Respondent determined deficiencies in petitioners' income taxes as follows:
Petitioner Year Deficiency Louis and Jeanne Lesser ............................... 1958 $8,834.99 1959 8,588.02 William and Ethel Malat ............................... 1958 9,058.30 1959 8,339.49 Louis and Shirley Rudman .............................. 1958 5,013.70 Louis and Claire Lomas ................................ 1958 4,938.09 Alvin and Carol Lesser ................................ 1958 1,676.39 Gerald Alan Malat Trust No. 1, Louis Lesser, Jeanne Lesser and Claire Lomas, Trustees ................... 1958 896.13 Melvin Harold Malat Trust No. 1, Louis Lesser, Jeanne Lesser and Claire Lomas, Trustees ................... 1958 896.13 Craig Adolphe Lesser Trust No. 1, William Malat and Ethel Malat, Trustees ............................... 1958 6,959.49 Cathy June Lesser Trust No. 1, William Malat and Ethel Malat, Trustees ............................... 1958 6,959.50 Francine Sharon Lesser Trust No. 1, William Malat and Ethel Malat, Trustees ........................... 1958 6,959.50 Therese Ann Lesser Trust No. 1, William Malat and Ethel Malat, Trustees ............................... 1958 6,959.50 Craig Adolphe Lesser Trust No. 2, Louis Rudman and Shirley Rudman, Trustees ............................ 1959 8,741.35 Cathy J. Lesser Trust No. 2, Louis Lomas and Claire Lomas, Trustees ..................................... 1959 8,741.35 Therese Ann Lesser Ford Trust No. 2, Louis Lomas and Claire Lomas, Trustees .............................. 1959 8,741.35 Francine S. Lesser Trust No. 2, Louis Rudman and Shirley Rudman, Trustees ............................ 1959 8,741.35 After various concessions by the parties the following issues remain for decision:
(1) Whether a loss in the amount of $124,148.80 sustained by the partnership Louis Lesser Enterprises, Ltd., in the fiscal year ended June 30, 1958, is to be classified as a "business" or "nonbusiness" bad debt.
(2) Whether the Commissioner erred in disallowing, to the extent of $62,074.40, a business bad debt deduction of $187,000 claimed by the foregoing partnership in its return for the fiscal year ended June 30, 1959.
(3) Whether the gain of $19,434.56 realized by the partnership from the sale of a tract of land (Mitchell property) was taxable as capital gain or ordinary income.
(4) What was the useful life of the so-called Helipot building for depreciation purposes?
FINDINGS OF FACT
Some of the facts have been stipulated, and, as stipulated, are incorporated herein by reference.
Joint returns of the husband and wife petitioners, Louis and Jeanne Lesser, William and Ethel Malat, Louis and Shirley Rudman, Louis and Claire Lomas, and Alvin and Carol Lesser, and the fiduciary returns of the trust petitioners, for the taxable year or years involved in the case of each of the petitioners, were filed with the district director of internal revenue at Los Angeles, Calif.
The deficiencies determined by respondent are all based on adjustments made by him in the income of two partnerships, Louis Lesser Enterprises, Ltd., hereinafter referred to as Enterprises, and Lesser Industrial Properties, Ltd., hereinafter referred to as Industrial. The partnership years involved are fiscal years ended June 30, 1958, and June 30, 1959, in the case of Enterprises, and June 30, 1959, in the case of Industrial. The taxable years of petitioners are calendar years, except in the case of Louis and Jeanne Lesser, who have a fiscal year ending November 30.
The managing partners of both partnerships were Louis Lesser and William Malat. Both partnerships were engaged in the real estate business. They operated out of the same office, located at 8737 Wilshire Boulevard, Beverly Hills, Calif. Louis Lesser, William Malat, Louis Lomas, Louis Rudman, and Alvin Lesser were general partners and the various petitioner trusts identified as "Trust #1" were limited partners in Enterprises. Louis Lesser and William Malat were general partners and the various petitioner trusts identified as "Trust #2" were limited partners in Industrial.
Enterprises commenced business on July 1, 1952, Industrial on July 8, 1952. On January 1, 1962, they were both succeeded by a single corporation, Louis Lesser Enterprises, Inc.
Business of Enterprises. — Enterprises, as one aspect of its business, beginning in 1952, bought land, subdivided it, built houses on the lots, and sold them. It did not do this directly but through partnerships in which it owned an interest.
Enterprises also acquired an interest in 10 or 12 so-called Wherry housing projects. These are apartment projects on a military base built for rental to military personnel. Enterprises built the buildings on ground leased from the U.S. Government. Its purpose was to hold these Wherry housing properties for rental income.
During the taxable years ending June 30, 1958, and June 30, 1959, Enterprises owned the Lesser Building, a commercial building. During those years rental income property accounted for about 50 percent in value of Enterprises' total assets.
In respect of the houses built through partnerships of Enterprises and others, Enterprises in several instances guaranteed loans made by a bank to finance the projects and also guaranteed repayment of several construction loans made in connection with other real estate projects.
Bad Debts. — On July 30, 1954, Enterprises entered into a partnership agreement, as equal partner, with Bauer Construction Co., Inc., an Oregon corporation, for the purpose of constructing houses. The partnership adopted the name of "Bauer-Lesser." The shareholders of Bauer Construction Co., Inc., were Bruce Bauer and Henry Hewitt. Enterprises had no interest in Bauer Construction Co., Inc.
On May 25, 1955, Bauer-Lesser entered into an agreement to construct houses on land acquired by Universal Construction Co., Inc., a California corporation incorporated March 15, 1950, and hereinafter referred to as Universal. In that agreement Universal was called the "Owner" and Bauer-Lesser the "Contractor." It provided in part as follows:
Owner agrees, in consideration of the performance of this agreement by Contractor, to pay or cause to be paid to Contractor a total sum equal to the amount expended by Contractor for materials and payments to subcontractors in accordance with subcontracts approved by Owner, and for the cost of labor or services in performance of this agreement by Contractor's employees, plus seventy per cent (70%) of the difference between Owner's net return from sales of houses built hereunder and the cost thereof to Owner, including the cost of the real property on which such houses are built and all costs of construction of the project other than the said seventy per cent (70%), which shall be for Contractor's profit. Progress payments shall become due and owing weekly or at such other intervals as Contractor presents statements of the work performed.
On the same date, May 25, 1955, the partnership agreement of Bauer-Lesser was amended to embrace in its specified activities the project with Universal.
Enterprises had, on December 26, 1952, purchased all of the stock of Universal, consisting of 1,000 shares, for a total cost of $1,000. The partners in Enterprises, in whose names the stock of Universal was held, held such stock for the benefit of Enterprises. On July 13, 1955, Enterprises sold 500 shares of Universal stock to Bauer Construction Co., Inc., for $500. The stock ownership remained the same throughout the period here involved.
The land acquired by Universal consisted of 2 different parcels, 1 consisting of 72 lots located in the city of San Bruno, Calif., and known as Parkview Terraces, and the other consisting of acreage in the city of Marysville, Calif., and known as Parkview Estates.
Universal executed a "Building Loan Agreement" with the Republic National Bank of Dallas, hereinafter referred to as Republic, for a loan for the Marysville project. A corresponding building loan agreement was made with Republic for the San Bruno project.
On June 27, 1955, a partnership of six corporations was formed under the name of Torrance Vista. In each corporation the stock was owned 37 1/2 percent by one Sam Len, and 62 1/2 percent by Enterprises. The purpose was to develop a property known as Torrance Vista, by subdividing, building houses, etc. This project was also financed by Republic. A loss was sustained on this project.
On October 1, 1955, Enterprises entered into a 50-50 partnership with Bauer Enterprises, a partnership. The partnership so formed was named "San Carlos Highlands," hereinafter referred to as San Carlos. It was organized for the purpose of developing into residential lots, and constructing houses on a certain parcel of land in San Carlos, Calif., known as Heather Highlands. This partnership was likewise financed by Republic. The members of Bauer Enterprises were Bruce Bauer and Henry Hewitt. There was also a "Bauer-Lesser of Oregon," a partnership of Enterprises and Bauer Construction Co., Inc., but for similar construction of houses in Oregon.
As to the San Bruno and Marysville projects, as required by the building loan agreement between Republic and Universal with respect to each property, the payment of any and all indebtedness of Universal to Republic thereunder was guaranteed "jointly and severally" by the partners of Enterprises, and by Bruce Bauer and Henry Hewitt, and by their respective wives. As among the partners of Enterprises these guarantees were executed by them in behalf of Enterprises; they signed as individuals because Republic so required in order to obtain their unlimited personal liability. Similar guarantees were executed in behalf of Enterprises in respect of the San Carlos and Torrance Vista projects.
The San Bruno lots were already improved when acquired, "streets and all," but the houses were still to be constructed. The houses were constructed by Bauer-Lesser for Universal, pursuant to the foregoing agreement of May 25, 1955. The houses cost more to build than had been anticipated; sales were slower than had been expected; heavy rains caused landslides with resulting damages that were costly to repair; and the sales broker stole sales deposits in excess of $150,000.
As to Marysville there were also higher construction costs than had been projected, and in addition there was a very bad mortgage market. Also, Camp Beal, a large Air Force base nearby which contributed heavily to the general economy of Marysville, was closed down. The demand for houses fell off, and it took a long time to sell them, with interest accruing during that time.
In June 1957, Republic demanded payment on the obligations to it of Torrance Vista, Universal, Bauer-Lesser (California), and San "Carlos. Enterprises, because of its guarantees of those obligations, on June 26, 1957, put up $500,000 worth of Magma Copper Co. stock as collateral.
On November 14, 1957, Enterprises borrowed $450,000 from Republic on a note, dated October 30, 1957, signed also by Industrial as accommodation maker, and secured by the aforesaid collateral. The proceeds of the loan were applied to the payment of the following obligations: 1. On a note of Torrance Vista, principal and interest ................................................. $81,796.47 2. On a note of Universal in connection with the Marysville project, principal and interest ................................... $84,706.12 3. On a note of Universal in connection with its San Bruno project, principal and interest ................................... 39,442.68 124,148.80 ---------- 4. On a note of Bauer-Lesser, principal and interest ................................................. 231,655.25 5. On a note of San Carlos Highlands, interest only ..................................................... 12,399.48 ---------- Total .................................................. 450,000.00 The Torrance Vista note was thereby paid in full; balances of $98,567.86 and $72,404.28 remained on the two Universal notes; a balance of $189,877.60 remained on the Bauer-Lesser note; and a balance of $805,356.30 remained on the note of San Carlos Highlands.
The amount of $450,000 so borrowed and disbursed was arrived at by mutual understanding of Enterprises and Republic as the excess of the obligations to Republic guaranteed by Enterprises over the expected realization from the assets of the several primary obligors. This determination was made separately as to each of the five obligations to which the proceeds of the $450,000 note were applied. That note was secured only by the Magma Copper Co. stock.
A deduction for business bad debts in the amount of $124,148.80, taken on the return of Enterprises for its year ended June 30, 1958, was based on the payments of $84,706.12 and $39,442.68 in connection with the Marysville and San Bruno projects. That amount was written off on the books of Enterprises in that year. At that time Universal had no assets or prospect of assets out of which any part of that amount could be recovered.
The note for $450,000 was renewed from time to time. On July 1, 1958, Enterprises made a payment of $374,000 on that note, out of the proceeds of an unrelated transaction, and the balance of $76,000 was incorporated on July 22, 1958, in a new note to Republic in the amount of $473,500, signed by Enterprises and Industrial. The new note, which was also secured by the Magma Copper Co. stock, has since been paid in full by Enterprises.
By book entry dated June 30, 1959, Enterprises wrote off an amount of $187,000, charging it to bad debts and crediting it to Bauer Construction Co., Inc. This amount was equal to one-half of the foregoing $374,000 payment to Republic on July 1, 1958. The explanation of the entry given on Enterprises' books was as follows: "Payment to Republic Bank of Bruce Bauer's share which L. Lesser Enterprises was required to pay as guarantor."
In its return for the fiscal year ended June 30, 1959, Enterprises claimed a business bad debt deduction of $187,000 in respect of the above item. The Commissioner disallowed the $187,000 deduction to the extent of $62,074.40, since the $374,000 payment which formed the basis for the deduction comprehended the $124,148.80 Universal bad debt which had already been written off and deducted for the preceding year ended June 30, 1958. The Commissioner explained his adjustment as follows:
The deduction claimed for bad debts in the amount of $187,000 is disallowed to the extent of $62,074.40 computed as follows:
Partnership's note ............................... $450,000.00 Paid by $473,500.00 note ......................... (76,000.00) ------------ Balance paid by partnership .................. 374,000.00 Less amount applicable to Universal Construction Co. ................................. 124,148.80 ------------ Amount applicable to partnerships ............ 249,851.20 ============ Your 1/2 interest allowable as a bad debt deduction ........................................ 124,925.60 Bad debts deducted in your return ................ 187,000.00 ------------ Adjustment ................................... 62,074.40
The income tax returns of Enterprises reflected its share of losses incurred by Bauer-Lesser of California, San Carlos Highlands, and Bauer-Lesser of Oregon for the taxable years ended June 30, 1957, June 30, 1958, and June 30, 1959, as follows: June 30, 1957 June 30, 1958 June 30, 1959 Bauer-Lesser of California ... $124,403.79 $27,386.04 $14,592.51 San Carlos Highlands ......... 30,344.61 67,900.02 15,229.50 Bauer-Lesser of Oregon ....... 25,756.20 253.76 9,202.04 ------------- ------------- ------------- Total..................... 180,504.60 95,539.82 39,024.05 As of June 30, 1959, Bruce Bauer, Henry Hewitt, Bauer Construction Co., Inc., and Bauer Enterprises were insolvent; no part of the amounts of $124,148.80 and $187,000 written off as a bad debt by Enterprises in 1958 and 1959, respectively, has ever been recovered from them. However, subsequent to June 30, 1961, the amount of $59,803.25 was recovered by Enterprises' corporate successor, Louis Lesser Enterprises, Inc., out of the remaining assets of San Carlos; this $59,803.25 amount was the gross amount, before any deductions were taken for administrative expenses involved therein. This $59,803.25 amount was included in the gross income of Enterprises' corporate successor.
Mitchell Property. — On February 15, 1955, Enterprises acquired a 35-acre parcel of unimproved land in the city of Buena Park (hereinafter referred to as the Mitchell Property), at a cost of $174,082.94. Since a fairly good linear footage of this property lay on a thoroughfare, Enterprises hoped that it could be rezoned for apartment development, or possibly commercial development. The plan was to construct apartment buildings and a shopping center on the property, to be retained by Enterprises for rental income. Subsequent to its acquisition it was learned that the hope that the property could be rezoned for apartment or commercial development could not be realized. Enterprises then decided to hold it for increase in value. Eventually, however, a group of home builders expressed an interest in the property and said they would like to buy it. The sale was then made, on August 29, 1957, to a partnership formed by the home builders with a corporation owned by Enterprises. The sales price was $193,517.50.
Enterprises never advertised the Mitchell property or listed it with a broker. It held a real estate broker's license during the fiscal year ending June 30, 1958. At the time of the sale the Mitchell property was not held by Enterprises primarily for sale to customers in the ordinary course of its trade or business.
Depreciation. — On June 10, 1958, Industrial (Lesser Industrial Properties, Ltd.) was advised by the treasurer of Beckman Instrument Corp. that that corporation was interested in selling its Helipot building located at 500 Superior Avenue, Newport Beach, Calif. This building had been constructed by the Beckman Instrument Corp. in July of 1957, and had been occupied and used by the Helipot Corp., a "division" of Beckman Instrument Corp., for approximately a year.
Industrial communicated with the Hughes Aircraft Co. (hereinafter referred to as Hughes) to ascertain whether that corporation would be interested in leasing the Helipot building. Upon being informed that Hughes was interested in such a lease, Industrial, on June 11, 1958, secured from Beckman Instrument Corp. an option to purchase the land and building at 500 Superior Avenue (hereinafter sometimes referred to as the Newport Beach property).
On June 12, 1958, Industrial received from Hughes a written offer to lease the Newport Beach property. The offer was accepted by Industrial. Neither Enterprises, Industrial, nor any of their members nor their corporate successor, at any time had an interest in Hughes.
On June 13, 1958, Enterprises and the Helipot Corp. entered into an agreement wherein the former agreed to purchase and the latter to sell the Newport Beach property. The agreement provided that the closing date of the transaction would be September 30, 1958, and that possession would be delivered on the closing date. In accordance with the terms of the agreement, the purchase from Helipot Corp. was completed, and Industrial acquired the Newport Beach property on September 30, 1958, at a total cost of $2,753,909.44. The purchase was made nominally by Enterprises, and the property then in turn conveyed by Enterprises to Industrial.
The Helipot building would not have been purchased by Industrial without first having a lease commitment.
Industrial did no remodeling or reconstruction work in respect of the Helipot building subsequent to purchasing the property from Helipot Corp.
The Helipot building as originally designed and constructed was usable for a variety of light manufacturing purposes and was not a one-purpose building. The basic structure of the building consisted of masonry, steel, concrete floors, and a wood frame roof with a gypsum roof deck on part of it. The basic structure or "shell" of the building was very substantial; it was "of a long-life nature, very permanent masonry type," with a useful life of up to 60 years. Other components of the building such as painting, electrical work, plumbing, air-conditioning, and other items had shorter useful lives and would require renewing or replacing prior to the end of the life of the building as a whole.
On July 21, 1958, Industrial and Hughes entered into a lease agreement, wherein Hughes leased from Industrial the Newport Beach property, together with the building, improvements, and appurtenances located thereon. The agreement provided in part as follows:
2. LESSOR'S GENERAL COVENANTS
Lessor covenants, represents and warrants that:
* * * * * * *
(b) * * * said leased premises contain approximately 14.8 acres, upon which there is presently existing a multiple-story building with approximately 156,000 sq. ft. of floor space together with lighting, power connections, built-in cafeteria kitchen equipment, air-conditioning, drapes, drapery hardware and carpets; and approximately 275,000 sq. ft of paved parking area.
* * * * * * *
3. LESSEE'S GENERAL COVENANTS
Lessee covenants, represents and warrants that:
* * * * * * *
(c) Lessee will not use nor suffer or permit said premises or any part thereof, to be used in any manner that will injure or impair the structural strength of said building, nor install nor suffer or permit to be installed in said premises any machinery or apparatus, the weight or vibration of which will tend to injure or impair the structural strength of said building.
4. BASIC TERM OF THIS LEASE
This lease shall be for a basic term of twenty (20) years commencing on the date possession of the premises is delivered to and accepted by the Lessee. * * *
5. RENT
(a) Lessee shall pay to Lessor as rent for the basic twenty (20) year term of this lease the sum of Six Million Dollars ($6,000,000.00), payable in equal monthly installments of Twenty-Five Thousand Dollars ($25,000.00) in advance on or before the first day of each calendar month during the term of this Lease. * * *
* * * * * * *
(e) As additional rental the Lessee shall, at its sole cost and expense maintain in good condition and repair during the term of this lease, all of the premises, including the outer walls and the roof of said building, * * *. At the termination of this Lease, Lessee shall surrender said building to the Lessor in good condition and repair, subject only to the effect of reasonable wear [and] tear during the term of this Lease. * * *
6. IMPROVEMENTS AND ALTERATIONS
(a) Lessee shall have the right to erect and install at its own expense, in or upon the building or buildings upon the premises leased hereunder, such improvements as it may desire subject only to all architectural restrictions, covenants, easements or reservations now of record and affecting the premises and to its General Covenant in subparagraph (c) of Paragraph 3 of this Lease.
(b) The Lessee shall have the right at its sole cost and expense to make alterations to the interior of said premises and to install therein fixtures, equipment and machinery subject only to its General Covenant in subparagraph (c) of Paragraph 3 of this Lease.
(c) At any time during the term of this Lease or at any time prior to seven (7) days after termination of this Lease, Lessee may, at its option, and at its cost, remove all improvements, machinery, fixtures and equipment installed by it, excluding any elevator that may have been installed by Lessee upon or in the demised premises. Lessee shall at its cost following such removal of said improvements, machinery, fixtures and equipment, repair any damage to the premises resulting from such removal; subject, however, to the effect of reasonable wear and tear. * * *
* * * * * * *
13. HOLDING OVER
Any holding over with Lessor's written consent after the original term of this Lease, except under an extension of said term pursuant to Paragraph 14 hereof shall be construed to be a tenancy from month-to-month, and otherwise shall be subject to the terms, conditions and covenants of this Lease insofar as the same are applicable.
14. LESSEE'S OPTION TO EXTEND
(a) Lessor hereby grants to the Lessee * * * six (6) separate successive options to extend the term of this Lease for six (6) successive five (5) year terms, the first extension commencing on the expiration of the basic twenty (20) year term, on the same terms and conditions and with the same options contained in this Lease except that the monthly rental * * * shall be changed * * *
Following the 20-year basic term, the lease provided progressively reduced rentals during the six 5-year renewal terms, ranging from $200,000 per year for the first renewal term to $120,000 per year for the sixth renewal term.
Hughes, upon taking possession of the Helipot building, immediately engaged in a $5 million program of completely remodeling and expanding the structure, for the sole purpose of converting it into a plant for the manufacture of semiconductors, diodes and transistors. Virtually all of the interior of the building was torn out; the building was extensively remodeled, and horizontal additions to the building resulted in almost doubling its original size.
The total cost of the Newport Beach property to Industrial, $2,753,909.44, was allocated by it between land and building on the basis of the property tax assessments, $88,675.88 being allocated to the land and $2,665,233.56 to the building. The total original cost of construction of the building to Industrial's vendor, about a year earlier, was $2,567,122.
The Helipot building had a depreciable life of 45 years from the date of its acquisition by Industrial.
OPINION
RAUM, Judge:
1. $124,148.80 Bad Debt Issue. — A deduction for business bad debts in the amount of $124,148.80 was taken in Enterprises' return for its fiscal year ending June 30, 1958, based upon payments of $84,706.12 and $39,442.68 in fulfillment of its guarantee of Universal's obligations in respect of the Marysville and San Bruno projects. The Commissioner's disallowance of the deduction was in substance on the sole ground that the loss had not yet occurred during that year. At the trial the Commissioner conceded that the loss was sustained in that year, but argued that it resulted from a "nonbusiness" rather than a "business" debt, the deduction of which is limited by reason of section 166(d)(1)(B) of the 1954 Code. Thus, the sole issue, and the only one that we decide, in respect of this item is whether the loss, conceded to arise from a "debt," is to be classified as "business" or "nonbusiness."
SEC. 166. BAD DEBTS.
(d) NONBUSINESS DEBTS. —
(1) GENERAL RULE. — In the case of a taxpayer other than a corporation —
* * * * * * *
(B) where any nonbusiness debt becomes worthless within the taxable year, the loss resulting therefrom shall be considered a loss from the sale or exchange, during the taxable year, of a capital asset held for not more than 6 months.
Section 166(d)(2) defines "nonbusiness debt" as follows:
(d) NONBUSINESS DEBTS. —
* * * * * * *
(2) NONBUSINESS DEBT DEFINED. — For purposes of paragraph (1), the term "nonbusiness debt" means a debt other than —
(A) a debt created or acquired (as the case may be) in connection with a trade or business of the taxpayer; or
(B) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.
We hold that the two components of the $124,148.80 item were plainly "business" bad debts.
A significant aspect of Enterprises' business was the development of subdivisions, building houses on the lots thereof, and selling the individual houses and lots. It conducted such business through partnerships, and, in this instance, in an equal partnership with Bauer Construction Co., Inc., known as Bauer-Lesser. That partnership was to receive 70 percent of the net profits derived from constructing and selling houses on land owned by Universal Construction Co., Inc. And it was in connection with the two parcels of real estate owned by Universal, known as the Marysville and San Bruno projects, that Enterprises sustained the losses here in issue. Its guarantees of Universal's obligations giving rise to those losses were directly connected with its business of constructing and selling houses (through the partnership of Bauer-Lesser), and those losses must therefore be classified as "business," wholly apart from Enterprises' further and more remote interest in the venture as a stockholder of Universal. Cf. Whipple v. Commissioner, 373 U.S. 193, 204-205; Wilfred J. Funk, 35 T.C. 42, 49, acq. 1961-2 C.B. 4; George P. Weddle, 39 T.C. 493, 498, affirmed 325 F.2d 849 (C.A. 2); Eugene H. Rietzke, 40 T.C. 443, 450-451; J. T. Dorminey, 26 T.C. 940, 945.
2. $187,000 Bad Debt Issue. — In its return for the fiscal year ending June 30, 1959, Enterprises claimed a bad debt deduction in the amount of $187,000. The Commissioner did not challenge the propriety of the deduction in general, but he reduced it by $62,074.40 on the ground that to this extent the deduction claimed was a duplication of a bad debt deduction taken for the preceding year.
There can be no serious doubt that the $187,000 deduction was based upon Enterprises' $374,000 payment on Republic's $450,000 note, as set forth in our findings, and reflected the coguarantor's or coguarantors' obligation to reimburse Enterprises for his or their one-half share of that payment, an obligation which had become worthless by the close of the fiscal year ending June 30, 1959. But it is equally clear that the $374,000 payment covered the $124,148.80 bad debt deduction which had been claimed for the preceding tax year, and which we have approved in 1, supra. Accordingly, the Commissioner correctly determined that since the $124,148.80 deducted as a bad debt in the fiscal year ending June 30, 1958, was included in the $374,000, and since one-half of $374,000, or $187,000, was claimed as a business bad debt loss in the fiscal year 1959, the duplicated item of one-half of $124,148.80, or $62,074.40, should be disallowed as a deduction in the latter year.
Enterprises' returns show large losses sustained by it in connection with the various Bauer enterprises, and we must assume, in the absence of evidence to the contrary, that its own one-half share of the foregoing payment was taken into account in the computations resulting in those losses that were thus deducted on the returns.
Petitioners' attempt to prove that the $124,148.80 was not included in the $374,000 was weak and unsatisfying. They had the burden of proof and in this they have utterly failed. Moreover, the evidence as a whole, including the book entry upon the basis of which the deduction was claimed, strongly refutes petitioners' position.
Indeed, the evidence persuasively indicates that Enterprises' accountant who made the $187,000 entry regarded the $124,148.80 item as being identified with the $374,000 payment, and although that accountant was in the courtroom, petitioners failed to call him as a witness.
Apparently realizing the weakness of their position that there was no duplication once it is assumed that the $187,000 bad debt deduction was itself based upon the $374,000 payment, petitioners at the trial offered some testimony to prove that the $187,000 claimed as a bad debt deduction was not related to the $374,000 payment at all, but was based on other debts the payments of which had been guaranteed by Enterprises and Bruce Bauer and his associates. And on brief counsel virtually abandoned the position that there was no duplication, arguing instead that "Even though the method used in determining the deduction involves a clear duplication, * * * the full deduction taken is allowable if, as a matter of fact, there was a loss during the year in the full amount deducted." There are two complete answers to this new position.
In the first place, the evidence produced does not convince us that the necessary underlying facts have been established. The presentation of evidence on this issue was marked by confusion, vagueness, and generalities. Throughout the trial we were continually groping for orientation in a thick fog, and we repeatedly called counsel's attention to the difficulties of comprehension generated by his method of developing the record. Notwithstanding our repeated suggestions to him, both on and off the record, to present his materials in a clear and meaningful manner, the record in respect of this issue is in a most unsatisfactory state. While there was some general testimony that might furnish a basis for counsel's present contention, we find it wholly unconvincing in the context of the record as a whole, and in the absence of a more precise foundation. To be sure, there was general testimony that Enterprises' bad debts were even greater, by $25,000, than the $187,000 claimed in its 1959 return. However, the components of these figures were never disclosed; nor was any evidence presented showing just how these figures were derived. Precisely what were the debts that added up to these figures? The record furnishes no clue, and we have no confidence in the bland conclusory assurances of the witnesses who asserted in general terms that there were bad debts in an aggregate amount which exceeded the claimed $187,000 by $25,000. We were left with these and other troubling doubts that were never resolved, and we received no assistance in this respect from petitioners' inadequate brief. In the circumstances we cannot in good conscience make any such finding as requested of us by counsel to the effect that Enterprises sustained bad debt losses in its fiscal year 1959 in an aggregate amount equal to at least $187,000 that was wholly unrelated to its $374,000 payment to Republic.
In the second place, no such alternative issue as counsel presses upon us was raised by the pleadings. Rule 7( c)(4)( B) of our Rules of Practice requires that the petition contain:
4. Clear and concise assignments of each and every error which the petitioner alleges to have been committed by the Commissioner in the determination of the deficiency. * * *
5. Clear and concise lettered statements of the facts upon which the petitioner relies as sustaining the assignments of error, * * *
These are not empty or meaningless requirements, and they are to be taken seriously. Compliance with these provisions is essential to the orderly conduct of the litigation.
The only assignments of error that relate in any way to this item are as follows:
These assignments and other references to or quotations from the pleadings are taken from docket No. 1469-62. Substantially identical language appears in the other dockets which involve this item.
g) The Commissioner erred in increasing the income of the partnership Louis Lesser Enterprises, Ltd., by the sum of $62,074.40, in respect of an item referred to as bad debts.
h) The Commissioner erred in failing instead to decrease the income of the said partnership by the sum of $62,851.20, being the excess of $187,000.00 (half of the sum of $374,000.00 referred to in paragraph 5(c) below) over the said sum of $124,148.80 referred to in subparagraph (a) above.
The only allegations of fact that in any way relate either to the $124,148.80 bad debt deduction for fiscal 1958 or to the $187,000 bad debt deduction for fiscal 1959 are, in their entirety, as follows:
5. In support of the foregoing assignments of error, petitioners allege the following facts:
a) The sums deducted by the partnership Louis Lesser Enterprises, Ltd., as payments made because of guarantees to a bank represent actual payments made by the said partnership in the years in which deducted. Although loans were made from the same bank in part for that purpose the loans were made in the same manner as if made at another bank and in the same manner as if made for another purpose or purposes, and the funds when paid on the guarantees were the partnership's funds.
b) The said guarantees were made in the regular course of the trade or business of the said partnership; the debts resulting therefrom were created in connection with the trade or business of the said partnership; and the loss from the worthlessness of said debts was incurred in the said partnership's trade or business.
c) In the year ended in 1959 the partnership Louis Lesser Enterprises, Ltd., paid a total of $374,000.00 on said guarantees.
Nowhere in the foregoing are there any "clear and concise * * * statements of the facts upon which the petitioner[s] rel[y] * * *" as supporting their claim to deduct a bad debt of $187,000, unreduced by the Commissioner's adjustment of $62,074.40. Nor is any theory spelled out upon the basis of which they contend the Commissioner was in error. At most there is merely the allegation that Enterprises paid a total of $374,000 on the guarantees in the taxable fiscal year 1959. But the Commissioner's determination accepted that fact as true; he merely went further and eliminated therefrom that portion of the deduction which in his view duplicated a deduction taken in the previous year. Accordingly, petitioners could have challenged that determination either by alleging facts showing the absence of duplication or by taking a new affirmative position alleging facts establishing that the full $187,000 was deductible in fiscal 1959 for reasons unrelated to the $374,000 payment and regardless of whether there was any duplication. They did neither, and no such latter new issue is in any way reasonably inferable from the pleadings. Moreover, even though the Court in its discretion could grant permission to amend the pleadings during the course of the trial to conform to the proof (see Rule 17( d), Tax Court Rules of Practice), no request therefore was made in respect of this issue, and we would not in any event grant that permission in these cases in order to raise such a distinctly different issue, where the pleadings were so inadequate, slipshod, and slippery in the first place, and where the alleged "proof" was so vague and unsatisfactory. Cf. Nathan Goldsmith, 31 T.C. 56, 63-64.
3. Mitchell Property. — This issue relates to the gain realized by Enterprises in its fiscal year ending June 30, 1958, from the sale of the Mitchell property, and whether that gain is taxable as ordinary income or capital gain. Under section 1221 of the Internal Revenue Code of 1954, the property sold qualifies as a "capital asset," the gain from the sale of which is taxable as capital gain, unless it is excluded from the definition of that term because it constitutes property held primarily for sale to customers in the ordinary course of the trade or business of Enterprises. The question presented is one of fact. After carefully considering the purpose of Enterprises in acquiring and holding the property, the time it held the property, its inactivity with respect to its sale, the nature of its business, and all other pertinent evidence, we have reached the conclusion, and found as a fact, that the Mitchell property was not held by Enterprises primarily for sale to customers in the ordinary course of its business. Respondent erred, therefore, in treating the gain from the sale as ordinary income and not as capital gain.
SEC. 1221. CAPITAL ASSET DEFINED.
For purposes of this subtitle, the term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include —
(1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;
4. Depreciation — Helipot Building. — Industrial computed its deduction for depreciation on the Helipot building for the fiscal year ending June 30, 1959, using the declining balance method, upon the basis of a 25-year life from date of acquisition. The Commissioner determined that the building had a useful life of 50 years and revised the deduction accordingly. The burden was upon petitioners to establish that a "reasonable allowance" for depreciation on the building should be based upon an estimated life of not more than 25 years.
Sec. 167 of the 1954 Code provides:
(a) GENERAL RULE. — There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear * * *
(1) of property used in the trade or business, or
* * * * * * *
(b) USE OF CERTAIN METHODS AND RATES. — For taxable years ending after December 31, 1953, the term "reasonable allowance" as used in subsection (a) shall include (but shall not be limited to) an allowance computed in accordance with regulations prescribed by the Secretary or his delegate, under any of the following methods:
(1) the straight line method,
(2) the declining balance method, using a rate not exceeding twice the rate which would have been used had the annual allowance been computed under the method described in paragraph (1),
(3) the sum of the years-digits method, and
(4) any other consistent method productive of an annual allowance which, when added to all allowances for the period commencing with the taxpayer's use of the property and including the taxable year, does not, during the first two-thirds of the useful life of the property, exceed the total of such allowances which would have been used had such allowances been computed under the method described in paragraph (2).
In support of their position petitioners urge, first, that the life of a building may be based upon a composite of all its components, taking into account not only the "shell" but also such other items as heating, plumbing, air-conditioning, electric wiring, etc., and that such composite life would not exceed 20 years in the case of the Helipot building. Second, they argue that Industrial bought the property only because it had Hughes' commitment for a 20-year lease which alone returned its entire investment to it, that the Helipot building was a unique, single-purpose building, and that it therefore had no useful life beyond the basic 20-year term of the lease.
The second contention may be briefly dismissed. We are satisfied by the evidence that the property was not a unique, single-purpose building, and that the termination of the basic 20-year term of the Hughes lease would not put an end to its useful life, wholly apart from the six renewal options of 5 years each which contemplated further occupancy of up to 30 additional years by Hughes beyond the 20-year basic term. And the mere fact that those who controlled Industrial were so fortunate, or had such business acumen, as to couple their acquisition of the property with so favorable a lease from Hughes that would pay off the entire purchase price and return a handsome profit as well during 20 years, is hardly a reason to conclude that the building had a useful life of only 20 years.
Nor are we convinced by petitioners' effort to prove that the life of the building, based upon all its components, was only about 20 years. Their position is founded largely upon the testimony of Estil R. McCollum, the general manager of the construction company that did the remodeling of the building for Hughes after it became lessee. Upon the basis of that testimony petitioners argue that the "shell" of the building, consisting of the masonry, steel, iron, walls, roof, etc., comprised 40 percent in value of the structure acquired by Industrial and had a life of 40 years, and that the remaining 60 percent in value of the building, composed of electrical work, plumbing, heating, air-conditioning, luminous ceilings, etc., had a life of only 10 to 15 years. We are by no means ready to accept these figures. We heard McCollum's testimony, and received the definite impression that he was shading it in petitioners' favor.
As to the basic structure of the building, which petitioners disparagingly refer to as the "shell," we reject the conclusion that it had a life of only 40 years. McCollum admitted that the "basic shell of the building * * * is of a long-life nature, very permanent masonry-type of a building," and that it was "very substantial." When asked how long a life it would have, he replied "40, 60 years." We do not accept at face value his subsequent testimony putting a limit of even less than 40 years' life for the basic structure. Our own evaluation of the record leads us to a conclusion that it was much closer to 60 years.
Moreover, we do not accept as accurate that the basic structure, or "shell," represented only 40 percent of the cost of the building to Industrial. Of course, Industrial did not buy separate components of the building; it purchased a unified structure. And if there is to be any allocation of the purchase price among the various elements that go to make up the total structure it must be based upon their relative values at the time of acquisition by Industrial. No evidence was presented in this respect as of the date of purchase. True, a schedule was received in evidence indicating the cost of the various components of the building to Industrial's predecessor somewhat more than a year before. But, in the context of the record before us, those figures appear to furnish a highly unreliable index of relative values at the time the property was purchased by Industrial. The evidence shows that during the comparatively brief period between the construction of the building by Industrial's predecessor and the purchase by Industrial some of the interior components had been subjected to considerable abuse. Also, some of the components such as the electrical work, plumbing, and air conditioning had become badly deteriorated because of corrosion due to the salt air from the nearby ocean.
In the circumstances, the comparative value of all such components in relation to the basic structure of the building obviously was considerably less than at the time of original construction; and, concomitantly, even if the basic structure represented only 40 percent of the total cost of construction, it reflected far more than 40 percent of the price thereafter paid by Industrial that was allocable by it to the building as a whole. Yet, though petitioners would take into account the deteriorated condition and lower remaining lives of the various components, apart from the "shell," they do not consistently allocate the necessarily resulting increased proportionate cost to the basic structure which is a vital factor in determining any composite life.
A further element militating against petitioners' position is the fact that at the time Industrial purchased the building it had already entered into the lease agreement with Hughes, and undoubtedly understood at that time that as a result of Hughes' extensive program of enlarging and remodeling the building a number of the interior components of the building would be torn out regardless of condition. And the rule has long been established that where one purchases property with intention of demolishing or removing a structure, that portion of the purchase price otherwise allocable to the demolished part must be treated as allocated to the remaining property. Cf. Blumenfeld Enterprises, 23 T.C. 665, 670, affirmed 232 F.2d 396 (C.A. 9); Lynchburg National Bank Trust Co., 20 T.C. 670, 673-674, affirmed on another ground 208 F.2d 757 (C.A. 4); Hillside National Bank, 35 T.C. 879; N.W. Ayer Son, Inc., 17 T.C. 631, 635. Accordingly, to the extent that it was contemplated at the time of acquisition of the building in this case that some components would be torn out, such components would not have any basis allocable to them nor would it be proper to take into account any theoretical remaining useful lives in respect of them.
The matter before us is not susceptible of any precise mathematical solution. The problem is one of judgment upon the basis of the entire record, taking into account the probable useful life of the building as a whole, and giving proper consideration to the condition of any of the components that may affect the composite life of the entire structure. Doing the best we can with the materials at hand, in the light of the discussion above, we have concluded and hereby find as a fact that the remaining useful life of the Helipot building when acquired by Industrial was 45 years.
Decisions will be entered under Rule 50.
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