Montgomery Co. v. Commissioner

The Montgomery Co., Petitioner v. Commissioner of Internal Revenue, Respondent

Montgomery Co. v. Commissioner

Docket No. 4328-67

United States Tax Court

54 T.C. 986; 1970 U.S. Tax Ct. LEXIS 143;

May 14, 1970, Filed

---

Decision will be entered under Rule 50.

1. Held, a certain lease cancellation payment of $ 10,000 in 1962 was made solely for the purpose of acquiring a new, more lucrative lease from a new tenant, the TraveLodge Corp.; consequently, the payment should be amortized over the life of the new TraveLodge lease.

2. Held, petitioner's earnings and profits for the taxable years 1962 through 1964 were not permitted to accumulate beyond the reasonable needs of petitioner's motel venture business including the reasonably anticipated needs of such business. Held, further, in view of the credit provided for in sec. 535(c)(1) of the 1954 Code, it is unnecessary to consider whether petitioner was formed or availed of for the proscribed purpose and, therefore, petitioner is not liable for the accumulated-earnings tax imposed by sec. 531. See secs. 531 through 537 of the 1954 Code.

D. Paul Alagia, Jr., and J. Bernard Brown, for the petitioner.

W. Gerald Thornton, for the respondent.

Bruce, Judge.

---

BRUCE

Respondent determined deficiencies in income tax for the taxable years ended December 31, 1962, 1963, and 1964, of $ 1,694.62, $ 4,965.47, and $ 4,467.65, respectively.

Two issues are presented:

(1) Is a certain "lease cancellation expense" of $ 10,000 incurred and paid by petitioner in 1962 deductible over a 2-year period as claimed by petitioner, or over a 25-year period as determined by the respondent?

(2) Was petitioner, during the taxable years, availed of for the purpose of avoiding income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being divided or distributed, so as to be subject to the accumulated-earnings tax imposed by section 531 of the Internal Revenue Code of 1954? ¹

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

Petitioner is a corporation organized and existing under the laws of the Commonwealth of Kentucky and, at the time of the filing of the petition, had its principal office and place of business at Second and Liberty Streets, Louisville, Jefferson County, Ky.

Petitioner filed its Federal income tax returns (Form 1120) for the taxable years ended December 31, 1962, 1963, and 1964, with the office of the district director of internal revenue, Louisville, Ky.

Petitioner was organized on January 26, 1948, under the name Montgomery Auto Co., to engage in the business of retail sale of automobiles and trucks under a franchise from the Chevrolet Motor Division of General Motors Corp. On May 30, 1952, the corporate name was officially changed to Montgomery Chevrolet, Inc. On July 15, 1953, petitioner changed its name to The Montgomery Co. and thereafter transferred its operating assets, exclusive of the real estate, plant and buildings, and insurance business, to a new corporation known as Montgomery Chevrolet, Inc., hereinafter sometimes referred to as Chevrolet. The insurance business was sold to Hufnagel & Stivers Insurance, Inc., on May 1, 1964.

During the years in issue, the total outstanding stock of petitioner was owned as follows:

	Number of shares
Name
	1962	1963	1964
Louise C. Montgomery	598 1/2	565 1/2	532 1/2
Schuhmann A. Montgomery	87 1/2	93	98 1/2
Richard L. Montgomery	87 1/2	93	98 1/2
Robert A. Montgomery	59 1/2	65	70 1/2
Herbert A. Montgomery	38 1/2	38 1/2	38 1/2
Rita L. Montgomery	38 1/2	44	49 1/2
Mary L. Montgomery	16 1/2	22	27 1/2
Suzanne M. Obergefell	16 1/2	22	27 1/2
Total shares outstanding	943	943	943

Louise C. Montgomery is the mother of the other seven stockholders of petitioner and is also the mother of Raymond E. Montgomery, Jr., a stockholder of Chevrolet but not a stockholder of petitioner. Herbert A. is also known as Adolph, and Raymond E. is also known as R.E. At the time of the trial herein Louise was 67 years of age and in reasonably good health.

During the years in issue, the directors of petitioner were as follows:

Name	1962	1963	1964
Louise C. Montgomery	x	x	x
Schuhmann A. Montgomery	x	x	x
Richard L. Montgomery	x	x	x
Robert A. Montgomery			x
Herbert A. Montgomery			x

During the years in issue, the officers of petitioner and the compensation paid to them by petitioner were as follows:

	Salary paid
Name and position
	1962	1963	1964
Louise C. Montgomery, president	$ 3,000	$ 3,000	$ 3,000
Schuhmann A. Montgomery, vice president	4,050	0	0
Richard L. Montgomery:
Secretary-treasurer (up to 4/6/64)	0	0
Secretary (since 4/6/64)
Robert A. Montgomery, treasurer (since 4/6/64)

Chevrolet, which was organized in 1953 to operate the Chevrolet Automobile Dealership business, has continued to operate such business to and including the taxable years in issue. During the years in issue, the outstanding stock of Chevrolet was owned as follows:

	Number of shares
Name
	1962	1963	1964
Louise C. Montgomery	840	790	740
Raymond E. Montgomery, Jr	1,150	1,174	1,200
Schuhmann A. Montgomery	225	225	215
Herbert A. Montgomery	198	223	258
Total shares outstanding	2,413	2,412	2,413

During the years in issue, the directors of Chevrolet were as follows:

Name	1962	1963	1964
Raymond E. Montgomery, Jr	x	x	x
Herbert A. Montgomery	x	x	x
Louise C. Montgomery	x	x	x
Schuhmann A. Montgomery	x	x	x

The officers of Chevrolet and the compensation paid to them by Chevrolet during the years in issue were as follows:

Name and position	1962	1963
President:
Raymond E. Montgomery, Jr	$ 18,700.92	$ 18,719.04
Vice president:
Herbert A. Montgomery (1/1/62 to 5/31/62)	4,252.20
Louise C. Montgomery (since 6/1/62)	1,997.44	7,422.72
Secretary-treasurer:
Schuhmann A. Montgomery (1/1/62 to 5/31/62)	6,300.00
Herbert A. Montgomery (since 6/1/62	4,200.00	8,935.28
Assistant secretary-treasurer:
Louise C. Montgomery (1/1/62 to 5/31/62)	1,997.44
Total	37,448.00	35,077.04

Name and position	1964
President:
Raymond E. Montgomery, Jr	$ 18,716.82
Vice president:
Herbert A. Montgomery (1/1/62 to 5/31/62)
Louise C. Montgomery (since 6/1/62)	7,412.40
Secretary-treasurer:
Schuhmann A. Montgomery (1/1/62 to 5/31/62)
Herbert A. Montgomery (since 6/1/62)	11,832.66
Assistant secretary-treasurer:
Louise C. Montgomery (1/1/62 to 5/31/62)
Total	37,961.88

Petitioner owns and, during the years in issue, did own real estate located on the north and south sides of Liberty Street and on the east side of Second Street in the City of Louisville, Ky.

On July 16, 1953, this property was leased to Chevrolet for a term of 5 years beginning on July 16, 1953, and ending on July 15, 1958, with an option to renew for an additional 5 years. The monthly rental stated therein was $ 2,000 per month.

On July 16, 1958, which was the renewal date of the 1953 lease, petitioner and Chevrolet executed a new lease of the same premises for a term of 2 years, with an option to renew for an additional 2 years. The monthly rental remained at $ 2,000.

Again, on July 16, 1960, which was the renewal date of the 1958 lease, the parties executed a new lease agreement for an additional 2 years with an option of renewal "provided, however, that the tenant must exercise the said option for renewal of this lease for the additional term of two years by giving notice in writing to the landlord of its exercise of the said option at least sixty days (60) in advance of the 15th day of July 1962." The monthly rental remained at $ 2,000.

On December 26, 1961, the TraveLodge Corp. of San Diego, Calif., hereinafter sometimes referred to as TraveLodge, made to petitioner an "Offer to lease" that certain parcel of land then under lease to Chevrolet situated on the southeast corner of Second and Liberty Streets, being approximately 48,970 square feet of building area, for a term of 49 years at a rental of $ 1,000 per month. The offer stated in part:

We propose to build a 100 unit motor-hotel on said property in accordance with plans and specifications to be prepared by us and mutually approved by both owner and tenant.

We are to have the privilege of putting on said property, a first mortgage loan on the land and the improvements not to exceed the sum of $ 350,000.00, the proceeds of which will be used as part of the cost of the construction of the improvements.

In addition to the $ 1,000.00 per month rent, net, we will pay you an extra rent which shall be 7 1/2% of all gross income from said property over the sum of $ 160,000.00 per annum.

This Offer to Lease is subject to The TraveLodge Corporation being able to get a building permit for said building and including permission to install a standard TraveLodge sign of not less than 50 square feet in area.

The terms of the lease are to be in accordance with the sample documents mutually agreed upon or as revised in accordance with our conversation of this date.

The TraveLodge Corporation further agrees to deposit $ 2,000.00 which amount is to include the payment due on the first two months of the lease.

This offer is for acceptance within 10 days from date. Lease rental and construction to start March 1, 1962 or April 1, 1962.

This offer was not accepted by petitioner. Petitioner, however, on February 20, 1962, made an "offer to lease" to TraveLodge to be accepted within 10 days, which was substantially the same as the offer from TraveLodge, except that the lease was to be for a term of 25 years instead of 49 and "This offer to lease is also subject to a joint venture agreement to be negotiated (and to be approved by The Montgomery Co.) for the operation of said motor hotel."

On February 26, 1962, Schuhmann A. Montgomery addressed a letter to one of the real estate brokers, M. A. Powers, in which, among other things, he stated that "I think that you will agree that both you and I knew that the only major disagreement would arise over the commission asked on the lease" and "I wish that you would consider forwarding our 'Offer to Lease' signed by Louise C. Montgomery, President, to TraveLodge if for no other reason but to show that we are definitely trying to get together."

Powers answered Schuhmann's letter on the same day suggesting that petitioner agree to a 49-year lease or options of renewing and also that petitioner increase its "commission offer."

On February 28, 1962, petitioner executed an agreement with the two real estate brokers, and also received from TraveLodge an "Offer to Lease" to be accepted within 1 day, the said southeastern corner for a term of 25 years with an option to renew for an additional period of 24 years. Also, the offer to lease was to be subject to a joint venture agreement and petitioner was to pay the two real estate brokers $ 14,000 as commission for services rendered. This offer to lease was accepted by petitioner within the date set for acceptance.

On March 21, 1962, the entire board of directors of petitioner held a special meeting. Louise C. acted as chairman and Richard L. as secretary. The minutes of this meeting are, in part, as follows:

The Secretary stated that as a result of negotiations which officers of the company had with M. A. Powers and Richard Clark, real estate brokers, the company had accepted an offer from the TraveLodge Corporation of San Diego, California, to lease the company's land situated on the south side of Liberty Street and east of Second Street, being approximately 48,970 square feet, for a term of twenty-five (25) years at a basic net rental of $ 1,000.00 per month with extra rent to be paid at the rate of 7 1/2% of all gross income from the property in excess of the sum of $ 160,000.00 per annum, and subject to a joint venture agreement to be negotiated (and to be approved by the Montgomery Co.) for the operation of a TraveLodge Motor Hotel. The Secretary called attention to the fact that the company had executed a lease agreement with Montgomery Chevrolet, Inc. for occupancy of the company's real estate at Second and Liberty Streets and including the tract of land on the southeast corner of Second and Liberty Streets, together with other properties, for a rental of $ 2,000.00 per month and for a period, under the option granted to expire on July 15, 1962.

The Secretary reported that an amendment to the lease agreement has been executed by the Montgomery Chevrolet, Inc. confirming in writing the agreement of that company to vacate the premises (southeast corner of Second and Liberty Streets) upon ten (10) days notice and to extend the lease agreement on the remaining portion of the properties leased from this company for two years at a rental of $ 1,500.00 per month in consideration of the sum of $ 10,000.00 to be paid by this company to Montgomery Chevrolet, Inc. for vacating a portion of the property (southeast corner of Second and Liberty Streets) and to cover the expenses to be incurred in moving cars, parts, signs, and equipment, and the reinstallation of the same at a new location. * * *

[Emphasis added.]

On March 20, 1962 (one day prior to the above-mentioned special meeting), an agreement called "Amendment to Agreement of Lease" was entered into between Chevrolet as "first party" and petitioner as "second party." The agreement recited that Whereas the parties have heretofore entered into the lease dated July 16, 1960, due to expire on July 15, 1962, and Whereas the second party has agreed to lease a portion of the said property covered in the July 16, 1960, lease to TraveLodge, and the first party has agreed to release all of its right in said portion:

Now Therefore, in consideration of the foregoing * * * the parties hereto have mutually agreed as follows:

(1) The first party will upon ten (10) days notice * * * abandon, and vacate, and surrender, its right, title, interest and possession to the portion of the property * * * being approximately 48,970 square feet of land area.

(2) The first and second parties hereto mutually agree that the Lease Agreement providing for a monthly rental of $ 2,000.00 and which expires under the terms thereof on July, 1962, shall terminate at the expiration of the 10 days notice period as stated in paragraph 1 herein, and the parties agree that a new Lease Agreement shall forthwith be executed by the parties for a period of two years following the date of termination of the present lease with respect to the properties then occupied by the first party and owned by second party under terms and conditions substantially the same as are stated in the present lease, with exception of the amount of the rent which shall be adjusted and reduced to the amount of Fifteen Hundred Dollars (1,500.00) per month during the two-year term of the new lease.

(3) In consideration of the agreement of the first party to vacate and surrender a portion of the property leased from second party as provided in paragraph (1) herein and in further consideration of the extension of the lease for a period of two years at a rental of $ 1,500.00 per month by the second party as provided in paragraph (2) herein, the second party agrees to indemnify and/or reimburse the first party in the sum of $ 10,000.00 as indemnity for vacating a portion of the property and extending the lease on the remaining property, and to cover the cost and expenses incurred by first party in moving its used cars and other personal property from the vacated premises, and for the expense of removing electric lighting and electric signs from the said premises and the erection of the same at a new location, and for expenses in connection with the expense of removal and reinstallation of a car lift and air compressor.

[Emphasis added.]

On March 22, 1962, petitioner executed a lease agreement with TraveLodge leasing the southeast corner property to TraveLodge for a term of 25 years with an option to renew for an additional 24 years. The rent stated therein was $ 1,000 per month, plus an annual percentage rent equal to 7 1/2 percent of TraveLodge's gross receipts from the operation of its business on the premises in excess of $ 160,000 during each lease year. The lease was executed by TraveLodgein the City of San Diego, Calif., on March 27, 1962.

On April 5, 1962, a majority of the board of directors of Chevrolet held a special meeting. R. E. Montgomery, Jr., acted as chairman and Schuhmann A. as secretary. The minutes of this meeting are, in part, as follows:

The Chairman stated that The Montgomery Co. from whom the company has been leasing the premises at the southeast corner of Second and Liberty Streets has negotiated an agreement with the TraveLodge Corporation * * * and that in connection therewith the lease agreement which will expire on July 15, 1962, has been amended in a manner so as to obligate this company to vacate that portion of the premises * * * upon ten (10) days notice and the lease shall continue on the remaining portion of the property for an extended period of two years at a monthly rental of $ 1,500.00 per month, in consideration of which The Montgomery Co. will pay as indemnity and as a reimbursement fund to cover cost of moving cars, parts and for the removal and reinstallation of electric lighting, electric signs, car lift and air compressor, the sum of $ 10,000.00. A copy of the amendment to the agreement of lease was reviewed by the Chairman and after a discussion of the matter and upon motion made, seconded and carried, it was

Resolved: That the amendment to the agreement of lease be and the same is hereby approved and confirmed.

[Emphasis added.]

On April 20, 1962, petitioner gave notice to Chevrolet to abandon, vacate, and surrender its right, title, and interest and possession to the portion of the property to be leased to TraveLodge.

On May 1, 1962, petitioner executed an agreement of lease with Chevrolet leasing the property at the northeast corner of Second and Liberty Streets comprising about 28,963 square feet of improved property "for a term of two years beginning May 1, 1962, and ending April 30, 1964, with an option of renewal for a period of one year and eight months" at a rental of $ 1,500 per month.

On May 23, 1962, petitioner paid Chevrolet $ 10,000. Upon the advice of its accountants, petitioner treated the $ 10,000 payment to Chevrolet as deferred lease cancellation expense which was to be amortized and deducted over the 2-year term of the new lease with Chevrolet beginning May 1, 1962. In accordance with this advice petitioner deducted as "lease cancellation expense" on its returns for the taxable years in question the following amounts:

Year	Amount	How computed
1962	$ 3,333.33	8/24 of $ 10,000
1963	4,999.92	12/24 of $ 10,000
1964	1,666.75	4/24 of $ 10,000

Respondent determined that the $ 10,000 paid by petitioner to Chevrolet should be deducted over a 25-year period instead of a 2-year period. In the statement attached to the deficiency notice respondent advised petitioner as follows:

It is held that lease cancellation expense of $ 10,000.00 paid to Montgomery Chevrolet, Inc., in May 1962 is deductible over the 25-year period of the new lease to the TraveLodge Corporation rather than over the period of the amended lease to Montgomery Chevrolet, Inc. This determination results in adjustments to deductions claimed in the returns for lease cancellation expense for the years 1962, 1963 and 1964, computed as follows:

	1962	1963
Claimed per return	$ 3,333.33	$ 4,999.92
As corrected:
1962 -- ($ 10,000 / 300 mos.x8 beginning 5/1/1962)	266.64
1963 -- ($ 10,000 / 300 mos.x12)		400.00
1964 -- ($ 10,000 / 300 mos.x12)
Adjustment	3,066.69	4,599.92

	1964
Claimed per return	$ 1,666.75
As corrected:
1962 -- ($ 10,000 / 300 mos.x8 beginning 5/1/1962)
1963 -- ($ 10,000 / 300 mos.x12)
1964 -- ($ 10,000 / 300 mos.x12)	400.00
Adjustment	1,266.75

The payment by petitioner to Chevrolet of the $ 10,000 was paid to indemnify and reimburse Chevrolet for the expense of removing its property from the southeast corner of Second and Liberty Streets to a new location. It actually cost Chevrolet $ 11,846.78 to make the move.

Issue 2

On February 7, 1967, respondent mailed by certified mail to petitioner a letter pursuant to the provisions of section 534(b).

Within 60 days after mailing the notification under section 534(b), petitioner timely filed a statement intending to comply with the provisions of section 534(c).

On October 1, 1968, petitioner filed a motion wherein petitioner, by its counsel, "moves the Court to determine in advance of trial that in accordance with Section 534 * * * the burden of proof with respect to the allegation that all or a part of the petitioner's earnings and profits were permitted to accumulate beyond the reasonable needs of the business shall be upon the respondent particularly with respect to the grounds set forth in Exhibit B to the petition." This motion was denied on the basis of not sufficient facts as required by section 534(c).

Motel Venture. -- The new TraveLodge lease executed by petitioner on March 22, 1962, and by TraveLodge on March 27, 1962, provided that TraveLodge would construct a new 100-unit motor hotel on the premises. In order that TraveLodge might secure the funds needed for construction, petitioner agreed to permit TraveLodge to execute a mortgage on the subject property in an amount not in excess of $ 350,000. TraveLodge obtained its initial financing from Scott and Ellen Louise King. The final financing arrangement, however, was made with the Lincoln National Life Insurance Co., Fort Wayne, Ind. This refinancing required a cancellation of the documents previously executed by petitioner and TraveLodge; therefore, another lease with the same terms as the prior lease was executed by petitioner on January 9, 1963, and by TraveLodge on January 14, 1963.

In connection with the final financing arrangement, petitioner deeded its southeast corner property to TraveLodge on December 25, 1962. On December 26, 1962, TraveLodge mortgaged the property to Lincoln National Life Insurance Co. in the principal sum of $ 350,000. The lender also required an assignment of rents, which was executed by TraveLodge on the same date as the mortgage. On December 27, 1962, TraveLodge deeded the property back to petitioner subject to the mortgage.

On March 20, 1962, Montgomery Motel, Inc., a Kentucky corporation, hereinafter sometimes referred to as Motel, was organized as a wholly owned subsidiary of petitioner to operate the Louisville TraveLodge as a joint venture with TraveLodge Corp. Petitioner paid $ 10,000 for all the capital stock of Motel. During the years in issue, the directors of Motel were Louise C. Montgomery and her sons, Schuhmann, Richard, and Robert. The officers were: Louise C. Montgomery, president; Schuhmann, vice president; Richard, treasurer; and Robert, secretary.

On or about March 27, 1962, Motel and TraveLodge formed a general partnership under the laws of the Commonwealth of Kentucky to be known as Louisville TraveLodge. On the same day, the partners executed a joint venture agreement which stated its purpose as being the construction and operation of the Louisville TraveLodge. Among other things, the agreement provided for the distribution of losses and profits on a 50-50 basis, that depreciation deductions be apportioned between the parties in proportion to their capital contributions, and that the managerial duties with respect to the operation of the motel would be the responsibility of Motel.

On or about April 6, 1962, the joint venture agreement was supplemented whereby the joint venture agreed to be responsible for the repayment of the $ 350,000 loan arranged by TraveLodge and the cash contribution of Motel to the joint venture, as required by the joint venture agreement, was set at $ 190,000.

On April 1, 1963, TraveLodge assigned to the joint venture the lease of the southeast corner property which it had obtained from petitioner.

The Louisville TraveLodge (partnership) began its business operations on November 15, 1962. On that date Motel addressed a letter to TraveLodge, the body of which is as follows:

Enclosed is our check #118 for $ 40,000.00 to Louisville TraveLodge to be deposited to the Louisville TraveLodge account. This check will complete our $ 190,000.00 commitment in consideration for our undivided one-half interest in the Louisville TraveLodge.

We are going to welcome our first guest this evening and are looking forward to a successful operation in partners with the TraveLodge Corp. here in Louisville.

The Louisville TraveLodge reported ordinary income (or loss) after deductions, as follows:

Year ending --	Amount
Feb. 28, 1963	($ 2,781.42)
Feb. 29, 1964	52,293.22
Feb. 28, 1965	94,083.16

In order to obtain the $ 190,000 to contribute to the joint venture, Motel began negotiating a loan from the First National Lincoln Bank of Louisville, Ky. The minutes of a special meeting of petitioner's board of directors held on June 8, 1962, state the following:

Montgomery Motel, Inc. is negotiating a loan in an amount up to, but not to exceed, $ 190,000.00 from the First National Lincoln Bank of Louisville, Kentucky, to be used in the construction of the motel. The Secretary stated that the bank will make the said loan to the Montgomery Motel, Inc., provided, this corporation executes the note as an endorser or co-maker and also gives as collateral security a mortgage on a portion of the company's real estate (with the exception of the property located South of Liberty Street and East of Second Street upon which the motel is to be constructed and which property has heretofore been leased under agreement with the TraveLodge Corporation).

The board then authorized Schuhmann, vice president, or Richard, treasurer, to execute the note as an endorser or comaker and to execute the mortgage "to secure payment of a loan, not to exceed $ 190,000.00 to Montgomery Motel, Inc."

At a special meeting of the board of directors of Motel held on June 8, 1962, Schuhmann, acting as chairman, stated that "he considered it advisable to conclude arrangements for a loan" from the First National Lincoln Bank. Thereupon, the board resolved: "That this corporation borrow from the First National Lincoln Bank of Louisville, Louisville, Kentucky, a sum up to, but not to exceed, $ 190,000.00 * * * and that vice president, Schuhmann, or treasurer, Richard, of the company be, and he is hereby, authorized to execute this company's promissory note for an amount not to exceed $ 190,000.00."

On July 13, 1962, petitioner by Schuhmann, vice president, and Motel by Schuhmann, vice president, executed a note reading in part as follows:

For value received, the undersigned THE MONTGOMERY CO., a corporation, promise and agree to pay to THE KENTUCKY TRUST COMPANY, TRUSTEE, a corporation, or order, in legal tender of the United States of America, the sum of ONE HUNDRED NINETY THOUSAND AND NO/100 Dollars, with interest thereon at the rate of 5 1/2%, said sum payable as follows:

The principal and interest of this note being payable in monthly installments of $ 2,063.40; the first installment falling due January 1, 1963, and one such installment each month thereafter until 120 installments have been paid.

Petitioner also executed a mortgage on its northeast corner property to secure the above-mentioned note of $ 190,000.

Motel received all of the proceeds of the loan, which ultimately amounted to only $ 165,000 rather than $ 190,000; and the loan account was in the name of "Montgomery Motel, Inc. (Montgomery Co.)." Motel has made timely payment of all installments due except eight. Petitioner made the first two installments in 1963 totaling $ 5,613.62 and six installments in 1965 totaling $ 10,751.40 on behalf of Motel. Several months later, petitioner was reimbursed.

Although petitioner was willing to assume the risk incurred in connection with the motel venture with TraveLodge, it nevertheless viewed the risk as considerable because of TraveLodge's rapid growth and because they viewed the entire motel business as being rather risky. No one in connection with petitioner nor with Motel had any prior experience in the operation of a motel.

In 1962 there were two motels in existence on Second Street servicing the downtown area, and two others were being planned within a distance of four blocks.

Motel reported taxable income (or loss) on its U.S. Corporation Income Tax Returns, as follows:

Fiscal year ending --	Amount
Feb. 28, 1963	($ 17,709.67)
Feb. 29, 1964	2,493.60
Feb. 28, 1965	3,815.66

The amount of the monthly payment on the $ 165,000 note to the Kentucky Trust Co. was $ 1,791.90, making a total annual payment of $ 21,502.80.

On December 31, 1962, 1963, and 1964, there was a balance due on the loan from the Kentucky Trust Co. of $ 165,000, $ 154,428.23, and $ 139,942.03, respectively.

The balance due on the $ 350,000 note to Lincoln National Life Insurance Co. at the end of 1962, 1963, and 1964, was $ 350,000, $ 331,792.34, and $ 310,655.77, respectively.

The amount of the monthly payment on the $ 350,000 note was $ 3,506.73, making a total annual payment of $ 42,080.76.

During the years 1962, 1963, and 1964, the directors of petitioner watched the progress of Motel closely and determined that in view of the fact that its profits were so small and its obligations so large, petitioner could not afford to distribute any more than $ 3,000 in dividends during each of those years.

The minutes of the regular annual meeting of the board of directors of petitioner held on April 5, 1965, are, in part, as follows:

Consideration was then given by the Board to the question of declaration and payment of a dividend to the company's shareholders and after a discussion of this matter, and upon motion made, seconded and carried, it was

Resolved: That no dividend be declared at this time due to the need for the company to conserve its funds and resources because of its currently pending and contingent liabilities, including, but not limited to, the company's liability on mortgage executed on real estate on North side of Liberty Street to secure note of Montgomery Motel, Inc. payable to The Kentucky Trust Company in the principal amount of $ 139,942.03 at December 31, 1964; and the company's liability on the indebtedness of Montgomery Motel, Inc. (jointly with TraveLodge Corporation) to the Lincoln National Life Insurance Company in the principal balance of $ 306,997.86 as at February 28, 1965, and secured by mortgage on the real estate owned by The Montgomery Co. and located on the Northeast corner of Second and Liberty Streets in Louisville, Kentucky; and also the company's contingent liability as an endorser on note of RCR Leasing, Inc. payable to the First National Lincoln Bank for loan of $ 50,000.00.

Urban Renewal. -- Petitioner's property was located within the boundaries of the East Downtown Urban Renewal District of the City of Louisville; however, both tracts were designated "NTBA" (Not To Be Acquired) by the Louisville Urban Community Development Agency, hereinafter sometimes referred to as the Agency. The Agency gives this designation to property which will require very little, if any, improvements to meet its standards. Since the new motel was being constructed on the southeast corner property, the only improvement requirements made by the Agency related to the northeast corner property. This tract contained the showroom, offices, and service department of Chevrolet.

Jack D. Leeth, executive director of the Agency, described the general "sprucing up" type improvements which the Agency had requested petitioner to make on the northeast corner property as "Some point tucking outside, cleaning, placing doors, changing windows, taking signs down, things like this." This "sprucing up" would not have cost petitioner more than $ 20,000. Nothing so substantial as changing or rebuilding an entire wall was ever required.

As of the date of trial, petitioner had not yet made any of these improvements. The very same conditions remained that existed in 1962. Petitioner's board of directors had discussed the Agency's requirements, but no specific plans and no estimate of costs were ever made.

GENERAL FINDINGS

Petitioner had accumulated earnings and profits on December 31 of each of the following years, as follows:

	Accumulated	Increase over
Year	earnings	prior years
	and profits
1961	$ 269,604.26
1962	278,891.50	$ 9,287.24
1963	279,780.46	888.96
1964	295,180.87	15,400.41

Petitioner reported gross income, deductions, and taxable income, as follows:

	1962	1963	1964
Interest	$ 8,465.62	$ 3,775.82	$ 2,188.50
Rents	27,000.00	34,387.74	36,324.38
Administrative income	0	3,000.00	0
Insurance commissions	1,056.23	1,461.28	0
Net gain from sale of insurance business	0	0	1,839.18
Total gross income	36,521.85	42,624.84	40,352.06
Less: Total deductions	32,593.15	26,284.54	16,761.79
Taxable income	3,928.70	16,340.30	23,590.27

The insurance commissions received by petitioner during the years 1962, 1963, and 1964 resulted almost exclusively from the renewals of policies originally sold to customers as part of the automobile business. Most of the insurance was automobile collision and liability coverage. Beginning in 1955 or 1956, petitioner began selling other types of insurance. Most of the solicitation for new business was confined to their automobile insurance policyholders.

Petitioner made practically no effort to promote the insurance business, and none of the earning and profits were accumulated for any purpose associated with the insurance business.

Petitioner's balance sheets as of December 31, 1961, 1962, 1963, and 1964, are as follows:

	1961	1962
Assets
Current assets:
Cash	$ 8,318.70	$ 20,899.01
Demand Notes:
Louise C. Montgomery	3,976.00	6,226.00
Schuhmann A. Montgomery	1,000.00	3,050.00
Robert A. Montgomery	17,500.00	13,500.00
Richard L. Montgomery	25,700.00	19,460.00
Raymond E. Montgomery	15,500.00	11,693.74
Total demand notes	63,676.00	53,929.74
Accounts receivable	20,475.90	409.79
Accrued interest	2,008.42	2,963.35
Unexpired insurance	854.82	3,209.19
Company car	2,809.36	0
Auto held for resale	0	0
Total current assets	107,143.20	81,411.08
Other assets:
Note of Louise	1,000.00	0
Note of Motel	0	15,000.00
Stock of Motel	0	10,000.00
Land	124,260.24	124,260.24
Building and equipment less depreciation	100,981.47	94,411.08
Deferred charges	0	15,345.72
Total other assets	226,241.71	259,017.04
Total assets	333,384.91	340,428.12
Liabilities and capital
Current liabilities:
Accounts payable	$ 974.51	$ 1,090.95
Provision for taxes	4,190.54	1,830.07
Total current liabilities	5,165.05	2,921.02
Capital stock outstanding	58,615.60	58,615.60
Earned surplus and undivided profits	269,604.26	278,891.50
Total liabilities and capital	333,384.91	340,428.12

	1963	1 1964
Assets
Current assets:
Cash	$ 27,042.94	$ 60,905.48
Demand Notes:
Louise C. Montgomery	6,226.00	6,226.00
Schuhmann A. Montgomery	2,550.00	2,904.66
Robert A. Montgomery	13,500.00	13,500.00
Richard L. Montgomery	16,460.00	11,000.00
Raymond E. Montgomery	11,693.74	10,000.00
Total demand notes	50,429.74	43,630.66
Accounts receivable	6,349.85	4,905.77
Accrued interest	1,495.73	1,077.73
Unexpired insurance	2,570.91	2,127.79
Company car	0	0
Auto held for resale	0	1,100.00
Total current assets	87,889.17	113,747.43
Other assets:
Note of Louise	0	0
Note of Motel	22,000.00	17,800.00
Stock of Motel	10,000.00	10,000.00
Land	124,260.24	124,260.24
Building and equipment less depreciation	89,414.29	84,426.78
Deferred charges	11,159.00	10,305.45
Total other assets	256,833.53	246,792.47
Total assets	344,722.70	360,539.90
Liabilities and capital
Current liabilities:
Accounts payable	$ 822.54	$ 585.13
Provision for taxes	5,504.10	6,158.30
Total current liabilities	6,326.64	6,743.43
Capital stock outstanding	58,615.60	58,615.60
Earned surplus and undivided profits	279,780.46	295,180.87
Total liabilities and capital	344,722.70	360,539.90

Petitioner's working capital, being the difference between current assets and current liabilities, was as follows:

Year	Amount
1961	$ 101,978.15
1962	78,490.06
1963	81,562.53
1964	107,004.00

The ratio of petitioner's current assets to current liabilities was as follows:

	Current assets to
year	current liabilities
1961	20.74 to 1
1962	27.87 to 1
1963	13.89 to 1
1964	16.86 to 1

The difference between petitioner's total capital and its working capital is the total of its other assets, as follows:

	1961	1962	1963	1964
Capital stock outstanding	$ 58,615.60	$ 58,615.60	$ 58,615.60	$ 58,615.60
Surplus	269,604.26	278,891.50	279,780.46	295,180.87
Total Capital	328,219.86	337,507.10	338,396.06	353,796.47
Less working capital	101,978.15	78,490.06	81,562.53	107,004.00
Total other assets	226,241.71	259,017.04	256,833.53	246,792.47

All of the notes receivable from stockholders were demand notes except two. One exception was a note in the amount of $ 1,000 executed by Louise C. Montgomery, dated May 22, 1961, which was payable on November 22, 1962. The other exception was a note in the amount of $ 1,000 executed by Schuhmann dated March 1, 1960, which was to be repaid in 12 monthly installments of $ 86.67 each, beginning 1 month after date; however, no payments were made on this note until 1962.

Petitioner also held demand notes receivable from Raymond E. Montgomery, Jr., who was another son of Louise C. Montgomery but not a stockholder of petitioner, as follows:

Year	Balance
Dec. 31, 1962	$ 11,693.74
Dec. 31, 1963	11,693.74
Dec. 31, 1964	10,000.00

In May of 1960, Richard and Robert bought a Chevrolet dealership called Whipple Motor Co., from George Whipple. Richard and Robert needed an additional $ 38,000 of capital to satisfy Chevrolet Motor Division, so they and petitioner executed a note with Lincoln Bank & Trust Co. for $ 38,000 and in turn signed it over to Whipple Motor Co. who, in turn, on May 31, 1960, executed a note reading in part as follows:

For Value Received, on or before December 1, 1965, the undersigned promises to pay to the order of THE MONTGOMERY CO., the sum of THIRTY-EIGHT THOUSAND DOLLARS ($ 38,000.00) with interest thereon at the rate of 5 1/2% per annum from date until paid, payable at the office of LINCOLN BANK AND TRUST COMPANY, 421 W. Market Street, Louisville, Kentucky, as hereinafter set forth.

The principal of this note is payable in twenty (20) quarter-annual installments of ONE THOUSAND NINE HUNDRED DOLLARS ($ 1,900.00) each, the first of said quarter-annual principal installments to be due and payable on March 1, 1961, and a like installment to be due and payable each three (3) months thereafter for nineteen (19) consecutive quarter-annual installments. The interest on this note is to be payable on the 1st day of September, 1960, and on the first day of December, March, June, and September each year thereafter, upon the unpaid principal balances of this note.

In February 1962, the name of Whipple Motor Co. was changed to Doublemont Chevrolet Co.

The note of $ 38,000 was fully paid by Doublemont in May 1965.

The loan to Whipple Motor Co. and the business of Whipple Motor Co. were in no way related to the business of petitioner. The only relationship between Whipple Motor Co. and petitioner was the fact that Richard and Robert, who were the owners of Whipple Motor Co., were among the principal stockholders of petitioner.

The dividends paid by petitioner were as follows:

Year	Amount
1953	$ 23,560.00
1954	0
1955	5,725.00
1956	5,615.00
1957	800.00
1958	3,950.00
1959	3,950.00
1960	3,950.00
1961	3,950.00
1962	3,000.00
1963	3,000.00
1964	3,000.00
1965	15,587.50
1966	15,587.50
1967	15,587.50
Total	107,262.50

For the years in issue, the rents received by petitioner under the lease agreements with TraveLodge were as follows:

Year	Amount
1962	$ 8,000.00
1963	16,387.74
1964	18,324.38

After the motel was completed and in operation petitioner decided to attempt to acquire the tract of land located east of the motel over to First Street with the intention of using this property in the form of an expansion to the facilities of the motel in the form of a restaurant and additional rooms. Schuhmann contacted Leeth about the intended acquisition east of the motel early in 1963. Thereafter a plan was drawn up by petitioner to put on this intended acquisition a restaurant and 46 additional units to be used in conjunction with the motel. Petitioner also had a plan to construct an office building on the intended acquisition. The cost of the entire project would have been in the vicinity of $ 200,000. The intended acquisition, however, never materialized.

When petitioner, on July 15, 1953, changed its name to the Montgomery Co. and transferred its operating assets, exclusive of the real estate, plant and buildings, and its insurance business, to Chevrolet, it amended its articles of incorporation. Article II of these amended articles of incorporation in stating the nature and purposes of petitioner's business, did not mention its insurance business. On July 29, 1954, petitioner again amended its articles of incorporation so as to amend article II to include its insurance business, as follows:

ARTICLE II. The nature and purpose of the business of the corporation shall be:

* * * *

(e) To engage in the business of conducting the business of an insurance agency for all types of insurance as agent, broker, or other representative; and to charge and collect fees, commissions, brokerage and other charges for services rendered in connection with the writing or placement of insurance; * * *

During the years 1953 through 1964, petitioner received insurance commissions, in amounts, as follows:

Year	Amount
1953	$ 3,030.44
1954	6,560.44
1955	12,902.59
1956	11,477.18
1957	6,656.47
1958	4,401.91
1959	4,024.18
1960	4,416.10
1961	1,848.39
1962	1,056.23
1963	1,461.28
1964	198.00
Total	58,033.21

In the statement attached to the deficiency notice respondent advised petitioner as follows:

It is held that during the taxable years 1962, 1963 and 1964 you were formed or availed of for the purpose of avoiding the income tax with respect to your shareholders by permitting earnings and profits to accumulate instead of being divided or distributed. Consequently, the accumulated earnings tax provided for under Section 531 of the Internal Revenue Code is applicable for each of the years 1962, 1963 and 1964.

ULTIMATE FINDINGS

During the taxable years here in question (1) petitioner was not a mere holding or investment company; (2) petitioner needed at least $ 200,000 in working capital to meet the reasonable and reasonably anticipated needs of its motel venture business; and (3) petitioner was not formed or availed of for the purpose of avoiding the income tax with respect to its shareholders.

OPINION

On the first issue we think the respondent's determination should be sustained.

Generally an amount paid by a lessor to a lessee for cancellation of a lease prior to the expiration of its term is a capital expenditure made in order to obtain possession of the premises and is deductible over the unexpired term of the canceled lease. Trustee Corporation, 482">42 T.C. 482 (1964), and the cases cited at page 488. But there is a well-established exception to the general rule. Business Real Estate Trust of Boston, 25 B.T.A. 191 (1932); Keiler v. United States, 285 F. Supp. 520 (W.D. Ky. 1966), affirmed per order 395 F. 2d 991 (C.A. 6, 1968); cf. Clara Hellman Heller Trust No. 7610, 7 T.C. 556">7 T.C. 556 (1946), reversed sub nom. Wells Fargo B. & U. Trust Co. v. Commissioner, 163 F. 2d 521 (C.A. 9, 1947), cited by us with approval in Trustee Corporation, supra. We think petitioner falls within the exception.

In the Keiler case the District Court said:

The facts of this case are stipulated ¹ and it is submitted on the merits. The record and the briefs of the parties have been considered and it is concluded that the expenditures made by the plaintiffs and their associates to obtain early possession of their leased premises are capital expenditures and to be amortized over the useful life of the new building which they built to lease to Walgreen.

It is stipulated that the "sole purpose in acquiring the subleases was to demolish the old building and to erect a new one in its place." The facts here, therefore, are similar in all material respects to the facts of Business Real Estate Trust of Boston v. Commissioner, 25 B.T.A. 191">25 B.T.A. 191 (1932). At p. 194 it states:

"There is no dispute between the parties that the expenditures in controversy were made solely in order to prepare the way for the new building to be leased to Filene's. It is equally clear that time was of the essence and that unless immediate possession of the entire property was had the deal could not be put through. * * * The payments were made to the tenants to obtain immediate possession so that the new building might be erected for lease to Filene's, and for no other purpose. It is the building that is to produce the income and it seems to us both just and reasonable that these expenditures should be added to the building cost and recovered over its life of 40 years."

The quoted reasoning of this opinion, both as to the characterization of plaintiffs' expenditures and the method of amortization, is adopted here. See also Cosmopolitan Corporation v. Commissioner, 18 T.C.M. (CCH) 542">18 T.C.M. 542.

[Footnote omitted.]

Petitioner contends that the so-called "exception" cases noted above are clearly distinguishable in that in those cases the court either specifically found or it had been stipulated that the "sole" purpose of the payment by the taxpayer (here the $ 10,000) was to acquire a new lease from a third party or to build a new building over the life of which the payments were to be amortized. Petitioner argues that there was no such stipulation by the parties in the instant case; that in the amendment to agreement of lease between petitioner and Chevrolet dated March 20, 1962, it is stated that the payment of $ 10,000 "was at least partly in consideration for the new lease" with Chevrolet; and that petitioner's accountants treated the $ 10,000 payment as being attributable to the new lease with Chevrolet.

We are not impressed with petitioner's contention or its supporting argument. It seems clear to us from the facts stated in our findings that while the July 16, 1960, lease between petitioner and Chevrolet was in effect, petitioner from December 26, 1961, through February 28, 1962, was negotiating with TraveLodge with a view of entering into a much more favorable lease with TraveLodge for the southeast corner of Second and Liberty Streets. Petitioner and TraveLodge came to an agreement on or about February 28, 1962, but before petitioner could lease the southeast corner to TraveLodge it had to get an agreement from Chevrolet to abandon, vacate, and surrender its right, title, interest, and possession to the southeast corner, which it accomplished in the agreement with Chevrolet dated March 20, 1962.

We are satisfied that if the negotiations with TraveLodge had not been successful petitioner would not have asked Chevrolet to vacate the southeast corner or have paid the $ 10,000 to Chevrolet to indemnify and reimburse it for the expense of removing its property from the southeast corner.

We hold the payment of $ 10,000 to be a capital expenditure amortizable over the 25-year lease with TraveLodge executed on March 22, 1962. Business Real Estate Trust of Boston, supra;Keiler v. United States, supra. The respondent's determination on this issue is sustained.

Issue 2

The accumulated-earnings tax (sec. 531-537) in one form or another has been on the statute books at least since the Act of September 8, 1916. ² Since that time approximately 254 cases involving this tax have been decided. ³ The material provisions of the 1954 Code are in the margin. ⁴

Ordinarily, the burden of proving that the respondent's determination is wrong rests on petitioner. Rule 32, Tax Court Rules of Practice; Helvering v. Taylor, 293 U.S. 507 (1935). In 1954, Congress enacted section 534. Respondent, by certified mail, mailed to petitioner the letter pursuant to section 534(b) and petitioner timely filed a statement intending to comply with section 534(c). At the opening of the trial petitioner filed a motion moving that the Court determine in advance of trial that in accordance with section 534 "the burden of proof with respect to the allegation that all or a part of the petitioner's earnings and profits were permitted to accumulate beyond the reasonable needs of the business shall be upon the respondent." After hearing the arguments on the motion the Court stated:

I'll deny the motion. I might say I previously read the statement attached to the Petition and also the additional facts not in the statement itself but referred to, and I definitely deem there are not sufficient facts stated in the statement filed in the Section 534 to justify the shifting of the burden of proof at this time.

I'm going to deny the motion, and the Petitioner has the burden of going forward. If I am in error about that, I think I can correct it in the final disposition of the case. Proceed with the evidence.

The evidence consists of a long stipulation of facts, approximately 90 exhibits, and 164 pages of testimony.

It may be noted that the statement submitted by petitioner under section 534(c) applies only to proof of unreasonable accumulation under section 533(a) and has no application to proof of whether petitioner was a "mere holding or investment company" as that term is used in section 533(b). Rhombar Co. v. Commissioner, 386 F.2d 510">386 F. 2d 510, 513 (C.A. 2, 1967), affirming 47 T.C. 75">47 T.C. 75 (1966).

It may also be noted that respondent did not specifically determine that petitioner was a mere holding or investment company but he now contends that the evidence shows that petitioner was such a company and that such fact under section 533(b) adds to petitioner's burden of showing it was not formed or availed of for the prohibited purpose. All three presumptions, the ordinary and the two presumptions under section 533, are rebuttable. United States v. R. C. Tway Coal Sales Co., 75 F. 2d 336, 337 (C.A. 6, 1935); Trico Securities Corporation, 41 B.T.A. 306">41 B.T.A. 306, 314 (1940).

In enacting the Revenue Act of 1934, Congress by section 351 of that Act levied a surtax on "personal" holding companies ⁵ and by section 102(a) of the same Act excluded "personal" holding companies "as defined in section 351" from the imposition of surtax on corporations improperly accumulating surplus. These sections of the 1934 Act now correspond with sections 542 and 532 of the 1954 Code, respectively. Of course, respondent has not determined, nor does he contend, that petitioner is a "personal" holding company for such companies, since the 1934 Act, are not subject to the accumulated-earnings tax.

Under section 533(b), the fact that a corporation is a "mere" holding or investment company is prima facie evidence of a purpose to avoid the income tax with respect to shareholders, and under section 535(c)(3), the accumulated-earnings credit is limited to the amount (if any) by which $ 100,000 exceeds the accumulated earnings and profits at the close of the preceding taxable year.

Regardless of where the burden might be, we have found as one of the ultimate facts that petitioner was not a mere holding or investment company during any of the taxable years here in question. In 1953, when petitioner transferred its operating assets to Chevrolet it retained its real estate, plant and buildings, and its insurance business. It leased its real estate north of Liberty Street and its plant and buildings to Chevrolet but retained its real estate south of Liberty Street and its insurance business. It continued to operate its insurance business until it was sold to Hufnagel & Stiners Insurance, Inc., on May 1, 1964. Having disposed of its Chevrolet agency business, petitioner, in 1961, began making plans looking to the undertaking of a new business, namely, the operation of a motel. On March 20, 1962, Motel was organized as a wholly owned subsidiary of petitioner to operate the Louisville Travelodge as a joint venture with TraveLodge Corp., it being agreed that Motel would have the responsibility of the operation of the motel being conducted by the joint venture. See sec. 1.537-3, Income Tax Regs.⁶ We think the record supports our ultimate finding that petitioner was not a "mere holding or investment company" during the years in question as that term is used in sections 533(b) and 535(c)(1) and (3). Cf. Seaboard Security Co., 38 B.T.A. 560">38 B.T.A. 560, 566 (1938); Mellbank Corporation, 38 B.T.A. 1108">38 B.T.A. 1108, 1116 (1938); Industrial Bankers Securities Corporation v. Higgins, 104 F. 2d 177, 181 (C.A. 2, 1939); Olin Corporation, 42 B.T.A. 1203">42 B.T.A. 1203, 1214 (1940), affd. 128 F. 2d 185 (C.A. 7, 1942); Jacob Sincoff, Inc., 20 T.C. 288">20 T.C. 288, 292 (1953), affd. 209 F. 2d 569 (C.A. 2, 1953); Nemours Corporation, 38 T.C. 585">38 T.C. 585, 601 (1962), affirmed per curiam 325 F. 2d 559 (C.A. 3, 1963).

We now turn to the question of whether, during the taxable years, petitioner permitted its earnings and profits to accumulate beyond the reasonable needs of its business. This is the "central issue." Faber Cement Block Co., 50 T.C. 317">50 T.C. 317, 327 (1968), acq. 2 C.B. 2">1968-2 C.B. 2. If it did, that fact "shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation by the preponderance of the evidence shall prove to the contrary." Sec. 533(a). This is a question of fact and the burden of proof is upon the petitioner. Breitfeller Sales, Inc., 28 T.C. 1164">28 T.C. 1164 (1957); John P. Scripps Newspapers, 44 T.C. 453">44 T.C. 453, 467 (1965); Walker v. Commissioner, 362 F. 2d 140 (C.A. 7, 1966), affirming a Memorandum Opinion of this Court.

At the outset it must be kept in mind that in determining the "reasonable needs of the business" (sec. 533) consideration must be given to the "reasonably anticipated needs of the business" (sec. 537). Magic Mart, Inc., 51 T.C. 775">51 T.C. 775, 796 (1969). Also, before the accumulated-earnings tax will be applicable, the taxpayer, during the years in question, must have been in a sufficiently liquid position to allow the distribution of dividends. See Smoot Sand & Gravel Corporation v. Commissioner, 274 F. 2d 495 (C.A. 4, 1960), affirming a Memorandum Opinion of this Court, certiorari denied 362 U.S. 976">362 U.S. 976 (1960), rehearing denied 363 U.S. 832">363 U.S. 832 (1960), wherein the Court of Appeals stated, at pages 500-501:

Thus, the size of the accumulated earnings and profits or surplus is not the crucial factor; rather, it is the reasonableness and nature of the surplus. Part of the surplus may be justifiably earmarked in the form of reserves, for specific, necessary business needs. [n3] Again, to the extent the surplus has been translated into plant expansion, increased receivables, enlarged inventories, or other assets related to its business, the corporation may accumulate surplus with impunity. * * * Where, on the other hand, the accumulation of surplus is reflected in liquid assets in excess of the immediate or reasonably foreseeable business needs of the corporation, there is a strong indication that the purpose of the accumulation is to prevent the imposition of income taxes upon dividends which would have been distributed to the shareholders. * * * [Footnote omitted. Emphasis supplied.]

Most of petitioner's accumulated earnings or surplus for the years 1961 through 1964 has been translated into "other assets" such as land, buildings and equipment, etc. The amount of petitioner's surplus reflected in "other assets" and in "net liquid assets." ⁷ is as follows:

Year	Other	Working	Surplus
	assets 1	capital
1961	$ 167,626.11	$ 101,978.15	$ 269,604.26
1962	200,401.44	78,490.06	278,891.50
1963	198,217.93	81,562.53	279,780.46
1964	188,176.87	107,004.00	295,180.87

The amount of the surplus translated into "other assets" is not available for dividends. Only the working capital ⁸ in excess of the immediate or reasonably foreseeable business needs of the corporation is so available. Smoot Sand & Gravel Corporation v. Commissioner, supra.

What were the immediate or reasonable business needs of petitioner? Respondent contends that during the taxable years petitioner had no business except its insurance business, which was of little consequence. As previously stated herein we do not agree with respondent that petitioner had no business other than its insurance business. It, through its wholly owned subsidiary, was deeply engaged in the motel venture. Petitioner does not contend that it needed to accumulate any earnings for its insurance business but strongly contends that it needed at least $ 782,800 for the following:

(1) Motel venture	$ 540,000
(2) Urban renewal	20,000
(3) Doublemont Chevrolet loan	22,800
(4) Plans for expansion	200,000
Total	782,800

The $ 540,000 is made up of the $ 190,000 note to the Kentucky Trust Co. and the $ 350,000 note to the Lincoln National Life Insurance Co. All of petitioner's real property was mortgaged to secure the payment of these loans. At the end of the taxable years in question the remaining unpaid balances of these loans were as follows:

	1962	1963	1964
$ 190,000 note	$ 165,000	$ 154,428.23	$ 139,942.03
$ 350,000 note	350,000	331,792.34	310,655.77
	515,000	486,220.57	450,597.80

Petitioner was primarily liable on the $ 190,000 note and its real property on the northeast corner of Second and Liberty Streets was mortgaged to secure the loan. The $ 350,000 note was secured by a mortgage of petitioner's real property on the southeast corner of Second and Liberty Streets. The joint venture agreed to be responsible for the repayment of the $ 350,000 note. Respondent in his brief says: "It is generally understood that the accumulation of earnings for the payment of the corporation's own debt is an acceptable ground. Regulations, section 1.537-2(b)(3)." These regulations provide that "To provide for the retirement of bona fide indebtedness created in connection with the trade or business * * * may indicate that the earnings and profits of a corporation are being accumulated for the reasonable needs of the business."

Respondent does not concede that petitioner was primarily liable on the $ 190,000 note. The note, the material part of which is set out in our findings, is in evidence as Exhibit 78-ZZZ, and shows petitioner as a primary obligor. Schuhmann A. Montgomery as vice president signed it first for petitioner and second for Motel.

The law also contemplates that a corporation may provide for certain contingencies. Fisher & Fisher, Inc., 32 B.T.A. 211">32 B.T.A. 211 (1935), affirmed per curiam 84 F. 2d 996 (C.A. 2, 1936). In that case we said (p. 218):

The evidence is that, had the contingencies facing the business materialized, a sum of $ 200,000 would have been insufficient to meet them. From this it follows that the profits accumulated were not in excess of the reasonable needs of the business.

Petitioner's contingent liabilities were large and had they materialized petitioner's liquid assets would not have been sufficient to meet them.

During the taxable years in question petitioner's directors watched the progress of Motel closely and determined that in view of the fact that its profits were so small and its obligations so large it could not afford to declare any more dividends than it did declare. We have often said that we should be reluctant to substitute our business judgment for that of the officers and directors of the corporation. Crawford County Printing & Publishing Co., 17 T.C. 1404">17 T.C. 1404, 1414 (1952); Bremerton Sun Publishing Co., 44 T.C. 566">44 T.C. 566, 583 (1965), appeal (C.A. 9) dismissed on stipulation of parties (1966); Faber Cement Block Co., supra at 329; Magic Mart, Inc., supra at 795. Furthermore, the tax is a penalty tax and should be construed strictly and not extended to cover cases which do not fall within its letter. United Business Corporation of America, 19 B.T.A. 809">19 B.T.A. 809, 826 (1930), affd. 62 F. 2d 754 (C.A. 2, 1933), certiorari denied 290 U.S. 635">290 U.S. 635 (1933); F. E. Watkins Motor Co., 31 T.C. 288">31 T.C. 288, 300 (1958).

On the basis of the facts before us, we believe that during the taxable years in question petitioner needed at least $ 200,000 in working capital to meet the reasonable needs and reasonably anticipated needs of its motel venture business, and we have so found as an ultimate fact. This holding and finding makes it unnecessary to consider the other three business needs strongly contended for by petitioner for the reason that the business needs of the motel venture were in excess of the liquid assets available for dividends.

In view of the credit provided for in section 535 (c)(1), it is unnecessary for us to consider whether or not petitioner was formed or availed of for the proscribed purpose. John P. Scripps Newspapers, supra at 474; Magic Mart, Inc., supra at 799. In the instant case the credit would be equal to the full amount of the retained earnings. Therefore, even if petitioner were formed or availed of for the proscribed purpose, under section 535(a) the accumulated taxable income, on which the section 531 tax is imposed, would be zero and petitioner would owe no section 531 tax. We so hold.

Decision will be entered under Rule 50.

---

Footnotes

• 1. All statutory references are to the Internal Revenue Code of 1954 unless otherwise indicated.↩

• 1. At the bottom of the balance sheet for 1964 appears the following note.

  "NOTE A: This statement was prepared by us without audit.

  B: The company has executed a mortgage to the Kentucky Trust Company, Louisville, Kentucky on all real estate located on the north side of Liberty Street to secure payment of a loan to Montgomery Motel, Inc., a wholly owned subsidiary. At December 31, 1964 the balance of this note is $ 139,942.03. Property located on the south side of Liberty Street is leased jointly to TraveLodge Corporation and Montgomery Motel, Inc. and the land and improvements thereon are mortgaged to the Lincoln Life National Insurance Company, Fort Wayne, Indiana. The balance of the indebtedness due by the lessee at February 29, 1964 was $ 328,364.00."

• 1. Total other assets less capital stock.↩

• 2. Sec. 3 of that Act (39 Stat. 756-801) provided in part: "and the fact that any such corporation * * * is a mere holding company, or that the gains and profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a fraudulent purpose to escape such tax."

• 3. Prentice-Hall in Federal Taxes, 1970, vol. 3, has a table of these cases digesting each case under 12 headings such as Reasonable needs of business, Purpose, Burden of proof, Plant expansion, Loans to stockholders, Prior years' accumulations, Mere holding or investment company, etc. The "Table" is explained at pp. 21,323 to 21,338 and appears at pp. 21,339 to 21,354.↩

• 4. SEC. 531. IMPOSITION OF ACCUMULATED EARNINGS TAX.

  In addition to other taxes imposed by this chapter, there is hereby imposed for each taxable year on the accumulated taxable income (as defined in section 535) of every corporation described in section 532, an accumulated earnings tax equal to the sum of --

  (1) 27 1/2 percent of the accumulated taxable income not in excess of $ 100,000, plus

  (2) 38 1/2 percent of the accumulated taxable income in excess of $ 100,000.

  SEC. 532. CORPORATIONS SUBJECT TO ACCUMULATED EARNINGS TAX.

  (a) General Rule. -- The accumulated earnings tax imposed by section 531 shall apply to every corporation (other than those described in subsection (b)) formed or availed of for the purpose of avoiding the income tax with respect to its shareholders or the shareholders of any other corporation, by permitting earnings and profits to accumulate instead of being divided or distributed.

  (b) Exceptions. -- The accumulated earnings tax imposed by section 531 shall not apply to --

  (1) a personal holding company (as defined in section 542).

  SEC. 533. EVIDENCE OF PURPOSE TO AVOID INCOME TAX.

  (a) Unreasonable Accumulation Determinative of Purpose. -- For purposes of section 532, the fact that the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation by the preponderance of the evidence shall prove to the contrary.

  (b) Holding or Investment Company. -- The fact that any corporation is a mere holding or investment company shall be prima facie evidence of the purpose to avoid the income tax with respect to shareholders.

  SEC. 534. BURDEN OF PROOF.

  (a) General Rule. -- In any proceeding before the Tax Court involving a notice of deficiency based in whole or in part on the allegation that all or any part of the earnings and profits have been permitted to accumulate beyond the reasonable needs of the business, the burden of proof with respect to such allegation shall --

  (1) if notification has not been sent in accordance with subsection (b), be on the Secretary or his delegate, or

  (2) if the taxpayer has submitted the statement described in subsection (c), be on the Secretary or his delegate with respect to the grounds set forth in such statement in accordance with the provisions of such subsection.

  (b) Notification by Secretary. -- Before mailing the notice of deficiency referred to in subsection (a) the Secretary or his delegate may send by certified mail or registered mail a notification informing the taxpayer that the proposed notice of deficiency includes an amount with respect to the accumulated earnings tax imposed by section 531. * * *

  (c) Statement by Taxpayer. -- Within such time (but not less than 30 days) after the mailing of the notification described in subsection (b) as the Secretary or his delegate may prescribe by regulations, the taxpayer may submit a statement of the grounds (together with facts sufficient to show the basis thereof) on which the taxpayer relies to establish that all or any part of the earnings and profits have not been permitted to accumulate beyond the reasonable needs of the business.

  SEC. 535. ACCUMULATED TAXABLE INCOME.

  (a) Definition. -- For purposes of this subtitle, the term "accumulated taxable income" means the taxable income, adjusted in the manner provided in subsection (b), minus the sum of the dividends paid deduction (as defined in section 561) and the accumulated earnings credit (as defined in subsection (c)).

  (b) Adjustments to Taxable Income. -- For purposes of subsection (a), taxable income shall be adjusted as follows:

  (1) Taxes. -- There shall be allowed as a deduction Federal income and excess profits taxes * * *

  * * * *

  (c) Accumulated Earnings Credit --

  (1) General rule. -- For purposes of subsection (a), in the case of a corporation other than a mere holding or investment company the accumulated earnings credit is (A) an amount equal to such part of the earnings and profits for the taxable year as are retained for the reasonable needs of the business * * *

  (2) Minimum credit. -- The credit allowable under paragraph (1) shall in no case be less than the amount by which $ 100,000 exceeds the accumulated earnings and profits of the corporation at the close of the preceding taxable year.

  (3) Holding and investment companies. -- In the case of a corporation which is a mere holding or investment company, the accumulated earnings credit is the amount (if any) by which $ 100,000 exceeds the accumulated earnings and profits of the corporation at the close of the preceding taxable year.

  SEC. 537. REASONABLE NEEDS OF THE BUSINESS.

  For purposes of this part, the term "reasonable needs of the business" includes the reasonably anticipated needs of the business.↩

• 5. In H. Rept. No. 704, 73d Cong., 2d Sess., Union Calendar No. 116, p. 11, 1939-1 C.B. (Part 2) 562, the House in beginning its discussion of personal holding companies said: "Perhaps the most prevalent form of tax avoidance practiced by individuals with large incomes is the scheme of the 'incorporated pocketbook.'"↩

• 6. Sec. 1.537-3 Business of the corporation.

  (a) The business of a corporation is not merely that which it has previously carried on but includes, in general, any line of business which it may undertake.

  (b) If one corporation owns the stock of another corporation and, in effect, operates the other corporation, the business of the latter corporation may be considered in substance, although not in legal form, the business of the first corporation. * * * Thus, the business of one corporation may be regarded as including the business of another corporation if such other corporation is a mere instrumentality of the first corporation; that may be established by showing that the first corporation owns at least 80 percent of the voting stock of the second corporation.

  [Note: In the instant case petitioner owned 100 percent of the voting stock of Motel.]↩

• 7. The term "net liquid assets" is synonymous with such terms as "net quick assets" and "working capital" found in the decided cases. Magic Mart, Inc., 51 T.C. 775">51 T.C. 775, 780↩ (1969).

• 8. At this point it may be noted that the parties are in disagreement as to the amount of working capital (current assets less current liabilities). We have found as a fact that the working capital for the years 1961 through 1964 was $ 101,978.15, $ 78,490.06, $ 81,562.53, and $ 107,004, respectively. Petitioner contends that these amounts should be reduced by the total demand notes of the Montgomerys of $ 63,676, $ 53,929.74, $ 50,429.74, and $ 43,630.66, respectively; whereas respondent contends that the amounts for 1962 through 1964 should be increased by the notes of Motel of $ 15,000, $ 22,000, and $ 17,800, respectively. In view of our ultimate holding which will appear later in this opinion, we need not discuss these contentions further. Suffice it to say, for present purposes, we abide by our findings.