MURNAGHAN, Circuit Judge:
The appellants, Anthony D. and Marjorie F. Cuzzocrea and the Estate of Daniel Leavitt, Deceased, et al., appeal the Tax
As shareholders of VAFLA Corporation,
The appellants contend, however, that the adjusted bases in their stock should be increased to reflect a $300,000 loan which VAFLA obtained from the Bank of Virginia ("Bank") on September 12, 1979, after the appellants, along with five other shareholders ("Shareholders-Guarantors"), had signed guarantee agreements whereby each agreed to be jointly and severally liable for all indebtedness of the corporation to the Bank.
VAFLA's financial statements and tax returns indicated that the bank loan was a loan from the Shareholders-Guarantors. Despite the representation to that effect, VAFLA made all of the loan payments, principal and interest, to the Bank. The appellants made no such payments. In addition, neither VAFLA nor the Shareholders-Guarantors treated the corporate payments on the loan as constructive income taxable to the Shareholders-Guarantors.
The appellants present the question whether the $300,000 bank loan is really, despite its form as a borrowing from the Bank, a capital contribution from the appellants to VAFLA. They contend that if the bank loan is characterized as equity, they are entitled to add a pro rata share of the $300,000 bank loan to their adjusted bases, thereby increasing the size of their operating loss deductions.
Finding no economic outlay, we need not address the question, which is extensively addressed in the briefs, of whether the characterization of the $300,000 was debt or equity.
To increase the basis in the stock of a subchapter S corporation, there must be an economic outlay on the part of the shareholder. See Brown v. Commissioner, 706 F.2d 755, 756 (6th Cir.1983), affg. T.C. Memo. 1981-608 (1981) ("In similar cases, the courts have consistently required some economic outlay by the guarantor in order to convert a mere loan guarantee into an investment."); Blum v. Commissioner, 59 T.C. 436, 440 (1972) (bank expected repayment of its loan from the corporation and not the taxpayers, i.e., no economic outlay from taxpayers).
The situation would be different if VAFLA had defaulted on the loan payments and the Shareholders-Guarantors had made actual disbursements on the corporate indebtedness. Those payments would represent corporate indebtedness to the shareholders which would increase their bases for the purpose of deducting net
The appellants accuse the Tax Court of not recognizing the critical distinction between § 1374(c)(2)(A) (adjusted basis in stock) and § 1374(c)(2)(B) (adjusted basis in indebtedness of corporation to shareholder). They argue that the "loan" is not really a loan, but is a capital contribution (equity). Therefore, they conclude, § 1374(c)(2)(A) applies and § 1374(c)(2)(B) is irrelevant. However, the appellants once again fail to distinguish between the initial question of economic outlay and the secondary issue of debt or equity. Only if the first question had an affirmative answer, would the second arise.
The majority opinion of the Tax Court, focusing on the first issue of economic outlay, determined that a guarantee, in and of itself, is not an event for which basis can be adjusted. It distinguished the situation presented to it from one where the guarantee is triggered and actual payments are made. In the latter scenario, the first question of economic outlay is answered affirmatively (and the second issue is apparent on its face, i.e., the payments represent indebtedness from the corporation to the shareholder as opposed to capital contribution from the shareholder to the corporation). To the contrary is the situation presented here. The Tax Court, far from confusing the issue by discussing irrelevant matters, was comprehensively explaining why the transaction before it could not represent any kind of economic outlay by the appellants.
The Tax Court correctly determined that the appellants' guarantees, unaccompanied by further acts, in and of themselves, have not constituted contributions of cash or other property which might increase the bases of the appellants' stock in the corporation.
The appellants, while they do not disagree with the Tax Court that the guarantees, standing alone, cannot adjust their bases in the stock, nevertheless argue that the "loan" to VAFLA was in its "true sense" a loan to the Shareholders-Guarantors who then theoretically advanced the $300,000 to the corporation as a capital contribution. The Tax Court declined the invitation to treat a loan and its uncalled-on security, the guarantee, as identical and to adopt the appellants' view of the "substance" of the transaction over the "form" of the transaction they took. The Tax Court did not err in doing so.
Generally, taxpayers are liable for the tax consequences of the transaction they actually execute and may not reap the benefit of recasting the transaction into another one substantially different in economic effect that they might have made. They are bound by the "form" of their transaction and may not argue that the "substance" of their transaction triggers different tax consequences. Don E. Williams Co. v. Commissioner, 429 U.S. 569, 579-80, 97 S.Ct. 850, 856-57, 51 L.Ed.2d 48 (1977); Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149, 94 S.Ct. 2129, 2137, 40 L.Ed.2d 717 (1974).
In the case before us, the Tax Court found that the "form" and "substance" of the transaction was a loan from the Bank to VAFLA and not to the appellants:
Whether the $300,000 was lent to the corporation or to the Shareholders/Guarantors is a factual issue which should not be disturbed unless clearly erroneous. Finding no error, we affirm.
It must be borne in mind that we do not merely encounter naive taxpayers caught in a complex trap for the unwary. They sought to claim deductions because the corporation lost money. If, however, VAFLA had been profitable, they would be arguing that the loan was in reality from the Bank to the corporation, and not to them, for that would then lessen their taxes. Under that description of the transaction, the loan repayments made by VAFLA would not be on the appellants' behalf, and, consequently, would not be taxed as constructive income to them. See Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 49 S.Ct. 499, 73 L.Ed. 918 (1929) (payment by a corporation of a personal expense or debt of a shareholder is considered as the receipt of a taxable benefit). It came down in effect to an ambiguity as to which way the appellants would jump, an effort to play both ends against the middle, until it should be determined whether VAFLA was a profitable or money-losing proposition. At that point, the appellants attempted to treat the transaction as cloaked in the guise having the more beneficial tax consequences for them.
Finally, the appellants complain that the Tax Court erred by failing to apply debt-equity principles
The appellants, in effect, attempt to collapse a two-step analysis into a one-step inquiry which would eliminate the initial determination of economic outlay by first concluding that the proceeds were a capital contribution (equity). Obviously, a capital contribution is an economic outlay so the basis in the stock would be adjusted accordingly. But such an approach simply ignores the factual determination by the Tax Court that the Bank lent the $300,000 to the corporation and not to the Shareholders-Guarantors.
The appellants rely on Blum v. Commissioner, 59 T.C. 436 (1972), and Selfe v. United States, 778 F.2d 769 (11th Cir.1985), to support their position. However, the appellants have misread those cases. In Blum, the Tax Court declined to apply debt-equity principles to determine whether the taxpayer's guarantee of a loan from a bank to a corporation was an indirect capital contribution.
The Tax Court then distinguished Plantation Patterns, 462 F.2d 712 (5th Cir.1972), relied on by Selfe, because that case involved a C corporation, reasoning that the application of debt-equity principles to subchapter S corporations would defeat Congress' intent to limit a shareholder's pass-through deduction to the amount he or she has actually invested in the corporation.
The Tax Court also distinguished In re Lane, 742 F.2d 1311 (11th Cir.1984), relied on by the Selfe court, on the basis that the shareholder had actually paid the amounts he had guaranteed, i.e., there was an economic outlay. In Lane, which involved a subchapter S corporation, the issue was "whether advances made by a shareholder to a corporation constitute debt or equity. . . ." Id. at 1313. If the advances were debt, then Lane could deduct them as bad debts. On the other hand, if the advances were capital, no bad debt deduction would be permitted. Thus, the issue of adjusted basis for purposes of flow-through deductions from net operating losses of the corporation was not at issue. There was no question of whether there had been an economic outlay.
Although Selfe does refer to debt-equity principles, the specific issue before it was whether any material facts existed making summary judgment inappropriate. The Eleventh Circuit said:
The Selfe court found that there was evidence that the bank primarily looked to the taxpayer and not the corporation for repayment of the loan.
Granted, that conclusion is clouded by the next and final statement of the Selfe court: "In short, we remand for the district court to apply Plantation Patterns and determine if the bank loan to Jane Simon, Inc. was in reality a loan to the taxpayer." Id.
In conclusion, the Tax Court correctly focused on the initial inquiry of whether an economic outlay existed. Finding none, the issue of whether debt-equity principles ought to apply to determine the nature of the economic outlay was not before the Tax Court. The Tax Court is
Selfe, 778 F.2d at 773.
It is important to note that those cases did not involve the question posed here of whether an economic outlay existed because it clearly did. Actual payments were made. The only question was what was the nature of the payments, debt or equity.
See also 26 U.S.C. § 385.
The appellants correctly state that the First, Fifth and Ninth Circuits have all applied traditional debt-equity principles in determining whether a shareholder's guarantee of a corporate debt was in substance a capital contribution. See Casco Bank & Trust Co. v. United States, 544 F.2d 528 (1st Cir.1976), cert. denied, 430 U.S. 907, 97 S.Ct. 1176, 51 L.Ed.2d 582 (1977); Plantation Patterns v. Commissioner, 462 F.2d 712 (5th Cir.1972), cert. denied, 409 U.S. 1076, 93 S.Ct. 683, 34 L.Ed.2d 664 (1972); Murphy Logging Co. v. United States, 378 F.2d 222 (9th Cir.1967). What the appellants fail to point out, however, is that those cases each involved activated guarantees, i.e., actual advances or payments on defaults. Therefore, the issue in those cases was not whether the taxpayer had made an "investment" — an economic outlay — in the corporation. The investment was admitted. The issue in those cases asked what was the nature of the investment — equity or debt. None of those cases involved the disallowance of deductions claimed by a shareholder pursuant to § 1374 for his or her share of an electing corporation's operating losses where there had simply been no economic outlay by the shareholder under the guarantee.
Blum, 59 T.C. at 439 n. 4. In other words, the Blum court never reached the second step of the analysis, if there is a second step, because it found that there was no economic outlay. The Tax Court focused on the first inquiry: "we must find that the bank in substance loaned the sums to petitioner, not the corporation, and that petitioner then proceeded to advance such funds to the corporation." Id. at 440. The court found that "there is no evidence to refute the fact that the bank expected repayment of its loan from the corporation and not the petitioner." Id.
Similarly, in Brown, the Sixth Circuit refused to "accept petitioners' contorted view of the transaction in furtherance of their `substance over form' argument when, as the court below observed, `the substance matched the form.'" Brown, 706 F.2d at 756. In other words, the loan to the corporation was, indeed, a loan to the corporation. See also In re Breit, 460 F.Supp. 873 (E.D.Va.1978).
The confusion may be explained to some degree because the test applied in Blum to determine whether the bank lent the money to the corporation or to the shareholders sounds similar to one of the debt-equity factors, i.e., the source of the payments. When focusing on the proper question, however, it becomes clear that the debt-equity principles are simply irrelevant to the determination of whether the $300,000, unquestionably a loan when it left the Bank, went to VAFLA or to the appellants. In Blum, the fact that the bank expected repayment from the corporation indicated that it actually lent the funds to the corporation and not the shareholder. Similarly, in the case before us, the fact that VAFLA paid the principal and interest on the $300,000 loan and did not treat the payments as constructive income taxable to the Shareholders-Guarantors, indicated that the Bank actually lent the money to VAFLA and not the appellants.
S.Rep. No. 1983, 85th Cong., 2d Sess. at 220, (1958-3 Cum.Bull. at 1141). The word "investment" was construed to mean the actual economic outlay of the shareholder in question. Perry v. Commissioner, 54 T.C. 1293, 1296 (1970).
In other words, the economic outlay must be found to exist first.
This particular situation is not before us and we decline to address the question of whether a guarantee can be an economic outlay when accompanied by pledged collateral.