Petition — Jack's Cookie Co. v. United States

eee

Supreme Court, U. S47

> FILED

JUL 19 1979

MICHAEL RODAK, JR., CLERK

IN THE

Supreme Cinut of the Wuited States

OCTOBER TERM, 1979

Xo 79-9 Bind

JACK’S COOKIE COMPANY,

Petitioner

V.

THE UNITED STATES OF AMERICA,

Respondent

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

JAMES O. MOORE

GEORGE R. HODGES

MOORE AND VAN ALLEN

8000 NCNB Plaza

Charlotte, North Carolina 28280

WILSON - EPES PRINTING Co., INC. - 789-0096 - WASHINGTON, D.C. 20001

INDEX

Page

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Reasons for granting the writ ..................ccccceceeeeeeeees 5

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CITATIONS

Cases:

Benton v. Commissioner, 197 F.2d 746 -................ 7

Commissioner v. Lincoln Savings and Loan As-

I a. sn nkseasececsccencenece 5, 6

WSBR, Inc. v. Commissioner, 30 T.C. 747............. 7

Statutes :

Internal Revenue Code of 1954 (26 U.S.C.):

CS LALO 7

rs sauennnenanece 6

a cvssesensseccee 6

Miscellaneous:

Giles County, Tennessee, Resolution of June 1,

SS ede I SEF a 1, 3,8

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;

IN THE

United States Cmot of Appeals

OCTOBER TERM, 1979

No.

JACK’S COOKIE COMPANY,

Petitioner

V.

THE UNITED STATES OF AMERICA,

Respondent

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

Jack’s Cookie Company petitions for a writ of certio-

rari to review the judgment of the United States Court

of Appeals for the Fourth Cireuit in this case.

OPINIONS BELOW

The findings of fact and opinion of the district court

(Appendix A, infra, p. la) are not reported. The opin-

ion of the Court of Appeals (Appendix B, infra, pp.

2a-24a) is reported at 597 F.2d 395.

JURISDICTION

The judgment of the Court of Appeals was entered on

April 25, 1979 (Appendix C, infra, p. 25a). The peti-

2

tioner’s timely filed petition for stay of mandate was

denied on May 29, 1979 (Appendix D, infra, p. 26a).

The jurisdiction of this Court is invoked under 28 U.S.C.

$ 1254(1).

QUESTION PRESENTED

Whether a payment by a lessee to the lessor denomi-

nated and required by the lease, State Industrial Reve-

nue Bond Acts and the County Resolution as current

rent is deductible at the time of payment as an ordinary

and necessary rental expense under Section 162(a) (3)

of the Internal Revenue Code.

STATUTES INVOLVED

The pertinent provisions of the Internal Revenue Code

of 1954 and the Tennessee State Statutes (1954 Code)

are set forth in Appendix E, infra, pp. 27a-28a. The

pertinent provisions of the lease agreement are set forth

in Appendix F, infra, pp. 29a-37a.

STATEMENT

Petitioner leases a fully equipped industrial plant from

Giles County, Tennessee, pursuant to a lease dated June

1, 1962. (Appendix F, infra, p. 29a). The term of the

lease is thirty years, with options for extension totalling

an additional thirty years. (Appendix F, infra, p. 29a-

30a).

Giles County, Tennessee, (the County), financed the

construction of the plant through two bond issues pur-

suant to the Tennessee Industrial Building Revenue Bond

Act of 1951' and the Tennessee Industrial Building Bond

Act of 1955.? State law requires that part of the rental

1 Tenn. Code Annot. § 6-1704 (1970 Supp.), Appendix E, infra,

p. 27a.

2 Jd. at § 6-1715. Appendix E, infra, p. 28a.

PP ER OE Crm cee

3

payments be used to create “reserves” sufficient to pay

the bonds used to finance the industrial buildings,’ and

the County resolution for the bonds required the estab-

lishment of a reserve fund.‘

The lease agreement between petitioner and the County

was entered into pursuant to the above statutes and

resolution. The rent was set at the amount equal to the

present obligations on the bonds, the cost of servicing

them, and a set sum to be placed in the reserve fund to

retire the bonds. Specifically, the ““mouthly rentals” were

to equal one-sixth of the semi-annual interest on the

bonds, one-twelfth of the next annual principal payment

due on the bonds, the expenses of administering the bond

issues, and “reserve payments” in an aggregate of

$285,000 payable in equal monthly installments over the

3 Td. at §§ 6-1704 & 6-1715.

4 The resolution of June 1, 1962, of Giles County provides:

Section 7. That there shall be and there is hereby created

an account to be known as the “Giles County Industrial

Building Revenue and Tax Deficiency Bond and Interest

Redemption Fund” (hereinafter sometimes referred to as

the “Bond Fund”) into which there shall be paid and set

aside such portion of the income and revenues from said

industrial building as will be sufficient to pay promptly

the interest on and principal of the bonds herein authorized

as same become due. All accrued interest received at the

time of issuance of the bonds shall be deposited in the Bond

Fund, together with a sufficient portion of the proceeds of

the bonds, to aggregate the sum of $150,000.00, which sum

is hereby found to be necessary to pay a portion of the

interest on the bonds during construction of the industrial

building and which sum shall be used soley for that

purpose.

From the income and revenues of said industrial build-

ing there shall be placed on the tenth day of each month

in the Bond Fund a sum equal to one-sixth (1/6) of next

semi-annual interest due plus one-twelfth (1/12) of next

annual principal due plus the Reserve payment and

Trustee's fee.

* * ¥ *

4

first 15 years after occupancy (i.e. $20,479.08 per year).

(Appendix F, infra, p. 80a). This “monthly rental” is

required by the Tennessee statutes, the County Resolu-

tion, and the lease and must be paid as a condition of

petitioner’s present and continued use of the plant. If

petitioner should fail to remit any portion of the total

rent due, including the reserve element, the county may

cancel the lease unless the arrears are promptly cured.

It is only the “reserve payment” element of the monthly

rental that the Government has challenged.

The lease gives petitioner the option to prepay the

remaining rent at any time after the fifteenth year.

(Appendix F, infra, p. 3la). Exercise of the option

would require a payment sufficient to retire the bond

issues, i.e., the aggregate of remaining rental payments

less the amount in the reserve fund. (Appendix F, infra,

p. 31a).

Petitioner paid the full “monthly rental” in 1970. This

includes the $20,479.08 reserve fund element as well as

the other elements of the rent. The rental payments were

made from Jack’s current operating income. In accord-

ance with generally accepted accounting principles, peti-

tioner treated the total rental payment as a current

expense in its yearly financial statement and deducted

it as a current rental expense in its 1970 federal income

tax return.

The Internal Revenue Service allowed as a present

deduction three elements of petitioner’s rent. It disal-

lowed only petitioner’s deduction of the reserve fund

element. That increased petitioner’s tax liability by

$9,829.96 plus interest. Petitioner paid that additional

tax and in this action sued for a refund. The district

court found for the taxpayer, holding that the reserve

fund elements are deductible in the year paid because

they are a current expense necessary for present occu-

5

pation of the plant. The court of appeals reversed, find-

ing that the payments were not a presently deductible

rental expense.

REASON FOR GRANTING THE WRIT

1. The United States Court of Appeals for the Fourth

Circuit misapplied the decision of this court in Commis-

sioner V. Lincoln Savings and Loan Association, 403 U.S.

345 (1971). Lincoln held that certain insurance premium

payments created for the taxpayer “a separate and dis-

tinct additional asset” and thus, were not deductible in

the year of payment. Lincoln, supra, 403 U.S. at 35.

The factors listed by the Lincoln court as making the

questioned payment a separate asset are not present here.

In Lincoln, the reserve fund could be used to pay losses

and only to the extent that other assets were unavailable

therefor; the County may use its reserve fund to meet

any current obligations or expenses of the revenue bonds

for which the current rental payments are insufficient.

Petitioner has no “distinct and recognized property in-

terest” in the reserve fund. The lease (Appendix F,

infra) grants petitioner no right to transfer the fund;

indeed petitioner has no interest in the fund to transfer.

There is no possibility that petitioner will obtain a re-

fund of its reserve element payments, nor will the fund

automatically be used to discharge petitioner’s future

rental obligations. It may be so used only if petitioner

elects to prepay, and does prepay, all remaining rental

payments, with no discount for early payment. Neither

petitioner nor the County treats the reserve fund as if it

were property in which petitioner has a property interest.

Both regard and treat the fund as property of the County

held for the purpose of securing payment of the bonds.

The Court of Appeals concluded that the reserve fund

was a separate and distinct asset of the petitioner but

failed to point out how it reached that conclusion. See

6

Appendix B p. 2a, infra. In order for the fund to be

an asset of the petitioner, the petitioner must have some

property interest in it. \Petitioner has no identifiable

property interest in the fund, and none was found by

the court of appeals. Therefore, the fund cannot be an

asset of the petitioner and Oi application of Lincoln

was improper.

This case would give the CouN an opportunity to

clarify the standard and proper application of the Lin-

coln case so that expenditures will nob automatically be

considered separate asset whenever they\may potentially

produce a benefit beyond the present taxable year.

2. Disallowing the rental expense deduction for the

year in which it was paid distorts petitioner’, financial

position for that and future years. The Internal\Revenue

the taxpayer regularly computes his income in k

his “books,” unless that method does not “clearly re

income.” Internal Revenue Code § 446(a) and (b). Peti

tioner treated all of the rental paid as an expense in i

records for the year in question. Because petitioner

presently has no interest in the reserve fund and no right

to the money contained in it, its accounting method clear-

ly reflects its income, and is the only method that will

do so. From petitioner’s standpoint, the reserve element

of its rental payments are indistinguishable from the

other elements: all are required to be paid currently, and

all are forever gone from petitioner’s treasury and con-

trol. Disallowance of the deduction in the year paid

forces inclusion in petitioner’s income for that year

funds that it does not presently hold and to which it

has no claim. Deduction in later years reduce peti-

tioner’s income below its actual level.

The reserve fund is unlike prepaid rent in that the

lessee, the petitioner here, cannot lay -claim to these

PETE EN Eee

7

funds nor command its use in a certain manner unless

it is willing to prepay all remaining rentals at their face

value. Prepaid rent is an asset that the lessor can use

only in a certain manner; the reserve fund can be used

by the County as rent, if all rent is prepaid, or to meet

current and unexpected expenses on the underlying bonds.

Because of the unique nature of the reserve fund, in-

clusion of that amount in income in the year of payment

inaccurately reflects petitioner’s income for that and

future years.

8. The rental expense deduction claimed by petitioner

fulfills the statutorily imposed requirements for that de-

duction. The applicable statute provides:

“There shall be allowed as a deduction all ordinary

and necessary expenses paid or incurred during the

taxable year in carrying on any trade or business,

including . . . rentals or other payments required to

be made as a condition to the continued use or pos-

session . . . , of property to which the taxpayer

has not taken or is not taking title or in which

he has no equity.”

Internal Revenue Code § 162(a) (3). The reserve ele-

ment of rental paid was required both by the lease agree-

ment and state law as a condition to present and con-

tinued use. Appendix F, infra, p. 36a; Tenn. Code

Annot. §§ 6-1715, Appendix E, infra, p. 28a. All parties

to the lease agreement regard the reserve element as a

part of present, not future rent. The possibility of an

ensuing future benefit should not override the basic char-

acteristic of the payment.

The court of appeals’ decision conflicts in principle with

that of the Fifth Circuit in Benton v. Commissioner, 197

F.2d 745 (5th Cir. 1952) and with that of the Tax Court

in WSBR, Inc. v. Commissioner, 30 T.C. 747 (1958).

Both of those decisions held that rental payments made

8

under a lease granting the lessee an option to buy at a

low sales price were properly deductible in the year of

payment as a rental expense. In WSBR, the lease option

set an option price that, by its terms, was to be reduced

by the amount of rental paid under the lease. Both

courts regarded as controlling the parties’ intentions

that the sums denominated by the leases as rent were to

be current rent and not a prepayment of the sales price,

that the sums were required as a condition to the con-

tinued use of the lease property, and that the purchase

prices were not, at the time of the agreement, unreason-

ably low.

Petitioner’s situation is analogous. The reserve ele-

ment was intended by the parties to be current rent. It

was required by state law to be included in current rent.

The petitioner must pay all rent, including the reserve

element, to remain in possession. There does remain a

possibility that at some time in the future, the reserve

fund will be used in a way that will benefit the petitioner.

That future benefit is certainly no greater than in the

WSBR case. If the contingency should occur, then the

benefit to petitioner can and will be included in its in-

come at that time and in the exact amount it is bene-

fitted. The method of accounting for the reserve pay-

ment advanced by petitioners is the simplest and most

accurate means of determining the tax consequences of

the reserve element.

Unquestionably, the reserve payment is rent; the lease,

the state statutes, and the County Resolution require

it to be part of current rent. The applicable Code pro-

vision allows a deduction for all rentals paid or incurred

during the taxable year. Petitioner made all rental pay-

ments, including the reserve element. The text of the

statute requires that a deduction for all rental paid by

petitioner be allowed.

9

CONCLUSION

The petition for a writ of certiorari should be granted.

Respectfully submitted,

JAMES O. MooRE, ESQUIRE

GEORGE R. HopGEs, ESQUIRE

MOORE AND VAN ALLEN

3000 NCNB Plaza

Charlotte, North Carolina 28280

Telephone: (704) 374-1800

July, 1979.

Appendices

la

APPENDIX A

UNITED STATES DISTRICT COURT FOR THE

WESTERN DISTRICT OF NORTH CAROLINA

No. C-C-75-358

Filed June 10, 1977

JACK’S COOKIE COMPANY,

‘~ Petitioner

.UNITED STATES OF AMERICA,

Respondent

This matter is before the Court on the plaintiff’s and

defendant’s cross motions for summary judgment. Upon

consideration of the stipulated facts and the briefs and

arguments of counsel, the Court finds that there are no

disputed material facts and concludes that the plaintiff

is entitled to summary judgment as a matter of law.

IT IS THEREFORE ORDERED, ADJUDGED, and

DECREED that: the plaintiff have and recover of the

defendant: (1) the principal amount of its deficiency

payment ($9,829.96) and the interest on that princi-

pal amount paid to the defendant ($1,646.17); plus (2)

interest at the rate of nine percent (9) per annum [or

such other rate of interest as established by the Com-

missioner of Internal Revenue pursuant to 26 U.S.CA.

§ 6621(b)] on those sums from August 3, 19738, to a

date determined by the Commissioner of Internal Revenue

not preceeding the date of the refund check by more than

30 days; plus (3) its costs in this action.

This the 10 day of June, 1977.

/s/ James B. McMillan

United States District Judge

2a

APPENDIX B

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

No. 77-2210

JACK’S COOKIE COMPANY,

Appellee

Vv.

THE UNITED STATES OF AMERICA,

Appellant

April 25, 1979

On Appeal from the United States District Court for the

Western District of North Carolina, at Charlotte.

James B. McMillan, District Judge.

Before BRYAN, Senior Circuit Judge; BUTZNER, Circuit

Judge, and FIELD, Senior Circuit Judge.

FIELD, Senior Circuit Judge:

On its income tax return for the year ending October

2, 1970 Jack’s Cookie Company (“Jack’s’) claimed a

business expense deduction in the amount of $191,720.92

for cash disbursements made during that year under the

terms of a written lease for an industrial building. The

Internal Revenue Service disallowed $20,479.08 of the de-

duction, which had the result of reducing taxpayer’s

1970 net operating loss and increasing by $9,829.96

Jack’s tax liability for a prior year to which the 1970

loss had been carried back. Jack’s paid the deficiency

for the prior year, plus interest, and brought this action

after a petition for a refund was denied. Upon stipu-

lated facts and exhibits, the district court awarded sum-

mary judgment in favor of Jack’s for the full amount of

the deficiency and interest, holding that the partial

3a

disallowance of the deduction claimed by Jack’s in 1970

was in error. The Government appeals, and we reverse.

I

To finance the construction of a county-owned indus-

trial building which Jack’s Cookie Company agreed to

lease for a term of 30 years, the County Court of Giles

County, Tennessee, authorized two issues of interest-

bearing bonds dated June 1, 1962, each in the principal

amount of $1,250,000 and each to mature serially over

the term of the lease. One issue consisted of “Industrial

Building Revenue Bonds” (“revenue bonds”) ,' which are

not general obligations of the county, the interest and

principal being payable solely from revenues realized

from the lease of the building. The other bonds, “In-

dustrial Building Revenue and Tax Deficiency Bonds”

(“tax deficiency bonds”),? are also retired from the

rental income, but if proceeds under the lease should ever

prove insufficient to meet the obligations to holders of

these bonds, county tax levies are pledged to satisfy any

deficiency. Repayment of both the revenue and tax de-

ficiency bonds is ultimately secured by a June, 1962, in-

denture of mortgage and deed of trust between Giles

County and a Memphis bank which serves as trustee for

the bondholders.

To ensure that proceeds from the lease are always ade-

quate to promptly service the bonds, the written lease

agreement between Giles County and Jack’s requires that

the lessee pay to the county “monthly rentals,” beginning

no later than June 1, 1964,’ in an amount equal to

1 See The Industrial Building Revenue Bond Act of 1951, TENN.

CopE ANN. §§ 6-1701 to 1716.

2 See The Industrial Building Bond Act of 1955, TENN. CODE

ANN. §§ 6-2901 to 2916.

3 The 30-year term of the lease began on June 1, 1962, but Jack’s

was required to pay no rent until the building was ready for

occupancy or June 1, 1964, whichever came first. In the interim, a

portion of the proceeds from the sale of bonds was used to pay

interest to bondholders.

4a

“One-sixth (1/6) of the next semi-annual interest

due on each of said bond issued, [sic] plus * * *

one-twelfth (1/12) of the next principal payment

due on each of said bond issues, plus all necessary

and reasonable expenses incurred by the Trustee and

Paying Agent in the Administration of said bond

meee * Tra

To these three sums, which are geared to the repayment

of the bonds, the agreement adds a fourth amount due

each month through the fifteenth year of the lease as

“rent”; the lessee is required to make what are termed

“reserve payments” in equal monthly installments suf-

ficient to total $285,000 by the end of the fifteenth year.

If Jack’s fails to timely pay any part of its monthly rent,

including the reserve payment, the county has the right

to cancel the lease unless arrears are cured within a

specified time.

Monthly rentals are payable to the trustee bank, which

is required by the indenture of mortgage to use all except

the reserve payments portion to pay principal and in-

terest as they come due on both types of bonds and to

cover expenses incurred by the bank as trustee. Ex-

pressly different treatment is afforded the reserve pay-

ment element of each monthly installment. Reserve pay-

ments may not be used to routinely service the bonds;

instead, they must be accumulated by the trustee and

expended only as follows:

—if Jack’s so directs, the trustee must invest re-

serve payments in obligations of the United States,

returning any interest earned thereon to the reserve

fund.

4 So long as Jack’s is currnet in its rental payments, as it was

throughout the period relevant to this case, the first three elements

used to calculate each month’s rent will, by definition, ensure suffi-

cient revenues to meet these needs.

—E

5a

—if ever other monies are unavailable to pay in-

terest and principal due on the revenue bonds, the

trustee may use reserve funds for that purpose.®

—if, as it is entitled to do anytime after the fif-

teenth year of the lease, Jack’s elects to prepay all

its remaining rent obligations (in an amount equal

to all unpaid principal and interest on all bonds,

plus call premiums), the funds then in the reserve

are to be credited against the amount due.

—if the rented premises are damaged or condemned,

the lessee can opt not to have them reconstructed,

in which case the lease will terminate upon prepay-

ment of all remaining rental obligations, against

which Jack’s is to receive a credit for the funds then

in the reserve.

All documents to which Jack’s is a party are silent as

to the disposition of the reserve funds in the unlikely

event that any exist when the full term of the lease

expires and all of the bonds have been retired. How-

ever, language in a county court resolution which au-

thorized the sale of revenue bonds suggests that the

county might lay claim to any such surplus.’

In the year ending October 2, 1970, Jack’s made

monthly rental payments totalling $191,720.92 pursuant

to the lease provisions set forth above. As heretofore

stated, the Internal Revenue Service disallowed as a

5E.g., if Jack’s defaults on its rent and if, while the default

continues, interest or principal comes due on revenue bonds, then

the trustee may dip into the reserves to satisfy the revenue bond

holders.

6 At oral. argument, it was agreed that, assuming Jack’s occupies

the building for the full term of the lease, the lessee would be

“economically foolish” not to prepay its rent at some time in order

to get the full benefit of any reserves as a credit against future

rent.

7 Appendix at 99.

6a

deduction for current business rental expense $20,479.08

of that amount, which was the amount of the “reserve

payments” made during that year. The Government’s

position is that taxpayer’s obligation to pay rent under

the lease boils down to an obligation only to retire the

outstanding bonds. Because the reserve payments, un-

like the rest of each month’s rent, were not used or

geared to satisfy any actual bond obligations during the

tax year in question, and because at the taxpayer’s elec-

tion they can be applied to that end at some future time,

e.g., as a credit in the event of prepayment of rent, it is

asserted that these expenditures were capital in nature

and that Jack’s may deduct them, not as current ex-

penses in the year they were paid to the trustee, but

rather only when the reserve fund is actually consumed

for the lessee’s benefit. In support of this view the Gov-

ernment points to cases which hold that security deposits

or advance rents which a lessee is required to pay the

lessor are deductible as rent only in the year or years

for which they are paid as rent and in which they are

applied toward satisfying the lessee’s actual rent obli-

gations, not in the year in which they are paid unless

that year is also one to which the payments or portions

thereof are considered applicable as rent.*®

Challenging the disallowance, taxpayer argues that

even though the reserve payments might benefit Jack’s

by fulfilling certain provisions of the lease beyond the

tax year in issue, the lessee had no choice but to make

the monthly payments into the reserve if it was to enjoy

continued use of the industrial building during the tax

year; failure to do so would have allowed the county to

8 Citing Kohler-Campbell Corp. v. United States, 298 F.2d 911,

913 (4 Cir. 1962); Commissioner v. Bolyston Market Ass’n., 131

F.2d 966 (1 Cir. 1942); Galatoire Bros. v. Lines, 23 F.2d 676 (5

Cir. 1928); Smith v. Commisisoner, 51 T.C. 429, 440 (1968) ;

Minneapolis Security Building Corp. v. Commissioner, 38 B.T.A.

1220 (19388).

—

Ta

cancel the lease. Thus, it is contended, the payments

constituted ordinary and necessary business rental ex-

penses deductible in the year paid under the plain lan-

guage of Section 162(a)(3) of the Internal Revenue

Code, 26 U.S.C. § 162(a) (3), which reads:

“(a) In general. There shall be allowed as a de-

duction all the ordinary and necessary expenses

paid or incurred during the taxable year in carry-

ing on any trade or business, including—

+ * * *

(3) rentals or other payments required to

be made as a condition to the continued use or

possession, for purposes of the trade or busi-

ness, of property to which the taxpayer has not

taken or is not taking title or in which he has

no equity.”

(Emphasis added).® Moreover, deduction of the reserve

element of the rent in the year paid would comport with

the company’s own treatment of the expense for internal

accounting purposes, and since this treatment of the

expense allegedly more clearly reflects the company’s true

income for the tax year than if deduction is deferred to

a later year, Jack’s maintains that deduction of the

reserve installments in the year they are made is also

sanctioned by the Code’s tax accounting guidelines.’°

® The company, which insists that the expenditures in question

were “rentals,” disclaimed at oral argument any reliance upon the

“or other payments” language of the statute. Also, neither party

contends that Jack’s has taken or is taking title to the leased

premises, or that Jack’s has any equity therein within the meaning

of Section 162(a) (3). Upon expiration of the 30-year term of the

lease on August 1, 1992, taxpayer has the option to renew for three

additional terms of 10 years each.

10 26 U.S.C. § 446 provides that “‘[t]axable income shall be com-

puted under the method of accounting on the basis of which the

taxpayer regularly computes his income in keeping his books,” but

8a

Taxpayer urges that the deduction be allowed and that

any benefit which might be derived from the reserve

fund in the future, such as a credit against prepaid rent,

be taxed as income to Jack’s in the year such benefit

accrues.

In awarding the company a refund of the tax it had

paid on account of the disallowed deduction," the district

court reasoned that the mandatory nature of the reserve

payments entitled the taxpayer to deduct them in the

year they were paid to the trustee:

“It seems to me that the government has the

better of the decided cases, but the taxpayer has

the advantage on the text of the statute and on the

common sense of this particular case. The taxpayer

had no part in creating the shape of the payments

nor the timing of them. There is no way it can get

the land without making the payments as required.

The payments are made now and are a necessary

current expense. The taxpayer gets the use of the

land now, and thus receives the value of the pay-

ments now. There has been no conniving. The ex-

cess payments and the interest on those payments

will be taxable to the taxpayer when the money is

released from escrow.” ”

We are of the opinion, however, that the propriety and

timing of the deduction are governed by considerations

other than the mandatory nature of the reserve payments

that “[i]f the method used does not clearly reflect income, the

computation of taxable income shall be made under such method

as, in the opinion of the Secretary, does clearly reflect income.”

11 The district court had jurisdiction of this action under 28

U.S.C. § 1846(a)(1), and venue was properly laid in the Western

District of North Carolina because taxpayer maintained its prin-

cipal place of business in that district. 28 U.S.C. § 1402(a) (2).

12 Jack’s Cookie Company v. United States, No. C-C-75-358 (W.D.

N.C., June 8, 1977).

9a

and that, applying those standards, the Government is

entitled to summary judgment upon the undisputed facts

as a matter of law."

II

In computing taxable income, a business is authorized

by Section 162(a) (3) of the Internal Revenue Code to

deduct “rentals” from its gross income. Although the

term “rentals” is not defined in the statute, as early as

1925 the Supreme Court recognized that the word is to

be taken in its “usual and ordinary sense” to mean “a

fixed sum, or property amounting to a fixed sum, to be

paid at stated times for the use of property.” Duffy v.

Central R.R., 268 U.S. 55, 68 (1925). This interpreta-

tion of “rentals,” which has never been legislatively al-

tered, has been consistently followed by the courts, al-

though not without elaboration.

Notably, it has been firmly established as a result of

litigation under § 162(a) (3) that, to qualify as a rental,

a payment made to secure the use of business property

must be “required” of the lessee, or, as put by one court,

“wrung from [the lessee] by compulsion of circumstances

delineated by law.” Utter-McKinley Mortuaries v. Com-

missioner, 225 F.2d 870, 874 (9 Cir. 1955). As an essen-

tial attribute of rentals, the compulsion to pay is most

often discussed in the context of contrived arrangements

between lessors and lessees which have as their evident

purpose the evasion of taxes,’* but it is nevertheless a

18 Like the plaintiff, the Government moved for summary judg-

ment in the district court.

14 F.g., Sparks Nuggett, Inc. v. Commissioner, 458 F.2d 631, 634

(9 Cir. 1972), cert. denied, 410 U.S. 928 (19738); Potter Electric

Signal and Mfg. Co. v. Commissioner, 286 F.2d 200, 202-208 (8 Cir.

1961) ; Kirschenmann v. Westover, 225 F.2d 69 (9 Cir. 1955), cert.

denied, 350 U.S. 834 (1955); Smith v. United States, 278 F.Supp.

230, 232 (S.D. Tex. 1968); H-Z Sew Enterprises, Inc. v. United

States, 260 F.Supp. 100, 118-119 (E.D. Mich. 1966). There is no

suggestion that the “reserve payments” provision of the lease be-

10a

characteristic which, as a common sense matter, any

claimed “rental” expenditure must possess if it is to be

treated as. such for purposes of an expense deduction. To

hold otherwise would be to invite the deduction as rent

of sums which are not truly paid “for the use of prop-

erty,” in contravention of the settled principle that stat-

utes authorizing deductions from income for federal tax

purposes are to be strictly construed. See Koerner Vv.

United States, 550 F.2d 1862 (4 Cir. 1977), cert. denied,

434 U.S. 984 (1977). Thus, unless a taxpayer is under

an obligation to compensate another in return for the

use of property for business purposes, the disbursement

is not a “rental” under § 162(a) (3).

The same is true of the “other payments” related to the

lease of property for which deductions are authorized by

this section of the Code—payments “ejusdem generis with

‘rentals,’ such as taxes, insurance, interest on mortgages,

and the like, constituting liabilities of the lessor on ac-

count of the leased premises which the lessee has cove-

nanted to pay.” Duffy v. Central R.R., supra, 268 U.S. at

64. In express terms, the statute allows a taxpayer to sub-

tract such outlays in arriving at taxable income only if

they are “required to be made as a condition to the con-

tinued use or possession” of the property.

But although an “obligation to pay” must exist before

a business will be allowed to deduct a lease-related pay-

ment under § 162(a) (3), it does not follow that all ex-

penditures which a business is compelled to make in order

to secure the use of property constitute “rentals” or

“other payments,” or that those which facially qualify

as such are deductible in the year paid. That a business

tween Jack’s and the county was contrived. Indeed, the county

may have been bound by state law to establish some sort of reserve

in light of the issuance of revenue bonds. See TENN. CoDE ANN.

§§ 6-1704(4), 1715.

lla

is “required” to incur an expense to avoid cancellation

of a lease, or as the court below stated, that “[t]here is

no way [the taxpayer] can get the land without making

the payments as required,” goes only to the threshold

factual question of whether the expenditure is of the

sort contemplated by subsection (3) of § 162(a), and it

is not dispositive of that issue, since there are other

characteristics which a disbursement must have if it

is to be treated as a “rental” or “other payment” within

the meaning of the statute. Moreover, once it is de-

termined that an expenditure is by nature a “rental” or

“other payment,” and the inquiry then turns to the mat-

ter of when a 162(a) (3) deduction in that amount may

be taken, the fact that a taxpayer was “required” by the

lease to pay the sum at a particular time is of less sig-

nificance and does not of itself warrant allowance of the

deduction in any particular year.

Not often advanced in explicit terms, these principles

are plain from the face of the “decided cases” referred to

in the opinion below. If it were true, for example, that by

reason of their mandatory nature all payments extracted

by contract as a condition to occupying another’s prop-

erty qualify as “rentals” or “other payments” under

§ 162(a) (3), then one would expect that a “security de-

posit” paid by a business as a prerequisite to possession

of premises, and sums periodically paid to continue the

possession, would be uniformly treated as such. Yet as

the decision in Minneapolis Security Building Corp. v.

Commissioner, 38 B.T.A. 1220, 1224 (1938), demon-

strates, such status may be denied a security deposit

which a business is “required” to pay at the outset of a

lease, and the cases are legion which on various grounds

have refused to treat as statutory “rentals” or “other

payments,” installments, though labelled “rent,” remitted

to the owner of property by a taxpayer business in ful-

fillment of the strict terms of a written lease. £.g.,

12a

Duffy v. Central R.R., supra, 268 U.S. 55 (rejecting the

argument that any payments under a lease, the failure

to make which would entitle the landowner to terminate

the possession of the property, constitute “rentals” under

the statute); Foyt v. United States, 561 F.2d 599 (5

Cir. 1977) (monthly “rental payments” were in fact

contributions to capital, not rentals); M & W Gear Co. Vv

Commissioner, 446 F.2d 841 (7 Cir. 1971) (claimed

“rentals” held instead to be partial payments on pur-

chase price); West Virginia Northern R. Co. v. Com-

missioner, 282 F.2d 63 (4 Cir. 1960), cert. denied, 366

U.S. 929 (1961) (sums designated “rentals” by lease

were actually payments in satisfaction of personal debt).

Obviously, something more than the compulsory nature

of a disbursement determines whether or not it qualifies

for deduction under the statute.

Similarly, a “requirement toe pay” cannot explain the

results in cases where the issue has been the timing of

deductions for sums which do qualify as “rentals” or

“other payments.” Although incurred in each instance

pursuant to contract, some costs of this kind—like the

elements of plaintiff’s rent which are defined in terms of

principal, interest, and administration expenses—are

commonly allowed as deductions in the year they fall due,

while others, notably “advance” or “prepaid” rentals, are

often allowed as deductions only in or over some later

period.** For cases of the latter kind, see n. 8, supra.

The only legitimate explanation for these differences is

that the matter of when a deduction may be claimed —

under § 162(a) (3) is not determined solely on the basis

of whether, under threat of penalty or dispossession, the

lessee was bound to remunerate the lessor in a given

amount on a certain date. The pertinent inquiry is of

. Wider scope.

15 Advance rentals may be so treated regardless of whether the

lessee reports deductions on an accrual or a cash basis. Williamson

v. Commissioner, 37 T.C. 941, 948 (1962).

13a

We conclude, therefore, that the brief rationale offered

by the court below does not sustain the judgment on ap-

peal. To qualify for a current deduction under § 162

(a) (3) of the Code, it is necessary, but not sufficient,

that an outlay made during the tax year was “required”

of the lessee as a condition to occupancy of the premises.

While Jack’s no doubt would have risked cancellation of

the lease had it not timely forwarded the “reserve pay-

ment” portion of the monthly installments to the trustee,

this circumstance satisfies only one element of the claim

for relief, and is not, in itself, dispositive under either

the taxpayer’s or the Government’s theory of the case.

III

The question of whether Jack’s was entitled to a cur-

rent deduction for the “reserve element” of the monthly

payments involves two closely related features of the

revenue laws. First, the Code draws a distinction between

various kinds of expenditures for the purpose of de-

termining their tax treatment. Different statutory pro-

visions, for example, govern the manner in which “trade

or business expenses”, on the one hand, and “capital

expenditures”, on the other, may be charged by the tax-

payer against gross income. The initial inquiry concerns

the nature of the cost incurred by the company; were the

payments into the reserve fund trade or business ex-

penses, were they capital in nature, or were they some-

thing else? Once the payments are so categorized, the

focus shifts to the guidelines which specify whether,

when, and in what amount disbursements of that kind

may be reflected in the calculation of taxable income.

The ultimate question is whether the applicable rules

sanction, in the year they were incurred, a deduction in

full for costs of the type in dispute.

Cast in these terms, the disagreement between the tax-

payer and the Government involves only the first stage of

l4a

the inquiry. The company argues that the reserve pay-

ments were “rentals”, a species of the “trade or business

expenses” made deductible by § 162(a),'* while the Gov-

ernment maintains that the expenditures were instead

“capital in nature”. Apart from this controversy as to

the nature of the disbursements, neither party disputes

the consequences which would follow if the opponent’s

characterization of the payments were to prevail. The

Government concedes that if they truly were trade or

business expenses within the meaning of § 162(a), then

the reserve increments of the monthly outlays were de-

ductible in the year paid and Jack’s was entitled to the

claimed deduction.” For its part, taxpayer acquiesces in

16 Jt is suggested in taxpayers brief on appeal that if an ex-

penditure meets the definition of “rental” for purposes of sub-

section (3) of § 162(a), then it need not also possess the charac-

teristics of a “trade or business expense” under § 162(a) in order

to constitute a deductible expense under § 162. See Brief of Appellee

at 12, 17-18. However, the plain language of the statute refutes this

argument, and we note that the courts have not observed this

distinction. Deductions claimed for “rentals” often have been dis-

allowed on the basis that the expenditures in question failed to pass

muster under § 162(a). See, e.g., Foyt v. United States, 561 F.2d

599 (5 Cir. 1977); Perry v. United States, 520 F.2d 235 (4 Cir.

1975), cert. denied, 423 U.S. 1052 (1976). Moreover, in recogniz-

ing and relying upon the notion that a sum must be “paid or

incurred during the taxable year” in order to be treated as a

“rental,” Brief at 6, even the appellee acknowledges that § 162(a) (3)

rentals must meet a requirement that is found only in § 162(a).

Accordingly, we view the taxpayer’s position to necessarily be that

the reserve payments qualified as deductible expenses not only be-

cause they satisfied the specific conditions which any “rental” must .

meet under § 162(a)(3), but also because they met the basic

tests of a § 162(a) trade or business expense, of which “rentals”

are but one variety.

>

1726 U.S.C. § 461(a) provides that a deduction for a § 161(a)

trade or business expense “shall be taken for the taxable year

which is the proper taxable year under the method of accounting

used in computing taxable income.” The “method of accounting

used in computing taxable income” is the method “on the basis of

which the taxpayer regularly computes his income in keeping his

books,” unless the taxpayer’s accounting method is challenged by

15a

the Government’s position that if found to be “capital

in nature”, the expenditures were not deductible in

the year paid, but rather may be used to reduce the com-

pany’s taxable income, if at all, only in some later year

or years when the reserve fund is actually applied in some

manner beneficial to the taxpayer.'®

The issue to be resolved is not an unfamiliar one for

on prior occasions we have been called upon to determine

into which category various expenditures should appro-

priately be placed.

the Secretary on the basis that it does not “clearly reflect income.”

26 U.S.C. §§ 446(a), (b). See n. 10, supra. The Government admits

that for internal accounting purposes, Jack’s treats as current rent

expense the full amount it paid under the lease, Brief of Appellant

at 7, and, except on the ground that the reserve payments were

“capital expenditures” not governed by § 461(a), the Government

does not challenge under § 446(b) this treatment of the disburse-

ments.

18 This treatment of the expenditures follows from the principle

that “[c]apital expenditures * * * if deductible at all, must be

amortized over the useful life of the asset,” Commissioner v. Tellier,

383 U.S. 687, 689-690 (1966), and is akin to the treatment afforded

“advance rentals” which, once they are recognized as “capital ex-

penditures,” may be subtracted in arriving at taxable income only

in the year or years in which they are actually used to displace

rental payments that the lessee would otherwise have to make

during those periods under the lease. Although “an expenditure

need not be for a capital asset, as described in Section 1221 of the

Code, 26 U.S.C. § 1221, in order to be classified as a capital ex-

penditure,” Georator Corp. v. United States, 485 F.2d 283, 285 (4

Cir. 1973), cert. denied, 417 U.S. 945 (1974), “the reason for dis-

allowing the deduction of the entire payment or obligation in the

taxable year is that there is no provision which permits deduction

{of a capital expenditure] other than that which allows depreciation

or amortization over the useful life of the asset acquired.” 2 J.

MERTENS, LAW OF FEDERAL INCOME TAXATION § 12.24 (1974 Revi-

sion). See 26 U.S.C. § 167. Appellee’s reliance upon 26 U.S.C.

§ 461(a) to avoid this result is misplaced, since § 461(a) does not

govern the timing of deductions for disbursements of a capital

nature.

l6a

A

Mindful that “[o]ur system of income taxation at-

tempts to match income and expenses of the taxable

year so as to tax only net income,” in Richmond Tele-

vision Corp. v. United States, 345 F.2d 901, 907 (4 Cir.

1965) ,'® we embraced the “one-year” rule then followed

by the Tenth Circuit, which treats an item as either a

business expense, fully deductible in the year paid, or a

capital expenditure, which is not, depending upon whether

it secures for the taxpayer a business advantage which

will be exhausted completely within the tax year.

“fAjn expenditure should be treated as one in the

nature of a capital outlay if it brings about the

acquisition of an asset having a period of useful

life in excess of one year, or if it secures a like

advantage to the taxpayer which has a life of more

than one year.” :

345 F.2d at 907.*° In applying the rule in that case, we

denied a current deduction for business expense to a

taxpayer which had spent $25,000 to acquire a staff of

trained employees from another corporation:

“A taxpayer may, therefore, not deduct as a current

business expense the full cost of acquiring an asset,

tangible or intangible, which benefits the taxpayer

for more than one year. * * *

«* * * This was in all regards the acquisition of a

capital asset whose value to the taxpayer would con-

tinue for many years, even though from time to time

individual staff members could be expected to leave

its employ.”

19 Vacated and remanded on other grounds, 382 U.S. 68 (1965),

on remand, 354 F.2d 410 (4 Cir. 1965).

20 Quoting United States v. Akin, 248 F.2d 742, 744 (10 Cir. :

1957).

17a

The one-year concept surfaced again in Darlington-

Hartsville Coca-Cola Bottling Co. v. United States, 393

F.2d 494 (4 Cir. 1968), cert. denied, 393 U.S. 962

(1968). There the taxpayer bottling companies deducted

in one year, as an ordinary and necessary business ex-

pense under § 162(a), amounts they had paid the owner

of a soft drink franchise to eliminate 2 middleman syrup

distributor. Elimination of the middleman reduced the

price of syrup to the bottlers, and there was every indi-

cation that the taxpayers would enjoy this more profit-

able arrangement in future years at no additional cost.

Citing Richmond Television, the district court upheld the

Commissioner’s determination that the amounts spent to

acquire the new syrup contracts were capital investments

despite the fact that the contracts were not physical

assets in the technical sense.2* We adopted the opinion

of the lower court with the observation that a capital

expenditure is marked by “its intendment to produce a

positive business benefit whose effects will be reaped in

seasons beyond a single year.” 393 F.2d at 496.

We last applied the one-year rule as an alterantive

ground for our decision in Georator Corp. v. United

States, 485 F.2d 283 (4 Cir. 1973), cert. denied, 417

U.S. 945 (1974). In Georator, which concerned the tax

treatment of legal fees incurred by a corporation in

successfully resisting the c-ncellation of a trademark

registration, we stated that

“Tfojur analysis of this question begins with the

principle of taxation reflected in Section 162(a) of

the Internal Revenue Code that an expenditure se-

curing benefits which are realized and exhausted in

the same tax period is fully deductible in that tax

21 Darlington-Hartsville Coca-Cola Bottling Co. v. United States,

278 F.Supp. 229 (D.S.C. 1967).

18a

period. Conversely, an expenditure securing benefits

beyond the taxable year must be capitalized.” ”

485 F.2d at 284. Because “the benefits of successful

opposition to the cancellation petition were likely to ex-

tend, and in fact did extend, beyond the tax period in

which they were secured,” 485 F.2d at 285, we concluded

that the legal fees should be capitalized even though they

were not among the expenditures expressly designated

as capital assets in § 1221 of the Internal Revenue Code.

The taxpayer suggests that under our recent decision

in First National Bank of South Carolina v. United

States, 558 F.2d 721 (4 Cir. 1977) (per curiam), the

one-year rule of our prior decisions has been replaced

by a new test in this area. In making this argument the

taxpayer points out that the opinion in that case makes

no mention of the one-year rule and cites none of the

foregoing cases. The Government, on the other hand,

contends that the one-year principle survived First Bank

and that, at most, the decision established only an alter-

native test which need not be applied in every case. In

our opinion, First Bank did not abrogate the rule fol-

lowed in our prior decisions, but merely refined and

made explicit certain limitations which have always been

inherent in its application.

At issue in First Bank was the tax status of assess-

ments paid by a bank to a non-profit association which

was established by a number of banks to operate a com-

puterized system for recording, authorizing, and billing

the credit card transactions of their customers. The joint

venture was undertaken to avoid duplication of costs and

achieve economies of scale. As a member of the associa-

tion, the taxpayer bank owned no stock, had no interest

in the organization’s assets, and was not entitled to any

22 Citing the Darlington-Hartsville and Richmond Television

cases.

19a

distribution of profits. Membership was non-transfer-

able, and upon dissolution, the assets of the association

were to be paid over to a tax-exempt charity.

The assessments in question were all paid by the bank

to cover expenses incurred in the association’s formative

state—salaries, office and equipment rental, general of-

fice expenses, advertising fees, and consultant’s costs.

Once operational, the association met expenses by charg-

ing each member bank a certain amount for each new

credit card issued. Taxpayer sought to deduct the pre-

operational assessments as an ordinary and necessary

business expense under § 162(a), but the Commissioner

disallowed the deduction on the theory that the payments

were membership fees in the nature of capital expendi-

tures because the benefit to the bank for which the assess-

ments were incurred would extend indefinitely into fu-

ture years.

Agreeing with the bank in its action for a refund, the

district court noted, but did not rely upon, the one-year

rule. Instead, it considered the facts of the case in the

light of language from the Supreme Court’s opinion in

Commissioner v. Lincoln Savings and Loan Association,

403 U.S. 345 (1971):

“{T]he presence of an ensuing benefit that may

have some future aspect is not controlling; many

expenses concededly deductible have prospective ef-

fect beyond the taxable year.

“What is important and controlling, we feel, is

that the § 404(d) payment serves to create or en-

hance for Lincoln what is essentially a separate and

distinct additional asset and that, as an inevitable

consequence, the payment is capital in nature and

not an expense, let alone an ordinary expense, de-

ductible under §162(a) in the absence of other

factors not established here.”

20a

403 U.S. at 354, quoted in 413 F.Supp. 1107, 1111

(D.S.C. 1976). Since the taxpayer’s membership in the

association was non-transferrable and, therefore, of no

intrinsic value, with the result that the bank had no

salable asset from which it could recoup its assessments,

the district judge concluded that the assessments could

not be regarded as creating for the bank “anything re-

motely similar to the ‘distinct and recognized property

interest’ which the Court in Lincoln Savings found that

the taxpayer had acquired.” /d.

On appeal, we affirmed on the opinion of the district

judge and referred to the above quotation from Lincoln

Savings as the standard by which capital expenditures

are to be distinguished from ordinary expenses. 558

F.2d at 723. While our per curiam opinion omitted any

reference to the one-year rule, it did describe as “indis-

tinguishable from the case at bar” the case of Colorado

Springs National Bank v. United States, 505 F.2d 1185

(10 Cir. 1974). There, in light of Lincoln Savings, the

Tenth Circuit, from which we imported the one-year rule,

observed that the rule “was intended to serve as a mere

guidepost for the resolution of the ultimate issue, not as

an absolute rule requiring the automatic capitalization

of every expenditure providing the taxpayer with a bene-

fit enduring for a period in excess of one year.” 505

F.2d at 1192 (emphasis added).

This, we think, explains any facial conflict there may

seem to be between First Bank and our earlier decisions.

While the one-year concept has been the focal point of

controversy and decision in several cases, the rule is not,

in itself, talismanic and we have never so held. In the

abstract many costs incurred by an on-going business

can be viewed as producing some type of benefit beyond

the taxable year, but we have never indicated that cap-

italization of an item is required on that basis alone. ©

First Bank is a case in point. The bank’s contribution

2la

helped to launch the association which, once established,

rendered a cost-saving service to the bank in subsequent

years; in this sense the pre-operational assessments would

have a future impact. They, nonetheless, were deemed

fully deductible in the year incurred.

But this is not to say that the potential of an expendi-

ture to produce a business advantage over and beyond

the tax year is irrelevant. To the contrary, unless an

expenditure which would otherwise be treated as a Sec-

tion 162(a) business expense results in benefits which

are not realized and exhausted within the taxable year,

its capitalization would be inappropriate in any event. A

business cost must produce a benefit that will extend into

future years if it is to be capitalized. Yet, that fact

alone is insufficient to require such treatment. The one-

year rule is useful because it serves to segregate from

all business costs those which cannot possibly be con-

sidered capital in nature because of their transitory

utility to the taxpayer. The rule, however, cannot be

applied inexorably in the other direction.

It is apparent that the “separate assets” test of Lincoln

Savings, which was followed in First Bank, necessarily

incorporates the one-year rule and that in order to war-

rant capitalization of an expense, one integral character-

istic of the “separate and distinct asset” which is “created

or enhanced” by the outlay, is that it will serve the tax-

payer in subsequent years.”* Unquestionably the rule

was refined by the language of Lincoln Savings which

cautions that the “future benefit” aspect of capitalized

costs should not be emphasized or applied to the exclusion

of other essential features which it identifies generally as

those possessed by “assets”. In this light, the significance

of our failure in First Bank to even mention the one-year

23 The expenditures which were found to be capital in nature in

Lincoln Savings were of potential benefit to the taxpayer beyond

the taxable year.

22a

rule is that its application was unnecessary because the

assessments in issue were found to lack another char-

acteristic of equal moment under the “separate assets”

test, ie., they did not create for the bank a property

interest in anything of intrinsic or salable value.”

In the light of these underlying considerations, it is

necessary to determine how the taxpayer’s claim fares

under the test of Lincoln Savings.

B

Although Jack’s had to pay the reserve element of its

monthly rents to continue in possession of the property,

and in that sense the payments were of current con-

sequence to the company, there is no doubt that the dis-

bursements also secured to the taxpayer benefits having

a useful life which extended substantially beyond the

close of the taxable year. This is clear from the inden-

ture of mortgage, which requires that the trustee credit

Jack’s with the amount in the reserve fund in the event

of prepayment of rent, and that the trustee return to

the fund any interest earned on the investment of the

reserves, thereby increasing the size of this credit. The

taxpayer makes the point that Jack’s might default on

the lease or that other circumstances might arise to

prevent Jack’s from receiving the benefit of the reserve,

24 The district court in First Bank discerned no inconsistency be-

tween its disposition of that case and our decision in Georator,

stating:

“* * * however, the Court [in Georator] assumed the

existence of a definite asset, the trademark, and * * * [dis-

missed] taxpayer’s argument that its legal fees should not

be capitalized because they only maintained and did not

enhance the value of the trademark. Georator was correctly

decided, but it is aot inconsistent with the result in this

case, where neither party can identify or define any asset

upon which taxpayer’s assessment expenditures have had

any effect.”

First Nat. Bank of South Carolina v. United States, 413 F.Supp.

1107, 1112 (D. S.C. 1976).

23a

but we do not see that this possibility requires treatment

of the payments as § 162(a) expenses. A similar argu-

ment was advanced by the taxpayer in Lincoln Savings,

but the Court rejected it with the observation that “this

hazard exists with any routine investment in a bank or

an insurance company and yet its presence does not make

that investment an expense rather than a capital under-

taking.” 403 U.S. at 357.

Moreover, measured by the standard of First Bank,

the fund into which the reserve element of the rents was

paid was essentially a “separate and distinct asset’? which

must be capitalized. As Plaintiff’s Exhibit 4, App. 85,

suggests, the reserve fund had an ascertainable and real

value to the taxpayer in an amount equal to the sum of

the reserve payments plus any investment income earned

thefeon. Together with the taxpayer’s exclusive right to

direct that the fund be invested and the fact that the

reserve would rebound to the benefit of Jack’s if and

when it chose to prepay rent, this establishes the requisite

“property interest” in the account. Taxpayer would have

us reach a contrary conclusion because in its view the

reserve belonged exclusively to the county at the close of

the tax year. This, however, ignores the power retained

by the taxpayer to direct the trustee to invest the re-

serves, as well as the plain language of the indenture of

mortgage which suggests that the fund will finally be

paid out only upon the occurrence of the contingencies

therein set forth.

In Lincoln Savings the Court found that the reserve

account into which the payment flowed was essentially a

separate asset because it was “available for only stated

and circumscribed purposes”, because it was “more

permanent than temporary”, and because the taxpayer

had a “distinct and recognized property interest” therein

(interest earned on FSLIC’s investment of taxpayer’s

contributions was credited to taxpayer’s share of the

24a

reserve). 403 U.S. at 355-356; the same can be said of

the reserve into which the disputed portion of Jack’s

monthly installments was paid. There, as here, the reserve

into which the taxpayer paid premiums was statutorily

mandated, but the Court noted that “the fact that a pay-

ment is imposed compulsorily upon a taxpayer does not

in and of itself make the payment an ordinary and

necessary expense within the meaning of § 162(a) of the

1954 Code.” 403 U.S. at 359. There, too, it was unlikely

that the taxpayer would ever recover its payments, but

the Court deemed this fact of little significance and found

that the bank could nonetheless benefit from its expendi-

ture in the future. 403 U.S. at 357. There the taxpayer,

like Jack’s, interposed the annual accounting concept of

the income tax as a factor which required that a current

deduction be allowed, but the Court viewed that argument

as having little bearing upon “the determination of

whether an item is or is not an ordinary expense.” 403

U.S. at 358. On balance, there is little of significance to

distinguish the two cases, and we discern nothing in

Lincoln Savings which would entitle Jack’s to a current

deduction.

Under the appropriate tests, we conclude that Jack’s

was not entitled to the deduction claimed by it under

§ 162(a). Accordingly, the judgment of the district court

is reversed and the case is remanded for entry of judg-

ment in favor of the Government.

REVERSED and REMANDED.

25a

APPENDIX C

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

No. 77-2210

4aJACK’S COOKIE COMPANY,

Appellee

Vv.

THE UNITED STATES OF AMERICA,

Appellant

Appeal from the United States District Court for the

Western District of North Carolina, at Charlotte

James B. McMillan, District Judge

(Filed and entered April 25, 1979)

JUDGMENT

This cause came on to be heard on the record from the

United States District Court for the Western District

of North Carolina, and was argued by counsel.

On consideration whereof, It is now here ordered and

adjudged by this Court that the judgment of the said

District Court appealed from, in this cause, be, and the

same is hereby, reversed. The case is remanded to the

United States District Court for the Western District

of North Carolina, at Charlotte, for entry of judgment

in favor of the Government consistent with the opinion

of this Court filed herewith.

26a

APPENDIX D

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

No. 77-2210

JACK’S COOKIE COMPANY,

Appellee,

versus

THE UNITED STATES OF AMERICA,

Appellant.

Appeal from the United States District Court for the

Western District of North Carolina, at Charlotte

James B. McMillan, District Judge

(Filed May 29, 1979)

Upon consideration of a motion of the appellee, by

counsel, for stay of mandate pending application to the

United States Supreme Court for a writ of certiorari,

IT IS ORDERED that the motion is DENIED.

For the Court—by Direction

/s/ William K. Slate, II

Clerk

27a

APPENDIX E

Internal Revenue Code of 1954 (26 U.S.C.):

Sec. 162. TRADE OR BUSINESS EXPENSES

(a) In General.—There shall be allowed as a de-

duction all the ordinary and necessary expenses paid

or incurred during the taxable year in carrying on

any trade or business, including—

(8) rentals or other payments required to be

made as a condition to the continued use or

possession, for purposes of the trade or busi-

ness, of property to which the taxpayer has not

taken or is not taking title or in which he has

no equity.

Sec. 446. GENERAL RULE FOR METHODS OF AC-

COUNTING

(a) General Rule.—Taxable income shall be com-

puted under the method of accounting on the basis

of which the taxpayer regularly computes his income

in keeping his books.

(b) Exceptions—If no method of accounting has

been regularly used by the taxpayer, or if the meth-

od used does not clearly reflect income, the com-

putation of taxable income shall be made under such

method as, in the opinion of the Secretary, does clear-

ly reflect income.

* * e *

Tennessee Code Annotated (1970 Supp.)

Sec. 6-1704. Powers of municipalities

In addition to powers which it may now have, any

municipality shall have power under this chapter:

Sec.

28a

(2) To issue its bonds to finance in whole or in part

the cost of the acquisition, purchase, construction,

reconstrution, improvement, betterment or extension

of any industrial building. The governing body of

the municipality in determining such cost may in-

clude all cost and estimated cost of the issuance of

said bonds, all engineering, inspection, fiscal and

legal expenses, and interest which it is estimated

will accrue during the construction period and for

six (6) months thereafter on money borrowed or

which it is estimated will be borrowed pursuant to

this chapter.

(3) To rent or lease such industrial buildings to

industrial or commercial concerns in such manner

that rents to be charged for the use of the industrial

buildings shall be fixed and revised from time to

time so as to produce income and revenues sufficient

to provide for the prompt payment of interest upon

all bonds issued hereunder and to create a sinking

fund to pay the principal of such bonds when due.

* * * *

6-1715. Rentals sufficient to pay bonds.

The governing body of a municipality issuing bonds

pursuant to this chapter shall prescribe and collect

rentals for industrial buildings and shall revise same

from time to time whenever necessary so that the

income and revenues to be derived from such rentals

will always be sufficient to pay when due all bonds

and interest thereon for the payment of which

such revenues are pledged, including reserves there-

for.

29a

APPENDIX F

LEASE

THIS INDENTURE OF LEASE made and entered

into as of the 1st day of June 1962, by and between the

County of Giles, Tennessee, (County) and Jack’s Cookie

Corporation, a corporation organized and existing under

and by virtue of the laws of the State of Ohio, with its

principal office in the City of Charlotte, North Carolina

(Company).

WITNESSETH

That the County does hereby lease to the Company and

the Company hereby rents from the County upon the

terms and conditions hereinafter set forth, the follow-

ing described real estate with the Industrial Building

agreed to be constructed thereon in accordance with the

plans and specifications of the Company and all ease-

ments and appurtenances thereunto belonging or in any

wise appertaining, together with such machinery for the

operation of a manufacturing plant as shall be specified

by the Company and installed in said building. Said

real property is described as follows:

(description omitted)

3. The term of this lease shall begin on the Ist day

of June 1962, and shall continue for a period ending

August 1, 1992 unless sooner terminated under the pro-

visions of Sections 13, 14, 17 and 18 hereof; however,

rental shall not begin until the Company shall be placed

in possession of the building and the machinery installed

and operative.

The County hereby grants to the Company an option to

renew or extend this lease for three (8) additional ten

(10) year terms in the maximum number of thirty (30)

30a

years commencing at the expiration of the lease, for an

annual rental equivalent to taxes that would be levied

by the County against said premises were the same tax-

able but not to exceed $12,000, avd under the same

terms and conditions, other than the amount of rentals, as

provided herein. Failure of the Company to give the

County written notice of at least sixty (60) days in ad-

vance of the expiration of the original terms or any ten

year additional term of an intent to terminate this lease

shall be conclusive evidence that the Company has elected

to renew this lease for such additional ten year term; but

provided that if the Company shall remain a tenant at

the conclusion of the third renewal term, and without

having given the required notice of an intent to termi-

nate, the lease shall thereafter continue in like fashion

as before on a year to year basis, subject however to

termination by either party by written notice one hundred

and twenty (120) days prior to the end of the final ten

year renewal or any annual period thereafter.

4. So long as any of the bonds are oustanding, the

Company binds itself to pay the County monthly rentals

each month, beginning when the Company shall be put in

possession of the building and all said machinery is in-

stalled and operable, but in no event later than June 1,

1964 and ending thirty (30) years from the date of the

bonds, such monthly payments to be equal to:

One-sixth (1/6) of the next semi-annual interest due

on each of said bond issues, plus, commencing with the

payment for July 1964, one-twelfth (1/12) of the next

principal payment due on each of said bond issues, plus

all necessary and reasonable expenses incurred by the

Trustee and Paying Agent in the Administration of said

bond issues, plus an aggregate sum of Two Hundred and

Eighty-Five Thousand Dollars ($285,000) payable in

equal monthly installments beginning upon occupancy of

the premises by the Company and terminating fifteen

8la

(15) years after date of the bonds, as Reserve Payments

into “Bond Fund Number One,” as defined in Section 5

hereof.

At any time after fifteen (15) years from the date of

said bonds, the Company shall have the option of pre-

paying all of its remaining rental payments by depositing

with the Trustee “all prepaid installments of rent” as

defined in Section 5 hereof.

5. All rental payments shall be due and payable on

the first day of each month.

For the purposes of definition as hereinafter referred

to, the term “all unpaid installments of rent’”’ shall mean

an amount equal to the entire principal amount of then

oustanding bonds of both issues, together with all in-

terest accrued and to accrue on and prior to the next

succeeding call date of such bonds, and together with any

call premiums required but deducting from such amount

the aggregate amount then on deposit in the “Industrial

Building” Revenue Bond and Interest Redemption Fund”

(sometimes called “Bond Fund Number One’’) and in the

“Industrial Building Revenue and Tax Deficiency Bond

and Interest Redemption Fund” created by the resolu-

tions of June 21, 1962, authorizing said bonds.

* * * *

9. The Company agrees that during the term of this

lease it will keep the leased premises and all the buildings

and improvements thereon and the appurtenances thereto

in good repair at its sole cost, and to pay all taxes law-

fully levied against said property, and upon the expira-

tion of or termination of this lease, it will surrender the

leased premises and the improvements thereon and ap-

purtenances thereto unto the County in as good condition

as prevailed at the time it was put in full possession

thereof, excepting, however, ordinary wear and tear, war

damage, and damage, destruction or loss under the con-

82a

ditions provided in Sections 13 and 14 hereof. In the

event that any part of the building or improvements

thereon and appurtenances thereto require replacement

during the term of this lease, the Company agrees to bear

the cost of such replacement unless it shall have paid all

rentals in advance pursuant to Sections 13 and 14 hereof,

provided, however, that any amount collected by the

Trustee under the aforesaid Indenture of Mortgage

and Deed of Trust under any insurance policy for casual-

ty or otherwise covering the cause for such replacement,

shall be paid over to the Company pursuant to the terms

of said Indenture of Mortgage or Deed or Trust.

* * * *

13. In the event of damage to or destruction of the

Industrial Building situated on the leased premises there

shall be no abatement or reduction in the rent payable by

the Company to the County, and the Company shall repair

or restore or reconstruct such building or construct a

new building or buildings suitable for the needs and use

of the Company as it may elect. In such events the

Company shall be entitled to receive all money received

as proceeds of any insurance carried on such Industrial

Building, either upon completion of such repair, recon-

struction or construction or periodically as such repair,

reconstruction or construction progresses (but limited to

the extent of the then cost of such reconstruction or con-

struction) as the Company may elect, such payments to

be applied by the Company to the payment of such cost

of repair, construction or reconstruction or, if such cost

has already been paid by the Company, to reimburse it

for such cost; provided however, that the aggregate sum

or sums so received by the Company shall in no event

exceed the cost for such reconstruction.

Any surplus insurance proceeds after such repair, re-

construction has been completed and paid for shall be .

deposited in the Bond Fund in an amount not exceeding

all unpaid installments of rent as defined in Section 5

33a

hereof. The Company shall be entitled to any surplus

thereafter remaining.

* aa * *

In lieu of the obligation as hereinafter set forth in this

section hereof to repair and restore or to reconstruct or

replace the Industrial Building, the Company may pay in

advance all unpaid installments of rent due hereunder in

the amount provided in Section 5 hereof, and if such

advance rental payment shall be in the full amount re-

quired by said Section 5 the Company shall not be re-

quired to repair and restore or to reconstruct or replace

such damaged or destroyed Industrial Building and this

lease shall, at the Option of the Company, cease and

terminate. If in such event the insurance proceeds shall

exceed such unpaid installments of rent the Company

shall be entitled to any surplus as compensation for the

loss of the use of the Industrial Building.

* * * +

14, If the whole of or any part of the leased premises

shall be taken or condemned by any competent authority

for any public or quasi-public use or purpose, then and

in that event, the net proceeds of the award or compen-

sation or damages recovered on account of any such

taking or condemnation, after deducting any expense in-

cluding counsel fees incurred by the County in litigating,

arbitrating, compromising or settling any claim arising

out of such condemnation, shall be disposed of in the

following manner:

(a) If such taking or condemnation shall involve the

taking or condemnation in whole of the leased premises or

the taking or condemnation thereof in part to such extent

that said premises are, in the sole judgment of the Com-

pany, thereby rendered unsuitable for economical usage

by the Company, there shall be, on account of such taking

or condemnation, no abatement or reduction in the rent

payable by the Company to the County during the term

34a

of this lease; and the Company, at its own cost shall, if

same can lawfully be done, repair and restore the leased

premises, in the event of such partial taking or con-

demnation; or reconstruct the Industrial Building or con-

struct a new building or buildings suitable for the needs

and use of the Company, as it may elect, in the event said

leased premises be wholly taken or condemned or taken

or condemned to such extent as to render said premises

unsuitable for such economical usage; but the net pro-

ceeds of such award or compensation or damages re-

covered on account of said taking or condemnation shall

be paid over to the Company, at Company’s election,

either upon the completion of such repairs and restora-

tion or of such reconstruction or construction, or periodi-

cally as such repairs and restoration or such reconstruc-

tion or construction progress (but limited to the extent

of the then cost of same), and be applied by the Company

to the payment of the cost thereof or, if such cost has

already been paid by the Company, to reimburse it for

such cost; provided, however, that the actual cost of such

repairs and restoration or of such reconstruction or con-

struction.

‘Athy surplus of the net award or compensation or dam-

ages remaining after the completion of and payment for

such repairs and restoration or such reconstruction or

construction shall be deposited in the Bond Fund; but if

such surplus shall exceed all unpaid installments of rent

as defined in Section 5 hereof, then the Company shall be

entitled to the excess of such surplus.

In the event the Company shall fail to repair and re-

store or to reconstruct or to replace and pay the costs of

repairing and restoring or of reconstructing or replacing

the leased premises, as it is obligated by this sub-section

(a) hereof to do, after the lapse of a reasonable time

and after due notice given by the County to the Company

the County may repair and restore or reconstruct said

85a

leased premises and recover the reasonable cost thereof

from the Company, less the net proceeds of such award or

compensation.

Notwithstanding anything to the contrary that may be

hereinbefore provided in this sub-section (a) hereof, in

the event the Industrial Building cannot lawfully be re-

paired and restored or reconstructed, or in the event said

Industrial Building cannot lawfully be replaced by a new

building or buildings, as hereinbefore in this sub-section

(a) is required or permitted to be done, or if by any

reason of the reduction in the size, shape, or dimensions

of the leased premises or for any reason otherwise it shall

not, in the sole judgment of the Company be economically

feasible and practicable to repair and restore or recon-

struct said Industrial Building or to replace such In-

dustrial Building with such new building or buildings so

that same will be sufficient for the then needs of and use

of the Company, then the Company shall not be required

and the County shall not be entitled to repair or restore

or reconstruct or replace the leased premises as herein-

before in this sub-section (a) hereof provided; and then

the net proceeds of such award or compensation or dam-

ages recovered on account of such taking or condemnation,

when collected or received, shall be deposited in the Bond

Fund. In the event the net proceeds of such award or

compensation or damages on the date the same is col-

lected or received shall exceed all unpaid installments of

rent as defined in Section 5 hereof, then and in that event,

there shall be deposited in the Bond Fund from such net

proceeds an amount equal to the amount of such unpaid

installments of rent, and the Company shall be entitled

to, and the surplus of such net proceeds shall be paid

over to the Company, and provided that if the net pro-

ceeds as deposited in the Bond Fund does not equal the

amount of such unpaid installments of rent the Company

shall pay the required rentals in advance, being the sum

equal to the difference between the net proceeds and the

A

36a

unpaid installments of rent, as defined in Section 5.

Upon the payment of the required rentals this lease, at

the sole option of the Company, shall cease and terminate.

(b) If such taking or condemnation shall not in the

sole judgment of the Company, render the leased premises

unsuitable for economic usage by the Company, then the

net proceeds of the award or compensation or damages

recovered on account of such taking or condemnation,

when collected or received, shall be deposited in the Bond

Fund. In the event the net proceeds of such award or

compensation or damages on the date same is collected

or received shall exceed all unpaid installments of rent as

defined in Section 5, hereof, then, and in that event, there

shall be deposited in the Bond Fund from such net pro-

ceeds and amount equal to the amount of such unpaid

installments of rent, and the Company shall be entitled

to, and the surplus of such net proceeds shall be paid

over to the Company.

* * * *

17. It is made a condition of this lease that if the

Company shall fail to pay any one or more monthly rental

installments or any part thereof the County, at its option,

may cancel and terminate this lease upon giving the

Company written notice of such election within the time

hereafter provided, which notice may be deposited in the

United States mail and addressed to the President of the

Company at its principal office in Charlotte, North Caro-

lina; provided, however, that within the respective periods

of 30 and 90 days from the receipt of said notice, as

hereinafter provided, the Company shall have the privilege

of paying the County all accrued and unpaid rentals, in

which event said notice shall be of no effect. Such notice

by the County shall be for the following periods:

(a) On and before January 1, 1966, 30 days notice _

of such election shall be given.

37a

(b) After January 1, 1966, 90 days notice of such

election shall be given.

18. It is further agreed that if the Company shall de-

fault in the performance of any of any of the terms,

provisions, covenants or conditions on its part to be

performed, kept or observed hereunder, other than the

non-payment of rent hereunder, then and in any such

event the County, at its election, may terminate this lease

at any time thereafter by giving ninety (90) days written

notice, which shall be mailed to the President of the Com-

pany at its principle office in Charlotte, North Carolina,

and at the expiration of such ninety (90) day period, this

lease and all of the estate, right, title and interest herein

granted to or vested in the Company shall cease and

terminate, unless within said ninety (90) day period all

such default or defaults shall have been fully remedied,

or the Company shall have commenced action and con-

tinued same in a reasonable manner to remove such

default or defaults.

* * * *

21. The Company is granted. the right to assign the

Lease or sublet the whole or any part of the demised

premises, subject to the approval of the original purchaser

of both bond issues, or its successor; provided, however,

that the Company shall at all times remain liable for the

payment of the required rentals.

* * * *