Harrington v. United States

• Decision Date: 17 January 1985
• Docket Number: Civ. A. No. 83-859 CMW.
• Citation: 605 F. Supp. 53
• Parties: Lewis B. and Annamae HARRINGTON, Plaintiffs, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — District of Delaware

605 F. Supp. 53

Lewis B. and Annamae HARRINGTON, Plaintiffs, v. UNITED STATES of America, Defendant.

Civ. A. No. 83-859 CMW.

United States District Court, D. Delaware.

January 17, 1985.

Robert E. Schlusser, of Schlusser & Reiver, Wilmington, Del., for plaintiffs.

Joseph J. Farnan, Jr., U.S. Atty., and Richard G. Andrews, Asst. U.S. Atty., Wilmington, Del., Robert L. Gordon, Tax Atty., Tax Div., U.S. Dept. of Justice, Washington, D.C., for defendant.

MEMORANDUM OPINION

CALEB M. WRIGHT, Senior District Judge.

This is a suit for the refund of individual income taxes paid by the plaintiffs for their 1980 taxable year. The amounts for which a refund is sought were paid on November 29, 1982, and the plaintiffs filed a timely claim for a refund pursuant to 26 U.S.C. § 6511(a). Jurisdiction is conferred upon this Court by 28 U.S.C. § 1346(a)(1).

The plaintiffs owned 2.5% of the stock in CAMB Enterprises, Inc. ("CAMB"), a Delaware corporation formed on February 29, 1980, for the purpose of owning and operating a restaurant in Dover, Delaware under a franchise from H.A. Winston and Company. CAMB filed a valid and timely election with the Internal Revenue Service (the "IRS") to have its taxable income or loss for its taxable year ended October 31, 1980 passed through to its shareholders pursuant to the then provisions of Subchapter S of the Internal Revenue Code of 1954 (the "I.R.C."), 26 U.S.C. § 1371 et seq. CAMB reported a loss of $62,026 for its 1980 taxable year, and the plaintiffs claimed a deduction of $1,675.00 as their pro rata share of this loss. The IRS denied the deduction and assessed a deficiency of $528.00. On June 7, 1983, the plaintiffs filed a claim for refund of the $528.00 in tax plus $81.18 in interest paid thereon, and the IRS has taken no action on the claim.

I.

Under I.R.C. § 1374, a shareholder of an electing small business corporation may deduct from his gross income his pro rata share of the corporation's net operating losses.¹ However, under § 1374(c)(2) this deduction may not exceed the total of the shareholder's adjusted basis for his stock in the corporation plus the adjusted basis of any indebtedness of the corporation to the shareholder.² The adjusted basis of Harrington's stock in CAMB at the end of his 1980 taxable year was $2.50. Harrington claims that his pro rata share of CAMB's 1980 indebtedness to its shareholders was $5,000.00. The characterization of the corporation's indebtedness constitutes the principal issue in this case.

On August 14, 1980, Harrington and the four other shareholders of CAMB executed a promissory note for $200,000 to establish a line of credit with the Delaware Trust Company. The proceeds of the note were to be used to purchase equipment for the restaurant operated by CAMB. According to the testimony at trial, which the Court has no reason to doubt, CAMB Enterprises, Inc., was not a signatory of the original note but was put on later at the bank's insistence to enable the bank to get a lien on the corporation's equipment. The bank also later insisted that the five shareholders' wives be brought in on the note, and this later note, signed by CAMB, the five shareholders and their wives as comakers, was backdated to August 14, 1980, since this was the date from which interest would run.

Harrington contends that the Delaware Trust Company loaned the $200,000 to the individual shareholders and that they, in turn, reloaned the money to CAMB. Under this theory, Harrington's adjusted basis in his CAMB stock plus his adjusted basis in CAMB's debt to him was $5,002.50 at the end of his 1980 taxable year, so that Harrington would be entitled to deduct up to that amount of CAMB's 1980 net operating losses from his gross income for 1980. The government maintains, on the other hand, that, however the rights and obligations of the shareholders and their wives arising from the $200,000 promissory note may be characterized, the note represents a loan from the bank to CAMB, so that there could have been no reloaning of the money from the shareholders to the corporation. On the government's theory, there was no indebtedness from the corporation to Harrington, and Harrington could deduct from his gross income only that portion of CAMB's net operating losses which did not exceed the adjusted basis of his stock in CAMB, or $2.50.

A second issue in the case concerns the amount of CAMB's net operating losses during its 1980 taxable year. In computing its losses for 1980, CAMB included $17,698.00 of expenses incurred in connection with the opening of the restaurant. Before the restaurant opened to the public, its employees were trained by personnel from the franchisor who were sent to the restaurant for that purpose. During the training period, from October 4, 1980 to October 12, 1980, the restaurant was not open to the public but served free lunches to residents of the Dover senior citizens centers for advertising purposes and to avoid wasting the food. On October 11, 1980, CAMB held a party for several hundred people from the Dover business community and government offices. When the restaurant opened on October 13, 1980, CAMB's employees were unable to handle the volume of business, and CAMB obtained additional trained help from the H.A. Winston Company. The $17,698 of deductions claimed by CAMB includes amounts paid to the H.A. Winston Company for training CAMB's employees, the cost of food and liquor given away to the senior citizens and during the opening party and the wages paid after opening to the additional help furnished by the H.A. Winston Company.

The government takes the position that none of these expenses is deductible as an ordinary and necessary business expense under I.R.C. § 162(a), because they are all start-up expenses. Under I.R.C. § 195, start-up expenses may be amortized over a period of not less than five years, if the taxpayer makes a valid election prior to the date of the business's first income tax return. The government argues that, since CAMB did not make the required election, it cannot deduct any portion of these expenses. Alternatively, the government maintains that these expenses are not deductible under I.R.C. § 162(a) because CAMB was not engaged in a trade or business at the time they were incurred, and because the expenses were used to acquire an asset that yielded benefits to the corporation after the close of its taxable year on October 31, 1980.

Because the adjusted basis of Harrington's CAMB stock is $2.50, no portion of the disputed $17,698 of expenses will be deductible by him unless the Delaware Trust Company loan created an indebtedness from the corporation to Harrington. Accordingly, if the Court finds that there was no indebtedness running from CAMB to Harrington, it need not consider the deductibility of the expenses incurred in connection with the opening of the restaurant.

II.

The government urges that the loans from the Delaware Trust Company must be deemed to have been made to CAMB as a matter of law and, thus, that there was no reloaning of the proceeds from the shareholders to the corporation. The government relies for its position on Frankel v. Commissioner, 61 T.C. 343 (1973), aff'd., 506 F.2d 1051 (3d Cir.1974). Frankel involved a loan from a partnership to a Subchapter S corporation in which the stock was owned in the same proportions as the capital interests in the partnership. The Tax Court held that indebtedness running from the corporation to the partnership was not an indebtedness of the corporation to its shareholders within the meaning of I.R.C. § 1374 and, consequently, that the shareholders could not use it to increase their individual adjusted bases in any indebtedness of the corporation to them. The Tax Court noted that no form of "indirect borrowing" is sufficient to give rise to an indebtedness from a Subchapter S corporation to its shareholders unless or until the shareholders pay part or all of the obligation, id. at 347, citing Raynor v. Commissioner, 50 T.C. 762 (1968).

In Raynor the taxpayer owned stock in three Subchapter S corporations and also made various loans to the corporations along with the other shareholders. In addition to these loans from shareholders, the corporations received loans from third parties that were co-signed or guaranteed by the shareholders, and the shareholders executed notes to one of these third parties as additional security for the corporation's debt. With respect to these latter loans, the Tax Court stated:

The fact that shareholders may be primarily liable on indebtedness of a corporation to a third party does not mean that this indebtedness is "indebtedness of the corporation to the shareholder" within the meaning of 1374(c)(2)(B). 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.

50 T.C. 762, 770-71 (1968), citing Borg v. Commissioner, 50 T.C. 257 (1968). Numerous later cases have followed the rule of Raynor and Borg. See, e.g., Brown v. Commissioner, 706 F.2d 755 (6th Cir.1983); Underwood v. Commissioner, 535 F.2d 309 (5th Cir.1976); Wheat v. United States, 353 F.Supp. 720 (S.D.Tex.1973); Silverstein v. United States, 349 F.Supp. 527 (E.D.La.1972); Neal v. United States, 313 F.Supp. 393 (C.D.Cal.1970); Blackman v. Commissioner, 41 T.C.M. 1512 (1981); Williams v. Commissioner, 41 T.C.M. 844 (1981).

The government argues that Raynor, et al. is controlling in this case, and that, because Harrington himself made no repayments on the Delaware Trust Company note during CAMB's 1980 taxable year, there was no indebtedness from the corporation to Harrington during the latter's taxable year.³ This result is indeed compelled if the case is one of "indirect borrowing;" that is, if the note represents a loan from the bank to CAMB as the principal debtor, with Harrington and the...