Shores Realty Company, Inc. v. United States

• Citation: 468 F.2d 572
• Decision Date: 24 October 1972
• Docket Number: No. 71-2198.,71-2198.
• Parties: SHORES REALTY COMPANY, INC., Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.
• Court: United States Courts of Appeals. United States Court of Appeals (5th Circuit)

468 F.2d 572 (1972)

SHORES REALTY COMPANY, INC., Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

No. 71-2198.

United States Court of Appeals, Fifth Circuit.

October 24, 1972.

Robert W. Rust, U. S. Atty., Clemens Hagglund, Asst. U. S. Atty., Miami, Fla., Johnnie M. Walters, Asst. Atty. Gen., Meyer Rothwacks, Atty., Dept. of Justice, Tax Div., Washington, D. C., Robert W. Rust, U. S. Atty., Miami, Fla., Fred B. Ugast, Act. Asst. Atty. Gen., Thomas L. Stapleton, Ann E. Belanger, William L. Goldman, Attys., Dept. of Justice, Tax Div., Washington, D. C., for defendant-appellant.

George G. Graham, Miami, Fla., for plaintiff-appellee.

Before WISDOM, COLEMAN and SIMPSON, Circuit Judges.

SIMPSON, Circuit Judge:

Disposition of this appeal requires that we determine the validity of Treasury Regulations § 1.1371-1(g), as amended,¹ interpreting the "one class of stock" criterion embodied in Section 1371(a)(4), Title 26, United States Code.² We expressly reserved decision as to this point in Brennan v. O'Donnell, 5 Cir. 1970, 426 F.2d 218. The "one class of stock" criterion must be satisfied in order for a corporate taxpayer to qualify for favorable tax treatment as a "small business corporation" under Subchapter S of the Internal Revenue Code of 1954, as amended.³ In this action for a refund of corporate income taxes paid, the district court impliedly⁴ found § 1.1371-1(g) to be in excess of the authority granted to the Commissioner of Internal Revenue and entered judgment for the taxpayer. On this appeal by the United States we affirm the judgment of the district court.

I. THE FACTS

Shores Realty Company (the taxpayer) was incorporated in the State of Florida on February 6, 1960, for the purpose of developing real estate for sales. Its total capitalization was $600.00, consisting of 600 shares of one dollar par value common stock which was, at all times relevant to this case, held as follows:

                Stockholders Shares
                  Raymond V. Guernsey            150
                  Mary P. Guernsey               150
                  Emerson D. Wertz               150
                  Berle Wertz                    150
                

Both the Guernseys and the Wertzes are husband and wife.

To start the corporate business, the taxpayer purchased a parcel of undeveloped land for a total price of $32,000.00. The taxpayer paid approximately $9,200.00 in cash. An outstanding mortgage was assumed and another was executed to cover the balance of the purchase price. Funds for the purchase of this property and for the anticipated development costs thereof were provided to the taxpayer by a series of advances from Raymond V. Guernsey and Emerson D. Wertz, commencing on March 18, 1960. Additional advances were made by the Guernsey Investment Corporation and the Guernsey Realty Corporation, both of which were owned by the Guernseys. These advances were carried on the taxpayer's books as loans and on January 1, 1962, demand notes were issued to Emerson D. Wertz ($30,000.00), Raymond V. Guernsey ($11,000.00), and Guernsey Investment Company, Inc. ($17,000.00). The notes provided for interest at the rate of six percent annually and were unsecured.

The taxpayer filed federal "small business corporation" income tax returns for the fiscal years ending January 31, 1962, 1963, and 1964. No taxes were shown due or paid on those returns. Acting under the authority of Treasury Regulations § 1.1371-1(g), the Commissioner of Internal Revenue determined that, for tax purposes, the loans to the corporation in fact constituted equity capital and a second class of stock, thereby disqualifying the taxpayer from treatment under Subchapter S. The taxpayer paid the asserted deficiencies, plus interest, and brought suit in the district court for a refund.

II. THE DECISION BELOW

Following a non-jury trial, the district court made findings of fact and conclusions of law. The following factual findings are relevant to the issue presented on this appeal:

"16. For the purpose of determining whether the taxpayer had more than one class of stock within the contemplation of 26 U.S.C. § 1371(a) (4), the advances involved were true and bona fide indebtedness.

"17. If not true and bona fide indebtedness, they were some form of surplus that is not a class of stock within the contemplation of 26 U.S.C. § 1371(a) (4).

"18. In either case, the taxpayer had only one class of stock for the purposes of treatment as a small business Corporation under Subchapter S of the Internal Revenue Code."

The district court concluded as more fully set out by Note 4, supra, that the advances made to taxpayer by its shareholders did not constitute a second class of stock so as to disqualify the taxpayers from obtaining tax treatment as a Subchapter S "small business corporation", asserting that to hold otherwise would defeat the intent of Congress regarding the tax liabilities of small business corporations.

III. CONTENTIONS ON APPEAL

The United States urges us to reverse the judgment of the district court on two grounds: (1) the district court allegedly erred in finding that the advances to the corporate taxpayer in question were true indebtedness for purposes of Title 26, U.S.C., § 1371(a) (4); and (2) contrary to the implicit holding of the district court, Treasury Regulations § 1.1371-1(g) properly provides that purported debt obligations which actually represent equity capital will constitute a second class of stock unless held in the same proportion as the nominal stock.

In reply, the taxpayer asks us to affirm the judgment of the court below for essentially two reasons: (1) the advances in question were true indebtedness for purposes of Title 26, U.S.C., § 1371(a) (4); and (2) Treasury Regulations § 1.1371-1(g) injects the irrelevant test of proportionality into the evaluation of the taxpayer's eligibility for treatment as a "small business corporation" under Subchapter S.

Before addressing ourselves to the merits of these contentions, we believe it appropriate first to review the development of the "one class of stock" requirement and of the present version of Treasury Regulations § 1.1371-1(g).

IV. THE "ONE CLASS OF STOCK" REQUIREMENT

Subchapter S of the Internal Revenue Code was enacted by means of Public Law 85-866, Title I, § 64(a), 72 Stat. 1650 (September 2, 1958). The only discussion of the "one class of stock" requirement which preceded the enactment of Subchapter S appeared in Senate Report No. 1622, Second Session, pp. 453-454:

"The corporation may have only one class of stock outstanding. No class of stock may be preferred over another as to either dividends, distributions, or voting rights. If this requirement were not made, undistributed current earnings could not be taxed to the shareholders without great complications. In a year when preferred stock dividends were paid in an amount exceeding the corporation\'s current earnings, it would be possible for preferred shareholders to receive income previously taxed to common shareholders, and the same earnings would be taxed twice unless a deduction for the earnings previously taxed were allowed to the common shareholders. Such an adjustment, however, would be extremely difficult where there had been a transfer of common stock in the interim." (1954 U.S.Code Congressional & Administrative News, pp. 4621, 5097)

The available legislative history regarding the "one class of stock" requirement indicates that Congress had two related objectives in mind: (1) the prevention of double taxation of earnings received by a "small business corporation"; and (2) the avoidance of complex adjustments made necessary by instances of such double taxation. It appears, therefore, that Congress did not address itself to the impact of extensive debt financing of a "small business corporation" by its nominal stockholders upon such a corporation's eligibility for favorable Subchapter S tax treatment. Congress did envision the infusion of borrowed funds or property into a "small business corporation" from its nominal stockholders because it enacted Title 26, U.S.C., § 1376(b) (2), which provides for the reduction in basis of indebtedness owing to a shareholder in the event a corporation experiences a net operating loss for any taxable year.

V. THE EVOLUTION OF THE TREASURY'S INTERPRETATION

Prior to 1966, Treasury Regulations § 1.1371-1(g) stipulated that ". . . if an instrument purporting to be a debt obligation is actually stock, it will constitute a second class of stock". In W. C. Gamman v. Commissioner, 1966, 46 T.C. 1, the United States Tax Court held that where the debt obligations were in the same proportion as the stock as to face amount and ownership, there was no second class of stock which would disqualify a taxpayer from Subchapter S treatment. The Commissioner of Internal Revenue acquiesced in the Gamman holding and subsequently amended § 1.1371-1(g) by deleting the above quoted language and by substituting therefore the language which is set out in Note 1, supra. As presently written, § 1.1371-1(g) seeks to apply two separate tests to a corporation's financial structure with regard to its eligibility for Subchapter S treatment: (1) do obligations which purport to represent debt actually represent equity capital?, and (2) if the answer to test (1) is in the affirmative, then are such obligations held by the corporation's nominal stockholders proportionate in face amount and ownership to the nominal stock ownership of the corporation? If the answer to test (2) is in the negative, the corporation, according to § 1.1371-1(g) fails to qualify for Subchapter S treatment.

The Tax Court, in James L. Stinnett, Jr. v. Commissioner, 1970, 54 T.C. 221, (relied upon by the district court in this case), held the amended § 1.1371-1(g) invalid, noting:

"We do not regard as controlling with respect to the question whether there is more than one class of stock within the meaning of section 1371(a) the fact that `debt\' characterized as `equity\' capital may be

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