Opinion ID: 273013
Heading Depth: 2
Heading Rank: 2

Heading: the statutory construction

Text: 30 Having determined that T.Reg. Section 1.1361-5(b) is plainly inconsistent with the ostensible purpose of the relevant revenue statutes, we consider the Commissioner's argument that the language of Section 1361 nevertheless justifies the result the regulation achieves. That determination is complicated because the statute is silent on the specific question whether incorporation of an electing enterprise has immediate tax consequences. The Commissioner has developed from the statutory language a series of assumptions which, he concludes, justify the regulation. The essential assumptions are: (A) that subsection (m) of Section 1361 expresses a Congressional intent to exclude from all of the tax-free or tax-deferred corporate reorganization provisions of the Code an enterprise which makes an election to be taxed as a corporation; (B) that a proprietorship which makes an election to be taxed as a corporation actually becomes, for tax purposes, a corporate entity, which the regulations term a Section 1361 corporation; a Section 1361 corporation revokes the election to be taxed as a corporation, which revocation must be treated as a liquidation and taxable distribution of the assets of the Section 1361 corporation according to the terms of subsection ( l ); and (D) that the regulation is justified by express delegation of Congress to the Secretary of the Treasury of extraordinary authority to supplement, as well as interpret, Section 1361. 31 The Commissioner's assumptions are interwoven into the incredibly complex scheme of the regulation. However, we find that, taken together or singly, the assumptions are unwarranted constructions of the statutory language and offer no justification for the attacked regulation. 18 32 A. Our unraveling begins with examination of the Commissioner's contention that subsection (m) of Section 1361 expresses a Congressional intent to preclude an electing enterprise from the benefit of all of the tax-free or tax-deferred corporate reorganization provisions of the Internal Revenue Code. Subsection (m) provides: 33 (m) Organizations and Reorganizations — An enterprise as to which an election has been made under subsection (a) shall not be considered a corporation, nor shall the proprietor or partners of such an enterprise be considered shareholders, for purposes of parts III and IV of subchapter C of this chapter (relating to corporate organizations, and reorganizations, and insolvency reorganizations) [with exceptions irrelevant here]   . 34 By its terms, subsection (m) says only that an enterprise shall not be considered a corporation and that its owners shall not be considered shareholders for purposes of Parts III and IV. Of the sections in Parts III and IV, 354-356 and 361-374 apply only to corporate taxpayers; subsection (m) therefore clearly prohibits a proprietorship which has made a Section 1361 election from the benefits of these sections. On the other hand, Sections 351, 357, and 358 are provisions which may be used by both individual and corporate taxpayers. Section 351(a) provides: 35 No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control    of the corporation.    (Emphasis added.) 36 Therefore, subsection (m) of Section 1361 by its terms does not make an individual proprietorship, such as Willett's, which has elected to be taxed as a corporation, ineligible for a tax-deferred incorporation under Section 351. 19 And, more broadly, subsection (m) therefore does not afford the Commissioner a broad Congressional mandate to restrict severely the utility of Section 1361 by making actual incorporation a taxable event in contravention of well-established Congressional policy. 37 Our construction of subsection (m) does not, as does the Treasury's interpretation, frustrate the purpose of Congress in enacting Section 1361 by making the section virtually a dead letter. Neither does our construction make subsection (m) a dead letter. Mertens' Law of Federal Income Taxation suggests that the purpose of subsection (m) is to keep the scope of Section 1361 within reasonable bounds. 20 Construing the subsection to preclude a proprietorship which elects to be taxed as a corporation from most but not all of the benefits of Parts III and IV of Subchapter C keeps Section 1361 reasonably within bounds. 38 B. The Commissioner's second assumption, i. e., that a proprietorship making a Section 1361 election actually becomes, for tax purposes, a corporate entity, raises a further obstacle to Willett's tax-deferred incorporation under Section 351. The regulations term this new entity a Section 1361 corporation; the Tax Court, in Estate of David Wein, supra, attributed to the entity or pseudo-corporation most of the characteristics of a corporation including ownership of the assets of the business. Once the existence of a Section 1361 corporation is acknowledged, the Commissioner argues, Section 351 is inapplicable because a Section 1361 corporation cannot qualify under the terms of Section 351(a) as a person eligible to transfer property in a tax-deferred exchange. Even if a Section 1361 corporation could be a person capable of transferring property under Section 351(a), the Commissioner further urges that the person thereafter in control of the transferee corporation is not the transferor (Section 1361 corporation), as Section 351 (a) requires, but is the former proprietor of that entity (Willett). Therefore, the concept of a Section 1361 corporation when supplemented with subsection (m), would completely preclude an electing enterprise from the tax-free and tax-deferred reorganization sections. 39 The Commissioner attempts to support his conclusion that a Section 1361 election creates a Section 1361 corporation by interpretation of several subsections. He points out that subsection (c) declares that an enterprise making an election  shall be considered a corporation in all respects for purpose of income taxes, with a few exceptions. (Emphasis added.) Subsection (g) provides that ownership of an interest in an electing enterprise shall be determined in accordance with the rules for constructive ownership of stock. (Emphasis added.) Subsection (g), adds the Senate Finance Committee Report accompanying the enactment of the section, it is intended to make applicable the attribution of ownership rules    relating to the rules for constructive ownership of stock. (Emphasis added.) 21 And, subsections (k) and ( l ) provide that distributions, whether or not in liquidation, shall be treated as a corporate liquidation, or, in the words of the Senate Report,  as if made by a corporation   . (Emphasis added.) 22 40 We do not agree with the Commissioner's reading of the statute. Subsection (a) of Section 1361 provides that certain unincorporated businesses may elect to be taxed  as a corporation.    (Emphasis added.) The Senate Report explains: 41 [Section 1361] is intended to permit certain proprietorships and partnerships the opportunity to be taxed as a domestic corporation while still conducting the business of the enterprise as a proprietorship or partnership. (Emphasis added.) 23 42 Terms providing that an electing enterprise shall be taxed as a corporation or considered a corporation, with corporate rules made applicable, and that its transactions are as if made by a corporation, plainly mean that an electing enterprise is not a corporation but instead is a proprietorship which pays taxes at corporate rates. Section 1361 corporation may be a convenient label for an unincorporated business which has elected under Section 1361 to be taxed as a domestic corporation. But it is no more than a label. We consider it unreasonable to permit the regulation rigidly to extend the concept of a Section 1361 corporation to negate the purpose of a remedial statute by disqualifying a Section 1361 corporation from a Section 351 tax-deferred incorporation. 43 C. The Commissioner's third assumption presents the question whether subsection (e) can be reasonably interpreted to mean that actual incorporation of an electing enterprise revokes the election to be taxed as a corporation, which revocation should be treated as a liquidation requiring taxable distribution of the assets under subsection ( l ). Subsection (e) provides, with exceptions irrelevant here, that a section 1361 election is irrevocable by the electing enterprise or by an un incorporated successor. The subsection does not say whether an election is also irrevocable by an incorporated successor to the electing enterprise. The Commissioner assumes that: 44 since an election to be taxed as a Subchapter R corporation is irrevocable under Section 1361 (e)    and that since the business of the enterprise is still continuing in other than Subchapter R form, that a [taxable] Distribution in Liquidation under Section 1361 ( l ), supra, effecting a revocation must have occurred. 24 45 But it would be as reasonable to assume from the statutory language that a 1361 election is revocable by an incorporated successor to an electing enterprise. Still another inference, and perhaps the most reasonable, is that Congress purposely did not specify whether an incorporated successor can revoke a section 1361 election because, after incorporation, the enterprise continues to be taxed as a corporation just as it was before incorporation. 25 Even assuming that incorporation revokes the election, revocation does not necessarily require a liquidation under subsection ( l ). For that conclusion to have any sort of logical consistency would require our acknowledgment of the validity of one or both of the Commissioner's first two assumptions. For example, if a section 1361 election makes the electing enterprise a Section 1361 corporation which owns the assets of the business, then one might conclude that revocation of the election requires liquidation of the Section 1361 corporation requiring distribution of the assets. Or, if the concept of a Section 1361 corporation and subsection (m) could together be said to express a Congressional intention to preclude an electing enterprise from a tax-deferred 351 incorporation, one might conclude that liquidation of the Section 1361 corporation is a permissible device for furthering Congressional intention. However, we have found that neither subsection (m) nor the concept of a Section 1361 corporation express a Congressional intention to make incorporation of an electing enterprise a taxable event. And, quite to the contrary, we have found that imposition of a tax upon the purely formal incorporation of a small proprietorship which had previously elected to be taxed as a corporation negates broadly remedial Congressional policy. Therefore, since the Commissioner's assumption that incorporation effects a revocation which should be treated as a taxable liquidation depends so largely upon an inaccurate determination of Congressional purpose, we find it is an unreasonable construction of the language of subsection (e) of Section 1361. 46 D. The Commissioner's final assumption, implicit, to be sure, in the miserly result T.Reg. Section 1.1361-5 (b) achieves, is that the tax collector may resolve statutory verbal difficulties in the interest of improving the health of the fisc. 26 The Commissioner is correct in suggesting that Congress intended that the regulations have special weight in the interpretation of Section 1361. Subsections (a) and (c) of the section delegate to the Secretary of the Treasury broad power to supplement the section in addition to his general authority under Section 7805 to interpret the Code. In 1958, the Senate Finance Committee anticipated that regulations indicating in more detail how the provision will be applied would fill gaps and eliminate ambiguities in the statutory language. 27 Since the statute is silent on the tax consequences of incorporation of a proprietorship which has made a Section 1361 election, the Secretary's broadest rule-making authority is applicable here. But the Secretary is only a delegate of the United States Congress. And even when Congress delegates to the Secretary extraordinary authority for promulgating tax regulations, regulations must be reasonable and consistent with the revenue statutes. 28 By that test, T. Reg. Section 1.1361-5(b) is clearly invalid. 47 The decision of the Tax Court is reversed.