Opinion
Docket Nos. 54757 54758.
1957-01-10
FISHING TACKLE PRODUCTS COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.SOUTH BEND BAIT COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
James F. Thornburg, Esq., and Casimer J. Major, Esq., for the petitioners. John L. Carey, Esq., for the respondent.
James F. Thornburg, Esq., and Casimer J. Major, Esq., for the petitioners. John L. Carey, Esq., for the respondent.
An Indiana corporation engaged in the manufacture and distribution of sport fishing equipment leased a factory in Iowa and organized a subsidiary Iowa corporation for purposes of manufacturing a patented new type fishing rod for sale to the parent corporation which distributed such rods nationally. The subsidiary was the parent corporations' sole source of supply of this particular type fishing rod and the subsidiary produced such rods for exclusive sale to the parent. Held, payments by the parent corporation to its subsidiary to reimburse the subsidiary for net operating losses sustained in supplying the parent are deductible by the parent as a business expense. Held, further, attorney expenses and statutory costs incurred by the parent in increasing its authorized capitalization are capital expenditures and are not deductible as a business expense. Held, further, the entire rental payments paid by the subsidiary for its occupancy of the factory site are deductible as a business expense. Held, further, the cost of permanent improvements added to the leasehold by the subsidiary shall be amortized over the period of the lease remaining after such improvements were added.
The respondent determined deficiencies in the income and excess profits taxes of petitioners as follows:
+------------------------------------------------+ ¦ ¦ ¦Deficiencies ¦ +----------+-----------+-------------------------¦ ¦Docket No.¦Fiscal year¦ ¦ ¦ +----------+-----------+----------+--------------¦ ¦ ¦ ¦ ¦Income and ¦ +----------+-----------+----------+--------------¦ ¦ ¦ ¦Income tax¦excess profits¦ +----------+-----------+----------+--------------¦ ¦ ¦ ¦ ¦tax ¦ +----------+-----------+----------+--------------¦ ¦ ¦(1949 ¦$2,042.10 ¦ ¦ +----------+-----------+----------+--------------¦ ¦54757 ¦(1950 ¦ ¦$4,047.88 ¦ +----------+-----------+----------+--------------¦ ¦ ¦(1951 ¦ ¦8,283.65 ¦ +----------+-----------+----------+--------------¦ ¦ ¦(1949 ¦914.15 ¦ ¦ +----------+-----------+----------+--------------¦ ¦54758 ¦(1950 ¦29,869.56 ¦ ¦ +------------------------------------------------+
The parties have reached agreement either by stipulation or on brief to several adjustments made by respondent and such agreement will be reflected in the Rule 50 computation. The following issues remain in dispute:
(1) Whether petitioner South Bend Bait Company is entitled to deduct as ordinary and necessary business expenses amounts paid by it to its subsidiary corporation, Fishing Tackle Products Company, to reimburse said company for operating losses sustained in the taxable years ending in 1949 and 1950;
(2) Whether petitioner South Bend Bait Company is entitled to deduct as ordinary and necessary business expenses certain attorney fees and local statutory costs incurred to obtain an increased capitalization;
(3) Whether petitioner Fishing Tackle Products Company is entitled to deduct as rental payments the entire amounts paid by it in connection with a lease of certain property which it occupied, such payments being made during the taxable years ending in 1949, 1950, and 1951;
(4) Whether respondent erred in determining that the cost of certain leasehold improvements made by petitioner Fishing Tackle Products Company should be amortized over the estimated useful life of the improvements rather than over the period of the lease.
FINDINGS OF FACT.
The stipulated facts, together with the exhibits attached, are found as facts and incorporated herein by this reference. Petitioner South Bend Bait Company (hereinafter referred to as South Bend) is an Indiana corporation with its principal offices and a manufacturing plant located at South Bend, Indiana. South Bend filed its Federal income tax returns for its fiscal years ending August 31, 1949 and 1950, with the collector of internal revenue for the district of Indiana.
Petitioner Fishing Tackle Products Company (hereinafter referred to as Tackle) is an Iowa corporation with its principal offices and a manufacturing plant located at Spencer, Iowa. Tackle filed its Federal income tax returns for its fiscal years ending August 31, 1949, 1950, and 1951, with the collector of internal revenue for the district of Iowa.
For many years prior to and during the years 1949 and 1950, South Bend was engaged in the business of manufacturing and selling sport fishing tackle including fishing baits, lures, and fishing rods, which items were nationally distributed by it. South Bend's plant at South Bend, Indiana, was primarily a bamboo rod and woodworking plant and prior to 1948, by virtue of the limited size and peculiar facilities of its South Bend plant, the company was engaged primarily in the manufacture of bamboo fishing rods and woodworking products.
After the close of World War II, experimentation was done to create fishing rods out of materials other than bamboo. Due to the increased public interest in metal rods after the war, South Bend sought a process for producing these metal rods with a distinctive feature which would identify them as a South Bend product and thus enhance their salability. The process which resulted from this investigation produced a stepdown or taper in the fishing rods which was exclusive in the South Bend product.
South Bend lacked the facilities to produce this type of fishing rod at its plant at South Bend, Indiana, and due to the high labor costs in that area, it determined to produce the metal fishing rods at some other location. In 1948 Spencer Industries, Inc., a nonprofit corporation sponsoring and assisting manufacturing institutions to locate in Spencer, Iowa, agreed to finance and build at its expense a new and modern design manufacturing plant at Spencer, Iowa, to meet the requirements of South Bend. South Bend obtained a lease from Spencer Industries, Inc., for such plant on May 5, 1948, for a term of 10 years ending in September 1958, on a monthly rental basis of $1,000 per month. The lease provided that South Bend should have the option to purchase the property at the end of any rent year upon 30 days' written notice, the option price at the end of the first year to be $94,000, at the end of the second year $88,000, and ‘at the end of each succeeding year said option shall be reduced $6,000 per year.’ It further provided that the party of the second part would not ‘sell, assign, underlet or relinquish the said premises without the written consent of the lessor under penalty of forfeiture of its rights under this lease at the election of the party of the first part.’ The lease contained no provision for renewal.
After consulting with its attorneys, South Bend determined that it would be more advantageous for it to organize a separate Iowa corporation to conduct the operation of the plant at Spencer, Iowa, rather than make such plant a branch of the present corporation. To this end South Bend caused the organization of Tackle in September 1948. Tackle was organized with the identical corporation purposes of South Bend. Tackle issued 8,750 shares of capital stock with a par value of $20. Of the total amount of stock issued during the fiscal year 1949, South Bend acquired 8,625 shares for a price of $172,500. One hundred of the remaining 125 shares were held by officers and directors of South Bend with 25 shares being held by a key employee. Subsequently, in 1952, South Bend acquired all of the outstanding capital stock of Tackle. The majority of the officers and directors of the 2 corporations were the same individuals.
South Bend provided Tackle with possession and use of the manufacturing plant site and facilities which South Bend had leased from Spencer Industries, Inc. Tackle moved into the plant in October 1948 and thereafter used and occupied said premises during the remainder of its taxable year 1949 and its entire taxable years 1950 and 1951. South Bend did not assign the lease to Tackle and there was never any understanding, written or oral, formal or informal, between South Bend and Tackle with respect to the transfer of the lease to Tackle or as to how long Tackle would be entitled to the use and possession of the Spencer property. Tackle paid the rental therefor to Spencer Industries, Inc., except the initial two payments which were paid by South Bend and later reimbursed by Tackle. These rental payments were in the following amounts:
+-----------------------+ ¦Fiscal year ¦Amount ¦ +--------------+--------¦ ¦1949 ¦$10,000 ¦ +--------------+--------¦ ¦1950 ¦12,000 ¦ +--------------+--------¦ ¦1951 ¦12,000 ¦ +-----------------------+
Such payments were deducted as ‘rental’ on Tackle's Federal income tax returns. Respondent disallowed one-half of each of these claimed deductions.
After Tackle moved into the plant at Spencer, Iowa, it commenced the manufacture of the new stepdown fishing rods. The operation was supervised by one of the former employees of South Bend. Since none of the employees of Tackle were familiar with the processes involved in manufacturing the new rods, a period of training was necessary.
South Bend determined the price, quantity, type and manufacturing schedule of all products produced by Tackle during the years 1949 and 1950. During these and subsequent years the entire production and output of Tackle were exclusively used for the benefit of South Bend. The output of fishing rods by Tackle during the taxable years 1949 and 1950 represented South Bend's sole source of volume supply for the distinctive stepdown type of fishing rod, without which South Bend would have been unable to meet the demands of its customers and its sales and position in the industry would have been affected.
When Tackle commenced production of the stepdown metal fishing rods in the latter part of 1948 the engineers of South Bend computed the sale price of the rods on the basis of a 16 2/3 per cent profit to Tackle, and it was on this basis that South Bend ordered its first stepdown fishing rods from Tackle. However, the price computed by the engineers was too low and Tackle was actually supplying South Bend with rods at a price below manufacturing costs. The officers and directors of South Bend recognized that substantial operating losses might be sustained by Tackle during the years it was operating exclusively for South Bend and on the latter's own terms and it was agreed that South Bend would reimburse Tackle for such losses when ascertained.
South Bend closed its books for the fiscal year 1949 and paid its income taxes before the amount, by which the rods were being sold by Tackle below cost, was known. Subsequently, when the books of Tackle were audited it was determined that it had an operating loss for the taxable year ending in 1949 amounting to $52,279.37. It filed its income tax return accordingly. On August 29, 1950, South Bend paid by check to Tackle the sum of $52,279.37. On October 29, 1950, Tackle filed an amended income tax return for the fiscal year 1949, showing the $52,279.37 as income received from South Bend and paid its Federal income tax accordingly. On August 29, 1950, South Bend filed a claim for refund with the collector of internal revenue for the district of Indiana for reimbursement of the amount of overpayment of income tax, which claimed overpayment had resulted by reason of South Bend's reimbursement of the $52,279.37 operating loss suffered by Tackle. Respondent subsequently disallowed such claim for refund.
During the fiscal year ending in 1950 the market demand for metal rods shifted to solid glass rods which were in turn displaced by a popular demand for hollow glass rods. During this period petitioners could not accurately predetermine the appropriate price for the sale of such rods to insure the desired profit margin for Tackle. Some of the invoices for rods sold to South Bend bore the remark ‘price later.’ In the fiscal year ending in 1950, Tackle incurred an operating loss of $66,415.77 on the sale of rods to South Bend. This operating loss was reimbursed to Tackle by South Bend through advances during the fiscal year ending in1950. The respondent disallowed this reimbursement as a deduction to South Bend.
South Bend acquired no capital stock from Tackle by reason of the reimbursement of the losses sustained in its sales to South Bend during the fiscal years ending in 1949 and 1950.
During the fiscal year ending August 31, 1949, Tackle made permanent leasehold improvements to the property at Spencer, Iowa, at a cost of $10,189.03. Tackle amortized the cost of these improvements over the period of the lease between Spencer Industries, Inc., and South Bend, and deducted such yearly amortized costs as an expense on its Federal income tax returns for the fiscal years ending in 1949, 1950, and 1951. The respondent determined that such costs should be amortized over the estimated useful life of the rental property and accordingly disallowed a portion of the claimed amortization expense.
In November 1948 South Bend authorized an increase of 8,000 shares of its capital stock for the purpose of permitting employees of South Bend to acquire a proprietary interest in the company. In carrying out this program South Bend incurred the following expenses:
+-------------------------------------------+ ¦Attorney fees ¦$400.31¦ +-----------------------------------+-------¦ ¦Indiana Securities Commission costs¦235.00 ¦ +-----------------------------------+-------¦ ¦Secretary of state of Indiana costs¦201.00 ¦ +-------------------------------------------+
The respondent disallowed these claimed expenses in their entirety on the ground that they represented capital expenditures.
During the fiscal year ending in 1949 South Bend incurred expenses for attorney fees amounting to $150 which were paid for conferences and services in connection with the preparation of a union contract, increasing capitalization to provide stock for sale to employees, and the preparation of corporate minutes relating to the increase in capitalization. Such expenses were claimed by South Bend as business expenses on its Federal income tax return for 1949. Respondent disallowed $100 of said claimed deduction.
OPINION.
BRUCE, Judge:
Issue 1.
The first issue for decision is whether petitioner South Bend Bait Company, under the provisions of section 23(a)(1)(A), Internal Revenue Code of 1939,
may deduct as ordinary and necessary business expenses paid or incurred in its taxable years ending in 1949 and 1950 the amounts of $52,279.37 and $66,415.77, respectively, which amounts South Bend had paid to its subsidiary, Fishing Tackle Products Company, to reimburse Tackle for operating losses suffered by it during such taxable years.
SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:(a) EXPENSES.—(1) TRADE OR BUSINESS EXPENSES.—(A) In General.— All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; * * * and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking or in which he has no equity. * * *
The determination of what constitutes an ordinary and necessary business expense involves the appreciation of particular situations and facts peculiar to the case in issue. Welch v. Helvering, 290 U.S. 111. However, it is well settled that expenditures made to protect and promote the taxpayer's business, and which do not result in the acquisition of a capital asset, are deductible. Scruggs-Vandervoort-Barney, Inc., 7 T.C. 779; Charles J. Dinardo, 22 T.C. 430.
In the instant case, South Bend received no stock or capital assets for the payments made by it to reimburse Tackle for the operating losses suffered by the latter during the taxable years ending in 1949 and 1950. Nor does it appear that Tackle was inadequately capitalized. In no sense, therefore, did the payments made by South Bend constitute capital expenditures. On the contrary, Tackle was South Bend's sole source of metal and glass fishing rods with the patented stepdown feature. Without this source South Bend would have been unable to meet the demands of customers for these rods and both its sales and its position in the industry would have suffered. The payments involved were made to maintain and preserve this source of supply and were clearly a business necessity. Scruggs-Vandervoort-Barney, Inc.; Charles J. Dinardo, both supra.
Moreover, it appears that the net operating losses suffered by Tackle resulted from the inability of the engineers to determine accurately, in advance, the manufacturing costs of the new type rods. South Bend realized that losses might occur and accordingly, as soon as the amount could accurately be determined, reimbursed Tackle to the extent of such losses. In effect, such reimbursement was merely an adjustment of the price of the rods sold to South Bend.
Whether considered as a business necessity or an adjustment of price, it is clear, and we so hold, that such payments were ordinary and necessary business expenses and are deductible as such within the meaning of section 23(a)(1)(A) of the Internal Revenue Code of 1939.
In urging that such payments were not ordinary and necessary business expenses, respondent has relied upon Interstate Transit Lines v. Commissioner, 319 U.S. 590; National Carbide Corporation v. Commissioner, 336 U.S. 422; Moline Properties, Inc. v. Commissioner, 319 U.S. 436; and Los Angeles & Salt Lake Railroad Co., 4 T.C. 634. These cases are distinguishable. In the Interstate Transit case the parent corporation was denied a deduction because the business conducted by its subsidiary was one which the parent was forbidden by law to engage in. In the Los Angeles & Salt Lake case a deduction with respect to losses reimbursed by the parent corporation to one of its subsidiaries was denied for similar reasons, and a deduction with respect to losses reimbursed to another subsidiary was not allowed because the business necessity for the expenditure was not established. Neither the National Carbide nor the Moline Properties case was concerned with the question of the deductibility of a business expense.
Issue 2.
The second issue is whether attorney fees, Indiana Securities Commission costs, and secretary of state of Indiana costs, aggregating.$936.31, all of which expenses were incurred by petitioner South Bend in connection with increasing its capitalization, are deductible as business expenses.
Petitioner concedes that expenses incurred in organizing a corporation or increasing its capitalization have been held to be capital expenditures. See Motion Pictures Capital Corporation v. Commissioner, 80 F.2d 872, affirming 32 B.T.A. 399; Skenandoa Rayon Corporation v. Commissioner, 122 F.2d 268, certiorari denied 314 U.S. 696. Petitioner contends that such expenses are deductible in the instant case since the increase in capitalization was for the purpose of ‘permitting employees of petitioner to acquire a proprietary interest in petitioner in order that petitioner might be assured of such employees' loyalty and improved devotion to service * * *.’ Petitioner analogizes this situation with that of establishment of a pension trust wherein the attorney fees incurred in arranging such a trust have been held to be deductible. Meldrum & Fewsmith, Inc., 20 T.C. 790, affirmed without discussion on this point 230 F.2d 283.
The purpose of petitioner in increasing its capitalization is immaterial. Such expenses were a cost of acquiring capital and accordingly are not deductible.
Issue 3.
The third issue is whether petitioner Tackle is entitled to deduct as an ordinary and necessary business expense the entire amount of ‘rental’ paid to Spencer Industries, Inc., for the use and occupancy of the plant site and facilities located at Spencer, Iowa. Respondent determined that one-half of such payments for each of the years in issue— $5,000 in 1949 and $6,000 each for 1950 and 1951— were not rental payments but rather that Tackle was acquiring an equity interest in the property in such amounts by virtue of the purchase option provisions in the lease agreement executed between Spencer Industries, Inc., and South Bend, and, accordingly, disallowed the deduction of such amounts pursuant to the provisions of section 23(a)(1)(A), Internal Revenue Code of 1939.
The respondent's determination insofar as such payments are concerned cannot be sustained. Under the lease between it and Spencer Industries, Inc., South Bend is the sole lessee of the plant site and facilities located at Spencer, Iowa. Tackle is not a party to that lease and there has been no assignment of the lease by South Bend to Tackle. While Tackle is occupying and using the property, it is doing so at the instance of South Bend, apparently without objection on the part of Spencer Industries, Inc. Such use and occupancy is consistent with that of a sublessee or tenant at will and does not necessarily confer upon Tackle the option right contained in the lease between South Bend and Spencer Industries, Inc. The chairman of the board of directors of South Bend, its president during the years involved, and likewise an officer and director of Tackle, testified without contradiction that this lease had never been assigned to Tackle and there was no ‘understanding, written or oral, formal or informal, between South Bend Bait Company and Fishing Tackle Products Company with respect to the transfer of that lease to Fishing Tackle Products Company.’ He further testified, without contradiction, that there was no such understanding ‘with respect to how long Fishing Tackle Products Company shall be entitled to have the use and possession of the Spencer property.’ It is clear from these facts that Tackle is not entitled to exercise the purchase option provided by such lease and, accordingly, is not acquiring an equity in the property within the meaning of section 23(a)(1)(A). There is no evidence, and we do not understand respondent to contend, that the $1,000 per month paid as rental was unreasonable or excessive. Accordingly, we hold that the entire rental payments involved herein which were paid during the fiscal years ending in 1949, 1950, and 1951 are deductible by Tackle as business expenses.
Issue 4.
The last issue involves the determination of the depreciation period of permanent improvements made to the leasehold by Tackle. Respondent determined that the useful life of such improvements was the proper period to use in computing the annual depreciation allowances for such improvements. Tackle contends, however, that the cost of such improvements should be amortized over the period of the lease remaining after such improvements were added.
The general rule for depreciation of leasehold improvements made by the lessee where the lease is for a fixed period is that the cost of such improvements shall be amortized over the remaining term of the lease or the useful life of the improvements, whichever is shorter. Duffy v. Central Railroad Co. of New Jersey, 268 U.S. 55; Fort Wharf Ice Co., 23 T.C. 202; 4 Mertens, Law of Federal Income Taxation sec. 23.92; Regs. 111, sec. 29.23(a)-10.
It is also well settled that where a lessee makes improvements on property leased for an indefinite period on a month-to-month basis or under a tenancy at will, depreciation is to be based on the estimated life of the improvements. See George H. Bowman Co., 7 B.T.A. 399, affd. 32 F.2d 404. In that case the petitioner occupied a warehouse used in carrying on its business, without having a lease for any stated period of time; its tenancy was indefinite, no arrangements having been made between it and the owner as to such occupancy, other than that petitioner should pay monthly rental in a fixed amount which had no relation to the improvements in question. We there said:
The duration of petitioner's tenancy of the building was indefinite and indeterminable. It occupied the premises at the will of the lessor and until it appears that petitioner's tenancy will end at some definite time, it is entitled to a deduction in the taxable year of no more than a reasonable allowance for the exhaustion of the cost of improvements over the useful life thereof. If petitioner's tenure extends over the period of the useful life of the improvements it will have recovered its cost through the annual allowance for exhaustion; if the tenure should for any reason terminate prior to the useful life of the improvements petitioner will then be entitled to a deduction from gross income of the unextinguished cost of such improvements. In either event petitioner will have obtained the deduction to which, under the statute, it is entitled. * * *
In the instant case Tackle's occupancy of the property involved is subject to the continued consent of South Bend. In that respect it is a tenancy for an indefinite period. If South Bend were the owner of the property or if South Bend's lease were for a period in excess of the estimated useful life of the improvements, Tackle would only be entitled to amortize the cost of the improvements made by it over the useful life of such improvements. Here, however, South Bend's tenancy is only for a period of 10 years with no expressed right of renewal. Although South Bend has an option to purchase the leasehold property, it has as yet indicated no intention to exercise such option. Under the circumstances it appears that Tackle's tenancy is presently limited by the 10-year period of South Bend's lease. Accordingly, we hold that Tackle is entitled to amortize the cost of the improvements made by it over the period of the 10-year lease remaining after such improvements were added. Rankin v. Commissioner, 60 F.2d 76; Leonard Refineries, Inc., 11 T.C. 1000; and Harry Gleis, 24 T.C. 941 (on appeal C.A. 6), relied upon by respondent, are distinguishable. In the Rankin case it was held that the contract under which the property was occupied was a contract of purchase and not a lease with option to purchase. In both the Leonard Refineries and the Gleis cases, it was found as a fact that the lessee intended to exercise the purchase option contained in the lease under which the property was being occupied.
Decisions will be entered under Rule 50.