SELFE v. U.S

SAM POINTER, Chief District Judge

In accordance with the accompanying Memorandum of Opinion, it is hereby ORDERED that the plaintiffs' motion for summary judgment is DENIED, the defendant's motion for summary judgment is GRANTED, and this case is DISMISSED, costs taxed against the plaintiffs.

The question raised in this case is whether a shareholder in a Subchapter S corporation who personally guarantees and secures a corporate debt may increase the adjusted basis of her stock in the corporation by the full amount of the debt in order to maximize her loss deductions under I.R.C. § 1374. The government and taxpayer have filed cross-motions for summary judgment. Upon due consideration of the parties' motions, and for the reasons that follow, the court concludes that such a Subchapter S shareholder and guarantor may augment her stock basis only to the extent she actually repays the corporation's obligations. Accordingly, since it is undisputed that the taxpayer in this case never repaid the corporation's debts, summary judgment is due to be granted in favor of the government.

In the Spring of 1977, Jane Selfe (then Jane Simon) entered into the business of selling women's clothing at retail. As a first step, Ms. Selfe obtained a $120,000 line of credit from AmSouth Bank (then The First National Bank of Birmingham) and granted the bank a security interest in 4,500 shares of Avondale Mills stock owned by her and members of her close family. Ms. Selfe used approximately $50,000 of the proceeds to purchase long term assets and make leasehold improvements.

Shortly thereafter, Ms. Selfe organized a Subchapter S corporation under the name of Hattie-Alabama, Inc. to carry on the clothing business, later changing the name of the corporation to Jane Simon, Inc. She initially contributed $5,100 to the corporation in capital. The corporation also assumed primary liability for repayment of the outstanding loan. Ms. Selfe remained liable as a guarantor, however, and the 4,500 shares of Avondale Mills stock remained pledged as collateral.

Richard Anthony, the loan officer at AmSouth who dealt with Ms. Selfe, testified in his deposition that AmSouth's primary inducement in making the loan was Ms. Selfe's personal guarantee and pledge of Avondale Mills stock. Mr. Anthony testified that primary liability for repayment of the loan was transferred to the corporation for administrative convenience only, since AmSouth's loan forms provided for a direct loan to the corporation coupled with a shareholder guarantee. Mr. Anthony stated that, in the event of default, AmSouth would have looked primarily to the Avondale Mills stock and Ms. Selfe's personal guarantee for repayment.

The evidence before the court shows that Jane Simon, Inc. was never a successful corporation and incurred operating losses during each of the years 1977 through 1980. In 1979, because of the poor financial condition of the corporation, AmSouth obtained an additional security interest in the corporation's inventory and receivables. Despite its poor performance, however, the corporation never defaulted on its loan payments and AmSouth was never required to proceed against either the Avondale Mills stock or Ms. Selfe personally.

On their joint return for the 1980 calendar year, Ms. Selfe and her husband, Edward Selfe, deducted $33,824 under I.R.C. § 1374, representing the net operating loss incurred by Jane Simon, Inc. for its fiscal year ending June 30, 1980. The Internal Revenue Service allowed this deduction to the extent of $4,946 only, based on its calculation of the adjusted basis of Ms. Selfe's stock in the corporation. Ms. Selfe and her husband now bring this action to recover the the taxes they subsequently paid to the government because of the disallowed deduction.

I.R.C. § 1374 permits a shareholder in a Subchapter S corporation to deduct his proportion of the corporation's net operating loss from his personal income. Section 1374 limits the amount of the deduction, however, to the sum of the adjusted basis of the shareholder's stock in the corporation plus the adjusted basis of any indebtedness of the corporation to the shareholder.

Relying on principles established in Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (5th Cir. 1972), Ms. Selfe argues she is entitled to augment the adjusted basis of her stock in Jane Simon, Inc. by the amount of the AmSouth loan.

In Plantation Patterns, the former Fifth Circuit held that a corporation's principal and interest payments on a debt to an independent third party constituted constructive dividends to the shareholder. The court based this holding on a consideration of traditional debt-equity factors, such as inadequate capitalization of the corporation, use of the loan proceeds to purchase long term assets, and the presence of a personal guarantee without which an objective independent third party would not have made the loan. Id. at 722. Looking at these factors, the court concluded that the transaction in question was in substance a loan to the principal stockholder and a subsequent contribution by him of the loan proceeds to the corporation's capital account. The corporation's payment of principal and interest on the loan therefore relieved the principal stockholder of a liability and constituted a constructive dividend.

Ms. Selfe argues that, although the facts of her case are different, the principles of Plantation Patterns should apply here because Jane Simon, Inc. was a thinly capitalized corporation that continually lost money and AmSouth's primary inducement in making the loan was Ms. Selfe's personal guarantee and pledge of Avondale Mills stock. The result of such reasoning, contends Ms. Selfe, is that her capital contribution to the corporation included not only the initial $5,100 but also the full amount of the loan proceeds, thereby entitling her to deduct the entire 1980 net operating loss of Jane Simon, Inc. from her personal income.

Peter Blum, 59 T.C. 436 (1972) furnishes support for Ms. Selfe's argument. In that case the Tax Court stated it could see no distinction, in principle, between a case such as Ms. Selfe's and Plantation Patterns. The Tax Court's statement, however, was unnecessary to support its holding and, in light of other precedent, is not entitled to great weight.

The government opposes Ms. Selfe's summary judgment motion and supports its own motion by arguing, first, that Plantation Patterns cannot apply to this case, and second, even assuming it does apply, summary judgment in favor of Ms. Selfe is inappropriate since application of the traditional debt-equity factors will require resolution of disputed issues of fact. The court agrees with the government in both respects.

First, relying primarily on the case of Brown v. Commissioner, 706 F.2d 755 (6th Cir. 1983), this court concludes that, within the context of I.R.C. § 1374, a shareholder guarantor must actually repay some portion of the corporation's debt before he may augment the adjusted basis of his stock in the corporation. The taxpayers in Brown were shareholders in a Subchapter S corporation who guaranteed a loan to the corporation. The shareholders attempted to augment their capital contribution to the corporation by the amount of the loan and thereby increase their net operating loss deduction under I.R.C. § 1374. The court held that, regardless of whether traditional debt-equity rules would indicate the loan was equity rather than debt, the shareholders were not entitled to augment their stock basis since they had not been called upon to repay any portion of the corporation's obligations. Id. at 757.

Second, even assuming that Plantation Patterns, and notBrown should control the outcome of the case, this court concludes that summary judgment cannot be granted in favor of Ms. Selfe. Application of the debt-equity rules in this case will involve a factual determination for a jury. Summary judgment in favor of Ms. Selfe is therefore precluded.

Accordingly, since the court is of the opinion that Brown ought to control the outcome of this case, summary judgment is due to be GRANTED in favor of the government and this case DISMISSED.

A separate order will be entered.