1946 U.S. Tax Ct. LEXIS 50">*50 Decisions will be entered under Rule 50.
In 1941 the petitioners were members of a partnership which was engaged in the manufacturing business and which occupied, under a term lease, premises owned by the mother of three of the petitioners. The lease provided for a rental of a fixed monthly amount plus an additional amount computed on percentages of the annual gross sales of the partnership. The rent was paid pursuant to the terms of the lease and deduction therefor was claimed on the partnership return. In determining the deficiency herein the respondent concluded that only a portion of the amount so paid was reasonable and disallowed the deduction claimed in so far as it exceeded the amount determined by him as reasonable. Held, that the entire rental paid for 1941 is deductible.
7 T.C. 1030">*1031 The respondent determined deficiencies in income tax against the petitioners for the year 1941 as follows:
| Docket No. | Deficiency | |
| Stanley Imerman | 5933 | $ 9,577.84 |
| W. G. Torrance | 5934 | 493.64 |
| Josephine Bloom | 5935 | 4,091.26 |
| Delia Meyers | 5936 | 4,091.25 |
The principal issue presented is the correctness of the respondent's disallowance of a portion of the deduction taken for rent by a partnership composed of the petitioners, the respondent having determined that the amount disallowed was in excess of a reasonable rental. All other issues were disposed of by stipulation of the parties.
FINDINGS OF FACT.
Some of the facts have been stipulated and are found as stipulated.
The petitioners are residents of Detroit, Michigan, and filed their income tax returns for 1941 with the collector in Detroit.
The petitioners, Stanley Imerman, Josephine Bloom, and Delia Meyers, are the children of John Imerman and Ella Imerman.
In 1922 John Imerman and Ella Imerman purchased certain real estate located1946 U.S. Tax Ct. LEXIS 50">*52 in the 6400 block of East Lafayette Avenue in Detroit for $ 61,000, which was to be paid in full within ten years. The premises were improved by a building.
On February 16, 1926, John, Ella, and Stanley Imerman and two other persons organized a Michigan corporation, under the name of Imerman Screw Products Co., to engage in the business of manufacturing and selling valves, screws, bolts, screw machine products, and other metal products. John Imerman was president, Ella Imerman was vice president, and Stanley Imerman was secretary and treasurer. Of the corporation's 15,000 authorized shares of capital stock, of a par value of $ 10 each, the three Imermans subscribed for a total of 10,500 shares. No cash was paid into the corporation for stock by the Imermans, the stock being issued for the assets, exclusive of the East Lafayette Avenue premises, of a similar business of the same name theretofore conducted by John Imerman as a sole proprietorship. The recited value of the business and assets received by the corporation for its stock was $ 105,000.
John Imerman died in November 1926, and Ella Imerman became the sole owner of the East Lafayette Avenue premises. In January 1927 she1946 U.S. Tax Ct. LEXIS 50">*53 became president of the corporation and continued to act as such until its dissolution, which occurred by expiration of its charter, on December 19, 1936. At the time of dissolution the corporation had 10,500 shares of stock outstanding which were owned as follows: Stanley Imerman, 5,401 shares; Josephine Bloom, 2,500 shares; Delia 7 T.C. 1030">*1032 Meyers, 2,500 shares; and Ella Imerman, 99 shares. By agreement of the stockholders the assets of the corporation were distributed to them in kind on final liquidation on December 31, 1936. Under the arrangement certain specific assets were distributed to each stockholder, with Ella Imerman receiving cash, certain shares of stock in other corporations, and a parcel of vacant real estate which apparently was not employed in the conduct of the business.
On the same day, December 31, 1936, Stanley Imerman, Josephine Bloom, and Delia Meyers entered into a partnership agreement to carry on the business formerly conducted by the corporation, with each contributing to the partnership the specific assets distributed to him or her upon final liquidation of the corporation. The business of the partnership was to be carried on under the same name of1946 U.S. Tax Ct. LEXIS 50">*54 Imerman Screw Products Co. and the respective interests of the partners in the firm and in its profits were as follows: Stanley Imerman, 52 per cent; Josephine Bloom, 24 per cent; and Delia Meyers, 24 per cent. Since its formation the firm has continued with the same partners with the same interests, except that on January 1, 1941, petitioner W. G. Torrance, an employee of the firm, became a partner, with a 1 per cent interest, at which time the interests of Josephine Bloom and Delia Meyers became 23 1/2 per cent each.
The corporation, during its existence, and the partnership, up to and including 1940, occupied only a portion of the East Lafayette Avenue premises. In 1932 the space occupied was about one-third of the building. By 1937 the space occupied was about 40 per cent. Beginning about 1938, the partnership began to occupy more of the premises so that in 1939 and 1940 there was only one other tenant, and that tenant occupied only a small amount of space. In 1941 the partnership was the sole tenant. None of the petitioners has any interest in the premises except through the partnership tenancy.
The East Lafayette Avenue premises are located about two and one-fourth miles1946 U.S. Tax Ct. LEXIS 50">*55 east of downtown Detroit and in an area that is zoned for heavy industry. The property has a frontage of about 230 feet on East Lafayette Avenue and is about 140 feet deep, with a portion of the rear facing on an alley. The principal improvement on the premises is the main or 2-story brick factory building which houses the partnership's machines and the principal portion of its operations. The first floor is of concrete throughout. The second floor is supported by metal beams and the joists have been reinforced. The main portion of the ceiling over the second floor is insulated. A basement under one portion of the building is used to contain two 5,000-gallon oil tanks, while a basement under another portion is available for storage purposes. At each end of the building is a 2-ton elevator and there is a sprinkler system throughout the building. A one-story brick addition to the main building is used for a tool room 7 T.C. 1030">*1033 or shop. There are approximately 27,000 square feet of space on the first floor of the main building and the addition and 25,000 square feet on the second floor of the main building. On one side of the main building is an open space covered with concrete. 1946 U.S. Tax Ct. LEXIS 50">*56 This faces a steel covered shed used for storing steel rods or raw material used by the partnership and having a capacity of approximately one million pounds of steel. The structures are well suited for the partnership's operations and their location is well adapted for receiving raw materials and sending out the finished products. Although the main building has been in use for manufacturing purposes for more than 20 years, it is well preserved.
The addition to the main building was made in 1940. According to Ella Imerman's 1941 income tax return, the cost of the addition was $ 3,682.59. Her return shows that an improvement to the property (apparently the steel-covered shed) was made in 1937, at a cost of $ 3,147, and that the cost of the main building, in 1926, was $ 40,000. The return further shows that to the end of 1940 depreciation of $ 16,800 had been sustained on the main building, $ 2,518.08 on the improvement made in 1937, and $ 1,000 on the addition made in 1940. The remaining estimated lives from January 1, 1941, of the three units are shown as 18, 1, and 3 years, respectively. Of the total cost of $ 46,829.59 of the improvements, $ 26,511.51 is shown as undepreciated1946 U.S. Tax Ct. LEXIS 50">*57 at the end of 1940.
The corporation's occupancy of the premises throughout its existence and the partnership's occupancy from its inception until in 1938 were on the basis of a fixed monthly or annual rental. During the period August 1, 1938, to December 31, 1940, the partnership occupied the premises under a lease entered into on January 6, 1938. The lease provided for a fixed rental of $ 150 a month for the last five months of 1938. For the years 1939 and 1940 the rental was $ 200 a month, payable on the first day of each month, plus an additional amount based on annual gross sales, payable after the close of the taxable year and computed as follows: Up to $ 200,000 of gross sales, zero per cent; on the next $ 100,000 of gross sales, 1 1/2 per cent; on the next $ 100,000 of gross sales, 2 1/2 per cent; on the next $ 100,000 of gross sales, 3 1/2 per cent; and on all gross sales in excess of $ 500,000, 4 per cent. Under the lease the partnership supplied its own heat for the premises.
Although the partnership business was declining during the fall of 1937, Stanley Imerman was considering expanding its operations so as to occupy all of the East Lafayette Avenue premises. The 1946 U.S. Tax Ct. LEXIS 50">*58 accountant and business counselor of the partnership, who had also served the corporation from 1932 in the same capacity, cautioned Imerman against increasing the overhead of the business by incurring an additional fixed charge for rent. He was acquainted with the 7 T.C. 1030">*1034 operation of percentage leases in other types of businesses, and suggested a percentage lease for the premises, with a fixed minimum rental based on gross sales of $ 200,000, the amount at which it was considered the business could operate at the "break-even point," that is, with little gain or loss, taking into account other existing fixed charges. After further discussion and conferences with the other partners, counsel, and Ella Imerman, the terms of the lease of January 6, 1938, were agreed upon. The percentages used in the lease were worked out in the light of past operations of the business, both corporate and partnership. At the time the lease was first discussed the annual sales of the business had never amounted to $ 500,000.
Although the partnership was under no compulsion to move, yet toward the end of 1940 Stanley Imerman was considering a further expansion of its business. Time was the essence1946 U.S. Tax Ct. LEXIS 50">*59 of the partnership's contracts for its products, and he looked for other space that was suitable for the partnership to move into and proceed with its work, but was unable to find any. After some discussion by Stanley Imerman, the partnership accountant, legal counsel, and Ella Imerman, the partnership, on January 2, 1941, entered into a new lease on the premises for a 3-year period ending December 31, 1943, on the same terms as those of the January 6, 1938, lease. When the lease of January 2, 1941, expired, a third 3-year lease with the same terms was executed. None of the leases contained any provision for making an adjustment in the percentages or in the rate of the rent charged.
Throughout the period 1926 through 1941 Ella Imerman reported income on the cash basis, while the corporation during its existence, and then the partnership, reported income on the accrual basis. The following is a statement, for the years 1926 through 1941, of the total annual rentals for the entire premises, rentals accrued by the corporation or partnership to Ella Imerman, rentals actually paid by the corporation or partnership to Ella Imerman, and total rentals paid by other tenants:
| Rentals | Rentals | |||
| accrued to | actually paid to | |||
| Total annual | Ella Imerman | Ella Imerman | Total rentals, | |
| Year | rentals | by corporation | by corporation | other tenants |
| or partnership | or partnership | |||
| 1926 | $ 1,820.00 | $ 300.00 | $ 1,520.00 | |
| 1927 | 7,050.00 | 2,100.00 | 4,950.00 | |
| 1928 | 11,387.50 | 2,100.00 | 9,287.50 | |
| 1929 | 8,135.35 | 2,100.00 | $ 5,889.87 | 6,035.35 |
| 1930 | 9,194.93 | 4,200.00 | 1,101.36 | 4,994.93 |
| 1931 | 7,811.10 | 4,200.00 | 217.28 | 3,611.00 |
| 1932 | 6,494.00 | 4,200.00 | 54.16 | 2,294.00 |
| 1933 | 6,650.31 | 4,200.00 | 16,130.13 | 2,450.31 |
| 1934 | 6,762.87 | 4,600.00 | 4,600.00 | 2,162.87 |
| 1935 | 7,387.00 | 5,400.00 | 5,400.00 | 1,987.60 |
| 1936 | 7,427.18 | 5,400.00 | 5,400.00 | 2,027.18 |
| 1937 | 7,870.00 | 6,600.00 | 6,600.00 | 1,270.00 |
| 1938 | 4,410.00 | 4,000.00 | 4,000.00 | 410.00 |
| 1939 | 6,167.63 | 5,807.63 | 5,807.63 | 360.00 |
| 1940 | 12,370.00 | 11,800.00 | 11,800.00 | 570.00 |
| 1941 | 33,206.75 | 33,206.75 | 33,206.75 |
1946 U.S. Tax Ct. LEXIS 50">*60 7 T.C. 1030">*1035 Ella Imerman also owns the premises adjacent to those occupied by the partnership. The lease on this property was not a percentage lease. The 1941 rent for the property, which has 9,600 square feet of floor space, was at the rate of $ 3,300 a year.
The following is a statement, for the indicated years, of the corporation's or partnership's sales, net profit or loss, the percentage of rent for year to net profit, and the rent which would have been paid, for years prior to 1939, if the percentage lease of January 6, 1938, or of January 2, 1941, had been in effect:
| Rental | ||||
| Per cent of | payable had | |||
| Net profit | rent paid | per cent | ||
| Year | Sales | or (loss) | to profits | lease been |
| in effect | ||||
| 1930 | $ 286,343 | $ 11,872 | 33.51 | $ 3,695 |
| 1931 | 115,774 | (12,857) | 100.00+ | 2,400 |
| 1932 | 97,143 | (5,762) | 100.00+ | 2,400 |
| 1933 | 114,090 | (4,090) | 100.00+ | 2,400 |
| 1934 | 181,493 | 4,109 | 100.00+ | 2,400 |
| 1935 | 293,751 | 44,799 | 12.05 | 3,806 |
| 1936 | 348,206 | 50,079 | 10.80 | 5,105 |
| 1937 | 483,911 | 76,185 | 8.66 | 9,337 |
| 1938 | 222,201 | (1,672) | 100.00+ | 2,733 |
| 1939 | 376,304 | 32,204 | 18.03 | |
| 1940 | 547,499 | 97,299 | 12.13 | |
| 1941 | 1,082,698 | 483,875 | 6.86 |
The partnership1946 U.S. Tax Ct. LEXIS 50">*61 sales for 1942 were approximately $ 2,000,000 and under its lease the rent for that year was about $ 66,000, or twice what it was for 1941.
All of the partnership's work is done under special orders and prior to 1940 its work had been devoted entirely to the manufacture of screw machine parts for automobiles. In the latter part of 1940 business began to change in that orders for armament or munitions work were being received. At the beginning of 1941, however, a substantial part, if not the greater part, of the orders continued to be for automobile work. By the end of 1941 most of the orders, if not all, were for war work. The war orders were subject to cancellation on short notice. At the beginning of 1941 it appeared that the year would be a good one for the partnership, but it was not known that the volume of business would reach $ 1,000,000.
Percentage leases came into vogue for retail businesses in Detroit in the late 1920's and early 1930's, and since 1934 have increased in popularity. Some leases provide for a fixed minimum amount plus a percentage or percentages of sales. Others provide only for a percentage or percentages of sales, with no fixed minimum amount. The1946 U.S. Tax Ct. LEXIS 50">*62 amount of the percentages varies with types of business, ranging from a low of 2 per cent to 3 per cent in the case of cigars and tobacco to a high of 10 per cent to 12 per cent in the case of millinery. So far as disclosed, the partnership's percentage leases were the only ones on 7 T.C. 1030">*1036 premises or space in Detroit which was used for manufacturing purposes.
Stanley Imerman has always lived with his mother. They occupy a house with Josephine Bloom and her husband. The house is owned one-half by Ella Imerman and one-half by Josephine Bloom and her husband.
The net income of Ella Imerman and her three children, petitioners herein, as shown by their income tax returns, was as follows for the years indicated:
| 1939 | 1940 | 1941 | |
| Ella Imerman | $ 2,836.19 | $ 10,611.36 | $ 30,340.53 |
| Stanley Imerman | 17,021.22 | 58,241.41 | 254,114.51 |
| Josephine Bloom | 3,595.98 | 20,682.74 | 111,529.41 |
| Delia Meyers | 4,865.74 | 21,449.36 | 112,198.24 |
In its return of income for 1941 the partnership took a deduction of $ 33,206.75 for rent on the East Lafayette Avenue premises for that year. In an audit of the return the respondent determined that $ 12,000 constituted a reasonable rental, disallowed1946 U.S. Tax Ct. LEXIS 50">*63 as a deductible expense $ 21,206.75 of the deduction taken, and indicated the amount of the petitioners' shares of partnership net income which resulted, in part, in the deficiencies here in controversy.
OPINION.
The single question for determination is whether the partnership was entitled to the full amount of the deduction taken for rent. The petitioners contend that under the applicable provision of the Internal Revenue Code and on the facts of record the amount deducted was proper and that the respondent erred in disallowing any portion thereof.
Section 23 (a) (1) (A) of the code provides for the allowance as deductions of all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business and "rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity." The petitioners contend that the amount deducted was actually paid as rent for the premises occupied and used by the partnership in the conduct of its business and that allowance of the deduction therefor1946 U.S. Tax Ct. LEXIS 50">*64 is required by the code. Petitioners further contend that, considering the premises and all the facts, the amount actually paid was not in anywise excessive. The position of the respondent is that the negotiation and execution of the lease providing for a rent based in part on percentages of gross 7 T.C. 1030">*1037 sales was not an arm's length transaction, but a mere family arrangement, that $ 12,000 constituted a reasonable rental, and that the portion of the deduction in excess of $ 12,000 involved the element of gift and was not allowable.
The code does not limit deductions for rental payments to "a reasonable allowance" as in the case of salary or compensation, but at the same time the code does not preclude the respondent from examining the facts relating to such payments for the purpose of determining their true character and from disallowing deductions claimed as rents where the payments were of a character not permitted as deductions by the code. Cf. ; affd., ; . Here the respondent1946 U.S. Tax Ct. LEXIS 50">*65 has merely determined that $ 12,000 constituted "a reasonable rental on the building occupied by the partnership." He has made no determination that the amount disallowed was in fact or in character something other than rent, although he does argue on brief that it involved the element of gift.
Rent paid or incurred during the taxable year is an allowable deduction and the fact that the amount thereof may have been high or low, when considered in the light of current conditions, does not of itself change or affect the amount of the deduction to which the taxpayer is entitled. Many circumstances and considerations which may have influenced the fixing of the amount of rent on the property for a term of years may not continue for the term or may not be present in some particular year or years of such term. That the amount of rent rises and falls with the trend of the business and is greater in the year or years when business is best is an accepted characteristic of a percentage lease.
The lease here was a renewal, in exact terms, of the lease entered into in 1938. There is no suggestion that there is any basis in the facts of record for any claim that the rents, when fixed in 1938, 1946 U.S. Tax Ct. LEXIS 50">*66 contained any element of gift to Ella Imerman from her children. That consideration was given in 1938 to the possibility that the volume of business might, at some time, reach or surpass the volume in the taxable year, is at once apparent, for the rent here in question was computed under those same rates. It is true that the volume of business in 1940 was substantially greater than in 1939 and the indications were that 1941 would be better than 1940. A substantial part, if not the greater part, of the orders on hand at the beginning of 1941 continued to be from automobile manufacturers, however, and while a part of the orders were for armament or munitions work, those orders were subject to cancellation on short notice. It is also true that between 1938 and 1941 some improvements and additions had been made to the property, and during the same period the partnership had expanded 7 T.C. 1030">*1038 its occupancy of the premises, so that by January 2, 1941, the date the lease was renewed, it occupied practically the entire property, and later in 1941 became the sole tenant.
The respondent has made no determination that any part of the amounts required and paid under the lease were anything1946 U.S. Tax Ct. LEXIS 50">*67 other than rent, and, except for the relationship between the lessor and the petitioners, we find nothing which might form a basis for claiming that the renewal of the lease on January 2, 1941, was not an arm's length transaction or that the payments were of any other nature or character than rents. The facts show that the amount here claimed as the rent deduction was the amount actually paid by the partnership, at rates originally fixed and agreed upon some years previous, for possession and use of the premises on which the partnership business was located. There is nothing in the schedule of rents when originally fixed suggesting any element of gift, and it is our conclusion, from the evidence of record, that the character of the payments did not change when the lease was renewed on January 2, 1941. The full amount paid by the partnership as rent under the lease is deductible under the statute, and the respondent was in error in disallowing any portion thereof. Whether under different facts and circumstances at a time of renewal of the lease an element of gift might be found to exist, we express no opinion.
Decisions will be entered under Rule 50.
Harron, J., 1946 U.S. Tax Ct. LEXIS 50">*68 dissenting: Respondent's position is that petitioner must show that the entire sum, $ 33,207, paid for the use of property, represented an ordinary and necessary expense of conducting the business in order to be deductible under section 23 (a) (1). The majority view gives no explicit answer to this contention, and it is not to be assumed that respondent's contention as to the requirements of section 23 (a) (1) has been rejected. The conclusion reached upon the facts is that the lease executed on January 2, 1941, was executed in an arm's length transaction, and that there was nothing "in the schedule of rents when originally fixed suggesting any element of gift." Reasonable minds may differ in the conclusions to be drawn from evidence, and no purpose would be served in expressing a different view about the facts shown by the record. But when a question is raised relating to the prerequisites set forth in a section of the code upon which a taxpayer relies for a deduction for an expense, there should be no difference of opinion as to what the code section prescribes and what limitations it imposes. I believe that there can be little doubt about the wording and meaning of section 231946 U.S. Tax Ct. LEXIS 50">*69 (a) (1). I express the view as a "dissent," because I believe that the majority opinion does not fully 7 T.C. 1030">*1039 answer the respective arguments of the parties on the requirements of section 23 (a) (1), as it applies to deductions for rent.
Section 23 (a) (1) sets forth a general requirement as the prerequisite of receiving a deduction for expenses paid or incurred in the conduct of a trade or business; the payments must be ordinary and necessary, and, with respect to rent, a deduction may be taken for payments required to be made as a condition for the continued use or possession of property, for purposes of the trade or business. See ; .
In view of the general rule that a taxpayer has the burden of proving that a determination by the Commissioner is wrong, such determination being prima facie correct, what must a taxpayer seeking a deduction for rent paid prove in order to overcome a determination made by the respondent that only some lesser amount is deductible? It is no less important in1946 U.S. Tax Ct. LEXIS 50">*70 the case of a claim for a rent deduction that the taxpayer show that the sum paid is reasonable, than in the instances of claims for other types of business expense deductions. There is no rule of thumb to apply to the test "reasonable." Circumstances will affect a conclusion on what payment is reasonable, whether the payment be for services, materials, or occupancy of property. But the test of reasonableness aids in determining whether an expense is necessary, or ordinary, or both. Under section 23 (a) (1) the standard prescribed is full of variables. As was said in , "The standard set up by the statute is not a rule of law; it is rather a way of life." The general standard prescribed by the statute for the allowance of all business expense deductions is the same, and business practices evidenced by arm's length business transactions are the norm. The relationship of the parties to the transaction which gives rise to the payment for which a taxpayer seeks deduction must be examined to determine whether the relationships and circumstances are such that the terms agreed to result in expenses which are both necessary1946 U.S. Tax Ct. LEXIS 50">*71 and ordinary in the operation of the particular business. If a contract is an arm's length business agreement, payments made pursuant thereto probably constitute a deductible business expense; if not, the mere fact that the payment for which deduction is sought is made under a contract is not ground for allowing the deduction. "The fact that an obligation to pay has arisen is not sufficient." . If the parties to a contract are parent and dummy subsidiary corporations, for example, a contract may be mere form and not the result of real bargaining. See . In the instance of rent, even though parties enter into a lease agreement and the payments are made under its terms, if the circumstances are such that the 7 T.C. 1030">*1040 lessee pays, out of his mere willingness, more than the lessor would require as a condition for the continued use of the property, then the sum paid over and above the required amount is not an ordinary and necessary business expense, and is not deductible, under section 23 (a) (1). Ordinarily, 1946 U.S. Tax Ct. LEXIS 50">*72 in a competitive market, different owners of like and comparable property will require payments for the use of their property at about the same rates, and the usual lessee exercises some bargaining power to avoid agreeing to pay more than is necessary.
If petitioner has proved in fact that the Imerman Co. was required to pay the entire sum of $ 33,207 for the continued use of the property, his claim should be allowed. He must have shown that the "requiring" by the owner of the property involved the arm's length considerations which ordinarily result in reasonable rent charges. Business necessity must be shown. . If petitioner has failed in such burden of proof, respondent's determination should be sustained. But, the question of the statutory requirements for and limitations upon the allowance for rent deduction is a question of law about which no doubt should exist.
Footnotes
1. Proceedings of the following petitioners are consolidated herewith: W. G. Torrance; Josephine Bloom; and Delia Meyers.↩