Rowland v. United States, HS-69-C-17.

• Decision Date: 28 July 1970
• Docket Number: No. HS-69-C-17.,HS-69-C-17.
• Parties: E. Driver ROWLAND and Mildred Rowland, Plaintiffs, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Western District of Arkansas

315 F. Supp. 596

E. Driver ROWLAND and Mildred Rowland, Plaintiffs, v. UNITED STATES of America, Defendant.

No. HS-69-C-17.

United States District Court, W. D. Arkansas, Hot Springs Division.

July 28, 1970.

Ben A. Douglas, Atty., Tax Division, Dept. of Justice, Fort Worth, Tex., for defendant.

Jerry T. Light, of Smith, Williams, Friday & Bowen, Little Rock, Ark., for plaintiffs.

OPINION

JOHN E. MILLER, Senior District Judge.

This is a civil action whereby plaintiffs seek a refund of federal income taxes together with interest allegedly illegally assessed by defendant and paid by plaintiffs, with respect to the calendar year 1964. The sole issue to be decided is whether a valid election was made by the Red Barn Restaurant, Inc., (hereinafter called Red Barn) in 1961 to be treated as a small business corporation under section 1372 et seq. of the Internal Revenue Code of 1954, so as to entitle plaintiffs to treat the losses of the corporation as their individual losses in 1964.¹

The following shall constitute the findings of fact and conclusions of law of the court, as contemplated by Rule 52(a), Fed.R.Civ.P.

The court has jurisdiction by virtue of 28 U.S.C. § 1346(a) (1).

Most of the relevant facts were stipulated and will be incorporated herein. Articles of incorporation for Red Barn were filed with the Arkansas Secretary of State on August 7, 1961, and with the County Clerk of Garland County, Arkansas, on August 9, 1961. Also, on August 7, 1961, the corporation issued common stock to plaintiffs and one other shareholder for a total consideration of $5,000.00 in cash. Red Barn and its officers engaged in no business activity and acquired no additional assets until August 19, 1961. On that date, the corporation purchased land and a building for a total price of $60,000.00.

Charles Hackney, the president of Red Barn, properly executed United States Treasury Department Form 2553, "Election by Small Business Corporation," on behalf of the corporation on September 6, 1961. On the same date, Hackney and the plaintiffs executed shareholder consent forms. Unfortunately, the election and consent forms were not mailed to the Internal Revenue Service until September 13, 1961, and were received on September 14, 1961, by the District Director at Little Rock, Arkansas.

Red Barn opened for business with the public on January 26, 1962. On June 26, 1962, Hackney transferred his common stock to plaintiff E. Driver Rowland, leaving plaintiffs as the sole stockholders of the corporation. For the fiscal years ending June 30, 1962, June 30, 1963, and June 30, 1964, Red Barn filed Treasury Form 1120 S, "U. S. Small Business Corporation Return of Income," reflecting a corporate loss each year, and the plaintiffs deducted their pro rata share thereof on their jointly filed individual income tax returns. The corporation did not timely file corporate income tax returns for the fiscal years ending June 30, 1965, and June 30, 1966, and its corporate charter was revoked by the State of Arkansas on February 23, 1966. During 1966, an audit of the plaintiffs' income tax returns for the years 1963, 1964 and 1965² was conducted by the Internal Revenue Service, and it was determined therefrom that Red Barn's election to be taxed as a small business corporation was not timely filed and was invalid. As a result, the IRS disallowed the corporate loss of $31,012.20 claimed by plaintiffs on their 1964 individual income tax return from the operation of Red Barn and assessed a deficiency against plaintiffs in the amount of $17,026.47³ for the year 1964. That sum was paid by plaintiffs to the District Director of Internal Revenue on May 16, 1969, and a claim for refund of the entire sum was filed by plaintiffs on June 18, 1969, and denied on June 23, 1969.

Subchapter S of Chapter 1 of the Internal Revenue Code of 1954, 26 U.S.C. §§ 1371-1377, provides for elections by certain small business corporations as to taxable status. In general, where a qualified corporation has so elected, it is not subject to income tax, and its undistributed taxable income is taxed to the shareholders pro rata or its net operating loss is allowable to the shareholders pro rata as a deduction from gross income. The manner and time of election are explicitly set forth in the statute and the regulations promulgated pursuant thereto. 26 U.S.C. § 1372(c) (1) provides that an election:

"* * * may be made by a small business corporation for any taxable year at any time during the first month of such taxable year, or at any time during the month preceding such first month. Such election shall be made in such manner as the Secretary or his delegate shall prescribe by regulations."

At the time the election was made by Red Barn, Treas.Reg. § 1.1372-2 (1961) provided in part:

"(b) * * * In the case of a new corporation whose taxable year begins after the first day of a particular month, the term `month' means the perid commencing with the beginning of the first day of the taxable year and ending with the close of the day preceding the numerically corresponding day of the succeeding calendar month, * * *. For purposes of this subparagraph, the first month of the taxable year of a new corporation does not begin until the corporation has shareholders or acquires assets or begins doing business, whichever is the first to occur." (Emphasis supplied.)

"(c) * * * An election is effective for the entire taxable year of the corporation for which it is made and for all succeeding taxable years of the corporation, unless it is terminated with respect to any taxable year. Thus, the election has a continuing effect and need not be renewed annually, although annual returns of information must be filed under section 6037."

Red Barn issued stock on August 7, 1961, and acquired assets in the form of cash in payment for the stock on the next day. It therefore seems clear that an election under Section 1372(a) should have been made no later than the close of September 6, 1961. Plaintiffs argue, however, that such a construction of the statute and the applicable regulations is not in keeping with common business practice, and that, until August 19, 1961, when Red Barn acquired land and a building, the corporation was acting merely as a caretaker of the cash funds acquired in payment for the issued stock and comprised nothing more than a "corporate shell." They contend that Red Barn's taxable year actually began on August 19, 1961, because it began to function actively as a corporation on that date. Plaintiffs therefore conclude that the election received by the IRS on September 14, 1961, was valid. It is, of course, undisputed that if Red Barn made a valid election in 1961, such election was continuing and valid for all succeeding taxable years pertinent to this litigation.

Plaintiffs' argument, in essence, is that the first month of a taxable year, for the purpose of a Subchapter S election, begins on the date a new corporation commences doing business, even if it has first acquired assets and shareholders. Plaintiffs would apparently construe Treas.Reg. § 1.1372-2 in the conjunctive or contend that common business practice dictates that "doing business" is the prime criterion. Such a construction is contrary to the explicit wording of the regulation and is unsupported by case authority. In Bone v. Commissioner, 52 T.C. 913, 919 (1969), the corporation came into existence on August 16, 1963, but did not acquire stockholders until October 29, 1964. From October 7, 1963, until the corporation acquired stockholders, it purchased and improved property, maintained a bank account and books and records, hired labor, paid taxes and expenses, arranged financing and generally directed its efforts toward the development of a profit-making capacity. A Subchapter S election was filed on November 16, 1964, and ultimately disallowed by the IRS. Petitioner argued in the Tax Court that the corporation did not acquire its assets and begin business until it acquired stockholders, and that it could not have filed a valid Subchapter S election until its stock was issued, for the reason that the land which formed the basis of the business operation was transferred to the corporation on the condition that an agreed-upon amount of stock would be issued to the vendor (petitioner). The Tax Court construed Treas.Reg. § 1.1372-2 in the disjunctive and held that the corporation acquired assets and began business prior to the date it acquired shareholders, stating at 52 T.C. 920:

"Since we have found that TBC acquired assets and began business no later than October 7, 1963, its first taxable year began no later than such date, and therefore its election filed on November 16, 1964, is clearly untimely

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