4, 1936		300.00		300.00
Total		430,500.00	74,091.94	504,591.94

In collecting these awards petitioner expended for legal fees $ 9,371.79 in 1932, $ 10,862.84 in 1935, and $ 10,750.60 in 1936, or a total of $ 30,985.23. The city of New York made an assessment against the remaining property in 1935 of $ 5,423.19, and, instead of issuing a warrant for the above total amount of $ 181,047.35, it issued two warrants, one for $ 5,423.19 and one for $ 175,624.16. The city of New York also made an assessment against the remaining property in 1936 of $ 6,946.95, and instead of issuing a warrant for the above total amount of $ 153,579.99, it issued two warrants, one for $ 6,946.95 and one for $ 146,633.04.

The amount of capital gain realized by petitioner (exclusive of interest) due to the taking of the above mentioned property was as follows:

1932	$ 23,527.98
1935	125,735.57
1936	101,116.10
Total	$ 250,379.65

The amount of the awards with respect to parcels Nos. 2, 14, 29, and 36a was in litigation until settled on or about November 7, 1935. The amount of the award with respect to parcel No. 31 was in litigation until settled on or about May 4, 1936.

The above total awards (except the two awards of $ 200 and $ 300) were for land and buildings, respectively, as follows:

Parcel No.	Land	Buildings	Total
2, 14	$ 60,000	$ 4,000	$ 64,000
29	155,000	22,000	177,000
36a	7,000	2,000	9,000
	222,000	28,000	250,000
31	170,000	10,000	180,000
Total	392,000	38,000	430,000

The nature of the above buildings which were compulsorily or involuntarily converted into money was as follows. On parcels 2 and 14 there was a two-story frame building. The first floor was used as a bicycle repair shop and a motorcycle salesroom. The second floor was occupied as an apartment. One tenant occupied that building for about five years preceding 1931. On parcel 29 there was a large brick warehouse erected about 1918 or 1919. It was one building divided by a curtain fireproof wall and was three stories high in front and two stories high in the rear. It also contained a concrete garage which was used for the storage of a moving van. The whole improvement was occupied by one tenant up until the time the city took it over. On parcel 36a there was a frame shop and a two-story frame building. The shop had been occupied for ten or twelve years prior to 1931 by an automobile man, who dealt in automobile accessories. The two-story building was occupied by a family. On parcel 31 there were several improvements consisting of a one-story concrete block store occupied by a barber shop; a three-story frame dwelling containing nine apartments upstairs and a hardware store, cigar store, tailor, a belt concern, and a binding concern downstairs; and a two-story frame store occupied as an apartment on the second floor and as a cigar store on the first floor. All of these tenants had occupied these improvements for several years prior to 1931.

During 1932 petitioner's manager, Laurence B. Halleran, personally went to the revenue office in Brooklyn and secured application blanks to establish a replacement fund. After reading the Commissioner's regulations on the establishment of a replacement fund, Halleran personally filled out the required form in triplicate and during 1932 mailed it to the person at the Brooklyn office to whom he had been told to send the application. The application was not accompanied by a completed bond. Petitioner, through a representative, later made several inquiries at the Brooklyn revenue office in regard to its application for the establishment of a replacement fund which petitioner mailed to that office in 1932, but no one at the Brooklyn office knew anything about it and the application has never been located or acted upon by the respondent.

In closing its books for the year 1932 petitioner set up on the liability side of its ledger an account called "Replacement Fund" in the amount of $ 160,292.96, which amount, except for a discrepancy of 15 cents, represented the total of the three awards received in 1932, less the collection fees paid in 1932.

On March 15, 1933, petitioner's vice president, William J. Halleran, addressed a letter to the collector at Brooklyn, the body of which is as follows:

We enclose herewith corporation returns for the Flushingside Realty & Construction Company, Twinboro Corporation and the Winter Realty & Construction Company.

You will note, in each instance, there has been set up a figure headed "replacement fund." This figure represents sixty (60) percent of the City's appraisal, of an award due each corporation for property taken by condemnation, along Northern Boulevard, Flushing, New York. The balance of this award has not, as yet, been paid.

It is the intention of each corporation, upon receipt of the balance of the award, to replace same in property in similar or related in service, or use of the property so converted; or, in the acquisition of control of corporation owning such other property.

Petitioner's balance sheets as of the close of the years 1932, 1933, and 1934, were as follows:

		Dec. 31, 1932	Dec. 31, 1933	Dec. 31, 1934
Assets:
	Cash	$ 10,059.18	$ 2,783.78	$ 5,419.50
	Notes and accounts receivable	5,000.00	6,500.00	46,218.72
	Interest accrued receivable		15,632.12	31,264.24
	Rents receivable	9,684.35	2,009.54	1,458.00
	Mortgages receivable	15,000.00	15,000.00	15,000.00
	Land	123,153.43	123,153.43	118,858.43
	Buildings	32,611.02	32,611.02	35,611.02
	Reserve for depreciation	(815.28)	(1,630.56)	(2,595.84)
	Assignment of city award	62,914.21	70,104.73	16,344.07
	Good will	14,000.00	14,000.00	14,000.00
	"N. G. Check"	15.00	300.00
	Total	271,621.91	280,464.06	281,578.14
Liabilities:
	Accounts payable		100.00	125.00
	Loans payable	1,500.00
	Mortgages payable	43,000.00	42,500.00	42,500.00
	Interest accrued payable		1,200.00
	Taxes accrued		8,440.44	9,576.42
	Replacement fund	160,292.96	160,292.96	160,292.96
	Capital stock	14,000.00	14,000.00	14,000.00
	Earned surplus and undivided
	profits	52,828.95	53,930.66	55,083.76
	Total	271,621.91	280,464.06	281,578.14

The "Mortgages Receivable" account as it appears in the above balance sheets represents a mortgage on some sixteen or seventeen acres of land purchased by petitioner on November 16, 1932, out of the award money. Petitioner purchased the mortgage from the Hoffman estate for the sum of $ 15,000. The mortgage is still outstanding.

Upon receipt of the balance of the award on parcels 2, 14, 29, and 36a, on November 7, 1935, petitioner increased the amount of the account captioned "Replacement Fund" on the liability side of its ledger from $ 160,292.96 to $ 291,451.72. This increase of $ 131,158.76 represented the difference between the amount of $ 142,021.60 received on November 7, 1935, and the collection fees of $ 10,862.84 paid in 1935.

Upon receipt of the balance of the award on parcel 31 on May 4, 1936, and the $ 300 award on June 4, 1936, petitioner increased the amount of the account captioned "Replacement Fund" on the liability side of its ledger from $ 291,451.72 to $ 399,514.77. This increase of $ 108,063.05, except for a discrepancy of 15 cents, represented the difference between the award money received in 1936 and the collection fees paid in 1936.

On November 8, 1935, petitioner purchased from the Mansion Realty Co. a mortgage for $ 150,000. This purchase was made out of the award money to the extent of $ 125,735.57 (award received November 7, 1935, less collection fees and special assessments). On May 4, 1936, petitioner purchased from the same company a mortgage for $ 50,000. This purchase was made out of the award money received on May 4, 1936. Both of these mortgages are still outstanding.

Petitioner's balance sheets as of the close of the years 1935 to 1938, inclusive, were as follows:

	Dec. 31,	Dec. 31,	Dec. 31,	Dec. 31,
	1935	1936	1937	1938
Assets:
Cash	$ 13,191.58	$ 6,122.68	$ 1,148.37	$ 1,616.25
Notes and accounts
receivable	31,158.20	37,744.24	3,529.00	5,334.00
Interest accrued receivable	6,726.65
Rents receivable	2,076.00	1,018.33	1,585.00
Mortgages receivable	165,000.00	215,000.00	215,000.00	215,000.00
Land	124,321.66	143,932.74	143,982.74	147,282.74
Buildings	35,871.65	54,964.65	124,888.15	119,592.22
Reserve for depreciation	(3,567.63)	(4,742.40)	(6,191.52)	(8,556.22)
Deferred charges			1,300.00	625.32
Assignment of city award	16,344.07
Good will	14,000.00	14,000.00	14,000.00	14,000.00
Total	405,122.18	468,040.24	499,241.74	494,894.31
Liabilities:
Accounts payable	200.00	350.00	34,511.00	41,154.01
Mortgages payable	42,500.00	42,500.00	42,500.00	42,500.00
Interest accrued payable			1,200.00	1,200.00
Taxes accrued	13,217.20	5,257.49	11,385.66	21,001.18
Replacement fund	291,451.72	399,514.77	399,514.77	399,514.77
Capital stock	14,000.00	14,000.00	14,000.00	14,000.00
Earned surplus and undivided
profits	43,753.26	6,417.98	(3,869.69)	(24,475.65)
Total	405,122.18	468,040.24	499,241.74	494,894.31

On February 3, 1937, petitioner filed with the Commissioner of Internal Revenue an "Application To Establish A Replacement Fund" on Form 1114, revised February 1927. This application had two schedules attached thereto, which were designated "Schedule A -- Statement of Facts" and "Schedule B -- Surety Bond." In schedule A petitioner stated "1937" as the "Date replacement will be completed." The bond was for $ 141,000, but was not signed, pending approval by the Commissioner. The printed instructions on this Form 1114 were in part as follows:

1. The applicant should execute the form of application in triplicate and fill in Schedule A. * * *

2. The applicant should execute the surety bond (Schedule B) or the penal bond (Schedule C) in triplicate, inserting the amount and indicating the surety or depositary proposed.

3. The applicant should then forward all three copies of the form to the Commissioner of Internal Revenue, who will consider the application and, if he grants it, will sign the permit and return the forms to the applicant.

4. The applicant should then forthwith procure the completion of the bond (Schedule B or C) in triplicate and submit it for approval by the Commissioner, which must be given before the permit will become effective. After the application is approved, one copy will be retained by the Commissioner, one copy returned to the applicant, and one copy will be forwarded to the surety if Schedule B is executed.

This application did not in any way refer to the first application made in 1932. Neither application has ever been approved by the Commissioner, and the surety bond (schedule B) has never been completed. On February 19, 1937, the office of the Commissioner addressed a letter to petitioner, the body of which is as follows:

Receipt is acknowledged of your application to establish a replacement fund in connection with property condemned for street widening in Flushing, New York.

You are advised that your application is being referred to the internal revenue agent in charge at Brooklyn, New York, for verification and comment, and that upon receipt of the revenue agent's report, the matter will receive prompt attention by this office.

In any further correspondence in connection with this matter, please refer to IT:B:7-JAPF.

The deficiency notice containing the above mentioned holding that petitioner had not established a replacement fund or had not forthwith expended the proceeds in the acquisition of other property similar or related in service or use to the property condemned was mailed to petitioner on March 6, 1941.

Petitioner acquired property and made improvements on dates and in amounts as follows:

Item	Date	Description	Land	Improvements
(1)	1931 to 1932	40-26 Main St		$ 32,644.32
(2)	July 1932	Bell Blvd. lots	$ 5,000.00
(3)	October 1932	136-91 Roosevelt Ave	7,902.25
(1)	1935	40-26 Main St		167.37
(3)	1935 to 1936	136-91 Roosevelt Ave		4,816.19
(4)	May 1936	136-88 Roosevelt Ave		11,938.61
(5)	1936 to 1937	Northern and Prince Sts	31,789.84	69,336.00
Total			44,692.09	118,902.49

Item (1) in the preceding schedule represented a two-story brick and steel building which petitioner built on a lot that it owned at 40-26 Main Street. Construction began on October 1931 and it was completed in July 1932, except for some additional steel stairs and plumbing which were added in 1935. The lower floor has been occupied by a butcher shop, liquor store, and barber shop. On the upper floor is a chiropodist's office, an employment office, and a Christian Science reading room.

Item (2) was a vacant plot 100 feet by 200 feet on Bell Boulevard, which was about three miles away from the property condemned. Petitioner purchased this ground with the intention of erecting business buildings thereon.

Item (3) was a vacant lot 25 by 75 feet, which petitioner acquired in October 1932 at a cost of $ 8,000. It later received a refund on the purchase price of the lot in the amount of $ 97.75. From December 1935 to June 1936 petitioner erected a one-story brick and stone building on this lot at a cost of $ 4,816.19.

Item (4) represented a one-story brick building 50 feet wide divided into four stores with a cellar underneath. The building was erected in May 1936 upon land which petitioner then owned.

Item (5) represented partly a one-story and partly a two-story brick and stone building of Dutch Colonial design constructed at Northern and Prince Streets between July 10, 1936, and May 10, 1937, at a cost of $ 69,336. The upper floor was originally used as a cafe. These improvements were made partly on land previously owned by petitioner and partly on additional land purchased. The additional land purchased consisted of two tracts, one purchased from a person named McCalky at a cost of $ 12,215.97, and one tract at 47-49 Broadway purchased from the Twinboro Corporation at a cost of $ 3,300. In addition to these costs petitioner paid certain benefit assessments in connection with the land previously owned in the amount of $ 16,273.87. The entire property was known as the Peter Haff Huis property.

Petitioner, upon receipt of the award money in 1932, 1935, and 1936, respectively, forthwith expended a part of the proceeds thereof in the acquisition of other property similar or related in service or use to the property taken by the city as follows:

1932	$ 45,713.94
1935	None
1936	51,116.25
Total	96,830.19

Petitioner did not segregate or set apart the money which it received as awards for the taking of its properties. The money when received was deposited in petitioner's bank account along with the money it received from other sources. Checks against this account were drawn from time to time during the years 1932 to 1936, inclusive, in payment of the purchases named in these findings and in payment of petitioner's obligations of all sorts, including current expenses, dividends, and expenditures for capital investments.

For the years 1932 to 1936, inclusive, petitioner reported gross income and deductions as follows:

	1932	1933	1934	1935	1936
Gross Income
Interest	$ 65.09	$ 20,160.56	$ 18,524.96	$ 15,677.32	$ 37,164.50
Rents	5,681.21	8,663.22	9,608.68	9,565.00	12,866.00
Capital loss			1,295.00
Total	5,746.30	28,823.78	26,838.64	25,242.32	50,030.50
Deductions
Officers' salaries		5,750.00	6,300.00	10,800.00	21,600.00
Repairs	974.50	28.25		469.13	487.32
Interest	2,793.80	2,571.08	3,112.33	3,049.65	4,741.28
Taxes	14,380.96	8,596.70	5,938.38	7,317.02	5,953.93
Depreciation	815.28	815.28	965.28	971.79	1,174.77
Wages and salaries	1,888.94	4,522.25	5,624.50	3,600.00	4,288.00
Collection costs	216.89	465.19		834.90	1,087.15
Insurance	1,465.87			428.90	316.90
Bad debts		7,898.25	1,067.00	430.00	1,490.50
Miscellaneous	767.65	490.74	2,678.05	899.48	1,154.54
Total	23,303.89	31,137.74	25,685.54	28,800.87	42,294.39

During the years in which the award money was received petitioner paid dividends of $ 21,500 in 1932, $ 7,200 in 1935, and $ 45,000 in 1936. No dividends were paid by petitioner during the years 1933, 1934, 1937, and 1938.

Issue (d). -- In the deficiency notice the respondent added to petitioner's income for 1932 interest in the amount of $ 3,415.67 and in the statement attached to the deficiency notice explained his action as follows: "(b) Unreported interest in the sum of $ 3,415.67 accrued on the Crommelin Realty Corporation loan is included in income."

Issue (e). -- Petitioner on its return for the year 1932 claimed a deduction for taxes in the amount of $ 14,380.96. The respondent in his deficiency notice disallowed $ 9,600.33 of the amount claimed, and in the statement attached to the deficiency notice he explained his action as follows:

(c) Claimed taxes on real estate in the sum of $ 9,483.07 are disallowed since they accrued prior to the taxable year. In addition, a tax deduction in the sum of $ 117.26 is disallowed since it represents a capital item, namely an assessment for local benefits.

Issues (f) and (h). -- As found under the first three issues, the city of New York on November 7, 1935, and May 4, 1936, paid petitioner the amounts of $ 39,025.75 and $ 35,066.19, respectively, under the heading of interest. On its returns for the years 1933 to 1936, inclusive, petitioner reported the following amounts as interest income accrued from this source:

1933	$ 15,632.12
1934	15,632.12
1935	14,488.16
1936	28,339.54
Total	74,091.94

For the year 1935 the respondent determined that the difference between the amount received by petitioner in that year and the amount reported by petitioner in that year was additional interest income to petitioner. In the statement attached to the deficiency notice he explained this determination as follows:

(a)	Interest on condemnation award accrued during the taxable
	year	$ 39,025.75
	Reported in return	14,488.16
	Additional income	24,537.59
	It is held that interest received on certain condemnation
	awards where the amount of the award is in litigation
	constitutes taxable income in the year the final court
	decree is entered.

For the year 1936 the respondent made a like determination relative to the interest received from the city on May 4, 1936, and in addition thereto added to petitioner's interest income $ 561.33 in connection with the Crommelin Realty Corporation loan. In the statement attached to the deficiency notice he explained this determination as follows:

(a) Interest income from a condemnation award has been increased by $ 6,726.65, $ 35,066.19 having accrued within the taxable year whereas only $ 28,339.54 was reported in the return.

It is held that interest received on certain condemnation awards where the amount of the award is in litigation constitutes taxable income in the year the final court decree is entered.

Interest income was further understated by $ 561.38, resulting from improperly giving effect in the taxable year to a prior year adjustment, relating to the Crommelin Realty Corporation loan.

Issue (g). -- During the taxable years 1935 to 1938, inclusive, petitioner paid or incurred salaries to its officers as follows:

Officer	1935	1936	1937	1938
Mary Donoghue	$ 3,600	$ 6,000	$ 6,000
John J. Halleran	3,600	6,000	6,000	$ 6,000
W. J. Halleran	3,600	3,600	3,600	3,600
Julia M. Halleran		6,000	6,000	6,000
J. Cyril Donoghue				6,000
Total	10,800	21,600	21,600	21,600

The respondent determined that a total of $ 2,400 for each year represented "a fair and reasonable allowance for personal services actually rendered within the purview of section 23 (a) of the applicable Revenue Acts" and disallowed the balance of $ 8,400 in 1935 and $ 19,200 in 1936, 1937, and 1938, respectively (matter in quotation marks is from the statement attached to the deficiency notice).

Mary Donoghue, Lauretta P. O'Neill, John J. Halleran, William J. Halleran, Laurence B. Halleran, and Thomas Halleran were brothers and sisters. Thomas died prior to 1932 and his widow is Julia M. Halleran. Mary died November 8, 1937, and J. Cyril Donoghue is her son. Lauretta died October 5, 1941.

During the period from 1932 to 1938, inclusive, petitioner had issued and outstanding 140 shares of capital stock. During the same period the Flushingside Realty & Construction Co. and the Twinboro Corporation each had issued and outstanding 100 shares of capital stock, respectively. The ownership of the stock in these corporations was distributed as follows throughout that period:

		Flushingside
		Realty &	Twinboro
	Petitioner	Construction	Corporation
		Co.
	Shares	Shares	Shares
Julia M. Halleran	23 1/3	28 4/7	28 4/7
Laurence B. Halleran	23 1/3	14 2/7	14 2/7
William J. Halleran	23 1/3	14 2/7	14 2/7
John J. Halleran	23 1/3	14 2/7	14 2/7
Mary Donoghue *	23 1/3	14 2/7	14 2/7
Lauretta P. O'Neill	23 1/3	14 2/7	14 2/7
Total	140	100	100

Each member of the Halleran family as enumerated above, except Laurence B. Halleran, was an officer of one or more of the three family-owned corporations. Petitioner's officers from 1935 to 1938, inclusive, were: Mary Donoghue, president for a part of the period and J. Cyril Donoghue, president for the remainder of the period; William J. Halleran, vice president; John J. Halleran, for a part of the period secretary and treasurer, and for the remainder of the period treasurer; and Julia M. Halleran, secretary for a part of the period. Laurence B. Halleran was not an officer, but he acted throughout the entire period as general manager of the petitioner, managing the leasing of its properties and generally doing most of the work connected with petitioner's properties and investments through his real estate office, known as the Halleran Agency. Petitioner, the Flushingside Realty & Construction Co., and the Twinboro Corporation all had their offices in the office of Halleran Agency. The latter made no charge for office rental, telephone service, stenographic help, or executing leases, but did charge a commission on collections. Laurence B. Halleran was paid a salary by petitioner of $ 3,600 in the year 1935, but was paid no salary by petitioner in the years 1936, 1937, and 1938. William J. Halleran, vice president, had supervision over the maintenance and repairs of the properties. The actual repair and maintenance work was done by independent contractors or by a handy man employed by the petitioner at a wage varying from $ 36 to $ 45 per week. The amounts expended for maintenance and repairs during the period from 1935 to 1938, inclusive, were $ 469.13, $ 487.32, $ 774.49, and $ 1,812.43, respectively. The above named officers participated in family consultations from time to time. The respondent allowed the deduction of the salaries and wages paid to all employees, including Laurence B. Halleran, in addition to the above mentioned total deduction of $ 2,400 each year for salaries of officers.

Each member of the Halleran family received a salary from one or more of the three family-owned corporations. The salary paid by each corporation to each stockholder was not the same, but the payments were so arranged that each stockholder (except Julia M. Halleran, who owned twice as much stock in two of the corporations) received from the three corporations substantially the same total amount in compensation and dividends. Julia M. Halleran received a larger amount than the others.

For the years 1937 and 1938, petitioner reported gross income and deductions ² as follows:

		1937	1938
Gross Income:
	Interest	$ 13,264.96	$ 10,516.63
	Rents	18,232.50	23,615.00
	Total	31,497.46	34,131.63
Deductions:
	Officers' salaries	21,600.00	21,600.00
	Repairs	774.49	1,812.43
	Interest	2,550.00	2,550.00
	Taxes	6,488.97	11,602.14
	Depreciation	1,449.12	2,964.70
	Wages and salaries	4,631.75	4,491.00
	Collection costs	1,544.72	1,891.58
	Insurance	105.10	1,489.95
	Bad debts	597.50	1,721.56
	Miscellaneous	1,252.51	2,214.23
	Total	40,994.16	52,337.59

Twenty-four hundred dollars per annum is a reasonable allowance for salaries and other compensation for personal services actually rendered by petitioner's officers in each of the years 1935, 1936, 1937, and 1938.

OPINION.

We shall consider the issues in the order assigned.

Issues (a), (b), and (c). -- Prior to 1932 the city of New York took by condemnation proceedings certain property owned by petitioner and during the years 1932, 1935, and 1936 it paid petitioner a total of $ 430,500 as compensation (exclusive of interest) for the property taken. This compensation represented a capital gain to petitioner of $ 250,379.65. Petitioner contends that it is entitled to the benefit of section 112 (f) of the Revenue Acts of 1932, 1934, and 1936, and that in accordance therewith no part of this gain should be recognized. Section 112 (f) is identical in the three acts mentioned, and is set forth in the margin. ³ The cases involving section 112 (f) and its prototype in other revenue acts are collected and analyzed in Mertens, Law of Federal Income Taxation, vol. 3, secs. 20.120 to 20.129, incl.

Petitioner contends that the award money it received as a result of the involuntary conversion of its property (parcels 2, 14, 29, 36a, and 31) into money was "forthwith in good faith, under regulations prescribed by the Commissioner with the approval of the Secretary, expended in the acquisition of other property similar or related in service or use to the property so converted * * * or in the establishment of a replacement fund." The respondent contends that neither one of these things occurred, and that, therefore, the entire gain should be recognized. Petitioner does not contend that any of the award money was expended "in the acquisition of control of a corporation owning such other property." In his opening statement counsel for the petitioner said "We agree with all the figures in the 90 day letter, except as to land value as of March 1st, 1913 on parcel 29, and also on parcel 31." Petitioner offered no evidence of a March 1, 1913, value different from that determined by the respondent, and in the absence of such evidence the respondent's determination is sustained.

We shall first consider whether any of the award money was expended in the establishment of a replacement fund. The statute requires that if any of the money is so expended it be done "under regulations prescribed by the Commissioner with the approval of the Secretary." The first award money received was on May 12, 1932. ⁴ The net amount received on that date, after deducting collection fees of $ 9,371.79, was $ 160,092.81. Article 580 of Regulations 77 is set forth in the margin. ⁵

At some time between May 12 and December 31, 1932, petitioner made an application for permission to establish a replacement fund. The respondent has no record of such application having been made and contends that no such application was made until the one that was filed on February 3, 1937. But we are satisfied from the testimony of petitioner's manager that after acquainting himself with the Commissioner's regulations he personally, during 1932, secured the necessary blanks, filled them out and filed them. This testimony is supported by the letter to the collector dated March 15, 1933, the body of which is in our findings, and by the testimony of a real estate man, William R. Plaatje, who had his office in the same room where petitioner had its office. Plaatje testified that he saw the forms being prepared in 1932, and that he furnished the necessary appraisals of the March 1, 1913, value of the condemned property. The respondent makes a point on there being no completed bond filed with the alleged application. The instructions on Form 1114 did not require the bond to be completed until after the Commissioner had granted the application by signing the "permit" printed thereon and had returned all three copies of the form to the applicant.

Petitioner made several inquiries about its application and was finally told to file another one, which petitioner did on February 3, 1937, the receipt of which was acknowledged by the Commissioner in his letter dated February 19, 1937. Aside from this letter of acknowledgment, the Commissioner has never acted upon the second application unless the deficiency notice herein be regarded as a rejection thereof. Under these circumstances we shall discuss this question as if petitioner had obtained "permission to establish a replacement fund" under article 580, supra.

Did petitioner in fact establish a replacement fund? The mere establishment of a replacement fund with the Commissioner's permission, even if one is established, does not forever exempt the gain from being recognized and taxed. The purpose of permitting such a fund to be established is only to give the taxpayer additional time to replace or restore the property condemned. If that is not done within the time allowed, then the taxpayer must pay the tax that would have been due in the year in which the award was received without any benefit from section 112 (f). In schedule A of the second application, filed February 3, 1937, petitioner stated "1937" as the "Date replacement will be completed." Up to the date of the hearing in this proceeding the only replacements that have been made are the replacements hereinafter mentioned. Petitioner invested $ 190,735.57 of the award money in mortgages, and the balance, after making due allowances for the amounts which were expended in acquiring property of a like kind or character, was commingled with its other funds and used to pay dividends and its current expenses.

The statute provides at least a temporary nonrecognition of the gain if money into which the property was involuntarily converted is forthwith "expended * * * in the establishment of a replacement fund." The setting up on the liability side of its ledger of a reserve account called "Replacement Fund" in the amounts set out in our findings is not in itself the establishment of a replacement fund. Cf. . Such an account does not reflect the investment of money in the establishment of a fund. The taxpayer must invest the money in assets which have been designated in some way as being held for replacement purposes. This was not done in the instant proceedings. We are unable to find among the petitioner's assets any account representing a separate fund set apart from the other assets to be used only for the purpose of replacing the property that was condemned. The petitioner does not call our attention to any. The only asset which might conceivably be adequate for this purpose is one described as "Mortgages receivable." However, this asset does not correspond in amount to the replacement fund item which the petitioner has set up among its liabilities and it has not been designated in any way as representing a replacement fund. Furthermore, mortgages would probably not be regarded as an ideal investment for the purpose of a replacement fund of this character because they might not be readily convertible when the time for actual replacement arrived. Thus, we regard the mortgages which this petitioner purchased as simply investments of a wholly different class from the property condemned and having no relation to a replacement fund. We hold, therefore, that no part of the award money was expended in the establishment of a replacement fund.

We next consider whether any of the award money was "forthwith in good faith, under regulations prescribed by the Commissioner with the approval of the Secretary, expended in the acquisition of other property similar or related in service or use to the property so converted." This is a question of fact. . We have found in our findings that petitioner did so expend $ 96,830.19 of the award money which it received. Our findings in this respect are quite full in that they set out in considerable detail the kind of property that was condemned and the kind of property that was acquired in its place. We are satisfied from the evidence that property acquired in the amount of $ 96,830.19 was similar or related in service or use to the property taken, and have so found as a fact, and that it was acquired "forthwith" as required by the statute. Cf. The respondent contends that the $ 16,273.87 which was expended for certain benefit assessments on the Peter Haff Huis property as shown in our findings of fact was not a replacement expenditure. We agree with respondent in this contention. However, it becomes unimportant to our decision. As pointed out hereinafter, although petitioner in 1936 expended $ 117,880.64 in the manner detailed in our findings, including the $ 16,273.87 to which respondent objects, it expended only $ 51,116.25 forthwith in the acquisition of other property similar or related to that which it gave up. Our explanation of this latter statement will follow later in our opinion.

The money which petitioner invested in mortgages as detailed in our findings, while expended "forthwith," was not expended in the acquisition of other property similar or related in service or use to the property which the city took. As stated in , "The test to be applied in determining whether there is a replacement is the character of the service or use. It is not a financial test."

Since only a part of the award money was forthwith expended in the acquisition of other property similar or related in service or use to the property condemned, the last sentence of section 112 (f), supra, becomes applicable, and the gain must be recognized "in an amount not in excess of the money which is not so expended." The parties are not in agreement as to the amount of "money" that could be expended for the purposes set out in section 112 (f). Petitioner contends that it is the gross award, less the collection fees and the special assessments. The respondent contends that it is the gross award, less only the special assessments, and that to deduct also the collection fees would be to allow a double deduction to that extent. We do not agree with the respondent on this point. There is no double deduction being allowed. Both items come off in determining the gain, as the respondent has done in his deficiency notice. The statute makes provision for the "basis" the newly acquired property is to take. See sections 113 (a) (10) of the Revenue Act of 1932 and 113 (a) (9) of the Revenue Acts of 1934 and 1936. Petitioner, in so far as the provisions of section 112 (f) are concerned, could not expend in the acquisition of other property more than the net amount of money it received, which would be the gross award less the collection fees and the special assessments. We hold, therefore, that the amount of capital gain determined by the respondent for the years 1932, 1935, and 1936 should, under section 112 (f), supra, be recognized as follows:

	1932	1935	1936
Gross award	$ 169,664.60	$ 142,021.60	$ 118,813.80
Less collection fees and special
assessments	9,371.79	16,286.03	17,697.55
Amount that could be expended for
similar property	160,292.81	125,735.57	101,116.25
Amount that was expended for similar
property	45,713.94	None	51,116.25
Amount that was not expended for
similar property	114,578.87	125,735.57	50,000.00
Gain realized	23,527.98	125,735.57	101,116.10
Gain to be recognized	23,527.98	125,735.57	50,000.00

It will be noted that in the above table we have said as to the year 1935: "Amount that was expended for similar property, none." The reason for that is that the evidence shows that in 1935 petitioner received a net amount of $ 125,735.57 from the awards. None of this was invested forthwith by petitioner in "other property similar or related in service or use to the property so converted." All this money was invested in mortgages, as detailed in our findings, and so far as the record shows it still remains so invested. Therefore, none of the gain realized by petitioner in 1935 from the collection of this $ 125,735.57 escapes taxation by reason of section 112 (f).

It will also be noted that in the above table we have said as to the year 1936: "Amount that was expended for similar property, $ 51,116.25." Our findings of fact show that petitioner in 1936 acquired land and made improvements to the amount of $ 117,880.64. However, not all this was done with award money. Petitioner received in 1936 a net amount of $ 101,116.25 as award from the city of New York. Of this amount $ 50,000 was immediately invested in mortgages, which we have held not to be other property similar or related in service or use to the property condemned by the city of New York. Therefore, of the $ 101,116.25 received by petitioner as award money in 1936, petitioner expended only $ 51,116.25 in the acquisition of other similar or related property. This latter amount is the amount to be used in reducing petitioner's gain to be recognized in 1936.

Issue (d). -- The assignment of error as to this issue is that the respondent erred by adding to petitioner's income interest "disallowed as a deduction" amounting to $ 3,415.67. There is no evidence that petitioner ever claimed this amount as a "deduction" for interest paid. What the respondent determined was that petitioner had made a loan to the Crommelin Realty Corporation; that during 1932 interest had accrued on this loan in the amount of $ 3,415.67; that petitioner had not reported this accrual as income; and that since petitioner was on the accrual basis it should have reported the interest as income. Petitioner's evidence in support of this assignment of error was very meager and we think is wholly insufficient to refute the presumed correctness of respondent's determination. We, therefore, sustain respondent as to this item of $ 3,415.67.

Issue (e). -- No evidence was offered as to this issue. We, therefore, sustain the respondent's determination as far as this issue is concerned.

Issues (f) and (h). -- In its assignments of error petitioner alleges that the respondent erred "by disallowing an interest deduction" of $ 24,537.59 and $ 7,287.98, respectively. Like issue (d), supra, the respondent did not "disallow" any interest deduction. What he did was to determine that petitioner failed to report all of the interest it received from the city in 1935 and 1936, respectively. The respondent determined that, because the amount of the award was in litigation, the interest thereon was not taxable income until the year the final court decree was entered and the amount of the award became fixed. This is in accord with ; certiorari denied, . Petitioner in its brief contends that the amounts designated as interest were not interest, but a part of the awards, citing , and under issues (a), (b) and (c), supra, it has contended that no gain from the awards should be recognized. It is now settled that the amounts received in 1935 and 1936 of $ 39,025.75 and $ 35,066.19, respectively, designated as interest were not a part of the awards, but were ordinary income under section 22 (a) of the Revenue Acts of 1934 and 1936, respectively. . These amounts did not accrue until 1935 and 1936, respectively, the years in which the final court decrees fixing the amount of the awards were entered. Since petitioner reported as interest from these awards in 1935 and 1936 only the amounts of $ 14,488.16 and $ 28,339.54, respectively, it follows that the respondent correctly added to petitioner's income for 1935 and 1936 the amounts of $ 24,537.59 and $ 6,726.65, respectively.

For the year 1936 the respondent also increased petitioner's income by interest in the amount of $ 561.33. This is a part of assignment of error (h). Petitioner offered no evidence as to this item, so the respondent's determination in connection therewith is sustained.

Issue (g). -- During the taxable year 1935 petitioner on its return claimed a deduction of $ 10,800 for officers' salaries, and for each of the years 1936, 1937, and 1938, it claimed a deduction of $ 21,600. The respondent determined that a total deduction of $ 2,400 for each of the years 1935 to 1938, inclusive, represented a fair and reasonable allowance.

The question of what constitutes a "reasonable allowance for salaries or other compensation for personal services actually rendered," allowed as deductions as "ordinary and necessary expenses" in computing net income under section 23 (a) of the Revenue Acts of 1934, 1936, and 1938, is a question of fact. The determination thereof by the respondent is prima facie correct and the burden is upon the petitioner to establish by a fair preponderance of the evidence that the determination is not correct. ; , and cases therein cited.

We do not think petitioner has met this burden. Most of the work of this corporation connected with the properties which it owned, such as the collection of interest and rents, was done by Laurence B. Halleran through his Halleran agency. He was petitioner's manager but was not one of its officers. For compensation as manager he was paid $ 3,600 in 1935 and nothing in 1936, 1937, and 1938. The respondent has allowed as an expense deduction all the compensation paid to Laurence. Small parts of the work of the corporation were done by two brothers, a sister, a sister-in-law, and a nephew of Laurence. For this comparatively small part of the work petitioner is claiming total officers' salaries of $ 75,600 for the four years in question. In the language of the Supreme Court in , "it is clear that extraordinary, unusual and extravagant amounts paid by a corporation to its officers in the guise and form of compensation for their services, but having no substantial relation to the measure of their services and being utterly disproportioned to their value, are not in reality payment for services, and cannot be regarded as 'ordinary and necessary expenses.'" The only officer who rendered any service to amount to anything, so far as the record of evidence shows, was William J. Halleran. He testified that he was the outside man that handled all the repairs (total repairs for 1935 to 1938, inclusive, amounted to only $ 3,543.37) for petitioner; that he was on call "in case anything happens" 24 hours a day; that he has been called out six to eight times a year on different things that happened; and that he had to see that the ragweed was cut from vacant land and snow shoveled from sidewalks. He did the same work for the other two family corporations, Flushingside and Twinboro. The other officers rendered practically no service. And when consideration is given to the fact that the payments made to the Halleran family were so arranged that each stockholder (except Julia who owned twice as much stock in two of the corporations) received from the three corporations substantially the same total amount in compensation and dividends, it seems clear that the respondent was justified in disallowing the greater part of the amounts deducted by petitioner as salaries of its officers. Petitioner has not shown that its officers actually rendered any personal services that would call for a reasonable allowance for salaries or other compensation of an amount in excess of that determined and allowed by the respondent. We, therefore, sustain the respondent's determination as to this issue.

Decision will be entered under Rule 50.

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Footnotes

• 1. The respondent has not included in petitioner's income the award of $ 200 paid in August 1932. Relative to the two awards paid on May 4 and June 4, 1936, in the total amount of $ 118,813.80, he included $ 118,813.65 thereof as representing the balance of the award on parcel No. 31. There is no issue relative to these dis crepancies.↩

• *. Upon Mary Donoghue's death her stock passed to and has since that time been owned by her heirs, J. Cyril Donoghue, and three other children in equal shares.↩

• 2. For the years 1932 to 1936, inclusive, see findings under issues (a), (b), and (c).↩

• 3. (f) Involuntary Conversions. -- If property (as a result of its destruction in whole or in part, theft or seizure, or an exercise of the power of requisition or condemnation, or the threat or imminence thereof) is compulsorily or involuntarily converted into property similar or related in service or use to the property so converted, or into money which is forthwith in good faith, under regulations prescribed by the Commissioner with the approval of the Secretary, expended in the acquisition of other property similar or related in service or use to the property so converted, or in the acquisition of control of a corporation owning such other property, or in the establishment of a replacement fund, no gain or loss shall be recognized. If any part of the money is not so expended, the gain, if any, shall be recognized, but in an amount not in excess of the money which is not so expended.↩

• 4. At that time the Revenue Act of 1932 had not yet been enacted. The Revenue Act of 1928 and Regulations 74 were then in effect. The Revenue Act of 1932 was approved on June 6, 1932, and its provisions were made to apply "to the taxable year 1932 and succeeding taxable years." Sec. 1, 1932 Act. Regulations 77 under the 1932 Act were approved on February 10, 1933. But section 112 (f) of the Revenue Act of 1932 and article 580 of Regulations 77 were identical with section 112 (f) of the Revenue Act of 1928 and article 580 of Regulations 74, respectively. So as far as the establishment of a replacement fund is concerned, the applicable statute and regulations for the year 1932 were not in any way changed from what they were on May 12, 1932, when the first award money was received.↩

• 5. Art. 580. Replacement funds↩. -- In any case where the taxpayer elects to replace or restore the converted property but it is not practicable to do so immediately, he may obtain permission to establish a replacement fund in his accounts in which part or all of the compensation so received shall be held, without deduction for the payment of any mortgage. In such a case the taxpayer should make application to the Commissioner on Form 1114 for permission to establish such a replacement fund, and in his application should recite all the facts relating to the transaction and declare that he will proceed as expeditiously as possible to replace or restore such property. The taxpayer will be required to furnish a bond with such surety as the Commissioner may require in an amount not in excess of double the estimated additional income taxes which would be payable if no replacement fund were established. (See section 1126 of the Revenue Act of 1926.) The estimated additional taxes, for the amount of which the claimant is required to furnish security, should be computed at the rates at which the claimant would have been obliged to pay, taking into consideration the remainder of his net income and resolving against him all matters in dispute affecting the amount of the tax. Only surety companies holding certificates of authority from the Secretary of the Treasury as acceptable sureties on Federal bonds will be approved as sureties. The application should be executed in triplicate, so that the Commissioner, the applicant, and the surety or depositary may each have a copy.