Rosenfeld v. C.I.R., 998

• Decision Date: 02 May 1983
• Docket Number: D,No. 998,998
• Citation: 706 F.2d 1277
• Parties: 83-1 USTC P 9341 George B. ROSENFELD and Harriet Rosenfeld, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant. ocket 82-4176.
• Court: U.S. Court of Appeals — Second Circuit

Page 1277

706 F.2d 1277

83-1 USTC P 9341

George B. ROSENFELD and Harriet Rosenfeld, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.

No. 998, Docket 82-4176.

United States Court of Appeals Second Circuit.

Argued March 10, 1983.

Decided May 2, 1983.

Jonathan S. Cohen, Washington, D.C. (Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, Gayle P. Miller, Attys., Tax Div., U.S. Dept. of Justice, Washington, D.C., of counsel), for appellant.

John P. Dee, Buffalo, N.Y. (Cohen, Swados, Wright, Haniflin, Bradford & Brett, Buffalo, N.Y., of counsel), for appellees.

Before KAUFMAN and KEARSE, Circuit Judges, and MacMAHON, District Judge. ^*

IRVING R. KAUFMAN, Circuit Judge:

For as long as governments have taxed their citizens, individuals have sought to minimize their tax burdens. On occasion, members of the public have employed elaborate devices to defer taxes or shift income to their associates and relatives in lower tax brackets. When such schemes completely lack legitimate purposes and affect no real economic or beneficial interests, courts have not hesitated to pierce the formal arrangements and examine the substance of the underlying transaction. At the same time, judges have recognized that taxpayers are generally free to order their investment and business decisions to reduce their tax liability. As Judge Learned Hand eloquently noted, "one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes." Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir.1934), aff'd, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935).

This case calls upon us to draw, once again, the fine line between valid business transactions and illegitimate tax avoidance ploys. We are required to determine, as a matter of first impression within this Circuit, whether a taxpayer who gives property to his children in trust may lease back that property for use as a professional office, and deduct the rent payments from his income pursuant to I.R.C. Sec. 162(a)(3). Because we believe these transactions involved real transfers of economic interests, and for other reasons set forth below, we affirm the Tax Court's order allowing the rent deductions.

I

Since the underlying facts are important to the resolution of this dispute, we set them forth in some detail.

In 1963 George B. Rosenfeld, ¹ a doctor practicing in Cheektowaga, New York, purchased a parcel of land in that town. Shortly thereafter, Rosenfeld arranged for a building to be constructed on the property, intended for use as a medical office. Since the completion of the building in 1964, Rosenfeld has been its sole occupant.

In 1969 Rosenfeld decided to establish a trust for the benefit of his three daughters, and to transfer the land and medical office to the trust. Prior to executing this transaction, he arranged for an independent firm, Grant Appraisal & Research Corporation, to value the property. After the appraiser concluded that the fair rental of the property was $14,000 per year, Rosenfeld created an irrevocable trust, and arranged for Samuel Goldman, his accountant, and Ira Powsner, his attorney, to act as trustees. Pursuant to the terms of the agreement, the trustees were responsible for collecting income produced by the property and investing it, until the termination of the trust, at which time the accumulated proceeds would be distributed to the beneficiaries.

The trust was to have a term of 10 1/2 years, and Rosenfeld retained a reversionary interest in the corpus. During the period of the trust, he remained liable for the mortgage payments and general upkeep of the property. The trustees were responsible for the payment of real estate taxes. Rosenfeld had no right to alter the terms of the trust, and was legally obligated to fulfill its requirements.

The trust agreement was executed on July 1, 1969, and on that same date, Rosenfeld entered into a lease with the trustees. Rosenfeld agreed to rent the medical property for the entire term of the trust for annual payments of $14,000, the amount fixed by the appraisers as fair and reasonable. The lease also required Rosenfeld to pay utility and other incidental expenses, and granted him the right to construct additions to the building at his expense.

In 1973, Rosenfeld decided to transfer his reversionary interest in the trust property to his wife. Two years later, appellee and the trustees agreed upon further changes and amended the trust to extend its termination date for 5 years, from 1980 to 1985. Also in 1975 the lease agreement was modified to increase the annual rent to $15,000, and alter the rental term to one year, renewable for an additional year at Rosenfeld's option.

We now approach the core of this dispute. In his tax returns for 1974 and 1975, Rosenfeld claimed a deduction for his rent payments to the trust pursuant to I.R.C. Sec. 162(a)(3), which allows a taxpayer to deduct from his income "ordinary and necessary" rent expenses incurred as a condition of the taxpayer's trade or business. The trust filed fiduciary returns, and reported the amounts paid by appellee as income. The trust also claimed deductions for real estate taxes and depreciation on the property. After auditing Rosenfeld's returns, the Commissioner disallowed the deductions for the rent expenses in 1974 and 1975. In October 1977, appellee received a statutory notice of deficiency, and, as one would anticipate under these circumstances, he challenged the Commissioner's assessment.

Eventually the case was heard by Judge Simpson, who concluded the rent payments were properly deducted by the taxpayer pursuant to Sec. 162(a)(3). Accordingly, the judge recalculated the deficiencies, and for the years 1974 and 1975 found Rosenfeld liable for items other than the rent deductions. Rosenfeld does not challenge these assessments. The Commissioner, however, filed a notice of appeal, questioning the Tax Court's rejection of the deficiencies relating to the rent deductions.

II

While, as we have noted, this appeal raises a question of first impression in this Circuit, we are not writing on a tabula rasa. The issue on this appeal has not suffered from lack of consideration by various tribunals. The Tax Court has been confronted with this problem on numerous occasions, and several other Circuits have also expressed their views. These authorities, however, have been divided on the proper tax treatment of a claimed deduction in a gift-leaseback situation. Generally the Tax Court's recent decisions have allowed deductions in similar situations. ² But we find the Courts of Appeals have split on this issue. The Third, Seventh, Eighth and Ninth Circuits have held in favor of the taxpayer, ³ while the Fourth and Fifth Circuits have adopted the Commissioner's view. ⁴ It is against this background of divergent views that we are called upon to exercise our Solomonic powers and resolve the instant dispute, by determining which of the conclusions reached among the Circuits accords with the law, and, indeed, is the fairer course to follow.

We commence our consideration by looking to the language of the statute. On its face it appears to grant a taxpayer the right to deduct his rent expenses, even where he previously owned the leased property. In relevant part, I.R.C. Sec. 162(a) provides:

There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including--

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(3) rentals and other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.

But the Commissioner claims Rosenfeld has no right to a deduction pursuant to this provision, because he voluntarily entered into the arrangement which created the need to pay rent. Appellant urges us to adopt the view that the gift-leaseback arrangement is a sham and the taxpayer should be prevented from taking advantage of his self-created rent liability to reduce his taxes.

In considering the validity of a claimed deduction in a gift-leaseback situation, we have been given some guidance by the Tax Court which has devised a four-prong test. To receive the deduction, "1) [t]he grantor must not retain substantially the same control over the property that he had before he made the gift, 2) [t]he leaseback should normally be in writing and must require the payment of a reasonable rent, 3) [t]he leaseback (as distinguished from the gift) must have a bona fide business purpose, [and] 4) [t]he grantor must not possess a disqualifying 'equity' in the property within the meaning of section 162(a)(3)." May v. Commissioner, 76 T.C. 7, 13 (1981), appeal pending (9th Cir. No. 82-7658); see Mathews v. Commissioner, 61 T.C. 12 (1973), rev'd, 520 F.2d 323 (5th Cir.1975), cert. denied, 424 U.S. 967, 96 S.Ct. 1463, 47 L.Ed.2d 734 (1976); see also Quinlivan v. Commissioner, 599 F.2d 269, 272 (8th Cir.), cert. denied, 444 U.S. 996, 100 S.Ct. 531, 62 L.Ed.2d 426 (1979).

For reasons stated below, we believe this test is an appropriate measure of the legitimacy of a deduction in a gift-leaseback situation. The Commissioner has conceded that the lease was properly executed and does not challenge the reasonableness of the rent. Appellant, however, asserts that Rosenfeld did not satisfy the first element of the May test because, in fact, he retained control of the property. The Commissioner also challenges the third prong of this test, contending that the gift and leaseback considered together must have a demonstrable bona fide business purpose. See Perry v. United States, 520 F.2d 235 (4th Cir.1975), cert. denied, 423 U.S. 1052, 96 S.Ct. 782, 46 L.Ed.2d 641 (1976); Van Zandt v. Commissioner, 341 F.2d 440 (5th Cir.), cert....