*166 Decision will be entered for the respondent.
Petitioner entered into so-called lease with owner of property (who also owned 50 per cent of petitioner's voting stock, the remaining stock being owned by his son and his son's wife and children) providing for "rental" payments equal to 2 per cent of petitioner's net sales; the lease was to run for 5 years but could be terminated annually by either party. Held, that the lease was not negotiated at arm's length, and that to the extent that the arrangement resulted in payments in excess of $ 12,000 a year such excess did not in fact constitute rent deductible under section 162(a)(3), I.R.C. 1954. Held, further, that such excess is not deductible as compensation.
*130 The Commissioner determined deficiencies in income taxes of the petitioner for the fiscal years ending January 31, 1955, through January 31, 1957, in the amounts of $ 6,118, $ 7,508.71, and $ 10,687.20, respectively. The deficiencies grow out of the Commissioner's determination that the alleged rental paid by petitioner for use of its principal business building was not deductible to the extent that it exceeded $ 12,000 a year.
*131 FINDINGS OF FACT.
Some of the facts have been stipulated and, as stipulated, are incorporated herein by reference.
Petitioner, an Ohio corporation, was organized in 1948. It kept its books and filed its income tax returns on an accrual basis. The returns for the fiscal years ending January 31, 1955, through 1957 were filed with the district director of internal revenue at Cleveland, Ohio.
The issued and outstanding stock of petitioner consisted of 720 shares of class A voting stock and 720 shares class B nonvoting stock. At all times material J. W. Kirk, president of petitioner, owned 360 shares of the voting*168 stock, and John D. Kirk, his son and petitioner's vice president and treasurer, owned 359 shares of the voting stock. The remaining share of voting stock was owned by the wife of John D. Kirk. All of the shares of the nonvoting stock were owned by J. W. Kirk, John D. Kirk, and the wife and children of John D. Kirk, in varying amounts from time to time. During the taxable years petitioner's board of directors consisted of J. W. Kirk, John D. Kirk, and Margaret V. Kirk (John D. Kirk's wife).
Since its incorporation petitioner has engaged in the business of selling at retail furniture, appliances, floor coverings, women's ready-to-wear clothing, and, until 1956, men's ready-to-wear clothing. As of February 1, 1954, about 50 per cent of its business was the sale of furniture, 25 per cent floor coverings, 16 per cent appliances, and 9 per cent clothing.
The business conducted by petitioner had been carried on in unincorporated form for many years prior to the incorporation of petitioner. The store in which this business was conducted, both before and after incorporation, was and continued to be known as "Kirks," and occupied a building in Barnesville, a small town in Belmont County, *169 Ohio. The building was constructed in 1899 and has been occupied by Kirks for 50 or more years. During the tax years the building was owned by J. W. Kirk, who had inherited it from his father, J. J. Kirk, in 1936. At the time the building was acquired by J. W. Kirk it had a fair market value of $ 13,300, and J. W. Kirk has since used a basis of $ 13,300 for depreciation of that building in his own income tax returns. During the years 1954, 1955, and 1956 the building was valued at $ 15,970 for county tax purposes.
In terms of merchandise, the business of petitioner and its unincorporated predecessor has been substantially the same since 1936, with the addition in 1946 of appliances.
There is no other business in Barnesville or Belmont County like that conducted by petitioner. It advertised widely in newspapers *132 and on television and drew customers from various cities in Ohio, West Virginia, and Pennsylvania. More than 80 per cent of its customers came from more than 20 miles from Barnesville. One of the main reasons customers were attracted to its store from such distances was the low prices at which it sold most of its merchandise. Its store was referred to in its*170 advertising as "Belmont County's Greatest Store" and "Eastern Ohio's Greatest Store." During the taxable years it had 39 employees, and operated 8 trucks and a station wagon.
The principal business district of Barnesville, accounting for 70 to 80 per cent of all the business in Barnesville, consists of but a single block on East Main Street, and Kirks' store is located in the middle of the north side of that block. The building was originally two buildings, converted into one by removing part of the common wall. It is constructed of brick, with a stone foundation; it has painted plaster walls and wooden floors. It has a partial basement and two floors, with a balcony or mezzanine between the first and second floors. It has a frontage of 45 1/2 feet. A 45-foot extension was added to the rear of the building in 1934. The building is distinctly old fashioned in appearance, although the lighting has been modernized. It is not air conditioned and has no parking space connected with it. A warehouse, operated in connection with the store, is located about 40 feet from the rear of the building, across an alley. Some merchandise is sold from the warehouse.
Prior to an addition of *171 5,000 square feet to the Kirk building in 1956, hereinafter set forth, the building had approximately 15,000 square feet of floor space. After the 1956 addition the number of square feet of floor space occupied by petitioner was as follows:
| East room: 1st floor, 143'8 x 22 | 3,160 | |
| Mezzanine, 68'8 x 22 | 1,328 | |
| 2d floor, 142'8 x 22 | 3,138 | |
| Basement, 98' x 22 | 2,126 | |
| Total sq. ft. east room | 9,752 | |
| West room: 1st floor, 163'8 x 21 | 3,437 | |
| Mezzanine, 80'8 x 21 | 1,694 | |
| 2d floor, 162'8 x 21 | 3,416 | |
| Basement, 98' x 21 | 2,058 | |
| Total sq. ft. west room | 10,605 | |
| Loading dock 20 x 23 | 460 | |
| Total | 20,817 |
With the exception of 2,000 square feet, all of the floor space in the Kirk building was used by petitioner as selling space.
*133 During its fiscal years ended January 31, 1949 through 1954, the amounts paid by petitioner to J. W. Kirk and John D. Kirk as compensation and to J. W. Kirk as rent were as follows:
| Compensation | Rent | ||
| Year | |||
| John D. Kirk | J. W. Kirk | J. W. Kirk | |
| 1949 | $ 22,500 | $ 15,000 | $ 3,600 |
| 1950 | 22,500 | 15,000 | 3,600 |
| 1951 | 22,500 | 15,000 | 3,600 |
| 1952 | 24,750 | 16,500 | 3,600 |
| 1953 | 26,235 | 17,490 | 3,600 |
| 1954 | 29,178 | 19,951 | 3,600 |
*172 These amounts were deducted by petitioner as compensation of officers and as rent in its income tax returns.
The building occupied by the J. C. Penney Company in Barnesville is located on the south side of East Main Street diagonally opposite the Kirk building. It is a 2-story brick building with basement and has a 40 foot frontage. It is the most modern building in downtown Barnesville. The Penney Company, as lessee, has occupied the first floor and basement since the building was constructed in 1938. The original lease was extended for a 5-year period in 1951. Both the original lease and the extension provided for a rental of $ 2,400 per annum plus 2 1/2 per cent of net sales in excess of $ 96,000. The first floor and basement each contain approximately 5,200 square feet of space. The maximum rental received by the landlord from the Penney Company in any month was $ 600.
The building occupied by William S. Moore is located in the same block as the Kirk building. It is owned by John D. Kirk. The original lease, entered into in 1946, was renewed in 1951. It provided for a rental of 3 per cent of net sales and a minimum monthly rental of $ 100 a month. The lease covered*173 the first floor which had approximately 1,500 square feet of floor space and a basement, a part of which was used as a selling area. The Moore store sold automobile parts. Its net sales and rental paid for the building for the years 1954 through 1957 were as follows:
| Year | Net sales | Rental |
| 1954 | $ 71,145 | $ 2,134 |
| 1955 | 76,152 | 2,287 |
| 1956 | 82,356 | 2,470 |
| 1957 | 79,100 | 2,372 |
The Atlantic and Pacific Tea Company occupied the ground floor of a building located on the corner of East Main Street and South Chestnut Street, two of the busiest streets in Barnesville. It is on *134 the opposite side of East Main Street from the Kirk store which is located in the center of the block. It has three floors, and a basement, each containing approximately 7,000 square feet of floor space. Although not as well maintained, it is a larger and "better built" building than the Kirk building and its location is at least as good as that of the Kirk building. It has a frontage of 45 feet. In 1953 the A & P paid a rental of $ 375 a month for the ground floor and basement. The landlord experienced difficulty in finding a tenant for the second and third floors, and when the Barnesville*174 Manufacturing Company offered to rent these floors for storage, he permitted it to use them for this purpose at a rental of $ 135 a month.
The building occupied by the McClelland-Kennard Company, a supermarket, is located in the northwest corner of the same block in which the Kirk building is located, and is about 110 feet from the Kirk store. John D. Kirk is one of the directors of this company. Its lease, entered into on July 1, 1953, for a 20-year term, provides for a rental of $ 600 per month for the first 10 years and $ 480 per month for the second 10 years, and for payment of all taxes by the lessee. The space in the building leased by the company was on the ground floor and consisted of 4,800 square feet.
In 1939 Kirks rented the second floor of a building owned by the Belmont Insurance Association which adjoined the Kirk building on East Main Street. The area rented was 1,485 square feet. Kirks cut a hole through the common wall and used the rented space for selling. The rental paid was $ 30 a month during the war, but after the war and during the taxable years it was $ 35 a month. At all times material herein, the rented space was not heated. The frontage of the Belmont*175 building is 24 feet, and the street floor was rented in 1954 to someone else at $ 125 a month.
A publication called Percentage Leases and prepared and published by the National Institute of Real Estate Brokers in 1954 lists data from more than 25 furniture stores and other businesses operated under percentage leases. The percentages of sales range generally from 3 per cent to 6 per cent in the case of furniture stores, many of which also sell appliances. In each case but one there is a guaranteed minimum annual rent. This publication and the statistics which it contains are relied upon by people in the real estate business as being accurate.
In early January 1954, petitioner and J. W. Kirk entered into a "Lease" agreement. Therein J. W. Kirk agreed to lease to petitioner the Kirk building for a period of 5 years beginning on February 1, 1954, and petitioner agreed to pay him an annual "rent" of 2 per cent of its net sales (gross receipts less returns and allowances), payable in quarterly installments on May 1, August 1, *135 November 1, and February 1 for the preceding quarter's sales. No minimum or maximum rental was specified. The agreement provided that the "lease" could*176 be terminated at the end of any 12-month period by either party giving 60 days' written notice to the other prior to the end of such period; and that the lessor insure the premises against loss or damage by fire "to the amount of not less than $ 64,000," and pay all real estate taxes and assessments. For about 6 months prior to January 1954 J. W. Kirk and John D. Kirk discussed from time to time the matter of a lease for petitioner and the rental to be paid. J. W. Kirk orally agreed to add 5,000 square feet of selling space to the building at some unspecified time at his expense. No such commitment was contained in the lease, but this additional space was added and became available to petitioner at some unspecified time in the calendar year 1956.
In 1948, Kirks, which had previously operated on a calendar year basis, changed to a fiscal year ending January 31. The net sales of petitioner, and its predecessor, and 2 per cent thereof, for the years 1940 to and including the fiscal year ended January 31, 1954, were as follows:
| Year | Net sales | 2 per cent of |
| net sales | ||
| 1940 | $ 187,844 | $ 3,757 |
| 1941 | 268,404 | 5,368 |
| 1942 | 237,137 | 4,743 |
| 1943 | 204,060 | 4,081 |
| 1944 | 209,140 | 4,183 |
| 1945 | 259,247 | 5,185 |
| 1946 | 369,860 | 7,397 |
| 1947 | 505,102 | 10,102 |
| First 2 mo. 1948 | 78,231 | |
| 11 mo. ending 1/31/49 | 716,712 | 1 14,676 |
| Fiscal 1950 | 766,261 | 15,325 |
| Fiscal 1951 | 941,901 | 18,838 |
| Fiscal 1952 | 1,094,992 | 21,900 |
| Fiscal 1953 | 1,065,702 | 21,314 |
| Fiscal 1954 | 1,123,524 | 22,470 |
Around the time that the January 1954 "lease" was entered into, J. W. Kirk, who was about 70 years old, was spending about 6 months a year in Florida, and, beginning with the fiscal year starting February 1, 1954, decided not to take any salary from petitioner, nor did petitioner pay him any salary during its fiscal years ending January 31, 1955 through 1957. When in Barnesville, J. W. Kirk rendered some services to petitioner. He did no selling, and did no active buying insofar as the actual selection of the merchandise was concerned.
During the calendar years 1954, 1955, and 1956, J. W. Kirk received dividends from petitioner in the amounts of $ 243.60, $ 243.60, and $ 63, respectively.
Petitioner's net sales for its fiscal years ended January 31, 1955, 1956, and 1957, and the amounts deducted by it as rent for the Kirk building in its income tax returns, were as follows: *136
| Fiscal year | Net sales | Rent |
| 1955 | $ 1,188,269.51 | $ 23,765.39 |
| 1956 | 1,336,544.80 | 1 26,439.84 |
| 1957 | 1,626,573.60 | 1 32,552.32 |
*178 In determining the deficiencies, respondent allowed as a deduction for rent for each year the amount of $ 12,000, and disallowed the deduction claimed for each year to the extent that it exceeded this amount.
The maximum fair rent for the leased premises during the taxable years was not in excess of $ 12,000 a year, and to the extent that petitioner paid J. W. Kirk "rent" in excess of that amount, such excess did not in fact constitute rent or other payment required to be made as a condition to the continued use or possession of the property.
OPINION.
1. Section 162(a)(3), I.R.C. 1954, provides that there shall be allowed as deductions all 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 * * *."
Petitioner contends that the respondent erred in disallowing as a deduction part of the amounts it deducted in its returns for the taxable years as rent for the Kirk building. In considering a similar contention in Roland P. Place, 17 T.C. 199">17 T.C. 199, 203,*179 affirmed 199 F. 2d 373 (C.A. 6), certiorari denied 344 U.S. 927">344 U.S. 927, this Court said:
The basic question is not whether these sums claimed as a rental deduction were reasonable in amount but rather whether they were in fact rent instead of something else paid under the guise of rent. The inquiry is whether the petitioner was in fact and at law "required" to pay these sums as rent. * * * When there is a close relationship between lessor and lessee and in addition there is no arm's length dealing between them, an inquiry into what constitutes reasonable rental is necessary to determine whether the sum paid is in excess of what the lessee would have been required to pay had he dealt at arm's length with a stranger. * * *
Cf. Stanley Imerman, 7 T.C. 1030">7 T.C. 1030, 1037.
The discussions during the latter part of 1953 which preceded and resulted in the January 1954 agreement were between J. W. Kirk and his son, John D. Kirk. J. W. Kirk was president of petitioner, a family corporation, and John D. Kirk, its vice president and treasurer. J. W. Kirk owned 50 per cent of petitioner's *137 voting stock and a*180 substantial minority interest in its nonvoting stock; all of the remaining stock, voting and nonvoting, was owned by John D. Kirk and members of his immediate family. For some years prior to 1954, J. W. Kirk had received annual rent of $ 3,600 for the property in controversy. Although this may have been on the low side, we cannot, on this record, agree with petitioner's contention that such rent was merely "token" or "nominal." It was substantial and was not significantly outside the range of rents paid in Barnesville.
At the time the lease was executed, J. W. Kirk was receiving not only the foregoing $ 3,600 rental from petitioner but also annual salary in the amount of $ 19,951, 1 or a total of approximately $ 23,500. However, in view of his prolonged periods of residence in Florida each year and intended withdrawal from active conduct of the business, he determined not to accept any more salary. This meant that payments to him by the corporation would be reduced from approximately $ 23,500 to $ 3,600. While there is no direct evidence from which we can find that the increased rental, payable under the lease, was designed to fill the gap caused by the cessation of J. W. Kirk's*181 salary, the effect of the new arrangement was to achieve substantially that result. Petitioner's annual net sales for a period of several years were in excess of $ 1 million, and the so-called rental based on 2 per cent of net sales was roughly equivalent to the aggregate amount that J. W. Kirk had been receiving from petitioner as salary and rent. Because of this, and the close relationship that existed between J. W. Kirk and John D. Kirk and the petitioner, the arm's-length character of the transaction is suspect and all evidence bearing on it must be scrutinized to determine whether the amount payable under the agreement as rent was in excess of what petitioner would have been required to pay had it dealt at arm's length with a stranger. Cf. Jos. N. Neel Co., 22 T.C. 1083">22 T.C. 1083, 1090.
Three qualified real estate*182 appraisers, two presented by petitioner and one by the respondent, expressed opinions as to the fair rental value of the Kirk building. Their opinions varied. The fair rental according to petitioner's witnesses was 2 per cent of net sales, and according to respondent's witness $ 9,000 per annum. We have given due consideration to the testimony of these experts, and all other evidence, and on the basis of the entire record have found that the maximum fair rent for the leased premises would not be in excess of $ 12,000 per annum. We cannot approve petitioner's contention *138 or accept the conclusory assertion of any witness that the transaction was negotiated at arm's length.
Whether a 2 per cent lease, or for that matter a 3 or 6 per cent lease, would have been reasonable as related to other property or to a different lessee, is beside the point. The question is whether the so-called rentals payable under this lease were so unreasonable as to justify the finding that a portion thereof was not rent at all and therefore not deductible as "rentals or other payments required to be made" for the continued use of the property.
It must be remembered that Kirks conducted an *183 unusual operation. Through aggressive advertising and a policy of low prices for its merchandise, it had achieved a level of sales that appeared to be wholly disproportionate to the small community in which it operated. More than 80 per cent of its customers came from distances in excess of 20 miles. Two per cent of petitioner's net sales was productive of an alleged rental that appears to have been proportionately far in excess of 2 or 3 per cent of net sales of other types of business in Barnesville.
Moreover, there is another significant factor that seems to have been ignored by petitioner's expert witnesses. Although the lease was stated to be for a 5-year term, it was terminable annually by either party. It is therefore sharply to be distinguished from a percentage lease covering a fixed period of years. Cf. Stanley Imerman, supra at 1037. The cancellation clause in effect permitted the parties to renegotiate the terms of the lease annually, requiring a forecast of sales for only a 1-year period in determining the expectable rent to be derived from the property during the coming year. In Stanley Imerman, supra,*184 it was said (p. 1037):
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 situation there referred to is completely absent here, in view of the termination clause which would enable either party to insist annually upon a fair rent measured by the facts as they appear from year to year. Cf. also Southern Ford Tractor Corporation, 29 T.C. 833">29 T.C. 833, 843.
When the lease was executed in January 1954, the net sales of petitioner had enjoyed a steady growth over a long period of years, with at most only an occasional minor or temporary decline. By January 1954 annual net sales had exceeded $ 1 million for at least several years. No convincing evidence was submitted that a substantial *139 decline in sales could reasonably be anticipated after the execution of the lease, and certainly not for*185 so short a period as 12 months. In fact, sales continued to increase thereafter.
Another consideration tending to show absence of arm's-length dealing is the fact that some of petitioner's selling was done at its warehouse, to the rear of the leased premises, as well as in the rented second floor space in the adjacent Belmont building. Yet, the net sales taken into account in determining its alleged rent included all sales, whether made on the leased premises (Kirk building) or at the warehouse or in the adjacent Belmont building. Certainly, it is highly doubtful whether a lessee dealing at arm's length would have consented to any such arrangement. The record does not show the extent of sales made at the warehouse or in the Belmont building, but we cannot assume in the absence of proof by petitioner that they were inconsequential.
We need not prolong this opinion on this point. Suffice it to say, on the basis of the entire record, including evidence as to rents paid for other commercial properties in Barnesville, we are satisfied that the maximum fair rent for the leased premises was not in excess of $ 12,000 a year, that the lease was not negotiated at arm's length, and *186 that to the extent that the arrangement between petitioner and J. W. Kirk resulted in payments in excess of $ 12,000 a year such excess did not in fact constitute rent. Cf. Herbert Davis, 26 T.C. 49">26 T.C. 49, 56.
2. Petitioner makes the alternative contention that if the amounts in controversy are not deductible as rent they are deductible as compensation paid for J. W. Kirk's personal services. We do not agree.
The evidence discloses that J. W. Kirk was spending about half of each year in Florida, and that he voluntarily agreed to take no salary beginning with the first fiscal year before us. Although there is evidence that he performed some services when in Barnesville, we are not convinced that such services were other than minimal. There is no evidence that when he was in Florida petitioner was required to hire someone else to do his work or that his services were not readily performed with negligible increased effort by other personnel already employed by petitioner. Nor are we satisfied by the evidence that he rendered any significant services by telephone or otherwise when he was in Florida. And the fact is that the amounts in question were not paid*187 to J. W. Kirk as compensation. In the circumstances of this case, petitioner cannot now treat payments which have been held not to be deductible as rent as compensation for which they were not intended. Cf. Roehl Construction Co., 17 T.C. 1037">17 T.C. 1037, 1041.
Multnomah Operating Co., a Memorandum Opinion of this Court, affirmed 248 F. 2d 661 (C.A. 9), relied upon by petitioner, is distinguishable. *140 In that case there was a genuine question of fact as to whether the amounts in dispute were intended as rent or compensation, regardless of the label, whereas here, as in the Roehl case, there is no serious question as to what the controverted payments were intended to be. The payments herein were certainly not intended as compensation, and are not deductible as such.
Decision will be entered for the respondent.
Footnotes
1. 13-month sales have been adjusted to reflect 12-month period↩
1. Amounts deducted in 1956 and 1957 do not constitute 2 per cent of net sales because they were based on unaudited sales figures.↩
1. Although $ 19,951 was his salary for the fiscal year ending January 31, 1954, his salary for the 3 preceding fiscal years was $ 17,490, $ 16,500, and $ 15,000, respectively.↩