reclassified debt as a second class of stock in subchapter

CREIGHTON LAW REVIEW

RECLASSIFIED DEBT AS A SECOND CLASS OFSTOCK IN SUBCHAPTER S CORPORATIONS -INVALIDATION OF TREASURY REGULATION

1,1371-1(9)

INTRODUCTION

In order to avoid double taxation in closely held corporations, itis common for the shareholders to partially finance the corporationby lending money instead of purchasing stock. In addition to othertax advantages from the debt financing, the interest paid on the loanis deductible to the corporation (dividends are not), and the repay-ment of the principal is not considered as a taxable dividend or dis-tribution to the shareholder. In order to prevent such tax avoidanceschemes, the Internal Revenue Service (Service) and the courtsoften reclassify purported debt as equity if certain criteria aremet.'

The Service has sought to apply the doctrine of debt reclassifica-tion to corporations which have elected subchapter S treatment.'In order to qualify for sub S treatment, a corporation must meetthe following requirements:

(1) It must have fewer than 10 shareholders;(2) All the shareholders must be individuals (or estates);(3) No shareholder may be a nonresident alien;(4) It may not have more than one class of stock.,The IRS has maintained in Treasury Regulation § 1.1371-1 (g)

that if debt is reclassified, the resulting equity "will generally con-stitute a second class of stock.", Traditional debt reclassification

1. B. BITTKER AND J. EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS ANDSHAREHOLDERS, §§ 4.01 to 4.09 (1971) ; Goldstein, Corporate Indebtedness to Share-holders: "Thin Capitalization" and Related Problems, 16 TAX L. REV. 1 (1960); Mur-ray, Debt v. Equity: Current Criteria for Distinguishing, 4 CREIGHTON L. REV. 5 (1970) ;Comment, Thin Incorporation: A Continuing Problem, 51 MARQ. L. REV. 158 (1968).

2. INT. REV. CODE OF 1954, § 1371-1379.3. INT. REV. CODE OF 1954, § 1371 (a).4. The regulation provides, in part:

* * * If the outstanding shares of stock of the corporation are notidentical with respect to the rights and interest which theyconvey in the control, profits, and assets of the corporation, thenthe corporation is considered to have more than one class ofstock. Thus, a difference as to voting rights, dividend rights,or liquidation preferences of outstanding stock will disqualify acorporation. However, if two or more groups of shares are iden-tical in every respect except that each group has the right toelect members of the board of directors in a number proportionateto the number of shares in each group, they are considered oneclass of stock. Obligations which purport to represent debt butwhich actually represent equity capital will generally constitute

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principles are applied to determine whether the purported debtrepresents an equity interest. When the purported debt is found tobe equity, the corporation is denied sub S treatment often retroac-tively. Thus, the corporation could be required to pay taxes for theyears in which it was ineligible, and the shareholders could be re-fused individual past deductions for corporate losses.

For varying reasons, the Tax Court, and the Fifth, and SeventhCircuits7 have refused to apply the regulation in determining wheth-er reclassified debt constitutes a second class of stock. This articlewill first examine the legislative history and the statutory plan ofsubchapter S in an attempt to determine the purpose of the oneclass of stock requirement and, second, examine the approacheswhich have been applied by the courts in dealing with the require-ment.

LEGISLATIVE HISTORY AND STATUTORY SCHEME

Before it can be determined whether reclascified debt shouldbe treated as a second class of stock or whether debt reclassifica-tion is relevant at all, it is necessary to examine the intentions ofCongress in adopting subchapter S and the one class of stock re-quirement. In many instances, the committee reports which dis-cuss amendments to subchapter S have adopted form statementsconcerning its purpose. Such form statements, while they may easethe administrative burden of writing reports, provide little guidancein ascertaining Congressional intention and have been omitted fromthe following discussion.

1954 - THE INITIAL PROPOSAL

In 1954 President Eisenhower recommended that small business-men be given the freedom to choose the appropriate form of busi-

a second class of stock. However, if such purported debt obliga-tions are owned solely by the owners of the nominal stock ofthe corporation in substantially the same proportion as theyown such nominal stock, such purported debt obligations willbe treated as contributions to capital rather than a second classof stock. But, if an issuance, redemption, sale, or other transferof nominal stock, or of purported debt obligations which actuallyrepresent equity capital, results in a change in a shareholder'sproportionate share of nominal stock or his proportionate shareof such purported debt, a new determination shall be made asto whether the corporation has more than one class of stockas of the time of such change. (Emphasis added)

5. James L. Stinnett, Jr., 54 T.C. 221 (1970).6. Amory Cotton Oil Co. v. United States, 468 F.2d 1046 (5th Cir. 1972), and

Shores Realty Co., Inc. v. United States, 468 F.2d 572 (5th Cir. 1972).7. Portage Plastics Co., Inc. v. United States, 470 F.2d 308, rev'd on rehearing

en banc, No. 71-1555 (7th Cir. 1972).8. S. REP. No. 91.552, 91st Cong., 1st Sess., U.S. CODE CONG. & AD. NEWS,

2027, 2250 (1969).

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ness organization without regard to tax consequences., As part of aprogram to aid small businesses, the Senate amended HR 8300 toallow certain unincorporated businesses to be taxed as corpora-tions and certain corporations to be taxed as partnerships. Thelatter provision was a forerunner of the present subchapter S.

In order to qualify for taxation as a partnership the corporationhad to meet the following requirements:

(1) There could be no more than 10 shareholders;(2) All shareholders had to be actively engaged in the conduct

of the business;(3) No shareholder could be a nonresident alien or foreign share-

holder;(4) With certain exceptions, the corporation could not have been

a party to a tax-free reorganization or have acquired prop-erty from a subsidiary in a tax-free reorganization;

(5) The corporation could have only one class of stock; and(6) No more than 80% of the stock could be owned by persons

who owned the corporation's business in the form of an unin-corporated enterprise taxable as a domestic corporation.'

The right to elect under this subchapter was limited by the aboverequirements because it was thought that they would ensure quali-fication only by small business corporations which were compa-rable to proprietorships and partnerships. The committee also dis-cussed the one class ot stock requirement:

The corporation may have only one class of stock out-standing. No class of stock may be preferred over anotheras to either dividends, distributions, or voting rights. If thisrequirement were not made, undistributed current earningscould not be taxed to the shareholders without great com-plications. In a year when preferred stock dividends werepaid in an amount exceeding the corporation's current earn-ings, it would be possible for preferred shareholders to re-ceive income previously taxed to common shareholders, andthe same earnings would be taxed twice unless a deduction forthe earnings previously taxed were allowed to the commonshareholder. Such an adjustment, however, would be extreme-ly difficult when there had been a transfer of common stock inthe interim.''

An example may serve to illustrate the problems of allocation.A corporation has preferred stock issued in equal amounts to A and

9. President Eisenhower, Budget Message to Congress, January 21, 1954, 100CONG. REC. 545 (83rd Cong., 2d Sess.), U.S. CODE CONG. & AD. NEWS, 1567 (1954).

10. SENATE FINANCE COMMITTEE REPORT ON THE INTERNAL REVENUE CODE OF

1954, 83rd Cong., 2d Sess., U.S. CODE CONG. & AD. NEWS, 4752, 5096-98 (1954).11. Id. at 5097.

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B and common stock issued in the same amounts to C and D. In year1, Corporation has current earnings and taxable income of $10,000,of which $6,000 is distributed equally as dividends to A, B, C and D.The remaining $4,000 is retained in the business. But since share-holders are taxed on their pro rata share of taxable income for thecorporation, whether distributed or not, A, B, C and D are eachtaxed on $2,500. The problem arises if in year 2, Corporation hascurrent earnings and taxable income of only $2,000 but declares adividend of $6,000 payable to preferred shareholders A and B. Insuch a case, $2,000 of the dividend comes from current earningsand the remaining $4,000 comes from the undistributed income ofyear 1. Unfortunately for C and D, they have already paid taxes onthe current earnings and the undistributed income from year 1,and yet all of the money goes to A and B. In order to be fair to Cand D, Congress should allow a deduction to C and D for the taxesthey have already paid. This was not a common problem, and couldhave been solved by a system of deductions to compensate C and Dfor taxes previously paid; Congress, however, wanted to avoid thisadministrative burden.

1958 - SUBCHAPTER S ENACTED

The 1954 proposal was rejected by the Conference Committee.'"But, in 1958, Congress enacted a slightly different measure which isthe present subchapter S.11 Instead of taxing the electing corporationexactly the same as a partnership, which the 1954 proposal hadplanned, subchapter S provided for minor differences in tax treat-ment. However, the basic idea of 1954, to eliminate the income taxpaid by the organization, was unchanged in 1958. By eliminatingthe double taxation on corporation and shareholder, Congresswould allow businessmen "to select the form of business organiza-tion desired, without the necessity of taking into account major dif-ferences in tax consequences. ' ' 4

The 1958 committee reports did not discuss thoroughly the pur-poses for the requirements which must be met by electing corpora-tions. But in view of the similarities between the requirements foreligibility (three of the four present requirements were includedin the 1954 bill), it seems logical to assume that the purposes for theserequirements were the same in 1958 as in 1954.

Since subchapter S, in its entirety, was enacted as an aid to bene-fit the small businessman, it is necessary to examine it as a whole

12. H.R. REP. No. 2543, 83rd Cong., 2d Sess., U.S. CODE CONG. & AD. NEWS,5280, 5333 (1954).

13. INT. REV. CODE OF 1954, § 1371-1378.14,. H.R_ REP. No. 775, S. REP. No. 1983, 85th Cong., 2d Sess., U.S. CODE CONG. &

AD. NEws, 4791, 4876 (1958).

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in determining the intent of Congress vis a vis debt reclassification.Internal Revenue Code section 1376 provides in part:

(b) (2) REDUCTION IN BASIS OF INDEBTEDNESS. The basisof any indebtedness of an electing small business corporationto a shareholder of such corporation shall be reduced (but notbelow zero) by an amount equal to the amount of the share-holder's portion of the corporation's net operating loss forany taxable year (as determined under section 1374 (c)), butonly to the extent that such amount exceeds the adjustedbasis of the stock of such corporation held by the shareholder.',In order to deduct corporate operating losses the shareholder

must reduce the basis of his stock (but not below zero). By allowingfurther adjustments in the basis of "any indebtedness" owing tothe shareholder, Congress allows further loss deductions to theshareholder whose basis in his stock has already been reduced tozero by previous losses. Congress did not place any limit to theamount of indebtedness which provides further operating loss de-ductions. This treatment of debt seems to indicate that not only didCongress recognize the frequency of debt financing in small cor-porations, but also that Congress did not care how much debt washeld nor in what proportion it was issued. It seems logical to concludethat Congress would not allow unlimited debt in section 1376 yetintend that such debt would disqualify a sub S election.

1964

In 1964, an amendment was adopted which prevented disqualifi-cation of the subchapter S election of a corporation which wasa member of an affiliated group owning stock in an inactive subsid-iary. Before the committee discussed the amendment, it reviewedthe function of subchapter S.

The right to elect the treatment provided under the new sub-chapter was limited to small business corporations in part be-cause of the complexity involved in passing the earnings ofa corporation through to its shareholders where the stock ofthe corporation is held by a widely diversified group of share-holders, and in part because it was thought that only the rela-tively small corporations were essentially comparable to thepartnership or proprietorship where the earnings are taxed tothe owners rather than to the business organization.'

15. See also INT. REV. CODE OF 1954, § 1374 (c) (2) (B).16. S. REP. No. 830, 88th Cong., 2d Sess., U.S. CODE CONG. & AD. NEWS, 1673,

1820 (1964).

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1969

As part of the Tax Reform Act of 1969, Congress enacted Codesection 385, which provides in part:

The Secretary . .. is authorized to prescribe such regula-tions as may be necessary or appropriate to determine wheth-er an interest in a corporation is to be treated for purposes ofthis title as stock or indebtedness (emphasis added.) , 7

While the majority of discussion in the legislative history reflectsCongressional concern over the use of debt in corporate acquisitionsand the deductibility of interest payments on debt to shareholders,there are several statements which indicate that this provision ap-plies to the entire Internal Revenue Code.

In view of the uncertainties and difficulties which the dis-tinction between debt and equity has produced in numeroussituations other than those involving corporate acquisitions,the committee further believes that it would be desirable toprovide rules for distinguishing debt from equity in the varietyof contexts in which the problem can arise.'8

Moreover, unlike the rules provided by the bill (as adoptedby the House) in a corporate acquisition context, which dealonly with the allowability of the interest deduction, the guidelines to be promulgated by the Secretary of the Treasury areto be applicable for all purposes of the Internal RevenueCode.',Section 385 does not automatically validate Treasury Regulation

§ 1.1371-1 (g). The statue only authorizes inquiry into whether pur-ported debt represents an equity interest. The regulations to beissued are to determine whether there is a "debtor-creditor rela-tionship" or a "corporation-shareholder relationship," not to deter-mine whether the shareholder has rights so as to constitute a secondclass of stock. In other words, section 385 only authorizes the firststep - debt reclassification - but says nothing about the secondstep - determining whether the reclassified debt is a second classof stock.

SUMMARY

There is no direct discussion in the legislative history of sub-chapter S concerning the problem of debt reclassification. There isonly a small amount of information concerning the purpose of sub-

17. INT. REV. CODE OF 1954, § 385 (a). It has been suggested that Section 385might be an unconstitutional delegation of legislative authority. See Brennan v.O'Donnell, 322 F. Supp. 1069, 1073 n.7 (N.D. Ala. 1971).

18. S. REP. No. 91-552, 91st Cong., 1st Sess., U.S. CODE CoNc. & AD. NEws,2027, 2170 (1969).

19. Id. at 2171.

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chapter S or the one class of stock requirement. From the informa-tion which is available, however, it is possible to draw the follow-ing conclusions:

(1) Congress enacted subchapter S to serve the followingpurposes:(a) To allow businessmen to choose the proper form of

organization without having to take into account fed-eral income tax considerations.

(b) To remove the double taxation of organizations andowners of small corporations and, by doing so, treatthe small corporation similar to partnerships andproprietorships.

(2) The one class of stock requirement was designed to elimi-nate the administrative difficulties of allocating incomeamong shareholders.

(3) Congress knew of and approved of debt financing in smallcorporations by providing additional loss deductions byadjusting the basis of indebtedness held by the share-holder.

(4) Congress wanted debt reclassification to apply to the en-tire Code, including subchapter S.

INVALIDATION OF TREASURY REGULATION §1.1371-1 (g)

THE FIRST REGULATION

Treasury Regulation § 1.1371-1 (g)2O was initially adopted to readas follows:

A corporation having more than one class of stock does notqualify as a small business corporation .... If the outstandingshares of stock of the corporation are not identical with respectto the rights and interest which they convey in the control,profits, and assets of the corporation, then the corporation isconsidered to have more than one class of stock. Thus, a differ-ence as to voting rights, dividend rights, or liquidation pref-erences of outstanding stock will disqualify a corporation ....If an instrument purporting to be a debt obligation is actuallystock, it will constitute a second class of stock (emphasis sup-plied).The regulation was applied in Catalina Homes, Inc.2" and Hender-

son v. United States, 22 but its validity was not questioned until the1966 Tax Court decision of W. C. Gammon. In that case, the share-

20. T.D. 6432, 1960-1 CuM. BULL. 317, 321.21. 33 P-H TAX CT. MEM. % 64,225 (1964).22. 245 F. Supp. 782 (M.D. Ala. 1965).23. 46 T.C. 1 (1966), noted in 41 N.Y.U. L. REV. 1012 (1966).

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holders of a corporation, established to construct housing facilitiesfor the Seattle World's Fair, had made extensive loans to the cor-poration in proportion to their shareholdings. The Service challengedthe corporation's eligibility as a sub S corporation, claiming that theadvances by the shareholders were actually equity advances andconstituted a second class of stock under the above-quoted regula-tion.24 A majority of the court held that the last sentence of the regu-lation was an invalid extension of the statute." After reviewing thelegislative history and the purpose of subchapter S,28 the court couldfind nothing which would justify holding that all instruments whichpurported to be debt but were actually equity must be treated as asecond class of stock.7 Apart from the regulation, the court madeits own determination whether the advances constituted a secondclass of stock and found that they did not. A two-step approach wasapplied: first, the purported debt was reclassified as an equity inter-est according to traditional principles; second, the resulting equityinterest was examined to see whether it was a second class of stock.The court concluded it was not, because the shareholders did not re-ceive any additional rights. The advances, which were in propor-tion to shareholdings, were "simply contributions of additionalcapital which were in reality reflected in the value of the commonstock already held by petitioners."2, Proportionality saved the cor-poration from disqualification because no group of shareholderswas preferred over another group. Any preferences in the incomeand assets of the corporation granted by the purported debt "werepreferences only over themselves as stockholders.",,

In August F. Nielsen Co., Inc.,3" Milton T. Raynor3' and LewisBuilding and Supplies, Inc.," the Tax Court adhered to their decisionin Gammon that advances made in proportion to the nominal share-holdings saved the corporation from disqualification, because share-holders did not receive preferences over other shareholders.

THE REVISED REGULATION

The regulation which was amended to follow Gammon reads inpart:

Obligations which purport to represent debt but which ac-tually represent equity capital will generally constitute a sec-ond class of stock. However, if such purported debt obligations

24. Id. at 6.25. Id. at 8.26. See text at nn. 10 & 11 supra.27. Id. at 8.28. Id. at 9.29. Id.30. 37 P.H TAX CT. MEM. 68,011 (1968).31. 50 T.C. 762 (1968).32. 35 P-H TAX CT. MEM. 66,159 (1966).

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are owned solely by the owners of the nominal stock of thecorporation in substantially the same proportion as their ownnominal stock, such purported debt obligations will be treatedas contributions to capital rather than as a second class ofstock."In James L. Stinnett, Jr.,4 the shareholders made substantial ad-

vances to the corporation evidenced by notes. However, the ad-vances were not proportionate to the shareholdings. The Servicechallenged the corporation's subchapter S eligibility under theamended regulation, and a majority of the Tax Court found that thenew regulation as applied was invalid., Disproportionality of ad-vances should not control whether the corporation had more thanone class of stock, because that would defeat the purpose of Congressand the underlying scheme of Code section 1376 (b) (2).11

The Stinnett approach has been adhered to in H. R. SpinnerCorp.17 and Estate of William M. Allison, 8 and apparently the TaxCourt considers the issue of disproportionate advances as a secondclass of stock settled. In other federal courts, however, the issue isstill open, or where the regulation has been rejected, the courtshave not always agreed on the reasons. The following cases deal witha situation in which shareholders have made disproportionate ad-vances, purported to be debt, to the subchapter S corporation.

In Brennan v. O'Donnell,3 9 the United States District Court forthe Northern District of Alabama refused to apply Treasury Regu-lation § 1.1371-1 (g) to invalidate the sub S election of the corpora-tion merely because the advances were not made in proportion tothe shareholdings. Even though the debt holders had a slight pref-erence over shareholders as shareholders in the distribution ofassets upon liquidation, the preference did not justify disqualifica-tion of sub S status. 4 The court indicated, however, that there mightbe situations where debt-equity interests might constitute a secondclass of stock.

Two panels of the Fifth Circuit, in separate cases, a]so refused toapply Treasury Regulation § 1.1371-1 (g) to disqualify subchapter Scorporations. In Shores Realty Co., Inc. v. United States,4' the courtconcluded that the objectives of the one class of stock requirementwere to prevent double taxation of earnings of a small business cor-

33. T.D. 6904, 1967-1 CuM. BULL. 219.34. 54 T.C, 221 (1971), appeal docketed, 9th Circuit, noted in 50 B.U. L. REV.

577 (1970) and 49 TEXAs L. REv. 376 (1971).35. Id. at 230.36. Id.37. 39 P-H TAX CT. MEM. 70,099 (1970).38. 57 T.C. 174 (1971).39. 322 F. Supp. 1069 (N.D. Ala. 1971).40. Id. at 1073.41. 468 F.2d 572 (5th Cir. 1972).

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poration and to remove administrative burdens in the allocation ofincome. In light of these objectives and the fact that Congress en-visioned debt financing of small business corporations, debt-equityinquiries were not applicable to sub S corporations. 42 There wasnothing in the legislative history to show that Congress wanted toprevent thinly capitalized corporations from making- a sub S elec-tion. Furthermore, Congress used the term "stock" instead of"equity" or "capital," which apparently meant more than capital.Assuming, arguendo, that debt-equity inquiry might be relevant,there was no support in the history of the statute itself for the con-tention that Congress intended to avoid disproportionate rights, atleast in liquidation.4

1

In Amory Cotton Oil Co. v. United States,4 a separate panel ofthe Fifth Circuit held that debt-equity inquiries were appropriatefor a sub S corporation. To hold otherwise would disregard the effectof Code section 385, which authorizes the Secretary of the Treasuryto establish regulations concerning debt reclassification, and wouldhinder examination of tax avoidance schemes.,, In determiningwhether the reclassified debt-is a second class of stock, there arethree factors which should be taken into consideration. The first isthe fact that the general purpose of subchapter S is to permit theselection of a business organization without regard for major taxdifferences. The second is the fact that the statute contemplatesloans from shareholders. The third is the use of the particulardebt.41 Since the regulation did not take into consideration these fac-tors but applied rigid, formalistic rules, it was invalid as written andas applied. The proportionality standard only added to the regula-tion's arbitrariness, because there was nothing to indicate that Con-gress had any intent to disqualify a corporation if loans by share-holders were not in proportion to shareholdings.41

The situation in Portage Plastics Co., Inc. v. United States" in-volved large advances, purported to be debt, by non-shareholderswho later become shareholders. The interest on the notes was afixed percentage of the corporation's profits. The district court foundthat the advances represented equity capital14 but were not a secondclass of stock."° Accordingly, the court refused to apply the regula-

42. /d. at 577.43. Id. at 577-78.44. 468 F.2d 1046 (5th Cir. 1972).45. Id. at 1050.46. Id. at 1051-52.47. Id. at 1054.48. 301 F. Supp. 684 (W.D. Wis. 1969), rev'd, 470 F.2d 308, rev'd on rehearing

en banc, No. 71-1555 (7th Cir. 1972). The first appellate decision was noted in 3MEM. ST. U. L. REV. 168 (1972).

49. 301 F. Supp. at 690.50. Id. at 694.

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tion, because debt-equity inquiry was not relevant to second class ofstock considerations.'

A divided panel of the Seventh Circuit reversed, upholding thevalidity of the regulation and finding that the purported debt inquestion constituted more than one class of stock. In view of thecommittee statement" that no class of stock may be preferred overanother with regard to dividend distribution or voting rights, thecourt decided that Congress sought to prevent one group of share-holders from having preferences over another. Debt-equity inquirywas a reasonable method for making this determination. Since thenotes in question constituted equity, they were a second class ofstock.,, Judge Cummings dissented on the grounds that Congresssought only to prevent allocation difficulties and did not care wheth-er there were inherent preferences, as long as no allocation problemswere present. The only function of debt reclassification is to defeattax avoidance schemes, not by finding more than one class of stock,but by denying the tax advantage sought.,,

Upon rehearing en banc, the Seventh Circuit adopted the reason-ing of Judge Cummings and invalidated the regulation. The onlypurpose of the one class of stock requirement was to prevent al-location problems. Debt reclassification was not relevant in deter-mining whether there was more than one class of stock, but still re-mains a proper method to defeat a tax avoidance scheme.,,

APPROACHES APPLIED TO THE PROBLEM

There have been three approaches used in considering whetherdebt financing leads to an invalidating second class of stock, all ofwhich are based in part upon the legislative intent of Congress inadopting subchapter S and the one class of stock requirement. Atopposite ends of the spectrum are the approaches used in Shoresand Portage on rehearing (debt reclassification is not relevant whendealing with the one class of stock requirement) and the approachtaken by the regulation and upheld in the first Portage appellatedecision (if the reclassified debt creates different rights, it is a sec-ond class of stock). An approach between the two extremes appliesa two-step analysis. It allows debt reclassification but subjects thereclassified debt to another test to see if it is a second class of stock.

51. Id. at 692.52. See text at n. 11 supra.53. 470 F.2d at 315.54. Id. at 317-18.55. United States Court of Appeals for the Seventh Circuit, No. 71-1555, de-

cided March 2, 1973.

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DEBT RECLASSIFICAION Is NOT RELEVANT

The approach taken by Shores and Portage draws heavily on in-ferences from the legislative history of subchapter S. The courtsfound that the one class of stock requirement was designed to servetwo purposes. First, it was to eliminate administrative difficulties inthe allocation of income among shareholders. Second, since the cor-poration was being taxed similar to proprietorships and partner-ships, the requirement would insure that the corporation had a com-parable structure. Inasmuch as there was nothing directly said toshow Congress was concerned with debt financing, debt reclassifi-cation should not be applied to the one class of stock requirement."6

This reflects a liberal interpretation of "one class of stock," whichallows shareholders to create different rights among themselveswith the only apparent limitation being that they do not specifyseparate classes in the share certificates. However, it overlooks thepossibility that by its use of the phrase "class of stock," Congress in-tended to forbid different rights among shareholders. Since thephrase is subject to more than one interpretation, it is dangerous torely on what was not said. Congressional silence is not always anindication of Congressional intent.

DIFFERENT RIGHTS CREATE A SECOND CLASS OF STOCK

The approach taken by Treasury Regulation § 1.1371-1 (g) andoriginally upheld in Portage involves a one-step analysis. If the pur-ported debt is reclassified, the different rights contained in thedebt automatically create more than one class of stock. Proportionalholdings save the corporation from disqualification because nogroup of shareholders has rights different from another .1

The interpretation of "one class of stock" is restrictive; it definesclass of stock to mean an equity interest which reflects differingrights in the corporation. "Class of stock" includes the totality ofrights, no matter how created, which the shareholders have in thecorporation. If the rights differ, the corporation has more than oneclass of stock. Even though the wording of the regulation is less than

56. See generally Braverman, Special Subchapter S Situations - Regulations RunRampant, 114 U. PA. L. REV. 680 (1966); McGaffey, The Requirement that a Sub-chapter S Corporation May Have Only One Class of Stock, 50 MARQ. L. REV. 365(1966); Case Comment, The One-Class-of-Stock Requirement of Subchapter S and theInvalidation of Treasury Regulation 1.1371-1 (g), 50 B. U. L. REV. 577 (1970); Note,Shareholder Lending and Tax Avoidance in a Subchapter S Corporation, 67 COLUM.L. REV. 495 (1967); Comment, Taxation - Federal Taxation of Income - Debt Obliga.tion of Subchapter S Corporation Held Not to Constitute Second Class of Stock, 41N.Y.U. L. REV. 1012 (1966).

57. See also the dissenting opinions of Judge Raum in Gamman, 46 T.C. at 13,and of Judge Sterrett in Stinnett, 54 T.C. at 236.

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mandatory, once debt is reclassified its inherent preferences willdisqualify the corporation on liqudation, since the shareholders, ascreditors, will be preferred over other shareholders in the distribu-tion of assets, unless proportionality exists. Since most debt is in-terest bearing, the creditor-shareholders will also receive a pref-erence in the distribution of the corporation's earnings.

The position of the regulation is based on the premise that Con-gress sought to preclude different rights among shareholders. Thisis supported by the committee statement that no class of stock may bepreferred over another, with regard to voting, distribution or liqui-dation rights."8 However, when this statement is read in contextwith the rest of the report, it appears that it only refers to the al-location of income problem. Thus it appears that differences inrights were forbidden only when they gave rise to allocation dif-ficulties.

The regulation also draws support from the statutory use of thephrase "class of stock." Conceptually, the regulation is probablycorrect in that different classes of stock represent different rightsand privileges among shareholders. However, when this concep-tualistic approach is adopted, the primary purpose of subchapter S,which is to allow businessmen to select the form of business or-ganization without regard to difference in tax treatment, is defeated.The businessman, if he has decided to use debt in the capitalizationof his business, will be required to take into account the variouscriteria which are applied to distinguish debt from equity in orderto guard against the possibility of the debt being reclassified intoa disqualifying second class of stock. Considering the great varietyof factors involved,"8 this is a great burden.

Under the regulation, the only way"0 to insure that the re-classified debt will not constitute a second class of stock is to haveit held in the same proportion as the shares. This places small busi-nesses which need additional capital at a great disadvantage. If allof the shareholders cannot afford to lend in proportion to their share-holdings, the corporation will be forced to re-capitalize instead ofborrow from the shareholders.

58. See quote associated with note 11 supra.59. Murray, supra, note 1, lists a total of thirty-five factors to be considered under

the traditional tests. Regulations pursuant to Section 385 which will, hopefully,simplify the process, have not yet been adopted.

60. The regulation is not clear as to whether there are other instances where reclassi-fied debt will not constitute a second class of stock. While the phrase "will generallyconstitute" seems to leave other possibilities open, only proportionality is listed as asaving feature. By its use of the above phrase the regulation is unclear as to whetherthere is merely a statistical likelihood of the reclassified debt constituting a secondclass of stock or whether the reclassified debt is presumed to be a second class ofstock and the taxpayer has the burden of disproving this presumption.

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In addition, the proportionality requirement restricts the free-dom of businessmen to allocate control and risk as they wish. Forexample, A and B wish to form a business corporation, and A pos-sesses the skill required to operate the business but very littlecapital; B possesses no skill but a considerable amount of capital.Without the proportionality standard, A could receive a majority ofthe shares of stock from his small capital so that he could controlthe operation of the business. B could loan money to the corporationin return for interest bearing notes which would insure that hewould receive at least an equal portion of the earnings. But underthe regulation, contributions to capital must be in proportion toshareholdings. This requires B, the large capital contributor with nomanufacturing or business acumen to have control over the opera-tion of the corporation. When the businessman is required to takethe debt-equity factors into account and assume the risk that thesub S election will be disallowed, it seems that his freedom tochoose an appropriate business organization without regard to dif-ferences in tax treatment is more illusion than reality. One maywonder if the Treasury Department, in amending the regulationafter Gamman, changed its mind or just its language."

MIDDLE OF THE ROAD APPROACH

The Tax Court in Stinnett and the courts in Brennan and Amoryhave rejected the absolutist position, and have used a two-stepanalysis. First, under traditional debt reclassification principles,does the purported debt represent an equity interest in the corpora-tion? Second, does this equity constitute a second class of stock? Thecourts have suggested two situations which would create a secondclass of stock. In botfh, they have agreed that proportionality shouldnot be the determining factor in finding a second class of stock.

Tax Avoidance

Although the courts have not yet been presented with a situationin which debt was used to avoid taxes, the Tax Court in Stinnettseems to intimate that debt reclassification may be appropriate insuch instances.62 In Amory the court recognized that the form of debtshould not be allowed to control when the substance of the trans-action established that the advances represented an equity inter-est. In conventional corporations (sub C) it may be permissible tolabel the equity interest as "stock." But the statutory plan and the

61. Bravenec, The One Class of Stock Requirement of Subchapter S - A RoundPeg in a Pentagonal Hole, 6 Hous. L. REV. 215 (1968).

62. 54 T.C. at 232.

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legislative history of subchapter S indicate that Congress did notintend to disqualify a corporation in all cases where purported debtis reclassified. If the label "stock" is applied to the resultingequity interest, the corporation would have to be disqualified be-cause of the use of the phrase "class of stock" in the statute. To solvethis labeling problem, the court created a special category, "nonstock equity." 3

The court indicated that the particular use of debt will determinewhether the equity interest represented by the purported debt willbe called "non stock equity" or "stock." In view of the fact that noundesirable uses of reclassified debt have as yet been suggested bythe courts, it appears that the traditional tax avoidance use maywell be the only one which will create a second class of stock.

While the pass-through provisions of subchapter S eliminatemost schemes to avoid taxes by the use of debt, the following is asummary of the few which remain.6 4

1. Income splitting. Notes from the corporation could be trans-ferred to someone in a lower tax bracket who would then report theinterest payments as income. To some extent, this problem is re-solved by Code section 1375 (c), which allows dividends received tobe allocated among members of the family to reflect the values ofservices actually rendered to the corporation.

2. PTI withdrawal-loanback. The shareholder is taxed accordingto his pro rata share of all the taxable income of the corporation,whether distributed to him or not. If not distributed to him, theamount already taxed is called previously taxed income (PTI) whichmay be later withdrawn tax free.65 This benefit may be lost if theshareholder transfers his shares or if the distribution from PTI ex-ceeds the shareholder's basis in his stock. 6 In order to protect thisPTI and still keep the money in the business, the taxpayer may with-draw the PTI and immediately loan it back to the corporation. Themoney is still in the business and is insulated as a debt instead ofPTI.

3. Additional loss deduction. In rare instances where the basisof his stock has already been reduced to zero by operating losses, theshareholder may wish to loan money to the corporation so that hemay deduct future losses.61

4. Property received as a distribution. In normal corporationsthe amount of a distribution treated as a dividend is the same whether

63. 468 F.2d at 1051.64. For a more detailed discussion see Note, Shareholder Lending and Tax

Avoidance in a Subchapter S Corporation, 67 COLUM. L. REV. 495 (1967).65. INT. REV. CODE OF 1954, § 1375 (d) (1).66. Treas. Reg. § 1.1375-4 (a), (e).67. INT. REV. CODE OF 1954, § 1374 (c) (2).

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it is in money or property. In a sub S corporation, a distribution ofproperty may result in greater taxable income than if it had been dis-tributed in cash.68 Since the amount of undistributed taxable incomeis not reduced by a distribution of property, this may occur when thecorporation's earnings and profits exceed taxable income or whenthe corporation has accumulated earnings and profits. If the share-holder wishes to avoid these undesirable tax consequences, he may"buy" the desired property from the corporation in exchange for pre-viously issued notes. Any capital gains incurred on the transactionwill probably be preferable to taxation resulting from such a dis-tribution of property.

5. Profits accumulated prior to election. If the corporation hasaccumulated profits prior to the election, the shareholder is not en-titled to receive a tax-free distribution of the money since he has notbeen taxed on that money. Therefore any distribution of that moneywill be treated as a dividend. To avoid this undesirable consequence,the corporation may pay off previously issued notes with the ac-cumulated profits, which is treated as repayment of a loan instead ofa dividend.

It has been suggested69 that debt reclassification would not benecessary to thwart the first three schemes. Reapportioning incomeamong family groups will solve most of the problems created by in-come splitting. To prevent PTI withdrawal-loanback, the Servicecould simply ignore the withdrawal of PTI funds and treat it as adistribution giving rise to ordinary income to the extent of earningsand profits. Where debt is issued to receive additional loss deduc-tions, the Service could disallow the additional deductions. Pre-sumably debt reclassification could be used in the last two situationsto prevent tax avoidance, not to create a second class of stock butto deny the unintended tax advantage.

Incidents of Stock

The Tax Court in Stinnett and the district court in Brennan alsorealized that there must be some permissible middle ground for in-struments which really are not debt, but do not constitute a secondclass of stock. In Stinnett, the court stated:

That is not to say that an instrument called a "note" may not byits very terms be something else. However, where the instru-ment is a simple installment note, without any incidents com-monly attributed to stock, it does not give rise to more than oneclass of stock within the meaning of section 1371 merely be-

68. Note, Shareholder Lending and Tax Avoidance in a Subchapter S Corporation,67 COLUM. L REV. 495 (1967).

69. 470 F.2d at 318 (Dissent by Judge Cummings).

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cause the debt creates disproportionate rights among the stock-holders to the assets of the corporation."

And in Brennan the court expressed the same thought:This is not, of course, to say that debt-equity interests can neverconstitute a second class of stock-there well may be situa-tions where such a conclusion is justified on a consideration oftheir impact on actual voting rights, dividend rights, and liqui-dation rights.7Thus, these courts are using a two-step analysis, with all of the tra-

ditional debt-equity criteria constituting the first test. In the secondstep, the courts examine the reclassified debt to find rights com-monly attributed to stock. But only those rights which courts feel areespecially pertinent to subchapter S will constitute a second class ofstock.

This approach allows some reconciliation of the conflicting state-ments of Congressional intent. By utilizing traditional debt-equityprinciples as the entire test for the first step, the analysis accom-modates the indications that Congress was concerned over the dif-ferences in rights among shareholders ((1) the explicit wording ofthe statute - "one class of stock," (2) the statement by the committeein 1954 that there may be no differences in rights among share-holders).

The second step uses only those traditional criteria which thecourts feel have particular relevance to sub S. This accommodatesthe indications that Congress was not so concerned with differencesin rights among shareholders ((1) the purposes of sub S were topermit small corporate operations similar to proprietorships andpartnerships, and to prevent allocation difficulties, (2) Congressknew debt-equity reclassification problems were common prior tosub S, yet it placed no limitation on debt financing in sub S).

The question in the second step then becomes what violationsof the traditional principles will seem to the courts so severe as torequire a declaration of a second class of stock. It is possible to shed

70. 54 T.C. at 232. The court explained this statement in the later case of Estateof William M. Allison, 57 T.C. 174 (1971). (See also Withey, J., concurring inGamman, 47 T.C. at 13, and Tannenwald, J., concurring in Stinnett, 54 T.C. at 234.)If the debt instrument would be considered stock under applicable state law itwould constitute a disqualifying second class of stock. While it is not uncommonfor local law to be referred to in the interpretation of a word in the Internal RevenueCode, it is questionable whether such an approach is desirable in this matter. Itmight well result in an undesirable lack of uniformity in the administration offederal tax laws, since state laws vary somewhat as to what rights may be granted byclasses of stock. Thus it would be possible for the same debt instrument to create asecond class of stock in State A but not so in State B. Since the phrase in questionis part of a federal statute, the interpretation could be based on federal principleswhich would take into account the special nature of subehapter S.

71. 322 F. Supp. at 1072.

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some light on this problem by examining the treatment the courtshave given to the three basic rights of a holder of a share of stock:the right to share pro-rata in the earnings, assets and control of thecorporation."

EarningsThere are two circumstances concerning earnings which have

been present in the cases dealing with debt reclassification in subS. The first involves the interest due on reclassified notes. After adetermination that the purported debt is equity, any interest paidon the "notes" could logically be called a dividend, and thus a sharein the corporation's earnings. This situation was present in theStinnett, Spinner and Allison cases, however, and the courts ap-parently did not feel that this was an incident of stock sufficientlyserious to require declaring the reclassified debt as a second class ofstock.

The second cirumstance was present in only the Portage case.There the interest on the notes was a fixed percentage of the com-pany's net profits. After reclassification, such a scheme would seemto provide for an obvious sharing in the corporation's earnings, sincethe holder's profit was directly proportional to the success of thecorporation. However, neither of the Portage opinions which in-validated the regulation applied the incidents of stock approach.Therefore, the question is open as to whether this is a sufficientlycritical incident of stock in those jurisdictions which apply a "middleof the road" analysis.

Assets

When the corporation is liquidated the stockholders have a rightto share in the distribution of assets which remain after the creditorshave been paid. If a stockholder is a creditor he is entitled to havehis debt paid before the other shareholders receive their portion ofthe assets.73

Once the debt has been reclassified, if the holder retains thisright to a preferred position on liquidation, it is arguable that thisis an incident of a second class of stock. However, Brennan andStinnett have held that this preference over other shareholders isnot great enough to warrant a finding of a second class of stock.

72. HENN, LAW OF CORPORATIONS, §§ 124, 160 (2d ed. 1970) ; Volume 1,HORNSTEIN, CORPORATION LAW AND PRACTICE, §§ 123-125 (1959).

73. The creditor-shareholder's claim may be subordinated to the claims of othercreditors either by express agreement or by operation of the so-called "Deep RockDoctrine" as expressed in Taylor v. Standard Gas & Electric Co, 306 U.S. 307 (1939).

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ControlThe right to participate in the control of the business is a uni-

versal right of the shareholder, although most states allow a cor-poration to issue non-voting stock. While the voting rights cases arenot necessarily parallel in applying the first step in the analysis(debt reclassification), they do shed light on application of the sec-ond step - i.e., what will create a second class of stock.

The Service has followed the position that any difference invoting rights will create a second class of stock. This was announcedin Revenue Ruling 63-226,11 which stated that where all shareholdersgranted an irrevocable proxy to one shareholder to vote all theshares of the corporation, the effect was to create two classes ofstock: voting and non-voting.

However, the United States District Court for the Southern Dis-trict of Ohio has questioned this reasoning. In A & N Furniture andAppliance Co. v. United States," the stockholders created a votingtrust with one stockholder having the power to vote all shares for aperiod of ten years. The court, applying an approach similar to thattaken in Shores and Portage, concluded that the purpose of theone class of stock requirement was to prevent difficulties in alloca-tion of income, and not to preclude different rights among share-holders. Since differences in voting rights created by a voting trustdid not create allocation difficulties, the court refused to apply theRevenue Ruling and held that an inquiry into the voting differencewas not relevant. The corporation did not have more than one classof stock.76

There has been one other case dealing with voting rights anda second class of stock. In Samuel Pollack," the charter of a cor-poration identified four classes of stock. The classes possessed equalrights except that two classes of stock had disproportionatelysmaller voting rights than the other two. The Tax Court found thatthe corporation had more than one class of stock, saying:

Granted that the difference between the classes was notgreat - merely a difference in voting power to elect direc-tors - it was nevertheless a difference that could have prac-tical consequences, and it is difficult to see how we can ignorethe plain words of the statute. The shareholders in the variousclasses had unequal voting power in respect of election ofdirectors; the classes were separately identified as such inthe charter, as amended; and it seems clear that the statutecovers the situation.7 1

74. 1963-2 CTM. BULL. 341.75. 271 F. Supp. 40 (S.D. Ohio 1967).76. Id. at 45.77. 47 T.C. 92 (1966).78. Id. at 109.

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The Fifth Circuit affirmed,79saying:(the corporation) not only issued four separate classes of

stock under the terms of its charter and applicable Florida law,it also unquestionably had "more than one class of stock"within the plain meaning of the language in Code section1371 (a)(4), since the various classes had unequal votingrights .... To subscribe to taxpayers' contention that the cor-poration had only one class of stock would disregard not onlythe separate class designations in the corporation's charter,but do violence to the history and plain words of the statute."The result is that the Tax Court and the Fifth Circuit, both of

which have taken a liberal view of the term "one class of stock"as applied to debt reclassification, have taken a restrictive viewwhere voting rights were concerned. There are two possible reasonsfor this apparent inconsistency. First, in Pollack the corporation'scharter specifically identified four classes of stock. As seen before,the courts have allowed the corporation and shareholders to createpreferences as long as they were created by instruments other thanshare certificates. But when the corporation labelled the differentrights as "class of stock," it was blatantly ignoring the wording ofthe statute. Thus, the court simply accepted the corporation's ownlabel. Of course, the courts will not accept the corporation's labelto prevent disqualification when the instrument is called a note;the rights created by the instrument must be examined to see ifthey are incidents commonly attributed to stock. The second factorleading to the disqualification in Pollack was the fact that the prefer-ences were in voting rights. Apparently the courts felt that the rightof control was too important to allow the corporation to maintainboth voting differences and sub S status.

It is clear, then, that a combination of the corporation's ownlabel and differences in the substantial right of voting will createa disqualifying second class of stock. However, it remains to beseen how a corporation will be treated when voting differences arecreated by an instrument which is not called a share certificate.The existence of a note evidencing indebtedness does not, by itself,create differences in voting power, but it is often combined withan arrangement which leads to differences in voting powers.

When a corporation is in need of large amounts of capital, it isnot uncommon for a lender to insist upon some measure of controlover the operation of the business. By exercising this control, such asthrough a voting trust where he is the trustee, the lender can protecthis investment by insuring that the business will pursue wise man-agement policies.

79. Samuel Pollack v. Comm'r, 392 F.2d 409 (5th Cir. 1968).80. Id. at 411.

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It seems that such an arrangement would lead to disqualificationif the lender is also a shareholder. By combining the preferencesinherent in debt with the superior right in control, the creditor-shareholder possesses all the incidents commonly attributed to stock- preferences in earnings, assets and control. In other words, he hasgone too far.

The balancing test as applied in the incidents of stock approachallows the businessman a great deal of freedom in capitalizing hiscorporation, which was one of the objectives of subchapter S. Ifhe stays within reasonable bounds in issuing debt he will not haveto worry about a sub S election being disqualified. However, he islimited by the principle expressed in the old Wall Street adage -"You can make money being a bear and you can make money beinga bull. But you can't make money being a pig." Once the businessmanbecomes greedy and seeks to create the totality of rights which wouldbe embodied in a separate class of stock, but uses the label of debtinstead of share certificates, he risks disqualification.

Traditionally, debt reclassification has been used for one pur-pose - the prevention of unintended tax advantages.' When con-ventional corporations were involved, the Service had no reasonto reclassify debt as equity for the sake of accurately characterizingthe interests involved; the only reason to reclassify debt was to pre-vent a tax avoidance scheme and insure that form would not prevailover substance when it came time for payment of taxes.

Under the Middle of the Road approach, debt reclassificationserves a dual function - preventing tax avoidance and accuratelycharacterizing the interest represented by the purported debt. Byusing debt reclassification to determine whether a second class ofstock has been created, the courts are assuming that Congresssought to prevent differences in rights which were equivalent todifferences in classes of stock but not labelled as such. However,there are only a few sentences in the legislative history which couldbe said to support this position.

Aside from the problem of using debt reclassification to finddifferences which Congress might not have cared about, the Middleof the Road approach presents another difficulty. It will require aconsiderable case by case inquiry to determine whether a secondclass of stock is created when debt is used in combination withother arrangements or in the case of debt instruments convertibleinto stock. Thus corporate planners are left with few guidelines tofollow when they establish a new corporation.

Despite its problems, the Middle of the Road approach seems tobe an acceptable method of reconciling what appears to be conflict-

81. See generally sources cited in note 1, supra.

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ing Congressional statements, while allowing a great deal of freedomin capitalizing the corporation. It is useful only as a stop-gap measureuntil Congress clarifies its position.

CONCLUSION

The one class of stock requirement has perplexed the courts andthey have failed to develop a completely satisfactory approach whichwill give full effect to the elusive legislative intent as expressedin the legislative history of subchapter S. Obviously, the solutionlies with Congress. There have been several proposals for legisla-tive reform of subchapter S82 but none have been adopted as yet.Until Congressional action is taken to clarify existing ambiguitiesin the law the small businessman is faced with the prospect of ex-pensive and time-consuming litigation in the event that the cor-porate debt is susceptible of reclassification as equity.

James P. Fitzgerald - '74

82. See JOINT STAFF OF HOUSE COMMITTEE ON WAYS AND MEANS AND SENATECOMMITTEE ON FINANCE, TAX REFORM STUDIES AND PROPOSALS, 91ST CONG., 1STSESS., U. S. Treasury Dept., part 2, at 271-275 (1969) ; Fischer, Proposals to RevampSubchapter S, 49 TAXES 407 (1971); Rosenkranz, Subchapter S: The PresidentialProposals, 55 A.B.A.J. 1181 (1969).

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reclassified debt as a second class of stock in subchapter

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