Petition for Writ of Certiorari — Graves v. Commissioner

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= ui MICHAEL ACBEK, JR.. CLERK |

In the Supreme Court of the

United States

Ocrosper Term 1972

No. 72-810 :

R. L. Graves, Firora J. Graves,

R. L. and Frora J. Graves, and :

Sparks Nuacet, Iyc. as TRANSFEREE,

Petitioners, ;

v.

CoMMISSIONER OF INTERNAL REVENUE.

HEELS OP

Petition for Writ of Certiorari to the United States

Court of Appeals for the Ninth Circuit

VALENTINE BROOKES

Derek T. KNnupsEN é

One Embarcadero Center

San Francisco, California 94111

Attorneys for Petitioners

ane ote

SORG PRINTING COMPANY OF CALIFORNIA, 346 FIRST STREET, SAN FRANCISCO 94105

INDEX

Page

Opinions Below 1

Jurisdiction 2

Questions Presented 2

Statutes and Constitutional Provisions Involved ........ 3

Statement of the Case 3

Reasons for Granting the Writ 6

Conclusion i9

Appendix A . 1

Appendix B 48

Appendix C 63

Appendix D 64

Appendix E 67

Appendix F 93

CITATIONS

CasEs

Pages

Automobile Club of Michigan v. Commissioner, (1957)

353 U.S. 180 13

The Challenger, Inc., (1964) 23 T.C.M. 2096 0. 3,15

Commissioner v. First Security Bank of Utah, (1972)

405 U.S, 394 8,11

Connecticut Ry. and Lighting Co. v. United States,

Ct.Cl. 1956) 142 F.Supp. 907 13

Connolly v. General Construction Co., (1926) 269 U.S.

385 17

Cramp v. Board of Public Instruction, (1961) 368 U.S.

278 17

Eisner v. Macomber, (1920) 252 U.S. 189 -........... 3, 18, 19

Exchange Parts Co. of Fort Worth v. United States,

(Ct.Cl. 1960) 279 F.2d 251 13

B. Forman Co., Inc. v. Commissioner, (C.A. 2, 1972)

453 F.2d 1144 9,12

Helvering v. Griffiths, (1943) 318 U.S. 371

Holsey v. Commissioner, (C.A. 3, 1958) 258 F.2d

865 14, 16, 19

Huber Homes, Ine. (1971) 55 T.C. 598 9

International Business Machines Corp. v. United

States, (Ct.Cl. 1965) 343 F.2d 914

Kahler Corp., (1972) 58 T.C. 496

Kerry Investment Co., (1972) 58 T.C. 479

Lanzetta v. New Jersey, (1939) 306 U.S. 451

Niederkrome v. Commissioner (C.A. 9, 1958) 266 F.2d

238, rev’g T.C. Memo. 1956-255, 15 T.C.M. 1312

-

CITATIONS lii

Pages

PPG Industries, Inc., (1970) 55 T.C. 928 9

Richard Rubin, (1968) 51 'T.C. 251 7

Richard Rubin, (1971) 56 T.C. 1155 10

Rubin v. C.I.R., (C.A. 2, 1970) 429 F.2d 650 ..6, 7, 8, 10, 12, 14

Sammons v. United States, (C.A. 5, 1970) 433 F.2d 728 18

Seminole Flavor Co., (1945) 4 T.C. 1215 9

Smith-Bridgman & Co., (1951) 16 T.C. 287 -............... 9

Tennessee-Arkansas Gravel Co. v. Commissioner,

(C.A. 6, 1940) 112 F.2d 508 9

Tucker v. Commissioner, (C.A. 8, 1955) 226 F.2d 177,

rev’g 23 T.C. 115 16

United States v. Kaiser, (1960) 363 U.S. 299 ww. 13

Weller v. Commissioner, (C.A. 3, 1959) 270 F.2d 294... 13

CoNSTITUTIONAL PROVISIONS

United States Constitution:

Amendment V 3

Amendment XVI 3,18

STATUTES

Internal Revenue Code of 1939:

Section 45 9

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

Section 61 2, 3, 6, 8

Section 162 2, 3, 4, 6, 7, 11, 13, 18

Section 163 2,11

Section 165 2,11

Section 269 9,15

Section 301 17

Section 304 15

Section 315 17

—

iv CrraTIons

Pages

Section 316 oF

Section 318 17

Section 482 .......... 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 18

Section 1551 9

Section 1561 15

Treasury Regulations:

Section 1.482-2(C) (1) 7

Section 1.482-2(C) (2) (c) 7

Revenue Rulings:

Rev. Rul. 58-614 1958-2 Cum. Bull. 920 14

Revenue Procedures:

Rev. Proce. 64-54, 1964-2 Cum. Bull. 1008 -...0..... 10

Rev. Proc. 65-17, 1965-1 Cum. Bull. 833, amended

1966-2 Cum. Bull. 1211 10

Rev. Proce. 65-31, 1965-2 Cum. Bull. 1024 -.000. 10

MISCELLANEOUS

7 Mertens, Law of Federal Income Taxation, p.176 9

Nauheim, “B. Forman & Co.—A Crucial Test of the

Future of Section 482”, 26 The Tax Lawyer (Fall

1972) 12

wa

In the Supreme Court of the

United States

Ocroser Term 1972

No.

R. L. Graves, Firora J. Graves,

R. L. and Fiora J. Graves, and

Sparks Nuacet, Inc. as TRANSFEREE,

Petitioners,

v.

CoMMISSIONER OF INTERNAL REVENUE.

Petition for Writ of Certiorari to the United States

Court of Appeals for the Ninth Circuit

eit a Rey SOS SE

R. L. Graves, Flora J. Graves, and Sparks Nugget, Inc., *

as Transferee of The Challenger, petition for a writ of i

certiorari to review the judgment of the United States

Court of Appeals for the Ninth Circuit in these cases which :

were consolidated in the courts below and present both iden-

tical and closely related questions.’ 3

OPINIONS BELOW

The opinion of the Tax Court (Appendix A, infra, pp. 1-

47....) is a memordandum decision of that court (T.C.

1. Rule 23(5) of the Rules of this Court.

a

Memo. 1970-74) which is not officially reported but which is

unofficially reported at 29 T.C.M. 318. The opinion of the ©

Court of Appeals (Appendix B, infra, pp. 48-62) is reported

at 458 F.2d 631.

JURISDICTION

The judgment of the Court of Appeals was entered on

April 6, 1972 (Appendix B, infra, p. 48). A petition for

rehearing was filed on April 20, 1972 and this was denied

on September 11, 1972 (Appendix C, infra, p. 63). The

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

1254(1).

QUESTIONS PRESENTED

1. Whether Internal Revenue Code Section 482’, con-

ferring on the Commissioner the power to allocate gross

income and deductions between commonly controlled jusi-

ness organizations, is exclusive or is rendered surplusage

by an implicit but unexpressed power to accomplish the

same intercorporate effect under Sections 162, 163 and 165,

allowing the deduction of business expenses, interest, and

losses from sales.

2. Whether the rule of decision that Section 482 author-

izes the allecation of gross income but not its creation can

be circumvented by the Commissioner’s proceeding instead

under Section 162(a) and Section 61, in the light of the

rule that the Commissioner may not so administer the tax

laws as to tax like persons differently.

3. Whether income in the form of a constructive divi-

dend can be found to exist where the shareholder’s only

economic benefits are the unrealized appreciation of his

corporate holdings and a corporate structure, having busi-

ness purpose, which is capable of producing future benefits

under the specific income tax laws Congress has enacted.

2. All statutory references are to the 1954 Internal Revenue

Code (26 U.S.C.) unless otherwise identified.

—,

3

4, Whether penal taxation totalling 143 per cent can be

pased upon rules of decision not stated in the statute in a

form sufficient to warn “men of common intelligence” of

the penalized standard of conduct, in view of the due pro-

cess requirements of the Fifth Amendment.

5. Whether taxable income can be found from economic

benefits which are still locked up in corporate solution and

which cannot be withdrawn without incurring a second tax,

in the absence of a clear Congressional command to re-

examine Eisner v. Macomber, (1920) 252 U.S. 189.

STATUTES AND CONSTITUTIONAL PROVISIONS INVOLVED

The statutes involved are Section 61, 162 and 482 of the

1954 Internal Revenue Code. The Constitutional provisions

involved are Amendments V and XVI of the United States

Constitution. All are set forth in Appendix D, infra,

pp. 64-66. ...

STATEMENT OF THE CASE

Petitioners Graves are husband and wife residing in Car-

son City, Nevada. They owned, as community property, the

entire outstanding stock in the following corporations: The

Challenger, Inc. ; The Pub, Inc.; United Waldorf, Inc. ; Cald-

well Sport Shop, Inc.; Saratoga Club, Inc.; and Sparks

Development Company, all of them but the last having done

business in Idaho before moving their assets and businesses

to Nevada.* The Challenger established a legal gaming

casino near Reno, Nevada, and by 1959 leased real property

from the other corporations for the conduct of its business.

It also leased slot machines from three of the four other

Idaho corporations.

3. Four of the five former Idaho corporations were either held

or conceded to have dominant business purposes in a prior ease.

The Challenger, Inc., T.C. Memo. Op. 1964-338, 23 T.C.M. 2096.

Before trial in this case, the same concession was made concerning

Sparks Developmert Co.

a

4

In a prior case* the Tax Court decided, inter alia, that the

slot machine rentals exceeded fair rental value and that the

excess was taxable to The Challenger and not to the cor.

pesate lessenn, Sut & sedused to Goside whether & was gee.

ceeding under Section 162(a) or Section 482.° In

why the amounts it held nondeductible by The Challenger

were not taxable to the three corporations which had ac.

tually received them, the Tax Court said that they could be

either a tax nullity, or a capital contribution by The Chal-

lenger to the other corporations, or a constructive dividend

to the Graves followed by a constructive capital contribu.

tion by them to the recipient corporations, and it need not

decide which they were.* Only the last alternative would

produce duplicate taxation of the same income, and the

Commissioner embraced that alternative and asserted the

duplicating tax against the Graves in this case.

The Commissioner applied the same technique to rentals

paid by The Challenger to Sparks Development Co. for

parking lots contiguous to the casino. He disallowed The

Challenger’s deduction for the portion he determined to

be in excess of fair rental values but in conformance with

the prior decision he did not assert a duplicating tax against

the recipient corporation ; he asserted it instead against the

Graves. For the corporate adjustment he had relied on Sec-

tion 482 in the prior case, and had attempted at the trial to

assert Section 162(a) as an alternative ground. In the in-

stant case the Commissioner reversed things: he relied on

Section 162(a) in the deficiency letter and attempted at the

trial to assert Section 482 as an alternative. In the prior

ease, the Tax Court held it need not decide which section

governed, and in the present case it held that Section 162(a)

4 See footnote 3, supra.

5. 23 T.C.M. at 2107. The relevant portions of the opinion are

reproduced in Appendix E, infra, pp. 67-92.

6. 23 T.C.M. at 2109 ( Appendix E, infra, p. 75).

5

contained authority for the intercorporate adjustment. The

Tax Court sustained the corporate adjustments described,

including rental disallowances for the slot machines for a

year subsequent to the years involved in the prior case.

The Tax Court also sustained the duplicating tax against

the Graves, even though the constructive dividends it taxed

were grossed up; «.e., they included the amounts held pay-

able to the United States by the Challenger as income tax.

Because both The Challenger and the Graves were in the

highest tax brackets effective in those years (52% and 91%,

respectively), the combined tax rate on the same income

was 143 per cent. Thus, for each $100.00 of income combined

taxes of $143.00 were imposed.

An appeal was taken to the Court of Appeals for the

Ninth Cireuit, which affirmed in an opinion written by

Senior District Judge Byrne. Both courts held the failure

of Congress to confer the power in Section 162(a) to con-

fine rental deductions to “reasonable” amounts as it ex-

pressly had in the same subsection for salary deductions,

was without significance where related taxpayers were

involved. The Tax Court did not discuss our contention that

Section 482 expressly confers that authority, is the sole

statutory implement for the purpose, and here was not

employed. It also did not discuss our contention that See-

tion 482 does not authorize either creation of income or

duplication of taxes on it but only the “allocation” from

one taxpayer to another of “gross income” or “deductions.”

The Court of Appeals discussed and rejected both conten-

tions, as well as our further contention that the Graves did

not have the economic benefit from the payment of rent by

one controlled corporation to another necessary to consti-

tute the economic equivalent of real income.

ee

6

REASONS FOR GRANTING THE WRIT

1. The decision below conflicts with the decision of the

Court of Appeals for the Second Cireuit in Rubin v. CR,

(1970) 429 F.2d 650, and in so doing increases the confusion

present in the court decisions concerning the proper seope

of 1954 Internal Revenue Code Section 482.

Section 482 (Appendix D, infra, p. 66) applies exclusively

to “two or more organizations (whether or not incorporated

. -) owned and controlled directly or indirectly by the same

interests . . .”, and it authorizes the Secretary or his dele.

gate to “distribute, apportion, or a gee tm,

deductions . . . between or among such organizations. . .

(Emphasis ours.) In Rubia v. C.1L.R., supra, n F.2i oe

the Court of Appeals for the Second Circuit held that See

tion 482 was the exclusive authority to allocate “gross in-

come” between related businesses, and the Commissioner

eould not seek to accomplish under Section 61, defining

“gross income”, what Section 482 gave him authority to do.

The court disapproved a reallocation of gross income be-

tween two corporations and their controlling shareholder

which both the Commissioner and the Tax Court had based

on Section 61, end remanded for reconsideration exclusively

under Section 482.

In the present case, the Court of Appeals for the Ninth

Cireuit permitted reallocations of rental deductions be

under Section 162, a deduction section. As noted above,

Section 482 specifically applies to allocation of “deductions”

as well as “gross income”. The court rejected the contention

that Section 482 was the exclusive statutory authority for

such an adjustment and permitted the reallocation to be

made as a disallowance of rent under its construction of

Section 162. The court noted the Rubin case and refused to

follow it, commenting that there was no occasion for the

Ninth Circuit joining it in adding “a new wrinkle to the

law.” (Appendix B, Infra, p. 52.)

7

The two decisions also conflict in their treatment of an

asserted constructive dividend to the common shareholder.

In Rubin, the Tax Court had held that the controlling share-

holder had constructive income under Section 61, which

includes “dividend” in its definition of gross income (51

T.C. %1), and the Court of Appeals reversed, noting that

under Section 482 ameliorative rulings, issued to avoid the

type of double taxation asserted both there and here, would

be available. This effect of Rubin was fully argued below,

bat the court did not diseuss that aspect of Rubin while

refusing to follow it.

The conelusion that Section 482 applies here is amply

supported by the statutory language extracted above and

set forth in full in the Appendix, and by Treas. Reg. Sec-

tions 1.482-2(e)(1) and (2)(c) (Appendix F, infra, p. 93)

in which the Secretary has exercised the discretion the sta-

tute confers on him. The first cited regulation specifically

applies Section 482 to rentals for tangible property be-

tween related parties, and the second one states the defini-

tion of a proper rental. The Commissioner did not dispute

below that Section 482 was applicable but contended it was

not exclusive and that he had his choice of proceeding under

it, which by his concession would have precluded a con-

structive dividend to the common shareholder, or under

Section 162, which would permit the constructive dividend.”

The court below allowed him this choice, and the Second

Cireuit in Rubin did not.

A conclusion that the Commissioner can choose to accom-

plish under other sections what Section 482 specifically

the Appellee, No. 26,504, United States Court of

Ninth Cireuit, pp. 23-25; the contention of opticnal

two sections and the concession that adjustments

Section 482 would not produce a constructive dividend were

it i im response to questions from the bench.

— ee

8

authorizes seems patently wrong. Certainly, it is illogical to

believe that Congress enacted Section 482 merely to length-

en the Internal Revenue Code.* Moreover, such a view

makes sport of the Court’s recent carefully considered limi-

tation on Section 482 in Commissioner v. First Security

Bank of Utah, (1972) 405 U.S. 394. If the Rubin case is

wrong and the decision below is correct, the Commissioner

is free to relitigate his Security Bank loss in later years

by relying on Section 61 instead of Section 482. As a differ-

ent statute is involved, collateral estoppel will not interfere,

Yet, we believe it clear that this Court thought it was doing

more than merely deciding an individual case for a particn-

lar year when it took that case and decided it.

Because the use of multiple corporations is a standard

business practice, the questions presented by this conflict of

decision are found in numerous instances and are inherently

of large revenue implications.

2. The exclusivity and scope of Section 482 present im-

portant questions under the Internal Revenue Code which

have not been but should be settled by this Court. The

exclusivity question is presented by the conflict between

the decision below and Rubin v. Commissioner, supra, point

1, 429 F.2d 650. The question of scope is presented here by

the issue whether duplication of income by creating con-

structive income at the second tier is proper.

Our view that reliance on Section 482 would preclude the

creation of constructive second tier income is fully sup-

ported by the heretofore settled rule, only recently chal-

lenged, that Section 482 authorizes the allocation of gross

income between related entities but not its creation. The

leading text states:

“Section 482 of the 1954 Code is predicated on the

existence of income. The courts have uniformly held

that there is no authority in the Secretary or his dele-

8. Section 482 is derived without significant change from See-

tion 45 of the Revenue Act of 1928.

gate under this provision to charge income to one of

the businesses, if, in fact, no income actually exists,

or to disallow deductions altogether, and that the only

authority is to allocate income or deductions in order

clearly to reflect the income of the controlled busi-

nesses. Section 482, in contrast to Sections 269 and

1551, does not authorize disallowances; it authorizes

only distributions, apportionments, and allocations.

Where Section 45 of the 1939 Code has been applied

to a related taxpayer, the Court will implement that

provision to avoid any duplication by disallowance of

deductions.” 7 Mertens, Law of Federal Income Taza-

tion, p. 176.

That rule is based on the decision in Tennessee-Arkansas

Gravel Co. v. Commissioner, (C.A. 6, 1940) 112 F.2d 508,

and cases following it; vizc., Smith-Bridgman € Co., (1951)

16 T.C. 287 (Aeq. 1951-1 Cum. Bull. 3, limited 1967-1

Cum. Bull. 117), and Seminole Flavor Co., (1945) 4 T.C.

1215 (Acq. 1945 Cum. Bull. 6). It has more recently been

followed by the Tax Court in Huber Homes, Inc., (1971) 55

T.C. 598, 607, PPG Industries, Inc., (1970) 55 T.C. 928, and

Kahler Corp., (1972) 58 T.C. 496.

Huber Homes, supra, was the first Tax Court decision to

reconsider that rule after the promulgation of the present

Treasury Regulations, and in a carefully considered opin-

ion by Judge Raum the court adhered to the settled rule.

Later, in B. Forman Co., Inc. v. Commissioner, (C.A. 2,

1972) 453 F.2d 1144, in an appeal from the Tax Court where

that court had not had occasion to consider the issue, the

appellate court per District Judge Zavatt held that under

Section 482 interest income could be imputed to a parent

which had made an interest-free loan to a controlled cor-

poration. In Kahler Corp., supra, the full Tax Court con-

sidered the Forman case and refused to follow it, saying:

“With due respect, we are of the opinion that [it]

incorrectly delineated both the purpose of Section 482

10 =

and the circumstances required before the statute can

operate. ...

“Section 482 does not punish the mere existence of

common control or ownership .. .”

The Tax Court’s view that Section 482 is not designed

to punish is emphasized by the Revenue Service’s own rul-

ings: Rev. Proc. 64-54, 1964-2 Cum. Bull. 1008; Rev. Prog.

65-17, 1965-1 Cum. Bull. 833, amended 1966-2 Cum. Bull.

1211; and Rev. Proc. 65-31, 1965-2 Cum. Bull. 1024. These

rulings permit the taxpayers to restore without duplicating

tax liability funds reallocated by the Commissioner under

Section 482. Rev. Proc. 65-17 even permits dividends paid

from funds later reallocated away from the payor to be

repaid without tax and the dividends removed from the tax-

able income of the recipient-repayor. No ruling seeks to

cope with the metaphysical gymnastics of constructively

repaying a dividend only constructively received, and un-

doubtedly this lack is because the Revenue Service then

recognized that if it makes a reallocation under Section 482

it cannot also create second tier constructive income.®

We are informed that following the decision in Forman,

the Revenue Service designated this issue as a primary

litigation issue, and the Commissioner has appealed the

Kahler case, as well as a companion case, Kerry Investment

Co., (1972) 58 T.C. 479.*° If the Commissioner should here

assert that the creation of second tier income is proper

under Section 482, this case will present an appropriate

vehicle for settling an issue which otherwise will produce

a large volume of litigation in the lower courts and prob-

ably require ultimate resolution here anyway.

9. On remand in Rubin, neither the Tax Court (56 T.C. 1155)

nor the Second Cireuit (460 F.2d 1216) departed from this princi-

ple. They permitted an allocation to the shareholder of enlarged

income from his personal services rendered to a controlled corpora-

tion, not a constructive dividend.

10. P-H Federal Taxes Report Bulletin, Nov. 9, 1972, p. 60,694.

11

At the corporate level, the application of Section 482

should also make a difference. The “allocation” of gross

income called for by Section 482 should consider the profit

margins of both corporations and not create a 17 per cent

rate of return for one and a nearly 50 per cent rate of

return for the other, as the Tax Court did here by con-

struing Section 162(a) to limit the rental deduction to a

figure which produced a normal parking lot rate of profit

for one and increased the rate of profit of the other from

45 per cent to 50 per cent.

Furthermore, the standard of Section 482 is to place

controlled corporations in the position of uncontrolled

corporations. When the casino was sold outside the con-

trolled group, the parking lot rental remained the same,

and has not been questioned or disallowed by the Revenue

Service. The situation was thus the converse of that which

was held to control the application of Section 482 in Com-

missioner Vv. First Security Bank of Utah, (1972) 405 U.S.

394. Proper consideration of the context of Section 482

might well eliminate any deficiency at the corporate level

insofar as the parking lot rents were concerned.

The importance of the questions is difficult to exaggerate.

In 1968 the first lengthy, detailed and all-encompassing

Treasury Regulations under Section 482 were issued, some

three vears after they were first proposed and an interlude

of hearings and revisions. They are applicable to all open

years. They are prolix with examples of intended scope

extending to all types of “gross income” and “deductions”

possibly involved in interecorporate economic relationships.

If the Commissioner has, as was held below, inherent power

under Section 162 to disallow rent paid by one affiliate to

another so that he need not invoke Section 482, then the

same is true of all other business expenses dealt with by

Section 162, and of interest (Section 163), losses (Section

12

165), and other cash items made deductible by some eight

sections, as well as of all types of gross income, including

income from rents, interest, and from sales of goods and

other property. Indeed, it is necessarily true, since the

income tax is derived from statutes, that there is some

statute in the Code taxing each type of “gross income” and

allowing each type of “deduction” to which Section 499

applies, so if the decision below is correct and that in Rubin

is wrong, it follows that the Commissioner has inherent

power derived generally from the Code which completely

duplicates Section 482.

The question of scope is likewise important and, as

noted above, will produce litigation to settle questions long

thought settled as well as the duplication of income issue

here presented. Parent corporations have long thought

that temporary contributions to the capital of subsidiaries

or affiliates in the form of interest-free loans or rent-free

leases of equipment were proper and free of adverse tax

consequences, so many such situations exist to be litigated

until the rules again become settled. This decision and the

Forman decision have thoroughly confused and unsettled

an important area of law and this case is an appropriate

vehicle for clarifying the law.

We are not alone in believing that clarification here is

necessary, in view of these conflicts. The same view is

expressed in Nauheim, B. Forman ¢ Co., Inc.—A Crucial

Test of the Future of Section 482, 26 The Tax Lawyer

(Fall, 1972), pp. 107, 122, 123.

3. The decision below conflicts with International Busi-

ness Machines Corp. v. United States, (Ct.Cl. 1965) 343

F.2d 914, and a number of other decisions holding that the

Commissioner must apply the tax law equally to taxpayers

situated alike. The decision is strangely inconsistent with

our basic concept of equal justice under the law. To permit

——

the Commissioner the choice of applying Section 482 with

its judicial and administrative rules designed to prevent

penal duplication of taxes, or Section 162 and constructive

dividend principles which here produced a cumulative tax

of 143 per cent of the disallowed rentals, is necessarily to

vest him with power to treat persons similarly situated

differently. By what standard is he to choose? We asked

the court below if it thought Congress intended to confer

on the Commissioner the power to confine the harsh rules

to Democrats in Republican administrations, and to Re-

publicans in Democratic administrations. Without express-

ing itself explicitly, the court necessarily answered the

question in the affirmative, which presents a fundamental

and important departure from an established principle,

and is in direct conflict with International Business Ma-

chines Corp. v. United States, supra, 343 F.2d 914. In that

ease, a tax which otherwise would have been valid was

held refundable where necessary to produce equality be-

tween two major competitors.

The principle was stated by Mr. Justice Frankfurter

in a concurring opinion in United States v. Kaiser, (1960)

363 U.S. 299, 308. “The Commissioner cannot tax one and

not tax another without some rational basis for the differ-

ence.” It was applied to sustain a retroactive revocation

of an administrative ruling in Automobile Club of Michigan

v. Commissioner, (1957) 353 U.S. 180, 185-186, where that

was deemed necessary to place all auto clubs on tax parity.

It has been the basis of decision in Connecticut Ry. and

Lighting Co. v. United States, (Ct.Cl., 1956) 142 F. Supp.

907, Weller v. Commissioner, (C.A. 3, 1959) 270 F.2d 294,

and Exchange Parts Co. v. United States, (Ct.Cl., 1960)

279 F.2d 251.

The court below treated the principle with disdain, since

its only reference to it was the oblique remark that the

14

court need not join Rubin v. Commissioner, supra, 429 F.24

650, which did apply it, in adding “a new wrinkle to the

law.” The conflict should be settled so that the courts may

understand that their obligation to construe the statutes

to tax equally situated taxpayers alike is an old and honor.

ed one and not “a new wrinkle.”

4. Wholly apart from Section 482, the decision below

also conflicts in principle with the important decision of

the Court of Appeals for the Third Circuit in Holsey y,

Commissioner, (1958) 258 F.2d 865. The Holsey case has

been accepted as correct since the announcement by the

Internal Revenue Service in 1958 that it would follow

Holsey (Rev. Rul. 58-614, 1958-2 Cum. Bull. 920). The

announcement brought litigation in that area to an end

and the law was thought to have become settled. The court

below did not acknowledge the conflict but attempted to

distinguish Holsey on grounds which are both incorrect

and insubstantial. Unless clarified by this Court, this con-

flict in principle between the circuits is certain to rekindle

the fires of litigation in an important area of income tax

law.

Both this case and Holsey involve the payment of cash

by a corporation to another person or corporation, and the

question whether that payment should be taxed as a con-

structive dividend to a third person, the sole shareholder.

In this case, the payment was rent; in Holsey, it was pay-

ment to another person for his stock. The question in each

case was whether the shareholder had sufficient economic

benefit from the payment to have it treated as income to

him, as a constructive dividend. In each case, the Tax

Court held that there was such benefit and sustained the

tax. It was reversed in Holsey and affirmed here.

The benefit to the shareholder in Holsey was clearer

than it is here. Holsey had had an option to buy all his

fellow shareholder’s stock, an he assigned the option to

———_

15

their corporation, which exercised it. If he was thus able

to become sole shareholder without having to become per-

sonally taxable on the corporate payments to the other

shareholder, he had a tax advantage, but the Court of

Appeals held that that was not a personal economic bene-

fit. Nor would it agree with the Tax Court that the acqui-

sition of corporate control without personal income tax

was an economic benefit constituting the equivalence of

income.

The instant case involves less economic benefit. There

is almost always some economic reason for the creation of

multiple corporations, and Congress has stated what tax

consequences it wishes them to have. In addition to Section

482, Congress has acted to deny them multiple surtax ex-

emptions (Section 1561), to deny them certain tax benefits

where their control was acquired principally for tax saving

purposes (Section 269), and to provide that the purchase

by one affiliate of the stock of a second constitutes a taxable

dividend if one would have resulted from the purchase of

its own stock by the second (Section 304). Only the last

section taxes constructive dividends, and it operates in a

carefully defined area, having no bearing here. Here, there

were no economic benefits to Graves not attributable to the

income tax structure. The test of need for multiple cor-

porate structures is whether one corporation could have

sufficed." Had there been but one corporation and no

income tax structure, The Challenger would have owned

the parking lots, paid the debt service on them, and paid

no rent. Similarly it would have owned the slot machines

and the casino building owned by The Pub, e¢ al., and would

have paid the debt service on the building the slot machine

11. As noted above, in a prior case by decision (The Challenger

’

Inc., (1964) T.C. Memo. Op. 1964-338, 23 T.C.M. 2096) and in the

instant case by concession, the dominant business reason for the use

of all the six corporations but one was established.

—

rentals helped pay. Then, when the Graves wished to sell

the stock of The Challenger, they simply would first have

had the parking lots and any other property they wished

to retain distributed to them in a dividend or in partial

liquidation and they could then have sold Ascuaga pre- |

cisely what they did sell him. Only our income tax structure |

makes such a solution uneconomic, because of the high taxes |

it imposes on the distribution of the property to be re.

tained.

Thus, the economic benefit to the Graves is not an econo.

mic benefit at all but a tax benefit, just as it was in H olsey,?

In Holsey a court of appeals held such a benefit was not

sufficient to be a constructive dividend to the controlling

shareholder and here a different court of appeals held that

it was. The conflict is inescapable.

The importance of the question in times of permanently

high income tax rates is that the search for constructive

income seems recently to have become a cardinal principle

of tax administration. The Graves’ constructive income was

taxed at 91 per cent, and the same exact amount was also

taxed to the corporation at 52 per cent. The combined,

penal rate of 143 per cent has obviously removed the tax

benefit, and since the tax benefit was the only economic

benefit it has also eliminated the economic benefit which

was supposed to represent income. This conflict thus pre-

sents in clear form the basic issue in the definition of that

nonstatutory concept: constructive income.

5. If the income tax statutes are properly interpreted

to mean what the lower courts held, they raise two serious

constitutional questions.

12. Holsey does not stand alone. See also Tucker v. Commis-

sioner, (C.A. 8, 1955) 226 F.2d 177, reversing 23 T.C. 115, and

Niederkrome v. Commissioner, (C.A. 9, 1958) 266 F.2d 238, revers-

ing on this issue T.C. Memo. 1956-255, 15 T.C.M. 1312. But it was

the decision in Holsey which the Commissioner announced he would

follow and that announcement is what ended litigation on those

facts.

—

A) The effective combined rate of tax imposed below

is 143 per cent, of which 52 per cent is on The Challenger

and 91 per cent on the Graves. No deduction from the con-

structive dividend taxed to the Graves was allowed for the

portion of it which the court held should be paid to the

Treasury in income tax, so 52 per cent of the constructive

dividend was required to be paid in tax at the corporate

level and yet was simultaneously taxed to the Graves at

91 per cent.

The statute does not so provide, in any way which would

be an intelligible warning to the citizen seeking to comply

before the fact. Yet its effect, if affairs are so conducted, is

to impose taxes of 143 per cent, which, because the total

exceeds the income on which it falls, are penal in amount.

A penalty on conduct not proscribed in terms under-

standable by “men of common intelligence” is a denial of

due process. Connolly v. General Construction Co., (1926)

269 U.S. 385, 391. The void for vagueness rule does not

apply only to criminal statutes but to civil penal statutes

as well. Cramp v. Board of Public Instruction, (1961) 368

U.S. 278. As this Court stated in Lanzetta v. New Jersey,

(1939) 306 U.S. 451, 453: :

“No one may be required at peril of life, liberty or

property to speculate as to the meaning of penal sta- :

tutes. All are entitled to be informed as to what the

State commands or forbids.” (Emphasis ours.)

There are two respects in which the income tax statutes ;

would conflict with this constitutional principle if they are

construed as they were below. First, the statute taxes “divi-

dends” and goes to some pains to define them (Sections 301,

316, cf. Section 315) but in no place does it either tax or

define “constructive dividends.” It refers to and defines

“Constructive Ownership of Stock” (Section 318) but not

18

“constructive income.” The implication is that “constrys.

tive dividends” are not known and taxed.

Second, Section 1€2(a) allows the deduction of “rentals”

without limiting them to “reasonable” as it does with gal.

aries, and without distinguishing between rentals paid to

affiliated corporations and those paii to outsiders, Ap

but would find nothing in the power there conferred to “dis.

tribute, apportion, or allocate” suggestive of the power to

impose a penalty by imposing cumulative taxes up to 143

trative interpretation of Section 482 both abstain from

asserting duplication of taxes.

A serious question is presented, if the statute was prop-

erly construed below, whether its imposition of cumulative

taxes penal in amount is not a denial of due process under

the Fifth Amendment because of the failure of the statute

to state intelligibly what conduct it will penalize.”

B) Construed as it was below, the statute presents seri-

ous question whether what it taxes is income in the consti-

tutional sense. In Kisner v. Macomber, (1920) 252 U.S. 189,

a common stock dividend paid to common stockholders was

held not to be income subject to unapportioned taxation

under the Sixteenth Amendment, and that case and its

ruling have remained a cardinal principle of taxation. This

Court held that it would be reexamined only under positive

command of Congress and absent such command the statutes

would not be interpreted to challenge it. Helvering v. Grif-

fiths, 1943) 318 U.S. 371, 394-404. The decision below can-

13. The principal support cited below for the constructive

dividend was not any statute but the decision in Sammons v.

19

not be reconciled with it. The Graves received no distribu-

tion, merely the appreciation in the value of their stock in

one corporation, which was balanced by the depreciation in

value of their stock in the other corporation. As in Eisner

y. Macomber and Holsey v. Commissioner, both supra, the

income which the Commissioner sought to tax was still

locked up in the corporation, and any effort to withdraw it

would produce a second tax on them, if there is a first tax

now. As those cases recognize, every shareholder is weal-

thier for his corporation's receipt of net income, but he is

not taxable on that account.

The decision below construes the statute to conflict with

that principle and raises a serious constitutional issue.

CONCLUSION

For the reasons stated above, the petition for a writ of

certiorari should be granted.

Respectfully submitted,

VaLentixe Brooxes

Derex T. Kxwvpsex

Attorneys for Petitioners

Appendix A

T. C. Memo. 1970-74

UNITED STATES TAX COURT

Nvecet, Ixc., er at.’ Petitioners v. CommissionER

or Iwrerwat Revenve, Respondent

(Filed Mareh 31, 1970.)

Memorandum Findings of Fact and Opinion

Sucpsox, Judge: The respondent determined liabilities

of the petitioners as follows:

Basis of Taxable Year

Decks’ Re Petitioner Labelity Ended Deficiency

Sparks

Nugget, Inc... Transfereeof 9/30/59 $ 69,622.34

The Chal- 9/30/60 86,211.78

lenger, Inc.

Sparks Devel-

opment Co. ... Income tax 11/30/61 9,940.29

deficiency

Flora J.

a Income tax 12/31/59 29,083.17

deficiency

R. L. Graves

and Flora J.

—_ Income tax 12/31/60 137,209.56

deficiency

R. L. Graves. Income tax 12/31/59 29,083.17

deficiency

Some of the issues in this case have been settled; those

- remaining for decision are:

(1) Whether The Challenger, Inc. (Challenger), can

deduct, under section 162 of the Internal Revenue Code of

1954, the full amount of payments it made with respect to

1. Cases of the following petitioners are consolidated herewith :

Sparks Development Co., Docket No. 4277-67; Flora J. Graves,

Docket No. 4278-67; R. L. Graves and Flora J. Graves, Docket No.

4279-67; and R. L. Graves, Docket No. 4280-67.

#4 All statutory references are to the Internal Revenue Code of

2 Appendiz

certain lots leased by it from Sparks Development (Co,

(Sparks Development).

(2) Whether, for purpose of determining the tax liability

of R. L. and Flora J. Graves (the Graves), Challenger

should be limited to $2.59 per month in rental deductions,

under section 162, for payments with respect to each slot

machine leased by it from The Pub, Inc., Saratoga Club,

Ine., and United Waldorf, Inc.

(3) Whether the portions of the payments with respect

to the lots and the slot machines which are not deductible

under section 162 constitute dividends taxable to the

Graves.

(4) Whether certain payments made by Sparks Devel-

opment during its taxable year 1961 to Mr. Graves are

deductible under section 162 as “a reasonable allowance for

salaries or other compensation.”

Findings of Fact

Some of the facts have been stipulated, and those facts

are so found.

Sparks Nugget, Inc., is a Nevada corporation which had

its principal place of business in Sparks, Nevada, at the

time its petition was filed in this case. Sparks Development,

also a Nevada corporation, had its principal office in

Sparks, Nevada, at the time its petition was filed in this

case. For its taxable year ending November 30, 1961, Sparks

Development filed its Federal income tax return, using the

accrual method of accounting, with the district director of

internal revenue, Reno, Nevada. The Graves are husband

and wife, who maintained their legal residence in Carson

City, Nevada, at the time their petitions were filed in this

case. They filed their 1959 individual and 1960 joint Federal

income tax returns, using the cash receipts and disburse-

ments method of accounting, with the district director of

internal revenue, Reno, Nevada.

Appendix 3

Sparks Nugget, Inc., was incorporated on September 29,

1960. Until June 26, 1961, all of the outstanding stock of

the corporation was owned by John J. Ascuaga and his

wife, Rose. After such date, the Ascuagas owned 98.8 per-

cent of the outstanding stock, and the Graves owned the

remaining 1.2 percent. Mr. Ascuaga has been the principal

executive officer of Sparks Nugget, Inc., since its incorpora-

tion. On September 30, 1960, Sparks Nugget, Inc., pur-

chased all of the outstanding stock of Challenger from the

Graves. Thereafter, on June 30, 1961, pursuant to a plan

of complete liquidation, Challenger dissolved and all of its

assets were distributed in complete liquidation to Sparks

Nugget, Inc. Prior to September 30, 1960, at all times rele-

vant hereto, the Graves owned all of the outstanding stock

of Challenger. During such years, Mr. Graves was the prin-

cipal executive officer of Challenger. From September 30,

1960, to June 30, 1961, Mr. Ascuaga was the principal execu-

tive officer of Challenger.

Mr. Graves proposed the sale of the Challenger stock to

Mr. Ascuaga. Mr. Ascuaga accepted the terms of the pro-

posal without substantial change. The purchase price of the

Challenger stock was set at $3,700,000; annual payments in

respect of such price were set at the greater of $300,000 or

4.57 percent of Challenger’s gross receipts. Sparks Nugget,

Inc., agreed that, until the purchase price was paid in full,

it would not incur yearly capital expenditures of more than

$10,000, without the permission of the Graves. The purchase

agreement provided that Mr. Graves would act as a con-

sultant to Sparks Nugget, Inc., for a period of 2 years for

an annual compensation of $25,000. Sparks Nugget, Inc.,

made the final payment in respect of the stock purchase in

September 1967.

Sparks Development was incorporated on July 31, 1957.

Its outstanding stock has always been wholly owned by

the Graves; Mr. Graves has always been its principal execu-

tive officer.

4 Appendtz

The Pub, Ine. (Pub), Caldwell Sports Shop, Inc. (Cald-

well), United Waldorf, Inc. (Waldorf), and Saratoga Club,

Inc. (Saratoga), are dissolved Idaho corporations. They

were organized in 1947 and at all times relevant hereto,

prior to May 31, 1963, were wholly owned by the Graves,

During such period, Mr. Graves was the principal executive

officer of each corporation. On May 31, 1963, the Graves

sold all their stock in the corporations to First National

Bank of Nevada, as trustee of certain trusts established by

the Graves for their children. On December 31, 1963, all

of the corporations were completely dissolved and liqui-

dated by the trustee.

I. Rental of Parking Lots

On June 17, 1959, Sparks Development leased 61% lots

located in Sparks, Nevada, to Challenger. Challenger used

the lots as parking lots in connection with a gambling casino

operated by it known as the Sparks Nugget Casino. Such

lots are hereinafter referred to as the Parking Lots.

Practically all of the customers of the Sparks Nugget

Casino travel there by car, and the availability of ample

free parking has been a substantial factor, contributing

toward the casino’s success. There is some free on-street

parking available in the area of the casino, but such space

is insufficient to accommodate all of the casino’s patrons.

The Parking Lots had originally been acquired by Mr.

Graves as follows:

Purchase Purchase

Let Date Price oy

Blk. 2

S. 65 Lot 1. 10/20/58 = $-:20,072.35 + = 3,250

Blk. 5 Lot 2. 11/24/58 32,170.22 7,000

Bik. 2 Lot 3 4/27/59 41,950.77 7,000

Bik. 4 Lot 5 2/28/59 35,570.41 7,000

Bik. 4 Lot 6 4/23/59 40,350.71 7,000

Bik. 4 Lot 7 1/ 6/59 40,485.25 7,000

Bik. 4 Lot 8. 7/23/58 43,009.33 7,000

$253,609.04 45,250

Appendiz

The location of the Parking Lots is shown below on a

plan of a portion of Sparks, Nevada.

SHoVsL, peorrt Tey

QVOUTIVH OTdIOVd NUAHLNOS

—_I_x2ord

Peters

14th Street

La o°

>

<a ia

< i aa

a. -_

> Fie o

: t

o

...

llth Street

as

°

lot ax

am

nO n=

w Q

°.

+ Roche

7

:

13th Street

b (Zundell!

eo

Soa hae

6 Appendiz

On June 3, 1959, Mr. Graves transferred title to the Park.

ing Lots to Sparks Development for cash, an assumption

of liabilities, and a note, aggregating in value $253,253.05,

and for additional Sparks Development common stock with

a par value of $20,000.00. On June 3, 1959, immediately

after acquiring title to the Parking Lots, Sparks Develop-

ment borrowed $150,000 from the Nevada Bank of Com-

merce on two notes, each bearing 6-percent interest, one

being in the amount of $115,000 secured by a first deed of

trust on Lots 2 and 3 of Block 2 and Lots 5, 6, and 7 of

Block 4, and the other an unsecured note for $35,000.

Mr. Graves negotiated the lease of the Parking Lots

(sometimes hereinafter referred to as the Parking Lot

Lease) on behalf of both Challenger and Sparks Develop-

ment. Mr. Ascuaga took no part in such negotiation. Mr.

Graves fixed the lease rental on the basis of the amount of

income that Sparks Development would need to pay his

compensation, its income taxes, and its purchase obligations

on the Parking Lots. He prepared a pro forma income and

expenditures statement which, together with the proposed

lease, he took to the Nevada Bank of Commerce. On the

basis thereof, the bank agreed to make the purchase money

loans necessary for Sparks Development to acquire the

Parking Lots.

The Parking Lot Lease, executed on June 17, 1959, leased

the Parking Lots to Challenger for a term of 5 years com-

mencing June 17, 1959, for the following rental : $9,400 per

month for the first year of the lease term and $8,000 per

month for the following 4 years of the lease term. The

larger rental in the first year of the lease term was provided

because of the higher loan payments required of Sparks

Development during such period. Under the terms of the

lease, Challenger was required to keep the premises in good

repair, to pay for all utilities used on the premises, to keep

——

Appendiz 7

the property free of any mechanics’ or other liens, to hold

Sparks Development harmless from any suits or claims

arising out of the operation of the property, to maintain

public liability insurance of not less than $100,000 for injury

to one person and not less than $300,000 for injury to more

than one person, and to pay all real estate taxes on the

premises. The lease provided that upon the expiration of

the initial term, Challenger could continue to rent the

Parking Lots for an additional 5-year term upon the terms

and conditions contained in the lease, except that the rental

would be renegotiated. If the parties could not agree on the

rental, the matter would be submitted to arbitration. In

the event the business of gambling was outlawed on the

demised premises, Challenger was given the right to termi-

nate the lease upon the payment of an amount equal to 4

months’ rent as liquidated damages.

The cost of removal of houses and other improvements

on the Parking Lots and the cost of surfacing and marking

the lots was borne by Challenger. The lots furnished

approximately 143 car spaces.

On September 30, 1960, Sparks Development modified the

Parking Lot Lease by providing that Challenger was

granted an option to extend the lease term for an additional

period commencing with the expiration of the last renewal

term and terminating on September 23, 1987. This extension

was made at the insistence of Mr. Ascuaga in connection

with the purchase of the Challenger stock by Sparks Nug-

get, Inc. The renewal was to be upon the same terms and

conditions contained in the Parking Lot Lease, except for

the rental, which was to be renegotiated each 5 years. In

the event of disagreement as to the monthly rental, the

matter would be submitted to arbitration in the same man-

ner provided in the Parking Lot Lease.

VT]

8 Appendiz

The Parking Lot Lease was renewed in accordance with

its terms after the expiration of the initial term in 1964,

The rental for the renewal term was not renegotiated and

remained at $8,000 per month.

Pursuant to the terms of the Parking Lot Lease, Chal.

lenger accrued and paid to Sparks Development $37,000 in

its taxable year ended September 30, 1959, and $107,200 in

its taxable year ended September 30, 1960. The respondent

determined that to the extent the monthly payments ex.

ceeded $4,000 they “were not required to be made for the

use of” the Parking Lots in Challenger’s business. Under

this computation, Challenger’s deductions were reduced to

$16,000 for 1959 and $48,000 for 1960.

The following information pertaining to other real estate

transactions involving the petitioners relates to the ques-

tion of the reasonable rental of the Parking Lots. The ref.-

erences to Block and Lots numbers correspond to the plan

of Sparks set forth previously.

A. The McDonald Premises

On September 25, 1954, Challenger leased the McDonald

premises for a term of 10 years, with a 10-year renewal

option, at a monthly rental of $700. The premises consist

of Lots 11 and 12 in Block 4 on the north side of B Street

and contain approximately 7,000 square feet. On the prem-

ises, Challenger opened on March 17, 1955, a bar, restau-

rant, and casino known as the Sparks Nugget.

B. The Peterson Premises

On April 27, 1955, Challenger leased the Peterson prem-

ises for a term of 3 years, with a 7-year renewal option, at

a monthly rental of $500, and a further 10-vear renewal

option at a monthly rental of $700. The premises consist

of Lot 10 in Block 4 on the north side of B Street and

wa

Appendix 9

contain approximately 3,500 square feet. The premises were

used for an expansion of the Sparks Nugget operation.

C. The Zundell Premises

On November 21, 1955, Mr. Graves leased the Zundell

premises effective January 1, 1956, for a term of 5 years

with a 5-year renewal option, at a monthly rental of $700,

and a further 10-year renewal option at a rental to be

negotiated. The premises consist of Lots 1, 2, and 3 in

Block 4 on the north side of B Street and contain approxi-

mately 10,500 square feet. On May 28, 1956, Mr. Graves

assigned the lease to Challenger. The premises in part were

used for an expansion of the Sparks Nugget operation.

D. The Sparks Nugget Casino Premises

On May 1, 1957, Mr. Graves created four irrevocable

trusts, each with a corpus of $6,000, one trust for each of

his children. The First National Bank of Nevada (herein-

after referred to as the Trustee) was made trustee and

given power to commingle the funds of the different trusts.

On the same day, the four trusts formed a joint venture

ealled the Graves Children Trust No. 1. The joint venture

bought eight lots, Lots 1-8 in Block 3, for a total of

$180,134.05. The bank took a mortgage of $153,000 on the

property. The eight lots were located across B Street from

the then location of the Sparks Nugget Casino which had

opened in March 1955.

On May 1, 1957, the Trustee leased the eight lots to

Challenger for a 10-year term for use as a parking lot. The

rent was fixed at $2,500 per month for the first year and

was then to be renegotiated but not to exceed $2,750 per

month. The premises contain approximately 56.000 square

feet. At the time of the Trustee’s purchase of the premises,

there were situated upon all or part thereof houses and

—

10 Appendix

related improvements, which were removed at the expense

of Challenger. Challenger also bore the expense of improv.

ing the premises thereafter for automobile parking. Chal-

lenger was obligated to pay in respect of the premises all

taxes and assessments, insurance, utilities, and all other

maintenance and operating expenses.

On August 29, 1957, Pub., Caldwell, Waldorf, and Sara-

toga formed a joint venture known as Nugget Enterprises,

for the purpose of leasing the eight lots, constructing a

casino building thereon, and subleasing it to Challenger,

The joint venturers agreed to share the profits and losses

equally.

On September 23, 1957, the lease of May 1, 1957, between

the Trustee and Challenger was cancelled by agreement of

the parties thereto. A new lease of the same premises was

entered into on the same date between the Trustee and Nug-

get Enterprises for 20 years at $3,750 per month for the

first 5 years. The rent was to be renegotiated each 5 years,

Nugget Enterprises had an option to renew for an addition-

al 10 years. The property was to be used for a gambling

casino, restaurant, and related facilities. Nugget Enter-

prises was obligated to pay in respect of the premises all

taxes and assessments, insurance, utilities, and all other

maintenance and operating expenses.

By an agreement dated the same day, September 23,

1957, Nugget Enterprises subleased the same premises to

Challenger for 10 years (with an option in Challenger

to renew for another 10 years) at $3,750 per month for the

first 7 months and $15,000 per month thereafter. On Sep-

tember 30, 1960, the sublease was extended in a manner

similar to the extension of the Parking Lot Lease. Chal-

lenger was obligated to pay, in respect of the premises, all

taxes and assessments, insurance, utilities, and al] other

maintenance and operating expenses. In accordance with

Appendix 11

the terms of the sublease, Nugget Enterprises constructed

a new casino building on Lots 4, 5, 6, and 37 feet of Lot

7 in Block 3 of the premises. The building was completed

on May 12, 1958, at a total cost, as of the end of 1958, of

$796,769.81. Lots 1, 2, 3, 8, and 13 feet of Lot 7, continued

to be used for casino parking.

On May 12, 1958, the Sparks Nugget operation was

moved from the McDonald and Peterson premises to the

new casino. On May 26, 1958, Challenger assigned the

McDonald and Peterson leases to Trader Dick’s Inc., a

Nevada corporation owned and controlled by Mr. Graves,

for use as a restaurant.

On November 1, 1959, Nugget Enterprises completed an

enlargement of a boiler room in the casino at a cost of

$31,933.65. On January 4, 1960, at a meeting of the board

of directors of Challenger, Mr. Graves indicated that the

new boiler room was necessary for safety reasons and that

a new addition to house a pancake restaurant was desir-

able. He stated that he estimated the cost of these additions

to be $150,000, and that Nugget Enterprises would furnish

them if the rental were increased from $15,000 a month

to $16,500 a month. The board of directors adopted a

resolution approving the improvement and agreeing to the

rental increase. On April 1, 1960, Nugget Enterprises en-

larged the casino by the addition of a restaurant called the

Pancake Parlor at a cost of $88,588.32. The boiler room

and pancake restaurant improvements occupied Lot 8 and

the remaining 13 feet of Lot 7. Effective March 1, 1960,

the rental paid by Challenger to Nugget Enterprises was

raised to $16,500 a month.

On July 1, 1962, Nugget Enterprises completed a theatre-

restaurant and related facilities on Lots 1, 2, and 3 in Block

3 at a cost of $1,650,895.45. The related facilities apparently

included 104 small hotel-roomettes available to the public

for hire, which were opened in September 1962.

12 Append

Mr. Graves conceived the idea of the theatre-restaurant

and was planning it in September 1960. On July 21, 1963,

Nugget Enterprises, by Mr. Graves, proposed to the

Trustee the construction of the theatre-restaurant on its

land and requested that the Trustee give its formal ap.

proval to construction. In consideration of such approval,

Nugget Enterprises suggested that the monthly rental op

the ground lease be increased to $6,000 a month The

proposal was acceptable to the Trustee, and commencing

on January 1, 1962, the monthly rental on the ground lease

of the casino premises between Nugget Enterprises and

the Trustee was increased to $6,000.

The construction of the theatre-restanrant commenced

in the middle of 1961, and it opened in July 1962. The new

boiler room, pancake restaurant, and theatre-restaurant

additions nearly doubled the size of the casino building, and

utilized areas that previously were used for automobile

parking. The opening of the theatre-restaurant increased

the need for parking, particularly because of large crowds

at show times.

In connection with the construction of the theatre-res-

taurant, the Trustee acquired a 6-foot strip of adjoining

land (@ x 140’) from the City of Sparkes by trade for a

similar 6-foot strip of Lot 8 in Block 4 owned by Sparks

Development. Although the 6-foot strip, which was traded

to the City of Sparks, was owned by Sparks Development

and was leased by Challenger under the Parking Lot Lease,

there was no reduction in the rental paid by Challenger to

Sparks Development for the loss of the 6-foot strip, nor

was any effort made to secure such a reduction.

On January 1, 1962, the rental paid by Sparks Nugget,

Inc., to Nugget Enterprises for the eight lots was raised

to $24,000 a month, and on July 1, 1962, the rental was

raised to $55,708.77 a month, pursuant to the terms of an

agreement dated November 14, 1961.

Appende 13

EB. The Hanson Premises

On December 12, 1958, Sparks Development leased eight

half lots from Frank E. and Rose Hanson for $1,000 «

month for a term of 5 years with an option to renew for

5 years on the same terms, and a further option to renew

for 10 years at a rental to be negotinied. The half lots are

Lots 5, 6, 7, 8, 9, 19, 20, and 21 in Block 5; each is 25 feet

wide and 140 feet deep. A brick market building was situ-

ated on half lots 5, 6, and 7. From time to time, Sparks De-

rented out the building for various uses at $700

a month. The Hanson premises contain 28,000 square feet,

of which 17,500 square feet is available for parking. On

December 12, 1958, Sparks Development subleased half lots

& 9, 19, 20, and 21 to Challenger for $1,000 a month for

automobile parking purposes. In 1963, Sparks Develop-

ment renewed the Hanson lease on the same terms, and in

1965, Sparks Nugget, Inc., reconstructed the Hanson build-

ing into a convention center.

F. The Southern Pacific Railroad Premises

On May 15, 1958, Challenger leased vacant unimproved

property for parking purposes from the Southern Pacific

Railroad at a rental of $100 a month. The lease was term-

inable by either party on 30 days’ notice. The property is

190 feet deep and 508 feet wide, and is located on the south

side of A Street between 11th and 12th Streets. Parking

improvements were made at Challenger's expense. Chal-

lenger was obligated to pay in respect of the premises all

taxes and assessments, utilities, and all other maintenance

and operating expenses.

In April 1962, a new lease was entered into between

Sparks Nugget. Inc., and the Southern Pacific Railroad for

a term of 5 years at a rental of $290 a month. The lease

was terminable by the lessor on 30 dave’ notice if the

property was needed, in the lessor’s judgment, for in-

dustrial, railroad, or highway purposes. The property

4 Appendiz

ineluded the property previously leased and additional]

property located south of A Street lying to the west of the

property previously leased. The total property leased

under this new lease is 190 feet deep and 908 feet wide,

being 172,520 square feet. The property was used for auto.

mobile parking purposes and all parking improvements

thereon were made at the expense of Sparks Nugget, Ine.

Sparks Nugget, Inc. was obligated to pay in respect of

the premises all taxes and assessments, utilities, and all

other maintenance and operating expenses. Further, in

the event that assessments for public improvements were

made, the lease provided that the rental should be increased

by 6 percent of the amount of the assessment per annum.

In December 1963, Sparks Nugget, Inc. and Southern

Pacifie Railroad made a revised lease of the premises for

a term of 5 years with a 5-year renewal option. Challenger

or Sparks Nugget, Inc., has continually occupied the South-

ern Pacific Railroad premises since the May 1958 lease.

The premises were originally used only for employee park-

ing, but after the need for parking grew, it was also used

by casino customers.

G. The Lazalt Premises

In December 1958, Mr. Graves sold Lot 13 in Block 3

to Paul D. Laxalt, custodian for Mr. Graves’ children under

the Nevada Uniform Custodian Act, fur the sum of $20,000.

In Angust 1959, the enstodian leased the lot, containing

7,000 square feet, ‘o Challenger. The lease was for a term

of 5 vears at $300 a month, with an option to renew for 5

years at a negotiated rent. The cost of removal of the

house and related improvements previously situated on the

lot and the parking ‘ot improvements were borne by Chal-

lenger. On September 30, 1960. the term of the lease was

extended in a manner similar to the extension of the Park-

ing Lot Lease. Challenger acquired use of the lot prin-

cipally for pedestrian aceess from the casino to the South-

Appendar 15

ern Pacific Railroad premises, but the lot was also used for

automobile parking. In 1964, the lease was renewed at the

same rental, at which time the property was still used for

the same purposes. Mr. Graves fixed the rental on the

hasis of his estimate of the fair rental value of the prop-

H. The Nugget Motor Lodge Premises

Mr. Graves purchased Lots 4 through 8 in Block 2 on

the dates and for the amounts as follows:

— hee

vat Dare Price

4 3/30/58 = $:-42, 140.96 7,000

———— 50,250.56 7,000

= 6/11/59 42,327.25 7,000

7 6 /8/59 42,344.91 7,000

| 6/ 3/59 42,135.94 7,000

$219,199.62 35,000

The total purchase price was advanced to Mr. Graves

by Challenger. In February 1960, Mr. Graves transferred

the lots to Challenger in cancellation of that advance, and

at about the same time, Challenger conveyed the lots to

Nugget Motor Lodge, Inc., a Nevada corporation, in ex-

change for 2,500 shares of its authorized capital stock of

5,000 shares. The Lodge, which has 140 rooms, was con-

ceived by Mr. Graves and was opened in 1960. The Lodge

building does not occupy the entire 5 lots; there is parking

beneath the building and on the balance of the lots.

1. The Williams, Peterson, Roche, and Church Premises

Sparks Development purchased 3 full lots and 3 half

lots in 1960 and 1962 as follows:

Purchase Purchase

lt aw Dete Price

Williams _. 4/13/62 $ 53,009 7,000

35,625

16 Appendiz

On August 1, 1962, Sparks Development and Sparks

Nugget, Inc., entered into a supplemental lease of the

Williams, Peterson, Roche, and Church lots. Such lease

was for a term ending with that of the Parking Lot Lease.

The rental to be charged Sparks Nugget, Inc., was $4,410

a month.

J. The State of Nevada Premises

On April 1, 1964, the State of Nevada leased to Sparks

Nugget, Inc., Lots 9 through 16, except Lot 13 (the Laxalt

premises), of Block 3, for use as a parking lot. Such lease

was on a month-to-month basis at a rental of $600 per

month for the first 22 months and $700 per month there-

after. The premises contained 49,000 square feet. Sparks

Nugget, Inc., was obligated to pay all utilities and to keep

the premises in good condition.

After construction of an elevated viaduct on the prem-

ises, the State, in December 1967, made a new lease of the

premises, including Lot 13, to Sparks Nugget, Tne., on a

month-to-month basis at a rental of $700 a month. The new

lease related to premises containing 56,000 square feet. The

lessee’s use of the premises and obligations were the same

as under the first lease.

In June 1968, Sparks Nugget, Inc., completed negotia-

tions of a new lease with the State, covering Lots 9 through

16 in both Blocks 2 and 3 (112,000 square feet), for a term

of 20 years at an annual rental of $27,500 for the first

5 years. Sparks Nugget, Inc., is obligated to pay taxes and

to make all improvements at its own expense. The lease

contemplates that the premises will be used for automobile

parking, being divided into approximately 312 car spaces.

At all times material in this case, neither Challenger,

Sparks Development, Pub, Caldwell, Waldorf, nor Saratoga

ever paid any dividends to the Graves. Although Mr. Graves

recognized that no corporate tax benefit could be obtained

by having Sparks Development lease the Parking Lots

Appendiz 17

to Challenger, he felt that such an arrangement could affect

the amount of his personal income tax. At the time of the

execution of the Parking Lot Lease, Mr. Graves had in

mind retiring early from active participation in Challen-

ger’s business, and the arrangement concerning the Parking

Lots facilitated his sale of Challenger stock, and financially

benefited him after such sale.

The reasonable rental of the Parking Lots during 1959

and 1960 did not exceed $4,000 per month.

Il. Rental of Slot Machines

On March 17, 1955, Pub, Saratoga, and Waldorf leased

100 slot machines to Challenger. Such lease continued in

effect with terms unchanged until October 1, 1960, when

the machines were sold to Challenger by the lessors for

$200 per machine. On its Federal income tax returns,

Challenger deducted as slot machine rentals $97,336.07 for

its taxable year ending September 30, 1959, and $103,821.15

for its taxable year ending September 30, 1960. The re-

spondent does not dispute that such amounts were actually

paid by Challenger to the lessors. However, he has deter-

mined that Challenger was not required to pay monthly

rent exceeding $2.59 per machine. Accordingly, he has

reduced the annual rent deductible by Challenger to $3,108

for both of its taxable years, 1959 and 1960.

In The Challenger, Inc. (Dec. 27,198(M)], 23 T. C. M.

2096, 33 P.-H. Memo. T. C. par. 64,338 (1964), we held that

a reasonable monthly rent for the slot machines here in

issue did not exceed $2.59 per machine for the taxable

years of Challenger 1955 through 1958, and to the extent

the claimed deductions exceeded such figure, they did not

represent amounts required to be paid for the use of the

slot machines in Challenger’s business and were not de-

ductible.

Appendiz

Ill. Payments by Sparks Development

to Mr. Graves

In its taxable year ending November 30, 1961, Sparks

Development paid Mr. Graves $8,539.01, which it treated

as compensation for services. As in other years, the pay-

ment was computed on the basis of 10 percent of the profits

of Sparks Development. During the taxable year, Mr.

Graves was the president, manager, and sole employee of

Sparks Development. Although in prior years, Mr. Graves

performed extensive services for Sparks Development in

connection with its real estate transactions, during the

taxable year his only service to the corporation was his

negotiation for the acquisition of the Roche property,

which was purchased by Sparks Development on October

29, 1962. Reasonable compensation for Mr. Graves’ services

during the taxable year was not less than $8,539.01.

Opinion

The respondent’s determinations are predicated on three

basic arguments. First, he contends that part of the

amounts paid by Challenger under the Parking Lot Lease

were excessive and not deductible, and that Sparks Nugget,

Inc., is liable as the transferee of Challenger for the result-

ing deficiencies. Secondly, he asserts that the Graves

received constructive dividends when Challenger paid to

Pub, Saratoga, and Waldorf excessive rentals for the use

of certain slot machines and when Challenger paid to

Sparks Development excessive rentals for the use of the

Parking Lots. Thirdly, he argues that Sparks Development

may not deduct, as compensation, certain amounts it paid

to Mr. Graves. At the trial, the respondent adopted the

alternative position that section 482 is applicable; however,

as a result of our decisions with respect to the other issues,

we do not reach that issue.

Appendiz 19

I. Rental of Parking Lots

Section 162(a) provides in part as follows:

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

tion all the ordinary and necessary expenses paid or

sneurred during the taxable year in carrying on any

trade or business, including—

(1) a reasonable allowance for salaries or other

compensation for personal services actually rendered ;

eo o o

(3) rentals or other payments required to be made

as a condition to the continued use or 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.

The petitioners point out that section 162(a)(3) does

not expressly limit the deduction for rent to reasonable

amounts, whereas section 162(a)(1) does limit deductions

for salaries or other compensation to reasonable amounts.

They contend that if Congress wished to limit rental deduc-

tions in the same manner as deductions for compensation,

it could easily have done so. According to this argument,

the absence of such a limitation reflects the congressional

intent that rental deductions should be allowed in toto for

all payments made for the purpose of renting property.

The petitioners assert that the payments claimed as deduc-

tions by Challenger were paid pursuant to a written lease ;

that the lease required such payments to be made; that

Challenger occupied the Parking Lots pursuant to the

lease; and that Sparks Development was the sole owner of

the Parking Lots. They conclude that whether the payments

made with respect to the Parking Lot Lease were reason-

able or unreasonable, they are properly deductible as a

business expense under section 162. Although the peti-

tioners argue for their position strongly and eloquently,

we do not agree.

20 Appendix

The authorities have differed over the significance of

the lack of an express reasonable limitation on the dedueti-

bility of rentals under section 162(a) (3). Section 162 limits

all deductions for business expenses to those which are

“ordinary and necessary.” It has been frequently asserted

that business expenses which are unreasonable in amount

are not ordinary and necessary and therefore not dedue-

tible. See. 1.212-1(d), Income Tax Regs.; Brown Printing

Co. v. Commissioner, 255 F. 2d 436 (C. A. 5, 1958), revg. a

Memorandum Opinion of this Court; Commissioner v. Lin-

coln Electric Co., 176 F. 2d 815 (C. A. 6, 1949), revg. a Mem-

orandum Opinion of this Court, cert. denied 338 U. S. 949

(1950); Limericks, Inc. v. Commissioner, 165 F. 2d 483

(C. A. 5, 1948), affg. 7 T. C. 1129 (1946) ; 7. T. 3581, 1942-2

C. B. 88. Other cases have indicated that, when parties to a

lease are unrelated or are otherwise shown to have been

dealing at arm’s length, rental deductions must be allowed

in full with no inquiry into the reasonableness of the

amount. Potter Electric Signal and Manufacturing Co. v.

Commissioner, 286 F. 2d 200 (C. A. 8, 1961), affg. a Mem-

orandum Opinion of this Court; Utter-McKinley Mortuar-

ies v. Commissioner, 225 F. 2d 870 (C. A. 9, 1955), affg. a

Memorandum Opinion of this Court; Anderson Dairy, Inc.,

39 T. C. 1027 (1963); Coe Laboratories, Inc., 34 T. C. 549

(1960) ; J. J. Kirk, Inc., 34 T. C. 130 (1960) affd. 289 F. 2d

935 (C. A. 9, 1961); Jos. N. Neel Co., 22 T. C. 1083 (1954) ;

Roland P. Place, 17 T.C. 199 (1951), affd. per curiam,

199 F. 2d 373 (C. A. 6, 1952), cert. denied 344 U. S. 927

(1953) ; Stanwick’s, Inc., 15 T. C. 556 (1950), affd., 190 F. 2d

84 (C. A. 4, 1951).

In view of the circumstances surrounding the making of

the Parking Lot Lease, it is not necessary for us to choose

between these conflicting authorities. If the parties to a

lease are closely related and if the transaction has not been

ww

Appendiz 21

negotiated at arm’s length, the courts have consistently

held that payments in excess of reasonable rent are not “re-

quired to be made” and are therefore not deductible under

section 162(a) (3). Potter Electric Signal and Manufactur-

ing Co. v. Commissioner, supra; Utter-McKinley Mortw-

aries v. Commissioner, supra; Coe Laboratories, Inc.,

supra; J. J. Kirk, Inc., supra; Jos. N. Neel Co., supra;

Roland P. Place, supra; Stanwick’s Inc., supra. The Graves

were the sole stockholders of both Challenger and Sparks

Development. Mr. Graves was the principal executive officer

of both corporations and whatever negotiations between

such corporations took place were between Mr. Graves and

himself. The evidence indicates that the amount of the

rental provided in the Parking Lot Lease was not calculated

to reflect the actual value of such lease, but rather, was

established with the dual purpose of building up the capital

of Sparks Development and providing it with sufficient

funds to meet obligations it incurred in connection with the

purchase of the Parking Lots. For these reasons, it is clear

that the Parking Lot Lease was negotiated between closely

related parties not dealing at arm’s length. See Midland

Ford Tractor Company v. Commissioner, 277 F. 2d 111

(C. A. 8, 1960), affg. a Memorandum Opinion of this Court,

cert. denied 364 U. S. 881 (1960). Accordingly, if the so-

called rental payments are excessive and unreasonable, the

excess is not deductible under section 162(a)(3). Such

amount is not deductible, irrespective of why it was paid

(Utter-McKinley Mortuaries v. Commissioner, supra), al-

though the reasons for the payment of the excess are con-

sidered later in connection with the question of whether

the Graves received any constructive dividends.

The question now becomes whether the rental provided

by the Parking Lot Lease was reasonable. The evidence

bearing on the reasonableness of the rentals charged chal-

22 Appendix

lenger under the Parking Lot Lease has come from three

principal sources. Extensive data has been supplied by way

of stipulation as to various real estate transactions occur-

ring in the period 1954 through 1968. Additionally, the

petitioners called as their witness Mr. Paul A. Walters, who

operates a chain of commercial parking lots in Reno

Nevada. Finally, the respondent called as his witness Mr,

Arthur W. Reber, a professional appraiser who prepared

an appraisal of the fair rental value of the Parking Lots,

Most of the argument has centered about the validity of

this appraisal.

Mr Reber concluded that the fair rental value of the

Parking Lot under the Parking Lot Lease was $36,681 a

year, or 81 cents per square foot per year. He reached his

conclusion by first determining the fair market value of the

Parking Lots at the time of execution of the lease by an

analysis of sales of real estate located in the vicinity of the

Parking Lots occurring between 1955 and 1964. From this

data he concluded that the fair market value of the Parking

Lots at the time of the lease was $282,163.00 or $6.24 per

square foot. To determine the fair rate of return, he ana-

lyzed comparable leases of real property and found that

the average rental provided in such leases was approxi-

mately 10 percent of the value of the leased premises. To

this figure, he added three percent to cover the anticipated

increase in the value of the Parking Lots over the term of

the lease, so that in his opinion, 13 percent was a fair rate

of return during the term of the lease. Although the re-

spondent allowed an annual rental of $48,000.00, or $1.06

per square foot per year, he does not seek to increase the

deficiency as a result of Mr. Reber’s conclusion.

The petitioners vigorously attack Mr. Reber’s appraisal

on numerous grounds:

Appendix 23

A. Qualifications of Mr. Reber

The petitioners contended that the Reber appraisal is

initially suspect and can in no event be accorded much

weight, since Mr. Reber has no extensive experience in ap-

praising Nevada gambling and parking properties. Mr.

Reber is an experienced appraiser whose abilities have been

noted by this Court in the past. Norman Baker Smith, 51

T. C. 429 (1968). He has appraised numerous properties in

the State of Nevada, including at least one gambling estab-

lishment. He has also appraised numerous commercial pro-

perties including parking lots. He testified that he was

qualified to make an expert appraisal of the Parking Lots,

and we believe him to be so qualified. However, the fact of

his qualification does not prove the correctness of his ap-

praisal, and we must now consider the petitioners’ substan-

tive objections to that appraisal.

B. Special Value of Parking Lots to Challenger

The petitioners argue that the Reber appraisal gave

no consideration to the unique value of the Parking Lots

to Challenger. They contend that without ample free park-

ing, the Sparks Nugget Casino could not have achieved its

great success, and that accordingly, the Parking Lots were

far more valuable than $282,163. In addition, they assert

that by leasing the Parking Lots, Challenger foreclosed

the possibility of the establishment of a competing casino

on those premises.

We recognize that free parking was a material factor

in the casino’s success; but it appears that the Reber ap-

praisal has given this factor adequate consideration. Mr.

Reber’s appraisal took account of the purchase of the

Parking Lots by Mr. Graves during the period July 1958

through April 1959, for a total purchase price of $253,-

609.04. Yet, Mr. Reber appraised their value as of June

—

24 Appendix

1959, just 2 months after the last acquisition, as $282.

163.00, $28,553.96 more than was paid for them. It may

be assumed that the sellers of the Parking Lots were

aware, at least in general terms, of Mr. Graves’ plans and

bargained for all that they could get for their properties,

In addition, Mr. Reber’s analysis took into consideration

the sales to Mr. Graves of other properties in the vicinity

of the casino, and the prices of these properties must have

reflected the bargaining of sellers who were attempting to

secure from him the highest possible prices for their prop.

erties. Thus, Mr. Reber’s determination of the fair market

value of the Parking Lots was based upon the prices paid

in the market place for properties used in connection with

the casino’s operations and therefore adequately reflects

the value of the Parking Lots to Challenger.

It also appears to us that Mr. Reber’s valuation gives

sufficient effect to the possibility of eliminating competition,

since such valuation is based upon the market price of

properties in that vicinity at that time. In addition, we

imagine that any number of lots in and around Sparks

could have provided a site for competition, and it hardly

seems practicable that the Graves could have eliminated

all potential competition in the Sparks vicinity by acquir-

ing or leasing all such lots. Furthermore, the petitioners

have not shown that competition would reduce the profit-

ability of the casino. The economic success of gambling

establishments in such areas as Las Vegas and Reno may

well be in substantial part due to the numerous casinos

in those areas, which may serve to draw more people to

each of them than would be drawn to a single casino in

the same location.

a

C. Validity of Comparable Sales

The Reber appraisal states that it arrives at the fair

market value of the Parking Lots by the market data or

—

Appendix 25

comparable sales approach. The petitioners note that cer-

tain of the comparable sales used by Mr. Reber were sales

of the Parking Lots themselves to Mr. Graves. Accordingly,

they argue that Mr. Reber’s appraisal actually combines

the comparable sale and the actual cost approach and that

such a mixture renders his conclusions valueless.

Whether or not Mr. Reber technically adhered to the

comparable sales approach, we perceive no reason, and

none has been advanced, why the use of the actual cost

of the Parking Lots diminishes the efficacy of the Reber

appraisal. See International Paper Company v. United

States, 227 F. 2d 201 (C. A. 8, 1955) ; United States v. 5139.5

Acres of Land, etc., 200 F. 2d 659 (C. A. 4, 1952) ; Ambas-

sador Apartments, Inc., 50 T. C. 236 (1968), affd. per

curiam 406 F. 2d 288 (C. A. 2, 1969). The Parking Lots

were purchased in arm’s length transactions within a year

of the valuation date, and their cost supplies as good an

index of their fair market value as the cost of similar lots.

The petitioners also criticize Mr. Reber’s technique, on

the grounds that he did not “verify” the cost data relating

to the post-1959 comparable sales. Mr. Reber obtained his

data for such sales from the Nevada State Highway Depart-

ment, who informed him that the sales had heen verified

by them. Apparently, it is the petitioners’ position that

data from a third party is inherently unreliable. However,

it is well established that an appraiser may use hearsay

information in formulating his appraisal, if such informa-

tion appears to be reliable. Standard Oil Company of Cali-

fornia v. Moore, 251 F. 2d 188, 221 (C. A. 9, 1957), cert.

denied 356 U. S. 975 (1958); District of Columbia Rede-

velopment Land Agency v. 61 Parcels of Land, 235 F. 2d

964 (C. A. D. C. 1956); International Paper Company v.

United States, supra; United States v. 5139.5 Acres of

Land, etc., swpra. In this case, we see no basis to question

the reliability of the information obtained from the State.

26 Appendix

The petitioners contend that the Reber appraisal is also

deficient inasmuch as it does not consider all the compa-

rable sales occurring in the vicinity of the Parking Lots.

They refer to four sales which they contend were not con-

sidered by Mr. Reber. Of those four sales, one occurred in

1957, one occurred in 1958, and two occurred in 1960.

The 1957 and 1958 sales were for prices substantially

lower than the average prices for comparable sales in those

years found by Mr. Reber, and the petitioners have not

demonstrated that the omission has prejudiced them in any

way. Mr. Reber did not detail the post-1959 comparable

sales that he considered in valuing the Parking Lots since

such data is not as relevant to determining market value

in 1959 as pre-1960 sales. Accordingly, we cannot be certain

whether or not Mr. Reber did in fact consider that 1960

sales mentioned by the petitioners. One of such sales was

for a price substantially lower than the average post-1959

sales prices considered by Mr. Reber, and the other sale

was for a substantially higher price. However, the petition-

ers have not indicated whether or not the higher-priced

sale was of improved realty—if it was, such fact might

account for the higher price. In any event, only one of the

sales allegedly not considered by Mr. Reber might be help-

ful to the petitioners, and its omission does not make any

significant difference in the result.

The petitioners object to the selection of most of the

comparable sales used by Mr. Reber, since such sales were

of property used at the times of sales for residential pur-

poses. From this fact, the petitioners conclude that the

purchase prices of the comparables were based on their

use as personal residences, and that they are not compa-

rable to property the purchase price of which is based on

its commercial use. We do not agree. The evidence indicates

that all of the comparable sales used by Mr. Reber were

of property zoned and appropriate for commercial use.

Appendix a

Furthermore, it is evident that almost all of the purchasers

intended to use the properties purchased by them for com-

mercial purposes. There is no indication in the record that

the sellers of the comparables sold them with the under-

standing that they would be used as residential property.

in negotiating the purchase price, the sellers would natu-

rally base their sales price on the market value of their

property, taking into consideration their potential use ss

commercial property.

D. Correctness of Rate of Return

The petitioners assert that Mr. Reber’s use of a 13-percent

rate of return is entirely insufficient to reflect the earning

power of the Parking Lots, that he failed to take into

consideration that the lease was to run for a 5-year period,

and that his allowance of 3 percent for an increase in the

value of the property was unrealistic. In support of these

contentions, they point out that Mr. Reber's computations

indicate increases in land value over the 5-year period from

1959 through 1964 of 27 percent.’

The parties to the leases which Mr. Reber used as his

comparables, no doubt, took into consideration the likeli-

hood of inflation and increase in the value of the property

in fixing the rate of rentals in such leases, and therefore,

the average rate of return of approximately 10 percent

found by Mr. Reber gave some effect to the expected

‘nerease in the value of the Parking Lots. Nevertheless,

Mr. Reber added 3 percent to the average in order to give

ample effect to the term of the lease and the likely increase

in the value of the properties during such term. This addi-

tion was more than adequate to cover the actual increase

—____—-_ ——_——-

3. The petitioners’ brief states that the land value increase

was “‘at least 20 percent.” Actually, such increase was 27 percent,

and we have used the latter figure in our

28 Appendix

in the value of the properties. It constituted a 30-percent

addition to the annual return on the value of the Parking

Lots under the lease; whereas, Mr. Reber’s study shows

that the property only increased 27 percent in value over

the 5 years of the lease, or approximately 5 percent

per year. Mr. Reber’s objective was to examine the circum.

stances existing in 1959, and based upon such circumstances,

to project the reasonable rental to be expected over the

5-year period of the lease. Midland Ford Tractor Company

v. Commissioner, supra; Brown Printing Co. v. Commis-

sioner, supra; J. J. Kirk, supra; Stanley Imerman, 7 T. C.

1030 (1946). Although the casino turned out to be a very

successful operation, his addition of more than 30 percent

to each year’s income to take into consideration the likely

changes over the term of the lease were generous in the

light of what could have been anticipated in 1959.

Although all but one of the 12 comparable leases consid-

ered by Mr. Reber involved gambling-associated property,

the petitioners argue that there are sufficient differences

between the comparables and the Parking Lot Lease to

render Mr. Reber’s appraisal valueless. The petitioners

note that certain of the comparables involved more specula-

tive operations than the Parking Lot Lease. However, if

such leases were more speculative, it seems that the rate

of return on them should have been higher than on the

Parking Lot Lease, and therefore, their use could not preju-

dice the petitioners. Some of the leases involved property

of less value than the Parking Lots; but this difference

does not affect the usefulness of such leases—the lesser

value reduces the gross rental, but does not affect the rate

of return. Other comparable leases are criticized by the

petitioners because they involved property not in Sparks,

Nevada. However, since all but one of the comparable leases

considered by Mr. Reber involved property used in connee-

Appendiz 29

tion with gambling establishments, we see no reason to re-

ject data from leases on property in different geographic

areas, especially since there were few leases of gambling

on the alternative grounds that they were

entered into as much as 7 years before the Parking Lot

Lease, or were leases of improved realty. The petitioners

have suggested no reason why these facts should materially

affect the reliability of Mr. Reber’s appraisal and we per-

ceive none.

The petitioners object to Mr. Reber’s omission of the

sublease between Challenger and Nugget Enterprises of

the Sparks Nugget Casino. This lease was found to be rea-

sonable in The Challenger, Inc., 23 T. C. M. 2096, 33 P.-H.

Memo. T. C. par. 64,338 (1964). We think Mr. Reber was

justified in disregarding this lease since the parties thereto

were closely related and did not negotiate it at arm’s length.

In addition, our prior holing was only that the rentals

under the lease were reasonable. We expressed no opinion

as to the fair rental value of the property which was the

object of Mr. Reber’s inquiry. Finally, the 80 cents per

square foot per year rental under such lease was less than

the amount found by Mr. Reber, and considerably less than

the amount allowed by the respondent in this case, and

consequently, the petitioners are not prejudiced by Mr.

Reber’s omission of the information concerning the lease

approved in the earlier Challenger case.

The petitioners point out that Mr. Reber was not con-

versant with all the terms of either the Parking Lot Lease

or the leases which he considered comparable. His testi-

mony indicates that he was aware that the Parking Lot

Lease was for a term of 5 years and was renewable, but

that he was unaware of the provision in the lease allowing

the lessee to terminate in the event gambling was outlawed

30 Appendiz

in Nevada. The fact that Mr. Reber was unaware of the

termination provision does not, we think, diminish the vi-

ability of his appraisal. His appraisal report sets forth the

term and the rental of each of the comparable leases he

employed. Such data is by far the most significant informa-

tion he required in making his appraisal. We cannot expect

appraisers appearing before this Court to be familiar with

all the provisions of the legal documents relating to com-

parable property selected by them in their appraisals.

It appears that Mr. Reber obtained his information on

all but two of the comparable leases by talking to persons

associated with either the lessor or the lessee. With respect

to the other leases, Mr. Reber was unclear as to his source

of information, but such information appears to have come

to him in his professional capacity during the course of

his appraisal. The petitioners contend that such informa-

tion is inherently unreliable and that Mr. Reber should have

consulted the provisions of the leases themselves. As we

have noted previously, the appraiser may rely upon hearsay

data in formulating his appraisal. In the present case, we

do not think that such reliance is untoward or significantly

affected the accuracy of the appraisal.

In summary, the petitioners’ objections to the Reber ap-

praisal are not well taken. His determination of the fair

market value of the Parking Lots at the time of the lease

is adequately supported by market data, and his use of

13 percent as the rate of return seems to be appropriate.

Accordingly, his conclusion as to the fair rental value of

the Parking Lots for the term of Parking Lot Lease is

valid.

The petitioners contend that the data relating to most

of the other real estate transactions in Sparks included in

our Findings of Fact is not relevant, because such trans-

actions are not comparable to the lease of the Parking Lots.

Appendiz 31

They emphasize that the Parking Lots furnished the most

convenient parking for the casino and therefore could

command much higher rentals than the other properties

jeased in Sparks. They also contend that most of the other

' transactions described in our findings are not pertinent

to our inquiry because they involved property which was

either improved, leased prior to the opening of the new

casino, acquired for employee parking, or acquired for

access. Rather, the petitioners take the position that the

most significant transactions were the acceptance of the

rental provisions of the Parking Lot Lease by Mr. Ascuaga

when Sparks Nugget, Inc., acquired Challenger ; the renewal

of such lease at the same rental in 1964; and the supple-

mental lease entered into between Sparks Development

and Sparks Nugget, Inc., on August 1, 1962.

In our opinion, none of these transactions constitute a

showing of substantial error in the Reber appraisal. Sparks

Nugget, Inc., controlled by the Ascuagas, acquired the stock

of Challenger, controlled by the Graves, on September 30,

1960. Although Mr. Ascuaga was @ former employee of

Mr. Graves, the evidence indicates that the transaction was

one at arm’s length. The petitioners point out that, as a

condition to the stock purchase, Mr. Ascuaga insisted on

the extension of the period for which the Parking Lot Lease

could be renewed; from that fact, the petitioners would

have us infer that the provisions of the lease were open

for renegotiation and that by not renegotiating the rental,

Mr. Ascuaga was acknowledging its reasonableness. We

do not think such an inference is warranted. In purchasing

Challenger’s stock, Sparks Nugget, Inc., in effect, acquired

the entire properties and liabilities of Challenger for a

total unallocated consideration. In such a situation, the

purchase price may be allocated among the various items

of property owned by the acquired corporation in any

32 Appendiz :

manner desired by the parties. For example, if Sparks —

Nugget, Inc., felt that the rental under the Parking Lot

Lease was unduly high, a readjustment of the rent would

not be necessary if there was a downward adjustment in

the purchase price of the stock. The fact that the period

of the lease was renegotiated is not persuasive to us. Al-

though excessive rentals under the lease could be compen.

sated by an adjustment in the purchase price of the Chal-

lenger stock, no such adjustment was possible with respect

to the length of the lease. The Parking Lots were important

to the casino’s success, and the only way Sparks Nugget,

Inc., could assure itself of their continued availability was

by securing a modification of the lease. An adjustment in

the purchase price of the stock could not take the place

of lengthening the lease.

Equally unpersuasive is the fact that Sparks Nugget,

Inc., renewed the Parking Lot Lease in 1964 at the same

rental of $8,000 per month. Although Mr. Reber did not

appraise the Parking Lots as of the renewal date, his

records do show that the average sales price of comparable

pieces of property increased from $5.99 per square foot

in 1959 to $7.57 per square foot in 1964, an increase of 27

percent. If the Parking Lots increased in value by this same

percentage, the annual rental of $2.12 per square foot for

the renewal term is only a 27-percent annual rate of return

based on the 1964 value of the Parking Lots as opposed to

a 34-percent rate of return based on the 1959 value. Thus,

although the lease was renewed at the same rental, the rate

of return was actually reduced, despite the fact that be-

tween 1959 and 1964, the casino operation expanded con-

siderably, resulting in a greater need for parking and a

diminution of available parking space. What is more, al-

though we have found that Sparks Development and Sparks

Nugget, Inc., dealt at arm’s length, we do not necessarily

Appendiz 33

find that each individual transaction between them was for

a consideration representing fair market value. Sparks

Nugget, Inc., was, to a certain extent, dependent for its

suecess on the good will of Sparks Development and its

owners, the Graves. During 1964, Sparks Development and

the trusts established by the Graves were leasing the casino

premises and at least two additional parking lots to Sparks

Nugget, Inc. Additionally, payments for the Challenger

stock were still being made to the Graves by Sparks Nug-

get, Inc., pursuant to the purchase agreement; accordingly,

Sparks Nugget, Inc., could not make capital expenditures

in excess of $10,000 per year without the Graves’ approval.

Furthermore, Mr. Graves was the controlling stockholder

of Nugget Motor Lodge, Inc., which owned and operated

a motel supplying considerable business to the casino. Fi-

nally, the Graves owned a small amount of the stock of

Sparks Nugget, Inc. These various associations hetween

lessor and lessee diminish the reliability of the rental paid

for the renewal term of the Parking Lot Lease as an index

of fair rental value of the Parking Lots.

The petitioners contend that the terms of the supple-

mental lease also call into question the conclusions of the

Reber appraisal. They point out that although this lease

involved property not as valuable to the casino operation

as the Parking Lots, the rental was $1.68 per square foot—

only 44 cents per square foot less than the rental of the

Parking Lots under the Parking Lot Lease, 87 cents per

square foot more than the Reber appraisal of the fair

rental value of the Parking Lots, and 62 cents per square

foot more than the reasonable rental allowed bv the re-

spondent. Since the properties subject to the supplemental

lease (Lots 1 and 2 in Block 1, Lot 4 in Block 4, and

Lots 22, 23, and 24 in Block 5) were further from the

casino than the Parking Lots, we agree with the petitioners’

34 Appendix

contention that they were not as valuable for parking pur-

poses as the Parking Lots. However, Mr. Reber determined

the fair rental value of the Parking Lots as of June 17,

1959, based upon the facts existing at that time and those

reasonably foreseeable. By 1962, when the supplemental

lease was made, there had been a spectacular expansion

in the casino operations, a reduction in the available park-

ing, and a vastly increased need for parking spaces. These

circumstances indicate a demand for parking that was not

foreseeable as of 1959 and explain why there may have

been an increase in the value of properties in the vicinity

of the casino that was not reasonably foreseeable as of

1959.

The most useful comparison, we think, can be drawn with

respect to Lots 1-8 in Block 3, which have been used for

both parking and as the casino premises. The Trustee

owned these premises and initially leased them to Challeng-

er on May 1, 1957, for parking, before the new casino was

built. The rental established under this lease was not to

exceed 59 cents per square foot. Subsequently, on Septem-

ber 23, 1957, the lease with Challenger was cancelled and

the Trustee leased the premises to Nugget Enterprises for

80 cents per square foot. The lease has a 20-year term and

a 10-year renewal option and provides that the rent be

renegotiated every 5 years. Nugget Enterprises constructed

the casino on a part of the premises and subleased it to

Challenger. On January 1, 1962, the lease between the

Trustee and Nugget Enterprises was amended to provide

a rental of $1.27 per square foot. If the 1957 rental and

the 1962 rental under this lease represent the fair rental

value of the casino property on those dates and if the fair

rental value increased ratably over that period, the fair

rental value of the property on June 17, 1959, was approxi-

mately 99 cents per square foot. This figure is 18 cents

Appendiz 35

higher than the fair rental value of the Parking Lots found

by Mr. Reber and 7 cents lower than the rental allowed

by the respondent in his determination. These premises,

as we have noted, were used for parking and as the site

of the casino. There is every reason to believe that they

were at least as valuable as the Parking Lots and had as

high a rental value per square foot as the Parking Lots.

In addition, the lessor of the premises was the trustee of

trusts for the Graves’ children. It was therefore under a

fiduciary duty of care not to lease the premises for an

unfairly low rent.

The petitioners have attempted to support the reason-

ableness of the rental under the Parking Lot Lease by the

testimony of Paul A. Walters, an operator of commercial

parking lots in Reno. Mr. Walters testified that the charge

for parking space in Reno was 50 cents for 4 hours. He

felt that the casino could charge 50 cents for 3 hours park-

ing since the Parking Lots were very convenient to the

casino. He also believed that each parking space in the

Parking Lots would turn over four to five times daily. He

concluded that each space would return $2.25 to $2.50 per

day or about $75 per month. The petitioners point out that

the Parking Lots contained 143 parking spaces, which, at

$75 per month, would yield more per month than the rental

paid in respect of such spaces under the Parking Lot Lease.

We do not find this testimony persuasive. Mr. Walters’

estimates were based upon the gross receipts to be derived

from the parking spaces and did not take into consideration

any expenses for overhead, personnel, taxes, ete. Further-

more, he was comparing the fees that could be charged for

parking in an area which included a variety of businesses.

We are not convinced that the patrons of the casino would

have paid comparable fees for parking. The uses of the

parking spaces which Mr. Walters had in mind are too

36 Appendiz

different from the uses of the parking spaces near the

casino to make comparisons reliable.

The petitioners have sought to convince us of the reason-

ableness of the rentals provided under the Parking Lot

Lease. Nothing in the evidence supports their position. The

rental of $2.49 per square foot for the first year of the

lease term is a 45-percent annual rate of return on Mr.

Graves’ cost of acquiring the Parking Lots; the rental of

$2.12 per square foot for the last 4 years of the initial

lease term is a 38-percent annual return on cost. The evi-

dence clearly indicates that the value of the Parking Lots

at the time the lease was executed was not substantially

greater than the cost to Mr. Graves. It is equally apparent

that Sparks Development incurred little risk and less ex-

pense in leasing the Parking Lots. In light of these facts,

the record clearly indicates that a rental which allows total

cost recovery in less than 3 years is wholly excessive.

After considering all these facts and arguments, we have

concluded that the reasonable rental of the Parking Lots

during the term of the Parking Lot Lease did not exceed

$4,000 per month, or $1.06 per square foot per year, the

amount allowed by the respondent in his determination.

Mr. Reber’s determination that the fair rental value was

81 cents per square foot per year appears to be reliable.

It represents a return of 13 percent on the fair market

value of the property. The respondent’s allowance repre-

sents a return of 17 percent on the fair market value of the

Parking Lots. Although we have carefully analyzed each

step of Mr. Reber’s analysis and carefully considered the

other evidence offered by the petitioners, there is nothing

to convince us that his conclusions are significantly in

error: there is nothing to lead us to believe that his allow-

ances should be increased by enough to offset the additional

allowance already approved by the respondent. According-

ly, we hold that the amounts paid under the Parking Lot

Appendix 37

Lease, to the extent that they exceed $4,000 per month,

were not required to be paid under such lease and are

not deductible under section 162.

Il. Constructive Dividends to the Graves

The respondent has determined that Challenger could

not deduct in full the amounts paid by it with respect

to the Parking Lot Lease and its lease of 100 slot machines.

He further determined that the amounts so disallowed con-

stitute a constructive dividend to the Graves as sharehold-

ers of Challenger, since the money was paid for their

penefit by one corporation owned by them to other corpo-

rations owned by them.

Although Sparks Nugget, Inc., transferee of Challenger,

has contested the correctness of the disallowance of rental

deductions with respect to the Parking Lots, it has con-

ceded the correctness of the respondent’s determination

disallowing Challenger rental deductions for payments

made to Pub, Waldorf, and Saratoga with respect to the

slot machines. However, the Graves, for purposes of deter-

mining the amount of any constructive dividends to them,

do dispute the question of whether any amounts paid in

respect of the slot machines may be disallowed to Chal-

lenger as rental deductions.

In its taxable year ending September 30, 1959, Challenger

paid Pub, Waldorf, and Saratoga a total of $97,336.07;

in its taxable year ending September 30, 1960, Challenger

paid such corporations a total of $103,821.15. Challenger

claimed these amounts as rental expense for the 100 slot

machines leased from such corporations. Computed on a

monthly basis, these figures result in a monthly rental

of $81.11 per machine in Challenger’s 1959 taxable year,

and $86.52 in its 1960 taxable year. In The Challenger, Inc.,

93 'T. C. M. 2096, 33 P.-H. Memo T. C. par. 64,338 (1964),

38 Appendiz

involving Challenger’s taxable years 1955 through 1958,

this Court found that the reasonable monthly rental for

the slot machines did not exceed $2.59 per machine. The

respondent contends that the doctrine of collateral estoppel

operates to bar us from again examining the reasonable

rental of the slot machines and that for purposes of the

Graves’ tax liability, we must consider all amounts paid

in respect of the slot machines which exceed $2.59 per month

per machine as unreasonable and nondeductible by Chal-

lenger under section 162(a) (3).

The petitioners repeat their argument that section 162

(a)(3) puts no limit on the amount deductible as rental

deductions for payments made pursuant to an enforceable

leasing agreement. They next argue that even if such a

limit does exist, the conclusion reached with respect to

reasonable rental in the Challenger case was erroneous

and that they are not collaterally estopped to show as much.

Finally, they argue that even if excessive amounts were

paid by Challenger to Sparks Development for the Park-

ing Lots, and to Pub, Waldorf, and Saratoga for the slot

machines, such amounts do not constitute constructive divi-

dends to the Graves.

We cannot agree with any of these contentions.

We have already held that section 162(a)(3) does not

operate to bar inquiry into the reasonableness of amounts

claimed as rental deductions, at least when the lessor and

lessee are closely related parties not dealing at arm’s length.

We must next consider whether the amounts claimed as

rental deductions under the slot machine lease were reason-

able.

The petitioners argue that collateral estoppel cannot be

applied in this proceeding, since the parties against whom

it is sought to be invoked were not parties in the earlier

Challenger case, and since there has been an intervening

Appendiz 39

change in applicable legal principles. It is true that the

raves were not technically parties in the prior proceeding.

However, collateral estoppel may be applicable when the

later case involves the same parties as in the earlier pro-

ceeding, or when it involves parties who were in privity

with the parties in the earlier proceeding. Sunshine Coal

Co. v. Adkins, 310 U. S. 381 (1940). Stockholders are con-

sidered to be in privity with their corporation, and, if the

other requirements of collateral estoppel are present, they

cannot relitigate determinations rendered in a proceeding

involving the corporation. D. Bruce Forrester, 4 T. C. 907

(1945) ; Jahncke Service, Inc., 20 B. T. A. 837 (1930), appeal

dismissed per curiam 112 F. 2d 169 (C. A. 5, 1933). See also

Seaboard Commercial Corporation, 28 T. C. 1034 (1957) ;

American Range Lines, Inc., i7 T. C. 764 (1951), affd. on

this issue 200 F. 2d 844 (C. A. 2, 1952). Moreover, it seems

manifestly reasonable to apply the doctrine in the present

case. The Graves were the sole shareholders of Challenger,

Pub, Waldorf, and Saratoga at the time of the previous

proceeding. The petitioners in that proceeding vigorously

defended the propriety of the rental deductions claimed by

Challenger in respect of its leasing of the slot machines.

It is plain that the Graves were as much concerned with

the outcome of the prior proceeding as if they had been

parties thereto, and we see no reason to allow them to reliti-

gate questions previously decided merely because they

were not technically parties in the Challenger case.

We also see no merit in the petitioners’ contention that

there has been a substantial modification in the law since

the decision in the Challenger case. Commissioner v. Sun-

nen, 333 U. S. 591 (1948). As support for this position, the

petitioners point to the case of Royal Farms Dairy Co., 40

T. C. 172 (1963), and Estate of Sol Goldenberg, 23 T. C. M.

810, 33 P.-H. Memo T. C. par. 64,184 (1964). In each of

these cases, we disallowed a portion of a rental deduction on

the grounds that the amount treated as rent was unreason-

#0 Appendar

able and was not required to be paid within the meaning of

section 162(a)(3). Both cases were appealed by both the

respondent and the petitioners to the Court of Appeals for

the Ninth Circuit; but the appeals were dismissed by the

court pursuant to the following stipulations of the parties:

The petitioners argue that this concession by the respond-

ent constitutes an acknowledgment by him that amounts

paid as rent are deductible without regard to their reason-

ableness. However, we think that no such interpretation of

the respondent's action is warranted. In the first place, he

merely conceded the deductibility of the rental payments

involved in these cases, and that concession may have been

due to a recognition that he could not successfully establish

that the rental payments were unreasonable. Furthermore,

those cases involved a different principle of law, because in

them the lessor and lessee were unrelated parties ; whereas,

in both the earlier Challenger case and in this case, the

lessor and the lessee were related parties not dealing at

arm's length.

We hold that the doctrine of collateral estoppel bars the

petitioners from relitigating the question of the reasonable

Appendix 41

Having found that Challenger paid excessive rentals

ander the Parking Lot Lease and for use of the slot ma-

chines, we reach the question of whether such excessive

amounts constitute constructive dividends to the Graves.

According to the respondent, Challenger served no corpo-

rate purpose of its own by paying excessive rentals to

Sparks Development, Pub, Waldorf, and Saratoga. Chal-

jenger made such payments only because the Graves owned

and controlled it and the other corporations. The Graves

arranged to have Challenger make the excessive payments

for their benefit. In effect, the Graves were thereby trans-

ferring funds from one corporation owned by them to other

corporations owned by them. It was as if Challenger had

distributed the excessive amounts to the Graves, and they

in turn contributed them to the other corporations.

Section 316 defines a dividend as a distribution of prop-

Worcester v. Commissioner, 370 F. 2d 713 (C. A. 1, 1966),

affg. in part a Memorandum Opinion of this Court; Equi-

one which may change from year to year. However, difference

does not provide a basis for not applying collateral estoppel.

In the first the petitioners have not raised the issue. In

the second they have introduced no evidence in this pro-

ceeding to prove that a material change of facts occurred

between the years involved in the and those

Pi

if

me E

|

Hl

sf

42 Appendaz

table Publishing Company v. Commissioner, 356 F. 2d 514

(C. A. 3, 1966), affg. per curiam a Memorandum Opinics

of this Court, cert. denied 385 U. S. 822 (1966); Biltmore

Homes, Inc v. Commissioner, 288 F. 2d 336 (C. A. 4, 1961),

affg. a Memorandum Opinion of this Court, cert. denied

368 U. S. 825 (1961); Helwering v. Gordon, 87 F. 2d 663

(C. A. 8, 1937), revg. 29 B. T. A. 275 (1933); L. L. Silwer-

stein, 36 T. C. 438 (1961); Limericks, Inc., 7 T. C. 119

(1946), affd. 165 F. 2d 483 (C. A. 5, 1948). The benefit con.

ferred by such a distribution need not be of a direct finan

cial nature. It may be merely the pursuit of a hobby, the

fulfillment of a moral obligation, or the making of a gift.

W. D. Gale, Inc. v. Commissioner, 297 F.2d 270 (C. A. 6,

1961), affg. a Memorandum Opinion of this Court; Byers

v. Commissioner, 190 F. 2d 273 (C. A. 8, 1952), affg. a Memo-

randum Opinion of this Court, cert. denied 345 U. S. 907

(1953) ; Commissioner v. Greenspun, 156 F. 2d 917 (C. A.

5, 1946), revg. in part a Memorandum Opinion of this Court,

Montgomery Engineering Company v. United States, 20

F. Supp. 838 (D. N. J. 1964), affd. per curiam 344 F. 24

996 (C. A. 3, 1965); Standwick’s Inc., supra. The essence

of a constructive dividend is a distribution of corporate

earnings for the private purposes of a shareholder. Cf.

Helwering v. Horst, 311 U.S. 112 (1940).

The petitioners argue that no tax or other benefit accrued

to the Graves by virtue of any excessive rentals paid by

Challenger to Sparks Development, Pub, Waldorf, and

Saratoga. The Graves wholly owned all of the corporations,

and all of them were in the highest corporate tax bracket.

In their view, any unjustified transfer of funds had no

greater effect than the transfer of funds by an individual

from one bank account to another. We cannot agree with

this contention since the Graves secured substantial bene-

fits by virtue of the arrangement.

Appendix 43

Although Mr. Graves was aware that the excessive ren-

tals would not have any corporate tax effect, he believed the

amount of the rentals could reduce his personal income

taxes. We do not know what benefit he had in mind, but

from an examination of the objective facts, we can see the

benefits which he derived from the arrangements. He op-

erated his business through many corporations. The casino

business itself was owned by one corporation, Challenger ;

the building and land on which it was built were owned by

another organization, the joint venture; the slot machines

were owned by other corporations; and the Parking Lots by

still another corporation. Mr. Graves tsstified that he always

had in mind retiring early, and this division of his business

into several organizations facilitated the sale of the casino

business, leaving him with investment properties from

which he could derive income with a minimum of active

management on his part. When he transferred funds from

one corporation to another, the transfer had a good deal

more signifieance than a transfer from one bank account

to another. Because Challenger paid excessive rentals for

the use of the slot machines to Pub, Waldorf, and Saratoga,

those corporations had available funds to be used in the

construction of the casino building that would otherwise

have had to be obtained in some other manner. For example,

without such excessive rentals, it might have been neces-

sary for Mr. Graves to make capital contributions to such

corporations out of his income on which he paid taxes. Simi-

larly, when he established the rental to be paid to Sparks

Development for the use of the Parking Lots, it was set

high enough to provide the funds necessary to pay off the

obligations incurred in the purchase of the Parking Lots.

Had the rentals been set at a lower figure—at the amount

which would have been paid in the market place for the

rental of such Parking Lots, it would have been necessary

+e Appendiz

for Sparks Development to have secured additional capita)

in some other manner, for example, by contributions from

Mr. Graves. In other words, as a result of the payment of

excessive rentals, the equity in Sparks Development, Pub,

Waldorf, and Saratoga was increased, and when the Chal.

lenger stock was sold to the Ascuagas, the Graves were

left with valuable corporations, Sparks Development, Pub,

Waldorf, and Saratoga.

The petitioners contend that the excessive rentals

amounted to nothing more than capital contributions by

Challenger to its sister corporations. See sec. 362(c). In

support of this contention, they have cited cases holding

that payments by nonstockholders to a corporation may

constitute capital contributions. Brown Shoe Co. v. Com-

missioner, 339 U. S. 583 (1950) ; Edwards v. Cuba Railroad,

268 U. S. 628 (1925); Federated Department Stores, Inc.,

51 T. C. 500 (1968); Sherwood Memorial Gardens, Inc.,

42 T. C. 211 (1964); Foresun, Inc., 41 T. C. 706 (1964),

affd. in part 348 F. 2d 1006 (C. A. 6, 1965); Veterans

Foundation, 38 T. C. 66 (1962), affd. 317 F. 2d 456 (C. A. 10,

1963). Although we agree that capital contributions do not

constitute taxable income, it is still necessary to examine

the surrounding circumstances to determine whether funds

were transferred for the purpose of making a capital con-

tribution, and the circumstances of this case do not indicate

that the excessive rentals were paid for such a purpose.

When a person who is not a shareholder makes a contri-

bution to the capital of a corporation, he does so because he

expects to benefit materially or otherwise from the corpora-

tion having the additional capital. Challenger could expect

no benefit to itself from the payment of the excessive

rentals. Indeed, it could have purchased the slot machines

with the amounts it paid each year for the rentals, and

Challenger derived no benefit from the fact that its exces-

Appendiz 45

sive rentals enabled Sparks Development to pay off quickly

the loans incurred in purchasing the Parking Lots. It seems

altogether clear that if Challenger had been independent

from control by the Graves, it would have had no reason to

make capital contributions to those corporations which

received the excessive rentals. They were paid because Mr.

Graves willed it so, not because Challenger benefited

thereby.

The petitioners contend that Challenger was under a

legal obligation to pay the full amount required as rent

under the Parking Lot Lease and the slot machine lease.

We need not pass on the effect of local law. The provisions

of the Internal Revenue Code take precedence over local

law in determining the tax consequences of a transaction.

For Federal tax purposes, the amounts claimed by Chal-

lenger as rental deductions were not required to be paid

as rent, irrespective of whether the leases were enforceable

under local law. Even if the sums were required to be paid

under local law, such fact does not relieve the Graves of

dividend liability when the sums so paid were in substance

adistribution of corporate earnings.

Finally, the petitioners argue that there is no justification

in taxing the excessive rental payments as dividends since

such payments remained in corporate solution after the

payments were made, and since they would be taxable when

eventually distributed to the Graves. In effect, it is argued

that funds may be transferred from one corporation to

another without tax consequences since nothing has actually

been distributed to the shareholders. However, this argu-

ment overlooks the fact that each corporation is consid-

ered a separate legal person for tax purposes, and in the

absence of some specific statutory or other exception, a

transfer of funds from one corporation to another has im-

mediate tax consequences. If one corporation sells goods

or furnishes services to another corporation, such trans-

46 Appendiz

actions must be recognized and given effect in determining

the taxation of the corporations. Likewise, when, as in this

case, there is a transfer of funds between corporations,

the transfer must have some effect upon the capital or earn-

ings and profits of the corporations. The effect of such

transfer cannot be ignored. We have found that, in this

case, the transfer was for the benefit of the Graves. It was

in effect a contribution to capital by them, and that fact

will influence the tax treatment of the corporations which

received the transfer. Finally, it does not follow, as claimed

by the petitioners, that the excessive rentals will eventually

be taxed to the Graves when distributed by Sparks Develop-

ment, Pub, Waldorf, and Saratoga. There is no certainty

that such payments will ever be distributed to the Graves,

and the taxation of any distributions to the Graves will

depend upon other circumstances existing at the time of

such distributi

Ill. Payments by Sparks Development to Mr. Graves

The final issue for our consideration is whether $8,539.01

paid by Sparks Development to Mr. Graves in its taxable

year ending November 30, 1961, is deductible under section

162(a). That provision states in part:

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, in-

cluding—

(1) a reasonable allowance for salaries or other

compensation for personal services actually rendered;

Mr. Graves testified at the trial of this proceeding as to

the services he rendered Sparks Development from the time

of its formation. Through his efforts, Sparks Development

acquired and leased various parcels of realty. It is obvious

that most of these activities occurred in years other than

Sparks Development’s taxable year 1961. There is no evi-

Appendix 47

dence before us of any activity by Sparks Development dur-

ing such year other than its collection of payments made

by Challenger pursuant to the Parking Lot Lease and its

payment on account of indebtedness incurred when it pur-

chased the Parking Lots. However, the record does indicate

that Mr. Graves engaged in protracted negotiations for a

parcel of property acquired by Sparks Development on

October 29, 1962, and we have inferred that some of such

negotiations did occur in 1961. Furthermore, since Mr.

Graves was compensated under an arrangement by which

he received a percentage of the earnings of Sparks Develop-

ment, it is clear that the adequacy of his compensation must

be judged over a period of years. See California Vegetable

Concentrates, Inc., 10 T. C. 1158 (1948). Although he per-

formed few services for Sparks Development in 1961, he

apparently performed extensive services for the corpora-

tion in other years. Obviously, Mr. Graves is a highly

qualified businessman, and his services are very valuable.

In view of the nature of the arrangement for his compen-

sation, and the extensive and valuable services performed

by him over the years for Sparks Development, we have

found that the compensation paid him during that year

was not excessive, and we hold that the entire amount,

$8,539.01, is deductible.

Decisions will be entered under Rule 50.

Appendiz

Appendix B

Sparks Nuaeet, Inc., et al.,

Petitioners-Appellants,

Vv.

CoMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

No. 26504.

United States Court of Appeals,

Ninth Circuit.

April 6, 1972.

Before E1y and Cuoy, Circuit Judges, and Byryeg,°* Dis-

trict Judge.

Wim M. Byryz, District Judge:

Appellants Sparks Nugget, Inc. (Sparks Nugget), and

R. L. and Flora Graves (sometimes referred to as the

Graves), taxpayers whose petitions for redetermination

of the Commissioner’s assessments of additional taxes were

consolidated for trial, have appealed to this court to reverse

the Tax Court’s decision sustaining the said assessments.

Jurisdiction to rule on the merits of this appeal has been

conferred under Section 7482 of the Internal Revenue Code

of 1954.

During 1958 and 1959, R. L. Graves acquired six and

one-half lots located in Sparks, Nevada, at a cost of $253,-

609.04. On June 3, 1959, he transferred title to the lots

*Honorable William M. Byrne. United States Senior District

Judge, Central District of California, sitting by designation.

Appendiz 49

to Sparks Development Company (Sparks Development),

a Nevada corporation wholly owned by the Graves, for

cash, an assumption of liabilities and a note, totaling $253,-

953.05, and for addition’: Sparks Development common

stock with a par value of $20,000. Upon acquiring title to

the lots, Sparks Development borrowed $150,000 from the

Nevada Bank of Commeree, of which $115,000 was secured

by a first deed of trust on several of the lots.

In June of 1959, Sparks Development leased the six and

one-half lots to Challenger, Inc. (Challenger), a Nevada

corporation wholly owned by the Graves, for a term of

five years at a monthly rental of $9,400 the first year and

$8,000 the next four years. These lots were used by Chal-

lenger as parking lots in connection with its operation of a

gambling casino known as the Sparks Nugget Casino (the

casino). The financial success enjoyed by the casino was

attributable, in part, to its ability to make available, by

way of the leased lots, ample free parking to its customers.

The lease agreement negotiated by R. L. Graves on be-

half of both Challenger and Sparks Development deter-

mined the rental on the basis of the amount of income that

Sparks Development would need to pay R. L.’s compensa-

tion, its income tax and its purchase obligation on the

parking lots. Pursuant to the terms of the lease, Challenger

was required to keep the premises in good repair, to main-

tain liability insurance and to pay the utilities as well as

the real property taxes. Additionally, Challenger bore the

cost of improvements, including the cost of resurfacing.

Sparks Nugget is a Nevada corporation which was in-

corporated on September 29, 1960. From the time of its

incorporation until June 26, 1961, all of Sparks Nugget’s

outstanding stock was owned by John and Rose Ascuaga.

On that day, the Graves secured ownership of 1.2 percent

of the outstanding stock.

50 Appendix

The day following its incorporation, September 30, 1960,

Sparks Nugget purchased all of the outstanding stock of

Challenger from the Graves. Thereafter, on June 30, 1961,

Challenger was dissolved and all of its assets were distrib.

uted in complete liquidation to Sparks Nugget. Prior to

trial, Sparks Nugget acknowledged that as transferee of

Challenger’s assets, it was liable for any deficiencies deter-

mined in the income taxes of Challenger for taxable years

1959 and 1960.

During the taxable years 1959 and 1960, Challenger’s

parking lot rental expenditures totaled $37,000 and $107,

200, respectively. Acting under Section 162" of the 1954

Code, the Commissioner disallowed rental deductions

claimed by Challenger with respect to the parking lots to

the extent the monthly payments exceeded $4,000 on the

ground that such excess amounts were not ordinary and

necessary business expenses required to be made for the

use of the lots. The Tax Court sustained this disallowance,

finding that “The reasonable rental of the parking lots

during 1959 and 1960 did not exceed $4,000 per month.”

Those portions of the payments which were in excess of

this “reasonable rental” value were deemed constructive

dividends to the Graves. :

The taxpayers have challenged the Tax Court’s invoca-

tion of Section 162. In their view, the disallowance of ex-

cessive rentals paid between related parties is the exclusive

1. Section 162 of the 1954 Code provides in pertinent part as

follows:

‘*(a) In general——There shall be allowed all the ordinary

and necessary expenses 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 possession 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.”

—_esapapsonetae

Appendix 51

domain of Section 482.? If that were not so, maintains the

taxpayers, that section’s provisions, as well as its explicat-

ing regulations, would be more redundancies, in that the

general provisions of Section 162 would also be controlling

of related, controlled or affiliated businesses. The signifi-

cance of this section’s applicability to the instant contro-

versy is, according to the taxpayers, that the Commissioner

would be precluded from effecting any taxable increase to

the income of the Graves.

The asserted pre-eminence of Section 482 in determining

the tax consequences of rental agreements among so-called

related parties is said to be underscored by the holding of

Rubin v. C. I. R., 429 F.2d 650 (2d Cir. 1970). There, fees

were paid to a corporation for managerial service ren-

dered by its controlling shareholder to a second corporation

controlled by the same shareholder. Pursuant to Section

61, the Tax Court ruled that the money paid the taxpayer’s

corporation, in fact, constituted income of the taxpayer

because he was the “true earner” of the money and that

«in substance” he was directly in the employ of the second

corporation. The Court of Appeals deemed the Tax Court’s

“approach” to be in error, holding that “resort to ‘ecommon-

law’ doctrines of taxation and the broad sweep of § 61”

was unnecessary because there was “a statutory provision

adequate to deal with the problem presented.” The court

9 Section 482 of the 1954 Code provides as follows:

‘¢ Allocation of income and deductions among taxpayers.

“In any ease of two or more organizations, trades, or busi-

nesses (whether or not incorporated, whether or not organ-

ized in the United States, and whether or not affiliated)

owned or controlled directly or indirectly by the same inter-

ests, the Secretary or his delegate may distribute, apportion,

or allocate gross income, deductions, credits, or allowances

between or among such organizations, trades, or businesses, if

he determines that such distribution, apportionment, or allo-

ection is necessary in order to prevent evasion of taxes or

clearly to reflect the income of any such organizations, trades,

or businesses.’’

52 Appendix

remanded the case to the Tax Court for consideration of the

substantive and procedural questions surrounding the

“Commissioner’s claim under § 482.” On remand (56 T.C,

1155) the Tax Court, noting that the Second Circuit had not

“disturb[ed]” its findings, determined that under these

“particular” facts, allocation of income pursuant to Section

482 was appropriate.

Although the somewhat distinctive factual setting of

Rubin, no doubt, was the principal factor responsible for

the Second Circuit’s analysis, the present mundane con-

troversy does not require that we too add a new wrinkle

to the law. As we view the issue, this case is yet another

example of evaluating a rental agreement negotiated by

closely related parties. The standards for such an evalua-

tion have been well established by the courts. In essence,

it has been consistently held that payments in excess of

reasonable rent made pursuant to an agreement between

closely related parties which was not the product of arm’s

length negotiation are not deemed “required” and thus are

not deductible under Section 162(a) (3). Southeastern

Canteen Co. v. C. I. R., 410 F.2d 615 (6th Cir. 1969), cert.

denied, 396 U.S. 833, 90 S.Ct. 89, 24 L.Ed.2d 84 (1969);

Potter Electric Signal and Manufacturing Co. v. C. I. R,,

986 F.2d 200 (8th Cir. 1961); Midland Ford Tractor Co. v.

C. I. R., 277 F.2d 111 (8th Cir. 1960), cert. denied, 364 US.

881, 81 S.Ct. 169, 5 L.Ed.2d 102 (1960); Utter-McKinley

Mortuaries v. C. I. R., 225 F.2d 870 (9th Cir. 1955). See,

Van Keppel Co. v. United States, 321 F.Supp. 1183

(W.D.Mo.1971).

A recent example of the thinking which has long pre-

vailed is Southeastern Canteen Co. v. C. I. R., supra. There

the Sixth Cireuit upheld the Tax Court’s disallowance of

part of the taxpayer’s deduction for rental payment paid

pursuant to the sale-leaseback agreement negotiated be-

wn

Appendix 53

tween corporations controlled by the same individuals. In

so ruling, the court relied upon the following general

rules :

“The fact that the parties designated, and one party

became obligated to pay to the other, a specified

amount as rent does not bind the government to treat

that amount as rent. (Citations omitted). Where there

is an absence of arm’s length dealing, the Commis-

sioner may inquire into what constitutes reasonable

rental to determine whether the amount paid exceeds

what would have been paid had the parties dealt at

arm’s length.” 410 F.2d at 619.

Applying these rules, the Court adopted the following

analysis of the Tax Court as its own:

“Petitioners’ position is further weakened by the fact

that during the entire negotiations leading up to the

execution of the sale-leaseback agreements, the owner

of both the lessor (Gladco) and the lessees (petition-

ers) was the same person, Virgil Gladieux. Petitioners’

attempt to transform such an identity of interest into

a relationship which petitioners characterize as ad-

verse, transgresses reasonable imagination. All the

more so since the facts show that the sale-leaseback

agreements were not intended to be ends in them-

selves 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.’ Roland P. Place,

supra.” 410 F.2d at 620.

oF Appendiz

As was true in Southeastern Canteen, we are also per.

suaded by the Tax Court’s application of the established

principles to the facts of the instant case. Specifically, we

are in full accord with that court’s conclusion “that the

Parking Lot Lease was negotiated between closely related

parties not dealing at arm’s length.” The bases of our ac.

cordance is the Tax Court's three-step analysis, summarized

as follows: (1) The Graves were the sole shareholders of

Challenger and Sparks Development; (2) R. L. Graves

being the principal executive officer of both corporations,

in effect, “negotiated” the lease agreement in his own mind;

(3) the rent “agreed upon” did not reflect the actual value

of the lease but served to aid Sparks Development in pay-

ing R. L. Graves’ salary and in meeting its purchase obliga-

tion on the parking lots. See, Potter Electric Signal and

Manufacturing Co. v. C. L. R., supra; Midland Ford Tractor

Co. v. C. L. R., supra.

In the absence of arm’s length negotiations “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

length with a stranger.” Place v. C. I. R., 17 T.C. 199, 208

(1951), aff’d., 199 F.2d 373 (6th Cir. 1952), cert. denied,

344 US. 927, 73 S.Ct. 496, 97 L. Ed. 714 (1953). Here, the

Tax Court weighed the evidence relating to the determina-

tion of the amount constituting monthly rent and concluded

that it was an unreasonable sum of money. In the Tax

Court’s view, the value of the parking lots did not exceed

$4,000 per month for the years 1959 and 1960. Unlike the

taxpayers, we find this view to be embedded in a sound

evidentiary foundation.

Arthur Reber, a professional appraiser who “has ap-

praised numerous properties in the State of Nevada,

including at least one gambling establishment . . . (as well

Appendiz 55

as) numerous commercial properties including parking

jots,” prepared an appraisal of the fair rental value of

reflected the parking lots’ value to Challenger because it

was based on the prior prices paid “in the market place

for properties used in connection with the casino’s opera-

tions.” Reber determined that the annual fair rental value

of the parking lots was $36,681, an amount considerably

jess than the $48,000 allowed by the Commissioner and

approved by the Tax Court.

In addition to Reber’s appraisal, the Tax Court's decision

is supported by the fact that the lease agreement between

Challenger and Sparks Development was not meant to

reflect the true rental value of the parking lots. As already

noted, the rent was determined on the income needs of

lessor Sparks Development. Thus, the “negotiating” parties

agreed to a fundamental term of the lease agreement absent

any consideration of the reasonable rental value.

It is also noteworthy that during the first year of the

lease, Challenger’s rental payments amounted to a 45 per-

cent annual rate of return on the original cost of the lots

(as already indicated, R. L. Graves purchased the lots for

a total of $253,609.04). For the next four years of the

lease, the rental payments yielded an annual rate of re-

turn of 38 percent. The higher rental payments imposed

on Challenger for the first year reflected the higher loan

payments required of Sparks Development in that vear.

The taxpayers maintain that the Tax Court’s assess-

ment of the parking lots’ rental value was in error hecause

it failed “to consider all the evidence.” Specifically, they

maintain that Reber’s appraisal cannot be viewed as reli-

able because it did not take into account the 34 percent

return earned by the Challenger on the casino and related

operations. Implicit in this challenge of the appraisal’s re-

56 Appendiz

liability is the suggestion that the said rate of return should

be correlated to the importance of the parking lots. Becange

Reber’s appraisal failed to appreciate this correlation, it

should not have been used by the Tax Court as a standard

to evaluate the rental payments made to Sparks Develop

ment.

Although the importance of the parking lots to the

easino’s success cannot be discounted, it is not a true re

flection of the evidence to correlate the two together. At

trial, General Manager John Ascuaga twice indicated “that

parking and fine food were [the] two big reasons for [the

casino’s] success.” Additionally, the casino, which was the

recipient of R. L. Graves’ managerial talents, provided

lounge entertainment to its customers. In short, the

evidence clearly indicates that credit for the financial sue-

cess enjoyed by the casino was to be shared by a host of

factors. Accordingly, we glean no error from appraiser

Reber’s failure to consider the rate of return in calculating

his computations.

Equally unpersuasive is the taxpayer’s complaint that

the Tax Court ignored the testimonial opinions of Ascuaga

and R. L. Graves that the rent for the parking lots was

“fair.” The Tax Court's refusal to give great weight to the

views opined by Ascuaga and R. L. Graves is embedded

in the strong evidentiary inference that self-interest

motivated the espousal thereof. Ascuaga and Graves, who

were long-time business associates, each, no doubt, had

special reason to vouch for the fairness of the rental terms.

Simply stated, Ascuaga’s concern was to have use of the

parking lots and R. L. Graves was intent on Challenger

being able to deduct in full the rent paid in 1959 and 1960.

Under these circumstances, it was not unreasonable for

the Tax Court to have trepidations about their testimony.

See, Simon v. C. I. R., 285 F.2d 422 (3rd Cir. 1960); Mid-

Appendiz 57

land Ford Tractor Co. v. C. L R., 277 F.2d 111 (8th Cir.

1960).

As indicated above, the Graves also challenge the Tax

Court’s conclusion that those portions of the rental pay-

ments made by Challenger not deductible under Section

162 constitute constructive dividends. According to the

Graves, no such dividend can be attributable to them be-

cause they were not the beneficiaries of these payments.

Illustrative of this point is said to be the holding in Holsey

y. C. L BR, 258 F.2d 865 (3rd Cir. 1958). There, the tax-

payer, a 50% owner of the Holsey Company, assigned his

option to purchase from the Greenville Company the re-

maining 50% of Holsey to that company, which in turn,

exercised the option for $80,000. The end result of this

transaction was that the taxpayer became the sole share-

holder of Holsey. The Tax Court sustained the Commis-

sioner’s ruling that Holsey’s purehase of the outstanding

stock for $80,000 (taxpayer had initially purchased a 50%

interest in Holsey for $11,000) was “essentially equivalent

to the distribution of a taxable dividend to the taxpayer.”

The Third Cireuit disagreed with this assessment, holding

that the indirect benefit inuring to the taxpayer (he now

“had 100% of the outstanding stock and the Greenville

Company none”) “could not give rise to taxable income

_.. until the corporation makes a distribution to the tax-

payer or his stock is sold.” Finding no “direct pecuniary

benefit to the taxpayer” resulting to the taxpayer as a

consequence of this transaction, the Court held “the Tax

Court erred in holding the distribution in question taxable

to him.”

In Niederkrome v. C. I. R., 266 F.2d 238 (9th Cir. 1958)

cert. denied, 359 U. S. 945, 79 S.Ct. 725, 3 L.Ed.2d 678

(1959), this court, in dictum, approved the reasoning of

Holsey.

58 Appendiz

The Graves argue that Challenger’s rental payments

constituted contributions to capital, as provided for in See.

tion 362(c), to its sister corporation. Because the Chal-

lenger “benefited from the use to which the recipients

put the rentals” (paying the bank loan and taxes which

Challenger would have had to pay had it purchased the

lots), the Graves maintain this case comes within the pur-

view of the rule that capital contributions to a corporation

by a non-shareholder arise when he receives a reciprocal

benefit therefrom. Brown Shoe Co., Inc., v. C. I. R., 339

U.S. 583, 70 S.Ct. 820, 94 L.Ed. 1081 (1950); Edwards y.

Cuba Railroad Co., 268 U.S. 628, 45 S.Ct. 614, 69 L.Ed.

1124 (1925).

The argument propounded by the Graves does not, in

our view, appreciate the significant differences between the

case at bar and those upon which they rely. In Holsey and

Niederkrome, the courts were impressed with the fact that

an “economic or financial advantage” was not determinable

merely by securing corporate control. Although they

acknowledged that there was a real possibility that such

“advantages” would flow as a result of this control, the

courts were hesitant to declare that this was an ipso facto

consequence. As noted by this court, the profits gained

from the sale of these shares were taxable, as well as any

surplus which might accumulate during the vears. In sum,

the courts saw no need to engage in financial speculation,

when the shareholders remained bound to the taxman

when their gains from the transactions were actually

realized.

By contrast, the Graves have obtained immediate bene-

fits from this leasing agreement. The nature of these bene-

fits was summarized by the Tax Court:

“Similarly, when he [R. L. Graves] established the

rental to he paid to Sparks Development for the use

-

Appendiz 59

of the Parking Lots, it was set high enough to provide

the funds necessary to pay off the obligations incurred

in the purchase of the Parking Lots. Had the rentals

been set at a lower figure—at the amount which would

have been paid in the market place for the rental of

such Parking Lots, it would have been necessary for

Sparks Development to have secured additional capital

in some other manner, for example, by contributions

from Mr. Graves. In other words, as a result of the

payment of excessive rentals, the equity in Sparks

Development . . . was increased, and when the Chal-

lenger stock was sold to the Ascuagas, the Graves were

left with [a] valuable corporation, Sparks Develop-

ment. ...”

The arrangement devised by R. L. Graves is similar to

one recently condemned by the Fifth Circuit. In Sammons

y. United States, 433 F.2d 728 (5th Cir. 1970), the taxpayer

received a constructive dividend as a result of transferring

stock between corporations which he either controlled or

owned outright. The pertinent facts are these: American

Republic, a corporation indirectly controlled by the tax-

payer, purchased the fixed assets of Atlanta Fulton while

the other assets were acquired by Texas Fulton, which was

owned by five corporations controlled by the taxpayers. The

fixed assets were then leased by American Republic to

Texas Fulton which commenced the operation of the multi-

bag business heretofore operated by Atlanta Fulton.

Thereafter, the five corporations already denoted sold

their Texas Fulton stock at cost to Fidelity National, an-

other of the taxpayer’s corporations. Fidelity then sold its

Texas Fulton stock to Westvaco and made a profit of

$556,000.

The jury found that Fidelity National received a bargain

purchase from its “brother” corporations in that the fair

market value of Texas Fulton was greater than the amount

60 Appendix

paid by Fidelity National. Specifically, the jury found that

the stock was worth $500,000 more than Fidelity Nationa}

had paid, thus leaving the taxpayer liable for taxes on this

sum as a@ constructive dividend. The Fifth Circuit upheld

the District Court’s approval of the jury’s finding:

“In conclusion, we hold that Mr. Sammons received

a constructive dividend when he moved the paper bag

business between wholly-owned or controlled corporate

entities at a price which the jury reasonably concluded

to be one-half million dollars below fair market value,

In reality then, the taxpayer took money from his five

corporations and placed it in a sixth. It is of little

consequence that he personally received no money

from the transaction, for it is the power to dispose of

income and the exercise of that power that determines

whether taxable income has been received.”

Sammons v. United States, supra.

Similarly, we find no merit in the contention that Chal-

lenger’s excessive rental payments can be viewed as con-

tributions to capital. As indicated by the Tax Court, there

is no evidentiary basis to support such a proposition be-

cause no benefit flowed to Challenger as a result therefrom:

“Challenger could expect no benefit to itself from the

payment of the excessive rentals. Indeed, . . . Chal-

lenger derived no benefit from the fact that its exces-

sive rentals enabled Sparks Development to pay off

quickly the loans incurred in purchasing the Parking

Lots. It seems altogther clear that if Challenger had

been independent from control by the Graves, it would

have had no reason to make capital contributions to [a

corporation] which received the excessive rentals.

They were paid because Mr. Graves willed it so, not

because Challenger benefited thereby.”

In March of 1955, Challenger leased 100 slot machines

from Pub, Inc., Saratoga Club, Inc., and United Waldorf

Appendix 61

Inc., three corporations wholly owned by the Graves. This

lease continued in effect with terms unchanged until

October 1, 1960, when the machines were sold to Challenger

for $200 per machine. In accordance with the terms of the

Jease, Challenger paid these corporations $97,336.07 and

$103,821.15 respectively, for the taxable years 1959 and

1960. In Challenger, Inc., 23 TCM 2096 (1964), the Tax

Court held that the reasonable rental value of the slot

machines did not exceed $2.59 per machine per month for

the taxable years 1955 through 1958. Accordingly, the Tax

Court sustained the Commissioner’s disallowance as rent-

al deduction those amounts which exceeded the machines’

true value. The Tax Court below held that by virtue of

this prior decision against their wholly-owned corporation,

Challenger, the Graves were collaterally estopped from

relitigating the reasonable rental value of the slot machines

for the years 1959 and 1960. As a consequence thereof, the

Graves were charged with constructive dividends for those

portions of the rental payments which exceeded the reason-

able rentg!_value of the slot machines.

R. L. Graves has challenged the Tax Court’s application

of collateral estoppel, maintaining in part, that his status

of Challenger’s controlling shareholder is not a basis upon

which privity may be established. The nature of this chal-

lenge has long troubled the courts. Read in broad terms,

there are a host of decisions which support or reject the

view advanced by this taxpayer.* Confronted with this

Solomon-like task, we have found most persuasive the com-

mon-sense reasoning set forth by Professor Moore: “It

would seem that the public policy underlying the doctrine

3. See generally, Foreign & Domestic Musie Corp. v. Licht, 196

F.2d 627 (2d Cir. 1952) ; Hornstein v. Kramer Bros. Freight Lines,

133 F.2d 143 (3rd Cir. 1943). By contrast, see generally, In Re

Shea’s Will, 309 N.Y. 605, 132 N.E.2d 864 (1956); D. Bruce For-

rester, 4 T.C. 907 (1945).

62 Appendiz

of res judicata, as a bar to repetitious litigation, would sup.

port a finding of privity between a close corporation and its

sole or controlling stockholder.” 1B Moore’s Federal Prag.

tice (2d ed.), par. 0.422[3].

Given the establishment of the Graves privity‘ with

Challenger, we are satisfied that the Tax Court’s inyo.

cation of the collateral estoppel doctrine was entirely

appropriate. As indicated, the Tax Court’s decision in

Challenger set forth the reasonable rental value of the slot

machines. In the interim between that decision and the one

now in controversy, nothing has occurred regarding rele-

vant facts or principles of law which could be deemed of

such significance to deny application of the doctrine. Ac-

cordingly, we find no error in the Tax Court’s finding of

constructive dividend with regard to the unreasonable por-

tions of rent paid for the use of the slot machines.®

Affirmed.

4. Flora Graves asserts that collateral estoppel cannot be ap-

plied to her because title in the Challenger’s stock was in the name

of her husband, R. L. Graves. Because Nevada is a community

property state (see Nev.Rev.Stat., §§ 123.220, 123.225) we must

disagree with this assertion. As the owner of one-half the commu-

nity, Mrs. Graves had an equal interest with her husband in the

Challenger stock. For this reason, we believe it reasonable to apply

the reasoning of Professor Moore to such an interest.

5. In so finding, we adopt the Tax Court’s analysis rejecting

the contention these payments constituted contribution to capital:

‘*Challenger could expect no benefit to itself from the payment of

the excessive rentals. Indeed, it could have purchasd the slot

machines with the amounts it paid each year for the rentals .. .”’

Appendiz 63

Appendix C

Filed Sep 11 1972

United States Court of Appeals

for the Ninth Circuit

No. 26504

Sparks Nuacet, Inc., as Transferee, R. L. Graves, et al.,

Appellants,

Vv.

CoMMISSIONER OF INTERNAL REVENUE,

Appellee.

ORDER

Before: Exy and Cuoy, Circuit Judges, and

Byrne, District Judge.*

The Petition for Rehearing is denied.

*Honorable William M. Byrne, Sr., Senior United States District

Judge, Los Angeles, California, sitting by designation.

64 Appendix

Appendix D

CONSTITUTIONAL AND STATUTORY

PROVISIONS INVOLVED

United States Constitution:

Amendment V

No person shall be held to answer for a capital, or other.

wise infamous crime, unless on a presentment or indictment

of a Grand Jury, except in cases arising in the land or

naval forces, or in the Militia, when in actual service in

time of War or public danger; nor shall any person be

subject for the same offence to be twice put in jeopardy of

life or limb; nor shall be compelled in any criminal case to

be a witness against himself, nor be deprived of life, liberty,

or property, without due process of law; nor shall private

property be taken for public use, without just compensation.

Amendment XVI [1913]

The Congress shall have power to lay and collect taxes

on incomes, from whatever source derived, without appor-

tionment among the several States, and without regard to

any census or enumeration.

Internal Revenue Code of 1954:

26 U.S.C. § 61. Gross income defined

(a) General definition—Except as otherwise provided in

this subtitle, gross income means all income from whatever

source derived, including (but not limited to) the following

items:

(1) Compensation for services, including fees, com-

missions, and similar items;

(2) Gross income derived from business;

(3) Gains derived from dealings in property;

Appendiz

(4) Interest;

(5) Rents;

(6) Royalties ;

(7) Dividends;

(8) Alimony and separate maintenance payments;

(9) Annuities ;

(10) Income from life insurance and endowment

contracts ;

(11) Pensions;

(12) Income from discharge of indebtedness;

(13) Distributive share of partnership gross income;

(14) Income in respect of a decedent; and

(15) Income from an interest in an estate or trust.

26 U.S.C. § 162. Trade 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 busi-

ness, including—

(1) a reasonable allowance for salaries or other com-

pensation for personal services actually rendered;

(2) traveling expenses (including amounts expended

for meals and lodging other than amounts which are

lavish or extravagant under the circumstances) while

away from home in the pursuit of a trade or business;

and

(3) rentals or other payments required to be made

as a condition to the continued use or 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.

For purposes of the preceding sentence, the place of resi-

dence of a Member of Congress (including any Delegate

and Resident Commissioner) within the State, congres-

66 Appendix

sional district, Territory, or possession which he repre.

sents in Congress shall be considered his home, but amounts

expended by such Members within each taxable year for

living expenses shall not be deductible for income tax

purposes in excess of $3,000.

26 U.S.C. §482. Allocation of income and deductions

among taxpayers

In any case of two or more organizations, trades, or busi-

nesses (whether or not incorporated, whether or not organ-

ized in the United States, and whether or not affiliated)

owned or controlled directly or indirectly by the same

interests, the Secretary or his delegate may distribute,

apportion, or allocate gross income, deductions, credits, or

allowances between or among such organizations, trades or

businesses, if he determines that such distribution, appor-

tionment, or allocation is necessary in order to prevent

evasion of taxes or clearly to reflect the income of any of

such organization, trades, or businesses,

Appendiz

Appendix E

T.C. Memo. 1964-338

United States Tax Court

THe CHALLENGER, Inc.’ v. COMMISSIONER OF

INTERNAL REVENUE

Memorandum Findings of Fact and Opinion

Train, Judge: Respondent determined deficiencies in

income taxes as follows:

FY Ended

The Challenger, Inc., Docket No. 88427.. 9-30-55

9-30-56

9-30-57

9-30-58

The Pub, Ine., Docket No. 90748 ...........- 8-31-57

8-31-58

8-31-59

Saratoga Club, Inc., Docket No. 90744.... 10-31-56

10-31-57

10-31-58

10-31-59

Caldwell Sport Shop, Inc., Docket No.

90745 5-31-59

United Waldorf, Inc., Docket No. 90746.. 6-30-56

6-30-57

6-30-58

6-30-59

Amount

$30,986.51

81,023.31

59,403.42

59,134.26

9,859.20

5,462.79

9,184.80

6,162.58

6,142.46

5,589.18

8,899.71

6,944.94

5,355.83

6,856.93

5,742.60

8,986.65

By amended petitions in docket Nos. 90743 through 90746,

the petitioners therein claim overpayments as follows:

FY Ended

The Pub, Ine., Docket No. 90748 ............ 8-31-57

8-31-58

8-31-59

Saratoga Club, Inc., Docket No. 90744... 10-31-56

10-31-57

10-31-58

10-31-59

Amount

$ 2,723.54

13,340.79

22,233.93

8,949.95

8,495.33

7,690.70

13,014.84

1. Proceedings of the following petitioners are consolidated

herewith: Carson City Nugget, Inc., Docket No. 90742; The Pub,

Inc., Docket No. 90743; Saratoga Club, Inc., Docket No. 90744;

Caldwell Sport Shop, Inc., Docket No. 90745; and United Waldorf,

Inc., Docket No. 90746.

68 Appendiz

FY Ended

Caldwell Sport Shop, Inc., Docket No.

90745 5-31-59

United Waldorf Inc., Docket No. 90746. 6-30-56

6-30-57

6-30-58

6-30-59

Respondent determined deficiencies in income taxes of

Twin Falls Brunswick, Inc., as follows:

FY Ended Amount

8-31-55 $30,256.54

8-31-56 43,538.24

Period 9-1-56 to 5-31-57 196.12

Respondent further gave notice that Carson City Nugget,

Ine., docket No. 90742, was liable as transferee for the

entire deficiencies of Twin Falls Brunswick, Inc. Carson

City Nugget, Inc., first admitted, but by amended petition

denied, its asserted transferee status. That issue has been

severed for trial at a later date if we should hold that there

are deficiencies in income taxes of Twin Falls Brunswick,

Inc. The above-listed dockets have been consolidated for

trial and briefing as to all other issues.

The issues remaining for decision are:

1. Whether respondent properly allocated to the Chal-

lenger certain slot machine income reported as rent income

by the Pub, Saratoga, and Waldorf and deducted as rent

expense by the Challenger;

2. If so, whether the taxable incomes of the Pub, Sara-

toga, and Waldorf should be reduced by the amounts

allocated to the Challenger;

3. Whether the Pub, Saratoga, and Waldorf are entitled

to surtax exemption ;?

4. Whether respondent properly disallowed portions of

the rent deductions taken by the Challenger and Nugget

Enterprises with regard to realty leased by them;

2. At trial, respondent conceded error in denying the surtax

exemption to Caldwell, Docket No. 90745.

ne

Appendix 69

5. Whether respondent properly disallowed a portion

of the rent deductions taken by Twin Falls with regard to

realty leased by it from Caldwell and, if so, whether such

receipts are includible in C

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