FIN HAY REALTY COMPANY v. United States

• Decision Date: 13 December 1966
• Docket Number: Civ. A. No. 847-64.
• Citation: 261 F. Supp. 823
• Parties: FIN HAY REALTY COMPANY, Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — District of New Jersey

261 F. Supp. 823

FIN HAY REALTY COMPANY, Plaintiff, v. UNITED STATES of America, Defendant.

Civ. A. No. 847-64.

United States District Court D. New Jersey.

December 13, 1966.

Herbert L. Zuckerman, Newark, N. J., for plaintiff.

David M. Satz, Jr., U. S. Atty., by Allen Schwait, Atty., Tax Div., Dept. of Justice, for defendant.

FINDINGS OF FACT AND CONCLUSIONS OF LAW

WORTENDYKE, District Judge:

This is a corporate taxpayer's action for refund, with interest, of Federal income taxes paid upon alleged deficiency assessments for the calendar years 1961 and 1962. The deficiency assessments resulted from a disallowance of expenses claimed as interest.

This Court has jurisdiction of the subject matter under 28 U.S.C. § 1346(a) (1) and over the parties. The statutory conditions precedent to the institution of the action have been complied with.

The payments received by the corporate taxpayer, upon which the taxpayer claimed allowance for interest paid during the tax years, were held to have been contributions to taxpayer's capital and not bona fide loans.

The facts were stipulated, and I find as follows:

1. The plaintiff is a New Jersey corporation which was organized in 1934 for purposes of acquiring and holding real estate for rental.

2. At its formation, stock was issued in equal amounts to Frank L. Finlaw and J. Louis Hay in consideration of payment of $10,000 from each.

3. On February 16, 1934, the two stockholders advanced to the plaintiff $15,000 a piece.

4. On March 1, 1934, plaintiff purchased a 24-family apartment building located at 214-216 Wainwright Street, Newark, New Jersey, for $39,000 in cash.

5. On April 30, 1934, Finlaw and Hay advanced to the plaintiff $35,000.

6. On May 1, 1934, the plaintiff purchased two 33-family brick apartment buildings at 241 and 249 South Arlington Avenue in East Orange, New Jersey, for $175,000 plus adjustments, of which $100,000 was paid through a purchase-money mortgage with Hoover Investment Company, and the balance from the cash advanced to the plaintiff by Finlaw and Hay.

7. The Wainwright and Arlington properties were the plaintiff's only income-producing assets.

8. On January 6, 1938, Finlaw advanced to the plaintiff $2,000 and on April 29, 1939, Hay also advanced to the plaintiff $2,000.

9. In 1939, the plaintiff purchased equipment (stokers and refrigerators) in the amount of $6,488.

10. On December 31, 1940, the two stockholders advanced to the plaintiff $1,000 each.

11. Sometime in 1940, the plaintiff purchased additional equipment in the amount of $2,014.58.

12. A summary of the advances made to the plaintiff by the stockholders, with the capital expenditures which followed the payments, is as follows:

                Amount Paid        Date          Expenditure       Date
                $ 30,000        Feb. 16, 1934     $ 39,000        Mar. 1, 1934
                  70,000        Apr. 30, 1934       75,000        May  1, 1934
                   4,000        Jan. 6, 1938
                                    and
                                Apr. 29, 1939        6,488        1939
                   2,000        Dec. 31, 1940        2,014.58     1940
                ___________                       ___________
                $106,000.00                       $122,502.58
                

13. Notes calling for interest to be paid at 6% annually were issued to the stockholders. The corporate books of account reflected the alleged notes as "Notes Payable-Officers", and interest on the advances was recorded as paid and deducted in each year since 1934.

14. The "notes" which were issued to the shareholders were unsecured demand notes and were secondary to the mortgages placed on the plaintiff's property.

15. No attempt was made to retire the notes by a sinking fund or other retirement provision.

16. Demand for repayment was never made by Finlaw or Hay. The only demands for repayment were by Hay's estate in 1951 and by the successors to Finlaw's interests in 1962 and 1963.

17. The plaintiff's Federal income tax returns for the years 1959 and 1960 were audited by Revenue Agent Michael Curtis, who, after concluding his audit on March 27, 1962, determined that the interest expense deductions attributable to the "notes" were not properly taken and should be disallowed.

18. The demand by the successors of Finlaw for the repayment of the "notes" in 1962 and 1963 was made shortly after the disallowance of the interest deduction.

19. Finlaw and Hay did not intend to have the amounts of money advanced to the plaintiff returned to them within a reasonable time.

20. The cash flow of the plaintiff did not permit the repayment of the amounts advanced out of earnings within a reasonable time after the amounts were advanced.

21. The amounts advanced to the plaintiff by its stockholders were made to purchase the plaintiff's assets necessary for its operation.

22. The amounts advanced to the plaintiff by its stockholders were placed at the risk of the plaintiff's business.

23. The plaintiff's original shareholders advanced money to the plaintiff in the same proportions; and they had a common interest in the amounts so advanced.

24. The real value of assets for purposes of computing the debt-to-equity ratio is the price at the time of sale to the plaintiff.

25. The plaintiff's debt of $200,000 is to be compared to its admitted equity of $20,000 to produce a 10:1 ratio of debt to equity.

26. The plaintiff timely filed Federal income tax returns for the years ended December 31, 1961 and December 31, 1962 with the District Director of Internal Revenue at Newark, New Jersey, and paid income taxes on the amounts reported on the respective returns. It deducted as interest expense the sums of $3,000 and $2,910 respectively for the years 1961 and 1962.

27. On or about March 2, 1964, the District Director assessed against the plaintiff additional taxes and interest of $1,680 for the year ended December 31, 1961 and $1,561.38 for the year ended December 31, 1962, by reason of the disallowance of these interest expenses. On or about March 2, 1964, the plaintiff paid to the District Director on account of such assessment the sum of $1,670.28 and $1,548.45. On March 12, 1964, the plaintiff filed, with the District Director of Internal Revenue, Claims for Refund (Form 843) for the years ended December 31, 1961 and December 31, 1962.

28. No action was taken by the defendant for six months on these refund claims.

The question here is whether the advances to plaintiff by the two stockholders were contributions to capital, or bona fide loans entitling the plaintiff to deduct the interest paid or accrued during the taxable years under consideration. It is noted that, though there are many cases in this general area which construe the kind of statutory indebtedness necessary to entitle one to make an interest expense deduction, there appears to be no single rule, principle or test that is controlling or decisive of the question. It must rather be decided upon a case-by-case factual analysis of the true nature of the undertaking and the intent of the parties.¹ It is substance, rather than form, which governs. Weller v. C. I. R., 270 F.2d 294, 297 (3rd Cir. 1959) cert. den. 364 U.S. 908, 81 S.Ct. 269, 5 L.Ed.2d 223 (1960).

The Internal Revenue Code of 1954, 26 U.S.C. § 163(a), provides: "There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." The term `interest on indebtedness' as used in this statutory section means "`* * * compensation for the use or forebearance of money.'" Carpenter v. C. I. R., 322 F.2d 733, 735 (3rd Cir. 1963) cert. den. 375 U.S. 992, 84 S.Ct. 631, 11 L.Ed.2d 478 (1964) citing Deputy v. Du Pont, 308 U.S. 488, 498, 60 S.Ct. 363, 84 L.Ed. 416 (1940). The taxpayer has the burden of proving "* * * the reality of the indebtedness * * * " i. e., that the deductions here in question were within the purview of the statutory provision relied upon. See P. M. Finance Corporation v. C. I. R., 302 F.2d 786, 789 (3rd Cir. 1962), citing White v. United States, 305 U.S. 281, 59 S.Ct. 179, 83 L.Ed. 172 (1938).

In the case at bar, practically all of the facts are either stipulated or disclosed in and by exhibits in evidence. This, of course, does not make the issue any less factual in nature. There was also limited oral testimony relevant to the sole question which the Court is called upon to answer. However, the intent of the taxpayer's only two stockholders must be inferred from the totality of the evidence in the light of the purpose of the statute and the burden cast upon the taxpayer to bring itself within the privilege of the deduction.

The evidence is persuasive that Frank L. Finlaw and J. Louis Hay organized the taxpayer New Jersey corporation for the purpose of conducting an enterprise for the acquisition, ownership and maintenance of rent-producing real estate. Each of these two stockholders subscribed and paid for an equal number of shares of common stock; each paying the sum of $10,000 for capital stock of the corporation. The receipt of these payments for stock subscriptions created a capital fund for the corporation of $20,000 with which to commence its business. The business could not function until the corporation had acquired some real estate from which rental income could commence to accrue.

On March 1, 1934, the same year in which the corporation was organized, it acquired a 24-family apartment building located at 214-216 Wainwright Street, Newark, New Jersey, for $39,000 in cash. While the evidence discloses that the price paid for that real estate acquisition was low, the corporation's available cash holdings, out of which payment for the property was made, totalled only $20,000. This purchase created a capital deficit of $19,000. I must assume that the real estate was purchased only after negotiations between the buyer-corporation and the prospective seller, and that when the purchase price was agreed upon, the capital deficit became apparent. I am forced to the conclusion, therefore, that the threatened deficit was obviated by the advance, on February 16, 1934,...