Frank Lyon Co. v. U.S., 75-1615

• Citation: 536 F.2d 746
• Decision Date: 06 August 1976
• Docket Number: No. 75-1615,75-1615
• Parties: 76-1 USTC P 9451, 76-2 USTC P 9589 FRANK LYON COMPANY, Appellee, v. UNITED STATES of America, Appellant.
• Court: United States Courts of Appeals. United States Court of Appeals (8th Circuit)

Page 746

536 F.2d 746

76-1 USTC P 9451, 76-2 USTC P 9589

FRANK LYON COMPANY, Appellee, v. UNITED STATES of America, Appellant.

No. 75-1615.

United States Court of Appeals Eighth Circuit.

Submitted Feb. 13, 1976.

Decided May 26, 1976.

As Modified on Denial of Rehearing and Rehearing En Banc Aug. 6, 1976.

Gary R. Allen, Atty., Tax Div., Dept. of Justice, Washington, D. C., for appellant; Scott P. Crampton, Asst. Atty. Gen., Gilbert E. Andrews, John A. Dudeck, Jr., Attys., Tax Div., Dept. of Justice, Washington, D. C., and Wilbur H. Dillahunty, U. S. Atty., Little Rock, Ark., on brief.

C. J. Giroir, Rose, Nash, Williamson, Carroll, Clay & Giroir, Little Rock, Ark., for appellee; J. Gaston Williamson and Rose, Nash, Williamson, Carroll, Clay & Giroir, Little Rock, Ark., on brief.

Before BRIGHT and HENLEY, Circuit Judges, and REGAN, ^* District Judge.

BRIGHT, Circuit Judge.

This income tax controversy arises from a series of complex documents which purport to effect a sale of a bank building (not including the underlying land) by a bank to taxpayer, Frank Lyon Company, and a 65-year leaseback with options to purchase the building by the bank. The question presented is whether these transactions vested taxpayer with ownership of the building for tax purposes so as to entitle taxpayer to deduct from its income the tax shelter benefits of depreciation of the building and interest paid on the building mortgage loan. The Commissioner of Internal Revenue ruled that taxpayer did not possess ownership of the building for tax purposes and denied taxpayer these tax advantages. Taxpayer paid the deficiency and successfully sued for a refund in the United States District Court for the Eastern District of Arkansas. The Government thereafter brought this appeal. We reverse, and sustain the Government's position.

Taxpayer acquired its interest in the building in question from the Worthen Bank and Trust Company of Little Rock, Arkansas (Worthen). In 1965, Worthen entered negotiations for the purchase of land in downtown Little Rock on which to construct a new bank building. When such land was purchased, Worthen drew up plans for the new building and entered into construction contracts.

Worthen initially intended to finance the construction itself and to retain ownership of the building. However, federal and state banking regulations forbade Worthen to carry such an expensive building as an asset on its own books. Worthen thereupon decided to adopt a sale-leaseback arrangement using a newly-formed, wholly-owned corporate subsidiary to hold title to the building. However, Worthen learned that debt financing for such a subsidiary could not be arranged.

In 1967, Worthen informed banking authorities that it had decided upon a sale-leaseback arrangement with an independent investor. This approach satisfied the applicable state and federal banking regulatory agencies. Worthen then obtained a verbal commitment from First National City Bank of New York ^CB for interim construction financing. A similar commitment for long-term financing of the building was obtained from New York Life Insurance Company. The long-term financing was conditioned upon approval by New York Life of the party nominated by Worthen to hold title to the building.

Worthen then commenced arm-length negotiations with several investors. Taxpayer Frank Lyon Company learned of these negotiations and informed Worthen of its interest. Frank Lyon, chairman of the board of taxpayer company, served on Worthen's board of directors and Frank Lyon Company does substantial business with Worthen.

Worthen's proposal to the investors specified that construction would cost approximately $7,500,000. After some negotiation, Worthen narrowed the field of potential investors down to taxpayer and one other party. Worthen then proposed that the investor selected should supply an ownership "equity" of $500,000, which would bear "interest" at the rate of six percent per year. The remaining financing would be supplied to the investor by the prearranged mortgage from New York Life at the rate of six and three-quarters percent, payable in 25 years. Worthen would lease back the building from the investor under the conditions discussed below and would retain an option to repurchase at the end of the 11th, 15th, 20th, and 25th years at specific amounts, plus an assumption of the New York Life mortgage. If Worthen did not purchase the building during the 25-year primary term, it would have eight additional options to extend the lease, each for a five-year period (40 years total). Worthen would agree to execute a 75-year ground lease for the land under the building (ownership of which Worthen retained) to the investor, and to subject the adjacent parking facility (of which Worthen also retained ownership) and certain building furnishings and equipment to the New York Life mortgage. Worthen retained the rights to the investment tax credit and sales tax savings generated by the building project.

Taxpayer was selected by Worthen as the investor when it agreed to accept these terms and additionally agreed to reduce Worthen's building lease payments by $21,000 per year for the first five years. It later developed that New York Life would not accept assignment of a lease incorporating this rental reduction. Worthen and taxpayer then entered a lease at the rental originally proposed but by separate agreement provided for some additional benefits to accrue to Worthen in an independent transaction. ¹ Thereafter, taxpayer, Worthen, First National City Bank, and New York Life Insurance Company entered into various leases, assignments, notes, and agreements effective May 1968 and December 1969, whereby Worthen "sold" its building as it was constructed to taxpayer and Worthen then "leased back" the building from the taxpayer. ²

The ultimate sale price of the Worthen building to taxpayer amounted to $7,640,000, of which New York Life furnished all but $500,000 through its mortgage. This mortgage was secured by a first deed of trust executed by taxpayer and Worthen which conveyed to New York Life title to the land, building, and a parking facility. As additional security, taxpayer, assigned to New York Life its interest in the building lease and ground lease. By separate agreement with New York Life, Worthen consented to this assignment and agreed not to terminate the building lease as long as the mortgage remained outstanding.

Worthen's annual rent for the first 25 years of the building lease represents the exact amount necessary to fully amortize the 25-year, $7,140,000 New York Life mortgage. ³ Should Worthen exercise its option to purchase during the primary term of 25 years, taxpayer would receive a net cash amount equal to its $500,000 "equity" investment plus six percent compounded interest. Should Worthen elect not to purchase the building and to continue paying rent for the potential additional 40-year life of the lease (eight extensions of five years), the rental payments provided will approach but not equal taxpayer's $500,000 investment compounded at a six percent rate. ⁴

As we have already noted, Worthen retains an option to repurchase the building at the end of 11, 15, 20, and 25 years at the exact amount of taxpayer's investment of $500,000 in the transaction, compounded at six percent per annum, plus assumption of the unpaid balance of the New York Life mortgage. We observe in this connection that the first option period occurs after the first 11 years of the lease during which income tax savings to taxpayer from interest and depreciation will amount to about $1,500,000. Thereafter, taxpayer would reap no tax benefits from ownership. Increasing amounts of the rental received from Worthen and passed on to New York Life would apply to the principal of the mortgage, rather than to interest, and hence would be nondeductible. At the same time, allowable depreciation on the building would not equal the non-interest portion of the rent. The net result would be taxable income to taxpayer.

The various terms of the lease provide that essentially all costs, risks, and responsibilities rest with Worthen. For example, Worthen bears all repair and maintenance expense, all public utility charges, mechanics' liens, taxes and levies of every sort, and all insurance expenses, including property, liability, fire, war risk, and sprinkler and boiler damage. Worthen also must indemnify the lessor for any claim arising out of the operation of the building and repair any damage or destruction. By the terms of the lease, the rent is absolutely net to the taxpayer (and hence to New York Life) without allowance for any counterclaim, setoff, or defense by the lessee, and is to be paid without notice, demand, counterclaim, setoff, or defense lessee might otherwise assert.

Worthen's obligation to make payment of rent to taxpayer is not affected by any damage or destruction to the building. Interestingly, any condemnation or insurance proceeds resulting from total destruction apply in the following order: (1) to New York Life in an amount sufficient to fully prepay the mortgage; (2) the balance to taxpayer up to the amount provided as the purchase price in the termination table (amortizing taxpayer's $500,000 investment at six percent); and (3) any excess to Worthen. Worthen has the option to either replace the building or to purchase it in the event there is a partial condemnation or total destruction on or after December 1, 1980. ⁵

On taxpayer's corporate income tax return for 1969, taxpayer reported the payments by Worthen under the building lease as rental income, and claimed deductions for depreciation on the Worthen building, interest paid on the interim and permanent mortgage loans, and other expenses it had borne with respect to the construction of the building. Upon audit of the taxpayer's return for 1969, the Commissioner determined that for federal tax purposes the taxpayer was not the owner of...