Opinion
Docket No. 20007.
1950-07-27
ISIDOR DOBKIN, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Jacob Rabkin, Esq., for the petitioner. Pershing W. Burgard, Esq., for the respondent.
Petitioner and his three associates organized a corporation to hold and manage a parcel of business realty. Approximately $27,000 was required to finance the purchase over and above outstanding first and second mortgages. Petitioner and his associates each paid $7,000 of which $500 was designated capital stock and the remaining $6,500 was set up on the corporation's books as ‘Loans Payable.‘ When additional working capital was required, the equality of investment was maintained by equal contributions. Held: The entire amount paid in by petitioner was intended to be risk capital. His loss upon liquidation of the corporation is not deductible in full as a bad debt but may be deducted as a capital loss subject to the limitations of section 117 of the Internal Revenue Code. Jacob Rabkin, Esq., for the petitioner. Pershing W. Burgard, Esq., for the respondent.
Respondent determined a deficiency in petitioner's income tax liability for the calendar year 1945 in the amount of $524.41.
The deficiency resulted principally from respondent's disallowance of a bad debt claimed by petitioner in the amount of $3,147.29. Respondent treated the transaction as a long term capital loss and allowed 50 per cent thereof, pursuant to section 117 of the Internal Revenue Code, in his computation of the deficiency. Other adjustments made by respondent in the determination of the deficiency are not contested.
FINDINGS OF FACT.
Petitioner is an individual residing at 1085 Anderson Avenue, New York, New York. His income tax return for the period here involved was filed with the collector of internal revenue for the third district of New York.
In November 1940, petitioner and his associates organized Huguenot Estates, Inc. (hereinafter called Huguenot), to acquire a specific parcel of business property located in Mount Vernon, New York. The total purchase price of the apartment building was $72,330.95. Outstanding first and second mortgages, in total amount of $43,750, reduced the amount of capital required of petitioner and his associates to approximately $27,000. To supply this capital, petitioner and his three associated contributed $7,000 each. In consideration of the $7,000 paid in, each received capital stock of Huguenot with an attributed value of $500 and 6 per cent promissory notes of Huguenot, payable on demand, for the remaining $6,500 contributed.
Petitioner's associates in the enterprise were Max Glickin, Ruth Rosen, and a partnership known as J. Schultz & Sons. Petitioner had had business dealings with these associates for a number of years. Their customary method of operation was to organize separate corporations for each of their real estate holdings in order to limit losses to the particular property involved.
Operating deficits of Huguenot required the furnishing of additional capital to it by petitioner and his three associates on three separate occasions in 1942 and 1943. In each instance equal funds were contributed by each of the four stockholders. The funds so paid in were recorded on Huguenot's books as loans payable. Additional funds were paid in to Huguenot by J. Schultz & Sons during 1943, but these advances were repaid by Huguenot within a short period of time so that the net amount that each of the four stockholders paid in to the corporation remained equal. Annual interest was paid by Huguenot through December 31, 1944, on the above amounts designated as loans payable. This interest was recorded on its books as ‘interest on Officers' Loans.‘
In August 1945, Huguenot sold its Mount Vernon property at a substantial loss. One thousand dollars was paid to each of the four stockholders thereafter, and following liquidation of Huguenot on September 30, 1945, they received an additional $3,702.71 each. These total payments of $4,702.71 were recorded in the ‘Loans Payable‘ accounts carried for each of the stockholders, leaving these accounts showing a balance due each stockholder of $3,147.29. Petitioner claimed the latter amount as a bad debt in his 1945 income tax return.
No change in the capital stock account of Huguenot occurred between the date of its organization and the date of its final liquidation, nor was any demand ever made by any of the stockholders for payment of the demand promissory notes issued by Huguenot. Yearly depreciation on the Mount Vernon realty amounted to $881.25 in 1945.
OPINION.
ARUNDELL, Judge:
Petitioner's contention that the funds which he paid in to Huguenot should be treated as loans so as to entitle him to a bad debt deduction on the corporation's liquidation runs squarely into our decision in Edward G. Janeway, 2 T.C. 197, affd., 147 Fed.(2d) 602.
Ordinary contributions by stockholders to their corporations are regarded as capital contributions that increase the cost basis of their stock, thus affecting the determination of gain or loss on ultimate dispositions of the stock. Harry Sackstein, 14 T.C. 566. Especially is this true when the capital stock of the corporation is issued for a minimum or nominal amount and the contributions which the stockholders designate as loans are in direct proportion to their shareholdings. Edward G. Janeway, supra.
When the organizers of a new enterprise arbitrarily designate as loans the major portion of the funds they lay out in order to get the business established and under way, a strong inference arises that the entire amount paid in is a contribution to the corporation's capital and is placed at risk in the business. Cohen v. Commissioner, 148 Fed.(2d) 336; Joseph B. Thomas, 2 T.C. 193. The formal characterization as loans on the part of the controlling stockholders may be a relevant factor
but should not be permitted to obscure the true substance of the transaction. Sam Schnitzer, 13 T.C. 43, 60.
The determinative intent described in Wilshire & Western Sandwiches, Inc., 175 Fed.(2d) 718, must necessarily be the objective intent disclosed by all the pertinent factors in the case and not the formal manifestation of intent declared by the taxpayer. Cf. O'Neill v. Commissioner, 170 Fed.(2d) 596, certiorari denied, 336 U.S. 937.
Here petitioner and his three associates designated as capital stock $500 of the $7,000 that each paid in when they organized the corporation. The balance was declared to be a loan to the corporation. Despite the form of the transaction, however, each associate placed at risk the entire $7,000 that he paid in.
The apartment building which the corporation was organized to acquire had a purchase price of approximately $72,000. Because of $44,000 of outstanding first and second mortgages, approximately $28,000 was required to purchase the equity in the property. To acquire this equity, petitioner and each of his associates supplied one-quarter of the requisite funds. Of the $28,000 thus paid in at the organization of Huguenot, $26,000 was arbitrarily designated on the corporate books as ‘loans Payable‘ and the remaining $2,000 designated as capital stock. Taking into account the $44,000 of first and second mortgages, the effect of this designation was to give the corporation a debt structure of $70,000 as against a capital stock investment of $2,000, or a ratio of 35 to 1 of indebtedness to capital stock.
In Mullin Building Corp., 9 T.C. 350, a claimed indebtedness was rejected where, if allowed, a 29 to 1 debt to capital ratio would have resulted.
This question of inadequate capitalization
is precisely the situation which the Supreme Court stated was not before it in John Kelley Co. v. Commissioner, 326 U.S. 521, 526:
Advances to corporations by controlling stockholders have been held capital contributions rather than indebtedness in several bankruptcy cases. Arnold v. Phillips, 117 Fed.(2d) 497 (CCA-5), certiorari denied, 313 U.S. 583. In Pepper v. Litton, 308 U.S. 295, 309-310, the Supreme Court said:And so-called loans or advances by the dominant or controlling stockholder will be subordinated to claims of other creditors and thus treated in effect as capital contributions by the stockholder not only in the foregoing types of situations but also where the paid-in capital is purely nominal, the capital necessary for the scope and magnitude of the operations of the company being furnished by the stockholder as a loan.See also Myron Semmel, Tax Consequences of Inadequate Capitalization, 48 Columbia Law Review 202.
As material amounts of capital were invested in stock, we need not consider the effect of extreme situations such as nominal stock investments and an obviously excessive debt structure. When at a later date this Court was confronted with the above situation, we held that the capital there paid in must be treated as stock rather than indebtedness. Swoby Corporation, 9 T.C. 887.
The chances that the so-called loans would be repaid depended upon the earnings of the corporation. Because of the limited amount attributed to capital on the corporate books, any attempt by petitioner or one of his associates to enforce payment of the demand notes would probably have rendered the corporation insolvent, and such attempted payment would have come within the ban of New York stock corporation law
forbidding repayment of loans from stockholders when a corporation is insolvent or when its insolvency is imminent. There was no evidence that petitioner or any of his associates ever demanded repayment of their purported loans or that they ever contemplated such repayment unless the enterprise proved so profitable that they could withdraw the major part of their original investment without impairing the corporation's working capital. On the contrary, when deficiencies in working capital did arise, petitioner and his associates contributed additional funds and in so doing contributed in exactly equal proportions so that their investments in the corporation would remain equal.
McKinney's Consolidated Laws of New York Annotated, Book 58, Art. 3, Sec. 15.
While it is true that Huguenot paid interest on the so-called loans, these payments were derived principally from the rental income of the property. These payments could just as readily have been made as dividends had the original capital contributions been correctly designated. Since petitioner and his associates kept both the purported loans and their stockholdings in equal proportions, it was immaterial to them whether the payments were made as dividends or interest. Petitioner's own testimony supports the conclusion that the division of his contribution into two portions, capital stock and loan, was merely a bookkeeping transaction. On cross-examination, he admitted that he had no knowledge of how many shares the $500 recorded on the corporate books as his capital stock represented, nor could he state whether the stock had a par value or was no par stock. It is clear that petitioner intended to place at risk the entire $7,000 which he paid in to Huguenot.
From the facts before us, we can find no valid distinction which would warrant our arriving at a different result than we reached in the Janeway case, supra.
The respondent did not err in determining a deficiency.
Decision will be entered under Rule 50.