UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT
decided: June 20, 1968.
FIN HAY REALTY CO., APPELLANT,
UNITED STATES OF AMERICA
Hastie, Chief Judge, and Freedman and Van Dusen, Circuit Judges. Van Dusen, Circuit Judge (dissenting).
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.*fn1
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,*fn2 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.*fn3 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.*fn4 Finlaw's daughters then became and still remain the sole shareholders of the corporation.*fn5
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.*fn6 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*fn7 that he can avoid the provision for nonrecognition of gains or losses on transfers of property to such a corporation under § 351.*fn8 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.*fn9
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.*fn10 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.*fn11 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 occupy 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 treated 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 shareholder'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.*fn12
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,*fn13 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.*fn14 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 Finlaw'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 advances represented capital contributions was incorrect.*fn15 The district court was justified in holding that the taxpayer had not met this burden.
The judgment of the district court will be affirmed.
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.*fn1
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);*fn2 J.S. Biritz Construction 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.*fn3
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.*fn4 When this test is used, the entire history of the corporate taxpayer becomes relevant*fn5 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,*fn6 carried 6% interest which was paid every year,*fn7 and was not subordinated in any way to similar debt of general creditors.*fn8 It was carried on the corporate books and tax returns as debt,*fn9 being payable on demand, it was always listed as a debt maturing in less than one year,*fn10 and on Mr. Finlaw's estate tax return was listed as promissory notes payable on demand.*fn11 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.*fn12 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.*fn13 Cases denying the validity of debt because it is contemporaneously advanced with the start of corporate life generally involve other industries*fn14 or a partnership becoming a corporation.*fn15
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.*fn16 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.*fn17 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 1962-1963.*fn18 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.