*214 Decisions will be entered under Rule 50.
1. Held, non-interest-bearing notes issued to the stockholders of an electing small business corporation in exchange for their capital in the predecessor partnership, whether regarded as "debt" or as "equity," did not give rise to more than one class of stock within the meaning of sec. 1371(a), I.R.C. 1954. Regs. sec. 1.1371-1(g) invalidated.
2. Held, the leasehold term was for an indefinite period and leasehold *215 improvements thereon must be depreciated over their useful life.
*222 Respondent determined deficiencies as follows:
| Docket No. | Petitioner(s) | Taxable | Deficiency |
| year | |||
| 3414-67 | James L. Stinnett, Jr | 1962 | $ 225.30 |
| 3415-67 | James L. Stinnett, Jr., and Bonnie H. Stinnett | 1963 | 446.40 |
| 1964 | 1,322.90 | ||
| 3416-67 | James E. Thomas and Cathern Thomas | 1963 | 565.82 |
| 1964 | 429.63 | ||
| 1962 | 211.26 | ||
| 3418-67 | Robert E. Brown and Grace H. Brown | 1963 | 530.61 |
| 1964 | 807.06 | ||
| 1962 | 636.95 | ||
| 3515-67 | Louis H. Heath and Mary S. Heath | 1963 | 1,605.05 |
| 1964 | 1,083.03 | ||
| 1962 | 169.63 | ||
| 5094-67 | Harold L. Roberts and Lois Roberts | 1963 | 4,413.60 |
| 1964 | 356.00 |
*216 The issues for decision are: (1) Whether International Meadows, Inc., had more than one class of stock within the meaning of section 1371(a) of the Internal Revenue Code of 1954 thereby rendering its election to be taxed as a small business corporation invalid; and (2) whether a lease pursuant to which the lessee made certain leasehold improvements was a lease for a term certain for purposes of amortizing the cost of such improvements. A decision on these questions will dispose of the issues in dockets Nos. 3414-67, 3415-67, 3416-67, 3418-67, 3515-67, and 5094-67.
FINDINGS OF FACT
Issue 1. Qualification Under Section 1371(a)Some of the facts were stipulated and they are so found. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.
Petitioner James L. Stinnett, Jr., at the time of filing his petition in this case resided in El Segundo, Calif. Petitioner Bonnie H. Stinnett resided in Seattle, Wash. James L. Stinnett, Jr., and Bonnie H. Stinnett were husband and wife during 1962, 1963, and 1964 and filed joint Federal income tax returns for said years with the district director of internal revenue at Los Angeles, Calif.
Petitioners*217 James E. Thomas and Cathern Thomas resided in El Segundo, Calif., at the time they filed their petition herein. They were husband and wife during 1963 and 1964 and filed joint Federal income tax returns with the district director of internal revenue at Los Angeles, Calif.
*223 Petitioners Robert E. Brown and Grace H. Brown resided in Anaheim, Calif., at the time they filed their petition herein. They were husband and wife during 1962, 1963, and 1964 and filed joint Federal income tax returns with the district director of internal revenue at Los Angeles, Calif.
Petitioners Louis H. Heath and Mary S. Heath resided in El Segundo, Calif., at the time they filed their petition herein. They were husband and wife during 1962, 1963, and 1964 and filed joint Federal income tax returns with the district director of internal revenue at Los Angeles, Calif.
Petitioners Harold L. Roberts and Lois Roberts resided in Reno, Nev., at the time they filed their petition herein. They were husband and wife during 1962, 1963, and 1964 and filed joint Federal income tax returns with the district director of internal revenue at Reno, Nev.
In early 1962 petitioners James L. Stinnett, Jr., Robert E. *218 Brown, Louis H. Heath, and Harold L. Roberts formed a partnership known as J. B. J. Co. for the purpose of operating a golf driving range in El Segundo, Calif. Prior to this time on October 6, 1961, J. B. J. Co., which at that time was composed of Stinnett, Brown, and Heath, executed a lease with the Standard Oil Co. of California (hereinafter referred to as Standard Oil). Under this lease J. B. J. Co. leased a certain tract in El Segundo, Calif., for 3 years for use as a golf driving range.
Petitioners Brown and Stinnett had spent 2 years and 9 months in attempts to obtain this lease from Standard Oil. During this period Brown and Stinnett engaged in surveys and projections in order to evaluate the possibilities of success for a driving range in the El Segundo area. In undertaking these surveys Brown and Stinnett incurred expenses which were unreimbursed.
When Brown and Stinnett realized that the lease from Standard Oil was forthcoming, they determined that they would need additional capital. They then contacted a mutual friend, petitioner Heath, who consented to join the venture.
Brown and Stinnett each contributed $ 10,000 and Heath contributed $ 20,000. Brown and Stinnett*219 were each to have a 35-percent interest in the partnership and Heath was to have 30 percent. In addition Heath was to manage the business and receive a salary. The reason for the discrepancy in the partnership percentage division was the aforenoted time and funds that Brown and Stinnett had expended in promoting the venture.
In the early part of 1962 petitioner Harold L. Roberts, another friend, joined the partnership. Roberts contributed about $ 53,000. As of May 31, 1962, the partners' percentages for sharing profits and losses were: *224
| Percent | |
| Robert E. Brown | 27 |
| James L. Stinnett | 27 |
| Louis H. Heath | 23 |
| Harold L. Roberts | 23 |
The partners' capital accounts were:
| Robert E. Brown | $ 8,504.35 |
| James L. Stinnett | 8,504.35 |
| Louis H. Heath | 18,753.62 |
| Harold L. Roberts | 52,252.17 |
On April 6, 1962, International Meadows, Inc. (hereinafter referred to as the corporation), was formed under the laws of the State of California for the purpose of operating the golf driving range that had been operated by J. B. J. Co. Article four of the articles of incorporation provided:
This corporation is authorized to issue only one class of shares of stock; the total number*220 of said shares shall be One Hundred (100) of a par value of One ($ 1.00) Dollar per share; and the aggregate par value of all shares having a par value is One Hundred (100.00) Dollars.
On May 25, 1962, the corporation obtained from the commissioner of corporations of the State of California a permit to sell and issue 100 shares of its common stock for $ 1 per share. The stock was issued and held of record as follows:
| Shares | |
| Robert E. Brown | 27 |
| James L. Stinnett | 27 |
| Louis H. Heath | 23 |
| Harold L. Roberts | 23 |
On May 31, 1962, J. B. J. transferred all of its assets and liabilities to the corporation. In return for the transfer each partner was to receive a promissory note equal to the amount of his capital account as of May 31, 1962. Such notes were ultimately issued on November 28, 1962, payable in 58 monthly installments without interest.
The notes were executed on behalf of the corporation by James L. Stinnett. The notes were identical except for the identity of the payee and the amount payable. The note given to petitioner Heath provided:
NOTE
El Segundo, California
November 28,1962$ 16,307.50
For Value received, International Meadows, Inc., a corporation, promises*221 to pay to Louis H. Heath and/or Mary S. Heath or order at El Segundo, California, the sum of Sixteen Thousand Three Hundred Seven and 50/100th Dollars without interest, payable in fifty-eight monthly installments, fifty-seven installments of $ 281.16 and one final installment of $ 281.38. First installment to be payable January 1, 1963.
PresidentSecretary-Treasurer*225 On June 14, 1962, the corporation timely elected under the provisions of section 1372 to be taxed as a small business corporation.
On or about July 15, 1962, Louis H. Heath transferred three shares of stock to Harold L. Roberts. At the same time Heath also transferred to Roberts $ 2,446.12 of the debt owed him by the corporation. This explains the deviation between Roberts' capital account as of May 31, 1962, and the amount of the note ($ 54,698.29) made payable to him. Roberts gave Heath approximately $ 6,000 in return for the transfer of the stock and the indebtedness.
The petitioners claim, and the respondent does not seriously dispute, that Brown, Stinnett, Heath, and Roberts fully expected the notes to be repaid over the term of the lease. However, due to problems encountered in *222 starting up the business and to its failure to come up to expectations, the corporation did not have the funds to make payments on the notes.
As of December 31, 1964, the corporation was also indebted to a bank in the sum of $ 18,500 in addition to certain other liabilities.
In December of 1962 James L. Stinnett, Jr., and Robert E. Brown each transferred four shares of stock of the corporation to James E. Thomas, as an inducement to Thomas to make a loan to the corporation. In November and December of 1962 Thomas made advances to the corporation of $ 20,000 at 6-percent interest. As of October 1967 the unpaid balance of the loan was $ 15,681.22 and interest had been paid up to that date.
For the taxable years in issue the corporation did not (a) have more than 10 shareholders, (b) have as a shareholder a person who is not an individual, (c) have a nonresident alien as a shareholder, and (d) have any passive investment income as that term is defined by section 1372(e)(5).
For the taxable years 1963 and 1964 each of the petitioners deducted their distributable share of the net operating loss of the corporation as follows:
| 1963 | 1964 | Total | |
| Stinnett | $ 8,529.29 | $ 6,854.55 | $ 15,383.84 |
| Thomas | 2,966.72 | 2,384.19 | 5,350.91 |
| Brown | 8,529.29 | 6,854.55 | 15,383.84 |
| Heath | 7,416.78 | 5,964.08 | 13,380.86 |
| Roberts | 9,641.80 | 7,748.94 | 17,390.74 |
| International Meadows | 37,083.88 | 2 29,806.31 | 66,890.19 |
In his notice of deficiency, respondent disallowed the deduction by the individual petitioners of their respective shares of the net operating losses of the corporation for the taxable years 1963 and 1964. In *226 support of these adjustments, the respondent took the position that the corporation did not qualify as a small business corporation under section 1371(a) of the 1954 Code.
Issue 2. Amortization of Leasehold ImprovementsAs stated heretofore, on October 6, 1961, J. B. J. Co. by James L. Stinnett, Jr., Robert E. Brown, and Louis H. Heath executed a lease with Standard Oil. The demised premises in El Segundo, Los Angeles County, Calif., were to be used exclusively as a golf driving range. The lease provided for a term of three years "from the*224 1st day of October, 1961 to the 1st day of October, 1964, and thereafter until terminated." The lease could be terminated on or after October 1, 1964, by either party upon giving not less than 90 days' written notice.
The lessee was required to pay a minimum rental of $ 500 per month plus a scheduled graduated percentage of the prior months' gross receipts. As additional consideration the lessee was required to make improvements to the exent of $ 40,000.
The original lease also contained a termination clause (section 5) which read in part as follows:
In the event Lessor, in its sole opinion, requires the demised premises in its business or operations, it may give Lessee one hundred eighty (180) days' written notice of its intention to buy back the leasehold estate herein granted and all buildings and appurtenances thereon, excluding personal property.
By an agreement entitled "Modification of Lease," dated October 1, 1962, the lessor consented to the transfer of the lessee's interest to the corporation. In addition, the lease was amended by increasing the term to 6 years from October 1, 1961, to October 1, 1967. After this term the lease (as in the original) could be terminated*225 by either party upon 90 days' written notice.
Initially, it was contemplated that the business would be limited to a driving range, and on February 28, 1962, the driving range had been placed in operation. After modification of the lease, the corporation expanded its operations from merely operating a driving range to a golf course having nine par-three holes and ultimately four par-four holes and five par-three holes. The expansion to a longer course with par-four holes occurred subsequent to 1963.
The use of the property as a driving range and golf course required certain leasehold improvements. The cost of these improvements as of May 31, 1962, was $ 74,740.62. As of December 31, 1962, the cost of leasehold improvements was $ 99,841.28. 3
*226 *227 Despite repeated requests by petitioner, the lessor has been unwilling to extend the term of the lease. As of the date of the trial, International Meadows remained in possession subject to 90 days' notice of termination.
On its partnership return of income for the taxable year from February 28, 1962, to May 31, 1962, J. B. J. claimed amortization deductions of $ 5,613.72 for its leasehold improvements on the theory that the original lease with Standard Oil provided for a fixed term expiring October 1, 1964. Respondent disallowed $ 4,636.29 of this amount on the grounds that the leasehold improvements should be depreciated over their useful lives rather than amortized over the 3-year period in the lease. The resulting increase in the taxable income of the partnership resulted in the deficiencies in the income tax of petitioners Stinnett, Brown, Heath, and Roberts for the taxable year 1962.
On the small business corporation returns of income for the fiscal years ending May 31, 1963, and May 31, 1964, the corporation amortized its leasehold improvements over the period specified in the amended lease. In his statutory notice of deficiency to each petitioner the respondent*227 disallowed the deductions for amortization. The respondent allowed depreciation based on the useful lives of each of the components of the account termed "leasehold improvements," which respondent determined to be as follows:
| Date | Years | ||
| Leasehold improvements | acquired | Cost | useful |
| life | |||
| Water system | 2/1/62 | $ 7,163.42 | 8 |
| Do | 6/1/62 | 975.53 | 8 |
| Electric system | 2/1/62 | 11,629.28 | 20 |
| Do | 5/1/63 | 2,089.90 | 20 |
| Do | 6/1/63 | 49.73 | 20 |
| Range fence | 2/1/62 | 6,000.00 | 4 |
| Do | 6/1/62 | 387.00 | 4 |
| Do | 6/1/62 | 1,497.52 | 4 |
| Outside fence | 2/1/62 | 3,387.24 | 10 |
| Building | 2/1/62 | 15,024.15 | 25 |
| Do | 6/1/62 | 3,661.32 | 25 |
| Paving | 2/1/62 | 4,677.43 | 10 |
| Do | 6/1/62 | 726.00 | 10 |
The petitioners did not introduce evidence with respect to the useful lives of the leasehold improvements. In the absence of such evidence, *228 the respondent's determination with respect to the useful lives of the leasehold improvements must be accepted as correct.
OPINION
Issue 1. Qualification under Section 1371(a)The corporation sustained losses during the years in question which were reflected in the individual income tax returns filed by the various petitioners on the*228 assumption that the corporation was a "small business corporation" as defined in section 1371(a) and had made a valid election to be taxed in accordance with the provisions of subchapter S. The respondent has disallowed those deductions on the ground that the corporation was not a small business corporation as defined in section 1371(a). That section provides:
(a) Small Business Corporation. -- For purposes of this subchapter, the term "small business corporation" means a domestic corporation which is not a member of an affiliated group (as defined in section 1504) and which does not --
(1) have more than 10 shareholders;
(2) have as a shareholder a person (other than an estate) who is not an individual;
(3) have a nonresident alien as a shareholder; and
(4) have more than one class of stock.
In the stipulation of facts, the respondent concedes that the corporation meets the first three requirements for qualification under section 1371(a) but contends that the corporation had outstanding more than one class of stock. In support of this position, the respondent argues that certain advances to the corporation by the petitioners evidenced by installment notes gave rise to an*229 "equity" interest which was, in substance and reality, redeemable preferred stock. As a result, the corporation had outstanding two classes of stock.
We have here a case in which four individuals joined together in a partnership to establish and operate a recreation facility on leased land. Each contributed an agreed amount to the capital of the partnership in order to finance the leasehold improvements. Each was to receive a share of the profits from the venture in percentages which varied, and appear not to have been dependent upon their respective capital contributions.
Within a relatively short period thereafter, the assets and liabilities of the partnership were transferred to a newly formed corporation which issued its common stock to the former partners in proportion to their share in the profits of the partnership. In addition, the corporation issued to each a non-interest-bearing note payable in installments for the amount of the capital contributed by each to the partnership. The installment payments on these notes were designed to liquidate the obligations over the term of the lease, thereby intending that the cash flow resulting from the amortization of the leasehold*230 *229 improvements and from profits would provide sufficient funds to pay off the notes.
The corporation had only a nominal capitalization wholly inadequate for the needs of the business. The notes were non-interest-bearing and were subordinated in fact, if not by their terms, to the other indebtedness of the corporation. Because of the circumstances, the respondent contends that for tax purposes the so-called "debt" represented by these notes should be regarded as "equity" capital. From this premise, the respondent concludes that the corporation had outstanding two classes of stock. While the respondent's premise may be well taken, were we concerned with treatment of payments of principal or interest on account of these notes under general tax law, it is not determinative of the issue in this case. Even accepting the respondent's argument, we would not have two classes of stock, one class being represented by the common stock, and the other being represented by the notes.
The notes did not entitle the holders to any right to vote or to participate in the decision-making process. The notes did not entitle the holders to participate in any of the earnings or growth of the*231 business, being limited solely to the repayment of the "debt" itself without interest. While the notes were subordinated and subject to all of the risks of the business, nevertheless it would be wholly unrealistic to treat these notes standing alone as another class of stock. The notes represented an "equity" interest only so long as coupled with the ownership of the common stock.
The obvious purpose of the notes was to provide that distributions by the corporation out of its "cash flow" would be applied first in repayment of the original capital shares of the former partners. Those amounts were disproportionate to their respective interests in the profits as represented by the common stock. Thus if we are to regard the notes as "equity," we either have an equity interest or capital advance which does not affect the character of the stock under section 1371, or we have three separate classes of stock. 4
*232 *230 Faced with this choice, it is our opinion that regardless whether the notes in question be considered as "debt" or as "equity" under other provisions of the internal revenue laws, for purposes of section 1371 such notes do not change the character of the common stock so as to give rise to more than one class of stock.
An instrument which upon its face constitutes evidence of indebtedness and does not carry with it rights or privileges commonly attributed to stock is generally deemed to be an "equity" interest by coupling the debt with a formal stock interest held by the same or a related person. That is the essence of the so-called thin-capitalization doctrine. Ambassador Apartments, Inc., 50 T.C. 236">50 T.C. 236, affirmed per curiam 406 F. 2d 288 (C.A. 2, 1969); Fin Hay Realty Co. v. United States, 398 F. 2d 694 (C.A. 3, 1968); J. S. Biritz Construction Co. v. Commissioner, 387 F. 2d 451 (C.A. 8, 1967); Tomlinson v. 1661 Corp., 377 F. 2d 291 (C.A. 5, 1967); Smith v. Commissioner, 370 F. 2d 178 (C.A. 6, 1966); see*233 also 42 Tul. L. Rev. 251">42 Tul. L. Rev. 251. In recognition of this, this Court concluded in W. C. Gamman, 46 T.C. 1 (1966), that where the debt was in the same proportion as the stock, there was not a second class of stock.
Following our decision in the Gamman case, the Commissioner amended regulations section 1.1371-1(g) to provide, in part, as follows:
Obligations which purport to represent debt but which actually represent equity capital will generally constitute a second class of stock. However, if such purported debt obligations are owned solely by the owners of the nominal stock of the corporation in substantially the same proportion as they own such nominal stock, such purported debt obligations will be treated as contributions to capital rather than a second class of stock. But, if an issuance, redemption, sale, or other transfer of nominal stock, or of purported debt obligations which actually represent equity capital, results in a change in a shareholder's proportionate share of nominal stock or his proportionate share of such purported debt, a new determination shall be made as to whether the corporation has more than *234 one class of stock as of the time of such change. [Emphasis supplied.]
We do not regard as controlling with respect to the question whether there is more than one class of stock within the meaning of section 1371(a) the fact that "debt" characterized as "equity" capital may be disproportionate to the respective common stock interests of the stockholders. Accordingly, we must hold the regulation invalid as applied to this case. To hold otherwise not only would serve largely to defeat the purpose for which Congress enacted subchapter S, but would be inconsistent with the underlying scheme of the statute as exemplified by section 1376(b)(2).
Section 1376(b)(2) treats debt owing to shockholders as a secondary equity interest, in any event. That section provides:
(b) Reduction in Basis of Stock and Indebtedness for Shareholder's Portion of Corporation Net Operating Loss. --
*231 (1) Reduction in Basis of Stock. -- The basis of shareholder's stock in an electing small business corporation shall be reduced (but not below zero) by an amount equal to the amount of his portion of the corporation's net operating loss for any taxable year attributable to such stock (as determined*235 under section 1374(c)).
(2) Reduction in Basis of Indebtedness. -- The basis of any indebtedness of an electing small business corporation to a shareholder of such corporation shall be reduced (but not below zero) by an amount equal to the amount of the shareholder's portion of the corporation's net operating loss for any taxable year (as determined under section 1374(c)), but only to the extent that such amount exceeds the adjusted basis of the stock of such corporation held by the shareholder.
Not only is this a clear indication that the statute contemplates that the stockholders of a subchapter S corporation would make advances or lend money to the corporation, but for the purpose of reflecting losses deducted by the stockholders in their returns, any resulting debt is treated as a part of the stockholder's "investment." The losses which are charged to that investment can only be attributable to the interest of the stockholder represented by the common stock.
If we look to the effect of section 1376(b)(2), it thus becomes apparent that for purposes of subchapter S, the statute treats debt owing to a stockholder, whether or not regarded as equity for other purposes, as a part*236 of that stockholder's equity interest in the corporation. Debt owing to a nonstockholder is treated differently.
It is not contemplated that all rights and interests of the stockholders of a subchapter S corporation will be equal. Even if the stockholder advances were initially in proportion to their respective stock interests, disproportionate rights could result on account of the limitation on the deductibility of losses which is dependent on the stockholder's basis for both the stock and debt.
In a case where the subchapter S corporation operates at a loss, the only effect of the mixed investment of stock and debt as between stockholders is to produce a different limitation -- disproportionate to their respective stock interests -- in the amount of loss each can deduct. A similar disproportion results if each acquires his stock at different times or at a different cost.
Where there are profits, application of the income in payment of the debt in lieu of the distribution of a dividend has the effect of increasing the basis -- also the limitation of deduction of any future losses -- of the stockholders who must report the income, and of reducing the overall investment of the stockholder*237 who receives payment on the debt. No foreseeable tax benefit results to either. Such a capital structure merely provides a means whereby a participant who does not have the capital resources is able to reinvest the aftertax earnings of the business and thereby repay funds advanced by other participants. Such obviously was the intent in the case before the Court.
*232 Since this type of transaction was clearly contemplated by the terms of the statute itself, and is the normal result of the operation of section 1376, it is only reasonable to assume that the Congress did not intend that debt owing to a stockholder of a subchapter S corporation would result in more than one class of stock under the thin-capitalization doctrine. That is not to say that an instrument called a "note" may not by its very terms be something else. However, where the instrument is a simple installment note, without any incidents commonly attributed to stock, it does not give rise to more than one class of stock within the meaning of section 1371 merely because the debt creates disproportionate rights among the stockholders to the assets of the corporation.
We do not have to decide whether the notes*238 involved in this case might nevertheless be treated as "equity" for other purposes. We are not here concerned with the treatment of interest paid on those notes. In fact, no interest was paid. Nor are we concerned with characterizing the transaction to determine whether petitioners might have a bad debt loss in the event of worthlessness. We are not even concerned with the question whether such debt may not be treated differently under other provisions of the tax laws, even in the case of a corporation which has elected to be taxed under subchapter S. For example, there might be situations in which earnings accumulated prior to qualification under subchapter S are sought to be distributed to a stockholder-creditor of the corporation in the "guise" or repayment of debt.
All we are called upon to decide is whether the corporation (International Meadows) had outstanding more than "one class" of stock within the meaning of section 1371 of the Code. In the corporate or formal sense, clearly the corporation did not. There can be no question that under the laws of the State of California the corporation had outstanding 100 shares of common stock and nothing more. The only real question*239 is whether in the "tax sense" -- in order to carry out the legislative intent -- we are required to disregard the form of the incorporation in order to reach a different conclusion.
The statute does not prescribe any rules which we may look to for guidance. The underlying rationale of the thin-capitalization doctrine seems to be, however, going back to Gregory v. Helvering, 293 U.S. 465">293 U.S. 465, that the court will disregard the form of the transaction where it is to some degree lacking in substance and a failure to do so would serve to frustrate the purpose of the taxing statute. As we have pointed out, this is not that type of case. In fact, the only result of a contrary holding on this case would be to defeat an election which the Congress clearly intended to be of benefit to the small and frequently "thinly capitalized" business.
*233 Issue 2. Amortization of Leasehold ImprovementsThe question is whether the petitioners' lease with Standard Oil should be regarded as a lease for a specified term or whether it should be regarded as a lease for an indefinite term. This has been held to constitute a mixed question of law and fact, which*240 requires us to look to not only the terms of the lease but the nature of the improvements and the relationship of the parties. G. W. Van Keppel Co. v. Commissioner, 295 F. 2d 767 (C.A. 8, 1961); Highland Hills Swimming Club, Inc. v. Wiseman, 272 F. 2d 176 (C.A. 10, 1959).
The evidence shows that the lessor was unwilling to commit itself to a lease of the property for a term certain. At most the lessor was willing to compensate the lessee for the unamortized cost of the property if the lessee's occupancy was terminated prior to 3 years, later extended to 6 years. In the event that the lessor exercised its right to take back the property prior to the expiration of the specified period, the lessor agreed to pay the lessee the unamortized costs of the improvements.
On the other hand, the lessee made substantial improvements to the property notwithstanding the petitioners' inability to obtain a lease for an longer term. While the lessee may have been protected in the event the tenancy terminated, prior to the expiration of the 3-year period, later modified to 6 years, it is doubtful if the petitioners would have *241 been willing to incur substantial expenditures and to undertake the risk of loss if they did not expect to be able to use the property for a longer period. The petitioners' entire case must rest upon the premise that they went into the transaction in order to make a profit. It would not have been undertaken if all that they anticipated was repayment of their unamortized costs. At trial the petitioners testified that they expected to recoup their investments in the venture over the 6-year term of the modified lease, but despite this fact the extent of the improvements made indicates to us that the peitioners intended and believed that they would remain in possession for longer than 6 years.
In our opinion, from a consideration not only of the terms of the lease itself but the testimony of the witnesses and other circumstances, the lease between petitioners and Standard Oil was intended as a lease for an indefinite term of years, with a prescribed minimum term first of 3 years and subsequently of 6 years. The improvements should be depreciated over their useful lives. G. W. Van Keppel Co. v. Commissioner, supra.
Decisions will be entered*242 under Rule 50.
*234 Tannenwald, J., concurring: The vice of respondent's regulations is that, in an attempt to minimize the effect of our decision in W. C. Gamman, 46 T.C. 1">46 T.C. 1 (1966), respondent has abandoned the "actually stock" concept contained in his original regulations. In my opinion, it is this concept that was in the mind of the Congress when section 1371(c)(4) was enacted, although I concede that the legislative history of that particular section is devoid of any material which would be of any direct assistance. Clearly, Congress was not concerned merely with different rights and liabilities among persons who had shareholder status as distinct from such rights and liabilities which inhere in that status as such. As the majority opinion points out, if this were not the case, the provisions of subchapter S dealing with indebtedness to shareholders would be, at the very least, anomalous. Moreover, there are prior indications that Congress had in mind shareholder status as such and was concerned with the allocation of undistributed earnings among shareholders because of differing claims on earnings which stemmed*243 from their shareholder status. 1 To me, the essential question, under subchapter S, is whether the instrument has sufficient characteristics under the applicable local law to be designated as "actually stock." See concurring opinion of Withey, J., in W. C. Gamman, 46 T.C. at 12-13.
I also think it significant that there is no authority under subchapter S for the respondent to promulgate legislative regulations. This is in sharp contrast to such a grant of such authority in section 1244 which was enacted along with subchapter S and was also designed to aid small business concerns. In*244 this connection, it should be noted that section 415 of the recently enacted Tax Reform Act of 1969, Pub. L. 91-172, 83 Stat. 487 (Dec. 30, 1969), provides legislative authority to respondent to determine whether "an interest in a corporation is to be treated for purposes of this title as stock or indebtedness." (Emphasis added.) This extremely broad grant still leaves open the question whether it includes authority to prescribe what is a second class of stock for purposes of subchapter S. Unfortunately, the legislative history is utterly silent on this point.
Featherston, J., concurring:
I agree with the conclusion of the majority but add these thoughts.
The regulation we held invalid in W. C. Gamman, 46 T.C. 1 (1966), provided that "If an instrument purporting to be a debt obligation is *235 actually stock, it will constitute a second class of stock." (Emphasis added.) Following our decision in Gamman, this language was amended to provide that "Obligations which purport to represent debt but which actually represent equity capital will generally constitute a second class of stock." (Emphasis added.) It is immediately observable*245 that this new language is even less consistent with the statute than the invalidated regulation it replaced, for section 1371(a)(4) refers to "stock" but not to "equity capital."
The effect of the present regulation is to subject a corporation's subchapter S status to all the uncertainties, inconsistencies, and confusion derived from the unceasing stream of cases involving the debt-equity dichotomy, which, after all, is merely a tool for reasoning. See, e.g., J. S. Biritz Construction Co. v. Commissioner, 387 F. 2d 451 (C.A. 8, 1967), reversing a Memorandum Opinion of this Court; Murphy Logging Co. v. United States, 378 F. 2d 222 (C.A. 9, 1967), reversing 239 F. Supp. 794">239 F. Supp. 794 (D. Oreg. 1965); Nassau Lens Co. v. Commissioner, 39">308 F. 2d 39 (C.A. 2, 1962), reversing 35 T.C. 268">35 T.C. 268 (1960); Byerlite Corp. v. Williams, 286 F. 2d 285 (C.A. 6, 1960), reversing 170 F. Supp. 48">170 F. Supp. 48 (N.D. Ohio 1958); Gilbert v. Commissioner, 248 F. 2d 399 (C.A. 2, 1957), *246 remanding a Memorandum Opinion of this Court, opinion on remand affirmed 262 F. 2d 512 (C.A. 2, 1959), certiorari denied 359 U.S. 1002">359 U.S. 1002 (1959); Miller's Estate v. Commissioner, 239 F. 2d 729 (C.A. 9, 1956), reversing 24 T.C. 923">24 T.C. 923 (1955); Kraft Foods Co. v. Commissioner, 232 F. 2d 118 (C.A. 2, 1956), reversing 21 T.C. 513">21 T.C. 513 (1954). Since small corporations customarily depend on stockholder loans and guarantees for financing, I do not think Congress intended to make the harsh consequences of a "retroactive" termination of the election under section 1372(e)(3) subject to such inexactitude.
One of the purposes of the requirement in section 1371(a)(4) was --
to avoid the complexities involved in passing the earnings of a corporation through to its stockholders where the stock of the corporation is held by a widely diversified group of stockholders with different rights. See S. Rept. No. 830, 88th Cong., 2d Sess., p. 146, 1964-1 C.B. (Part 2) 650.
W. C. Gamman, supra at 7-8.*247 The other pass-through provisions of subchapter S (i.e., those dealing with capital gains and net operating losses) likewise are workable only if there is a simple corporate structure with one class of stock. However, even the regulation implicitly recognizes that the computation of these pass-throughs is not complicated by the existence of notes held in proportion to stockholdings. And such computations are no more complex where the notes are held disproportionately. 1
*236 For these additional reasons, I agree that the regulation under consideration is so clearly at odds with the language and purposes of the statute that it cannot be sustained. See generally*248 Kurzner v. United States, 413 F. 2d 97 (C.A. 5, 1969); O'Neill v. United States, 410 F. 2d 888 (C.A. 6, 1969); United States v. Empey, 406 F. 2d 157 (C.A. 10, 1969); Edward A. Moradian, 53 T.C. 207">53 T.C. 207, 210-211 (1969); Vincent B. Rodgers, 51 T.C. 927">51 T.C. 927, 930 (1969).
Sterrett, J., dissenting: With respect to the first issue, the problem presented for our decision is whether certain obligations denoted as debt, in fact, represent an equity interest and, if so, whether said equity interest results in the issuing corporation having more than one class of stock. I would give an affirmative answer to both questions and hence nullify the corporation's election to be taxed as a subchapter S corporation. Sec. 1371(a)(4).
It seems evident, in weighing the indicia of debt and equity of the obligations, that the latter predominate: (1) The notes were not interest bearing; (2) the debt-equity ratio was 1080:1 (without the inclusion of indebtedness owed to outsiders); (3) an outside investor would not have made advances under*249 the same terms as those accepted by the petitioner; (4) repayment of principal was to be made out of earnings only; 1 and (5) as was said in 2554-58 Creston Corp., 40 T.C. 932">40 T.C. 932, 935 (1963): "A stockholder [in contrast to a creditor] * * * intends to make an investment and take the risks of the venture."
Since I do not understand the majority seriously to contest the fact that for all other purposes of the Code the obligations at issue would be deemed equity, there is no need to belabor this conclusion.
What is worth emphasizing is the fact that the majority*250 would apply a special rule to the subchapter S situation. This I would not do and, in so holding, am reminded of this Court's opinion in Edwin C. Hollenbeck, 50 T.C. 740">50 T.C. 740, 747 (1968), wherein we said:
The debt-equity inquiry is essentially the same in all areas. The precise determination to be made -- is there more than one class of stock, are notes bona fide indebtedness, etc., varies from case to case, but the basic standards remain the same in all cases where the respondent seeks to reclassify debt or equity. * * * [Emphasis supplied.]
The above quotation is singularly appropriate here for it was made in the context of a determination under section 1244 of the Code.
*237 Furthermore, we said in another case involving section 1244, Wesley H. Morgan, 46 T.C. 878">46 T.C. 878, 889 (1966):
but section 1244 being designed to provide a tax benefit to a rather limited group of taxpayers as it is, we feel that qualification for those benefits requires strict compliance with the requirements of the law and the regulations promulgated pursuant to the specific instructions therefor included in section 1244(e). *251 [Emphasis supplied.]
The common goals of section 1244 and subchapter S make the above cases particularly pertinent. Section 1244 and subchapter S were both enacted as part of Pub. L. 85-866 which was approved on September 2, 1958. Section 1244 is entitled "Losses on Small Business Stock" and subchapter S is entitled "Election of Certain Small Business Corporations as to Taxable Status." There is no doubt that the two were enacted for largely overlapping purposes, namely, to aid small business.
Since it is my view, in concert with the foregoing authorities, that the obligations in issue represent an equity interest, then the question must be faced as to whether said equity interest results in the corporation having more than one class of stock.
Income Tax Regs. section 1.1371-1(g) provides in part as follows:
(g) Classes of stock. A corporation having more than one class of stock does not qualify as a small business corporation. * * * Obligations which purport to represent debt but which actually represent equity capital will generally constitute a second class of stock. However, if such purported debt obligations are owned solely by the owners of the nominal stock of*252 the corporation in substantially the same proportion as they own such nominal stock, such purported debt obligations will be treated as contributions to capital rather than a second class of stock. * * * [Emphasis supplied.]
The above regulation is consistent with our comment in W. C. Gamman, 46 T.C. 1">46 T.C. 1, 9 (1966):
we must also look to the realities of the situation to determine whether the instruments, even though they might represent equity capital, actually gave the holders thereof any rights and interests in the corporation different from that owned by the holders of the nominal stock. We do not think they did under the circumstances here present, because the advances were made and the notes were held by the stockholders in direct proportion to their stockholdings. * * * [Emphasis supplied.]
It will be recalled that the so-called debt obligations were held by the shareholders in disproportionate amounts to their stockholdings, a fact of which petitioners make much in support of their debt argument. However, once it is decided that the obligations in fact represent an equity interest, petitioners are hoisted on their own petard. It seems*253 indisputable that, upon liquidation, distribution of the assets would first have to be made with respect to the so-called debt obligations with any excess thereof being distributed according to the *238 nominal stockholdings. Further, since the face amount of the alleged indebtedness is only payable out of earnings or profits, the holders of the alleged indebtedness are also entitled to a priority in the profits. This being so, the alleged debt instruments must represent at least a second class of stock. The general rule set forth in the regulations quoted above seems clearly applicable.
In reaching an opposite conclusion the majority necessarily invalidates the regulation quoted above. It seems to me that in so doing the majority is ignoring the following oft-quoted language of the Supreme Court in Commissioner v. South Texas Co., 333 U.S. 496">333 U.S. 496, 501 (1948):
This Court has many times declared that Treasury regulations must be sustained unless unreasonable and plainly inconsistent with the revenue statutes and that they constitute contemporaneous constructions by those charged with administration of these statutes which should not be overruled*254 except for weighty reasons. * * *
See also Bingler v. Johnson, 394 U.S. 741">394 U.S. 741, 749-750; Fawcus Machine Co. v. United States, 282 U.S. 375">282 U.S. 375, 378; Boske v. Comingore, 177 U.S. 459">177 U.S. 459, 470; Brewster v. Gage, 280 U.S. 327">280 U.S. 327, 336; Textile Mills Corp. v. Commissioner, 314 U.S. 326">314 U.S. 326, 336-339; Colgate Co. v. United States, 320 U.S. 422">320 U.S. 422, 426; William F. Sanford, 50 T.C. 823">50 T.C. 823, 832, affd. 412 F.2d 201">412 F.2d 201 (C.A. 2), certiorari denied 396 U.S. 841">396 U.S. 841. I fail to see how the regulations can be deemed "unreasonable and plainly inconsistent" with the applicable statute.
The majority's case rests primarily on the view that Congress had the more traditional concepts of stock in mind when it prohibited a subchapter S corporation from having more than one class of stock. The difficulty with this view is that it is impossible to give it any direct support from the subchapter's legislative history. Hence, it rests on speculation*255 which may be reasonable or unreasonable. However, even reasonable speculation, by any other name, remains speculation. I do not feel that we are justified in invalidating the Commissioner's regulation based upon speculation, particularly in light of the Supreme Court's opinions relating to the sanctity of regulations.
The majority cites section 1376(b) 2 as proof of the fact that subchapter S contemplates that a shareholder may also make loans to his corporation. The short answer to that is, of course. But, that fact is of no assistance to us here in determining whether the particular obligation at issue represents a debt or equity interest.
The significance of section 1376(b) is limited to the fact that the pass-through provisions *256 of subchapter S obviously necessitated a further provision which would provide the manner in which the amounts *239 passed through should be treated on each shareholder's individual income tax return. This significance or fact is, however, irrelevant to the problem at hand.
For all of the foregoing reasons I respectfully dissent from the majority opinion.
Footnotes
1. The following proceedings are herewith consolidated: James L. Stinnett, Jr., and Bonnie H. Stinnett, docket No. 3415-67; James E. Thomas and Cathern Thomas, docket No. 3416-67; Robert E. Brown and Grace H. Brown, docket No. 3418-67; Louis H. Heath and Mary S. Heath, docket No. 3515-67; Harold L. Roberts and Lois Roberts, docket No. 5094-67. Bonnie H. Stinnett, Cathern Thomas, Grace H. Brown, Mary S. Heath, and Lois Roberts are parties herein only because they filed joint returns with their husbands.↩
2. There is a discrepancy between the amount of loss distributable according to the corporation's return for 1963, i.e., $ 29,802.41, and the total amount deducted by all shareholders, i.e., $ 29,806.31. This small discrepancy is not explained in the record.↩
3. International Meadows' balance sheet, Dec. 31, 1962, describes these leasehold improvements as follows:
Earth moving $ 8,177.93 Water system 6,889.10 Electric system 11,629.28 Electric alarm system 198.64 Fence 3,621.75 Buildings -- clubhouse 16,269.28 Buildings -- food service 2,400.00 Paving 4,677.43 Landscaping 4,103.77 Signs 570.33 Golf course 38,269.75 These amounts total $ 96,807.26. From this it appears that $ 3,034.02 expended for rent, social security, taxes, bond and blue prints, telephone, office, legal and accounting, and insurance were included in the category "Leasehold Improvements."↩
4. At the outset the interests of Robert E. Browm and James L. Stinnett represented by stock and that represented by the notes were proportionate each to the other, but disproportionate to the interests of Louis H. Heath and Harold L. Roberts, and the respective interests of the latter were also disproportionate each to the other, as shown by the following comparison:
↩
Proportionate Proportionate right to right to distributions vote and share on account in earnings of notes Class one: Robert E. Brown 27/100 8,504.35 88,014.49 James L. Stinnett 27/100 8,504.35 88,014.49 Class two: Louis H. Heath 23/100 18,753.62 88,014.49 Class three: Harold L. Roberts 23/100 52,252.17 88,014.49 1. Similar provisions to accompany the 1954 Code, which were not adopted, were discussed in S. Rept. No. 1622, 83d Cong., 2d Sess. (1954), which stated (p. 453): "No class of stock may be preferred over another as to either dividends, distributions, or voting rights. If this requirement were not made, undistributed current earnings could not be taxed to the shareholders without great complications."↩
1. While the character in the hands of the shareholders of distributions in retirement of disproportionately, or even proportionately, held notes, and the effect of the distributions on the corporation's earnings and profits, may depend upon whether the notes constitute "debt" or "equity," such distributions do not affect computation of the pass-throughs.↩
1. Having heard all of the testimony and having examined the documentary evidence, it would be my finding that the notes in question were to be repaid from only earnings or profits on a monthly basis over the life of the lease. Compare the opinion of the majority, supra↩ at 229. Since the business was that of operating a driving range and small golf course at a particular location, presumably the business would be terminated upon expiration of the lease.
2. With respect to the majority's comment that no foreseeable tax benefit results from the application of section 1376, see R. Anthoine, "Federal Tax Legislation of 1958: The Corporate Election and Collapsible Amendment," 58 Colum. L. Rev. 1146">58 Colum. L. Rev. 1146, 1161-1162↩.