Benjamin D. And Madeline Prentice Gilbert v. Commissioner of Internal Revenue

WATERMAN, Circuit Judge

(concurring).

I concur in remanding this cause to the Tax Court for further proceedings. The opinion of the Tax Court does not state the ground upon which its decision rests. Therefore, affirmance or outright, reversal by us would not be a review of the Tax Court’s decision but an initial, determination by us of the correctness, of the deficiency assessed by the Commissioner.

The differences within our Court relate to the stating of the principles that we believe should govern the Tax Court when it reconsiders this case upon remand. 1 I am in accord with the approach expressed by Judge Medina. 2

The petitioners and the Commissioner have argued this appeal upon the theory that the decision of the Tax Court was a decision of fact and that it may not be disturbed unless clearly erroneous. I cannot agree. The issue before the Tax Court and this court is whether the advances made by Gilbert gave rise to “debts” as that term is used in Section 23 (k) of the Internal Revenue Code. Such an issue is not merely one of fact. It is an issue — often called a “mixed question of law and fact” — which calls for the application of a statutory term to a particular set of facts. Prior to 1948, the courts were required to affirm Tax Court decisions made in cases that involved such mixed questions if the decision had “a ‘warrant in the record’ and a reasonable basis in the law.” Dobson v. Commissioner, 1943, 320 U.S. 489, 501 , 64 S.Ct. 239, 246 , 88 L.Ed. 248 . But in that year, Congress amended 26 U.S.C. § 1141 (a) 3 and this amendment, *409 becoming law subsequent to the decision in Dobson v. Commissioner, requires, I believe, that we examine in detail the issues presented here.

If characterization of the advances made by Mr. Gilbert depended solely upon the terms of the instruments under which the parties’ rights were governed, it is clear that the decision of the Tax Court would have to be reversed. Each note received by Gilbert contained an unconditional promise to pay 3%% interest semi-annually and to pay the principal upon demand. The notes were transferable, and did not by their terms confer the right to participate in the management of the corporation. 4 Moreover, the notes were not subordinated to the claims of other creditors. Unlike the situation presented in Gregg Co. of Delaware v. Commissioner, 2 Cir., 1956, 239 F.2d 498 , where so-called “hybrid” securities were involved, these instruments are on their faces ordinary unsecured interest-bearing promissory notes payable upon demand.

But numerous cases have indicated That even though the form of the instrument evidencing an advance of funds is •appropriate to the creation thereby of a debt, the circumstances surrounding the creation of the obligation may be such as to indicate that characterization of the advance as a loan would be improper within the meaning of the federal tax statute. Thus, in Reed v. Commissioner, 2 Cir., 1957, 242 F.2d 334 , where the instruments were promissory notes similar to the obligations in the present case, this court, after an appraisal of the surrounding circumstances, sustained the Tax Court’s determination that the advances there in question were contributions to capital and not loans. Cf. Gregg Co. of Delaware v. Commissioner, supra.

Although the facts of Dittmar v. Commissioner, 1955, 23 T.C. 789 are not identical with those in the present case, that decision is not without application here. There, the taxpayer, a stockholder, had made continuous advances to the corporation in response to needs for both capital assets and working capital without regard to the normal creditor safeguards. Under these circumstances, it was held that the advances were not loans to the corporation as the taxpayer contended but were contributions to corporate capital. It is true that in that case, unlike the present case, no formal instruments evidencing indebtedness were executed, but the similarities in the two cases are most impressive. In each the alleged loans were unsecured even though the interest on prior loans was in default and the corporation had a continuous history of losses. In each no attempt was ever made to enforce the obligations. 5 Since the distinction between loans and contributions to capital depends in part upon the type of risk assumed by an investor, the fact that the advances were made under circumstances more closely approximating those associated with the investment of equity capital is relevant to a determination of the character of the advances for purposes of federal income taxation.

Another circumstance tending to support the conclusion of the Tax Court is the agreement between petitioner and Borden that the financing of Gilbor, Inc., was to be shared equally between them. While this factor is not conclusive, it is one which “subjects the transaction *410 to close scrutiny.” Wilshire & Western Sandwiches, Inc., v. Commissioner, 9 Cir., 1949, 175 F.2d 718, 721 ; 1432 Broadway Corp. v. Commissioner, 1945, 4 T.C. 1158 , affirmed per curiam 2 Cir., 1947, 160 F.2d 885 . The agreement has particular significance in this case because of other evidence that the parties intended that distributions made by the corporation should at all times be equal to their proprietary interests. In December 1946, the board of directors authorized the officers of Gilbor to borrow $10,000 from Mrs. Gilbert in exchange for a demand promissory note. That note, pursuant to the resolution of the board, contained a provision that it was “transferable immediately into preferred stock.” At the same meeting the board' of directors gave Borden an option to purchase $10,000 of preferred stock, exercisable by him only upon the condition that Mrs. Gilbert exercise her conversion rights. The clear purpose of granting this option to Borden was to protect his right to share equally with the Gilberts in the anticipated distributions of the corporation.

The Commissioner also relies upon the fact that the cash available for expenditures was from the beginning insufficient to finance the scope of activities which the parties apparently planned. The pertinence of this argument is not, however, clear. We have decided several cases in which the inadequacy of equity capital contributed to characterization of advances as contributions to capital rather than as loans. E. g., 241 Corporation v. Commissioner, 2 Cir., 1957, 242 F.2d 759 ; 1432 Broadway Corp. v. Commissioner, supra. But as indicated by the Supreme Court in John Kelley Co. v. Commissioner, 1946, 326 U.S. 521 , 66 S.Ct. 299, 302 , 90 L.Ed. 278 , this test has value only in “extreme situations such as nominal stock investments and an obviously excessive debt structure.” In a case such as the present, where the ratio of debt to equity never exceeded 2.19 to 1, the “thin corporation” standard is of no value. It is not clear, however, whether this is the thrust of the argument, or whether the Commissioner contends that since the parties from the start knew there would be a need for larger amounts of capital, all later advances must be considered as having been invested as equity rather than as having been loaned. In either case, it would appear that the argument must fail. Once it is established that the parties’ equity investment is more than nominal, the means by which the corporation’s activities are financed is a matter to be handled in whatever way seems most advantageous to it. Wilshire & Western Sandwiches, Inc., v. Commissioner, supra.

It appears to me that the only factors which tend to support the conclusion of the Tax Court are that the advances were made in proportion to the equity investments of the parties and that they were continuously made without regard to normal creditor safeguards under the circumstances. 6 The need for safeguards is attested to by the fact that when the parties obtained outside loans these loans were secured not only by the property of the corporation, but also by the personal guarantees of Gilbert and Borden. Whether these factors are sufficient to preclude characterization of the advances as loans for income tax purposes is a question which, at least in the first instance, must be answered by the Tax Court.

. There is, of course, no disagreement among the members of the court if the decision of the Tax Court, based upon substantial evidence, is that the notes in issue were a mere pretense and “that the parties truly intended to and actually did enter into another and hidden agreement by which their rights were to be governed.” Only if the Tax Court concludes that the parties truly intended to create debts will the discussion contained in this concurring opinion be relevant.

. I do not understand Judge Medina’s opinion to hold that the motive of a taxpayer is never a proper subject of inquiry. Oases may arise — indeed, this may be one —in which the Commissioner may contend that the way the taxpayer reports a transaction upon his income tax return must be disregarded because it does not evidence the entire true transaction and is a mere pretense. In such a case, the desire of the taxpayer to avoid his taxes is a relevant subject for inquiry because it provides a motive for the sham which the Commissioner seeks to prove.

. This amendment inserted the italicized words into the statute:

*409 “§ 1141. (a). The United States Courts of Appeals and the United States Court of Appeals for the District of Columbia shall have exclusive jurisdiction to review the decisions of the Tax Court, except as provided in Section 1254 of Title 28 of the United States Code, in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury; and the judgment of any such court shall be final, except that it shall be subject to review by the Supreme Court of the United States upon certiorari, in the manner provided in Section 1254 of Title 28 of the United States Code.”

. This factor is, of course, of limited significance in a closely held corporation, especially where, as here, the notes are issued in proportion to shareholdings.

. These facts would also tend to support an inference that at the time the advances were made the parties did not truly intend that they should give rise to enforceable debts.

. The record discloses that this factor may have been given little weight by the Tax Court, for it characterized the advanees made by Mrs. Gilbert as loans even though she never sought or obtained such safeguards.