Burr Oaks Corp. v. Commissioner

*635 Respondent, pursuant to a statutory notice of deficiency, determined deficiencies in the income tax of petitioner Burr Oaks Corp. for its taxable years ended September 30, 1958, 1959, and 1960, in the respective amounts of $ 15,067.26, $ 52,595.26, and $ 16,602.61. With regard to the various individual petitioners, respondent determined the following deficiencies in their respective income taxes:

*636 Petitioner Burr Oaks Corp. will hereinafter be referred to as the petitioner, and petitioners A. Aaron Elkind, Harold A. Watkins, and Maurice Ritz will hereinafter sometimes be referred to respectively as Elkind, Watkins, and Ritz, or as the individual petitioners.

The only question*133 ² remaining to be determined insofar as petitioner is concerned is its correct basis in certain unimproved real estate transferred to it by Elkind, Watkins, and Ritz. In order to make this determination, we must first decide whether the transfer by Elkind, Watkins, and Ritz to petitioner constituted a valid sale or a contribution to capital. In the event we find it to be the latter, we must further determine whether it constitutes a transfer to a controlled corporation within the meaning of section 351. ³

*134 Insofar as petitioners Elkind, Watkins, and Ritz are concerned, we must determine whether certain amounts received by them during 1959 from petitioner were taxable as ordinary income, rather than as long-term capital gain. ⁴

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulation of facts, together with the exhibits attached thereto, is incorporated herein by this reference.

Petitioner is a corporation formed under the laws of the State of Wisconsin. It maintains its books of account and files its Federal income tax returns on the basis of an accrual method of accounting and a fiscal year ended September 30. It filed its Federal income tax returns for its fiscal years ended September 30, 1958 through 1960, with the district director of internal revenue at Milwaukee, Wis.

A. Aaron and Rosella Elkind were, at all times relevant*135 hereto, husband and wife. They filed joint Federal income tax returns for 1958, 1959, and 1960, prepared on the basis of a calendar year and the cash method of accounting, with the district director of internal revenue at Milwaukee, Wis.

Harold A. and Fannie G. Watkins were, at all times relevant hereto, husband and wife. They filed a joint Federal income tax return for 1959, prepared on the basis of a calendar year and the cash method of accounting, with the district director of internal revenue, Milwaukee, Wis.

*637 Maurice and Esther Leah Ritz were, at all times relevant hereto, husband and wife. They filed a joint Federal income tax return for 1959, prepared on the basis of a calendar year and the cash method of accounting, with the district director of internal revenue at Milwaukee, Wis.

Elkind, at all times relevant hereto, has been engaged in various aspects of real estate development, with primary emphasis on the development of tracts of one-family houses. These various endeavors were generally conducted through corporations in which Elkind or members of his family were majority stockholders. Elkind also has made a number of investments in real estate, including *136 raw land as well as improved property producing rental income.

Ritz, at all times relevant hereto, was a certified public accountant and the senior partner of an accounting firm of which Elkind was a client. Ritz had made various investments in improved and unimproved real estate prior to the years in issue herein, primarily as a result of opportunities which he came across in connection with his accounting practice.

At all times relevant hereto, Watkins was the president and principal stockholder of a corporation engaged in the manufacture and sale of slippers and other types of casual footwear. Watkins, also, had made several investments in real property over the years, primarily in improved properties producing rental income.

Elkind, Watkins, and Ritz have, at least upon one occasion other than that involved herein, jointly invested in a relatively large tract of unimproved real estate. Thus, on June 4, 1953, they purchased for the sum of $ 70,124.15 a tract of undeveloped land located just outside the city of Madison, Wis. These individuals held that property (hereinafter referred to as the Gay Farm) jointly until April 20, 1954, at which time it was sold to one of Elkind's*137 development corporations for the sum of $ 149,650.79. That corporation subdivided the property into 353 lots, constructed one-family homes thereon, and made substantial profits totaling approximately $ 500,000 upon their sale.

In the fall of 1954 Elkind came across the opportunity to purchase a similar piece of property, this time a tract of land of approximately 70 acres, also located near the outskirts of the city of Madison and theretofore used as a golf course. This property will hereinafter sometimes be referred to as the Burr Oaks property.

Elkind, in December of the same year, contacted Ritz and Watkins in regard to their participation with him in the purchase of that land. Watkins and Ritz agreed to join him in the acquisition upon the understanding that each of them would obtain a one-third interest therein. On December 7 of that year, Elkind tendered to the owner *638 of said property a written offer to purchase the property for the sum of $ 100,000. The offer provided that $ 10,000 of the purchase price was payable at the time of acceptance, $ 10,000 on February 15, 1955, $ 5,000 on April 1, 1955, with payments of $ 5,000 due quarterly thereafter until the final*138 balance was paid. The offer was accepted on December 8, 1954.

From the time they acquired the Burr Oaks property through the summer of 1957 Elkind, Watkins, and Ritz attempted to develop said property as a shopping center site or as an industrial park. In furtherance of this plan, they purchased in 1955 an additional 80 feet of frontage on an adjoining thoroughfare for the purpose of providing better access to the Burr Oaks property in the event of its commercial development. This 80 feet of frontage will hereinafter be referred to as the Brinkman property. Their efforts to develop the Burr Oaks property for commercial purposes, however, proved fruitless.

Sometime during 1957 Elkind became convinced that their plans to develop the Burr Oaks property as a shopping center or an industrial park would not materialize. Contemplating that one of his corporations might purchase the property for purposes of subdivision or development, Elkind requested two of his business associates to investigate the zoning and platting possibilities of the Burr Oaks property. On March 11, 1957, a petition was filed with the City Council of Madison, Wis., to change the zoning of the Burr Oaks property*139 from residential A (single-family dwellings) to residential A2 and B (two-family and four-family dwellings) and commercial A and B.

Elkind then proposed to Watkins and Ritz that the three of them sell the Burr Oaks property to one of Elkind's real estate corporations, as they had done with the Gay Farm property. Watkins and Ritz, recalling the substantial profits made by Elkind's corporation after they had sold the Gay Farm property to it, rejected this proposal. Ritz suggested that the three of them transfer the Burr Oaks property to a corporation which they would form for the purpose of subdividing, developing, and selling the property; that the shareholders thereof would be comprised of his two brothers and the wives of Watkins and Elkind; and that in return for the transfer of the land, the corporation would issue promissory notes to Elkind, Watkins, and Ritz. It was agreed that they would follow Ritz' suggestions.

On September 9, 1957, the City Council of Madison approved a preliminary plat incorporating the zoning proposed for the property in the aforementioned petition filed on March 11, 1957. The land as platted contained 89 lots zoned for single-family dwellings (residential*140 *639 A); 65 lots zoned for four-family apartments (residential B); 110 lots zoned for multiple-family apartments (residential C); 1 site zoned for commercial use; and 1 site zoned for a school. This zoning received final approval from the Madison City Council on November 25, 1957.

Petitioner was incorporated on October 8, 1957, for the purpose of (1) acquiring the Burr Oaks property from Elkind, Watkins, and Ritz; (2) developing and subdividing said property; and (3) selling improved lots therefrom to customers. At the time petitioner was formed, the Burr Oaks property was completely unimproved. Elkind, Watkins, and Ritz were aware of a local ordinance pursuant to which owners of unimproved land could request the city of Madison to make improvements thereon such as streets, sewers, water, and sidewalks. The city would make these improvements and assess the costs incurred in connection therewith against the property. However, it was realized that the cost of some of the improvements to be made, such as grading and supplying crushed stone, would have to be borne directly by the developers. The total cost of such improvements, as estimated by petitioner, was in the amount *141 of $ 107,243.33.

It was determined by Ritz, Watkins, and Elkind that petitioner's initial capital would be $ 4,500.

Petitioner issued a total of 450 shares of its common stock to a group composed of Elkind's wife, Watkins' wife, and Ritz' brothers, Philip and Erwin, for an aggregate consideration of $ 4,500. Elkind's wife received 150 shares of the stock; Watkins' wife also received 150 shares; and Philip and Erwin Ritz each received 75 shares. The record does not indicate the exact date when this stock was issued. Philip and Erwin Ritz paid for their stock by their respective checks, each in the amount of $ 750 and dated October 9, 1957. Watkins' wife paid for her stock by a check in the amount of $ 1,500 dated October 14, 1957. Each of the above-mentioned four persons received from petitioner a receipt dated November 1, 1957, evidencing their payment for the stock. At all times relevant hereto, petitioner's stockholders of record and officers and directors were as follows:

*142 *640 Petitioner's articles of incorporation, at all times relevant hereto, provided:

(c) Any stock that is hereafter issued by the corporation may be sold to such persons and at such prices but not less than such prices as may be determined by the majority of the Board of Directors, and without first offering any part of said stock to the then present holders of stock in the corporation.

On November 1, 1957, Elkind, Watkins, and Ritz transferred their respective interests in the Burr Oaks property to petitioner. In consideration for this transfer, petitioner assumed the remaining unpaid balance for the property, namely $ 30,000, and issued to each of Elkind, Watkins, and Ritz what purported on the face thereof to be a promissory note in the principal amount of $ 110,000. Each of the notes recited that it bore interest at the rate of 6 percent and that it was payable 2 years after the making thereof. The $ 30,000 obligation for the Burr Oaks property to its original owner, assumed by petitioner from Elkind, Watkins, and Ritz, was entered on petitioner's books under an account captioned "Mortgage Payable." An additional account was set up under the title "Land Contract Payable" *143 in the amount of $ 330,000 to represent the alleged promissory notes. At the time Elkind, Watkins, and Ritz transferred the Burr Oaks property to petitioner, the fair market value of said property was substantially less than $ 360,000. The property was not worth more than $ 165,000 at that time.

Although at the time Elkind, Watkins, and Ritz transferred their interests in said property to petitioner they hoped that petitioner's business would be successful, petitioner's prospects were uncertain. The nature of their investment can best be described by the term "speculative."

Shortly after its incorporation, petitioner found that it did not have sufficient funds on hand with which to commence operations. Therefore, on November 30, 1957, it borrowed $ 15,000 from Elkind. On February 28, 1958, Elkind loaned petitioner an additional $ 10,000. These loans, together with interest thereon in the amount of $ 1,859.78, were repaid on June 30, 1959.

None of petitioner's stockholders of record, namely Watkins' and Elkind's respective wives and Ritz' brothers, took any active interest in the management of petitioner. In fact, none of them had any real idea of the nature of petitioner's *144 business, other than some vague notion that it was engaged in "real estate" in some way or other.

Watkins and Ritz hired Albert McGinnes to manage petitioner. His work included the supervision of the platting, development, and subdivision of the land, as well as taking charge of advertising and sales. McGinnes had known and worked for Elkind and his various *641 corporations for approximately 15 years prior to that time as a lawyer and real estate broker and in various other capacities. McGinnes, moreover, was the person who first interested Elkind in purchasing the Burr Oaks property and checked into the zoning and platting possibilities for the land. During the years in issue, McGinnes continued to work for various Elkind interests.

Ritz' accounting firm, Ritz, Holman & Co., kept petitioner's books and took care of its accounting work. McGinnes was required to account to Ritz, Holman & Co. for the funds which he took in and disbursed in connection with his operation of petitioner's business.

Upon a number of occasions, petitioner transferred various lots or parcels of property to Elkind, Watkins, and Ritz, either at no cost or at a price less than the amount for which such*145 lots could have been sold to third parties. Thus, by deed dated November 3, 1958, petitioner conveyed to Elkind, Watkins, and Ritz a strip of commercial property, 70 feet by 120 feet, located in the southeast corner of the Burr Oaks property. This property was contiguous with another piece of commercial property, the Brinkman property, which Elkind, Watkins, and Ritz had purchased when they were contemplating using Burr Oaks for a shopping center. Nothing was paid to petitioner in consideration for this transfer. The deed by which the transfer was effected purported on its face to correct an erroneous conveyance of the land to petitioner in the first place.

On November 14, 1958, petitioner sold five lots at a price of $ 3,000 per lot to the Leo Building Corp., which was owned and controlled by Elkind and an associate of his. On the same date petitioner sold an additional five lots for the same price to Carsons, Inc., a corporation owned by Watkins. Petitioner, on May 20, 1960, sold five more lots at $ 3,000 per lot to M & L Investment, Inc., a corporation in which Ritz owned a substantial interest. Each of the lots involved in these transfers was zoned residential B to accommodate*146 four-family apartments. The evidence indicates that, at the time they were sold after having been platted, subdivided, and improved, each of these lots could have been sold to outsiders for $ 500 to $ 1,000 more than was received from the above corporations. None of petitioner's shareholders of record (Philip and Erwin Ritz, Elkind's wife, or Watkins' wife) was consulted with regard to, or knew of, any of these transfers. Nor was any such transfer authorized by a meeting of petitioner's board of directors.

Although McGinnes was in charge of petitioner's day-to-day operations, Elkind, Watkins, and Ritz controlled and dominated petitioner's affairs.

*642 During its taxable years 1958 through 1963, inclusive, petitioner had gross receipts in the following amounts as a result of its subdivision and sale of the Burr Oaks property:

As had been contemplated by Elkind, Watkins, and Ritz at the time of petitioner's incorporation, improvements to the Burr Oaks property, such as streets, sewers, water, and sidewalks, were made*147 by the city of Madison. The city was to recover the cost of these improvements by special assessments against the lots, which assessments were generally payable over a period of 5 to 8 years. To the extent that installments of the special assessments came due prior to the sale of the lots, they were paid by petitioner and added to the price of the lots. To the extent the assessments had not been paid prior to the sale of the lots, they were assumed by the purchaser. Certain costs incurred in connection with the subdivision and improvement of the Burr Oaks property were borne directly by petitioner. These costs included the following: (1) The cost of installing a sewer along one of the streets in the subdivision; (2) a surveying fee running from $ 25 to $ 40 per lot; and (3) the costs of grading and supplying crushed stone. The cost of improvements incurred by petitioner in subdividing the Burr Oaks property, including the special assessments paid by it, totaled $ 107,243.33.

In addition to the foregoing costs, petitioner during its taxable years ended September 30, 1958, through September 30, 1963, incurred the following operating expenses in connection with its subdivision *148 and sale of the Burr Oaks property:

In the latter part of 1959 Elkind, Watkins, and Ritz surrendered to petitioner the original "promissory notes" which they had received from petitioner in connection with their transfer of the Burr Oaks property. In return for the surrender of the notes, each of the individual *643 petitioners received from petitioner a distribution of $ 23,000 in cash and a promissory note dated November 1, 1959, in the principal amount of $ 87,000. The new notes recited (1) that they were payable 1 year after the making thereof and (2) that they bore interest at the rate of 6 percent per annum. Later that same year, petitioner paid an additional $ 8,000 apiece to Elkind, Watkins, and Ritz. Petitioner at that time, in exchange for each of their notes in the principal amount of $ 87,000, issued to each of them a new promissory note in the principal amount of $ 79,000.

On December 29, 1959, petitioner purported to repay the outstanding balance on these "new promissory notes." At the close of business on that date*149 petitioner had a bank balance of $ 5,398.88. The record does not clearly indicate how petitioner purported to repay these notes. However, the record does clearly indicate that petitioner urgently needed as working capital the $ 237,000 which it claims to have used to repay the three promissory notes. Therefore, immediately after those notes were "repaid," Elkind, Watkins, and Ritz each "loaned" $ 79,000 to petitioner, and petitioner, in turn, issued to each of the individual petitioners a "new" 1-year promissory note dated December 31, 1959, in the principal amount of $ 79,000. This transaction did not represent a repayment of the alleged "promissory notes." It was merely an extension of the purported maturity date. The individual petitioners never had any intention of enforcing their "notes" against petitioner.

In addition to the foregoing, petitioner made the following distributions to each of the individual petitioners with regard to the "promissory notes":

There was an aggregate balance of $ 138,000 outstanding upon *150 the three "notes" at the time of the trial in this proceeding, or a total of $ 46,000 due upon each of said notes.

Petitioner has not distributed any of its earnings to any of the shareholders of record.

Elkind, Watkins, and Ritz treated their transfer of the Burr Oaks property to petitioner in November 1957 as a sale. Petitioner did likewise and set up on its books a cost of $ 360,000 for said property. Elkind, Watkins, and Ritz, however, did not report any gain with regard to this alleged sale until 1959 when petitioner purportedly paid in full the promissory notes which it had issued to them in connection with said transfer. In their respective income tax returns for 1959, *644 each of them reported long-term capital gain in the amount of $ 85,729.06 as a result of their transfer of the Burr Oaks property to petitioner in 1957.

Respondent, pursuant to separate notices of deficiency issued to Elkind, Watkins, and Ritz with respect to their taxable year ended December 31, 1959, determined that --

the gain realized from the sale of * * * [the Burr Oaks property] in the total amount of $ 85,729.06 is taxable as ordinary income rather than as long-term capital gains reported*151 on your income tax return. * * *

Pursuant to a statutory notice of deficiency issued to petitioner with respect to its taxable years 1958 through 1960, respondent increased petitioner's taxable income for said years by an aggregate amount totaling $ 192,686.98. This increase was based on respondent's determination that petitioner had understated its income for those years by claiming too high a basis or cost in the land sold by it in that period. The notice of deficiency indicates that, in making his determination, respondent treated petitioner as having a basis of $ 100,000 in the Burr Oaks property, rather than a basis of $ 360,000, as petitioner had claimed.

OPINION

There are two issues to be determined in this case. These are (1) petitioner's correct basis in the Burr Oaks property and (2) the proper tax treatment of the amounts received by Elkind, Watkins, and Ritz from petitioner during 1959. In order to resolve these issues, we must classify, for tax purposes, the transaction wherein each of the individual petitioners in November 1957 (1) transferred his respective interest in the Burr Oaks property to petitioner and (2) in return therefor received an instrument purporting*152 to be a promissory note in the principal amount of $ 110,000.

It is contended by Elkind, Watkins, and Ritz (1) that their transfer of the Burr Oaks property to petitioner constitutes the sale or exchange of a capital asset held in excess of 6 months; (2) that the promissory note received by each of them in return therefor represents a valid indebtedness incurred by petitioner; and (3) that the gain realized by them in connection with said transfer is properly reportable in 1959 when they allege that petitioner "paid in full" the "promissory notes" which had been issued to them. ⁵

*153 *645 It is contended by petitioner that it purchased the Burr Oaks property from Elkind, Watkins, and Ritz at a cost of $ 360,000 and that such cost is its correct basis in said property.

The plethora of arguments advanced by respondent in his opening statement and on brief indicates to us that the Government had some difficulty in formulating a suitable rationale under which to classify the transfer of the Burr Oaks property to petitioner. It would serve no purpose to set forth at this point the various contentions made by respondent since we believe that the transaction was not a sale, but an equity contribution. ⁶

*154 It is true that Elkind, Watkins, and Ritz attempted to cast their transfer of the Burr Oaks property to petitioner in the form of a sale. It is also true that, from a standpoint of form, the alleged promissory notes issued to the individual petitioners are clear evidences of indebtedness. However, it has often been noted in connection with similar issues, the substance of the transaction, rather than its form, is the controlling factor in the determination of the proper tax treatment to be accorded thereto. Sherwood Memorial Gardens, Inc., 42 T.C. 211 (1964), on appeal (C.A. 7, Aug. 10, 1964); 1432 Broadway Corporation, 4 T.C. 1158 (1945), affd. 160 F. 2d 885 (C.A. 2, 1947). Whether a transaction such as the one we are now confronted with is in substance, as well as in form, a sale is essentially *646 a question of fact. Gooding Amusement Co., 23 T.C. 408 (1954), affd. 236 F. 2d 159 (C.A. 6, 1956), certiorari denied 352 U.S. 1031 (1957).

As we view the creditable evidence presently before us, the transfer*155 of the Burr Oaks property to petitioner is so lacking in the essential characteristics of a sale and is replete with so many of the elements normally found in an equity contribution (cf. Emanuel N. ( Manny) Kolkey, 27 T.C. 37 (1956), affd. 254 F. 2d 51 (C.A. 7, 1958), and Bruce v. Knox, 180 F. Supp. 907 (D. Minn. 1960)) that it appears to us as nothing more than a shabby attempt to withdraw from petitioner, at capital gains rates, the developer's profit normally inherent in the subdivision and sale of raw acreage such as the Burr Oaks property.

This Court has been required upon numerous occasions to determine the true nature of alleged sales or transfers of assets to corporations. In the Kolkey case, we listed the following questions as among the relevant criteria for making such a determination:

Was the capital and credit structure of the new corporation realistic? What was the business purpose, if any, of organizing the new corporation? Were the noteholders the actual promoters and entrepreneurs of the new adventure? Did the noteholders bear the principal risks of loss attendant*156 upon the adventure? Were payments of "principal and interest" on the notes subordinated to dividends and to the claims of creditors? Did the noteholders have substantial control over the business operations; and if so, was such control reserved to them as an integral part of the plan under which the notes were issued? Was the "price" of the properties, for which the notes were issued, disproportionate to the fair market value of such properties? Did the noteholders, when default of the notes occurred, attempt to enforce the obligations? [Emanuel N. ( Manny) Kolkey, supra at 59.]

We have set forth in our Findings of Fact, with some degree of specificity, the various factors which cause us to conclude that the transfer of the Burr Oaks property to petitioner was an equity contribution, rather than a sale. We set forth below some of the more significant factors which led us to this conclusion.

In the first place, petitioner, from the start of its existence, was not only undercapitalized, but, in fact, had no significant capitalization at all. Cf. Hoguet Real Estate Corporation, 30 T.C. 580, 598 (1958). Thus, *157 petitioner was organized in October with a paid-in capital of $ 4,500. Shortly thereafter, when Elkind, Watkins, and Ritz transferred the Burr Oaks property to petitioner, its books of account reflected liabilities of $ 360,000. In addition, it was contemplated from the very outset of petitioner's existence that although the city of Madison would initially pay the major portion of the cost of improving the Burr Oaks property, petitioner would, nevertheless, be required to incur substantial development costs. Petitioner estimated that these costs would be in excess of $ 100,000.

Another factor indicating that petitioner was undercapitalized and did not have sufficient funds with which to commence business *647 is that on November 30, 1957, less than 2 months after it was formed, it borrowed $ 15,000 from Elkind. On February 28, 1958, it borrowed an additional $ 10,000 from Elkind.

Moreover, the land transferred to petitioner by Elkind, Watkins, and Ritz was its only asset of significance and, without it, petitioner could not have engaged in business. See and compare Edward G. Janeway, 2 T.C. 197 (1943), affd. 147 F. 2d 602*158 (C.A. 2, 1945); Aqualane Shores, Inc., 30 T.C. 519 (1958), affd. 269 F. 2d 116 (C.A. 5, 1959). It was at all times contemplated by Elkind, Watkins, and Ritz that the land would remain at the risk of petitioner's business.

It is generally recognized that one of the crucial factors in determining whether the transfer of property to a thinly capitalized corporation constitutes a bona fide sale, rather than a mere contribution to capital, is the anticipated source of payment to the transferor. Gilbert v. Commissioner, 262 F. 2d 512, 514 (C.A. 2, 1959), affirming a Memorandum Opinion of this Court, certiorari denied 359 U.S. 1002