Frank Lyon Company v. United States

• Decision Date: 18 April 1978
• Docket Number: No. 76-624,76-624
• Citation: 55 L.Ed.2d 550,435 U.S. 561,98 S.Ct. 1291
• Parties: FRANK LYON COMPANY, Petitioner, v. UNITED STATES
• Court: U.S. Supreme Court

55 L.Ed.2d 550

98 S.Ct. 1291

435 U.S. 561

FRANK LYON COMPANY, Petitioner,

v UNITED STATES.

No. 76-624.

Argued Nov. 2, 1977.

Decided April 18, 1978.

Syllabus

A state bank, which was a member of the Federal Reserve System, upon realizing that it was not feasible, because of various state and federal regulations, for it to finance by conventional mortgage and other financing a building under construction for its headquarters and principal banking facility, entered into sale-and- easeback agreements by which petitioner took title to the building and leased it back to the bank for long-term use, petitioner obtaining both a construction loan and permanent mortgage financing. The bank is obligated to pay rent equal to the principal and interest payments on petitioner's mortgage and has an option to repurchase the building at various times at prices equal to the then unpaid balance of petitioner's mortgage and initial $500,000 investment. On its federal income tax return for the year in which the building was completed and the bank took possession, petitioner accrued rent from the bank and claimed as deductions depreciation on the building, interest on its construction loan and mortgage, and other expenses related to the sale-and-leaseback transaction. The Commissioner of Internal Revenue disallowed the deductions on the ground that petitioner was not the owner of the building for tax purposes but that the sale-and-leaseback arrangement was a financing transaction in which petitioner loaned the bank $500,000 and acted as a conduit for the transmission of principal and interest to petitioner's mortgagee. This resulted in a deficiency in petitioner's income tax, which it paid. After its claim for a refund was denied, it brought suit in the District Court to recover the amount so paid. The court held that the claimed deductions were allowable, but the Court of Appeals reversed, agreeing with the Commissioner. Held: Petitioner is entitled to the claimed deductions. Pp. 572-584.

(a) Although the rent agreed to be paid by he bank equaled the amounts due from the petitioner to its mortgagee, the sale-and-leaseback transaction is not a simple sham by which petitioner was but a conduit used to forward the mortgage payments made under the guise of rent paid by the bank to petitioner, on to the mortgagee, but the construction loan and mortgage note obligations on which petitioner paid interest are its obligations alone, and, accordingly, it is entitled to claim deductions therefor under § 163(a) of the Internal Revenue Code of 1954. Helvering v. Lazarus & Co., 308 U.S. 252, 60 S.Ct. 209, 84 L.Ed. 226, distinguished. Pp. 572-581.

(b) While it is clear that none of the parties to the sale-and-leaseback agreements is the owner of the building in any simple sense, it is equally clear that petitioner is the one whose capital was invested in the building and is therefore the party entitled to claim depreciation for the consumption of that capital under § 167 of the Code. P. 581.

(c) Where, as here, there is a genuine multiple-party transaction with economic substance that is compelled or encouraged by business or regulatory realities, that is imbued with tax-independent considerations, and that is not shaped solely by tax-avoidance features to which meaningless labels are attached, the Government should honor the allocation of rights and duties effectuated by the parties; so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes. Pp. 581-584.

536 F.2d 746, reversed.

Erwin N. Griswold, Washington, D. C., for petitioner.

Stuart A. Smith, Washington, D. C., for respondent.

Mr. Justice BLACKMUN delivered the opinion of the Court.

This case concerns the federal income tax consequences of a sale-and-leaseback in which petitioner Frank Lyon Company (Lyon) took title to a building under construction by Worthen Bank & Trust Company (Worthen) of Little Rock, Ark., and simultaneously leased the building back to Worthen for long-term use as its headquarters and principal banking facility.

I

The underlying pertinent facts are undisputed. They are established by stipulations, App. 9, 14, the trial testimony, and the documentary evidence, and are reflected in the District Court's findings.

A.

Lyon is a closely held Arkansas corporation engaged in the distribution of home furnishings, primarily hirlpool and RCA electrical products. Worthen in 1965 was an Arkansas-chartered bank and a member of the Federal Reserve System. Frank Lyon was Lyon's majority shareholder and board chairman; he also served on Worthen's board. Worthen at that time began to plan the construction of a multistory bank and office building to replace its existing facility in Little Rock. About the same time Worthen's competitor, Union National Bank of Little Rock, also began to plan a new bank and office building. Adjacent sites on Capitol Avenue, separated only by Spring Street, were acquired by the two banks. It became a matter of competition, for both banking business and tenants, and prestige as to which bank would start and complete its building first.

Worthen initially hoped to finance, to build, and to own the proposed facility at a total cost of $9 million for the site, building, and adjoining parking deck. This was to be accomplished by selling $4 million in debentures and using the proceeds in the acquisition of the capital stock of a wholly owned real estate subsidiary. This subsidiary would have formal title and would raise the remaining $5 million by a conventional mortgage loan on the new premises. Worthen's plan, however, had to be abandoned for two significant reasons:

1. As a bank chartered under Arkansas law, Worthen legally could not pay more interest on any debentures it might issue than that then specified by Arkansas law. But the proposed obligations would not be marketable at that rate.

2. Applicable statutes or regulations of the Arkansas State Bank Department and the Federal Reserve System required Worthen, as a state bank subject to their supervision, to obtain prior permission for the investment in banking premises of any amount (including that placed in a real estate subsidiary) in excess of the bank's capital stock or of 40% of its capital stock and surplus.¹ See Ark.Stat.Ann. § 67-547.1 (Supp.1977); 12 U.S.C. § 371d (1976 ed.); 12 CFR § 265.2(f)(7) (1977). Worthen, accordingly, was advised by staff employees of the Federal Reserve System that they would not recommend approval of the plan by the System's Board of Governors.

Worthen therefore was forced to seek an alternative solution that would provide it with the use of the building, satisfy the state and federal regulators, and attract the necessary capital. In September 1967 it proposed a sale-and-leaseback arrangement. The State Bank Department and the Federal Reserve System approved this approach, but the Department required that Worthen possess an option to purchase the leased property at the end of the 15th year of the lease at a set price, and the federal regulator required that the building be owned by an independent third party.

Detailed negotiations ensued with investors that had indicated interest, namely, Goldman, Sachs & Company; White, Weld & Co.; Eastman Dillon, Union Securities & Company; and Stephens, Inc. Certain of these firms made specific proposals.

Worthen then obtained a commitment from New York Life Insurance Company to provide $7,140,000 in permanent mortgage financing on the building, conditioned upon its approval of the titleholder. At this point Lyon entered the negotiations and it, too, made a proposal.

Worthen submitted a counterproposal that incorporated the best features, from its point of view, of the several offers. Lyon accepted the counterproposal, suggesting, by way of further inducement, a $21,000 reduction in the annual rent for the first five years of the building lease. Worthen selected Lyon as the investor. After further negotiations, resulting in the elimination of that rent reduction (offset, however, by higher interest Lyon was to pay Worthen on a subsequent unrel ted loan), Lyon in November 1967 was approved as an acceptable borrower by First National City Bank for the construction financing, and by New York Life, as the permanent lender. In April 1968 the approvals of the state and federal regulators were received.

In the meantime, on September 15, before Lyon was selected, Worthen itself began construction.

B

In May 1968 Worthen, Lyon, City Bank, and New York Life executed complementary and interlocking agreements under which the building was sold by Worthen to Lyon as it was constructed, and Worthen leased the completed building back from Lyon:

1. Agreements between Worthen and Lyon. Worthen and Lyon executed a ground lease, a sales agreement, and a building lease.

Under the ground lease dated May 1, 1968, App. 366, Worthen leased the site to Lyon for 76 years and 7 months through November 2044. The first 19 months were the estimated construction period. The ground rents payable by Lyon to Worthen were $50 for the first 26 years and 7 months and thereafter in quarterly payments:

12/1/94 through 11/30/99 (5 years) —$100,000 annually

12/1/99 through 11/30/04 (5 years) —$150,000 annually

12/1/04 through 11/30/09 (5 years) —$200,000 annually

12/1/09 through 11/30/34 (25 years) —$250,000 annually

12/1/34 through 11/30/44 (10 years) —$10,000 annually.

Under the sales agreement dated May 19, 1968, id., at 508, Worthen agreed to sell the building to Lyon, and Lyon agreed to buy it, piece by piece as it was constructed, for a total price not to exceed $7,640,000, in reimbursements to Worthen for its expenditures for the construction of the building.²

Under the building lease dated May 1, 1968, id., at 376, Lyon leased the building back to Worthen for a primary term of 25 years from December 1, 1969, with options...