Alexander v. Commissioner

*50 The respondent determined an income tax deficiency in the amount of $72,967.04, against the estate of Kate H. Alexander, deceased, for the year 1934. The deficiency is due to four adjustments made by the Commissioner in the income tax return filed by Kate H. Alexander for the year 1934. These adjustments were stated in the deficiency notice as follows:

The Commissioner also made one adjustment in petitioners' favor, which was to allow as a deduction additional depreciation of $2,342.47. The only one of the foregoing adjustments which the petitioners contest is adjustment*743 (c), which is contested by an appropriate assignment of error.

*51 FINDINGS OF FACT.

The petitioners are the legal executors of the estate of Kate H. Alexander, who died on February 19, 1936, and is sometimes hereinafter referred to as the decedent. At the time of her death the decedent was the widow of A. J. A. Alexander, of Woodford County, Kentucky, who died on March 10, 1929. The return involved was filed with the collector of internal revenue for the district of Kentucky.

Early in the year 1938 Alexander had under negotiation the sale of a long term leasehold which he owned in the city of Chicago, Illinois, at a price of something like three-quarters of a million dollars. The convenience of long term leasehold property as an investment appealed to Alexander and it was his desire, in case of the sale, to reinvest the proceeds in like property in the city of Louisville, Kentucky. Pending the negotiation Alexander advised with officials of the Fidelity & Columbia Trust Co. (hereinafter called the trust company) in Louisiville respecting such an investment. Among other things, he told the officials that in case the sale of his Chicago property went through he*744 would have about three-quarters of a million dollars to invest in long term leasehold property in Louisville, and asked if they knew of any such property he could buy, or property he could buy and, in the same connection, effect a long term lease. At this time the trust company held title, for a syndicate here known as "Chambers & Jones," to a parcel of unimproved city property bordering on the east line of South Fourth Street, between Chestnut Street and Broadway, in Louisville, which was available for sale. Fourth Street is the principal business street in the city of Louisville. The parcel had a frontage of 132 feet on Fourth Street and a depth of 70 feet. It represented the unsold portion of a one-time larger tract (252 ft. X 200 ft.) which the syndicate purchased through the trust company in a prior year for exploitation purposes. Following this interview with Alexander the officials of the trust company took up with Chambers & Jones the proposition of offering to sell the tract to Alexander, under a contract to improve and take back under a ninety-nine year lease. The suggestion was favored by Chambers & Jones and several conferences between themselves, Alexander, and the*745 trust company officers followed, in which details for a contract were discussed and agreed upon. The terms agreed upon were put into a formal offer and submitted to Alexander in a letter dated February 17, 1928, by the Theatre Realty Corporation, a corporation organized by Chambers & Jones. The letter stated, among other things, that the Theatre Realty Corporation was owner of the property offered and proposed selling it to Alexander for the cash price of $792,000 upon certain conditions, including the following:

*52 Should you accept this offer it would be one of the considerations and conditions of the sale, that, immediately following the delivery of the deed to you, you as the landlord and we as the tenant would enter into a lease of said property covering a period of ninety-nine (99) years, and providing for an annual money rental of Forty-four Thousand Dollars ($44,000) payable each year in * * * monthly installments being payable in advance at the beginning of each month.

The lease would further provide:

* * *

(b) That simultaneously with the execution of the lease, and as security for the performance of the obligations therein undertaken by the tenant, the*746 tenant would deposit with the Fidelity and Columbia Trust Company, as Trustee under the lease, high grade securities to be approved by the Trustee and aggregating in market value at least Two Hundred and Fifty Thousand Dollars ($250,000). It would be provided that if the tenant improved said property with any building or buildings suitable for business purposes that then the Trustee would be authorized to sell a requisite portion of said securities and apply the proceeds of sale to the payment of the cost of said building or buildings, as same progressed, such payment being made upon the authority of the architect in charge of the construction.

Alexander accepted the offer on February 18, 1928, by endorsement across the bottom of the letter, and thereafter paid in cash the consideration named. He received title to the property, through conveyance, by deed from the Theatre Realty Corporation dated March 17, 1928. On the same date and coincidental with said transfer, Alexander and wife, as "landlord", the Theatre Realty Corporation, as "tenant", and the trust company as "trustee", entered into a ninety-nine year lease of the property to begin March 27, 1928, and end March 27, 2027, upon*747 terms in conformity with the offer of sale. The lease provided annual rentals in amount of $44,000, in stated monthly installments payable in advance on the first day of each month, beginning April 1, 1928. It also bound the tenant to pay all taxes and other charges which might become a lien upon the property, and contained the usual forfeiture clause made in conventional long term leases giving the landlord the right, at his election in case of default on the part of the tenant, to reenter and retake possession of the premises, to hold the tenant liable for all unperformed monetary obligations with interest at 6 percent, and, as liquidated damages, to be entitled to the ownership of all improvements placed on the property by the tenant and to all cash, securities, and other property in the hands of or on deposit with the trustee.

The lease recited, as a condition of the offer already performed, the following:

Simultaneously with the executing of this lease and as security for the performance by the Tenant of the obligations herein by it undertaken, the Tenant has agreed to deposit and has deposited with the Trustee high grade securities approved by the Landlord and the Trustee*748 and aggregating in market value at least Two Hundred Fifty Thousand Dollars ($250,000).

*53 On the subject of improvements, the lease provided as follows:

SECTION 1. The Tenant shall have the right to erect upon the leased property, or any portion thereof, any building or buildings or other improvement which in the opinion of the Trustee would be a suitable utilization of the leased property for business purposes.

* * *

The Theatre Realty Corporation took possession under the lease and erected a two-story business and office building on the premises at a cost of $253,778.24, completing the same about March 1, 1929. On March 10, 1929, Alexander died, leaving a will under which his widow, Kate H. Alexander, the decedent, became owner of the property as devisee. The interest which Alexander owned in the property at the time of his death was valued by the Commissioner for Federal estate tax purposes at $792,000.

The lessee operated the property until June 20, 1932, on which date, in order to relieve itself from liability for rent and other money obligations as tenant, it sold and assigned the lease to the Mercantile Realty Co., an insolvent corporation. The latter*749 corporation took possession of the building, rewrote the leases with all subtenants, and began at once the collection of rentals from the lessees, as their lessor. It paid no rent, however, to the owner of the premises and the lease was in default at all times after said assignment. Kate H. Alexander refused to recognize the assignment of the lease and brought suit on August 23, 1932, in the state court to have the same set aside and to hold the Theatre Realty Corporation liable as tenant under the lease terms. In the meantime, after some negotiations between the attorney for Kate Alexander, and the Mercantile Realty Co., the latter delivered over the leased property to the Kentucky Title & Trust Co., as agent for Kate H. Alexander, in an assignment executed by its president on May 20, 1933. This assignment is headed "Assignment of Lease" and reads as follows:

WHEREAS, Mercantile Realty Company, a corporation, lessor, party of the first part, has executed the following leases of the Theatre Building, at South Fourth Street, Louisville, Kentucky:

[Here follows the names and descriptions of the subleases which were assigned. The subleases were all of space in the building herein*750 involved and need not be set out in detail.]

Now, THEREFORE, for a valuable consideration, the receipt of which is hereby acknowledged, the said lessor, party of the first part, hereby assigns and transfers to Kentucky Title Trust Company, Agent, party of the second part, each and all of said leases with all rights, benefits, privileges and covenants contained therein, with the further right to collect any past, present or future rent from the said lessees and to pay the rents to the owner of said real estate.

IN WITNESS WHEREOF, the parties of the first and second parts have hereunto signed their names and affixed their corporate seals this 20th day of May, 1933.

The Mercantile Realty Co. never repossessed itself of the leased property and at all times here shown after the latter date, it was *54 held and controlled by the Kentucky Title & Trust Co., as agent for Kate H. Alexander.

On April 25, 1933, Ernest S. Clarke, trust officer of the Kentucky Title & Trust Co. of Louisville, wrote a letter to C. N. Manning, president of the Security Trust Co., Lexington, Kentucky, who was acting for Kate H. Alexander, in which he stated:

I have asked our Mr. Brewer, in charge*751 of our Real Estate Department, to take charge of the Fourth Street property belonging to the estate of Dr. A. J. A. Alexander and manage same under the direction of Mr. W. W. Crawford, Attorney for the estate.

Mr. Brewer will give the matter his personal attention and has an appointment with Mr. Crawford for tomorrow morning and will proceed only as directed by Mr. Crawford.

On October 7, 1933, the lower court sustained the assignment of the ninety-nine year lease from the Theatre Realty Corporation to the Mercantile Realty Co., and the decision of the lower court was affirmed by the appellate court on March 23, 1934. Thereafter, under date of May 17, 1934, a contract of settlement was entered into between the Mercantile Realty Co., as first party, and Kate H. Alexander, individually, and Kate H. Alexander and the Security Trust Co., as executrix and executor, respectively, of the will of Alexander J. A. Alexander, parties of the second part, which provided, among other things, as follows:

Now, THEREFORE, for and in consideration of the release by the parties of the second part of the party of the first part from all liabilities and obligations of every nature and character*752 growing out of the aforesaid lease, including all liability for rent accrued or hereafter to accrue, or for the payment of taxes, insurance and any and all obligations of every kind and character incident to said lease, the party of the first part hereby delivers up and cancels and surrenders said lease and sells, assigns, transfers and conveys to the parties of the second part all of its right, title and interest in and to the aforesaid lease and property covered thereby and cancels the same and surrenders the same unto the parties of the second part. The parties of the second part hereby accept such surrender and cancellation and agree that such surrender and cancellation shall be in full satisfaction of all claims of whatsoever kind or character which have arisen or which are to arise by virtue of said lease, and it is agreed from this date that said lease shall be null and void and of no effect.

Kate H. Alexander died February 29, 1936, and as of that date the Commissioner of Internal Revenue valued the property for Federal estate tax purposes at $491,000. The property, including the building surrendered by the lessee, had no greater value than $491,000 at the time the Mercantile*753 Realty Co. surrendered the possession of the building to Kate H. Alexander in 1933 or at the time the Mercantile Realty Co. executed the formal written relinquishment of the lease, May 17, 1934.

The fair market value of the building erected by the tenant on the leased property was not less than $150,000 in May 1933, when *55 the Mercantile Realty Co. surrendered possession of it to Kate H. Alexander and was not less than that amount on May 17, 1934, when the formal relinquishment of the lease was executed. Kate H. Alexander included no amount in her income tax return for the years 1933 or 1934 to represent gain derived on account of the forfeiture of the lease and repossession of the building. The respondent holds that the agreement of May 17, 1934, was the incident which released to the taxpayer the untrammeled possession of the improvement and resulted in her realization of taxable gain to the extent of the value found. Upon this point the Commissioner states in the deficiency notice as follows:

It is held that upon cancellation of the lease on the Fourth Street property, and the acquisition by you of untrammeled title, possession and control of the premises, you realized*754 taxable income to the extent of the fair market value of the building erected on the property by the lessee, which has been determined to be $150,000.00.

OPINION.

BLACK: The petition contains only one assignment of error, and it is as follows:

The respondent erred in including in petitioner's income for the year 1934 on account of the cancellation of a ninety-nine year lease on property located in the City of Louisville, State of Kentucky, the sum of $150,000.00, which represents the respondent's alleged value, at the time of said cancellation, of improvements made on said property by the lessee.

The petitioners, who are the executors of the estate of Kate H. Alexander, in their brief advance several points in support of their contention that the estate should not be taxed with the $150,000 which the Commissioner has determined.

The most of these points and a considerable part of the brief are devoted to an effort to establish the proposition that the fair market value of the building was not income to the estate in any year. We shall not undertake to enumerate these arguments in detail, but simply say that we are not impressed by them. In our judgment, under the Supreme*755 Court's decision in , the fair market value of the building was clearly income to the decedent, to use the language of the court, "in the year of repossession." See also ; .

So in the light of the foregoing authorities, we think the important inquiry in the instant case is, what was the year of repossession? If that year was 1934, as respondent has determined, then we think the estate is taxable on the $150,000 in question, because there is really no dispute about the value of the building. The overwhelming testimony is to the effect that it had a value of at least $150,000 apart from the land.

*56 Petitioners dispute that 1934 was the year of repossession. One of their several points as to why the estate should not be taxed with the $150,000 in the year 1934 is that the lessee surrendered possession and enjoyment by assignment in 1933, and no gain was realized in 1934.

Petitioners on this point alleged facts in their petition as follows:

(k) On June 20, 1932, said The Theatre-Realty Corporation*756 assigned the said ninety-nine (99) year leasehold to the Mercantile Realty Company, a corporation, which paid no part of the rental of $44,000.00 per year during the period June 20, 1932 to May 17, 1934.

(k)(1) On May 20, 1933, the Mercantile Realty Company assigned, in writing, to the owner of the real estate, possession and enjoyment of the land and building.

l) Due to default of the Mercantile Realty Company, the lease was formally cancelled on May 17, 1934.

The evidence at the hearing established the correctness of the foregoing facts alleged in the petition. What is the legal effect of these facts? We think it is that the decedent came into the untrammeled possession and control of the building in 1933, although the lease was not formally canceled and annulled until 1934. It must be remembered that legal title to the building from the very moment of its erection vested in the owner of the land. It was only the possession of the land and building which was withheld from the landlord as long as the tenant exercised his privileges under the lease and managed and controlled the peoperty. When the tenant no longer exercised management and control of the property and surrendered*757 possession to the fee owner of the land and building, that surrender of possession and control became the occasion for the tax.

The lease in question became burdensome to the original lessee, the Theatre Realty Corporation, and on June 20, 1932, it assigned the lease to the Mercantile Realty Co., an irresponsible and insolvent corporation, for an alleged consideration of $250. Decedent refused to recognize the validity of this assignment and in 1932 entered suit in the Jefferson Circuit Court, Chancery Branch, Second Division, against the Theatre Realty Corporation, et al., seeking a declaration of rights under the lease and adking that this assignment be adjudged invalid and therefore fraudulent and void. On October 7, 1933, the court sustained the validity of the assignment of the lease from the Theatre Realty Corporation to the Mercantile Realty Co., and its decision was affirmed by the Court of Appeals of Kentucky, March 23, 1934.

Prior to the decision of the lower court on October 7, 1933, upholding the validity of the assignment of the lease to the Mercantile Realty Co. that corporation had surrendered all possession and*758 control of the building to the agent of Kate H. Alexander.

*57 On May 20, 1933, the Kentucky Title & Trust Co., as agent of Kate H. Alexander, took over from Mercantile Realty Co. by assignment all subleases on the property and took possession, and enjoyment of the property and since then has managed the property, paid taxes and all operating expenses, secured tenants, and collected all rentals and income and accounted therefor periodically to Kate H. Alexander or her legal representatives, as owners of the property. We think these facts fix the time of decedent's coming into untrammeled possession and enjoyment of the building as 1933, and not 1934, as the respondent has determined.

After May 20, 1933, who was disputing decedent's untrammeled right of possession and control of the premises? Certainly not the Theatre Realty Corporation, the original lessee. In 1932 it had assigned all of its interests to the Mercantile Realty Co. and thereafter disclaimed any ownership or control whatever over the leased property. Certainly not the Mercantile Realty Co., for on May 20, 1933, it assigned every sublease that it had taken on the peoperty to the agent of decedent, turned*759 the property over to the agent of decedent, and thereafter made no attempt to exercise any dominion and control over the building.

It is true that it was not until March 23, 1934, that the Court of Appeals of Kentucky affirmed the decision of the lower court, which upheld the validity of the assignment of the lease to the Mercantile Realty Co., and it was not until May 17, 1934, thereafter that the Mercantile Realty Co. formally delivered up and canceled the lease to decedent by a written instrument. This formal, written cancellation and surrender of the lease was, however, in our judgment no more than a recognition and affirmance of what had already been done in 1933, and can not be made the incidence of the tax.

Under these circumstances we think that the fair market value of the building was income to decedent in 1933 and not in 1934, as the Commissioner has determined. Cf. . See also , in which we said:

Therefore we do not regard as controlling the fact, so strongly relied on by petitioner, that its deed was not delivered until 1936, for the consummation*760 of a sale is not dependent upon delivery of a deed where, as here, the consideration was received and the benefits and burdens of ownership were transferred previously ; . * * *

In the recent case of , the question was whether the value of a building erected on the premises by the lessee was income to the lessor in the year when he regained control over the property. The court held that it was, *58 affirming a memorandum opinion of the Board to the same effect. Among other things, the court said:

* * * While the petitioners make much of the argument that the trustees would not give up the old lease until a new one was agreed to, none the less the agreement of Gowern and his co-owners was necessary to bring the new lease into being. The owners had control of the property for that purpose and it is that control which makes the gain to the owners taxable under Section 22(a), not a medieval conception of an instant in time in which the owner of land may re-enter and take possession. *761 The owner has control and dominion of improvements when he procures a lease for them and presently rents them. * * * [Italics ours.]

In the instant case, after May 20, 1933, Kate H. Alexander, through her agent, collected all rents from the subtenants of the building, had the right to negotiate all new leases for vacant space therein, paid all taxes, and otherwise exercised complete control and dominion over the building and premises. Therefore, it seems clear to us that on May 20, 1933, the benefits and burdens of the building passed to her and then was the incidence of the tax, and not in 1934, when the Mercantile Realty Co. executed a formal written relinquishment of the lease and premises.

We sustain petitioners on this point, and it is determinative in their favor of the only issue involved, because we do not have the year 1933 before us.

Decision will be entered under Rule 50.