Opinion
Docket Nos. 4534-62, 385-63, 765-64.
Filed October 28, 1966.
1. A group of persons joined together to buy and operate a hotel. They formed a Florida corporation for this purpose and purchased its stock. An amendment to the corporate charter stated that there were to be 100 shares of stock made up of classes A, B, C, and D, consisting of 33 1/3, 33 1/3, 16 2/3, and 16 2/3 shares, respectively. Each class had the right to elect a director. Held, the corporation had four classes of stock with disproportionate voting rights (not withstanding that the certificates issued failed to contain descriptive words identifying the various classes) and did not qualify as a "small business corporation" under sec. 1371(a), I.R.C. 1954.
2. Amount of loss on sale of stock determined.
3. Election on taxpayer's return to report the entire gain from a sale of land in the year of sale was final. The disallowance of losses claimed in that year in an unrelated venture does not enable taxpayer to change his mind and elect to report the gain on the installment method.
Hugh F. Culverhouse and Arthur J. England, Jr., for the petitioners.
James D. Burroughs and Louis J. DeReuil, for the respondent.
The Commissioner determined the following deficiencies in income tax against petitioners for the calendar years 1958 and 1959: 1958 1959
Samuel and Annie Pollack ................ $7,239.72 $3,584.62 Irving and Marcella Pollack ............. 13,731.83 10,565.38 Irving E. and Shirley Miller ............ 37,998.92 18,720.41 At issue is whether a corporation of which petitioners were shareholders qualified under subchapter S of the 1954 Code as a "small business corporation" so that the losses of the corporation could be deducted by the shareholders on their returns. Two other issues are also presented, namely, the determination of the amount of gain or loss recognized by Irving Pollack on the sale of some of his stock in the corporation in 1959, and the availability of the installment method of reporting the gain on a 1959 sale of certain real estate by Irving E. Miller where the Millers had elected to report such gain in full on their original 1959 return.FINDINGS OF FACT
The facts stipulated by the parties along with accompanying exhibits are incorporated herein by this reference.
Petitioners Samuel and Annie Pollack, Irving and Marcella Pollack, and Irving E. and Shirley Miller were husbands and wives, respectively, during the years 1958 and 1959. During those years Samuel and Annie Pollack lived at 16551 N.E. 10th Avenue, North Miami Beach, Fla., and Irving and Marcella Pollack lived at 4595 N. Michigan Avenue, Miami Beach, Fla. In 1958, Irving E. and Shirley Miller resided at 1451 N. Bayshore Drive, Miami, Fla., and in 1959 they resided at 1674 Meridian Avenue, Miami Beach, Fla. Each couple filed joint Federal income tax returns for the years 1958 and 1959 with the district director of internal revenue, Jacksonville, Fla. Samuel Pollack, since deceased, was the father of Irving Pollack.
Irving Pollack (hereinafter sometimes referred to as Pollack) has been in the hotel business since 1945. As such he has been active in the ownership and management of a number of hotels primarily, but not exclusively, in the Miami Beach, Fla., area. From time to time he would organize groups with capital to build or purchase a hotel and then operate it.
In the early part of 1957, Pollack learned that the Shelborne Hotel in Miami Beach was for sale. It was owned by Hasam Realty Corp. which was controlled by a person named Sam Friedland. The sales price for the hotel was $2,250,000, of which $1,750,000 was payable from the proceeds of mortgage notes in respect of the property, thereby leaving $500,000 in cash required to make the purchase. There were then tentative plans to enlarge the hotel by building an addition thereto with about 100 rooms. Friedland, who was anxious to effect a sale, agreed to various demands made by Pollack, including the furnishing of primary financing for constructing the proposed addition to the hotel. In view of the secondary financing that was said to be available for such construction, it appeared that no further cash investment would be required in order to erect the proposed addition.
Under the conditions upon which the hotel was offered to him Pollack believed that it represented a good investment, and efforts were then made to obtain the $500,000 cash that was necessary to buy the property. As hereinafter more fully set forth, such cash was obtained from four different sources in the amounts of $125,000 each, namely, from Pollack himself, from Charles Yavers and members of his family, from Morris Popkin, and from Irving E. Miller.
Charles Yavers had been in the hotel business for many years and had been associated with Pollack in various ventures in Miami Beach since 1950. He agreed to join in the acquisition of the Shelborne Hotel and took some part in the negotiations for its purchase. It was understood that he and Pollack together would manage the hotel.
Isidore Yavers, brother of Charles Yavers, is a New York attorney. He had invested in hotels in Miami Beach on previous occasions, some with his brother and Pollack that had proved successful, and he agreed to join with Charles in investing in the Shelborne Hotel. Also, three other members of the Yavers family were permitted to join in investing the total of the $125,000 share identified with Charles Yavers, namely, another brother named Joseph Yavorofsky and two other relatives named Louis Weinberg and William B. Hirsch.
Morris Popkin, a resident of New York, was in the fish business. He had know Isidore Yavers for many years and had been associated with him in some real estate deals. At the suggestion of Isidore Yavers, Popkin agreed to invest $125,000 in the purchase of the Shelborne Hotel. It was understood that he would not be active in the management of the hotel.
Irving E. Miller, petitioner herein, had been in the real estate business in and around Miami Beach for a number of years. He had been associated with Pollack and Charles Yavers in several ventures. He agreed to invest $125,000 in the purchase of the hotel with the understanding that he would be a "silent partner" and would not be active in its management.
It was understood that Miller and Popkin would each obtain a one-sixth interest in the venture, but that Pollack and the Yavers group would each obtain a one-third interest in the venture.
After making a deal with Sam Friedland to purchase the Shelborne Hotel, Pollack retained Milton Weiss of the law firm of Meyer, Weiss, Rosen Rose of Miami Beach to represent the purchasers in the acquisition of the hotel. Weiss conferred with Friedland's attorney to work out the details of the purchase. Thereafter, on February 14, 1957, a contract was entered into for the purchase of the Shelborne Hotel. Hasam Realty Corp. appeared therein as the seller and Irving Pollack, Charles Yavers, and Isidore Yavers as the purchasers. The purchase price was $2,250,000, $150,000 of which was payable upon execution of the contract and $350,000 upon closing; notes and a purchase money mortgage were to be given for the remaining $1,750,000. The closing was to take place on March 1, 1957, in the law office of Milton Weiss. The contract was transferable to a corporation.
At the option of the purchasers an additional $150,000 was payable prior to the closing, in which event Pollack and Charles Yavers were to be permitted to enter upon the premises for certain specified purposes and the amount payable at the closing was to be reduced to $200,000.
At Pollack's request, Milton Weiss proceeded to organize Shelborne Enterprises, Inc., as a corporation to take title to the property and to take care of all the formalities necessary to put the corporation in business. Shelborne Enterprises, Inc., was incorporated under the laws of Florida on February 26, 1957, and its articles of incorporation were filed with the secretary of state of Florida on February 28, 1957. Those articles authorized the issuance of 100 shares of stock having a par value of $100 per share, for a total capital investment of $10,000. Milton Weiss and employees of his law firm acted as dummy officers, directors, and stockholders, and appeared as subscribers as follows:
Number of shares Name and present value
Milton Weiss ............................ 33 1/3 $3,333.33 Audrey M. Bernstein ..................... 33 1/3 3,333.34 Geraldine F. Brooks ..................... 16 2/3 1,666.66 Phyllis Rosenthal ....................... 16 2/3 1,666.67
As of March 15, 1957, the foregoing persons resigned as officers and directors. Irving Pollack, Charles Yavers, Irving E. Miller, and Morris Popkin were thereupon elected directors. Also at the same time the dummy subscribers transferred all of their subscription rights as follows: Milton Weiss, 33 1/3 shares, to Irving Pollack; Audrey M. Bernstein, 33 1/3 shares, to Charles Yavers; Geraldine F. Brooks, 16 2/3 shares, to Irving E. Miller; Phyllis Rosenthal, 16 2/3 shares, to Morris Popkin. Charles Yavers was designated as president of the corporation and Irving Pollack as secretary. No further meetings of either officers, directors, or stockholders were ever held.
During the years 1957 to 1959, inclusive, Shelborne Enterprises, Inc., had its legal place of business at 1801 Collins Avenue, Miami Beach, Fla., and was engaged in the operation of the Shelborne Hotel at the same address. Irving Pollack was primarily responsible for the operation of the hotel, particularly the care and maintenance of the hotel building and all financial matters. Charles Yavers devoted his time primarily to sales, reservations, and the general operation of the hotel. He also hired entertainers and other employees of the hotel. Both Irving Pollack and Charles Yavers received salaries from the corporation. None of the other stockholders were active in the operation of the hotel, although they were kept advised as to what was going on.
Shelborne Enterprises, Inc., filed corporate income tax returns for the years 1957 to 1959, inclusive, with the district director of internal revenue, Jacksonville, Fla. It filed a Form 1120 for 1957 and Form 1120-S for the years 1958 and 1959. An amended Form 1120-S was also filed for the year 1958.
The contract of February 14, 1957, was assigned to Shelborne Enterprises, Inc., and on March 1, 1957, the closing for the purchase of the hotel took place between Hasam Realty Corp. and Shelborne Enterprises, Inc. Prior to the closing $300,000 had been paid and an additional cash amount of $208,327.19 was paid at the closing. A purchase-money mortgage and two notes totaling $1,750,000 were given by Shelborne Enterprises, Inc., at the closing. The purchase price of $2,250,000 was allocated as follows:
The additional $8,327.19 resulted from a credit to the seller and the cost of documentary stamps.
Assets Costs
Building (old) ............................ $1,462,500 Furniture and fixtures .................... 225,000 Land ...................................... 562,500 ---------- 2,250,000
At some time not clearly fixed in the record, but not after the foregoing corporate meeting of March 15, 1957, Pollack instructed Milton Weiss to provide for a total capital of $100,000 instead of a capital of $10,000. This was prompted by tax considerations after the matter had been discussed with Pollack's accountants, who deemed it advisable to show the $500,000 cash investment in a 4 to 1 ratio of debt to capital, it being contemplated that $400,000 in debenture bonds would be issued to represent the debt.
Provision for increase of the total capital to $100,000 was made in an amendment to the articles of incorporation which was approved by resolution at the foregoing corporate meeting of March 15, 1957.
The amendment was embodied in a certificate dated April 12, 1957, which was filed with the secretary of state of Florida on April 18, 1957. The certificate read as follows:
CERTIFICATE AMENDING ARTICLES OF INCORPORATION OF SHELBORNE ENTERPRISES, INC.
"BE IT RESOLVED that the Articles of Incorporation of SHELBORNE ENTERPRISES, INC. be amended so that the same shall read:
III.
The maximum number of shares of stock that this corporation is authorized to have issued and outstanding at any time is one hundred (100) shares having a par value of One Thousand ($1,000.00) Dollars each share. The shares of stock of this corporation shall be divided into four classes:
Class A ................................ 33 1/3 shares Class B ................................ 33 1/3 shares Class C ................................ 16 2/3 shares Class D ................................ 16 2/3 shares
Stockholders of Class A stock shall have the power to elect one (1) director of this corporation.
Stockholders of Class B stock shall have the power to elect one (1) director of this corporation.
Stockholders of Class C stock shall have the power to elect one (1) director of this corporation.
Stockholders of Class D stock shall have the power to elect one (1) director of this corporation.
Vacancies on the Board of Directors shall be filled by an election by the stockholders of that class of stock who elected the director whose position has been vacated."
The undersigned, President and Secretary of the above corporation, do hereby certify that, at a meeting of the Directors of the corporation duly called in compliance with Section 608.18, Florida Statutes 1955, the above and foregoing Resolution was duly adopted and the above and foregoing Resolution is a true copy of the Resolution adopted by the Board of Directors for the purpose of amending the Articles of Incorporation.
The undersigned do further certify that all of the subscribers to the capital stock of the corporation were likewise notified of such meeting of the Board of Directors and attended said meeting, and that all of the Directors and all of the Subscribers to the capital stock of the corporation voted unanimously in favor of the Resolution hereinabove set forth.
Dated, this 12th day of April, 1957.
In accordance with the understanding that Pollack and the Yavers group would each have a one-third interest in the enterprise while Miller and Popkin would each have a one-sixth interest, the stock of Shelborne Enterprises, Inc., was originally issued to them on April 18, 1957, as follows: Shares Par Value
Irving Pollack ......................... 33 1/3 $33,333.33 Yavers group: Charles Yavers ....................... 8 1/3 8,333.34 Isidore Yavers ....................... 8 1/3 8,333.33 Joseph Yavorofsky .................... 8 1/3 8,333.33 Louis Weinberg ....................... 4 1/3 4,333.33 William B. Hirsch .................... 4 4,000.00 Irving E. Miller ....................... 16 2/3 16,666.67 Morris Popkin .......................... 16 2/3 16,666.67 ---------- 100,000.00 The original stock certificates had a stock transferability agreement attached to them restricting the sale of the stock to outsiders without prior offer to sell to the corporation or to other stockholders. New certificates were issued at a later date to remove these restrictions. Neither the original certificates nor those issued thereafter were identified as being class A, B, C, or D, as specified in the articles of incorporation, as amended, nor was any reference made to the existence of different classes of stock or charter provisions with respect to differences in voting rights. However, on at least two occasions the existence of the four classes of stock was specifically recognized in contracts signed by the principal stockholders.On May 13, 1958, Charles Yavers, Isidore Yavers, Irving E. Miller, and Morris Popkin executed an agreement setting forth their respective personal obligations as among themselves on account of any personal endorsements made on any notes of Shelborne Enterprises, Inc. This agreement provided in part as follows:
1. That each of the parties hereto agrees that he will endorse or guarantee any of the obligations of SHELBORNE ENTERPRISES, INC., where said endorsement or guarantee is required by the obligee of SHELBORNE ENTERPRISES, INC.
2. That each of the parties hereto agrees that he will hold each of the other parties harmless from any and all claims of any kind or nature whatsoever which may be hereafter made against any of the parties hereto as a result of his guaranteeing or endorsing any obligations of SHELBORNE ENTERPRISES, INC., but such indemnification shall be limited in direct proportion to the percentage that the amount of the original stock ownership in SHELBORNE ENTERPRISES, INC., of the party bears to the amount of the endorsing party's liability, and such indemnification shall include the same proportionate share of Court costs and attorneys' fees in any suit brought on any personal endorsement or guarantee.
3. That the original stock ownership of the parties hereto in SHELBORNE ENTERPRISES, INC., is as follows:
Irving Pollack ............... 33 1/3 shares — Class A Charles Yavers ............... 33 1/3 shares — Class B Irving E. Miller ............. 16 2/3 shares — Class C Morris Popkin ................ 16 2/3 shares — Class D
4. That for the purposes of this agreement, in order to define the liability of ISADORE YAVERS under the terms hereof, ISADORE YAVERS shall be considered as a co-owner with CHARLES YAVERS of 33 1/3 shares of Class B stock, and the liability of CHARLES YAVERS and ISADORE YAVERS shall be one-third of the total liability of the parties hereto.
Pollack read but refused to sign the agreement; however, it does not appear that his refusal was related in any way to the reference to the four classes of stock.
An undated agreement was executed by Irving Pollack, Charles Yavers, Irving E. Miller, and Morris Popkin, in respect of dividends that might be paid by the corporation. This agreement set forth their stock and debenture ownership, and provided in part as follows:
Each of the parties to this Agreement is the owner of capital stock of SHELBORNE ENTERPRISES, INC., a Florida corporation, in the amount set forth opposite the respective names of the parties hereto, and the total of all of the capital stock so owned is the total issued and outstanding capital stock of SHELBORNE ENTERPRISES, INC.:
Irving Pollack ............... 33 1/3 shares — Class A Charles Yavers ............... 33 1/3 shares — Class B Irving E. Miller ............. 16 2/3 shares — Class C Morris Popkin ................ 16 2/3 shares — Class D
Each of the parties is also the owner of certain debenture bonds issued by SHELBORNE ENTERPRISES, INC., in amounts set forth opposite their respective names:
#1 Irving Pollack ........................... $91,666.67 #2 Charles Yavers ........................... 58,333.33 #2A Charles Yavers ........................... 16,000.00 #2B Charles Yavers ........................... 17,333.34 #3 Irving E. Miller ......................... 66,666.66 #3A Irving E. Miller ......................... 41,666.67 #4 Morris Popkin ............................ 66,666.66 #4A Morris Popkin ............................ 41,666.67
CHARLES YAVERS and IRVING POLLACK, as owners of the capital stock of SHELBORNE ENTERPRISES, INC., above set forth, agree that each time and every time a dividend is paid to them and each of them, as a result of their ownership of the stock above referred to, each of them will, immediately upon such payment, pay or cause to be paid to each of the owners of debenture bonds #3A and #4A, twenty-five (25%) percent of such dividend, to be applied against the principal indebtedness of such debentures, and they further agree that if the shares of stock owned by them are sold, pledged, assigned or hypothecated, they will notify the respective parties with whom they are dealing, of the existence of this agreement; it being the intention of the parties that the provisions of this agreement shall apply to whomsoever shall own the stock, or be entitled to the dividends payable thereon.
Although $400,000 out of the original total cash investment of $500,000 was allocated to debenture bonds, the entire $500,000 appears to have been credited originally to the corporation's capital stock account. On August 31, 1958, the following entry was made in the general journal of Shelborne Enterprises, Inc., and was also reflected in the ledger sheets containing the capital stock account and debenture bond payable account:
In addition to the materials set forth in the above and following paragraphs, the record in relation to the $400,000 is confusing and contradictory in a still further respect. The stipulation of facts refers to the $400,000 as having been paid into the corporation by Irving Pollack, Charles Yavers, Irving E. Miller, and Morris Popkin in specified amounts on Mar. 31, 1957. Yet the record is clear that the entire $500,000 (including this $400,000) had been supplied no later than Mar. 1, 1957, when the closing took place.
Debit to capital stock ............. $400,000 Credit to debenture bonds payable .......... $400,000
Debenture bonds were issued by Shelborne Enterprises, Inc., pursuant to a corporate resolution of March 15, 1957, to the following persons and in the following amounts:
Irving Pollack .............................. $133,333.34 Charles Yavers .............................. 133,333.34 Irving E. Miller ............................ 66,666.66 Morris Popkin ............................... 66,666.66 ----------- 400,000.00
These debenture bonds matured in 5 years and bore interest at the rate of 10 percent per annum payable at maturity. There was no sinking fund and payment of the obligations on the debenture bonds was dependent on the prosperity of the corporation.
At some time after the original issue of these debenture bonds, Pollack transferred debenture bonds in the amount of $41,666.67 to Irving E. Miller and personally guaranteed payment thereof to Miller. Charles Yavers similarly transferred $41,666.67 of his debenture bonds to Morris Popkin. The debenture bonds of Shelborne Enterprises, Inc., were thereafter held during 1958 and 1959 as follows:
Irving Pollack .............................. $91,666.67 Charles Yavers .............................. 91,666.67 Irving E. Miller ............................ 108,333.33 Morris Popkin ............................... 108,333.33 ---------- 400,000.00
During the years 1957, 1958, and 1959, the corporation accrued interest at the rate of 10 percent per annum with respect to these debenture bonds in the amounts of $33,496.32, $40,000, and $39,999.96, respectively. It is stipulated that the corporation took interest deductions in 1958 and 1959 with respect to the foregoing amounts of $40,000 and $39,999.96. The stipulation does not disclose whether a similar deduction was taken for 1957. No interest was in fact ever paid on these debenture bonds.
As noted above, the parties contemplated an addition of approximately 100 rooms to the hotel at the time of acquisition. The seller undertook to provide primary financing for this addition and secondary financing was available in an amount that appeared to be sufficient to cover the estimated cost of the new construction without the investment of any additional funds. However, the actual cost proved to be much greater than anticipated.
Shelborne Enterprises, Inc., began to operate the hotel as of March 1, 1957, and for the period March 1 to April 30, 1957, it realized net earnings in the amount of $57,518. The construction of the additional rooms and other renovations of the hotel commenced about June 1, 1957. The construction made operation of the hotel impractical, so that it was closed in July or August of that year until completion of the project.
The actual costs of construction turned out to be greatly in excess of the estimate. Plans for the addition drawn by the architect for Shelborne Enterprises, Inc., were based on a set of plans given to Pollack by Sam Friedland which proved to be incorrect in important particulars (such as the existence of pilings at certain places on the property), and costly changes were therefore required during the course of construction. Also, other changes in plans were made during construction (such as installing new plumbing and providing central air conditioning for the entire hotel) that resulted in substantial increases over the original estimated cost. In addition, scarcity of labor caused by a building boom in Miami Beach at that time was responsible for greatly increased labor costs. The total cost of the new building, equipment and related assets was $1,692,310.70.
The hotel was not able to open in time for Christmas 1957, as planned, and the major portion of the building was not open until March 1958. Thus, the winter season was largely lost, and even when the hotel did open it was unable to produce the earnings anticipated because of the unusually bad weather in the area during the winter of 1957-58 which depressed the tourist market in Miami Beach. As a consequence, additional funds were required. Efforts to obtain such funds from banks and other sources on acceptable terms were unsuccessful.
In an attempt to keep the hotel going, some of the stockholders advanced additional funds to the corporation commencing in 1958, in the following amounts:
Stockholder Amount of advances
Irving Pollack .............................. $54,000.00 Charles Yavers .............................. 17,187.78 Isidore Yavers .............................. 12,000.00 Irving E. Miller ............................ 63,000.00 Morris Popkin ............................... 40,000.00 ---------- 186,187.78
As of December 31, 1958, the total amount of the outstanding advances by the stockholders to the corporation was $179.000. These advances were carried on open accounts. No notes were given therefore.
The advances were not made by the stockholders in proportion to their stockholdings. Whoever was able to advance the money when it was needed did so. The advances were to be repaid by the corporation whenever money for repayment became available out of its earnings. Although no interest was expected on them, the corporation accrued interest on those advances during the years 1958 and 1959 at the rate of 1 percent per month, and took deductions for such interest in the respective amounts of $20,038.69 and $21,762.39. The interest accrued was never paid.
During 1958, the 100 total outstanding shares of common stock of Shelborne Enterprises, Inc., were owned as follows:
Irving Pollack .............................. 20 Samuel Pollack .............................. 5 Charles Yavers .............................. 8 5/6 Isidore Yavers .............................. 8 Joseph Yavorofsky ........................... 8 Estate of Louis Weinberg .................... 4 1/3 Irving E. Miller ............................ 16 2/3 Leonard Miller .............................. 8 1/3 Morris Popkin ............................... 20 5/6 ------ 100
On or before January 1, 1958, Morris Popkin had received 4 1/6 shares of the stock from Charles Yavers. At or about the same time Leonard Miller, a brother of Irving E. Miller, purchased 8 1/3 shares from Irving Pollack. The five shares owned by Samuel Pollack appear to have come from his son, Irving Pollack, but there is no evidence as to the nature of the transfer or the date thereof.
During 1959, the stockholders remained the same as in 1958, except that on January 2, 1959, Irving Pollack sold his 20 shares to Morris Popkin for $10,000.
Shelborne Enterprises, Inc., filed an election to qualify as a "small business corporation" under subchapter S of the 1954 Code on December 1, 1958. On its U.S. Small Business Corporation Returns of Income, Shelborne Enterprises, Inc., reported losses for 1958 and 1959 in the respective amounts of $495,448.47 and $263,216.37, of which the petitioners deducted on their joint income tax returns the following amounts: Petitioners 1958 1959
Samuel and Annie Pollack .................... $24,772.42 $13,160.82 Irving and Marcella Pollack ................. 99,089.69 None Irving and Shirley Miller ................... 82,541.72 43,869.39 Since Irving Pollack had sold his stock on January 2, 1959, no portion of the 1959 corporate loss was claimed on the joint income tax return filed by him and his wife for 1959. However, they claimed a net operating loss carryover from 1958 in the amount of $47,713.44, which carryover was derived solely from the loss claimed from Shelborne Enterprises, Inc., in 1958 in the amount of $99,089.69.On their joint income tax return for 1959, Irving and Marcella Pollack reported a loss in the amount of $23,000 from the sale of the 20 shares of common stock of Shelborne Enterprises, Inc., held by Irving Pollack; the loss was computed as follows:
Cost or other basis, March 1957 ................. $33,000 Sales price, Jan. 2, 1959 ....................... 10,000 ------- Loss ........................................ 23,000
In 1959, Irving Miller sold an undivided 25-percent interest in unimproved real property located in Dade County, Fla., for $564,173.41, of which $146,995.29 was received in cash at the closing, $213,353.12 was in the form of a purchase-money mortgage and mortgage notes, and $203,825 was represented by mortgages which the purchaser assumed. He reportedly had a basis in the property of $283,500. No payments were made to Irving E. Miller in 1959 on the purchase-money mortgage and mortgage notes received by him from the sale.
The $280,673.41 profit on the sale was reported in its entirety as capital gain by the Millers in their return for 1959. Prior to filing that return, Irving E. Miller had discussions with his accountant as to whether the gain should be reported in full in 1959 or on the installment basis. It was decided that they would report the entire gain for 1959. The return thus filed contained many items of income and deductions, including $77,505.09 net profit from Irving E. Miller's business as a real estate broker, $309,806.48 net gain on sale of capital assets, $9,271.86 net income from rents and royalties, and other lesser items of income. Among the deductions claimed were $130,210.40 for contributions, interest, and taxes. In addition, the return showed a net loss of $96,980.19 in a schedule entitled "Income from Partnerships." In another schedule entitled "Subchapter S Income," there was reported a loss of $43,869.39 attributable to Shelborne Enterprises, Inc., as well as two items of income from two other entities in the amounts of $18,497.92 and $12,821.19; the net effect of these three items was a reported loss of $12,550.28 in respect of subchapter S income. The net effect of all the entries in the return was a taxable income in the amount of $909.21. In deciding to report the gain on sale of the unimproved land in full rather than on the installment method, Irving E. Miller and his accountant were motivated by the expectation that such gain together with other reported income would be largely offset by various deductions, including the loss from Shelborne Enterprises, Inc., thus leaving only a comparatively minor amount of taxable income.
Thereafter, in anticipation that the subchapter S issue in respect of Shelborne Enterprises, Inc., might be decided against them, with the result that their $43,869.39 share of the 1959 loss therefrom would be disallowed, the Millers attempted, during or shortly after the trial of this case, to reverse their election to report the full gain on sale of the unimproved land for 1959. They sought to do this by mailing a document on or about April 22, 1966, which they designated as an amended return for 1959, to the district director of internal revenue, Jacksonville, Fla., and in which they took the position that they were entitled to report the sale on the installment method.
OPINION
1. Qualification of Shelborne Enterprises, Inc., as "Small Business Corporation". — In 1957, Irving Pollack and others joined together to purchase the Shelborne Hotel in Miami Beach, Fla. The price was payable in large part out of the proceeds of mortgage notes, but additional cash in the amount of $500,000 was required. Such cash was put up as follows: $125,000 by Pollack; $125,000 by a group headed by Charles Yavers, who was to be active with Pollack in managing the hotel; and $125,000 each by Irving E. Miller and Morris Popkin, neither of whom was to take part in operating the property. It was understood that Pollack and the Yavers group would each obtain a one-third interest in the venture but that Miller and Popkin would each acquire only a one-sixth interest therein. Title to the hotel was taken in the name of a corporation, Shelborne Enterprises, Inc., that was organized for that purpose. For reasons appearing in our findings the operation of the hotel resulted in substantial losses.
In 1958, Shelborne Enterprises, Inc., as a "small business corporation," elected under section 1372 of the 1954 Code not to be subject to income tax. In general, the shareholders of such electing small business corporation must account for any undistributed net income (sec. 1373), but they are also allowed deductions in respect of net operating losses (sec. 1374). The Commissioner supports his disallowance of such losses claimed herein for the years 1958 and 1959 on the ground that Shelborne Enterprises, Inc., was not entitled to make the election since it did not qualify as a "small business corporation" by reason of its failure to satisfy the requirement of section 1371(a)(4) that it may not have more than one class of stock. The narrow question before us is therefore whether the corporation did have more than one class of stock. On this record the answer appears clear to us that it did and that it therefore failed to qualify as a small business corporation.
SEC. 1371. DEFINITIONS.
(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.
At about the time the corporation was organized, and prior to the issuance of any stock, an amendment to the articles of incorporation was adopted to the effect that there were to be four classes of common stock consisting of the following number of shares:
Number of shares
Class A ............................ 33 1/3 Class B ............................ 33 1/3 Class C ............................ 16 2/3 Class D ............................ 16 2/3
The amendment set forth that each class was to have the right to elect one director so that the right to elect directors was not proportionate to the number of shares in each class. The reason for this rather unusual classification would seem to be plain enough. Miller and Popkin each supplied one-fourth of the cash for the venture but obtained only a one-sixth interest therein. It seems entirely reasonable in the circumstances that they would be given an equal voice in the selection of directors.
Petitioners make various arguments (some of them confusingly overlapping) in answer to the Commissioner's position, but we think they can be conveniently considered under two principal contentions: (a) That no such different classes of stock were in fact effectively issued and outstanding at the time of the election; and (b) that even if they were effectively issued they did not constitute "more than one class of stock" under the Code as properly construed in the light of administrative rulings. We think that neither of these contentions is sound.
(a) The Florida statutes provide, Fla. Stat. Ann. sec. 608.14(1), that a corporation may issue the shares of stock authorized by its charter "and none other," and that its common or preferred stock may be divided into classes with such distinguishing characteristics relating to, among other things, "voting powers or restrictions or qualifications of voting powers as shall be stated in the certificate of incorporation." The same section of the statute further states that "Restrictions and qualifications of voting powers so imposed shall control in all cases where any vote * * * is * * * required by statute unless such statute shall expressly provide to the contrary."
608.14 Capital stock; power to issue, etc.
(1) Every corporation may issue the shares of stock authorized by its certificate of incorporation and none other. Such shares may consist of common stock of a par value stated in the certificate of incorporation, common stock of no par value, and preferred stock. Each may consist of two or more kinds, which may be divided into classes and classes into series, and each kind, class and series may have such distinguishing characteristics, including designations, preferences or restrictions as regards dividends, redemption, voting powers or restrictions or qualifications of voting powers as shall be stated in the certificate of incorporation. Restrictions and qualifications of voting powers so imposed shall control in all cases where any vote or consent of stockholders is now or hereafter required by statute unless such statute shall expressly provide to the contrary. [Italic supplied.]
Accordingly, since the Shelborne charter directed that the 100 authorized shares be divided into four specified classes with unequal voting power in respect of election of directors, it would seem that the only way in which the corporation could have issued its shares would have been to issue them in the four classes authorized by the charter, namely, A, B, C, and D. The fact that the certificates actually given to the shareholders were not explicitly identified as falling within those classes could hardly avoid the plain statutory directive that a corporation may issue the shares authorized by its charter "and none other." And although the certificates did not bear any legend identifying the class involved, the record herein is clear that the shares issued to Pollack were class A, those to the Yavers group class B, those to Miller class C, and those to Popkin class D. Indeed, petitioner's counsel conceded at the hearing that "It is true that under the laws of Florida a stock certificate doesn't have to bear the legend that it is a separate class * * *." Petitioner's counsel does not renew this concession on brief but appears to argue that other provisions of the Florida Statutes, sec. 608.41(1)(b), require each stock certificate to summarize or to incorporate by reference or to set forth in full any class designation and pertinent distinguishing characteristics. Whether such is required by those provisions may well be open to question. They certainly do not explicitly impose such requirement, and whether they do so by implication is at least arguable. But we need not resolve this possible issue, for, even if there were such requirement, failure to comply with it would not vitiate the plain mandate of section 608.14(1) which permits a corporation to issue only those shares authorized by its charter. At most, such failure might give rise to rights against the corporation or others in favor of a particular stockholder who was damaged in some way by that failure. But plainly it would not transmute the various classes of stock into classless stock in clear violation of section 608.14(1) under which the corporation had power to issue stock in the classes designated by its articles "and none other."
He went on to state, however, that he would offer oral testimony to establish that the parties never intended or agreed "to treat any stock as separate classes." We consider this argument hereinafter.
608.41 Stock certificates; bonds and debentures
(1)(a) Every stockholder shall be entitled to have for each kind, class or series of stock held, a certificate certifying the number of shares thereof held of record by him. Certificates shall be signed by the president or a vice-president and the treasurer or an assistant treasurer, or the secretary or an assistant secretary, and sealed with the seal of the corporation. The seal may be facsimile, engraved, or printed. Where such certificate is signed by (a) a transfer agent or an assistant transfer agent, other than the corporation itself, or by (b) a transfer clerk acting on behalf of the corporation and a registrar, the signature of any of those officers named herein may be facsimile. In case any officer who signed, or whose facsimile signature has been used on any certificate shall cease to be such officer for any reason before the certificate has been delivered by the corporation, such certificate may nevertheless be adopted by the corporation and issued and delivered as though the person who signed it or whose facsimile signature has been used thereon had not ceased to be such officer.
(b) It shall not be necessary to set forth in said certificate the provisions of the certificate of incorporation in original or amended form showing the class or classes of stock authorized to be issued by the corporation and the distinguishing characteristics thereof. If the corporation so elects, said provisions may be either (a) summarized on the face or back of the certificate or (b) incorporated by reference made on the face or back of the certificate where such reference states that a copy of said provisions, certified by an officer of the corporation, will be furnished by the corporation or its transfer agent, without cost, to and upon request of the certificate holder.
Petitioners argue also that the interested parties were unaware of the existence of the four separate classes of stock and that the attorney, Milton Weiss, had no authority to provide therefore in the articles of incorporation. However, whether the subscribers may or may not have been aware that there were four classes of stock because they failed to read or otherwise inform themselves of the contents of the articles is a matter that affords them no relief under State law. Cf. Bryan v. St. Andrews Bay Community Hotel Corp., 99 Fla. 132, 141, 126 So. 142, 145. Moreover, we are not satisfied on this record that the stockholders were in fact unaware of the existence of the four classes of stock or that Milton Weiss was in fact without authority to make provision therefore.
While it is true that there was testimony tending to disclaim knowledge by the stockholders with respect to the four classes of stock, we found it far from convincing. On at least two occasions the principals executed instruments in which their stockholdings were clearly and prominently identified by class. Pollack signed only one of them, but read the other with sufficient care to refuse to sign it on grounds unrelated to the matter of classification. We are satisfied that the parties to these instruments, who were shrewd and perceptive businessmen, read them with care, and that they were fully on notice with respect to the classification of their stockholdings. In addition, there was testimony by Popkin that he understood that the could have elected himself a director — a matter plainly referable to the voting power associated with his class of stock.
Similarly, there is no credible evidence that Weiss acted without authority. True, the amendment to the charter was probably precipitated by Pollack's request to increase the corporate capital from $10,000 to $100,000. But the record contains no convincing evidence that he acted without authorization in setting up the four classes of stock. Weiss was retained to organize the corporation and to put it into business. In drafting the original articles as well as the virtually contemporaneous amendment, he, like other lawyers similarly engaged, undoubtedly had at least implied authority to use his professional judgment as to the numerous matters to be included in such documents for the purpose of achieving the basic objective for which he was retained. At the very least, the parties were on notice that articles of incorporation and an amendment thereto had been drafted, and they surely were in a position to reject any provisions that they found unsatisfactory. They did not do so. The charge that he acted without authority is further belied by their subsequent acquiescence in the description of their stockholdings in the two agreements discussed above. They certainly could have had the articles amended again at that time so as to eliminate the four classes of stock if they had disapproved thereof, but they took no such action.
Furthermore, in view of the stress laid upon Weiss' alleged lack of authority, petitioners' case is further weakened by their failure to present him as a witness. Their explanation for his alleged unavailability as a witness at the time of trial was not satisfying, and no effort appears to have been made to obtain his deposition or to seek the scheduling of the trial at a time when he might be available. The burden of proof was upon petitioners and we cannot assume that the testimony of a critical absentee witness would have been favorable to them. Indeed, the normal inference is that it would have been unfavorable. Cf. Stoumen v. Commissioner, 208 F.2d 903, 907 (C.A. 3); Wichita Terminal Elevator Co., 6 T.C. 1158, 1165, affirmed 162 F.2d 513 (C.A. 10); Interstate Circuit v. United States, 306 U.S. 208, 226.
The Court's response of "All right" at the trial after counsel's attempted explanation for the absence of Weiss was not intended to indicate that it was satisfied with the explanation. It merely indicated that, having called the situation to counsel's attention, it was not pursuing the matter further.
Nor is there any basis for attack upon the establishment of the four classes of stock by referring to the use of dummies in the incorporation process and their election of Pollack, Charles Yavers, Miller, and Popkin as directors. As already noted, Weiss was retained to organize the corporation and to put it into business. The use of dummies (acting under the direction of the attorney) for this purpose is common, and petitioners cannot be heard at this late date to disavow the acts of such nominal parties. They cannot now pick and choose, selecting only those aspects of the incorporation that are advantageous to them, while at the same time rejecting others that turn out to be unfavorable.
(b) Petitioners argue alternatively that even if the corporation had the four classes of stock spelled out in its charter, the difference between those classes was not such as to result in more than one class of stock within section 1371(a)(4) of the Internal Revenue Code of 1954 (fn. 6, supra at 105). We hold otherwise.
Granted that the difference between the classes was not great — merely a difference in voting power to elect directors — it was nevertheless a difference that could have practical consequences, and it is difficult to see how we can ignore the plain words of the statute. The shareholders in the various classes had unequal voting power in respect of election of directors; the classes were separately identified as such in the charter, as amended; and it seems clear that the statute covers this situation.
The Government's position is confirmed by the Treasury regulations which construe section 1371(a)(4). The regulations make it clear that "a difference as to voting rights * * * will disqualify a corporation." However, it was recognized that there might be situations where stock would be artificially designated as comprising several classes for the purpose of selection of directors but where the voting power as among the shares of stock of the various classes was not unequal. There would thus in fact be no difference whatever in the quality of the voting power associated with the various nominal classes of stock, and the regulations therefore provided further that:
Income Tax Regs., sec. 1.1371-1(g):
(g) Classes of stock. A corporation having more than one class of stock does not qualify as a small business corporation. * * * If the outstanding shares of stock of the corporation are not identical with respect to the rights and interest which they convey in the control, profits, and assets of the corporation, then the corporation is considered to have more than one class of stock. Thus, a difference as to voting rights, dividend rights, or liquidation preferences of outstanding stock will disqualify a corporation. However, if two or more groups of shares are identical in every respect except that each group has the right to elect members of the board of directors in a number proportionate to the number of shares in each group, they are considered one class of stock. If an instrument purporting to be a debt obligation is actually stock, it will constitute a second class of stock. [Italic supplied.]
if two or more groups of shares are identical in every respect except that each group has the right to elect members of the board of directors in a number proportionate to the number of shares in each group, they are considered one class of stock. * * *
Thus, if the charter created two nominal classes of stock of 50 shares each, and provided that the stockholders of each class were empowered to elect an equal number of directors, the voting power of each share would be identical with the voting power of any other. Accordingly, the regulations quite appropriately treated that situation as involving in fact only one class of stock. The present case is different, because the voting power of the various shares of stock was unequal, depending upon their classification.
Petitioners appear to recognize that, in view of the absence of the required proportionality, their case does not fall within the limited exception articulated in the regulations. But they nevertheless argue that these regulations must somehow or other be ignored because they were promulgated December 18, 1959, only shortly before the end of the second of the two tax years here involved and because they are allegedly in conflict with a "release" issued about a year earlier by the Internal Revenue Service. We think these grounds are without substance. The statute itself, apart from the regulations, disqualifies Shelborne as a "small business corporation." Moreover, not only are the regulations applicable to the tax years in question, but their force cannot be diminished by the release, which was in any event arguably ambiguous in this respect.
Subchapter S, relating to small business corporations was added to the 1954 Code on September 2, 1958, by section 64 of the Technical Amendments Act of 1958, 72 Stat. 1606, and the regulations here involved were promulgated a year and several months thereafter. Section 7805 of the 1954 Code authorizes the Commissioner to prescribe all necessary rules and regulations for the enforcement of the revenue laws and further provides that he may prescribe the extent to which any ruling or regulation shall be applied without retroactive effect. It is clear therefore, that unless the Commissioner otherwise specifies, regulations are retroactive to the date on which the statute was enacted. Dixon v. United States, 318 U.S. 68, 72-75; Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 183-184; Helvering v. Reynolds, 313 U.S. 428; Manhattan General Equipment Co. v. Commissioner, 297 U.S. 129, 134-135. The Commissioner has at no time specified that the regulation here involved was not to be given retroactive effect. We reject petitioners' contention which is based upon the date of promulgation of the regulation.
SEC. 7805. RULES AND REGULATIONS.
(a) AUTHORIZATION. — Except where such authority is expressly given by this title to any person other than an officer or employee of the Treasury Department, the Secretary or his delegate shall prescribe all needful rules and regulations for the enforcement of this title, including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue.
(b) RETROACTIVITY OF REGULATIONS OR RULINGS. — The Secretary or his delegate may prescribe the extent, if any, to which any ruling or regulation, relating to the internal revenue laws, shall be applied without retroactive effect.
Nor is a different result called for by reason of a Technical Information Release published November 26, 1958, T.I.R. No. 113, upon which petitioners rely. That release certainly could not bind the Commissioner, cf. Dixon v. United States, 381 U.S. 68, and in any event it was at best ambiguous in respect of the problem before us. In question and answer form it undertook to deal with a number of questions relating to small business corporations. Among other things, it stated that a corporation would be considered to have only one class of stock where it has "class A common and class B common with equal dividend rights, equal liquidation preferences, and equal voting rights except that each class has the right to elect half the members of the board of directors." This release does not explicitly contain the further requirement of proportionality, but it is at least arguable that such should be implied since the release was obviously undertaking to describe shares of stock having identical rights. It was certainly within the Treasury's rule-making power to clarify the matter by regulation, as it did. Petitioners have no vested rights in their interpretation of the release. Dixon v. United States, supra.
Since we have concluded that the corporation had more than one class of stock by reason of the provisions for class A, B, C, and D common, we do not reach the further question presented by the Government that Shelborne was in any event disqualified because the debentures and obligations on the cash advances to the corporation constituted another class of stock, nor do we consider the applicability of W. C. Gamman, 46 T.C. 1, which appears in any event to present a different factual situation.
2. Pollack's 1959 Loss on Sale of Shelborne Stock. — On January 2, 1959, Irving Pollack sold his remaining 20 shares of Shelborne stock to Morris Popkin for $10,000. In computing the loss on that sale he claimed a basis of $33,000 with a resulting loss of $23,000. Both parties appear to agree that Pollack's cost basis of these shares was $20,000. Accordingly, since we have decided that Shelborne was not a small business corporation, adjustments to that basis are not required by reason of the corporate losses. Pollack is therefore entitled to a capital loss deduction in the amount of $10,000 on the sale.
3. Installment Method of Reporting Gain on Sale of Real Estate. — The final issue involves only the petitioners Miller and relates to the year 1959. In 1959, Irving E. Miller sold an interest in unimproved land at a sales price of $564,173.41, of which he received $146,995.29 in cash at the closing. The remainder of the sales price was represented by purchase money mortgage notes in the amount of $213,353.12, and the purchaser's assumption of outstanding mortgage obligations in the amount of $203,825. The property had a reported basis of $283,500, and thus the gain realized on that sale was $280,673.41. Miller was fully aware that he could report that gain in full for 1959, or that he might elect to report it by the installment method whereby he would be accountable in 1959 only for the proportionate amount of the profit reflected in the payment actually received in 1959. He chose to report the entire gain for 1959.
SEC. 453. INSTALLMENT METHOD.
(a) DEALERS IN PERSONAL PROPERTY. — Under regulations prescribed by the Secretary or his delegate, a person who regularly sells or otherwise disposes of personal property on the installment plan may return as income therefrom in any taxable year that proportion of the installment payments actually received in that year which the gross profit, realized or to be realized when payment is completed, bears to the total contract price.
(b) SALES OF REALTY AND CASUAL SALES OF PERSONALTY. —
(1) GENERAL RULE. — Income from —
(A) a sale or other disposition of real property, * * *
* * * * * * *
may (under regulations prescribed by the Secretary or his delegate) be returned on the basis and in the manner prescribed in subsection (a).
(2) LIMITATION. — Paragraph (1) shall apply —
(A) In the case of a sale or other disposition during a taxable year beginning after December 31, 1953 (whether or not such taxable year ends after the date of enactment of this title), only if in the taxable year of the sale or other disposition —
(i) there are no payments, or
(ii) the payments (exclusive of evidences of indebtedness of the purchaser) do not exceed 30 percent of the selling price.
The 1959 return filed by Miller and his wife was an involved one. It contained many items of income and deductions. The aggregate amounts were large, but the net effect of all the items was a comparatively insignificant amount of taxable income. One of the factors which produced this result was Miller's $43,869.39 claimed share of the 1959 loss sustained by Shelborne Enterprises, Inc. And the expectation of taking this loss as a deduction was one of the elements considered in deciding to report the full $280,673.41 gain on sale of the unimproved land in 1959.
We reject any testimony or inference that this was the sole item taken into account in deciding not to use the installment method. Obviously, Miller and his accountant were considering the net effect of all the items on the return, and the Shelborne loss was but one of a number of large deductions that would be utilized to offset all the income to be reported.
After it appeared that the Shelborne loss might not be deductible by reason of the corporation's failure to qualify as a small business corporation, the Millers attempted to reverse their election to report the gain on sale of the unimproved land in full in 1959 and they now seek to have that gain taxed on the installment method. We hold that petitioners are bound by the election made on their original 1959 return.
Although petitioners would have been entitled to utilize the installment method of reporting, they elected otherwise, and their attempt to take advantage of that method now comes too late. They may not undo what they have done. Pacific National Co. v. Welch, 304 U.S. 191; United States v. Kaplan, 304 U.S. 195.
This case is unlike the situations and decisions dealt with in Rev. Rul. 65-297, 1965-2 C.B. 152 (see also T.I.R. 756, Aug. 24, 1965), where there was a failure to make any election in the original return; nor is it like the situation where the election that the taxpayer attempted to make was not open to him. Cf. Mamula v. Commissioner, 346 F.2d 1016 (C.A. 9), reversing 41 T.C. 572. Here, petitioners did make an available election on their original return. They could have selected either the installment method or the method that they actually used. Having thus made that election they may not now reverse such action. The very situation before us was distinguished in Hornberger v. Commissioner, 289 F.2d 602 (C.A. 5), where the court reached a different result on the facts before it (p. 604):
Cf., e.g., Jack Farber, 36 T.C. 1142, affirmed 312 F.2d 729 (C.A. 2), certiorari denied 374 U.S. 828; John F. Bayley, 35 T.C. 288; Nathan C. Spivey, 40 T.C. 1051; John P. Reaver, 42 T.C. 72.
We are not dealing with a case where a taxpayer has made an election by reporting the sale on a deferred payment basis and subsequently seeks to change his position, as was the situation in Pacific National Company v. Welch, 304 U.S. 191, 58 S.Ct. 857, 82 L.Ed. 1282, and in Jacobs v. Commissioner, 9 Cir., 224 F.2d 412, * * *
Since we have concluded that petitioners were bound by the election made on their 1959 return, we do not reach the Commissioner's further contention that the installment method is in any event not available to petitioners since they have failed to show that there were no payments by the purchaser in 1959 on the assumed mortgage obligation which together with the cash received at the closing might exceed the permissible 30-percent limit. Cf. Ivan Irwin, Jr., 45 T.C. 544, on appeal (C.A. 5).
Decisions will be entered under Rule 50.