Perry v. Comm'r of Internal Revenue , Docket No. 4428-66.
| Decision Date | 16 June 1970 |
| Docket Number | Docket No. 4428-66. |
| Parties | WILLIAM H. PERRY AND MARION E. PERRY, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Max Myers, William H. Perry III, and Richard M. Webster, for the petitioners.
Hugh C. McMahon, for the respondent.
Held: The partially tax motivated transactions between petitioner and a small business corporation controlled by him, in which petitioner's demand notes were issued to the corporation in exchange for its long-term in like amounts, were not sufficient to create ‘indebtedness' within the meaning of sec. 1374(c)(2) (B). Accordingly, the portion of petitioner's sec. 1374(a) deduction attributable to such ‘indebtedness' was properly disallowed by respondent.
Respondent determined a deficiency of $9,450.16 in petitioners' income tax for the calendar year 1962. Certain questions having been resolved by the parties, the sole issue presented is whether, in computing their personal income tax, petitioners are entitled to take as a deduction that part of the net operating loss of a small business corporation which exceeds $4,200— the amount allowed by respondent.
Petitioners William H. and Marion E. Perry are husband and wife and were residents of Webb City, Mo., at the time the petition herein was filed. Petitioners, who employed a hybrid method of computing income— part cash basis and part accrual— timely filed a joint tax return for the calendar year 1962 with the district director of internal revenue, Kansas City, Mo. Because Marion E. Perry is a party to this case only by virtue of having joined with her husband in filing their Federal income tax return for the year in issue, reference to the petitioner will be limited to petitioner William H. Perry (hereinafter William).
On March 11, 1960, Cardinal Castings, Inc. (hereinafter Cardinal), was incorporated under the laws of the State of Missouri. Of the 3,000 shares of stock issued by Cardinal, 2,999 were owned by petitioner and his wife. During the period under review, Cardinal was at all times an electing small business corporation with a November 1 to October 31 fiscal year.
From its inception, Cardinal had encountered financial difficulties. For the fiscal year ending October 31, 1961, it experienced a net operating loss of $6,069.53; and, for the fiscal year ending October 31, 1962, it experienced a net operating loss of $13,698.50.
During the period November 1, 1961, through October 31, 1962, Cardinal occupied premises owned by the petitioner which were rented to Cardinal at a charge of $100 per month. Though no rent was received by petitioner during this period, petitioner reported the sum of $1,200 as an income accrual on his 1962 Federal tax return. This sum, coupled with advances made to the corporation by petitioner in the net amount of $3,000, represents the undisputed portion of corporate indebtedness— $4,200— claimed to have been owed petitioner (by Cardinal) on October 31, 1962.
The contested portion of corporate indebtedness alleged to have been owed petitioner (by Cardinal) on this date may be traced to the following ‘loan’ transactions between petitioner and the corporation. (A) At an undetermined time subsequent to October 31, 1961, petitioner issued to Cardinal a demand note for $7,942.33. In return, the corporation executed a long-term note (payable to petitioner on January 1, 1964) in a like amount. (B) Similarly, on October 31, 1962, petitioner issued to Cardinal a second demand note in the amount of $13,704.14 ($5.64 more than the corporation's net operating loss for its 1961-62 fiscal year) and received from the corporation a long-term note (payable January 1, 1964) in a like amount.
Both of the demand notes executed by petitioner were given current assets status on the financial statements of the corporation, while the notes issued by the corporation were listed as long-term obligations. By reflecting petitioner's demand notes as current assets (and thereby improving the ratio of current assets to current liabilities), petitioner and his accountant hoped to make Cardinal's balance sheet more attractive to those persons who would be dealing with the corporation, and who would look beyond the corporation to petitioner in assessing Cardinal's financial strength. Additionally, given petitioner's ‘cash-poor’ status, his accountant viewed Cardinal's execution of these notes as the only means by which corporate indebtedness to petitioner, sufficient to create a section 1374(c)(2)(B) basis large enough to absorb Cardinal's operating losses for each of its loss years, could be generated. 1
On his tax return for the calendar year 1962, petitioner and his wife treated their entire prorata share ($13,691.65) of the corporation's fiscal year 1961-62 net operating loss as a section 1374 deduction. As indicated above, respondent allowed this deduction only to the extent of $4,200.
OPINIONThe question before us is whether a shareholder in a small business corporation can create corporate indebtedness within the purview of section 1374(c)(2)(B)2 by a partially tax-motivated transaction in which the shareholder's demand note is issued to the corporation in exchange for its long-term note in a like amount. We hold that this question must be answered in the negative.
Viewed from our vantage point, the facts of this case yield an aroma of alchemist's brew. Cf. Knetsch v. United States, 364 U.S. 361 (1960). As we see matters, the transactions in this case amounted to little more than the posting of offsetting book entries, accompanied by the drafting of illusory instruments in commemoration thereof. Whether, in fact, petitioner's notes could, at some future time, have been enforced by Cardinal is, to our way of thinking, irrelevant. What is relevant is that in pure, pragmatic terms the exchanges of notes which generated Cardinal's long-term ‘indebtedness' left petitioner economically unimpaired, both actually and constructively.
Section 1374(c)(2)(B), along with the other tax option corporation provisions which were part of the Technical Amendments Act of 1958, originated in the Senate. The report of the Committee on Finance of the Senate discloses the purpose of this section as follows:
The amount of the net operating loss apportioned to any shareholder pursuant to the above rule is limited under section 1374(c)(2) and to the adjusted basis of the shareholder's investment in the corporation; that is, to the adjusted basis of the stock in the corporation owned by the shareholder and the adjusted basis of any indebtedness of the corporation to the shareholder. * * * (1958-3 C.B. 1141.)
As we construed the language employed by the Committee on Finance, it appears to us that, given its most familiar meaning, Old Colony R. Co. v. Commissioner, 284 U.S. 553 (1932), the use of the word ‘investment3 reveals an...
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