*278 Decision will be entered for the respondent.
Petitioner, a corporation, under a "Sale and Lease Agreement" sold equipment to a partnership composed of its sole stockholders and simultaneously leased it back. The agreement gave petitioner exclusive right to lease the equipment and a first option to purchase upon dissolution of the partnership. Held, amounts paid as alleged rentals to the partnership were not deductible under section 23 (a) (1) (A) of the Internal Revenue Code.
*356 Respondent has determined deficiencies in excess profits tax for the years 1944 and 1945 in the amounts of $ 20,537.77 and $ 22,220.52, respectively.
The only issue before us is whether respondent erred in disallowing deductions taken by petitioner in 1944 and 1945 for amounts paid as rent on equipment under certain "Sale and Lease Agreements" entered into with stockholders of petitioner, doing business as Equipment Associates, a partnership.
FINDINGS OF FACT.
The facts which were stipulated are so found and are incorporated herein by reference.
Petitioner is a corporation, *279 having been organized under the laws of the State of Washington on April 16, 1921. It is engaged in the business of operating warehouse terminals and storage. Its office and principal place of business is in Tacoma, Washington. Petitioner keeps its books and files its returns on the accrual basis. Its returns for the years here involved were filed with the collector of internal revenue for the District of Washington, at Tacoma.
On January 1, 1943, the outstanding capital stock of petitioner was owned by the following persons:
| Shareholder | Shares |
| R. H. Shaffer | 108 |
| Samuel B. Stocking | 72 |
| K. M. Kennell | 12 |
| W. Hopkins | 8 |
| Total | 200 |
On October 20, 1943, R. H. Shaffer died. His shares of stock in petitioner were acquired by the surviving shareholders. On December 31, 1943, the capital stock of petitioner was held as follows: *357
| Per cent of | ||
| Shareholder | Shares | Ownership |
| Samuel B. Stocking | 157 | 78.5 |
| K. M. Kennell | 26 | 13 |
| W. Hopkins | 17 | 8.5 |
| Total | 200 | 100 |
During the period here involved and after the death of R. H. Shaffer, the sole officers of petitioner, who were also its sole stockholders, were as follows:
| Samuel B. Stocking | President |
| K. M. Kennell | Vice President-Secretary |
| W. Hopkins | Treasurer |
*280 The business of petitioner increased very rapidly and continuously from July 1942 through 1943 and the subsequent war years. This increase was due to war business provided by the United States Army and Navy, the Russian Government and the British Government. It involved the handling of different cargoes, including supplies for the Alcan Highway and Lend Lease cargo destined for Russia. Petitioner handled these various cargoes on a daily basis, under an arrangement with the named Governments, which was expected to and did continue for the duration of the war.
The use of certain dock equipment and machinery such as Clark-Fork type lift trucks was essential to the proper conduct of petitioner's business. Petitioner had practically no equipment of this type and was compelled to rent it from the army under a temporary arrangement until such equipment could be acquired by petitioner. Additional equipment was also rented from local stevedoring concerns. Early in 1943, due to the increase in business and the increasing pressure from the army for the return of the rented equipment, it became apparent to the officers of petitioner that additional equipment should be acquired. This equipment*281 was essential war material and could not be acquired except on priority. Petitioner could obtain the priority because of its essential war activities. Petitioner applied for and was granted priority to purchase new equipment in April 1943.
On September 22, 1943, a partnership was organized by the individuals named above under the style of Equipment Associates (sometimes hereinafter referred to as the partnership). Subsequent to the death of R. H. Shaffer on October 20, 1943, decedent's interest was acquired equally by the surviving partners and the business was conducted as a partnership under the same name. The partnership agreement dated October 8, 1943, evidencing the oral agreement entered into September 22, 1943, provided in part as follows:
2. The purpose and business of said copartnership shall be primarily to furnish certain equipment for the use of Shaffer Terminals, Inc. and used in essential war *358 work. It is understood that the finances of Shaffer Terminals, Inc. are not sufficient to justify the purchase by said Shaffer Terminals, Inc. of said equipment, such as dock tractors, lift trucks, etc. Equipment Associates will purchase such equipment, hold the *282 same for the exclusive use of Shaffer Terminals, Inc. during the duration of the present emergency, and lease said equipment to said Shaffer Terminals, Inc. at a reasonable rate of rental. When not being used by Shaffer Terminals, Inc., said equipment may, with the consent of Shaffer Terminals, Inc., be temporarily leased to others who have use for said equipment in essential war work.
* * * *
6. The copartnership is authorized and empowered to purchase from Shaffer Terminals, Inc. such equipment as Shaffer Terminals, Inc. may desire to dispose of at prices to be agreed upon between the copartnership and said Shaffer Terminals, Inc.
The capital invested in Equipment Associates consisted solely of cash furnished in equal amounts by the partners. Each partner contributed $ 2,500. The investment made by W. Hopkins was from his personal funds. Investments made by the other partners were in part from personal funds and in part from bank loans.
The affairs of Equipment Associates were managed by Samuel B. Stocking, for which he was paid $ 200 per month, and its books of account were kept by E. A. Seaton, for which he was paid $ 30 per month, both items being deductions before partners' *283 distribution of earnings. E. A. Seaton was also the regular bookkeeper for petitioner. Equipment Associates employed no other employees. It used the office of petitioner for which no rent or charge was paid. Petitioner and Equipment Associates kept separate books and records and there was no intermingling of the partnership and corporate funds or records. The partnership owned no other property except the terminal equipment leased to petitioner.
Subsequent to September 22, 1943, and at all times here material, petitioner obtained the necessary priorities and purchased equipment similar to that already described above. The partnership did not apply for priorities. Petitioner made these purchases on September 30, 1943, March 21, 1944, and June 16, 1945. After each purchase, petitioner transferred legal title to the equipment to the partnership, pursuant to certain "Sale and Lease Agreements" executed in October 1943, in March 1944, and in June 1945.
With respect to the first purchase, petitioner ordered the equipment in September 1943 and received delivery thereof in the same month. Petitioner sent its check dated September 30, 1943, in payment thereof, in the amount of $ 9,529.44, *284 which included the freight charges. This check cleared petitioner's bank on October 13, 1943. The partnership paid petitioner by check dated October 11, 1943. With respect to the second purchase, petitioner ordered the equipment and received delivery thereof some time before March 21, 1944. Petitioner sent its *359 check, dated March 21, 1944, in payment thereof, in the amount of $ 10,298.60, which included the freight charges. This check cleared petitioner's bank on April 3, 1944. The partnership paid the petitioner by check dated March 27, 1944. With respect to the third purchase, petitioner ordered the equipment, and received delivery thereof, some time before June 16, 1945. Petitioner sent its check, dated June 16, 1945, in payment thereof, in the amount of $ 10,319.61, which included the freight charges. This check cleared petitioner's bank on June 27, 1945. The partnership paid petitioner on July 30, 1945.
The first purchase of equipment by the partnership was paid for out of the original contributions of capital made by the partners. The second and third purchases were financed by separate loans obtained from the Puget Sound National Bank of Tacoma, secured *285 by chattel mortgages. These loans were classified as commercial or short term, and notes therefor were drawn on terms of 90 days.
All of the sale and lease agreements were substantially similar in terms to the "Sale and Lease Agreement" executed October 8, 1943, differing only as to date and the amount of the sales value of the equipment. The "Sale and Lease Agreement" executed October 8, 1943, reads in part as follows:
WITNESSETH: Shaffer Terminals, Inc. has heretofore purchased certain machinery and equipment described in "Exhibit A," hereto attached and made a part hereof, as if fully set forth in this paragraph.
On September 30, 1943, Shaffer Terminals, Inc. sold and transferred said equipment to said Equipment Associates for the sum of $ 9,529.44, under the following terms and conditions, to-wit:
Shaffer Terminals, Inc. reserves the exclusive right to lease said equipment from Equipment Associates during the entire time of the emergency created by the existing war in which the Government of the United States of America is engaged and said Shaffer Terminals, Inc. agrees to pay to Equipment Associates a monthly rental of $ 3.00 per hour of use, minimum 200 hours per month for *286 the use of said equipment and machinery until a different monthly rental is agreed upon by the parties hereto. [Rate reduced to $ 2.75 per hour with no minimum on March 1, 1944].
In the event Equipment Associates shall determine to dispose of any of said equipment, Shaffer Terminals, Inc. is given the first right to purchase said equipment at a price to be agreed upon by the parties hereto * * *.
It is contemplated that further equipment and machinery will be required from time to time by Shaffer Terminals, Inc. and that said equipment will be provided by said copartnership and leased by said Shaffer Terminals, Inc. * * *.
It is understood that the equipment and machinery herein referred to is necessary for the operations of Shaffer Terminals, Inc. in doing essential war work; that the finances of said Shaffer Terminals, Inc. are not such at this time as to justify the purchase by said Shaffer Terminals, Inc. of said equipment and machinery and that the said partnership, Equipment Associates, has been organized for the purpose, among other things, of providing the necessary finances for Shaffer Terminals, Inc.
*360 Shaffer Terminals, Inc. will at all times keep any and all of*287 said leased property insured against fire, theft, property damage and public liability, such insurance to be payable to the parties as their interests may appear. Shaffer Terminals, Inc. will hold Equipment Associates harmless from any liability on account of any accidents which may happen to said equipment and machinery and all liability to any parties for the use thereof. Shaffer Terminals, Inc. will pay all operating costs and ordinary maintenance and repairs for said equipment and machinery and at the termination of the rental period will return said property to Equipment Associates in as good condition as when received, ordinary wear and tear excepted.
The rentals paid by petitioner to the partnership were in accord with Tacoma Terminal Tariffs filed with the Public Service Commission of the State of Washington in compliance with section 10383 of Remington's Revised Statutes of Washington. The amounts paid were as follows:
| 1943 | $ 6,892.50 |
| 1944 | 41,134.82 |
| 1945 | 29,434.46 |
| 1946 | 11,782.32 |
| 1947 | 900.00 |
| Total | 90,144.10 |
During the period here involved no dividends were declared by petitioner. Prior to this period the last dividend was in 1942, and the first dividend*288 after this period was in January 1946, in the amount of $ 12,000. Corporate salaries authorized by petitioner under dates of September 1, 1941, and November 1, 1943, and paid to the officers designated below during the period here involved, were as follows:
| September 1, | November 1, | |
| Officer | 1941 | 1943 |
| R. H. Shaffer | $ 12,000 | |
| Samuel B. Stocking | 9,600 | $ 12,750 |
| K. M. Kennell | 4,800 | 9,850 |
| W. Hopkins | 4,500 | 6,000 |
| Total | 30,900 | 28,600 |
A summary of petitioner's working capital position at the end of the tax years, and on or about the dates when the equipment was acquired, follows:
| Accounts | Accounts | Social security | |||
| Date | Cash | receivable | Notes payable | payable | and income |
| tax reserves | |||||
| 8/31/43 | $ 115.72 | $ 120,946.06 | $ 15,000.00 | $ 27,399.19 | $ 23,670.46 |
| 9/30/43 | 28,683.33 | 134,756.42 | 35,000.00 | 37,538.50 | 13,293.22 |
| 12/31/43 | 19,297.28 | 104,345.78 | 32,000.00 | 12,317.73 | |
| 3/21/44 | 30,512.47 | 51,782.87 | 27,000.00 | 9,867.93 | 43,849.77 |
| 12/31/44 | 86,818.60 | 80,945.50 | 52,000.00 | 49,496.67 | |
| 6/16/45 | 63,129.76 | 108,473.80 | 7,000.00 | 33,168.15 | 20,178.05 |
*361 The earned surplus on December 31, 1944, and December 31, 1945, was $ 67,303.28*289 and $ 68,922.29, respectively. This earned surplus is made up largely from cash and accounts receivable owing by the Soviet Purchasing Commission, the British Purchasing Commission, and the United States Army, Navy and Department of Agriculture.
Petitioner's cash balance on or about the dates of acquisition of the equipment was adequate to cover checks drawn in payment therefor.
The Puget Sound National Bank had made loans to petitioner during the years from 1930 to 1941 when petitioner's record was not too satisfactory. During the years 1942 to 1945 petitioner's financial statements showed additional strength and the size of the loans was increased. These loans were usually made for short terms upon assignment to the bank of accounts receivable and were primarily used to meet current expenses.
In 1943, due to the pending possibility of petitioner being unable to obtain rental equipment, officers of petitioner began considering the feasibility of purchasing new equipment. Informal discussions were had with E. E. Searles, vice president of the Puget Sound National Bank, concerning the purchase of equipment and the possibility of obtaining a loan for this purpose. No formal loan*290 application was made by petitioner for consideration by the loan committee of the bank.
As pointed out above the initial purchase by the partnership of the equipment leased to petitioner was paid for by means of personal loans made to the partners by the bank. Subsequent purchases were financed by loans from the bank made upon the basis of chattel mortgages and the increased earnings of the partnership.
The partnership filed income tax returns for the years 1944 to 1946, inclusive, also the period from January 1, 1947, to June 30, 1947, when it was liquidated, in which it reported gross profits, deductions and net profits as follows:
| 1944 | 1945 | 1946 | 1/1-6/30/47 | |
| Gross Profit | $ 41,468.32 | $ 30,568.07 | $ 11,725.32 | $ 912.72 |
| Deductions * | 7,183.40 | 8,277.91 | 5,135.23 | 1,035.79 |
| 34,284.92 | 22,290.16 | 6,590.09 | (123.07) | |
| Distribution | ||||
| Stocking | $ 11,428.31 | $ 7,430.05 | $ 2,196.69 | |
| Kennell | 11,428.31 | 7,430.05 | 2,196.70 | |
| Hopkins | 11,428.30 | 7,430.06 | 2,196.70 |
Of the gross profits realized by the partnership, rentals paid by petitioner accounted for all except $ 333.50*291 in 1944 and $ 1,277 in 1945.
*362 The partnership was liquidated and dissolved as of June 30, 1947. On April 23, 1947, it transferred part of the equipment covered by the "Sale and Lease Agreements" back to petitioner for the sum of $ 10,613.49, the book value of said equipment, plus sales tax of $ 318.40. The remaining equipment was distributed in final liquidation on June 30, 1947, to the individual partners who transferred it to petitioner on October 27, 1947, for a total consideration of $ 7,500. The book value, or depreciated value of this equipment was $ 7,223.73 on December 31, 1946.
Petitioner's profits were such that it already was in the 90 per cent bracket under the excess profits tax, and no substantial benefit would have resulted from petitioner acquiring the necessary equipment. The stockholders of petitioner organized the partnership, primarily to avoid the excess profits tax and its impact on the earnings of petitioner. It was not organized for the purpose of financing the purchase of equipment which petitioner needed in its business.
OPINION.
The issue for determination is whether amounts paid as "rent" by petitioner to a partnership composed of its sole*292 stockholders under certain "Sale and Lease Agreements" are proper deductions in the computation of excess profits tax during the years 1944 and 1945 under section 23 (a) (1) (A) 1 of the Internal Revenue Code.
This issue depends for its determination upon the fundamental question of whether the transaction here involved is a recognizable sale and lease for tax purposes. Considering first the parties to the transaction, we find the lessor partnership composed of the sole stockholders*293 of petitioner, the lessee. Such a situation bears special scrutiny. Higgins v. Smith, 308 U.S. 473">308 U.S. 473. The president of petitioner was also manager of the partnership. The office of the partnership was the same as that of petitioner. The partnership paid no rent and hired no employees except petitioner's regular bookkeeper. The establishment of policies for both petitioner and the partnership was the responsibility of the same individuals. These circumstances, we believe, do not lend toward arm's length dealing in a transaction recognizable for tax purposes.
*363 Petitioner asserts that the partnership was formed for the purpose of acquiring the necessary capital with which to purchase the equipment. This, however, does not impress us in view of petitioner's working capital position at the time of the various purchases which was ample to cover checks drawn on its account. Furthermore, the funds with which the partnership purchased the initial equipment were in the main obtained by bank loans to the partners whose source of repayment was the revenue earned by petitioner. It is also to be noted that the subsequent purchases of equipment *294 by the partnership were financed by bank loans made against chattel mortages and the increased earnings of the partnership which were the rentals paid by petitioner. In actual effect it was the earning power of petitioner which formed the basis for these financial arrangements. And finally, the testimony of E. E. Searles, of the Puget Sound National Bank, although contradictory, is to the effect that petitioner would have been granted a short term loan had it made application.
The mere fact that these payments, made by the corporation to the partnership, were labeled rent does not, in fact, make them so. They may be dividend distributions or something other than rent. Ingle Coal Corporation v. Commissioner (CA-7, 1949), 174 Fed. (2d) 569; Limericks, Inc. v. Commissioner (CA-5), 165 Fed. (2d) 483. Nor does the fact that there may have been a legally enforceable obligation to pay, as between petitioner and the partnership, make such payments deductible as rent or otherwise under section 23 (a) (1) (A) of the Internal Revenue Code. Interstate Transit Lines, 44 B. T. A. 957, affd., *295 130 Fed. (2d) 136, affd., 319 U.S. 590">319 U.S. 590; Deputy v. Du Pont, 308 U.S. 488">308 U.S. 488.
Whether the "Sale and Lease Agreement" which gave rise to the obligation to pay "rent" is such a transaction as is recognizable for tax purposes depends, we think, upon the practical effect of the end result. These various steps were not separate, independent transactions, but integrated parts of a single plan and "in determining tax consequences we must consider the substance rather than the form of the transaction." Ingle Coal Corporation v. Commissioner, supra.
Petitioner asserts on the authority of Gregory v. Helvering, 293 U.S. 465">293 U.S. 465, that it is within the right of a taxpayer to decrease the amount of his tax liability by means within the limits of the law. This is no doubt true. However, the principle enunciated in that case, as we understand it, aside from the question of tax avoidance, is whether the transaction under scrutiny is in substance what it purports to be in form.
Here, the partnership, composed of the sole stockholders of petitioner *296 was formed for the purpose of purchasing from it and holding for its exclusive use the equipment required. When not being used by petitioner, but only with its consent, the equipment could be temporarily *364 leased to others. The partnership owned nothing but the equipment purchased from petitioner and simultaneously leased back to it. Equipment Associates employed only a manager, who was also the president of petitioner, and a part time bookkeeper regularly employed by petitioner. By these transactions petitioner, in addition to possessing the exclusive right to lease the equipment, had full control over its use as well and by exercising its first option to purchase the equipment also controlled the partnership's disposition of the equipment.
The net effect of the agreement was to strip the partnership of all incidents of ownership, vesting in it only bare legal title while control over the property remained in petitioner. Such a reservation of control contradicts a sale which presupposes that the seller loses not only title but control. Esperson v. Commissioner (CA-5), 49 Fed. (2d) 259; Shoenberg v. Commissioner (CA-8), 77 Fed. (2d) 446.*297 Such command over the property marks petitioner as the real owner for income tax purposes. Commissioner v. Court Holding Co., 324 U.S. 331">324 U.S. 331. As the Supreme Court stated in Higgins v. Smith, supra, pp. 477, 478:
* * * The Government may look at actualities and upon determination that the form employed for doing business or carrying out the challenged tax event is unreal or a sham may sustain or disregard the effect of the fiction as best serves the purposes of the tax statute. To hold otherwise would permit the schemes of taxpayers to supersede legislation in the determination of the time and manner of taxation. It is command of income and its benefits which marks the real owner of property.
Nor does it make any difference that such command "may be exercised through specific retention of legal title or the creation of a new equitable but controlled interest, or the maintenance of effective benefit through the interposition of a subservient agency." Griffiths v. Helvering, 308 U.S. 355">308 U.S. 355.
The artificiality of these transactions is further emphasized when we view the ultimate result. *298 The partnership purchased the required equipment at the initial cost to petitioner of $ 30,147.65. From October 1943, until February 1947, petitioner paid rent to the partnership in the amount of $ 90,144.10. On April 23, 1946, the partnership sold six pieces of this equipment back to petitioner at the depreciated book value of $ 10,613.49, plus sales tax of $ 318.40. The remaining pieces of equipment were distributed to the partners upon the dissolution of the partnership on June 30, 1947, and were sold to petitioner on October 27, 1947, for $ 7,500. The total sum paid by petitioner to the partnership for the use and subsequent purchase of equipment initially costing $ 30,147.65 was $ 108,575.99. The "rental" paid by petitioner comprised the total amount of the partnership earnings, except for a small sum received in rent from others than petitioner, *365 from which the distribution of partnership profits was made to the partners. Petitioner paid no dividends in the years 1943 to 1945, inclusive.
Upon close scrutiny, this entire plan is not, in substance, a sale and lease transaction recognizable for tax purposes and we therefore hold that the amounts paid the partnership*299 by petitioner are not deductible as rent under section 23 (a) (1) (A) of the Code.
The facts in the instant case present an even stronger case for respondent than those presented in a similar sale and lease transaction considered in Catherine G. Armston, 12 T. C. 539. There, a family corporation sold certain construction equipment to its major stockholder, the taxpayer, who in turn leased it back to the corporation, which paid rent for the use of the equipment. This Court held that this did not constitute a recognizable sale creating a valid obligation to pay rent. There the lessor possessed control over the use of the equipment and full right of sale, whereas in the case before us no such right existed.
Skemp v. Commissioner (CA-7, 1948), 168 Fed. (2d) 598, reversing 8 T.C. 415">8 T. C. 415, is distinguishable from the instant case on the facts. There, ownership and control were relinquished by the donor by irrevocably divesting himself of all title and right to the property upon conveying it to an independent trustee over which the donor had no control. On these facts, the Court of Appeals held *300 that a bona fide lease existed.
Petitioner cites Buffalo Meter Co., 10 T. C. 83, and Seminole Flavor Co., 4 T. C. 1215, which are not applicable here. In those cases there was an actual and real separation of economic interests between two independent business entities, not the creation of a subservient agency from which independence and control has been stripped as in the case before us.
Decision will be entered for the respondent.
Footnotes
*. Includes salary for S. B. Stocking of $ 2,400.00 per year for 1944, 1945 and $ 1,050.00 for 1946.↩
1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
(a) Expenses. --
(1) Trade or business expenses. --
(A) In General. -- All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including * * * 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.↩