BELL REALTY TRUST v. COMMISSIONER OF INTERNAL REVENUE

RAUM, Judge:

The Commissioner determined deficiencies of $10,703.71 and $15,324.71 in petitioner's Federal corporate income taxes for the fiscal years ended June 30, 1967, and June 30, 1968, respectively. At issue is whether during each of those years petitioner was a "personal holding company" within the meaning of section 542, I.R.C. 1954, and therefore, subject to the special tax imposed on such corporations by section 541.

The parties have filed a stipulation of facts along with exhibits which are incorporated herein by this reference.

Petitioner is a Massachusetts business trust located in Revere, Mass. Taxable as a corporation, it filed Federal corporate income tax returns for the fiscal years ended June 30, 1967, and June 30, 1968, with the Internal Revenue Service Center, Andover, Mass.

During the years in issue petitioner's business activities appear to have been confined primarily, if not exclusively, to the rental of real property. Such property comprised nearly all of its assets with the exception of certain loans receivable hereinafter described. Its sole reported gross income for the tax years was as follows: FYE FYE June 30, 1967 June 30, 1968 Rents ...................... $61,764.00 $84,147.30 Miscellaneous .............. 203.51 9.54 ---------- ---------- 61,967.51 84,156.84 At all relevant times, Alice Bell and Gussie Bell each owned one-half of petitioner's outstanding stock.

Abel Ford, Inc. (Abel Ford), and Bell Oldsmobile, Inc. (Bell Olds), were two corporations which owned and operated retail automobile dealerships. At all relevant times, the stock of these corporations was also held by members of the Bell family. Thus, in April 1964, Alexander Bell, Alice's husband, and his brother Morris Bell, Gussie's husband, each owned one-half of the stock of Abel Ford. In September 1967, after the death of Alexander Bell, one-third of the stock of Abel Ford was held by each of the following: Morris Bell, the estate of Alexander Bell, and Sidney Weiner. Weiner, son-in-law of Alexander and Alice Bell, had served as president and general manager of Abel Ford since its inception in 1961. In September 1967, the stock of Bell Olds was equally divided between Alice Bell (who had succeeded to the interest of her deceased husband, Alexander) and Morris Bell.

In April of 1964, Abel Ford was in a poor cash position and needed additional financing. Unsuccessful efforts were made to secure that financing from the National Shawmut Bank which had been serving as Abel Ford's primary source of working capital. After other efforts to obtain funds proved equally fruitless, M. G. Sherman, a financial adviser and accountant employed by the Bell family and its businesses, recommended that petitioner borrow money to enable it to, in turn, provide funds to Abel Ford.

In accordance with this suggestion, on or about April 16, 1964, petitioner borrowed $250,000 at 5 3/4-percent interest from the Charlestown Savings Bank, Boston, Mass. (Charlestown), executing a note in that amount and granting Charlestown a mortgage on certain real estate petitioner owned. Although Charlestown engaged in this type of mortgage lending, it was not a commercial bank and did not extend open lines of credit to businesses. Abel Ford owned no real estate.

The proceeds obtained from Charlestown were applied as follows:

To repay a loan from National Shawmut Bank to petitioner ....................... $72,329.58 To repay a loan from First National Bank of Boston to petitioner ............. 16,188.28 Interest payable to Charlestown ............ 259.74 Legal fees incurred in connection with the loan from Charlestown ........... 1,398.10 To repay a loan from National Shawmut Bank to Abel Ford ........................ 37,270.72 Distributed to Abel Ford ................... 122,729.28 ---------- 250,000.00

The $160,000 which was distributed to or on behalf of Abel Ford (the sum of the last two items in the above schedule) was treated as a loan receivable on petitioner's books and as a loan payable on the books of Abel Ford. This indebtedness was neither secured nor evidenced by a note.

Charlestown may well have known that some of the loan proceeds would eventually be distributed by petitioner to or for the benefit of Abel Ford. Sidney Weiner, president of Abel Ford but neither an officer, director, or shareholder of petitioner, conducted the negotiations with Charlestown. Moreover, at some point during those negotiations he provided Charlestown with a financial statement of Abel Ford. Nevertheless, Abel Ford did not endorse petitioner's note nor did it in any other manner guarantee the repayment of petitioner's indebtedness to Charlestown.

On or about November 12, 1964, petitioner borrowed $282,000 at 5 3/4-percent interest from Charlestown giving a note and mortgage on certain of its real estate as security. It used these borrowed funds in part to satisfy the outstanding balance of the loan which it had received on or about April 16, 1964, and in part to purchase certain real estate in Revere, Mass., for $35,000. No portion of the $282,000 was loaned to Abel Ford or Bell Olds.

During the summer of 1967 Abel Ford was again experiencing financial difficulties. This time Sherman suggested that petitioner borrow additional funds for distribution not only to Abel Ford but also to Bell Olds, the latter having likewise developed a cash shortage. Pursuant to these recommendations, on or about August 31, 1967, petitioner borrowed $350,000 at 6 1/4-percent interest from Charlestown, the indebtedness again evidenced by a note and secured by a mortgage. After applying part of the proceeds to repay the outstanding balance on the earlier loan from Charlestown, petitioner distributed the remaining $103,307.60 as follows:

On 9/7/67:

To Bell Olds ................ $46,653.80 To Abel Ford ................ $46,653.80 On 9/25/67: To Bell Olds ................ 5,000.00 To Abel Ford ................ 5,000.00 ---------- 103,307.60

These distributions were carried as loans receivable on petitioner's books and records, and loans payable on the books and records of Bell Olds and Abel Ford to the extent of their respective distributions. Petitioner did not receive any notes or security in respect of these distributions.

During the negotiations for this latest loan from Charlestown to petitioner Weiner provided the bank with financial statements of Abel Ford and Bell Olds. In addition, he advised Charlestown that the proceeds not used to repay petitioner's outstanding indebtedness would be distributed to those corporations. However, neither Bell Olds nor Abel Ford endorsed petitioner's note to Charlestown or otherwise guaranteed that indebtedness.

Shortly thereafter, on or about October 16, 1967, to satisfy certain requirements imposed by General Motors, Morris Bell personally assumed responsibility for the repayment of the $51,653.80 which Bell Olds had received from petitioner, as well as the interest thereon from September 5, 1967, to October 16, 1967, and certain legal fees incurred in connection with the indebtedness which together totaled $534.02. This transaction was treated on the books of Bell Olds as a contribution to capital of $50,000 and a loan of $2,187.82 from Morris Bell.

At all relevant times only petitioner was liable for the repayment of the indebtedness to Charlestown. Petitioner paid the entire amount of each monthly installment (consisting partly of interest and partly of the repayment of principal) due thereon. About the time each such payment became due, however, Abel Ford and Morris Bell paid to petitioner amounts designated interest and repayment of principal in respect of the amounts which had been distributed to Abel Ford and Bell Olds. The amounts as paid by Abel Ford bore the same ratio, respectively, to the interest and principal payments made by petitioner to Charlestown, as the amounts which had been distributed to Abel Ford bore to the total amounts petitioner borrowed from Charlestown. The amounts paid to petitioner by Morris Bell were similarly related to the portion of the proceeds from the Charlestown loans which had been distributed to Bell Olds. The effect of determining the interest and principal payments of Abel Ford and Morris Bell in this manner was to impose upon them the same interest rates and payment schedules applicable to the repayment of petitioner's loans from Charlestown.

In this manner, petitioner received principal and interest payments from Abel Ford, during the fiscal year ended June 30, 1967, in the amounts of $5,882.74 and $10,068.62, respectively. During the same fiscal year petitioner paid Charlestown $13,495.73 designated repayment of principal and $14,608.27 designated interest.

During the fiscal year ended June 30, 1968, matters were complicated somewhat by the refinancing that occurred on or about August 31, 1967, and the subsequent distributions in September 1967, to Abel Ford and Bell Olds. Thus, in respect of the situation prior to those events, petitioner received principal and interest payments of $1,352.59 and $1,305.97, respectively, from Abel Ford, and paid to Charlestown $2,325.52 in repayment of principal and $4,024.89 of interest. In respect of the situation after the refinancing and additional distributions in 1967, the following occurred: petitioner received principal and interest payments of $5,820.86 and $9,635.02, respectively, from Abel Ford; petitioner received from Morris Bell $1,614.35 designated repayment of principal and $2,612.31 designated interest in respect of the distributions to Bell Olds; and petitioner paid Charlestown $12,050.61 in repayment of principal and $16,266.39 of interest.

On its Federal corporate income tax returns for the fiscal years ended June 30, 1967, and June 30, 1968, petitioner did not include in gross income any of the amounts constituting interest which it had received from Abel Ford or Morris Bell during those years. On each of those returns, however, it claimed deductions for interest paid only in the amount by which in that year the interest it paid to Charlestown exceeded the interest which it received from Abel Ford and Morris Bell.

In his deficiency notice the Commissioner made the following determinations:

It is determined that you should have reported as interest income in the year June 30, 1967, $10,068.12 received from Abel Ford, Inc. in respect of its indebtedness to you. You improperly treated such amount as an offset to interest expense. Since the $10,068.12, represents more than 10 percent of your ordinary gross income, and no dividends were paid, your adjusted income from rents constitutes personal holding company income and the total personal holding company income exceeds 60 percent of the adjusted ordinary gross income. Therefore, you qualify as the personal holding company * * * subject to the personal holding company tax under Section 541 of the Code.

It is determined that you should have reported as interest income in the year ended June 30, 1968, $10,940.99 received from Abel Ford, Inc. and $2,612.31 received from Morris E. Bell in respect of their indebtedness to you. You improperly treated such amounts as an offset to interest expense. Since the $13,533.30 represents more than 10 percent of your ordinary gross income, and no dividends were paid, your adjusted income from rents constitutes personal holding company income and the total personal holding company income exceeds 60 percent of the adjusted ordinary gross income. Therefore, you quality as a personal holding company * * * subject to the personal holding company tax * * *

The ultimate issue in this case is whether, for the taxable years, petitioner was a "personal holding company." If so, then it was subject to the 70-percent tax imposed by section 541, I.R.C. 1954, on the undistributed personal holding company income of every personal holding company, and, as the parties have stipulated, there are deficiencies in the amounts determined by the Commissioner. Section 542(a) defines "personal holding company" to mean any corporation satisfying the following requirements:

(1) ADJUSTED ORDINARY GROSS INCOME REQUIREMENT. — At least 60 percent of its adjusted ordinary gross income (as defined in section 543(b)(2)) for the taxable year is personal holding company income (as defined in section 543(a)), and

(2) STOCK OWNERSHIP REQUIREMENT. — At any time during the last half of the taxable year more than 50 percent in value of its outstanding stock is owned, directly or indirectly, by or for not more than 5 individuals. * * *

The parties have stipulated that petitioner satisfied the stock ownership requirement during each of the relevant years. They disagree, however, as to whether petitioner also met the first test relating to the composition of its "adjusted ordinary gross income."

The "adjusted ordinary gross income" requirement is only the beginning of a convoluted statutory path which must be followed in order to compute the two quantities — "adjusted ordinary gross income" and "personal holding company income" — we are required by the terms of section 542(a)(1) to compare. Cf. Pleasanton Gravel Co., 64 T.C. 510, 516. The term "personal holding company income" is itself defined in section 543(a) to mean a portion (computed in a specified manner) of the "adjusted ordinary gross income," and the term "adjusted ordinary gross income" is in turn defined in section 543(b)(2) to mean "ordinary gross income," as adjusted in a specified manner. Finally, section 543(b)(1) makes clear that the term "ordinary gross income" is based upon the familiar concept of "gross income" that is fundamental in our income tax law.

However, it is not necessary for us to trace our way through these various highly complicated statutory provisions, for there is no dispute between the parties as to their application here at each step, the sole issue between them being merely whether in the first instance the interest payments which petitioner received from Abel Ford and Morris Bell were includable in petitioner's "gross income." If such payments were thus includable, it is agreed by both parties that the "adjusted ordinary gross income" requirement of section 542(a)(1) has been satisfied. We therefore proceed directly to a consideration of the crucial issue whether the Commissioner correctly included these interest payments in petitioner's "gross income."

There is no controversy between the parties that "gross income" must be determined in accordance with the definition contained in section 61 of the Code. And that definition explicitly states that gross income "means all income from whatever source derived, including (but not limited to) the following items: * * * (4) Interest." Accordingly, it would plainly appear to follow that the items of interest received by petitioner from Abel Ford and Morris Bell must be included in its gross income, thus putting an end to the entire controversy herein. Petitioner, however, argues that it should not be treated as having received any such interest, that it was a mere conduit in respect of the loans to Abel Ford and Bell Olds, and that to the extent that interest was paid by Abel Ford and Morris Bell (on behalf of Bell Olds) it was received by petitioner merely as a conduit for transmission to the Charlestown Savings Bank. We do not so view the transaction.

To be sure, petitioner's borrowings from Charlestown were motivated in large part by its intention to make the greater portion of the loan proceeds available to Abel Ford and Bell Olds. Moreover, in view of the close family situation there was no disposition to charge Abel Ford and Bell Olds a higher rate of interest than petitioner was required to pay to Charlestown. Also, Charlestown obviously was aware that the larger portion of the proceeds would find its way into the hands of Abel Ford and Bell Olds. But Charlestown made its loans to petitioner only — loans that were secured solely by petitioner's real estate and which were in no way guaranteed by Abel Ford or Bell Olds. The obligation to repay those loans was exclusively that of petitioner, and it was petitioner alone that was liable to Charlestown in respect of the interest on those loans. Neither Abel Ford nor Bell Olds had any obligation to Charlestown. Their obligations ran to petitioner. It was petitioner alone that had the right to compel repayment of the amounts which it advanced to or on behalf of Abel Ford and Bell Olds, and it was petitioner alone that had the right to receive interest on those loans. When petitioner received such interest, it became petitioner's gross income.

Of course, petitioner had a right to a deduction under section 163 for interest which it paid to Charlestown. And, as a consequence, the interest that it received from Abel Ford and Bell Olds was offset by the corresponding deduction to which it was entitled when it paid its interest to Charlestown. But petitioner was not a conduit. The obligations were separate and distinct. The Code is so constructed that items of income must be included in "gross income," notwithstanding that available deductions may neutralize their tax consequences for purposes of the ordinary income tax. In the case of personal holding companies, however, the concept of "gross income" was made crucial by the Congress. We have no alternative but to hold the interest received by petitioner herein must be included in its "gross income."

We are quite aware that there may be circumstances in which it may fairly be said that a party to a transaction was a "mere conduit through which the flow of borrowed funds was channeled." Cf. Oak Hill Finance Co., 40 T.C. 419, 430. Cf. also Joan A. Nunez, 28 T.C.M. 1150. That is not the case here, however, where petitioner received the interest payments in question under its own claim of right. Such payments were its gross income regardless of the fact that it was under a wholly separate, although concomitant obligation, to pay interest in a still larger amount to its creditor, Charlestown, in respect of its own borrowed funds, part of which it had in turn lent to Abel Ford and Bell Olds. We are not persuaded otherwise by certain language in United States v. Ross, 251 F. Supp. 175, 183 (S.D. N.Y.), affirmed 368 F.2d 455 (2d Cir.), upon which petitioner principally relies. That language was merely obiter dicta, and regardless of its validity in the light of the problem before the court in that case, we are satisfied in this case that petitioner was no mere conduit in respect of the interest payments which it received for the loans which it in fact had made to Abel Ford and Bell Olds. That interest was includable in its "gross income."

We are not without sympathy for petitioner's situation as a result of the circumstances in which it finds itself. In view of the exasperatingly complex statutory provisions, it may well have stumbled unwittingly into the status of a personal holding company, subject to the burdensome special tax imposed upon such entities, without any intention to achieve the end Congress sought to discourage, namely, to shield those of its shareholders that might be in the upper brackets from the tax on dividends. Cf. L. C. Bohart Plumbing Heating Co., 64 T.C. 602, 606. Nevertheless, it is well settled that the personal holding company provisions provide for a mechanical test in which the absence of such motive is irrelevant. Cf. O'Sullivan Rubber Co. v. Commissioner, 120 F.2d 845, 847-848 (2d Cir.); American Package Corp. v. Commissioner, 125 F.2d 413, 416-417 (4th Cir.); Cedarburg Canning Co. v. Commissioner, 149 F.2d 526, 528-529 (7th Cir.); Coshocton Securities Co., 26 T.C. 935. Congress, however, has provided some relief for corporations that have been adjudicated to qualify as personal holding companies, and the adverse effects of the result herein upon petitioner may be softened through its payment of deficiency dividends in accordance with the provisions of section 547.

Decision will be entered for the respondent.