Davis & Sons, Inc. v. Commissioner
| Citation | 41 TCM (CCH) 1263,1981 TC Memo 178 |
| Decision Date | 13 April 1981 |
| Docket Number | Docket No. 549-79. |
| Parties | William E. Davis & Sons, Inc. v. Commissioner. |
| Court | United States Tax Court |
Richard G. Taft and Reid E. Robison, 100 Park Ave., Oklahoma City, Okla., for the petitioner. Charles N. Woodward, for the respondent.
Memorandum Findings of Fact and Opinion
Respondent determined deficiencies in petitioner's Federal income tax for the taxable years ended June 30, 1974, June 30, 1975, and June 30, 1976, in the amounts of $24,142.35, $24,330.12 and $37,355.19, respectively.
Due to concessions by the parties, the sole issue for decision is whether petitioner, for the taxable years in question, may deduct as rent amounts paid to its majority shareholders for the use of land and improvements pursuant to a lease which contained a base rent amount and a percentage of gross sales amount. The respondent disallowed as a deduction in each year of part of the sum paid as rent upon his determination that part of the amount was excessive.
Some of the facts have been stipulated. The stipulation and the exhibits attached thereto are incorporated herein by this reference.
Petitioner, William E. Davis & Sons, Inc., is a corporation organized and existing under the laws of the State of Oklahoma. Its principal place of business at the time the petition was filed herein was located in Oklahoma City, Oklahoma.
Petitioner's business commenced in 1953 as a partnership consisting of William E. and Margaret H. Davis (hereinafter the "Davises"). Petitioner was incorporated on August 1, 1959. During the years in issue, the Davises owned 2,160 shares of petitioner, their children owned the remaining 840 shares of petitioner and the Davises managed petitioner's business.
At all times material herein, petitioner's business involved the distribution of groceries and related non-food items to institutional customers such as schools, hospitals, restaurants, hotels, clubs, nursing homes, day-care centers and camps throughout the State of Oklahoma and the surrounding area. Petitioner is a distributor of dry and canned foods, frozen foods, produce, paper products, janitorial goods, kitchen goods, meat, and table-top equipment (cutlery, dishes, etc.). Petitioner maintains a fleet of refrigerated, compartmentalized trucks for deliveries.
From 1959 to 1969, petitioner's business was located in its old facility. That building contained approximately 18,000 square feet of warehouse and office space. Its ceilings were 13 feet high. In 1963, when petitioner went into frozen foods, it obtained outside storage space and two small portable freezers since there was no room in the old facility for frozen foods. In 1967, petitioner's gross sales were $2,266,000.
In 1967, petitioner determined that a larger and more sophisticated distribution facility was required to accommodate its expanding business. No facility suitable to its needs existed in Oklahoma at that time. Petitioner decided to construct its own facility. Several potential lenders were contacted on behalf of petitioner in an attempt to borrow the funds necessary to acquire unimproved land and construct a new facility in which petitioner's business would continue. The efforts to borrow funds on behalf of petitioner were unsuccessful.
Thereafter, in 1968, the Davises purchased approximately 9.54 acres of unimproved land for $58,000 with their own funds. In 1969 the Davises arranged financing, on which they were personally liable, for the purpose of constructing a new distribution facility to lease to petitioner. The land acquired for the new facility was located within the city limits of Oklahoma City, but was removed from the downtown area. During all times material herein, approximately 15 percent of petitioner's business was in the Oklahoma City area and the remainder was in the State of Oklahoma and the fringe areas of surrounding states.
The Davises' original investment for the new facility included $58,000 in land, $360,872 for improvements (of which $345,000 was financed) and $16,000 for railroad trackage, or a total of $434,872. They obtained a $345,000 loan for construction of the distribution facility from City National Bank and Trust Company of Oklahoma City, Oklahoma (hereinafter "CNBT" or "interim lender"), pursuant to the terms of a commitment letter form CNBT to the Davises dated May 28, 1969. The commitment letter provided, among other things, that as a condition to the loan the completed premises be leased to petitioner for a term of not less than 20 years for an annual gross rental of not less than $60,000.
The new facility was built in 1969 with additional improvements made in 1973 and 1974. It was constructed with concrete slab foundation, steel frame, concrete block and rail siding walls, nine loading docks and adequate heating and lighting. The building has a sprinkler and alarm sytem and has 26-foot-high ceilings to accommodate forklifts.
When the building was completed and ready for use, it consisted of a total of 45,907 square feet: 35,416 square feet of dry storage space, 6,864 square feet of cold storage space and 3,627 square feet of office and display space.
The Davises executed a Building Lease Agreement with petitioner on March 15, 1969, whereby the Davises leased the new distribution facility to petitioner for a term of 20 years from the first day of the month following completion of construction of the building. The rent payable by petitioner under the lease was $5,000 per month ("base rent") and an additional amount of one percent of the annual gross sales of petitioner in excess of $4,000,000 per year ("percentage rent"), for the entire term of the lease. Petitioner, the lessee, was required to pay all property taxes, maintenance expenses and costs of insurance coverage for the building for the term of the lease.
On June 16, 1969, the Davises executed a promissory note for $345,000 payable to CNBT, the interim lender. On the same date, as a condition to granting the loan and as security for payment of the promissory note, the Davises executed an Assignment of Lease and a Conditional Assignment of Rentals to CNBT. Subsequently, CNBT assigned the lease and rights under the Assignment of Rentals to the permanent lender, the Prudential Insurance Company of America.
An amendment to the lease on September 26, 1973, increased the base rent to $6,650 per month for 17 years commencing November 1, 1973, because 4,920 square feet of cold storage space was added to the premises in 1973. The percentage of gross sales provision remained the same.
Another amendment to the lease on June 1, 1974, acknowledged the payment of $400 over the base rent for the months of April and May, 1974, due to additional improvements, and increased the base rent to $7,275 per month for the remainder of the term of the lease commencing June 1, 1974, because 2,240 square feet of garage space, 1,722 square feet of office space, 646 square feet for a computer room and a driveway and packing area was added to the premises in 1974. All other provisions of the lease remained in effect. Subsequent amendments to the lease have been made but are not relevant to the amount deducted as rent by petitioner during the years in question.
Petitioner's sales are normally accomplished by salesmen who travel to customers' places of business and secure orders. Very few sales are generated from petitioner's facility which serves mainly as storage and office space and as a distribution center. Petitioner's gross sales for the fiscal years ending June 30 of the following years were as follows:
Year Gross Sales
1967 ......... $2,266,000
1968 ......... 2,710,000
1969 ......... 3,037,000
1970 ......... 3,443,000
1971 ......... 3,843,000
1972 ......... 4,836,000
1973 ......... 6,269,000
1974 ......... 7,620,000
1975 ......... 7,742,000
1976 ......... 9,844,000
Although petitioner's gross sales exceeded $4,000,000 for the first time in 1972, no percentage rent was paid for that fiscal year.
For the fiscal year ending in 1973 and for each subsequent fiscal year, in addition to the base rent due and owing under the lease and its amendments, petitioner paid the Davises, as lessors, one percent of annual gross sales in excess of $4,000,000 as provided by the terms of the lease.
A perimeter fence which petitioner placed around a portion of its premises during the fiscal year ending June 30, 1976, at a cost of $2,397.30, constitutes capital asset subject to depreciation with a useful life of three years, with no salvage value. Certain hard surfacing installed by petitioner during the fiscal year ending June 30, 1976, at a cost of $5,518, constitutes a capital asset subject to depreciation with a useful life of seven years, with no salvage value.
OpinionThe issue for decision is whether petitioner, a corporation wholly owned by the Davis family, is entitled to deduct as rent amounts paid during the taxable years in question to its majority shareholders pursuant to the terms of a lease which contains a base rent amount and a percentage of gross sales amount. The respondent partially disallowed the deductions based on his determination that the sums paid were unreasonable in amount. The following chart shows the amounts petitioner deducted as rent in each of the years in issue, the amounts allowed by respondent as rent deductions, and the amounts disallowed by respondent:
Fiscal Year
Ending Rent Deduction
June 30 Claimed Allowed Disallowed
1974 ... $112,296.57 $62,000.00 $50,296.571
1975 ... 125,387.80 74,700.00 50,687.80
1976 ... 145,898.00...To continue reading
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