Ernst Kern Co. v. Comm'r of Internal Revenue

• Decision Date: 15 December 1942
• Docket Number: Docket No. 104946.
• Citation: 1 T.C. 249
• Parties: THE ERNST KERN COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: U.S. Tax Court

1 T.C. 249

THE ERNST KERN COMPANY, PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket No. 104946.

Tax Court of the United States.

Promulgated December 15, 1942.

1. During the taxable year, pursuant to a plan for the readjustment of the obligations of the petitioner and the Kern Realty Corporation, the petitioner acquired leasehold estates of the realty company in business premises occupied by the petitioner; the defaulted first mortgage leasehold bonds of the realty company were canceled; the petitioner issued to the holders of such bonds debentures and shares of its preferred and common stock; the petitioner's indebtedness of $80,000 to a bank was canceled; and the petitioner paid additional rent and interest on its debentures and dividends on its preferred stock for the period beginning with the time when the plan was by its terms to become effective and ending with the time when it was consummated. Held:

(a) There was not a statutory reorganization within clauses (C) and (D) of section 112(g)(1), or a nontaxable transfer within section 112(b)(5), Revenue Act of 1934.

(b) The petitioner, in computing the deductions for depreciation on the property acquired from the realty company, may not use as a basis the basis of such property in the hands of the realty company.

(c) The petitioner did not realize a gain of $536,578.66 when it issued its debentures and stock to the holders of the leasehold bonds, since it never assumed an obligation to pay the amount of principal and interest due on the leasehold bonds.

(d) The petitioner realized income to the extent of $80,000 from the cancelation of its indebtedness to the bank.

(e) The payments of additional rent and of interest on the debentures are deductible as rent and interest. Such payments and the dividends paid on the preferred stock were not part of the cost of the property acquired from the realty company, and they should be excluded from such cost in computing deductions for depreciation.

2. The petitioner purchased real property in the city of Detroit on May 1, 1937. Held, city taxes paid thereon, which, under the city charter, became a personal obligation of the petitioner's vendor on April 1, are not deductible by the petitioner; but Wayne County taxes which, under the state law, became both a lien and a personal liability subsequent to May 1, 1937, are deductible. Thomas G. Long, Esq., and H. A. Mihills, C.P.A., for the petitioner.

Philip M. Clark, Esq., for the respondent.

The respondent determined deficiencies of $88,295.51 in income tax and $30,735.24 in excess profits tax for the fiscal year ended January 31, 1936, and deficiencies of $3,775,36 and $2,255.31 in income tax for the fiscal years ended January 31, 1938, and January 31, 1939, respectively.

The issues presented, except the sixth mentioned below, arise from the consumption, in the fiscal year ended January 31, 1936, of a plan for the readjustment of obligations of the Kern Realty Corporation and the petitioner. They are as follows:

(1) Whether the petitioner realized a taxable gain of $536,578.66 from the transaction, or whether the transaction was tax-free under section 112(b) of the Revenue Act of 1936.

(2) Whether, for the purpose of computing depreciation for the fiscal years ended January 31, 1936, 1938, and 1939, with respect to the property acquired in the transaction, the petitioner is entitled to use a basis the adjusted basis of such property in the hands of its transferor or the cost of such property to the petitioner; and also whether the deduction for depreciation for the fiscal year ended January 31, 1936, should be allowed for 344/365 or 11/12 of that year.

(3) Whether petitioner realized taxable income in the amount of $80,000 from the cancelation of that much of its indebtedness to the First National Bank of Detroit.

(4) Whether the amount of $3,719.17 is deductible in the fiscal year ended January 31, 1936, as rent accrued for the period August 1, 1934, to January 31, 1935.

(5) Whether the amount of $14,663.86 is deductible in the fiscal year ended January 31, 1936, as interest accrued for the period of August 1, 1934, to January 31, 1935.

(6) Whether the petitioner is entitled, in computing its net income for the fiscal year ended January 31, 1938, to deduct the amounts of $2,605.64 and $577.48, paid to the city of Detroit and Wayne County, respectively, as taxes on real estate purchased on May 1, 1937.

The petitioner assigns error in the disallowance of a deduction of $9,243.51 for wages paid to carpenters and painters for the fiscal year ended January 31, 1938. The deduction of that amount is conceded to be correct by the respondent.

Petitioner claims an overpayment of $375.80 as income tax for the fiscal year ended January 31, 1936.

Most of the facts are stipulated and the stipulation, with the exceptions hereinafter shown in our opinion, is hereby adopted as part of our findings of fact. The stipulation provided, inter alia, that the facts stated in the exhibits attached thereto are to be taken as true. In the following findings of fact we set forth those portions of the stipulation and its accompanying exhibits which are deemed necessary for consideration of the issues presented, together with our findings on the additional evidence introduced at the hearing.

FINDINGS OF FACT.

The petitioner is a corporation which was organized under the laws of the State of Michigan in 1923, and it has its principal office and place of business in Detroit. The petitioner has employed the accrual method of accounting in keeping its books and has regularly filed Federal income tax returns on the accrual basis. It filed returns for the fiscal years here involved with the collector for the district of Michigan.

The petitioner is, and for many years has been, engaged in the operation of a department store at the southeast corner of Woodward and Gratiot Avenues in Detroit. During the year 1934, and up to February 21, 1935, the petitioner's outstanding capital stock, consisting of 13,000 shares of common stock, was owned as follows: Ernst Kern, president, 4,999 shares; Otto Kern, vice president and general manager, 4,999 shares; Christopher Wagner, Jr., secretary, 2 shares; and Kern Realty Corporation, 3,000 shares. The Kern Realty Corporation, hereinafter referred to as the realty company, is a Michigan corporation, and throughout the period here involved it had outstanding 4,000 shares of common stock, all of which, except for two shares owned by Christopher Wagner, Jr., were owned in equal proportions by Ernst and Otto Kern.

On October 26, 1925, the realty company executed and delivered to the Detroit Trust Co., as trustee, a trust mortgage dated September 15, 1925, to secure an issue of $2,000,000 of first mortgage leasehold bonds, bearing interest at the rate of 5 1/2 percent per annum, payable semiannually on the 15th day of March and September, and maturing serially, in stated amounts, on September 15 of each year from 1926 to 1940, inclusive. As security for the bonds, which are hereinafter referred to as ‘leasehold bonds,‘ the realty company conveyed to the trustee leasehold estates in lots 40, 41, 42, and 43, and the west 30 feet of lot 79, all in section 7, Governor and Judges Plan of the City of Detroit, situated at Woodward and Gratiot Avenues. The leasehold estates ran for varying terms, all expiring in 1946 or subsequent years, and were acquired by the realty company in June 1923 by assignment from lessees of the owners of the fee.

Of the above mentioned lots, lots 40 and 41, the north 30.52 feet of lot 42, and the west 30 feet of lot 79, constituted a single parcel improved by a department store building. By the terms of the trust mortgage the realty company agreed to lease that parcel to the petitioner for a term of 15 years at a rental which at all times was to be equal to the ground rents and other charges payable on the underlying leases covering all the mortgaged parcels and the interest on the bonds and the amounts required to meet the serial maturities thereof. The rental from the lease to petitioner was assigned to the trustee as further security for the bonds. Pursuant to this provision of the trust mortgage, and on October 26, 1925, the realty company executed a lease to the petitioner of the above mentioned lots 40 and 41, the north 30.52 feet of lot 42, and the west 30 feet of lot 79. The lease, which is hereinafter referred to as the ‘store lease,‘ was for a term beginning September 15, 1925, and expiring September 15, 1940. It provided for annual rentals ranging from $370,750 for the first year to $538.750 for the last year. Since the execution of the store lease, the petitioner has continuously occupied the building on the leased parcel and has conducted a department store business therein.

For a time not clearly disclosed by the record the petitioner produced substantially all of the income required by the realty company to meet its obligations to the holders of the leasehold bonds and to the fee owners and lessors of the parcel occupied by the store building, who are hereinafter referred to as the ‘landlords.‘ Because of the economic conditions prevailing in October 1932, and the decline in the volume of the department store business and the falling off of collections, the petitioner and the realty company were in financial difficulties and were unable to meet their respective obligations. The petitioner had been unable to pay the full rental due to the realty company up to October 1, 1932, under the store lease. A committee representing the holders of the leasehold bonds, hereinafter referred to as the bondholders' committee, was claiming a deficiency in rental due to the realty company, but such deficiency was not admitted by the petitioner. The petitioner was indebted to the First National Bank of Detroit, hereinafter referred to as the ‘bank,‘ in the amount of $372,000, on short term notes and the bank and other...