# Petition for A Writ of Certiorari — Your Host, Inc. v. Commissioner > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385607_1916%3A1 ## Record - **Collection:** Supreme Court brief - **Document type:** Petition for A Writ of Certiorari - **Published:** January 1, 1974 - **Citation:** 419 U.S. 829 ## Text ISR 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 i : q 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. A 3 | 4 @ 4 a ; 3 ? 2 $ j 2 i ‘ j a sk AOE SRO ah MIN ORE eee ae oe See 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) | : Prin 8 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 “§ 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 specifi [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385607_1916%3A1. Public record. Not legal advice.