at the rate of $520 a month for 20 years. Staley intended to repay his $2,500 note and had a reasonable prospect of doing so as of the end of 1966.

Petitioners deducted the loan as a nonbusiness bad debt on their 1966 income tax return.

OPINION

1. Rental Deduction

Petitioners contend that payments made to the four trusts are ordinary and necessary business expenses in the nature of rent deductible pursuant to section 162(a)(3).1 However, respondent contends that such payments are not deductible, principally because petitioners are said to have retained a disqualifying interest in the property. We agree with petitioners.

The question whether a taxpayer, who has transferred to a trust property previously owned by him and used in his trade or business, may lease this property from the trust and deduct his rental payments pursuant to section 162(a)(3) has been considered by the courts on numerous occasions.

Under the cases, it is common ground that rent paid by a grantor to a trustee in such a gift and leaseback is deductible under section 162(a) (3) only if the following requirements are met:

(1) The grantor must not retain "substantially the same control over the property that he had before" he made the gift. Sidney W. Penn, 51 T.C. 144, 150 (1968). This requirement is usually met through a transfer to an independent trustee who has the right and the opportunity to negotiate regarding the leaseback and who acts for the primary benefit of the trust beneficiaries, rather than the grantor. Van Zandt v. Commissioner, 341 F. 2d 440 (C.A. 5, 1965), affirming 40 T.C. 824 (1963), certiorari denied 382 U.S. 814 (1965); Brown v. Commissioner, 180 F. 2d 926 (C. A. 3, 1950), reversing 12 T.C. 1095 (1949), certiorari denied 340 U.S. 814 (1950); Skemp v. Commissioner, 168 F. 2d 598 (C.A. 7, 1948), reversing 8 T.C. 415 (1947).

2

(2) The leaseback should normally be in writing and must require payment of a reasonable rental. Sidney W. Penn, supra at 152-153.

1 All Code references are to the Internal Revenue Code of 1954, as in effect during the years in issue.

Sec. 162 (a) (3) provides:

(a) IN GENERAL.-There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including

(3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.

But see Brooke v. United States, 468 F. 2d 1155 (C.A. 9, 1972).

(3) The leaseback (as distinguished from the gift) must have a bona fide business purpose. Alden B. Oakes, 44 T.C. 524 (1965). We find that these requirements are met.

First, the trustee, we have found as a fact, acted independently of the petitioners-grantors under broad powers specifically set forth in the four trust agreements. See Brown v. Commissioner, supra; Alden B. Oakes, supra; Albert T. Felix, 21 T.C. 794 (1954). As such trustee, he entered into a 1-year written lease of the property which was renewable annually only if mutually agreeable terms could be reached by the trustee and petitioner. The years here in issue were renewal periods. The trustee collected rents due under the lease, paid the trusts' expenses, negotiated renewals with the grantor as required, and distributed the net income for the benefit of the minor beneficiaries or directly to their legal guardian. In this respect the case must be distinguished from cases such as Van Zandt v. Commissioner, supra, relied on by respondent, in which lack of independence in the trustee was deduced not only from the fact that the grantor named himself as trustee but also from the fact that the lease transaction was prearranged at the inception of the trust, apparently for the entire 10-year term of the trust. In Van Zandt, the trustee had little or no room, therefore, for the exercise of independent discretion and had little to do in his fiduciary capacity but collect the prearranged rentals. The grantor thus failed to relinquish effective control over the property and was not permitted to deduct rentals paid therefor.

Secondly, the lease in question was in writing, and we have found as a fact that the rent paid by petitioners to the trusts was a reasonable rent for the property. See Alden B. Oakes, supra; Albert T. Felix,

supra.

Third, there was demonstrated business purpose for the lease. The rent was clearly both ordinary and necessary and was required to be paid as a condition to continued use of the property. "[W]e think that where, as here, a grantor gives business property to a valid irrevocable trust over which he retains no control and then leases it back, it is not necessary for us to inquire as to whether there was a business reason for making the gift. Admittedly there was none. Under such circumstances the test of business necessity should be made by viewing the situation as it exists after the gift is made." Alden B. Oakes, supra at 532; Brooke v. United States, 468 F. 2d 1155 (C.A. 9, 1972). Here petitioner needed the building to carry on his funeral business and agreed to rent the property from the trustee for a reasonable rent.

But, respondent argues, all of the above points are immaterial because petitioners had a disqualifying equity in the property, in the

form of a reversionary interest, and under the plain words of the statute a taxpayer can deduct rent only if paid for “property to which the taxpayer has not taken or is not taking title or in which he has no equity." (Emphasis added.) The question is whether petitioner's ownership of a reversionary interest constituted an "equity" in the rental "property" within the meaning of section 162 (a) (3). The statutory phrase is singularly opaque, and on its face could be susceptible to a number of different meanings. Reading the language at its broadest, the term "property" could mean the fee simple absolute title to the parcel of real estate in question, and the term "equity” could mean any beneficial share (beyond the leasehold interest itself) in the bundle of rights making up such title. If this construction were correct, respondent would prevail, for petitioner concededly held a reversionary interest in the funeral home property, to become possessory upon expiration of the term of years held by the trust. On the other hand, in the context of section 162, it is at least equally permissible to contend that the "property" in which petitioner may not take title or have an equity is, for this purpose, limited to the particular bundle of property rights owned by the lessor at the inception of the lease and forming the subject matter of the lease. Under the latter construction, petitioner would prevail, for the only property owned by the lessor-trusts was the term of years which constituted the trusts corpus, petitioner at no time owned part of the trusts' corpus, and the trusts at no relevant time owned or leased to petitioner any part of petitioner's reversion. In the construction of section 162 (a) (3), we are unassisted by any legislative history explaining the phrase, or by any prior holdings of this Court considering it in the present context of a lessee's ownership of a reversionary interest to become possessory at or after the expiration of the lease. In the absence of any guidance from legislative history or well-reasoned earlier case law, we must reach the best answer we can in light of the application of commonsense to the general structure and purpose of the Internal Revenue Code, and specifically, section 162.

Most of the cases dealing with this particular phrase of section 162 (a) (3) concern whether a purported lease of property is in actuality a sale, so that the so-called "rental" payment secured for the

The funeral home property appears to have been subject to a mortgage, but the record does not disclose whether the trusts or the grantors were making principal payments (if any) on the mortgage note. Since respondent does not contend that any "equity" was being built up out of rentals through this mechanism, but relies solely on petitioners' retention of the reversion, we need not speculate on what would be the effect on rental deductions under sec. 162 (a)(3) of mortgage principal payments by a trust.

The phrase came into the statute in 1916, sec. 12(a) (1st) of the Revenue Act of 1916, Pub. L. No. 271, 64th Cong., 1st Sess.

"lessee" not only the right to use and possession during the lease term, but in addition an ownership interest, or equity, in the "leased" property. Purported rentals which are a disguised purchase price of a "lessor's" property rights must be capitalized rather than deducted. Benton v. Commissioner, 197 F. 2d 745 (C.A. 5, 1952) ; M & W Gear Co., 54 T.C. 385 (1970), modified by 446 F. 2d 841 (C.A. 7, 1971); Earl L. Lester, 32 T.C. 711 (1959); Chicago Stoker Corp., 14 T.C. 441 (1950); Judson Mills, 11 T.C. 25 (1948). See Rev. Rul. 55-540, 1955-2 C.B. 39; 4A Mertens, Law of Federal Income Taxation, sec. 25.108. Such use of section 162 (a) (3) is unexceptionable on any interpretation. The transaction is in fact a purchase, and rather than deducting the payments currently as rentals, the lessee must add them to his basis and may thereafter obtain tax recognition of them in the prescribed manner, normally under either section 167 (by depreciation) or section 1001 (a) (in determining the amount of gain or loss on disposition).

It is equally clear that where the purported property of the lessor for tax purposes is treated as owned by the lessee because of an ineffectual gift, as to a nonindependent trustee, the requirements of section 162 (a) (3) have not been met. In such case, the lessee has an equity in the property in the form of effective ownership. E.g., Van Zandt v. Commissioner, supra; Sidney W. Penn, supra.

But respondent would give the phrase in question a much broader meaning. He contends that even if the rental payments in question secured for the lessee nothing more than the use or possession of property during the limited period to which the payments relate, the payments are nevertheless not deductible if the lessee happens to own property rights in the same asset, albeit not derived from the lessor's rights, and not scheduled to become possessory until a later period. Thus, contends respondent, the disqualifying "equity in the property" as used in section 162 (a) (3) includes a reversionary interest owned at all times by the lessee and not acquired from the lessor through the lease.

At the outset, we note that if the term "equity," as respondent appears to contend, is claimed to include any rights in an asset which could be enforced by a court of equity, respondent proves too much. Any lessee has such rights, including a right to specific performance of the terms of the lease. See, e.g., Crossman v. Fontainebleau Hotel Corp., 273 F. 2d 720 (C.A. 5, 1959); Thurman v. Trin, 199 Kan. 679, 433 P. 2d 367 (1967); Pedrick v. Vidal, 95 Fla. 952, 116 So. 857 (1928). No rentals would ever be deductible under this construction. Thus it is at least clear that "equity" has a narrower meaning. The issue is whether that narrower meaning is still broad enough to cover

a lessee's ownership rights in an asset held concurrently with, but not derived from, the lessor's property rights or enlarged through the rental payments. If, for example, a lessee was at all times the owner of a 50-percent undivided interest in a parcel of land, would he be precluded by section 162(a)(3) from deducting the rental paid to his coowner for the use of the latter's rights? In answer to this question, we must of course set aside the particular facts of the present case, with its overtones of careful tax planning, for if the term "equity" has in the present context the broad meaning for which respondent argues, it must have the same meaning where no tax plan is involved.

We gain some help from the language of the statute. The language "property to which the taxpayer has not taken or is not taking title" (emphasis added) appears clearly enough to indicate that Congress had in mind an ongoing process in which the taxpayer takes (not "has") title to the property, evidently from the lessor through the purported rental payments. It is difficult to read into this language a prohibition on preexisting ownership of property rights in the asset other than those owned or purportedly owned by the lessor and the subject of the lease. We note, furthermore, that the disjunctive "or" rather than the conjunctive "and" is used after the phrase "the taxpayer has not taken or is not taking title." Literally, the rent would therefore pass muster if the taxpayer "has not taken or is not taking title" without regard to whether he has an "equity"; and even if title is taken, the rental for the property would still not be rendered nondeductible by the "taking title" language unless the taxpayer has an equity. Whether or not this reading is warranted, however, the disjunctive at the least seems to render it clearer that Congress intended the "or" clause to be read in conjunction with the preceding language. This would suggest that the kind of "equity" in the "property" referred to must be one "taken" (from the lessor), or at least overlapping a purported ownership interest of the lessor.

The statutory language, however, is so murky that it is too frail a reed to lean on alone. While it appears from the foregoing that Congress probably intended to disqualify an equity taken (from the lessor) rather than a preexisting ownership interest not derived from or enlarged under the lease, the language literally refers to the taxpayer having rather than taking an equity, and the disjunctive "or" may have been an oversight. We rest our conclusion therefore primarily on the fact that respondent's construction would produce such anomalous and unfair tax results in the present context that we cannot hold that Congress could have intended such construction without com

5 Without adverting to the literally disjunctive phraseology, Oesterreich v. Commissioner, 226 F. 2d 798 (C.A. 9, 1955), reads the requirements of the statute in the conjunctive.