Brennan v. O'DONNELL, 27705.
| Decision Date | 12 May 1970 |
| Docket Number | No. 27705.,27705. |
| Citation | 426 F.2d 218 |
| Parties | Frances U. BRENNAN, as Executrix of the Last Will and Testament of William J. Brennan, Deceased, etc., et al., Plaintiffs-Appellees, v. A. J. O'DONNELL, District Director of Internal Revenue, Defendant-Appellant. |
| Court | U.S. Court of Appeals — Fifth Circuit |
Macon L. Weaver, U. S. Atty., Birmingham, Ala., Lester R. Uretz, Chief, Internal Revenue Dept., Washington, D. C., Johnnie M. Walters, Asst. Atty. Gen., Lee A. Jackson, Chief, Appellate Section, Tax Div., Jonathan S. Cohen, Michael B. Arkin, Harry Baum, Howard M. Koff, Stuart A. Smith, Attys., Dept. of Justice, Washington, D. C., for defendant-appellant.
C. V. Stelzenmuller, Birmingham, Ala., for plaintiffs-appellees.
Before BELL, AINSWORTH and CARSWELL,* Circuit Judges.
The issue presented in this case is whether certain cash advances made by taxpayers to a corporation in which they were shareholders should be considered as creating a class of stock in the corporation for the purpose of determining the corporation's eligibility to obtain the special tax treatment made available by Subchapter S, Int.Rev.Code of 1954, §§ 1371-1377, to "small business corporations" and their shareholders. If these advances are not to be considered as creating a class of stock in the corporation, as the District Court concluded, the corporation qualified for Subchapter S treatment during the taxable years 1961 and 1962, and taxpayers were, therefore, entitled to deduct the net operating losses sustained by their corporation during those years in preparing their individual returns. Int.Rev.Code of 1954, § 1374. On the other hand, if these advances are to be considered as creating a class of stock, as the Government contends, the corporation did not qualify for Subchapter S treatment, and its losses were not directly deductible by taxpayers as if the corporation were organized as a partnership. Int.Rev.Code of 1954, § 1371(a) (4).
This is a tax refund suit brought by taxpayers1 against the District Director of Internal Revenue for the State of Alabama in part2 to recover income taxes assessed against them and collected by the Commissioner of Internal Revenue for the taxable years 1961 and 1962. The case was submitted to the District Court for a judgment on the pleadings, the pretrial order, a stipulation as to facts and documents, and the briefs filed by the parties. On the basis of the stipulated facts, the District Court agreed with taxpayers' contentions regarding certain deductions they had claimed in their returns for the years 1961 and 1962 and ordered a refund to the extent of these deductions. From this judgment the Government appeals.3
During the years 1961 and 1962, taxpayers were shareholders in WFLI, Inc., a Tennessee corporation organized in 1959 to construct and operate a radio station in Chattanooga, Tennessee. In their income tax returns for these years, taxpayers deducted from their gross incomes amounts equal to their pro rata shares of the net operating losses sustained by WFLI in 1961 and 1962. They computed their tax liabilities in reliance upon section 1374 of the Internal Revenue Code of 1954. This section, part of Subchapter S, provides that shareholders of a "small business corporation," as defined in section 1371(a) of the Code, are entitled (provided the corporation elects to be taxed under the provisions of Subchapter S) to deduct from their gross incomes an amount equal to their portion of the corporation's net operating losses for the taxable year. The Commissioner determined that taxpayers were not entitled to the section 1374 deductions on the ground that WFLI was not a "small business corporation" within the meaning of section 1371(a) and was not, therefore, eligible to elect to be taxed under Subchapter S. He based this determination upon his finding that the corporation had more than one class of stock as a result of certain cash advances taxpayers had made to it and thus did not come within the statutory definition of a "small business corporation." Int. Rev.Code of 1954, § 1371(a) (4). Accordingly, he found deficiencies in taxpayers' reported tax liabilities for the years here in issue. Taxpayers paid the deficiencies and made refund claims asserting that the Commissioner's determination was erroneous. This suit followed the Commissioner's disallowance of taxpayers' claims.
The stipulation upon which the District Court concluded that the Commissioner had erred regarding the eligibility of WFLI for Subchapter S treatment was prepared by the parties in light of Treas.Reg. § 1.1371-1(g) (1960). This regulation, at the time the stipulation was made, read in part as follows:
(Emphasis added.) The parties stipulated, among other facts, that
(1) WFLI was incorporated in 1959 with an initial capitalization of $1,000.
(2) The corporation was initially capitalized through the issuance of 100 shares of stock having a par value of $10 per share to the following individuals:
Iralee W. Benns 45 shares
James G. Stelzenmuller, Jr. 25 shares
Cyril G. Brennan 25 shares
T. Julian Skinner, Jr. 5 shares
(3) Cyril G. Brennan was William J. Brennan's brother, while Skinner was Iralee W. Benns' nephew.
(4) On February 15, 1960, William J. Brennan bought the 25 shares of stock issued to Stelzenmuller.
(5) On September 8, 1961, William E. Benns, Jr. bought 10 shares of WFLI stock from his mother, Iralee W. Benns. After this transaction, the issued common stock of WFLI was owned as follows:
Iralee W. Benns 35 shares
William J. Brennan 25 shares
Cyril G. Brennan 25 shares
T. Julian Skinner, Jr. 5 shares
William E. Benns, Jr. 10 shares
(6) During the years 1959-1961, the Brennan brothers and Iralee W. Benns advanced to WFLI as payment for the common stock issued to them and as "equity capital" the following amounts:
Advanced
Payment as
for "equity
stock cap."
Iralee W. Benns $450 $34,550
William J. Brennan $250 $55,990
Cyril G. Brennan $250 $10,110
(7) During the period from April 12, 1960, through April 5, 1962, William E. Benns, Jr. advanced $24,335.01 to WFLI. Of the total amount advanced, $15,890.01 became "equity capital" on September 8, 1961, when Benns, Jr. became a WFLI shareholder. The remaining $8,445 advanced became "equity capital" on the dates the advances were made.
(8) The amounts designated as advances of "equity capital" constituted "equity capital within the meaning of the decided tax cases which hold that interest payments made by a thinly capitalized corporation on loans from its shareholders constitute dividends for income tax purposes."
(9) This "equity capital" was carried on WFLI's books as debts of the corporation which were owed to its shareholders. The parties did not stipulate as to the existence of debt instruments of any kind which were evidence of these advances, and no such instruments were introduced.
Before the District Judge issued his determination on whether the advances made to WFLI as "equity capital" are to be treated as a class of stock in the corporation, Treas.Reg. § 1.1371-1(g) was amended to have retroactive effect as follows:
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