Hilgenberg v. United States

• Decision Date: 29 November 1937
• Citation: 21 F. Supp. 453
• Parties: HILGENBERG v. UNITED STATES.
• Court: U.S. District Court — District of Maryland

21 F. Supp. 453

HILGENBERG v. UNITED STATES.

District Court, D. Maryland.

November 29, 1937.

Venable, Baetjer & Howard and J. Crossan Cooper Jr., all of Baltimore, Md., for plaintiff.

James P. Garland, Sp. Asst. to Atty. Gen., and G. Randolph Aiken, Asst. U. S. Atty., of Baltimore, Md.

WILLIAM C. COLEMAN, District Judge.

This is a suit brought by the plaintiff against the United States under section 24, subdivision 20, of the Judicial Code (28 U.S.C.A. § 41 (20), to recover, because claimed to have been illegally assessed under the Revenue Act of 1932 (chapter 209, 47 Stat. 169), the sum of $824.66 with interest, which plaintiff paid as income taxes for the calendar year 1933. Pursuant to the above section of the Judicial Code, the case was heard by the court without a jury.

Broadly stated, the primary question involved is this: When a lessee of property makes improvements, pursuant to a lease agreement, at his own expense, but which are to belong to the landlord when the lease ends, does the value of those improvements, when made, constitute income then taxable to the landlord? Without stating at length the facts in the present case, suffice it to say that in 1931 the plaintiff leased to the Oriole Cafeterias, Incorporated, for a period of 20 years, without right of renewal, under a written agreement, certain real estate in Baltimore City which he owned in fee simple. The lease permitted the tenant to erect improvements, entirely at its own expense, but did not require the tenant to do so. In 1933, extensive improvements were completed by the tenant, costing approximately $92,000. Two provisions of the lease have a very important bearing upon the issue. Those provisions are contained in articles 5 and 6 of the lease, which, without quoting the exact phraseology, are to the effect (1), that any alterations or improvements shall be done at the lessee's own expense, to suit the lessee's business, provided no structural changes shall be made without the approval first had of the lessor, all such alterations to become the property of the lessor at the termination of the lease; and (2) the lessee is given the right to use the property for any purpose that he may see fit, a cafeteria being in immediate contemplation, with the exception that the leased premises are not to be used as a hotel, apartment house, residence, or for any purpose which might, by any present or future laws of the state of Maryland, accord to the lessee the right to redeem the rent and acquire the leased property.

Under section 22(a) of the Revenue Act of 1932, 47 Stat. 178 (26 U.S.C.A. § 22 and note), and article 63 of Treasury Regulation 77, issued relative thereto, the Commissioner of Internal Revenue assessed a deficiency against the plaintiff, based in part upon the inclusion, in gross income, of the sum of $1,844.61, representing one-eighteenth of the value of these improvements depreciated at the rate of 1½ per cent. per annum, to the end of the lease.

The pertinent part of section 22(a) of the Revenue Act of 1932 is as follows: "`Gross income' includes gains, profits, and income derived from * * * rent * * * or gains or profits and income derived from any source whatever." The provisions of article 63 of Treasury Regulation 77 are as follows: "When buildings are erected or improvements made by lessee in pursuance of an agreement with the lessor, and such buildings or improvements are not subject to removal by the lessee, the lessor may at its option report the income therefrom upon either of the following bases: (a) The lessor may report as income at the time when such buildings or improvements are completed the fair market value of such buildings or improvements, subject to the lease. (b) The lessor may spread over the life of the lease the admitted depreciated value of such buildings or improvements at the expiration of the lease, and report as income for each year of the lease an aliquot part thereof."

It is provision (b) that has been applied to the present case.

The court believes that there is no sound basis for so treating the improvements here under consideration as "income" of the landlord, the plaintiff, within the contemplation of the Sixteenth Amendment to the Federal Constitution, or of the provisions of the taxing statute here involved. The Commissioner of Internal Revenue appears to have fallen into error in his regulation interpreting the definition of "income." In Eisner v. Macomber, 252 U.S. 189, at page 207, 40 S. Ct. 189, 193, 64 L.Ed. 521, 9 A.L.R. 1570, the Supreme Court, in 1919, in holding that, by virtue of the Sixteenth Amendment, Congress could not tax, as income of a stockholder and without apportionment, a stock dividend, thus defined income under that Amendment: "After examining dictionaries in common use (Bouv. L.D.; Standard Dict.; Webster's Internat. Dict.; Century Dict.), we find little to add to the succinct definition adopted in two cases arising under the Corporation Tax Act of 1909 (Stratton's Independence v. Howbert, 231 U.S. 399, 415, 34 S.Ct. 136, 58 L.Ed. 285; Doyle v. Mitchell Bros. Co., 247 U.S. 179, 185, 38 S.Ct. 467, 62 L.Ed. 1054), `Income may be defined as the gain derived from capital, from labor, or from both combined,' provided it be understood to include profit gained through a sale or conversion of capital assets, to which it was applied in the Doyle Case, 247 U.S. 179, at pages 183, 185, 38 S.Ct. 467, 62 L.Ed. 1054.

"Brief as it is, it indicates the characteristic and distinguishing attribute of income essential for a correct solution of the present controversy. The government, although basing its argument upon the definition as quoted, placed chief emphasis upon the word `gain,' which was extended to include a variety of meanings; while the significance of the next three words was either overlooked or misconceived. `Derived — from — capital'; `the gain — derived — from — capital,' etc. Here we have the essential matter; not a gain accruing to capital; not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value, proceeding from the property, severed from the capital, however invested or employed, and coming in, being `derived,' — that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal — that is income derived from property. Nothing else answers the description.

"The same fundamental conception is clearly set forth in the Sixteenth Amendment — `incomes, from whatever source derived' — the essential thought being expressed with a conciseness and lucidity entirely in harmony with the form and style of the Constitution."

This court is not aware that that definition has ever been departed from by the Supreme Court. See United States v. Phellis, 257 U.S. 156, 42 S.Ct. 63, 66 L. Ed. 180; Rockefeller v. United States, 257 U.S. 176, 42 S.Ct. 68, 66 L.Ed. 186; Cullinan v. Walker, 262 U.S. 134, 43 S.Ct. 495, 67 L.Ed. 906; Weiss v. Stearn, 265 U.S. 242, 44 S.Ct. 490, 68 L.Ed. 1001, 33 A.L.R. 520; Marr v. United States, 268 U.S. 536, 45 S.Ct. 575, 69 L.Ed. 1079; Edwards v. Cuba R. R. Co., 268 U.S. 628, 45 S.Ct. 614, 69 L.Ed. 1124. Applying the definition to the present case, we are at a loss to see how, by any sound argument, the value of the improvements involved in the present case can be held to be income taxable to the landlord.

It has been urged upon the court by the plaintiff that these improvements, as a matter of fact, do not even fall within the regulation upon which the government relies, and which has just been quoted, because that regulation aims to tax, as income, improvements of this nature only when made by a lessee "in pursuance of an agreement with the lessor," and also, only when "not subject to removal by the lessee." It is clear from those portions of the lease which have already been referred to, that, at any time, the tenant had a right to remove any part of the improvements that he made, provided only such did not affect the structural plan of the building, in which case, changes could only be made with the approval first had of the landlord. Thus the tenant could virtually make over, if and when he saw fit, at any time during the term of the lease, the entire interior and, indeed, could make very substantial alterations to the exterior of the building, without violating the lease. If he did so the landlord would have no valid claim under the lease to any of the improvements, thus discarded to make way for other improvements, save lighting fixtures, as to which there is a special exception, but only to such as remained in the premises "at the termination of the lease"; and this is true regardless of whether any part so removed be fixtures or movable property in legal contemplation. Such is a proper interpretation of the provision in the lease that "All such alterations, changes and additions become the property of the lessor at the termination of this lease." So there is considerable weight in plaintiff's argument that for these reasons the present case does not fall within the treasury regulation.

The additional argument that the regulation is not applicable because there is no actual agreement or contract between the landlord and the tenant, in the present case, that the latter shall make any improvements, but merely that he may make them, is not convincing, because the regulation employs the words "in pursuance of an agreement with the lessor," and certainly there is an agreement here, to wit, the lease, which is sufficient to satisfy the requirement.

Although there is much substance to the first of these two arguments advanced by the plaintiff, I prefer to rest the case squarely upon the answer to the question whether it is permissible, under the Sixteenth Amendment to tax, as income, improvements which have been made under the conditions existing in the present case. The answer must be in the negative.

The Circuit Court of Appeals for the Second Circuit...