Frank Lyon Co. v. United States
435 U.S. 561 (1978)

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U.S. Supreme Court

Frank Lyon Co. v. United States, 435 U.S. 561 (1978)

Frank Lyon Co. v. United States

No. 76-624

Argued November 2, 1977

Decided April 18, 1978

435 U.S. 561

CERTIORARI TO THE UNITED STATES COURT OF APPEALS

FOR THE EIGHTH CIRCUIT

Syllabus

A state bank, which was a member of the Federal Reserve System, upon realizing that it was not feasible, because of various state and federal regulations, for it to finance by conventional mortgage and other financing a building under construction for its headquarters and principal banking facility, entered into sale and lease-back agreements by which petitioner took title to the building and leased it back to the hank for long-term use, petitioner obtaining both a construction loan and permanent mortgage financing. The bank is obligated to pay rent equal to the principal and interest payments on petitioner's mortgage, and has an option to repurchase the building at various times at prices equal to the then unpaid balance of petitioner's mortgage and initial $500,000 investment. On its federal income tax return for the year in which the building was completed and the bank took possession, petitioner accrued rent from the bank and claimed as deductions depreciation on the building, interest on its construction loan and mortgage, and other expenses related to the sale and lease-back transaction. The Commissioner of Internal Revenue disallowed the deductions on the ground that petitioner was not the owner of the building for tax purposes, but that the sale and lease-back arrangement was a financing transaction in which petitioner loaned the bank $500,000 and acted as a conduit for the transmission of principal and interest to petitioner's mortgagee. This resulted in a deficiency in petitioner's income tax, which it paid. After its claim for a refund was denied, it brought suit in the District Court to recover the amount so paid. That court held that the claimed deductions were allowable, but the Court of Appeals reversed, agreeing with the Commissioner.

Held: Petitioner is entitled to the claimed deductions. Pp. 435 U. S. 572-584.

(a) Although the rent agreed to be paid by the bank equaled the amounts due from the petitioner to its mortgagee, the sale and lease-back transaction is not a simple sham by which petitioner was but a conduit used to forward the mortgage payments made under the guise of rent paid by the bank to petitioner, on to the mortgagee, but the construction loan and mortgage note obligations on which petitioner paid interest are its obligations alone, and, accordingly, it is entitled to claim deductions

Page 435 U. S. 562

therefor under § 163(a) of the Internal Revenue Code of 1954. Helvering v. Lazarus & Co.,308 U. S. 252, distinguished. Pp. 435 U. S. 572-581.

(b) While it is clear that none of the parties to the sale and lease-back agreements is the owner of the building in any simple sense, it is equally clear that petitioner is the one whose capital was invested in the building, and is therefore the party entitled to claim depreciation for the consumption of that capital under § 167 of the Code. P. 435 U. S. 581.

(c) Where, as here, there is a genuine multiple-party transaction with economic substance that is compelled or encouraged by business or regulatory realities, that is imbued with tax-independent considerations, and that is not shaped solely by tax-avoidance features to which meaningless labels are attached, the Government should honor the allocation of rights and duties effectuated by the parties; so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes. Pp. 435 U. S. 581-584.

536 F. d 746, reversed.

BLACKMUN, J., delivered the opinion of the Court, in which BURGER, C.J., and BRENNAN, STEWART, MARSHALL, POWELL, and REHNQUIST, JJ., joined. WHITE, J., filed a dissenting statement, post, p. 435 U. S. 584. STEVENS, J., filed a dissenting opinion, post, p. 435 U. S. 584.

MR. JUSTICE BLACKMUN delivered the opinion of the Court.

This case concerns the federal income tax consequences of a sale and lease-back in which petitioner Frank Lyon Company (Lyon) took title to a building under construction by Worthen Bank & Trust Company (Worthen) of Little Rock, Ark., and simultaneously leased the building back to Worthen for long-term use as its headquarters and principal banking facility.

Page 435 U. S. 563

I

The underlying pertinent facts are undisputed. They are established by stipulations, App. 9, 14, the trial testimony, and the documentary evidence, and are reflected in the District Court's findings.

A

Lyon is a closely held Arkansas corporation engaged in the distribution of home furnishings, primarily Whirlpool and RCA electrical products. Worthen, in 1965, was an Arkansas-chartered bank and a member of the Federal Reserve System. Frank Lyon was Lyon's majority shareholder and board chairman; he also served on Worthen's board. Worthen at that time began to plan the construction of a multistory bank and office building to replace its existing facility in Little Rock. About the same time, Worthen's competitor, Union National Bank of Little Rock, also began to plan a new bank and office building. Adjacent sites on Capitol Avenue, separated only by Spring Street, were acquired by the two banks. It became a matter of competition, for both banking business and tenants, and prestige as to which bank would start and complete its building first.

Worthen initially hoped to finance, to build, and to own the proposed facility at a total cost of $9 million for the site, building, and adjoining parking deck. This was to be accomplished by selling $4 million in debentures and using the proceeds in the acquisition of the capital stock of a wholly owned real estate subsidiary. This subsidiary would have formal title, and would raise the remaining $5 million by a conventional mortgage loan on the new premises. Worthen's plan, however, had to be abandoned for two significant reasons:

1. As a bank chartered under Arkansas law, Worthen legally could not pay more interest on any debentures it might issue than that then specified by Arkansas law. But the proposed obligations would not be marketable at that rate.

Page 435 U. S. 564

2. Applicable statutes or regulations of the Arkansas State Bank Department and the Federal Reserve System required Worthen, as a state bank subject to their supervision, to obtain prior permission for the investment in banking premises of any amount (including that placed in a real estate subsidiary) in excess of the bank's capital stock or of 40% of its capital stock and surplus. [Footnote 1] See Ark.Stat.Ann. § 67-547.1 (Supp. 1977); 12 U.S.C. § 371d (1976 ed.); 12 CFR § 265.2(f)(7) (1977). Worthen, accordingly, was advised by staff employees of the Federal Reserve System that they would not recommend approval of the plan by the System's Board of Governors.

Worthen therefore was forced to seek an alternative solution that would provide it with the use of the building, satisfy the state and federal regulators, and attract the necessary capital. In September, 1967, it proposed a sale and lease-back arrangement. The State Bank Department and the Federal Reserve System approved this approach, but the Department required that Worthen possess an option to purchase the leased property at the end of the 15th year of the lease at a set price, and the federal regulator required that the building be owned by an independent third party.

Detailed negotiations ensued with investors that had indicated interest, namely, Goldman, Sachs & Company; White, Weld & Co.; Eastman Dillon, Union Securities & Company; and Stephens, Inc. Certain of these firms made specific proposals.

Worthen then obtained a commitment from New York Life Insurance Company to provide $7,140,000 in permanent mortgage financing on the building, conditioned upon its approval of the titleholder. At this point, Lyon entered the negotiations, and it, too, made a proposal.

Page 435 U. S. 565

Worthen submitted a counterproposal that incorporated the best features, from its point of view, of the several offers. Lyon accepted the counterproposal, suggesting, by way of further inducement, a $21,000 reduction in the annual rent for the first five years of the building lease. Worthen selected Lyon as the investor. After further negotiations, resulting in the elimination of that rent reduction (offset, however, by higher interest Lyon was to pay Worthen on a subsequent unrelated loan), Lyon, in November, 1967, was approved as an acceptable borrower by First National City Bank for the construction financing, and by New York Life, as the permanent lender. In April, 1968, the approvals of the state and federal regulators were received.

In the meantime, on September 15, before Lyon was selected, Worthen itself began construction.

B

In May, 1968, Worthen, Lyon, City Bank, and New York Life executed complementary and interlocking agreements under which the building was sold by Worthen to Lyon as it was constructed, and Worthen leased the completed building back from Lyon.

1. Agreements between Worthen and Lyon. Worthen and Lyon executed a ground lease, a sales agreement, and a building lease.

Under the ground lease dated May 1, 1968, App. 366, Worthen leased the site to Lyon for 76 years and 7 months through November 30, 2044. The first 19 months were the estimated construction period. The ground rents payable by Lyon to Worthen were $50 for the first 26 years and 7 months, and thereafter in quarterly payments:

12/1/94 through 11/30/99 (5 years) -- $100,000 annually

12/1/99 through 11/30/04 (5 years) -- $150,000 annually

12/1/04 through 11/30/09 (5 years) -- $200,000 annually

12/1/09 through 11/30/34 (25 years) -- $250,000 annually

12/1/34 through 11/30/44 (10 years) -- $10,000 annually.

Page 435 U. S. 566

Under the sales agreement dated May 19, 1968, id. at 508, Worthen agreed to sell the building to Lyon, and Lyon agreed to buy it, piece by piece as it was constructed, for a total price not to exceed $7,640,000, in reimbursements to Worthen for its expenditures for the construction of the building. [Footnote 2]

Under the building lease dated May 1, 1968, id. at 376, Lyon leased the building back to Worthen for a primary term of 25 years from December 1, 1969, with options in Worthen to extend the lease for eight additional 5-year terms, a total of 65 years. During the period between the expiration of the building lease (at the latest, November 30, 2034, if fully extended) and the end of the ground lease on November 30, 2044, full ownership, use, and control of the building were Lyon's, unless, of course, the building had been repurchased by Worthen. Id. at 369. Worthen was not obligated to pay rent under the building lease until completion of the building. For the first 11 years of the lease, that is, until November 30, 1980, the stated quarterly rent was $145,581.03 ($582,324.12 for the year). For the next 14 years, the quarterly rent was $153,289.32 ($613,157.28 for the year), and for the option periods the rent was $300,000 a year, payable quarterly. Id. at 378-379. The total rent for the building over the 25-year primary term of the lease thus was $14,989,767.24. That rent equaled the principal and interest payments that would amortize the $7,140,000 New York Life mortgage loan over the same period. When the mortgage was paid off at the end of the primary term, the annual building rent, if Worthen extended the lease, came down to the stated $300,000. Lyon's

Page 435 U. S. 567

net rentals from the building would be further reduced by the increase in ground rent Worthen would receive from Lyon during the extension. [Footnote 3]

The building lease was a "net lease," under which Worthen was responsible for all expenses usually associated with the maintenance of an office building, including repairs, taxes, utility charges, and insurance, and was to keep the premises in good condition, excluding, however, reasonable wear and tear.

Finally, under the lease, Worthen had the option to repurchase the building at the following times and prices:

11/30/80 (after 11 years) -- $6,325,169.85

11/30/84 (after 15 years) -- $5,432,607.32

11/30/89 (after 20 years) -- $4,187,328.04

11/30/94 (after 25 years) -- $2,145,935.00

These repurchase option prices were the sum of the unpaid balance of the New York Life mortgage, Lyon's $500,000 investment, and 6% interest compounded on that investment.

2. Construction financing agreement. By agreement dated May 14, 1968, id. at 462, City Bank agreed to lend Lyon $7,000,000 for the construction of the building. This loan was secured by a mortgage on the building and the parking deck, executed by Worthen as well as by Lyon, and an assignment by Lyon of its interests in the building lease and in the ground lease.

3. Permanent financing agreement. By Note Purchase

Page 435 U. S. 568

Agreement dated May 1, 1968, id. at 443, New York Life agreed to purchase Lyon's $7,140,000 6 3/4% 25-year secured note to be issued upon completion of the building. Under this agreement, Lyon warranted that it would lease the building to Worthen for a noncancelable term of at least 25 years under a net lease at a rent at least equal to the mortgage payments on the note. Lyon agreed to make quarterly payments of principal and interest equal to the rentals payable by Worthen during the corresponding primary term of the lease. Id. at 623. The security for the note was a first deed of trust and Lyon's assignment of its interests in the building lease and in the ground lease. Id. at 527, 571. Worthen joined in the deed of trust as the owner of the fee and the parking deck.

In December, 1969, the building was completed, and Worthen took possession. At that time, Lyon received the permanent loan from New York Life, and it discharged the interim loan from City Bank. The actual cost of constructing the office building and parking complex (excluding the cost of the land) exceeded $10,000,000.

C

Lyon filed its federal income tax returns on the accrual and calendar year basis. On its 1969 return, Lyon accrued rent from Worthen for December. It asserted as deductions one month's interest to New York Life; one month's depreciation on the building; interest on the construction loan from City Bank; and sums for legal and other expenses incurred in connection with the transaction.

On audit of Lyon's 1969 return, the Commissioner of Internal Revenue determined that Lyon was "not the owner for tax purposes of any portion of the Worthen Building," and ruled that "the income and expenses related to this building are not allowable . . . for Federal income tax purposes." App. 304-305, 299. He also added $2,298.15 to Lyon's 1969 income as "accrued interest income." This was the computed 1969 portion of a gain, considered the equivalent of interest income,

Page 435 U. S. 569

the realization of which was based on the assumption that Worthen would exercise its option to buy the building after 11 years, on November 30, 1980, at the price stated in the lease, and on the additional determination that Lyon had "loaned" $500,000 to Worthen. In other words, the Commissioner determined that the sale and lease-back arrangement was a financing transaction in which Lyon loaned Worthen $500,000 and acted as a conduit for the transmission of principal and interest from Worthen to New York Life.

All this resulted in a total increase of $497,219.18 over Lyon's reported income for 1969, and a deficiency in Lyon's federal income tax for that year in the amount of $236,596.36. The Commissioner assessed that amount, together with interest of $43,790.84, for a total of $280,387.20. [Footnote 4]

Lyon paid the assessment and filed a timely claim for its refund. The claim was denied, and this suit, to recover the amount so paid, was instituted in the United States District Court for the Eastern District of Arkansas within the time allowed by 26 U.S.C. § 6532(a)(1).

After trial without a jury, the District Court, in a memorandum letter opinion setting forth findings and conclusions, ruled in Lyon's favor and held that its claimed deductions were allowable. 75-2 USTC

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