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petitioners. Respondent argues that the purported lease
agreement between petitioners and GRC was not negotiated at arm's
length, that the lease should be disregarded, and that the money
GRC expended on the Ashland Building should be treated as
constructive dividends to petitioners. Petitioners argue that
section 109 specifically removes the expenditures at issue from
the definition of gross income, and that GRC's expenditures are
thereby not income to petitioners. Petitioners bear the burden
of proving respondent's determination wrong. Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933).
I. Economic Reality and The Lease Agreement
As a general rule, improvements made by a lessee to a
leasehold estate do not result in the realization of income by
the lessor in the year of the improvement or upon termination of
the lease. Sec. 109; M.E. Blatt Co. v. United States, 305 U.S.
267 (1938); Bardes v. Commissioner, 37 T.C. 1134 (1962); Weigel
v. Commissioner, T.C. Memo. 1996-485. However, this rule and the
case law developed thereon do not apply where the lease agreement
is determined to be a subterfuge or a sham. Commissioner v.
Court Holding Co., 324 U.S. 331 (1945); Jaeger Motor Car Co. v.
Commissioner, T.C. Memo. 1958-223, affd. 284 F.2d 127 (7th Cir.
1960). Therefore, as an initial matter, we must ascertain
whether the lease arrangement between GRC and petitioners has any
economic reality and should be respected for tax purposes.
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