ZAVATT, District Judge.
These are cross-appeals from a decision of the Tax Court, 54 T.C. 913 (1970), holding (1) that 26 U.S.C. § 482 (the Internal Revenue Code of 1954, hereinafter the "Code") did not authorize the Commissioner to allocate to B. Forman Co., Inc. (Forman) and McCurdy & Co., Inc. (McCurdy) (both referred to herein as taxpayers) interest income attributable to interest free loans made by the taxpayers to Midtown Holdings Corp. (Midtown), because of the absence of the requisite § 482 control of Midtown by the taxpayers; and (2) that annual payments of $75,000.00 each made by taxpayers to Midtown were not ordinary and necessary business expenses deductible under 26 U.S.C. § 162. The Commissioner appeals from the first of these holdings; the taxpayers appeal from the second. We reverse the decision of the Tax Court as to the first and affirm as to the second of these holdings.
These consolidated cases involve the corporate income tax liability of Forman and of McCurdy for the fiscal years 1965, 1966 and 1967. Having disallowed the annual payments of $75,000.00 each year by the taxpayers to Midtown and having allocated as income to each taxpayer interest at the rate of 5% per annum on a $1,000,000.00 loan made by each taxpayer to Midtown prior to the fiscal years in question, the Commissioner assessed tax deficiencies against each taxpayer (now in dispute) as follows:
Forman McCurdy 1965 $ 62,425.55 $ 59,181.99 1966 58,775.14 59,643.92 1967 59,692.00 62,343.56 ___________ ___________ Totals $180,892.69 $181,169.47
Following receipt of the Commissioner's notices of these deficiencies and on January 31, 1969, each taxpayer filed a petition with the Tax Court for a review of the respective tax deficiency determinations of the Commissioner, both of which petitions were consolidated.
For several years prior to and as of the date of incorporation of Midtown, McCurdy (a New York corporation since 1901) operated a retail general department store at 285 Main Street East, Rochester, New York and Forman (a New York corporation since 1912) operated a retail department store, specializing in men's and women's apparel, at 46 Clinton Avenue South, Rochester, New York. All of the stock of McCurdy was owned by or in behalf of members of the McCurdy family. All of the stock of Forman was owned by or in behalf of members of the Forman family. McCurdy and Forman had no common shareholders, directors or officers. Both corporations were competitors.
In an effort to stem declining incomes, McCurdy and Forman caused Midtown to be formed in 1958. On March 23, 1959 they entered into an agreement with reference to their participation in the building and development of a midtown shopping center in Rochester which would adjoin the rear entrances to their respective stores. By that time the Board of Directors and officers of Midtown consisted of the following:
Relationship to McCurdy and Forman Gilbert J. C. McCurdy (President — Chairman of the Board of and Chairman of Board of Directors and President of McCurdy Directors of Midtown) Gordon W. McCurdy (Secretary — Vice-Chairman of the Board and a Director of Midtown) of Directors and Senior Vice-President of McCurdy Maurice R. Forman (Vice-President — Chairman of the Board of and a Director of Midtown) Directors and President of Forman Fred Forman (Treasurer and a — Member of the Board of Director of Midtown) Directors and Senior Vice-President of Forman Lynn Johnston (Vice-President and General Manager of Midtown)
McCurdy and Forman had already acquired 50% each of the issued and outstanding shares of Midtown. In exchange for the real estate interests they were to assign and convey to Midtown, each of them was to receive an additional 810 common, no par value shares of Midtown, thus continuing their equal stock ownership in Midtown. If, prior to January 1, 1965, the Board of Directors of Midtown should determine, by resolution, that additional funds were necessary or advisable, McCurdy and Forman agreed to purchase additional shares of Midtown "so that their aggregate holding shall be One Million Dollars ($1,000,000) each, at any time, and from time to time . . ." In addition, each party to this agreement agreed to loan to Midtown additional amounts
This agreement also provided for the control of Midtown by McCurdy and Forman by requiring each party thereto to vote its respective Midtown stock so as to provide for a Board of Directors consisting of three Directors designated by the Board of Directors of McCurdy and three Directors designated by the Board of Directors of Forman. At the request of either McCurdy or Forman, each party to the agreement undertook to vote its Midtown stock for a seventh Director. In the event they were unable to agree upon the seventh Director, McCurdy and Forman were to designate their respective representatives who would designate the seventh Director to be elected "by the parties hereto . ." In the event that these representatives were unable to agree upon a seventh Director, a Justice of the Appellate Division of the Supreme Court, Fourth Judicial Department, was to act with the two representatives and the seventh Director of Midtown was then to be designated by majority vote of the Justice and the two representatives of the parties.
The agreement also limited the right of the parties to dispose of their Midtown stock to detailed conditions set forth therein.
Although the agreement provided for the designation of three Midtown Directors
President and Director Gilbert J. C. McCurdy Vice President and Director Maurice R. Forman Secretary and Director Gordon W. McCurdy Treasurer and Director Fred Forman (until his death) Robert Aex (after Fred Forman's death) Aex represented Forman's interests Vice President and Lynn Johnston (to April 1, 1963) General Manager Angelo Chiarella (from May 27, 1963 on)
The shopping center, completed and opened for business in 1962, consisted of an eighteen story building, a four story building (adjoining the Mall), and a three level underground parking garage. Each taxpayer initially invested a total of $1,000,000.00 in return for Midtown stock. The original estimated cost of the shopping center was $8,000,000.00. The actual cost exceeded $18,000,000.00.
Construction commenced in 1959. The record does not reveal all of the financing for this project. It does show that Midtown entered into a building loan agreement with Lincoln Rochester Trust Company (Lincoln), dated April 18, 1961, providing for advances not to exceed $11,000,000.00 to be evidenced by notes bearing interest at the rate of six percent per year, secured by the "personal guarantees of certain officers of the Company and others" and "a conditional assignment of rents of the premises." During 1958 and 1959, McCurdy and Forman made several loans to Midtown, the amounts of which are not revealed by the record or stated in the stipulation of facts in the proceeding before the Tax Court. It was so stipulated, however, that, on May 1, 1959, the several loans were consolidated into single obligations of Midtown of $662,500.00 each to McCurdy and Forman, represented by thirty-year notes of Midtown, each bearing interest at the rate of five percent per annum. (These notes were satisfied in July of 1959, without interest, from the proceeds of a $2,700,000.00 line of credit established by Midtown with Lincoln. The fact that McCurdy and Forman each waived interest on these notes is not involved in the instant case.)
Allocation of Interest Income under 26 U.S.C. § 482
The issue as to allocation of income to McCurdy and Forman for the fiscal years 1965, 1966 and 1967 stems from loans of $1,000,000.00 each by the taxpayers to Midtown on September 9, 1960, each represented by a three-year note of Midtown to each taxpayer, bearing interest at the rate of three and one-half percent per annum. These notes were cancelled in April 1961, without payment of any principal or interest. In lieu thereof, they were replaced by notes of $1,000,000.00 each, predated September 9, 1960 and bearing no interest. On their due date, September 9, 1963, they were replaced by three-year notes in the same principal amounts, bearing no interest — without any payment of principal or interest having been made thereon. These notes, dated September 9, 1963, were replaced on September 9, 1966 by three-year notes in the same amounts, bearing no interest, without any payment of principal or interest having been paid thereon. No payments of principal or interest have ever been made on the notes dated, respectively, September 9, 1960, September 9, 1963 and September 9, 1966. The issue as to the Commissioner's allocation of income to McCurdy and Forman relates to the notes dated September 9, 1963 and September 9, 1966.
The Commissioner imputed interest income at the rate of five percent per annum on those $1,000,000.00 loans by McCurdy and Forman to Midtown ($50,000.00 of income to each taxpayer during their fiscal years 1965, 1966 and 1967), pursuant to 26 U.S.C. § 482, which provides:
The Tax Court reversed the Commissioner's determination, holding in effect that Midtown was not "controlled directly or indirectly" by either McCurdy or by Forman and that McCurdy and Forman may not be regarded as a single entity controlling Midtown.
26 U.S.C. § 482 derives from section 45 of the Internal Revenue Code of 1928. The House report with reference to section 45 of the 1928 Code explained that its purpose was to allow the Commissioner to
Provisions somewhat similar to those in section 45 were contained in prior Revenue Acts. Section 240(d) of the Revenue Act of 1924, 43 Stat. 288, Internal Revenue Acts of 1924 to Date, 26 U.S.C.A. p. 45, authorized the Commissioner to consolidate the accounts of two or more related trades or businesses owned or controlled by the same interests. It did not authorize him to distribute, apportion, or allocate, as in section 482. Section 240(f) of the Revenue Act of 1926, 44 Stat. 46, Internal Revenue Acts of 1924 to Date, 26 U.S.C.A. p. 191 contained the very same language as in section 240(d) of the Revenue Act of 1924. Section 45 of the Revenue Act of 1928, 45 Stat. 806, Internal Revenue Acts of 1924 to Date, 26 U.S.C.A. p. 364, effected a change. The sections of the prior acts were under the caption "Consolidated Returns of Corporations." The caption of section 45 of the Revenue Act of 1928 was "Allocation of Income and Deductions." Its language is substantially identical to that in present section 482. The same is true of section 45 of the Revenue Act of 1932, 47 Stat. 186, Internal Revenue Acts 1924 to Date, 26 U.S.C.A. p. 498; section 45 of the Revenue Act of 1934, 48 Stat. 695, Internal Revenue Acts of 1924 to Date, 26 U.S.C.A. p. 680; section 45 of the Revenue Act of 1936, 49 Stat. 1667, Internal Revenue Acts of 1924 to Date, 26 U.S.C.A. p. 840; section 45 of the Revenue Act of 1938, 52 Stat. 474, Internal Revenue Acts of 1924 to Date, 26 U.S.C.A. p. 1028 and section 45 of the Internal Revenue Code of 1939, 26 U.S.C.A. § 45; the Internal Revenue Code of 1954, section 482. The Revenue Act of 1928 eliminated the right of affiliated corporations to file consolidated returns and the right of the Commissioner to consolidate the accounts of two or more related trades or businesses controlled by the same interests. In lieu thereof section 45 was inserted which "broadened considerably" former section 240(f) of the 1926 Act "in order to afford adequate protection to the Government
The decision of the Tax Court in Lake Erie & Pittsburg Railway Co. v. Commissioner, 5 T.C. 558 (1945), is the only judicial determination based on facts substantially similar to those in the instant case. The Tax Court reaffirmed that decision in the instant case. In Lake Erie, the New York Central Railroad and the Pennsylvania Railroad (two independent competing corporations, having no common stockholders, officers or directors), formed a third corporation, the Lake Erie & Pittsburg Railway Co. (Lake Erie), for the purpose of acquiring, building, maintaining, leasing and operating a railroad between Lorain and Youngstown, Ohio. New York Central and Pennsylvania railroads were the sole, equal stockholders of Lake Erie. They used the facilities of Lake Erie for which use they originally paid rent pursuant to a 1908 agreement and Lake Erie paid dividends to these two stockholders. This agreement was modified in 1939 so as to release the two railroads from their obligation to pay rent to Lake Erie and release Lake Erie of its obligation to pay them (as stockholders) dividends. The Commissioner allocated to Lake Erie as income to it, during 1937, 1938, 1939 and 1940, from the gross income of the railroads an amount equal to the rent which the railroads were originally obligated to pay to Lake Erie. Lake Erie had reported no taxable net income for each of these years. The Tax Court reversed the determination of the Commissioner on the ground that he was without authority to make the questioned allocation pursuant to section 45 of the Internal Revenue Code of 1939:
The Commissioner acquiesced in the decision of the Tax Court in Lake Erie. 1945 Cum.Bull. 5. In 1965, however, the Commissioner withdrew the prior acquiescence and substituted nonacquiescence. Rev.Rul. 65-142, 1965-1 Cum.Bul. 223.
The declared purpose of section 482 is "to prevent evasion of taxes or clearly to reflect the income of . . . organizations . . . owned or controlled directly or indirectly by the same interests." This legislative purpose is reflected in the Treasury Regulations where it is stated that:
The courts recognize the congressional purpose of section 482 to prevent evasion or avoidance of otherwise payable taxes by means of shifting profits or by other financial devices and have given broad scope to the Commissioner's discretion in making reallocations of income, where the exercise of this power
Whether the Commissioner was correct in allocating to McCurdy and Forman interest on their respective loans of $1,000,000.00 each is essentially one of fact, and his decision must be affirmed if supported by substantial evidence. Advance Machinery Exchange, supra, at 1007. Where, as here however, the Tax Court has reversed the Commissioner, the decision of the Tax Court must be affirmed unless clearly erroneous. Commissioner of Internal Revenue v. Duberstein, 363 U.S. 278, 80 S.Ct. 1190, 4 L. Ed.2d 1218 (1960); Schley v. Commissioner of Internal Revenue, 375 F.2d 747 (2d Cir. 1967); LaMont v. Commissioner of Internal Revenue, 339 F.2d 377 (2d Cir. 1964). In order to justify an allocating of income pursuant to section 482, the Commissioner must find that (1) there are two or more trades, businesses or organizations (2) owned or controlled by the same interests and (3) that it is necessary to allocate gross income, deductions, credits, or allowances among them in order to prevent evasion of taxes or in order to clearly reflect their income.
Treasury regulations must be sustained unless unreasonable and plainly inconsistent with the revenue statutes. Commissioner of Internal Revenue v. South Texas Lumber Co., 333 U.S. 496, 501, 68 S.Ct. 695, 698, 92 L.Ed. 831 (1948); Sanford v. Commissioner of Internal Revenue, 412 F.2d 201, 202 (2d Cir.), cert. denied, 396 U.S. 841, 90 S.Ct. 104, 24 L.Ed.2d 92 (1969).
The terms "organization," "trade," "business" are broadly defined in Treas.Reg. § 1.482-1(a) (1) and (2). In Borge v. Commissioner of Internal Revenue, 405 F.2d 673 (2d Cir. 1968), cert. denied, sub nom, Danica Enterprises, Inc. v. Commissioner of Internal Revenue, 395 U.S. 933, 89 S.Ct. 1994, 23 L.Ed.2d 448 (1969), this court found that an individual stockholder and his wholly owned corporation satisfied the two or more business prerequisite of section 482. Certainly, Midtown, McCurdy and Forman satisfy this prerequisite.
No definition of "control" is contained in section 482. It has been opined that this omission was intentional in order to allow for flexibility of administration. Plumb and Kapp, Reallocation of Income and Deductions Under Section 482, 41 Taxes 808, 811 (1963).
Guidelines for determining control are contained in Treas.Reg. 1.482-1(a) (3):
To the same effect see Treas.Reg. 39.45-1(a) (3) and annual Treasury regulations thereafter.
As to "same interests," there is no statutory definition and no Treasury regulations guidelines.
In order to find control, no percentage requirements are specified nor are any precise requirements necessary. The trend in the recent case law is to apply the realistic approach. Borge v. Commissioner of Internal Revenue, supra; Hall v. Commissioner, 32 T.C. 390 (1959), aff'd, 294 F.2d 82 (5th Cir. 1961); Grenada Industries, Inc. v. Commissioner, 17 T.C. 231 (1951), aff'd 202 F.2d 873 (5th Cir.), cert. denied, 346 U.S. 819, 74 S.Ct. 32, 98 L.Ed. 345 (1953). Despite the fact that these cases are all distinguishable on their facts, they lend support to the view that the Commissioner urges here.
In Borge v. Commissioner of Internal Revenue, supra, this Court held that an individual (the entertainer Victor Borge) and his wholly owned corporation, conducting a poultry business, were commonly controlled within the purview of § 482 and that the Commissioner was justified in allocating income from the corporation to Victor Borge, because the contract between him and his wholly owned corporation would never have been made between two unrelated parties dealing at arm's length.
In Hall v. Commissioner, supra, the taxpayer (Hall) conducted a business individually. Thereafter he formed a corporation and transferred nearly all of his shares of stock of that corporation to his son. The court upheld the allocation of income between Hall and the corporation under § 45 of the 1939 Code. It disregarded the issue of who actually owned the stock, holding that Hall, in fact, actively controlled the corporation, despite his contention that he had transferred ownership of the stock. The Tax Court, in Ach v. Commissioner, 42 T.C. 114 (1964), aff'd, 358 F.2d 342 (6th Cir.), cert. denied, 385 U.S. 899, 87 S.Ct. 205, 17 L.Ed.2d 131 (1966), restated its view that it is not the record ownership of stock which determines control; that control is to be determined by ascertaining who, in fact, has control.
In Grenada Industries, Inc. v. Commissioner, supra, two corporations and two partnerships were owned by four families in identical 35%-35%-20%-10% proportions. In upholding an allocation of income among the four organizations, the court noted that it was immaterial that the record ownership of the stock and the partnership interests may not have been in the identical persons at the same time. Control was inferred from the actions of the parties.
If Midtown was the creature of only one of the taxpayers, and all of its stock were owned by that single parent, i. e., if Midtown were a strange creature having a father but no mother, the most rigid, literal wooden interpretation of section 482 would bring Midtown within the ambit of that section. It is the contention of the taxpayers, however, that section 482 is not applicable because Midtown is the normal child of a father and a mother, the product of an earthy relationship between McCurdy and Forman, twentieth century parents exercising no control over their progeny.
Midtown is the creation of a union of McCurdy and Forman—not in holy matrimony but in a legitimate business enterprise. Their interests in the existence and career of Midtown and the interests of Midtown are identical.
To contend that these parents do not control their child is to fly in the face of reality. They have had complete control of Midtown from the day of conception (its incorporation) throughout the years relevant to this case. Every act of Midtown has been dictated by papa and mamma who, directly or indirectly, have financed its career and controlled its every move.
In apparent disregard of the reality of the circumstances, the Tax Court below
The Commission is supported by the views of commentators.
The loans by taxpayers to Midtown, without interest, affected the incomes of taxpayers and of Midtown. By not reporting interest on these loans, taxpayers reported lower earnings and, in turn, lower taxes. Midtown, in not paying interest, eliminated a business expense which would have further increased its yearly losses. Because of Midtown's unfavorable financial condition, it was encountering difficulty in the rental of stores, a matter of concern to McCurdy and Forman, the actual owners of Midtown. Midtown, McCurdy and Forman were loathe to show as further losses annual interest payments on $2,000,000.00 of loans at 5% i. e., $100,000.00 per year, and the elimination of annual payments of $150,000.00 by McCurdy and Forman. Reference to these payments will be made infra. Mr. Chiarella, general manager of Midtown, testifying before the Tax Court as to these annual payments of $150,000.00, said that they definitely helped to narrow Midtown's deficit; that without these payments Midtown would have had to get that money from some place. Appendix p. 280a. This explanation is equally applicable
Whether McCurdy and Forman are regarded as a partnership or joint venture, de facto, in forming Midtown, the conclusion is inescapable that they acted in concert in making loans without interest to a corporation, all of whose stock they owned and all of whose directors and officers were their alter egos. They were not competitors in their dealings with one another or with Midtown as to Midtown. Their interests in Midtown were identical. When the Commissioner withdrew his acquiescence in Lake Erie, he gave reality of control as one of the reasons for doing so. "[T]he reality of control by the same interests is present no less than if they [the two parent railroads] had formed a partnership . . . to deal with the petitioner [Lake Erie Railway Company] or had formed another corporation to deal with petitioner." Rev.Rul. 64-142. We agree.
We find clearly erroneous the holding of the Tax Court that the requisite control of Midtown by the taxpayers was not present and find further that McCurdy and Forman had the same interests in Midtown.
Having found two businesses under common control, we reach the question as to whether the Commissioner properly allocated interest on the two loans of $1,000,000.00 each as income to the taxpayers.
"Transactions between one controlled taxpayer and another will be subjected to special scrutiny to ascertain whether the common control is being used to reduce, avoid, or escape taxes." Treas.Reg. 1.482-1(c). To same effect, see Local Finance Corp. v. Commissioner of Internal Revenue, 407 F.2d 629, 632 (7th Cir.), cert. denied, 396 U.S. 956, 90 S.Ct. 428, 24 L.Ed.2d 420 (1969). To justify the allocation as income to McCurdy and Forman of interest on their loans, it must be found that their waiver of interest "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 controlled taxpayer." Treas.Reg. 1.482-1(c). See also, Local Finance Corp. v. Commissioner of Internal Revenue, supra, at 632; Lilly and Co. v. United States, 372 F.2d 990, 1000 (Ct.Cl.1967); Oil Base, Inc. v. Commissioner of Internal Revenue, 362 F.2d 212, 214 (9th Cir.), cert. denied, 385 U.S. 928, 87 S.Ct. 287, 17 L. Ed.2d 211 (1966). "In determining the true taxable income of a controlled taxpayer, the district director 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." Treas. Reg. 1.482-1(c).
Reallocation is necessary here in order to properly reflect the income of taxpayers and Midtown. Taxpayers have advanced an argument, supported by case law, that the Commissioner may not create income where none actually existed. In Tennessee-Arkansas Gravel Co. v. Commissioner of Internal Revenue, 112 F.2d 508 (6th Cir. 1940), the court held that the Commissioner could not increase the income of a taxpayer whose property had been used by a related corporation without the payment of rent. The court concluded that, since no rent was called for, none could be created. In Smith-Bridgman & Co. v. Commissioner, 16 T.C. 287 (1951), the Commissioner had added interest to the taxable income of Smith-Bridgman & Co., as allegedly constituting interest which should have been charged by it on noninterest bearing loans to its parent corporation, Continental Department Stores (Continental). Taxpayer did not report as income any interest on these loans. The Tax Court, in overruling the Commissioner, who had allocated interest to Smith-Bridgman, refused to authorize the creation of income where no income was realized. This decision was thought to rest on the fact that the Commissioner had added interest to taxpayer, but had failed to make an adjustment to the income of Continental.
Several cases have held that one related party is not required to charge another related party interest on a loan; that the lender is not to be taxed on interest, with respect to a loan, where it was not intended that interest be collected. In Combs Lumber Co. v. Commissioner, 41 B.T.A. 339 (1940), it was the practice of the corporation to lend money to its stockholders without interest. The Board of Tax Appeals ruled that, under the circumstances, no liability for interest was created and, thus, the Commissioner could not impute interest to the lender. In Society Brand Clothes, Inc. v. Commissioner, 18 T.C. 304 (1952), a corporation held a ten year note of its wholly owned subsidiary. The note provided for the payment of interest, but it was executed with the understanding that no interest would be charged until some date in the future. The Tax Court held that the corporation was not required to report any interest not received by it. A similar result was reached in Atchison, Topeka & Sante Fe Railway Co. v. Commissioner, 36 T.C. 584 (1961).
To the extent that the above cases cited by taxpayers may be read as holding that no interest can be allocated under § 482 under the facts of this case, they are not in accord with either economic reality, or with the declared purpose of section 482. They seriously impair the usefulness of § 482. Those cases may be correct from a pure accounting standpoint. Nevertheless, interest income may be added to taxpayers' incomes, as long as a correlative adjustment is made to Midtown, for then the true taxable income of all involved will be properly reflected. Treas.Reg. § 1.482-1(a) (6) provides:
Treas.Reg. § 1.482-2(a) provides:
These regulations must prevail, for they are entirely consistent with the scope and purpose of § 482. The instant loans without interest are obviously not at arm's length, since no unrelated parties would loan such large sums without interest. The allocation of the interest income to taxpayers was necessary in order to properly reflect their taxable incomes.
Taxpayers contend that the $1,000,000.00 loans were not in fact loans; that they were contributions to capital. This argument is completely without merit. The terms of the loans plus the terms of the 1959 Agreement, specifying the creation of $1,000,000.00 loans, leave no doubt that the parties intended to and did treat these transactions as loans. Further, there is no evidence in the record that the taxpayers received additional stock of Midtown for these alleged capital contributions.
Midtown's balance sheets reveal that it paid interest on various loans, ranging from 4 and 1/2% to 6% per annum. (See for example pp. 97, 106, 109, 112, 133 and 166 of the Exhibit file.) Midtown had outstanding loans from Lincoln Rochester Trust Co. payable at 5 and ½% interest; from Central Trust Co. payable at 5 and 1/2% per annum and from D. Raffelson payable at 5% per annum. Considering the rate of interest Midtown paid on its arm's length loans and the Treasury Regulations, 5% is an appropriate rate of interest.
This Court finds that the reversal by the Tax Court of the determination of the Commissioner allocating to the taxpayers interest income at 5% on their respective loans of $1,000,000.00 to Midtown is clearly erroneous.
The annual payments of $75,000.00 each by McCurdy and Forman to Midtown
The initial plans for the enclosed mall shopping center (Midtown Plaza) contemplated kiosks in the southern portion of the mall (South Mall) and the northern portion thereof (North Mall). Midtown constructed and rented four kiosks in the South Mall. No more than three of these kiosks were rented and occupied at one time. No kiosks were erected in the North Mall, although "utility pits" for future kiosks in the North Mall were completed so that, if kiosks were erected there in the future, they could be readily connected to utilities. The Tax Court found that, at some time after the original plan to erect kiosks in the North Mall, Midtown decided not to do so but, rather, to preserve the North Mall space (180 feet by 110 feet with twice the square footage of the South Mall) for non-commercial events. The record amply supports this finding. The North Mall, with its fountain and permanent exhibit known as the "Clock of Nations," was a focal point of Midtown Plaza, used for numerous non-commercial activities which attracted considerable publicity.
At the hearing before the Tax Court, Angelo Chiarella (Chiarella), employed by Midtown as its General Manager, pursuant to a written contract of employment, testified that it was his suggestion that kiosks be erected in the North Mall. His contract of employment provided that he was to serve as General Manager of Midtown "under the general supervision and direction of the President of the Corporation and with such duties as may be reasonably assigned to him by the President of the Corporation and by its Board of Directors . . ." Entrance to the stores of both taxpayers
On October 27, 1964, Midtown (by Chiarella, Vice-President) made a written offer to Gilbert J. C. McCurdy, Chairman of the Board of McCurdy, and Maurice R. Forman, President of Forman, that Midtown would accede to the said wishes of McCurdy and Forman and would not conduct any promotional events or rent the North Mall for any events or displays that would be conducted in a manner to distract from the esthetic dignity of McCurdy and Forman, in consideration of the payment by each of them of the sum of $75,000.00 per year commencing February 1, 1964. Each taxpayer accepted this offer on November 6 1964, McCurdy, by the Chairman of the Board; Forman, by its President. It would appear that there was a studied avoidance of any signature to this Midtown offer by any officer or director holding stock in Midtown. Nevertheless, it is obvious from the terms of his employment contract that he signed this Midtown offer pursuant to the direction of the President of Midtown and that the offer was made with the knowledge and/or subsequent consent of the Board of Directors of Midtown. In effect, of course, McCurdy and Forman (as owners of Midtown and of the taxpayer stores) were dealing with one another at less than an arm's length transaction. McCurdy and Forman had the power to prevent the erection of kiosks by Midtown (its controlled entity) in the North Mall.
McCurdy and Forman each paid $75,000.00 to Midtown during their fiscal years 1965, 1966 and 1967 or a total of $225,000.00 each. They deducted these annual payments as ordinary and necessary business expenses paid during each taxable year in carrying on their respective businesses. 26 U.S.C. § 162(a). The taxpayers took the position that absence of kiosks in the North Mall was responsible for substantial benefits which "more than justified the expense involved"; that kiosks in the North Mall would have obstructed the visibility of their display windows; that they would have siphoned off "impulse shoppers"; would have created a "crass commercial atmosphere" inconsistent with their status as "quality" stores; that they would have taken up so much space that it would have been impossible for Midtown to hold the special events which were held in the mall, e. g., charity balls, scientific exhibits, dinners, etc.; that the holding of such events was a form of advertising by Forman and McCurdy, which would have been prevented if the kiosks were erected; that they regarded these annual payments of $75,000.00 as rental payments, in the sense that these payments insured that the mall area surrounding their stores would not be used in a "detrimental manner." The taxpayers assert that, during the period from the opening of Midtown Plaza through the
The Commissioner disallowed these deductions. The Tax Court affirmed the determinations of the Commissioner. It found that these "Kiosk-Prevention Payments" were not ordinary and necessary business expenses, but, rather, "disguised capital contributions and therefore not deductible expenses," 54 T.C. at 926; that "[a]t least by April 10, 1962, when Midtown Plaza opened for business, Midtown had made a firm decision not to construct and rent kiosks on the North Mall and such decision continued in full force and effect during all the periods relevant herein," 54 T.C. at 921;
The record fully warrants the Tax Court's conclusion that the annual payments made by the taxpayers to Midtown were not ordinary and necessary expenses deductible under 26 U.S.C. § 162. The determination of whether or not a payment constitutes an ordinary and necessary business expense is, in most instances, a question of fact. Commissioner of Internal Revenue v. Duberstein, 363 U.S. 278, 80 S.Ct. 1190, 4 L.Ed.2d 1218 (1960); Commissioner of Internal Revenue v. Heininger, 320 U.S. 467, 64 S.Ct. 249, 88 L.Ed. 171 (1943); Chenango Textile Corp. v. Commissioner of Internal Revenue, 148 F.2d 296 (2d Cir. 1945). The Tax Court's findings must be sustained unless clearly erroneous. Commissioner of Internal
The record shows, as the Tax Court so found, that:
The substance of the expense, not its legal form, controls its deductibility under § 162. Interstate Transit Lines v. Commissioner of Internal Revenue, 319 U.S. 590, 63 S.Ct. 1279, 87 L.Ed. 1607 (1943); Deputy v. DuPont, 308 U.S. 488, 60 S.Ct. 363, 84 L.Ed. 416 (1940); Lots, Inc. v. Commissioner, 49 T.C. 541 (1968). Thus, the characterization of the expense by taxpayers as being either for advertising or for rent is not determinative. The payment in question is to be judged in light of all the terms and conditions of the agreement establishing the obligation to pay and all the facts and circumstances existing at the time the agreement was made. The fact that the taxpayer is contractually bound to make the payment does not render it an ordinary expense. Interstate Transit Lines v. Commissioner of Internal Revenue, supra; Swed Distributing Co. v. Commissioner of Internal Revenue, 323 F.2d 480 (5th Cir. 1963); Atlantic Monthly Co. v. Commissioner, 5 T.C. 1025 (1945). Considering the close relationship between taxpayers and Midtown, the payments to prevent the building of the kiosks must be subject to close scrutiny. Higgins v. Smith, 308 U.S. 473, 60 S.Ct. 355, 84 L.Ed. 406 (1940); Darco Realty Corp. v. Commissioner of Internal Revenue, 301 F.2d 190 (2d Cir. 1962); Ingle Coal Corp. v. Commissioner of Internal Revenue, 174 F.2d 569 (7th Cir. 1949). The identity of interests between the officers, directors and stockholders of taxpayers and of Midtown renders the transaction one of less than at arm's length. Ray's Clothes v. Commissioner, 22 T.C. 1332 (1959). The evidence bearing on the transaction must be scrutinized to determine the true character of the agreement and whether it would have been entered into were the taxpayers and Midtown dealing at arm's length. In Place v. Commissioner, 17 T.C. 199 (1951), aff'd, 199 F.2d 373 (6th Cir. 1952), cert. denied, 344 U.S. 927, 73 S.Ct. 496, 97 L.Ed. 714 (1953), a businessman voluntarily increased his rental payments to his lessor, his wife. The Court disallowed the deduction of the additional rent as a business expense, holding that the increased sum was not paid as rent, that it was paid under the guise of rent. The close relationship between the parties and the lack of arm's length dealing made the increase an attempt to avoid taxes. The test for determining deductibility is whether a hard-headed businessman, under the circumstances, would have incurred the expense. 4A Mertens Law of Federal Income Taxation § 25.09, p. 50. Application
Taxpayers relied on two cases in support of their contention that the $75,000.00 annual payments by each of them were deductible. Neither Hamlin Trust v. Commissioner, 19 T.C. 718 (1953), aff'd, 209 F.2d 761 (10th Cir. 1954), nor Ullman v. Commissioner, 29 T.C. 129 (1957), aff'd, 264 F.2d 305 (2d Cir. 1959), relied upon by the taxpayers, is applicable. Both of these cases involved covenants not to compete, which were reached as a result of arm's length negotiations which clearly distinguish them from the instant case.
We hold that the finding of the Tax Court, that the annual payments by the taxpayers to Midtown were capital contributions—not rent or business expenses, was not clearly erroneous.
We affirm the Tax Court's decision that these annual payments were not deductible as ordinary and necessary business expenses. We reverse the Tax Court decision that the Commissioner was without authority to allocate to the taxpayers interest income on their non-interest bearing loans to Midtown and remand to the Tax Court for such allocation.
As to the opinion of the court in Lake Erie that common control was negated because the two parent corporations had separate and independent shareholders, Hewitt made the following comment in a subsequent article:
The authors of an article, "Reallocation of Income and Deductions Under Section 482," in 41 Taxes 809, 812 (1963), commented on the decision in Lake Erie as follows: