*2071 Evidence examined and held not to establish any market value for a leasehold transferred to a corporation immediately after execution.
*774 Respondent has determined deficiencies in income and profits taxes for the period May 1, 1920, to December 31, 1920, and for the calendar year 1921 in the respective amounts of $6,997.29 and $12,495.45. It is alleged that respondent erred (1) in refusing a deduction for the exhaustion of a certain leasehold; (2) in failing to allow as paid-in surplus the value of said leasehold; and (3) in refusing to allow as invested capital the value of said lease, which was paid in for capital stock. At the hearing the last two errors were waived.
FINDINGS OF FACT.
Petitioner is a corporation which was incorporated under the laws of the State of New York on May 1, 1920, for the purpose of taking over the lease hereinafter referred to, and with an authorized capital stock of 5,000 shares no par value common stock and 1,000 shares nonvoting 7 per cent*2072 preferred stock of the par value of $100 per share.
The Lawrence family was the owner of large tracts of land in and surrounding Bronxville, N.Y. They were developing these tracts of land as an exclusive and highly restricted residential section. As *775 an adjunct to such development the Lawrence family, in 1905, erected the Hotel Gramatan at a cost of about $300,000. In the early part of 1917 additions were made to the hotel at the approximate cost of $60,000. The hotel is of wooden framework with a stucco finish. It contains 257 guest rooms; a dining room with a capacity of 600 people; a laundry and a servants' building, and there adjoins the hotel property a casino which takes care of guests when there is an overflow, and in which there is a bowling alley. There are also a golf course and tennis court, the privileges of which are extended to its guests.
In May, 1920, practically all the land owned by the Lawrence family around the railroad station at Bronxville was developed. Other land in Bronxville was developed to the extent of 60 per cent and other tracts so owned near Yonkers were undeveloped.
The Hotel Gramatan is and was a well known residential hotel*2073 within thirty minutes commuting time of New York City. Its clientele consists of the high-class family type, approximately one-half of whom rent their rooms on a yearly basis, irrespective of whether they remain or not; the other half consists of people who come up for six to eight months and go away in the summer. Some of the guests are retired business men and others are employed in New York City in responsible professions. The hotel is open the year around.
From 1905 to 1910 the Lawrence family leased the hotel to Joseph Lannin. In 1910 the Hotel Gramatan, Inc. was organized under the laws of the State of New York by the Lawrence family for the purpose of operating the hotel. The Hotel Gramatan, Inc. is a close corporation, and its stock has at all times been practically owned and controlled by the Lawrence family. From 1910 to May, 1920, Henri Pauchey was assistant manager, and later manager of the Hotel Gramatan, and through his management succeeded in establishing the hotel on a highly successful and profitable basis. During such management Henri Pauchey made daily reports to the Lawrence family of the gross income and operating expenses of the hotel.
The only hotels*2074 near New York City similar to the Gramatan were the Forest Hills Inn at Forest Hills, Long Island, the Garden City Hotel at Garden City, Long Island, and the Gedney Farms Hotel at White Plains, Westchester County, New York. Of these the Gramatan had the most favorable location, except perhaps that of the Forest Hills Inn.
Beginning in 1917 there was a housing shortage in New York City which became acute in 1918; reached its peak in June, 1919, and from that time receded, but which was quite acute in 1922. This shortage was reflected in largely increased demand for hotel accommodations. In 1919 the hotel was operated at about 85 to 90 per cent capacity, *776 and in 1920 it was crowded to its limit. Its rates were raised in 1918 to the extent of 20 per cent, and in the same year another raise of 10 per cent went into effect, making a total raise of approximately 32 per cent. These rates are still in effect. The raises did not go into effect immediately, but were reflected in the earnings for 1919.
The following table shows the interest paid by the Hotel Gramatan, Inc. on bonded indebtedness, and its operating profit (that is gross earnings less operating expenses, *2075 being the sum total of the amounts reported by Henri Pauchey daily to the corporation) for the years 1916 to 1919, inclusive:
| Year | Interest | Operating profit 1 |
| 1916 | $15,000 | $87,000 |
| 1917 | 15,000 | 97,000 |
| 1918 | 15,000 | 135,000 |
| 1919 | 16,600 | 170,000 |
The following table shows the gross earnings, depreciation deducted, repairs, and its net taxable income as finally adjusted for the years 1916 to 1919, inclusive.
| Year | Gross earnings | Depreciation on buildings | Depreciation on furniture and fixtures, etc. | Repairs | Taxable net income |
| 1916 | 1 $366,000.00 | $14,507.70 | $15,382.76 | 1 $22,000.00 | $40,891.70 |
| 1917 | 1 418,000.00 | 14,552.08 | 15,947.67 | 1 22,000.00 | 49,698.60 |
| 1918 | 1 477,000.00 | 9,719.76 | 16,852.62 | 1 32,000.00 | 87,337.59 |
| 1919 | 1 608,000.00 | 1 16,500.00 | 1 16,500.00 | 1 32,000.00 | 97,893.27 |
On May 15, 1920, the Hotel Gramatan, Inc. and Henri Pauchey entered into a lease of the hotel properties for the term of fifteen years from said date, the material parts of which read:
1. The Tenant will occupy and use the demised premises only for the purposes*2076 of a high class hotel, with the necessary laundry, servants, store buildings, and other buildings, if any accessory to such use.
2. The Tenant will pay as rent monthly a sum equal to fifteen per cent of the gross receipts accruing during the preceding month from the Tenant's business conducted upon the demised premises, including any income from sources incidental to or in any way connected with such business, and receipts from the subletting of any portion or portions of the demised premises. Said monthly payments shall be made the first on or before June 10, 1920, and the rest each on or before the 10th day of each successive month during the term. The Tenant shall submit monthly to the Landlord on or before the 5th day of the month a complete statement showing total receipts from all sources for the previous month. In accounting all amounts receivable shall be treated as receipts, but debts due to the Tenant which after reasonable effort on the part of the Tenant shall prove to be uncollectible and shall be charged off *777 the Tenant's books shall be deducted from the gross receipts of the month in which they shall be so charged off. (The words "reasonable effort" *2077 shall not be construed to mean by legal proceedings.)
* * *
If at any time the payments so to be made by the Tenant computed upon the above basis for six successive months shall fall below Thirty-seven Thousand Five Hundred Dollars ($37,500) in the aggregate then, unless the Lessee shall on or before the day on which the rent for the last of such six months is due and payable elect to pay therewith such sum as will bring the aggregate for said six months up to Thirty-seven Thousand Five Hundred Dollars ($37,500) the Landlord may, at its option, terminate this lease by thirty days previous notice in writing given within thirty days after the date on which the option of the Tenant to elect as aforesaid expires.
3. The Tenant will pay all taxes, water rates and other charges upon the demised premises, other than assessments for public improvements, promptly as the same shall severally become due and payable, and if any such tax, water rate or other charge shall not be paid within thirty days after the same shall have become due and payable the Landlord may pay the same and the Tenant will on demand repay to the Landlord as additional rent all sums so paid by the Landlord, with*2078 interest thereon at six per cent.
* * *
4. The Tenant shall take good care of the demised premises and the improvements and fixtures thereon, shall do no damage, suffer no waste and make no alterations without the written consent of the Landlord.
Except as in the next article of this lease provided, the Tenant shall maintain the demised premises in good condition and shall at its expense make all repairs of every description, and shall comply with all rules, regulations and requirements of all municipal and state authorities and of the New York Fire Insurance Exchange, Board of Fire Underwriters, or other board having to do with the matter of insurance upon the demised premises, including as well as all other requirements those which call for alterations, structural or otherwise.
In view of the fact that the hotel building is located in the high class residential area known as Lawrence Park, the Tenant shall at all times maintain the grounds about the hotel building in a neat and presentable condition in conformity with the surroundings.
* * *
6. The Tenant will at the end or other termination of the demised term deliver up in good condition and order the demised*2079 premises with the appurtenances and fixtures, together with all improvements added by the Tenant, without compensation for any such improvement.
7. The Tenant shall not, without the written assent of the Landlord, assign this lease or sublet the whole or any part of the demised premises except such sublettings of rooms or apartments as are customarily made by hotels to guests, and except that the Tenant may sublet the stores contained in the hotel building, and except that the Tenant may assign this lease to a corporation having a paid in capital of at least One Hundred thousand dollars ($100,000) and upon such assignment to the said corporation and the assumption by said corporation of all the terms and conditions contained in this lease, the liability of Henri Pauchey (the Tenant mentioned herein) shall cease and determine. This consent is not to operate as a waiver of the foregoing provisions requiring the assent of the Landlord to assignments and sub-lettings so far as affecting any further assignment or any subletting.
* * *
18. *778 If prior to April 30, 1935, this lease shall be terminated pursuant to any of the provisions hereof, the Landlord shall have the*2080 right at its option to purchase the furniture, furnishings and equipment then in the demised premises at two-thirds (2/3) of its appraised value. Said appraisement shall be made by two disinterested persons or corporations. The Landlord and the Tenant each are to choose one appraiser and in the event that said appraisers cannot agree upon a valuation for said furniture, furnishings and equipment, the appraisers are to choose a third appraiser, whose decision shall be final. In no event, however, shall the Landlord be compelled to pay a sum in excess of One hundred thousand dollars ($100,000) for said furniture, furnishings and equipment, irrespective of the value placed thereon by said appraisers.
The preferred stock of petitioner, to wit, 1,000 shares of the par value of $100 each, was subscribed and paid for and the amount thus raised, to wit, $100,000, was used to purchase the furniture of the Hotel Gramatan, Inc. One-fourth of such preferred stock was retired from the earnings of the hotel for 1920 at 102 and interest and the remaining three-fourths were retired at the same cost from the earnings for 1921.
The organizers of petitioner were Henri Pauchey, and his son, *2081 M. J. Pauchey, and William R. Wood. Each of these subscribed for two shares of petitioner's common stock and paid therefor $100 per share. At a special meeting of petitioner's board of directors, which consisted of the two Paucheys and Wood, Henri Pauchey offered to sell to petitioner the lease above set forth for the sum of $499,400, and to accept in payment therefor 4,994 shares of its common stock, and in the event that his offer was accepted, to donate to the company 2,000 shares of said stock for the purpose of giving the corporation additional financial strength. The offer was accepted by the board; the lease was transferred to petitioner; and it issued to Henri Pauchey, 4,994 shares of its common stock. Petitioner's Gross sales (gross income), its earnings without deduction of exhaustion on lease, rent paid and officers' salaries (operating net income), and amounts claimed as deductions for depreciation on furniture and fixtures and for exhaustion of lease and its net taxable income for the period May 1 to December 31, 1920, and the years 1921, 1922, 1923, and 1924 are shown by the following table:
| Year | Gross sales | Operating net | Rent paid | Officers' | Depreciation |
| income | salaries | on furniture | |||
| and fixtures | |||||
| 1920 1 | $477,740.13 | $173,109.57 | $71,661.02 | $27,263.28 | $10,000.00 |
| 1921 | 646,847.86 | 211,290.96 | 97,027.18 | 34,999.83 | 10,000.00 |
| 1922 | 581,535.11 | 186,732.53 | 90,241.71 | 34,999.84 | 10,000.00 |
| 1923 | 561,660.54 | 165,604.21 | 85,641.45 | 34,999.88 | 10,000.00 |
| 1924 | 532,543.81 | 151,732.26 | 81,411.50 | 35,000.00 | 10,000.00 |
| Repairs | ||||
| Year | Building | Furniture | Exhaustion claimed | Taxable net income |
| on lease | reported | |||
| 1920 1 | $8,608.92 | $2,628.00 | $11,111.10 | $63,342.14 |
| 1921 | 15,120.20 | 7,180.42 | 16,666.66 | 62,597.29 |
| 1922 | 7,493.87 | 4,499.83 | 16,666.66 | 44,824.32 |
| 1923 | 10,219.77 | 3,997.49 | 16,666.66 | 28,296.22 |
| 1924 | 6,779.11 | 3,065.71 | 16,666.66 | 18,654.10 |
*779 Respondent has disallowed as deductions the amounts above set forth as exhaustion claimed on the lease.
The petitioner in its capital stock tax return on Form 707, which was subscribed and sworn to July 23, 1920, and filed July 24, 1920, returned its outstanding capital stock as 5,000 shares of no par value common stock and 1,000 shares of first preferred of the par value of $100 each. It reported no surplus and no undivided profits, and that the fair value of its total capital stock was $100,000.
OPINION.
PHILLIPS: 1 In the petition it is asserted that the lease of May 15 1920, between the Hotel Gramatan, Inc., and Henri Pauchey had a value when paid in for its stock three days afterward of not less than $250,000. In support of this contention petitioner*2083 introduced certain witnesses who testified as to the history of the hotel and also two witnesses who testified as experts. The first of these expert witnesses, Demarest, stated that from a real estate standpoint the lease had a value of $150,000, but from the standpoint of this particular lessee it had a value of $250,000. He gave no clear reason for the distinction which he drew, nor is it material what the value of the lease was from the standpoint of Pauchey where we are seeking the value another would pay for it. The second witness, Crandall, placed the value of the lease at, at least, $300,000.
While the Board may not arbitrarily ignore or discredit the testimony of unimpeached witnesses, it should weigh opinion evidence by the facts of the record, the qualifications of the witnesses, and their knowledge of the material facts. Otherwise, we might be placed in the position of determining values out of all proportion to what a willing seller would accept and a willing buyer would offer. *2084 ; ; ; .
It remains to test the opinion evidence by these standards. Before doing this, it may be pointed out that at the time this lease was paid in for stock, petitioner's officers were uncertain as to its value or rather whether it had any value at all. Thus, while they entered the lease on their books at a value of $250,000, yet in their capital stock tax return, made only two months later they returned as of no value the common stock which had been paid in for the lease. There is a pertinent issue that has not been cleared up, and *780 that is the circumstance under which the lease was executed. The Lawrence family owned or controlled practically all the stock of the Hotel Gramatan, Inc. They had leased the hotel for the first five years of its existence and operated it through a corporation for the next ten years. They were thoroughly familiar with its earning capacity, and with this knowledge*2085 entered into the lease. The same is largely true of Henri Pauchey, who for the past ten years had been assistant manager and later manager of the hotel. It would seem that this lease was entered into at arm's length; that the one party was giving as little as possible and the other obtaining what it could exact. This assumption is apparently verified by the stringent terms of the lease. Yet neither Henri Pauchey nor any member of the Lawrence family was introduced as a witness.
Both the opinion witnesses stated that persons who are engaged in real estate developments similar to those of the Lawrence family were forced to erect hotels which served for advertising purposes, which were generally operated for such purposes and not for profit. While it appears that this hotel was erected as an adjunct to their real estate enterprises, it is an outstanding fact that fifteen years had elapsed between that date and the execution of the lease. The tracts of land owned by the Lawrence interests in the immediate neighborhood of the railway station had been developed and their other properties in the municipality had been developed to the extent of 60 per cent. In 1920 the hotel was*2086 not merely an adjunct to another enterprise. It was no longer an experiment. Its reputation had been established and for the past four years (the only prior period of which we are informed) it had been operated at a profit. As set forth in our findings, Henri Pauchey through his management had succeeded in establishing the hotel on a highly successful and profitable basis. Here there is introduced the personal element of the management of a family hotel - an element essential in all hotels, but most peculiar to this class. How far this element entered into the earnings of the hotel we are not informed. It is an important element which none of the witnesses took into consideration in making his estimate as to the value of the lease, although one of the witnesses testified, "one man can earn money in a hotel and another can lose it."
The two opinion witnesses asserted that a lessee could operate a hotel at less expense than an owner, that he would pay less for repairs and would sustain less depreciation on furniture than an owner.
Demarest placed a value on the lease for real estate purposes of $150,000. After stating that he would consider the earnings of the hotel for 1916, *2087 1917, 1918, and 1919 as of importance, he proceeded *781 to confine himself to the earnings of the hotel for 1919. In his cross-examination the following appears:
Q: I understood your first value of $150,000 was placed primarily and exactly upon the earnings during 1919.
A: That is true, yes sir.
Again asked to give his process of reasoning in arriving at this value he answered:
A: I reasoned the lease had a period of fifteen years to run.
Q: Yes sir.
A: I took its apparent gross income on the period of one year.
Q: What do you mean, current 1919?
A: I say apparent.
Q: Apparent?
A: Yes, and I multiplied that by the the number of years the lease had to run. In the first place I do not consider a fifteen year lease an extremely long lease, and, well, it is not the same value as a long term lease has.
This one year, and that a peak year of inflation resulting from the war, is entirely too narrow a basis upon which to compute the value of the lease which had fifteen years to run. At this time there was a housing shortage in New York City which greatly enhanced the demand for hotel accommodations, but this gave no one the right to expect that such*2088 a condition would continue through the life of the lease.
Crandall qualified as a hotel man of large experience and we would be inclined to give weight to his opinion, if he had applied the rule by which he stated he would be governed if he had purchased a hotel lease and if the facts upon which he based his opinion found place in the record. Asked within what period the capital invested should be returned in computing the value of the hotel lease, he answered:
A: The usual period is five years. If a hotel is presented to me I first want to know the earnings for the past five years, and on such basis I would be willing to buy it on five-year earnings. For example if I could see a hotel earned $100,000 a year I would be prepared to negotiate for it at $500,000 so that it would pay itself out in that time. That is usual with all hotel leases which are sold or bought.
It is pertinent to point out that the witness does not disclose the length of the lease which he had in mind. Evidently one would not pay the capital value so computed for a lease that had only five years to run. He further stated that in arriving at the value of this particular lease he would take the net*2089 taxable income of Hotel Gramatan, Inc. for previous years and add to it all interest on bonded indebtedness, depreciation on buildings, the excess of depreciation on furniture and fixtures deducted by an owner over that deducted by a tenant, and the excess which the owner would pay for repairs over what a tenant would pay for the same purpose, which *782 last amount he placed at from $5,000 to $6,000, and from the total deduct the rent required by the lease. Having stated that this was the standard he was applying, he was asked on his cross-examination to apply it to the year 1919, which was the only year he attempted to compute at length. In making this computation he stated that the result was $163,000, which less rent of $75,000 left net earnings around $88,000, which he stated were the figures upon which he reached the conclusion that the lease was worth $300,000. This computation was erroneous in two particulars; first, if we add to the net taxable income of the Hotel Gramatan, Inc. for 1919 all the items which he mentioned, the result is $143,493.27. Again, computing the rent upon the basis of the lease, it would have been $91,200 and the net earnings would have been*2090 $52,293.27 instead of $88,000. Making this same computation for the three preceding years, we find that the probable net earnings of the lessee under this lease would have been:
| 1916 | $6,782.16 |
| 1917 | 14,198.35 |
| 1918 | 49,909.97 |
Each of these computations is made upon the assumption that the lessee could effect a saving of approximately $12,000 a year in cost of repairs and in depreciation of the furnishings. This is largely a matter of conjecture upon which the opinion of the witness would be of little value without much more detailed knowledge of this particular property than he possessed. There are other elements of weakness in this computation, even though we accept the theory that five-year earnings are to be capitalized. We have four years instead of five. This is important when we see how small would have been the net earnings under this lease for the year 1916. The year 1915 might have shown a considerable loss. Another factor is the personal element of the management of Pauchey, mentioned above. Because of the shortage in housing, conditions in the year 1919 were abnormal, as is amply demonstrated by the testimony, which shows the steady decrease in*2091 gross income, operating income, and net income after 1920.
In such a situation as we have here we must reach the conclusion that the lease reflected the rental value of the property, accept the opinions of witnesses who apparently had made no adequate preparation to value the lease here in question, or arrive at some value by using the figures shown in the record and applying the general principles embodied in the opinion testimony. In this case we are of opinion that the first is the soundest view. The Lawrence interests had been engaged for years in developing this community. They had received daily reports on the operation of the hotel. They were *783 in the real estate business and much more familiar with the whole situation than either of the witnesses who expressed an opinion of value. There is no apparent reason why the lease should have been given to Pauchey on more favorable terms than to another equally desirable lessee. Neither party to the lease was called as a witness to show that any unusual situation existed which prompted a lease to Pauchey, which, in the market, would have a value of $250,000. Nor did the petitioner recognize any such value when it*2092 made its capital stock tax return. We believe that the contemporaneous estimate of the rental value of the premises and of the lease is more reliable than the very general and generous estimates of the witnesses, made several years after the event.
Decision will be entered for the respondent.