Milbrew v.
Commissioner (1983)
MILBREW, INC., et al.,
Petitioners-Appellants, v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee
No. 82-2692
UNITED STATES COURT OF APPEALS FOR
THE SEVENTH CIRCUIT
710 F.2d 1302; 83-2 U.S. Tax Cas. (CCH)
P9467; 52 A.F.T.R.2d
(P-H) 5576
May 23, 1983, Argued
July 12, 1983, Decided
PRIOR HISTORY:
Appeal from the United States Tax Court.
COUNSEL: Gaar W. Steiner, Michael, Best
& Griedrich, Milwaukee, Wisconsin, for Petitioner.
Mary L. Fahey, Asst. Atty. Gen., Tax Div., Dept. of
Justice, Washington,
District of Columbia, for Respondent.
JUDGES: Cudahy, Posner, and Coffey, Circuit Judges.
OPINIONBY: POSNER
OPINION: POSNER, Circuit Judge.
The principal question in this appeal from a decision
of the Tax Court
disallowing deductions for depreciation, interest, and
payment of rent is
whether the Tax Court's finding that the sale of a
plant was a sham transaction
that should be disregarded for federal income tax
purposes was clearly
erroneous, the standard applicable to such a finding,
Thompson v. Commissioner,
631 F.2d 642, 646 (9th Cir. 1980).
The case concerns the Bernstein family, which can for
our purposes be divided
into two groups: the brothers Ace and Marty, and
everyone else. The taxpayers
call the second group the "cousins" and we
shall follow that terminology
although Ace and Marty in fact are uncles rather than
cousins of two of the
other Bernsteins. Until 1966 the cousins, on the one
hand, and Ace and Marty,
on the other, had gone their separate ways. The
cousins owned and operated
Milbrew, Inc., which manufactured an animal food
additive and a yeast used in
the brewery business. By late 1966 most of Milbrew's
manufacturing was being
done on a toll (i.e. fee) basis by a plant in Juneau,
Wisconsin, owned by a
dairy cooperative. Milbrew's business was in very bad
shape and in 1967 the
cousins induced Ace, a successful businessman in an
unrelated field, to take a
hand in running the company. At the same time
Northland Developers, a
corporation wholly owned by Ace and Marty, bought the
Juneau plant from the
dairy cooperative for a shade under $525,000; and for
the rest of 1967 and all
of 1968, Milbrew paid Northland rent for the plant at
an annual rate of about
$100,000.
On January 1, 1969, the Bernstein family created a
limited partnership called
NVST Company. All the Bernsteins received shares of
the partnership, and Ace
and Marty the lion's share -- 40 percent. On the day
of its creation NVST
entered into a contract with Northland to buy the
Juneau plant for $3 million.
The contract provided that NVST would pay Northland
interest at 4 percent, but
no principal, for the first five years, $50,000 a year
for the next five years,
and $300,000 a year for the succeeding ten years; the
remaining principal was
due at the end of the 20 years. Between 1969 and 1973
NVST charged annual rent
to Milbrew rising from $220,000 to $542,000, and
charged off against this rental
income annual depreciation rising from $219,000 to
$307,000 and interest on its
contract with Northland rising from $27,000 in 1970 to
$58,000 in 1973.
Milbrew's large rental expense for the Juneau plant
virtually wiped out its
taxable income, which rose from $1,500 in 1969 to
$8,100 in 1973 on gross sales
that rose from $1.5 million to $2.9 million. The
Internal Revenue Service
disallowed the depreciation and interest deductions
claimed by NVST (and passed
through to the partners in NVST, i.e., the Bernsteins),
and disallowed Milbrew's
annual deduction for rental expense to the extent it
exceeded $120,000 ($150,000
for 1973), the Service's estimate of the plant's fair
rental value. The premise
for these adjustments is that Northland's sale of the
Juneau plant to NVST in
1969 was a phony.
With Ace and Marty the sole owners of the seller of
the plant (Northland) and
major owners of the buyer (NVST), Ace the putative
savior of the tenant
(Milbrew), and everyone else in the picture a relative
of Ace and Marty's, the
sale was not an arm's length transaction, so there is
no presumption that it
reflected market values. The sale of the plant for
almost six times as much as
Northland had paid 20 months before is of course
highly suspicious and the terms
of the sale suggest that Northland was not serious
about collecting the inflated
purchase price. Also, even in 1969 4 percent was far
below the interest rate on
long-term, inherently risky loans, while the $50,000
due annually between the
sixth and [*1305] tenth years of the contract was less
than 2 percent. The
$300,000 a year due between the eleventh and twentieth
years actually
represented less than 10 percent of the principal,
since not only would the
principal balance not have been paid down at all by
the eleventh year but it
would have been increased by the interest arrears from
the sixth through tenth
years. If the stream of payments due on the contract,
treating the $3 million
principal as due in a lump at the end of the contract
period, is discounted to
present value at a 10 percent discount rate, the 1969
sale price was really only
$1.7 million. Moreover, during the first five years of
the contract, when NVST
was nominally obligated to pay a total of $600,000, it
actually paid only
$137,000. This not only was far below any reasonable
estimate of the interest
that an arm's length installment seller would have
charged for the $3 million
that Northland in effect loaned to NVST by deferring
receipt of principal, but
it meant that NVST was in default from the beginning
-- a circumstance that
seems not to have troubled Northland.
As soon as the deal was signed, NVST, Milbrew's new
landlord for the Juneau
plant, doubled the rent, and thereafter kept raising
it without rhyme or
apparent reason other than to minimize Milbrew's
taxable income. What otherwise
would have been taxable income to Milbrew was thus
shifted to NVST, which was
able to shield this rental income from tax by
depreciating the Juneau plant on
the basis of the $3 million that it had
"paid" Northland for the plant.
Northland also escaped having to pay substantial
income tax on the sale, because
NVST paid it little interest and no principal. So the
tax on Milbrew's income
was not merely shifted, but avoided altogether. The
key to the scheme was the $3
million sale price: if the price had been the same as
Northland had paid 20
months earlier, NVST could not have taken large enough
depreciation deductions
to offset its income from the huge rentals that it
charged Milbrew.
When persons who are not dealing with each other at
arm's length enter into a
transaction that gives them tremendous tax savings,
the Internal Revenue Service
is entitled to be suspicious of the genuineness of the
transaction; and here the
sale price, payment terms, subsequent payment history,
and rental increases
rightly reinforced the Service's suspicions. In
addition, the parties treated
the sale with extreme informality. It was not
recorded, and Northland continued
to represent the plant as being its own property,
unencumbered by any sale
contract. It is noteworthy, too, that the contract of
sale originally provided
for interest at the absurdly low rate of 1 percent and
that Ace changed this to
4 percent, just before the contract was signed,
without consulting any other
Bernsteins and without changing the price or any other
term in the contract --
which is why the $50,000 payments required in the
fifth through ninth years
would not even cover the interest contractually due in
those years.
The facts reviewed thus far make this case much like
Narver v. Commissioner,
75 T.C. 53, 100-01 (1980), aff'd per curiam, 670 F.2d
855 (9th Cir. 1982); but
we have to consider two types of rebuttal evidence
offered by the taxpayers.
The first was that after Ace became the guiding light
of Milbrew in 1967 it
experienced a rapid improvement in its business
prospects which enabled it to
pay a higher rent and which therefore increased the
fair market value of the
Juneau plant. The second is that after 1973 (the last
tax year in the case)
NVST made very substantial payments on the contract --
$1.1 million by the end
of 1978, though all of this was interest -- and that
in May 1983, while this
appeal was pending, a large corporation unrelated to
any of the Bernsteins
executed a letter of intent to purchase NVST's assets,
consisting primarily of
the Juneau plant, for $8.7 million.
The post-1973 evidence has little significance, and
not only because nine
years after the contract had been signed the purchaser
had still not begun to
repay principal. In having NVST make payments after
1973 the taxpayers may have
been trying to [*1306] shore up their case against the
very substantial tax
liability involved here (the deficiencies assessed by
the IRS on the Bernsteins
and on Milbrew exceed $800,000 for 1972 and 1973
alone). As for the expected
sale of the plant in 1983, even if we can go outside
the record before the Tax
Court (more on this question later) and accept the
proposition that the plant
indeed is worth almost $9 million today, this does not
show that it was worth at
least $3 million 14 years ago. Inflation, improvements
made to the plant, and
unexpected increases in the demand for the plant's
product could, singly or in
combination, dramatically increase the plant's value
over so long a period of
time. The plant easily could have appreciated, because
of inflation and other
factors, at an annual rate of 10 percent; if so, and
if the plant is worth $8.7
million today, it was worth only $2.3 million in 1969,
and we shall see that it
does these taxpayers little good to establish a fair
market value of more than
$525,000 but less than $3 million.
The evidence with regard to Milbrew's improving
fortunes between 1967, when
Northland bought the plant for $525,000, and 1969,
when it sold it to NVST for
$3 million, deserves more weight. The record shows
that in 1967 the dairy
business was in substantial decline in Wisconsin and
that dairy processing
plants such as the Juneau plant could be bought at
their scrap value, between
$400,000 and $600,000. True, the Juneau plant had a
nondairy tenant, Milbrew,
but Milbrew was, as we noted earlier, in a parlous
state too, which is why it
had called in Ace. The dairy cooperative that owned
the plant presumably knew
nothing of Ace's plans to revitalize Milbrew and was
therefore happy to be able
to sell the plant to Northland at a price
approximately equal to its scrap
value. By the end of 1968 things were looking up for
Milbrew. Between 1967 and
1969 its gross sales almost doubled. Therefore, to
determine the market value
of the Juneau plant on January 1, 1969, we must
imagine what the probable
outcome of negotiations between NVST and the dairy
cooperative, dealing at arm's
length, would have been if NVST had tried to buy the
plant from the cooperative
on January 1, 1969, Northland never having entered the
picture. On the one
hand, NVST might have said it would not pay more than
scrap value for the plant
because it could buy an equivalent surplus dairy plant
elsewhere in Wisconsin
for scrap value and rent that to Milbrew. On the other
hand, the dairy
cooperative could have pointed out that Milbrew's
business and the Juneau plant
had made an exceptionally good match that had rescued
Milbrew and put it on the
road to prosperity, and that surely Milbrew would pay
a hefty rental to continue
enjoying the use of the plant; if so, the plant would
be worth a lot to NVST,
Milbrew's landlord if NVST bought the plant. The
Service does not contend that
the $100,000 rent that Northland had been charging
Milbrew in 1968 was
unrealistic and this implies that the plant must have
been worth more than
$525,000 then, for the Service argues that a landlord
can expect to recover
between 14 and 16 percent of the value of his property
in the rental for it and
this would imply that the fair market value of the
plant was around $700,000 in
1969.
If the Juneau plant was the only one that Milbrew
could have survived in, a
proposition the record supports, this is a classic
case of bilateral monopoly --
a case where two persons (Milbrew and the owner of the
Juneau plant) can, as a
practical matter, deal only with each other. See,
e.g., Chicago & North Western
Transport Co. v. United States, 678 F.2d 665, 667-68
(7th Cir. 1982). In such a
setting, the price at which the parties will transact
may be anywhere in the
range bounded at the lower end by the minimum price
that the seller is willing
to accept and at the upper end by the maximum price
that the buyer is willing to
pay -- a range that is broad because of the assumption
that neither party can
practicably turn elsewhere if his offer is refused. In
this case the lower end
of the range was about $400,000, the minimum scrap
value for dairy
plants in Wisconsin in this period. The upper end of
the bargaining range was
the maximum price that someone could pay who planned
to rent the plant to
Milbrew; this price would be limited by the rental
payments that could be
squeezed out of Milbrew without breaking the company.
If Milbrew could pay
$450,000 a year in rent, this would imply that the
plant might be worth as much
as $3 million to a purchaser, since at that price the
purchaser would earn 15
percent a year on his investment.
On these assumptions there would be a bargaining range
between $400,000 and
$3 million for the Juneau plant, and the actual price
might be anywhere in
between. But this analysis cannot carry the day for
the taxpayers in this case.
To begin with, $3 million is too generous an estimate
of the upper end of the
bargaining range. In the first year of the sale, 1969,
NVST charged Milbrew
rent of $220,000, which at a 15 percent return on
investment implies that the
plant was worth less than $1.5 million. Moreover,
Milbrew did not actually pay
cash, but merely recorded the rental as a bookkeeping
entry. This means that
the nominal rental was more than Milbrew actually
could pay, and hence that even
$1.5 million is above the upper end of the bargaining
range.
In any event, the dairy cooperative would not have
dreamed of holding out for
such a high price unless it had happened to discover
by January 1, 1969, that
Milbrew's fortunes were on the upswing, a fact Milbrew
would try to conceal from
it. Finally, a party to self-dealing -- treating the
Bernsteins as a single
entity, as we must -- will not be heard to argue that
a deal should be valued on
the basis of a hypothetical transaction the outcome of
which is inherently
indeterminate. Cf. Chicago & North Western
Transport Co. v. United States,
supra, 678 F.2d at 670; In re Valuation Proceedings,
Etc., Regional Rail
Reorganization, 445 F. Supp. 994, 1015 (Spec. Ct.
R.R.R.A. 1977) (Friendly, J.);
Stigler, The Theory of Price 207 (3d ed. 1966). It is
required to provide more
tangible evidence of value. Although the Bernsteins
did introduce evidence of
the replacement cost of the Juneau plant, replacement
cost is not a valid
estimate of fair market value in a declining market,
Fox River Paper Corp. v.
United States, 165 F.2d 639 (7th Cir. 1948), as the
market for dairy plants in
Wisconsin was in the 1960s. In such a market a buyer
knows that he will not
have to build a new plant if the sale falls through --
that he can buy an old
one at a distress price, which is what Northland had
done in 1967 -- and armed
with such knowledge no buyer would pay a price equal
to replacement cost.
It is only a minor embarrassment to the Service that
one of its own expert
witnesses valued the Juneau plant at its replacement
cost -- and maybe no
embarrassment, since the witness estimated that cost
at only $1.6 million. It
cannot carry the day for the Bernsteins merely to show
that the plant was worth
between what Northland had paid in 1967, $525,000, and
what NVST purported to
pay Northland in 1969, $3 million. NVST had to
calculate depreciation on the
basis of its cost, see 26 U.S.C. @@ 167(g), 1011,
1012, and to establish its
cost for the Juneau plant had to show that it had
actually bought it. If the
sale was a phony, the plant remained, in the
contemplation of the law, in
Northland's hands. The fair market value of the plant
on January 1, 1969, is
just one of the factors entering into a judgment of
the genuineness of the sale.
If that value were $3 million it would go some way to
dispel the inference of
sham created by the other suspicious circumstances
that we have discussed, but
on no reasonable reading of this record can the fair
market value be pushed up
that high. The unrealistic price in the contract,
together with the payment
terms and history, the family relationship, the
presence of a strong
tax-avoidance motive, and the informality of the
arrangement persuade us that
the Tax Court did not clearly err in concluding that
the sale was a sham. And
if the sale was a sham, the [*1308] plant's fair
market value in 1969 is
immaterial. A taxpayer may not increase depreciation
by revaluing the property
being depreciated, Parsons v. United States, 227 F.2d
437, 439 (3d Cir. 1955);
he must use his original cost. Detroit Edison Co. v.
Commissioner, 319 U.S. 98,
87 L. Ed. 1286, 63 S. Ct. 902, 102 (1943). NVST had no
original cost, because,
as a matter of federal tax law, it never acquired the
plant.
The fact that the plant may have been worth more than
$525,000 in 1969 is
relevant, however, to whether Milbrew's rental
deductions were excessive, for 26
U.S.C. @ 162(a)(3) entitles Milbrew to a reasonable
rental deduction whether
NVST or Northland owned the plant. But obviously, in
light of all we have said,
the amount of rent that Milbrew agreed to pay NVST is
no evidence of what a
reasonable rent for the plant would have been. We have
to imagine what rent
Milbrew would have agreed in an arm's length
transaction to pay. The higher the
fair market value of the plant the greater that rent
would have been. But the
Service was sufficiently generous in its adjustments
in allowing Milbrew a
$150,000 deduction for rent in 1973, implying that the
fair market value of
the plant that year was about $1 million, a reasonable
estimate. For 1972 the
Service allowed a smaller deduction -- $120,000,
implying a fair market value of
about $850,000, but this was still reasonable. (The
previous year's rental
deductions are not in issue in this appeal.) The
higher rentals charged Milbrew
by NVST in these years not only were unrealistic in
relation to the fair rental
value of the plant but exceeded Milbrew's ability to
pay on a cash basis, and
were properly disallowed. See Southeastern Canteen Co.
v. Commissioner, 410
F.2d 615, 619 (6th Cir. 1969); Baldwin Bros., Inc. v.
Commissioner, 361 F.2d 668
(3d Cir. 1966); S & S Meats, Inc. v. Commissioner,
38 T.C.M. (CCH) 36,036
(1979).
The taxpayers' remaining arguments are procedural. The
Tax Court judge
before whom the case was tried retired after the trial
but before rendering his
opinion. The taxpayers agreed that the case could be
reassigned to another
judge for decision on the record compiled before the
first judge, and this was
done. Having been willing to take their chances before
the second judge they
cannot complain because he decided the case against
them. The first judge had
made comments during the course of the trial that were
very favorable to the
taxpayers. The taxpayers were confident that his
successor would be influenced
by those comments and would decide for them. They were
disappointed. Of course
if he had decided for them they would be defending
vigorously the procedure that
was adopted. By consenting to the procedure they
waived any objection.
Last, aware of our probable unwillingness to consider
evidence that was not
before the Tax Court the taxpayers ask that we order
that court to give them a
new trial on the basis of newly discovered evidence,
namely the 1983 letter of
intent to buy NVST's assets, including the Juneau
plant, for $8.7 million. It
would have to be an extraordinary case to warrant our
ordering the Tax Court to
set aside its decision and receive new evidence.
Normally we would go ahead and
decide the case and leave it to the Tax Court to
decide afterward whether to
reopen it. In any event, as we explained earlier, the
newly discovered evidence
has little probative value and cannot justify the
extraordinary procedural
relief that the taxpayers are asking from us.
The judgment of the Tax Court is AFFIRMED.
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