W & W FERTILIZER CORPORATION v. United States

• Citation: 527 F.2d 621
• Decision Date: 17 December 1975
• Docket Number: No. 17-74.,17-74.
• Parties: W & W FERTILIZER CORPORATION v. The UNITED STATES.
• Court: U.S. Claims Court

527 F.2d 621

W & W FERTILIZER CORPORATION v. The UNITED STATES.

No. 17-74.

United States Court of Claims.

December 17, 1975.

Sherwin P. Simmons, Tampa, Fla., atty. of record, for plaintiff; Harold W. Mullis, Jr., Ronald S. Nauveen and Trenam, Simmons, Kemker, Scharf & Barkin, Tampa, Fla., of counsel.

Charles E. Auslander, Jr., Washington, D. C., with whom was Asst. Atty. Gen. Scott P. Crampton, for defendant; Theodore D. Peyser, Jr., and Donald H. Olson, Washington, D. C., of counsel.

Before COWEN, Chief Judge, LARAMORE, Senior Judge, and BENNETT, Judge.

ON DEFENDANT'S MOTION FOR SUMMARY JUDGMENT AND PLAINTIFF'S CROSS-MOTION FOR SUMMARY JUDGMENT

LARAMORE, Senior Judge:

This is an action to recover Federal corporate income taxes paid by plaintiff, under protest, for the taxable year ended March 31, 1970. The sole question presented is whether the taxpayer's prior election to be treated as a "small business corporation" under Subchapter S of the Internal Revenue Code of 1954,¹ terminated when one of its shareholders transferred his stock to a revocable inter vivos trust.²

The relevant facts are as follows: Plaintiff, W&W Fertilizer Corporation (hereinafter referred to as "W&W" or as "taxpayer"), was incorporated under the laws of the State of Florida in 1907. In 1965 the company elected to be treated as a Subchapter S corporation, effective for its taxable year ended March 31, 1966, and subsequent years unless terminated. Immediately prior to February 25, 1970 (the date of the transfer to the trust), W&W had only two shareholders: Lemuel P. Woods, owning 47 percent of the company's stock, and Fred J. Woods, his brother owning 53 percent. On the above date, Lemuel established the Lemuel P. Woods Revocable Trust (hereinafter referred to as the "Woods Trust") pursuant to a revocable trust agreement. Among the assets transferred to the trust on that date were all of the shares of W&W stock owned by Lemuel.

The Woods Trust was a revocable inter vivos or living trust, all of the income of which was taxable to and reported for Federal income tax purposes by Lemuel. As the grantor, Lemuel had reserved in himself the right to revoke at any time and to revest title to the trust's assets in himself, with the provision, however, that such right be exercised only in writing and after 90 days' notice to the trustee.³ A bank was designated as co-trustee, along with Julia Woods, Lemuel's wife. Lemuel was sole income beneficiary for life, and at the time of the trust's inception, the remainder was variously divided among his wife and family.

Section 1372(e)(3)⁴ of the Code provides that a Subchapter S election is terminated at such time as a corporation ceases to be a "small business corporation" as defined in section 1371(a).⁵ Subsection 2 of section 1371(a) specifies that a small business corporation may not "have as a shareholder a person (other than an estate) who is not an individual."

In light of sections 1371(a)(2) and 1372(e)(3), it is understandably not disputed that if during the taxable year ended March 31, 1970 taxpayer had as a shareholder a person who was not an individual, its Subchapter S election terminated. Both parties agree that a trust is not an individual within the meaning of section 1371(a)(2), and is, therefore, prohibited from becoming a Subchapter S shareholder. Hence, the resolution of this case turns on whether the revocable inter vivos trust described herein is to be accorded recognition for Federal tax purposes as a shareholder in taxpayer or, instead, whether the grantor-beneficiary is to be so recognized and the trust disregarded.

The government contends that when Lemuel transferred his shares to the Woods Trust, taxpayer's Subchapter S election terminated because, having a trust as a shareholder, it ceased to be a qualified "small business corporation" within the meaning of section 1371(a). Taxpayer, however, urges that "small business corporation" status continued even after the transfer because the Woods Trust should be disregarded, and Lemuel, the grantor, still accorded status as the owner.

In support of this, taxpayer makes three basic contentions. The first is that it is appropriate in this case to apply the well-settled rule that substance must govern over form. It is urged that because Lemuel retained de facto and de jure control over the trust res, in substance he, not the trust, must be regarded as the owner of the trust property. The second argument is that Lemuel never surrendered the beneficial interest in his W&W shares, and it is this interest that should control for purposes of deciding whether he remained the shareholder within the contemplation of section 1371(a)(2). Finally, taxpayer urges that uniform application of certain Federal tax principles compel recognition of the grantor as the "tax" owner of the shares nominally held by the Woods Trust. Paramount among these principles is what is termed the "grantor trust rules," embodied in the Internal Revenue Code, which hold that a grantor of a trust who retains either administrative control, a reversionary interest, power to control beneficial enjoyment, or the power of revocation, will be taxed on the income derived from the assets of the trust. (Section 671 et seq.)

For reasons which follow, we reject all three points and hold instead that taxpayer's Subchapter S election terminated upon the transfer of the shares in question into the hands and ownership of the Woods Trust.

I.

In its first contention, taxpayer cautions us against the exaltation of form over substance by reminding of the fact that Lemuel, as grantor of the trust, retained a quantum of economic control over the trust res by retaining the power to revoke. This power, along with his ability to influence the trustees' administrative decisions, is said, in economic substance, to make him the owner of the shares of taxpayer held by the Woods Trust.⁶

However, one of the persistent problems of income taxation, as of other branches of the law, is the extent to which legal consequences should turn on the economic substance of a transaction rather than on its form. It is easy to say that substance should control, but in practice form usually has some substantive consequence, so that if two transactions differ in form, they will probably not be identical as to substance. Congressional enactments of tax law often take note of this. To determine where the true substance of a particular enactment lies requires an inquiry into the reason for the passage of the law.

Subchapter S was enacted to afford a qualified "small business corporation" the option of eliminating Federal income tax at the corporate level, thereby avoiding double taxation. S.Rep.No.1983, 85th Cong., 2d Sess. 87 (1958), (1958-3 Cum.Bull. 922, 1008). If a corporation qualifies, it pays no tax and its income is "passed through" to its shareholders. An examination of the legislative history of the Act reveals that Congress' motive for including qualification requirements was to insure both the efficacy of the law's remedial purpose and the avoidance of an extreme administrative burden otherwise falling on the government in applying the law. Congress, therefore, expressly incorporated a requirement of form into the Act by excepting certain types of business organization from the ambit of the law's effect.

More specifically, section 1371(a)(2) was intended to effectuate two congressional objectives. Fulk & Needham, Inc. v. United States, 411 F.2d 1403 (4th Cir. 1969). First, it was designed to make the same tax treatment previously only available to proprietorships and partnerships also available to those small corporate business structures economically similar to proprietorships and partnerships. However, the similarity to partnerships and proprietorships was not complete under the congressional scheme. While partnership earnings may quite properly be passed through any type of business organization entitled by law to participate in a partnership, Congress expressly limited the availability of the special similar tax treatment to certain specified forms of business organization. The existence of a trust as a shareholder in a Subchapter S corporation would complicate the structure by adding another entity through which earnings would of necessity be passed. Congress anticipated this type of circumvention of the Act's objective by specifying qualification requirements of form for Subchapter S corporation shareholders.

The second, and equally compelling, reason for the adoption of the qualification requirement of section 1371(a)(2), was to avoid placing an enormous administrative burden on the government of tracing earnings to, and possibly through, a widely diversified and multitiered group of shareholders. If the Internal Revenue Service were required to verify and monitor the identity of owners of artificial entities, themselves the owners of Subchapter S shares, the task would be monumental.⁷ Such a possibility was obviated by specifically prohibiting persons "other than individuals" from owning Subchapter S stock.

In light of these two objectives, the impact of the qualification requirements upon the question of form and substance presented in this case was made abundantly clear in the Senate Committee Report, S.Rep.No.1983, 85th Cong., 2d Sess. 217-218 (1958), (1958-3 Cum.Bull. 922, 1138-1139):

Under section 1372(e)(3), an election terminates if the corporation ceases to be a small-business corporation. Thus, if an eleventh person or a nonresident alien becomes a shareholder in the corporation, if a corporation, partnership, or trust becomes a shareholder, or if another class of stock is issued by the corporation, the election is terminated. Emphasis supplied.

In our view, the above language spells clearly that the organizational form of the would-be shareholder constitutes the substance which must be examined when applying the qualification requirement contained in section 1371(a...