Estate of Willett v. CIR, 21971.

• Decision Date: 29 July 1966
• Docket Number: No. 21971.,21971.
• Citation: 365 F.2d 760
• Parties: ESTATE of J. O. WILLETT, Deceased, R. S. Turner and Zoe C. Willett, Co-Executors, and Zoe C. Willett, Surviving wife, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

365 F.2d 760 (1966) ESTATE of J. O. WILLETT, Deceased, R. S. Turner and Zoe C. Willett, Co-Executors, and Zoe C. Willett, Surviving wife, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 21971.

United States Court of Appeals Fifth Circuit.

July 29, 1966.

C. McVea Oliver, Monroe, La., for petitioner.

Louis F. Oberdorfer, Asst. Atty. Gen., Tax Div., John B. Jones, Jr., Acting Asst. Atty. Gen., Lee A. Jackson, Herbert Grossman, Harry Baum, Attys., Dept. of Justice, Sheldon S. Cohen, Chief Counsel, Max G. Ansbacher, Atty., I.R.S., Washington, D. C., for respondent.

Before WISDOM and COLEMAN, Circuit Judges, and DAWKINS, Jr., District Judge.

WISDOM, Circuit Judge:

The narrow question for decision is whether the incorporation of a proprietorship that has previously made an election to be taxed as a corporation, under Section 1361 of the Internal Revenue Code,¹ is a taxable event, under Treasury Regulation Section 1.1361-5(b). We hold that it is not a taxable event. The regulation must yield to Congressional intent to protect unwary small businessmen from just such a tax.

J. O. Willett, the taxpayer, now deceased, was the sole owner of the "J. O. (Red) Willett Pipeline Stringing Co.," a small business performing services for the oil and gas pipeline construction industry. He elected, effective January 1, 1955, to have his proprietorship taxed as a corporation under Section 1361. Three years later, Willett incorporated his business by transferring all the assets to "J. O. (Red) Willett Pipeline Stringing Corporation" in exchange for all the capital stock of the corporation and for the corporation's assumption of the proprietorship's liabilities.

Treasury Regulation Section 1.1361-5 (b), filling a void in the statutory language, provides that the incorporation of a proprietorship that previously has made a Section 1361 election is a taxable event. The Commissioner imposed a capital gains tax of $86,764 on $338,108.83, the amount of the proprietorship's gain between the effective date of the Section 1361 election and the date of the actual incorporation. Relying on Estate of David Wein, 40 T.C. 454, aff'd, Wein's Estate v. Commissioner of Internal Revenue, 3 Cir. 1964, 330 F.2d 957 (per curiam), the Tax Court upheld the Commissioner. Estate of J. O. Willett, 23 T.C.M. 733, T.C. Memo 1964-125.

On appeal the taxpayer's representative argues that the regulation is invalid. While Treasury Regulations interpreting and implementing the Internal Revenue Code ordinarily have the force of law, courts will not enforce regulations which are unreasonable and plainly inconsistent with the Revenue Statutes. Commissioner of Internal Revenue v. South Texas Lumber Co., 1948, 333 U.S. 496, 501, 68 S.Ct. 695, 92 L.Ed. 831, 836; see Commissioner of Internal Revenue v. Acker, 1959, 361 U.S. 87, 80 S.Ct. 144, 4 L.Ed.2d 127. Applying that standard, we hold that T.Reg. Section 1.1361-5(b) is invalid. (I) The tax upon incorporation of an enterprise that has made a Section 1361 election, when considered with Section 351 of the Code, destroys the Congressional remedial objective of minimizing the distorting influence of tax considerations in a small businessman's choice of business organization. (II) The regulation is at war with the Code. The policy of the Code is to refuse to find tax consequences in purely formal business readjustments which do not alter the character of the relationship between the owner and his business. The regulation can be supported only by a series of assumptions which are unreasonable constructions of the language of Section 1361.

Reluctantly, because of our respect for Treasury regulations, the Tax Court, and the Court of Appeals for the Third Circuit, we reverse.

* * *

I. THE LEGISLATIVE PURPOSE

Congress included in the Internal Revenue Code of 1954 a new Subchapter R (Section 1361) granting certain small proprietorships and partnerships the option to be treated "as * * * domestic corporations" for federal income tax purposes. The primary impetus for the enactment of Section 1361 came from President Eisenhower's Budget Message to the Eighty-Third Congress:

Small businesses should be able to operate under whatever form of organization is desirable for their particular circumstances without incurring unnecessary tax penalties. To secure this result, I recommend that corporations with a small number of active stockholders be given the option to be taxed as partnerships and that certain partnerships be given the option to be taxed as corporations.²

The Report of the Senate Finance Committee recommending enactment of Section 1361 shows that the Congressional purpose mirrored the President's recommendation:

Your committee has adopted new provisions which for the first time will eliminate the effect of Federal tax laws on the form of organization adopted by certain small businesses. * * *³

In the Technical Amendments Act of 1958, Congress reaffirmed and expanded its commitment to the broadly remedial purpose supporting Section 1361; the Act both reinstated Section 1361 and enacted a complementary Subchapter S (Sections 1371-1377) following the President's further recommendation that small corporations be permitted to be taxed in some respects as partnerships.⁴

A number of commentators applauded the "drastic change of existing theory and practice":

There has existed a recognition for some time that it should be possible to arrive at business decisions on the basis of business and economic considerations, without being subject to the influence and frequent distortion dictated by a necessity to respond to income tax considerations. It has also become recognized that there is little substantive distinction, in the case of a closely owned business, between its conduct as a proprietorship and partnership and the manner in which it could discharge its functions if it were to don the corporate cloak.⁵

Not unexpectedly, the Department of the Treasury was unenthusiastic over the change. Upon enactment of Section 1361, the Treasury urged Congress to repeal the section retroactively.⁶ The regulations were long delayed. Finally, Congress, in order to avoid unfairness to small businessmen who made early Section 1361 elections, amended the section in 1958 to permit revocation of an election within ninety days after promulgation of regulations by the Treasury.⁷

Six years after the enactment of Section 1361, the Treasury got around to issuing a set of comprehensive regulations, Sections 1.1361-1 to 1.1361-15. T.D. 6496 (October 10, 1960). They are not distinguished for their simplicity nor for their fully carrying out the Congressional purposes expressed in Section 1361.⁸

T.Reg. Section 1.1361-5(b) provides that if the owners of an enterprise make a Section 1361 election and subsequently

"* * * cease conducting the business of the enterprise in an unincorporated form the election terminates and the assets of the enterprise are deemed to have been distributed to the owners in a complete liquidation of the section 1361 corporation. The effect of the liquidation on the owners shall be determined under the provisions of section 331, 334(a), and, in appropriate cases, 341. Therefore, if a substantial part of the business is transferred to an actual corporation, the transaction shall be treated as if immediately before the transfer all of the assets of the enterprise had been distributed to the owners in a complete liquidation. Accordingly, the transfer of the assets to the actual corporation shall be treated as a transfer made by the owners in their individual capacities immediately after the liquidation."

A recent revenue ruling elaborates the regulation. Rev.Rul. 66-25, I.R.B. 1966-5, 12. The regulation's complex scheme begins with the assumption that a section 1361 election makes the electing enterprise for tax purposes an independent entity, a "Section 1361 corporation". On this assumption, the scheme proceeds as follows. Actual incorporation of the business is deemed to require liquidation of the "Section 1361 corporation". At liquidation the "Section 1361 corporation" distributes its assets to the sole "shareholder", Willett. I.R.C. Section 331(a) (1) treats amounts distributed in liquidation of a corporation as made in full payment in exchange for the stock of the corporation. Willett's gain or loss from this distribution in liquidation is subject to capital gains and losses provisions of the code. See T.Reg. Section 1.331-1(b). In computing Willett's gain, the basis of the property distributed to him is the fair market value of the property at the time of distribution. I.R.C. Section 334(a). The time of distribution of the property to Willett is "the date that the assets of the enterprise were transferred to the actual corporation." See Rev.Rul. 66-25, I.R.B. 1966-5, 12. Willett's basis on the date of actual incorporation, January 1, 1958, was $481,357.55 (assets minus liabilities). On January 1, 1955, the effective date Willett elected to have his proprietorship taxed as a corporation, its basis was $143,248.72. Therefore, the Commissioner determined that during the life of the so-called "Section 1361 corporation", Willett realized a long-term capital gain of $338,108.83; on this amount, the Commissioner imposed a tax of $86,764.

A. The regulation's taxation of the process of incorporating an electing enterprise makes Section 1361 virtually a dead letter. The Code ostensibly offers a small businessman, such as Willett, a choice of methods for achieving taxation at the lower corporate rates. The proprietor may incorporate under Section 351 with no immediate recognition of gain (or allowance of loss).⁹ Or he may continue to operate his business as a proprietorship but elect under Section 1361 to pay taxes as a corporation. In fact, however, for most proprietors there is no choice. Tax-deferred incorporation under Section 351, although it may require an otherwise undesirable business...