Prescott v. Commissioner

• Decision Date: 29 November 1983
• Docket Number: Docket No. 5432-82.
• Citation: 47 TCM (CCH) 435,1983 TC Memo 709
• Parties: Walter C. Prescott and Amelia J. Prescott v. Commissioner.
• Court: U.S. Tax Court

47 TCM (CCH) 435

1983 TC Memo 709

T.C. Memo. 1983-709.

Walter C. Prescott and Amelia J. Prescott v. Commissioner.

Docket No. 5432-82.

United States Tax Court.

Filed November 29, 1983.

Joseph B. Alala, Jr., 192 S. St., Gastonia, N.C. and J. Robert Wren, Jr., for the petitioners. Mathew E. Bates, for the respondent.

Memorandum Opinion

KÖRNER, Judge:

Respondent determined a deficiency of $10,511.05 in petitioners' 1978 Federal income tax. After concessions, the sole issue for decision (as presented by the parties) is whether petitioners received $21,000 of dividend income during 1978 which they failed to report on their return.

This case was submitted fully stipulated pursuant to Rule 122.¹ The stipulations of fact, together with the attached exhibits, are incorporated herein by this reference.

Walter C. (hereinafter "petitioner") and Amelia J. Prescott, husband and wife, (hereinafter collectively referred to as "petitioners") resided at Gastonia, North Carolina at the time the petition was filed in this case. They filed their joint Federal income tax return for their 1978 calendar year with the Internal Revenue Service Center at Memphis, Tennessee.

Prior to and throughout 1978, petitioner was president and sole shareholder of Industrial Electroplating Company, Inc. (hereinafter "IEC"), a North Carolina corporation which files its Federal income tax returns on the basis of a fiscal year ending January 31.² IEC qualified as an electing small business corporation under sections 1371 through 1379 during its fiscal year ending January 31, 1978.³ However, IEC's small business election was terminated for its fiscal years after January 31, 1978.

As of January 31, 1978, IEC's total undistributed taxable income as defined in section 1373(c) was $46,710.99.⁴ Petitioners reported this entire amount as income on their 1978 joint Federal income tax return.

On February 3, 1978, after the close of IEC's fiscal year ending January 31, 1978, and after its small business election had been terminated, IEC distributed a $14,000 check to petitioner in partial distribution of its undistributed taxable income. The proceeds of this distribution were retained by petitioner.

On February 28, 1978, IEC gave petitioner a check for $50,000, $32,710.99 of which purported to represent a distribution of the remainder of IEC's undistributed taxable income which existed as of January 31, 1978, and $17,289.01 of which purported to represent a loan from IEC to petitioner. Prior to this purported distribution, on February 28, 1978, IEC had $52,205.42 in its checking account maintained at Independence National Bank, Gastonia, North Carolina. On the same day, petitioner drew a $50,000 check on his individual account payable to IEC and delivered it to IEC. The transfer of the $50,000 check to IEC was cast in the form of a loan from petitioner to IEC with petitioner taking back a demand note payable on or before December 31, 1978, with interest at seven percent.⁵

Following February 28, 1978, IEC made payments to petitioner in discharge of its obligation under the note of February 28, 1978. These payments were made by IEC over the remainder of the year with the following payments being made before April 15, 1978:

                  Payment Date               Amount
                  March 6, 1978 .........    $ 2,000
                  March 21, 1978 ........      6,000
                  April 12, 1978 ........      3,000
                                            _________
                         Total .........    $11,000
                

The remaining principal and interest due under this note were paid by IEC to petitioner prior to December 31, 1978. On their 1978 joint Federal income tax returns, petitioners reported interest income they received from IEC totalling $2,217.56.

In the statutory notice of deficiency, respondent determined in pertinent part as follows:

(a) It is determined that for the tax year 1978 you received dividend income of $21,000.00 from IEC which you failed to report on your return. Accordingly, your taxable income is increased $21,000.00.

Although respondent has, from the outset, maintained that the transactions between petitioners and IEC which occurred on February 28, 1978, in substance, amounted solely to a distribution by IEC to petitioner of a $50,000 note, respondent has not relied upon this alleged distribution in support of the above determination. Instead respondent relies upon a "constructive distribution" theory in support of his determination. More precisely, it is respondent's position that a corporation which loses its small business election, and which possesses undistributed taxable income for the last year it qualified as an electing small business corporation, must actually distribute its undistributed taxable income within two and one-half months after the close of the last taxable year it qualified as an electing small business corporation. If the corporation fails to do so, respondent claims that any amounts remaining undistributed at the expiration of the two and one-half month period must be taken into income by the corporation's shareholders at that time. Applying these "rules" to the facts of this case (as respondent views them) respondent alleges that IEC had undistributed taxable income of $21,000 which remained undistributed as of April 15, 1978, and therefore contends that this amount must be included in petitioners' income for their 1978 tax year, in addition to the amounts otherwise included by them on their 1978 return.

Thus, on brief respondent frames the issue, and his proposed resolution thereof, in the following terms:

As of February 28, 1978, petitioner's subchapter S corporation, IEC, had undistributed taxable income of $32,710.99. On that date, petitioner and his corporation exchanged $50,000.00 checks, after which the corporation gave him its note for $50,000.00. As of April 15, 1978, two and one half months after the close of IEC's taxable year, $11,000.00 was paid, by IEC to petitioner on the note leaving a balance of $39,000.00 due on the note.

Respondent concluded that the $50,000.00 check exchange was of no consequence, since it obviously lacked any economic effect, that the $50,000.00 note could also not result in a distribution since it represented property rather than cash and that the only distribution of undistributed taxable income IEC made to petitioner between February 28, 1978 and April 15, 1978 occurred when it paid petitioner $11,000.00 on the note, thereby reducing its undistributed taxable income to $21,710.99. For reasons not in controversy here, respondent ignored $710.99 of that amount and determined that IEC's undistributed taxable income of $21,000.00 as of April 15, 1978, was properly includible in petitioner's taxable income for 1978 . . . because this $21,000.00 was not distributed to petitioner within two and one half months after the end of IEC's taxable year.

In their petition, and by their arguments on brief, petitioners make it apparent that they are attempting to resist respondent's determination by showing that all of the undistributed taxable income of IEC was distributed to petitioner before April 15, 1978. Thus, in their petition, petitioners state:

(d) IEC made distributions of undistributed taxalbe sic income in the form of checks to . . . Petitioner, in the amount of $46,710.99 during the period of February 3, 1978, to February 28, 1978.

On brief, petitioners argue that the form of the transactions of February 28, 1978, between petitioner and IEC, reflected their true substance (i.e., the distribution of all IEC's undistributed taxable income remaining on that date combined with a loan to petitioner by IEC, followed by a loan by petitioner to IEC of $50,000), and therefore argue that respondent's determination that they received $21,000 of dividend income which they failed to report on their return, is erroneous.

Respondent's statement of the case and petitioners' response thereto, as well as the stipulated facts and pleadings, make it apparent that a certain amount of confusion is present regarding the operation of the provisions of Subchapter S. It is therefore necessary to begin with an examination of the nature and general frame-work of Subchapter S as it was in effect during the years in issue.⁶

A qualifying corporation, see section 1371 (a), which elects Subchapter S status (i.e., an "electing small business corporation") is relieved from taxation of its income. Section 1372(b). The taxable income, as defined in section 1373(d),⁷ of such a corporation is instead taxed to its shareholders on a pro rata basis at the individual shareholders' rates, irrespective of whether such income is distributed to the shareholders or retained in corporate solution. See generally, Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, par. 6.05 (4th ed. 1979).

This result is achieved through application of the following statutory mechanics. Amounts actually distributed to shareholders out of current earnings of an electing small business corporation are included in the gross income of the shareholders in the same manner as dividends distributed by nonelecting corporations.⁸ See sections 1.1372-1(c)(2) and (7), Income Tax Regs.; DeTreville v. United States 71-2 USTC ¶ 9575, 445 F. 2d 1306, 1309 (4th Cir. 1971); Clark v. Commissioner Dec. 31,341, 58 T.C. 94, 99 (1972). Amounts of the electing small business corporation's section 1373(d) taxable income which remain undistributed at the close of the corporation's taxable year are then treated as constructively distributed pro rata to the shareholders pursuant to section 1373(b). For purposes of section 1373, the term "undistributed taxable income" is basically the corporation's section 1373(d) taxable income less the amount of money actually distributed during the year out of current earnings of the corporation as specified in section 316(a).⁹ Section 1373(c).

Like other dividends, year-end constuctive distributions under section 1373(b) are deemed to be made out of most...