Petition for A Writ of Certiorari — Your Host, Inc. v. Commissioner
Supreme Court brief1974
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BUPREME COURT, U. S. aie
ivi
IN THE
Supreme Court of the United States
October Term, 1973
No. . : 7.3 - 1652
YOUR HOST, INC., e¢ al.,
Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE.
CHEF FOODS, INC., e¢ al,
Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE.
PETITION FOR A WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS FOR
THE SECOND CIRCUIT
ALBRECHT, MAGUIRE, HEFFERN
& GREGG,
Attorneys for Petitioners,
2110 Main Place Tower,
Buffalo, New York 14202.
Of Counsel:
Raupx J. Greae,
Georce M. ZIMMERMANN.
————
BATAVIA TIMES, APPELLATE COURT PRINTERS whe
&. GERALD KLEPS, REPRESENTATIVE
BATAVIA, H. ¥. 14020
716-343-0487
7 1974
i.
PEELS PV LN TT eng sae i EE 5 ;
TINDEX
PAGE
oa in dU sian keane wm oa new an 2
7 ae RE SS Is Ro an a ee 2
IESG Y on EE Pee eee 2
As to Your Host, Inc. and Chef Foods, Ine. ........ 2
As to Sher-Del Foods, Inc. and Your Host Bakery.
ee eer oe ating ead Caan eae d on 3
ie ancecmens 3
Statutes and Regulations Involved .................. 3
ar ee a Gh was s wig'e bias x « 4
Reasons for Granting the Writ .................... 7
EN, Gi 5.2% SEEN one we auabrd sb bedadncaeee ss ve eee 10
ee ee 10
As to the Issue of Due Process ................... 12
TEER SEI, Gira ok Ee ca 3 NE a 15
CENA a Ce iertpee al he Bey Gr cee Pace Pe AD 16
SIE « 555d baaban Heke wdvas ceieiakka de eceo ee 52
EE occa ork ntacereacunaakbanereevcoes’ 68
ETE 22x sine ap ava d@teUs ees ch hae so srbs ce bed xs 70
Crrations.
Baldwin-Lima-Hamilton Corp. v. United States, 435 F.
Be TR eee eS ER cere aa cen Sen ai )
W. Braun Co., Inc. v. C.1.R., 396 F. 2d 264........ 7, 8,9, 10
Bush Hog Manufacturing Co., Ine v. C.I.R., 42 T.C.
a Eat ee hos Wray 7,10
The Challenger, Inc., 23 TCM 2096 ................. 8
Chelsea Products, Ine. v. C.1.R., 197 F. 2d 620 ........ 7,10
Dorba Homes, Ine. v. C.1LR., 26 _2.t 2 See 10
First Security Bank of Utah v. C.I.R., 405 U.S. 394.... 11
aA Wis CeO ee eae
rey ya ver ed
TT.
PAGE
Hamburger’s York Road, Inc. v. Cd.R., 41 T.C. 821... .8, 10,
11,13
Helvering v. Taylor, 293 U.S. 507 .................2.. 9
Lufkin Foundry & Machine Co. v. C.LR., 468 F.2d 805. 9
Mare’s Big Boy-Prospect, Ine. v. C.i.R., 52 T.C. 1073... 11
Moline Properties, Inc. v. C.LR., 319 U.S. 486 ....... 8
W,, Ba. Beene ©. CE Ge Ta BO oa ceencenscscvcas 10
National Carbide Corp. v. C.LR., 486 U.S. 422 ....... 9
Philipp Bros. Chemicals, Ine. v. C.I.R., 485 F. 2d 53. ..9, 10
Wisconsin Big Boy Corp. v. C.I.R., 452 F. 2d 137. .7, 8,9, 11
Se En Ss He RS io Gs res cast veda nca edocs 7, 8,9
STaTUTEs.
I oe Sa SS ecawe o.4 ue owe eee eels 2
Internal Revenue of 1954:
I i ok oe pier bee’ ba nee et eae
oa. oe ky clei Wale ae hoes we ne dae ee 10
Ns org a ce uatee ane 3, 5, 6, 11, 12; 13, 14
ES oo hee al eueh 2, 5, 6, 7, 8, 10, 11, 12, 14
REGULATIONS.
eh Te REI ck occ seecndeenacdsexvedeess 7
Reg. Sec. 1.482-1(b)(1) 2.22... ccc cece cece eeeeeceee 8
Bem. See. 1.482-1(d)(2) ....... 2. .cceceeceencccccces 8
Reg. See. 1.482-2(b)(1) 2.2... cee eee eee eee eens 9
og RULEs.
Rule 19 of the Rules of the Supreme Court .......... 13
REPoRTs.
House Rep. No. 2, 70th Congress, Ist Session ......-.. 8
House of Representatives, Report No. 586, 82nd Con-
- gress, First Session, CB 1951-2, 506-507 .........--. 14
Senate Report Number $30, 88th Congress, Second Ses-
sion, CB 1964-1 (Part 2) G54 ........ eee eee ee eee 14
MISCELLANEOUS.
Journal of Taxation, Vol. 40, No. 4, April, 1974 ...... 12
IN THE
Supreme Court of the United States
October Term, 1973
Bs ooo
YOUR HOST, INC., et al.,
Petitioners,
\
COMMISSIONER OF INTERNAL REVENUE.
CHEF FOODS, INC., et al.,
Petitioners,
Vv.
COMMISSIONER OF INTERNAL REVENUE.
PETITION FOR A WIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS FOR
THE SECOND CIRCUIT °
Petitioners Your Host, Inc., Sher-Del Foods, Inc., 309
Delaware Ave., Inc., Alro Realty, Inc., Royal Host, Ine.,
Telesnax, Inc. and Main Host, Inc., pray that a writ or
writs of certiorari issue to review the judgment of the
United States Court of Appeals for the Second Circuit in
these cases.
3
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:
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2
Opinions Below
The opinion of the Tax Court (Appendix A, infra pp.
16-51) is reported at 58 T.C. 10. The opinion of the Court
of Appeals (Appendix B, infra pp. 52-67) is reported at
489 F.2d 957.
Jurisdiction
The judgment of the Court of Appeals was entered on
December 11, 1973. A petition for rehearing was de-
nied and filed by the Court of Appeals on February 6,
1974. The jurisdiction of this Court is invoked under 28
USC 1254 (1).
Questions Presented
The questions presented are:
As to Your Host, Inc. and Chef Foods, Inc.
1. Whether the Commissioner of Internal Revenue
may use § 482 to consolidate the income of two or more
corporations formed for business reasons, having sub-
stantial income producing assets and conducting their own
businesses ?
2. Whether the authority granted by Congress to the
Commissioner under §¢482 to “distribute, apportion or
allocate” the income or expense of corporations under
common control includes the power to “deny” all but one
of multiple surtax exemptions by the ruse of “distribut-
ing, apportioning or allocating” all of their income to one
of them to be taxed with the benefit of only one surtax
exemption.
,
As to Sher-Del Foods, Inc. and
Your Host Bakery, Inc.
3. Same as No, 1. above.
4. Same as No. 2 above:
5. Whether the Court of Appeals was correct in sustain-
ing a 100% allocation of income and refusing to remand
the case to the Tax Court, even though it found that the
only income or expense that could he said to have been
arbitrarily shifted by management was a minor item—
billing and delivery expense—the amount of which the
taxpayer could readily prove if afforded the opportunity.
As to the § 269 Issues
May the Internal Revenue Service, without depriving the
taxpayers of due process of law, reaudit the same facts 17
times over a span of 20 years with the conclusion that the
corporations were not formed for tax avoidance purposes,
and then, on the 18th audit, after the deaths of the men
whose intent, purposes or mental processes are challenged,
reverse itself and claim that their intent, purpose and
motivation was tax avoidance?
Statutes and Regulations Involved
The relevant provisions of the Internal Revenue Code
of 1954 and the Treasury Regulations on Income Tax
(1954 Code) are set forts in Appendix D, infra pp. 70-75.
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Statement
The Internal Revenue Service audited the tay returns
of Alfred Durrenberger’s corporations for the 18th time in
1967. In 17 prior audits going back to 1947, agents had
found nothing to question about the corporate structure or
the right of each corporation to its own income and ex-
pense.
In 1967 there were 36 restaurants operating under the
name “Your Host” in Buffalo, Rochester and smaller com-
munities in Western New York. They were owned, in
varying numbers, by 11 restaurant corporations which had
been formed during the vears 1947 through 1955 for a
number of sound and varied business reasons which had
been serutinized and approved in audit after audit from
1947 on. A 12th corporation operated a night-club requir-
ing separate status to hold a liquor license.
Four other corporations, making 16 in all, performed dif-
ferent but essential functions. Sher-Del Foods, Ine., in-
corporated in 1947, was.a commissary. It purchased meats
and provisions from packing plants, growers and ‘packers
and sold processed and packaged foods to restaurants at
wholesale. Your Host Bakery, Inc., incorporated in 1956,
operated independently as a wholesale bakery of donuts,
pastries and other sweet goods. 30% to 40% of their sales
were to customers other than Your Host Restaurants.
Chef Foods, Inc., incorporated in 1958 too late to com-
pete, as intended, in the in-plant feeding or catering busi-
ness, Was prospering as a cigarette vending machine com-
pany. The 16th corporation, Alro Realty, Inc., had been
formed in 1951 as a real estate corporation to develop and
operate a business block of stores and offices.
Vee, MURR 11 Cee ESD
9)
The Revenue Agents making the audit in 1967 could find
no indication of any shifting of income or expense, omis-
sion of income, unreasonable deductions or any other evi-
dence that the corporations’ returns did not fairly and
accurately reflect the income of each corporation or that
the business relationships were anything other than arms-
length.
Their sole concern was that the owner of these corpora-
tions had the benefit of too many surtax exemptions. So,
they disallowed 14 of the 16 surtax exemptions on altzrna-
tive grounds. First, they cited §61 and ¢ 482 as their
authority to allocate the net income of 11 of the restaurant
corporations and the cigarette vending machine company
to the first corporation Durrenberger formed in 1947, name-
ly Your Host, Inc. They explained that they were using
§ 61 and § 482 to disallow 13 of the 14 surtax exemptions ;
that, in this way, the consolidated income would he taxed
to Your Host, Inc. at 48% with the benefit of only Your
Host’s surtax exemption. They then attributed the net
income of Your Host Bakery, Ine. te Sher-Del Foods, Ine.
under § 61 and ¢ 482 for the same reason.
On the chance that it might not be proper to use § 61
and § 482 in this fashion to disallow surtax exemptions
indirectly, they used § 269 and § 1551, in the alternative, to
disallow the surtax exemptions directly. The disallow-
ance was purely speculative, with no investigation of the
historical facts.
At or before the trial they eoneeded that § 61 was in-
applicable becanse these were not sham corporations and
that § 1551 did not apply because no corporation was the
transferee of the assets of any other corporation.
6
The Tax Court sustained their § 482 allocation only as to
Chef Foods, Inc. (the allocation of the income of the
cigarette vending machine company formed in 1958 to Your
liost, Inc. formed in 1947) and Your [lost Bakery, Ine.
(the allocation of the net income of the bakery formed
in 1956 to the commissary formed in 1947).
With respect to the § 269 issues, the Courts below found
that 11 of the corporations had been formed for business
reasons but that taxpayers had failed to overcome the
presumption that five of them had been formed primarily
to qualify for surtax exemptions. One had been incor-
porated in 1948 when there were no surtax exemptions,
three in 1951 and the fifth in 1955. The Internal Revenue
Service had actually explored the business reasons for the
formation of four of them in 1955 and concluded they had
been formed for business and not tax reasons. But. when
the case was tried 20 years after the fact. the taxpayers
were severely handicapped in their efforts to reconstruct
the business facts of the post-war era and the motivation
of businessmen under the 1939 Code. Both men. whose
business motivation was at issue, were deceased, Ross T.
Wesson in 1956 and Alfred J. Durrenberger in 1968.
The Second Cireuit Court of Appeals affirmed the find-
ings and rationale of the Tax Court. A dissenting opinion
shows there wus a fundamental disagreement over the
right of the Internal Revenne Service to use the 100%
allocation formula in dealing with separate, viable cor-
porate entities.
AS a Rete RATE
Reasons for Granting the Writ
The reasons for granting the writ are as follows:
1. The decision below aggravates a state of confusion
which has developed among the Circuit Courts and, in addi-
tion, creates a conflict within the Second Circuit itself, as
shown by the answers given by them to the following ques-
tions:
(a) May the Commissioner, for tax purposes, use § 482
to consolidate the net income of corporations which were
formed for sound business reasons and conduct their own
businesses and tax the combined amount to one of them?
No Third Cireuit C.LR. v. Chelsea Products, Inc., 197
F.2d 620
No Second Cireuit W. Braun Co., Ine. v. C.I.R., 396 F.
2d 264
No Reg. See. 1.482- The section is not intended to be
(b)(3) used to get the equivalent of a
consolidation of taxable income
Yes Seventh Cireuit Wisconsin Big Boy Corp. v. C.LR.,
452 F.2d 137
Yes Second Cireuit Your Host, Ine. v. C.I.R.
(But see dissenting opinion)
(b) May the Commissioner allocate the net income of
a group of controlled corporations to one of them in the
absence of any evidence that the owner has shifted or dis-
torted the income?
No Second Cireuit W. Braun Co., Inc. v. C.I.R. (supra)
No Tax Court Bush Hog Mfg. Co., Ine. v. C.I.R.,
42 T.C. 713
No Third Cireuit C.IL.R. v. Chelsea Procucts, Inc.
(supra)
Yes Seventh Cireuit Wisconsin Big Boy, Inc. (supra)
|
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Prin
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Yes Second Cirenit Your Host, Ine. v. C.L.R.
(But see dissenting opinion)
No_ Reg. See. 1.482- Only if the owner has distorted the
1(b) (1) income
No House Rep. No. This section was designed to pre-
2, 70th Con- vent the arbitrary shifting of
gress, Ist Ses- profits from one corporation to
sion, p. 16 another
(ec) May the Commissioner use his power under § 482
to “distribute, apportion or allocate” gross income and de-
ductions as a ploy to “deny” surtax exemptions?
No Tax Court The Challenger, Ine., 23 TCM 2096
(where. the IRS explained that
this was what it was doing)
Yes Tax Court Hlamburger’s York Road, Inc., 41
T.C. 821 (where the TRS did not
disclose what it was doing)
No Reg. See. 1.482- District Directors must make cor-
1(d) (2) relative adjustments of income
and expense. (There is no cor-
relative adjustment for the de-
nial of a surtax exemption)"
No Second Cireuit W. Braun Co., Ine. v. C.LR. (supra)
Yes Seventh Cireuit Wisconsin Big Boy Corp. v. C.LR.
(supra)
Yes Second Cireuit Your Host, Inc. v. C.LR. (supra)
(ad) Should income be taxed to the person or entity
which actually earns it?
Yes Supreme Court Moline Properties, Ine. v. C.LR.,
319 U.S. 436
“) The tax result is truly ridiculous. Your Host, Inc. is now paying
the taxes of two corporations, while Chef Foods, Inc. has in excess of
$35,000.00 of net income on which it pays nothing. Even the IRS
is confused about how to handle it.
Yes Supreme Court National Carbide Corp. v. C.LR.,
436 U.S. 422
Yes Second Cireuit W. Braun Co., Ine. v. C.LR. (supra)
Yes Second Cirenit Philipp Bros. Chemicals v. C.I.R.
(supra)
No Seventh Cirenit Wisconsin Big Boy Corp. v. C.LR.
(supra) The taxpayer must prove
the Commissioner was completely
unreasonable in allocating the in-
come to a corporation that did not
earn it
No Second Cireuit Your Host, Ine. v. C.1L.R. (supra)
Where it was undisputed that
Your Host did not earn it. It
was taxed to Your Host, Inc. only
heeause it was Durrenberger’s
first corporation
(e) Must a 100% alloeation be sustained where the
taxpayer proves that a lesser allocation is proper but fails
to prove the exact amount? Should a remand to enable
him to prove the exact amount be denied?
No Supreme Court — Helvering v. Taylor, 293 U.S. 507
No Fifth Cireuit Lufkin Foundry & Machine Co. v.
C.1.R., 468 F.2d 805
No Seventh Cireuit Baldwin-Lima-Hamilton Corp. v. U.
S., 485 F.2d 182
Yes Seventh Cireuit Wisconsin Big Boy Corp. v. U.S.
(supra)
Yes Second Cireuit Your Host, Ine.'*'™
(2) It was undisputed that the only adjustment required to reflect
the true income of Sher-Del Foods, Inc. and Your Host Bakery, Inc.
was a charge to Your Host Bakery, Inc. for billing and delivery services
performed by Sher-Del Foods, Inc. The Court below recognized this,
but refused to remand the case to the trial court for a determination of
the proper allocation. The dissenting judge would have remanded.
‘3) Reg. Sec. 1.482-2 (b) (1) provides that where a controlled cor-
poration performs marketing or other services for the benefit of another
scanned corporation without charge, the District Director should
make appropriate allocations to reflect an arms-length charge for such
services. A 100% allocation is obviously not an arms-length charge.
[Brides v
10
ARGUMENT
As to the § 482 Issues
There is a fundamental conflict among the Circuits as
to the boundaries of the Commissioner's authority to dis-
tribute, apportion or allocate gross income or deductions
under § 482.
In Chelsea Products (supra) the Third Circuit said that
both Treasury Regulations and the Committee Reports
clearly delineate the scope of §45 (now § 482); that the
standard to be applied in every case is that of an uncon-
trolled taxpayer dealing at arms length with an unecon-
trolled taxpayer, but that that it was “not intended to effect
in any case . . . a result equivalent to a computation of
consolidated net income under § 141.”
The Third Cireuit refused to allow the Commissioner
to allocate all the net income of three corporations to a
fourth, saying “There is no mention (in § 45) of authority
to disregard completely the corporate entity by combining
the net income of controlled corporations. The plain lan-
guage of § 45 must prevail.”
For a time other Circuit Courts reached the same con-
clusion. W. Braun Co. v. C.LR. (supra) where the Court
said Ҥ 482 does not give the Commissioner the power to
disregard separate corporate entities if they are being used
for a bona fide business purpose”: Philipp Bros. Chemicals
v. CLLR. (supra)
The Tax Court held that same view. Bush Hog Manu-
facturing Co. v. C.1.R., 42 T.C. 713: V. H. Monette v. C.1.R.,
45 T.C. 15; Dorba Homes, Inc. v. C.1.R., 26 TCM. 693.
However, in 1964, the Tax Court started the line of con-
flicting decisions with Hamburger’s York Road, Inc. v.
:
11
C.I.R., 41 TC 821. The Internal Revenue Service sought to
disallow the surtax exemption of Hamburger’s York Road,
Ine. under { 269 by claiming it had been created to get the
benefit of a surtax exemption. In the alternative it con-
solidated its net income with that of Isaac Hamburger &
Sons Co. under § 482. The Tax Court could have denied
the surtax exemption under § 269. Instead, it taxed Isaac
Hamburger & Sons on the combined income with one surtax
exemption.
This § 482 approach to the disallowance of surtax ex-
emptions was adopted by the Tax Court in Marc’s Big Boy-
Prospect, Inc. v. C.1.R., 52 TC 1073 and its decision was
affirmed by the Seventh Cireuit Court of Appeals in
Wisconsin Big Boy Corp. +. C.1.R., 452 F.2d 137.
In both Hamburger’s York Road and Wisconsin Big Boy
there is no recognition of the fact that the Court, by re-
quiring the equivalent of a consolidated return, was in fact
disallowing surtax exemptions. But the deficiencies show
that the amount of tax involved was the exact net differ-
ence between the tax computed with and without the benefit
of surtax exemptions.
In the Your Host ease there was abundant and undis-
puted proof that the Commissioner was deliberately con-
solidating the income of 14 of the corporations to Your
Hlost, Ine, and Sher-Del Foods, Inc. solely for the purpose
of disallowing their surtax exemptions and documentation
showing that the deficiencies computed under ¢ 482 were,
to the penny, the same as from the denial of surtax exemp-
tions under ¢ 269.
The Supreme Court has had only one oceasion (Commis-
stoner v. First Security Bank of Utah, 405 U.S. 394) to rule
on § 482 since the adoption of the Internal Revenue Code of
‘
Spiteri ha edna dale BIEN Ne eR 1 ae me
12
1954 and the emergence of § 482 as one of the most litigated
corporate sections of the Code. Meanwhile, the lower
Courts have been struggling with its provisions, inevitably
arriving at conflicting and confusing conclusions.
The issue that has given them the most difficulty is the
Commissioner’s arbitrary use of the 100% allocation as an
alternative to § 269 to disallow surtax exemptions and to
transfer the burden of proof of the correct arms-length
allocation to the taxpayer.
This case contains an abundance of clear-cut facts for a
comprehensive analysis and determination of the scope and
purpose of § 482 and the perimeters beyond which the Com-
missioner’s use of it is arbitrary, unreasonable, unautho-
rized and unfair to the taxpayers."
As to the Issue of Due Process
The taxpayers stoutly objected to being assigned the bur-
den of proving Wesson and Durrenherger’s intent, state of
mind or motivation for forming corporations during the
years 1948 through 1955, with both long since deceased and
no one left to explain their business decisions except Dur- °
renberger’s widow and an office employee.
The Trial Court denied the taxpayers the right to present
this evidence:
1. Audit reports showing that the TRS had audited
Durrenberger’s corporations 17 times from 1947 on, during
‘” For an independent confirmation of the fundamental conflict
and confusion described above, see Journal of Taration, Vol. 40. No.
4, April, 1974, page 222. It describes Your Host as a “startling con-
trast” to prior decisions of the Second Circuit and as showing how the
Courts “by putting heavy procedural burdens on a taxpayer caught up
in § 482 litigation” are letting the Internal Revenue Service use its
100% allocation of income approach to § 482 “behind a procedural
smoke screen”.
13
all the years the corporations were being formed and for
over a decade thereafter, and had accepted their returns
with minor adjustments.
2. Documentation of the audit in 1955 when, with the
facts still fresh and Wesson and Durrenberger still alive,
the IRS had explored all the circumstances surrounding the
incorporation of 309 Delaware Avenue, Ine. in 1948 and
Royal Host, Inc., Telesnax, Inc., and Alro Realty, Ine. in
1951 and agreed that they were not incorporated for tax
avoidance purposes.
3. The revenue agent's report showing that he had
raised the § 269 and § 1551 issues on pure speculation and
without any inquiry into the facts and only because he got
the idea from reading Hamburger’s York Road, Inc. v.
C.1.R. (supra) (Government Counsel conceded this, in
effect, by saying that the § 269 issue had been raised to
“protect the revenues”).
The court imposed the burden on the taxpayers of prov-
ing that the Commissioner's determination was unreason-
able, arbitrary and capricious. Yet, it deprived the tax-
payers of the right to present the very evidence which
would have demonstrated the unreasonableness of the Com-
missioner’s sudden turnabout."*?
Instead, the taxpayers had to eall on Durrenberger’s
widow in an effort to explain and justify major business
decisions he had made twenty vears before. Tf she and
the bookkeeper had died before trial. the taxpayers would
have been totally defenseless.
‘) The exclusion of evidence so essential to the taxpayers’ burden
of proof was a gross departure from “the accepted and usual course of
judicial proceedings” within the meaning of Rule 19 of the Rules of
the Supreme Court.
4 LENA A
gt ia MD LOSES
a Jae aE fs
Betta: Ree ee ost eT Oe!
14
In short, the IRS was allowed an 18th audit of the same
tax that had been present in 17 prior audits. For example,
Wesson and Durrenberger incorporated Telesnax, Inc. in
1951 to allow a key employee to become a one-third owner
as an added incentive to stay in their employ. Their pur-
poses and objectives and the surrounding circumstances all
relate to 1951. These business reasons became fixed in 1951
and never changed. They were fully explvred in 1955 and
the IRS agreed their intent was employee oriented and not
tax avoidance.
Tt was not a fair hearing in 1971 when their survivors
were deprived of the henefit of the facts that had been
accepted by the TRS in 1955 and proof that the TRS had
re-audited the same facts time after time from 1955 until
1967. Tt was not a fair hearing when the taxpayers had to
reconstruct business reasons and intent best known to
Wesson and Durrenberger and the realtors or landlords
with whom they negotiated leases, all of whom were
deceased or otherwise unavailable to testify.
Congress has said that separate corporations may be
formed for legitimate business reasons such as those which
motivated the incorporation of the petitioners without fear
of attack under either § 269 or § 482. House of Represen-
tatives, Report Number 586, 82nd Congress, First Session.
CB 1951-2, 506-507: Senate Report Number 830, 88th Con-
gress, Second Session, CB 1964-1 (Part 2) 654.
Yet the effect of the decision helow is that such corpora-
tions are subject to attack at the whim of any revenue
agent, 20, 40, or even 50 vears after the facts hecame fixed
and unchangeable, no matter how many revenue agents had
approved and reapproved their right to surtax exemptions
and no matter how much of the evidence or the testimony
has heen forgotten, lost or destroyed because of deaths and
the passage of time.
15
Conclusion
The petition for a writ of certiorari should be granted.
Respectfully submitted,
ALBRECHT, MAGUIRE, HEFFERN
& GREGG,
Attorneys for Petitioners,
2110 Main Place Tower,
Buffalo, New York 14202.
Dated: April 15, 1974.
Of Counsel:
Raupu J. GREGG,
Georce M. ZIMMERMANN.
16
1 Listing of Tax Court docket numbers.
; APPENDIX A
4
; IN THE
: UNITED STATES TAX COURT
}
; YOUR HOST, INC., et al.,!
; Petitioners,
j COMMISSIONER OF INTERNAL REVENUE,
i Respondent.
4 Docket Nos. 2673-69, 2675-69—2688-69, 446-70, 448-70—
; 461-70, 1194-71—1207-71.
: Filed April 6, 1972.
; Opinion
i Irwin, Judge:
3 Respondent determined the following deficiencies in the
; corporate income taxes of petitioners:
; Deficiency
: Petitioner Docket
No. Year Sec. 482 Sec. 531
| me fue ane tees
9 Your Host, Inc. .............. | 446-70 1967 170,930.11 94'309.00
\ 1194-71 1968 170,198.45 93,000.00
} 2675-69 1965 BIE tle sn ssiccnse'
Alro Realty, Inc. .......00060 | an a aoe
1207-71 1968 OS dines Gusice
2676-69 { 1965 BI ovncvinn setae
Boulevard Host, Inc. ......... 448-70 Fe aueeae digits ak i
1197-71 198 = 5,500.00 22... sss
17
Appendia A
Deficiency
iti Docket
cpanel No. Year Sec. 482 Sec, 531
mo fe ate
Chef Foods, Inc. ........+++0+: 449-70 1967 4999.96 ..
1198-71 1968 5,500.00
2678-69 1965 road
Main Host, Inc. .........6006. ance ‘ine Sana
1199-71 1968 5,500.00
2679-69 § 1965 5,000.08
: 1966 5,000.08
Niagara Host, Inc. ........--- 451-70 1967 4,999.84
1200-71 1968
2680-69 1965
Rochester Host, Inc. .......... 1966
452-70 1967
2681-69 § 1965
1966
Royal Host, Inc. ..........-+- 453-70 1967
1201-71 1968
2682-69 § 1965
1966
Sharlem Host, Me cca takaees 454-70 1967
1202-71 1968
2683-69 {1965 ;
1966 :
Telesnax, Inc. ............006- 455-70 1967 :
1203-71 1968 r
2684-69 § 1965 ee eae
309 Delaware Ave, Inc. ....... nn ae. aa
1206-71 1968 SE oes ica vkes en
2685-69 § 1965 WIE Ss vicsccnvsecs
Transit Host, Ine. ...2++200++ 457-70 ‘1967 477368 2
1205-71 1968 NE es ce
2686-69 § 1965 I coos seca ks
Utica Host, Ine. .......s0s204s 45-70 ‘1967 408800 20002
1204-71 1968 Rok vc dndsex y's
ee fe er:
Sher-Del Foods, Inc. eccccccce 459-70 1967 19,087.40 28,709.00
1195-71 198 — 21,509.43 18,115.00
2688-69 1965 BRIE Son ccusvotcses
Your Host Bakery, Inc. ....... 460-70 oar Hoey ig hah ss a woth
1196-71 1968 _ pirates
oi hee tee $
Ribu Ta
a ay aE fa =
18
Appendia A
Respondent has conceded that petitioners Your Host,
Inc., and Sher-Del Foods, Ine., are not subject to the ac-
cumulated-earnings tax imposed by section 531? for the
years in question. After other concessions the following
issues remain for decision:
(1) Whether respondent was arbitrary in allocating
under section 482 all of the income and deductions of the
10 corporations operating restaurants and the vending
machine corporation to Your Host, Ine.; and
(2) In the alternative to the first issue, whether the sur-
tax exemptions provided by section 11(d) should be
disallowed under section 269 in the cases of these corpora-
tions; and |
(3) Whether respondent, was arbitrary in allocating
under section 482 all of the income and deductions of Your
Host Bakery, Inc., to Sher-Del Foods, Inc. ; and
(4) In the alternative to the third issue, whether the
surtax exemptions of Your Host Bakery, Tne., and Alro
Realty, Inc., should be disallowed under section, 269; and
(5) Whether as an alternative to proceeding under sec-
tion 269 the surtax exemption of Alro Realty, Ine., should
he disallowed under section 1551.
We need not consider the second issue if the first issue is
found in respondent's favor, nor the fourth:issue if the
third: is found in respondent’s favor. Similarly, there will
he no deficiencies against the restaurant corporations if we
uphold respondent on the first issue and no deficiency
against Your Host Bakery, Inc., if we ‘uphold respondent
on the third issue.
? All statutory references are to the Internal Revenue Code of 1954,
as amended.
19
Appendix A
FINDINGS OF FACT
Some of the facts have been stipulated and they are so
found. The exhibits attached to the stipulation are incor-
porated herein by this reference.
All of the petitioners herein are corporations chartered
under the laws of the State of New York. For each of the
vears in question petitioners filed their Federal income tax
returns with the district director of internal revenue. Buf-
falo, N.Y. During the years in issue the business address
and principal place of business of petitioners was 3491
Delaware Avenue, Kenmore, N.Y.
The founders, principal stockholders, and officers of all
of the corporations involved herein were Alfred J. Durren-
herger, Jr. (Durrenberger), and Ross T. Wesson (Wesson).
Wesson was killed in an airplane crash on July 17, 1956,
and Durrenberger died on October 28, 1968. Wesson and
Durrenberger will in some instances he referred to as the
partners.
Before going into business together in 1944, Durrenber-
ger had been a butcher and the owner of a retail meat mar-
ket in the village of Kenmore, N.Y., and Wesson had run a
diner in the village of Gowanda, N.Y. On May 1, 1944,
Wesson and Durrenberger filed a certificate in the office of
the Clerk of Erie County that they were conducting busi-
ness under the assumed name and style of “Your Host,”
giving their business address as 461 Kenmore Avenue,
Kenmore, N.Y., and thereupon proceeded to open a hot dog
stand at that location. Tn 1946 they purchased the land on
which the hot dog stand was located.
Basen
20
Appendix A
In December 1944, Wesson and Durrenberger leased
property at 2835 Delaware Avenue, Kenmore, N.Y., next to
Durrenberger’s meat market, made leasehold improvements
therein, and opened their first restaurant, known as Your
Ifost Restaurant.
Tn 1945 Wesson and Durrenherger opened two more
restaurants in the Buffalo area. These restaurants were
all similar in appearance, operation, and menu and each
operated under the name of Your Host Restaurant.
Your Host, Ine. (hereinafter Your Host), was ineorpo-
rated and commenced business on January 1, 1947, with
Durrenberger and Wesson as equal stockholders. They
transferred to it the business assets and liabilities they had
acquired as a partnership, inelnding the leasehold improve-
ments at the three restaurants and the hot dog stand, for
promissory notes totaling $62,518.15 and 100 shares of the
common stock of the par value of $100 per share.
On Mareh 20, 1947, Wesson and Durrenberger purchased
lots on Delaware Avenue in the town of Tonawanda. N.Y..
(now known as 3491 Delaware Avenue), upon which was
located a one-story cement block bnilding intended to be
used as a commissary. They therenpon incorporated Sher-
Del Foods, Tne. (hereinafter Sher-Del). to operate a food-
processing plant and commissary, and it commenced Insi-
ness on September 1, 1947. They transferred to it the
property which they had hought at 3491 Delaware Avenne
and other current and fixed assets for promissory notes
totaling $43,400 and 100 shares of common stock of the
par value of $100 per share. Sher-Del assumed Durren-
herger’s and Wesson’s individual liabilities with respect to
341 Delaware Avenue upon said transfer, and repaid the
$43,400 promissory notes in the middle 1950's.
21
Appendix A
In 1947 Your Host opened two additional restaurants
upon leased premises. These restaurants were similar in
appearance, operation, and menu to the restaurants previ-
ously in business and each operated under the name of
Your Host Restaurant.
On April 20, 1948, Wesson and Durrenberger. doing busi-
ness as Your Host leased the premises at 309 Delaware
Avenue, Buffalo, N.Y. The lease agreement required that
the tenants operate a restaurant under the name of and in
the manner of existing Your Host Restaurants. The lease
further permitted the tenants to assign the lease to a corpo-
ration organized by them at which time their personal
obligation for the rent would cease.
The prospects for a restaurant at 309 Delaware Avenue
were not as favorable as those enjoyed at the other Your
Tlost locations. The rent was higher there than for other
locations ($250 to $300 per month over a 7-year period com-
pared to a $200 maximum per month on a 10-year lease at
3232 Bailey Avenue). There were no adjacent parking
facilities, and pedestrian traffie was not as heavy as at
other locations. In light of these factors the atterney for
Wesson, Durrenberger, and Your Host, F. Paul Norton
(Norton), recommended that the restaurant at 309 Dela-
ware Avenue be incorporated separately.
On June 9, 1948, Wesson and Durrenberger incorporated
309 Delaware Avenue, Ine. (hereafter 309 Delaware), as
equal shareholders. Subsequently, 309 Delaware began
operation of a Your Host Restaurant at 309 Delaware
Avenne and heeame the assignee of the lease for those
premises,
ke eet ROMS Tl adhe ble 4 @
22
Appendix A
During the period from 1951 to 1954 Wesson and Dur-
renberger caused three more corporations to be formed to
operate Your Host Restaurants. These corporations were
Royal Host, Ine. (Royal), Telesnax, Ine. ( Telesnax), and
Utica Host, Ine. (Utiea). The cireumstance surrounding
their incorporation are summarized below :
1. Telesnax—Wesson and Duarrenberger set up Teles-
nax with two principal ideas in mind. First. they desired
to give their accountant, James L. Clements, an oppor-
tunity to obtain a proprietary interest in the success of
Your Host Restaurants. Second, they desired to take
advantage of the burgeoning popularity of television by
offering viewers an opportunity to order meals on the
telephone that would he delivered to their homes. The
name Telesnax was designed to convey this second purpose
to the public, and by using Telesnax as a corporate name
they felt that they could prevent its appropriation by an-
other operation.
Clements did in fact obtain one-third of the stock of
Telesnax; however, the meals-at-home idea was never
developed and no attempt was made to obtain trademark
protection for the Telesnax name. Instead of using Tele-
snax to develop the meals-at-home idea, Durrenberger felt
it advisable to use the new corporation to operate a Your
Host Restaurant in some empty store space next to a
supermarket. This restaurant was opened for business in
1951.
2. Royal Host—No particularly compelling reason was
offered at trial for the formation of Royal Host in 1951 by
Wesson and Durrenberger. Clements testified that there
was concern that there would be infringement upon the
23
Appendix A
Your Host name by other businesses using a similar name.
Consequently, the partners filed an application for incor-
poration under the name of The Host. Inc. This applica-
tion was rejected because of its similarity to The Host,
Incorporated, an already existing corporation. Incorpora-
tion of Royal Host and other corporations whose names
ineluded the word Host was seen as offering some protec-
tion for the Your Host business. The subsequent use of
the Royal Host name by Wesson and Durrenberger is noted
in the margin.*
Royal Host commenced operating a Your Host Restau-
rant in 1951 on leased premises.
3. Utica Host. Wesson and Durrenberger formed Utica
lost in September 1954 to operate a Your Host Restaurant
upon leased premises upon which a former tenant had
operated a restaurant. This restaurant had failed and the
landlord had become the owner of the restaurant assets.
The former restaurant had a record of a small sales volume.
was poorly designed, and was located in a “changing neigh-
horhood.” In light of these factors the partners decided
the restaurant was a risky venture and should be separately
incorporated.
* The Your Host Restaurants were very simple establishments em-
phasizing hamburger sandwiches on their menus. Wesson wanted to
open up a fancy restaurant or steak house which served liquor. In
1954 Wesson and Durrenberger formed Air Host, Inc., as equal
shareholders. Air Host commenced operating a restaurant of the
type desired by Wesson called the Royal Host. Respondent has con-
ceded the cases involving Air Host. Inc.. and has not allocated the
income and deductions of Air Host to Your Host. These concessions
notwithstanding, Air Host will be mentioned in the opinion. It is
important to remember that the Roval Host Restaurant was run by
Air Host, Ine., and not by Roval Host. Inc.. or one of the other
“Host” petitioners.
24
Appendix A
Prior to 1953 all of the Your Host Restaurants except
one were located in downtown commercial areas or in resi-
dential areas; however, in 1953 Wesson and Durrenberger
heeame interested in placing restaurants in large suburban
shopping plazas. At that time the development of large
suburban shopping plazas was in its early stages. Norton
recommended against placing Your Host Restaurants in
the plazas because the shopping plaza idea was as vet un-
tried in the Buffalo area, the plazas were not accessible to
publie transportation, and the onset of the Korean conflict
made the availability of private automobiles and gasoline
doubtful in his mind. In addition, placing restaurants in
the plazas required a lease obligation of a longer term and
for greater rent than Your Host had become accustomed
to undertake. Beeause Wesson and Durrenberger felt that
the plazas showed promise, Norton advised that + ach new
restaurant he placed in a separate corporation in order to
insniate Your Host in the event that the plazas did not live
up to the partners’ expectations.
During the period from 1953 to 1956 the following four
corporations were organized to operate a Your Host Res-
taurant in a new shopping plaza:
: Year plaza
Corporation name restaurant
(abbreviation) Shopping plaza Date incorporated opened
Boulevard Host, Inc. ...... Northtown Plaza .......... TO ea nsasas 1953
(Boulevard)
Niagara Host, Inc. ....... Marvin Gardens Plaza ..... February 1955 ..... 1955
(Niagara)
Transit Host, Inc. ......... Transitown Plaza ......... Be TO sacaacans 1956
(Transit)
Sharlem Host, Inc. ........ Sheridan-Harlem Plaza ....Jume 1956 ......... 1957
(Sharlem)
25
Appendix A
Boulevard, Niagara, and Sharlem were each incorpo-
rated with Wesson and Durrenberger as equal sharehold-
ers. Transit was a wholly owned subsidiary of Your Host
upon its organization. In December 1955 Your Host ac-
quired all of the stock of Niagara, and in February 1957
Your Host acquired all of the stock of Sharlem.
In addition to the above changes in the corporate family
tree, Royal acquired all of the stock of Utica in December
1955.
In September 1955 Durrenberger became interested in a
location for a Your Host Restaurant near the village of
Williamsville. Durrenberger decided to set up a separate
corporation to operate a restaurant on this location hecause
he felt that his own resources and those of the othe> cor-
porations had become overextended with the expansion of
the Your Host chain into the shopping plazas. At this time
Wesson was occupying himself primarily with running the
Royal Host Steak House, fulfilling his duties as an officer
in both the local and national restaurant associations, and
flying his private airplane. There was no economic reason
peculiar to the Williamsville location which indicated the
need for a separate corporation.
In September 1955 Main Host. Inc. (Main), was organ-
ized by Wesson and Durrenberger and in January 1956 all
of its stock was aequired by Royal. During 1956 Main
commenced operating a Your Host Restaurant upon the
Williamsville location.
In early 1956 Wesson and Durrenberger became inter-
ested in developing a chain of Your Host Restaurants in
the area of Rochester, N.Y.. which is about 70 miles dis-
dats ie
26
Appendix A
tant. Two of their Buffalo area competitors had tried to
penetrate the Rochester area previously without success.
The partners anticipated problems stemming from the
absentee management of the Rochester operations and were
not confident of succeeding in the new area. Accordingly,
they organized Rochester Host, Inc. (Rochester), in May
1956 as equal shareholders. After delays caused by the
death of Wesson, Rochester opened its first Your Host
Restaurant in the Rochester area in the latter part of 1957.
Rochester was the last corporation formed by the part-
ners to operate Your Host Restaurants; however, new
restaurants were added to the chain without creating any
additional corporation. The following chart indicates the
development of the Your Host restaurant chain from 1944
to 1969 by showing the names of the corporations and the
years in which each first opened a restaurant as well as the
latter years in which each corporation opened additional
restaurants:
Years In WHICH RESTAURANTS WERE OPENED
10th
thru
Corporation Ist 2d 3d 4th: «=OSth:)«= 6th: ss 7th:)«= 8th: Ss 8th:=Ssd1Sth
Your Host ..... 1944 1944 1945 1945 1947 1947 1958 1959 1960 1969
309 Delaware .. 1948 1949 1950 1959 ...........2-.-- 202 e- eee ee eee eee ee
(OS eee ne ae osweenhaerescesansme
Roulevard ..... O00 a oe a ee
MD vc nese rr rn i ceeesieneesernscconrrers
Niagara ....... ee oueinnyesebnemeareete
os anaes enna berbasendanmnnere
WE 5 cence SE a mee
Sharlem ....... ee meieeareraenenconts
Rochester ...... oe winapauinoeeeniandsn
Telesnax ...... EET eA Ee a
1 Terminated business in 1968.
? Replaced first restaurant,
Appendix A
The capital needed for the expansion of the Your Host
Restaurant chain came primarily from three sources: (1)
Relatively small capital contributions from either the part-
ners or one of the corporations; (2) substantial open-
account interest-free cash loans from Your Host, Sher-Del
Foods, or one of the other restaurant corporations; and (3)
credit from Sher-Del for supplies used during the first few
weeks of a new restaurant’s business.
_ Tn all cases the corporations were only responsible for
the rent payments on the premises on which they actually
operated restaurants. In any case in which Wesson and
Durrenberger, Your Host, or one of the restaurant corpo-
rations negotiated a lease for a new restaurant location the
lease contained provisions permitting its transfer to an-
other corporation without any liability on the part of the
initial lessee. Apparently the lease hetween Wesson and
Durrenberger and the landlord of 309 Delaware Avenue
entered into in 1948 served as a model for all subsequent
leases for Your Host Restaurants.
In 1947 Wesson and Durrenberger incorporated Sher-
Del Foods, Inc., to operate a food-processing plant and
commissary. The Your Host Restaurants were only able to
buy meat and other supplies at retail prices: therefore, it
was necessary to establish Sher-Del as a bona fide inde-
pendent food wholesaler so that it could take advantage
of the wholesale prices available to such concerns. The Your
Host Restaurants buy all of their supplies from Sher-Del
on an open-account basis: however, 30 pereent of Sher-Del’s
business on the average is with outside customers. The
prices charged Your Host Restaurants and outsiders are
the same.
cesta nadite
Pe ae ae en ys el acy
28
Appendix A
Initially Sher-Del operated the commissary business in
one-story building located at 3491 Delaware Avenue, Tona-
wanda, N.Y. Wesson and Durrenberger had purchased
this building and nine lots at this address in 1947 and con-
tributed them to Sher-Del. In 1948 and 1949 Sher-Del
bought four lots adjoining the commissary, began to develop
the property as a business block, and added storefront
space. In 1950 Sher-Del improved and enlarged its com-
missary operation upon this property, and in August 1951
Royal commenced operating a Your Host Restaurant in the
storefront space.
On October 1, 1951, Sher-Del sold this property to a new
corporation formed by Wesson and Durrenberger, Alro
Realty, Inc. (Alro), for $112,822.93 represented by a 4
percent promissory note.
Alro Realty, Inc., was formed in September 195i
with Wesson and Durrenberger as equal shareholders.
The partners believed that they could obtain better
mortgage financing if one corporation owned all of the
real estate that at that time was owned by Your Host and
Sher-Del. They also hoped to infuse some cash into Sher-
Del when Alro paid the $112,822.93 note with which it pur-
chased 3491 Delaware Avenue and adjacent land from Sher-
Del. In fact, Alro was never particularly profitable and
did not reduce the unpaid balance of the note below
$110,000; however, Alro did purchase additional land
adjacent to 3491 Delaware Avenue until it had acquired an
entire city block. Upon this block it developed a small
plaza which housed the business offices of all of the related
corporations and provided space for unrelated tenants.
29
Appendix A
In 1955 the partners were presented with an opportunity
to purchase a fully equipped bakery for an investment of
$15,000 in cash and a mortgage of $18,000. Not only was the
purchase price of the bakery favorable, but also the acquisi-
tion protected the restaurants from a loss of local supplies
of sweet baked goods. A significant portion of the business
of the Your Host Restaurants came from the sale of pies,
cakes, doughnuts, and other sweet goods, and this business
would suffer if an adequate supply of sweet goods could
not be maintained.
Although the bakery would have assured purchasers
for its products in the Your Host Restaurants, the part-
ners felt that their inexperience in the baking business made
the success of the bakery somewhat doubtful and that it
would be best to limit the liability of the other businesses
to the $15,000 cash investment. Accordingly, Your Host
Bakery, Ine. (Bakery), was formed in November 1955 with
Wesson and Durrenberger as equal shareholders to operate
the bakery.
Bakery was a successful venture. It did not sell any of
its products directly to the public or to the restaurants.
Sher-Del took orders for baked goods from the restaurants
and made purchases from Bakery. The prices which Sher-
Del paid Bakery for baked goods and which the restaurants
paid Sher-Del for the same items were identical and were
based upon the wholesale pricelist of a commercial baking
corporation.
Chef Foods, Ine. (Chef), was the last corporation to be
formed. In 1956 Wesson and Durrenberger began
exploring the idea of providing meal-eatering service
Baars Vala. § sila aerane
30
Appendix A
in industrial plants. The death of Wesson in 1956 and the
expansion of the restaurant business caused Durrenberger
to defer the development of the in-plant feeding idea. In
1958 he formed Chef Foods, Inc., to go into the in-plant
feeding business; however, this business was never de-
veloped. Instead, Chef purchased vending machines in
1959 and 1962. These machines were placed only in Your
Host Restaurants. In addition, Chef purchased refrigeration
and storage plants located at 2646 Delaware Avenue in
1959. Sher-Del leased from Chef a part of these facilities
for use in the commissary business and Chef used the other
part for the vending business.
The Your Host Restaurants were all similar in appear-
ance, served identical menus at the same prices, and were
open for business 24 hours a day. In their advertising the
restaurants tried to convey to the publie that each
restaurant was a part of a chain with the same management.
No attempt was made to convey to the public the separate
corporation ownership of some of the restaurants. Solicita-
tions in the newspapers for employees were made in the
name of Your Host Restaurants, and letters were sent
under the cover “Your Host and Family Restaurants” even
though they were signed in the name of individual corpora-
tions.
The president of each corporation was Durrenberger from
Wesson’s death in 1956 until his own death in 1968. Follow-
ing her busband’s death, Durrenberger’s widow became the
president of each corporation. As will be explained infra, the
restaurants shared the same top management personnel.
None of the corporations paid Your Host for use of the
Your Host trademark.
31
Appendix A
Each of the corporations maintained its own minute
book; however, the minutes recorded for Your Host were
meager while those recorded for the other corporations
were nearly nonexistent. Each corporation had at least
one bank account, and each restaurant maintained a de-
posiiory account at a bank situated near to it. Deposits
representing daily receipts of each restaurant were placed
in the respective depository accounts and then transferred
on weekly basis to the bank account of the corporation to
which they belonged. Each corporation used its own bank
account to pay most of the expenses attributable to the
operation of its restaurants. These expenses included sup-
plies purchased from Sher-Del, utility bills, rent, Federal
and State income taxes, social security taxes and income
taxes withheld from employees, fire insurance, license
fees, and sign bonds (where necessary).
Because Your Host could obtain master policies for
public liability insurance and workmen’s compensation
covering all the restaurants and their employees for a cost
that was less than the combined cost of separate policies for
each corporation, Your Host advanced the premium pay-
ment to obtain such master policies. Your Host was then
reimbursed by the other corporations for their share of the
premium, which was computed by the insurer or it agent
according to a formula based upon the payroll of each
corporation.
At one time the corporations paid the wages for their
employees in cash; however, in 1952 wages began to be
paid by check for security reasons. For administrative
convenience and to enable the employees to eash their
- P 4 os + a t= oe ~~ —— cs
pee aig eee ERAS Wee eck ING SE SH KM Biobe. it Ree SHS ee |
pa AA Rye A Rie.
Df
4
3
id
B
a
3
¥
iat
ad
~
*
4%
32
Appendia A
checks without difficulty, salaries for all employees of every
corporation were paid from a special zero-balance payroll
account maintained by Your, Host. This account worked in
the following manner: Every week each corporation com-
puted its own net payroll (after deduction for withholding
items) and paid this amount into the “Your Host, Ine.,
Payroll Account”; all wages were then paid from this ac-
count leaving a “Zero balance.” This payroll account was
not carried as an asset upon the books of Your Host.
‘ach restaurant had its own manager who was generally
responsible for the operation of his restaurant. His duties
included ordering supplies and hiring and firing employees ;
however, the manager had no authority to change the
menu of the restaurant, change its business hours, or pur-
chase supplies from someone other than Sher-Del. The
restaurant managers could not write checks. The managers
were compensated on a salary-plus-bonus arrangement.
The amount of the manager’s bonus depended upon the sue-
cess of his location.
The personnel needed to adminisier and maintain all
16 corporations were nominally the employees of Your
Host; however, the expenses attributable to these employees
were in fact shared by all of the corporations during the
years in issue in the following manner:
(1) With exceptions noted below, the cost of the
administrative staff (bookkeepers, typists, clerks, and the
like), group insurance premiums, and the expenses of the
administrative office were allocated among the corporations
eccording to gross sales;
33
Appendix A
(2) Advertising costs were allocated among the cor-
porations operating Your Host Restaurants in the Buf-
falo area according to gross sales;
(3) The cost of the maintenance crew and the salaries
of the Your Host Restaurant area supervisors—six or
seven men who each oversaw the operations of six or seven
restaurants—were allocated among the corporations operat-
ing Your Host Restaurants.
The gross sales of Air Host which operated the Royal
Host Restaurant were included in the administrative ex-
pense allocation at only half of actual sales excluding liquor
sales. This adjustment was made to reflect the fact that the
Royal Host Restaurant sold liquor and meals which were
considerably more expensive than those available in Your
Host outlets. The high price of Royal Host meals did not
command a proportionately high amount of administrative
effort.
The gross sales of Sher. Del were included in the adminis-
trative expense allocation at a figure that was less than
actual sales to reflect the fact that intercorporate sales
did not require a great deal of administrative effort and
that Sher-Del employed a small administrative staff of its
own. The figure used for gross sales was either one-half
actual sales or twice sales to unrelated customers.
Rochester Host was not ineluded in the advertising ex-
pense allocation because the Rochester restaurant could
not benefit from Buffalo area advertising. It appears from
the record that Your Host paid more than its share for
advertising under the furmula. No explanation can be found
ee ee ae
Dares ae rrrenin Perinie Rite se
34
Appendix A
for the discrepancy except that Your Host may have paid
entirely on its own for certain small advertising items like
help-wanted ads.
The corporations not running restaurants and Air Host
were allocated no part of the advertising or area supervisor
expenses because these items related particularly to the
sales of the Your Host Restaurants.
Although Your Host advanced the funds necessary to take
eare of the administrative, advertising, and supervisory
expenses, each of the corporations did in fact pay its al-
located share of the expenses. Only the allocable part of the
expenses appear on the returns of each corporation.
In all of the years in issue Durrenberger drew part of his
salary from each of the corporations. The following chart
represents his draw from each corporation:
1965 1966 1967 1968
Shel-Del Foods, Inc. .............-- $22,500 $22500 $22500 $18,750
a OE eee ee 12,600 12,600 11,400 11,400
309 Delaware Ave., Inc. ..........-- 7,800 5,400 4200 1,500
Biewal Tithe, Te. oc cc cevesccsccsces 1,500 1,000 1,000 833
Oe) aera 1,000 1,000 1,000 833
Boulevard Host, Inc. ..............- 1 1,000 1,000 1,000
cos Oe eee 1,100 1,000 1,000 833
Clem Bieet, Bee, .ccccccsccccccccces 1,100 1,500 2,000 1,667
Dileenen Tiest, Ene. ....22.2200000 1,100 2,000 4,000 3,333
- "2 a 1,100 1,200 1,667
Tc cn cocanusneuheen 1,100 1,200 1,200 1,333
eras 1,100 1,500 2,000 1,667
Peeters Tek, BER. ccncccencccvces 1,100 1,500 2,200 833
Your Host Bakery, Inc. ............ 1,000 1,500 1,500 1,333
EE ——E—————————— 1,000 1,000 1,000 833
Cer Ses TL, coscccncccssusnsces 1,000 1,500 1,500 1,333
TO cccucnsseucsatavavee 57,100 57,400 58,500 49,148
a
35
Appendix A
The 15 corporations reported the following amounts of
taxable income for the years in issue:
1965 1966 1967 1968
Your Host ..........seeeeeeecenes $136,702 $107,101 $126,338 $111,310
309 Delaware ........-.---.eeeeeee 47,960 45,859 48,816 38,820
re 31,894 35,587 33,107 39,142
Boulevard .........-+-++eeeeeeeees 25,932 28,596 23,973
WED cc ccccccccccccccccccccceccess 28,132 23,451 420 25,674
Niagara .......-ccccerecceeceecees 36,646 58,971 71,358 $8,031
Oe rere 16,231 35,680
Teemelt ..cccccccccccccceccscccess 38,402 36,092 23,866 16,602
Shasdems .......ccccccccccccecccees 29,695 29,607 36,748 30,273
Rochester ........2--+0-eseeeeeees 11,693 2,447 1,082 (Loss)
OS er 31,098 42,882 41,727 35,7600
Telesmax ........ccceeeceeeeeeeees 16,459 18,737 17,284 17,253
penceccesensneusuceacceuas 44,882 43
Sher-Del ......--2cceeeceeeeeecees 41,212 79,494 158,231 64,816
AW 22. ccccccccccccccceccsececess 7, 13,799 13,309 11,908
OPINION
In 1944 Wesson and Durrenberger opened the Your Host
hot dog stand in Buffalo as a partnership. In the same year
they commenced operating the first Your Host Restaurant,
a high-quality short-order restaurant. Two more Your
Host Restaurants were opened in 1945. In 1947 Your Host,
Ine., was formed by the partners to operate their hot dog
stand and the three restaurants. In 1947 the partners
formed Sher-Del to operate a commissary which would
supply their restaurants and other customers. Between
1948 and 1956 10 more corporations were formed for various
reasons (or for no apparent reason at all) to operate addi-
tional Your Host Restaurants. In 1951 the partners placed
all of the real estate holdings of Your Host and Sher-Del
into a new corporation, Alro, in order to develop these
holdings commercially. In 1955 the partners formed Bakery
to operate a hakery which would supply the restaurants
ba Ne washes onal
a wt Tie
Oe) ee ae) eee eT er eel
a ee
36
Appendiz A
with their needs for sweet baked goods. In 1958 Chef was
formed to operate vending machines in Your Host Restau-
rants. No additional corporations were formed after 1958;
however, the size of the restaurant chain grew consider-
ably. In 1969 there were 40 Your Host Restaurants of which
Your Host operated 15 with each of the 10 other restaurant
corporations operating four or fewer locations.
After Wesson’s death in 1956 all of the corporations ex-
cept one were either wholly owned by Durrenberger or
wholly subsidiaries of one of Durrenberger’s corporations.
Durrenberger was the president of each corporation, and
all the corporations shared the same administrative per-
sonnel. All of the Your Host Restaurants operated by 11
corporations were similar in appearance, served the same
menu, and were open for business 24 hours a day. Through
advertising and telephone directory listings the public was
given the impression that each Your Host Restaurant was
a member of a chain with a single management.
Respondents allocated all of the income and deductions
of the 10 corporations operating restaurants and the vend-
ing machine corporation to Your Host and the income and
deductions of Bakery to Sher-Del. In the alternative, re-
spondent has disallowed the surtax exemptions of every
corporation except Your Host and Sher-Del under either
section 269 or section 1551. We are to decide whether re-
spondent’s determinations are correct.
The facts of this case have many similarities to those of
Mare’s Big Boy-Prospect, Inc., 52 T.C. 1073 (1969), affd.
452 F. 2d 137 (C.A. 7, 1971), under which respondent be-
lieves his allocations under section 482 can be supported
without question. If the present ease were the mirror image
37
Appendix A
of Mare’s Big Boy-Prospect, Inc—which it is in respond-
ent’s view—our task would be much simpler than we now
foresee ; however, in our view there are several facts which
distinguish this ease from Marc’s Big Boy-Prospect, Inc.,
and which require a result unlike that of the former case.
Accordingly, we shall try to place this case within the
proper prospective of section 482 and the pertinent cases
which deal with section 482.
Section 482 permits the Secretary or his delegate to
allocate income and deductions among two or more organi-
zations owned or controlled by the same interests if he
determines that such allocation is necessary to prevent
evasion of taxes or clearly to refiect the income of such
organization. The Commissioner's authority to allocate,
though broad, does not permit him to abuse his discretion
or be arbitrary, capricious, or unreasonable. The burden
is, however, upon petitioner to show that the Commissioner
has overstepped his authority. Marc’s Big Boy-Prospect,
Inc., supra; Bush Hog Manufacturing Co., 42 T.C. 713
(1964). See particularly Phillip Brothers Chemicals, Inc.
(N.Y.) v. Commissioner, 435 F. 2d 53 (C.A. 2, 1970), which
arises in the cireuit in which appeal herein would lie. De-
spite petitioner’s burden, if the Commissioner’s allegation
does not appear reasonable in light of the record, we must
conclude that he abused his discretion. V. H. Monette &
Co., 45 T.C. 15, 36-37 (1965).
The parties have approached section 482 as if it dealt
with several types of prohibited activity; however, our re-
view of the statute and its legislative and judicial history
indicates that section 482 is designed to remedy only one
abuse: the shifting of income from one commonly controlled
entity to another. Hamburgers York Road, Inc., 41 T.C.
rrr eect et 8 Be RE UNE MME SEVER SR
38
Appendix A
821, 833 (1964); Ballentine Motor Co. v. Commissioner, 321
F. 2d 796 (C.A. 4, 1963), affirming 39 T.C. 348 (1962); H.
Rept. No. 2, 70th Cong., Ist Sess., pp. 16-17, 1939 C.B. (Part
2) 395. Tax-avoidance motives or the lack of a business pur-
pose in forming several corporations are relevant in a
section 482 case only to the extent that they prove that there
has been an actual shifting of income from one corporation
to another. Section 482 is not designed to punish the mere
existence of commonly controlled entities nor the unex-
cised power to shift income among them. Grenada Indus-
- tries, Inc., 17 T.C. 231 (1951), affd. 202 F. 2d 873 (C.A. 5,
1953); Bush Hog Manufacturing Co., supra at 725; W.
Braun Co. v. Commissioner, 396 F. 2d 264 (C.A. 2, 1968).
Similarly, if there has been an actual shifting of income,
purity of purpose and the presence of sound business rea-
sons for forming multiple corporations are no defense un-
der section 482. In short, section 482 does not deal with
motivation and purpose as do section 269 and section 1151
but with economic reality.
Many section 482 cases involve a specific transaction or
group of transactions which must be scrutinized for their
effect in shifting income from one entity to another; how-
ever, it is well settled that the Commissioner can use section
482 to allocate all of the income and deductions of one
entity to another where the economic realities so warrant.
Hamburgers York Road, Inc., supra; Marc’s Big Boy-Pros-
pect, Inc., supra.
In Hamburgers York Road, Inc., a successful downtown
department store decided to establish a suburban branch
store; however, instead of operating the store as a branch
the suburban store was incorporated with its ownership
related to that of the corporation operating the downtown
TELAT ARON etna ee are ok en ee
39
alppendia A
store. On the record in that case we found that the down-
town store provided without adequate compensation so
many services for the suburban store that were essential
to the suburban store’s economic viability that the income
of the suburban store was in fact earned by the downtown
store. 41 T.C. at 835-838.
As we noted previously, the facts in Marc's Big Boy-Pros-
pect, Inc., resemble those of the present case in many ways.
In the former case, Wisconsin Big Boy (WBB) acquired
the Big Boy restaurant franchise for the State of Wisconsin.
Within a few years it set up or acquired from its share-
holders several subsidiary corporations to operate restau-
rants in the Milwaukee area and two corporations to run
commissaries. Fach of the subsidiaries operated a restau-
rant under a subfranchise agreement with WBB. The
agreement provided that WBB could supply each subfran-
chise with supervisory and management services for a
modest sliding-scale percentage-of-profits fee. The sub-
franchisees also received the right to use the national Big
Boy trademark under the agreement. Under the arrange-
ment, WBB was responsible for running the whole restau-
rant chain. Accordingly, we found that WBB and the
Milwaukee area subfranchisees constituted a single inte-
grated business enterprise. This fact along with the fact
that there was no economic reason for setting up multiple
corporations created a strong inference that the subsidiary
corporations were used to svyphon off to the subsidiaries
income which was earned by WBB. 52 T.C. at 1099. More
iinportantly, WBB was unable to show that the fees that it
received from its subsidiaries represented adequate com
pensation for the services that it rendered the subsidiaries.
On these grounds, we hold that respondent was not unrea-
sbi ee
40
Appendix A
sonable in allocating all of the income and deductions of
the subsidiaries to WBB.
A large part of our opinion in Marc’s Big Boy was devoted
to detailing the integration of the Milwaukee area Big Boy
restaurants as a single business enterprise; however, we be-
lieved that it was clear that we were not using section 482 to
penalize the petitioners merely for operating a single busi-
ness through several corporations but to reflect the fact that
subsidiaries were being used to distort the amount of income
reported by WBB. The operation of a single business
through several corporations creates a likelihood that sub-
sidiaries will be used either to permit the parent to evade
taxes or to understate its income. We believed that with-
out evidence that the parent and its subsidiaries dealt at
arm’s length with each other this liklihood formed a reason-
able basis for the Commissioner's allocation under section
482. 52 T.C. at 1099. Accordingly, the allocation to WBB
was sustained not because there was an integrated business
but because there was no proof that WBB and its subsidi-
aries dealt at arm's length.
With differences that we shall diseuss infra, the Your
Host Restaurants constituted as much of a single integrated
business enterprise as did the Milwaukee area Big Boy
chain; however, approval of respondent’s allocation under
section 482 is not ineluctable.
We note that in several respects the restaurant corpora-
tions in this ease were more viable economically than were
the restaurant subsidiaries in Marc’s Big Boy. All of the
corporations paid directly most ef their own costs of doing
business. These costs included supplies purchased from
Sher-Del, utility bills, Federal and State income taxes,
oe RI at
2 eA, TTI DA ST Ce
41
Appendix A
social security taxes and income taxes withheld from em-
ployees, fire insurance, and license fees. More importantly,
each corporation paid the rent for the locations on which
it operated restaurants and was solely responsible for it.
Your Host did not guarantee payment of the rent for any
locations except its own, and landlords were apparently
willing to rely upon the financial responsibility and re-
sources of each corporation rather than those of the total
enterprise.
We are also convineed that the fact that Your Host ob-
tained master policies for public liability insurance and
workmen’s compensation for reasons of economy and ad-
ministrative convenience does not detract from the fact that
each corporation paid its appropriate share of the cost of
these items. We think that the situation of Your Host
with respect to these expenses is different from that of
WBB in Marc's Big Boy. WBB operated no restaurants
of its own and its only activities were related to running
the restaurants owned by its subsidiaries. Hence, it would
be impossible to distinguish between WBB’s obtaining in-
surance for its subsidiaries and its providing every other
management service for them. On the other hand, Your
Host operated as many as 15 restaurants of its own. It
incurred no expense in obtaining insurance for the other
corporations and benefited from the reduced rates which
were available when a larger number of restaurants were
insured on the same policy.
Each of the corporations in effect paid the salaries for its
own nonadministrative employees. Your Host did no more
than lend its name to the “Zero balance” account from which
these employees were paid. Your Host did not advance
its own funds to pay salaries from this account but only
SRP RE YANN CRP I CT NES
42
Appendix A
contributed the net salary of its own employees as did the
other corporations. The service charges by the bank for
the “Zero balance” account were apportioned among the
corporations along with other administrative expenses.
The main point of contention between the parties is
whether the 15 corporations shared the same administra-
tive staff and maintenance crew or whether Your Host pro-
vided for a fee administrative and maintenance services.
Under either theory respondent contends that the amounts
paid by corporations for these services were computed un-
der an arbitrary and ever-changing formula. We think it
immaterial that the corporations may have used a different
formula in other years because those years are not before
us. During the years before us the cost of providing ad-
ministrative and maintenance services for all corporations
was generally apportioned according to gross sales. Re-
spondent did not determine that this method was unreason-
able and we believe it to be based reasonably upon economic
realities. We also find it reasonable that advertising ex-
penses and the costs attributable to the district supervisors
and maintenance men were only apportioned among the
corporations which couid benefit from these expenditures.
In fact, to have apportioned otherwise would have distorted
the income of the nonbenefiting corporations.
The only deviations from the allocation based on gross
sales involving a corporation whose case is before us are an
adjustment for Sher-Del and the apportionment of the
salary paid Durrenberger. The accountant for all of the
corporations testified that sales between Sher-Del and its
sister corporations did not involve as much administrative
effort as did sales to outside customers. Accordingly, he
felt that it was necessary to reduce the amount of Sher-Del’s
ib BLUR ES EE
43
alppendiax A
gross sales for purposes of making the administrative ex-
pense allocation. From his testimony and other evidence
in the record we find that the adjustments made were rea-
sonable.
Durrenberger received about 40 percent of his total salary
from Sher-Del, a fact which is explained by his background
and expertise in the provisions business. The remainder
of his salary was contributed by the other corporations.
In the case of the restaurant corporations the amount paid
appears roughly to reflect the business activity and number
of restaurants of each corporation.
In our opinion petitioners have demonstrated that each
corporation paid its own way and that they were economi-
cally viable business entities. We are convinced that except
for de minimis items like help-wanted ads Your Host bore
no more of the administrative burden for the restaurant
chain than could be accounted for by its own sales. Your
Host provided no service for the other corporations for
which it was not adequately compensated. Accordingly,
unless Your Host could have commanded all of the profits
of the other restaurant corporations for the use of its
trademark and goodwill, we believe that respondent’s al-
location is unreasonable for failing to allocate any part of
the profits to the corporations which earned them through
their own efforts and expense. We emphasize again that the
purpose of section 482 is not to punish the existence of
multiple corporations but to require each corporation to
report its true income.
The trademark and goodwill possessed by Your Host
differ considerably from those of WBB in Marc’s Big Boy
and of the downtown store corporation in Hamburgers York
Tr enFs: west
iehaensasictirs inistatd Siln d sire ssid witb
44
Appendix A
Road, Inc. First, the restaurants operated by Your Host
were on the average no older or more well established than
those operated by the 10 other restaurant corporations.
The restaurants operated by the 10 other corporations did
not trade upon goodwill generated by the restaurants run
by Your Host; all of the restaurants generated goodwill
which was shared by all of them equally. The public did
not associate a particular restaurant with the corporatior
that operated it, and it makes as much sense to assume that
the 10 restaurant corporations donated goodwill to Your
Host as it does to assume that Your Host donated goodwill
to the other 10. Therefore, the situation is obviously dif-
ferent from that which obtained in Hamburgers York Road,
Inc., where the success of the suburban store depended
largely upon the public’s belief that it was a branch of the
old and respected downtown store. Second, we believe that
the Your Host trademark had little value in addition to the
goodwill generated from the operation of the restaurants
themselves. The Your Host trademark cannot be compared
to the Big Boy trademark in Mare’s Big Boy which. was used
nationally and which permitted the Milwaukee area restau-
rants to benefit from the goodwill generated by others
across the country. Although Your Host owned the trade-
mark, the concept of Your Host Restaurants really belonged
to Wesson and Durrenberger who could donate their idea
to their corporations. Without doubt there was an advan-
tage to being a Your Host Restaurant rather than another
short-order cafe; however, we feel that this advantage
flowed primarily from the local advertising and management
shared by all of the corporations. We have already deter-
mined that the corporations divided up these items equit-
ably. The near failure of the Rochester Your Host Restau-
rants, which had absentee management problems, indicated
COMER 5
a etbtay SBS 8 aT
45
Appendix A
that without the concentrated local advertising and local
management the Your Host name was not worth a great
deal.
We hold in light of the record in this case that the 10
restaurant corporations were viable economic entities
which earned their own income and that Your Host pro-
vided no service or benefit to these 10 corporations for which
it was not adequately compensated. Accordingly, we hold
that respondent may not allocate to Your Host, Inc., all of
the income and deductions of the 10 restaurant corporations
for the years in issue.‘
While we believe that the 10 restaurant corporations
were economically viable, this opinion does not, hold true in
the cases of Chef, the vending machine corporation, and
Bakery.
All of Chef’s income was derived from renting refrigera
tion and storage facilities to Sher-Del and from operating
vending machines which were located solely in Your Host
Restaurants. There is nothing in the reeord which indi-
eates whether the terms upon which Chef dealt with its
parent, Sher-Del, or its sister corporations were fair and
reasonable. Chef, in substance, conducted no business:
therefore, it was reasonable for respondent to determine
that it did not earn its income. Accordingly, we hold that
respondent did not abuse his discretion in allocating all of
* The parties have proceeded upon an all-or-nothing approach with
respect to sec. 482. -A partial allocation under sec. 482 was not among
the several alternative resolutions of this case presented by the parties.
Accordingly, we do not think that a partial allocation, the basis of
which is not readily apparent from record, would be appropriate in
this case. Cf. Marc’s Big Boy-Prospect, Inc., 52 T.C. 10%3 at 1105-
1106: Helvering v. Taylor, 293 U.S. 507 (1935).
Peer wee tre a) | aha
| eee PE at ea,
46
Appendia A
Chef’s: income and deductions to Your Host under section
482.
We view the operations of Bakery in a similar light.
Bakery only sold its products to Sher-Del; it could hardly
be considered to have conducted any business. In addition,
Sher-Del paid Bakery the same prices for its products as
Sher-Del charged the restaurants. This arrangement gar-
nered for Bakery all of the profit from the manufacture and
sale of baked goods. We believe that respondent proceeded
upon a reasonable basis in allocating all of Bakery’s income
and deductions to Sher-Del under section 482 and uphold
his determination.
Although we have found that the 10 restaurant corpora-
tions earned their own income and reported it correctly for
purposes of section 482, it does not follow that every one of
this host of corporations is entitled to the surtax exemption
provided by section 11(d). Respondent contends that the
principal ,purpose for forming the 10 restaurant corpora-
tions was to obtain additional surtax exemptions and that
section 269(a) is applicable to disallow these benefits. We
agree with respondent with respect, to 309 Delaware, Royal,
Main, Telesnax, and Alro only.
Section 269 provides the following in part:
SEC. 269. ACQUISITIONS MADE TO EVADE OR
AVOID INCOME TAX.
(a) In GenERaL.—If—
(1) any person or persons acquire, or acquired on
or after October 8, 1940, directly or indirectly, control
of a corporation, or |
St aed eae Oa ee een
Appendix A
(2) any corporation acqu'res, or acquired on or after
October 8, 1940, directly or indirectly, property of an-
other corporation, not controlled, directly or indirectly,
immediately before such acquisition, by such acquiring
corporation or its stockholders, the basis of which prop-
erty, in the hands of the acquiring corporation, is de-
termined by reference to the basis in the hands of the
transfer corporation,
and the principal purpose for which such acquisition was
made is evasion or avoidance of Federal income tax by
securing the benefit of a deduction, credit, or other allow-
ance which such person or corporation would not otherwise
enjoy, then the Secretary or his delegate may disallow such
deduction, credit, or other allowance. For purposes of
paragraphs (1) and (2), control means the ownership of
stock possessing at least 50 percent of the total combined
voting power of all classes of stock entitled to vote or at
least 50 percent of the total value of shares of all classes of
stock of the corporation.
It is well established that the formation of a new corpo-
ration is an acquisition for purposes of section 269. James
Realiy Co. v. United States, 280 F. 2d 394 (C.A. 8, 1960).
We have also held that section 269 applies to an aequired
corporation as well as an acquiring corporation. Concord
Supply Corporation, 37 T.C. 919 (1962). On the facts in
this case there is no dispute that the requisite control is
present. Accordingly, the only question remaining under
section 269 is whether the corporations were formed for
tax-avoidance purposes.
Respondent has pointed to several facts as ruling out all
non-tax-avoidance purposes for forming the 10 corpora-
tions. These facts include the integration of the 10 eor-
porations into a single business, the thin capitalization of
the corporations, and the frequent interest-free loans and
mts see |
4s
Appendiz A
advances among the corporations which were not evidenced
by notes. In addition, respondent finds no business reason
in his view of the record which justifies the existence of
more than one corporation. Concord Supply Corporation,
supra; Joe (Joseph) Dillier, 41 T.C. 762 (1964), affirmed
sub nom. Made Rite Investment Co. v. Commissioner, 357
F. 2d 647 (C.A. 9, 1966). Petitioner, on the other hand,
has attempted to show the economic reasons underlying the
formation of each corporation. Southeastern Canteen Co.
vr. Commissioner, 410 F. 24 615 (C.A. 6, 1969), certiorari
denied 396 U.S. 833 (1969).
We believe tha‘ ihe facts noted by respondent are strong
cireumstantial evidence that tax avoidance was a principal
purpose in the formation of the 10 corporations. We also
tend to discount petitioners claim that the corporations
were set up solely on the advice of their attorney who was
an expert in real estate matters without any knowledge of
taxation. The benefit of multiple surtax exemptions is, we
helieve, as obvious to a layman as it is to a tax expert.
Throughout the trial and on brief petitioners have com-
plained that their burden of proof under section 269 is
impossible because the corporations were formed from 13
to 22 years hefore trial and heeause the principals involved
in developing the Your Host Restaurant chain were either
dead or unavailable for trial. We sympathize with peti-
tioners and have allowed them great !atitude in submitting
evidence concerning the formation of the restaurant corpo-
rations. We also note that respondent's ability to rebut
evidence of purpose has not improved with the passage of
time. More importantly. the existence of a principal non-
tax-avoidance purpose for forming the corporations can
49
Appendix A
better be proven with evidence of objective facts rather
than with subjective evidence of intent provided by the
principals. Bobsee Corporation v. United States, 411 F. 2d
231 (C.A. 5, 1969). Petitioners have brought forth such
evidence in the cases of Boulevard, Niagara, Transit, and
Sharlem (the shopping plaza corporations) and in the cases
of Utica and Rochester.
We believe that the risks involved in the mid-1950’s in
opening up restaurants in the emerging new suburban shop-
ping plazas on long-term leases justified the formation of
separate corporations. The chance of failure in these loca-
tions was substantial and formed the principal motivation
for the formation of Boulevard, Niagara, Transit, and
Sharlem. The first of these corporations, Boulevard, was
formed in 1953 and the last, Sharlem, in 1956 before it
became apparent that the shopping plazas were desirable
locations. We must lend eredence to petitioners’ conten-
tion that the riskiness of heing a pioneer in shopping plaza
development was the primary purpose for the formation
of the four corporations hecause following the success of
the first plaza locations additional plaza locations were
opened without the use of additional corporations.
Ttiea was formed in 1954 to operate a restaurant in a
location upon which a former restaurant proprietor had
failed. The restaurant was also in a neighborhood which
the partners felt was incompatible with the kind of people
who patronized Your Host Restaurants. We believe that
the previous record of failure and the problems in the
neighborhood in which the restaurant was to be located
were the principle factors which motivated the partners to
form Utica.
ee eee ee
Foe ee eee
te Wratten nem
ee ee Pe ee ee re eer)
50
Appendia A
Rochester was incorporated in 1956 to begin developing a
chain of Your Host Restaurants in the Rochester area. The
problems involved in operating restaurants 70 miles dis-
tant from Your Host’s normal base of operations were in
our opinion substantial. The partner’s principal purpose
in forming Rochester was to protect their enterprise from
the significant risk of losses from the Rochester operation.
The partners’ fears about the potential for failure in
Rochester turned out to be justified in fact as two of the
three restaurants opened there failed while the third is
harely profitable.
We have examined the reasons offered by petitioners
for the formation of the other four restaurant corporations
and have found them to be either fantastic or merely un-
supportable upon the record. We have set forth these rea-
sons in detail in the Findings of Fact. Quite predictably
petitioners have argued that the partners wished to limit
their liability when opening up new locations even when
there was no particular reason for believing that the new
location would be unsuccessful. Petitioners have also
claimed that several of the corporations were necessary to
protect the various Host names from appropriation. Be-
cause the creation of any corporation will provide its share-
holders with limited liability and prevent another corpora-
tion from getting a charter under the same name, we
cannot take these arguments too seriously unless there is
additional evidence showing the need for multiple corpora-
tions.
In light of the strong cireumstantial evidence of intent
to evade taxes provided hy the existence of an integrated
51
Appendiz A
business, the thin-capital structure and intercorporate bor-
rowing, and the absence of believable business reasons for
their formation, we find that the principal purpose for the
formation of 309 Delaware, Roya!, Main, and Telesnax was
tax avoidance. Similarly, there is no reason evident upon
the record other than tax avoidance that explains the for-
mation of the real estate holding company, Alro, in 1951.
Therefore, we find that the principal purpose for the part-
ners’ creation of Alro was tax avoidance.
Accordingly, we hold that respondent was correct in dis-
allowing the surtax exemptions of 309 Delaware, Royal,
Main, Telesnax, and Alro.
In the light of the foregoing.
Decisions will be entered for the respondent in dock-
et Nos. 2675-69, 461-70, 1207-71, 2678-69, 450-70, 1199-
71, 2681-69, 453-70, 1201-71, 2683-69, 455-70, 1203-71.
2684-69, 456-70, and 1206-71.
Decisions will be entered for the petitioners in dock-
et Nos. 2676-69, 448-70, 1197-71, 2679-69, 451-70, 1200-
71, 2680-69, 452-70, 2682-69, 454-70, 1202-71, 2685-69,
457-70, 1205-71, 2686-69, 458-70, and 1204-71.
Decisions will be entered under Rule 50 in docket
Nos. 2673-69, 446-70, 1194-71, 2687-69, 459-70, 1195-71,
2677-69, 449-70, 1198-71, 2688-69, 460-70. and 1196-71.
+e wal ene |
ve So andl
(at 6 Pee Set
52
APPENDIX B
UNITED STATES COURT OF APPEALS
For THE Seconp Circuit
Nos. 242-268—September Term, 1973.
(Argued October 18, 1973 Decided December 11, 1973.)
Docket Nos. 73-1311-73-1337
YOUR HOST, INC., et al.,
Petitioners-A ppellants,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-A ppellee.
CHEF FOODS, INC., et al.,
Petitioners-Appellees,
Vv.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-A ppellant.
Before: Kavrmax. Chief Judge, Lemparv and Timpers,
Circuit Judges.
Appeal from judgments of the United States Tax Court
(Irwin, J.) in consolidated cases in which the Tax Court
upheld determinations by the Commissioner, pursuant to _
26 U.S.C. §§ 482 and 269, of income tax deficiencies for
1965 through 1968 regarding seven of petitioners-appel-
lants’ affiliated corporations.
Affirmed. j
53
.lppendix B
Ralph J. Gregg, Buffalo, New York (Albrecht, Maguire,
Heffern & Gregg, and George M. Zimmermann, on the
brief), Attorneys for Your Host, Inc., et al., Petitioners-
Appellants and Chef Foods, Inc., et al., Petitioners-Appel-
lees.
William A. Friedlander, Washington, D. C. (Seott P.
Crampton, Assistant Attorney General, Ernest J. Brown
and Richard 8S. Halberstein, Attorneys, Tax Division, De-
partment of Justice, Washington, D. C., on the brief), At-
torneys for Commissioner of Internal Revenue.
Lumsarb, Circuit Judge:
Petitioners-appellants, Your Host, Inc., and its affiliated
companies, appeal from judgments of the United States
Tax Court (Irwin, J.,) which upheld determinations by the
Commissioner of income tax deficiencies assessed for the
years 1965 through 1968. Your Host, Inc., e¢ al., 58 T.C. 10
(1972). The deficiencies were assessed pursuant to 26
U.S.C. § 482, which allows the Commissioner to allocate
income among affiliated companies more properly to reflect
the earning of income,' and pursuant to 26 U.S.C. § 269,
which permits the Commissioner to deny tax exemptions
126 U.S.C. § 482 provides:
In any case of two or more organizations, trades, or businesses
(whether or not incorporatd, 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, apportion, or allocate gross income, de-
ductions, 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 or-
ganizations, trades, or businesses.
ara tate Rika Ghee A ‘
whe
SO ied bo A me w
ites ar Leta BL AL eae 2 8
* Appendix B
and deductions where an affiliated company was “aequired”
for tax avoidance purposes.* We affirm.
Your Host, Inc., and its affiliates, operate a restaurant
chain and food business in the Buffalo area. From modest
beginnings in a one-restaurant partnership of A. J. Dur-
renberger and R. T. Wesson in 1944, the business grew
so that by the mid 1960’s it consisted of sixteen inter-
related corporations which operated some forty “Your
Host” restaurants, a food supply commissary, a bakery, @
real estate holding company, and a vending machine and
leasehold operations.’ All of these enterprises remained
2 26 U.S.C. § 269 provides in relevant part:
(a) In general.—If—
(1) any person or persons acquire, or acquired on or after
October 8, 1940, directly or indirectly, control of a corporation,
or
(2) any corporation acquires, or acquired on or after October
8, 1940, directly or indirectly, property of another corporation,
not controlled, directly or indirectly, immediately before such
acquisition, by such acquiring corporation or its steckholders,
the basis of which property, in the hands of the acquiring
tion, is determined by reference to the basis in the
hands of the transferor corporation,
and the principal purpose for which such acquisition Was
made is evasion or avoidance of Federal income tax by securing
the benefit of a deduction, credit, or other allowance which
such person or corporation would not otherwise enjoy, then the
Secretary or his delegate may disallow such deduction, credit.
or other allowance.
8 The principal corporations among the group were Your Host, Ine.,
the original company begun as a partnership in 1944 and incorporated
in 1947 and which now operates fifteen “Your Host” restaurants, and
Sher-Del-Foods, Inc., also incorporated in 1947. which owns and runs
the food processing part of the business. In addition to these two
principal companies, there are ten subsidiaries and affiliates which run
“Your Host” restaurants : 309 Delaware Ave., Inc., (four restaurants).
Royal Host, Inc. (one). Boulevard Host, Inc. (two), Utica Host, Inc.
( Footnote continued on following page)
TE CR res
ed RR Pe 2 RR I men Sa ak SS OR
alppendix B
under the control of two original partners and later, after
Wesson’s death in 1956, under the control of Durrenberger
alone.
Out of the sixteen companies the Commissioner, pursuant
to 26 U.S.C. § 482, allocated the income of twelve of them
to Your Host, Inc.* and the income of one of them (Your
Host Bakery, Inc.) to Sher-Del Foods, Inc. He further-
more determined that, pursuant to 26 U.S.C. 4 269, thirteen
of the companies had been established for the principal
purpose of tax avoidance and he accordingly denied them
the corporate surtax exemptions.*
Upon review the Tax Court upheld the Commissioner’s
determinations under § 482 as to only two of the affiliated
companies: the allocation of Chef Foods’ income to Your
Host, Ine., and the allocation of Your Host Bakery’s in-
come to Sher-Del Foods, Inc. The Tax Court held that
the ten restaurant operating companies whose income had
( Footnote continued from preceding page)
(four). Niagara Host, Inc. (four), Main Host. Ine. (three). Transit
Host, Ine. (two), Sharlem Host, Ine. (three). Rochester Host, Ine.
(originally three, now one). and Telesnax, Inc. (one). ‘There is also
Air Host, Inc., which runs the business’s one “Royal Host” restaurant.
The remaining three companies are Your Host Bakery. Inc. (supplier
of bakery goods to the business), Chef Foods, Inc. (a subsidiary of
Sher-Del which handles vending machine operations and which leases
storage facilities to Sher-De!l and Your Host Bakery), and Alro Realty.
Ine. (another subsidiary of Sher-Del which owns the principal business
property of Sher-Del and Your Host).
* These were the tencompanies (aside from Your Host, Inc.) which
operated “Your Host” restaurants (see fn. 3). plus Air Host. Inc.. and
Chef Foods, Ine.
° These were again the ten companies operating “Your Host” restau-
rants, plus Chef Foods, Inc.. Your Host Bakery, Inc., and Alro Realty,
Ine.
SS LRN EMRE CRY ae FES ¥
56
Appendix B
been allocated were “viable economic entities which earned
their own income” and hence were not subject to income
allocation.
The Tax Court also upheld the Commissioner’s deter-
minations under § 269 as to five of the affiliated companies:
309 Delaware Ave., Inc., Royal Host, Inc., Main Host, Inc.,
Telesnax, Inc., and Alro Realty, Inc. With respect to the
other eight companies which had been denied surtax exemp-
tion, however, the court held as to six that the Commis-
sioner had erred in finding that they had been established
for the principal purpose of tax avoidance. The court did
not assess the validity of the Commissioner’s § 269 deter-
minations as to Chef Foods and Your Host Bakery, having
already sustained the Commissioner’s 100% reallocation
of the income of both companies under § 482.
Since the Commissioner has elected not appeal the
Tax Court’s finding adverse to the government,’ we need
concern ourselves here only with the Tax Court’s findings’
sustaining the Commissioner’s determinations. As to these
we note at the outset that the Commissioner’s determina-
tions are to be set aside only if “unreasonable, arbitrary,
or capricious,” in the ease of § 482 allocations, Wisconsin
Big Boy Corp. v. C.I.R., 452 F.2d 137, 140 (7th Cir. 1971);
® The Commissioner has filed a protective cross-appeal requesting
that, in the event we reverse the Commissioner’s § 482 determinations
as to Chef Foods and Your Host Bakery, we remand to the ‘Tax Court
for consideration of the Commissioner’s § 269 determinations with re-
spect to both companies. Since we affirm the decision below, we need
not consider this cross-appeal.
7 We have not thought it necessary to recount all the findings of the
Tax Court since they are set out in detail in its opinion, 58 T.C. 10
(1972).
‘
DEO DE CRO GE PORES A. te 8 AO ELLE ERED A DT ITN ACID tT
57
«lppendix B
Philipp Bros. Chemicals, Inc. v. C.I.R., 435 F.2d 53, 57 (2d
Cir. 1970), and only if “clearly erroneous” in the case of
denials of surtax exemptions under § 269, Dorba Homes,
Inc. v. C.1.R., 403 F.2d 502, 505 (2nd Cir. 1968); J. T. Slo-
comb Co. v. C.1.R., 334 F.2d 269, 273-74 (2nd Cir. 1964).
Under these standards of review, we cannot say that
the Commissioner’s § 482 determinations were arbitrary
or unreasonable. In the case of Chef Foods, Ine., whose
income was allocated to Your Host, Ine., for the four
Years in question, it was found that Chef Foods was
originally formed in 1958 to provide a vehicle for devel-
oping catering services in industrial plants. This line,
however, was never developed. Instead Sher-Del Foods
acquired all the stock of Chef Foods for $6,000. Chef
Foods was then used to purchase cigarette vending ma-
chines which were placed only in “Your Hosts” restaurants.
It purchased cigarettes wholesale and sold them through
vending concessions at the restaurants, the profits being
shared through concession commissions to each restau-
rant. Chef Foods also acquired refrigeration and storage
facilities in Buffalo, almost all of which were leased to
Sher-Del Foods and to Your Host Bakery. For these
operations, Chef Foods utilized one employee, a vending
machine repairman, whosé salary and expenses consti-
tuted virtually all of the operating expenses of the com-
pany. Otherwise Chef Foods shared its aliquot portion
of taxes, insurance, utility, and other costs along with the
other corporations as summarily determined by the com-
mon executive management of the companies. The por-
tion of Chef Foods’ profit which Durrenberger, then the
58
Appendix B
surviving original partner, took as his salary was also
similarly determined. Chef Foods’ income from the vend-
ing machine sales and from rents averaged roughly
$160,000 for each year between 1965 and 1968, with ap-
proximately 75% coming from the vending machines sales.
Thus while it is true, as the dissent suggests, that Chef
Foods conducted sizeable business operations in terms of
cash flow, the very imbalance between the firm’s posture
on its balance sheets and the actual scope of its opera-
tions, in terms of its labor force, capitalization, work site,
and so forth, suggests that the firm was kindred in na-
ture to the kind of sham enterprise which this court held
properly subject to income allocation in Philipp Bros.
Chemicals, Inc. v. C.I.R., supra. At least, given Chef
Foods’ position within the “Your Host” group, it was not
unreasonable for the Commissioner to have allocated the
income of Chef Foods as he did. See also Wisconsin Big
Boy Corp. v. C.1.R., supra; and Hamburgers Y ork Road,
Inc., 41 T.C. 821 (1964).
For the same reasons we are constrained not to dis-
turb the Commissioner’s allocation of the income of Your
Host Bakery, Inc., to Sher-Del Foods, Inc. The bakery
sold its products only to Sher-Del. Sher-Del in turn sold
these products to the various “Your Host” restaurants
but at the same price at which it had bought them. The
entire profit of the baking part of the enterprise thus
went to the bakery even though Sher-Del Foods was the
seller to the rest of the chain. In addition, although the
bakery did employ a sizeable work force (unlike Chef
Foods), it did share the same top-level management as
Your Host, Inc., and Sher-Del Foods, Inec., with similar
WANE Sig det:
59
Appendix B
apportionment of salaries and expenses. Furthermore, it
shared the same preniises with Sher-Del Foods.
Although not conceding the point, appellants contend
that under these circumstances the Commissioner’ was at
best entitled to allocate the bakery’s income to Sher-Del
only to the extent of determining a reasonable profit to
Sher-Del for its services in distributing the bakery’s prod-
ucts to the “Your Host” chain. The dissent endorses this
position, and cites in support of it language in our deei-
sion in W. Braun Co. v. C.1.R., 396 F.2d 264 (2d Cir.
1968). However, in view of the highly integrated nature
of the business enterprise, we do not believe that it was
unreasonable for the Commissioner to have concluded that
all of the bakery’s income should be attributable to Sher-
Del. As we said in the later case of Philipp Bros. Chemi-
cals, Inc. v. C.I.R., supra, at 59:
[T]he taxpayer had the burden of showing that. the
100% allocation of income to the [parent] corpora-
tion was unjustified. Taxpayers ask us to remand
the case in order to allow them an opportunity to
establish that the 100 per cent allocation was’ un-
reasonable and to show what a reasonable allocation
would be. We see no reason for according them
another chance. . . .
The petitioners here having similarly failed to demon-
strate the reasonable allocation which they claim was their
due, we believe our position as stated in the Philipp case
is controlling. See also Wisconsin Big Boy ( ‘orp v. C.LR.,
supra, at 140; Ballentine Motor Co. v. C.1.R., 321 F.2d
796 (4th Cir. 1963); Hall v. C.1LR.. 294 F.2d 82 (5th Cir.
1961).
Diteittetitiatet.ctrnas ertescce
9 GP EA cei RLI CNBR AO LI as Wil aR RR NCR stk Tae td, Btn
Re Sy OATES MIME,
; 60
Appendix B "
The Commissioner’s determinations under 26 U.S.C.
§ 269, to disallow the surtax exemption for five of the ap-
pellants’ corporations, were also within permissible lim-
its.8 We note that four of these five (Telesnax, Inc., Royal
- Host, Ine., Main Host, Ine., and 309 Delaware Ave., Inc.)
were merely alternate vehicles for operating additional
“Your Host” restaurants. They were all thinly capital-
ized. They were all financed by substantial loans from
Your Host, Inc., and from Sher-Del Foods, Inc., loans
either not evidenced by notes or established through a
system of delayed billing. More importantly, in none of
these four instances were the appellants able to proffer
reasons for their separate incorporation other than a
desire to limit liability for its own sake (which is in any
event a necessary consequence of incorporation) and, in
' the ease of Telesnax. the additional desire to give Wesson
and Durrenberger’s accountant a capital share in the busi-
ness. Unlike the situation regarding the six “Your Host”
companies where the Tax Court found the prineipal pur-
pose of incorporation to have heen other than tax avoid-
ance, for these four restaurant operating corporations the
appellants cited no’ unusual risks ‘incumbent on the
ventures, such as location in an untried shopping center
development or in a community with strong pre-established
competition, nor any other factors, such as the need to
protect a corporate name not already protected or
to protect the goodwill of a particular restaurant, which
8 There is of course, no longer any question that the formation of a
new corporation can be an acquisition for the purposes of § 269, James
Realty Co. v. United States, 280 F.2d 394 (8th Cir. 1960), and also
that § 269 applies to‘an acquired corporation as well as to an acquiring
corporation, Concord Supply Corp., 37 T.C. 919 (1962).
61
Appendix B
might have been persuasive of the necessity for separate in-
corporation. Accordingly, the Commissioner’s conclusion
that tax avoidance was the principal purpose behind their
separate incorporation was not “clearly erroneous.” See
Scroll, Inc. v. C.1.R., 447 F.2d 612 (5th Cir. 1971): Bobsee
Corp. v. United States, 411 F.2d 231 (5th Cir. 1969);
Borge v. C.1.R., 405 F.2d 673 (2d Cir 1968).
Although incorporated for reasons other than operating
a “Your Host” restaurant, Alro Realty, Ine., presents no
different considerations in regard to the Commissioner’s
disallowance of its surtax exemption. Appellants argued
before the Tax Court that the principal purpose for
establishing Alro was to facilitate real estate mortgage
financing for the overall enterprise. Yet, the operation of
Alro subsequent to its formation undercuts that contention.
Alro was created by Wesson and Durrenberger in 1951
with a capitalization of $2,000. It then purchased all of
Sher-Del Foods’ business real estate, including the com-
missary building, by delivering promissory notes totalling
$112,822.93, but failed to assume Sher-Del's prior mortgage
obligation. Moreover, although Alro has repaid a mere
$3,000 on these notes, Sher-Del has continued making
capital advances to Alro. In sum, Alro has never been
utilized as a financing vehicle or in any other manner to
improve the working capital position of its parent, Sher-
Del, or its affiliate, Your Host. Ine. On these facts the
® The circumstances which the dissent urges as justifying the separ-
ate incorporation of 309 Delaware Ave., Inc., for example the slightly
higher rent, the smaller number of pedestrians, and so forth, are mar-
ginal at best. ‘These factors are not equivalent to such substantial
risks as taking on established competition or beginning business opera-
tions in a city where the “Your Host” name was generally unknown.
Vis ected Sate Grae
write d 4
atl pow
ot vee
PR eee re a er re ee
ate en
62
Appendiz B
Commissioner was not clearly erroneous in determining
that Alro was established for the principal purpose of tax
avoidance. See Bobsee Corp. v. United States, supra, at
238: Dorba Homes v. C.1.R., supra, at 505-506.
The only troublesome point which remains concerns the
apparent inconsistency of the Tax Court’s conclusions un-
der §§ 482 and 269. The four restaurant operating cor-
porations of the “Host” group which have been denied the
surtax exemption because of their “acquisition” for the
principal purpose of tax avoidance were also found, how-
ever, to have “sound business rgasons” for the separate
corporate existence, so that as to them the Tax Court
reversed the Commissioner’s income allocations under ¢ 482.
This apparent inconsistency is resolved by the fact that
a company may operate from day to day as a valid eco-
nomic entity although it may have originated as a tax
avoidance device. Sections 482 and 269 of the Code look
to different periods in a corporation’s existence, as they
also look to different elements of proof; economic reality
in reference to income versus inference of intent in ref-
erence to tax savings. Thus even though the establishment
of these elements requires in part the assessment of common
facts in the conduct of a company after its “acquisition,”
the purposes relevant to such assessment may be quite
distinct. In a case very similar to the present one, this
court cautioned against
confus[ing] “a purpose,” the continued existence of
which may be enough to eliminate [an adverse deter-
mination under 482], with “the principal purpose”
to evade or avoid the Federal income tax, the initial
presence of which governs § 269 and which may exist
alongside other secondary reasons for the formation
of the corporation.
63
Appendix B
Dorba Homes, Inc. v. C.1.R., supra, at 506. That caution
is no less applicable to the facts of the instant case.
We find no merit in the appellants’ final contention that
the application by the Commissioner of the sanctions of
§ 269 “so many years after the fact” is a violation of the
due process clause.
The judgments of the Tax Court are accordingly affirmed.
Timpers, Circuit Judge (dissenting in part) :
Since I am disturbed by certain inconsistencies in the
Tax Court decision and by the majority’s placing the im-
primatur of our Court on those inconsistencies, I respect-
fully dissent in part.
With respect to the Section 482 allocations, I dissent
from the majority opinion to the extent that it affirms the
Tax Court in upholding the Commissioner's allocation of
Chef Foods’ income to Your Host and his allocation of the
entire income of Your Host Bakery to Sher-Del Foods. As
to the Chef allocation, I would reverse. As to the Bakery
allocation, I would reverse, and remand for determination
of a proper adjustment and a reallocation of income.
With respect to the Section 269 surtax exemptions, T
agree with the majority's affirmance of the Tax Court in
upholding the Commissioner's disallowance of surtax ex-
emptions for four of appellant's five affiliated companies.
As to the 309 Delaware restaurant, however, I would re-
verse and hold that the Commissioner’s disallowance of its
surtax exemption was clearly erroneous.
7 Oy gr TS La. SPT NS
td
Appendiz B
L
Section 482 of the Internal Revenue Code of 1954, 26
U.S.C. § 482 (1970), authorizes the Commissioner to “allo-
cate gross income” among the units of commonly controlled
business organizations. Its purpose is to prevent tax eva-
sion or clearly to reflect the income of the various parts of
an integrated corporate group. While this statute gives the
Commissioner broad discretion to allocate income, it does
not permit him to disregard a separate corporate entity if
it exists for “a bona fide business purpose”, W. Brawn Co.
v. C.1.R., 396 F.2d 264, 268 (2 Cir. 1968), and if it conducts
substantial business activities and earns its own income.
Philipp Brothers Chemicals, Inc. v. C.1.R., 485 F.2d 53 (2
Cir. 1970). Nor does this statute permit the Commissioner
to substitute his business judgment for that of management.
The fact that a parent corporation might have performed
services for itself rather than establishing a subsidiary
for that purpose is irrelevant so long as the latter is a
viable, going concern. Philipp Brothers Chemicals, Inc.
v. C.1LR., supra, 435 F.2d at 58. Income allocation is proper
only when the income earned by one corporation is artifieal-
ly deflected to another.’
Applying these criteria to the instant case, the Tax Court
held that the ten restaurant corporations were “econom-
ieally viable business entities”. 58 T.C. at 27. It refused
to uphold the Commissioner’s allocation of their income to
Your Host. The Tax Court hased its conciusion on the
1 See 7 Mertens, Law of Federal Income Taxation § 38.63 (Zimet &
Barton rev., 1967) :
“The identity of business is to be preserved and the Secretary or
his delegate has no authority under [§ 482] to merge them into
one single business unless the businesses are carried on and ma-
nipulated in such a way as to constitute one single business, or un-
less the ‘controlled enterprise’ is a sham” (citations omitted).
65
Appendix B
fact that these corporations earned their own income and
paid their own costs of doing business.*
If the Tax Court was correct in holding such operational
autonomy to be a bar to income allocation with respect
to the ten restaurant corporations, I fail to understand the
majority’s conclusion with respect to Chef Foods. Chef
was a viable, independently functioning business enter-
prise. It had cigarette vending machine sales averaging
$130,000 per year; it had a salaried employee for whom it
paid workmen's compensation and social security contribu-
tions; it owned its own vending machines and maintained a
substantial inventory: it paid its own utilities, taxes. auto-
mobile expenses and, as did the ten restaurant corpora-
tions, a proportionate share of group insurance and general!
administrative costs. Chef conducted its business no dif-
fe ently than did its competitors. It serviced its own ma-
chines, collected receipts and paid commissions hased upon
the amount of merchandise sold.
These factors clearly distinguish the instant case from
Philipp Brothers Chemicals, Inc. v. CLR. supra. There
we affirmed the Tax Court in sustaining the Commiss‘oner's
allocation of the entire income of foreign sales subsidiaries
to their parent upon a finding that they had no em-
ployees, no inventory and did nothing whatever to earn
? Each of the ten restaurant corporations paid for its own non-
administrative help, supplies, utilities, state and federal taxes, social
security contributions, fire insurance premiums and license fees. Each
was solely responsible for payment of its own rent. Each paid a pro-
portionate share of the common administrative and group insurance
costs.
* The majority notes that Chef had insubstantial business expenses.
As long as Chef was a viable enterprise and received no services from
Your Host for which the latter was not adequately compensated—i.e.
no income distortion—that fact would appear irrelevant.
‘
a a a a ea ee
eas
i te aah
ree Se
ene ee ee ee ee
i al
66
Appendix B
the income they reported. That is a far ery from the
situation here.
The case against allocating all of Your Ilost Bakery’s
income to Sher-Del Foods is even more compelling.
Bakery had sales in excess of $175,000; it had a payroll of
approximately $50,000; it purchased more than $80,000
worth of raw materials; and it paid for its own insurance,
linen, laundry and operating supplies. These are clear
indices of operational autonomy. They demonstrate that
Bakery was a viable, income earning enterprise. I see no
basis for the Tax Court's conclusion that Bakery “could
hardly be considered to have conducted any business.” 58
T.C. at 28-29.
True, Bakery sold its entire output through Sher-Del
which acted without charge as Bakery’s middleman, de-
livery and billing agent. There was some income distor-
tion. This does not mean, however, that a Section 482
allocation of 100% of the subsidiary’s income is appro-
priate. While Sher-Del has not established the adjust-
ment necessary to reflect the cost to it of these services, it
has demonstrated that Bakery earned a substantial portion
of its reported income. In an analogous situation, we held
that
“(t]he Commissioner was . . . not justified in arbitrar-
ily allocating all of [the subsidiary’s] taxable income
to petitioner.” W. Braun Co. v. C.L.R. supra, 396 F.2d
at 268. (emphasis added).
I would remand for a determination of the proper adjust-
ment of Sher-Del’s costs as a basis for reallocating Bakery’s
income to Sher-Del according to law.*
4A proper adjustment would involve an increase in Sher-Del’s in-
come sufficient to reflect the cost to it of the billing and delivery services
provided for Bakery and a corresponding decrease in Bakery’s income.
OEE NILER OI
Appendix B
Il.
Since Your Host did not demonstrate non-tax avoidance
reasons for the separate incorporation of 'Telesnax, Ine.,
Royal Host, Inc., Main Host, Inc. and Arlo Realty, Ine.,
the Tax Court correctly upheld the Commissioner’s dis-
allowance of their surtax exemptions pursuant to Section
269 of the Internal Revenue Code of 1954, 26 U.S.C. § 269
(1970).
The specific findings of the Tax Court with respect to
309 Delaware Ave, Inc.,° however, establish that it was
formed for the very reasons said to have justified the
formation of the eight other “Host” companies as to which
the Tax Court found the principal purpose of incorpora-
tion to have been other than tax avoidance. These findings
by the Tax Court strike me as undermining the majority's
assumption that there were “no unusual risks . . . which
might have been persuasive of the necessity for separate
incorporation” of 309 Delaware. I would hold that the
Commissioner’s disallowance of its surtax exemption was
clearly erroneous. See Borge v. C.1.R., 405 F.2d 673 (2d
Cir. 1968).
° The Tax Court found with respect to the 309 Delaware restaurant:
“The prospects for a restaurant at 309 Delaware Avenue were
not as favorable as those enjoyed at the other Your Host locations.
The rent was higher there than for other locations ($250 to $300
per month over a seven-year period compared to a $200 maximum
per month on a ten-year lease at 3232 Bailey Avenue). There were
no adjacent parking facilities and pedestrian traffic was not as
heavy as at other locations.” 58 T.C. at 14.
RT 5 IEC ht ee pees TEESE Ea FE ERE
asl eo
68
APPENDIX C
UNITED STATES COURT OF APPEALS
Seconp Circuit
At a Stated Term of the United States Court of
Appeals, in and for the Second Circuit, held
at the United States Courthouse in the City of
New York, on the eleventh day of December
one thousand nine hundred and seventy-three.
Present: How. Irvine R. Kaurman, Chief Judge.
Hon. J. Epwarp LumBarp,
Hon. Wiuiam H. Trmpers, Circuit Judges.
YOUR HOST, INC., ALRO REALTY, INC., MAIN
HOST, INC., ROYAL HOST, INC., TELESNAX,
INCORPORATED, 309 Delaware Ave., Inc, SHER-DEL
FOODS, INC.,
Petitioners-A ppellants,
vs.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-A ppellee-A ppellant.
Tax Court Docket Nos. 2673-69, 2675-69, 2678-69, 2681-69,
2683-69, 2684-69, 2687-69, 446-70, 450-70, 453-70, 455-70,
456-70, 459-70, 461-70, 1194-71, 1195-71, 1199-71, 1201-71,
1203-71, 1206-71, 1207-71.
73-1311 thru 73-1337.
69
Appendiz C
Appeal from The Tax Court of the United States.
This cause came on to be heard on the transcript of
record from The Tax Court of the United States ;
and was argued by counsel.
ON CONSIDERATION WHEREOF, it is now hereby
ordered, adjudged, and decreed that the orders of said
The Tax Court of the United States be and they hereby
are affirmed with costs to he taxed against the petitioners-
appellants.
A. DANTEL FUSARO,
Clerk,
By: Vincent A. Carwin,
Chief Deputy Clerk.
70
APPENDIX D
See. 482. Allocation 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 affili-
ated) owned or controlled directly or indirectly by the
same interests, the Secretary or his delegate may distribute,
apportion, or allocate gross income, deductions, credits, or
allowances between or among such organizations, trades,
or businesses, if he determines that. such distribution, ap-
portionment, or allocation is necessary in order to prevent
evasion of taxes or clearly to reflect the income of any
of such organizations, trades, or businesses.
See. 269. Acquisitions Made to Evade or Avoid Income
Tax.
[See. 269(a) ]
(a) In GeneraL.—lr—
(1) any person or persons acquire, or acquired on
or after October 8, 1940, directly or indirectly, control
of a corporation, or
(2) any corporation acquires, or acquired on or
after October 8, 1940, directly or indirectly, property
of another corporation, not controlled, directly or in-
directly, immediately before such acquisition, by such
acquiring corporation or its stockholders, the basis of
which property, in the hands of the acquiring corpora-
tion, is determined by reference to the basis in the
hands of the transferor corporation.
NA
2 71
Appendix D
and the principal purpose for which such acquisition was
made is evasion or avoidance of Federal income tax by
securing the benefit of a deduction, credit, or other allow-
ance which such person or corporation would not otherwise
enjoy, then the Secretary or his delegate may disallow
such deduction, credit, or other allowance. For the pur-
poses of paragraphs (1) and (2), control means the owner-
ship of stock possessing at least 50 percent of the total
combined voting power of all classes of stock entitled to
vote or at least 50 percent of the total value of shares of
all classes of stock of the corporation.
REGULATIONS
§ 1.482-1 Allocation of income and deductions among
taxpayers.—
(b) Scope and purpose. (1) The purpose of section
482 is to place a controlled taxpayer on a tax parity with
an uncontrolled taxpayer, by determining, according to
the standard of an uncontrolled taxpayer, the true taxable
income from the preperty and business of a controlled tax-
payer. The interests controlling a group of controlled tax-
payers are assumed to have complete power to cause each
controlled taxpayer so to conduct its affairs that its trans-
actions and accounting records truly reflect the taxable
income from the property and business of each of the eon-
trolled taxpayers. If, however, this has not been done,
and the taxable incomes are thereby understated, the dis-
trict director shall intervene, and, by making such distribu-
tions, apportionments, or allocations as he may deem neces-
sary of gross income, deductions, credits, or allowances, or
72
Appendix D
of any item or element affecting taxable income, between
or among the controlled taxpayers constituting the group,
shall determine the true taxable income of each controlled
taxpayer. The standard to be applied in every case is that
of an uncontrolled taxpayer dealing at arm’s length with
another uncontrolled taxpayer.
(2) Section 482 and this section apply to the case of
any controlled taxpayer, whether such taxpayer makes a
separate or a consolidated return. If a controlled tax-
payer makes a separate return, the determination is of its
true separate taxable income. If a controlled taxpayer is
@ party to a consolidated return, the true consolidated tax-
able income of the affiliated group and the true separate
taxable income of the controlled taxpayer are determined
consistently with the principles of a consolidated return.
(3) Section 482 grants no right to a controlled tax-
payer to apply its provisions at will, nor does it grant any
right to compel the district director to apply such pro-
visions. It is not intended (except in the case of the com-
putation of consolidated taxable income under a con-
solidated return) to effect in any case such a distribution,
apportionment, or allocation of gross income, deductions,
credits, or allowances, or any item of gross income, deduc-
tions, credits, or allowances, as would produce a_ result
equivalent to a computation of consolidated taxable income
under subchapter A, chapter 6 of the Code.
(d) Method of allocation. (1) The method of allocat-
ing, apportioning, or distributing income, deductions
credits, and allowances to be used by the district director
in any ease, including the form of the adjustments and the
73,
4 ppendiz D
/
character and source of amounts aliocated, shall be de-
termined with reference to the substance of the particular
transactions or arrangements which result in the avoidance
of taxes or the failure to clearly reflect income. The ap-
propriate adjustments may take the form of an increase
or decrease in gross income, increase or decrease in dedue-
tions (including, depreciation), increase or decrease in basis
of assets (including inventory) or any other adjustment
which may be appropriate under the circumstances. See
§ 1.482-2 for specific rules relating to methods of alloca-
tion in the case of several types of business transactions.
, (2) Whenever the district director makes | ad just-
prea to the income of one member of a group of controlled
taxpayers (such adjustments being referred to in this
paragraph as “primary” adjustments) he shall also make
appropriate cor relative adjustments to the income of any
other member of the group involved i in the allocation. The
correlative adjustment shall actually be made if the U.S
income tax liability of the other member would be afféeted
for any pending taxable year. Thus, if the district
director makes an allocation of income, he shall not only
increase the income of one iwember of the group, but shall
deerease the income of the other member if such adjustment
would have an effect on the U. S. income tax liability of the
other member for any pending taxable vear, For we
purposes of this subparagraph, a “pending taxable vear”
is any taxable year with respect to which the U. 8. income
tax return of the other member has been filed by the time
the allocation is made, and with respect to which a credit
or refund is not barred by the operation of any law or rule
of law. Tf a correlative adjustment is not actually made
because it would have no affect on the U. S. income tax
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74
Appendix D
liability of the other member involved in the allocation for
any pending taxable year, such adjustment. shall never-
theless be deemed to have been made for the purpose of
determining the U..S. income tax liability of such member
for a later taxable year, or for the purposes of determining
the U. S. income tax liability of any person for any taxable
year. The district director shall furnish to the taxpayer
with respect to which the primary adjustment is made a
written statement of the amount and nature of the correla-
tive adjustment which is deemed to have been made. For
purposes of this subparagraph, a primary adjustment shall
not be considered to have heen made (and therefore a
correlative adjustment is not required to be made) until
the first occurring of the following events with respect to
the primary adjustment:
' ” * *
§ 1.482-2. Determination of taxable income in specific
situations— ,
(b) Performance of services for another—(1) General
rule. Where one member of a group of controlled ent*ties
performs marketing, managerial, administrative, technical,
or other services for the benefit of, or on behalf of another
member of the group without charge, or at a charge which
is not equal to an arm’s length charge as defined in sub-
paragraph (3) of this paragraph, the district director may
make appropriate allocations to reflect an arm’s length
charge for such services.
(2) Benefit test. (i) Allocations may be made to
reflect arm’s length charges with respect to services under-
taken for the joint benefit of the members of a group of
controlled entities, as well as with respect to services
t \
75
Appendix D
performed by one member of the group exclusively for the
benefit of another member of the group. Any allocations
made shall be consistent with the relative benefits intended
from the services, based upon the facts known at the time
the services were rendered, and shall be made even if the
potential benefits anticipated are not realized. No alloca-
tions shall be made if the probable benefits to the other
members were so indirect or remote that unrelated parties
would not have charged for such services. In general, alloea-
tions may be made if the service, at tne time it was per-
formed, related to the carrying on of an activity by another
member or was intended to benefit another member, either
in the member’s overall operations or in its day-to-day
activities. The principles of this subdivision may be
illustrated by the following examples in each of which it is
assumed that X and Y are corporate members of the same
group of controlled entities:
ved
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.