Opinion
Docket No. 4428-66.
1970-06-16
WILLIAM H. PERRY AND MARION E. PERRY, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Max Myers, William H. Perry III, and Richard M. Webster, for the petitioners. Hugh C. McMahon, for the respondent.
Max Myers, William H. Perry III, and Richard M. Webster, for the petitioners. Hugh C. McMahon, for the respondent.
Held: The partially tax motivated transactions between petitioner and a small business corporation controlled by him, in which petitioner's demand notes were issued to the corporation in exchange for its long-term in like amounts, were not sufficient to create ‘indebtedness' within the meaning of sec. 1374(c)(2) (B). Accordingly, the portion of petitioner's sec. 1374(a) deduction attributable to such ‘indebtedness' was properly disallowed by respondent.
IRWIN, Judge:
Respondent determined a deficiency of $9,450.16 in petitioners' income tax for the calendar year 1962. Certain questions having been resolved by the parties, the sole issue presented is whether, in computing their personal income tax, petitioners are entitled to take as a deduction that part of the net operating loss of a small business corporation which exceeds $4,200— the amount allowed by respondent.
FINDINGS OF FACT
Petitioners William H. and Marion E. Perry are husband and wife and were residents of Webb City, Mo., at the time the petition herein was filed. Petitioners, who employed a hybrid method of computing income— part cash basis and part accrual— timely filed a joint tax return for the calendar year 1962 with the district director of internal revenue, Kansas City, Mo. Because Marion E. Perry is a party to this case only by virtue of having joined with her husband in filing their Federal income tax return for the year in issue, reference to the petitioner will be limited to petitioner William H. Perry (hereinafter William).
On March 11, 1960, Cardinal Castings, Inc. (hereinafter Cardinal), was incorporated under the laws of the State of Missouri. Of the 3,000 shares of stock issued by Cardinal, 2,999 were owned by petitioner and his wife. During the period under review, Cardinal was at all times an electing small business corporation with a November 1 to October 31 fiscal year.
From its inception, Cardinal had encountered financial difficulties. For the fiscal year ending October 31, 1961, it experienced a net operating loss of $6,069.53; and, for the fiscal year ending October 31, 1962, it experienced a net operating loss of $13,698.50.
During the period November 1, 1961, through October 31, 1962, Cardinal occupied premises owned by the petitioner which were rented to Cardinal at a charge of $100 per month. Though no rent was received by petitioner during this period, petitioner reported the sum of $1,200 as an income accrual on his 1962 Federal tax return. This sum, coupled with advances made to the corporation by petitioner in the net amount of $3,000, represents the undisputed portion of corporate indebtedness— $4,200— claimed to have been owed petitioner (by Cardinal) on October 31, 1962.
The contested portion of corporate indebtedness alleged to have been owed petitioner (by Cardinal) on this date may be traced to the following ‘loan’ transactions between petitioner and the corporation. (A) At an undetermined time subsequent to October 31, 1961, petitioner issued to Cardinal a demand note for $7,942.33. In return, the corporation executed a long-term note (payable to petitioner on January 1, 1964) in a like amount. (B) Similarly, on October 31, 1962, petitioner issued to Cardinal a second demand note in the amount of $13,704.14 ($5.64 more than the corporation's net operating loss for its 1961-62 fiscal year) and received from the corporation a long-term note (payable January 1, 1964) in a like amount.
Both of the demand notes executed by petitioner were given current assets status on the financial statements of the corporation, while the notes issued by the corporation were listed as long-term obligations. By reflecting petitioner's demand notes as current assets (and thereby improving the ratio of current assets to current liabilities), petitioner and his accountant hoped to make Cardinal's balance sheet more attractive to those persons who would be dealing with the corporation, and who would look beyond the corporation to petitioner in assessing Cardinal's financial strength. Additionally, given petitioner's ‘cash-poor’ status, his accountant viewed Cardinal's execution of these notes as the only means by which corporate indebtedness to petitioner, sufficient to create a section 1374(c)(2)(B) basis large enough to absorb Cardinal's operating losses for each of its loss years, could be generated.
For purposes of sec. 1374(c)(2)(A) of the 1954 Code, petitioner's adjusted basis in the capital stock of Cardinal on Oct. 31, 1961, was zero. Additionally, since corporate indebtedness owed to petitioner on Oct. 31, 1961, in the amount of $2,621.50 had already been utilized as a sec. 1374 deduction on petitioner's 1961 tax return, petitioner's basis in such indebtedness was also zero at the beginning of the year now before us.
On his tax return for the calendar year 1962, petitioner and his wife treated their entire prorata share ($13,691.65) of the corporation's fiscal year 1961-62 net operating loss as a section 1374 deduction. As indicated above, respondent allowed this deduction only to the extent of $4,200.
OPINION
The question before us is whether a shareholder in a small business corporation can create corporate indebtedness within the purview of section 1374(c)(2)(B)
by a partially tax-motivated transaction in which the shareholder's demand note is issued to the corporation in exchange for its long-term note in a like amount. We hold that this question must be answered in the negative.
All statutory references, unless otherwise indicated, are to the Internal Revenue Code of 1954, as amended.SEC. 1374. CORPORATION NEW OPERATING LOSS ALLOWED TO SHAREHOLDERS.(c) DETERMINATION OF SHAREHOLDERS PORTION.—(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—(B) the adjusted basis (determined without regard to any adjustment under section 1376 for the taxable year) of any indebtedness of the corporation to the shareholder, determined as of the close of the taxable year of the corporation (or, if the shareholder is not a shareholder as of the close of such taxable year, as the close of the last day in such taxable year on which the shareholder was a shareholder in the corporation).
Viewed from our vantage point, the facts of this case yield an aroma of alchemist's brew. Cf. Knetsch v. United States, 364 U.S. 361 (1960). As we see matters, the transactions in this case amounted to little more than the posting of offsetting book entries, accompanied by the drafting of illusory instruments in commemoration thereof. Whether, in fact, petitioner's notes could, at some future time, have been enforced by Cardinal is, to our way of thinking, irrelevant. What is relevant is that in pure, pragmatic terms the exchanges of notes which generated Cardinal's long-term ‘indebtedness' left petitioner economically unimpaired, both actually and constructively.
Section 1374(c)(2)(B), along with the other tax option corporation provisions which were part of the Technical Amendments Act of 1958, originated in the Senate. The report of the Committee on Finance of the Senate discloses the purpose of this section as follows:
The amount of the net operating loss apportioned to any shareholder pursuant to the above rule is limited under section 1374(c)(2) and 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. * * * (1958-3 C.B. 1141.)
As we construed the language employed by the Committee on Finance, it appears to us that, given its most familiar meaning, Old Colony R. Co. v. Commissioner, 284 U.S. 553 (1932), the use of the word ‘investment
reveals an intent, on the part of the committee, to limit the applicability of section 1374(c)(2)(B) to the actual economic outlay of the shareholder in question.
Webster's Seventh New Collegiate Dictionary defines investment as ‘the outlay of money for income or profit;‘ also, ‘the sum invested or property purchased.’
The rule which we reach by this interpretation is no more than a restatement of the well-settled maxim which requires that ‘Before any deduction is allowable there must have occurred some transaction which when fully consummated left the taxpayer poorer in a material sense.’ Frederick R. Horne, 5 T.C. 250 (1945). See also Shoenberg v. Commissioner, 77 F.2d 446 (C.A. 8, 1935), affirming 30 B.T.A. 659 (1934); and Joseph W. Powell, 34 B.T.A. 655 (1936), affd. 94 F.2d 483 (C.A. 1, 1938). As we see it, the exchange of paper in the case at bar left the taxpayer herein no poorer than the shareholder in Shoenberg who, after selling shares of stock through a broker at less than their cost, attempted to regain the shares (without forfeiting his loss deduction) by (a) having a corporation controlled by him purchase like shares which had been obtained by the broker, and (b) causing the corporation to sell the shares back to him. In affirming the Board and holding that no deductible loss had occurred, the Court of Appeals in Shoenberg employed the following language:
To secure a deduction, the statute requires that an actual loss be sustained. An actual loss is not sustained unless when the entire transaction is concluded the taxpayer is poorer to the extent of the loss claimed; in other words, he has that much less than before.
A loss as to particular property is usually realized by a sale thereof for less than it cost. However, where such sale is made as part of a plan whereby substantially identical property is to be reacquired and that plan is carried out, the realization of loss is not genuine and substantial; it is not real. This is true because the taxpayer has not actually changed his position and is no poorer than before the sale. The particular sale may be real, but the entire transaction prevents the loss from being actually suffered. Taxation is concerned with realities, and no loss is deductible which is not real.
Though Shoenberg dealt with an illusory sale of securities, the reasoning set out above is in our estimation equally applicable to the analogous transactions in the case now before us. Accordingly, we are compelled to deny the deductions sought by petitioner herein.
In arriving at this result, we are aware of the fact that petitioner maintained a hybrid system of tax accounting in which some transactions with corporations controlled by him were subject to accrual, and others not. However, even if we were to assume arguendo that petitioner had established to our satisfaction (which he has not) that the accrual method was employed by him in all transactions with Cardinal, including those now before us, we would still conclude that for purposes of section 1374(c)(2)(B) no method of accounting, in the absence of an actual loan of money or other valuable consideration, can serve as a philosopher's stone through which paper is transformed into indebtedness. Compare Milton T. Raynor, 50 T.C. 762 (1968), in which we held, in part, that notes executed by shareholders of a tax option corporation in favor of creditors of the corporation merely constituted additional security to such creditors, and could not, until the notes were actually satisfied, be considered as payment by the shareholders so as to give rise to section 1374(c)(2)(B) corporate indebtedness.
Like the notes in Raynor, the notes executed by petitioner in the instant case were, at best, no more than a form of indirect security intended to offer reassurance to those creditors of Cardinal who looked beyond the corporation to petitioner in assessing Cardinal's financial strength. Accordingly, the deduction sought by petitioner must be denied.
To reflect the agreement reached by the parties,
Decision will be entered under Rule 50.