Court Opinion

ID: 9458945
Source: CourtListenerOpinion
Date Created: 2023-08-04 21:06:17.966639+00
Date Added: 2024-06-11T17:35:57.601437
License: Public Domain

CUMMINGS, Circuit Judge
(dissenting).
I agree with the lower court (301 F. Supp. 684, 692) that application of the *317traditional thin capitalization doctrine tests1 for determining whether a purported loan should be treated as an equity contribution is not suited to determine whether “more than one class of stock” exists within the meaning of Internal Revenue Code of 1954, § 1371(a) (4).
The thin capitalization doctrine emerged to prevent improper tax avoidance through the use of debt rather than equity. It operates to reclassify as equity that which would otherwise constitute a contribution to capital but for a label of debt applied to gain an unintended tax benefit. In the normal corporate context, indebtedness instead of equity may be used to avoid corporate level taxation on earnings paid out as interest since interest payments are deductible.2 Int.Rev.Code of 1954, § 163(a). It may be utilized so that a corporate distribution appears as a non-taxable or capital gain (if in excess of basis) repayment of principal' where it would otherwise constitute a non-qualifying stock redemption giving rise to ordinary income.3 Int.Rev.Code of 1954, §§ 301 (c), 302(d), 1232. Ostensible debt may be used so that in the event of adversity an ordinary loss bad debt deduction under Int.Rev.Code of 1954, § 166 is available.4 Debt may be used to hedge against imposition of the accumulated earnings surtax.5 Int.Rev.Code of 1954, § 531. Finally, a corporation may issue short-term debt obligations instead of stock in exchange for depreciable property in order to circumvent the non-recognition provisions of Int.Rev. Code of 1954, § 351 and thus acquire a stepped-up basis for the property.6 Int. Rev.Code of 1954, § 362.
Because there is no tax at the corporate level for a Subehapter S corporation — the earnings and losses being passed through to the shareholders under Int.Rev.Code of 1954, §§ 1373 and 1374 — the advantages of internal debt financing are largely removed, as the majority readily appears to concede. Of the possible tax avoidance prospects which the thin capitalization doctrine is designed to foreclose in the ordinary *318Corporation, only the benefit to be derived through the exchange of debt instruments for depreciable property and the benefit to be gained through distribution of pre-election, accumulated earnings and profits in the form of repayment of principal remain as possibilities in a Subehapter S format.7 The former possibility is non-existent in this case because the debt instruments issued to Elizabeth G. Berst and Sara Garnett were tendered in exchange for monetary advances of $12,500 from each. 301 F. Supp. at 686. With respect to the latter potential for improper tax avoidance, the district court pointed out that although the corporate taxpayer did have accumulated earnings from a period prior to its election of Subchapter S status, neither Elizabeth G. Berst nor Sara Garnett attempted to gain a tax-free or capital gain redemption of her advance. What is more important for our purposes is the lower court’s astute observation that
“even if Elizabeth G. Berst and Sara Garnett had attempted to achieve a taxfree redemption of the advances, the dispute would not be one which directly involved the tax liability of plaintiff. In such a situation presumably the debt-equity tests would be applicable to determine whether the advances should be characterized as loans or contributions to capital for the purpose of preventing Elizabeth G. Berst and Sara- Garnett from gaining an unintended tax advantage.” 301 F.Supp. at 693 n. 1.
The point deserves re-emphasis. To the extent that improper tax avoidance by use of the guise of debt is still possible in the Subehapter S context, the thin capitalization doctrine remains available to prevent the abuse. Where on the facts of a particular case the Commissioner shows that the taxpayer spuriously labeled an advance as debt in order to reap an improper tax benefit, the thin capitalization doctrine serves its intended purpose when it is invoked to deny the particular benefit wrongfully taken or claimed in the taxable years in question. However, when that doctrine is pressed into service as well to deny retroactively Subchapter S status to the corporation, it serves neither its intended purpose nor, as will be shown, the purpose of Section 1371(a) (4). Denying Subchapter S status as a remedy for thin capitalization used to secure a particular advantage would seem wholly illogical and unwarranted as a measure to prevent tax avoidance,8 for in the normal corporate setting only the claimed benefit is taken away. Much less would it be appropriate where, as here, characterization of the advances as debt was not shown to involve any element of tax avoidance at all.9 Only if thin capi*319talization gives rise to a second class of stock under Section 1371(a) (4) can the Subchapter S status itself be deemed forbidden fruit.
Since the prevention of tax avoidance —the raison d’etre of the thin capitalization doctrine — offers no support for finding a reclassified debt to be a second class of stock, whether purported debt should be so characterized depends upon the purpose of Section 1371(a) (4). Needless to say, the Commissioner's semantic argument that reclassified debt must be denominated stock, and since different from the common shares, a second class of stock is singularly unpersuasive. One would have thought that long ago the law, even tax law, was freed from the rigors of such formalism. The only inquiry must be a functionally oriented one, engaged in with the realization that because a debt may be considered the equivalent of stock for one purpose it is not thereby the equivalent of stock for all other purposes.
The majority divines the purpose of the single class of stock requirement to be that “no class of stock * * * be preferred over another as to either dividends, distributions, or voting rights.” This interpretation is, in my view, both untenable and unwarranted by the legislative history from which it seeks to derive support. As a matter of economic policy or in the interests of “equity,” why would Congress want homogeneous treatment for all participants in a Sub-chapter S corporate venture? The majority does not inform us. To posit such legislative purpose without explanation is suspect since it is antithetical to the primary policy underlying the enactment of Subehapter S- — “to permit businesses to select the form of business organization desired without the necessity of taking into account major differences in tax consequences.”10 Subchapter S was clearly designed to allow electing corporations to be treated for tax purposes more nearly like partnerships.11 One of the hallmarks of partnership organization is the ability of the participants in the venture to differentiate among themselves with respect to their shares in earnings and losses, their distribution rights, and their power to steer the venture. Int.Rev.Code of 1954, § 704(a). *320Why Congress in seeking to approximate partnership tax treatment would view one of the basic characteristics of the partnership format to be inherently bad from an economic or equitable point of view is not easily understood.
The 1958 Senate Report on which the majority relies reads as follows:
“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 the common shareholders, and the same earnings would be taxed twice unless a deduction for the earnings previously taxed were [sic] 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.”
S.Rep.No. 1622, 83d Cong., 2d Sess. 453-454 (1954), U.S.Code Cong. & Admin. News p. 5097.
By extracting the second sentence from its context, the majority ignores the real thrust of the Report. There is nothing intrinsically wrong with another class of stock, but its existence would cause administrative complexity in the allocation of income when preferred dividends were paid in excess of current earnings from undistributed but taxed prior earnings.12 The lower court generally described the problem Congress envisioned as follows:
“Under § 1373(b) a shareholder of an electing small business corporation must include in his gross income the amount which he would have received as a dividend if there were distributed pro rata to the stockholders at the end *321of the taxable year an amount equal to the corporation’s undistributed taxable income for the year. ‘Undistributed taxable income’ is defined by § 1373(c) as taxable income less the tax imposed by § 1378(a) and less the amount of money distributed as dividends during the taxable year. Where dividends in excess of earnings are distributed to the preferred stockholders, an inequity to the common stockholders results. The common stockholders have already been taxed on the amounts distributed to the preferred stockholders in excess of earnings, since these amounts represent undistributed taxable income of the corporation in prior years. However, the common stockholder can only receive a capital loss benefit for his part of the previously taxed income. Section 1376(a). Some sort of refund mechanism would, therefore, be necessary to prevent inequity to the common stockholder in such circumstances.” 301 F.Supp. at 693.
Since interest on indebtedness is deductible in calculating the corporation’s net taxable income and since in a year in which the interest payment exceeds earnings, the net operating loss is passed through to the shareholders, the above problem is not encountered with debt, whether held by the shareholders proportionately or disproportionately or held by outsiders — so long as interest is treated as' interest. That is, since the shareholders are permitted a deduction for the excess of interest payments over earnings, they are adequately compensated for having been previously taxed on the earnings out of which the interest payments were later made, and no inequity which requires a special administrative refund mechanism exists. The Code already embodies an equalizing scheme when interest payments are made in excess of current earnings. Only if the interest payments are re-characterized as preferred dividends does the administrative problem occur, but, of course, justifying finding a second class of stock on this basis is specious since it assumes the conclusion at the outset.13 Thus debt in a thinly capitalized Subchapter S corporation does not itself create the administrative complexity Congress intended to avoid.
However, even if there were an independent reason to call the interest payment a dividend, as the lower court pointed out, the administrative problem envisioned by Congress could not arise in the case at bar since
“the ‘interest’ on the advances is to be paid only out of net profits before taxes. Where the ‘interest’ payments are made in the year in which they accrue, the only difficulty presented is one of characterizing the ‘interest’ payments. Whatever the characterization, however, no administrative problem is presented. If the ‘interest’ payments are characterized as interest, the amount of the interest is not part of the taxable income of the corporation. If, on the other hand, the ‘interest’ payments are characterized as dividends, the amount of the dividends is not part of the ‘undistributed taxable income’ of the corporation within the meaning of § 1373(b).” 301 F.Supp. at 693-694.
*322In summary it is my view, the studied view of the lower court, the view of the other courts which have addressed the issue of late,14 as well as the view of the commentators15 that the purpose of Section 1371(a) (4) was not to require a homogeneity among risk capital investors based on notions of equity or economic policy, but rather to sidestep the particular administrative problem created by the payment of dividends to preferred shareholders in excess of current earnings. This problem is not created if the Commissioner would simply accept taxpayer’s denomination of the advances as loans. Because Congress so clearly intended Subchapter S to “permit businesses to select the form of business organization desired without the necessity of taking into account major differences in tax consequences” (supra p. 319), and additionally because a contrary result is unduly harsh16 and involves in Subchap-ter S election an element of risk I cannot believe it was intended to involve,17 the single class of stock “requirement should not be unnecessarily expanded beyond the area dealing with the technical problem of allocation of earnings.”18 Utilizing the thin capitalization doctrine, which remains viable to thwart tax avoidance, to determine compliance with Section 1371(a) (4) is just such an unnecessary expansion. Insofar as Treas. Reg. § 1.1371-l(g) (1969) sanctions this, it is “out of harmony with the statute” and unreasonable. Manhattan General Equipment v. Commissioner, 297 U. S. 129, 134, 56 S.Ct. 397, 80 L.Ed. 528 (1936). Therefore, I would affirm.

. Contrary to the majority’s intimation, rejection of the thin capitalization doctrine for purposes of § 1371(a) (4) has not been based on a too narrow interpretation of that doctrine as connoting only a debt to equity ratio test. See Brennan v. O’Donnell, 322 F.Supp. 1069 (N.D.Ala.1971); Estate of Allison, 57 T.C. 174 (1971); Shores Realty Co. v. United States, 27 A.F.T.R.2d 679 (S.D.Fla.1971); Amory Cotton Oil Co. v. United States, 320 F.Supp. 951 (N.D.Miss.1970); H. R. Spinner Corp., 29 T.C.M. 462 (1970); James L. Stinnett, Jr., 54 T.C. 221 (1970); Comment, The One-Class-of-Stock Requirement of Subchapter S and the Invalidation of Treasury Regulation 1.1371-1 (g), 50 B.U.L.Rev. 577, 578 n. 9 (1970) ; Note, Shareholder Lending and Tax Avoidance in the Subchapter S Corporation, 67 Colum.L.Rev. 495 n. 2 (1967) ; McGaffey, The Requirement that a Subchapter S Corporation May Have Only One Class of Stock, 50 Marq. L.Rev. 365, 373 n. 26 (1966) (hereinafter cited as McGaffey). Of course, as the first part of the majority opinion (with which I am in agreement) demonstrates, the court below considered all the pertinent tests of the thin capitalization doctrine.

. See, e. g., Sherwood Memorial Gardens v. Commissioner, 350 F.2d 225 (7th Cir. 1965); Foresun, Inc, v. Commissioner, 348 F.2d 1006 (6th Cir. 1965); Wood Preserving Corp. of Baltimore, Inc. v. United States, 347 F.2d 117 (4th Cir. 1965); Montclair, Inc. v. Commissioner, 318 F.2d 38 (5th Cir. 1963).

. See, e. g., Moughon v. Commissioner, 329 F.2d 399 (6th Cir. 1964); P.M. Finance Corp. v. Commissioner, 302 F.2d 7,86 (3d Cir. 1962); Gooding Amusement Co. v. Commissioner, 236 F.2d 159 (6th Cir. 1956).

. See, e. g., United States v. Henderson, 375 F.2d 36 (5th Cir. 1967); Smith v. Commissioner, 370 F.2d 178 (6th Cir. 1966); Arlington Park Jockey Club, Inc. v. Sauber, 262 F.2d 902 (7th Cir. 1959).

. See, e. g., Gazette Telegraph Co., 19 T.C. 692 (1953), affirmed, 209 F.2d 926 (10th Cir. 1954).

. Cf. Turner v. Commissioner, 303 F.2d 94 (4th Cir. 1962); John W. Harrison, 24 T.C. 46 (1955), affirmed, 235 F.2d 587 (8th Cir.), certiorari denied, 352 U.S. 952, 77 S.Ct. 327, 1 L.Ed.2d 243 (1956).

. See Rosenkranz, Subchapter S—An Illusory Promise?, 6 Georgia L.Rev. 109, 117 n. 55 (1971); Comment, supra n. 1, 50 B.U.L.Rev. at 588 n. 73; Note, supra, n. 1, 67 Colum.L.Rev. at 501; McGaffey at 375-376; Caplin, Subchapter S and Its Effect on the Capitalization of Corporations, 13 Vand.L.Rev. 185, 191 (1959).

. See Comment, supra, n. 1, 50 B.U.L. Rev. at 588-589; Note, supra, n. 1, 67 Colum.L.Rev. at 505, 509-512; Note, Debt Obligation of Subchapter S Corporation Held Not to Constitute Second Class of Stock, 41 N.T.U.L.Rev. 1012, 1015-1017 (1966).

. In addition to the traditional prospects for tax avoidance through the use of debt which survive in the Subchapter S context, Subehapter S provides several peeuliar opportunities for tax advantages to be derived through use of indebtedness. Of course, a distinction must be made between legitimate tax minimization through debt, the use of which Subchapter S provisions clearly contemplate (See Int.Rev. Code of 1954, § 1376), and tax avoidance. In the realm of possible tax avoidance, for example, debt may be utilized for income splitting among a family group, for avoiding the vulnerability of previously taxed but undistributed income to forfeiture of its taxfree withdrawal status (See Int.Rev.Code of 1954, § 1375(d) ; Treas.Reg. § 1.1375-4 (a) and (e) (1969)), or for gaining additional net operating loss deductions when the basis of stock has been exhausted by previous loss deductions (See Int.Rev.Code of 1954, § 1374(c) (2)). See Caplin, supra, n. 7 at 190-194; Note, supra, n. 1, 67 *319Colum.L.Itev. at 501-504. However, thwarting these tax avoidance schemes in no way necessitates finding a second class of stock. Reapportioning income and losses according to respective capital contributions is adequate to frustrate intra-family income splitting. See Note, supra, n. 1, 07 Colum.L.Rev. at 518-510; cf. McGaffey at 366-367. Although reclassifying debt as equity would effectively terminate any attempt to avoid the precariousness of previously taxed income through the “payout-loanback,” since bona fide debt might be utilized in the same" avoidance scheme, another remedy would seem more appropriate. It has been cogently suggested that where borrowed funds are substituted for previously taxed income, the simplest and most immediate remedy is to ignore the withdrawal of previously taxed income and treat the transaction as a distribution of corporate obligations giving rise to ordinary income to the extent of earnings and profits. See Treas.Reg. § 1.1373-1 (d) (1969); Note, supra, n. 1, 67 Colum. L.Rev. at 520-521; Caplin, supra, n. 7 at 194. In the rare case where a loan is advanced solely to gain a loss deduction, denial of the deduction is nil that is needed to remedy the sham. What is more important, even where reclassifying the debt might be thought appropriate to thwart any particular tax avoidance scheme, equating the reclassified debt with a second class of stock so as to deny Subchapter S status is unwarranted. Simply put, such a measure would in no wise be remedial. In any case, suffice it to say that in the case at bar there is no suggestion that the loans of Elizabetli G. Berst and Sara Garnett accomplished or were designed to accomplish any possible tax avoidance peculiarly available within the confines of Subchapter S.

. S.Rep.No.1983, 85th Cong., 2d Sess. 87 (1958); see S.Rep.No.830, 88th Cong., 2d Sess. 146 (1964).

. See S.Rep.No.1622, 83d Cong., 2d Sess. 452-53 (1954), U.S.Code Cong. & Admin. News, p. 4629, the original bill which proposed precisely the partnership taxation format for electing corporations; Note, An Approach to Legislative Revision of Subchapter S, 26 Tax.L.Rev. 799, 800 (1971).

. The Senate Finance Committee’s Report on the Revenue Act of 1964, S.Rep. No. 830, 88th Cong., 2d Sess. 146 (1964), suggests the general administrative problem of allocating earnings and losses among various classes of stock as a possible rationale for the single class of stock requirement. No such problem inheres in the existence of a second class of stock which has a preference as to dividend or liquidation rights (so long as earnings are sufficient to cover dividends). See McGaffey at 368. Rather, the problem is caused by Sections 1373 and 1374 which provide for the pass-through of undistributed earnings or losses to the shareholders pro rata according to their holdings of the corporation's stock. If a preferential class of stock exists and one assumes that together with the common stock it is to be included in the class of stock to which the pass-through provisions apply, the pro rata allocation could present a formidable administrative problem of weighing differences between the types of stock. See Note, supra, n. 1, 67 Colum. L.Rev. at 515. (Of course, if one simply counts one share of preferred as the equivalent of one share of common (see Note, Disproportionate Advances by Shareholders of Subchapter S Corporation and the One Class of Stock Requirement, 31 Louisiana L.Rev. 510, 516-518 (1971)), no problem is jiresented, but that procedure appears unsupportable.) Given a single class of stock requirement, the pro rata allocation provisions make eminent administrative sense, but it is highly unlikely that the allocation problem identified above originally inspired the single class of stock requirement since excluding the preferred stock from the pro rata pass-through provisions, taxing the preferred holder according to his specified right to income, would have obviated the problem. Moreover, no supports appears for the proposition that the pro rata taxing scheme emerged as a matter of economic policy rather than simply as the logical administrative concomitant of a single class of stock. Notably, the legislative history contemporaneous with Congress’ original consideration of the single class of stock requirement is devoid of reference to this problem, and the 1964 Senate Report is retrospective. In any event, the lower court considered this possible problem of allocation among different classes of stock and correctly observed the problem is non-existent so long as debt is treated as debt. 301 F.Supp. at 693.

. It may be argued that where there lias been a partial transfer of stock, a problem occurs even if the debt is not first reclassified. That is, since a shareholder’s share of previously taxed but undistributed income is not reduced by a partial transfer of his holdings (Treas.Reg. § 1.1375-4(e) (1969)), to the extent of tiie shares he no longer owns, a net operating loss deduction for interest paid in excess of earnings will be lost. Int.Rev. Code of 1954, § 1374(c) ; Treas.Reg. § 1.1374-1 (b) (1969). If this is a problem (see Note, supra, n. 1, 67 Colum.L.Rev. at 513-514), the argument proves too much since the same problem exists in the case of bona fide debt as it would in the case of debt which would be reclassified under thin capitalization tests. See id.; Note, Debt Obligation of Subchapter S Capitalization Held Not to Constitute Second Class of Stock, 41 N.Y.U.L.Rev. 1012, 1017-1019 (1966).

. See Brennan v. O’Donnell, 322 F.Supp. 1069 (N.D.Ala.1971); Estate of Allison, 57 T.C. 174 (1971); Amory Cotton Oil Co. v. United States, 320 F.Supp. 951 (N.D.Miss.1970); cf. James L. Stinnett, Jr., 54 T.C. 221 (1970).

. See Note, supra, n. 12, 31 Louisiana L. Rev. at 511-514; Rosenkranz, supra, n. 7 at 114-118; Comment, supra, n. 1, 50 B.U.L.Rev. at 581-584; Note, supra, n. 1, 67 Colum.L.Rev. at 513-517; McGaffey at 366-370; Note, supra, n. 13, 41 N.Y.U.L.Rev. at 1018.

. A determination that the corporation is disqualified from electing Subchapter S treatment retroactively subjects the corporation to corporate level tax for the years in question. Although in the instant case the taxpayer retained substantial amounts of earnings apparently to meet the requirements of rapid expansion (301 F.Supp. at 687-688), normally a Subchapter S corporation will distribute its entire earnings so that the shareholders will have money to pay taxes on their shares of the earnings (the primary reason for the taxpayer’s 1962 and 1963 distributions here, 301 F.Supp. at 688) as well as for personal needs and so that the hazards to the taxfree withdrawal .status of previously taxed income are avoided. See n. 9, supra. Normally then, a Sub-chapter S corporation would be in an unfavorable cash position to withstand retroactive corporate tax assessment since it probably would not have distributed as much earnings had corporate tax liability been known. See McGaffey at 365-366.

. See James L. Stinnett, Jr., 54 T.C. 221, 235 (1970) (concurring opinion of Featherston, J.); Note, supra, n. 11 at 808; McGaffey at 379.

. McGaffey at 368.