Petition for A Writ of Certiorari — Your Host, Inc. v. Commissioner

Supreme Court brief1974

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Gn the Supreme Court of the Gnited States

OctToBEeR TERM, 1973

No.

CoMMISSIONER OF INTERNAL REVENUE, - PETITIONER

Cuer Foops, Inc. anpD Your Host Bakery, Inc.

PETITION FOR A WRIT OF CERTIORARI TO THE UNITED STATES

COURT OF APPEALS FOR THE SECOND CIRCUIT

The Solicitor General, on behalf of the Commis-

sioner of Internal Revenue, petitions for a writ of

certiorari to review the judgment of the United States

Court of Appeals for the Second Circuit in these

cases, but only if the Court grants the petition for a writ

of certiorari in No. 73-1652.

OPINIONS BELOW

The findings of fact and opinion of the Tax Court

(Appendix A, infra, pp. 5-40) are reported at 58 T.C.

10. The opinion of the court appeals (Appendix B,

infra, pp. 41-55) is reported at 489 F. 2d 957.

JURISDICTION

The judgment of the court of appeals (Appendix C,

infra, pp. 56-57) was entered on December 11, 1973. By

(1)

539-270—74 1

order dated March 4, 1974, Mr. Justice Marshall ex-

tended the time for filing a petition for a writ of cer-

tiorari to and including May 10, 1974. The jurisdiction

of this Court is invoked under 28 U.S.C. 1254(1).

QUESTION PRESENTED

Whether additional corporate surtax exemptions

under Section 11(d) of the Internal Revenue Code of

1954 claimed by respondent corporations should be

disallowed under Section 269(a) of the Code, on the

ground that respondents were formed and acquired

for the principal purpose of securing the benefits of

the surtax exemptions.

STATUTES INVOLVED

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

Sec. 11. Tax imposed.

* * * * *

(d) [as amended by See. 121, Revenue Act of

1964, P.L. 88-272, 78 Stat. 25] Surtax Exemp-

tion.—For purposes of this subtitle, the surtax

exemption for any taxable year is $25,000,

except that, with respect to a corporation to

which section 1561 or 1564 (relating to surtax

exemptions in case of certain controlled corpo-

rations) apres for the taxable year, the surtax

exemption for the taxable year is the amount

determined under such section. |

* * * * *

Sec. 269. Acquisitions made to evade or avoid in-

come tax.

(a) In General.—If—

(1) any person or persons acquire, or ac-

quired, on or after October 8, 1940, directly or

indirectly control of a corporation, or

NOT LED LI TGR a RRE ety

(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

stockholders, the basis of which property, in

the hands of the acquiring corporation, is deter-

mined by reference to the basis in the hands of

the transferor corporation,

and the principal purpose for which such ac-

quisition 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 allow-

ance. For purposes of paragraphs (1) and (2),

control means the ownership of stock possess-

ing 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.

* * * * *

STATEMENT

Respondent corporations were among those in a

group of interrelated corporations through which a

chain of restaurants, and related activities, were oper-

ated in the Buffalo, New York area. Pursuant to Sec-

tion 482 of the Internal Revenue Code, the Commis-

sioner reallocated income for the years 1965-1968

among these corporations, allocating to other mem-

bers of the corporate group all of the income reported

by the respondents. As an alternative position, in the

event the income in question was determined to be

properly that of the respondents, the Commissioner

disallowed under Section 269 of the Code the surtax

exemptions claimed by respondents. This resulted in

heii ee

the determination of deficiencies against respondents

of approximately $40,000 (Appendix A, infra, pp. 7-8).

The Tax Court sustained the Commissioner’s re-

allocatien of all of respondents’ income to the other

corporations. As a result, there was no oceasion for it

to reach the Commissioner’s alternative contention

against respondents (Appendix A, infra, p. 36). On

appeal of the decision of the Tax Court by the corpo-

rations to which the income of respondents was reallo-

cated, the Commissioner cross appealed to preserve

his alternative position against respondents in order

to protect the revenue. The court of appeals affirmed

the decision of the Tax Court and similarly did not

reach the Commissioner’s alternative contention (Ap-

pendix B, infra, p.45n.6).

REASON FOR GRANTING THE WRIT

The corporations to which the income originally

reported by respondents have filed a petition for a

writ of certiorari. Your Host, Inc. v. Commisstoner,

No. 73-1652. Should the Court grant that petition, it

should also grant the present petition. This is necessary

to preserve the Commissioner’s alternative position if

the Court should reverse the judgment of the court of

appeals in No. 73-1652.

CONCLUSION

The petition for a writ of certiorari should be

granted, but only if the Court grants the petition in

No. 73-1652.

Respectfully submitted.

Rosert H. Bork,

Solicitor General.

May 1973.

ee ec z mtn o A REN, SR WEE

APPENDIX A

58 T.C. No. 2

United States Tax Court

Your Host, [Nc., Er au.’ PETITIONERS

Vv.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Dockets Nos. 2673-69, 2675-69 through 2688-69, 446-

70, 448-70 through 461-70, and 1194-71 through

1207-71

Filed April 6, 1972

(1) Your Host, Inc., was formed in 1947 by Wesson

and Durrenberger to operate four Your Host Restau-

rants. Between 1948 and 1956 ten more corporations

were formed to operate Your Host Restaurants. In

1969 there were 40 Your Host Restaurants of which

Your Host operated 15 with each of the other restau-

rant corporations operating four or fewer locations.

In addition to Your Host and the ten restaurant cor-

porations, Wesson and Durrenberger formed a com-

missary corporation in 1947, a real estate holding

corporation in 1951, and a bakery corporation in 1955.

Following Wesson’s death Durrenberger formed a

vending machine corporation in 1958.

1 Cases of the following petitioners are consolidated herewith:

Alro Realty, Inc., dockets Nos. 2675-69, 461-70, and 1207-71:

Boulevard Host, Inc., dockets Nos. 2676-69, 448-70, and 1197-

(5)

All of the Your Host Restaurants were similar in ap-

pearance, served the same menu, and were open for

business 24 hours a day. The restaurants projected an

image to the public of being under the same marage-

ment. Although the 15 corporations together comprised

an integrated business entity, each paid the salaries of

its own employees and the insurance and utility ex-

penses for its locations. Each corporation was solely

responsible for payment of the rent for its locations.

Each corporation paid a portion of the salary of Dur-

renberger, and each paid a fair share of the costs of

management, administration, advertising, and main-

tenance for the whole enterprise.

Held: Respondent abused his discretion in allocat-

ing all of the income and deductions of the ten restau-

rant corporations to Your, Host under section 482;

Held, further: Respondent did not abuse his disere-

tion in alloeating all of the income and deductions of

the bakery corporation to Sher-Del and vending ma-

chine corporation to Your Host under section 482

where these corporations did business only with related

corporations and where the dealings between the cor-

porations were not at arm’s length.

(2) Held, further. The principal purpose for the

formation of four of the restaurant corporaticns and

71; Chef Foods, Inc.. dockets Nos. 2677-69, 449-70, and 1198-71.

Main Host Ine., dockets Nos. 2678-69, 450-70, and 1199-71:

Niagara Host, Inc., dockets Nos. 2679-69, 451-70, and 1200-71:

Rochester Host, Inc., dockets Nos. 2680-69 and 452-70. Royal

Host. Inc.. dockets Nos. 2681-69, 453-70, and 1201-71; Sharlem

Host, Inc., dockets Nos. 2682-69, 454-70, and 1202-71; Telesnav,

Incorporated, dockets Nos. 2683-69, 455-70, and 1203-71; 309

Delaware Ave., Inc., dockets Nos. 2684-69, 456-70, and 1206-71:

_ Transit Hest, Inc., dockets Nos. 2685-69, 457-70, and 1205-71:

Utica Host, Inc., dockets Nos. 2686-69, 458-70, and 1204-71;

Sher-Del Foods, Inc.. dockets Nos. 2687-69, 459-70, and 1195-

71; and Your Host Bakery, tae., dockets Nos. 2688-69, 460-70.

and 1196-71.

the real estate holding corporation v as tax avoidance;

therefore, respondent’s disallowance of the surtax

exemptions of these corporations under section 269

Was correct.

Ralph J. Gregg and George M. Zimmerman, for the

petitioners.

Stephen M. Miller for the respondent.

Irwin, Judge: Respondent determined the follow-

ing deficiencies in the corporate income taxes of

petitioners:

Docket Deficiency

Petitioner No. Year

Sec. 482 Sec. 531

Your Host, Ine. ....<s-...- 2673-69 1965 $154,584.85 $93, 040. 86

1966 173, 381. 44 98, 958. 31

446-70 1967 170, 930. 11 94, 399. 0G

1194-71 1968 170, 198. 45 93, 000. 00

Alro Realty, Inc. _....-.-_- 2675-69 1965 3, 541. 84

1966 i A) SE aaa

461-70 1967 OU AC

1207-71 1968 OO os cencesee

Boulevard Host, Inc_..-____- 2676-69 1965 eee ooo

1966 OC . e

448-70 1967 BPO oa cocacmvoce

1197-71 1968 ty AO 2 ee

Chef Foods, Inc_......__._- 2677-69 1965 5, 000. 04 _-_-__ Le

1966 Se

449-70 1967 hf Sas

1198-71 1968 5, 500. 00

Tas Teh, te. S .. ss. 2678-69 1965 We OE as oan ck Seis:

1966 || ale

450-70 1967 Pe eee aa Soc ane

1199-71 1968 ie EO ea

Niagara Host, Inc____.-.--_- 2679-69 1965 TOROS nnnncncwccme

451-70 1967 4, 84

1200-71 1968 oo el

are 0a ON tial Mit hae cll bles AANA nh NEPAL TA SAS Re Le RN Lee ae kd UH Aut MR A nd 9 WO) mend cat SNE 6 wel Rane rakes Aw Sea a a» Bile Med Ai alt ee |

Docket Deficiency

Petitioner No. Year

Sec. 482 Sec. 531

Rochester Host, Ine. ._.---_- 2680-69 1965 _ § eae aa

1966 i a

452-70 1967 pie eer

ee 2681-69 1965 | UR ee r

1966 ik | yeti pel oe

453-70 1967 eS as eee

1201-71 1968 4 eee

Sharlem Host, Ine__....---- 2682-69 1965 cS Seen

1966 i ft aaa

454-70 1967 5 ae

1202-7i 1968 2} gee

ia cecanmosenae 2683-69 1965 EE aceon cccas

1966 f 8 eee

455-70 1967 4, 494. 32

1203-71 1968 of eae

309 Delaware Ave., Inc_--~-_- 2684-69 1965 - a

1966 Pi, ahertrwdnae

456-70 1967 OE soa ncacmaeoh

1206-71 1968 RO eo cn Sc dcs

Transit Host, Inc. ...._.--- 2685-69 1965 I iatcatiton konbaiise

1966 5 |} ae

457-70 1967 eS SS lacs cpa

1205-71 1968 6 aaa

Utica Host, Inc. _.......-.- 2686-69 1965 ee ae

1966 OE Sd tciass

458-70 1967 i alse

1204-71 1968 8 a

Sher-Del Foods, Inc_--_---- 2687-69 1965 15, 250.86 $14, 175. 28

1966 19, 998. 48 21, 377. 40

459-70 1967 19, 087. 40 28, 709. 00

1195-71 1968 21, 509. 43 18, 115 00

Your Hos‘ Bakery, Inc- ---~- 2688-69 1965 8 Of pee eee

1966 of eae

460-70 1967 MM raccnemcu

1196-71 1968 Ge OP San cance

Respondent has conceded that petitioners Your Host,

Ine., and Sher-Del Foods, Inc., are not subject to the

accumulated 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 ten corporations operating restaurants and the

vending machine corporation to Your Host, Ine.; and

(2) In the alternative to the first issue, whether

the surtax exemptions provided by section 11(d)

should be disallowed under section 269 in the cases

of these 11 corporations; 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, Ine.;

and

(4) In the alternative to the third issue, whether

the surtax exemptions of Your Host Bakery, Ine.,

and Alro Realty, Ine., should be disallowed under

section 269; and

(5) Whether as an alternative to proceeding under

section 269 the surtax exemption of Alro Realty, Inc.,

should be 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 be 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.

539-270—74——_2

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FINDING OF Fact

Some of the facts have been stipulated and they

are so found. The exhibits attached to the stipulation

are incorporated herein by this reference.

All of the petitioners herein are corporations char-

tered under the laws of the State of New York. For

each of the years in question petitioners filed their

Federal income tax returns with the district director

of internal revenue, Buffalo, N.Y. During the years in

issue the business address and principal place of busi-

ness of petitioners was 3491 Delaware Avenue, Ken-

more, N.Y.

The founders, principal stockholders and officers of

all of the corporations involved herein were Alfred J.

Durrenberger, Jr. (Durrenheger) 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 in-

stances be referred to as the partners.

Before going into business together in 1944, Durren-

berger had been a butcher and the owner of a retail

meat market 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 business under the assumed

~ name and style of ‘‘Your Host,’’ giving their business

address at 461 Kenmore Avenue, Kenmore, N.Y., and

thereupon proceeded to open a hot dog stand at that

location. In 1946 they purchased the land on which

the hot dog stand was located.

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 restau-

rant, known as Your Host Restaurant.

In 1945 Wesson and Durrenberger 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 in-

corporated and commenced business on January 1, 1947,

with Durrenberger and Wesson as equal stockholders.

They transferred to it the business assets and liabili-

ties they had acquired as a partnership, including the

leasehold improvements at the three restaurants and

the hot dog stand, for promissory notes totalling $62.-

918.15 and 100 shares of the common stock of the par

value of $100 per share.

On March 20, 1947, Wesson and Durrenberger pur-

chased lots on Delaware Avenue in the town of Tona-

wanda, N.Y., (now known as 3491 Delaware Avenue),

upon which was located a one-story cement block

building intended to be used as a commissary. They

thereupon incorporated Sher-Del Foods, Inc. (herein-

after Sher-Del) to operate a food processing plant

and commissary, and it commenced business on Sep-

tember 1, 1947. They transferred to it the property

which they had bought at 3491 Delaware Avenue and

other current and fixed assets for promissory notes

totalling $43,400 and 100 shares of common stock of

the par value of $100 per share. Sher-Del assumed

Durrenberger’s and Wesson’s individua! liabilities

with respect to 3491 Delaware Avenue upon said

transfer, and repaid the $43,400 promissory notes in

the middle 1950's.

In 1947 Your Host opened two additional restan-

rants upon leased premises. These restaurants were

similar in appearance, operation, and menu to the

restaurants previously in business and each operated

under the name of Your Host Restaurant.

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On April 20, 1948, Wesson and Durrenberger, doing

business 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 corporation 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 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 pedes-

trian traffie was not as heavy as at other locations.

In light of these factors the attornev for Wesson,

Durrenberger, and Your Host, F. Paul Norton (Nor-

ton), reeommended that the restaurant at 309 Dela-

ware Avenue be incorporated separately.

On June 9, 1948, Wesson and Durrenberger incor-

porated 309 Delaware Avenue, Inc. (hereafter 309

Delaware) as equal shareholders. Subsequently, 309

Delaware began operation of a Your Host Restaurant

at 309 Delaware Avenue and became the assignee of

the lease for those premises.

During the period from 1951 to 1954 Wesson and

Durrenberger caused three more corporations to he

formed to operate Your Host Restaurants. These cor-

porations were Roya! Host, Ine. (Royal), Telesnax,

Inc. (Telesnax), and Utiea Host, Inc. (Utiea). The

circumstance surrounding their incorporation are

summarized below:

1. TELESNAX

Wesson and Durrenberger set up Telesnax with two

principal ideas in mind, First, they desired to give

their accountant, James L. Clements, an opportunity

to obtain a proprietary interest in the success of Your

Host Restaurants. Second, they desired to take ad-

vantage of the burgeoning popularity of television by

offering viewers an opportunity to order meals on the

telephone that would be delivered to their homes. The

name Telesnax was designed to convey this second

purpose to the public, and by using Telesnax as a cor-

porate name they felt that they could prevent its ap-

propriation by another 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 Telesnax to develop the meals-at-home idea,

Durrenberger felt it advisable to use the new corpora-

tion to operate a Your Host Restaurant in some

empty store space next to a supermarket. This restau-

rant 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 Your Host name by other businesses using

a similar name. Consequently, the partners filed an

application for incorporation under the name of The

Host, Inc. This application was rejected because of

its similarity to The Host, Incorporated, an already

existing corporation. Incorporation of Royal Host and

other corporations whose names included the word

Host was seen as offering some protection for the

adel stad pb hapa

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 Res-

taurant in 1951 on leased premises.

3. UTICA HOST

Wesson and Durrenberger formed Utica Host 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 “‘ehanging neighborhood.” In light of these

factors the partners decided the restaurant was a risky

venture and should be separately incorporated.

Prior to 1953 all of the Your Host Restaurants

except one were located in downtown commercial

areas or in residential areas; however, in 1953 Wesson

and Durrenberger became interested in placing restau-

rants 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 Your Host Restaurants were very simple establishments

emphasizing 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 operat-

ing a restaurant of the type desired by Wesson called the Royal

Host. Respondent has conceded 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 re-

member that the Royal Host Restaurant was run by Air Host,

Inec., and not by Royal Host, Inc., or one of the other “Host”

petitioners.

the shopping plaza idea was as yet untried in the

Buffalo area, the plazas were not accessible to public

transportation, and the onset of the Korean conflict

made the availability of private automobiles and gaso-

line doubtful in his mind. In addition, placing restau-

rants in the plazas required a lease obligation of a

longer term and for greater rent than Your Host had

become accustomed to undertake. Because Wesson

and Durrenberger felt that the plazas showed promise,

Norton advised that each new restaurant be placed

in a separate corporation in order to insulate 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 Restaurant in a new shopping plaza:

Corporation name Shopping Date Year plaza

(abbreviation) plaza incorporated restaurant

opened

Boulevard Host, Inc. (Boule- Northtown___ June 1953____ 1953

vard).

Niagara Host, Inc. (Niagara)... Marvin February 1955

Gardens. 1955.

Transit Host, Inc. (Transit).. Transitown_.. May 1955___- 1956

Sharlem Host, Inc. (Sharlem)__ Sheridan- June 1956-___- 1957

Harlem.

Boulevard, Niagara, and Sharlem were each incor-

porated with Wesson and Durrenberger as equal

shareholders. Transit was a wholly-owned subsidiary

of Your Host upon its organization. In December

1955 Ycur Host acquired 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 Utiea in

December 1955.

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In September 1955 Durrenberger became interested

in & location for a Your Host Restaurant near the vil-

lage of Williamsville. Durrenberger decided to set up

a separate corporation to operate a restaurant on this

location because he felt that his own resources and

those of the other corporations had become over-

extended with the expansion of the Your Host chain

into the shopping plazas. At this time Wesson was

occupying himself primarily with rimning 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 eco-

nomic reason peculiar to the Williamsville location

which indicated the rieed for a separate corporation.

In September 1955 Main Host, Inc. (Main) was

organized by Wesson and Durrenberger and in Janu-

ary 1956 all of its stock was acquired by Royal. Dur-

ing 1956 Main commenced operating a Your Host Res-

taurant upon the Williamsville location.

In early 1956 Wesson and Durrenberger became in-

terested in developing a chain of Your Host Restau-

rants in the area of Rochester, N.Y., which is about 70

miles distant. 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 Roch-

ester operations and were not confident of succeed-

ing in the new area. Accordingly, they organized

Rochester Host, Ine. (Rochester), in May 1956 as

equal shareholders. After delays caused by the death

of Wesson, Rochester opened its first Your Host Res-

taurant in the Rochester area in the latter part of

1957.

Rochester was the latest corporation formed by the

partners to operate Your Host Restaurants; however,

new restaurants were added to the chain without creat-

ing 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

Corporation 10th-

Ist 2d 3d 4th 5th 6th 7th 8th 9th 15th

Your Host.......... 1944 1944 194 1945 1947 1947 1958 1959 1960 1969

309 Delaware... ..-. ee. ee. ee, I | ee i ectasneidednswcceudes Spey arn

OGRE cwsssxenesuce EE “ah sdcsndeasds sUbsusemenneddes cuatastanssesparesaaapatseeteneteeuoneades

Boulevard. ........- Es PEP aE aa ax cnteaswannseiesegaensilan Mey a aawmS alsclebde Denizen

Weis ceiiccoene = ED fin, ache patig elancnsd tembina aa aimee ight anda oltiediee

Winght@:....55.2..-. Ei Re he gt OO rn ee eens te es ee

ee ree 1956 1959 IE aint 26 cae haediapat an aeeiineie niga dita ain aec aceuanourcebees

| ee oe Se) ME | eaitieghs vanbh dondstendddnandbdcodubbididemaptduwaawhanadaicalbi

GRAM. en knee once FE I. INS tani Suisps lta <naliecaedcieiniine Belescenhjansnclgl seit eacaricialootass

Rochester. BE: UES. TES can wnaktedimcuntnndkacscnipancendlaiadsts Caipedanglicghiie

Telesnax__.....-.-.- ON cds stesso un ent ncbadeesaenaebeniethen elec caw ae

1 Terminated business in 1968.

2 Replaced first restaurant.

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 partners 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.

In all cases the corporations were only responsible

for the rent payments on the premises on which they

actually operated restaurants. In any ease in which

Wesson and Durrenberger, Your Host, or one of the

restaurant corporations negotiated a lease for a new

restaurant location the lease contained provisions per-

mitting its transfer to another corporation without

any liability on the part of the initial lessee. Ap-

539-270—74——3

Pe a rs

parently the lease between 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, Inec., to operate a food processing

plant and commissary. The Your Host Restaurants

were only able to buy meat and other supplies at re-

tail prices; therefore, it was necessary to establish

Sher-Del as a bona fide independent food wholesaler

so that it could take advantage of the wholesale prices

available to such concerns. The Your Host Restau-

rants buy all of their supplies from Sher-Del on an

open account basis; however, 30 percent of Sher-Del’s

business on the average is with outside customers. The

prices charged Your Host Restaurants and outsiders

are the same.

Initially Sher-Del operated the commissary busi-

ness in a one-story building located at 3491 Delaware

Avenue, Tonawanda, N.Y. Wesson and Durrenberger

had purchased this building and nine lots at this

address in 1947 and contributed them to Sher-Del. In

1948 and 1949 Sher-Del bought four lots adjoining the

commissary, began to develop the property as a busi-

ness block, and added store front space. In 1950 Sher-

Del improved and enlarged its commissary operation

upon this property, and in August 1951 Royal com-

menced operating a Your Host Restaurant in the

store front space.

On October 1, 1951, Sher-Del sold this property to

a new corporation formed by Wesson and Durren-

berger, Alro Relaty, Inc. (Alro), for $112,822.93 rep-

resented by a four percent promissory note.

Alro Realty, Inc., was formed in September 1951

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 purchased 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 cor-

porations and provided space for unrelated tenants.

In 1955 the partners were presented with an op-

portunity to purchase a fully equipped bakery for

an investment of $15,000 in cash and a mortgage of

$18,006. Not only was the purchase price of the bakery

favorable, but also the acquisition protected the res-

taurants 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

partners 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 Durren-

berger 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 restau-

rants. Sher-Del took orders for baked goods from the

restaurants and made purchases from Bakery. The

OP a Ba ep ee

' 20

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 upun the whole-

sale price list of a commercial baking corporation.

Chef Foods, Inc. (Chef), was the last corporation

to be formed. In 1956 Wesson and Durrenberger began

exploring the idea of providing meal catering service

in industrial plants. The death of Wesson in 1956 and

the expansion of the restaurant business caused Dur-

renberger to defer the development of the, in-plant

feeding idea. In 1958 he formed Chef Foods, Ine.,

to go into the in-plant feeding business; however, this

business was never developed. Instead, Chef purchased

vending machines in 1959 and 1962. These machines :

were ‘placed only in Your Host Restaurants. In addi-

tion, 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 i in ap-

pearance, 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 pub-

lie that each restaurant was a part of a chain with

the same management. No attempt was made to convey

to the public the separate corporate ownership of some

of the restaurants. Solicitations in the newspaper for

employees were made in the name of Your Host Res-

taurants, and letters were sent under the cover ‘‘Your

Host the Family Restaurants” even though they were

signed in the name of individual eorporations.

The President of each corporation was Durrenber-

ger from Wesson’s death in 1956 until his own death

in 1968. Following her husband’s death, Durrenber-

ger’s widow hecame the president of each corporation.

As will be explained infra, the restaurants shared the

same top management personnel. None of the corpora-

tions paid Your Host for use of the Your Host

Trademark.

tach of the corporations maintained its own minute

book; however, the minutes recorded for Your Host

were meager while those recorded for the other cor-

porations were nearly non-existent. Ea+h corporation

had at least one bank account, and each restaurant

maintained a depository 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 a weekly basis to the

hank account of the corporation to which they be-

longed. Each corporation used its own hank account

to pay most of the expenses attributable to the opera-

tion of its restaurants. These experses included sup-

plies purchased from Sher-Del, utility bills, rent, Fed-

eral and State income taxes, social security taxes and

income taxes withheld from employees, fire insurance,

license fees, and sign bonds (where necessary’.

Beeause Your Host could obtain master policies for

public liability insurance and workmen's .ompensa-

tion 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 ad-

ranced the premium payment 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 its agent according

to a formula based upon the payroll of each corpora-

tion.

At one time the corporation 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 em-

ten Aileen retraite sists ae Piast saa abe bar tb —

en ac

avd

ployees to cash their 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 computed its own

net payroll (after deduction for withholding items)

and paid this amount into the “Your Host, Inc., Pay-

roll Aceount”; all wages were then paid from this

account leaving a “Zero balance.” This payroll ac-

count was not carried as an asset upon the books of

Your Host.

Each restaurant had its own manager who was gen-

erally responsible for the operation of hiseestaurant.

His duties ineluded ordering supplies and hiring and

firing employees; however, the manager had no au-

thority to change the menu of the restaurant, change

its business hours, or purchase 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 success of his

location.

The personnel needed to administer and maintain

all 16 corporations were nominally the employees of

Yeur Host; however, the expenses attributable to

these employees were in fact shared by all of the cor-

porations during the years in issue in the following

manner:

(1) With exceptions noted helow, the cost of the

administrative staff (hookkeepers, typist, clerks, and

the like), group insurance premiums, and the ex-

penses of the administrative office were allocated

among the corporations according to gross sales;

(2) Advertising costs were allocated among the

corporations operating Your Host Restaurants in the

Buffalo area according to gross sales;

(3) The cost of the maintenance crew and the sal-

aries 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 operating Your Host Restaurants.

The gross sales of Air Host which operated the

Royal Host Restaurant were included in the admin-

istrative expense allocation at only half of actual

sales excluding liquor sales. This adjustment was

made to reflect the fact that the Royal Host Restau-

rant 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 admin-

istrative effort.

The gross sales of Sher-Del were included in the

adininistrative expense allocation at a figure that was

less than actual sales to reflect the fact that inter-

corporate sales did not require a great deal of admin-

istrative effort and that Sher-Del employed a small

administrative staff on its own. The figure used for

gross sales was either one-half actual sales or twice

sales to unrelated customers.

Rochester Host was not included in the advertising

expense allocation hecause the Rochester restaurant

could not benefit from Buffalo area advertising. It

appears from the reeord that Your Host paid more

than its share for advertising under the formula. No

explanation can be found for the diserepaney except

that Your Host may have paid entirely on its own

for certain small advertising items like help-wanted

ads.

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in nai La Adal sin nt AA il a BNE

Biditinicriier tt enrivmrinnnetin

The corporations not running restaurants and Air

Host were allocated no part of the advertising or area

supervisor expenses because these items related par-

ticularly to the sales of the Your Host Restaurants.

Although Your Host advanced the funds necessary

to take care of the administrative, advertising, and

supervisory expenses, each of the corporations did in

fact pay its allocated share of the expenses. Only the

alloeable 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

-» cnciuiedatannasaiindaat

Sher-Del Foods, Inc____-_______. $22,500 $22,500 $22,500 SIS, 750

0 | SS See dieu 12,600 12,600 11,400 11, 400

309 Delaware Ave., Inc_________- 7, 800 5, 400 4, 200 1, 500

I en cwnene t, 500 1, 000 1, 000 833

CO EEE 1, 000 1, 000 $33

Boulevard Host, Ine __-_--- eects ae 1, 000 1, 000 1, 000

pO Sa ee 1, 100 1, 000 1, 000 833

CY OS SS eae 1, 100 1, 500 2. 000- 1, 667

Niagara Host, Inc_.............. 1,100 2,000 4,000 3, 33:

OO — eee -—~ ae 1, 200 2, 000 1, 667

2 ee ee 1, 100 1, 200 1, 200 1, 333

Sharlem Host, Inc_-_........-.--- 1, 100 1, 500 2, 000 1, 667

Rochester Host, Inc__._....-.-_- 1, 100 1, 500 1, 200 833

Your Host Bakery, Inc__-__~---_- 1, 000 1, 500 1, 500 1, 333

pO ae 1, 000 1, 000 1, 000 833

Chefs Foods, Inc___._--- he 1, 000 1, 500 1, 500 1, 333

- EN, aR Eee ewe 57,100 57,400 58,500 49, 148

The fifteen corporations reported the following

amounts of taxable income for the year in issue:

1965 1966 1967 1968

Your Host_______..____..-__ $136,702 $107,101 $126,338 $111,310

309 Delaware... ___..__ 47,960 645,859 48, 816 38, 820

EE ee ee a 31,894 35,587 33,107 39, 142

Boulevard__.._.._.__________- 25,932 28.596 23,973 27,

Uties. ....._- avian be Me 28,132 23.451 20,420 25, 674

ha ee 36,646 58.971 71,358 58, 031

Pe 16,231 35,680 38,153 50, 392

a 88, 402 36, 092 23, 866 16, 602

Ee 29,695 29.607 36,7 30, 273

an in es 11, 693 2, 447 1, 082 (Loss)

| FELIS, 31,098 42,882 41,727 35, 760

i RARE il Maat 16,459 18,737 17,284 17, 253

Ss RE 34,896 44,882 43,390 43, 327

OS SE 41,212 79,494 158,231 64, 816

| edehane eleanor 17,708 13,799 13,309 11, 908

OPINION

In 1944 Wesson and Durrenberger opened the Your

Host hot dog sand in Buffalo as a partnership. In the

same year they geese operating the first Your

Host Restaurant, 2 high quality short-order restau-

rant. Two more Ye our Host Restaurants were opened

in 1945. In 1947 the partners formed Sher-Del to oper-

ate a commissary which would supply their restau-

rants and other customers. Between 1948 and 1956 ten

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

539-270—74——4

PD icstnnstnctnctaivinetdias

BERT At ee

develop these holdings commercially. In 1955 the part-

ners formed Bakery to operate 2a bakery which would

supply the restaurants with their needs for sweet

baked goods. In 1958 Chef was formed to operate

vending machines in Your Host Restaurants. No addi-

tional corporations were formed after 1958; however,

the size of the restaurant chain grew considerably. In

1968 there were 40 Your Host Restaurants of which

Your Host operated 15 with each of the ten other

restaurant corporations operating four or fewer

loeations.

After Wesson’s death in 1956 all of the corporations

except one were either wholly owned by Durrenberger

or wholly owned subsidiaries of one of Durrenberger’s

corporations. Durrenberger was the president of each

corporation, and all the corporations shared the same

administrative personnel. 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.

Respondent allocated all of the income and deduc-

tions of the ten corporations operating restaurants

and the vending machine corporation to Your Host

and the income and deductions of Bakery to Sher-Del.

In the alternative respondent has disallowed the sur-

tax exemptions of every corporation except Your Host

and Sher-Del under either section 269 or section 1551.

We are to decide whether respondent’s determinations

are correct.

The facts of this case have many similarities to

those of Marc’s Big Boy-Prospect, Inc., 52 T.C. 1073

(1969), affd.

F. 2d (C.A. 7, 1971), under which respondent

believes his allocations under section 482 can be sup-

ported without question. If the present case were the

mirror image of Marc’s Big Boy-Prospect, Inc.—

which it is in respondent’s view—our task would be

much simpler than we now foresee; however, in our

view there are several facts which distinguish this

case from Marc’s Big Boy-Prospect, Inc. and which

require a result unlike that of the former case. Ac-

cordingly, we shall try to place this case within the

proper perspective of section 482 and the pertinent

cases which deal with section 482.

Section 482 permits the Secretary or his delegate

to allocate income and deducations among two or more

organizations owned or controlled by the same inter-

ests if he determines that such allocation is necessary

to prevent evasion of taxes or clearly to reflect the

income of such organization. The Commissioner’s au-

thority 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. Mare’s Big Boy-Prospect, Inc., supra;

Bush Hog Manufacturing Co., 42 T.C. 713 (1964). See

particularly Phillip Brothers Chemicals, Ine. (N.Y.)

v. Commissioner, 435 F. 2d 53 (C.A. 2, 1970), which

arises in the cireuit in which appeal herein would lie.

Despite petitioner’s burden, if the Commissioner’s al-

location does not appear reasonable in light of the

record, we must conelude that he abused his discre-

tion. 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; how-

ever, our review 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. Ham-

burgers York Road, Inc., 41 T.C. 821, 833 (1964);

eC ee ae

Pee PT er a ela Did whee ale dvd 10 Sort ha Mii) boat

Bowsers ei ibaa Sela beth st Senn 2

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., 1st Sess., pp. 16-17, 1939 C.B.

(Part 2) 395. Tax avoidance motives or the lack of a

‘business purpose 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 com-

monly controlled entities nor the unexercised power

to shift income among them. Grenada Industries, Inc.,

17 T.C., 231 (1951), affd. 202 F. 2d 873 (C.A. 5,

1953); Bush Hog Manufacturing Co., supra, at 37;

W. Braun Co. v. Commissioner, 396 F. 2d 264 (C.A. 2,

1968). Similarly, if there has been an actual shifting

of ineome, purity of purpose and the presence of

sound business reasons for forming multiple corpora-

tions are no defense under sections 482. In short, sec-

tion 482 does not deal with motivation and purpose as

do section 269 and section 1551 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 an-

other; however, it is well settled that the Commis-

sioner can use section 482 to allocate all of the income

and deductions of one entity to another where the eco-

nomic realities so warrant. Hamburgers York Road,

Tne., supra; Mare’s Big Boy-Prospect, Inc., supra.

In Hamburgers York Road, Inc., a successful down-

town 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 oper-

ating the downtown store. On the record in that case

we found that the downtown 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 subur-

ban store was in fact earned by the downtown store.

41 T.C. at 835-38.

As we noted previously, the facts in Mare’s Big

Boy-Prospect, 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 shareholders several subsidiary

corporations to operate restaurants in the Milwaukee

area and two corporations to run commissaries. Each

of the subsidiaries operated a restaurant under a sub-

franchise agreement with WBB. The agreement pro-

vided that WBB would supply each subfranchisee

with supervisory and management services for a mod-

est sliding-secale percentage-of-profits fee. The sub-

franchisees also received the right to use the national

Big Boy trademark under the agreement. Under the

arrangement, WBB was responsible for running the

whole restaurant chain. Accordingly, we found that

WBB and the Milwaukee area subfranchisees consti-

tuted a single integrated 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

syphon off to the subsidiaries income which was earned

by WBB. 52 T.C. at 1099. More importantly, WBB

was unable to show that the fees that it received from

its subsidiaries represented adequate compensation for

the services that it rendered the subsidiaries. On these

grounds, we held that respondent was not unreason-

able in allocating all of the income and deductions of

the subsidiaries to WBB.

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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 enter-

prise; however, we believed that it was clear that we

were not using section 482 to penalize the petitioners

merely for operating a single business through several

corporations but to reflect the fact that subsidiaries

were being used to distort the amount of income re-

ported by WBB. The operation of a single business

through several corporations creates a likelihood that

subsidiaries will be used either to permit the parent

to evade taxes or to understate its income. We be-

lieved that without evidence that the parent and its

subsidiaries dealt at arm’s length with each other this

likelihood formed a reasonable basis for the Commis-

sioner’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 subsidiaries

dealt at arm’s length.

With differences that we shall discuss infra, the

Your Host Restaurants constituted as much of a

single integrated business enterprise as did the Mil-

waukee area Big Boy chain; however, approval of

respondent’s allocation under section 482 is not

ineluctable.

We note that in several respects the restaurant cor-

porations in this case were more viable economically

than were the restaurant subsidiaries in Mare’s Big

Boy. All of the corporations paid directly most of their

own costs of doing business. These costs included sup-

plies purchased from Sher-Del, utility bills, Federal

and state income taxes, social security taxes and in-

come taxes withheld from employees, 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 apparent-

ly willing to rely upon the financial responsibility and

resources of each corporation rather than those of the

total enterprise.

We are also convinced that the faet that Your Host

obtained master policies for public liability insurance

and workmen’s compensation for reasons of economy

and administrative convenience does not detract from

the fact that each corporation paid its appropriate

share of the cost of these items. We think that the sit-

uation 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 ae-

tivities were related to running the restaurants owned

by its subsidiaries. Hence, it would be impossible to

distinguish between WBB’s obtaining insurance for

its subsidiaries and its providing every other manage-

ment service for them. On the other hand, Your Host

operated as many as 15 restaurants of its own. It in-

eurred no expense in obtaining insurance for the other

corporations and benefited from the reduced rates

which were available when a larger number of restau-

rants 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 contributed the net salary

of its own employees as did the other corporations.

The service charges by the bank for the ‘‘Zero bal-

ance’’ account were apportioned among the corpora-

tions along with other administrative expenses.

The main point of contention between the parties

is whether the 15 corporations shared the same admin-

Daa Gall ea aria aha tla Sa mS

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istrative staff and maintenance crew or whether Your

Host provided for a fee administrative and mainte-

nance services. Under either theory respondent con-

tends that the amounts paid by corporations for these

services were computed under 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-

ministative and maintenanees services for all corpora-

tions was generally apportioned according to gross

sales. Respondent did not determine that this method

was unreasonable and we believe it to be based rea-

sonably upon economic realities. We also find it

reasonable that advertising expenses and the costs at-

tributable to the district supervisors and maintenance

men were only apportioned among the corporations

which could benefit from these expenditures. In fact,

to have apportioned otherwise would have distorted

the income of the non-benefiting corporations.

The only deviations from the allocation based on

gross sales involving a corporation whose case is he-

fore us is an adjustment for Sher-Del and the appor-

tionment of the salary paid Durrenberger. The aec-

countant 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 gross

sales for purposes of making the administrative ex-

pense allocation. From his testimony and other evi-

dence in the record we find that the adjustments made

wele reasonable.

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 busi-

‘ness. The remainder of his salary was contributed, by

the other corporations. In the case of the restaurant

corporations the amount paid appears roughly to re-

flect 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

. economically viable business entities. We are con-

vinced that except for de minimis items like help-

wanted ads Your Host bore no more of the admin-

istrative 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 trade-

mark and goodwill, we believe that respondent’s allo-

cation 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 Mare’s Big

Boy and of the downtown store corporation in .Ham-

burgers York Road, Inc. First, the restaurants oper-

ated by Your Host were on the average no older or

more well established than those operated by the ten

other restaurant corporations. The restaurants oper-

ated by the ten 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 corporation

that operated it, and it makes as much sense to

assume that the ten restaurant corporations donated

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goodwill to Your Host as it does to assume that Your

Host donated goodwill to the other ten. Therefore,

the situation is obviously different 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, be 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 restaurants to. benefit

from the goodwill generated by others across the coun-

try. Although Your Host owned the trademark, 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

advantage to being a Your Host Restaurant rather

than another short order cafe; however, we feel that

this advantage flowed primarily from the local adver-

tising and management shared by all of the corpora-

tions. We have already determined that the corpora-

tions divided up these items equitably. The near

failure of the Rochéster Your Host Restaurants, which

had absentee management problems, indicated that

without the concentrated loeal advertising and local

management the Your Host name was not worth a

great deal.

We hold in light of ibe: record in this ease that the

ten restaurant corporations were viable economic en-

‘tities whieh earned their own income and that Your

Host provided no service or benefit to those ten corpo-

' rations for which it was not adequately compensated.

Accordingly, we hold that respondent may not allo-

eate to Your Host, Ine., all of the income and deduc-

tions of the ten restaurant corporations for the years

in issue.’

While we believe that the ten restaurant corpora-

tions were economically viable, this opinion does not

hold true in the cases of Chef, the vending machine

corporation, and Bakery.

Al! of Chef’s income was derived from renting re-

frigeration and storage facilities to Sher-Del and from

operating vending machines which were located solely

in Your Host Restaurants. There is nothing in the

record which indicates whether the terms upon which

Chef dealt with its parent, Sher-Del, or its sister

corporations were fair and reasonable. Chef, in sub-

stance, conducted no business; therefore, it was rea-

sonable 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 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 restau-

‘ants. This arrangement garnered 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

*The parties have proceeded upon an all-or-nothing approach

with respect to section 482. A partial allocation under section

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., supra at 1105-6, Helvering v.

Taylor, 295 U.S. 507 (1935).

bes ob dill ae

| eT Tr. et ren tae ee Git

and deductions to Sher-Del under section 482 and up-

hold his determination.

Although we have found that the ten restaurant

corporations 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 pur-

pose for forming the ten restaurant corporations was

to obtain additional surtax exemptions and that sec-

tion 269(a) is applicable to disallow these benefits.

We agree with respondent with respect to 309 Dela-

ware, Royal, Main, Telesnax, and Alro only.

Section 269 provides the following in part:

Sec. 269. Acovistrions Mane To Evape or

Avorw Income Tax.

(a) IN Generan. —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 ac-

quiring corporation or its stockhold-

ers, 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,

and the principal purpose for which

such acquisition was made is evasion

or avoi 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 de-

duction, 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

corporation is an aequisition for purposes of section

269. James Realty Company 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

acquirmg 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. Ac-

cordingly, 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 nontax-avoidance purposes for forming the ten

corporations. These facts include the integration of

the ten corporations into a single business, the thin

capitalization of the corporations, and the frequent

interest-free loans and advances among the corpora-

tions 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), affd. sub nom.

Made Rite Investment Co. v. Commissioner, 357 F. 2d

647 (C.A. 6, 1966). Petitioner, on the other hand, has

attempted to show the economic reasons underlying

the formation of each corporation. Southeastern Can-

el she a

a ee ee ee ee ee es ee

ae Te eae eS ee eee

teen Co. v. Commissioner, 410 F. 2d 615 (C.A. 6, 1969),

certiorari denied 396 U.S. 833 (1969).

We believe that the facts noted by respondent are

strong circumstantial evidence that tax avoidance was

a principal purpose in the formation of the ten cor-

porations. We also tend to discount petitioner’s 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 hene-

fit of multiple surtax exemptions is, we believe, as ob-

vious to a layman as it is to a tax expert.

Throughout the trial and on brief petitioners have

complained that their burden of proof under section

269 is impossible because the corporations were

formed from 13 to 22 years before trial and because

the principals involved in developing the Your Host

Restaurant chain were either dead or unavailable for

trial. We sympathize with petitioners and have allowed

them great latitude in submitting evidence concern-

ing the formation of the restaurant corporations. We

also note that respondent’s ability te 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

ean better be proven with evidence of objective facts

rather than with subjective evidence of intent pro-

vided 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 Boule-

vard, Niagara, Transit, and Sharlem (the shopping

plaza corporations) and in the cases of Utiea and

Rochester.

We helieve that the risks involved in the mid-1950’s

in opening up restaurants in the emerging new sub-

urban shopping piazas on long-term leases justified the

formation of separate corporations. The chance of

failure in these locations was substantial and formed

the principal motivation for the formation of Boule-

vard, Niagara. Transit, and Sharlem. The first of

these corporations, Boulevard, was formed in 1953

and the last, Sharlem, in 1956 before it became appar-

ent that the shopping plazas were desirable locations.

We must lend credence to petitioners’ contention that

the riskiness of being a pioneer in shopping plaza

development was the primary purpose for the forma-

tion of the four corporations because following the

success of the first plaza locations additional plaza

locations were opened without the use of additional

corporations.

Utica was formed in 1954 to operate a restaurant in

a loeation 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 principal factors which

motivated the partners to form Utica.

Rochester was incorporated in 1956 to begin devel-

oping a ehain of Your Host Restaurants in the

Rochester area. The problems involved in operating

restaurants 70 miles distant from Your Host’s normal

base of operations were in our opinion substantial.

The partners’ principal purpose in forming Rochester

was to protect their enterprise from the significant

risk of losses from the Rochester operation. The part-

ners’ 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

barely profitable.

We have examined the reasons offered by petition-

ers for the formation of the other four restaurant cor-

porations and have found them to be either fantastie

or merely unsupportable upon the record. We have set

forth these reasons in detail in the findings of fact.

Quite predictably petitioners have argued that the

partners wished to limit their liability when opening

up new loeations even when there was no particular

reason for believing that the new location would be

unsuecessful. Petitioners have also claimed that sev-

eral of the corporations were necessary to protect the

variots Host names from appropriation. Because the

creation of any corporatien will provide tts share-

holders with limited liability and prevent another cor-

poration from getting a charter under the same name,

we cannot take these arguments too seriously wnless

there is additional evidence showing the need for

multiple corporations.

Tn light of the strong circumstantial evidenee of in-

tent to evade taxes provided by the existence of an

integrated business, the thin capitel strueture and in-

tercorporate borrowing, and the absence of believable

business reasons for their formation, we find that the

principal purpose for the formation of 309 Delaware,

Royal, Main, and Telesnax was tax avoidance. Simi-

larly, there is no reason evident upon the record other

than tax avoidance that explains the formation of the

real estate holding eompany, Alro, in 1951. Therefore,

we find that the principal purpose for the partners’

ereation of Alro was tax avoidance.

Accordingly, we hold that respondent was eorrect in

disallowing the surtax exemptions of 309 Delaware,

Royal, Main, Telesnax, and Alro.

Tn light of the foregoing.

Decisions will be entered under Rule 50.

x Qa area mee et i ee EN I RI Bm

APPENDIX B

United States Court of Appeals for the Second Cireuit

Nos. 242-268—September Term, 1973

(Argued October 18, 1973; decided December 11, 1973)

Dockets Nos. 73-1311—73-1337

Your Host, INc., Ev AL., PETITIONERS-APPELLANTS

COMMISSIONER OF INTERNAL REVENUE,

RESPONDENT-APPELLEE

CueEr Foops, [Nc., ET AL., PETITIONERS-APPELLEES

CoMMISSIONER OF INTERNAL REVENUE,

RESPONDENT APPELLANT

Before KavrMan, Chief Judge, LUMBarp and Trers,

Circuit Judges

Appeal from judgments of the United States Tax

Court (Irwin, J.) in consolidated eases in which the

Tax Court upheld determinations by the Commis-

sioner, pursuant to 26 U.S.C. §§ 482 and 269, of in-

(41)

MDH eae |

pai a act ae Rae Lae Rite tie A ROR Slat veka se

come tax deficiencies for 1965 through 1968 regarding

seven of petitioners-appellants’ affiliated corporations.

Affirmed.

Ratpu J. Greaa,

Buffalo, New York (Albrecht, Maguire, Hef-

fern & Gregg, and George M. Zimmerman,

on the brief), Attorneys for Your Host, Inc.,

et al., Petitioners-Appellants and Chef

Foods, Inc., et al., Petitioners-A ppellees.

Winntram A. FRIEDLANDER,

Washington, D.C. (Scott P. Crampton, Assist-

ant Attorney General, Ernest J. Brown and

Richard S. Halberstein, Attorneys, Tax Di-

viston, Department of Justice, Washinggton,

D.C., on the brief), Attorneys for Commis-

stoner of Internal Revenue.

Lumparp, Cirewit Judge: Petitioners-appellants,

Your Host, Ine., and its affiliated companies, appeal

from judgments of the United States Tax Court

(Irwin, J.) which upheld determinations by the Com-

missioner of income tax deficiencies assessed for the

years 1965 through 1968. Your Host, Inc., et al., 58

T.C. 10 (1972). The deficiencies were assessed pur-

suant to 26 U.S.C. § 482, which allows the Commis-

sioner to allocate income among affiliated companies

more properly to reflect the earning of income,* and

196 U.S.C. $482 provides: “In any case of two or more

organizations, trades, or businesses (whether or not incor-

porated, whether or not organized in the United States. and

whether or not affiliated) owned or controlled directly or in-

directly 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.

apportionment, 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.”

2D) SPs eR FS

IRE EEE MEN SE TOI

pursuant to 26 U.S.C. § 269, which permits the Com-

missioner to deny tax exemptions and deductions

where an affiliated company was “acquired’’ for tax

avoidance purposes.” We affirm.

Your Hosi, Ine., and its affiliates, operate a restau-

rant chain and food business in the Buffalo area.

From modest beginnings in a one-restaurant partner-

ship of A. J. Durrenberger and R. T. Wesson in 1944,

the business grew so that by the mid 1960's it con-

sisted of sixteen interrelated corporations which oper-

ated some forty “Your Host’’ restaurants, a food sup-

ply commissary, a bakery, a real estate holding com-

pany, and a vending machine and leasehold operation.*

2296 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 corpora-

tion, or

“(2) any corporation acquires, or acquired on or after

October 8, 1940, directly or indireciiy, property of another

corporation, not controlled, directly or indirectly, immediately

before such acquisition, by such acquiring corporation or its

stockholders, the basis of which property, in the hands of the

acquiring corporation, 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 secur-

ing 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.”

*The principal corporations among the group were Your

Host, Inc., 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” restau-

rants: 309 Delaware Ave., Inc. (four restanrants), Royal Host,

FARM eth DA AA

mA ‘. x ny . ‘ -

Diteeietess:: EN MRED UT aba Mc ny tie

All of these enterprises remained 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, Ine. He furthermore determined that, pur-

suant to 26 U.S.C. § 269, thirteen of the companies

had been established for the principal purpose of tax

avoidance and he accordingly denied them the cor-

porate surtax exemption.°

Upon review the Tax Court upheld the Commis-

sioner’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 income to Sher-Del Foods, Inc. The

Tax Court held that the ten restaurant operating com-

panies whose income had been allocated were “via-

ble economic entities which earned their own income”’

and hence were not subject to income allocation.

Ine. (one), Boulevard Host, Ine. (two), Utica Host, Ine.,

(four), Niagara Host. Inc. (four), Main Host. Ine. (three),

Transit Host. Inc. (two). Sharlem Host, Ine. (three), Roch-

ester Host. Inc. (originally three, now one). and Telesnax,

Ine. (one). There is also Air Host, Inc., which runs the busi-

ness’s one “Royal Host” restaurant. The remaining three com-

panies 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-Del and Your Host Bakery), and Alro

Realty, Inc. (another subsidiary of Sher-Del which owns the

principal business property of Sher-Del and Your Flost).

* These were the ten companies (aside from Your Host, Inc.)

which operated “Your Host” restaurants (see fn. 3), plus Air

Host, Inc., and Chef Foods, Inc.

5 These were again the ten companies operating “Your Host”

restaurants, plus Chef Foods. Inc., Your Host Bakery, Inc.,

and Alro Realty, Inc.

0 Faas

The Tax Court also upheld the Commissioner’s de-

termination under § 269 as to five of the affiliated com-

panies: 309 Delaware Ave., Inc., Royal Host, Inc.,

Main Host, Inc., Telesnax, Inc., and Alro Realty, Ine.

With respect to the other eight companies which had

been denied surtax exemption, however, the court held

as to six that the Commissioner had erred in finding

that they had been established for the principal pur-

pose of tax avoidance. The court did not assess the

validity of the Commissioner’s § 269 determinations

as to Chef Foods and Your Host Bakery, having al-

ready sustained the Commissioner’s 100% reallocation

of the income of both companies under §¢ 482.

Since the Commissioner has elected not to 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 deter-

minations. As to these we note at the outset that the

Commissioner’s determinations are to be set aside

only if ‘‘unreasonable, arbitrary, or capricious,’’ in

the ease of § 482 allocations, Wisconsin Big Boy Corp.

v. C.L.R., 452 F. 2d 137, 140 (7th Cir. 1971); Philipp

Bros. Chemicals, Ine. v. C.I.R., 485 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 (2d Cir.

1968) ; J. T. Slocomb Co. v. C.I.R., 334 F. 2d 269, 273-

74 (2d Cir. 1964).

® The Commissioner has filed a protective cross-appeal request-

ing that, in the event we reverse the Commissioner's § 482 deter-

minations as to Chef Foods and Your Host Bakery, we remand

to the Tax Court for consideration of the Commissioner's ¢ 269

determinations with respect to both companies. Since we aflirm

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).

eh riage ES Sods Ye ne

prea Bama,

WAN AAG cinta NR ahs

Under these standards of review, we cannot say that

the Commissioner’s § 482 determinations were arbi-

trary or unreasonable. In the case of Chef Foods,

Tne., whose income was allocated to Your Host, Inc.,

for the four years in question, it was found that Chef

Foods was originally formed in 1958 to provide a ve-

hicle for developing catering services in industrial

plants. This line, however, was never developed. In-

stead Sher-Del Foods acquired all the stock of Chefs

Foods for $6,000. Chef Foods was then used to pur-

chase cigarette vending machines which were placed

only in ‘*Your Host’’ restaurants. It purchased ciga-

rettes wholesale and sold them through vending con-

cessions at the restaurants, the profits being shared

through concession commissions to each restaurant.

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, whose salary and ex-

penses constituted virtually all of the operating ex-

penses of the company. Otherwise Chef Foods shared

its aliquot portion of taxes, insurance, utility, and

other costs along with the other corporations as sum-

marily determined by the common executive manage-

ment of the companies. The portion of Chef Foods’

profit which Durrenberger, then the surviving original

partner, took as his salary was also similarly deter-

mined. Chef Foods’ income from the vending machine

sales and from rents averaged roughly $160,000 for

each year between 1965 and 1968, with approximately

75% coming from the vending machines sales. Thus

while it is true, as the dissent suggests, that Chef

Foods conducted sizable 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 operations, in terms of its labor force, capitaliza-

tion, work site, and so forth, suggests that the firm

was kindred in nature to the kind of sham enterprise

which this court held properly subject to income allo-

eation in Philipp Bros. Chemicals, Ine. 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. Vv.

C.I.R., supra; and Hamburgers York Road, Inc., 41

T.C. 821 (1964).

For the same reasons we are constrained net-to-dis-

turb the Comimissioner’s allocation of the income of '

Your Host Bakery, Inc., to Sher-Del Foods, Ine. 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, Inc., with similar apportionment of sala- |

ries and expenses. Furthermore, it shared the same

premises with Sher-Del Foods.

Although not conceding the point, appellants con-

tend 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 reason-

able profit to Sher-Del for its services in distributing

the bakery’s products to the “Your Host”’ chain. The

dissent endorses this position, and cites in support of

it language in our decision in W. Braun Co. v. C.1.R.,

396 F. 2d 264 (2d Cir. 1968). However, in view of the

highly ir:tegrated nature of, the business enterprise,

we do not believe that it was unreasonable for the

2 eae Sack atch Galena, Wace Wa Male ae

A ENS IAEA SRL A Lea rae tie

Commissioner to have concluded that all of the bak-

ery’s income should be attributable to Sher-Del. As we

said in the later case of Philipp Bros. Chemicals, Inc.

Vv. ¢. I.R., supra, at 59:

[T]he taxpayer had the burden of showing that

the 100%: allocation of income to the [parent]

corporation was unjustified. Taxpayers ask us

to remand the case in order to allow them an

opportunity to establish that the 100 per cent

alloeation was unreasonable and to show what a

‘reasonable allocation would be. We see no rea-

son 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 Corp. v. C.I.R., supra, at 140; Ballentine Motor

Co. v. CI.R., 321 F. 2d'796 (4th Cir. 1963); Hall v.

C.I.R., 294 Fd 2d 82 (5th Cir, 1961).

The Commissioner’s determinations under 26 U.S.C.

§ 269, to disallow the surtax exemption for five of the

appellants’ corporations, were also within permissible

limits.2 We note that four of these five (Telesnax,

Ine., Royal Host, Inc., Main Host, Inc., and 309 Dela-

ware Ave., Inc.) were merely alternate vehicles for

operating additional “Your Host” restaurants. They

- were all thinly capitalized. They were all financed by

substantial loans from Your Host, Inc., and from

Sher-Del Foods, Jne:, loans either not evidenced by

notes or established through a system of delayed bill-

ing. More importantly, in none of these four instances

8 There is, of course, no longer any question that the forma-

tion of a new corporation can be an acquisition for the purposes

of § 269. James Realty Co. y. United States, 280 F. 2d 394 (8th

Cir. 1960), and also that § 269 applies to an, ac quired corpora-

tion as well as to an acquiring corporation, Concord Supply

Corp., 37 T.C. 919 (1962). ,

were the appellants able to proffer reasons for their

separate incorporation other than a desire to limit lia-

bility for its own sake (which is in any event a neces-

sary consequence of incorporation) and, in the case of

Telesnax, the additional desire to give Wesson and

Durrenberger’s accountant 2 capital share in the busi-

ness. Unlike the situation regarding the six “Your

Host’’ companies where the Tax Court found the prin-

cipal purpose of incorporation to have been other than

tax avoidance, for these four restaurant operating cor-

porations the appellants cited no unusual risks incum-

bent on the ventures, such as location in an untried

shopping center development or in a community with

strong pre-established competition, nor any other fac- .

tors, such as the need to protect a corporate name not

already protested or to protect the goodwill of a par-

ticular restaurant, which might have been persuasive

of the necessity for separate incorporation,’ Accord-

ingly, the Commissioner’s conclusion that tax avoid-

ance was the principal purpose behind their separate

incorporation was not ‘clearly erroncous.’’ See Scroll,

Ine. v. C.I.R., 447 2d 612 (5th Cir. 1971); Bobsee

Corp. v. United States, 411 PF. 2d 231 (5th Cir. 1969) ;

Borge v. C.1.R., 405 F. 2d 673 (2d Cir, 1968).

Although incorporated for reasons other than oper-

ating a “Your Host” restaurant, Alro Realty, Inc.,

presents no different considerations in regard to the

Commissioner’s disallowance of its surtax exemption.

Appellants argued before the Tax Court that the prin-

cipal purpose for establishing Alro was to facilitate

° The circumstances which the dissent urges as justifying the

separate incorporation of 509 Delaware Ave., Inc., for example

the slightly higher rent, the smaller number of pedestrians, and

so forth, are marginal at best. These factors are not equivalent

to such substantial risks as taking on established competition

or beginning business operations in a city where the “Your

Host” name was generally unknown.

oe? SST wT ere

real estate mortgage financing for the overall enter-

prise. Yet, the operation of Alro subsequent to its

formation undereuts 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 commissary 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 continned making eapital advances to Alro.

In sum, Alro has never been utilized as a financing

vehicle or in any other manner to improve the work-

ing capital position of its parent, Sher-Del, or its af-

filiate, Your Host, Ine. On these facts the Commis-

sioner 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 vy. C.1.R., supra, at 505-506,

The only troublesome point which remains concerns

the apparent inconsistency of the Tax Court's conclu-

sions under $& 482 and 269. The four restaurant oper-

ating corporations of the **Host’’ group which have

been denied the surtax exemption because of their

“aequisition”’ for the principal purpose of tax avoid-

ance were also found, however, to have “sound busi-

ness reasons”’ for their separate corporate existence,

so that as to them the Tax Court reversed the Com-

missioner’s income allocations under 4 482. This ap-

parent inconsistency is resalved 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 ex-

istence, as they also look to different elements of

proof: economic reality in reference to income versus

inference of intent in reference to tax savings. Thus

even though the establishment of these elements re-

quires in part the assessment of common facts in the

conduct of a company after its *‘acquisition,”’ the pur-

poses relevant to such assessment may be quite dis-

tinct. In a case very similar to the present one, this

court cautioned against

confus[ing] ‘‘a purpose,’ the continued exist-

ence of which may be enough to eliminate [an

adverse determination under § 482], with ‘*the

principal purpose” to evade er avoid the Fed-

eral income tax, the intial presence of which

governs §269 and which may exist alongside

other secondary reasons for the formation of

the corporation.

Dorba Homes, Inc. v. C.1.R., supra, at 506, That cau-

tion 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 sane-

tions of § 269 “so many years after the fact” is a viola-

tion of the due process clause.

The judgments of the Tax Court are accordingly

affirmed.

Timers, Circuit Judge (dissenting in part): Since

I am disturbed by certain inconsistences in the Tax

Court decision and by the majority’s placing the im-

primatur of our Court on those inconsistencies, I re-

spectfully dissent in part.

With respect to the Section 482 allocations, I dis-

sent 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 alloca-

tion, I would reverse. As to the Bakery allocation,

I would reverse, and remand for determination of a

proper adjustment and a reallocation of income.

iets ee

— ee

With respect to the Section 269 surtax exemptions,

I agree with the majority’s affirmance of the Tax

Court in upholding the Commissioner’s disallowance

of surtax exemptions for four of appellant’s five affili-

ated companies. As to the 309 Delaware restaurant,

however, I would reverse and hold that the Commis-

sioner’s disallowance of its surtax exemptions was

clearly erroneous.

Section 482 of the Internal Revenue Code of 1954,

26 U.S.C. § 482 (1970), authorizes the Commissioner

to “allocate gross income” among the units of com-

monly controlled business organizations. Its purpose

is to prevent tax evasion or clearly to reflect the in-

come of the various parts of an integrated corporate

group. While this statute gives the Commissioner

broad discertion to alloeate income, it does not permit _

him to disregard a separate corporate entity if it

exists for ‘ta bena fide business purpose”, W. Braun

Co. v. CLILR., 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.IR., 435 F. 2d 53 (2 Cir. 1970). Nor does this

statute permit the Commissioner to substitute his busi-

ness 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,

Ine. v. C.I.R., supra, 435 F. 2d at 58. Income alloca-

tion is proper only when the income earned by one

corporation is artificially deflected to another.”

“See 7 Mertens Law of Federal Income Taxation § 38.63

(Zimet & Barton rev., 1967): “The identity of businesses is to

be preserved and the Secretary or his delegate has no au-

thority under [$482] to merge them into one single business

Applying these ¢riteria to the instant case, the Tax

Court held that the ten restaurant corporations were

‘‘eeonomically viaPle business entities”. 58 T.C. at 27.

It refused to uphold the Commissioner’s allocation of

their income to Your Host. The Tax Court based its

conclusion on the 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 opera-

tional autonomy te be a bar to income allocation with

respect to the ten restaurant corporations, I fail to

understand the m2jority’s conclusion with respect to

Chef Foods. Chef Was a viable, independently fune-

tioning business efterprise. It had cigarette vending

machine sales averaging $130,000 per year; it had a

salaried employee for whom it paid workmen’s com-

pensation and social security contributions; it owned

its own vending machines and maintained a substan-

tial inventory; it paid its own utilities, taxes, automo-

bile expenses and, a8 did the ten restaurant corpora-

tions, a proportionate share of group insurance and

general administrative costs.* Chef conducted its busi-

ness no differently than did its competitors. It serviced

unless the businesses are carried on and manipulated in such a

way as to constitute one single business, or unless the ‘con-

trolled enterprise’ is a Sham.” (citations omitted).

%t Bach 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 proportionate share of the common adminis-

trative 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 ade-

quately compensated—i-e. no income distortion—that fact would

appear irrelevant.

= ei OP EI FLO LGO

alicia Dace iy

its own machines, collected receipts and paid commis-

sions based upon the amount of merchandise sold.

These factors clearly distinguish the instant case

from Philipp Brothers Chemicals, Inc. v. C.I.R. supra.

There we affirmed the Tax Court in sustaining the

Commissioner’s allocation of the entire income of for-

eign sales subsidiaries to their parent upon a finding

that they had had no employees, no inventory and

did nothing ayhatever to earn the income they re-

ported. That is a far ery from the situation here.

The case against allocating all of Your Host Bak-

ery’s income to Sher-Del Foods is even more compel-

ling. 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 sup-

plies. 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 middle-

man, delivery and billing agent. There was some in-

come distortion. This does not mean, however, that a

Section 482 allocation of 100% of the subsidiary’s in-

come is appropriate. While Sher-Del has not estab-

lished the adjustment 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

“*Tt]he Commissioner was * * * not justified in

arbitrarily allocating all of [the subsidiary’s]

taxable income to petitioner.’”’ W. Brawm Co. v.

C.I.R., supra, 396 F. 2d at 268. (emphasis

added).

I would remand for a determination of the proper ad-

justment of Sher-Del’s costs as a basis for reallocat-

ing Bakery’s income to Sher-Del according to law.”

Since Your Host did not demonstrate non-tax avoid-

ance reasons for the separate incorporation of Tele-

snax, Ine., Royal Host, Inc., Main Host, Inc. and Arlo

Realty, Inc., the Tax Court correctly upheld the Com-

missioner’s disallowance 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

ef ineorperation te have been other than tax avoid-

ance. These findings by the Tax Court strike me as

undermining the majority’s assumption that there

were “‘no unustial risks * * * which might have been

persuasive of the necessity for separate incorpora-

tion” of 309 Delaware. I would hold that the Commis-

sioner’s disallowance of its surtax exemption was

clearly erroneous. See Borge v. C.I.R., 405 F. 2d 673

(2d Cir. 1968).

1° 4 proper adjustment would involve an increase in Sher-

Del's income sufficient to reflect the cost to it of the billing and

delivery services provided for Bakery and a corresponding de-

crease in Bakery’s income.

% The Tax Court with respect to the 309 Delaware restau-

rant: “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

(3250 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.

POLO dal AR Noa hing NLA el tae.) wie

APPENDIX C

United States Court of Appeals for the Second

Circuit

Nos. 242-268—September Term, 1973

(Argued October 18, 1973; decided December 11, 1975

Doekets Nos. 73-1311—73-i337

Your Host, Ixc., ET AL., PETITIONERS-APPELLANTS

ev.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT-

APPELLEE

Cuer Foovs, INc., ev AL., PETITIONERS-APPELLEES

CoMMISSIONER OF INTERNAL REVENUE, RFSPONDENT-

APPELLANT

Before KaurmMan, Chief Judge, LumBarp and

Trusers, 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 Commis-

sioner, pursuant to 26 U.S.C. §§ 482 and 269, of in-

(56)

come tax deficiencies for 1965 through 1968 regard-

ing seven of petitioners-appellants’ affiliated corpora-

tions.

Affirmed.

Ratpeu J. GREGG,

Buffalo, New York (Albrecht, Maguire, Hef-

fern & Gregg, and George M. Zimmermann,

on the brief), attorneys for Your Host, Inc.,

et al., petitioners-appellants and Chef Foods,

Inc., et al., petitioners-appellees.

Wituiam A. FRIEDLANDER,

Washington, D.C. (Scott P. Crampton,

Assistant Attorney General, Ernest J. Brown

and Richard S. Halberstcin, Attorneys, Tax

Division, Department of Justice, Washing-

ton, D.C., on the brief), attorneys for Com-

missioner of Internal Revenue.

U.S. GOVERNMENT PRINTING OFFICE: 19/4

Ss = ee Ma oe > . ne

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.