Powers v. Commissioner , 44 T.C.M. 1265 ( 1982 )

GEORGE POWERS and WEETA POWERS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Powers v. Commissioner

Docket No. 8716-79.

United States Tax Court

T.C. Memo 1982-567; 1982 Tax Ct. Memo LEXIS 180; 44 T.C.M. (CCH) 1265; T.C.M. (RIA) 82567;

September 28, 1982.

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Walter J. Lynwood and Louis Vago, for the petitioners.

Judy Jacobs, for the respondent.

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WILES

MEMORANDUM FINDINGS OF FACT AND OPINION

WILES, Judge: Respondent determined deficiencies in petitioners' Federal income taxes for the following years:

Year	Deficiency
1970 1	$1,306
1973	7,541
1974	10,771
1975	16,854

In an amendment to his answer, respondent redetermined the deficiencies in taxes for 1973 and 1974 as $12.026 and $22,729, respectively.

After concessions, the sole issue for decision is whether petitioners' transactions with Marineland Corporation and LSD Corporation were not at arm's length, necessitating an allocation of income to petitioner under section 482. ²

FINDINGS OF FACT

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

George Powers (hereinafter petitioner) and Weeta Powers, husband and wife, resided in Streator, Illinois, when they filed their 1973, 1974, and 1975 joint Federal income tax returns and when they filed their petition in this case.

Marineland Lease

From at least 1965 until 1978, petitioner owned a controlling interest in Marineland Corporation (hereinafter Marineland). During the yers in issue, Marineland owned approximately 72 acres of real estate in La Salle County, Illinois, approximately 13 acres of which comprised a marina known as Starved Rock Marina (hereinafter "the marina"). On November 1, 1965, Marineland leased the marina to petitioner for an initial term of 10 years. The lease was amended several times between 1968 and 1974. The amendments, inter alia, provided for periodic increases in rent and obligated petitioner to pay real estate taxes on the marina property.

During the years in issue, Marineland's sole business was leasing real estate to petitioner. Such real estate consisted of land and various improvements made to the property by Marineland. The following schedules list the improvements owned and leased by Marineland in 1973, 1974, and 1975, showing their date of acquisition, original cost, accumulated depreciation, and remaining undepreciated cost:

	1973
	Date of	Original	Depreciation	Remaining
Asset Group	Acquisition	Cost	as of 1/1/73	Undepreciated Cost
Land improvements		$122,232		$122,232
Buildings	1962-1972	185,972	$80,936	105,036
	Mar. 1973	7,529		7,529
Machinery & Equipment	1962	371	203	168

	1974
	Date of	Original	Depreciation	Remaining
Asset Group	Acquisition	Cost	as of 1/1/74	Undepreciated Cost
Land improvements		$122,232		$122,232
Buildings	1962-1972	185,972	$91,657	94,315
	Mar. 1973	7,529	282	7,247
	June 1974	6,882		6,882
Machinery & Equipment	1962	371	220	151

	1975
	Date of	Original	Depreciation	Remaining
Asset Group	Acquisition	Cost	as of 1/1/75	Undepreciated Cost
Land improvements		$122,232		$122,232
Buildings	1962-1972	185,972	$100,338	85,634
	Mar. 1973	7,529	659	6,870
	June 1974	6,882	172	6,710
	June 1975	80,494		80,494
Machinery & Equipment	1962	371	316	55
	June 1975	10,248		10,248

LSD Lease

In 1967, petitioner formed an Illinois corporation known as Starved Rock Marina Launching, Storage and Docking Corporation (hereinafter LSD). Since that time he has owned a controlling interest in LSD. Petitioner formed LSD to operate the marina, so, in 1967, he subleased to it all of the improved real estate leased to him from Marineland, except for approximately 5,000 square feet of one 12,300 square foot building. ³ Petitioner used that 5,000 square feet for a new boat sales business which he operated as a sole proprietorship during the years in issue.

During 1972, 1973, and 1974, LSD used the subleased property to operate the marina, which rented, launched, stored, docked, and serviced boats for the general public. In September of 1972, LSD also began operating a restaurant and clothing store at the marina in a new building built by Marineland. An addition to the restaurant and clothing store building was completed around June of 1975.

From 1969 through 1975, petitioner added various improvements to the property he leased from Marineland. Petitioner claimed depreciation deductions for those improvements on his 1973, 1974, and 1975 Federal income tax returns. Approximately 90 percent of the improvements was used by LSD in its operation of the marina; the remaining 10 percent was used by petitioner in his boat sales business. The schedules below list the improvements owned by petitioner in 1973, 1974, and 1975, and detail their date of acquisition, original cost, accumulated depreciation, and remaining undepreciated cost:

	1973
	Date of	Original	Depreciation	Remaining
Asset Group	Acquisition	Cost	as of 1/1/73	Undepreciated
				Cost
Machinery & Equipment	1969-1972	$19,374	$7,169	$12,205
	2/1/73	195		195
Furniture & Fixtures	1969-1972	37,141	10,792	26,349
	June 1973	15,526		15,526
Leasehold improvements	1969-1972	204,834	90,361	114,473
	June 1973	38,450		38,450
Auto & Trucks	Prior to 1972	16,453	11,109	5,344
	1972	3,600	905	2,695
	Mar. 1973	6,753		6,753

	1974
	Date of	Original	Depreciation	Remaining
Asset Group	Acquisition	Cost	as of 1/1/74	Undepreciated
				Cost
Machinery & Equipment	1969-1972	$19,374	$9,130	$10,244
	2/1/73	195	10	185
Furniture & Fixtures	1969-1972	37,141	15,490	21,651
	June 1973	15,526	970	14,556
	June 1974	12,949		12,949
Leasehold improvements	1969-1972	204,834	114,837	89,997
	June 1973	38,450	932	37,518
	June 1974	14,559		14,559
Auto & Trucks	Prior to 1972	16,453	15,047	1,406
	1972	3,600	2,105	1,495
	Mar. 1973	6,753	2,532	4,221

	1975
	Date of	Original	Depreciation	Remaining
Asset Group	Acquisition	Cost	as of 1/1/75	Undepreciated
				Cost
Machinery & Equipment	1969-1972	$19,374	$11,091	$8,283
	2/1/73	195	34	161
Furniture & Fixtures	1969-1972	37,141	20,187	16,954
	June 1973	15,526	2,824	12,702
	June 1974	12,949	1,619	11,330
Leasehold improvements	1969-1972	204,834	134,237	70,597
	June 1973	38,450	2,796	35,654
	June 1974	14,559	705	13,854
	12/31/74	16,763		16,763
	1/1/75	855		855
	2/1/75	461		461
	3/1/75	1,898		1,898
	4/1/75	4,890		4,890
	7/1/75	46,735		46,735
	9/1/75	2,842		2,842
	11/1/75	850		850
	12/1/75	2,737		2,737
Auto & Trucks	Prior to 1972	16,453	15,753	700
	1972	3,600	3,305	295
	Mar. 1973	6,753	4,643	2,110

Notice of Deficiency and Amended Answer

On Schedules C of his 1973, 1974, and 1975 Federal income tax returns, petitioner claimed deductions for rents paid to Marineland and included in gross receipts rents received from LSD as follows:

	Rent Paid to	Rent Received
Year	Marineland	from LSD
1973	$36,845	$35,543
1974	33,260	44,755
1975	58,500	40,100

On those returns, petitioner also claimed deductions for Marineland's real estate taxes, which he paid pursuant to the 1973 amended lease agreement:

Year	Taxes Paid
1973	$5,325
1974	9,252
1975	3,199

In the notice of deficiency, respondent determined that petitioner's sublease with LSD was not an arm's-length transaction and under section 482 allocated additional rental income to petitioner of $29,458, $13,574, and $37,516 for 1973, 1974, and 1975, respectively. Additionally, respondent disallowed the deductions claimed by petitioner for Marineland's real estate taxes paid by him in 1973, 1974, and 1975. In an amended answer, respondent determined that both the lease from Marineland to petitioner and the sublease from petitioner to LSD were not arm's-length transactions and, therefore, a section 482 allocation is necessary to clearly reflect the income of petitioner, Marineland, and LSD. ⁴ On brief, respondent restated his allocations to petitioner's income as $21,081, $12,212, and $38,047 for 1973, 1974, and 1975, respectively. ⁵ Using 10 percent of cost less depreciation as the fair rental value of the improvements leased by Marineland to petitioner, plus the fair rental value of the land as determined by petitioner's expert witness C. William Shonkwiler, respondent reduced the rents paid to Marineland by petitioner as follows:

	Marineland
	Rent Paid 6	Rent Allowed
Year	By Petitioner	by Respondent
1973	$36,845	$32,758
1974	33,260	33,238
1975	58,500	38,237

To obtain a fair rental value of the property subleased to LSD, respondent first calculated 10 percent of the depreciated cost of the improvements petitioner placed on the marina. He reduced this amount by 10 percent to take out the fair rnetal value of the improvements petitioner used in his boat sales business. To this figure, respondent added the fair rental value of the marina as previously calculated, less the rental value of the 5,000 square feet of building (again, as determined by Mr. Shonkwiler) used by petitioner in his business. Respondent thus increased the rents petitioner received from LSD as follows:

	LSD
	Rent Received	Rent Allowed
Year	By Petitioner	By Respondent
1973	$35,543	$47,212
1974	44,755	47,693
1975	40,100	54,685

The following schedule summarizes respondent's section 482 adjustments to petitioner's income:

Respondent's Section 482 Adjustments Summarized

Marineland Lease	1973	1974	1975
Rent paid by petitioner	$36,845	33,260	$58,500
FRV of marina property
leased to petitioner	32,758	33,238	38,237
Excess rent paid to Marineland	4,087	22	20,263
Real estate taxes	5,325	9,252	3,199
Total excess rent paid to
Marineland	9,412	9,274	23,462
LSD Lease
FRV of marina property
subleased to LSD	$32,758	$33,238	$38,237
Less portion used by petitioner	(2,943)	(3,098)	(3,407)
	29,815	30,140	34,830
FRV of improvements leased
to LSD	17,397	17,552	19,855
Total	47,212	47,692	54,685
Rent received from LSD	35,543	44,755	40,100
Total underpayment by LSD	11,669	2,937	14,585
Total sec. 482 adjustment	21,081	12,211	38,047

OPINION

We must determine whether pursuant to section 482, respondent may allocate income to petitioner from Marineland and LSD by adjusting petitioner's payments and receipts of rent. ⁷

Section 482 provides:

In amy case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary or his delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such organizations, trades, or businesses.

Section 482 was enacted to prevent two or more related businesses from arbitrarily shifting income between or among themselves. Murphy v. Commissioner,231 F. 2d 639 (6th Cir. 1956); Brittingham v. Commissioner,66 T.C. 373">66 T.C. 373 (1976), affd. 598 F. 2d 1375 (5th Cir. 1979); Huber Homes, Inc. v. Commissioner,55 T.C. 598">55 T.C. 598 (1971). Its purpose is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer; hence the standard to be applied is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer. Section 1.482-1(b)(1), Income Tax Regs.Section 482 vests the Commissioner with broad discretion, and his determinations in applying such section must be upheld unless the taxpayer establishes that such determinations are unreasonable, arbitrary, or capricious. Baldwin-Lima-Hamilton Corp. v. United States,435 F. 2d 182, 185 (7th Cir. 1970); Philipp Brothers Chemicals, Inc. (N.Y.) v. Commissioner,435 F. 2d 53, 57 (2d Cir. 1970), affg. 52 T.C. 240">52 T.C. 240 (1969); Ach v. Commissioner,358 F. 2d 342 (6th Cir. 1966), affg. 42 T.C. 114">42 T.C. 114 (1964).

Section 1.482-2(c)(1), Income Tax Regs., deals specifically with the "use of tangible property" and empowers the Commissioner to allocate rental income as follows:

Where possession, use, or occupancy of tangible property owned or leased by one member of a group of controlled entities * * * is transferred by lease or other arrangement to another member of such group * * * at a charge which is not equal to an arm's length rental charge * * * the * * * [Commissioner] may make appropriate allocations to properly reflect such arm's length charge.

Focusing on the standard of an arm's-length charge as required by the statute and regulations, petitioner argues that the rentals he received from LSD from the sublease of the marina were equal to the fair rental value of such property and were, therefore, the equivalent of an arm's-length charge. Petitioner also argues that respondent's allocations are arbitrary and unreasonable because they are based in part upon calculations which include $122,232 of nonexistent assets. Finally, petitioner maintains that the transactions in question were carried on for valid business reasons and were not shams, and thus section 482 is inapplicable.

Respondent, on the other hand, contends that the leasing transactions between Marineland and petitioner, and petitioner and LSD were not carried on at arm's length. We agree with respondent for the reasons set out below.

Petitioner had the following rent expense and income for the years 1973, 1974, and 1975:

	Rent Paid	Rent Received
Year	to Marineland	from LSD
1973	$36,845	$35,543
1974	33,260	44,755
1975	58,500	40,100

Petitioner leased approximately 13 acres of land and improvements from Marineland. He then subleased virtually all of this property, ⁸ plus improvements and some of his own assets to LSD. However, as can be seen from the above table, the rent petitioner received from LSD was in two of the three years at issue less than the rent petitioner paid to Marineland. Obviously, either the rent paid to Marineland was excessive, or the rent paid by LSD was less than the property's fair rental value.

Petitioner contends that the transactions between him and LSD were arm's-length transactions because LSD could not afford to pay any more rent than it did. The regulations under section 482 provide a definition of an arm's-length charge (for property leased by an owner or user not in the business of renting property) ⁹ based on a formula taking into account what is essentially depreciation, a charge similar to interest, and certain expenses and deductions for the property. Section 1.482-2(c)(2), Income Tax Regs. There is no limitation on this amount imposed by the lessee's ability to pay. Petitioner argues that the fact that the lease actually called for more rent than was paid by LSD shows the transactions were at arm's length in that petitioner was trying to get the maximum rents obtainable. We believe, however, that this fact supports respondent's position that the transactions at issue were not carried on as they would have been between petitioner and an unrelated third party. Certainly, had an uncontrolled lessee consistently defaulted on a portion of its rental payments, petitioner would have looked elsewhere for a tenant better able to pay the rents provided for in its lease.

Petitioner has also attempted to refute respondent's determination by introducing into evidence two prior leases of the marina to unrelated third parties at amounts lower than those received from LSD. We have carefully examined the two prior leases and find them to be unpersuasive. The prior leases, executed 9 and 10 years before the first of the years here in issue, encompassed different areas on different terms than the lease between petitioner and LSD, and are thus not relevant to our determination of a fair rental value.

Petitioner takes the position that he has introduced evidence that the rentals charged were fair and reasonable and that such evidence is uncontroverted and unimpeached, and therefore should be accepted. Petitioner's evidence consisted of the testimony of two witnesses offered as experts. Each of these witnesses stated that in his opinion the rentals paid by LSD exceeded the fair rental value of the leased property. ¹⁰ Petitioner's first expert witness, C. William Shonkwiler (hereinafter Shonkwiler), testified that he used the comparative, or market data, approach, in determining the fair rental value of the land itself. He placed the value at $9,450 in 1973, $10,500 in 1974, and $11,550 in 1975. He explained further that, being unable to find any comparable rented property in the area, he used the investor's approach to value the improvements. Shonkwiler defined this approach as one in which the appraiser assumes an investor would want the most profitable likely use to which a property can be put and the highest net return on his investment. Shonkwiler believed that an investor would normally expect a net return of 10 percent of the fair market value, or cost less depreciation, of the leased improvements.

The other expert witness offered by petitioner, Charles H. Stokes (hereinafter Stokes), had no reasonable foundation for his opinion as to a fair rental value. Although Stokes had been a marina consultant for many years, upon cross-examination it became apparent that he had little or no experience in appraising. He valued the property on the basis of the marina's sales volume and what he personally would be willing to pay to rent the marina; yet he only had a limited knowledge of the property and improvements involved. Stokes was unable to give the acreage of the marina property, and he did not know the age, cost, or construction material of the buildings involved. Moreover, he indicated in his report two allegedly comparable marinas which supported his valuations. A close examination of those marinas reveals neither one is comparable.

After reviewing the testimony of the two expert witnesses, we believe Shonkwiler rendered a more accurate estimate of the value of the marina property. Shonkwiler was an experienced real estate appraiser, and he used appraisal methods which we believe to be fair and reasonable. ¹¹ However, the record reveals that he neglected to include in his appraisal many of the improvements and assets placed on the land by Marineland and petitioner. Inasmuch as respondent has agreed Shonkwiler's appraisal methods are reasonable, and has used those methods in recomputing petitioner's tax deficiencies, we sustain respondent's formulation of fair rental values for the marina and improvements.

Petitioner argues that it is unfair for us to consider Marineland because the statute of limitations bars Marineland from claiming a refund, and Marineland was liquidated and is no longer even in existence. We agree with respondent that the Marineland transactions are an integral part of this case. Moreover, respondent has conceded in his reply brief that if we determine the rent paid by petitioner to Marineland is excessive, then he will in the Rule 155 computation reduce petitioner's tax liability by the amount of any refund to which Marineland would be entitled.

Petitioner argues further that respondent's allocations are arbitrary and unreasonable because they are based in part upon calculations which include $122,232 of "mythical assets." These assets are mentioned on Marineland's depreciation schedule worksheet as merely "Land Improvements" costing $122,232. No date of acquisition is listed, and no depreciation for those improvements is claimed on that schedule or on Marineland's income tax returns.The improvements are not listed as assets on the Schedules L (Balance Sheets) of Marineland's tax returns, nor are they included in Marineland's assets as set out in paragraph 6 of the parties' stipulation of facts. However, petitioner himself testified to the existence of those improvements and the approximate cost thereof, and several of the stipulated exhibits describe the improvements. While we will not lightly disregard facts to which the parties have stipulated, (Rule 91(e); Mifflin v. Commissioner,24 T.C. 973">24 T.C. 973 (1955)), because petitioner's own testimony is contrary to paragraph 6, and because the stipulation of facts is itself internally inconsistent, we must look to the record as a whole. We are convinced such improvements do in fact exist and respondent's computation is therefore correct.

Even were we to decide otherwise, as we have already determined the Marineland transactions are properly at issue, the same result obtains due to the correlative adjustment to Marineland's income:

Respondent's Section 482 Adjustments

	1973	1974	1975	Total
Total Sec. 482 adjustment	$21,081	$12,211	$38,047	$71,339

428 ADJUSTMENTS EXCLUDING $122,232 LAND IMPROVEMENTS

MARINELAND LEASE	1973	1974	1975	Total
Rent paid by petitioner	$36,845	$33,260	$58,500
FRV of marina property leased
to petitioner	* 20,535	21,015	26,014
Excess rent paid to Marineland	16,310	12,245	32,486
Real estate taxes	5,325	9,252	3,199
Total excess rent paid to
Marineland	21,635	21,497	35,685	78,817
LSD LEASE
FRV of Marina property subleased
to LSD	* 20,535	21,015	26,014
Less portion used by petitioner	(2,943)	(3,098)	(3,407)
	17,592	17,917	22,607
FRV of improvements leased
to LSD	17,397	17,552	19,855
Total	34,989	35,469	42,462
Rent received from LSD	35,543	44,755	40,100
Total underpayment by LSD	( 554)	(9,286)	2,362	(7,478)
Total Sec. 482 adjustment	21,081	12,211	38,047	71,339

Petitioner alleges the excess rent paid to Marineland was attributable to the rest of the 72 acres Marineland owned and leased to petitioner but which petitioner did not sublease to LSD. He argues that respondent introduced no evidence to prove the value of those acres and thus failed to carry his burden of proof under Rule 142(a). This appears to us as a last-ditch argument formulated some time after the trial of this case. Petitioner's testimony and the lease agreements in evidence clearly show that Marineland leased petitioner only the 13 acres of marina property, and that petitioner subleased to LSD everything that he had leased from Marineland, except the 5,000 square feet of one building.

Finally, petitioner maintains that he had valid business purposes for arranging the leases as he did and thus the transactions were not shams. Respondent has never attacked the structure of the transactions, and his authority is not so limited. Section 1.482-1(c), Income Tax Regs., states:

In determining the true taxable income of a controlled taxpayer, the * * * [Commissioner] is not restricted to the case of improper accounting, to the case of a fraudulent, colorable, or sham transaction, or to the case of a device designed to reduce or avoid tax by shifting or distorting income, deductions, credits, or allowances. The authority to determine true taxable income extends to any case in which either by inadvertence or design the taxable income, in whole or in part, of a controlled taxpayer, is other than it would have been had the taxpayer in the conduct of his affairs been an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer.

See Dillard-Waltermire, Inc. v. Campbell,255 F. 2d 433, 436 (5th Cir. 1958); Eli Lilly and Co. v. United States,178 Ct. Cl. 666">178 Ct. Cl. 666, 671-681, 372 F. 2d 990, 999 (1967); Your Host, Inc. v. Commissioner,58 T.C. 10">58 T.C. 10, 24 (1972), affd. 489 F. 2d 957 (2d Cir. 1973).

To reflect the foregoing,

Decision will be entered under Rule 155.

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Footnotes

• 1. The deficiency determined for the 1970 taxable year resulted from the disallowance of a $1,306 refund from a tentative investment credit carryback from 1973 to 1970.↩

• 2. Unless otherwise indicated, all statutory references are to the Internal Revenue Code of 1954, as amended. All rule references are to the Tax Court Rules of Practice and Procedure.↩

• 3. The original sublease was amended in 1967, 1968, 1969, 1973, and 1974. The amendments correlated with those made to the lease between petitioner and Marineland, i.e., they provided for periodic increases in rent and obligation LSD to pay real estate taxes on the marina.↩

• 4. In a second amended answer respondent alternatively contended that a sec. 482↩ allocation was necessary based on depreciation, as petitioner was depreciating that portion of the improvements not used in his boat sales business but leased to LSD. Respondent allocated additional income to petitioner of $43,394, $38,077, and $28,836 for 1973, 1974, and 1975, respectively.

• 5. While respondent's allocation for 1975 is greater than those contained in either the notice of deficiency or the second amended answer, respondent has not alleged a correspondingly greater deficiency for that year.↩

• 6. These amounts do not include the real estate taxes paid by petitioner for Marineland.↩

• 7. On brief, respondent abandoned his alternate issue with respect to a section 482↩ allocation based on depreciation, and thus we will not conside it.

• 8. Petitioner subleased to LSD all of the marina property except 5,000 square feet of one building. The fair rental value of this 5,000 square feet is minimal: petitioner's expert Shonkwiler testified that he would value it at $2,943 in 1973, $3,098 in 1974, and $3,407 in 1975.↩

• 9. Sec. 1.482-2(c)(2)(i), Income Tax Regs.↩, states in part: "[A]n owner or user shall be considered to be in the trade or business of renting property if it engages in the trade or business of renting property of the same general type as the property in question to unrelated parties." There is no evidence in the record indicating that petitioner is in the trade or business of renting marinas during the taxable years in question.

• 10. Apparently, because respondent has the burden of proof with respect to the Marineland lease (Rule 142(a)), and because petitioner objected to the amended answer putting such lease in issue, petitioner offered no expert testimony on this point.↩

• 11. We approved a method similar to Shonkwiler's investor's approach in Clairton Slag, Inc. v. Commissioner,T.C. Memo. 1979-485↩ (9.5 percent of fair market value equals a fair rental value for purpose of sec. 162(a)(3) deduction).

• *. FRV of marina property leased to petitioner per respondent's adjustments less FRV (10%) of $122,232 land improvements.↩