Opposition Brief — Graves v. Commissioner

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CITATIONS

Cases :

B. Forman Co. v. Commissioner, 453 F. 2d 1144, certiorari

i ds i cob abcneneneettanenwute > 8

Biltmore Homes, Inc. vy. Commissioner, 288 F. 2d 336,

certiorari denied, 368 U.S. 825..................... 6

Brown Printing Co. v. Commissioner, 255 F. 2d 436..... 8

Challenger, Inc. v. Commissioner, 23 T.C.M. 2096...... 4

Clark v. Commissioner, 266 F. 2d 698................ 5

Commissioner v. First Security Bank of Utah, 405 U.S.

tt Minin ct Seat tnpehhe hee beeen heh enaenteany ee 8

Holsey v. Commissioner, 258 F. 2d 865................ 7

Limericks, Inc. v. Commissioner, 165 F. 2d 483........ 5

Midland Ford Tractor Co. v. Commissioner, 277 F. 2d

Di -Ge tds ceaukteddahtaensann ebindéndedseukeess 8

Rubin v. Commissioner, 429 F. 2d 650, on remand, 56

T.C. 1155, affirmed per curiam, 460 F. 2d 1216....... 7,8

Sachs v. Commissioner, 277 F. 2d 879, certiorari denied,

i titel sete edie aibeesenbenenumat 5

Sammons v. United States, 433 F. 2d 728, certiorari

tC Tih . viseccaesengcecaoowssenvenes 6,9

Southeastern Canteen Co. v. Commissioner, 410 F. 2d

ll cde UUEEReb Sede eenbéhaedeteesesecuaesnaeee 8

Tennessee-Arkansas Gravel Co. v. Commissioner, 112

Di ‘iihcpdkt ns esehesspeaetasedeckaonskted 8

Waldheim v. Commissioner, 244 F.2d 1............... 5

Worcester v. Commissioner, 370 F. 2d 713............. 6

Statutes and regulations:

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

See. 61

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In the Supreme Court of the Gnited States

Ocroser Term, 1972

No. 72-810

R. L. Graves, Fiona J. Graves, R. L. anp Frora J.

GRAVES, AND Sparks Nuacet, Inc. as TRANSFEREE,

PETITIONERS

Vv.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR

THE NINTH CIRCUIT

BRIEF FOR THE RESPONDENT IN OPPOSITION

OPINIONS BELOW

The memorandum opinion of the Tax Court (Pet.

App. 1-47) is reported at 29 T.C.M. 318. The opinion of

the court of appeals (Pet. App. 48-62) is reported at

458 F. 2d 631.

JURISDICTION

The judgment of the court of appeals was entered on

April 6, 1972 (Pet. App. 48). A petition for rehearing

was denied on September 11, 1972 (Pet. App. 63). The

(1)

2

petition for certiorari was filed on December 4, 1972,

The jurisdiction of this Court is invoked under 28

U.S.C. 1254(1).

QUESTION PRESENTED

Whether the courts below correctly held that peti-

tioners Flora J. Graves and R. L. Graves constructively

received dividends when funds were transferred, under

the guise of purported rental payments, from one of

their wholly-owned corporations to others.

STATUTES INVOLVED

The relevant provisions of Sections 61, 162, 301, 316

and 482 of the Internal Revenue Code of 1954 are set

forth in the Appendix, infra, pp. 11-13.

STATEMENT

Petitioners Flora J. Graves and R. L. Graves (the

Graveses), at all relevant times prior to September 30,

1960, owned all the outstanding stock of The Chal-

lenger, Inc. The Graveses also owned all the stock of

Sparks Development, Inc., during the years in issue.

Petitioner Sparks Nugget, Inc., purchased all of the

stock of The Challenger on September 30, 1960. Chal-

lenger was subsequently liquidated by Sparks Nugget,

and the latter corporation is a party to this action only

in its role as transferee of Challenger (Pet. App.

49-50).

a. Rental of parking lots

Challenger, in June of 1959, leased six and one-half

lots located in Sparks, Nevada, from its sister corpora-

3

tion, Sparks Development. These lots were used by

Challenger as parking lots in connection with its opera-

tion of a gambling casino known as the Sparks Nugget

Casino (Pet. App. 48-49). The initial term of the

lease was five years, and the rental was $9,400 pet

month for the first year and $8,000 monthly for the

next four years. These rentals were determined by R.

L. Graves, acting on behalf of both Challenger and

Sparks Development, so as to provide the latter with

sufficient income to pay his compensation, its income

taxes, and its purchase obligations on the parking lots.

During the taxable years 1959 and 1960, Challenger’s

parking lot rental expenditures totaled $37,000 and

$107,200, respectively (Pet. App. 49-50).

The Commissioner, acting under Section 162 of the

Internal Revenue Code of 1954, disallowed rental de-

ductions claimed by Challenger with respect to its

leasing of the parking lots to the extent the monthly

payments exceeded $4,000 on the ground that the excess

amounts were not ordinary and necessary business

expenses. The Tax Court sustained his action, finding

that the reasonable rental value of the parking lots did

not exceed $4,000 per month (Pet. App. 17, 36-37). The

court of appeals affirmed (Pet. App. 50-57).

b. Rental of slot machines

Challenger leased 100 slot machines from certain

other corporations owned by the Graveses in 1955."

This lease continued in effect with terms unchanged

1 Specifically, the lessors of the slot machines were The Pub, Inc.,

United Waldorf, Inc., and Saratoga Club Inc. (Pet. App. 60-61).

——

4

until 1960 when Challenger purchased all the machines

at a total cost of $20,000. Challenger paid its sister

corporations $97,336.07 during 1959 and $103,821.15

during 1960 in accordance with the terms of the lease,

Computed on a monthly basis, these figures resulted in a

monthly rental per machine of $81.11 in 1959 and $86.52

in 1960 (Pet. App. 60-61). The Commissioner deter-

mined that amounts in excess of $2.59 per month per

machine were not bona fide rental payments, and,

accordingly, disallowed claimed deductions for such

amounts. In Challenger, Inc. v. Commissioner, 23

T.C.M. 2096, the Tax Court held that the reasonable

rental value of these same slot machines did not exceed

$2.59 per machine per month for the taxable years

1955 through 1958. Consequently, the Tax Court here

held that by virtue of this prior decision against their

wholly-owned corporation, Challenger, the Graveses

were collaterally estopped from relitigating the reason-

able rental value of the slot machines for the years 1959

and 1960. The Ninth Circuit agreed with the Tax

Court’s application of collateral estoppel (Pet. App.

61-62).

ce. Constructive dividends to the Graveses

The Commissioner determined that the amounts

diverted by the Graveses from Challenger to their

other corporations in the form of excessive rental pay-

ments for the parking lots and slot machines were

taxable to them as a constructive dividend. Both courts

below held that the Commissioner’s action was war-

ranted since the Graveses had realized an immediate

economic benefit from the distribution of Challenger’s

5

earnings (Pet. App. 58-59). It is this determination

which petitioners challenge here.

ARGUMENT

The decision below is correct. There is no conflict or

any other reason for further review by this Court.

1. Sections 301(¢)(1) and 316(a) of the Internal

Revenue Code of 1954 (Appendix, infra, pp. 11-12) pro-

vide that a distribution to a stockholder out of a corpo-

ration’s earnings and profits constitutes a dividend,

and that such a distribution is ineludable in the stock-

holder’s gross income. But it has long been settled

that there may be a constructive dividend to a stock-

holder even though there is no formal declaration and

distribution of a dividend. See Clark v. Commissioner,

266 F. 2d 698 (C.A. 9). The test is whether there is a

diminution in the earnings and profits of a corporation

which inures to the benefit of a stockholder, in one

form or another. Familiar examples of constructive

dividend situations are cases in which there is a trans-

fer of corporate assets to a stockholder for a price

which is less than the property’s fair market value

(Waldheim v. Commissioner, 244 F. 2d 1 (C.A. 7)), or

in which a corporation pays a stockholder’s debt to a

third party (Sachs v. Commissioner, 277 F. 2d 879

(C.A. 8), certiorari denied, 364 U.S. 833), or where

a corporation makes rental payments to a stockholder

for use of his property in excess of the reasonable

rental value of the property (Limericks, Inc. v. Com-

missioner, 165 F. 2d 483 (C.A. 5)).

In the same regard, the courts have consistently held

that a stockholder who causes one of his corporations to

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transfer a portion of its assets to a second corporation,

owned or controlled by him, gratuitously or for inade-

quate consideration, realizes dividend income in the

amount of earnings thus diverted. See, e.g., Sammons

v. United States, 433 F. 24 728 (C.A. 5), certiorari de-

nied, 402 U.S. 945; Biltmore Homes, Inc. v. Commis-

sioner, 288 F. 2d 336 (C.A. 4), certiorari denied, 368

U.S. 825; Worcester v. Commissioner, 370 F. 2d 713

(C.A. 1). In these situations the stockholder is eco-

nomically benefited by the enrichment of his second

corporation, just as he is by the payment of a debt

which he owes to a third party.

Here, the Graveses, under the guise of purported

rental payments, diverted funds from their highly

successful casino corporation (Challenger) to other

corporations which they owned. The economic benefit

to the Graveses from such diversion, justifying the

imposition of a constructive dividend by both courts

below, is clear. First, Challenger, despite its history

of continuous and large earnings, never paid any divi-

dends (Pet. App. 16). By diverting Challenger’s earn-

ings to several of their other corporations, the Graveses

avoided the possibility of Challenger having to pay

the accumulated earnings tax imposed by Section 531

of the Code. In addition, by transferring Challenger's

earnings to passive corporations, the Graveses put

themselves in a position whereby they could obtain

these earnings, at capital gains rather than dividend

rates (without affecting the income-producing Chal-

lenger), by simply selling or liquidating the recipient

corporations. Finally, as both courts below pointed

equity in Sparks Development so that when Challenger

was sold they were left with a valuable corporation.”

2. Petitioners erroneously assert conflict with Rubiw

+, Commissioner, 429 F. 24 650 (C.A. 2) (Pet. 6-8).

In Rubin, the Second Cireuit criticized the Tax Court

for relying on Section 61 of the Code, Appendix, infra,

p 1 (which defines gross income), and on “common

jaw” doctrines of taxation in determining that pay-

ments made by one corporation to another on account

of services rendered to it by the controlling shareholder

of both corporations (purportedly as an employee of

as it had reached under Section 61 (56 T.C. 1155),

and the court of appeals affirmed, per curiam (460 P.

2d 1216).

The court's holding in Rubin that application of

Section 61 is inappropriate in cases where Section 492

is available is not inconsistent with the application of

Section 162, Appendix, infra, p. 11, by both courts

below. Sections 61 and 162 cannot be considered idep-

tical in breadth of scope. Section 61 is a catchall pro-

vision and is the broadest statute in the Code." Section

162, on the other hand, pertains only to ordinary and

necessary business expenses and is the specific statutory

provision dealing with rental payments. Moreover, the

decision of the Ninth Circuit below is in accord with

numerous other decisions in which the courts have

relied on Section 162 in determining whether rental

payments between related parties were excessive. See,

¢.g., Southeastern Canteen Co. v. Commissioner, 410

F. 2d 615 (C.A. 6); Brown Printing Co. v. Commis-

sioner, 255 F. 2d 436 (C.A. 5); Midland Ford Tractor

Co. v. Commissioner, 277 F. 2d 111 (C.A. 8).

Cases such as Commissioner v. First Security Bank

of Utah, 405 U.S. 394, B. Forman Co. v. Commissioner,

453 F. 2d 1144 (C.A. 2), certiorari denied, 407 U.S. 934,

and Tennessee-Arkansas Gravel Co. v. Commissioner,

112 F. 2d 508 (C.A. 6), relied on by petitioners (Pet.

9-12), raise factual and legal questions different from

those involved here. These cases do not deal with the

imposition of constructive dividends upon shareholders

* Indeed, the regulations under Section 61 (Treasury Regula

tions on Income Tax, § 1.61-1(b) (26 C.F.R.)) state that the statute

is not to be applied where there is some other specifie Code pro-

vision applicable.

but rather involve the allocation, under Section 482, of

income among controlled corporations.

In any event, the application of Section 482 in lieu of

Section 162 in this case would not have produced a

different result, contrary to petitioners’ contention

(Pet. 8-14). Whatever differences may exist between

Sections 162 and 482 are of no consequence in deter-

supra.

4. Finally, petitioners (Pet. 16-18) that the

corporations on the ground that they were non-taxable

contributions of capital by the Graveses. The only

effect of the Commissioner’s action, sustained by the

«The Commissioner filed amended answers in the Tax Court in

which he raised Section 482 as an alternative basis for his determi-

nation of deficiencies in the income taxes of the Graveses. This

alternative position was asserted in the government's brief in the

court of appeals (pp. 34-37), and allegations by petitioners (Pet.

1, fm. 7) that the government eouceded at oral argument that no

constructive dividend would have resulted had Section 482 been

applied are unfounded.

——e

10

courts below, was that the Graveses were required to

pay taxes on the funds they diverted from Challenger

to their other corporations in the same manner as if

there had been a direct distribution to them. There ig

nothing penal in this result.

CONCLUSION

The petition for a writ of certiorari should be denied.

Respectfully submitted.

Erwin N. Griswo.p,

Solicitor General.

Scorr P. Crampron,

Assistant Attorney General.

Bennet N. Hoiianper,

Ricuarp Farser,

Attorneys.

Janvary 1973.

APPENDIX

Internal Revenue Code of 1954 (26 U.8.C.):

Seo. 61. Gross Income Derrnep.

(a) General Definition —Except as otherwise

provided in this subtitle, gross income means all

income from whatever source derived, including

(but not limited’to) the following items:

oe e *

Sec. 162. Trape on Business Expenses.

(a) In General—There shall be allowed as a

deduction all the ordinary and necessary expenses

paid or incurred during the taxable year in carry-

ing on any trade or business, including—

* * oa

(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.

* * *

Sec. 301. Disrriputions oF PROPERTY.

* * _

(c) Amount Tazable.—In the case of a distribu-

tion to which subsection (a) applies—

(1) Amount constituting dividend.—That

portion of the distribution which is a dividend

ll

12

(as defined in section 316) shall be included in

gross income.

Sec. 316. Drvmenp Derrxep.

(a) General Rule—For purposes of this sub-

title, the term “‘dividend’’ means any distribution

of property made by a corporation to its share.

holders—

(1) out of it earnings and profits accumu.

lated after February 28, 1913, or

(2) out of its earnings and profits of the

taxable year (computed as of the close of the

taxable year without diminution by reason of

any distributions made during the taxable

year), without regard to the amount of the

earnings and profits at the time the distribu-

tion was made.

Except as otherwise provided in this subtitle, every

distribution is made out of earnings and profits to

the extent thereof, and from the most recently

accumulated earnings and profits. To the extent

that any distribution is, under any provision of

this subchapter, treated as a distribution of prop-

erty to which section 301 applies, such distribution

shall be treated as a distribution of property for

purposes of this subsection.

13

Sro, 482. AtLocaTion oF INcoME aND DEDUCTIONS

AmonG TAXPAYERS.

In any case of two or more organizations, trades,

or businesses (whether or not incorporated,

whether or not organized in the United States,

and whether or not affiliated) owned or controlled

directly or indirectly by the same interests, the

Secretary or his delegate may distribute, appor-

tion, or allocate gross income, deductions, credits,

or allowances between or among such organiza-

tions, trades, or businesses, if he determines that

such distribution, apportionment, or allocation is

necessary in order to prevent evasion of taxes or

clearly to reflect the income of any of such organi-

zations, trades, or businesses.

wy U.S. Government Printing Office: 1973—492-721/454