Blum v. Comm'r of Internal Revenue

• Decision Date: 19 December 1972
• Docket Number: Docket No. 2738-71.
• Citation: 59 T.C. 436,32 T.C.M. (CCH) 158
• Parties: PETER E. BLUM, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

32 T.C.M. (CCH) 158

59 T.C. 436

PETER E. BLUM, PETITIONER

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 2738-71.

United States Tax Court

Filed December 19, 1972.

Karl W. Windhorst, for the petitioner.

Frank Simmons, for the respondent.

The allowable portion of a net operating loss properly deductible by a shareholder in an electing small business corporation does not include corporate debts to third parties which have been guaranteed by the shareholder. The guaranteed debt was not indebtedness of the corporation to the shareholder and was not in substance a loan from the third-party lender to the shareholder followed by the shareholder's equity contribution to the corporation.

OPINION

FAY, Judge:

Respondent determined a deficiency in petitioner's income tax for the taxable year 1968 in the amount of $8,039.49. A certain concession having been made, the sole issue remaining for decision is the amount of corporate net operating losses deductible by petitioner under section 1374.¹

All of the facts have been stipulated. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference and are adopted as our findings.

Peter E. Blum (petitioner) was a resident of Atlanta, Ga., at the time of the filing of the petition herein. Petitioner filed his Federal income tax return for the taxable year 1968 with the Southeast Service Center, Chamblee, Ga.

Peachtree Ltd., Inc. (hereinafter referred to as the corporation), was incorporated under the laws of the State of Georgia on December 29, 1966, for the purpose of ‘raising and racing horses.’

On July 29, 1967, the corporation filed an election under section 1372 to be treated as a small business corporation. Fifty shares of $100 par value common stock were authorized and were issued by the corporation to petitioner for $5,000 on July 15, 1967. Petitioner has, at all times, been the sole stockholder, president, and treasurer. The corporation filed a Federal income tax return for the period ended November 30, 1967, showing a net operating loss of $3,719.12. On his 1967 Federal income tax return petitioner deducted the loss of $3,719.12 from the corporation.

During the corporation's taxable years 1967 and 1968 petitioner made loans totaling $3,150 to the corporation. These loans were evidenced by the corporation's 6-percent demand notes and were completely repaid during the corporation's fiscal year ended November 30, 1968. In March of 1968 the corporation borrowed a total of $5,000 from the First National Bank of Atlanta on 7 1/2-percent, 90-day notes. These loans were renewed for 90-day periods and remained outstanding on November 30, 1968.

During the period beginning on March 18, 1968, and ending November 25, 1968, the corporation borrowed money from the Citizens & Southern National Bank of Atlanta on eight notes. Payment of all notes referred to in this paragraph was guaranteed by petitioner and was secured by collateral consisting of petitioner's 200 shares of common stock of Communications Satellite Corp. and 100 shares of common stock of Kerr McGee Corp. The collateral during the taxable year 1968 had at all times a fair market value in excess of the total indebtedness of $16,500 evidenced by the notes which remained outstanding at November 30, 1968.

During most of the time in which these loans were negotiated the corporation's unaudited balance sheets disclose that liabilities exceeded assets, and from March 31, 1968, through November 30, 1968, there was a deficit balance in the stockholder's equity account.

As of November 30, 1968, the corporation had liabilities to banks in the amount of $21,500 and did not have any indebtedness to petitioner.

The corporation filed a Federal income tax return for the fiscal year ended November 30, 1968, showing a net operating loss of $12,766. On his 1968 Federal income tax return petitioner deducted a loss from the corporation of . $14,214. Respondent in his notice of deficiency increased petitioner's taxable income to reflect the allowance of this deduction only to the extent of $1,281, which was petitioner's adjusted basis in the capital stock.

The corporation, with the consent of its sole shareholder, the petitioner, elected under section 1372 not to be subject to the taxes imposed by chapter 1 of the Code. In its fiscal year ending November 30, 1968, the corporation realized a net operating loss of $12,766. Section 1374(a) provides, as a general rule, that a new operating loss of an electing small business corporation for any taxable year shall be allowed as a deduction from the gross income of the shareholders of such corporation. Section 1374(c) limits the extent to which an individual shareholder can reflect the corporation's losses. Specifically, a shareholder's deductible portion of the new operating loss may not exceed the sum of his adjusted basis in his stock in the electing corporation and the adjusted basis of any indebtedness of the corporation to the stockholder.² At issue in the present case is the precise amount of petitioner's adjusted basis in the stock or the indebtedness of the corporation to petitioner. Petitioner originally had an equity investment in the corporation of $5,000. The basis of this investment was reduced to $1,281 when petitioner deducted $3,719.12³ on his 1967 Federal income tax return. This reflected the corporation's loss for its taxable year of 1967. It is respondent's contention that for the year 1968 petitioner is limited to a deduction of $1,281, his remaining basis in the stock of the corporation, for any losses incurred by the corporation.

Petitioner challenges respondent's position with two alternative theories. His claim is that loans guaranteed by him which were made to the corporation by third parties were either indebtedness of the corporation to him or in substance loans to him by the third parties, followed by his capital contribution to the corporation. Petitioner in reliance on these theories contends that the basis in his stock or indebtedness must be increased and he is therefore entitled to additional loss deductions under section 1374.

Petitioner's first contention, that guaranteed notes represent corporate to the guarantor, has been raised and correctly rejected by this Court on numberous occasions. See, for example, William H. Perry, 47 T.C. 159 (1966), affd. 392 F.2d 458 (C.A. 8, 1968); Joe E. Borg, 50 T.C. 257 (1968); and Milton T. Raynor, 50 T.C. 762 (1968). As was noted in those cases, the fact that shareholders may be liable on indebtedness of a corporation to a third party does not mean that this indebtedness is ‘indebtedness of the corporation to the shareholder’ within the meaning of section 2374(c)(2)(B).

No form of indirect borrowing, be it guaranty, surety, accommodation, comaking or otherwise, gives rise to indebtedness from the corporation to the shareholders until and unless the shareholders pay part or all of the obligation. Prior to that crucial act, ‘liability’ may exist, but not debt to the shareholders. * * * (Milton T. Raynor, supra at 770-771.)

In the absence of a showing that the debt in question runs ‘directly to the shareholder’ we must reject petitioner's first contention. See Ruth M. Prashker, 59 T.C. 172 (1972).

Petitioner's second contention represents a new twist in a taxpayer's attempt to reap the benefits of guaranteed loans to a subchapter S corporation for purposes of the limitations imposed by section 1374- (c)(2). Petitioner contends that the loans were indirect capital contributions which were in fact loans by the bank to petitioner followed by an increased capital contribution on his part, and as such the adjusted basis of his stock in the corporation must be increased to the extent of the guaranteed loans. Petitioner's only argument in this regard is that his corporation was thinly capitalized and according to an unaudited balance sheet was in fact insolvent at the time of the loans. Petitioner contends that there are numerous cases which hold that guaranteed loans to a corporation in such straits are in substance equity investments.

It is true that the respondent on numerous occasions has attempted to apply the ‘substance over form’ doctrine and recharacterize guaranteed loans as equity investments. See Murphy Logging Co. v. United States, 378 F.2d 222 (C.A. 9, 1967); Santa Anita Consolidated, Inc., 50 T.C. 536 (1968); Fors Farms, Inc. v. United States, an unreported case (W.D. Wash. 1966, 17 A.F.T.R. 2d 222, 66-1 U.S.T.C. par. 9206); J. Paul Smyers, 57 T.C. 189 (1971); and Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (C.A. 5, 1972), affirming a Memorandum Opinion of this Court, certiorari applied for Sept. 30, 1972.

It is also true that at least on one occasion this Court has permitted the taxpayer to successfully challenge the form of his own choosing and claim that guaranteed loans were in substance an equity contribution by the taxpayer. See J. A. Maurer, Inc., 30 T.C. 1273 (1958).

The question of whether advances made by a stockholder to a corporation constitute debts or contributions to capital usually arises in cases where the respondent has disallowed deductions claimed on account of the accrual or payment of alleged interest. Petitioner has not cited and we have not found any cases in which the debt-equity determination was resorted to for purposes of increasing a shareholder's loss basis in a subchapter S corporation. However,...