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FRANK LYON CO. v. UNITED STATES

decided: April 18, 1978.

FRANK LYON CO
v.
UNITED STATES



CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE EIGHTH CIRCUIT.

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. 584. Stevens, J., filed a dissenting opinion, post, p. 584.

Author: Blackmun

[ 435 U.S. Page 562]

 MR. JUSTICE BLACKMUN delivered the opinion of the Court.

This case concerns the federal income tax consequences of a sale-and-leaseback 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 longterm use as its headquarters and principal banking facility.

[ 435 U.S. Page 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.

[ 435 U.S. Page 5642]

     . 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.*fn1 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-leaseback 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.

[ 435 U.S. Page 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.

[ 435 U.S. Page 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.*fn2

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

[ 435 U.S. Page 567]

     net rentals from the building would be further reduced by the increase in ground rent Worthen would receive from Lyon during the extension.*fn3

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) ...


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