Figueroa Street Hotel Co. v. Commissioner , 18 B.T.A. 709 ( 1930 )

FIGUEROA STREET HOTEL CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Figueroa Street Hotel Co. v. Commissioner

Docket Nos. 14484, 18037.

United States Board of Tax Appeals

18 B.T.A. 709; 1930 BTA LEXIS 2604;

January 9, 1930, Promulgated

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1. A 10-year lease of hotel property was obtained by individuals free of cost other than the agreed rental and the lease was transferred to a corporation for certain shares of its capital stock. Held that the lease had no bonus value for invested capital or depreciation purposes.

2. Petitioner purchased the furnishings for its hotel on the installment plan. Held that this does not constitute such a use of borrowed capital as to create an abnormality under section 327 of the Revenue Acts of 1918 and 1921.

George H. Koster, Esq., for the petitioner.

J. L. Backstrom, Esq., for the respondent.

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SMITH

The Commissioner determined deficiencies in income and profits tax in Docket No. 14484 for 1919 of $3,717.15 and for 1920 of $6,654.84, and in Docket No. 18037 for 1921 of $2,467.76. Petitioner claims that the Commissioner erred in not including in its invested capital a lease of hotel property at a valuation of $60,000; that he erred in not allowing depreciation of the value of the lease at March 1, 1913, in the sum of $6,000 per year; and that he erred in not granting special assessment under section 327 of the Revenue Acts of 1918 and 1921 because of abnormalities in capital and income resulting from the exclusion of said lease from invested capital, the use of borrowed capital, the cost of advertising, and payment of low salaries to its officers. The cases were consolidated by order of the Board for hearing and decision upon the issues defined in subdivisions (a) and (b) of Rule 62.

FINDINGS OF FACT.

Petitioner is a California corporation engaged in operating a hotel. Its principal office is at Los Angeles. In the fall of 1912 Lee Holladay and Arthur H. Johnston, both hotel men, were in the market to lease a hotel in Los Angeles. After considering a number of sites they finally entered into a lease with Carroll W. Gates, by which they leased from him the Gates Hotel at Sixth and Figueroa Streets in Los Angeles for a period of 10 years beginning February 15, 1913. The hotel proper consisted of 260 rooms. The lessees agreed to pay as rent the aggregate sum of $340,080 monthly in advance as follows: $2,080 during the first year; $2,340 during the second year; $2,600 during the third year; $2,860 during the fourth and fifth years; and $3,120 during the remaining five years of the lease. This was $8 per room per month for the first year; $9 per room per month for the second year; $10 per room per month for the third year; $11 per room per month for the fourth and fifth years; and $12 per room per month for the last five years of the lease. In addition the lesses rented space for cafe purposes for five years at an additional rental of $9,600 for the term, ranging from $100 per month for the first year to $250 per month for the fifth year. The building contained four or five storerooms, which were retained by the landlord and rented to other persons at from $50 to $75 per month.

The lease contained the usual terms and conditions of similar leases in that locality as to the duties and liabilities of the parties. There was no right of renewal, and lessees had no right to transfer, assign, or sublet without the written consent of the lessor except to a corporation organized and controlled by them for the purpose of operating the hotel. There was no right of cancellation except on the part of the landlord for nonpayment of rent.

It was further provided in the lease that the lessees were to furnish the hotel suitably for a transient and family hotel at a cost of not less than $50,000 and that P. N. Jenkins and E. W. Goodan, furniture dealers, should supply the furniture and enter into an agreement to guarantee the payment of the rent for the hotel premises.

In December, 1912, the petitioner corporation was organized to take over the lease and furnishings above described and to operate the hotel. Holladay and Johnston transferred to the petitioner their interests in the lease and furnishings and with two other associates paid in to the petitioner $20,000 in cash, or its equivalent, in consideration for which the petitioner issued to them $80,000 par value of its capital stock. The petitioner was capitalized at $100,000 divided into 100,000 shares of a par value of $1 each. The $80,000 of stock was issued to Holladay and the others in proportion to the amount of cash or the equivalent that each had contributed to the petitioner. No other stock was issued except one qualifying share to each of the five directors.

No bonus was paid by the original lessees to obtain the lease, nor was any paid by petitioner other than the stock. The hotel at the time the lease was entered into and at the time it was transferred to petitioner was in course of construction. It was a modern fire-proof, reinforced concrete building costing about $300,000 to construct and was on ground valued at about $125,000. It was located at Sixth and Figueroa Streets, Los Angeles, about five blocks from the business section of the city.

Other hotels of smaller capacity were renting at from $10 to $15 per room monthly. This hotel was in the hands of a number of real estate agents and hotel brokers for five or six months and numerous unsuccessful efforts were made to rent it on a graduated scale from $10 to $15 per room monthly, but this was found too high and the lease herein involved was finally made as the best that could be obtained. Petitioner's claimed value of $60,000 for the lease is arrived at by adding $2 per month per room to the agreed rental, viz., that the rental was $2 cheaper per room per month than the market price, and this difference constituted the cost or value. The lease was not valued on the books until 1919 when it was set up at $60,000.

The lease had no cash value in excess of the rentals provided therein either for invested capital or depreciation purposes.

Petitioner expended about $80,000 for furnishings for the hotel, upon which it made an initial cash payment of $10,000, and agreed to pay the balance in installments of $600 monthly with interest. It kept up these payments until it began to lose money, after which it made payments whenever it could. Petitioner also became in arrears in the payment of rent until on December 31, 1918, it owed rent of $43,806.45, which was reduced to $28,740.90 by December 31, 1919. On January 13, 1920, a loan was obtained from a bank and the rent paid in full. The balance due on furniture was paid in 1921. In its earlier years the hotel was not successful. During the taxable years under consideration a boom was in progress in Los Angeles and the business yielded large profits.

Excluding any valuation of the lease for invested capital or depreciation purposes, the invested capital and net income of petitioner for the taxable years were as follows: 1919 invested capital $20,005, net income $26,378.72; 1920 invested capital $20,005, net income $67,152.68; 1921 invested capital $37,642.58, net income $52,037.63.

From 1913 to 1921, inclusive, petitioner expended $19,870.35 for advertising, but no attempt has been made to divide the cost between ordinary expense and capital expenditures and it has all been claimed and allowed as a deductible expense in the years when made.

During 1913 and 1914 Holladay and Johnston each drew salaries of $150 monthly and were furnished board and room at the hotel for themselves and wives and in addition George A. Collins, the vice president, was also furnished room and board for himself and wife. In 1914 Johnston left and thereafter until 1919 Holladay was paid $250 monthly. In 1919 Holladay was paid $7,800 and Collins $4,200; in 1920 Holladay was paid $9,900 and Collins was paid $6,900; in 1921 Holladay was paid $12,000 and Collins was paid $9,000. E. W. Cason was the real estate broker who represented Carroll Gates, the landlord, in negotiating the lease. He afterwards became a stockholder in petitioner corporation, paying in $3,500 for $14,000 par value stock, which he sold in 1920 for $7,000. There were no other sales of stock.

OPINION.

SMITH: Petitioner's principal and first cause of complaint is that the respondent erred in not fixing a value upon the lease for invested capital and amortization purposes. Its theory is that the lease was worth $2 per room per month more than the agreed rental and that this difference for the entire term amounted to $60,000, the amount claimed as the cost and the March 1, 1913, value of the lease. To support this claim the testimony of two witnesses is introduced, Lee Holladay, president of petitioner, and Edward W. Cason, a stockholder, both of whom give their opinion that the lease was worth $60,000. This opinion evidence, however, was given 17 years after the making of the lease and in our opinion does not accord with and is not sustained by the facts. In matters of this kind we are not bound by opinion evidence where it is not in accord with the facts, and subsequent events may not form the basis for fixing a value at a prior date. .

In this case the hotel was in course of construction during 1912 and while under construction the owner had it listed for rental with a number of real estate agents and hotel brokers for five or six months. One of these was Edward W. Cason, who finally negotiated the lease to Holladay and Johnston. During construction of the hotel Holladay and Johnston were in search of a hotel to rent and and after examining a number of others, and after declining to rent the Gates Hotel at a minimum of $10 per room monthly, entered into the lease in controversy. It was an arm's-length agreement and the best that could be had. Edward W. Cason, agent for the owner, testified as follows:

Q. Were you acting as agent for Mr. Gates in those rentals?

A. Yes, sir. Q. Still agent for Mr. Gates? A. Yes, sir. Q. Receiving a commission from him on his business? A. Every dollar.

Q. Did you make any effort to obtain a higher rental from anybody for Mr. Gates than this?

A. He had one offer higher.

Q. He was not satisfactory, I believe you stated. Did you make any further effort to lease the property?

A. Oh, yes; I presented it to different people. I don't remember the net rentals, but we first asked for the property, ten for a period, eleven for a period, twelve for a period, and fifteen for a period. We found that to be too high, and we began looking for a tenant who would fit the property, and that was the result.

The Board had before it similar questions in , and , where hotel leases had been procured by individuals without cost and shortly thereafter transferred to operating corporations for capital stock and it was held that the Commissioner's determinations of no value for the leases for invested capital or depreciation purposes were correct. .

The rental provided in the lease herein represented, apparently, the best judgment of the parties as to the value of the lease at the time it was entered into and we think fairly represents its value at that time. There was so little time intervening between the signing of the lease and march 1, 1913, that there was no change in the situation and the respondent's determination of no value on either date for invested capital or depreciation purposes is approved.

Petitioner further claims that it is entitled to special assessment under section 327 of the Revenue Acts of 1918 and 1921 because of abnormalities in income and invested capital resulting (1) from the exclusion of the alleged value of the lease of $60,000 from invested capital, (2) from the use of borrowed capital, and (3) cost of advertising and low salaries paid to officers.

Relative to the exclusion of any value for the lease, it is sufficient to refer to the recent case of , where certain patents were excluded from invested capital and it was claimed this created an abnormality. It was there said:

The findings of the Board in its above cited opinion is to the effect that there was no proven cash value of the patent at the time it was acquired by the petitioner in 1914 and that accordingly it was not entitled to include in invested capital any amount in respect of the patent; further, that it sustained no deductible loss in 1917, when the patent was determined to be worthless. Section 207 of the Revenue Act of 1917 defines what constitutes invested capital. Among other things it is the actual value of tangible property paid in other than cash for stock or shares of a corporation. If the property paid in for the shares had no actual cash value the petitioner is not entitled under the law to the inclusion in invested capital of any amount for the patent paid in. We can not see how there is any proof of abnormality of invested capital where a patent having no cash value is paid in to a corporation for stock or shares and the corporation is denied the right of including in invested capital any amount for the patent. If the patent never had any value it was not entitled to deduct from gross income of 1917 any amount in respect of proof of the worthlessness of the patent. The denial of such a deduction does not cause an abnormality of income.

Petitioner claims that the use of its furniture purchased on the installment plan constituted the use of borrowed capital and that, since section 326(b) provides that "invested capital" does not include "borrowed capital," there was created an abnormality in capital and income entitling it to special assessment.

Assuming for the purpose of this proceeding that the assets purchased on the installment plan and used in the petitioner's business constituted borrowed capital, there is no proof of whether the amount of such furnishings was abnormal or unusual in the conduct of similar businesses.

In , we said:

Evidence was introduced to show that tangible assets to the extent of approximately $62,000, the title to which was still held by Beckmann, were left in the business and the petitioner contends that such borrowed capital created an abnormality which brings petitioner within the provisions of section 327 of the Revenue Act of 1918. However, the petitioner has not shown what the normal condition in this particular business is.

In , the Board said:

The petitioner further contends that the accounts payable and notes payable were in effect borrowed money used by the petitioner in its business in the production of its income and that the total amount of borrowed money, including these items, was so large in comparison with its invested capital as to constitute an abnormality when the gross sales and net income are taken into consideration. The record also discloses that the petitioner during 1920 had accounts receivable in the amount of $56,186.47 and for 1921 had accounts receivable in the amount of $53,580.98. The accounts payable and rceivable at the end of each of the years indicate that the petitioner both bought and sold to some extent on credit, but the credit purchases in this case, even if we should hold that they constitute the use of borrowed capital, are not shown to constitute an abnormal situation as contemplated by section 327. The mortgage indebtedness is not explained, but, in our opinion, both the money actually borrowed and the purchases made on credit represented by notes payable are not shown to have constituted such an abnormal condition affecting the petitioner's capital as is contemplated in section 327. It may well be that the use of as much money as was borrowed by the petitioner and the use of credit of which the petitioner availed itself during the years involved to the extent involved in this case was the usual, normal and ordinary course of business dealings by corporations engaged in the same or similar enterprises.

Cf. ; ; .

What we have said relative to the use of borrowed capital applies equally to the cost of advertising, , and to amounts of salaries paid to officers. There is no proof that either was abnormal. The salaries paid while petitioner was building up its business may have been conservative, but not abnormally low for a losing business. As soon as success came they were increased proportionately, but not excessively. Section 327(d) expressly provides that it shall not apply where the tax is high merely because the corporation earned within the taxable year a high rate of profit upon a normal invested capital.

It seems to us that there is no abnormality in this case which entitles the petitioner to special assessment and that the comparatively large profits in the taxable years are attributable principally to the improved business conditions and the increase in hotel business over former years.

Judgment will be entered for the respondent.