Docket No. 48026.
Bernard V. Lentz, Esq., for the petitioner. Edward Resin, Esq., for the respondent.
Petitioner held to have realized rental income during 1948, 1949, and 1950 when it furnished occupancy to a sublessee pursuant to a previous agreement with its lessee, rather than in 1943 when petitioner executed and delivered a nonnegotiable instrument to its lessee and the lessee, in turn, satisfied a judgment outstanding against petitioner. Bernard V. Lentz, Esq., for the petitioner. Edward Resin, Esq., for the respondent.
The respondent determined deficiencies in the income tax of petitioner as follows:
+--------------------+ ¦Year ¦Deficiency ¦ +------+-------------¦ ¦1948 ¦$1,997.94 ¦ +------+-------------¦ ¦1949 ¦26,203.91 ¦ +------+-------------¦ ¦1950 ¦11,598.87 ¦ +--------------------+
The issue common to all three taxable years is the correctness of the respondent's action in including in petitioner's income for 1948, 1948, and 1950 amounts representing rental income realized by petitioner in the form of a discharge of indebtedness due the lessee. Additional issues have been disposed of by stipulation.
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
The petitioner is a Pennsylvania corporation organized on May 8, 1936, with its principal place of business at 1500 Walnut Street, Philadelphia, Pennsylvania. Petitioner filed its income tax returns for 1948, 1949, and 1950 with the collector of internal revenue for the first district of Pennsylvania.
Wiltshire Realty Company, Inc., sometimes hereinafter referred to as Wiltshire, the corporate predecessor of petitioner, was a Pennsylvania corporation organized on June 22, 1926. Wiltshire was organized to acquire and operate an office building and premises at 1500 Walnut Street situated in Philadelphia.
On March 31, 1927, Frank F. Barker, as lessor, and the First National Bank of Philadelphia, sometimes hereinafter referred to as National, as lessee, executed a lease covering the first floor and other specified portions of the premises situated at 1500 Walnut Street. On April 1, 1927, Barker transferred his interest in the above-mentioned lease to Wiltshire.
At the time of the execution of the lease on March 31, 1927, Wiltshire was indebted to National for loans in the total principal amount of $325,000, which were evidenced by 6 per cent 22-year debentures, with interest coupons attached, issued by Wiltshire to National. These debentures were redeemable prior to maturity upon payment of 105 per cent of their face value, together with all interest accrued to the date of redemption.
The lease executed on March 31, 1927, was to run for a term of 20 years. The total rental was fixed at $1,225,000, of which $900,000 was payable in money and $325,000 was payable in the debentures of Wiltshire. Rent was payable monthly. The lease provided that upon default by Wiltshire in the payment of any of the 6 per cent 22-year debenture interest coupons National should have the right (1) to demand payment of the defaulted coupons in cash, or (2) to retain the coupons and thereupon to extend the lease and apply the coupons against the rental for such further term as would be necessary to exhaust them. National also was given the specific right to extend the original 20-year term for a period of 2 additional years at a total rental of $122,500, and the right to deliver in payment of any installment of rent during such extension any unpaid interest coupons upon Wiltshire's 6 per cent 22-year debentures to the extent of their face value. The premises were to be used by National only for the purpose of conducting a banking business. National could not sublet the premises without the consent of the lessor. The 20 year term of the lease commenced on June 15, 1928. As security for the loans advanced to Wiltshire the lease created a prior lien on the premises in favor of National.
Wiltshire consistently defaulted in the payment of interest on its 6 per cent 22-year debenture coupons with the result that as of April 1, 1936, the defaulted interest coupons amounted to $74,140.62 and the interest on such defaulted coupons amounted to $11,172.84, making an aggregate amount of $85,313.46 due National as interest on such debentures. The total principle amount of the debentures remaining unpaid on April 1, 1936, was $211,250.
Proceedings for the reorganization of Wiltshire were instituted in the United States District Court for the Eastern District of Pennsylvania and the plan of reorganization was approved by the final decree of that court entered June 1, 1936. Pursuant to the decree, all the assets of Wiltshire, including its interest in the land and improvements thereon located at 1500 Walnut Street, were conveyed to petitioner on June 15, 1946, and petitioner also assumed the debts and obligations of Wiltshire. The interest of Wiltshire in the lease dated March 31, 1927, was assigned to petitioner by an agreement dated April 1, 1936, but executed by Wiltshire on June 15, 1936, and by petitioner on June 16, 1936.
Petitioner and National executed a supplemental lease on June 16, 1936. The supplemental lease provided that the aggregate indebtedness of $85,313.46 due National as interest, together with interest on the aforementioned debenture coupons which might accrue after April 1, 1936, should be applied only as rental payments on an extension of the original 20-year term. Petitioner delivered to National as its own obligation its 6 per cent 13-year debentures, bearing date of March 31, 1936, in the principal amount of $211,250, in substitution for the total principal obligation theretofore outstanding on Wiltshire's 6 per cent 22-year debentures.
During the proceedings for the reorganization of Wiltshire, National presented no claim for satisfaction of the defaulted interest in the amount of $85,313.46. No obligations with respect to such interest survived the reorganization proceedings except as provided in the supplemental lease.
Petitioner defaulted in the payment of interest on its own 6 per cent 13-year debentures. As of April 1, 1942, the total of the defaulted interest coupons on such debentures since October 1, 1936, amounted to $53,868.75. In addition, National held defaulted coupons in the amount of $3,168.75 due June 1, 1936, on the 6 per cent 13-year debentures issued by petitioner.
Early in 1942 a dispute arose between petitioner and National as to their respective rights under the lease of March 31, 1927, as supplemented by the lease agreement dated March 31, 1936, with respect to the defaulted interest on petitioner's 6 per cent 13-year debentures which had accrued from October 1, 1936, through April 1, 1942, in the total amount of $53,868.75.
National found that it needed more ground floor space. Subject to the consenting by petitioner to a sublease, National made arrangements to sublease the space occupied by it in petitioner's office building to Drexel & Company and to buy a building occupied by that company. Petitioner at first withheld its consent and took the position that National had exercised an option to extend the lease because it had failed to sue on each defaulted coupon as it matured. Thereupon National commenced court proceedings to obtain an adjudication of the question of whether its failure to sue petitioner on matured debenture coupons constituted an election to extend the original term of the lease. National also brought another suit against petitioner to recover $53,868.75 on defaulted interest coupons which had matured during the period of October 1, 1936, through April 1, 1942.
While the foregoing court proceedings were pending, petitioner and National on September 14, 1942, executed an agreement which provided, among other things that petitioner would consent to a sublease by National to Drexel & Company of the premises of petitioner then occupied by National for a term beginning not later than March 31, 1943, and ending on June 14, 1950. In consideration of the foregoing, National agreed that if it should be adjudicated not to have exercised any of the options to extend the original term of its lease ending on June 14, 1948, then it would satisfy of record any judgment which might be rendered against petitioner on its unpaid coupons. Petitioner further agreed to execute and deliver to National promissory notes, in the aggregate amount of the unpaid debenture coupons represented in part by any judgment, and National in turn agreed to use and apply such notes, together with the sums of money representing unpaid coupons of Wiltshire, to the payment of rent during the extended 2-year term of the lease from June 15, 1948, and further agreed to release petitioner from any interest that might be due on unpaid coupons of petitioner or Wiltshire.
In the first of the above-mentioned suits brought by National, it was held that National had not elected to extend the original term of the lease by reason of its failure to sue petitioner on overdue debenture coupons. In the second suit, National was awarded judgement against petitioner on May 3, 1943, for $53,868.75, plus interest.
Pursuant to the agreement executed September 14, 1942, petitioner, on May 28, 1943, executed and delivered to National an instrument reading as follows:
$53,868.75— May 28, 1943.
On demand FIFTEEN HUNDRED WALNUT STREET CORPORATION promises to pay to THE FIRST NATIONAL BANK OF PHILADELPHIA, Fifty-three Thousand, Eight Hundred Sixty-eight Dollars and Seventy-five cents ($53,868.75) without interest. This note is executed and delivered in accordance with Agreement dated September 4, 1942 between Maker and Payee, as amended, and shall be used and applied, together with the sums of money representing unpaid coupons of Wiltshire Realty Company, as provided in a certain Supplemental Agreement between said parties dated as of March 31, 1936, to the payment of rent during the extended term of Lease dated March 31, 1927 for a portion of premises No. 1500 Walnut Street, Philadelphia, Pa. of two (2) years from June 15, 1948. Payee further agrees to cancel and return to Maker any balance of such promissory note which shall not be required for the payment of rent during such extended term.
Payable at Philadelphia, Pennsylvania.
The coupons which matured from October 1, 1936, through April 1, 1942, on petitioner's 6 per cent 13-year debentures were destroyed on July 14, 1943.
Pursuant to the agreement of September 4, 1942, National satisfied of record its judgment in the amount of $53,868.75 against the petitioner.
The aforementioned instrument executed by petitioner on May 28, 1943, was canceled by National and returned to petitioner on August 21, 1943, and another instrument, reading as follows, was executed by petitioner and delivered to National: $122,500.00— PHILADELPHIA, PA., August 21st, 1943.
ON DEMAND, FIFTEEN HUNDRED WALNUT STREET CORPORATION promises to pay to THE FIRST NATIONAL BANK OF PHILADELPHIA One Hundred and Twenty-Two Thousand, Five Hundred Dollars ($122,500.00) without interest.
This note is executed and delivered in accordance with a certain agreement dated September 4, 1942, as amended, between Maker and Payee, to which reference is hereby made, it being intended that the within note shall evidence all of the outstanding indebtedness due, or to become due, by Maker, to Payee, with respect to all unpaid coupons, with accumulated interest thereon, on the Twenty-two Year Six Percent Debentures of Wiltshire Realty Company and Thirteen Year Six Percent Debentures of Fifteen Hundred Walnut Street Corporation and promissory note dated May 28, 1943, of Fifteen Hundred Walnut Street Corporation payable to The First National Bank of Philadelphia in the amount of $53,868.75, except the indebtedness due Payee by Maker and evidenced by $81,250.00 principal amount of Thirteen Year Six Percent Debentures, with interest thereon, secured by deposit and pledge of General Mortgage Bonds of like amount due April 1, 1947.
Payee having exercised its option to extend for a period of two (2) years from June 15, 1948 the term of a certain lease dated March 31, 1927 between Frank F. Barker and Payee, as supplemented, for a portion of premises No. 1500 Walnut Street, Philadelphia, Pa., (to which lease as supplemented reference is hereby made), the entire principal amount of the within note shall be used and applied solely to the payment of rent during such extended term of two years from June 15, 1948, in the same manner as coupons are to be applied for such purpose as provided in said lease as supplemented, and when and as the principal amount of this note is applied to the payment of such rent during such extended term, such payment shall be noted hereon, and at the expiration of said extended term this note shall be cancelled and returned to Maker.
Payable at Philadelphia, Pa.
For value received.
Petitioner made the following journal entries to record the issuance of the foregoing instrument:
+----------------------------------------------------------------------------+ ¦August 21, 1943 ¦ ¦ +----------------------------------------------------------------+-----------¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------+----------+-----------¦ ¦Note payable—First National Bank ¦$53,868.75¦ ¦ +-----------------------------------------------------+----------+-----------¦ ¦Unpaid coupons thirteen year six per cent. Debentures¦3,168.75 ¦ ¦ +-----------------------------------------------------+----------+-----------¦ ¦Unpaid coupons former twenty-two year debentures ¦74,140.62 ¦ ¦ +-----------------------------------------------------+----------+-----------¦ ¦Note payable—First National Bank ¦ ¦$122,500.00¦ +-----------------------------------------------------+----------+-----------¦ ¦Surplus from operations ¦ ¦8,678.12 ¦ +----------------------------------------------------------------------------+
To record issuance of demand note without interest in accordance with Agreement of September 4, 1942 as amended February 25, 1943, intended to evidence all outstanding indebtedness due or to become due by corporation to First National Bank with respect to all unpaid coupons with accumulated interest thereon on the Twenty-Two Year Six Per Cent. Debentures of Wiltshire Realty Company and Thirteen Year Six Per Cent. Debentures and promissory note dated May 28, 1943 in the amount of $53,868.75, except the indebtedness evidenced by $81,250.00 principal amount of Thirteen Year Six Per Cent. Debentures and interest thereon. Principal of note to be used and applied solely to the payment of rent during the extended term of lease for two years from June 15, 1948; such payments to be noted on the note and at the expiration of the extended term the note to be cancelled and returned to corporation.
During the period from June 15, 1948, to December 31, 1948, petitioner debited on its books an account entitled ‘Note Payable— First National Bank’ with the amount of $33,177.10. This amount was credited on petitioner's books as rental income and reported on its Federal income tax return for 1948. During 1949 the foregoing account was debited on petitioner's books in the amount of $61,250.04 and from January 1, 1950, through June 14, 1950, the account was debited in the amount of $28,072.86. The total debits to this account during the period from June 15, 1948 through June 14, 1950, equaled $122,500, the amount appearing on the face of the instrument executed August 21, 1943, set out above.
During the 2-year term beginning June 15, 1948, and ending June 14, 1950, National made monthly notations on the back of the instrument of August 21, 1943, indicating the expiration of monthly coupons and reducing the value of the instrument by an amount equal to one month's rent. Moreover, National actually prepared checks in full payment of each month's rent as it accrued and internally cleared them prior to crediting petitioner's note in the amount of each such check. National did not enter the instrument of August 21, 1943, on its books as an asset but carried it on a memorandum ledger sheet. Periodic credits to interest income and debits to rental expense were recorded by National on its regular books of account. On or about June 14, 1950, the instrument of August 21, 1943, had been credited in an amount equal to $122,500, and National then marked it ‘Cancelled’ and returned it to petitioner.
No portion of the $122,500 referred to in the instrument of August 21, 1943, was entered by petitioner on its books of account nor included as income in its income tax return for 1943. No portion of the $61,250.04 with which the above-mentioned ‘Note Payable— First National Bank’ account was debited by petitioner on its books during 1949 was reported as income on its return for that year nor was any portion of the $28,072.86 by which that account was debited through June 14, 1950, included by petitioner in its gross income for 1950.
From the time of its organization to the time of the hearing herein the sole business conducted by the petitioner has been the owning and operating of the office building and premises at 1500 Walnut Street in Philadelphia.
At all times pertinent herein the petitioner kept its books and records on an accrual basis and prepared its income tax returns from its books and records kept on such basis.
Petitioner takes the position that the amounts of $33,177.10, $61,250.04, and $28,072.86 with which petitioner debited the ‘Note Payable— First National Bank’ account on its books during 1948, 1949, and 1950, respectively, and which National credited as interest income on its books during those years, did not constitute income taxable to it for 1948, 1949, and 1950. In support of its position, petitioner contends that such amounts constituted advance rental realized in 1943 when the judgment against it was satisfied and its note was executed and delivered to National.
Respondent contends that petitioner realized rental income in the foregoing amounts during 1948, 1949, and 1950, because of its services in providing office space to National's sublessee, Drexel & Co., for the 2-year period commencing June 15, 1948. Respondent argues that rentals accrued under the lease involved herein simultaneously with National's monthly reduction of the aggregate amount of the outstanding balance due on the instrument executed August 21, 1943.
In support of its position, petitioner relies on Commissioner v. Lyon, 97 F.2d 70. In that case, decedent executed a lease under the terms of which he received from the lessee an immediate cash payment of $75,000, one tenth of which was to be applied to the rental due for each of the last 10 months of the term. The lease provided that the $75,000 payment would be repayable by the lessor only in the event that the lease was terminated otherwise than by default of the lessee. The United States Court of Appeals for the Ninth Circuit held that the provisions of the lease made it clear that in the contemplation of the parties the $75,000 cash payment was fully earned by the lessor upon execution of the lease and therefore that the amount in question was income realized in the year of execution since the lessor had in that year acquired an unconditional right to receive it.
We are of the opinion that the facts before us are readily distinguishable from those involved in Commissioner v. Lyon, supra. Whether petitioner received advance rental in 1943, as it contends, depends in part upon the intention of the parties to the lease. Estate of Budd Frankenfield, 17 T.C. 1304; Commissioner v. Lyon, supra. Nowhere in the original lease, in subsequent modifications thereof, or in the circumstances surrounding its execution or modification can we find evidence supporting petitioner's position that a prepayment of rent in 1943 was intended by the parties. Petitioner's contention that it received in 1943 an advance rental payment in the amount of $122,500 upon execution and delivery of its note to National, satisfaction by National of the judgment outstanding against petitioner, and destruction of the coupons on which that judgment was based, is not supported by the record. As a result of the agreement executed September 4, 1942, and the execution pursuant thereto and delivery to National of the instrument executed August 21, 1943, in the face amount of $122,500, petitioner received in 1943 a conditional contractual right, i.e., the right to keep its assets free of National's claim for cash payment of the defaulted coupons and accrued interest and the relinquishment of any claim arising out of the defaulted Wiltshire coupons, provided it met its obligation to furnish office space for National's sublessee during the period commencing June 15, 1948.
During the period beginning June 15, 1948, and ending June 14, 1950, monthly notations were made by National on the back of the instrument executed August 21, 1943, as evidence of the proportionate discharge of petitioner's obligation.
Petitioner recorded the issuance of the instrument on its books as a ‘Note Payable’ with a notation stating that the note was intended to evidence all outstanding indebtedness due National with respect to the debentures issued by petitioner. The total debits made by petitioner to this ‘Note Payable’ account during the period June 15, 1948, through June 14, 1950, equaled $122,500, the face amount of the instrument.
From the foregoing, it is apparent to us that petitioner could not accrue as income the release of its combined cash and occupancy liability valued at $122,500 until it had provided space on its premises for occupancy by National's sublessee, Drexel & Co., for a 2-year period commencing June 15, 1948, since prior thereto its unrestricted right to the extinguishment of its indebtedness had not matured. Spring City Foundry Co. v. Commissioner, 292 U.S. 182.
Moreover, the bookkeeping entries made both by National and petitioner indicate that they intended the rent to be a currently payable obligation, rather than a prepayment as petitioner maintains. Consequently, during the period beginning June 15, 1948, and ending June 14, 1950, petitioner was released from its obligation valued at $122,500 in return for providing space to Drexel & Co.
Since, pursuant to the reorganization proceeding in 1936, petitioner assumed the debts and obligations of Wiltshire, the obligation represented by the Wiltshire coupons was imposed upon petitioner by decree of the bankruptcy court. The subsequent monthly installment discharges of this obligation by National in 1948, 1949, and 1950 resulted in the realization of income in those years by proportionately freeing petitioner's assets from the encumbrance of a lien.
A somewhat analogous situation was involved in Isidore Brown, 22 T.C. 147. There, taxpayer-lessor agreed to contribute $65,000 toward the cost of improving the leased property, one-half of which was payable in cash and one-half of which was to be credited against the cash rent payable by the lessee. In holding that the discharge of the lessor's obligation to pay for the cost of improvements to the extent of $32,500 was equivalent to the receipt by him of that amount in the years in which the improvements were made and the rent retained by the lessee, we stated, at page 151:
Much of the difficulty in this case is attributable to petitioner's insistence that the question is not whether the 432,500 credited pursuant to paragraph 22(b) of the lease is income, but when it is income. If that item was income at all, $20,528.72 there was realized in 1948, and $11,971.28 in 1949, when these amounts were effectively applied to extinguish petitioner's liability to the lessee. Income may be realized in a variety of ways, other than by direct payment to the taxpayer, and, in such situations, the income may be attributed to him when it is in fact realized * * *.
Applying the principle there enunciated to the facts before us, we are of the opinion that the amounts in question were income realized by petitioner during the period from June 15, 1948, through June 14, 1950, when it furnished National's subtenant with office space as satisfaction in part of its obligation to National on its defaulted debenture coupons, with interest.
In view of the foregoing, we hold that the amounts of $33,177.10, $61,250.04, and $28,072.86 here in controversy with respect to the years 1948, 1949, and 1950, respectively, constituted income taxable to the petitioner for those years.
Decision will be entered under Rule 50.