1977 U.S. Tax Ct. LEXIS 5">*5 Petitioner was formed as a nonprofit corporation to take over the educational functions of Hancock Schools, Inc. Petitioner assumed a liability for goodwill in an excessive amount and agreed to require parents of its students to make interest-free loans to Hancock Schools, Inc. An application for determination of qualification and exemption under
69 T.C. 488">*488 OPINION
Respondent determined that petitioner does not qualify for exemption from Federal income tax under
This case was submitted for decision on the stipulated administrative record under
1977 U.S. Tax Ct. LEXIS 5">*9 Hancock Academy of Savannah, Inc. (petitioner) is a Georgia corporation with its registered office in Savannah, Ga. Petitioner filed its application for recognition of exemption under
Petitioner is a recent spin off from a group of for-profit schools founded by Emmie Ruth Hancock (Mrs. Hancock). The original school, Hancock Day School, Inc., was founded in 1951 by Mrs. Hancock and continues in existence today. Mrs. Hancock is the president and a director of Hancock Day School, Inc. Her son, William L. Bell (Mr. Bell) is vice president and a director. Hilma S. Traver is secretary-treasurer and a director. Hancock Day School, Inc., is owned by Mrs. Hancock and Mr. Bell.
Initially, Hancock Day School, Inc., operated kindergarten through the seventh grade. Due to space limitations, however, a new corporation, Hancock Schools, Inc., was formed in 1972 to facilitate expansion. The officers and directors of Hancock Schools, Inc., are: Mrs. Hancock, president and a director; Mr. Bell, vice president and a director; and Alvin M. Hitt, Jr., secretary-treasurer and a director. Each of these individuals 1977 U.S. Tax Ct. LEXIS 5">*10 owns a one-third interest in Hancock Schools, Inc.
Upon its formation, Hancock Schools, Inc., purchased from 69 T.C. 488">*490 Hancock Day Schools, Inc., the operations of grades four and up for an amount including $ 50,000 which was identified as payment for one-half of the goodwill of Hancock Day Schools, Inc. The $ 50,000 was payable on an installment basis over 10 years with $ 5,000 due annually beginning in 1982 and with 6-percent interest due on any unpaid balance. Under the terms of the sale, Hancock Day Schools, Inc., agreed to cease operating grades four and up.
Hancock Schools, Inc., moved to a new location, erected a larger building, took over the operation of grades four through seven, and adopted plans to add a new grade each year until grades four through twelve were offered. Hancock Day School, Inc., continued to operate in its original location, but handled only kindergarten through third grade.
Hancock Schools, Inc., adopted an interest-free loan program whereby, in addition to making tuition payments, parents were required to loan to Hancock Schools, Inc., without interest, $ 500 for the first child and $ 100 for each additional child in attendance. The loans were repayable1977 U.S. Tax Ct. LEXIS 5">*11 by the school within 1 year after the parent's children were no longer in attendance.
Hancock Schools, Inc., operated as a school for 3 years. In 1975, however, its officers decided to form a nonprofit corporation to take over the school operations and to obtain tax-exempt status to encourage contributions which then would be tax deductible. Petitioner was formed for this purpose. Mr. Bell was named president and trustee for petitioner. Mr. Bell's spouse, Doris C. Bell, and Mrs. Hancock were named vice presidents and trustees. Six other trustees also were named: Dr. Harold Black, Mrs. Angela Deering, Rev. W.H. Ford, Mr. Walton Ruff, Mrs. Martha Stewart, and Mr. Abe Tenenbaum.
Hancock Schools, Inc., continued to own the land and buildings for the school operation and leased the property to petitioner under a lease with a term of 15 years. Petitioner was responsible for all taxes, maintenance, and utility expenses related to the school. Hancock Schools, Inc., was responsible for an annual insurance payment of approximately $ 500. The monthly lease payments of $ 2,000 bring a return of 8.4 percent to Hancock Schools, Inc., on the land and improvements purchased at an aggregate1977 U.S. Tax Ct. LEXIS 5">*12 cost of $ 280,159. This rate of return is less than that generally received on similar real estate investments in the area.
69 T.C. 488">*491 Petitioner purchased outright from Hancock Schools, Inc., all of the personal property used in the school operation and assumed all liabilities related thereto. Petitioner also assumed the $ 50,000 debt owed by Hancock Schools, Inc., to Hancock Day Schools, Inc., for the acquisition of goodwill.
Petitioner agreed to continue the parent loan program for the benefit of Hancock Schools, Inc. The loan funds were to be utilized for building and ground improvements as directed by petitioner. Hancock Schools, Inc., remained responsible for repaying the loans as they came due.
For the year ended June 30, 1975, Hancock Schools, Inc., had total receipts of $ 205,492 and total expenses of $ 201,524, for a net profit of $ 3,968. Petitioner's budget for 1975-76 called for income of $ 240,005 and expenses of $ 244,404 for a net loss of $ 4,399. The projection for 1976-77 is for expenses to equal income of $ 295,000.
1977 U.S. Tax Ct. LEXIS 5">*14 Respondent determined that the first two of these prerequisites were each violated by two circumstances in petitioner's history. First, respondent asserts, petitioner assumed a liability for goodwill in an excessive amount. Second, petitioner required 69 T.C. 488">*492 parents of its students to make interest-free loans to its for-profit predecessor, Hancock Schools, Inc. These two incidents, respondent argues, mean that petitioner was not organized and operated exclusively for educational purposes and that part of petitioner's net earnings will inure to the benefit of private individuals.
The burden of proof is on petitioner to overcome the grounds set forth in respondent's notice of determination.
The first ground for disqualification is petitioner's assumption of the liability for goodwill. Incurring debt to purchase an asset at fair market value and subsequently retiring that debt with earnings is not a violation of the exempt purposes requirement or the private inurement of net earnings proscription of
In the instant case there was a majority of identity among the officers of the three corporations involved in the transactions. Most of these officers were in a position to personally gain from the transaction since they were the owners of the for-profit corporations. Moreover, there is no indication in the record that any disinterested party seeking to establish a private school in the area would be a willing buyer of the goodwill in question for $ 50,000. Thus, although the officers may have acted in good faith, an independent analysis of objective factors is appropriate 69 T.C. 488">*493 under these circumstances to determine if the liability assumed was excessive. 5
1977 U.S. Tax Ct. LEXIS 5">*17 Respondent's determination that the amount of liability assumed for goodwill is excessive, is based on the fact that a net loss was projected for petitioner's first 2 years of operation. From this respondent concludes that the value of the goodwill is nominal, the liability assumed was excessive and the transaction benefited private individuals. The statistics used by respondent to compute the goodwill value span only a short period of time, but they are the best figures available in the record. The record contains no evidence suggesting more appropriate figures on which to base the capitalization of earnings approach for determining the value of goodwill. Moreover, rather than attacking the premise of no excess earnings potential, petitioner instead advances two alternative arguments.
First, petitioner argues that the capitalization of earnings approach is inappropriate in valuing the good name of Hancock and the importance of that name to the financial viability of petitioner. The difficulty with this is dual. As respondent properly points out, this approach is premised on facts not contained in the administrative record. Petitioner's allegations on brief that many new private1977 U.S. Tax Ct. LEXIS 5">*18 schools in the Savannah area have folded because they lacked an established name in the community may well be true, but these facts were not presented to respondent to aid in his administrative determination and are not properly before us now.
Even if these facts were before us, we are not prepared to accept that $ 50,000 was a reasonable amount for the Hancock name. Reputation in the community is an important asset, perhaps priceless, but if it becomes a commodity sold as part of a business, it must be valued as such. In the absence of better evidence, fair market value of goodwill is determined by capitalizing the income from a business and subtracting from 69 T.C. 488">*494 the resulting figure the fair market value of the other assets.
1977 U.S. Tax Ct. LEXIS 5">*19 Petitioner's alternative argument for goodwill valuation is that the amount for goodwill may more properly be labeled as covenant not to compete for which $ 50,000 was reasonable compensation to Hancock Day Schools, Inc., and Hancock Schools, Inc., for giving up the right to teach grades four and up. We find this argument unpersuasive. In fact, the sales agreement specifically assigned the $ 50,000 price to goodwill without allocating any portion of the price to the covenant.
Futhermore, even if we were to accept petitioner's contention that the $ 50,000 was for the covenant not to compete, this would not alter our holding. A covenant not to compete is a natural concomitant of goodwill. See
Such private benefit violates both the direct proscription against net earnings inuring to private individuals and the requirement that petitioner be organized and operated exclusively for exempt purposes.
The second ground for disqualification under
1977 U.S. Tax Ct. LEXIS 5">*23 69 T.C. 488">*496 After considering all the facts and circumstances, we conclude that the loan requirement did contravene the requirements of
Accordingly, since petitioner failed to meet the requirements of
1. Unless specified otherwise, all section references are to the Internal Revenue Code of 1954, as amended and in effect during the year in issue.↩
2. The prerequisites for this declaratory judgment have been satisfied: petitioner exhausted its administrative remedies,
3. For declaratory judgments not involving revocation, submission for disposition on the basis of the administrative record is in accordance with
4.
(a) Exemption From Taxation. -- An organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503.
* * * *
(c) List of Exempt Organizations. -- The following organizations are referred to in subsection (a): * * * * (3) Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation, (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of any candidate for public office.↩
5. On brief and in its petition, petitioner seeks to bolster its view of the transactions by alleging subsequent ratification by petitioner's full board of trustees. There is no evidence in the record of this ratification or of the surrounding circumstances. The coincidence of officers who completed the transaction remains and an independent evaluation still would be appropriate.
To conclude otherwise would enable the owners of any private school to create a nonprofit corporation with themselves as officers and then to cause the nonprofit corporation to purchase the school at a price including their self-interested, subjective valuation of goodwill. Not requiring objective evidence that the value assigned to goodwill is fair would render ineffectual the requirements for tax-exempt status.↩
6. The entire approach of having a nonprofit corporation pay an amount for goodwill is troublesome. By definition a nonprofit educational institution does not operate its school to make a profit. For a nonprofit school to pay for goodwill, generally a measure of the profit advantage in an established business, is anomalous. Although payment for goodwill may be appropriate for a private organization designed to make money to support unrelated exempt purposes or to take over a formerly highly profitable business to be operated thereafter entirely for exempt purposes, this Court is hard pressed to conceive of a situation where payment for goodwill to take over an unprofitable business would be appropriate. To the contrary, such a payment under usual circumstances necessarily would cause the earnings of the corporation to inure to private individuals.↩
7. Petitioner had a previous opportunity to challenge respondent's determination regarding this issue, but did not address the issue when administratively appealing respondent's initial determination of nonqualification.↩
8. Respondent commissioned an appraisal which reported a rate of return of 8.4 percent. This figure was computed by dividing the cost of the realty including improvements ($ 280,159) by the net lease proceeds ($ 23,500). Respondent's failure to include the value of the interest-free loans is understandable since the lease and the loan requirement were incorporated as separate clauses in the same document which included all provisions for the takeover of school operations by petitioner.↩
9. The record contains no evidence on what the interest rates to Hancock Schools, Inc., would have been if it had borrowed the funds on the open market, on what the range of fair market rental return is for similar property (on brief, petitioner alleges it to be 12 to 15 percent) or on what method of calculating the rate of return is preferable. Petitioner argues generally that the loans should be ignored since, if Hancock Schools, Inc., had borrowed the funds on the open market, lease payments and tuition would have been increased a corresponding amount, and the deduction for interest would have offset the increased income. Although this argument appears to be supported by appealingly simple logic, the argument is based on speculation, is unresponsive to the method used by respondent to calculate the rate of return here, and is an insufficient basis to permit a conclusion that the lease payments including the loan value were not excessive.
Respondent's method of calculating rate of return was based on the gross cost of the realty including improvements, not on net investment excluding loans. If considered as part of the lease, under respondent's method the value of the interest-free loans would be considered an incremental return to Hancock Schools, Inc., not as an amount which would be offset by an interest expense if borrowed on the open market, and which therefore should be ignored. Hancock Schools, Inc., had an actual rate of return on net investment excluding loans which undoubtedly varied from that calculated by respondent. Since there is no evidence on the actual capital structure of Hancock Schools, Inc., on availability, and cost of outside loans or on its net return on equity investment, there is no way to evaluate petitioner's contentions.
We must deal with the facts as they appear in the record. The 8.4-percent return was based on gross cost of the realty and the direct lease payments less the cost of insurance. If viewed as a part of the lease, the interest-free loans had a value to Hancock Schools, Inc., which increased its rate of return. Since there is no evidence that the resulting rate was not excessive, we reject petitioner's argument.
We note that the inadequacy of the record may be attributable in part to the fact that it was developed at a time before the declaratory judgment was available as a method to review administrative determinations of nonqualification.↩
10. Respondent argues that this provision in the lease was nullified by another clause which prevented improvements to the realty without prior approval by Hancock Schools, Inc. We find the terms ambiguous and do not rely on respondent's argument since we find private benefit regardless.↩
11. It is not clear to us that this benefit necessarily also violated the requirement that no part of petitioner's net earnings may inure to the benefit of any private shareholder. Due to the poorly developed record, the view we have taken of the loan requirement is admittedly artificial. To extend the analysis to the question of inurement of net earnings would be a meaningless exercise. In any event, we find it unnecessary to resolve this issue since it would not alter the holding in this case.↩