# Petition for Writ of Certiorari — Graves v. Commissioner > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385606_1731%3A1 ## Record - **Collection:** Supreme Court brief - **Document type:** Petition for Writ of Certiorari - **Published:** January 1, 1973 - **Citation:** 410 U.S. 928 ## Text sega ° ° 3 $ G3 Court, i ,% FILE COPY TL i, | D> ® | EC 4 4972 = 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° > 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. Grav [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385606_1731%3A1. Public record. Not legal advice.