South Texas Rice Warehouse Co. v. CIR, 22834.

• Decision Date: 04 October 1966
• Docket Number: No. 22834.,22834.
• Citation: 366 F.2d 890
• Parties: SOUTH TEXAS RICE WAREHOUSE CO., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

366 F.2d 890 (1966)

SOUTH TEXAS RICE WAREHOUSE CO., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 22834.

United States Court of Appeals Fifth Circuit.

August 22, 1966.

Rehearing Denied October 4, 1966.

COPYRIGHT MATERIAL OMITTED

Homer L. Bruce, William C. Griffith, Robert J. Piro, Houston, Tex., Baker, Botts, Shepherd & Coates, Houston, Tex., of counsel, for petitioner.

John B. Jones, Jr., Acting Asst. Atty. Gen., Lee A. Jackson, Atty., Dept. of Justice, Mitchell Rogovin, Chief Counsel, Hu S. Vandervort, Atty., I.R.S., C. Moxley Featherston, Acting Asst. Atty. Gen., Fred R. Becker, Harry Baum, Attys., Dept. of Justice, Washington, D. C., Richard M. Roberts, Acting Asst. Atty. Gen., for respondent.

Before RIVES and BELL, Circuit Judges, and FULTON, District Judge.

RIVES, Circuit Judge:

This is a companion case to Davant v. Commissioner of Internal Revenue, 366 F.2d 874 (5 Cir. 1966). While this case and Davant contain certain common issues of fact, they each involve distinct questions of law. For that reason we have elected to write separate opinions. The Tax Court held that the Commissioner did not abuse the discretion conferred by section 482¹ when he reallocated certain income between South Texas Rice Warehouse Company,² the petitioner in this case, and a partnership formed for the purpose of operating the assets of Warehouse. 43 T.C. 540 (1965). We affirm.

The stock in Warehouse was owned by four families, each possessing a one-fourth interest. Within each family unit there was varied division of stock among family members. Warehouse owned drying and storage facilities used to process rice. The rice dried and stored by Warehouse came primarily from land owned by the four families' interests and worked by sharecroppers.³

The original storage facilities built in 1936, compared to present day structures, were somewhat primitive. The rice was stored in sacks and was not artificially dried. About 1949 Warehouse constructed a rice dryer and bulk storage facility. Additional bulk storage buildings and machinery were added in 1951 and 1955. A 65,000 barrel bulk storage area costing $165,748.48 was built in 1957. Minor improvements were added throughout the remaining tax years here in question.⁴

In May of 1957, R. Q. Pegram, Jr., E. W. Clark, Thurman S. Clements, and John E. Davant consulted Homer L. Bruce, Esq., an attorney who had represented Warehouse and the four families for many years. They asked whether a partnership could be formed for the purpose of leasing and operating the assets of Warehouse. Bruce told them that this could be done if a reasonable rent was paid for the use of Warehouse's operating assets.

South Texas Rice Enterprises,⁵ a partnership, was formed about June 1, 1957. The managing partners borrowed between $15,000 and $20,000 to initiate the partnership, but no other initial capital investment was made.⁶ Enterprises, like Warehouse, was owned by the same four families with each family receiving a one-fourth interest.⁷ The two older Clements were no longer active in the business. Their shares in the partnership were given to their children, who were active. There was also a slight variance in the distribution of ownership within the Pegram family.⁸

A meeting was held in Mr. Bruce's office at which it was agreed that $4,000 per month would be paid as rental by Enterprises to Warehouse for use of its operating assets.⁹ On July 1, 1957, E. W. Clark acting for both Warehouse and Enterprises signed the lease agreement. The lease was for one year with Enterprises given the right to extend the lease one year at a time for two successive years. In June 1960 Warehouse and Enterprises executed another lease substantially the same as the first, except that the rent was raised to $4,166.66 per month in order to reflect new improvements made by Warehouse.

Enterprises, like Warehouse, before the leases, was a very successful business venture. The leases, however, separated the entity that was depreciating¹⁰ the assets from the entity that was receiving the income occasioned by operating the assets. Because of this separation and the fact that the rent paid by Enterprises was not sufficient to cover Warehouse's book expenses, Warehouse showed a yearly loss. Warehouse attempted to carry this loss back to previous years and filed a return asking for a tax refund. The Commissioner objected, taking the position that under section 482 Enterprises' income and expenses should be attributed to Warehouse. In the alternative, the Commissioner contended that the rent paid for Warehouse's assets was insufficient. Under section 482 the Commissioner sought to attribute sufficient income from Enterprises to Warehouse to constitute what the Commissioner conceived to be a reasonable rent, i. e., $78,000.

The Tax Court found against the Commissioner on his first contention. No appeal having been taken from this part of the Tax Court's opinion, we can give the Commissioner no relief. The Tax Court did, however, find for the Commissioner on his alternative argument that $78,000 was a reasonable rent.

Warehouse contends that the Tax Court erred because section 482 should not apply in this case and because $48,000, not $78,000, was a reasonable rent. Section 482 reads as follows:

"In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary or his delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of such organizations, trades, or businesses."

Two elements must coalesce for the Commissioner to use his section 482 power: 1) The businesses must be under common control. 2) The reallocation must be necessary to reflect the proper income of the businesses or prevent tax evasion.

We agree with the Tax Court that these businesses were under common control. The statute applies whether the control is direct or indirect. Viewed in the broadest sense, both Enterprises and Warehouse were owned by exactly "the same interests." Each family as a unit retained its 25% interest in the income generated by the businesses. Individuals who owned 65% of Warehouse's stock owned all of Enterprises'. The only two persons who did not participate in both were the older Clements. Under the circumstances of this case, we do not believe that their lack of absolute control over the assets involved for periods not in excess of three years was sufficient to defeat the operation of section 482.

The purpose of forming Enterprises was to effect a short-term reallocation of income among the family members of certain units without in any way affecting their long-term ownership or control. The Tax Court found (43 T.C. at 560):

"This partnership was not a sham. It was organized for the business purpose of transferring to the adult children of L. D. and S. M. Clements, the fathers\' interest in the rice drying and warehousing operation, while permitting the fathers to retain their ownership interests in the physical properties."

In this statement the Tax Court was only half right. Certainly the partnership was not a sham in the sense that it made only a fleeting appearance as a shield for some other transaction. The partnership was a real functional entity intended to last at least from one to three years.

But whether the intention to shift income within a family unit is a "business purpose" justifying its recognition as a distinct noncontrolled business entity must be judged by the statutory function of section 482. The entire purpose of section 482 is to prevent the use of two organizations to distort income or avoid taxes. That purpose would be frustrated if a short-term diversion of income were sufficient to defeat a finding of control where the shift is among related family members and no change takes place in the actual ownership of the "physical properties."

Warehouse argues that the income involved in this case was really generated not by the "physical properties" involved but by the diligent efforts of those managing the business. In this way it is argued that no distortion of income took place and that there is really no identity of ownership of the income generating properties. This argument misses the mark. Not all of those receiving income through either Warehouse or the partnership actually took part in their management. What is more important is that the argument depends upon what is a fair salary for the executives running the business enterprise. Even if all of Enterprises' income were attributable to Warehouse, under section 482 Warehouse would be entitled to deduct reasonable salaries for its and Enterprises' employees. The question here is whether splitting the distribution of income generated by this business from the entity that retained ownership of the assets can be used to create a tax loss and to receive a refund of back taxes.

Moreover, this record does not show that it was the extraordinary effort of any one individual as opposed to the operating assets of Warehouse and its accumulated good will that generated the income in question. We cannot say that a three-year reallocation of income approved by the elder Clements with a donative intent brought the type of break in continuity of interest or control that would prevent the application of section 482 in this case. See Advance Machine Exch. v. Commissioner of Internal Revenue, 196 F.2d 1006 (2 Cir. 1952), cert. den., 344 U.S. 835, 73 S.Ct. 45, 97 L.Ed. 650. Cf. Section 673; also compare Commissioner of Internal Revenue v. Owens, 69 F.2d 597 (5 Cir. 1934).

Warehouse further argues that the requisite...