## Facts

- Cal-Maine Foods, Inc. (Cal-Maine) petitioned the U.S. Tax Court as successor to Adams Egg Farms, Inc. (Farms) and Adams Foods, Inc., seeking redetermination of income-tax deficiencies for tax periods ending September 8, 1966 and May 27, 1967.
- Fred Adams Jr., a principal shareholder of Farms, planned a large, specialized egg-production facility designed to house more than one million laying hens, aiming to reduce production costs and increase profits.
- Farms lacked the capital to construct the facility and sought a third party to finance construction and lease the completed property to Farms.
- Farms entered into an agreement with Cargill, Inc. (Cargill) under which Cargill would construct and own the land, building/improvements, and necessary equipment, and then lease the property to Farms.
- The lease had an initial term of 12 years. During that term, Farms agreed to pay rent equal to $11.10 per month for every $1,000 of Cargill’s total original cost, stipulated to be $2,505,251.
- Farms could renew the lease annually for up to 10 additional years at decreasing rental rates.
- Farms had an option to purchase the property after the initial lease term for 12% of Cargill’s original cost; the lease did not credit prior rent payments toward the option price.
- The lease was structured as a net lease: Farms was responsible for taxes and assessments, maintenance and repairs, and comprehensive insurance, and it assumed the risk of loss.
- The facility and equipment were expected to depreciate rapidly, and the useful life of the improvements was found to roughly match the 12-year initial lease term.
- There was no showing that the arrangement was entered into for tax-avoidance reasons, and the rent did not exceed the property’s fair rental value.
- Farms deducted the payments to Cargill as rent under I.R.C. § 162(a)(3). The Commissioner disallowed the deductions, asserting the arrangement was in substance a sale financed by Cargill.
- After concessions, the case turned on a single remaining question: whether the payments were deductible rent or nondeductible purchase payments.

## Issues

1. Whether the payments Farms made to Cargill under the agreement were deductible as “rentals or other payments” under I.R.C. § 162(a)(3).
2. Whether, based on the economic substance of the transaction, the agreement should be treated as a sale/financing arrangement so that the payments were purchase-price installments rather than rent.

## Decision

- The Tax Court held the Cargill arrangement was a true lease, not a disguised sale.
- The court allowed the deductions under I.R.C. § 162(a)(3), treating the payments as rent.
- The Commissioner’s recharacterization was rejected, and the deficiencies attributable to the rent disallowance were not sustained (with computations to be entered under Rule 155).

## Legal Principles

- For federal income tax purposes, whether an agreement is a lease or a sale depends on the transaction’s economic substance, not the labels used by the parties.
- A purchase option does not by itself convert a lease into a sale; the option price must be so low compared to expected value that exercise is effectively compelled before a sale recharacterization is warranted.
- The absence of “equity build-up” (such as crediting rent toward a purchase price) supports lease treatment where periodic payments function as rent rather than principal repayment.
- A net lease shifting taxes, insurance, maintenance, and risk of loss to the lessee is common in commercial practice and is not, standing alone, enough to treat the transaction as a sale.
- The relationship between the lease term and the property’s useful life is relevant, but it is weighed together with the option terms, rent reasonableness, and the parties’ overall allocation of rights and obligations.
- Evidence that rent is consistent with fair rental value and that the arrangement reflects business needs (rather than tax-driven structuring) supports respecting the agreement as a lease.

## Conclusion

The Tax Court concluded that Farms’ payments to Cargill under the 12-year facility lease were deductible rent under I.R.C. § 162(a)(3) because the agreement, viewed as a whole, reflected a bona fide lease rather than a financed sale, given the non-nominal option structure, lack of rent crediting, commercially reasonable rent, and the fact that net-lease risk shifting did not negate Cargill’s ownership.


Cal-Maine Foods, Inc. v. Commissioner, T.C. Memo. 1977–89 (1977)