Lafayette Distributors, Inc. v. United States

• Decision Date: 23 July 1975
• Docket Number: Civ. A. No. 74-897.
• Citation: 397 F. Supp. 719
• Parties: LAFAYETTE DISTRIBUTORS, INC. v. UNITED STATES of America.
• Court: U.S. District Court — Western District of Louisiana

397 F. Supp. 719

LAFAYETTE DISTRIBUTORS, INC. v. UNITED STATES of America.

Civ. A. No. 74-897.

United States District Court, W. D. Louisiana, Alexandria Division.

July 23, 1975.

Edwin K. Hunter, Camp, Carmouche, Palmer, Carwile & Barsh, Lake Charles, La., for plaintiff.

Donald E. Walter, U. S. Atty., Shreveport, La., Steven Shapero, Atty., Tax Div., Dept. of Justice, Washington, D. C., for defendant.

OPINION

NAUMAN S. SCOTT, District Judge.

This is a civil action for the refund of deficiency income taxes totaling $92,058.76 for the calendar year 1970. Jurisdiction is present under the provisions of 28 U.S.C. § 1346(a).

The largest part of this tax assessment was based on a determination by the Internal Revenue Service that Lafayette Distributors, Inc. lost its Sub-Chapter S status as a result of the execution of a "voting trust" agreement by rightful shareholders seeking control of the corporation. The remainder of the assessment results from (1) the disallowance of deductions for admission tickets to an area racetrack purchased by plaintiff for its customers and other business associates; (2) the disallowance of a deduction for alleged unreasonable salaries paid to officers-employees; and (3) the disallowance of a deduction for contributions to a qualified pension plan. It was agreed by the parties and accepted by the Court that the Sub-Chapter S issue should be severed and submitted on stipulations and decided first, since its resolution in favor of the taxpayer would moot the other questions.

Essentially, this lawsuit poses the question whether a corporation forfeits its status as an electing small business corporation under 26 U.S.C. § 1371 et seq (Sub-Chapter S) where one or more of its shareholders establish a voting trust.

The following facts are established by stipulation.

Lafayette Distributors, Inc. (the taxpayer) is a Louisiana corporation organized on June 14, 1973. It is in the business of distributing beer in and around Lafayette, Louisiana. On January 24, 1968, pursuant to Section 1372(a) of the Internal Revenue Code, taxpayer elected, with the consent of all its shareholders, to be treated as a small business corporation for income tax purposes, and for the calendar year 1968 and 1969, taxpayer was taxed in accordance with the Sub-Chapter S. However, by 1970, two factions had developed among the shareholders, and a struggle erupted for control over taxpayer's board of directors. The factions may be depicted as follows:

                                   I                                        II
                   A) Beulah H. Stansbury       8 1/3        A) Kenneth M. Stansbury     16 2/3
                   B) Beulah H. Stansbury —                B) Paul C. Elmer —
                      usufructuary for Randy                        Community property —
                      S. and Deborah A.                             spouse Marie F. Elmer    22 2/9
                      Stansbury                41 2/3
                                                ______
                                                                 C) Marie F. Elmer —
                                                                    community property —
                                                                    spouse Paul C. Elmer     11 1/9
                                                                                             ______
                                               50 Shares                                     50 Shares
                

By virtue of LSA-R.S. 12:51¹ neither faction could vote more than 49 shares and neither faction could obtain control of the taxpayer. As a result, a deadlock ensued.

In July of 1970, the members of the second faction set forth above felt they could obtain effective control over taxpayer by establishing a voting trust, and, thereby, coalescing the fractional shares and giving a voting trustee the power to vote 50 shares rather than the 49 which could be voted individually. Consequently, by the terms of the voting agreement dated July 29, 1970, and in accordance with the applicable Louisiana law, LSA-R.S. 12:78, the 50 shares subject to the voting trust were surrendered to the corporation, cancelled and reissued in a new certificate to the name of "J. Berry Mouton as trustee pursuant to voting trust agreement dated July 29, 1970."² The trustee thereafter executed and delivered voting trust certificates to the transferors.

On audit of the taxpayer's 1970 small business corporation income tax return (Form 1120-S) the Commissioner of Internal Revenue determined that the taxpayer's Sub-Chapter S election was terminated when the voting trust agreement was entered into, thus making the income of the corporation taxable to the corporation rather than to its shareholders. Accordingly, deficiency income taxes totaling $92,058.76 were charged against the taxpayer for 1970. Taxpayer paid the charged deficiency and filed a Form 843, Claim for Refund, and ultimately, filed this complaint on September 24, 1974.

A corporation that elects under Sub-chapter S is treated as a regular corporation in all respects except for tax purposes. Tax-wise, the effect of an election under Section 1372(a) is to permit the shareholders of the electing corporation to list as deductions on their personal income tax returns losses that the corporation sustained just as though the corporation were a partnership or a proprietorship. The income of the corporation, whether distributed or not to the shareholder, is taxed to him in accordance with his particular income bracket. The Commissioner disallowed the Sub-Chapter S tax treatment on the grounds that the creation of a voting trust rendered the corporation ineligible to qualify as a small business corporation under Sub-Chapter S. Section 1371(a) of the Internal Revenue Code provides:

"For purposes of this subchapter, the term `small business corporation' means a domestic corporation which is not a member of an affiliated group (as defined in 1504) and which does not —

(1) have more than 10 shareholders;

(2) have as a shareholder a person (other than an estate) who is not an individual;

(3) have a nonresident alien as a shareholder; and

(4) have more than one class of stock."

The Commissioner charges that the voting trust was, in effect, a shareholder other than an individual in violation of Section 1371(a)(2).

By enacting the Sub-Chapter S legislation, the intention of Congress was to permit small businesses to select the form of organization desired, without the necessity of taking into account major differences in tax consequences. H. R. 775, S.R.1983, Conference R. 2632, Technical Amendment Act of 1958, P.L. 85-866, 85th Cong., 2nd Sess., 3 U.S. Code Congressional & Administrative News pp. 4791, 4876-4878 (1958). However, the Congress placed limitations on Sub-Chapter S tax treatment by prescribing eligibility requirements. Congressional reasoning for this action is recapitulated by the District Court in A & N Furniture & Appliance Co. v. United States, 271 F.Supp. 40, 43 (S.D. Ohio 1967):

"First, it was thought that only relatively small corporations were essentially comparable to the partnership or proprietorship, where earnings are taxed to owners rather than to the business organization. Thus the restrictions as to the amount of shareholders and to shareholders who are individuals only. Secondly, it was thought that the complexity involved in passing the earnings of a corporation through to its shareholders, where the stock of a corporation was held by a widely diversified group of shareholders, created accounting complications which were too great a burden for the government to bear, and thus the restriction as to one class of stock. Senate Finance Committee Report on the Internal Revenue Code of 1954, 83rd Cong., 2nd Sess., U. S. Code Congressional & Administrative News, pp. 4752, 5096-5098 (1954)."

Examining the issue in this light, it is the contention of the Commissioner that the taxpayer terminated its election under Section 1372(a) to be taxed as a Sub-Chapter S corporation when it issued a certificate representing 50 shares of its stock to the trustee of the voting trust created on July 29, 1970. Hence, the trust itself became a shareholder other than an individual. The Commissioner places his reliance on Treasury Regulations on Income Tax, Sections 1.1371-1(d)(1) and (e), 26 C.F.R. §§ 1.1371-1(d)(1) and (e), which state that a trust, including a voting trust, is not an individual under Section 1371(a)(2) of the Internal Revenue Code, supra. Section 1.1371-1(d)(1) "Number of Shareholders" provides:

"A corporation does not qualify as a small business corporation if it has more than 10 shareholders. Ordinarily the persons who would have to include in gross income dividends distributed with respect to the stock of a corporation are considered to be the shareholders of the corporation. Persons for whom a stock in a corporation is held by a nominee, agent, guardian, or custodian, would generally be considered shareholders of a corporation. If stock is owned by a trust which is subject to the provisions of Sub-Chapters D, F, H or J, or Chapter 1 of the Code, or by a voting trust, the trust is considered a shareholder even though the dividends paid to the trust are includable directly in the income of the grantor or some other person." (Emphasis ours).

Section 1.1371-1(e) "Shareholders Must be Individuals or Estates" provides:

"A corporation in which any shareholder is a corporation, trust or partnership does not qualify as a small business corporation. The word `trust' as used in this paragraph includes all trusts, subject to the provisions of Sub-Chapter D, F, H or J (including Sub-part E thereof) Chapter 1 of the Code and voting trusts. Thus, even though the grantor is treated as the owner of all or any part of a trust, the corporation in which such trust is a shareholder does not meet the qualifications of a small business corporation." (Emphasis ours).

The taxpayer argues (1) that the regulations relied upon by the Commissioner are in conflict with the Congressional intent of the Internal Revenue Code of...