Merkra Holding Co., Inc., et al. v. Comm.

Decisions will be entered under Rule 50.

Jacob Rabkin, Esq., and Alvin D. Lurie, Esq., for the petitioners. William J. O'Neill, Esq., for the respondent.

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The respondent determined a deficiency in the income and excess profits taxes of the Merkra Holding Co., Inc., for the fiscal year ended February 28, 1951, in the amount of 211,303.92. The respondent also determined, in Docket Nos. 52238, 52239, 52240, and 52241, that the several stockholders of Merkra Holding Co., Inc., were liable as transferees for varying portions of the 211,303.92 deficiency. These dockets were consolidated for the hearing.

The issues are: (1) Whether the gain on the sale of certain real property on January 30, 1951, is taxable to Merkra Holding Co., Inc., or whether such gain is properly taxable to its several stockholders; and (2) whether certain rental and interest income realized between May 31, 1950, the date of the holding company's liquidation, and January 30, 1951, is properly taxable to Merkra Holding Co., Inc., or whether such income is taxable to its several stockholders. Consideration will be given to certain other adjustments in the Rule 50 computation. FINDINGS OF FACT.

Some of the facts have been stipulated and they are hereby incorporated by this reference.

Merkra Holding Co., Inc., hereinafter called Merkra, was incorporated under the laws of the State of New York on April 14, 1922, and maintained its principal place of business in New York, New York, during the period here involved. The stockholders of Merkra, during the years material here, were Benjamin Kramer, David Kramer, Irving Kramer, and the Anna L. Heit Trust. Merkra filed its Federal income and excess profits tax return on an accrual basis for the fiscal year ended February 28, 1951, with the then collector of internal revenue for the Upper Manhattan District of New York.

On or about May 14, 1929, Merkra acquired an improved parcel of land known as 82-84 Broad Street, New York, New York, hereinafter called the Merkra parcel, at a cost of 295,009.64. On October 24, 1929, Merkra leased the Merkra parcel to Marex Realty Corporation, hereinafter called Marex, for a 21-year term beginning on February 1, 1930, and expiring January 31, 1951, with 3 successive options of renewal, each calling for an additional 21-year term. Under the

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terms of the lease Marex had the option to purchase the Merkra parcel at any time before January 31, 1951, for 1,000,000, provided that 6 months' notice of intention to exercise the option was given. A provision for a purchase option was inserted in the lease at the request of Marex after all negotiations as to the terms of the lease had been settled by the parties. The option provision appeared in paragraph 24 of the lease, as follows:

Twenty-fourth: The Tenant shall have the right and option, at any time prior to the 31st day of January, One thousand nine hundred and fifty-one, to purchase the fee of the demised premises for the sum of One million (1,000,000) Dollars, said sum to be paid to the Landlord in gold coin of the United States of America of or equal to the present standard of weight and fineness at the time of the delivery by the Landlord to the Tenant of the deed of the fee of said demised premises. The deed shall be prepared, executed, acknowledged and delivered at the Landlord's own proper cost and expense; it shall contain a general warranty and the usual full covenants for the conveying and assuring to the Tenant the fee simple of the said premises free from any mortgage covering the fee of the demised premises, but subject, nevertheless, to all the other encumbrances enumerated in this lease and subject also to any liens or encumbrances placed thereon by the Tenant and subject further to any restrictions or limitations that may in the future be placed upon the demised premises by any duly constituted public authority.

It is mutually understood and agreed that the Tenant shall give the Landlord six months' notice in writing of its intention to exercise the foregoing option of purchase and that said notice of exercise of option shall specify the place within the City of New York and the date for the closing of said transaction.

The purchase option was never modified after its inclusion in the lease executed October 24, 1929.

The Merkra parcel was adjoined on each side along Broad Street by parcels of land known respectively as Nos. 78-80 Broad Street and No. 86 Broad Street, both owned by the Maritime Association of the Port of New York, hereinafter called Maritime. Marex entered into a lease with Maritime on February 17, 1930, for these parcels for an identical term and renewal terms as were provided under the lease with Merkra.

On February 17, 1930, Marex entered into an agreement with Merkra and Maritime providing for the erection by Marex of a 37-story office building on the combined Merkra and Maritime parcels, to be let to Marex under the leases with Merkra and Maritime dated October 24, 1929, and February 17, 1930, respectively. Marex met with financial difficulties in 1932 which caused its bondholder-creditors to institute a reorganization proceeding under the Real Property Law of New York. This resulted in the entry of an order in the Supreme Court of the State of New York, New York County, on June 30, 1936, providing for the formation of a new corporation, known as 80 Broad Street, Inc., hereinafter called 80 Broad. The new corporation was the nominee of the bondholder-creditors of Marex. Pursuant to court

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order, 80 Broad took title to and possession of the aforesaid leasehold estates of Marex, and it issued 1,820,000 worth of bonds to the bondholder-creditors of Marex, secured by a first mortgage upon said leasehold estates.

By agreement dated April 8, 1937, the rentals under the Merkra lease and the Maritime lease were modified for the balance of the lease terms ending January 31, 1951. The fixed monthly rent payment to Merkra was reduced from 5,000 to 3,541.67, due on the 20th of each month. In addition, an extra payment was due after each fiscal year ending August 31, the amount of which was measured entirely by the income and other receipts of 80 Broad for such year.

On August 2, 1949, 80 Broad, as successor in interest to Marex in the leasehold estates, exercised its options to renew the lease with Merkra and the lease with Maritime for additional terms of 21 years, beginning on February 1, 1951, and expiring on January 31, 1972. The rental to be paid by 80 Broad to Merkra during the additional term of the Merkra lease was 60,000 a year. Merkra had the right under the lease to receive as rental annually 6 per cent of the value of the Merkra parcel instead of the annual rental of 60,000. Maritime had a similar right under its lease. Merkra consulted with Maritime for the purpose of determining whether to require that the rent be fixed under the 6 per cent formula. Merkra and Maritime accepted the opinion of a real estate expert that their respective parcels were not worth more than 700,000 or 800,000 at that time and decided to accept the 60,000 annual rent under respective leases.

Early in 1950, 80 Broad conceived of a plan to acquire the Merkra parcel through exercise of its purchase option under the lease with Merkra. To acquire the funds necessary to exercise such option, 80 Broad made efforts to obtain a mortgage loan, with the result that a commitment was obtained from Massachusetts Mutual Life Insurance Company on February 8, 1950, for a mortgage loan of 1,000,000 for 25 years at 4 per cent. A part of the security stipulated for this loan was a first mortgage on the leasehold estate under the lease with Maritime. To conform to the requirements of Massachusetts law governing insurance company loans, the commitment required that the lease term be converted into a single 99-year term in lieu of the 3 renewal terms aggregating 63 years remaining under the lease. Consequently, 80 Broad initiated negotiations with Maritime to bring about such a modification of the lease, which culminated in an agreement dated May 15, 1950, whereby Maritime agreed, on certain conditions subsequent, to execute such a lease modification in return for various valuable considerations from 80 Broad.

As a result of the order entered in the reorganization proceeding against Marex on June 30, 1936, the Supreme Court of the State of

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New York, hereinafter called the court, had jurisdiction over 80 Broad, and any exercise of the purchase option by 80 Broad under the Merkra lease required the approval of that court. On April 26, 1950, an application was presented by 80 Broad to the court for approval of a plan of reorganization pursuant to the Real Property Law of the State of New York with these principal features: (a) Exercise of the purchase option; (b) a loan, on security of a new first mortgage on the assets of 80 Broad, to carry out the contemplated purchase; (c) the subordination of the existing first lien of bondholders to the lien of the new first mortgage; (d) a modification of the lease with Maritime to provide for a 99-year term. 80 Broad reserved the right to withdraw the plan at any time prior to its becoming effective.

Notice of the hearing on the reorganization plan was published, pursuant to court order, on April 28, 1950, in The New York Times and in the Wall Street Journal. Merkra was not required under the court order to be served with notice of the hearing, and it was not in fact served with any document containing notice of the aforesaid judicial proceedings relating to the reorganization plan. Merkra was not made a party to the proceedings and did not participate in them.

Merkra learned early in May 1950 of the pending court proceeding on the reorganization plan and of the intention of 80 Broad to exercise the purchase option. Prior to this Merkra was unaware of the negotiations between 80 Broad and Maritime concerning the purchase of the Merkra parcel by 80 Broad. Upon learning of the pending proceeding Merkra's attorney and one of its stockholders attempted to learn more about the proceeding through conversations with the attorney for 80 Broad, with the general counsel of Maritime, and with the attorney for the bondholders' protective committee. Merkra was able to get information about the proceeding only from the attorney for the bondholders.

The application filed by 80 Broad on April 26, 1950, for approval of the reorganization plan met with immediate opposition from the bondholders' protective committee formed under the name of 80 Broad Street Building Bondholders Committee, and from several individual bondholders. The bondholders' committee registered its opposition in a letter distributed to all bondholders under date of May 4, 1950. Further opposition was recorded by individual bondholders and by the bondholders' committee in affidavits filed in the proceeding on various dates between the initiation of the proceeding and May 16, 1950, the return date thereof, and in statements in open court at the hearings held on the reorganization plan on May 19 and May 23, 1950. The opposition of the bondholders to the plan was based upon numerous grounds, including impairment of security, failure to provide

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adequately for liquidation of the bonds, enlargement of the risk to the bondholders, unpopularity of second mortgages, and expected depression in the market value of the bonds. The opposition of the objecting bondholders continued through the second hearing before the court on May 23, 1950. A series of conferences were held in the court's chambers and among the attorneys for the interested parties between May 25 and May 31, 1950, in an attempt to achieve agreement in sufficient time to permit exercise of the purchase option under the lease with Merkra. A revised plan of reorganization, dated May 29, 1950, was presented to the court on June 1, 1950, which preserved the principal features of the original plan while providing greater safeguards for the bondholders and the opportunity for the bondholders to propose other financing arrangements. At the hearing on June 1, 1950, the court reserved jurisdiction for the subsequent promulgation of a plan which could embrace sale of the 80 Broad properties in lieu of purchase of the Merkra parcel. The court signed an order on June 2, 1950, approving the revised plan, with the proviso that the plan could not become effective until June 25, 1950, and then only if bondholders holding at least one-third in amount of the principal indebtedness did not file dissents from the plan by that date. The order provided for reservation of jurisdiction by the court until the ultimate consummation of the plan, and provided further that 80 Broad was to make a report to the court on or before October 1, 1950, pertaining to its efforts to obtain other mortgages of at least 1,000,000 to be used to finance the purchase of the Merkra parcel in lieu of the mortgage committed by Massachusetts Mutual Life Insurance Company.

While the reorganization proceeding was pending 80 Broad proposed to Merkra that if Merkra would grant to 80 Broad a reduction in rent under the Merkra lease for the renewal term commencing February 1, 1951, from 60,000 to 40,000 a year, 80 Broad would abandon the reorganization plan. Merkra rejected this proposal on or about May 29, 1950.

On about May 15, 1950, the Merkra stockholders, officers, and directors consulted a tax attorney for the purpose of obtaining advice as to the minimization of income taxes to be paid by Merkra.

At a joint meeting held on May 31, 1950, the stockholders and directors of Merkra adopted resolutions for the immediate cessation of business and complete liquidation of the assets of Merkra, and also adopted resolutions for the prompt filing of a certificate of dissolution with the secretary of state of New York. In implementation of the liquidation and dissolution resolutions the following action was taken: (a) A deed to the Merkra parcel was executed and delivered on May 31, 1950, to the Merkra stockholders; (b) all other assets of Merkra were distributed ratably to the stockholders; (c) a certificate

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of dissolution, dated May 31, 1950, was forwarded to the secretary of state of New York; (d) a notice of adoption of a plan of liquidation required by the Commissioner of Internal Revenue was executed and mailed May 31, 1950; (e) certificates of stock for all the outstanding shares of Merkra were surrendered to Merkra for cancellation; and (f) written notice, dated June 1, 1950, was sent to 80 Broad by Merkra advising of the transfer of the Merkra parcel to the Merkra stockholders and advising that all future rents were to be paid to David Kramer, as agent.

The decision to liquidate Merkra was reached sometime in the middle of May 1950, after obtaining information regarding the pending reorganization proceeding of 80 Broad, and the actual liquidation date was deferred to the end of the month for accounting convenience. At no time prior to its liquidation did Merkra or any one on its behalf negotiate for the sale of the Merkra parcel. Merkra engaged in no business activities after its liquidation on May 31, 1950, and retained no assets after that date. The secretary of state of New York issued a certificate of dissolution to Merkra on October 13, 1950.

The reorganization plan of 80 Broad became effective June 25, 1950, under the terms of the court order, and on June 27, 1950, 80 Broad sent letters to the Merkra stockholders and to Merkra advising them of its intention to exercise the purchase option under the lease with Merkra, fixing January 30, 1951, as the closing date.

On October 18, 1950, a new mortgage loan commitment was given to 80 Broad by the Mutual Benefit Life Insurance Company for a 21-year self-liquidating loan of 1,000,000 at 4 per cent, which required higher annual amortization payments than the prior proposal of Massachusetts Mutual Life Insurance Company but which did not require the security of a 99-year Maritime leasehold estate. The court, by an order entered November 3, 1950, approved acceptance of the new commitment in place of the proposal of Massachusetts Mutual Life Insurance Company, subject to the condition that the new mortgage proposal would become a part of the reorganization only if one-third of the bondholders of 80 Broad did not file dissents thereto on or before December 8, 1950. The new mortgage loan proposal of the Mutual Benefit Life Insurance Company obviated the necessity of converting the Maritime lease into a 99-year lease, which had been done in the Maritime-80 Broad agreement dated May 15, 1950. 80 Broad sought to cancel this agreement with Maritime but Maritime threatened to hold 80 Broad liable for damages for breach of said agreement, and a negotiated settlement was agreed upon on December 4, 1950, and approved by the court on December 8, 1950.

On January 17, 1951, the Mutual Benefit Life Insurance Company advised 80 Broad that the laws of the proposed lender's State of incorporation, New Jersey, and internal regulations of the proposed

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lender prevented a mortgage loan on the security of a leasehold estate where the terms of the loan exceeded 80 per cent of the term of the remaining leasehold estate, and that therefore the only mortgage loan that could be made by the lender on the security of a 21-year leasehold estate would be for a 17-year term. A new commitment for a 17-year mortgage was issued by the Mutual Benefit Life Insurance Company on January 19, 1951. The withdrawal by the lender of its prior commitment created a crisis for 80 Broad because no other mortgage was available at that late date, and failure to obtain a mortgage would render 80 Broad unable to pay for the Merkra parcel in accordance with the purchase option. Therefore, because of the requirement of a closing on the Merkra parcel on January 30, 1951, the court dispensed with the requirement in the plan for a 30-day period within which the bondholders of 80 Broad could object to any substituted mortgage and signed an order on January 29, 1951, approving the substitution of the 17-year mortgage for the 21-year mortgage.

On January 19, 1951, 80 Broad gave notice to its stockholders of a special meeting called to approve the new 17-year mortgage, which meeting was held and stockholder approval granted on January 29, 1951, that being the earliest date on which a meeting of stockholders could be called under the 10-day notice requirement of the New York Stock Corporation Law.

The closing was held on January 30, 1951, pursuant to the notice of exercise of the option by 80 Broad to Merkra under date of June 27, 1950. The former Merkra stockholders, in their capacities as individual co-owners of the Merkra parcel, executed and delivered to Broadmar Corporation, the nominee of 80 Broad, a deed transferring the fee simple estate in the Merkra parcel to Broadmar Corporation, against a certified check in the sum of 1,000,000 issued by the Mutual Benefit Life Insurance Company and made payable to the order of "David Kramer, Benjamin Kramer, Irving Kramer, Benjamin Burstein, as Trustee for Anna L. Heit under Trust Indenture dated December 18, 1946, between David Kramer and Benjamin Burstein." The check was deposited in a bank account maintained in the name of David Kramer, Special, and David Kramer in turn delivered to each of the other aforesaid individuals a check in the amount of 74,074.07, representing each such individual's proportionate interest in the proceeds of the sale of the Merkra parcel and retained for himself as his share of the proceeds the sum of $777,777.79.

After the liquidation of Merkra, the Merkra parcel was operated by the former Merkra stockholders as a joint venture, and each of the former stockholders received their distributive shares of the rent monthly. Rent from the Merkra parcel received by the joint venture amounted to 3,541.67 during each of the months of June through December 1950. In addition, the amount of 54,733.82 was received by the joint venture

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as rent in October 1950, representing the end-of-year rental adjustment with respect to the fiscal year ending August 31, 1950, under the Merkra lease. These items of income, as well as interest accruing after May 31, 1950, on United States Government bonds distributed in liquidation of Merkra, in the amount of 583.75, were reported on a partnership information return filed for the period June 1, 1950, to December 31, 1950, for the joint venture. The individual income tax returns of the joint venturers for the year 1950 reported the respective distributive shares of the foregoing rent and interest, and also reported the gains realized by the stockholders on the liquidation of Merkra. The respondent determined that the sale of the Merkra parcel was made by Merkra Holding Co., Inc., on January 31, 1951, and that the capital gain of 704,990.36 realized on such sale was taxable to the corporation in the fiscal year ended February 28, 1951. Respondent also determined that Merkra Holding Co., Inc., realized rental income from the Merkra parcel in the amount of 79,525.51 and interest income in the amount of 583.75 for the period June 1, 1950, through January 31, 1951. OPINION

The primary question in this case is whether the gain on the sale of the property known as 82-84 Broad Street, New York, New York, by the Kramers is taxable to Merkra. As shown in our Findings of Fact, Merkra leased this property in 1929 to Marex Realty Corporation for a 21-year term with renewal option rights, and the lease further provided the lessee had the option to purchase the property at any time before January 31, 1951, provided that 6 months' notice of intention to exercise the option was given. The Marex Realty Corporation suffered financial difficulties in 1932 and a reorganization proceeding was instituted under State law which resulted in the formation of a new corporation known as 80 Broad Street, Inc. The latter corporation took title to the assets of Marex Realty Corporation, amongst them being the rights under the aforementioned lease. In May of 1950 Merkra was dissolved and its assets, including the property at 82-84 Broad Street, New York, New York, were distributed to its four shareholders. It fairly appears the distribution in kind was made after Merkra learned the option would probably be exercised and in order to escape heavier taxes which would result if Merkra then held title. 80 Broad Street, Inc., did decide to exercise the option to purchase the building and in June of 1950 it gave written notice to that effect to the Kramers who were then the holders of the title to the property, the notice fixing the closing date in January 1951. The transfer was consummated in January 1951 by the Kramers deeding the property to 80 Broad Street, Inc., and the latter paying them 1,000,000. The Kramers, who are the petitioners

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in the other cases, admit they would be liable as transferees if it be held the gain was taxable to Merkra.

Respondent relies upon Commissioner v. Court Holding Co., 324 U.S. 331, affirming Court Holding Co., 2 T. C. 531. In the cited case a husbandand wife owned all of the stock of a corporation and they orally agreed with a prospective purchaser to sell an apartment building, which was the corporation's sole asset, at an agreed price. They accepted a downpayment of 1,000 but when they met with the prospective purchasers for execution of the formal sales contract they were informed that a sale by the corporation would cause heavy income taxes. No contract of sale was then executed but the stockholders immediately liquidated the corporation, with a distribution of the assets in kind to the stockholders. The stockholders then, as individuals, completed the sale and applied the original downpayment made to them as representatives of the corporation, to the purchase price. The Supreme Court in its opinion in the Court Holding Co. case approved the action of the Tax Court in viewing the transaction as a whole from the commencement of negotiations to the consummation of the sale and held, under all of the facts, the Tax Court's determination that the corporation had not abandoned the sales negotiations and the sale by the shareholders was in substance the sale of the corporation, was supported by the evidence.

The rule of the Court Holding Co. case does not mean that all sales of corporate property by the shareholders shortly after liquidation and distribution in kind are to be attributed to the corporation. United States v. Cumberland Public Service Co., 338 U.S. 451; Amos L. Beaty & Co., 14 T. C. 52; Frank E. Gilman, 14 T. C. 833; Doyle Hosiery Corporation, 17 T. C. 641; Steubenville Bridge Co., 11 T. C. 789; Oahu Beach & Country Homes, Ltd., 17 T. C. 1472. In the Cumberland case it was stated "While the distinction between sales by a corporation as compared with distribution in kind followed by shareholder sales may be particularly shadowy and artificial when the corporation is closely held, Congress has chosen to recognize such a distinction for tax purposes."

In Steubenville Bridge Co., supra, we reviewed many of the prior decisions of this and other courts and announced the "basic question" to be "as to who made the sale." We approved the rule of Wichita Terminal Elevator Co., 6 T. C. 1158, affd. 162 F. 2d 513, and quoted from that case as follows:

If, in fact, the sale of petitioner's elevator properties was conceived and negotiated by its president, acting in its behalf prior to its dissolution, and such sale was carried out through an arrangement whereby petitioner was dissolved and the properties to be sold were conveyed to a liquidating agent or to its stockholders and the formal contract to sell was executed by the party or parties then holding legal title, such sale was, for tax purposes, made by the corporation.

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We went on in the Steubenville case to review some of the cases where it was held the sale would not be attributable to the corporation and we drew this rule from such authorities:

On the other hand, where the sale has been made by the stockholders after liquidation has been initiated and with no contractual obligations assumed by the corporation prior to the negotiation of liquidation, the courts have generally taxed the resulting gain to the stockholders. * * *

It is not necessary to reconcile all of the litigated situations where it has been held the stockholders' sales after liquidation in kind were or were not attributable to the corporation. Certain it is from all of the authorities the sale cannot be attributed to the corporation unless the corporation has, while still the owner of the property, carried on negotiations looking toward a sale of the property, and in most cases the negotiations must have culminated in some sort of sales agreement or understanding so it can be said the later transfer by the stockholders was actually pursuant to the earlier bargain struck ² by the corporation -- and the dissolution and distribution in kind was merely a device employed to carry out the corporation's agreement or understanding.

Here there were no negotiations with Merkra and 80 Broad Street, Inc., looking toward a sale of the property by Merkra. Respondent argues the required negotiations by Merkra for a sale of the property can be found in the evidence of the negotiations with Marex in 1929 for the lease which contained the option to purchase. But these negotiations were in no sense negotiations by Merkra looking toward a sale of its property. They were negotiations by Merkra to rent its property. They culminated in a lease of the property for a first period of 21 years with granted renewal rights to the lessee for two following periods of 21 years each. Before one could say there were negotiations by Merkra looking toward a sale of the property, the evidence should show Merkra desired to sell and the other party to the negotiations desired to purchase. The purchase option clause was placed in the lease at the request of the lessee but one of the Kramers who participated in the lease negotiations said this was an "afterthought" and he said the figure set (1,000,000) was "fantastic." This is believable when it is seen Merkra had acquired the building 5 months before for approximately 295,000.

We recognize there could be situations where the giving of an option to buy is but a step in a planned sale. Meurer Steel Barrel Co v. Commissioner, 144 F. 2d 282, cited by respondent. That is not this case. Here the giving of the long-time option to buy as part of the lease contract does not represent sales negotiations. It was no more than

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the reply of an owner pressed to place a price on property he is anxious to rent and reluctant to sell. The option is given to one who desires to rent but thinks some day he might want to buy. The option price was not the result of negotiations between parties who offer to buy and sell. It was merely a figure fixed by the owner that it would accept if offered within the next 21 years. There were no negotiations for a sale of the property, within the rule of the Court Holding Co. case, and such negotiations as were had did not result in any contract of sale on the part of Merkra before liquidation. We conclude the sale was not made by Merkra; that it was made by the individuals who held title to the property as co-owners and that the sale should not be attributed to Merkra.

Our holding for the petitioners on the primary issue disposes of the second issue. After the dissolution the building was operated as a joint venture by the shareholders and each reported his distributive share of the post-liquidation income up to the closing date when the property was transferred. Respondent's argument that the post-liquidation rents were actually corporate rents of Merkra is based entirely on his theory that the sale was attributable to Merkra. Since we hold the sale was not attributable to Merkra the argument falls.

Decisions will be entered under Rule 50.

¹ The following proceedings are consolidated herewith: Benjamin Kramer, Docket No. 52238; David Kramer, Docket No. 52239; Irving Kramer, Docket No. 52240; and Anna L. Heit Trust, Benjamin Burstein, Trustee, Docket No. 52241.

² In Fairfield S. S. Corporation v. Commissioner, 157 F. 2d 321, Judge Learned Hand said Commissioner v. Court Holding Co., 324 U.S. 331, "turned upon the fact that all the preliminary negotiations had been made expressly with the corporation; and that it was only after the bargain had been struck, that the device of a liquidation was brought in as deus ex machine."