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Braunstein v. Commissioner of Internal Revenue

decided: July 6, 1962.


Author: Lumbard

Before LUMBARD, Chief Judge, and SMITH and MARSHALL, Circuit Judges.

LUMBARD, Chief Judge.

The taxpayers,*fn1 who had previously been active in constructing homes and apartment buildings, formed two corporations in 1948 for the purpose of building apartment houses in a development called Oakland Gardens in Bayside, Queens County, New York, to be financed under § 608 of the National Housing Act.*fn2 The Federal Housing Administration (FHA) guaranteed mortgage loans to the two corporations which then built the proposed projects.Each corporation had an excess of mortgage loan funds remaining after the costs of construction had been paid. In 1950, the year following completion of construction, the three taxpayers sold their stock in both corporations at a profit and, as part of the sale transaction, received distributions which included the excess mortgage funds from the two corporations. The taxpayers reported the excess of the amounts they received - both on the distributions from the corporations and on sale of their stock - over their bases in the stock and the expenses of sale as long-term capital gains of $313,854.17 each. The Commissioner asserted that the two corporations were collapsible corporations under § 117(m) of the Internal Revenue Code of 1939*fn3 so that the gains from the distributions and from the sale of the stock were ordinary income. In a decision which was reviewed by the full court, the Tax Court upheld the Commissioner with one judge dissenting. 36 T.C. 22 (1961). The taxpayers appeal, and we affirm.

The Taxpayers Had the Requisite View During Construction

According to § 117(m)(1) of the 1939 Code, gain from the sale or exchange of stock of a "collapsible corporation," which gain, but for § 117(m), would be long-term capital gain, is ordinary income. According to § 117(m)(2)(A), a corporation is a "collapsible corporation" if it is formed or availed of principally for the construction of property "with a view to * * * the sale or exchange of stock by its shareholders * * * or a distribution to its shareholders, prior to the realization by the corporation * * * constructing * * * the property of a substantial part of the net income to be derived from such property" and "with a view to * * * the realization by such shareholders of gain attributable to such property." This "view" is present "whether such action [sale or exchange of the stock or distribution to shareholders] was contemplated unconditionally, conditionally, or as a recognized possibility." Treas. Reg. 111, § 29.117-11(b) (1953). The "view" to such sale or distribution must exist at some time "during construction." Treas. Reg. 111, § 29.117-11 (b) (1953). See Jacobson v. Commissioner, 281 F.2d 703 (3 Cir. 1960). But see Glickman v. Commissioner, 256 F.2d 108, 110-111 (2 Cir. 1958) (dictum). Thus, if "the sale, exchang, or distribution is attributable to circumstances present at the time of * * * construction * * * the corporation shall, in the absence of compelling facts to the contrary, be considered to have been so formed or availed of." Treas. Reg. 111 § 29.117-11(b) (1953). The regulations state that when a corporation's construction of property is substantial in relation to its other activities and its shareholders sell their stock or receive a distribution, thus recognizing a gain before the corporation has realized a substantial part of the net income from the property, these facts will ordinarily be sufficient, in the absence of other facts, to establish that the corporation is collapsible. Treas. Reg. 111, § 29.117-11(d) (1953).

In an attempt to satisfy their burden of proof that they did not have the requisite view to sale or distribution during construction the taxpayers make two main arguments. They contend that they intended the two corporations to be repositories for the accumulation of substantial estates for their families, and thus meant the corporations to be long-term investments. They further contend that the distributions and sales were attributable to an unanticipated decline in the profitability of the two corporations - a decrease in rent income and an increase in expenses - which occurred after construction was completed. The Tax Court found that although the taxpayers may have been attempting to make profits, the facts were inconsistent with the use of the two corporations as a repository for these profits. The Tax Court also found that the facts did not bear out the taxpayers' claims that there was an unexpected decline in profitability after the completion of construction. We conclude that the Tax Court was not wrong when it found that the taxpayers had the requisite "view" prior to the completion of the two projects.*fn4

Although Benjamin Neisloss testified that the two corporations were intended as a long-term repository for the accumulation of a large estate, the Tax Court need not accept the unsupported testimony of an interested party. See, e. g., Hartman v. Commissioner, 296 F.2d 726, 727-728 (2 Cir. 1961); Payne v. Commissioner, 268 F.2d 617, 621 (5 Cir. 1959); Cohen v. Commissioner, 148 F.2d 336 (2 Cir. 1945). Thus it is necessary for us to examine the facts to see if they lend support to the taxpayers' contention.

Benjamin and Harry Neisloss were brothers active in various real estate construction enterprises since 1919. Benjamin Braunstein is an architect who had been associated with the other two since about 1930. Beginning in 1943 the three taxpayers organized and were equal stockholders in seven corporations which constructed multiple dwelling gardentype apartments financed under § 608 of the National Housing Act. After the passage of between one and ten years from the completion of these projects, the taxpayers sold their stock in the seven corporations in 1949, 1950, and 1953. This case concerns the distribution of cash and the sale of the stock of two of these corporations.

On March 31, 1948 Springfield Development Company, Inc., and Hill Development Company, Inc., were incorporated. Each of the three taxpayers purchased ten shares of the common A stock of each corporation for $1 per share. The FHA purchased 100 shares of each corporation's preferred stock for $1 per share. Thus the two corporations' total paid-in capital was only $260. The taxpayers and their other corporations made loans to Springfield and Hill which were repaid out of the mortgage loan proceeds. Although such a nominal capitalization is not wholly inconsistent with the taxpayers' claims that they intended Springfield and Hill as a repository for the accumulation of their estates, it certainly does not lend weight to their contentions.

Previously the taxpayers had obtained a commitment from the FHA for mortgage loan insurance for the two projects, which were in fact parts of a signle overall development. The FHA's total estimated cost of the projects was $6,845,804 and the total mortgage insurance commitments were $6,101,600.Both corporations entered into loan agreements with the Bank of Manhattan Company to advance the amount of the FHA mortgage insurance commitment with 4% interest.

Springfield and Hill entered into contracts with the N.B. Construction Company, Inc., of which the three taxpayers were equal shareholders, for the construction of the projects.*fn5 Although these contracts specified a lump sum consideration, in practice Springfield and Hill merely reimbursed N.B. Construction for its costs.

Construction was begun in April 1948 and the various buildings were completed between September 1948 and June 1949. The costs of construction were less than had been estimated. Instead of contracting out the carpentry and plumbing work, the taxpayers had their own men do the work, saving $80,000 on carpentry and $85,000 on plumbing and heating. A decline in the cost of lumber resulted in a saving of $50,000. There were other savings amounting to nearly $90,000 in title and recording expenses and legal and organizational expenses. Furthermore, the FHA cost estimates had included $599,741 as the total builder's and architect's fees to be incurred by Springfield and Hill. N.B. Construction acted as builder (in addition to doing the construction work) and Benjamin Braunstein acted as architect for the two corporations without pay,*fn6 thus saving nearly $600,000 more.

Thus the mortgage loan proceeds exceeded the cash expenditures in constructing the two projects by more than $150,000. These excess funds were not used to prepay a part of the corporations' large mortgage indebtedness which was costing them 4% interest. Rather, these funds were loaned interest free to the taxpayers' other construction projects. Therefore, Springfield and Hill, far from accumulating the taxpayers' estate, were incurring uncompensated interest expenses while taxpayers' other corporations use the money to make a profit.

The land on which these projects were built was not owned by Springfield and Hill. In April and May 1947 Benjamin Neisloss entered into contracts to purchase the land for $120,000. On December 15, 1947, this land was conveyed to the wives of the three taxpayers who leased it to Springfield and Hill for 99 years at a total annual rental of $23,824, a rate which would repay the original cost in five years. In the FHA project analysis it was estimated that this land would be worth $595,600, five times its purchase price, after the projects were built. Although the legality or the propriety of this transaction is not questioned, it is evident that burdening the corporations with a substantial long-term rent obligation and shifting the benefit of the increase in value of the land due to the construction thereon from the corporations to the taxpayers' wives are not consistent with the taxpayers' claimed purpose to make Springfield and Hill long-term repositories of their increased estates.

These facts - nominal capitalization, interest free loans, and ownership of the land by the taxpayers' wives - while not necessarily inconsistent with Neisloss' testimony that the taxpayers intended to hold Springfield and Hill as longterm investments, lend little support to it. We turn now to the taxpayers' other contention, that the decision to sell was due solely to circumstances arising after construction which could not reasonably have been anticipated at the time of construction.

In making application for mortgage loan insurance the taxpayers submitted estimates of Springfield's and Hill's annual income and expenses. The FHA in making a project analysis made their own estimates. Rather than computing projected net income, the taxpayers and the FHA estimated net cash inflow, i. e., they started with estimated rent income and then deducted estimated cash expenses, estimated payments to the reserve for replacement of refrigerators, stoves, and equipment to be held by the mortgagee, and the amount of annual debt service (interest and principal payments and the cost of mortgage insurance), thus arriving at "Cash available for income taxes, corporate taxes, dividends and surplus." The estimates were as follows:

FHA Taxpayers'

Estimate Estimate

Springfield $53,925 $28,361

Hill 24,916 16,631

Total $78,841 $44,992

The Tax Court found that in entering into the project the taxpayers were relying upon their own estimates and not ...

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