Comm'r of Internal Revenue

Tax Court of the United States.Jul 8, 1969
52 T.C. 631 (U.S.T.C. 1969)
52 T.C. 631T.C.

Docket Nos. 1486-68 1487-68.



Donald G. Daiker, for the petitioner. Richard D. Worsley, for the respondent.

Donald G. Daiker, for the petitioner. Richard D. Worsley, for the respondent.

Petitioners leased property to the California Highway Patrol under a 10-year lease beginning in January 1963. Later in that year problems with the septic tank used for the property developed which petitioners sought to remedy in various ways. Petitioners sold the property, subject to the lease, in June 1964. Soon thereafter there was a recurrence of the septic tank trouble and petitioners voluntarily took over the problem. In 1965 petitioners paid $7,281.26 in connection with the installation of a connecting sewer pipe from the property to the municipal sewage system. Held: The expenditures are not deductible as ordinary and necessary business expenses by petitioners in 1965. Respondent's determination that the expenditures were deductible as capital losses in 1965 approved.


Respondent determined deficiencies in the petitioner's income taxes for 1965 in the following amounts:

+-----------------------------------+ ¦Docket ¦ ¦ ¦ +--------+-----------------+--------¦ ¦No. ¦Petitioner ¦Amount ¦ +--------+-----------------+--------¦ ¦ ¦ ¦ ¦ +--------+-----------------+--------¦ ¦1486-68 ¦John E. Turco ¦$702.74 ¦ +--------+-----------------+--------¦ ¦1487-68 ¦Louis B. Sullivan¦946.35 ¦ +-----------------------------------+

The issue in these consolidated cases is whether petitioners are entitled to deduct as ordinary and necessary business expense certain costs incurred by them in 1965 in the installation of a sewerage system on property which had been sold by them in 1964. Concessions made by both parties in docket No. 1487-68 (Louis B. Sullivan) will be given effect in the Rule 50 computation.


Some of the facts were stipulated and they are so found.

John E. Turco and Louis B. Sullivan were both residents of San Jose, Calif., at the time of the filing of their respective petitions in these cases. John E. Turco and Louis B. Sullivan each filed an individual Federal income tax return for 1965 with the district director of internal revenue at San Francisco, Calif.

At the date of trial both Turco and Sullivan were principally employed as insurance brokers in San Jose, Calif. Turco had been so engaged for about 12 years and Sullivan for about 16 years. In 1961 petitioners entered the business of constructing and leasing real properties to the California Highway Patrol (hereinafter Highway Patrol), a department of the State Government. When the department needed a new facility, it would first invite interested parties to submit site proposals and then invite the successful applicants to submit lease proposals on the contemplated facility. The department presented the successful applicants with a basic outline of plans and specifications for the building to be constructed, the applicants then submitted lease proposals, and the low bid (for rental) was almost always accepted by the State. The successful bidder then submitted a final set of plans and specifications for approval.

In 1961 petitioners constructed and leased such a facility in San Jose, Calif., to the Highway Patrol; in 1962 they constructed and leased a second such facility in Santa Cruz; and they constructed and leased a third facility in Vallejo which was occupied by the Highway Patrol on January 15, 1963, under a 10-year lease expiring on January 1, 1973. Subsequently the petitioners made several unsuccessful bids to construct similar facilities for the Highway Patrol at various locations, and finally, in about the year 1967, the petitioners ceased their efforts to obtain such work because of the refusal by the State of California to enter leases that contained a tax escalation clause.

Sometime in 1963 it was discovered that the septic tank installation on the Vallejo facility did not function properly. Petitioners undertook to correct the septic system problem by reconstructing the leach fields in order to properly handle the effluent, and also constructed a berm, which was an asphalt mound designed to divert water from the property.

In the latter part of June 1964 petitioners sold the Vallejo facility to Grace Lerner subject to the 10-year lease, and the Highway Patrol was promptly advised of the sale. About 2 months after the sale of the property to Grace Lerner the Solano County Department of Public Health found that the septic tank system on the property was inadequate. Grace Lerner's attorney notified petitioners of the recurring difficulties with the septic tank and petitioners undertook to remedy the problem without permanent success.

On June 7, 1965, the Solano County Department of Public Health notified Grace Lerner and petitioners that the existing septic tank and drain lines were still inadequate and constituted a health hazard and that it would be necessary to connect the sewage effluent from the Vallejo property to the municipal sewage system.

In 1965 petitioners paid $6,372 with respect to the installation of a sewerline connecting the Vallejo facility to the municipal sewage system of Vallejo. In the same year they also paid legal fees of $175 and engineering fees of $734.26 in connection with the installation. A connection fee of $797.26 incurred as part of the cost of the new sewer installation was paid by Grace Lerner in 1965.

Although the various efforts to remedy the sewage problem and finally the installation of the connecting sewerline was voluntarily undertaken by petitioners when the problems arose, it was always the stated position of Grace Lerner that petitioners were at all times fully liable and responsible for the sewage facility problems on the Vallejo property.

Each petitioner claimed a deduction as an ordinary and necessary business expense in 1965 of one-half of the total costs and expenses ($7,281.26) incurred in the sewage line installation for the Vallejo property in that year. Respondent determined that these expenditures were not allowable as ordinary deductions but that petitioners were entitled to deduct these amounts in 1965 as capital losses; the capital losses were allowed to reduce capital gains realized and reported by both petitioners for 1965.


Petitioners argue that they undertook in 1965 to correct the septic tank problems on the Vallejo property sold by them in 1964 for the purpose of fostering the goodwill of the Highway Patrol; that the expenditures incurred were in furtherance of their business of leasing property; and that consequently they are entitled to deduct such amounts as ordinary and necessary business expenses under section 162, I.R.C. 1954. Respondent contends that the expenditures incurred in 1965 were not ordinary and necessary expenses of petitioners' business, but were directly related to the sale of the Vallejo property in 1964 and that, under the rationale of Arrowsmith v. Commissioner, 344 U.S. 6 (1952), they must be accorded the same treatment for tax purposes as the gain reported on the sale of the property, i.e., as capital losses.

Petitioners do not argue that the expenditures are deductible under sec. 212 of the Code.

In Arrowsmith v. Commissioner, supra, the taxpayers were transferees of corporate assets received by them in a complete corporate liquidation in earlier years (1937-40). They had reported the gains received from these distributions as capital gains. About 4 years after the final corporate distribution the taxpayers, as transferees, were required to pay a judgment rendered against the corporation. The Supreme Court determined that under these circumstances it was proper to examine the earlier transactions in order properly to classify the character of the later loss for tax purposes and, since the payment of the judgment in the later year was integrally related to the earlier liquidating distributions, such payment in the later year took on the character of the earlier transactions and should be deducted as a capital loss rather than an ordinary loss. See Alvin B. Lowe, 44 T.C. 363 (1965); Rees Blow Pipe Manufacturing Co., 41 T.C. 598 (1964), affirmed per curiam 342 F.2d 990 (C.A. 9, 1965); and Estate of James M. Shannonhouse, 21 T.C. 422 (1953). But see William L. Mitchell, 52 T.C. 170 (1969).

The Supreme Court stated in part as follows (pp. 8-9):‘It is contended, however, that this payment (of the judgment) which would have been a capital transaction in 1940 (the year of the final liquidating distribution) was transformed into an ordinary business transaction in 1944 because of the well-established principle that each taxable year is a separate unit for tax accounting purposes. * * * (Citations omitted.) But this principle is not breached by considering all the 1937-1944 liquidation transaction events in order properly to classify the nature of the 1944 loss for tax purposes. Such an examination is not an attempt to reopen and readjust the 1937 to 1940 tax returns, an action that would be inconsistent with the annual tax accounting principle.’

Here, the petitioners sold the Vallejo property to Grace Lerner in June 1964 and reported a long-term capital gain from the sale. When the difficulties with the septic tank system on the property arose some 2 months after the sale, the petitioners, in reply to a letter from the attorney for Grace Lerner notifying them of the difficulty, advised him that ‘we would take over the problem.’ Petitioners had previously been confronted with the septic system malfunction on the property in 1963 and had made efforts to correct it so the problem was a familiar and recurring one.

Petitioners insist on brief that no legal determination was ever made that they were obligated to make these repairs in 1965. We do not believe it was necessary. We think that the natural inference of their undertaking to make the necessary changes is that they recognized and assumed their legal responsibility under the sale of the Vallejo property to cure these defects that materialized so soon after the sale. At the trial counsel for petitioners acknowledge that had these expenditures been made at the time of the sale they would have been offset against the capital gain realized on the sale. See Arrowsmith v. Commissioner, supra. We do not believe petitioners' purpose in incurring these expenditures in 1965 was any different than it would have been had they been incurred at the time of the sale. Moreover, it appears in the evidence that Grace Lerner's legal position at all times was that the petitioners were fully liable and responsible for whatever problems arose from the sanitation sewage facilities. In any event, we think it makes no difference in this case in applying the Arrowsmith doctrine whether the expenditures were made voluntarily or under a legal obligation to make them. The relationship of the payments to the sale transaction here is what determines the character of the deduction. Whether the payments were made voluntarily or under legal obligation would, at most, be of some evidentiary value in determining the reason they were made.

The main thrust of petitioners' argument is that they expended the sum of $7,281.26 to maintain a ‘good working relationship’ with the Highway Patrol and that consequently it was an ordinary and necessary expense in their business of owning and leasing buildings. This argument is simply not supported by the record. First, we have the testimony of the facilities officer of the Highway Patrol that leases were negotiable and were freely sold, in some instances a number of times. While the Highway Patrol wanted notice of transfer of the underlying property in order to know to whom rent was to be paid, it did not reserve the right of approval of the transfer. We cannot believe that a prior owner of property under lease to the Highway Patrol would be expected to continue maintenance of a property no longer his. In fact, the facilities officer stated that so far as the Highway Patrol was concerned, when the Vallejo property was sold the responsibilities immediately became those of the buyer, Grace Lerner. Finally, the facilities officer was asked whether petitioners' failure to make these corrections on the Vallejo property would in any way influence the Highway Patrol in considering future bids made by petitioners and he testified that ‘in my opinion it would not have affected their situation.’

We are not convinced by the evidence that petitioners made these expenditures in 1965 to keep up their good relations with the Highway Patrol rather than in recognition of their obligations under the sale of the Vallejo property and as an integral part of that transaction.

Respondent's determination is presumptively correct and petitioners have the burden of proving that respondent erred. Respondent determined that the expenditures here involved were not allowable as ordinary deductions but were deductible as capital losses. Petitioners have failed to establish by the record in this case that these expenditures were ordinary and necessary business expenses of petitioners' business and that respondent erred in his determinations. Accordingly, respondent's determinations must be approved.

Decision will be entered for the respondent in docket No. 1486-68. Decision will be entered under Rule 50 in docket No. 1487-68.