After the loan was received, the Sewall Co. improved the property by making an addition to Building No. 4, which is know as Building No. 5. The cost of improvements and additions to the property totaled $ 92,741.59, and of this sum $ 42,044.19 was spent in the remaining 4 months of 1952 and $ 47,923.57 was spent the following year. During the 5-year period of the loan, Sewall Co. paid all taxes, insurance, and other expenses of maintaining the property.

Sewall repaid the RFC loan as follows:

1963 U.S. Tax Ct. LEXIS 106">*114 The final payment was made in August of 1957 and Haag immediately notified Sewall of his intention to exercise his option. He repurchased the property on September 1, 1957, and the same day agreed to lease the property once again to Sewall for $ 1,800 per month beginning that date. He had not received any rent or other compensation for use of the property during the 5 years in which the Sewall Co. had title.

The Sewall Co. received $ 72,000 in consideration for the conveyance to Haag of the property free and clear of any indebtedness. This was exactly what had been paid for the property 5 years before. The consideration consisted of the preferred stock, which had an agreed valuation equal to its then par value and fair market value of $ 52,000, $ 15,600 of accrued but undeclared dividends on the preferred stock, plus $ 1,872 interest accrued on the dividends, and Haag's check for $ 2,528. On September 1, 1957, the Sewall Co. had an income tax basis for this property of $ 85,611.29, but the fair market value of the property was then $ 150,000, as follows:

1963 U.S. Tax Ct. LEXIS 106">*115 40 T.C. 488">*492 ULTIMATE FINDINGS OF FACT

When Haag received his property back in 1957 with the improvements and additions thereon and with an accordingly increased valuation at the price agreed upon by the parties 5 years before, he received ordinary taxable income of $ 78,000, the difference between the then value of the property and the prearranged bargain price he was enabled to pay.

OPINION

It is well settled that our taxing system has ordinarily treated an arm's-length purchase of property as a nontaxable event, even though the purchase price is more or less than the value of the property purchased. Commissioner v. LoBue, 351 U.S. 243">351 U.S. 243 (1956); Palmer v. Commissioner, 302 U.S. 63">302 U.S. 63 (1937); Elverson Corporation, 40 B.T.A. 615">40 B.T.A. 615 (1939), affd. 122 F.2d 295 (C.A. 2, 1941). Under this general rule taxable income does not accrue until the purchaser sells or otherwise disposes of the property. 302 U.S. 63">Palmer v. Commissioner, supra.

It is equally well established that in the tax field the outward appearance of a transaction is not always 1963 U.S. Tax Ct. LEXIS 106">*116 determinative of its true character. The veil of form is often lifted in order to scrutinize carefully the entire transaction. Commissioner v. Court Holding Co., 324 U.S. 331">324 U.S. 331 (1945), affirming 2 T.C. 531">2 T.C. 531 (1943); Shoenberg v. Commissioner, 77 F.2d 446 (C.A. 8, 1935), affirming 30 B.T.A. 659">30 B.T.A. 659 (1934); Jacobs v. Commissioner, 34 F.2d 233 (C.A. 8, 1929). This principle has been applied by both the courts and the regulations to a purchase at a bargain price when the parties involved have a special relationship such as stockholders ¹ or employees. ²

1963 U.S. Tax Ct. LEXIS 106">*117 In 351 U.S. 243">Commissioner v. LoBue, supra, the Supreme Court found that a stock option arrangement, although in the form of a purchase, was actually compensation, and in language particularly appropriate to the instant case stated:

But that is not to say that when a transfer which is in reality compensation is given the form of a purchase the Government cannot tax the gain under § 22(a). [Sec. 61(a), 1954 Code.] The transaction here was unlike a mere purchase. It was not an arm's length transaction between strangers. Instead it was an arrangement by which an employer transferred valuable property to his employees in recognition of their services. We hold that LoBue realized taxable gain when he purchased the stock.

We feel that we must examine carefully the substance rather than the form of the transaction in this case. Was the transfer here in reality compensation? Although the legal document is entitled a sales and option agreement, and the parties are related as corporation 40 T.C. 488">*493 and stockholder, the significant preexisting relationship is that of lessor and lessee. Haag rented the property to the corporation before the 1952 transfer and also1963 U.S. Tax Ct. LEXIS 106">*118 after he reacquired the property in 1957. When it became necessary for the Sewall Co. to hold title to the property, a substitute for the rental payments was devised. Since the corporation had no cash, the low option price was a favorable alternative. During the negotiations it became clear that E. B. Sewall, the majority stockholder, would not give up control of the company to get the loan. In like manner, the minority shareholder, Haag, was not willing to give up 5 years rent in order to obtain the loan for the company.

Although he was repeatedly pressed for an explanation of why the low option price was agreed upon, the only reasons given by Haag at trial for the inordinately low option price were that the company would be benefited by obtaining the needed loan, and that he would not have been interested in an option if he had no idea what he was going to pay for the property. E. B. Sewall also had no explanation as to why the company granted the bargain price option with all the facts known. He merely stated that the RFC loan would be beneficial because of the corporation's needs and that they felt "it was a good deal for the company at that time." We can only conclude, 1963 U.S. Tax Ct. LEXIS 106">*119 as we have, that it was for the purpose of compensating Haag for the corporation's use of the property and for his loss of rental income during the time title was held by the Sewall Co.

In place of rent over the 5-year period, Haag in effect received $ 15,600 in dividends on the preferred stock he acquired in 1952 and $ 1,872 in accrued interest thereon, plus the $ 78,000 of added value to the property. When spread over the 5-year period, this amounts to approximately $ 1,600 per month, if no interest factor is considered. Taking into account that Haag was also relieved of the costs of insurance, taxes, and maintenance during this period, the total he received is obviously comparable to the new rental of $ 1,800 per month at which the property was rerented to Sewall immediately upon exercise of the option.

Although not argued by the parties, our holding here would preclude the exclusion afforded by section 109 of the 1954 Code.

Petitioners argue that if a sale and repurchase is not found the transaction should be treated as a loan of the property with the option serving as the payment for the loan. They contend that the payment occurred in 1952 when the option was received and not1963 U.S. Tax Ct. LEXIS 106">*120 on its exercise in 1957. We are unable to concur in this line of argument. It is undisputed here that the market value of the property and the option price were the same when the option was given. The record convinces us that the parties did not contemplate or intend that the "option" was given to compensate Haag for the use of his property by Sewall40 T.C. 488">*494 for the 5-year period. It was merely a mechanical device to insure the return of his property to Haag after the RFC loan had been paid off. The intention of the parties was to compensate Haag for the use of his property by returning the improved and more valuable property to him at the end of the term when the "option" was exercised. The option itself was merely a cog in the financial arrangement machinery; it had no economic significance when granted.

The significant economic event occurred when Haag exercised his right to repurchase the improved and more valuable property at the predetermined bargain price. This was the taxable as well as the economic event and the substance of the entire transaction, of which the "option" was merely an incidental mechanical step. Even if we found the option to be bona fide and exactly1963 U.S. Tax Ct. LEXIS 106">*121 what it purports to be, which we do not, it was not intended to be compensation until its exercise in 1957, and therefore the bargain purchase is taxable in that year. Cf. Commissioner v. Smith, 324 U.S. 177">324 U.S. 177 (1945). The petitioners' reliance upon stock-option cases holding that some such options constitute compensation when received is misplaced, and the cases relied upon are distinguishable. We hold, instead, that the "option" was not bona fide, as such, but simply a part of the financial arrangement by which Haag was to be compensated for the loss of rent and for the use of his property until the loan from RFC was repaid.

We hold here that the transfer of the improved real property at a bargain price in 1957 has the characteristics of a deferred rental payment or other compensation for the use of petitioners' property and that the difference between the price paid and the then value of the property is taxable as income under section 61(a) of the Internal Revenue Code of 1954. Since the taxpayer is on the cash basis and the payment was not received by him until 1957, it is taxable in that year. Sec. 451(a), I.R.C. 1954.

We also hold, as the 1963 U.S. Tax Ct. LEXIS 106">*122 parties have agreed, that in view of our holding that the petitioners in Docket No. 91191 received compensation the Sewall Co. is entitled to a deduction of $ 13,611.29 for its 1958 year.

Decisions will be entered under Rule 50.