Reply Brief — South Texas Rice Warehouse Co. v. Commissioner

teiies Court of the United States

October ‘Term, 1966

SOUTH TEXAS RICE WAREHOUSE CO., Petitioner

v. |

‘ “COMMISSIONER OF INTERNAL REVENUE,

ae ' Respondent

7.

* On Petition For A Writ Of Certiorari To The United

States Court Of Appeals For. The Fifth Circuit

_REPLY BRIEF OF PETITIONER

“1

Homer L. BRUCE |

WILLIAM C. GRIFFITH .

. RoBERT J. Prro -

BAKER, BoTTS, SHEPHERD 1600 Esperson Building

& CoaTEs Houston, Texas 77002

Of Counsel Attorneys for Petitioner

Alpha Law Brief Co, M&M Bldg., Houston, Texas 77002

INDEX

~ Cases: — ; | i

Commissioner v. Brown, 380 U.S. 563 '........ +5

Hanover Bank v. Commissioner, 369 U.S.672 ... . 2 |

Helvering v. Flaccus Leather Co., 313 U.S. 247. 2:

Helvering vy. Hammel, 311 U.S. 504 Pete ea 2

Loesch -& Green Const. Co. v. C.LR:, 211 F. 2d

essay ASAI ee eee ee 13°

Old Colony Railroad Co. v. Commissioner, 284

US. 552 ...

Statutes:

Internal Revenue Code of 1954 (26: US.C.) .

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NO. 910

Supreme Court of the United States

October Term, 1966

SOUTH TEXAS RICE WARE CO., ‘Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

——

On Petition For A Writ Of Certiorari To The United.

States Comet Of Appeals rer The Fite Circuit .

REPLY BRIEF OF PETITIONER

We desire to file this brief reply to the respondent’ S

memorandum in opposition because of what we regard as

“one of the most fundamental questions presented to this

Court in recent years. If the. many inaccurate statements

in the opinions of the two courts below and the memo- —

randum of respondent are taken at their face value and

accepted by this Court, then we have small hopes of its

granting our petition for a writ of certiorari as this Court

would assume that. this case involves only: a conflict in

thé evidence that was resolved against the petitioner and

therefore the judgments below should be left undisturbed.

Padi? te PR ds

2

However, if this Court will bear with us_briefly, we. be-

lieve we ‘can illustrate that it involves a most fundamental

_ ‘question concerning the extent of the power of the Com- -”

~ missioner of Internal, Revenue under section 482 of the =

- Internal Revenue Code. We feel that this Court should

express to the world its interpretation and application of

- that section just as it has so recently and emphatically

expressed its views of. other sections in Commissioner v.

Brown, 380 U.S. 563; Hanover Bank v. Commissioner,

369 U.S: 672; Turnbow v. Commissioner, 368: U.S. 527;

Helvering v. Flaccus Leather Co., 313 U.S. 247; Helvering

v. Hammel, 311 U.S. 504; and Old Colony Railroad Co.

v. Commissioner, 284 U.S. 552.

This fundamental question is:

' Where reputable, taxpaying citizens of the United -

States as a result of hard bargaining on both sides

agree on a rental of $48,000, a year to be paid by the

lessees and their testimony and that of a disinterested,

qualified third party is unimpeached that the rental

_ is reasonable, may the Commissioner of Internal

“Revenue and the Tax Court and the Court of Ap-

peals, without any evidence to the contrary, com-

pletely rewrite the trade so carefully made and raise

the rental to $78;000 in the face of the uncontra-

dicted testimony of the lessees that they would not |

have leased the property if the rental had been over .

$48,000? : hae

We have in Appendix B to our petition (pages 44-55)

set out verbatim most of the testimony and evidence

bearing on this fundamental question and for the con-

3

.

- venience of this Court will repeat part of it here. First,

though: we would like to set out certain erroneous state-

ments of the courts below that formed the basis of their

decisions and then follow them with the real evidence.

The Tax Court said: a °

“This partnership | was not-a sham. It was organized

_ for the business purpose of transferring to the adult

~children-of L. D. and S. M. Clements, the fathers’

interests in the rice drying and..warehousing opera-

tion, while permitting the fathers to retain their

ownership interest in the physical properties.” (R.

230)

“There was considerable testimony as to the ne-

gotiations which took place between representatives

of .Enterprises and S. M. Clements and L. D. Cle- —

ments who were ‘stockholders in Warehouse but not

partners in Enterprises. While we do not doubt that

the matter was negotiated and the result of the ne-

gotiation was the $48,000 figure, the logical infer-

ence for the record as a whole is that .the negotiation.

was not an arm’s length one but was for the purpose

of satisfying the condition that the attorney who had

been consulted by the prospective partners had placed

as a requirement for ‘the transaction not being ques-

tioned taxwise, “That they could lease the property

but * * * would have to pay a reasonable rent.’”

(R. 237)

The Court of Appeals accepted those two erroneous

statements as ‘a basis of its affirmance. (recon 30, foot-

note 8, 32-33)

The Court of Appeals further s@id (Petition 40):

“The Court must look at the substance of a witness’

testimony as well as his conclusions. The testimony

must be weighed along with all other relevant evi-

dence. Here the Tax Court pointed out.that the

witnesses overlooked several significant factors in

reaching their conclusions.” (Petition -40)

The Tax Court’s statement on this point was:

———oerrerererrereerrrrerrrroerrr

eee

PRR ah BA ie dn

4

“In the case of Warehouse, we view the statements

of the two partners that the fair market value: of

the assets of Warehouse were at no time from June

30, 1957, throughout the years there involved, less |

than $700,000 as in the nature of ‘an admission.

These witnesses in no way reconciled their opinion °

as to a fair rental value of the assets with their

testimony as to the fair market value of those assets.

This failure to explain two opinions which without

such-explanation seem inconsistent persuades us to

give little weight to the opinion as to rental value

of these interested witnesses. The’ burden is on peti-

tioner to establish a fair rental value for properties

of a lesser amount than the $78,000 a year deter-

mined by respondent.” (R. 237-238)

As to this $700,000 value we will later show that only

_ one witness, S. M. Clements, and not two, wr no par-

-ticular weight to it,

We will now give the real material evidence on these

points.

J. E. Davant testified:. .

“Q. Now, you were one of the original parties to

the formation of the partnership, South: “Texas Rice

Enterprises?

A. That’s right.

Q. State whether or not you and Bob Pegram,

that’s R. Q., Jr., and Eddie Clark, and at that time, |

Thurmon Clements, came up to see me some time

in May, 1957, about the possibility of forming a

_ partnership and leasing this property from the ware-

house ,.company.

| A, We did. .

Q. Do you recall in substance, what I told you

about it? |

A. Yes, sir.

_ Q. What was that?

A. You said that we could leasé the property but

we. would have to \pay a reasonable rent.

Q. You then asked me to get up the partnership

agreement, did you not?

_A. Yes, sir, we employed you to do that for us.

Q. And that partnership agreement has been in-

troduced in evidence. and all of you executed a part-

nership agreement?

A. That’s correct.” (R.. 51)

Q. What did you all do about fixing the rent, Mr.

L. D..Clements_ and S. M. Clements not being in the

- partnership, how did you come to a figure?

‘A. We made an offer of $3,000\a month, coming

to $36,000 a year. Dick wouldn’t hear to it. He

wanted fifty thousand dollars cash. »

We finally, after; I guess, about an hour of argu-

- ment or a little er: arrived at $4,000 a month.

We wanted it on a monthly basis. And that was

$48,000, and he finally agreed to that.

Q. What was Mr. S. M. Clements’ attitude about °

your thirty;thousand and fifty thousand dollars? —

A. Mr. S. M. Clements was right along with Mr.

Dick Clements. They wanted what they considered a -

better rental than we had offered them. They didn’t

‘want to lease it and wouldn’t agree to it until we -

came up with a forty-eight thousand dollar figure.”

(R. 53)

“Q. You say you were there about an’ hour and a

- half? .

A. We were there longer than that, but at least

that one thing was discussed for at least an hour and

a half.” (R. 54)

“Q. All right. ‘

Mr. Davant, if that rent, if they had demended

$78,000, like the government is claiming in this case,

as the rent, state whether,or not you would have

gone into this partnership and rented it for- $78,000

a year.

6

A. No, sir, I wouldn’t. But I would like to Anum

that.” (R.- 54-55) :

“Q. Well, Mr. Davant, if they demanded more than

$48, 000, and wouldn’t have leased it to you for less,

would you have leased it for more than $48,000?

_ A. No, I wouldn’t, because that is more than the

_ going price for dryers at that time.” (R. 55)

Edward -W. Clark, one of the. partners in the lessee,::

testified on direct examination by Mr. Bruce:

“Q. You had that meeting, testified to by Mr.

Davant, in my office. Do nt as recall when you had

it and came to an agreement as to what the rental

would be?’

A. Yes, sir, I. recall.’

‘Q. And just tell the Court briefly tls leiaead

there and what the attitude of Spence Clements and

L. D. Clements and S. M. was and what your attitude

was.

A. We proposed a‘ rental of $36,000, which we

thought, in. my opinion, I thought was adequate

rental, three thousand dollars per month, to operate

those: facilities. It is quite a responsibility as far as

ownership; there is a good deal of liability to be

considered in operating a warehouse company and

drying rice and storing rice, to be liable for the dam-

' aging of it. So'I thought $36,000 was very reasonable

‘rent for the lessor. And Mr.: Dick Clements thought

it should be more. I don’t know whether it was forty-

eight or fifty or fifty-two, or whatever figure it was,

_ but we finally ‘decided, or he made a remark that |

forty-eight would be all right with him.

And he said, ‘Well, boys, I don’t think I want any

part of it, a partnership. I don’t want any part of it.

But you all are young. If you go busted or broke,

you have a chance to come batk. But I am older

and I don’t want any liabilities from damaging of

rice that you boys don’t realize could happen to

you.’” (R. 105) 7

a

7

* “QO. Would you is gone into it and rented that

if Mr. Dick Clements held out for higher rent?

A. I don’t think so. 1 might have paid fifty thous-~

and dollars, but that would have been the most I

think I would: have paid, in my opinion, at that ‘time,

and I would have aims less. ” (R. 106)

Mr. William S. Fly, one of the partners, testified on

direct examination by Mr: Bruce:

“Q. Mr. Fly, you have been present during the

testimony and have heard the testimony with refer-

‘ence to. the formation of: South Texas Enterprises

partnership and the leasing of these properties from

_ the Warehouse Company. It’s been testified that you

were at the conference in my office when it was finally

agreed, in June, 1957, the first rent would be ies -

..000?° °

A. Yes, sir.

—Q Would you tell the Court, briefly—when I say

briefly, in the light of what has beén testified—as to

whether or not what happened there was substantially

the same as Mr. Davant and Mr. Clark testified to?”

(R. 127-128) |

“A. My recollection is substantially ‘the same. My..

father-in-law, Mr. Dick Clements, did not want to

go into it.:We argued with him relative to the amount

of rental, as Mr. Davant and Mr. Clark said.

- Q. State whether or not there was considerable

discussion as to what the lease would be. :

' A. There was considerable discussion and .we were.

‘putting some pressure pretty good on Mr. Dick to >

try. to. get this rent down to where we thought we

could make some money.

Q. And you didn’t think that was.going to en- °

danger your marital Telationship with your father-in-

~ Jaw?.

A. No. We walked on it pretty hard, but he went

along with it finally. ms

ee

Q. Why did you want to go into this?

A. I wanted the opportunity to make some ——

(R. 128-9)

S. M. Clements and L. D. Clements. (the latter having

died before the trial) were two stockholders in petitioner -

and \ vhe and L. D. Clements were the ones: who forced

the. lessee to pay up to the $48,000 rent. The evidence

showed * ‘that in 1960, three years after the 1957 lease, —

petitioner sold the properties to South Texas Water Com-

_ pany. for $700, 000. Clements testified that in his opinion

the $48,000 was a reasonable rent. The following occurred

between the Court, and Clements: |

““Q. Well, now; the Court was dei isa deed

here in evidence; Exhibit 16, which involved; ap- .

parently, the sale of this South Texas property at a

-.“ time in 1960 when, apparently, there was still out-

'. standing a lease, and the Court was looking at the

documentary stamp on that, which gives a rough idea

of the price;.and I just wondered ‘if, you had given

_ any consideration:.to what the sale pricesmight have

been back in 1957 of this property when you con- . .

‘sidered the fifty thousand dollar rental.

_ A. Well, I don’t. know that we had thought shies 7

_ the sale price of it back in 1957. But ‘it certainly

' would be substantially the same as we ‘sold it for

. when this took place, except for additional improve-

. ments that may have been made. I’d say about the

‘game.

- Q. You don’t know whether you gave any con-

sideration to what the sale price of this property -

. would be had you chosen to sell it instead of leasing

_ it when you took the fifty thousand dollars?

A.. There was no consideration of that that I recall

at that time.” (R. 137-138) ©

Now on the strength of that one statement by Clements

_ that in considering the rent in 1957-he did not take into

_ 7 t ;

aN ‘

account what the property sold for. three years later in

1960, the Tax Court and the Court of Appeals said his

testimony was unworthy of belief, the Court of Appeals

saying:

“Here the Tax. Court pointed out that the witnesses

overlooked several significant factors in ne their

conclusions. Fe (Petition 40). |

R. Q. Pegram, Jr., another partner, testified: :

“By Mr. Bruce:

Q. Mr. Pegram, you have heard the witnesses tes-

tify about the conference that was had between mem-

bers of the Rice Enterprises partnership and Dick -

- Clements and Spence Clements and myself up in my

office abdut how this was fixed?

A. Yes, sir. |

Q. Were you at that cee ; .

A. Yes, sir. |

-Q. What was your thought at that time as to ager

rent you should pay?

A. I thought thirty-six. thousand dollars a year or

three thousand dollars a month was entirely adequate

and all we could afford to pay.

Q. What was Mr. Dick Clements’ attitude?

A. Mr. Dick Clements’ attitude was that it should

bring at least fifty thousand dollars a year into the

corporation.

Q. And you ‘finally agreed on forty-eight thousand ;

dollars? .

| A, Yes, sir, four thousand dottars a month.” (R.

141)

‘“Q. Mr. Pegram, if the Enterprises could not have

gotten this property, this lease, for around forty-eight

‘thousand dollars, state whether or not you would

have been willing to go into the lease.

A. I would not. I was hesitant about paying forty-

eight thousand dollars. meee

‘\

S

+ ner ee RP

-

10

Q. State whether or not you knew that the part-

ners would be personally liable for that forty-eight

thousand dollars if you didn’t. make any money in

the warehouse. :

A. I was fully aware of that.” (R. 142)

Mr. Marcus W. Mauritz, 55 years of age, saiieels in-

= dependent. of all. parties interested in this case, a man

‘who spent his whole life in growing and handling Tice, ;

testified:

_ “Q. Now, Mr. Mauritz; have you become per-’

sonally fam_liar. with the business properties at Ro-

(sharon that constitute this South Texas cel ain :

rice warehouse and dryer?

A. Yes, sir, I have.

Q. I believe the record shows that they have a’silo

’ with a capacity of 65,000 barrels, a quonset ware-

house of. 36,000 barrels, and a dryer of 36,000 bar-

- rels and a warehouse of 137 by 400 feet, with the ,

‘machinery that goes along with such a warehouse.

Now, Mr. ‘Mauritz, from your experience in the

rice business, state whether or not in your opinion

the rental of $48,00u that was provided for in this |

lease effective July 1, 1957, would be a reasonable

rental to pay for the rent of this warehouse property.

A. In my opinion it is excessive.” (R. 152)

“Q. Mr. Mauritz, then address your attention to .

Petitioner’s Exhibit No. 18, which shows the total

receipts of the Warehouse Company. Say, for ex-.

ample, for the end of June, the year ending June:

30, 1957, 280,000 barrels; coming down, 264,000,

barrels. And the next three years, 265,000 and then

76,000 for the year ended June 30. |

Now, I call your attention to the next column and

‘point out that the large amount of volume of rice

‘available or that you processed as shown under col-

umn SERF was the South Texas Rice Farms rice.

11

Now, with-that volume of rice going through there,

‘what would be your thought or your opinion from

your experience with a dryer putting that amount of

rice through as to whether this $48,000 was a rea-

sonable rental or whether it was, as. you say, eX-

cessive?” (R. 154) a

' “A, My opinion that it’s excessive, from looking

at these figures, that the only rice they are sure of

getting would be their half of the rice that they -are

farming on halves, because they do have the control

of that. That is not a sufficient amount to justify

paying that much rent. © .

The rest of it is all problematical.

Basing -it upon the last or the previous years of

drying, even, and if they would get. the same per-

centage of not only their own but their tenants’ and

‘their public, in my opinion it is still excessive rent

because I do not think 280,000 barrels, for instance,

that was dried in 1956 is sufficient of an insurance —

to pay $48,0U0 rent for.” (R. 156)

* *

“And, as has been brought out here, the farmer is

going to take.advantage of whatever he can to get

more for his crop. And.then he has to take the neces-

sary step to do that. Sometimes there is storage and

sometimes there is not. And I do not think $48,000,

to my mind, would be any bargain price at all.”

(R.557) .

_ We submit that the above unimpéached testimony com-

pletely refutes the statements.by the two courts below

upon which they based their holdings.

The respondent says that this lease was made so as to

have petitioner show a loss and thus have a carryback

to the prior three years and get refunds on them. The

foregoing evidence shows there is no basis for such a

statement. ‘

,

AR LEAS ON REN te

a?

12

‘\ smn

As to the so-called loss of petitioner, we show on

pages 21-22 of our petition that this was due to heavy

amortization deductions allowed over a five-year period

‘under the ‘Federal agricultural program. Furthermore,

we point out on that page 21 that petitioner for the three

years June 30, 1958, 1959 and 1960, actually had net

cash gains of $39,008.49, $40,253.53 and $40,951.33.

To show the erroneous attitude of the.Court of Ap-

en we. quote the following statement by it:

“We cannot say) that a three-year reallocation of

‘income approved by the elder Clements with a dona-

tive intent brought the type of break in continuity

of interest or control that would prevent the appli-

cation of section 482 in this case. ” (Petition 34)

‘How could that court base its opinion on that concept

of a three-year reallocation of income? The record showed

that in 1960: petitioner sold its properties to the South

Texas Water. Company: and on the trial of the case in-

1964 this lease was still in effect and respondent knows

_ that it is now in 1967 still in effect, the rent having been

raised in 1960 to $50,000. .

We ask this Court to look frankly at the taxing pro-

cedure in this case. The lease was made with a $48,000 .

rental. Petitioner then filed: its tax return for the year ©

ended June 30, 1958, and found it had a loss. It then

carried this léss back to- June 30, 1955, 1956 and 1957,

and got small refunds. A revenue agent then audits the

1957 return and sees that; if he raises the rent to $78,000,

there will be no loss, no carryback and no refund. So,

he says $78,000 isa reasonable rent. The courts below,

with absolutely “no evidence from the Government and

in the face of petitioner’s evidence, hold to the $78,000

figure under section 482.

13.

We ask: Is this a reasonable basis of taxation? Do not

the taxpaying citizens of the United States have any

right to manage their affairs in a fair and reasonable

manner? :

| How can a judge of the Tax Court, who never saw the

properties involved or ran a rice drying business, say

merely out of her own head that $48,000 was unreason-

ably low? We repeat our quotation on page 24 of our

petition from Loesch & Green Const. Co. v.'C.1.R., 211

F.2d 210; 211; -

“Their testimony was unimpeached and should have

.been accepted by the Tax Court in a matter in which

it had no knowledge or experience upon which it

could: exercise independent judgment; and such evi-

dence cannot be arbitrarily disregarded.” ©

In addition to the foregoing, we still urge, as in point 5,

page 7, of our petition, that in view of Article 5.10 of ©

the Texas Business Corporation Act, section 482 may

not come into play in this-case. '

CONCLUSION

We respectfully submit that it is. just as important for

this Court to express to the citizen taxpayers its views

- as to how far the Commissioner of Internal Revenue

may and may not go under section 482 as it was to ex-

press its views on the questions involved in Commissioner

v. Brown, 380 US. 563.

In addition, if this judgment below is allowed to stand,

‘a tremendous amount of work will be. thrown on the .

corporations involved and the twelve partners that sonar

the property and the Government. |

IF ee ene

5 ela

Coe

14

In the first place, as is shown in J. E. Davant, et al., v.

‘Commissioner of Internal Revenue, No. 911 on this

Court’s present: docket, petitioner was dissolved and its

properties were sold to South Texas Water Company on

. August 26, 1960. The lease of these properties is still in

effect in this year of 1967 with Water. Company as lessor.

The whole matter of the reasonableness of the rental for

‘1960 to date will be litigated again as Water Company

is not bound by the judgment in their case.

@ Further, if this judgment stands, all of the twelve

partners of the lessee partnership will under the mitiga-

tion sections 1311 to 1314 of the Code have the right

to have their 120 income tax returns for the years 1957

through 1966 re-audited with their being given credit for

the additional rent -deduction: from $48,000 ¢$50,000

beginning in 1960) to $78,000 and; as they are all sub-

ject to the increasingly high individual income tax rates,

it is entirely possible that the Government will have to

refund to them more taxes that it. collects from the lessor

corporations. :

We respectfully pray that this petition. for a writ of

certiorari be granted.

Respectfully ieitend,

o | HoMER L. BRUCE

WILLIAM C. GRIFFITH

- ROBERT J. Prro

Counsel for Petitioner

1600 Esperson Building

Houston, Texas. 77002

Attorneys for Petitioner

BaKER, BoTTs, SHEPHERD

' & COATES

Of Counsel