Hotel Waldorf Co. v. Commissioner

*430 These proceedings were brought to redetermine deficiencies in income and war and excess-profits taxes as follows:

In Docket No. 24273 the following errors are alleged on the part of the respondent: (1) The disallowance of a deduction for a loss of $43,211.79 in 1919 in connection with the operation of its dining room; (2) the disallowance of a deduction of an additional loss of $4,956.29 in 1919 in connection with the same operation; (3) the disallowance of the cash value of the leasehold as invested capital; (4) the disallowance of depreciation on the leasehold of the Hotel Waldorf; (5) the denial of special assessment under the provisions of section 328 of the Revenue Act of 1918.

The issue relating to depreciation was asserted in Docket Nos. 25037 and 36723 and the respondent's denial of*2124 the petitioner's affiliation with the Hotel Waldorf Drug Company during 1923 and 1924 was also charged as error in Docket No. 36723. It was stipulated that the petitioner and Hotel Waldorf Drug Company were affiliated and that the drug company sustained deductible losses of $4,193.48 for 1923 and $4,425 for 1924.

FINDINGS OF FACT.

In 1916, Earl P. Severcool and Eldon B. Edmonds, men of large experience and considerable skill in the management of hotels, were operating the Hotel Waldorf at the intersection of Summit and Madison Streets, one of the principal business corners in Toledo, Ohio. At that time Hotel Waldorf consisted of 200 rooms, about 65 per cent of which were equipped with baths. The Waldorf Realty Company, a corporation, owned the land on which the hotel was built and had leased it under a 15-year lease to Severcool and *431 Edmonds. In the fall of that year Severcool and Edmonds entered into negotiations with the Waldorf Realty Company for the construction of an additional unit of 300 rooms. The terms of the agreement finally concluded were embodied in a letter of proposal dated January 4, 1917, directed to Sidney Spitzer & Company, an underwriting firm, *2125 and signed by Severcool and Edmonds. In the proposal letter Severcool and Edmonds requested the addressee to purchase a bond issue of $750,000, secured by a mortgage executed by the Waldorf Realty Company, and to induce such purchase agreed to organize a hotel corporation with paid-up capital stock of at least $100,000; to transfer to that corporation the present Waldorf Hotel business, good will, etc.; to pay certain cash rentals under a 31-year lease which they agreed to secure from the Waldorf Realty Company, covering the enlarged Waldorf Hotel property; and to pay certain fixed and current operating charges. The following endorsements appear below the signatures of Severcool and Edmonds:

It is hereby agreed that the written lease which is hereto attached contains all the covenants, terms and conditions as agreed and refered (sic) to in the above agreement.

(Signed) EARL P. SEVERCOOL,

ELDON B. EDMONDS,

THE WALDORF HOTEL COMPANY.

BY GEORGE P. WALDORF,

President.

TOLEDO, OHIO, January 4, 1917.

The undersigned, The Waldorf Realty Company, in consideration of the above, hereby agrees to promptly execute the lease above referred to, as soon as it can be*2126 drafted, the covenants, terms and conditions of which have been fully and clearly agreed upon, and deliver the same to Earl P. Severcool and Elden B. Edmonds.

THE WALDORF REALTY COMPANY,

(Signed) BY GEORGE P. WALDORF,

President.

On January 29, 1917, pursuant to the above proposal the petitioner corporation, the Hotel Waldorf Company, was organized under the laws of Ohio with an authorized capital stock of $200,000, of which $120,000 was common and $80,000 preferred stock. Severcool and Edmonds were the equal owners of all common stock but four shares of the par value of $100 each were issued to nominal qualifying stockholders who were also directors. On February 19, 1917, Severcool and Edmonds made a formal offer to sell to the petitioner the contract of lease with the Waldorf Realty Company for the old and the proposed units of Hotel Waldorf, together with the assets, business and good will of the hotel. The purchase price was $120,000, to be paid in the common stock of the petitioner, including *432 the four shares issued to qualifying stockholders. The offer was accepted by the directors and stockholders of the petitioner on February 19, 1917, by proper resolutions*2127 entered on its records. A formal bill of sale was "issued" March 6, 1917, and the lease between the Waldorf Realty Company and the petitioner bore the date of March 29, 1917. The delay in executing these instruments was caused by the failure of counsel to act promptly, by the necessity of printing the form of lease, and by the unforeseen difficulties which the Realty Company was compelled to adjust in connection with the 99-year lease. As between Severcool and Edmonds and the petitioner the sale was consummated on February 19, 1917. The lease for the hotel property was valued at $56,670.71, an arbitrary amount so fixed as to make up the purchase price of $120,000 paid to Severcool and Edmonds. For bookkeeping purposes that value was retained on the records of the petitioner and formed the basis of its income tax returns for 1917, 1918, and 1919. The printed lease was essentially the same as that attached to the letter to Spitzer & Company, dated January 4, 1917. The term of the lease was from January 1, 1917, to December 31, 1948. The following rentals were fixed in the lease:

$32,062.75 per year until the new structure is fully completed and ready for occupancy.

$97,500.00*2128 per year from the time the new structure is fully completed and ready for occupancy, to December 31, 1927.

$104,700.00 per year for the last twenty years of the lease.

The new hotel unit was completed in November, 1917. It was a 10-story structure of the most modern design and sound construction. The enlarged hotel provided 483 rooms for guests and 22 rooms for offices, storerooms and other necessary administrative purposes. It contained a dining room on the first floor with the usual complement of kitchen and pantries. The petitioner purchased the requisite dining room and kitchen equipment. At that time one Harry T. Foard was operating a cafeteria under a lease from the petitioner. In order to avoid a duplication of working forces and the operation of separate kitchens, an agreement was entered into between the petitioner, through Severcool and Edmonds, its officers, and Foard, whereby a corporation called the Waldorf Catering Company was organized to operate the Foard Cafeteria and the Hotel Waldorf dining room. Foard and the petitioner retained ownership of their respective equipments. Foard and the petitioner each subscribed to one-half of the capital stock of the*2129 Waldorf Catering Company, but neither paid the subscription. No other person ever subscribed to or became owners of capital stock. No certificates of stock were ever issued.

*433 Under a verbal contract Foard and the petitioner agreed that Foard was to receive $500 per month as a salary for managing both enterprises. The operating losses, if any, were to be borne by the petitioner, which also was to pay certain of Foard's debts. Thereupon, the petitioner opened on its books an account with the Waldorf Catering Company. The monthly rental of $227.18 due under the lease of the Foard Cafeteria was charged against the Catering Company and a charge of $200 per month was made for the use of the hotel dining room, kitchens and equipment. Current items, such as laundry, steam heat, light, electric bulbs and other incidental expenses were charged to the Catering Company. All amounts, including rent, so charged were credited to the petitioner's income and were included in its income tax returns. Payments made to the petitioner by guests whose meals were charged were credited to the Catering Company. No part of the revenue received through the operation of the cafeteria and*2130 the dining room was retained by Foard, Severcool, and Edmonds, or the petitioner, but all such receipts were kept by the Catering Company and used in its business. The Catering Company kept its own books, which were neither accessible to nor under the control of the petitioner or its officers. The verbal contract remained in force until April 18, 1919, when, after the repeated and insistent demands of Foard's attorney, a written agreement, bearing date of November 22, 1918, was signed by Foard as party of the first part, by Severcool and Edmonds as parties of the second part, and by the Catering Company as party of the third part. Severcool and Edmonds signed this agreement individually because Foard and his attorney knew nothing about the petitioner corporation but did know that Severcool and Edmonds would pay their obligations and, hence, wanted them as guarantors. Severcool and Edmonds were not represented by counsel at the various conferences preceding or at the time of the execution of the agreement. The agreement contains the following clause:

Second parties agree to take any steps necessary or proper to secure the consent or approval, if necessary, of said The Hotel Waldorf*2131 Company to the execution of said leases, or any of them.

Severcool and Edmonds were not stockholders in the Catering Company nor as owners or lessees of the petitioner did they possess or control the dining room and kitchen and the equipment thereof which they undertook to lease to the Catering Company. The petitioner received all rentals from the Catering Company. After the execution of the agreement dated November 22, 1918, Severcool and Edmonds took no steps to secure the consent of the petitioner to the execution of the lease for the dining room, etc., but continued to treat the Catering Company as the petitioner's own lessee in all *434 respects as it had from the inception of the arrangement made in November, 1917.

On December 31, 1919, charges for salaries, rent, supplies, and current expenses appearing on the books of the petitioner against the Catering Company aggregated $43,211.79. The account for supplies arose from bills therefor presented to the petitioner by the Catering Company's bookkeeper, approved by the petitioner's officers and paid by the petitioner's checks. The large amount of indebtedness was due chiefly to a strike lasting for several months*2132 in 1919 and a consequent boycott against the dining room. The Catering Company was practically insolvent; it had no assets; it owned no equipment; its bookkeepers were unreliable; its books and records were unobtainable. Foard did not make reports concerning the business when requested and could not pay his own debts or those of the Catering Company when an accounting was demanded from him. Later, a search was instituted for the Catering Company's books, but they could not be found. On April 1, 1920, a notice to terminate the lease of the hotel dining room, etc., mentioned in the contract dated November 22, 1918, was sent to the Catering Company. That document was signed by Earl P. Severcool and Eldon B. Edmonds and by the petitioner.

The item of $4,956.29 covered replacements to Foard's cafeteria equipment made pursuant to the verbal contract of November, 1917. The amount was charged off as an operating loss during 1919. It was an expenditure for which petitioner was liable under the contract of November 22, 1918.

The respondent disallowed the item of $43,211.79 because the petitioner "was not obligated in any way to make good any deficit which might occur between the*2133 Waldorf Catering Company and stockholders of the [petitioner] corporation acting as individuals and creating personal obligations." The respondent disallowed the item of $4,956.29 because the petitioner "was not a party to the contract by virtue of which this amount was advanced to certain individuals."

The common stock of the petitioner was held as originally issued to Severcool and Edmonds and the nominal stockholders until April 2, 1920, when all the common stock was sold to James F. Keenan for the sum of $350,000. That sale was occasioned by the ill health of Edmonds' wife, who was ordered by her physicians to live in California. On December 31, 1919, the net worth of the petitioner, excluding the value of the leasehold covering the hotel property, was about $100,000 and was approximately the same at the time of the sale. Outstanding preferred stock amounting to $21,000 was *435 paid by Severcool and Edmonds out of the purchase price of $350,000. In four years of operation Keenan recouped the purchase price of $350,000 out of the profits of the hotel.

The petitioner operated a first-class commercial hotel in 1917. It had only one competitor, the Hotel Secor, *2134 and that hotel did not cater to exactly the same class of guests as did the petitioner. At the time of the acquisition of the leasehold by the petitioner there was a great demand for good hotel accommodations in Toledo. The terms of the lease secured by Severcool and Edmonds from the Waldorf Realty Company were extremely advantageous by reason of the fact that the lessor would not erect a hotel building for anyone but Severcool and Edmonds and did not desire to construct an office or commercial building provided Severcool and Edmonds would operate the enlarged hotel. The value of the leasehold as of February 19, 1917, was $200,000. The respondent disallowed the value claimed by the petitioner because satisfactory evidence in substantiation thereof had not been furnished.

OPINION.

VAN FOSSAN: The first two issues are based on the same principle and may be considered together. The respondent has disallowed the item of $43,211.79, representing a loss claimed by the petitioner in connection with the operation of its dining room by the Waldorf Catering Company. The respondent's action is based on the theory that the contract dated November 22, 1918, between Foard, Severcool*2135 and Edmonds and the Waldorf Catering Company was entered into by Severcool and Edmonds in their individual capacity and not as officers or agents of the petitioner. The evidence discloses unquestionably that this conclusion is erroneous. By their signatures to the document Severcool and Edmonds intended to obligate petitioner as a corporation, with secondary liability on themselves as guarantors. The testimony to that effect is amply corroborated.

The Foard Cafeteria and the Hotel Waldorf dining room had been conducted previously for many months as a joint enterprise under a verbal contract between Foard and the petitioner. From the inception of that contract in November, 1917, until the notice of termination dated April 1, 1920, all parties thereto recognized that it was not an agreement with Severcool and Edmonds individually but was the obligation of the petitioner and they so treated it. Furthermore, the actions of the petitioner, subsequent to November 22, 1918, exhibit not only a passive acquiescence and admission of its *436 obligations under the contract, but also an active ratification and confirmation of its participation in the rights and privileges enjoyed*2136 thereunder.

The item of $43,211.79 consisted of charges for unpaid rent of space used by the Catering Company, together with amounts advanced by petitioner for salaries, supplies and other expenses, none of which items could be collected by petitioner due to the insolvency of the Catering Company. Having ascertained the debt to be worthless, petitioner properly charged it off in 1919. The second item of $4,956.29 charged off in 1919 also arose from petitioner's obligation under its contract with Foard. It represented payments by petitioner on account of replacements of equipment. Both sums of $43,211.79 and $4,956.29 should be allowed as deductions in the year 1919.

The third issue relates to the valuation of the leasehold covering the improved and enlarged Hotel Waldorf, which Severcool and Edmonds sold to the petitioner on February 19, 1917. We have found that that lease was worth at least $200,000. For the purposes of invested capital and depreciation, the value of $200,000 for the Hotel Waldorf leasehold may be taken as a basis of computation as of February 19, 1917.

The fourth issue, relating to special assessment, will be automatically disposed of by the allowances*2137 herein made.

Judgment will be entered under Rule 50.