Lowe v. Comm'r of Internal Revenue

• Decision Date: 11 June 1965
• Docket Number: Docket No. 4745-62.
• Citation: 44 T.C. 363
• Parties: ALVIN B. LOWE AND RUTH LOWE, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

44 T.C. 363

ALVIN B. LOWE AND RUTH LOWE, PETITIONERS,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 4745-62.

Tax Court of the United States.

Filed June 11, 1965.

Thomas L. Wolfe, for the petitioners.

Kenneth G. Anderson, for the respondent.

Petitioner in 1955 sold to one Levitus all of the stock of a corporation which had a lease on a hotel. Levitus made a downpayment on the purchase price in 1955, gave petitioner a promissory note for the balance, deposited the shares with him as security, and immediately began managing the hotel. Levitus continued such management until he defaulted in payment of the remaining purchase price in 1958. Levitus then reconveyed the to taxpayer and taxpayer released him from any further obligation under the 1955 sale. Taxpayer retained $22,500 previously paid by Levitus toward the purchase price. Respondent determined that the $22,500 was ordinary income in 1958. Held, the $22,500 was capital gain to taxpayer in 1958 under the principle of Arrowsmith v. Commissioner, 344 U.S. 6 (1952).

DAWSON, Judge:¹

Respondent determined a deficiency in petitioners' income tax for the taxable year ended December 31, 1958, in the amount of $14,364.84.

The deficiency is based upon respondent's determination that $22,500 retained by Alvin B. Lowe on the reacquisition of stock in 1958 represents ordinary income to him and that certain management expenses are not deductible as ordinary and necessary business expenses. The parties have agreed that a portion of the management expenses is deductible. Thus the only issue remaining for decision is whether the amount retained by petitioner Alvin B. Lowe on the reacquisition of F. H. Operating Co. stock in 1958 was taxable to him as ordinary income or as capital gain.

FINDINGS OF FACT

Some facts were stipulated by the parties and are found accordingly.

Alvin B. Lowe and Ruth Lowe are residents of Miami Beach, Fla. They filed their joint income tax return for the taxable year ended December 31, 1958, with the district director of internal revenue, Jacksonville, Fla. All subsequent references to petitioner shall mean Alvin B. Lowe.

In July 1955 petitioner owned all of the 250 outstanding shares of F. H. Operating Co., an Ohio corporation (hereinafter sometimes called lessee). The principal nonliquid asset of this corporation was a lease dated December 16, 1947, from Fenway Hall Hotel Corp., an Ohio corporation (hereinafter sometimes called lessor), on an apartment and commercial hotel located in Cleveland, Ohio.

Revelant terms of the lease were as follows:

1. The term was for 10 years with the lessee having an option immediately prior to the end of the term to renew for an additional 15 years if it had performed all terms and conditions of the lease.

2. Lessee agreed to deposit with the lessor U.S. bonds, in bearer form, of $150,000 par value as security for faithful performance of the terms and conditions. If the lessee failed to so perform, the bonds would belong to the lessor as fixed, liquidated, and agreed damages.

3. The lessee was required to carry liability insurance, fire insurance on the hotel's contents, and fire and windstorm insurance on the building; to replace all broken glass; to comply with all fire regulations; to remove all waste materials, garbage, and rubbish from the premises and to provide proper receptables for same; and to yield the premises in good order and condition on the termination of the lease except for ordinary wear and tear and damage not the fault of the lessee.

4. If the lessee defaulted in payment of rent ($9,583.33 per month) and continued in default for 10 days, or if it defaulted in any of the other terms and conditions of the lease without same being cured within 30 days, or if it filed a petition in bankruptcy or was adjudicated a bankrupt, or made an assignment for the benefit of creditors or took advantage of any insolvency act, the lessor had the right to terminate the lease on 5 days' notice. Failure to cure the default within the 5-day period meant that the lessor could require forfeiture of the security.

5. The lessee could assign the lease without the lessor's consent, provided the assignment was to ‘reputable hotel operators' and the assignee assumed all terms and conditions of the lease.

On July 31, 1955, petitioner and A. W. Levitus entered an agreement whereby petitioner² agreed to sell all of the stock of lessee to Levitus for $185,000. The agreement recites that $35,000 was paid on signing and the balance of the purchase price, $150,000, was payable in 88 consecutive monthly installments of $1,000 each beginning October 1, 1955, with principal unpaid at the end of such period payable by March 1, 1963. Interest at 5 1/2 percent on the unpaid balance was to be computed and paid with each monthly installment, with interest on the remaining principal of $62,000 that was payable by March 1, 1963, to be accrued from the date of the final monthly payment and paid with the final payment of principal.

Other relevant terms of the agreement were as follows:

1. Levitus was required to devote his time and best efforts to conducting the business in a ‘high-grade’ manner.

2. Levitus could not assign the agreement without the petitioner's consent.

3. Hotel revenues had to be used for taxes, license fees, Government charges, rent, and operating costs before they could be used for alterations to the property or payment of compensation to Levitus.

4. If Levitus was not in default immediately prior to the end of the original lease, he could at that time elect to exercise the option of renew the lease for the additional term of 15 years.

5. The lessee's current accountant was to continue to audit the operations and was to submit monthly operating statements to petitioner.

6. Concurrently with Levitus' payment of $35,000 to petitioner, the latter would deliver to the parties' escrow agents the lessee's shares endorsed in blank and its corporate books and records. The escrow agents would hold these articles until the purchase price was completely paid and at that time would deliver them to Levitus.

7. Petitioner could elect to transfer the shares to Levitus and in case of such election Levitus would deposit the shares with petitioner as security for payment of the balance of the purchase price. Concurrently, Levitus would be required to execute a note payable to petitioner or order incorporating the terms of payment previously stated.

8. If Levitus executed the note and observed its terms, he was to have all beneficial rights in the shares of lessee, except he could not vote the shares for any of the following purposes:

(a) to dispose of or encumber any of lessee's property;

(b) to alter the lease or enter any agreement with the lessor that would affect the Government bonds held as security thereunder;

(c) to dissolve, liquidate, or reorganize the lessee, or consolidate or merge it with another corporation, unless he deposited with petitioner, in substitution for the pledged stock, security satisfactory to petitioner;

(d) to alter the lessee's authorized capital or declare or pay any dividends;

(e) to borrow money or issue evidences of indebtedness, except for loans from Levitus to lessee in the ordinary course of lessee's business; but such loans had to be subordinated to other creditors and could not be repaid until petitioner's note was paid; and

(f) to authorize any advance to, or withdrawal by, any shareholder, director, or officer, except in payment of reasonable compensation to such person.

9. In the event of default in payments on the note, or of rent, or of any other amounts due under the agreement or the lease, or failure to perform the terms and conditions of the lease or agreement, or if the company became solvent or if a petition in bankruptcy or for reorganization was filed against it and it was adjudicated a bankrupt, or if an assignment for the benefit of creditors was made or if a receiver was appointed, then the holder of the note could declare the entire balance immediately due and payable and become vested with all rights of both shareholders of record and beneficial owners of the shares. The holder would also have the right (a) to sell the shares, (b) to put title to the shares in his own name, and (c) to remove all officers and directors of lessee.

10. If Levitus defaulted in the payment of rent or other charges under the lease, or in the payment of principal or interest due under the agreement, or in the performance of the terms and conditions of the lease or the agreement, petitioner had the right to end his authority to manage the hotel. If such termination occurred, all amounts that had been paid by Levitus to petitioner under the agreement were to be retained by petitioner as liquidated damages.

11. If the lessee's current assets on July 31, 1955, exceeded its current liabilities, such excess would be paid to petitioner; if the current liabilities exceeded the current assets, petitioner would pay such excess to Levitus.

Petitioner transferred the shares to Levitus and Levitus executed on July 31, 1955, a note for $150,000 payable to petitioner and his wife under the terms previously stated. The note was secured by deposit of the shares. Pursuant to the terms of the agreement, Levitus paid $35,000 to petitioner on signing and made 30 monthly payments of $1,000 each, plus interest, between the signing of the agreement and 1958.

Petitioner's adjusted basis for the stock of lessee was $75,000. He did not include any part of the $65,000 paid toward the purchase price in his gross income. Such exclusion was based on advice of counsel that he need not include such receipts in gross income until he had recovered his adjusted basis for the shares.

Shortly before December 1957, the end of the original lease period, Levitus, in accordance with the terms of the 1955 agreement, elected to renew the lease. He was not in default under the agreement at the date of such renewal....