Mills v. Comm'r of Internal Revenue, Docket No. 9926.

• Decision Date: 14 July 1948
• Docket Number: Docket No. 9926.
• Parties: JUDSON MILLS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

11 T.C. 25

JUDSON MILLS, PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 9926.

Tax Court of the United States.

Promulgated July 14, 1948.

The taxpayer, a textile producer, acquired new mill machinery under agreements called leases whereby it was required to make fixed monthly payments called rentals to the machinery manufacturers for about five years and could then acquire title to the machinery by payment of a relatively small additional amount. As set forth in correspondence, the totals payable in monthly installments were computed to include 5 or 6 per cent interest on the ‘principal,‘ and interest tables were attached to the manufacturers' letters explanatory of the terms of the agreements. Held:

(1) The monthly amounts paid are not deductible as rentals because the taxpayer thereby acquired an equity interest in the machinery. Sec. 23(a)(1)(A), I.R.C.

(2) A portion of the monthly payments equal to the factor designated interest in the letters explanatory of the terms of the agreements is deductible as interest. Percy W. Phillips, Esq., for the petitioner.

B. D. Hathcock, Esq., for the respondent.

The Commissioner determined a deficiency of $3,383.73 in petitioner's income tax for the taxable year ended March 31, 1940, by disallowing a deduction of $30,786.78 claimed by it as rentals paid for use of machinery.

Petitioners assigns as error: (a) The disallowance by the Commissioner of such amounts claimed by it to have been paid as rentals on machinery, and (b), in the alternative, avers that, if the instruments upon which the alleged rental payments were made ‘are to be reformed into conditional bills of sale,‘ then petitioner should be permitted to deduct such portion of the payments made thereunder as ‘would represent interest.‘

Another issue, involving the deductibility of South Carolina State income tax claimed by petitioner in its amended petition, has been conceded by respondent in petitioner's favor.

FINDINGS OF FACT

Petitioner is a corporation, with its principal office at Greenville, South Carolina. The Federal income tax return for the period involved was filed by it with the collector of internal revenue for the district of South Carolina.

Petitioner, during the fiscal year, and long prior thereto and since, was a manufacturer of cotton and rayon textile products, principally the latter.

In 1925 Judson Mills was very profitable and was regarded as one of the best in the United States, but by 1938 it had become unprofitable, having lost $565,000 in 1937 and $380,000 in 1938. In December 1938 Alan B. Sibley was elected treasurer and made the general manager in complete charge of the mill's operation. He found the machinery and equipment were incapable of producing the type of goods which commanded the highest price and the greatest profit, and thereupon he took steps to modernize the machinery and equipment.

To this end he entered into negotiations with three manufacturers: The Atwood Machine Co., Crompton & Knowles Loom Works, and the Draper Corporation, from whom petitioner produced new machinery. This machinery was delivered and installed in its mill during the taxable year ended March 31, 1940, under agreements whereby the manufacturer, designated lessor, purported to lease the equipment for stipulated monthly payments, termed rentals, to petitioner, designated lessee. Prior to making these agreements, however, petitioner and the manufacturer reached a precise understanding as to how the recurrent payments should be computed and the factors entering into the totals payable, and this understanding was set forth in correspondence between them.

The terms of the first agreement, made on June 30, 1939, with the Atwood Machine Co., reflect the figures submitted by the manufacturer in a letter of June 15, 1939. In this letter aggregate payments of $25,958.64 were required for the first two years, of $25,958.52 for the next three years, and of $6,198.87 on exercise of the option— all computed to include ‘accumulated interest at 5% at end of 5 year term $5,948.87.‘ An attached schedule shows the amount of interest for each month of the first two years, diminishing as the amount of principal diminishes. The agreement itself is in substance as follows:

THE ATWOOD AGREEMENT: Is for a period of five years, commencing on the first day of June 1939, and expiring on May 31, 1944. Lessor at its own expense is to install the machinery in the plant of the lessee prior to July 31, 1939. Lessee agrees:

1. That it will pay the Lessor at Stonington, Connecticut, as rent for the leased property the sum of $1,081.61 on the 1st day of June, 1939, and the sum of $1,081.61 on the 1st day of each and every month thereafter, up to and including the 1st day of May, 1941, and the sum of $721.07 on the first day of each and every month thereafter up to and including the 1st day of May, 1944.

Lessee further agrees with reference to its possession of the machinery to ‘safely keep and carefully use‘ same, to keep it insured at lessee's expense, to pay all taxes on same and keep same at lessee's plant and not remove therefrom without consent of lessor; to make all necessary repairs and maintain same in good order and condition at lessee's expense, ‘procuring from the lessor, at the lessor's usual selling prices, all parts for repairing the same, and insert such parts at the lessee's own cost and charge; and the lessee shall be responsible for any damage to said machines and machinery while in its possession‘; to return machinery at ‘expiration of lease‘ in good condition, reasonable wear and tear excepted, and pay lessor for replacement of broken or missing parts. If lessee abandons property, is declared insolvent, fails to pay rent within ten days after due, or fails to pay taxes, insurance, etc., lessor ‘at its option may terminate lease‘ and take possession of machinery.

3. Failure to pay any such rental instalment for more than ten (10) days after written notice has been sent to the Lessee by the Lessor that the same has become due and payable shall cause all the remaining instalments of rent to become due and payable immediately.

4. That at the termination of this lease on May 31, 1944, but not sooner, the Lessee, it not being then in arrears for rent, taxes, parts or insurance, or in default as to any of its agreements herein contained, shall have the right and option to purchase from the Lessor the machines and machinery hereinbefore described, together with any additions or improvements which may be added thereto by the Lessee, for the sum of $6,198.87.

5. In the event the Lessee exercises the option to purchase, provided for in the preceding paragraph hereof, then and in that event the Lessor shall execute and deliver to the Lessee a bill of sale for said machines and machinery, conveying an unencumbered title to the same to the Lessee, and thereupon this lease and the liability of the Lessee for further rents shall be terminated.

6. If at the termination of this lease the Lessee does not wish to exercise its option to purchase as hereinbefore provided for, it shall, if it be not then in arrears for rent, taxes, parts, insurance, or in default as to any of its agreements hereinbefore contained, have the option to renew this lease for a period of one (1) year and from year to year thereafter on the same terms and conditions as above stated except that the rent to be paid by it to Lessor shall be $2,400.00 per annum, payable in equal monthly instalments.

The terms of the second agreement, made on July 3, 1939, with Crompton & Knowles Loom Works, reflect figures submitted by the manufacturer in a letter of July 18, 1939, which purports to show how the manufacturer's comptroller ‘computed the figures used in the contract.‘ This computation sets forth periodic payments aggregating $111,300.25, described as principal; $13,786.15 termed interest at 6 per cent (a total of $125,086.40); and $10,118.20, ‘amount allocated as option purchase price,‘ which must be increased by $2,731.91, representing 6 per cent interest for 4 1/2 years, or ‘If option price extended over 6 months period— add int. $177.07.‘ The agreement itself is in substance as follows:

CROMPTON & KNOWLES AGREEMENT: Begins October 2, 1939, (date of delivery of machinery) and to continue for a period of ‘four and one-half (4 1/2) years unless previously terminated or extended.‘

III. In consideration of the above letting, the Lessee covenants and agrees with the Lessor as follows:

1. The Lessee shall pay as rent for the said machinery, during the original term of the lease, the sum of ONE HUNDRED TWENTY FIVE THOUSAND EIGHTY SIX DOLLARS ($125,086.00). This sum shall be paid in consecutive monthly installments, commencing with an installment payable on October 2, 1939. Each installment so payable shall equal one-twelfth of the total amount payable during each twelve-month period, beginning with the twelve-month period commencing October 2, 1939, and one-sixth of the total amount payable for any six months period; the total amounts payable during each of said periods being:

+------------------------------------+
                ¦First period (12 months) ¦$34,399.00¦
                +-------------------------+----------¦
                ¦Second period (12 months)¦34,399.00 ¦
                +-------------------------+----------¦
                ¦Third period (12 months) ¦22,927.00 ¦
                +-------------------------+----------¦
                ¦Fourth period (12 months)¦22,927.00 ¦
                +-------------------------+----------¦
                ¦Fifth period (6 months)  ¦10,434.00 ¦
                +------------------------------------+
                

4. The said machinery shall, at all times during the said term or for such time as it may be extended, remain and be the sole and exclusive property of the Lessor, and the Lessee shall have no right of property or equity therein, but only the right to use the same in the manner and upon the conditions herein set forth. * * *

V. If default be made in the due payment of any of the installment rent payments herein stated, or if this...