The Board of Trade of the City of Chicago and Subsidiaries v. Commissioner

106 T.C. No. 21UNITED STATES TAX COURT
THE BOARD OF TRADE OF THE CITY OF CHICAGO AND SUBSIDIARIES,
Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8202-93. Filed May 29, 1996.
Petitioner (P) is a taxable membership corporation
that operates a futures exchange. When a membership on
the exchange is transferred, the transferee must pay P
a transfer fee, which, under P’s bylaws, is to be used
to “purchase, retire or redeem the indebtedness
encumbering the Board of Trade Building”, which houses
P’s trading floor and substantial office space leased
to third-party tenants. Held, the transfer fees are
nontaxable contributions to capital, rather than
taxable payments for services, because the transferees
pay the fees with an investment motive, as evidenced by
(1) the earmarking of the fees for reduction of P’s
mortgage indebtedness, (2) the resulting increase in
the members’ equity in P, and (3) the members’
opportunity to profit from their investment in P
because of the lack of restrictions on the
transferability of their membership interests.
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George B. Javaras, Barbara M. Angus, Richard E. Peterson,
and Raymond P. Wexler for petitioner.
Joseph T. Ferrick, for respondent.
BEGHE, Judge: Respondent determined deficiencies in
petitioner's Federal income tax for the years 1988, 1989, and
1990 in the amounts of $108,859, $113,473, and $65,051,
respectively.
The deficiencies arise from respondent’s inclusion in
petitioner’s gross income of membership transfer fees. The sole
issue is whether the membership transfer fees paid to petitioner
during 1988, 1989, and 1990 are contributions to capital or
payments for services. We hold the transfer fees to be excluded
from gross income as contributions to capital.
FINDINGS OF FACT
The parties have stipulated some facts, and the stipulation
of facts and the attached exhibits are incorporated in this
opinion. At all relevant times, petitioner maintained its
principal place of business in Chicago, Illinois.
Petitioner, the Board of Trade of the City of Chicago
(commonly referred to as the CBOT), is a taxable membership
corporation organized in 1859 under a special act of the Illinois
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legislature. Petitioner's principal business is the operation of
a futures exchange. Petitioner owns and manages the commercial
office building (CBOT building) that houses its exchange
facilities. The bulk of the space in the CBOT building,
approximately 80-85 percent, is leased to third-party tenants.
The CBOT building is the largest asset shown on petitioner's
balance sheet. Petitioner's management believes that the current
fair market value of the CBOT building is between $350 and $400
million. The CBOT building consists of the original landmark
building constructed in the 1930's, a new trading floor that
petitioner constructed in the early 1970's, and an adjacent 22-
story commercial building that petitioner constructed in the
early 1980's at a cost of between $110 and $120 million.
Petitioner's borrowings to finance these acquisitions are
represented by one consolidated and extended mortgage debt
secured by the CBOT building.
During the years in issue, the mortgage debt encumbering the
CBOT building represented petitioner's single largest liability.
The amounts of the mortgage debt as of December 31, 1988, 1989,
and 1990 were $33,315,792, $30,695,564, and $27,793,779,
respectively. Petitioner made payments of principal and interest
on the mortgage debt in the total amount of $5,914,269 in each of
the years in issue.
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Ownership of petitioner is vested in its members and is
represented by five classes of transferable memberships: Full
memberships, associate memberships, Government Instruments Market
(GIM) memberships, Commodity Options Market (COM) memberships,
and Index, Debt and Energy Market (IDEM) memberships.
Each class of membership carries specified voting rights,
dissolution rights, and trading privileges. The most
comprehensive membership, a full membership, has trading
privileges on all markets on the CBOT, a full share on
liquidation, and one vote on all matters voted on by CBOT
members. The most restricted membership, an IDEM membership, has
trading privileges only on the Index, Debt and Energy market, a
one-half percent of one share on liquidation and voting rights to
elect members of an IDEM liaison committee to the board of
directors of the CBOT. The following chart shows the numbers of
different memberships during the years in issue and summarizes
the rights and privileges of each class:
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Class of Numbers of memberships as Trading Voting Dissol- Transfer
Member- of: Privileges Rights ution fee
ship 1/1/88 12/31/88 12/31/89 12/31/90 Rights
FULL 1402 1402 1402 1402 All 1 vote 1 share $1,000
futures on all
contracts matters
and full voted
trading on by
privileges the
on the owners
CBOT and of CBOT
CBOE ** member-
ships
ASSOCIATE 713 722 739 748 All 1/6 of 1/6 of $1,000
futures 1 vote 1 share
contracts on all
except matters
agri- voted
cultural on by
and the
associated owners
markets of CBOT
member-
ships
GIM 1374* 1393* 1491* Only Voting 11% of $350
1493* Government rights 1 share
Instrument to
Market elect a
GIM
liaison
commit-
tee
COM * * * * Only Voting 1/2% of $350
Commodity rights 1 share
Options to
Market elect a
COM
liaison
commit-
tee
IDEM * * * * Only Voting 1/2% of $0
Index, rights 1 share
Debt and to
Energy elect
Market an IDEM
liaison
commit-
tee
* These numbers are the totals of the combined GIM, COM and IDEM
memberships on the dates indicated. There is no evidence in the record, other
than records of the numbers of transfers during a year of each class of
membership (see infra p. 6) of the specific numbers of each of these three
classes of membership on any of the specified dates.
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** The Chicago Board of Option Exchange (CBOE) is an organization
separate from the CBOT.
The bundles of rights inherent in CBOT memberships are
divisible into two components: the ownership or equity component
and the trading privilege component. Although all members of a
class of membership have equal rights and privileges,
approximately 35 to 40 percent of petitioner's members do not
exercise their trading privileges. The owner of a membership is
entitled to lease or delegate the trading privileges attributable
to the membership. A member who leases or delegates trading
privileges retains the voting and dissolution rights attributable
to the membership. Included in the 35 to 40 percent of members
who do not exercise their trading privileges are approximately 16
percent of petitioner's members who neither exercise their
trading privileges nor lease or delegate them to third parties.
Petitioner's members may freely sell or transfer their
memberships pursuant to petitioner's rules and procedures
described infra pp. 10-11. During the taxable years 1988 through
1990, 494 full memberships, 334 associate memberships, 25 GIM
memberships, 487 COM memberships, and 432 IDEM memberships were
sold or otherwise transferred. At the time of trial, spring
1994, the fair market value of a full membership was
approximately $575,000. When a membership is transferred, the
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transferee, in accordance with petitioner’s rule 243,1 must pay a
transfer fee.
Petitioner's rule 243 is separated into three sentences.
The first states that “No transfer of a membership may be
consummated unless the transferee pays to the Association a
transfer fee”.2 The transfer fee applies not only to sales of
memberships but also to transfers of memberships without
consideration, such as intrafamily transfers and intrafirm
transfers from the name of an owner firm’s qualified partner or
employee to another qualified individual in the firm.
Petitioner’s management regards the transfer fees as necessary
for applicants to understand and recognize that they are the
owners of the association.
The second sentence of rule 243 states that “The amount of
[the transfer fee] is established from time to time by the Board
of Directors.”3 The amount of the transfer fee depends on the
class of membership transferred. During the taxable years 1988
through 1990, the transfer fees set by petitioner's board of
1
Rule 243 is part of the bylaws of the CBOT, adopted and
amended by the owners of CBOT memberships.
2
In 1925, the CBOT members adopted the predecessor of rule
243, then known as rule 111. Rule 111 was amended in 1937 to
specify that the purchaser of a membership would pay the transfer
fee. Prior thereto, rule 111 specified that the seller would pay
the fee.
3
In 1970, rule 111 was amended to provide that the amount
of the transfer fee would be set by the board of directors.
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directors were $1,000 for full and associate memberships, $350
for GIM and COM memberships, and no fee for an IDEM membership.
In the early 1970's petitioner's board of directors increased the
transfer fees for full and associate memberships from $500 to
$750. During this same period, petitioner constructed the new
trading floor. In 1978, petitioner's board of directors
increased the transfer fee for full and associate memberships
from $750 to $1,000, effective in 1979 when petitioner began
construction of the adjacent 22-story commercial building.
The final sentence of rule 243 states that “The transfer fee
so collected shall be used to purchase, retire or redeem the
indebtedness encumbering the Board of Trade Building.”4 In 1988,
1989, and 1990, petitioner received transfer fees totaling
$319,800, $333,350, and $345,050, respectively. The amount of
4
In 1937, petitioner and Chicago Board of Trade Safe
Deposit Co. (a corporation affiliated with petitioner, which
owned and leased the CBOT building to petitioner because at that
time petitioner was not permitted under Illinois law to own
property with a value in excess of $200,000), had an opportunity
to refinance the CBOT building at a lower interest rate and on
more favorable payment terms, provided that the outstanding
mortgage principal balance was reduced by $1,218,000. In order
to raise capital needed to reduce the mortgage principal,
petitioner made a special assessment against all members, and
rule 111 was amended to require that all transfer fees be used
for the purchase, retirement, or reduction of the mortgage
obligation. In 1947, after repeal of the property ownership
prohibition, petitioner acquired its building from Chicago Board
of Trade Safe Deposit Co., and rule 111 was amended to reflect
the ownership change of the CBOT building. As amended, rule 111
required that all transfer fees be used for the purchase,
retirement, or redemption of the indebtedness encumbering the
CBOT building.
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mortgage principal payments made by petitioner in each of the
taxable years substantially exceeded the amount of the transfer
fees collected by petitioner during those years. For example,
the transfer fees received in 1989 and 1990, respectively, of
$333,350 and $345,050, compare with the mortgage principal
payments of $2,620,288 and $2,901,785 during those respective
years.
For accounting purposes, each transfer fee received by
petitioner is recorded as "Restricted Capital" in one or the
other of two capital accounts. Petitioner uses account No. 2810
(Capital-Membership Transfers) for transfer fees collected on
transfers of full and associate memberships, and account No. 2808
(Capital-Interest Transfers) for transfer fees collected on
transfers of GIM and COM memberships. After a mortgage principal
payment is made, an equivalent amount of the transfer fees in
accounts Nos. 2808 and 2810 is considered by petitioner as
"Unrestricted Capital". From time to time, the balances in
account Nos. 2808 and 2810 are transferred to account No. 2850
(Retained Earnings). These accounting transfers are not made
until the amount of mortgage principal paid by petitioner exceeds
the balances in accounts Nos. 2808 and 2810.
For financial reporting purposes, the transfer fees received
by petitioner during the year are reflected in the Statements of
Consolidated Members’ Equity as capital contributions of new
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members. Since 1937, petitioner has so treated the transfer fees
received. The transfer fees received by petitioner in 1988 and
1989 were the only amounts reflected in the Statements of
Consolidated Member's Equity in petitioner’s financial statements
as capital contributions of new members. The amount of capital
contributions of new members reflected on the 1990 financial
statements is the sum of the amount of transfer fees received in
1990 and the amounts received by petitioner on sales of new
participation interests to members in 1990.5 Petitioner showed,
on Schedule L of Form 1120, U.S. Corporation Income Tax Return,
all transfer fees collected during the taxable years 1988 through
1990 as contributions to capital.
A member who wishes to sell a membership submits to
petitioner an offer to sell, which includes an offer price.
Petitioner posts all offers to sell and bids to purchase on the
bulletin board of the CBOT. A sale is effected when there is a
match between an offer and a bid.
Petitioner’s Member Services Department collects the
transfer fees in connection with the transfers of memberships.
5
Petitioner collected $345,050 in transfer fees in 1990.
The capital contributions received from new members during 1990
was $474,364; the balance of $129,314 was the proceeds of sales
of new memberships received by petitioner in 1990. The parties’
supplemental stipulation of facts states that transfer fees
received by petitioner in 1988 and 1989 were the only capital
contributions made in those years, notwithstanding that there
were increases in the number of memberships in those years, as
well as in 1990.
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When a membership is transferred, petitioner: (1) Maintains and
publishes a list of bids to purchase and offers to sell; (2)
receives and holds bid purchase money and transfer fees while
bids to purchase are pending; (3) receives and holds the
authorization of sale submitted by a prospective seller; (4)
notifies the buyer and seller whenever a bid and offer match; (5)
withholds from the tendered purchase price an amount necessary to
pay any outstanding exchange fees or fines of the seller, as well
as any trading related debts or membership financing of the
seller owed to other members or clearing firms; (6) remits
membership sale proceeds to all parties who submitted claims
against the seller for repayment of outstanding debt, that have
been "allowed" by the exchange; and (7) keeps records of all
membership transfers, including intrafirm and intrafamily
transfers, and membership exchanges.
Within 5 business days of acquiring the membership (unless
the application was submitted and approved prior to the
acquisition), the purchaser must submit an application for
membership to petitioner. As part of the application process,
prospective members are given a copy of petitioner’s rules and
they are tested on their knowledge of these rules. If the new
owner of a membership fails to submit an application, is not
elected to membership, or withdraws the application, petitioner's
regulations require the new owner to sell the acquired membership
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within a 30-day period. If the membership is not sold within the
30-day period, petitioner auctions the membership and remits the
proceeds to the seller. On all these compulsory resales of
memberships, petitioner retains the transfer fee that was paid by
the original purchaser and also collects a transfer fee from the
new purchaser on the resale.
In addition to collecting the transfer fees, the Member
Services Department collects fees from applicants, members, and
others in the following five categories: (I) Application fees,
(ii) delegate fees, (iii) registration fees, (iv) badge fees, and
(v) miscellaneous fees.
Petitioner's Member Services Department collects application
fees in connection with the processing of membership
applications. From time to time, petitioner's board of directors
reconsiders and revises the amount of the application fee.
Increases in the application fee have been related to increases
in the cost of operating the CBOT Member Services Department.
The application fee for all first time applicants for any type of
membership was $750 from January 1, 1988, through December 31,
1989, and $1,000 from January 1, 1990, through December 31, 1990.
The application fee must be paid, regardless of whether the
purchaser already owns another membership. However, a person who
already owns a CBOT membership submits a short-form application
in connection with the acquisition of an additional membership.
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During the years in issue, the application fee for a short-form
application was $300.
The Member Services Department collects a delegate fee
whenever a member wishes to lease the trading rights associated
with his membership. The delegate-lessee must submit a delegate
application and pay a nonrefundable delegate fee. Every firm
trading on the CBOT must be registered with petitioner and pay a
registration fee in connection with its registration. All
individuals who are required to wear a badge on the trading floor
must pay the badge fee to petitioner.6 The Member Services
Department collects various miscellaneous fees, including fees
for fingerprinting, certificates, and coat room services.
For financial reporting and tax purposes, petitioner reports
the application, delegate, registration, badge, and miscellaneous
fees as revenues included in gross income. For 1988, 1989, and
1990, these revenues equaled $1,167,750, $1,115,021 and
$2,718,419, respectively.7 For each of the taxable years 1988
6
The badge fees were collected by another department of
the CBOT prior to 1990.
7
The amounts of these other fees and expenses of the
Member Services Department during the taxable years were:
Type of fee 1988 1989 1990
Application fees $720,425 $644,550 $766,825
Delegate fees 367,800 391,800 811,200
Registration fees 75,790 72,210 74,400
Miscellaneous fees 3,735 6,461 83,609
Badge fees 0 0 982,385
Totals 1,167,750 1,115,021 2,718,419
(continued...)
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through 1990, the revenues of the Member Services Department
exceeded its expenses.
The bulk of petitioner’s revenues is derived from
transaction fees paid for each trade executed on the exchange and
from rents for the lease of space in the CBOT building. For the
years in issue, petitioner received the following revenues from
these sources:
Year Transaction Fees Building Rents
1988 $42,375,000 $22,558,000
1989 41,489,000 24,644,000
1990 43,688,000 24,655,000
All funds received by petitioner, including transfer fees, are
commingled in one bank account.
During 1988 and 1989 and prior years, CBOT members had paid
quarterly dues assessed by the CBOT board of directors to help
cover operating expenses. However, petitioner waived membership
dues for every year from 19908 through the time of trial,
7
(...continued)
Expenses 719,423 807,749 1,074,709
8
Petitioner’s 1990 financial statement states that
membership dues were waived in each quarter of 1990. However,
the 1990 statement of consolidated income member’s dues column
reports total dues of $888,000.
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primarily because of the surplus in petitioner's operating
revenues.
OPINION
The issue for decision is whether petitioner must include in
gross income the transfer fees that prospective members pay in
connection with their acquisitions of memberships. Petitioner
characterizes the transfer fees as contributions to capital and
principally relies on section 1189 for the proposition that
contributions to capital are not included in the gross income of
a corporation. Respondent characterizes the transfer fees as
taxable payments for services that do not qualify as
contributions to capital.
Section 118(a) states that “In the case of a corporation,
gross income does not include any contribution to the capital of
the taxpayer.” Congress enacted section 118 to codify10 the
preexisting concept of a capital contribution by a
nonshareholder, Brown Shoe Co. v. Commissioner, 339 U.S. 583, 591
(1950), or shareholder, 874 Park Ave. Corp. v. Commissioner, 23
9
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue.
10
Sec. 118 was a new provision of the 1954 Code. The
House Ways and Means Committee report described the section as
merely stating the existing law as developed through
administrative and court decisions. H. Rept. 1337, 83d Cong., 2d
Sess. A38 (1954).
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B.T.A. 400 (1931); Paducah & Ill. R.R. v. Commissioner, 2 B.T.A.
1001 (1925); G.C.M. 4015, VII-1 C.B. 120 (1928), revoked by Rev.
Rul. 77-354, 1977-2 C.B. 50.
Respondent postulates that, under section 1.118-1, Income
Tax Regs., a payment cannot be a contribution to capital unless
it is voluntary, pro rata, and required by the corporation to
conduct its business, as described by the somewhat circumscribed
example in the regulations.11 Respondent argues that the
transfer fees are not contributions to capital because they are
not needed by petitioner to conduct its business, and are neither
voluntary nor pro rata.
That the transfer fees are neither voluntary nor pro rata is
not dispositive of whether the fees are capital contributions.
Mandatory payments to a corporation may qualify as capital
contributions, Concord Village, Inc. v. Commissioner, 65 T.C.
11Sec. 1.118-1. Contributions to the capital of
a corporation.--
In the case of a corporation, section 118 provides
an exclusion from gross income with respect to any
contribution of money or property to the capital of the
taxpayer. Thus, if a corporation requires additional
funds for conducting its business and obtains such
funds through voluntary pro rata payments by its
shareholders, the amounts so received being credited to
its surplus account or to a special account, such
amounts do not constitute income, although there is no
increase in the outstanding shares of stock in the
corporation. * * * However, the exclusion does not
apply to any money or property transferred to the
corporation in consideration for goods or services
rendered * * *. [Emphasis added.]
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142 (1975); Lake Petersburg Association v. Commissioner, T.C.
Memo. 1974-55, and the Supreme Court has observed that a payment
to a corporation can be a capital contribution even if some
shareholders contribute less than others or nothing at all,
Commissioner v. Fink, 483 U.S. 89 (1987); see also Sackstein v.
Commissioner, 14 T.C. 566 (1950). These cases confirm that the
language of the regulation is merely illustrative and does not
exhaust the definition of a capital contribution.
Nor does petitioner’s lack of need for the transfer fees in
order to conduct its business compel the conclusion that they are
not contributions to capital. The corporation’s need is only
another element of the illustrative language of the regulation.
A payment can be a contribution to capital where it is not needed
by the corporation for the conduct of its business. See
Cambridge Apartment Bldg. Corp. v. Commissioner, 44 B.T.A. 617(1941) (holding shareholder payments in excess of operating
requirements to be contributions to capital when used to retire
bonded indebtedness).
The correct characterization of a shareholder payment to a
corporation depends on the capacities in which the shareholder
and the corporation deal with each other in making and receiving
the payment. Cf. sec. 1.301-1(c), Income Tax Regs. (limiting
dividend treatment to amounts paid by a corporation to a
shareholder in his capacity as such), sec. 1.311-1(e)(1), Income
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Tax Regs. (applying sec. 31112 to distributions to shareholders
made by reason of the corporation-shareholder relationship and
not to transactions between a corporation and a shareholder in
his capacity as debtor, creditor, employee, or vendee, where the
fact that the distributee is a shareholder is incidental to the
transaction). Here the characterization issue is complicated by
the fact that the payors of the transfer fees become both equity
owners of petitioner and its primary customers, and that, by
becoming members, the payors of the transfer fees become entitled
to use the trading facilities of the exchange.
CBOT members’ use of petitioner’s trading facilities does
not prevent the transfer fees from being contributions to
capital. A payment by a member-owner of an organization can be a
contribution to capital even where the member-owners receive
goods or services from the corporation. See Concord Village,
Inc. v. Commissioner, supra (payments by members to a cooperative
housing corporation to fund a replacement reserve held to be
contributions to capital, even though members also leased
property from the corporation); Minnequa Univ. Club v.
Commissioner, T.C. Memo. 1971-305 (payments by members to an
12
The general nonrecognition rule of sec. 311(a), as
interpreted by this regulation, was repealed as part of the
fairly comprehensive repeal by the Tax Reform Act of 1986, Pub.L.
99-514, 100 Stat. 2085, of the statutory enactments of General
Utils. & Operating Co. v. Helvering, 296 U.S. 200 (1935). The
regulation was removed from the regulations in 1993 by T.D. 8474,
1993-1 C.B. 242.
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incorporated non-stock social club to repair and improve the
club's building held to be capital contributions even though the
club's principal business was providing services to its members);
Lake Forest, Inc. v. Commissioner, T.C. Memo. 1963-39 (payments
by members to a cooperative housing corporation to meet mortgage
amortization obligations were held to be capital contributions
even though members also leased property from the corporation).
Because petitioner's members have a dual role as users of the
CBOT services and facilities and holders of equity interests in
the CBOT, we must determine whether the payments were made in
consideration of the receipt of goods or services from petitioner
or as an investment in the capital of the corporation.
Respondent argues that the transfer fees are payments in
consideration of obtaining access to the trading facilities and
thus are ordinary income. We disagree. Petitioner charges its
members a separate transaction fee for each trade executed on the
exchange. A transaction fee is paid in consideration of the use
of the trading facilities every time a trade is executed. The
transaction fees amounted to more than $40 million in each of the
3 years in issue and are petitioner’s primary source of revenue.
We are not persuaded that the transfer fees, amounting to less
than 1 percent of the transaction fees charged for actual use of
the trading facilities, are payments in consideration of the use
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of trading facilities, even though payment of the transfer fee is
a prerequisite to obtaining or retaining membership.
Respondent also argues that the transfer fees paid to
petitioner were for services provided to its members in
consideration of and in connection with membership transfers and
are thus taxable income. In support of this argument, respondent
asserts that, in exchange for the transfer fees, petitioner
performs the services listed supra p. 11.
We are not persuaded that these services are provided in
consideration of the transfer fee. An indicator of whether a
payment is for a good or service is whether the amount of the
payment is directly related to the amount and number of services
provided or merely incidental thereto. See James Hotel Co. v.
Commissioner, 39 T.C. 135, 142 (1962), affd. 325 F.2d 280 (10th
Cir. 1963); cf. sec. 1.311-1(e)(1), Income Tax Regs. In the case
at hand, the amounts of petitioner's transfer fees have no
quantifiable correlation with the amounts or extent of the
functions performed or services rendered by the Member Services
Department. The same functions are performed for the different
classes of members even though they pay different transfer fees.
In fact, 432 IDEM memberships were either sold or transferred
during the taxable years without the transferees paying any
transfer fees, and the Member Services Department performed the
same functions with respect to these transfers as it would have
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performed for a full membership transferee who paid $1,000.
Petitioner, in some instances, assesses the same fees despite
substantial differences in the amounts of services. For
instance, the transfer fee for an intrafamily transfer of a full
membership, which requires few of the services listed, is
normally $1,000, the same transfer fee payable in connection with
an outright sale of a full membership, which requires the entire
range of services.
In contrast to the transfer fees, the application fees paid
in connection with applications for CBOT memberships are directly
related to the services performed in connection with the
applications. Short-form applications, which obviously require
fewer services, require a lower fee than full applications. The
application fees are based on the services rendered and, as such,
are treated as ordinary income. On the other hand, the transfer
fees are not based on the functions performed. Rather, the
transfer functions are performed incidentally to the paying of
the transfer fee. The lack of correlation between the different
transfer fees and the functions performed by the Member Services
Department supports the conclusion that the transfer fees are not
payments for or in consideration of these services.
The parties agree that the payor’s motive controls whether a
payment is a contribution to capital, whether the payor is a
nonshareholder, see United States v. Chicago, B & Q. R.R., 412
U.S. 401, 411-413 (1973); Brown Shoe Co. v. Commissioner, 339
- 22 -
U.S. at 591, or a shareholder, Washington Athletic Club v. United
States, 614 F.2d 670, 673-677 (9th Cir. 1980). If the payor is a
shareholder, we specifically look to see whether the payor has an
investment motive in making the payment. See, id. (holding the
investment motive to be the crucial element of capital
contributions). If an investment motive exists, then the payment
is a contribution to capital. See Lake Petersburg Association v.
Commissioner, T.C. Memo. 1974-55 (holding that payments of
assessments to a housing cooperative were capital contributions
and not membership fees for services turned on the conclusion
that an investment motive existed); Minnequa Univ. Club v.
Commissioner, supra (an investment interest in members' payment
of assessments to a social club led to the conclusion that the
payments were contributions to capital). The question in the
case at hand is whether the CBOT members had an investment motive
in paying the transfer fee.
Direct proof of the motive of the payor is rarely
available.13 Whenever state of mind is relevant under the tax
laws, the most important operational question usually concerns
the weight to be attached to external factors. Blum, “Motive,
13
None of petitioner’s members testified about their
motives in paying the transfer fees. However, petitioner’s
Senior Vice President of Planning and Operations, Frank Grede,
testified that petitioner’s management views the transfer fees as
necessary for applicants to understand and recognize that they
are the owners of the association.
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Intent, and Purpose in Federal Income Taxation”, 34 U. Chi. Law
Rev. 485, 544 (1967); cf. Recklitis v. Commissioner, 91 T.C. 874,
910 (1988) (the objective “badges” or indicia of fraud under sec.
6663); sec. 1.183-2(b), Income Tax Regs. (enumerating the
objective factors taken into account evidencing a profit motive).
The proper tax characterization cannot turn on the separate
intentions of multiple participants in an organization, since
each participant is apt to take a different view. Blum, supra at
539. Instead, motive or intent must be determined at the
institutional level, which necessarily requires an examination of
external factors. Therefore, we look to the objective facts and
circumstances surrounding the payment to determine whether the
members must or should be deemed to have an investment motive in
paying the transfer fees.
There is no preexisting checklist of objective factors that
can be used as a template for deciding if the payors have an
investment motive. Therefore, we look to other shareholder/club
member capital contribution cases to isolate the objective
factors that have tended to show an investment motive.
The transfer fees are similar to assessments paid by owners
of interests in a housing cooperative, because any assessment
paid by the cooperative owners can arguably be a charge for the
privilege of residing on the premises, just as, respondent
argues, the transfer fee should be considered merely another
- 24 -
charge for the privilege of trading on the CBOT. However, we
held early on that some kinds of assessments imposed upon
cooperative housing members by the cooperative are nontaxable
contributions to capital. We will look to these cases to find
some of the objective factors for our inquiry.14
In 874 Park Ave. v. Commissioner, 23 B.T.A. 400 (1931), a
housing cooperative corporation, pursuant to the terms of the
proprietary leases, levied assessments on its tenant-shareholders
for the purpose of amortizing debt secured by mortgages on its
property. The taxpayer used the assessments to amortize the
mortgage debt and credited the payments to its capital stock
account. The Board of Tax Appeals held that these assessments
14
Respondent argues that housing cooperative cases are
inapplicable because of "the special relationship between the
shareholder-tenants and the cooperative, insofar as the tax
statutes are concerned", citing Eckstein v. United States, 196
Ct. Cl. 644, 665, 452 F.2d 1036, 1048 (1971), which concerned
whether the payments by tenant-shareholders to be applied to the
mortgage were income to the corporation for the purpose of the
80-percent requirement of sec. 216(b). Eckstein refers to cases
cited in Lake Forest, Inc. v. Commissioner, T.C. Memo. 1963-39,
on which Eckstein relies, along with Cambridge Apartment Bldg.
Corp. v. Commissioner, 44 B.T.A. 617 (1941), and 874 Park Ave. v.
Commissioner, 23 B.T.A. 400 (1931). All this Court said in Lake
Forest is that it did not interpret United Grocers, Ltd. v.
United States, 308 F.2d 634 (9th Cir. 1962); James Hotel Co. v.
Commissioner, 39 T.C. 135 (1962), affd. 325 F.2d 280 (10th Cir.
1963); Affiliated Govt. Employees Distrib. Co., 37 T.C. 909(1962), affd. 322 F.2d 872 (9th Cir. 1963); Federal Employees'
Distrib. Co. v. United States, 206 F. Supp. 330 (S.D. Cal.,
1962), judgment revd. 322 F.2d 891 (9th Cir. 1963), as requiring
a different result.
- 25 -
were nontaxable contributions to capital because they were
provided for in the leases and used for capital purposes.
In Cambridge Apartment Bldg. Corp. v. Commissioner, 44
B.T.A. 617 (1941), the Commissioner determined deficiencies
against a cooperative housing corporation on the ground that
assessments collected from the tenant-shareholders for the
ostensible purpose of retiring bonded indebtedness were income to
the corporation. The taxpayer used most of the funds for
operating expenses, but used any excess funds to retire its
bonds. The Board, relying on 874 Park Ave., held that the excess
of assessments used to retire bonds were nontaxable contributions
to capital, notwithstanding the lack of an explicit agreement
between the corporation and the shareholders or any requirement
that the corporation use the excess funds to retire the bonds.
Our most recent opinion on the housing coop capital
contribution issue, Concord Village, Inc. v. Commissioner, 65
T.C. 142 (1975), is instructive. The taxpayer was a nonstock
not-for-profit housing corporation operated for the benefit of
its members, who had proprietary interests. However, upon the
sale of their interests, members were required under the
taxpayer’s bylaws to forfeit to the corporation the part of the
sale price that exceeded the FHA transfer value. We held that
the forfeitures were taxable gain to the taxpayer, but that all
proceeds of assessments accumulated in the taxpayer’s replacement
- 26 -
reserve were nontaxable contributions to capital. We upheld
capital contribution treatment of the assessments on the ground
that the replacement reserve was in a separate bank account
earmarked solely for capital expenditures, and the member
received no goods or services in consideration for the payments
to the replacement reserve. Although we were concerned that
members had no right, upon the transfer of their memberships or
at any other time, to any of the contributed amounts in the
replacement reserve, we concluded that this did not compel a
different result because it did appear that the amounts
contributed to the replacement reserve did bear some relation to
the value of the members’ equity in the taxpayer. Id. at 157.
Cases that have denied capital contribution treatment, on
which respondent relies, are also instructive in determining the
characteristics of a capital contribution.
In United Grocers, Ltd. v. United States, 308 F.2d 634 (9th
Cir. 1962), the taxpayer, a grocery-buying cooperative, charged
its members monthly dues to participate in the cooperative. The
Court of Appeals for the Ninth Circuit concluded that the members
had no investment motive in paying the dues because memberships
were not transferable, and there was no way that members could
recover their investments in the corporation.
In Washington Athletic Club v. United States, 614 F.2d 670(9th Cir. 1980), the court concluded that the membership-type
- 27 -
fees, although earmarked for capital expenditures, could not be
treated as capital contributions because the members had no
equity interest in the club and received no legal entitlement for
the payment of the fees other than access to the club and the
right to vote for the board of directors. The court commented
that the earmarking of the payments for capital expenditures was
relevant and pertinent, but not determinative of, a contribution
to capital. Id at 675.
In Affiliated Government Employees Distrib. Co. v.
Commissioner, 37 T.C. 909 (1962), affd. 322 F.2d 872 (9th Cir.
1963), we addressed whether membership fees paid to the taxpayer,
a nonstock membership corporation operating department stores for
the exclusive use of its members and their guests, were
contributions to capital. We held that the fees were payments
for the privilege of shopping at the taxpayer’s stores and were
not contributions to capital because the members were not
entitled to share in the profits of the enterprise and had no
assurance of a share in the dissolution proceeds because the
memberships were nonassignable and terminated at death. Id. at
918.
In Oakland Hills Country Club v. Commissioner, 74 T.C. 35(1980), we denied a country club's motion for summary judgment,
holding that a "proprietary interest" is not sufficient to turn a
membership fee into a capital contribution. However, the members
- 28 -
could not resell their memberships or profit from appreciation in
the value of the membership. We found the only benefit to the
members was their right to use the club's facilities.
In American Medical Association v. United States, 887 F.2d
760 (7th Cir. 1989), the Court of Appeals for the Seventh
Circuit, to which an appeal in this case would lie, provided
useful guidance in dealing with the member capital contribution
issue. In holding that member dues placed in the AMA’s
“association equity” reserve account were current membership
receipts that could be allocated to circulation income in the
year received, the court rejected the taxpayer’s alternative
argument that membership fees so placed “should be likened to
capital contributions.” Id. at 773. The Court of Appeals
explained:
The problem with this argument is that the AMA members
received nothing in return for their “investment” in
the AMA other than the right to receive the benefits of
membership in the single annual period for which dues
were assessed. In exchange for a capital contribution
the contributor receives a future or residual claim,
for example, for return of capital as dividends or as
the proceeds of liquidation. A capital contribution is
in the nature of an investment whereby the investor
purchases a continuing interest in an enterprise.14 In
this case there is no evidence that AMA members
received anything more for their annual membership fee
than an annual membership; they received no claim of
future benefit.
14. See, e.g., Commissioner v. Fink, 483 U.S. 89, 97
* * * (1987) (contributors must intend “to protect or
increase the value of their investment in the
corporation”); In the Matter of Larson, 862 F.2d 112,
117 (7th Cir. 1988)(capital contribution characterized
- 29 -
by fact that investor expects to recoup her investment,
hopefully with a profit, in the event the corporation
is successful.
Id. at 773-774.
Explaining and applying Washington Athletic Club v. United
States, supra, the Court of Appeals noted:
Since members received no benefit through payment of
the surcharge other than the rights attendant to an
annual membership in the club, the members lacked an
“investment motive” in making the payments, and
therefore treatment of the monies received as a capital
contribution was inappropriate. [Id.]
The reasoning of Washington Athletic Club is
persuasive, and directly applicable here. The AMA’s
members received no continuing benefit from their
payments into the association equity account; the sum
paid as an annual membership fee entitled the member
only to the benefits of membership in the year of
payment. Therefore the funds placed in the association
equity account were current “income” of the AMA * * *.
[American Medical Association v. United States, supra
at 774.]
In reconciling the cases relied upon by petitioner and
respondent, we discern three objective factors whose presence
tends to support the existence of an investment motive: (1) The
fee in question is earmarked for application to a capital
acquisition or expenditure; (2) the payors are the equity owners
of the corporation and there is an increase in the equity capital
of the organization by virtue of the payment; and (3) the members
have an opportunity to profit from their investment in the
corporation.
- 30 -
The first factor is whether the payment is specifically
earmarked or applied to a capital acquisition or expenditure.
Webster’s Ninth New Collegiate Dictionary defines earmarking as
“to designate or set aside (funds) for a specific use or owner”.
The repealed excise tax on club dues15 and the regulations
thereunder provide an appropriate framework for giving content to
the concept of earmarking as it should be applied in this case.16
Section 4241 imposed an excise tax on club dues and section 4243
provided an exemption from the excise tax for members’ payments
for the construction or reconstruction of capital improvements.17
The structure for imposing the club dues excise tax and allowing
the capital expenditure exemption parallels the approach under
section 118 for differentiating payments for services from
capital contributions; amounts that corporate shareholders or
association members pay for the use of corporation or association
facilities and services are ordinary income to the recipient,
15
Secs. 4241 and 4243, and the regulations thereunder,
were repealed by sec. 301 of the Excise Tax Reduction Act of
1965, Pub. L. 89-44, 79 Stat. 145.
16
The Commissioner has recognized that Federal income tax
principles can be relevant to the consideration of Federal excise
tax issues. G.C.M. 37989 (June 22, 1979); G.C.M. 36046 (Oct. 9,
1974); G.C.M. 35442 (Aug. 16, 1973).
17
Congress enacted sec. 4243 to provide club dues excise
tax relief from the burdensome and heavy initial cost of
construction or reconstruction of a club facility, whereas
“charges which go to the upkeep and operation of social,
athletic, or sporting clubs [were to] continue to be taxable.”
Conf. Rept. 2596, 85th Cong., 2d Sess. 4437-4438 (1958).
- 31 -
whereas their payments in aid of capital improvements are capital
contributions.
The interpretive regulations under section 4243 stated that
the exemption applied to amounts paid for the retirement of
indebtedness (a mortgage loan, for example) incurred by reason of
the construction or reconstruction of any capital addition,
improvement or facility.18 Sec. 49.4243-2(b)(iii), Excise Tax
Regs. However, the regulations did not allow the exemption
unless the funds were earmarked for capital purposes. Id.In Atlanta Athletic Club v. United States, 277 F.Supp. 669(N.D. Ga. 1967), the court held that the board’s resolution to
divert 40 percent of future assessments to qualified purposes
allowed the payments so used to qualify for the exemption. The
court based its holding on the facts that the assessments were
based upon known existing needs, although no specific project was
stated, and the funds, although commingled with operating funds,
were held for future construction requirements.
In Gibbons v. United States, 277 F.Supp. 749 (S.D. Ill.
1967), the court held that there was insufficient earmarking for
the exception to apply where the members were not told that a
18
For payments made before Nov. 1, 1959, the regulation
stated that “Assessments paid for the retirement of indebtedness
(a mortgage loan, for example) incurred by reason of the
construction or reconstruction of any such facility * * * are
considered to be assessments for construction or reconstruction.”
Sec. 49.4243-2(a), Excise Tax Regs.
- 32 -
specific portion of fees would be set aside for capital
improvements, and all income and receipts were commingled. The
court stated that “the amount or proportion to be used for
capital improvements must be stated at the time of ‘assessment’
and earmarked for that purpose at the time of receipt.”
In Maryland Country Club, Inc. v. United States, 75-2 USTC
par. 16,190 (D. Md. 1975), judgment revd. 539 F.2d 345 (4th Cir.
1976), the court, after examining the above- cited cases19,
concluded that there were three basic conditions of earmarking:
First, there must be a definite commitment to engage in some
capital construction; second, at the time of the initial payment,
both the club and the member must be operating under the
19
In addition to the above-cited cases, the court also
examined Cactus Heights Country Club v. United States, 280
F.Supp. 534 (D.S.D. 1967)(holding that a resolution, prior to
collection of the funds, to apply 80 percent of the funds
collected to capital improvements was sufficient to bring that 80
percent within the exception), and Pinehurst Country Club v.
United States, 248 F.Supp 690, 692-693 (D. Colo. 1965). The
court said that Pinehurst was probably at the clearly qualified
end of the scale of acceptable earmarking, stating that,
“Although earmarking was not in question in that case, the
earmarking which did occur and which was plainly acceptable
serves as a useful example in other cases.” Maryland Country
Club, Inc. v. United States, 75-2 USTC par. 16,190, at 88,952 (D.
Md. 1975), judgment revd. 539 F.2d 345 (4th Cir. 1976). In
Pinehurst the new members, in addition to paying dues, had an
option of paying an assessment for capital improvements and
construction in cash or in installments. The amounts paid as
capital contributions were accounted for separately and deposited
in a separate escrow bank account, and thereafter were
transferred directly from the escrow account to a construction
account at which time members who had paid construction
assessments were credited with the amounts not used.
- 33 -
assumption that the funds so collected will be used for capital
purposes; and, three, the funds must be accounted for at the time
of payment and held for that purpose and for no other purpose.
Using this test, the court held that the earmarking requirement
had not been met because the club used the amounts in the capital
accounts for operating expenses. The court held that this use
related back to and invalidated the initial purported earmarking.
In light of this history, we conclude that petitioner’s
procedures for the collection, accounting, and use of the
transfer fees provide sufficient assurance that the transfer fees
are dedicated to the required purpose of reducing petitioner’s
mortgage debt, in accordance with the requirements of rule 243.
As in Maryland Country Club v. United States, supra, petitioner’s
rule 243 illustrates petitioner’s definite commitment to engage
in a capital use with the funds; i.e., the retirement and
redemption of the CBOT building indebtedness, which was incurred
to finance capital construction projects. Both petitioner and
its members are aware that the transfer fees are collected for a
designated purpose. Prospective members are given a copy of, and
tested on, petitioner’s rules, including rule 243. Finally, the
fees are accounted for separately from operating revenues. They
are accounted for by book entries as “restricted capital”. The
funds are held in these accounts until petitioner makes a
mortgage principal payment in an amount greater than the amounts
- 34 -
in the book entries. Only then are the amounts in the book
entries reclassified as “unrestricted capital”. The bylaw
restriction in rule 243 and the accounting ledger accounts
sufficiently restrict the amounts of the transfer fees collected
until an equal amount is paid toward the mortgage principal.20
We thus conclude that petitioner's rule 243 and its accounting
procedures sufficiently earmark the transfer fees for use in
reducing its mortgage debt, a designated capital expenditure.
The second factor is whether the equity interest of the
members increased because of the contribution to the membership
organization. There is no dispute that petitioner's members are
the equity owners of petitioner. They have voting rights and
liquidation rights according to the interest held, and their
interests are freely transferable to qualified purchasers or
transferees. Because petitioner's largest liability is the
mortgage on the CBOT building, any decrease in that liability
directly increases petitioner's members' equity. The transfer
fees accounted for over $300,000 of the mortgage principal
20
The Commissioner in Maryland Country Club v. United
States, supra, argued that earmarking, under sec. 4243, required
that the taxpayer record the funds in a separate bookkeeping
account, which was to be matched by available qualified funds in
a bank account, and/or to designate funds as capital
contributions by some formal mechanism such as a bylaw. In the
case at hand, petitioner records the transfer fees in separate
bookkeeping accounts, which are always matched by available
qualified funds in its general bank account, and the transfer
fees are designated as capital contributions by petitioner’s rule
243.
- 35 -
payments made in each of the taxable years. The members' equity
accounts increased each year by an amount no less than the
transfer fees collected.
Respondent argues that the members cannot have an investment
motive because they enjoy no right to any return of the amount of
transfer fees paid in connection with that membership. We are
not persuaded. There is no requirement that the payments
directly increase the individual payor's equity interest on a
dollar-for-dollar basis. Nor is there any requirement that a
member must have a right to recover from petitioner the amount of
the transfer fee paid.21 Although an individual member's
interest does not directly reflect the amount of transfer fees
paid in connection with that membership, members' equity as a
whole is increased by each transfer fee paid. See Concord
Village, Inc. v. Commissioner, 65 T.C. 142, 156 (1975). We are
21
Respondent seems to be arguing that, in order for the
transfer fees to be capital contributions, petitioner must
maintain a capital account for each member that directly reflects
the actual amounts paid in respect of that particular membership
interest. Petitioner is a corporation, not a partnership. There
is no such requirement for corporations. A corporation is a
separate legal entity, whereas a partnership is an aggregate of
its partners. Partnership capital accounts reflect what each
partner can draw from the partnership. A corporation does not
have individual drawing accounts for each of its shareholders.
Any shareholder simply has an ownership interest in this separate
entity represented by the number of shares owned by him.
- 36 -
satisfied that the transfer fees enhance the equity interests of
petitioner’s members.22
The third factor is whether the payor has an opportunity to
profit from the appreciation in his investment. The CBOT
memberships are freely transferable, allowing the members to
realize a profit from any appreciation of their investment.23
22
Respondent relied heavily on Rev. Rul. 77-354, 1977-2
C.B. 50, arguing that it requires a finding here that the
transfer fees are not capital contributions. A revenue ruling is
nothing more than respondent’s litigation position, Stark v.
Commissioner, 86 T.C. 243, 250-251 (1986); however, the revenue
ruling cited actually supports petitioner’s position in this
case. In Rev. Rul. 77-354, the Internal Revenue Service
overruled its position in G.C.M. 4015, VII-1 C.B. 120 (1928), in
holding that a securities exchange’s initiation fees were not
capital contributions. The Service based its holding on the
facts that neither new members nor existing members derived any
enhanced equity value by virtue of the payment, the funds were
not earmarked or restricted in their use to capital expenditures,
and the fees bore no relation to the capital needs of the
exchange. Here, petitioner’s members do derive an enhanced
equity value by virtue of the payment of the transfer fee, the
funds are earmarked or restricted in their use to a capital
expenditure, and the fees bear a relation to the capital needs of
the exchange, the mortgage indebtedness. In earlier rulings, the
Service had concluded that fees paid by members to membership
organizations were capital contributions where members held
substantial equity rights in the organizations and the payments
enhanced the members’ collective interest in the organization.
Rev. Rul. 72-132, 1972-1 C.B. 21 (membership certificates sold by
an unincorporated securities exchange); Rev. Rul. 74-563, 1974-2
C.B. 38 (special assessments levied by a homeowners association
to pave a community parking lot); Rev. Rul. 75-371, 1975-2 C.B.
52 (special assessments levied by a condominium to replace the
outdoor furniture surrounding the swimming pool).
23
The facts of the case at hand are more compelling in
justifying capital contribution treatment than many of the above
cited cases because the CBOT members suffer no restriction on
their rights to retain the entire proceeds of sale of their
(continued...)
- 37 -
Over 35 percent of petitioner's members do not trade on
petitioner's exchange, but instead hold their interests for
investment. The majority of these members lease their trading
privileges to others, but approximately 16 percent of the members
neither use their trading privileges nor lease them to third
parties, apparently expecting to realize a profit on the ultimate
disposition of their memberships.
The transfer fees are used to amortize the debt on a
revenue-raising asset, the CBOT building. Petitioner leases 80
to 85 percent of the space in the CBOT building to third parties.
The leases generate substantial rental income to petitioner. The
CBOT building also houses the trading floor, which generates
transaction fees, petitioner’s primary source of revenue. It is
clear that members’ payments of assessments to finance initial
construction of those assets would have been contributions to
capital because they would have increased the members’ equity in
23
(...continued)
interests. Some of the members’ interests in the cases discussed
above, even those allowing capital contribution treatment, were
subject to such a restriction. Cf. Concord Village, Inc. v.
Commissioner, 65 T.C. 142 (1975); United Grocers, Ltd. v. United
States, 308 F.2d 634 (9th Cir. 1962); Washington Athletic Club v.
United States, 614 F.2d 670 (9th Cir. 1980); Affiliated
Government Employees Distrib. Co. v. Commissioner, 37 T.C. 909(1962), affd. 322 F.2d 872 (9th Cir. 1963); Oakland Hills Country
Club v. Commissioner, 74 T.C. 35 (1980). The restriction on the
amount of profit a member can make from his transfer of an
interest attenuates the members’ financial interest in the equity
of the organization. There is no such restriction in the case at
hand.
- 38 -
petitioner and directly paid for capital assets used for the
production of income in petitioner’s trade or business, and there
would have been no tenable argument that the payments were in
consideration for goods or services. The transfer fees, paid at
the time of the acquisition of a membership, reduce the principal
of the mortgage debt on the CBOT building each year. The
periodic collection of the transfer fees is the equivalent of
installment payments for the building. We fail to see a
significant difference where petitioner's members make their
capital contributions in “installments instead of all at once."
See Lake Forest, Inc. v. Commissioner, T.C. Memo. 1963-39; see
also sec. 49.4243-2(a), Excise Tax Regs. supra note 18, which
equate amounts paid to retire mortgage indebtedness incurred to
finance construction or reconstruction of capital improvements
with exempt payments for capital improvements.
Petitioner's members have not paid dues since at least 1990.
The dues were eliminated because of a surplus in petitioner's
operating revenues, largely attributable to petitioner’s lease
revenues and transaction fees. The nonpayment of dues is a form
of additional profit to the members. See Minnequa Univ. Club v.
Commissioner, T.C. Memo 1971-305. The transfer fees, therefore,
help finance the major sources of petitioner's revenues and
directly increase the members' profit potential from their
investment.
- 39 -
We conclude that the transfer fees are primarily paid with
an investment motive. Although there may be some attenuated and
incidental senses in which the transfer fees may be paid in
consideration for services rendered and to be rendered, we hold,
on balance, that the transfer fees paid to petitioner are paid
primarily to reduce petitioner’s mortgage debt, which was
incurred to finance capital improvements. The transfer fees are,
therefore, nontaxable contributions to petitioner's capital and
are not includable in gross income.
To reflect the foregoing,
Decision will be entered for
petitioner.