Held, T corp. was not a mere conduit in respect of certain interest payments received by it; such payments were includable in its own "gross income," with the consequence that it qualified as a personal holding company under sec. 542, I.R.C. 1954, and thereby became subject to the special tax imposed by sec. 541 on its undistributed *176 personal holding company income.
John R. Berman, for the petitioner.
David W. Johnson, *177 for the respondent.
Raum, Judge.
RAUM
*766 The Commissioner determined deficiencies of $ 10,703.71 and $ 15,324.71 in petitioner's Federal corporate income taxes for the fiscal years ended June 30, 1967, and June 30, 1968, respectively. At issue is whether during each of those years petitioner was*178 a "personal holding company" within the meaning of section 542, I.R.C. 1954, and therefore, subject to the special tax imposed on such corporations by section 541.
FINDINGS OF FACT
The parties have filed a stipulation of facts along with exhibits which are incorporated herein by this reference.
Petitioner is a Massachusetts business trust located in Revere, Mass. Taxable as a corporation, it filed Federal corporate income tax returns for the fiscal years ended June 30, 1967, and June 30, 1968, with the Internal Revenue Service Center, Andover, Mass.
During the years in issue petitioner's business activities appear to have been confined primarily, if not exclusively, to the rental of real property. Such property comprised nearly all of its assets with the exception of certain loans receivable hereinafter *767 described. Its sole reported gross income for the tax years was as follows:
FYE
FYE
June 30, 1967
June 30, 1968
Rents
$ 61,764.00
$ 84,147.30
Miscellaneous
203.51
9.54
61,967.51
84,156.84
At all relevant times, Alice Bell and Gussie Bell each owned one-half of petitioner's outstanding stock.
Abel Ford, Inc. (Abel Ford), and Bell Oldsmobile, Inc. *179 (Bell Olds), were two corporations which owned and operated retail automobile dealerships. At all relevant times, the stock of these corporations was also held by members of the Bell family. Thus, in April 1964, Alexander Bell, Alice's husband, and his brother Morris Bell, Gussie's husband, each owned one-half of the stock of Abel Ford. In September 1967, after the death of Alexander Bell, one-third of the stock of Abel Ford was held by each of the following: Morris Bell, the estate of Alexander Bell, and Sidney Weiner. Weiner, son-in-law of Alexander and Alice Bell, had served as president and general manager of Abel Ford since its inception in 1961. In September 1967, the stock of Bell Olds was equally divided between Alice Bell (who had succeeded to the interest of her deceased husband, Alexander) and Morris Bell.
In April of 1964, Abel Ford was in a poor cash position and needed additional financing. Unsuccessful efforts were made to secure that financing from the National Shawmut Bank which had been serving as Abel Ford's primary source of working capital. After other efforts to obtain funds proved equally fruitless, M. G. Sherman, a financial adviser and accountant employed*180 by the Bell family and its businesses, recommended that petitioner borrow money to enable it to, in turn, provide funds to Abel Ford.
In accordance with this suggestion, on or about April 16, 1964, petitioner borrowed $ 250,000 at 5 3/4-percent interest from the Charlestown Savings Bank, Boston, Mass. (Charlestown), executing a note in that amount and granting Charlestown a mortgage on certain real estate petitioner owned. Although Charlestown engaged in this type of mortgage lending, it was not a commercial bank and did not extend open lines of credit to businesses. Abel Ford owned no real estate.
*768 The proceeds obtained from Charlestown were applied as follows:
These distributions were carried as loans receivable on petitioner's books and records, and loans payable on the books and records of Bell Olds and Abel Ford to the extent of their respective distributions. Petitioner did not receive any notes or security in respect of these distributions.
*183 During the negotiations for this latest loan from Charlestown to petitioner Weiner provided the bank with financial statements of Abel Ford and Bell Olds. In addition, he advised Charlestown that the proceeds not used to repay petitioner's outstanding indebtedness would be distributed to those corporations. However, neither Bell Olds nor Abel Ford endorsed petitioner's note to Charlestown or otherwise guaranteed that indebtedness.
Shortly thereafter, on or about October 16, 1967, to satisfy certain requirements imposed by General Motors, Morris Bell personally assumed responsibility for the repayment of the $ 51,653.80 which Bell Olds had received from petitioner, as well as the interest thereon from September 5, 1967, to October 16, 1967, and certain legal fees incurred in connection with the indebtedness which together totaled $ 534.02. This transaction was treated on the books of Bell Olds as a contribution to capital of $ 50,000 and a loan of $ 2,187.82 from Morris Bell.
At all relevant times only petitioner was liable for the repayment of the indebtedness to Charlestown. Petitioner paid the entire amount of each monthly installment (consisting partly of interest and partly*184 of the repayment of principal) due thereon. About the time each such payment became due, however, Abel Ford and Morris Bell paid to petitioner amounts designated *770 interest and repayment of principal in respect of the amounts which had been distributed to Abel Ford and Bell Olds. The amounts as paid by Abel Ford bore the same ratio, respectively, to the interest and principal payments made by petitioner to Charlestown, as the amounts which had been distributed to Abel Ford bore to the total amounts petitioner borrowed from Charlestown. The amounts paid to petitioner by Morris Bell were similarly related to the portion of the proceeds from the Charlestown loans which had been distributed to Bell Olds. The effect of determining the interest and principal payments of Abel Ford and Morris Bell in this manner was to impose upon them the same interest rates and payment schedules applicable to the repayment of petitioner's loans from Charlestown.
In this manner, petitioner received principal and interest payments from Abel Ford, during the fiscal year ended June 30, 1967, in the amounts of $ 5,882.74 and $ 10,068.62, respectively. During the same fiscal year petitioner paid *185 Charlestown $ 13,495.73 designated repayment of principal and $ 14,608.27 designated interest.
During the fiscal year ended June 30, 1968, matters were complicated somewhat by the refinancing that occurred on or about August 31, 1967, and the subsequent distributions in September 1967, to Abel Ford and Bell Olds. Thus, in respect of the situation prior to those events, petitioner received principal and interest payments of $ 1,352.59 and $ 1,305.97, respectively, from Abel Ford, and paid to Charlestown $ 2,325.52 in repayment of principal and $ 4,024.89 of interest. In respect of the situation after the refinancing and additional distributions in 1967, the following occurred: petitioner received principal and interest payments of $ 5,820.86 and $ 9,635.02, respectively, from Abel Ford; petitioner received from Morris Bell $ 1,614.35 designated repayment of principal and $ 2,612.31 designated interest in respect of the distributions to Bell Olds; and petitioner paid Charlestown $ 12,050.61 in repayment of principal and $ 16,266.39 of interest.
On its Federal corporate income tax returns for the fiscal years ended June 30, 1967, and June 30, 1968, petitioner did not include in gross*186 income any of the amounts constituting interest which it had received from Abel Ford or Morris Bell during those years. On each of those returns, however, it claimed deductions for interest paid only in the amount by which in that year the *771 interest it paid to Charlestown exceeded the interest which it received from Abel Ford and Morris Bell.
In his deficiency notice the Commissioner made the following determinations:
It is determined that you should have reported as interest income in the year June 30, 1967, $ 10,068.12 received from Abel Ford, Inc. in respect of its indebtedness to you. You improperly treated such amount as an offset to interest expense. Since the $ 10,068.12, represents more than 10 percent of your ordinary gross income, and no dividends were paid, your adjusted income from rents constitutes personal holding company income and the total personal holding company income exceeds 60 percent of the adjusted ordinary gross income. Therefore, you qualify as the personal holding company * * * subject to the personal holding company tax under Section 541 of the Code.
It is determined that you should have reported as interest income in the year ended June 30, *187 1968, $ 10,940.99 received from Abel Ford, Inc. and $ 2,612.31 received from Morris E. Bell in respect of their indebtedness to you. You improperly treated such amounts as an offset to interest expense. Since the $ 13,533.30 represents more than 10 percent of your ordinary gross income, and no dividends were paid, your adjusted income from rents constitutes personal holding company income and the total personal holding company income exceeds 60 percent of the adjusted ordinary gross income. Therefore, you qualify as a personal holding company * * * subject to the personal holding company tax * * *
OPINION
The ultimate issue in this case is whether, for the taxable years, petitioner was a "personal holding company." If so, then it was subject to the 70-percent tax imposed by section 541, I.R.C. 1954, on the undistributed personal holding company income of every personal holding company, and, as the parties have stipulated, there are deficiencies in the amounts determined by the Commissioner. Section 542(a) defines "personal holding company" to mean any corporation satisfying the following requirements:
(1) Adjusted ordinary gross income requirement. -- At least 60 percent of its*188 adjusted ordinary gross income (as defined in section 543(b)(2)) for the taxable year is personal holding company income (as defined in section 543(a)), and
(2) Stock ownership requirement. -- At any time during the last half of the taxable year more than 50 percent in value of its outstanding stock is owned, directly or indirectly, by or for not more than 5 individuals. * * *
The parties have stipulated that petitioner satisfied the stock ownership requirement during each of the relevant years. They disagree, however, as to whether petitioner also met the first test *772 relating to the composition of its "adjusted ordinary gross income."
*190 However, it is not necessary for us to trace our way through these various highly complicated statutory provisions, for there is no dispute between the parties as to their application here at each step, the sole issue between them being merely whether in the first instance the interest payments which petitioner received from Abel Ford and Morris Bell were includable in petitioner's "gross income." If such payments were thus includable, it is agreed by both parties that the "adjusted ordinary gross income" requirement of section 542(a)(1) has been satisfied. We therefore proceed directly to a consideration of the crucial issue whether *773 the Commissioner correctly included these interest payments in petitioner's "gross income."
There is no controversy between the parties that "gross income" must be determined in accordance with the definition contained in section 61 of the Code. And that definition explicitly states that gross income "means all income from whatever source derived, including (but not limited to) the following items: * * * (4) Interest." Accordingly, it would plainly appear to follow that the items of interest received by petitioner from Abel Ford and Morris*191 Bell must be included in its gross income, thus putting an end to the entire controversy herein. Petitioner, however, argues that it should not be treated as having received any such interest, that it was a mere conduit in respect of the loans to Abel Ford and Bell Olds, and that to the extent that interest was paid by Abel Ford and Morris Bell (on behalf of Bell Olds) it was received by petitioner merely as a conduit for transmission to the Charlestown Savings Bank. We do not so view the transaction.
To be sure, petitioner's borrowings from Charlestown were motivated in large part by its intention to make the greater portion of the loan proceeds available to Abel Ford and Bell Olds. Moreover, in view of the close family situation there was no disposition to charge Abel Ford and Bell Olds a higher rate of interest than petitioner was required to pay to Charlestown. Also, Charlestown obviously was aware that the larger portion of the proceeds would find its way into the hands of Abel Ford and Bell Olds. But Charlestown made its loans to petitioner only -- loans that were secured solely by petitioner's real estate and which were in no way guaranteed by Abel Ford or Bell Olds. *192 The obligation to repay those loans was exclusively that of petitioner, and it was petitioner alone that was liable to Charlestown in respect of the interest on those loans. Neither Abel Ford nor Bell Olds had any obligation to Charlestown. Their obligations ran to petitioner. It was petitioner alone that had the right to compel repayment of the amounts which it advanced to or on behalf of Abel Ford and Bell Olds, and it was petitioner alone that had the right to receive interest on those loans. *774 received such interest, it became petitioner's gross income.
*193 Of course, petitioner had a right to a deduction under section 163 for interest which it paid to Charlestown. And, as a consequence, the interest that it received from Abel Ford and Bell Olds was offset by the corresponding deduction to which it was entitled when it paid its interest to Charlestown. But petitioner was not a conduit. The obligations were separate and distinct. The Code is so constructed that items of income must be included in "gross income," notwithstanding that available deductions may neutralize their tax consequences for purposes of the ordinary income tax.
2. To the extent involved herein, sec. 543(a) provides:
SEC. 543. PERSONAL HOLDING COMPANY INCOME.
(a) General Rule. -- For purposes of this subtitle, the term "personal holding company income" means the portion of the adjusted ordinary gross income which consists of:
(1) Dividends, etc. -- Dividends, interest, royalties (other than mineral, oil, or gas royalties or copyright royalties), and annuities. * * *
* * *
(2) Rents. -- The adjusted income from rents; except that such adjusted income shall not be included if --
(A) such adjusted income constitutes 50 percent or more of the adjusted ordinary gross income, and
(B) the sum of --
(i) the dividends paid during the taxable year (determined under section 562),
(ii) the dividends considered as paid on the last day of the taxable year under section 563(c) (as limited by the second sentence of section 563(b)), and
(iii) the consent dividends for the taxable year (determined under section 565),
equals or exceeds the amount, if any, by which the personal holding company income for the taxable year (computed without regard to this paragraph and * * *) exceeds 10 percent of the ordinary gross income.↩
3. The separate character of these loans is underscored by the fact that if there had been a default in the repayment of petitioner's loans to Abel Ford and Bell Olds, petitioner would still have remained liable on its obligation to repay the entire indebtedness to Charlestown; similarly, a default on the part of petitioner to pay its debt to Charlestown would not have relieved Abel Ford and Bell Olds from their obligation to petitioner.↩
4. It could be quite possible that even for ordinary income tax purposes the tax consequences would not be completely neutralized in all circumstances. Thus, if interest owed by Abel Ford and Bell Olds were paid to petitioner on the last day of petitioner's tax year and if petitioner in turn paid the interest owed by it to Charlestown on the following day, petitioner would be required to report as income in the earlier year the amounts of income paid to it, but might be entitled to the offsetting deductions only on its return for the later year, with possibly different tax consequences. Of course, such result would depend upon petitioner's being a cash basis taxpayer, a fact that has not otherwise been established on this record. In any event, regardless of whether this particular petitioner were on the cash basis, the point is that such discrepancy would be possible in the case of a similarly situated cash basis taxpayer, thus emphasizing the absence of a true conduit role in circumstances like those present here.↩
5. Petitioner also relies on Commissioner v. Kresge Department Stores, Inc., 134 F. 2d 76 (3d Cir.), reversing 44 B.T.A. 1210">44 B.T.A. 1210, certiorari denied 319 U.S. 761">319 U.S. 761, in which, on distinguishable facts, the court held that amounts the taxpayer corporation received from various department stores (primarily those owned by corporations in which it held stock) in reimbursement of expenses incurred in operating a central buying office for their benefit were not includable in its gross income. In reaching that result the court relied not solely on the equivalence of expenditures and reimbursements, but also on the particular relationship between the taxpayer corporation and the various entities involved. Indeed, the court distinguished without criticizing Andrew Jergens Co., 40 B.T.A. 868↩, where on somewhat different facts the opposite result had been reached.