AR Lantz Co. v. United States
| Decision Date | 10 April 1968 |
| Docket Number | Civ. No. 66-814. |
| Citation | 283 F. Supp. 164 |
| Court | U.S. District Court — Central District of California |
| Parties | A. R. LANTZ CO., Inc., Plaintiff, v. UNITED STATES of America, Defendant. |
Eugene J. Brenner, Janin, Morgan & Brenner, San Francisco, Cal., for plaintiff.
Wm. Matthew Byrne, Jr., U. S. Atty., Loyal E. Keir, Asst. U. S. Atty., Chief of Tax Division, Jerry R. Stern, Asst. U. S. Atty., Los Angeles, Cal., for the Government.
This is an action for refund of corporate income taxes and interest. Jurisdiction is based on 26 U.S.C. § 7422 and 28 U.S.C. § 1346.
The dispute arises from tax returns filed for the fiscal years ending in February of 1963 and 1964. In each return the plaintiff claimed deductions for interest paid to A. R. Lantz and Gus D. Vellis, the stockholders of the taxpayer. The returns were audited by the Internal Revenue Service and additional taxes were assessed by reason of the disallowance of the deductions. The plaintiff paid the additional assessments plus interest and filed a claim for refund. No action was taken on the refund claim within six months and this lawsuit followed.
The plaintiff was incorporated on June 1, 1955. Its predecessor was an equal partnership of Lantz and Vellis doing business under the name of A. R. Lantz Co. During the two months prior to incorporation, David Cornman advanced $51,000 to the partnership. It was understood by all concerned that this sum represented the value of a one-third interest in the partnership and was made in anticipation of the incorporation. The three individuals agreed that upon incorporation of the plaintiff, each would receive $15,000 of common stock as partial consideration for his interest in or claim against the partnership and that the balance of this interest or claim would be a loan to the plaintiff.
On May 31, 1955, the three individuals had the following interests in or claims against the partnership:
Lantz Vellis Cornman
Equity $46,768.08 $46,768.08
Debt 10,005.00 $51,000.00
At the time of incorporation the principal assets of the partnership
were approximately $120,000.00 of accounts receivable and approximately
$60,000.00 of inventory. The principal liabilities were $45,000.00
of notes payable and the loan payable to Cornman. On June
1, 1955, all the partnership assets and liabilities were transferred to
the plaintiff. The journal entry reflecting the transfer shows $45,000
in capital stock subscribed plus the following amounts due to the three
shareholders
Cornman $36,000.00
Vellis 41,773.08
Lantz 31,768.08
On June 1, 1955, the books and records reflect that various notes were
issued by the plaintiff to its shareholders in the following amounts
Lantz 1. $46,768.08
2. 31,768.08
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Vellis 3. 46,768.08
4. 10,005.00
5. 41,773.08
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Cornman 6. 51,000.00
7. 36,000.00
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Notes 1, 3, and 6 bore interest at the rate of 7% per annum and were due on June 1, 1960. At the same time the books and records reflect that each shareholder subscribed to $15,000 worth of stock. It is apparent that note 1 less the subscription equals 2; notes 3 & 4 less the subscription equal 5; and 6 less the subscription equals 7. There is, however, some confusion as to when the various notes were delivered to the individuals and what, if any, cancellation procedures were taken with some of the notes. In addition there seems to have been a substantial delay between the subscription for the stock and its actual delivery.
Various small loans were made to plaintiff by each of the shareholders during the first years of operation. On January 30, 1957, stock was finally issued to Lantz, Vellis, and Cornman. Notes 1, 3, and 6 above were cancelled and new notes in the amounts of $31,768.08 for Lantz and Vellis and $36,000.00 for Cornman were issued. Note 4 to Vellis had previously been paid off by the plaintiff. It is not clear what became of notes 2, 5, and 7 or whether in fact they were ever issued. In any event, by July 31, 1957, each shareholder owned $15,000 worth of stock and was owed $36,000 by the corporation.
None of the notes contained an acceleration clause. Some interest payments were made to the noteholders, though not always at the stipulated rate or time. No payments of principal were made on the notes after equalization was achieved.
On September 15, 1958, Lantz and Vellis agreed to buy out Cornman. The books reflect that the corporation purchased the stock by obtaining loans from a bank and from Lantz and Vellis. Cornman's stock certificate was never cancelled. The plaintiff's records show that on October 1, 1959, new $60,000 notes were issued to Lantz and Vellis to cover the new full amount of their loans to the plaintiff. According to the books these notes were not issued until May of 1960. There was never any sinking fund for the retirement of the notes or any collateral security.
The corporation never paid any dividends. The noteholders were the shareholders and the officers of the plaintiff. The noteholders individually guaranteed the indebtedness of the plaintiff to the Bank of America and subordinated their loans to any bank lending.
The quest to find a clear test to determine whether a particular advance is a loan or a capital investment is not an easy one. The massive briefs filed by the parties to this action contain innumerable citations. From each case cited various factors favoring the selector are extracted and compared with factors allegedly present in our case. The trial of the case followed the same lines with each side stressing individual characteristics of the transactions. The most cited case in all the Ninth Circuit opinions on this subject is Wilshire & Western Sandwiches, Inc. v. Commissioner of Internal Revenue, 175 F.2d 718 (9th Cir. 1949). That case, as this one, dealt with an attempt to deduct certain interest payments made on notes given to shareholders in return for advances. In that case the shareholders advanced some $55,000 to the corporation prior to its commencing business. No receipts were provided for this money. Sometime later the parties decided that $30,000 should be allocated to stock and the remaining $25,000 should be loans. Notes were issued but no interest was paid. Originally the advances were not carried on the books as loans. However, this was subsequently corrected. The shareholders expected to be repaid but indicated that they would try not to injure the corporation by any such repayment.
The Ninth Circuit held for the taxpayer. The court stated that the obligation was unconditional and legally enforceable. Further reliance was placed on the fact that the shareholders had non-tax motives in reaching their decision to allocate their advances in the above described manner. Primary reliance was placed on the intent of the taxpayers in making the advances. The intent which the Court discussed is the intent to either make an investment and take the risks of the venture, or to seek a definite obligation which is payable in any event. This "intent" test has been cited and followed in Utility Trailer Mfg. Co. v. United States, 212 F.Supp. 773 (S.D.Cal.1962); Earle v. W. J. Jones & Son, Inc., 200 F.2d 846 (9th Cir. 1952); and Los Angeles Shipbuilding & Drydock Corp. v. United States, 289 F.2d 222 (9th Cir. 1961).
Perhaps the next significant case in this area is Miller's Estate v. Commissioner of Internal Revenue, 239 F.2d 729 (9th Cir. 1956). In that case three brothers who operated a partnership learned that one had contracted terminal cancer. They went to their attorney to seek a plan whereby the business could be continued without interruption in the event of the death of one of the partners. They also desired to be able to take some of the money from the business so that it might be distributed through estate plans. After considering a trust arrangement, the decision was reached to incorporate the partnership. The assets were transferred to the corporation in exchange for a small amount of stock and a substantial amount of notes.
The Ninth Circuit held that the payments received on the notes were a repayment of loans rather than disguised dividends. The Court stated that as long as the terms of the obligations were absolute, it was permissible to pay interest and principal out of earnings. The Court also noted the Wilshire test and commented that the circumstances indicated that repayment must have been intended. The key to the Court's decision, however, rested on the legitimate business purpose test first enunciated in the case of Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935). The Court found that the creation of the loans in this case was not a sham transaction. The clear objectives of the parties to continue the business and to simplify estate planning problems showed that there were definite non-tax motivations for designing the business entity along the chosen lines.
The next important Ninth Circuit case is O. H. Kruse Grain & Milling v. Commissioner of Internal Revenue, 279 F.2d 123 (9th Cir. 1960). In that...
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