Ray's Clothes, Inc. v. Commissioner , 22 T.C. 1332 ( 1954 )

Ray's Clothes, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent

Ray's Clothes, Inc. v. Commissioner

Docket Nos. 41759, 45093, 45094, 45095

United States Tax Court

22 T.C. 1332; 1954 U.S. Tax Ct. LEXIS 84;

September 30, 1954, Filed September 30, 1954, Filed

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Decisions will be entered under Rule 50.

Respondent determined that petitioner was entitled to deduct as rental expense, for each of its fiscal years ended June 30, 1947, through 1950, only $ 10,000 rather than the greater amounts paid to lessor corporation under a percentage lease with a minimum agreed rental of $ 10,000 per annum. Held, had petitioner and lessor corporation dealt at arm's length petitioner would not have been "required," under section 23 (a) (1) (A) of the 1939 Code, to pay rent in excess of $ 6,000 per annum until January 1, 1948, the termination date of the unexpired lease from the former owner. From and after January 1, 1948, however, the rental provided for in the July 1, 1946, lease between lessor corporation and petitioner was reasonable, all circumstances considered. Consequently, respondent's determination is sustained for the 1947 fiscal year but is held erroneous for the 1949 and 1950 fiscal years. Rental for the 1948 fiscal year is determined as $ 3,000 (one-half of $ 6,000 per annum) for the period July 1-December 31, 1947, plus 6 per cent of gross sales for the period January 1-July 30, 1948.

Adrian Block, Esq., and Isador Setel, Esq ., for the petitioner.

A. W. Dickinson, Esq., for the respondent.

Black, Judge. Baar, J., dissenting. Withey, J., agrees with this dissent.

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BLACK

The Commisioner has determined the following deficiencies in petitioner's income taxes:

Fiscal year ended
June 30	Deficiency
1947	$ 10,444.88
1948	10,704.85
1949	17,005.42
1950	15,051.55

The deficiencies result from adjustments made by the Commissioner in petitioner's reported net income for the aforementioned years. Most of those adjustments are more or less minor in amount and are not contested by petitioner and will be taken into account in the Rule 50 computation. The Commissioner in his determination of the deficiencies for the fiscal year ended June 30, 1947, made an adjustment as follows:

Unallowable deductions and additional income:
(a) Rent expense	$ 21,759.62

This adjustment was explained in the deficiency notice as follows:

(a) It is held that, of the total of $ 31,759.62 claimed by you as a deduction for rent to 1901 Main Street, Inc., $ 21,759.62 does not constitute an allowable deduction under Section 23 (a) (1) (A) of the Internal Revenue Code. Accordingly, the deduction for rent is limited to $ 10,000.00.

Similar adjustments, except as to amounts, with similar explanations were made for the other 3 taxable years.

The contested adjustments raise the following common issue for each year: Whether the Commissioner erred in disallowing as a deduction, under section 23 (a) (1) (A) of the 1939 Internal Revenue Code, all but the guaranteed minimum ($ 10,000 per annum) paid under a percentage lease to a lessor corporation whose controlling stockholders were the sole stockholders of petitioner.

FINDINGS OF FACT.

Some of the facts have been stipulated and are so found.

Petitioner is a corporation organized under the laws of the State of New York and engaged in the sale at retail of "popular priced" men's clothing, furnishings, haberdashery, and hats. Its office and principal place of business has at all times been at 1901 Main Street, Niagara Falls, New York. Petitioner keeps its books and files its returns pursuant to an accrual accounting method and on the basis of a fiscal year ending June 30. It filed its returns for the years here involved with the collector of internal revenue at Buffalo, New York.

Petitioner began business on July 1, 1946. Its stock is wholly owned in equal shares by Samuel David, its president, and Edward I. Seeberg, its vice president. Petitioner's predecessor, which conducted business until July 1, 1946, was an equal partnership composed of David and Seeberg. The partnership engaged in the same business as petitioner and likewise was located at 1901 Main Street, Niagara Falls, New York (hereinafter sometimes referred to as the business property).

In 1938, the partnership leased the ground floor and basement of the business property for 5 years, with an option to renew for an additional 5 years, which it exercised, thereby extending the term of the lease to January 1, 1948. The rental under that lease was $ 6,000 per annum. For the 5 years prior to July 1, 1946, the partnership's sales, rent paid under the lease, and net income were as follows:

Year	Sales	Rent	Net income
1941 2	$ 158,326.07	1 $ 2,400.00	$ 28,328.95
1942	301,564.60	1 5,400.00	43,920.54
1943	243,883.62	6,000.00	55,302.23
1944	229,383.53	6,000.00	37,440.71
1945	316,711.79	6,000.00	66,957.38
1946 3	296,536.30	1 5,705.45	50,398.43

On about two or three occasions prior to 1945, the owner of the property, an elderly lady, offered to sell it to David and Seeberg for $ 140,000, but the latter were not interested in purchasing it. In May 1945, the owner again offered to sell the business property, this time for $ 115,000. Upon receiving this offer the partners sought the advice of their accountant. They also desired the advice of an experienced attorney and were recommended to Isador Setel, who specialized in real estate law and was himself an owner of commercial properties. The partners told Setel, among other things, that they had $ 40,000 to invest in the business property. They asked him whether they should buy it at the offered price and, if so, how they were to finance it.

Setel advised the partners that the purchase of the business property for $ 115,000 was an excellent bargain and, the same day, drew up a contract for sale and obtained the owner's signature thereon. Setel then proceeded to negotiate for the $ 75,000 loan necessary (along with the $ 40,000 the partners possessed) to finance the purchase. He contacted Dean R. Hill, the president of a mortgage company in which he (Setel) had an interest. The mortgage company was engaged in the business of originating and servicing mortgage loans for principals such as banks, insurance companies, and the like. It had offices both in Buffalo and Niagara Falls.

It was Setel's and Hill's opinion that the rent then being paid by the partnership was unusually low. Setel and Hill consulted various real estate manuals which contained information on rental values and rents actually being paid by tenants in businesses and localities similar to that of the partnership, and considered rentals being paid on similar properties in Niagara Falls. They concluded that, in order to secure the $ 75,000 loan from one of the mortgage company's principals, the partnership should pay a rental for that part of the property used by it of 6 per cent of gross sales with a minimum annual rental to be not less than $ 10,000. Neither David, Seeberg, nor their accountant had anything to do with the initial discussion of the rental nor, in fact, ever met Hill prior to that discussion. Following approval by David and Seeberg of the proposed rental Hill obtained a loan commitment from one of his principals, an insurance company, which commitment was specifically subject to the making of a lease containing the aforementioned proposed rental.

A corporation, which was named 1901 Main Street, Inc., was formed under the laws of the State of New York to purchase the business property. Its stock was owned 50 per cent by David, 25 per cent by Seeberg, and 25 per cent by Seeberg's wife. The conveyance of the business property was supposed to be made on July 1, 1945, but difficulty in clearing title delayed it until sometime in June 1946, when the conveyance was made for $ 115,655.09. David and Seeberg thereupon incorporated their men's wear business at their accountant's suggestion and, as aforementioned, that corporation (petitioner herein) began operations on July 1, 1945. On that same day a 10-year lease (July 1, 1946-July 1, 1956) ¹ was entered into between 1901 Main Street, Inc. (hereinafter referred to as the lessor), and petitioner for the ground floor and basement of the business property. The annual rental reserved therein was 6 per cent of petitioner's gross sales, with a $ 10,000 minimum. The lease was assigned, along with a mortgage of the business property, by the lessor to the insurance company which loaned lessor $ 75,000 in performance of its commitment to so do.

For the years here in issue petitioner's gross sales, the rent it paid under the percentage lease (which rent was reported as income in the lessor's returns), and its net sales were as follows:

Fiscal year ended June 30	Gross sales	Rent	Net income
1947	$ 530,496.57	1 $ 31,759.62	$ 22,968.73
1948	509,121.25	30,547.28	25,848.84
1949	529,090.68	31,745.44	15,617.01
1950	473,390.64	28,403.44	23,420.86

Neither petitioner nor the lessor distributed dividends for the years in issue.

Niagara Falls is the home of a number of industrial plants, is the source of electric power supplied to the surrounding country, and is a well known tourist center. Its population in 1946 was about 80,000. There are two bridges connecting it with the Dominion of Canada and about 25 per cent of its retail trade is conducted with visiting Canadians.

The business property, 1901 Main Street, is a 3-story building on a corner lot in the heart of probably the best retail mercantile district in Niagara Falls. The building has a 38-foot frontage on Main Street and a 90-foot frontage on South Street, which is an active side street. A half block from the business property, on Main Street, is one of the largest department stores in the city, and stores dealing in a variety of retail merchandise are located in the Main Street area in which the business property is located. For the type of retail men's wear business in which petitioner was engaged, the business property was in one of the best, if not the best, locations in Niagara Falls. Petitioner occupied the ground floor of the building, which has an extensive display window area, and used the basement to store stock. The two upper floors were rented to other tenants.

In 1946, when the lease between petitioner and the lessor was executed, it was not unusual for store leases to retail merchants such as petitioner to provide for rentals of a specified percentage of gross sales with guaranteed annual minimums. An important motive for such leases was to protect the lessor against inflation with its concomitant reduction in the value of money. Six per cent of gross sales was a representative percentage rent for retailers of men's wear such as petitioner, and was in line with the percentages charged similar businesses in the area in which petitioner was located. The rental provided for in the lease between lessor and petitioner was fair and reasonable for the period from and after January 1, 1948. However, for the period July 1, 1946, through December 31, 1947, petitioner was not required to pay rent in excess of $ 6,000 per annum because of a lease on the same property extending to January 1, 1948, owned by the partnership which petitioner succeeded.

OPINION.

Respondent has determined that, for each of its fiscal years 1947 through 1950, petitioner may only deduct, under section 23 (a) (1) (A) of the 1939 Internal Revenue Code, ² $ 10,000 of the rent paid the lessor corporation under a lease providing for annual rental payments of 6 per cent of gross sales, with a $ 10,000 minimum.

Lessor was formed to purchase the business property, 1901 Main Street, following an advantageous offer of sale thereof made to petitioner's sole stockholders, David and Seeberg, by the former owner of the business property. At the time of that offer, petitioner's business was then being conducted as a partnership, by David and Seeberg, on the leased ground floor and basement of the business property. Lessors' sole stockholders were David, Seeberg, and Seeberg's wife. David and Seeberg owned 75 per cent of the stock of the lessor corporation and, therefore, were in complete control of it, as they were of petitioner.

We think the determination of respondent except to the extent set out in our Findings of Fact and hereinafter discussed, is not sustainable and that the cases cited in support thereof are distinguishable on their facts. ³

In view of the stock ownership of lessor and lessee corporation, however, inquiry must be directed to the terms of the lease executed between lessor and petitioner on July 1, 1946. As this Court stated in Jos. N. Neel Co., 22 T. C. 1083:

The qualified identity of interests between the * * * stockholders of the lessor * * * and the * * * stockholders of petitioner prevents the transaction in question from assuming an arm's-length character in the ordinary sense of the term. Thus, although a deduction for rent paid is not limited by the Code, as in the case of salary or compensation, to a "reasonable allowance," see Stanley Imerman, 7 T. C. 1030, under such circumstances as are here present a critical examination of all the evidence bearing upon the transaction involved, in the light of the situation known then to exist, is required to determine the true character of the item and to ascertain whether the rental arrangement was in fact sufficiently reasonable to achieve the same result as arm's-length dealings.

Or, to phrase it somewhat differently, it must be determined what rental petitioner, had it dealt at arm's length with a stranger, would have been "required" to pay "as a condition to the continued use or possession" of the property. Sec. 23 (a) (1) (A), supra; Roland P. Place, 199">17 T. C. 199, 203, affirmed per curiam (C. A. 6) 199 F. 2d 373, certiorari denied 344 U.S. 927">344 U.S. 927. In the Place case, we said:

The basic question is not whether these sums claimed as a rental deduction were reasonable in amount but rather whether they were in fact rent instead of something else paid under the guise of rent. The inquiry is whether the petitioner was in fact and at law "required" to pay these sums as rent. * * * When there is a close relationship between lessor and lessee and in addition there is no arm's length dealing between them, an inquiry into what constitutes reasonable rental is necessary to determine whether the sum paid is in excess of what the lessee would have been required to pay had he dealt at arm's length as a stranger. [Citing cases.]

We further said, among other things, in deciding against the taxpayer in Place, supra:

We have not had the benefit of the advice of disinterested experts as to what in their opinion would be a fair rental or a fair valuation of the properties. There is no evidence of comparable rentals or any explanation why this method of computation of the 45 per cent rate rather than some other method or a lesser or higher rate was selected by petitioner. * * *

In the instant case, however, we do have the explanation for the making of the rental contract and the benefit of expert testimony as to the reasonableness of the rents which were to be paid under the contract. Therefore, a brief summary of the evidence particularly pertinent to the inquiry we have here to make is appropriate.

The business property consists of a building of 3 stories and a basement which is located on a corner lot in the center of probably the best retail mercantile district of Niagara Falls. It has a 38-foot frontage on the city's main business street, 90-foot frontage on an active side street, and extensive display window area. Niagara Falls is an industrial and tourist center on the Canadian border; visiting Canadians account for about 25 per cent of the city's retail trade.

Petitioner and its predecessor, the David and Seeberg partnership, occupied the first floor and basement of the building. Prior to 1946, petitioner's predecessor rented the building for $ 6,000 per year under a lease which was to expire January 1, 1948. In May 1945, the building's owner offered to sell it to David and Seeberg for $ 115,000 which, according to the uncontradicted evidence, was a low price for that property, and a contract of sale was signed after consulting with Isador Setel, an attorney versed in real estate matters. It was necessary to borrow $ 75,000 to finance the purchase. Setel discussed this with the president of a mortgage company and they, independently of David and Seeberg, concluded that petitioner's predecessor (later petitioner) should pay annual rent of 6 per cent of gross sales, with a $ 10,000 minimum, in order to secure the mortgage loan. David and Seeberg agreed on the proposed rent and an insurance company agreed to make the loan conditioned on the making of a lease containing the proposed rent.

Delay in clearing title postponed the transfer of the property for about a year, at which time the transfer was made for $ 115,655.09 to lessor corporation which was formed for that purpose by David and Seeberg. David and Seeberg also formed petitioner, which took over the partnership's men's wear business on July 1, 1946. A 10-year lease, dating from July 1, 1946, and containing the aforementioned percentage rental provision, was executed between lessor corporation and petitioner. The lease was assigned, along with a mortgage, to the insurance company which loaned the $ 75,000.

Setel, who was David's and Seeberg's counsel in the above dealings, the president of the mortgage company through which lessor corporation obtained the $ 75,000 mortgage loan, and two real estate men of long experience who were in no way connected with the transaction in issue, all testified that as of July 1, 1946, the making of percentage leases for retail stores was an accepted practice, that the business property in question was an excellent one, and that the percentage rate and minimum provided in the lease for that property were fair and reasonable and in line with rentals charged similar businesses in that particular area. Setel also testified that, as of the time the rental was determined, he had two other clients who would have been willing to rent the property on those terms. Respondent, on the other hand, introduced no direct evidence and we do not believe that his cross-examination of the aforementioned witnesses or the other evidence present in the case impugns their testimony or would justify us in reaching a different conclusion from that which we have reached. A. & A. Tool & Supply Co. v. Commissioner, (C. A. 10) 182 F. 2d 300; Roth Office Equipment Co. v. Gallagher, (C. A. 6) 172 F.2d 452">172 F. 2d 452.

We hold, therefore, that, except for the period July 1, 1946, through December 31, 1947, which will be discussed below, the rent prescribed in the percentage lease was reasonable and is what would have been arrived at had petitioner and lessor corporation been dealing at arm's length. Our conclusion is based upon the testimony mentioned in the preceding paragraph and our findings regarding the location and character of the business property and the rents actually being charged other stores in the particular area.

We are not, of course, unaware of the fact that the rental payments under the percentage lease were high in relation to the purchase price paid for the business property by the lessor corporation and that they were greatly in excess of the rents paid by petitioner's predecessor under the former lease. As regards comparative rents under the percentage lease and the former lease, it is noted first that the former lease was executed in 1938 when business conditions and property values in general were depressed compared with the period in which the percentage lease was negotiated and executed. Moreover, when 6 per cent of gross sales was determined as the measure of rent to be incorporated in the percentage lease, annual gross sales of petitioner's predecessor were around $ 300,000. Thereafter, annual sales jumped to around $ 500,000, resulting in rental payments considerably in excess of those originally contemplated. Such increases in rent with increases in business "is an accepted characteristic of a percentage lease," Stanley Imerman, 7 T.C. 1030">7 T. C. 1030, 1037, and is of no particular consequence when, as here, the percentage agreed upon has been found fair and reasonable. Neither is it necessary that such lease, so long as the terms are fair and reasonable, be particularly "beneficial" to petitioner. See Stearns Magnetic Mfg. Co. v. Commissioner, (C. A. 7) 208 F. 2d 849.

Turning to a consideration of the period July 1, 1946, through December 31, 1947, the evidence, we think, compels a different conclusion. Petitioner's predecessor was operating under a lease which called for rent of $ 6,000 per year and was not due to expire until January 1, 1948. There is nothing in the record to indicate that such lease provided for termination either upon sale of the property by the former owner or upon change of the lessee from a partnership to a corporation. We therefore believe that petitioner could have availed itself of the benefits of that unexpired lease in an arm's-length transaction.

Instead of so doing, however, petitioner entered into the percentage lease to begin immediately instead of waiting for the expiration of the term of the old lease. No cash consideration or other concessions were received by petitioner for entering into that lease. Neither do the facts indicate that petitioner wished to assure itself a longer term of occupancy in order to justify contemplated capital expenditures or expansion of the business as in Consolidated Apparel Co. v. Commissioner, (C. A. 7) 207 F. 2d 580, reversing 17 T. C. 1570. And, we think also that no justification for petitioner's action is furnished by the possibility that lessor corporation might have encountered difficulty in obtaining a mortgage loan had the percentage lease not been executed to become effective without delay. Petitioner was not the lessor, it was the lessee. Under such circumstances we are of the opinion that, had petitioner and lessor corporation dealt at arm's length, petitioner would not have been "required" to pay rent in excess of $ 6,000 per year for the unexpired period (July 1, 1946, through December 31, 1947) of the lease in effect between petitioner's predecessor and the former owner of the business property. Cf. Stanwick's, Inc., 15 T. C. 556, affirmed per curiam (C. A. 4) 190 F. 2d 84. Respondent, in fact, permitted rental deductions of $ 10,000 per annum for that period. He has not alleged that he erred in so doing nor has he asked for any increased deficiency.

Our decision results in the sustaining of respondent's determination for the 1947 fiscal year and in the disallowance of his determinations for the 1949 and 1950 fiscal years. For the 1948 fiscal year the rent deduction to which we hold petitioner is entitled is as follows:

Period	Rent
July 1-December 31, 1947	$ 3,000.00
January 1-June 30, 1948	15,273.64
Total	18,273.64

The $ 3,000 represents one-half the annual rent provided for under the former lease. The $ 15,273.64 is 6 per cent of one-half of the gross sales reported in petitioner's return for the 1948 fiscal year. In the absence of evidence concerning what portion of the fiscal year's gross sales was actually made during January 1-June 30, 1948, we have determined that a pro rata apportionment thereof is the most appropriate.

Decisions will be entered under Rule 50.

BAAR

Baar, J., dissenting: In my opinion the petitioner is entitled to deduct the full amount of the rental payable for the period from July 1, 1946, through December 31, 1947, in accordance with the terms of the new lease.

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Footnotes

• 2. July 1 to December 31.↩

• 1. The record contains no explanation of the apparent differential between these rental figures and the stipulated annual rental of $ 6,000.↩

• 3. January 1 to June 30.↩

• 1. On December 3, 1948, the termination date of the lease was amended to January 1, 1954.↩

• 1. Six per cent of gross sales for fiscal year 1947 is $ 31,829.79. The record contains no explanation for this discrepancy.↩

• 2. SEC. 23. DEDUCTIONS FROM GROSS INCOME.

  In computing net income there shall be allowed as deductions:

  (a) Expenses. --

  (1) Trade or business expenses. --

  (A) In general. -- All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or businees; and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity. * * *↩

• 3. The major cases relied on by respondent are White v. Fitzpatrick, (C. A. 2) 193 F. 2d 398 (in which the question concerned deductibility by a husband of payments made to his wife for the use of income producing properties which the husband had given as a gift to the wife but of which he had informally retained administrative control); Shaffer Terminals, Inc., 16 T.C. 356">16 T. C. 356, affirmed per curiam (C. A. 9) 194 F. 2d 539 (in which a corporation claimed deductions for rental of equipment it had sold to its sole shareholders and immediately leased back from them); and Stanwicks, Inc., 15 T. C. 556, affirmed per curiam (C. A. 4) 190 F. 2d 84↩ (in which a husband leased business property for a flat rental, subleased it to his wife at the same rental, and his wife subleased it at a percentage rental to the taxpayer corporation which was wholly owned by the husband).