WHEAT v. UNITED STATES, (S.D.Tex. 1973)

Citation Codes

Equivalent Citations

citation codes

Docket Number

Civ. A. Nos. 70-H-786 to 70-H-789.

Motions

Motion for summary judgment : Granted

Attorney(S)

Charles J. Sullivan, Dyche, Wright, Sullivan, Bailey King, Houston, Tex., for plaintiffs. Anthony J.P. Farris, U.S. Atty., Houston, Tex., Scott P. Crampton, Asst. Atty. Gen., Washington, D.C., Jerome Fink, William W. Guild, Howard A. Weinberger, Attys., Tax Div., Dept. of Justice, Dallas, Tex., for defendant.

Judges

Carl Olaf Bue

Acts

Internal Revenue Code — Procedure And Administration — Judicial Proceedings — Proceedings By Taxpayers And Third Parties — Civil Actions For Refund
Internal Revenue Code — Income Taxes — Normal Taxes And Surtaxes — Determination Of Tax Liability — Credits Against Tax — Nonrefundable Personal Credits — Limitation Based On Tax Liability; Definition Of Tax Liability
Internal Revenue Code — Income Taxes — Normal Taxes And Surtaxes — Tax Treatment Of S Corporations And Their Shareholders — Special Rules — Tax Imposed On Certain Built-In Gains

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Smart Summary

Factual and Procedural Background

These four consolidated actions involve shareholders of Student Housing, Inc., an electing small business corporation (Subchapter S), who sought refunds of income taxes and assessed interest under 26 U.S.C. § 7422(a) and 26 U.S.C. § 1346. The plaintiffs reported, on their individual 1964 returns, each a pro rata share ($25,897.84) of the corporation's 1964 net operating loss ($258,978.47) computed on the assumption that their stock basis included two corporate loans totaling $285,585.89 which the shareholders had personally guaranteed. The Bank of Texas had made two loans to the corporation in 1963, secured by chattel mortgages on corporate property and by personal guarantees of the individual shareholders; the corporation did not default and the shareholders were never required to pay. The corporation's records and returns reflected the loans as corporate obligations; corporate records did not show indebtedness to the plaintiffs. The IRS allowed each shareholder only a $3,782.46 deduction (reflecting actual capital investment). The United States moved for summary judgment under Rule 56, Fed.R.Civ.P., attacking the propriety of plaintiffs' cause of action; the plaintiffs opposed, contending the transactions (including a Stockholders' Agreement) reflected an intention to create indebtedness of the corporation to the shareholders.

Legal Issues Presented

Whether the shareholders' personal guarantees of corporate loans constitute "any indebtedness of the corporation to the shareholder" within the meaning of 26 U.S.C. § 1374(c)(2)(B) (thus increasing each shareholder's basis for deducting the corporation's net operating loss on individual returns).
Whether, on the undisputed facts as presented, the Government is entitled to summary judgment as a matter of law.

Arguments of the Parties

Government's Arguments

The documents reflecting the loans and guarantees demonstrate that the shareholders executed personal guarantees to the bank and that such guarantees cannot create an indebtedness from the corporation to the shareholders as required by the statute.
This conclusion is asserted to follow regardless of the parties' subjective intentions at the time the loans were executed.
On these grounds, the Government contends it is entitled to summary judgment as a matter of law.

Plaintiffs' Arguments

The shareholders argue they lent their individual credit to the corporation to secure the bank loans and that the guarantees were executed pursuant to the Stockholders' Agreement.
The plaintiffs assert that the shareholders, the bank and the corporation intended that an indebtedness be created between the corporation and the shareholders and that this indebtedness should be included in the shareholders' basis for loss deduction purposes.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
Shahid v. Gulf Power Co., 291 F.2d 422, 423 (5th Cir. 1961), rehearing denied, 298 F.2d 793 (5th Cir. 1961), cert. denied, 370 U.S. 923, 82 S.Ct. 1563, 8 L.Ed.2d 503 (1962)	Standard for summary judgment: no genuine issue as to any material fact and moving party entitled to judgment as a matter of law.	The Court cited this case to state the governing summary judgment standard.
Brunswick Corp. v. Vineberg, 370 F.2d 605, 612 (5th Cir. 1967)	Warning that summary judgment is a "lethal weapon" and should be used with caution.	The Court invoked this caution while nonetheless granting summary judgment on the facts presented.
Tomlinson v. 1661 Corp., 377 F.2d 291, 295 (5th Cir. 1967)	Holds that the term "indebtedness" implies an existing unconditional and legally enforceable obligation to pay.	Used to support the statutory construction that "indebtedness" is limited to enforceable obligations, not mere guaranties.
United States v. Virgin, 230 F.2d 880 (5th Cir. 1956)	Reinforces that "indebtedness" implies an enforceable obligation.	Applied as supporting authority for limiting "indebtedness" to enforceable obligations.
Gilman v. Commissioner, 53 F.2d 47 (8th Cir. 1931)	Another authority stating that "indebtedness" implies an enforceable obligation.	Relied on to bolster the Court's construction of the statutory term.
Neal v. United States, 313 F. Supp. 393 (C.D.Cal. 1970)	Holds that a shareholder's contract of guaranty with corporate creditors is not tantamount to an indebtedness of the corporation to the shareholder under the statute.	The Court noted Neal presented a practically identical factual situation and adopted its rationale in concluding guaranties do not create the required statutory indebtedness.
Perry v. Commissioner, 47 T.C. 159 (1966), aff'd, 392 F.2d 458 (8th Cir. 1968)	Tax Court decision that personal guaranties by shareholders are not equivalent to indebtedness for the statutory purpose.	Cited (via Neal) as supporting the conclusion that guaranties do not create corporate indebtedness to shareholders.
Borg v. Commissioner, 50 T.C. 257 (1968)	Tax Court decision reaching a similar conclusion about personal guaranties.	Cited as additional Tax Court authority consistent with the view that guaranties are not statutory indebtedness.
Raynor v. Commissioner, 50 T.C. 762 (1968)	Tax Court decision finding personal guaranties are not indebtedness under the statute.	Relied upon to support the Court's conclusion; also cited later with Putnam for the guarantor principle.
Putnam v. Commissioner, 352 U.S. 82, 77 S.Ct. 175, 1 L.Ed.2d 144 (1956)	Supports the proposition that a guarantor is not a creditor until the guarantor pays and that a contingent obligation does not constitute a "debt" until the contingency occurs.	Cited to show that at the time of the stockholders' agreement there was no indebtedness and that shareholders remained mere guarantors until called upon to pay.
Graham v. San Antonio Machine and Supply Corp., 418 S.W.2d 303 (Tex.Civ.App.-San Antonio 1967, writ ref'd n.r.e)	Illustrates similar principles regarding guarantors and obligations under Texas law.	Used as supporting authority for the characterization of the shareholders as guarantors rather than creditors.
Knetsch v. United States, 364 U.S. 361, 81 S.Ct. 132, 5 L.Ed.2d 128 (1960)	Demonstrates that the term "indebtedness" can have varying meanings in different statutory contexts; one must probe Congressional intent.	The Court acknowledged Knetsch (and similar cases) only for the proposition that statutory meaning requires examining Congressional intent and found those cases consistent with its conclusion.
Helvering v. Sabine Transportation Co., 318 U.S. 306, 63 S.Ct. 569, 87 L.Ed. 773 (1943)	Also cited for the proposition that statutory terms may have varying meanings requiring inquiry into Congressional intent.	Cited as part of the group of cases illustrating the need to determine Congressional intent in construing "indebtedness."
Deputy v. Du Pont, 308 U.S. 488, 60 S.Ct. 363, 84 L.Ed. 416 (1940)	Same as above regarding varying statutory meanings and necessity of ascertaining Congressional intent.	Used to support the Court's method of statutory interpretation.
Commissioner v. Tennessee Co., 111 F.2d 678 (3d Cir. 1940)	Included among authorities showing statutory terms may vary in meaning depending on intent.	Cited to show these precedents do not conflict with the Court's construction.
Amory Cotton Oil Co. v. United States, 468 F.2d 1046 (5th Cir. 1972)	Illustrates that lending money directly to an S corporation may be treated as a second class of stock, jeopardizing S corporation status.	Referenced in a footnote as an example of the risk to shareholders if loans were treated as indebtedness for basis purposes.
Brennan v. O'Donnell, 322 F. Supp. 1069 (N.D.Ala. 1971)	Similar authority cited in the footnote regarding the risk of treating shareholder loans as capital that might affect S corporation status.	Referenced as additional supporting authority for the Court's cautionary remarks in the footnote.
Stinnett v. Commissioner, 54 T.C. 221 (1970)	Tax Court decision cited with others concerning classification of shareholder loans and related problems.	Used in the footnote to illustrate potential consequences of treating shareholder-related transactions as indebtedness.

Court's Reasoning and Analysis

The Court summarized undisputed facts showing the Bank of Texas made two loans to the corporation in 1963, secured by chattel mortgages on corporate property and by personal guarantees of the shareholders, with no corporate default and no payments by shareholders. The Court examined the Subchapter S statutory limitation (26 U.S.C. § 1374(c)(2)) which limits a shareholder's deductible portion of a corporate net operating loss to the adjusted basis of the shareholder's stock and "the adjusted basis . . . of any indebtedness of the corporation to the shareholder." The Court relied on legislative history indicating that "indebtedness" was intended to be comparable to capital investment and on precedent holding that "indebtedness" connotes an existing unconditional and legally enforceable obligation to pay (citing Tomlinson, United States v. Virgin, Gilman, and a treatise).

The Court discussed Neal v. United States and related Tax Court decisions (Perry, Borg, Raynor), which concluded that personal guaranties by shareholders do not constitute indebtedness of the corporation to the shareholders under the statute. The Court explained that a guarantor's contractual obligation does not create a debt owed by the principal (corporation) to the guarantor until and unless the guarantor pays; a contingent obligation becomes a debt only when the contingency occurs. The Court rejected the plaintiffs' attempt to incorporate the Stockholders' Agreement into the loan transaction to establish indebtedness, reasoning that at the time of that agreement no indebtedness (within the statutory meaning) existed and none arose because the contingency (shareholder payment) never occurred. The plaintiffs therefore remained mere guarantors or sureties, not creditors of the corporation.

The Court acknowledged authorities cited by plaintiffs (Knetsch, Helvering, Deputy, Commissioner v. Tennessee Co.) showing that statutory meaning may vary by context and that Congressional intent must be probed. The Court stated that it had undertaken that inquiry and found those authorities consistent with its conclusion. The Court also noted, by reference to other cases and commentary, that treating the transactions as loans could have adverse tax consequences (e.g., affecting S corporation status), but concluded that any statutory shortcomings are matters for Congress to address.

Applying the summary judgment standards and the cited authorities to the undisputed facts, the Court concluded there was no genuine issue of material fact and that the Government was entitled to judgment as a matter of law.

Holding and Implications

Holding: The Court granted the Government's motion for summary judgment.

Implications: The direct effect is that the Government prevailed on its motion and the plaintiffs' attempt to treat their personal guarantees (and the Stockholders' Agreement) as creating "indebtedness of the corporation to the shareholder" for purposes of increasing their basis for deducting the corporation's net operating loss was rejected. The Court emphasized that the shareholders were, at best, guarantors until and unless they paid — which did not occur — and thus no statutory indebtedness arose. The opinion does not announce the creation of a new legal doctrine; it applies existing statutory construction and case law and notes that any legislative change or relief from the statutory limitations must come from Congress.

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Tom H. WHEAT and Tilda Wheat, Plaintiffs, v. UNITED STATES of America, Defendant. E. Philip GEMMER, Jr., and Jo Kathryn Gemmer, Plaintiffs,

MEMORANDUM AND ORDER

CARL O. BUE, Jr., District Judge.

In these four consolidated actions the plaintiffs seek a refund of income taxes and assessed interest as a result of the allegedly erroneous disallowance of certain deductions for their pro rata share of the net operating loss of an electing small business corporation under Subchapter S of the Internal Revenue Code pursuant to 26 U.S.C. § 7422(a) and 26 U.S.C. § 1346. In a direct attack on the propriety of plaintiffs' cause of action, the Government has moved for summary judgment pursuant to Rule 56, Fed.R.Civ.P.

To capsule the undisputed facts, the plaintiffs are shareholders in a small business corporation, Student Housing, Inc. This corporation was formed on October 1, 1962, by ten shareholders, four of whom are plaintiffs in these lawsuits, for the purpose of constructing and operating student dormitories on various college campuses. At the time of incorporation, the shareholders executed an agreement entitled Stockholders' Agreement which provided, among other things, for shareholder contribution to the corporation's capital structure as a method for securing any additional corporate financing which might be needed to successfully conduct the intended business operations. Notwithstanding this method to secure additional financing, the corporation in 1963 through its officers employed an alternate method and made application for and duly received two loans in the amount of $285,585.89 from the Bank of Texas. The loans, which were represented by two promissory notes, were secured by chattel mortgages on the corporation's property and personal guarantees of the individual shareholders. The terms of these individual guarantees permitted the bank, in effect, to proceed directly against the individual guarantors upon default in the loan installment payments without the necessity of proceeding initially against the corporation or the collateral for the loans. In fact, however, the corporation never defaulted on the loan payments, and the shareholders were never called upon to pay any part of the loans. Further, the corporation's tax returns and financial statements reflected these loans as corporate obligations owing to the bank. The corporate records do not reflect any form of indebtedness owing to the plaintiffs.

In 1964 the corporation incurred an operating loss of $258,978.47. To reduce their individual tax liability each of the ten shareholders reported on his individual income tax return for 1964 a loss deduction of $25,897.84 as his pro rata share of the corporation's loss. This was computed on the assumption that the basis of their stock in the corporation included the two loans totaling $285,585.89 which constituted an indebtedness owed to them by the corporation. However, to the shareholders' consternation and dissatisfaction each was allowed only a $3,782.46 loss deduction which was comparable to each shareholder's actual capital investment or stock ownership in the corporation.

In support of its motion for summary judgment the Government relies upon the documents which reflect the substance of the transactions between the Bank of Texas, the shareholders and the corporation. The Government then contends that, even assuming that the facts asserted by the plaintiffs are true, it is entitled to a judgment as a matter of law. It is the Government's position that the guarantees executed by the shareholders in reference to the corporate loans cannot create an indebtedness from the corporation to the shareholders as required by the statute for the deduction sought by plaintiffs to be allowable. This is necessarily true, it is argued, regardless of the intention of the parties at the time the loans were executed. In rebuttal to the motion for summary judgment, the plaintiffs contend that the shareholders lent their individual credit to the corporation for the purpose of securing the loans from the bank and guaranteed the loans only as a result of the initial Stockholders' Agreement. It is asserted that the various parties to these transactions — the shareholders, the bank and the corporation — intended that an indebtedness be created between the corporation and the shareholders.

Summary judgment is a useful tool to cut off litigation where "there is no genuine issue as to any material fact and . . . the moving party is entitled to a judgment as a matter of law." Shahid v. Gulf Power Co., 291 F.2d 422, 423 (5th Cir. 1961), rehearing denied, 298 F.2d 793 (5th Cir. 1961), cert. denied, 370 U.S. 923, 82 S.Ct. 1563, 8 L.Ed.2d 503 (1962). However, the Fifth Circuit Court of Appeals has wisely cautioned that "[s]ummary judgment is a lethal weapon, and courts must be mindful of its aims and targets and beware of over-kill in its use." Brunswick Corp. v. Vineberg, 370 F.2d 605, 612 (5th Cir. 1967).

Subchapter S of the Internal Revenue Code which was enacted in 1958, permits shareholders of qualifying corporations to elect to pay taxes individually on the corporation's income. The provisions were designed for small corporations which seek the advantages of the corporate form of organization but who are reluctant to incur the double taxation which that form entails. The legislative intent was to permit "business to select the form of business organization desired, without the necessity of taking into account major differences in tax consequences." S.Rep. No. 1983, 85th Cong., 2d Sess. 87 (1958), U.S. Code Cong. Admin.News 4876. As a correlative procedure to the individual payment of taxes on the corporate income, the shareholders also are permitted to deduct on their individual income tax returns their proportionate share of the corporation's net operating loss. The intended result is to create a tax situation comparable to that encountered when operating losses are sustained by a partnership or sole proprietorship.

Necessarily, however, in view of the corporate form of organization, there is a limitation as to the deductible amount of a corporate operating loss which any shareholder can utilize for tax purposes. Thus the statute provides that:

(2) Limitation. — A shareholder's portion of the net operating loss of an electing small business corporation for any taxable year shall not exceed the sum of —

(A) the adjusted basis . . . of the shareholder's stock in the electing small business corporation, determined as of the close of the taxable year of the corporation . . and

(B) the adjusted basis . . . of any indebtedness of the corporation to the shareholder, determined as of the close of the taxable year of the corporation. . . .

26 U.S.C. § 1374(c)(2). The legislative history reflects that the deductible net operating loss to any shareholder was limited "to the adjusted basis of the shareholder's investment in the corporation; that is, to the adjusted basis of the stock in the corporation owned by the shareholder and the adjusted basis of any indebtedness of the corporation to the shareholder." S.Rep. No. 1983, 85th Cong., 2d Sess., U.S. Code Cong. Admin.News 5008 (1958). Thus, the concept of indebtedness of the corporation to the shareholders as employed in the statute was intended to be comparable to actual capital investment by the shareholders. This construction of the statute is bolstered by the fact that it has been repeatedly held that "[t]he term `indebtedness' implies an existing unconditional and legally enforceable obligation to pay." Tomlinson v. 1661 Corp., 377 F.2d 291, 295 (5th Cir. 1967); United States v. Virgin, 230 F.2d 880 (5th Cir. 1956); Gilman v. Commissioner, 53 F.2d 47 (8th Cir. 1931); 4A J. Mertens, The Law of Federal Income Taxation § 26.04 (1972 Rev.Ed.).

In Neal v. United States, 313 F. Supp. 393 (C.D.Cal. 1970), a factual situation practically identical to that in the instant lawsuits was considered. The Court concluded after canvassing the legislative intent that a shareholder's contract of guaranty with corporate creditors is not tantamount to an indebtedness of the corporation to the shareholder within the meaning of the statute. The Court's rationale was delineated as follow:

[The corporation] owed nothing to its shareholders by reason of their endorsement, and it continued to owe nothing to them until and unless they paid part or all of the obligation, which they never did. While a sum of money may be payable upon a contingency, it becomes a debt only when the contingency has happened, the term "debt" being opposed to "liability." The fact that the granting of the loan by the creditor to the corporation was expressly conditional upon the personal guaranty of the individual shareholders, to the extent that they became primarily liable to the creditor as co-makers, has no bearing upon the "indebtedness" contemplated by Section 1374(c)(2)(B).

313 F. Supp. at 396. The latter Court relied upon three United States Tax Court decisions which similarly had concluded that personal guaranties by shareholders of corporate obligations were not equivalent to an indebtedness within the meaning of the statute. Perry v. Commissioner, 47 T.C. 159 (1966), aff'd, 392 F.2d 458 (8th Cir. 1968); Borg v. Commissioner, 50 T.C. 257 (1968); Raynor v. Commissioner, 50 T.C. 762 (1968).

The law review commentators appear to be at odds with one another as to whether the statutory construction set forth in these recent decisions is "unduly restrictive" or the mandatory foreclosing of an "ingenuity to bolster basis." Landon, An Approach to Legislative Revision of Subchapter S, 26 Tax L.Rev. 799, 821 (1971); Rosenkranz, Subchapter S — An Illusory Promise?, 6 Ga.L.Rev. 109, 151 (1971). Nevertheless, this well-acknowledged construction of the statute appears to be consistent with the statutory purpose and legislative intent. Therefore, any shortcomings in the statute, if they exist at all, must be relegated to Congress for appropriate legislative revision. Additionally, it would appear that if the Court followed plaintiffs' proffered construction of the statute and construed these transactions as, in effect, loans, it would be a one-headed virtue — one-headed vice for the shareholders. It is apparently a risky transaction for shareholders to lend money directly to their electing small business corporation, since such a loan may be construed, under certain circumstances, as a second class of stock which would destroy the corporation's right to be considered a small business corporation for tax purposes. See Amory Cotton Oil Co. v. United States, 468 F.2d 1046 (5th Cir. 1972); Brennan v. O'Donnell, 322 F. Supp. 1069 (N.D.Ala. 1971); Stinnett v. Commissioner, 54 T.C. 221 (1970); Goldstein, Corporate Indebtedness to Shareholders: "Then Capitalization" and Related Problems, 16 Tax L.Rev. 1 (1960).

In order to circumvent these decisions, the plaintiffs are seeking to establish the requisite statutory "indebtedness" by including the Stockholders' Agreement in the loan transaction. However, this attempt to bolster their investment basis in the corporation cannot succeed. At the time of the execution of the Stockholders' Agreement there was no indebtedness within the meaning of the statute, and no such indebtedness could arise until such time as the shareholders were actually called upon to assume a real position in the loan transaction by paying part or all of the obligation owed to the bank. This situation never occurred. Until that time they were, at best, mere guarantors or sureties of the loans. See Putnam v. Commissioner, 352 U.S. 82, 77 S.Ct. 175, 1 L.Ed.2d 144 (1956); Raynor v. Commissioner, 50 T.C. 762 (1968); Graham v. San Antonio Machine and Supply Corp., 418 S.W.2d 303 (Tex.Civ.App.-San Antonio 1967, writ ref'd n.r.e).

Plaintiffs have cited several decisions as standing for the proposition that the term "indebtedness" as used in the statute should include the transaction in issue. Knetsch v. United States, 364 U.S. 361, 81 S.Ct. 132, 5 L.Ed.2d 128 (1960); Helvering v. Sabine Transportation Co., 318 U.S. 306, 63 S.Ct. 569, 87 L.Ed. 773 (1943); Deputy v. Du Pont, 308 U.S. 488, 60 S.Ct. 363, 84 L.Ed. 416 (1940); Commissioner v. Tennessee Co., 111 F.2d 678 (3d Cir. 1940). However, a close examination of these decisions reflects that they stand only for the proposition that the term "indebtedness" can have varying meanings in varying contexts with the result that it is necessary to probe the Congressional intent in order to ascertain the intended meaning within any particular statute. The Court has done precisely that in this instance. These decisions are by no means inconsistent with the Court's conclusion.

The Court can only conclude from the case as submitted that there is no genuine issue as to any material fact and that the Government is entitled to a judgment as a matter of law. Accordingly, the Government's motion for summary judgment is granted.