Case Name: William B. Howell and Fay S. Howell, et al., Petitioners v. Commissioner of Internal Revenue, Respondent
Court: United States Tax Court
Jurisdiction: United States
Decision Date: 1972-01-31
Citations: 57 T.C. 546
Docket Number: Docket Nos. 1538-70, 1546-70, 1596-70, 1597-70
Parties: William B. Howell and Fay S. Howell, et al., Petitioners v. Commissioner of Internal Revenue, Respondent
Judges: Goffe, J., agrees with this dissent.
Reporter: Reports of the Tax Court of the United States
Volume: 57
Pages: 546–568

Head Matter:
William B. Howell and Fay S. Howell, et al., Petitioners v. Commissioner of Internal Revenue, Respondent
Docket Nos. 1538-70, 1546-70, 1596-70, 1597-70.
Filed January 31, 1972.
Torn Watson Brown and Samuel F. Dosier, Jr., for the petitioners.
James D. Burroughs, for the respondent.
Proceedings of the following petitioners are consolidated herewith: George E. Chase and Jan P. Chase, docket No. 1546-70 ; Alien S. Hardin and Katharine C. Hardin, docket No. 1596-70 ; and Hectare, Inc., docket No. 1597-70.

Opinion:
Steeeett, Judge:
Respondent determined deficiencies in petitioners' income taxes for the years and in the amounts as follows:
The issues for decision are:
(1) Whether certain real property, which constituted the only property held by Hectare, Inc., and was sold by it during 1964, 1965, and 1966, was a capital asset within the meaning of section 1221,I.R.C. 1954, or whether such property was held by the corporation primarily for sale to customers in the ordinary course of the corporate trade or business.
(2) Whether Hectare, Inc., was entitled to the small business corporation election provided for under section 1372.
(3) Whether respondent properly determined that distributions the stockholders of Hectare, Inc., received from that corporation constituted ordinary income to the stockholders and not long-term capital gain.
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
William B. and Fay S. Howell (husband and wife), George E. and Jan P. Chase (husband and wife), and Allen S. and Katharine C. Hardin (husband and wife), all resided in Atlanta, Ga., at the time their petitions in this case were filed. Each of the petitioner couples filed joint Federal income tax returns for the taxable years 1965 and 1966 with the district director of internal revenue, Atlanta, Ga.
Hectare, Inc. (Hectare), is a corporation organized under the laws of the State of Georgia on November 9, 1961, with its principal place of business at the time of the filing of its petition in this case in Atlanta, Ga. It filed Forms 1120-S, TJ.S. small business corporation income tax returns, for the years 1965 and 1966 with the district director of internal revenue at Atlanta, Ga.
In 1961 a real estate agent by the name of Robert Hughes (Hughes) approached William B. Howell (Howell) with respect to the purchase of certain property owned by heirs of the estate of W. A. Montgomery (hereinafter referred to as the Montgomery property). Howell was employed as a real estate agent in the same firm in which Hughes was employed. Howell was a longtime friend of Allen S. Hardin (Hardin) who was engaged in the general contracting business as an officer and project manager of Ira H. Hardin Co. This company was engaged in building commercial and industrial buildings. Howell talked with Hardin concerning the acquisition of the Montgomery property.
Hughes, Howell, and Hardin decided to purchase the Montgomery property and agreed they would form a corporation and have the corporation acquire the land. They formed Hectare which had a total of 120 shares of stock with Hardin, Howell's wife, Fay, and Hughes each owning 40 shares. Subsequently, Hughes sold 20 of his shares to Jan P. Chase and the other 20 shares to Ray H. Fechtel. During the taxable years 1965 and 1966 Hectare's stock was owned as follows:
Stockholder Humber of shares
Allen S. Hardin_ 40
Fay S. Howell_ 40
Jan P. Chase_ 20
Ray H. Fechtel_ 20
The charter of Hectare states:
The object of said proposed corporation is pecuniary gain and profit to the stockholders. The general nature of the business which they wish to carry on is to engage in a general investment business, investing in both real and personal property as well as other general investments.
On January 23, 1962, Hectare acquired the Montgomery property which consisted of 42.86 acres of unimproved land located along the comer of and bordering on Oakcliff Road and Pleasantdale Road in DeKalb County, Ga. One hundred and eight thousand, six hundred and forty-two dollars of the purchase price was by a note given to the Montgomery heirs secured by a warranty deed to secure debt. This warranty deed contained provisions for release of acreage on the payment of $3,500 or $4,000 per acre depending upon its location within the tract. The Montgomery property was located contiguous to and across the street from land being developed by Atlanta DeKalb Industrial Park, Inc., a corporation of which Ira H. Hardin was president. This development which commenced in 1960 was for office and warehouse use.
Hardin was president of Plectare and Howell was vice president. In 1964 it was decided that Hectare would borrow $110,000 from the First National Bank of Atlanta to pay the sum owing to the Montgomery heirs. Arrangements for this loan were made on behalf of Hectare by Howell. The First National Bank of Atlanta was represented in the loan negotiations by Arthur H. Huber (Huber) who at the time was vice president and loan officer. Howell and Huber were personal friends and Huber was aware of the personal net worth of the Howells, the Hardins, and the Chases. Howell told Huber that the land had been purchased for resale. Although the property was vacant land, Huber was of the opinion that it could be considered as improved property under banking regulations since it was bordered by improved roads, had utility lines contiguous to it, and had a sewer running through it. The bank made the $110,000 loan to Hectare on March 24, 1964, and the note to the bank was personally endorsed by Hardin, Howell, and Jan D. 'Chase.
On December 30, 1964, Hectare sold 0.9 acre of the Montgomery property to Cobb Enterprises, Inc., and at the same time Atlanta DeKalb Industrial Park conveyed 0.29 acre of adjacent land to Cobb Enterprises, Inc., by the same warranty deed. On May 6,1965, Howell, in a conversation with Huber, told Huber of the sale of the 0.9 'acre and informed Huber that a number of prospective buyers had been looking at the Hectare property and that the offering price had been increased to $12,000 per acre.
On December 15, 1965, Hectare sold 2.2 acres of the Montgomery property to William T. Newman. Newman is a general contractor and a personal friend of Howell.
On January 14,1966, Hectare sold the remaining 39.74 acres of the Montgomery property to Pleasantdale Corp. Pleasantdale Corp. was controlled by an individual who was a friend of Howell. The sale to Pleasantdale Corp. was arranged by John Maddox, a real estate agent. Maddox approached the officers of Hectare with respect to the purchase of the property as had the purchasers of the 0.9 acre and the 2.2 acres. However, Hectare paid John Maddox a commission on the sale of the 39.74 acres since such a commission was customary under the circumstances.
Newman constructed two buildings on the 2.2 acres which he purchased from Hectare, and Pleasantdale Corp. developed the property which it purchased.
Hectare held stockholders and directors meetings, filed its annual State registration forms and its State and Federal income tax returns, and declared and paid ad valorem taxes on the Montgomery property. It never received any rent or other income from use of the Montgomery tract during the time it owned the property. None of the individual stockholders of Hectare nor any of their spouses have ever participated together in any real estate investment ventures, except for their investment in Hectare, either before, during, or after the formation of Hectare. None of the stockholders of Hectare had been extensively engaged in dealing for his own account in real estate as distinguished from acting as a real estate agent or broker prior to or after the formation of Hectare, either individually or as a joint venturer. Hardin had at one time participated in a group that developed a shopping center and in 1969 or 1970 was involved in several joint venture developments. Howell was a joint venturer in a tract of real property with respect to which he reported a gain of $2,060.45 on his 1965 income tax return. Most of Howell's income was from dividends and interest, only between 15 and 20 percent of the income he reported being from his activities as a real estate agent or broker. No stockholder of Hectare at any time made any personal use of the Montgomery tract for any purpose.
Hectare at no time subdivided the Montgomery tract or made any improvements on the property or took any steps toward developing the property. Hectare did not advertise the property for sale, but its stockholders understood that the objective of Hectare was to sell the Montgomery tract at a profit. The only business that Hectare ever engaged in was selling the Montgomery property. Hectare has been inactive since the sale of the Montgomery property. The stockholders of Hectare had no common interest in participating in other projects, primarily because the other shareholders found it difficult to communicate with Nay H. Fechtel and decided that they would cease doing business through Hectare. After the sale of the Montgomery property, the other stockholders of Hectare attempted to have Hectare obtain Fechtel's stock. Since they were unable to have Hectare obtain Fech-tel's stock, they made no plans to continue in any investments through the corporation or otherwise.
On January 31,1964, Hectare filed an election to be taxed as a small business corporation under subchapter S of the Internal Revenue Code of 1954. At all times during the existence of Hectare it has had less than 10 stockholders, all of whom have been individuals and it has never had more than one class of stock.
Hectare, on its TJ.'S. small business corporation income tax returns, Form 1120-S, for 1965 and 1966, reported income, expenses, and net income as follows:
Income: ms me
Net long-term capital gain reduced by any net
short-term capital loss_$24,514.50 $150, 834. 75
Deductions: ms me
Taxes_ $894. 65 $10. 60
Interest_6, 617. 12 810. 13
Organization expense_ 52. 00 52. 00
Other deductions_ 202. 44 209. 55
Total deductions_ 7, 766. 21 1, 082. 28
Net income_ 16, 748. 29 149, 752. 47
The other deductions consisted of accounting fees of $100 in 1965 and $70 in 1966, insurance of $84 in 1965 and a credit of $30' on insurance in 1966, office expense of $18.44 in 1965 and $1.42 in 1966, and an engineering expense of $168.13 in 1966.
On its returns for 1965 and 1966 Hectare reported that none of its stockholders devoted any time to its business or received any compensation and reported stock ownership and distributions to them as follows:
William B. and Fay S. Howell on their joint Federal income tax return for 1965 reported an ordinary loss of $2,588.74 and a long-term capital gain of $8,171.50 from Hectare, and on the joint return for 1966 reported an ordinary loss of $360.76 and a long-term capital gain of $50,278.25 from Hectare.
George E. and Jan P. Chase on their joint Federal income tax return for 1965 reported an ordinary loss of $1,294.37 and a long-term capital gain of $4,085.75 from Hectare, and on their joint return for 1966 reported an ordinary loss of $180.38 and a long-term capital gain of $25,139.13 from Hectare.
Allen S. and Katharine C. Hardin on their joint Federal income tax return for 1965 reported an ordinary loss of $2,589 and a long-term capital gain of $8,171 from Hectare, and on their joint return for 1966 reported an ordinary loss of $361 and a long-term capital gain of $50,278 from Hectare.
Respondent in his notice of deficiency to Hectare explained his determination of deficiencies as follows:
It is determined that you are not entitled to the election under section 1372, subehapter S, 1954 Code for the taxable year ended December 31, 1965 and 1966, because you were not engaged in a trade or business. Further, it is determined that you realized ordinary income from the sale of real estate, rather than long-term capital gain, and therefore you are not entitled to the alternative tax computation provided under section 1201 of the Internal Revenue Code. Accordingly, taxable income as shown on Forms 1120-S for 1965 and 1966 is subject to the tax under section 11 of the Code.
In bis notice of deficiency to William B. and Fay S. Howell, respondent determined tbat they received dividends from Hectare in the amount of $5,582.76 for 1965 and $49,917.49 for 1966 and were not entitled to tbe ordinary loss claimed from Hectare of $2,588.74 in 1965 and $360.76 in 1966, thereby increasing tbeir reported taxable income by $8,171.50 and $50,278.25 in 1965 and 1966, respectively.
Respondent in his notice of deficiency to the Chases and in his notice of deficiency to the Iiardins made adjustments exactly as those made in his notice to the Howells except the figures used were those applicable to the receipts by the particular taxpayers from Hectare and the ordinary-loss deduction claimed by those taxpayers.
OPINION
The case at bar presents for our determination three issues, the first of which relates to whether property sold by Hectare was a capital asset within the meaning of section 1221, or whether such property was held by the corporation primarily for sale to customers in the ordinary course of the corporate trade or business. Section 1221 states in part:
SEC. 1221. CAPITAL ASSET DEFINED.
For the purposes of this subtitle, the term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include—
(1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;
Restating the basic facts briefly Hughes approached Howell in 1961 with respect to the purchase of certain property being sold by the heirs of the estate of W. A. Montgomery. Hughes, Howell, and one Hardin decided to acquire the property and agreed to form a corporation and have the corporation purchase the land. In accordance with their agreement Hectare was incorporated, and on January 23, 1962, acquired the Montgomery property which consisted of 42.86 acres of land. Hectare had no other assets and never received any rent or other income from the property. On January 31,1964, Hectare filed an election to be taxed as a small business corporation. On December 30,1964, Hectare sold 0.9 acre of the property. This was followed by a sale of 2.2 acres on December 15, 1965. Finally on January 14, 1966, Hectare sold the remaining 39.74 acres of property. The gain recognized on the three sales was reported as long-term capital gain by the shareholders pursuant to their election to have Hectare taxed as a subchapter S corporation.
Preliminarily, we point out that respondent bas not questioned the validity of the corporation structure. Bather, both parties agree that Hectare was a viable corporation. Such an understanding is appropriate in light of the Supreme Court's determination in Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943).
As we understand the principal thrust of respondent's present position it is that, since the holding and subsequent sale of the real property was the only activity engaged in by Hectare, such sole activity must have resulted in the receipt of ordinary income. Or to state the proposition in the negative, a corporation cannot have as its sole activity an investment activity which qualifies its only income as capital gain even though in another setting this same income might be so treated.
We cannot accept this contention. There is nothing unique or improper about a corporation engaging in exclusively investment activity. We can find no basis in the Code, the regulations thereunder, the decided cases, or the generally accepted concepts of tax law for requiring that every corporation must have some "ordinary income" activity. Further, we find no need here to ignore the recognized precepts of corporate law, with respect to corporate viability, to maintain the integrity of the Internal Bevenue Code.
The limited authority that exists on this novel question supports this conclusion. The language in section 1221 itself, the section which creates the distinction here involved, makes reference to "property held by the taxpayer." Section 7701 defines taxpayer to include individuals and corporations. Therefore, it is clear that a corporation may hold a capital asset, and there would seem to be no justification for holding otherwise merely because such property is the corporation's only asset. In making the initial determination whether the property is a capital asset, logic requires that the property be subjected to the same tests applied to an individual.
In further support of this position we note that in 512 W. Fifty-sixth St. Corp. v. Commissioner, 151 F. 2d 942 (C.A. 2, 1945), affirming a Memorandum Opinion of this Court, the only property owned by the taxpayer corporation had been bought for sale, was continually held for that purpose, and was its sole business. The Second Circuit held that the sale of property was a capital loss. It stated:
Hence we are to judge whether the taxpayer was engaged in any business by its own activities . So judged, there can be not the least doubt that it had no "business," as [sec. 1221(a) (1)] uses the word. It never held in all more than the two parcels we have mentioned and that which was foreclosed. Whatever the reason, the disposition of the two hung fire for years: the first parcel for twenty years; the second, for thirteen. Indeed, the Tax Court was altogether justified in concluding that the first parcel was not held "primarily for sale" at all. If so, tJie putative "business" consisted, in acquiring, and after long delay, in selling one parcel of property . Much more eoiv-tinuous activity in buying and selling is necessary to constitute a "business." [Emphasis supplied. 151 E. 2d at 944.]
More recently in Morris Cohen, 39 T.C. 886 (1963), petitioners were interested in acquiring land for investment. They formed DOM Corporation to hold the property. Though the issue presented dealt with the applicability of the collapsible corporation provisions, this Court pointed out that "The very limited activities of DOM did not put [it! in the real estate business."
We believe the foregoing authorities support our conclusion that a corporation may hold, as its only property, investment assets.
Having made that determination, we must proceed to an analysis of whether the real property at hand was held primarily for sale to customers in the ordinary course of such business or held for investment purposes. This poses a pure question of fact. W. T. Thrift, Sr., 15 T.C. 366 (1950). Faced with this question on innumerable occasions, the courts have adopted several well-recognized tests. These tests include: (1) The purpose for which the asset was acquired; (2) the frequency, continuity, and size of the sales; (3) the activities of the seller in the improvement and disposition of the property; (4) the extent of improvements made to the property; (5) the proximity of sale to purchase; and (6) the purpose for which the property was held during the taxable years. Robert W. Pointer, 48 T.C. 906 (1967), affd. 419 F. 2d 213 (C.A. 9, 1969); James G. Hoover, 32 T.C. 618 (1959).
We are of the opinion that Hectare was engaged solely in investment activities in acquiring and selling the real estate. In support of this conclusion we note that the property in question was acquired in January of 1962 and was not completely disposed of until January of 1966, 4 years later. There were a total of three sales, with the first two being merely incidental to the final sale which disposed of over 90 percent of the initial tract of land. The real estate was unimproved and Hectare made no attempt to improve or subdivide it. The property was not advertised for sale; the officers of Hectare were approached with respect to the purchase of the real estate.
We note that, though the property may have been acquired with the ultimate intention of reselling, this does not result in a determination that the property was held primarily for sale in the ordinary course of business. Eather, as the Fifth Circuit noted in Dunlap v. Oldham Lumber Co., 178 F. 2d 781, 785 (C.A. 5, 1950), property must not only have been "held primarily for sale," but also for sale in the "ordinary course of business." See also United States v. Winthrop, 417 F. 2d 905 (C.A. 5, 1969); Wellesley A. Ayling, 32 T.C. 704 (1959). As noted above, the facts indicate that the property was held for investment. In further support of this conclusion we point to the Supreme Court's opinion in Malat v. Riddell, 383 U.S. 569, 572 (1966), wherein it was stated:
The purpose of the statutory provision with which we deal is to differentiate between the "profits and losses arising from the everyday operation of a business" on the one hand (Corn Products Co. v. Commissioner, 350 U.S. 46, 52) and "the realization of appreciation in value accrued over a substantial period of time" on the other. (Commissioner v. Gillette Motor Co., 364 U.S. 130, 134.) A literal reading of the statute is consistent with this legislative purpose. We hold that, as used in section 1221 (1), "primarily" means "of first importance" or "principally."
It is manifest that the profit arising in the instant transaction was the realization of appreciation in value accruing over a period of time; and the fact that such appreciation was anticipated and was the raison d'etre for the purchase does not serve to alter this basic fact.
Upon an examination of the entire record we conclude that Hectare was engaged in investment activities in acquiring and selling the real estate.
The second issue requires us to determine whether Hectare was entitled to the small business corporation election provided for within section 1372.
Section 1371 defines small business corporation as a domestic corporation which has satisfied certain specific requirements. We have already pointed out that Hectare was a viable corporation and, re spondent concedes that the 1371 requirements have been complied with. Therefore, it is apparent to this Court that Hectare was a viable small business corporation.
Respondent contends however, that if we determined Hectare to have been holding the Montgomery property for investment then Hectare cannot be a small business corporation as it has no active trade or business. In support of this assertion respondent relies on the legis-laitive history of section 1378 which states in part:
When the "passthrough" type of tax treatment was provided for corporations, Congress decided to limit the availability of this treatment to small businesses actively engaged in trades or businesses. Therefore, it denied this treatment to corporations with large amounts of passive income. [S. Kept. No. 1007, 89th Cong., 2d Sess. 1966-1 C.B. 532.]
Respondent's reliance is misplaced. The mam import of the quoted language was to exclude from the small business corporation provisions, corporations with large amounts of passive income; which was defined by Congress to include royalties, rents, dividends, interests, annuities, and gross receipts from the sale of stock or securities. See section 1372(e) (5) as it read during the years before the Court. Since Hectare's only income was received from the sale of real estate, it had no passive investment income and therefore was not prohibited from electing to be taxed as a small business corporation.
We also note that respondent's reliance on DuPont v. United States, 234 F. Supp. 681 (D. Del. 1964), is also inappropriate. The court in DuPont was concerned with whether the corporation in question was operated with the intention of making a profit or merely incorporated as a hobby. It stated:
Generally understood, a "business" corporation is one which is operated for purposes of making a profit. A more detailed analysis of the Code substantiates the conclusion that Subchapter S was intended to apply to corporations whose aim is to make money. [234 F. Supp. at 683.]
Clearly Hectare was attempting to make a profit and thereby was a business corporation.
Further we point out that respondent's own regulations, at 1.1375-1 (d), demonstrate that the Commissioner contemplated a situation wherein a subchapter S corporation would be availed of merely to sell property and this regulation does not attempt to avoid such an election. We therefore conclude that Hectare was a valid small business corporation, and the gain realized on the sale of the property is passed through to the shareholders.
Finally we note that, though we have determined the Montgomery real estate to have been acquired by Hectare for investment, the regulations at sec. 1.1375-1 (d) require, in addition, that a determination be made with respect to the character of the property in the hands of the shareholder, for if the property is held not to be a capital asset in his hands, then the gain is to be treated as ordinary income.
Specifically without passing on the validity of this regulation we note that, though one of the shareholders was a real estate broker, this does not necessitate a determination that he was in the business of buying and selling property. Rather, he was an agent whose job it was to obtain buyers for property. However, even if it is determined that he was in the business of buying and selling property that does not require a finding that the Montgomery property was so held. It is established that a person may be both a dealer and an investor. Real Estate Corporation, 35 T.C. 610 (1961), affd. 301 F. 2d 423 (C.A. 10, 1962); Charles B. Mieg, 32 T.C. 1314 (1959). As noted above, the facts indicate that the property was not sold for 4 years. Further, no attempt was made to subdivide, improve, or sell the property. Clearly the intent of the shareholders was to hold the property for investment. Therefore, assuming arguendo that the regulation is valid, we find on the facts presented that the real estate would have been a capital asset in the hands of the shareholders thereby requiring the gain realized by Hectare on the sale of the property to be taxed as capital gain at the shareholder level.
Reviewed by the Court.
Decisions will be entered for the fetitioners.
All references are to the Internal Revenue Code of 1954 unless otherwise Indicated.
Respondent, appropriately, does not contend that a corporation cannot hold property for investment. In Graves Brothers Co., 17 T.C. 1499, 1506 (1952), this Conrt stated, "It is easily conceivable that a corporation might acquire real property for uses other than in its trade or business." And more recently in Maddux Construction Co., 54 T.C. 1278, 1287 (1970), this forum pointed out that, "We cannot conclude from the Tecord before us that the profit realized by petitioner on this one isolated transaction represents 'profits ♦ arising from the everyday operation of a (petitioner's] business.' Instead we believe the profit represented 'the realization of appreciation in value accrued over a substantial period of time' whUe petitioner held the property." The Court concluded that the gain was taxable as capital gain.
The Second Circuit points out that the corporation's only income consisted of rents from the parcels of land. However they, note that "All three parcels — the only property owned by the taxpayer — had been bought for sale and were continually held for that purpose, and it had no other business." (151 F. 2d at 943.)
SBC. 1371. DEFINITIONS.
(a) Small Business Corporation. — For purposes of this subchapter, the term "small business corporation" means a domestic corporation which is not a member of an affiliated group (as defined in section 1504) and which does not—
(1) have more than 10 shareholders;
(2) have as a shareholder a person (other than an estate) who is not an individual;
(3) have a nonresident alien as a shareholder ; and
(4) have more than one class of stock.
(b) Electing Small Business Corporation. — For purposes of this subchapter, the term "electing small business corporation" means, with respect to any taxable year, a small business corporation which has made an election under section 1372(a) which, under section 1372, is in effect for such, taxable year.
The regulations at see. 1.1375-1 (d) state in part:
See. 1.1375-1 (d). Level for determining character of gain. Ordinarily, for purposes of determining whether gain on the sale or exchange of an asset by an electing small business corporation is capital gain, the character of the asset is determined at the corporate level. However, if an electing small business corporation is availed of by any shareholder or group of shareholders owning a substantial portion of the stock of such corporation for the purpose of selling property which in the hands of such shareholder or shareholders would not have been an asset, gain from the sale of which would be capital gain, then the gain on the sale of such property by the corporation shall not be treated as capital gain.
We note in passing that dne to its effective date sec. 1378 is not applicable to the instant cases.
Sec. 1.1375-1 (d) supra.