*14 Decisions will be entered under Rule 50.
1. Held, T was sole stockholder of X corporation and election filed by it as small business corporation, accompanied by T's consent, under sec. 1372, I.R.C. 1954, not to be taxed was valid and binding. The fact that S, prior owner of the stock, held it "in escrow" as security for the payment of X's obligation to her on a note did not constitute her a "shareholder" whose consent was required for the election.
2. Held, a series of notes given to S by X for advances to X which were embodied in the foregoing note did not constitute a second class of stock which disqualified X as a small business corporation. The obligation in respect thereof was a bona fide debt and did not represent a capital interest of any kind.
3. Held, a statement embodied in X's return filed for 1959 in March 1960 was ineffective as a revocation of the election for 1959 or 1960 under sec. 1372(e)(2); but in the special circumstances presented such statement was in substantial compliance with the requirements for a revocation of the election and was effective for the year 1961.
*219 The Commissioner determined a deficiency in income tax of Alfred N. Hoffman and Deli Hoffman in the amounts of $ 9,362.35 for 1959, $ 11,520,89 for 1960, and $ 8,675.07 for 1961. The principal issue is whether Reba Martin, Inc., of which Alfred N. Hoffman was allegedly the sole stockholder, was an electing small business corporation under section 1372 of the Internal Revenue Code of 1954 in the years 1959-61, with the consequence that its undistributed taxable income for those years was chargeable to him under section 1373. This issue turns primarily upon whether Alfred N. Hoffman was in fact the sole stockholder when the election (accompanied by his consent) was made. A related *17 issue is whether such election, if valid, was revoked or terminated as to any of the years involved. The determination of deficiences against Reba Martin, Inc., in the amounts of $ 944.06 for 1959 and $ 1,124.16 for 1960, was based upon certain adjustments no longer in dispute, and was made for protective purposes on the assumption that Reba Martin, Inc., was not an electing small business corporation for those years.
FINDINGS OF FACT
The stipulation of facts filed by the parties together with the exhibits attached thereto, are incorporated herein by this reference.
Alfred N. and Deli Hoffman, husband and wife, residents of Miami, Fla., filed timely joint Federal income tax returns for the calendar years 1959, 1960, and 1961 with the district director of internal revenue, Jacksonville, Fla. The husband will hereinafter sometimes be referred to as petitioner.
Reba Martin, Inc. (hereinafter sometimes referred to as RMI), filed timely corporate income tax returns (Form 1120) for the calendar years 1959-61 with the district director of internal revenue, Jacksonville, Fla.; it also filed amended corporate income tax returns (Form 1120) for 1959 and 1960 on June 9, 1964.
RMI was incorporated*18 in New York in 1935. It was and is engaged in the business of designing and printing advertising materials for retail establishments throughout the United States. Its business is conducted almost entirely by mail. Lawrence K. Hoffman, petitioner's stepfather, owned all of RMI's 100 outstanding shares, and conducted the business for a number of years. At some time prior to 1951, 25 of those shares were given to petitioner as a wedding present. His stepfather continued to own the remaining 75 shares. The total capital *220 stock investment in RMI has always been carried on its books as $ 200. Petitioner had become "associated with" RMI in 1947 and was active in its affairs.
In 1951, as a result of the stepfather's ill health, the family moved from New York to Miami, Fla., and the activities of RMI were similarly transferred to Miami. Lawrence's mental illness prevented him from taking any part in the business from that time until his death in 1961. Petitioner, as vice president, was the sole manager of the enterprise at the time of the move to Miami, and continued in that capacity until mid-1953. Petitioner's mother, who had once owned a business of her own, was unfamiliar*19 with RMI's operations and took no part therein.
Following the move to Miami, RMI's financial position became precarious. It had incurred large expenses in relocating its plant and equipment. In addition, it lost a number of its New York accounts, which it never regained. Finally, postage rates on postal cards -- its principal advertising medium -- were doubled, further increasing the cost of doing business. Its reported taxable income (or losses) for the years 1951-56 "before net operating loss deductions and special deductions" was as follows:
| Taxable | |
| income | |
| Year | (or loss) |
| 1951 | ($ 16,934.28) |
| 1952 | (5,562.01) |
| 1953 | (2,628.71) |
| 1954 | (10,004.88) |
| 1955 | 4,342.37 |
| 1956 | (1,901.02) |
Although the corporation had previously been financed through the profits of the business, such course was no longer open to it; steady losses made it necessary at this point to look elsewhere for funds. These funds were not forthcoming from local Miami banks, which were reluctant to lend money to new ventures in the area, especially since RMI had little in the way of valuable assets of the type customarily used as security. Petitioner therefore turned to his mother, Serena Hoffman, for the*20 funds needed to pay the current outstanding debts of RMI and to make acquisitions of machinery needed in the business.
In return for the approximately $ 18,000 which Serena advanced from time to time out of her personal funds to RMI from February 1951 to mid-1953, she demanded and received with each advance a "demand promissory note" bearing interest at 6 percent. These notes were unsecured, had no maturity dates, and were payable only after all other creditors of RMI had been paid. Serena never demanded, nor did she receive, any payments of either principal or interest on these notes prior to September 1956.
*221 Serena took no part in running the business while petitioner was managing it since she knew nothing about it. Petitioner did consult her from time to time concerning broad policy matters of the corporation, especially after Serena had made advances from her personal funds to the corporation. However, it was never a condition to Serena's advances that she have the right to determine the corporation's policies or participate in its operation and management, and she in fact had no such right as a result of her advances to RMI.
In spite of Serena's advances, the corporation*21 continued to lose money, and basic disagreements about the conduct of the business arose between petitioner and his mother. Their relationship was marked by much bitterness. In mid-1953 petitioner returned to Serena his 25 shares of stock, and severed all connection with RMI. He took control of Martin & Hoffman, a small corporation engaged in the sale of calendars which had theretofore been run as part of RMI. He operated that business for several months, but it was unsuccessful. Thereafter, he and a person named William Goldstaub started another direct mail advertising business in Miami called Advertising Aids, Inc., in direct competition with RMI, which was then being run by petitioner's mother. Since the earnings of this business proved insufficient to sustain both petitioner and Goldstaub, petitioner sold his interest to Goldstaub and took a job in 1954 with a retail organization in Mobile, Ala.
When petitioner left RMI, Serena took over the business, since her husband remained incapable of doing so. She formally became the owner of all the outstanding shares of RMI in 1955 when her husband was declared mentally incompetent by a court. However, she had for all practical*22 purposes complete control of the business and regarded herself as the owner from the time of her son's departure in mid-1953. Serena made additional advances of approximately $ 10,000 to RMI while she was in sole control of the business.
Petitioner's relationship with his mother after his separation from RMI was "absolutely nil." While in Mobile, however, petitioner became a religious convert, and underwent a complete change in his outlook on life. As a result of his conversion, he accepted full responsibility for the destruction of the family relationship with his mother and resolved to reestablish a good rapport with her. To this end, he visited Miami in 1956, and indicated his repentance to Serena.
Serena had always wanted her son to take over the family business, and by 1956 she found she was unable to manage it herself. Therefore, shortly after petitioner's visit and attempted reconciliation, Serena communicated with him in Mobile and offered to negotiate with respect to his taking over the business. Petitioner again returned to Miami, where a contract was negotiated, and signed.
*222 Serena was represented in the negotiations by her brother, George Wolfe, a criminal*23 lawyer from New York. She wanted an agreement which would prevent a recurrence of petitioner's leaving RMI, since she was still unsure of him. The negotiations and the resulting agreement were bona fide, arm's-length transactions and at all times relevant herein both sides fully intended to live up to and enforce the agreement. The final contract was drafted by George Wolfe.
The agreement contemplated petitioner's assumption of full management and control of the corporation, the disposition by Serena of the entire 100 shares of stock in such manner that petitioner would emerge as the sole stockholder, and the undertaking by the corporation to pay her $ 59,504.72 in installments on a promissory note bearing interest at the rate of 6 percent per annum. The face amount of that note was the sum of two components: $ 28,194.63, the aggregate of Serena's outstanding advances to the corporation, and $ 31,310.09 for 95 shares of RMI stock to be sold to the corporation. The remaining 5 shares were to be transferred to petitioner without any separately stated consideration, but such transfer was an integral part of the entire transaction, and it was through the acquisition of those 5 shares*24 in these circumstances that petitioner was to become the sole stockholder of RMI. The agreement also provided for Serena's withdrawal from the control and management or any other participation in the affairs of the corporation (except to the extent that her consent might be required for certain corporate expenditures or other specified corporate action as long as its note to her remained unpaid). There was also a separate agreement under which RMI was to purchase all of the stock of Advertising Aids, Inc., from William Goldstaub.
The foregoing basic agreement was dated September 20, 1956. The parties thereto were Serena Hoffman ("party of the first part"), petitioner ("party of the second part"), and RMI ("the corporation"). It was signed by Serena and petitioner, individually, as well as by Serena as "President" on behalf of RMI. It provided in part as follows:
WITNESSETH
Whereas, the party of the first part is the sole owner of all of the outstanding shares of capital stock of Reba Martin, Inc., amounting to one hundred shares, and is president, treasurer and a director of the Corporation; and
Whereas, the Corporation is presently indebted to the party of the first part in *25 the amount of $ 28,194.63, $ 25,194.63 of which was due and owing as of June 30th, 1956; and
Whereas, the party of the first part is desirous of retiring from control and management of said Corporation and completely investing it in the party of the second part, so that he will ultimately become the sole owner of all outstanding shares of stock of said corporation,
Now Therefore, * * * it is agreed between the parties as follows:
1. The Corporation shall repay to the party of the first part its indebtedness to her of $ 28,194.63 in the manner hereinafter described, with 6% interest per annum.
*223 2. The party of the first part agrees to sell to the Corporation ninety-five (95) shares of capital stock of said Corporation, and the Corporation agrees to purchase said shares of stock from the party of the first part at the agreed price of $ 31,310.09, to be repaid in the manner hereinafter described, with 6% interest per annum.
3. Before payment of the purchase price of $ 31,310.09, the Corporation shall pay its indebtedness of $ 28,194.63 in installments of $ 125 each week commencing as of July 1st, 1956, to be first applied against the principal amount of said loan, until such *26 time as the amount of the indebtedness of the Corporation to one William Goldstaub, amounting to $ 12,210.83 and interest, under an agreement of even date for the purchase by the corporation of fifty shares of capital stock of Advertising Aids, Inc., be fully paid, at which time the weekly payments to the party of the first part shall be increased to $ 225.00.
4. Upon completion of full payment of the principal amount of the indebtedness of $ 28,194.63, the principal amount of the purchase price of $ 31,310.09 shall be paid in weekly installments of $ 125 provided the aforesaid indebtedness to William Goldstaub remains unpaid; but if the said indebtedness to William Goldstaub has been fully paid, then the weekly payments of the purchase price shall be $ 225 a week, which shall be first applied against principal.
5. When the principal amounts of the indebtedness to the party of the first part of $ 28,194.63 and the purchase price of $ 31,310.09 shall have been fully paid, then the accrued interest of 6% per annum on the total amount of $ 59,504.72 shall be paid in weekly installments of $ 225. However designated, weekly payments to the party of the first part since July 1, 1956, and*27 the date of the signing of this agreement, shall be regarded as weekly payments of principal hereunder. Where such weekly payments exceed $ 125, the aggregate amount of the excess shall be regarded as additional payment of principal, in reduction of the principal amount of $ 59,504.72.
6. To effectuate the purposes of this agreement and to assure sole and complete control of the corporation by the party of the second part upon full payment of the aforesaid indebtedness and purchase price with interest, the party of the first part hereby gives and transfers to the party of the second part five (5) shares of capital stock of the Corporation.
7. At the time of the signing of this agreement, the party of the first part shall surrender to the Corporation, Certificate No. 7 representing the one hundred shares of capital stock owned by her and the Corporation shall issue in its place two certificates, one for ninety-five shares, the other for five shares.
8. The said one hundred shares of capital stock of the Corporation and fifty shares of capital stock of Advertising Aids, Inc. shall be security for the payment to the party of the first part of the aforesaid indebtedness and purchase *28 price with interest, and for the complete performance by the party of the second part and the Corporation of each of the promises, terms and conditions to be performed. The said one hundred shares of stock of the Corporation, properly endorsed, with resignations of the party of the first part as President, Treasurer and Director, and the said fifty shares of capital stock of Advertising Aids, Inc., properly endorsed, with resignations of all of its officers and directors, shall be deposited with and held in escrow by Serena Hoffman of 141 South Shore Drive, Miami Beach, Florida. Upon full and final payment to the party of the first part of the aforesaid indebtedness of $ 28,194.63 and the purchase price of $ 31,310.09, with interest at 6% per annum, the said Serena Hoffman is authorized by the party of the first part and shall deliver to the party of the second part all of said shares of stock of the Corporation and Advertising Aids, Inc. with the said resignations, in which event, after surrending to the Corporation the certificate of stock for 95 shares, the party of the second part shall then become the *224 sole and exclusive owner of all of the outstanding capital stock*29 of the Corporation and Advertising Aids, Inc. and shall have sole and exclusive control of both corporations.
9. In the event of default of payment by the Corporation of the aforesaid indebtedness and/or the said purchase price, or in the event of the failure of the Corporation and/or party of the second part to faithfully perform and carry out any of the promises, terms and conditions of this agreement, Serena Hoffman is authorized by the party of the second part and the Corporation and shall deliver to the party of the first part all of the aforesaid stock of the Corporation and Advertising Aids, Inc., together with the aforesaid resignations, in which event the party of the first part shall then become the sole and exclusive owner of all of the capital stock of the Corporation and Advertising Aids, Inc. and shall have sole and exclusive control of both corporations. In the latter event, so much of the indebtedness of $ 28,194.63 repaid to the party of the first part to the date of default shall be applied in reduction of the amount of said indebtedness, and the balance remaining due, with accrued interest of 6% per annum up to the date of default, shall be restored to the books*30 and records of the Corporation as an indebtedness due and owing the party of the first part; and since the parties agree that the damages suffered by the party of the first part by reason of any such default or breach cannot be readily ascertained, any amount of the purchase price received by the party of the first part up to the date of such default or breach shall be regarded as liquidated damages and retained by the party of the first part as her sole and exclusive property.
9-A. Notwithstanding anything to the contrary herein contained, all of the aforesaid stock of the Corporation and Advertising Aids, Inc., held by the party of the first part as security hereunder, shall be released upon full payment to the party of the first part of the principal sum of $ 59,504.72; in which event the party of the first part shall surrender to the Corporation the certificate of stock of the Corporation for 95 shares and shall deliver to the party of the second part the certificate of stock of the corporation for 5 shares, together with the shares of stock of Advertising Aids, Inc., with the resignations referred to in paragraph "8". Notwithstanding the release of such security by the party*31 of the first part, the obligation of the Corporation to pay the accrued interest shall remain and continue as provided for in paragraph "5".
10. The amount of the aforesaid indebtedness and purchase price shall be evidenced by the execution by the Corporation and delivery to the party of the first part of an installment promissory note for $ 59,504.72, dated September 20th, 1956, bearing interest at the rate of 6% per annum, and payable in the manner hereinbefore provided. * * *
* * * *
12. The party of the second part agrees to devote his entire time and ability exclusively to the management of the business of the Corporation and shall not engage in any other trade, business or occupation, directly or indirectly.
13. As compensation for his services, the party of the second part shall receive a maximum weekly drawing of $ 175, and shall receive no other compensation by way of a drawing account or bonus except at such times when the parties of the first and second part mutually agree that the corporation is possessed of sufficient cash surplus to warrant it. In the latter event, the Corporation shall pay to the party of the second part 25% of any amount determined by the parties *32 of the first and second part to be in excess of sufficient amount of required surplus as additional compensation, and shall pay to the party of the first part 75% of the amount of such excess in reduction of its obligation to her under this agreement. *225 * * * The Corporation, if it so desires, may engage the services of Deli Hoffman, wife of the party of the second part, as a free lance artist, providing that total yearly amount paid does not exceed the sum of $ 2500.00.
14. The party of the second part and the Corporation agree to furnish to the party of the first part, written quarterly reports of the financial condition and operations of the Corporation and copies of all income tax and other returns until payment in full to the party of the first part of the aforesaid sum of $ 59,504.72 with interest.
15. The party of the second part and the Corporation agree that the party of the first part, in company with her agents and accountants, shall have at all reasonable times, full and complete access to all books, records and accounts of the Corporation, as well as those of Advertising Aids, Inc., and may make such examination and take such excerpts therefrom as she or they *33 may deem necessary or desirable.
16. The party of the second part and the Corporation covenant and agree that until full payment to the party of the first part of the amount required to be paid under this agreement, with interest, they shall not:
(a) Make any changes whatsoever in the corporate structure of the Corporation or Advertising Aids, Inc. or in their Certificates of Incorporation, or in the amount of their authorized or issued capital stock;
(b) Enter into any transactions on behalf of either or both corporations other than in the ordinary course of business;
(c) Sell, assign or otherwise dispose of the trade name of the Corporation or Advertising Aids, Inc.;
(d) Default in the filing of any reports or returns due to any federal, state or municipal authority.
(e) Remove the business of the Corporation and/or Advertising Aids, Inc. from its present location at 4201 N.W. Second Avenue and 4201 1/2 N.W. Second Avenue, Miami, Florida.
(f) Mortgage, sell or otherwise dispose of any of the fixtures, machinery, equipment or other personal property belonging to the Corporation and/or Advertising Aids, Inc. without the written consent of the party of the first part.
(g) Purchase any*34 individual item of machinery or equipment in excess of $ 1000, without the written consent of the party of the first part.
(h) Assign any of his or its rights under this agreement.
17. If the relationship between the party of the second part with the Corporation be severed by reason of default of any payment hereunder by the Corporation or by any breach of the Corporation and/or the party of the second part of any of the promises, terms and conditions of this agreement, the party of the second part for a period of five years shall not, directly or indirectly, become engaged or employed in any business similar to that of the Corporation or Advertising Aids, Inc.
* * * *
19. The party of the first part assumes sole liability and responsibility for any taxes due and owing by the Corporation for prior years to and including 1955, and further agrees and warrants that the liabilities represented on the balance sheet of the Corporation as of June 30, 1956, are true and correct. If the Corporation shall be obligated to pay any taxes assessed against it for the period prior to January 1, 1956, or any liabilities as of June 30, 1956, other than those reflected upon the said balance sheet, *35 then the amount of such taxes and/or liabilities paid by the Corporation shall be chargeable to the party of the first part and applied to reduce the principal amount required to be paid to her under the terms of this agreement.
*226 20. The party of the second part agrees to procure a satisfaction of mortgage dated July 1, 1956, purporting to be made by the Corporation to William Goldstaub upon machinery, equipment and personal property of the Corporation.
21. Upon the signing of this agreement, the party of the second part shall be elected president-treasurer of the Corporation and his designees shall be elected secretary and directors of the Corporation. So long as the Corporation and/or the party of the second part is not in default under this agreement, the party of the second part shall be in complete control of the affairs of the Corporation subject to the promises, terms and conditions contained herein.
* * * *
24. The parties agree that the automobile referred to in the June 30, 1956 financial statement prepared by Parker, Bernstein & Henriquez, shall be transferred by the Corporation on February 26, 1957 to the party of the first part, in which event the party of the*36 first part shall assume and repay the Corporation the liability of the Corporation to Central Bank & Trust Company amounting to $ 549.84.
Pursuant to the agreement, RMI gave Serena its installment promissory note for $ 59,504.72 with interest at the rate of 6 percent per annum. The note provided in part as follows:
INSTALLMENT PROMISSORY NOTE
$ 59,504.72
Miami, Florida
September 20, 1956
For value received, REBA MARTIN, INC. * * * promises to pay to the order of SERENA HOFFMAN the sum of Fifty Nine Thousand, Five Hundred and Four Dollars and Seventy Two Cents ($ 59,504.72) with interest at the rate of six (6%) percent per annum, * * * payable in weekly installments of principal, * * *.
Under an agreement dated September 20, 1956, between SERENA HOFFMAN (referred to as Party of the First Part), ALFRED N. HOFFMAN (referred to as Party of the Second Part) and REBA MARTIN, INC. (referred to as the Corporation), there is deposited with SERENA HOFFMAN and held by her in escrow as collateral security for the payments of this note, the following securities:
95 shares of capital stock of Reba Martin, Inc., issued to Serena Hoffman, with assignment in blank signed by Serena Hoffman. (Certificate*37 No. for 95 shares).
5 shares of capital stock of Reba Martin, Inc., issued to Serena Hoffman, with assignment to Alfred N. Hoffman signed by Serena Hoffman, and with assignment in blank signed by Alfred N. Hoffman. (Certificate No. for 5 shares).
50 shares of capital stock of Advertising Aids, Inc., issued to William Goldstaub, with assignment in blank signed by William Goldstaub. (Certificate No. for 50 shares).
Upon failure of the undersigned to pay any installment of principal or interest when due, or upon failure of the undersigned and/or Alfred N. Hoffman to perform and carry out any of the promises, terms and conditions of the aforesaid agreement dated September 20, 1956, and such default continues for ten (10) days, then, the entire unpaid principal amount of this note with accrued interest shall, at the option of Serena Hoffman, immediately become due and payable, in which event said Serena Hoffman shall become the sole and exclusive *227 owner of all of the above mentioned collateral security, freed and discharged from any right or equity of redemption. No delay or failure on the part of Serena Hoffman to exercise any power or right as to any default*38 of payment by the undersigned or of any breach by the undersigned and/or Alfred N. Hoffman of any of the promises, terms and conditions of the aforesaid agreement, shall operate as an estoppel or waiver as to the exercise of her rights for subsequent defaults or breaches, nor shall a partial exercise of any of her rights preclude subsequent full exercise thereof.
On September 20, 1956, pursuant to paragraph 6 of the agreement, George Wolfe, as agent of Serena, handed petitioner 5 shares of RMI stock endorsed to petitioner by Serena Hoffman. Wolfe told petitioner to endorse the shares, which petitioner did, and then took back the shares.
Pursuant to the agreement and promissory note, the following were deposited with Serena to be held in escrow pending payment of the entire principal amount of RMI's promissory note:
(a) Ninety-five shares of capital stock of RMI issued to Serena with assignment in blank executed by Serena.
(b) Five shares of capital stock of RMI issued to Serena with assignment to petitioner, and assignment in blank executed by him.
(c) Fifty shares of the capital stock of Advertising Aids, Inc., issued to William Goldstaub, with assignment in blank executed by William*39 Goldstaub, which stock was being purchased by RMI from Goldstaub.
At the time of executing the agreement and note of September 20, 1956, Serena did not surrender any of the series of 6-percent demand promissory notes in the aggregate amount of $ 28,194.63, the liability for which was embodied in and superseded by the note of September 20, 1956.
On September 21, 1956, Serena wrote a letter to the cashier, Central Bank & Trust Co., Miami, Fla., advising that on September 20, 1956, she had "sold the firm" of Reba Martin, Inc., to petitioner. The corporate funds in the bank were released by her. She informed the bank that the funds could be used and withdrawn by petitioner or his designees.
Petitioner assumed full control and management of the business of RMI pursuant to the terms of the agreement of September 20, 1956, and subject to the conditions therein. At all times, and until final payment of principal in October 1961, petitioner abided by the terms of the agreement, and obtained the necessary approvals for purchases and/or sales of equipment and machinery, the dissolution of Advertising Aids, Inc., and subsequent increases in his salary. Except for an objection to petitioner's*40 election of subchapter S status for RMI, as hereinafter set forth, Serena consented to all of petitioner's requests. Apart from the consents required by the agreement of September 20, 1956, and the objection to the subchapter S election, Serena Hoffman gave up possession and control of the assets and business of RMI and took no part in management or policymaking.
*228 Pursuant to the agreement and promisory note of September 20, 1956, RMI made principal payments of $ 59,504.72 and interest payments of $ 12,274.37, or a total of $ 71,779.09, as follows:
| Year | Amount |
| 1956 (July 1-Dec. 31) | $ 3,675.00 |
| 1957 | 8,050.00 |
| 1958 | 9,100.00 |
| 1959 | 16,875.00 |
| 1960 | 11,700.00 |
| 1961 | 14,275.00 |
| 1962 (Jan. 1-Sept. 21) | 8,104.09 |
| Total | 71,779.09 |
As of January 1, 1959, the principal payments on the note (allocable to the $ 28,194.63 advances) had reached an aggregate of $ 20,825. The final payment on the principal amount of $ 59,504.72 was made in October 1961. Following such payment Serena delivered to petitioner the two stock certificates of RMI (for 95 and 5 shares, respectively) and the 50 shares of Advertising Aids, Inc., all of which she had been holding in escrow. At the*41 same time she also delivered to him the series of 6-percent demand promissory notes which she held against RMI for advances.
In January 1959, petitioner's accountant informed him of the recently enacted (Sept. 2, 1958) amendments to the Internal Revenue Code relating to small business corporations (so-called subch. S corporations). Petitioner was familiar with the basic terms of subchapter S when it was explained to him, and he agreed with his accountant that it would be beneficial for him to have RMI elect to be a subchapter S corporation. In general, such election relieves the corporation of all tax upon its income, but its undistributed income is taxable directly to its stockholders. On January 16, 1959, petitioner as president of RMI, executed Form 2553, Election By Small Business Corporation. The election was for the taxable year 1959, and showed the number of shares of RMI issued and outstanding to be 5 in number, all owned by petitioner.
Petitioner attached to Form 2553 the following statement:
Stockholders statement of consent to election to be taxed as a small business corporation under Section 1372 (A) of the Internal Revenue Code
I, Alfred N. Hoffman, residing*42 at 202 N. W. 100th Street, Miami, Florida, being the owner of 5 shares of no par common stock of Reba Martin, Inc., acquired on September 25, 1956, do hereby consent to the election made by Reba Martin, Inc., to be taxed as a small business corporation for the taxable year January 1, 1959 to December 31, 1959.
(S) Alfred N. Hoffman
Alfred N. Hoffman
*229 Form 2553 and the attached consent were mailed to the district director of internal revenue, Jacksonville, Fla., and were received by that office on January 19, 1959. Form 2553 and the stockholder's consent were signed by petitioner in good faith, since he believed that he was the sole owner of the outstanding stock of RMI.
Serena learned of the subchapter S election by RMI in October 1959. Although she didn't know what it meant, she thought that it was a departure by petitioner from his contract, and immediately called her brother, George Wolfe, who advised her that the election would constitute a violation of the agreement of September 20, 1956, and that her interests were being jeopardized thereby. She protested to petititioner and also wrote the following letter to RMI on October 20, 1959:
After carefully considering your*43 submission of form 2553 (Election by Small Business Corporation) I find that I am not in agreement with this procedure.
Since the person signing as stockholder is not the actual owner of the stock of REBA MARTIN and had no authority to change the corporate structure, I am hereby advising you of my wishes to continue the corporation under its original status.
Upon receipt of the letter, petitioner and his accountant telephoned the Internal Revenue Service in Miami to find out how to go about revoking the earlier election. The person to whom they spoke, whose position was not identified and whose name petitioner cannot recall, advised them to continue to file the regular corporate tax return (Form 1120) for RMI, not the subchapter S information return (Form 1120-S), and to attach a statement to RMI's 1959 return stating that the January election had been made in error and to set out the circumstances which led to the election and its subsequent revocation.
On March 15, 1960, petitioner filed a regular corporate income tax return, Form 1120, on behalf of RMI, with the district director of internal revenue, Jacksonville, Fla. Attached to the corporate income tax return was the following*44 statement.
It has been determined that Form 2553 -- Election by Small Business Corporation had been filed in error and that the persons signing as stockholders were not the actual owners of the stock of Reba Martin, Inc. Therefore the corporation is submitting Form 1120 for the calendar year 1959 instead of Form 1120-S.
Consistent therewith, petitioner continued to treat RMI as a regular corporation and caused RMI to file timely corporate income tax returns, Form 1120, for the years 1960 and 1961.
In the 1960 joint Federal income tax return filed by Serena on behalf of herself and her husband she disclosed a sale of 95 shares of Reba Martin, Inc., stock in 1956 for $ 31,300.09, which was being reported on a deferred basis, with $ 12,310.79 thereof having been received in 1960.
In December 1962, during the course of an investigation of Serena's *230 tax liability, petitioner gave the Internal Revenue Service a sworn affidavit regarding his acquisition of RMI stock. In this affidavit he stated that he acquired all of the issued and outstanding stock of RMI, namely 5 shares, as of July 1, 1956, and that since that date he had been the sole owner of the stock. He further stated*45 that Serena terminated her full and complete control by selling all of her shares of stock, and that she did not thereafter act in any capacity as a director, officer, consultant, or employee of RMI.
OPINION
In January 1959 RMI, as a "small business corporations," 1*46 filed an election under section 13722 of the Code not to be subject to income taxes. The Code had then recently been amended (Sept. 2, 1958) by the addition of new sections 1371-1377, 3 sometimes referred to in the aggregate as subchapter S, whereby a "small business corporation" might elect to be free of Federal income taxes with the consequence that its undistributed taxable income would in general be chargeable directly to its shareholders (sec. 1373). Such election is valid only if all the shareholders consent thereto (sec. 1372(a)), and is effective not only for the taxable year for which it is made but also "for all succeeding taxable years" (sec. 1372(d)) unless terminated for any such year under sec. 1372(e). 4
*47 Petitioner was familiar with the basic terms of subchapter S and concluded that it would be beneficial to him to have RMI make the *231 election. He believed in good faith that he was the sole stockholder of RMI, and on January 16, 1959, as president, he signed Form 2553 whereby such election was made on behalf of RMI. He was the only stockholder listed on that form, which, in turn, was accompanied by a statement executed by him as a stockholder in which he consented to the election.
An attempt was subsequently made to disavow the election, but the Commissioner treated the election as valid and binding for the years in issue, 1959-61, and charged petitioner with the undistributed taxable income of the corporation. Petitioner challenges this determination on three grounds: (1) That the election was invalid in the first instance since Serena remained a stockholder and did not consent thereto; (2) that Serena's advances to the corporation resulted in a second class of stock which disqualified RMI as a small business corporation; and (3) that there was in any event a revocation of the election that was effective for the years 1960 and 1961. We hold that the election was valid*48 since in our judgment petitioner was the sole stockholder and consented thereto, that there was only one class of stock, but that there was in substance a revocation which, however, was effective only as to 1961.
1. Whether petitioner was the sole shareholder in RMI in 1959. -- Prior to September 20, 1956, petitioner's mother, Serena, owned all of the 100 shares of stock that had been issued by RMI. On that day she entered into a contract with petitioner and the corporation whereby petitioner assumed full management and control of RMI, and it undertook to pay her $ 59,504.72 on a note plus interest. Part of that note ($ 28,194.63) superseded a series of outstanding notes for advances that Serena had previously made to the corporation, and the remainder ($ 31,310.09) represented payment for 95 shares of RMI that she was selling to the corporation. An integral part of the agreement was the transfer of the remaining 5 shares to petitioner without any separately stated consideration. She endorsed the certificate for the 5 shares to petitioner who thereupon endorsed and returned it. She had also executed an assignment in blank on the certificate for the 95 shares. Under the *49 agreement of September 20, 1956, and the terms of the note, as we read those documents, she thereafter was required to hold both certificates "in escrow" as collateral security for the payments on the note.
It is not disputed between the parties that if, as a result of this transaction, Serena ceased to be the owner of these shares, petitioner must be regarded as the owner of the only outstanding shares issued by the corporation. For, the corporation would be regarded as the owner of 95 shares which would be treated as treasury stock that would not be taken into account for the purpose of furnishing the required *232 shareholder consent to the election, 5 and petitioner would thus emerge as the sole shareholder by reason of his ownership of the remaining five shares. The real dispute between petitioner and the Government is thus reduced to an interpretation of the agreement of September 20, 1956. Did that agreement result in a present sale of RMI stock by Serena accompanied by a pledge thereof to her until the note should be paid, or did she retain actual ownership thereof until the certificates were physically delivered to petitioner in 1961 when final payment of principal*50 was made on the notes?
Although there is language in the agreement pointing both ways, 6 the dominant thrust of that agreement establishes to our satisfaction that Serena in fact parted with all beneficial interest in the 100 shares on September 20, 1956, in exchange for the $ 59,504.72 note and other undertakings in the agreement, that she thereafter held the certificates endorsed in blank only as security for the note, and that she retained no interest whatever in the corporation apart from her interest as a secured creditor under the terms of the agreement. Under that agreement, as we construe it, all the fruits of the enterprise were*51 to *233 inure to the benefit of petitioner, subject only to the payment of Serena's note. In these circumstances, it is our conclusion that petitioner was in fact the sole stockholder of RMI in January 1959 when he filed the election on behalf of the corporation and executed the shareholder consent thereto.
*52 The present situation has its counterpart in cases raising the question who, as between seller and buyer, is subject to tax on dividends declared on stock which has been the subject of a contract of sale but which has been pledged with seller pending payment of the purchase price. The result appears to be firmly established that the buyer is the true owner of the stock, regardless of who has technical legal title, and that it is the buyer rather than the seller who must account for the dividends notwithstanding that they may in fact have been paid to the seller to be applied against the purchase price. Moore v. Commissioner, 124 F. 2d 991 (C.A. 7); Estate of Arthur L. Hobson, 17 T.C. 854">17 T.C. 854, acq. 1 C.B. 2">1952-1 C.B. 2; Rev. Rul. 56-153, 1 C.B. 166">1956-1 C.B. 166. Cf. Levy v. United States, 67 F. Supp. 958">67 F. Supp. 958 (Ct. Cl.); Northern Trust Co. v. United States, 193 F. 2d 127 (C.A. 7); Alvin B. Lowe, 44 T.C. 363">44 T.C. 363. See also Mayer v. Donnelly, 247 F. 2d 322, 326*53 (C.A. 5). The present case is closer to these decisions than to 2 Lexington Avenue Corp., 26 T.C. 816">26 T.C. 816, upon which petitioner relies.
Our conclusion that beneficial ownership of the stock, as opposed to technical legal title thereto, 7 is critical in determining who is a shareholder, is supported by the regulations as well as the general legislative purpose underlying subchapter S. Section 1.1371-1(d)(1) of the regulations, in dealing with the requirement that a small business corporation may not have more than 10 "shareholders," defines that term as follows:
Ordinarily, the persons who would have to include in gross income dividends distributed with respect to the stock of the corporation are considered to be the shareholders of the corporation. * * *
This definition is in accord with the basic purpose of subchapter S which was recently set forth in W. C. Gamman, 46 T.C. 1">46 T.C. 1, 7, as follows:
the object of the provisions was to permit businesses to select the form of business organization desired, without the necessity of taking into account major differences in tax consequences. The provisions were a counterpart *54 to the provisions enacted in the 1954 Code (sec. 1361) [repealed by Congress in 1966], which permitted proprietorships and partnerships to elect to be taxed like corporations, and were designed to permit electing corporations to forgo *234 the payment of tax and require their shareholders to report the corporate income (whether or not distributed) as their own for tax purposes. * * * See S. Rept. No. 1983, 85th Cong., 2d Sess., pp. 87-89, 3 C.B. 922">1958-3 C.B. 922, pp. 1008-1010.
If the holder of the naked legal title is given a veto power over the election, he would have the power to frustrate the wishes of the true owners whom Congress wished to be free to choose the corporate form of business organization without giving up the advantages of having the tax burden determined as though the enterprise were a proprietorship or partnership.
*55 The major consequence of a subchapter S election to the shareholders is that, as the price of receiving dividends undiminished by corporate taxes, they must pay tax at personal income tax rates on corporate income which they have not yet received. This may or may not be beneficial to the shareholders; obviously, the corporation's earnings prospects, its dividend policy, the expected savings in corporate tax, and each shareholder's personal tax bracket will play a large part in his determination of whether to consent to the election. What is important to note, however, is that in determining who is taxable on the corporation's undistributed income, section 1.1373-1 (a)(2) of the regulations incorporates by reference the same definition of "shareholder" which was set forth in section 1.1371-1(d)(1), supra, and which the Commissioner seeks to apply here; i.e., only those who would be taxed on an actual distribution of dividends with respect to the corporation's stock will be taxed on a prorata share of the corporation's undistributed income. Thus, if a "shareholder" is not in fact taxable on dividends received with respect to stock which he holds, as, for example, where he holds*56 the stock as agent for another, cf. Rupe Investment Co. v. Commissioner, 266 F. 2d 624 (C.A. 5), affirming 30 T.C. 240">30 T.C. 240, or where stock is held merely as security for the payment of an obligation, Estate of Arthur L. Hobson, 17 T.C. 854">17 T.C. 854, acq. 1 C.B. 2">1952-1 C.B. 2, the subchapter S election can have no effect on him and consequently there is no reason why his consent should be required. Here, Serena was in fact only a creditor, regardless of whether she held title to the stock as security, and plainly could not have been taxed on the corporation's undistributed earnings. Accordingly, since no part of the corporate earnings were properly allocable to her, there is no basis whatever for requiring her consent to the subchapter S election. 8
*57 *235 To be sure, there is a statement in the report of the Senate Finance Committee (S. Rept. No. 1983, 85th Cong., 2d Sess., p. 87) referring to the consenting shareholders as those "of record" as of the first day of the taxable year, or if the election is made after that time, as those "of record" when the election is made. While this use of the words "of record" furnishes some support for petitioner's position, it is entirely inconsistent with the basic congressional purpose to tax the undistributed corporate income only to the persons who are accountable for dividends paid by the corporation, and those persons are the real owners of the stock whether or not they are the shareholders "of record." In the circumstances, we must rely upon the all pervasive legislative purpose and not upon the foregoing fragmentary phrase in the committee report. In our judgment Serena was not a "shareholder" within the meaning of the statute and her consent to the election was not required. Petitioner was the sole shareholder; he caused the corporation to file the election; and he consented thereto. That was enough to constitute a valid and binding election until terminated under section *58 1372(e). It was he who had the sole beneficial interest in the corporate earnings, and it was he, rather than Serena, who was chargeable with any undistributed earnings if any election were to be made under subchapter S. Indeed, it would have been wholly contrary to the framework and purpose of the statute to treat Serena as a "shareholder" and to require her consent to the election so as to render her accountable for any part of the undistributed earnings of RMI.
Since we have concluded that petitioner was the sole shareholder, there is no basis for petitioner's further contention that the election was made under a mistake and must for that reason be set aside.
2. Whether there were two classes of stock by reason of Serena's advances. -- Petitioner argues that even if Serena no longer owned any of the original 100 shares of stock, the subchapter S election was invalid because the demand promissory notes which she had received for her advances to RMI during the period 1951-55 were actually another class of stock and RMI for that reason failed to qualify as a small business corporation. See sec. 1371(a)(4), supra, fn. 1. We think that the point is without substance.
Although*59 Serena retained physical possession of these notes until 1961, they were no longer outstanding obligations of RMI in 1959, because the liability relating thereto had been embodied in and superseded by the $ 59,504.72 note given to Serena pursuant to the agreement of September 20, 1956. That note comprehended all the outstanding advances, in the aggregate amount of $ 28,194.63, and by January 1, 1959, the year in which the election herein was made, principal payments in the aggregate amount of $ 20,825 had already been made to Serena in respect of that portion of the note referable to the advances.
*236 It seems clear to us that, at least as of the taxable years herein, any obligation to Serena in respect of the advances was a bona fide debt and did not represent a capital interest like the advances in W. C. Gamman, 46 T.C. 1">46 T.C. 1. We therefore do not reach the question decided in Gamman as to whether they would constitute another class of stock if they were not bona fide debts. We hold that only one class of stock was outstanding during the taxable years, and that RMI was a fully qualified small business corporation under section 1371(a).
3. *60 Revocation. -- Petitioner contends finally, in the alternative, that even if there were a valid election, it was revoked by the filing of the normal corporate tax return (Form 1120) for 1959 incorporating therein a statement to the effect that the election had been filed in error. Petitioner testified that he followed this procedure as the result of a telephone conversation with an unidentified Internal Revenue Service employee in Miami in October 1959. The return was dated March 14, 1960, and was signed by petitioner as president of RMI. He did not file any separate consent to the revocation in his capacity as stockholder.
Plainly, the alleged revocation, if otherwise valid, would not be applicable to 1959, because section 1372(e)(2), fn. 4, supra, makes clear that its provisions apply only to a revocation for a taxable year "after the first taxable year for which the election is effective." As a consequence, petitioner does not argue that the election was revoked as to 1959, but he does contend that it was effective as to 1960 and 1961. However, the explicit terms of section 1372(e)(2) similarly preclude the effectiveness of the revocation for 1960. These provisions*61 plainly state:
A revocation under this paragraph shall be effective --
(A) for the taxable year in which made, if made before the close of the first month of such taxable year,
(B) for the taxable year following the taxable year in which made, if made after the close of such first month,
and for all succeeding taxable years of the corporation. * * *Since the alleged revocation was filed in March 1960 it could not apply, under these provisions, to the year 1960.
There remains, therefore, the question whether the revocation was valid as to 1961. The final sentence in section 1372(e)(2) requires that the "revocation shall be made in such manner as the Secretary or his delegate shall prescribe by regulations." And in this instance temporary rules were first issued September 22, 1958, T.D. 6317, 2 C.B. 1096">1958-2 C.B. 1096, 1098, and published in the Federal Register for September 26, 1958, 23 Fed. Reg. 7484; these were then superseded by final regulations promulgated December 15, 1959, T.D. 6432, 1 C.B. 317">1960-1 C.B. 317, 327, and published in the Federal Register December 19, 1959, 24 Fed. Reg. 10294.*62 Both the temporary rules and the final regulations (sec. 1.1372-4 (b)(2)) provide in essence that the revocation must be made *237 by the filing of a statement by the corporation accompanied by a statement of consent signed by each shareholder.
Admittedly, no such formally labeled revocation was filed, nor was any separately signed statement executed by petitioner as the sole stockholder. The Government therefore argues that there has been a failure to comply with the regulations and that there was thus no valid revocation.
Although the matter may not be free from doubt, we think that on the whole there was substantial compliance with the regulations. No special form of revocation is required, and we think that the statement embodied in the 1959 return may fairly be read as fulfilling the basic requirements of the regulations as to the character of the statement itself. The more difficult problem is the absence of an explicitly labeled consent by petitioner as sole stockholder. In the absence of a consent the revocation would be fatally defective and the Government would be entitled to prevail. However, petitioner did sign RMI's return. True, he signed in the capacity as*63 RMI's president. But we think that, in substance, he would be bound individually by the statement of revocation in the return signed by him which affects not only the corporation but also its stockholders. We hold that in these unusual circumstances there was substantial compliance with the regulations and that there was therefore an effective revocation for 1961 and subsequent years. Cf. Fred J. Sperapani, 42 T.C. 308">42 T.C. 308.
Decisions will be entered under Rule 50.
Footnotes
1. A small business corporation is defined by sec. 1371(a) as "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."↩
2. SEC. 1372. ELECTION BY SMALL BUSINESS CORPORATION.
(a) Eligibility. -- Except as provided in subsection (f), any small business corporation may elect, in accordance with the provisions of this section, not to be subject to the taxes imposed by this chapter. Such election shall be valid only if all persons who are shareholders in such corporation --
(1) on the first day of the first taxable year for which such election is effective, if such election is made on or before such first day, or
(2) on the day on which the election is made, if the election is made after such first day,↩
consent to such election.3. Sec. 64, Technical Amendments Act of 1958, 72 Stat. 1606.↩
4. Subsec. (e) deals not only with situations in which there would be automatic termination (such as the failure of new stockholders to give their consent as required, or the failure of the corporation to continue to qualify as a "small business corporation"), but it also provides for revocation of the election by the corporation itself, as follows:
(2) Revocation. -- An election under subsection (a) made by a small business corporation may be revoked by it for any taxable year of the corporation after the first taxable year for which the election is effective. An election may be revoked only if all persons who are shareholders in the corporation on the day on which the revocation is made consent to the revocation. A revocation under this paragraph shall be effective --
(A) for the taxable year in which made, if made before the close of the first month of such taxable year,
(B) for the taxable year following the taxable year in which made, if made after the close of such first month,↩
and for all succeeding taxable years of the corporation. Such revocation shall be made in such manner as the Secretary or his delegate shall prescribe by regulations.5. Compare regulations sec. 1.1371-1(g) dealing with classes of stock, which provides:
In determining whether a corporation has more than one class of stock, only stock which is issued and outstanding is considered. Therefore, treasury stock and unissued stock of a different class than that held by the shareholders will not disqualify a corporation under section 1371(a)(4). * * *↩
6. The competing considerations emerging from the agreement and note are fairly summarized by respondent as follows:
Factors in support of petitioner's position:
(1) The third Whereas clause makes reference to Alfred Hoffman ultimately becoming the sole owner of all outstanding shares of stock of Reba Martin, Inc.
(2) Paragraph 6 of the agreement states that the five shares of stock are given by Serena Hoffman to Alfred Hoffman to assure sole and complete control of the corporation by him upon full payment of the indebtedness and purchase price.
(3) Paragraph 8 states that upon full and final payment Serena Hoffman will deliver the certificate of stock for 95 shares to the corporation and that Alfred Hoffman shall then become the sole and exclusive owner of all of the outstanding capital stock.
Factors in support of respondent's position:
(1) Paragraph 8 of the agreement states that the one hundred shares of capital stock of Reba Martin, Inc., shall be security for the payment of the indebtedness and purchase price with interest and for the complete performance by Alfred Hoffman and the corporation of the agreement.
(2) Paragraph 9 states that in the event of a default by the corporation or Alfred Hoffman, Serena Hoffman shall then become the sole and exclusive owner of all the capital stock of Reba Martin, Inc. This indicates she was not regarded as the owner of the stock under the agreement until there was a default.
(3) Paragraph 9-A states that the stock of Reba Martin, Inc., held by Serena Hoffman as security shall be released upon full payment to Serena Hoffman of the amount specified under the agreement.
(4) The restrictions and agreements contained in paragraphs 13, 14, 15 and 16 of the agreement tend to indicate Serena Hoffman was regarded as a creditor in lieu of being recognized as the owner.
(5) Paragraphs 19, 20 and 24 fix the liabilities of the parties with respect to taxes, an outstanding mortgage and an automobile. This tends to indicate a sale.
(6) Paragraph 21 of the agreement clearly provides that Alfred Hoffman shall be in complete control of the affairs of Reba Martin, Inc., unless there is a default by him or the corporation. This indicates a sale with Alfred Hoffman assuming all of the responsibility of the business.
(7) The promissory note executed with the agreement on September 20, 1956, states that the stock is to be held by Serena Hoffman as collateral security for the payment of the note.↩
7. We do not mean to suggest that the title to the shares of RMI was in Serena. The point is that, regardless of who had naked title, the shares were really owned by petitioner and were merely pledged as collateral. In this connection, compare Seletha O. Thompson, 9 B.T.A. 1342">9 B.T.A. 1342, where it was said that the assignor (p. 1350):
by placing the assignment in escrow, retained the bare legal title for one purpose only, i.e., to secure payment of the notes. Neither the practical nor the legal situation differs from a conveyance of title to the vendee with a mortgage from him to the vendor to secure payment of a part of the purchase price. * * *
See also 2 Williston, Sales 285 (rev. ed. 1948).↩
8. Moreover, it is difficult to see how that election could in any way have been a disadvantage to her. At most it relieved the corporation of income taxes and thus enhanced the value of the security for her note. It is equally difficult to see how the election could in any way have constituted a change in the corporate structure in violation of the agreement of Sept. 20, 1956, or could have jeopardized her interests thereunder. Petitioner's suggestions that RMI was thereby "prevented" from issuing a second class of stock, or from becoming affiliated with another corporation, or from obtaining foreign income, are all specious. No such prohibitions existed. The consequence of any such action might mean only that RMI would be disqualified as a "small business corporation" and the election would merely be terminated under sec. 1372(e)↩ of the Code.