Selfe v. U.S.

• Citation: 778 F.2d 769
• Decision Date: 23 December 1985
• Docket Number: No. 85-7026,85-7026
• Parties: -464, 86-1 USTC P 9115 Edward M. SELFE and Jane B. Selfe, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (11th Circuit)

Page 769

778 F.2d 769

57 A.F.T.R.2d 86-464, 86-1 USTC P 9115

Edward M. SELFE and Jane B. Selfe, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.

No. 85-7026.

United States Court of Appeals, Eleventh Circuit.

Dec. 23, 1985.

Frank W. Donaldson, U.S. Atty., Caryl P. Privett, Birmingham, Ala., Michael L. Paup, Atty., Tax Division, Dept. of Justice, Washington, D.C., Glenn L. Archer, Jr., Richard Farber, Teresa E. McLaughlin, Washington, D.C., for defendant-appellee.

Appeal from the United States District Court for the Northern District of Alabama.

Before TJOFLAT and KRAVITCH, Circuit Judges, and DUMBAULD ^*, District Judge.

KRAVITCH, Circuit Judge:

This appeal requires us to determine whether a shareholder in a Subchapter S corporation, who personally guarantees and secures a corporate debt, may increase the adjusted basis of her stock by the full amount of the debt in order to maximize her loss deductions under I.R.C. section 1374. ¹

The district court granted summary judgment in favor of the government and dismissed taxpayers' suit for refund of $24,287 in federal income taxes and interest paid. The district court also denied appellants' motion for summary judgment. We reverse and remand.

Taxpayer, Jane B. Selfe, formerly Jane Simon, entered into a retail clothing business in 1977 under the name of Jane Simon, Inc. She applied to the First National Bank of Birmingham for financing. In consideration of her pledge of 4500 shares of stock in Avondale Mills owned by her and close family members, the bank agreed to extend a line of credit to her in the amount of $120,000 for use in the business. Shortly thereafter, the business was incorporated. Taxpayer and her former husband were issued all of the stock, which was subsequently conveyed to Jane upon their divorce. The shareholders of the corporation elected to have the corporation taxed pursuant to Subchapter S of the Internal Revenue Code of 1954. At the request of the bank, all loans made to the taxpayer individually pursuant to the line of credit, except $10,000 initially advanced, were converted to corporate loans. Taxpayer executed an agreement guaranteeing the corporation's indebtedness to the bank. The loan officer testified that the bank wanted the assurance of having the corporation primarily liable to repay the loan, but that the conversion did not abridge the stock pledged as collateral, or the bank's rights against the taxpayer as guarantor, in the event of the corporation's default. Subsequently, the corporation granted the bank a security interest in its receivables, inventory and contract rights in order to obtain a renewal of its loans. The business began operations on August 4, 1977 and suffered losses for each year through 1980. It never, however, defaulted on its loan payments and the bank never was required to proceed against either the Avondale Mills stock or the taxpayer. On June 30, 1980, the outstanding balance of the corporation's indebtedness to the bank exceeded $130,000.

The net operating loss of Jane Simon, Inc. for the fiscal year ending June 30, 1980 was $33,824. Taxpayer and her new husband, Edward Selfe, deducted the entire loss from gross income on their joint income tax return for the year 1980. The government, however, determined that the allowable portion of the loss was limited to $4,946, the amount it determined was the taxpayer's adjusted basis in the corporation, and accordingly disallowed $28,878 of the claimed deduction, giving rise to an income tax deficiency in the amount of $16,839.42 plus interest in the amount of $7,648.64. Taxpayer paid the claim and then filed a claim for refund of the tax and interest. The government disallowed the claim and the taxpayer instituted a refund suit in the district court. The district court judge denied the taxpayer's motion for summary judgment, but granted summary judgment to the government.

I.R.C. section 1374 permits a shareholder in a Subchapter S corporation to deduct his portion of the corporation's net operating loss from his personal income. Section 1374 limits the amount of the deduction, however, to the sum of the adjusted basis of the shareholder's stock in the corporation, plus the adjusted basis of any indebtedness of the corporation to the shareholder. Relying upon the principles of Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (5th Cir.), cert. denied, 409 U.S. 1076, 93 S.Ct. 683, 34 L.Ed.2d 664 (1972), ² the appellant argues that the bank is deemed to have made the loan directly to her and that she then contributed the loan proceeds to Jane Simon, Inc., thereby increasing her basis in the stock of the corporation. In Plantation Patterns, the Fifth Circuit held that a loan is deemed to be made to a stockholder who has guaranteed a corporate note when the facts indicate that the lender is looking primarily to the stockholder for repayment. Plantation Patterns, however, did not involve section 1372 as the corporation in that case was not a Subchapter S corporation. Rather, in Plantation Patterns, the former Fifth Circuit affirmed as not clearly erroneous, a Tax Court finding that a transaction structured as a loan by an independent third party to a corporation, and guaranteed by a shareholder, was in substance a loan to the shareholder followed by his contribution of the loan proceeds to the capital of the corporation, and that as a result, the corporation's payments of principal and interest on the debt constituted constructive dividends to the shareholder. The taxpayer here does not argue that the cases are identical; rather, she argues that the principles announced in Plantation Patterns should apply here and points to the testimony of her bank officer that the loan to Jane Simon, Inc. was secured by the taxpayer's Avondale stock and that the bank was primarily looking to the taxpayer and her pledged stock for repayment of the loan. ³

Taxpayer's position is supported further by Peter Blum, 59 T.C. 436 (1972) and In re Lane, 742 F.2d 1311 (11th Cir.1984). In dicta, in the Blum case, the Tax Court stated it could see no distinction in principle between a situation such as Selfe's and Plantation Patterns. In Lane we observed that "we pay close heed to the dictates set forth by ... Plantation Patterns," when determining whether a shareholder's capital infusion is a loan or equity investment. 742 F.2d at 1320 (citations omitted). The taxpayer also points to proposed regulations, section 1.385-9, under section 385 of the code, which apply the principles of Plantation Patterns. ⁴ These regulations, however, were withdrawn in 1983.

The district court, primarily relying upon Brown v. Commissioner, 706 F.2d 755 (6th Cir.1983), held that an economic outlay resulting in an increase in a shareholder's basis in a Subchapter S corporation occurs only when the shareholder-guarantor is called upon to pay the corporation's debt. Here, although the corporation each year had suffered losses, it did not default on the payments due the bank on the loan. Furthermore, the bank had renewed the loan to the corporation upon assignment of its accounts receivable. The government points out that taxpayer has cited no decision in which a court has held that a shareholder's guarantee of a loan made to a Subchapter S corporation increased his basis in the corporation and states that similar attempts to circumvent the limitations of section 1374(c)(2) repeatedly have been rejected by the courts. ⁵

We find the Sixth Circuit's reasoning in Brown only partially persuasive. We agree with Brown inasmuch as that court reaffirms that economic outlay is required before a stockholder in a Subchapter S corporation may increase her basis. ⁶ We disagree, however, with the proposition that a stockholder/taxpayer must, in all cases, absolve a corporation's debt before she may recognize an increased basis as a guarantor of a loan to a corporation. ⁷ Instead we conclude that under the principles of Plantation Patterns, a shareholder who has guaranteed a loan to a Subchapter S corporation may increase her basis where the facts demonstrate that, in substance, the shareholder has borrowed funds and subsequently advanced them to her corporation.

The government correctly argues that generally taxpayers are liable for the tax consequences of the transaction they actually execute and may not reap the benefit of some other transaction that they might have made. In other words, taxpayers ordinarily are bound by the "form" of their transaction and may not argue that the "substance" of their transaction triggers different tax consequences. In Commissioner v. National Alfalfa-dehydrating, 417 U.S. 134, 149, 94 S.Ct. 2129, 2137, 40 L.Ed.2d 717 (1974) the Court observed:

While a taxpayer is free to organize his affairs as he choses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, ... and may not enjoy the benefit of some other route he might have chosen to follow but did not.

See also Don E. Williams Co. v. Commissioner, 429 U.S. 569, 579, 97 S.Ct. 850, 856, 51 L.Ed.2d 48 (1977); Brown, 706 F.2d at 756.

It is equally well settled that the Commissioner need not always determine the tax effect of transactions based on the form of the transaction. Higgins v. Smith, 308 U.S. 473, 477, 60 S.Ct. 355, 357-58, 84 L.Ed. 406 (1940). This principle is particularly evident where characterization of capital as debt or equity will have different tax consequences. Thus in Plantation Patterns the court held that interest payments by a corporation on debentures were constructive stockholder dividends and could not be deducted by the corporation as interest payments. There, the former Fifth Circuit recharacterized debt as equity at the insistence of the Commissioner. These principles, however, are not solely for the government's benefit. I.R.C. section 385(b) sets forth five factors which are available to determine "whether a...