469 F.2d 1183 (9th Cir. 1972), 24843-24848, Kean v. C.I.R.

Docket Nº:24843-24848.
Citation:469 F.2d 1183
Party Name:Harold C. & Margaret I. KEAN, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Inga L. BARDAHL, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Ole BARDAHL, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Murdock D. & Mary Ellen MacPHERSON, Petitioners-
Case Date:November 14, 1972
Court:United States Courts of Appeals, Court of Appeals for the Ninth Circuit
 
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Page 1183

469 F.2d 1183 (9th Cir. 1972)

Harold C. & Margaret I. KEAN, Petitioners-Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Inga L. BARDAHL, Petitioner-Appellant,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Ole BARDAHL, Petitioner-Appellant,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Murdock D. & Mary Ellen MacPHERSON, Petitioners-Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

William R. & Dorothy L. MacPHERSON, Petitioners-Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

C. E. MILAM & Verda Milam, Petitioners-Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nos. 24843-24848.

United States Court of Appeals, Ninth Circuit.

November 14, 1972

         Rehearing Denied Dec. 18, 1972.

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Page 1185

         Gerald R. Hergert (argued), Joseph H. Trethewey, Seattle, Wash., for appellants.

         Paul M. Ginsburg (argued), K. Martin Worthy, Chief Counsel, Johnnie M. Walters, Asst. Atty. Gen., Washington, D. C., for appellee.

         Before HAMLEY and KILKENNY, Circuit Judges, and WM. MATTHEW BYRNE, Jr., District Judge. [*]

         WM. MATTHEW BYRNE, Jr., District Judge:

         Appellants, petitioners in the Tax Court, were shareholders in Ocean Shores Bowl, Inc., hereinafter referred to as Bowl, a Washington corporation. They appeal from a judgment of the Tax Court, 51 T.C. 337, invalidating Bowl's election under Subchapter S, §§ 1371-1379 of the Internal Revenue Code of 1954, and disallowing petitioners' deductions on their personal tax returns of their pro rata shares of Bowl's 1962 and 1963 net operating losses.

         Bowl was formed on March 20, 1962 and had only one class of stock issued and outstanding. On October 30, 1962 Bowl filed a timely election to be taxed as a small business corporation pursuant to § 1372 of the Internal Revenue Code of 1954. Consents to such election were contemporaneously filed by all of the shareholders of record and their wives. As a result of the election, Bowl's net operating losses of $15,316 for the short taxable year 1962 and $56,638.28 for 1963 were deducted in pro rata shares by petitioners on their 1962 and 1963 personal income tax returns.

         Some Bowl debentures and 125 shares of Bowl stock were held in the name of petitioner, William MacPherson. He and his brother, petitioner Murdock MacPherson, were engaged in the real estate business in a company called MacPhersons, Inc. Each brother owned 45% of the stock of MacPhersons, Inc. with the remaining 10% being held by their mother. William and Murdock MacPherson had many joint investments which were conducted without any written agreement. Whoever initiated the investment would normally be responsible for its management. Neither held a power of attorney for the other. The books and records of MacPhersons, Inc. were maintained by its employee, Donald Minkler.

         On their 1962 joint income tax return William MacPherson and his wife deducted the net operating loss of Bowl accruing to the 125 shares in William's name. In 1963 William MacPherson and his wife deducted one half of the net operating loss for that year attributed to said shares while Murdock MacPherson and his wife deducted the other one half on their joint return. In 1964 the William MacPhersons and the Murdock MacPhersons each reported the sale of one half of the 125 shares of Bowl stock and one half of the Bowl debentures. All of these returns were prepared by Donald Minkler.

         A 1965 Internal Revenue Service audit disclosed that the 125 shares of Bowl stock and Bowl debentures, issued to William MacPherson in 1962, were purchased with a MacPhersons, Inc. check. The cost of the purchase was charged on the books of MacPhersons, Inc. equally against the drawing accounts of William and Murdock. Murdock MacPherson has never been repaid by William MacPherson for the amounts taken out of his drawing account to pay for the stock and debentures.

         Murdock MacPherson was not a shareholder of record of Bowl. Neither he nor his wife were mentioned in the Subchapter S election filed with the Internal Revenue Service in October, 1962; nor

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did they file a consent to the election. None of the other shareholders knew that Murdock MacPherson was involved in any way with Bowl until the 1965 audit.

         The Tax Court held that Bowl's Subchapter S election was invalid because Murdock MacPherson, as a beneficial owner of Bowl stock, was a shareholder within the meaning of § 1372 and had not consented to the corporation's election. Based on this finding, the court disallowed petitioners' deduction of their pro rata shares of the corporation's net operating losses.

         Subchapter S of the Internal Revenue Code of 1954 allows a small business corporation, as defined by § 1371, to elect to be exempt from corporate income taxes with the consequence that its shareholders are taxed directly on the corporation's earnings or may deduct the corporation's losses. Section 1372 provides that the corporation's election is "valid only if all persons who are shareholders . . . consent to such election."

          Petitioners contend that since Murdock MacPherson was not a shareholder of record and was not able to exercise any rights as a shareholder under Washington law, he was not a "shareholder" under § 1372. We disagree. The question of who is a shareholder as the term is used in Subchapter S must be determined by federal rather than state law. Putnam's Estate v. Commissioner of Internal Revenue, 324 U.S. 393, 65 S.Ct. 811, 89 L.Ed. 1023 (1945); Morgan v. Commissioner of Internal Revenue, 309 U.S. 78, 60 S.Ct. 424, 84 L.Ed. 585 (1940); Old Virginia Brick Company v. Commissioner of Internal Revenue, 367 F.2d 276 (4th Cir. 1966). Treasury Regulation § 1.1371-1(d)(1), implementing Subchapter S, states that "Ordinarily, the persons who would have to include in gross income dividends distributed with respect to the stock of the corporation are considered to be shareholders of the corporation."

         Petitioners...

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