Estate of Leavitt v. C.I.R.

• Decision Date: 19 May 1989
• Docket Number: No. 88-3129,88-3129
• Citation: 875 F.2d 420
• Parties: -1437, 89-1 USTC P 9332 ESTATE of Daniel LEAVITT, Deceased, Charles D. Fox, III, Executor; Estate of Evelyn M. Leavitt, Deceased, Charles D. Fox, III, Executor; Anthony D. Cuzzocrea; Marjorie F. Cuzzocrea, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 420

875 F.2d 420

63 A.F.T.R.2d 89-1437, 89-1 USTC P 9332

ESTATE of Daniel LEAVITT, Deceased, Charles D. Fox, III,

Executor; Estate of Evelyn M. Leavitt, Deceased, Charles D.

Fox, III, Executor; Anthony D. Cuzzocrea; Marjorie F.

Cuzzocrea, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 88-3129.

United States Court of Appeals, Fourth Circuit.

Argued Feb. 9, 1989.

Decided May 19, 1989.

Dianne E.H. Wilcox (Nicholas C. Conte, Woods, Rogers & Hazlegrove, Roanoke, Va., on brief), for petitioners-appellants.

Teresa Ellen McLaughlin (Gary R. Allen, Richard Farber, Tax Div., Dept. of Justice, Washington, D.C., William E. Rose, Jr., Asst. Atty. Gen., on brief), for respondent-appellee.

Before MURNAGHAN, Circuit Judge, BUTZNER, Senior Circuit Judge, and TILLEY, District Judge for the Middle District of North Carolina, sitting by designation.

MURNAGHAN, Circuit Judge:

The appellants, Anthony D. and Marjorie F. Cuzzocrea and the Estate of Daniel Leavitt, Deceased, et al., appeal the Tax Court's decision holding them liable for tax deficiencies for the tax years 1979, 1980 and 1981. Finding the appellants' arguments unpersuasive, we affirm the Tax Court.

I.

As shareholders of VAFLA Corporation, ¹ a subchapter S corporation during the years at issue, the appellants claimed deductions ² under Sec. 1374 of the Internal Revenue Code of 1954 ³ to reflect the corporation's operating losses during the three years in question. ⁴ The Commissioner disallowed deductions above the $10,000 bases each appellant had from their original investments.

The appellants contend, however, that the adjusted bases in their stock should be increased to reflect a $300,000 loan which VAFLA obtained from the Bank of Virginia ("Bank") on September 12, 1979, after the appellants, along with five other shareholders ("Shareholders-Guarantors"), had signed guarantee agreements whereby each agreed to be jointly and severally liable for all indebtedness of the corporation to the Bank. ⁵ At the time of the loan, VAFLA's liability exceeded its assets, ⁶ it could not meet its cash flow requirements and it had virtually no assets to use as collateral. The appellants assert that the Bank would not have lent the $300,000 without their personal guarantees.

VAFLA's financial statements and tax returns indicated that the bank loan was a loan from the Shareholders-Guarantors. Despite the representation to that effect, VAFLA made all of the loan payments, principal and interest, to the Bank. The appellants made no such payments. In addition, neither VAFLA nor the Shareholders-Guarantors treated the corporate payments on the loan as constructive income taxable to the Shareholders-Guarantors.

The appellants present the question whether the $300,000 bank loan is really, despite its form as a borrowing from the Bank, a capital contribution from the appellants to VAFLA. They contend that if the bank loan is characterized as equity, they are entitled to add a pro rata share of the $300,000 bank loan to their adjusted bases, thereby increasing the size of their operating loss deductions. ⁷ Implicit in the appellants' characterization of the bank loan as equity in VAFLA is a determination that the Bank lent the $300,000 to the Shareholders-Guarantors who then contributed the funds to the corporation. The appellants' approach fails to realize that the $300,000 transaction, regardless of whether it is equity or debt, would permit them to adjust the bases in their stock if, indeed, the appellants, and not the Bank, had advanced VAFLA the money. The more precise question, which the appellants fail initially to ask, is whether the guaranteed loan from the Bank to VAFLA is an economic outlay of any kind by the Shareholders-Guarantors. To decide this question, we must determine whether the transaction involving the $300,000 was a loan from the Bank to VAFLA or was it instead a loan to the Shareholders-Guarantors who then gave it to VAFLA, as either a loan or a capital contribution.

Finding no economic outlay, we need not address the question, which is extensively addressed in the briefs, of whether the characterization of the $300,000 was debt or equity.

II.

To increase the basis in the stock of a subchapter S corporation, there must be an economic outlay on the part of the shareholder. See Brown v. Commissioner, 706 F.2d 755, 756 (6th Cir.1983), affg. T.C. Memo 1981-608 (1981) ("In similar cases, the courts have consistently required some economic outlay by the guarantor in order to convert a mere loan guarantee into an investment."); Blum v. Commissioner, 59 T.C. 436, 440 (1972) (bank expected repayment of its loan from the corporation and not the taxpayers, i.e., no economic outlay from taxpayers). ⁸ A guarantee, in and of itself, cannot fulfill that requirement. The guarantee is merely a promise to pay in the future if certain unfortunate events should occur. At the present time, the appellants have experienced no such call as guarantors, have engaged in no economic outlay, and have suffered no cost. ⁹

The situation would be different if VAFLA had defaulted on the loan payments and the Shareholders-Guarantors had made actual disbursements on the corporate indebtedness. Those payments would represent corporate indebtedness to the shareholders which would increase their bases for the purpose of deducting net operating losses under Sec. 1374(c)(2)(B). Brown, 706 F.2d at 757. See also Raynor v. Commissioner, 50 T.C. 762, 770-71 (1968) ("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.").

The appellants accuse the Tax Court of not recognizing the critical distinction between Sec. 1374(c)(2)(A) (adjusted basis in stock) and Sec. 1374(c)(2)(B) (adjusted basis in indebtedness of corporation to shareholder). They argue that the "loan" is not really a loan, but is a capital contribution (equity). Therefore, they conclude, Sec. 1374(c)(2)(A) applies and Sec. 1374(c)(2)(B) is irrelevant. However, the appellants once again fail to distinguish between the initial question of economic outlay and the secondary issue of debt or equity. Only if the first question had an affirmative answer, would the second arise.

The majority opinion of the Tax Court, focusing on the first issue of economic outlay, determined that a guarantee, in and of itself, is not an event for which basis can be adjusted. It distinguished the situation presented to it from one where the guarantee is triggered and actual payments are made. In the latter scenario, the first question of economic outlay is answered affirmatively (and the second issue is apparent on its face, i.e., the payments represent indebtedness from the corporation to the shareholder as opposed to capital contribution from the shareholder to the corporation). To the contrary is the situation presented here. The Tax Court, far from confusing the issue by discussing irrelevant matters, was comprehensively explaining why the transaction before it could not represent any kind of economic outlay by the appellants.

The Tax Court correctly determined that the appellants' guarantees, unaccompanied by further acts, in and of themselves, have not constituted contributions of cash or other property which might increase the bases of the appellants' stock in the corporation.

The appellants, while they do not disagree with the Tax Court that the guarantees, standing alone, cannot adjust their bases in the stock, nevertheless argue that the "loan" to VAFLA was in its "true sense" a loan to the Shareholders-Guarantors who then theoretically advanced the $300,000 to the corporation as a capital contribution. The Tax Court declined the invitation to treat a loan and its uncalled-on security, the guarantee, as identical and to adopt the appellants' view of the "substance" of the transaction over the "form" of the transaction they took. The Tax Court did not err in doing so.

Generally, taxpayers are liable for the tax consequences of the transaction they actually execute and may not reap the benefit of recasting the transaction into another one substantially different in economic effect that they might have made. They are bound by the "form" of their transaction and may not argue that the "substance" of their transaction triggers different tax consequences. Don E. Williams Co. v. Commissioner, 429 U.S. 569, 579-80, 97 S.Ct. 850, 856-57, 51 L.Ed.2d 48 (1977); Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149, 94 S.Ct. 2129, 2137, 40 L.Ed.2d 717 (1974). ¹⁰ In the situation of guaranteed corporate debt, where the form of the transaction may not be so clear, courts have permitted the taxpayer to argue that the substance of the transaction was in actuality a loan to the shareholder. See Blum, 59 T.C. at 440. However, the burden is on the taxpayer and it has been a difficult one to meet. That is especially so where, as here, the transaction is cast in sufficiently ambiguous terms to permit an argument either way depending on which is subsequently advantageous from a tax point of view.

In the case before us, the Tax Court found that the "form" and "substance" of the transaction was a loan from the Bank to VAFLA and not to the appellants:

The Bank of Virginia loaned the money to the corporation and not to petitioners. The proceeds of the loan were to be used in the operation of the corporation's business. Petitioners submitted no evidence that they were free to dispose of the proceeds of the loan as they wished. Nor were the payments on the loan reported as constructive dividends on the corporation's Federal income tax returns or on the petitioners' Federal income tax returns during the years in issue. Accordingly, we find that the transaction was in fact a loan by the bank to the corporation guaranteed by the...