1949 U.S. Tax Ct. LEXIS 16">*16
The petitioner corporation, which kept its books on the cash basis, owned substantially all land comprised in a California reclamation district. The district had outstanding 2,000 6 per cent bonds of $ 1,000 face value each, payable from the proceeds of improvement taxes assessed against the land. The petitioner and its only shareholders, husband and wife, and holding companies wholly owned by the shareholders held 1,680 of the district's bonds at the beginning of the fiscal year 1944 and acquired 310 more about the middle of the year. To pay interest on the bonds, the reclamation district, through the county treasurer, made assessment calls which petitioner paid during the year, and, deducting such payments as taxes, it computed a net operating loss for the fiscal year 1944 which it claims as a carry-back deduction for the fiscal year 1942.
(1) A revenue agent's report addressed to the petitioner, in which the tax payments were allowed as deductions,
(2) Amounts paid on call of the county treasurer as taxes to meet interest on bonds of a California public reclamation district,
13 T.C. 930">*931 The Commissioner determined deficiencies of $ 7,833.44 and $ 11,915.67 in petitioner's income tax for the fiscal years ended September 30, 1941 and 1942, respectively, and deficiencies of $ 4,565.41 and $ 1,687.10 in declared value excess profits tax for those respective years. In the original petition error was assigned in the determination that petitioner's books were kept on the cash basis, not on an accrual basis, and in the consequent disallowance of deductions claimed by petitioner on account of accrued taxes, payable but unpaid, to a California reclamation district. In a proceeding involving the fiscal years 1937 and 1939, Docket No. 109993, this Court decided like issues adversely to petitioner's contention while this case was pending, and after affirmance of that decision on appeal petitioner abandoned those assignments and amended its petition to claim a carry-back deductible in the fiscal year 1942 because of an alleged net operating1949 U.S. Tax Ct. LEXIS 16">*19 loss sustained in the fiscal year 1944. The Commissioner allowed no carry-back deduction, having computed a net income of $ 34,711.50 for the fiscal year 1944. In so doing he did not allow the deduction of taxes of $ 221,610.87 actually paid to the reclamation district in that year on the ground that petitioner owned all the land of the district and it or its stockholders owned substantially all the bonds of the district, so that petitioner's obligation to pay taxes and the district's obligation to pay interest on the bonds was lacking in substance. Petitioner contests the disallowance and the resulting determination that there was no net loss carry-back available as a deduction for the fiscal year 1942 under
13 T.C. 930">*932 FINDINGS OF FACT.
Petitioner, a Nevada corporation with principal office at Los Angeles, California, filed its income tax returns for 1949 U.S. Tax Ct. LEXIS 16">*20 the fiscal years ended September 30, 1941, 1942, and 1944 with the collector of internal revenue for the sixth district of California. Petitioner was organized on October 15, 1934, by A. Otis Birch and his wife, M. Estelle C. Birch, who transferred to it a 21,000-acre tract of land known as the Conaway Ranch and certain other property. On the same date Birch and wife also organized the Birch Securities Co. (hereinafter called Securities) as a Nevada corporation and transferred to it 1,594 bonds, each of $ 1,000 face value, issued by Reclamation District No. 2035 (California), certain stocks, and other assets. The two transfers comprised all of their property. On the same date they also organized the Birch Holding Co. (hereinafter called Holding); all shares of petitioner and Securities were transferred to it, and it issued 49 per cent of its shares to Birch and 51 per cent to Birch's wife. Birch was president and in control of the affairs of all three corporations. Securities and Holding were formed for convenience and conducted no business. Petitioner operated the Conaway Ranch, raising and selling crops and sheep.
The Conaway Ranch is situated in Yolo County, California, about1949 U.S. Tax Ct. LEXIS 16">*21 five miles from Sacramento. It was purchased in 1914 and thereafter enlarged by the Birch Oil Co., a partnership in which petitioner and his wife, the wife's parents, and Birch's nieces, hereinafter called the Hopkins sisters, held interests. At the time of the initial purchase the Sacramento and San Joaquin Drainage District, created under the laws of California, was making surveys in the area for a flood control project, and the reclamation board of the state later informed the Birch Oil Co. that if it would construct a levee across the ranch adjacent to a proposed Yolo bypass, an assessment would be made against all lands in the drainage district to pay for the construction and for flowage rights. Desiring to develop its land, the Birch Oil Co. later petitioned the supervisors of Yolo County to create a reclamation district which would comprise the ranch, and in April 1919 the supervisors approved the establishment of Reclamation District No. 2035. B. F. Conaway, Birch's father-in-law, C. Harold Hopkins, the husband of Birch's niece, and a local attorney were appointed district trustees. A program of improvements, estimated to cost $ 2,264,740, was authorized, and commissioners1949 U.S. Tax Ct. LEXIS 16">*22 were named who apportioned the cost of the improvements among lands in the district according to the benefits to be received, and filed with the treasurer of Yolo County assessments against the lands to meet such cost.
The Birch Oil Co., under direction of the district's engineer, constructed the improvements, which consisted of many miles of roadways, 13 T.C. 930">*933 canals, ditches, bridges, pumping plants, and other structures, at a cost of slightly over two million dollars. It financed the work, and after completion in 1924 received a warrant, dated January 5, 1925, directing that the district, through the treasurer of Yolo County, pay it two million dollars. On January 23, 1925, 2,000 bonds of the district, each of a par value of $ 1,000, were offered at auction to provide the necessary funds, and Birch purchased all of them, giving the $ 2,000,000 warrant in payment. These bonds bore 6 per cent interest, payable on January 1 and July 1 of 1925 and each year thereafter on presentation of an interest coupon to the county treasurer; 227 bonds were to mature on January 1 of 1935 and a like number on January 1 of each succeeding year, ending with maturity of the last 184 on January 1949 U.S. Tax Ct. LEXIS 16">*23 1, 1943. Principal and interest were payable out of moneys collected by the treasurer of Yolo County from assessments against the benefited lands, which assessments were to be deposited "into the main county treasury," but "credited to the bond fund" of the district, as provided by section 3480, art. II, ch. 1, title 8, Deering's Political Code of California.
Pursuant to a contract of 1924 Birch and wife purchased the Hopkins sisters' interests in the ranch and Birch Oil Co., and in 1926 they purchased the wife's parents' interest. By virtue of these acquisitions and the purchase of small adjacent parcels of land they came into ownership of the entire ranch, then consisting of about 21,000 acres. The ranch was coterminous with Reclamation District No. 2035, except for 1,300 ranch acres which lay outside the district and 240 district acres which lay outside the ranch. In buying the interests of the Hopkins sisters, Birch paid them $ 1,000 cash and 786 district bonds. Simultaneously, he and his wife agreed to buy back from them the 786 bonds at face value in specified annual installments on January 1 of each year from 1926 to 1934, and as security for performance they placed their1949 U.S. Tax Ct. LEXIS 16">*24 remaining 1,214 bonds with trustees empowered to sell and make good any default by them on the contract. The Hopkins sisters, however, reserved the right not to sell on any installment date. During the first 6 years petitioner and wife paid for and received 476 bonds, as contemplated by the contract. Because of financial difficulties they thereafter ceased to purchase installments of the remaining 310. But instead of invoking action by the trustees, the Hopkins sisters granted them a time extension without release from the obligation to buy. Prior to 1937 petitioner and wife sold 10 of their district bonds to Lula Minter, a cousin of Birch, and 86 to the Great Republic Life Insurance Co., of which Birch was president and a director.
During the years 1925-1930 Birch and wife paid to the county treasurer of Yolo County on call of the assessment against the ranch 13 T.C. 930">*934 the amounts necessary to meet interest payments on the bonds, and the Hopkins sisters collected their interest from the treasurer on presentation of the matured coupons. In succeeding years Birch bought the coupons of the Hopkins sisters as they matured, and deposited them with the treasurer, receiving a receipt1949 U.S. Tax Ct. LEXIS 16">*25 and credit on the assessment against the ranch. After petitioner acquired the ranch in 1934, it too purchased at face value matured interest coupons from the Hopkins sisters and from Lula Minter, turning them in to the county treasurer. It did not buy matured coupons on the 86 bonds held by the insurance company, and that company's successor in interest eventually brought suit to enforce collection of interest. The suit was settled by petitioner's purchase of the 86 bonds and accrued interest in 1940 for $ 65,000.
No amount was ever paid into the reclamation district by Birch and his wife or by petitioner for the purpose of paying off the bonds. But prior to maturity of the first 227 bonds and in 1935 the original issue was refunded by 2,000 new 6 per cent bonds of $ 1,000 face value, of which 50 were to mature on January 1 of 1945 and of each succeeding year. To test the legality of the original issue the district trustees filed a complaint with the Superior Court of Yolo County, and after consideration of the evidence the court on March 2, 1925, entered a decree that "said bonds are a valid, legal obligation of said Reclamation District No. 2035 * * *." The refunding bonds 1949 U.S. Tax Ct. LEXIS 16">*26 were likewise held a legal obligation of the district by decree entered in a similar proceeding on June 25, 1935. The proceedings were not contested.
Since organization petitioner has operated the Conaway Ranch, and has borne all costs and expenses of maintaining and operating the improvements of the reclamation district, treating such disbursements as part of its expenses in operating the ranch in a manner which would be no different if there were no reclamation district, whether formal or actual, and the district has no expenses which are not taken care of by petitioner. For its ranch operations petitioner keeps a set of books on the basis of cash receipts and disbursements.
The officials of California counties are lenient with the owners of assessed lands in reclamation districts, and, while there was no express agreement, the treasurer of Yolo County refrained, in and after 1937, from making any calls on petitioner for payments or declaring defaults or taking foreclosure action against the ranch, being aware that petitioner was in no position to pay an assessment. Petitioner nonetheless accrued on its books and deducted on its income tax returns an amount of $ 120,000 a year1949 U.S. Tax Ct. LEXIS 16">*27 for which a call could have been made to provide the county treasurer with moneys necessary for the payment of the annual 6 per cent interest on the $ 2,000,000 face 13 T.C. 930">*935 value bonds. It continued to buy at face value the maturing interest coupons on the 310 bonds of the Hopkins sisters and the 10 bonds of Lula Minter, paying $ 18,600 and $ 600 a year, respectively, for them. The Commissioner allowed a deduction of the $ 600 paid to Lula Minter, but disallowed the rest of the $ 120,000 claimed. Petitioner contested such disallowances for 1937 and 1939 in a proceeding before the Tax Court, Docket No. 109993. The Court held that the $ 18,600 paid to the Hopkins sisters was deductible, and sustained disallowance of the rest. Memorandum opinion entered April 20, 1944; affd. Jan. 6, 1946
On September 30, 1943, petitioner held the 86 bonds acquired from the life insurance company; Securities held the 1,594 transferred to it at organization; 1949 U.S. Tax Ct. LEXIS 16">*28 the Hopkins sisters held 310 subject to the sale contract with Birch and wife; and Lula Minter held 10. On March 15, 1944, Birch and wife bought the remaining 310 bonds from the Hopkins sisters, and before the close of the fiscal year on September 30, Securities was liquidated and dissolved. Securities had been suspended since 1938 for failure to pay a state tax. Thus at the close of the fiscal year 1944 Birch and wife held directly 310 of the 2,000 bonds of the district; Holding held 1,594 from the liquidation of Securities; petitioner held 86; and Lula Minter 10. In March 1943 petitioner and Birch and wife gave to several individuals a written option to purchase the Conaway Ranch and all the district bonds.
During the period 1937 until late in 1943 petitioner made no cash payment to the county treasurer to provide interest on the bonds and received no call to make a payment. In 1943, however, funds became available to it, and on October 13, 1943, the treasurer made a call for $ 58,565.92, payable November 12. Petitioner advised the treasurer that it could not pay the amount until later and would submit to a delinquency penalty. In reply the treasurer explained that the penalty1949 U.S. Tax Ct. LEXIS 16">*29 was "part and parcel of the Call" which was "for interest only." On December 28, 1943, Securities transmitted to the treasurer coupons from 166 bonds and advised that the trustees for the Hopkins sisters would present coupons from 1,278 bonds. It requested remittance of $ 49,320 to cover the accrued interest. The following day petitioner paid the assessment call and a penalty of $ 5,856.59 by its check for $ 64,422.51 drawn in favor of the county treasurer, and the treasurer remitted $ 49,320 interest to Securities on January 8, 1944. On April 10, 1944, the treasurer made another call, for $ 53,721.65, payable May 10. Petitioner paid this call and a 10 per cent delinquency penalty of $ 5,371.94 by its check for $ 59,093.59 dated June 28, 13 T.C. 930">*936 1944. On August 12, 1944, petitioner gave to the treasurer its check for $ 37,325.28 in satisfaction of the unpaid portion of a call dated December 1, 1935, together with penalty. Before making this remittance petitioner inquired of the treasurer by letter if the treasurer would pay the interest coupons in arrears upon receipt of the amount. On September 20, 1944, it paid the treasurer $ 60,769.49 in satisfaction of a call dated September1949 U.S. Tax Ct. LEXIS 16">*30 8, 1944. In making calls, the treasurer computed an amount which, with any balance on hand, was sufficient to provide $ 60,000 for the semiannual interest due on the bonds, and amounts paid as penalties were reflected in his computations. The four payments which petitioner made during its fiscal year 1944 aggregated $ 221,610.87. Soon after the collection of money by call the treasurer paid interest on the bonds, but no interest was ever paid without such preceding collection.
On its tax returns for the fiscal years ended September 30, 1941 and 1942, petitioner claimed a deduction of $ 120,000 on account of the tax due Reclamation District No. 2035, and for each year the Commissioner disallowed the deduction "except as to $ 19,200 paid to the Hopkins sisters and Miss Minter." On July 7, 1947, after affirmance of this Court's decision in Docket No. 109993, petitioner paid to the collector $ 12,398.85 on account of the deficiencies determined in its income and declared value excess profits taxes for the fiscal year 1941. As there had been no assessment of the determined deficiencies, the payment was credited by the collector to a suspense account and not applied in satisfaction 1949 U.S. Tax Ct. LEXIS 16">*31 of a tax. On its return for the fiscal year ended September 30, 1944, petitioner claimed a deduction of $ 118,890.87 as taxes paid to Reclamation District No. 2035, and reported a net loss of $ 84,179.37 for the year. In a report dated January 23, 1947, addressed to petitioner, the revenue agent in charge of the Los Angeles division recomputed a net loss of $ 186,899.37 for the year, and, in so doing, allowed a deduction of $ 221,610.87, or the amount actually paid to the treasurer of Yolo County on account of the district taxes and penalties. In a subsequent report, dated December 8, 1947, deduction of the $ 221,610.87 was disallowed on the ground that:
* * * there was no real or actual obligation outstanding against the taxpayer, since Reclamation District No. 2035 was comprised exclusively of the taxpayer's property, and since A. Otis Birch and his wife, Estelle Birch, the sole stockholders of the Birch Ranch and Oil Company hold substantially all the bonds of the Reclamation District.
* * * *
As the interest received by A. Otis Birch and his wife, Estelle Birch, is nontaxable, the amounts claimed as taxes paid by the Birch Ranch and Oil Company is considered non-deductible.
1949 U.S. Tax Ct. LEXIS 16">*32 As a consequence of this disallowance, the Commissioner determined that petitioner had no net loss carry-back from the fiscal year 1944 to the fiscal year 1942.
13 T.C. 930">*937 OPINION.
Petitioner charges the Commissioner with error in failing to allow the deduction of a net operating loss carry-back in the computation of its income and declared value excess profits taxes for the fiscal year ended September 30, 1942, by virtue of a net operating loss of $ 186,899.37 sustained by it for the fiscal year ended September 30, 1944. Originally petitioner also assigned as error the Commissioner's disallowance of the unpaid portion of a deduction of $ 120,000 claimed on each of its returns for the fiscal years 1941 and 1942 as accrued taxes payable by it to Reclamation District No. 2035. When the petition was filed, a similar issue was pending before this Court in Docket No. 109993, involving petitioner's right to deduct the same accrued liability of $ 120,000 for each of the fiscal years 1937 and 1939. This Court's holding that petitioner's books were kept on a cash basis and that it was entitled to deduct only the $ 18,600 paid to the Hopkins sisters and the $ 600 paid to Lula Minter was 1949 U.S. Tax Ct. LEXIS 16">*33 affirmed by the Circuit Court of Appeals for the Ninth Circuit on January 6, 1942, as reported at
At the first hearing of this proceeding, on June 30, 1947, petitioner, accepting the holding that its books were kept on the cash basis, conceded that there were deficiencies in tax as determined for its fiscal years 1941 and 1942, but asked the Court to provide in its order that the tax liability for the fiscal year 1942 be computed to reflect the carry-back of losses sustained by it in the fiscal year 1944. Rejecting respondent's contention that a decision of deficiencies in the amounts determined be entered without adjustment for any carry-back, this Court, in a memorandum opinion entered March 24, 1948, took note that petitioner's right to a carry-back was properly raised as an issue and held that such issue was a proper subject for decision. Petitioner then moved to reopen the case for the purpose of presenting evidence relative to its net operating loss for the fiscal year 1944. This motion was granted, and petitioner thereafter amended its petition to make allegations concerning the payments made to the county treasurer and to plead1949 U.S. Tax Ct. LEXIS 16">*34 that the respondent was estopped to deny the deduction of these payments in the fiscal year 1944. The issue thus raised for decision requires a determination of petitioner's right to deduct as taxes in the fiscal year 1944 the $ 221,610.87 which it paid in that year to the treasurer of Yolo County on calls under the tax assessment of the reclamation district against the Conaway Ranch.
In a report dated January 23, 1947, addressed to petitioner, the revenue agent in charge of the Los Angeles division allowed the deduction in question and computed a net operating loss of $ 186,899.37 for the fiscal year 1944. Petitioner now argues on brief that, since it paid the deficiencies of $ 12,398.85 determined (but not assessed) for the 13 T.C. 930">*938 fiscal year 1941 in reliance on this report, respondent should be estopped from denying it the advantage of the carry-back deduction therein recognized as allowable for the fiscal year 1942, which deduction it anticipated in making the payment. The agent's first computation was reversed, however, and in a later report, dated December 8, 1947, the payment of the $ 221,610.87 was not allowed as a deduction, with the result that the net loss for 19441949 U.S. Tax Ct. LEXIS 16">*35 was converted into a net income of $ 34,711.50. As a consequence the Commissioner determined that there was no loss carry-back from the fiscal year 1944 available as a deduction for the fiscal year 1942.
We fail to perceive in the Commissioner's action any basis whatever for an estoppel. The amount of the deficiency for the fiscal year 1941 was in nowise affected by any deduction on account of a loss carry-back to which petitioner might or might not be entitled for 1942. Petitioner had no right, under the decision in Docket No. 109993, to deduct in 1941 taxes due to the reclamation district which it had accrued but not paid. It so admits by abandoning all issues relating to the fiscal year 1941. There was hence no issue raised as to 1941 about which the Commissioner's action could have misled petitioner, and in any event the payment was not applied to the 1941 deficiencies, which have not yet been assessed, but was placed in a suspense account.
By
(E) taxes assessed against local benefits of a kind tending to increase the value of the property assessed; but this paragraph1949 U.S. Tax Ct. LEXIS 16">*36 shall not exclude the allowance as a deduction of so much of such taxes as is properly allocable to maintenance or interest charges; * * *
As all of the $ 221,610.87 paid to the county treasurer was for application to interest charges, none of it is excluded as a deduction by the statutory exceptions, and respondent does not contend that it was. Its disallowance was explained in the agent's second report as follows:
This disallowance is based on the fact that there was no real or actual obligation outstanding against the taxpayer, since Reclamation District No. 2035 was comprised exclusively of the taxpayer's property, and since A. Otis Birch and his wife, Estelle Birch, the sole stockholders of the Birch Ranch and Oil Company hold substantially all the bonds of the Reclamation District.
Deductions from Gross Income. In computing net income there shall be allowed as deductions: (b) Interest. -- All interest paid or accrued within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations * * * the interest upon which is wholly exempt from taxes by this chapter. 13 T.C. 930">*939 1949 U.S. Tax Ct. LEXIS 16">*37 (c) Taxes -- Generally. -- (1) Allowances in general -- taxes paid or accrued within the taxable year except -- (a) taxes assessed against local benefits of a kind tending to increase the value of the property assessed.
As the interest received by A. Otis Birch and his wife, Estelle Birch, is nontaxable the amount claimed as taxes paid by the Birch Ranch and Oil Company is considered non-deductible.
Respondent, now defending the disallowance on both the above grounds, argues, first, that the Birches, the petitioner, and the reclamation district were all one and the same in substance, since petitioner owned all the assessed land in the district, the Birches through Holding owned all the stock of petitioner, and they and petitioner owned substantially all the bonds of the district. On this background he reasons that in effect the same party paid the taxes in controversy and received the tax-exempt interest which those taxes supplied. He urges that under such circumstances the district should be ignored for tax purposes as a legal fiction, and that the tax and interest payments should be disregarded as not having any business purpose and not discharging any real legal obligation.
1949 U.S. Tax Ct. LEXIS 16">*38 To buttress this view, respondent cites numerous sections of the Political Code of California, part 3, title 8, ch. 1, art. 2, relating to reclamation districts, pointing out that section 3472 authorizes the formation of a district without the intervention of trustees by parties owning all the land affected; that section 3480 empowers the landowners of those districts which are under trustees to authorize bonds by vote; requires that 10 per cent of any bonds issued be retired within ten years of issuance; that a fund be created for such retirement; that parcels of land be sold to provide delinquencies in assessment payments; that the district's bonds may be used in satisfaction of assessments; and that section 3493 permits owners of 50 per cent of the land to dissolve the district. He concludes that Reclamation District No. 2035 was in fact, if not in form, a private district; that in actual operation it was treated as a private district, because no assessment taxes were paid from 1937 to 1943, no sinking fund was created, and the fiction of a public district was artificially kept alive to the end that petitioner might deduct the amount which it paid as taxes, which amount it or 1949 U.S. Tax Ct. LEXIS 16">*39 its two stockholders received back as tax-exempt interest.
The essential factual premises or inferences which respondent assumes for this argument are not adequately supported by the evidence. We can disregard as negligible the 240 district acres which petitioner did not own and against which an assessment for bond interest apparently was not made, but we can not lightly ignore a public district invested with taxing powers and other sovereign attributes and the substance attaching to the very large number of bonds which were 13 T.C. 930">*940 held by parties who had no identity of interest with the Birches and whose right to bond interest was consistently observed -- in one case, after threat of suit. The Hopkins sisters acquired 786 of the 2,000 bonds in 1925; they owned 310 from 1931 to March 15, 1944, or during 5 1/2 months of the fiscal year 1944. At an undisclosed date the Birches sold 86 bonds to the Great Republic Life Insurance Co., and its successors sold these bonds to petitioner in 1940; the Birches sold 10 bonds to Lula Minter, who held them throughout the fiscal year 1944. Petitioner regularly paid to the Hopkins sisters and to Lula Minter the amount of accrued current interest1949 U.S. Tax Ct. LEXIS 16">*40 due them, receiving and turning over the interest coupons to the county treasurer. By so doing it acquired a credit in the same amount on the district's assessment for interest (see sec. 11, art. II, ch. 1, title 8, part 3, Political Code of California), and hence it is not technically correct to say that no assessment taxes were paid from 1937 to 1944. An amount of $ 19,200 was paid each year, and, under this Court's decision in Docket No. 109993, the amounts so paid were deductible.
Without formally pleading
Respondent cites
Respondent correctly asserts that in numerous cases deductions such as interest have been held unallowable where it appeared that the payor and payee were economically identical, 1949 U.S. Tax Ct. LEXIS 16">*43 e. g.,
Respondent argues further that the "payments of interest on reclamation bonds" were the payment of interest on indebtedness incurred and continued to purchase and carry tax-exempt obligations, and hence such payments are not deductible under
We hold that the Commissioner erred in failing to allow the deduction of the taxes of $ 221,610.87 paid by petitioner in the fiscal year 1944, and that1949 U.S. Tax Ct. LEXIS 16">*45 the amount of petitioner's net operating loss for that year, available as a carry-back to the fiscal year 1942 under the provisions of
* * * a determination of a disallowance of a deduction claimed by the petitioner for the taxable year 1944 in the amount of $ 221,610.87 for alleged taxes or interest paid, and that as a result of such disallowance the respondent has found and determined that petitioner had no net loss carry-back from 1944 to the taxable year 1942; * * *
As no factor of computation other than treatment of the $ 221,610.87 taxes paid was put in issue, the effect of this decision is limited to a deduction of those taxes in arriving at the amount of net operating loss for the fiscal year 1944 and the carry-back available as a deduction for the fiscal year 1942.
