Opinion
Docket No. 30984.
1953-10-22
EAST COAST EQUIPMENT COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Harry Norman Ball, Esq., for the petitioner. John D. Armstrong, Esq., for the respondent.
Harry Norman Ball, Esq., for the petitioner. John D. Armstrong, Esq., for the respondent.
1. The petitioner, who was engaged in the trade or business of selling construction equipment, entered into 26 ‘equipment rental agreements,‘ together with purchase options which gave the purported lessee the right to purchase the equipment at the end of the lease for a consideration amounting to the downpayment and the installments required in the rental agreement and provided further that the ‘rental payments‘ should apply to the purchase price. To secure performance from the lessee, interest-bearing notes were required by the petitioner. These notes, together with the contracts and purchase options, were immediately assigned by the petitioner to a finance company. Held, the equipment rental agreements were sales and the installment obligations resulting were distributed, transmitted, sold, or otherwise disposed of by the petitioner within the meaning of section 44(d) of the Internal Revenue Code.
2. Bad debt deduction disallowed for failure of proof that the settlement of the indebtedness out of which the claimed deduction arose was a bona fide transaction or that any part of the indebtedness was uncollectible.
3. The petitioner's attorney rendered services during the taxable year 1948 in connection with matters ordinary and necessary to petitioner's business and rendered his bill for $1,500 in that year. Held, the petitioner is entitled to accrue the amount of $1,500 as a deductible expense for the year 1948 even though the amount was not paid until 1950.
4. The amount of reasonable compensation for services of Loretta B. Frantz in the year 1948 determined.
5. The petitioner in good faith relied upon the advice of reputable counsel and failed to file an excess profits tax return for the taxable hear 1946. Held, the failure to file the return was due to reasonable cause and not due to willful neglect, and the penalty imposed by section 291 of the Internal Revenue Code is not applicable.
The respondent has determined deficiencies and penalty in the tax liability of the petitioner for the taxable years ending March 31, 1946, and March 31, 1948, as follows:
+---------------------------------------------------------------+ ¦ ¦ ¦ ¦Penalty under¦ +----+---------------------------------+----------+-------------¦ ¦Year¦Kind of tax ¦Deficiency¦section 291 ¦ +----+---------------------------------+----------+-------------¦ ¦ ¦ ¦ ¦of I. R. C. ¦ +----+---------------------------------+----------+-------------¦ ¦1946¦Income tax ¦$2,906.17 ¦ ¦ +----+---------------------------------+----------+-------------¦ ¦ ¦Declared value excess-profits tax¦2,718.88 ¦ ¦ +----+---------------------------------+----------+-------------¦ ¦ ¦Excess profits tax ¦6,047.44 ¦$1,511.86 ¦ +----+---------------------------------+----------+-------------¦ ¦1948¦Income tax ¦15,534.73 ¦ ¦ +---------------------------------------------------------------+
Certain issues raised by the petition were abandoned by the petitioner at the hearing and the issues remaining for our decision are as follows:
(1) Whether certain equipment rental contracts executed by the petitioner, together with purchase options in favor of the lessee, constituted sales and, if so, whether the petitioner distributed, transmitted, sold, or otherwise disposed of the installment obligations within the meaning of section 44(d) of the Internal Revenue Code.
(2) Whether the petitioner is entitled to a bad debt deduction in the amount of $38,500 in the taxable year 1948.
(3) Whether the petitioner is entitled to a deduction of $1,500 in the taxable year 1948 for legal expenses.
(4) Whether the compensation paid by petitioner to Loretta B. Frantz, its secretary and treasurer, for the year 1948 was unreasonable and excessive.
(5) Whether the petitioner's failure to file an excess profits tax return for the taxable year 1946 was due to reasonable cause and not due to willful neglect.
FINDINGS OF FACT.
The facts stipulated by the parties are found accordingly.
The petitioner, which is a New Jersey corporation, filed a corporation income and declared value excess-profits tax return for its taxable year ending March 31, 1946, with the collector of internal revenue for the fifth district of New Jersey. Petitioner filed a corporation income tax return for the taxable year ending March 31, 1948, with the same collector. The petitioner kept its accounts and reported its income on the accrual basis.
During the taxable years 1946 and 1948 the petitioner was engaged in the business of selling construction equipment. The petitioner entered into 26 contracts denominated equipment rental contracts during the taxable years 1946 and 1947. Simultaneously with the execution of these agreements, the lessee was granted a purchase option covering the equipment purportedly leased. Each of these equipment rental agreements provided for large initial payments and smaller monthly installment payments running from 6 to 18 months. The purchase option, which in each case was executed simultaneously with the rental agreement, provided that the person obtaining the equipment would have the option to purchase it, exercisable at any time prior to the end of the term of the lease agreement, at a stated price, which in each case equaled the amount of the initial payment plus the installments indicated in the rental agreement. Upon the exercise of the option to purchase, the rentals that had been paid to the date of the purchase were to be applied on the purchase price. In each case the option was exercised. The payments referred to as rentals exceeded in each case the amount of depreciation allowable on such equipment for tax purposes.
Identical forms were used in all of the equipment rental agreements and in all of the purchase options. Each agreement and each option was distinct from others only in respect of date, lessee-optionee, equipment involved, term of agreement, stated value of equipment to be paid in installments either as rental or purchase price, and the amounts and dates when such payments were to be made. A typical rental agreement recites in part as follows:
EQUIPMENT RENTAL AGREEMENT
CONTRACT NO. 119
This Agreement made this 28th day of March, 1946, between EAST COAST EQUIPMENT COMPANY, 31 North Avenue, Garwood, New Jersey, hereinafter called the lessor, of AND JOSEPH APPIO, hereinafter called the lessee, witnesseth that in consideration of the covenants hereinafter contained, the lessor hereby leases to the lessee the equipment hereinafter described for the period, at the rate, and upon and subject to the terms and conditions herein contained.
To be shipped to Salem St., Dover, N.J., by way of . . .
+-------------------+ ¦LIST OF EQUIPMENT ¦ +-------------------¦ ¦ ¦ ¦ ¦ ¦ +----+----+----+----¦ ¦ ¦ ¦ ¦ ¦ +-------------------+
Rental Period Value of Number of Description of Equipment Equipment Months Rate Per Month [Items omitted] 3775.00 12 11 notes at 209.72 1 note at 209.75
The rental shall be payable as follows: $1258.33 Dollars upon the signing of this agreement; $100.00 deposit, 1158.33 on delivery Dollars on or before the date of (sic) the equipment is loaded for shipment; and as schedule above Dollars monthly in advance, without notice or demand, at the office of the lessor, before the 28th day of each and every month thereafter during the term of this lease.
The purchase option executed and delivered simultaneously with the above rental agreement recites in part as follows:
Garwood, New Jersey March 28, 1946 Date
PURCHASE OPTION
BETWEEN JOSEPH APPIO party of the first part, and EAST COAST EQUIPMENT COMPANY, party of the second part.
If the party of the first part shall have faithfully and punctually kept and performed all of the terms of a certain lease agreement between the parties dated March 28, 1946, the party of the first part shall have the privilege of purchasing the equipment described in said lease agreement at any time prior to the 28th day of March 2947, said option to be exercised only by the delivery of a notice, in writing, by registered mail, to EAST COAST EQUIPMENT COMPANY, at its office in Philadelphia, of the intention of the party of the first part to exercise the option, accompanied by a payment, in cash or certified check, to EAST COAST EQUIPMENT COMPANY, on or before said date, of the sum of $3775.00 Three thousand seven hundred seventy-five dollars and no/100 which shall be the full value of the equipment as set out in the lease contract, plus the value of all parts and accessories attached to or connected with said equipment, plus all sums which said party of the first part may owe EAST COAST EQUIPMENT COMPANY for supplies, repairs and services purchased by said party of the first part from EAST COAST EQUIPMENT COMPANY.
If the option is exercised as hereinbefore provided before the 28th day of March 1947, a sum equal to 100 percentage of the rentals paid to and received by EAST COAST EQUIPMENT COMPANY, in cash, under the aforesaid lease agreement, shall apply on account of the purchase price set out above.
Title to the equipment covered by said agreement shall remain in EAST COAST EQUIPMENT COMPANY until such time as the full purchase price shall be paid to EAST COAST EQUIPMENT COMPANY, in cash, and upon the exercise of said option as above, together with the cash payment, EAST COAST EQUIPMENT COMPANY shall execute and deliver to the party of the first part a Bill of Sale transferring the title and ownership of the said equipment to the party of the first part.
The petitioner carried these transactions on its books under the heading of rental equipment, but it took no depreciation on the equipment disposed of under the equipment rental agreements.
To secure performance the petitioner required interest-bearing notes from the persons receiving the equipment, which were immediately assigned, together with the equipment rental agreement and the option contract, to a finance company doing business as the Contractors Acceptance Corporation.
The agreement, which was executed in every case between the petitioner and the Contractors Acceptance Corporation, provided in material part as follows:
ASSIGNMENT AND RECOURSE AGREEMENT
For value received, the undersigned hereby sells and transfers unto CONTRACTORS ACCEPTANCE CORPORATION a certain contract or agreement (including the property covered thereby and the proceeds of any policies of insurance on such property) between the undersigned and: . . . dated the . . . day of . . ., 19. ., and all moneys due and to become due thereunder. The undersigned hereby guarantees the payment of all moneys due or to become due under the terms of the said contract and agrees that in the event of default by the purchaser or lessee named in the said contract in the performance of any conditions or agreements on his part to be performed, including the payment of any money, the undersigned will, within sixty (60) days from the date of such default, pay to CONTRACTORS ACCEPTANCE CORPORATION all moneys so in default or perform such conditions and agreements so in default. Provided, however, that in the event the undersigned, upon demand, will pay to CONTRACTORS ACCEPTANCE CORPORATION the entire balance of the contract, whereupon the contract shall be reassigned to the undersigned. Unless withdrawn by written notice from CONTRACTORS ACCEPTANCE CORPORATION to the undersigned, the undersigned shall have the right, in its own name but for the account of CONTRACTORS ACCEPTANCE CORPORATION, to pursue every remedy given the undersigned in the event of default on the part of the purchaser or lessee.
The resulting transactions were recorded on the books on Contractors Acceptance Corporation as a purchase of the installment paper. Contractors Acceptance Corporation in turn assigned the contracts and notes receivable from the petitioner to the Philadelphia National Bank to secure its own loans from that bank.
None of the property covered by the agreements here involved was previously rented or leased but was held by the petitioner for sale to customers in the ordinary course of its trade or business, and the installment obligations in question were distributed, transmitted, sold, or otherwise disposed of immediately upon their acquisition by the petitioner. during the taxable years 1946 through 1948 the stockholders of the petitioner and the number of shares held by each of them were as follows:
+---------------------------------------------------+ ¦Name ¦No. of shares ¦ +-----------------------------------+---------------¦ ¦W. H. Frantz ¦850 ¦ +-----------------------------------+---------------¦ ¦L. B. Frantz (wife of W. H. Frantz)¦850 ¦ +-----------------------------------+---------------¦ ¦H. P. Frantz ¦300 ¦ +-----------------------------------+---------------¦ ¦Harry Norman Ball ¦1 ¦ +---------------------------------------------------+
The stockholders of Frantz Tractor Company and the percentages of stock held by each during the years 1946 to 1948, inclusive, were as follows:
+----------------------------------------------+ ¦Name ¦Per cent ¦ +-----------------------------------+----------¦ ¦W. H. Frantz ¦45.14 ¦ +-----------------------------------+----------¦ ¦L. B. Frantz (wife of W. H. Frantz)¦45.14 ¦ +-----------------------------------+----------¦ ¦H. P. Frantz ¦9.72 ¦ +----------------------------------------------+
The stockholders of Seaboard Construction Company and the percentages of stock held by each during the years 1946 to 1948, inclusive, were as follows:
+-----------------------------+ ¦Name ¦Per cent ¦ +------------------+----------¦ ¦W. H. Frantz ¦60 ¦ +------------------+----------¦ ¦H. P. Frantz ¦30 ¦ +------------------+----------¦ ¦James J. McDevitt ¦10 ¦ +-----------------------------+
The petitioner sold used construction equipment and parts to the Frantz Tractor Company (hereinafter referred to as Tractor) during the taxable year 1948.
As of March 1948 Tractor was indebted to the petitioner in the amount of $67,610.04. The indebtedness arose from the sales of parts, used equipment, and services rendered to Tractor by the petitioner over a period of about a year. Prior to March 1948, the Seaboard Construction Company had executed and delivered to Tractor four notes aggregating $48,500 in connection with purchases and rentals of equipment and supplies. In March 1948, Tractor delivered the Seaboard notes to the petitioner endorsed in blank, together with its own note for an amount of approximately $18,000, in settlement of the debt of $67,610.04 owed by Tractor to the petitioner. At the time of such transaction the Seaboard notes had a value not exceeding $10,000. The petitioner accepted the Seaboard notes and the Tractor note at their face value in full settlement of the indebtedness due it from Tractor. At the time of such transaction Tractor was, and at all times since its incorporation has been, a solvent and operating company. This transaction between petitioner and Tractor was not a bona fide settlement of an indebtedness, but a device used to shift Tractor's loss on the Seaboard notes to the petitioner. On March 24, 1948, petitioner sold the Seaboard notes in the aggregate to a finance company for $10,000.
As of August 31, 1948, the balance sheet of Seaboard Construction Company showed total assets of $54,244.29 and total liabilities of $145,838.97. Petitioner made no effort to collect the Seaboard notes from either Seaboard or Tractor.
The petitioner paid Loretta B. Frantz the sum of $2,500 during the taxable year 1948 for services rendered in her capacity as secretary and treasurer. Loretta B. Frantz is the wife of W. H. Frantz. Together they own the controlling interest in the petitioner as well as in Tractor. In 1948 she had three young children and resided in the suburbs of Philadelphia, some distance from the petitioner's office, which was located 15 or 20 miles west of Newark, New Jersey. Loretta B. Frantz had no office of her own at the petitioner's place of business but on her visits about once a week to the offices would stay in Thomas G. Frantz' office. She attended formal meetings and signed formal documents necessary for the conduct of petitioner's business. She participated in consultations on sales volume, expenses, and personnel. The same service was rendered by her in 1946 without compensation. The sum paid to Loretta B. Frantz as compensation during the year 1948 was unreasonable in amount for services rendered during that year. Reasonable compensation for such services in $1,200.
Harry Norman Ball, the petitioner's attorney herein, represented East Coast Equipment Company during the taxable year 1948. Ball billed the petitioner as a minimum retainer for the year 1948 the sum of $1,500, which was paid in April 1950. His services during the year 1948 included passing on franchises and agreements between petitioner and manufacturers, collection items, conducting or supervising litigation involving petitioner, and other general work. The petitioner was obligated to Harry Norman Ball in the amount of $1,500 during the taxable year 1948 for services rendered.
The petitioner reported its income during the taxable years in question and filed its returns in accordance with the advice of its accountant, E. Marx Schwerin, a certified public accountant with practicing experience in excess of 30 years. Schwerin had consulted the petitioner's counsel, Harry Norman Ball, and the petitioner's method of reporting income from the equipment rental agreements here involved was the product of the combined advice of the two, both of whom were, so far as the petitioner knew, qualified to give tax advice. The failure of the petitioner to file an excess profits tax return for the taxable year 1946 was due to reasonable cause.
OPINION.
HILL, Judge:
During the taxable years 1946 and 1947 the petitioner, which was engaged in the trade or business of selling construction equipment, entered into 26 agreements. Each of these agreements was captioned ‘Equipment Rental Agreement.‘ Simultaneously with the execution of these agreements, the petitioner and the purported lessee executed a purchase option covering the same property included in the rental agreement.
The petitioner contends that the transactions in controversy accomplished no more than the rental of the construction equipment involved and that the exercise of the option granted to the purported lessee resulted in a sale or exchange of a capital asset.
On the other hand, the respondent argues that the agreements were intended to and did effect installment sales of equipment held for sale in the ordinary course of the petitioner's business and, further, that the petitioner distributed, transmitted, sold, and otherwise disposed of the installment obligations when it transferred the agreements to the Contractors Acceptance Corporation.
To support its argument, the petitioner relies upon the formal terms of the equipment rental agreement alone and ignores the purchase option agreement executed simultaneously therewith and as part of the same transaction. Obviously such segregated consideration is not permissible under the factual situation here presented. The consideration of both agreements as constituting together the basis of interpretation of the purport and effect of the transaction as an integrated whole is required. We thus are enabled to ascertain the real substance of the transaction despite diverting formality of terms if the rental agreement were considered separately and alone. As between substance and form, the former must prevail. Commissioner v. Court Holding Co., 324 U.S. 331.
An examination of the agreements and the circumstances out of which the transactions arose leads us to the conclusion that the determination of the respondent with respect to this issue is correct. The equipment rental agreements must be read in the light of the terms of the purchase option granted to the purported lessee. When this is done it appears that the equipment involved was held for sale and not for lease. It was not intended that such property should be leased except in connection with an option to purchase at the price of the total downpayment and installment rental payments. It is inconceivable that the optionee would not exercise the option to purchase since the financial burden thereof was the same as his financial obligations under the so-called rental agreements. No one in the exercise of reasonable business judgment would refuse or neglect to take title to valuable assets, the purchase price of which he has already paid or the amount of which he is obligated to pay whether or not he takes such title. Indeed, such was the case in every instance here. At the end of the so-called rental period the lessee acquired title to the property without further payment. Further, interest-bearing notes were required by the petitioner from the purported lessee to secure the payment of the monthly installments.
While the petitioner set these transactions up on its books under the heading ‘Rental Equipment,‘ it is interesting to note that it claimed no depreciation on the equipment as it would have been entitled to do had the equipment been in fact rented.
No authority is cited by the petitioner in support of its contention that the agreements here involved accomplished rentals as a matter of law, nor do the facts support such a proposition. The petitioner's argument that the equipment sold under the agreements constituted capital assets is equally without basis. Our findings of fact in any event are determinative of this question for there can be no doubt that the equipment covered by the rental agreements was property held for sale by the petitioner in the ordinary course of its business.
Each of the 26 agreements involved in this proceeding was transferred by the petitioner immediately upon acquisition to the Contractors Acceptance Corporation. To effect the transfer the petitioner signed in each case the ‘Assignment and Recourse Agreement‘ set forth in our Findings of Fact. As the terms of that agreement indicate, the petitioner sold and transferred the installment obligation to Contractors Acceptance Corporation and received in turn a cash equivalent. Elmer v. Commissioner, 65 F.2d 568. The petitioner contends that in doing so it did not dispose of the installment obligations but simply pledged them with the finance company as collateral security for loans. However, the evidence fails to bear this out. There is nothing in the agreements between the petitioner and the contractors Acceptance Corporation to indicate that the parties thereto intended that the installment obligations should simply be pledged as security for loans. On the contrary, the conduct of Contractors Acceptance Corporation indicates otherwise for the record reveals that it was the habit of Contractors Acceptance Corporation to deal with the installment obligations as it would its own property. In many instances Contractors Acceptance Corporation in turn transferred the installment obligations to a bank to secure moneys needed in its business. Further, Contractors Acceptance Corporation was compensated for its efforts not by the petitioner but by the equipment purchasers who bore the tariff in the guise of interest-bearing notes transferred by the petitioner to Contractors Acceptance Corporation along with the other contracts. Further, the books of Contractors Acceptance indicate that the corporation considered the transaction one of purchase and of sale. We do not deem the facts that the petitioner guaranteed the installment paper significant. Thos. Goggan & Bro., 45 B.T.A. 218; Miller Saw-Trimmer Co., 32 B.T.A. 931. Nor is the fact that the petitioner issued bills of sale to the purchasers of the equipment determinative.
The petitioner points to the terms of the equipment rental agreement requiring the purchaser to insure for the benefit of the petitioner the equipment purchased, to properly protect the equipment and keep it in good condition and repair, and granting the petitioner the right to inspect the equipment as considerations supporting its position. However, such provisions can hardly be deemed strangers to installment sales contracts. In any event, the benefits of these provisions passed to the Contractors Acceptance Corporation along with the right to payment, when the installment obligations were sold by the petitioner.
The privileges granted by section 44(a) of the Internal Revenue Code are therefore not available to the petitioner because the conditions imposed by section 44(d) provide that the gain or loss resulting from the distribution, transfer, or sale of installment obligations shall result in gain or loss in the year in which the installment obligations are disposed of. Rhett W. Woody, 19 T.C. 350. Further, the petitioner's gain results in ordinary income for the amounts received on the installment obligations represented the proceeds derived from the sale of equipment held by the petitioner for sale to customers in the ordinary course of its business.
The second issue for our decision grows out of the following facts: Tractor was indebted to the petitioner in the amount of approximately $67,000. The debt, which resulted from sales on open account and from services rendered, was due and owing in the taxable year 1948. In March of that year the petitioner accepted in full settlement of its debt Tractor's note in the sum of $18,210.04, plus four notes made by the Seaboard Construction Company, which were the property of Tractor, aggregating in face amount $48,500, which had a fair market value on the date of settlement of $10,000. On March 24, 1948, the petitioner sold the Seaboard notes for $10,000 and in its tax return for the taxable year 1948 reported the difference between the fair market value of the Seaboard notes and their face value, or $38,500, as a ‘loss on sale of note.‘
The claimed deduction was disallowed by the respondent. At the hearing the petitioner's counsel stated to the Court that the petitioner was claiming a bad debt deduction in the amount of $38,500, but on brief the petitioner claims alternatively a deduction as an ordinary and necessary business expense or a bad debt.
We do not deem it necessary to consider either of these positions for we are not convinced that the transaction out of which the claimed deduction arises was a bona fide settlement of an indebtedness. In reaching this decision we are not unmindful of the fact that the same persons controlled all three of the corporations involved. This, coupled with the lack of evidence concerning the financial position of Tractor, makes it difficult for us to believe that the transaction was any more than a voluntary arrangement between the petitioner and Tractor for the purpose of shifting the loss incurred by Tractor, as the result of the poor financial condition of Seaboard, to the petitioner, which, as the record indicates, stood to derive the greatest tax benefits thereby. Tractor was a solvent operating company at all times. There is nothing in the evidence to indicate that Tractor could not have paid the petitioner in full or the reasons why id did not beyond the statement of one of the witnesses to the effect that Tractor was in a ‘tight‘ cash position.
The petitioner has the burden of disproving the correctness of the respondent's determination. This it has failed to do. We, therefore, sustain the respondent's determination with respect to the issue.
The third issue concerns the respondent's disallowance of a deduction claimed by the petitioner for attorney's fees. The evidence shows that the services were in fact rendered in connection with the routine matters ordinary and necessary to the petitioner's business in the year claimed and that in that year the attorney in question rendered his bill. Since the petitioner reported on the accrual basis, we hold that the petitioner is entitled to a deduction of $1,500 for attorney's fees in the taxable year 1948. Lanova Corporation, 17 T.C. 1178.
The fourth issue concerns the reasonableness of the salary paid by the petitioner to its secretary and treasurer, Loretta B. Frantz. We think our findings of fact in respect of this issue clearly indicate that the allowable deduction for compensation paid her for services in 1948 is reasonably the amount of $1,200.
The petitioner failed to file an excess profits tax return for the taxable year 1946. The respondent in determining the deficiencies herein imposed the penalty required by section 291 of the Internal Revenue Code. The evidence establishes that the petitioner relied upon the advice of both its accountant and its attorney and failed to file an excess profits tax return for 1946 as the result of this advice. Reliance in good faith on reasonable grounds upon the advice of reputable counsel constitutes reasonable cause for failure to file a required return. Such reliance is sufficient to save the petitioner from the imposition of the penalty here in question. C. R. Lindback Foundation, 4 T.C. 652.
Decision will be entered under Rule 50.