Watson v. Commissioner

*466 This proceeding is for the redetermination of a deficiency of $6,389.02 in income tax for 1924. The question presented is whether a certain instrument, transferring personal property and operating rights in a bus line owned by the petitioner to the Pickwick Stages, a corporation, was an agreement of lease or sale.

FINDINGS OF FACT.

Prior to 1923 the petitioner was engaged in operating a bus line between Los Angeles and Santa Ana, Calif. On or about November 13, 1922, the petitioner agreed to sell his franchise and busses to the Pickwick Stages, Northern Division, a California corporation, for approximately $100,000. Prior to the consummation of the sale it was intimated by the Railroad Commission*1639 of the State of California, which body regulated the operation of common carriers within the State, that it would disapprove the proposed transfer. As a result of the Commission's attitude the agreement of November 13, 1922, was canceled and a second agreement was entered into by the same parties on or about February 21, 1923.

The second contract, drafted pursuant to suggestions of the Railroad Commission, which is practically the same in its terms as the first one, except that it is called a lease, provides in part as follows:

THIS LEASE AND OPTION, entered into in triplicate this 21st day of February, 1923, by and between A. B. Watson, doing business under the fictitious name and style of "Crown Stages", as Lessor, and Pickwick Stages, Northern Division, a California corporation, as Lessee,

*467 WITNESSETH:

Whereas, the parties hereto have heretofore entered into a certain conditional sales and purchase agreement for the sale by said Lessor to the said Lessee of certain personal property and operating rights, hereinafter more particularly described, and dated the 13th day of November, 1922, and, whereas, the parties hereto have heretofore sought the approval of the*1640 Railroad Commission to said agreement and a transfer pursuant thereto, all as recited and set forth in Application No. 8431, made to the Railroad Commission of the State of California by said parties, and, whereas, it is now desirable to change and alter the terms of said agreement, and, whereas, the parties hereto are now agreed as to what the terms of said transaction should be,

Now THEREFORE, IT IS HEREBY MUTUALLY AGREED by and between said parties as follows:

1. That said agreement of November 13th, 1922, be and the same is hereby canceled and annulled.

2. That subject to the approval of the Railroad Commission of the State of California, and in consideration of the payment by said Lessee at the times and in the manner hereinafter provided of the rental hereinafter set forth, and of the faithful performance of the terms of this Lease upon the part of said Lessee, said Lessor has leased, let and demised, and does hereby lease, let and demise to said Lessee for the period commencing on the tenth (10th) day after this Lease shall have been approved by the Railroad Commission of the State of California, and ending forty-seven (47) months thereafter, all of the personal property, *1641 automobile equipment and operative rights, known as the Los Angeles-Santa Ana division, for the transportation of passengers and express matter, as more specifically described and set forth in Exhibits A, B and C annexed hereto and by this reference hereby made a part of this Lease.

3. That the rental for said term shall be One Hundred Nine Thousand Nine Hundred ($109,900.00), which sum the Lessee hereby agrees to pay or cause to be paid to said Lessor, and said Lessor to accept in the following installments, to wit: Ten Thousand Dollars ($10,000.00) upon the execution of this agreement, receipt whereof is hereby acknowledged, Twenty Thousand Dollars ($20,000.00) within ten (10) days after the approval of this agreement and the terms thereof by the Railroad Commission of the State of California, and before taking possession, and Seventeen Hundred Dollars ($1,700.00) on the 15th day of each and every month thereafter until, by the monthly payments of $1,700.00 there shall have been paid to said Lessee [Lessor] the balance of said term rental of $109,900.00.

* * *

That on the payment of each monthly payment of $1,700.00 as above specified and agreed to be paid, the Lessor*1642 will execute and deliver to the lessee a transfer of one of the automobile busses described in Inventory "A", vesting in the lessee good and valid title thereto.

4. That contemporaneously with the execution of this instrument, the parties hereto hereby agree to join in an appropriate amendment to said Application No. 8431 to said Railroad Commission for permission to consummate this Lease, and in the event the approval of this Lease is finally refused by said Railroad Commission, this instrument shall be null and void, and pending the decision by said Railroad Commission upon said application, said Lessor shall operate said operative rights continuously.

* * *

6. That in the event of the approval of this Lease by said Railroad Commission, the exercise by said Lessee of said operative rights shall commence *468 as of midnight of the tenth (10th) day from and after the date of the order of said Railroad Commission approving this Lease.

7. That in such event, said Lessor agrees to cease the exercise by him of the said operative rights from and after the time last mentioned.

8. That it is mutually agreed that this Lease is entered into without warranty of title*1643 on the part of said Lessor.

* * *

17. That in the event said Lessee pays the said rental for the full period or term of this Lease, and during such term keeps and performs in the manner herein provided all of the other covenants of this Lease on the part of said Lessee to be kept and performed, then upon the expiration of this Lease, if Lessee desires so to do, it shall have and is hereby given and granted the sole and exclusive option and privilege of purchasing the said operative right and all of said property hereby leased, for the sum of One Dollar in cash, and upon such payment being made said Lessor agrees to execute, acknowledge and deliver to said Lessee an appropriate bill of sale or other instrument conveying to said Lessee all of said Lessor's then existing right, title and interest in and to said operative right, but without warranty of title thereto, and also to said personal property described in said Exhibits, as well as leasehold interest therein described.

* * *

23. In the event that the Railroad Commission of the State of California shall not approve this indenture and the terms thereof, then the lessor shall repay to the lessee the $10,000.00 above receipted*1644 for, without interest.

24. The lessee shall have no right, power, or authority to assign, sell, or transfer this indenture, or any of the property or rights therein described to any person, natural or artificial, prior to the full payment of the term rental, without the written consent of the lessor, except, however, that it may sell such automobile busses as it may have obtained title to under this indenture.

The omitted portions of the above agreement contain definitions of terms used in the instrument; provisions for filing a cancelation of schedules and tariffs by the lessor and the substitution of new schedules and tariffs by the lessee with the Railroad Commission; a covenant that the payment of the rentals and performance by the lessee shall be deemed conditions precedent to the exercise and enjoyment of the operative rights and property leased by the lessor; a covenant by the lessee that all its filings with the Railroad Commission shall contain a notation showing that the filing is made pursuant to the foregoing lease; a covenant that the lessee will exercise the operative rights in a lawful manner and in accordance with the rules, regulations and requirements of the*1645 Railroad Commission, in a manner that will not lessen the value of the operative rights and in such a manner as to obviate the granting of operating rights to competing parties; a covenant that lessee will notify the lessor of the filing or pendency of any suit, litigation, claim, hearing, or proceeding affecting said operative rights before any official body or court; a covenant that the lessor will not engage in or apply for operative rights covering any two points served by route mentioned in the above agreement; *469 a mutual covenant that any order made by Railroad Commission approving the execution of this instrument may contain a provision stating that approval is granted subject to all terms and conditions of said agreement; a covenant that lessee will pay all licenses, taxes and assessments upon the property leased; a covenant that lessor will save and hold harmless the lessee from any and all claims, demands, and damages arising out of or in connection with the operation of said line prior to date lessee takes over operation of said bus line; a covenant by lessee that upon default lessor may, at his option, terminate the agreement upon the 15th day after written notice*1646 of his intention to lessee; a covenant that upon exercise of the option by lessee, set forth in paragraph 17, supra, both parties will join in an appropriate application to Railroad Commission "for permission to consummate such sale"; a mutual covenant that lessee at his option may change the situation of depot premises at any point covered by said bus line; time is declared to be of the essence of this contract, and a ten-day default by lessee after written demand to pay rental or perform conditions herein contained permits the lessor (1) to declare balance of $109,900 term rental immediately due and payable, or (2) to terminate the agreement and take immediate possession of the operative rights and all property described in Exhibits B and C, mentioned in paragraph two, supra, and the then unpaid for automobile busses listed in Exhibit A, and thereafter to operate same as if this indenture had never been executed; a covenant by lessee that on taking possession it will pay to the lessor all sums then paid as rent for depot grounds and at that date unearned in addition to $109,900 rentals, with credits to lessee by lessor for advance rentals received from concession holders*1647 at bus terminals; a mutual covenant that the lessee after taking possession will accept and honor for transportation all tickets of lessor's issue, which said tickets will be paid for by the lessor at regular tariff rates of lessor.

The exhibits referred to in paragraph numbered two of the above agreement, inventoried, in Exhibit A, twenty Reo automobile busses; in Exhibit B, the depot facilities, furniture and fixtures at Orange, Anaheim, Fullerton, and Los Angeles, and also the operative rights held by petitioner and all rights which may be acquired under certain applications which were then pending before the Railroad Commission; in Exhibit C, the leases held by Watson covering depot facilities at Orange, Anaheim, Fullerton, and Los Angeles, together with subleases entered into by petitioner covering concessions at said depots.

After various hearings during 1923 covering the application by petitioner with respect to the above agreement, the Railroad Commission handed down a decision, effective March 1, 1924, approving *470 the transfer of petitioner's operating rights and equipment to the Pickwick Stages, Northern Division, as shown by the following excerpt from its*1648 order:

That the lease contract agreement between A. B. Watson, operating under the fictitious name and style of Crown Stages, and Pickwick Stages, Northern Division, a corporation, for the lease of operative rights for the operation of a stage line for the transportation of passengers and express packages between Los Angeles and Santa Ana, as more particularly set forth in Paragraph I of this order, be and the same hereby is approved, except as to any value placed on equipment, personal property, operative rights, good will or going concern value as appearing in the agreement made a portion of the application for transfer by lease contract and such statements of value shall never be claimed as having received the approval of this Commission before it or any judicial or regulatory body in any valuation or rate fixing proceeding, the values being only considered as those satisfactory to the contracting parties for the purpose of the agreement and in no wise binding upon or approved by this Commission in any other manner than the approval of the lease contract by which the line is transferred.

After approval of the transfer by the Railroad Commission the petitioner received $20,000*1649 pursuant to the terms of said agreement, and payments of $1,700 each month thereafter until the completion of the contract. With each monthly payment the petitioner delivered title to one of the twenty busses by signing over his State registration card to the lessee. No document or bill of sale passed between the parties other than the said agreement and the State registration cards aforementioned.

At or about the time the Pickwick Stages took over the line in 1924 the petitioner assigned certain depot subleases which he held to the lessee, so that Pickwick Stages would be in possession of the depot premises as tenant before the termination of the subleases, since some, if not all of the subleases, expired prior to the time of completion of the contract hereinabove set forth. Other than these assignments, petitioner conveyed the property covered by the lease and option agreement in accordance with the terms thereof. Pickwick Stages having taken over the general equipment of the line such as depot equipment and garages, etc., together with leases upon the depots, in 1924, and delivery of title to all the busses having been completed by the end of 1925, nothing remained to be*1650 transferred upon the event of exercise of the option except the franchise itself.

In 1928 the option to purchase the "operative right and all of said property hereby leased, for the sum of One Dollar in cash" was exercised by the Motor Transit Company, which said company was the assignee of Pickwick Stages, and after jointly petitioning the Railroad Commission, transfer of the franchise was effected. Until the exercise and completion of payments under the contract of said option there was no assurance that the petitioner would not be compelled *471 to repossess the operative rights, which would have necessitated reequipping the line for operation, and which would have required an outlay of capital of approximately $250,000.

In making his return for 1923, the petitioner did not report the $10,000 received at the time the agreement was executed, since he held this sum pending approval of the transaction by the Railroad Commission. Upon approval of the agreement in 1924 petitioner returned the initial payment of $10,000 as income from lease rentals received in 1924. The total income reported by petitioner on his return for 1924 as rentals received under the above contract*1651 was $38,047.47, designated therein, however, "profit on lease of Los Angeles Division." During the years subsequent to 1924 petitioner reported the rentals received under the above contracts in his returns for the respective years.

The respondent determined that the above transaction was a sale completed in 1924. Therefore, he reduced petitioner's net income by $38,047.47, and determined a capital net gain of $79,259.39, which resulted in a deficiency for 1924 of $6,389.02.

OPINION.

MORRIS: The issue presented by the pleadings is whether the respondent erred in determining that a profit of $79,259.39 was realized by the petitioner during the year 1924 from the alleged sale of certain personalty and bus line operative rights upon the theory that the agreement of lease entered into by the petitioner, under which the property is alleged to have passed, was in fact an agreement of conditional sale.

The petitioner owned, and was engaged in operating, a bus line, which in November, 1922, he agreed to sell, together with his franchise, to the Pickwick Stages, for approximately $100,000. Prior to the consummation of said sale the Railroad Commission of the State of California*1652 intimated that it would disapprove the transaction and consequently the agreement of sale was canceled. Another agreement was entered into, however, in February, 1923, entitled "Lease and Option Agreement," which was finally approved by the said Railroad Commission in March, 1924. The latter agreement, instead of providing for the outright sale of the properties, as did the former, let and demised the properties for a term of forty-seven months for a total rental of $109,900, payable $10,000 upon execution of the agreement, $20,000 after approval thereof by the Railroad Commission and $1,700 monthly until fully paid, the petitioner to transfer to and vest in the lessee valid title to one of the twenty busses, purportedly leased thereby, upon the payment of each of said monthly instalments, and should the *472 lessee pay said rental and otherwise perform the covenants of the alleged lease, then, it was given the option of purchasing said properties for the sum of $1 cash, the petitioner to deliver proper documents of title thereto.

We can not hold that a relationship of lessor and lessee resulted from the foregoing transaction, merely because of the legal*1653 form employed and the words used therein, when it appears more clearly that the parties obviously intended, and by their various acts and deeds accomplished, a sale instead. From the point of view of the taxing statutes we are more concerned with the practical and real effect of the things done than with the chosen means of their accomplishment, and this is especially true where they are wholly inconsistent with each other. In determining what is taxable income "substance rather than form is to be given controlling weight." , and . Any other rule would permit transactions otherwise taxable to escape taxation altogether merely through the proper choice of form and words.

What are the really substantial factors versus form? To begin with, one thing is clear and unmistakable and that is that the parties intended, and in fact attempted, to consummate an outright sale of these properties, but they were thwarted in their plans by the threatened disapproval of the Railroad Commission. That was their intention in November, 1922, as manifested by their acts, and although*1654 it is entirely possible that their intentions may have changed by the time the agreement of February, 1923, was consummated, there is not a scintilla of evidence in the record to that effect. Granted that their intentions did change, or more accurately stated, were changed, we are convinced that the changed intention ran only to the means and did not affect the ends sought, which were, to accomplish an outright sale. In fact there appears to have been very little deviation from their original plans. The consideration for the outright sale of the properties in the original agreement was "approximately" $100,000, whereas the total consideration, called rental, provided for in the agreement here considered was $109,900. It is highly possible, of course, that the two sums were identical, but the witness only stated "approximately" and we are limited by the record as made. The petitioner testified at the hearing that the agreement which was actually carried out was practically the same in its terms as the first agreement, except as to the use of the word lease.

The petitioner directs attention to the option clause of the agreement and he cites the following tests of conditional*1655 sales from in support of his contention that this was not a sale:

*473 With but few exceptions, the cases support the view that the essential elements of a conditional sale of personalty are a reservation of title in the seller, and an obligation upon the part of the buyer to accept and pay for the property in accordance with the terms of the contract, the title passing automatically upon the performance of that condition.

He does not contend, as he obviously could not consistently with his position, that he did not reserve the title in himself, but he does contend that there was no obligation upon the part of the buyer to "accept and pay for the property" except that it may desire to so do. This part of the test naturally, and of necessity, presupposes that the property has not already been paid for. Here, when the option was finally alleged to have been exercised the property had been fully paid for, at least that is the practical effect of what was done since only the payment of a nominal sum of $1 was exacted and paid in order to acquire all of the property under the agreement. Respecting the remainder of the test, that is, the*1656 obligation to accept the property under the terms of the agreement, to even assume that Pickwick Stages would have failed to exercise its option and accept the property thereunder after having fully and completely paid therefor defies all natural reason and logic. Thus the option clause, in our opinion, was perfectly meaningless from a practical point of view and does not render the real state of affairs inconsistent with a conditional sale as laid down in the above test. The said option clause is rendered even more meaningless when we consider paragraph twenty-four of the agreement, which provides that "The lessee shall have no right, power, or authority to assign, sell, or transfer this indenture, or any of the property or rights therein described to any person, natural or artificial, prior to the full payment of the term rental, without the written consent of the lessor, except, however, that it may sell such automobile busses as it may have obtained title to under this indenture." The logical deduction to be drawn from this language is that while Pickwick Stages could not dispose of the properties prior to the full payment of $109,900, after such payment it could. Therefore, *1657 if it was necessary for that company to exercise its option to purchase, before it became the rightful owner of the properties thereunder, why should the aforesaid paragraph inferentially grant the power to dispose thereof upon payment of the entire so-called rental? Furthermore, Pickwick Stages had taken over the general properties of the line, such as depot equipment and garages, etc., had received an assignment of all subleases upon depots and had received title to all of the busses long prior to the actual exercise of the option clause, constituting all of the petitioner's property with the exception of the franchise itself, so that, with the exception noted, no property *474 remained to be accepted under the option clause. Tested from every conceivable angle, the option clause appears to be nothing more than a provision to satisfy the State Commission.

It is well settled that "an interest in the reversion is necessary to the relation of landlord and tenant," ; *1658 . A reversionary clause, providing that the leased properties shall revert to the lessor at the end of the term, is commonly found in instruments where the relation of lessor and lessee is intended. There is not only no reversionary clause in the present agreement, but reversion, if such was ever intended, was rendered wholly improbable, except upon default, not only by the agreement itself but by the acts of the parties. For instance, it was agreed that if the lessee complied with the provisions of the lease the petitioner, upon termination thereof, would transfer the properties absolutely in consideration of the sum of $1. As we have already pointed out, it would be ridiculously illogical to assume that the option would not be exercised, thereby depriving the petitioner of any possibility of a reversion except, as just indicated, in case of default. Then, too, all of the properties except the franchise were transferred to Pickwick Stages within a short time after consummation of the agreement, so that there was nothing to revert.

We have carefully examined the authorities relied upon by the petitioner, but are unable to concede that they are controlling. *1659 In ; , the court said, "* * * when it appears from the terms of the instrument that the intention of the parties was to make a sale of the property, courts will give such construction to the instrument irrespective of the name by which the parties have designated it." See also ; ; ; ; ; ; ; and , specifically, or by necessary implication, holding that the intentions of the parties shall govern in determining whether a lease or a contract of sale resulted. See also , affirmed as to similar question here in controversy by the *1660 .

Viewing the intentions of the parties, the ends which they obviously sought to accomplish and the practical things done, we are of the opinion that a sale was effected and that the respondent correctly so held.

Decision will be entered for the respondent.