Fin Hay Realty Co. v. United States

398 F.2d 694, 22 A.F.T.R.2d (RIA) 5004, 1968 U.S. App. LEXIS 6435

• Court: Court of Appeals for the Third Circuit
• Decided: June 20, 1968
• Docket: 16582
• Status: Published

Opinions

OPINION OF THE COURT

FREEDMAN, Circuit Judge.

We are presented in this case with the recurrent problem whether funds paid to a close corporation by its shareholders were additional contributions to capital or loans on which the corporation’s payment of interest was deductible under § 163 of the Internal Revenue Code of 1954.¹

The problem necessarily calls for an evaluation of the facts, which we therefore detail.

Fin Hay Realty Co., the taxpayer, was organized on February 14, 1934,² by Frank L. Finlaw and J. Louis Hay. Each of them contributed $10,000 for which he received one-half of the corporation’s stock and at the same time each advanced an additional $15,000 for which the corporation issued to him its unsecured promissory note payable on demand and bearing interest at the rate of six per cent per annum. The corporation immediately purchased an apartment house in Newark, New Jersey, for $39,000 in cash. About a month later the two shareholders each advanced an additional $35,000 to the corporation in return for six per cent demand promissory notes and next day the corporation purchased two apartment buildings in East Orange, New Jersey, for which it paid $75,000 in cash and gave the seller a six per cent, five year purchase money mortgage for the balance of $100,000.

Three years later, in October, 1937, the corporation created a new mortgage on all three properties and from the proceeds paid off the old mortgage on the East Orange property, which had been partially amortized. The new mortgage was for a five year term in the amount of $82,000 with interest at four and one-half per cent. In the following three years each of the shareholders advanced an additional $3,000 to the corporation, bringing the total advanced -by each shareholder to $53,000, in addition to their acknowledged stock subscriptions of $10,000 each.

Finlaw died in 1941 and his stock and notes passed to his two daughters in equal shares. A year later the mortgage, which was about to fall due, was extended for a further period of five years with interest at four per cent. From the record it appears that it was subsequently extended until 1951.³ In 1949 Hay died and in 1951 his executor requested the retirement of his stock and the payment of his notes. The corporation thereupon refinanced its real estate for $125,000 and sold one of the buildings. With the net proceeds it paid Hay’s estate $24,000 in redemption of his stock and $53,000 in retirement of his notes.⁴ Finlaw’s daughters then became and still remain the sole shareholders of the corporation.⁵

Thereafter the corporation continued to pay and deduct interest on Finlaw’s notes, now held by his two daughters. In 1962 the Internal Revenue Service for the first time declared the payments on the notes not allowable as interest deductions and disallowed them for the tax years 1959 and 1960. The corporation thereupon repaid a total of $6,000 on account of the outstanding notes and in the following year after refinancing the mortgage on its real estate repaid the balance of $47,000. A short time later the Internal Revenue Service disallowed the interest deductions for the years 1961 and 1962. When the corporation failed to obtain refunds it brought this refund action in the district court. After a nonjury trial the court denied the claims and entered judgment for the United States. 261 F.Supp. 823 (D.N. J.1967), From this judgment the corporation appeals.

This case arose in a factual setting where it is the corporation which is the party concerned that its obligations be deemed to represent a debt and not a stock interest. In the long run in cases of this kind it is also important to the shareholder that his advance be deemed a loan rather than a capital contribution, for in such a case his receipt of repayment may be treated as the retirement of a loan rather than a taxable dividend.⁶ There are other instances in which it is in the shareholder’s interest that his advance to the corporation be considered a debt rather than an increase in his equity. A loss resulting from the worthlessness of stock is a capital loss under § 165(g), whereas a bad debt may be treated as an ordinary loss if it qualifies as a business bad debt under § 166. Similarly, it is only if a taxpayer receives debt obligations of a controlled corporation ⁷ that he can avoid the provision for nonrecognition of gains or losses on transfers of property to such a corporation under § 351.⁸ These advantages in having the funds entrusted to a corporation treated as corporate obligations instead of contributions to capital have required the courts to look beyond the literal terms in which the parties have cast the transaction in order to determine its substantive nature.

In attempting to deal with this problem courts and commentators have isolated a number of criteria by which to judge the true nature of an investment which is in form a debt: (1) the intent" of the parties; (2) the identity between creditors and shareholders; (3) the extent of participation in management by the holder of the instrument; (4) the ability of the corporation to obtain funds from outside sources; (5) the “thinness” of the capital structure in relation to debt; (6) the risk involved; (7) the formal indicia of the arrangement; (8) the relative position of the obligees as to other creditors regarding the payment of interest and principal; (9) the voting power of the holder of the instrument; (10) the provision of a fixed rate of interest; (11) a contingency on the obligation to repay; (12) the source of the interest payments; (13) the presence or absence of a fixed maturity date; (14) a provision for redemption by the corporation; (15) a provision for redemption at the option of the holder; and (16) the timing of the advance with reference to the organization of the corporation.⁹ __

While the Internal Revenue Code of 1954 was under consideration, and after its adoption, Congress sought to identify the criteria which would determine whether an investment represents a debt or equity, but these and similar efforts have not found acceptance.¹⁰ It still remains true that neither any single criterion nor any series of criteria can provide a conclusive answer in the kaleidoscopic circumstances which individual cases present. See John Kelley Co. v. Commissioner of Internal Revenue, 326 U.S. 521, 530, 66 S.Ct. 299, 90 L.Ed. 278 (1946).

The various factors which have been identified in the cases are only aids in answering the ultimate question whether the. investment, analyzed in terms of its economic reality, constitutes risk capital entirely subject to the fortunes of the corporate venture or represents a strict debtor-creditor relationship.¹¹ Since there is often an element of risk in a loan, just as there is an element of risk in an equity interest, the conflicting elements do not end at a clear line in all cases.

In a corporation which has numerous shareholders with varying interests, the arm’s-length relationship between the corporation and a shareholder who supplies funds to it inevitably results in a transaction whose form mirrors its substance. Where the corporation is closely held, however, and the same persons oc-both sides of the bargaining table, form does not necessarily correspond to the intrinsic economic nature of the transaction, for the parties may mold it at their will with no countervailing pull. This is particularly so where a shareholder can have the funds he advances to a corporation treáted as corporate obligations instead of contributions to capital without affecting his proportionate)/ equity interest. Labels, which are perhaps the best expression of the subjective intention of parties to a transaction, thus lose their meaningfulness.

To seek economic reality in objective terms of course disregards the personal interest which a shareholder may have in the welfare of the corporation in which he is a dominant force. But an objective standard is one imposed by the very fact of his dominant position and is much fairer than one which would presumptively construe all such transactions against the shareholder’s interest. Under an objective test of economic reality it is useful to compare the form which a similar transaction would have taken had it been between the corporation and an outside lender, and if the sharehold-v er’s advance is far more speculative than what an outsider would make, it is obviously a loan in name only.

In the present case all the formal indicia of an obligation were meticulously made to appear. The corporation, however, was the complete creature of the two shareholders who had the power to create whatever appearance would be of tax benefit to them despite the economic reality of the transaction. Each shareholder owned an equal proportion of stock and was making an equal additional contribution, so that whether Finlaw and Hay designated any part of their additional contributions as debt or as stock would not dilute their proportionate equity interests. There was no restriction because of the possible excessive debt structure, for the corporation had been created to acquire real estate and had no outside creditors except mortgagees who, of course, would have no concern for general creditors because they had priority in the security of the real estate. The position of the mortgagees also rendered of no significance the ^possible subordination of the notes to other debts of the corporation, a matter which in some cases this Court has deemed significant.¹²

The shareholders here, moreover, lacked one of the principal advantages of creditors. Although the corporation issued demand notes for the advances, nevertheless, as the court below found, it could not have repaid them for a number of years. The economic reality was that the corporation used the proceeds of the notes to purchase its original assets,¹³ and the advances represented a long term commitment dependent on the future value of the real estate and the ability of the corporation to sell or refinance it. Only because such an entwining of interest existed between the two shareholders and the corporation, so different from the arm’s-length relationship between a corporation and an outside creditor, were they willing to invest in the notes and allow them to go unpaid for so many years while the corporation continued to enjoy the advantages of uninterrupted ownership of its real estate.

It is true that real estate values rose steadily with a consequent improvement in the mortgage market, so that looking back the investment now appears to have been a good one. As events unfolded, the corporation reached a point at which it could have repaid the notes through refinancing, but this does not obliterate the uncontradicted testimony that in 1934 it was impossible to obtain any outside mortgage financing for real estate of this kind except through the device of a purchase money mortgage taken back by the seller.

It is argued that the rate of interest at six per cent per annum was far more than the shareholders could have obtained from other investments. This argument, however, is self-defeating, for it implies that the shareholders would damage their own corporation by an overcharge for interest. There was, moreover, enough objective evidence to neutralize this contention. The outside mortgage obtained at the time the corporation purchased the East Orange property bore interest at the rate of six per cent even though the mortgagee was protected by an equity in excess of forty per cent of the value of the property.¹⁴ In any event, to compare the six per cent interest rate of the notes with other 1934 rates ignores the most salient feature of the notes — their risk. It is difficult to escape the inference that a prudent outside businessman would not have risked his capital in six per cent unsecured demand notes in Fin Hay Realty Co. in 1934. The evidence therefore amply justifies the conclusion of the district court that the form which the parties gave to their transaction did not match its economic reality.

It is argued that even if the advances may be deemed to have been contributions to capital when they were originally made in 1934, a decisive change occurred when the original shareholder, Finlaw, died and his heirs continued to hold the notes without demanding payment. This, it is said could be construed as a decision to reinvest, and if by 1941 the notes were sufficiently secure to be considered bona fide debt, they should now be so treated for tax purposes. Such a conclusion, however, does not inevitably follow. Indeed, the weight of the circumstances leads to the opposite conclusion.

First, there is nothing in the record to indicate that the corporation could have readily raised the cash with which to pay off Finlaw’s notes on his death in 1941. When Hay, the other shareholder, died in 1949 and his executor two years later requested the retirement of his interest, the corporation in order to carry this out sold one of its properties and refinanced the others. Again, when in 1963 the corporation paid off the notes held by Finlaw’s daughters after the Internal Revenue Service had disallowed the interest deductions for 1961 and 1962 it again refinanced its real estate. There is nothing in the record which would sustain a finding that the corporation could have readily undertaken a similar financing in 1941, when Finlaw died even if we assume that the corporation was able to undertake the appropriate refinancing ten years later to liquidate Hay’s interest. Moreover, there was no objective evidence to indicate that in 1941 Finlaw’s daughters viewed the notes as changed in character or in security, or indeed that they viewed the stock and notes as separate and distinct investments. To indulge in a theoretical conversion of equity contributions into a debt obligation in 1941 when Finlaw died would be to ignore what such a conversion might have entailed. For Fin-law’s estate might then have been chargeable with the receipt of dividends at the time the equity was redeemed and converted into a debt. To recognize retrospectively such a change in the character of the obligation would be to assume a conclusion with consequences unfavorable to the parties, which they themselves never acknowledged.

The burden was on the taxpayer to prove that the determination by the Internal Revenue Service that the advances represented capital contributions was incorrect.¹⁵ The district court was justified in holding that the taxpayer had not met this burden.

The judgment of the district court will be affirmed.

1 . Section 163(a) provides: “There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.”

2 . The formal date of incorporation was March 1, 1934.

3 . The corporation’s tax returns show a continuing decline in the principal of the debt until that year.

4 . The record is fragmentary and provides no clear basis from which to reconstruct the events of 1951. It may perhaps be inferred from it that Hay’s estate received tlie total of $77,000 solely for the redemption of his stock and that the notes of $53,000 were retired either from the proceeds of the sale of real estate or in some other manner during the same year. In such event the total paid in redemption of Hay’s stock and the retirement of his notes would be $130,000 rather than $77,000.

5 . The husband of one of the daughters, who is a director of the corporation, holds a single qualifying share and his wife holds one share less than her sister.

6 . The partial retirement of an equity interest may be considered as essentially equivalent to a dividend under § 302, while the repayment of even a debt whose principal has appreciated is taxed only as a capital gain under § 1232.

7 . While not all debt obligations qualify for the desired tax treatment, equity interests can never qualify.

8 . A taxpayer might wish to avoid § 351 when he transfers depreciated property to the corporation and seeks to recognize the loss immediately and also when the transferred property is to be resold by the corporation but will not qualify for capital gains treatment in the hands of the corporation.

9 . See J. S. Biritz Construction Co. v. Commissioner of Internal Revenue, 387 F.2d 451 (8 Cir. 1967); Tomlinson v. 1661 Corporation, 377 F.2d 291 (5 Cir. 1967) ; Smith v. Commissioner of Internal Revenue, 370 F.2d 178 (6 Cir. 1966) ; Gilbert v. Commissioner of Internal Revenue, 262 F.2d 512 (2 Cir. 1959) ; 4A Mertens, Law of Federal Income Taxation, §§ 26.10a, 26.10c (1966).

10 . The original House version of the 1954 Code, H.R. 8300, 83d Cong., 2d Sess., contained a provision, § 312, which distinguished between “securities”, “participating stock”, and “nonparticipating stock”. Only payments with regard to “securities” were deductible by the corporation as interest. See proposed § 275. “Securities” were defined as unconditional obligations to pay a sum certain with an unconditional interest requirement not dependent on corporate earnings. The Senate rejected the proposed classification on the ground that it was inflexible. See S.Rep. No. 1622, 83d Cong., 2d Sess., 1954 U.S.C.Cong. & Admin.News, pp. 4621, 4673.

A similar list of determinants was proposed in 1957 by an advisory group to a subcommittee of the House Committee on Ways and Means, but was not acted upon.

In 1954 the American Law Institute embodied such a test in § x500 of its draft income tax statute. See ALI Federal Tax Project, Income Tax Problems of Corporations and Shareholders 396 (1958).

11 . See Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders, § 4.04, at 127 (2d ed. 1966); Stone, Debt-Equity Distinctions in the Tax Treatment of the Corporation and Its Shareholders, 42 Tulane L.Rev. 251, 253-62 (1968).

12 . See P. M. Finance Corp. v. Commissioner of Internal Revenue, 302 F.2d 786 (3 Cir. 1962); General Alloy Casting Co. v. Commissioner of Internal Revenue, 345 F.2d 794 (3 Cir. 1965), aff’g per curiam 23 CCH T.C.Mem. 887 (1964).

13 . See United States v. Henderson, 375 F.2d 36, 40 (5 Cir. 1967).

14 . The corporation purchased the property for $175,000 and the sellers took back a purchase money mortgage of $100,000.

15 . See P. M. Finance Corp. v. Commissioner of Internal Revenue, 302 F.2d 786, 789 (3 Cir. 1962).