DeTreville v. United States, 15156

• Decision Date: 03 August 1971
• Docket Number: No. 15156,15157.,15156
• Citation: 445 F.2d 1306
• Parties: Marie L. DeTREVILLE, Appellee, v. UNITED STATES of America, Appellant. Marie L. DeTREVILLE, Appellant, v. UNITED STATES of America, Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

445 F.2d 1306 (1971)

Marie L. DeTREVILLE, Appellee, v. UNITED STATES of America, Appellant.

Marie L. DeTREVILLE, Appellant, v. UNITED STATES of America, Appellee.

Nos. 15156, 15157.

United States Court of Appeals, Fourth Circuit.

Argued May 14, 1971.

Decided August 3, 1971.

William L. Goldman, Atty., Dept. of Justice (Johnnie M. Walters, Asst. Atty. Gen., Meyer Rothwacks, Thomas L. Stapleton, Attys., Dept. of Justice, Joseph O. Rogers, Jr., U. S. Atty., and Wistar D. Stuckey, Asst. U. S. Atty., on brief) for the United States.

Gene V. Pruet, Columbia, S. C. (Cooper, Gary, Nexsen & Pruet, Columbia, S. C., on brief), for Marie L. DeTreville.

Before SOBELOFF, Senior Circuit Judge, and WINTER and CRAVEN, Circuit Judges.

SOBELOFF, Senior Circuit Judge:

These appeals involve a claim for refund of federal income taxes for the year 1960. The District Court entered judgment in favor of the taxpayer for about two-thirds of the recovery sought.¹

Neither party is satisfied and each seeks to improve his lot by appealing. We hold that the Government's appeal should prevail and the taxpayer's should not.

Marie L. DeTreville, the taxpayer, is a stockholder in Forest Land Company, Inc., a South Carolina corporation organized in 1931. At the end of 1958, the stockholders elected to qualify the corporation as a "small business corporation" under Subchapter S of the Internal Revenue Code, 26 U.S.C. §§ 1371-78. The effect of such an election is to eliminate the corporation's income tax and to cause the corporation's income to be taxed proportionately to its shareholders, regardless of whether the income is distributed or retained by the company. See 26 U.S.C. § 1373. Taxable income retained by the corporation may then be distributed tax-free in subsequent years. 26 U.S.C. § 1375(d).

On December 16, 1960, Forest Land Company and its shareholders formed the Mount Vernon Life Insurance Company. Forest Land Company received 13,756 shares of capital stock in the insurance company, valued at $22.50 per share, in return for certain real estate properties. On December 31 of that year the corporation made a distribution to its stockholders of checks totalling $212,868.64. Less than a week later each stockholder purchased from the company shares of insurance stock equal in value to his share of the previous cash distribution.

The Government argued, and the District Court held, that the transactions between the company and its shareholders amounted to a property distribution rather than a distribution of cash. For reasons that will be elaborated below, the Government also argued that as a property distribution the entire distribution was taxable to the shareholders as a dividend. The District Court, however, ruling invalid Treasury Regulation § 1.1375-4(b), held the distribution only partially taxable and granted judgment for the taxpayer in the amount of $6,413.33 plus interest.

We affirm the conclusion of the District Court that the 1960 distribution was one of property rather than money, but vacate the judgment, as we conclude that the challenged Treasury Regulation is not invalid.

I. The Property Distribution

As will be discussed at some length in part II of this opinion, property distributions by Subchapter S corporations are taxed differently from money distributions. If the December 31 distribution was a money distribution, there is no question that the taxpayer should prevail and recover the full refund which she is seeking. If the distribution was one of property, however, she is entitled to no refund unless, as the District Court held, Treasury Regulation § 1.1375-4(b) is invalid, in which case the taxpayer would be entitled to the partial refund awarded by the District Court.

There is no question that checks were issued to the shareholders on December 31, 1960, or that the insurance company stock was not "sold" to the stockholders until January 6, 1961. However, the reasoning of the District Court was founded on the principle established by Commissioner of Internal Revenue v. Court Holding Co., 324 U.S. 331, 65 S. Ct. 707, 89 L.Ed. 981 (1945), and Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935), that issues of taxation are to be governed by the substance rather than the form of the underlying transactions.

The District Court found that the corporation and its stockholders originally intended to distribute the insurance company stock directly to the stockholders. It was only after discovering that a direct property distribution would not be tax-free that the cash distribution and sale procedure was worked out. As the first step, on December 31, 1960, checks totalling $212,868.64 were made out to the shareholders. The company's bank balance at the time was $4,209.56.

The check made out to the taxpayer was in the amount of $17,631.34. On January 6, 1961, she purchased 784 shares of the insurance stock from Forest Land Company for $17,640. The other stockholders also purchased proportionate amounts of stock corresponding to their "cash" dividends. In each case the company's check and the stockholder's check were deposited on the same day, creating offsetting transactions. Of further note is the fact that the insurance company stock certificates were dated December 30, 1960, the day preceding the date of issue of the distribution checks.

These facts amply support the finding of the District Court that in substance this transaction was a distribution of property, insurance company stock, to Forest Land Company's stockholders. The checks, amounting to fifty times the bank balance available to pay them, served only to conceal the true nature of the transaction. Testimony that the stockholders were not bound to purchase the stock and that funds could easily have been obtained to cover the checks was quite properly accorded little weight. Overwhelming that evidence is the fact that every stockholder did purchase a proportionate amount of stock, as must have been anticipated considering the woeful insufficiency of the company's bank account had any of the checks been presented for payment.

II. The Treasury Regulation

Subchapter S was intended to allow certain small business corporations to be taxed almost as if they were partnerships rather than corporations — "it permits businesses to select the form of business organization desired, without the necessity of taking into account major differences in tax consequences."² Thus, the primary benefit offered by Subchapter S is a means to avoid the taxation of income both to the corporation as a separate entity and again to the stockholders as dividends when distributed.

A first principle critical to an understanding of the operation of Subchapter S is that when any corporation, including a Subchapter S corporation, makes a distribution of its earnings and profits to its stockholders, the distribution is taxed to the stockholders as a dividend. 26 U.S.C. § 316(a). Accordingly, under Subchapter S, money distributions are taxable to shareholders as dividends to the extent of the current year's earnings and profits. However, to the extent that the taxable income of a Subchapter S corporation exceeds money distributions for the current year, the difference is also taxed directly to the shareholders at their personal rates rather than being taxed to the corporation as a separate entity. 26 U.S.C. § 1373(b)³ This undistributed taxable income is then treated as if it had been distributed and paid back in by the shareholders as a contribution to capital — the company's earnings and profits are reduced by the amount of undistributed taxable income (26 U.S.C. § 1377(a))⁴, and the basis of each shareholder's stock is increased by an amount equal to his proportionate share of undistributed taxable income. 26 U.S.C. § 1376(a)⁵

It is the transfer of undistributed taxable income from the earnings and profits account to the capital account which prevents double taxation of that income. Whenever a shareholder's undistributed taxable income is subsequently paid out to him it will not be taxable to him because it will not be a distribution made "out of the company's earnings and profits" within the meaning of § 316(a). Should a shareholder dispose of his stock before the accumulated undistributed taxable income has been distributed, it is also protected from further taxation at capital gains rates because of the previous upward adjustment of the shareholder's basis in his stock.

One further taxation principle is central to an understanding of Subchapter S and Treasury Regulation § 1.1375-4(b). Section 316(a) of the Internal Revenue Code, besides defining a dividend as a distribution out of earnings and profits, declares the general rule that "every distribution is made out of earnings and profits to the extent thereof." Thus, a corporation which has accumulated earnings and profits may not declare a distribution to be one of capital and therefore, tax-free. Subchapter S, however, in addition to eliminating the double taxation of corporate income, provides the further benefit in § 1375(d)⁶ of allowing distributions to be attributed first to previously taxed undistributed taxable income even though the company has accumulated earnings and profits.⁷

With these legal principles in mind, we turn again to the facts of this case. In 1959 Forest Land Company had taxable income of $128,956.24, of which $888.70 was distributed, leaving $128,067.54 as undistributed taxable income. In 1960 the company earned $158,183.84, of which $73,382.74 was indisputably distributed in the form of money. The Government argues that the shareholders owe taxes on the remaining $84,801.10 of 1960 corporate income as undistributed taxable income under § 1373, as well as on the entire December 31 distribution as a dividend paid out of accumulated earnings and profits, because a distribution of property rather than money. The taxpayer argues that the distribution should first reduce the 1960...