Wheat v. United States, Civ. A. No. 70-H-786 to 70-H-789.

• Citation: 353 F. Supp. 720
• Decision Date: 18 January 1973
• Docket Number: Civ. A. No. 70-H-786 to 70-H-789.
• Parties: Tom H. WHEAT and Tilda Wheat, Plaintiffs, v. UNITED STATES of America, Defendant. E. Philip GEMMER, Jr., and Jo Kathryn Gemmer, Plaintiffs, v. UNITED STATES of America, Defendants. James R. GRAVES and Elizabeth J. Graves, Plaintiffs, v. UNITED STATES of America, Defendant. Allan C. KING and Gloria G. King, Plaintiffs, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Southern District of Texas

353 F. Supp. 720

Tom H. WHEAT and Tilda Wheat, Plaintiffs, v. UNITED STATES of America, Defendant.

E. Philip GEMMER, Jr., and Jo Kathryn Gemmer, Plaintiffs, v. UNITED STATES of America, Defendants.

James R. GRAVES and Elizabeth J. Graves, Plaintiffs, v. UNITED STATES of America, Defendant.

Allan C. KING and Gloria G. King, Plaintiffs, v. UNITED STATES of America, Defendant.

Civ. A. Nos. 70-H-786 to 70-H-789.

United States District Court, S. D. Texas, Houston Division.

January 18, 1973.

Charles J. Sullivan, Dyche, Wright, Sullivan, Bailey & King, Houston, Tex., for plaintiffs.

Anthony J. P. Farris, U. S. Atty., Houston, Tex., Scott P. Crampton, Asst. Atty. Gen., Washington, D. C., Jerome Fink, William W. Guild, Howard A. Weinberger, Attys., Tax Div., Dept. of Justice, Dallas, Tex., for defendant.

MEMORANDUM AND ORDER

CARL O. BUE, Jr., District Judge.

In these four consolidated actions the plaintiffs seek a refund of income taxes and assessed interest as a result of the allegedly erroneous disallowance of certain deductions for their pro rata share of the net operating loss of an electing small business corporation under Subchapter S of the Internal Revenue Code pursuant to 26 U.S.C. § 7422(a) and 26 U.S.C. § 1346. In a direct attack on the propriety of plaintiffs' cause of action, the Government has moved for summary judgment pursuant to Rule 56, Fed.R.Civ.P.

To capsule the undisputed facts, the plaintiffs are shareholders in a small business corporation, Student Housing, Inc. This corporation was formed on October 1, 1962, by ten shareholders, four of whom are plaintiffs in these lawsuits, for the purpose of constructing and operating student dormitories on various college campuses. At the time of incorporation, the shareholders executed an agreement entitled Stockholders' Agreement which provided, among other things, for shareholder contribution to the corporation's capital structure as a method for securing any additional corporate financing which might be needed to successfully conduct the intended business operations. Notwithstanding this method to secure additional financing, the corporation in 1963 through its officers employed an alternate method and made application for and duly received two loans in the amount of $285,585.89 from the Bank of Texas. The loans, which were represented by two promissory notes, were secured by chattel mortgages on the corporation's property and personal guarantees of the individual shareholders. The terms of these individual guarantees permitted the bank, in effect, to proceed directly against the individual guarantors upon default in the loan installment payments without the necessity of proceeding initially against the corporation or the collateral for the loans. In fact, however, the corporation never defaulted on the loan payments, and the shareholders were never called upon to pay any part of the loans. Further, the corporation's tax returns and financial statements reflected these loans as corporate obligations owing to the bank. The corporate records do not reflect any form of indebtedness owing to the plaintiffs.

In 1964 the corporation incurred an operating loss of $258,978.47. To reduce their individual tax liability each of the ten shareholders reported on his individual income tax return for 1964 a loss deduction of $25,897.84 as his pro rata share of the corporation's loss. This was computed on the assumption that the basis of their stock in the corporation included the two loans totaling $285,585.89 which constituted an indebtedness owed to them by the corporation. However, to the shareholders' consternation and dissatisfaction each was allowed only a $3,782.46 loss deduction which was comparable to each shareholder's actual capital investment or stock ownership in the corporation.

In support of its motion for summary judgment the Government relies upon the documents which reflect the substance of the transactions between the Bank of Texas, the shareholders and the corporation. The Government then contends that, even assuming that the facts asserted by the plaintiffs are true, it is entitled to a judgment as a matter of law. It is the Government's position that the guarantees executed by the shareholders in reference to the corporate loans cannot create an indebtedness from the corporation to the shareholders as required by the statute for the deduction sought by plaintiffs to be allowable. This is necessarily true, it is argued, regardless of the intention of the parties at the time the loans were executed. In rebuttal to the motion for summary judgment, the plaintiffs contend that the shareholders lent their individual credit to the corporation for the purpose of securing the loans from the bank and guaranteed the loans only as a result of the initial Stockholders' Agreement. It is asserted that the various parties to these transactions—the shareholders, the bank and the corporation—intended that an indebtedness be created between the corporation and the shareholders.

Summary judgment is a useful tool to cut off litigation where "there is no genuine issue as to any material fact and . . . the moving party is entitled to a judgment as a matter of law." Shahid v. Gulf Power Co., 291 F.2d 422, 423 (5th Cir. 1961), rehearing denied, 298 F.2d 793 (5th Cir. 1961), cert. denied, 370 U.S. 923, 82 S.Ct. 1563, 8 L.Ed.2d 503 (1962). However, the Fifth Circuit Court of Appeals has wisely cautioned that "summary judgment is a lethal weapon, and courts must be mindful of its aims and targets and beware of overkill in its use." Brunswick Corp. v. Vineberg, 370 F.2d 605, 612 (5th Cir. 1967).

Subchapter S of the Internal Revenue Code which was enacted in 1958, permits shareholders of qualifying corporations to elect to pay taxes individually on the corporation's income. The provisions were designed for small corporations which seek the advantages of the corporate form of organization but who are reluctant to incur the double taxation which that form entails. The legislative intent was to permit "business to select the form of business organization desired, without the necessity of taking into account major differences in tax consequences." S.Rep.No.1983, 85th Cong., 2d Sess. 87 (1958), U.S.Code Cong. & Admin.News 4876. As a correlative procedure to the individual payment of taxes on the corporate income, the shareholders also are permitted to deduct on their individual income tax returns their proportionate share of the corporation's net operating loss. The intended result is to create a tax situation comparable to that encountered when operating losses are sustained by a partnership or sole proprietorship.

Necessarily, however, in view of the corporate form of organization, there is a limitation as to the deductible amount of a corporate operating loss which any shareholder can utilize for tax purposes. Thus the statute provides that:

(2) Limitation. — A shareholder's portion of the net operating loss of an electing small business corporation for any taxable year shall not exceed the sum of—

(A) the adjusted basis . . . of the shareholder's stock in the electing small business corporation, determined as of the close of the taxable year of the corporation . . and

(B) the adjusted basis . . . of any indebtedness of the corporation to the shareholder, determined as of the close of the taxable year of the corporation . . . .

26 U.S.C. § 1374(c)(2). The legislative history reflects that the deductible net operating loss to any shareholder was limited "to the adjusted basis of the shareholder's investment in the corporation; that is, to the adjusted basis of the stock in the corporation owned by the shareholder and the adjusted basis of any indebtedness of the corporation to the shareholder." S.Rep.No.1983, 85th Cong., 2d Sess., U.S.Code Cong. & Admin. News 5008 (1958). Thus, the concept of...