Cummings and Sprecher, Circuit Judges, and Laramore,*fn* Senior Judge. Cummings, Circuit Judge (dissenting).
This is a Federal income tax case which presents an issue relevant to a great number of small business corporations which have elected, or may elect in the future, to be taxed under Subchapter S of the Internal Revenue Code of 1954.*fn1 It is an issue involving section 1371(a) (4) of said Code, together with Treasury Regulation § 1.1371-1(g), as amended by T.D. 6904, 1967-1 Cum.Bull. 219, the regulation promulgated to explain the Code section first noted. Furthermore, it is an issue which has been considered by district courts other than the one from which this appeal is taken, as well as an issue which has been dealt with by Tax Court cases. Those cases, all to be noted hereafter, have singularly decided the issue against the government's position. Nevertheless, upon the facts as presented in this case, we hold in favor of the government's position that Regulation § 1.1371-1(g) is a reasonable and consistent interpretation of Code section 1371(a) (4). We thereby reverse the decision of the trial court in this case, namely, the U.S. District Court for the Western District of Wisconsin, 301 F. Supp. 684 (1969).
The above-noted decision of the District Court held that plaintiff-appellee was entitled to a refund of $142,413.79 of Federal income taxes paid, together with interest thereon computed from the date of payment, as a refund of taxes paid by the plaintiff corporation for fiscal years ending 1961, 1962 and 1963. The taxes were paid after being assessed by the Internal Revenue Service upon the theory that plaintiff failed to qualify as a small business corporation within the meaning of section 1371(a) because, contrary to the specific requirement of section 1371(a) (4), plaintiff had in existence during the years in question more than one class of stock.*fn2 Having allegedly failed to qualify as a small business corporation, the government contended, and assessed accordingly, that plaintiff was subject to the corporate income tax which would have otherwise been paid had not plaintiff elected to be taxed pursuant to the special provisions of Subchapter S.
It is plaintiff's contention that it did not fail to qualify as a small business corporation because, first, it did not have more than one class of stock and, second, even if the evidences of an obligation owing are reclassified as representative of equity in the corporation, it is not a second class of stock within the meaning of section 1371(a) (4). The facts giving rise to this controversy are set forth in detail in the opinion of the lower court and since there is no dispute as to those facts, we shall repeat only that portion we feel necessary for an understanding of this opinion.
Plaintiff is a Wisconsin corporation with its principal place of business at Portage, Wisconsin. It kept its books according to the accrual method of accounting with a fiscal year for tax purposes ending May 31. It was originally organized as a corporation on June 1, 1957, following the purchase of assets from, and an assumption of certain liabilities of, Standard Container Corporation (Standard). Said purchase was made possible when the original organizers of plaintiff corporation paid in $10,000 in return for the authorized common stock of the plaintiff. The articles of incorporation originally authorized 1,000 shares of common stock with a par value of $10 per share. However, effective January 23, 1962, the articles were amended to provide for an increase of the authorized shares of common stock to 20,000 shares with the same $10 par value. At all times relevant hereto no other class or series of stock was authorized by plaintiff's articles of incorporation.
The original stockholders were William G. Hamilton, whose holdings are set forth below along with all other stockholders of plaintiff during the years 1957 through 1964,*fn3 Ann Hamilton Kirk and Eugene Palmbach. These three stockholders also comprised the original Board of Directors until June 4, 1961 when Ann Hamilton Kirk was replaced by Armand Cimaroli. Note, however, that the two main characters in our story are yet to be named since they were not designated as stockholders or organizers of the plaintiff corporation. Nevertheless, on June 1, 1957, in exchange for certain instruments to be discussed hereafter, Elizabeth G. Berst and Sara Garnett agreed to advance to plaintiff the sum of $12,500 each. Said advances were made by Elizabeth G. Berst on June 1, 1957, in the amount of $8,500; on August 27, 1957, in the amount of $2,000, and on December 16, 1957, in the amount of $2,000. Sara Garnett fulfilled her part of the deal by advancing $5,000 on June 1, 1957, and $7,500 on December 4, 1957.
The above-noted instruments provided that the plaintiff was to pay Elizabeth G. Berst and Sara Garnett $12,500 each, payable at Portage, Wisconsin on June 1, 1962, with interest to be paid in the amount of five percent of plaintiff's net profits before taxes. In addition to the agreement evidenced by the written instruments, it was orally agreed that at the end of the 5-year period (June 1, 1962) either or both ladies could renew the June 1, 1957 instrument at her request for a period of similar duration. Pursuant to that agreement, the two instruments, on June 1, 1962, were renewed for an additional 5-year period. In June of 1963, however, Elizabeth and Sara exchanged the June 1, 1962 instruments for 245 shares each of the common stock of plaintiff. At no time relevant to this case did plaintiff unilaterally have the right to renew the instruments in question.
Those instruments, in standard note form, did not provide, nor did any other agreement, oral or written, for the repayment of the amounts advanced in the event of default on payment of the so-called "interest." Nor was there established by plaintiff a sinking fund of any sort to provide for the retirement of the obligations within the time periods provided.
Also with reference to payment of those obligations Elizabeth G. Berst and Sara Garnett executed, in June of 1959, separate written agreements which subordinated all their rights pertaining to the instruments in favor of the City Bank of Portage for a period of one year. Also, Elizabeth and Sara, on February 8, 1962, and March 26, 1962, respectively, agreed to subordinate their rights under the instruments in favor of the First National Bank of Chicago.
The instruments in question were recorded as notes payable on the books of the corporation and were listed as long-term debts and notes payable on plaintiff's financial statements prepared by certified public accountants. The accrual and payment of those amounts characterized by plaintiff as "interest" were recorded on the books of the corporation in the accrued interest payable account. Those amounts paid are as follows: Both ladies received $957.87 in 1959; $4,916.05 in 1960; $4,737.31 in 1961; $3,323.79 in 1962; and $2,245.03 in 1963, for a total of $16,180.05 as a return on an investment of $12,500.
Thus, it is easily seen that with regard to the business conducted by plaintiff corporation, with the exception of the first year of operation, the plastics business proved to be quite a successful venture.*fn4 It did have, therefore, a relatively high debt to equity ratio during the years in question since plaintiff found it necessary to borrow funds to fulfill the increasing needs for capital to meet the demands of expansion. Nevertheless, plaintiff made no actual distributions with respect to its common stock during its fiscal years ending 1958 through 1961. In fiscal year 1962, however, plaintiff distributed a total of $40,000 and in fiscal year 1963 the aggregate amount of $36,000 was distributed. It appears that a primary reason for such distributions was to enable the shareholders to meet their tax obligations brought about as a result of plaintiff's timely election to be taxed pursuant to the provisions of Subchapter S of the Internal Revenue Code for its fiscal years ending in 1961, 1962 and 1963. It was this election, coupled with the existence of the described obligations of the corporation in favor of Elizabeth G. Berst and Sara Garnett, which raised the issue to be hereinafter discussed.
The foregoing facts, taken almost verbatim from the lower court's opinion of Judge Doyle, supra, led to the conclusion by Judge Doyle that the obligations in question were not actually evidences of a debt owing by the corporation but were more closely akin to evidences of equity in the corporation. He reached this conclusion by applying the facts of this case to the established criteria in the tax law which are used to determine whether an instrument purporting to represent debt is in reality an instrument representing equity in the corporation. By using those standards Judge Doyle found that the instruments in question constituted "contributions to capital" rather than representing "loans" to the corporation. He went on to hold, however, that even though these instruments were evidence of contributions to capital, they did not constitute a second class of stock within the meaning of section 1371(a) (4). In our opinion, Judge Doyle applied the proper criteria and reached the correct conclusion that the instruments in question were evidence of contributions to capital and, therefore, we have no dispute with that portion of his opinion and findings. Indeed, as we shall indicate hereafter, we are thoroughly in favor of using the approach taken by Judge Doyle in determining the question of whether an advance is a loan or a contribution to capital. We would not hesitate, however, to add that having decided the instruments were not evidences of a loan to the corporation they must be some kind of evidence of equity in the corporation and not merely "contributions to capital," where the circumstances warrant such a conclusion. In other words, we would not be reluctant to call these instruments "stock" as that is the term commonly used to designate an instrument which represents an interest in the equity of a corporation. This is especially true where the contributors do not hold any other instruments as evidence of an interest in the equity of the corporation. Having made such a designation we would then go on to consider whether the "stock," as reclassified, was a second class of stock within the meaning of section 1371(a) (4), just as Judge Doyle did. However, at this juncture we would differ with the lower court since it is our opinion that once the initial judicial determination has been made, the law, as set forth by section 1371(a) (4) and Treasury Regulation § 1.1371-1(g) answers the second question. In other words, we are of the opinion that there is no such thing as "non-stock equity," the creature of a conclusion that the evidences of a capital contribution are not stock, and, furthermore, we are of the opinion that Regulation § 1.1371-1(g) is a reasonable and consistent interpretation of section 1371(a) (4) when used properly. In this case the regulation in question, in our opinion, should have been followed since the lower court used relevant standards, for purposes of section 1371(a) (4), in determination of the true nature of the advances.
The lower court noted in its discussion of the advances to the plaintiff that the question of whether they represent debt or equity is essentially one of fact, 301 F. Supp. at 688. It was concluded from that assumption that "the burden is upon the taxpayer to establish that the advances constitute loans," supra at 688-689, citing Sherwood Memorial Gardens, Inc. v. Commissioner of Internal Revenue, 350 F.2d 225, 228 (7th Cir. 1965); Arlington Park Jockey Club, Inc. v. Sauber, 262 F.2d 902, 905 (7th Cir. 1959). Therefore, adhering to the previous position taken by this circuit, we must be governed by the "clearly erroneous" rule when reviewing this portion ...