Town & Country
Food Co., Inc. v. Commissioner (1969)
Town and Country Food Co., Inc.,
Petitioner
v. Commissioner of Internal
Revenue, Respondent
Docket Nos. 3177-63, 2619-66
UNITED STATES TAX COURT
51 T.C. 1049
March 31, 1969
DISPOSITION:
Decisions will re entered under Rule 50.
CORE TERMS: installment, membership, freezer, food,
taxable year ended, installment method, disposition, mortgage, customer,
personal property, indebtedness, purchaser, chattel mortgage, net
operating loss, reporting, default, collection, sell, taxable years ended,
promissory, disposed, income tax, aggregate, evidenced, installment plan,
line of credit, finance, report income, taxable year, conditional
SYLLABUS: The petitioner regularly sold food, food
freezers, and "life memberships" on the installment plan. Held,
petitioner's sales of life memberships were not sales of personal property
within the meaning of sec. 453(a), I.R.C. 1954, and petitioner is
therefore not entitled to report the income from such sales upon the
installment method. Held, further: That petitioner is entitled to report
income from installment sales of freezers (together with initial sales of
food in in connection therewith) upon the installment method under sec.
453(a). The subjection of the installment obligations to the lien of a
chattel mortgage given by petitioner to secure loans obtained under a line
of credit from a third party did not constitute a sale or other
disposition of such obligations requiring the reporting of gain under sec.
453(d) of the Code.
COUNSEL: Lester M. Ponder and Maxwell P. Smith, for
the petitioner.
Eugene M. Corbin, for the respondent.
JUDGES: Atkins, Judge.
OPINIONBY: ATKINS
OPINION: The respondent determined deficiencies in
income tax against the petitioner in the amounts of $ 66,367.97, $
136,946.97, $ 159,223.72, $ 27,857.71, $ 71,963.41, and $ 110,129.81, for
the taxable years ended April 30, 1956, through April 30, 1961,
respectively; additions to tax under section 6653(b) of the Internal
Revenue Code of 1954 of $ 33,183.98, $ 68,473.48, $ 79,611.86, and $
13,928.86, for the taxable years ended April 30, 1956, through April 30,
1959, respectively; and an addition to tax under section 6653(a) of $
3,598.17 for the taxable year ended April 30, 1960.
The parties have by stipulation settled all issues
with respect to all such taxable years except those related to the amount
of a net operating loss for the taxable year ended April 30, 1962, which
would constitute a carryback to the taxable years ended April 30, 1959,
1960, and 1961. The issues remaining are (1) whether in computing the
petitioner's net operating loss for the taxable year ended April 30, 1962,
it is entitled to use the installment method of reporting income on sales
of life memberships in a home frozen food plan; and (2) whether any
installment obligations received by petitioner were "distributed,
transmitted, sold, or otherwise disposed of" resulting in gain or
loss within the contemplation of section 453(d) of the Code.
FINDINGS OF FACT
Some of the facts have been stipulated and are
incorporated herein by this reference.
The petitioner is a corporation organized and existing
under the laws of the State of Indiana, with its principal office and
place of business of Fort Wayne, Ind. It was incorporated on February 27,
1947. It keeps its books and records, and files its income tax returns, on
the basis of a fiscal year ended April 30 and on an accrual method of
accounting, except that for the taxable year ended April 30, 1962, it
reported a portion of its sales on the installment method. Its Federal
income tax returns for the taxable years in question were filed with the
district director of internal revenue, Indianapolis, Ind.
As of April 30, 1961, and April 30, 1962, Robert O.
Locke and Carl H. Bruns each owned approximately 45 percent of the
petitioner's outstanding stock. The remainder was held in small blocks.
During the taxable year ended April 30, 1962, Locke and Bruns were both on
the petitioner's board of directors.
During the taxable year ended April 30, 1962, the
petitioner regularly sold food and food freezers on the installment plan,
as well as for cash. In connection with the sale of a freezer the
purchaser received a 1-year service contract and a 5-year warranty on the
freezer. Petitioner also sold for cash or on the installment plan, at a
cost of $ 265 each, "life memberships" to persons who did not
buy freezers from it, but who already owned freezers purchased from
others. Such life memberships gave the purchaser a 3-year service warranty
on his own freezer and entitled him, among other things, to purchase food
at a price guaranteed to be competitive with any other food distributor
for similar quality, size, and service, to have food delivered, to receive
profit-sharing dividends, to receive premiums from referrals, to purchase,
for an additional fee, credit life, health, and accident insurance, and to
have the entire amount paid for the membership applied toward the purchase
of a freezer from the petitioner at any time.
Upon the purchase of a freezer or a life membership a
purchaser generally made an initial purchase of food. Approximately 60
percent of the freezer and life membership sales were made on credit. A
downpayment was made and the balance, which included interest and services
charges and the cost of any initial purchase of food, was evidenced by a
promissory note payable in regular installments, generally over a period
of a year or more. The freezers were sold under conditional sales
contracts which contained the promissory notes. The life memberships did
not involved conditional sales contracts.
Subsequent sales of food to freezer purchasers and
holders of life memberships were made either for cash or on the
installment plan.
Prior to the taxable year ended April 30, 1962, the
petitioner had followed the practice of selling to several companies the
contracts and notes which it had received from customers. In the years
immediately preceding that year such sales had been made primarily to Town
& Country Securities Corp. (hereinafter referred to as Securities). n1
Commencing with the taxable year ending April 30, 1962, the petitioner
discontinued its practice of selling the freezer contracts and notes and
the life membership notes (but continued to sell notes received upon the
above-mentioned subsequent sales of food). Instead it decided to retain
title to the above notes, and arranged for a $ 3 million line of credit
with Securities, under which it would receive loans from Securities upon
the security of such notes and its other assets. On May 16, 1961, the
board of directors of Securities held a meeting, the minutes of which
contain the following:
Mr. Locke announced that the Town & Country Food
Co., Inc. had adopted a policy of retaining title to its paper and giving
a chattel mortgage on its paper and certain assets to secure loans made to
it by Town & Country Securities Corporation.
* * * it was resolved unanimously that the company
lend money to Town & Country Food Co., Inc. of Fort Wayne, Indiana in
varying amounts from time to time, not to exceed in the aggregate of $
3,000,000.00 at any one time. These loans shall be evidenced by promissory
notes dated as of the date of each individual loan with interest rates to
be agreed upon from time to time between the Secretary of the Company and
the Treasurer of Town & Country Food Co., Inc., not to exceed 12%
simple interest per annum. Said notes shall be secured by the chattel
mortgage of all assets of said Food Company presented to this board, a
copy of which is attached hereto and marked Exhibit "A",
provided that said mortgage shall be made to include specifically customer
lists of said Food Company, and shall be re-executed by appropriate Food
Company officers. Said mortgage shall secure all loans made prior to May
1, 1962.
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n1 As of Apr. 30, 1961, Locke and Bruns, and a
partnership in which they were equal partners, and trusts of which they
were grantors, owned in the aggregate 33,788 of the total of 728,215
outstanding shares of stock of Securities. As of Apr. 30, 1962, they owned
approximately the same proportion of stock of Securities. Petitioner had
seven directors and Securities had nine directors. The two corporations
had four directors in common, which included Locke and Bruns. Locke was
the president of each corporation.
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Pursuant to its $ 3 million line of credit petitioner
borrowed from Securities, on promissory notes, various sums of money. On
May 31 it borrowed $ 200,000 from Securities, giving a negotiable
promissory note bearing interest of 12 percent and payable on demand. Such
note, which is typical of all notes thereafter issued by petitioner to
Securities, contained the following:
This note is secured by a chattel mortgage made by
[petitioner] to [Securities], dated May 31, 1961 securing notes executed
between May 31, 1961 and May 31, 1962 evidencing indebtedness in amounts
not to exceed an aggregate of $ 3,000,000.00, and recorded in the office
of the recorder of Allen County, Indiana.
The chattel mortgage above referred to provides in
part as follows:
TOWN & COUNTRY FOOD CO. [petitioner] * * *, for
value received, does hereby mortgage to TOWN AND COUNTRY SECURITIES
CORPORATION * * *
All conditional sales contracts, customer lists,
promissory notes, secured and unsecured, chattel mortgages, installment
sale contracts and any and all other evidences of indebtedness which the
Mortgagor now owns and which it may acquire in connection with its
business in the future, and all of its furniture, fixtures and equipment
located in its office and plant on the California Road, Fort Wayne,
Indiana.
This mortgage is given to secure the payment of
indebtedness evidenced by a promissory note for the principal sum of two
hundred thousand -- ($ 200,000.00) Dollars, dated May 31, 1961, and to
secure the payment of indebtedness to be evidenced by promissory notes
executed within a period of one (1) year from the date of execution of the
mortgage, not to exceed an aggregate principal indebtedness of Three
Million ($ 3,000,000.00) Dollars, all executed by Mortgagor to Mortgagee
with interest as in said notes provided and with attorneys' fees, * * *
1. WARRANTIES. -- Mortgagor warrants that it is and
will be the lawful owner and possessor of all of the instruments and
personal property covered by the mortgage, that they are and will be free
from any and all other liens or encumbrances, and that it will warrant and
defend said property against all persons, claims and demands whatsoever. *
* *
2. POSSESSION. -- Mortgagor may lawfully retain
possession of the instruments and property mortgaged hereunder, so long as
Mortgagor shall not assign, sell, pledge, or exchange, or in any way
encumber or otherwise dispose of the instruments or property, nor remove
any of the property from its present location, without the prior written
consent of the Mortgagee. Mortgagor at its own expense shall keep such
goods and chattels in a good state of repair, and shall pay promptly all
taxes or assessments levied thereon. Risk of loss or damage to the
property shall be upon Mortgagor, until actual possession of the property
be taken by Mortgagee under this mortgage, upon default of Mortgagor as
hereinafter provided. Mortgagor agrees to keep the property insured in the
manner required by Mortgagee, and in a Company satisfactory to Mortgagee,
to the extent required by Mortgagee. The policies of insurance * * * shall
provide that loss thereunder shall be payable to Mortgagee as its interest
may appear.
* * * *
5. REMEDIES OF MORTGAGEE UPON DEFAULT. -- In the event
of default by Mortgagor under the terms of this instrument, Mortgagee
shall have the right to take immediate and unconditional possession of the
mortgaged property and instruments * * *. Mortgagee shall at its option
have the full right, power, and authority to enforce Mortgagor's rights
and remedies under the instruments mortgaged against the obligors on the
same or it may sell or assign said instruments and the mortgaged property
* * * after giving ten (10) days' notice of the time, place and terms of
sale to said Mortgagor * * *. Said sale shall be free and clear of any
equity of redemption, and all exemptions. * *
* From the proceeds of said sale, Mortgagee shall pay
first its attorneys' fees, and all costs and expenses incident to the
taking possession of the property and the sale thereof, and shall apply
the remainder toward the satisfaction of the indebtedness hereby secured.
Any surplus shall be promptly remitted to Mortgagor. If the proceeds of
sale do not satisfy the debt, interest, and expenses, the Mortgagor shall
remain liable for said deficiency, and shall pay forthwith any unpaid
balance of the indebtedness secured by this mortgage. * * *
Thereafter during the taxable year ended April 30,
1962, the petitioner continued to borrow amounts from Securities and made
repayments on two occasions. Laurel J. Short, petitioner's vice president,
treasurer, and chief finance officer, made the decision as to the amounts
to be borrowed and repaid, and the times of such borrowing and repayment,
based upon his projections of the cash needs of the petitioner for 30 days
in advance. He took into account projected receipts from customers on
installment contracts and attempted to keep the interest expense on
borrowed funds as low as possible.
The following tabulation shows, as of the end of each
month of the taxable year ended April 30, 1962, the balances, as shown on
petitioner's books, of petitioner's notes payable to Securities and its
notes receivable from sales of freezers and life memberships:
Notes receivable Notes receivable End of -- Notes from
sales from sales
payable of freezers of life
memberships
May $ 200,000 $ 125,385.35 $ 28,002.00 June 500,000
231,685.46 56,473.35 July 500,000 401,248.63 87,391.40 August 450,000
558,149.30 109,948.53 September 450,000 678,202.87 127,994.29 October
600,000 811,711.90 142,977.91 November 2,000,000 937,737.25 156,251.51
December 2,200,000 999,341.39 157,320.54 January 2,550,000 1,049,634.77
155,411.38 February 2,650,000 1,121,961.85 158,883.94 March 2,750,000
1,192,195.78 157,442.26 April 3,000,000 1,235,558.31 156,693.42
During the taxable year ended April 30, 1962,
petitioner retained physical possession of, and collected and deposited in
its bank account the installment payments on, notes received from sales of
freezers and life memberships, its employees making the accounting entries
necessary to credit the customers with such payments. If an account became
delinquent, petitioner sent a series of three notices to the customer over
a 17-day period, and collected any payments made as a result of such
notices. If such notices did not result in payment the account was then
referred to Securities n2 or some other agency for collection, for which
petitioner paid a fee. In the case of collections referred to Securities
the fee was paid on a per-diem basis. The accounts were not assigned to
Securities or other collection agencies. In all cases the amounts
collected, less charges, were remitted to petitioner.
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n2 Securities also acted as collection agent for other
companies.
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Prior to the beginning of its taxable year ended April
30, 1962, the petitioner kept its books and records and filed its income
tax returns entirely on an accrual method of accounting. However, for such
taxable year it elected on its return "to use the installment method
of reporting installment sales."
As of April 30, 1962, petitioner's books and records
indicate that it had deferred income from sales of life memberships and
freezers in in the amount of $ 647,300.76 ($ 97,977.90 for life
memberships and $ 549,322.86 for freezers) and interest or finance charges
on such sales in the amount of $ 184,725.91 ($ 9,696.15 for life
memberships and $ 175,029.73 for freezers), or a total deferral of $
832,026.67. n3
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n3 Petitioner did not defer income from subsequent
installment sales of food. The notes involved in such food sales were sold
during the taxable year. No issue as to this income has been raised.
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In its Federal income tax return for the taxable year
ended April 30, 1962, petitioner reported a net operating loss of $
543,112.16, which resulted in part from the above deferrals of income.
In the notice of deficiency the respondent made
several adjustments to petitioner's reported taxable income, resulting in
determinations of taxable income of $ 189,869.22, $ 333,589.54, and $
222,692.40, respectively, for the taxable years ended April 30, 1959,
1960, and 1961. As heretofore pointed out, the parties have now reached
agreement as to those adjustments. In its petition relating to the
deficiency determined for the taxable year ended April 30, 1961, the
petitioner alleges that the respondent erred in not allowing it to deduct
$ 210,976.27, representing the portion of the claimed $ 543,112.16 net
operating loss for the taxable year ended April 30, 1962, remaining after
application thereof against the income of the taxable years ended April
30, 1959, and April 30, 1960. In his answer to the petition the respondent
denies error in this respect. The parties have stipulated all the
controversial items in regard to the computation of the net operating loss
for the taxable year ended April 30, 1962, except those relating to the
deferral, upon the installment method, of income resulting from
installment sales of freezers and life memberships and the interest and
finance charges in connection therewith. It is the respondent's primary
position that there was a disposition of 57.82 percent n4 of the $
1,392,251.73 face value of installment obligations received from sales of
freezers and life memberships during the taxable year ended April 30,
1962, as a result of the chattel mortgage arrangement between the
petitioner and Securities, and that consequently that percentage of the
total deferred income of $ 832,026.67, or $ 481,077.82, was improperly
deferred by the petitioner. It is his alternative position that, if it be
held that there was not such a disposition of any of the installment
obligations, then the petitioner is not entitled to report income upon the
sales of life memberships on the installment method since such sales do
not constitute sales of personal property.
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n4 The respondent arrives at this percentage in the
following manner. He takes the position that only $ 805,000 of the $ 3
million balance owing to Securities as of the end of the year represented
obligations of the petitioner (the balance representing obligations of
petitioner's subsidiaries), and that to that extent the petitioner
disposed of its installment obligations which constitutes 57.82 percent of
the total installment obligations of $
1,392,251.73.
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OPINION
The petitioner contends that in computing its net
operating loss for the taxable year ended April 30, 1962, it is entitled
to report its income from sales of both freezers and life memberships on
the installment method prescribed by section 453(a) of the Code. n5 One of
respondent's contentions is that the petitioner's sales of life
memberships did not constitute sales of personal property entitling it to
report income from that source upon the installment method. The
petitioner, on the other hand, contends that the sales of the life
memberships constituted sales of intangible personal property and are
within the statute.
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n5 Sec. 453(a) of the Code provides:
(a) Dealers in Personal Property. -- Under regulations
prescribed by the Secretary or his delegate, a person who regularly sells
or otherwise disposes of personal property on the installment plan may
return as income therefrom in any taxable year that proportion of the
installment payments actually received in that year which the gross
profit, realized or to be realized when payment is completed, bears to the
total contract price.
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We agree with the respondent that the sales of life
memberships did not constitute sales of personal property within the
meaning of the statute. A life membership granted the purchaser a number
of rights, principally the right to purchase food from the petitioner at
competitive prices and have it delivered, the right to the services of the
petitioner under a 3-year service warranty on the customer's own freezer,
and the right, if he should at any time purchase a freezer from the
petitioner, to have the purchase price of the membership applied on the
purchase price of the freezer. Thus, a life membership amounted
principally to an agreement by the petitioner to render services to the
purchaser in the future and to sell property to the purchaser in the
future at the purchaser's election. The sale of a life membership did not
itself effect the sale by the petitioner of any property whatsoever. And
clearly the statute does not relate to the reporting of income arising
from an agreement to render services. We hold that the petitioner is not
entitled to report income from the sale of life memberships on the
installment method.
It should be noted that at the time of purchasing a
life membership the purchaser generally also made an initial purchase of
food, the cost of which was included in the same deferred-payment note
which evidenced the balance due on the cost of the life membership. Food
is, of course, personal property, the installment sale of which would come
within the scope of the installment method provided in section 453. The
record seems to indicate, although this is not entirely clear, that the
petitioner in reporting income from sales of life memberships on the
installment method included therein the income from initial sales of food.
However, if so, the petitioner has not shown the amount thereof and has
not shown the factors which would be necessary to permit us to make a
segregation and apply the installment method to the income from such
initial sales of food. Accordingly, in the recomputation of the
petitioner's net operating loss for the taxable year ended April 30, 1962,
the full amount of income upon sales of life memberships, including any
income from initial sales of food which may be contained therein, will be
included in taxable income.
The petitioner during its taxable year ended April 30,
1962, regularly sold freezer (together with initial orders of food) on the
installment plan, and there can be no question that these sales were sales
of personal property for purposes of section 453(a) of the Code. During
such year it borrowed funds from Securities under an arrangement for a
line of credit whereby all its conditional sales contracts and promissory
notes (and certain other assets) automatically, as they came into
existence, became subject to the lien of the chattel mortgage which it
gave Securities. The respondent takes the position that "by the use
of these installment contracts and notes as collateral for loans" the
petitioner disposed of its installment obligations, or a portion thereof,
within the contemplation of section 453(d) of the Code, n6 and that gain
or loss is to be recognized upon such disposition. He argues that section
453 and its predecessor statutes were enacted to relieve taxpayers from
having to pay income tax in the year of sale based on the full amount of
anticipated profits when they had received in cash only a portion of the
sales price, citing Commissioner v. South Texas Co., 333 U.S. 496; that
when the equivalent of subsection (d) of section 453 of the Code was
enacted in the Revenue Act of 1928, it was the intention of Congress to
terminate the privilege of longer deferring the profit if the seller at
any time realizes such profit by disposing of the installment obligation;
and that here the petitioner, by using the installment obligations as
security for its line of credit from Securities, is immediately receiving
cash based on such obligations while deferring the reporting of the income
to a later taxable period, and is thus attempting to circumvent the intent
of Congress.
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n6 Sec. 453(d) of the Code provides in part as
follows:
Gain or Loss on Disposition of Installment
Obligations. --
(1) General Rule. -- If an installment obligation is
satisfied at other than its face value or distributed, transmitted, sold,
or otherwise disposed of, gain or loss shall result to the extent of the
difference between the basis of the obligation and --
(A) the amount realized, in the case of satisfaction
at other than face value or a sale or exchange, or
(B) the fair market value of the obligation at the
time of distribution, transmission, or disposition, in the case of the
distribution, transmission, or disposition otherwise than by sale or
exchange.
Any gain or loss so resulting shall be considered as
resulting from the sale or exchange of the property in respect of which
the installment obligation was received.
(2) Basis of obligation. -- The basis of an
installment obligation shall be the excess of the face value of the
obligation over an amount equal to the income which would be returnable
were the obligation satisfied in full.
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The petitioner, on the other hand, contends that
subjecting the installment obligations to the chattel mortgage did not
constitute the sale or other disposition of such notes and that section
453(d) of the Code is not applicable.
Section 453(d) predicates its application upon a sale
or exchange or other disposition of installment obligations. We think it
is obvious that a disposition involves the relinquishment of the
substantial incidents of ownership of the obligations. It may well be that
in some instances involving claimed borrowing arrangements the taxpayer
parts with such a substantial portion of his ownership rights in the
obligations as to require the conclusion that he has, in effect, sold or
otherwise disposed of the obligations. On the other hand, if it is clear
that the taxpayer has merely subjected the obligations to a lien for the
payment of indebtedness, he does not lose the privilege of reporting the
income from the installment method. As stated in Elmer v. Commissioner
(C.A. 2) 65 F. 2d 568, affirming 22 B.T.A. 224:
If a merchant discounts his customer's note at a bank,
endorsing it, but getting immediate credit for its discount value, it
would be a most unnatural thing to consider it a loan from the bank. He
remains liable if the customer defaults, but the collection is in the
bank's hands, and the transaction is closed in the absence of a default.
If on the other hand, a merchant pledges his accounts to a
"finance" company and collects them himself, paying the loan out
of his collections, it is clearly a loan, and has always been so
considered. * * *
Each case must be decided upon the basis of its
particular circumstances. Here, petitioner did not part at any time during
the taxable year ended April 30, 1962, with any substantial incident of
ownership in its installment obligations. There was nothing more than the
subjection of the installment obligations, along with other assets of the
petitioner, to the lien of the chattel mortgage. There is nothing to
suggest that the transaction was other than what it purports to be. The
amounts which the petitioner obtained as loans from Securities bore no
direct relationship to any particular installment obligation or the
aggregate of them. It did not realize the cash equivalent of the
obligations as they became subject to the lien. Furthermore, the repayment
of the petitioner's indebtedness to Securities was not geared to the
petitioner's collections upon its installment obligations. The petitioner
retained title to, and possession of, the installment obligations. It
collected payments as they became due and deposited them in its own bank
account. Only in the event of a default by petitioner on its indebtedness
to Securities could
Securities obtain possession of the installment
obligations, and then only for the purpose of satisfying its loan to the
petitioner. If the installment obligations were sold upon default any
amount received in excess of the amount necessary to satisfy such
indebtedness was required to be remitted to the petitioner.
The petitioner did not during the taxable year ended
April 30, 1962, sell or otherwise dispose of its installment obligations.
n7 Cases cited by the respondent, such as Thomas Goggan & Bro., 45
B.T.A. 218, and East Coast Equipment Co., (C.A. 3) 222 F. 2d 676,
affirming 21 T.C. 112, involved circumstances entirely different from
those of the instant case, and therefore are not applicable.
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n7 There was admitted in evidence an exhibit, with
attachments, showing some change in the arrangements between petitioner
and Securities during years subsequent to the taxable year ended Apr. 30,
1962, which respondent contends bears upon the sec. 453(d) issue for the
year ended Apr. 30, 1962. Such subsequent arrangement does not affect the
question herein decided, and we express no opinion as to any issue which
might arise in subsequent years.
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We accordingly hold that the petitioner in computing
its net operating loss for the taxable year ended April 30, 1962, is
entitled to take into account the income from the installment sales of
freezers (together with initial sales of food) in accordance with the
installment method provided in section 453(a), and that section 453(d) is
not here applicable.
Upon the recomputation under Rule 50 the correct
amount of the net operating loss for the taxable year ended April 30,
1962, will be computed and be carried back and applied as a net operating
loss deduction for each of the taxable years ended April 30, 1959, 1960,
and 1961, in accordance with the provisions of section 172 of the Code.
Decisions will re entered under Rule 50.
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