Vogeler, Alan R.

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Special Problems Incident to the Operation of a Business

Case Western Reserve University School of Law

Case Western Reserve Law ReviewVolume 11 | Issue 21960Special Problems Incident to the Operation of aBusinessAlan R. VogelerFollow this and additional works at: https://scholarlycommons.law.case.edu/caselrevPart of the Law CommonsThis Symposium is brought to you for free and open access by the Student Journals at Case Western Reserve University School of Law ScholarlyCommons. It has been accepted for inclusion in Case Western Reserve Law Review by an authorized administrator of Case Western Reserve UniversitySchool of Law Scholarly Commons.Recommended CitationAlan R. Vogeler, Special Problems Incident to the Operation of a Business, 11 Wes. Res. L. Rev. 200 (1960)Available at: https://scholarlycommons.law.case.edu/caselrev/vol11/iss2/9WESTERN RESERVE LAW REVIEWTax Problems Incident To the Management ofAcquired Real EstateIVSPECIAL PROBLEMS INCIDENT TO THE OPERATION OF A BUSINESSAlan R. VogelerOWNERSHIP OR LEASINGThere are many considerations in determining whether real estateused for business operations should be owned or should be leased.The non-tax advantages of ownership include the freedom to use theproperty as the owner desires, subject to zoning laws, and the possi-bility of realizing an increase in the value of the property from aninflationary or expanding economy. The non-tax disadvantages in-clude the dedication of a sub-stantial amount of capital, theTHE AUTHOR (A.B., 1938, Kentucky, LL.B., inability of the owner to move1940, Kentucky, LL.M., 1941, Michigan) is freely to another location, anda Cincinnati attorney and instructor in Taxa-tion, Salmon P. Chase Law School. possible depreciation in theproperty value. The advan-tages and disadvantages ofleasing are generally the converse of those of ownership.A lease with an option to purchase offers most of the advantagesof both types of holding. However, owners are generally not anxiousto grant privileges of purchase on the basis of prices current at thebeginning of the lease. Such a privilege, which binds only the owner,operates solely to the advantage of the lessee, fixing a maximum priceon the property should the lessee decide that purchase is advan-tageous.The respective tax advantages of owning or leasing may best beshown by an example. Assume that a 10-acre tract of land for a fac-tory site will cost $100,000 and that erecting a factory will cost $400,-000. The outright purchase of such a plant would cost $500,000cash. Assume that a corporate taxpayer buys the land and buildsthe factory. It borrows $250,000 in the form of a short-term, re-newable bank loan based on its own credit rating, for which it paysSy % interest, and borrows $250,000 from an insurance company ona mortgage loan at interest of 6%, with annual principal paymentsof $20,000. Assume further that the estimated useful life of thebuilding is 40 years and that the declining balance method of depre-[March1960] MANAGEMENT OF REAL ESTATE 201ciation is adopted.1 The ownership cash picture at the end of thefirst year would be as follows:Cash outlay - interest ------------------ $28,750principal ------------------ 20,000Total cash paid ------------------------------- $48,750Deductions from income:Interest on short-term loan ------------ $13,750Interest on mortage ------------------ 15,000Depreciation on building --------------- 20,000Total deductions ----------------------- $48,750Tax reduction in a 52% tax bracket:52% of $48,750 ----------------------- $25,350Net cash outlay for first year ----------------- $23,400If the same property were leased for an amount equal to 10% ofits cost, the annual rent would be $50,000, all of which would bedeductible. In a 52% tax bracket, that would mean a tax reductionof $26,000 and a net cash outlay of $24,000 per year. This presentsa cash savings in favor of owning in the first year of $600.After a period of five years the comparison is as follows:OWNERSHIPCash outlay - interest ----------------- $131,750principal ----------------- 100,000Total cash paid .------------------------- $231,750Deductions from income:Interest on short-term loan renewed ------ $ 68,750Interest on mortgage loan ------------ 63,000Depreciation on 'building ------------- 90,487Total deductions --------------------- $222,237Tax reduction in a 52% tax -bracket:52% of $222,237 --------------------- $115,563Net cash outlay for 5 years' ownership --------------- $116,187LEASINGFive years' rent ------------------------------- $250,000Tax saving at 52% ---------------------------- $130,000Net cash outlay for 5 years' leasing ----------------- $120,0001. See pp. 197-98.2. First year - $20,000; second year - $19,000; third year - $18,050; fourth year -$17,147; fifth year - $16,290.WESTERN RESERVE LAW REVIEWIt appears that over a five-year period it would cost less to ownthan to rent. Not only is there a cash savings of nearly $4,000, butalso an equity of $9,513 (mortgage amortization of $100,000 lessdepreciation of $90,487) has been acquired. However, the taxpayerhas had $500,000 tied up in land, brick, and mortar. If this sameamount of money had been used to purchase inventory and convertedinto $1,000,000 of sales annually with a 4% net return, the taxpayerwould be substantially better off with a lease.Of course rental payments, interest rates, and tax rates may fluc-tuate. Futhermore, the ability to borrow, rather than the tax con-siderations, may finally be the controlling consideration. Each casemust be examined and calculations made to attempt to determine thebest course of action.A popular method of financing for those companies which owntheir plants but need additional funds is the sale and leaseback. Thetax effects of such transactions have been considered in several cases.In Century Electric Company v. Commissioner,3 the taxpayer owneda foundry which had an adjusted basis of $532,000. To increaseworking capital, the taxpayer sold the property to a college for $150,-000, an amount equal to the highest bid received from prospectivebuyers; the college, in turn, granted a twenty-five year lease to thetaxpayer, renewable for seven additional ten year terms.Affirming the Tax Court,4 the Court of Appeals for the EighthCircuit held that the transaction constituted an exchange of businessproperty (the fee) for like business property (the long-term lease-hold) and, therefore, under the provisions of the Internal RevenueCode of 1939, section 112 (b) (1),' the loss could not be recognized.The unrecovered cost of the land and building was converted intocost of the leasehold, and was to be recovered ratably over the ninety-five year term of the lease. The rental payments, however, would bedeductible.The Century Electric doctrine has recently been challenged bythe Court of Appeals for the Second Circuit in Jordan Marsh Com-pany v. Commissioner." In the Jordan Marsh case the taxpayer, in1944, sold its deparfment store and the underlying land, which hadan adjusted basis of $4,769,000, for their conceded fair market valueof $2,300,000. Simultaneously, the taxpayer took back a thirty-yearlease of the property at concededly normal and full rentals, whichlease was renewable for an additional thirty years. The Commis-sioner disallowed a deduction of the loss on the sale, which action wasupheld by the Tax Court on the basis of the Century Electric case.3. 192 F.2d 155 (8th Cir. 1951), cert. denied, 342 U.S. 954 (1952).4. 15 T.C. 581 (1950).5. Now INT. REV. CODE OF 1954, § 1031(a).6. 269 F.2d 433 (2d Cit. 1959), reversing 26 P-H Tax Ct. Mem. 927 (1957). The In-ternal Revenue Service, however, has announced that it will not follow the Jordan Marsh case.T.I.R. 194, 4 P-H 1959 FED. TAx SERV. 5 55,160. See discussion p. 249.[MarchMANAGEMENT OF REAL ESTATEHowever, the court of appeals found that the transaction constituteda sale, not an exchange, and that the doctrine of nonrecognition ofgain or loss on exchange of business property for like business prop-erty was therefore inapplicable. In essence, the court held that thetaxpayer's money was no longer tied up in the same kind of property.The court of appeals distinguished the Century Electric case fromthe situation facing it in the Jordan Marsh case on the ground that inthe former case there was no finding that the purchase price was theequivalent of the property's value, or that the rent was equal to therental value of the premises.This, however, can hardly serve as a valid distinction. A closeexamination of the Century Electric case reveals that the sale priceof the building was equal to the highest bona fide offer receivedfrom several bidders. The rentals for the first 10 years averageda net return of 13%, after which they dropped to 7.6%. Certainlythis appears to have been a full and normal rental.Thus, there appears to be a clear conflict between the CenturyElectric and Jordan Marsh cases. The more logical rule is pro-pounded in the latter case. If the sale is at fair market value andthe leaseback is at fair and reasonable figures, any loss sustained onthe sale should be recognized. The money thereby saved in taxes,when added to the sales price receipts, would substantially increasecapital funds.In Ohio, buildings are sometimes owned by persons other thanthe fee holders of the underlying land. This is another convenientmethod of financing the construction of buildings. For example,if a builder desires to construct an office building on a site occupiedby low-income-producing property, he could acquire the land with itsexisting structure at present value, tear the building down, encumberthe land with a long-term lease to his own construction corporation,and sell the land at the capitalized value of the ground rent. Withthis money and funds borrowed on his resulting equity he could nowconstruct the building, which then produces sufficient income both topay the ground rent and to amortize the construction costs.Many times, in the operation of a business, plant expansion is re-quired. The same considerations involved in determining whetherthe original acquisition should be of the fee or of a leasehold againcome into play. If the existing plant is owned by a taxpayer, he mayhave little choice but to build the additional facilities himself. But ifhe is leasing the premises, perhaps the lessor will consent to constructthe addition.7 The length of the remaining term of the lease, theprobability of renewal, the cost of borrowing money, and the rate ofreturn from funds invested in the business are pertinent factors. Thelessor, if he is asked to build, may ask for rent on the basis of presentvalues, and may ask for an increase in the rental for the existing7. See p. 187.1960]WESTERN RESERVE LAW REVIEWplant. If the lessee builds, the costs are amortizable over the remain-ing term of the lease."PERSONAL HOLDING COMPANIESA personal holding company is defined in the Internal RevenueCode of 1954, section 542, as a corporation with five or less personsowning a majority of its stock, at least 80% of the income of whichis personal holding company income. Rent is personal holding com-pany income, unless it constitutes more than 50 % of the gross incomeof the corporation. 9 Amounts paid for the use of corporate propertyby an individual who directly or indirectly owns 25 % or more of thecorporate stock, are treated as personal holding company income, andnot as rents, if 10% or more of the corporation's gross income isfrom other personal holding company sources. 0 Since a personalholding company is subject to prohibitive surtaxes unless it distributesall its personal holding company income to its shareholders, and sincethe shareholders may be put into high income tax brackets if such in-come is distributed, it behooves every corporation to avoid the per-sonal holding company classification.Thus, if a corporation is formed, the majority of the stock ofwhich is owned by five or less persons, one should carefully considerthe tax consequences before real property owned by the corporation isleased to a 25 % shareholder. If more than 90% of the income ofthe corporation comes from property rental, whether from share-holders or strangers, the personal holding company classification isavoided.'If rental income of a corporation amounts to less than 50% of itsgross income, then such rental income constitutes personal holding12company income. This automatically classifies rental income from25 % shareholders as additional personal holding company income.Unless the corporation has ordinary business income equal to morethan 20% of the corporation's gross income, the penalty surtax willapply to undistributed personal holding company income.SURTAX ON ACCUMULATED EARNINGSA surtax is imposed when a corporation accumulates surplus forthe purpose of avoiding the imposition of additional income taxes onits shareholders. 13 However, amounts up to $100,000 may be ac-cumulated without penalty. The question is whether surplus over this8. But see INT. REV. CODE OF 1954, § 178, discussed pp. 190-92.9. INT. REV. CODE OF 1954, § 543(a) (7).10. INT. REv. CODE OF 1954, §§ 543 (a) (6), (7).11. Treas. Reg. § 1.543-1(b) (9) (1958).12. INT. REV. CODE OF 1954, 5 54 3(a) (7).13. INT. REv. CODE OF 1954, 55 531-37.[MarchMANAGEMINT OF REAL ESTATEamount has been accumulated beyond the reasonable needs of thebusiness. If so, the corporation must prove by a preponderance ofthe evidence that such accumulation was not to avoid the impositionof income taxes upon its shareholders. 14The fact that a corporation is a mere holding company or invest-ment company is prima facie proof of the proscribed purpose to avoidtaxes upon the shareholders. 5 A corporation which merely holdsproperty and collects the income therefrom is a holding company.'"If the corporation trades in real estate, securities, and other invest-ment property, it is considered an investment company.The question has been raised whether payments on mortgages byreal estate development companies constitute an unreasonable accumu-lation. In Frank H. Ayres & Son,' 7 a father and son had been en-gaged for many years in acting as agent for owners of real estate inarranging financing, subdividing, and selling lots. In 1946, with onlyone agency contract for 400 acres remaining, the father and son real-ized that in order to perpetuate their business they would have topurchase their own real estate for subdivision. They thereuponformed the taxpayer corporation, purchasing its stock for cash. Thecorporation took over the job of selling the remaining subdividedlots on the 400-acre tract and began an active search for other realproperty satisfactory for subdivision. From 1946 to 1950 the cor-poration purchased only a 47 % interest in a 75-acre tract. Mean-while, its commission earnings from the 400-acre tract were substan-tial, but no dividends were paid.The Tax Court held that the corporation was not formed oravailed of for the purpose of preventing the imposition of tax on itsshareholders. The court said that, in addition to its general workingcapital needs, the corporation had to acquire real property to providea source of future income and that a substantial investment is re-quired for subdivision.The .lyres case appears to be authority for the view that where areal estate development company purchases land on a small margin,the balance of indebtedness perhaps being secured by a mortgage,the accumulation of earnings to pay such indebtedness would be valid,even though this adds to the surplus of the corporation. In anyevent, there appears to be no reason why a contract could not beentered into with the seller under which the purchasing corporationbinds itself not to pay any dividends until the remaining balance ofthe purchase price either is paid in full, or is at least substantiallyreduced.14. INT. REv. CODE OF 1954, § 533(a).15. INT. REv. CODE OF 1954, § 533(b).16. Treas. Reg. § 1.533-1(c) (1959).17. 23 P-H Tax Ct. Mee. 886 (1954).1960]206 WESTERN RESERVE LAW REVIEW [MarchOnce the courts have decided that the earnings of a corporationhave been accumulated for the "fatal" purpose, future accumulationswill nearly always come within the same category. In such situa-tions, thought should be given to a liquidation of the corporation. Aliquidation will result in capital gain to the shareholders, with a maxi-mum tax of 25 %o on such gain. The Board of Tax Appeals has heldthat a corporation in the process of immediate liquidation could notbe said to be avoiding the imposition of tax on its shareholdersthrough the medium of withholding surplus distributions. 1818. Florida Metal & Iron Co., 11 P-H B.T.A. Mere., 1015 (1942).

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Special Problems Incident to the Operation of a Business

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