Milbrew, Inc. v. C.I.R.

• Decision Date: 12 July 1983
• Docket Number: No. 82-2692,82-2692
• Parties: 83-2 USTC P 9467 MILBREW, INC., et al., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1302

710 F.2d 1302

83-2 USTC P 9467

MILBREW, INC., et al., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 82-2692.

United States Court of Appeals Seventh Circuit.

Argued May 23, 1983.

Decided July 12, 1983.

Gaar W. Steiner, Michael, Best & Griedrich, Milwaukee, Wis., for petitioners-appellants.

Mary L. Fahey, Asst. Atty. Gen., Tax Div. Dept. of Justice, Washington, D.C., for respondent-appellee.

Before CUDAHY, POSNER and COFFEY, Circuit Judges.

POSNER, Circuit Judge.

The principal question in this appeal from a decision of the Tax Court disallowing deductions for depreciation, interest, and payment of rent is whether the Tax Court's finding that the sale of a plant was a sham transaction that should be disregarded for federal income tax purposes was clearly erroneous, the standard applicable to such a finding, Thompson v. Commissioner, 631 F.2d 642, 646 (9th Cir.1980).

The case concerns the Bernstein family, which can for our purposes be divided into two groups: the brothers Ace and Marty, and everyone else. The taxpayers call the second group the "cousins" and we shall follow that terminology although Ace and Marty in fact are uncles rather than cousins of two of the other Bernsteins. Until 1966 the cousins, on the one hand, and Ace and Marty, on the other, had gone their separate ways. The cousins owned and operated Milbrew, Inc., which manufactured an animal food additive and a yeast used in the brewery business. By late 1966 most of Milbrew's manufacturing was being done on a toll (i.e., fee) basis by a plant in Juneau, Wisconsin, owned by a dairy cooperative. Milbrew's business was in very bad shape and in 1967 the cousins induced Ace, a successful businessman in an unrelated field, to take a hand in running the company. At the same time Northland Developers, a corporation wholly owned by Ace and Marty, bought the Juneau plant from the dairy cooperative for a shade under $525,000; and for the rest of 1967 and all of 1968, Milbrew paid Northland rent for the plant at an annual rate of about $100,000.

On January 1, 1969, the Bernstein family created a limited partnership called NVST Company. All the Bernsteins received shares of the partnership, and Ace and Marty the lion's share--40 percent. On the day of its creation NVST entered into a contract with Northland to buy the Juneau plant for $3 million. The contract provided that NVST would pay Northland interest at 4 percent, but no principal, for the first five years, $50,000 a year for the next five years, and $300,000 a year for the succeeding ten years; the remaining principal was due at the end of the 20 years. Between 1969 and 1973 NVST charged annual rent to Milbrew rising from $220,000 to $542,000, and charged off against this rental income annual depreciation rising from $219,000 to $307,000 and interest on its contract with Northland rising from $27,000 in 1970 to $58,000 in 1973. Milbrew's large rental expense for the Juneau plant virtually wiped out its taxable income, which rose from $1,500 in 1969 to $8,100 in 1973 on gross sales that rose from $1.5 million to $2.9 million. The Internal Revenue Service disallowed the depreciation and interest deductions claimed by NVST (and passed through to the partners in NVST, i.e., the Bernsteins), and disallowed Milbrew's annual deduction for rental expense to the extent it exceeded $120,000 ($150,000 for 1973), the Service's estimate of the plant's fair rental value. The premise for these adjustments is that Northland's sale of the Juneau plant to NVST in 1969 was a phony.

With Ace and Marty the sole owners of the seller of the plant (Northland) and major owners of the buyer (NVST), Ace the putative savior of the tenant (Milbrew), and everyone else in the picture a relative of Ace and Marty's, the sale was not an arm's length transaction, so there is no presumption that it reflected market values. The sale of the plant for almost six times as much as Northland had paid 20 months before is of course highly suspicious and the terms of the sale suggest that Northland was not serious about collecting the inflated purchase price. Also, even in 1969 4 percent was far below the interest rate on long-term, inherently risky loans, while the $50,000 due annually between the sixth and tenth years of the contract was less than 2 percent. The $300,000 a year due between the eleventh and twentieth years actually represented less than 10 percent of the principal, since not only would the principal balance not have been paid down at all by the eleventh year but it would have been increased by the interest arrears from the sixth through tenth years. If the stream of payments due on the contract, treating the $3 million principal as due in a lump at the end of the contract period, is discounted to present value at a 10 percent discount rate, the 1969 sale price was really only $1.7 million. Moreover, during the first five years of the contract, when NVST was nominally obligated to pay a total of $600,000, it actually paid only $137,000. This not only was far below any reasonable estimate of the interest that an arm's length installment seller would have charged for the $3 million that Northland in effect loaned to NVST by deferring receipt of principal, but it meant that NVST was in default from the beginning--a circumstance that seems not to have troubled Northland.

As soon as the deal was signed, NVST, Milbrew's new landlord for the Juneau plant, doubled the rent, and thereafter kept raising it without rhyme or apparent reason other than to minimize Milbrew's taxable income. What otherwise would have been taxable income to Milbrew was thus shifted to NVST, which was able to shield this rental income from tax by depreciating the Juneau plant on the basis of the $3 million that it had "paid" Northland for the plant. Northland also escaped having to pay substantial income tax on the sale, because NVST paid it little interest and no principal. So the tax on Milbrew's income was not merely shifted, but avoided altogether. The key to the scheme was the $3 million sale price: if the price had been the same as Northland had paid 20 months earlier NVST could not have taken large enough depreciation deductions to offset its income from the huge rentals that it charged Milbrew.

When persons who are not dealing with each other at arm's length enter into a transaction that gives them tremendous tax savings, the Internal Revenue Service is entitled to be suspicious of the genuineness of the transaction; and here the sale price, payment terms, subsequent payment history, and rental increases rightly reinforced the Service's suspicions. In addition, the parties treated the sale with extreme informality. It was not recorded, and Northland continued to represent the plant as being its own property, unencumbered by any sale contract. It is noteworthy, too, that the contract of sale originally provided for interest at the absurdly low rate of 1 percent and that Ace changed this to 4 percent, just before the contract was signed, without consulting any other Bernsteins and without changing the price or any other term in the contract--which is why the $50,000 payments required in the fifth through ninth years would not even cover the interest contractually due in those years.

The facts reviewed thus far make this case much like Narver v. Commissioner, 75 T.C. 53, 100-01 (1980), aff'd per curiam, 670 F.2d 855 (9th Cir.1982); but we have to consider two types of rebuttal evidence offered by the taxpayers. The first was that after Ace became the guiding light of Milbrew in 1967 it experienced a rapid improvement in its business prospects which enabled it to pay a higher rent and which therefore increased the fair market value of the Juneau plant. The second is that after 1973 (the last tax year in the case) NVST made very substantial payments on the contract--$1.1 million by the end of 1978, though all of this was interest--and that in May 1983, while this appeal was pending, a large corporation unrelated to any of the Bernsteins executed a letter of intent to purchase NVST's assets, consisting primarily of the Juneau plant, for $8.7 million.

The post-1973 evidence has little significance, and not only because nine years after the contract had been signed the purchaser had still not begun to repay principal. In having NVST make payments after 1973 the taxpayers may have been trying to shore up their case against the very substantial tax liability involved here (the deficiencies assessed by the IRS on the Bernsteins and on Milbrew exceed $800,000 for 1972 and 1973 alone). As for the expected sale of...