Appeal from the United States District Court for the Eastern District of Wisconsin. No. 93 C 287 -- Robert W. Warren, Judge.
Before POSNER, Chief Judge, and EASTERBROOK and KANNE, Circuit Judges.
Appeal from the United States Tax Court.
Subchapter S of the Internal Revenue Code entitles certain corporations to elect to be taxed almost (though not quite: see 26 U.S.C. sec. 1371(a)(1), and compare 26 U.S.C. sec. 731 with 26 U.S.C. sec. 311(b)) as if they were partnerships. The Subchapter S corporation's profits and losses flow through to the shareholders and are reported on their individual income tax returns, 26 U.S.C. sec. 1366, thus avoiding double taxation of corporate earnings. The election, however, requires the consent of all persons who are shareholders on the date of the election, 26 U.S.C. sec. 1362(a)(2), which in the case of Cabintaxi Corporation was November 11, 1983. An extension of time for making the election is possible if the original election failed because a shareholder had not consented, Treas. Reg. sec. 1.1362-6(b)(3)(iii) (superseding Treas. Reg. sec. 1.1372-3(c), which was in force back in 1983); Kean v. Commissioner, 469 F.2d 1183, 1188-89 (9th Cir. 1972), but Cabintaxi did not get around to asking for the extension until 1995. The Internal Revenue Service refused to grant it, both because of the eleven-year delay in asking for it and because in the interim Cabintaxi had acquired foreign shareholders, making it ineligible for Subchapter S status. 26 U.S.C. sec. 1361(b)(1)(C). This would not matter if -- this is the first issue in the case -- Cabintaxi acquired that status back in 1983, for it had no foreign shareholders either then or, later, when it incurred the losses that it seeks to pass through to its shareholders. The validity of the denial of the requested extension is not before us.
The Tax Court, finding the requirement of unanimous consent not satisfied, refused to allow Cabintaxi to pass through to its four shareholders the $17,000 loss that it sustained in 1984 and the $19,000 loss that it sustained the following year. Only one of the four had signed the consent form by the election date. Nor would the court allow Cabintaxi to deduct these losses on its own income tax return, because the court found that Cabintaxi had not been engaged in a trade or business during those two years. 68 T.C.M. (CCH) 49 (T.C. 1994). Cabintaxi challenges both rulings, although the second is germane only if the first is upheld -- and even if it is, might appear to be moot because Cabintaxi has never had a profit from which to deduct a loss. Business losses can be carried forward for up to 15 years, however, 26 U.S.C. sec. 172(b)(1) (A)(ii), so the possibility of Cabintaxi's deducting losses that it incurred in 1984 and 1985 will not expire until 1999 and 2000, and Cabintaxi may have some profits by then from which to deduct the losses, or be able to use the losses in a merger. 26 U.S.C. secs. 381(a), (c)(1).
The facts relating to the Subchapter S election are simple and uncontested. On August 13, 1983, Cabintaxi had just one shareholder, its founder Lamkin, who owned 5,000 shares, and two directors, Lamkin and the corporation's "tax matters person," petitioner Elder. (A "tax matters person," the Subchapter S corporation's counterpart to a partnership's "tax matters partner," 26 U.S.C. sec. 6231(a)(7), represents the corporation in its dealings with the Internal Revenue Service. See Temp. Treas. Reg. sec. 301.6224(c)- 2T(b)(3) (1987).) The board of directors was enlarged two days later by the addition of two individuals who (along with Lamkin and Elder) wanted to invest in Cabintaxi. The new board voted to issue 145,000 additional shares of stock, at a price of 10? per share, to the four directors -- 43,750 shares to Lamkin, 48,750 to Irving, 37,500 to Doyle, and 15,000 to Elder. There were no written subscription agreements, merely oral understandings that the four investors would pay for the stock as they were able. Irving paid $3,250 of the $4,875 due from him before the election, which was November 11, 1983. The other three also paid some part of the money they owed for their stock by then, though how much the record does not show. No stock certificates were issued to any of the investors, however, other than Lamkin, until March 1, 1984, which was after the election. Until then Lamkin was the only shareholder who had a stock certificate and also the only shareholder listed in the records of the corporation. And he was the only shareholder to sign the form electing Subchapter S status.
Although the Tax Court's analysis of whether Lamkin was the only shareholder on the date of the election (in which event the Subchapter S election was valid) is disjointed and, as we are about to see, startlingly incomplete, the court made one sound point. Because Subchapter S enables a shareholder to deduct corporate expenses (including losses) against his personal income (including his share of any corporate income), the question whether a person was a shareholder on the date of the election to be taxed under Subchapter S is equivalent to the question whether, had there been a valid election, he would have been required to report as personal income profits earned by the corporation on that date. Treas. Reg. sec. 1.1371-1(d)(1) (as amended in 1983); Kean v. Commissioner, supra, 469 F.2d at 1187; Wilson v. Commissioner, 560 F.2d 687, 689 (5th Cir. 1977). This in turn depends on whether he would have been deemed a beneficial owner of shares in the corporation, entitled therefore to demand from the nominal owner the dividends or any other distributions of earnings on those shares. Speca v. Commissioner, 630 F.2d 554, 557 (7th Cir. 1980); Wilson v. Commissioner, supra, 560 F.2d at 689; Willie v. Commissioner, 61 T.C.M. (CCH) 2475, 2480-81 (T.C. 1991); Hume v. Commissioner, 56 T.C.M. (CCH) 290, 293 (T.C. 1988) aff'd without opinion, 899 F.2d 1225 (9th Cir. 1990). Concretely in this case, it depends on whether, had Cabintaxi shown a profit on November 11, 1983, the three investors (besides Lamkin), each of whom had paid some but not all of the purchase price of his stock, would have had an interest in that profit as earnings on shares beneficially owned by them. If so, they were shareholders and their failure to sign the election form means that Cabintaxi did not become a Subchapter S corporation.
Whether the three investors were beneficial owners of shares in Cabintaxi depends in the first instance on the wording of the agreement between the investors and Cabintaxi, and in the second on state contract and corporate law, which might constrain the agreement, or fill gaps in it, or do both. For, although the meaning of "shareholder" for purposes of Subchapter S election has been said to be a matter of federal law rather than of state law, Kean v. Commissioner, supra, 469 F.2d at 1186, this means only that it is federal law which determines which kind of shareholder -- namely, beneficial rather than record -- is required to elect in order for the corporation to achieve Subchapter S status. Whether a particular investor was a shareholder of that kind -- in this case was a beneficial shareholder of Cabintaxi on the date of the election -- is an issue of state law. United States v. National Bank of Commerce, 472 U.S. 713, 722 (1985); Aquilino v. United States, 363 U.S. 509, 513 (1960); United States v. Denlinger, 982 F.2d 233, 235 (7th Cir. 1992). It is true that a case decided by this court many years ago, HFG Co. v. Pioneer Publishing Co., 162 F.2d 536 (7th Cir. 1947), held that whether the beneficial owner of shares is a "shareholder" is a question of federal law; but the question arose in the context of the right to maintain a derivative suit. The court treated it as a procedural question, to be decided by interpretation of Fed. R. Civ. P. 23(b) (now 23.1). Whether this approach was correct or not (it was not, see Kamen v. Kemper Financial Services, Inc., 500 U.S. 90, 96-97 (1991); 7C Charles Alan Wright, Arthur R. Miller & Mary Kay Kane, Federal Practice and Procedure sec. 1826, pp. 43-45 (2d ed. 1986)), it has no bearing on whether the question should be treated as one of state law when the issue is whether someone is a beneficial owner for purposes of Subchapter S status rather than for the purpose of being allowed to bring a derivative suit. In light of the Supreme Court cases that we have cited, the answer is very plainly "yes."
On the issue of what the agreement between Cabintaxi and the investors meant, whether as a matter of simple interpretation or as a matter of contract or corporate law, the trial record, the Tax Court's decision, and the briefs and oral arguments of the parties are essentially a blank. The corporate resolution authorizing the issuance of the 145,000 new shares says nothing about the terms of payment. It does say that when all of the shares have been issued they "shall be fully paid and nonassessable," but all that this boilerplate means is that once they are paid for in full the shareholder (unlike a partner) will not be subject to a demand for additional capital (a capital call), should the corporation need more capital. 13A Fletcher Cyclopedia of the Law of Private Corporations sec. 6589 (permanent ed., Cora M Thompson ed. 1984).
Since the shares were priced at only 10? apiece, one might suppose that on election day each of the three latter-day investors owned as many shares as the number of dollars he had paid, multiplied by ten. Alternatively, however, one might suppose that the parties agreed that until the shares were paid for in full none of the investors (except Lamkin of course) would be entitled to any dividends or other distribution of profits. Presumably, until these investors were paid up any profits of the corporation were unlikely to have reflected their contributions, since there is an interval between investing capital and reaping a profit from the activity made possible by the investment.
The record is silent on the terms of the oral understanding that authorized and defined the installment method of paying for the shares; nor have the parties informed us of any pertinent gap-filling provisions of state corporate or contract law. Our own research has turned up a provision of Delaware law that authorizes a Delaware corporation (which Cabintaxi is) to issue shares when they have been only partly paid for, and if the corporation subsequently declares a dividend the owners of these shares receive the same fraction of the dividend as the fraction of the purchase price that they have already paid. Del. Code, tit. 8, sec. 156. But the issue here is not issuance. That did not occur until March 1, when the share certificates were actually delivered to the three new investors. Graham v. Commercial Credit Co., 200 A.2d 828, 830 (Del. 1964); Smith v. Universal Service Motors Co., 147 Atl. 247 (Del. Ch. 1929). Delaware law is clear that status as a shareholder does not depend on the issuance of a certificate of stock, since the certificate is merely evidence of ownership. Id.; cf. Richardson v. Shaw, 209 U.S. 365, 378 (1908); Lucas v. Lucas, 946 F.2d 1318, 1323 (8th Cir. 1991).
Two Delaware cases do hold that dividends are not earned on stock prior to its issuance; but the cases are readily distinguishable from our case. In Holland v. National Automotive Fibres, Inc., 194 Atl. 124, 126 (Del. Ch. 1937), preferred shareholders had a right to convert their preferred stock to common stock, and the question was whether, until they converted, they were entitled to the dividends on the common stock -- along with the dividends they were continuing to receive on the preferred stock because it had not yet been converted. Of course the answer was no. In Blandin v. United North & South Development Co., 134 A.2d 706, 707-08 (Del. 1957), the issue was not conversion, but merely the entitlement of a preferred shareholder to dividends for the period before the preferred stock had been issued (though after it had been authorized). The court was concerned that if ...