Shaffer v. Commissioner ( 1927 )

JOHN C. SHAFFER, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Shaffer v. Commissioner

Docket No. 1072.

United States Board of Tax Appeals

9 B.T.A. 504; 1927 BTA LEXIS 2566;

December 9, 1927, Promulgated

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">*2566 1. Petitioner is entitled to a reasonable deduction from gross income for each of the years 1918 and 1919 for exhaustion of his leasehold of elevator properties acquired prior to March 1, 1913, equal to an aliquot portion of the value thereof as of said date.

2. Value of leasehold determined for exhaustion purposes.

Chas. D. Hamel, Esq., Benjamin Saunders, Esq., and George K. Bowden, Esq., for the petitioner.

E. C. Lake, Esq., for the respondent.

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TRAMMELL

">*505 This is a proceeding for the redetermination of deficiencies in income tax for the years 1918 and 1919 in amounts aggregating $38,714.73. The original petition was amended by leave of the Board, and the only issue arising under the amended pleadings is the value, if any, of a certain leasehold of elevator properties as of March 1, 1913, for exhaustion purposes. Petitioner's claim for these deductions is made for the first time in this proceeding.

FINDINGS OF FACT.

Petitioner resides at Evanston, Ill., and for many years has been engaged in the business of publishing newspapers, and also in operating a grain business in the City of Chicago.

In 1893 and 1894, Charles">*2567 Counselman, a grain merchant of Chicago, constructed three elevator buildings in South Chicago, near the mouth of the Calumet River, known as elevators "C," "C Annex," and "D"; they were also known as the Counselman Elevators, and as the South Chicago Elevators. From the time they were built, the elevators were operated by the South Chicago Elevator Co., all of whose stock was then owned by Counselman.

Counselman died in March, 1904, and shortly thereafter the Counselman estate decided to sell its elevator properties. In July, 1904, petitioner entered into negotiations for the purchase of this property, and finally completed the purchase for $700,000 cash. By deed dated September 30, 1904, the property was transferred to petitioner by the South Chicago Elevator Co., an Illinois corporation. All of the stock of this corporation was then owned by the Counselman estate, and was later transferred to petitioner in 1905. Petitioner had an appraisal made by engineers in July, 1904, which showed a value of plant of $982,000, exclusive of the land. Petitioner valued the land at $375,000. He obtained a loan on the property of $800,000 from the First National Bank of Chicago. He then">*2568 organized the Chicago & Rock Island Elevator Co., an Illinois corporation, and began negotiations to sell the property to the Chicago, Rock Island & Pacific Railway Co. Thereafter, the following transactions all occurred on October 1, 1904:

(a) By deed of that date, petitioner, joined by his wife, conveyed the elevator property in question to the Chicago & Rock Island Elevator Co.

(b) On the same date, the Chicago, Rock Island & Pacific Railway Co. and the petitioner entered into a contract of purchase and sale, whereby the railway company agreed to purchase and petitioner agreed to sell to it, said elevator property, referred to as the Counselman ">*506 Elevators, at the price of $1,000,000, upon the following principal terms and conditions:

Petitioner agreed to procure and cause a deed of conveyance to be duly executed by a corporation having at the time title to said elevators, whereby a perfect title thereto should be conveyed to the railway company, subject only to a certain lien of $1,000,000.

It was agreed that the grantor corporation should, prior to the date of such conveyance, by a mortgage or deed of trust, convey and mortgage said elevators to the First">*2569 Trust & Savings Bank, as trustee, to secure the payment of bonds aggregating the principal sum of $1,000,000 and 5 per cent interest thereon.

The railway company agreed to pay the purchase price of $1,000,000 to the trustee in monthly installments, commencing on the first day of November, 1904, of 2 cents per 100 pounds on all grain which might be delivered to said elevators during the continuance of the agreement, and which originated on the line of said railway company west of Joliet, Ill., or which was carried continuously over its rails to the City of Chicago from any point distant therefrom 40 miles or more, together with 5 per cent interest payable semiannually.

The railway company agreed to pay all taxes and insurance.

The railway company further agreed to pay to said trustee for the benefit of the holder of said bonds, during each year from and after October 1, 1904, an amount, equal to all interest due on said bonds, and, in addition at least $50,000 on the principal sum.

(c) On the same date, the Chicago & Rock Island Elevator Co. executed a mortgage or deed of trust to the First Trust & Savings Bank, trustee, an Illinois corporation, wherein it conveyed said">*2570 elevator property to said trustee to secure the payment of $1,000,000 of mortgage bonds, dated October 1, 1904, in denominations of $1,000 each, with interest at 5 per cent per annum, payable semiannually, and maturing on the first day of October, 1924, but redeemable on any interest-paying date at par and accrued interest.

(d) On the same date, the Chicago & Rock Island Elevator Co. conveyed the property to the Chicago, Rock Island & Pacific Railway Co. for a stated consideration of $1 and other good and valuable considerations, the deed containing the following provision:

This conveyance is made subject to a Mortgage or Deed of Trust to the First Trust & Savings Bank of Chicago, Illinois, dated October 1st, A.D. 1904, and conveying the property herein described to secure an issue of bonds of said Chicago & Rock Island Elevator Company dated October 1st, A.D. 1904, and aggregating the sum of One Million Dollars ($1,000,000).

(e) On the same date, to wit, October 1, 1904, the railway company, as lessor, and petitioner, as lessee, entered into a lease contract containing the following clauses:

">*507 WHEREAS, the Lessee has procured a conveyance to be made to the Lessor, ">*2571 of the real estate and premises hereinafter described, for and upon the consideration, in part, that the Lessor would lease and demise the same to the Lessee for and during the term hereinafter mentioned, free from and without the payment of any money consideration as rental therefor; and

WHEREAS, contemporaneously with said conveyance, a contract has been entered into by and between the parties hereto, providing, among other things, for the payment to First Trust and Savings Bank, of the City of Chicago, Illinois, as Trustee, of the purchase price for the said real estate * * * and it is desired and intended by the parties hereto that the term of this lease shall be coextensive with the term of said contract, and shall cease and terminate at the same time that said contract, by its terms, shall cease and terminate, * * *.

The contract also contained, among others, the following pertinent provisions:

The lessee agreed to maintain and keep in good repair, the interior of the elevators, including machinery, and to pay all water rents; to give preference to the lessor in the shipment of all grain into or out of said elevators, provided the rates of freight of said railway company">*2572 should be as favorable as the rates of other companies; to operate the said elevators actively and continuously during the term of the lease, and that there should be delivered to the elevators not less than five million bushels of grain during every period of one year. The lessee further agreed that in the event of failure to deliver the minimum of five million bushels of grain at said elevators, for any period of one year, while the lease was in force, he would forfeit and pay to the lessor, as liquidated damages, an amount equal to one cent for each bushel of grain constituting the difference between the number of bushels of grain less than said five million bushels actually delivered in any one year and said agreed amount of five million bushels.

The lessor agreed to maintain and keep in repair the permanent outside structure of the elevator buildings, and to furnish the lessee reasonable facilities for the transportation of grain to and from said elevators.

The lease contract further provided that in the event of the destruction of the elevators by fire, casualty, cyclone, lightning, flood, or act of God, or if they be damaged from any such cause to the extent of $300,000, ">*2573 then the lease would be terminated, and if the damage from any such cause was to the extent of $100,000, then the lease would be terminated as to such elevator or elevators destroyed or damaged, or that the lessor should, at its option, rebuild or restore such elevator or elevators within one year and that the lease should be held to be applicable to such rebuilt or restored elevator or elevators, but if the lessor decided not to rebuild or restore any destroyed or damaged elevators, the lease would be held to be terminated ">*508 as of the date of destruction or damage, but that the lessee should not be held to his covenant to deliver to said elevators the amount of grain as provided for in the lease.

Petitioner conducted his grain business under the name of J. C. Shaffer & Co. From 1909 to 1920, the elevators were operated by the South Chicago Elevator Co. as a department of J. C. Shaffer & Co. Substantially all the stock of the elevator company was then owned by petitioner. The elevator company had no written lease, but paid to J. C. Shaffer & Co. a rental of $20,000 per year for the years 1909 and 1910, and a rental of $36,000 per year for the years 1911 to 1920, inclusive, ">*2574 and permitted him a limited use of the elevators. The elevators were a necessity to petitioner in the operation of his grain business. Without them the grain business could not have been conducted profitably. With the use of the elevators, petitioner's grain business was very profitable, producing an average annual profit of better than $125,000, with a capital investment of approximately half a million dollars.

The South Chicago Elevators had a total maximum capacity of about 4,500,000 bushels, and a practical working capacity of about 3,800,000 bushels. Elevator "C" was the largest public elevator in the City of Chicago. These elevators were very favorably situated, having excellent facilities for receiving and shipping grain, both by rail and water. During the 20-year period ended September 30, 1914, which covered the maximum term of the leasehold involved herein, the Rock Island Railway delivered to the South Chicago Elevators, 101,839,345 bushels of grain. At the end of 1912, the railway way company had delivered to the elevators 40,267,954 bushels of grain. The lease contract required delivery of a minimum of 5,000,000 bushels per year, so there was actually delivered">*2575 to the elevators during the 20-year period an excess of 1,839,345 bushels over and above the minimum requirement, and the lessee was never required to pay any amount under the forfeiture provision of the lease contract.

A great many elevators in the country are owned by the railroads. It is a general practice of the railroads to lease such elevators upon what is called the Missouri River basis, which provides for an annual rental of 5 per cent on the valuation of the elevators, excluding the value of the land. This system of rental was in effect in 1913.

The term of petitioner's leasehold acquired in 1904 was, according to the terms of the lease contract, to be coextensive with the terms of the contract of purchase and sale entered into by the parties contemporaneously therewith, which was a maximum period of 20 years from October 1, 1904. The railway company did in fact ">*509 complete payment of the purchase price, under and in accordance with the terms of the purchase contract, in 20 years from October 1, 1904, and, by deed of release dated October 14, 1924, the trustee formally released the mortgage or deed of trust. Petitioner's lease contract did also in fact run">*2576 for 20 years from October 1, 1904, expiring on September 30, 1924.

Upon the expiration of petitioner's leasehold, the railway company leased the elevator properties to the J. C. Shaffer Grain Co., a corporation, from the first day of October, 1924, to the thirtieth day of June, 1929, "unless sooner terminated by either party hereto serving upon the other party 90 days' notice in writing prior to March 31 of any one year of the term hereof," at a rental of $34,488 per annum, payable in equal quarterly installments. Effective from March 12, 1925, the rentals, however, were reduced to $33,300 per annum in consideration of the lessee releasing, protecting, indemnifying and saving harmless the lessor from all liability for loss or damage to any grain and other property owned or controlled by the lessee arising from "fir connected with the operation of the first party's (lessor's) railroad or its engines or cars * * *."

This new lease contract was made on the Missouri River basis of 5 per cent of the appraised value of the improvements, excluding the value of the land. Accordingly, prior to execution of the contract, the railway company and petitioner's corporation appointed a board">*2577 of appraisers, consisting of members of three elevator construction companies, which board appraised the value of the improvements at slightly less than $690,000 at that time. On this basis the annual rental of $34,488 was determined. The elevators had been kept in good repair, and the physical condition in 1924 was the same as in 1904, less the ordinary depreciation.

The new lease provided that in the case of fire it would be optional with the lessor whether it would rebuild the destroyed or damaged property or restore them to a condition suitable for operation. The stipulations in the lease as to repairs were substantially the same as in the prior lease. There were however no provisions with respect to a minimum quantity of grain to be handled.

On March 1, 1913, petitioner's leasehold had an unexpired life or term of 11 7/12 years. The fair market value of petitioner's leasehold on March 1, 1913, was $212,000.

OPINION.

TRAMMELL: Petitioner filed his original petition herein on December 13, 1924, asserting as error the refusal of respondent to allow a deduction for certain alleged bad debts. By leave of the Board, petitioner filed an amended petition on December 5, 1925, wherein">*2578 ">*510 no reference was made to, nor claim asserted in respect of, any deduction for bad debts, but in which it was alleged as error that respondent had failed and refused to determine the proper March 1, 1913, value of a certain leasehold of elevator properties and had failed and refused to allow petitioner a proper deduction for exhaustion of its leasehold for each of the years involved. On motion granted by the Board on January 15, 1927, petitioner amended paragraph 5 of his amended petition, but did not materially change the allegations contained therein. At the hearing, counsel for petitioner stated in substance that the issues tendered in the original petition were abandoned, and that proof would be offered only on the issue contained in the amended petition. No evidence was offered touching the question of bad debts. The determination of the respondent in that respect is therefore approved.

In his amended petition, petitioner alleges that the value of his leasehold on March 1, 1913, was not less than $500,000, and that he is entitled to an annual deduction for exhaustion in the amount of $45,555.55. Respondent avers that said leasehold had no value at March 1, 1913, and">*2579 that therefore petitioner is not entitled to any deduction for exhaustion. A single, clear-cut issue of fact is thus presented.

If petitioner's leasehold had any value at March 1, 1913, having been acquired prior to that date, he is entitled to a deduction for exhaustion in an amount equal to an aliquot portion of such value for each of the years 1918 and 1919. . The respondent raises no issue on this point, but contends that petitioner is not entitled to any deduction on account of exhaustion solely for the reason that his leasehold had no value as of March 1, 1913. With this contention, we are unable to agree. The evidence of record clearly and conclusively establishes that the leasehold in question had a very substantial value on that date. However, the problem of determining with reasonable accuracy the definite amount of such value is not so easily solved.

This lease enabled the petitioner to operate his grain business at an average annual profit of more than $125,000, upon a capital investment of approximately half a million dollars, and without the leasehold such business could not have been operated profitably.

">*2580 In the process of determining the value of the leasehold in question, an element of vital importance is the life expectancy of the lease contract or the remaining length of time it had to run from March 1, 1913. The value of the leasehold depends largely on the term over which it was to run.

The evidence discloses that it was intended by the parties that the term of the lease should be coextensive with the term of the contract ">*511 under which petitioner sold the property to the railway company, and that the lease should cease and terminate at the same time that said contract by its terms should cease and terminate. To ascertain the life of the lease, we must, therefore, look to the terms of the sale contract. Under that contract, the railway company agreed to pay the purchase price of $1,000,000 in monthly installments equal to 2 cents per 100 pounds on the grain delivered by it to the elevators, together with the interest, but further agreed to pay during each year an amount equal to all interest and in addition at least $50,000 on the principal sum.

The bonds in the principal sum of $1,000,000, representing the purchase price to be paid by the railway company, ">*2581 were payable at and matured on October 1, 1924, but contained the provision that they should be redeemable on any interest-paying date at par and accrued interest. In other words, the term of the lease was 20 years unless the happening of a contingency shortened it. The lease provided that the term should be the time provided in the contract of purchase of the leased premises. The railway company was to pay the purchase price from freight receipts. In each year, beginning October 1, 1904, the railway company was to pay 2 cents on each 100 pounds of grain shipped into the elevators over its railway from points west of Joliet, Ill., or carried by it 40 miles or more, except that at least $50,000 and interest should be paid each year. During the period from 1904 up to 1913, under the terms of this contract, judging by conditions then existing and the amount of freight so handled, it would have required more than 20 years to complete the payments out of the freight receipts alone. The railway company was primarily interested in profits to be derived from the transportation of grain. The operation of the elevators was only incidental to and as an aid in securing freight business">*2582 for the railway company. In 1913, the date as of which the value of the leasehold is to be determined, more than eight years had run, during which time the railway company had carried out the provisions of the lease contract by making the minimum annual payments set out therein. During that period, no question or controversy had arisen with respect to the redemption of the bonds prior to their maturity at the end of the 20-year period. The railway company, during that period, had not redeemed the bonds, and the lease actually ran for 20 years. Upon consideration of all the evidence in the case, we believe it was the intention of the parties in 1913, as in 1904, that the lease should run until 1924.

In determining the value of this leasehold, another element for consideration is the restrictions imposed by the contract on the lessee. ">*512 These related mainly to the giving of preference to the Rock Island Railway in the shipment of grain into and out of the elevators, and the requirement that at least 5,000,000 bushels per year should be delivered by the railway company to the elevators. However, the lessee was not required to ship its grain over the lines of this railway">*2583 unless its rates were as favorable and its service as efficient as those of other railroads. Bearing in mind the fact that these elevators were located directly on the Rock Island Lines in Chicago, which enabled that company to render an expedited service, particularly important in the grain business, and which also eliminated an onerous switching charge imposed by other lines, the preference restrictions do not appear to have been unfavorable to the lessee, nor to have materially detracted from the value of the leasehold. Also, considering the capacity of the elevators, the quantity of grain handled by them annually, and the other pertinent facts, the stipulation that 5,000,000 bushels of grain should be delivered by the Rock Island Railway each year does not appear to have been burdensome. From 1904 to the beginning of 1913, an average amount in excess of the minimum had in fact been so delivered, and no forfeiture had been exacted of the lessee. From the facts and conditions known or reasonably based on experience, it was not contemplated that any forfeiture would likely be exacted in the future.

Coming now to the matter of determining the value of the leasehold at March 1, 1913, we">*2584 find that the evidence offered by the petitioner to establish such value varies widely.

For the years 1909 and 1910, the corporation operating the elevators paid to petitioner an annual rental of $20,000 and for the years 1911 to 1920 the corporation paid an annual rental of $36,000 and permitted the petitioner a certain limited use of the elevators. All the stock of this corporation was owned by petitioner. We do not regard these facts, standing alone, as a satisfactory basis for determining the value, but is the rental of $36,000 which was actually paid during the year 1913 and subsequent years by the corporation for the use of the elevators, under all the facts and circumstances, a fair and reasonable rental?

Witnesses for the petitioner testified that in their opinion the annual rental value at March 1, 1913, was $50,000, while petitioner testified that in his opinion the leasehold on that date had a value of $75,000 per year for the remaining life of the contract. The terms and conditions of this lease enter so largely into the question of determining its value, that we do not give great weight to opinions of rental value under conditions which are not shown to be similar.

">*2585 ">*513 It also appears from the evidence that in 1913 the Rosenbaum Grain Co. paid $30,000 per year for an elevator of 1,000,000 bushels capacity, and that in 1916 the Northwestern Railroad Co. leased its elevators of 10,000,000 bushels capacity to the Armour Grain Co. at a rental of $300,000 per year. Comparing the capacity of the South Chicago Elevators with the capacity of the elevators leased to the Rosenbaum and Armour companies, the value of petitioner's leasehold in 1913 was $135,000 per year. However, this evidence is not impressive as a criterion by which to measure the value of petitioner's lease in 1913, in the absence of information with respect to the comparative conditions and terms of the various leases involved.

The evidence durther shows that upon expiration of petitioner's lease contract in 1924, the railroad company leased the elevators to petitioner's corporation for a period of five years at an annual rental of $34,488, which amount was reduced from March 12, 1925, to $33,300 in consideration of the lessee assuming and relieving the lessor of certain liabilities. Here the parties were again dealing at arm's length, in respect of the very property">*2586 the rental value of which we are seeking to ascertain, although the transaction occurred more than eleven years subsequent to March 1, 1913. This new lease contract was made on the Missouri River basis, which fixed the annual rental at $34,488. This, in our opinion, establishes a minimum rental value as of 1913, but in 1924 depreciation had been sustained over a period of 11 7/12 years. We have no evidence upon which to determine the extent or rate of depreciation. The lease in 1913 had more than 11 years to run, while the 1924 lease had a term of only 5 years. We think that the rental value on March 1, 1913, for the lease in question, considering the fact that the property had depreciated from that date to 1924, was in excess of the rental value in 1924. On the Missouri River basis the rental was based on the value of the elevator properties not including the land. Considering all the evidence, we think that the rental of $36,000 which was actually paid to the petitioner in 1913, was a fair and reasonable rental value. The evidence as a whole tends to corroborate this valuation. The lease contract at that time had an unexpired life or term of 11 7/12 years, and the aggregate">*2587 rental value on this basis, reduced to present worth as of March 1, 1913, gives substantially the amount which we have found was the fair market value of petitioner's leasehold at that date. This amount should be the basis for deductions on account of exhaustion, as indicated in our opinion hereinabove.

Reviewed by the Board.

Judgment will be entered on 15 days' notice, under Rule 50.