Estate of Leavitt v. Commissioner

Fay, J., dissenting: The majority opinion holds that petitioners’ guarantees do not increase the amount of their section 1374(c)(2) limitations. The majority opinion errs by not recognizing the applicability of traditional debt-equity principles in determining the Federal tax effect of petitioners’ guarantees and by not recognizing the existence and presence of the type of economic outlay proven by petitioners. Before addressing these errors, I will first discuss the distinctions between section 1374(c)(2)(A) and section 1374(c)(2)(B), distinctions which the majority does not fully address.

The portion of the net operating loss of an electing small business corporation which may be deducted by a shareholder is limited to the sum of the amount determined in section 1374(c)(2)(A) and the amount determined in section 1374(c)(2)(B). Section 1374(c)(2)(A) pertains to the adjusted basis in stock of the electing small business corporation. Section 1374(c)(2)(B) pertains to the adjusted basis of any indebtedness of the electing smaill business corporation to the shareholder.

Though petitioners clearly and specifically argue that section 1374(c)(2)(B) is not applicable here, the majority opinion begins its legal analysis by quoting from Raynor v. Commissioner, 50 T.C. 762, 770-771 (1968):

No form of indirect borrowing, be it guaranty, surety, accommodation, comaking or otherwise, gives rise to indebtedness from the corporation to the shareholders until and unless the shareholders pay part or all of the obligation. [ 50 T.C. at 770-771 . Emphasis added.]

Majority opinion at p. 211. I fully agree with this settled statement of the law, but view it as irrelevant to the issue presented. Petitioners are not arguing that their guarantees increased the amount of “any indebtedness of the corporation to the shareholder,” as used in section 1374(c)(2)(B) and interpreted in Raynor v. Commissioner, supra. Rather, petitioners contend that since the Bank of Virginia looked primarily to petitioners and the other shareholder/guarantors, not VAFLA, for repayment of the $300,000, in substance petitioners and the other shareholder/guarantors borrowed the $300,000 from the Bank of Virginia and made a capital contribution of such amount to VAFLA. Accordingly, petitioners are arguing that they are entitled to an increase in their “adjusted basis * * * of the shareholder’s stock in the electing small business corporation” as used in section 1374(c)(2)(A).

That the majority did not recognize the distinctions between section 1374(c)(2)(A) and section 1374(c)(2)(B) is illustrated by the majority’s quote from Borg v. Commissioner, 50 T.C. 257, 263 (1968), and the conclusion drawn therefrom. The majority opinion quotes a passage from Borg, the final sentence of which is:

Since the services performed by petitioner Joe E. Borg had no cost within the meaning of section 1012, his notes for unpaid salary had a basis of zero and, therefore, added nothing to the adjusted basis for indebtedness for the purpose of computing the section 1374(c)(2) limitation on net operating loss deductions, [50 T.C. at 263. Emphasis added.]

Majority opinion at p. 213. From this quote, which is no more relevant to the issue presented than the quote from Raynor v. Commissioner, supra, the majority makes the quantum leap without explanation, to the conclusion that:

Without capital outlay or a realization of income, as required by Borg, petitioners cannot increase their adjusted basis in their stock in the corporation. [Majority opinion at p. 213. Emphasis added.]

The majority, by not recognizing the distinctions between section 1374(c)(2)(A) and section 1374(c)(2)(B), was prevented from weeding out irrelevant cases and properly focusing on the issue presented. Further, petitioners herein have recognized, as has this Court, that shareholder-guaranteed corporate debt cannot be characterized as an indebtedness of the corporation to the shareholder. 1 I will now address the errors of the majority opinion.

I. Debt-equity principles are applicable in determining whether a shareholder-guaranteed corporate debt should be characterized as a capital contribution.

That a shareholder-guaranteed corporate debt can be characterized for Federal tax purposes as a capital contribution is hardly a novel legal theory. This legal theory has been considered in at least 20 opinions. 2 Almost invariably, these opinions consider traditional debt-equity principles in determining whether to characterize a guaranteed debt as a capital contribution. 3 Despite this heavy weight of authority, the majority opinion “decline[s] to adopt traditional debt-equity principles in this case.” Majority opinion at p. 215. The majority opinion bases its declination to apply traditional debt-equity principles on its erroneous interpretation of Blum, v. Commissioner, 59 T.C. 436 (1972), and on its unsound refusal to follow Selfe v. United States, 778 F.2d 769 (11th Cir. 1985).

The majority opinion states that in Blum—

[the Tax Court] declined to decide the issue as to the applicability of debt-equity principles because the taxpayer had failed his burden of proving that the bank in substance had loaned the funds to the taxpayer and not to the corporation. Blum v. Commissioner, 69 T.C. at 439, n. 4. [Majority opinion at p. 216.]

The majority opinion misstates the holding in Blum wherein the Court stated:

As we stated in Santa Anita Consolidated, Inc. [v. Commissioner, 50 T.C. 536, 550 (1968)], “Whether such debt [guaranteed debt] is to be treated as an indirect capital contribution must be resolved by an investigation of the facts in light of traditional debt-equity principles.” In the present fully stipulated case, after applying many of those traditional principles, we find that petitioner simply has not carried his burden of proof and has not convinced this Court that the guaranteed loans should properly be characterized as equity investments. [Blum v. Commissioner, supra at 439-440. Bracketed phrase, “guaranteed debt,” in original.]

Contrary to the majority opinion, the Tax Court did not decline to apply traditional debt-equity principles because the taxpayer failed in his burden of proof, but rather applied traditional debt-equity principles to determine that the taxpayer failed in his burden of proof. The distinction is more than merely semantical. As will be seen below, petitioners herein have carried their burden of proof. Accordingly, a proper interpretation of Blum and a proper application of traditional debt-equity principles, as mandated by Blum, would lead to a result contrary to the result reached by the majority. 4

In Selfe v. United States, supra, the 11th Circuit held that traditional debt-equity principles are applicable in determining whether a shareholder-guaranteed subchapter-S corporate debt should be recharacterized as a capital contribution. 5 The majority disagreed with the 11th Circuit and refused to follow Selfe because Selfe relied on Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (5th Cir. 1972), affg. T.C. Memo. 1970-182 , and In re Lane, 742 F.2d 1311 (11th Cir. 1984).

Plantation Patterns held that corporate deductions for interest paid on shareholder-guaranteed corporate debts were improper and the principal payments 6 made on such debts were taxable income to the guaranteeing shareholder because such debts were in substance capital contributions. The majority opinion determined that Selfe’s reliance on Plantation Patterns is inappropriate because:

the corporation in Plantation Patterns was a subchapter C corporation. We decline to apply the debt-equity analysis used in Plantation Patterns to the guarantee of a loan to a subchapter S corporation. [Majority opinion at p. 216.]

This determination by the majority opinion not to apply subchapter C precedent to subchapter S corporations evinces a lack of understanding as to the purpose of applying traditional debt-equity principles to a given situation. Traditional debt-equity principles are applied to determine the substance of a transaction. After making such determination, the substance of the transaction, not the form, is evaluated for Federal income tax purposes. See Diedrich v. Commissioner, 457 U.S. 191, 195 (1982) (substance, not form, controls). Determining the substance of a transaction is the initial step in resolving a given issue and transcends the legal analysis. The substance of a particular transaction is fixed for that transaction. It does not vary depending upon the legal analysis to which it will be subjected. If a guarantee of a corporate debt is in substance a capital contribution, then it is a capital contribution regardless of whether the corporation is a subchapter S corporation or a subchapter C corporation. That the substance of the transaction transcends the legal analysis is illustrated in Plantation Patterns. Interest is deductible by subchapter C and subchapter S corporations. Sec. 163. The disallowance of the interest deduction in Plantation Patterns was independent of the corporation’s status as a subchapter C or subchapter S corporation. 7

The majority attempts to gain support by quoting the following passage from a Senate Finance Committee report:

The amount of the net operating loss apportioned to any shareholder * * * is limited under section 1374(c)(2) 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. [S. Rept. 1983, 85th Cong., 2d Sess. 220 (1958), 1958- 3 C.B. 922 , 1141. Emphasis added.]

See majority opinion at p. 217. Where the guaranteed loan is treated in substance as a capital contribution, the guaranteeing shareholder’s adjusted basis in the stock of the corporation will be increased, 8 and so would the shareholder’s “investment in the corporation,” as that phrase is used by the Senate Finance Committee. Accordingly, the Senate Finance Committee’s report could be read as an expression of congressional intent to allow an increase in the section 1374(c)(2) limitation where a shareholder-guaranteed corporate debt is in substance a capital contribution. Actually, though, the Senate Finance Committee report cannot fairly be read as an expression of congressional intent either to allow or disallow an increase in the amount of the section 1374(c)(2) limitation where a shareholder-guaranteed corporate debt is in substance a capital contribution.

Whatever sin was committed by the 11th Circuit in relying on subchapter C precedent in a subchapter S case, this Court has committed on innumerable occasions. 9 We have even stated, in Blum v. Commissioner, supra at 439:

regardless of the context in which a debt-equity determination arises, we can see no distinction in principle between the case before us [relating to a subchapter S corporation] and the numerous cases in the area which serve as judicial guideposts [relating to subchapter C corporations]. [Citation and fn. ref. omitted.]

Further, respondent is not here arguing that subchapter C precedent is inapplicable to subchapter S cases. It is unnecessary for the majority opinion to reach this issue, criticize the 11th Circuit for relying on subchapter C precedent in a subchapter S case, while ignoring the innumerable occasions in which this Court has done the same, and directly contradict language in our opinion in Blum, where neither party is asking the Court to do so. The 11th Circuit’s reliance on Plantation Patterns is not an appropriate basis for the majority to decline to follow Selfe.

The majority opinion also attempts to impugn Selfe for its reliance on In re Lane, supra. In that case, the taxpayer claimed a bad debt deduction for payments made pursuant to his guarantee of a loan made to a corporation in which he was a shareholder. 10 The 11th Circuit considered traditional debt-equity principles and concluded that as of the time of the guarantee, the taxpayer, not the corporation, was the true debtor and that the taxpayer had made a capital contribution of the loan proceeds to the corporation. In re Lane, supra at 1320 . Payments later made pursuant to the guarantee could not be considered bad debts. The 11th Circuit disallowed the claimed deductions. In re Lane, supra at 1320 .

The majority states,

In Lane, the shareholder had actually paid the amounts he had guaranteed and, therefore, the amounts he paid could be considered a capital contribution. [Majority opinion at p. 217. Emphasis added.]

It is true that the taxpayer in In re Lane had made payments pursuant to the guarantee. However, the holding in In re Lane, which was the basis of Selfe’s reliance on In re Lane, was that a shareholder-guaranteed corporate debt can, depending on an analysis of traditional debt-equity principles, be characterized as a capital contribution, and the analysis of whether the shareholder-guaranteed debt is to be so characterized is made as of the time of the guarantee, not at some later date, e.g., when payment is made pursuant to the guarantee. Accordingly, In re Lane was properly relied upon in Selfe. 11

The reasons advanced in the majority opinion for not following Selfe are not convincing. Selfe is on all fours, and its holding that traditional debt-equity principles are applicable in determining whether a shareholder-guaranteed corporate debt is in substance a capital contribution should be followed.

The majority, as stated earlier, decided not to apply traditional debt-equity principles to the issue presented. This decision was based on an erroneous interpretation of Blum and an unsound refusal to follow Selfe. Based on the opinions of this Court and the opinions of the First, Fifth, Ninth, and Eleventh Circuits, traditional debt-equity principles should be applied in determining whether a shareholder-guaranteed corporate debt should be characterized as a capital contribution.

In Santa Anita Consolidated, Inc. v. Commissioner, 50 T.C. 536, 550 (1968), and quoting Santa Anita Consolidated, Inc., in Blum v. Commissioner, supra at 439, and Smyers v. Commissioner, 57 T.C. 189, 198 (1971), we stated:

Whether [guaranteed] debt is to be treated as an indirect capital contribution must be resolved by an investigation of the facts in light of traditional debt-equity principles.

In Casco Bank & Trust Co. v. United States, 544 F.2d 528 (1st Cir. 1976), the First Circuit held, after applying traditional debt-equity principles, that a shareholder’s agreement to indemnify a bonding company that bonded the shareholder’s corporation was in substance a capital contribution. In Plantation Patterns, Inc. v. Commissioner, supra, the Fifth Circuit held, after applying traditional debt-equity principles, that a shareholder’s guarantee of a corporate debt was in substance a capital contribution. In Murphy Logging Co. v. United States, 378 F.2d 222 (9th Cir. 1967), the Ninth Circuit held, after applying traditional debt-equity principles, that a shareholder-guaranteed corporate debt was not in substance the shareholders’ debt. In In re Lane, supra, the 11th Circuit held, after applying traditional debt-equity principles, that a shareholder’s guarantee of a corporate debt was in substance a capital contribution. In Selfe v. United States, supra, the 11th Circuit held that debt-equity principles should be applied in determining whether a shareholder-guaranteed corporate debt should be characterized as a shareholder debt. 12 See also Kavich v. United States, 507 F. Supp 1339 (D. Neb. 1981); In re Breit, 460 F. Supp 873 (E.D. Va. 1978); Ackerson v. United States, 277 F. Supp 475 (W.D. Ky. 1967); and Fors Farms, Inc. v. Commissioner, an unreported case (W.D. Wash. 1966, 17 AFTR 2d 222, 66-1 USTC par. 9706 ). Other than the majority opinion, there exists, to my knowledge, no authority that refuses to apply traditional debt-equity principles in determining whether a shareholder-guaranteed corporate debt is in substance a capital contribution. 13

It is appropriate to consider traditional debt-equity factors in determining whether a shareholder-guaranteed corporate debt is in substance a capital contribution because such factors facilitate a determination of whether the funds advanced to a corporation were placed at the risk of the corporation’s business. In re Lane, supra at 1314 . Funds placed at the risk of the corporation’s business represent equity, not debt. Slappey Drive Ind. Park v. United States, 561 F.2d 572 (5th Cir. 1977). As a general rule, third-party creditors, such as the Bank of Virginia herein, seek a more reliable investment for the funds they advance and avoid placing such funds at the risk of a corporation’s business. Where such a third-party creditor makes a loan to a corporation, such loan is guaranteed by the corporation’s shareholders, and the proceeds of such loan are ultimately placed at the risk of the corporation’s business, the loan is properly treated as made by the third-party creditor to the shareholder/guarantors. As to the third-party creditor, the money lent is not at the risk of the corporation’s business because the third-party creditor looks to the guarantor for repayment. As to the shareholder/guarantor, the money is at the risk of the corporation’s business and is treated as an equity investment.

For the foregoing reasons, I believe that the majority inauspiciously erred in deciding not to apply traditional debt-equity principles to the issue presented.

II. Two types of economic outlay exist.

The majority opinion, citing Brown v. Commissioner, 706 F.2d 755 (6th Cir. 1983), affg. T.C. Memo 1981-608 , states that to increase the basis in the stock of a subchapter S corporation, there must be an economic outlay. Majority opinion at p. 212. I agree that economic outlay is required. However, because the majority did not determine the substance of the transaction by applying traditional debt equity factors, the majority did not discern the existence of a second type of economic outlay, the type that petitioners have proven to be present here.

The economic outlay requirement was born of the Supreme Court’s opinion in Putman v. Commissioner, 352 U.S. 82 (1956). See Perry v. Commissioner, 47 T.C. 159, 164 (1966). There, a shareholder had guaranteed a loan by a third-party creditor to the shareholder’s corporation. The shareholder was required by the third-party creditor to pay the corporation’s loan in accordance with the guarantee. The Supreme Court held that upon payment of the loan, the shareholder was subrogated to the third-party creditor’s rights, and the corporate debt to the third-party creditor was transformed into a corporate debt to the shareholder. The corporation was unable to pay its debt to the shareholder, and the Supreme Court held that the shareholder could deduct the amount paid pursuant to the guarantee as a bad debt but not as a loss incurred in a transaction entered into for profit.

The relevance of the Putnam opinion to the issue at hand is that, where a shareholder guarantees a loan to his corporation, the loan is not treated as indebtedness of the corporation to the shareholder until the shareholder pays the loan pursuant to the guarantee. Upon payment of the loan, the debt of the corporation to the third-party creditor instantly becomes a debt of the corporation to the shareholder. As such, the debt becomes an “indebtedness of the corporation to the shareholder” within the meaning of section 1374(c)(2)(B), and the amount of the shareholder’s section 1374(c)(2) limitation is thereby increased. The payment by the shareholder/guarantor of the debt is the type of economic outlay referred to in Brown v. Commissioner, supra. See also Raynor v. Commissioner, supra; Borg v. Commissioner, supra; and Perry v. Commissioner, 47 T.C. 159, 164 (1966).

The applicability of Putnam extends only so far as the debt is initially the debt of the corporation. See In re Lane, supra at 1319 ; Casco Bank & Trust Co. v. United States, 544 F.2d 528 (1st Cir. 1976); and Kavich v. United States, 507 F. Supp. 1339 (D. Neb. 1981). 14 In Putnam, the debt was the corporation’s debt prior to the payment by the shareholder. There was no allegation or suggestion that the debt was the shareholder’s prior to such time. For Federal tax purposes, where the debt is treated initially as the debt of the shareholder, payment of the debt by the shareholder will not result in a subrogation of creditors but rather will result in the extinguishment of the debt.

That is not to say that there can be no economic outlay, where the debt is initially treated as the shareholder/guarantor’s debt. In such a situation, the shareholder/guarantor’s deemed transfer of the loan proceeds to the corporation is the economic outlay. Selfe v. United States, supra. The economic outlay occurs upon the third-party creditor’s disbursement of the loan proceeds, which are deemed transferred from the third-party creditor to the shareholder/ guarantor to the corporation. Selfe v. United States, supra; In re Lane, supra. Thus, there are two types of economic outlay: the economic outlay, a la Putnam, where the debt is initially treated as a corporate debt, and the shareholder/ guarantor pays the debt pursuant to the guarantee; and the economic outlay, a la In re Lane, where the debt is initially treated as the shareholder’s debt, and the loan proceeds are deemed transferred from the third-party creditor to the shareholder to the corporation.

The majority assumed there to be but one type of economic outlay, economic outlay a la Putnam. Constrained by this erroneous assumption, the majority correctly concluded that petitioners faded to make an economic outlay (economic outlay, a la Putnam) because petitioners had not paid the loan nominally made by the Bank of Virginia to VAFLA. However, had the majority not been constrained to such erroneous assumption, the majority would have considered the existence of the second type of economic outlay, economic outlay a la In re Lane. The majority’s refusal to consider the existence and presence in this case of economic outlay, a la In re Lane, ultimately led the majority to reach the wrong result in this case.

III. Application of traditional debt-equity principles in the present case indicates that petitioners’ guarantee should be considered a capital contribution.

The traditional debt-equity factors include the following: (I) The label given the instrument; (2) the presence or absence of a fixed maturity date; (3) the source of payments thereon; (4) the right to enforce payment of principal and interest; (5) participation in management flowing as a result; (6) the status of the contribution in relation to other creditors; (7) the intent of the parties; (8) “thin” or inadequate capitalization; (9) identity of interest between creditors and stockholders; (10) source of interest payments; (II) the ability of the corporation to obtain loans from outside lending institutions; (12) the extent to which the advance was used to acquire capital assets, and (13) the failure of the debtor to repay on the due date or to seek a postponement. In re Lane, supra; Texas Farm Bureau v. United States, 725 F.2d 307, 311 (5th Cir. 1984); Estate of Mixon v. United States, 464 F.2d 394, 410 (5th Cir. 1972); Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968). 15 These various factors are not equally significant. “The object of the inquiry is not to count factors, but to evaluate them.” Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir. 1969).

At first blush, the transaction at issue has the outward appearance of a debt transaction — a guaranteed loan with scheduled repayments. However, other factors clearly indicate the equity nature of the transaction.

Although the Bank of Virginia was nominally to look to VAFLA for repayment of the $300,000 loan, it is apparent that the Bank of Virginia looked solely to the shareholder/guarantors for repayment. 16 The shareholder/guarantors executed the guarantees prior to the time the Bank of Virginia advanced the loan proceeds. Their aggregate net worth was 10 times the amount of the loan and the aggregate value of their quick assets was slightly greater than the amount of the loan. “The loan was approved only because of the financial strength of the guarantors.” Majority opinion at p. 209.

VAFLA’s financial condition at the time the loan was made illustrates why the Bank of Virginia based its approval solely on the guarantees of the shareholder/guarantors. VAFLA’s liabilities exceeded the value of its assets by $82,410.16. During its first 3 months of operations, it had lost $142,410.16. Its principal asset, and essentially its only asset, Six-Gun Park, was mortgaged to the previous owner of Six-Gun Park. The Bank of Virginia did not obtain a security interest in any of VAFLA’s assets nor did it obtain a pledge of VAFLA’s accounts receivable. The Bank of Virginia apparently viewed VAFLA’s financial condition and the preexisting mortgage as making such courses of action futile.

VAFLA’s financial statements as of September 30, 1979, less than 1 month after the Bank of Virginia advanced the $300,000, paint an even bleaker picture of VAFLA’s financial condition. During its first taxable year, a short year, VAFLA lost $345,370.20. It then had a negative net worth of $185,370.20. Its debt-to-equity ratio was over 10 to 1. Its current assets of $42,041.10 were greatly overshadowed by its current liabilities of $294,321.65. VAFLA was a thinly capitalized corporation. See Plantation Patterns, Inc. v. Commissioner, supra at 722.

VAFLA could not have borrowed money from a third-party creditor such as the Bank of Virginia without outside support, such as guarantors. A portion of the $300,000 loan proceeds, at least $162,736.83, 17 was used to acquire capital assets or used to reduce the outstanding balance of indebtedness incurred to acquire capital assets. See Plantation Patterns, Inc. v. Commissioner, supra at 722. (“Of critical importance in determining whether financial input is debt or equity is whether or not the money is expended for capital assets.”) I consider the expenditure of funds to reduce debt incurred to acquire capital assets to be tantamount to expending such funds to acquire capital assets, particularly where, as here, there is only a short period of time between incurring debt to acquire capital assets and reducing such debt with other borrowings.

During the years in issue, VAFLA made principal payments on the $300,000 loan and all of the interest payments. The shareholder/guarantors made no payments of principal or interest on the $300,000 loan. I do not consider this factor to be indicative of a true debt transaction. “The transaction must be judged on the conditions that existed when the deal was consummated, and not on conditions as they developed with the passage of time.” Plantation Patterns, Inc. v. Commissioner, supra at 723. Citations omitted. At any rate, VAFLA was able to make the principal and interest payments only as a result of $800,000 of loans and shareholder contributions. 18

Not all of VAFLA’s shareholders guaranteed the $300,000 loan. However, shareholders other than petitioners, both guarantors of the $300,000 loan, advanced $800,000 to VAFLA as loans and capital contributions. 19 The $800,000 received from other shareholders may have made the totals of each of the shareholders’ loans and capital contributions to VAFLA proportionate to their stockholdings in VAFLA.

The Bank of Virginia’s approval of the $300,000 loan was based solely on the guarantees of the shareholder/guarantors. The financial health of the shareholder/guarantors, vigorous, and VAFLA, feeble, indicates that the Bank of Virginia prudently and appropriately looked solely to the shareholder/guarantors for repayment. “Under the principles of Plantation Patterns, a shareholder guarantee of a loan may be treated for tax purposes as an equity investment in the corporation where the lender looks to the shareholder as the primary obligor. Essential to the Plantation Patterns court’s analysis was that the notes guaranteed by the shareholder were issued by a thinly capitalized corporation and had more equity characteristics than debt.” Selfe v. United States, supra at 774. VAFLA was thinly capitalized. More than half of the $300,000 was used to acquire capital assets or to reduce the outstanding balance of indebtedness used to acquire capital assets. VAFLA could not have borrowed money from a third-party creditor such as the Bank of Virginia without outside support, such as guarantors. Payments on the $300,000 loan were made from funds provided by shareholders. I would hold that the Bank of Virginia in substance lent the $300,000 to the shareholder/guarantors who made a capital contribution thereof to VAFLA. 20 As a result, petitioners herein, two of the shareholder/guarantors, should be entitled to an increase in the amount of their section 1374(c)(2) limitation.

To determine the amount of the section 1374(c)(2) limitation each petitioner is entitled to, I would look to State law to determine what each petitioner’s legal rights and obligations are as a result of their guaranty of the $300,000 loan. See Burnet v. Harmel, 287 U.S. 103, 110 (1932). (“The State law creates legal interests but the federal statute determines when and how they shall be taxed.”) The guaranty signed by petitioners states that it “shall be governed and construed in accordance with the laws of the State of Virginia.” Accordingly, I would look to Virginia State law.

Each of the shareholder/guarantors bound themselves to jointly and severally guarantee the $300,000 indebtedness of VAFLA to the Bank of Virginia. Although the shareholder/ guarantors may have owned various percentages of VAFLA, their obligations arising from their guarantees were identical. 21 See Cooper v. Greenberg, 191 Va. 495 , 61 S.E.2d 875, 877 (1950). Pursuant to the guarantees, the Bank of Virginia could proceed against any one of the shareholder/ guarantors for the full amount of the indebtedness without first attempting to collect from VAFLA. A shareholder/ guarantor required to pay the indebtedness could proceed against the other shareholder/guarantors pursuant to the equitable principle of contribution “that where two or more persons are subject to a common burden it shall be borne equally, since the law implies a contract between them to contribute ratably towards the discharge of the obligation.” Wiley N. Jackson Co. v. City of Norfolk, 197 Va. 62 , 87 S.E.2d 781, 784 (1955).

Although the shareholder/guarantors were each obligated to pay the full amount of VAFLA’s indebtedness to the Bank of Virginia, I would conclude in light of their rights to contribution that the shareholder/guarantors were each effectively obligated to pay only their aliquot portion of the indebtedness. See Cooper v. Greenberg, supra. 22 Since there were seven shareholder/guarantors, each was effectively obligated to pay one-seventh of the $300,000 debt or $42,857. 23 I would conclude that both petitioners should be deemed to have made a contribution to VAFLA’s capital in the amount of $42,857.

A collateral issue presented by the manner in which I would decide this case is the proper treatment of principal and interest payments made by VAFLA. Since the $300,000 received by VAFLA would be treated as a capital contribution, the payments of principal and interest made by VAFLA would have to be treated as cash distributions by VAFLA to the shareholder/guarantors, one-seventh each, and as payments of principal and interest by the shareholder/guarantors, one-seventh each, to the Bank of Virginia. 24

IV. Conclusion.

The majority opinion has reached an incorrect result because (1) it did not recognize the distinctions between section 1374(c)(2)(A) and section 1374(c)(2)(B), (2) it incorrectly stated the Blum opinion, (3) it unsoundly refused to follow Selfe, (4) it erroneously believed subchapter C precedent is not applicable to a subchapter S corporation, (5) it unsoundly refused to apply traditional debt-equity principles to determine the substance of the transaction at issue, (6) it refused to follow, without discussion, numerous opinions of this and other courts, and (7) it refused to recognize the existence and presence of economic outlay, a la In re Lane. This Court has dangled an elusive carrot before taxpayers’ eyes for more than 15 years stating that on the proper showing, a shareholder-guaranteed corporate debt can be characterized as a capital contribution. 25 Petitioners have here made the proper showing, to which the majority states, “we were only kidding.”

For the foregoing reasons, I respectfully dissent.

As will be seen below, whether a shareholder-guaranteed corporate debt is in substance a shareholder debt turns on whether an analysis of traditional debt-equity factors reveals the presence of more equity than debt factors. Where more equity factors are present, the shareholder-guaranteed corporate debt is characterized as shareholder debt. The deemed advance of the loan proceeds from the shareholder to the corporation must, of course, be characterized as a capital contribution, rather than a loan, because more equity than debt factors are present. As a capital contribution, the shareholder receives an increase in the basis of stock (see sec. 1374(c)(2)(A)), and not an increase in any indebtedness of the corporation to the shareholder (see sec. 1374(c)(2)(B)). See also Bader v. Commissioner, T.C. Memo. 1987-30 .

See Blum v. Commissioner, 59 T.C. 436, 439-440 (1972); Smyers v. Commissioner, 57 T.C. 189, 198 (1971); Santa Anita Consolidated, Inc. v. Commissioner, 50 T.C. 536, 550 (1968); J.A. Maurer, Inc. v. Commissioner, 30 T.C. 1273 , 1290 n. 2 (1958); Schneiderman v. Commissioner, T.C. Memo. 1987-551 ; Gurda v. Commissioner, T.C. Memo. 1987-394 ; Bader v. Commissioner, T.C. Memo. 1987-30 ; Blackman v. Commissioner, T.C. Memo. 1981-244 ; Albert v. Commissioner, T.C. Memo. 1980-567 ; LaStaiti v. Commissioner, T.C. Memo. 1980-547 ; Selfe v. United States, 778 F.2d 769, 774 (11th Cir. 1985); In re Lane, 742 F.2d 1311, 1319-1320 (11th Cir. 1984); Casco Bank & Trust Co. v. United States, 544 F.2d 528, 534-535 (1st Cir. 1976); Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712, 722-724 (5th Cir. 1972), affg. T.C. Memo. 1970-182 ; Murphy Logging Co. v. United States, 378 F.2d 222, 224 (9th Cir. 1967); Kavich v. United States, 507 F. Supp. 1339, 1342 (D. Neb. 1981); In re Breit, 460 F. Supp. 873, 875 (E.D. Va. 1978); Ackerson v. United States, 277 F. Supp 475, 477 (W.D. Ky. 1967); and Fors Farms, Inc. v. Commissioner, an unreported case (W.D. Wash. 1966) (17 AFTR 2d 222, 66-1 USTC par. 9206 ). See also Ellisberg v. Commissioner, 9 T.C. 463 (1947), and Pierce v. Commissioner, 41 B.T.A. 1261 (1940), wherein the issue was whether a guarantee could be characterized as a gift.

See Blum v. Commissioner, supra; Smyers v. Commissioner, supra; Santa Anita Consolidated, Inc. v. Commissioner, supra; La Staiti v. Commissioner, supra; Selfe v. United States, supra; In re Lane, supra; Casco Bank & Trust Co. v. United States, supra; Plantation Patterns, Inc. v. Commissioner, supra; Murphy Logging Co. v. United States, supra; Kavich v. United States, supra; In re Breit, supra; Ackerson v. United States, supra; and Fors Farms, Inc. v. Commissioner, supra

The majority opinion attempts to draw undue weight from note 4 in Blum v. Commissioner, supra at 439, which provides:

“The respondent has argued that the entire equity-contribution argument espoused by petitioner is inimical to the subch. S area. Because of our holding that the facts do not warrant the applicability of this doctrine to the present case we will not consider this rather fascinating question.”

It is clear that “doctrine” as used in the note does not mean “the applicability of debt-equity principles to determine if shareholder-guaranteed debt should be characterized as a capital contribution,” but rather means “characterization of a shareholder-guaranteed corporate debt as a capital contribution after evaluation of traditional debt-equity principles.” Consider the Court’s textual statement, “after applying many of those traditional principles, we find * * * .” Blum v. Commissioner, supra at 439, quoted herein, supra at 222. Note 4 in Blum was improperly relied on by the majority.

J. Eustice & J. Kuntz in Taxation of S Corporations, par. 10.03[2][i], n. 184 (rev. 2d ed. Supp. 198Y), refer to Selfe v. United States, supra, as a “well reasoned opinion.”

See note 24 infra

Consider the following hypothetical:

Corporation A, a C corporation, pays “interest” on a shareholder-guaranteed debt to a bank. Respondent determines and this Court agrees that because the shareholder-guaranteed debt is in substance a capital contribution, the interest deduction is not allowable. Later corporation A becomes an S corporation. Would the “interest” payments now be deductible under the majority opinion’s analysis?

Frantz v. Commissioner, 83 T.C. 162, 172 (1984), affd. 784 F.2d 119 (2d Cir. 1986).

Citation to subch. S cases relying on subch. C precedent would serve no purpose. Suffice it to say that all, or nearly all, subch. S cases cite subch. C precedent or subch. S precedent which relied on subch. C precedent.

The taxpayer in In re Lane, supra, did not actually make payments; rather, assets belonging to the taxpayer were sold to satisfy the obligation arising from the guarantee. We see no distinction between the two and analyze In re Lane, supra, as if the taxpayer did make payments pursuant to the guarantee.

In re Lane was also relied on in Selfe for the proposition that the taxpayer as well as the Government may question whether a shareholder’s advance to a corporation is debt or equity. Neither the majority nor respondent argues that petitioners are precluded from arguing substance over form. In Selfe v. United States, supra, the taxpayer was allowed to argue substance over form in claiming that her guarantee of a bank loan to an electing small business corporation in which she was a shareholder increased the amount of her sec. 1374(c)(2) limitation. The 11th Circuit stated:

“Although the question of whether a stockholder’s advances to a corporation constitute debt or capital contributions is usually raised by the government, nothing in the Internal Revenue Code or our decisions suggests that the factors used to determine the substantive character of a taxpayer’s interest in a corporation are available only to the government. See In re Lane, 742 F.2d at 1315 ; cf. Peter E. Blum, 59 T.C. 436, 439 (1972) (principles for resolving debt-equity detérminations are consistent regardless of the context in which such determinations arise); J.A. Maurer, Inc., 30 T.C. 1273 (1958). Accordingly, where the nature of a taxpayer’s interest in a corporation is in issue, courts may look beyond the form of the interest and investigate the substance of the transaction. These situations present an exception to the general proposition that a shareholder/taxpayer is bound by the form of her transaction. See Georgia-Pacific Corp. v. Commissioner, 63 T.C. 790, 795-796 (1975). [Selfe v. United States, supra at 774.]

Appeal in this case lies to the Fourth Circuit. Accordingly we are not required by Golsen v. Commissioner 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971), to follow the opinions in Casco Bank & Trust Co. v. United States, supra (1st Cir.); Plantation Patterns, Inc. v. Commissioner, supra (5th Cir.); Murphy Logging Co. v. United States, supra (9th Cir.); In re Lane, supra (11th Cir.); of Selfe v. United States, supra (11th Cir.). Some commentators think that the Tax Court should be bound by Circuit Court precedent even when the case is not appealable to that Circuit Court. See Geier, “The Emasculated Role of Judicial Precedent in the Tax Court and Internal Revenue Service,” 39 Okla. L. Rev. 427 (1986). At any rate, were this case appealable to the First, Fifth, Ninth, or Eleventh Circuit Courts of Appeals, Golseti v. Commissioner, supra, might well have mandated a result different from the result reached by the majority.

In Brown v. Commissioner, 706 F.2d 755, 756 (6th Cir. 1983), affg. T.C. Memo. 1981-608 , the Sixth Circuit accepted the Tax Court’s holding that, with respect to the transaction there at issue, “the substance matched the form.” The Sixth Circuit did not reveal the analysis it utilized in deciding to accept the Tax Court’s holding, but it clearly did not refuse to apply traditional debt-equity principles in making that decision.

In In re Lane, supra, relying on Casco Bank & Trust Co. v. United States, supra, and Kavich v. United States, supra, the 11th Circuit examined traditional debt-equity principles to determine that, as of the time the taxpayer guaranteed a nominal debt of his corporation to a bank, he, not his corporation, was in substance the debtor. The nominal corporate debt was treated as the taxpayer’s debt with the loan proceeds being deemed transferred from the bank to the taxpayer to his corporation, with the latter transfer being a contribution to capital, not a loan. The 11th Circuit held that Putnam v. Commissioner, 352 U.S. 82 (1956), was not applicable and that the taxpayer was not entitled to a bad debt deduction.

See also sec. 385, the text of which is reproduced in note 8 in the majority opinion. Though sec. 385 was added by the Tax Reform Act of 1969, Pub. L. 91-172, sec. 415 (a), 83 Stat. 487 , 613, no regulations under this provision are currently in effect.

VAFLA apparently intended for the Bank of Virginia to look to the shareholder/guarantors for repayment as well. VAFLA reported the $300,000 loan as a liability to shareholders, not as a liability to the Bank of Virginia.

The $162,736.83 figure was arrived at as follows: During VAFLA’s taxable year ended Sept. 30, 1979, VAFLA used funds to (1) acquire capital assets, (2) reduce the outstanding balance of indebtedness incurred to acquire capital assets, (3) pay organizational expenses, (4) prepay insurance, (6) purchase inventory, and (6) finance its operations. As of Sept. 30, 1979, VAFLA had $4,200 in cash. Accordingly, it expended $295,800 on a combination of the six items described above. Financing operations required $102,009.63 [VAFLA’s loss for its taxable year ended Sept. 30, 1979, was $345,370.20. However, several of the items contributing to VAFLA’s loss did not require the expenditure of cash during such year. They were: depreciation — $88,845.35; accrued but unpaid sales tax — $1,969.91; accrued but unpaid property tax — $13,511.14; accrued but unpaid interest — $69,183.22; and various accrued but unpaid items represented by accounts payable — $69,850.95. After adjusting for these items, VAFLA made cash expenditures to finance its operations of only $102,009.63.], the purchase of inventory required $5,079.29 [The inventory may have been purchased on credit. If so, $5,079.29 of the $69,850.95 of accounts payable should have been considered incurred to acquire inventory and should not have been considered an accrued but unpaid item in determining the amount of VAFLA’s cash expenditures to finance its operations. See the immediately preceding bracketed material. As such, VAFLA’s cash expenditures to finance its operations would be $5,079.29 more and its cash expenditures to purchase inventory $5,079.29 less. The items would cancel one another out in determining the amount expended by VAFLA to acquire capital assets and to reduce the outstanding balance of indebtedness incurred to acquire capital assets.], the prepayment of insurance required $25,282.87, and the payment of organizational expenditures required $691.38 [Organizational expenditures may have been paid with credit. See the immediately preceding bracketed material.]. Accordingly, at least $162,736.83 of the $300,000 loan proceeds was used to acquire capital assets or to reduce the outstanding balance of debt incurred to acquire capital assets.

The Sept. 30, 1980, financial statements show that during VAFLA’s taxable year ended on Sept. 30, 1980, VAFLA received from shareholders $600,000 reported as a loan and $200,000 reported as a capital contribution. Petitioners did not participate in either the $600,000 or the $200,000 advance.

See note 18 supra.

I recognize that a corporation will lose its status as an electing small business corporation if it has more than one class of stock. Sec. 1371(a)(4). I do not consider the seven shareholder/guarantors’ deemed equity investments to give rise to a second “class of stock” within the meaning of see. 1371(a)(4). See Amory Cotton Oil Co. v. United States, 468 F.2d 1046 (5th Cir. 1972); Estate of Allison v. Commissioner, 57 T.C. 174 (1971); Stinnett v. Commissioner, 54 T.C. 221 (1970).

Respondént contends, and I agree, that petitioner Anthony D. Cuzzocrea should be treated no differently than the other shareholder/guarantors. I consider his guarantee which is limited to $300,000 “plus any other indebtedness related thereto and any costs and expenses * * * incurred to enforce this guaranty” to be, in effect, indistinguishable from the guarantees of the other shareholder/guarantors.

See also In re Breit, 460 F. Supp. 873 , 876 n. 3 (B.D. Va. 1978). (“Their fellow guarantors * * * were equally liable in the event of nonpayment by the corporation, and appellants failed to show why all the guarantors should not share equally in the deduction.”)

The determination of the number of shareholder/guarantors and the amount of the obligation is to be made as of the time the loan proceeds are advanced because it is at this time that the shareholder/guarantors are deemed to make a capital contribution.

See Plantation Patterns Inc. v. Commissioner, T.C. Memo. 1970-182 , wherein respondent was contending that only the principal payments made by the corporation on the shareholder-guaranteed debt were taxable to the taxpayer-shareholders because of the offsetting interest deductions which would be available to them.

See Blum v. Commissioner, 59 T.C. 436 (1972); Schneiderman v. Commissioner, T.C. Memo. 1987-551 (“A loan will be deemed to have been made to its guarantors only if the guarantors can show, among other things, that the lender looked primarily to them for repayment.”); Bader v. Commissioner, T.C. Memo. 1987-30 (“petitioners [shareholder/guarantors] have not established that CNB [the third-party creditor] looked primarily to them for satisfaction of the debt.”); Blackman v. Commissioner, T.C. Memo. 1981-244 (“Although we accept petitioners’ general proposition that the substance of a transaction and not merely the form in which it is cast controls its treatment for tax purposes, petitioners have failed to convince this Court that the guaranteed loans should be characterized as indirect capital contributions.”); and Albert v. Commissioner, T.C. Memo. 1980-567 (“this is not a case where a Subchapter S corporation was thinly capitalized, or insolvent at the time of the [guaranteed] loan. * * * Nor is there any suggestion from the facts herein that the guaranteed loan was in substance an equity contribution by the taxpayer.”).