Appendix — Gotthelf v. Commissioner

Supreme Court brief1969

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. APPENDIX A.

OPINION OF THE UNITED STATES COURT OF APPEALS

FOR THE SIXTH CIRCUIT.

(Decided May 13, 1969.)

Before: Weick, Chief Judge, O’SuLtiIvaN and

Puiiuips, Circuit Judges. —

O’SULLIVAN, CirQyit Judge. Pustiiners, Southeastern

Canteen Co. aid Canteen Service Co. of Toledo petition

for off review of a decision of the Tax Court, entered

September 19, 1967, upholding the Respondent-Commis- —

sioner’s assessment of deficiencies in income tax in the

amounts of $16,589.82 and $58,863.73, respectively. These

deficiencies arose’ primarily from gisallowance of parts of

deductions from income taken "by taxpayer corporations

for rent and commissions paid by them to the then owner

_of uipment used by taxpayers, and from disallow-

ance of Southeastern Canteen Co.’s claim of corporate

exemption from surtax on the first $25,000 of its earnings.

Reason for these rulings was provided by a finding that

the disallowed rent and commissions paid were not “ordi-

nary and necessary expenses paid or incurred * * * in

carrying on” the taxpayers’ trade or business, within the

meaning of the Internal Revenue Code of 1954, 26 U.S.C.

§ 162(a). Disallowance of the exemption from surtax of

the first $25,000 of Southeastern Canteen Co. earnings, 26

U.S.C. § 11(d), was the product of the Tax Court’s finding

that Southeastern Canteen Co. was formed by the owners

of Canteen Service Co. with the principal purpose-of secur-

- ing-the surtax exemption of $25,000 of its earnings, con-

trary to Section 269 of the Internal Revenue Code of 1954,

26 U.S.C. § 269. : |

We agree with the Tax Court’s affirmance of the Com-

missioner’s disallowance of amounts claimed as rent and .

other business expenses. We reverse its holding which

‘ 2

denied Senticztem Canteen Co.’s use of the surtax ex-

emption.

The Tax Court decision, filed. September 19, 1967, is

reported as Southeastern Canteen Co. and Canteen Service

Co. of Toledo %. Comm’r, 36 P-H Tax Ct. Mem. 973,

{ 67,183 (1967). The factual history is complicated. Bud-

dies Box Lunch, Inc. was formed as an Ohio corporation

on July 16, 1931. The outstandirig capital stock was owned

. fifty percent by Virgil A. Gladieux and fifty percent by his

brother, Nelson Gladieux. In 1955, Virgil became sole

stockholder and in 1960 the corporate name was changed ~

to Gladieux Corporation (hereinafter Gladco). Gladco

was principally engaged in the operation of cafeterias and

lunch counters and the dispensing of food in several manu-

facturing plants in Toledo, Ohio. It also sold candy, gum

and nuts both at its lunch counters and through vending ©

machines at locations in and near Toledo.

Canteen Service Co. of Toledo w§s incorporated as an

Ohio corporation on March 16, 1946, and was principally |

engaged in the operation of.vending machines in Lucas, |

Fulton and Wood counties in Northwestern Ohio under a |

franchise granted by Automatic Canteen Company of/

America (hereinafter Automatic). Its sole shareholder

was Ben T. Handwork. On May 10, 1946, Gladco entered

into an agreement with Canteen Service whereby Gladco

transferred to Canteen Service its vending machine busi-

ness in exchange for payment of location commissions on

all gross sales of candy, gum and nuts sold through svend-

ing machines previously operated by Gladco and at all

locations where Gladco then operated food dispensing

__faeilities. Gladco, pursuant to an option in the agreement,

~ _- purchased seventy-five percent, df Canteen Service’ s stock

on or before October 31, 1946. Later, as a result of re- -

demption of Handwork’s remaining twenty-five percent

—

stock interest, Gladco became the sole owner of Canteen

Service. 7

Southeastern Canteen Co. was incorporated as a

Michigan corporation on January 19, 1956. Its business

was the same as Canteen Service’s—the sale of food and

beverages through vending machines under a franchise

granted by Automatic—but the territory of ‘the business

was Lenawee and Monroe counties in southeastern Michi-

gan. Southeastern issued twenty shares of stock—fifteen

to Virgil Gladieux and five to Ben Handwork. In 1959,

Southeastern redeemed Handwork’s stock, with Gladieux

thereby becoming sole steckholder. >

Thus, by 1960 Canteen Service Co., an Ohio corpora-

tion, was wholly owned by the Gladieux Corporation

(Gladco) and the corporate shares of Gladco and South-

eastern, the Michigan corporation, were whglly owned

by Virgil T. Gladieux. Virgil and his wife, Beatrice G.

Gladieux, were also the sole shareholders in twelve other

corporations engaged in the merchandising and vending

of food, beverages and,gum in various areas of the United

States. On June 30, 1960, Virgil and his wife agreed to

transfer all fifteen corporations to ABC Vending Cor-

poration, a large publicly owned Delaware corporation,

in exchange for 80,000 shares of its stock, an option to

purchase 5,000 additional shares, and an executive posi-

tion with ABC at an annual salary of $62,500.’ The fran-

chise agreements which Canteen Service and Southeast-

_ern had with Automatic; however, gave Automatic a right

to withhold consent to a transfer of Canteen Service or

Southeastern.* Automatic exercised this right and refused

to permit the transfer of either company to ABC. Virgil

1 ABC, at the time, had 8,522 shareholders owning 1,228,328

‘shares of common stock included 48,960 treasury shares. ~~“

2 Article V, Section 25 of Franchise Agreement.

' Gladieux’s arrangement to circumvent this refusal brought —

about most of the litigation before us.

Prevented from total performance of the June 30,

1960 agreement, Virgil, on January 26, 1961, by “Supple- -

mental Agreement” transferred to ABC his other thirteen _

corporations, including Gladco, in exchange for 68,500

shares of stock, the stock option, and the executive position

with ABC.* There were also -negotiated, as of January

31, 1961, agreements between Gladco ‘(then owned by

ABC) and Canteen Service (controlled by Virgil Glad- -

ieux), and between Gladco and Southeastern (still con-

trolled by Virgil). The terms of these latter agreeménts

were substantially as follows: Canteen Service and South-

eastern (petitioners) would transfer to Gladco their

tangible physical assets at a price determined by their

net book value as of October 1, 1960. Gladco would then

lease back to petitioners all such assets for.:a term of

twenty years, beginning October 1,°1960, and would

- lease to petitioners “all additional equipment necessary

for tHe operation of the vending machine business.” Peti-

tioners would pay to Gladco for such leased assets a

“rental” equal to ten percent of their gross sales attribu-

‘* table to the vending machine business during the term of

Af the lease, provided such “rental” did not create a deficit

.-in the net income of either petitioner’ Petitioners would

pay increased “‘fixed location commissions” to Gladco with

respect to all sales at vending machine locations derived

through Gladco, Virgil or any affiliated corporations. In

consideration for the transfer of their physical assets,

Gladco paid to Canteen Service and Southeastern

* The six-month delay in negotiations was caused by the fact

that Automatic’s refusal to consent was submitted to arbitration,

and the arbitrator’s decision (in Automatic’s favor) was not ren-

dered until December 27, 1960. *

$184,659.85 and $5,109.43, respectively. All of this money

was used along with $201,827.30 and $52,863.64, respec-

tively, out of their other funds, to purchase 11,500 shares —

of. ABC stock in the spring of “1961. By this ‘purchase,

Virgil then held, directly or indirectly, the 80,000 shares

of stock he would have acquired had the original agree-

ment not been blocked by Automatic.

The Commissioner made the following deficiency as-

sessments: against Canteen Service Co. of Toledo and

Southeastern, together, $58,863.71 for the tax year end-

‘ing September 30, 1961;* against Southeastern Canteen

Co. (the Michigan Corporation), $4,936.82, $5,458.89 and

$6,194.61 for the tax years ending October 3, 1959, Octo-

ber 1, 1960, and September 30, 1961, respectively.’ |

We consider then, 1) disallowance of rental payments

made by petitioners to Gladco, 2) disallowance. of location

-commissions paid by petitioners to Gladco, and 3) disal-

lowance of surtax exemption claimed by Southeastern.

1) Purported Rental Payments. |

For their fiscal year ending September 30, 1961, peti-

tioners Canteen Service and Southeastern claimed deduc-

tions of $121,172.15 and $12,211.30, respectively, for

amounts paid as rent to Gladco pursuant to the sale-lease-

back agreement of January 31, 1961. These’ deductions

were claimed under Section 162(a)(3) of the Internal

Revenue Code of 1954, 26 U.S.C. § 162(a) (3), which reads

in pertinent part as follows:

+ Thi¢ amount represents the disallowance of a portion of the

rental and location commission deductions taken by Canteen

. Service and Southeastern.

5 These were the consequence of disallowing Southeastern’s

surtax exemption for the mentioned years.

6 f

“(a) There shall be allowed as a deduction all the

ordinary and necessary expenses paid or incurred

during the taxable year in carrying on any trade or

business, including— at

(3) rentals or other payments required to be

made as a‘condition to the continued use or posses-

sion, for purposes of the trade or business, of property

. to which the taxpayer has not taken or is not taking

title or in which he has no equity.”

The . Commissioner, : however, disallowed petitioners’

claimed deductions to the extent that they exceeded

$53,592.79 and $1,906.59, respectively. He based his de-

termination on the conclusions that the sale-leaseback

agreement was not negotiated at arm’s length between

adverse parties and that the claimed rentals did not-repre-__

sent the fair rental value of the assets leased. The fact ”

that the parties designated, and: one party became. obli- =~

gated to pay to-the other, a specified amount as rent does

“not bind the government to treat that amount as‘rent.. -

Catherine G. Armston, 12 T.C. 539,548 (1949), aff'd sub |

nom. W. H. Armston™ Co., Inc. v. Comm’r, 188 F(2)

~~ +531, 533 (5th Cir. 1951). Where theréis-an absence of

arm’s length dealing, the Commissioner may inquire jMto

_ » what constitutes reasonable rental to determine whether

the amount paid exceeds what would have been paid had

the parties dealt at arm’s length. Roland P. Place, 17 T.C.

199, 203 (1951), affirmed, 199 F(2) 373 (6th Cir. 1952),

-cert. denied, 344 U.S. 927 (1953). See also, J. J. Kirk,

Inc., 34 T.C. 130 (1960), affirmed 289 sais 935 (6th Cir.

1961).°,

s. e

‘ This power given the Commissioner is but a corollary to

the broader proposition that the substance of a transaction rather

than the form is controlling. Gregory v. Helvering, 293 U.S.

465, 79 L.Ed. 596 (1935); Smith v. Comm’r, 370 F(2) 178. (6th

Cir. 1966).

The issue is whether the involved parties negotiated ,

the sale-leaseback agreement at arm’s length. This is an

- issue of fact, and the Tax Court’s findings can be reversed

only if found to be clearly erroneous. Comm’r v. Duber-.

stein, 363 U.S. 278, 291 (1960).. We consider that the

Court’s findings are not clearly erroneous, and agree with

the following from the Tax Court’s decision: ;

_“The dominant motives of both Virgil‘ and ABC

throughout the negotiations which culminated in the

sale-leaseback agreements are crystal clear. Virgil

sought to obtain ABC stock and an executive position

with the company and ABC sought to acquire Virgil’s

15 food service companies. In light of these facts,

we think it abundantly cléar that the sale-leaseback

agreements were designe solely to fulfill the per-

sonal objectives of Virgil. There was no legitimate

business purpose for petitioners to undertake the

sale and subsequent leaseback of their tangible assets

other than to satisfy Virgil’s purpose of shifting in-

come from petitioners to Gladco’ in order to induce

ABC to go through with the deal. Thus, this is not a

case where a corporation entered a sale-leaseback

@frgngement in order to generate néeded cash for

business expansion. To the contrary, all the money

received by petitioners upon the sale of their tangible

assets, together with substantial additional amounts,

was used to purchase ABC stock, thus serving no

meaningful business purpose to petitioners.

‘Petitioners’ position is further weakened by the

. fact that during the entire — leading up

to the execution of the sale-leaseback agreements, the

owner of both the lessor:(Gladco) and the lessees

(petitioners) was the same perso Viral Gladieux.

Petitioners’ attempt-to transform ‘such an identity |

of interest into a relationship which petitioners

characterize as adverse, transgresses reasonable im-

agination. All the more so since the facts show that

the sale-leaseback agreements were mot intended to

be ends in themselves but merely steps in an inte-

grated plan to secure to Virgil and ABC advantages

which could not benefit petitioners in any meaningful

way. From a review of all the facts bearing on this is-

sue, which have been set out at length in our findings,

we are convinced that the sale-leaseback agreements

in question were not the result of arm’s length negoti-

ation between adverse parties and, therefore, we must

_detéfmine whether the purported rentals were ‘in

excess of — the lessee[s| Would have been required

to pay had * * * [they] dealt at arm’ S length with a

stranger.’ Roland r. Place, supra.”

An important consideration is that Virgil Gladieux was, on

the one hand, sole stockholder of the petitioners and, on

the other, a stockholder and executive of ABC. It was not

essential to him that he profit in his capacity as owner of

the petitioners, but only that he profit in the sale-leaseback

transaction as a whole. if

Petitioners do not squarely: raise the contention that,

whether or not the involved negotiations and dealings were

at arm’s length, the rental payments were reasonable. We

are not comtpelled to reach this question but the fgllowing,

brought to our attention by the government’s brief, per-

suades us that the Tax Court’s determination of deficiency

was not clearly erroneous:

“Taxpayers argue that the rentals paid were reason-

able in light of the fact that the lessor (Gladco)

furnished them with additional equipment for their

use. However, even taking this fact into considera-

tion, the record shows that the glaring disparity is

still present. For the period October 1, 1960, through

, October 3, 1964, taxpayer, Southeastern, paid the

lessor (Gladco) total rentals of $62,487.98, receiving

on the other hand for the period OctoberJ1, 1960,

* through December 27, 1964, additional equipment

‘a;

costing Gladco $12,097.91. For the same aes nis

teen Service paid Gladco total rentals of $432,835.18,

receiving from Gladco additional equipment eosting

‘the latter $595,591.12. Thus, Southeastern paid

Gladco $62,487.98 to lease-equipment valued by the -

parties at $17,207.34 ($5,109.43 sales price plus $12,-

097.91) and Canteen Service paid Gladco $432,835.18.

to lease equipment valued by the parties at $780,250.-

.97 ($184,659.85 sales price plus $595,591.12). More-

over, an even greater disparity existed for the period

October 1, 1960, through December, 1962 with respect

to assets costing Gladco a total of $251,197.03 which

were rented to Canteen Service for $208, 176. 08 as of

September 29, 1962.” - .

2) Location Commissions.

In 1946, subsequent to Canteen Service’s incorpora-

tion, it entered into an agreement with Gladco (then

named Buddies Lunch System, Inc) whereby. Gladco:

transferred to Canteen Service its ‘vending machine 'busi-

ness in exchange for payment of location commissions on

| sales of candy, gum ‘and nuts. sold through vending

machines previously operated by Gladco or at locations

where Gladco then operated food dispensing facilities. At

the time, Canteen Service was wholly-owned by Ben

Handwork, and Gladco by Virgil and Nelson Gladieux.

This 1946 agreement was continued and substantially

modified and extended. by the January 31, 1961 agreement.

between Canteen Service :(then controlled by Virgil) and

Gladco (then owned by ABC). An agreement of the same

date between Southeastern and: Gladco established loca-

tion commissions payable from Southeastern to Gladco,

although there is no ——— of a previous ‘agreement

between these parties. .

_In their fiscal year 1961, Canteen Service and South-

eastern. paid or accrued to Gladco location commissions

—

Pee ,

of $134,920.68 and $9,174.57, respectively. In their cor-.

porate income tax returns for that year, they deducted

those amounts as “ordinary and necessary expenses paid

or incurred *:* * in carrying on any trade or business,”

under Section 162 (a) of the Iriternal Revenue Code of

1954, 26 U.S.C. $162(a). :

Of these amounts, the Comacee: disallowed

$74,088.26 and $1,593.84, respectively.» $69,429.16 of Can-

teen Service’s disallowance was attributable to the entire

location commissions at two large corporations, LOF Glass

(Libbey-Owens-Ford) and Toledo Scale. The remaining

amount disallowed to Canteen—$4,659.10~and the full

amount disallowed to Southeastern constituted excess

location commissions corhputed under the higher, rates

determined in the January 31, 1961 agreement but appli-

cable retroactively, beginning October 1, 1960, at a time:

when the 1946 agreement was still in effect.

The Commissioner found, and the Tax Court affirmed, .

that the disallowed portions of the location commissions

were not ‘ ‘ordinary and necessary’ ’ business expenses, nor ®

were they ‘ ‘appropriate and ‘heJpful” to petitioners’ -busi--

ness. See Comim’r v: Tellier, 383 U.S. 687, 689 (1966).

With regard to the location commissions at LOF Glass and

Toledo Scale, the Tax Court stated: ;

“{Plrior to the 1961 agreerhent, imposing in-

creased location commissions on petitioners retro-

actively to. October 1, 1960, Gladco had waived all

commission payments due from Canteen Service on:

the LOF Glass and Toledo Scale business. The waivers .

as to those commission payments occurred at the time

Canteen Service began making location commission

payments directly to the industrial clients, LOF Glass

- and Pbledo Scale. Thus, for several years prior to the

1961 agreement, Canteen Service was not required

~~ to make any location commission payments to Gladco °

eer

11 ae

Glnacs to Gladco. To accomplish this gett

Canteen Service was required to reinstitute location

commission payments to’Gladco dn its LOF Glass‘and |

. Toledo Scale business, which was, of course, in addi-

tion: to the amounts Canteen Service was required to

pay Gladco as ‘purported rental payments. We caw

‘ find no ‘reasonable explanation for reinstituting such

location commissions except as a further :device to

i a the shifting of all petitioners’ income to.

' ladco e record specifically shows,that-at the time

Vira wa was negotiating with representatives ‘of ABC, °

e felt ABC was intending to acquire, by the various -

; agreements, all the operating income of petitioners.

. “Even more objectionable to allowing’ Canteen

Service’s location commissions in question is the fact:

that not only prior to, but for the year in. question,

-Canteen Service paid location commissions ‘directly to

LOF Glass and Toledo Scale for the right to operate

vending machines on the premises of those industrial

‘customers. In 1961, Canteen Service paid to thosp.

customers the. combined amount of $12,401.70 in lo-

cation commissions. In spite of this, petitioners con-|

tend ‘that. they are entitled to deduct the further:

amount? of $69,429.16 paid to Gladco as location com- -

missions for vending machine sales on the premises

of the same two customers. The record fails to re-

flect any business or economic need for Canteen Serv-

ice to make the location gommission payments in ques- ,

tion, and in light of the fact that Canteen Service was

already making payments directly to LOF Glass and -

Toledo Scale, we know of none, Lacking in any mean-

ingful. business purpose we fail to see how the pay-

ment of such obviously unnecessary amounts could

be ‘appropriate and helpful’ for the development of

Canteen Service’s business.” . ,

E _ 12 . a. a s

‘With regard to the additional, rééroactive commissions, the

Court found that the ComgfBsioner had disallowed only *(

that amount which, | Pt Me.

“exceeded tlre commissions ROPE Ener to the

rates in e under the agreement between Canteen

Service and-Gladeo, dated y 46, 1946.. Thus, for

the, period Octgber 1, 1960,- through February 20,

1961, respondent disallowed only $4,659.10 out of

$25,999.22 claimed by Canteen Service and disallowed °

$1,593.84 out of $3,558.36 claimed yby Southeastern.

‘Since respondent has allowed petitiofers\ claimed lo-

cation cofmmissions, although at the lower rates in

effect prior to the 1961 agreements, the only ques-

tion presented is whether respondent correctly dis- .

allowed the retroagtive increases reqyited by the 1961

agreements. .

° “Petitioners contend that the totation commigsions °

were made retroactive to Getober 1, 1960, because that

was the date,. originally contemplated by ABC and

Virgil in their agreement vf June 30, 1960, when the

exchange of Virgil’s 15 companies. vas to -be made in ; e-

* return for ABC stock. This fact is apparently relied

upon by petitioners to justify making the commission -

payments retroactive to October 4; 1960. Even con-

ceding that the October 1 date was set for that pur-

pose, which the record does not necessarily support,

we think petitioners’ position is irrelevant with regard

to the payment of location commissions by Canteen _

Service and Southeastern inasmuch as_the limited

question for our determination is whether the retro-

active payments constituted ordinary and necessary

business expensés to petitioners. Thus, while the Oc-

tober 1 date may have been required in order for Vir-

gil to consummate his deal with ABC, we find no valid

business reason in the record for petitioners to retro-

actively pay increased location commissions for more

than 4 months. The record is devoid of any mean-

ingful economic benefit flowing to petitioners for such —

= .* payments, and consistent with our prior determina-

tion, supra, we think the retroactively increased rates .

_ imposed upon petitioners under their 196l agreements .

with Gladco merely constituted a necessary concession

on Virgil’s , in order to consummate his personal

(Pre, deal with , irrespective of whether such a result

proved ‘appropriate-and helpful’ for the development

of petitioners’ business.”

The question of whether these claimed deductions © *

come within Section 162(a).is a factual determination.

Comm’r v. Heininger, 320 U.S. 467, 475, 88 L.Ed171, me

§ (1943). It is thus reversible, only if clearly erroneous.

Comm’r v. Duberstein, supra. We are of the opinion that

the Tay Court’s findings and conclusions in this regard are

not clearly erroneous.

Petitioners’ principal argument is that the location

commissions were adopted by the 1946 agreement ne-

gotiated at arnf’s length between Canteen Service and

Gladco which were, at that time, owned by separate, un-

‘pelated parties. The 1946 agreement covered only commis-

sions on candy, gum and ‘nuts. Pe 1961 agreements en-

compassed commissions on seven additional items: «coffee,

pastry, milk, ice cream, sandwiches, hot foods, and cig-

arettes. The «146 agreement Was not merely “supple-

' mented” by the 1961 agreement, as petitioners argue, but

“was brpadened and extended manyfold. Ig cannot be con- ~

sidered an erroneous finding that the ‘disallowed loca-

tion commissions were derived from the 1961 agreements,

and failed to serve an excludable business purpose.

_ s a ol ™ 2

3) Denial of Surtax Exemption.

Th 1936 Southeastern Canteen (Co. was organized as a

* Michigan ¢otporation by Virgil Gladieux and Ben T. Hand-

work, who then, were the owners of Canteen Service Co. of

\ -)

Toledo. Later Virgil Gladieux Became its sole shareholder.

Section 11 of the Internal Revenue Code of 1954, 26 U.S.C.

§-11, imposes a tax on the taxable income of corporations

consisting of a normal tax and a surtax. Under Section

11(d); the surtax is not imposed upon the first $25,000 of a

corporation’s taxable income. Both Canteen Service and

Southeastern had claimed his $25,000 surtax exemption

each year. The Commissioner, however, determined: that

Southeastern—which engaged in the same business as

Canteen ‘but in two Soutlieastern Michigan counties while

Canteen operated in Northwest Ohio—was not entitled to

the surtax exemption for its fiscal years ending October 3,

1959, October 1,-1960, and September 30, 1961, on the

authority of Section 269(a) of the Code, 26 U.S.C. § 269

(a), which reads in pertinent part:

“In general—if— , ds

(1) any person or persons acquire, or acquired ~

on or after @@tober 8, 1940, directly or indirectly; con-

* trol of a corporation,

* * x x "8

and the principal purpose for which such acquisition

was made is evasion or avoidance of Federal income ‘ - -

tax by securing the benefit of a deduction, credit, or

other allowance which such ‘person .or corporation

would not otherwise enjoy, then the Secretary or his

delegate may disallow such deduction, credit, or other

allowance: For purposes of-paragraphs (1) and (2) >

control. means the ownership of stock possessing ‘at

least 50 percent of the total combined voting power

of all classes of stock entitled to vote or at least 50

percent of the total walue of shares of all classes of

stock of the corporation.”

Specifically, the Commissioner found that Virgil Gladieux

and Ben Handwork, sole stockholders in Canteen Service,

in 1956 formed or “acquired” Southeastern, of which they

: ae :

became sole stockholders, for the principal purpose of

gaining a second $25,000 surtax exemption.

The Tax Court affirmed this determination, stating,

“Upon a consideration of the entire record, we think the

facts require us to hold that Southeastern was incorporated

in 1956 for the principal purpose of avoiding Federal

‘ income taxes * * *.”

The issue, then, is whether the “principal purpose” of

Southeastern’s acquisition was “avoidance of Federal in-

come tax.” “Principal purpose” is further defined by

Treasury Regulations, Section 1.269-3(a), 26 C-F.R.

§ 1.269-3(a), as follows: y

“If the purpose te evade or avoid Federal income tax

exceeds in importance any other purpose, it is the

principal purpose. This does not mean that only those °

acquisitions fall within the provisions of Section 269

which would not have been made if the evasion or .

avoidance purpose was not present. The determina-

tion of the purpose for which an acquisition was made

requires a scrutiny of the entire circumstances in

which the transaction or course of conduct occurred,

* in connegtion with the tax result claimed to arise

therefr6m.”

. This issue invetVes a factual determination which can be

reversed only if found to be clearly erroneous. Comm’r v.

Duberstein'363 U.S. 278 (1960). The.Commissioner’s dis-,

allowance of the wortax exemption is presumptively cor-

rect, and the burden of disproving such determination by@

preponderance of the evidence is on petitioners. 26 C.F.R.

§ 1.269-5; Welch v. Helvering, 290 U.S. 111, 115, 78 L-Ed.

212, 215 (1933) ; Helvering v. Taylor, 293 U.S. 507, 515, 79

L.Ed. 623, 629 (1935).

We believe, however, that petitioners met their bur-

den of proving by a preponderance of the evidence that the +

‘principal purpose of forming Southeastern was not tax

avoidance. At trial before the Tax Court, the sole witness

.- to testify on this issue was Virgil Gladieux, controlling

stockholder of both Canteen Service and Southeastern at

the time in question. Gladieux testified that no considera-

tion to Federal income tax law was given at the timg of

-Southeastern’s incorporation,’ and that the reason for a

separate corboration was that “w® needed identity, local

identity, and we*needéed a Michigan image.” Respondent

urges that neither this Court nor the Tax Court is bound

to accept the testimony of Gladieux, an interested party,

even though not contradicted, citing Quock Ting v. United

States, 140 U.S. 417 (1891). But this is not to say that

clear, convincing and uncontradicted testimony can be

ignored just because of the interest of the witness. The

correct rule is recited in Quock Ting:

“Undoubtedly, as a general rule, positive testimony as

to a particular fact, uncontradicted by any one, should

control the decision of the court; but that rule admits

of many exceptions. There may be such an inherent

improbability in the statements of a witness as to

induce the-court .or jury to disregard his evidence,

even in the absence of any direct conflicting testi-

‘mony.” 140 US. S. at 420. © ¢

Gladjeux’s testimony went unchallenged by the govern-

ment. This Court has held that “where unimpeached,

competent, and relevant testimony on behalf of a taxpayer

is uncontradicted, it may not be arbitrarily discredited

and disregarded, and the Tax Court cannot reject or ignore

this evidence * * *” Loesch & Green Const. Co. v.

Comm’r, 211 F(2) 210, 212 (6th Cir. 1954). See also,

Tank v. Comm’r, 270 F(2) 477, 487 (6th Cir. 1959). The

*The attorney employed by Gladieux in incorporating

Southeastern, a Mr. Smith, was deceased at the time of heating.

eee 17 ~e

Treasury Regulations indicate that “‘a scrutiny of the entire

circumstances” surrounding the acquisition must be made.

26 C.F.R. § 1.269-3(a). Obeying such Regulations, we are

persuaded that a review of the “entire circumstances’’

substantiates Gladieux’s® testimony. Southeastern was

given a Separate “Michigan image” by Gladieux. Books

and records of Canteen Service and Southeastern were

kept separate and distinct. There were separate ware-

heuses and bank-accounts in Michigan. None of Cantgen’s

inventory was used in Southeastern’s operations. South-

eastern’s two resident mahagers were based in Adrian

and Monroe, Michigan—the county seats of the two Michi-

gan counties Southeastern serviced—rather than in Toledo

where Canteen’s headquarters was located. Virgil

Gladieux had ‘established a. tradition of incorporating a

‘new company whenever he initiated a new, albeit related,

- enterprise. In 1961 he controlled a total of fifteen corpo-

rations, all ‘engaged in the food distribution business.

For example, Ohio corporations, controlled by Gladieux,

operated in-plant feeding at corporations in Ohio whose

vending machines were serviced by Canteen Service, but

in-plant feeding at the Revco Corporation plant in Deer-

field, Michigan—in the vending machine territory of

Southeastern—was performed by Buddies Lunch System,

a Gladieux-controlled Michigan corporation.

The Tax Court sought to tarnish Gladieux’s ““Michigan.

image” argument by noting that “the franchise agreement

urfer which Southeastern obtained virtually all its vend- .

ing machines, specifically prohibited Southeastern from

using its name on the vending machines in a manner which

would give the appearance that Southeastern was the

owner of the machines.” (Emphasis supplied.) The

franchise agreement, however, permitted Southeastern to

advertise’on the machines that it was servicing them.

In this way, Southeastern was able to effectively present a

“Michigan image” to the public.

“ A recent Court of Claims case parallels the instant

case in some respects. In Louisville Store of Liberty, Ky.,

Inc. v. United States, 179 Ct. Cl. 847, 376 F(2) 314-1967),

a partnership consisting of five related partners owned ~

‘ thirteen clothing stores in nine Kentucky towns. In 1959,

the partners incorporated eleven of the stores in eleven

separate corporations. The Commissioner, relying on’:

Section 269, allowed but one surtax exemption to the

entire group of corporations. The Court of Claims, adopt-

ing the opinion of Court Commissioner Day, determined ~

- that the purpose of incorporation of the companies was not

principally to avoid tax within the meaning of Section 269,

and held that each company was entitled to the benefit

of the $25,000 surtax exemption. , The Commissioner’s

opinion agreed with the United States Senate Finance

Committee that, where corporations controlled by the same

persons engage in the same type business in different

_geographic locations, there are legitimate business reasons _

for establishing arate corporations.

“Congress, in considering the Reyeriue Act of 1964,

reviewed the application ofathe provisions of section

269, concluding that’ there were jhdeed legitimate

business reasons in the use of multiple corporations

where corporations owned or controlled’ by the same

interests, as here, conduct the same type of business.

in different geographical locales, as here. The Senate

Finance Committee made the following comment in

this connection:

While the House and your committee recognize the

advantages of use of multiple-corporations, it is be-

lieved, as it has. been in the past, that, where cor-

porations owned and controlled by the same interests

engage in different businesses in the same area or

- conduct the same type business in different geographi-

cal locales, there are legitimate business reasons for

use of separate corporations and, therefore, the sepa-

rate corporations should generally be recognized as

separate taxpayers, retaining the benefit of use of

multiple surtax exemptions. However, the House and

- your committee do not intend to encourage the forma-

tion of these multiple corporations and therefore

propose to apply higher tax Yates to corporations

-which are members of an affiliated group of corpe-

rations. Of course, nothing in this bill is intended as

changing the application of sections 269, 1551, or 482

if the multiple corporation form of organization is

adopted ‘to avoid taxes.’

“Sen. Rep. 830, 88th‘Cong. 2d Sess., pp. 149-150, Cum.

Bull. 1964-1 (Part 2) pp. 653-654.

“The House Ways and Means Committee adopted

similar language in its. report on the same subject.

See H.R. Rep. No. 749, 88th Cong. 1st Sess. Cum. Bull.

1964-1 (Part 2) p. 242.” 376 F(2) at 319.

Such, in substance, were the holdings in Bush Hog Mfg.

| Co., 42 T.C. 713, 726-729 (1964), and V. H. Monette & Co.,

45 T.C. 15, 33-35 (1965), aff'd on other grounds, 374 ities

116 (4th Cir. 1967). :

We hold that, under tHe circumstances where the

controlling stockholder of both the parent and acquired

corporation testified that the reason for creating a separate

corporation to engage in the same business in a different.

geographic location was to present a local image and was.

‘not tax avoidance, where the testimony was uncon-

troverted and unimpeached, and where there was sub-

stantial evidence to corroborate his testimony regarding -

the presentation of the local image; it was impropgg for -

the Commissioner to deny the acquired corporation its

| 20° oe

$25,000 surtax exemption. To the extent that this holding

may be factually inconsistent with the Tax Court’s find-

ings of fact, we hold, obedient to Comm’r v. Duberstein,

supra, that its findings are clearly erroneous. |

The judgment of the Tax Court sustained the Com-

missioner’s disallowance of rental and location, commis-

its is affirmed; the judgment of the Tax Court

Commissioner’s disallowance of the surtax

exemption as to Southeastern Canteeg Co. is reversed and

vacated. Each party shall pay its own costs. iF

—_, ne

° +

~ *

bi RS ao

m~, =

; i

_ APPENDIX B.

MEMORANDUM FINDINGS OF FACT AND OPINION OF

__. THE UNITED STATES TAX COURT. a.

(Filed September 19, 1967°)

WitHey, Judge: Respondent. determined deficiencies ~

in petitioners’ income tax for the yéars and i in the amounts

as follows: ar Rane

ee aia ag

oe, Docket Taxable - ? °

; Petitioner No. year ended: Deficiency

Southeastern Canteen Oct. 341959 _ -§ 4,936.32;

Co. ' 4301-64 ~ Oct. 1, 1960 ‘5,458.

_Canteen Service Co. Sept. 30, 1961. 6,194.61

of Toledo 4302-64 Sept: 30, 1961 _ .- 58,863.73

The cases have been consolidated and will be decided

together. ¢

The issues for decision are:

mes) Whether the purported rentals paid or accrued

in Sole of the Gladieux Corporation by petitioners for

_ their fiscal year ended September 30, 1961, constitute

allowable deductions their respective gross incomes

in that year, pursuan ° section 162 (a) (3) of the Internal

--Revenue Code of 1954

(2) Whether the nen commissions paid or ac-

crued in favor of the Gladieux Corporation by petitioners

for their fiscal year ended September 30, 1961, constitute

allowable deductions from their respective ¥ross incomes

-in that year, pursuant to section! 162(a) of the Code.

(3) Whether respondent properly disallowed South-

eastern Canteen Co. a statutory surtax exemption for its

fiscal years ended October 3, 1959, October 1, 1960, and

September,30, 1961, pursuant to section 269 or 1551 of’

the Code.

on7

1 All statutory veherences henetaiiiinn’ are to the Internal Rev-

enue Code of 1954.

ry a

ee ee a f

- FINDINGS OF FACT.

Some of the facts have been stipulated and are found,

accordingly. ; es

dane Canteen Service Co.: ‘of Toledo (hereinafter

“gy

ie J

called Canteen Service) is, and at at all times pertinent

hereto was, ‘a corporation incorpqrated March 16, 1946,

under the laws of the State .of Ohio with its priticipal

offi¢e i in Toledo, Ohio. :For’the tax year ended September

30, 1961, Canteeri Service filed its. corporate income tax

return with the district director at Cleveland, Ohio, listing

its corporate address as 3156 Bellevue Road, Toledo 6,

Ohio. ,: ee .

Petitioner Southeastern Canteen¢:Co. (hereinafter

Southeastern) is, and-at all times pertinent hereto was, a

corporation incorporated under the laws of the State of ©

Michigan on January 19, 1956. Its registered office was in

Detroit, Michigan, and its corporate officers weresyoused

in Toledo, Ohio. For the tax years ended October 3, 1959, —

October 1, 1960; and September. 30, 1961, ‘Southeastern

filed its corporate income tax returns with the district

director at Cleveland, Ohio, listing its. cofporate address

as 3156 Bellevue Road, Toledo 6; Ohio.

At the time Canteen Service was. incorporated, its .

entire capital common “stock was issued’ to Ben T. ‘Hand-

work Hae Handwork) in exchange, among other: .

things, for the use by Canteen Service .pf a franchise

. previously granted to Handwork by Automatic Canteen ,

Company of America (hereinafter sometimes Automatic)

for the sale of candy, gum, nuts, and related items +

through vending machines. In early: 1953, Canteen Serv-

ice, with the oral permission,of Automatic, began oper-

ating eight.canteen locations at the Revco Manufacturing

' Co. in Deerfield, Lenawee County, Michigan. On May 15,

1956, Canteen Service filed a notice of withdravhl with

/ i * a

a ® °

t 23

the Michigan . Corporation and Securities Commisssion

me 7

"and, subsequent to that date, no longer conducted business »

in: Michigan.

- During the tax year involving Canteen Service, 1961,

its books and records were maintained under the accrual’

system of accounting and the 13-period system of tabu-

lating its income and expénses was employed, each such

pgriod consisting of 4 weeks. During that year, Canteen

Service sold’ food and beverages through vending . ma-

chines in certain territories in western Ohio, such terri-

tories being among those originally designated in_a °

-. franchise and distributor’s lease agreement entered into

between Automatic and Handwork on July 6, 1947, and

assigned to Canteen Service on that day by Handwork

with the consent of Automatic. Under this franchise and

lease agreement, Canteen Service leased. canteens’ from

Automatic in its-fiscal year 1961, in numbers varying from

1,627 to 1 676, and reported to Automatic gross sa from

those canteens of $1,318,901. C teenService re d on

its tax return for fiscal 1961, gross sales of $1,651, 490.29."

Upon the incorporation of Southeastern in. 1956, its

authorized capital stock consisted of 1,000 common shares

of the par value of $50. Of that amount, Virgil Gladieux

(hereinafter sometimes referred to as Virgil) ‘and Hand-

work subscribed for 15 shargs and-5 shares, respectively.

- On July 21,.1959,-Southeagtern redeeméd“the 5 shares.

‘owned by Handwork which redemption resulted in Virgil's

becoming the owner-of Southeastern’s entire ‘outstanding

common stock. :

2 Under the franchise and lease agreement, a “Canteen” was

defined as a candy, gum, nut, or other vending machine, al-

though that word will sometimes be used hereinafter to desig- .

nate more than gne such machine at a given location.

+ The additional revenue reported on its tax return was‘at-

tributable to vending | machines owned. oainagnt ‘by Canteen

Service. a

ci &

' ; > oe

During the tax years involving Southeastern, its

\ books were maintained under the acerual System of ac-

counting and the 13-period system of tabulating its iricome’

and expenses was employed, each such period conSitiag

of 4 weeks. During those years, Southeastern had_the\ex-

clusive rights to the sale of food and beverages through

vending machines in Lenawee and Monroe Counties in

southeastern Michigan, such countiés being among: those

originally designated in a franchise and distributor’s lease

agreement entered into* between Automatic and Hand-

work on January 20, 1956, and assigned to Southeastern

on that day by Handwork with the consent of Automatic.

Under this franchise and lease agreement, Southeastern *

. leased canteens from Automatic in its fiscal year 1961, in

numbers varying from 252 to 273, and reported to Auto-

matic gross sales-from these canteens of $185,469.

j Southeastern’ s franchise from Automatic provided

. not only for exclusive territory but also for the leasing

of canteens from Automatic to Southeastern for fent. It

also provided that Southeastern was to periodically de-

‘ liver to Automatic a report ofthe canteen sales, from which

such rentals were determined. It provided further that ~

title to the rented canteens was to remain a in Automatic, _

that Southeastern -was prohibited from attaching its name

to the canteens except to show that it was servicing such

equipment, that the franchise could be canceled. under :

certain circumstances, and that a sum of $50 would be

payable’ by Southeastern to Automatic, as liquidated

damages, for each canteen if either the franchise was

canceled or if there was any interference by Southeastern

with the continued ownership and use of such: canteen

location. by . Automatic. The franchise further provided

‘that if Handwork disposed of, or attempted to dispose of

the franchise bysale, assignment, transfer, rent, or sub-

“. 2S

lease, without the prior consent of Automatic, the franchise

agreement was to be null and void.

Southeastern commenced business on January "21,

1956,-starting its route operations with vending machines, —

inventory, and trucks. As of that date, Southeastern’s

capital was $1,000. On January 23, 1956, Southeastern’s

directors, at their first board meeting, adopted resolutions,

among other things, to purchase vending machines from

Automatic and to open an account at a bank in Mor-

roe, Michigan. Southeastérn employed a resident of each

of those countiés to supervise the company’s operations. .

Thus, at its inception, Southeastern’s operations were con-

ducted frem the Michigan residences of those two em-

ployees. Later, Southeastern established warehouse and

refrigeration facilities in Monroe County, Michigan. Al-

though Southeastern acquired certain operating =~ and

leased vendirig machines from Automatic, as providgd in

its franchise agreement, Automatic had no stock interest

in Southeastern.

Prior to May 10, 1946, the Gladieux ‘Corporation

(hereinafter Gladco)* was principally engaged in the

_ business of operating cafeterias and lunch counters, and

dispensing -food in several manufacturing plants in the

city of Toledo and vicinity. It also sold candy, gum, and

nuts both over its counters and through vending machines

-at such food locations, at gas stations, and other locations.

Gladco’s books and records were maintained on the ac-

crual system of acequnting and on a calendar year basis.

* Gladieux Corporation’s predecessor business was incor-

porated in 1931 under the name of Buddies Box Lunch, Inc. It

was Only after three corporate name changes that the name of

the business became Gladieux Corporation,on November 2, 1960.

To avoid confusion, use of the name Gladco will be used to refer

to the same business, both before and after its name became ©

Gladieux Corporation.

26 cae

As of May 10, 1946, Gladco’s- outstanding capital stock -

was. owned equally by Virgil Gladieux and his brother

Nelson. On May 25, 1955, Virgil became the sole stock-

holder of Gladco.

. On May 10, 1946, an agreement was entered into be-

tween Gladce and the Gladieux brothers, on the one handy~

and Canteen Service ‘and Handwork; on the other. ‘Pur-

suant to the agreement, Gladco transferred its vending

machine business in Lucas, Fulton, and Wood Counties,

Ohio, to Canteen Service. The agreement provided, in

part, that Canteen Service would pay Gladco a 12. per-

cent commission on all gross sales of candy, gum, and

nuts sold by Canteen Service through vending machirfes

at all locations within Lucas, Fulton, and Wood Counties,

Ohio, where Gladco “now or hereafter operate|s| cafete-

rias, lunch counters or other food dispensing facilities.”

Pursuant to that provision and prior to 1958, Canteen __

Service paid a 12 percent location Comfmission to Gladco —

on sales made by Canteen Service through vending ma-

chines located at the facilities of Libbey-Owens-Ford Glass

Company (hereinafter LOF Glass). The 1946 agreement

further. provided that Cantéen Service would assume

Gladco’s obligation.to pay to the owners.of the locations

where Gladco vending machines were operated, but where

no counter food was sold, an 8 percent commission on the »

gross sales of candy, gum, and nuts sold through vending

_ Machines. It was provided, however, that Canteen Serv-

ice would not be required to pay Gladco’ any commis-

_ sion on sales made.through vending machines at such

locations.”

* While Southeastern never entered into any written agree-

ment respecting payment of location commissions to Gladco, it

followed the same pattern of paying such commissions on vending

business generated by Gladco’s in-plant feeding business as did

Canteen Service.

é a 27

Prior to 1958, Canteen Service had paid location com-

missions to Virgil on the LOF Glass business. In ‘1958,

LOF Glass negotiated for location commissions to be paid .

directly to it by Canteen Service. Subsequently, Canteen

Service, as the result of a waiver by*Virgil and the

Gladieux interests, neither paid nor accrued any~further

location ‘commissions to Virgil or Gladco on_,the LOF

Glass business until October 1, 1960, when such payments

were again required pursuant to the sale-leaseback agree-

ment between Canteen Service and Gladco, dated January

1, 1961. ‘

Beginning in 1953,-Canteen Service paid location

commissions to Toledo Scale. Although Canteen Service

did not pay Virgil or Gladco additional location commis-

sions, as a result of negotiations between Virgil and

Toledo Scale in 1955 or 1956, Toledo Scale thereafter re-

mitted to Gladco approximately 85 percent of the commis-

sions received by Toledo Scale from Canteen Service.

Canteen Service, however, never paid or accrued location

commissions directly to Gladco for vending machine sales

at Toledo Scale until October 1, 1960, pursuant to the

sale-leaseback agreement between Canteen Service and

Gladco, dated January 31, 1961. >

The transfer of Gladco’s vending operations to Can-

teen Service, pursuant to the agreement of May 10, 1946, —

appealed strongly to Virgil for financial reasons since, -

pursuant to Automatic’s franchise arrangement _under

.which Canteen Servicd was then operating, Canteen Serv-

ice could lease its vending equipment from Automatic

whereas up to that time Gladco was compelled to purchase

such equipment. thereby limiting its figancial resources.

for expansion. The agreement also appealed to Gladco

inasmuch’ as it provided an option pursuant to which

Gladco could purchase up to 75 percent of the stock in

Canteen Service on or before October 31, 1946. In the

event such option was exercised and in the further event

Handwork or Gladco later wished to sell their respective

stockholdings, they were required to offer them to each

other under a reciprocal right of first refusal. Gladco later

‘exercised its right of purchase, and as a result of Cantéen

Service’s subsequent redemption of Handwork’s 25 fer-

cent stock interest in Canteen Service, Gladco became the

sole owner of Canteen Service.

After May 10, 1946, as vending machines. were

adapted to handle food products other than candy, gum,

and nuts, such as milk, coffee, and ice cream, Virgil and

Gladco exacted varying. rates of location commissions

from Canteen Service depending upon the relative profit

margins of the foods being vended as well as the amount

of location commissions Gladco was required to pay to its

industrial clients. Thus in time there arose an incon-

sistent pattern of location commissions — to Gladco

by Canteen Service. :

On.or about Decethber 4, 1953, Gladco began operat-

ing a restaurant and cafeteria at the plant and facilities of ~

Toledo Scale Co. of Toledo, Ohio (hereinafter Toledo

Scale), and continued such operations throughout Can-

teen Service’s taxable year in question. Also, about De-

cember 4, 1953, Canteen Service was permitted to install

canteens at nine different plant locations of Toledo Scale.

Fora period occurring between 1953 and 1960, Gladeo

waived the location commissions payable to it by Canteen

Service’ on the Toledo Scale business and. did not again

require commission payments to be made to it on that

business until the sale-leaseback agreement entered into

between it and Canteen Service on January 31, 1961,

which agreement increased such commission payments

retroactively to October 1, 1960. 2

_ Gladco, during the years in question, operated various

food systems, such-as in-plant employees feeding concerns,

cafeterias, snack bars, and dining rooms. During those

years and until February 2, 1961, of the outstanding capital

stock of Gladco, consisting “of 500 no par common es,

499 shares were owned by 7 and the remaining share

by his wife.

On June 30, 1960, Virgil and his wife owned .the

entire outstanding capital stock of 15 corporations en=

gaged in the merchandising and vending of food, bever-

ages, cigarettes, and gum> Included among those 15

corporations were Canteen Service, Southeastern, and _

~ Gladco.

Immediately prior to June 30, 1960, ABC Vending

Corporation (whose name has since been changed to ABC :

Consolidated Corporation and hereinafter will be re-

ferred to as ABC) was primarily engaged in the food and

beverage merchandising and vending business with book

‘net worth in excess of $16/million and with annual sales

from its vending business exceeding $60 million. At that

time, ABC was a publicly owned corporation with stock

listed on the New York Stock Exchange. In January of

1961, it had 8,522 shareholders who owned 1,228,328

shares of = are stock. Additionally, it held 48,960

shares of treasury stock. Prior to February 2, 1961,

neither. Virgil nor his wife owned any capital stock of

ABC... *

On June 30, 1960, ABC and Virgil entered into an

agreement whereby Virgil agreed, among other things, to

transfer to ABC all of the outstanding capital stock of the

15 corporations owned by him and his wife, in exchange

for 80,000 shares of the capital common stock of ABC. The

agreement provided that Virgil was to be retained by ABC

in a “major managerial capacity” at an annual salary of

$62,500 for 5 years, after which his salary would be

reased to $67,500. The agreement further provided

that ABC would deliver to Virgil a stock option certificate

giving him the right to acquire 5,000 shares of ABC com-

mon stock at a price equal to 85,-percent of the market

value-of -the stock on the New York Stock Exchange on

the date of settlement-of the foregoing agreement.

Automatic, relyifig on the provisions of the franchise

agreement. which it had entered into with Canteen Serv-

ice on July 1, 1947, refused to consent to Virgil’s attempted

transfer to ABC of.the outstanding capital stock of Can- =

teen Service and Southeastern.” Pursuant to a section of

that agreement which defined the procedure for handling

a dispute as to petitioners’ right to transfer, Automatic’s

refusal to consent to the sale and transfer was submitted

to arbitration. On December 27, 1960,.the arbitration tri-

bunal decided that the withholding of such consent by

Automatic .was not unreasonable, arbitrary, or capricious.»

Subsequent to the arbitration decision, Virgil and

ABC executed a “Stpplemental Agreement” on.January ~

26/ 1961, amending their agreement of June, 30, 1960, by’

inating from the 1960 agreement the requirement that

irgil transfer the outstanding stock of Canteen Service

and Southeastern to ABC. The “amendatory. agreement

also reduced the number of ABC shares to be delivered to

Virgil from 80,000 to 68,500.

Also,’on January 26, 1961, Virgil, A resilient

Service, Southeastern, and Gladco executed an a ent

which provided that since Virgil was no longer able to ~

' transfer petitioners’ stock to ABC, Gladco and petitioners |

not, without the consent of Automatic, sell, assign, or transfer

any interest in the agreement. It further provided that Auto-

matic would not “unreasonably, arbitrarily or capriciously” with- ~

hold its consent to sueha sale, assignment, or transfer.

“The franchise agreement poh that petitioner could

“

would enter into an agreement which would ‘provide,

among other things, that: (1) petitioners would sell and

transfer to Gladco their designated tangible physical assets

in the. following amounts: $184,659.85 as to Canteen

Service and $5,109.43 as to Southeastern;’ (2) Gladco

would lease back to petitioners all such assets for a term

of 20 years from October 1, 1960,, with the further agree-

ment that during that term Gladco would provide and

lease to petitioners “all additional equipment necéssary

for the operation of the vending machine business” con-

_,ducted by petitioners; A3) petitioners.wotld pay to Glad-

co for such leased assets a “rental” equal to 10 percent of

the gross sales from the vending machine business “on

and after October 1, 1960, and-until the end of the term

of the said lease’ and any extended term thereof’;” (4)

such “rentals” were not to be such in ‘amount as would

create a deficit in net income: of Ses aan het in-

come being computed— :

* The amount Gladco agreed to pay petitioners for their

»tangible physical assets constituted their net book value, after

accrued depreciation as shown on petitioners’ books ‘as of October

1, 1960. Included in. such .assets trahsferred were 299 vend-

ing machines owned by Canteen. Service and 4 vending ma-

chines owned by Southeastern. Journal entries reflecting the

sale were posted on the books of Gladco and each petitioner on

February 18, 1961. -

* For the period October 1, 1960, ‘through December’ 27, 1964,

Gladco purchased “additional equipment” for lease to petitioners

in the following amounts: As to Canteen Service, $595,591.12, and

as to Southeastern, $12,097.91. For the period October 1, 1960,

through-December 1962, “additional equipment” in the amount

of $66,537.18 was purchased for Canteen Service.

® For the period. October 1,-1960, through October 3, 1964,

*petitioners made “rental” payments to Gladco in the following

amounts: Canteen Service, $432,835.18 and Southeastern,

$62,487.98. For the period Octéber 1, 1960, through September

1962, Canteen Service made “rental” payments to Gladco totaling

$208,176.58. i es oo

\ Dea

~- ae

before Federal ‘income taxes and before any salaries ~

or expenses paid to or attributable to Virgil A.

Gladieux or any member of his family, * * *

(5) any.incdme, loss, ‘or expense of petitioners “derived

_ from or attributable. to’ marketable securities or any other -

investment not germane to the operation of the vending

machine business” was to, be excluded from the deter-

mination of such net income; (6) petitioners were to pay

increased fixed location commissions to Gladco ‘as of

' October 1, 1960, -with respect to all sales at all vending

locations derived through Virgil, Gladco, or any affiliated

_ corporations; and (7) Gladco could, at its option, extend

the lease provisions for four consecutive periods of 20

years each. An agreement,. dated January. 31, 1961, con-

taining the foregoing provisions, was executed by Gladco

with Ae petitioner.’ On February 2, 1961, pursuant

to the terms of the. oe Agreement” between

Virgil and ABC, ABC ‘delivered. 68,500 shares of its capi- |

tal common: stock to Virgil and his wife in the respective

amounts of 54,200 ‘and 14,300 “shares. On that same

day, Virgil and. his wife transferred to ABC the outstand-

ing shares of Stock in 13 corporations swholly. owned by

them, constituting all of the corporations referred to in

the agreement ‘dated June 30, -1960, with, the exception of

Canteen. Service and ; Southeastern. .

1 During the itieiiibaiiene ‘between ABC and Virgil in the

latter part of 1960 and early part of 1961, which culminated in

. the January 1961 agreements, Virgil was of the view that the

representatives of ABC contemplated that the sale-leaseback ar- _

rangements provided for in those agreements would take most

of tioners’ profits. As anticipated, the leaseback arrange-

: inf pcorbed all of the profits, with the exception of divi-

nds from petitioners’ ABC stock, of Canteen Service for its

1961 through 1963 fiscal years, and Southeastern for its 1961

throughp 1964 fiscal years.-

The $184,659.85 received by Canteen Service under

‘the January 31, 1961, agreement, together with an addi-

tional $201,827.30 of its other funds, was used by Can-

teen Service to purchase’ shares of ABC stock in the

‘spring of 1961. Similarly, the $5,109.43 received by South=

eastern under the Jaguary 3¥, 1961, agreement, together

with an additional $52,863.64 of its other funds, was used.

by Southeastern to purchase ABC stock w the spring of

1961.'' The total investment by petitioners of $444,460.22 .

in' the spring of 1961, was used to purchase 11,500 shares

‘of ABC stock.

During the negotiations between ABC and Virgil

_ which were carried on beth before and after the arbitration

decision, Canteen Service was the owner of an 8'4-acre

parcel of vacant land, purchased by it in 1959, and located

-in Toledo, Ohio. Efforts were then being made by Canteen

‘Service to sell the property and on April 27, 1961, the

property was sold for $75,000 resulting in a net gain to

Canteen Service, after expenses of sale, of $33,238.50.

This property was not included in the assets of Canteen

Service sold to Gladco Ander the agreement dated January

31, 1961, and Gladco at no time held title to this property. .

. For the fistal year ended September 30, 1961, Canteen

Service.paid or acerued on its books as a liability in favor

of,Gladco, as purported rentals under the January 31»

1961, agreement, the-sum of $121,172.15, including an

amount of $28,897.95 with ‘respect to the 842-acre parcel

11 Although theJanuary 31, 1961, agreement between Gladco

and each petitioner’ provided that Gladco would deliver to each

petitioner its promissory note in the amount of the respective

purchase price, the journal entries on éhe books of Canteen

Service and Southeastern, recording the sale of assets to Gladco,

recited that Gladcod “gave a note to ABC Vendiig Corporation

for * * * [stated dollar amount] and we received check from

ABC Vending Corporation.” xe

- ment of January 31, 1961, thus

34 ‘

‘sold by Canteen Service on April 27, 1961.7? Canteen

Service subsequently deducted the purported rentals .

- from its gross income for its fiscal year 1961. During the

calendar years 1960 and 1961, Gladco included as: rental

_ income, in its taxable income, the amount of $1215172.15

so paid to it or accrued as a liability in its favor by Canteen “

Service. Respondent allowed Canteen Servite a rental .

deduction in the amount of $53,592.79 for the \fiscal year

ended September 30,1961. The amount so allowed consti-.

tuted the total depreciation, on a straight: line’ method with ©

various lives, charged off and deducted as an expense by -

Canteen Service for the fiscal year ended October 1, 1960,

on the buildings; improvements, trucks, machinery, equip-

ment, furniture, fixtures, and vending machines trans-

ferred by Canteen Service to sap pursuant to the agree-

isallowing as a deduction

from the taxable income of Canteen - Service $67; sah 36

of such rentals so paid or accrued. tip

During the fiscal. year ended September 30, 1961,

‘ Southeastern paid or accrued on its books as a liability in

favor of Gladco, as purported rentals under the January~

31, 1961, agreement, the sum of $12,211.30. Southeastern

_ subsequently deducted the purported rentals from its gross

income for its fiscal year 1961. ‘During the calendar years

1960 and 1961, Gladco included as rental income in ‘its

‘ taxable income the amount of such rentals so paid to it

or accrued as a liability in its favor by Southgastern during

_ the fiscal year ended September 30, 1961. Respondent

allowed Southeastern a rental deduction in the amdtnt of

sees 59, for the fiscal year ended September. 20, 1961.

12 2 Durkag a suanitiiiitiiies between Virgil anil representa-

tives of ABC leading to the agreements of January 1961, it was

agreed, that’ the profit from the sale of this land would be in-

cluded in the operating income of Canteen Service for the pur-

pose of computing “rentals” under the contemplated’ contracts.

;

35 ;

The amount so allowed constituted the total depreciation,

on a straight line method with various lives, charged off

! _, and deducted as an expense by Southeastern for the fiscal

ma, = ended ‘October 1, 1960; on the trucks, furniture, fix-

ures, and vending machines assigned by Southeastern to

Gladco pursuant to the agreement of January 31, 1961,

~ thus disallowing as a deduction from the taxable income

of Southeastern $10,304.71 of such rentals so: paid or

accrued. : é

For the accounting periods ended October 29, 1960,

November 26, 1960, December 24, 1960, January 22, 1961,

and February.20, 1961, location commissions. payable by |

Canteen Service to Gladco under their agreement of’

. January 31, 1961, were retroactively increased and ac-

crued, from and after October 1, 1960, by journal entries

made to the books of Caiiteen Service on March 18, 1961.

* “On April 15, 1961, Canteen Service paid these accruals to

Gladco. The foregoing location. commissions, as well as

the location commissions paid or accrued for the account-

ing periods of Canteen Service commencing February 24,

1961, and ended September 30, 1961, together with the 4

» Portions thereof which were allowed and disallowed by |

-. the Comfflissioner were as, follows:"* |

8 :

'? In addition to locations commissions wail or accrued to

Gladco by Canteen Service for its fiscal year 1961, Canteen Serv-

ice also paid such commissions directly to. LOF Glass in the

amount of $8,656.76 and to Toledo Seale in the amount of

$3,744.94.

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———

a 37

Rcsstien commissions in the amount of $74,088.26

+ which were paid or accrued by Canteen Service for the

fiscal. year ended September 30, 1961, and which were

disallowed by respondent as a deduction from the gross

income of-Canteen Service for Federal income tax pur-

poses for said fiscal year; were included in the taxable in-

come of the following corporations in-the amounts and for

the taxable years as follows?

. Includ by Gladco in its 1960 Federal

eee e tax return _ $24,286.68

y Gladco in its 961 Federal

income tak return 44,213.28

Included by Buddies of Lucas County, .

Inc. (one of the Gladco-companies

acquired by ABC) in its, 1961

Federal income tax return. _ 5,588.30

Total , + 74,088.26

For the accounting ert, ended October 29, 1960,

November 26, 1960, December 24,1960, January 22.1961,

and February 20, 1961, location commissions payable by _

Southeastern to Gladco under their agreement of January

31, 1961, were retroactively increased and accrued, from

and after October 1, 1960, by journal entries made to the

books of Southeastern on March 18, 1961. The foregoing

location commissions, as. well as the location commissions

paid or accrued for the accounting periods of Southeasigfh

commencing February 21, 1961, and ended September 30,

1961, together with the portions thereof which were al-

lowed and disallowed by the Commissioner, are as follows:

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‘in the amount of $1,593.84

ons

which were paid or accrued by Southeastern for the fiscal

ion commissi

Locat

1S-

and which were d

year ended September 30, 1961,

-gross in-

allowed by respondent as a deduction from the

came of Southeastern for Federal inc

e tax purposes for

said fiscal year, were included in the taxable income of

Gladco in its Federal income tax returns as follows:

. For the yéar 1960 $995.63

' For the year 1961 ? 598.21

| ase see an > 1,593.84

3 i | | ;

OPINION. . :

FENN 1. Purportep RENTAL Péveciers.

_ For the fiscal year ended September 30, 1961, Can-

teen Service and Southeastern claimed as a deduction for

purported rental payrgents, the respective amounts of

$121;172.15 and $12,211.30, constituting the amounts. they

paid Gladco under certain‘sale-leaseback agreements dated

January 31, 1961. Respondent has determined that the

amounts so claimed are excessive to the extent that they

exceed $53,592.79 as to Canteen Service and $1,906.59

as to Southeastern. Petitioners’ principal contention

appears-o be that since the contracts imposing the ques-

tioned rentals were the result of arm’s length negotiation

between unrelated parties having adverse interests, the

claimed rental deductions are not subject to attack by |

respondent as being unreasonable. Thus, it is argued that

under the relevant statutory provision, section 162(a) (3)

. of the 1954 Code," if the purported rentals were required

‘tn hae geld pee: to-an-arm’s length agreement, the ©

14 Sec. 162. TrapE or Business EXPENSES.

(a) In General.—There shall be allowed as a deduction all

the ordinary and necessary expenses paid or: incurred during the

taxable year in carrying on_any trade or -business, including—-

* * * x * cis.

(3) snails or her payments required to be made as a

condition to the continued. use of possession, for purposes of

the trade or business, of property to which the taxpayer has

not taken or is not taking title or in which he has no equity.

- 40

reasonableness of the rentals so paid cannot be judicially

assailed. In considering a similar contention in Roland P.

Place, 17 T. C. 199, 203 (1951), affd. 199 F.2d 373 (C.A. 6,.

1952), certforari denied 334 U. S. 927 (1953), this Court

stated:

The basic. question is not whether ine sums —

: claimed as a rental deduction were reasonable in

amount but rather whether. they were in fact rent

instead of something else paid under the guise of rent.

The inquiry is whether the petitioner was in fact and

at law “required” to pay these sums as rent: * * *

When there is a close relationship between lessor and

lessee and §& addition’ there is no arm’s length deal-

ing between: them, an inquiry into what constitutes

reasonable rental is necessary to determine whether

the sum paid is in excess of what the lessee would

have been required to pay had he dealt at arm’s s Jength

with a stranger. * * ** \

Even though petitioners’ contention might be correct if the

purported rentals at issue were in fact.arrived at as the

result of arm’s length negotiation between adverse parties,

it is incumbent upon this Court, to determine, in the first

instance, whether such is in fact the case. In an attempt

to support their position, that the sale-leaseback agree-

ments were arrived at by arm’s length negotiation between

ayose out of negotiations between representatives of ABC,

Who, on the one hand, were representing Gladco, and

| Visi, who, on‘ the other hand, pas representing peti-

tioners. According to this theory, since ABC was to ac:

quire Gladco from Virgil, ABC was interested in securing

the best possible rental agreement for Gladco, whereas

15 To the same effect, see J. J. Kirk, Inc., 34 T. C. 130 (1960),

affd. per curiam 289 F. 2d 935 (C. A. 6, 1961); Southern Ford

Tractor Corporation, 29 T. C. 833 (1958) ; and E-Z Sew Enter-

prises, Inc. v. United States, 260 F. Supp 100 (E. D. Mich. 1466).

Of ~

- Virgil, being the owner of Canteen Service and South-

eastern, was striving to— .

1.. maintain -the close relationship ake had:

theretofore existed between Gladieux Corporation and

Petitioners, since Gladieux Corporation had generated

more than seventy-five per cent (75% ) of the vending |

business enjoyed by Petitioners,

2. assure the Petitioners against any operating.

loss as the result of the rental arrangement, and

3. assure’ the Petitioners of the availability of

funds for expansion, for acquisitions of other vending _

compaMies which he then had in mind and for the

eventual purchase by Gladieux Corporation of the

vending machines then. being rented by the Peti- -

tioners from Automatic at no additional cost to

Petitioners. -

1 While the. foregoing objectives may have existed in

Virgil’s mind prior to the execution of the sale-leaseback

agreements, we are convinced, from a thorough considera-

tion of the entire record, that such objectives were sub-

servient, to Virgil’s principal objective of consummating

sa business deal with ABC along the lines established by

their agreement of June 30, 1960. .

- Thus, the true motivating force for the sale-leaseback

agreements was a ee on the part of Virgil to transfer

his interest in his food service companies in exchange for

an executive position with ABC at a starting salary of

$62,500, acquisition of 80,000.shares of ABC stock, and.a

stock optign for an additional 5, 000 shares of ABC stock

at 85 percent of market value. However, when Automatic,

who was petitioners’ franchisor as well as a competitor of

ABC, objected to the transfer of petitioners’ stock to ABC,

and that objection was upheld by an arbitration award, it

became necessary for Virgil to devise an alternative plan.

for accomplishing the same results without transferring

tee

petitioners’ stock to ABC. As shown by the-record, Virgil

¢ and ABC agreed to a plan whereby Virgil would transfer

ownership in 13 of his 15 companies to ABC, and funnel —

the profits of the remaining 2 companies, Canteen Service »

* and Southeastern, into Gladco by way of the sale-leaseback

agreements. While that plan did not secure to ABC the

ownership ‘of all 15 of Virgil’s. food service companies asg

ABC originally desired, the effect of the several agree-

ments between the parties accomplished much the same |

thing inasmuch as ABC acquired stock ownership in 13 of

the 15 companies and received, under the provisions of the

sale-leaseback agreements, virtually all the profits of Can-

teen Service and-Southeastern. Virgil, on the other hand,

obtained his executive position with ABC, rezeived 68,500

- shares of ABC. stock, and acquired the option to purchase

9,000 additional shares of ABC stock at 85 peréentrof

market value. Shortly after. the foregoing results Were

accomplished, Virgil caused petitioners, to collectively

purchase 11,500 shares of ABC stock,.thereby securing to

himself, directly and through his ownership of. petitioners;,

_ the 80,000 shares of ABC stock originally contemplated by

the June 30, 1960, agreement between himself and ABC. »

- «The dominant motives of both Virgil and ABC &

throughout the negotiations which culminated in ‘the sale-

leaseback-agreements are crystal clear: Virgil sought to

~ obtain ABC stock and dn executive position with the com-

_. pany and ABC sought to acquire Virgil’s 15 food service

companies. In light of thése: facts, we think it abundantly

clear that the sale-leaseback agreements were designed. °

solely to fulfill.the personal objectives of Virgil. There was

no legitimate business purpose for petitioners to under-

take the sale and.subsequent leaseback of their tangible

‘assets other than to satisfy Virgil’s purpose of shifting

income from petitioners to Gladco in order to induce ABC

AON,

° /

43 .

to go through with the deal., Thu this is not ‘a case

where a corporation entered a sale-leaseback arrangement

in order to generate needed cash for business expansion.

To the contrary, all the money received by petitioners -

upon the sale, of their tangible assets, together with sub-

* stantial additional amounts, was used to purchase ABC

. Stock, thus serving no meaningful ene purpose to

petitioners. x

Petitioners’ position is further weakened a the fact

that during the entire negotiations leading up to the execu- :

tion of the sale-leaseback agreements, the owner of both

the lessor (Gladco) and the lessees (petitioners) was the

same person, Virgil Gladieux. Petitioners’ attempt to

transform such an identity of interest into a relationship

which petitioners characterize as adverse, transgresses

reasonable imaginati6n. All the more go since the facts

show that the sale-leaseback agreements were not intended

to be ends in themselves but merely steps in an integrated

plan to secure to Virgil and ABC advantages which could

not benefit petitioners in any meaningful way. From a

‘review of all the facts bearing on this issue, which have

been set out at length in our findings, we are convinced

that the sale-leaseback agreements in question were not

the result of arm’s length negotiation. between adverse

parties and, therefore, we must determine whether the

purported rentals were “in excess of what the lessee [s]

would have been required to pay had * * * [they] dealt

at arm’s length with a stranger.” jilead P. Place, supra.

The terms of the sale-leaseback agreerhents provided

to Gladco equal to 10 percent of petitioners’ gross sales on

and after October 1, 1960, derived from their vending

machine business. The agreements provided, however,

that if for any annual fiscal. period any rent payable to

Gladco would result in a deficit to petitioners’ net income,,

then such rental would be “abated or refunded in such

amount as to eliminate Such deficit.” The contract pro-

vided that net income, as used to calculate the existence -

of a deficit, was to be determined—

before Federal income taxes and before any salaries

or expenses paid to or’ attributable to Virgil A.

Gladieux or any member of his family~and excluding

from the determination of such net income any in- *

come, loss or expense of * * * [petitioner] from or

attributable to marketable securities or any other

investment not germane to the operation of. the

vending. machine business of.* * * [petitioner J.

For the fiscal year ended September 30, 1961, 10 per-

cent of Canteen Service’s sales amounted to $165,149.03

and 10 percent of Southeastern’s sales amounted to. re

$17,006.69. Inasmuch as the payment of such ‘“rental’* 3

would have resulted in a deficit to petitioners’ net operat-

ing income for that year, the rentals payable to Gladco

under the provisions of the January 31, 1961, contract

- were reduced as to Canteen Service and Southeastern, to

$121,172.15 and $12,211.30, respectively. The foregoing’

amounts were subsequently claimed by petitioners as

rental deductions in their tax returns for their fiscal year |

> 1961.

As to the claimed deductions for the ‘period com=

mencing October 1, 1960, and ended January 31, 1961, we

failed to perceive how the amounts paid during that. period

“could satisfy the statutory requirements of section 162(a)

(3). That provisibn specifically provides that to constitute

a deductible expense, the payment must be—

——_

‘required *% * * as a condition to the continued use

or possession * * * of property to which the taxpayer

has not taken or is not taking title or in which he has

no equity. {Emphasis supplied. | :

e oo aS <

—

~*~

. \ shee 45 |

The sale-leaseback agreements were not executed before

January 31, 1961. The language employed in those agree-

ments in no way suggests that petitioners were attempting

to sell their. tangible assets to Gladco as of October 1,

1960. To the contrary, the opening paragraph of the re-

spective agreements states that petitioner “hereby sells,

transfers and assigns to Gladieux Corporation,” thereby

evidencing an intent on petitioners’ part to make a present

sale of their assets on January 31, 1961. While it is true

that the agreements subsequently recite that Gladco “‘here-

_ by leases” to petitioners the aforementioned tangible as-

sets “for a term of twenty years from October 1, 1960,”

the retroactive aspect of this lease provision can in no way-

convert ownership of petitioners’ assets to Gladco. It fol-

lows, that petitioners had not parted with title to their

tangible assets, at least until the execution of the sale-

leaseback agreements on or after January 31, 1961. That

being the case, the retroactive payments-made by peti-

tioners to Gladco for the 4 -month period from October 1,

we to January 31, 1961,-was for property which peti-

ioners owned. Such payments are therefore net deducti-

‘ble as rentals under the explicit language of section

162(a) (3) of the Code. The fact that payments were

designated as “rentals” and Gladco may have had an en-

forceable contract right against petitioners: for the amounts

so designated, in no way alters this result: “As we stated j

in Catherine G. Armston, 12 te Od 539, 548 (1949), affd.

188 F.2d 531 .(C.A. 5, 1951): i

. the mere designation of * * * amounts as rental

does not legally characterize them as'such. Nor does

the fact that as between the * * * [lessor and les-

-sees|, the parties to the agreement, the obligation to

“pay may have been enforceable, render the payment |

deductible as rent or otherwise * * *

- &

Equally objectionable is Canteen Service's inclusion

in its claimed rental deduction of the amount of $28,897.95 -

which constitutes part of the profits realized by Canteen

Service upon the sale of an 8%4-acre vacant lot on April

27, 1961. Although Canteen Service paid or accrued this

amount on its bggks | as a liability in favor of Gladco, as

purported rental under the sale-leaseback agreement,

the facts as well as the applicable Code provision fail te

support petitioners’ treatment of this item as a “ren

deduction. The sale-leaseback agreement provided that

the “rental” payment would be equal to 10 percent of

Canteen Service’s gross sales frem its vending machine

business, with the further provision that the canal “ren-

tal” would not. be perme? to cause a deficit in Canteen

Service’s “net income.” The agreement further provided

that “net income,” as used in the rental formula, would

exclude income “derived from orggtributable to market-

able securities or any other investment not germane to

the operation of the vending machine business of Canteen

[Service].” Since the foregoing contract provisions were

in effect at the time the land ig question was sold, the

profits derived from its sale could not have beer included

in Canteen Service’s net income for purposes of calcu-

lating its “rental” liability to Gladco without violating

. the express provisions of the sale-leaseback agreement.

The fact that the profits so derived were included in

Canteen Service’s net operating income for purposes of

calculating the “rental” payment, lends additional support |

to the fact that the series of transactions entered -into

among petitioners, Gladco, ABC, and Virgil in January

1961 were intended to shift virtually all of - -petitioners’

income to Gladco rather than to serve any legitimate busi-

ness purpose of petitioners. However, an additional and

more serious objection arises with regard to petitioners’

—¢treatment of the real estate profits as “rental.” Section

162(a) (3) of the Code specifically excludes as rental

deductions, amounts paid for the use of property where

title remains in the taxpayer-lessee. Since we, have pre-

viously found that the land in question was never sokl

,to Gladco by Canteen Service, and that Gladco at no time

held title to such property, any “rental” payments made

to Gladco by Canteen Service with respect to ~~

derived from the sale of that land could not satisfy

relevant statutory provision, Thus, as to the dail

rentals paid on the profits derived from the sale of Canteen

Service’s vacant land, we hold that respondent’s dis-

allowance was proper.

In determining the reasonableness of the remaining

amounts claimed by petitioners as rental deductions for

the fiscal year 1961, one factor which we deem significant

is the gross disparity between the price Gladco paid peti-

tioners for their tangible assets and the purported rentals

; petitioners were required to pay Gladco in fiscal 1961 in

“order to lease ‘back those same assets. In 1961 Canteen

Service transferred its office, warehouse, trucks, cars,

furniture, fixtures, vending machines, and related hard-

ware to Gladco for $184,659.85, and yet was required to

pay a purported rental of $121,172.15 in order to lease

back those same assets for 8 months. For the same year,

Southeastern similarly transferred its car, trucks, fur-

niture, fixtures, vending machines, and related hardware

to Gladco for $5,109.43, and was required to pay a fitr-

ported rental of $12,211.30 in order to lease back those

same assets for 8 months. It is evident that the payments

made by petitioners in 1961 as “rentals” were patently ex- .

,cessive and bore no reasonable relationship to an amount

which woteld be required to be paid‘as rentals for such

assets if the petitioners had dealt with a lessor at arm’s

length. Limericks, Inc., 7 T.C. 1129 (1946), affd. 165 F.2d

483 (C. A. 5, 1948). Petitioners contended, however,

that since the sale-leaseback agreements further required

Gladco to “provide and lease to * * * [petitioners] all

_ additional equipment reasonably necessary,” the pur-

ported rentals were not unreasonable. Under the con-

tract provision relied upon, the determination of how

much, if any, additional equipment “was reasonably neces-

_ sary” was apparently a judgment which Gladco alone

would make. The record discloses that for the period

October 1, 1960, through October 3, 1964, Southeastern

paid Gladco total “rentals” of $62,487.98, receiving in

return, for the period October 1, 1960, through Decem-

ber 27, 1964, “additional equipment” costing Gladco

$12,097.91. For the same periods, Canteen Service paid

Gladco total “rentals” of $432,835.18, receiving in return’

“additional equipment” costing Gladco $595,591.12. Thus,

Southeastern paid Gladco $62,487.98 to “lease” equipment

_ valued by the parties at $5,109.43 and $12,097.91, for a

paid Gladco $432,835.18 to “lease” equipment valued by

the parties at $184,659.85 and $595,591.12, or “a total of

$780,250.97. With regard to Canteen“Seérvice, an even

greater disparity occurred for the period October 1, 1960, ~-

through approximately December 1962.. During that

period Gladco leased to Canteen Service former assets

valued at $184,659.85 plus additional assets costing Gladco

$66,537.18, or total assets of $251,197.03. As of Septem-

ber 29, 1962, Canteen Service had paid Gladco $208,176.58

in rentals. The unreasonableness of such rentals is strik-

ing. The amounts paid by petitioners were almost suffi-

cient to purchase outright. the assets “leased.” Consider-

ing the gross disparity existing between the value of the

properties rented to petitioners and “rentals” obtained by

Gladco under the sale-leaseback agreements, a

reject petitioners’ contention that Gladco’s obligation to

provide “all additional equipment reasonably necessary”

for petitioners’ vending machine operations justified their

otherwise excessive “rentals.” We have carefully con-

sidered the many alternative contentions presented by

the parties respecting the rental issue and are satisfied

that they do not alter our conclusion that the purported

rentals paid by petitioners to Gladco for their ‘fiscal year

ended September 30, 1961, were grossly excessive, did

not represent the fair rental value of the assets léased,

and would not have been “required” to be paid by peti- -

tioners had they negotiated at arm ’s length with an adverse

party. Having so:concluded, we must hold that the amount

‘respondent determined to be the maximum petitioners

would have been required to pay must stand, since it .

has not been shown to be patently inadequate. Roland P.

Place, supra.

2 ~

’ Issue 2. Lecinsd sw 'Conmassions.

During their fiscal y 1961, Canteen Service and

Southeastern paid or accrued total location commissions of

$163,468.56 and $11,221.38, respectively. Of those

amounts Canteen Servi¢e paid or accrued to Gladco

$134,920.68 and Southeastern paid or accrued to Gladco »

$9,174.57. Of the amounts paid or accrued to Gladco by

petitioners, respondent disallowed $74,088.26 as to Can-

teen Service and $1,593.84 as to Southeastern. ;

The $74,088.26 disallowed Canteen Service consists

’ of two components, location commissions paid ‘or accrued.

to Gladco for sales at LOF Glass and Toledo Scale, and

location commissions paid or accrued to Gladco for “all

other business.” The amount of the disallowances at-.

tributable to the LOF Glass and Toledo Scale business was

750

$69,429.16, which constituted the entire Siiiditn commis-

‘sions claimed by Canteen Service as to those customers.

The remaining amount disallowed, $4,659.10, constituted

the excess in location commissions. for Canteen Service’s

accounting periods beginning October 1, 1960, and end-

ing February 20, 1961, on all Canteen Service’s other busi-

ness as computed under the rates set forth in the January

= 1961, agreement between Canteen Service and Gladco,

over the rates in effect under the May 10, 1946, agree-

ment.'* The $1,593.84 disallowed Southeastern constituted

the excess in location commissions, for its entire 1961

fiscal year, as computed under the rates set forth in the

_ January 31, 1961, agreement between Southeastern and

Gladco, over the rates in effect prior to that agreement.

Respondent has thus disallowed location commis-

sions which fall into two categories. The first category is

composed of the disallowance of all location commissions

paid or accrued to Gladco by Canteen Service for sales at

Toledo Scale and LOF Glass, for Canteen Service’s 1961

fiscal year. The second category covers a partial disallow-

ance of location commissions paid or accrued on Canteen

Service’s business, other than LOF Glass and Toledo

Scale, and all of Southeastern’s business, for the period

-. October 1, 1960, through February 20,1961.

_ The*basic issue is whether that portion of the location

commissions paid or accrued by’petitioners in their fiscal

year 1961, and which has been disallowed by respondent,

constituted “ordinary and necessary expenses” to peti-

tioners under section 162(a) of the Code. Petitioners con-

tend, and respondent appears to concede, that the statu-

16 Respondent allowed all location commissions claimed on

this latter component, “all other business,” for the remainder of

Canteen Service’s fiscal year, February 21, 1961, through oP

tember 30, 1961.

‘ee requirement of “ordinary and necessary” is satisfied

Srovided the claimed deduction is for an expense which

is merely “appropriate and helpful” to the development

of the taxpayer’s business, citing the case of Commissioner

v. Tellier, 383 U. S. 687 ( 1966) . In applying such a stand-

ard to the instant case, it has been necessary to consider a

multitude of facts, many of which have been contested

by the parties, in an attenipt to réconstruct a meaningful

fact pattern. After careful consideration of all the relevant

facts bearing on this issue, as well as the numerous argu-

ments presented by both parties, we are of the view that

respondent’s disallowance of petitioners’ location com-

missions must be sustained.

With respect to the disallowance of Canteen Service’s

commission payments to Gladco for sales at LOF Glass and

Toledo Scale, we are convinced that such payments satis-

fied no meaningful business purpose of Canteen Service,

but rather, constituted only a further effort on the part of

Virgil Gladieux to transfer virtually all petitioners’ income

to Gladco and thereby secure to himself an executive posi-

tion with ABC at a starting salary of $62,500, as well as

to aequire 80,000 shares of ABC stock. :

Petitioners contend that the location commissions

paid to Gladco by Canteen Service for the year in question

arose out of a contractual obligation between Canteen

Service and Gladco which was negotiated at arm’s length

in 1946, and was rewritten in 1961 in order to standardize

the rate structure on Canteen Service’s business, a change

allegedly made necessary by the increaséd number of

foods used in Canteen Service’s vending machines as well

as the different Wtation commission rates prevailing in

different geographical areas for the same foods.

We do not question that the 1946 agreement between

Canteen Service and Gladco was negotiated at arm’s length

‘between adverse parties. At that time Gladco was owned

‘equally by Virgil and his brother Nelson, and Canteen

‘Service was owned by an unrelated party, Ben Handwork.

The weakness in petitioners’ contention, however, is that

all location commissions in question arose out of the 1961

agreement, not the agreement of 1946, and as we have al-

ready determined under issue 1, supra, the 1961 agreement

was entered into between corporations ‘wholly owned by

~ Mirgil and his wife, for the principal purpose of shifting in-

come from petitioners to Gladco and not for any meaning-

ful business purpose as far as petitioners were concerned.

This conclusion is further supported by the fact that prior

to the 1961 agreement, imposing increased location com-

missions on petitioners retroactively to October 1, 1960,

Gladco had waived all commission payments due from

Canteen Service on the LOF Glass and Toledo Scale busi-

ness. The waivers as to those commission payments oc-

curred at the time Canteen Service began making location

commission payments directly creas industrial clients,

LOF Glass and Toledo Scale. Thus; for sevdgal years prior

to the 1961 agreement, Canteen Service was not required

to make any location commission payments to Gladco on

its LOF Glass and Toledo Scale’ business. However, in

order for Virgil’s deal with ABC to be consummated, it

became necessary to shift all income of petitioners to

Gladco. To accomplish this objective Canteen Service was

required to reinstitute location commission payments to

Gladco on its LOF Glass and Toledo Scale business, which

was, of course, in addition t6 the amounts Canteen Service

was required to pay Gladco as purported rental payments.

We can find no reasonable explanation for reinstituting

such location commissions except as a further device to

accomplish the shifting of all petitioners’ income to Gladco.

The record specifically shows that at the time Virgil was

negotiating with representatives of ABC; he felt ABC was

intending to acquire, ‘by the various agreements, all the

operating income of petitioners. -

Even more objectionable to allowing Canteen Serv-

ice’s location commissions in question is the fact that not

only prior to, but for the year in question, Canteen Service

paid location commissions directly to LOF Glass and To-

ledo Scale for the right to operate vending machines on

the premises of those industrial customers. In 1961, Can-

teen Service paid to those customers the combined amount

of .$12,401.70 in location commissions. In spite of this,

petitioners contend that they are entitled to deduct the

further amount of $69,429.16 paid t6 Gladco as location

gommissions for vending machine sales on the premises

of the same two customers. The record fails to reflect

any bysiness or economic need for Canteen SerVice to

make the location commission payments in question, and

in light of the fact that Canteen Service was already

making payments directly to LOF Glass and Toledo Scale,

we know of none. Lacking in any meaningful business

purpose we fail to see how the — of such obviously

unnecessary amounts could be “appropriate and helpful”

for the development of Canteen Service’s business. Ac-

cordingly we hold that as to the location commissions paid

by Canteen Service to Gladco on the sales at LOF Glass

and Toledo Scale for the year in question, petitioners are

not entitled to a business expense deduction under sec:

~ tion 162 (a). é

> There remains for our determination the correctness

of respondent’s partial disallowance with respect to lo-

cation commissions made by Canteen Service to Gladco

on sales other than at LOF Glass and Toledo Scale, for

the period October 1, 1960, through February 20, 1961,

- and with respect to location commissions made by South-

‘

eastern to Gladco for the same pegiod."’ Respondent has

disallowed only so much of the foregoing location commis-

sions.as exceeded the commissions computed pursuant

to the rates in effect under the agreement between Can-

teen Service and Gladco, dated May 10, 1946. Thus,

for the period October 1, 1960, through February 20, 1961,

respondent disallowed only $4,659.10 out of $25,999.22

claimed by Canteen Service and disallowed $1,593. an

of $3, 558,36 claimed ky Southeastern. Since respondent

has allowed petitioners’ claimed location commissions, al-.

though at the lower rates in effect prior to the 1961 agree- °

ments, the only question presented is whether respondent

correctly disallowed the retroactive increases required by

the 1961 agréements. |

| Petitioners contend that the location commissions

were made retroactive to October 1, 1960, because that

was the date, originally contemplated by ABC and Virgyl

in their agreement of June 30, 1960, when the exchange

of Virgil’s 15 companies was to be made in return for ABC

stock. This fact is apparently relied upon by petitioners

to justify making the commission payments retroactive to

October 1, 1960. Even conceding that the October 1 daté

was set for that purpose, which the record does not neces-

sarily support, we think petitioners’ position is irrelevant

with regard to the payment of location commissions by

Canteen Service and Southeastern inasmuch as the limited

question for our ‘determination is whether the retroactive

payments constituted ordinary and necessary business

expenses to petitioners. Thus, while the October 1 date

17 Except for Canteen Service’s commission payments com-

puted upon sales to LOF Glass and Toledo Scale, respondent

allowed all location commissions claimed by petitioners for the

period February 21, 1961, through September 30, 1961, at the

increased rates contained in the 1961 agreements between peti-

tioners and Gladco.

we, ee

b. 55 |

may have been required inporder for Virgil to consum-

“mate his deal with ABC, we find no-valid business reason

in the record for petitioners to,retroactively pay increased

location commissions for, more than 4 months. The rec-

ord is devoid of any meaningful economic benefit flowing

to petitioners for such payments, and ‘consistent with

our prior determination, supra, we think the retroactively

increased rates imposed upon ip under their

_ 1961 agreements with Gladco merely conStituted a neces-

sary concession on Virgil’s part, in order to consummate

his personal deal with ABC, irrespective of whether such

a result proved “appropriate and helpful” for the develop-

ment of petitioners’ business. Accordingly we sustain,

. under section 162(a), respondent’s disallowance of that

portion of petitioners’ claimed location commissions coni-" -

* puted under the retroactive provisions of their 1961 agree-

ments with Gladco. — “<

Issur 3. SurTaAx ExEMPTIONS.

_Respondent has determined that Southeastern was

- not entitled to a surtax exemption for its fiscal years ended

October 3, 1959, October 1, 1960, and September 30, 1961.

In his deficiency notice, dated June 19, 1964, respondent

assigned as his reason for such disallowance, the following:

In your income tax returns for the above taxable

years, you claim¢d a surtax exemption. ‘It is held

that pursuant to Section 1551 and/or Section 269 of

the Internal Revenue Code of 1954, no ‘such surtax

exemption is‘ allowable. of

<see 1551 of the Code™ provides, in pertinent part,

18 SEc. 1551. DISALLOWANCE OF SURTAX EXEMPTION AND

ACCUMULATED EARNINGS CREDIT. .

If any corporation transfers, on or after J: anuary 1, 1951, all

or part of its property (other than money) to another corpora- :

(Continued on following page)

° that if a corporation transfers all ér part of its property

(other than money) to another corporation which was

either created for the purpose of acquiring such property

or was not actively engaged,in business at the time of

such ‘atquisition, and after stf¢h transfer the transferor

corporation or its,stockholders are in control of the trans- -

feree corporation, ther the transferee corporation shall not °*

sbe allowed the $25,000 surtax exemption unle$s it estab-

lishes by a clear preponderance of the evidence that the

securing of such exemption was not a major purpose of

the transfer. In. order that Southeastern’s surtax exemp-

tion be denied under section 1551, respondent recognizes

_ that there must have been a “transfer of property” from

. “another corporation to Southeastern at the ‘time “of its

incorporation. Respondent contends that consistent with

(Continued from preceding page) %

tion which was created forathe purpose of acquiring such prop-

erty or which was not actively engaged in business.at the time.

of such acquisition, and if after such transfer the transferor cor- -

poration or its stockholders, or both, are in control.of such * >

transferee corporation during any part of the taxable year of

such transferee corporation, then such transferee corporation

shall not for such taxable year (except as' may be- otherwise-de-

termined under section 269 (b)) be allowed‘either the $25,000

exemption from surtax provided in section 11(c) or the

_., $100,000 accumulated earnings credit provided in paragraph (2)

or (3) of section 535 (¢), unless such transferee corporation

shall establish by the clear preponderance of the’ evidence that « °

the securing of such exemption or credit was not a major pur-

e . F.

pose of such ‘transfer. Eor purposes of this section, control

means ,the ownership of stock possessing at least 80 percent of

the total combined voting power of all classes of stock entitled

to vote or at least 80 percent of the total value of shares of all

classes of stock of the corporation. In determining the ownership

of stock for the purpose of this section, the ownership of ,stock

shall be determined in accordance with the provisions of section

544, except that constructive ownership under section 544 (a)

(2) shall be determined only with respect to the individual’s

spouse and minor children, The provisions of-section 269 (b),

and the authority. of the Secretary under such section, shall, to

the extent not inconsistent with the provisions of this section,

be applicable to this section.. a.

the statutory requirement under section 1551, Canteen .

Service transferred its. eight “Canteen” * locations at the .

Revco Manifacturing Co., in Deerfield, Michigan to South-

eastern at a'time when Southeastern was not yet actively

engaged in business.” —

While it is true that Southeastern, upon its incorpora-

tion in 1956, began operating the eight “Canteens” for-

merly operated by Canteen Service, that fact does not sat- «

isfy the statutory transfer requirement inasmuch as there

has been no showing that the “Canteefrs” transferred to

South@astern were in any way owned by Canteen Service.

To the contrary, Automatic owned the vending equipment

- used at the Revco locations and through its franchise,

Automatic determined who would operate such. “Can-

’ teens.” The reeord élearly reflects the fact. that ‘Senay.

* eastern operated the “Canteens” at Revco under such a

franchise agreement with Automatic. In light of this.fact _.

we do*not think Canteen Service ever’ possessed. such a

_ property right in the eight. “Canteens” which could have

been the subject of ee to Southeastern. That being

the case, the transfer requirement of section 1551 has not -

been met and Southeastern may not be denied its surtax

exemption under that statutory provision. . é

Respondent contends, however, that Southeastern’s

surtax exemption should also be denied under section 269.

of the Code.’ The- pertinent provisions of that section

f SEc. 269. AtquisITIONS Mabe To EvapE or Avoid INCOME

Tay. ,

(a) In General.—If— ~° a 2. waremaeg®

(1) any person.or persons acquire, or acquired on or

after October 8, 1940, ” sea or indirectly, control of a cor-. '

poration, or

(2) any corporation acquires, or eicaiond on or after

' October 8, 1940, directly or, indirectly, property of another *

(Continued on following page)

a3 hee 58

provide that where any person or persons acquire con-

trol of a corporation for the “principal purpose” o{ evad-

ing or avoiding Federal income tax by securing the bene-.

fit of a deduction or other allowance which such person

would not otherwise enjoy, the Secretary may disallow

such deduction or other allowance. Upon a consideration

of the entire record, we think ‘the facts require us to hold

that Southeastern was incorporated in 1956 for the princi-

.*(Continued from preceding page) : -

tion... not controlled, directly, or indirectly, ., _im-

' mediately ore such acquisition, by such acquiring cor-

poration or ‘its stockholders, the is of: which property,

\ _ in the hands of the acquiring corporation, is determined by

“ reference to the basis in the hands of the transferor corpora-

tion,. ,

lich such acquisition was made

income tax by securing the

and thé principal purpose for

is evasion or avoidance of F

benefit of a deduction; credit@gir other allowance which such

person or corporation would otherwise enjoy, then such de-

duction, credit, or other allowance shall not be allowed. For

purposes of paragraphs (1) and (2), control means the owner-

ship of stock possessing at least 50 percent of the total com-

bined voting power of all classes of stock entitled to vote or at

least 50 percent of the total value of shares of all classes of stock 3

of the corporation.

(b) Power of Secretary or His Delefate To Allow Deduc-

tion, Etc., in Part—lIn any case to which subsection (a) applies

the Secretary or his delegate is authorized—

(1) to allow as a°deduction, credit; or allowance any

part of any amount disallowed by such subsection, if he de-

termines that such allowance will not result in the evasion

or avoidance of Federal income tax f fd which the acquisition

was made; or’

-. (2) to distribute, ‘egkton, or allocate gross income,

and distribute, apportion, or allocate the deductions, credits, m-*’

or. allowances the benefit of which was sought to be secured, :

between or among the corporations, or properties, or parts

p cheer involved, and to allow such deductions, credits, or

owarices so distributed, apportioned, or allocated, but to

give effect to such allowance only to such extent as he de-

termines will not result in the evasion or avoidance of Fed-

eral income tax for which the acquisition was made; or

_(3) to exercise his powers in part under paragraph

(1) and in part under paragraph (2). o

: 39

pal purpose, of avoiding Federal income taxes, although

in arriving at our determination’ we recognize that the

creation of Southeastern may also have served: legitimate

_ business purposes.

_____In ‘an_attempt—to—convince us that tax avoidance

was not the principal purpose of incorporating South-

eastern, petitioners rely heavily on Virgil’s self-serving

testimony which was to the effect that his company’s pro-

jected expansion into Michigan required, the creation of a

“local identity” or “Michigan image.” We are asked to

accor ‘great weight to this conclusion because of the fact

that Virgil “has béen experienced and successful in busi-

* While the successful expansion of Virgil’s vending

busines in Michigan ‘may have necessitated the use of a

ichigan” corporation, the record does not support such

a: lconclusion.

' In 1953 Canteen Service, an Ohio corporation, ait

fied to do business in Michigan and received authorization

from Automatic to operate “Canteens” at Revco’s plant in

Deerfield, Michigan. Canteen Service continued to oper-

ate those “Canteens” until Southeastern began its Michi-

gan operations in 1956. Virgil’s testimony, as well as

petitioners’ briefs, goes to great length to show, that after

Southeastern began its -operations it esthblighed head-

' quarters in Michigan, hired two men, residing: an Michigan

to supervise its operations, opened bank accounts in

Michigan, and established warehouse and refrigeration |

facilities in Michigan. While we do not question these

facts, the weakness in petitioners’ position is that there is

no reason skown, and we know of none, which would have

forbidden Canteen’ Service from adopting the same

Michigan contacts. Of additignal significance is the fact

that although Virgil’s testimony stressed the importance

of a Michigan image, the franchise agreement under which

Southeastern obtained virtually all its vending machines,

: ;

* oe

> Ss

;

: 60

specifically prohibited Southeastern from using its name

,on the vending machines in a manner which would give

the appearance that Southeastern -was the owner of the

machines. Thus, at the time of Southeastern’s incorpora-

tion, both Canteen Service and Southeastern were owned

by the same individuals (Virgil and Handwork) in the

same percentages (75 and 25, respectively); Southeastern

took over virtually the same Michigan business that Can-

teen Service gave up; both businesses were based upon a

franchise with Automatic which provided the necessary

“Canteens” for an agreed rental; both corporations were

_on the 13-period system of tabulating income ard ex-

penses, using the same fiscal year; and both cerporations

used thé same street address in Toledo, Ohio, to designate

thei corporate address on their Federal income tax re-

turns. It is in no way apparent from the record why Can-

teen Service could not have continued to operate and

expand the Michigan business. Virgil’s conclusory state-

ment regarding the need for a Michigah image finds no

support in the record. Considering his business experi-

ence and suctess, as vouched for by petitioners and re-

vealed by the number and extent of his food service

corporations, we think it a fair assumption that he was

well aware of the Federal income tax advantages to be

gained by the addition of yet another corporation to his

already extensive operations. Considering the totality of

facts bearing upon this issue, we are satisfied that petition-

ers have failed to show that the acquisition of an addi-

tional surtax exemption was not the “principal purpose”

of incorporating Southeastern in 1956. Accordingly we

must sustain respondent’s\disallowance of Southeastern’s

-surtax exemption for the = et at issue, pursuant to sec-

tion 269 of the Code.

Decisions will be entered for the Tespondent. a

APPENDIX C.

STATUTE INVOLVED.

§ 162(a) of the Internal Revenue Code of 1954 states

"in pertinent parts:

“Sec. 162(a) In General—There shall be allowed

as a deduction all the ordinary and necessary ex-

:penses paid or incurred during the taxable year in

carrying on any trade or business, including * * *.

(3) rentals or other payments required to be

made as a condition to the continued use or posses-

sion, for purposes of the trade or business, of property

to which the taxpayer‘Ras not taken or is not taking.

title or in which he has no equity. * * *” :

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.