Consol.-Hammer Dry Plate & Film Co.
v.
Comm'r of Internal Revenue

Tax Court of the United States.Dec 6, 1967
49 T.C. 153 (U.S.T.C. 1967)
49 T.C. 153T.C.

Docket No. 1872-64.

1967-12-6

CONSOLIDATED-HAMMER DRY PLATE & FILM COMPANY, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Maurice P. Raizes, for the petitioner. Nelson E. Shafer, for the respondent.


Maurice P. Raizes, for the petitioner. Nelson E. Shafer, for the respondent.

Held: 1. Petitioner is not entitled to carry over and deduct from the income of its postreorganization business, under sec. 122, I.R.C. 1939, net operating losses which it had sustained in its prereorganization business. ‘Continuity of business enterprise’ principle of Libson Shops, Inc. v. Koehler, 353 U.S. 382, applied.

2. Real estate taxes paid by petitioner-lessee, an accrual basis taxpayer, under a lease agreement requiring lessee to pay all real estate taxes assessed on underlying property are not deductible in the year when such taxes are assessed and a lien attaches but only in the year when the taxes become due and payable.

3. Petitioner is not entitled to deduct the amount of $17,671.09 for real estate taxes allegedly paid as additional rent where the bookkeeping entry upon which such deduction is based is not substantiated by the record.

WITHEY, Judge:

Respondent determined deficiencies in petitioner's income tax for the years and in the amounts as follows:

+--------------------+ ¦Year ¦Deficiency ¦ +------+-------------¦ ¦1952 ¦$7,879.06 ¦ +------+-------------¦ ¦1954 ¦49,200.07 ¦ +------+-------------¦ ¦1955 ¦32,803.68 ¦ +------+-------------¦ ¦1956 ¦17,088.03 ¦ +--------------------+

Inasmuch as a substantial number of issues have been resolved by agreement of the parties, a Rule 50 computation will be necessary.

The main issues for decision are:

(1) Whether petitioner Consolidated-Hammer Dry Plate & Film Co. is entitled to carry over and claim deductions for net operating losses incurred by Hammer Dry Plate & Film Co. in its taxable calendar years 1948, 1949, and 1950, pursuant to section 122 of the Internal Revenue Code of 1939.

All statutory references hereinafter are to the Internal Revenue Code of 1939 unless otherwise noted.

Sugarman therefore owned 98.33 percent of the stock, leaving Hammer's prereorganization shareholders owning only 1.67 percent. The directors and officers of Photo Engravers, from the date of its incorporation until the merger with Consolidated-Hammer, and Consolidated-Hammer's directors and officers subsequent to the merger, were as follows:

The $126,550.87 loss reported in 1950 was first used to absorb the balance of Consolidated-Hammer's reported 1951 net income, and the balance of the loss was carried over as an offset to Consolidated-Hammer's reported 1952 net income.
In its Federal income tax return for the calendar year 1953, Consolidated-Hammer reported a net loss of $20,865.32. For the calendar year 1954, it reported net income of $80,908.56 and claimed an offsetting net operating loss deduction of $80,908.56. The $80,908.56 arose from an alleged unused net operating loss carryover of $85,594.90 from 1950 and $20,865.32 from 1953. The net operating loss carryover from 1950 claimed in 1954 resulted from an alleged overstatement of income reported for 1952 and a consequent alleged overstatement of the amount of the net operating loss carryover from 1950 which had previously been reported as absorbed or used in 1952. In its Federal income tax return for the calendar year 1955, Consolidated-Hammer reported net income of $47,629.01 and claimed an offsetting net operating loss deduction of $25,551.66 consisting of an alleged loss carryover of $4,686.34 from 1950 and an alleged loss carryover of $20,865.32 from 1953.
On or about June 1, 1953, petitioner entered into an agreement of sublease for the premises commonly known as 4501 S. Western Ave., Chicago, Ill., with Russell Electric Co. The sublease provided, among other things, the following:
4. As net rental for said premises during said term, lessee shall pay to Lessor and * * * the aggregate sum of $692,466.67, in installments as follows:
$3,333.34 each on June 1, July 1 and August 1, 1953,
$9,840.00 on August 20, 1953,
$3,333.34 each on September 1, October 1, November 1 and December 1, 1953,
$60,800 on December 15, 1953,
$3,333.34 on January 1, 1954,
$5,160.00 on January 20, 1954,
$3,333.34 on February 1, 1954, and on the first day of each and every month thereafter throughout the term, with the privilege of prepaying any amounts of rental due from lessee during the term.
7. In addition to all rights of the lessee hereunder being subject and subordinate to all provisions of the basic lease and the Staffin lease, lessee further covenants and agrees that:
(a) It will undertake and fully and faithfully perform all obligations imposed upon or assumed by lessor by or under the basic lease and the Staffin lease (including, without limiting the foregoing, payment of general taxes, and special assessments against the premises, insurance premiums, maintenance and operating expenses thereof, without right of reimbursement in any respect from Lessor).
To implement said covenants and agreements of lessee, all provisions of the basic lease are hereby incorporated herein by reference, as completely as if the same were set forth in full herein once again, and with the same force and effect as if the lessor were substituted as the landlord, and the lessee as the tenant, in the basic lease * * *
Russell Electric was lessee in the basic lease which provided, in part, as follows:
7. Lessee will pay, in addition to the rent above specified, * * * all real estate taxes, charges and assessments, * * * which shall or may during the term of this lease be charged, laid, levied or assessed on said demised premises, * * * and in case said * * * real estate taxes, charges, and assessments, * * * shall not be paid when due, Lessor shall have the right to pay the same, which amounts so paid are declared to be so much additional rent and payable with the installment of rent next due thereafter * * *
The leasehold interest acquired by petitioner through its agreement of sublease was recorded on its books of account as a capital expenditure in the amount of $75,800, which represented the total amounts payable to Russell Electric on August 20, 1953, December 15, 1953, and January 20, 1954, in the respective amounts of $9,840, $60,800, and $5,160. The cost of the leasehold has been and is being amortized over the 185-month period for which the sublease was to run, resulting in a monthly amortization of $409.73. On December 31, 1953, the closing balance of petitioner's bookkeeping account No. 359, Amortization of Leasehold, was $2,868.11, which amount was closed to profit and loss on petitioner's books and deducted on its Federal income tax return for 1953. That amount consisted of $409.73 per month for 7 months.
On or about August 29, 1953, petitioner issued its check No. 14053 in the amount of $7,894.53 to Russell Electric, and charged account No. 355, Rent Expense, with the amount thereof. As of December 31, 1953, the balance of that account was $31,227.85, which amount was closed to profit and loss on petitioner's books and deducted on its Federal income tax return for 1953. That amount was composed of the following:

The stipulation filed by the parties sometimes refers to this amount as $190.90. Real estate taxes on the leased premises were recorded by petitioner on its books of account in account No. 354, Real Estate Taxes. At the close of each year, the balance in account No. 354 was closed to profit and loss on petitioner's books and deducted on its Federal income tax return for the calendar year. An analysis of petitioner's account No. 354 for the taxable years 1954 through 1960 reflects the following:

Although the parties have stipulated to this total, no explanation is given for the fact that it is in error to the extent of 90 cents.
Petitioner's adjusting journal entry 169-6, dated December 31, 1956, designated AD169-6, was as follows:

Represents check No. 14053 deducted through rent expense account No. 355.

It appears that, in the first year of the sublease, petitioner paid amounts representing taxes attributable to the presublease period. The record is not clear in this regard and, in any event, it does not seem that such action in and of itself should be deemed sufficient to overcome the clear language of the agreement.

(2)(a) Whether petitioner, a lessee and an accrual basis taxpayer whose lease requires it to pay real estate taxes on leased premises, is entitled to deduct real estate taxes in the year when the taxes become a lien on such property, or in the subsequent year when the taxes are payable.

(b) Whether petitioner is entitled to deduct the sum of $17,671.09 as real estate tax expense for its taxable year 1956.

FINDINGS OF FACT

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

Hammer Dry Plate & Film Co. (hereinafter referred to as Hammer) was incorporated under the laws of the State of Delaware on or about April 1, 1940. Prior to certain hereinafter described changes in its capitalization, Hammer's authorized capital stock was as follows:

+---------------------------------------------------------------------------+ ¦ ¦(3,000 shares preferred stock ($10 per share ¦ +-----------------------------+---------------------------------------------¦ ¦ ¦( par value) ¦ +-----------------------------+---------------------------------------------¦ ¦Date of incorporation ¦(1,000 shares common stock ($0.50 per share ¦ +-----------------------------+---------------------------------------------¦ ¦ ¦( par value) ¦ +-----------------------------+---------------------------------------------¦ ¦ ¦ ¦ +-----------------------------+---------------------------------------------¦ ¦ ¦(3,000 shares preferred stock ($10 per share ¦ +-----------------------------+---------------------------------------------¦ ¦ ¦( par value) ¦ +-----------------------------+---------------------------------------------¦ ¦Amendment dated Dec. 7, 1945 ¦(200,000 shares common stock ($0.50 per share¦ +-----------------------------+---------------------------------------------¦ ¦ ¦( par value) ¦ +-----------------------------+---------------------------------------------¦ ¦ ¦ ¦ +-----------------------------+---------------------------------------------¦ ¦ ¦(no preferred stock ¦ +-----------------------------+---------------------------------------------¦ ¦Amendment dated Mar. 30, 1946¦(200,000 shares common stock ($0.50 per share¦ +-----------------------------+---------------------------------------------¦ ¦ ¦( par value) ¦ +---------------------------------------------------------------------------+

Hammer was located in St. Louis, Mo., and was engaged in the business of manufacturing photographic plates and film for the printing industry. Its activities were conducted in its manufacturing plant that was subject to an outstanding mortgage of the Reconstruction Finance Corporation (hereinafter RFC). Hammer's operations resulted in losses from approximately 1947 to 1949, by which time Hammer was in default on the RFC mortgage that had a then outstanding balance of approximately $180,000. RFC thereupon advertised the mortgaged property for sale on or about June 28, 1949.

In or about 1948 or 1949, Kenneth Coffman, Earl H. Gromer, and David L. Heath formed D. L. Heath & Associates (hereinafter referred to as Associates or the Heath group) to develop and exploit a ‘Kenman process,‘ developed by Kenneth Coffman, for the manufacture of photographic film for use in the photoengraving industry.

Hammer's articles of incorporation provided, among other things, that the corporation could:‘manufacture, purchase or otherwise acquire, own, mortgage, pledge, sell, assign and transfer, or otherwise dispose of, to invest, trade, deal in and deal with photographic materials and supplies and other goods, wares and merchandise and personal property of every class and description.‘In general, to carry on any other business in connection with the foregoing, and to have and exercise all the powers conferred by the laws of Delaware upon corporations formed under the act hereinafter referred to, and to do any or all of the things hereinbefore set forth to the same extent as natural persons might or could do.’

$16,715.51 was claimed on the return as “taxes”; $7,905 of that amount was attributable to St. Louis operations and the balance ($8,810.51) was the amount re: 4501 S. Western Ave., Chicago, Ill.

Pursuant to an agreement embodied in a proposal dated June 16, 1949, and in board of directors resolutions dated June 17, 1949, between Hammer & Associates, Hammer, inter alia: (a) Received a $75,000 loan from Associates; (b) surrendered immediate possession of its plant to Associates for the production of photographic film by the Kenman process under the supervision of Kenneth Coffman and a new board of directors; (c) was recapitalized, pursuant to an amendment to its certificate of incorporation, with an authorized capital stock of 500,000 shares of 10-cent par-value common stock, of which amount 480,000 shares were issued as follows: 114,000 shares (23.75 percent) to the old Hammer stockholders, and 366,000 shares (76.25 percent) to the Heath group. On or about June 24, 1949, RFC agreed to defer its foreclosure proceeding and to accept, inter alia, the payment of $3,000 per month on the mortgage principal.

Hammer reported a loss in 1949, and continued to operate at a loss during 1950. Hammer thereupon filed a voluntary petition for reorganization under chapter X of the Bankruptcy Act with the U.S. District Court for the Eastern District of Missouri, Eastern Division. That court approved Hammer's petition on or about April 12, 1950, and a trustee was appointed for Hammer. On or about May 1, 1950, the aforementioned court-appointed trustee rendered a report of his investigation on Hammer's affairs.

On or about May 15, 1950, Benjamin Sugarman (hereinafter Sugarman) proposed a plan of reorganization for Hammer which, as modified by a proposal filed May 19, 1950, included the following:

(a) Existing shareholders were to surrender their common stock, totaling 480,000 shares, receiving in exchange 1 share of common stock for each 10 shares surrendered;

(b) Hammer was authorized to issue 1,000 shares of $100 par value preferred stock;

(c) Hammer's general creditors were given the option of receiving either 10 percent of their claims in cash, or 20 percent of their claims in preferred stock. Certain preferred creditors were to be paid in full.

The plan of reorganization was approved by the court, all Hammer's debts and liabilities (other than the RFC loan) were discharged, and Sugarman purchased the net amount of 432,000 shares of common stock surrendered by the old stockholders, along with 500 shares of the authorized preferred stock, for the total amount of $50,000. All shares purchased by Sugarman were retained by him until they were exchanged for shares of petitioner on a later date. The change in ownership of Hammer's common stock resulting from the reorganization was as follows:

+------------------------------------------------------------+ ¦ ¦Before reorganization¦After reorganization¦ +-----------------+---------------------+--------------------¦ ¦ ¦Shares ¦Percent of ¦Shares ¦Percent of ¦ +-----------------+--------+------------+-------+------------¦ ¦ ¦ ¦total ¦ ¦total ¦ +-----------------+--------+------------+-------+------------¦ ¦Old shareholders ¦480,000 ¦100 ¦48,000 ¦10 ¦ +-----------------+--------+------------+-------+------------¦ ¦Benjamin Sugarman¦ ¦ ¦432,000¦90 ¦ +-----------------+--------+------------+-------+------------¦ ¦ ¦_ ¦_ ¦_ ¦_ ¦ +-----------------+--------+------------+-------+------------¦ ¦Total ¦480,000 ¦100 ¦480,000¦100 ¦ +------------------------------------------------------------+

Hammer's shareholders immediately prior and subsequent to the chapter X reorganization were the same, with the exception of Sugarman. The majority of those shareholders had acquired their stock prior to 1947. Within a few months after the reorganization, which was a tax-free transaction, Hammer discontinued use of the Kenman process because it was deemed to be unworkable.

The directors and officers of Hammer, prior and subsequent to the firm's reorganization in 1950, were as follows:

+---------------------------------------------------------+ ¦Directors ¦ +---------------------------------------------------------¦ ¦Prior to reorganization ¦Subsequent to reorganization ¦ +-------------------------+-------------------------------¦ ¦Kenneth K. Coffman ¦Benjamin Sugarman ¦ +-------------------------+-------------------------------¦ ¦D. L. Heath ¦Jack A. Cohon ¦ +-------------------------+-------------------------------¦ ¦Ray Tichacek ¦Alfred Levine ¦ +-------------------------+-------------------------------¦ ¦George A. Mahler ¦Samuel Becker ¦ +-------------------------+-------------------------------¦ ¦Earl H. Gromer ¦Robert McHale ¦ +-------------------------+-------------------------------¦ ¦Lou Rassieur ¦Faye Sugarman (wife of Benjamin¦ +-------------------------+-------------------------------¦ ¦James H. Batchelor ¦Sugarman) ¦ +-------------------------+-------------------------------¦ ¦ ¦R. W. Salzgaber ¦ +-------------------------+-------------------------------¦ ¦ ¦ ¦ ¦ +---------------------------------------------------------+

Officers Title Prior to reorganization Subsequent to reorganization President Kenneth K. Coffman Benjamin Sugarman Vice-president D. L. Heath R. W. Salzgaber Secretary Jack A. Cohon Treasurer Benjamin Sugarman Secretary-treasurer R. W. Salzgaber Assistant Ray Tichacek secretary-treasurer

Consolidated Photo Engravers & Lithographers Equipment Co. (hereinafter referred to as Photo Engravers) was incorporated under the laws of Illinois on or about December 1, 1946, as the successor to a sole proprietorship which had been conducted by Sugarman since 1940. Photo Engravers' capitalization consisted of 500 shares of common stock having a par value of $100 per share, all of which, except for qualifying shares held by Sugarman's wife, were owned by Sugarman. Photo Engravers manufactured and sold cameras and other equipment used in the photoengraving and allied fields, with principal offices in Chicago, Ill.

Photo Engravers' articles of incorporation provided that the corporation was organized to:‘design, engineer and manufacture printing and publishing equipment and other kinds and types of mechanical equipment, devices and supplies; and in addition thereto:‘To exercise all of the other powers authorized by the Business Corporation Act.’

1953 taxes in the amount of $17,621.02, less credit of $9,776.56 allowed at time of execution of agreement of sublease.

Photo Engravers reported taxable net income of more than $36,000 for the taxable year ended November 30, 1948, and reported taxable net income of $50,000 or more for each of its taxable years ended November 30, 1949, and November 30, 1950.

In November 1950, Hammer's certificate of incorporation was amended so as to change its corporate name from Hammer Dry Plate & Film Co. to Consolidated-Hammer Dry Plate & Film Co. (hereinafter referred to as Consolidated-Hammer).

Pursuant to an agreement of merger, Photo Engravers was merged into Consolidated-Hammer, the surviving corporation, on or about August 31, 1951, under the laws of Delaware, and all of the assets of Photo Engravers, in the ascribed amount of $477,126, were transferred to Consolidated-Hammer. Consolidated-Hammer's capitalization after the foregoing merger consisted of 2,880,000 shares of common stock having a par value of 10 cents per share, and 844 shares of nonvoting preferred stock having a par value of $100 per share, which was issued as follows to shareholders of each of the component corporations:

(a) To shareholders of Hammer: One share of common stock of the merged corporation for each share of Hammer common stock, and 1 share of preferred stock of the merged corporation for each share of Hammer preferred stock. Shareholders of Hammer therefore acquired 480,000 shares of common stock in the merged corporation, or 20 percent of the total.

(b) To shareholders of Photo Engravers (Sugarman and wife): 4,800 shares of common stock of Consolidated-Hammer for each share of Photo Engravers stock. Shareholders of Photo Engravers therefore acquired 2,400,000 shares of common stock in Consolidated-Hammer, of 80 percent of the total. Sugarman's aggregate ownership of Consolidated-Hammer's common stock, as a result of the merger, was as follows:

+----------------------------------------------+ ¦As a Hammer stockholder ¦432,000 ¦ +--------------------------------+-------------¦ ¦As a Photo Engravers stockholder¦2,400,000 ¦ +--------------------------------+-------------¦ ¦ ¦1 2,832,000¦ +--------------------------------+-------------¦ ¦ ¦ ¦ +----------------------------------------------+

Consolidated-Hammer were as follows:

+-----------------------------------------------------------------------------+ ¦COMPONENT PARTS OF NET INCOME REPORTED BY CONSOLIDATED-HAMMER (WITHOUT REGARD¦ ¦TO NET OPERATING LOSS DEDUCTIONS) ¦ +-----------------------------------------------------------------------------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------+

1951 1952 1953 1954 1955 Net income (loss) from specific business activity formerly conducted by Photo Engravers $318,634.80 $186,081.16 $33,517.40 $127,603.29 ($168,684.47) Net income (loss) from the specific business activity formerly conducted by Hammer (102,677.27) (62,593.57) (54,382.72) (46,694.73) 1 216,313.48 Net income (loss) reported by Consolidated-Hammer (without regard to claimed operating loss 215,957.53 123,487.59 (20,865.32) 80,908.56 47,629.01 deductions) 1 Gain on sale of $67,230.84 assets Gain on sale of 150,000.00 lease

217,230.84 Operating loss (917.36) Total above 216,313.48

Consolidated-Hammer's returns for the calendar years 1951 and 1952 claimed net operating loss deductions of $215,957.53 and $122,667.49, respectively. These deductions were computed from Hammer's reported net losses, as follows:

+-----------------------------+ ¦NET OPERATING LOSS CARRYOVER ¦ +-----------------------------¦ ¦ ¦ ¦ ¦ +-----------------------------+

To From 1951 1952 1948 $112,114.53 1949 99,959.62 1950 1 3,883.38 $122,667.49 215,957.53 122,667.49

Following are the total amounts of debits reflected in the general ledger of the books and records of petitioner for the accounts respectively listed hereafter for the calendar year ended December 31, 1956:

+------------------------------------------+ ¦Account No. ¦Item ¦Total amount ¦ +-------------+-------------+--------------¦ ¦352 ¦Utilities ¦$6,723.41 ¦ +-------------+-------------+--------------¦ ¦355 ¦Rent expense ¦40,007.55 ¦ +-------------+-------------+--------------¦ ¦356 ¦Salaries ¦1,639.49 ¦ +-------------+-------------+--------------¦ ¦358 ¦Miscellaneous¦3,339.84 ¦ +------------------------------------------+

On or about January 14, 1957, a statutory notice of deficiency was mailed to petitioner as transferee of Photo Engravers, transferor, with respect to the transferor's tax liabilities for the taxable years or periods ended November 30, 1950, and August 31, 1951. The adjustments proposed with respect to the transferor were contested in a Tax Court proceeding, and on April 25, 1962, the Tax Court rendered an opinion in that proceeding and held, in part, that the transferor's reported inventory of $313,616.15 on August 31, 1951, was overstated by $58,826.10, and that said inventory was $254,790.05. No appeal was taken from the Tax Court opinion with respect to this particular issue. Upon the merger of Photo Engravers into Consolidated-Hammer, on or about August 31, 1951, Consolidated-Hammer acquired Photo Engravers' foregoing inventory at an assigned value of $313,616.16.

1958 taxes plus interest on 1957 taxes in the amount of $1,725.98 paid in 1959.


Consolidated-Hammer Dry Plate & Film Co., T.C. Memo. 1962-97.

Disregards refund credited to real estate tax account.

The parties agree that in the event Consolidated-Hammer is entitled to carry over and deduct from its income any net operating losses sustained by Hammer in any of its calendar years 1948 through 1950, Consolidated-Hammer's net income for 1951 should be recomputed or otherwise adjusted and increased in the amount of $58,826.10, with respect to the foregoing inventory, to determine the proper net operating loss carryover deductions, if any, for the years in question, notwithstanding the fact that 1951 is otherwise barred for the assessment of taxes for said year by the statute of limitations in sec. 6501(a), I.R.C. 1954, and/or sec. 275(a), I.R.C. 1939.

Respondent contends that although the lease agreement imposed upon petitioner the obligation of paying all real estate taxes levied upon the rental property, the amount so paid by petitioner constituted ‘additional rent’ which was only deductible, as in the case of rent, when payable. Petitioner, on the other hand, contends that irrespective of whether the deduction is designated additional rent or real estate taxes, it was entitled to accrue the expense in the year when the lien attached.

Relevant regulations promulgated under both the 1939 and 1954 Internal Revenue Codes provide:

Sec. 39.23(a)-10(a), Regs. 118; sec. 1.162-11(a), Income Tax Regs.

Taxes paid by a tenant to or for a landlord for business property are additional rent and constitute a deductible item to the tenant and taxable income to the landlord, the amount of the tax being deductible by the latter.

To the same effect, see Caroline T. Kissel, 15 B.T.A. 1270, 1274 (1929). It is evident from the foregoing that insofar as it may be pertinent to the disposition of this issue, petitioner's deduction for real estate taxes must be treated as a rental expense.

It is now well established that under the accrual system of accounting, an item of expense may not be deducted until all the events have occurred which fix the taxpayer's liability. United States v. Anderson, 269 U.S. 422, 424 (1926); Dixie Pine Co. v. Commissioner, 320 U.S. 516 (1944). If petitioner is to prevail, we must find from the record that its liability for the real estate taxes in question became fixed in the year when the lien attached. Petitioner can derive no support for its position from the relevant State law since the liability which attached thereunder was specifically limited to the ‘owner of the property on the first day of April.’ Its liability is to be determined only by its sublease and the underlying basic lease to which it refers. While the sublease is silent on the question of when the lessee is required to pay taxes, the basic lease does provide that if the lessee fails to pay real estate taxes

when due, Lessor shall have the right to pay the same, which amounts so paid are declared to be so much additional rent and payable with the installment of rent next due thereafter * * *

If we are to accord the foregoing lease provision its obvious meaning, it seems necessary to conclude that, as between the parties, the lessee incurred no obligation to pay real estate taxes until they became due.

However, petitioner relies for support on the cases of Denholm & McKay Co., 39 B.T.A. 767 (1939), and Metropolitan Co. v. United States, 176 F.Supp. 195 (S.D. Ohio 1959).

In Denholm & McKay, the petitioner, an accrual basis taxpayer whose fiscal year ended January 31, entered into a lease agreement which, for the taxable year at issue, required it to pay as rent (1) dividends on the preferred stock of the lessor if and when the lessor defaulted in making such payments, and (2) real estate taxes assessed by the City of Worcester, Mass., on certain rental property which it rented from a real estate company, all of whose common stock was owned by the petitioner. During its taxable year ended January 31, 1935, the year in controversy, the taxpayer-lessee paid $36,150.50 in dividends on the lessor's preferred stock. With respect to the taxes, the City of Worcester made a tax assessment of $56,112.40 on April 1, 1934, and an assessment of $56,222.08 on January 1, 1935. The former was payable on or before October 27, 1934, and the latter was payable one-half on July 1, 1935, and one-half on October 1, 1935.

Respondent contended as to both the dividend payment and the payment of taxes, that those expenditures were in the nature of capital investments which enhanced the value of petitioner's stock and for that reason were not deductible, and the amount so paid should be added to the cost of petitioner's stock. Petitioner, on the other hand, contended that the amounts so paid were rent, deductible as an allowable business expense.

The Court sustained petitioner's position on both items of expense and held, as to the real estate taxes, that petitioner, as an accrual basis taxpayer, could deduct the taxes as of the date of assessment, relying on the case of H. H. Brown Co., 8 B.T.A. 112 (1927). In the Brown case, petitioner was an accrual basis taxpayer reporting income on the fiscal year ended June 30. On June 30, 1922, petitioner accrued Massachusetts State and local taxes by setting up an appropriate reserve on its books. The Massachusetts taxable year commenced on April 1 of each year, at which time the taxes became a lien even though the taxes were not due and payable until the following October. The taxes involved in the Brown case were of two classes— (1) direct taxes on real estate and personal estate, and (2) corporate excise taxes. For the taxable year in question, the real estate taxes were assessed to the person who was either the owner or possessor of the property and the taxes on personal estate were assessed to the owner in the town where he resided. In holding that petitioner properly accrued the taxes which were assessed as of April 1, 1922, and paid on September 26, 1922, the Court specifically recognized that the taxes in question ‘were liabilities of petitioner on April 1 of that year.’

We think the Brown case stands for the proposition that an accrual basis taxpayer may deduct real estate taxes in the year when he becomes liable for such taxes, and not before. The taxpayer in Brown was not a lessee claiming a deduction for real estate taxes paid as additional rent but was the owner of the property in question and, as such, became personally liable for the taxes on the lien date, April 1. Inasmuch as the facts in Denholm & McKay fail to reveal specifically whether the petitioner-lessee in that case became primarily liable for the real estate taxes, because of the Court's reliance there on Brown, supra, we must assume that such was the fact. The case is for that reason distinguished from the case at bar.

We think the foregoing case analysis disposes of petitioner's reliance on Metropolitan Co. case, for in that case although the court allowed the petitioner-lessee to accrue real estate taxes as of the lien date, the Court specifically found that under applicable State law, the payment of the real estate taxes in question became an obligation of petitioner-lessee on the lien date. However, in the case at bar, since the applicable Illinois law specifically provided that ‘The owner of the property * * * shall be liable for the taxes of that year,‘ it is clear that under applicable State law, petitioner incurred no liability for the real estate taxes on the lien date in question. Consequently, we must sustain respondent's determination and hold that petitioner was not entitled to accrue the amount of those taxes as additional rent until they became due and payable under the terms of its leasehold.

Issue 2(b). Validity of Bookkeeping Entries

For the year 1955, real estate taxes were imposed on the leasehold property in the amount of $19,090.60, and under our holding in issue 2(a), supra, that amount, together with interest of $190.90, would ordinarily be deductible by petitioner as additional rent for the year 1956. While the parties have stipulated that such amounts were paid to the treasurer of Cook County in fulfillment of the tax obligation on the leasehold property in question, the only evidence suggesting that petitioner paid such amounts is contained in petitioner's books of account. Respondent contends that of the $19,281.50 paid as taxes in 1956, petitioner is entitled to deduct as additional rent expense only $1,610.41 on the ground that the balance ($17,671.09) arose from an unexplained adjusting entry to petitioner's books and records.

After considering all the facts in the record bearing on this issue, we find that petitioner has failed to adequately substantiate the underlying bookkeeping entries which make up the adjusting entry in question. We must therefore sustain the presumption of validity to which respondent's disallowance is entitled, and hold that for the year 1956, petitioner was only entitled to deduct $1,610.41 for real estate taxes paid as an additional rental expense.

Reviewed by the Court.

Decision will be entered under Rule 50.

RAUM, J., concurs in the result.

TANNENWALD, J., dissenting in part: I think the majority opinion correctly sets forth the general test of deductibility but then misapplies it to the facts of this case.

The findings of fact contained only a partial quotation of the applicable provision of the basic lease, which was specifically incorporated by reference in the sublease. The full provision is as follows:

7. Lessee will pay, in addition to the rent above specified, all water rents, gas and electric light and power bills and all real estate taxes, charges, and assessments, and governmental impositions in lieu of or in substitution for real estate taxes, charges, or assessments, which shall or may during the term of this lease be charged, laid, levied or assessed on said demised premises, insofar as and to the extent that, the same pertains to the period of this lease, or any extension thereof, and which shall be due and payable during the term of this lease, and in case said water rents, bills for gas, electric light and power and real estate taxes, charges, and assessments, and such governmental impositions shall not be paid when due, Lessor shall have the right to pay the same, which amounts so paid are declared to be so much additional rent and payable with the installment of rent next due thereafter, provided, however, that nothing herein shall prevent Lessee from contesting, protesting or reviewing by legal proceedings, or in such other manner as may be legal, in Lessor's name or otherwise (which, if instituted, shall be conducted at Lessee's own expense) any tax, water rent or utility bill or other such governmental imposition.

The words ‘and which shall be due and payable during the term of this lease’ were obviously stricken from the original draft of the basic lease and such action was initialed by the parties to that lease.

The lien date was April 1. The tax year was the calendar year. By December 31, the petitioner had been in possession of the leased premises for all or part of the calendar year, and the precise amount of the tax attributable to its period of occupancy had been fixed. Thus, the taxes had been ‘charged, laid, levied or assessed’ and they clearly met the requirement that they '(pertain) to the period of (the) lease.' Consequently, all of the events had occurred to fix petitioner's liability. That the determination of its liability was not postponed until the following year, when the taxes became ‘due and payable,‘ is self-evident from the fact that the language specifically providing for such postponement had been excised from the basic lease.1

As far as Denholm & McKay Co., 39 B.T.A. 767 (1939), is concerned, I disagree that it is distinguishable simply on the ground that the petitioner therein was ‘primarily liable’ for the real estate taxes. The fact of the matter is that, in that case, the issue before the Court was capitalization versus expense of the amount representing taxes and the question of the time of accrual of the obligation to pay that amount was not in dispute.

On the basis of the foregoing, I would hold that the petitioner is entitled to deduct, for each calendar year or part thereof, an amount equal to the taxes attributable to the period of petitioner's occupancy.

TIETJENS and HOYT, JJ., agree with this dissent.

SIMPSON, J., dissenting in part: I must disagree with the conclusion of the majority regarding the deductibility of the taxes paid by the taxpayer. I agree that the payment of these taxes is a form of additional rent and that the answer to the question turns on the interpretation of the lease. However, I disagree with the majority's interpretation of the lease.

Since this taxpayer used the accrual method of accounting, the question is when did it incur the liability to pay the taxes— not when were such taxes to be paid. There are pertinent portions of the lease that were not quoted in the majority's opinion. The full paragraph 7 provides:

7. Lessee will pay, in addition to the rent above specified, all water rents, gas and electric light and power bills and all real estate taxes, charges, and assessments, and governmental impositions in lieu of or in substitution for real estate taxes, charges, or assessments, which shall or may during the term of this lease be charged, laid, levied or assessed on said demised premises, insofar as to the extent that, the same pertains to the period of this lease, or any extension thereof, and which shall be due and payable during the term of this lease, and in case said water rents, bills for gas, electric light and power and real estate taxes, charges, and assessments, and such governmental impositions shall not be paid when due, Lessor shall have the right to pay the same, which amounts so paid are declared to be so much additional rent and payable with the installment of rent next due thereafter, provided, however, that nothing herein shall prevent Lessee from contesting, protesting or reviewing by legal proceedings, or in such other manner as may be legal, in Lessor's name or otherwise (which, if instituted, shall be conducted at Lessee's own expense) any tax, water rent or utility bill or other such governmental imposition.

It seems clear to me that this paragraph imposed a liability upon the taxpayer when the taxes were assessed. The obligatory part of the paragraph states that the lessee shall pay all real estate taxes ‘which shall or may during the term of the lease be charged, laid, levied or assessed on said demised premises.’ Thus, under this language, the obligation arose when the taxes were assessed during the lease. Such interpretation is reinforced by the provision that the obligation applies to real estate taxes ‘insofar as and to the extent that, the same pertains to the period of this lease.’ In addition, the real estate taxes are treated in the same manner as the payments for ‘water rents, gas and electric light and power bills.’ If our question concerned the water rents or the gas and electric bills to be paid by the lessee, it seems clear that the lessee's obligation applied to the water, gas, and electricity that it used during the lease— and not to those bills which happened to come due during the lease. Finally, the lease as originally drawn apparently restricted the lessee's obligation to those amounts ‘which shall be due and payable during the term of this lease’; however, this phrase was stricken from the lease, and the modification was initialed by the parties. This change in the terms of the lease makes it abundantly clear that the parties considered the question and decided that the obligation did not apply merely to those payments which became due during the lease. Taking all these circumstances into consideration, I am convinced that the lessee's liability arose when the taxes were assessed.

The majority's interpretation rests in part on the provision relating to what happens if the lessee does not make the required payments. In my opinion, this provision merely sets forth a procedure under which the lessor can protect his interest in the property by making the payments when the lessee fails to perform his obligation. This provision did not establish the lessee's liability, nor fix the time when such liability was incurred.

There is some evidence that during the first year of the lease, the parties understood the obligation to apply to the taxes that became due at that time. Although this understanding of the parties is pertinent in interpreting the lease, it does not overcome what I consider to be the clear meaning of the terms of the lease.

TIETJENS and HOYT, JJ., agree with this dissent.

+-----------------------------------------------------------------+ ¦Directors ¦ ¦ +-----------------------------------------------------------------¦ ¦Photo Engravers (premerger) ¦Consolidated-Hammer (postmerger) ¦ +-----------------------------+-----------------------------------¦ ¦ ¦ ¦ ¦ +-----------------------------+-----------------------------------¦ ¦Benjamin Sugarman ¦Benjamin Sugarman ¦ +-----------------------------+-----------------------------------¦ ¦Faye Sugarman ¦Faye Sugarman ¦ +-----------------------------+-----------------------------------¦ ¦(Sugarman's wife) ¦Jack A. Cohon ¦ +-----------------------------+-----------------------------------¦ ¦Abe Sugarman ¦C.M. Ruegs ¦ +-----------------------------+-----------------------------------¦ ¦(Sugarman's father) ¦Alfred Levine ¦ +-----------------------------+-----------------------------------¦ ¦ ¦Abe Sugarman ¦ +-----------------------------+-----------------------------------¦ ¦ ¦Robert Burnett ¦ +-----------------------------------------------------------------+

Officers Consolidated-Hammer (postmerger) Title Photo Engravers (premerger) President Benjamin Sugarman Benjamin Sugarman Vice president Abe Sugarman Alfred Levine Secretary Faye Sugarman Faye Sugarman Treasurer Benjamin Sugarman Benjamin Sugarman

Photo Engravers and Consolidated-Hammer had the following objectives in merging: (1) The combination of camera equipment (produced by Photo Engravers) and film (produced by Consolidated-Hammer) would create a profitable business; (2) savings would be effected by having combined sales offices and combined research, engineering, and development efforts; (3) competition would be met more effectively by discounting film to purchasers of Photo Engravers camera equipment; (4) the St. Louis area would be serviced with Photo Engravers products; and (5) combined efforts could be utilized for Government contracts.

After the merger between Photo Engravers and Consolidated-Hammer, joint activities worked for the benefit of both companies in the following manner: (1) A method of producing a new product called Koloroid color proofing was developed by the Research Department of Consolidated-Hammer and the Engineering Department of Photo Engravers, utilizing joint equipment and supplies; (2) joint advertising was utilized; (3) joint sales and dealership forces were created; (4) combined research and development was used for developing the Koloroid process, film cutting equipment, and the strip and pin register system; and (5) joint representations were made at all trade shows and conventions between 1950 and 1954.

Hammer filed its Federal income tax returns on a calendar year accrual basis. Photo Engravers filed its Federal income tax returns on the accrual basis for the fiscal year ending November 30, except for its final return which was filed for the period December 1, 1950, through August 31, 1951. Consolidated-Hammer filed its returns on a calendar year accrual basis. During all years in question, petitioner filed its Federal income tax returns with the district director of internal revenue, Chicago, Ill.

+-----------------------------------------------------------+ ¦Rent (June-December 1953; 7 months at $3,333.33/¦ ¦ +------------------------------------------------+----------¦ ¦month) ¦$23,333.32¦ +------------------------------------------------+----------¦ ¦Payment to Russell Electric (check No. 14053) ¦7,894.53 ¦ +------------------------------------------------+----------¦ ¦ ¦31,227.85 ¦ +-----------------------------------------------------------+

Pursuant to the law of Illinois during the years in question, real estate taxes became a lien on real estate as of April 1, although the taxes were not payable by the owner of the property until the subsequent year, at which time tax bills were issued. Real estate taxes on the property commonly known as 4501 S. Western Avenue, Chicago, Ill., were paid to the treasurer of Cook County, Ill., as follows:

+----+ ¦¦¦¦¦¦ +----+

Approximate Real estate Installment date on Amount paid Amount paid tax year which tax as tax as interest, paid etc. 1952 2 Sept. 8,1953 $7,894.53 1953 1 May 3,1954 8,810.51 1953 2 Sept. 2,1954 8,810.51 1954 1 May 9,1955 9,180.87 1954 2 Sept. 16,1955 9,180.87 1955 1 July 12,1956 9,545.30 1955 2 Oct. 29,1956 9,545.30 1 $190.00 1956 1 Oct. 24,1957 9,906.30 1956 2 Oct. 24,1957 9,906.30 1957 1 Feb. 25,1959 10,784.53 971.06 1957 2 Mar. 6,1959 10,784.53 754.92 1958 1 Feb. 1,1960 11,629.21 (1,279.57) 1958 2 Feb. 1,1960 11,629.21 1959 1 Sept. 16,1960 11,607.75 1959 2 Sept. 29,1960 11,607.75 116.08 1960 1 Feb. 23,1962 12,773.45 (1,916.47) 1960 2 Feb. 23,1962 12,773.45

+--------------------------------------------+ ¦Date ¦Explanation¦Folio ¦Debit ¦Credit¦ +-------+-----------+-------+---------+------¦ ¦ ¦ ¦ ¦ ¦ ¦ +-------+-----------+-------+---------+------¦ ¦6/30/54¦1953 taxes ¦JV88-20¦$8,810.51¦ ¦ +--------------------------------------------+

12/31/54 To P & L $8,810.51 8,810.51 8,810.51 4/30/55 1954 taxes—1st inst CD4-3 9,180.87 9/6/55 1954 taxes—2nd inst CD9-1 9,180.87 12/31/55 To P & L 18,361.74

18,361.74 18,361.74 7/31/56 1955 taxes—1st inst CD7-1 9,545.30 10/27/56 1955 taxes—2nd inst CD10-1 9,545.30 10/27/56 Interest, etc., re 1955 taxes CD10-1 190.90 12/31/56 AD169-6 17,671.09 12/31/56 To P & L J170-2 1,610.41

19,281.50 19,281.50 12/31/57 1956 taxes J173-1 1,000.00 12/31/57 1956 taxes AJ177-21 18,812.60 12/31/57 To P & L J179-1 19,812.60

19,812.60 19,812.60 6/30/58 J182-8 18,812.60 12/31/58 AJ186-3 12,833.37 12/31/58 AJ186-6 26,979.23 12/31/58 To P & L CJ187-1 21,000.00

39,812.60 39,812.60 12/31/59 1957 taxes and int. paid in 1959 J189-7 23,295.04 12/31/59 1958 taxes paid 1/60 J192-29 24,537.09 12/31/59 Estimated 1959 taxes J191-19 25,000.00 12/31/59 From C I & E books J188-1 27.00 12/31/59 Re prior years taxes J191-20 3,657.19 12/31/59 To reverse AJ 186-6 J188-3 26,979.23 12/31/59 To correct prior years taxes J192-27 10,272.35 12/31/59 To P & L J193-37 39,265.64

1 76,517.22 76,517.22 12/31/60 Estimated 1960 taxes J195-6 25,678.98 12/31/60 Refund 1951 & 1953 R&E taxes J196-7 560.22 12/31/60 To P & L J198-2 25,118.76

25,678.98 25,678.98

+----------------------------------------------------+ ¦Debit ¦ ¦ ¦¦ +-------+---------------------------------+---------+¦ ¦352 ¦Utilities ¦$4,875.77¦¦ +-------+---------------------------------+---------+¦ ¦355 ¦Rent expense ¦13,342.89¦¦ +-------+---------------------------------+---------+¦ ¦356 ¦Salaries ¦1,339.80 ¦¦ +-------+---------------------------------+---------+¦ ¦358 ¦Miscellaneous ¦458.20 ¦¦ +-------+---------------------------------+---------+¦ ¦203 ¦Accounts payable—Russell Electric¦27,304.43¦¦ +-------+---------------------------------+---------+¦ ¦ ¦ ¦ ¦¦ +----------------------------------------------------+

Credit 177 Leasehold $18,000.00 350 Rental income 11,650.00 354 Real estate tax 17,671.09

The amounts deducted in petitioner's returns and the respective contentions of the parties with respect to petitioner's alleged allowable deductions attributable to real estate taxes are summarized as follows:

+----------------------------------------------------+ ¦ ¦ ¦Amount ¦ ¦ +----+-------------+-------------------+-------------¦ ¦ ¦Deduction now¦designated as ¦Deduction now¦ +----+-------------+-------------------+-------------¦ ¦Year¦claimed by ¦“taxes” and ¦allowed by ¦ +----+-------------+-------------------+-------------¦ ¦ ¦petitioner ¦deducted as such ¦respondent ¦ +----+-------------+-------------------+-------------¦ ¦ ¦ ¦per return (re:4501¦ ¦ +----+-------------+-------------------+-------------¦ ¦ ¦ ¦S. Western Ave.) ¦ ¦ +----+-------------+-------------------+-------------¦ ¦ ¦ ¦ ¦ ¦ +----+-------------+-------------------+-------------¦ ¦1953¦$7,844.46 ¦1 $7,894.53 ¦ ¦ +----+-------------+-------------------+-------------¦ ¦1954¦18,361.74 ¦2 8,810.51 ¦3 $7,844.46¦ +----+-------------+-------------------+-------------¦ ¦1955¦19,090.60 ¦18,361.74 ¦18,361.74 ¦ +----+-------------+-------------------+-------------¦ ¦1956¦19,812.60 ¦1,610.41 ¦4 19,281.50¦ +----+-------------+-------------------+-------------¦ ¦1957¦21,569.06 ¦19,812.60 ¦19,812.60 ¦ +----+-------------+-------------------+-------------¦ ¦1958¦23,258.42 ¦21,000.00 ¦21,569.06 ¦ +----+-------------+-------------------+-------------¦ ¦1959¦23,215.50 ¦39,265.64 ¦5 24,984.40¦ +----+-------------+-------------------+-------------¦ ¦1960¦25,546.90 ¦6 25,678.98 ¦7 24,611.15¦ +----+-------------+-------------------+-------------¦ ¦ ¦ ¦ ¦ ¦ +----------------------------------------------------+

OPINION

Issue 1. Net Operating Loss Carryover Deduction

Issue 2(a). Real Estate Tax Deductions