Harrah v. Comm'r of Internal Revenue

• Decision Date: 19 September 1958
• Docket Number: 64480.,Docket Nos. 64479
• Citation: 30 T.C. 1236
• Parties: JOSEPH A. HARRAH, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.ROBERT E. HARRAH, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: U.S. Tax Court

30 T.C. 1236

JOSEPH A. HARRAH, PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.ROBERT E. HARRAH, PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket Nos. 64479

64480.

Tax Court of the United States.

Filed September 19, 1958.

Cyrus B. King, Esq., for the petitioners.

Aaron S. Resnik, Esq., and Leslie T. Jones, Jr., Esq., for the respondent.

1. Petitioners' transferor was engaged in the construction of sawmill plants and equipment which it sold in the ordinary course of its business. It also engaged in experimental work. On its own initiative it undertook the construction of an experimental portable sawmill to determine the feasibility of including such mill in its lines. It contemplated operating the mill for test purposes itself. When the mill was nearly completed, it was approached by an individual interested in purchasing it. His initial offer to purchase was refused because the worth of the mill was then unknown. Subsequently, the parties executed a 1-year lease of the mill with an option to purchase in the lessee. After the agreement was in effect 9 months, the lessee exercised the option. Held, the mill constituted property held primarily for sale to customers in the ordinary course of the transferor's business, and the gain on its sale was taxable as ordinary income.

2. The lease-option agreement provided for an initial payment by the lessee of $15,000 which it designated rent. It further provided that in the event the option was exercised the $15,000, with other payments, was to be credited on the purchase price. No provision for return of the $15,000 in the event the option was not exercised was made. Held, the $15,000 was paid primarily as rent and is taxable in the year of its receipt.

TIETJENS, Judge:

These proceedings involve deficiencies in income and excess profits tax determined due from petitioners as transferees of Harrah Bros., Inc., for the taxable periods set forth below.

+----------------------------------------------------+
                ¦Fiscal year  ¦                         ¦            ¦
                +-------------+-------------------------+------------¦
                ¦ended        ¦Tax                      ¦Deficiency  ¦
                +-------------+-------------------------+------------¦
                ¦Mar. 31, 1952¦Income                   ¦$8,606.43   ¦
                +-------------+-------------------------+------------¦
                ¦Nov. 20, 1952¦Income and excess profits¦22,452.12   ¦
                +----------------------------------------------------+
                

While conceding their liability as transferees, petitioners contest the deficiencies determined against their transferor by the Commissioner.

The issues are: (1) Whether a sawmill constructed by Harrah Bros., Inc., constituted property used in its trade or business within the meaning of section 117(j) of the 1939 Code, so that the gain realized on its sale under a lease-option agreement was taxable at capital gain rates; and (2) whether the amounts received under the agreement, which were subsequently allowed as credits on the purchase price, were rentals taxable in the year of their receipt, or were part of the purchase price taxable in the year when the option to purchase was exercised.

FINDINGS OF FACT.

Joseph A. and Robert E. Harrah (hereinafter referred to as petitioners) are transferees of Harrah Bros., Inc., a dissolved corporation, each having received from that corporation assets in excess of the amount of the deficiencies in tax determined against it by the Commissioner.

Harrah Bros., Inc. (hereinafter referred to as the corporation) maintained its principal place of business at Willits, California, during the years in issue. It filed its Federal income tax return for the fiscal year ended March 31, 1952, with the former collector of internal revenue for the first district of California. Its return for the taxable period ended November 30, 1952, was filed with the director of internal revenue for the first district of California.

In 1943 petitioners formed a copartnership known as the Harrah Brothers Machine Works which engaged in the operation of a repair shop. The business subsequently expanded to include the construction of sawmill equipment and machinery and the design and manufacture of complete sawmill plants.

In April 1951 petitioners organized Harrah Bros., Inc., which succeeded to the business then being carried on by the partnership. Its articles of incorporation provided that it was organized to ‘manufacture machinery, repair, install and build mills and machinery of all kinds, operate and sell lumber mills and machinery.’

In the ordinary course of business, when either the corporation or its predecessor build complete sawmills they did so on the order and specification of individual purchasers. In some instances the machinery was built and shipped to the customer for construction of the mill; in others, the construction work was done by the corporation or its predecessor.

In addition to the above-mentioned activities, the corporation and its predecessor engaged in experimental work. That work resulted in the development of a considerable amount of automatic sawmill equipment, and in the construction of the first all air-operated mill on the Pacific coast.

In late 1950 or early 1951 experimental work was commenced on a portable sawmill. Numerous inquiries had been received concerning that type mill, and it was hoped that one could be efficiently built and operated. At the outset the corporation intended to experiment with the portable mill to determine the efficiency and economy of its operations. If the experiment proved a success it intended to build other portable mills and sell them. The immediate goal, however, was the construction of a mill which could be economically operated by few workmen; could be moved rapidly from one location to another; could be profitable operated for the manufacture of only a million or so feet of timber; and could be set up in less time and at less expense than the standard fixed mill.

While the mill was still in its preliminary planning and construction stage, the Harrah brothers discussed certain proposals with respect to its ultimate operation. The corporation attempted to negotiate an agreement with a lumber manufacturing firm under which the mill could be tested. Those negotiations were terminated, and others begun relative to the lease of certain land in Willits upon which the mill could be set up and tried out on logs purchased from the owners of small tracts of timberlands.

In either July or August of 1951, Mal Coombs (hereinafter referred to as Coombs) came into the corporation's shop to look at the mill. He had heard that one was under construction and was interested in its function. At that time the mill was approximately 70 per cent complete. Some 2 weeks to a month later, Coombs returned, indicating that he was interested in buying the mill. Petitioners responded that they did not wish to sell the mill at that time because it was untried and further that they did not know how much they had expended on it nor the price which it would bring on the market. However, they indicated that they expected to test it on certain lands in Willits and if the tests proved successful they would build a mill for Coombs. Coombs then suggested that the mill might be set up on his property instead of at Willits in order that he might lease it.

Further meetings were held and after securing Coombs' consent to make an initial payment of $15,000 to the corporation and deed to it certain real property, it was agreed that the mill would be made available to him for his operation at a rental to be based on the number of board feet produced. The parties then went before petitioners' attorneys who drafter a proposed lease-option agreement to effectuate their desires, which was executed on October 12, 1951.

The agreement provided that Harrah Bros., Inc., lease the mill to Coombs for a period of 1 year after the date of its completion for a total rental of $39,000, and further provided:

Said rental shall be paid as follows: $15,000.00 upon the execution of this agreement * * * ; the further sum of $4.00 per thousand board feet of lumber produced in said mill, or a minimum monthly payment of $2,000.00, whichever is greater * * *

If the Lessee at time of exercise of option is not then in default in the payment of rent hereunder as hereinabove provided, then the Lessor hereby gives and grants to the Lessee the right and option to purchase said real property and said sawmill thereon for the total sum of $75,000.00 in lawful money of the United States. Said $75,000.00 shall be payable at the rate of $4.00 per thousand board feet of lumber produced in said mill monthly, with a minimum payment of not less than $2,000.00 monthly, whichever is greater * * *

If any sum in excess of $39,000.00 be paid by the Lessee to the Lessor during the one year term of this lease, such excess will either be refunded by the Lessor to the Lessee, or applied toward the purchase price in the event that Lessee exercises the right of option to purchase said property.

If said option be exercised by Lessee, the $15,000.00 payment hereinabove provided for plus $2.00 per thousand board feet of lumber produced paid during the term of said lease shall be a credit on the total purchase price of $75,000.00.

Incident to the above agreement, Coombs deeded to the corporation the property upon which the mill was to be constructed. It was agreed that the land would be deeded back when all obligations under the agreement were met. The $15,000 payment provided for was paid by Coombs in two equal installments of $7,500 on September 30, 1951, and on October 31, 1951. Between January 9 and March 2 of 1952 the mill was erected on the agreed location. During the period extending from April 1, 1952, to November 25, 1952, Coombs paid the sums of $24,000 rental and $5,150.63 excess rental pursuant to the terms of the agreement. It had been expected that the mill would cut approximately 30,000 feet of...