Fin Hay Realty Co. v. United States

VAN DUSEN, Circuit Judge

(dissenting).

I respectfully dissent on the ground that the “entire evidence,” in light of appellate court decisions discussing the often-presented problem of corporate debt versus equity, does not permit the conclusion reached by the District Court. 1

When the parties holding debt of the taxpayer corporation have a formal debt obligation and it is clear that all parties intended the investment to take the form of debt, a series of considerations such as those mentioned by the District Court should be used to determine whether the form and intent should be disregarded for federal tax purposes. Tomlinson v. 1661 Corporation, 377 F.2d 291 (5th Cir. 1967); 2 J. S. Biritz Con *700 struction Co. v. C. I. R., 387 F.2d 451, 455-456 (8th Cir. 1967). As I read the District Court’s opinion, the focus was entirely on inferring “the intent of the taxpayer’s only two stockholders” at the time the debt was created. To that end, the District Court drew certain inferences which are largely immaterial to the proper decision, and which are clearly erroneous in light of the stipulated facts and uncontroverted evidence. 3

Whether or not the corporate taxpayer is entitled to an interest deduction turns in this case on the “real nature of the transaction in question” or on whether “the degree of risk may be said to be reasonably equivalent to that which equity capital would bear had an investor, under similar circumstances, made the advances * * Diamond Bros. Company v. C. I. R., 322 F.2d 725, 732 (3rd Cir. 1963); Tomlinson v. 1661 Corporation, supra, at 295 . 4 When this test is used, the entire history of the corporate taxpayer becomes relevant 5 and a focus solely on the year of incorporation or investment of the debt is not sufficient.

Turning within this framework to the facts, the record does not justify the conclusion that the form of the debt should be disregarded for purposes of federal taxation. The debt was evidenced by written notes, 6 carried 6% *701 which was paid every year, 7 and was not subordinated in any way to simdebt of general creditors. 8 It was carried on the corporate books and tax returns as debt, 9 being payable on demand, it was always listed as a debt manuring in less than one year, 10 and on Mr. Finlaw’s estate tax return was listed as promissory notes payable on demand. 11 The parties clearly intended the advances as debt and unfailingly treated them as such. The only testimony on the usual capitalization of real estate companies in the Newark area was that:

“The usual capitalization is a thousand dollar investment in capital and then the rest of the monies are loaned either * * * by individuals or stockholders of the corporation to the corporation, which in turn the individuals lending the money expect a return for their loans.

“[Of the real estate corporations that] I have dealt with, at least ninety-five per cent and more have had a thousand capitalization and, of course, loans from the various lenders would depend upon the size of the transaction, monies that were required.”

On this record, Conclusions of Law 3-8 as worded are not justified. The District Court placed heavy reliance on the fact that the stockholder’s debt was in the same proportion as their equity holdings. This fact, without more, is not controlling since there is no doubt that investors can have a dual status. 12 *702 The inferences that “more” was involved in this case are not justified by this record. The fact that the loans were used to begin the corporate life and buy the income-producing assets must be placed in proper perspective. Without any basis in the record, the District Court assumed that the loans were advanced to prevent a sudden corporate deficit that was created by the Wainwright Street property investment’s unexpectedly requiring more funds than the corporation had. Real estate cases, however, and uncontroverted testimony in this case show that corporations owning and operating buildings frequently and traditionally borrow the substantial part of money needed to secure their principal assets and that this was contemplated by a corporate resolution passed in the month of organization at the original directors’ meeting. 13 Cases denying the validity of debt because it is contemporaneously advanced with the start of corporate life generally involve other industries 14 or a partnership becoming a corporation. 15

The loans were denied debt status because there was no intent to seek repayment within a “reasonable time,” because the corporation had no retirement provision (or fund) for the principal and because the debt had no maturity date (Conclusions 3 and 4). To the contrary, demand notes have a maturity date at the discretion of the holder (or of his transferee when the notes are freely negotiable, as were the Fin Hay notes). And failure to transfer the notes or demand payment is irrelevant when, as here, the evidence shows that the 6% rate made the debt a good investment. 16 . In addition, when a corporation holds appreciating real estate and contemplates recourse to refinancing, the lack of a sinking fund assumes little, if any, significance. 17 There was no evidence and no discussion of what constitutes a “reasonable time” for refraining from making a demand on such a promissory note.

The loans were also found to be equity because redemption was expected only out of future earnings or surplus and because they were unsecured and subordinate to prior secured loans (Conclusions 6 and 8). To the contrary, the evidence shows that the parties contemplated redemption out of “refinancing” as well if a demand were made when surplus was deficient; and this in fact was what happened in 1951 and 1962- *703 1963. 18 Corporate debt does not become equity because it is contemplated that principal will be retired by refinancing. In addition, a review of the “subordination” cases shows that there was no “subordination” in this case as that term is used in other cases where the challenged debt was subordinated to all other debt of similar type or otherwise subordinated by agreement. 19

The District Court also placed emphasis on the fact that at the end of 1935 the shareholders’ salaries were accrued but unpaid in the amount of $2400 and that in 1938 through 1940 the shareholders advanced an additional $6000 as loans. The corporate tax returns and books, however, show that the salaries could have been paid at the end of 1935 from $4,340.21 in cash on deposit, 20 and that during the period of the additional loans of $6000 the shareholders received $6800 in dividends from the corporation. 21 These additional facts, unexplained by the District Court, negate the implication that Fin Hay Realty Company was in serious financial trouble at the outset of its existence, at least to any such degree that all the challenged loans were made “at a risk” similar to that of venture capital. 22 It is noted, in addition, that by 1938, when the original purchase money mortgage was re-financed, $18,000 of principal had been paid.

Although appellate decisions on the debt-equity problem constantly reiterate the maxim that each instance of defini *704 tion turns on the particular facts of each case, a reading of many of these cases, including all those cited above, indicates two rather distinct conclusions concerning the assessment of the severity of the “risk” attached to alleged debt transactions. First, when the problem of definition arises under 26 U.S.C. §§ 165 , 166 (worthless stock, bad debt), the risk of failure has already been realized and the party seeking to minimize the degree of such risk must show more “factors” than otherwise clearly argue for a debt classification. Secondly, regardless of the end purpose for defining indebtedness, fewer factors need be present (such as subordination, no interest, etc.) to allow a conclusion of “equity” when, as a matter of common knowledge, the economic enterprise has a higher chance of commercial failure. Consequently, few cases (and particularly few where taxpayers holding formal debt lose) deny debt status or even raise the question where the enterprise risk, as in this case, involves the mere holding and operation of real estate. As the risks increase, involving in addition construction of the real estate, or non-real estate operations subject to more immediate risk-creating problems of marketing, labor, advertisement, supplies, etc., the frequency of cases challenging debt and of decisions finding equity increase. The uncontradicted testimony (without finding of lack of credibility) of the universal practice in the Newark area in conformity to the course followed by taxpayer (p. 696, supra) is entitled to consideration. Also, the subsequent successful history of this corporate taxpayer cannot be disregarded and militates strongly against denying an interest deduction on this record. The Fin Hay Realty Co. did not go bankrupt, was not unable to refinance or extend its purchase money mortgage due in 1939, and has never failed to meet a demanded purchase of the notes.

On this record, these loans were bona fide loans, “at risk” in this enterprise in no different way than any debt investment is “at risk” for a general creditor 23 of a real estate holding and operating corporation. The District Court pointedly took judicial notice, both of the bargain real estate purchases possible in 1934 and of the steadily rising real estate values in Essex County, New Jersey. 24 Subsequent refinancings by the taxpayer, as well as the entire course of its history, demonstrate that this investment in this particular venture was not a “risk capital” investment of the type that should compel disregarding the clear intent of the parties and form of the transaction. Two recent “real estate” decisions (involving, moreover, construction as well as holding of real estate) suggest the proper result for the present case. As stated in Tomlinson v. 1661 Corporation, supra, at 300:

“We cannot, by manipulation of tax law, preclude the parties from exercising sound business judgment in obtaining needed investment funds at the most favorable rate possible, whether it be a commercial loan, or, more likely and as is the case here, a loan from private interested sources with sufficient faith in the success of the venture and their ultimate repayment to delete or minimize the ‘risk factor’ in their rate of return.”

Similarly, in J. S. Biritz Construction Co. v. C. I. R., supra, at 459, the court said:

“There is actually no evidence that this was not a loan, was not intended to be a loan, or that Biritz actually in *705 tended to make a capital investment rather than a loan.

“We think the Tax Court has painted with too broad a brush in limiting the permissible activities of an entrepreneur in personally financing his business. Financing embraces both equity and debt transactions and we do not think the courts should enunciate a rule of law that a sole stockholder may not loan money or transfer assets to a corporation in a loan transaction. If this is to be the law, Congress should so declare it. We feel the controlling principle should be that any transaction which is intrinsically clear upon its face should be accorded its legal due unless the transaction is a mere sham or subterfuge set up solely or principally for tax-avoidance purposes.”

I would reverse and enter judgment for the corporate taxpayer.

. As to the determination of the trial court that payments were not “interest paid * * * on indebtedness” ( 26 U.S.C. § 163 ), this court has stated:

“ * * * it is well-settled that such findings are ‘in the nature of an ultimate finding of fact and since such finding is but a legal inference from other facts it is subject to review free of the restraining impact of the so-called “clearly erroneous” rule applicable to ordinary findings of fact by the trial court. * * *’ ”

Kaltreider v. Commissioner of Internal Revenue, 255 F.2d 833, 837 (3rd Cir. 1958). Although listed under legal conclusions by the District Court, this determination is similar to the “findings” referred to in Kaltreider . See, also. Soles v. Franzblau, 352 F.2d 47, 50 (3rd Cir. 1965). Moreover, regardless of the characterization of the District Court’s findings, I am “left with the definite and firm conviction that a mistake has been committed” by the trial court on the record in this case. Diamond Bros. Company v. C. I. R., 322 F.2d 725, 731, n. 9 (3rd Cir. 1963), quoting from United States v. United States Gypsum Co., 333 U.S. 364, 395 , 68 S.Ct. 525 , 92 L.Ed. 746 (1948).

. The panel which decided Tomlinson included Senior Circuit Judge Maris of this *700 court. The corporate taxpayer seeking to deduct interest payments was engaged in the construction, owning and operation of a certain office building, an economic activity quite similar to that of the corporate taxpayer in this case except that construction of real estate arguably increases the “risk” involved in the enterprise. Tomlinson relied heavily on United States v. Snyder Brothers Company, 367 F.2d 980 (5th Cir. 1966), in which the Fifth Circuit adopted with approval the conceptual analysis of Kraft Foods Company v. Commissioner of Internal Revenue, 232 F.2d 118, 123 (2nd Cir. 1956). This carefully reasoned Second Circuit decision suggested that the relevant inquiry for courts seeking to define “indebtedness” under 26 U.S.C. § 163 should turn initially on whether the alleged debt is a “hybrid,” partaking of certain characteristics of traditional corporate equity as well as characteristics of debt, or whether the alleged debt is in form entirely debt and intended to be such. See, also, Gloucester Ice & Cold Storage Co. v. C. I. R., 298 F.2d 183, 185 (1st Cir. 1962). It is noteworthy that the Third Circuit case relied on heavily by the District Court, Mullin Building Corporation v. C. I. R., 9 T.C. 350 (1947), aff’d 167 F.2d 1001 (3rd Cir. 1948), is a case of a “hybrid” investment which, although the corporate taxpayer was formed solely to hold real estate, was named “debenture preferred stock” and demanded corporate liquidation before the “debenture preferred stock” principal could be returned. Similarly, Messenger Publishing Co. v. C. I. R., P.H.Memo, T.C., U 41.241, aff’d 168 F.2d 903 (3rd Cir. 1948), involved a hybrid named “preferred stock.”

. To the extent that the District Court proceeded under a misconception as to the relevant legal test, this court is not bound by the “clearly erroneous” rule of F.R.Civ.P. 52. See C. I. R. v. Danielson, 378 F.2d 771 , 774 (3rd Cir. 1967). See, also, United States v. United Steelworkers of America, 271 F.2d 676, 685 (3rd Cir.), aff’d 361 U.S. 39 , 80 S.Ct. 1 , 4 L.Ed.2d 12 (1959); and Kraft Foods Company v. Commissioner of Internal Revenue, supra, 232 F.2d at 122 ; “ * * * where, as here, the evidence consisted of stipulated facts, this Court is entitled to draw its own inferences of ultimate fact from the record.”

. Charter Wire, Inc. v. United States, 309 F.2d 878, 880 (7th Cir. 1962), cited by the District Court as a source of the relevant criteria, also suggests that the test is whether “the totality of facts indicates a risk-capital investment.” The corporate taxpayer in the Charter Wire case, however, was involved in manufacturing, not real estate; the debt, 100 times the size of equity, was subordinated to other unsecured debt of general creditors; and a new shareholder was forced to buy debt in proportion to his new stock at a time when no additional financing was needed.

. See, e. g., Wilbur Security Company v. C. I. R., 279 F.2d 657 , 662 (9th Cir. 1960).

. See, e. g., Diamond Bros. Company v. C. I. R., supra, where the only evidence of debts was book entries; Wilbur Security Company v. C. I. R., supra, where the first written evidence of debt was *701 28 years after investment; Montclair v. C. I. R., 318 F.2d 38 (5th Cir. 1963).

. See, e. g., Tomlinson v. 1661 Corporation, supra, where the debt was upheld even with a provision for accruing and accumulating interest when not paid; Montclair v. C. I. R., supra, where no fixed interest was given and the debt was disallowed; United States v. Henderson, 375 F.2d 36 (5th Cir. 1967), no interest paid; Diamond Bros. Company v. C. I. R., supra, no interest paid.

. See, e. g., P. M. Finance Corporation v. C. I. R., 302 F.2d 786 (3rd Cir. 1962), agreement prevented any payment on loans until bank loans paid off in full— loans could not be paid off while corporation continued in bar and cocktail lounge financing business; Gooding Amusement Co. v. C. I. R., 236 F.2d 159 (6th Cir. 1966), subordination to general creditors; United States v. Snyder Brothers Company, supra; McSorley’s Inc. v. United States, 323 F.2d 900 (9th Cir. 1963); subordinated by agreement to all debt, existing or not, secured or not; Charter Wire, Inc. v. United States, supra, subordinate to later bank loan.

. See, e. g., “hybrid” cases such as John Wanamaker Philadelphia v. Com’r of Int. Revenue, 139 F.2d 644 (3rd Cir. 1943; Mullin Building Corporation v. C. I. R., supra; Pierce Estates v. Commissioner of Internal Revenue, 195 F.2d 475 (3rd Cir. 1952), where the instruments had names that indicated equity attributes and were carried as capital entries.

. Apparently the District Court regarded demand notes as having no fixed ma t urity, see Conclusion of Law 4. This seems incorrect since demand paper means that the debt is “mature” at the holder’s option. The better characterization would seem to be that demand notes held by someone with a voice in management are a type of long-term investment. See, e. g., Taft v. C. I. R., 314 F.2d 620 (9th Cir. 1963).

. This consistent treatment does not, of course, estop either the Commissioner or the taxpayer any more than the decision in this case controls the tax status of repaid principal on these loans in the hands of the remaining Fin Hay shareholders. The Government may well have sought to challenge these corporate interest deductions before challenging the individuals’ returns as a matter of tactics, but this, and the question of the tax consequences of the liquidation of the remaining loans in 1962-1963, should not influence the decision in the present case, see Budd Company v. United States, 252 F.2d 456, 458 (3rd Cir. 1957).

. See, e. g., Farley Realty Corporation v. C. I. R., 279 F.2d 701, 704 (2nd Cir. 1960) ; Wilshire & West Sandwiches v. Commissioner of Int. R., 175 F.2d 718, 720 (9th Cir. 1949). As noted in P. M. Finance Corporation v. C. I. R., supra, at 789, control of the corporation re *702 quires the courts to examine the shareholder-creditor relationship with great care but “the decisions [footnote omitted] in most instances have required some further indication that sole or pro-rata shareholder ‘debt’ is in reality equity rather than indebtedness.”

. See, e. g., Tomlinson v. 1661 Corporation, supra; Mullin Building Corporation v. C. I. R., supra; Farley Realty Corporation v. C. I. R., supra; McSorley’s Inc. v. United States, supra.

. See, e. g., United States v. Henderson, supra, relied upon by the majority, involving an iron castings foundry.

. See, e. g., United States v. Snyder Brothers Company, supra; Gooding Amusement Co. v. C. I. R., supra.

. See, e. g., Tomlinson v. 1661 Corporation, supra, at 297. Uncontroverted testimony of one creditor-stockholder showed that he regarded the 6% return as a good investment (it is noted that interest was always paid on time) and nothing on the record or in any other cases showing interest rates in 1934 or later indicates that a 6% return on an unsecured demand note was unreasonably low when issued in 1934 or subsequently anything other than the good investment alleged. Many corporations are forced to continue with initial financing at higher rates (such as the 6% here) and an interest rate that fluctuated with the “going rate” would be an additional indication against the' bona fides of this debt. See, e. g., Montclair Inc. v. C. I. R., supra, at 40. The Fin Hay notes were freely transferable, unlike the situation, for instance, in Mullin Building Corporation v. O. I. R., supra, and such transferability is additional argument for allowing debt status under § 163.

. See J. S. Biritz Construction Co. v. C. I. R., supra, at 457.

. The Hay interests were bought out entirely in 1951, apparently after arm’s-length dealing with his executor. After study of the tax returns and corporate books introduced as exhibits, the cash events of 1951 seem to be as follows (figures rounded off):

A. Refinance, new mortgage of.................... $124,000.

B. Pay Hay notes ................................ 53,000.

Balance .................................. $ 71,000.

O. Sell Wainwright Street ......................... 79,000.

Balance .................................. $150,000.

D. Expenses — cost of sale ......................... $ 3,000.

Capital Gains tax ............................ 10,000.

Pay off old mortgage......................... 40,000. 53,000.

Balance .................................. $ 97,000.

E. Redeem Hay stock ............................. 77,000.

Balance .................................. $ 20,000.

The 1952 return lists the $20,000 as invested in “S. & L. Assn.” As can be seen, even though the sale proceeds were used to pay off the old mortgage, more than enough money was available from the refinancing to pay off the notes and the mortgage. Similarly, the 1963 re-mortgaging gave net mortgage proceeds of approximately $210,000 for paying $47,000 of the remaining $53,000 in notes ($6,000 was apparently paid for out of earnings).

. See cases in footnote 8, supra. The majority also seems to agree with this reading of the cases, see their footnote 12.

. Even with the subsequent payment of these salaries, the 1936 salaries of $4000 and a $1600 dividend for 1936, the 1936 year-end cash balance improved to $5,-657.13. It does not appear that the corporation had to maintain such large cash balances; subsequent tax returns show several lower year-end totals: 1937— $158.29; 1939 — $536.98; 1940 — $2,532.-93.

. Thus the stockholders received $800 more than they loaned during the period 1938-1940. These dividends were paid continuously from 1936 through 1952, a total of $26,000.00.

. See, for instance, the factors of “risk” noted in Gilbert v. C. I. R., 262 F.2d 512, 514 (2nd Cir. 1959).

. The interest paid reflects to a certain extent the risk involved, Tomlinson v. 1661 Corporation, supra, at 300, and the 6% rate does not appear to be sufficiently low to suggest that in this case a substantial amount of risk was unreflected in the interest rate and, hence, the notes must be equity investment.

. And see the court’s observations on real estate transactions, entrepreneurs wishing to limit equity investment, and payment out of earnings in J. S. Biritz Construction Co. v. C. I. R., supra, at 459.