Gilbert v. Commissioner of Internal Revenue

• Decision Date: 26 September 1957
• Docket Number: No. 331,Docket 24469.,331
• Parties: Benjamin D. and Madeline Prentice GILBERT, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Second Circuit

248 F.2d 399 (1957)

Benjamin D. and Madeline Prentice GILBERT, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 331, Docket 24469.

United States Court of Appeals Second Circuit.

Argued April 10, 1957.

Decided September 26, 1957.

Francis E. H. Davies, New York City (Fred R. Tansill and Goodwin, Rosenbaum, Meacham & White, Washington, D. C., of counsel), for petitioners.

Charles K. Rice, Asst. Atty. Gen., Hilbert P. Zarky and Fred E. Youngman, Attys., Dept. of Justice, Washington, D. C. (Joseph Goetten, Washington, D. C., of counsel), for respondent.

Before HAND, MEDINA and WATERMAN, Circuit Judges.

MEDINA, Circuit Judge.

This case presents a recurrent problem in the income tax field, namely whether advances by a taxpayer to his corporation will be treated as loans for tax purposes.

The facts are fully stated in the findings and opinion of the Tax Court, 15 T.C.M. 688, but the following abbreviated summary will serve as background to the ensuing discussion. The critical question in the case is: what is the principle to be applied by the finder of the facts in determining whether a given advance of money by a shareholder to a closely held corporation is a loan within the meaning of the Internal Revenue Code? As we cannot tell from the record before us what was the principle, or what were the standards, applied by the Tax Court, we are remanding the case for further and more explicit findings.

The taxpayers, husband and wife, filed a joint return for the taxable year 1948, claiming bad debt deductions in the amount of $80,404.25, for advances made by them in the years 1946, 1947 and 1948 to Gilbor, Inc. The Tax Court held the advances made by the husband to be contributions to capital, and hence, as to him, did not reach the subsidiary question of whether such advances were deductible only as nonbusiness bad debts within the meaning of Section 23(k) (4), of the applicable Internal Revenue Code of 1939, 26 U.S.C.A. § 23(k) (4). As to the wife the Tax Court found her advances to be debts but only deductible as nonbusiness bad debts, but this issue and some others decided by the Tax Court in this case are not now in dispute between the parties. Accordingly, the Tax Court affirmed the deficiency assessed by the Commissioner for the year 1948 in the amount of $48,518.65.

Gilbor, Inc. was organized as a New York corporation on June 11, 1946, with an authorized capital stock of $120,000, of which 1,000 shares were preferred stock having a par value of $100, and 20,000 shares were common stock with a par value of $1. Gilbert, the husband petitioner, and one Borden became the principal stockholders and there was an understanding between them that the financing of Gilbor, Inc. "would be generally on about a 50-50 basis." On June 27, 1946 Borden acquired 4000 shares of common stock in exchange for $40,000, of which $4000 was credited to capital stock and $36,000 to capital surplus. On July 1, 1946 Gilbert acquired 4000 shares of common stock in exchange for the assets of a business owned by him, which were valued by the directors of Gilbor, Inc. at $40,000, including $2107.85 cash and good will of $35,000. As in the case of Borden, $4000 was credited to capital stock and $36,000 to capital surplus. One share of common stock was issued for $10 cash to one Richards, and $1 was credited to capital stock and $9 to capital surplus. Both Gilbert and Borden became officers and directors and Gilbert, as president, "actively participated in the business" of Gilbor, Inc.

Most of the available cash was promptly expended in the purchase of the stock of other enterprises which Gilbor, Inc. took over, and Borden loaned the corporation $15,000. From time to time, during the years 1946, 1947 and 1948, until the corporation was liquidated at the end of the taxable year 1948, further advances were made by Gilbert and his wife on the one hand, and Borden on the other. The loans by Gilbert, for which demand promissory notes were issued, and the rates of interest payable thereon were as follows:

                  Oct.  28, 1947    $10,000    Demand    3½%    payable semiannually
                  Dec.   9, 1947      1,000    Demand    3½%    payable semiannually
                  Feb.  20, 1948      6,000    Demand    3½%    payable semiannually
                  May    4, 1948      4,800    Demand    3½%    payable semiannually
                  Aug.  25, 1948      3,000    Demand    3½%    payable semiannually
                  Sept.  1, 1948      1,000    Demand    3½%    payable semiannually
                  Sept. 27, 1948      1,000    Demand    3½%
                  Oct.  28, 1948        600    Demand    3½%
                  Dec.  30, 1948      4,000    Demand    3½%
                                    ________
                      Total         $31,400
                

The advances by Mrs. Gilbert were:

                  Sept. 23, 1946    $ 1,150    Demand      ----
                  Nov.   1, 1946     12,000    Demand       5%
                                               (After
                                               1/1/47)
                  Dec.  12, 1946     10,000    Demand       5%          payable semiannually
                  Jan.   6, 1948      2,500    Demand   3½%      payable semiannually
                  Jan.   8, 1948      5,000    Demand   3½%      payable semiannually
                  Mar.  10, 1948      1,000    Demand   3½%      payable semiannually
                  Apr.  28, 1948     10,000    Demand   3½%      payable semiannually
                  May   26, 1948      4,000    Demand   3½%      payable semiannually
                  June   7, 1948      1,000    Demand      ----
                  July   6, 1948        500    Demand      ----
                  July  12, 1948        500    Demand      ----
                  July  15, 1948      1,000    Demand   3½%      payable semiannually
                                    _______
                      Total          $48,650
                

Further advances from time to time were made by Gilbert on open account; but the amount owing Borden at the end was more or less the same as that owing Gilbert and his wife. All these sums were used "for necessary operating expenses." Moreover, shortly after the corporation was organized a loan was negotiated with the Credit Suisse "in order to provide funds with which to conduct the operation of the corporation," and the note covering this loan was guaranteed by both Gilbert and Borden, each of whom put up personally-owned securities as additional security. Other personally-owned securities were loaned at various times by Gilbert and Borden to Gilbor, Inc. and its subsidiaries, to be used as collateral in obtaining other loans from outside sources.

The note payable to Mrs. Gilbert, dated December 12, 1946, for $10,000, contained a provision that it was "transferable immediately into preferred stock," although the privilege was never exercised; and, at the same meeting at which the loan on such terms was authorized, Borden was given an option to purchase the same amount of preferred stock for $10,000, this option to be available only if Mrs. Gilbert exercised her right to convert the note into stock.

During its existence the corporation was actively engaged in the prosecution of various ventures, with the usual ups and downs, but none of them came up to expectations, and no profit was earned in any year. No interest was ever paid on any of the notes issued to Gilbert or his wife, nor was any interest credited on the books until shortly before the end.

The finding of the Tax Court was: "In view of all of the circumstances established by the voluminous record herein, we have concluded that the advances by Benjamin Gilbert were, in reality, contributions of risk capital and did not give rise to bona fide debts on the part of the corporation."

The problem, which typically arises as the result of an advance by a shareholder to a closely held corporation, has been dealt with in scores of cases. Generally we find an effort by the taxpayer to induce the Commissioner and the courts to make a finding that these transactions are loans. Two major reasons for this are: (1) the Code provides a deduction for "all interest paid or accrued within the taxable year on indebtedness," I.R.C.1954, Section 163(a), 26 U.S.C.A. § 163(a) I.R.C.1939, Section 23(b); and (2) when a business "debt" becomes worthless the lender is entitled to a full deduction not subject to the limitations imposed on capital losses, I.R.C.1954, Section 166(a), 26 U.S.C.A. § 166(a), I.R.C.1939, Section 23(k).¹

By way of preliminary, it is trite to say that the mere empty form of the transaction does not preclude further inquiry. It is always open to the Commissioner to prove that the transaction is not what it appears, that the parties truly intended to and actually did enter into another and hidden agreement by which their rights are to be governed. It is also clear that, for purposes of the federal tax statute, even though the parties have intended to create a debt, the courts will not recognize it as such as against the taxing power if they have failed to create a binding obligation. Day v. Helvering, 2 Cir., 121 F.2d 856; Johnson v. Commissioner, 2 Cir., 86 F.2d 710.

The classic debt is an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor's income or lack thereof. While some variation from this formula is not fatal to the taxpayer's effort to have the advance treated as a debt for tax purposes, Commissioner of Internal Revenue v. O. P. P. Holding Corp., 2 Cir., 76 F.2d 11, too great a variation will of course preclude such treatment. Gregg Co. of Del. v. Commissioner, 2 Cir., 239 F.2d 498; Jewel Tea Co. v. United States, 2 Cir., 90 F.2d 451.

Assuming then that the true nature of the obligation has been established, and that it is not so unlike a classic debt as to preclude treatment as such, the inquiry is not yet ended, for "the form of a transaction as reflected by correct corporate accounting opens questions as to the proper application of a taxing statute; it does not close them." Bazley v. Commissioner, 331 U.S. 737, 741, 67 S.Ct. 1489, 1491, 91 L.Ed. 1782. This principle is generally said to derive from Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79...