Hancock Acad. of Savannah, Inc. v. Comm'r of Internal Revenue

• Decision Date: 19 December 1977
• Docket Number: Docket No. 5431-77X.
• Citation: 69 T.C. 488
• Parties: HANCOCK ACADEMY of SAVANNAH, INC., PETITIONER v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

69 T.C. 488

HANCOCK ACADEMY of SAVANNAH, INC., PETITIONER

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 5431-77X.

United States Tax Court

Filed December 19, 1977.

Petitioner was formed as a nonprofit corporation to take over the educational functions of Hancock Schools, Inc. Petitioner assumed a liability for goodwill in an excessive amount and agreed to require parents of its students to make interest-free loans to Hancock Schools, Inc. An application for determination of qualification and exemption under sec. 501(c)(3), I.R.C. 1954, was filed with the Internal Revenue Service on petitioner's behalf. The Internal Revenue Service determined that petitioner did not qualify for tax-exempt status. Thereafter petitioner filed a petition with this Court for a declaratory judgment pursuant to sec. 7428, I.R.C. 1954. Held, petitioner failed to meet the requirements of sec. 501(c)(3) because (1) it was not organized and operated exclusively for exempt purposes and (2) part of its net earnings may inure to private individuals. Alvin M. Hitt, Jr., for the petitioner.

James J. McGovern, for the respondent.

OPINION

DAWSON, Judge:

Respondent determined that petitioner does not qualify for exemption from Federal income tax under section 501(c)(3).¹ Petitioner challenges respondent's determination and has invoked the jurisdiction of this Court for a declaratory judgment² pursuant to section 7428. The issue for our decision is whether petitioner served private interests in contravention of the requirements for exempt status under section 501(c)(3)

This case was submitted for decision on the stipulated administrative record under Rule 122, Tax Court Rules of Practice and Procedure.³ The evidentiary facts and representations contained in the administrative record are assumed to be true for purposes of this proceeding. The pertinent facts are summarized below.

Hancock Academy of Savannah, Inc. (petitioner) is a Georgia corporation with its registered office in Savannah, Ga. Petitioner filed its application for recognition of exemption under section 501(c)(3) with the District Director of Internal Revenue in Atlanta, Ga.

Petitioner is a recent spin off from a group of for-profit schools founded by Emmie Ruth Hancock (Mrs. Hancock). The original school, Hancock Day School, Inc., was founded in 1951 by Mrs. Hancock and continues in existence today. Mrs. Hancock is the president and a director of Hancock Day School, Inc. Her son, William L. Bell (Mr. Bell) is vice president and a director. Hilma S. Traver is secretary-treasurer and a director. Hancock Day School, Inc., is owned by Mrs. Hancock and Mr. Bell.

Initially, Hancock Day School, Inc., operated kindergarten through the seventh grade. Due to space limitations, however, a new corporation, Hancock Schools, Inc., was formed in 1972 to facilitate expansion. The officers and directors of Hancock Schools, Inc., are: Mrs. Hancock, president and a director; Mr. Bell, vice president and a director; and Alvin M. Hitt, Jr., secretary-treasurer and a director. Each of these individuals owns a one-third interest in Hancock Schools, Inc.

Upon its formation, Hancock Schools, Inc., purchased from Hancock Day Schools, Inc., the operations of grades four and up for an amount including $50,000 which was identified as payment for one-half of the goodwill of Hancock Day Schools, Inc. The $50,000 was payable on an installment basis over 10 years with $5,000 due annually beginning in 1982 and with 6-percent interest due on any unpaid balance. Under the terms of the sale, Hancock Day Schools, Inc., agreed to cease operating grades four and up.

Hancock Schools, Inc., moved to a new location, erected a larger building, took over the operation of grades four through seven, and adopted plans to add a new grade each year until grades four through twelve were offered. Hancock Day School, Inc., continued to operate in its original location, but handled only kindergarten through third grade.

Hancock Schools, Inc., adopted an interest-free loan program whereby, in addition to making tuition payments, parents were required to loan to Hancock Schools, Inc., without interest, $500 for the first child and $100 for each additional child in attendance. The loans were repayable by the school within 1 year after the parent's children were no longer in attendance.

Hancock Schools, Inc., operated as a school for 3 years. In 1975, however, its officers decided to form a nonprofit corporation to take over the school operations and to obtain tax-exempt status to encourage contributions which then would be tax deductible. Petitioner was formed for this purpose. Mr. Bell was named president and trustee for petitioner. Mr. Bell's spouse, Doris C. Bell, and Mrs. Hancock were named vice presidents and trustees. Six other trustees also were named: Dr. Harold Black, Mrs. Angela Deering, Rev. W.H. Ford, Mr. Walton Ruff, Mrs. Martha Stewart, and Mr. Abe Tenenbaum.

Hancock Schools, Inc., continued to own the land and buildings for the school operation and leased the property to petitioner under a lease with a term of 15 years. Petitioner was responsible for all taxes, maintenance, and utility expenses related to the school. Hancock Schools, Inc., was responsible for an annual insurance payment of approximately $500. The monthly lease payments of $2,000 bring a return of 8.4 percent to Hancock Schools, Inc., on the land and improvements purchased at an aggregate cost of $280,159. This rate of return is less than that generally received on similar real estate investments in the area.

Petitioner purchased outright from Hancock Schools, Inc., all of the personal property used in the school operation and assumed all liabilities related thereto. Petitioner also assumed the $50,000 debt owed by Hancock Schools, Inc., to Hancock Day Schools, Inc., for the acquisition of goodwill.

Petitioner agreed to continue the parent loan program for the benefit of Hancock Schools, Inc. The loan funds were to be utilized for building and ground improvements as directed by petitioner. Hancock Schools, Inc., remained responsible for repaying the loans as they came due.

For the year ended June 30, 1975, Hancock Schools, Inc., had total receipts of $205,492 and total expenses of $201,524, for a net profit of $3,968. Petitioner's budget for 1975-76 called for income of $240,005 and expenses of $244,404 for a net loss of $4,399. The projection for 1976-77 is for expenses to equal income of $295,000.

Sections 501(a) and 501(c)(3) provide⁴ an exemption from Federal income tax for an organization devoted to education if three prerequisites are satisfied: (1) The organization must be organized and operated exclusively for education alone or in conjunction with other exempt purposes; (2) no part of its net earnings may inure to the benefit of any private shareholder or individual; and (3) it must not devote a substantial part of its activities to political or lobbying activity.

Respondent determined that the first two of these prerequisites were each violated by two circumstances in petitioner's history. First, respondent asserts, petitioner assumed a liability for goodwill in an excessive amount. Second, petitioner required parents of its students to make interest-free loans to its for-profit predecessor, Hancock Schools, Inc. These two incidents, respondent argues, mean that petitioner was not organized and operated exclusively for educational purposes and that part of petitioner's net earnings will inure to the benefit of private individuals.

The burden of proof is on petitioner to overcome the grounds set forth in respondent's notice of determination. Rule 217(c)(2)(i), Tax Court Rules of Practice and Procedure. Moreover, the requirements for exemption under section 501(c)(3) are stated in the conjunctive; failure to satisfy any one of them will prevent exemption. Stevens Bros. Foundation, Inc. v. Commissioner, 39 T.C. 93, 110, affd. in part and revd. in part 324 F.2d 633 (8th Cir. 1963), cert. denied 376 U.S. 969 (1964). To prevail here, therefore, petitioner must prove that neither of the circumstances identified by respondent violates either of the relevant requirements of section 501(c)(3). Petitioner failed to meet this burden.

The first ground for disqualification is petitioner's assumption of the liability for goodwill. Incurring debt to purchase an asset at fair market value and subsequently retiring that debt with earnings is not a violation of the exempt purposes requirement or the private inurement of net earnings proscription of section 501(c)(3). See Shiffman v. Commissioner, 32 T.C. 1073, 1079-1080 (1959); Estate of Howes v. Commissioner, 30 T.C. 909, 920-926 (1958), affd. sub nom. Commissioner v. Johnson, 267 F.2d 382 (1st Cir. 1959); Ohio Furnace Co. v. Commissioner, 25 T.C. 179, 188-190 (1955), appeal dismissed (6th Cir. 1956). If the purchase price is in excess of the fair market value, however, violation of the requirements of section 501(c)(3) results. Cf. Kolkey v. Commissioner, 27 T.C. 37, 61-63 (1956), affd. 254 F.2d 51 (7th Cir. 1958).

In the instant case there was a majority of identity among the officers of the three corporations involved in the transactions. Most of these officers were in a position to personally gain from the transaction since they were the owners of the for-profit corporations. Moreover, there is no indication in the record that any disinterested party seeking to establish a private school in the area would be a willing buyer of the goodwill in question for $50,000. Thus, although the officers may have acted in good faith, an independent analysis of objective factors is appropriate under these circumstances to determine if the liability assumed was excessive.⁵

Respondent's determination that the amount of liability assumed for goodwill is excessive, is based on the fact that a net loss was projected for petitioner's first 2 years of operation. From this respondent concludes...