Harris v. U.S., 89-3024

• Decision Date: 07 June 1990
• Docket Number: No. 89-3024,89-3024
• Citation: 902 F.2d 439
• Parties: -5104, 90-2 USTC P 50,341 J.H. HARRIS, and William J. Martin, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 439

902 F.2d 439

66 A.F.T.R.2d 90-5104, 90-2 USTC P 50,341

J.H. HARRIS, and William J. Martin, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.

No. 89-3024.

United States Court of Appeals Fifth Circuit.

June 7, 1990.

Warren M. Schultz, Jr., Alexander P. Trostorff, Jones, Walker, Waechter, Poitevent, Carrere & Denegre, New Orleans, La., for plaintiffs-appellants.

Teresa E. McLaughlin, Gary R. Allen, Richard Farber, Chief, Appellate Section, Tax Div., Dept. of Justice, Washington, D.C., John P. Volz, U.S. Atty., Eneid Francis, Asst. U.S. Atty., New Orleans, La., Paul M. Predmore, Trial Atty., Tax Div., U.S. Dept. of Justice, Washington, D.C., for defendant-appellee.

Appeal from the United States District Court for the Eastern District of Louisiana.

Before JOHNSON, WILLIAMS and GARWOOD, Circuit Judges.

GARWOOD, Circuit Judge:

In this federal income tax refund suit, plaintiffs-appellants, J.H. Harris (Harris) and William J. Martin (Martin), collectively Taxpayers, appeal the district court's summary judgment in favor of defendant-appellee, the United States (Government). We affirm.

Facts and Proceedings Below

In June 1982, Taxpayers contracted with Trans-Lux New Orleans Corporation to purchase for $665,585 cash a New Orleans pornographic theater that they intended to convert into a wedding hall. The Taxpayers' obligations under the contract were conditioned on their being able to secure from a third party a loan for not less than $600,000 repayable in fifteen to twenty years. ¹ Shortly before this time, Taxpayers had contacted John Smith (Smith), a real estate loan officer with Hibernia National Bank (Hibernia), to discuss the possibility of obtaining financing for the impending acquisition. Smith orally committed to lend Taxpayers $700,000. ²

Subsequently, to shield themselves from the potential adverse publicity that could follow from the purchase of the pornographic theater, as well as to limit their personal liability and enhance their chances of qualifying for industrial revenue bonds to finance the theater's renovation, in July 1982 Taxpayers formed Harmar (Harmar), a Louisiana corporation, which elected to be taxed pursuant to Subchapter S of the Internal Revenue Code, to purchase and operate the subject property. Harris and Martin each initially contributed $1,000 to the corporation, receiving its stock in return, and each also loaned Harmar $47,500 to satisfy operating expenses. Harris and Martin were the sole shareholders of Harmar, each owning half of its stock.

The purchase of the theater closed on November 1, 1982, and the theater was conveyed to Harmar on that date. Hibernia furnished the $700,000 necessary to close the transaction. ³ In borrowing the funds necessary to acquire the subject property, Harmar executed two promissory notes payable to Hibernia for $350,000 each, each dated November 1, 1982. One of these notes was secured by a $50,322.09 Hibernia certificate of deposit in Harris' name and another $304,972.49 certificate of deposit in the name of his wholly-owned corporation, Harris Mortgage Corporation. Harmar secured the other note, in accordance with its collateral pledge agreement, by its $3,000,000 note (which was unfunded apart from the $700,000) and its collateral mortgage on the theater, each executed by Harmar in favor of Hibernia and dated November 1, 1982. Under the terms of the collateral pledge agreement executed by Harmar in reference to the $3,000,000 note and mortgage, the mortgage secured "not only" Harmar's $350,000 note to Hibernia, "but also any and every other debts, liabilities and obligations" (other than consumer credit debt) of Harmar to Hibernia whether "due or to become due, or whether such debts, liabilities and obligations" of Harmar "are now existing or will arise in the future." Thus, the collateral mortgage secured the full $700,000 loan from Hibernia. Additionally, Taxpayers each executed personal continuing guarantees of Harmar indebtedness in the amount of $700,000 in favor of Hibernia. Smith testified in his deposition that the transaction was structured so that half the loan, as represented by one of the $350,000 notes, would be primarily secured by the certificates of deposit and the other half, represented by the other $350,000 note, primarily by the mortgage on the property purchased, with the entire amount also secured by Taxpayers' individual guarantees.

On its income tax return for the year ending December 31, 1982, Harmar reported a net operating loss of $104,013. Pursuant to section 1374 of the Internal Revenue Code of 1954 ⁴, Taxpayers each claimed half of the loss as a deduction on their 1982 individual returns ⁵, concluding that their bases in Harmar were in fact greater than Harmar's net operating loss for that year and that they therefore were entitled to deduct the entire loss on their personal returns. On audit, the Internal Revenue Service (IRS) found to the contrary and determined that Harris and Martin each had a basis of $1,000 in his Harmar stock and an adjusted basis in Harmar's indebtedness to each of them as shareholders of $47,500. Pursuant to I.R.C. Sec. 1374(c)(2), the IRS limited Taxpayers' deductions of the net operating loss to what it considered to be their bases in Harmar, $48,500 each. The IRS's disallowance of a portion of the deductions claimed by Taxpayers ⁶ resulted in additional tax liability, including interest, for Martin of $3,150.58 and for Harris of $1,280. Taxpayers paid the tax in dispute and now appeal the district court's summary judgment dismissing their suit for refund.

Discussion

Taxpayers contend on appeal that in determining the deduction allowable for Harmar's net operating loss, the IRS should have included in Taxpayers' bases in their Harmar stock the full value of the $700,000 Hibernia loan they guaranteed. I.R.C. Sec. 1374 permits a Subchapter S shareholder to deduct from his personal return a proportionate share of his corporation's net operating loss to the extent that the loss does not exceed the sum of the adjusted basis of his Subchapter S corporation stock and any corporate indebtedness to him. See section 1374(c)(2) (now section 1366(d)(1)). To arrive at their basis figure, Taxpayers seek to recast the transaction in question. They in essence urge that we disregard the form of the Hibernia loan--one from Hibernia to Harmar--in favor of what Taxpayers consider as the substance of the transaction--a $700,000 loan from Hibernia to them, the $700,000 proceeds of which they then equally contributed to Harmar's capital account. As evidence of their view of the substance of the transaction, Taxpayers point to the deposition testimony of Smith indicating that Hibernia looked primarily to Taxpayers, rather than to Harmar, for repayment of the loan, and they call attention to the $700,000 guarantees they each provided Hibernia as well as the $355,294.58 in certificates of deposit that Harris pledged to Hibernia as part of the November 1, 1982 loan transaction.

In its summary judgment memorandum, the district court declared that Brown v. Commissioner, 706 F.2d 755 (6th Cir.1983), was "on all fours" with the instant case and therefore resolved it. In Brown, the Sixth Circuit rejected shareholders' substance over form argument in ruling that the shareholders' guarantees of loans to their Subchapter S corporation could not increase their bases in their stock in the corporation unless the shareholders made an economic outlay by satisfying at least a portion of the guaranteed debt. Id. at 757. Without such an outlay, the Brown court concluded that " 'the substance matched the form' " of the transaction before it. Id. at 756. The reasoning of Brown was followed by the Fourth Circuit in Estate of Leavitt v. Commissioner, 875 F.2d 420 (4th Cir.1989), aff'g, 90 T.C. 206 (1988). There, the court, affirming the en banc Tax Court, held that shareholder guarantees of a loan to a Subchapter S corporation did not increase shareholders' stock basis because such guarantees had not "cost" shareholders anything and thus did not constitute an economic outlay. Leavitt, 875 F.2d at 422 & n. 9. ⁷ In reaching this conclusion, the Fourth Circuit affirmed as not clearly erroneous a finding of the Tax Court that the loan, in form as well as in substance, was made to the corporation rather than to the shareholders. ⁸ Id. at 424. The court rejected appellants' suggestion that it employ the debt/equity principles espoused in Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (5th Cir.1972), in determining whether the shareholders had actually made an economic outlay, ⁹ instead choosing to employ a debt/equity analysis only after making a finding that an economic outlay had occurred. ¹⁰ Leavitt, 875 F.2d at 427. The Leavitt court reasoned that the legislative history of section 1374 limiting the basis of a Subchapter S shareholder to his corporate investment or outlay could not be circumvented through the use of debt/equity principles. ¹¹ Id. at 426 & n. 16. See generally Bogdanski, Shareholder Guarantees, Interest Deductions, and S Corporation Stock Basis: The Problems with Putnam, 13 J.Corp.Tax'n 264, 268-89 (1986).

Taxpayers press this Court to follow the contrary holding of Selfe v. United States, 778 F.2d 769 (11th Cir.1985). There, the Eleventh Circuit ruled that a shareholder's guaranty of a Subchapter S corporation loan could result in an increase in equity or debt basis even though the shareholder had not satisfied any portion of the obligation. Selfe, 778 F.2d at 775. The court remanded the case to the district court for it to employ debt/equity principles in determining if the loan in question was in substance one to the shareholder rather than to the corporation. Id.

The courts have uniformly ruled that a shareholder must make an economic outlay to increase his Subchapter S corporation stock basis. See Leavitt, 875 F.2d at 422; Selfe, 778 F.2d at 772; Brown, 706...