26 Tax L. Rev. 369 PDF

The Federal Income Tax Significance
of Corporate Debt:
A Critical Analysis and a Proposal
0
WILLIAM T. PLUMB, JR.
[S]tockholders of corporations have always been free to commit to

corporate operations such capital as they choose and to lend such ad-
ditional amounts as they may elect to assist in the operation if that is
their true intent, always thus reserving the right to share with other
creditors a distribution of assets if the enterprise fails.,
[T]he search for this intent often takes on an Alice in Wonderland
quality when a stockholder is dealing with his closely-held corpora-
tion .... 2
"When I use a word," Humpty Dumpty said ... , "it means just
what I choose it to mean-neither more nor less."
"The question is," said Alice, "whether you can make words mean
so many different things."
"The question is," said Humpty Dumpty, "which is to be master-
that's all." 3
In many ways-some obvious and well known, others more subtle

the federal tax law draws a sharp distinction between the tax
consequences of debt and of stock, of interest and of dividends;
but it provides no definitions of those concepts.4 The Supreme
*Wmwxm T. PrDIIB, JR. is a member of the District of Columbia Bar and is a
partner in the firm of Hogan & Hartson in Washington, D.C.
I Rowan v. United States, 219 F.2d 51, 55 (5th Cir. 1955).
2 Albert Ravano, 26 T.C.M. 793, 799 (1967).
3 CARaoLL (DODGSON), THEOuGH THE LOOKING GLASS, eh. VI, 238 (1946 ed.).
4 "The absence of a statutory definition appears to be a pernicious legacy of a bygone
era of federal taxation... when the rustic simplicity of the label... was sufficient"
Kurzner v. United States, 413 P.2d 97, 99 (5th Cir. 1969) (referring to the vord cor-
poration). The most the Code can offer is a declaration that "The term 'stoch' includes
shares in an association, joint-stock company, or insurance company."2 LR.O. § 7701
(a)(7). The existing regulations contribute little to a solution, in stating, "A bona
fide debt is a debt which arises from a debtor-creditor relationship based upon a valid
and enforceable obligation to pay a fixed or determinable sum of money." Beg. § 16-
1(e). For limited purposes, the regulations go into more detail concerning the effect of
subordination and contingency of principal and interest. Beg. § 1.302-4(d); Beg.
§ 1.545-2(g) (2). The definition of a "dividend" in section 318(a), although sometimes
cited in this connection (Pacific Southwest Realty Co. v. Comm'r, 128 F.2d 8IG, 818
(9th Cir.), cert. ened, 317 U.S. 663 (1942)), really begs the present question and con-
tributes little, if anything, to its solution.
369
Imaged with the Permission of N.Y.U. Tax Law Review

TAX LAW REVIEW [Vol. 26:
Court once said that such terms are "well understood" and "need
no further definition"; 1 but a "jungle" 6 of several hundred court
decisions which "defy symmetry" have, in the ensuing quarter
century, proved the error of that assumption. The Supreme Court
has declined every subsequent opportunity to clarify (or perhaps
to add to) the confusion,8 and the proposals of several prestigious
groups for amendment of the statute have found no support in
Congress." Now the Congress has passed the ball to the Treasury,
with a broad authorization to establish, by regulations, standards
for distinguishing debt from stock for all purposes of the Internal
Revenue Code. 10
5 John Kelley Co. v. Comm'r, 326 U.S. 521, 530 (1946); of. Old Colony 1.R. v.
Comm'r, 284 U.S. 552, 561 (1932) ("the words [interest on indebtedness] do not refer
to some esoteric concept derived from subtle and theoretic analysis y).
6 See Comm'r v. Union Mut. Ins. Co. of Providence, 386 F.2d 974, 978 (1st Cir. 1967).
This jungle is more tangled, although perhaps less sticky, than the "morass" of decisions
(Ballenger v. United States, 301 F.2d 192, 196 (4th Cir. 1962)), partially drained by
the Supreme Court in United States v. Davis, 397 U.S. 301 (1970), on the not unrelated
question of when a redemption of stock is essentially equivalent to a dividend.
7 Tyler v. Tomlinson, 414 F.2d 844, 847 (5th Cir. 1969).
8 Certiorari has been denied in at least 19 cases involving various aspects of the
distinction between debt and stock. Universal Oil Products Co. v. Campbell, 181 F.2d
451 (7th Cir.), cert. denied, 340 U.S. 850 (1950); Schnitzer v. Comm'r, 183 F.2d 70
(9th Cir. 1950), cert. denied, 340 U.S. 911 (1951); Gooding Amusement Co. v. Comm'r,
236 F.2d 159 (6th Cir. 1956), cert. denied, 352 U.S. 1031 (1957); Gregg Co. v. Comm'r,
239 F.2d 498 (2d Cir. 1956), cert. denied, 353 U.S. 946 (1957); 241 Corp. v. Comnn'r,
242 F.2d 759 (2d Cir.), cert. denied, 354 U.S. 938 (1957); Perrault (Gunn) v. Comm'r,
244 F.2d 408 (10th Cir.), cert. denied, 355 U.S. 830 (1957) ; Gilbert v. Comm'r, 262 F.2d
512 (2d Cir.), cert. denied, 359 U.S. 1002 (1959) ; R.C. Owen Co. v. United States, 180 F.
Supp. 369 (Ct. 01.), cert. denied, 363 U.S. 819 (1960); American-La France-Foamito
Corp. v. Com-m'r, 284 F.2d 723 (2d Cir. 1960), cert. denied, 365 U.S. 881 (1961) ; Milwau-
kee & Suburban Transport Corp. v. Comm'r, 283 F.2d 279 (7th Cir. 1960), vcrt. denied,
366 U.S. 965 (1961); Charter Wire, Inc. v. United States, 309 F.2d 878 (7th Cir. 1902),
cert. denied, 372 U.S. 965 (1963); Gardens of Faith, Inc. v. Comm'r, 345 F.2d 180 (4th
Cir.), cert. denied, 382 U.S. 927 (1965); R.C. Owen Co. v. Comm'r, 351 E.2d 410 (0th
Cir. 1965), cert. denied, 383 U.S. 967 (1966) ; Burr Oaks Corp. v. Comm'r, 365 P.2d 24
(7th Cir. 1966); cert. denied, 385 U.S. 1007 (1967); United States v. Snyder Bros. Co.,
367 F.2d 980 (5th Cir. 1966), cert. denied, 386 U.S. 956 (1967); Reef Corp. v. Comm'r,
368 F.2d 125 (5th Cir. 1966), cert. denied, 386 U.S. 1018 (1967); Curry v. United States,
396 F.2d 630 (5th Cir.), cert. denied, 393 U.S. 967 (1968); Northeastern Consolidated
Co. v. United States, 406 F.2d 76 (7th Cir.), cert. denied, 396 U.S. 819 (1969); Stanley,
Inc. v. Schuster, 421 F.2d 1360 (6th Cir.), cert. denied, 400 U.S. 822 (1970).
9 The proposals of the American Law Institute, the American Bar Association, and
the Advisory Group on Subchapter C are discussed at notes 126C-81 infra. In general,
their approach was to provide a "safe harbor" or nonexelusive definition of debt, on
which tax planners might rely, while those who fell short of the statutory standard would
be left free to roam the preexisting judicial.jungle in search of support for debt treat.
ment.
10 I.R.C. § 385, added by section 415 (a) of the Tax Reform Act of 196D. So S. RIEP. No.
91-552, 91st Cong., 1st Sess. 138-39 (1969). Although such regulations will plainly be

1971] CORPORATE DEBT
This vexing subject has no doubt been written to death.' Per-

haps, however, in anticipation of the prospective regulatory "solu-
tion" to the problem, an iconoclastic analysis of the reasoning of
the court decisions and a somewhat radical (but not unprecedented)
proposal for reform by legislation may excuse some unavoidable
replowing of old ground.
Tax Effects of the Debt-Stock Distinction

Before plunging into the jungle of criteria by which the courts
have attempted to distinguish debt from equity, let us consider
briefly the areas in which the distinction makes a federal tax dif-
ference, for it is in these contexts that the controversies arise. We
shall see that the problem has multiple aspects, for the tax con-
sequences of an instrument that is determined to reflect an in-
debtedness may differ depending on whether it is or is not deemed
a "security"; and the consequences of a purported loan that is
determined to .be equity investment may vary depending on
whether it is deemed to be a class of stock having preference over
the common or to be merely an additional investment in the existing
common stock. In some of these areas the distinction affects the
corporation's tax liabilities; in others, the investors'. But, with
few exceptions, the tax consequ6nces of debt are generally more
favorable than those of stock.
legislative in character, there is little doubt that Congress may validly delegate to the
Treasury the power to establish such standards. Burnet v. S. & L. Bldg. Corp., 288 U.S.
406, 414 (1933); Allstate Ins. Co. v. United States, 329 F.2d 346, 349 (7th Cir. 1904);
Boynton v. Pedriel 136 F. Supp. 888, 890 (S.D.N.Y. 1954), aff'd on another point, 228
F.2d 745 (2d Cir. 1955), cert. denied, 351 U.S. 938 (1956); of. Arizona v. California,
373 U.S. 546, 593 (1963) (dissenting opinion at 625-26). See Dvis, ADxnUsTRATI
LAw TRnTIsE §§ 2.01, 5.04 (1958); Note, Toward ZArew Modes of Tax DecisonmaLing-
The Debt-Equity Imbroglio and Dislocations in Taz Lawmaking Responsibility, 83
Ht&v. L. BEv. 1695 (1970). Presumably the regulations will be nonretroactive in effect
(see Hearings on the Subject of Tax, B form Before the House Committee on Ways and
Mfeans, 91st Cong., 1st Sess. 5511-12 (1969)), so the jungle will be with us for some
time in litigated cases, even if the regulations realize the impossible dream of clarifica-
tion for the future.
ilAmong the seminal contributions to the subject are Stone, Debt-Equify DLsiCnc.
timos in the Tax Treatment of the Corporation and Its Sharcholders, 42 Tu L. Rv.
251 (1968); Hiekman, Incorporationand Capitalization:27w Threat of the "Potential
Income" Item and a Sensible Approach to Problems of Thinness, 40 TAXs 974, 983-
94 (1962); Goldstein, CorporateIndebtedness to Shareholders: "Thin Capitalization'"
and Related Problem, 16 TAx L. REv. 1 (1960); Caplin, The Caloric Count of a Thin
Incorporation,17 N.Y.U. INST. 771 (1959), 43 MnQ. Is. REV. 31 (1959); Bitther, Thin
CapitalizationL: Some Current Questions, 34 TA.Xs 830 (1950), 10 U. I". L. ftv. 25
(1957); Semmel, Tax Consequences of Inadequate Capitalization,48 COLVU. L. Rzv. 202
(1948).

TAX LAW REVIEW (Vol. 26 :
Since we are dealing with "things [that] are seldom what they
seem, skim milk [that] masquerades as cream," 12 it is necessary
at the outset to establish a glossary of terms that do not assume the
point at issue. 13 Therefore, in general, the term "purported debt"
will be used for a relationship that is designed to be treated as
debt, "unrecognized debt" for a relationship so designed that
is not given effect for tax purposes and "recognized" or "bona
fide debt" for one which is given its intended effect. The term
"nominal stock" will be used for that which is stock in name
(whether or not nominal in amount), to distinguish it from un-
recognized debt which is treated as a class of stock or as a capital
contribution. Parallel terminology will be used with respect to
purported sales to controlled corporations. The semantic problem
is further complicated by the fact that the term "security" is used
in the statute, for purposes within the scope of this discussion,
with two entirely different meanings-one defined narrowly in the
statute, the other more broadly by the courts. Rather than tinker
with the statutory terminology, I shall indicate the applicable
meaning, in text or footnote, whenever the word is used.
INTEREST, DIscouNT, PREMIUM, ET CETERA
The fact that the Code allows an income tax deduction for "all
interest paid or accrued. .. on indebtedness" 14 but allows no such
deduction for dividends paid, 15 creates a powerful incentive for
financing, to the maximum extent that credit and other business
considerations permit, with debt rather than stock. 0 In order to
12 GMBET, H.M.S. PINAFoRE, Act 2, applied to the present problem by Judge Dawson
in S.S. Ballin Agency, Inc., 28 T.C.M. 1058, 1074 (1969).
13 Cf. Daro Corp., 20 T.C.M. 1588, 1600 (1961), in which tho Commissioner stipulated
himself out of court by agreeing to the unqualified language of loan in describing a
transaction he contended did not give rise to debt; Rowan v. United States, 219 F.2d 51,
54 (5th Cir. 1955), in which the use in the government's affidavit of the words "debts
... owed" precluded summary judgment.
14I.R.C. § 163(a). Notwithstanding the breadth of the quoted language, certain
restrictions are imposed on the deduction of interest related to the production of tax-
exempt income (I.R.C. §§ 264(a) and 265) and interest on certain obligations incurred
in business takeovers (I.R.C. § 279, added by section 411 of the Tax Reform Act of
1969).
15 A limited exception is provided with respect to dividends paid on public utility
preferred stock originating before October 1, 1942. I.R.C. § 247. We are not here con-
cerned with certain special taxes measured by -ndistributed income, for purposes of
which a deduction is allowed for dividends paid. I.R.C. §§ 535(a), 545(a), 556(a),
561(a).
16State franchise taxes, which are frequently measured by stock capital or not
worth, add their mite to the incentive for debt financing, although a few states Iuvo

pay a $6 dividend on a share of preferred or common stock, a cor-

poration must earn approximately $12 before taxes,"- whereas a
bond bearing $6 interest can be carried with only $6 of earnings.
Thus, the leverage that results from the use of either debt instru-
ments or preferred stock to obtain capital, which it is hoped will
earn a return for the common stockholders in excess of the fixed
cost of carrying such securities, is magnified when the tax deduc-
tion, allowable only with respect to debt, in effect cuts that cost in
half. Even the largest corporations take advantage of this oppor-
tunity, either by initially issuing debt instruments or by substitut-
ing such instruments for outstanding preferred stock.1 8 The will-
ingness of certain conglomerates to incur the business risks of
excessive indebtedness has-ntil some restraint was imposed by
recent legislation ' 9 -enabled them to take over much larger cor-
porations simply by offering convertible debt which pays (at less
net cost to the payer) a larger return to the shareholders than their
stock 20 The small corporation, while its opportunities for leverage
may be limited by the unavailability of outside financing, neverthe-
less may profit by designating part of its stockholders' interest as
debt, thereby mitigating the "double taxation" of corporate earn-
ings through the payment of what amounts in substance to deducti-
ble dividends.
The advantage which the corporation gains by paying interest
rather than dividends is only occasionally offset by any disadvan-
met the problem haead-on by including fixed debt in the capital base. See Southern
Realty Corp. v. MeCallum, 65 F.2d 934, 936 (5th Cir. 1933).
17 Assuming corporate tax rates in the 50 per cent range.
's See, e.g., MIolloy, Federal Incanze Taz Aspects of Ncw Trends in R1aflroad Corpo.
rate Finance, 12 TAx L. REv. 113 (1957), concerning the trend in the railroad industry
to substitute debt (subordinated income debentures) for preferred stoel wvhich in
turn had replaced debt that had driven the railroads into receivership or banliraptcy.
The tax benefits of debt to the corporate payer are substantially diluted rhen bond
yields are high in relation to the return on common stock.
19 LRC. § 279, added by section 411(a) of the Tax Reform Act of 1969. See text
at note 1243 infra.
20 The acquiring corporation might, for example, offer a convertible debenture paying
$4 interest for each share of a stock that had been paying a $3 dividend. The acquirer,
so long as it continues to receive $3 dividends, will pay federal tax, say at a GO per
cent rate, on a maximum of 45 cents thereof, after taking the 85 per cent dividend
received deduction (LB.C. § 243(a)(1)), and will have $2.775 left from which to
pay the interest which, with the benefit of the tax deduetion, costs the acquirer only
$2 of after-tax income. If the acquirer gets 80 per cent control and either qualifles
for the 100 per cent dividend received deduction (IE.C. §§ 243(a) (3) and (b)) or
elects to file consolidated returns (Reg. § 1.1502-14(a)), the dividends will be tax-free
and the acquirer's margin will be greater. See Hearings on, the Subjcct of Tax Reform
Before the House Committee onZWays and Means, 91st Cong., 1st Sczs. 2418-19 (1969).

tage suffered by the recipient. To the extent that the payment ex-
ceeds the corporation's current and accumulated earnings and
profits, a distribution with respect to stock would ordinarily be
tax-free as a return of capital, 21 whereas interest is taxable whether
or not the paying corporation has earnings. 22 In most cases, how-
ever, for a shareholder other than a corporation, interest is taxed
no more heavily than dividends.23 If the recipient is itself a cor-
poration, on the other hand, it will pay much more tax on interest
than on dividends, against which it is allowed a deduction of 85
or 100 per cent 4 But, to the extent that its interests coincide with
those of the paying corporation (i.e., if they are parent and sub-
sidiary), the aggregate advantage still favors the payment of in-
25
terest.
In many cases, of course, the double taxation of corporate in-
come is a mirage, since a growing corporation may retain earnings
indefinitely and thus insulate its shareholders from incurring the
second level of taxation. 28 If a shareholder-creditor is in a high
211R.C. § 301(e)(2). If the distribution exceeds the shareholder's basis for his
stock, the excess will, with some exceptions, be capital gain. I.R.C. § 301(c) (3).
2
2See Zilkha & Sons, Inc., 52 T.C. 607 (1969), in which-inverting is and the
taxpayer's usual positions-the Commissioner (unsuccessfully) contended that a recoipt
was interest on indebtedness, while the taxpayer maintained that it was a distribution
on preferred stock, tax-free in the absence of corporate earnings Lind profits. In that
case the corporation, knowing it would have no earnings to offset an interest deduction,
agreed to the preferred stock form for the financier's tax advantage.
23 The $100 exclusion allowed by section 116 is negligible in its effect, and in any
event may be absorbed by dividends from other investments.
24 I.R.C. § 243(a).
25When a corporation earns $100 and pays $50 tax thereon, and distributes the
balance as a dividend to a corporate shareholder which is entitled under section
243(a)(1) to deduct only 85 per cent thereof, $46.25 will remain after payment of
tax (at a 50 per cent rate) at two levels. If $50 is instead paid out as interest) the
payer's tax on the undistributed $50 and the recipient's tax on the intoresb received
will aggregate $50 leaving them $25 each, or $3.75 more than if the payment had
been a dividend. If the corporate shareholder is only one among many, howover, or
if it holds preferred stock, its interests will not coincide with those of the payer,
and the payer's $25 saving will not compensate the recipient for its $21.25 greater
tax cost. The resulting conflict is illustrated in Ragland Investment Co., 52 T.C. 867
(1969), aff'd per curiain, 435 F.2d 118 (6th Cir. 1970), where a corporation buying
a business had acceded to the corporate seller's demand for the issuance of preferred
stock, on which it might enjoy the dividend received deduction pending payment of the
balance of the price. The Commissioner, after the buyer had claimed that its payments
were deductible as interest, challenged (unsuccessfully) the seller's dividend received
deduction. See text at notes 469-74 infra.
26 Unless the threat of the penalty tax on unreasonable accumulation of corporate
income (I.R.C. §§ 531-37) forces earlier distributions of dividends, the shareholder
may be able ultimately to enjoy the benefit of the resulting increment of assets as
capital gain on the sale of his stock or on the ultimate liquidation of the business.

tax bracket, and the corporation is otherwise in a position to ac-

cumulate its earnings, the advantage of a corporate interest de-
duction may not compensate the shareholder for the tax cost of his
receiving interest income.2 7 But, unless one individual shareholder,
his family and certain related entities own more than 50 per cent
of the value of the outstanding stock,2 8 he may be able to have his
cake and eat it; for the corporation, if on the accrual basis of ac-
counting, may deduct the interest as it is incurred, even though
payment is deferred until (if ever) it is to the tax advantage of
the shareholder-creditor to receive the interest.20 Such maneuvers
may, however, if overdone, jeopardize the corporation's interest
deduction, as we shall see later, by casting doubt on the bona fides
of the debt. 0
Closely related to the matter of interest is the amortization
of bond discount. The corporate debtor is allowed to amortize bond
discount annually against income, 3 ' even though (in the case of
Or, if he dies sooner, the increment may be free of any income tax in the hands of
his heirs. I.R.C. § 1014.
27 The point is illustrated in King, Tax Planning in Corporate Becapitalication, 2
P-11 TAx IDEAs 24,017.1(3).
28 Section 267(a) (2) denies an expense or interest deduction where the parties occupy
such relationship, unless the amount is taxable to the creditor under his accounting
method, or unless payment is made within two and one half months after the corpo-
ration's taxable year. If a creditor and those related to him own preeisely 50 per
cent (or less) of the stock, there is no restriction on the deduction of accrued but
unpaid interest on debt held by him. Albany & Northern Ry. v. Allen, 81 F. Supp.
666 (M.D. Ga. 1949); Hallbrett Realty Corp., 15 T.C. 157 (1950).
29In some circumstances the interest may be taxable to the slhrebolder-creditor on
the ground that it has been made available to him and hence is constructively received.
Beg. § 1.451-2. If the shareholder uses the accrual method of accounting, interest
income may be taxable whether received or not, whereas a dividend on stock would
not be taxed until it is actually or constructively distributed to him. :Reg. § 1.301-1(b).
If shareholders cancel accrued interest as a contribution to the capital of their corpora-
tion, the corporation may incur no tax despite the tax benefit previously enjoyed through
deduction of the interest. Comm'r v. Auto Strop Safety Razor Co. 74 .2d 220, 227 (2d
Cir. 1934); flartland Associates, 54 T.C. 1580 (1970). But of. Reg. § 1.61-12(a). The
shareholders themselves might, however, be held taxable as a result of their exerciso of
the power to dispose of their right to income by enhancing the value of their stock. Cf.
Comu'r v. Fender Sa]es, Inc., 338 P.2d 924 928-29 (9th Cir. 1904), cert. denicd sub
ner. Randall v. Comm'r, 381 U.S. 935 (1965). But cf. Abegg v. Comm'r, 429 F.2d 1209,
1216 (2d Cir. 1970), cert. denied sub nom. Cresta Corp. v. Comm'r (Jan. 18, 1971).
so A purported obligation that is thus lightly disregarded may be viewed as an equity
investment. See notes 715-17 infra.
3 Nassau Lens Co. v. Comm'r, 308 F.2d 39 (2d Cir. 1962); Reg. § L163-3(a)(1).
The discount on issuance of a convertible bond is amortizable, but the right to amortize
ceases upon conversion. G.C.M. 9674, X-2 C.B. 354 (1931). See Pierce Oil Corp., 32
B.T.A. 403, 421-22 (1935). The issue price for this purpose includes any amount paid
for the conversion privilege, so the amortizable discount on the debt may not be
enhanced by allocating a portion of the price to such privilege. Beg. § L163-3(b) Ex. 2.

bonds issued or contracted to be issued on or before May 27,
1969 82) the holder has no corresponding obligation to report the
discount as income until the bond is sold or retired."3 On the other
hand, no deduction is allowed to the corporation with respect to
stock which it sells at a discount from the par or liquidating value.84
Similarly, the commissions and other expenses of issuing debt
may be amortized by the corporation, 5 but stock issue expenses
may not be deducted by way of amortization s or otherwise."7
If debt is retired at a premium above the issue price (adjusted
for amortization allowed), the corporation may deduct the pre-
mium to the extent that it is not attributable to the existence of a
privilege to convert the debt into stock; 38 but no deduction is
allowed for a premium paid on redemption of stock.39
On the other hand, if bonds are sold with stock warrants, an allocation of the price
is made, thus enlarging the discount on the debt. Reg. §§ 1.163-3(a)(2), 1.1232-
3 (b) (2) (ii) (a).
32 Under section 1232 (a) (3), added by section 413(a) of the Tax Reform Act of 169,
the holder is required to amortize as income the original issue discount (or, if less,
the discount at which he purchased) on corporate bonds issued after May 27, 1969
(unless earlier contracted for).
33 Corn Exchange Bank, 6 B.T.A. 158 (1927). See H.R. RnP. No. 91-413 (Part 1),
91st Cong., 1st Sess. 109 (1969). Upon sale or retirement of the bonds, an appro-
priate proportion of the original issue discount (or the gain, if less) is taxed to the
holder as ordinary income. I.R.C. § 1232(a) (2) (B), as amended by section 413(a) of
the Tax Reform Act of 1969.
34I.R.C. § 1032; Baltimore & Ohio R.R. v. Comm'r, 78 F.2d 460 (4th Cir. 1933);
Carter Hotel Co. v. Comm'r, 67 F.2d 642 (4th Cir. 1933); McCoy-Garton Realty Co.,
14 B.T.A. 853 (1928).
85 Helvering v. Union Pacifie R.R., 293 U.S. 282 (1934); Leach Corp., 30 T.C. 563,
579 (1958); G.C.M. 14349, XIV-1 C.B. 47 (1935).

86 Amortization is not allowed over the period in which the stock is required to
be redeemed (Commercial Investment Trust Corp., 28 B.T.A. 143 (1933), aff'd, 74
F.2d 1015 (2d Cir. 1935)); nor over the life of the corporate franchise, if limited
(Surety Finance Co. v. Comm'r, 77 F.2d 221 (9th Cir. 1935)); nor over the period
provided for organization expenses under section 248 (Reg. § 1.248-1 (b) (3) (1)).
37 Deduction is not allowed when the expense is paid or incurred (Baltimoro & Ohio
R.R. v. Cornm'r, 78 F.2d 460, 463 (4th Cir. 1935)), nor upon redemption (Corning
Glass Works, 9 B.T.A. 771, 788 (1927), aff'd, 37 F.2d 798 (D.C. Cir. 1929), ocrt.
denied, 281 U.S. 742 (1930)), nor upon dissolution of the corporation (James I. Van
Keuren, 28 B.T.A. 480 (1933)).
88Reg. § 1.163-3(c)(1). If convertible bonds are repurehased after April 22, 1909
at a premium over the issue price (adjusted for amortization), any excess over a
normal call premium is attributed to the elimination of the conversion right and Is not
deductible. I.R.C. § 249, added by section 414(a) of the Tax Reform Act of 1969. Whether
that principle applies to earlier repurchases of convertible bonds renmains debatable.
Compare Reg. § 1.163-3(c) (2), and Rev. Rul. 67-409, 1967-2 C.B. 02, with Roberts &
Porter, Inc. v. Comm'r, 307 F.2d 745 (7th Cir. 1962). See section 414(c) of the Tax
Reform Act of 1969.
39 Jewel Tea Co. v. United States, 90 F.2d 451 (2d Cir. 1937); Kingsmill Corp.,
28 T.C. 330 (1957).

1971] CORPORATE DEBT 377
On the other hand, the corporation realizes taxable income, which
is reportable on an amortized basis, if it sells its bonds at a pre-
-mium over the amount it must repay at maturity,4 0 whereas it in-
curs no tax as a result of issuing stock at a premium. 4' The bond-
holder, correspondingly, deducts amortization of the premium he
pays,' while the stockholder is denied amortization; but the stock-
holder does take the premium into account as a cost in computing
his gain or loss on ultimate disposition of his stock If the cor-
poration repurchases its bonds for less than the issue price (ad-
justed for amortization), or otherwise settles a fixed debt for less
than was owing, the corporation is ordinarily taxable on the sav-
ing; 4 but the retirement of stock for less than its issue price re-
sults in no income to the corporation.4 1 If the corporation transfers
appreciated property in satisfaction of a debt or interest thereon,
it realizes gain as if the property had been sold for cash; " but,
-with some significant exceptions, no taxable gain results to the
corporation from a distribution of appreciated property in retire-
ment of or as a dividend on stock.47 While these last mentioned
4o Reg. § 1.61-12(c)(2); Chicago & N.W. By., 22 B.T.A. 1407, 1433 (1931), rCv'
on other issues, 66 F.2d 61 (7th Cir.), cert. denied, 290 U.S. 672 (1933). Any portion
of the premium that is attributable to a conversion feature in the bond is excluded.
Beg. § 1.61-12(c) (2).
4 I.R.C. § 1032; Beg. § 1.1032-1(a).
42 LR.C. § 171. The amount of premium attributable to a conversion feature is not
deductible. I.R.C. § 171(b) (1) (C) ; Reg. § 1.171-2 (c).
43 I.R.C. § 1012.
44Corm'r v. Jacobson, 336 U.S. 28 (1949); United States v. Kirby Lumber Co.,
284 U.S. 1 (1931). The exceptions to that rule, when the reduction of the debt amounts
to a capital contribution, a gift or an adjustment of the purchase price of property,
or results from insolvency, are detailed in Eustice, Canceflat(on of Ihebtcnes and
the Federal Income Tax: A .Problemof Creeping Confusion, 14 TAX L. RLV. 225 (1959).
45United National Corp. v. Comm'r, 143 F.2d 580 (9th Cir. 1944); JA. Maurer,
Inc., 30 T.C. 1273 (1958) (purported debt deemed equity, so corporation realized no
income from retirement for less than the issue price); ef. Universal Oil Products Co.
v. Campbell, 181 F.2d 451 (7th Cir.), cert. denied, 340 U.S. 850 (1950) (receipt of
corporation's own security in settlement of a claim to an item of income held taxable
only to extent of fair market value, since security was deemed stock; if it had been
debt, the full amount which the corporation was relieved of paying would have been
taxable).
48Lutz & Schramm Co., 1 T.C. 682 (1943); of. United States v. Davis, 370 U.S.
65 (1962).
471.R.C. §§ 311(a), 336; cf. Langeloth Townsite Co., 20 T.C.M. 91, 98-99 (1961).
The exceptions include distributions of appreciated property in redemption of stock
(subject to a number of limitations) (section 311(d), added by section 905(a) of the
Tax Reform Act of 1969); redemption or dividend distributions of LIFO inventories
(section 311(b)), or of other property if subject to debt in excess of its basis (section
311(c)); and distributions, whether in liquidation of the corporation or redemption
of stock or as a dividend, of installment obligations (section 453(d)), certain deprei-

differences tend to favor stock over debt, and thus may cause the
taxpayer and the Commissioner to reverse their usual litigating
positions, these possibilities would rarely weigh significantly in
planning the capitalization of a corporation.
WITHDRAWAL OF CAPITAL
For the closely held corporation, there is another advantage of

debt that often outweighs even the deductibility of interest. 48 The
investor in public corporations, needing funds, can liquidate a por-
tion of his investments, recovering his cost tax-free and paying
the capital gain tax rate on the excess. But one whose capital is
invested in the equity in a close corporation ordinarily cannot get
it out, short of complete or partial liquidation of the corporate
business, 49 without paying dividend tax at ordinary rates (to the
extent of the corporation's current and accumulated earnings and
profits), unless he and, in some circumstances, his family as well
are prepared to relinquish a significant part of the proportionate
interest in and control of the business 0 Yet with a little advance
able property (sections 1245, 1250), and certain farming properties (sections 1251,
1252, added by sections 211(a) and 214(a) of the Tax Reform Act of 1969).
4s The interest deduction has been involved in far more of the reported decisions
than has the repayment of principal, probably because, if the purported debt is interest
bearing, the deduction issue arises earlier, and the shareholder-creditor commonly
would not risk collecting the principal until its status as debt or stock is thereby
resolved. See Goldstein, Corporate Indebtedness to Shareholders: "Thin Capitalization"
and Belated Problfms, 16 TAx L. REv. 1, 40 (1960).
49 Capital may ordinarily be withdrawn in complete or partial liquidation with only
capital gain consequences (I.R.C. §§ 331, 346), unless the corporation is collapsible
(I.R.C. § 341).
50 The redemption of stock, like a sale to a third party, results in tax-free recovery
of cost and (unless the corporation is collapsible) capital gain treatment of the excoss,
provided the shareholder's remaining interest is less than 50 per cent of the total
voting power and is less than 80 per cent of his former percentage interest in the
voting and common stocks (I.R.C. § 302(b)(2)), taking into account the interests
of certain related parties (sections 302(c)(1) and 318). If his interest and personal
participation in the corporation and its affairs are completely terminated, the con-
tinuing interests of family members are disregarded (sections 302(b) (3) nnd (0) (2)).
If those tests are not met, the entire distribution (not just the gain) may be subjected
to tax as a dividend, to the extent that the corporation has available earnings and
profits, unless the taxpayer can show that the redemption is not essentially equivalent
to a dividend (section 301(b)(1)), something which is no longer possible if the
redemption is from all shareholders proportionately. United States v. Davis, 397 U.S.
301 (1970). Payment of principal of an unrecognized debt may similarly be treated
as essentially equivalent to a dividend when proportionate to stock (Moughon v. Comm 'r,
329 F.2d 399, 401-02 (6th Cir. 1964); Gooding Amusement Co., 23 T.C. 408, 421-22
(1954), aff'd, 236 P.2d 159 (6th Cir. 1956), cert. denied, 352 U.S. 1031 (1957)), and
sometimes even when it is not (Burr Oaks Corp., 43 T.C. 635, 651-52 (1965), aff'd,
365 F.2d 24 (7th Cir. 1966), cert. denied, 385 U.S. 1007 (1967) (in which the treat-

planning, the well-advised businessman can set up a capital st'uc-

tare in which a moderate (but "adequate") amount is dedicated to
equity and other needed funds are provided through bona fide
loans by (or guaranteed by) the shareholders; and the earnings of
the business may then be dedicated to the repayment of the debt,
free of dividend tax 5 1 and normally free even of the capital gain
tax.2 Even before the corporation is prepared to apply its earn-
ings to debt repayment, the debt may be more marketable than
closely held stock (and without affecting control), and thus may
afford the investor liquidity. 3 As a bonus, so long as earnings are
needed for the purpose of paying bona fide debt, the corporation
may enjoy substantial protection from that bugaboo of the closely
held business, the tax imposed by section 531 on unreasonable
accmnulation of earnings. 4
ment of the purported debt as preferred stock removed it from the protection of
the safe harbors of sections 302(b)(2) and (3)); Sansberry v. United State3, 70-1
U.S.T.C. 9216 (S.D. Ind. 1970)).
51 Estate of Miller v. Comm'r, 239 :F.2d 729 (9th Cir. 195), revcrsing 24 T.C. 923
(1955). The severity of the resulting tax burden if debt is not recognized has no
doubt inclined courts in some cases to uphold the bona fides of purported debt w1hen
the issue involved taxation of the repayment rather than denial of the interest deduction.
See James D. Lancaster, 23 T.C.M. 631, 635 (1964), -vhero the court was "somewhat
reluctant" to tax the repayment, but felt bound by the result it had reachet on the
interest issue. Cf. Taft v. Commissioner, 314 F.2d 620, 023 (9th Cir. 1963), calling
the tax on the repayment double taxation. See text at notes 1113-26 infra.
52 If the debt has a basis less than its face amount (as may result when tho debt
originated in a tax-free transfer of property to the corporation under section 3-51,
discussed in the text at note 57 infra, or if the corporation has made a enbehapter S
election, diseussed in the text at note 102 infra, and has previously passed through
to its shareholders losses exceeding the basis of their stock (section 1376(b) (2); Rev.
Rul. 64-162, 1964-1 (Pt. 1) C.B. 304)), the difference may be taxable as capital gain
under section 1232.
53 See Conrad N. Hilton, 13 T.C. 623 (1949).
514Provision "for the retirement of bona fide indebtedness created in connection
with the trade or business, such as the establishment of a sinking fund for the purpose
of retiring bonds issued. by the corporation in accordance with contract obligations
incurred on issue" is one of the grounds which may indicate that earnings are being
accumulated for reasonable needs of the business. Reg. § 1.537-2(b) (3). There has
never been a really persuasive answer, however, to the question whether a shareholder
debt structure clearly designed to permit the tax-free withdrawal of capital investment
by replacing it with earned surplus would escape the penalty tax. Sec Sclc3inger,
"Thin" Corporations: Income Tax Advantages and Pitfalls, 61 Hmxv. L. DEv. 5O, 57
(1947); Holland, Taz Effects of Stoc:holder Loans to Corporations, 9 N.Y.U. LmST.
1083, 1101 (1951); Cary, Current Beflections on Scotion 102, 8 N.Y.U. Lnsr. 125O,
1254-55 (1950); Cary, Section 102 May Not Be ViMenace e Some Tax Mcu Consfder
It to Be, 89 J. Accountancy 219, 222 (1950). The cases usually cited for the inapplicabil-
ity of the tax are Gazette Telegraph Co., 19 T.C. 692, 706 (1953), aff'1d on another issue,
209 F.2d 926 (10th Cir. 1954); and Lion Clothing Co., 8 T.C. 1181, 1189 (1947); but,
while shareholder debt was present in each case, it was the early maturing outside debt

An unrelated financier, on the other hand, may demand an in-
strument in the form of preferred stock with a redemption value
in excess of the issue price, from which he hopes to derive his
compensation principally in the form of low taxed dividends or
capital gains "I(whereas any interest or discount on a debt would
be taxable to him as ordinary income 56).
TAxABim TRANSFER OF PROPERTY: STEP-UP OF BAsis
Corporate debt to shareholders may result not only from loans

but also from sales of property by them to the corporation. While
it is possible for shareholders who together own the requisite 80
per cent control to transfer property to the corporation tax-free,5
the consequence is to cause the transferor's basis for the property
to become the corporation's basis18 Investors therefore may pre-
fer a taxable transfer, not only to obtain the debt advantages
already mentioned but also to step up the corporation's basis for
computing gain or loss or for depreciation. The burden of the re-
sulting tax on the transferor may be mitigated by qualifying the
transaction for the installment method of reporting gain, which
defers the tax until cash proceeds are received, substantially as
if the transfer had been tax-free, yet without incurring the dis-
advantage of a low corporate asset basis." A taxable transfer has
on which the court relied in sustaining the accumulation. At least if the debt is excessivo
(Smoot Sand & Gravel Corp., 15 T.C.M. 418, 432 (1956), remanded on other grounds, 241
F.2d 197 (4th Cir.), cert. denied, 354 U.S. 922 (1957)) or if its retiremont is provided
for more rapidly than reasonably necessary (of. Helvering v. Chicago Stock Yards Co.,
318 U.S. 693, 700-01 (1943); United Business Corp. of America, 33 B.T.A. 83, 87
(1935)), such debt may not be as readily accepted as justification.
55' See text at note 25 supra and at notes 469-74 infra. As a consequence, the cor.
poration loses its deduction for the cost of the financing. May Hosiery Mills, Inc. v.
Comm'r, 123 F.2d 858, 860 (4th Cir. 1941); Pigeon-Hole Parking, Inc. v. United
States, 194 P. Supp. 591, 593 (E.D. Wash. 1961); Kingsmill Corp., 28 T.C. 330, 837
(1957).
56 I.R.C. § 1232.
57 I.R.C. § 351(a). Control is discussed in the text at notes 113-17 infra.
58I.R.C. § 362(a). In addition, the transferors' basis for the property becomes the
basis of the stock and other securities they receive in exchange (section 358(a) (1)), thus
paving the way for potential double taxation of the preincorporation appreciation. Se
Faris v. Helvering, 71 F.2d 610, 613 (9th Cir. 1934). But the doubling of the tax may
be long deferred or may be escaped entirely.
59 I.R.C. § 453(b), as amended by section 412(a) of the Tax Reform Act of 1969. The
principal requirements are that the payments in the year of sale not exceed 30 per cent
of the selling price and that the purchaser's obligations not be in readily marketable
form. If the seller, not having or acquiring the requisite control for a tax-free transfer
under section 351 (note 57 supra), accepts stock rather than debt of the purchasor, the
gain will ordinarily be immediately taxable since it will not qualify for installment treat-
ment. Wilson & :Fields, 21 T.C.M. 1080 (1962). In unusual circumstances the use of the

particular appeal if, as in the case of land which is about to be

subdivided for sale, the property is a capital asset in the share-
holder's hands but would result in ordinary income to the extent
that the appreciation becomes taxable to the corporate developer
In the case of depreciable property, the advantage of stepping up
the corporate basis by a taxable transfer has been tempered by
loophole closing provisions which, under specified circumstances,
treat all or part of the transferor's gain on such property as or-
dinary income; but their coverage is incomplete. 0 '
In this area, however, as we shall see later, there is a further
subdivision of the debt category. For, even if the obligation re-
sulting from the transfer is recognized as debt, and has all the
other tax effects of debt, a step-up of corporate asset basis will be
denied (and the transferor will not be taxed on the transfer) if the
requisite control exists and if the debt has such characteristics
of a more or less permanent investment in the business that it is
classified as a security.'
installment method may backfire and cause the taxpayer to contend that the transfer
was not a true sale after all but was a tax-free transfer for stock or securities. Harry
F. Shannon, 29 T.C. 702 (1958) (decedent's estate sold property to controlled cor-
poration for long-term installment obligations, which became taxable all at once, under
predecessor of section 453(d), -when estate distributed notes to beneficiaries).
6o0talph E. Gordy, 36 T.C. 855 (1961). But cf. Burgher v. Campbell, 244 F.2d 803
(5th Cir. 1957); Royce W. Brown, 54 T.C. 1475 (1970), on appeal to the Tenth Circuit.
Congress has prescribed detailed conditions under which long-term appreciation in land
may be segregated from subdivision profits, and each portion taxed according to its
nature when the gain is realized by sales of lots (LR.C. § 1237); but those restraints
may be evaded by interposing a controlled corporation as purchaser of the tract. See
Ralph E. Gordy supra.
61Without going into all the refinements, the rules may be stated as follows: The
transferor's gain on most personal property will be subject to ordinary income tax to
the extent of depreciation deductions allowed or allowable in periods after 1961 (but not
earlier). I.R.C. § 1245. His gain on most real property is similarly treated, but ordinarily
only to the extent of the excess of depreciation deductions actually allowed or allowable
over those allowable on the straight line method, in periods after 1969 (and various
fractions of such excess for the years 1964 through 1969). I.R.C. § 1250, as amended by
section 521(b) of the Tax Reform Act of 1969. Irrespective of previous enjoyment of de.
preciation deductions, his entire gain on depreCiable real or personal property w~il be
taxed as ordinary income if the transferor is an individual who, with his spouse and
minor children, directly owns more than 80 per cent of the value of the outstanding
stock (LR.C. § 1239)-a provision so ineffectual that beneficial ownership of stoc beld
in trust for such persons is disregarded by the courts (Mitebell v. Comm'r, 300 F.2d 533
(4th Cir. 1962); United States v. Rothenberg, 350 F.2d 319 (10th Cir. 1905). But of.
Reg. § 1.1239-1), and transfers to most corporations with more than one shareholder are
not even arguably reached. Cf. Trotz v. Comm'r, 361 F.2d 927 (10th Cir. 1960).
62A transfer to a controlled corporation in exchange for stock or securities is tax-free
under section 351(a), and hence causes the corporation to tahe the transferor's basis
despite its ultimate obligation to pay the fixed debt. Sec Campbell v. Carter Foundation
Production Co., 322 F.2d 827 (5th Cir. 1963); Baker Commodities, Ic., 48 T.C. 374, 401

TAX L&W REVIEW [Vol. 26 :
The question whether a transaction, if tax-free treatment is
avoided, gives rise to capital gain or loss is governed (when other
conditions are met) by whether it is a sale or exchange0 3 Since a
sale or exchange may be effected for any form of consideration,
including an equity interest in the purchasing corporation, as well
as for its debt, the question of sale versus no sale is not identical
to the question of debt versus stock, 4 and the applicable criteria
are not the same. For example, the well-kmown Clay Brown deci-
sion establishes that there may be a sale, giving rise to capital gain,
even though the entire risk of the transaction remains on the
sellers, whose only source of payment is the property itself and its
earnings.6 5 In contrast, debt ordinarily does not result if the pur-
ported creditor is subject to an undue extent to the risks of the
enterprise.66 Aside from the capital gain question, however, pur-
ported debts arising from sales (recognized as such) can give rise
to many of the questions that do turn on whether the instruments
represent debt or equity, such as the deductibility or taxable status
of purported interest 67 or discount,08 the worthlessness of the obli-
(1967), aff'd on another issue, 415 F.2d 519 (9th Cir. 1969), ccrt. denied, 397 U.S. 988
(1970). Concerning the meaning of "securities" in this context, see text at notes
1127-1240 infra.
63 I.R.C. § 1222. We are not here concerned with certain situations in which the law
considers gains or losses to result from a sale or exchange, even though the transactions
are not such, simply as a definitional device for giving them the tax treatment of capital
gains or losses.
64McCormae v. United States, 697 COH ff 7912 (Comm'r Rep., Ct. CI. 1969),
rev'd on other grounds, 424 F.2d 607 (Ct. C1. 1970). Although those questions wero said
to be the same in Sherwood Memorial Gardens, Inc., 42 T.C. 211, 227 (1964), aff' d, 350
F.2d 225 (7th Cir. 1965), the statement antedated Commissioner v. Brown, 380 U.S.
563 (1965), and in any event did not relate to an issue of capital gain or loss.
s5 Comm rv. Brown, 380 U.S. 563, 570, 574 (1965).
66 See text at notes 766-91 infra.
67 Gooding Amusement Co. v. Comm'r, 236 F.2d 159 (6th Cir. 1956), cert. donied,
352 U.S. 1031 (1957); Ambassador Apartments, Inc., 50 T.C. 236 (1968), aff'd, 400
F.2d 288 (2d Cir. 1969); Foresun, Inc, 41 T.C. 706 (1964), aff'd, 348 F.2d 1000 (6th
Cir. 1965).
68Nassau Lens Co. v. Comm'r, 308 F.2d 39, 46-47 (2d Cir. 1962). The Tax R~eform
Act of 1969 has narrowed the area in which the discount issue can arise in sales of
property for purported debt. On the creditor's side, an obligation issued for property
other than cash is now considered to have been issued at a discount only if the obligation
itself is traded on an established securities market or if it isissued for stock or securities
which are so traded; in all other cases, the price of the property is considered to be
equal to the stated redemption price of the obligation at maturity, and no discount
results. I.ThC. § 1232(b) (2), as amended by section 413(b) of the Tax Reform Act of
1969. The avowed purpose of the amendment was to prevent whipsawing of the govern-
ment in cases where the corporation and the creditors might compute discount based upon
inconsistent valuations of property having no readily established market value. Sco
Treasury letter to Senator Williams, 115 CoNG. Eo. 36730 (1969). However, the failure

gation, and other issues herein considered. The capital gain ques-
tion itself may be affected; for, if the consideration for an admitted
sale or exchange is deemed equity rather than debt, its retirement
may, in appropriate circumstances, be taxed as a dividend."0
WORTHLESSNESS OF THE ILMV STMNT
In many situations, debt enjoys no tax advantage over equity

when the investment becomes worthless. If the debt is represented
by a "security" (a term which here has a narrower and more
precisely defined meaning than under the preceding heading),"0
the loss will ordinarily be a long-term capital loss, just as if it were
sustained on stock.7 If the shareholder-creditor is a corporation
owning at least 95 per cent of each class of the defunct corpora-
tion's stock, and if other prescribed conditions are met, the parent
may take an ordinary loss deduction, with respect to either stock
or a debt constituting a security. -2
If the debt is not a security, the differences between debt and
stock become more significant. If the creditor is a corporation, it
may deduct a bad debt against ordinary income, whereas a stock
loss may offset only capital gains. For most individuals, the obliga-
tions of their own corporations would result in nonbusiness bad
of Congress to make a conforming amendment to section 103, or to any other provision
dealing -with the corporate deduction, leaves open the possibility that a debtor might
still as under prior law, claim deductions for amortization of discount on obligations
issued in excess of the fair market value of property acquired therefor, under circum-
stances in wheh the amended section 1232(b) (2) would not tax the creditor on discount.
Compare Nassau Lens Co. v. Conim'r, 308 F.2d 39, 43-44 (2d Cir. 1902), a d Amer-
ican Smelting & Refining Co. v. United States, 130 F.2d 883 (3a Cir. 1942), writh Man-
tana Power Co. v. United States, 232 F.2d 541, 545-50 (3d Cir. 1956) (concurring
opinion).
69Burr Oaks Corp. v. Comm'r, 365 F.2d 24 (7th Cir. 1966), cert. denicd, 385 U.S.
1007 (1967); Gardens of Faith, Inc., 23 T.C.M. 1045 (1964), off'd, 345 F.2d 180 (4th
Cir.), cert. denied, 382 U.S. 927 (1965); Kolkey v. Comm1'r, 254 F.2d 51 (7th Cir. 19538);
Gooding Amusement Co. v. Comm'r, 236 P.2d 159, 163 (6th Cir. 1956), cert. denied, 352
U.S. 1031 (1957); Houck v. Rinds, 215 F.2d 673 (10th Cir. 1954). Sec text at note 50
.supra.
70A debt is a security for this purpose only if represented by "a bond, debenture,
note, or certificate, or other evidence of indebtedness, issued by a corporation..., with
interest coupons or in registered form." LT.C. § 165(g) (2) (C) (emphasis added). It
seems clear from the rephrasing of the definition in section 1.165-5(a)(3) of the reg-
ulations that the italicized phrase qualifies all the terms that precede it.
71 .C. §§ 165(g) (1) and (2). The loss is treated as if sustained on a ale of the
stock or other security on the last day of the taxable year in which it becomes worthless,
so it would always be long-term unless the investment was made in the last six months
of the same year. Securities held by a dealer for sale to customera would, of course, be
excepted from such treatment.
72 I.R.C. § 165(g) (3).

debts, which are treated as short-term capital losses (irrespective
of their actual holding period) " and thus occupy a position inter-
mediate between stock losses and ordinary deductions.1 4 Only in
unusual circumstances would loans or sales by individual share-
holders result inordinary deductions for business bad debts, which
must arise from some business of the lender or seller himself,
apart from the business of the corporate debtor.1
73 LR.C. § 166(d), applicable to " a taxpayer other than a corporation."
74 Both net long-term and net short-term capital losses are subject to the samo $1,000
limitation on the amount that can be offset against ordinary income. But, elthor by
offsetting capital gains or over a longer range by carryovers against ordinary income,
the tax benefit of a short-term capital loss may be as much as twice that of a long-term
capital loss. I.R.C. §§ 1211(b), 1212(b), as amended by sections 513(a) and (b) of the
Tax Reform Act of 1969.
i5Whipple v. Comm'r, 373 U.S. 193 (1963). A business bad debt may be allowed to
one who is a promoter, in the business of seeking out opportunities, organizing and
Inancing the enterprises, and selling them at a profit or loss (Giblin v. Comm'r, 227 F.2d
692, 696 (5th Cir. 1955); Ralph Biernbaum, 22 T.C.M. 1046 (1963)), but only if the
particular loan was proximately related to such activity (United States v. Clark, 358
F.2d 892 (1st Cir. 1966)); a person who organizes one or many corporations does not
thereby qualify as a promoter, if he neither earns fees for promotion nor profits on
quick sales, but seeks only the investor's gains from long-term operations and ultimate
disposition. Townshend v. United States, 384 F.2d 1008 (Ct. Cl. 1967); Syor v. United
States, 380 F.2d 1009 (4th Cir. 1967); United States v. Byck, 325 F.2d 551 (5th Cir.
1963). One who is in the business of lending money for profit may qualify for business
bad debt treatment, provided the particular loan proximately arose therefrom; but
loans to corporations in which one has a substantial investment or family interest would
rarely so qualify. Gross v. Comm'r, 401 F.2d 600 (9th Cir. 1968); United States v.
Henderson, 375 F.2d 36, 41 (5th Cir. 1967). Loans made to assure a source of supply
or otherwise to protect one's individual business (J.T. Dorminoy, 26 T.C. 940 (1956)),
or to keep a tenant of one's individual property afloat (Maloney v. Spencor, 172 lF.2d
638 (9th Cir. 1949)), may result in business bad debts; but not if there is no shortage
of supply or of good tenants, so that the real motivation of the loan is seen to be the
lender's investment in the debtor. Spillers v. Comm'r, 407 F.2d 530, 534-35 (5th Cir.
1969). One's employment is itself a business, and a loan or guarantee exacted from
a minority shareholder as a condition to his employment may result in a business bad
debt (Trent v. Comm'r, 291 F.2d 669 (2d Cir. 1961)); a like condition imposed by a
controlling shareholder upon himself as an employee is more likely, however, to be
attributed to his investment interest (United States v. Worrell, 398 F.2d 427 (5th Cir.
1968)), particularly if the salary he takes is modest in comparison with his investment
(Millsap v. Comm'r, 387 P.2d 420 (8th Cir. 1968). But see United States v. Gonores,
427 F.2d 279 (5th Cir. 1970), cert. requested (Oct. 21, 1970); Weddle v. Comm'r, 325
F.2d 849, 851 (2d Cir. 1963)) or if he could readily obtain equivalent employment
(Niblock v. Comm'r, 417 F.2d 1185 (7th Cir. 1969)); nevertheless, even a controlling
shareholder may relate the loan to his job if he might be unemployable other than in a
business of his own (Estate of Kent Avery, 28 T.C.M. 364 (1969); Istdor Taffo, 26
T.C.M. 1063 (1967)) and perhaps without such a showing (B.A. Faucher, 29 T.C.M.
950, 955 (1970)). In exceptional circumstances, even an equity investment may be so
proximately connected with the shareholder's own business that the entire amount lost
may qualify as an ordinary business deduction (see Steadman v. Commissioner, 424 F. 2d
1, 5-6 (6th ir.), cert. denied, 400 U.S. 869 (1970)); but the test of business connection

In limited circumstances, stock losses may enjoy an advantage
over bad debts. Individual investors in certain "small business
corporations" may take ordinary deductions (rather than capital
losses) for an aggregate of $25,000 of losses on qualified common
stock in any one year ($50,000 for husband and wife filing a joint
return), if precise technical procedures were observed at the time
they invested.76 This tax advantage may provide some incentive for
the use of stock rather than debt capital, at least up to the amount
of the limitation, although the investor, characteristically optimis-
tic at the inception, may still prefer debt, with its opportunity for
tax-free withdrawal of capital if the business succeeds, to stock
on w ich he may take an ordinary loss if the venture fails. 7 To
some degree, the investor can hedge his bets, since he is permitted
to substitute qualified stock for previously outstanding debt 1 8
provided the debt -was not represented by securities 70 and was not
really in the nature of an equity investment,8 0 and provided he does
not delay the substitution so long that the issuance of stock is a
is even more stringent than for a business bad debt. Miles Production Co., 28 T.O.M.
1387,1411 (1969), on appeal to the Fifth Circuit.
7IT.R.C. § 1244. Among other requirements, not here of concern, the corporation must
adopt a written plan to offer common stock in a specified maximum dollar amount
during a specified period not exceeding two years from the date of adoption. Failure
to set out such limitations on amount and time is fatal to qualification, even though
they may seem surplusage to an unsophisticated small businessman contemplnting only
an immediate specific investment. Godart v. Comm'r, 425 F.2d 633 (2d Cir. 1970);
Spillers v. Comm'r, 407 F.2d 530 (5th Cir. 1969). There must, in form, be an o Ter by
the corporation, not an acceptance by it of the investor's offer, even though (at least in
a close corporation) the substance is identical. Childs v. Comm'r, 408 F.2d 531, 533
(3d Cir. 1969) ; Godart v. Comm'r, supra. See William Siebert, Sr., 53 T.C. 1 (1969). If
the investor subscribes to stock before incorporation, and hence before there can be
corporate action adopting a plan, he must be careful to condition the subSCription upon
such adoption. Compare Reg. § 1.1244(e)-I(c)(3), with William 0. Hayden, 52 T.C.
1112, 1126 (1969); Wesley H. Morgan, 46 T.C. 878, 890 (1906).
77 See Herwitz, Allocation of Stoc. Betwer Services and Capital in the Organization
of a Close Corporation,75 HARv. L. REv. 1098, 1120-21 (1962).
78 Common stock issued in cancellation of debt, pursuant to a plan satisfying the
statutory requirements, will qualify (Reg. § 1.1244()-1(f)(1)), but the ordinary ]oSa
allowed, on later worthlessness of the stock may not exceed the value of the debt (not
its face amount) at the time of the substitution. R1ev. Rul. 00-293, 196O-2 OXB. 305. If
the debt is merely contributed to capital, however, enhancing the basis of already exist-
ing section 1244 stock, any later stock loss allocable to such increment will not qunlify
for an ordinary deduction. I.R.C. § 1244(d) (1) (B); Reg. § 1.1244(d)-2.
9 I.R.C. § 244(c) (1) (D). "Securities" is not deflined for this purpose, but pre-
sumably has the same meaning it has been given in decisions under sections 351 and 354,
discussea in the text at notes 1127-1240 infra.
so If the purported debt is considered to have been in the nature of equity, the sub-
stitution of stock pursuant to a section 1244 plan commits no mew capital to the cor-
poration, and is not qualified. Hollenbeck v. Comnm'r, 422 P.2d 2 (gth Cir. 1970).

meaningless step in the dissolution process.8, In the upper reaches
of the definition of small business, the use of debt may help to keep
the corporation within the size limitations, since one of the require-
ments is that amounts received (or to be received under the plan)
by the corporation after June 30, 1958 for stock, as a contribution
to capital, or as paid-in surplus shall not exceed $500,000.2
The debt-stock distinction may affect not only the nature (and re-
sulting benefit) of the loss deduction but also its timing. If advances
to a corporation are recognized as bona fide debt, the stock invest-
ment may be viewed as worthless even while there remains a
chance of some recovery on the debt. 3 On the other hand, if the
advances are treated as capital contributions, they would impart
some value to the common stock, even after the amount originally
invested is gone, and thus would postpone the loss until the added
value too is exhausted.8 4 But if the advances, although denied rec-
ognition as debt, are regarded as in effect a class of stock having
preference over the common, the common stock may become worth-
less despite some lingering value in the superior equity.8 1
81 Bruce v. United States, 279 P. Supp. 686 (S.D. Tex. 1967), aff'd, 409 P.2d 1317 (5th
Cir. 1969); Raymond G. Hill, 51 T.C. 621 (1969); R~oland E. Scott, 27 T.C.M. 785
(1968). When the shareholder-creditors waived payment of their debt in bankruptcy,
and as a result received a distribution on account of their stock (which had boon issued
pursuant to section 1244), the ordinary stock loss was reduced by the distribution,
leaving the shareholders with only a short-term capital loss on their (nonbusiness) debt.
Sofie Eger, 28 T.C.M. 850 (1969).
82 It is further required that the sum of the equity capital (whether originating before
or after June 30, 1958) and the new capital to be received under the plan shall not
exceed $1 million. Equity capital is measured net of indebtedness other thanindobtcd-
ness to shareholders--i.e., bona fide debt to shareholders is considered equity for pur-
poses of this maximum size limitation, but not in measuring the limitation on post-Juno
30, 1958 investment. Both tests are applied as of the date of adoption of the plan
(except that stock to be issued under the plan is included). I.R.C. § 1244(e) (2).
83 Brandtjen & Kluge, Inc., 34 T.C. 416, 444-45 (1960); J.T. Dorminey, 26 T.C. 940,
946-47 (1956) ; Richard M. Drachman, 23 T.C. 558, 563-64 (1954). Although at least
one court has allowed a debt as worthless despite a finding of potential value negativing
worthlessness of the stock (Deeds v. Comm'r, 47 F.2d 695 (6th Cir. 1931)), most
decisions agree with the dissent (id. at 699) that if the debt is worthless, the stock
must also have lost all value then or sooner. Minneapolis, St. Paul & Sault Ste. Mario
R.R. v. United States, 164 Ct. Cl. 226, 247 (1964); Brandtjen & Kluge, Inc., supra;
Winthrop M. Mayo, 16 T.C.M. 49, 56 (1957).
s4JeweU Ridge Coal Corp., 21 T.C.M. 1048, 1056 (1962), aff'd, 318 F.2d 695, 699 (4th
Cir. 1963); Rassieur v. Comm'r, 129 F.2d 820, 825-26 (8th Cir. 1942); In ro Park's
Estate v. Comm'r, 58 F.2d 965 (2d Cir. 1932); RH.. Bodzy, 21 T.O.M. 219) 233 (1962),
rev'd on other grounds, 321 F.2d 331 (5th Cir. 1963); Martin M. Dittmar, 23 T.C. 789,
797-98 (1955).
85 Preferred and common stock may become worthless at different times. Mahler v.
Comm'r, 119 F.2d 869, 873 (2d Cir. 1941). When advances are not in proportion to
stock, those making them enjoy a legal preference, even if for tax purposes they are

19711 CORPORATE DEBT
COO ATE LiQOiRDATIOs
When a subsidiary corporation is liquidated, and its purported

debt to its parent exceeds its available assets, the tax consequences
may be vitally affected by the status accorded the debt. Section
332(b) (2) of the Internal Revenue Code denies recognition of gain
or loss on a distribution received Iin complete cancellation or re-
demption of all [the] stock" of a corporation in which the parent
owns stock possessing 80 per cent of the voting power, as well as 80
per cent of the total number of shares of nonvoting stock (other
than certain nonvoting preferred stock). In such a case, the parent
ordinarily takes over the basis of the subsidiary's assets and suc-
ceeds to the subsidiary's rights to loss carryovers and certain other
tax attributes. "" But if the subsidiary is insolvent, and the parent
acquires its assets solely in the capacity of bona fide creditor, there
will be nothing distributed in cancellation or redemption of the
stock, and section 332 will be inapplicable.87 The parent will then
lose the benefit of the subsidiary's loss carryovers and will not
succeed to the subsidiary's asset basis.11 It may or may not be
not deemed creditors, and they have been said to be "in the position of" (Foresun,
Inc., 41 T.C. 706, 717 (1964), aff'd, 348 F.2d 1006 (6th Cir. 1905)) or I"not unikll"
preferred shareholders (Sherwood Memorial Gardens, Inc., 42 T.C. 211, 230 (1964),
aff1', 350 F.2d 225 (7th Cir. 1965)), or even, flatly, to "constitute" such (Burr Oa s
Corp., 43 T.C. 635, 649 (1965), aff'd, 365 F.2d 24 (7th Cir. 1966), cert. dericd, 385
U.S. 1007 (1967)). The Tax Court applied this analysis even to advances by a solo
shareholder in Piedmont Corp., 25 T.C.1L 1344, 1349 (1960), rculd, 388 1.2d 886 (4th
Cir. 1968), but another court viewed unrecognized advances in such circumstances as
simply additional investment in the common stock. Byerlyte Corp. v. Williism, 170 F.
Supp. 48, 62-63 (N.D. Ohio 1958), r'cvd on other grounds, 280 F.2a 285 (6th Cir. 19GO).
See also Reg. § 1.1371-1(g), discussed in the text at notes 107-12 infra. In Jewel
Ridge Coal Corp., 21 T.C.M. 1048, 1056 (1902), aff'd, 318 F.2d 005, 099 (4th Cir.
1963), on the other hand, the capital contribution analysis (resulting in deferral of the
common stock loss) was applied despite the fact that the advances were made only by
the majority shareholder and were reflected by demand notes enjoying a preference over
the nonnadvancing shareholders.
srI.R.C. §§ 334(b) (1), 381. An exception is made whero the parent purchased the
80 per cent interest within a limited period before the liquidation. LE.C. §§ 334(b) (2),
381(a) (1).
87 H.G. Hill Stores, Ine, 44 B.T.A. 1182 (1941) ; leg. § 1.332-2(b) ; 1ev. Rul. 59-296,
1959-2 C.33. 87.
88 Other consequences to the parent and subsidiary of disqualiflation for scecton 332
treatment axe too numerous to be detailed here. Among other things, the subsidiary
(unless its losses are sufficient to offset the amounts) will incur tax on the recapture
of past depreciation deductions, will hamve to restore its unued1 bad debt rcerve to
income and will be deemed to have realized as gain the appreciation on assets applic
on debts. The parent will lose the right to use accelerated depreciation methods on
property received from the subsidiary.

TAX LAW REVIEW [Vol. 26 :
compensated therefor by the allowability of losses for its invest-
ment in the stock and for the unrecovered portion of the debt. The
loss on the stock will be a capital loss (often of little value to a cor-
porate taxpayer), unless the parent owns directly, not 80 per cent,
but 95 per cent of each class of the subsidiary's stock, including in
this case nonvoting preferred stock, and unless other conditions
prescribed in section 165(g) (3) for the allowance of an ordinary
loss on stock are met.89 The bad debt, on the other hand, will be an
ordinary deduction, unless the debt is represented by a security
(here meaning an instrument with interest coupons or in regis-
tered form),*90 In the latter event, the unrecovered portion of the
debt will be a capital loss (usually long-term), even if the other
requirements of section 165(g) (3) are met, for that provision al-
lows an ordinary deduction only if the security is a total, not a par-
tial, lossY1
Suppose, however, that the purported debt to the parent is not
recognized as such for tax purposes, but that it is deemed an equity
investment in a class of stock distinct from the common (a conclu-
sion that may be reached if there are minority shareholders over
whom the parent's advances enjoy a legal preference).9 2 The Tax
Court and the Second Circuit, although without the concurrence
of the Commissioner, have held that section 332 is not applicable to
the liquidation of a solvent subsidiary, if there is a partial distribu-
tion on preferred stock but none on the common, even if the parent
holds both. It is considered that there is lacking the requisite distri-
bution "in complete cancellation .. of all [the] stock," if there
is nothing left for the common. 3 If unrecognized debt is treated
like preferred stock, the tax effects will be the same as those de-
scribed above with respect to debt which is recognized, but with
some important exceptions. -Whereas recognized debt, if it does not
89 More than 90 per cent of all the gross receipts during the period of the sub-
sidiary's existence must have been from sources other than royalties, rents, dividends,
interest, annuities and gains from sales or exchanges of stocks and securities (with
certain exceptions permitted in the case of rents and interest). I.R.C. § 165(g) (3) (B).
90 See note 70 supra.
91 Northeastern Consolidated Co. v. United States, 406 F.2d 76, 79 (7th Cir.), cert.
denied, 396 U.S. 819 (1969); Byerlyte Corp. v. Williams, 170 F. Supp. 48, 58-60 (N.D.
Ohio 1958), rev'c on other grounds, 286 F.2d 285 (6th Cir. 1960) ; Reg. § 1.165-5(d) (1).
93 Comm'r v. Spaulding Bakeries, Inc. 252 F.2d 693 (2d Cir. 1958), afflrMing 27
T.C. 684 (1957) (emphasis by the court). The Commissioner's nonacquiesconee, 1957-2
C.B. 8, in the Tax Court's decision remains outstanding, but he would not be precluded
from relying on the case when it was to the advantage of the revenue.

1971] CORPORATE3 DEBT
have the interest coupons or registered form that would classify it

as a security, would give rise to an ordinary bad debt deduction,
unrecognized debt which is viewed as preferred stock is per se a
security, -without regard to its form; 04 and, if the loss of the un-
recognized debt (which may be much the larger portion of the
parent's investment) is not total, that loss will be only a capital
loss, even if the loss on the common is qualified under section
165(g) (3) for ordinary loss treatment." Further, unless both the
stock and the unrecognized debt, viewed as a separate class of
stock, are at least 95 per cent owned by the parent, the parent will
forfeit ordinary loss treatment even on the common stock, since it
will not own the 95 per cent of each class of stock, requisite to qual-
ification under section 165 (g) (3).90
Now suppose that the purported debt is unrecognized but is held
to be a capital contribution, enhancing the common stock invest-
ment, rather than to constitute a separate class of stock. In that
event the amount recovered on the purported debt will be a distri-
bution "in complete cancellation or redemption" of the common,
and section 332 will apply, resulting in denial of any deductions
for loss of the parent's investment in stock and puriported debt,
but preserving for the parent the compensating benefits of the sub-
sidiary's asset basis and carryovers' 7 In readily conceivable cir-
cumstances, the parent might much prefer to have the debt un-
recognized in such a case."
In section 332 liquidations of subsidiaries, and other specially
treated corporate liquidations under sections 333 and 337, the tax
immunities and benefits which the law grants to the liquidating
91 I.R.C. § 165(g) (2) (A).
95 See note 91 supra. An ordinary loss on the conunon stock was permitted under sec-
tion 165(g) (3) in Commissioner v. Spaulding Bakeries, Inc., 252 F.2d 693 (2d Cir. 1958).
The loss on the preferred was not involved in the ease, but it appears it would have been
a capital loss for the reason stated in the text.
96Northeastem Consolidated Co. v. United States, 406 F.2d 76, 70 (7th Cir.), cert.
denied, 396 U.S. 819 (1969).
97Byerlyte Corp. v. Williams, 170 F. Supp. 48, 61-63 (N.D. Ohio 1958), rev'1d on
other grounds, 286 F.2d 285 (6th Cir. 1960); Republic Steel Corp. v. United Stat3, 15D
F. Supp. 366, 371 (Ct. CL 1958). Cf. Allied Stores Corp., 19 T.C.ML 1149 (19060); Glen-
more Distilleries Co., 47 B.T.A. 213, 227 (1942), in which the Commissioner's attachs
on the debts failed and section 332 or its predecessor was beld inapplicable to deny
the stock and debt losses. This was also the ground of reversal in Byerlyto Corp. v.
Williams, supra.
98 Or, if the debt is valid, the parent might cancel it in anticipation of the liquida-
tion, a move that was ruled ineffective to bring the transaction within section 332,
in Revenue Rluling 68-602, 1968-2 C.B. 135.

corporation or its shareholders are conditioned upon completion
of the distribution within a specified time. 9 lUnder sections 333 and
337, and possibly under section 332, it is permissible for the cor-
poration to retain, beyond the prescribed period, assets reasonably
required to meet unsettled debts.10 0 If a purported debt is construed
to be equity, however, retention of assets to satisfy it will disqualify
the liquidation under those provisions."'
SUBCHAPTER S CORPORATIONS
The question whether advances not recognized as debt are to be

treated as capital contributions or as a second class of stock as-
sumes primary importance in the case of certain small business
corporations electing to avoid tax at the corporate level and to
99 Tax-free liquidation of a subsidiary under section 332 must be completed by transfer
of all the property within the taxable year or, subject to certain conditions, within three
years after the close of the taxable year in which the first distribution is made. I.R.C.
§ 332(b). Liquidation under section 333, which is partially tax-free to the recipients,
must be completed within a single calendar month. I.R.C. § 333(a) (2). Liquidation
under section 337, under which the corporation itself escapes tax on certain sales by it,
must be completed within twelve months. I.R.C. § 337 (a) (2).
100 Section 337(a) (2) expressly permits retention of assets to meet claims. Soo Rog.
§ 1.337-2(b). The regulations under section 333 permit retention for "unascortaned or
contingent liabilities and expenses." Reg. § 1.333-1(b); Rev. :Rul. 56-286, 1956-1 C.B.
172. Section 332 and the regulations thereunder contain no comparable provision, and
the regulations prescribe that within the period, the corporation and its receiver or
trustees in liquidation must be "finally divested of all the property (both tangible and
intangible)," except a nominal amount if necessary to preserve the corporation's legal
existence. Reg. § 1.332-2(c). Nevertheless, the requirement of the statute itself is that
not "all the property," but "tall the property under the liquidation" (I.R.O. § 332
(b) (3)) be timely distributed, and the identical language in section 333 provided the
basis for section 1.333-1(b) of the regulations permitting retention of assets to pay
unascertained or contingent liabilities. See Estate of Lewis B. Meyer, 15 T.C. 850, 862-
63 (1950), rev'd on other grounds, 200 F.2d 592 (5th Cir. 1952). The conclusion that a
liquidation (not under one of the special provisions) was not rendered incomplete by
such retention was reached, without benefit of express statute or regulation, in Colonial
Enterprises, Inc., 47 B.T.A. 518, 522 (1942). There are, however, no decisions or rulings
in point under section 332.
101 John Town, Ine., 46 T.C. 107 (1966), aff'd per curiam, 67-1 U.S.T.C. 9462 (7th
Cir. 1967) (under section 337). The retained assets there included installment notes
derived from the sale of corporate assets, and the unpaid liabilities included the install.
ments remaining on the corporation's purchase of assets from its sole shareholder (which
was not recognized as giving rise to a bona fide debt). The result (taxation of the cor-
poration on its gain) has been characterized as especially outrageous because money not
retained to pay indebtedness would go to the same shareholder anyway. Hickman, The
Thin Corporation:Another Look at an Old Disease, 44 TAX S 883, 888 (1966). But It Is
the timing, not the destination, of the distribution that is important. The whole idea of
section 337 is that relief from double taxation of gains on sales pending liquidation,
through exemption of the corporation, is conditioned upon the shareholder receiving his
entire equity and being taxed on his gain within a limited time.

have their income taxed (and their losses allowed) directly to their
shareholders. 1 2 One condition to the eligibility of a corporation
to make or maintain such election is that it not have "more than one
class of stock." 1o3 Until 1966, the Treasury Regulations took the
flat position that "[i]f an instrument purporting to be a debt obli-
gation is actually stock, it will constitute a second class of
stock," 104 and the Service contended, with some success, that
any unrecognized debt was "actually stock," regardless of the
circumstances.1 15 However, in response to a taxpayer's frontal
assault on the validity of the regulation, the Tax Court rejected
the "second class of stock" analysis where the advances were sub-
stantially in proportion to stock and the circumstances made it
likely that they would be subordinated to creditors in bankruptcy,
so that the notes were "a nullity insofar as they purported to give
[the holders] any rights and interests in the income and assets of
the corporation different from the rights and interests they had as
owners of all the capital stock of the corporation." 100
Bowing to that decision, the Treasury amended the regulation to
provide that purported obligations which "actually represent
equity capital" will be treated as capital contributions rather than
as a second class of stock if they are owned solely and substantially
proportionately by shareholders .1 7 Disproportionate advances,
which ordinarily stand a much better chance to be recognized as
debt,""8 will still, if unrecognized, be "generally" regarded by the
102 LRC. §§ 1371-78. In contrast to section 1244, which defines a Itsmall busineS3 cor-
poration" in terms of its size in dollars (note 82 supra), subcbnpter S loolzs only to
the number and character of its shareholders (L.C. § 1371(a)), and is unconcerned
whether the corporation may be engaged in an oil operation with "annual income in
the multimillions." Richardson Foundation v. United States, 69-1 U.S.T.C. T 9341 (S.D.
Tex. 1969), aff'd, 430 P.2d 710 (5th Cir. 1970), cert. requested (Jan. 11, 1971).
1o3LR.C. § 1371(a)(4). Although such corporations are not concerned with most of
the usual incentives to debt financing above discussed, they have reasons peculiar to
themselves for incurring shareholder debt. See Note, Bhiarehioldcr Lending and Tax
Avoidance in the Subchapter S Corporation,67 CoLU. L. REv. 495, 500-04 (1907).
3o4Reg. § 1.1371-1(g), T.D. 6432j 24 FED. REG. 10294 (Dee. 19, 1959), prior to
amendment by T.D. 6904, 31 IE. REG. 16527 (Dee. 28, 1966).
305 Catalina Homes, Inc., 23 T.C.M. 1361 (1964) (disproportionate advances on open
account, the only instrument being a prior written agreement to mahe them); Henderson
v. United States, 245 F. Supp. 782 (I.D. Ala. 1965) (notes held in proportion to stock).
106 W.C. Gamman, 46 T.C. 1,9 (1966).
107 Reg. § 1.1371-1(g), as amended by T.D. 6904, 31 FtD. REo. 16527 (De. 28, 1906).
Before such amendment capital contributions had been found despite minor departure3
from proportionality. W.C. Gamman, 46 T.C. 1 (1966); Lewis Bldg. & Supplie3, Inc.,
25 T.COM 844 (1966).

Treasury as a second class of stock. 10 9 The amended regulations
injected a further note of uncertainty by prescribing that the
status of proportionate advances might change from capital con-
tributions to a second class of stock if transfers or redemptions of
either the common stock or the purported obligations later resulted
in disproportionate holdings. But, in a case where there were dis-
proportionate repayments of purported debt as well as family
transfers of stock, each upsetting the initial proportionality of the
shareholder advances, the Tax Court held that their character was
unaffected because such changes were not intended to create a pre-
ferred interest, different from that represented by the nominal
stockholdings. 110
Again when frontal assaults were made, the courts dealt no more
gently with the amended regulation than with its predecessor, view-
ing the traditional debt-equity dichotomy as irrelevant to, and
in fact subversive of, the purposes of subchapter S.111 At least
where purported debt is deemed "actually [to] represent equity
capital" only because (and so long as) it is coupled with the owner-
ship of common stock by the same or related persons, whether in
the same or different proportions, the Tax Court and others decline
12
to view it as a disqualifying second class of stock.
MEASUREMENT OF CONTROL
The applicability of numerous provisions of the Code which de-
pend upon whether someone owns a specified percentage of the out-
109 The anomaly was noted in the dissenting opinion in James L. Stinnett, Jr., Z4 T.C.
221, 239 (1970), on appeal to the Ninth Circuit, stating that the taxpayer, having argued
disproportionality in a vain effort to gain recognition of the debt, was "hoist on his
own petard" when it came to the subchapter S issue.
110 August F. Nielsen Co., 27 T.C.M. 44 (1968).
ll Portage Plastics Co. v. United States, 301 F. Supp. 684, 690-94 (W.D. Wis. 1969);
James L. Stinnett, Jr., 54 T.C. 221 (1970), on appeal to the Ninth Circuit. Of. Brennan
v. O'Donnell, 426 F.2d 218 (5th Cir. 1970) (avoiding opinion on validity of regulation).
See Note, Shareholder Lending and Tax Avoidance in the Subchapter B Gorporation,
67 CoLu. L. REv. 495 (1967). Four concurring judges in Stinnett, however, raised but
left open the question whether the invalid regulation might have been validated prospec-
tively by the newly granted blanket power to prescribe regulations " Ito determine whether
an interest in a corporation is to be treated for purposes of [the internal revenue laws]
as stock indebtedness." I.R.C. § 385, added by section 415(a) of the Tax Reform Act
of 1969. Does that embrace the power to decree whether that which is defined as "stock"
is a second "class of stock"? See text at note 1340 infra.
112 James L. Stinnett, Jr, 54 T.C. 221 (1970), on appeal to the Ninth Circuit. Earlier,
without questioning the regulation, the Tax Court had found unequal advances to be in
fact proportionate where the shareholders had agreed among themselves to make good
the loss of anyone who had advanced more than his share. Milton T. Raynor, 50 T.C. 702,
768-69 (1968).

standing stock of a corporation may be affected by the treatment
of purported debt as equity.
The tax-free character (and other tax consequences) of certain
corporate transactions depends upon the existence of control,
which is defined in section 368(c) as "the ownership of stock pos-
sessing at least 80 percent of the total combined voting power of
all classes of stock entitled to vote and at least 80 percent of the
total number of shares of all other classes of stock of the corpora-
tion." The Internal Revenue Service construes the second leg of
that test to mean that 80 per cent of each class of nonvoting stock
must be owned; 1 3 and, as we have seen, unrecognized debt, particu-
larly when not held in proportion to stock, may be deemed a class
of stock (which, in most cases, would be nonvoting) .114 Therefore.
a transfer to a corporation that has issued purported debt which is
so considered may fail to qualify as tax-free under section 351 11o
or section 368(a) (1) (D) 111 unless the transferors collectively (or,
under the latter provision, the transferor corporation or its share-
holders or both) own the requisite control not only of the nominal
stock but of the unrecognized debt as well. 17 If one corporation ac-
quires substantially all the assets of another by merger or other-
wise, using stock of the parent of the acquiring corporation as the
consideration, or if the acquiring corporation retransfers all or part
313 Rev. Eul. 59-259, 1959-2 C.B. 115.
114 The right to vote only on certain limited matters, or only on default, v.ou d not
make the unrecognized debt voting stock. Cf. Erie Lighting Co. v. Comm', 93 F.2d 893
(1st Oir. 1937); Vermont Hydro-Eleetric Corp., 29 B.T.A. 1000 (1934). See Beg.
§ 1.302-3(a).
"i5 Section 351, in general, denies recognition of gain or loss on a transfer of property
by one or more persons solely in exchange for stock or securities in such corporation if,
immediately after the exchange, the transferors are in control of the corporation.
16 Section 368(a) (1) (D) defines a "reorganization" to include a transfer by a
corporation of all or part of its assets to another corporation if, immediately after the
transfer, the transferor, or one or more of its shareholders, or any combination thereof,
is in control of the transferee, and if certain other conditions are met.
-17 The failure of the transferors to control the nonvoting preferred stock (to which
unreeognized debt may be equated) was fatal to qualifications under section 351 or
under the predecessor of section 368(a) (1) (D) in Stock Yards National Bank of
South St. Paul, 3 T.C.M. 424, zodifted, 3 T.C.ML 972 (1944), rcv'd on other 9rounds,
153 F.2d 708 (8th Cir. 1946); Ernst Kern Co., I T.C. 249, 261-62 (1942); Rev.
Rul. 59-259, 1959-2 C.B. 115. If the transfer for stock and the transfer giving rise to
the unrecognized debt are part of a single plan, the holdings of both tmrnsferors or
groups of transferors may be aggregated for the purpose of determining control under
section 35L Burr Oaks Corp. v. Comm-r, 365 F.2d 24, 28 (7th Cir. 1966), cert. denfed,
385 U.S. 1007 (1967); Marsan Realty Corp., 22 T.C.L 1513, 1523-24 (1903); f. Book
Production Industries, Inc. 24 T.C.ML 339, 351 (1965) (rejecting, on the fact3s, the
Commissioner's argument that purported debt was equity for the purpose of establishing
a reincorporation).

of the assets to a subsidiary, the transaction may fail to qualify as
a reorganization under section 368(a) (1) (A) or (C), as the case
may be, if the parent does not own at least 80 per cent of the un-
recognized debt, as well as of the nominal stock, of its subsidiary. 8
An acquisition of stock of one corporation solely for voting stock of
another, under section 368(a) (1) (B), may involve the control ques-
tion on both sides of the transaction." 9 If the consideration given is
voting stock of the parent rather than of the acquiring corporation
itself, the transaction may be disqualified if the parent happens not
to own 80 per cent of the unrecognized debt of the acquiring cor-
poration and thus lacks the requisite control.12 0 On the other side, if
the acquiring corporation does not hold, after the transaction, the
requisite control not only of the nominal stock of the acquired cor-
poration but of its unrecognized debt, or if the unrecognized debt
is acquired for a consideration other than voting stock, the transac-
tion may be disqualified. 2
A spin-off distribution of stock of a subsidiary, or other corporate
separation under section 355, may be affected in two ways by this
question.1 2 2 It cannot be tax-free to the recipients unless the dis-
-18 A statutory merger, using stock of the corporation in control of the surviving
corporation as the consideration, may qualify as tax-free under section 368(a) (1) (A)
of the Code if the conditions of section 368(a) (2) (D) are met. Under section 368(a)
(1) (0), an acquisition of substantially all the assets of a corporation may be tax-free if,
in general, the consideration is solely voting stock either of the acquiring corporation
or of a corporation having control of the acquiring corporation. Retransfor of the
acquired assets to a subsidiary may disqualify a reorganization (Helvering v. Bashford,
302 U.S. 454, 458 (1938); Anheuser-Busch, Inc. v. Helvering, 115 F.2d 662 (8th Cir.
1940), cert. denied, 312 U.S. 699 (1941)) unless control of the subsidiary exists. I.R.C.
§ 368(a) (2) (C).
119 Under section 368(a) (1) (B), an acquisition by one corporation of stock of an-
other, solely in exchange for voting stock either of the acquiring corporation or of a
corporation having control of the acquiring corporation, is tax-free if the acquiring cor-
poration has control of the acquired corporation immediately after the acquisition of
stock.
120 If the acquiring corporation retransfers the acquired stock to a subsidiary, it must
be one of which the acquiring corporation has the requisite control (I.R.C. § 368 (a) (2)
(0)), including ownership of unrecognized debt if viewed as a class of stock.
121 See Merritt, Tax-Free Acqzuisition of Corporate Business, 13 N.Y.U. INST. 693, 728-
29 (1955). On the other hand, if the debt is recognized as such, it may be acquired, or
satisfied in the same transaction, for cash or any other consideration, or may be loft un-
changed, without impairing the tax-free character of the exchange of stock for stock
(assuming the consideration is realistically allocated). Rev. Rul. 69-142, 1969-1 C.B.
107; Rev. Rul. 69-91, 1969-1 C.B. 106. The transfer of debt of the acquired corpora.
tion in exchange for additional voting stock will be taxable if the debt is recognized as
such (see Shop Talk, 29 J. TAxAT o 319, 320 (1968)), but will be tax-free if the pur-
ported debt is deemed equity (assuming the transaction otherwise fits section 368
(a) (1) (B)).
122 Section 355 relieves the shareholder of tax on the receipt of a distribution of stock

tributing corporation had control of the subsidiary, and hence may

be disqualified by the existence of unrecognized debt of which the
parent fails to hold the requisite 80 per cent. Further, the stock
distribution ordinarily cannot be tax-free unless the distribution in-
cludes all the stock of the subsidiary (including unrecognized debt)
which the distributing corporation holds, as well as any bona fide
debt which is represented by a security;- 4 but other recognized
debt of the subsidiary need not be distributed to the shareholders.
In another group of provisions, including sections 332, 382, 1504
and 1563, nonvoting stock that is limited and preferred as to divi-
dends is disregarded in determining the stock ownership percen-
tages. 2 5 Thus unrecognized debt which is viewed as a class of non-
voting preferred stock should have no effect under these provisions;
yet the Commissioner has argued in one case under section 1504
that advances by a party related to the nominal stockhbfolder were
capital contributions that altered the control ratio. =0
of a corporation controlled by the distributor, within the meaning of section 363(e), if
certain conditions are met.
123 f, for example, the unrecognized debt is held by the shareholders or by an
afflate of the distributing corporation, the control requirement will not be met (cf.
Rev. Rul. 56-513, 1956-2 C.B. 212), even if in anticipation of the distribution the un-
recognized debt is contributed to the capital of the distributor. Cf. Rev. Rlul. 63-260,
1963-2 C.B. 147.
-24A "~security" for this purpose means any debt instrument that has the qualitie3
of a long-term stake in the business (sec text at notes 1127-1240 infra), rather than the
narrow formal meaning ascribed to the term under section 165(g) (2), sce note 70 supra.
So long as stock (including unrecognized debt) sufficient to constitute control is dis-
tributed, the exclusion of securities and any remaining stock from the distribution may
be excused upon satisfactory showing that tax avoidance was not ono of the principal
purposes for their retention. IE.C. § 355(a) (1) (D). Although ordinarily required to be
included in the distribution as a condition to tax-free treatment of the stoc, tho debt
securities themselves (unlike unrecognized debt considered as stoO;) will not be tax-free
to the recipient, except to the extent of the amount of securities of the distributing cor-
poration which he surrenders in exchange. L.C. §§ 355(a) (1) (A) (ii), 356(d) (2) (C).
125 Section 332 denies recognition of gain or loss on the complete liquidation of a
corporation whose parent holds stock possessing at least 80 per cent of the voting power
and also 80 per cent of the total number of shares of all other classes, excluding non-
voting preferred. Section 382(a) denies net operating loss carryovers in certain case3
where the ownership of the total value of the outstanding stock (exclusive of nonvoting
preferred) has changed, by purchase, by more than 50 percentage points. Section 382(b)
limits such carryovers in cases where, as a result of a reorganization, the shareholders of
the loss corporation own less than 20 per cent of the value of the outstanding stock of
the acquiring corporation, with the same exception. Section 1504(a) defines an affilkated
group eligible to file a consolidated return, in terms of ownership of stock posesng at
least 80 per cent of the voting power and of 80 per cent of each class of the nonvoting
stock, with the same exception. Sections 1563 (a) and (c) (1) define a controlled group
of corporations, for the purpose of limiting multiple surtax exemptions and other
benefits, in similar terms.
12 In Book Production Industries) Inc., 24 T.C.M 339, 352 (1965), the B Corpora-

396 TAX LAW REVIEW [Vol. 26:
The applicability of a number of other Code provisions, including
sections 267, 318, 341, 542, 552, 1235 and 1239, is made to depend
upon whether certain persons own, or are deemed through attribu-
tion from related parties to own, a specified percentage of the value
of the outstanding stock of a corporation. 27 Since all classes of stock
are aggregated on a value basis for these purposes, the ownership
of unrecognized debt (whether deemed a class of stock or a capital
contribution) may bring a person over the prescribed amount al-
though his nominal stock alone might be insufficient; and the own-
ership of such debt by others may inflate the denominator of the
fraction sufficiently to bring him below the prescribed percentage
of the aggregate stock equity, thus affording the taxpayer an in-
centive to impeach the purported debt.1 28
tion's asserted right to include M Corporation in its consolidated return was based on a
$5,000 investment by B in all the nominal stock of M. A related corporation (A), not a
member of the affiliated group, had made advances aggregating 100 times such stock
investment. The Commissioner, viewing A 's advances as capital contributions, denied
M's affiliation with B. The Tax Court, although stating that the advances "could con.
stitute another class of stock," ignored the statutory injunction to disregard a non.
voting preferred class and was "inclined to agree" with the Commissioner. But it
denied affiliation on another ground.
127 Section 267 disallows deductions for certain losses and unpaid exponses and in-
terest, in transactions between an individual and a corporation more than 50 per cent
owned, directly or indirectly, by him, and in transactions between two corporations so
owned by the same individual if either of such corporations was a personal holding
company for the preceding year. Sections 318(a) (2) (C) and (a) (3) (0), for the purpose
of certain provisions relating to stock redemptions, loss carryovers, ot cetera (see section
318(b)), deems a corporation to own stock held directly or indirectly by the owner of
50 per cent or more of its stock, and vice versa. Section 341(d)(1) provides relief for
the owner of no more than 5 per cent of the stock of a collapsible corporation; and relief
under section 341(e) is dependent in several respects upon the status or activities of tho
owners of more than 5, 20 or 50 per cent of the stock. Classification of a corporation as a
personal holding company or as a foreign personal holding company is dopondont in
part, under sections 542(a) (2) and 552(a) (2), upon direct or indirect ownership by
not more than five individuals of more than 50 per cent of the stock. Transfer of a patent
to a corporation owned 25 per cent or more by the transferor is excluded by section
1235(d) from the capital gain treatment provided by section 1235 (although it hits been
ruled, in Revenue Ruling 69-482, 1969-2 C.B. 164, note 415 infra, that the transforor
so excluded can then obtain almost the same treatment under general principles). Sec.
tion 1239(a)(2) denies capital gain treatment on transfers of depreciablo property
between an individual and a corporation more than 80 per cent owned by him and
specified related parties.
128 In Washmont Corp. v. Hendricksen, 137 F.2d 306 (9th Cir. 1943), a corporation
with only three nominal shareholders sought to avoid personal holding company status
by contending that participating debentures, in an amount 25 times the nominal stock,
were in fact stock, and that no five individuals owned more than 50 per cent of the
total. The court held the debentures to be true debt, leaning heavily against the taxpayer
because of its earlier inconsistency in claiming deductions for interest. See BflrrE1 &
EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOIDERS 252 (2d od.
1966).

In certain other provisions, including sections 269, 304 and 1551,

that possible escape route is impeded by the prescription of two
alternative tests of control. Those provisions are applicable if
either stock possessing the prescribed percentage of the voting
power or the prescribed percentage of the total value of all classes
of stock is owned." -While ownership of unrecognized debt may
bring a situation withild those provisions, that might escape them if
only the nominal stock were considered, the taxpayer could rarely
profit by claiming that purported debt in other hands is really
stock, since the proportions of ownership of the voting stock would
not be altered thereby. 130
REDE Xm IONs TO PAY DEATH TAXEs

The debt-stock question can have conflicting effects upon the
application of section 303, which permits the redemption of stock
of a closely held corporation from a decedent's estate or its dis-
tributees, free of the risk of dividend equivalency, up to the amount
of the death taxes and expenses. Such privilege is granted only if
the value of the stock includable in the decedent's estate exceeds
either 35 per cent of the value of the gross estate or 50 per cent of
the value of the taxable estate.' If the decedent had financed the
corporation to a significant extent with purported debt, however,
the value of the nominal stock alone might well fail to satisfy either
of those tests. Treatment of the purported debt as stock, whether a
capital contribution or a separate class, would increase the chance
of satisfying one or both of those value tests, to the extent that the
decedent himself (and not a related party, such as another corpo-
29 Section 269 denies certain tax benefits, including loss carryovers ann multiple sur-
tax exemptions, if any person or persons acquire 50 per cent stock control of a cor-
poration, or if a corporation acquires, in a tax-free transaction, property of another
corporation not previously controlled by it, for the principal purpose of scuring such
tax benefits. Section 304 treats as a stock redemption, for the purpose of the dividend
equivalency provisions, the purchase of stock from a shareholder by a corporation
-which is in common 50 per cent control with the issuing corporation or is at least 5O
per cent controlled by the issuing corporation. Section 1551 denies multiple surtax
exemptions and accumulated earnings credits where a corporation has transferred prop-
erty to an 80 per cent controlled corporation, or where five or fewer individuals have
transferred property to an 80 per cent or 50 per cent controlled corporation (depending
on the circumstances), with a major purpose of obtaining such benefits.
13o Conceivably, where the voting power test is not met, the ownership of purported
debt might make the difference, one way or the other, in whether the aggregate value
test is satisfied, as discussed in the preceding paragraph. Possibly also, the purported
debt might carry voting rights that would cause it to be included in the voting power
equation. But see note 114 supra.
131 IR.C. § 303(b) (2) (A).

ration owned by him) 132 made the advances. While it would be a
brave, if not foolhardly, executor who would undertake a section 303
redemption of the stock if its eligibility depended upon successfully
impeaching the purported debt, 1 33 he might with more confidence
accept repayment of the debt, relying on its being a return of cap-
ital if the debt is recognized and a redemption of eligible "stock"
under section 303 if it is equity (provided, of course, that the time
and amount limitations of that provision are observed).
Although section 303 refers in general to redemption by a single
corporation that meets the relative value standard, it provides
that a number of corporations may be considered as a unit (so that
redemptions by any or all of them will qualify) provided that more
than 75 per cent of the value of the outstanding stock of each of
them is includable in the decedent's estate.' If the several corpora-
tions have financed each other by intercompany advances, however,
there is a danger that such purported debts, if viewed as equity
capital (not owned directly by the decedent) ,135 will suffice to nega-
tive his ownership of 75 per cent of the equity value, even though
he may have owned all the nominal stock of each corporation. 130
IqIsoELLAxOITS EFPFCTS
There are countless other ways in which the distinction between

debt and stock may have significant tax effects.
(1) If stock, or purported debt which is deemed stock, is distrib-
uted as a dividend to shareholders or is exchanged for stock in a
recapitalization, merger or other reorganization, it will usually
be received tax-free, subject to the possibility of ordinary income
taxation upon later redemption or sale. 137 On the other hand, if
132 Stock (or other equity) owned indirectly by the decedent, as a stockholder of the
actual owner, will not help toward meeting the value tests of section 303. Estate of
Byrd v. ComIm'r, 388 F.2d 223 (5th Cir. 1967).
134 LR.C. § 303(b) (2) (B). A surviving spouse's interest in stock bold as community
property is considered to have been included in the gross estate, for the purpose of the
75 per cent test.
336 The effect may be merely to make it unsafe to undertake section 303 redemptions
(or debt repayments) by the purportedly indebted corporation; or it may procludo
such redemptions by any of the estate owned corporations if the 35 per cent or 50 per
cent tests cannot be met without including the purportedly indebted corporation in the
group of 75 per cent oiwned corporations which are considered as one.
137 With limited exceptions, receipt of a dividend in any form of stock is tax-froo
(I.R.C. § 305), as is the receipt of stock in a reorganization (I.R.C. § 354). But if it is
not common stock, the proceeds of its later sale or redemption may, with some exceptions,

bona fide debt, or purported stock with the characteristics of debt,

is distributed as a dividend or included with actual stock in an ex-
change for stock in a reorganization, it will ordinarily be subject
to dividend taxation at the time of the distribution or exchange; Is
or, if it is the sole or principal consideration in a purported reor-
ganization, the transaction may be taxed as a sale.13
(2) A shareholder whose stock is redeemed may insulate him-
self against the possibility of the redemption being treated as es-
sentially equivalent to a dividend by qualifying under either of
two safe harbor tests. 40 Under one test, he may qualify if his
own interest is completely terminated, even though family mem-
bers continue to control the corporation; he may himself then re-
tain an interest "as a creditor," ' 4 1 but the regulations prescribe
that his claim "must not in any sense be proprietary and must not
be subordinate to the claims of general creditors," and that neither
the amount nor the certainty of the principal obligation nor the rate
of purported interest should be dependent upon earnings of the cor-
poration..' 42 Under the other test, his interest need not be completely
incur ordinary income tax. LR.C. § 306. If the purported debt is deemed an extension
of the common stock, its redemption (but ordinarily not its sale) may be deemed
equivalent to a dividend, under section 302. See notes 50 and 85 supra.
138 Distributions of obligations of the corporation as dividends, or in a purported
recapitalization, are taxable to the extent of corporate earnings and profits. LE.C. § 301;
Bazley v. Comm'r, 331 U.S. 737 (1947); Patterson v. Anderson, 20 F. Supp. 799
(S.D.N.Y. 1937) ; Reg. §§ 1.301-1(d) and (1). See Brrxm & EUSTIC; FED-AT. iuco0sn
TAxAmON or CORPORA-os Am . S oLDE
0 s § 5.40 (2d ed. 1966). An exchange of
stock for stock and debt in a reorganization ordinarily results in dividend taxation of
the amount of the debt (limited to the lesser of the shareholder's gain on his stock or
his portion of the earnings and profits); but if the debt is represented by a security, it
may be tax-free to the extent of the amount of any securities surrendered in exchange.
LR.C. §§ 35(a) (2), 356(a) (2) and (d).
130LeTulle v. Scofield, 308 U.S. 415 .1940); Southwest Natural Gas Co. v. Commr,
189 F.2d 332 (5th Cir.), cert. denied, 342 U.S. 860 (1951). Purported preferred stock
which is (expressly or by side agreement) to be redeemed in a short time or at the Will
of the holder may be viewed as debt, lacking the continuity of interest required for a
reorganization. See AI , INCOME TAX PROBLEMS Or CORPORATIONS AD STIAREOLDEUS
284 (Report of Working Views of Staff, 1958); Chirelstein, Tax .Poolingand Tax Post-
ponement-The CapitaZ Exchange Funds, 75 YALE L.S. 183, 209-10 (1965); of. Estate
of Henry A. Rosenberg, 36 T.C. 716 (1961); Ericsson Screw Machine Products Co., 14
T.C. 757 (1950); John A. Nelson Co., 28 B.T.A. 529, 542 (1933), aff'd, 75 F.2d 696
(7th Cir.), rev'd, 296 U.S. 374 (1935) (the Board's decision does not disclose the terms
of the retirement provision which it considered made the preferred stock no different
from short-term debt, and the appellate opinions ignored the provision). Bust of. Ragland
Investment Co., 52 T.C. 867, 877-78 (1969), aff'd per curiarn, 435 F.2d 118 (6th Cir.
1970).
141 I.R.d. § 302(c) (2) (A) (i).
142 Reg. § 1.302-4 (d). Except for the last, those criteria are stated as absolutea Con-

TAX LAW RLTM [Vol. 26 :
terminated, but he must substantially reduce his proportionate
interest in the voting stock and in the aggregate fair market value
of the common stock, taking both his own and related interests into
account.'4 3 If he continues to hold purported debt which is not
recognized as such, it would have no effect on this second test, un-
less the obligation is viewed as a form of common stock rather than
as nonvoting stock having a preference over the common.
(3) Section 341 of the Code, relating to collapsible corporations,
was designed to prevent the conversion of what would have been
corporate ordinary income into shareholder capital gain through
sales or redemptions of stock, liquidations or other distributions. 44
With some exceptions, the gain on such transactions, involving a
collapsible corporation, is taxed as ordinary income to the share-
holder, and the liquidation of such a corporation cannot qualify
for the benefits of sections 333 or 337.145 Section 341(e), one of
the longest and most complex subsections in a long and complex
Code, 46 was enacted to relieve taxpayers from collapsible treat
ment in certain circumstances where such treatment was not re-
quired by the purpose of the statute,'4 7 as evidenced by, among
other things, the fact that the unrealized appreciation on certain
assets of an ordinary income nature 148 does not exceed 15 per cent
of the net worth of the corporation. Taxpayers may have an in-
centive to capitalize with stock or to argue for treatment of pur-
ported debt as equity, since that would inflate the net worth 149 and
thus reduce the resulting percentage.
(4) Gains from the receipt of a condemnation award, or of insur-
ance on property destroyed or stolen, may be relieved of tax if the
taxpayer reinvests the proceeds in certain similar property or pur-
chases controlling stock in a corporation owning similar prop-
erty.150 The requirement may be met by organizing a new corpo-
tingent interest is cited as a feature which may "in some cases" cause the holder not
to be truly a creditor.
143 I..C. § 302(b) (2).
144 See Braunstein v. Comm'r, 374 U.S. 65, 68-71 (1963).
145 I.R.C. §§ 333(a), 337(c) (1), 341(a) and (d).
146 The first sentence of the subsection is nearly 500 words long. It goes downhill from
there.
147 S. REP. No. 1983, 85th Cong., 2d Sess. 31-32 (1958).
148 I.R.C. § 341(e) (5).
149 "Net worth" is defined as the fair market value of the assets, plus provious
distributions in the course of complete liquidation, less the "liabilities." I.R.C. § 341
(e)(7).
150 I.R.C. § 1033 (a).

ration to acquire such replacement property; but if the taxpayer,

with his eye on the other tax advantages of corporate debt, loans
all or part of the proceeds to the corporation, that amount will not
have been reinvested in stock (unless the taxpayer successfully
attacks the debt he created), and the relief will be denied. ' A
corporate taxpayer realizing such a gain may qualify for relief
by purchasing the replacement property from its own sharehold-
ers; but if it makes a shoestring purchase that is deemed to be in
reality a capital contribution by the shareholders, resulting in no
true debt for the price, the statute will not be satisfied.1 12
(5) Percentage depletion allowed with respect to the extraction
of natural resources is measured by a percentage of the gross in-
come from the property, but cannot exceed 50 per cent of the tax-
payer's taxable (net) income from the property.1 53 Since interest
on indebtedness incurred to acquire, equip, develop or otherwise
finance the property decreases the taxable income from the prop-
erty, and thus reduces the depletion deduction if the 50 per cent
limitation is effective,1 4 the resulting dilution of the tax benefit
of an interest deduction may weigh against adoption of a heavy
debt structure in a corporation holding such properties.'i
(6) The tax-exempt status of certain nonprofit organizations is
conditioned upon no part of their net earnings inuring to the bene-
fit of any private shareholder or individual.150 1 When such organi-
zations engage in bootstrap purchases of property, dedicating a
major part of the earnings therefrom to payment of the price,
that is not considered an inurement of the earnings to private
benefit if the sale is deemed bona fide; 157 but it may result in a
151 Joseph Sachs, 22 T.O.M. 475 (19 63).
3.52 Gyro Engineering Corp. v. United States, 276 F. Supp. 454, 472-73 (C.D. Cal.
1967), rev'd o other grounds, 417 F.2d 437 (9th Cir. 1969). The corporation there
applied the condemnation proceeds on the down payment for a far larger property, giving
its notes to shareholders for the balance. On appeal, the sale was held to be bona fido and
section 1033 -was applied to relieve the condemnation gain of tax.
153 I.R.C. § 613 (a).
154 Guanacevi Mining Co. v. Comm'r, 127 F.2d 49, 51-52 (9th Cir. 1942); Sheridan-
Wyoming Coal Co. v. Helvering, 125 P.2d 42 (D.C. Cir. 1941).
155 While half a deduction for interest is better than none, it must be weighed against
the taxability of 100 per cent of the interest to the shareholder-particularly if the
shareholder is a corporation, which could receive the same amount as dividends at
minimum tax cost, vithout diluting the subsidiary's deduction for depletion.
3.56 I.R.C. §§ 501(e) (3), (6), (7), (9), (n) and (13).
157Comm'r v. Kensico Cemetery, 96 F.2d 594 (2d Cir. 1938) ; Forest Lawn Memorial
Park Ass'n, 45 B.T.A. 1091 (1941); cf. University Hill Foundation, 51 T.C. 548 (1069),
on appeal to the Ninth Circuit.

TAX LAW REVIEWV [Vol. 26 :
loss of exemption if the sellers are considered to have acquired
or retained an equity interest.1 18
(7) Similarly, the special tax status of certain mutual insur-
ance companies 159 is dependent upon their not distributing profits
to shareholders. 160 The exigencies of their financing, however,
often require that they issue to nonmember investors "guaranty
fund certificates" which, in any other context, would be consid-
ered to have many of the characteristics of equity investment
rather than debt. The Commissioner has conceded that because
of the special circumstances of the industry, such certificates will
be recognized as debt and will not cause loss of mutual status. 10'
(8) Although the question rarely arises at this late date, the
recognition or nonrecognition of purported debt may affect the
special deduction allowable to a personal holding company for
certain amounts paid or set aside to pay or retire "indebtedness
of any kind" incurred before January 1, 1934.102
(9) Our several wartime excess profits taxes have measured
what profits are excess, in part by reference to a specified normal
return on invested capital. Since the deductibility of interest
has the effect of excluding the return on borrowed capital from
the tax base, the World War I law gave credit only for investment
in stock.'63 The World War II and Korean war statutes, how-
ever, in recognition of the popularity of leverage, gave credit for
a return on 50 and 75 per cent of "borrowed invested capital," par-
tially offset by denial of a like percentage of the interest deduction
158 If the property produces unrelated business income, the organization will be tax-
able thereon but will remain otherwise exempt. I.R.C. §§ 511-14. But if it is related to
the exempt function (e.g., a school or cemetery), the only recourse is to deny exemption
of the organization. Knollwood Memorial Gardens, 46 T.C. 764 (1966) ; Rev. Ilul. 61-137,
1961-2 C.B. 118. See Eliasberg, Does the Enollwood Decision Auger [sic] an End to
Cemetcry Bootstrap Deals?, 27 J. TAXATION 224 (1967).
169 Mutual insurance companies (other than life or marine companies and certain fire
and flood companies) are taxed under the special provisions of sections 821 through 826.
Certain small mutual companies are exempt from tax. I.R.C. § 501(o) (15).
160 See Penn Mut. Life Ins. Co. v. Lederer, 252 U.S. 523, 533 (1920).
16.Comm'r v. National Grange Mut. Liability Co., 80 F.2d 316 (Ist Cir. 1935);
Holyoke Mut. Fire Ins. Co., 28 T.C. 112 (1957), accepted in Rev. Rul. 58-010, 1958-2
O.B. 928. Cf. Rev. Tul. 68-515, 1968-2 C.B. 297.
162I.R.C. § 545(b)(7); Reg. § 1.545-2(g). In Haffenroffer Brewing Co. v. Commis-
sioner, 116 F.2d 465 (1st Cir. 1940), preferred stock which was required to be retired
by a sinking fund out of net earnings was held not to be indebtedness for this purpose.
Section 200(b)(3) of the so-called "deadwood" bill, H.R. 25, 92d Cong., 1st Seas.
(1971), would repeal this provision as one which is "obsolete or . . . unimportant and
rarely used."I
183 Revenue Act of 1917, § 207 (a).

for this purpose. 10 4 But there was still enough advantage in stock
capitalization to induce some taxpayers
16 5
to contend that what they
had set up as debt was really equity.
(10) Finally, the debt-stock distinction may affect the collecti-
bility of tax assessments. 'When a corporation makes distributions
to shareholders -withrespect to their stock, leaving the corporation
unable to pay its tax liabilities (whether or not yet ascertained),
the shareholders may be held liable for the tax as transferees.lco
But when an insolvent corporation pays a debt to its shareholder,
transferee liability would not ordinarily result,10 7 unless preferen-
tial payments are voidable under the state law,'s or unless the
purported debt is a sham and its payment is in substance a return
of contributed capital by the corporation.1 6 However, since the
imposition of transferee liability is dependent upon state law (fed-
eral law merely providing a simplified procedure for its enforce-
ment), 1 0 a debt to a shareholder might be valid for this purpose
even though disregarded for purposes of determining the tax lia-
7
bility. 1
164 I.R.C. §§ 711(a) (2) (B), 719 (1939), added by section 201 of the Second Rbevenue
Act of 1940; LR.O. §§ 433 (a) (1) (N) and (0), 437, 439 (1939), added by section 101
of the Excess Profits Tax Act of 1950.
165 See Tri-State Realty Co., 12 T.C. 192 (1949), aff'd, 180 F.2d 593 (5th Cir. 1950)
(in -which the advances, being on open account rather than evidenced by a bond, note,
et cetera, did not qualify even as borrowed invested capital). Of. Powers Photo En-
graving Co., v. Comm'r, 197 F.2d 704, 705 (2d Cir. 1952).
3-6 Phillips v. Comm'r%283 U.S. 589, 592 (1931); Comm'r v. Kuchenberg, 309 P.2d
202, 206-07 (9th Cir. 1962), cert. denied, 373 U.S. 909 (1963); Neill v. Phinney, 245
F.2d 645 (5th Cir. 1957); Rev. Rul. 69-211, 1969-1 C.B. 305.
167 Well v. Comn'r, 91 ]P.2d 944 (2d Cir. 1937); Charlotte Weinberg, 29 T.C.M.
1370 (1970); Newman & Carey Subway Constr. Co., 37 B.T.A. 1163, 1108 (1938). Cf.
Cole v. Comm.'r, 297 F.2d 174 (8th Cir. 1961); Jane E. Nutter, 54 T.C. 290 (1970); R~uth
Mendelson, 52 T.C. 727, 738-40 (1969). See 15A ForCHEB, PrvA= ConnO s
§§ 7379, 7421-27 (1967).
1Gs Charlie Delia, 23 T.C.M. 2018 (1964), aff'd, 362 F.2d 400, 402 (6th Cir. 1960);
United States v. 58th St. Plaza Theatre, Inc., 287 F. Supp. 475, 499-500 (S.D.N.Y.
1968). See 15A F.trcHEo, PBuvATE CORPOATioNs §§ 7422, 7428 (1967). In addition,
the officer making payment of the debt to shareholders may, if the corporation is in-
solvent, incur personal liability under REv. ST .T. § 3467 (1875), 31 U.S.C. § 192
(1954). Lakeshore Apartments, Inc., 351 F.2d 349 (9th Cir. 1965); United States v.
58th St. Plaza Theatre, Ine, supra, at 496. See Plumb, FederalLiens and Prioritie.-
Agenda for the ZYext Decade, 77 Y&i L.T. 228, 256-57 (1967).
19 Powers Photo Engraving C., 17 T.O. 393 (1951), remanded on other grounds, 197
F.2d 704 (2d Cir. 1952); Robert . Osborne, 13 T.C.M. 428 (1954). If the corporation
gave security for the sham debt, the tax claim would have priority over it. Cf. United
States v. Regensburg & Sons, 221 F.2d 336 (2d Cir.), cert. denied, 350 U.S. 842 (1955).
Comm'r v. Stern, 357 U.S. 39 (1958); see L.tC. § 6901.
o70
-1 Iu United States v. Plastic Electro-Finishing Corp., 313 P. Supp. 330, 331

TAX LAW REVIEWV [Vol. 26 :
The question may cut the other way when the shareholder-cred-
itor is the delinquent taxpayer. The tax collector may levy upon
the corporation as a debtor of the taxpayer, and the corporation
must then pay over the amount of the debt (or of the levy, if less),
in accordance with the terms of the obligation.172 But the corpora-
tion may resist the levy on the ground that what appear on the
books as loans were really contributions to capital.11 8 Although
that defense may defeat the levy, the corporation may nevertheless
be subject to assessment as a transferee of the shareholder, if the
tax liability was for a period before the capital contribution and
it left him insolvent except for the value of his stock,1 4 provided
17 5
state law imposes liability in such circumstances.
Debt Distinguished From Equity Investment

INTRODUCTION
The "vital difference between the shareholder and the creditor,"

it was said in an early case, is that the "shareholder is an adven-
turer in the corporate business; he takes the risk, and profits from
success. The creditor, in compensation for not sharing the profits,
is to be paid independently of the risk of success, and gets a right
to dip into capital when the payment date arrives." 170 "The
classic debt" is said to be "an unqualified obligation to pay a sum
certain at a reasonably close fixed maturity date along with a fixed
percentage in interest payable regardless of the debtor's income or
the lack thereof. While some variation from this formula is not
(E.D.N.Y. 1970), it was suggested, but not decided, that the federal debt-equity standards
(hereafter discussed) might govern for transferee liability purposes.
172 I.R.C. §§ 6331, 6332 (a).
17s United States v. Seaside Properties, Inc, 62-2 U.S.T.C. 9668 (S.D. Fla. 1962).
174 The rule in many states is that creditors cannot be required to look alone to the
stock and securities which are thus substituted for available, visible assets of the debtor.
Kamen Soap Products Co., 13 T.C.M. 945, 948 (1954), aff 'd on other grounds, 230 F.2d
565 (2d Cir. 1956); Continental Baking Co., 27 B.T.A. 884, 887-88 (1933), aff'd on
other grounds, 75 F.2d 243 (D.C. Cir. 1934), cert. denied, 295 U.S. 756 (1935).
175 Some jurisdictions hold that the stock received by the transferor is sufficient con-
sideration for the transfer of his assets, and no liability is imposed on the corporation
as transferee in the absence of an assumption. West Texas Refining & Development Co.
v. Comm'r, 68 F.2d 77, 81-82 (10th Cir. 1933); Youngren v. Chase, Inc, 53-1 U.S.T.C.
9358 (D.Idaho 1953).
176 Cornmr v. O.P.P. Holding Corp., 76 F.2d 11, 12 (2d Cir. 1935). Similar classic
definitions are found in United States v. Title Guarantee & Trust Co., 133 F.2d 990, 993
(6th Cir. 1943), and Commissioner v. Meridian & Thirteenth Realty Co., 132 F.2d 182,
186 (7th Cir. 1942).

fatal to the taxpayer's effort to have the advance treated as a debt

for tax purposes,... too great a variation will of course preclude
such treatment." 177
Once upon a time, in a day now happily beyond recall, the courts
were content to distinguish debt from stock, in a particular case,
by a process of "construction of documents to ascertain the real
intention of the parties" 17---or, if there were no documents, by
examining the entries on the books of account.1 70 If a corporation
chose to capitalize (or recapitalize) itself with five dollars in stock
and $750,000 in debentures, 8 or to borrow over 100 times its nom-
inal capital from shareholders on running account,181 so be it:
The records showed they intended to create debt, and Congress
had attached certain tax consequences to debt.
The decisional process was not simple, however, even in that
simplistic age. Taxpayers, torn between the attractions of the
favorable tax treatment of debt and their fear of its adverse effects
on their general credit and on their solvency in hard times, experi-
mented with many forms of hybrid security 1 8 -"- Ia 'security de-
vice' which is in truth neither stock nor bond, but the half-breed
offspring of both," 1 83 which "look[s] like preferred stock to credi-
tors but will, it is hoped, pass muster as a debt for tax purposes." 18 ,
Such hybrids as subordinated income debentures could often be
distinguished from cumulative preferred stock only in marginal
and insubstantial ways. 85 Nevertheless, the courts, focusing pri-
177 Gilbert v. Comm'r, 248 F.2d 399, 402-03 (2d Cir. 1957).
178 See Comm'r v. Meridian & Thirteenth Realty Co., 132 F.2d 182, 184 (7th Cir.
1942).
179 Glenmnore Distilleries Co., 47 B.T.A. 213, 227-28 (1942); Eduard atzinger Co.,
44 B.T.A. 533, 536 (1941), aff'd on another issue, 129 P.2d 74 (7th Cir. 1942).
180 250 Hudson Street Corp., 5 T.C.M. 722 (1946) (the debentures had been ex-
changed for original preferred stock, at a time when the corporate property was
actually depressed in value).
is'.Glenmore Distilleries Co., 47 B.T.A. 213 (1942) ($1,000 capital; $131,458 hbare-
holder advances).
182 To give the devil his due, it may be acknowledged that apart from tax considera-
tions, some of the "myriad variations" were "Ino doubt ... developed to meet funda-
mental business needs," and that others were "window dressing to catch the eye of
the purchasing public." See Comm'r v. HLP. Hood & Sons, Inc., 141 F.2d 467, 4G9
Cast Cir. 1944).
183 Jobn Kelley Co. v. Comm'r, 326 U.S. 521, 535 (1946) (disenting opinion).
sBriT"KE & EUsTicE, FERAL INcox TxATxOi
8 OP CORPO.ATiOiS xD Sna E.
HoLDEs 123 (2d ed. 1966).
28 5 See Lee Telephone Co. v. Comm'r, 260 F.2a 114, 115 (4th Cir. 1958) ; Comm'r v.
Meridian & Thirteenth Realty Co., 132 F.2d 182, 186 (7th Cir. 1942); Jewel Te. Co.
v. United States, 90 F.2d 451j 452 (2d Cir. 1937). In rare cases, the courts have gone

marily on the four corners of the instrument, undertook, by a

process of "minute comparison of, and effort to differentiate, the
multitudinous microscopic details," 180 to draw the distinction that
the law required to be made. Among the numerous criteria to
which the courts then referred as aids in the determination,1 87
however, primary if not controlling weight was generally given to
the presence 188 or absence 189 of a definite maturity date at which
the holder would be unconditionally entitled to enforce payment.
What the courts were slow to grasp was that the limitations on
the rights of purported creditors that must be carefully spelled
out in the instruments when outside investors are involved may
exist as tacit understandings when the common shareholders or
closely related parties themselves supply the funds. 10° Share-
holders advancing funds might shun the hybrid shoals by formally
providing for unconditional obligations payable with fixed inter-
est at fixed dates, although they had no expectation of enforcing
their rights to the detriment of their own business and although
they stood ready, by personal guaranties and subordination agree-
ments, to place their outside lenders and suppliers in the same po-
so far as to hold purported preferred stock to be debt for tax purposes. See text at notes
465-66 infra.
186 John Kelley Co. v. Comm'r, 326 U.S. 521, 532 (1946) (dissenting opinion).
187 The criteria were listed in Commissioner v. Meridian & Thirteenth Realty Co.,
132 F.2d 182, 185 n.5 (7th Cir. 1942), as "Fixed maturity; payment of dividends out
of earnings only; cumulative dividends; participation in management; whether unpaid
dividends bear interest; right to sue in case of default, and whether status is equal to,
or inferior to that of regular corporate creditors; nomenclature used in the documents;
intent of the parties."1
188 CommI'r v. H.P. Hood & Sons, Inc., 141 F.2d 467, 470 (lst Cir. 1944); United
States v. Title Guarantee & Trust Co., 183 F.2d 990, 992-93 (6th Cir. 1943).
189Brown-Rogers-Dixson Co. v. Comm'r, 122 F.2d 347, 350 (4th Cir. 1941); Haffen-
reffer Brewing Co. v. Comm'r, 116 F.2d 465, 468 (1st Cir. 1940); Comm'r v. Schmoll
Fils Associated, Inc., 110 F.2d 611, 614 (2d Cir. 1940). But of. Holvering v. Richmond,
F. & P.R.R., 90 F.2d 971, 974 (4th Cir. 1937).
190An arm's length relationship "inevitably results in a transaction whoso form
mirrors its substance," but where IIthe same persons occupy both sides of the bargain.
ing table, form does not necessarily correspond to the intrinsic economic nature of the
transaction, for the parties may mold it at their will with no countervailing pull." F in
Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968). Although it has been
said that the "taxpayer has graduated from the hybrid age" (Caplin, The Calorie
Count of a Thin Incorporation,17 N.Y.U. INST. 771, 779 (1959)) and that hybrids " aro
no longer fashionable" (BITE&R & EUSICE, FEDERAr INCOME TAXATION or ConRPA-
TIOxS A") SHAREHOLDRS § 4.04 (2d ed. 1966)), only the internally financed corporation
can afford to leave rights or limitations unexpressed. Publicly financed enterprises, while
avoiding those forms which the courts have found questionable (see P.M. Finance
Corp. v. Comm'r, 302 F.2d 786, 789 m.14 (3d Cir. 1962)), still play the hybrid game.
See text at notes 18-20 supra.

sition as if those expressed rights did not exist.9 1 Like so many

other tax devices,'9 2 however, this one was ridden into the ground
by those who used no restraint. The courts, initially in situations
where businesses operated almost exclusively on capital purport-
edly borrowed from shareholders, 1 13 but ultimately in cases much
less extreme,194 were impelled to look beyond the face of the instru-
ment to ascertain "whether the investment, analyzed in terms of
its economic reality, constitutes risk capital entirely subject to
the fortunes of the corporate venture or represents a strict debtor-
creditor relationship." 5
Unfortunately, the laudable effort of the courts to strike through
the form to the realities has "generated intolerable confusion." 0
To vest the process of analysis with a semblance of order, the
courts habitually recite a varying list of as many as 16 criteria
or factors to be considered 1'2 -- although a recent writer has actu-
ally isolated "at least 38 factors" on which different courts have
relied.1 98 Failure of a trial court to set out the standards upon
which its factual conclusion was based has even been held to be
reversible error 199 The utility of the criteria is limited, however,
by the fact that, at least in the litigable cases, they rarely all point
191 See text at notes 641-77 infra. Bee also note 323 infra.
192E.g., Rothschild v. 'nited States, 407 F.2d 404 (CL. CL 1969), and Weller v.
Commissioner, 270 F.2d. 294 (3d Cir. 1959), cert. denfed, 364 U.S. 908 (1960), involving
other abuses of the interest deduction. See also Gregory v. Helverng, 293 U.S. 465
(1935).
193 Edwara G. Janeway, 2 T.C. 197 (1943), afr'd, 147 F.2d 600 (2a Cir. 1945).
194After an interval in -which tax practitioners felt secure if the debt-equity ratio
was no greater than 4 to 1 (see note 802 infra), they vere brought down to earth by
Gooding Amusement Co., 23 T.C. 408 (1954), aff'd, 236 F.2a 19 (6th Cir. 1950), cert.
denied, 352 U.S. 1031 (1957), in which, taking the value of goodwill into account the
purported debt was no greater than the equity remaining for the stock (see 23 T.C. at
419).
195 Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968).
1963 RABKm & JOHNSON, FD A lxcomE GiFT A EsTATE TAX 0o.'o§ 35.08(4).
197 Sixteen criteria are listed in Fin Hay Realty Co. v. United States, 398 F.2a 694,
696 (3d Cir. 1968), and 15 (including three which Fin Hay omits or combines) in
Tomlinson v. 1661 Corp., 377 F.2d 291, 296 (5th Cir. 1967). An independent list of
eight tests, originating in Emanuel N. Kolkey, 27 T.C. 37, 59 (1950), aff'c, 254 P.2d
51 (7th Cir. 1958), is often quoted in cases involving purported sales to corporations, al-
though the essential inquiry is the same as for purported loans (except with respect to
the issue of capital gain treatment). See text at notes 63-69 supra.
198Holzman, The Interest-Dividend Guidelines, 47 TAXS 4 (1969). See also 4A
MEmrES, FEDERAL Iico TAXATON §§ 26.10a, 26.10e.
199 Gilbert v. Comm'r, 248 F.2a 399, 407-08 (2d Cir. 1957). On remand the Tax
Court duly elaborated its findings, involving seven factors pertinent to the case
(Benjamin D. Gilbert, 17 T.C.M. 29 (1958)), and was afitrmea on the second appeal
despite the taxpayer's objection that still others should have been discussed. Gilbert v.
Comm'r, 262 F.2d 512 (2d Cir.), cert. denied, 359 U.S. 1002 (1959).

TAX IL&W REVIEW [Vol. 26:
in one direction, 200
and they have no established relative weights.20 1
In consequence, it has justly been said that the "courts are at lib-
erty to arrive at opposite results on identical facts depending upon
their own whims as to which factors they wish to stress," 202 and
that one "can find a case which supports almost any reasonable
argument." 203 While the courts lace their opinions liberally with
citations, they eschew case analysis on the ground that "each par-
ticular case must be adjudicated upon its own facts." 204 Too often
it appears that a court relies "on an internal reaction to the 'pro-
priety' of the transaction, and then assembles a combination of
previously enunciated standards to sustain its conclusion." 205
200 See Wood Preserving Corp. v. United States, 233 F. Supp. 600, 605 (D. Md. 1964),
aff'd, 347 F.2d 117 (4th Cir. 1965). "The various factors which have boon identiflod in
the cases are only aids in answering the ultimate question [and] the conflicting elements
do not end at a clear line in all cases." Fin Hay Realty Co. v. United States, 398 P.2d
694, 697 (3d Cir. 1968).
201 " It is not enough when examining such a precedential checklist to test each item
for its presence or absence, but it is necessary also to weigh each item." Universal Cast-
ings Corp., 37 T.C. 107, 114 (1961), aif'd, 303 F.2d 620 (7th Cir. 1962). Accord, Tyler
v. Tomlinson, 414 F.2d 844, 848 (5th Cir. 1969). A court must "evaluate each of the
... factors and then somehow weigh them in arriving at a decision" (A.R. Lantz Co.
v. United States, 283 F. Supp. 164, 167 (C.D. Cal. 1968), aff1'd, 424 P.2d 1330 (9th Cir.
1970)), deciding "which are the most important factors under all the circumstances"
(Wood Preserving Corp. v. United States, 233 P. Supp. 600, 605 (D. Md. 1964), aff'd,
347 F.2d 117 (4th Cir. 1965)), with "now one factor or combination of factors and now
another [being] regarded as the important one ' (Brake & Electric Sales Corp. v. United
States, 185 F. Supp. 1, 3 (D. Mass. 1960), aff'd, 287 F.2d 426 (lst Cir. 1961)).
202 Weis, The Labyrinth of the Thin Corporation, 40 TAXES 568, 589 (1962). Caplin,
The Cuaorio Count of a Thin Inworporaton, 17 N.Y.U. INST. 771, 808 (1959), protests
"the flagrant way the judges are able to discard previously emphasized tests to reach
conclusions they have fixed upon. '
20 Hickman, The Thin C&rporation:Another Look at an Old Disease, 44 TAXES 883,
885 (1966). What appears to be a minority view, that the "authorities from antiquity
have fashioned a very carefully reasoned framework of case law, regulations and rulings,
differentiating between debt and equity" (emphasis added), is expressed in Jewell, The
Tax Legislation Agains Conglomerates-The Case Against the Tax Legislation,CONaLOM-
ERATE M RGERS AND ACQUISrIIONS: OPnTIoN AND ANALYSIs, 44 ST. Joux's L. REv.
1073, 1079 (spee. ed. 1970).
204 Gooding Amusement Co. v. Comm'r, 236 F.2d 159, 165 (6th Cir. 1956), cort, de-
nied, 352 U.S. 1031 (1957) ("no good purpose would be served by entering upon a
review of the decided cases"); accord, Campbell v. Carter F1oundation Production Co.,
322 F.2d 827, 832 (5th Cir. 1963) ("it would serve no useful purpose for us to dis.
tinguish the cases relied on by the Government 1).
205 Caplin, The Calorie Count of a Thin Incorporation, 17 N.Y.U. INST. 771, 811
(1959). With uncommon candor, the Tax Court has said "Extended discussions of factual
materials, pro and con, terminating in a conclusion that is based in the last analysis
upon a subjective judgment about the weight of the various materials considered, often
gives merely the illusion of a process of reasoning, when in fact the result reached is
simply the trial court's ultimate finding on the record as a whole." Waldemar J. CoUz,
22 T.C.M. 1775, 1785 (1963).

One recent decision compared the "often intuitive and subjective"

process here involved to the problem of judicially defining por-
nography, of which Mr. Justice Stewart said, "perhaps I could
never succeed in intelligibly doing so. But I know it when I see
it .... Y 206
Since the nature of the problem ordinarily inhibits effective ap-

pellate review, at least in the majority of judicial circuits,207 the
taxpayer's pocketbook and the power of the government to block
abuses are both at the mercy of the particular trial judge's "ex-
perience with the mainsprings of human conduct," 203 the acuity
of his sense of smell,209 and the degree of his commitment to the
208 Sansberry v. United States, 70-1 U.S.T.C. f 9216 (S.D. Ind. 1970), citing Mr. Jus-
tice Stewart's concurring opinion in Jacobellis v. Ohio, 378 U.S. 184, 197 (1964).
207 Although the once virtually absolute barrier to appellate review of ease3 of this
nature on appeal from the Tax Court (John Kelley Co. v. Comm'r, 326 U.S. 521 (1946))
has been overturned (LR.C. § 7482(a)), the great majority of courts of appeals agree
that the conclusion of the trial court on the issue is a finding of fact which, under Fw.
R. Civ. P. 52(a), can be set aside only if it is clearly erroneous (i.e., as was said in
United States v. United States Gypsum Co., 333 U.S. 364, 395 (1948), if there is "defi.
nite and firm conviction that a mistake has been committed"). Braho & Elcetrie Sale3
Corp. v. United States, 287 F.2d 426, 428 (1st Cir. 1901); Gilbert v. Comm'r, 262 F.2d
512, 513 (2d Cir.), cert. denied, 359 U.S. 1002 (1959) (but cf. Waterman, T., concurring
in Gilbert v. Comm'r, 248 F.2d 399, 408 (2d Cir. 1957)); Diamond Bros. Co. v. Comm'r,
322 F.2d 725, 731 (3d Cir. 1963) (but cf. Van Dusen, J., dissenting in Fin Hay Realty
Co. v. United States, 398 F.2d 694, 699-700 nn.1 & 3 (3d Cir. 1968)); Road materials,
Inc. v. Conm'r, 407 F.2d 1121, 1123-24 (4th Cir. 1969); Gooding Amusement Co. v.
Comm r, 236 F.2d 159, 166 (6th Cir. 1956), cert. denicd, 352 U.S. 1031 (1957) (but ace
Austin Village, Inc. v. United States, 432 F.2d 741, 744 (6th Cir. 1970)); Charter
Wire, Inc. v. Comm'r, 309 F.2d 878) 880 (7th Cir. 1962), cert. denied, 372 U.S. 965
(1963) (but cf. Ortmayer v. Comm'r, 265 F.2d 848, 854 (7th Cir. 1959)); A.R. Lantz
Co. v. United States, 424 F.2d 1330, 1334 (9th Cir. 1970) (but cf. Taft v. Comm'r, 314
F.2d 620 (9th Cir. 1963)); MeSorley's, Inc. v. United States, 323 F.2d 900 (10th Cir.
1963)). Of all courts, however, the Nlinth Circuit has been the one most ready to find a
decision denying recognition of debt to be clearly erroneous. E.g., Gyro Engincering
Corp. v. United States, 417 F.2d 437 (9th Cir. 1969); Murphy Logging Co. v. United
States, 378 F.2d 222 (9th Cir. 1967); Lundgren v. Comm'r, 376 F.2d 623 (9th Cir.
1967); Taft v. Comm'r, supra; Estate of Miller v. Coxmn'r, 239 F.2d 729 (9th Cir.
1956); Wilshire & Western Sandwiches v. Comm'r, 175 F.2d 718 (9th Mr. 1949).
208S ee Commissioner v. Duberstein, 363 U.S. 278, 289 (1960), relying on such ev.e-
rience of the trial judges in deciding, with comparable lack of uniformity, a different
issue of fact affecting many taxpayers. Mr. Justice Frankfurter, although concurring,
declared that trial judges are thus set "to sail on an inimitable ocean of individual
beliefs and experiences," which "can hardly fail to invite, if indeed not to encourage,
too individualized diversities in the administration of the income tax law." Id. at 297.
Mr. Justice Rutledge, dissenting on the present question in John Kelley Co. v. Commis-
sioner, 326 U.S. 521, 536 (1946), concluded: "The right of taxpayers to be treated
with equal justice before the law is denied."
209 What for one judge may appear to be "(t]ax reduction [which) is not evil if
you do not do it evilly" (Gyro Engineering Corp. v. United States, 417 F.2d 437, 440 (9th
Cir. 1969) quoting Murphy Logging Co. v. United States, 378 P.2d 222, 223 (9th Cir.

TAX LAW REVIEW [Vol. 26
established system of double taxation of corporate income.2 10 In
those judicial circuits where a broader power of review is as-
serted,211 the same variables on the part of the appellate judges,
even within the same court, affect the litigants' rights.2 12
Nevertheless, since factors are the materials we have to work
with, and since factors are what the Treasury has now been di-
rected by Congress to set forth in regulations having the force of
law, 213 a critical analysis of the factors heretofore given weight by
the courts is in order. It is recognized that no single factor ever
stands alone and that what a court may have said about a factor
is necessarily taken out of context of the case as a whole. But it
is only by examining each brick separately that its suitability for
incorporation in future structures, judicial, regulatory or legisla-
tive, can be determined.
It will facilitate analysis to observe at the outset the classic dis-
tinction between factum probandum, or the proposition to be
established, and factum probans, or the material evidencing the
1967)) may to another be "nothing more than a shabby attempt" to withdraw cor-
porate profits at favorable tax rates (Burr Oaks Corp., 43 T.C. 635, 646 (1965), aff'1,
365 F.2d 24 (7th Cir. 1966), cert. denied, 385 U.S. 1007 (1967)).
21oCompare Taft v. Comm'r, 314 F.2d 620, 623 (9th Cir. 1963) ("in 1054 Taft
had $106,931.82 in tax paid assets which he transferred to the corporation. In 1959, whon
he was repaid [out of earnings], he still had only $106,931.82. However, the Commissioner
seeks a double taxation."), with Bertram Meyer, 5 T.C. 165j 170 (1945) ("1We consider
it immaterial whether ... the preferred stock [even if intended as a-loan] was issued
bona fide and for property .... The important consideration is that under its
plan the corporation could, by redeeming shares of that stoc- from year to year, dis-
tribute all of its earnings tax-free to its sole stockholder.") See text at notes 1113-26
infra.
211 The Fifth and Eighth Circuits regard the issue as one of law, or mixed law and
fact. United States v. Snyder Bros. Co., 367 F.2d 980, 982, 990 (5th Cir. 1966), cert.
denied, 386 U.S. 956 (1967); J.S. Biritz Construction Co. v. Comm'r, 387 P.2d 451,
455 (8th Cir. 1967) (but of. Crown Iron Works Co. v. Comm'r, 245 F.2d 857, 358, 360
(8th Cir. 1957)). Some, at least, of the courts cited for the majority view, see note 207
supra, would not abide by the clearly erroneous standard if the ovidentiary facts are
undisputed (Gloucester Ice & Cold Storage Co. v. Comm'r, 298 F.2d 183) 185 (1st Cir.
1962)) or are stipulated (Harris v. United States, 370 F.2d 887, 894 (4th Cir. 1900);
Kraft Foods Co. v. Comm'r, 232 F.2d 118, 122 (2d Cir. 1956)). Although the Second Cir-
cuit (and others) regarded the Kraft exception as overturned by Commissioner v.
Duberstein, 363 U.S. 278, 291 (1960) (see Austin v. Comm'r, 298 F.2d 583, 584 (2d
Cir. 1962)), it seems now to have been restored. United States v. General Motors Corp.,
381 U.S. 127, 141 n.16 (1966); Hicks v. United States, 368 F.2d 626, 630-31 (4th Cir.
1966).
212 The differences in viewpoint within the same court are particularly apparent in
the Pifth Circuit. Coinpare Harlan v. 'UnitedStates, 409 P.2d 904 (5th Cir. 1909), with
United States v. Snyder Bros. Co., 367 F.2d 980 (5th Cir. 1966), and Tyler v. Tomlinson,
414 P.2d 844 (5th Cir. 1969), ivith Tomlinson v. 1661 Corp., 377 1.2d 291 (6th Cir. 1907).
213 I.R.C. § 385, added by section 415(a) of the Tax Reform Act of 1969. See note 10
supra.

proposition. 2 .4 It is error to include as evidentiary factors such

items as intent of the parties, risk of the business, and economic
reality.21 5 Those are probanda,to the establishment of which the
other factors commonly relied upon are directed; 210 they are not,
or should not be, factors having independent weight. Yet it is not
unusual to see intent, in particular, not only listed as an indepen-
dent factor21' but offered, -where the evidentiary factors are ad-
verse, as the sole ground of distinction from other essentially sim-
ilar cases.21 s
In the following discussion, the evidentiary factors will be
grouped somewhat arbitrarily (since the lines are not really this
sharp) 219 into:
(1) Those involving the formal rights and remedies of creditors as
distixguished from stockholders:
Maturity (p. 413)
Remedies for Default (p. 420)
214 1 WEGMOP, E- mC § 2 (3d ed. 1940).
215 As in the five factor list in Tiflans Corp. v. United States, 390 F.2d 965, 968-69
(Ct. CL 1968).
216 Min Hay Realty Co. v. United States, 398 P.2d 694, 697 (3d Cir. 1908) (factors
are "aids in answering the ultimate question whether the investment, analyzed in terms
of its eeonomie reality, constitutes risk capital"); Gilbert v. Comm'r, 202 F.2d 512,
514 (2d Cir.), cert. denied, 359 U.S. 1002 (1959) ("The term 'substantial economic
reality' is merely a way of expressing the fact that the determination . . . must be
made in the light of all the facts of the particular case"); Sarkes Tarzn, Inc. v.
United States, 240 F.2d 467, 470 (7th Cir. 1957) ("intent is to be ascertained from
all relevant facts and circumstances, and of necessity the ewe is largely dependent upon
eircumstantial evidence"). See Hiekman, The Thin Corporation: Another look: at an
Old Disease, 44 TAXEs 883, 886 (1966) ("the statement that debt will be considered
equity if it is 'at the risk of the business' ... is the statement of a result, not a test") ;
Goldstein, Corporate Indebtedness to Shareholders: "Thin Capitalatior" and Related
Problems, 16 TAx L. RFv. 1, 25 (1960) ("Some courts speak of the intent of the par-
ties as if it were in independent factor .... Actually, the whole proecess describeO in
this article is one of determining whether the parties had the intent .... ").
2=E.g., Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968), list-
ing intent of the parties as criterion number one.
21 E.g., Gounares Bros. & Co. v. United States, 185 F. Supp. 794, 800 (SD. Ala.
1960), rev 'd (but approvedi on this issue, without discussion), 292 F.d 79 (5th Cir.
1961) ; Santa Anita Consolidated, Inc., 50 T.C. 536, 551-52 (1968) ; Charles E. Carry, 43
T.C. 667, 689, 692 (1965). See Goldstein, Corporate Indebtedness to ,Shareholders:
"Thin Capitalzationl"ard Belated Problems, 16 TAx L. Rv. 1, 25 (1960).
2M9 See P.M. Finance Corp. v. Commissioner, 302 F.2d 786, 789 n.14 (3d Cir. 1962),
which segregates those factors w ich may preclude recognition even of an instrument
containing classie debt provisions (categories (2) and (3) infra) from those which in-
volve hybrid eharacteristics on the face of the instrument (category (1)). Another
classification, advanced by the government, would separate the bootstrap factors (for-
mal evidence created by the taxpayer) that should be given little weight as they do not
go to the economic realities. See Utility Trailer Mfg. Co. v. United States, 212 P. Supp.
773, 785 (S.D. Cal. 1962).

Subordination (p. 421)
Certainty of Income (p. 430)
Absence or Inadequacy of Interest (p. 432)
Participation in the Success of the Venture (p. 434)
Participation in Both Success and Failure (p. 442)
Participation in Control (p. 447)
The Name of the Instrument (p. 450)
(2) Those bearing on the genuineness of the intention to create a
debtor-creditor relationship:
In General (p. 457)
Formal Documentation (p. 461)
Declarations of the Parties (p. 465)
Security and Sinking Fund (p. 466)
Proportionality (p. 470)
Disproportionality (p. 473)
Guaranties by Shareholders (p. 482)
Variations on the Theme (p. 488)
Payment History (p. 490)
Failure to Enforce on Default (p. 493)
Voluntary Subordination (p. 497)
Change of Ownership (p. 499)
(3) Those bearing on the reasonableness or economic reality of that
intention (the risk element):
In General (p. 503)
Thin or Inadequate Capitalization (p. 507)
Use of Funds Advanced (p. 520)
Source of Payments (p. 526)
Independent Creditor Test (p. 530)
Salvage Loans (p. 535)
(4) Those which are merely rhetorical expressions of a result, having
no proper evidentiary weight in themselves:
Tax Motivation and Business Purpose (p. 538)
Dividend and Salary Policy (p. 549)
Arbitrary Separation (p. 551)
No New Capital (p. 551)
Double Taxation (p. 553)
FoRMAL RIGHTS AND REMIEDIES
"There is little difficulty in distinguishing the ordinary share

of common stock, on the one hand, and the mortgage secured bond
on the other." 220 But the line of distinction between preferred
stock and, say, subordinated income debentures is far more difficult
to define.2 21 Fiscal considerations aside, Congress might logically
and reasonably have determined to treat the common shareholders
alone as the corporation, "since they alone share profits and man-
220 Comm'r v. H.P. Hood & Sons, Inc., 141 F.2d 467, 469 (1st Cir. 1944).

age the enterprise," and to "treat all others as separate groups

with whom they deal as third parties." Since Congress chose in-
stead to distinguish creditors from preferred shareholders, "re-
garding the first as outside the corporate aggregation, and the sec-
ond as embarked as owners along with the common shareholders,"
it is necessary to seek out the points of distinction. " ' Those attri-
butes which preferred stock and debt have in common can have
little weight for this purpose.23
Maturity
The most important of the formal factors is a provision for a

fixed (or "relatively fixed" 2 or "ascertainable" 2"-)time when
the purported creditor is unconditionally entitled to require pay-
ment of the principal. 228 The presence of a maturity date does not
guarantee recognition of indebtedness, if other factors indicate
an equity investment, since "it is not unusual for preferred stock
to have a maturity or retirement date,1p1227 and since there may be
an unexpressed intention not to enforce the obligation when it comes
due.228 But the absence of such an unconditional right to demand
payment is most often conclusive. Although it is true that "[d ] ebts
which never become due are not unknown in the financing of gov-
ernments and large private corporations," 22 the analogy to such
unique securities is hardly pertinent where the issue is whether
222 Jewel Tea Co. v. United States, 90 F.2d 451, 452 (2a Cir. 1937).
223 Comm'r v. Meridian & Thirteenth Realty Co., 132 F.23 182, 180, 187 (7th Cir.
1942); Charles L. Huisking & Co., 4 T.C. 595, 599 (1945).
224 See Nassau Lens Co. v. Comm'r, 308 P.2a 39, 47 (2d Cir. 1902).
225 P.P. Scheidelman & Sons, Inc., 24 T.C.M. 168, 172 (1965). See also Cleveland
Adolph Mayer Realty Corp., 6 T.C. 730, 737-38 (1946), rov'd onranother iue, 160
F.2d 1012 (6th Cir. 1947), discussed in the text at note 23,5 infra.
226 Wood Preserving Corp. v. United States, 347 F.2d 117, 119 (4th Cir. 1905) (obliga-
tion to repay at all events and a fixed or ascertainable maturity date referred to as two
"supposedly indispensable indicia"); Comm'r v. Sehmoll Fils Associated, 110 F.2a
611, 613 (2d CJfr. 1940) ("debentures closely resemble cumulative preferred stock in
having no maturity date"). See Comm'r v. H.P. Hood & Sons, 141 F.2d 4G7, 470 (Ist
Cir. 1944). See a7so I.R.C. § 385(b) (1), added by section 415(a) of the Tax Reform Act
of 1969.
-7 See Charles L. Huiskng & Co, 4 T.C. 595, 599 (1955) (subordinated income de-
bentures). Concerning the status of preferred stock, so labeled, which has such a pro-
vision, see text at notes 448-51 infra.
228 See Utility Trailer Mfg. Co. v. United States, 212 1P. Supp. 773, 785 (S.D. Cal.
1962), in -which the government argued that the presence of a maturity date, like the
nomenclature of the instrument, wa a bootstrap factor with little velght. Factors bear-
ig on the reality of the intention to tollect at maturity are discussed in text at note3
475-765 infa.
229 See Commissioner v. H.]F. Neighbors Realty Co., 81 F.2d 173, 175 (6th Cir. 1930),
-which did not involve the present issue, but whether a trust deed, absolute in form and
with no prescribed obligation to redeem, vas a mortgage or a taxable sale.

an investor has "embark[ed] upon the corporate adventure" and
assumed its risks; 230 for the debt which never matures is indis-
tinguishable in this respect from cumulative preferred stock.2' 8
Even when the shareholders and purported creditors are identical,
"those are not creditors, who cannot withdraw . . . without the
consent of the rest, demanding a fixed sum at some period set in
advance." 232
An obligation that is to become payable only upon dissolution
or reorganization of the corporation, or upon disposition of its
properties, is not considered to have a maturity date, and therefore
is ordinarily deemed to be at the risk of the business, 2 3 even if the
life of the corporation is itself limited to a fixed term; for the share-
holders have it within their power to extend the time for payment
indefinitely by amending the charter.8 4 It has been held, however,
that an obligation that is to mature only at the expiration of the
lease on the premises owned by the corporation, or any extension
or renewal thereof, had a sufficiently determinable maturity, which
was not dependent upon final termination of the corporate busi-
235
ness.
An obligation which, short of dissolution of the corporation,
is payable only out of net earnings lacks the essential characteristic
of a debt,2 0 although it will not be disqualified merely because the
2 0 See United States v. Title Guarantee & Trust Co., 133 F.2d 990, 993 (6th air.
1943).
231 Comm'r v. Schmoll Pls Associated, 110 F.2d 611 (2d Cir. 1940).
232 Jewel Tea Co. v. United States, 90 F.2d 451, 453 (2d Cir. 1937) (emphasis added);
241 Corp., 15 T.C.M. 901, 905 (1956), aff'd, 242 FV.2d 759 (2d Cir.), cort. denied, 354
U.S. 938 (1957). Accord, Austin Village, Inc. v. United States, 432 F'.2d 741, 745 (6th
Cir. 1970) (maturity date in such circumstances is "at best, illusory").
238 Beaver Pipe Tools, Inc. v. Carey, 139 F. Supp. 470 (N.D. Ohio 1955), aff'd, 240
F.2d 843 (6th Cir. 1957); Mullin Bldg. Corp., 9 T.C. 350, 353-54 (1947), afif'd, 167
P.2d 1001 (3d Cir. 1948); Green Bay & Western R.R. v. Comm'r, 147 P.2d 585 (7th Cir.
1945). An obligation which, as a practical matter, can be paid only from the proceeds
of disposition of the operating assets is similarly regarded as an equity investment.
2554-58 Creston Corp., 40 T.C. 932, 938 (1963); Mullin Bldg. Corp., supra, at 355. Soo
text at notes 883-903 infra. Cf. Dillin v. United States, 433 F.2d 1097, 1101 (5th Cir.
1970) (holding company's obligation was to be paid only when it was able to sell part
of stock to public without impairing control).
234 Jordan Co. v. Allen, 85 F. Supp. 437, 445 (M.D. Ga. 1949).
235 Cleveland Adolph Mayer Realty Corp., 6 T.C. 730, 737-39 (1946), rev'd on another
issue, 160 F.2d 1012 (6th Cir. 1947) (debenture was not clear whether payment was
to be postponed by renewals of lease beyond the fixed renewal term set in existing lease,
but same result in any event).
238Reg. §§ 1.166-1(c), 1.302-4(d); United States v. Henderson, 375 F.2d 30, 40
(5th Cir. 1967); Wood Preserving Corp. v. United States, 347 F.2d 117, 119 (4th Cir.
1965); Universal Oil Products Co. v. Campbell, 181 F.2d 451, 476-77 (7th Cr.), coert.
denied, 340 U.S. 850 (1950); Mary Duerr, 30 T.C. 944, 947 (1958); Lucia Chnso

schedule of payments is made dependent upon earnings or cash
flow, provided a fixed ultimate date is set for payment of the full
principal.23 7 There are some cases, however, holding that contin-
gency of ultimate payment upon availability of earnings is not
conclusive against the existence of a debt, at least if there is a rea-
sonable expectancy that full payment will occur. - And, in the
peculiar circumstances of the mutual insurance business, it is now
established that "guaranty fund certificates," issued in order to
provide a reserve against extraordinary losses and repayable only
in the discretion of the directors out of earned surplus in excess of
a prescribed minimum, constitute true indebtedness.2 3
Even a definitely fixed maturity date may be unacceptable if it
is not "in the reasonable future" 240 but is "inordinately post-
poned." 21 'What is "reasonable" will vary with the circumstances
of the particular business. An 89 year term has been sustained
where the period was substantially coextensive with the term of a
Ewing, 20 T.C. 216, 229 (1953), aff'd on other grounds, 213 F.2d 438 (2d Cir. 19s4);
Ticker Publishing C., 46 B.T.A. 399, 404, 410 (1942); of. Lee Telephone Co. v.
Comm'r, 260 F.2d 114, 115 (4th Cir. 1958); United States v. Virgin, 230 P.2R 880,
882 (5th Cir. 1956); Jewel Tea Co. v. United States, 90 F.2a 451, 453 (2d Cir. 1937).
See LR.C. § 385(b) (1), added by section 415(a) of the Tax Reform Act of 1969.
237 Charles E. Curry, 43 T.C. 667, 693 (1965); Leach Corp., 30 T.C. 563, 571-72, 576
(1958).
23s Harlan v. United States. 409 F.2d 904, 909 (5th Cir. 1969) ("9surplus notc3" of
life insurance company, payable only when the amount advanced had been replaced
from surplus earnings, whieh occurred within a few years); Ortmayer v. Cmm'r, 265
F.2d 848, 855 (7th Cir. 1959); of. United Gas Improvement Co. v. Comm'r, 240 .2d
312, 318 (3d Cir. 1956). In Gounares Bros. & Co. v. United States, 292 F.2d 79, 81,
83 (5th Cir. 1961), reversing on other grounds 185 F. Supp. 794, 800 (S.D. Ala. 19G0),
the court allowed deduction of interest actually paid on an obligation that bad no ma-
turity and "was to be paid only if the corporation was successful," despite the fact
that, until war conditions intervened, there had not been any prospect that the corpora-
tion "would ever be able to break even, much less produce an operating profit."
Focusing on the time of accrual of the interest rather than on the character of the
purported debt, the court of appeals accepted without discussion the district court'a
determination that the taxpayer's intent to create a debt overcame all factors indicating
the contrary. In Jamison v. United States, 297 F. Supp. 221, 229-30 (N.D. Cal. 1968),
on appeal to the Ninth Circuit, a contingent contract right to payment from a per-
centage of utility revenues was held to be an "evidence of indebtedness," the payment
of which gave rise to capital gain under section 1232, on the special ground, however, that
section 1232 had been intended by Congress to bring the treatment of debt retirements
in line with that of stock redemptions and that this purpose would be defeated if lifo
treatment were not extended to obligations intermediate between stock and debt.
239 Comm'r v. Union Mut. Ins. Co., 386 F.2d 974 977 (ht Cir. 1967), accepted in
Rev. RuL 68-515, 1968-2 C.B. 297, diseussed in text at note 1071 infra. Of. Camm'r
v. National Grange Mut. Liability Co., 80 F.2R 316, 320 (1st Cir. 1935).
240 See John Kelley Co. v. Comm'r, 326 U.S. 521, 526 (1946).
241 See Rowan v. United States, 219 F.2d 51, 55 (5th Cir. 1955).

2 2 and a num-
ground lease on property owned by the corporation,
ber of cases have viewed terms of 40 to 50 years as consistent with
debt.2 43 On the other hand, a term of 99 years was obviously unrea-
sonable when it far exceeded the life of the corporation's principal
asset,244 and even a 20 year term has been viewed as an adverse
factor when the purported debt was inadequately protected in other
respects. 245 A 15 year term may be excessive in the case of an ex-
2 0 Considering the life ex-
tractive industry with limited reserves.
pectancy of the average business, it seems unrealistic to distinguish
very many purported corporate debts with terms of 20 years or
more from stock (or from instruments payable only upon liquida-
tion) on the basis that the latter are at the risk of the business
"permanently or indefinitely" and the former only for "a reason-
able length of time." 247 In fact, the investment in most such cases
is "at the risk of the business in that it [is] deferred to the busi-
ness." 248 The longer the term, the more free the corporation is to
use the funds "without at least an eye to the upcoming [repay-
ment]" and the greater the probability that, like corporate capital,
2 40
the funds may be lost in the business and never repaid.
242 Ruspyn Corp., 18 T.C. 769, 779 (1952).
243 Comm'r v. H.P. Hood & Sons, 141 F.2d 467 (1st Cir. 1944) (40 year income do-
bentures); Harry F. Shannon, 29 T.C. 702 (1958) (49 year installment obligation for
purchase of ranch); Chas. Schaefer & Son, Inc., 9 T.C.M. 1035, 1037 (1950) (50 year
income notes). Notes given for the purchase of apartment houses, payable in install-
ments over 39 years, were considered to have an inordinately postponed duo date in
Gyro Engineering Corp. v. United States, 276 F. Supp. 454, 458, 460 (C.D. Cal.
1967), but the Ninth Circuit reversed, 417 F.2d 437 (1969), on the basis of the "1self-
liquidating potential' " of the property.
244 Swoby Corp., 9 T.C. 887, 894 (1949).
245 United States v. Snyder Bros. Co, 367 F.2d 980, 984 (5th Cir. 1966), cort. aenied,
386 U.S. 956 (1967); Ram Corp. v. United States, 305 F. Supp. 831, 833 (W.D.N.O.
1969).
246 Reef Corp., 24 T.C.M. 379, 397 (1965), aff'd, 368 F.2d 125, 132 (5th Cir. 1960),
cert. de ied, 386 U.S. 1018 (1967).
247 See the distinction drawn in Gordon Lubricating Co., 24 T.C.M, 697, 711 (1005),
upholding 20 year debentures, despite a thin equity margin and subordination to bank
credit.
240 See Beef Corp. v. Conun'r, 368 F.2d 125, 132 (5th Cir. 1966), oert. denied, 886
U.S. 1018 (1967).
249 Cf. Mooney Aircraft, Inc. v. United States, 420 F.2d 400, 409-10 (5th Cir.
1969), in which each purchaser of aircraft was required to purchase a $1,000 bond of
the seller, repayable only when the aircraft was permanently retired from servicoe, which
might be 15 to 30 years later. The seller, for the reasons stated in the text, was required
to include the proceeds in income with no offset for the fixed but long deferred obliga-
tion to repay the bonds. However questionable the decision may be as a matter of
accrual accounting (of. Rev. Bul. 70-119, 1970-11 I.R.B. 15 (March 16)), it does sug-
gest an approach to the present issue.

If a purported obligation lacks an acceptable maturity date,

the fact that it may be sooner callable at the option of the corpora-
tion ordinarily will not suffice to make it recognizable as indebted-
ness,2 50 since the maturity cannot be left solely in the discretion of
the corporation. 251 Even the power of the corporation unilaterally
to extend a short-term obligation annually, up to a maximum of 20
years, has been regarded as such a departure from normal practice
as to raise a "strong inference"I of an equity contribution,- 2 despite
the fact that a 20 year note, prepayable by the corporation (which
is identical in effect), would have escaped criticism in this re-
gard 3
It should make no difference that the power to extend the ma-
turity Tests not in the corporation as such but in a specified per-
centage of the purported creditors themselves, at least if they are
also shareholders with investment interests to protect; 2" for it
is equally true in such a case that one "cannot withdraw from the
venture without the consent of the rest." 15 Yet there are some de-
250Brown-Eogers-Dixson Co. v. Comm'r, 122 F.2d 347 (4th Cir. 1941); Comm'r v.
Schmoll FPs Associated, 110 F.2d 611 (2d Cir. 1940).
251 241 Corp., 15 T.C.M. 901, 905 (1956), aff'd, 242 F.2d 759 (2d Cr.), cert. dnfeid,
354: U.S. 938 (1957); Jordan Co. v. Allen, 85 F. Supp. 437, 445 (MD. Ga. 1949).
252Peco Co., 26 T.C.M. 207, 211 (1967). But of. Charles E. Curry, 43 T.C. 667, 681,
693 (1965), in which postponement of maturity, up to an ultimate limit of 20 years,
was dependent upon an objective standard, but one which was in the control of the
corporation (insufficiency of net cash flow after capital expenditures); the provision
was conceded to be "unheard of" in institutional lending, but not inconsistent with
indebtedness in the ease of family lenders.
253 The corporation's right to prepay ordinarily is, and should be, a neutral factor,
since it neither adds to nor detracts from the rights of the purported creditor and sheds
little light on the intent to pay at (or before) maturity. Luden's, Inc. v. United State3,
196 F. Supp. 526, 531-32 (E.D. Pa. 1961) (rejecting government's contention that
eallability was an equity-like characteristic). Callable securities were recognized as debt,
with mo stress being laid on this feature, in such cases as United States v. Title Guarantee
& Trust Co., 133 F.2d 990, 992 (6th Cir. 1943); Commissioner v. O.P.P. Holding Corp.,
76 F.2d 11, 12 (2d Cir. 1935); Leach Corp., 30 T.O. 503, 570, 579 (1958); Rev.
Rul. 68-54, 1968-1 C.B. 69. Yet one decision irrationally regarded the fact that
the purported creditors confidently expected the corporation to be able to prepay as
evidence that they were "not relying on their right to force repayment of the deben-
tures at maturity," and hence as indicative of a capital investment. Fellinger v. United
States, 238 F. Supp. 67, 77 (N.D. Ohio 1964), aff'd, 363 F.2d 82G (6th Cir. 196G).
2s4 Fellinger v. United States, 238 F. Supp. 67, 76 (N.D.Ohio 1964), aff'd, 368 F.2d
826 (6th Cir. 1966); B.C. Owen Co. v. United States, 180 F. Supp. 369, 372 (Ct. Cl.),
cert. denied, 363 U.S. 819 (1960). Cf. Commissioner v. H.P. Hood & Sons, 141 F.2d 467,
470 (1st Cir. 1944), giving no adverse weight to the power of two-thirds of the debenture
holders to alter their terms, since the power did not extend to changing the absolute
obligation at maturity.

cisions that regard such power in the majority of the shareholders,

in their capacity as creditors, as not inconsistent with the require-
ment of a fixed maturity date.2 5c
A demand note, although it sets no definite time for payment,
does have an ascertainable due date which is within the control of
the purported creditor,257 and therefore may be recognized as debt
if other factors are favorable. 2 8 A requirement of reasonable no-
tice,259 or a limitation on the amount which may be demanded in
any one year,26 0 would ordinarily be acceptable. More questionably,
a provision that effective demand may be made only when surplus
has been accumulated to a certain size, 201 or a requirement that a
majority of the creditor-shareholders join in the demand, 0 2 has
been held consistent with indebtedness. In the absence of a favor-
able history of repayments, however, demand notes are peculiarly
subject to attack because they may evidence a casual attitude
toward repayment and an intention to leave the funds at the risk
258 Comm'r v. O.P.P. Holding Corp., 76 F.2d 11, 12 (2d Cir. 1935); Plastic Toys,
Inc., 27 T.C.M. 707, 708, 710 (1968).
25? Piedmont Minerals Co. v. United States, 429 F.2d 560, 563 n.5 (4th Cir. 1970);
P.P. Scheidelman & Sons, Inc., 24 T.C.M. 168, 172 (1965); see Fin Hay R~ealty Co.
v. United States, 398 F.2d 694, 702 (3d Cir. 1968) (dissenting opinion). "Demand
notes are the ultimate in unsecured obligee protection and would seem to be the very typo
of instrument which should be included in the debt catgory." ALl, INcomn TAX
PROBLFUS OP CORPORATIONS AND SHAREHOLDERS 430 (Report of Working Views of
Staff, 1958).
258 J.S. Biritz Construction Co. v. Comm'r, 387 F.2d 451, 459 (8th Cir. 1967);
Taft v. Comm'r, 314 F.2d 620, 622 (9th Cir. 1963); Security Finance & Loan Co. v.
Koehler, 210 F. Supp. 603, 606 (D. Kan. 1962). See I.R.C. § 385(b)(1), added by
section 415(a) of the Tax Reform Act of 1969.
259P.F. Scheidelman & Sons, Inc., 24 T.C.M. 168, 172 (1965) (30 days' notice
before any interest date). Although a note payable one year after demand was said in
Raleigh Properties, Inc., 21 T.C.M. 812, 819 (1962), to have "neither a fixed nor
determinable maturity," there were other substantial adverse factors present in that
case.
260 P.P. Seheidelman & Sons, Inc., 24 T.C.M. 168, 172, 173 (1965) (demands lir.
ited to 10 per cent each year, equated to a ten year maturity). But of. Fnanco
& Investment Corp. v. Burnet, 57 F.2d 444, 446 (D.C. Cir. 1932), in which preferred
stock was held not to constitute indebtedness despite redeemability on demand (subject
to a limitation of 10 per cent a year) because, among other things, "Ino express time is
fixed for payment without the exercise of such option." The Tax Court in Sohwidolman
distinguished the case on the basis of the absence of any history of payments.
261Harlan v. United States, 409 F.2d 904, 905-06, 907 (5th ir. 1969). But seo
note 236 supra, concerning debts payable only from surplus. A provision for payment on
demand is meaningless if a subordination agreement postpones payment while the senior
debt remains outstanding. Affiliated Research, Inc. v. United States, 351 1P.2d 646, 049
(Ct. CL 1965); General Alloy Casting Co., 23 T.C.M. 887, 895 (1964), aff'd, 345
l.2d 794 (3d Cir. 1965). See text at note 307 infra.
282 Arthur V. McDermott, 13 T.C. 468, 469, 471 (1949). But see note 254 supra.

19711 CORPORATE D TBT
of the business until their withdrawal is convenient.2 A note with
a long, but realistic, maturity is more likely to be respected by the
courts than a demand note which plainly could not be repaid "for a
4
number of years."1 1
An open account, similarly, is as capable of giving rise to an en-
forceable obligation as a note, 65 and may be given the tax effect
of a demand loan if the conduct of the parties evidences an intent
that the advance be a temporary one.2 0 But where the absence of
a formal maturity is coupled with a failure to make any provision
for repayment on some reasonable schedule, and where curtails
occur, if at all, only when the corporation has unneeded funds,
open account advances are likely to be regarded as capital contribu-
tions.267
It should not be inferred that the decisions view a fixed maturity,
or an obligation to pay on demand, as essential in all circumstances.
A few decisions have held instruments to be debts although they
were to mature only if ever there was a default in the payment of
interest, in which event the principal obligation might be enforced
on a parity with, or with priority over, general creditors. -3 There
283 Tyler v. Tomlinson, 414 F.2d 844, 849 (5th Cir. 1969) ("such a provision [for
payment on demand] cannot be realistically considered as mannifesting a genuine
interest in repayment in view of the financial condition of the corporation and the com-
plete identity of shareholders and noteholders") ; Fin Hay Realty Co. v. United States,
398 F.2d 694, 698 (3d Cir. 1968); O.H. Kruse Grain & 11illing, 18 T.C.M. 487, 489-00
(1959), aff'd, 279 F.2d 123, 126 (9th Cir. 1960).
264&Fin Hay Realty Co. v. United States, 398 F.2d 694, 698 (3d Cir. 1968). Cf. note
708 infra, concerning the preference for a long maturity over a sborter maturity that
must be extended.
265 See American Processing & Sales Co. v. United States, 371 F.2d 842C 857 (Ct
CL 1967).
2
66Byerlite Corp. v. Williams, 286 FM.2d 285, 291 (6th ir. 1960) ("intended to bo
of short duration"); Irbco Corp., 25 T.C.ML 359, 367 (1966) ("no specifo maturity
date . . . since the parties viewed it in the nature of a demand loan to be repaid
promptly"); Leonard J. Erickson, 15 T.C.ML 1338, 1343 (1956) (construction advances
by shareholders, intended to be repaid from permanent financing that failed to material-
ize). See also notes 518-19 infra.
267Montelair, Inc., 21 T.C.M. 39, 42 (1962), aff'd, 318 F.2d 38 (5th Cir. 1963);
Wachovia Bank & Trust Co. v. United States, 288 F.2d 750, 754 (4th Cir. 1901);
241 Corp., 15 T.C.ML 901 905 (1956), aff'd, 242 F.2d 759 (2d Cir.), cert. de-sied, 3R4
U.S. 938 (1957); Sansberry v. United States, 70-1 U.S.T.C. 9210 (S.D. Ind. 1970).
See also note 709 infra.
268 n Helvering v. Riehmond, F. & P.R.R., 90 F.2d 971 (4th Cir. 1937), the
"guaranteed stock" had a first mortgage lien on all the assets of the railroad; but it
was followed in Third Scottish American Trust Co. v. United States, 37 P. Supp. 279
(Ct. CL 1941), where the "debenture stock" had no lien, yet the court declared that be-
cause of its equality with creditors upon liquidation or earlier default, the holders had
not risked their capital on the fortunes of the corporation. Cf. Brush-Mfoore Newpapers,
37 B.T.A. 787, 792 (1938), note 459 infra, in vhich the substitution of preferred stock

are also some questionable decisions recognizing advances, shown
on the balance sheets as contributed surplus, as true debt even
though repayment was to be made only when the directors deemed
it "advisable," 269 and declaring that a provision for withdraw-
ability of funds by shareholders, even subject to the unanimous
consent of the directors, is "completely inconsistent with true paid-
in surplus." 270
Remedies for Default
The "right to force payment of the sum as a debt in the event of

default" is a very significant, if not essential, factor.2 7 1 A number
of cases suggest that a right only to sue for the amount in default
may not suffice, and that the absence of a clause accelerating the
22
maturity of the entire principal may tend to negative a debt, al-
though provision for a grace period of as long as two or three years
after default appears permissible. It has been held that a re-
quirement of the concurrence of a certain percentage of the obligees
in order to accelerate the maturity upon default is consistent with
indebtedness, since creditors, as such, have an interest in prevent-
ing a minority from "upsetting the financial applecart if there
should be a default of no genuine economic consequence"; 274 but
other cases have recognized that if the purported creditors also
have shareholder interests to consider, the majority may not con-
for debt was held to have had the effect merely of postponing indefinitely the payment
of principal, without affecting the status of the debt.
209 Jennings v. United States, 272 F.2d 842 (7th Cir. 1959).
27o Austin Village, Inc. v. United States, 296 F. Supp. 382, 395 (2N.D. Ohio 1968),
rev'd, 432 F.2d 741 (6th Cir. 1970), note 232 supra. See text at note 527 infra.
271 See United States v. South Georgia Ry., 107 F.2d 3, 5 (5th Cir. 1939).
272 National Farmers Union Serv. Corp. v. United States, 400 P.2d 483, 485 (10th
Cir. 1968); Coleman Good, Inc. v. United States, 65-2 U.S.T.C. 9750 (W.D. Pa.
1965), aff'd, 359 P.2d 434 (3d Cir. 1966); Moughon v. Comm'r, 329 F.2d 399, 401
(6th Cir. 1964); Mullin Bldg. Corp., 9 T.C. 350, 354 (1947), aff'd, 167 P.2d 1001
(3d Cir. 1948). But see Lansing Community Hotel Corp., 14 T.C. 183, 190 (1950), aft'd,
187 F.2d 487 (6th Cir. 1951) (deemed suffilcient that defaulted interest could be sued
for, without accelerating principal); Rev. Rul. 68-54, 1968-1 C.B. 69. Strangely, in Hale.
Justis Drug Co, 2 T.C.M. 39, 41, 43 (1943), an acceleration clause was considered to
detract from the weight of a fixed maturity because there were "so many eventuali.
ties in which at the election of the debenture-holders the debentures might be caused to
fall immediately. I"
273 Elliott-Lewis Co., 4 T.C.M. 136, 142 (1945), aff'd 154 F.2d 292 (3d Cir. 1940);
Comm'r v. J.N. Bray Co, 126 F.2d 612, 613 (5th Cir. 1942); Graves Bros. Co., 17
T.C. 1499, 1503 (1952).
274Luden's Inc. v. United States, 196 P. Supp. 526, 533 (E.D. Pa. 1961); accord,
Charles E. Curry, 43 T.C. 667, 686 n.16 (1965); Atlantic Acceptance Corp. v. Tomlin.
son, 58-2 U.S.T.C. 9892 (S.D. Fla. 1958). See text at note 262 supra.

1971] CORPORLTV,DEBT
fine the use of their veto power to inconsequential defaults, but

may virtually nullify the protection of the supposed indebted-
275
ness.
Even an arm's length arrangement may not result in debt if the
remedies provided are those typical of preferred stock, such as
the assumption of control of the managementF" or even the right
to procure the appointment of a receiver who may liquidate the
corporation if necessary, 77 although such provisions may be ac-
ceptable if they supplement rather than displace the right to sue
for payment. 27 An expressed right to bring suit only at the time of
liquidation of the corporation adds nothing to the right which a pre-
ferred shareholder would have to enforce his priority of distribu-
tion.2 7 9 A right given the purported creditor to take over ownership
of the common stock upon default may2 1 or may not 2' be an
adequate substitute for a right to sue the corporation.
Subordination
It has been said that a distinction between preferred stock and

debt is that the preferred stockholder "has not quite achieved
the protection which a creditor or bondholder enjoys, for he is sub-
ject to that very creditor's prior right to complete satisfaction of
his obligation, in the distribution of the company's assets." At
least in terms of relative standing in the winding up of the corpora-
tion, the holder of subordinated debt is in a position not significantly
275 Dillin v. United States, 433 P.2d 1097, 1101-02 (5th Cir. 1970); Hippodrome Bldg.
Co., 24 T.C3 113, 121 (1965), and Fellinger v. United States, 238 F. Supp. 67, 75-76
(N.D. Ohio 1964), botl& aff'd sub nom. Fellinger v. United State3, 303 P.2d 826 (6th
Cir. 1966); R.C. Owen Co. v. United States, 180 F. Supp. 369, 372 (Ct. CL), cert. denied,
363 U.S. 819 (1960). See text at note 254 supra.
276 Gardens of Faith, ne., 23 T.C.M. 1045, 1058 (1964), aff'd, 345 F.2d 180 (4th
Cir.), ceft denied, 382 U.S. 927 (1965); Elliott-Lewis Co., 4 T.C.M. 136, 143 (1945),
aff'1d, 154 F.2d 292 (3d Cir. 1946). See note 451 infra, regarding the efect of such
powers in the case of no-inal preferred stock which is claimed to be debt.
277 United States v. South Georgia Ay., 107 F.2a 3, 5 (5th Cir. 1939). Cf. Comm'r
v. Meridian & Thirteenth Realty Co., 132 F.2a 182, 187 (7th Cir. 1942).
27sHemenway-Johnson Furniture Co., 7 T.C.M. 380, 382-83, 387 (1948), afft'd, 174
F.2d 793 (5th Cir. 1949); Elliott-Lewis Co, 4 T.C.M. 136, 140 (1945), aft'd, 154 F.2d
292 (3d Cir. 1946).
279 Mfullin Bldg. Corp, 9 T.C. 350, 354 (1947), aff'd, 167 F.2d 1001 (3d Cir. 1948).
280Bowersock Mft & Power Co. v. Comm'r, 172 F.2d 904 (10th Cir. 1949); Him
v. United States, 243 P. Supp. 910, 914 (S.D. Ala. 1965). See text at note 460 infra.
281 Zilkha & Sons, Inc., 52 T.C. 607 (1969).
282 Comm'r v. Mferidian & Thirteenth Realty Co., 132 F.2a 182, 180 (7th Cir. 1942).
See also Crawford Drug Stores v. United States, 220 P.2d 292, 296 (10th Cir. 1955),
quoted at note 447 infra. See LR.C. § 385(b) (2), added by section 415(a) of the Tax
Reform Act of 1969.

different from that of a preferred stockholder, 213
and "Ithe financial
community regards subordinated debt as quasi-equity." 284 There-
fore, it is not surprising that the decisions are replete with declara-
tions that subordination "tends to wipe out a most significant
characteristic of the creditor-debtor relationship, the right to share
with general creditors in the assets in the event of dissolution or
liquidation"; 285 that it raises a "strong presumption," 280 or is a
factor "strongly indicating that the holders were sharing in the
risk of the venture in a manner more compatible with the status
of stockholders than creditors"; 281 that "subordination neces-
sarily destroys one of the essential rights of the creditor, and the
willingness to subordinate is indicative of equity investment"; 218
that it "denigrates the existence of a debtor-creditor relation-
ship" 289 and is "practically an admission that the advances were
considered capital advances." 290 Many cases, accordingly, have
cited subordination as one of a number of factors leading to non-
283 Conn'r v. Sehmoll Fils Associated, 110 F.2d 611, 613 (2d Cir. 1940); Foresun,
Inc., 41 T.O. 706, 717 (1964), aff'd, 348 F.2d 1006 (6th Cir. 1965); Charles L.
Huisking & Co., 4 T.C. 595, 599 (1945) ; see Goldstein, CorporateIndebtedness to Share-
holders: "Thin Capitalization."and Belated Problems, 16 TAx L. BLv. 1, 14-15 (1960).
284 Calligar, Purposes and Uses of Subordination Agreements, 23 Bus. LAW. 33, 34
(1967). The author goes on to prove that, nevertheless, "subordinated debt is not
equity," by an example: Assume a bankrupt owes $500,000 of subordinated debt, $500,000
of senior debt (to which the former is subordinated), and $500,000 of other general
debts. If available assets are $600,000, each class would be entitled to $200,000 but, by
virtue of the subordination provision, the senior debt receives double dividends-i.c.,
the senior creditor gets $400,000, the other general creditors $200,000 and the subordi-
nated creditors nothing; whereas, if the subordinated debt were legally doomed equity
(preferred stock), the senior debt and the other general creditors would have taken
$300,000 each, and the subordinated creditors nothing. That distinction may be meaning-
ful to the senior creditor but it hardly proves a difference in the position of the subordi-
nated creditor. Modification of the example, however, shows up such a difference: If
assets were $900,000, the senior creditor would get his full $500,000, the other general
creditors $300,000, and the subordinated creditors $100,000, whereas if the subordinated
creditors held equity they would have received nothing. That differenco would exist only
if the subordination is to less than all other debts.
285 P.M. Finance Corp. v. Comnm'r, 302 P.2d 786, 789-90 (3d Cir. 1962).
286 See Helvering v. Richmond, P. & P.R.R., 90 F.2d 971, 974 (4th Cir. 1937) (dictum,
in holding a security to be debt, in part because it was not subordinated).
287 Jordan Co. v. Allen, 85 F. Supp. 437, 444 (M.D. Ga. 1949); accord, Schneider
Lumber Co., 15 T.C.M. 120, 123 (1956).
288 Sarkes Tarzian, Inc. v. United States, 240 F.2d 467, 470-71 (7th Cir. 1957). On
remand, 159 P. Supp. 253 (S.D. Ind. 1958), the district court nevertheless recognized the
debt.
289 R.C. Owen Co., 23 T.C.M. 673, 676 (1964), afr'd, 351 F.2d 410 (6th Cir. 1965),
cert. denfed, 383 U.S. 967 (1966).
290 Brinker v. United States, 116 F. Supp. 294, 298 (N.D. Cal. 1953), aff'd, 221 F.2d
478 (9th Cir. 1955).

recognition of purported debt.20 ' The significant fact in this regard

is said to be whether the purported debt was subordinated at the
time of issuance, regardless of whether subsequent prosperity
may have satisfied the condition for relief from the subordina-
2 92
tion.
Nevertheless, despite those strong expressions, it is an over-
statement to say that subordination is "nearly always fatal." -
On the contrary, it is universally recognized that "[s]ubordination
is not condemned but is an approved business practice," 2 4 that
"[d] ebt is still debt despite subordination," O" and that subordi-
nation is "not fatal" 296 except in combination with other substan-
tial adverse factors.297 Subordinated debt, although similar in
291 Reef Corp. v. Comm'r, 368 F.2d 125, 132 (5th Cir. 1966), cert. denied, 380 U.S.
1018 (1967) (purported debt was "at the risk of the business in that it vas deferred to
the business"); United States v. Snyder Bros. Co., 367 F.2d 980, 983 (5th Cir. 1966),
cert. denied, 386 U.S. 956 (1967); MeSorley's, Inc. v. United States, 323 F.2d 900, 902
(10th Cir. 1963); P.M. Finance Corp. v. United States, 302 F.2d 786, 789-90 (3d Cir.
1962); O.R. Kruse Grain & Milling v. Comm'r, 279 F.2d 123, 125-26 (9th Cir.
1960); R.C. Owen Co. v. United States, 180 F. Supp. 369, 372 (Ct. CL), cert. denied,
363 U.S. 819 (1960); Wetteran Grocer Co. v. Comm'r, 179 F.2d 158, 160 (8th Cir. 195o).
See also I.R.C. § 385(b)(2), added by section 415(a) of the Tax Reform Act of
1969; Reg. § 1.302-4(d), note 142 supra. Of. Edwards Motor Transit Co., 23 T.C.M.
1968, 1978 (1964), in which the purported debt was subordinated not only to general
creditors but to preferred stockholders; and Green Bay & Western R., 147 P.2d 585,
586 (7th Cir. 1945), in which one class of debentures was equal to and the other subordi-
nate to the common stock. In Plantation Patterns, Inc., 29 T.C.M. 817 (1970), a sub-
ordinated obligation guaranteed by a shareholder was denied recognition. as debt although
it was superior to another subordinated debt which, being held by an outsider and not
guaranteed, was recognized. Concerning the effect of a purported creditor's consenting to
subordination of a previously unsubordinated obligation, sec text at notes 734-46 infra.
292R.C. Owen Co., 23 T.C.M. 673, 676 (1964), aff'd, 351 F.2d 410 (6th Cir. 1965),
cert. denied, 383 U.S. 967 (1966).
293As was said in Dixon, The Interest-Dividend Syndrome: What Are the Criteria
Jiow!, 24 N.Y.U. INsT. 1267, 1281 (1966).
294 Green Bay Structural Steel, Inc., 53 T.C. 451, 457 (1969), quoting dissenting
opinion in United States v. Snyder Bros., 367 F.2d 980, 989 (5th Cr. 1960). The state-
ment misses the point, since the issue is not whether subordination is condemned, but
whether it makes the obligation more like stock than debt.
-9 Kraft Foods Co. v. ComIm'r, 232 F.2d 118, 125-26 (2d Cir. 1950).
296 Cornm'r v. H.P. Hood & Sons, 141 F.2d 467, 470 (1st Cir. 1944) ; Sabine Royalty
Corp., 17 T.C. 1071, 1076 (1951).
297 Subordinated debts have been recognized in a large number of other instaneei, in-
cluding John Kelley Co., 1 T.C. 457, 462 (1943), rev'd, 146 F.2d 466 (7th Cir. 1944),
rev:'d, 326 U.S. 521 (1946); Harlan v. United States, 409 F.12d 904, 907-08 (6th Cir.
1969); Bowersock Mills & Power Co. v. Comm'r, 172 F.2d 904, 908 (10th Cr. 1949);
United States v. Title Guarantee & Trust Co., 133 F.2d 990, 993 (6th Cir. 1943); Comm'r
v. O.P.P. Holding Corp., 76 P.2d 11, 12 (2d Cir. 1935); Rev. R]l. 68-54, 1908-1
C.B. 69, 70. In an Internal Revenue Service letter quoted in Tax Clinic, 127 J. Account-
ancy 75 (Jan. 1969), it was stated that subordination is only one of "many factora

priority, may differ significantly from preferred stock. "The fact
that ultimately [the holder] must be paid a definite sum at a fixed
time marks his relationship to the corporation as that of creditor
rather than shareholder." 298 In addition, even when interest on
subordinated debt is dependent on corporate earnings, it is com-
monly payable without need for discretionary action of the direc-
tors2 99 and the remedies for default are creditor, not shareholder,
remedies. 300 When the holders deal at arm's length with the cor-
poration, the presence or absence of those other features will ordi-
narily have more weight than subordination itself. When pur-
ported debt is held by shareholders, however, subordination takes
on added significance, as it bears upon both the intention of the
holder to act like a creditor 80' and the reasonableness of his expec-
tation of repayment. 2
The weight given to subordination may vary with its terms.
Obviously, subordination to mortgage debt is a cross which any
general creditor must bear,303 and subordination to bank credit or
to the claims of other specific creditors is not so unusual as to cast
doubt, in most cases, on the bona fides of purported debt.804 But
to be considered in determining whether a bond issue represents equity or indebtedness,"
and that the "ultimate answer would depend upon other factors involved."
298 Comm'r v. O.P.P. Holding Corp., 76 F.2d 11, 12 (2d Cir. 1935).
299 See text at notes 338-48 infra. This difference was not enough to save subordinated
income debentures in Commissioner v. Schmoll Fils Associated, 110 F.2d 611, 613 (2d
Cir. 1940), where no fixed maturity was provided.
300 See text at notes 271-81 supra. A difference in this respect was one of the grounds
on which one class of subordinated debentures was recognized and another was -not, in
Elliott-Lewis Co., 4 T.C.M. 136, 142-43 (1945), aff'd, 154 F.2d 292 (3d Cir. 1946).
so' Foresun, Inc., 41 T.C. 706, 717-18 (1964), aff'd, 348 F.2d 1006 (6th Cir. 1965);
Brinker v. United States, 116 F. Supp. 294, 297-98 (N.D. Cal. 1953), aff'd, 221 F.2d 478
(9th Cir. 1955); cf. Jack Daniel Distillery v. United States, 379 F.2d 569, 582 (Ct. CL.
1967); Oak Motors, Inc., 23 T.C.M. 520, 524 (1964) (subordination lacks weight in
view of repayments). See text at notes 734-46 infra.
302 Subordination enhances the weight given to thin capitalization (Tyler v. Tomlin.
son, 414 F.2d 844, 848 (5th Cir. 1969)), and casts doubt on the reality of the power to
enforce the obligation on default. United States v. Snyder Bros. Co., 367 1.2d 980, 984-
85 (5th Cir. 1966), cert. denied, 386 U.S. 956 (1967); Affiliated Research, Inc. v. United
States, 351 F.2d 646, 649 (Ct. Cl. 1965). See text at notes 836, 976-78 infra.
803 Lifians Corp. v. United States, 390 F.2d 965, 971 (Ct. C1. 1968); Jack Daniel
Distillery v. United States, 379 F.2d 569, 582 (Ct. C. 1967); Tomlinson v. 1661 Corp.,
377 P.2d 291, 298 (5th Cir. 1967); Alstate-Schuylkill Co., 28 T.C.M. 32, 39 (1969); ace
Fin Hay Realty Co. v. United States, 398 F.2d 694, 702-03 (3d Cir. 1968) (dissenting
opinion).
8o4 Baker Commodities, Inc., 48 T.C. 374, 399 (1967), aff'd on another issue, 415 F.2d
519 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970); Daro Corp., 20 T.C.M. 1588,
1600 (1961); Hofert Co. v. United States, 69-1 U.S.T.C. 9220 (C.D. Cal. 1969);
Utility Trailer Mfg. Co. v. United States, 212 F. Supp. 773, 788 (S.D. Cal. 1962);
Atlantic Acceptance Corp. v. Tomlinon, 58-2 U.S.T.C. 9892 (S.D. Fla. 1958).

even that degree of subordination may shed light on the reason-
ableness of the expectation of repayment, where the mortgage or
other debt, to which a purported debt to shareholders is subordi-
nated, is a substantial part of the indebtedness of the corpora-
tion.30 5 Of perhaps greater significance is whether the subordina-
tion is "complete" or "inchoate." 300 The inchoate type, which is
common in subordinated debentures issued to the public, permits
payments of principal and interest to be made on the subordinated
debt until the occurrence of a specified event, such as insolvency
or bankruptcy, or default on the senior debt. Complete subordina-
tion, which is more common in the case of purported indebtedness
to shareholders and related parties, and would rarely be acceptable
to outside lenders, precludes (or sets limits upon) any payments
on the subordinated debt until senior debt has been retired. Al-
though most tax cases dealing with subordinated debts fail to
distinguish the type which was involved, there has been increasing
recognition that complete subordination, even to a single senior
creditor, not only affects the priority of the purported debt but
injects an element of contingency into the essential "power to
demand payment at a fixed maturity date," 3 7 at least in the ab-
305 Tyler v. Tomlinson, 414 F.2d 844, 851 (5th Cir. 1969); Ambassador Apartments,
Inc., 50 T.C. 236, 245 (1968), aff'd, 406 F.2d 288 (2d Cir. 1969); Fin flay R~ealty Co.
v. United States, 398 F.2d 694, 698 (3d Cir. 1968); Hippodrome Bldg. Co., 24 T.C2A.
113, 121 (1965), aff'd sub nom. Fellinger v. United States, 363 F.2d 820 (6th Cir.
1966); Foresun, Inc., 41 T.C. 706, 717 (1964), aff'd, 348 F.2d 1006 (6th Cir. 1965);
Consumers Credit Rural Electric Cooperative Corp., 37 T.C. 136, 145 (1961), aff'd, 319
F.2d 475, 478 (6th Cir. 1963); Colony, Inc., 26 T.C. 30, 43 (1956), aff'd on another
issue, 244 F.2d 75 (6th Cir. 1957), rev'd, 357 U.S. 28 (1958); Peco Co, 26 T.C.U. 207,
212 (1967). But cf. Gounares Bros. v. United States, 292 F.2a 79, 83-84 (5th Cir. 1961),
note 238 supra (fact that most other debts of corporation would give rise to deferred
maritime liens relied on in holding payment of shareholder debt was so improbable that
time of accrual of interest was deferred, but not deemed to negative a debt on which
interest was deductible when paid). Section 279(b) (2) (A), added by section 411(a) of
the Tax Reform Act of 1969, dealing with disallowance of deductions for interest on cer-
tain debts incurred in corporate takeovers, lists as one adverse factor the subordination of
the obligation either to trade creditors generally or to "'any substantial amount of un-
secured indebtedness, whether outstanding or subsequently issued." See text at notes
1394 -96 infra.
08 See Calligar, Subordination Agreements, 70 YAE L.J. 376, 377-83 (1961). Others
prefer such terms as "ab initio," "corporate security" or "Issue" subordination in
lieu of "inchoate." Everett, Analysis of .ParticularSubordinationProvisions, 23 Bus.
LA.w. 41, 42 (1967).
so P.L Finance Corp. v. Comm'r, 302 F.2d 786, 790 (3d Cir. 1902); accord, Tyler
v. Tomlinson, 414 F.2d 844, 849 (5th Cir. 1969); Beef Corp. v. Comm'r, 308 F.2d 125,
132 (5th Cir. 1966), cert. denied, 386 U.S. 1018 (1967); Coleman Good, Inc. v. United
States, 65-2 U.S.T.C. 9750 (W.D. Pa. 1965), aff'd, 359 F.2d 434 (3d Cir. 190);
O.R. Kruse Grain & Mdilling, 18 T.C.M. 487, 490 (1959), aff'd, 279 F.2d 123 (gth (sr.
1960); Sam Schnitzer, 13 T.C. 43, 59. 63 (1949), aff'd, 183 F.2d 70 (9th Cir. 1950),

sence of persuasive evidence that the senior debt can and Will be
paid on time; 308 whereas inchoate subordination ordinarily im-
poses no barrier to payment in due course, even though senior
debt remains outstanding.309
Frequently, the courts will justify any degree of subordination,
on the ground that it was necessary in order to meet the capital
requirements of a regulatory agency 310 or franchisor 311 or to
facilitate outside financing and credit312 and thus, being "dic.
cert. denied, 340 U.S. 911 (1951); Affiliated Research, Inc. v. United States, 351 F.2d
646, 649 (Ct. Cl. 1965).
8 Debt was recognized in such circumstances in Lundgren v. Commissioner, 370 P.2d
623, 626 (9th Cir. 1967), reversing 24 T.C.M. 1753, 1755 (1965); Green Bay Structural
Steel, Inc., 53 T.C. 451, 457 (1969); Alstate-Schuylkill Co., 28 T.C.M. 32, 39 (1909);
Hofert Co. v. United States, 69-1 U.S.T.C. 9220, p. 84,002 (C.D. Cal. 1969). Of. Plastic
Toys, Inc., 27 T.C.M. 707, 710 (1968). Curiously, such complete subordination was dis.
missed in one case with the assertion that "these claims could be asserted with the con-
sent of [the bank] so we doubt that this restriction would have a serious practical offect
in the event the business went completely sour." Gordon Lubricating Co., 24 T.C.M. 697,
711 (1965).
209 In Harlan v. United States, 409 F.2d 904, 907-08 (5th Cir. 1969), a debt payable
only out of surplus in excess of a specified amount was viewed as not subordinated, at
least in any significant sense, since it could be (and was) paid while liabilities remained
outstanding. But in Pocatello Coca-Cola Bottling Co. v. United States, 139 F. Supp. 912
(D. Idaho 1956), a purported debt that was subordinated to all creditors in liquidation,
the payment of which could be demanded only while the obligor was solvent and whon
all its obligations were fully paid in accordance with their terms, was viewed as having
"for all intents and purposes... no maturity date." In United States v. Snyder Bros.
Co., 367 F.2d 980, 981, 984-85 (5th Cir. 1966), cert. denied, 386 U.S. 956 (1907),
inchoate subordination was deemed an adverse factor because one of the specified events
triggering subordination was a default in payment of interest or principal of the sub-
ordinated debentures themselves, which would cause all other debts to become im-
mediately due and payable, so that the debenture holders would really be helpless in the
event of a default. Contra, Green Bay Structural Steel Inc., 53 T.C. 451, 457 (1969),
approving the dissent in Snyder and finding a like provision unobjectionable "whon it
is dictated by . . . circumstances."
310oarlan v. United States, 409 F.2d 904 (5th Cir. 1969) ("surplus notes" of life
insurance company, viewed as capital for insurance law purposes); Comm'r v. Union
Mut. Ins. Co., 386 F.2d 974 (1st Cir. 1967) (guaranty fund of mutual insurance com-
pany); Wilson & Fields, 21 T.C.M. 1080, 1083, 1091 (1962) (form of preferred stock
used because Federal Housing Administration would not permit secondary financing).
The Internal Revenue Service has recognized subordinated debt created to satisfy the
capital requirements imposed on brokers by the New York Stock Exchange. Rev. Rul.
68-54, 1968-1 C.B. 69. But of. William L. Copley, 27 T.C.M. 383 (1968).
31 Oak Motors, Inc., 23 T.C.M. 520, 522-23 (1964). But of. Arlington Park Joehoy
Club v. Sauber, 262 F.2d 902, 906 (7th Cir. 1959); First Mortgage Corp. v. Comm'r,
135 F.2d 121, 124 (3d Cir. 1943).
312 United States v. Title Guarantee & Trust Co., 133 F.2d 990, 992, 995 (6th Cr.
1943); Comm'r v. Proctor Shop, Inc., 82 F.2d 792, 795 (9th Cir. 1930); Green Bay
Structural Steel, Inc., 53 T.C. 451, 457 (1969); Brighton Recreations, Inc., 20 T.O.M.
127, 136 (1961); Southwest Grease & Oil, Inc. v. United States, 308 P. Supp. 107, 110

tated by circumstances," had a business purpose. ' '3 The courts,

it is said, should not penalize a distressed taxpayer for the condi-
tions imposed upon it in order to secure a loan. 1 4 The better view,
however, would be to regard such "business necessity," so far as
the terms imposed may be indicative of equity, as evidence that
"the needs of the business could best be met by instruments which
did not create the debtor-creditor relationship," ' and to ques-
tion whether "there can be any form of corporate security which
is to be regarded for income tax purposes as corporate indebted-
ness, and for credit purposes as part of the capital structure of
the corporatiom" 316 The requirements of the regulators3 1 T or
of the outside creditors 318 are some evidence that, without the pur-
ported debt, the corporate capital is inadequate, and subordina-
(D. Ran. 1969), rev'd on another issue, 435 P.2d 675 (10th Cir. 1971); Universal
Tractor-Equipment Corp. v. United States, 67-1 U.S.T.C. 9409, p. 84,122 (E.D. Va.
1967).
313 The American Bar Association adopted this viewpoint in connection with its legisla-
ive proposal, note 1268 infra, that would have constructed a safe harbor in which pur-
ported debt would be assured recognition if, among other things, it was "not sub-
ordinated [by its terms] to the claims of trade creditors generally," but might still be
recognized despite failure to meet the standards if the failure was "duo to busina
requirements of the corporation. For example to obtain outside financial fls3Stauco a
lender may require the stockholders also to loan some money to the corporation on a
subordinated basis." ABA TAxATION SEcTxo., PROG I Am Co0'.m-r EP ofmTS 37
(1956), also found in Advisory Group Recommendations on Subchnpters C, 3, ana K of
the Internal Revenue Coae, Hearings Before the House omnittee on Ways and Means,
86th Cong., 1st Sess. 931 (1959). Actually, it seems difficult to conceivo of a mubordina-
tion provision that would not facilitate credit, or that would be agreed to if it did not
serve that purpose. Concerning the effect of business purpose generally, ace text at note
1024-82 infra.
314 Austin Village, Inc. v. United States, 296 P. Supp. 382, 396, 397 (N.D.Ohio 1968),
rev 'Id, 432 F.2d 741 (6th Cir. 1970), note 318 infra.
31s Universal Castings Corp., 37 T.C. 107, 117 (1961), aff'd, 303 F.d 620 (7th Cir.
1962) (emphasis added).
316 Crown Iron Works Co. v. Comm'r, 245 F.2d 357, 359-GO (8th Cir. 1957); accord,
Dorsey v. United States, 311 F. Supp. 625, 629 (S.D. Fla. 1909); George J. Schaefer,
24 T.C. 638, 643, 649 (1955). See also the dissenting opinion in Bowersock Mills &
Power Co., 172 F.2d 904, 910 (10th Cir. 1949), which concludes, perhaps too naively in
this context, "No one has yet been able to devise a scheme by w.hich one may eat his
cake and yet have it."1
317 Of. Lee Telephone Co. v. Comm'r, 260 F.2d 114, 115-16 (4th ir. 1958); William
L. Copley, 27 T.C.M. 383, 385 (1968).
-1 Austin Village, Inc. v. United States, 432 F.2d 741, 745-46 (6th Cir. 1970) (subordi-
nated advances necessitated by "inability to obtain sufficient conventional financing" are
"Ia classic example of an investment of risk capital") ; Tyler v. Tomlinson, 414 F.2a 844,
848 (5th Cir. 1969); Affiliated Research, Inc. v. United States, 351 F.2d 646, 48-49
(Ct. CL 1965); General Alloy Casting Co., 23 T.C.M 887, 889, 895 (1904), alffd, 345
F.2d 794 (3d Cir. 1965); Harkins Bowling, Inc. v. Kno:; 104 P. Supp. 801, 807 (D.
Minn. 1958); see Leonard Lundgren, 24 T.C.AL 1753, 1757 (1965), rcv'd, 376 l.2d 623
(9th Cir. 1967). Concerning the effect of the unwillingness of outside creditors to lend
on the same terms, see text at notes 971-81 infra.

TAX IAW REVIEW [Vol. 26 :
tion may be deemed a representation to the world that the addi-
tional amount is at the risk of the business, at least so long as
such inadequacy exists. 19
If purported debt is not subordinated, that fact is itself persuasive
20 The absence of formal
evidence for its recognition as valid debt.
subordination does not, of course, foreclose consideration of
whether a shareholder-creditor truly intended to enforce his equal
21 But, given the requisite intention, it does afford proof
rights.
of the economic reality of the indebtedness if the corporation is
able to obtain credit from others on a parity with shareholder-
creditors, 22 although the evidence may lose much of its weight if,
by guaranteeing the corporation's principal obligations, the share-
holders place themselves in much the same practical position as
if their claims were subordinated.2 3
Nonsubordination would be
a neutral fact in this regard if the corporation has and expects no
significant outside debts, 24 or if the principal outside obligations
25
are secured.3
Even though not formally subordinated, a purported debt to
shareholders may be treated in bankruptcy as a subordinated claim
319 See Broadway Drive-In Theatre, Inc. v. United States, 220 F. Supp. 707, 709-
10 (E.D. Mo. 1963); of. Milwaukee & Suburban Transport Corp. v. Comm'r, 283 F.2d
279, 283 (7th Cir. 1960), cert. denied, 366 U.S. 965 (1961), remanded on other issuo,
367 U.S. 906 (1961); Mullin Bldg. Corp., 9 T.C. 350, 358 (1947), aff'd, 167 F.2d 1001
(3d Cir. 1948); Walter C. McMinn, Jr. 21 T.C.M. 913, 925 (1962).
320 Liflans Corp. v. United States, 390 F 2d 965, 969 (Ct. Cl. 1968); Taft v. Comm'r,
314 F.2d 620, 622 (9th Cir. 1963); Rowan v. United States, 219 F.2d 51, 55 (5th Cir.
1955); New England Lime Co., 13 T.C. 799, 804 (1949).
821 Gooding Amusement Co. v. Comm'r, 236 F.2d 159, 162-63 (6th Cir. 19560), oert.
denied, 352 U.S. 1031 (1957); Estate of Herbert B. Miller, 24 T. 923, 934 (1955),
rev'd, 239 F.2d 729, 732 (9th Cir. 1956). See Chirelstein, Learned Hand's Contribution
to the Law of Tax Avoidance, 77 YALE L.J. 440, 464-65 (1968). Despite largo unsub-
ordinated debts shown on the balance sheet, prospective suppliers may "rely on tho
personal reputation of the shareholder rather than on the balance sheet in deciding
whether to extend credit." ALI, INcOMB TAX PROBLEMS OF CORPORATIONS AND SuARE.
HOLDERS 402 (Report of Working Views of Staff, 1958). See text at notes 734-46 infra.
322 Haley v. United States, 60-1 U.S.T.C. 9169, p. 75,307 (D. Ore. 1959) (corporation
was able to obtain credit from banks and suppliers without subordination or guarantoo).
323 Although it is true that legally the effect of a shareholder's guaranteeing outside
debts is not identical to the effect of his subordinating his own independent claim (Leo
v. L & M Realty Corp., 228 F.2d 89 (4th Cir. 1955)), the practical effect in each caso,
except in unusual circumstances, is that the other debts will be satisfied at the expense
of his recovery. Diamond Bros. Co. v. Comm'r, 322 F.2d 725, 732 (3d Cir. 1903); Heart
of Atlanta Motel, Inc. v. United States, 63-1 U.S.T.C. 9110, pp. 87,127-28 (N.D. Ga.
1962). But of. Santa Anita Consolidated, Inc., 50 T.C. 536, 553 (1968); Ackorson v.
United States, 277 F. Supp. 475 (W.D. Ky. 1967). See text at notes 979-81 infra.
324 Gregg Co. of Delaware v. Comm'r, 239 F.2d 498, 501 (2d Cir. 1956); Erard A.
Matthiessen, 16 T.C. 781, 784 (1951), aff'd, 194 P.2d 659 (2d Cir. 1952).

or as o- capital contribution.1 0
Such treatment does not follow
automatically from the existence of the relationship, - but may
result if the claim had its origin in mismanagement or overreach-
ing; 328 or (even in the absence of misconduct) if the claimant has
exercised such domination over the corporation for his own bene-
fit that the purported debtor is a mere instrumentality of the claim-
ant; 329 or if the claim has been allowed to lie dormant with no
intent to collect it until profitable operations make it convenient
or until the corporation is pressed by other creditors; -0 or if the
shareholders have launched the business with an entirely inade-
quate capitalization for the planned scope and magnitude of its
operations, with the intent of supplying the necessary capital by
purported loans, 33 ' taking "all the winnings which may be made
32
6 See Gleiek, Subordination of Claims in Banl.ruptcy Under the Equitable Power of
the Bankruptcy Court, 16 Bus. L.w. 631 (1961); Annot., 51 A.L. .21 989 (1957).
227 The automatie subordination rule deelared in In re V. Loewer-s Gambrinus Brewery
Co., 167 F.2d 318 (2d Cir. 1948), cannot stand in the light of Comstock v. Group of
Institutional Investors, 335 U.S. 211, 229 (1948). See In re Calpa Products Co., 249
F. Supp. 71, 73 (E.D. Pa. 1965), aff'd, 354 F.2d1 1002 (3d Cir. 1965), cert. deinied, 383
U.S. 947 (1966).
328 This is the familiar "Deep Rock" doctrine. Taylor v. Standard Gas & Electric Co.,
306 U.S. 307 (1939) (purported debt to parent corporation subordinated to preferred
shareholders of bankrupt subsidiary); see Pepper v. Litton, 308 U.S. 295, 308 (1939).
S2aCostello v. Fazio, 256 F.2d 903, 909-10 (9th Cir. 1958); International Tel. & Tel.
Corp. v. Holton, 247 F.2d. 178, 183 (4th Cir. 1957); Gannett Co. v. Larry, 221 .21d 269,
275 (2d Cir. 1955) (operation not primarily to make the subsidiary profitable, but to
tarn it into a source of supply for the parent); see Pepper v. Litton, 308 U.S. 295, 309
(1939). Mere domination of the subsidiary does not make it an instrumentality if the
parent acts in the subsidiary's interest and there is no "unconscionable use of the
opportunity afforded." Comstoek v. Group of Institutional Investors, 335 U.S. 211, 229
(1948) ; Farmers Bank of Clinton v. Julian, 383 F.2d 314, 322-23 (8th Cir.), ccrt. denied,
389 U.S. 1021 (1967); Arnold v. Phillips, 117 F.2d. 497, 02 (5th Cir. 1941).
330 Pepper v. Litton, 308 U.S. 295, 301, 302, 311 (1939).
332 Taylor v. Standard Gas & Electric Co., 306 U.S. 307, 315-1 (1939); Braddy v.
Randolph, 352F .2d 80, 82 (4th Cir. 1965); Costello v. Fazio, 256 P-.d 903, 907, 0-10
(9th Cir. 1958) ; Li & M Realty Corp. v. Leo, 249 F.2d 668, 670 (4th Cir. 1957) ; Boyum
v. Johnson, 127 F.2d1 491, 491 (8th Cir. 1942); Arnold v. Phillips, 117 F.2d 497, Sol
(5th Cir. 1941); see Pepper v. Litton, 308 U.S. 295, 310 (1939) ("where the paid-in
capital is purely nominal, the capital necessary for the scope and magnitude of the
operations of the company being furnished by the stockholder as a loan"). While the
capital -was more than purely nominal in some of the cases cited (e.g., $50,000 in
Arnold v. Phillips, supra), the dictum in Pepper v. Litton, supra, led the court in Brown
v. Freedman, 125 F.2d 151, 156 (1st Cir. 1942), to recognize shareholder debt in bank-
ruptecy -where the capital of $12,000 to $15,000, while inadequate, was not "purely
nominal"3 For the similar problem in the tax context, see text at note 830 infra. Addi-
tional advances made, in the face of adversity, after a corporation has been soundly
launched, stand on a stronger footing in bankruptcy. In re Black Ranhe3, Inc., 362
F.2a 19, 37 (8th Cir. 1966); Zn. re Madelaine, Inc., 164 F.2d 419 (md Cir. 1947); Arno1
v. Phillips, supra, at 501-02.

TAX LAW REVIEW [Vol. 26 .
on their advances while the company is successful [but exposing]

themselves only to creditors' risks, if it fails." 1132 Although the
bankruptcy rule has an "altogether different background," the
tax question is similar if not identical "in principle" 38 and, as we
shall see hereafter, each of the foregoing "factual situations has
its tax counterpart." 34 Therefore, the probability that subordi-
nation would be imposed by operation of law, 880 or the fact that
the claim was actually subordinated in bankruptcy, 30 has in some
cases been given the same adverse weight as contractual subordi-
nation; and the allowance of the claim on a parity with others in
bankruptcy has been viewed as a favorable fact. 837
Certainty of Income
It is characteristic of preferred stock that the holder's right cur-

rently to receive income thereon is dependent not only upon the
existence of corporate earnings or surplus but upon discretionary
action of the board of directors, 83 8 subject to typical shareholder
332 International Tel. & Tel. Corp. v. Holton, 247 F.2d 178, 183 (4th Cir. 1957),
quoting with approval Judge Learned Hand's concurring opinion in In ro V. Loowor's
Gambrinus Brewery Co., 167 F.2d 318 (2d Cir. 1948).
33 See Jewell Ridge Coal Corp. v. Comm'r, 318 F.2d 695, 699 (4th Cir. 1963). But of.
Rowan v. United States, 219 F.2d 51, 54 (5th Cir. 1955), a tax case distinguishing
Arnold v. Phillips, 117 F.2d 497, 501 (5th Cir. 1941), as one in which creditors bad
attacked the validity of the debt.
8s4 See Kraft Foods Co. v. Comm'r, 232 F.2d 118, 125 (2d Cir. 1956). For oxample,
see text at notes 705-46 and 792-882 infra.
385 Jewell Ridge Coal Corp. v. United States, 318 F.2d 695, 699 (4th Cir. 1963);
Janeway v. Comm'r, 147 F.2d 602 (2d Cir. 1945); Estate of Herbert B. Miller, 24
T.C. 923, 934 (1955), rev'd, 239 F.2d 729 (9th ir. 1956); Isidor Dobkin, 15 T.C. 31,
33 (1950), aff'd, 192 F.2d 392 (2d Cir. 1951). But see Van Clief v. Helvering, 135 P.2d
254, 256 (D.C. Cir. 1943), declaring that fact that a shareholder debt would have boon
postponed in bankruptcy makes it no less a debt for tax purposes.
338 Joseph H. Hubbard, 11 T.C.M. 958, 961 (1952).
337 J.B. Reilly, 14 T.C.M. 22, 25 (1955); Weldon D. Smith, 17 T.C. 135, 145 (1951),
rev'd on other grounds, 203 F.2d 310 (2d Cir.), cert. denied, 346 U.S. 816 (1953). In
graft Foods Co. v. Commissioner, 232 F.2d 118, 124-25 (2d Cir. 1956), reversing 21
T.C. 513, 599 (1954), although bankruptcy did not occur, the Second Circuit concluded
that the debt would not have been subordinated under the bankruptcy rules, and declared
that the Tax Court had made an unwarranted extension of the dictum in Prudence
Securities Corp. v. Commissioner, 135 F.2d 340, 341 (2d Cir. 1943), that "A corpora-
tion, ordinarily, cannot in a real sense become a creditor of one of its own incorporated
departments." (f. Gilbert v. Comm'r, 248 F.2d 399, 410-11 (2d Cir. 1957) (dissenting
opinion), viewing the purported debt as one that would have been allowable under the
bankruptcy rules, but declaring that this does not settle the question for tax purposes.
838Milwaukee & Suburban Transport Corp. v. Comm'r, 283 F.2d 279, 283 (7th Cir.
1960), cert. denied, 366 U.S. 965, remanded on another issue, 367 U.S. 906 (1961); Leo

remedies in case of nonpayment. 30 On the other hand, "it is

a common attribute of a debt that the holder thereof is entitled
to interest thereon even though there are no net earnings" 3o or,
at the least, that the interest, if contingent, is absolutely enforce-
341
able if the condition is met.
Therefore, the fact that interest is payable absolutely is a factor
tending to establish a true debt. 342 If the payment of interest on
purported debt is dependent upon a discretionary determination
by the board of directors, the debt will ordinarily not be recognized
as such,343 although some cases hold otherwise if the interest will
become absolutely payable at a fixed ultimate maturity date."
Telephone Co. v. Comm 'r, 260 F.2d 114, 116 (4th Cir. 1958); Crawford Drug Stores,
Inc. v. United States, 220 P.2d 292, 296 (10th Cir. 1955); Pacfle Southwest Realty
Co. v. Comm'r, 128 F.2d 815 (9th Cir.), cert. denied, 317 U.S. 663 (1942).
339Lee Telephone Go. v. Comm'r, 260 F.2a 114, 116 (4th Cir. 1958); King, mill
Corp, 28 T.C. 330, 337 (1957).
340 Crawford Drug Stores, Inc. v. United States, 220 F.2d 292, 290 (10th Cir. 1955).
3n Gokey Properties, Inc., 34 T.C. 829, 835 (1960), aft'd, 290 F.2d 870 (2d Cir.
1961).
342 Third Scottish American Trust Co. v. United States, 37 F. Supp. 279 (Ct. CL 1941);
Tribune Publishing Co., 17 T.C. 1228, 1234 (1952); Brush-Moore Newspapers, Inc., 37
3.T.A. 787 (1938). However, the fact that "guaranteed preferred stock" providc3 for
"interest" payable regardless of earnings does not establish that the preferred is an
indebtedness. Texas Drivurself System, Inc., 3 T.C.M. 289 (1944); of. Dorsoy v. United
States, 311 P. Supp. 625, 627-28 (S.D. Fla. 1969); Zilkhi & Sons, Inc., 52 T.C. 607,
618 (1969).
343 Berkowitz v. United States, 411 F.2d 818, 821 (5th Cir. 1969) ; Gohey Properties,
Inc., 34 T.C. 829, 835 (1960), aff'd, 290 P.2d 870 (2d Cir. 1961); Wilbur Security
Co., 31 T.C. 938, 951 (1959), aff'd, 279 F.2d 657 (9th Cir. 1960); Wetterau Grocer
Co. v. Comm'r, 179 F.2d 158, 160 (8th Cir. 1950) ; Green Bay & Western R.R. v. Comm'r,
147 F.2a 585, 586 (7th Cir. 1945); Bakers' Mut Cooperative Ars'n, 40 B.T.A. 050, 062
(1939), aff'd, 117 F.2d 27 (3d Cir. 1941); Catalina Homes, Inc., 23 T.C.M. 1361, 1365
(1964); Charles L. Huisking Co., 4 T.C. 595, 599 (1945); Ticker Publishing Co., 46
B.T.A. 399, 411 (1942).
34Comm'r v. O.P.P. Holding Corp., 76 F.2d 11 (2d Cir. 1935) (distinguishing
cumulative preferred dividends which, under the applicable state law, were ultimately
payable only from earnings); Brighton Recreations, Inc., 20 T.C.M. 127 (1961); Clydo
Bacon, Inc., 4 T.C. 1107, 1115-16 (1945). But of. Talbot Mills v. Comm'r, 146 P.2a 809,
811, 812 (1st Cir. 1944), aff'd sub nom. John Kelley Co. v. Comm'r, 326 U.S. 521 (1946)
(stressing that deferred interest, although partially cumulative, dit1 not bear interest
and remained subject to risks of business); Gregg Co. of Delaware v. Comni'r, 230 PF.2d
498, 500-01 (2d Cir. 1956), cert. denied, 353 U.S. 946 (1957) (cumulative if deferred,
but not if not earned); Universal Oil Products Co. v. Campbell, 181 P.2d 451, 47G-77
(7th Cir.), cert. denied, 340 U.S. 850 (1950) (cumulative); Si.oby Corp., 9 T.O. 887,
889-90, 891 (1947). The fact that dividends on cumulative preferred stock are pre-
scribed to be payable ultimately regardless of earnings does not give the stock the
quality of a debt. Milwaukee & Suburban Transport Corp. v. Comm'r, 283 P.2d 279, 283
(7th Cir. 1960), cert. denied, 366 U.S. 965, remanded on anotfhe issue, 367 U.S. 0o
(1961); First Mortgage Corp. v. Comm'r, 135 F.2d 121, 124-25 (3d Cir. 1943); Paciflc

However, if (as in the typical income bonds) payment of interest
is conditional upon corporate earnings but requires no discretion-
ary action, 34 5 the debt will normally be recognized, whether the
right to interest is cumulative 341 or not 4 7-at
- least in the absence
of additional significant factors indicative of equity. 84 8
Absence or Inadequacy of Interest
If discretionary interest is bad and contingent interest is

suspect, what are we to say of the purported debt that bears no
interest at all, or bears interest at a nominal rate? Such arrange-
ments are not uncommon in shareholder "loans," where the share-
holder's tax bracket and financial position make interest income
unattractive to him, or where the payment of interest would de-
Southwest Realty Co. v. Comm'r, 128 F.2d 815, 818 (9th Cir.), cert. denied, 317 U.S.
663 (1942).
345 If, in the determination of earnings available for payment of interest, the directors
are permitted first to set aside certain reserves for working capital, contingencies, im-
provements, et cetera, the right to interest will be viewed as subject to a discretionary
power. Universal Castings Corp., 37 T.C. 107, 112, 116 (1961), aff'd, 303 F.2d 620 (7th
Cir. 1962); Universal Oil Products Co. v. Campbell, 181 F.2d 451 (7th Cir.), cart.
denied, 340 U.S. 850 (1950); Swoby Corp., 9 T.C. 887 (1947).
340 Lansing Community Hotel Corp., 14 T.C. 183, 189 (1950), aff'd, 187 F.2d 487
(6th Cir. 1951); Comm'r v. H.P. Hood & Sons, 141 F.2d 467, 470 (1st Cir. 1944);
Washmont Corp. v. Hendricksen, 137 F.2d 306, 308 (9th Cir. 1943); Comm'r v. Na-
tional Grange Mut. Liability Co., 80 F.2d 316, 319 (1st Cir. 1935); Comm'r v. O.P.P.
Holding Corp., 76 F.2d 11 (2d Cir. 1935).
347 John Kelley Co., 1 T.C. 457, 462 (1943), rev'd, 146 F.2d 466, 468-69 (7th Cir.
1944), rev'd (on the basis of the scope of review), 326 U.S. 521 (1946); Now England
Lime Co., 13 T.C. 799, 804 (1949); S. Glaser & Sons, Inc., 3 T.C.M. 611 (1944); of.
Gounares Bros. & Co. v. United States, 292 F.2d 79 (5th Cir. 1961), discussed at noto
238 supra.
348 Dependence of interest on earnings is included as an adverse factor in most of
the standard lists of criteria for recognition of purported debt (e.g., Fin Hay Realty
Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968); O.H. Kruso Grain & Milling v.
Comm'r, 279 F.2d 123, 125-26 (9th Cir. 1960); Rowan v. United States, 219 F.2d 51,
55 (5th Cir. 1955)), although it is omitted as a factor in J.S. Biritz Construction Co.
v. Commissioner, 387 F.2d 451, 457 (8th Cir. 1967). Where other adverse elements such
as subordination were also present, income bonds were denied recognition as debts In
Gregg Co. of Delaware v. Commissioner, 239 F.2d 498 (2d Cir. 1956), cert. acnied, 353
U.S. 946 (1957); Talbot Mills v. Commissioner, 146 F.2d 809, 811, 812 (lst Cir. 1944),
aff'd sub nom. John Kelley Co. v. Commissioner, 326 U.S. 521 (1946); Commissioner v.
Sebmoll Fils Associated, 110 F.2d 611 (2d Cir. 1940) (cumulative but subordinated);
and Jordan Co. v. Allen, 85 F. Supp. 437, 444 (M.D. Ga. 1949). Of. Northern Refrigerator
Line, Inc., 1 T.C. 824, 828 (1943) (cumulative preferred stock with fixed maturity, not
deemed debt as payment could never be made except from funds "availablo for divi.
dends"). See generally Note, Bonds-Income Bonds-ights of Bondholders and Do-
ductbiity for Federal Income Tax Purposes, 56 Mian L. REv. 1334 (1958).

1971] CORPORTE DEBT 433
prive the corporation of needed funds or slow up its (hopefully)
tax-free payment of the principal of the purported debt.3 9
A true lender is concerned with interest, and the failure to pro-
vide for it evidences a primary concern for enhancing the earnings
of the corporation and increasing the market value of its stock,
which is the attitude of a shareholder, not that of a money
lender. 350 Therefore, the Supreme Court (although the point was
not in issue) has said, "Since no interest ran on these accounts,
the 'loans' were identical, except in name, with contributions of
capital." 351 And countless cases have cited the failure to provide
for (or to collect) interest as evidence that purported debt was
truly capital contribution. -2 The prescription of an interest rate
which is not commensurate with the risk involved, " 3 or is less than
independent lenders had demanded, 314 may also be an adverse fac-
tor. Of course, the absence of provision for interest may be ex-
plained if the obligation was issued at a discount,3 or if it arose
from a sale of property to the corporation at a price reflecting the
349 An additional reason for avoiding provision for interest on notes of a closely beld
corporation may exist if the interest obligation may in some year be more than the
corporation can conveniently meet. If more than 50 per cent of the stoc is held1 by
creditors who are members of one family unit or partnership, and if other conditions
of section 267(a) (2) exist, the deduction for the accrued but unpaid interest may be
forever lost to the corporation, without relieving the shareholders of tax thereon vhen
payment ultimately occurs. Reg. § 1.267(a)-l(b) (2). The problem may be dealt with by
giving the corporation's negotiable note for the interest, if the note is readily marketable.
Mid-State Products Co., 21 T.C. 696, 719 (1954). Btut of. Robert J. Dial, 24 T.C7. 117,
122-23 (1955). But the price of such action is immediate taxability of the recipient
without his receipt of cash.
350 Curry v. United States, 396 P.2d 630, 634 (5th Cir.), cert. denied, 393 U.S. 967
(1968); Jeweil Ridge Coal Corp. v. Comm'r, 318 F.2d 695, 699 (4th Cir. 1063).
351 National Carbide Corp. v. Comm'r, 336 U.S. 422, 435 n.16 (1949).
352Road Materials, Tne. v. Cyomn'r, 407 F.2d. 1121, 1125 (4th Cir. 1969); Curry v.
United States, 396 F.2d 630, 634 (5th Cir.), cert. denied, 393 U.S. 967 (1968); Jones
v. Comm'r, 357 F.2d 644, 645 (6th Cir. 1966); Sherwood Memorial Gardens, Inc. v.
Commnr, 350 P.24 225, 228 (7th Cir. 1965); Alfred R. Bachrach, 18 T.C. 479, 485
(1952), aff'd, 205 F.2d 151 (2d Cir. 1953). Concerning the effect of failure to pay
interest, when interest has been provided for, sec text at notes 714-20 infra.
353 Fin Hay Realty Co. v. United States, 398 F.2d 694, 698 (3d Cir. 1908); Curry v.
United States, 396 F.2d 630 (5th Cir.), cert. denied, 393 U.S. 9G7 (1988) ; Jewell Ridge
Coal Corp. v. Comm'r, 318 F.2d 695, 699 (4th Cir. 1963); Reed v. Comm'r, 242 F.2d
334 (2d Cir. 1957).
354MeSorley's, Inc. v. United States, 63-1 U.S.T.C. T 9231 (D. Colo. 1902)2 af'd, 323
F.2d 900 (10th Cir. 1963); Leonard Lundgren, 24 T.C.M. 1753, 1757 (1965), rc'd,
376 F.2d 623 (9th Cir. 1967); 2554-58 Creston Corp., 40 T.C. 932, 937 (1963). Con-
cerning the effect of inability to obtain outside financing on comparable terms, see text
at notes 973-74 infra.
355 Potter Electric Signal & Mfg. Co., 19 T.C.M. 160, 168 (1960).

effect of the deferral of payment. 35 6 And, even where those features
are lacking, courts intent on sustaining a purported indebtedness
have no difficulty in brushing aside the absence -7 or inadequacy ,81
of interest as perhaps an adverse, but certainly not a conclusive,
factor. One decision even viewed the failure to charge interest
as strengthening the case for recognition of debt, since profits were
thus freed for (tax-free) repayment of principal as rapidly as
funds were available.3 59
Participation in the Success of the Venture
Many devices have been employed to make loans more attractive

by giving the lender the opportunity to profit if the business suc-
ceeds, while he remains entitled to recover a fixed sum, in prefer-
ence to shareholders, if it does not. It may be difficult to explain
why sharing in the risk of loss makes a purported lender look like
a shareholder, 30 while sharing in the opportunity for profit leaves
his creditor status unimpaired. 361 But, when we consider that
shareholders may, in the absence of other adverse factors, be rec-
358 Gyro Engineering Corp. v. United States, 417 F.2d 437, 440 n.5 (9th Cir. 1069); Sun
Properties v. United States, 220 F.2d 171, 176 (5th Cir. 1955); Charles E. Curry, 43
T.C. 667, 694 (1965). Under section 483, the law in general now deems that taxable in-
terest is included in a sale price, if the parties fail to provide for at least 4 per cont
interest. Reg. § 1.483-1(d).
357Byerlite Corp. v. Williams, 286 F.2d 285, 290-91 (6th Cir. 1960); Ortmayor v.
Comm'r, 265 F.2d 848, 855 (7th Cir. 1959); American Processing & Sales Co. v. United
States, 371 F.2d 842, 845, 852 (Ct. Cl. 1967); Barnes Theatre Ticket Service, Inc., 20
T.C.M. 1290, 1295 (1967) (making the sound but irrelevant observation that the absence
of interest is "not surprising" in a one man corporation); see Diamond Bros. Co. v.
Comm'r, 322 F.2d 725, 732 (3d Cir. 1963) (denying recognition of debt, but declaring
that absence of interest "Ishould not weigh in the balance"I in the ease of debt to share-
holders). In Road Materials, Inc. v. Commissioner, 407 F.2d 1121, 1125 (4th Cir. 1969),
the American Processing and Byerlite cases were explained on the basis that the debtors
there were affiliates which "transacted business as substitutes for" the lending cor-
porations, and the court declared that, whatever weight business purpose might have
generally (see text at notes 1024-82 infra), when no interest is payable "the existenco of
some other business purpose is relevant. "
358 Charles E. Curry, 43 T.C. 667, 692 (1965); Gordon Lubricating Co., 24 T.C.M.
697, 711 (1965).
359 Amleto U. Salvadore, 22 T.C.M. 1718, 1723 (1963).
36o See text at notes 766-91 infra.
361 See text at note 176 supra distinguishing a shareholder, who "takes the risk, and
profits from success," from a creditor, who "in compensation for not sharing in the
profits, is to be paid independently of the risk of success." In Stone, Dobt.Equity Dis-
tinctionsin the Tax Treatment of the Corporation and Its Shareholders, 42 TUL. L. Rbiv.
250, 257-58 (1968), it is maintained that the benefit element, "the equity owner 's
right to share in the corporation's unlimited success and growth," is at least as im-
portant a factor as the risk of loss.

ognized as creditors of their own corporations,102 it is not sur-

prising that the courts have generally treated the bonds sold to
outside investors as also separable from their equity participa-
363
tion.
The simplest case is the package sale of bonds with stock or
warrants added as a sweetener. It is generally considered that
"a bond does not cease to be a bond merely because a share of
stock was issued -with it," 34 despite equivocal declarations in
some cases (where additional factors were adverse) that an intent
to make an equity investment is evidenced by the fact that the
purported loan would not have been made without the possibility
of profit on the stock that was offered with it,30 and that package
sales are "a common corporate practice in the disposition of pre-
ferred stock" and hence indicative thereof.100
A convertible bond differs from a bond with a warrant princi-
pally in that, whereas exercise of the warrant brings in new cash
but leaves the corporation indebted on the bond, conversion ex-
tinguishes the bond indebtedness. So long as the convertible bond
is held, however, it confers none of the attributes of immediate
stock ownership 3G7 and does not impose an equity-like risk on the
holder 6 s Therefore, despite some suggestion that convertibility
is a factor that might "tip the scale to the equity side" in appro-
priate circumstances, 301 every published ruling and decision to date
362 See text at note 572 infra.
363,See Farley Realty Corp. v. Com'ar, 279 F.2d 701, 704 (2doCir. 1960).
364Ree Helvering v. Rictmond, F. & P.hR.R, 90 F.2d 971, 974 (4th Cir. 1937).
Debt has been recognized where bond purchasers, as an added inducement, were given
stock warrants (Gordon Lubricating Co., 24 T.C.XM 697, 711 (1905)) or nominally
priced stock (Leach Corp., 30 T.C. 563, 566-67 (1958)). The regulations expressly recog-
nize the deductibility of bond discount (and hence, inferentially, recognize the debt
in all respects) where a portion of the price of bonds is allocable to warrants sold with
them. :Reg. § 1.163-3.
365 Fellinger v. United States, 238 F. Supp. 67, 74-75 (N.D. Ohio 19M4), and Hippo-
drome Bldg. Co., 24 T.C.M. 113, 120-21 (1965), both aff'd sub nom. Fellinger v. United
States, 363 F.2d 826 (6th Cir. 1966); Universal Castings Corp. v. Comm'r, 303 F-.d
620, 625 (7th Cir. 1962).
366 Kentucky River Coal Corp. v. Lucas, 51 F.2d 586, 587 (W.D. Ky. 1931), aff'd
63 F.2d 1007 (6th Cir. 1932).
SU6Rev. BuL 69-91. 1969-1 C.B. 106; R1ev. Eul. 67-269, 19G7-2 C.B. 298.
368 Pierce Oil Corp., 32 B.T.A. 403, 421 (1935); Universal Tractor-Equipment Corp. v.
United States, 67-1 U.S.T.C. f 9409 (E.D. Va. 1967).
369 See letter from the Internal Revenue Service quoted in Taz Clini , 127 T.
Accountancy 75 (Jan. 1969). In United States v. Title Guarantee & Trust Co., 133 F.2d
990, 993 (6th Cir. 1943), which held preferred stock to be debt in the circumstances of
the case, the court distinguished four other cases as involving contingent earnings, ab-
sence of a maturity or an obligatioi to redeem, "or the certificates were convertible into
common stck"- But none of the cases there cited involved convertible securities. Ab-

treats convertible debt (unless subject to nonrecognition for in-
dependent reasons) as having all the tax effects of debt until actu-
ally converted.
The recent widespread use or abuse of convertible bonds in cor-
porate acquisitions, 37 ' however, provoked Congress in the Tax
Reform Act of 1969 to provide for disallowance of deductions for
interest or discount with respect to indebtedness issued in certain
senee of conversion rights was cited as favorable to debt treatment in Intermountain
Furniture Mfg. Co. v. United States, 67-2 U.S.T.C. 119735 (D. Utah 1967). But in cases
in which the Commissioner has sought to deny recognition of debt, the conversion feature
has generally not been stressed in argument. See Southwest Grease & Oil Co. v. United
States, 308 F. Supp. 107 (D. Kan. 1969), rev'd on another issue, 435 F.2d 675
(10th Cir. 1971); Hemenway-Johnson Furniture Co., 7 T.C.M. 380, 386 (1948), aff'd, 174
F.2d 793 (5th Cir. 1949); of. Royalty Service Corp. v. United States, 178 F. Supp. 216,
222 (D.Mont. 1959). Of course, if the convertibility was at the option of the corporation,
so that it was free to satisfy its obligation in stock rather than cash, it would be strongly
indicative of an equity interest existing from the outset. Covey Investment Co. v. 'United
States, 377 F.2d 403, 404 (10th Cir. 1967); Lanova Corp., 17 T.C. 1178, 1183 (1952);
cf. Utility Trailer Mfg. Co. v. United States, 212 F. Supp. 773, 790 (S.D. Cal. 1962).
But of. Chazen & Ross, Conversion-Option Debentures, 79 YALE L.J. 647 (1970), pro-
posing that public corporations, now deterred from seeking the tax advantages of high
debt-equity ratios by the fear of bankruptcy and reorganization, might enjoy the game
without the pain by issuing securities convertible into stock at one rate at the option of
the holder and at another rate, several times as great, at the option of the corporation.
Thus, if the common stock declined so greatly as to make the latter option attractive to
the corporation, it could turn the bondholders into stockholders before default occurred,
thereby causing a shift of control similar to that resulting from reorganization but pro-
serving for the equity holders some of the benefit of the saving of reorganization costs.
The thesis of the writers is that, if the option ratio is "sufficiently steep," viewed at the
date of issuance, to make its exercise onerous to the corporation, the obligation would
involve no more risk to the holder than certain other types reflected in "contemporary
financing methods," and should be recognized as debt. Chazen & Ross, supra, at 652-54.
870Until conversion occurs, the corporation is permitted to deduct interest (L.Z.
Dickey Grocery Co., 1 B.T.A. 108, 111 (1924)) and to amortize discount (seanote 31
supra), and if the bonds are called and not converted, may deduct so much of the redemp-
tion premium as is not attributable to the conversion feature (see note 38 supra) ; and the
bondholder, until conversion, may amortize the premium he had paid, so far as not attrib-
utable to the value of the conversion privilege. Albert J. Ades, 38 T.C. 501, 510-11 (1962),
aff'd, 316 F.2d 734 (2d Cir. 1963); I.R.C. § 171(b). Convertible bonds are not a class
of stock, 80 per cent of which must be acquired in order to qualify a stock for stock
acquisition as a tax-free reorganization under section 368(a) (1) (B)3, note 121 supra
(Rev. Rul. 69-91, 1969-1 C.B. 106), or the existence of which will disqualify a corpora-
tion under section 1371(a) (4), note 103 supra, to elect under subehapter S not to be
taxed as a corporation. Rev. Rul. 67-269, 1967-2 C.B. 298. See Fleiseher & Cary, The Tax.
ation of Convertible Bonds and Stocks, 74 HAiv. L. REv 473 (1961). In Southwest Grease
& Oil Co. v. United States, 308 F. Supp. 107, 110 (D. Kan. 1969), rev'd on another issue,
435 F.2d 675 (10th Cir. 1971), it was held that convertibility "Idoes not destroy the
true nature of the indebtedness," despite a finding that, because of subordination, the
debentures "provided very little in the way of security" and convertibility was added as
an incentive to their sale.
373 See notes 19-20 supra,

corporate acquisitions if (in addition to being subordinated and
failing certain ratio tests) the indebtedness is convertible into
stock of the issuing corporation or an affiliate, or is part of an
investment unit that includes an option to acquire such stock.3' 2
That express provision is of limited application, and applies with-
out reference to whether the bond is recognized as indebtedness for
general purposes of the tax law. 7 3 But Congress at the same time
directed the Treasury to prescribe regulations governing the recog-
nition of debt for all purposes of the tax law, and specifically re-
ferred to convertibility as a factor which "may" be taken into
account in making the determinations.37 4 While Congress refrained
from dictating the weight to be given to this factor or the circum-
stances in which it is to be considered at all," 15 its inclusion in
the statutory list and the pointed comments of the congressional
committees 376 may be expected77 to give this factor a prominence
3
it has not heretofore enjoyed.
t Purported lenders may also be permitted to share in the suc-
cess of the enterprise, while enjoying the protection of creditors,
by measuring the amount of interest payable by a percentage of
the net profits. If there is no reasonable floor or ceiling on the
participation, it would seem strongly indicative of an equity in-
terest; for, even, though the principal obligation is fixed, the pur-
ported creditor is, with respect to the reward for the use of his
capital, not only subject to the risks of the business but a sharer
in its fruits.37 8 Although it has been held that the compensation
for the use of money is deductible as interest even though variable
372 I.R.C. § 279, added by section 411(a) of the Tax Reform Act of 1909. See text at
notes 1242-45 infra.'
373 S. R . No. 91-552, 91st Cong., 1st Sess. 139 (1969). See note 1311 infra.
37-4LR.C. § 385(b) (4), added by section 415(a) of the Tax Reform Act of 1069.
3s5 S. REP. No. 91-552, 91st Cong., 1st Sess. 138 (1969). See text at note 1250 infra.
376See note 1441 infra.
377 See text at -notes 1440-51 infra. It has been pointed out that in times of economic
growth, convertible bonds are sold as an indirect means of raising equity funds today at
tomorrow's higher common stock prices, and that the issuer often expects that the debt
will be converted rather than collected. Thus, the legal "supposition [which] is indulged
that [the bond] will be paid in full" (Pierce Oil Corp., 32 B.T.A. 403, 421 (1935)) may
be contrary to business understanding, at least where the maturity or earlier call date is
fairly remote. Fleischer & Cary, The Taxation of Convertible Bonds and Stock., 74
HARv. L. REv. 473, 474, 506 (1961). The lament that "Although this argument has con-
siderable merit as a matter of theory, it has no current support in law" may no longer be
justified.
37sPortage Plastics Co. v. United States, 301 F. Supp. 684, 689 (W.D. Wis. 199);
cf. Lubin v. Comm-r, 335 F.2d 209, 213 (2d Cir. 1904). Se Bleg. § 1.302-4(d), note
142 supra. The income bond cases, notes 346-47 =mpra, may be distinguished by the fact
that the profit participation is not unlimited.

with the borrower's profits, without limitation, the leading case

379
for that view involved a noncorporate debtor, and the court
was not faced with the necessity of distinguishing interest from
the return on equity capital-which, after all, is also in the nature
of compensation for the use of money, but is not deductible under
the law.38 0 Nevertheless, some cases have applied the same ra-
tionale to recognize purported corporate debts bearing interest
wholly contingent on profits.8 8 '
A stronger case for recognition of debt, in the absence of addi-
tional adverse factors, can be made where a reasonable minimum
and maximum interest are prescribed, with participation in profits
between those limits, provided the participation is not discretion-
ary."8 2 If the right to participate is dependent upon action by the
directors,8 3 or is measured by the dividends declared on the com-
mon stock, 88 4 it tends to mark the security as an equity interest,
although even such features may be overcome by others indicative
379 Dorzbach v. Collison, 195 F.2d 69, 72-73 (3d Cir. 1952). In allowing deduction for
25 per cent of the borrower's profits, required to be paid "in lieu of interest," not-
withstanding that the annual payments during the taxable years nearly equalled or
exceeded the principal of the loan, the court said:
Throughout the ages lenders have exacted all they could from borrowers for the
use of money. How much has been exacted has depended upon the desperation of the
borrower and the exigency of the moment. There is no requirement in [I.R.C.
§ 163(a)] that deductible interest be ordinary and necessary or even that it bo
reasonable .... Hence, the phrase "All interest paid" contained in that section
must be taken in its plain and literal meaning to include whatever sums the tax-
payer has actually had to pay for the use of money which he has borrowed.
380 See Farley Realty Corp. v. Comm'r, 279 F.2d 701, 705 (2d Cir. 1960).
381 Stevens Brothers & Miller-Hutchinson Co., 24 T.C. 953, 956 (1055) (performance
of construction contract financed by charitable foundation controlled by taxpayer's
majority stockholders, in return for half of profits); of. Wynnefield Heights, Inc., 25
T.C.M. 953 (1966) (interest was contingent on number of lots sold, not on profits there-
from, and court stressed that compensation was thus dependent, not on success of the
venture, but only on its completion).
382 New England Lime Co., 13 T.C. 799, 804 (1949) (3 per cent interest plus 3 per
cent more if earned, nondiscretionary but noncumulative); Rev. Rul. 68-54, 1968-1 C.B.
69, 70 (7 per cent interest, plus one per cent if earned). Except for the provision for
minimum interest, such obligations do not differ from the income bonds in th cases
cited in notes 346-47 supra. In Talbot Mills, 3 T.C. 95, 99-100 (1944), aff'd, 146 F.2d
809, 812 (1st Cir. 1944), aff'd sub noin. John Kelley Co. v. Commissioner, 326 U.S. 521
(1946), other adverse features, including a power in the directors to defer payment of
earned interest, caused nonrecognition of purported debt bearing interest variable
from 2 per cent to 10 per cent depending on earnings, but the Tax Court acknowledged
that variable interest was not bad per se.
383 Hale-Justis Drug Co., 2 T.C.M. 39, 41, 43 (1943) ; National Savings & Trust Co.
v. United States, 285 F. Supp. 325, 332 (D.D.C. 1968).
384 Pottstown Finance Co. v. United States, 73 F. Supp. 1011, 1014 (E.D. Pa. 1947).
Cf. Haffenreffer Brewing Co. v. Commissioner, 116 F.2d 465 (Ist Cir. 1940), and

of debt.3 5 In one case, deduction of the fixed minimum payment
was allowed as interest on indebtedness but the amount of the
discretionary participation was denied deduction as an "incident
of stock ownership" that had been added to the normal rights of
a creditor to make the loan attractive s A similar judgment of
Solomon was pronounced in a case where a financier had exacted
interest at 13 to 15 per cent and, in addition, a right to 50 per cent
of the appreciation in value of the corporate property, whenever
it might be realized by sale. Although the basic interest had been
allowed by the Commissioner without question, deduction of a
payment in settlement of the contingent right was denied on the
ground that it represented a "right to share in the corporation's
financial success" and, although it grew out of a single indivisible
investment, it was an "equity interest in the property" which
was "separable from [the financier's] right to repayment of his
. . . loan with interest thereon." 387 1
Arrangements involving a fixed but exorbitant rate of interest,
or an excessive discount, often raise the same questions. u When
the purported creditors are also shareholders, the excessive rate
of return may suggest either a high risk (indicative of equity)
or a disguised distribution of corporate profits (which may call
Yingsmill Corp., 28 T.C. 330 (1957), denying debt treatment of cumulative participating
preferred stock.
38 5
n Washmont Corp. v. Hendricksen, 137 F.2d 306, 308 (9th Cir. 1943), de-
bentare holders were to participate when dividends were declared on the common stock,
after each had received a certain amount, and also were to share in surplus on liquidation
or redemption. The court viewed such provisions as indicativo of preferred stock,
but deemed them outweighed by the fixed obligation to repay on maturity, which was
secured by a lien. Significantly, it was the government which there contended for debt
treatment, and the taxpayer failed its burden to overcomo the determination. Deducti-
bility of the participating interest payments was not in issue. In Commissioner v. Union
Mut. Ins. Co. of Providence, 386 P.2a 974, 976, 978 (1st Cir. 1967), which -was accepted
in Revenue Ruling 68-515, 1968-2 C.B. 297, interest which was variablo from 7 per
cent to 10 per cent in the discretion of the directors, as well as other factors strongly
indicative of equity, was dismissed as unimportant in view of "the unique problem of
financing" faced by a mutual insurance company.
3s8Richmond, F. & P.R.R, 33 B.T.A. 895, 899 (1936), aff'd, 90 F.2d 971, 974 (4th
Cir. 1937). Although the security was in the form of preferred stock, it had a prior lien
on corporate assets. Only the deduction of the fixe, amount was in issue on appeal.
387 Farley Realty Corp. v. Comm'r, 279 F.2d 701, 704 (2d Cir. 1960). The conceptual
difficulties in the court's dictum treating the entire investment as a loan an. a part
of the compensation therefor as an equity interest are analyzed in Stone, Debt-Eitzty
Distinctions in the Tax Treatment of thw Corporation and Its Sharchocrs,42 TML. I.
REv. 250, 251, 273-75 (1968).
388 See ALT, INCOME TAX PROBTL-ElS OP CORPOn.TIONS AN'D STIATIEHOLDEllS 433 (Re-
port of Working Views of Staff, 1958).

440 TAX LAW REVMW [Vol. 26:
for treating the excess as a dividend, without denying recognition
of the debt),' s ' If the financier is independent of the sharehold-
ers, the courts tend to view even a usurious return as interest nec-
essarily paid for the use of borrowed money, 0° although the pur-
ported debt may nevertheless be treated as equity in the more
extreme cases, particularly if the capital invested by the promoters
holding the common stock is nominal in amount 091
Similarly, if the principal amount of a purported debt arising
from a transfer of property to a corporation substantially exceeds
the then fair market value of the property, the arrangement may
389 James D. Lancaster, 23 T.C.M. 631, 634 (1964). See also Fin Hay Realty Co. v.
United States, 398 F.2d 694, 698 (3d Cir. 1968) (shareholders' argument that purported
loan at 6 per cent was good investment because it was far more than they could earn
elsewhere called "self-defeating"); Nassau Lens Co. v. Comm1r, 308 F.2d 39, 47 (2d
Cir. 1962) ("although the usual question relates to whether the debt is too risky, the
court may also consider whether the loan is not risky enough in the sense that the
interest or discount sought to be deducted is substantially higher than the going market
rate for loans of the kind involved" (emphasis added)); CommIr v. John Xolloy Co.,
146 F.2d 466, 468 (7th Cir. 1944), rev'd (based on scope of review), 326 U.S. 521
(1946) (8 per cent interest not fixed with regard to money market but to drain off
profits); Oak Hill Finance Co., 40 T.C. 419, 435 (1963) (unlawful 12 per cent interest
to shareholders evidences equity investment) ; Kraft Foods Co., 21 T.C. 513, 598 (1954),
rev'd, 232 F.2d 118 (2d Cir. 1956) (parent charged subsidiary substantially more
interest than parent had to pay); Elliott-Lewis Co., 4 T.C.M. 136, 143 (1945), aff'd, 154
F.2d 292 (3d Cir. 1946) (deduction denied for usurious 60 per cent interest on share.
holder held debentures, which had replaced stock and were not the result of necessity for
a loan). The reasonableness of the interest rate on shareholder hold notes was cited asi a
favorable factor in Harlan v. United States, 409 F.2d 904, 909-10 (5th Cir. 1900).
390 The law does not limit the interest deduction to a reasonable amount (note 879
supra), and even if the rate is usurious, allowance of the deduction would not appear
to frustrate sharply defined legislative policies (of. Tank Truck Rentals, Inc. v. Comm'r,
356 U.S. 30, 33 (1958)), since it is not the purpose of the usury laws to penalize the
necessitous borrower. Arthur R. Jones Syndicate v. Comm'r, 23 F.2d 833, 884 (7th
Cir. 1927) (allowing, as interest, the dividends on preferred stock, cast in that form
to evade the usury law); of. Wiggin Terminals, Inc. v. United States, 36 F.2d 893,
898 (1st Cir. 1929); Blaise, Inc. v. United States, 59-2 U.S.T.C. 9725 (E.D. La. 1959).
But see Brown-Rogers-Dixson Co. v. Comm'r, 122 F.2d 347, 350 (4th Cir. 1941). In
Wynnefield Heights, Inc., 25 T.C.M. 953 (1966), a loan of $300,000 by outside financiors,
to be repaid with an additional $175,000 "in lieu of interest," was recognized as debt.
On the other hand, a bad debt deduction may be denied to the creditor if no enforceable
debt exists under state law. William K. Harriman, 26 T.C.M. 941 (1067).
39'Lubin v. Comm'r, 335 F.2d 209, 213 (2d Cir. 1964); Alden Hlomes, Inc., 33 T.C.
582, 606 (1959) (2 per cent debentures issued for $100, with $168 face value; stock, held
by promoters, was nominal in amount); Merlo Builders, Inc., 23 T.C.M. 185, 190 (1904)
(notes with $150,000 face value issued to outside investor for $50,000, by corporation
with $1,000 capital); cf. Pigeon Hole Parking, Inc. v. United States, 194 F. Supp.
591 (E.D. Wash. 1961) (stock sold to financiers at $3, with option in them to put it to
corporation at $4.50; court declined to construe it as a loan). See Stone, Debt-
Bquity Distinctions in the Tax Treatment of the Corporation and Its Shareholdvrs, 42
TuL. L. Rnv. 250, 275-76 (1968).

be viewed as "nothing more than a shabby attempt to withdraw

*. . at capital gains rates" the profits attributable to the corpo-
ration's own subsequent activities. 3 2 The purported debt may
then be viewed as an equity interest, the retirement of which may
result in dividend tax on the entire amount (to the extent of avail-
able earnings and profits) ; 313 but if the corporation is adequately
capitalized and other circumstances indicative of debt are present,
the debt may be recognized as valid, in which event no more than
the excess over the fair market value may be taxable as a divi-
dend 94 Ordinarily neither result would follow if the discrepancy
between the price and the value reflects merely an honest differ-
ence of opinion among appraisers,0 5 or represents a fair time-price
differential."' 0
392 Burr Oaks Corp., 43 T.C. 635, 646, 649 (1965), aff'd, 365 F.2d 24 (7th Cir. 1960),
cert. denied, 385 U.S. 1007 (1967).
393 Burr Oaks Corp., supra note 392; Emanuel X. (Manny) Kolhoy, 27 T.C. 37, 59, 61-
70 (1956), aff'd, 254 F.2d 51 (7th Cir. 1958); Daro Corp., 20 T.C.ML 1588, 1597-98
(1963); of. Wilhelmina Dauth, 42 B.T.A. 1181, 1189 (1940). Unles the corporation
has other substantial assets, the purported sale may result in a negative net worth,
affording a further reason (see text at notes 792-882 infra) for nonrecognition of the
debt. Burr Oaks Corp., supra, at 646; Marsan Realty Corp., 22 T.C.M. 1513, 1521-22
(1963); cf. Aqualane Shores, Inc., 30 T.C. 519, 527-28 (1958), aff'd, 269 F2a 116
(5th Cir. 1959) (recognition of debt denied on grounds of inadequacy of capital, despite
finding that price, several times what shareholder had paid eight months earlier, was not
excessive). In Piedmont Corp. v. Commissioner, 388 F.2d 886, 890 (4th Cir. 1908), the
fact that the price was fair and the purchaser "could gain from the venture and not
have all of its gain diverted to" the sharebolder-sellers was cited as favorable to
recognition of debt Of. Comm'r v. Brown, 380 U.S. 503, 573 (1965) (finding that a boot-
strap sale to charity qualified as a sale or exchange for capital gain purposes, the debt-
equity issue not being involved). In Revenue "Ruling 66-153, 196(-1 C.B. 187, it was said
that the Brown decision would not be extended to a purported sale for an excessive price,
which was viewed as "in substance an attempt to convert future business profits to
capital gains." But cf. the pre-Brown case of Union Bank v. United States, 285 F.2d
126 (Ct. CL 1961).
39&Arthur L Rosenthal, 24 T.C.M. 1373, 1382 (1965) "When a purchaser pays more
for property than its present worth, the excess may represent something other than the
sales price; but it does not necessarily mean the transaction is not a sale."); of. In re
Margulies, 271 F. Supp. 50 (D.N.J. 1967) (sale for ten times value, to a corporation with
no earnings and profits available for dividends).
395 Charles B. Curry, 43 T.C. 667, 693-94 (1965); Miles Production Co., 28 T.C-.
1387, 1416-17 (1969), on appeal to the Fifth Circuit; of. George F. Getz, Jr., 24 T.C.M.
580, 586 (1965).
398 See note 356 supra. In such event, all or part of the differential may be deemed, not
a dividend, but imputed interest under section 483. If the property sold is a stoch or
security traded on an established securities market, or if the purchase obligation isitself
a part of an issue so traded, the entire differential, so far as not deemed interest, would
be treated as original issue discount under section 1232(b) (2), as amended by section
413(b) of the Tax Reform Act of 1969.

Participation in Both Success and Failure
The ultimate in participation by purported creditors odcurs
when the amount of the principal of the obligation is wholly or
primarily dependent upon the results of corporate operations.
We have seen that a contract to repay a fixed sum, if and when
earnings are sufficient, generally does not give rise to a debt for
purposes of the tax laws,897 and the addition of the further equity
feature of participation in earnings beyond the amount invested
does not improve the case. Therefore, when money is advanced
to a corporation, either by the nominal holders of its stock or by
third parties, under an agreement, not for the return of the prin-
cipal, but for payment of a percentage of profits or sales, either
indefinitely or for a specified period, the arrangement lacks even
the form of a debt and will generally be viewed as resulting in
a proprietary investment at the risk of the business, a device
adopted in order to share the financial results of the operations
along with the shareholders.""8 Even as a matter of nontax law,
there is a serious question whether amounts earned but unpaid
under such a contingent agreement constitute debts recognizable in
99
bankruptcy.
Since such obligations more often arise from transfers of prop-
erty than from cash investments, however, the focus of the debt-
equity issue may be blurred by the presence of the quite distinct
question of whether the transaction is a sale or exchange, which
governs the purported seller's entitlement to capital gain treat-
ment. 400 Although the Supreme Court has expressed the dictum
397 See text at notes 236-38 supra.
398 Sherwood Memorial Gardens, Inc., 42 T.C. 211, 227 (1964), aff'd, 350 F.2d 225,
228 (7th Cir. 1965); Gardens of Faith, Inc., 23 T.C.M. 1045, 1058 (1964), aff'd, 345
F.2d 180 (4th Cir.), cert. denied, 382 U.S. 927 (1965); Knollwood Memorial Gardens,
46 T.C. 764, 780-01 (1966). Those cases involved purported sales of cemetery land, or
the financing of its purchase, and additional cash investments for development, in return
for "certificates of indebtedness" entitling the holders to a percentage of sales proceeds
for an extended period. Another form of downside participation is reflected In debentures
convertible into stock at the option of the corporation, discussed in note 369 supra.
399 In re Hawkeye Oil Co., 19 F.2d 151 (D. Del. 1927) ; United States & Mexican Oil
Co. v. Keystone Gas & Oil Service Co., 19 F.2d 624 (W.D. Pa. 1924). But of. Laugharn
v. Bank of America National Trust & Savings Ass'n, 88 F.2d 551, 553 (9th Cir. 1937),
in effect overruling In re Lathrap, 61 F.2d 37 (9th Cir. 1932), which had applied the
Hawkeye principle to treat "percent holders"' in an oil producing operation as equiva-
lent to preferred stockholders; the later case held that under local law they had an
interest in the property itself.
400 I.R.C. § 1222. That the issues are distinct (since property may be sold or ox-
changed for an equity interest as well as a debt), see text at notes 63-69 supra. In
some cases, the arrangement may be construed as a joint venture rather than a sale.
Kleinschmidt v. United States, 146 F. Supp. 253, 256 (D. Mass. 1956). See Rowen, Pay-

that "A sale, in the ordinary sense of the word, is a transfer of
property for a fixed price in money or its equivalent," 0 1 it is firmly
established that contingency of the price upon production, sales or
profits does not negate a sale or exchange, at least when the sub-
ject matter is a patent,4 2 copyright,4 0 3 1now-how,04 trade name 401
or similar property, cemetery land,400 stock of a wasting asset cor-
poration, 40 7 a franchise or goodwill. 408 The fixed price dictum
has, however, been relied upon in one case holding that a contin-
gent price negatives a sale except where, as in the above situations,
the difficulty of setting a fair price has made sales for contingent
payments the established method of disposition30
menat Out of 'rofits or Produciion,38 TAxEs 517, 525-20 (1960). Even assuming a valid
sale, the contingent payments may be construca as a reserved interest in the production
or income rather than part of the sale proceeds (thereby permitting the purchesr to ex-
clude the payments from its income, although the seller lose3 his capital gain benefits).
Moberg v. Comm'r, 365 F.2d 337 (5th Cir. 1966); Estate of Gowdey v. Comm'r, 307 r."d
816, 820 (4th Cir. 1962); Nassau Suffolk Lumber & Supply Corp, 53 T.C. 280 (1969).
Such construction was rejected on the facts in Bryant v. Commissioner, 399 F.2 800
(5th Cir. 1968); Larry D. Hibler, 46 T.C. 663 (1966), aff'd, 383 F.2d 989 (5th Cir.
1967), cert. denied, 390 U.S. 949 (1968); Vermont Transit Co. v. Commis3iouer, 218
F.2d 468 (2d Cir.), cert. denied, 349 U.S. 945 (1955); Victor E. Stromsted, 53 T.C.
330 (1969). See United States v. Wernentin, 351 P.2d 757 (8th Cir. 1965), reviewing
conflicting results reached on essentially similar fact situations. In the field of depletable
natural resources, a right to payments measured by production, sales or profits is gen-
erally viewed as a retained interest in the property. Kirby Petroleum Co. v. Comm'r,
326 U.S. 599 (1946); Palmer v. Bender, 287 U.S. 551 (1933); United State3 v. White,
401 F.2d 610 (10th Cir. 1968); Kline v. Comm'r, 268 F.2d 854: (9th Cir. 1959).
4o Commit v. Brown, 380 U.S. 563, 571 (1965) (emphasis added). It was dictum
because the price there was fixed, although the only possible source of payment was the
property itself or its earnings. The Court, in addition, took note of the fact that a
Treasury proposal in 1963 to deny capital gain treatment to sale proceeds contingent on
future income bad failed of passage and had in any event been confined to payments ex-
tending beyond five years. Id. at 578.
402 United States v. Dresser Industries, Inc., 324 F.2d 56 (5th Cir. 1903); Rev. Rul.
69-482, 1969-2 C.B. 164.
403 Rev. :Rul. 60-226, 1960-1 C.B. 26.
404 United States Mineral Products Co., 52 T.C. 177 (1909).
405 Rose Marie Reid, 26 T.C. 622 (1956).
4 oMcormzc v. United States, 697 CCH 7912 (ommIr Rep., CL CL 1909), rcv'd
on other groumds, 424 F.2d 607 (Ct. C1. 1970). But cf. note 418 infra.
4o7 Haynes v. United States, 50 F. Supp. 238 (Ct. CL 1943); George James Nicholson, 3
T.C. 596 (1944); cf. Estate of Raymond T. Marshall, 20 T.C. 979 (1953).
40oLarry D. Hibler, 46 T.C. 663 (1966), aff'd, 383 P.2d 989 (5th Cir. 1967), cert.
denied, 390 U.S. 949 (1968); Vermont Transit C. v. Cmm'r, 218 F.2d 408 (2d Cir.).
crt.denied, 349 U.S. 945 (1955).
4o9 Grinnell Corp. v. United States, 390 P.2d 932, 947-48 (Ct. CL 1908). Sec Hall,
The Clay Brown Case and Belatcd Problems, 1906 S. CM/w. Iz;sT. 337, 374-75. A
price is not deemed contingent on earnings merely because such earnings were a major
factor in setting the price (Harry F. Guggenheun, 40 T.C. 559, 569 (1906); Arthur F.
Brook, 23 T.C.M. 1730, 1737 (1961), rev'd on another issue, 300 P.2a 1011 (2d Cir.

Because of the latitude generally given the term "sale or ex-
change," it is possible for a shareholder to utilize a contingent
price sale to draw off a portion of the fruits of corporate opera-
tions and growth, reporting the proceeds as capital gain (unless
some limitation thereon is applicable) while the corporation writes
off the payments against ordinary income, as a cost of the prop-
erty. 410 In the case of patents, when Congress enacted section
1235 of the 1954 Code, assuring capital gain treatment to inventors
and their financial backers under prescribed conditions, it ex-
pressly excluded from the scope of the provision a transfer to
a corporation 25 per cent or more controlled by the transferor
and related parties, 41' in order to "avoid giving capital gains
treatment to possible non-arm's length transactions between re-
lated taxpayers" and "prevent possible abuses arising from the
sale of patents within essentially the same economic group." 41 2 But
the legislative history also indicated that existing law was to govern
in areas beyond the scope of section 1235.413 And because of the
established "body of law which enunciates the principle that the
transfer of a patent constitutes a sale or exchange even when the
1966)), nor because the property itself and its earnings constitute the only sourco of
payment (Comm'r v. Brown, 380 U.S. 563 (1965)).
410 If the term of the contingent payments is coextensive with the life of the property,
as in the case of patent royalties, the payments (although deemed the price of property)
may be deducted when made. Best Lock Corp., 31 T.C. 1217, 1234 (1959); 11ev. Rul.
67-136, 1967-1 C.B. 58. If the property is of indefinite life, however, the corporation
cannot deduct the payments as they are made, even though the payments also are to
continue indefinitely. Dunn v. United States, 400 F.2d 679, 681 (10th Cir. 1968).
411 I.R.C. § 1235(d). Until the 1958 amendment thereof, section 1235 could be availed
of in the absence of more than 50 per cent control
412 H.R. REP. No.1337, 83d Cong., 2d Sess. A280-81 (1954). See also S. REP,. No. 1622,
83d Cong., 2d Sess. 441 (1954), repeating the second quoted statement. When the more
stringent test of stock relationship was adopted in 1958 (note 411 supra), it was taken
for granted by Congress that " [t]his capital gains treatment is not available . . .when
the patent is sold to certain specified related persons." H.R. RnP. No,775, 85th Cong.,
Ist Sess. 33 (1958).
413 S. REP.No. 1622, 83d Cong., 2d Sess. 441 (1954). The statement is preceded, how.
ever, by the assertion that "It is the intention of your committee that, if the modo of
payment is [coterminous with the transferee's use of the patent and contingent on
productivity, use or disposition], the sale of a patent by any 'holder' [inventor or
financial backer] must qualify under the section in order for such (holder' to obtain
capital gain treatment." Thus, the reference to existing law seems confined to transfers
by others than holders and transfers for a fixed consideration. See Myron C. Poole, 46
T.C. 392, 404 (1966). But section 1.1235-1(b) of the regulations goes furthor, and
provides that "a transfer by a holder to a related person isnot governed by section
1235" and its "tax consequences . . .shall be determined under other provisions of
the internal revenue laws."

1971] coRPORATE DEBT 44,)
consideration is payable periodically over the life of the patent

or is contingent on the productivity, use or disposition of the prop-
erty transferred," '4 4 it is now settled that one may accomplish
with his (80 per cent or less) controlled corporation almost every-
thing that section 1235 permits with a stranger.41 1 In the case
of assets other than patents, the statute does not even arguably
impose a restriction on the device.
Debt-equity considerations are not wholly excluded in such cases,
however. While contingency per se probably has little tendency
to negative a debt where the obligation arises from a salee410 a
capital contribution or a disguised arrangement for dividends
may be indicated if there are such additional factors as inade-
quate capitalization, subordination and retained controls,4 1T or if
4 14
See Magnus v. Comm'r, 259 F.2d 893, 902 (3d Cir. 1958).
415Rev. Rul. 69-482, 1969-2 C.B. 164, repudiating Myron C. Poole, 46 T.O. 392
(1966), see note 413 supra. All Congress accomplished by enacting and then tightening
the exclusion of transfers to related parties was to leave applicable in such cases two
relatively minor requirements of general law from which section 1235 gave relief: the
invention must have been held for more than six months and it must not have been held
for sale to customers in the ordinary course of the transferor's business (sce Thomson v.
United States, 70-1 U.S.T.C. 9193 (E.D.N.Y. 1969)); but oven a profc~siona in-
ventor has been permitted to escape the latter requirement w7hen his practice was to
transfer his inventions, not to customers at large, but only to ono corporation in which
he had a substantial interest. Leo P. Curtin, 6 T.C.M. 457, 465 (1947). But of. Patteron
v. Belcher, 302 F.2d 289, 294 (5th Cir. 1962). The only remaining effective limitation
is that if the transferor, his spouse and minor descendants, directly and not through
trusts (Mitcell v. Comm'r, 300 F.2d 533 (4th Cir. 1962)), own inore than 80 pcr cent
of the value of the outstanding stock, the payments will be reportable as ordinary in-
come, since patents axe property "of a character vhich is subject to the allowance for
depreciation," for which section 1239 prescribes such treatment. Royco Kershaw., 34
T.C. 453 (1960); Rev. Rul. 59-210, 1959-1 C.B. 217. Yet it has been held that section
1239 is escaped if the invention is transferred before grant of a patent, since it is not
yet subject to depreciation. Estate of William F. Stabl, 52 T.C. 591 (1969), on appeal
to the Seventh Circuit. The decision seems insupportable, however, for the invention is
the same property before and after the grant of a patent (Samuel E. Dicscer, 30 B.T.A.
732, 743-44 (1937), aff'd on astother issue, 110 F.2d 90 (3d Cir.), cert. dcnied, 310
U.S. 650 (1940)), and its character as an asset subject to the allowanco for deprciation
is not altered by the fact that depreciation is temporarily in uspense. Cf. Twentieth
Century-Fox Film Corp., 45 T.C. 137, 144 (1965), aff'd w th1out passing on this argu-
ment, 372 F.2d 281, 285 n.11 (2d Cir. 1967).
416 Section 483(d) of the Code and section 1.483-1(e) of the regnlations clearly con-
template that there may be interest income and deductions, and hence indebtedn23, ro-
sulting from at least some sales for a contingent price. And the allowanceo of the
amount of patent royalties as depreciation of the cost of acquiring the inventions even
ebn the transferors are the shareholders (as in Associated Patentecs, Inc., 4 T.O. 979
(1945), approvea in Rev. RuL 67-136, 1967-1 C.B. 58, note 410 s.pra) nceesarily as-
sumes that the contingent rights of the transferors are not, in all CaECs, equity.
417 Gardens of Faitb, Inc., 23 T.C.M. 1045, 1058 (1964), aff'd, 345 F.2d 180 (4th

the contingent price is excessive in light of the existing value of

the property. 4 8 In that event, notwithstanding that there is a sale or
410
exchange, the payments may be taxed as equivalent to dividends,
and the purchaser, if it was purportedly a nonprofit corporation,
may be denied tax exemption. 420 The purchaser's deduction for
and the seller's taxability on any interest on, or deemed included
in, the contingent payments would also depend on whether recog-
nizable debt resulted from the sale. 42' And if, viewing the con-
Cir.), cert. denied, 382 U.S. 927 (1965) (sale of cemetery land); Sarkes Tarzian, Inc.
v. United States, 240 F.2d 467 (7th Cir. 1957) (patent). On remand of the lattor case,
159 F. Supp. 253 (S.D. Ind. 1958), the royalty was recognized as valid debt.
418 Dunn v. United States, 400 F.2d 679 (10th Cir. 1968) (franchise transforrod to
controlled corporation for an overriding royalty, in addition to assumption of royalty to
franchisor); Peterson v. Comm'r, 380 F.2d 1, 2 (9th Cir. 1967) (cemotery land trans-
ferred to controlled corporation for a "very, very high price," 20 per cent of lot sale
proceeds and 10 per cent of marker sales, indefinitely; designed "not to got his money
back with interest as would normally be the case, but to indefinitely s1dm off most of
the cream"); Knollwood Memorial Gardens, 46 T.C. 764 (1966) (cemetery land
transferred to nonprofit corporation for 20 per cent of proceeds of lot sales, without
limitation; potential return was 15 times transferors' cost). Bee also text at notes 392-93
supra. In Albert E. Crabtree, 22 T.C. 61 (1954), aff'd, 221 F.2d 807 (2d Cir. 1955), a
transfer of a franchise to a corporation in return for all its stock plus a promise to pay
over 50 per cent of the profits for ten years was held to involve a disguised dividond of
such payments. It is difficult to find fault with the result, but the reason given by the
court, that "'the stock itself was full and adequate consideration for the francbiso," begs
the question. Since the value of the stock would be depleted by the prior obligation to
pay out half the profits, if that were recognized as debt, the stock alone would equal the
value of the franchise only if we first assume the point in issue and disregard the pur-
ported debt. The court's reasoning has permitted later decisions to distinguish the case
as having involved an excessive purchase price. Magnus v. Comm'r, 259 l.2d 893, 902
(3d Cir. 1958). See A.A. Emmerson, 44 T.C. 86, 90 (1965).
419 Peterson v. Comm'r, 380 F.2d 1 (9th Cir. 1967). Where the taxpayer holds nothing
but the contingent obligation, the nominal stock (if any) being held by another, taxation
of the payments as equivalent to a dividend raises problems under section 302, which are
dealt with at length in Stone, Debt-Equity Distinctions in the Tax reatmcnt of the
Corporation and Its Shareholders, 42 Tim. L. Rzv. 250, 281-88 (1968). In Gardens of
Faith, Inc., 23 T.C.M. 1045 (1964), aff'd, 345 F.2d 180 (4th Cir.), cert. denied, 382 U.S.
927 (1965), the contingent payments on cemetery certificates were taxed as dividends to
the promoter, who held half the certificates and all the nominal stock; payments to non-
stockholding holders of certificates were not involved.
420 Knollwood Memorial Gardens, 46 T.C. 764 (1966); Rev. Rul. 61-137, 1961-2 C.B.
118.
421 See Stone, Debt-Bquity Distinctions in the Tax Treatment of the Corporationand
Its Shareholders, 42 Tum. L. Rzv. 250, 278 (1968). While a contingent price normally
would not bear interest, at least before accrual and default, a portion of each payment
is ordinarily treated as interest for tax purposes, provided the resulting obligation is
a debt. See note 416 supra. Patent royalties are excepted from this treatment, if the
transfer is one "described in section 1235(a)." I.R.C. § 483(f)(4). It appears that
royalties on patents transferred to corporations 25 per cent or more controlled by the
transferor are also excluded from such treatment, since they are "described in section

tingent right as in the nature of stock or as a capital contribution,

the statutory requirements for a carryover of basis are satisfied,
the corporation will succeed to the cost basis of its transferors,
with no credit for the contingent payments above that amount.'
Participation in Control
Controlling shareholders would rarely, if ever, have occasion
to provide voting rights in purported debt instruments held by
them, since such rights would add nothing to the control they
otherwise have. But an outside financier or a minority shareholder
might well condition a loan upon his having some voice in the
management. All the standard judicial lists of criteria for dis-
tinguishing equity from debt list participation in management as
a factor to be considered.4 23 Yet it is still almost correct to say,
as one court said long ago, that "The question of voting rights and
a voice in the management of the company has frequently been
discussed but has never been stressed in the determination of the
issue. 14
Although that court, by dictum, said that the presence of voting
rights would "strongly indicate" an equity interest, 42 5 it is all
but impossible to find a decision in which that view has been ap-
plied. The courts have frequently justified giving purported cred-
itors, even in the absence of default, the right to designate as many
as half the directors -Z or to vote along with the common
1235 (a)" even though, by virtue of section 1235(d) (note 411 supra), section 1235(a)
does not apply to them. Floyd G. Paxton, 53 T.C. 202 (1969). See Reg. § 1A83-2(b) (4).
422 In Gardens of Faith, Inc., 23 T.C.M. 1045 (1964), aff'd, 345 F.2d 180 (4th Cir.),
cert. denied, 382 U.S. 927 (1965), the corporation acquired cemetery land in exchange
for its obligation to pay 25 per cent of lot sale proceeds to the transferors, who owned
none of the nomina stock. Finding the contingent obligations not to bo true debt, the
Tax Court excluded the payments from the corporation's basis for the land (d. at 1001),
but accepted the Commissioner's concession, evidently based upon sections 351 and
361(a) (1), that in the transferor's cost was allowable as the basis. In Sherwood Memo-
rial Gardens, Inc., 42 T.C. 211, 227 (1964), aff' d, 350 P.2d 225 (7th Cir. 1965), however,
a basis of zero was allowed, based upon a misapplication of section 362(c). See note 039
infra.
423 E.g., Fin Hay Realty Co. v. United States, 398 F.2d 694 690 (3d Cir. 1968) (list-
ing both participation in management and voting power as separate factors); T.S.
Biritz Construction Co. v. Comm'r, 387 F.2d 451, 457 (8th Cir. 1967); Tomlinson v.
1661 Corp., 377 :P.2d 291, 296 (5th Cir. 1967).
424Jordan Co. v. Allen, 85 F. Supp. 437, 443 (MMD. Ga. 1949).
425 Ibid.
420 Union Mut. Ins. Co. of Providenee, 46 T.C. 842, 845 (1966), aff'd, 380 F.2d 974,
978 (lst Cir. 1967) (guaranty fund certificate3 of mutual insurance company carried
right to elect half directors; accepted in Revenue Ruling 68-515, 1908-2 0.3. 297, but

stock,4 7 on the ground that such rights merely served to protect
their interests as creditors or made the investment more attractive.
Ordinarily, when a voice in management has been given weight
against a finding of debt, the instrument has been in the form and
has had some of the other characteristics of preferred stock, al-
though with some debt-like features added.4 28 In a very few cases,
however, involving instruments labeled indebtedness but having a
number of features tending strongly to negate debt, the courts
have cited as stock-like incidents the power of the purported cred-
itors or their representative to veto any election of directors by
the common shareholders and to declare a default if their own
choices were not elected,42 9 or their power to dismiss the manager
(the nominal sole shareholder) if a prescribed volume of sales
was not maintained.4 8 0
Clearly, voting powers acquired or effective after default, to
permit creditors to control the process of winding up, would have
no adverse significance, 431 unless such powers were granted to the
exclusion of other typical remedies of creditors. 43 Also, the power
of purported creditors to vote on particular matters affecting their
interests, such as mergers, sales or encumbrance of assets, or the
only as applied to mutual insurers); Comm'r v. Johnson, 267 F.2d 382, 384, 385 (lot
Cir. 1959) (mortgage bondholders could elect part of directors); W.H. Trusehol, 29
T.C. 433, 439 (1957) (similar); Hemenway-Johnson Furniture Co., 7 T.C.M. 380, 880,
387 (1948), aff'd, 174 l.2d 793 (5th Cir. 1949) (subordinated debentures, with right
to elect three of seven directors, and a fourth in case of default).
427 Helvering v. Richmond, F. & P.R.R., 90 F.2d 971, 974 (4th Cir. 1937) (guaranteed
dividend preferred stock construed as debt because of prior lien on assets; voting rights
"were doubtless added to the ordinary rights of a secured creditor for the purpose of
making the loan attractive" ).
42SRagland Investment Co., 52 T.C. 867, 877 (1969), aff'd per ouriam, 435 F.2d 118
(6th Cir. 1970), (seller of business took nonvoting preferred stock but, by agreement
with common shareholders, was given right to name two directors); Zilkha & Sons,
Inc., 52 T.C. 607, 616 (1969) (right to name two of 14 directors claimed to be moroly a
means of watching investment, but court found they took active role, although minority
position gives this factor little weight); Ernst Kern Co, 1 T.C. 249, 271 (1942) (pre-
ferred could elect one director); Texas Drivurself System, Inc., 3 T.C.M. 28D, 293
(1944) (preferred stock bearing fixed "interest" but having voting rights, which are
"not usually found in certificates of indebtedness").
429 1ale-Justis Drug Co, 2 T.C.M. 39, 43-44 (1943) (the directors in turn were em-
powered to confer voting rights on the debenture holders).
43o Gardens of Faith, Inc., 23 T.C.M. 1045, 1058 (1964), aff'd, 345 F.2d 180 (4th
Cir.), cert. denied, 382 U.S. 927 (1965).
431 Cf. Richard M. Drachman, 23 T.C. 558, 563 (1954) (existing creditors made
salvage loans to protect their interests, and worthless stock was issued to them to give
control).
432 ee notes 276-78 supra.

like, is not inconsistent with indebtedness. 43 3
But their power in
effect to vote to amend their own contract would constitute "vot-
ing rights not ordinarily characteristic of debentures." 431
The absence of voting rights should properly be given no weight
in distinguishing debt from equity, even when the purported cred-
itors are outside parties, since preferred stock, like debt, fre-
quently carries no voting rights.4 35 A fortiori, the lack of formal
voting rights is meaningless when the purported lenders control
the corporation through common stock ownership. 410 Neverthe-
less, while most decisions recognize those realities, some have given
weight to the fact that the shareholder-creditors, as creditors,had
no rights to participate in the management 437 that the purported
loan did not iizerease the voting power of the already controlling
shareholder, 43 or that the purported creditors would lose their
voting power if, by their own acts, the ownership of stock and
debt should become separated. 4 39 The analogy of purported debt
to nonvoting preferred stock was rejected in one case, where the
433 Baker Commodities, Ine., 48 T.C. 374, 399-400 (1967), aff'd orn another isme, 415
F.2d 519 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970); Luden's, Inc. v. United
States, 196 F. Supp. 526, 532-33 (E.D. Pa. 1961).
434R.C. Owen Co. v. United States, 180 F. Supp. 369, 372 (Ct. C0.), cert. denied, 303
U.S. 819 (1960).
435 Green Bay & Western I.M, 3 T.C. 372, 379 (1944), aff'd, 147 F.2a 585 (7th Cir.
1945); Comm'r v. H.P. Hood & Sons, 141 F.2d 467, 469 (1st Cir. 1944); Comm'r v.
Sehmol Fils Associated, 110 F.2d 611, 613 (2d Cir. 1940); Portage Plastics Co. v.
United States, 301 P. Supp. 684, 690 (W.D. Wis. 1969); Charles L. Huisking & Co.,
4 T.C. 595, 600 (1945).
436 Dillin v. United States, 433 F.2d 1097, 1101 (5th Cir. 1970); Talbot Mills v.
Comm'r, 146 .2d 809, 811 (1st Cr. 1944), aff'd sub notm. John Kelley Co. v. Comm'r,
326 U.S. 521 (1946); Comm'r v. John Kelley Co., 146 F.2d 406, 408 (7th Cir. 1944),
rev'd (based on scope of review), 326 U.S. 521 (1946); MeSorley's, Inc. v. United
States, 63-1 U.S.T.C. 9231 (D. Colo. 1962), aff'd, 323 F.2d 900 (10th Cir. 1903);
Diamond Bros. Co, 21 T.C.M. 696, 706 (1962), aff'd, 322 F.2d 725 (3d Cir. 1963); Uni-
versal Castings Corp., 37 T.C. 107, 116 (1961), aff'd, 303 P.2d 620 (7th Cir. 1962); Peco
Co., 26 T.C.M. 207, 2nl-12 (1967). Of course, the control which they exerciEe as shiare-
holders should be as much a neutral fact as the absence of voting rights in the deben-
tures, since it is unquestioned that shareholders may be creditors of their corporation.
Tomlinson v. 1661 Corp., 377 F.2d 291, 296-97 (5th Cr. 1967).
437Lansing Community Hotel Corp., 14 T.C. 183, 189 (1950), aff'd, 187 F.2d 487
(6th Cir. 1951). See also Gloucester Ice & Cold Storage Co. v. Comm'r, 298 P.2d 183,
185 (1st Cir. 1962).
438 Lundgren v. Comm'r, 376 F.2d 623, 626 (9th Cir. 1967) (70 per cent shareholder);
Taft v. Comm 'r, 314 F.2d 620, 622 (9th Cir. 1963) (lender held majority stol , most of
balance held by children).
49 Tomlinson v. 1661 Corp., 377 F.2d. 291, 297 (5th Cir. 1967); see Talbot Mills v.
Comm'Ir, 146 F.2d 809, 814 n.2 (1st Cir. 1944) (dissenting opinion), aff'd sub nomo. John
Kelley Co. v. Comm'r, 326 U.S. 521 (1946).

court said, "The entire absence of voting rights under any circum-
stances or conditions, while not unknown, is very unusual in pre-
ferred stocks." 440 And where debentures had been issued in
exchange for stock that had voting power, the relinquishment of
that proprietary power was deemed indicative that the substitute
was true debt.441
The Name of the Instrument
If an instrument is labeled "preferred stock," the taxpayer has

very little chance of getting it treated as debt; 442 and the same
is true of those once common Janus-faced instruments with such
contradictory labels as "debenture preferred stock." 44 Despite
the substantial similarities between cumulative preferred stock
and subordinated income debentures, 444 Congress clearly intended
that preferred stock be treated differently from debt, and the line
must be drawn on the basis of such shadowy distinctions as ex-
ist.445 The label itself, while not conclusive, may be a substantive
440 Comm'r v. National Grange Mut. Liability Co., 80 P.2d 316, 320 (lot Cir. 1935).
442 P.F. Scheidelman & Sons, Inc., 24 T.C.M. 168, 173 (1965) ; Sabino Royalty Corp.,
17 T.C. 1071, 1076 (1951).
442 Milwaukee & Suburban Transport Corp. v. Comm'r, 283 F.2d 279 (7th Cir. 1960),
cert. denied, 366 U.S. 965 (1961), remanded on another issue, 367 'U.S. 906 (1961); Leo
Telephone Co. v. Comm'r, 260 F.2d 114 (4th Cir. 1958); Crown Iron Works Co. v.
Comm'r, 245 F.2d 357 (8th Cir. 1957); Crawford Drug Stores v. United States, 220
F.2d 292 (10th Cir. 1955); First Mortgage Corp. v. Comm'r, 135 F.2d 121 (3d Cir.
1943); CommIr v. Meridian & Thirteenth Realty Co., 132 F.2d 182 (7th Cir. 1942);
Pacific Southwest Realty Co. v. Comm'r, 128 F.2d 815 (9th Cir.), cert. denied, 317 U.S.
663 (1942); Haffenreffer Brewing Co. v. Comm1r, 116 F.2d 465 (1st Cir. 1940); Dayton
& Michigan R.R. v. Comm'r, 112 F.2d 627 (4th Cir. 1940); United States v. South
Georgia Ry., 107 F.2d 3 (5th Cir. 1939); Jewel Tea Co. v. United States, 90 F.2d 451
(2d Cir. 1937).
443 Beaver Pipe Tools, Inc. v. Carey, 139 F. Supp. 470 (N.D. Ohio 1955), aff'd, 240
F.2d 843 (6th Cir. 1957) ("preferred debentures"); Mullin Building Corp, 9 T.C. 350
(1947), aff'd, 167 F.2d 1001 (3d Cir. 1948) ("debenture preferred stock"); Brown-
Rogers-Dixson Co. v. Comm'r, 122 F.2d 347 (4th Cir. 1941) ("debenture preference
stock') ; Kentucky River Coal Corp. v. Lucas, 51 F.2d 586 (W.D. Ky. 1931), af'd,
63 F.2d 1007 (6th Cir. 1932); Schneider Lumber Co., 15 T.C.M. 120 (1956) ("preferrod
debenture stock" ); Jordan Co. v. Allen, 85 F. Supp. 437 (M.D. Ga. 1949) ("1debenture
stock"); Pottstown Finance Co. v. United States, 73 F. Supp. 1011 (E.D. Pa. 1947).
"Debenture preference stock," having a fixed maturity and an absolute obligation for
"interest," was recognized as debt in Commissioner v. J.N. Bray Co., 120 F.2d 612
(6th Cir. 1942); and Commissioner v. Proctor Shop, Inc., 82 F.2d 792 (9th Cir. 1936).
"Debenture stock," bearing fixed interest but having no maturity in the absence of
default was so recognized in Third Scottish American Trust Co. v. United States, 37
F. Supp. 279 (Ct. Cl. 1941).
444 As we have seen, notes 282-348 supra, debt may be (but is not always) recognized
as such despite subordination and dependence of interest on earnings.
445 The distinction is "an altogether conventional conception [which] in taxation...

distinction, since the corporate law attaches certain consequences

to preferred stock which the parties cannot control by agree-
ment. 46 The subordination to general creditors which injects an
element of ambiguity into purported debt is given more weight
when the use of the preferred stock label removes the ambiguity.4 4 7
Since provision for retirement by a definite date, or through a
sinking fund, although characteristic of debt, is also not uncommon
in preferred stock,448 the presence of that feature is given relatively
440
little weight in classifying what is, on its face, preferred stock,
particularly if the obligation may be satisfied only out of surplus,450
must be treated as real, [although] the test cannot be merely the name given to the
security." Jewel Tea Co. v. United States, 90 F.2d 451, 452 (2d Cir. 1937). See text
at notes 221-23 and 298-300 supra. Even though, if instruments with substantially Sim-
ilar characteristics -were denominated bonds, "nobody would contend that they were
not true evidences of debt, . . . a corporate taxpayer has no good reason to complain
if issues which it calls preferred stock are . .. treated as such by the Commissioner."
Pacific Southwest Realty Co. v. Comm'r, 128 P.2d 815, 819-20 (9th Cir.) (concurring
opinion), cert. denied, 317 U.S. 663 (1942).
446 Pacific Southwest Realty Co. v. Comm'r, 128 F.2d 815 (9th Cir.), cert. denied, 317
U.S. 663 (1942) (although preferred shareholders could ultimately enforce principal
and income like general creditors, legal effect of form adopted was that meanwhile dis-
tributions could be made only by declaration out of profits); Dayton & Michlgan RE.
v. Comm'r, 112 F.2d 627 (4th Cir. 1940) (purported mortgage to secure preferred stock
-was legally subordinate to general creditors) ; United States v. South Georgia Ry., 107
F.2d 3 (5th Cir. 1939) (similar); Kentucky River Coal Corp. v. Lucas, 51 F.2a 580
(W.D.Ky. 1931), aff' d, 63 F.2d 1007 (6th Cir. 1932) (unconditional undertakzing to
redeem in ten years not enforceable to detriment of creditors); see Jewel Tea Co. v.
United States, 90 F.2a 451, 453 (2d Cir. 1937); cf. Commn'r v. Meridian & Thirteenth
Realty Co., 132 F.2d 182, 186, 187 (7th Cir. 1942) (debt-like characteristics of preferred
stock denied weight when state law recognizes them as permissible incidents of pre-
ferred).
]
-7 See cases cited at note 442 supra. "[I t is normally an attribute of a creditor
relationship that in the event of dissolution or liquidation creditors 9ere in tho assets
'before stoc:holders, while the only right given the holders of preferred stock is that
they be paid 'before the holders of any other class of sfocT. arc paid." Crawford Drug
Stores, Inc. v. United States, 220 F.2d 292, 296 (10th Cr. 1955) (empbasis added).
If that statement begs the question (and it does), the fault lies in the line which the
law requires to be drawn.
-8 See ComIm'r v. Meridian & Thirteenth Realty Co., 132 P.2d 182, 187 (7th Cir. 1942).
449 Even an apparently unconditional obligation to retire preferred stock did not con-
stitute it a debt in Crawford Drug Stores, Inc. v. United States, 220 F.2d 292 (10th Cir.
1955); Commissioner v. Meridian & Thirteenth Realty Co., 132 F.2d 182, 187 (7th Cir.
1942); Pacific Southwest Realty Co. v. Comm'r, 128 F.2d 815 (9th Cir.), cert. denied,
317 U.S. 663 (1942); Finance & Investment Corp. v. Burnet, 57 F.2d. 444 (D.C. Cir.
1932) (redeemable on demand of holder); Dorsey v. United States, 311 P. Supp. 625
(S.D.Fla. 1969).
45O Lee Telephone Co. v. omm'r, 260 F.2d 114, 115 (4th Cir. 1958); Haffenreffer
Brewing Co. v. Commr, 116 F.2d 465 (1st Cir. 1940); Jewel Tea Co. v. United State3,
90 F.2d 451, 453 (2d Cir. 1937); Northern Refrigerator Line, Inc., 1 T.. 824, 828
(1943); cf. Milwaukee & Suburban Transport Corp. v. Comm'r, 283 F.2d 279, 283 (7th
Cir. 1960), cert. denied, 366 U.S. 965, rcmanded on another issue, 367 U.S. 906 (1961).

or if the remedies for default are stockholder remedies (assump-
tion of management powers) rather than creditor remedies. 451 The
absence of voting power 452 and the presence of provisions restrict-
ing the payment of salaries and common stock dividends, the in-
curring of debt or the transfer of property,"4 3 being characteristic
of preferred stock as well as of debt, also have little or no signifi-
cance in this regard. The one feature which seems clearly to dis-
tinguish nominal preferred stock from debt, and which may, there-
fore, be controlling even where both principal and accumulated
dividends are ultimately enforceable as unconditional (but sub-
ordinated) obligations, 514 is that current dividends not only are
payable solely from earnings (as is true also of an income bond)
but are dependent upon declaration in the discretion of the board
of directors, subject to typical stockholder remedies in case of non-
455
payment.
Nevertheless, it is recognized that "conceivably there may be
...bonds going by the name of preferred shares," just as equity
interests may masquerade as bonds.4 ' 6 Some judges, contrary to
the weight of authority, 4 17 have held that debt was intended, despite
the preferred stock label and the dependence of current dividends
upon declaration out of earnings, if there were to come a time when
redemption was required absolutely, with cumulative dividends."8
451. Milwaukee & Suburban Transport Corp. v. Comm'r, 283 F.2d 279 (7th Cir. 1960);
Lee Telephone Co. v. Comm'r, 260 F.2d 114 (4th Cir. 1958); First Mortgage Corp. v.
Comm'r, 135 F.2d 121, 124 (3d Cir. 1943); Kingsmill Corp., 28 T.C. 330, 337 (1957);
cf. Zilkha & Sons, Inc., 52 T.C. 607, 617 (1969) (right to assume control on default, oven
though coupled with option to acquire all common stock for nominal sum, hold not to
give a creditor's degree of assurance of redemption). But of. Choctaw, Inc., 12 T.C.M.
1393, 1396, 1397 (1953).
4
52 Jordan Co. v. Allen, 85 F. Supp. 437, 443 (M.D. Ga. 1949); Schneider Lumber
Co., 15 T.C.M. 120, 123 (1956). See text at note 435 srupra.
453 Comm'r v. Meridian & Thirteenth Realty Co., 132 F.2d 182 (7th Cir. 1942),
reversing 44 B.T.A. 865, 867, 869 (1941) (which had relied in part upon such rostric-
tions in viewing the preferred stock as debt); Kentucky River Coal Corp. v. Lucas, 51
F.2d 586, 588 (W.D. Ky. 1931), aff'd, 63 F.2d 1007 (6th Cir. 1932); Kingsmill Corp.,
28 T.C. 330, 337 (1957); Schneider Lumber Co., 15 T.C.M. 120 (1056).
54 Coim'ir v. Meridian & Thirteenth Realty Co., 132 P.2d 182, 187 (7th Cir. 1942);
Crawford Drug Stores, Inc. v. United States, 220 F.2d 292, 295-96 (10th Cir. 1955);
Pacific Southwest Realty Co. v. Comm1r, 128 F.2d 815 (9th Cir.), cert. denied, 317 US.
663 (1942).
4r,See notes 338-48 supra.
458 Jewel Tea Co. v. United States, 90 F.2d 451, 453 (2d Cir. 1937). See also John
Kelley Co. v. Comm'r, 326 U.S. 521, 530 (1946).
45 See notes 448-51 supra.
458 United States v. Title Guaranty & Trust Co., 133 F.2d 990 (6th Cir. 1943), is
only superficially authority for the proposition that "the preferred stock constitutod
indebtedness" in such circumstances. Both the dissenting and concurring judges, con-

Usually the process of reasoning is to concede that the preferred

stock was not itself a debt, but to conclude that it "secured" an un-
derlying independent contract that did create a debt.4 9 Sometimes
sympathy for the taxpayer is a factor in the decision, as where a
lender had demanded exorbitant interest and required the bor-
rower to use the form of preferred stock in an effort to circumvent
the usury laws.400 But such sympathy is pressed to an unwarranted
extreme when it is determined that the parties intended a debt
but adopted the form of preferred stock for a different reason
"personal to the parties," namely, that it was necessaryto the pres-
ervation of the corporation's credit that the debt not show as such
on the balance sheet. 4 61 The better reasoned cases, however, ques-
tion whether "there can be any form of corporate security which is
to be regarded for income tax purposes as corporate indebtedness,
and for credit purposes as part of the capital structure of the cor-
poration." 462 Some decisions have taken an intermediate position,
not questioning that stock issued in order to improve the corporate
stituting a majority, denied the significance which Judge McAllister's prevailing opinion
gave to the fixed maturity date in preferred stock, but the concurring judge felt that the
absence of a. complete record precluded review of the ultimate finding that debt was
intended, which might have been based on facts extraneous to the face of the instru-
ment. See Lee Telephone Co. v. United States, 260 F.2d 114, 110 (4th Cir. 1958).
459 Bowersock Mifl & Power Co. v. Comm'r, 172 F.2d 904 (10th Cir. 1949) (holder
of defaulted mortgage, not desiring to foreclose, agreed to "cchange the form of said
indebtedness" by taking preferred stock, guaranteed by pledge of common stock;
creditor "had no disposition to become an investor" but intended merely to subordinate
the existing debt to general bank credit); Palmer, Stacy- errill, Inc, 37 B.T.A. 530
(1938), Tnodifted, 39 B.T.A. 636 (1939), aff'd, 111 F.2d 809 (9th Cir. 1940) (purdhase
of business, issuing preferred stock to seller, with redemption and dividends guaranteed
by parent company; stock deemed accepted by seller, not as an investment but as security
for the price); Brush-Moore Newspapers, Inc., 37 B.T.A. 787 (1938) (seller of businti3
accepted preferred stock in lieu of defaulted mortgage; to protect him from losing by
the substitution, corporation separately agreed to pay "interest in lieu of dividends"
whenever dividends were insufficient); Wilson & Fields, 21 TC.M. 1080 (1962) (pro-
ferrea stock issued for land purchase because Federal Housing Administration's regula-
tions precluded secondary financing). In the Bowcrsocl: and Brush.Moorc casq, there
was -not even a maturity date when the corporation was bound, to pay. Cf. Richard M.
Drachman, 23 T.C. 558 (1954) (common stock, with a par value equal to the amount
advanced, but in fact worthless, was issued to the makers of salvage loans, for the cole
purpose of placing creditors in control).
460 Arthur R. Jones Syndicate v. Comm'r, 23 F.2d 833j 834 (7th Cir. 1927) ("a bor-
rower whose necessities lead him to the door of the usurer may lvways abow-by evidence
alinnde the contract-the real character of the transaction"). See note 390 supra.
461 United States v. Title Guarantee & Trust Co., 133 F.2d 990, 992, 993 (6th Cir.
1943) (discussed at note 458 supra); Comm'r v. Proctor Shop, Inc, 82 P.2d 791, 795
(9th Cir. 1936); Choctaw, Inc., 12 T.C.M. 1393 (1953).
462 Crown Iron Works Co. v. Comm'r, 245 F.2d 357, 359-60 (8th Cir. 1957). See text
at notes 310-19 supra.

balance sheet is indeed an equity security (and thus not opening
the door to an interest deduction), but holding that the redemption
of stock that was intended from the outset to provide only tempo-
rary capital is not "essentially equivalent to a dividend" 4 08 -a
stance now apparently foreclosed by the Supreme Court.40 4
In unique circumstances, purported preferred stock has been
held to be debt even though it would never mature (short of dissolu-
tion) in the absence of a default in the payment of guaranteed div-
idends. The controlling factors were that the "stock" was secured
by a valid first lien on all the corporate assets, ahead even of other
secured creditors, and that the guaranteed dividends were payable
absolutely, from general assets if there were no earnings. 451 There
was no such justification, however, for excusing the absence of a
fixed corporate obligation to redeem in another case where both
those features were lacking, but the court relied upon a collateral
agreement by the common stockholders, secured by pledge of their
common stock, to purchase a portion of the preferred stock each
year. Declaring that "actually, and in a very real sense, the corpo-
ration was the common stockholders," and that the power to take
over the pledged common stock upon default enabled the "so-called
preferred stockholders [to become] owners of the corporation as
effectively, if not more so, than by foreclosure" on the corporate
assets, the court constructed a corporate indebtedness. 40 In two
recent decisions, on the other hand, the Tax Court has held that an
agreement by the shareholders to cause the corporation to redeem
the preferred stock by a fixed date, 467 even when accompanied by an
option in the preferred shareholders to acquire the common stock
463 Cobb v. Callan Court Corp., 274 F.2d 532, 538 (5th Cir. 1960); Keefe v. Cote, 213
F.2d 651, 657 (Ist Cir. 1954); Dorsey v. United States, 311 P. Supp. 625, 630 (S.D.
Fla. 1969); Joe L. Smith, Jr., 49 T.C. 476 (1968); G.E. Nicholson, 17 T.C. 1399 (1952);
see Zelie Berenbaum, 24 T.C.M. 758, 760 (1965), rev'd on other grounds, 369 P.2d 337
(10th Cir. 1966).
464United States v. Davis, 397 U.S. 301 (1970), note 50 supra.
465 Eelvering v. Richmond, F. & P.R.R., 90 F.2d 971 (4th Cir. 1937) (such factors
even overcame the fact that the stock had voting power and participated equally with the
common in dividends above the amount guaranteed). Whore the attempt to provide a
lien and a guarantee of preferred stock dividends was found invalid under stato law,
the Biohmond case was distinguished. Dayton & Michigan R.R. v. Comm'r, 112 F.2d
627 (4th Cir. 1940) ; of. United States v. South Georgia Ry., 107 P.2d 3 (5th Cir. 1939).
468 Bowersock Mills & Power Co. v. Comm'r, 172 F.2d 904, 907 (10th Cir. 1949). Hav-
ing found a corporate obligation, the court then reasoned, as indicated at note 459 supra,
with respect to the preferred stock which, by itself, "must be held to create an invest-
ment, not an indebtedness" (id. at 907).
467 Ragland Investment Co., 52 T.C. 867, 878 (1969), aff'd per ouriam, 435 P.2d
118 (6th Cir. 1970); accord, Northern Refrigerator Line, Inc., 1 T.C. 824, 829 (1943).

for a nominal sum in the event of default,09 was not the equivalent
of a fixed obligation imposed on the corporation itself.
In each of those recent decisions, it was the taxpayer (a seller
inone case, a financier in the other) who, for his own tax advantage,
had imposed on an unrelated corporation an obligation in the
form of preferred stock which contained protective provisions
highly indicative of indebtedness; and in each the form chosen was
upheld against the Commissioner's contention that debt was cre-
ated. One of them contains language which may presage the final
triumph of form over substance in this area, wherever unity of
interest among the affected parties is absent:
It is our view that, given a transaction where the contract is negotiated
between parties with conflicting tax interests and where the resultant docu-
ment set forth duties and obligations which conform to the business or
economic realities of the situation, this Court should not take upon itself
the task of recasting the agreement. Rather, under such circumstances, we
are inclined to leave the parties to live up to their own agreement.0 9
The minority replied:
The majority apparently is willing to accept the labels attached by the
parties to the payments in question as determinative of the tax conse-
quences-i.e., the parties to a business transaction can determine between
themselves which party the Government shall tax. This is nonsense. Even
though every "i" is dotted and every "t" is crossed, this "opens questions
as to the proper application of a taxing statute; it does not close them."...
[H] ow can the parties to a contract bind the Commissioner, who is not a
party... ?
The idea that parties with adverse tax interests should be per-
mitted, by adopting the prescribed form of words, to write their
own tax ticket is not without precedent as a solution to difficult
issues in the tax law. In connection with covenants not to compete
with the purchaser of one's business, the Third Circuit has adopted
the view that the seller cannot deny the reality of his covenant, in
order to escape ordinary income tax on the consideration allocated
thereto (and, in consequence, to cause the buyer to lose his tax de-
ductions for the payments), in the absence of such circumstances
4zs Zilkha & Sons, Inc., 52 T.C. 607, 617 (1969).
469 Ragland Investment Co., 52 T.C. 867, 879 (1969), aff'd per curtain, 435 FX2d
118 (6th Cir. 1970). Cf. Kingsmill Corp., 28 T.C. 330, 337 (1957), in which the party
-who had acceded to a demand that it issue preferred stock rather than a note sought in
vain to escape the effect of the form adopted by arguing that the intent of the parties
was to effect a loan, since that was what it had asdcg for (and had been denied by the
financier). In Bagland, it was the party that gained a tax advantage thereby who was
allowed to stand on the form.

of fraud, duress, mistake or the like as would vitiate the contract
as between the parties. 470 The reasonably anticipated tax benefits
to one party and tax detriments to the other have a substantial ef-
fect on the terms the parties will agree upon, and it should be
viewed, at least, as a breach of contract if one of them thereafter
takes advantage of the murkiness of the tax law to seek relief
from the burden which the other paid him to bear. 47 ' But it is quite
another thing to bind the Commissioner by the parties' agreement,
however antithetical their interests may be.472 The tax detriments
470 Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir.) (a 4 to 3 decision on
bane), cert. denied, 389 U.S. 858 (1967), hailed in Note, Judicial Treatment of Govenants
Not to Compete: The Third Circuit Takes a Giant Step, 24 TAx L. :RIv. 513 (19069).
The Tax Court has not yet decided generally whether to accept the Danielson rule. See
Henry P. Wager, 52 T.C. 416, 418 (1969). It has held the rule inapplicable where both
parties were before the court in a consolidated case and the Commissioner stood neutral
-although that seems the situation most clearly calling for holding the parties to the
form they agreed upon, if it is ever appropriate in a tax case. J. Leonard Sehmitz, 51
T.C. 306 (1968), on appeal to the Ninth Circuit (actually, there was no majority for
taking any position on Danielson, since both the concurring and dissenting judges relied
on other grounds).
4
7' In Stern & Co. v. State Loan & Finance Corp., 238 F. Supp. 901 (D. Del. 1965), the
seller recovered from the purchaser for the expense of tax litigation in which it became
involved as a result of the purchaser's claim for a deduction for payments allegedly
allocable to a noncompetition covenant, contrary to the contractual intent that nothing
be allocated thereto. Query, if the seller had lost the tax case, could he also have re-
covered from the purchaser the amount of the additional tax occasioned by the lattor's
successful departure from the tax pattern envisioned by the contract?
472 In a few instances, by action of Congress itself and not of the courts, parties
have been permitted to bind the revenue conclusively, by the form of words chosen in
their agreements, with respect to the allocation of tax burdens in areas of uncertainty.
Under sections 71(b) and 215 (a) of the Code, that portion of an alimony payment which
is expressly designated, by decree or agreement, as a sum certain allocable to child sup-
port is not taxable to the ex-wife or deductible by the ex-husband; but if they refrain
-from such express designation, the husband will get his deduction and the wife will be
taxed (presumably in a lower tax bracket) despite clear inferences that a readily doter-
minable amount was intended for child support. Comm'r v. Lester, 366 U.S. 299 (1061).
There, as in the case of the recently enacted provision for assigning dependency exomp.
ions to a divorced husband or wife in accordance with the divorce decree or their
agreement (I.R.C. § 152(e)(2)(A)), the policy of achieving cortainty between the
warring spouses outweighed the relatively small tax loss involved. Moro questionable is
the policy behind sections 736 and 741, enabling a partnership to determine conclusivoly,
by the form of words used in its agreement, whether payments made to a retiring
partner in respect of goodwill (which, in the case of any other sale of business, would
be required to be capitalized by the buyer, Victor E. Stromsted, 53 T.C. 330 (1960), and
would be capital gain to the seller, Bankers Guarantee Title & Trust Co. v. United
States, 418 F.2d 1084 (6th Cir. 1969)) shall instead be treated as a distributive share
of partnership income (excludable from income of the continuing partners and taxable
to the retiring partner at his usually lower postretirement tax bracket). Smith v. Comm'r,
313 F.2d 16 (10th Cir. 1962). That option, while it achieves certainty-if not the in-
tended simpliity-as between the parties (David A. Foxman, 41 T.C. 535, 551 (1964),
aff'd, 352 F.2d 466 (3d Cir. 1965)), enables the parties to bargain for the greatest

4 3
to one and the benefits to the other are rarely equal' and a formal
arrangement tailored for the greatest aggregate tax advantage, as
the Third Circuit clearly recognized, should not be immune from
challenge by the taxing authorities if the substance differs from
the form adopted.474
FACTORS BEARING O INTENTIOIN
In General
Mhen parties deal at arm's length, it may fairly be assumed that

the form (although perhaps not the label adopted) reflects the sub-
stance of the transaction,4 75 and the inquiry can ordinarily end
-with the foregoing comparison of the formal rights and remedies
provided -withthose which are characteristic of debt and of stock.410
But when "the same persons occupy both sides of the bargaining
table, form does not necessarily correspond to the intrinsic eco-
nomic nature of the transaction," 477 since "the arm's length deal-
ing that characterizes the money market is lacking." 8 Particu-
larly "where it would be the tax advantage of the parties to
describe a transaction as something other than it really is," 4
their formal manifestations of intention should be given little
weight, since their "[c] omplete control of the corporation will
enable [them] to render nugatory the absolute language of any in-
strument of indebtedness." 480 To make form controlling would
aggregate tax advantage, at substantial expense to the revenue. It affords no valid
precedent for judicial legislation in other areas of uncertainty in the tax law.
473 For example, in Zilkha & Sons, Inc., 52 T.C. 607, 618 (1969), note 468 supra, the
corporation to which the taxpayer supplied funds had no early expectation of having
income against which to offset interest deductions, so it readily agreed to the financier's
desire to cast the arrangement in the form of preferred stock, from which (there being
no earnings and profits) tax-free income might be derived.
474 Comm'r v. Danielson, 378 F.2d 771, 774 (3d Cir.), cert. dcenicd, 389 U.S. 858
(1967).
4 75
See Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968).
476 Cf. Ragland Investment Co, 52 T.C. 867, 878-79 (1969), aff'd per cirtan, 435
F.2d 118 (6th Cir. 1970), discussed in the text at notes 469-74 supra. See further
text at notes 595-600 infra.
477 Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1908); accord,
Donisi v. Comnm'r, 405 F.2d 481, 483 (6th Cir. 1968) (the taxpayer's intention "can
appropriately be viewed with some diffidence unless supported by other facts which
bring the transaction much closer to a normal arms-length loan").
48Road Materials, Inc. v. Comm'r, 407 :F.2d. 1121, 1124 (4th Cir. 1069).
4-sSee Brake & lectrie Sales Corp. v. United States, 185 F. Supp. 1, 3 (D. Mass.
1960), aff'd, 287 F.2d 426 (1st Cir. 1961).
480 PM,Finance Corp. v. Comm'r, 302 F.2d 786, 789 (3d Cir. 1962).

TAX LAW REVIEW [Vol, 26 :
provide "a blueprint for tax avoidance by the simple expedient of
using the proper nomenclature and bookkeeping entries." 481
Therefore, most courts today would agree that the characteriza-
tion of purported debt for tax purposes must be determined from
the "objective" intent or, more accurately, the intent as "objec-
tively ascertained by looking beneath mere form to all relevant
facts and circumstances." 482 The Second and Fifth Circuits, it
might seem, have gone further by declaring that, where the instru-
ments "are entirely conventional in form and contain no ambiguity
on their face [as in the hybrid cases heretofore considered] the
problem is not one of ascertaining 'intent', since the parties have
objectively manifested their intent. It is a problem of whether the
intent and acts of these parties should be disregarded in character-
izing the transaction for federal tax purposes." 483 The difference in
approach is largely a semantic one, however, for those courts evi-
dently apply the term "intent" narrowly, as referring to the form
which the parties adopted and the tax and other consequences they
sought to achieve. Those courts, like most others, base their con-
clusions on "all relevant facts and circumstances," whether the
process is described as a search for the "real intent" or an inquiry
whether the "manifested intent" shall be disregarded. The ter-
481 Jordan Co. v. Allen, 85 F. Supp. 437, 444 (M.D. Ga. 1949).
482 Gyro Engineering Corp. v. United States, 276 F. Supp. 454, 465 (C.D. Cal. 1967),
rev'd, 417 F.2d 437 (9th Cir. 1969); accord, Wood Preserving Corp. v. Unitod States,
347 F.2d 117, 119 (4th Cir. 1965); Brinker v. United States, 116 F. Supp. 294, 297
(N.D. Cal. 1953), aif'd, 221 F.2d 478 (9th Cir. 1955) ; Isidor Dobkln, 15 T.C. 31, 33 n,1
(1950), aff'd, 192 F.2d 392 (2d Cir. 1951). The semantic difficulty encountered with the
term "objective intent" is illustrated in S.P. Realty Co., 27 T.C.M. 764, 766n (1968),
in which the opinion as first released read, "we must also look beyond the &ubjeotive
intent of the parties to determine their real intent from all the relevant circumstances,"I
but was later amended to read, "we must also look beyond the objeotive intent of the
parties to determine their subjective intent from all the relevant circumstances."
(Emphasis added.) Whether the intent sought is viewed as "objective," 11roal" or
"subjective," however, it must be "objectively ascertained" from sources other than,
or in addition to, the formal declarations. A.R. Lantz Co. v. United States, 424 F.2d
1330, 1333 (9th Cir. 1970).
483 United States v. Snyder Bros. Co., 367 F.2d 980, 982-83 (5th Cir. 1966), cert.
denied, 386 U.S. 956 (1967), quoting Kraft Foods Co. v. Comm'r, 232 E.2d 118, 123
(2d Cir. 1956); accord, United States v. Hertwig, 398 F.2d 452, 455 (5th Cir. 1908)
("It is well settled that the intent of the parties does not control the tax consequences
of their actions."); Tomlinson v. 1661 Corp., 377 F.2d 291, 299 (5th Cir. 1967) (despite
"heavily extravagant statements found in many judicial opinions . . . the issue Is not
so much what the parties intended, but whether for tax purposes the transaction will be
so recognized"); Farley Realty Corp. v. Comm'r, 279 F.2d 701, 705 (2d Cir. 1960)
("the parties' bona fide intentions may be ignored if the relationship the parties have
created does not coincide with their intentions").

minology used, however, has led the Fifth Circuit into the anoma-
lous position of holding that, whereas the "manifested intent" may
be disregarded in light of all the circumstances if the instrument
is uizambiguously in the form of debt,48 4 the intent of shareholders
to create an indebtedness must be given weight when there are
terms characteristic of stock which make the instrument ambigu-
4 s5
ous.
There are differences other than semantic, however, in the ap-
proach of the decisions to the question of intent (or, in those courts
that purport to disregard intent, in what is required to be estab-
lished by consideration of the surroundng circumstances). Some
decisions would give almost controlling weight to the form adopted,
unless it is found to a "sham or masquerade." 480 Judge Learned
Hand, in a celebrated dissent, declared, "To say that [the test]
is whether the transaction... is a 'sham' or 'masquerade' [is] to
leave the test undefined, because they do not state the facts that are
to be determinative." 41 7 The factual test that he proposed was
whether the transactionI"does not appreciably affect [the taxpay-
er's] beneficial interest except to reduce his tax ... When a tax-
payer supposes that the transaction, in addition to its effect on his
tax, will promote his beneficial interests in the venture, he will of
course secure the desired reduction .... " 4I" Under that view, it
would suffice that the form adopted enables the shareholder-creditor
to share with other creditors in the event of failure,4 80 or to recover
his stake ahead of promoters or service contributors who make
4 90
nominal investments in stock.
The generally prevailing view is less permissive, however, and
may deny the tax benefits of debt "even where the taxpayer could
484 Tyler v. Tomlinson, 414 F.2d 844, 849-50 (5th Cir. 1969).
485 Harlan v. United States, 409 F.2d 904, 908 (5th Cir. 1969) ("surplus notes," pay-
able only from surplus after a certain amount was accumulated).
486J.S. Biritz Construction Co. v. Comm'r, 387 P.2d 451, 459 (8th Cir. 1067);
Gloucester Ice & Cold Storage Co. v. Comm'r, 298 F.2d 183, 185 (1st Cir. 1902); Estate
of Miller v. Comm'r, 239 F.2d 729, 734 (9th Cir. 1956). Belying on such language in the
cases, a taxpayer has persuaded a district court (but not the court of appeals) that
the burden of proof is on the government as in a fraud cwe, because nonrecognition
of the purported debt requires finding "a phony arrangement to defeat tho tax col-
lector." United States v. Intermountain Furniture Mfg. Co., 363 F.2d 54, 556 (10th
Cir. 1966). Regarding business purpose and tax avoidance motivation as tests for recogni-
lion of debt, see text at notes 998-1082 infra.
4s7 Gilbert v. Comm'r, 248 P.2d 399, 412 (2d Cir. 1957).
48 Id. at 411.
489 Charles D. Vantress, 23 T.C.AL 711, 717 (1964).
490 See notes 604 and 632-33 infra.

show that the creditor-debtor relationship had other practical dif-
ferences from equity ownership aside from those relating to
taxes." '41It is generally not enough that the arrangement creates
a debt enforceable under state law, 492 if the purported creditor has
no intention to enforce it according to its terms 41 or, in the case
of an open account or demand note, to call for payment 494 when it
"in any way would weaken or undermine the . . . business." 415
When there is an "understanding and intention, tacit or explicit,
that the assets are committed to the risks of the .. venture in the
same manner as ... money paid in for stock," 490 and will not be
withdrawn until the corporation is conveniently able to pay from
profits "I or from the proceeds of ultimate liquidation of operating
assets,4 98 it evidence that the shareholders are "little interested
in their role as creditors" 4" but are " satisfied to let [their] money
ride with the ups and downs of the venture, hoping ... some day
[to] reap the fruits of a successful investment." 0
That is no doubt a stringent standard, for it is a rare owner of
491
See Arlington Park Jockey Club v. Sauber, 164 P. Supp. 576, 582 (N.D. Ill. 1958),
aff'd, 262 F.2d 902 (7th Cir. 1959).
492Road Materials, Inc. v. Comm'r, 407 F.2d 1121, 1124 (4th Cir. 1969); United
States v. Snyder Bros. Co., 367 F.2d 980, 982 (5th Cir. 1966), cert. dcnied, 386 U.S. 956
(1967); see Kraft Foods Co. v. Comm'r, 232 F.2d 118, 123 (2d Cir. 1956).
493 A.R. Lantz Co. v. United States, 424 F.2d 1330 (9th Cir. 1970) ; Brake & Electric
Sales Corp. v. United States, 287 F.2d 426, 427 (1st Cir. 1961); Gooding Amusement
Co. v. Comm'r, 236 F.2d 159, 163 (6th Cir. 1956), cert. denied, 352 U.S. 1031 (1957).
494 See notes 263 and 267 supra.
495 See Burr Oaks Corp., 43 T.C. 635, 648 (1965), aff'd, 365 F.2d 24 (7th Cir. 1966),
cert. denied, 385 U.S. 1007 (1967); Estate of Herbert B. Miller, 24 T.C. 923, 930
(1955), rev'd, 239 F.2d 729 (9th Cir. 1956); Castle Heights Inc. v. United States, 242
F. Supp. 350, 357 (E.D. Tenn. 1965). See text at notes 577-81 infra.
496 Gyro Engineering Corp. v. United States, 276 F. Supp. 454, 466 (C.D. Cal. 1967),
rev'd, 417 F.2d 437 (9th Cir. 1969); accord, Gooding Amusement Co. v. Comm'r, 236
F.2d 159, 163 (6th Cir. 1956), cert. denied, 352 U.S. 1031 (1957).
497 241 Corp., 15 T.C.M. 901, 905 (1956), aff'd, 242 l.2d 759 (2d Cir.), cert. deaied,
354 U.S. 938 (1957); Isidor Dobkin, 15 T.C. 31, 34 (1950), aff'd, 192 l.2d 392 (2d
Cir. 1951). On the other hand, debt is not negatived by the fact that reasonably
anticipated earnings are the expected (but not the only possible) source for repayment.
See text at notes 929-37 infra.
498 Fin Hay Realty Co. v. United States, 398 F.2d 694, 698 (3d Cir. 1968). See note
923 infra.
499 Charter Wire, Inc. v. United States, 309 F.2d 878, 881 (7th Cir. 1962), cert. denicd,
372 U.S. 965 (1963).
5o Phil L. Hudson, 31 T.C. 574, 583 (1958); accord, Diamond Bros. Co. v. Comm 'r,
322 F.2d 725, 733 (3d Cir. 1963) ("hoped primarily for an increase in the value of its
stock holdings . . . rather than for repayment"); 2554-58 Creston Corp., 40 T.C. 932,
939 (1963) ("principal objective was to make a success out of their venture").

a business -who stands ready to push his corporation to the wall

while the hope for recovery and ultimate profit remains. 0 ' But the
price of being treated like a creditor for tax purposes is that one
must intend to act like a creditor, although perhaps one need not
be as hard-nosed as a banker °2 Since an intention not to act like a
creditor is not to be presumed from the relationship alone, 103 and
since the courts lack "sorcery powers to divine the parties' sub-
jective intent" "4 and cannot "probe the subconscious of the stock-
holder," 505 the intent must be ascertained from objective factors.
In this inquiry, "What the parties do is more important than what
they say." 506
Formal Documentation
The issuance of unconditional promissory notes or bonds, T or

the book treatment of open accounts as liabilities of the corpora-
tion,. °8 isrelevant and entitled to consideration as evidence of in-
tention to create a debt. The prevailing view, however, is that
neither the formal use of notes or debentures ro nor the maldng
of appropriate book entries 510 can obscure the substance of the
transaction. If other factors are sufficiently adverse, the observance
of such formalities will not even suffice to carry the case to the
501 See note 581 infra.
See note 727 infra.
o502
3
50 See notes 583-84 infra.
504 Ragland Investment Co., 52 T.C. 867, 876 (1969), aff'd per curiam, 435 F.2d 118
(6th Cir. 1970).
505 Albert Ravano, 26 T.C.M. 793, 799 (1967). See note 2 supra.
508 Wilbur Security Co. v. Comm'r, 279 F.2d 657, 662 (9th Cir. 1960).
507TLiflans Corp. v. United States, 390 F.2d 965, 969 (CL CL 1908); Lundgren V.
Comm'r, 376 F.2d 623, 626 (9th Cir. 1967); Gloucester Ice & Cold Storage Co. v.
Comm'r, 298 P.2d 183, 185 (1st Cir. 1962); Wilshire & Western Sandaichw, Inc. r.
Comm'r, 175 F.2d 718, 720 (9th Cir. 1949); Charles E. Curry, 43 T.C. 007, 68G-87
(1965).
508Byerlite Corp. v. Williams, 286 F.2d 285, 290 (6th Cir. 1960); Scotland Mfills,
Inc., 24 T.C.M. 265, 274 (1965).
5o9 Fin Ray Realty Co. v. United States, 398 F.2d 694, 697-98 (3d Cir. 1968) ; United
States v. Henderson, 375 F.2d 36, 40 (5th Cir. 1967); United States v. Intermountain
Furniture M1fg. Co., 363 F.2d 554, 556 (10th Cir. 1966); Brake & Electric Sales Corp.
v. United States, 287 F.2d 426, 428 (1st Cir. 1961); Gilbert v. Comm'r, 248 F.2d 399,
402, 409 (2d Cir. 1957); Gooding Amusement Co. v. Comm'r, 230 P.2d 159 (6th Cir.
1956), cert. denied, 352 U.S. 1031 (1957); Affiliated Research, Inc. v. United States,
351 F.2d 646, 648 (Ct. CL 1965).
510 Diamond Bros. Co., 21 T.C. . 696, 705 (1962), aff'd, 322 F.2d 725 (3d Cir. 1903)
(book entries of "slight significance" in face of other evidence); Fred L Nystrom,
28 T.C.L 1050, 1055 (1969). See W.C. Gamman, 46 T.C. 1, 10 (1966).

TAX LAW REVIEV [Vol. 26:
jury. 1' A cognovit note, 12 or even a mortgage note,' is not im-
mune from question.
On the other hand, the failure of the taxpayer to follow form
may well be used as evidence that debt was not intended.1 4 The
absence of appropriate corporate action to authorize borrowing,"'
the "rather casual" issuance of notes without bothering to specify
the maturity or the interest rate, 5' 6 or the failure to issue notes at
all 517 may be adverse evidence, unless the circumstances are such
(as in the case of a running account for sales of goods) that such
formalities would not be normal practice even in arm's length
dealings.5 18 Such deficiencies, however, are usually cited by the
courts only as makeweights, where the other facts are also adverse,
and they have little significance in themselves.1 9
511 Tyler v. Tomlinson, 414 F.2d 844 (5th Cir. 1969); Berkowitz v. United States,
411 F.2d 818 (5th Cir. 1969).
512 Stanley, Inc. v. Schuster, 295 F. Supp. 812, 815 (S.D. Ohio 1969), aff'd, 421
F.2d 1360 (6th Cir.), cert. denied, 400 U.S. 822 (1970); Max D. Gustin, 27 T.C.M. 186
(1968), aff'd, 412 F.2d 803 (6th Cir. 1969).
613 Stanley, Inc. v. Schuster, supra note 512. See text at notes 547-50 infra.
514When the taxpayer "seeks a tax-advantage by reason of terminology selected
by itself to describe its relationship and obligation," its self-serving nature limits the
weight to be accorded to form; but the use of forms inconsistent with debt may have
the weight of an admission against interest. See First Mortgage Corp. v. Comm'r, 135
F.2d 121, 123-24 (3d Cir. 1943). See -note 442 supra.
515 Cohen v. Comm 'r, 148 F.2d 336, 337 (2d Cir. 1945); Powers Photo Engraving
Co., 17 T.C. 393, 400-01 (1951), remanded on other grounds, 197 F.2d 704 (2d Cir.
1952). But of. Ray v. United States, 68-1 U.S.T.C. 9152 (M.D. Tenn. 1967) (holding
such authorization unnecessary, as a pure formality in a closely held corporation).
56 Jones v. Comm'r, 357 F.2d 644, 645 (6th Cir. 1966).
517 Anthony V. Donisi, 26 T.C.M. 327, 330-31 (1967), aff'd, 405 F.2d 481 (6th Cir.
1968); Wood Preserving Corp. v. United States, 347 F.2d 117, 119 (4th Cir. 1965);
American-La France-Foamite Corp. v. Comm'r, 284 F.2d 723, 725 (2d Cir. 1960), cort.
denied, 365 U.S. 881 (1961); see I.R.C. § 385(a), added by section 415(a) of the Tax
Reform Act of 1969. It would seem particularly adverse if the informality goes to the
extent of the shareholder paying corporate expenses directly and pocketing corporate
receipts as payments on the debt. Montclair, Inc., 21 T.C.M. 39, 42 (1962), affld, 318
F.2d 38 (5th Cir. 1963); Lewis L. Culley, 29 T.C. 1076, 1087 (1958). Replacement of
an open account with notes after a tax question had been raised would have littlo if any
weight even prospectively. Wilbur Security Co., 31 T.C. 938, 949, 950 (1959), aff'd, 279
F.2d 657 (9th Cir. 1960).
518 American Processing & Sales Co. v. United States, 371 F.2d 842, 857 (Ct. C.
1967) ("Noninterest bearing open accounts resulting from mutual trading are a com-
mercial commonplace, and none can say that an enforceable obligation to repay does
not arise fully as much as from a promissory note."); Scotland Mills, Inc., 24 T.C.M.
265, 274-75 (1965); cf. Rowan v. United States, 219 F.2d 51, 55 (5th Cir. 1955)
(attaching no significance to the absence of notes for working capital advances because
the balance was changing frequently).
519 Byerlite Corp. v. Williams, 286 F.2d 285, 290-91 (6th Cir. 1960); Ortmayor v.

If the shareholder advances are entered on the books, not as

accounts payable, but as "donated surplus" (or the equivalent),
thereby representing to outside creditors that the funds are at the
risk of the business, it is evidentiary that no debt was intended,"'0
although proof of a mistake of the bookkeeper or of an unauthor-
ized officer in making the entry may be ground for relief,5-1 at least
if the error was timely corrected and not exploited by taking in-
consistent positions. 522 Likewise, cancellation of a bona fide share-
holder debt, in order to improve the balance sheet, ordinarily should
negative continued existence of indebtedness.52 Yet, in a surprising
number of decisions, the courts have been willing to disregard such
public representations, regarding both initial contributions to sr-
plus 524and later advances 525 or debt cancellations 121 so designated,
Comm'r, 265 F.2d 848, 855 (7th Cir. 1959). Such lacks are "at best clues to proof of
the ultimate fact." C.M. Gooch Lumber Sales Co, 49 T.C. 649, 056 (1908). "Formal
debt paraphernalia of this type in a closeknit family... are not as necessary to insure
repayment as may be the ease between unrelated entities .... " American Processing &
Sales Co. v. United States, 371 F.2d 842, 857 (CL. CL 1967). Cf. Diamond Bros. Co. v.
Comm'r, 322 F.2d 725, 732 (3d Cir. 1963) (absence of notes "9hould not weigh in the
balance" -when purported creditor was in control and free to take repayment at Will).
520 Lewis L. Culey, 29 T.C. 1076, 1089 (1958) ; R.E. Nelson, 19 T.C. 575 (1952) ; of.
Frank Nelson, Jr., 17 T.C.M. 888, 903 (1958), aff'd on another issue, 281 F.2d 1 (5th
Cir. 1960) (treated on books as accounts payable, but on balance sheets as paidain
capital). Cf. text at notes 442-74 supra, concerning use of the form of preferred stock.
-5 2 lOrtmayer v. Comm'r, 265 F.2d 848, 853 (7th Cir. 1959); Wilshire & western
Sandwiches, Inc. v. Comm'r 175 F.2d 718, 720 (9th Cir. 1949); McCarty v. Cripe, 52-2
U.S.T.C. 9437 (S.D. Ind. 1952), aff'd on another issue, 201 F.2d 679 (7th Cir. 1953);
B.A. Faucher, 29 T.C.M. 950 (1970). Cf. Com'r v. Callner, 287 F.2d 642 (7th Cir.
1961); Powers Photo Engraving Co., 17 T.C. 393, 400 (1951), remanded on other
groun&, 197 F.2d 704 (2d Cir. 1952) ("the uncontrolled judgment of an accountant
can hardly determine the legal character of these advances").
522 Failure to correct the entry would tend to 'negative the claim of mistak:o (Oak
Hill Finance Co., 40 T.C. 419, 434-35 (1963)), as would the basing of inconsistent tax
positions thereon (R.E. Nelson, 19 T.C. 575, 580 (1952)). Cf. O.H. Kruse Grain & Mill-
ing, 18 T.C.M. 487, 490 (1959), aff'd, 279 F.2d 123, 126 (9th Cir. 1060). But in Charles
H. Martin, 13 T.C.M. 1, 4 (1954), the taxpayer was held not estopped by such a shift of
position. In Carl G. Ortmayer, 28 T.C. 64, 69 78 (1957), the taxpayer's sworn state-
ment, for excess profits tax purposes, that the advances were intended as equity capital,
as originally shown on the books, was taken as evidence against him in later taxing re-
payment as a dividend. The decision was reversed in Ortmayer v. Commi~sioner, 265 F.2d
848, 854 (7th Cir. 1959), on the ground that the Commissioner, with equal inconsistency,
had rejected the excess profits tax claim.
523 Lidgerwooa Mfg. Co. v. Comm'r, 229 F.2d 241 (2d Cir.), cert. denied?, 351 U.S.
951 (1956) ; Bratton v. Comm'r, 217 P.2d 486, 489 (6th Cir. 1954) ; Estate of Liggett v.
Comm'r, 216 F.2d 548 (10th Cir. 1954); Oak Hill Finance Co, 40 T.C. 419 (1903);
Walter C. M Minn, Jr., 21 T.O.M. 913, 925 (1962).
524 Charles H. Martin, 13 T.C.M. 1 (1954); cf. Harlan v. United States, 409 F.2d 904
(5th Cir. 1969) ("surplus notes" issued to shareholders by a life insurance company
for part of their investment, maturing only when earned surplus was sufficient to replace

TAX LAW RTIEW [Vol. 26:
upon finding a private intention of the corporation and its share-
holders that the amounts would be repaid when and if the corpora-
tion was conveniently able to do so. 27
Investors are sometimes uncertain at the outset what capital
structure they wish to establish, and they may then advance the
entire initial funds of their corporation as purported loans, or
without specific designation, with a view to making an allocation
to capital at a later date. Such initial formal ambiguity may make
the status of the entire amount suspect, 28 although it may not be
fatal if the allocation ultimately made between debt and capital is
5 29
a reasonable one.
the amount; not considered legal liabilities under state law, but so treated for federal
tax purposes).
525 Ortmayer v. Comm'r, 265 P.2d 848, 853 (7th Cir. 1959) (1"capital loans
to be paid... out of future earnings when and as such funds are availablo"; originally
entered as donated surplus) ; Weaver v. Comm'r, 58 F.2d 755 (9th Cir. 1932) (verbal
understanding that amounts entered as contributed surplus would be returned at some
future date).
528 Jennings v. Comm'r, 272 F.2d 842, 844 (7th Cir. 1959) (note surrendered in time of
stringency, and credited to "contributed or paid-in surplus"; minutes recited that
amount would be repaid when board of directors "Ideems such action advisablo1; rof or-
ence in minutes to Weaver v. Comm'r, 58 F.2d 755 (9th Cir. 1932), accepted as evidonce
of intent); Austin Village, Inc. v. United States, 296 F. Supp. 382, 392, 396 (N.D. Ohio
1968), rev'd, 432 F.2d 741 (6th Cir. 1970) (notes changed to capital contributions, with.
drawable only with unanimous consent of directors; nomenclature explained by nood
for outside financing). But of. Oak Hill Pinance Co., 40 T.O. 419, 435 (1963) ("In.
tended that their loans, at least for a few years, were to be made available to the cor-
poration as working capital,"2 hence as equity).
527 As we have seen, such an indefinite intention is often enough to deny recognition
even to that which on its face is debt. See text at notes 224-70 supra.
528 Sam Schnitzer, 13 T.C. 43, 62-63 (1949), aff'd, 183 F.2d 70 (9th Cir. 190),
cert. denied, 340 U.S. 911 (1951); S.P. Realty Co, 27 T.C.M. 764) 765, 767 (1908);
Broadway Drive-In Theatre, Inc. v. United States, 220 F. Supp. 707, 710 (fl.D. Mo.
1963). In each case, the inadequacy of the nominal capital, as finally determined, was
such that the purported debt might well have been denied recognition even if the allo-
cation had been duly made at the outset. Cf. Wilbur Security Co., 31 T.C. 938, 949-50
(1959), aff'd, 279 F.2d 657 (9th Cir. 1960), in which, instead of paying in their sub.
scriptions for $25,000 of stock, the investors deposited $200,000 in a special stock-
holders' account; later they satisfied their stock subscriptions by capitalizing earnings,
leaving the stockholders' account outstanding for many years as a purported loan, which
was not recognized. When it is established that the initial purported loans were in-
tended to be credited on stock subscriptions if and when the corporation got under way,
they may be viewed as equity capital even though the condition never happened. Scott
Fink, 23 T.C.M. 475, 479 (1964). But of. Royalty Service Corp. v. United States, 178 F.
Supp. 216 (D. Mont. 1959).
529 Wilshire & Western Sandwiches, Inc. v. Comm'r, 175 P.2d 718 (9th Cir. 1949),
reversing 7 T.C.M. 406, 410 (1948). It has been argued that such afterthoughts should
not be held against the taxpayer because, even if the ambiguous initial contribution was
equity, it could have been converted into recognizable debt when the definitive ontrios

Declarations of the Parties
Conclusory declarations that the parties intended to create debts,

or intended to limit their investment to a certain amount, evidence
only "an agreement about mere form" r30 and, while no doubt ad-
missible as evidence, 31 should have little weight, whether em-
bodied in formal corporate resolutions 512 or expressed in testi-
mony.53 The question whether a shareholder making advances to
his own corporation really intended, at the time they were made,
to act like a creditor regardless of the success of the business must
be answered primarily from circumstantial evidence 134 rather than
from interested testimony. Since a "court is not bound by what
[the] parties say they intended if their actions were inconsistent
with their words," 535 a means of testing such testimony is afforded
in cases where, in response to the needs of the business, the pur-
ported creditors failed to enforce the obligation according to its
terms.5 38 But if the business prospered and the advances were
repaid, any testimony concerning what would have been done in
circumstances that did not arise is purely hypothetical 537-like the
answer to the question, "Would you have married your present
wife if you had met Mary first?" 538 While a candid answer to the
were made. Fuchs, Thi2n Incorporation-Debtor Stock?, 5 AI. U. INST. 141, 163 (1953).
That analysis, however, opens the possibility of dividend treatment of the conversion
itself (to the extent of earnings and profits at the time). See Fin Hay Realty Co. v.
United States, 398 F.2d 694, 698-99 (3d Cir. 1968); ef. text at notes 758-65 infra.
530 Sam Schnitzer, 13 T.C. 43, 62 (1949), aff'd, 183 F.2d 70 (9th Cir. 1950), cert.
denied, 340 U.S. 911 (1951).
531 See generahy, regarding testimony to one's own intention, 2 Wiaioa, EvmzcE
§ 581 (3d ed. 1940).
532Donisi v. Comm'r, 405 F.2d 481, 483 (6th Cir. 1968) (such evidence "can appro-
priately be viewed with some diffidence unless supported by other facts which bring the
transaction much closer to a normal arm's length loan"); S.P. Realty Co., 27 T.C.M.
764, 766 (1968).
533Roatd Materials, Inc. v. Comm'r, 407 l.2d 1121,M 1124 (4th Cir. 1969); Diamond
Bros. Co. v. Comm'r, 322 F.2d 725, 731 (3d Cir. 1963); Farley Realty Corp. v. Comm'r,
279 F.2d 701, 705 (2d Cir. 1960) ; Crawford Drug Stores, Imc. v. Unitea States, 220 F.2d
292, 296 (10th Cir. 1955); Sam Schnitzer, 13 T.C. 43, 62 (1949), aff'd, 183 F.2d 70
(9th Cir. 1950), cert. denied, 340 U.S. 911 (1951).
534 See Sarkes Tarzian, Inc. v. United States, 240 F.2d 467, 470 (7th Cir. 1957).
s35 Wood Preserving Corp. v. United States, 347 F.2d 117, 119 (4th Ci. 1905).
537 See James D. Lancaster, 23 T.C.M. 631, 634 (1964) ("we do not knov. vhat would
have happened here had the corporation not been successful and other creditors had
pressed claims"); cf. Murphy Logging Co. v. Unitea States, 239 F. Supp. 794, 707 (D.
Ore. 1965), rev'd, 378 F.2d 222 (9th Cir. 1967), quoted at note 659 infra.
538 Such contrary to fact hypotheticals are not unfamiliar in the tax law. E.g., under
section 269, "woul [you] have bought the stock if [the corporation] had not had a lom3

question may help destroy the taxpayer's case, 53a an answer care-
fully tailored to his interests may defy verification.
Nevertheless, some decisions appear to give substantial weight
to such self-serving resolutions 540 and testimony; 541 and the tax-
payer's failure to present testimony that a debt was intended42-to
be enforced has been viewed as an element adverse to his case.
Security and Sinking Fund
The taking of security, provided it validly places the shareholder-

lender in a position superior to general creditors,54 3 is powerful
evidence that a debt was intended, 44 even if the security is only a
carry-forward"? Goodwyn Crockery Co., 37 T.C. 355, 364 (1961), aff'd, 315 P.2d 110
(6th Cir. 1963).
59 A.R. Lantz Co. v. United States, 283 F. Supp. 164, 170 (C.D. Cal. 1968), aff'd,
424 F.2d 1330 (9th Cir. 1970) (testimony that enforcement rights would not have
been "exercised under any normal circumstances"); Wood Preserving Corp. v. United
States, 347 F.2d 117, 119 (4th Cir. 1965) (testimony that repayment was intended only
if profits were earned); Brake & Electric Sales Corp. v. United States, 287 F.2d 420, 428
(1st Cir. 1961) (testimony that repayment would never have been demanded if the cor-
poration would be required to borrow elsewhere); Gooding Amusement Co., 23 T.C. 408,
419 n.5 (1954), aff'd, 236 F.2d 159 (6th Cir. 1956), cert. denied, 352 U.S. 1031 (1957)
(testimony that family obligations could be put off whereas other creditors had to be
paid); John S. Taft, 20 T.C.M. 1135, 1138 (1961), rev'd, 314 F.2d 620 (9th Cir. 1963)
(testimony that shareholder-creditor, to preserve good credit rating, would have seen
that other creditors be paid before he was). But of. Modern Woodworking, Inc. v.
United States, 69-1 U.S.T.C. 9256 (D. Colo. 1968) (testimony that bank would have
been paid first if corporation got into difficulty brushed aside as "purely theoretical").
540 Scotland Mills, Inc., 24 T.C.M. 265, 274 (1965) (resolution formally limiting
capital to be invested, listed first of several factors deemed controlling).
541Woolley Equipment Co, 268 F. Supp. 358, 363 (E.D. Tex. 1966) (testimony of
shareholder was unequivocal that he intended sales, not capital contributions, to wholly
owned corporations, and was corroborated by the form used and the business purpose for
the transactions); J.B. Reilly, 14 T.C.M. 22, 25 (1955).
5420.H. Kruse Grain & Milling v. Comm'r, 279 F.2d 123, 120 (9th Cir. 1900),
affirming 18 T.C.M. 487, 490 (1959) (court was entitled to draw adverse inference from
silence, which left intent "only partially explained"); Anthony V. Donisi, 26 T.C.M.
327, 331 (1967), aff'd, 405 F.2d 481 (6th Cir. 1968).
543 In some circumstances, security given by an inadequately capitalized corporation
for advances by a shareholder may be invalid in bankruptcy. International Tel. & Tel.
Corp. v. Holton, 247 F.2d 178 (4th Cir. 1957); Arnold v. Phillips, 117 F.2d 497 (5th
Cir.), cert. denied, 313 U.S. 583 (1941). See notes 326-37 supra. Compare the cases, note
465 supra, concerning preferred stock for which an ineffective attempt was made to pro-
vide a lien. In Estate of Herbert B. Miller, 24 T.C. 923, 934 (1955), in finding that
shareholder advances were not intended as loans, the court expressed Serious doubts
concerning the validity of the chattel mortgage taken as purported security therefor.
In reversing on the question of intent, the Ninth Circuit did not discuss the validity
or effect of the security. Estate of Miller v. Comm'r, 239 F.2d 729 (9th Cir. 1956).
54 Estate of Ernest G. Howes, 30 T.C. 909, 923 (1958), aff'd sub norn. Comm'r v.
Johnson, 267 F.2d 382, 385 (1st Cir. 1959); Washmont Corp. v. Hendrickson, 137 P.2d
306, 308 (9th Cir. 1943); J.I. Morgan, Inc., 30 T.C. 881, 891 (1958), rcv'd on another

junior lien.54 5 The failure to record or file the security interest is

regarded by some as merely a permissible subordination of the
debt to certain other creditors and purchasers,"O and by others as
evidence of a lack of a bona fide intention to create a debt. " But
the evidentiary weight of the taking of security is clearly vitiated
if the property constituting the security is grossly inadequate,"1B or
if the purported creditor fails to enforce his rights,"4 0 or if en-
forcement is not permitted until after senior debt has been fully
satisfied 5 0 The nonrecognition of secured "debts" can give rise
to the curious anomaly of "equity" interests which are superior,
under state law, to unsecured advances (made under different
circumstances) which may be recognized as debts for tax pur-
poses.""
The failure to take security is not necessarily inconsistent with
issue, 272 F.2d 936 (9th Cir. 1959); Harry F. Shannon, 29 T.C. 702, 718 (1958); War-
ren H. Brown, 27 T.C. 27, 35 (1956); Acherson v. United States, 277 F. Supp. 475, 477
(W.D. Ky. 1967). A valid prior lien may even cause preferred stock to be recognized as
debt. See note 465 supra.
-45 Charles E. Curry, 43 T.C. 667, 693 (1965); Plastic Toys, Inc., 27 T.C.M. 707, 710
(1968).
546Evwalt Development Corp., 22 T.C.M. 220, 227 (1963). Cf. American Processing
& Sales Co. v. United States, 371 F.2d 842, 845, 852 (CL C1. 1967) (giving weight to
equitable vendor's lien as security, although it was vulnerable to bona ilde purchasers).
Regarding subordination generally, see text at notes 282-337 supra.
547Marsan Realty Corp., 22 T.C.M. 1513, 1522 (1963); 85 Es Realty, Inc. v. United
States, 59-1 U.S.T.C. 9232 (S.D.N.Y. 1958) (jury instructions).
54sAmbassador Apartments, Inc., 50 T.C. 236, 245 (1968), affd, 400 F.2d 288 (2d
Cir. 1969) (fourth mortgage with very narrow margin); Morris Moughon, 22 T.O.M. 94,
100 (1963), aff'd, 329 F.2d 399 (6th Cir. 1964) (debentures purportedly scured by
general lien, but tangible assets behind them were nominal); American-La France-
Foamite Corp., 18 T.C.M. 447, 452 (1959), aff' d, 284 P.2d 723 (2d Cir. 190), cert. de-
nied, 365 U.S. 881 (1961) (assignment of receivables, which never equalled the ever
growing advances); Marsan Realty Corp., 22 T.C.M. 1513, 1521 (1963); Bon P. Gale,
15 T.C.M. 518, 524 (1956). The effect of inadequacy of the security may be overcome if
the purported debt is otherwise protected, as by a reasonable sinking fund. Leach Corp.,
30 T.C. 563, 576 (1958).
549Motel Co. v. Comm'r, 340 F.2d 445, 446 (2d Cir. 1965). The dissipation of the
security through partial releases given without commensurate payment is also adverse
evidence. Stanley, Inc. v. Schuster, 295 P. Supp. 812, 816 (S.D. Ohio 1909), aff'd, 421
F.2d 1360 (6th Cir.), cert denied, 400 U.S. 822 (1970).
550 Reef Corp., 24 T.C.M. 379, 397 (1965), aff 'Id, 368 F.2d 125, 132 (5th Cir. 1960),
cert. denied, 386 U.S. 1018 (1967); Foresun, Inc., 41 T.C. 706, 709, 717 (1964), aff'd,
348 F.2d 1006 (6th Cir. 1965); cf. text at notes 306-09 supra.
55 Motel Co., 22 T.C.M. 825 (1963), aff 'd, 340 F.2d 445 (2d Cir. 1905) (no appeal by
Commissioner on the unsecured debts that were recognized). of. Reef Corp., 24 T.CLM.
379 (1965), aff1'd, 368 F.2d 125 (5th Cir. 1966), cert. denfcd, 38G U.S. 1018 (1907)
(second and third mortgage notes denied recognition so far as held by continuing sharo-
holders, but not questioned so far as held by retiring shareholders, whose third mortgage
notes were legally inferior to the unrecognized second mortgage notes of the others).

an intention to create a debt, since debentures and other unsecured

obligations are common in the business world and may be sound
risks, 55-2 at least when the business is an established one, Na and has
ample equity.' 54 Usually, when the absence of security has been
weighed against the taxpayer, that was only one of many factors
tending to negative a genuine indebtedness." When a corpora-
tion has had a history of losses,; 56 or when outside creditors de-
manded (or, if asked for credit, would have demanded) security,5' 7
the failure of a shareholder to take security for his advances may
cast doubt upon his intention to act like a creditor, as well as upon
his reasonable expectation of repayment 5 8 Yet those are the very
circumstances in which some sympathetic courts consider that a
shareholder could not reasonably be expected to embarrass his cor-
poration's capacity for outside financing by taking security but
still would intend that his insecure advances be collectible as
debts. 59
552 J.S. Biritz Construction Co. v. Comm'r, 387 F.2d 451, 459 (8th Cir. 1967); Jack
Daniel Distillery v. United States, 379 F.2d 569, 582-83 (Ct. Cl. 1967); Luden's, Inc. v.
United States, 196 F. Supp. 526, 533-34 (E.D. Pa. 1961); Charles D. Vantress, 23 T.C.M.
711, 718 (1964).
553 Arthur F. Brook, 23 T.C.M. 1730, 1738 (1964), rev'd on another issue, 360 .2d
1011 (2d Cir. 1966).
554 Jack Daniel Distillery v. United States, 379 F.2d 569, 583 (Ct. Cl. 1967) ; Decker
v. United States, 244 F. Supp. 31, 33 (N.D. Iowa 1965). But of. Anthony V. Donis,
26 T.C.M. 327, 330 (1967), aff'd, 405 F.2d 481 (6th Cir. 1968), in which the failure to
take a lieu on the assets acquired with the advances, which "were of a kind which nor-
mally are considered excellent security," was deemed evidence of an intent to make
capital contributions.
555 Although one writer has construed Benjamin D. Gilbert, 17 T.C.M. 20 (1958), aff'd,
262 F.2d 512 (2d Cir.), cert. denied, 359 U.S. 1002 (1959), as signifying that the
absence of security was the biggest single factor (Note, Financing of SmaZl Corporations:
Debt or Equity?, 42 MARQ. L. REv. 387 (1959)), the court's finding was that, in the
circumstances, no independent party would have made the advance without security;
and there were six other factors negativing a debt, with no relative weights assigned to
them by the court.
55a Jewell Ridge Coal Corp. v. Comm'r, 318 F.2d 695, 699 (4th Cir. 1963); Benjamin
D. Gilbert, 17 T.C.M. 29 (1958), aff'd, 262 F.2d 512 (2d Cir.), cert. denied, 359 U.S.
1002 (1959).
557 Wood Preserving Corp. v. United Ctates, 347 F.2d 117, 119 (4th Cir. 1965); Affil.
iated Research, Inc. v. United States, 351 F.2d 646, 648-49 (Ct. 01. 1965) ; Zephyr Mills,
Inc., 18 T.C.M. 794, 795, 799 (1959), aff'd, 279 F.2d 494 (3d Cir. 1960); Gilbert v.
Comm 'r, 248 F.2d 399, 410 (2d Cir. 1957) (concurring opinion); Brard A. Mattlliesson,
16 T.C. 781, 786 (1951), aff'd, 194 F.2d 659 (2d Cir. 1952). But of. J.S. Biritz Con-
struction Co. v. Comm'r, 387 F.2d 451, 459 (8th Cir. 1967).
558 Concerning the relevance of reasonable expectation of repayment, see text at notes
766-91 infra.
559 American Processing & Sales Co. v. United States, 371 F.2d 842, 856 (Ct. Cl. 1907)
Austin Village, Inc. v. United States, 296 F. Supp. 382, 394 (N.D. Ohio 1968), rcv'd,
432 F.2d 741 (6th Cir. 1970).

The absence of a sinking fund or some form of reserve to pro-

vide for the ultimate retirement of purported debt is often referred
to as evidence of the lack of an unconditional intent that the obli-
gation be repaid, since repayment in a lump sum might require
liquidation of essential assets. 60 The lack may be excused, however,
-where a sinking fund would be inappropriate, if there is other evi-
dence of the reality of the debt.50 ' On the other hand, the presence
of a sinldng fund provision, even if the requirement is dependent
upon earnings,r 62 may afford affirmative evidence of the intent to
repay 563-unless, of course, the provision is disregarded in prac-
tice. " "' It can be particularly significant in the case of a long-term
debt, which may come under scrutiny of the taxing authorities be-
fore there would otherwise be any history of repayments of prin-
cipal to corroborate the asserted intention2A
The genuineness of an indebtedness may also be evidenced by
protective provisions limiting the giving of mortgages, the in-
curring of other debts, or the payment of dividends and salaries
while the purported debt is outstanding 6°---although their eviden-
560 Tyler v. Tomlinson, 414 F.2d 844, 849 (5th Cir. 1969) ; NationnI Farmers Union
Service Corp. v. United States, 67-1 U.S.T.C. 9234 (D. Colo. 1967), aff'd, 400 F.2d
483 (10th Cir. 1968); Morris Moughon, 22 T.C.M. 94, 100 (1963), aff'd, 329 F.2d 399
(6th Cir. 1964); Charter Wire, Inc. v. United States, 309 F.2d 878, 881 (7th Cir. 1962),
cert. dnied, 372 U.S. 965 (1963); see Hickman, Incorporationand Capitai7iation:The
Threat of he "'PotentialInome" Item and a Sensible Approach to Problecas of Thin-
ness, 40 TAX=s 974 992 (1962).
561 J.S. Biritz Construction Co. v. Comm'r, 387 F.2d 451, 457 (8th Cir. 1967) (de-
claring that a sinking fund would be in order in a large debenture issue but would be
"unwonted" in the case of advances by a sole shareholder for development of land for
sale); Luden's, Inc. v. United. States, 196 P. Supp. 526, 533-34 (E.D. Pa. 1001); Green
Bay Structural Steel, Inc., 53 T.C. 451, 457-58 (1969); see Fin Hay Realty Co. v. United
States, 398 F.2d 694 702 (3d Cir. 1968) (dissenting opinion) (absence caled mot signifi-
cant where corporation holds appreciating real estate and contemplates repayment of
shareholder advances from refinancing).
562 Provision for a sinking fund out of earnings may strengthen the otherr iso inade-
quate security of an obligation ultimately payable unconditionally. Leach Corp., 30 T.C.
563) 576 (1958). .But cf. Fellinger v. United States, 238 F. Supp. 67, 76-77 (N.D. Ohio
1964), aff'd, 363 F.2d 826 (6th Cir. 1966). Such a sinking fund requirement in pre-
ferred stock, however, will not suffice to classify it as debt. Sea note3 448-51 mpra.
563 1661 Corp. v. Tomlinson, 247 F. Supp. 936, 937 (3.D. Fla. 1005), aff'd, 377 P-41d
291 (5th Cir. 1967); Blaise, Inc. v. United States, 59-2 U.S.T.C. 9725 (E.D. La. 1959)
(fixed amortization designed to assure full payment in 20 years, and additional sum based
on gross, not net, earnings).
564National Savings & Trust Co. v. United States, 285 F. Supp. 325, 33. (D.D.C.
1968). But cf. Leach Corp., 30 T.C. 563, 577-78 (1958) (bondholders consented to use
of sinking fund as working capital for war production).
56.5 Hickman, The Thin Corporation:Another Look at an Old Disease, 44 TAxms 883,
892 (1966). See text at note 691 infra.
588 Baker Commodities, Ine., 48 T.C. 374, 399-400 (1967), aff'd on another isme, 415

TAX LAW REVIEW [Vol. 26:•
tiary effect may be adverse if, having been provided, they are dis-
regarded in practice. 6
Proportionality
One of the "very pertinent circumstances" which may raise

WO8
a "strong inference" 51 that what is in form debt is truly equity
investment is the fact that the purported debt is held in substan-
tially the same proportions as the corporate stock.?7 When the par-
ties are in effect dealing with themselves, it is necessary to look be-
yond the form-the notes with a fixed maturity and rigid creditor
safeguards-to determine from all the circumstances the intrinsic
71
economic character of the transaction.
Once it is acknowledged, however, that a shareholder may oc-
cupy a dual status as investor and creditor, proportionality per so
cannot be viewed as affirmative evidence for treatment of purported
debt as equity. 7 2 Proportionality negatives what would otherwise
have been a powerful argument for debt treatment, 517 and thus
"render[s] the relationship suspect"M and subject to "close
F.2d 519 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970); Luden's, Inc. v. United
States, 196 F. Supp. 526, 532-34 (E.D. Pa. 1961). The Commissioner's argument in
those cases that such requirements were inconsistent with debt, because evidencing a
proprietary control of the business, was rejected. However, their affirmativo weight is
lessened by the fact that they are also not uncommon in preferred stock. See note 453
supra.
567 Fellinger v. United States, 238 P. Supp. 67, 77 (N.D.Ohio 1964), af'cd, 363 F.2d
826 (6th Cir. 1966); Ram Corp. v. United States, 805 F. Supp. 831, 833 (W.D.N.C.
1969).
5s Wachovia Bank & Trust Co. v. United States, 288 F.2d 750, 756 (4th Cir. 1961).
569 Charter Wire, Inc. v. Comm'r, 309 F.2d 878, 880 (7th Cir. 1962), cert. dented, 372
U.S. 965 (1963), criticized in Note, Taxation-Classification of Advances to Close Cor.
porations by Shareholders--Debtor Equity, 1964 Wis. L. Rzv. 331. See also 2554-58
Creston Corp., 40 T.C. 932, 936 (1963).
670 Bee I.R.C. § 385(b) (5), added by section 415(a) of the Tax Reform Act of 190{9.
57X See text at notes 477-81 supra.
172 Wilshire & Western Sandwiches, Inc. v. Comm'r, 175 F.2d 718, 721 (9th Cir. 1949).
See also Harlan v. United States, 409 F.2d 904, 909 (5th Cir. 1969) (proportionality isa
factor to consider but has no significant importance); J.S. Biritz Construction Co. v.
Coimn'r, 387 F.2d 451, 457, 459 (8th Cir. 1967) (factor is "not applicable" to advances
by a sole shareholder, since any advance by him would be proportionate and it is up to
Congress to set the limits); Kraft Foods Co. v. Comm 'r, 232 F.2d 118, 123-24 (2d Cir.
1956) (scheme of statute, by taxing corporation and shareholder separately, gives legal
significance to transactions between them, even though they have little economic signifl.
cance).
s73 See Piedmont Corp. v. Comm'r, 388 F.2d 886, 889 (4th Cir. 1968); Ambassador
Apartments, Inc., 50 T.C. 236, 244-45 (1968), aff'd, 406 F.2d 288 (2d Cir. 1969). Con-
erning the effect of disproportionality, see text at notes 595-640 infra.
574 Sayles Finishing Plants, Inc. v. United States, 399 F.2d 214, 221 (Ct. Cl. 1908).

1971] CORPORATE, DEBT
scrutiny." But ordinarily there must be "something more," of

the nature hereafter discussed, to support the inference that the
shareholder did not really intend to act like a creditor.570
Nevertheless, the strength of the inference that may be drawn
from the mere fact of proportionality may vary 'with the standard
of conduct which the particular court (or judge) expects of a cred-
itor who also has shareholder interests to consider. If, as some de-
cisions have suggested, debt may be negatived where the share-
holder does not intend or expect to demand or enforce payment at
maturity if it "in any way would weaken or undermine the busi-
ness" 577 or if it -would "impair the credit rating of the corporation,
cause it to borrow from other sources the funds necessary to meet
the'payments, or bring about its dissolution," *18 there would seem
to be not merely an inference but an almost irrebuttable presump-
tion to that effect arising from the fact of the relationship itself.50
Experience with "the mainsprings of human conduct" 1so tells us
that "it is not within the realm of sane business practice,"
and therefore could not have been intended, that a controlling
shareholder-creditor, except in extremis, would take action which
would have the effect of "killing or irreparably debilitating the
goose that lays the golden eggs." s On the other hand, if the
court feels, in Professor Bittker's phrase, that a shareholder-cred-
itor need not be "as authentic a Shylock as an outside lender," , 2
unquestionably the existence of the relationship, by itself, affords
no evidentiary basis for inferring that he would let the funds ride
indefinitely with the ups and downs of the business 583 or would not
575Kraft Foods Co. v. Comm'r, 232 P.2d 118, 123 (2d Cir. 195G); Wilslbio & Westorn
Sandwiches, Inc. v. Comm 'r, 175 F.2d 718, 721 (9th Cir. 1949); M lone & Hyde, Inc., 49
T.C. 575, 578 (1968).
576 Liflans Corp. v. United States, 390 F.2d 965, 971 (CL CL 1968); Piedmont Corp.
v. Comm'r, 388 F.2d 886, 889 (4th Cir. 1968); see Fin Hay Realty Co. v. Unitcd States,
398 F.2d 694, 701-02 (3d Cir. 1968) (dissenting opinion).
578 Gooding Amusement Co., 23 T.C. 408j 418-19 (1951), aff'd, 236 F.2d 159 (6th Cir.
1956), cert. denied, 352 U.S. 1031 (1957).
579 BEPTEER & EUSTICE, FEDERAL II.cor TA-ATioN or Co0ronAT'0.S A .-D Sxw.-
HOWERS 127 (2a ed. 1966).
580 See Comm'rv. Duberstein, 363 U.S. 278, 289 (1960).
581 See Mu~lin Building Corp., 9 T.C. 350, 355-56 (1947), a'd, 167 F.2d 1001 (3d
Cir. 1948).
582 BITTnE & EtuSTICE, FEDE-AL Ixcom. TAzATION op Caron 0TmND Su=.
oLEws 126 (2d ed. 1966). See Earle v. W.I. Zones & Son, 200 P.2d 846, 850 (9th
Cir. 1952). See discussion in text at notes 705-33 infra.
583 Cf. Fin Hay Realty Co. V. United States, 398 F.2d 694, 697 (3d Cir. 1968) ("To
seek economic reality in objective terms of course 'disregards the personal interest which
a shareholder may have in the welfare of the corporation in which he is a dominant

assert his creditor position in the event of bankrupty.584 But, when
coupled with evidence that it was clear from the outset that a de-
mand for payment "would have completely havocked the corpora-
tion," proportionality may still support the inference that, unlike
outside creditors, the shareholders were "extremely unlikely" to
have contemplated enforcement "under any normal circum-
stances." 1
Proportionality may have affirmative evidentiary weight also
where the stock and purported debt are locked together by a re-
quirement or understanding that shareholders make and maintain
proportionate advances, 816 to be repaid only when all can be paid
proportionately, 5 7 that each incoming shareholder make an equiv-
alent advance, 588 that stock and purported debt be transferred only
as a unit,5 89 or that demand for repayment of the advance be ac-
companied by surrender of stock for redemption. 00 For " Ia reluc-
tance to 'lend' money to the corporation unless [one's] fellow
shareholders 'lend' proportionate amounts belies a feeling of con-
fidence that the funds will be returned regardless of the success of
the venture." '591
force. But an objective standard... is much fairer than one which would presumptively
construe all such transactions against the shareholder's interest.").
584 Piedmont Corp. v. Comm'r, 388 F.2d 886, 889-90 (4th Cir. 1968).
685 Tyler v. Tomlinson, 414 F.2d 844, 849 (5th Cir. 1969).
586 Arlington Park Jockey Club v. Sauber, 164 F. Supp. 576, 585 (N.D. Ill. 1958), af'd,
262 F.2d 902, 906 (7th Cir. 1959) ; Gilbert v. Comm'r, 248 P.2d 399, 401, 407, 409-10
(2d Cir. 1957); of. Wilbur Security Co., 31 T.C. 938, 949-50 (1959), aff'd, 279 lP.2d
657 (9th Cir. 1960). But cf. Austin Village, Inc. v. United States, 296 F. Supp. 382,
386-87, 395 (N.D. Ohio 1968), rev'd, 432 F.2d 741 (6th Cir. 1970). The fact that ad-
vances, initially disproportionate, are later brought into balance may evidence such an
understanding. A.R. Lantz Co. v. United States, 283 F. Supp. 164, 169 (C.D. Cal. 1968),
aff'd, 424 F.2d 1330 (9th Cir. 1970); cf. Mason-Dixon Sand and Gravel Co., 20 T.C.M.
1351, 1358 (1961).
587 241 Corp., 15 T.C.M. 901, 905 (1956), aff'd, 242 P.2d 759 (2d Cir.), ocrM denied,
354 U.S. 938 (1957).
588 Charter Wire, Inc. v. United States, 61-2 U.S.T.C. 9769, p. 82,043 (E.D. Wis.
1961), aff'd, 309 F.2d 878 (7th Cir. 1962), cert. denied, 372 U.S. 965 (1963); Heart of
Atlanta Motel, Inc. v. United States, 63-1 U.S.T.C. I 9110 (N.D. Ga. 1962). But of.
Austin Village, Inc. v. United States, 296 P. Supp. 382, 389 (N.D. Ohio 1968), rev'd,
432 F.2d 741 (6th Cir. 1970).
589 Universal Castings Corp., 37 T.C. 107, 113, 115 (1961), aff 'd, 303 F.2d 620 (7th
Cir. 1962). But of. Brighton Recreations, Inc., 20 T.C.M. 127, 132 (1961).
59OLockwood Realty Corp., 17 T.C.M. 247, 251 (1958), aff'd, but rev'd on othcr
grounds, 264 F.2d 241 (6th Cir. 1959).
591 Gilbert v. Comm'r, 248 F.2d 399, 407 (2d Cir. 1957). It -was presumably in this
sense that the court in J.S. Biritz Construction Co. v. Commissioner, 387 F.2d 451, 457
(8th Cir. 1967), note 572 supra, said that the proportionality test is "not applicable" in
the case of a sole shareholder who, of course, would be bound by no agreement with his

On the other hand, it has been said that, if the purported debts
are freely transferable, this "substantially dispels the element of
proportional control," 692 since the obligation might conceivably
pass into the hands of someone who would be more inclined than a
shareholder to enforce it according to its terms. Other courts have
viewed with proper skepticism the possibility that a shareholder
would be any more likely to place such a weapon in the hands of
an adverse party than to use it himself.5 3 In the case of a widely
held corporation, however, there is no reason to suppose that
initial proportionality, resulting from a package sale of stock and
debentures, will long endure. 9
Disproportionality
The farther we get from proportionality, the more respect is

paid to the form in which the parties have cast their arrange-
ment. s9 If the rights and remedies provided are those of cred-
itors, rather than those of preferred shareholders, it is ordinarily
assumed that unrelated investors will take all appropriate steps for
collection -withlittle concern for the effect on the ultimate success
of the corporation,"96 and that the corporation would not have un-
fellows, although he would be even less likely than members of a group to act to the
detriment of the equity interest.
592 Tomlinson v. 1661 Corp., 377 F.2d 291, 297 (5th Cir. 1967) ; accord, United State3
v. Haskel Engineering & Supply Co., 380 F.2d 786, 788 (9th Cir. 1967); Fin Hay Realty
Co. v. United States, 398 F.2d 694, 702 (3d Cir. 1968) (dissenting opinion). Concerning
the effect when purported debt, initially held proportionately, becomes disproportionate ,
see text at notes 757-65 ifra
593 Coleman Good, Inc. v. United States, 65-2 U.S.T.C. 9750 (W.D. Pa. 1965), aff'ds
359 F. 2d 434 (3d Cir. 1966); Brake & Electric Sales Corp., 185 F. Supp. 1, 4 (D. Mass.
1960), aff'd, 287 F.2d 426 (Ist Cir. 1961) ; Xraft Foods Co.v 21 T.C. 513, 599 (1954),
rev'd, 232 F.2d 118 (2d Cir. 1956); 1432 Broadway Corp., 4 T.C. 1158 (1945)2 aff'd,
160 F.2d 885 (2a Cir. 1947). The court in 1661 Corp. and the dissenting judge in Vin
Hay, note 592 supra, in contrast, saw no significance in the fact that no separate transfers
had actually occurred, explaining it by presuming that the obligations may have been
retained simply because they were good investments in themselves. A stronger case for
disregard of proportionality may have been made in Estate of Miller v. Commissoner,
239 F.2d 729, 732-33 (9th Cir. 1956), where it was known from the outset that the stock
and notes held by a dying shareholder would shortly pass to a trustee who T.ould have a
fiduciary obligation to enforce the notes; yet the trustee would seem to have the same
motivation as any other shareholder-creditor to give primary consideration to the corpo-
ration's interests. Foresun, Inc., 41 T.C. 706, 718 (1964), aff'd, 348 F.2. 1000 (6th Cir.
1965). See Goldstein, Corporate Intdebtedness to Shareholders: "Tdn Capitalization"
and Belated Problem., 16 TAx L. REV. 1, 30 (1960). See also note 625 infra.
591 Green Bay Structural Steel, Inc., 53 T.C. 451, 456 (1969) ; Medical Tor.er, Inc. v.
United States, 69-1 U.S.T.C. 19305 (E].D. Va. 1969).
595 Cf. note 276 supra.
596 See Tyler v. Tomlinson, 414 F.2d 844, 849 (5th Cir. 1969) (fact that demand for

TAX LAW EVEW [Vol. 26:
dertaken more than it genuinely expects to perform 0 Except in
certain extreme situations,598 such factors as thin capitalization,
by which the reality of the expressed intentions of shareholder-
creditors is tested,"9" have little relevance where outside parties
are involved. 0 0
The same favorable inferences are frequently drawn where mi-
nority 601 or even one or more of the controlling (02 shareholders
make all the advances, or where all the shareholders participate
but in proportions varying with their available cash rather than
with their relative shareholdings.60 3 Like inferences may be drawn
when debt instruments are issued to certain of the organizers of a
corporation in order to adjust the proprietary interests in desired
proportions different from the relative amounts contributed by
them. 60 4 The premise is that the shareholder-creditor who holds
payment "would have completely havocked the corporation [is] normally . . . not
unacceptable to a creditor in search of repayment").
597 See Fn Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1068) (an
" arm 's-length relationship ... inevitably results in a transaction whose form mirrors its
substance").
800 Leach Corp., 30 T.C. 563, 578-79 (1958) (close corporation financed by sale
of bonds to independent investors, who also acquired 48 per cent of stock for nominal
price; I'disproportion tends strongly to neutralize the inferences that might otherwise
be drawn from the high debt-to-equity ratio," which was at least 400 to 1); W.H.
Traschel, 29 T.C. 433, 439 (1957) (ratio of 22,000 to 1 given no significance in a boot-
strap sale of business to an exempt entity, since "the alleged bondholders . . . and
stockholders are [not] the same persons"); Now England Lime Co., 13 T.C. 799, 804
(1949) (stock and bonds were widely distributed and not held in uniform proportion);
Rev. ul. 68-54, 1968-1 C.B. 69 (ratio of subordinated debentures, held by nonshare-
holders, to equity capital exceeded 20 to 1 by an unspecified amount, sinco ratio would
be as low as 20 to 1 only if debentures were considered stock). Since one of the tests
of the reality of shareholder debt is what an outside lender would have advanced (see
text at notes 946-81 ifra), an actual loan by an outsider is the best evidence of its
own reality as debt. See Piedmont Corp. v. Comm'r, 388 F.2d 886, 889 (4th Cir. 1968).
6ol Weldon D. Smith, 17 T.C. 135, 145 (1951), rev'd on another issue, 203 P.2d 310
(2d Cir. 1953) (almost all advances were by 20 per cent shareholder); B.M.C. Corp.,
11 T.C.M. 376, 378 (1952) (viewing related groups as units, holders of 3.5 per cont
of stock held 70 per cent of debt, and holders of 92 per cent of stock hold 30 per cent
of debt); Decker v. United States, 244 F. Supp. 31, 32-33 (N.D. Iowa 1965) (advances
by 25 per cent shareholder alone, not increasing his equity).
002 Ortmayer v. Comm'r, 265 F.2d 848, 855 (7th Cir. 1959) (no evidence that others
made advances in proportion to those of 50 per cent shareholder); Earle v, W.J.
Jones & Son, 200 F.2d 846, 850 (9th Cir. 1952) (proportionate advances by 80 per cent
of shareholders, but none by others).
803 Hofert Co. v. United States, 69-1 U.S.T.C. 9220, p. 84,003 (C.D. Cal. 1969);
Austin Village, Inc. v. United States, 296 F. Supp. 382, 397 (N.D. Ohio 1968), rcv,'d,
432 F.2d 741 (6th Cir. 1970).
e04 J.I. Morgan, Inc., 30 T.C. 881 (1958), rev 'd on another issue, 272 F.2d 936 (9th

debt instruments resulting from contributions out of proportion

to his potential benefit from the success of the business is more
likely to exercise his legal right to recover that excess. But the
courts go beyond the logic of the situation when they stress rela-
tively inconsequential variations in the proportions of stock and
debt,6 0 5 and when they presume that not merely the excess of a
shareholder's purported debt claims over his proportionate share
but the entire amount purportedly owed to him and his fellows is
more likely to be enforced to the detriment of the corporation than
if the amounts were strictly proportionate.00 0
In some instances, the same or related transactions will give rise
to purported indebtedness to shareholders and also to unrelated
parties. Although some courts hold that "the same instruments
[cannot be] stock in the hands of some holders and debts in the
hands of others," 07 that is not a universal principle, for the share-
holder's and nonshareholder's attitude toward enforcement of the
same obligation may be entirely different.0 08
Cir. 1959) (property sold to corporation on credit in order not to dilute 40 per cent
ownership of employees who lacked capital to contribute); Sheldon Tauber, 24 T.C. 179,
184 (1955) (variations in amounts of notes reflected differences in withdrawals from
predecessor partnership); Bulkley Dntn & Co., 20 T.C.M. 000, 601-62, 005 (1901)
(one -who had supplied 80 per cent of capital, but was to bold only 65 per cent of stoc,
was given note for excess) ; cf. Murphy Logging Co. v. United States, 239 F. Supp. 794,
796, 797 (D. Ore. 1965), rev'd, 378 F.2d 222, 223 (9th Cir. 1967) (form of sale of
business to corporations allegedly adopted in order to equalize formerly disproportion-
ate ownership, but viewed by district court as masquerade to enable stepping-up asset
basis; appellate court viewed such tax avoidance as not evil if not done evilly).
605 Arthur V. MfcDermott, 13 T.C. 468, 471 (1949) (eight equal owners received pro-
portionate notes aggregating $100,000, and three of them, for a reason not stated, re-
ceived additional notes aggregating $8,148, which sufficed to make their interests as credi-
tors and stockholders "inot identical"; debt recognized although only $5,533 in property
was paid in for stock). See also cases cited at note 603 supra.
cos Cf. AT., Iwcomm TAx PROBLt-S op CoRPORLTxioS AwD SuAnrOLDfS 422-23 (Re-
port of Working Views of Staff, 1958), suggesting that only the excess over one's pro-
portionate share be viewed as non pro rata.
607 Utility Trailer Mfg. Co. v. United States, 212 F. Supp. 773, 790 (S.D. Cal. 1902),
relying on Gloucester Ice & Cold Storage Co. v. Comm'r, 298 F.2d 183, 185 (1st Cir.
1962). Of course, the fact that unrelated parties made loans on the same terms is evi-
deuce of the corporation's capacity to borrow at arm's length. Jaeger Auto Finance Co.
v. Nelson. 191 P. Supp. 693, 697 (E.D. Wis. 1961) (loans made by shareholders and by
two nonstoeckholding employees on same terms).
608 Reef Corp., 24 T.C.M. 379, 396-98 (1965), affI'd, 368 F.2d 125 (5th Cir. 1960),
cert. denied, 386 U.S. 1018 (1967) (notes resulting from purported sae of businez to
corporation owned by part of old shareholders, not questioned as debt in hands of re-
tiring shareholders, but denied recognition so far as continuing shareholders held them);
Gilbert v. Cowm'r, 262 F.2d 512, 514 (2d Cir.), cert. denicd, 359 U.S. 1002 (1959) (no
inconsistency in denying recognition to purported loans by one Ehareholder w7hilo recog.
nizing loans by his wife and by an equal shareholder (the latter apparently not having
even been questioned by the Commissioner), since "each person had a sufficiently dif.

The judicial emphasis on disproportionality has led some com-
mentators to suggest, as a protective measure, that the share-
holders vary their proportions of stock and debt. For example, if
A and B each put $5,000 in the business, A might take $3,000 in
debt and $2,000 in stock, while B takes $2,000 in debt and $3,000 in
stock. 09 The trouble is that, if the purported debts are subject to
the kind of risks that would ordinarily lead to nonrecognition for
tax purposes if they had been made proportionately, A is likely
to want some offsetting advantage to compensate him for enjoying
only 40 per cent of the chance of profit while exposing himself to
substantially 50 per cent of the potential loss. If there is a col-
lateral agreement under which the purported lender has a claim
over against the other investors for indemnification against any
loss of advances in excess of his proportionate equity interest, the
courts will view the advances as proportionate.61 0 If the compensat-
ing arrangement is more subtle-e.g., if A takes a correspondingly
larger interest in some other venture, so that over all their inter-
ests in stock and purported debt are substantially in proportion, 1 '
or if the redemption price of the "debt" instruments is adjusted
to give an equivalent profit to the makers of the excess advances 012
-it is doubtful that many courts would be blinded to the reali-
ties. 1 3
If the shareholders and purported lenders are part of a single
economic unit, it may be more feasible (but less effective) for them
to vary the proportions. Although the several statutory provisions
by which certain family members are IIconsidered'I to own the stock
ferent relationship with [the corporation] to justify these conclusions"). See Stone,
Debt-Equity Distinctions in the Tax Treatment of the Corporation and Its Shareholders,
42 TuL. L. REv. 251, 256-57 (1968).
809 This is referred to as an "important planning technique" in Weis, Successfu ly In-
corporatingThin, 51 IL. B.J. 898 (1963).
010 Sam Schnitzer, 13 T.C. 43, 52, 62-63 (1949), aff'd, 183 F.2d 70 (9th Cir. 1950),
cert. denied, 340 U.S. 911 (1951); of. Milton T. Raynor, 50 T.C. 762, 769 (1968) (such
advances deemed proportionate in deciding for taxpayer under section 1.1371-1(g) of
the regulations, note 107 supra); Scott Fink, 23 T.C.M. 475 (1964) (advances, although
disproportionate, were to have been credited on stock subscriptions if corporation had
gotten license to operate); R.H. Bodzy, 21 T.C.M. 219, 231 (1962), rev'd on other
grounds, 321 F.2d 331 (5th Cir. 1963) (disproportionate advances were equalized after
corporation failed).
61, See Boughner, How the Tax-Wise Investor Buys Real Estate Today, 9 J. TAXATIoN
30, 32 (1958).
612 Alden Homes, Inc., 33 T.C. 582, 588-89, 605-07 (1959).
613 Stone, Debt-Equity Distinctions in the Tax Treatment of the Corporation and Its
Shareholders,42 Tim. L. REv. 251, 264 (1968).

held by others 614 have not been made applicable for present pur-
poses,6 5 efforts to take advantage of that omission have rarely met
with success. Since the disproportionality of advances to nominal
equity does not give rise to a statutory immunity from nonrecogni-
tion, 16 but only to a factual inference that the purported lenders
would act like creditors, the force of that inference may be weak-
ened by the existence of the relationship, whether or not the rela-
tionship is one that would fall within the ambit of the statutory at-
tribution rules. 617 Accordingly, almost without exception, husband
and wife have been treated as a unit for purposes of determining
proportionality of their advances,018 as have minor children and
their parents. 19 Generous parents, mothers-in-law and grand-
814 M.g., I.RC. §§ 267(c), 318(a), and 544 (a). See Ringel, Surrey & Warren, Adtrbu.
tion of Stock Ownership in the Internal Revenue Code, 720 HAnv. L. Rzr. 209 (1953).
615 Such provisions apply only with respect to statutory rules that expressly incorporate
them. See Hyman H. Berghash, 43 T.C. 743, 757 (1965), aff'd, 3G1 F.2d 257 (2d Cir.
1966); Rev. Rul. 59-187, 1959-1 C.B. 224, cited in the present connection in Catalina
Homes, Inc., 23 T..M 1361, 1367 (1964). One of the ways in which the debt-equity
question may arise involves whether the redemption of purported debt, if it is deemed
equity, is essentially equivalent to a dividend under section 302 (note O supra), which
is a provision to which the attribution of ownership rules of section 318 xpr qaly apply.
But since "the matter of characterization logically precedes the use of the constructive
ownership rules," it is doubtful that section 318 could be applied even in such a case
to the threshold. question of whether the purported debt is stock subject to section 302.
See Roekier, Transfers to Controlled Corporaions: Considerations of Thinness and
3Muitplicity, 39 TxEs 1078, 1092 n.91 (1961). Section 318 was not relied upon in apply-
ing section 302 to repayment of family held debt in Burr Oaks Corp., 43 T.C. 635, 648,
651-52 (1965), aff'd, 365 F.2d 24 (7th Cir. 1966), cert. denied, 385 US. 1007 (1967).
616 ee text at notes 595-600 supra.
61 See Stone, Debt-Equity Distinctions in the Tax Treatment of the Corporationand
Its Shareho7ders, 42 Ttm L. REv. 251, 263-61 (1968). The forthcoming regulations
authorized by section 385, added by section 415(a) of the Tax Reform Act of 1909, in
dealing with the factor of "the relationship between holdings of stock of the corpo-
ration and holdings of the interest in question" (LR.C. § 385(b)(5)), might appro-
priately cover the matter of family relationship. See text at notes 1457-61 infra.
ME=Burr Oaks Corp., 43 T.C. 635, 648 (1965), aff'd, 365 P.2d1 24 (7th Cir. 1906),
cert. den cd, 385 U.S. 1007 (1967); P.M. Finance Corp. v. Commxr, 302 P.2d 780,
787, 789 (3d Cir. 1962); Gooding Amusement Co., 23 T.C. 408, 418-19 (1954), aff'd,
236 F.2d 159 (6th Cir. 1956), cert. denied, 352 U.S. 1031 (1957); Peco Co., 26 T.C.M.
207, 212 (1967). The Tax Court's lapse in recognizing loans by a wife whilo disal1ow-
ing those by her shareholder husband, in Benjamin D. Gilbert, 15 T.C.3L. 088, 694 (1950),
remande oan another point, 248 F.2d 399 (2d Cir. 1957). was regretted (but could not
be rectified) by it on remand, 17 T.C.M. 29, 30 (1958), aff'd, 262 P.2d 512 (2d Cir.),
cert. denied, 359 U.S. 1002 (1959).
619 Gooding Amusement Co., 23 T.C. 408 (1954), aff'd, 230 F.2d 159 (Oth Cir. 1056),
cert. denied, 352 U.S. 1031 (1957); Demor, Inc., 27 T.C.M. 1496, 1497-98, 1501 (1968)
(loans from savings bank Totten trusts created and controlled by father for infants);
Ryan Contracting Co., 15 T.C.M. 999 (1956) (loans by daughter, of undkiclosed age, of
money given to her by parents at Christmas).

mothers-in-law, whose motivation was to help set their descendants
up in business, have not been viewed as arm's length lenders.0 20 Ad-
vances made by brothers and sisters 621 or by adult children and
their spouses, 22 at least if theirs is a close-knit family group, are
similarly suspect, but may be viewed as arm's length transactions
if the family members are " knowledgeable" and "capable of inde-
pendent action." 623 With one significant exception, 24 the courts
have generally been skeptical of the argument that a family trustee
or executor, as a purported creditor, would act independently of
the interests of the beneficiaries, who were also the shareholders
of the corporation.62
Advances between corporations in common control are judged by
620 Dilin v. United States, 433 F.2d 1097, 1102 (5th Cir. 1970); United States v. Hen-
derson, 375 F.2d 36, 38 (5th Cir. 1967); Foresun, Inc., 41 T.C. 706, 716-18 (1964), aff'd,
348 F.2d 1006 (6th Cir. 1965); Motel Co. v. Comm'r, 340 F.2d 445 (2d Cir. 1965); W.O.
Covey, Inc., 28 T.C.M. 1379 (1969); Catalina Homes, Inc., 23 T.C.. 1301, 1307
(1964).
621 Burr Oaks Corp., 43 T.C. 635, 648 (1965), aff'd, 365 F.2d 24 (7th Cir. 1966),
cert. denied, 385 U.S. 1007 (1967) ; Murphy Logging Co. v. United States, 239 F. Supp.
794, 797 (D. Ore. 1965), rev'd, 378 F.2d 222 (9th Cir. 1967); Wilbur Security Co., 31
T.C. 938, 942, 946-47, 951 (1959), aff'd, 279 F.2d 657 (9th ir. 1960); Randolph D.
Rouse, 23 T.C.M. 1823, 1824, 1837 (1964); Dezso Goldner, 27 T.C. 455 (1956).
622 Gloucester Ice & Cold Storage Co., 19 T.C.M. 1015, 1017, 1020 (1960), rcvd, 298
F.2d 183 (1st Cir. 1962); Wilbur Security Co., 31 T.C. 938 (1959), aff'd, 279 F.2d 057
(9th Cir. 1960).
623 Charles E. Curry, 43 T.C. 667, 687 (1965); accord, Comm'r v. Proctor Shop, Inc.,
82 F.2d 792 (9th Cir. 1936) (father of shareholder); Arthur V. McDermott, 13 T.C.
468 (1949) (brothers and sisters, with slight disproportion among them); Hofort Co.
v. United States, 69-1 U.S.T.C. 1 9220 (C.D. Cal. 1969) (spouses and adult children
of shareholders, who were brother and sister); Jaeger Auto Finance Co. v. Nelson, 191
F. Supp. 693, 695, 697 (E.D. Wis. 1961) (advances by 85 per cent shareholder, hils
daughters and their spouses, were not in proportion to their stock). The Curry case is
criticized in Stone, Debt-Bquity Distinctions in the Taz Treatment of the Corporation
and Its Shareholders, 42 Tu-L. L. REv. 251, 270 (1968), on the ground that "ITho share.
holders were so closely related and the debt-equity ratio so high that the court should
probably have required them to satisfy a heavier burden than could be mot by demeanor
evidence. "
624 Estate of Miller v. Comm'r, 239 F.2d 729 (9th Cir. 1956), discussed in note 693
supra.
625 Affiliated Research, Inc. v. United States, 351 F.2d 646, 649 (Ct. Ci. 1965);
Foresun, Inc., 41 T.C. 706, 717-18 (1964), aff'd, 348 F.2d 1006 (6th Cir. 1965); Zephyr
Mills, Inc., 18 T.C.M. 794, 799 (1959), aff'd, 279 F.2d 494 (3d Cir. 1960). In Affiliated
Research, the government had failed to challenge purported loans by trusts the share-
holders had created for wives and children, while denying recognition to advances by
an estate of which the shareholders were sole beneficiaries. The court did not pass on
the validity of the differentiation (p. 649 n.6). Perhaps an independent trustee or executor
might be expected to deal at arm's length with the corporation (of. Alden B. Oakes,
44 T.C. 524 (1965), and cases cited therein), although this may be open to question
if the trust or estate, by itself or in conjunction with its beneficiaries, is a propor.
tionate holder of stock and purported debt.

0
the same standards as proportional advances by shareholders,
even -whenthere are some variations in the minority interests in the
debtor and creditor corporations, 7- and even when one party is,
or is owned by, a family charitable foundation. It has been argued
in a dissenting opinion that it is illogical to treat the sister corpo-
ratibn as having made a capital contribution because any profit re-
sulting from the use of the funds will benefit, not the purported
lender, but its shareholders 2 ' Logic, however, might lead, not to
the conclusion that the corporation made loans (since it may not
have any more intention than its shareholders would have had to
enforce the claim), but to the view that a corporation which per-
mitted its shareholders to enjoy the chance of profit from the funds
advanced thereby made a taxable distribution to them.00
626 Liles Production Co, 28 T.C.M. 1387, 1413 (1969), on appeal to the Fifth Circuit;
Charles W. Williams Contracting Co., 25 T.C.M. 500, 504 (1966); Ludwig Baumann &
Co., 20 T.C.M. 1415, 1421 (1961), aff'd, 312 F.2d 557 (2d Cir. 1963); of. Republic Steel
Corp. v. United States, 159 F. Supp. 366 (CL CL 1958). Similarly, advances by an in-
dividual to a corporation in which another of his corporations as a beneficial interest
may be judged with due regard for his indirect interest. Cf. Randolph D. Rouse, 23
T.C.M. 1823, 1837 (1964).
627 Road Materials, Inc. v. Comm'r, 407 F.2d 1121, 1124 (4th Cir. 1969); North-
eastern Consolidated Co. v. United States, 406 P.2d 76 (7th Cir.), cert. denied, 393 U.S.
819 (1969); of. Jewell Ridge Coal Corp. v. Comm'r, 318 F.2d 695, 098-99 (4th Cir.
1963) (purported lender owned only two thirds of the stock of debtor but "remainder
was owned in large measure by persons closely tied" to it, through ownership of bare
majority of lender's stock). When significant disproportionality is found to exift, it is
based upon looking through corporate entities to the ultimate beneficial ownerahip.
B.M.C. Mfg. Corp., 11 T.C.M. 376, 378 (1952). But of. E.W. MeGab, 20 T.O.M. 783,
789-90 (1961), in which the court declined to view multiple corporations in the aggregate
for purposes of applying the proportionality and other debt-equity tests.
628 C.M. Gooch Lumber Sales Co., 49 T.C. 649, 650, 659 (1968).
629 Northeastern Consolidated Co. v. United States, 406 F.2d 76, 81 (7th Cir), cert.
denied, 396 U.S. 819 (1969); cf. Washington Institute of Technology, Inc., 10 T.C.Of.
17,19 (1951).
630 Cf. David A. Aysworth, 22 T.C.M. 1111, 1113-14 (1963); Morrison Industrie3,
Ine., 21 T.C.M. 853, 864 (1962). See Road Materials) Inc., 26 T.C.M. 922, 931-32 (19G7),
aff'd without discussing this issue, 407 F.2d 1121 (4th Cir. 190). However, unless the
court is able to find that one corporation made the purported loan to the other without
the intention to recover the funds in any manner, rather than merely that it intended to
acquire an interest in the nature of a senior equity (i.e., preferred stock), there wil
have been no distribution to their mutual shareholder which could be taxed as a dividend.
Of. General Aggregates Corp. v. Comn'r, 313 F.2d 25, 28 (1st Cir.), cal. denied, 375
U.S. 815 (1963); W.B. Rushing, 52 T.C. 888, 893-94 (1969), on appeal to the Fifth
Circuit. If there is at least a "tenuous" business purpose for the corporation to make
the investment, it may be viewed as not made "solely for the personal benefit of the
shareholders." Christie Coal & Coke Co., 28 T.C.M. 498, 523-24 (1969). If the sister
corporation is on the verge of bankruptcy, and further advances may result in salvaging
something on previous debts to the lending corporation but not in restoring value to the
stock, there can be no resulting dividend to the shareholders except to the extent that

Instances of genuine disproportionality may arise when it is
agreed that certain of the shareholders are to provide all or most
of the necessary financing, while others supply their skills or con-
tribute the business opportunity. Frequently in such cases the ini-
tial capitalization of the corporation is nominal, with the financiers
taking purported debt in recognition of their right to recoup their
investment before profits are shared. 63' Some decisions, even where
the undercapitalization is extreme, give almost controlling weight
to such disproportionality, declaring that the need to avoid diluting
the relative interests of the noncontributing shareholders is a suffi-
cient business purpose for all-debt financing 63 2 and evidences an
intention "to require for their own purposes that the debts created
be actually treated as valid obligations." (33 Other decisions, often
citing the fact that the noncontributing shareholders had made bal-
ancing contributions of another sort,(34 have declined to recognize
investors' advances as debt despite the failure of promoters, find-
ers, inventors or key employees to contribute proportionately to
their equity interests. 3 5 Almost invariably, however, such cases
the advances enable the debtor to discharge obligations on which the shareholders Oro
guarantors. Old Dominion Plywood Corp., 25 T.C.M. 678, 699-700 (1966).
6s The more cautious may take preferred stock for a portion of their investment in
order to give an appearance of substance to the capitalization. See Horwitz, AZlocation
of Stock Between Services and Capital in the Organization of a (lose Corporation, 75
HARV L. R v. 1098, 1121 (1962).
632 Piedmont Minerals Co. v. United States, 429 F.2d 560 (4th Cir. 1970) ; Lots, Inc.,
49 T.C. 541, 547 (1968); Baker Commodities, Inc., 48 T.C. 374, 398 (1067), aff'd on
anotherissue, 415 F.2d 519 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970); J.1. Mor-
gan, Inc., 30 T.C. 881, 890-91 (1958), rev'd on another issue, 272 F.2d 936 (9th air.
1959); Gordon Lubricating Co., 24 T.C.M. 697, 710-11 (1965).
633 Davidson Bldg. Co., 20 T.C.M. 1291, 1297-98 (1961) ; accord, Earle v. W.Y. Jones
& Son, 200 F.2d 846, 850 (9th Cir. 1952); Leach Corp., 30 T.C. 563, 578-79 (1958).
884 Reed v. Comm'r, 242 F.2d 334, 335 (2d Cir. 1957); Sansberry v. United States,
70-1 U.S.T.C. 9216 (S.D. Ind. 1970); Broadway Drive-In Theatre, Inc. v. United
States, 220 F. Supp. 707, 710 (E.D. Mo. 1963); Ben P. Gale, 15 T.C.M. 518, 524 (1956).
But cf. Gordon Lubricating Co., 24 T.C.M. 697, 711 n.6 (1965), declaring that if the
know-how and skills furnished by one were deemed to balance the cash advanced by the
others, he should have received debentures for them.
885 Sherwood Memorial Gardens, Inc. v. Comm'r, 350 F.2d 225, 227 (7th Cir. 1905);
Gardens of Faith, Inc., 23 T.C.M. 1045, 1061 (1964), aff'd, 345 F.2d 180 (4th ir.),
cert. deied, 382 U.S. 927 (1965); Schine Chain Theatres, Inc., 22 T.C.M. 488, 501
(1963), aff'd, 331 F.2d 849 (2d Cir. 1964); Diamond Bros. Co. v. Comm'r, 322 F.2d
725, 731-32 (3d Cir. 1963); American-La France-Foamite Corp. v. Comm'r, 284 F.2d
723, 725 (2d Cir. 1960), cert. denied, 365 U.S. 881 (1961); Aldon Homes, Inc., 33 T.O.
582, 605-07 (1959); Phil. L. Hudson, 31 T.C. 574, 583 (1958); Lewis L. Culloy, 29
T.C. 1076, 1088 (1958); The Colony, Inc., 26 T.C. 30, 43 (1956), aff'd on another issue,
244 F.2d 75 (6th Cir. 1957), rev'd, 357 U.S. 28 (1958); Phil Kalech, 23 T.C. 672, 675-76,
680 (1955); cf. James L. Stinnett, Jr., 54 T.C. 221, 229 (1970), on appeal to the
Ninth Circuit.

have involved extreme inadequacy of capital; 030 for, if the corpora-

tion is otherwise soundly financed, such investors might well be
more inclined to act like creditors, despite the intangible contribu-
lions of others, than they would be if enforcement action would af-
fect their equity interests in strict proportion to their claims.
Genuine disproportionality also loses its evidentiary weight
where advances are made under conditions of financial crisis, when
substantial stockholders may pump in more capital (in the guise of
loans) in a desperate effort to salvage their equity position, without
regard to the ability or willingness of others to do the same. 37
The nonrecognition of disproportionate advances as debt, partic-
ularly when the purported lenders own none of the nominal stock,
poses some conceptual difficulties. The courts sometimes label them
capital contributions, citing the principle that even nonshareholders
may make contributions to the capital of corporations.6 That
analysis, however, if pushed to its logical conclusion, could have
the wholly unwarranted consequence of causing the basis of the
corporate assets to be reduced by the amount so contributed.6
636 Even 'where there was a strong debt-equity ratio, however, one decision has found
a "complete identity of interest" (indicating, along with other evidence, that the obli-
gation -would not be enforced to the detriment of the corporation) despite the fact that
nearly 25 per cent of the stock was held by employees who made no advances. Gooding
Amusement Co., 23 T.C. 408, 415, 418 (1954), aff'd, 236 F.2d 159 (6th Cir. 1956), cert.
denied,352 U.S. 1031 (1957).
637 William L. Copley, 27 T.C.M. 383 (1968) ; Rludolph A. Zivnuslm, 33 T.C. 220, 228,
235 (1959) ; Ben P. Gale, 15 T.C.M. 518, 525 (1956) ; Samuel T. Tauber, 11 T.C.M. 269,
273-74 (1952); :Fred A. Bitdmaier, 17 T.C. 620, 626 (1951). Concerning salvage loans
generally, see text at notes 982-97 infra.
6ss Sherwood Memorial Gardens, Inc. v. Comm'r, 350 F.2d 225, 227 (7th Cir. 1965);
Foresun, Tne., 41 T.C. 706, 716 (1964), aff'd, 348 F.2d 1000 (6th Cir. 1905); Motel Co.,
22 T.C.M. 825, 832 (1963), af'Id, 340 F.2d 445 (2d Cir. 1965). The courts cited Fection
362(e); Brown Shoe Co. v. Comm'r, 339 U.S. 583 (1950); nd Veterans Foundation v.
Comm'r, 317 F.2d 456 (10th Cir. 1963), -which arose out of an entirely different type of
situation (gratuitous contributions from wholly unrelated parties).
6s9 In reaction to Brown Shoe Co. v. Commissioner, 339 U.S. 583 (1950), Congress pro-
vided in section 362(e) that if a capital contribution is made other than "by a sbare-
holder as such," it shall have a zero basis or, if in cash, shall result in reduction of the
basis of certain corporate assets. In Sherwood Memorial Gardens, Inc., 42 T.C. 211, 227
(1964), aff'd, 350 F.2d. 225 (7th Cir. 1965), the corporation acquired cemetery land in
exchange for its obligation to pay 25 per cent of lot sale proceeds to the transferors, wvho
owned none of the nominal stock. The court analyzed the transaction as a capital con-
tribution by noishareholders, resulting in a zero basis for the land. If the contingent cer-
tificates had been properly viewed as a class of stock, the corporation's basis would have
been the transferor's cost, under sections 351 and 362(a) (1). See note 422 supra. Vihloe
the proportionate interest requirement of section 112(b) (5) of the 1939 Code, the prede-
cessor of present section 351, formerly made reliance thereon difficult in cases of this
type (Jefferson Memorial Gardens, Inc. v. Comm'r, 390 F.2d 161, 164 (Uth Cir. 1963)),
section 351 is now ordinarily applicable despite differences in the holdings of the pro-

Since the purported lender ordinarily expects ultimately to recoup
his contribution, although only from the success of the business,
the more appropriate analysis is that disproportionate advances,
if not debt, constitute an investment in preferred stock, ultimately
enjoying priority over the common, although intended meanwhile
to ride with the ups and downs of the business.640
Guaranties by Shareholders
Since banks and other independent creditors, having no stake
in the success of the enterprise, ipso facto, have the requisite in-
tention to enforce corporation obligations held by them, the thought
naturally occurs: Why not avoid all the tax risks of shareholder
financing of thinly capitalized corporations by having the corpora-
tion borrow from a bank, with the shareholders functioning merely
as guarantors or endorsers? 641 The funds the shareholders might
have advanced may then be retained in other investments, perhaps
pledged to the bank but still earning individual income comparable
to the interest the shareholders would have derived from loans to
the corporation,64 2 while the corporation enjoys a less vulnerablo
deduction for the interest it pays the bank.043 The corporation's
need to repay the bank debt affords an unassailable excuse for ac-
cumulation of earnings, 644 and thdse earnings may then be drawn
off to the bank with less fear that the payment of the debt will re-
sult in dividend tax to the shareholders; 145 yet, as surely as if they
moter and the investors (cf. Burr Oaks Corp. v. Comm'r, 365 F.2d 24, 28 (7th Cir.
1966), cert. denied, 385 U.S. 1007 (1967)), unless the promoter contributes nothing
substantial except his services or unless the transfer of the land is a transaction truly
independent of the organization of the corporation. Reg. § 1.351-1.
641 See Lutz, Capital Formation of Speculative Enterprises,34 TAXEs 420, 423 (1950),
describing this as a "technique which should wholly eliminate the problem of thin in.
corporation." For convenience, the term "guaranty" will be used hero to include trans-
actions in which the shareholder is either endorser or co-maker of obligations incurred
for corporate use, and "bank" will be used to refer to any outside lender.
642 The suggestion that the guaranty device lacks the advantage of a steady flow of
interest income, which goes to the bank rather than to the shareholder (Goldstein, Cor-
porate Indebtedness to Shareholders: "Thin Capitalization" and Bclated Problems, 10
TAX L. REV. 1, 28 (1960); Note, Thin Capitalizationand Tax Avoidance, 55 CoUm. L.
BEv. 1054, 1064 (1955)), seems to overlook the fact that the shareholder's funds need
not be idle-although it is true that an investment in property acceptable to a bank as
collateral may earn less income than the bank's rate of interest.
64. Murphy Logging Co. v. United States, 378 F.2d 222 (9th Cir. 1967) ; Fors Farms,
Inc. v. United States, 66-1 U.S.T.C. 9206 (W.D. Wash. 1966) (Commissioner unsuc.
cessfully sought to deny deduction for interest on guaranteed bank loan).
6,45Ackerson v. United States, 277 F. Supp. 475 (W.D. Ky. 1967); Fors Farms,
Inc. v. United States, 66-1 U.S.T.C. 1 9206 (W.D. Wash. 1966).

had advanced and recovered their own funds, the shareholders will
have accomplished their purpose of building up the business from
its own earnings without permanently tying up their capital. 4 If
the corporation is to acquire a business or other assets from the
shareholders on credit in a taxable transaction, its chance to ob-
tain a stepped-up basis equal to the stated price "7may be greater
if the purchase is made with cash borrowed from a bank than if
purchase money notes are given to the shareholders.4 8 The business
risk to the shareholders is ordinarily no greater when they endorse
corporate notes than if they advance their own funds; but, if the
business does fail, the payments by the shareholder-guarantors to
the bank may more surely result in bad debt deductions than if
they hold corporate notes directly. 4 9 Thus, assuming such financing
is obtainable 650 and its possibly greater costs are acceptable, the
tax goals commonly sought through shareholder financing can more
safely be achieved.15 ' So, at least, runs the reasoning.
To the contrary, it has been said that such reasoning "under-
648Murphy Logging Co. v. United States, 378 F.2d 222 (9th Cir. 1967).
64
9 See note 655 infra. Satisfaction of the debt by the guarantor gives rise to a bad debt
deduction if his right to recover from the corporation is worthless. Putnam v. Comm'r,
352 U.S. 82 (1956). Like a direct advance (recognized as debt) which becomes worth-
less, this will often (but not invariably) be treated as a short-term capital loss, which
may be of little if any more value to the taxpayer than the usually long-term capital
loss resulting from worthlessness of stock and of advances not recognized as debts. See
text at notes 73-75 supra. In some circumstances, however, by settling his liability to
the creditor in a way that does not give rise to a worthless right of subrogation, the
guarantor may qualify for an ordinary loss deduction and thus may be better off even
than if he had initially made a direct advance that was recognized as debt. Comm'r v.
Condit, 333 F.2d 585 (10th Cir. 1964); T.J. Shea, 36 T.C. 577 (1961), aff'd, 327 :F.2d
1002 (5th Cir. 1964); Eugene H. Eietzke, 40 T.C. 443 (1963); cf. Santa Anita Con-
solidated, Inc., 50 T.C. 536, 555, 560-61 (1968). Contra, United States v. Hoffmann, 423
F.2d 1217 (9th Cir. 1970); Stratmore v. United States, 420 F.2d 461, 464-5 (3d Cir.),
cert. denied, 398 U.S. 951 (1970); of. J. Meredith Siple, 54 T.C. 1 (1970).
690Even wvith a collateralized guaranty it may not be poslblo to got bank financing
tailored to the peculiar needs (e.g., a long term for payment, and subordination of the
principal debt to suppliers or to general creditors) of a thinly capitalized corporation.
1"[I]n the normal case,... whether or not the bank makes the loan depends on 'whetber
it thinks the business will generate the cash to repay the loan in accordance with its
terms." See Hickman, !The Thin Corporation: Avother LooT; at an Old Disease, 44
TAXs 883, 890 (1966) (emphasis in the original).
65. In the ease of a subchapter S corporation (sea text at notes 102-112 supra), bowr
ever, a guaranteed loan is less advantageous than a direct loan because, if the corpora-
tion incurs losses, the shareholders may avail of them as individual deductions only to
the extent of the combined adjusted bases of the stock and debt of the corporation which
they hold (LR.C. § 1374(c) (2)), not including guaranteed debts on vhidch they arve not
yet made good. Milton T. Rlaynor, 50 T.C. 762, 770 (1968).

estimates the perspicacity of the courts. Just as a 'bond' is not
necessarily a bond, so a 'lender' is not necessarily a lender; and a
'guarantor' is not necessarily a guarantor." 652 The Supreme Court
in the Putnam case, although the debt-equity issue was not involved,
sounded the keynote when it declared:
There is no real economic difference between the loss of an investment
made in the form of a direct loan to a corporation and one made indirectly
in the form of a guaranteed bank loan. The tax consequences should in all
reason be the same....
6"
There are a few decisions in which, in apparent reliance on another

statement in that case that "the loss sustained by the guarantor
unable to recover from his debtor is by its very nature a loss from
the worthlessness of a debt," (14 bad debt deductions have been
allowed to shareholders on their guaranties even when the corpora-
tion's capitalization or its financial condition was such that direct
advances by the shareholders were viewed as capital contribu-
tions.55 But there is ample authority to the contrary. If, at the time
652 BITTKER & EUSTICE, FiEDERAL INcOmE TAXATION OF CORPORATIONS AND SnAREIOLD-
ERS 137 (2d ed. 1966). See also Note, Loan Versus Investment-Inadequato Capitaliza.
tion, 5 TAx L. REv. 424, 427 (1950), referring to "camouflaging the existence of under-
capitalization [by] making it appear as though outsiders were the true creditors."
653 Putnam v. Comm 'r, 352 U.S. 82, 92-93 (1956). See also Stratmoro v. United States,
420 F.2d 461, 465 (3d Cir.), cert. denied, 398 U.S. 951 (1970); of. United States v.
Keeler, 308 F.2d 424, 434 (9th Cir. 1962), cert. denied, 373 U.S. 932 (1963). In bank-
ruptcy, where an inadequately capitalized subsidiary was financed by a purported loan
from its parent, a part of which was later repaid by means of an insurance company
loan guaranteed by the parent, both obligations were denied recognition, the guarantood
loan being deemed no different from the direct advance. International Tel. & Tel. Corp.
v. Holton, 247 F.2d 178, 184 (4th Cir. 1957).
654See Putnam v. Commissioner, 352 U.S. 82, 85 (1956) (emphasis added), which
actually did not involve the issue whether the arrangement might constitute a capital
contribution.
655 Don T. Allen, 18 T.C.M. 1101, 1107-08 (1959), inodifted an other issues, 283 F.2d
785 (7th Cir. 1960) ; Frank Nelson, Jr., 17 T.C.M. 888, 899-901 (1958), aff 'a on otler
issues, 281 F.2d 1 (5th Cir. 1960); of. Diamond Bros. Co., 21 T.C.M. 60, 706 (1962),
aff'd on another issue, 322 F.2d 725 (3d Cir. 1963) (loss on guaranty not questioned by
Commissioner, possibly because it was partially secured by accounts receivable). In Miles
Production Co., 28 T.C.M. 1387, 1411 (1969), on appeal to the Fifth Circuit, it was said
that, notwithstanding thin capitalization, the fact that "the loans herein wero made
largely by banks negates the possibility of other factors, such as failure to pay intorest,
which might indicate equity instead of debt." In Stratmore v. United States, 292 F.
Supp. 59, 64 (D.N.J. 1968), rev'd on other grounds, 420 F.2d 461 (3d Cir.), cart. denied,
398 U.S. 951 (1970), it was held that guaranteed loans were true debts whether or not
the initial direct advance (not in issue) was a capital contribution. However, whoro a
shareholder who had guaranteed the corporation's rent obligations did not make pay-
ment to the landlord (which action might have given rise to a recognizable debt by
subrogation) but instead made advances with which the corporation paid the rent, the

the guaranty was given,056 the prospect of payment by the corpora-

tion appeared remote 657 or was dependent upon the uncertain suc-
cess of the business, 8 or if the corporation could not have ob-
tained credit without the guaranty and the lender relied primarily
on the credit of the guarantor, 9 the courts are quite prepared to
conclude that "those funds nominally advanced to [the corpora-
tion] by banks, but only on the credit and collateral of [the share-
holder], were in reality advanced by [him] who ultimately [by
satisfying the obligation] acquired the notes evidencing these ad-
vances." 660
The government has been less successful when the issue was
other than the allowability of a bad debt deduction. In order to
bring about some of the other usual tax consequences of nonrecog-
nition of purported debt, it is necessary to go further in reconstruct-
ing the transaction in fictional terms-not merely that the bank in
effect made the loan to the shareholders and they contributed the
sum to capital,6 6 t but that the corporation (not being truly indebted)
advances were held capital contributions. Samuel Abrams, 23 T.C.M. 1546, 1548, 1551
(1964). But cf. Don T. Allen, supra, at 1108.
656 The crucial time is when the guaranty is entered into, not when the grantor Eatis-
fies the obligation previously undertaken. W.D. Roussel, 37 T.C. 235, 242-43 (1901). Sec
Putnam v. Comm'r, 352 U.S. 82, 88-89 (1956) ; Bratton v. Comm'r, 217 F.2d 486, 488
(6th Cir. 1954).
657Barclay Co, 23 T.C.M. 1695, 1709 (1964); Max Bernstein, 19 T.C.M. 1569, 157G
(1960); George B. Marlke, 'r., 17 T.C. 1593, 1598-99 (1952). Of. Hoyt v. Commissioner,
145 F.2d 634 (2d Cir. 1944), and E.J. Ellisberg, 9 T.C. 463, 460-67 (1947), finding guar-
anties of family debts to be gratuitous when made without reasonable expectation that
the debtor could pay.
658 J. Meredith Siple, 54 T.C. 1, 9 (1970); Christie Coal & Cole Co., 28 T.C3.M 498,
520-21 (1969). Cf. Syer v. United States, 380 F.2d 1009, 1012-13 (4th Cir. 1907); T.A.
Maurer, Inc., 30 T.C. 1273, 1290 (1958).
659 Curry v. United States, 67-2 U.S.T.C. 9559 (SD. Fla. 1967), aff'd, 390 F.2
630, 634 (5th Cir.), cert. denied, 393 U.S. 967 (1968); Plantation Patterns, Inc., 29
T.C.M. 817, 826-27 (1970); Christie Coal & Colie Co., 28 T.C.M. 498, 521 (1989). Cf.
J.A. Maurer, In., 30 T.C. 1273, 1283, 1290 (1958). In Murphy Logging Co. v. United
States, 239 F. Supp. 794, 797 (D. Ore. 1965), rev'd, 378 P.2d 222 (9th Cir. 1967), the
district court rejected a bank officer's hypothetical testimony that the bank would have
been willing to make the loan even without the shareholders' guaranty, calling it "just
another instance in which a bank officer stretched the truth for a good customer on facts
that did not and probably would never occur." Cf. the similar aeptical reaction in
John Lizak, Inc., 28 T.C.M. 804, 808 (1969).
60 J.A. Maurer, Inc., 30 T.C. 1273, 1290 n.3 (1958); of. Putnam v. Comm'r, 352 U.8.
82, 93 n.20 (1956) ("Yet from the petitioner's viewpoint, the situation would have been
precisely the same had he himself borrowed the money and then lent it to the corpora-
tion.") The faurer ase is unusual in that it was the corporation itself that argued, suc-
cessfully, for nonrecognition of the advances and guaranties as debts, in order to avoid
being taxed on the amount of net assets freed when the claims were reduced by agree-
ment.
661 Or, in the case of a purported sale of property to the corporation (paid for with

made its payments of interest and principal to or for the benefit
of the shareholder-guarantors as dividends which were applied on
their own obligations to the bank.66 2 The necessity to reason in "as
if" terms has caused some difficulty in focusing the attack, 0 3 partic-
ularly in view of the principle-forever in collision with the rule
that substance controls over form c6 4-- that, if there are two ways
of reaching a given result, the taxpayer is not to be deprived of the
tax consequences of the route he chose merely because another
more costly route was open to him."' Hence, some decisions have
declined to apply the foregoing analysis on the ground that the
papers showed that no such relationship was " intended." 0
Nevertheless, notwithstanding some aberrant language, all
the more recent guaranty cases lost by the government have
applied the debt-equity factor analysis, and it is evident that the
courts, according to their lights, would have reached the same re-
funds borrowed on the shareholder's guaranty), as if the shareholder had contributed the
property to capital and had himself borrowed money from the bank. Such analysis was
adopted by the district court in Murphy Logging Co. v. United States, 239 F. Supp.
794, 797 (D. Ore. 1965), rev'd, 378 F.2d 222 (9th Cir. 1967).
662 See Aarons, Debt v. Equity : Special Hazards in Setting Up the Corporate Capital
Structure, 23 J. TAxATION 194, 195 (1965). Under the above analysis, the shareholders
should be entitled to interest deductions offsetting the portion of the dividend attribu-
table to the corporation's payment of interest, constructively on their behalf (sea Plan-
tation Patterns, Inc., 29 T.C.M. 817, 824 (1970); of. Leward Cotton Mills v. Comm'r,
245 F.2d 314 (4th Cir. 1957); Norman Cooledge, 40 B.T.A. 1325, 1328 (1939); but of.
Arthur L. Kniffen, 39 T.C. 553, 566-67 (1962)) so the not effect is to deny the interest
deduction to the corporation and to tax the shareholder on the principal payment, as in
the case of nonrecognition of direct advances. Alternative forms of reconstructing the
transaction (e.g., that the shareholders are loaning their own money through the bank
as a conduit) seem farther from the mark and do not merit discussion here. They are
reviewed in Goldstein, Corporate Indebtedness to Shareholders: "Thin Capitalization"
and Belated Problems, 16 TAx L. REV. 1, 29 (1960).
663 See Moore & Sorlien, Adventures in Subehapter S and Section 1244, 14 TAx L.
Ry.v. 453, 493 n.108 (1959) One writer goes so far as to say that even if a high ratio
is present, the arguments in favor of the taxpayer in such a case are "overwhelming."
Pennell, Tax Planning at the Time of Incorporation, 35 TAxi:s 927, 980 (1957).
664 Compare Comm'r v. Court Holding Co., 324 U.S. 331, 334 (1945) ("The incl-
dence of taxation depends upon the substance of a transaction."), with United States
v. Cumberland Public Service Co., 338 U.S. 451 (1950) (permitting escape from the
effect of the former decision by adoption of the proper form, provided it is thought of
at an early enough stage).
685 Nassau Lens Co. v. Comm2r, 308 F.2d 39, 44-46 (2d Cir. 1962); Woodworth v.
Comm'r, 218 F.2d 719, 724 (6th Cir. 1955). If the form of guaranteed debt wore recog-
nized, the fact that the payments by the principal debtor relieved the guarantor of his
obligation as such would not cause him to realize taxable income, since he merely avoids
a potential loss. Cf. George H. Landreth, 50 T.C. 803, 812-13 (1968); Rye. Ru]. 09-808,
1969-2 C.B. 43, 44.
66e See Wynnefield Heights, Inc., 25 T.C.M. 953, 960 (1966). Cf. Santa Anita Con.
solidated, Inc., 50 T.C. 536, 548, 550, 553 (1968).

0 The
suits if the shareholders had made the advances directly.c
decisions have turned to a large extent on the finding that the
creditor's insistence upon a guaranty did not signify that the cor-
porate capital was thought to be inadequate or that the share-
holder's credit was primarily relied upon," but reflected a gen-
eral policy of banks to require guaranties by the shareholders of
close corporations, 6 9 in order to assure their continued interest
and participation in the corporation's affairs," ° or was designed
to preclude, without need for a complex indenture, the impairment
of the assets behind the debt through dividend and salary pay-
ments. 67'1 Plainly, if corporate capital were ample to support recog-
nition of debt if the shareholder had made the advances, the tax-
payers should not be prejudiced by the bank's eagerness to fortify
itself in every way possible, or by its routinely investigating the
guarantor's credit as well as that of the corporation. 1 2- The gov-
ernment misconceives the issue, therefore, if it stresses the ample
resources of the shareholder-guarantor for, as the NTinth Circuit has
said:
[I]f the [shareholders] had been worthless (instead of affluent in personal
assets) and the bank had still made the loan, then the tax-payer might
have been better off in contesting with the [revenue] agents in so far as the
667 Murphy Logging Co. v. United States, 378 F.2d 222, 224 (9th Cir. 1907) (capital
found adequate, despite thin appearance on books); Santa Anita Consolidated, Inc., 50
T.C. 536, 550-55 (1968) (capital was "not nominal," and repayments were scaled to
debtor's cash flow projections; acknowledged that nothing in Muirphy Logging pre-
eludes applying debt-equity analysis to guarantees); Book Production Tndustries, Inc.,
24 T.C.M. 339, 356-57 (1965) (despite insolvency and continuing losses, court could not
say that expectation of repayment by principal debtor was absent); Aderson v. United
States, 277 F. Supp. 475, 477 (W.D. Ky. 1967) (capital deemed adequate); Fors Farms,
Inc. v. United States, 66-1 U.S.T.C. T 9206 (W.D. Was. 1966) (although shareholder.
guarantors gave mortgages, corporate capital was found adequate to support debt).
68s Santa Anita Consolidated, Inc., 50 T.C. 536, 550 (1968) (bank required extensive
financial data from primary obligor); Diamond Bros. Co., 21 T.C0.L 690, 700 (1962),
aff'd on another issue, 322 P.2d 725 (3d Cir. 1963) (bank made no investigation of
guarantor's credit). See note 672 infra.
669 Fors Farms, Inc. v. United States. 66-1 U.S.T.C. 9200 (W.D. Was. 19aI). The
policy and its purposes are well described in Hickman, The Thin Corporation:Another
LooTb at an Old Disease, 44 T.xEs 883, 890 (1960).
87o Diamond Bros. Co., 21 T.C.M. 696, 700 (1962), aff'd on another iwue, 322 F.2d
725 (3d Cir. 1963).

671 Aekerson v. United States, 277 F. Supp. 475, 477 (W.D. Ky. 1907). Seo Hickman,
.The Thin Corporation:Another Loo at an Old Disease, 44 TAxr.s 883, 890 (1900).
672 While it may be the practice of some banks not to require financial statements from
the guarantor (note 668 supra), many banks feel that they should obtain such data
even -when it plays no major part in their judgment of the loan. Hickman, Thc Thin
Corporation:Aothzer Loo: at an Old Disease, 44 TAxEs 883, 890-91 (19).

TAX LAW REVIEW [Vol. 26:•
obligation to the bank was concerned,
73
but we do not think they should bo
penalized here for responsibility.0
In addition, it should make no difference that the bank requires the

shareholders to co-sign as principals rather than as endorsers or
guarantors, 674 or reserves the right to proceed against them with-
out exhausting its remedies against the corporation,7 5 provided
it is expected that the corporation will satisfy the debt incurred
for its use.
A shareholder guaranteed debt should be, and apparently in
most courts will be, judged by the same standards as if the share-
holder had himself advanced the money. The real question is: Did
the shareholder intend and reasonably expect, as a matter of ec-
onomic reality, that the corporation would repay the loan according
to its terms, or did he intend and expect that the funds would re-
main at the risk of the business until payment could conveniently
be made from corporate profits and that until then he would pay
the debt himself at maturity or refinance it on his guaranty? If the
latter is the fact, the shareholder's providing his credit to the cor-
poration through guaranties is, or should be, as vulnerable as di-
rect advances to treatment as part of his equity
7
investment, 7 0 with
all the consequences that flow therefromY
Variations on the Theme

Sometimes, by choice or necessity, instead of guaranteeing cor-
porate borrowings, a shareholder himself borrows from a bank or
other outside lender and advances the funds to his corporation.
That arrangement may deprive the parties of whatever argument
they might have had that the bank relied primarily on the credit of
the corporation. 78 In some circumstances, however, it may be
673 Murphy Logging Co. v. United States, 378 F.2d 222, 224 (9th Cir. 1967) (emphasis
added); accord, Santa Anita Consolidated, Inc., 50 T.C. 536, 553 (1968).
874 Fors Farms, Inc. v. United States, 66-1 U.S.T.C. 9206 (W.D. Wash. 1960); of.
Frank Ciaio, 47 T.C. 447 (1967).
675 Santa Anita Consolidated, Inc., 50 T.C. 536, 548-50 (1968).
6T6 See Syer v. United States, 380 F.2d 1009, 1012-13 (4th Cir. 1969); J. Meredith
Siple, 54 T.C. 1, 9 (1970); Plantation Patterns, Inc., 29 T.C.M. 817 (1970).
677 See ALI, INcomE TAX PROBLEMS OF CORPORATIONS AND SHAREHOLDERs 420 (Roport
of Working Views of Staff, 1958).
67B George T. Smith, 23 T.C.M. 1689 (1964), aff'd, 370 F.2d 178 (6th Cir. 1966);
S.S. Balimn Agency, Inc., 28 T.C.M. 1058, 1067, 1074 (1969); Christie Coal & Coke
Co., 28 T.C.M. 498, 525-26 (1969) (rejecting the argument that, because the sharo-
holder had borrowed, at the same interest rate, the funds he loaned to the corporation,
he was a mere conduit; rather, he was an essential party to the transactions, as the
corporation had neither capital nor credit of its own, and the bank looked only to him

1971] CORP01TUTECDDT
shown that the bank, although preferring for some reason to deal
with the shareholder as borrower, knew that the funds would be
passed on to the corporation and relied for repayment on the
shareholder's ability (and intention) to collect the necessary funds
from the corporation at maturity. 7 Even without such reliance by
the outside lender, the shareholder may establish unilaterally his
intention to collect from the corporation by the fact that he has no
other source from which to satisfy his own obligation to pay the
lender.680 However, such circumstantial evidence of intention may
not suffice if the shareholder's expectation of meeting his obliga-
tion with corporate funds is not a reasonable one,0 1 or if he in fact
lets the funds ride with the business. 2
The fact that it was an affiliated group's "established method of
doing business" to have the parent corporation use its stronger
credit to borrow funds to finance its subsidiaries has been cited as
proof that advances to a particular subsidiary were valid debt; m
but evidence of such a practice actually beclouds the issue, for the
pertinent question is whether, in the case of the particular sub-
for payment); Orange Securities Corp., 45 B.T.A. 24, 31 (1941), aff'd on another isre,
131 F.2d 662 (5th Cir. 1942). A shareholder's claim that he could have achieved the
same result without adverse tax consequences by having the corporation borrow on his
guaranty (a questionable premise in view of the foregoing discuason) was rojected in
Robert L. Osborne, 13 T.C.LM. 428, 430 (1954), on the ground that h was bound by the
form he adopted.
679 'aek Daniel Distillery v. United States, 379 F.2d 569, 585 (CL CL 1967) ("most
important factor" supporting linding of debt was that bank knew parent was a conduit
to subsidiary and needed timely repayment if bank was to be repaid in turn); Oah
Motors, Inc, 23 T.C.M. 520 (1964) (bank could not loan to corporation because of
necessity to subordinate to other creditors, so it loaned to shareholder on pledge of cor-
poration's subordinated note held by him; bank looked to corporation as source of re-
payment); cf. Frank iaio, 47 T.C. 447, 461 (1967) (shareholder was substituted for
corporation as purchaser of stock of dissidents, as bank feared a loan to corporation,
with its assets depleted by redemption, would be criticized by examiners). But in Na-
tional Farmers Union Service Co. v. United States, 400 F.2d 483, 486 (10th Cir. 1968),
the court declined to extend the conduit theory to a ease where the proceeds of public
sale of debentures by a parent corporation were purportedly loaned to its subsidiary;
it was not shown that the bond purchasers knew the use to which the money would be
put or relied on the subsidiary's ability to pay; and the terms and circumstances of the
advance to the subsidiary made collection remote.
680Alstate-Schuylkil Co., 28 T.C.M. 32, 39-40 (1969); Irbeo Corp., 25 T.X. 359,
366 (1966); Paul F. Murphy, 21 T.C.M. 1161, 1163-64 (1962); Seven Sixty Ranch Co.
v. Kennedy, 66-1 U.S.T.C. 9293 (D. Wyo. 1966); of. Estate of Isadoro Benjamin,
28 T.C.101, 111-12 (1957).
681National Farmers Union Service Co. v. United States, 400 F.2a 483, 486 (10th
Cir. 1968), discussed in note 679 supra.
682 Aithony V. Donisi, 26 T.C.M. 327, 331 (1967), aff'I, 405 F.2d. 481 (Gth Cir. 1908).
68s3Alled Stores Corp., 19 T.C.M. 1149, 1155-50, 1162 (1960); cf. Malone & Hyde,
Inc., 49 T.C. 575, 577 (1968) (fact found but not relied on in opinion).

sidiary, there was a reasonably founded intention and expectation
that the advance would be repaid like a debt."3 4
Another variation of the guaranty theme arises when a share-
holder, as a condition to his corporation's obtaining an outside
loan or in order to improve the balance sheet, gives the corporation
legal title to individually owned property, intending to retake the
property when the credit need ceases. In substance, such a transac-
tion is similar to an advance of cash which is represented on the
books as donated surplus, 685 or to the shareholder's providing col-
lateral for outside credit,""0 and it would seem appropriate to view
the transaction as a capital contribution, placing the property at
the risk of the business, in the same circumstances in which a
direct advance or a guaranty would be so regarded. But the few
authorities in point have not had occasion to apply that analysis, 87
contenting themselves instead with ascertaining that the conduct
of the parties in the interim was consistent with beneficial owner-
ship having continued in the shareholder, and holding, therefore,
that his retaking of legal title was not a dividend "88 and that the
corporation was not taxable on the income derived from the prop-
erty and might deduct what it paid the shareholder for its use.""'
Payment History
Since actions speak louder than words, e00 it is often necessary
to prove intention by retrospective evidence. By the time the tax
effect of a purported debt is placed in issue both the taxpayer and
the government will have the benefit of hindsight.
Perhaps the most persuasive evidence of an initial intention to
repay purported debt is the fact that all payments are actually met
684 C.M. Gooch Lumber Sales Co., 49 T.C. 649, 655-56 (1968).
685 See text at note 520 supra.
687 But cf. Thomas Machine Mfg. Co., 23 T.C.M. 1630, 1640 (1964)) in which machinos
previously leased to the corporation by the shareholder had been transferred to it as it
condition to a Reconstruction Finance Corporation loan, then reconveyod when the loan
was retired, and then purportedly resold to the corporation for an installment obligation.
Although the earlier transfer and reconveyance were not in issue, they were considorod
along with other factors as evidence of a course of dealing with the property that caused
nonrecognition of the later transaction as a sale giving rise to bona fide debt.
688 Conmi'r v. Callner, 287 F.2d 642 (7th Cir. 1961).
689 See P.R. Ingram. 20 T.C.M. 1447, 1459, 1467 (1961); of. Rev. Rul. 60-455,
1969-2 C.B. 9 (shareholders of stockbroker met stock exchange capital requirements by
subordinating their own brokerage accounts to customers' claims, but remained bene.
ficial owners).

on time 691 (or, in the case of a demand obligation, within a reason-

able time 692). Weight has been given even to repayment effected
by splitting off part of the business to the purported creditor C9 3
although it would seem much less indicative of the initial intention
than repayment in cash would be. The evidentiary effect of re-
payments is generally neutralized if they are offset by new ad-
vances,6 94 although some decisions give weight to "continual pay-
ments on the account" despite a steady growth in the year-end
balances.69 If the only repayments are of advances made for
temporary purposes, 696 or to equalize the advances of different
shareholders, 6 7 they have little weight with respect to the balance
of the account. Repayments that are determined more by the rela-
tive cash needs of the shareholder and the corporation than by the
force of a binding obligation have little weight.0 s And repayment
that is precipitated by a tax audit in which the validity of the
purported debt is questioned is naturally viewed with some skepti-
691 Piedmont Corp. v. Comm'r, 388 F.2d 886, 891 (4th Cir. 1968); Jack Daniel Dis-
tillery v. United States, 379 F.2d 569, 582 (Ct Cl. 1967); Baker Commoditi c3, Inc., 48
T.C. 374, 397-98 (1967), aff'd on another issue, 415 F.2d 519 (9th Cr. 1969), cert.
denied, 397 U.S. 988 (1970).
692 Harlan v. United States, 409 F.2d 904, 909 (5th Cir. 1969) (two to three yeats);
P.F. Scheidelman & Sons, Inc, 24 T.C.M. 168, 173 (1965) (five years); Donald C. Nib-
lock, 27 T.C.M. 1381, 1386 (1968), aff d on another issue, 417 F.2d 1185 (7th Cir. 1969)
(even partial and intermittent repayments are indicative of the existence of a reasonable
expectation of repayment). See Irbeo Corp., 25 T.C.M. 359, 366 (1966).
693 Gordon Lubricating Co., 24 T.C.M. 697, 701, 710, 711 (1965).
94 Max D. Gustin, 27 T.C3L 186, 192 (1968), aff'd, 412 F.2d 803 (Oth Cir. 1969);
Diamond Bros. Co. v. Comm'r, 322 F.2d 725, 732 (3d Cir. 1963); American-La, France-
Poamite Corp. v. Comm'r, 284 F.2d 723, 724-25 (2a Cir. 190), cert. deied, 365 U.S.
881 (1961); of. Atlanta Biltmore Hotel Corp. v. Comm'r, 349 F.2d 677, 080 (5th Cir.
1965).
695 C.M. Gooch Lumber Sales Co., 49 T.C. 649, 657 (1968); Albert lavano, 26
T.C.M. 793, 796, 799-800 (1967); Scotland Mills, Inc., 24 T.C.M. 265, 26S-70, 274
(1965). In the Ravano case (p. 799) the frequent shifting of funds back and forth
among related corporations and between the shareholder and his corporations, as vork-
ing capital needs fuctuated, was deemed evidence that each advanco was temporary;
although the money might be considered permanent capital of the overall organization,
it was not capital of any one entity.
69"-Edwin C. Rollenbeck, 50 T.C. 740, 749-50 (1968), aff'd, 422 F.2d 2 (9th Cir.
1970).
697A.R. Lantz Co. v. United States, 283 F. Supp. 164, 166, 169 (C.D. Cal. 1968),
aff'd, 421 F.2d 1330 (9th Cir. 1970).
698 John Lizak, Inc., 28 T.C.M. 804, 809 (1969) ; accord, Anthony V. Donisi, 20 T.C.M.
327, 331 (1967), aff'd, 405 l0.2d 481 (6th Cir. 1908) ; Fred L Nystrom, Jr., 28 T.C.M.
1050, 1055 (1969).

6 99
cism. Hindsight is in any event only evidentiary, 700
and even
timely repayment does not necessarily overcome other evidence
that, at the time the advances were made, repayment was intended
701
or expected only if the business was successful.
Some decisions, even in the absence of principal payments, give
affirmative weight to the faithful payment of interest,7 0 2 particu-
larly if it is paid when earnings are lacking; 703 but the significance
of payment of interest as evidence of intention is limited when the
corporation has earnings, which could as readily have been paid
70 4
out as dividends.
699 Fin Hay Realty Co. v. United States, 261 F. Supp. 823, 828 (D.N.J. 1966), aff'd,
398 F.2d 694 (3d Cir. 1968); Wood Preserving Co. v. United States, 233 F. Supp. 600,
604 (D. Md. 1964), afr'd, 347 F.2d 117 (4th Cir. 1965); Motel Co., 22 T.C.M. 825, 832
(1963), aff'd, 340 F.2d 445, 446 (2d Cir. 1965) ; O.H. Kruse Grain & Milling v. Comm 'r,
279 F.2d 123, 126 (9th Cir. 1960) ; S.P. Realty Co., 27 T.C.M. 764, 767 (1968) ; Thomas
Machine Mfg. Co, 23 T.C.M. 1630, 1641 (1964). But, while such timing is a "highly dis-
turbing circumstance," it may be overcome by other evidence that repayment was In.
tended all along. Albert Ravano, 26 T.C.M. 793, 800-01 (1967).
700 Diamond Bros. Co. v. Comm'r, 322 F.2d 725, 732 (3d Cir. 1963).
701Piedmont Corp., 25 T.C.M. 1344, 1348 (1966)) rev'd, 388 F.2d 886 (4th Cir.
1968) (reversal was on ground that there was no support in the evidence for the in-
ference that the shareholders would not have insisted upon payment if the business had
not been successful); Thomas Machine Mfg. Co., 23 T.C.M. 1630, 1641 (1964); James
D. Lancaster, 23 T.C.M. 631, 633, 634 (1964); Bruce v. Knox, 180 F. Supp. 907, 911
(D. Minn. 1960). The Commissioner has sought (albeit unsuccessfully) to deny recog-
nition of working capital advances to a corporation even though they were repaid from
profits within a year. Albert W. Peterson, 24 T.C.M. 752, 756 (1965).
702 Gordon Lubricating Co., 24 T.C.M. 697, 706, 710 (1965) (20 year debentures, with
sinking fund in default, but significant that interest, formerly in arrears, had boon
brought current); Utility Trailer Mfg. Co. v. United States, 212 F. Supp. 773, 786 (S.D.
Cal 1962) (principal unpaid and term extended because of expansion needs, but interest
paid regularly). See Fin Hay Realty Co. v. United States, 398 P.2d 694, 700-01 (3d
Cir. 1968) (dissenting opinion).
70 See Kipsborough Realty Corp., 10 T.C.M. 932, 934 (1951) ("a very strong con
sideration" in such circumstances, although here overcome by other factors).
704 Isidor Dobkin, 15 T.C. 31, 34 (1950), aff'd, 192 F.2d 392 (24 Cir. 1951) ; 2L54-
58 Creston Corp., 40 T.C. 932, 939 (1963); James D. Lancaster, 23 T.C.M. 631, 034
(1964). The Dobkin decision has been criticized (by counsel for the taxpayer) for
"inexplicably" stating that enforcement of the principal debt would have rendered
the transparently thin corporation insolvent, and then "paradoxically" stating that the
"insolvent" corporation could as well have made its payments of purported interest in
the form of dividends. 3 RASKIN & JOHNSON, FEDERAL INCOME GIFT AND ESTATn TAX-
ATiOx § 35.08(4). But, when other factors indicate that the principal amount of a
purported debt is capital investment at the risk of the business, it is entirely consistent
to view interest payments as a neutral factor, since those payments (to the extent of
earnings and profits) are equivalent to the dividend return on such capital. Regular
payment of interest was thus outweighed in Fin Hay Realty Co. v. United States, 398
F.2d 694, 698 (3d Cir. 1968); and Affiliated Research, Inc. v. United States, 351 P.2d
646, 648 (Ct. Cl. 1965). In Charter Wire, Inc. v. United States, 309 F.2d 878, 879, 881
(7th Cir. 1962), the court was more impressed by the fact, among others, that the share-

Failure to Enforce on Default

Subsequent conduct that is inconsistent with the asserted intent
can, of course, be very damaging to the taxpayer's case. If the
purported creditor fails to "act like a creditor," 70 but instead tol-
erates prolonged defaults in the payment of principal70 01 and even
7
07
continues his advances after the default, or agrees to unreason-
able or repeated extensions of the maturity date,708 or indefinitely
defers making demand for payment of a demand note or open ac-
count, 0 9 it evidences a "state of mind . . . akin to that of an
ordinary shareholder who understands that his investment is sub-
holder-creditors permitted suspension of interest during a prolonged striLe than by the
regular4ty of other interest payments.
705 See Wood Preserving Co. v. United States, 347 F.2a 117, -19 (4th Cir. 1965).
706 Hollenbeck v. Comm-r, 422 F.2a 2, 4 (9th Cir. 1970) (such attitude is "not con-
sistent -withthe ordinary relation of debtor and creditor") ; Berkowitz v. United States,
411 F.2d 818, 819, 821 (5th Cir. 1969) (overdue note not paid even when corporation
had money from sale of property); Motel Co. v. Comm'r, 340 F.2d 445, 446 (2d Cir.
1965) (failed to enforce until tax question raised; then foreclosed and leased bach);
Ambassador Apartments, Inc., 50 T.C. 236, 246 (1968), aff'd, 406 F.2d 288 (2d Cir.
1969) (on default, granted extension, but then failed to enforce -Then again due);
Gooding Amusement Co. v. Comm'r, 236 F.2d 159, 162-3 (6th Cr. 1956), cet. deried,
352 U.S. 1031 (1957) (payment not required because of heavy outside debts; deemed
equivalent to voluntary subordination).
707 Doda v. Comm'r, 298 F.2d 570, 578 (4th Cir. 1962); Gilberf v. Comm'r, 262 F.2d
512, 514 (2d Cir.), cert. denied, 359 U.S. 1002 (1959); Henderson v. United States, 245
F. Supp. 782 785 (M.D. Ala. 1965); Southeastern Aviation Underwriters, Inc., 25
T.C.M. 412, 425 (1966).
708 Foresun, Inc., 41 T.C. 706, 714, 717 (1964), aff'd, 348 F.2d 1006 (6th Cir. 1965)
(mother of shareholders, satisfiea with interest income, extendea maturity and rceived
no principal payments); Charter Wire, Inc. v. United States, 309 F.2d 878, 881 (7th
Cir. 1962), cert. denied, 372 U.S. 965 (1963) (extensions showed littlo concern with pay-
ment when due); P.M. Finance Corp., 20 T.C.M. 537, 540 (1961), aft'd, 302 F.2d 786
(3d Cir. 1962) (extensions not justified by advice of counsel); Brake & Electrie Sales
Corp. v. United States, 287 F.2d 426, 428 (1st Cir. 1961) (fire year notes twice ex-
tended); O1 Dominion Plywood Corp., 25 T.C.M. 678, 694 (1966) (repeated renewals) ;
Louisquisset Golf Club, Inc., 21 T.C.M. 15772 1586 (1962) (20 year bonds extended 20
years, with no provision for retirement). It appears that short-term obligations, not
paid for ten years because repeatedly extended, may be more vulnerable to nonrecogni-
tion (Edwards Motor Transit Co., 23 T.C.M. 1968, 1978-79 (1964); but of. Hofert Co.
v. United States, 69-1 U.S.T.C. 9220 (C.D. Cal. 1969)) than obligations with an initial
term of ten years or more. Cf. text at notes 252-53 supra.
709Tyler v. Tomlinson, 414: F.2d 844, 849 (5th Cr. 1969) (demand r ould have
"havocked" the corporation); Fin Ray Realty Co. v. United States, 261 F. Supp. 823,
827, 829 (D.N.J. 1966), aff'd, 398 F.2d 694 (3d Cir. 1968) (no demands until holders
died); Wood Preserving Co. v. United States, 347 F.2d 117, 119 (4th Cr. 1005) (open
account not collected); 3.S. Biritz Construction Co., T.C.M. 1175, 1185 (1966), rev'd,
387 F.2d 451 (8th Cir. 1967) (no demand for five years, until felt corporation was able);
Zephyr Mills, Inc., 18 T.C.M. 794, 799 (1959), aff'd, 279 P.2d 494 (3d Cir. 1960); W.O.
Covey, Inc., 28 T.C.M. 1379, 1396 (1969); S.S. Ballin Agency, 28 T.C.M. 1058, 1074
(1969).

ject to the risks of the venture" 710 and a readiness to put his
shareholder interests ahead of his creditor interests when it serves
the needs of the corporation.711 If the corporation pays dividends
while the purported debt is in default, particularly if such pay-
ments violate the covenants of the bond, 712 its attitude is hardly
that of a "conscientious debtor dealing at arm's length with' inde-
pendent interests." 713 Although defaults in the payment of inter-
est, even when funds were available, have occasionally been re-
garded as of less significance than principal defaults,71 4 an attitude
of ignoring prescribed interest payments completely, 7 r or paying
interest only sporadically when earnings are available, 70 or pay- 717
ing it with funds supplied by the purported creditor himself,
is generally regarded as evidence that the purported creditor is
more concerned with increasing the earnings and market value of
his stock by means of his advances than in earning a return on a
fixed obligation. 71. Even an agreement to defer interest tempo-
71oGooding Amusement Co. v. Comm'r, 236 F.2d 159, 163 (6th Cir. 1956), cort.
denied, 352 U.S. 1031 (1957).
711 Covey Investment Co. v. United States, 377 F.2d 403, 404 (10th Cir. 1967) ; Charter
Wire, Inc. v. United States, 309 F.2d 878, 881 (7th Cir. 1962), cert. dcnied, 372 U.S.
965 (1963); Foresun, Inc., 41 T.C. 706, 716-17 (1964), aff'd, 348 .'.2d 1006 (6th Cir.
1965).
712 See notes 1090-91 infra.
713 Covey Investment Co. v. United States, 377 F.2d 403, 405 (10th Cir. 1907).
714 Tomlinson v. 1661 Corp., 377 F.2d 291, 299 (5th Cir. 1967) (11it is not for this
Court to speculate on the business reasons" for such failure).
715 Austin Village, Inc. v. United States, 432 F.2d 741, 745-46 (6th ir. 1970) ; Hollon-
beck v. Comm'r, 422 F.2d 2, 4 (9th Cir. 1970); Cuyuna Realty Co. v. United States, 382
F.2d 298, 301-02 (Ct. Cl. 1967); United States v. Henderson, 375 F.2d 36, 40 (5th Cir.
1967); Jewell Ridge Coal Corp. v. Comm'r, 318 P.2d 695, 699 (4th Cir. 19063); 0.1.
Kruse Grain & Milling v. Comm'r, 279 F.2d 123, 126 (9th Cir. 1960); 1432 Broadway
Corp., 4 T.C. 1158, 1164, 1166 (1945), aff'd, 160 F.2d 885 (2d Cir. 1947).
716Tyler v. Tomlinson, 414 F.2d 844, 849, 850 (5th Cir. 1969) ("sporadic pay.
ments"); Covey Investment Co. v. United States, 377 F.2d 403, 404 (10th Cir. 1067)
(part of interest forgiven in bad years); Zephyr Mills, Inc., 18 T.C.M. 794, 797, 799
(1959), aff'd, 279 F.2d 494 (3d Cir. 1960) (interest paid irrogularly); Erard A.
Matthiessen, 16 T.C. 781, 786 (1951), aff'd, 194 F.2d 659 (2d Cir. 1952) (interest rarely
paid) ; Hoguet Realty Corp., 30 T.C. 580, 599 (1958) (interest repeatedly postponed
except when had sufficient earnings; "not a characteristic of an interest obligation
but ... characteristic of the duty to pay dividends"); Heart of Atlanta Motel, Inc. v.
United States, 63-1 U.S.T.C. 9110 (N.D. Ga. 1962) (agreed at outset not to insist
on interest payments for a limited period).
717 Peco Co., 26 T.C.M. 207, 210, 211, 212 (1967) (payment from now loans by share.
holders was "illusory," "mere paper shuffling"); Old Dominion Plywood Corp., 25
T.C.M. 678, 694-95 (1966).
718 Tyler v. Tomlinson, 414 F.2d 844, 849 (5th Cir. 1969); Curry v. United Statos,
396 F.2d 630, 634 (5th Cir.), cert. denied, 393 U.S. 967 (1968). Of. Dillin v. United
States, 433 F.2d 1097, 1102 (5th Cir. 1970); Jewell Ridge Coal Corp. v. Comm'r, 318

1971] CORPORIkTE DEBT
rarily during a strike or other emergency has been viewed as evi-

dence that the purported creditor put his shareholder interests
first,7 9 as has a willingness to accede to a reduction of the rate 2 -
However, since the fact to be proved is the intention with which
the advances were made,1-2 the evidentiary effect of later defaults
and extensions may be neutralized by showing that the need was
not reasonably anticipated at the outset. Deferral of payment has
been excused by the need for funds to perform war contracts,7 2
or to expand or improve the corporate facilities or business 72
(circumstances in which new advances might well have been recog-
2
nized as debts) ,72- as well as by unforeseen economic difficulties,Y
or simply by the fact that "the money wasn't there.I' M - The
shareholder-creditor need not be "as hard-nosed as a banker" '-
or other institutional lender, who has the examiner looking over
his shoulder, 72 but if he is more lenient than an independent indi-
vidual creditor would be in the circumstances,7 -0 he should not be
F.2d 695, 699 (4th Cir. 1963) ("scarcely the attitude of a money lender"). In the Fifth
Circuit, obviously, "you pays your money and you tahes your choice., See note 714 supra.
719 Charter Wire, Inc. v. United States, 309 F.2d 878, 879-80, 881 (7th Cir. 1962),
cert. denied, 372 U.S. 965 (1963), criticized in Note, 1904 Wis. L. RIuv. 331. But of.
Lifians Corp. v. United States, 390 F.2d 965, 969 (Ct. CL 1968).
720 Charter Wire, Inc. v. United States, 309 F.2d 878, 880, 881 (7th Cir. 1962), cert.
denied, 372 U.S. 965 (1963); Kraft Foods Co., 21 T.C. 513, 598 (1954), retv'd, 232 F.2d
118 (2d Cir. 1956).
721 Santa Anita Consolidated, Inc, 50 T.C. 536, 554 (1908). See Ambassador Apart-
ments, Inc., 50 T.C. 236, 241 (1968), aff'd, 406 F.2d 288 (2d Ch-. 1969); Hfarkins
Bowling, Inc. v. Knox, 164 F. Supp. 801, 807 (D. Minn. 1958); 85 Es Realty, Inc. v.
United States, 59-1 U.S.T.C. 9232 (S.D.N.Y. 1958) (jury instructions).
722 Leach Corp., 30 T.C. 563, 577 (1958).
72 Marlo Coil Co. v. United States, 697 CCH 7915 (Comm'r Rep., Ct. CI. 190G);
Utility Trailer Mfg. Co. v. United States, 212 F. Supp. 773, 788 (S.D. Cal. 1962);
Charles E. Curry, 43 T.C. 667, 690 (1965) (cash shortage caused by capital improve-
ments that enhanced the security); Bulldey Dunton & Co., 20 T.C.M. 060, 066 (1961).
724 See text at note 895 infra.
725Liflans Corp. v. United States, 390 F.2d 965, 969 (CL CL 1908); Irbco Corp., 25
T.C.M. 359, 366 (1966).
72E Austin Village, Inc., 296 F. Supp. 382, 392 (N.D. Ohio 1908), rcv'd, 432 F.12d 741
(6th Cir. 1970). The fact that the debtor cannot pay at maturity doe3 not mean that
there was never a debt. Motel Co., 22 T.C.M. 825, 834 (1963), aff'd on another issue,
340 F.2d 445 (2a Cir. 1965).
727 Earle v. W.J. Jones, 200 F.2d 846, 850 (9th Cir. 1952); Wilshire & Western
Sandwiches, Inc. v. Comm'r, 175 F.2d 718, 721 (9th Cir. 1949). see Wood Prezerving
Co. v. United States, 233 IF. Supp. 600, 606 (D. Md. 19G4), aff'd, 347 F.2d 117 (4th Cir.
1965).
728 See Charles E. Curry, 43 T.C. 667, 681 (1905) ("Institutional invrstors, which are
usually subject to some form of governmental regulation, require a safe and steady rate
of return. Noninstitutional sellers may be willing and able to take greater ril"s.").
729 Sayles Finishing Plants, Inc. v. United States, 399 F.2d 214, 221 (Ce. Cl. 1963);

surprised if a court, applying hindsight, casts a jaundiced eye
upon his original intentions. 8 ' The cruelest dilemma is that faced
by the shareholder-creditor who, threatened with (or merely antici-
pating in his own mind) the possibility of dividend tax on the re-
covery of his principal, withholds collection so that the issue can
be resolved while only the interest deduction is at stake-and
thereby creates additional evidence to weaken the case for recog-
nition of debt. 73 1 If the conduct of the parties with respect to the
purported debt is otherwise exemplary, however, stoppage of pay-
ment in such circumstances would afford little, if any, evidence of
prior intent.a2
Even if the requisite intention to be a true creditor existed at the
outset, enlarged needs of the business or other altered circum-
stances may bring about a change in the intention, as evidenced by
a prolonged failure to collect the obligation; and what was once
a debt may thus be transformed into an equity investment.73 3
A.R. Lantz Co. v. United States, 283 F. Supp. 164, 168 (C.D. Cal. 1968), aff'd, 424
P.2d 1330 (9th Cir. 1970). But of. Green Bay Structural Steel, Inc., 53 T.C. 451, 457-58
(1969), in which the court excused the extension of a ten year note at maturity, despite
a curtail of only 2.5 per cent and the absence of any reserve or other provision for
retirement, by saying "Refinancing . . . is an accepted business practice."
78o Ambassador Apartments, Inc., 50 T.C. 236, 246 (1968), aff'd, 406 F.2d 288 (2d
Cir. 1969) (even though parties at arm's length might have agreed on a similar oxton.
sion, it is an adverse factor to consider). See notes 705-11 supra. But see Bittker, Thin
Capitalization: Some Current Questions, 34 TAXES 830, 837-40 (1956) (shareholder can
never be " the psychological equivalent' '--'Ias authentic a Shylock' '-as an independent
lender, and should not be expected to be).
731 The fact was cited in deciding against the taxpayers in Wood Preserving Corp. v.
United States, 233 F. Supp. 600, 604 (D. Md. 1964), aff'd, 347 F.2d 117 (4th Cir. 1905);
P.M. Finance Corp., 20 T.C.M. 537, 539, 540 (1961), aff'd, 302 F.2d 786 (3d Cir. 1962) ;
R.M. Gunn, 25 T.C. 424, 437 (1955), aff'd, 244 F.2d 408 (10th Cir.), cert. denied, 355
U.S. 830 (1957); Merlo Builders, Inc., 23 T.C.M. 185, 188, 190 (1964). But only in
Gunn and perhaps in Merle Builders was it given significant weight as evidence of in-
tent. See Gooding Test "Vhat Was Stoekholder-Debtor's [sic] Intent?" Is Unfair, 7
J. TAXATION 70 (1957).
732 Piedmont Minerals Co. v. United States, 429 F.2d 560 (4th Cir. 1970) (payments
escrowed to await outcome of tax case); Piedmont Corp. v. Comm'r, 388 F.2d 886, 889
(4th Cir. 1968) ("until the bona fides of the transactions were [sie] questioned, the
interest and installments of principal were paid when due"); J.I. Morgan, Inc., 30
T.C. 881, 886-87 (1958) (see 896, dissenting opinion), rev'd an another issue, 272
F.2d 936 (9th Cir. 1959); Bulkley Dunton & Co., 20 T.C.M. 660, 664 (1961); Hofort Co.
v. United States, 69-1 U.S.T.C. 9220 (C.D. Cal. 1969).
733A.R. Lantz Co. v. United States, 283 F. Supp. 164, 170 (C.D. Cal. 1968), aff'd,
424 F.2d 1330 (9th Cir. 1970); Edwin C. Hollenbeek, 50 T.C. 740, 748 (1968), aff'd,
422 F.2d 2 (9th Cir. 1970); Sayles Finishing Plants, Inc. v. United States, 399 F.2d
214, 217, 220-21 (Ct. C. 1968); Cuyuna Realty Co. v. United States, 382 r.2d 298, 301
(Ct. Cl. 1967); National Say. & Trust Co. v. United States, 285 F. Supp. 325, 332
(D.D.C.1968).

Voluntary Subordination
Although obligations that are subordinated from the outset are
frequently recognized as debts, 734 the shareholder-creditor who
starts out with rights on a parity with general creditors and then,
to assist the corporation in obtaining outside credit, voluntarily
agrees to subordination, 7 or (without formal action) permits
other claims to be preferred,- 86 casts doubt upon his original in-
tention to assert his rights as a creditor.737 Some decisions, how-
ever, give such forbearance no more evidentiary weight than ini-
tial subordination; 73s and, if there is other sufficient evidence of
a bona lide debt, a later agreement to subordinate, without releas-
ing the ultimate obligation to repay,739 is not in itself a contribu-
7s See text at notes 294-314 supra.
735 Subsequent subordination to bank loans: Charter Wire, Inc. v. United States, 303
F.2d 878, 881 (7th Cir. 1962), cert. denied, 372 U.S. 965 (1963); Zephyr Mills, Inc., 18
T.C.MAL 794 799 (1959), aff'd, 279 F.2d 494 (3d Cir. 1960) ; O.H. Kruse Grain & Mill-
ing v. Comm'r, 279 F.2d 123, 126 (9th Cir. 1960).
Subordination to a supplier: Stanley, Inc. v. Schuster, 295 F. Supp. 812, 816 (S.D.
Ohio 1969), aff'd, 421 F.2d 1360 (6th Cir.), cert. denied, 400 U.S. 822 (1970).
Subordination of first mortgage to outside loan: Foresun, Inc. v. Comm'r, 348 F -d
1006, 1009 (6th Cir. 1965) (insurance company loan to enable corporation to buy prop-
erty from related corporation in need of funds).
736 Max D. Gustin, 27 T.C.AL 186, 192 (1968), aff'd, 412 F.2d 803 (6th Cir. 1969);
United States v. Henderson, 375 F.2d 36, 40 (5th Cir. 1967); Gooding Amusement Co.
v. Comm% 236 F.2d 159, 162-63 (6th Cir. 1956), cert. denied, 352 U.S. 1031 (1957).
737 On the other hand, refusal to subordinate their claims for the sake of the cor-
poration's credit is favorable evidence. Amleto U. Salvadore, 22 T.0.2L 1718, 1721-22
(1963); cf. Utility Trailer Mfg. Co. v. United States, 212 F. Supp. 773, 778, 788 (S.D.
Cal. 1962).
738 Subordination to all creditors to get a credit rating: John W. Walter, Inc., .3
T.C. 550, 557 (1954).
Subordination to bank: Gordon Lubricating Co., 24 T.C.M. 697, 711 (1965); Security
Finance & Loan Co. v. Koehler, 210 F. Supp. 603, 605, 606 (D. Kan. 1962); of. A.D .
Lantz Co.v. United States, 283 F. Supp. 164, 168, 170 (C.D. Cal. 1968), aff'd, 421 F.2d
1330 (9th Cir. 1970) (later subordination to bank deemed "much the same as subordina-
tion from the outset" but, with other factors, it leads to nonrecognition).
Subordination of mortgage: Charles E. Curry, 43 T.C. 607, 690 (1965) (later mort-
gage fnanced improvements that enhanced the security); Plastic Toys, Inc., 27 T.C.M.
707, 710 (1968) (deemed sufficient that claim was still superior to general creditors).
79 An outright release of the debt, in an effort to rehabilitate a failing business,
would ordinarily be a capital contribution (Lidgerwood Mfg. Co. v. Comm'r, 229 F.24
241 (2d Cir.), cert. denied, 351 U.S. 951 (1956); Bratton v. Comm'r, 217 F.2d 496
(6th Cir. 1954) ; Estate of Liggett v. Comm'r, 216 F.2d 548 (10th Cir. 1954) ; Johnson,
Drake & Piper, Inc. v. Helvering, 69 F.2d 151 (8th Cir. 1934); Utilities & Industrie3
Corp., 41 T.C. 888, 917 (1961), aff'd and rcv'd on othcr grounds sub nom. South Bay
Corp. v. Comm'r, 345 F.2d 698 (2d Cir. 1965)), although some courts may allow a bad
debt deduction if the debt was already worthless, despite the intended restorative in.
tent of the release. Giblin v. Corm'r, 227 F.2d 692, 698-99 (5th Cir. 1955); Dccag v.

tion of the claim to the corporate capital.7 40 But if the subordina-
tion takes the form of converting the debt to paid-in surplus 711
or to preferred stock,7 42 even with the intent to repay the original
sum when the corporation is able, it is usually held that a debt no
74 3
longer exists. Nevertheless, there is some contrary authority.
If a shareholder-creditor voluntarily subordinates himself, not
to improve the corporation's credit or to stave off disaster, but to
spare outside creditors from loss in the final windup, "because lie
was so closely identified with the corporation that he did not think
it would be honorable" to assert his rights as a creditor, a court
may be so carried away with admiration that it not only recognizes
the debt but allows a deduction for the possible recovery on which
he turned his back.7 44 But one must postulate a late blooming
sense of honor for, if the advances were made with that possibility
in mind, his self-denial "is practically an admission that the ad-
Comm'r, 47 F.2d 695 (6th Cir. 1931) (holding that cancellation made the debt worthless
and deductible, although it restored potential value to the stock and precluded a worthless
stock loss). Release of the obligation does not necessarily establish that there was no
bona fide debt previously. Campbell v. Carter Foundation Production Co., 322 l.2d 827,
832 (5th Cir. 1963).
740 Giles E. Bullock, 26 T.C. 276, 299 (1956), aff'd on other issues, 253 l.2d 715 (2d
Cir. 1958); Harry Levine, 22 T.C.M. 1164, 1168, 1173 (1963); Washington Institute of
Technology, Inc., 10 T.C.M. 17 20 (1951) (all involving subordination agreed to in
proceedings under chapter X or XI of the Bankruptcy Act, in an effort to keep the
business going and perhaps enhance the possibility of ultimate recovery); of. W.D.
Roussel, 37 T.C. 235, 244-45 (1961).
741 Oak Hill Finance Co., 40 T.C. 419, 434-35 (1963) (debt subordinated to bank
and designated as "permanent working capital"); Walter C. McMinn, Jr., 21 T.C.M.
913, 925 (1962) (to get bank credit, shareholder cancelled debt and recorded the
amount as "contributed surplus," thus representing to world that there was no debt,
although "nebulous" intent to repay continued). See text at note 523 supra.
742 Leon R. Meyer, 46 T.C. 65, 101-03 (1966), remanded on other grounds, 383 F.2d
883 (8th Cir. 1967); Riss & Co., 23 T.C.M. 1113, 1146-47 (1964); Herbert E. Plinor,
20 T.C.M. 1073 (1961); Confidential Loan Corp., 16 T.C.M. 99 (1957) (even though it
replaced debt and periodic retirement was required, the very purpose of the substitu-
tion was to eliminate debt on the balance sheet; hence, the stock was not debt); of.
Isidore Himmel, 41 T.C. 62, 72-73 (1963), rev'd on other grounds, 338 F.2d 815 (2d
Cir. 1964) (advances, which issuance of preferred satisfied, found not debt in the first
place). See text at notes 442-55 supra.
743 See notes 459 and 526 supra. Other courts gave effect to the substitution of pro-
ferred stock for debt, but held the later redemption not equivalent to a dividend be-
cause of the business purpose of the transaction, a course now foreclosed by United
States v. Davis, 397 U.S. 301 (1970). See notes 463-64 supra.
744 Maytag v. United States, 289 F.2d 647, 651 (Ct. Cl. 1961) ; of. Harry Levino, 22
T.C.M. 1164, 1168 (1963). In a case where the debtor had not gone bad, the shareholder'a
admission on the stand that he would have seen that an outside creditor was paid first
was held not to negative a debt, because he had no legal obligation to do so. Piedmont
Minerals Co. v. United States, 429 F.2d 560, 563 n.6 (4th Cir. 1970).

vances were considered capital investments." 4 "However com-

mendable such a course may be," a shareholder may not "at one
and the same time treat [himself] as a true creditor and also as
ready to relinquish [his] right to payment and by so doing charge
off the item as a [deduction] against [his] income." 140
Change of Ownership
Ordinarily, unless a shareholder-creditor formally relinquishes

his claim, 747 or evidences a change in his intention to act as a credi-
tor,7 48 the mere exhaustion of corporate net worth through ad-
versity will not change bona fide debt into equity investment.71
Even when new interests then purchase the stock and debt of the
corporation for a fraction of the original investment, some courts
have held that they are entitled to take the capital structure as
they find it and reap such tax benefits as inhere therein7 0 unless
the principal purpose of the acquisition was to obtain such bene-
7 51
fits.
M45Watson v. Comm'r, 124 F.2d 437, 440 (2d Cir. 1942); accord, United States v.
Henderson, 375 F.2d 36, 40 (5th Cir. 1967); Jewell Ridge Coal Corp., 21 T.C.M. 1048,
1056 (1962), aff'd, 318 F.2d 695 (4th Cir. 1963); Reed v. Comm'r, 242 F.2d 334 (2d
Cir. 1957); Sansberry v. United States, 70-1 U.S.T.C. 9210 (SD. Ind. 1070); Martin
M. Dittmar, 23 T.C. 789, 797 (1955); J. Terry Huffstutler, 12 T.C.M. 1422, 1427 (1953).
746 Olympia Harbor Lumber Co. v. Comm 'r, 79 F.2d 394, 306 (9th Cir. 1935). Iccogni-
tion of the indebtedness was not there in issue. The tax'payer claimed a partial bad debt
measured by the amount that would be unrecoverable if all outside creditors were paid
first. The court upheld the Commissioner's right in his discretion to deny any partial bad
debt deduction, but added a dictum that at most the deduction could be only the oy3
that. would result if assets were distributed pro rata to all creditors. Cf. Irbeo Corp., 25
T.C.M. 359, 371-72 (1966) (debt recognized but bad debt deduction denied because of
forbearance to collect what could have been recovered).
7 See mote 739 supra.
749 First National Co. v. Comm'r, 289 F.2d 861, 866 (Gith Cir. 1961) ("A valid note
does not become invalid because its maker becomes insolvent and the note is no longer
of any value."); Earle v. W.J. Jones & Co., 200 F.2d 846, 851 (9th Cir. 1952); c.
Helvering v. Southwest Consolidated Corp., 315 U.S. 194, 202 (1942). The adequacy of
the capital to support the debt (see text at notes 871-S2 (nfra) must be judged without
benefit of "the 20-20 vision of hindsight." Donald C. Nibloch-, Jr., 27 T.C.M. 1381,
1387 (1968), aff' d on other grounds, 417 F.2d 1185 (7th Cir. 1909).
750 Imperial Car Distributors, Inc. v. Comm 'r, 427 P.2d 1334 (3d Cir. 1970) ; Edwards
v. Comm'r, 415 F.2d 578, 583 (1Oth Cir. 1969); First National Co. v. Comm'r, 289 F.2d
861 (6th Cir. 1961); cf. Hans C. Altmann, 27 T.C.M. 1 (1968).
7i When the corporation has become a mere shell and the principal purpose of the
acquisition is to gain tax advantages through pumping new assets and businc-s into it,
section 269, note 129 supra, traditionally a weapon against misuse of los carryovers,
may be availed of also to deny the corporate interest deduction and the nor. shareholders'
capital gain treatment of collections on the purchased debt. Luke v. Comm'r, 351 F.2d

Other cases, however, have found a transmutation of debt into
equity when debt which had lost its equity cushion was sold in a
package with stock.7 52 The Tax Court approaches such cases by
inquiring whether the purchase of the debt had "independent sig-
nificance" or whether the purchasers were primarily interested
in acquiring the business at a certain aggregate price allocated
between debt and stock-oblivious to the fact that whether they
acquire the debt for investment or as a mere incident, the price
they will pay for the stock is necessarily a function of the amount
of debt outstanding. 75 More reasonably, the courts also consider
whether, if the price paid by the purchaser for the stock were the
total equity capital of the corporation, a direct advance of the
amount of the debt made at the time the debt changed hands would
have been recognized as debt. 7 4 That inquiry gets closer to tho
essential question whether the present holders of the obligation
have the requisite intention and expectation that the debt will be
paid regardless of the success of the business. Just as the inten-
tion of the original creditors may change with the passage of
time, 755 so also may new holders of the debt have a different in-
75
tention than their predecessors.
If purported debt is originally subject to nonrecognition for the
568 (7th Cir. 1965); J.T. Slocomb Co. v. Comm'r, 334 F.2d 269 (2d Cir. 1964); Brown
Dynalube Co. v. Comm'ir, 297 F.2d 915 (4th Cir. 1962); Army Times Sides Co., 85 T.O.
688 (1961).
752 Jewell Ridge Coal Corp. v. Comm'r, 318 1.2d 695, 699 (4th Cir. 1903), affirming 21
T.C.M. 1048, 1055 (1962); R.M. Edwards, 50 T.C. 220, 228-29 (1968), ro'cd, 415 F.2d
578 (10th Cir. 1969); Imperial Car Distributors, Inc., 28 T.C.M. 49, 52 (1969), rev'd,
427 F.2d 1334 (3d Cir. 1970); of. Universal Castings Corp. v. Comm'r, 303 F.2d 620 (7th
Cir. 1962) (in which the new owners evidenced their different attitude toward the debt
by altering its form to long-term subordinated income notes, locked together with the
stoek).
753 In R.M. Edwards, 50 T.C. 220 (1968), rmv'd, 415 F.2d 578 (10th Cir. 1969), the
Tax Court relied upon the fact that, after the price of the stock had boon agreed upon,
the purchaser learned of an undisclosed debt to shareholders and insisted upon sale
of both stock and debt for the same aggregate price for which he had been willing to
buy the stock alone, "there being no suggestion that the assignment of the notes war-
ranted any additional consideration." That reasoning was effectively demolisliod by the
Tenth Circuit in reversing. Similar arguments appear in the Tax Court's opinions in the
Jewell Bidge and Imperial Car cases, supra note 752.
754Jewell Ridge Coal Corp. v. Comm'r, 318 F.2d 695, 699 (4th Cir. 1963); Imperial
Car Distributors, Inc., 28 T.C.M. 49, 52 (1969), rev'd, 427 F.2d 1334 (3d Cir. 1970); of.
J.T. Slocomb Co. v. Comm'r, 334 F.2d 269, 275 (2d Cir. 1964).
756 Similarly, if changes in the ownership of either stock or debt cause holdings that
were initially disproportionate to become proportionate (see text at notes 508-93 supra),
the intentions of the purported creditors should be reassessed. Dillin v. United states,
433 F.2d 1097, 1101-02 (5th Cir. 1970).

1971] CORPORATE DEBT 5u1
reason, in conjunction with others, that it is held in the same pro-

portions as the nominal stock, its status may conceivably change
from equity capital into debt after transfers of either stock or pur-
ported debt result in a divergence of shareholder and noteholder
interests-although not, of course, if the transfer is merely within
the family, without affecting the practical control of the corpora-
tion.7 57 It seems, at least, to be the general assumption that such
a change of status would, or should, occur.78 There appears to
have been little consideration, however, of the collateral conse-
quences that such an ipso facto conversion of equity into debt
might entail.759 We have seen that redemption of unrecognized
debt directly from a common stockholder, like a redemption of
preferred stock from him, may be taxed as essentially equivalent
757 General Alloy Casting Co., 23 T.C.M1. 887, 890, 895 (1904), aff'd, 345 F.2d 794 (3d
Cir. 1965) (voting trust certificates given or sold to family, retaining notc3 and con-
trol of voting trust) ; Montclair, Inc. v. Comm'r, 318 F.Md 38, 40 (5th Cir. 1963) (gift
of stock, retaining notes and managerial control); R.0. Owen Co. v. United State,
180 F. Supp. 369, 371 (Ct. CL), cert. denied, 363 U.S. 819 (1960) (exchange of father's
stock for debentures held by sons; father continued in management); Hoguet Real
Estate Corp., 30 T.C. 580, 599 (1958) (gift of stock); Texoma Supply Co., 17 T.O.M.
147 (1958) (transfer of debenture to sister for consideration); of. Fin Hay Rellty
Co. v. United States, 398 F.2d 694, 698-99 (3s Cir. 1968), whero both stock and notes
had passed from an original holder to heirs and it was contended that the soundness of
the purported debt should be judged anew, as if the heirs had mad a loan at that time;
the court rejected the argument on the facts, as it was not shown that payment could
then have been made.
75sNo square authority has been found for the proposition that purported debt,
originally unrecognized, becomes true debt when transferred (or when the stock is
transferred). In W.T. Jones & Son v. Earle, 52-1 U.S.T.C. 1 9150 (D. Ore. 1951), aff'd
on other groun&, 200 F.2d 846 (9th Cir. 1952), the district court found alternatively
that the debt was valid in its inception or that it became so when transferred for value
to a, controlled corporation. A number of cases, note 594 supra, hare cited the fact that
transfers did occur as evidence that, from the outsct proportionality was not intended
to be an immutable faet, and hence, that repayment of the debt according to its terms
was anticipated. In the course of argument in James L. Stinnett, Jr., 54 T.C. 221, 229
(1970), on appeal to the Ninth Circuit, the court stated that the "notes represented
an 'equity' interest only so long as coupled with the ownership of the common stock";
but no question of change of status was there involved. It was the working view of the
staff of the American Law Institute that shareholder debt which bad failed to qualify
for the proposed safe harbor of recognition solely because of an excessive debt-equity
ratio should become qualified after it passed into the hands of nonsharebolders, who
were not to be subject to the ratio test, ALI, IrCOr. TAX Pnonumms or Conron&Txos
_u,D S- oLDRrnVs 428-29 (Report of Working Views of Staff, 1958).
,59 The question was adverted to in Fin Hay Realty Co. v. United States, 308 F.2d
694-, 698-99 (3d Cir. 1968), in which the argument, note 757 supra, that the transfer
of stock and notes to heirs required a reassessment of the status of purported debt was
met with the suggestion that such a conversion, if found, might have resulted in a re-
demption equivalent to a dividend to the estate. It did not deal with the situation where
the transferees of purported debt are neither shareholders nor in an attribution of
ownership, section 318(a), relationship to shareholders.

to a dividend.7 01 But since a common stockholder may ordinarily
sell his preferred stock (if it was originally issued for an invest-
ment of cash or property by him) to a transferee, who, after a
decent interval and without too obvious prearrangement, may have
the preferred stock redeemed without causing dividend tax either
to himself 761 or to his transferor,762 it may be supposed that un-
recognized debt may similarly be transferred and later retired
with impunity. 3 That is not necessarily so, if the transfer au-
tomatically endows the transferee with the status of a creditor.
The substitution of debt for equity is a taxable transaction in the
nature of a redemption of stock; 764 and such "redemption" here
occurs instanter, rather than being deferred until a later transac-
tion to which the common stockholder is not formally a party.
761 Parker v. United States, 88 F.2d 907, 909 (7th Cir. 1937); I.R.C. §§ 302(b) (2)
and (3). If the transferee of the preferred stock (or its equivalent in unrecognized dobt)
also acquires the common, he may be as vulnerable to dividend treatment of a later
redemption of preferred as was his transferor, even though he recovers no moro than his
cost. Cf. Television Industries, Inc. v. Comm 'r, 284 F.2d 322, 325 (2d Cir. 1960).
762 Northup v. United States, 137 F. Supp. 268, 269 (D. Conn. 1955), rev'c on other
grounds, 240 F.2d 304 (2d Cir. 1957); of. Chamberlin v. Comm'r, 207 F.2d 462 (6th
Cir. 1953), cert. denied, 347 U.S. 918 (1954); Milton F. Priester, 38 T.C. 310, 325
(1962); W.P. Hobby, 2 T.C. 980 (1943). Although section 306, which overturned the
result in the specific Chamberlin situation, may result in ordinary income tax on tho
proceeds of sale of preferred stock which had been received in a reorganization or as a
tax-free stock dividend, it has no application to preferred stock which originates in
an investment of cash or property.
763 Such a transfer has been suggested as a way out for a shareholder faced with
the threat of dividend tax on collection of potentially unrecognized debt. Manly, What
to Do About the New Intent Test in Thin Corporations;More on Gooding, 5 J.TAxATION
379, 380 (1956). In Charles D. Vantress, 23 T.C.M. 711 (1964), the taxpayer elaborated
on that device by indemnifying his purchaser against loss, which caused the Commis-
sioner to assert that the redemption was actually made from the shareholder through a
conduit (see note 765 infra); the court found the debt to have boon valid from Its
inception, but on a collateral issue-treatment of interest-it went on to hold that tho
sale was effective even though it had "no other business purpose beyond that of realizing
capital gain." In Bittker, Thin Capitalization: Some Current Questions, 34 TAXEs 830,
833 (1956), it is suggested that, if the unrecognized debt were viewed as a contribution
to capital rather than as preferred stock (see note 85 supra), the instruments evidencing
the loans would be "totally disregarded" and the entire proceeds of sale would bo tax.
able "since there would be no offsetting basis"; and further, that the proceeds would
be ordinary income since the "phantom instruments" would not be property within tho
definition of "capital assets." It seems, however, that an investment is not nonexistent
as property merely because it is deemed capital rather than a loan; and that a portion
of one's capital interest in a corporation would have a portion of its basis when the
interest is subdivided by a sale. Reg. § 1.61-6 (a).
764 I.R.C. §§ 317, 354(a) (2); Reg. § 1.354-1(d) Ex. 3. Before the enactment of the
1954 Code, the substitution of securities for stock of the same corporation was ordinarily
a tax-free recapitalization exchange. Alan 0. Hickok, 32 T.C. 80 (1959).

Although the transformation into true debt does not occur in the
shareholder's hands, he is a participant in, and receives the fruits
of, the very transaction constituting the "redemption," and may
thus be subject to dividend tax thereon."15
FACTORS B EnRG ON RISK AND ECONoIUO REALTY
In General
Purported debts may be denied recognition if, as a matter of

"substantial economic reality," the funds were not "advanced
with reasonable expectations of repayment regardless of the suc-
cess of the venture" 766 but, like risk capital, they "bear a sub-
stantial risk of the enterprise." 77 Since Congress has chosen to
give different tax consequences to debt and to stock, it "would
do violence to the congressional policy" to treat as debt a pur-
ported loan that "is so risky that it can properly be regarded only
as venture capital." 71 It would seem, therefore, that the risk
765 Despite the liberality shown in the cases cited at note 761 supra, obvious prear-
rangement of redemption of stock or debt from a purchaser may result in treatment of
the stock as having been redeemed from the seller, through a conduit or intermediary.
Davant v. Comm'r, 366 F.2d 874, 878-81 (5th Cir. 1960), cert. dcnicd, 380 U.S. 1022
(1967); Luke v. Comm'r, 351 F.2d 568, 572-73 (7th Cir. 1965); Martin Weiner, 21
T.C.M. 252, 255-56 (1962), aff'd, 316 F.2d 473 (3d Cir. 1963); Ferro v. Comm'r, 242
F.2d. 838, 840 (3d Cir. 1957); Humacid Co., 42 T.C. 894, 910-11 (1964); Estate of
Henry A. Rosenberg, 36 T.C. 716 (1961). The result would be the same if the dispro-
portionality and consequent transformation of equity (unrceognized debt) into true
debt resulted from a transfer of stock, the debt being retained. In that cvent, the re-
demption (constructive substitution of true debt for equity) would be from the former
shareholder directly, with no conduit
766 Gilbert v. Comm'r, 248 F.2d 399, 406 (2d Cir. 1957). Sco also Jwell Ridge Coal
Corp., 21 T.C.M. 1048, 1055 (1962), aff'd, 318 F.2d 695 (4th Cir. 1903) ("genuine and
reasonable expectation that [the advances] wil be repaid at a certain time in all events
and regardless of the earnings of profits by the corporation"). Some courts seem to treat
"substantial economic reality" as a factor or test separate from "reasonablo expecta-
tions of payment," construing the former to refer to whether the transaction was "com-
patible with sound business practice." Liflans Corp. v. United States, 390 F.2d 965, 970-
71 (Ct. CL 1968); of. C.M. Gooch Lumber Sales Co. v. United States, 49 T.C. 649, 656
(1968).
76e7assau Lens Co. v. Comm'r, 308 F.2d 39, 47 (2d Cir. 1962); accord, 2554 58
Creston Corp., 40 T.C. 932, 935-36 (1963). When a loan is between unrelated individuals,
its character as debt is not affected by the fact that the possibility of recovery is de-
-pendent upon the financial success of the borrower's business. Giffin Andrew, 54 T.C.
239, 245 (1970). But when the purported debtor is a corporation, the scheme of the
tax law injects the alternative of classifying the advance as capital investment.
768 Gilbert v. Comm'r, 248 F.2d 399, 407 (2d Cir. 1957). Although section 385 of the
Code, added by section 415(a) of the Tax Rleform Act of 1969, doe3 not expressly list
"reasonable expectation of payment" as a factor to be included in the forthcoming reg-
ulations, the Senate report states that among the factors which may lead to classification

test should be imposed as an additionalstandard, which may cause
nonrecognition even when the parties' intention to create a debt
is unimpeachable.0 Some cases, however, seem to apply a sub-
jective rather than an objective test of expectation of payment 1".
and refer to the "realistic prospect of repayment" merely as
"strong evidence of [the requisite] intention" 7II-thereby open-
ing the door in some instances to recognition of debt where the
court is otherwise satisfied of the intention, even if the realistic
prospect is absent.772 Even courts that have, in other cases, fully
embraced the risk test frequently, after finding factors strongly
suggesting the presence of an inordinate degree of risk, recoil from
of purported debt as equity is "whether the corporation's debt-equity structure i such
that it is reasonable to expect that it will be able to meet its obligations to pay the prin.
cipal and interest on the bond or debenture when due." S. REP. No. 91-552, 91st Cong.,
1st Sess. 137 (1969).
769 "Thus a debt without capital to stand behind it is not debt whether or not the
shareholder intends to levy on the corporation if necessary." Lanning, Tax Erosion and
the "Bootstrap Sale" of a Business, 108 U. PA. L. REv. 623, 663 (1960). In Gilbert v.
Comm'r, 248 P.2d 399 (2d Cir. 1957), "[a]ll three judges [who rendered separate
opinions] seem to have agreed that the parties 'truly intended' to create debt." Caplin,
The Caloric Count of a Thin Incorporation, 17 N.Y.U. INST. 771, 799 (1959). See also
note 585 supra. Cf. American Processing & Sales Co. v. United States, 371 F.2d 842,
857 (Ct. C1. 1967) ("The real differences lie in the debt-creating intention of the
parties, and the genuineness of repayment prospects in the light of economic realities"
(emphasis added)). But see the reference to that case, note 772 infra.
770 This tendency of the courts has been aptly criticized as out of harmony with the
purpose of the test to measure the economic reality of the purported lender's inten-
tions. Blum, Motive, Intent, and.Purpose in FederalIncome Taxation, 34 U. COr. L. 1Rv.
485, 538-42 (1967).
771 Estate of Kent Avery, 28 T.C.M. 364, 370 (1969). See notes 934-36 infra. Cf. ALI,
Ii'comx TAX PROBLEMS OF CORPOATIONS AND SHAREnoLIDEs 434-35 (Report of Working
Views of Staff, 1958). Some regard testing the reality of the shareholdor-creditor's
intention by the economic reality of his expectation of repayment as a fair alternative
to what might otherwise be a strong presumption in every case that he would not
embarass his corporation by enforcement action (see notes 577-85 supra). Pin Hay
Realty Co. v. United States, 398 P.2d 694, 697 (3d Cir. 1968). Seoo BiTmEn & EuVTnE,
YEDERA, Ilcomn TAXATION OF CORPORATIONS AND SHAREHOLDERS 126-27 (2d ed. 1960).
772 In American Processing & Sales Co. v. United States, 371 F.2d 842, 850 (Ct. Cl.
1967), it was said that "[w]here the borrower is insolvent it is more credible that the
lender would loan rather than invest," and that "1[e]ases abound where 'indebtedness'
was found despite the weak financial condition and operating losses of the debtor cor-
porations." In Austin Village, Inc. v. United States, 296 F. Supp. 382, 396-97 (N.D.
Ohio 1968), rev'd, 432 F.2d 741 (6th Cir. 1970), in which subordination and other restric.
tions imposed in order to enable outside financing admittedly negatived any Ireasonable
expectation of repayment [of shareholder advances] if the venture was not a success,"
the district court said that this "must be viewed in the light of this corporation's
financial plight," and declined to hold that "when a corporation is in a position of
financial distress any additional funds which are invested by a shareholder which are in
actual fact at the risk of the corporationmust be considered equity." (Emphasis added.)
But see text at notes 991-97 infra.

the logical conclusion by declaring that "these factors must be
weighed against the basic rule that, unless the debt is a mere sham
or subterfuge, taxpayers are not foreclosed from financing a trans-
action in a manner to provide a minimum exposure of their assets
to the risk of the venture" 73 and that the "courts are loathe to
rewrite corporation balance sheets to reflect a Government ver-
sion of glowing corporate health." 174
In any event, there is general agreement that there need only
be a "reasonable," not an "unqualified" expectation of repay-
7 5
mentY. Any debt, particularly if unsecured, 70 subordinated 'I
or long-term, 778 involves some risk of loss, and its repayment is
thus to some extent dependent upon the success (or at least the
survival) of the business. 779 Some have gone so far, therefore, as
to say that "it does not help in the solution of the problem to speak
of the man who invests in stock of a corporation as the one who
takes the risks and the creditor as the one who seeks a definite obli-
gation, payable in any event." 7S0 Nevertheless, while the distinc-
tion between risk capital and a risky loan is an "elusive categoriza-
tion," it is one which the law requires to be made.7 81 The difference,
however imperfectly defined, lies in the vature aizd degree of the
773 Santa Anita Consolidated, Inc., 50 T.C. 536, 551 (1968).
774Amierican Processing & Sales Co. v. United States, 371 F.2d 842, 853 (CL Cl. 1967);
accord, Tomlinson v. 1661 Corp., 377 P.2d 291, 300 (5th Cir. 1967) ("tapplication of
these so-called factors ... must be tempered by an awareness that.., as Judge3 we
are not qualified, or certainly not the best qualified persons, to determine the many
intricacies of transactions in the business world",); C.AL Gooch Lumber Sale Co., 49
T.C. 649, 656 (1968); Scotland iuifils, Inc., 24 T.C.ML 265, 274 (1965). But see Ambas-
sador Apartments, Inc., 50 T.C. 236, 241 (1968), aff'd, 400 F.2d 288 (2d Cir. 1069).
Since that attitude reflects a reluctance to indulge in "tad 1oo judicial regulation of
business practices without legislative guidance" (Nassau Lens Co. v. Comm1r, 30 F.2d
39, 45 (2d Cir. 1962)), the door is open for such guidance to be provided, under legis-
lative delegation, in the regulations to be issued under section 385, added by the Tax
Reform Act of 1969.
775 Santa Anita Consolidated, Inc., 50 T.C. 536, 552 (1968).
776 Earle v. W.J. Jones & Sons, Inc., 200 F.2d 846, 851 (9th Cir. 1952) ; Santa Anita
Consolidated, Inc., 60 T.C. 536 (1968).
777 Gordon Lubricating Co., 24 T.C.M. 697, 711 (1965), holding that, since a sub-
ordinated note would fall due in 20 years, it was not at the risk of the busines
"indefinitely."
778 George A. Nye, 50 T.C. 203, 216 (1968).
779 American Processing & Sales Co. v. United States, 371 F.2d 842, 850 (Ct. Cl.
1967); George A. Nye, 50 T.C. 203 (1968).
780 Byerlite Corp. v. Williams., 286 F.2d 285, 292 (0th Cir. 1960), disparaging the
distinction which the same Judge McAllister had called the "essential diffterece bc-
tween a stocl:olwder and a creditor," in United States v. Title Guaranty & Trust Co.,
133 F.2d 990, 993 (6th Cir. 1943) (emphasis by the court).
7S' Motel Co. v. Comm'r, 340 F.2d 445, 446 (2d Cir. 1965).

risk assumed 7 82
-i.e., whether it is "the creditor's risk that the
business will fail and be unable to meet its debts [or] the entre-
preneurial risk that the business will prosper as well as en-
dure." 783
Although the estimable Judge Learned Hand was critical of the
"economic reality" standard as one which "leave [s] the test unde-
fined, because [it does] not state the facts that are to be determina-
tive," 784 a number of the factors stressed by the courts bear di-
rectly upon this point.7 5 Among them are some that have hereto-
fore been considered in other connections. Thus, subordination
and the absence of security, when the circumstances are such that
a true creditor would not reasonably have accepted such a condi-
7 80
tion, may evidence the assumption of an entrepreneurial risk.
Even proportionality may bear on risk (as well as on intention),
since the "reluctance to 'lend' money to the corporation unless
[one's] fellow shareholders 'lend' proportionate amounts belies a
feeling of confidence that the funds will be returned regardless of
the success of the venture." 787 A history of timely payments, on
the other hand, affords persuasive hindsight evidence not merely
that repayment was intended but that it was reasonably expected,
since "financial success... attests to the sound business judgment"
of the planners of the capital structure,788 which "is not to be set
aside by the dogma of an Internal Revenue theoretician." 1'89 While
such hindsight is not conclusive, since the prospects at the time the
782 Affiliated Research, Inc. v. United States, 351 F.2d 646, 648 (Ct. Cl. 1965);
Diamond Bros. Co. v. Comm'r, 322 F.2d 725, 732 (3d Cir. 1963); Gilbort v. Comm'r,
248 F.2d 399, 407 (2d Cir. 1957).
783 Sherwood Memorial Gardens, Inc., 42 T.C. 211, 229 n.10 (1964), aff'd, 350 F.2d
225 (7th Cir. 1965) (emphasis by the court).
784 Gilbert v. Comm'r, 248 F.2d 399, 412 (2d Cir. 1957) (dissenting opinion).
785 The prevailing opinions in Gilbert v. Comm 'r, 248 F.2d 399, 407, 409-10 (2d Cir.
1957), actually went to some pains to relate the evidentiary factors to the risk test,
although the judges were not in agreement on all points. See also Flin Hay Realty
Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1968).
78 United States v. Snyder Bros. Co., 367 F.2d 980, 984-85 (5th Cir. 1966), cert.
denied, 386 U.S. 956 (1967); Affiliated Research, Inc. v. United States, 351 F.2d 646,
648 (Ct. C. 1965); Gilbert v. Comm'r, 262 F.2d 512, 513 (2d Cir.), cert. denied, 350
U.S. 1002 (1959). See text at notes 282-337 and 543-59 supra.
77 Gilbert v. Comm'r, 248 F.2d 399, 407 (2d Cir. 1957).
788 Baker Commodities, Inc., 48 T.C. 374, 397 (1967), aff'd on another issue, 415 P.2d
519 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970). See also Liflans Corp. v. United
States, 390 F.2d 965, 970 (Ct. Cl. 1968) (19the reasonableness of the expectation was
verified by complete repayment"). See Hickman, Incorporation and Capitalization: The
Threat of the "Potential Income" Item and a Sensible Approach to Problems of
Thinness, 40 TAxES 974, 991 (1962).
789 Sherry Park, Inc. v. United States, 64-2 U.S.T.C. ff 9681 p. 93,710 (S.D. Fla. 1064).

1971] CORPORA TU DEBT
advances were made are the controlling fact,10° the taxpayer's bur-
den of persuasion is undoubtedly less than where the risk of fail-
ure has materialized. 701
Thin or Inadequate Capitalization

One evidentiary factor which gained prominence long before
the articulation of the risk test as such, "2 but which survives today
principally as an element of that test,713 is the inadequacy of the
equity capital of the corporation. The "Age of Ratios" ,01 was
ushered in, no doubt unwittingly, by a passing dictum of the Su-
preme Court in Johit Kelley Co. v. Commissioner, in which the
Court stated what it was zot deciding:
As material amounts of capital -were invested in stock, we need not
consider the effect of extreme situations such as nominal stock invest-
ments and an obviously excessive debt structure.j 5
The actual decision of the Court was only that the virtually ir-
reconcilable results reached by the Tax Court in two cases, one rec-
ognizing and the other denying recognition of purported debt on
facts not differing in substance, were beyond the power of appellate
correction under the then applicable standard of review. 7 6 But the
Tax Court,which had theretofore recognized formal debts despite
extreme ratios,7 97 now concluded that "a corporation's financial
structure in which a wholly inadequate part of the investment is
attributed to stock while the bulk is represented by bonds or other
evidence of indebtedness to stockholders is lacking in the substance
necessary for recognition for tax purposes, and must be interpreted
79D Neither success (Fin Hay Realty Co. v. United States, 398 F.2d 694, 698 (3d Cir.
1968); see note 701 supra) nor failure (Santa Anita Consolidated, Inc. 50 T.C. ,530)
554 (1968) ; see note 726 supra) is conclusive of the issue.
791 See Fin Hay Realty Co. v. United States, 398 F.2d 694, 704 (3d Cir. 1063) (dis-
senting opinion).
792 The risk test, in its present form, may be dated from the decision in Gilbert v.
Commissioner, 248 F.2a 399 (2d Cir. 1957), note 766 supra, although the term, "at
the risk of the business," had long been used to express the conclusion when recogni.
tion of debt was denied.
794 The decade from 1946 to 1956 is so denominated in Caplin, The Caloric Count
of a TMin Incorporation,17 N.Y.U. IsT. 771, 777 (1959).
795 326 U.S. 521, 526 (1946).
798Under Dobson v. Commissioner, 320 U.S. 489, 501-02 (1943), Tax Court dcisions
eould be reviewed only for "clear-cut" errors of law, but not for errors on mixed que3-
tions of fact and law. Since 1948, however, Tax Court decisions have been reviewable to
the same extent as those of district courts sitting without a jury. LI.C. § 7482(a). See
notes 207 and 211 supra.

in accordance with the realities." 71 In some cases, it seemingly
interpreted the Supreme Court's language as a mandate to give
primary, and even controlling, weight to excessive debt-equity
ratios as grounds for nonrecognition of debt,70 9 despite the Court's
caveat that no one characteristic was controlling. 00o On the other
hand, the ratio test, applied as a rule of thumb, became a two-edged
sword, since it appeared for a time that any ratio of less than four
dollars of debt to one of capital, which had been the ratio in the
more extreme of the two cases considered in Kelley,80 ' was per so
not an excessive debt structure, and hence was safe if the more for-
mal requirements for debt were met.802 It seemed that taxpayers had
been granted their much sought "Iblueprint for tax avoidance," 803
for they could, with a 4 to I ratio, obtain the tax advantages of debt
with respect to 80 per cent of the over-all investment, without in-
curring the risks of adventuring with more extreme ratios.80'
798Sam Schnitzer, 13 T.C. 43, 62 (1949), aff'd, 183 F.2d 70 (9th Cir. 1950), oort.
denied, 340 U.S. 911 (1951).
799 See Swoby Corp., 9 T.C. 887, 893 (1947). A 35 to I ratio of debt to equity
appears to have been the only significant feature relied upon in Isidor Dobkin, 15 T.C.
31 (1950), aff'd, 192 F.2d 392 (2d Cir. 1951). And in Erard A. Matthiesson, 10 T.C.
781, 785-86 (1951), aff'd, 194 F.2d 659 (2d Cir. 1952), although there were other ad-
verse factors, the 6 to 1 ratio was said to be "alone sufficient to support the conclusion
that the money advanced .. was at all times put at the risk of the business as capital"
(emphasis added).
800 John Kelley Co. v. Comm'r, 326 U.S. 521, 530 (1946).
s0 In the Kelley case itself, the book equity several times exceeded the debt, which
was recognized as such (see John Kelley Co., 1 T.C. 457, 459, 460 (1943)), and it was
in the companion case of Talbot Mills, in which recognition was denied, that the 4 to 1
ratio was found. But the court's statement that this was not an "obviously excessive
debt structure" was thought to neutralize such a ratio as an adverso factor.
802 After the Commissioner acquiesced, 1952-2 C.B. 3, in Ruspyn Corp., 18 T.C. 769, 778
(1952), where the Tax Court said: "In view of the substantial equity investment . . .
and a ratio of debt to equity investment of only 3Y2 to 1, the situation is as favorable to
petitioner as that involved in Kelley v. Commissioner," the belief spread among prac.
titioners that "tax advisers might now feel freer to recommend ratios of one dollar
of capital to three of loans." See Kramer, Tax Consequences of Inadequate Bquity
Capital: The Thin CorporationProblem, 96 J. ACcouNTANcY 449, 450 (1953). But s0e
Treuseh, Corporate Distributionsand Adjustments: Recent Case Beminders of Sonic Old
Problems Under the New Code, 32 TAXEs 1023, 1026 (1954); of. Sam Schnitzer, 13
T.C. 43, 61 (1949), aff'd, 183 F.2d 70 (9th Cir. 1950), cert. denied, 340 U.S. 911 (1951),
(denying recognition where the ratio was about 4 to 1). Where the ratio was in the
Kelley range, the Tax Court generally looked to other factors as controlling. 3. Terry
Huffstutler, 12 T.C.M. 1422, 1427 (1953).
80 See Jordan Co. v. Allen, 85 F. Supp. 437, 444 (M.D. Ga. 1949).
so4dSe 2 ALI, FED. INCxomE TAX STAT. 232 (Feb. 1954 Draft); Surrey, Income Tax
problems of Corporations and Shareholders: American Law Institute Tax Projet-
American Bar Association Committee Study on Legislative BeCVision 14 TAX L. REv. 1,
46 (1958). With a safe 4 to 1 ratio, the corporation could deduct interest on 80 por cent
of the capital invested and the shareholder could enjoy a tax-free recovery of 80 per cent

As a rule of thumb useful to the taxpayer, the ratio test was laid
to rest a decade after Kelley, with the development of the rules
that one -who claims to be a creditor must have the genuine inten-
tion to collect the purported debt 1o' and a reasonable expectation
of realizing that intentionsoo Absent such intention and expecta-
tion, no "magic or sanitized ratio" 8 0 - -not even 1 to 1 8°--will
save purported debt from nonrecognition. But the Commissioner
too found the rule of thumb unreliable, for the courts developed
no consistent pattern of unacceptable ratios0 0 Whereas a 21 to 1
ratio was described in one case as "thin to the point of being trans-
parent," 810 the same ratio was elsewhere viewed as acceptable
because the corporation's needs for any further capital were
"modest." 811 In special circumstances, ratios in the 20,000 to 1
range were approved. 812 In the numbers game, it became possible
to justify almost any ratio by finding some precedent case which
had approved a higher one, 13 or by citing industry practices which
themselves were strongly influenced by the tax advantages to be
gained from thin capitalization.8 1 4
of his cash investment, with other tax benefits in proportion. A risky 9 to 1 ratio weuld
add only ten percentage points to the benefits that might be hoped for.
so5 See text at notes 475-765 supra.
807 Anthony V. Donis4 26 T.C.M. 327, 331 (1967), aff'd, 405 F.2d 481 (Gth Cir.
1968); accord, Wood Preserving Corp. v. United States, 347 F.2d 117, 120 (4th Cir.
1965).
so8 Gooding Amusement Co, 23 T.C. 408, 419 (1954), aff'd, 23G F.2a lo (oth Cir.
1956), cert. denied, 352 U.S. 1031 (1957). See Caplin, The Calorio Count of a Tldn
Incorporation,17 N.Y.U. IxST. 771, 784-88 (1959). In Gilbert v. Commissioner, 243 F.2d
399 (2d Cir. 1957), the ratio at its peak was a little over 2 to 1.
809 See Caplin, The Caloric Count of a Thin Incorporation, 17 N.Y.U. I.sr. 771 (19 ),
reviewing the ratios that had been approved or disapproved before 1959.
810 Berkowitz v. United States, 411 F.2d 818, 819 (5th Cir. 1969).
sn Arthur F. Brook, 23 T.C.ML 1730, 1738 (1964), rev'd on another issue, 'G@ F.2a
1011 (2d Cir. 1966).
312 Byerlite Corp. v. Williams, 286 F.2d 285 (6th Cir. 190) (advances to a subsidiary,
intended to be of short duration, to provide parent with a source of supply); W.H.
Trusehel, 29 T.C. 433 (1957) (sale of business to unrelated charity).
si3 See Liflaus Corp. v. United States, 390 F.2d 965, 970 (CL. CL 1968) ("17-1 is welt
within limits courts have accepted"); Charles E. Curry, 43 T.C. 007, 091-92 (1965)
(30 to 1 is "somewhat high" but no worse than those in other cases cited therein);
Arthur AL Rosenthal, 24 T.C.M. 1373, 1382 (1965) ('"14-1 is higher than normal,
[but] it is mot unusual," citing Curry); Davidson Bldg. Co., 20 T.C.M. 1291, 1293
(1961) (15 to I is not "without parallel').
sl4Tomlinson v. 1661 Corp., 377 F.2a 291, 299 n.18 (5th Cir. 1967) ("LeVerage i3
the aim of many entrepreneurs, many of whom are quite successful in securing financing
on high ratios"-ignoring the fact that shareholder financing, as in the case at'b
judce, is usually superimposed on the maximum available leverage financing from
outsiders); W.H. Trusehel, 29 T.C. 433, 439 (1957) (justifying thin capitalization

The courts recognized that an amount of equity capital that
would be inadequate to launch a corporation in one industry may
be quite sufficient by the standards of another, and that within one
industry the standard may vary with the type of operation
planned. 15 In general, the more stable the industry and the less
speculative the operation, the higher the proportion of debt it can
carry.8s1 A corporation engaged in oil drilling, 817 logging, 18 con-
struetion81 9 or subdivision development 820 is ordinarily less able
to carry a heavy debt burden than one engaged in owning improved
real estate, with limited working capital requirements 121 and a
reasonably predictable cash flow.122 In the latter cases, the courts
sometimes justify high ratios of shareholder debt by citing the
traditional ability of real estate operators to borrow a large per-
centage of the improved value of the property, even in situations
where the particular corporation was unsuccessful in obtaining
such financing from conventional sources, 82 8 or could have obtained
it only at a prohibitive rate,824 or had superimposed the share-
holder debt on the maximum obtainable from outside lenders. 2
Nevertheless, real estate operators have not been immune from at-
tack where they have stretched the purported debt beyond economic
in a bootstrap sale to charity on the ground that "it is not unusual to find only a min.
imum amount of capital stock outstanding when the new corporation into which others
have been merged is a nonprofit organization"). See Fin Hay Realty Co. v. United
States, 398 F.2d 694, 701 (3d Cir. 1968) (dissenting opinion), citing testimony that
the "usual capitalization" of a real estate corporation was $1,000 in capital and the
rest in loans from shareholders and others.
s15 Scotland Mills, Inc., 24 T.C.M. 265, 272 (1965); Security Finance & Loan Co. v.
Koehler, 210 F. Supp. 603, 605 (D. Kan. 1962). See Bittker, Thin Capitalization:Some
Current Questions, 34 TAXES 830, 831 (1956).
81 Note, Thin Capitalization and Tax Avoidance, 55 CoLuM. L. REv. 1054, 1058-59
n.37 (1955).
81T Michael Cohen, 3 T.C.M. 236, 238 (1944), aff'd, 148 P.2d 336 (2d Cir. 1945).
sis Murphy Logging Co. v. United States, 239 F. Supp. 794, 797 (D. Ore. 1965), rv1'd,
378 F.2d 222 (9th Cir. 1967).
819 John Lizak, Inc., 28 T.C.M. 804, 808 (1969). See Fin Hay Realty Co. v. United
States, 398 F.2d 694, 704 (3d Cir. 1968) (dissenting opinion).
821 Lifilans Corp. v. United States, 390 F.2d 965, 971 (Ct. Cl. 1968); Mulder Bros.,
Inc., 26 T.C.M. 217, 228 (1967).
822 Hickman, Incorporationand Capitalization:The Threat of the 'rPotcntial Income"
Item and a Sensible Approach to Problems of Thinness, 40 TAxEs 974, 991 (1962).
8213Leonard J. Erickson, 15 T.C.M. 1338, 1341, 1343 (1956) (changed conditions were
found to have made the expected permanent financing unobtainable).
824 Tomlinson v. 1661 Corp., 377 F.2d 291, 300 (5th Cir. 1967). But of. MeSorloy's,
Inc. v. United States, 323 F.2d 900 (10th Cir. 1963). See text at notes 973-74 infra.
825 See note 814 supra. Compare the dissenting opinion in Fin Hay ]Realty Co. v. United
States, 398 F.2d 694, 704 (3d Cir. 1968), with the facts set out in the majority opinion.

19711 CORPORATE3 DEBT
limits.82 6 Standard ratio patterns also cannot well be applied to

finance companies, since money is their stock in trade, borrowed
in large amounts to be loaned to others at a profit."- But even
finance companies require some margin of permanent capital and,
if such money is supplied in substantial part by purported loans
from shareholders, it may well be held to be at the risk of the busi-
8 28
ness.
The ratio test was never universally applied. Since the Supreme
Court in the John Kelley Co. case had viewed the presence of
99ozaterial amounts of capital" as negativing "extreme situations
such as nominal stock investments and an obviously excessive debt
structure," 829 some judges subscribed to the view that the debt-
equity ratio was not to be considered as even a significant factor if
the equity capital was "more than nominal." 30 And the Fifth Cir-
826 Ambassador Apartments, Inc., 50 T.C. 236, 245 (1908), aff'd, 400 F.2a 288 (2I
Cir. 1969) (123 to 1; court cannot believe a creditor would make such a loan belind thrco
prior liens); Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 19GS) (11 to
I ratio, no early prospect of paying demand notes, behind mortgages); MeSorley's,
Inc. v. United States, 323 P.2d 900 (10th Cir. 1963) (11 to 1 ratio, no net cash flow
after payments on prior debts); 2554--58 Creston Corp., 40 T.C. 932, 937 (1903) ($1,000
capital, 205 to 1 ratio); Lockwoocl Realty Corp., 17 T.C.ML 247, 251 (1958), rcv'd on
another issue, 264 F.2d 241 (6th Cir. 1959) (24 to 1 ratio); 85 Es R lty, Inc. v.
United States, 59-1 U.S.T.C. 9232 (S.D.N.Y. 1958) (jury instructions).
827 Security Finance &- Loan Co. v. Koehler, 210 F. Supp. 003 (D. Xan. 1902); Jaeger
Auto Finance Co. v. Nelson, 191 F. Supp. 693 (E.D. Wis. 1961). In section 270, added
by section 411 of the Tax Reform Act of 1969, which disallows deductions for intere3t
on indebtedness incurred in certain corporate acquisitions if, among other things, certain
debt-equity and interest coverage ratios are not met, any debt vhich "arises out of the
banking ... , lending or finance business of [the] corporation" is excluded from econ-
sideration on both sides of the ratios. I..C. § 279(e) (5). While no inference is to be
drawn from the section 279 rules, in developing regulations distinguishing debt from
equity for other purposes (section 279(j); S. REP. No. 91-552, 91st Cong., 1st Seszs.
138-39 (1969)), it is evident that Congress recognized the special circumstances of
such businesses.
S28 Consumers Credit Rural Electric Cooperative Corp., 37 T.C. 130, 144 (1061), aff'd,
319 F.2d 475, 478 (6th Cir. 1963); P.L Finance Corp. v. Comm'r, 302 F.2a 786 (3d
Cir. 1962); Wilbur Security Co., 31 T.C. 938 (1959), aff'd, 279 F.2d 657 (9th Cir.
1960); Oak Hill Finance Co, 40 T.C. 419, 433-36 (1963).
829 See text at note 795 supra (emphasis added).
83D See Waterman, 3., concurring in Gilbert v. Commissioner, 248 F.2d 399, 410 (2d
Cir. 1957), quoted with approval in Utility Trailer Mfg. Co. v. United States, 212 F.
Supp. 773, 789 (S.D. Cal. 1962); accord, Santa Anita Consolidated, Inc., 50 T.C. 536,
551 (1968). The Tax Court has frequently recognized debt despite very high ratios,
distinguishing seemingly contrary cases as involving nominal amounts of stock. Arthur
M. Rosenthal, 24 T.C.M. 1373. 1382 (1965) (ratio was 14 to 1 but "wbere there has been
a substantial [$46,906] capital contribution and vhere property ownership is not Qsen-
tial and not necessarily placed at the risk of the business,... the debt to equity ratio
is not a significant factor"); Evwalt Developement Corp., 22 T.C.?& 220, 227 (1963)
($19,500 capital, although "not large in absolute amount, 'was not negligible, as was

cuit flatly rejected the ratio test, declaring that it found "no au-
thority for the proposition that the stockholders of a corporation
may not determine just how much of their funds they care to risk
in the form of capital and how much, if any, they are willing to lend
as a credit," and that the Commissioner and the courts, without
a specific mandate from Congress, could not deny a stockholder
the "right to launch a corporate business without investing in it
all the money it needed, and investing it in the way that is most ad-
vantageous to himself, both as relates to taxation and as to other
creditors." 131
In recent years, the courts-including the formerly recusant
Fifth Circuit 8W2 -have placed the debt-equity ratio in perspective,
as not requiring nonrecognition as a matter of law 883 (even when
the ratio is as high as 692 to 1 834) but as one of the significant fac-
tors bearing on the reasonableness of the expectation of repay-
ment, reflecting the extent of the cushion by which the purported
the situation in many of the cases"); Davidson Bldg. Co., 20 T.C.M. 1291, 1208
(1961) ($36,000 cash capital, $259,200 debentures; but "1[w]hen the 'ratio' is rollod
upon . . . , there is often an absurdly high ratio of debt to equity ranging as high
as 1250 to I . . . ; or, if not, at least a purely nominal investment in capital stock,
such as $1,200"); Harry F. Shannon, 29 T.C. 702, 720 (1958) ($177,840 capital,
$2,450,000 long-term debt to shareholders). Others, however, recognized that "1(wihat
is nominal depends upon the circumstances." Arlington Park Jockey Club v. Sauber,
164 F. Supp. 576, 584 (N.D. Ill. 1958), aff'd, 262 F.2d 902 (7th Cir. 1959) ($20,000
capital was nominal where heavy payroll and other obligations required shareholder
advances; ratio ranged from 10 to 1 to 22 to 1); accord, Northeastern Consolidated Co.,
279 F. Supp. 592, 593 (N.D. I11. 1967), aff'd, 406 P.2d 76 (7th Cir.), cort. denied, 396
U.S. 819 (1969) ($12,000 capital); Erard A. Matthiessen, 16 T.C. 781, 785-88 (1951),
aff'd, 194 F.2d 659 (2d Cir. 1952) (inadequacy of $12,000 capital deemed "alone suf-
ficient" for nonrecognition, although there were other adverse factors); William Bern-
stein, 11 T.C.M. 118, 122 (1952) (stock of $30,000 deemed "issued for a nominal
amount in view of [the] required capital"). Stock capital of $187,800 was viowed as
"only a fraction of the minimum requirements" where purported loans of four times
as much were needed to acquire an essential asset. Sam Schnitzer, 13 T.C. 43, 61 (1949),
aff'd, 189 F.2d 70 (9th Cir. 1950), cert. denied, 340 U.S. 911 (1951).
831 Rowan v. United States, 219 F.2d 51, 54, 55 (5th Cir. 1955) (recognizing open
account advances that reached 28 times equity at their peak and 14 to 1 at dissolution) ;
accord, Sun Properties, Inc. v. United States, 220 F.2d 171, 175 (5th Cir. 1955) (310
to I ratio).
832 Tyler v. Tomilinson, 414 F.2d 844, 848 (5th Cir. 1969); Curry v. United States, 396
F.2d 630, 634 (5th Cir.), cert. denied, 393 U.S. 967 (1968) ; United States v. Honderson,
375 F.2d 36, 40 (5th Cir. 1967); Montclair, Inc. v. Comm'r, 318 F.2d 38, 40 (6th Cir.
1963).
833 Tomlinson v. 1661 Corp., 377 F.2d 291, 299 n.18 (5th Cir. 1967); Gilbert v.
Comm'r, 248 F.2d 399, 407 (2d Cir. 1957). See Scotland Mills, Inc., 24 T.C.M. 265, 273
(1965), in which the court received expert testimony on whether the company was "1ado-
quately capitalized by the standards of the industry."
834 Baker Commodities, Inc., 48 T.C. 374, 396 (1967), aff'd on another issue, 415 F.2d
519 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970).

creditors are shielded against the effects of business losses and

declines in property values.s 'Thinness of capitalization is partic-
ularly significant, therefore, when coupled with subordination to
other creditorsM6 But the adverse effect of thinness may be over-
come by showing a reasonably assured cash flow sufficient to ser-
vice the purported debt 37
Congress now, however, in authorizing the Treasury Depart-
ment to prescribe standards by which debt may be distinguished
from equity, has expressly referred to "the ratio of debt to equity
of the corporation" as one of the factors to which the authorized
regulations may give weights 38 Since ratios might thus assume
renewed significance, it may be profitable to examine the past con-
troversies over the manner in which the ratio was determined.
On the debt side of the ratio, numerous decisions have taken into
account obligations not only to shareholders but to outside creditors
as well,839 on the reasonable premise that the adequacy of the equity
835Ambassador Apartments, Inc, 50 T.C. 236, 245 (1968), aff'd, 400 l.2d 283 (2d
Cir. 1969); Northeastern Consolidated Co. v. United States, 279 F. Supp. 592, 595 (N.D.
f1l. 1967), aff'd, 406 F.2d 76 (7th Cir.), cert. denied, 39G U.S. 819 (1969); Gilbert V.
Comm'r, 248 P.2d 399, 407 (2d Cir. 1957). See also note 815 supra. Cf. Ackersou v.
United States, 277 F. Supp. 475, 477 (W.D. Ky. 1967) (expressing approval of a 4 to
1 ratio in terms of "a margin of security of more than 2%Oll"); Barnes Theatre Ticket
Service, Inc, 26 T.C.M. 1290, 1295 (1967) ("There must be a sufficient capital cushion
to absorb a reasonableportion of the risk of loss of the funds" (emphasis added)). See
Note, Thin Capitalizationand Tax Avoidance, 55 CoL.u. L. REv. 1054, 1058 (1955).
836 Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir. 1969). See text at notes 282-337
supra.
837 Compare Liflans Corp., 390 F.2d 965, 970 (Ct. CL 1908); Piedmont Corp. v.
Comm'r, 388 P.2d 886, 890-91 (4th Cir. 1968); and Baker Commodities, Inc., 48 T.C.
374, 396-97 (1967), afr'd on another issue, 415 F.2d 519 (9th Cr. 1969), cert. denied,
397 U.S. 888 (1970); with Burr Oaks Corp., 43 T.O. 635, 647 (1965), aff'cJ, 365 F.2d
24 (7th Cir. 1966), cert. denied, 385 U.S. 1007 (1967) (a crucial factor, in the case of "a
thinly capitalized corporation" is "the anticipated source of payments"). Concerning
the source of payment test, see text at notes 923-45 infra. See also Hiclmaan, Incorpora-
tion and Capitalization: The T1hreat of the "Potential Income" Item and a Sensible
Approach to Problems of Thinness, 40 TAxEs 974, 989-90 (1962).
838 I.R.C. § 385, as added by section 415(a) of the Tax Reform Act of 1969. That Con-
gress would have the power to prescribe a ratio limitation was indicated in Rowan v.
United States, 219 F.2d 51, 55 (5th Cir. 1955); of. T.S. Biritz Construction Co. v. Comm'r,
387 F.2d 451, 459 (8th Cir. 1967). There is little doubt that it may do so through
its delegate. See note 10 supra.
839 Ambassador Apartments, Inc., 50 T.C. 236, 245 (1968), off'Id, 406 F.2d 288 (2d
Cir. 1969); Tomlinson v. 1661 Corp., 377 F.2d 291, 299 n.18 (5th Cir. 1967); Lock-
-wood Realty Corp., 17 T.C.M. 247, 251 (1958), aff'd, but rev'd on another 4se, 264
F.2d 241 (6th Cir. 1959); 241 Corp., 15 T.C.M. 901, 900 (1950), aff'd, 242 P.2d. 759
(2d Cir.), cert. denied, 351 U.S. 938 (1957); Isidor Dobkin, 15 T.C. 31, 33 (1950), aff'd,
192 F.2d 392 (2d Cir. 1951); 2554-58 Creston Corp., 40 T.C. 932, 937 (1963); Raleigh
Properties, Inc., 21 T.C.M. 812, 819 (1962); Don T. Allen, 18 T.C.M. 1101, 1107 (1959),
inodifted on other grounds, 283 F.2d 785 (7th Cir. 1960); The Colony, Inc., 26 T.C. 30,

514 TAX LAW [Vol. 26:
cushion to protect any creditor is affected by the amount of credit
extended by others whose claims are preferred to or on a parity
with his own.8 40 Other cases, with little analysis, ignore outside
debt and consider only the proportions in which the shareholders
have divided their own investment between stock and purported
debt. 41 But it is a rare case in which the court's inclusion or exclu-
42 (1956), aff'd on another issue, 244 F.2d 75 (6th Cir. 1957), rcv'd, 357 U.S. 28
(1958); J. Terry Huffstutler, 12 T.C.M. 1422, 1427 (1953); of. Anthony V. Donisi,
26 T.C.M. 327, 331 (1967), aff'd, 405 F.2d 481 (6th Cir. 1968). In BITTiKcE &
EusTIcE, FEDERAL INCom0 TAxATION OF Co~puoRATIoNs AND SHAREHOLDERS 125 (2d
ed. 1966), it is said that " 'outside' debt is generally counted, especially if guaranteed
by the stockholders." If a recognized debt to an outside party is subordinated to the ques-
tioned obligation, it seems that it should be considered like equity for purposes of the
ratio, since it is part of the protective cushion; but in Plantation Patterns, Inc., 29
T.C.M. 817, 826 (1970), the court illogically held that if the outside obligation is debt
for one purpose (interest deduction), it must be considered debt in the ratio as woll.
As an odd variation, two cases computed the ratio by comparing the nominal stock with
only the outside debt, ignoring the purported debt to shareholders, but the omission
did not affect the result. Diamond Bros. Co., 21 T.C.M. 696, 705 (1962), aff'd, 322 F.2d
725 (3d Cir. 1963) ; George L. Sogg, 9 T.C.M. 927, 931 (1950), aff'd, 194 F.2d 540 (6th
Cir. 1952).
840 See Ambassador Apartments, Inc., 50 T.C. 236 (1968), aff'd, 406 :F.2d 288 (2d
Cir. 1969), with respect to debts having priority. Even when other debts are on a
parity, "one creditor's protection from the capital cushion will vary in inverse pro-
portion to the amount of credit extended by others." ALI, INcom TAX PROBLEMS O
CoRPoRATioNS AND SHAREHOLDERS 414 (Report of Working Views of Staff, 1958). It
has been urged that the "presence of corporate obligations in the hands of outsiders does
not contribute to an inference of under-capitalization (but] tends to negative such
inference." Fuchs, Thin Incorporations-Debtor Stock, 5 Am. U. INST. 141, 151 (1953).
But that point has validity only if the outsiders advanced credit under the same circum-
stances as the shareholders, without requiring either subordination or guaranty (see
text at notes 975-81 infra), and even then is a reason not for disregarding the outside
debt but for finding the ratio to be reasonable on the basis of the objective evidence.
841 P.M. Finance Corp. v. Comm'r, 302 F.2d 786, 788 (3d Cir 1962); Gloucester Ico
& Cold Storage Co., 19 T.C.M. 1015, 1022 (1960), rev'd an other grounds, 298 F.2d 183
(1st Cir. 1962); Leonard J. Erickson, 15 T.C.M. 1338, 1343 (1956); Kipsborough lealty
Corp., 10 T.C.M. 932, 934 (1951). Myths die hard, and it has been repeatedly assorted,
without examination or authority, that "usually" or "in most cases" the courts dis-
regard outside debt. SURREY & WARREN, FEDERAL INCOrn- TAXATIOii CASES AND MA-
ERIALs 1195 (1960 ed.); Ellis, Tax Problems in Sales to Controlled Corporations, 21
VAND. L. R~v. 196, 222 (1968); Gerver, De-emphasis of Debt-Equity Test for Thin
Corporations Requires New Defense Tactics, 23 J. TAXATIo 28, 29 (1965); Wcls,
The Labyrinth of the Thin Corporation,40 TAXEs 568, 576 (1962); Caplin, The CTalorio
Count of a Thin Incorporation, 17 N.Y.U. INST. 771, 778 (1959). The logislativo pro-
posal of the Advisory Group on Subchapter C, notes 1272-82 infra, would computo tho
ratio without regard to debt not held or guaranteed by shareholders, although staff of the
American Law Institute (ALI, INComE TAX PROBLEMS OF CORPORATIONS AND SHARE-
HOLDERS 60, 412-13 (Report of Working Views of Staff, 1958)), candidly acknowl.
edges that such omissions can be justified only on the basis of a legislativo policy to give
a tax advantage to small business. But that dependence on a policy decision to be made
by Congress was apparently overlooked by the Third Circuit in citing the study for tho
point that it was "far from clear" that a corporation with heavy outside debt, in

sion of outside debt seems to have made any difference in the

reslt.84 Whichever standard is applied, however, it is necessary
to take into consideration any additional obligations reasonably ex-
pected to be incurred for the planned scope of activities 4 3 'When
obligations are contingent in amount, some measurement of the
expected payout is essential.8 44
On the equity side, the courts include not only the paid-in cap-
ital but also the accumulated earnings, whether such earnings have
been dedicated to capital 845 or remain potentially available for
distribution as dividends.8 4 Unpaid stock subscriptions have also
been counted as capital. 47 The price for which new interests pur-
addition to purported debt to shareholders, was thinly capitalized. See P.M. Finance
Corp. v. Camom'r, 302 F.2d 786, 788 (3d Cir. 1902).
842 In most of the cases cited in notes 839 and 841 supra, the ratio ouid have been
extreme by any standard, and debt was not recognized. In the Huffstutlcr case, on the
other hand, the 5 to 1 ratio determined by the court would bave been only 2 to 1 if
outside debt had been ignored, but nonrecognition was based on grounds other than
ratio. In the 1661 Corp. case, debt was recognized despite choice of the method produc-
ing the higher ratio. In the Eric7xson case, which found an acceptable ratio of about 4 to
1 by comparing shareholder debt alone with the market value of the equity, the ratio
would. have been little more than 5 to 1 if mortgage debt had been considered. Con-
ceivably the result in the Loc1:wood case was affected by the finding of a 24 to 1 ratio,
as against about 6 to 1 if outside debt had been ignored.
843 Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir. 1969); United States v. Hender-
son, 375 F.2d 36j 40 (5th Cir. 1967); Diamond Bros. Co. v. Conm'r, 322 P.2d 725, 731
(3d Cir. 1963); Old Dominion Plywood Corp., 25 T.C.M. 678j 694 (1966); Alfred RI.
Bachrach, 18 T.C. 479, 485 (1952), aff'd, 205 F.2d 151 (2d Cir. 1953); Erard A.
Matthiessen, 16 T.C. 781, 786 (1951), aff'd, 194 F.2d 659 (2d Cir. 1952); Sam Schnitzer,
13 T.C. 43, 61 (1949), aff'd, 183 F.2d 70 (9th Cir. 1950), cert. dcided, 340 U.S. 911
(1951); J. Terry Huffstutler, 12 T.C.M. 1422, 1427 (1953). To ignore anticipated financ-
ing would place a premium on timing, since the ratio might appear deceptively reason-
able when the shareholder makes his initial investment in stock and debt before the
necessary additional financing is provided. See ALI, INco=In TAX PROBLEMS oP Con-
POnmIONS Ax SH&EnHoLDEs, 415 (Report of Working views of Staff, 1958). Sec text
at note 874 infra, concerning unanticipated needs.
84 Gardens of Faith, .c, 23 T.C.M. 1045, 1058-60 (1964), aff'd, 345 P2ad 180 (4th
Cir.), cert. denied, 382 U.S. 927 (1965).
845 Utility Trailer Mfg. Co. v. United States, 212 F. Supp. 773, 789 (S.D. Cal. 1062);
cf. Wilbur Security Co., 31 T.C. 938, 949-50 (1959), aff'd, 279 F.2d 657 (9th Cir. 1960).
s4sB.MLC. Mfg. Corp., 11 T.C.M. 376, 378 (1952); of. Affillated Research, Inc. v.
United States, 351 F.2d 646, 650 n.8 (CL CL 1965). See Bittker, 71idm Capitalication:
Some Current Questions, 34 TAxEs 830, 832 (1956), noting that conventional financial
analysis takes surplus into account despite the possibility of its distribution. But of.
Semmel, Tax Consequences of Inadguate Capitalization, 48 COLIA L. REv. 202, 216
(1948).
s R.M.L Gunn, 25 T.C. 424, 432, 437 (1955), aff'd sub. nor. Perrault v. Corom'r,
244 F.2d 408 (10th Cir.), cert. denied, 355 U.S. 830 (1957) (demand note3 for sub-
scriptions were partially paid in next seven years , and shareholders "have always been
prepared to make full payment"); of. Gardens of Faith, Inc., 23 T.C2. 1045, 1059-60
(1964), aff'd, 345 F.2d 180 (4th Cir.), cert. denied, 382 U.S. 927 (1965) (subscription

chase the stock of former owners is not, of course, considered in
the ratio, since the money does not become corporate capital. 48
A down payment made by the corporation on a purported purchase
of property is not counted as equity if it is financed by a mortgage
loan having priority over the seller, 49 or (with less reason) if it
washes out against money paid in by the seller himself for his
stock.85 0 When the initial advances to get a corporation under way
have been determined to constitute equity capital, they may improve
the ratio enough to cause recognition of subsequent advances as
debt. 5 '
Attention is not riveted on the book net worth, however, but on
the fair market value of the net assets 852 or, in default of proof of
notes were later paid; although court looks to "available invested capital," which
seems to mean the amount actually paid in, the ratio it computes does include tho sub-
scriptions). Both may be viewed as dicta or arguendo, since the resulting ratios were still
found excessive.
848 John S. Taft, 20 T.C.M. 1135, 1138 (1961), rev'd on other grounds, 314 F.2d
620 (9th Cir. 1963). The amount paid may, however, evidence the value of the equity at
the time of the stock transfer, and may thus have a bearing on the intentions and
expectations of the new owners of the stock and purported debt. See text at notes 752-50
supra.
849 Foresun, Inc., 41 T.C. 706, 715 (1964), aff'd, 348 F.2d 1006 (6th Cir. 1965). But of.
Evwalt Developement Corp., 22 T.C.M. 220, 227 (1963) (holding inexplicably that the
assumption of the existing purchase money mortgage was "Iin effect a down payment'1).
850 Bruce v. Knox, 180 F. Supp. 907, 909, 912 (D. Minn. 1960). Assuming tlio prop-
erty was not overpriced, the court erred in computing the ratio by reference only to the
net cash remaining in the corporation and ignoring the equity in the property resulting
from the down payment. Regardless, there were ample grounds for finding undercapital-
ization.
851 Motel Co., 22 T.C.M. 825, 833-34 (1963), aff'd on another issue, 340 F.2d 445 (2d
Cir. 1965) (nonrecognition of third mortgage loan to finance initial acquisition of assots
resulted in a 3 to 1 ratio, enabling recognition of later advances although they wore
unsecured; inability to get bank financing was explained away by fact that the balance
sheet showed as secured debt that which the court here deemed equity) ; J. Terry Hluff-
stutler, 12 T.C.M. 1422, 1427, 1428 (1953) (continuing advances to new corporation
deemed capital contributions for first four months, and loans thereafter); of. Amorican
Processing & Sales Co. v. United States, 371 F.2d 842, 846-47, 853 (at. Cl. 1967) (ratio
of purported loans by the taxpayer and a commonly controlled corporation to a sub-
sidiary of the latter was 120 to 1, but ratio would be 4 to 1 if the parent's advances
were deemed capital; although the status of the parent's advances had never been ad-
judicated, the court recognized the taxpayer's advances as debt). But of. C.M. Gooch
Lumber Sales Co., 49 T.C. 649, 658 n.6 (1968) (declining to treat parent's advances as
equity in order to improve the ratio, when only a related corporation's advances had boon
questioned). In John Wrather, 14 T.C.M. 345, 347 (1955), the taxpayer conceded that
his initial advances were capital, thereby paving the way for recognition of later ones.
A similar principle was applied in bankruptcy in Arnold v. Phillips, 117 F.2d 497, 502
(5th Cir.), cert. denied, 313 U.S. 583 (1941).
852 Estate of Miller v. Comm'r, 239 F.2d 729, 733 (9th Cir. 1956); Kraft Foods Co.
v. Comm'r, 232 F.2d 118, 127 (2d Cir. 1956). Book values are "notoriously poor guides"
to the real value of a corporation. George A. Nye, 50 T.C. 203, 216 (1968).

asset values, on the market value of the stock of the corporation.'

Accordingly, appreciation in the value of real estate s ' or of a con-
tract or option for its purchase,"" is considered, including any ex-
cess value expected to result from improvements to be made with
the money purportedly borrowed; 86 but a long-term commitment
dependent on the future growth in the value of real estate may not
be sustained.8 5 The courts may view skeptically a claim of sudden
appreciation above a recent arm's length purchase price, s15 al-
though a bona fide offer s19 or successful outside financingc0 or the
discovery of a mineral deposit,80' may supply the proof. Assets not
shown on the books, such as supplies and tools which had been
charged to expense,s662 or unbilled items and existing orders and
contrats, 6 3 may be taken into account. But one decision, question-
ably, viewed the failure to carry a leasehold on the books as evi-
8
dence that it had no value.
Although weight has even been given to the value to the corpora-
tion of the owner-manager's own skill, contacts and reputation, s65
such assets are usually personal rather than corporate G and, at
853 Estate of Miller v. Comm 'r, 239 F.2d 729, 731, 733 (9th Cir. 1956); Novw England
Lime Co., 13 T.C. 799, 804 (1949).
s84Fellinger v. United States, 238 F. Supp. 67, 73 (N.D. Ohio 1964), aff'd, 303
F.2d 826 (6th Cir. 1966); Cleveland Adolph Mayer Realty Corp., 6 T.C. 730, 741 (194G),
rev' d on another issue, 160 F.2d 1012 (6th Cir. 1947).
s Earle v. W.J. Jones & Son, 200 F.2d 846, 848, 850 (9th Cir. 1952); Davidson
Bldg. Co., 20 T.C.M. 1291, 1298 (1961).
s 6Liflans Corp. v. United States, 390 F.2d 965, 969-70 (CL Cl. 1968); Leonard J.
Erickson, 15 T.C.M. 1338, 1343 (1956); cf. Paul F. Murphy, 21 T.C.M. 1101, 1103 (1962).
In Ray A. Myers, 42 T.C. 195, 207 (1964), the expected profit from retailing bouses con-
strueted with the money was considered as an asset.
sr7 Fin Ray Realty Co. v. United States, 398 F.2d 694, 698 (3d Cir. 1968). See note
927 infra.
8s Affiliated Research, Inc. v. United States, 351 F.2d 640, 650 (Ct. CL 1965) ; Motel
Corp., 54 T.C. 1433, 1437-38 (1970); Ambassador Apartments, Inc, 50 T.C. 230, 242-
44 (1968), aff'd, 406 F.2d 288 (2d Cir. 1969).
sz9 Liftans Corp. v. United States, 390 F.2d 965, 968, 970 (Ct. CL 1968).
860 Paul F. Murphy, 21 T.C.-I. 1161, 1162, 1163 (1962).
s6 Mason-Dixon Sana & Gravel Co, 20 T.C.M. 1351, 1353, 1357 (1901); cf. Earle v.
W.J. Jones & Co, 200 F.2d 846, 850-51 (9th Cir. 1952), relying on estimatcs of mine
value that soon proved unfounded.
S62AMIeto U. Salvadore, 22 T.C.M. 1718j 1720, 1722 n.1 (1963); Mauriceo H. Brown,
18 T.C.M. 483, 484, 486 (1959).
863 Ainslie Perrault, 25 T.C. 439, 450-51 (1955), off'd, 244 F.2a 408 (10th Cir.
1957); Sheldon Tauber, 24 T.C. 179, 181, 183-84 (1955); Amleto U. Salvadore, 22
T.C.M. 1718 (1963) ; Haley v. United States, 60-1 U.S.T.C. 9169 (D. Ore. 1959).
864 Gloucester Ice & Cold Storage Co., 19 T.C.M. 1015, 1022 (1900), rev'd on other
grounds, 298 F.2d 183 (1st Cir. 1962).
s6s Murphy Logging Co. v. United States, 378 r.2d 222), 224 (9th Cir. 1967).
£6 Cf. Stanton H. Bryden, 18 T.C.M. 810, 814 (1959); Estate of Robert Rn. Gannon,

least unless backed by an employment and noncompetition con-
tract, may have limited significance in a credit analysis.80 1 On the
other hand, goodwill, going concern value and similar intangibles
which inhere in the business are generally taken into account, if
they reflect proven earning capacity 8'l rather than merely poten-
tial value. 0 9 However, such intangibles may be volatile and may
have little realizable value to creditors in the event of default, so
the proportion of debt which can be supported thereby may be less
870
than in the case of tangible assets.
Many cases have held that, if the capital of the corporation ap-
peared adequate when it was organized, later advances required
by financial adversity, 8 1 expansion of the business, 8 2 construction
costs exceeding estimates 873 or other unforeseen needs 874 may be
21 T.C. 1073 (1954); Ruth M. Cullen, 14 T.C. 368, 372 (1950); Howard B. Lawton,
6 T.C. 1093, 1100 (1946), rev'd on another issue, 164 F.2d 380 (6th Cir. 1947); D.K.
MacDonald, 3 T.C. 720, 727 (1944). But see Rev. Rul. 64-235, 1964-2 0.B. 18.
867 Dahme Associates, Inc. v. United States, 71-1 U.S.T.C. 9170 (Ct. Cl. 1971) ; of.
Harkins Bowling, Inc. v. Knox, 164 F. Supp. 801, 805-06 (D. Minn. 1958). See God-
stein, CorporateIndebtedness to Shareholders: "Thin Capitalization" and Belated Prob-
le=s, 16 TAx L. REv. 1, 19 (1960).
868 Estate of Miller v. Comm'r, 239 F.2d 729, 731, 733 (9th Cir. 1956) ; Kraft Foods
Co. v. Comm'r, 232 F.2d 118, 122, 127 (2d Cir. 1956); Ackerson v. United States, 277
F. Supp. 475, 477 (W.D. Ky. 1967) (captive business); George A. Nye, 50 T.O. 203, 215
(1968).
869 Affiliated Research, Inc. v. United States, 351 F.2d 646, 650 (Ct. Cl. 1965); Arling.
ton Park Jockey Club v. Sauber, 262 F.2d 902, 903, 905 (7th Cir. 1959) ; Frod I. Ny-
strom, Jr., 28 T.C.M. 1050, 1054 (1969) (purchased goodwill of a then losing business).
870 Moughon v. Comm'r, 329 F.2d 399 (6th Cir. 1964) (business with conceded value of
$316,000 could not support $166,000 debt where tangibles were only $10,000).
871 Austin Village, Inc. v. United States, 296 F. Supp. 382, 394, 397 (N.D. Ohio 19068),
rev'd, 432 F.2d 741 (6th Cir. 1970) ; Bijou-Pensacola Corp. v. United States, 172 F. Supp.
309, 313 (N.D. Fla. 1959); Donald C. Nibloek, Jr., 27 T.C.M. 1381, 1386-87 (1968), aff'd
on another issue, 417 F.2d 1185 (7th Cir. 1969). See text at notes 982-97 infra.
872 Sarkes Tarzian, Inc., 159 F. Supp. 253, 267 (S.D. Ind. 1958) ; Amleto U. Salvadore,
22 T.C.M. 1718, 1722-23 (1963). But of. Gloucester Ice & Cold Storage Co., 19 T.O.M.
1015, 1021 (1960), rev 'd, 298 F.2d 183 (1st Cir. 1962) ("The same strong inference [of
a capital contribution] arises when the stockholders make advancements in order to
expand a going business that is almost wholly without the necessary capital to finance the
expansion. "1).
873 Waterman Steamship Corp. v. United States, 203 F. Supp. 915, 919 (S.D. Ala.
1962), rev'd on other issues, 330 F.2d 128 (5th Cir. 1964), aff'd, 381 U.S. 252
(1965); Ray A. Myers, 42 T.C. 195, 207-08 (1964). But cf. Bijou-Pensacola Corp. v.
United States, 172 F. Supp. 309, 311, 313 (N.D. Fla. 1959).
874See Drown v. United States, 203 F. Supp. 514, 519 (S.D. Cal. 1962), rev'cd on
another point, 328 F.2d 314 (9th Cir. 1964); Scotland Mills, Inc., 24 T.C.M. 265, 275
(1965). The latter case relied on a statement in Earle v. W.J. Jones & Son, 200 P.2d
846, 851 (9th Cir. 1952), that what appeared, on hindsight, to be an excessivo debt
structure "was not the result of design but of the unfortunate course of events." In
Jones, however, the advances were made before the "unfortunate course of events,"

1971] CORPOR ATE DEBT
recognized regardless of the resulting thinness of the capital

structure at that time, unless the corporation is so far gone that
the purported debt appears utterly worthless when contractedV7 8
One case even held that the capital that had been adequate to launch
the business as a partnership was necessarily sufficient equity cap-
ital for the expanded and expanding business when it was incor-
porated five years later.87 Those decisions seem to reflect the for-
malistic notions of an earlier day, that the malum prohibitum is
"arbitrarily designat[ing] as loans the major portion of the funds
[the shareholders] lay out ht order to get the business established
and under way," 877 and that any ratio is permissible so long as
"material amounts of capital" were provided. 78 Logically, how-
ever, if the debt-equity ratio is viewed, as it generally is today, as
evidence of the riskiness of the purported loan and of the reasonable
expectation of its repayment, 79 the appropriate time to determine
the ratio is when each advance is made,88 0 taldng into account not
only accretions to that date but also any declines in value sst and any
deficits sustained in operations.8 2
and were found "not excessive in light of fairly well grounded estimnte3 of the value
of the mining property at the time the advances were made." (Emphasis added.)
S75 See text at notes 982-97 infra.
876 Amleto U. Salvadore, 22 T.C.M. 1718, 1722 (1963); accord, Bahaus & Bure,Inc.,
14 T.C.ML 919. 924 (1955). But of. Joseph H. Hubbard, 11 T.C.M. 958, 061 (1952)
("[P]etitioners left their share of the partnership income in the partnership busines3
because it was needed for business activities. There is no evidence to indicate that an
enigmatic change altered this situation when the partnership business was transferred to
the corporation.").
877 Isidor Dobkin, 15 T.C. 31, 33 (1950), aff'd, 192 F.2d. 392 (2d Cir. 1951) (emphasis
added), notes 1096-1101 infra. See Weldon D. Smith, 17 T.C. 135, 145 (1951), rcvd' or.
other grounds, 203 F.2d 310 (2d Cir. 1953), distinguishing Dobiin on the ground that
"the questionable amount was not a portion of the original corporate investment, but
rather was money subsequently advanced2
S78 See note 830 supra.
880 See Affiliated Research, Inc. v. United States, 351 F.2a 640, 050 (Ct. CL 195);
Diamond Bros. Co. v. Comm'r, 322 F.2d 725, 731 (3d Cir. 1903); Earlo v. W.T. Jone3
& Son, 200 F.2d 846, 851 (9th Cir. 1952). See also Goldstein, Corporate ZThebtedness
to Sharehtolders:"Thin Capitalization" and Belated Problems,16 T2. L. Rv. 1, 48-49
(1960).
88. Christie Coal & Coke Co., 28 T.C.M. 498, 520-21 (1969).
S82 See W.C. Gamman, 46 T.C. 1, 10 (1966); Erara A. Matthie-men, 16 T.C. 781,
786 (1951), aff'd, 194: F.2d 659 (2d Cir. 1952). The staff of the American Law In-
stitute (AIAT, Ix'com TAx PoBLs op ConPon.ToNS Am Sar noLDrns 00, 417-
19 (Report of Working Views of Staff, 1958)), has acknowledge1 that disregard of the
dissipation of contributed capital, occurring prior to the advances, as proposed by the
Advisory Group Recommendations on Subehapters C0, J and K of the nternal Revenuo
Code, Hearings Before the House Comm. on Ways and Mcans, 80th Cong., 1st Sez.

Use of Funds Advanced
Undercapitalization of a corporation may also be evidenced by

the fact that the purported obligation to shareholders was incurred
in the acquisition or construction of the "core assets" permanently
needed in the business,8s 3 including goodwill 884 as well as physical
plant and equipment,8 s5 without which the corporation would have
been a mere shell 886 and could not have carried on its business.88 7
Such assets are said to be "by their very nature placed at the risk
of the business"; 888 and, when they have constituted the capital of
an unincorporated enterprise, "sums previously placed at the risk
of the business cannot suddenly be transmuted into debts not at
the risk of that business by the mere act of incorporation." 8I0
The courts have sometimes avoided application of the "core as-
sets" concept by concluding that the necessary realty and equip-
ment could just as well have been obtained by lease (even where
that method had been used and abandoned, presumably for good
business reasons) ; I'l or, in the case of a land developer, by reason-
ing that the shareholder might have retained and developed the
lots himself, selling them separately to the corporation whenever
882 (1959), can be justified only in terms of giving a tax advantage to a corporation
that has encountered hard times.
883 Wood Preserving Corp. v. United States, 347 F.2d 117, 120 (4th Cir. 1065). In
Dillin v. United States, 433 F.2d 1097, 1102 (5th Cir. 1970), this principle was deomed
relevant in denying recognition of debt incurred by a holding company formed to make
a II shoestring22 purchase of controlling stock of another.
884 Morris Moughon, 22 T.C.M. 94, 100 (1963), aff'd, 329 F.2d 399 (6th Cir. 1964).
885 McSorley's, Inc. v. United States, 323 F.2d 900, 902 (10th Cir. 1963) ; 241 Corp.,
15 T.C.M. 901, 905-06 (1956), aff'd, 242 F.2d 759 (2d Cir.), cert. denied, 354 U.S.
938 (1957); Sam Schnitzer, 13 T.C. 43, 61 (1949), aff'd, 183 F.2d 70 (0th Cir. 1950),
cert. denied, 340 U.S. 911 (1951).
888 Berkowitz v. United States, 411 F.2d 818, 821 (5th Cir. 1969).
887 Charter Wire, Inc. v. United States, 309 P.2d 878, 880 (7th Cir. 1962), oert. denied,
372 U.S. 965 (1963). See Rowan v. United States, 219 F.2d 51, 54, 55 (5th Cir. 1955),
referring to the bankruptcy case of Arnold v. Phillips, 117 F.2d 497, 501 (5th Cr.
1941), which distinguished purported loans required to build and equip the plant from
subsequent advances to meet losses. The principle is endorsed in Helierstoin, Planning
the Corporation,1958 TUL. TAX I~sT. 416, 432.
888 Sam Schnitzer, 13 T.C. 43, 61 (1949), aff'd, 183 F.2d 70 (9th Cir. 1950), cert.
denied, 340 F.2d 911 (1951); accord, General Alloy Casting Co., 23 T.C.M. 887, 894-
95 (1964), aff'd, 345 F.2d 794 (3d Cir. 1965).
889 Peco Co, 26 T.C.M. 207, 211 (1967); accord, Joseph H. Hubbard, 11 T.C.M. 958,
961 (1952). But cf. note 876 supra.
soe Arthur M. Rosenthal, 24 T.C.M. 1373, 1382 (1965) ; Maurice H. Brown, 18 T.C.M.
483, 485 (1959); J.I. Morgan, Inc., 30 T.C. 881, 890 (1958), rev'd on another issue,
272 F.2d 936 (9th Cir. 1959); Warren H. Brown, 27 T.C. 27, 34 (1956). Concerning
leasing from shareholders as a way around the debt-equity problem, see text at note
1528 infra.

it was ready to build houses on them. s11 Other decisions, however,

focus on the corporation's actual method of doing business, and
consider whether it could have operated as it did if it were deprived
of the asset. 92 A dealer in land may find another escape from the
principle in that the land, while the essential base of corporate
operations, is intended to be sold and thus to liquidate the debt; 813
but the weight of that argument depends on the extent of develop-
ment required to put the land in condition for sale.8 91 The core as-
sets concept has not been applied where additional assets are ac-
quired to expand an established business,890 although the difference
essentially is not in the kind but in the weight of the inferences
that may be drawn from the character of the assets financed. 00
Nnhile an excessive debt-equity ratio and investment in perma-
nent or essential assets are mutually reinforcing factors s o" the
latter may have independent significance even when the corporate
capitalization is not thin. s8p On the other hand, as a principle of gen-
eral application, it is belied by the many decisions that have tol-
erated the incorporation of new and going businesses, essential as-
sets and all, with significant portions of the value reflected in debt
to shareholders.8 11
891 J.S. Biritz Construction Co. v. Comm'r, 387 F.2d 451, 459 (8th Cir. 1067).
892 Edwin C. Hollenbeek, 50 T.C. 740, 741-42 (1968), aff'd, 422 F.2d 2 (9th Cr.
1970) (purchase of realty and equipment formerly leased); J.S. Biritz Construction
Co., 25 T.C.M. 1175, 1185-86 (1966), rev'd, 387 F.2d 451 (8th Cir. 167); Gloucester
Ice & Cold Storage Co., 19 T.C.M. 1015, 1020-21 (1960), rov'd, 298 F.2d 183 (Ist Cir.
1962); Ryan Contracting Co., 15 T.C.M. 999, 1000, 1001 (1956) (profits dependel on
taking advantage of cash discounts, which advances made possible); Robert L. 03borne,
13 T.C.ML 428, 430 (1954).
893 J.S. Biritz Construction Co. v. Comm'r, 387 F.2d 451, 459 (8th Cir. 1967). But ef.
Sansberry v. United States, 70-1 U.S.T.C. T 9216 (S.D. Ind. 1970).

895 Utility Trailer Mfg. Co. v. United State , 212 P. Supp. 773, 786 (S.D. Cal. 1962);
Evwalt Developement Corp., 22 T.C.ML 220, 227-28 (1903) (note for additional land
could be paid from proceeds of sales of earlier lots).
89G See text at notes 902-03 infra.
s97United States v. Henderson, 375 F.2d 36, 40 (5th Cir. 1967); Laidley, Inc., 20
T.C.M. 917, 921-22 (1961); Alden Homes, Inc., 33 T.C. 582, 606 (1959).
898 Charter Wire, Inc. v. United States, 309 :.2d 878, 880 (7th Cir. 1962), cert. denfed,
372 U.S. 965 (1963); Brake & Electric Sales Corp. v. United States, 185 F. Supp. 1, 3
(D. Mass. 1960), aff'd, 287 P.2d 426, 428 (1st Cir. 1901). But see Harkins Bowling, Inc.
v. Kno:, 164 F. Supp. 801, 806 (D. !Minn. 1958).
899B.g., United States v. Haskel Engineering & Supply Co., 380 P.21 786 (9th Cir.
1967); Tomlinson v. 1661 Corp., 377 F.2d 291 (5th Cir. 1967); Estate of Miller v.
Comm'r, 239 F.2d 729 (9th Cir. 1956), reversing 24 T.C. 923, 929-30 (1955) (in vhich
the Tax Court had relied on the permanent capital point as wel as the ratio, but the
Ninth Circuit refuted the latter on the facts and ignored the former) ; Jack Daniel Dis-
tillery v. United States, 379 F.2d 569, 580-85 (Ct. CL 1967); George A. Nye ,50 T.C.

Plainly, despite occasional verbal flourishes suggesting the con-
trary, the core asset concept is not and cannot be a rule of law,0 01
since essential assets of a business are often acquired with the aid
of outside credit and there is no reason, per se, to discriminate
merely because shareholders supply the funds. 01' We have seen,
however, that the shareholder-creditor's attitude toward a pur-
ported debt may differ from that of an outside lender or seller, and
the essentiality of the assets may have an important evidentiary
bearing on whether he would realistically intend enforcement ac-
tion that might deprive the corporation of their use."2 In effect, the
character of the assets narrows the sources from which repayment
may reasonably be expected, and places the burden on the taxpayer
to show that the debt can be paid at maturity out of expendable as-
203, 214-15 (1968); Maurice H. Brown, 18 T.C.M. 483 (1959); John W. Walter, Inc.,
23 T.C. 550 (1954); Ruspyn Corp., 18 T.C. 769 (1952).
00 Daytona Marine Supply Co. v. United States, 61-2 U.S.T.C. 1 9523 (S.D. Fla.
1961); Charles D. Vantress, 23 T.C.M. 711, 717-18 (1964); of. Charles E. Curry, 43 T.C.
667, 692 (1965). A number of the more comprehensive judicial lists of eriteria (see note
197 supra) fail to include "the use to which the funds are put," even as an ovidontiary
factor. Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968) (which
does, however, include "the timing of the advance with reference to the organization of
the corporation"); J.S. Biritz Construction Co. v. Comm'r, 387 F.2d 451, 457 (8th
Cir. 1967) (which seems to merge this factor with undercapitalization) ; Burr Oaks Corp.
v. Comm'r, 365 F.2d 24, 27 (7th Cir. 1966), Vert. denied, 385 U.S. 1007 (1967); O.H.
Kruse Grain & Milling Co. v. Comm'r, 279 F.2d 123, 125 (9th Cir. 1960). But see
Tomlinson v. 1661 Corp., 377 F.2d 291, 296 n.9 (5th Cir. 1967); P.M. Finance Corp. v.
Comm'r, 302 F.2d 786, 789 n.14 (3d Cir. 1962); Gilbert v. Comm'r, 248 P.2d 399, 407
(2d Cir. 1957).
go, BI nm & EusTIc, FEDERAL INCOME TAXATION Or ConroLATioNs AND SHARE-
HOLDERS 126 (2d ed. 1966); Hickman, The Thin Corporation: Anotlwr Look at an Old
Disease, 44 TAXES 883, 886 (1966); Aarons, Debt. v. Equity: Special Hazards in Soting
up the Corporate Capital Structure, 23 J. TAXATiox 194 (1965). But of. Goldstoin,
Corporate Indebtedness to Shareholders: "Thin Capitalization" and Belated Problems,
16 TAx L. RmE. 1, 32 (1960) ("arm's length creditor would almost never lend to a busi-
ness until the equity owners had at least provided the basic assets"). It has boon sug-
gested that the test be whether the asset is one for which debt financing would be
appropriate (e.g., certain fixed assets) or is one which makes its recovery dependent
entirely upon the success of the enterprise (e.g., speculative development costs). Knicker.
bocker, The Logical Difficulties of Let's Pretend Tax Law, 9 VmL. L. REv. 8, 9-10
(1963). See Berkowitz v. United States, 411 F.2d 818, 821 (5th Cir. 1969) (without the
asset, corporation would have been a mere shell because financing could not have been
obtained elsewhere).
902 Charter Wire, Inc. v. United States, 309 F.2d 878, 880-81 (7th Cir. 1962), cert.
denied, 372 U.S. 965 (1963); Estate of Herbert B. Miller, 24 T.C. 923, 929-30 (1955),
rev'd, 239 F.2d 729 (9th Cir. 1956); Mullin Bldg. Corp., 9 T.C. 350, 355 (1947), aff'd,
167 F.2d 1001 (3d Cir. 1948). See Gilbert v. Comm'r, 248 F.2d 399, 407 (2d ir. 1957).
But of. Utility Trailer Mfg. Co. v. United States, 212 F. Supp. 773, 788-89 (S.D. Cal.
1962) (necessity to curtail operations if debt were paid is not same as inability to pay).
See generafly text at notes 475-765 supra.

sets, soundly anticipated cash flow, or other sources not

3
unduly de-
pendent upon the uncertain success of the business.°
Working capital is just as essential and just as much at the risk
of the business as plant and equipment 04 Purported loans made
to an embryo business for such basic needs can ordinarily be re-
covered, without crippling or forcing liquidation of the enter-
prise,90 5 only if and when the venture succeeds 0GAlthough borrow-
ing for working capital is an accepted business practice, such loans
are commonly secured by a greater amount of inventory and re-
ceivables, 90 7 and disinterested parties would rarely make such
loans on inadequate security at the very inception of a business,
before it has shown its capacity for profit-malking I'l and has es-
tablished a credit standing. 09 Therefore, if the organizers of a cor-
poration fail to provide the equity capital forseeably necessary to
carry on its planned scope of operations, but immediately 10 or
903 See Brake & Eleetrie Sales Corp. v. United States, 287 F.2d 426, 428 n.1 (Ist Cir.
1961). If payment is "totally dependent on the continuation of corporate earnings"
(Moughon v. Comm'r, 329 F.2d 399, 401 (6th Cir. 1964); accord, Berkowitz v. United
States, 411 F.2d 818, 821 (5th Cir. 1969)), the earnings should be well assured. Estate
of Miller v. Comm'r, 239 F.2d 729, 732 (9th Cir. 1956). Sec the discucion of tho
Ccsource of payment" factor in text at notes 923-45 infra.
904 Gloucester Ice & Cold Storage Co., 19 T.C.AL 1015, 1021 (1960), rev'd, 298 F.2d
183 (lst Cir. 1962) ("There is really no differenco between the stochholders supplying
all of the working capital... or substantially all of such working capital..., and tho
stockholders supplying the corporation funds to invest in its fixed assets."). See Hiclkan,
IncorporationT and Capitalization: Die Thrcat of the "Potential Incanie" Item and a
Sens-bWe ApproacJ to Probleras of Thinness, 40 TAxrs 974, 993 (1902); Bitther, Thfin
Capitalization:Some Current Questions, 34 T.ss 830, 837 (1956).
905 Consumers Credit Rural Electric Cooperative Corp., 319 F.2d 475, 478 (Gth Cir.
1963); Fred I. Nystrom, Jr., 28 T.C.M. 1050, 1054 (1969).
90 Dodd v. Comm'r, 298 F.2d 570, 578 (4th Cir. 1962); American-La Frmce-Fonmito
Corp. v. Comm'r, 284 F.2d 723, 725 (2d Cir. 1900), cert. denied, 365 U.S. 881 (1961);
Gilbert v. Comm'r, 262 F.2d 512, 514 (2d Cir.), ccrt. denied, 359 U.S. 1002 (199).
907In a number of cases, the working capital loans by shareholders were superimposed
on the maximum obtainable from banks or factors on the security of the current asets
(P.M Finance Corp. v. Comm'r, 302 P.2d 786 (3d Cir. 1962)) or far exceed d the
amount obtainable in that manner. Zephyr Mills, Inc., 18 T.C.M. 794, 799 (1959), aff'c,
279 F.2a 49, (3d Cir. 1960); cf. American-La Prance-Foamite Corp. v. Comm'r, 284
F.2d 723, 724-25 (2d Cir. 1960), cert. denied, 365 U.S. 881 (1961).
908 Coleman Good, Inc. v. United States, 65-2 U.S.T.C. 9750, p. 97,055 (W.D. Pa.
1965), aff 'd, 359 F.2d 434 (3d Cir. 1966) ((no prior corporate financial history that
offers assurance that the funds initially advanced are being successfully invested");
Wood Preserving Corp. v. United States, 233 F. Supp. 600, 600 (D. Md. 19M4), aff'd,
347 F.2d 117 (4th Cir. 1965); Brard A. Matthiessen, 16 T.C. 781, 78G (1951), aff'd, 194
F.2d 659 (2d Cir. 1952).
209 Joseph Verner Reed, 14 T.C.M. 455, 460 (1955), aff'd, 242 F.2d 334 (2d Cir. 1957).
910 George T. Smith, 23 T.C.ML 1689, 1694 (1964), aff'd, 370 F.2d1 178 (6th Cir.
1966) ; Lewis L. Culley, 29 T.C. 1076, 1087-88 (1958).

continuously 911 advance funds for that purpose, most courts will
view the advances as risk capital intended to ride the ups and
downs of the venture. 2
Nevertheless, there is some authority for recognition of un-
secured advances made to pay the operating expenses of a busi-
ness during its formative period of heavy losses, even though
repayment depended entirely upon the purported debtor's
financial success, 91 8 at least if the corporate capital is "more than
nominal," 91 or if the advances are not proportionate to stockhold-
ings,9 15 or if the working capital needs prove greater than had
been honestly anticipated and provided for.9 10
911 Arlington Park Jockey Club v. Sauber, 262 F.2d 902, 906 (7th Cir. 1959); Fred
I. Nystrom, Jr., 28 T.C.M. 1050, 1051, 1054 (1969).
912 Max D. Gustin, 27 T.C.M. 186, 192 (1968), aff'd, 412 F.2d 803 (6th Cir. 1060);
Melville D. Frank, 24 T.C.M. 979, 981 (1965) ; Phil L. Hudson, 31 T.C. 574, 583 (1958)
and cases cited at notes 904-11 supra. A passive bolder of unproductive realty may bo
deemed undercapitalized if it is not provided with the equity capital necessary to carry
interest and taxes. Hoguet Real Estate Corp., 30 T.C. 580, 595, 601 (1958); William
Bernstein, 11 T.C.M. 118, 122 (1952).
91s American Processing & Sales Co. v. United States, 371 F.2d 842, 846, 853, 856
(Ct. CL 1967); of. Scotland Mills, Inc., 24 T.C.M. 265, 273 (1965), making the remark-
able bootstrap argument that there was no need to provide the corporation with operat-
ing capital since it was able to purchase raw materials from its shareholder on credit.
914 Earle v. W.J. Jones & Son, 200 F.2d 846, 850-51 (9th Cir. 1952); Scotland Mills,
Inc., 24 T.C.M. 265, 273 (1965). See Gilbert v. Comm'r, 248 F.2d 399, 410 (2d Cir.
1957) (concurring opinion). Cf. note 830 supra. Numerous cases, however, havo denied
recognition of advances for initial working capital where the capital provided was
neither nominal nor particularly thin (at least at the outset). Arlington Park Jockey
Club v. Sauber, 262 F.2d 902, 903, 905 (7th Cir. 1959); Gilbert v. Commr, 248 F.2d
399, 401 (2d Cir. 1957), second appeal, 262 F.2d 512 (2d Cir.), cert. denied, 359 U.S.
1002 (1959); Coleman Good, Inc. v. United States, 65-2 U.S.T.C. 1 9750 (W.D. Pa.
1965), aff'd, 359 F.2d 434 (3d Cir. 1966); Wood Preserving Corp. v. United States,
347 F.2d 117, 118 (4th Cir. 1965); Fred I. Nystrom, Jr., 28 T.C.M. 1050, 1051 (1969).
915 Earle v. W.J. Jones & Son, 200 F.2d 846, 850 (9th Cir. 1952); Janet McBride, 23
T.C. 926, 928, 932 (1955); Weldon D. Smith, 17 T.C. 135, 144-45 (1951), rvI'd on
other grounds, 203 F.2d 310 (2d Cir. 1953). Of. text at notes 595-637 supra. But dis-
proportionate advances for initial working capital have often been denied recognition.
American-La France-Foamite Corp. v. Comm'r, 284 F.2d 723 (2d Cir. 1960), ocrt.
denied, 365 U.S. 881 (1961); Schine Chain Theatres, Inc., 22 T.C.M. 488 (1963), aff'd,
331 F.2d 849 (2d Cir. 1964); Phil L. Hudson, 31 T.C. 574 (1958); Dezso Goldner, 27
T.C. 455, 459 (1956).
916 Maloney v. Spencer, 172 F.2d 638, 640 (9th Cir. 1949) (expected to obtain out-
side financing for operating expenses, but wartime conditions prevented); Maytag v.
United States, 153 Ct. C. 622, 632-36 (1961) (findings of fact not reproduced in 280
F.2d 647); Seven Sixty Ranch Co. v. Kennedy, 66-1 U.S.T.C. 9293 (D. Wyo. 1966);
Santa Anita Consolidated, Inc., 50 T.C. 536, 540-42, 554 (1968); Scotland Mills, Inc.,
24 T.C.M. 265, 275 (1965). Of. note 874 supra. The fact that the failure to foresee tho
extent of the need resulted from inexperience and overconfidence has boon hold im-
material. Drown v. United States, 203 F. Supp. 514, 520 (S.D. Cal. 1962), rcv'd on
other grounds, 328 F.2d 314 (9th Cir. 1964); Alstate-Schuylkill Co., 28 T.C.M. 32, 39
(1969); Lucia Chase Ewing, 5 T.C.M. 908, 910 (1946).

At least where the initial capital appears adequate, the courts

tend strongly to favor subsequent shareholder advances to provide
additional working capital, 17 which is generally viewed as a short-
term need 9 18 and is expected to generate its own cash flow from
which the advances can be repaid.01 9 Advances to carry an ex-
panded volume of business are viewed differently from those made
to start the business, even though the additional worldng capital
may be permanently needed 20 And, barring utter hopelessness,0 2 '
advances to restore worldng capital depleted by adversity are
ordinarily recognized as debts despite uncontrollable growth of
9 22
the account.
917 Rowan v. United States, 219 F.2d 51, 53-55 (5th Cir. 1955), citing the bank-
ruptcy ease of Arnold v. Phillips, 117 F.2d 497 (5th Cir.), cert. denied, 313 U.S. 583
(1941), whieli denied debt treatment to initial advances for capital assets but recognized
those made for working capital after the business was established. But of. the curious
inversion of the usual distinction, in Green Bay Structural Steel, Inc., 53 T.C. 451, 458
(1969), recognizing debt because "'[w]e do not have here a situation of repeated ad-
vanees by stockholders to the corporation to keep it going [but) a single input of
funds for initial financing."
s1 Motel Co. 22 T.C.1L 825, 833 (1963), aff'd on another issue, 340 F.2d 445 (2d Cir.
1965); cf. Christie Coal & Coke Co., 28 T.C.M. 498, 524 (1909) (purported debts aris-
ing from furnishing of goods and services; "source of payment 'was not income to be
earned at some indeterminable time inthe future but rather from present revenues peti-
tioners were aiding [the debtor] to earn").
919 Alstate-SchuykiMl Co., 28 T.C.M. 32, 39 (1969); 31alone & Hyde, Inc., 49 T.C.
575, 579 (1968); Albert W. Petersen, 24 T.C.M. 752, 751 (1965). Open running accounts
reflecting mutually beneficial intercompany transactions seem particularly favored by the
courts. American Processing & Sales Co. v. United States, 371 F.2d 842, 857 (Ct. Cl.
1967); Christie Coal & Coke Co., 28 T.C.M. 498, 524 (1969); C. Gooch Lumber
Sales Co., 49 T.C. 649, 657 (1968) ; Scotland Mills, Inc., 24 T.C.M. 265, 2.75 (1905).
920 Hofert Co. v. United States, 69-1 U.S.T.C. T 9220 (C.D. Cal. 1969) ; Sarbe3 Tarzian,
Inc. v. United States, 159 F. Supp. 253, 267 (S.D. Ind. 1958); Christie Coal & Coke
Co., 28 T.C.M 498, 519 (1969); Malone & Hyde, Inc., 49 T.C. 575, 579 (1908); Allied
Stores Corp. 19 T.C.M 1149, 1154, 1162 (1960); Arvid Strand, 13 T..M. 703, 704
(1954). But of. Allen v. Comm'r, 283 l.2d 785, 788 (7th Cir. 1960); Powers Photo
Engraving Co., 17 T.C. 393, 402 (1951), remanded on other grounds, 197 P 1 704 (2d
Cir. 1952). Such advances have sometimes been recognized even when capital was in-
adequate for expansion in contemplation from the outset. Los Angeles Shipbuilding &
Drydock Corp. v. United States, 289 F.2d 222, 224 (9th Cir. 1961) ; Amleto U. Salvadore,
22 T.C.M. 1718, 1722-23 (1963).
2
9 1 See text at notes 991-97 infra.
922 Stratmore v. United States, 292 F. Supp. 59, 63-64 (D.N.J. 19068), rTet ld on an-
other point, 420 F.2d 461 (3d Cir.), ccrt. denicd, 398 U.S. 951 (1970); Donald C.
Niblock, Jr., 27 T.C.ML 1381, 1387 (1968), aff' d on another point, 417 1F.2d3,185 (7th
Cir. 1969) ("when the corporation was formed there wvas nothing to indicate that it
-vas inadequately capitalized for the type of business it expected to conduct .... We
cannot at this date, by using the 20-20 vision of hindsight, second gueS3 petitioner.").
see text at notes 982-90 infra. If new sbarebolders take over after capital has been
depleted, however, their working capital advances may be judged as if they had then
formed a new corporation with insufficient capital. Sea note 986 infra.

TAX L'AW, REVfEW [Vol. 26 :
Source of Payments
Perhaps the most obvious criterion of whether payment of a pur-

ported debt may reasonably be expected is the projection of the
sources from which payments may be made. In general, there are
only four possible sources for consideration: (1) liquidation of as-
sets, (2) profits from the business, (3) cash flow, and (4) refinanc-
ing with another lender.
If the uncertainties of successful operation are such that the
only reasonably assured source of funds for repayment, at ma-
turity or within a reasonable time, is the liquidation of the enter-
prise, a strong inference arises that no such drastic action would
be contemplated by the purported creditors . 23 In the case of a cor-
poration formed to sell real estate, however, the very business of
the corporation is the liquidation of its assets. If the property
has been developed to the point where there is "some degree of
certainty" of success 02 4 -particularly if the results achieved bear
out the expectations 2 5 --0r if sales at cost would repay the pur-
ported debt, so that recovery depends "not on the success . . .
but merely upon completion of the project, whether at a profit or at
a loss," 926 the courts tend to sustain the debt, notwithstanding thin
capitalization. On the other hand, if the development is a specula-
tive venture, acquired from related parties at a price that antici-
pates the profits to be derived from extensive development, for the
cost of which no equity capital is provided, the investment is plainly
at the risk of the business,92 7 even when the payments are scheduled
923Ram Corp. v. United States, 305 F. Supp. 831, 834 (W.D.N.C. 1969); National
Savings & Trust Co. v. United States, 285 F. Supp. 325, 332 (D.D.C. 1968); MeSorloy 's,
Inc. v. United States, 63-1 U.S.T.C. 9231 (D. Colo. 1962), aff'd, 323 F.2d 900 (10th
Cir. 1963); Fred I. Nystrom, Jr., 28 T.C.M. 1050, 1054 (1969); Newman E. Jones, Jr.,
23 T.C.M. 1613, 1615 (1964); 2554-58 Creston Corp., 40 T.C. 932, 938 (1963); Mullin
Bldg. Corp., 9 T.C. 350, 355 (1947), aff'd, 167 P.2d 1001 (3d Cir. 1948).
924 Piedmont Corp. v. Comm 'r, 388 F.2d 886, 890 (4th Cir. 1968); accord, Lots, Inc.,
49 T.C. 541, 548 (1968); Evwalt Developement Corp., 22 T.C.M. 220, 228 (1963).
925 Sherry Park, Inc. v. United States, 64-2 U.S.T.C. 9681 (S.D. Pla, 1964); As.
sociated Investors, Inc. v. United States, 57-1 U.S.T.C. 1 9396 (D. Kan. 1956).
926 Wynnefield Heights, Inc., 25 T.C.M. 953, 959-60 (1966); accord, Lots, Inc., 49
T.C.541, 548 (1968).
927Aqualane Shores, Inc. v. Comm'r, 269 F.2d 116, 119 (5th Cir. 1959); Sansborry
v. United States, 70-1 U.S.T.C. 9216 (S.D. Ind. 1970); Castle Heights, Inc. v. United
States, 242 F. Supp. 350, 353 (E.D. Tenn. 1965); Bruce v. Knox, 180 P. Supp. 907, 912
(D. Minn. 1960); Motel Corp., 54 T.C. 1433, 1436 (1970); Burr Oaks Corp., 43 T.O.
635, 647 (1965), aff'd, 365 F.2d 24 (7th Cir. 1966), cert. denied, 385 U.S. 1007 (19067) ;
Dare Corp., 20 T.C.M. 1588, 1599 (1961); of. James D. Lancaster, 23 T.O.M. 631, 634
(1964), declaring that the shareholders "could look only to the earnings and profits of
the business" for recovery of their advances of development costs, as there was no source
available except the lots. But of. J.S. Biritz Construction Co. v. Comm'r, 387 F.2d 451,

1971] CORPORATEI DEBT
to correspond to the anticipated cash flow from development and

28
sale.9
Some decisions have looked with equal disfavor on an expecta-
tion to pay the purported debt out of future profits, however as-
sured they might be. It was felt that the assets or cash transferred
to the corporation at its inception were "intended to remain therein
as part of its permanent capital structure [and] only surplus earn-
ings to be subsequently acquired as a result of successful opera-
tions of the business were in fact intended to be withdrawn."
Hence, setting -up the purported debt was "a device to siphon sub-
sequent earnings from the enterprise while leaving the basic
business assets with the corporation." 120 That pragmatic (anti-
bail-out) approach, however, has long since given way to a more
conceptual view, in recognition of the fact that the law does regard
debt differently from investment in stock and that earnings are the
normal and customary source of debt payment by any borrower
that does not contemplate liquidation of its assets. 30 Favorable
earnings prospects of an established business, therefore, are
strongly indicative of the reality of the expectation of repayment
of a purported debt,9 31 even if the debt-equity ratio is relatively
high. 2 ' On the other hand, a purported debt that can be paid only
454, 459 (8th Cir. 1967), recognizing debt despite the need for substantial additional
expenditure for development, on the ground that the "lande ould have been sold at any
time to pay off the corporate loan."
928 Bruce v. Know 180 F. Supp. 907, 909 (D. Mlinn. 1900).
929 Estate of Herbert B. Miller, 24 T.C. 923, 930 (1955), rcu'd, 239 F.2a 729 (9th Cir.
1956) ; accord, Sam Schnitzer, 13 T.C. 43, 61-62 (1949), affId, 183 P.2d 70 (9th Cir.
1950), cert. denied, 340 U.S. 911 (1951). In Fellinger v. United States, 238 F. Supp.
67, 77 (N.D. Ohio 1964), aff'd, 363 F.2d 826 (6th Cir. 1906), testimony that earnings
were expected to be so good that the purported debt could be paid even before maturity
was cited as evidence that the investor was relying not on his power to enforce payment
but primarily on earnings, and hence had not made a real loan. See Goldstein, Cor-
porate Indebtedness to Shareholders: "Thin Capitaliation" and Rcatcd Problkiis, 16
TAX L. REv. 1, 39-43 (1960).
930 J.S. Biritz Construction Co. v. Cornm'r, 387 F.2d 451, 458 (8th Cir. 1967) ; Estate
of Miller v. Comm'r, 239 F.2d 729, 732 (9th Cir. 1950); George A. Xye, 50 T.C. 203,
216 (1968).
93' Estat of Miller v. Comm'r, 239 F.2d 729, 731 (9th Cir. 1956); Jacl Daniel Dis-
tillery v. United States' 379 F.2d 569, 582-83 (Ct. CI. 1967); Ae1herson v. United Stateq,
277 F. Supp. 475, 477 (W.D. Ky. 1967); Malone & Hyde, Inc., 49 T.C. 57, 578 (1968);
Plastic Toys, Ine., 27 T.C.M. 707, 711 (1968); Rev. Rul. 68-54, 1968-1 C.B. 69, 70. In
,TacL-Daniel, supra at 583, the court rejected the government's contention that the fact
that payment was dependent upon success was more significant than the likelihood of
such success.
932 Gyro Engineering Corp. v. United States, 417 F.2d 437, 439 (9th Cir. 199);
Piedmont Corp. v. Comm'r, 388 F.2a 886, 890, 891 (4th Cir. 1968); Sun Properticq, Inc.
v. United States, 220 F.2d 171, 175 (5th Cir. 1955); Piedmont Minerals Co. v. United

if an untried business proves profitable will ordinarily be regarded
as capital investment at the risk of the business.93 Some decisions,
however, seem to be satisfied with the owners' own expectations of
success, 34 even if reflecting overconfidence born of inexperience 931
and even if dependent upon the development and marketing of a new
product. 36 The case for recognition of debt may be substantially
strengthened if hindsight sustains the optimistic projections of the
organizers and "attests to [their]
9 37
sound business judgment" in
arranging the capital structure.
Perhaps the most meaningful criterion of the economic reality
of a purported debt is whether the projected net cash flow is ade-
quate to retire the obligation according to its terms.9 38 "While cash
flow depends upon the production of gross revenue it does not
States, 294 F. Supp. 1040, 1047 (MI.D.N.C. 1969), aff'd, 429 F.2d 560 (4th Cir. 1970);
George A. Nye, 50 T.C. 203, 214 (1968); Baker Commodities, Inc., 48 T.C. 374, 896-
98 (1967), aff'd on another issue, 415 F.2d 519 (9th Cir. 1969), cert. denied, 397 U.S.
988 (1970) (692 to 1 ratio; past earnings were less than prescribed payments, but
projected growth would cover them); Arthur F. Brook, 23 T.C.M. 1730, 1738 (1964),
rev'd on other grounds, 360 F.2d 1011 (2d Cir. 1966).
933 Berkowitz v. United States, 411 F.2d 818, 821 (5th Cir. 19609); American-La
Franee-Foamite Corp. v. Comm'r, 284 F.2d 723, 725 (2d Cir. 1960), cert. denied, 365
U.S. 881 (1961); Arlington Park Jockey Club v. Sauber, 262 F.2d 902, 905-06 (7th Cir.
1959); Gilbert v. Comm'r, 262 F.2d 512, 514 (2d Cir.), cert. denied, 359 U.S. 1002
(1959); Coleman Good, Inc. v. United States, 65-2 U.S.T.C. 9750 (W.D. Pa. 1965),
aff'd, 359 F.2d 434 (3d Cir. 1966); Harkins Bowling, Inc. v. Knox, 164 P. Supp. 801,
807 (D. Minn. 1958); Fred I. Nystrom, Jr., 28 T.C.M. 1050, 1053-54 (1969); Burr
Oaks Corp., 43 T.C. 635, 647 (1965), aff'd, 365 F.2d 24 (7th Cir. 1966), dort. denied,
385 U.S. 1007 (1967); Isidor Dobkin, 15 T.C. 31, 34 (1959), aff'd, 192 P4.2d 392 (2d
Cir. 1951). See Hickman, Incorporation and Capitalization: The Threat of the "Poten.
tial Income" Item and a Sensible Approach to Problems of Thinness, 40 TAXES 974, 991
(1962).
934 American Processing & Sales Co. v. United States, 371 F.2d 842, 850-57 (Ct. C1.
1967); of. Santa Anita Consolidated, Inc., 50 T.C. 536, 554 (1968).
936 Maytag v. United States, 153 Ct. Cl. 622, 632-36 (1961) (findings of fact not re.
produced in 289 F.2d 647); Alstate-Schuylkill Co., 28 T.C.M. 32, 38 (1969); Washington
Institute of Technology, 10 T.C.M. 17, 19 (1951); Valentine E. Maey, Jr., 8 T.C.M. 45,
52 (1949). But of. George T. Smith, 23 T.C.M. 1689, 1691, 1694 (1964), aff'd, 370 F.2d
178 (6th Cir. 1966); J.A. Maurer, Inc., 30 T.C. 1273, 1276-77, 1290 (1958) (de-
velopment of new products by existing corporation in postwar reconversion, for which Its
capital was inadequate).
937 Baker Commodities, Inc., 48 T.C. 374, 397 (1967), aff'd on another issue, 415 F.2d
519 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970); accord, Sherry Park, Inc. v.
United States, 64-2 U.S.T.C. 9681 (S.D. Fla. 1964). But of. Aifiliated Research, Inc. v.
United States, 351 F.2d 646, 651 n.10 (Ct. Cl. 1965). See Hickman, Incorporation and
Capitalization: The Threat of the "Potential Income" Item and a Sensible Approach
to Problems of Thinness, 40 TAXES 974, 991 (1962).
938 Hickman, Incorporationand Capitalization:The Threat of the "Potcntial Income''
Item and a Sensible Approach to Problems of Thinness, 40 TAXES 974, 990-91 (1962),
citing DONALDSON, CORPORATE DEBT CAPACrrY (Harv. Bus. S. 1961).

necessarily depend upon profits," particularly if the corporation

enjoys a substantial depreciation allowance,039 so such projections
have been given much -weight even in the case of new or expanding
businesses. 4 0 If the projected cash flow is fully committed to pay-
ments on debts having priority, however, it is evidence that timely
repayment is not reasonably expected.""
A comparable source of payment is inventory flow, where a
parent corporation finances its subsidiary's production of goods
or materials, which are expected to be delivered to the parent in
satisfaction of the debt, and where the risk involved is really inci-
dent to the conduct of the parent's own business, not to an invest-
ment in a distinct business of an affiliate."-
Even if payment at maturity, from cash flow or other acceptable
sources, is not fairly anticipated, debt may be recognized if there
is a reasonable expectation that outside refinancing of the out-
standing balance can then be accomplished. 3 But if the possibility
of refinancing is merely conjectural and is itself dependent upon
the success of the business in the interim, it has no weight.0 " And
the possibility may not be considered if it is apparent that the share-
holder has no intention of demanding payment "if the corporation
would be required by such demand to raise the cash by borrowing
from another source." 945
939 Santa Anita Consolidated, Inc., 50 T.C. 536, 553 (1968); accord, Liflans Corp.
v. -United States, 390 F.2d 965, 971 (Ct. CL 1968).
940 In addition to the cases cited in note 939 supra, sc Jack Daniel Distillery v. United
States, 379 F.2d 569, 583 (CL C1. 1967) ; Alstate-Schuylkill C0., 28 T.C.M. 32, 39 (1960);
Baker Commodities, Inc., 48 T.C. 374, 397 (1967), aff'd on another issue, 415 F.2d 519
(9th Cir. 1969), cert. denied, 397 U.S. 988 (1970).
941 Wood Preserving Co. v. United Statea, 233 F. Supp. 600, 606 (D. id. 19&i)1 aft'd,
347 P.2d 117 (4th Cir. 1965); Ambassador Apartments, Ine., 50 T.C. 230, 245 (1968),
aff'd, 406 F.2d 288 (2d Cir. 1969) ; 2554-58 Creston Corp., 40 T.C. 932, 938 (1963).
942 Piedmont Minerals Co. v. United States, 429 P.2d 560, 563 n.7 (4th Cir. 1070);
Byerlite Corp. v. Williams, 286 P.2d 285, 292-93 (6th Cir. 1960); C.M. Gooch Lumber
Sales Co., 49 T.C. 649, 657 (1968); cf. American Processing & Sale3 Co. v. United
States, 371 F.2d 842, 852 (Ct. Cl. 1967). But cf.Martin M. Dittmar, 23 T.C. 789, 797
(1955).
943 Campbell v. Carter Foundation Production Co., 322 F.2d 827, 832 (5th Cir. 1963);
85 Es Realty, Inc. v. United States, 59-1 U.S.T.C. %9232, p. 71,459 (S.D.X.Y. 1953)
(jury instructions); Motel Co., 22 T.C.M. 825, 833 (1963), aff'd on another issue, 340
F.2d 445 (2d Cir. 1965); Evwalt Developement Corp., 22 T.C.M. 220, 228 (1963);
Leonard J. Erickson, 15 T.C.M. 1338, 1341 (1956). See Fin Hay Realty Co. v. United
States, 398 F.2d 694, 702 (3d Cir. 1968) (dissenting opinion).
s- MeSorley's, Ine. v. United States, 63-1 U.S.T.C. 9231, at p. 87,488 (D.Colo. 1962),
afr'd, 323 F.2d 900 (10th Cir. 1963) ; 2554-58 Creston Corp., 40 T.C. 932, 938 (1063).
See W.C. Gamman, 46 T.C. 1, 4, 10 (1966).
9 Brake & Electric Sales Corp. v. United States, 287 F.2d 426, 428 (lst Cir. 1961).

Independent Creditor Test
The acid test of the economic reality of a purported debt is
whether an unrelated party would have extended credit in the cir-
cumstances.948 When a corporation is embarking on a speculative
venture,9 47 the "funds necessary for such an essentially capital
purpose could not be borrowed from any outside source," 48 for
the corporation has not established a credit standing.0D If it is
steadily losing money, outside credit would ordinarily be unavail-
able. 95 0 If the corporation has borrowed to the limit of its collateral
and its prospective cash flow, further outside borrowing would
be impossible.' 1 The independent creditor test, therefore, so far
as it can feasibly be applied, affords an objective measure of the
appropriate debt-equity ratio, cash flow coverage and other cri-
teria,95 2 and is consistent with the general principle that transac-
tions between shareholders and their corporations are "recog-
nized or disregarded for tax purposes according to the extent
to which they comply with arm's length standards" and "normal
business practice." 953
946 Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3d Cir. 1988) ("if the
shareholder's advance is far more speculative than what an outsider would realco, it is
obviously a loan in name only"); and authorities cited at notes 947-81 infra.
947 Erard A. Matthiessen, 16 T.C. 781, 786 (1951), aff'd, 194 F.2d 659 (2d Cir. 1952).
The argument that it is difficult for certain businesses to obtain loans supports the con-
clusion that they are inadequately capitalized for the type of business conducted. Gardons
of Faith, Inc., 23 T.C.M. 1045, 1060 (1964), aff'd, 345 F.2d 180 (4th Cir.), cert. denied,
382 U.S. 927 (1965). See Stone, Debt-Equity Distinctions in the Tax Treatment of tho
Corporation and Its Shareholders, 42 TuL. L. RFv. 251, 261 (1968). of. text at notes
310-19 supra.
948J.A. Maurer, Inc., 30 T.C. 1273, 1290 (1958); accord, Austin Village, Inc. v.
United States, 432 F.2d 741, 745-46 (6th Cir. 1970) (advances necessitated by I'Inability
to obtain sufficient conventional financing for the project (were] a classic example of
an investment of risk capital").
949 Joseph Verner Reed, 14 T.C.M. 455, 460 (1955), aff'd, 242 F.2d 334 (2d Cir. 1957).
See Hickman, Incorporation and Capitalization:The Threat of the "Potential Inoomo"
Item and a Sensible Approach to Problems of Thinness, 40 TAXs 974, 991 (1962).
950 Northeastern Consolidated Co. v. United States, 279 F. Supp. 592, 596 (N.D. Il.
1967), aff'd, 406 F.2d 76 (7th Cir.), cert. denied, 396 U.S. 819 (1969).
951 Ambassador Apartments, Inc., 50 T.C. 236, 245 (1968), aff'd, 406 F.2d 288 (2d Cir.
1969); Foresun, Inc., 41 T.C. 706, 718 (1964), aff'd, 348 F.2d 1006 (6th Cir. 1965);
Diamond Bros. Co, 21 T.C.M. 696, 705-06 (1962), aff'd, 322 F.2d 725 (3d Cir. 1903);
P.M. Finance Corp., 20 T.C.M. 537, 540 (1961), aft'd, 302 F.2d 786 (3d Cir. 1962). Soe
note 941 supra.
952 See Hickman, Incorporation and Capitalization: The Threat of the "PIotontial In-
come" Item and a Sensible Approach to Problems of Thinness, 40 TA.E 974, 087 of
seq. (1962).
953 Nassau Lens Co. v. Comm'r, 308 F.2d 39, 46 (2d Cir. 1962); accord, C.M. Qooch
Lumber Sales Co., 49 T.C. 649, 656 (1968) ("Our task is to examine the particular facts

The test is not an easy one to apply, however, since "different

creditors invariably undertake different degrees of risk." 0 It
seems clear that "stockholders need not be as hard-nosed as bank-
ers [and] that in some circumstances they may make a bona fide
loan when a banker would not." The question rather is whether
"no responsible banker or businessman" would have made such
a loan,950 at least without the inducement of a substantial stake in
57
the enterprise.
The axiom that "the nonavailability of commercial bank loans
... is not an unfailing bar" 11s has, however, sometimes led too
easily to the extension that recognition of debt is not precluded
even if 'zo unrelated party would have made the advance.Y 9 No
doubt, to give conclusive effect to the corporation's inability to ob-
tain outside credit would unfairly discriminate against small busi-
ness which, although meeting abstract credit standards, may lack
ready access to financial markets.OG° But the arm's length standard
before us in light of 'the realities of the business world and the manner in which
transactions are handled in the normal and ordinary course of doing businvs.-' ").
954C.M Gooch Lumber Sales Co., 49 T.C. 649, 659 (1968). See ALI, IDco=.n TAx
PROBLEmS op CoRPoRATIoNs AID SHAREHOLDERS 410 (Report of Wor"ldng Views of Staff,
1958).
955 Motel Co, 22 T.C.M. 825, 833 (1963), aff'd on another issue, 340 F.2d 445 (2d Cir.
1965); accord, Charles E. Curry, 43 T.C. 667, 681 (1965). Cf. note 727 supra. But cf.
O.H. ruse Grain & Willing v. Comm'r, 279 F.2d 123, 126 (9th Cir. 100) ("very few
financial institutions" would lend).
95G Wood Preserving Corp. v. United States, 347 F.2d 117, 119 (4th Cir. 1965) (Em-
phasis added); accord, C.M. Gooch Lumber Sales Co., 49 T.C. 649, 059 (1968).
9
57 See rxlington Park .Tockey Club v. Sauber, 161 F. Supp. 576, 584 (N.D. Il. 1958),
aff'd, 262 P.2d 902 (7th Cir. 1959). But cf. Wynnefield Heights, Inc., 25 T.W2L 953, 9M0
(1966). If the corporation, although unable to obtain conventional loans, would have
been able to borrow from independent parties by giving them the inducement of come
form of profit participation, and if such form of financing would have bcn recognizeil
as debt (see text at notes 360-96 supra), it seems that financing by shareholders should
be recognized, even without such inducement added (since they already have the ultimate
participation). However, no decisions have been found that refined the comparativea in
this manner, and it may merely beg the question to do so, since any such participatory
fnancing would itself have to be subjected to the test of cconomic reality if the cor-
poration is inadequately capitalized. See text at notes 631-36 supra. Of. text at note3
973-74 and 1440-53 infra.
25 American Processing & Sales Co. v. United States, 371 F.2a 842, 852 (Ct. CL
1967).
959Lundgren v. Comm'r, 376 P.2d 623, 626 (9th Cir. 1967); Jach Daniel Dis-tilery
v. United States, 379 F.2d 569, 584 (Ct. CL 1967); Santa Anita Consolidated, Inc., 50
T.C. 536, 553 (1968).
90 ALI, IxcomE TAx PROnLmtS op COnponTxOS AD Sunwiomzms 410 (Report of
Working Views of Staff, 1958); Hickman, Incorporationand Capitalization:The Threat
of the "Potential Income" Item and a Sensiblo Approach to Problems of Thinnes, 40
Txs 974, 987-88 (1962).

TAX LAW RLEV [Vol. 26:
does afford the revenue the protection of a useful automatic check
on the extent of the tax advantages which close corporations and
their shareholders may deal themselves through the use of debt,901
and it does place a limit on the reverse discrimination that would
otherwise exist as against corporations dependent upon third party
financing.0 6 The courts, therefore, tend to favor a sort of reason-
able man test, 963 based not upon the actual availability of outside
credit to the corporation but upon comparability to the general
standards of the financial community,"o4 of which the actual failure
of the corporation's efforts to borrow may be evidentiary.0 1 Such
unsuccessful efforts to obtain outside loans have in some cases not
only been discounted as adverse evidence,1 6 but have been viewed
as affirmative indication that the advances which the shareholders
made in lieu thereof were intended to create debts.'"
If, on the other hand, the corporation did actually obtain signifi-
cant outside credit on comparable terms, on a parity with the
shareholders' claims and without their guaranties, it is virtually
conclusive on the question of economic reality,0 8 although it does
901 Hickman, supra,note 960 at 987.
962 Stone, Debt-Equity Distinctions in the Tax Treatment of the Corporation and Its
Shareholders, 42 TuIxE2 L. REv. 251, 261 (1968); Hiekman, s-upra, note 960 at 987.
963 Hickman, supra, note 960 at 988.
984 Nassau Lens Co. v. Comm'r, 308 F.2d 39, 46 (2d Cir. 1962); of. Tomlinson v. 1601
Corp., 377 F.2d 291, 299-300 (5th Cir. 1967).
965 Christie Coal & Coke Co., 28 T.C.M. 498, 521 (1969); George T. Smith, 28 T.C.M.
1689, 1694 (1964), aff'd, 370 F.2d 178 (6th Cir. 1966). See Hickman, note 960 supra,
at 988.
968Tomlinson v. 1661 Corp., 377 F.2d 291, 299-300 (5th Cir. 1967), affirming 247 F.
Supp. 936, 938 (M.D. Fla. 1965); Lundgren v. Comm'r, 376 F.2d 623, 626 (9th Cir.
1967), reversing 24 T.C.M. 1753, 1754 (1965); Maloney v. Spencer, 172 P.2d 638, 640
(9th Cir. 1949) ; Motel Co., 22 T.C.M. 825, 833 (1963), aff'd on another issue, 340 F.2d
445 (2d Cir. 1965); Brighton Recreations, Inc., 20 T.C.M. 127, 180 (1961).
907 Austin Village, Inc. v. United States, 296 P. Supp. 382, 394 (N.D. Ohio 1068),
rev'd, 432 F.2d 731 (6th Cir. 1970), see note 948 supra ("when the shareholders wore
required to advance funds to compensate for their inability to acquire pormanent inane.
ing it would be reasonable for such advances to have been intended to be true loans");
Sherry Park, Inc. v. United States, 64-2 U.S.T.C. 9681 (S.D. Fla. 1904) (unsuccessful
attempt to get bank financing shows shareholder loans resulted from "practical
1 business
necessity" rather than tax motivation). Consistently, the failure even to make the at-
tempt has been deemed evidence that it was understood that the shareholder "was to
underwrite all of the corporation's financial requirements," and hence his advances
were capital. Martin M. Dittmar, 23 T.C. 789, 797 (1955).
988 Jack Daniel Distillery v. United States, 379 F.2d 569, 582 (Ct. C. 1967); Haloy
v. United States, 60-1 U.S.T.C. 9169 (D. Ore. 1959); of. Sylvan Makovor, 20 T.C.M.
288, 294 (1967); Oak Motors, Inc., 23 T.C.MIL 520, 522-23 (1964). An odd variation of
this principle is found in Charles E. Curry, 43 T.C. 667, 681, 688-89 (1965), in which a
sale to a corporation on credit terms " Iunheard of"I in transactions financed by institu-

not necessarily resolve the matter of the shareholders' bona fide

intention to create a debt 09 Purely hypothetical testimony of a
banker that such a loan would have been made, however, may be
rejected as "wholly unconvincing." 070
The principal difficulty lies in establishing the comparability
of the outside credit that is actually or hypothetically obtainable.
The test is frequently expressed in terms of whether an outsider
would lend on the same terms, thus bringing under scrutiny not
only the financial circumstances of the purported debtor but also
the conformity to arm's length standards of such features as the
maturity of the obligation, its secured or subordinated position,
and the interest rate.91 Others, however, take the position that
"where debtor and creditor are related, the lender might under-
standably offer more lenient terms than could be secured else-
where." 972 Some courts, accordingly, have viewed the availability
of outside credit as adequately established by the fact that loans
tional investors was deemed to conform to arm's length standards on the ground that an
independent buyer (i.e., prospective debtor, not creditor) had offered to purchase on
similar terms, which the sellers had rejected; this, said the court, howedl that "an
arrangement of that kind was advantageous to the buyer [no doubt about itl], and not
only to the sellers."
969 Charter Wire, Thc. v. United States, 309 F.2d 878, 881 (7th Cir. 1962) (corpo-
ration had excellent credit and could have borrowed elsewhere at lower interest, but
conduct negatived intent to be a creditor); Gooding Amusement Co. v. Comm'r, 23G
P.2d 159, 167 (6th Cir. 1956), cert denied, 352 U.S. 1031 (1957) (diesenting opinion
stressing that others had extended credit without formal subordination of shareholder
claims; decision was that intention to act like creditors was lacing). Sce text at notc3
475-765 supra. Cf. Brake & Electric Sales Corp. v. United States, 185 F.Supp. 1, 3 (D.
mass. 1960), aff'd, 287 F.2d 426 (1st Cir. 1961) (applying core aszet concept, note 898
suLpra).
97o John Lizak, Inc., 28 T.C.M. 804, 808 (1969); accord, Murphy Logging Co. v.
United States 239 F. Supp. 794, 797 (D.Ore. 1965), rcv'd, 378 P.2d 222 (9th Cir. 1967)
("just another instance in which a bank officer stretched the truth for a good customer
on facts that did not and probably would never occur").
-1Northeastern Consolidated Co. v. United States, 406 F.2d 76, 78 (7th Cir.), cert.
dene, 396 U.S. 819 (1969); Foresun, Inc. v. Com-'r, 348 P.2d 1000, 1009 (6th Mr.
1965); Wood Preserving Corp. v. United States, 347 F.2c. 117, 119 (4th Cir. 19S);
O.H. Kruse Grain & Milling v. Comm'r, 279 E.2d 123, 126 (9th Cir. 1060); M!otel
Corp., 54 T.C. 1433, 1438 (1970); Sohn Lizar, Inc., 28 T.C.M. 804, 808 (1969); John
Town, Inc., 46 T.C. 107, 131 (1966), aff'd, 67-1 U.S.T.C. 9462 (7th Cir. 1967) ; 2554-58
Creston Corp., 40 T.C. 932, 937 (1963); Swoby Corp., 9 .C.887, 894-95 (1947).
972 C L Gooch Lumber Sales Co., 49 T.C. 649, 659 (1908); accord, Charle E.
Curry, 43 T.C.667, 681 (1965). See Stapleton, Taz .Problersof Interconpany Indebted.
ness, 20 TAx ETcurIvm 6, 13 (1967) ("The granting of favorable terms to the sub-
sidiary not obtainable from outside sources might be a cloud on the arm's length nature
of a debt transaction, but it should not destroy its status in the absence of other diLa-
bilities.").

could have been obtained at a "prohibitive" rate of interest,973
74
but others are to the contrary.
More significance is, or should be, attached to the inability of the
corporation to borrow on the basis of its own assets.0 75 If an out-
sider is willing to extend credit only if the shareholders will ac-
cept subordination,9 76 or will make additional subordinated ad-
vances,97 7 it indicates that the creditor considers the nominal
capitalization inadequate for the risks of the venture; yet the
willingness of the outsider to lend on those terms has been cited
as evidence of the reality of the shareholders' subordinated
loans. 97 Similarly, if outside creditors demand shareholder guaran-
ties, and the requirement is not otherwise adequately explained,""0
it may indicate that they regard the corporate equity as insufficient
backing for the loans; 080 yet the corporation's ability to obtain
973 Tomlinson v. 1661 Corp., 377 F.2d 291, 299-300 (5th Cir. 1967); Medical Tower,
Inc. v. United States, 69-1 U.S.T.C. 9305 (E.D. Va. 1969).
974McSorley's, Inc. v. United States, 63-1 U.S.T.C. 9231 (D. Colo. 1962), aff'd,
323 F.2d 900 (10th Cir. 1963) (second mortgage financing available at 12 por cent;
shareholders charged 4 per cent, without security); Motel Corp., 54 T.C. 1433, 1438
(1970) (outsiders wanted 13 to 14 per cent; shareholders took 5.5 per cent); S.P.
Realty Co., 27 T.C.M. 764, 767 (1968) (no outsider would have loaned at 5 per cent) ;
2554-58 Creston Corp., 40 T.C. 932, 937 (1963) (outsiders wanted 18 per cent; share.
holders took 10 per cent) ; of. Curry v. United States, 396 F.2d 630, 634 (Gth Cir.), oort.
denied, 393 U.S. 967 (1968).
975 Affiliated Research, Inc. v. United States, 351 F.2d 646, 649-50 (Ct. C1. 1965).
976 Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir. 1969); Affiliated Research, Inc. v.
United States, 351 F.2d 646, 648-50 (Ct. Cl. 1965); P.M. Finance Corp. v. Comm'r,
302 F.2d 786, 787-88 (3d Cir. 1962); cf. Foresun, Inc. v. Comm'r, 348 P.2d 1006, 1009
(6th Cir. 1965). Concerning the shareholder's failure to take security when outside credi-
tors would not loan without it, see text at note 557 supra.
977 Harkins Bowling, Inc. v. Knox, 164 F. Supp. 801, 807 (D. Minn. 1058); Christlo
Coal & Coke Co., 28 T.C.M. 498, 521 (1969); Leonard Lundgren, 24 T.C.M. 1753, 1757
(1965), rev'd, 376 F.2d 623 (9th Cir. 1967); George 3. Schaefer, 24 T.C. 638, 643, 049
(1955).
978 Green Bay Structural Steel, Inc., 53 T.C. 451, 458 (1969) ("Outside funds woro
available as evidenced by [a bank loan]. The conditions attached thereto resulting in
subordination do not seem unusual for a borrower just emerging from bankruptcy, and
we do not feel that this shows an unavailability of outside funds as the Commissioner
would have us believe."); Alstate-Schuylkill Co., 28 T.C.I. 32, 34, 38-39 (1969); of.
Daro Corp., 20 T.C.M. 1588, 1600 (1961). See text at notes 310-19 supra.
979 Regarding banks' routine requirement of shareholder guaranties, seo text at
notes 668-72 supra.
980 Carry v. United States, 396 F.2d 630, 634 (5th Cir. 1968); Diamond Bros. Co.
v. Comm'r, 322 F.2d 725, 732 (3d Cir. 1963) ; Affiliated Research, Inc. v. United States,
351 F.2d 646, 648 (Ct. CL 1965); Christie Coal & Coke Co., 28 T.C.M. 498, 521 (1969);
Demor, Inc., 27 T.C.M. 1496, 1502 (1968); Old Dominion Plywood Corp., 25 T.C.M.
678, 695 (1966); H.H. Bodzy, 21 T.C.M. 219, 231 (1962), rev'd on other grounds, 321
P.2d 331 (5th Cir. 1963). See Gilbert v. Comm'r, 248 F.2d 399, 410 (2d Cir. 1957)
(concurring opinion).

credit with the shareholders' guaranty has been cited as evidence

for recognition of purported debts to shareholders.8 s
Salvage Loans
The circumstance in which a disinterested lender would be least
likely to extend credit occurs when a corporation has depleted or
exhausted its capital through continuous losses and is making a
desperate effort to survive.982 The situation would seem more ap-
propriate for an infusion of new equity capital by the shareholders
or by new interests, rather than for loans.9 83 But, influenced by
the view that "[n] o stockholder could safely advance money to
strengthen the faltering steps of his corporation [if he must invest
it] in the way that is most disadvantageous to himself, both as
relates to taxation and as to other creditors," 084 the courts com-
monly relax the usual risk criteria in such cases, and in effect
revert almost to a pure intention test 85 except in cases where cap-
ital had been inadequate from the outset.9sGIt is said that "[w]here
981 Daytona Marine Supply Co. v. United States, 61-2 U.S.T.C. 9523, p. 81,218
(SD.la. 1961) (bank required endorsement, but court was impre ed that it did not
require subordination, although the practical, if not the legal, effect is similar (note 323
supra)); Irbeo Corp., 25 T.C.M. 359, 367 (1966). Although a "guaranty is simply one
form of security" which a bank may require (Santa Anita Consolidated, Inc., 50 T.C.
536, 553 (1968)), it is a form that is peculiarly available to outsiders and affords some
evidence that others would not lend on the basis of the assets available to protect the
shareholder-lenders.
982 See Wachovia Bank & Trust Co. v. United States, 288 F.2a 750, 755, 756 (4th Cir.
1961); Fred L Nystrom, Jr., 28 T.C.M. 1050, 1055 (1969); C.M. Gooch Lumber Sales
Co., 49 T.C. 649, 659 (1968); Samuel Abrams, 23 T.C.M. 1540, 1551 (1904); Diamond
Bros. Co., 21 T.C.M. 696, 705-06 (1962), aff'd, 322 F.2d 725 (3d Cir. 1963); Erara A.
Matt iessen, 16 T.C. 781, 786 (1951), aff'd, 194 F.2d 659 (2d Cr. 1952); f. Santa
Anita Consolidated, Inc., 50 T.C. 536, 553 (1968).
983 Xay .Alan Van CHef, 1941 B.T- 41,450, rte'd, 135 F.2d 254, 2554-G (D.C.
Cir. 1943) (which quotes the Board of Tax Appeals decision).
9s4 B wan v. United States, 219 F.2d 51, 55 (5th Cir. 1955).
9s Austin village, Inc. v. United States, 296 F. Supp. 382, 397 (N.D.Ohio 1068),
rev'd, 432 F.2d 741 (6th Cir. 1970); United Engineers & Constructors, Inc. v. Smith,
59-1 U.S.T.C. 9322 (E.D. Pa. 1959); Donald C. Niblock, 27 T.O.M. 1381, 1386 (1968),
aff'a on another issue, 417 F.2d 1185 (7th Cr. 1969); Fred A. Bilimaier, 17 T.C. 620,
626 (1951). See also cases cited at notes 987-90 infra. Of. Arnold v. Phillips, 117 F.2d
497, 501 (5th Cir.), cert. denied, 313 U.S. 583 (1941) (bank1ruptcy case). It is difficult
to reconcile Samuel Abrams, 23 T.C.M. 1546, 1551 (1904), in which a corporation formed
*with $40,000 capital required advances of $37,500 during six losing years, and its pros-
pects, while "by no means hopeless" -were less than "roseate"; the court denied
recognition on the grounds that no outside creditor would have made such loans and that
the funds were placed at the risk of the business.
9s6Wachovia Bank & Trust Co. v. United States, 288 F.2d 750, 755 (4th Cir. 1901);
Arlington Park Jockey Club v. Sauber, 262 F.2d 902, 905 (7th Cir. 1959) ; Wood Preserv-
ing Corp. v. United States, 233 F. Supp. 600, 605, 606 (D. Md. 1964), aff'cJ, 347 F.d

the borrower is insolvent it is more credible that the lender would
loan rather than invest, for a creditor enjoys a certain priority,"
and that "[in the final analysis all loans to a company depend for
their repayment on the success of the borrower, and this is, of
course, equally true of salvaging equity investments." 987 From the
truism that recognition of debt does not depend upon an "unqual-
ified expectation" of repayment, it is reasoned that itis enough that
the shareholder-creditor be "hopeful," "8 or perhaps just blindly
optimistic, 989 about the chances of turning the corporate fortunes
around. 9 0
There comes a point, however, when the hope for recovery is
so remote and speculative that, even under a liberal application of
the intention test, the courts are unable to visualize further ad-
vances as creating debts 91-- particularly if they are made after
the taxpayer has already claimed earlier advances to have become
worthless. 992 The shareholder may contend that even if his earlier
117 (4th Cir. 1965); Fred I. Nystrom, Jr., 28 T.C.M. 1050, 1054 (1969); Martin M.
Dittmar, 23 T.C. 789, 796-97 (1955); Erard A. Matthiessen, 16 T.C. 781, 780 (1951),
aff'd, 194 F.2d 659 (2d Cir. 1952). When new shareholders stop in and "strengthon
the faltering steps" of a corporation that has depleted its initial capital through losses,
their advances for operations may be denied recognition in the same manner as if they
had formed a new corporation with insufficient capital. Diamond Bros. Co. v. Comm'r,
322 F.2d 725 (3d Cir. 1963); Jewell Ridge Coal Corp. v. Comm'r, 318 F.2d 695, 097
(4th Cir. 1963). But of. Ernest E. Dison, 24 T.O.M. 794, 796 (1965).
987 American Processing & Sales Co. v. United States, 371 F.2d 842, 856 (Ct. Cl. 1067)
(emphasis added); Santa Anita Consolidated, Inc., 50 T.C. 536, 552 (1968).
988 Ernest E. Dison, 24 T.C.M. 794, 796 (1965).
989 Lucia Chase Ewing, 5 T.C.M. 908 (1946). This case is a little old to be a reliable
precedent, but it was followed in Drown v. United States, 203 F. Supp. 514, 520 (S.D.
Cal. 1962), rev'd on another issue, 328 F.2d 314 (9th Cir. 1964). See note 770 supra. In
Austin Village v. United States, 296 F. Supp. 382, 397 (N.D. Ohio 1968), rev'd, 432 F.,d
741 (6th Cir. 1970), the district court agreed that the "shareholders had no reasonable
expectation of repayment if the venture was not a success," but said that this "must
be viewed in the light of the corporation's financial plight."
990 Like results were reached, without stating the test so broadly, in American Process-
ing & Sales Co. v. United States, 371 F.2d 842, 857 (Ct. CI. 1967) ("roasonablo grounds
to believe" they would succeed); Santa Anita Consolidated, Inc., 50 T.C. 536, 537, 543,
552-53 (1968) (payment was "expected" from cash flow based on grossly excessive
independent projections of patronage); Book Production Industries, Inc., 24 T.O.M.
339, 356 (1965) ("reasonable expectation" of payment not negatived by losses and in.
solvency attributed to temporary causes).
99 United Engineers & Constructors, Inc. v. Smith, 59-1 U.S.T.C. 1 9322 (fl.D. Pa.
1959); C.M. Gooch Lumber Sales Co, 49 T.C. 649, 658-59 (1968); Scotland Mills, Inc.,
24 T.C.M. 265, 276-77 (1965); Wilfred J. Funk, 35 T.O. 42, 50 (1960).
992 Dodd v. Comm'r, 298 F.2d 570, 578 (4th Cir. 1962); Fred I. Nystrom, Jr., 28
T.C.M. 1050, 1054 (1969); Christie Coal & Coke Co., 28 T.C.M. 498, 521 (1969); Schino
Chain Theatres, Inc., 22 T.C.M. 488, 500-01 (1963), aff'd, 331 F.2d 849 (2d Cir. 1904);
Fred A. Bihlmaier, 17 T.C. 620, 626 (1951).

advances were lost beyond hope, he expected the process of winding

up to generate enough cash to repay at least the amount of those
final advances. 93 If it can be shown that the motivation for the ad-
ditional advances is to protect one's position as creditor,by salvag-
ing something in addition for application on recognized debts
created earlier, there may be merit in that argument, although it
appears to have been accepted only when the purported lender's
interest in the business is primarily as a creditorY3 If those final
advances are made in order to preserve a salable going concern 01
or otherwise to salvage something of the stock investment,2 0 theT
courts generally will not recognize them as giving rise to debtsY9
FALsE GODS Ain RHBToBic
The foregoing criteria, while frequently misapplied, do have

an obvious relevance to the differentiation of equity capital from
debt. There remains a mixed bag of other factors of questionable
pertinence to the issue, which the courts have occasionally relied
93
9 See Miles Production Co, 28 T.C.ML 1387, 1413 (1969), on appeal to the Fifth Cir-
euit (court acknowledges "some justification" might exist in such circumstancel, but
finds that cash generated was far less than the additional advances rcquired); cf.
George E. Warren Corp. v. United States, 135 CL CL 305, 330 (1956) (findings of fact
not reproduced in 141 F. Supp. 935). But cf. United Engincers & Constructors, Inc. v.
Smith, 59-1 U.S.T.C. 9322, p. 71,746 (E.D. Pa. 1959) (rejecting such a =If0 ap-
proach and holding that any recovery would be applicable to the earlier (rcaogaizci)
debts so the later purported obligations were incurred without hope of payment).
994 Old Dominion Plywood Corp., 25 T.C.1L 678, 700 (1906); Clement L. Hirzeb, 20
T.C.ML 1341, 1344 (1961); National Lead Co., 23 T.C. 988, 995-90 (1955); Richard
IL Dracnhman, 23 T.C. 558, 563 (1954).
995Newman E. Jones, Jr., 23 T.C.ML 1613, 1615 (1964), aff'd, 357 F.2d 644 (oth Mr.
1966).
996 Shareholder motivation was found in Diamond Bros. Co. v. Commr, 322 F.21 725,
732-33 (3d Cir. 1963); Lloyd E. Mangrum, 19 T.C.3L 700, 703 (1900); Ben P. Galo,
15 T.C.M. 518, 525 (1956); Samuel T. Tauber, 11 T.O.L 269, 274 (1952).
997 Although none of the cases which discussed motivation (notes 995 and 990 supra)
involved shareholders who had made previous advances recognized as debts, that feature
was present in the cases cited in note 991 supra. In extrcmis, it matters not that the
shareholders make advances disproportionate to their relative stock interests. See note
637 supra. In some circumstances, advances made to pay the debts of an insolvent corpo-
ration in liquidation may be construed as deductible expenses of protecting a busincs3 in
which the shareholder is personally engaged. Allen v. Comm'r, "83 F.2d 78,, 790 (7th
Cir. 1960); Lutz v. Comm'r, 282 F.2d 614 (5th Cir. 1900); Christie Coal & Colie Co., 28
T.C.1L 498, 523 (1969). But the shaxeholder's primary claim that be intended reim.
bursement out of the proceeds of liquidation may be turned against him, for such
expectation is inconsistent with the nature of an expense; therefore, if not a bad debt,
his umrecovered outlay is a stock loss. Southeastern Aviation Underwriters, Inc., 25 T.C.2.
412, 427-28 (1966); of. Richard AL Draehman, 23 T.O. 558, 562 (1954).

TAX L AW REVIEW [Vol. 26 :
upon but have more often used as rhetorical support for conclu-
sions reached on other grounds.
Tax Motivation and Business Purpose

It is questionable whether, in living memory, any corporate cap-
ital structure has been set up or rearranged without consideration
of the tax advantages ordinarily obtainable through the use of
debt 9s The knowledge is part of the basic equipment of every
corporate counsel and accountant, whether or not he is a tax
specialist, and he would be derelict in his duty if he failed to pro-
vide his client, to the maximum extent consistent with business
judgment, with the tax savings which the client's competitors en-
joy. 9 If tax-saving motivation were viewed as, per so, a serious
impediment to recognition of the form of corporate capital struc-
ture, few purported debts of close corporations (and not all
those of public corporations) 1000 would pass muster.
It seems clear, however, that (in this area as in others) "the
law does not require that directors be either ostriches or perjur-
ers." 1o0 It is true that the lack of "business reason" or "business
advantage" in a capital structure is sometimes cited, 100 2 and a tax
avoidance purpose has been said to be "a substantial factor to be
considered in determining whether [a] transaction lacks genuine-
ness. ' 1003 But findings to the effect that "the only substantial
998 See Hickman, Incorporation and Capitalization: The Threat of the r'Potential
Income" Item and a Sensible Approach to Problems of Thinness, 40 TAXEs 974, 904
(1962). Corporations electing under subehapter S, of course, present a special ease. Soo
note 103 supra.
999 "[ [T]he tax laws exist as an economic reality in the businessman's world, much
like the existence of a competitor. Businessmen plan their affairs around both, and a tax
dollar is just as real as one derived from any other source." Justico THarlan, concurring
in Comm'r v. Brown, 380 U.S. 563, 579-80 (1965). "Often an inefficiont operator, wiso
as to taxes, can do better than an efficient operator who is stupid about his taxes."
Murphy Logging Co. v. United States, 378 P.2d 222, 223 (9th Cir. 1967).
1000 Tax motivated capital structures are not confined to closely hold corporations. See
notes 18-20 supra.
1001 Schenuit Rubber Co. v. United States, 293 F. Supp. 280, 294 (D. Md. 1968) (a
section 531 case).
1002 O.H. Kruse Grain & Milling v. Comm'r, 279 F.2d 123, 126 (Oth Cir. 1960);
Wetterau Grocer Co. v. Comm'r, 179 F.2d 158, 160 (8th Cir. 1950); Estate of Herbert
B. Miller, 24 T.C. 923, 933 (1955), rev'd, 239 F.2d 729 (9th Cir. 1956).
2003 Sherwood Memorial Gardens, The., 42 T.C. 211, 229 (1964), aff'd, 350 F.2d 225,
229 (7th Cir. 1965); accord, Sayles Pinishing Plants, Inc. v. United States, 399 F.2d
214, 220 (Ct. Cl. 1968); Brake & Electric Sales Corp. v. United States, 185 F. Supp. 1,
4 (D. Mass. 1960), aff'd, 287 F.2d 426 (1st Cir. 1961); Gardens of Faith, Inc., 23
T.C.M. 1045, 1061 (1964), aff'd, 345 F.2d 180 (4th Cir.), cert. denied, 382 U.S. 927
(1965); Mullin Bldg. Corp., 9 T.C. 350, 358 (1947), aff'd, 167 F.2d 1001 (3d Cir.
1948).

1971] CORPOR&AM DEBT
purpose motivating the transaction was one of tax avoidance"

are often put forward merely in refutation of a taxpayer's re-
liance upon alleged business purposes, 100 4 and a reference to "ac-
counting hocus-pocus, guided by a little too clever legal planning,"
or the like, is frequently not a finding at all but the court's rhetori-
cal expression of a conclusion based, not upon motivation, but
upon defects of form, intention or economic reality.1 00 5 The strong
trend of decisions (if it was ever really otherwise) is that a busi-
ness purpose need not be shown in order to sustain a corporate
debt structure,'0 6 and that tax motivation, while it invites scrutiny
of the reality of the purported debt, 0 07 is not in itself evidence
that a transaction is other than it purports to be. 0 08 Tax ninimiza-
tion, it is said, is not "an improper objective of corporate manage-
ment" 1009 and "is not evil if you do not do it evilly," with "pure
gimmicks of form." 0 1 0 Whether or not an all-equity capital struc-
ture might have served business needs as well or better,OU the
taxpayer is free to adopt the less "tax-burdensome" form in the
first instance 01 2 or to convert to it later; 1013 or the taxpayer may
1004 Gooding Amusement Co., 23 T.C. 408, 420-21 (1954), af'Td, 236 P d 159 (6th Cir.
1956), cert. denied, 352 U.S. 1031 (1957); accord, Talbot 3il v. Comm'r, 140 F.2d
809, 811 (1st Cir. 19M), aff 'Idsub om. John Kelley Co. v. Comm'r, 320 U.S. 521 (1940).
005 Comm'r v. Xohn Kelley Co., 146 P.2d 460, 468 (7th Cir. 1944), rev'd (bascd on
scope of review), 326 U.S. 521 (1946); accord, Burr Oaks Corp., 43 T.C. 035, 646 (1905),
aff'd, 365 F.2d 24 (7th Cir. 1966), cert. d cnied, 385 U.S. 1007 (1967) ("nothing moro
than a shabby attempt" to withdraw corporate profits at capital gain mte-). Sea Gil-
bert v. Comm-r, 248 F.2d 399, 407 (2d Cir. 1957) ("Where the courts have spohen of
tax avoidance motives, they have as a rule had reference to their conclusions rather than
to the evidence.").
10o Nassau Lens Co. v. Comm'r 308 F.2d 39, 44-46 (2a Cfr. 1902); Sun Propertip,
Inc. v. United States, 220 F.2t 171, 174-75 (5th Cir. 1955); Charles E. Curry, 43 T.C.
667, 695 (1965); cf. Goldstein v. Comm'r, 364 P.2d 734, 741 (2d Cir. 1960).
1007 Truck Terminals, Inc. v. Comm'r, 314 P.2d 449, 453 (9th Cir. 1963); Charlc3 E.
Curry, 43 T.C. 667, 688 (1965).
1008 Charles D. Yantress, 23 T.C.M. 711, 718 (1904).
3o9 Kraft Foods Co. v. Comm'r, 232 F.2d 318, 127-28 (2d Cir. 1956).
101-0 Murphy Logging Co. v. United States, 378 F.2c 222, 223j 221 (9th Cir. 1967);
accord, Gooding Amusement Co., 23 T.C. 408, 418 (1954), aff1'd, 236 F.2d 159 (0th Cir.
1956), cert. denied, 352 U.S. 1031 (1957) ("There is nothing reprehensible in casting
one's transactions in such a fashion as to produce the least tax/" in the absence of
"sham").
1o Nassau Lens Co. v. Comm'r, 308 P.2d 39, 44,45 (2d Cir. 1902).
-- See Truck Terminals, Inc. v. Commnr, 314 F.1td 449, 453 (9th Cr. 1963); accord,
J.S. Biritz Construction Co. v. Comm'r, 387 F.2d 451 (8th Cir. 1907) (taxpayer may
"operate as expeditiously and frugally as he desires"); Nassau Lenm Co. v. Comm'r,
308 F.2d 39 (2d Cir. 1962).
1013 Kraft Foods Co. v. Comm'r, 232 F.2c 118, 120-28 (2d Cir. 1956); Comm'r v.
H.P. Hood & Sons, In, 141 F.2d 467, 471 (1st Cir. 1944); Toledo Blade Co, 11
T.C. 1079, 1085 (1948), aff'1d on another issue, 180 P.2d 357 (6th Cir. 1950). Bce

TAX LAW 1EVMNW [Vol. 26 :
1 14
choose the equity form if that is to its tax advantage. 0 The ques-
tions are "not what the purpose of the taxpayer is, but whether
what is claimed to be, is in fact," 1015 and "whether what was done,
apart from the tax motive, was the thing which the statute in-
tended." 1016
Some decisions go so far in recognizing the universality and
legitimacy of tax planning as to decline to attribute to a taxpayer
an intention to create a relationship that would have reflected
1 0 17 If the intention to create a debt is unclear, a
poor tax planning.
court may explain it by the fact that "the venture [was not] di-
rected from the start by tax counsel and accountants." 1018 And, if
the tax planning is clearly evident, the taxpayer's intention "to be-
come indebted [is supported by the fact that] the desired deductions
could be secured only if it created genuine indebtedness." '0ll
Tax motivation and the lack of business purpose are truly "rel-
evant only insofar as they contribute to an understanding of the
external facts of the situation." 1020 The business or tax motiva-
tion may serve "as a means of getting at the intent of the parties
and hence as one indication of the true nature of the transaction,"
but it "need not be the sole, nor is it always the most reliable,
guide to be followed in characterizing actions with tax conse-
quences." 1021 Taxpayers are "not entitled to act unrealistically
simply for the purpose of maximizing their tax benefits," 1022 and
the absence of a good business purpose for using the form of debt
may be significant "not because it necessarily indicate[s] a diver-
Talbot Mills v. Comm'r, 146 F.2d 809, 813 (lst Cir. 1944) (dissonting opinion), aff'd
(based on scope of r view) sub. inm. John Kelley Co. v. Comm'r, 826 U.S. 521 (1946).
1014 Ragland Investment Co., 52 T.C. 867, 878 (1969), aff'd per curiam, 435 1.2d 118
(6th Ofr. 1970).
1013 Xraft ]Foods Co. v. Comm'r, 232 F.2d 118, 128 (2a Cir. 1956).
1016Nassau Lens Co. v. Comm2r, 308 E.2d 39, 44 (2d Cir. 1902), appying Gregory v.
Helvering, 293 U.S. 465, 469 (1935); of. Chisholm v. Comm'r, 79 J.2d 14, 15 (2d Cir.
1935) (1the purpose which counts is one which defeats or contradicts the apparent trans-
action, not the purpose to escape taxation").
1017 Sylvan Makover, 26 T.C.M. 288, 293 (1967).
101sAmerican.La France-Foamite Corp. v. Commn'r, 284 F.2d 723, 724 (2d Cir. 1960),
cert. denied, 865 U.S. 881 (1961) ("'intention' is often a highly artweincil and by.
pothetical concept because most frequently business ventures originate and are carried
on without any clear intent as to taz consequences" (emphasis added)).
0193Kraft Foods Co. v. Comm'r, 232 F.2d 118, 122 (2d Cir. 1950) (emphasis
added).
1020 Gilbert v. Commir, 248 F1.2399, 407 (2d Cir. 1957).
1021 Truck Terminals, Inc. v. Comm'r, 314 F.2d 449, 453-54 (9th Cir. 103) (om.
phasis added); accord, Diamond Bros. Co., 21 T.C.M. 696, 706 (1962), aff'd, 322 F.2d
725 (3d Cir. 1963).
2022 Sofie Eger, 28 T.C.M. 850, 852 (1969).

1971] CO11PORATE =TB
gence of substance from form, but because it fail [s] to negate other
evidence inducing that inference." 1023
Conversely, the taxpayer's ignorance of, or asserted lack of con-
cern with, the tax consequences of the chosen capital structure
should be a neutral factor. 0 24 Except possibly in the Eighth Cir-
cuit,10 25 a finding of tax motivation is not essential to nonrecogni-
tion of a purported debt.0 2 G An affirmative showing of a business
purpose for using debt, 027- on the other hand, may have significant
weight,128 as tending to confirm that the real nature of the ar-
rangement coincided -with its form. 0- Such a business purpose
would frequently be of a nature that would indicate an intention to
enforce the debt; and it may explain, and perhaps excuse, any "de-
parture from normal business patterns." 1030 But those cases are
questionable which go further and permit the more presence of a
business purpose to overcome the effect of gross inadequacy of
capitalization or other substantive factors casting serious doubt
on the economic reality of purported debt.103' Tax consequences
1023 Truck Terminals, Inc. v. Comm'r, 314 P.2d 449, 453 (9th Cir. 1903). It has been
suggested that, if a purported debt does not bear interest (or diEaunt), it may be more
necessary to show some other business purpose for the form of debt. Road Tnteials,
Inc. v. Comm-'r, 407 F.2d 1121, 1125 n.5 (4th Cir. 199).
1024 Cf. Comm'r v. 'Wilson, 353 F.2d 184, 187 (9th Cir. 1965). Such an azsertion of
ignorance or innocence, of course, is often difficult to refute. A.R. Lantz Co. v. United
States, 283 F. Supp. 164, 169 (C.D. Cal. 1968), aff'd, 424 F.2d 1330 (9th Cir. 1970). It
was accepted by the court in Piedmont Minerals Co. v. United States, 294 F. Supp. 1040,
1044 (M.D.N.C. 1969), aff'd, 429 F.2d 560 (4th Cir. 1970).
1025 J.S. Biritz Construction Co. v. Comm'r, 387 F.2d 451, 458 (8th Cir. 1967).
102 Ambassador Apartments, Inc. v. Comm'r, 400 F.2d 288 (2d Cir. 1969) (declining
to follow J.S. Biritz, supra note 1025); Ailiated Research, Inc. v. United States, 351
F.2d 646, 651 (Ct. CL 1965); Truck Terminals, Inc. v. Comm'r, 314 F.2a 449, 453
(9th Cir. 1963); Diamond Bros. Co., 21 T.C.M. 696, 706 (1962), aff'd, 322 F.2d 725
(3d Cir. 1963). Purported debts have been denied recognition although they antedated
enactment of the income tax laws. Cuyuna Realty Co. v. United States, 382 F.d 298,
301 (Ct. CL 1967); Nqational Savings & Trust Co. v. United States, 285 1. Supp. 325,
332 (D.D.C. 1968).
1027 A business purpose and the absence of a tax avoidance purpose are not two aide3
of the same coin. Of. Comm'r v. Wilson, 353 1.2d 184, 187 (9th Cir. 1965) ; Campbell v.
Wheeler, 342 F.2d 837, 840-41 (5th Cir. 1965).
102sSeotland Mills, Inc., 24 T.C.M. 265, 274-75 (1965) ("highly significant");
Ruspyn Corp., 18 T.C. 769, 777 (1952).
1029 Track Terminals, Inc. v. Commn'r, 314 P.2d 449, 453 (9th Cir. 1963).
1030 See Nassau Lens Co. v. Comm'r, 308 F.2d 39, 47 (2d Cir. 1962).
103, Scotland M1lls, Inc. 24 T.C.M. 265, 274-75 (1965). It is assert d in such case3
that "the courts have usually recognized advances or loans to a closely held corporation
as creating a true debtor-creditor relationship where there is a demonstrable businez3 pur-
pose in making a loan and the transaction is not a tax-avoidance scheme or a sliam or
masquerade." J.S. Biritz Construction Co. v. Comm'r, 387 F.2d 451, 458 (8th Cir.
1967); accord, Piedmont IMinerals Co. v. United States, 294 F. Supp. 1040, 1045 (M.D.
N.C.1969), aff'd, 429 F.2d 560 (4th Cir. 1970).

542 TAX LAW RrNMW [Vol. 26:
should depend on "what was done, not why it was done," "0"2 and
the existence of a legitimate corporate business reason for an ar-
rangement should not alone control its federal tax treatment.1 0 83
It has been said too that a business purpose will not suffice when it
is "combined with an impermissible contrivance to avoid taxes." 1034
Whatever merit there may be, in other contexts, in the distinc-
tion between corporate business purposes and those of the share-
holders, 08 5 it is clear that most of the purposes Which have been
given weight on the present issue are shareholder purposes. On
the above premise that business purpose is here relevant princi-
pally on the question of the shareholder-creditor's intention to act
like a creditor, it is appropriate that his personal business objec-
tives be considered. 0 3 6
The desire to protect one's personal capital from the risks of
the business by achieving equality with general creditors is the
most obvious such purpose and the one most relevant to the ques-
tion of intention to be a creditor,1 0 37 provided the alleged purpose
is not belied by subordination in terms or in practice 1038 or by other
adverse factors. 8 9 Specific desires to extract cash from the cor-
poration in order to meet personal obligations for the purchase
1032 See United States v. Hertwig, 398 F.2d 452, 455 (5th Cir. 1968).
1038 Austin Village, Inc. v. United States, 432 F.2d 741, 745 (6th Cir. 1970)
(failure to
satisfy "objective factors" is not excused although "their absence was attributable to
... legitimate business reasons"); James D. Lancaster, 23 T.C.M. 631, 635 (1964).
1034Reef Corp. v. Comm'r, 368 F.2d 125, 133 (5th Cir. 1966), cert. denied, 380 U.S.
1018 (1967).
1035 Compare Estate of Parshelsky v. Comm 'r, 303 P.2d 14, 18 (2d Cir. 1962) ; with
Campbell v. Wheeler, 342 F.2d 837, 840-41 (5th Cir. 1965).
1036Estate of Miller v. Comm'r, 239 F.2d 729, 734 (9th Cir. 1956). But of. Genoral
Alloy Casting Co., 23 T.C.M. 887, 895 (1964), aff'd, 345 F.2d 794 (3d Cir. 1965)
("purely personal objectives without consideration for the financial needs" of the cor-
poration "hardly qualif[y] as a business purpose").
1037 Maurice H. Brown, 18 T.C.M. 483, 486 (1959); Gazette Telegraph Co, 19 T.C.
692, 699, 705 (1953), aff'd on another issue, 209 F.2d 926 (10th Cir. 1954).
los Gooding Amusement Co, 23 T.C. 408, 419 (1954), aff'd, 236 F.2d 19 (6th Cir.
1956), cert. denied, 352 U.S. 1031 (1957). See text at notes 282-337 and 734-46 supra.
The shareholder's guaranty of corporate debts would also tend to negate a purpose to
protect his capital.
1039 Ambassador Apartments, Inc., 50 T.C. 236, 246 (1968), aff'd, 406 F.2d 288 (2d
Cir. 1969) (property mortgaged to shareholders for nearly full value, allegedly to pro-
tect against loss by tort liability; no evidence on likelihood of loss exceeding insurance);
241 Corp., 15 T.C.M. 901, 905 (1956), aff'd, 242 F.2d 759 (2d Cir.), cert. dnied, 354
U.S. 938 (1957) (alleged desire to recover investment from earnings before mortgage
matured; but failed to set a date when payment could be required); Gooding Amuse-
ment Co., 23 T.C. 408 (1954), aff'd, 236 F.2d 159 (6th Cir. 1956), cert. denied, 352 U.S.
1031 (1957) (alleged fear of tort liabilities, which were insured against, was con-
tradicted by readiness to adopt partnership form when it was more advantageous tax-
wise).

price of the business oor to make more diversified investments o,

have been recognized as business purposes, confirmatory of the
intent. The fact that notes may be pledged or disposed of if one
shareholder should need funds, without disturbing the propor-
tionate interests, 10 42 or that the corporation itself may be more
salable when the outstanding notes provide a built-in method of
financing the sale, 10 43 may also be given weight.
Estate planning purposes are recognized, including the desire
to provide a means for paying estate taxes,10 "4 to give family mem-
bers an assured income after the shareholder's death,'(" or to
perpetuate the business through facilitating sale of stock to sur-
vivors. 0 46 A purpose to make possible inter vives gifts of notes1 T
while retaining the equity, however, has been given no weight.
The refusal or inability of one or more of the shareholders to
make investments commensurate with their proprietary shares,1°48
particularly when they are key employees of the business,' °0 0 has
1040 Paul F. Murphy, 21 T.C.M. 1161, 1164 (1962).
-041 Gazette Telegraph Co., 19 T.C. 692, 699, 705 (1953), aff'1d on another issue, 209
F.2t 926 (1Oth Cir. 1951).
1042 Ibid. Such alleged purpose was disbelieved in Talbot Mills v. Com-m'r, 146 F.2d
809, 811 (Ist Cir. 1944), aff'd s-ub nom. John Kelley Co. v. Comm'r, 326 U.S. 5.11
(1946), 'where the terms of the purported debt limited its marketaibilty.
1043Luden's, Inc. v. United States, 196 F. Supp. 526, 530 (EXD. Pa. 161) (stoch
might be sold, retaining debentures to be paid from subsequent corporate earnings).
30" Dominion Oil Co. v. United States, 58-2 U.S.T.C. 9643 (E.D. Va. 1958); Gazette
Telegraph Co., 19 T.C. 692, 705 (1953), aff'rd on another issue, 209 F.2d 926 (10th Cir.
1954).
1045 Estate of Miller v. Comm'r, 239 F.2a 729, 734 (9th Cir. 1956) ; Dominion Oil Co.
v. United States, 58-2 U.S.T.C. 9643 (EXD. Va. 1958). A purpose to provide a fixed
investment that could be bequeathed to the widow and daughter, whi1e leaving stoch to
the son, did not suffice to overcome adverse factors in Charter Wire, Inc. v. United
States, 61-2 U.S.T.C. 1 9769 (E.D. Wis. 1901), aff' d, 309 F.2d 878 (7th Cir. 1962),
cert. denied, 372 U.S. 965 (1963). An allegec purpose to relieve an aging woman of
management responsibilities and give her an assured income was rejected on the
ground that the situation was not materially changed in those respects by the transfer
in Foresun, Inc., 43 T.C. 706, 715 (1964), aff'J, 348 F.2d 1006 (6th Cir. 19G5). Cf.
Mullin Bldg. Corp., 9 T.C. 350, 358 (1947), aff'd, 167 F-.2d 1001 (3d Cir. 1948).
104 Baker Commodities, Inc., 48 T.C. 374, 398 (19G7), aff' d on another issue, 415 id
519 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970). Such purpose was insuMeient to
overcome other factors in Charter Wire, Inc. v. United States, 61-2 U.S.T.C. t 9769 (E.D.
Wis. 1961), aff'd, 309 F.2d 878 (7th Cir. 1962), cert. denied, 372 U.S. 965 (1903).
104 General Alloy Casting Co., 23 T.C.L 887, 890 (1964), aff' d, 345 P.0.d 794 (3d Cir.
1965) (purpose found as a fact but mot referred to in opinion).
o04s Warren H. Brown, 27 T.C. 27, 29, 35 (1956).
o1049Piedmont Minerals Co. v. United States, 429 F.2d 560 (4th Cir. 1970); Dominion
Oil Co. v. United States, 58-2 U.S.T.C. 9643 (E.D. Va. 1958); Baker Commoditie3,
Inc., 48 T.C. 374, 398 (1967), aff'd on another issue, 415 F.2d 519 (9th Cr. 1969), cert.
denied, 397 U.S. 988 (1970); Gordon Lubricating Co., 24 T.O.M. 697, 710-11 (1965);
%T.iMorgan, Inc., 30 T.C. 881, 890-92 (1958), rev'd oan another issue, 272 F.2d 930

often been cited as a business purpose, although it is one that ordi-
narily could be satisfied as well by issuing preferred stock.o1° °
A business purpose to establish or preserve an affiliated source
of supply,10 51 sales outlet 1052 or tenant 1053 has sometimes been
cited as a ground for recognizing purported debts, even in ex-
treme circumstances. In the leading case of Byerlite Corporation
v. Williams, 0 "4 a manufacturer of asphaltic products contracted
to purchase a supply of material from abroad and organized a
foreign subsidiary to prepare the material for shipment. To
minimize the risk of foreign operations, the parent capitalized the
subsidiary with $30, and financed all its expenditures on open ac-
count. The venture was ultimately liquidated at a heavy loss,
which the court allowed as an ordinary deduction. The decision
contains broad language from which other courts have drawn the
conclusion that even "large loans to corporations with slight cap-
ital," if made "only to promote the business purposes of the...
lender," o1r must be recognized as debt pursuant to the dogma
that stockholders are free to "determine just how much of their
funds they care to risk in the form of capital." 101 Properly,
however, such "business purposes" as obtaining a source of sup-
ply should be viewed as irrelevant to the debt-equity analysis, for
(9th Cir. 1959). In Green Bay Structural Steel, Inc., 53 T.C. 451, 452, 458 (1969), the
purchasers of a bankrupt business set up a debt structure designed to enable the managor
and former proprietor eventually to reacquire the business.
1050 Sansberry v. United States, 70-1 U.S.T.C. 9216 (S.D. Ind. 1970). Comparable
purposes were also found insufficient to overcome adverse factors in W.O. Covey, Inc.,
28 T.C.M. 1379, 1386-87 (1969); Morris Moughon, 22 T.C.M. 94, 96, 99 (1963), aff'd,
329 F.2d 399 (6th Cir. 1964).
105 Byerlite Corp. v. Williams, 286 F.2d 285 (6th Cir. 1960); American Processing
& Sales Co. v. United States, 371 F.2d 842, 854 (Ct. Cl. 1967); George E. Warren Corp.
v. United States, 141 F. Supp. 935, 939 (Ct. Cl. 1956); C.M. Gooch Lumber Sales Co.,
49 T.C. 649, 656-57 (1968).
1o52 Scotland Mills, Inc., 24 T.C.M. 265, 275 (1965).
los Irbeo Corp., 25 T.C.M. 359, 367 (1966); of. Maloney v. Spencer, 172 F.2d 638,
641 (9th Cir. 1949); Christie Coal & Coke Co., 28 T.O.M. 498, 523 (1969).
1054 286 F.2d 285 (6th Cir. 1960).
1055 Id. at 291.
1056 Id. at 290. The case is cited in J.S. Biritz Construction Co. v. Commissioner, 887
F.2d 451, 458 (8th Cir. 1967) ("the courts have usually recognized advances ... where
there is a demonstrable business purpose in making a loan"); American Processing &
Sales Co. v. United States, 371 F.2d 842, 854-56 (Ct. Cl. 1967) ("business purpose" to
avoid unionization by creating a distinct entity for separable activities; Byerlto sus.
tained indebtedness despite an "astronomically greater" ratio and "weak financial
condition"); Austin Village, Inc. v. United States, 296 P. Supp. 382, 394, 397 (N.D.
Ohio 1968), rev'd, 432 F.2d 741 (6th Cir. 1970), note 1033 supra; Piedmont Minerals Co.
v. United States, 294 F. Supp. 1040, 1045-46 (M.D.N.C. 1969), aff'd, 429 l.2d 560
(4th Cir. 1970).

one might for the same business reasons intend a permanent capi-
tal investment or one which is indefinitely at the risk of the busi-
ness of the related corporation. The sounder rationale of the
Byerlite case, on which much of the court's argument actually
rests,1 57 is found in the principle, now sustained by many deci-
sions, that the acquisition of either a debt or an equity interest
may, if a loss results, give rise to an ordinary deduction, provided
the interest was acquired, and continued to be held, not as an in-
vestment motivated by the chance of profit from the affiliate's
business, but as an integral and necessary part of the conduct of
the business of the purported lender or stock purchaser itself.105e
Within the lhnimtations of that principle, 101" advances made to a
supplier or other affiliate functioning as an integral part of the
purported lender's business,10 0 without the requisite reasonable
1057 Byerlite Corp. v. Williams, 286 F.2d 285, 291, 293 (6th Cir. 1960).
1058 See cases reviewed in Waterman, Largen & Co. v. United States, 419 ].2d 845
(Ct. CL 1969), cert. demied, 400 U.S. 869 (1970). See also Troxell & Noa, Judfdal Bro-
sion of the Concept of Securies as Capital AssetS, 19 TAz It. REV. 185 (194). Al-
though most often applied to purchases of stock, the principle has been applied to
advances that were deemed equity (Old Dominion Plywood Corp., 25 T.O.L 678 (1960))
as well as to debentures that were recognized as debt securities (Tulano Harawooa
Lumber Co., 24 T.C. 1146 (1955); Rev. RuL 58-40, 1958-1 C.B. 275). In Blectrced
Fittings Corp., 33 T.C. 1026, 1032 (1960), this analysis was said to make it unnece3-
sary to decide -whether the advances were loans or capital contributions. Although the
Commissioner has resisted extension of that doetrino to situations wbero thero ras
unity of control (see Rev. BuL 58-40 aupra; Electrical Fittings Corp., supra, at 1031),
the courts have applied it in such cases. F S Services, Inc. v. United States, 413 P.
548 (Ct. CL 1969); John J. Grier Co. v. United States, 328 F.2a 103 (7th Cir. 1904);
Pittsburgh Reflector Co., 27 T.C.M. 377 (1968) ; Old Dominion Plywood Corp., pra, at
697 (conceding that the acquisition of control may "tend to sugge3t ' an investment
motive).
305 For example, retaining the interest beyond the temporary period in which it serves
a function integral to the taxpayer's business, plus a reasonable time for its disposition
or liquidation, may convert it into an investment. Missisquol Corp., 37 T.C. 791 (1902);
Gulftex Drug Co., 29 T.C. 118 (1957): aff'd, 261 F.2d 238 (5th Cir. 1959) ; of. Waterman,
Largen & Co. v. United States, 419 F.2d 845, 855 (C. CL 1909), ccrt. denfcd, 400 U.S.
869 (1970); F S Services, Inc. v. Unitea States, 413 F.2d 548, 4-55 (Ct. CL 1969).
1080 Although the principle originated in cases vhere interests wiere acquired in order
to overcome a shortage of supply, and has been accepted by the Service principally in
that context (Rev. Rul. 58-40, 1958-1 CXB. 275), it has been extended by the courts to
acquisitions of interests in present or prospective customers, clients and sales outlets.
Steadman v. Comm'r, 424 F.2t 1 (6th Cir. 1970) cecrt denie, 400 U.S. 869 (1970);
Waterman, Largen & Co. v. United States, 419 F.2d 845 (Ct. CL 1909), cer. denied,
400 U.S. 869 (1970); Hagan v. United States, 221 F. Supp. 248 (W.D. Ark. 1903); South-
eastern Aviation Undevriters, Inc., 25 T.C.M. 412, 424 (1966); Weather-Sea], Inc., 22
T.C.ML 471, 474 (1963); cf. Pittsburgh Reflector Co., 27 T.C.L 377 (1908). But see
dissenting opinion in Waterman, Largen & Co. v. United States, supra, at 859-63. Of.
Gulledge v. Comm'r, 249 F.2d 225 (4th Cir. 1957); Daffey v. Lothert, 03-1 U.S.T.C.
9442 (D. Minn- 1963). While the courts have rejected a strict te3t that the acqulaitlon

TAX LAW 1LTIEW [Vol. 26:
expectation of repayment, may give rise to an ordinary business
loss, not because the business relationship makes the advances debt
if they would not otherwise qualify as such, but because even
capital contributions would have the same effect. 10 0 1 If the con-
ditions of the rule are not met-e.g., if the affiliate conducts busi-
ness for its own account and not as a substitute for the purported
lender,10 2 or if the investment is a permanent one 1013 or the ad-
vances are continued beyond the time when the business need is
served 10 4 --the mere interrelationship of the businesses should be
a neutral fact.""6
Business purposes that are accomplished simply by incorpora-

tion of the business, without regard to whether the capitalization
consists of stock or debt or any combination thereof, should logi-
cally be completely neutral in their effect on whether purported
debt is to be recognized.10o6 Yet sometimes the courts, after as-
must be necessary to the very survival of the business in order for the principle to apply
(Waterman, Largen & Co. v. United States, supra, at 853; Helen If. Livosloy, 19 T.C.M.
133, 140 (1960)), little respect is shown for the separateness of the corporate entity
when the principle is applied to the acquisition of a subsidiary (however strong the
business reason for continuing its existence) to engage in a distinct enterprise similar
in nature to the taxpayer's business, as in John J. Grier Co. v. United States, 328 F.2d
163 (7th Cir. 1964).
2061 The few cases, see note 1058 supra, which have applied the principle to debts and
purported debts have involved only the loss deduction issue, and not such questions as
the purported debtor's deduction for interest or the dividend treatment of repayments to
the purported lender.
1062 Road Materials, Inc. v. Comm'r, 407 F.2d 1121, 1125 (4th Cir. 1969); North.
eastern Consolidated Co. v. United States, 406 P.2d 76, 79 (7th Cir.), cert. denied, 396
U.S. 819 (1969). But cf. John J. Grier Co. v. United States, 328 P.2d 163 (7th Cir.
1964); Old Dominion Plywood Corp., 25 T.C.M. 678, 697 (1966).
1083 See note 1059 supra. In Byerlite Corp. v. Williams, 286 F.2d 285, 201 (6th Cir.
1960), the court stressed that the arrangement was intended to be of short duration.
1064 Old Dominion Plywood Corp., 25 T.C.M. 678, 698 (1966).
1065 Recognition of debt was denied in American-La France-Foamite Corp. v. Com-
missioner, 284 F.2d 723 (2d Cir. 1960), cert. denied, 365 U.S. 881 (1961) (sales sub-
sidiary) ; Allen v. Commissioner, 283 F.2d 785, 790 (7th Cir. 1900) (similar business in
another state); Melville D. Prank, 24 T.C.M. 979 (1965) (corporation formed by in-
surance agent to place substandard risks; operated like a division of the agency); and
Martin M. Dittmar, 23 T.C. 789, 797 (1955) (source of supply). In Christie Coal &
Coke Co., 28 T.C.M. 498, 523 (1969), the court rejected the source of supply argument
because the outlay was disproportionate to the expected benefit. In Road Materials, Inc.,
26 T.C.M. 922, 930 (1967), aff'd, 407 P.2d 1121 (4th Cir. 1969), it was said that ad-
vances to a corporation in common control, as distinguished from a subsidiary, were not
made to promote the business of the purported lender but that of the stockholder. .But
see Northeastern Consolidated Co. v. United States, 406 P.2d 76, 79-80 (7th Cir.) (dis-
senting opinion), cert. denied, 396 U.S. 819 (1969); Old Dominion Plywood Corp., 25
T.C.M. 678, 695-97 (1966).
1066Truck Terminals, Inc., 33 T.C. 876, 886 (1960), aff'd, 314 F.2d 449 (9th Cir.
1963); Estate of Herbert . Miller, 24 T.C. 923, 933 (1955), rev'd, 239 P.2d 729 (9th

serting the significance of "a good business reason for the issuance
of debt securities," proceed to support recognition of purported
debt by finding business reasons for incorporating."' 1 On the
other hand, if the corporation itself is so lacking in business pur-
pose or function that it is not recognized as an entity separate from
its shareholders for tax purposes, it plainly cannot create recog-
nizable debt to them. 18 s
While it would be unusual for the corporation itself to benefit,
other than taxwise, from being burdened with debt rather than
enjoying an infusion of equity capital, some corporate business
purposes have been recognized in the cases. When a business
found that its capacity to borrow from banks was limited by the
low cost at which its assets were carried on the books, an inter-
corporate installment sale which stepped up the book values and
thereby increased the borrowing capacity was found to be a rea-
sonable solution to business problems and hence to be a "substan-
tial non-tax business reason" supporting recognition of the debt
and stepping up the cost for tax purposes as well.1' 0 The use
of a preexisting shell of a corporation, without new equity capital,
has been justified as a device to escape Mexican legal restrictions
on alien ownership of newly formed or capitalized corporations.1 0 70
Most significantly, the fact that mutual insurance companies are
not authorized to issue stock, and yet must raise capital as a guar-
anty fund against losses if they are to spare their members from
liability to assessments, has been accepted as a reason, arising
out of the necessary requirements of the mutual insurance busi-
ness, for recognizing an all-debt capitalization, even though the
instruments lacked the most basic formal characteristics of debt.107 1
The mere fact, however, that state or foreign law or institutional
lending standards place the parties in the position where they must
Cir. 1956); Mullin Bldg. Corp., 9 T.C. 350, 358 (1947), aff'd, 167 F.2d 1001 (3d Cir.
1948). See George A. Nye, 50 T.C. 203, 212 (1968).
1067:Ruspyn Corp., 18 T.C. 769, 777 (1952), criticized on this ground in Fuehs, 27Tin
Incorporation-Debtor Stoc:?, 5 Am. U. IN~ST. 141, 157 (1953); accord, J.S. Biritz
Construction Co. v. Comm'r, 387 F.2d 451, 458, 459 (8th Cir. 1967); Jaek Daniel
Distillery v. United States, 379 F.2d 569, 584 (Ct Cl. 1967); Arthur K ]Iosenthal, 24
T.C.k 1373, 1382 (1965).
1068 O 'Neil v. Comm'r, 170 F.2d 596, 597 (2d Cir. 1948).
o69 Woolley Equipment Co. v. United States, 268 F. Supp. 358, 303-65 (ED. Tem.
1966).
1070 Earle v. W.J. Jones & Son, 200 F.2d 846, 848 (9th Cir. 1952).
omm'r v. Union Mut Ins. Co. of Providence, 38G P.2d 974 (lst Cir. 1907),
10710
accepted in R:ev. Rul. 68-515, 1968-2 C.B. 297. The certificates lathed a maturity date,
being payable only out of surplus earnings in the discretion of the company; "interest"
was payable only from profits; and the holders were entitled to elect half the diretors.

TAX LAW I LTIEW (Vol. 26 :
label as debt that which in substance is not debt, and that such
formalism is accepted for those purposes, is not a sound reason
for recognizing purported debt for purposes of the federal tax
law. 1072 Accordingly, when one investor in a family corporation
took most of his investment in the form of debt rather than stock,
in order that the corporation would not be disqualified as a bor-
rower from an institution of which he was an officer and director,
the court found such characterization, however necessary, to be
an insufficient business purpose to require recognition of the
debt.10 7 An objective to save state taxes and fees by minimizing
the corporate capital has also been held an insufficient business
1° 4
purpose to require that federal tax benefits be granted as well.
Despite the importance of taxes in the business world, it would
be a travesty if the purpose to save federal taxes were regarded
not merely as a neutral factor but as a business purpose favorable
to a finding of true debt.10 75 Yet one remarkable decision, involving
a charitable foundation which, when Congress declared its policy
that such entities should be taxed on unrelated business income,10 0
reacted by organizing a subsidiary with a topheavy debt capitali.
zation, sustained the foundation's "good faith efforts ... to main-
tain its income free and clear" by creating offsetting deductions
in response to a "business need [which] arose because of a change
in tax laws." 1077 One district court has declared that "tax con.
siderations have become so important today that tax avoidance
alone may well constitute a legitimate business purpose," and has
accordingly viewed as a substantial business reason the desire to
create, by stepping up the tax basis of assets, a tax-free "guaranteed
cash flow, not dependent on profits" and thereby enabling payment
of dividends which would make the corporation's stock attractive
78
0
to outside investors.
1072 See Peco Co., 26 T.C.M. 207, 212 (1967); of. text at notes 310-19 supra.
1073 Ibid.
1074 1ames D. Lancaster, 23 T.C.M. 631, 635 (1964).
1075 See Ballenger v. United States, 301 F.2d 192, 397 (4th Cir. 1962) (a section
302 ase).
1076 See I.R.C. §§ 511-15.
1077 Campbell v. Carter Foundation Production Co., 322 F.2d 827, 831, 832 (5th Cr.
1963) ; of. Kraft Foods Co. v. Comm'r, 232 l.2d 118 (2d Cir. 1956), seo text at note
1019 supra, sustaining debt which was created by an intercorporato dividend of dobon-
tures when the abolition of the consolidated return privilege (in the 1930's) made it
desirable to have interest paid by a profitable subsidiary to a losing parent; but the
court had the grace not to label such motivation a cleansing business purpose, stating
instead that such purpose was unnecessary.
3.0s Woolley Equipment Co. v. United States, 268 F. Supp. 358, 363-64 (E.D. Tox.
1966).

1971] CORPORATIE DEBT
It is sometimes argued that advances made by a parent to its

subsidiaries have a business purpose, and hence should be recog-
nized as debt, because the parent's established business practice
is to make such advances to all its subsidiaries (or to suppliers,
customers, et cetera) .1070 That argument merely beclouds the issue,
however, for in the circumstances of the particular purported
debtor the established practice080
may be to make capital contribu-
tions to it rather than loans.
Corporate business purposes are frequently advanced, not as
reasons for the use of debt, but as justification for the absence of
a fixed maturity, or for complete subordination, contingent pay-
ments or the use of labels inconsistent with debt.10 s3 One may,
however, have business reasons for equity financing as well as
for debt, and terms required by such business necessities are more
properly viewed as evidence that "the needs of the business could
best be met by instruments that did not create the debtor-creditor
relationship." 1082
Dividend and Salary Policy

The practice of a corporation in paying or not paying dividends
to shareholders has been mentioned (although not currently) 1083
as a factor to be considered in determining the status of purported
debt. 08 4 The fact that the shareholders obtained the fruits of a
lucrative venture through purported interest rather than dividend
payments has sometimes been referred to as evidence of a "device
[for] drawing off regular profits from the corporation under a
label designed to give the corporation an income tax deduc-
tion," 315 while the fact that they "expected ... to have some-
thing substantial left over" for dividend payments after satisfying
1079 Allied Stores Corp., 19 T.C.M. 1149, 1155-56 (1960); of. American Procesaing
& Sales Co. v. United States, 371 F.2d 842, 852 (Ct. CL 1967).
1080 See C.ML Gooch Lumber Sales Co., 49 T.C. 649, 055-56 (1968); accord, Christlo
Coal & Coke Co., 28 T.C.M. 498, 523 (1969).
1os1 See notes 239, 310-19, 398 and 461 supra.
082Universal Castings Corp., 37 T.C. 107, 117 (1961), aff'd, 303 F.,41a 620 (7th Cir.
1962). See also Gardens of Faith, Inc., 23 T.C.ML 1045, 1060 (1964), aff'J, 345 F.2d
180 (4th Cir.), cert. denied, 382 U.S. 927 (1965).
-083 It is omitted even in the most comprehensive current judicial listings of factors,
note 197 supra.
3o84 Sarkes Tarzian, Inc. v. United States, 240 F.2a 467, 470 (7th Cir. 1957).
-085 Brake & Electric Sales Corp. v. United States, 185 P. Supp. 1, 4 (D.I 19GO),
afr'd, 287 F.2d 426 (1st Clr. 1961); accord, B.C. Owen Co. v. United State3, 180 F.
Supp. 369, 373 (Ct. CL), cert. denied, 363 U.S. 819 (1960); A.B. Lantz Co. v. United
States, 283 F. Supp. 164, 169, 170 (C.D. Cal. 1968), aff'd, 42'4 F.2d 1330 (9th Cr. 1970).

the interest has been viewed as favorable to debt. 1 80 On the other
hand, in one case, the fact that the corporation refrained from
paying any dividends to the shareholder until it had fully dis-
charged its debt to him has been cited in favor of recognition of
debt. 08 7 The better view, however, is that nonpayment of divi-
dends is a neutral factor with no real relevance to the issue.108 8
Payment of dividends likewise has no tendency to show that
purported debt, if otherwise subject to question, is genuine, 1 8 D
and may even have a contrary tendency if such payments are
prejudicial to the purported debt, particularly when an express re-
striction on dividends is disregarded 1090 or when the obligation
is in default.'0 91
Although the Commissioner has argued that nonpayment of
salaries evidences in some manner the unreality of a debt arising
from a purported sale to a corporation, 9 2 the Tax Court has given
it the opposite effect, on the ground that the corporation's lack of
interest in salary deductions showed that it was not tax moti-
vated. 10 93 The effect of such nonpayment even on the tax avoid-
ance issue is ambivalent, when the officer-shareholder's tax situa-
tion is weighed in the balance; 1014 but it should in any event be
10s Ruspyn Corp, 18 T.C. 769, 779 (1952). It has been inferred that the court may
have meant "that corporate structures may be judged by whether the parties intended
to avoid all or only some part of the corporation's taxes." F'uchs, Thin Incorporation--
Debt or Stoc?, 5 Am. U. INrsT. 141, 160 (1953). Cf. Henry Van Hummell, Inc. v.
United States, 364 F.2d 746, 751 (10th Cir. 1966), cert. denied, 386 U.S. 956 (1967), ro-
jecting a similar approach under section 531 of the Code.
1082 Taft v. Comm'r, 314 F.2d 620, 622 (9th Cir. 1963).
1088o.H. Rruse Grain & Milling v. Comm'r, 279 F.2d 123, 126 (9th Cir.
1960);
Charles E. Curry, 43 T.C. 667, 694 (1965).
1059 Dillin v. United States, 433 F.2d 1097, 1102-03 (5th Cir. 1970) (personal holding
company necessarily distributed all ordinary income as dividends, but used capital gain
to repay purported debt); R.C. Owen Co. v. Comm 'r, 351 F.2d 410, 413 (6th Cir. 1965),
cert. denied, 383 U.S. 967 (1966). See note 1086 supra.
o1090
Fellinger v. United States, 238 F. Supp. 67, 77 (N.D. Ohio 1964), ar'cZ, 303 r.2d
826 (6th Cir. 1966); Ram Corp. v. United States, 305 F. Supp. 831 (W.D.N.C. 1969);
Catalina Homes, Inc., 23 T.C.M. 1361, 1362, 1366 (1964).
1091 Sayles Finishing Plants, Inc. v. United States, 399 F.2d 214, 221 (Ct. Cl. 1968);
Thomas Machine Mfg. Co., 23 T.C.M. 1630, 1642 (1964). See text at notes 712-13 supra.
1092 Charles E. Curry, 43 T.C. 667, 695 (1965). The court found that services were
in fact paid for through a management fee to an affflate, so it does not discuss the
effect which nonpayment would have had.
1093 Bulkley Dunton & Co., Inc., 20 T.C.M. 660, 665 (1961).
1094 In contrast to the decision in Bulkley Dunton & Co., Inc., 20 T.C.M. 660 (19061),
nonpayment of salaries has been deemed, in cases under section 531, to be evidenco of
a general purpose of the corporation to avoid taxes at the shareholder love]. Young
Motor Co. v. Comm'r, 339 F.2d 481, 483 (1st Cir. 1964); Factories Investment Corp.

accorded no greater relevance to the present question than the

matter of tax avoidance itself 1 :D
Arbitrary Separation
Some decisions, especially early ones, seemingly give adverse
weight to the fact that "the organizers of a new enterprise arbi-
trarily designate as loans the major portion of the funds they lay
out in order to get the business established and under way," 13
or that the purported sale of some assets and the exchange of
others for stock "were simply arbitrary component steps in a
single transaction" with no "business reasons" being shown for
their separation. 1 09 7 The point has been analyzed as "a combina-
tion of pro rata holding, 'permanent capital structure' and in-
formality." 1 0o But it seems generally, like the tax motivation
factor to which it is closely akin, to be merely the court's rhetorical
expression of a conclusion reached on the basis of all the factors.'e"
Wlhen the substantive factors are in order, the courts have no diffi-
culty in finding the division not to be arbitrary 0 and the "con-
secutive steps . . . closely related in time and purpose" to be
"entirely different in nature and therefore separate and distinct
legal transactions." 1101
No New Capital
The courts in denying recognition of purported debt have fre-
quently made the point that its creation brought no new money
or assets into the business. 10 2 Occasionally this is said even with
v. United States, 328 F.2d 781, 784 (2d Cir. 1964); Battelstein Investment Co. v. United
States, 302 F. S pp. 320, 331 (S.D. Tex. 1969), aff'd 71-1 U.S.T.C. U 9227 (Gth Gir.
1971).
lo96Isidor Dobkin, 15 T.C. 31, 33 (1950), aff'd, 192 F.2( 392 (2d Cir. 1951)
(emphasis added). Such language occasionally appears even today. Fin Hay Realty Co.
v. United States, 261 F. Supp. 823, 828 (D.N.T. 1966), aff'd, 398 F.21 694 (3d cir.
1968); S.P. Realty, TIe., 27 T.C.ML 764, 767 (1968).
log7 Nassau Lens Co., 35 T.C. 268, 272 (1960), remandcd, 308 F.12d 39 (2a Cir.
1962); cf. Gokey Properties, Inc., 34 T.C. 829, 836 (1960), aff'd, 290 F.2d 870 (2a
Cir. 1961) ("no identification or allocation of the assets exchanged for the stomAi and
the assets exchanged for the bonds").
1ogs Goldstein, Corporate Indebtedness to Sliarcholdcrs: "Thin Capitazatior," and
Belated .Problems,16 TA-x L. RLv. 1, 27 (1960).
-100 Liflans Corp. v. United States, 390 F.2d 965, 972 (Ct. CL 1968).
no, Warren H. Brown, 27 T.C. 27, 35 (1956) ; cf. H.B. Zachry Co, 49 T.C. 73, 81-84
(1967).
-102 Of. section 385(b) (1), added by section 415(a) of the Tax Reform Act of 1069,

TAX LAW RLTMfW [Vol. 26:
respect to the initial capitalization of a corporation, where the
effect of the issuance of debentures is to transmute what had been
capital of an unincorporated business into purported corporate in-
debtedness. 1 03 In that context, it is merely a variation of the
arbitrary separation point last discussed, and it has no greater
10 4
independent validity.
More often, the no new capital argument occurs in cases where
corporate indebtedness was created by a dividend distribution of
obligations,-" 5 or by an exchange of obligations for outstanding
preferred 108 or common stock,110 7 or in conjunction with a rein-
corporation 1108 or corporate separation. 110 9 Invariably, however,
such language has been mere rhetorical makeweight, in cases
where the substantive factors strongly negatived true debt.1110
It is well established that, if those factors are in order, debt recog-
nizable for tax purposes may arise not merely from loans and
listing "an adequate and full consideration in money or monoy's worth" as a factor
which "may" be given weight in the forthcoming regulations distinguishing debt from
equity.
11osR.C. Owen Co. v. United States, 180 F. Supp. 369, 872 (COt. Cl.), cert. donied,
363 U.S. 819 (1960); 1.C. Owen Co., 23 T.C.M. 673, 676 (1964), aff'd, 351 F.2d 410
(6th Cir. 1965), cert. denied, 383 U.S. 967 (1966); Morris Moughon, 22 T.O.M. 94, 100-01
(1963), aff'd, 329 F.2d 399 (6th Cir. 1964); Gokey Properties, Inc., 34 T.C. 829,
836 (1960), aff'd, 290 F.2d 870 (2d Cir. 1961).
11o4Luden's, Inc. v. United States, 196 P. Supp. 526, 531-32 (ED. Pa. 1901). In
R.C. Owen Co., 23 T.C.M. 673, 676 n.5 (1964), aff'd, 851 F.2d 410 (6th Cir. 1065),
the Tax Court distinguished Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d Cir.
1956) (which rejected the no new capital argument), on the ground that Kraft involved
an unambiguous debt instrument and Owen did not.
1105 Comm'r v. John Kelley Co, 146 F.2d 466, 467 (7th Cir. 1944), rev'd (based on
scope of review), 326 U.S. 521 (1946) (debentures sold to shareholders on open ac.
count, satisfied by application of later dividends to the account; "transaction did not
put a penny of new money into the treasury of the corporation"). See Lansing Com-
munity Hotel Corp., 14 T.C. 183, 191 (1950) (dissenting opinion), aff'd, 187 P.2d 487
(6th Cir. 1951).
1106 Beaver Pipe Tools, Inc. v. Carey, 240 F.2d 843 (6th Cir. 1957) ; Wottorau Grocer
Co. v. Comm'r, 179 P.2d 158, 160 (8th Cir. 1950).
1107 Talbot Mills v. Comm 'r, 146 F.2d 809, 811 (1st Cir. 1944), aff'd (based on soopo
of review) sub nom. John Kelley Co. v. Comm'r, 326 U.S. 521 (1946); Brown-Rogors-
Dixson Co. v. Comm'r, 122 F.2d 347, 350 (4th Cir. 1941).
1108 Sayles Finishing Plants, Inc. v. United States, 399 F.2d 214, 218 (Ct. Cl. 1908).
1109 Gregg Co. v. Comm'r, 239 F.2d 498, 502 (2d Cir. 1956), cort. dened, 353 U.S.
946 (1957); Mullin Bldg. Corp., 9 T.C. 350, 358 (1947), aff'd, 167 F.2d 1001 (3d Cir.
(1948).
l3, See Luden's, Inc. v. United States, 196 P. Supp. 526, 531 (E.D. Pa. 1901) ("ian
element which fades almost into insignificance when compared with the other factors
present in those cases"). But see Goldstein, Corporate Indebtedness to Shareholdcrs:
"Thin Capitalization'"and Belated Problems, 16 TAX L. REv. 1, 22-23 (1960), con-
tending that "if the debt instruments in question reach the shareholders via a dividond
or recapitalization, they look much less like outside debts no matter what their form."

19711 CORPVORATE DEBT
purchases, but also from dividend distributions "'I and capital

adjustments.""
Double Taxation
The scheme of the federal tax statute, whether rightly or
wrongly, is that income earned by a corporation is taxed once to
the corporation and again to the shareholder, when and if it is
distributed to him. Furthermore, once an amount has been dedi-
cated to corporate capital, it is theoretically impossible (except
in certain transactions having the characteristics of a complete or
partial liquidation of the corporation or of a true sale of stock) 1113
for a shareholder to recover that capital tax-free unless all the
corporation's post-1913 earnings and profits have first been dis-
tributed and subjected to dividend taxation, since the law conclu-
sively deems all unexcepted distributions, to shareholders as such, 14
to be derived from earnings and profits to the extent thereof."
If no exception fits, it is immaterial that the corporation may
designate the distribution as a return to the shareholders of paid-in
surplus consisting of the accumulated earnings of a predecessor
unincorporated business on which they had once been taxed.' 5
It is not that the former earnings are being taxed twice but that,
under the priorities established by law, they are considered to be
frozen into the corporate capital until the corporation's own earn-
ings have been distributed as taxable dividends or until an ex-
cepted transaction takes place. Nevertheless, there is authority
that where a shareholder-employee had received preferred stock
in satisfaction of an obligation for undrawn salary on which he
had been taxed, and where such stock was later redeemed under
circumstances that might otherwise have been considered equiva-
'in-iKYaft Foods Co. v. Comm'r, 232 F.2d 118, 126 (2d Cir. 1950); Comm'r v. H.P.
Hood & Sons, 141 F.2d 467 (Ist Cir. 1944) ; Graves Bros. Co. 17 T.C. 1499, 15O4 (1952) ;
Lansing Community Hotel Corp., 14 T.C. 183, 190 (1950), aff'd, 187 P.2d 487 (6th Cir.
1951). See Reg. § 1.163-1(c) ("Interest paid by a corporation on scrip dividends is an
allowable deduction").
-119 Comm'r v. H.P. Hood & Sons, 141 F.2a 467, 471 (1st Cir. 1944) ("there is nothing
to prevent.. . replacing an instrument which rests on one side of the line separating
indebtedness from proprietorship with one which rests on the other sido of tho line");
Sabine Royalty Co., 17 T.C. 1071, 1077 (1951); Cleveland Adolph 2Mayer Realty Corp.,
6 T.C. 730, 740-41 (1946), rev'd on another point, 160 F.2d 1012 (Oth Cir. 1947) (rein-
corporation); Elliott-Lewis Co., 4 T.C.M. 130, 142 (1945), aff'd, 154 P.2d 292 (3d Cir.
1946); John ]Kelley Co., 1 T.C. 457, 462 (1943), rcv'd, 146 F.2d 460 (7th Cir. 1944),
rev'Id (based on scope of review), 326 U.S. 521 (1946).
-3LR.C. §§ 302, 331, 346; United States v. Davis, 397 U.S. 301, 311 (1970).
U14 L.. §§ 301(c), 316(a).
-5Leland v. Comm'r, 50 P.2d 523 (Ist Cir. 1931).

lent to a dividend,' tax may not be imposed on the distribution,
in part because to do so would have the effect of taxing his salary
twice."1 The principal basis of that decision, however, and the
only basis of the appellate authority on which it relied, was that
the fact of income tax having once been paid on the salary tended
to negative a tax avoidance purpose for, and to confirm the busi-
ness purpose of, the issuance and redemption of the stock.1118 The
recent Davis decision of the Supreme Court, firmly rejecting
business purpose as a test of the equivalence of a pro rata stock
redemption to a dividend, has removed the underpinnings of
those decisions."' 9
Although Congress has adopted numerous and complex anti-
bail-out provisions designed to prevent circumvention of the prin-
ciple that corporate earnings generally come out before capital, 1 20
it left the door open for those who have the foresight to include
debts to shareholders in their capital structures.112 ' If adequate
attention has been paid to both form and substance, shareholders
may receive payment of such debts without incurring dividend
tax in addition to whatever income tax they may have incurred
on the amount involved when they originally acquired the right
to it. In a number of cases, where the Commissioner has chal-
lenged the reality of purported debts to shareholders, the courts
have declined to tax the payment thereof as dividends," 2 in part
on the ground that the amount had previously been taxed to the
shareholders. In particular, where an amount equal to all the
accumulated and reinvested earnings of an unincorporated busi-
ness had been designated as debt upon its incorporation, it has
been viewed as "inconceivable" that such former earnings could
be "metamorphosed into dividends" and thus taxed twicoe.112
1116 See I.R.C. § 302(b).
1117 Estate of Henry A. Goldwynne, 26 T.C. 1209, 1212-13 (1956).
1218 Ibid., relying on Keefe v. Cote, 213 F.2d 651, 657 (1st Cir. 1954), which actually
held no more than that such facts were enough to carry the dividend equivalency quos-
tion to the jury.
2119 United States v. Davis, 397 U.S. 301, 310-13 (1970). The former business pur-
pose test is discussed in Moore, Dividend Bquivalecij-Taxaton of Distributions in
Redemption of Stock, 19 TAx L. REv. 249, 255-67 (1964).
1121 See Cohen, Surrey, Tarleau & Warren, A Technical Revision of the Federal In.
come Tax Treatment of CorporationDistributionsto Shareholders, 52 CoLuM. L. IRnv. 1,
27-28 (1952).
1122 Concerning dividend treatment of the repayment when purported debt is not
recognized, see text at notes 50-51 supra.
1123Harris v. United States, 370 F.2d 887, 894 (4th Cir. 1966); accord, Taft v.
Comm'r, 314 F.2d 620, 623 (9th Cir. 1963), note 210 supra; Amleto U. Salvadoro, 22
T.C.M. 1718, 1723 (1963); of. Christie Coal & Coke Co., 28 T.C.M. 498, 524 (1969) (bad

Since most wealth, unless derived from patrimonial gifts or other

exempt sources, was subjected to income tax when it was first ac-
quired by its owner, the logic of that argument would apply even
when the connection between the purported debt and the previous
realization of income is more remote.'" 4 There may be a valid
objection to the established system of taxing corporate earnings
to shareholders without first letting them recover their "tax-paid"
capital.1 "' But, given the scheme of the statute, the fact that the
amount contributed by the shareholder had once been taxed as
income has no legal or evidentiary relevance to the question
whether he contributed it as capital (and thus froze it into the
corporation until corporate earnings have been withdrawn as divi-
dends) or made a loan recognizable as such for tax purposes.1120
The Not-to-Be-Forgotten Term "Securities" '.
lIx GENERAL
A purported debt may be found to be bona fide and recognizable

for general purposes of the tax law (such as the corporate interest
debt allowed, noting that purported receivables for services had been taxed as income
when they accrued). In Sylvan Makover, 26 T.C.M. 288, 293 (1967), an intention merely
to loan to a new corporation the proceeds of sales on which the predecessor partnerahip
had been taxed was inferred because it would have been "poor tax planning" to con-
tribute it to capital and expose it to a second tax when recovered from corporate
earnings.
214But cf. Swan v. Comm'r, 355 F.2d 795, 798-99 (Oth Cir. 19), in which the fact
that the shareholder-employee had cashed his salary checks and then reinvested the
proceeds in stock, which was later redeemed, was held to have "closed the salary ac-
count" and rendered inapplicable the Goldwyrnn principle, see note 1117 supra.
1=25 See Spanbock, Carro & Katz, Nourishing the Thin Corporation, 34 TAxsrs 687,
692 (1956) ("Funds loaned by a taxpayer to his corporation in most instances have
already been subject to income taxation. Unless a lender can recover, tax-free, his
loan of such funds to a corporation, he may be discouraged from lending risk money.
If debt is not recognized because its amount is in excess of an arbitrarily established
upper limit or because the lender is also a shareholder, this opportunity for recovery of
loans, tax-free, is effectively blocked. ").
112See Goldstein, Corporate Indebtedness to Shareholders: "This Capitaliciatiot"
and Related Pro'blems, 16 TAx L. REv. 1, 41-42 (1960); of. United Engineers & Con-
structors, Inc. v. Smith, 59-1 U.S.T.C. 9322, p. 71,746 (E.D. Pa. 1959) ("1I can maho
no distinction between advancing money without hope of repayment and rendering a
service without hope of being payed [sic] anything for it"); C.M. Gooch Lumber Salk
Co., 49 T.C. 649, 659-60 (1968). Both were bad debt cases but the same principle should
apply where taxability of the recovery is in issue. See Walter C. M clinn, Xr., 21 T.C .
913, 915, 924-26 (1962) (undrawn salary contributed to capital, taxed as dividend
when -withdrawn; not stated whether salary had been taxed).
-. 7 Compare Comment, Section 351 Transfers to Controlled Corporations: 2h For-
gotte'n Term---"Securities," 114 U. PA. L. :REV. 314 (1905); with Stone, Deot.Equity
Distinctionsin the Tax Treatment of the Corporationand Its 8hareholders, 42 TMU.L.
REv. 251, 267-72, (1968).

TAX LAW REV-EW [Vol. 26 :
deduction), and yet certain of the anticipated tax consequences of
debt may be denied if the obligation is categorized as a security.
We have seen that a loss from the worthlessness of a corporate
debt may be treated like a stock loss if the debt constitutes a secur-
ity, for which purpose the term is expressly defined as "a bond,
debenture, note or certificate, or other evidence of indebtedness,
issued by a corporation .. . , with interest coupons or in regis-
tered form." 1128 We are here concerned, however, with a number
of other provisions of the Internal Revenue Code, relating to tax-
free (or partially tax-free) corporate organizations, reorganiza-
tions and separations, which use the term "stock or securities"
without definition. For purposes of those provisions, the effects of
which will first be briefly described, the courts have given the word
112 1
"securities" a broader, but somewhat amorphous, meaning.
Under section 351, a transfer of property to a corporation, of
which the transferors collectively have the requisite 80 per cent
stock control immediately thereafter, is ordinarily tax-free if the
transfer is solely in exchange for stock or securities, or both.118 0
But any gain resulting from the transaction will be taxable to the
extent that the transferors receive boot (other property or money),
including recognized debts not constituting securities.118 ' Any such
debts received as boot will have a basis to the transferors equal
to their then fair market value,"1 2 so that there will be little, if
any, additional taxable gain (and no equivalent to a dividend tax)
upon their later collection; and the corporation's basis for depre-
ciation or for gain or loss on its later sales of the assets will be
the transferors' basis, stepped up by the amount of gain that is
taxable to them by reason of receipt of such debt or other boot. u 3
1128 I.R.C. § 165(g). This provision has been dealt with in the text at notes 70-72
supra, and will not be further discussed in this part.
11 9 The term "securities" has been held to have the same meaning wherever it occurs
in the provisions next discussed. Neville Coke & Chemical Co. v. Comm'r, 148 l.2d 500,
601 (3d Cir.), cert. denied, 326 U.S. 726 (1945); Lloyd-Smith v. Comm'r, 116 F.2d
642, 644 (2d Cir.), cert. denied, 313 U.S. 588 (1941); Camp Welters Enterprises, Inc.,
22 T.C. 737, 750 (1954), aff'd, 230 F.2d 555 (5th Cir.), cert. denied, 852 U.S. 826 (1956).
The term also appears, without definition, in section 1244(c)(1)(D), note 79 supra,
where it presumably has the same meaning.
1130 In certain circumstances, transfers to investment companies (Rog. § 1.851-1 (0))
and to foreign corporation (I.R.C. § 367) are denied the benofits of section 351. Con-
cerning the 80 per cent control requirement, see notes 113-17 supra.
1181 I.R.C. § 351(b) ; Turner v. Comm'r. 303 F.2d 94 (4th Cir.), cert. denid, 871 U.S.
922 (1962); Harrison v. Comm't, 235 F.2d 587 (8th Cir.), cert. denicd 352 U.S. 952
(1956).
1182 LR.C.§ 358 (a) (2).
123 I.R.C. § 362(a).

1971] CORPOIRATE DEBT
We have seen that it is sometimes worth incurring a taxable gain

to the transferors in order to achieve such a basis advantage for
a controlled corporation, 34 but the effort may be frustrated by
the categorization of the corporate indebtedness as a security, just
as by its treatment as in the nature of stock. If the transaction is
deemed tax-free to the transferors on that account, the corporation
must use their asset basis, notwithstanding that it has undertaken
a fixed obligation to pay out a greater amount when it retires the
securities; 11'0 and the transferors' asset basis will also become
their basis for the stock and securities they receive (allocated in
proportion to the respective market values), so that upon retire-
ment or sale of the securities they will realize, without correspond-
ing basis benefit to the corporation, a portion of the taxable gain
they initially escaped upon the transfer 1 30 (although they may
still be far better off than if the debt were deemed stock and its
retirement taxable as a dividend 1137).
Many of the judicial precedents on the meaning of the term
"securities" have involved exchanges in corporate reorganiza-
tions, =1 although statutory changes have greatly diminished the
significance of the debt-securities dichotomy in that area. No gain
or loss is recognized to the corporate transferor upon its transfer
of property in exchange for stock or securities of another party to
the reorganization; but, even if it receives boot, including debt not
constituting securities, the transferor is taxable on its gain, if any,
only to the extent that (in rare cases) it does not distribute such
2 34See text at notes 57-62 supra.
135 .RC. § 362 (a); Ernest W. Brown, Inc., 28 T.C. 682 (1957), aff'7, 258 Ffd 829
(2d Cir. 1958). See Stone, Debt-Equity Distinctions in the Tax Treatment of tho Cor.
poraion and Its Slarehol drs, 42 Tur. L. xv. 251, 271 (1968).
1136T.C. §§ 358(a)(1) and (b)(1); Reg. § 1.358-2(b). See Stone, Debt-EquitJ
Distinction in the Tax Treatment of the Corporation and Its Sharcholdcers, 42 TUL.
, REv. 251, 271 (1968).
137 See text at notes 48-52 supra. In general, the gain on retirement or disposition of a
low basis security will be a capital gain under section 1232. That provision imposes ordi.
nary income tax only with respect to the original issue discount, which is defined as the
excess of the stated redemption price over the issue price. When a debt is issue for
property, rather than for cash, the issue price is in some Circumstace3 deemed equal
to the redemption price (resulting in no discount) and in others is the then fair marhot
value of the property. I.UC. § 1232(b) (2), as amended by section 413 of the Tax Re-
form Act of 1969. In no event would the difference between the redemption price and
the substitutea basis of the securities be deemed original issue dicount. Cf. Montana
Power Co. v. United States, 232 P.2d 541, 543 (3d Cir.), cert. denfed, 352 U.S. 843
(1956).
138 Defined in I.].C. § 368. see notes 116 and 118 supra. Parallel rule3 for certain in.
iolvency reorganizations are provided in sections 371-74.

boot pursuant to the plan of reorganization.1 18 9 No gain or loss
is recognized to the investors on their receipt of stock of a party
to the reorganization, in exchange for either stock or securities; 1140
but the investors (except in the case of certain insolvency reorgani-
zations 1141) are tax-free on their receipt of securities only to the
extent that the principal amount thereof does not exceed the prin-
cipal amount of the securities they surrender.1 142 Any gain the
investors may have, however, is taxable (ordinarily as a dividend)
to the extent that they receive money or other property, including
excess securities and any corporate debts not constituting securi-
ties." 43 The securities classification is pertinent not only to the
consideration received by the investors, but also to what is given
up, since the receipt in a reorganization of either stock or securi-
ties in exchange for existing debts not constituting securities is
outside the scope of the provision for nonrecognition of gain or
lOSS. 11 4 4
119 I.R.C. §§ 361, 371(a), 374(a). The acquiring corporation takes over the basis of
the assets, adjusted for any recognized gain to the transferor (but not for gain
recognized to the transferor's investors, note 1143 infra). I.R.C. §§ 362(b), 372(a),
374(b).
140oI.R.C. §§ 354(a)(1), 355(a)(1), 371(b)(1). Under certain conditions, the term
"party to a reorganization" includes the parent of the corporation acquiring the assets.
I.R.C. § 368(b).
1141 Section 371(b)(1) does not restrict the amount of stock or securities that may
be received in a qualified insolvency reorganization in consideration for the relinquish-
ment or extinguishment of stock or securities, presumably because the upgrading
of stock to securities would be most unusual in such cases.
1142 I.R.C. §§ 354(a), 355(a) (1) (A) and (a) (3). Until 1954, there was no restriction
upon upgrading stock to securities through a reorganization exchange, unless the quali-
fication of the reorganization itself was vitiated by the predominance (as in LoTullo
v. Scofield, 308 U.S. 415, 420-21 (1940), and Southwest Natural Gas Co. v. Comm'r,
189 F.2d 332 (5th Cir.), cert. denied, 342 U.S. 860 (1951)), or in some cases by the
mere presence (I.R.C. §§ l12 (g) (1) (B) and (C) (1939), now I.R.C. §§ 308(a) (1) (B)
and (C)) of consideration other than stock.
1143 I.R.C. § 356. Concerning the transfer of the investors' basis and its adjustment
for recognized gain, see section 358.
1144 Neville Coke & Chemical Co. v. Comm 'r, 148 F.2d 599, 601 (3d Cir.), ert. denied,
326 U.S. 726 (1945) ; Comm'r v. Sisto Financial Corp., 139 P.2d 253 (2d Cir. 1943). The
result is criticized in Griswold, "Securities" and "Continuity of Interest," 58 HAM.
L. R.v. 705 (1945), on the ground the "securities" definition imports the standard of
continuity of interest, which is pertinent only to what is received in the exchange, and
that nothing in the policy of the law requires that tax be imposed when ordinary (non.
"security") debts are converted into a more permanent investment in stock or securities
in a reorganization. See also SURREY & WARREN, FEDERAL INCOME TAxATIxO OASES AND
MAITmIALs 1571 (1962 ed.). It would seem, however, that if the purpose of the reorgani.
zation provisions is to disregard only those exchanges which substitute one form for
another form of substantially the same investment (Rog. § 1.368-1(b)), the ordinary
trade creditor or short-term lender who acquires a permanent stake in the enterprise in
the form of stock or securities is as far outside that purpose as is a stockholder or

1971] CORPORAT DEBT 559
Section 355, relating to spin-offs and similar distributions to
shareholders of stock of a corporation controlled by the distrib-
utor, requires among other things that (unless excused by good
business reasons) the distribution include all the stock and securi-
ties of the controlled corporation that the distibutor ownsn4_.
although only the distribution of the stock will ordinarily be tax-
free.11 46 A debt of the controlled corporation need not be distrib-
ated if it is not considered a security.
Since the foregoing provisions use the word "securities" in
contradistinction to stock, it is evident that securities refers not to
stock (or to purported debts that are considered stock) but to some
form of recognized debt."17 On the other hand, it is clear that not
all debts rise to the dignity of securities. 1148 The line of demarca-
tion between securities and other debts, however, is shrouded in
much the same uncertainty as the line between debt and equity.
The statute affords no guidance, except such as may be inferred
from the association of the terms "stock" and "securities." The
present regulations are of little help,1 149 and the recent statutory
mandate to establish the meaning of "indebtedness" by reguila-
tion does not extend to this refinement of the classification.1 1 0
The Supreme Court, no more willing to shed light on this question
than on the debt-equity issue, '5m1 has contributed only single con-
bondholder who receives a short-term note. Frequently, the Xcviflo rule vorks to the tax-
payer's advantage, since it is usually in distress situations, involving a loss, that ordinary
debts -would be so converted.
1345 I...C. § 355(a) (1) (D).
1146 The distribution of the securities would ordinarily be taxable as a dividend, except
to the extent of the securities of the distributor surrendered in exchange therefor; but
the price of an unexcused failure to distribute the securities is taxability of the stock
distribution itself. See notes 122-24 supra.
1147 See Camp Wolters Enterprises, Inc. v. Commr, 230 F.2d 555, 560 (5th Cir.), cert.
denied, 352 U.S. 826 (1956); Comm'r v. Neustadt's Trust, 131 P.2d. 528, 529 (2a Cir.
1942). It has been held that securities also embrace warrants to acquire stock (E.P.
Raymond, 37 B.T.A. 423 (1938)), but the Treasury view is to the contrary. Reg. §§
1.351-1(a) (1), 1.354-1(e), 1.355-1(a); cf. William H. Bateman, 40 T.C. 408 (1063).
See Comm'r v. Baan 382 F.2d 485, 492 (9th Cir. 1967), aff1d on other grounds sub
nom. Comm'r v. Gordon, 391 U.S.83 (1968).
-148 Pinellas Ice & Cold Storage Co. v. Comm 'r, 287 U.S. 462, 468 (1933).
-149 Apart from the thrice repeated declaration that stock warrants are not sczuritiea
(note 1147 supra), the regulations contain only the statement that "A short-term pur-
chase money note is not a security within the meaning of this section [L.0. § 371, re-
lating to insolvency reorganizations], and the transfer of the properties of the insolvent
corporation for cash and deferred payment obligations of the transferee evidenced by
short-term notes is a sale and not an exchange. 7 I eg. § 1.371-1(a) (5).
-~o I.R.C. § 385, addea by section 415 (a) of the Tax Reform Act of 109. Sea text at
note 1339 infra.
-51 Certiorari has been denied in at least seven cases involving the meaning of the term

clusory sentences in each of three opinions, in only one of which
11 2
was the statement necessary to the result of the case. ,
The decisions of the lower courts, like those involving the basic
debt-equity distinction,1 15 tend to be determined "on a case-by-
case basis," on the "particular facts," 14 based upon a subjectivo
"overall evaluation" of multiple factors.", Tadng their cue from
the purpose of the nonrecognition provisions in which the term
"securities." Burnham v. Comm'r, 86 F.2d 776 (7th Cir. 1936), cert. denied, 300 U.S.
683 (1937) ; Lloyd-Smith v. Comm'r, 116 F.2d 642 (2d Cir.), cert. denied, 313 U.S. 588
(1941) ; Skenandoa Rayon Corp. v. Comm'r, 122 F.2d 268 (2d Cir.), ocrt. denied, 314
U.S. 696 (1941); Neville Coke & Chemical Co. v. Comm'r, 148 F.2d 599 (3d Cir.), cort.
denied, 326 U.S. 726 (1945); Camp Wolters Enterprises, Inc. v. Comm'r, 230 r.2d 555
(5th Cir.), cert. denied, 352 U.S. 826 (1956); Harrison v. Comm'r, 235 1'.2d 587 (8th
Cir.), cert. denied, 352 U.S. 952 (1956); Turner v. Comm'r, 303 F.2d 94 (4th Cir.), cort.
denied, 371 U.S. 922 (1962). Cf. note 8 supra.
1152 In Pinellas lee & Cold Storage Co. v. Commissioner, 287 U.S. 462, 468-69 (1933),
in holding that a transfer solely for cash and short-term notes was a sale and not a
reorganization, the Court said that "These notes-mere evidence of obligation to pay
the purchase price-were not securities within the intendment of the act and woro prop-
erly regarded as the equivalent of cash." But, as later cases demonstrated, the result
would have been the same if the sole consideration wore 20 year bonds (clearly socuri-
ties) (Helvering v. Tyng, 308 U.S. 527 (1940), reversing 106 F.2d 55 (2d Cir. 1939)),
and the "brief passage in the opinion about securities now appears to have been funda-
mentally nothing more than another way of stating the continuity of interest test. I" Gris-
wold, "Securities" and "Continuity of Interest," 58 H.Av. L. Rrv. 705, 708-09 (1945).
In Helvering v. Watts, 296 U.S. 387, 389 (1935), involving an exchange for stock
(which provided the necessary continuity of interest) and mortgage bonds, the Court
found a reorganization and, without even reciting the terms of the bonds, rejected the
Commissioner's further contention that the bonds were taxable as "other property"
(boot), by saying, "The bonds, we think, were securities within the definition and can-
not be regarded as cash, as were the short term notes referred to in Pinellas .... 1
In Bazley v. Commissioner, 331 U.S. 737, 742-43 (1947), the whole burden of the decision
was that an exchange of stock for stock and debentures of the same corporation was in
substance a dividend of debentures and not a tax-free recapitalization, but the Court
injected the statement, with respect to the long-term debentures in one of the cases
before it, that "they were virtually cash because they were callable at the will of the
corporation which in this case was the will of the taxpayer," and hence, "even if this
transaction were deemed a reorganization, the facts would equally sustain the tax on the
debentures under § 112(c) (1) and (2) [now I.R.C. § 356 "--.e., that the bonds wero
"other property" than stock or securities.
.153 See text at notes 196-206 supra.
1154 See United States v. Mills, 399 F.2d 944, 948 (5th Cir. 1968). In Campbell v.
Carter Foundation Production Co., 322 F.2d 827, 834 (5th Cir. 1963), the court said
that "no purpose would be served in trying to recast the principles which are to be
distilled from our prior decisions." Cf. note 204 supra.
-155 "Though time is an important factor, the controlling consideration is an overall
evaluation of the nature of the debt, degree of participation and continuing interest, the
extent of proprietary interest compared with the similarity of the note to a cash pay-
ment, the purpose of the advances, etc." Camp Wolters Enterprises, Inc. v. Comm'r,
230 F.2d 555, 560 (5th Cir.), cert. denied, 352 U.S. 826 (1956), quoting with approval
the opinion below, 22 T.C. 737, 751 (1954).

appears,'-" the courts seek by such analysis to distinguish debts

arising from "a practical substitute for a cash sale" 11*7 from
those which, while not deemed equity for other purposes of the
tax law, nevertheless are the "substantial equivalent of equity se-
curities" ns in that they afford the creditor "some assured par-
ticipation in the business of the debtor, or, in other words, an
investment in the business." 11 It is generally considered that
such assured participation must derive from the obligation itself,
and that the fact that the holder is also a shareholder and partici-
pates in that capacity cannot make an obligation a security if it
would not be such in the hands of a stranger; 110 but one recent
3156 See Relvering v. Minnesota Tea Co, 296 U.S. 378, 38540 (1935); Beg. § 1.368-
1(b). The asserted confusion of the continuity of interest doctrine with the question
whether, when there is stock to provide the continuity, the debt which accompanic3 it is
tax-free as a "security," is criticized in Griswold, "Securities" and "Continutiy of
Interest," 58 H&v. L. REV. 705, 719 (1945), which maintains that any debt should
be deemed a security in such circumstances. The law, however, has talen a different
course.
2157 L. & E. Stirn, Inc. v. Comm'r, 107 F.2d 390, 392 (2d Cir. 1939). See Pinellas
lee & Cold Storage Co. v. Comm'r, 287 U.S. 462, 468-69 (1933).
s15s
As one court confessed, in holding notes to be securities for basis carryover pur-
poses, because the "economic ownership [remainedJ the same" and they were "the sub-
stantial equivalent of equity securities," although they were held not to be equity for
the purpose of denying the corporate interest deduction, "tax law is harily a complete
symmetry." Campbell v. Carter Foundation Production Co., 322 F.2d 827, 833 (5th
Cir. 1963). The symmetry of the Carter decision is particularly showed by the fact that
the writer of the opinion, Judge Brown, did not agree with this part of it, but noted
his personal view that the notes were neither stock nor securities. Since Judge Wisdom
considered them equity capital, it was only the "swing man," Judge Bell, who con-
sidered them recognizable debt yet enough like equity to be securitie3; and be did not
write an opinion.
1159 Baker Commodities, Inc.j 48 T.C. 374, 403 (1967), affTd on another issuo, 415
F.2a 519 (9th Cir. 1969), cert. denied, 397 'U.S. 988 (1970) (citing Wellington Fund,
Inc., 4 T.C. 185, 189 (1944)); cf. Turner Construction Co. v. United State3, 3G4 P.2d
525, 535 (2d Cir. 1966) ("meaningful continuity of ownership intere3t"). The term
"proprietary interest" is frequently loosely used for debts constituting securitie3
(Camp Wolters Enterprises, Inc. v. Comm'r, 230 F.2d 555, 560 (Sth Cir.), cert. enied,
352 U.S. 826 (1956); Neville Coke & Chemical Co. v. Comm'r, 148 F.2d 599, 602 (3d
Cir.), cert. denied, 326 U.S. 726 (1945)), despite the Supreme Court's declaration, with
respect to continuity of interest in a reorganization, that it cannot be said that the re-
cipient of bonds (securities) "retains any proprietary interest in the enterprise." I&.
Tulle v. Seofield, 308 U.S. 415, 421 (1940).
-160 Comm'r v. Sisto Financial Corp., 139 F.2d 253, 255-50 (2d Cir. 1043); accord,
Turner Construction Co. v. United States, 36 F.2d 525, 535 (2d Cr. 196); Arthur
F. Brook, 23 T.C.M 1730, 1739 (1964), rev'd on another isue, 300 F.2d 101 (2d Cir.
1966) ("Petitioner's installment obligation was not intended to give Brook a continuing
investment or stake in petitioner's business. On the contrary, the purpose of the con-
tract was to ]iquidate, as quickly as was consistent with petitioner's busine- ana inan.
cial exigencies, all of Brook's interest, other than that arising in connectiorn with hiz
stocb ownersip, in petitioner's economic well-being." (emphacis added). An obligation

Tax Court decision viewed as additional evidence, supporting its
view that debts were securities, the fact that the holders thereof
also retained a 30 per cent stock interest and "continued to actively
participate in the management of the business not only as direc-
tors, but also as key employees and officers." 0
TERM
Despite frequent judicial declarations that "The test as to
whether notes are securities is not a mechanical determination of
the time period of the note," 1612
there is no question that the length
of the term is the single most important factor in determining
whether the obligation has "an investment quality rather than the
characteristics of cash." 1103 The suggestion in one case that "the
term of the obligations is not material" to their status as securi-
ties "I" has not been followed in other cases, and reflects a mis-
application of the Supreme Court's decision in LeTulle 'v. Sco-
field,1165 from which that language was quoted. The Supreme
Court did not deny that the one to twelve year serial bonds there
involved might be securities, as the court below had determined
them to be,1106 but held that the receipt of nothing but securities,
however long their term, could not satisfy the continuity of inter-
est requirement for a reorganization.
A demand note I'l or drawing account, "Is or a note 1109 or bond
may be a security even though no stock is held by the creditor (Comm'r v. Tyng, 106 I.d
55 (2d Cir. 1939), rev'd on other grounds, 308 U.S. 527 (1940)), although the absence
of continuity of stock interest affects the related, but independent, question whothor the
exchange constitutes a reorganization (LeTulle v. Scofield, 308 U.S. 415, 420-21 (1940))
and possibly whether section 351 is satisfied (compare Seiberling Rubber Co., 8 T.C.
467, 479 (1947), rev'd on other grounds, 169 F.2d 595 (6th Cir. 1948); and BITllEn
& EuSTIcE, FEDEi.AL INcomrE TAXATION OF CORPORATIONS AND SnAREHOLDERS 68 (2d
ed. 1966); with Marsan Realty Corp., 22 T.C.M. 1513, 1523-24 (1963)).
lie' Baker Commodities, ihc., 48 T.C. 374, 404 (1967), aff'd on another issue, 415 F.2d
519 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970).
1162 Camp Wolters Enterprises, Inc. v. Comm'r, 230 F.2d 555, 560 (5th Cir.), cert.
denied, 352 U.S. 826 (1956).

1163 See George A. Nye, 50 T.C. 203, 212 (1968).
1164 Neville Coke & Chemical Co. v. Comm 'r, 148 F.2d 599, 602 (3d Cir.), cart. denied,
326 U.S. 726 (1945), holding notes payable in three to five years not to be securities.
1165 308 U.S. 415, 420 (1940).
1166 Scofield v. LeTufle, 103 F.2d 20, 22 (5th Cir. 1939).
1167 Pacific Public Service Co. v. Comm'r, 154 F.2d 713 (9th Cir. 1946); Comm'r
v. Sisto Financial Corp., 139 F.2d 253 (2d Cir. 1943); Peter Raich, 46 T.C. 604, 612
(1966).
1SHarrison v. Comm'r, 235 F.2d 587, 590 (8th Cir.), cert. denied, 352 U.S. 952
(1956).
1169 Pinellas Ice & Cold Storage Co. v. Comm'r, 287 U.S. 462, 468-60 (1933) (45 to

issue 1170 payable in full -within five years, would almost ipso facto
not be considered securities, 1 1 71 except in circumstances where the
stated maturity is unreal because payment is dependent upon the
success of a risky enterprise 1172 or because the parties contem-
plate indefinite extension of the note 117: or its replacement with
stock 74
On the other hand, a bond 1-7 or note 117 maturing in ten years
or more is almost certainly of sufficient dignity to constitute a se-
curity; and, while some caution is indicated in the intermediate
area,1 7. none with terms of more than five years have yet been
105 day secured purchase money notes); Turner v. Comm'r, 303 F.2d 04 (4th Cir.),
cert. denied, 371 U.S. 922 (1962) (13 months); Neville Coke & Chemical Co. v. Comm'r
148 F.2d 599 (3d Cir.), cert. denied, 326 U.S. 726 (1945) (three to five years); Lloyd-
Smith v. Comm'r, 116 F.2d 642 (2d Cir.), cert denied, 313 U.S. 588 (1941) (two years) ;
"Rev. Rul. 56-303, 1956-2 C.B. 193 (one to four years, average term two and one half
years) (withdrawn by Rev. Rul. 63-28, 1963-1 C.B. 76, pursubnt to policy not to isue
advance rulings on whether obligations constitute securitics).
1170L. & E. Stin, Inc. v. Comm'r, 107 F.2d 390 (2d Cir. 1939) (one to flo year
serial bonds, actually retired in ten months).
1171 But see Campbell v. Carter Foundation Production Co., 322 P.2a 827, 832-35 (5th
Cir. 1963) (five year installment notes held securities), discussed in text at note 1238
infra., for the exception that proves the rule.
112 Aqualane Shores, Inc. v. Comm'r, 269 F.2d 110 (5th Cir. 1959) (purchase money
obligation payable in five annual installments, by corporation planning to reclaim and
subdivide swampland). The ease could as well have been rested, as it was in the Tax
Court, 30 T.C. 519 (1958), on the ground that the purported debt Yas equity capital,
very much at the risk of the business. But the Fifth Circuit, using the camo remoning,
reached the same tax result by concluding that it was a security.
1173 United. States v. Mills, 399 F.2d 944 (5th Cir. 1908) (one year note found by
jury to be a seerity, based on testimony that real intention was "that the principal
never be paid."; status as a debt was not in issue). But of. Turner v. Comm'r, 303 P.2m
91 (4th Cir.), cert. dened, 371 U.S. 922 (1962) (later substitution of long-term bond for
short-term mote was not planned at time of transaction).
174 Turner Construction Co. v. United States, 364 F.2d 525, 536 (2a Cir. 1066), on
remand sub nom. Prentis v. United States, 273 F. Supp. 460, 476 (SMD.N.Y. 1967).
=17s Comm'r v. Neustadt's Trust, 131 F.2d 528, 529 (2d Cir. 1942) (ten year do-
bentures); Comrnm'r v. Tyng, 106 F.2d 55 (2d Cir. 1939), rcv'd on other grounds, 308
U.S. 527 (1940) (20 to 40 year debentures); Comm'r v. Kolb, 100 P.2d. 920, 925 (9th
Cir. 1938) (ten year debentures); I. Grady fanning Trust 15 T.C. 930, 943 (1950) (20
year debentures).
1176Parkland Place Co. v. United States, 354 F.2d 916 (5th Cir. 1906), af7rm~ng
248 F. Supp. 974 (N.D. Tex. 1964) (ten years); Burnham v. Comm'r, 80 F.2& 776
(7th Cir. 1936). cert. denied, 300 U.S. 683 (1937) (ten years); George A. Nye, 50
T.C. 203, 212 (1968) (ten year installments).
U77 "Notes with a five year term or less seem to be unable to qualify as "securitite,'
while a term of ten years or more is apparently sufficient to bring them ithin the
,
statute. BTTmR . & EUSTICE, FEDERAL INC0ZIE TA AIOzz OF Cor'olA.Tn s AD
SHAR-oLDERS 73 (2d ed. 1966).

denied such status.11 8
Serial bonds '171 and installment notes 1180
calling for payments both before and after the five year dividing
line have also been held to be securities, although it may be that
the average life, rather than the date of the final payment, is the
81
significant fact.1
The character of long-term obligations as securities is not af-
fected by the fact that they may be callable at an early date, since
such provisions are commonly found in securities and since the
option to redeem them does not rest with the holder. 182 Even
actual prepayment within a short period does not necessarily alter
their status, since they must be "examine[d] ... as of the date
of issuance." "1s Where long-term callable bonds are closely held
by the same persons who control the issuing corporation, how-
ever, the Supreme Court has said that they are not securities but
are "virtually cash because they were callable at the Will of the
corporation which in this case was the will of the [shareholder-
creditor]." 1184 It has been suggested that the logic of that state-
1178Five year secured notes were held securities (being "obviously far from tho
equivalent of cash") in Pan American Trust Co., 4 T.C.M. 555, 556 (1945), and install.
ment notes payable between five and nine years after issuanco were so treated in Camp
Wolters Enterprises, Inc. v. Commissioner, 230 F.2d 555 (5th Cir.), cert. denied, 352
U.S. 826 (1956), although in the latter case the term was said to be only ono of tho
factors given weight. Cf. Comm'r v. Freund, 98 F.2d 201 (3d Cir. 1938) (six year serial
bonds); Rev. RuL 59-98, 1959-1 C.B. 76 (stressing six and one half year average torm
of serial bonds).
-179 Scofield v. LeTulle, 103 F.2d 20, 22 (5th Cir. 1939), aff'd on other grounds, 308
U.S. 415 (1940) (one to 12 years); Comm'r v. Freund, 98 P.2d 201 (3d ir. 1938) (one
to six years with 58.3 per cent of principal due in final year) ; Rev. Rul. 59-98, 1959-1
C.B. 76 (three to ten years).
1180 United States v. Hertwig, 398 F.2d 452 (5th Cir. 1968) (121/ years); Georgo A.
Nye, 50 T.C. 203, 213 (1968) (ten years); Baker Commodities, Inc., 48 T.O. 374, 403
(1967), aff'd on another issue, 415 F.2d 519 (9th Cir. 1969), cert. denied, 397 U.S. 988
(1970) (15 years).
1181 Cf. Rev. Rul. 59-98, 1959-1 C.B. 76 (six and one half year average term, hold a
security); L. & E. Stirn, Inc. v. Comm'r, 107 F.2d 390, 392 (2d Cir. 1939); Rov. Eul.
56-303, 1956-2 C.B. 193 (withdrawn by Rev. Rul. 63-28, 1963-1 C.B. 76) (two and ono
half year average term, held not a security). Although the average term was specifically
referred to, the result in each instance would apparently have been the same if tho dato
of final payment were the standard applied.
1182 Wolf Envelope Co., 17 T.C. 471, 480 (1951); Pan American Trust Co., 4 T.O.M.
555 (1945).
1183 Camp Wolters Enterprises, Inc. v. Comm'r, 230 F.2d 555, 560 (5th Cir.), cert.
denied, 352 U.S. 826 (1956). But of. George D. Graham, 37 B.T.A. 623, 629 (1938).
Prepayment occurring within ten months was referred to in holding bonds not to be
securities in L. & E. Stirn, Inc. v. Commissioner, 107 P.2d 390, 392 (2d Cir. 1930), but
only as a makeweight since the bonds were short-term in any event. See also Peter Ealeh,
46 T.C. 604, 612 (1966), stressing the fact that demand notes were in fact paid off in
a few years, as evidence inconsistent with a proprietary interest.
1184 This was the alternative ground for decision in one of the two cases considorod

1971] CORPORATE DEB3T
ment might apply equally where the bonds were not callable, since
the bondholders, as controlling shareholders, may decide to pre-
pay at any time;" 8 5 but the Court did not go so far, 1 80 and the
tendency of subsequent lower court decisions has been to broaden
rather than narrow the treatment of closely held obligations as
securities-' 7 It would seem that, whether the obligations are
callable or not, the fact of control of the payer by the payees should
be significant only in conjunction with evidence not only of the
intention but also of the capacity to liquidate the obligation in a
short time rather than to tie up the investment "indefinitely and
inextricably with the success of the venture." "8
FoRm
Although some early decisions were interpreted as drawing a
line between bonds and notes, 1 8 9 it now seems firmly established
in Bazley v. Commissioner, 331 U.S. 737, 742 (1947). See note 1.52 supra. Vhilo
unnecessary to disposition of the case, the Court's statement casts doubt on Mary .
Crofoot, 4 T.C.X. 97, 100 (1945), which had held early calability not to affect the
security status of 20 year notes issued to shareholders of a family corporation. Later,
in Camp Wolters Enterprises, Inc. v. Commissioner, 230 F.2d 555 (5th Cir.), cert.
denied, 352 U.S. 826 (1956), the Baz7y statement was not referred to although the
notes were held proportionately by the shareholders; but there were 89 of them, no
one of whom presumably could cause his note to be prepaid, and the time of payment
was, as the court stressed, dependent upon the success of the venture.
118s5See Eisenstein, Boob .eview, 20 TAx L. REV. 215, 230 (196); Emery, Taxing
Distributons Pursuant to Corporate Beorganizations, 50 MI.ft L. uREV. 549, 556-57
(1952). In holding bonds with an average term of six and one half years to be securitie3,
in tev. RuL 59-98, 1959-1 C.B. 76, the Service appeared to attach some significance to
the fact that they were held by nonshareholders.
-saThe Court's "virtually cash" statement, and the conclusion therefrom that the
bonds were not securities but boot under the predecessor of section 356, occur only in
the discussion of the ase (BaZey) involving callable bonds. The companion casa
(Adams), involving closely held 20 year noncallable bonds, was said to be governed by
the treatment of the Bazey case, but the Court then referred to the ordinary dividend
provision on which it had primarily relied in Barley, and did not repeat its reference to
the boot provision.
87 See the cases cited at notes 1171-74 and 1180 supra.
1s8 Camp Wolters Enterprises, Inc. v. Comm'r, 230 F.2d 555, 560 (sth Cir.), cert.
denied, 352 U.S. 826 (1956). Such elements were ignored by the Supreme Court in its
statement in Bazey, which involved a hazardoaus road construction businem3 with its
surplus tied up in plant and equipment (see 4 T.C. 897, 898, 904-05 (1945)).
i1s9 Rapp, Thirty Years of Section 112(b)(5); Can Any Conclusion Be Drawn?, 10
N.Y.U. INsT. 1181, 1181 (1952); Griswold, "Sccurities" and "Continuity of 1hitrcst,"
58 BHAv L. E v. 705, 717-18 (1945). Actually, although the short-term instruments held
not to be securities in Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U.S. 462
(1933), and other cases (note 1169 supra), happened to be in the form of notes, that
was not what made them the equivalent of eash. But when the court in Neville Co1ze &
Chemical Co. v. Commisi oner, 148 F.2d 599, 602 (3d Cir.), cert. denied, 326 U.S. 726
(1945), declared that "the term of the obligations is not material," and failed to state

that it is immaterial for this purpose whether an instrument is
labeled a bond, debenture, note, scrip or otherwise. A long-term
promissory note,1190 or scrip issued for back dividends,'"' may
be a security, and a short-term bond may not, 11112although con-
ceivably the label may be given some weight in marginal cases.l03
Formalism has been given controlling weight in another respect,
however, in four decisions of the Tax Court, none of them reviewed
by the full court. A distinction is drawn between, on the one
hand, a transfer of property to a controlled corporation in ex-
change for long-term obligations constituting securities, in that
they "clearly secured to the noteholder ... the continuing par-
ticipation in the business which is so characteristic of a security
interest"; 1194 and, on the other hand, a bona fide sale of property
to a controlled corporation in return for equally long-term obli-
gations, with the intent, not "to insure the [transferor] a continued
participation in the business of the transferee corporation [other
than that arising in connection with his stock ownership], but
* * * rather to effect a termination of such a continuing inter-
est.' "15 Yet, assuming in each case that the requisite 80 per
cent stock control exists immediately after the transaction, there
what other characteristic made the three to five year notes not securities, it was in-
ferred that notes could not qualify, whatever their term. Professor Griswold also ro-
ferred to Wesley V.E. Terhune, 40 B.T.A. 750, 756-57 (1939), as authority for tho
"current doctrine that notes are not 'securities' "; but Terhune rested on the failuro
of the taxpayer to put in any evidence concerning the terms of the note. In Weiss, Notes
as Securities Within Section 112(b)(3), 26 TAxEs 228, 230 (1948), it was concluded
that "such a distinction [between bonds and notes] does not appear to be rooted in the
decisions. "
1190 See notes 1176 and 1178 supra. Even shorter term notes may be deomed securltes
in appropriate circumstances. See note 1238 infra.
1191 Globe-News Publishing Co., 3 T.C. 1199 (1944) (25 year term); of. Skonandoa
Rayon Co. v. Commissioner, 122 F.2d 268j 270 (2d Cir.), cert. denied, 314 1.S. 690
(1941), declaring that the right to arrears of undeclared preferred dividends may itself
be a security, if viewed separately from the stock.
1192,. & E. Stirn Co. v. Comm'r, 107 F.2d 390 (2d Cir. 1939) (one to five year
serial debenture bonds); Worcester Salt Co. v. Comm'r, 75 F.2d 251 (2d Cir. 1935)
(five year term, a fact not disclosed in the opinion, but stated in Birn, supra, at 892).
1193 In Heivering v. Watts, 296 U.S. 387, 389 (1935), mortgage bonds wore hold securi-
ties without even mentioning when they matured, which was serially from two months
to eight years, as disclosed in 28 B.T.A. 1056 (1933). See also Comm'r v. Freund, 98
F.2d 201 (3d Cir. 1938) (one to six year serial bonds).
1194Baker Commodities, Inc., 48 T.C. 374, 403 (1967), aff'd on another issue, 415
F.2d 519 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970).
195 Warren U. Brown, 27 T.C. 27, 36 (1956). The necessary qualification, inserted
in the second brackets in the quotation, is found in Arthur F. Brook, 23 T.C.M. 1730,
1739 (1964), rev'd on another iss-ue, 360 F.2d 1011 (2d Cir. 1966). See note 1160 supra.

is no substantive difference between an I exchange' " for a long-term

obligation and a "sale" for such an obligation. Each continues the
participation of the transferor during the payout period and termi-
nates such participation (apart from stock ownership) when the
payout period ends, and the participation is no more and no less
in one case than in the other.
In two of those Tax Court cases, the obligation to make long-
term installment payments was reflected, not in formal notes, but
only in the contract of sale, and the Tax Court was unable to con-
clude that a mere "installment sales contract reserving title in the
seller" had the quality of a security.1 00 Significantly, however,
the Fifth Circuit has found no conceptual impediment to designat-
ing an installment sale contract a security, despite the absence of
1 19 7
notes.
In the other two Tax Court cases,1 e8 the obligation to pay for
the property was reflected in long-term installment notes, and the
judges were confronted with the fact that a unanimous Tax Court
(affirmed by the court of appeals and with certiorari denied by
the Supreme Court) had previously held that such instruments
are, or in appropriate circumstances may be, securities.1' In
these two cases, however, it was deemed unnecessary even to con-
sider the argument that the installment notes were securities, 1- 0
because section 351 (or its predecessor), which would make the
transaction nontaxable with consequent carryover of the trans-
"'go Warren H. Brown, note 1195 supra (ten year term); Arthur P. Brook, note 1195
supra (15 year term). Step-up in basis to reflect payments to be made to ahareloldenr
under installment sale contracts was also allowed in Sun Properties, Inc. v. Commissioner,
220 F.2d 171 (5th Cir. 1955); and in 3.L Morgan, Inc., 30 T.C. 881 (19,58), rev'd on
another issue, 272 F.2d 936 (9th Cir. 1959); but both cases focused on the question
whether the purported debts were in fact equity capital, and the intermediate pesa1.
bility that they might be securities was evidently forgotten (note 11-7 supra) by both
government counsel and the courts.
1197 Aqualane Shores, Inc. v. Commr, 269 F.2d 116, 119 (5th Cir. 1959), affirmfng 30
T.C. 519 (1958). The Tax Court had held the purported debt to be equity capital, but
the Fifth Circuit, using the same reasoning, arrived at the conclusion tnt the contract
was a security, with the same effect on basis.
1gs Charles E. Curry, 43 T.C. 667, 696-97 (1965); Harry F. Shannon, 29 T.C. 702,
717-19 (1958). In Arthur M. Rosenthal, 24 T.C.M. 1373 (1905), the Tax Court also
found a sale for installment notes to have been intended, but the Commissioner had
rested his ease entirely on the contention that the notes were equity interests, and the
possibility that they were securities (which would have disposed of the basis issue but
not of the interest deduction) was apparently forgotten.
-99 Camp Wolters Enterprises, Inc., 22 T.C. 737 (1954), aff'd, 230 F.2d 555 (Gth
Cir.), cert. denied, 352 U.S. 826 (1956) (five to nine year installments).
1200 Charles . Curry, 43 T.C. 667, 697 (1965); Harry F. Shannon, 29 T.C. 702,
719 (1958).

feror's low asset basis, was held applicable only to an "exchange"
for stock or securities, not to a "bona fide sale," even to a controlled
corporation, for long-term notes whether or not they were securi-
20 1
ties.
In the earlier of the cases, Harry F. Shannon, the court sup-
ported its distinction without a difference on three untenable
grounds: 1202 (1) the parties had used language of sale (al-
though it is hornbook law that "the fact that they referred to it as
a sale would [not] change its nature and effect, nor operate to
exclude it from the meaning of the statute if it would otherwise
fall therein") ; 1203 (2) the transferors had reserved a vendor's
lien (although the retention of a security interest is not incon-
sistent with an "exchange" for securities); 124 and (3) the
presence of a down payment was more typical of a sale than of an
exchange (although the law contemplates that cash may pass in an
otherwise tax-free exchange) 1205
In the second case, Charles E. Curry, the court first found that
the parties "intended to consummate a bona fide sale" in response
to the Commissioner's contention that the purported purchase.
money debt was really equity capital, '( and it merely referred
1203 Taxability of the transfer was involved in Shannon and basis step-up in CurrVy,
so the Commissioner found himself taking opposite sides in the two cases and must,
therefore, share the blame for the result. The Commissioner improvidently noted his
acquiescence in Curry, 1965-2 C.B. 4, but soon reversed himself, 1968-2 C.B. 3.
1202 29 T.C. 702, 717-18 (1958).
1208RawCo, Inc., 37 B.T.A. 128, 141 (1938); accord, Davant v. Comm1r, 306 F.2d
874, 882 (5th Cir. 1966), cert. denied, 386 U.S. 1022 (1967); J.M. Turner & Co. v.
Comm'r, 247 F.2d 370, 376 (4th Cir. 1957); Pebble Springs Distilling Co. v. Comm'r,
231 F.2d 288 (7th Cir.), cert. denied, 352 U.S. 836 (1956); Liddon v. Comm'r, 230 F.2d
304 (6th Cir.), cert. denied, 352 U.S. 824 (1956). In Richard M. Mills, 39 T.C. 393, 403
(1963), three concurring judges, including the author of Shannon, relied upon tho fact
that a stock for stock agreement (with minimal boot) was cast in terms of purchase and
sale, as evidence that a tax-free reorganization under section 368 (a) (1) (B) had not
occurred. The Commissioner wisely disclaimed reliance on that ground in the appellate
court. Mills v. Comm'r, 331 F.2d 321, 323 (5th Cir. 1964).
1204 See text at notes 1224-25 infra. In Campbell v. Carter Foundation Production Co.,
322 F.2d 827, 832-34 (5th Cir. 1963), the predecessor of section 351 was hold appli.
cable to a transfer of property in return for installment notes secured by a vendor's
lien.
1205 I.R.C. § 351(b), then I.R.C. § 112(c) (1) (1939). The down payment was only 2
per cent of the stated price, and came from cash recently paid in by the same people
for stock, but the court deemed this a sufficient distinction from R.M. Gunn, 25 T.C. 424
(1955), aff'd, 244 F.2d 408 (10th Cir.), cert. denied, 355 U.S. 830 (1957), which had
applied the predecessor of section 351 to a purported installment sale in which there
was no payment at all until three months after the "sale" (a fact which was said to make
that transaction "more typically an exchange of assets for notes").
120843 T.C. 667, 686-89 (1965).

1971] CORPORAT'IE DEBT
back to that flnding in dismissing the alternative position that in

any event, the notes -were securities issued in a section 351 ex-
change, 207 although tie reasons in support of the former finding
are of questionable relevance, at best, to the latter issue. The
identifiable grounds of decision are (1): "in form the instru-
ments are clearly debt," reciting "that they represent a portion
of the balance due on the purchase price," and "secured by deeds
of trust" (although form is not controlling and secured debts may
be securities) ;1208 (2) the relative holdings of stock and notes
effected a substantial reshuffling of the beneficial interests in the
property (although, whatever relevance such disproportion within
the family might have on the debt-equity issue, ° Congress in 1954
had, as the Tax Court itself has recognized in other cases,' 10 elimi-
nated proportionality as a factor for consideration in connection
-with section 351); 11 and (3) the transaction was "inspired
by [rejected] proposals from an unrelated party to consummate
a bona fide sale" and" [ilt -was natural for the parties, having been
introduced to the benefits associated with a bona fide sale, to con-
tinue to plan within that framework" (although -what that has to
do with -whether the actual transaction, not with an unrelated party
but with a controlled corporation, -was a sale or a section 351 ex-
change is difficult to see)."'
The Tax Court, however, although still without review by the
full court, seems now to be coming back to the view, adopted also
by the Fifth Circuit( the ancestral home of the notion that the in-
1207 Id. at 696-97.
:2os See notes 1203 and 1204 supra.
121oBurr Oaks Corp., 43 T.C. 635, 650 (1965), aff'd, 365 F.2d 24 (7th Cir. 1966), cert.
denied, 385 U.S. 1007 (1967) ; Marsan Realty Corp., 22 T.C.M. 1513, 1524 (1963). The
Curry case was followed on this point, however, in Stevens Pass, Inc., 48 T.O. 532
(1967). See note 117 supra.
21Compare I.R.C. § 351(a), with I.TC. § 112(b) (5) (1939). See S. RP. No. 1622,
83d Cong., 2d Sess. 264 (1954); Stanley, Inc. v. Schuster, 295 F. Supp. 812, 816-17
(S.D. Ohio 1969), aff'd, 421 P.2d 1360 (6th Cir.), cert. d8nicd, 400 U.S. 822 (1970).
Even if section 351 might be inapplicable to the transfer of half the property by two
individuals who received only notes and held no stock (sec note 1100 supra), section 3G1
should still apply to the transfer of the other hlf of the property (plus cash) by two
persons -who received notes and 55 per cent of the stock, since another person concur-
rently transferred cash for 45 per cent of the stock, and collectively those three trans-
ferors had 100 per cent stock control Burr Oaks Corp. 43 T.C. 635 (1905), aff'd, 305
F.2d 24 (7th Cir. 1966), cert. denied, 385 'U.S. 1007 (19G7).
121 One is reminded of Woolley Equipment Co. v. United States, 26S P. Supp. 358
(B.D. Tex. 1966), note 1078 supra, finding that a sale vas intended becauso only by thus
stepping up the basis could the taxpayer achieve the tax-free cash flov that would make
its sto&k attractive to investors. In that easwe, as in many others, the securities issue Ts
forgotten and only debt-equity was argued or considered.

tention to make a sale is all-important), 1 that the application of
section 351 is not optional with the taxpayer or dependent upon
his intention to make or avoid making a sale to his controlled cor-
poration. 4 If the control requirement is met, and if the resultant
obligations qualify as securities, no form of words or other evi-
dence of intention can, or should, make a taxable sale of what
is essentially a continuation of the transferor's
121
investment in a
new permanent or " semi-permanent" form. ,
1 21 6
SECURITY AND INSECURITY
The fact that a debt is unsecured does not, in itself, prevent its
being a security, 1217 for unsecured creditors "are more substan-
tially subjected to the risk of the business than mortgage bond-
holders" 1218 and such debts, therefore, are more akin to stock,
with which the term "securities" is linked in the statute.12 19 Such
risk factors as subordination,1 2 0 thin capitalization, 1-"1 and ex-
121s See Sun Properties, Inc. v. United States, 220 F.2d 171 (5th Cir. 1955), in which,
however, the securities question was not argued (note 1196 supra).
1214 United States v. Hertwig, 398 F.2d 452, 455 (5th Cir. 1968); George A. Nye, 50
T.C. 203, 209, 211 (1968).
1216 Section 351 or its predecessor has been held applicable to securities (installment
notes) received for property purportedly sold to controlled corporations in the cases
cited in notes 1194, 1199, 1204 and 1214 supra. The Fifth Circuit has reached the same
conclusion with respect to a purported installment sale contract, even where there wore
no notes. See note 1197 upra. In extreme cases, of course, purported debts arising from
transfers intended as sales of assets may be deemed not securities but equity, with Sim-
ilar effects on basis but with the additional consequences of nonrecognition of debt hero-
tofore considered. E.g., Stanley, Inc. v. Schuster, 295 F. Supp. 812 (S.D. Ohio 1969),
ajf'd, 421 P.2d 1360 (6th Cir.), cert. denied, 400 U.S. 822 (1970); Burr Oaks Corp. v.
Comm'r, 365 F.2d 24 (7th Cir. 1966), cert. denied, 385 U.S. 1007 (1967); Truck Tor.
minals, Inc. v. Comm'r, 314 F.2d 449 (9th Cir. 1963).
1216 The poverty of our vocabulary is evident in framing the question "Must there be
security for a security I 1"
1217 Camp Wolters Enterprises, Inc. v. Comm'r, 230 F.2d 555 (5th Cir.), cert. don16d,
352 U.S. 826 (1956) (see facts in 22 T.C. 737, 743 (1954)); Comm'r v. Noustadt's
Trust, 131 F.2d 528, 529 (2d Cir. 1942) ("Conceivably the word might be construed to
include mortgage bonds but to exclude debentures. But it is usual financial practice to
speak of debentures as 'securities' and the term should be given its ordinary moan.
kng."); Burnham v. Comm'r, 86 F.2d 776 (7th Cir. 1936) (see facts in 33 B.T.A. 147
(1935); George A. Nye, 50 T.C. 203 (1968).
1218 Comm'r v. Tyng, 106 F.2d 55, 59 (2d Cir. 1939), rev'd on other grounds, 308 U.S.
527 (1940).
1219 Cf. Xamison v. United States, 297 F. Supp. 221, 230 (N.D. Cal. 1968), on appeal
to the Ninth Circuit.
1220 Camp Wolters Enterprises, Inc. v. Comm'r, 230 F.2d 555, 560 (5th Cir.), cort.
denied, 352 U.S. 826 (1956) (complete subordination to bank loan might preclude pay.
ment of notes at maturity, and thus subject them to a substantial risk of the enter-
prise) I Estate of William Bernstein, 22 T.C. 1364, 1369-70 (1954).
1221 United States v. Hertwig, 398 F.2d 452, 455 (5th Cir. 1968) (300 to 1 ratio of

posure to the risks of an undeveloped business,'' 2 when not suffi-

cient to cause nonrecognition of debts, may nevertheless be factors
contributing to their being viewed as securities. Even nominally
short-term debts may be so viewed if the risks of the business make
timely payment "dependent upon and at the risk of the venture,"
so that the creditors "participat[e] in the pot luck of the enter-
prise." 1223
On the other hand, the fact that an obligation is secured, by
mortgage or otherwise, is not generally a factor adverse to its be-
ing considered a security, and may even have affirmative weight
in a borderline case, on the theory that the right to acquire the
property on default is "a definite and material interest in the af-
fairs" of the debtor .2 -4 At least one case, however, implies that
the retention of title until payment actually negatives the requi-
site continuing interest, apparently because it makes the ultimate
cash payment, and consequent termination of the transferor's in-
terest, more certain. 22 5
Other protective devices frequently demanded by creditors, such
as a formal indenture imposing duties and restrictions on the
debt to equity "preelnde[s] any finding but that . . .holders of the notes had a con-
tinuing proprietary interest in the success of the venture"; helisezuritie3); Gcorge
A. Nye, 50 T.C. 203, 213-14 (1968).
1222 Aqualane Shores, Inc. v. Comm'r, 269 F.2d 116, 119 (5th Cir. 1959) (obligations
of undercapitalized subdivider of swampland could be paid only if and vhen &110 .cre
made); of. Scofield v. LeTulle, 103 F.2d 20, 22 (5th Cir. 1939), aff'cd on other groumds,
308 U.S. 415 (1940) (debtor had no independent financial strength and sellers would be
paid only if the business prospered; otherwise they would probably only get the prop-
erty back).
=23 Aqualane Shores, Inc. v. Comm'r, 269 F.2d 116 (5th Cir. 1959) (one to five year
installment contract).
l 2 4Comm'r v. Freund, 98 F.2d 201, 206-07 (3d Cir. 1938) (one to six year cerial
bonds, with right in mortgage trustee "to enter and take po-session . . . in case of
default"). In Helvering v. Watts, 296 U.S. 387 (1935), the only relevant fact recited by
the Court concerning the bonds which were held to be sceurities was that they wero
mortgage bonds. The Court apparently did not, in the circumstances, consider the fact
(set out only in 28 B.T.A. 1056, 1059 (1933)) that they were serial bonds with a rela-
tively sort average term (maturing in two months to eight years) to be material to the
question. The fact that serial bonds were secured by mortgage was stressea equnlly with
their six and one half year average term, in holding them securities in Rev. RUl. 59-98,
1959-1 C.B.76.
1225 Warren H. Brown, 27 T.C. 27, 36 (1956), discussed in text at note3 1104-9 supra;
cf. Harry F. Shannon, 29 T.C. 702, 718 (1958), discussed in text at notes 1198-1205 spra,
which did not reach the securities question, but similarly viewed the retention of a
vendor's lien as more consistent with a sale than with an exchange for installment notes
(whether or not they constituted securities). But of. Campbell v. Carter Foundation
Production Co., 322 F.2d 827, 832-34 (5th Cir. 1963), holding a purportedi installment
sale for one to five year notes secured by a vendor's lien to be a tax-free exchange for
securities.

TAX LAW REVIEW (Vol. 26:
debtor with respect to maintenance and insurance of its property,
merger or sale of assets, incurring of debt, payment of dividends
and compensation, and the like, have been viewed as affording
the "continuing interest" and "participation in [the debtor's]
affairs" requisite to treatment of the obligations as securities. 220
Despite the fact that such provisions enhance the probability of
timely payment and termination of the creditor's interest, one
early case viewed such an indenture as a factor outweighing the
short term of the obligation; 1227 and a recent Tax Court opinion
viewed such provisions as even more important to the decision
than the fact that the obligations were payable over a 15 year pe-
228
riod.1
CONVERTIBILJTY
A short-term obligation is not deemed a security merely because

it is convertible into stock, if the choice of acquiring an equity
22 But if
interest or quickly getting out rests with the holder.
the obligation otherwise qualifies as a security, it should not be
rendered less so by the fact that it is convertible, since either of
the alternative rights0 embodied in the instrument would constitute
12
stock or securities.
If the substitution of stock for a short-term note is part of the
original plan,1 231 or if the choice to satisfy the note by delivering
stock rests with the corporation, 232 the obligation should be viewed
as a security, if not as stock.
CORCT MSTANCES OF ISSUANCE

The Fifth Circuit, where most of the more recent cases on the
meaning of "securities" have arisen, has developed a test of its
12Baker Commodities, Inc., 48 T.C. 374, 403-04 (1967), aff'd on another issue,
415 F.2d 519 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970); IKarl B. Segall, 38
B.T.A. 43, 50-51 (1938), rev'd on other grounds, 114 l.2d 706 (6th Cir. 1940), cart.
denied, 313 U.S. 562 (1941).
1227 Karl B. Segall, supra note 1226 (one to five year serial debentures).
1228 Baker Commodities, Inc., supra note 1226 (installment notes).
129 Neville Coke & Chemical Co. v. Comm'r, 148 l.2d 599, 603 (3d Cir.), crt. denid,
326 U.S. 726 (1945).

1280 Where it is necessary to distinguish stock from securities, as under sections
354(a) (2) and 355(a)(3), it seems that the obligation should be deemed a security,
since-at least under existing authorities-it is viewed as debt until converted. So text
12s3 Turner Construction Co. v. United States, 364 F.2d 525, 536 (2d Cir. 1960), on
remand sub nom. Prentis v. United States, 273 F. Supp. 460, 476 (S.D.N.Y. 1967) (hold
to be securities).
1232 Lanova Corp., 17 T.C. 1178, 1183 (1952) (held to be stock).

own, 3
2
3 which
has recently won some support in the Tax Court.
If the obligations "did not evidence an isolated transaction of pur-
chase and sale, having its inception after the forming and launch-
ing of the corporation, but were an integral part of the scheme of
its forming and financing," the obligations and stock are viewed
as being "together different forms of the assured participation
in the pot luck of the enterprise." 135 That test sounds strangely
like the core assets concept which some courts have applied, not
to subdivide the debt category, but to determine whether debt has
been created at all. 123O But the core asset concept is not an abso-
lute. Purported debts to shareholders, arising in the "forming and
launching of the corporation," in connection with the acquisition
of its essential assets, are often recognized, as we have seen, when
the equity capital is deemed adequate, the earnings prospects are
good, the holdings of stock and obligations are disproportionate,
or the mood of the court is favorable. The Fifth Circuit's test,
operating on initial debts to shareholders even though those debts
are recognized as bona fide in every respect, would, if broadly and
consistently applied, remove one of the principal advantages some-
times sought by capitalizing with debt, namely, a fresh start on
the basis for depreciation of property or for computing ordinary
profits on its sale by the corporation (so far as patchwork legisla-
tive "tax reforms" have not otherwise made such devices un-
profitable).2r
Although most of the cases applying this test might have been
decided the same way if attention were focused instead on the
length of the term, the test has been applied in one case, by a
divided court, even to a relatively short-term obligation, payable
in monthly installments over a five year period, thus serving warn-
ing that, in this court at least, a basis step-up cannot be achieved
merely by setting the term on the safe side of the conventional
five year dividing line. 238
1233Unitea States v. Hertwig, 398 F.2d 452, 455 (5th Cir. 1908); Camp Wolters
Enterprises, Inc. v. Comnm'r, 230 F.2d 555, 559-60 (5th Cir.), cert. denicd, 352 U.S. 826
(1956).
1234 George A. Nye, 50 T.C. 203, 213 (1968). As the opinion was not reviowe& by the
full court, and there were other grounds for the result reached, it remains to be seen
how broadly the Tax Court will apply the Fifth Circuit's langunge.
1235 Camp Wolters Enterprises, Inc. v. Conm'r, 230 F.2 u55p, 559, 56o (5th Cir.),
cert. denied, 352 U.S. 826 (1956).
138 Campbell v. Carter Foundation Production Co, 322 F.2d 827 (5th Cir. 1963). The
court had earlier held equally short-term debt to be securities in Aqualane Shores, Inc.

TAX LAW ==VIW [Vol. 26.
Logically, the concept that a transfer to a controlled corporation

for a note leaves the shareholders' economic ownership and par-
ticipation in the "pot luck of the enterprise" unchanged would
apply equally to significant transfers of additional property sub-
sequent to the inception of the business. The Fifth Circuit's state-
ment of the concept, however, has distinguished and, by dictum,
excluded debts arising from "an isolated transaction of purchase
and sale, having its inception after the forming and launching of
the corporation." 1239 Lest it be assumed that purported sales by
shareholders to existing corporations are thus given carte blanche,
it should be noted that the same court has applied section 351 to
deny a step-up in basis on a transfer of additional land to an exist-
ing controlled corporation in return for a ten year note, which was
found to be a security, apparently by applying conventional
standards.24 0 To date, however, there has been no indication that
the Fifth Circuit's special concept, which may apply even to short-
term notes, will be applied to debts arising in such postincorpora-
tion transactions.
The Regulations-To-Be
THE MANDATE
The epidemic of corporate takeovers by conglomerates during

the late 1960's,12 4' frequently involving the tender of large amounts
of esoteric forms of purported debt in exchange for stock and en-
abling the acquiring corporation, trading on the interest deduction,
12 2
to offer a higher return to the investors at less cost to itself,
finally focused the attention of Congress upon the need for defini-
tions by which bona fide debt might be distinguished from equity
v. Commissioner, 269 F.2d 116 (5th Cir. 1959), but on the ground that payment at
maturity was dependent upon the success of a speculative business. In the Carter Founda-
tion case, however, the corporation was found to have been adequately capitalized and
capable of meeting the obligation at maturity.
1239 Camp Wolters Enterprises, Inc. v. Comm'r, 230 F.2d 555, 559 (5th Cir.), cort.
denied, 352 U.S. 826 (1956).
1240 Parkland Place Co. v. United States, 354 F.2d 916 (5th Cir. 1966), affirming 248
F. Supp. 974 (N.D. Tex. 1964); accord, Ernest W. Brown, Inc. v. Commir, 258 P .2d
829 (2d Cir. 1958), affirming 28 T.C. 682, 685 (1957). Even though no now stock Is
issued in connection with such an exchange for securities, section 351 applies where the
requisite 80 per cent stock control exists before and continues after the transfer. Of.
Commissioner v. Huntzinger, 137 F.2d 128, 129 (10th Cir. 1943).
1241 See Hearings on the Subject of Tax Beform Before the House Committee on
Ways and Means, 91st Cong., 1st Sess. 2363-2550 (1969) (hereinafter cited as 1969 House
Hearings).

19711 CORPORAT DEBT 575
capital. Perhaps motivated more by the desire to attack a nontax
problem with the blunt instrument of the tax laws than by a pur-
pose to protect the revenue base from further erosion, Congress in
the Tax Reform Act of 1969 prescribed detailed rules by which in-
terest (in excess of a liberal $5,000,000 a year) is to be denied de-
duction in the case of obligations issued in connection with certain
corporate acquisitions if, in general, the obligations are sub-
ordinated and convertible (or accompanied by warrants), and if
either the ratio of debt to equity (measured by adjusted basis) or
the ratio of interest charges to projected (actually historic) earn-
ings exceeds specified standards. 43 The details, however, are not
important here,1 44 except as they may suggest approaches to the
broader problem, for Congress was careful to state that the pre-
scription of such standards for that limited purpose should give
rise to no inference "that any instrument designated as a bond,
debenture, note, or certificate or other evidence of indebtedness
by its issuer represents an obligation or indebtedness of such issuer
in applying any other provision" of the tax law. r21
In a statement to the House Ways and Means Committee, ques-
tioning an earlier version of that proposal, Assistant Secretary of
the Treasury Edwin S. Cohen declared:
In our tax structure, an interest deduction is properly disallowed only
if the underlying obligation constitutes equity rather than debt.... The
Treasury is presently seeking to develop rules or a Regulation that Will
aid in distinguishing debt from equity and disallow the interest deduction
where the interest payments represent in substance a return on equity.
These rules would apply whether the instrument comes into existence in
an acquisition, in a recapitalization, or in any other manner, and whether
the company is closely held or publicly held. ... Any new Regulations
promulgated in this area would, however, have prospective application
2 46
only.
Although Congress was determined nevertheless to deal specific-
ally with the deductibility of interest on the particular category of
1243 L.C. § 279, added by section 411 of the Tax Reform Act of 1969. Not only
stated interest but also unstated or imputed interest (section 483) and original issue
discount are disallowed. S. REP. No. 91-552, 91st Cong., 1st Sess. 139 (1969).
44 The provision is comprehensively described, analyzed and criticized in a numbor
of articles in a symposium on CONGLOUERATE MERO!S . AmQcQmsmons: Opnioi, A2 -D
AiALYsis, 44 ST. JoHN's L. REv. (spee. ed. 1970), particularly at 1029-30 (Silver-
stein). The proposals, before final amendment and enactment, were described in Sax,
The Conglomerate and Taz Reform: A Brief Review, 25 TAx L. RLv. 235 (1070).
2245 I.C. § 279 (i).
124 1969 House Hearings, note 1241 supra, 5511-12, 5 42 538L The statement is
reproduced in Cohen. The Administration's Interim Program of Taz Reform and Taz
Belief, 47 T~xEs 325, 341 (1969).

TAX LAW REVIW [Vol. 26:
obligations arising in corporate acquisitions, the Senate added to
the bill, and Congress enacted, a specific delegation of regulatory
power, calculated to strengthen the Treasury's hand in its ambi-
tious plan to resolve the over-all debt-equity problem. The Treasury
was authorized to "prescribe such regulations as may be neces-
sary or appropriate to determine whether an interest in a cor-
poration is to be treated for purposes of this title [the Internal
Revenue Code] as stock or indebtedness." 1247
The Treasury was expressly directed to set forth in the regula-
tions "factors which are to be taken into account .. with respect
to a particular factual situation." 1248 The act mentions five factors
Which "may" be included "among other[s]" in the regulations:
(1) whether there is a written unconditional promise to pay on
demand or on a specified date a sum certain in money in return
for an adequate consideration in money or money's worth, and
to pay a fixed rate of interest,
(2) whether there is subordination to or preference over any
indebtedness of the corporation,
(3) the ratio of debt to equity of the corporation,
(4) whether there is convertibility into the stock of the cor-
poration, and
(5) the relationship between holdings of stock 12 4
in the cor-
poration and holdings of the interest in question. 9
But the Senate Finance Committee report makes clear:
It is not intended that only these factors be included in the guidelines
or that, with respect to a particular situation, any of these factors must
be included in the guidelines, or that any of the factors which are included
by statute must necessarily be given any more weight than other factors
added by the regulations.-2 "
Although there are well over a thousand specific delegations of
rulemaking authority in the Internal Revenue Code, 1211 the present
1247I.R.C. § 385(a), added by section 415(a) of the Tax Reform Act of 1969.
1248 I.R.C. § 385(b).
1249 Ibid.
1250S. :REP. No. 91-552, 91st Cong., 1st Sess. 138 (1969). Nor is the Treasury for
this purpose to be "bound or limited by the specific rules" provided "Ifor distinguishing
debt from equity in the corporate acquisition context." Id. at 138-39 (quoted in noto
1306 infra).
12, A count some years ago showed 1,338 such instances (Williams, Preparationand
Promulgation of Treasury Department Begulations Under Internal 2evelUn Coda of
1954, 1956 S. CALIF. INST. 733, 736), but subsequent amendments havo added many
more, including over 70 in the Tax Reform Act of 1969 alone. See Hearings on H.R.
13270 Before the Senate Finance Committee, 9 1st Cong., 1st Sess. 5148 (1969).

instance is unusual (but far from unique) in that Congress has

provided no guidance concerning the policy to be implemented
under the delegated power.1- 2 Nor is reference to the policies of
the underlying provisions in which a distinction is made between
debt and stock -53 particularly helpful, for the statutory determin-
ation to treat borrowed capital one way and equity capital another,
thereby permitting "the taxpayer to choose between legal forms
similar in an economic sense but having disparate tax conse-
quences," 154 is based upon congressional discretion rather than
upon principle. "Absent some definitive principle which requires
the choice of some factors over others as controlling, that discre-
tion [which Congress has now delegated] remains essentially un-
fettered." 121 The Treasury might, within the scope of the power
granted, do anything from putting the imprimatur of authority
upon the government's latest litigating position to adopting the
extreme permissiveness of certain highborn legislative proposals
that have lain dormant for more than a decade.'-;
Tim QuEsT FoR CERTANTY
The Problem
However the policy lines may be drawn, the Treasury faces a

formidable, and perhaps impossible, task in formulating a clear
definitional line between debt and stock. The classic example of an
attempt by regulation to resolve the uncertainty and confusion
surrounding a much litigated issue, which has sometimes been re-
ferred to as a precedent for like resolution of the present prob-
lem, 1 is the so-called Clifford regulation of a quarter century
ago, 2 8 relating to the treatment of the grantor of a trust in some
circumstances as in practical effect the owner of the trust and its
1252See Comment, Toward New Modes of Tax Dccisionmakfng"-The Dcbt-E-quity
Imbroglio and Dislocations in Tax Lawmaking Respoisibility, 83 HAv. L. REv. 1695,
1696 (1970).
12s4 See Nassau Lens Co. v. Comm'r, 308 F.2d 39, 44-45 (2a Cir. 1902).
255 Comment, Toward New Modes of Tax DccisionmaNng-Tlio Debt-Equity Imbrog.
Uo and Disocations in Tax LawmaL-ng :Rsponsibility, 83 HAuv L. Thzv. 1095, 1706
(1970).
22- See text at notes 1266-81 infra.
1257 See ALI, IaTcoE TAz PROBLEM'S OF CO1PO.TIOnS AND S=AIUMOLDEnS 436-37
(Report of Working Views of Staff, 1958) (hereinafter cited as ATI ST'r).
1258 T.D. 5488, 1946-1 C.B. 19, amended by TM). 5567, 1947-2 C.B. 9; Reg. 118, §
39.22(a)-21 (1953).

income for tax purposes. 12 5 9 The regulation provided that the re-
tention of any one of three carefully described strings on the trust
would cause the grantor to be taxable on its income, and their ab-
sence would assure freedom from Treasury attack. 200 The debt-
equity problem is far more complex, however, because of "the
numerous characteristics of an interchangeable nature which can
be given to these instruments." 120I
Probably the regulations can afford the certainty of fixed rules

and predetermined tax consequences, if at all, only at the ex-
tremes-mainly in cases where there is little uncertainty even
today. On the one hand, as in the Clifford situation, there may be
circumstances (such as the absence of any maturity date short of
liquidation of the corporation, unavailability of the customary
remedies of creditors or the dependence of payments of purported
interest upon the discretion of the directors) which could be deemed
sufficient even in isolation to mark a purported debt as substan-
tially indistinguishable from preferred stock, regardless of the
presence of factors that in another context might point the other
way. There may be other factors (such as some forms of sub-
ordination, a top-heavy debt structure, contingency of the amount
of purported interest upon earnings and the presence of conver-
sion rights or warrants) which by themselves are only factors to
consider but which in specified combinations may be decreed
sufficient to cause automatic nonrecognition of the purported
debt.126 2
At the other extreme, there no doubt are factors (such as a fixed
date on or before which a fixed sum must be paid unconditionally,
an unqualified right to sue on default, fixed or cumulative interest
1259 The problem originated with Helvering v. Clifford, 309 U.S. 331 (1940), which the
lower courts then struggled to understand and apply.
1260 Although the regulation succeeded in the latter objective (see Mim. 5968, 1940-1
C.B. 25), it failed in the former, as the regulation was merely interpretative and lacked
the authority of a specific congressional mandate to prescribe the rules, Commr v.
Clark, 202 F.2d 94 (7th Cir. 1953). Congress thereafter wrote the substance of the rogula-
tions into the statute. I.R.C. §§ 671-78.
1261 S. REP. No. 1622, 83d Cong., 2d Sess. 42 (1954), rejecting as impracticablo an
effort at exclusive definitions relating to debt and stock, undertaken by tho Houso in
its version of the bill that became the Internal Revenue Code of 1954 (H.R. 8300, 83d
Cong., 2d Sess. §§ 275, 302(b), 312(c) and (d) (1954)).
1262That such devices, "conceived by ingenious ]awyers or advisers," as subordi-
nated convertible debentures and debentures with warrants attached may be singled out
for special treatment is inferable from speeches by Assistant Secretary of the Treasury
Edwin S. Cohen (printed in J. Accountancy, June 1970, p. 65, at 66) and by Commis.
sioner of Internal Revenue Randolph W. Thrower (printed in 25 Bus. LAw. 641, 643-47
(1970)). Bee also S. REP. No. 91-552, 91st Cong., 1st Sess. 137 (1969).

and absence of significant subordination) which, in combination,

would identify an obligation beyond question as debt; and it may
be possible-and would surely please certain large corporate is-
suers 1----to go further and declare that the presence of a single
one, or perhaps more than one, of certain features that in other
circumstances might have an adverse tendency (such as noncumu-
lative contingent interest, limited subordination or specified vot-
ing rights), shall not prevent recognition of debt if all else is in
order. But I submit that perfection or near-perfection of form
should suffice, -without more, only where an arm's length relation-
ship between the parties warrants the reality of the terms of the
instrument and the economic viability of the obligation.12:
Predictably, however, the proposal has been made that, even with
respect to purported debts held by shareholders of closely-held
corporations, the regulations should offer "nonlitigious taxpayers
... a 'safe harbor'... -a nonexclusive, arbitrarily defined area of
debt-by reference to which, together with their lawyers, they
could plan the capitalization of closely-held corporations in confi-
dence that certain payments would be deductible as interest." The
safe harbor would be constructed by "arbitrary elevation of se-
lected factors from mere relevance to controlling status." But, for
the "adventurous taxpayer," the proposal is that there be left
open "the possibility of litigation in the fringe areas of debt and
equity," unhampered by "an all-embracing definition of the terms
'debt' and 'equity' by identification of their essential characteris-
tics," or even by an authoritative listing of relevant factors that
might be given weight against him."'
Previous Safe Harbor Proposals

The safe harbor proposal, of course, is not new. It was first put
forward as long ago as 1954 by the American Law Institute
and was soon seconded, with modifications, by the American Bar
=.63 See Hearings on General Bevenue Bevision Before tho House Committee on WFays
and JMeans, 85th Cong., 2d Sess. 3195-97, 3206-07 (1958) (hereinafter cited as 1958
House Hearings); Molloy, Federal Tncom Tax Asp cts of New Ircnds in Ra1?road cor.
porateFinancing,12 TAX L. REv. 113 (1957) ; Comment, Bonds-Incomo Bond--Bighta
of Bonhwlders and Deductibility of Interest for FederalIncome Tax purposev, 50 2..cm.
L. Rtzv. 1334, 1352 (1958) ; cf. S. Rr. No. 1622, 83d Cong., 2d Sem. 42 (195r ), ojeting
a House proposal that would have resulted in denial of deduction of interest on "many
income debentures now outstanding."-
2264 See text at notes 190-95 and 475-76 supra.
22e5 Comment, Toward New fodes of Tax Dccislonma:ng-Tho Dcbt-Equffy Inbrog.
No and Dislocations in Tax LawmaY.ing Besponsibilfity, 83 HAnv. t. RZ. 1695, 1701
(1970).

'TAX TAW REVIEW (Vol. 26 :
Association. 1260 They urged that indebtedness be defined
by law to include, but not be limited to, any obligation, whether
held by strangers or proportionately by shareholders, if it satis-
fied certain formal criteria:
(1) an unconditional obligation to pay a sum certain in money;
(2) maturity on demand or on a specified date (the ALI
omitted "on demand"y);
(3) issuance for "an adequate consideration in money or
money's worth" or as a dividend to shareholders (the ABA
omitted issuance as a dividend);
(4) no subordination, "by the terms of the obligation," to
claims of trade creditors generally (the ALI omitted quoted
words, but the comments show same meaning was intended);
(5) no right to vote for directors except in the event of default
(omitted by the ABA); and
(6) interest payments, "if any," not dependent in amount
upon earnings, and unconditionally owing no later than maturity
date of the principal.
The ABA proposal made a token concession to the thin capitaliza-
tion doctrine by denying the absolute protection of the provision
when "the principal amount of obligations held in the aggregate
by stockholders [exceeds] by more than ten to one the fair market
value of the stock held in the aggregate by stockholders immediately
after the obligations are issued." That restriction was meaningless
window dressing, however, not only because the 10 to 1 ratio far
exceeded arm's length standards in most industries, but because,
in measuring the ratio, it ignored outside liabilities, whether
guaranteed by shareholders or not; and purported debts to rela-
tives and affiliated corporations not only were not themselves sub-
jected to the ratio test but were ignored as liabilities in applying
1268 The Al proposal is found in 2 AL FED. INCOME TAx STAT. § X500(g), at 224-
233 (Feb. 1954 Draft) (hereinafter cited as 1954 ALI). The ABA proposal is found in 81
ABA REP. 160 (1956), and is also set out, with an explanation, in Advisory Group
Recommendations on Subehapters C, J, and X of the Internal Revenue Code, Hearings
Before the House Committee on Ways andl Means, 86th Cong., 1st Sess. 933-35 (1959)
(hereinafter cited as Advisory Group Hearings). For a detailed critique of those safe har-
bor proposals, and of the further modifications made by the Advisory Group on subchapter
C (see text at notes 1272-81 infra), see Goldstein, Corporate Indebtedness to Bharehold-
ers: "Thin Capitalization" and Belated Problems, 16 TAx L. REv. 1, 63-73 (1900). A
proposed regulation, styled as "much more rigorous than any previously suggested,"
but still subject to a number of the criticisms of earlier proposals set out bolow, is
found in Bordman, Section 385: Clasification of Certain Interests as Stook or Indebted.
neas-ProposedBegulations, 23 TAx ExEo. 391, 408 (1970).

the test to shareholder-held obligations. The corporation need have

equity capital equal, not to one eleventh of its total capital needs,
but only one eleventh of the residue needed after all sources of
guaranteed and related party credit had first been exhausted.' r To
cap it all, the ABA proposed that, if an obligation failed to meet
one or more (or presumably all) of the prescribed conditions, it
should still qualify for safe harbor protection if such failure "was
due to the business requirements of the corporation' '-e.g., if its
credit was so weak that it had no choice but to subordinate pur-
ported shareholder debt to trade creditors.'(
Those proposals would have provided that desideratum of all
tax planners, a blueprint which, if faithfully followed, would as-
sure the sought-after tax consequences. If the formal requirements
were met, debt was to be recognized absolutely, even if the equity
cushion (as compared with the total debt it must support) was
transparently thin, the obligation was expressly subordinated to
major creditors other than trade creditors or was subordinated to
trade creditors under the bankruptcy law or the Deep Rock doc-
trine because of extreme ndereapitalization,'2 ° the maturity was
extremely long, and interest was not provided for at all, and re-
gardless of the nature of the remedies provided for default, the
actual record of payments, and the conduct of the purported cred-
itors in asserting and enforcing their rights-in short, without
regard to the parties' private intentions to observe and enforce
the formal terms or the practical possibility of carrying out those
intentions if they had them.' 0° On the other hand, if the obligation
1267 The AIl proposal had provided no ratio limitation, explaining that "extremely
high debt-capital ratios are common, and even necessary, in certain industrie"-a fact
that might warrant consideration if a corporation in such an industry failed a (non-
exclusive) ratio test, but hardly a reason for granting afe harbor to corporations in all
industries regardless of their departures from customary ratios. S&o Goldstein, supra
note 1266, at 65. The fatuity of the ABA ratio test gave point to the further argument
of the AIl that there was little purpose served by incurring the difficulties of framing
and applying a ratio test since a taxpayer could still achieve 90 per cent of the potential
tax savings, and Iincreasing the ratio infinitely thereafter will permit the further caving
of only 10%." 1954 ALI, note 1266 supra, at 231-32. The staff of the ALI later came
around to the view that a debt-equity ratio, somewhat stricter than the ABA. proposal,
vas a desirable addition to the safe harbor test. Sec ALI ST.Ur, note 1f-57 supra, at
62-63,405-07.
1268 See the ABA's example, quoted at note 313 supra, and the discusion in text
1270 ,See Xoeler, Transfers to Controlled Corporations:Considcrationsof Tldnness anrd
Multiplicity, 39 TXxEs 1078, 1093 (1961); Cary, Reflections Upon Vic Anniccan Law
ITtitute Tax project and the internal Revenuo Code: A Plea for a Moratorium anid

TAX LAW REMIEW [Vol. 26 :
was conditional, lacked any maturity date, was issued gratuitously,
was subordinated to all creditors, provided for voting rights, or
carried contingent interest, such failures were "not intended to be
conclusive, or even indicative, of the fact that indebtedness has not
been created"; such cases were to be left,27
as ever, to the vagaries
and often tender mercies of the courts.1 1
The Advisory Group Recommendation

The Advisory Group on Subchapter C, appointed in 1956 by a
subcommittee of the House Committee on Ways and Means, took a
somewhat more conservative approach than its predecessors, at
considerable expense to the tax planner's goal of certainty-in fact,
there is some question whether its proposal can fairly be described
as embodying a safe harbor approach at all.127 2 The formal re-
quirements for assured protection followed the same pattern as
the others, except that the obligation had to be in writing, no voting
rights could be provided even on default, subordination to trade
creditors could not be provided "by agreement" (presumably in-
eluding even a subsequent voluntary agreement), 3 and the obli-
gation might be issued either for an adequate consideration or as
a "distribution" to shareholders. 2 74 However, it was added that
the maturity date must not be "unreasonably distant," the in-
terest rate must not be "excessive," and the obligation must
have been issued "under circumstances which do not negative any
reasonable expectation of payment." 1275 Those standards require
the exercise of administrative or judicial discrimination, even as
under existing law. Although some would disarm the "reasonable
expectation" test by construing it to refer to the subjective intention
the creditor to treat the obligation as a debt, 1 270 the reference to
Beappraisal, 60 CoLium. L. REv. 259, 276 (1960); Goldstein, supra note 1260, at 65. Se
also text at notes 475-506 and 766-91 supra.
1271 See 1954 ALI, supra note 1266, at 225.
1272 See 1958 House Hearings,supra note 1263, at 3196.
1274 The last mentioned change was a relaxation of the earlier proposals. The ALI
proposal had extended safe harbor protection to obligations issued as a dividend, but not
to those originating in distributions not taxed as dividends (see I.R.C. §§ 301 (o) (2)
and (3), 316), lest it open the door to tax-free distribution of bonds when the corpora.
tion has no earnings and later tax-free payment thereof when earnings are available.
1954 A-LI, siupra note 1266, at 228. This lapse by the Advisory Group is not explained.
1275 The proposal is set out in Advisory Group Hearings, supra note 1260, at 579,
and reported on at pages 501 and 502 thereof (although with no real discussion of the
terms).
1276 AIl STAFF, supra note 1257, at 434-35; of. Goldstein, Corporate Indobedneas to

"circumstances" suggests that the economic reality of the expecta-

tion would have to be tested objectively by the risk involved (with
attention limited perhaps to extreme risks, since there must not be
"'ay reasonable expectation") 1277 Whichever interpretation is
correct, the inclusion of that test-which, incidentally, is not in
terms confined to shareholder-held debt-seems to be a confession
that one or the other, if not both, of the Gooding (intention) m.g8
and Gilbert (risk) 179 tests, those twin anathemata of the seekers
after certainty and safe harbors, cannot be wholly dispensed with
after all, lest the tax planners walk off with the Treasury.
The Advisory Group also tightened up the ABA's ratio test in
two respects, reducing the permitted ratio from 10 to 1 to 5 to 1 and
treating shareholder-guaranteed obligations like those held by
shareholders. But it still ignored loans by relatives and affiliates,
as well as outside debts, in the determination and application of the
ratio, so that if, for example, a corporation with no other assets
bought property for $1,000,000, giving a $750,000 mortgage to the
seller, borrowing $100,000 from relatives (or from an outside
source) on second mortgage, and obtaining the $150,000 margin
from shareholders, of which a bare $25,000 was labeled equity and
the remaining $125,000 followed the requisite form for debt (al-
thought it might be subordinated to bank credit), recognition of the
shareholder and relative-held obligations would follow automatic-
ally, unless the circumstances negatived "any reasonable expecta-
tion of payment.1'- 8 0 The Advisory Group also provided an
optional alternative ratio test based, not on existing market values
of corporate property, but on historic capital and paid-in surplus,
apparently in order to permit the recognizable status of share-
holders' loans to a corporation whose equity had disappeared or
Shareholders: "Thin Capitalication-" and cbatcd Problcms, 16 TAx L. ]brv. 1, 72
(1960). See text at notes 770-72 supra.
1277 A "reasonable expectation that the corporation will, if conditions warrant, pay
dividends to its shareholders (in the guise of payments of interest or principal) Thca it
is able to do so' might, under this interpretation, be insufficient. See Advisory Group
Hearings,supra note 1266, at 1034-35.
278 Gooding Amusement Co. v. Comm'r, 236 F.2d 159 (6th Cir. 195G), cert. deied,
352 U.S. 1031 (1957). see text at notes 475-506 supra.
2279 Gilbert v. Comm'z, 248 F.2d 399 (2d Cir. 1957). See text at notes 760-91 supra.
The three different opinions expressed by the panel in the Gilbert ea e (note 785 supra)
were referred to by the Advisory Group as evidcneo of the uncertaintic3 of existing law.
Advisoryj Group Hearings,supra note 1266, at 502.
1280 The example is adapted from one by Prof. Bittker in Advisory Group Hearing8,
supra note 1266, at 1034.

had become depleted through adversity to be tested as if the van-
128
ished values still existed. '
The Limits of Certainty
The sponsors of the earlier safe harbor proposals candidly ad-

mitted that their permissive approach with respect to purported
debt held by shareholders could not be justified by any objective
standard of financial analysis or arm's length lending, but only on
the basis of affording a tax incentive to investment in close cor-
porations (presumptively, but by no means invariably, being
small business), by enabling the shareholders to withdraw the
major part of their capital stake tax-free or at capital gain
rates, without first having to exhaust corporate earnings
through taxable dividends. 28 2 There may be good reasons of policy
for affording such an incentive, 288 but the proliferation of anti-bail-
out provisions designed to prevent or restrict the withdrawal of
corporate funds free of dividend tax, while retaining one's invest-
ment position in the corporation substantially unchanged, evidences
that Congress has adopted no such general policy at the present
time.1284 Any major relaxation of that anti-bail-out policy should be
1281s ee discussion of salvage loans in text at notes 982-97 supra. In extromis, of
course, the reasonable expectation test and the probable necessity for subordination
might preclude safe harbor qualification.
1282 ALl STArF, supra note 1257, at 408-15 (discussing three alternative approaches
to setting the permissible ratio, of which only the approach of giving a tax advantage
would support the disregard of the burden of outside debt); ABA Sra'nroN oP TAXATION,
PROGRAM AND COMMITTEE REPORTS 37 (1956), also found in Advisory Group tearings,
supra note 1266, at 934 ("One of the principal deterrents to incorporating a business
has been that money invested in a corporation for its stock cannot be recovered to moot
personal financial necessities without incurring a tax at ordinary rates whenever the
corporation has earnings available for dividends."). The Advisory Group, on the other
hand, insisted that its proposal would relieve from substantive scrutiny only "very
narrowly limited types of obligations of the clearest sort" (Advisory Group Hlearings,
supra note 1266 at 502)-a claim that was questioned by Prof. Bittker, note 1280 supra.
1283 See also note 1125 supra.
1284 Except in the case of a complete or partial liquidation under sections 331 and 340
and certain redemptions of stock to pay death taxes under section 303, the law gon-
erally treats every distribution as derived from earnings and profits to the extent
thereof, even if designated by the corporation as a return of capital (I.R.C. § 316(a);
Leland v. Commissioner, 50 F.2d 523 (1st Cir.), cert. denied, 284 U.S. 650 (1931));
treats redemptions of stock as dividends if they do not substantially alter the share.
holder's proportionate interest in the corporation (I.R.C. § 302; United States v. Davis,
397 U.S. 301 (1970)) ; treats most boot distributions in recapitalizations and reorganiza-
tions as dividends rather than as proceeds of an exchange of stock (I.R.C. § 356(a) (2) ;
Comm'r v. Estate of Bedford, 325 U.S. 283 (1945); Ross v. United States, 173 F. Supp.
793 (Ct. CL), cert. denied, 361 U.S. 875 (1959)), and makes elaborate provision to ro.
strain the evasion of those rules by the sale of stock to related corporations (I.R.C.
§ 304; United States v. Collins, 300 F.2d 821 (1st Cir. 1962)) or by the issuance of

considered directly by Congress and adopted, if at all, only after

fully considering (and perhaps changing) the effect of certain gen-
eral rules which now make it improbable that corporate earnings
will ever be subjected to dividend tax if the first amounts with-
drawn are not so treated; I-5 such a policy change should not be
allowed to slip into the law by the back door in the form of a purely
mechanical definition of debt.=o Certainly, in the context of con-
gressional concern over the avoidance of tax through the excessive
use of debt securities 3187 (even though attention was focused pri-
marily on public, not closely held corporations), the simple direc-
tive to prescribe rules distinguishing debt from stock can hardly
be construed as a mandate to adopt any such policy change by
abandoning, rather than merely clarifying and regularizing, the
standards by which the bona fides of shareholder-held debt has
heretofore been tested.
Nevertheless, even with respect to shareholder-held debt, there
is some room for the regulations to provide a safe harbor for truly
temporary advances. 288 It should be possible for a close corpora-
preferred stock, as a dividend or in a recapitalization or reorganization, with a view to
its later sale or redemption (I.R.C. § 306). The courts also have generally been astute
to prevent avoidance of those safeguards by devious devices. Bazley v. Comm'r, 331 U.S.
737 (1947); Gregory v. Helvering, 293 U.S. 465 (1935); Davant v. Comm'r, 360 P.2d
874 (5th Cir. 1966), cert. denied, 386 U.S. 1022 (1967). Sec also text at notes 1113-10
3285 The statement by the ABA in support of its safe harbor proposal that "no cor-
porate earnings escape tax which they would otherwise bear," when sharebolders are
permitted first to withdraw their investment in the guise of repayment of debt (Ad-
visory Group Hearings, supra note 1266, at 934), simply is not correct If the earn-
ings are deemed to remain in the corporation while the shareholder first enjoys a return
of his capital, the chance that be -will later realize the benefit of those carnings at capital
gain rates by liquidating the corporation or by selling to another who will liquidate, or
that the step-up of his stock basis at his death (TB.C. § 1014) will enable tax-free
realization of such earnings, is greatly enhanced. See Goldstein, Corporate Indebtedncs
to Shareholders: "Thin Capitalization" and Bdated Problcns, 10 TAx L. RLv. 1,
39, 40 (1960). With the narrowing of the margin between the tax rates on capital gain
and ordinary income, and the phasing out of the principal opportunities for avoiding the
upper bracket of corporate income tax through using multiple entities, as effected by
the Tax Reform Act of 1969, the bail-out problem may become less acute, except for
the ever-present but generally unattractive possibility of escaping tax through the
mortuary.
86 See Prof. Boris Bittker's statement in Advisory Group Ilcarngs,supra note 1206,
at 1034.
is7 S. REP.No. 91-552, 91st Cong., 1st Sess. 137-38 (1969).
2as It is inferable from a speech by Assistant Secretary of the Treasury Edain S.
Cohen, reported in J. Accountancy, June 1970, p. 65, at 06, that the regulations may at-
tempt to "state with clarity the tax effects" of "a customary form of lrnporary in-
debtedness from a corporation to its shareholders" (emphasis added). The Treaury's
concept of temporary may,of course, be anything from six months to 20 years.

TAX LAW REVIEW (Vo]. 26:
tion, even a thinly capitalized one, to borrow from its shareholders
to meet demonstrably temporary needs, without any fear that the
timely repayment of the advances will be deemed a dividend to its
shareholders or that its interest payments, if any, will be treated
less favorably than if made to a bank. 128s An obligation which is
payable on demand or within, say, a year or two, and which is in
fact paid within such period and is not renewed or offset by new
advances, 20 would seem sufficiently free from the taint of a "pre-
conceived plan to drain off fat profits accumulated over a period of
years in the form of capital gain" 1201 to be recognized automatically
as debt, without regard to formal documentation, debt-equity ratio,
subordination, or factors bearing on the hypothetical initial inten-
tion or reasonable expectation of making the payment when it was
made. This is not, of course, the only situation in which corporate
debt to shareholders should be recognized; but it may be the only
one in which recognition should be accorded without reference to
factors external to the form of the instrument.
Between the extremes of obvious equity capital and safe debt,
there is a gray area-broad in the case of shareholder-held debt,
where "skim milk [often] masquerades as cream," 1292 perhaps
1289 See 1954 ALI, supra note 1266, at 231; Stone, Debt-Equity Distinctions in the
Tax Treatment of the Corporation and Its Shareholders, 42 Tuim. L. REv. 251, 201
(1968); Cohen, Surrey, Tarleau & Warren, A9 Technical Revision of the Federal Income
Taz Treatment of Corporate Distributions to Shareholders, 52 COLm!. L. RFV. 1, 28
(1952). Such temporary needs might arise, for example, from unanticipated delays in
deliveries (Mason-Dixon Sand & Gravel Co., 20 T.C.M. 1351, 1353-54 (19061)), self
financing of improvements in anticipation of refinancing elsewhere after completion
(Leonard J. Erickson, 15 T.C.M. 1338, 1343 (1956)), or carrying the expenditures of
a new corporation pending the anticipated sale of stock to the promoters and others
(Royalty Service Corp. v. United States, 178 F. Supp. 216, 221 (D. Mont. 1959)).
More marginal in terms of policy, but difficult to distinguish as a practical matter, is the
case where foreseeable needs for working capital are provided for, not by equity capital,
but from shareholder advances which are in fact quickly repaid from the profits of suc-
cessful operation. Albert W. Petersen, 24 T.C.M. 752, 756 (1965).
3290 See note 694 supra. Earlier proponents of safe harbors, despairing of coping
with the problem of "evasion [of a 20 or 25 year limitation] by means of renewal or
reissue," opted for granting safe harbor treatment without limitation on the term.
1954 AlI, supra note 1266, at 227-28. Cf. ALI STAFF, supra note 1257, at 430-31. But
if the safe period is made short enough so that the outcome will be known by the time
the first affected tax return is audited, there is no difficulty in excluding those obliga-
tions which are continuously outstanding beyond the set period, irrespective of their
formally prescribed maturity. Cf. T x. Civ. STAT., tit. 122A, § 12.01 (1) (a) (ii) (basing
corporate franchise tax, in part, on debts maturing in one year or more, or "continuously
outstanding"I for that period).
1291 Cf. G.E. Nicholson, 17 T.C. 1399, 1403 (1952), applying the quoted language to
redemption of preferred stock within a year after incorporation.

narrow in the case of hybrid securities held by strangers-where

the ambivalence of the factors causes the principal uncertainties
today 93 and where the regulations cannot feasibly provide solu-
tions with mathematical precision. Merely to "set forth factors
which are to be taken into account" ' 4 would not achieve certainty,
and would add little to what the courts have done already, '1 except
perhaps to winnow the list. In comparable circumstances, in defin-
ing by regulation the essentially formal distinction between a part-
nership or trust and an association taxable as a corporation,1 2 10
the Treasury resolved the problem of ambivalent factors by rest-
ing the determination upon the presence or absence of a simple
majority of the relevant factors, without assigning them varying
weights. 2 9 7 In this more complex field, however, "[t]he object of
the inquiry [should be] not to count factors but to evaluate
them." "Is The "relationship between holdings of stock in the cor-
poration and holdings of the interest in question," for example,
although listed in the statute as a permissible factor to be consid-
ered,29 9 is not so much a factor in itself as a precondition to the
relevance of certain other factors bearing upon the reality of the
intention to collect the purported debt.1: 0 .And surely such ju-
dicially declared factors as the formality of the instrument, the
absence of voting power, and the business purpose of the arrange-
ment, if they are hereafter to be considered at all, cannot be weighed
equally in the scales against complete subordination, contingency
of the right to income and principal and the absence of a reason-
able maturity date. Nor will it suffice to decree arbitrarily that
certain factors count three points, others two, and others one, for
the significance of most factors may vary from case to case.
It does not follow, however, that the inability to achieve precision
in the gray area should cause the Treasury to limit its exercise of
1-93 See note 200 supra.
12 4 LR.C. § 385(b).
1296 The parallel to the debt-equity distinction is noted in Nassau Lens Co. v. Com-
missioner, 308 F.2d, 39, 46 (2d Cir. 1962) ("By the same reasoning it may make little
Ceconomie' difference to [the owner] 'whether he has an unincorporated bune:3 or a
corporation in which he is the sole stockholder .... But the Code . . . recognizes
and treats corporations as separate entities and affords significance to the type of invest.
ment chosen in them .... " ).
297R eg. § 301.7701-2 (a) (3).
2
1 98 Tyler v. Tomlinson, 414 E.2d 844, 848 (5th Cir. 1909). See note 201 supra.
But of. Weylin Corp. v. Unitea States, 312 F. Supp. 400, 40. (W.D. Mo. 1970), recog.
nizing debt on the ground that it passed "a majority" of the ten tests there listed.
1299 IR.C. § 385(b) (5).

TAX LAW REVIW ['Vol. 26 :
its mandate to those situations where clear answers can be pro-
vided.1301 Although the responsibility for weighing all the circum-
stances of the particular case must still, in the marginal situations,
be left to the administrators and the courts, valuable guidance can
be afforded by including in the regulations short essays on the sig-
nificance, if any, to be attached to each factor or combination of
factors, 13 - putting them in perspective and correcting some aber-
rant notions that have appeared.
MULTIPLE STANDARDS?
Perhaps the first question for the Treasury to consider is whether

there should be, and whether its mandate permits, varying mean-
ings for the terms "stock" and "indebtedness" for different
purposes of the tax law. It is not unheard-of for the same word to
have more than one connotation even in the same statute, 18°8 a
familiar example being the concept of a "gift" for purposes of in-
come, estate and gift taxes, of which Judge Frank remarked, "IPer-
haps to assuage the feelings and aid the understanding of affected
taxpayers, Congress might use different symbols to describe the
taxable conduct in the several statutes, calling it a 'gift' in the
gift tax law, a 'gaft' in the income tax law, and a 'geft' in the es-
tate tax law." 1'o4 Should the Treasury here, as the delegate of
Congress, in effect provide definitions not only of a "debt" but of
a "dit" and a "dat" as well?
It is debatable whether the delegation of power Ito provide such
regulations as may be necessary" to distinguish stock from in-
debtedness "for purposes of this title" 10 requires that a uniform
standard be applied for all such purposes. It has been argued that,
since the Senate report states that "the guidelines to be promul-
gated... are to be applicable for all purposes of the Internal Rev-
enue Code," 1306 the Treasury is "limited to one test or set
13o But see Comment, Toward New Modes of Taz Decisionmakng-The Dobt-Equity
Imbroglio and Dislocations in Tax Lawmaking Besponsibility, 83 ErARv. L. REV. 1695,
1705 (1970), urging that neither an "all-embracing definition" nor an identiflcation of
relevant factors should be provided outside the safe harbor area.
1302 For an example of this approach, see Reg. § 1.482-2, relating to reallocation of
income and deductions among related haxpayers.
13o3 Helvering v. Stockholms Enskilda Bank, 293 U.S. 84, 87 (1934); Baley v.
United States, 360 F.2d 113, 116 (9th Cir. 1966).
1304 Comm'r v. Beck's Estate, 129 F.2d 243, 246 (2d Cir. 1942). Even within the in.
come tax law itself, the word "gift" has at least two different connotations. Se6 Crosby
Valve & Gage Co. v. Comm'r, 380 F.2d 146 (1st Cir.), cert. denied, 389 U.S. 976 (1967).
13o See note 1247 supra.
130 S. R P,. No. 91-552, 91st Cong., 1st Sess. 139 (1969). The full quotation is: "In

of tests of uniform applicability." 1307 In context, however, it is

evident that that statement in the report was made, not to restrict
the power, but to emphasize is breadth, in contrast to the narrow
scope of section 279, which dealt only with the interest deduction
and -with a narrow category of obligations. There is nothing in the
statement to preclude distinctions being made by the guidelines
themselves, and the report in fact takes note of "the variety of
contexts in which this problem can arise," and authorizes the
Treasury to "prescribe the appropriate rules for distinguishing
debt from equity in these different situations." 13o-
It may also be debatable whether, assuming the power exists, it
is advisable to prescribe varying definitions, which one writer has
said would be "an undesirable step in the wrong direction." ': Ob-
viously, the meaning must be the same for the purposes of provi-
sions that are interrelated, such as those which define tax-free ex-
changes and those that prescribe basis after the exchange. And if
purported debt to shareholders is deemed stock for the purpose of
denying interest deductions, consistency demands that the provi-
sions prescribing the tax treatment of distributions to share-
holders 131o be deemed applicable to the payments, lest a double
penalty be imposed 31 1 But no conflict and no real harm, except
developing these guidelines, the Secretary of the Treasury is not to be bound or limited
by the specific rules which the committee amendments and the ouse bill provide for
distinguishing debt from equity in the corporate acquisition context. Thus, an obliga.
tion the interest on which is not disallowed under the corporate acquisition cetion
nevertheless might be found to constitute equity (and hence the interest disallowied)
under the general debt-equity regulatory guidelines. Moreover, unlike the rules provided
by the bill in a corporate acquisition context, which deal only with the allowability of
the interest deduction, the guidelines to be promulgated by the Secretary of the Treasury
are to be applicable for all purposes of the Internal Revenue Code." Id. at 138-39.
13o Shors, Corporate BeorganaWtons: Some Current Deredopments Ircluding the
Tax Beform Act of 1969, CoNGLo T i MEGmES Amw AcqusITsiS: OPnno!i ANm
TE
A rsimsS, 44 ST. Tomx 's L. REv. 1128, 1140 (spec. ed. 1970).
1os S. REP. No. 91-552, 91st Cong., 1st Sess. 138 (1969). Section 385(b) itself dirccts
that the regulations set forth "with respect to a particular factual situation" -which
factors are to be taken into account, suggesting that different factors may be given
weight in different situations. But since the reference is to factual situations rather than
to different provisions of law, it may suggest that the "variety of contexts" and "dif-
ferent situations" referred to in the report may also be factual rather than legal.
3209 Shors, note 1307 supra, at 1140.
3.31o E.g., I.R.C. §§ 116 (dividend exclusion), 243 (deduction for intercorporate divi.
dends received), 301 and 316 (limitation to earnings and profits), 902 (foreign tax
credit).
13u The failure of section 279 to provide for such coordination (since it simply
denies the interest deduction rather than describing the security as "stock" or the
payment as a "dividend") has been noted. Knickerboch-er, 2tiching Mallccho: The Tax
Beformers" Sneak Attack; on Conglomerates,COxroi=w zm s . r AcqUISrnONs:

TAX LAW REVIEW [Vol. 26;:
perhaps to "Ithe feelings and ... the understanding of affected tax-
payers," 1312 would result if it should be determined to treat the
same instrument in the same circumstances as debt, say, for pur-
poses of allowing interest deductions and as stock for redemption
purposes, or as stock for the former purpose and debt for purposes
of the tax-free exchange provisions.
I submit that the heart of the debt-equity dilemma that has con-
founded the courts and frustrated the would-be reformers lies in
their compulsion to adopt a single definitional approach to widely
varying tax issues. The effort to give relief in one area opens the
door to abuse in another, and an assault on abuse in one area pro-
duces inequity in another. 31 3 It is frequently urged that the appli-
cation of a strict arm's length or risk standard imposes an un-
warranted penalty upon a small or struggling closely held company,
largely dependent upon internal financing, in competition with
larger and stronger well-leveraged companies having unlimited
access to outside financing. 3 4 That may well be an appealing
policy reason for some liberality in the debt-equity criteria as ap-
plied to the deduction for interest (although not necessarily for
so much liberality as to cause the discrimination in reverse that
now often results from judicial toleration of ratios of shareholder
debt to equity, far in excess of industry standards). 81 1 5 But the
question of tax-free repayment (or bail-out) of the shareholders'

investment is one peculiar to closely-held corporations, and the
element of competitive disadvantage is not there involved, 18 10 ex-
cept perhaps insofar as the use of tax-favored debt may in some
cases facilitate the bootstrap purchase of a business by a small op-
erator and thus may contribute to deterring the concentration of
OPmON AxD ANALYSiS, 44 ST. JoH'S L. REv. 1047, 1052 (spec. ed. 1970). It is entirely
possible that the interest that is disallowed to the debtor corporation under section 279
might be taxable to the recipient as interest, not as a dividend; and that the original
issue discount which the debtor is not allowed to amortize would have to be amortized as
income by the bondholder or treated as ordinary income when realized by sale or retire-
ment. I.R.C. § 1232, as amended by section 413 of The Tax Reform Act of 1969. Cf. note
68 supra.
.313 Goldstein, Corporate Indebtedness to Shareholders: "Thin Capitalizaton" and
Belated Problems,16 TAx L. REv. 1, 66, 73 (1960).
1314 See 1954 ALI, supra note 1226, at 232; Advisory Group Hearings,supra note 1200,
at 502; Hickman, Incorporation and Capitalization: The Threat of the "Potontial In.
come" Item and a Sensible Approach to Problems of Thinness, 40 TAXs 974, 985-86
(1962).
1315 See Stone, Debt-Equity Distinctions in the Tax Treatment of Corporate DWribu-
tions to Shareholders,42 TUL. L. Rv. 251, 261 (1968).
1316 See Goldstein, supra note 1313, at 66, 76-77.

business ownership in ever larger units.1 31 7 In any event, contra-
vening considerations of policy may call for a substantially
stricter definition of debt for this purpose.1 318
It has been urged by Mr. William M. Goldstein that the
word "debt" should be given a "somewhat more expansive in-
terpretation" for the purpose of a nonbusiness bad debt deduction
under section 166(d) of the Code than may be desirable in either
the interest deduction or repayment areas. His argument is that
section 166(d), which treats nonbusiness bad debts as short-term
capital losses, regardless of the actual holding period, was "spe-
cifically designed as a compromise measure to handle close cases
between bona fide debts and gifts," and that a shareholder should
no more be required to act the role of a hardhearted creditor of his
corporation than the father who has made a loan to his son. He cites
the policy of Congress to encourage investment in small business
by granting liberal loss deductions, as evidenced in subchapter S
and section 1244,:13" but it is doubtful that the usually small differ-
ence in tax dollars between a short-term capital loss (if a nonbusi-
ness debt is recognized) and a long-term capital loss (if it is deemed
1317 See 1969 House Hearings,supra note 1241, at 250-05; Swenson, Actio. Against
Congomerates--WU It Hurt Small Business?, CONGLO.aI T Mmno1s . Acqmsr-
Tioxs: OPnION ANwDAiTALYSIs, 44 ST. TomrT's L. TEv. 1153, 1158-59 (SpeC. ed. 1970).
While the purchase money debt in such cases would frequently run from the corporation
to an unrelated seller or lnancier, it would ordinarily be guaranteed by the shareholders
of the purchaser; in some eases, the money might be borrowed in the first instance by the
shareholders and advanced to the corporation (see text at notes 678-82 supra). In
either event, any restrictions imposed on shareholder heldt obligations would presumably
be applicable.
iss See text at notes 1282-87 supra. The House version of the bill which became the
Internal :Revenue Code of 1954 'would have subjected to the dividend equivalence rulc3
of section 302 the redemption of purported debt, "known generally" as a corporate
security (an ill chosen qualification that imports considerations of marketability foreign
to the purpose of section 302, cf. United States v. Leslie Salt Co., 35G U.S. 383 (1956)),
if (1) the interest payments, if any, were dependent in amount upon earnings and were
not unconditionally payable no later than the maturity date of the principal or if (2) the
obligations were held by persons who together owned (or were deemed by the attribu-
tion of ownership rules to own) 25 per cent or more of the common stock and were sub-
ordinated to the claims of trade creditors generally. H.R 8300, 83d Cong., 2 SC s3. g§
302(b), 312 (c) and (d) (1954). Primarily because it was tied in with the disallowance
of interest deductions (H.R. 8300, 83d Cong., 2d Sess. § 275 (1954)) in the same terms,
and because the Senate Finance Committee was appalled at the magnitude of the tashL
of rewriting subehapter C, of which this was a part, the provision died in the Senate.
S. ]R. No.1622, 83d Cong., 2d Sess. 42 (1954).
1319Goldstein, Corporate Indebtedness to Shareholders: "Thin Capitalatfo," ' and
Belate roblems, 16 TAx L. REV. 1, 49-50 (1960). Subehapter 8 (ace text at notes 102-
12 supra) and section 1244 (see text at notes 76-82 supra), however, are each heavily
conditioned by Congress, so they can hardly bL viewed as a mandate for liberalization of
deductions where stock masquerades as debt.

stock) 1820 would afford enough encouragement to justify having
a special definition for this limited purpose. The real stakes in bad
debt cases exist where an individual shareholder makes a purported
business loan allegedly in connection with his employment or other
personal business interests, 1321 or where the loan is made by a cor-
poration, in either of which cases the consequence of recognition of
debt is a full deduction against ordinary income. The anomalous
effect of the proposal, which would not extend the same liberality
of interpretation to those cases, would be that such business trans-
actions would be more vulnerable than those of the individual pas-
sive investor who, in substance, may have simply enlarged his
stock investment in the guise of debt.
One of the most inequitable consequences of nonrecognition of
purported debt relates to close corporations electing, under
subchapter S of the Code, to have their income taxed to their share-
holders and not at the corporate level. 1322 Under present regula-
tions, 1 323 if shareholders make advances to such a corporation un-
der circumstances generally warranting nonrecognition of debt,
and if the advances are not substantially in proportion to the hold-
ings of the nominal stock, the corporation and its shareholders may
not merely lose whatever tax advantages might have flowed from
the use of debt, 1 32 4 but will be wholly disqualified for the benefits of
subehapter S, for which a corporation having more than one class
of stock is ineligible.3 25 While a nice concern for symmetry in the
law may dictate that unrecognized debt that is held disproportion-
ately, and hence gives its holders rights different from and su-
perior to those of the common shareholders generally, must be a
distinct class of stock, the courts that have questioned the present
regulation have concluded that the application of traditional thin
capitalization doctrines for this purpose is wholly at variance with
the intent of subchapter S to help small business.""20 The Treasury
has in effect acknowledged this by proposing to Congress, as part of
a general legislative overhaul of subchapter S, that
the existence of any interest not designated as stock, which has neither
voting rights nor rights to distributions beyond a fixed annual interest rate
1322 IR.C. §§ 1371-79.
1323 Reg. § 1.1371-1(g).
1325 I.R.C. § 1371 (a) (4).

and a fixed amount upon redemption or payment, will not cause the cor-
poration to be disqualified even if the interest is determined to be equity
327
capital.3
If it is agreed, however, that the delegated power to distinguish
stock from indebtedness permits the line to be drawn differently
in different contexts, the way is opened for adopting that particular
reform by regulation without awaiting the long overdue general
32 -
revision of subchapter S. 8
The drawing of the debt-stock distinction as applied to tax-free
reorganizations involves some perplexities. While classification
of purported debt as stock would rarely affect the qualification of
a reorganization under section 368 of the Internal Revenue
Code' 3 29 except as it may distort the application of the control
1327 1969 House Hearings,supra note 1241, at 5232. The holders of unrceogizded debt,
if they heldinone of the nominal stecl would not be considered shareholders for purposes
of the rules excluding corporations having more than ten shareholders or having sbare-
holders who axe not individuals or estates or who are nonresident aliens; and their
consent to the election would not be required. "Interest" distributions would be tax-
able to them whether or not the corporation had earnings and profits. Id. at 5233. Con-
sideration might be given to whether the purposes of the one class of stoch requirement
really necessitate imposing conditions with respect to the voting rights of the purported
creditors (see Rosencranz, Subchapter S: Thw PresidentialProposals, 55 A.B.A.J. 1181,
1182-83 (1969)) and excluding obligations the "interest" on which is payable only
out of net earnings (see Portage Plastics Co. v. United States, 301 F. Supp. 084, 693-94
(W.D. Wis. 1969)).
132s The concurring opinion of Judge Tannenwald in Tames L. Stinnett, Jr., 54 T.C.
221, 234 (1970), on appeal to the Ninth Circuit, suggests a doubt whether the Treasury's
mandate to distinguish stock from indebtedness permits it also to declare whetber that
which is stock is a separate class thereof. If my thesis is correct that stoch itself may
be defined differently for different purposes of the law, the question that troubled Judge
Tannenwald does not arise.
1329 Such purported debt would rarely carry voting rights, so would not constitute
voting stock as required by sections 368 (a) (1) (B) and (C). In a statutory merger or
consolidation under section 368(a) (1) (A), however, the only requirement respecting the
consideration is that it provide continuity of interest (leg. § 1.368-1(b)), which is
lacIng when the sole or principal consideration is debt (see note 139 supra), but may
be satisfied even with nonvoting preferred stock. Nelson Co. v. Helvering, 206 U.S. 374
(1935). Although Shors, Corporate Beorganicaions: Some Current Devdopments It-
eluding the Taz Beform Act of 1969, CoxGmERAom Mnainis A.,.D AcqUxSro.s:
OPnioN AD ANALYSIS, 44 ST. JmT's L. EV. 1128, 1140-41 (spce. cd. 1970), spccu-
lates that the application of the continuity test will not be aiceted by the prospective
definitions, because neither the statute nor the regulation uses the to-be-defncd term
"stock" in this connection, it seems that the proprietary interest which is implicit in
classification of purported debt as stock would satisfy the requirement. See Rv. Proc.
66-34 § 3.02, 1966-2 C.B. 1232, expressing the test in terms of "cstoc1." Of. Silverstein,
Impact of the Acquisition Indebtedness Provisions of the Tax .7eoorm Act of 1969 on
Corporate Mergers, CONGLOMERATE MERGERS AND AcQuIsrriozs: OpnOuo Aim A2.-ALsis,
44 ST. Jom's L. R~v. 1014, 1018-19 (spee. ed. 1970).

TAX LAW REVI]%W [Vol. 26 :
test, where applicable, by creating an additional class of nonvoting
stock which must be taken into account, 13 80 the effect would more
often be felt at the level of the shareholder who receives such pur-
ported debt as full or partial consideration for his stock in ali
otherwise tax-free exchange. The upgrading of a shareholder's in-
terest to a fixed claim for money, whether or not the claim consti-
tutes a security, is considered by Congress to be an appropriate
occasion for imposing a tax, which may often be a dividend tax if
he also retains an interest as shareholder; 1381 but that tax may be
avoided if purported debt is deemed stock for this purpose. Where
the reason for so viewing the purported debt is that the holder lacks
the essential rights and remedies of a creditor, or does not intend
or cannot reasonably and realistically expect to collect the obliga-
tion unless the business succeeds, it is appropriate that it be re-
ceived tax-free like stock. 1832 But if, as is conceivable, convertible
debentures should in some circumstances be considered so to re-
semble equity capital, from the standpoint of the corporation,
that the regulations might treat them as stock for the purpose of
denying interest deductions, 883 it does not follow that they should
also be considered stock when received by a shareholder in a re-
organization. From his standpoint, his status has been upgraded
to that of a creditor in the same fashion as if he received ordinary
bonds, since he has the option not to convert but to require that
the debentures be redeemed for a fixed sum at maturity (or when
sooner called).'8
For many purposes a contingent obligation is not treated as
13so See text at notes 113-24 supra.
1331 See text at notes 1142-43 supra. See Brrrxm & EUSTIOE, FEDERAL INcoME TAX-
ATION Op CORPORATIONS AD SHAREHOLDERS § 12.34 (2d ed. 1966).
1882 As stock Iother than common stock," received in a reorganization, it would ordi-
narily constitute section 306 stock, thus generally causing the shareholder to incur on
sale or redemption the ordinary income tax of which he was relieved upon receipt of the
purported but unrecognized debt. I.R.C. § 306.
1334 Cf. Tiger, The New Law's "Anti-Conglomerate" Provisions Can Be Accommo.
dated With Proper Planning, 32 J. TAXATION 130, 133 (1970), suggesting that the
possibility that convertible bonds might be received tax-free in mergers could cause the
Treasury to go slow in classifying them as stock. On the other hand, since the Service
has apparently been willing to rule that preferred stock which the issuor is required to
redeem after a five year period is nevertheless stock for reorganization purposes, the
Treasury may have no compunction about treating a convertible bond as stock for this
purpose if the circumstances make it appear such for other purposes of the law. See
Sinrich, Taz Incentives and the Conglomerate Merger: An Introduction, CONOLOMERATr
MERoERS AND AcQuisrIIONS: OPinioN AN AxAL~s, 44 ST. JOHN'S L. RTv. 100D, 1011
(spec. ed. 1970).

1971] CORPORA&TE DEBT
an indebtedness. But section 1232 of the Code, which treats the re-
tirement of certain evidences of indebtedness as a sale or exchange
thereof, and in general as giving rise to capital gain or loss (except
for amounts deemed to be recovery of original issue discount), was
designed to bring the treatment of such debt retirements into line
-withthat of retirements of stock. It may be appropriate, therefore,
to define "indebtedness," for the limited purpose of section 1232,
broadly enough to embrace contingent obligations, where the cir-
cumstances do not -warrant their classification as stock. Otherwise,
the very circumstance that makes them too much like stock to be
debt, -while still too much like debt to be stock, may leave them in
limbo, denied the treatment that either stock or debt may enjoy.'
In the case of mutual insurance companies, -which frequently
obtain necessary capital by issuing guaranty fund certificates lack-
ing the most basic formal and substantive characteristics of debt,
it has heretofore been deemed necessary to recognize such certifi-
cates as debt for all purposes, lest many companies be disqualified
for tax treatment as mutuals on the ground that payments to cer-
tificate holders are distributions of profits to shareholders. A more
flexible definitional approach -would permit the regulations to
acknowledge that such certificates are not inconsistent with the
nature of mutual companies, hence are not stock for purposes of
disqualification, while still subjecting them for all other purposes
to the debt-equity standards applicable to taxpayers generally.3 0
With respect to most of the other situations in Which the debt-
stock distinction is relevant,' 337 it is difficult to discern any reasons
1335 Bee Jamison v. United States, 297 F. Supp. 221, 229-30 (N.D. Cal. 1968), on
appeal to the Ninth Circuit. In some circumstances, no doubt, it will be more appro-
priate to treat a contingent obligation as stock than as debt (sco text at notes 236-38
and 397-99 upra), thereby subjecting its retirement to the terms of section 302 (Gar-
dens of Faith, Inc., 23 T.C.MAL 1045, 1061 (1964), aff'd, 345 F.2d 180 (4th Cir.), cert.
denied, 382 U.S. 927 (1965)); but it should not be deemed neithcr debt nor stock, at
least for this purpose.
13 6 See text at notes 159-61 and 1071 supra. When the capital of a mutual or co-
operative organization, which is sui generis, must be shoehorned into conventional defi-
nitional molds, in the absence of other directive from Congress, consideration should bo
given to the function it serves. See Mississippi Chemical Corp. v. Uitea States,
431 F.2d 1320, 1327 (5th Cir. 1970) (dissenting opinion). With respect to the taxable
status of the entity, the Treasury might simply reinstate (and broaden to cover all
mutual insurance companies) the regulation that was in force from 1918 to 1943, stating
that "A mutual fire insurance company which has a guaranty capital is taxed lieh
other mutual fire insurance companies." See Holyoke Mut. Fire Ins. Co., 28 T.C. 112,
118-19 (1957).

of policy for making further exceptions to whatever general rules
may be adopted.
SUBDIMSION OF THE CATEGORIES
Attempts by taxpayers to step up the basis of property, without

altering their economic interest in it, by making taxable transfers
to controlled corporations in return for purported debt which, they
hope, is neither "stock" nor "securities" under section 351 of the
Code, might be restrained by broadly defining the quoted terms for
this purpose.183 8 Since the Treasury's express mandate is only to
distinguish stock from indebtedness, and not to draw a line between
those debts which are and those which are not securities, a broad
definition of securities-while highly desirable to shed light in a
murky corner of the law-would presumably have only the weight
of an interpretative regulation under the general power of the
Treasury, 339 and thus would be burdened with the weight of past
judicial precedent. The Treasury may have more latitude in broadly
defining for this purpose the circumstances in which purported debt
to shareholders shall be deemed stock.
There is a similar question whether, in defining "stock," the del-
egated power extends to declaring the circumstances in which un-
recognized debt shall be treated as a separate class of stock or as
a mere augmentation of the investment in the common shares. 18 10
This question can vitally affect the qualification of a corporation
for subchapter S treatment (if the issue is not to be resolved by re-
defining the term "stock" itself for this special purpose), 841 and
it may also in some cases affect the application of the control test
1338 See text at notes 1127-1240 supra. The House version of the bill that became the
Internal Revenue Code of 1954, by broadly defining "securities" and defining a now
term, "nonparticipating stock," would have broadened the reach of section 351, pro-
vided the 80 per cent control test was met, to cover transfers in exchange (1) for any
unconditional obligation (except an open account), regardless of the length of its tcrm,
if the amount of interest was not contingent on earnings (or else was cumulative) and if
the obligation was not subordinated to trade creditors generally or (2) for any obliga-
tion that failed those requirements if it were "known generally" as a corporate so-
curity (e.g., a debenture). H.R. 8300, 83d Cong., 2d Sess. §§ 312(c) and (d), 351(a)
(1954). An attempted taxable transfer could have escaped only if the consideration
was an open account, or was an installment contract obligation or a note (not known
generally as a security) which was subordinated or bore contingent interest-and such
obligations might still have been deemed stock on extrastatutory grounds. See note
1318 supra,concerning the demise of those provisions in the Senate.
1339 I.R.C. § 7805 (a). See note 1149 supra, concerning the present inadequate treat-
ment of the subject in the regulations.
1341 See text at notes 1322-28 stpra.

of section 368(c) for purposes of a number of corporate transac-

tions, 3 1 as well as altering the timing of deductions for worthless-
ness of a shareholder's investment, 1 jeopardizing the tax-free
status of the liquidation of a subsidiary, 131 affecting the substan-
tially disproportionate character of a stock redemption,1 31 1 and
determining whether the disposition of the purported debt may re-
sult in ordinary income tax under section 306.134( Even if the dele-
gated power does not extend to this refinement, an interpretative
declaration on this subject might appropriately be included in the
regulations. 3 47
TimE FACTORS
Statutory Factors
Without unduly repeating the previous detailed discussion of
the factors which have been given weight by the courts in dis-
tinguishing stock from indebtedness, I submit here some sugges-
tions for their treatment in the regulations, beginning with the
factors expressly mentioned in the statute:
(1) A "written ... promise." The absence of a note or other
writing would have no significance in arm's length dealings, and
should have little even with respect to advances by shareholders if
they are truly temporary and are promptly repaid. When share-
holder advances, not formally evidenced, are permitted to remain
outstanding beyond a limited period, however, that fact may be
strongly, if perhaps not conclusively, indicative of an equity in-
vestment. 348
-346 See note 137 supra.
3347 Treatment as a separate class would seem to lead to undesirable rcsults in the
case of subehapter S corporations, worthles stock deductions and subsidiary liquidations.
With respect to the control test, the problem is usually created when the unrecognized
debt is held, not by shareholders, but by related parties, which make3 it difficult not to
regard it as a separate class; here, amendment of section 368(e), to eliminate from
consideration any "nonvoting stock which is limited and preferred as to Iividends,"
(see text at notes 125-26 supra) may be the only answer. The separate transferability
of unrecognized debt seems to require treating it as a class of preferred stock for pur-
poses of section 306, even when it is held in proportion to common stock.
1348 See text at notes 507-19 supra. That some liberality with repcet to truly tewpo-
rary advances is essential, -ee text at notes 1288-91 supra. Of the threo legislative pro-
posals discussed in text at notes 126C-81 supra, only that of the Advisory Group vould

(2) An "unconditional promise to pay .. . a sum certain in
money." Perhaps in most, if not all, cases in which the amount ul-
timately payable as principal of an obligation is contingent upon
earnings, with or without a participation in excess of a fixed
amount, it would be appropriate to classify the instrument as stock,
whether or not the nominal stock is held by the same persons. 1 40
It might, however, require more radical surgery on existing con-
cepts than was probably contemplated by Congress to apply that
principle to obligations to pay a contingent purchase price, at least
if the contingency relates to production or sales rather than to prof-
its and if the arrangement conforms to arm's length standards. 1 0
And, except in unusual circumstances, 185 1 an obligation for 'which
the issuer undertakes no personal liability in excess of the proceeds
that may be realized from the property constituting the security 1 2
has long been regarded as indebtedness, although conditional, 3
and it should be made clear that no change in this principle is
contemplated.
(3) Payable "on demand or on a specified date." The one factor
that should most clearly be made indispensable to debt classifica-
tion is that there must finally come a time, not dependent upon the
will of the purported debtor or upon circumstances (such as the
sufficiency of surplus) which may never arise, when the creditor is
entitled to demand and enforce payment. 13 53 This is "perhaps the
only consistent difference between bonds and preferred stocks." 1854
The imposition of such a requirement would be futile, however,
without also prescribing that the maturity must be "not unreason-
have denied safe harbor treatment in the absence of a writing, if form was otherwise
followed.
1348 See text at notes 236-38 and 397-99 supra. Sec also text at note 1335 supra
concerning the special problem under I.R.C. § 1232.
1350 See text at notes 400-22 supra. Cf. the unenacted proposal for treatment of cortain
contingent payments of purchase price as ordinary income, if they extended beyond five
years. Hearings With Bespect to the President's 1963 Tax Message Before the Houso
Committee on Ways and Means, 88th Cong., 1st Sess. 154-56 (1963). That proposal did
not, however, relate to the status of the obligation as debt.
135, See Rev. Rul. 69-77, 1969-1 C.B. 59, noting an exception for transactions which,
"in the light of all the facts and circumstances," appear "designed to improperly
create or inflate depreciation deductions. "I
1352Reg. § 1.163-1(b); Old Colony Trust Associates v. flassett, 150 F.2d 179, 183
(1st Cir. 1945); Manuel D. Mayerson, 47 T.C. 340 (1966); Clay Drilling Co. of Texas,
6 T.C. 324, 331 (1946); New McDermott, Inc., 44 B.T.A. 1035, 1040 (1941).
1354 Note, Bonds-Income Bonds-Rights of Bondholders and cdutibility of Interest
for Federal Income Tax Purposes, 56 MicH. L. Rzv. 1334, 1350 (1958); accord, Gold-
stein, Corporate Indebtedness to Shareholders: "Thin Capitalization" and Blelated
Problems, 16 TAx L. REV. 1, 31 (1960).

ably distant. "'3 55
Such a requirement is difficult to define in any
meaningful way, but it is important, for the sake of such certainty
as the circumstances permit, that the regulations set out the
standards by which reasonableness is to be judged. ' -" Reference
may be made to the maximum term customary for ordinary bonds
issued by corporations in similar businesses, and to the probable
duration of* the particular corporation's life if that is foresee-
able. 35 7 Different standards might be made applicable to secured
and to unsecured (or inadequately secured) obligations.'3 It may
be possible and desirable to establish a safe harbor based on a
specific permissible term of years, or possibly a number of differ-
ent such terms applicable in certain objectively determinable cir-
cumstances, 1359 leaving open to the taxpayer the opportunity of
proving that a longer term is reasonable in a particular case.3G
It is no doubt true that, where the owners of a corporation also
hold its purported debt, any limitation imposed on the term of the
obligations may be evaded by ignoring or extending the maturity,
perhaps long after the tax question has come to a head. 3 6' But that
is no reason for not imposing the restriction, for a fixed and reason-
able maturity date establishes the standard against which the
intention and the reasonable expectation of compliance therewith
may be tested by other evidence.
Although the statute refers to payability "on demand or on a
specified date," the regulations ought to express the requirement
somewhat less arbitrarily. An obligation to pay a reasonable time
after demand, or to pay on demand after a specified time (within
1355,See text at notes 240-49 supra. The Advisory Group proposed such a limitation,
not as an absolute prerequisite to recognition of debt, but as a condition to safe harbor
treatment. Advisory Group Hearings,supra note 1266, at 579.
1356 Compare the guidance afforded by Reg. § 1.162-7, relating to reasonablene43 of
compensation, and Reg. § 1.482-2, relating to charges between related business entities.
1357 Note, 56 MIicH. L. REV. 1334, 1350 (1958).
135s ALl STATPP supra note 1257, at 431.
1359 With its greater access to knowledge of financing practices in different broad
categories of business, the Treasury could thus save many taxpayers the burden of prov-
ing, and of anticipating at the outset the probability of success in proving, that a par-
ticular term is reasonable.
1380 In 1954 ALI, supra note 1266, at 227, in declining to set a maximum term even as
a condition to safe harbor treatment, it was stated that "it is impoiible to fi a single
time limit without doing injustice in many cases which actually require later maturity."I
The question may fairly be raised whether what those businesses "actually require" in
such circumstances is equity capital (ef. note 315 supra); but in any event no injustice
is done in requiring the taxpayer to establish the ned for a maturity longer than the
norm.
1361 This was one reason given in 1954 ALI, supra note 1266, at 227-28, for imposing
no limitation.

the permissible limits for fixed maturities), should suffice.1 03 2 And
an obligation payable "on or before" a specified date should qual-
ify, since a right of prepayment does not detract from a debt."0 3
An obligation that is payable at a time not specifically fixed but as-
certainable by reference to events certain to occur within the per-
missible period should also qualify.
Equal in importance to the maturity date, and cl6sely related
thereto (although not expressly mentioned in the statute) is the
question of the remedies available to the purported creditor if pay-
ment is not made when due. 13 64 It should be made an essential ele-
ment that, at least by some time within the maximum permissible
maturity period, the purported creditor be free to enforce his
rights by suit against the corporate debtor, although some limita-
tion on his remedies in the event of interim defaults, or for a lim-
ited period after final maturity, may be acceptable. Any provision
making the collection rights and remedies of a purported creditor
subject to the will of his fellows (except with respect to interim
defaults of a relatively minor nature) should be viewed with sus-
picion, 13 5 and should be a disqualifying factor whenever those
whose consent is required have an adverse interest as shareholders
of the obligor corporation. 136 6
(4) "Adequate considerationin money or money's worth." Al-
though the concept of an adequate and full consideration in money
or money's worth has long been a familiar one in the federal tax
statutes,3 67 including the provision describing claims deductible
for estate tax purposes, 130 8 the existence of consideration has not
heretofore been generally considered a prerequisite to recognition
of indebtedness, 8 69 unless its absence made the obligation legally
unenforceable.3 7 0 Now for the first time the adequacy of the consid-
1363 See note 253 supra. See 1954 ALI, supra note 1266, at 227.
1305 Such provisions are strictly ]imited, in obligations subject to the federal securities
laws, by the Trust Indenture Act of 1939, 15 U.S.C. § 77ppp. (1964).
1367 I.R.C. §§ 2043(a) (estate tax on inter vivos transfers), 2512(b) (gift tax), 0323
(h) (6) (priority of purchasers over federal tax liens). Cf. I.R.C. § 6323 (h)(1) (priority
of security interests).
1368 I.R.C. § 2053(c).
1369 Kraft Foods Co. v. Comm1r, 232 F.2d 118, 122-23 (2d Cir. 1956) (debentures
issued as a dividend); Preston v. Comm'r, 132 F.2d 763, 765 (2d Cir. 1942) (oblga-
tion under seal, created by gift); Comm'r v. Park, 113 F.2d 352, 354 (3d Cir. 1940)
(same).
1370 Brown v. Comm 'r, 241 F.2d 827 (8th Cir. 1957); John G. Sellers, 22 T.C.M. 1327
(1963).

eration may be a factor to consider (although probably not an ab-

solute prerequisite) in the recognition of corporate debt.1'3
Under the existing provisions which use similar language, 1312 it
is well established that a genuine business transaction is not to be
challenged for inadequacy of consideration merely because one
1 73
party appears to have enjoyed a bargain.. 3 On the other hand, an
obvious and legitimate target of the new requirement would be the
purported sale of property to a corporation for notes exceeding
the value of the property, where the sale is clearly a device to milk4
off the profits of later corporate development and operations.2'
It remains to be seen, however, whether the Treasury may seize
upon the provision as a means of giving independent force to the
argument, often made by the government but heretofore adopted
by the courts only as a rhetorical makeweight where there were
other sufficient reasons for nonrecognition, that purported debt
which brings no new capital to the business is not bona fide."7'5
Such action would not be surprising, in view of the atmosphere of
congressional hostility to certain substitutions of debt for stock in
corporate acquisitions, of which the directive to regulate the
broader aspects of the subject was a by-produt. 1'31 But "no new
capital" is not synonymous with "no adequate consideration." The
argument has most often been advanced where shareholders had re-
ceived purported debt in exchange for surrender of stock, which
assuredly represents money's worth, even though the exchange
1 T
may not augment the gross assets of the corporation. 3
The no new capital argument has also been advanced, heretofore
unsuccessfully, where the purported debt had been distributed to
shareholders as a dividend,1 378 and debts so arising may now be
subject to nonrecognition if adequate consideration in money or
money's worth is made a prerequisite. The Treasury has some lati-
1371 The factor was included in the ALIT ABA and Advisory Group legislative pro-
posals, as a condition to safe harbor treatment, but absence of consideration would not
have precluded recognition of debt. The A.I commentary indicated that it was primarily
designed to "prevent the fraudulent issuance of non-bona fide debt for tax avoidance
purposes." 1954 ALI, supranote 1266, at 228.
1372 The omission from section 385(b) (1), of the redundant "and full" which ap.
pears in the older provisions, notes 1367 and 1368 supra, would not seem significant.
373 Comm'r v. Wemyss, 324 U.S. 303, 306 (1945); Reg. §§ 25.2512-8, 30L0323-1
(b) (1) ; . REP. No. 1884, 89th Cong., 2d Sess. 12, 49 (1960) (Federal Tax Lien Act).
1376ER.
H REP. No. 91-413 (Part 1), 91st Cong., 1st Sess. 104 (1969); S. Rr.p. No. 91-
552, 91st Cong., 1st Sess. 137 (1969).
1377 Of. Erie Lackawanna R.R. v. United States, 422 F.2d 425 (Ct C1. 1970).

tude in the weight to be given the factor, however, and there would
seem to be no reason to deny recognition where the shareholders
have been taxed on the dividend, in effect as if they had received
cash and reinvested it in the corporation. 87 0 On the other hand,
where obligations are distributed tax-free to shareholders at a
time when the corporation has no earnings and profits, and might
later be paid from subsequent earnings, still free of dividend tax,
if the purported debt were recognized, recognition might ap-
propriately be denied, 130 although perhaps not for all purposes of
the tax law. 381
(5) "To pay a fixed rate of interest." This factor, as expressed
in the statute, would require not only that the interest, if any, be
1882
fixed in amount, but that interest in some amount be charged.
The factor, however, breaks down into several elements, of varying
weights.
The complete absence of an obligation to pay interest may be
consistent with indebtedness in the case of certain short-term cred-
its, as well as when it is explainable in terms of a time price dif-
ferential or a discount factor. In other cases, however, although
only if shareholders are the purported lenders, the lack of concern
with interest has some tendency to negative an intention to make a
loan rather than to enhance a stock investment. Consistency would
seem to require that, to the extent that the absence of interest is
made an adverse factor, a clearly inadequate interest rate should
be given similar weight, under the Treasury's power to designate
8 83
additional factors to be taken into account.
137l More marginal, perhaps, is the debt created by an intercorporato dividend, taxable
at no more than 15 per cent of the applicable tax rate (I.R.C. § 243), which may be
used as a device to shift taxable income between corporations by creating interest do-
ductions. Kraft Foods Co. v. Comm'r, 232 F.2d 118 (2d Cir. 1956).
138o The ALI, which proposed an exception to the consideration requirement whoro an
obligation was "distributed as a dividend" (1954 ALI, supra note 1266, § X500(g)
(2)), would not, for the above reason, extend the exception to corporate distributions of
obligations which escaped dividend treatment. Treating the purported debt as stock
would not make it section 306 stock, in the circumstances stated, in view of the absence
of earnings and profits at the time of the distribution. I.R.C. § 306(e) (2). Therefore,
the obligation could still be sold without fear of ordinary income consequences; but its
redemption might well incur dividend tax, not under section 306(a) (2), but under
section 302 (d).
13s See text at notes 1316-18 supra. Apart from the bail-out possibility, there appears
to be no reason for denying recognition on account of the origin of the obligation, if it
meets all other requirements. But of. Goldstein, Corporate Indebtedness to Shareholders:
"Thin Capitalization" and Belated Problems, 16 TAx L. REV. 1, 75, 76 (1960).
1382 The ALI, ABA and Advisory Group proposals would have granted safe harbor
to noninterest bearing obligations, if the other conditions were met.
1383 See text at notes 349-59 supra. See discussion in ALI STAY, *upra note 1257, at
433-34.

A provision for interest contingent upon the sufficiency of earn-

ings resembles the limited participation of preferred stock in the
"potluck of the enterprise," but the weight of precedent and prac-
tice supports recognition of debt despite such a provision, although
it may be given adverse effect when combined with subordination
or other factors, 38 4 and perhaps even by itself if the corporation
fails to show that such a provision "is particularly adapted to, or
customary in, its business." 13 If the purported interest, although
enjoying a preference over dividends on common stock, is payable
only in the discretion of the directors, the resemblance to preferred
stock may be so substantial that not even the obligation to pay prin-
cipal at a fixed date should outweigh it.. But if cumulative interest
is unconditionally payable at maturity regardless of the sufficiency
of earnings, the interim deferrability of the payments, whether or
not discretionary, should be given no adverse weight at all.Y
If the purported interest not only varies with profits but is sub-
ject to no reasonable ceiling, that fact might well be made con-
clusive that the purported debt constitutes stock.3 7 A fixed but
exorbitant rate of interest, or an excessive discount, although not
a statutory factor, is similar in effect and should be included in the
regulations as at least an adverse factor to be taken into account,
although perhaps only in the case of shareholder-held obliga-
88
tions.13
If the rate of interest is contingent upon external factors unre-
lated to the results of corporate operations, such as variations in
the general level of interest rates, that should have no tendency to
cast doubt upon the status of the debt.
13s4 See text at notes 338-48 supra.
1385 This is suggested in Goldstein, Corporate InTbtcdness 1o Shareholders: "Thin
Capitalization'"and Related Prolems, 16 TAx L. REv. 1, 31 (1960).

1386 Since all or part of the obligation to pay interest may properly be deferred until
maturity in the case of bonds issued at a discount, it should make no difference that a
part of the ultimately fixed amount of interest may be paid sooner, on whatever condi-
tions. The AlI, ABA and Advisory Group proposals (although there was some ambiguity
of wording in the latter two) 'would have made it sufflcient for safe harbor purposes if
a txed amount of interest were payable no later than maturity. See ALI SuN', supra
note 1266, at 434.
.387 See text at notes 378-87 supra. See Stone, Dcbt.Equity Distinctions iv. the Tax
Treatment of the Corporati n and Its Sharcholders, 42 TUL. L. TRh. 251, 272 (1968),
suggesting the importance of "equity benefit" even in the case of purported debt not
held by nominal shareholders. There appears to be no reasonable basis in law for adopting
the position of some courts that the same obligation is a debt with respect to the fixed
minimum "interest" and is stock with respect to the additional participation. See note3
386, 387 supra.
1388 See text at notes 388-91 supra. The Advisory Group proposal would have denied
safe harbor treatment if interest was "I excessive."

TAX LA&W REVIEW [Vol. 26 :
(6) "Subordination to ... any indebtedness of the corporation."

The subordination factor may be one of the most difficult to formu-
late in the regulations, not merely because subordination may take
such widely varied forms but because it is so easy to become emo-
tional over the question. Unquestionably, "[s]ubordination is not
condemned but is an approved business practice," l81 and no doubt
there is often a legitimate business necessity for shareholders to
subordinate their advances if they are to obtain outside credit or
s°-in
to satisfy certain minimum capitalization requirements 10 1
fact, it is hard to conceive of shareholder-creditors accepting
subordination if it did not serve a business purpose. But the issu-
ance of stock is not condemned either, so the business necessity for
some form of subordinated investment by shareholders has little
if any relevance to whether the investment is more in the nature of
stock or of debt and has no legitimate place in the test for distin-
guishing them.
The significance of the subordination factor undoubtedly varies
with the identity of the purported creditors. When subordinated
obligations are held by parties unrelated to the shareholders, they
differ in realistic ways from preferred stock: There will come a
time, short of winding up of the business, when they must be paid
absolutely; and interim defaults in interest payments may lead to
enforcement action. In such cases, subordination in itself should
not be viewed as a significantly adverse factor, unless combined
with others, such as provisions for contingent interest and con-
vertibility, that lessen, respectively, the risk of interim defaults
180
and the probability of having to make payment at maturity. '
Subordination takes on added and independent significance, how-
ever, when purported debt is held by shareholders. Since the conse-
quences of default on shareholder-held obligations are rarely of
much concern to the corporation, subordination vitiates the one re-
maining significant difference (parity with other creditors in bank-
ruptcy or liquidation) between debt and stock. The shareholder-
creditor, having priority over no one but himself, will be the last one
paid in the event of failure, and his investment is as much exposed
to the risk of the business as if his entire interest had been desig-
iss9 Bee note 294 supra.
isgi In Rev. Rul. 68-54, 1968-1 C.B. 69, the Service recognized subordinated debon-
tures as debt, despite a high ratio and partially contingent interest. Commissionor
Randolph W. Thrower, discussion the ruling in a speech printed in 25 Bus. LAW. 041,
644 (1970), stressed that the debentures were neither held by sharoholdors nor con.
vertible into stock.

1971] CORPORTE DEBT
nated as stock. 1392 The redemption (normally from the fruits of

success) of an investment that was thus far subjected to the risks of
the business would seem appropriately to be treated like a stock re-
demption, although an exception might be made for relatively short-
term subordinated advances if other factors are in order and if re-
payment is timely. On the other hand, solely for the purpose of the
interest deduction, if different rules are to be applied for that pur-
pose in order to avoid contributing to the competitive disadvan-
tage of small or struggling closely held businesses, it might be ap-
propriate to permit subordination of shareholder-held obligations,
33
subject to a ratio limitation.' 1
Obviously, subordination to one or a limited number of creditors
does not ordinarily have the same significance as subordination to
all creditors, but the line is not easily drawn since a seemingly lim-
ited preferred class may in fact embrace most of the creditors of a
particular business. The proponents of safe harbor proposals
thought they had found the formula in terms of subordination to
"the claims of trade creditors generally." But the requirements of
trade creditors may be met, without need for general subordina-
tion, by paying them promptly in cash from the proceeds of regular
working capital loans from banks or finance companies, senior to
the claims of shareholder-creditors.' 39 Holding or investment com-
panies, among others, although often heavily indebted, may have
few, if any, trade creditors. Therefore, in describing the kinds of
subordination which, in common with other factors, would cause
denial of interest deductions in the special case of debts incurred
in certain corporate acquisitions, Congress included subordination
not only to trade creditors generally, but also to "any substantial
amount of unsecured indebtedness, whether outstanding or subse-
quently issued." 1315 In the general context, however, the subordina-
tion of shareholders even to secured debts-e.g., when real estate
constituting the corporation's principal asset is heavily mort-
gaged or when inventory and receivables are regularly pledged
'394 It has been noted that, since trade creditors must ordinarily be paid within 30
to 60 days, the requirement that longer-term shareholder claims not be subordinated to
them seems of little importance in any event. Advisory Group iHcarings,supra note 1260,
at 1033-34.
2395 I.R.C. § 279 (b) (2), added by section 411 of the Tax Reform Act of 1969, see note
1244 supra. In the House version, only subordination to trade creditors was mentioned,
but the Senate recognized that the conglomerate holding companie3 dhich were the
targets of the provision might have few such creditors. S. REP. No. 91-552, 91st Cong.,
1st Sess. 139 (1969).

to the limit-may sometimes be entitled to consideration. 1 00 Sub-
ordination to a particular creditor may have greater weight than
it otherwise might have, if the subordination is not inchoate but
complete in the sense that the subordinated obligation may not be
paid even in the ordinary course of business while the senior debt
is outstanding; 1317 but the significance of that feature may depend
on the probability that the senior debt will be outstanding when
the subordinated debt matures.
A later voluntary agreement to subordinate shareholder-held
claims should be given almost the same weight as original sub-
ordination, at least unless the occasion arose from circumstances
unforeseen when the purported debt was incurred.1 8 8
In some cases, subordination to banks and like creditors may
be explainable by reference to their general policy to insist upon
subordination agreements (as well as guaranties) by shareholders
without regard to the corporation's financial strength. But the mere
existence of such a policy should not alone vitiate the significance
of subordination, in the absence of proof in a particular case that,
under the lender's established standards, the loans would have been
made without requiring subordination if the shareholder-held obli-
8
gations had been owing to a third party. 1
It is probably just as well to confine attention to express subordi-
nation, rather than turn the Tax Court loose to speculate on whether
the circumstances are such that subordination would be judicially
imposed in the event of bankruptcy-a matter on which the bank-
ruptcy courts themselves have evolved no very clear standards. 140
Any circumstances that might give rise to involuntary subordina-
tion, and that should properly have tax significance as well, might
1898 See text at notes 73-46 supra. See Advisory Group Hearings, supra note 1266,
at 796.
1399 See text at notes 975-81 supra. The safe harbor proposals would have ignored
subordination to banks in all cases because this policy of banks made it difficult to assess
the significance of the requirement of subordination in a particular case. The working
view of the staff of the ALI was that "the ratio test might better be used to control
the thin capitalization problem" in those cases where the bank's insistence on sub.
ordination might truly reflect insufficiency of equity cushion. ALI STAFP, supra note 1257,
at 432. But even the most stringent of the ratio tests in the safe harbor proposals was
hardly designed to be a fair measure of the adequacy of corporate capital to support
credit. See text at notes 1267 and 1280-82 supra. A more realistic ratio test (aee text
at notes 1405-25 infra) might make it less necessary to be strict on subordination, at
least for purposes of the interest deduction.
1400 See text at notes 326-37 and 1269 supra.

better be identified for purposes of the tax laws by express inclu-

sion in the regulations.
(7) "Preference over any indebtedness of the corporation."
The presence or absence of security is, of course, a factor to be
considered, although, as heretofore discussed, its weight either
way may vary with the circumstances.'4 1
(8) "The ratio of debt to equity of tMe corporation." The long-
lacking power to prescribe ratios 1402 has now been granted to the
Treasury in carte blanche terms. On the face of it, the Treasury
might, like the proponents of safe harbor legislation, set out delib-
erately to confer a tax advantage upon closely held (presumptively
small) businesses, by setting a permissible ratio much higher than
the market could ordinarily sustain; 1403 but I submit that, while the
range of discretion is broad, the prescribed ratio or ratios must at
least be relevant to the stated purpose of determining "whether the
corporation's debt-equity structure is such that it is reasonable to
expect that it will be able to meet its obligations to pay the prin-
cipal and interest... when due." 1404
Before considering the appropriate size of the permitted ratio,
it is necessary to define its components. From the standpoint of the
adequacy of the equity cushion to protect the purported debt from
loss, it seems most reasonable to compare the net assets of the
corporation, at their fair market value, 1405 with the sum of the
shareholder-held purported debt and all other debt which is prior
1L401See text at notes 543-59 supra.
1402 See motes 831 and 838 supra.
1404 S. REP. NO. 91-552, 91st Cong, 1st Sess. 137 (1969).
i4os See text at notes 852-70 supra. Unpaid stock subscriptions (ace note 847 supra)
should not be counted as assets, inflating the permissible debt, but should be netted
against purported debts to the shareholders whose subscriptions are unpaid. Section
279(c) (2), relating to disallowance of interest deduetions on corporate acquisition
indebtedness, looks to the adjusted basis (usually equal to net book value) of the assets
rather than to their actual value, which has the advantage of avoiding valuation prob-
lems but has little relevance to the economie reality of a purported debt, and can have
an adverse effect in the ease of corporations which hold highly appreciated assets or
-which have availed of accelerated depreciation, and wvhich can support more debt than
their book value would indicate. Hearings on H.R. 13270 Beforo the Senate Finance
Committee, 91st Cong., 1st Sess. 5191 (1969). The ABA and Advisory Group pro-
posals would have looked to the fair value of the nominal stock rather than to net
asset values (which may often be greater, in view of the umnarhotability of closely
held stock); but it is asset values, not stock value, that would concern a corporate
creditor, and it is probable that asset values would usually be more readily determinable
in the close corporations with which we are hero concerned. A formula for valuation is
suggested in Clary, Stockholder Debt-A Proposed Solution, 47 TAxS 682, 692-94
(1969). If the economic reality of the debt is the probandum, there is no reason to

to or on a parity with it,1400 as well as any subordinated outside
debt that is guaranteed by shareholders, 401 in each case including
both existing and reasonably anticipated obligations, 10 8 as of the
time the questioned advances are made. 409 Some commentators
have argued that it is "logical" to disregard debts to outsiders 1410
since "[s]tockholder-held debt is the primary concern." 1411 But
the staff of the ALI has acknowledged that disregard of outside
debt in the ratio can be justified, not on the basis of credit analysis,
but only as a means of conferring a tax advantage on the share-
holders of close corporations,14 1 2 for which I submit that Congress
has given no mandate. 41 3
Although the reasonableness of a 4 to 1 ratio of debt to equity
has been an article of faith among many tax practitioners,1 4 1 4 the
fact is that, except in certain fields such as rental real estate and
finance, one dollar of equity cannot support anywhere near four
dollars of debt arising from arm's length dealings. On the contrary,
while the trend, undoubtedly influenced by the tax laws, is rising,
provide, as the Advisory Group did (see note 1281 supra) an alternative test based on
historic capital investment. See ALI STAFF, supra note 1257, at 417-19.
1406 See notes 839, 840 supra.
1407 Note, Thin Capitalization and Tax Avoidance, 55 CoLUm. L. RFV. 1054, 1064
(1955); accord, Goldstein, Corporate Indebtedness to Shareholders: "Thin. Capitaliva.
tion'" and Related P'roblems, 16 TAX L. REv. 1, 18, 19 (1960).
1408 Under section 279, which is suggestive rather than preeedential for present pur-
poses (see note 1250 supra), even "short-term liabilities such as accounts payable" are
to be considered in the debt-equity ratio. H.R. Rnp. No. 91-413 (Part 2), 91st Cong.,
1st Sess. 78 (1969). Although inclusion of anticipated debts in the ratio gives rise to
some practical problems of measuring the ratio with precision (ALI SrAip, supra note
1257, at 415-16), failure to include them would place a premium on timing shareholder
advances with reference to outside debts. See note 843 supra.
1409 See text at notes 871-82 supra. For example, assume 2 to 1 is the acceptable
ratio. A corporation is formed with $1,000 in stock and $2,000 in purported debt to
shareholders. It buys land from a stranger for $9,000, paying $3,000 down and giving
a mortgage for $6,000. It expects to spend $15,000 in developing the land for sale, but
any resulting enhancement in value beyond the amount expended is speculative. The
gross assets when the project is completed will be $24,000, so the permitted ratio Is
$8,000 of capital and $16,000 of debt. With outside debt of $6,000, the recognizable
shareholder debt is $10,000. If the corporation later borrows $5,000 from a bank to
repair flood damage (an unanticipated need), that would not affect the recognition of
preexisting debt to shareholders, but would be takcn into account in classifying later
shareholder advances.
1410 Gerver, De-Emphasis of Debt-Equity Test for Thin Corporations Requires New
Defense Tactics, 23 J. TAXATION 28, 29 (1965).

1411 Caplin, The Caloric Count of a Thin Incorporation, 17 N.Y.U. INST. 771, 778
(1959). See also note 840 supra.

it appears that in cyclical businesses the typical ratio for even the
stronger companies may be as low as one dollar of debt to three
of stock, 415 and that even the more stable public utilities seldom
have a debt-equity ratio as high as 2 to 1.1411 A prescribed maxi-
mum ratio of 4 to 1 or higher would not only far exceed normal
arm's length standards and go beyond the asserted necessity of
eliminating discrimination in certain areas of the tax law, but
would hardly make it worth the trouble of formulating and ap-
plying a ratio test at all, since such a high ratio permits the tax-
payer to achieve safely 80 per cent or more of the tax benefits that
might be hoped to result from even an all debt capitalization.4
It is noteworthy (although it was not intended as a general prece-
dent) that, in the special case of disallowance of interest on cer-
tain acquisition indebtedness, Congress rejected a 4 to 1 ratio
and set the limit at 2 to 1.8
The ALI initially resisted the setting of any fixed ratio limita-
tion on the ground that "extremely high debt-capital ratios are
common, and even necessary, in certain industries." 1410 To impose
upon taxpayers in those fields a ratio determined by the general
1
practice of other businesses might result in "grave inequities."
On the other hand, to permit extreme ratios in all cases does not
seem a reasonable response to the fact that such ratios are "com-
1415 Chazen & Ross, Conversion-Option Debcntures, 79 YTLn L.S. 647, 648 (1970)
(quoting the chief executive of Bethlehem Steel Corp.); Hickman, Incorporation ard
Capitalization:The Threat of the "Potential Income" Item and a Sensible Approach
to Problems of Thinness, 40 TAx.s 974, 989 (1902); Spanbock, Carro & Katz, Nourish-
ing the Thin Corporation,34 TAxEs 687, 688 u.13 (1956). Cf. Pw O.TAz, FEDEA TAX
PoiaOY 108, 112-13 (1966); Lent, Bond Interest Deduction and the Federal Corporate
Income Tax, 2 N"r'L T. .X . 131, 138-39 (1949). The rapidly rising trend is evident in
the statistics for 1958 to 1968, in 1969 House Hearings,supra note 11-41, at 2380.
1416 Hickman. supra note 1415, at 989; Goldstein, supra note 1407, at 70.
1418 I.R.C. § 279 (b) (4) (A), see text at notes 1241-45 supra. See H.M . RiP. No. 01-782,
91st Cong., 1st Sess. 306, 307 (1969) (Conference Report on Tax Rleforn Act of 1969).
As a practical matter, the limit thereunder would generally be less than 2 to 1, because
the equity element was measured by adjusted basis of the corporate aets, wvhich in
an inflationary era would ordinarily be less than the value.
1419 1954 ALI,supra note 1266, at 232. See gcnra~ly text at notes 815-28 supra.
Note, Thin Capitalization and Taz Avoidance, 55 CoLu .. L. RiL. 1054, 1005
o420
(1955). I reserve for later discussion (see text at notes 1648-51 infra) tho question
-whether industries or companies which, because of their greater affluence and stability,
are able to subsist on a smaller maxgin of equity eapital should incur a leser burden
of taxes for the privilege of doing business in corporate form. The fact is that thoy are
subjected to lower taxes by present law, and Congress has given no mandate for a
change. If some members of an industry can gain such advantages through outside
financing, it is inequitable to treat less favorably the dosely held companies which
obtain a like proportion of their financing through loans from shareholders.

mon, and even necessary" in a few. 1 21 Flexibility may be achieved,
without opening the floodgates either to tax avoidance or to exten-
sive litigation, by setting by regulation a safe harbor ratio of 1 to 1,
or perhaps 2 to 1, which is reasonable and perhaps even generous
in the light of general experience, 4 22 and requiring those exceeding
that ratio to justify themselves by showing that their capitalization
is comparable to that which is common among those in their indus-
try dependent upon outside financing.'42 The Treasury might fur-
ther narrow the area of controversy by establishing additional
safe harbor ratios for particular industries, such as rental real
estate, where high ratios are well recognized and norms can readily
be established.14 24 In the case of certain financial institutions whose
function is to act as middlemen in assembling funds from the public
to lend to others, the amount so obtained might appropriately be
excluded from consideration on both sides of the ratio.4
As an alternative where the permissible debt-equity ratio is ex-
ceeded or cannot readily be applied, the regulations might appropri-
ately provide that debt may nevertheless be recognized upon a
showing of the sufficiency of projected cash flow to cover interest
payments and to retire the purported debt in accordance with its
terms. Although not listed as a statutory factor, the test has sup-
port in the cases 1426 and there is precedent of a sort in the new
provision on corporate acquisition indebtedness, which prescribes,
as an alternative to the debt-equity ratio test, a test based on
treble coverage of interest (but not principal) payments by pro-
1427
jected cash flow.
1421 Goldstein, Corporate Indebtedness to Shareholders: "Thin Capitalization" and
Belated Problems, 16 TAx L. Rv. 1, 65 (1960).
1422 Id. at 75; accord, Hickman, supra note 1415, at 989.
1423 Cf. Goldstein, supra note 1421, at 73-75, proposing that interest be made allow-
able on a reasonable portion of shareholder advances, determined by reference to 'Ithe
stability of the business, its earnings record, and the capital structures of both closely-
and widely-held corporations engaged in similar ventures." Reference to comparatives is
a familiar way of establishing the reasonableness of compensation. Reg. § 1.162-7(b) (1).
Comparison with other shareholder-financed businesses would not be probative since it
assumes the point in issue, that their own purported debts are bona fide. See note 814
supra.
1424 It might be appropriate also, with respect to corporations generally, to apply
separate norms to secured and unsecured debts. For example, if one to one was con-
sidered the maximum acceptable ratio for a manufacturing business, but a factory could
be mortgaged at arm's length for 75 per cent of its value (a 3 to 1 ratio), the tests
might be applied separately to each category.
1425 Cf. I.R.C. § 279(e) (5); see note 827 supra.
1427I.R.C. §§ 279(b) (4) (B) and (c)(4). Here also a special rule is provided for
financial institutions which act as middlemen for funds. I.R.C. §§ 279(c)(5)(B) and
(C). The earnings coverage test as applied under section 279 is described in Silverstein,

It may be appropriate to specify that the debt-equity ratio and

earnings coverage shall be measured anew when new interests
purchase the controlling stock and previously recognized debt of
a corporation, since its true status in their hands may be quite
different if the corporation has gone downhill since the debt was
incurred. 1 2
The application of any ratio or coverage test may be punitive
in its effects, if a taxpayer's misjudgment, say, of asset values or
(if a flexible test is adopted) of the permissible ratio may cause
total nonrecognition of a purported debt.1 42 9 In cases where the
other relevant factors are sufficiently indicative of debt and only
the ratio and coverage factors are adverse, the regulations should
provide for recognition of so much of the purported debt as does
not exceed the difference between the total outside debt and the
maximum amount of debt permissible under the more favorable of
the tests, determined as of the time when the purported debt is in-
curred.4 3 Admittedly there are practical problems in implement-
ing this proposal, but they are not insurmountable 14 3 and they
should be faced rather than "seeking refuge in an all-or-nothing
approach" which would "yield a result far removed from re-
ality." 1432
Although all the obligations of a corporation should be taken
into account in computing the ratios, not all can appropriately be
subjected to the ratio tests. 1 433 It seems reasonable to immunize
Impact of the Acquisition Indebtedness Provisions of thle Tax Reform Act of 1969 on
CorporateMergers, CoxGLomERA MmoERS AD AcquisrioNs: OPnior AD A.rALrSIS,
44 ST. JomH's L. ERV. 1014, 1034-35 (spec. ed. 1970).
1429 The courts have never heretofore divided a single purported loan into a reason-
able amount to be recognized as debt and the balance to be deemed stoclr. Brir n &
EusTica, tFEBAL IiTco= TAXATION Op CORPORATioNS mmD SmHurDfoD1ms 122 (2d ea.
1966). They have frequently, however, applied different treatments to advances mado
at different times and under different circumstances. See note 851 supra.
u30 Cf. Goldstein, supra note 1421, at 67. Neither the ABA nor Advisory Group pro-
posals provided for fragmentation of purported debts which exceeded the ratio, although
the version initially approved by the ABA Committee on Corporate-Stockholder Rela-
tionships had so provided. Compare ABA TAXATION SECTIOi, PnOGHA2£ AND Comnr =
REPORTS 36 (1956), with, the final version in 81 ABA 112. 160-61 (1951). The Com-
mittee on Taxation of the Philadelphia Bar Association urged a similar amendment of
the Advisory Group proposal. 1958 House Hearings, supra note 163, at 3239-40.
,431 ALl STA=, supra note 1257, at 425-28.
1432 ee C..L Gooch Lumber Sales Co., 49 T.C. 649, 657 (1968). In American Process-
ing & Sales Co. v. United States, 371 F.2a 842, 856 (Ct. CL 19G7), the court recognized
all the questioned advances as debt rather than approve the government's position
which would "impress on [the corporation] an all-capital rather than a mostly debt
structure, a more absurd result than reason permits to be entertained.'.
.433 "The issue of what obligations are to be tested by the ratio is not to be confused

truly temporary financing by shareholders, where timely repay-
ment is in fact made within a year, or perhaps two. 43' The ratio
limitations also cannot very well be applied to test the economic
reality or substance of obligations neither owed to nor guaranteed
by shareholders 1415 or those united in interest with them,"" at
least if the obligations are not convertible or otherwise endowed
with an equity participation. 41 3 7 When advances made or guaran-
teed by shareholders and parties related to them are not propor-
tionate to their equity interests, the amounts in excess of their
proportionate share of the total purported debt to shareholders
and related parties might appropriately be relieved of subjection to
the ratio or coverage test; 148 but if such excess advances are
made for a relatively long term and if the failure of others to match
their advances proportionately is explained by their rendition of
vital services, it may be reasonable to view the excess advances
4 9
as preferred stock if the tests are not met. 3
(9) "Convertibility into stock of the corporation." Since con-
vertibility has not heretofore been viewed as a significant factor
indicating that purported debt is in substance stock,1440 the Treas-
ury will be writing on a clean slate in giving effect to the evident in-
tention of Congress that, at least in some circumstances, a bond
with the issue of what obligations are to be utilized in computing the ratio." ALI STAFF,
supra note 1257, at 421n. When the permissible amount, at any given time, has been
computed, the debts not subject to the ratio limitation should be subtracted therofrom,
and the remaining purported debts, if otherwise qualified, should be recognized to the
extent of the balance of such amount.
1435 See text at notes 595-600 supra. Although some public corporations have over-
extended their issuance of debt obligations, it is probable that "catching them in the
thin incorporation net will require a little more weaving than we now have." Knicker.
bocker, Miching Mallecho: The Tax Beformers' Sneak Attack on Conglomcrates, CON-
GLOMERATE) MERGERS AND ACQuiSITIoNS: OPIlNION AND ANALYSIS, 44 ST. sOHN'SIL. REV.
1047, 1071 (spee. ed. 1970).
3436 See text at notes 614-30 supra and at notes 1462-66 infra.
1438 See text at notes 601-13 supra. Cf. S. REP. NO. 91-552, 91st Cong., lot Seso. 134
(1969), relating to certain tax benefits of multiple corporations, viewing one who owns
70 per cent of one corporation and 30 per cent of another as holding 30 per cent
"identically. I
1439See text at notes 631-36 supra. The very fact of an abnormally high ratio,
coupled with the obligation to finance the business in return for the other's sorvices,
tends to negative arm's length dealing with respect to the purported debt. The parties
should not enjoy a tax windfall by reason of their division of the service and financing
functions. The ALI staff concluded, although mainly on the ground of avoiding corn-
plexity, that disproportionate shareholder advances should not be exempted from the
ratio tests. ALI STAFF, supra note 1257, at 421-23.
.440 See text at notes 367-77 supra.

which "will allow the bondholder to participate in the future growth
of the company" should be viewed as "more nearly like equity
than debt." '"' Not merely the weight of history, but the very real
fact that the holder of a convertible obligation has the option to de-
mand that he be paid like any other creditor, 14 2 argues against any
sweeping declaration that convertibility alone makes the equity
feature predominant. In combination with other factors, however,
it may indicate that the corporation is in substance merely making
"a postponed sale of stock [and] in the interim ... using the inter-
est payment as a deduction... to avoid tax liability, 1 4 13 and that,
to the bondholder, "the dominant attraction of the debenture is in
the right, through conversion, to participate in future growth [by]
cashing in on the stock rise [rather than by] collecting a
'debt.' ",14"
The features which may cause convertible obligations to be more
nearly like equity are suggested in a speech delivered by the Com-
missioner of Internal Revenue in October 1969, although he was
addressing himself to the special problem of debts arising from
acquisitions by conglomerates. 144 In such acquisitions, he noted,
the "convertible debentures may .. be subordinated to various
classes of other creditors," it "appears reasonable to conjecture
that the... earnings ... may not be adequate to service the princi-
pal of the convertible debentures, together with its interest obliga-
tions," 16 and "the mere size of the convertible debentures to be
issued can.., create a 'thin capitalization' situation .... Where
... a top-heavy debt structure results," he concluded, "it is difficult
to see how the former owners of the acquired corporation suddenly
become prudent lenders." 1447 Contrasting a revenue ruling in
which the Service had recognized as debt certain subordinated obli-
gations of brokerage firms despite a very high debt-equity ratio,
he noted that the funds therein "were being advanced by strangers
-with no equity in the corporation," and that "I[t]here was no ele-
ment of convertibility into equity." 14 8 It would appear, therefore,
3. S. RF'. No. 91-552, 91st Cong., 1st Sess. 137 (1969). See also H.R. RU. No.
91-413 (Part 1), 91st Cong., 1st Sess. 103-04 (1969).
1442 1969 House Hearings,supra note 1241, at 2513.
1443 1969 House Hearings, supra note 1241, at 2372 (statement of Rep. Byrne3).
14 Speech of Commissioner of Internal Revenue Randolph W. Throwver to the Na-
tional Institute of the American Bar Association, October 23, 19G9, printed in 25 Bus.
LAw. 641, 616 (1970).
1445 Ibid.
144r Id. at 645.
1447 Id. at 646.
1448sId. at 644, discussing Rev. Rul. 68-54, 1968-1 C.B. 69.

that convertibility may cause purported debt to be judged by stan-
dards similar to those applicable to shareholder-held claims, and
that subordination, high debt-equity ratio and inadequate cover-
age by cash flow may have greater significance than in the case
of obligations held by persons who neither are nor have the option
1449
to become shareholders.
Another feature that might possibly be considered to make
convertibles more nearly like equity is the remoteness of the ma-
turity or call date, enhancing the probability, in a generally infla-
tionary economy, that the bond will be converted rather than re-
deemed. 1450 As previously noted, however, there may be good reason
to treat convertibles as debt for purposes of taxing their receipt in
reorganization exchanges, even if they are viewed as stock for other
1451
purposes.
Although the statutory list of factors for consideration refers to
convertibility and not to the inclusion of stock warrants in an in-
vestment unit with the purported debt, the list is expressly non-
exclusive and the Treasury may determine to give the same weight
to either feature, as Congress itself has done in disallowing deduc-
tions for interest on certain acquisition indebtedness. 14 2 There is
a significant difference, in that the obligation will remain outstand-
ing even after the warrant is exercised; but the bondholder's will-
ingness to accept the risks of subordination and excessive ratios
evidences that his potential equity interest predominates, and may
make it appropriate to judge such an obligation, as well as one that
is convertible, by the standards made applicable to disproportion-
43
ate purported debts to shareholders.1 1
10. "The relationship between holdings of stock in the corpora-
tion and holdings of the interest in question." Although there is no
warrant under present law for denying recognition of purported
1449 Under section 279, disallowance of interest on certain corporate acquisition in.
debtedness is required only if both subordination and failure of the ratio or coverago
tests coexist with convertibility. Since the rules of section 279 are not binding upon tho
Treasury in framing the general regulations distinguishing debt from equity, however
(I.R.C. § 279(j); S. REP. No. 91-552, 91st Cong., 1st Sess. 238-39 (19609)), either
subordination or top-heavy debt alone might conceivably, although improbably, bo made
sufficient to cause nonrecognition of convertible bonds as debt.
145o See note 377 supra.
1452 I.R.C. § 279(b) (3) (B). See Silverstein, Impact of the Acquisition Indebtedness
Provisionsof the Tax Beforin Act of 1969 on CorporateMergers, CONGLOMERATE MEROERS
AND ACQUISITIONS: OPINION AND ANALYSIS, 44 ST. JOHN'S L. Rzv. 1014, 1036 (spec. od.
1970).

1971] CORPORITE DEBT
debt merely on the ground that it is held by shareholders, 4 " it

is the existence of such relationship (including possibly the poten-
tiality thereof, through conversion) 4Ur that makes the formal
factors, which interested parties may disregard in practice, insuffi-
cient as tests of the reality of debt and necessitates that additional
factors be considered. The ratio factor, which in effect imposes a
rule of reason that the market would be expected to impose in arm's
length dealings, is ordinarily relevant only if some relationship
exists; 145 6 and adequacy of consideration is almost irrebuttably
presumed in the absence of a relationship., T Subordination,
unless combined with other factors, has much less weight where the
purported creditors are unrelated.'" To the extent that non-
statutory factors bearing on intention and risk are to be considered
under the regulations, they would be relevant only where there is
a relationship.1 4 9
Truly random and fortuitous relationships between holdings of
stock and purported debt should not characterize an obligation as
shareholder-held for purposes of making applicable those addi-
tional factors (such as the ratio test) ; but variations in holdings
which are not of such nature and magnitude as to be apt to cause
the purported creditor to act in disregard of his shareholder in-
terest should be given no effect. In appropriate circumstances, the
excess of one's holdings over his proportionate share of all pur-
ported debts to shareholders and related parties might be relieved
of application of the additional factors.1 4 0 If obligations are guar-
anteed by shareholders, the shareholders should be considered as
standing in the shoes of the nominal obligees.'4 0
Although no statutory attribution of ownership rules are made
applicable for the purpose of distinguishing debt from stock,1 40
the delegated authority to consider the "relationship" between
45 See text at notes 572-76 supra. Seo Stone, Debt-Equity Distinctions in 11he Tax
Treatment of the Corporation and Its Shareholders,42 TUL. L. Rriv. 251, 200-02 (1968).
Even the fact that holdings of stock and debt may be locked together by agrcement (ace
text at notes 586-91 supra) should not be a ground for nonrecognition, provided
separate enforcement action is permitted without restraint and the other factors are in
order.

TAX LAWV REIEW [Vol, 26 :
holdings of stock and purported debt seems sufficient to permit the
regulations to take into account the holdings of those whose rela-
tionship to the shareholders is such that they may be expected to
place the debtor corporation's interests ahead of their interests as
creditors. In identifying those purported debts which are to be sub-
ject to the tests applicable to shareholder-held obligations, both
stock and purported debts owned by corporations, 1413 partnerships,
trusts 14 4 and estates should be viewed as if held by the ultimate
beneficial owners. Family attribution should not be applied arbi-
trarily, as under section 318 of the Code, but with reference to
the actual unity of economic interest and generosity of motivation
of the parties, 146 5 including in some cases family members (such as
siblings and in-laws) who would be beyond the reach of an arbitrary
attribution rule; 1466but the very fact that a family member assumes
the risks of an abnormally high debt-equity ratio and other de-
partures from arm's length credit standards should in itself make
a prima facie case that the dealings are not at arm's length.
The regulations should also deal with the much mooted but never
adjudicated question of whether a purported debt, originally sub-
ject to nonrecognition under the rules applicable to shareholder
held obligations, may be transmuted into good debt when transfers
of either stock or debt to unrelated 7parties terminate the relation-
ship between the holdings thereof.146
Nonstatutory Factors
The Treasury is clearly authorized to prescribe that factors
408
other than those set out in the statute shall be taken into account.1
While a proliferation of factors should be avoided if possible, the
following may be considered.
1465 Cf. Estate of Arthur H. Squier, 35 T.C. 950, 955 (1961).
1466 See text at notes 614-25 supra. Treatment of relative-held purported debt as
stock, if it fails, for example, the ratio test, would not cause its redemption to be taxed
as a dividend unless the express attribution rules of section 318, were satisfied. But it
might cause denial of the corporate interest deduction and other tax bonofits.
1407 See text at notes 758-65 supra. In ALI STAPF, supra note 1257, at 428-29, "the
most desirable" solution is said to be that "disqualification [continue] only so long
as the obligations are held by shareholders." But the collateral consequences of the
transmutation should be considered.
140s see text at notes 1249-50 supra. Mention has previously been made of such pos.
sible nonstatutory factors as the nature of the remedies for default (notes 1304-06
supra), inadequate interest (note 1383 supra), excessive interest (note 1388 supra), earn-
ings coverage (notes 1426-27 supra), and the inclusion of stock warrants in an invest-
ment unit (notes 1452-53 supra).

(1) Name of the instrument. The fact that an instrument is or is

not labeled preferred stock should, in itself, have no weight, al-
though any incidents which the corporate law may attach to an
instrument so labeled should be taken into account.1" 0 In. partic-
uJar, the preferred stock label should not bind the revenue when it
is adopted by the parties to conceal the true nature of a transaction
and gain a tax advantage. 470
(2) V7oting rights. The absence of voting rights should be ac-
corded no significance. And it is doubtful that, if other factors in-
dicate bona fide debt, the existence of voting rights should have any
adverse tendency, unless such rights stand in the place of, rather
than supplement, the normal protections and remedies of credi-
tors ,17. or enable shareholder-creditors to alter materially the
rights of their fellows. 1472
(3) Payment history. If financial ratio tests are adopted which
realistically reflect the level of debt that would result from arm's
length dealings, it should be possible to dispense with the more
subjective and speculative criteria bearing upon the intention of a
shareholder to act like a creditor.1 473 Nevertheless, objective evi-
dence that the corporation failed to make reasonable provision for
payment 1 47 4 or that the purported creditor did not insist upon
his rights might fairly be taken into account as indicating that the
maturity date and other formal terms were, from the inception, a
mere facade, thus disqualifying otherwise recognizable debt.1415
(4) Ristc factors. Now that the debt-equity ratio test rests upon
clear congressional authority, I hope that it may be possible to
supplant therewith the several criteria which, during the "experi-
mental period" of the law, 47 6 were developed to test the economic
reality of the form adopted; ,4 but this hope is conditioned upon
the adoption of a flexible ratio test that fairly reflects the standards
to which corporations generally, in each industry, are subjected by
the marketplace.1 478
If a purported debt to shareholders meets all the requirements
1472 See text at notes 254-56, 262, 274, 275 and 434 supra.
1-,75 See text at notes 690-746 supra.
1476 See Miller Bros. Co. v. Maryland, 347 U.S. 340, 344 (1954).
1477 See text at notes 766-997 spra.

TAX LAWV REVIEW% [Vol. 26 :
concerning form, nonsubordination, etc., that may be prescribed
by the regulations, and the proportionate size of the equity cushion
is comparable to that which the regulations and the marketplace
impose upon competing firms, a corporation whose size, stage of
development, and prospects for immediate success are not such as
to qualify it for independent credit of comparable amount should
not thereby be denied the opportunity to obtain interest deductions
commensurate with those allowable to its competitors. Therefore,
at least for purposes of the interest deduction, 14 9 the "independent
creditor" test might well be laid to rest.1 8 0 On the other hand, if
different definitional standards may be applied for different
purposes of the tax law, it may be appropriate to retain
the "independent creditor" criterion as an additional and over-
riding limitation where the issue is whether repayment of the
purported debt to shareholders out of earnings should be subjected
to dividend tax.148 1 Since competitive disadvantage is not here a
consideration, it should suffice to permit the shareholder to ac-
complish as much but no more of a "bail-out" of earnings than could
have, in effect, been accomplished if he had committed to capital
so much of the necessary funds as the particular corporation could
not have obtained by borrowing from outside sources.'4 82
Also slated for oblivion should be the question whether the pur-
ported debt was incurred in acquiring the essential assets of the
business.' 183 Essential assets are often acquired with the aid of
outside credit, and the controlling consideration should be, not the
use made of the funds, but the probability of their repayment
without forced liquidation of those assets. A ratio test reflecting
industry standards, possibly supplemented for some purposes by
a more particularized test of what an independent creditor would
advance, should suffice to establish that fact.
(5) Tax motivation and business purpose. Nothing need be added
to the previous discussion of the illegitimacy of these factors as
1481 See text at notes 1316-18 supra. Since the relevance of the independent creditor
test to the distinguishment of debt from equity is recognized by the courts, this addi-
tional strictness would be within the scope of the legislative mandate, assuming multiple
standards are deemed authorized.
1482 To the extent that the actual availability of outside credit would have enabled the
shareholder to limit his capital commitment, there is no point in penalizing the use of
shareholder loans even though their repayment accomplishes a bail-out. Of. Cromwell
Corp., 43 T.C. 313, 320-22 (1964), construing section 269 as inapplicable where alterna-
tive, acceptable means of tax avoidance were available.

evidence of whether an investment is truly debt or stock. 4 4 If it is

otherwise debt, it should be recognized as such even if the sole mo-
five for not using an all-stock capitalization was to obtain the
tax advantages -whichthe law allows. If application of the relevant
factors identifies it as in substance stock, it is stock despite the
strongest of business reasons for using it.
The Need for Legislative Reappraisal

The fault, dear Brutus, is not in our definitions but in our diehotomy. 14S5
There is nothing more complex than trying to draw a line which does
not exist.14 6
IT GBxEI 1
Judicial efforts to distinguish debt from equity capital have not

only "generated intolerable confusion" 4 87 but have produced tax
results repugnant to anyone schooled in the "ability to pay" theory
of taxation. An essentially formal distinction (between debt and
preferred stock) has been overlaid with an unreal criterion (whether
a shareholder would act like a creditor if his own corporation should
default), the reality of which is tested by a discriminatory standard
(in effect requiring the risky business to pay higher taxes on the
same revenues than one which is established and affluent or has
some assurance of success). 1488 It is improbable that the Treasury,
presumably -unwilling to let down the bars to abuse yet having no
mandate for a really new departure, can do more than winnow and
clarify the evidentiary factors bearing upon those existing stan-
dards.14 9
1485 Adapted from SHA sPaE, JuIuS CAEsAR, act I, scene iL
1486 Lanming, Some Bealities of Tax Beform, 1 Cou"APnirUm op PAPEnS o Bno.x-
ENmG THE TAx BAsr 19, 55 (Comm. Print 1959).
1488 See text at notes 923-41 supra. The companies whose debts are disqualified by the
risk test are "most likely . . . the new, the small, the high risk companies .... It
would be ironic if judicial embroidery in this area, purportedly designed to effectuate
Congressional poliey, was in fact designed to work at cross purposes with the demon-
strated. Congressional philosophy of encouraging this type of business activity." Hich.
man, Ineorporation and Capitaliation:The Thrcat of the "Potential Income " Item
and a Sensible Approach to ProbUems of Thinncss, 40 Tas 974, 98G (1902). Mr.
Hickman's proposed test, however, based upon coverage by assured cash flor., while
supportable under present law, does not remove the discrimination against corporations
with no such assurance of success.
14s9 The regulations are to determine, among other things, whether "it is reasonable
to expect that [the corporation] will be able to meet its obligations . . vhen due."
S. Rmn. No. 91-552, 91st Cong., 1st Sess. 137 (1969). See text at notes 1473-83 supra.

I submit that it is time for Congress to reexamine the purposes,

if any, served by distinguishing debt from equity and, to the extent
that it is possible, to bring that fruitless exercise to an end. It is
necessary to frame clear questions before we can hope for clear
answers. The pertinent questions are not whether "the stockholders
[or] the Government [should] have the right to determine the
financing arrangements of a corporation"; 140 nor whether the
stockholders should be "foreclosed from financing a transaction in
a manner to provide a minimum exposure of their assets to the
risks of the venture"; 1401 nor whether the tax laws and adminis-
trators should "dictate what portion of a corporation's operations
shall be provided for by equity rather than by debt" 40 2 and "re-
write corporation balance sheets to reflect a Government version
of glowing corporate health." 1493 Those are loaded questions, sug-
gesting that the tax laws are invading a province properly left to
the business judgment of the owners, subject only to the laws of
corporations and of creditors' rights. The truly pertinent ques-
tions, relevant to the soundness of the tax system, are whether the
tax laws should discriminate against equity capital and discourage
the formation of new and risky enterprises on which the growth
of the economy depends; 1 94 whether the tax laws should compel
corporations, if they are to remain competitive, 14 to make the
maximum possible use of debt financing, even to an extent that
may be unhealthy in the case of outside debt 1410 and unrealistic in
149o Liflans Corp. v. United States, 390 l.2d 965, 971 (Ct. Cl. 1968); accord, ABA
TAXATION SECTIOIN, PROGRAM AND COMMITTEE REPO1TS 37 (1956) (also found in Ad-
visory Group Hearings, supra note 1266, at 934) ("some area of cortainty should bo
established by legislation within which corporations might be financed with assuranco
that what investors desire to be treated as debt will be so treated." (emphasis added)).
1491 Santa Anita Consolidated, Inc., 50 T.C. 536, 551 (1968); accord, Byorlito Corp.
v. Williams, 286 F.2d 285, 290 (6th Cir. 1960).
1492J.S. Biritz Construction Co. v. Comm'r, 387 l.2d 451, 458 (8th Cir. 196);
Nassau Lens Co. v. Comm'r, 308 F.2d 39, 46 (2d ir. 1962); Estato of Millor v.
Comm'r, 239 F.2d 729, 734 (9th Cir. 1956).
1493 American Processing & Sales Co. v. United States, 371 F.2d 842, 853 (Ct. Cl.
1967); accord, Rowan v. United States, 219 F.2d 51, 54 (5th Cir. 1965).
1494 SMrH, F DRnAL TAX lixo0Rm 192 (1961) ; Blakely & Zebms, A New Loob at thi
Corporate Income Tax, 20 TAX EXEC. 287, 291-92 (1968); Weis, The LabVrinth of the
Thin Corporation,40 TAXES 568, 589 (1962).
1495 See Murphy Logging Co. v. United States, 378 F.2d 222 (9th Cir. 1967) ("Often
an inefficient operator, wise as to taxes, can do better than an efficient operator wbo
is stupid about his taxes. "1).
1496 PEOHM~AN, FEDERAL TAX POLICY 112 (1966) ; Blakely & Zehms, A Noto Loolk at the
Corporate Income Tax, 20 TAX EXEC. 287, 291-92 (1968); Lent, Bond Interest Deduc.
tion and the Federal Corporation Income Tax, 2 NATI'L. TAX J. 131 (1949). But of.
BrTTKER & EUSTICE, FEDERAL INCOMnE TAXATION OP CORPORATIONS AND SHAREHOLDERS

the case of debt to shareholders, 4 " or whether the tax laws should
be as neutral as possible in their effect upon such business judg-
ments; 48 and finally, whether an equitable and efficient tax system
can longer tolerate a self-selected tax burden, permitting a tax-
payer, by exercising his admittedly free right to choose a capital
structure, to determine for himself how large a tax shall be borne
for the privilege of doing business in corporate form.
Such a self-selected tax burden is what we have today, subject
to suct relatively modest restraints as may be imposed by the courts
and, hereafter, by the regulations. 1419 The congressional ideal of
so framing the corporate tax provisions as to "insure that the
same tax consequences result from the different types of transac-
tions which are available to accomplish substantially the same
result," so that "taxpayers cannot, by choosing the type of trans-
action, in effect choose the type of tax for which they are liable," ,OO
has not yet been applied with respect to corporate debt. In the sim-
plest case, one who (not having consulted a tax planner) contrib-
utes money and property to a controlled corporation solely for
stock, and later recovers his. stake through distributions out of
earnings, whether in redemption of stock or otherwise, will be sub-
119-20 (2d ed. 1966), suggesting that "the opportunity to 'trade on a thin equity'
may attract speculative investment by shareholders, with favorable consequences for the
national economy that in the long run, may outweigh the dangers of excessive debt."
Although the SEC and many state regulatory agencies bave long urged the reduction
of bondea debt, it is reported that "Many [public utility] commissions appear to believe
that there really is not only nothing immoral in carrying heavier debt in order to relieve
the tax burden, but they seem to think it almost immoral not to do this, vhere the
alternative is subjecting the public to higher rates." Ardery & Abner, Income Bonds
Bevisited, 57 PUB. UTIL. FoRT. 517, 523 (1956).
1498 The confusion of the questions is evident in Spanbock, Carro & Katz, 2Itourishing
the Thin Corporation, 34 TAx s 687, 687 m.4 (1956), whih states the tax neutrality
ideal as the premise for the conclusion that the taxpayer should be entitled "to utilize
usual patterns of corporate fnancing," and to cajoy, Ae tax conscquences of the form
chosen.
149 The "courts have not attributed to Congress a general purpose . . . to deprive
the taxpayer in each case of freedom to ch-oose between legal forms similar in a broad
economic sense but having disparate tax consequences .... It is all very well to smy
that it makes little 'economic' difference whether the investment here =as divided
between debt and equity or was entirely allocated to equity. But by the same rensoning
it may make little Ieconomie' difference to (the shareholder] whether he has an unincor-
porated. business or a corporation in which he is the sole stockholder.... But this
Code... recognizes and treats corporations as separate entities and affords significance
to the type of investment chosen in them so long as that investment has substantial
economic reality . ." Nassau Lens Co. v. Comm'r, 308 F.2d 39, 44-45, 40 (2d Cir.
1962).
.500 H, REP. No. 1337, 83d Cong., 2d Sess. 39 (1954).

TAX LAWV REMIEW [Vol. 26 :
jected to dividend tax, because Congress considers that he still
possesses his stake in the form of stock of the continuing enter-
prise, and that his first withdrawals are from profits. 1501 But if
(having been better advised) in his corporate capacity he promises
himself that payments equal to a substantial portion of his invest-
ment will be made to him, and if the economic reality of the prom-
ise is assured by the prospect of sufficient earnings, he may recover
so much of his stake from earnings free of dividend tax, and the
earnings applied to interest will escape corporate tax. 11°2 Further,
in the case first stated, he will generally have neither taxable gain
nor deductible loss on the property exchanged for stock of the
corporation, which will succeed to his basis for depreciation and
gain or loss thereon, because it is the view of Congress that no real
change in beneficial interest has occurred.60o But if the corpora-
tion purchases the property from him, and the earnings prospects
are so good that it can give him a relatively short-term obligation
having economic reality, the corporation may enjoy a stepped-up
basis (at the expense of a taxable gain to him), 1 04 although his
continuing beneficial interest in the property, even after the obli-
gation is fully paid, will be the same.
The federal corporate income tax is at best an imperfect instru-
ment. It is criticized, on the one hand, as discriminating against
business conducted in corporate form, in that corporate earnings
are twiced taxed, once to the corporate entity when earned, and
again to the shareholders when earnings are distributed as divi-
dends or when sale or redemption of the stock or liquidation of the
corporation realizes the value of the undistributed earnings. It is
criticized, on the other hand, as enabling the shareholders by vari-
ous devices to use the shield of the corporate entity to escape or
mitigate the impact of progressive individual tax rates while ac-
cumulating wealth. Perhaps one day a politically, economically and
administratively feasible plan will be devised and put into effect
whereby the double taxation may be relieved without at the same
time enlarging the existing tax shelter of the corporate form.101 5
As a small step in that direction, subchapter S of the income tax
'5o See text at notes 1113-15 and 1283-86 supra.
1503I.R.C. §§ 351(a), 362(a). See Portland Oil Co. v. Comm'r, 109 l.2d 479, 488
(lst Cir.), cert. denied, 310 U.S. 650 (1940).
1505 Among many such criticisms and proposals, see 3 COMPENDIUM or PA'mS ow
BROADENING THE TAX BASE 1537-1609 (Comm. Print 1959); PEOHMrAN, FIPDElAL TAX
PoLicY 134-38 (1966); SMiTH, FEDERAL TAx BEFoRM 205-18 (1961).

law 150 6
has relieved many closely held corporations of the corpo-
rate tax burden, conditioned, however, on the shareholders' ac-
ceptance of most (although not all) of the tax consequences of un-
incorporated operation1 0 0 7 Nevertheless, with
all its faults, the
corporate income tax remains our second most productive tax,1 3
and realistic tax reform must start from the assumption that it will
be a part of our tax system for the foreseeable future.'15° For
those taxpayers whom Congress has not seen fit to make eligible
for subehapter S relief, 1510 and for those who, finding greater tax
benefits for themselves in the shelter of the corporate entity, have
not chosen to accept the conditions, Congress should endeavor not
"to provide an escape from the liabilities that it sought to im-
pose." 1511
Fiscal expediency aside, the excuse for taxing the corporation
as an entity, in addition to taxing the shareholders, is that the
"choice of the advantage of incorporation to do business . . .
require[s] the acceptance of the tax disadvantages." 1_12 Among
the advantages attainable by incorporation are the ability to limit
"the personal liability of the participants to the property em-
1506 I.R.C. §§ 1371-79.
1507 The shareholders must pay tax at individual rates on undistributed corporate
income (I.R.C. § 1373), and retirement benefits for shareholder-employees of subchapter
S corporations have now been subjected to limitations similar to those imposed by H.I.
10 in the case of the proprietors of unincorporated businesses (LEXO. § 1379, added by
section 531 of the Tax Reform Act of 1969). But certain tax-free fringe benefits
allowed for corporate owner-employees and not for individual operators may still be
enjoyed. E.g., I.R.C. §§ 101(b), 105, 106, 119, 421-25.
:15o8In the fiscal year 1969, the corporate income tax accounted for about 20 per cent
of all internal revenue collections, second only to the individual income tax. Co'.nns-
SIONER op IINTERiAL R.EVEg ANNUAL REPoRT 108 (1969).
S029o6e Sinf, FDE AT TAx REFORMI 189, 191 (1961); Blakely & Zebrs, A New
Look: at the CorporateIncome Tax, 20 TAx EXEc. 287, 288-89 (1968); Cohen, Surrey,
Tarleau & Warren, A Proposed Bevision of the Federal Income Tax Treatment of the
Sale of a Business Enterprise,5- Cor.umn L. ERv. 157, 159-0 (1954).
1510 LR.C. §§ 1371(a), 1372(e) (5). Relaxation of the eligibility requirements, as well
as amelioration of some of the faults that have made subeapter S unattractive, has
been recommended by the administration but not yet adopted. 1909 House Hcarings,
supra note 1241, at 5228-75.
15-" [W]e cannot suppose that it was part of the purpose of the act to provide an
escape from the liabilities that it sought to impose." Gilbert v. Comi'r, 248 F.2d 399,
411 (2a Cir. 1957) (L. Hand, J., dissenting). See Chirelstein, Learned Hand's Con-
tribution to the Law of Tax Avoidance, 77 YALE L.J. 440, 473 (1968), inferring that
Judge Rand "thought it unlikely, and at any rate pointless and self-defeating, that
Congress should have included in its principal taxing statute both high-tax and low-tax
alternatives -which the tapayer, in his sole discretion, would be free to choose betwcen
at will."
152 Moline Properties, Inc. v. Comm'r, 319 U.S. 436, 438-39 (1943). Se PicmmxSAu ,
FEDER TAx PoLIcY 98-99 (1966).

barked in the undertaking," 1'13 and the further capacity to achieve
priority over or equality with the creditors of their own business
even with respect to the assets embarked in the undertaking, to
the extent that a portion of their investment may be designated
as secured or unsecured (but unsubordinated) debts."1 4 The
chosen measure of the value of the privilege of enjoying those and
other advantages, when relief under subchapter S is not or cannot
be availed of, is a percentage of the net profits of the corpora-
tion.5 151 Yet, as the law operates today, that measure often works
inversely to the actual benefit enjoyed. Heavy outside borrowing
exposes the shareholders' investment to greater speculative risks,
for the sake of greater equity profits through leverage, and makes
doubly important the protection of their personal assets from
such risks; yet, the greater the leverage, the greater is the inter-
est deduction and the lower is the tax which the law exacts for the
privilege of limiting the exposure of their property to the risks of
the business and enjoying the other advantages of corporate op-
eration."1 " And to the degree that the beneficial owners themselves
assume the role of creditors and thus may enhance their insulation
from loss, not merely of their personal assets, but of the money
and property they have "put into the corporation for the purpose
of insuring the shareholder[s] the benefits of the corporation's
growth," 117 the double tax burden which was intended as the
price of such benefits is reduced1 1 8
1 13 See Morrissey v. Comm'r, 296 U.S. 344, 359 (1935).
1514 The credit needs of the business may in a given case limit or precludo the attain-
ability of both those goals, as shareholder guarantees or subordination may be de-
manded, although substantial protection from tort liabilities may nevortholess bo
achieved. In any event, if the corporate form is adopted, the tax law draws no distinction
based on the extent of the "economic difference"l it makes. See note 1499 supra. Other
advantages of incorporation include centralization of management, continuity of life,
and free transferability of shares.
1515 I.R.C. §§ 11(a), 63(a). Cf. Flint v. Stone Tracy Co., 220 U.S. 107, 165-66 (1911).
1516 "The lower the interest rate on the borrowed money, the greater the leverage.
Since interest is deductible, and at a 52 per cent corporate rate the not cost of borrow-
ing is only 48 per cent of the interest payable, it is easy to see that the federal income
tax substantially contributes to leverage and to the desirability and profitability of
incurring outside debt."2 Hickman, Incorporation and Capitalization:T7 Thrcat of the
"Potential Income" Item and a Sensible Approach to Problems of Thinness, 40 TAXrs
974, 985 (1962).
1517 See Stone, Debt-Equity Distinctionsin the Tax Treatment of the Corporation and
Its Shareholders,42 TUL. L. lEpv. 251, 257-58 (1968) (which continues, "As long as the
'debt' money is contributed pro rata, the equity benefit derived from the additional
investment in debt form is no less than it would have been if all the shareholders had
bought additional equity. Only the tax consequences are different.")
1518 See text at notes 1113-26, 1502 and 1504 supra.

TEE RETUR ON INVESTED CAPrTAL

0
Interest As a Nondeductible Expense 151
One obvious way to eliminate the discrimination against equity
capital and to relieve the pressure to maximize debt would be to
make interest nondeductible for corporate income tax purposes, in
effect treating borrowed as well as equity capital as embarked upon
the corporate venture and its product as fairly included in the
measure of the taxable value of the privilege of doing business
as a corporation. In effect, however, that would tend to make the
corporate income tax a gross income tax, for the amount paid for
the use of money is as much an expense of producing income as the
rent, wages and costs of raw materials which the corporation must
pay.152 0 Such a measure might threaten the solvency of many cor-
porations and the safety of many obligations entered into in reli-
ance upon the deductibility of the interest; 1121 or, if made applica-
ble only to future obligations, would seriously discriminate against
new businesses. 5 2 Even with a compensating reduction of the
tax rate, such a measure would impose a disproportionate burden
on the less successful, more heavily indebted companies, while
giving a windfall to the more prosperous ones, although these
effects might be avoided if, as has been proposed, the corporate
tax rate were restructlred and graduated according to the rate
of return earned on the combined borrowed and invested capital. 2 3
Such dislocations might be Tinimized if the disallowance of the
deduction were confined to interest on debts held substantially pro-
portionately by shareholders, which are the ldnd of debts most sub-
1519 References herein to interest should be read as implying consistent treatment of
discount and premium. See text at notes 14-47 supra.
1520 See Cayuna Realty Co. v. United States, 382 F.2d 298, 301 (Ct. C. 1967) ; Gilbert
v. Comm'r, 248 F.2d 399, 406-07 (2d Cir. 1957). See also Jewell, The Tax LegiZslatioon
Against Conglomerates-The Case Against the Tax Legislation, CO. ,GLO0!r=Tr MOMSns
AxD AcQuismoxs: OPmioN AND A.ALs IS, 44 ST. ffom-'s L. Riv. 1073 (spec. ed. 1970).
3.521 Lent, Bond Interest Deduction and the Federal Income Tax, 2 NAg'L TAx J. 131,
140 (1949). Of. S. REP. No. 1622, 83d Cong., 2d Sess. 41 (1954). Although the premise
of denial of the deduction would be that the return on borrowed capital also benefits
from the corporate form, the resulting tax would have to be paid from what would
otherwise remain for the common shareholders. Lent, supra, at 139. Without refer nce
to the controversial question whether, in the long run, the corporate income tax may bo
shifted either to lenders or to customers (of. note 1505 supra), retroactive applieation
clearly could be disastrous to common shareholders. Cf. Gardens of Faith, In, 23 T.C02!
1045, 1061-62 (1964), aff'd, 345 F.2d 180 (4th Cir.), cert. denied, 382 U.S. 027 (1965).
1522 See teXt at note 1553 infra.
1 .2See Blakely & Zebms, A New Loob at the Corporate Income Tax, 20 Txx E.Ec.
287 (1968), proposing application of such a graduated tax, coupled with the denial of
the interest deduction.

ject to abuse and least likely to lead to bankruptcy if defaults
result from a removal of tax advantages heretofore enjoyed. It
has been argued that a shareholder of a close corporation can never
fill the role of creditor 1524 and that every dollar he puts into the
corporation in any form contributes to its success and growth, in
which he shares without limitation. 1525 But, whatever the concep-
tual validity of those arguments, it would be grossly discriminatory
to deny shareholder-financed corporations offsets to taxable income
relatively comparable to those allowable to their competitors who
may have better access to outside loans. 1 2 ' Although it has been
contended that no discrimination results, under such a rule, since
all who qualify for the deduction must subject themselves to po-
tentially hostile creditors, 527 no reason of policy is apparent for
imposing a tax penalty to drive small businesses into the hands of
the money lenders.
Denial of the interest deduction, whether generally or on a lim-
ited basis, would in any event not resolve but only shift the focus
of the tax minimization problem, by encouraging such alternatives
to borrowing (or to credit purchases) as the leasing or licensing
of property, as well as the sale and leaseback of property the cor-
poration already holds. 28 It would also encourage experimenta-
1524Lanning, Tax Erosion and the "Bootstrap Sale" of a Business, 108 U. PA. L.
REV. 623, 665-66 (1960). See text at notes 569-94 supra.
1525 Stone, Debt-Equity Distinctions in the Taz Treatment of the Corporation and Its
Shareholders,42 Tu- L. REV. 251, 256-61 (1968); of. Tyler v. Tomlinson, 414 F.2d 844,
849 (5th Cir. 1969).
1526 Of. 1954 ALI, supra note 1266, at 232; Hickman, Incorporation and Capitaliza-
tion: The Threat of the "P'otential Income" Item and a Sensible Approach to Problems
of Thinness, 40 TAXEs 974, 986 (1962); Weis, The Labyrinth of the Timn Corporation,
40 TAxES 568, 582 (1962).
12527 Stone, Dcbt-Equity Distinctions in the Tax Treatment of the Corporation and Its
Shareholders, 42 TuL. L. REv. 251, 261 (1968): "Any argument that this would force
close corporations, particularly those beginning new businesses to exist at the mercy of
unfriendly creditors only supports the assertion that there is no point at which pro rata
shareholder loans are really debt investments. In a sense, allowance of the interest
deduction on loans extended by shareholders on a pro rata basis discriminates against
widely held corporations, who must obtain funds at arm's length from potentially
hostile sources." (Emphasis in the original.)
1528 Lent, Bond Interest Deduction and the Federal CorporationIncome Tax, 2 NAT'L
TAx J. 131, 140 (1949). Leasing of property from shareholders, if the rental is reason-
able (Roland F. Place, 17 T.C. 199 (1951), aff'd, 199 F.2d 373 (6th Cir. 1952), cert.
denied, 344 U.S. 927 (1953)), has often been advocated as a safer way of achieving
the general effects of shareholder-held debt. Nicholson, Tax Planning on Organizing
a Closely Held Corporation, 4 INCoiE TAX TECHNIQUES § 17.05 (1965); Note, Thin
Capitalizationand Tax Avoidance, 55 COLUm. L. REv. 1054, 1064-65 (1955). Not only
is the rental or royalty deduction free of debt-equity standards, but the fact that prop-
erty is rented rather than owned may so reduce the corporation's capital requlrements

tion with such devices as partnerships (or joint ventures) 1J- and
limited partnerships 1;30 between financiers or shareholders and
corporations, designed to divert part of the fruits of corporate ac-
tivity directly to individuals.
Dividends As a Deductible Expense

Moving now to the opposite pole, the discrimination between
debt and equity capital might be eliminated by granting a dedue-
tion for dividends paid. Full deductibility of dividends would re-
duce the corporate income tax to the vestigial status of a tax on
undistributed profits, serving only to police avoidance of tax on
corporate earnings at the individual level, 1531 and is unlikely to
be permitted while Congress remains fiscally committed to the
corporate tax. 53 2 It might fairly be recognized, however, that the
return on equity capital includes not only the element of entrepre-
nurial profit, on which double tax is properly imposed under our
present system,""3 but also a pure interest element of compensa-
tion for the use of the shareholders' capital,1 534 which might fairly
that the case for recognizing purported debts to shareholders is also strengthened. Arthur
F. Brool , 23 T.C.ML 1730, 1738 (1964), rev'd on another point, 360 F.2d 1011 (2d Cir.
1966). Of. note 890 supra. The ultimate extension of the lease device is a leaso of an
entire operating business in return for a large percentage of its profits, which the
Commissioner successfully challenged in the Tax Court only to concede the iSuo on
appeal. Warren Brekke, 40 T.C. 789 (1963), on remand, 25 T.C.M 1003, 1064 (1960);
Royal Farms Dairy Co., 40 T.C. 172 (1963), appeal dismised by stipulation, 60-1
U.S.T.C. 9296 (9th Cir. 1965). See O'Neill, Salcs of Businesses to Oharitfes--Tho
Brown Case and Its Aftermath, 43 TxEs 507, 513-17 (1965); Lnning, Tax Erosion
and the "Bootstrap Sale" of a Business, 108 U. PA. L. Riv. 623, 637-38, 687-89 (1900).
1529 Walter F. Maxwell, 29 T.C.ML 1356 (1970); A.L. Stanhfiela, 24 T.C.M. 1681
(1965). But cf. E.O.L Hill, Inc., 9 T.C. 153 (1947); Forcum-Jame3 Co., 7 T.O. 1195
(1946).
1530 Gf. Reg. § 301.7701-2(d) (2). The Service has indicated that it may vior sauch
limited partnerships as associations taxable as corporations, where tho individual
limited partners have a significant (20 per cent or more) interest in thO corporate
general partner or the corporate assets are deemed inadequate, although its rationale is
not clearly apparent. See "Tax Tidbits" in Tax Management Memoranda 6D-21 (1969)
and 70-10 (1970).
1531 Smith, Taz Treatment of Dividends, 3 CuPri ritr op' PAlms o Bno mr Tim
TAx BASE 1543, 1545-46 (Comm. Print 1959); Burgess, Tax Treatment of Dfitiden
Income, id.at 1591,1601-02.
1533 Gilbert v. Commir, 248 F.2d 399, 407 (2d Cir. 1957). See Jewell, Th Tax Leg9la-
ion Against Congloaerates--ThoCase Against the Tax Legislation, Coaro.tr.= Mmn-
GERs Aim AcQunsmoxs: OPzmoy A ArAIYSrs, 44 ST. Jomr's L. RnV. 1073, 1079
(spee.3 ed. 1970).
35 "In economic theory, the term 'interest' refers to that imaginary fraction of the
return to the owner of capital, w1icthicr he is creditor or owner, for the use of capital
if such use entails no risk. Any surplus over this imaginary amount represents economic

628 TAX LAW RE, Ew [Vol. 26:
be excluded from the corporate tax base like interest and other
costs. Perhaps the practical problem of measuring and segregating
the interest element, 115 as well as the probable revenue loss, mili-
tates too strongly against granting such partial relief in the case
of common stock dividends. But the concept would support the
more limited step of allowing deductions for nonparticipating divi-
dends on preferred stock,13 which-despite some formal differ-
ences-are not practically distinguishable from the interest on
certain forms of recognized debt., 18
Congress has not heretofore been willing even to go so far, ap-
parently because, in the absence of any restraint such as that which
credit requirements and the risk of bankruptcy impose with respect
to bona fide debt, there would be almost no limit upon the amount
of preferred stock with which a corporation might be capitalized
in order to shelter its earnings from corporate tax.158 8 If the
profits, which are in the nature of a premium for risk of capital loss." (Emphasls
added.) BADER & GUtTE=wN, INVESTMENT PRINOIPLES AND PRACTICES 70 (roY. od.
1936). "In our economy, a business must provide an adequate return on its aggregate
investment if it is to survive. In that sense return to investors is a business Cost .... 1
Hickman, Incorporation and Capitalization: The Threat of the "Potential Income"
Item and a Sensible Approach to Problems of Thinness, 40 TAXES 974, 986 (1962). See
also Note, 83 HARv.L. REv. 1695, 1706 (1970).
1535 Of. McCandless Tile Service Co. v. United States, 422 F.2d 1336, 1339-40 (Ct. 01.
1970), in which admittedly reasonable salaries paid to stockholders loft no margin for
dividends, and the court undertook to measure a fair return for their IIstockholder-roles
(i.e., supplying risk capital, assuming corporate obligations, and participating in cor-
porate decisions)" as a nondeductible element of the payments to them.
1536 Smith, Tax Treatment of Dividends, 3 COvPENDIUm or PAPERS oN BROADENING
THE TAX BASE 1543, 1545-46 (Comm. Print 1959); Lent, Bond Interest Deduotion and
the Federal Income Tax, 2 NATL TAX J. 131, 132, 141 (1949). The burden of the
tax resulting from nondeductibility of preferred stock dividends, like the burden that
would result if interest were made nondeductible, falls on the common stock equity.
Making preferred dividends deductible would thus give some relief to the common oven
though common stock dividends were not themselves made deductible.
1537 See text at notes 220-348 and 442-74 supra. IIt would have been an entirely logi-
eal and reasonable theory" "to treat preferred shares like debts, that is, as constitut-
ing merely a claim upon the company-the common shareholders. Such a view would
make the common shareholders alone the company, since they alone share profits and
manage the enterprise; it would treat all others as separate groups with whom they
deal as third parties." Jewel Tea Co. v. United States, 90 F.2d 451, 452 (2d Cir. 1937)
(L. Hand, J.). "Although differing fundamentally from the bondholder in theory, tho
preferred stockholder in practice occupies a position almost identical with that of the
bondholder [and] the practical aspects of the situation so far outweigh the theoretical
that preferred stocks sell strictly on a yield basis except when dividends are in arrears,
or where the financial condition of the company is such as to jeopardize the continuanco
of the dividend." BADGE & GUTHmANN, INVESTMENT PRINCIPLES AND PRACICES 81
(rev. ed. 1936).
13 In 1942, when public utilities were squeezed between greatly increased corporate
tax rates and the fixed charges for dividends on large amounts of preferred stock, they

premise is sound that a fair return on invested capital (as distin-

guished from the element of entrepreneurial profit) is a properly
chargeable cost of producing income, no such limitation on the
amount would be necessary or justified, with respect to either pre-
ferred stock or purported debt to shareholders, at least so long
as they reflect actual capital investment and not capitalization of
past or anticipated earnings. But if fiscal considerations require
some limitation in order to mi nimie the revenue effect of a change
in the law, let it no longer be a limitation that fosters the adoption
of unsound capital structures and discriminates against the small,
the new and the struggling business. 1 39
Limitation of Interest Deduction

I suggest that such a limitation might be patterned, in general,
after those imposed by several early revenue acts.Y'" In its sim-
plest form, as prescribed by the Revenue Act of 1913, the limita-
tion was that deduction should be allowable for interest only upon
an amount of debt "not exceeding one half of the sum of its in-
terest bearing indebtedness and its paid-up capital stock outstand-
ing at the close of the year"--in effect imposing a I to 1 debt-equity
ratio, which was increased to 2 to 1 (in some circumstances) in
1916.1541 Refining the idea for present purposes, and assuming
appealed for relief in the form of deductibility of preferred stock dividends. Congress
granted relief only with respect to past stoek issues (now LRhC. § 247), presumably be-
cause, as Senator Taft remarked, if the deduction were made applicable to now issues,
"Every corporation formed after this time would have two-thirds of its capital in pre-
ferred stocks." Hearings on the Bcvenue Act of 1942 Before the Senate Committco on
Finance, 77th Cong., 2d Sess. 163 (1942). The Senator may be forgiven for not fore-
seeing that, in the fullness of time, the courts might sanction a far greater proportion
of deduction qualified capital in the form of "bona fide debt." See text at note3 792-837
supra.
14o The staff of the American Law Institute has stated, with respect to the imposition
of a limit on deductions for interest on outside debt, that "the thinking today in this
field has not gone that far." ALI STAPP, supra note 1257, at 408. The extent of the
opinion sampling is not stated. Such a limitation was advocated in Semmel, Taz Conae-
quences of Inadequate Capitalization, 48 COLUm. L. Rv. 202 (1948), and more recently
in 1969 House Hearings, &upranote 1241, at 2373, 2509.
1541 The pertinent language of the 1909, 1913 and 1916 laws is quoted in Goldstein,
CorporateIndebtedness to Shareholders: "Thin Capitalization" and Bdatei Problems,
16 TAx L. REv. 1, 4-5 (1960), and the history is reviewed in Semmel, Tax Conequences
of Inadequate Capitalization,48 COLUm. L. REV. 202, 205-00 (1948). Tho evenue Act
of 1909, ch. 6, § 38(2d), 36 Stat. 113, bad allowed interest only on an amount of debt
equal to the capital stock, thus severely penalizing the undercapitalized corporation, in
that corporation A, with $10,000 of equity and $290,000 of debt, could deduct interest
only on $10,000 of the debt, while corporation B, with $100,000 of equity and $200,000
of debt could deduct interest on $100,000 of debt. The levenue Act of 1913, ch. 16, §

for illustration that the prescribed ratio is 2 to 1, the law might

provide that there shall first be determined the aggregate of the
paid-in capital and borrowed capital of the corporation; 1142 and,
in order to prevent avoidance of the limitation, the value of rented
and licensed assets might be included in the total capital employed
in the business. 51 48 Then, two-thirds (or other appropriate frac-
tion) of that amount shall be determined, and the value assigned
to rented and licensed assets deducted therefrom. The balance
would be the amount of debt the interest on which would be de-
ductible. " 44 If the limitation is exceeded, the taxpayer might be
permitted to select the debts on which the interest should be al-
lowed, except that the disallowance might well be applied first to
shareholder-held debt.' Within such limitation, any purported
ZIG(b), 38 Stat. 173, in effect, struck an average and allowed each of those corpora-
tions to deduct interest on $150,000 (half its aggregate equity and borrowed capital).
The Revenue Act of 1916, ch. 463, § 12(a) (3d), 39 Stat. 768, was still more liberal, but
again penalized the more highly leveraged corporation, by allowing interest on an amount
of debt equal to the sum of the paid-up stock and half the debt; corporation A could
then deduct interest on $155,000 of debt, whereas corporation .B could deduct intorest
on the full $200,000 of debt (a 2 to 1 ratio in its case). The limitation of the interest
deduction was held constitutional in Brushaber v. Union Pacific R.IR., 240 U.S. 1, 23
(1916). However, when an excess profits tax was adopted in the 1918 act, Congress
determined that it would be unfair to restrict the deduction of interest whon borrowed
money was not included in the invested capital credit. H.R. REP. No. 767, 65th Cong.,
2d Sess. 12-13 (1918). Somehow, after the excess profits tax expired, the idea of limiting
the interest deduction was not revived.
164 Paid-in capital might be determined at the end of each taxable year as the sum
of the money paid in and the unadjusted basis of property paid in for stock (or as
paid-in surplus), reduced by distributions out of capital. No adjustment is suggested
for earned surplus (since it does not seem appropriate to reward further the successful
corporation that accumulates its earnings free of dividend taxation by permitting it to
enlarge the amount of subsequent earnings that escape the corporate level of tax through
interest deductions) or for deficits (since such an adjustment would penalize the unsuc-
cessful by reducing their deductible interest); but those are policy details. Borrowed
capital might exclude that which does not bear interest (as in the early acts), unless
there is a discount involved. When new interests acquire the controlling stock and debt
of a deficit corporation, it may be appropriate to reduce the aggregate capital for this
purpose to an amount reflecting their actual outlay. Cf. text at notes 750-56 supra,
and I.R.C. § 382.
1543 Bee text at note 1528 supra. In general, the acquisition value (perhaps, for im-
plicity, determined by formula as a multiple of the rental) should be determined as of
the time when the rent was last renegotiated, free of prior commitment; and a sale-
leaseback should be viewed as a borrowing of the price. Licenses of property of uncer-
tain value may present more difficulty.
1544 The deductibility of interest should be determined by the limitation applicable to
the year when it accrues, even when the corporation is on the cash basis and allows
the interest obligation to accumulate. Cf. Brilliant Coal Co. v. United States, 59 Ct. C1.
481, 491-94 (1924), discussing the operation of the 1913 and 1916 acts in this respect.
1545 Interest which is disallowed on shareholder debts should be treated as dividends
for all purposes, including the dividend received deduction for corporate shareholders

debt should be recognized,14 6 free of the ideal debt standards which

new, small or struggling businesses can satisfy, if at all, only by
subterfuge. Possibly, since a public corporation may not be in a
position to qualify a part of its common shareholders' investment
as debt, even in form, and should neither be under pressure un-
wisely to increase its debts to outsiders nor be discriminated
against if it refrains from doing so, the law should further pro-
vide that nonparticipating dividends on preferred stock may qualify
for deduction to the extent of any unused margin of the limitation,
conditioned upon relinquishment by the holders thereof of the
14
benefits of dividend treatment. 5 7
The question inevitably arises whether a generally applicable
limitation, based perhaps upon a 1 or 2 to 1 ratio, would bear un-
fairly upon those corporations or industries which historically have
been able to carry a heavier debt burden, even on an arm's length
basis." 48 While this is a matter for policy determination, I submit
that (except for such special provision as should be made for in-
stitutions acting as middlemen in assembling and lending funds,
and any comparable situations), 1 the congressional "policy of
achieving some uniformity among corporations in the relative
amount of interest deductions available," 1110 as expresed in the
early revenue acts, is a sound one, and that industries or particular
corporations which, because of their greater affluence and stability,
government subsidies, or other favorable circumstances, are able
to subsist on a smaller margin of equity capital should not for that
reason be subject to a lesser tax on the fruits of corporate activity
under section 243, in order to avoid doubling the tax at the corporate level. It would
make little sense, however, to allow such relief to an unrelated corporate creditor, merely
because its debtor had been denied a deduction.
1546 Subject to a reasonable ceiling on the rate of interest for which deduction may be
allowed, in order to preclude distribution of profits in the guiso of deductible interest.
1547 This would have to be a matter of consent, since unrelated preferred Ahareholders,
particularly those that are corporations, would be deprived of the benefit of the lower
tax applicable to dividends although they do not benefit from the distributing corpora-
tion's deduction. Perhaps in the future, however, a variety of preferred stoch (no less
attractive to noncorporate purchasers) would be developed with that consent granted by
its terms. Corporations could notify their shareholders annually of the amount which
qualified for the dividend received deduction or exclusion, as mutual funds do now
under section 854(b) (2), and the amount stated in the notice could be made binding
on both the distributing corporation and the recipients unless the Commissioner elects
to go behind it.
1is4See text at notes 1419-24 supra.
1s49 See text at note 1425 supra.
is5zoSee Goldstein, Corporate Indebtedness to Shareholders: "Tian Capiftal amfon"
an4 .elated Problems,16 TAx L. BEv. 1, 5 (1960).

than is imposed upon others for the privilege of doing business in
corporate form. 1 51
If corporate interest deductions are restricted by Congress to
an amount significantly less than had been allowable under previ-
ous judicial standards, or may be allowable under the forthcoming
regulations, some form of grandfather clause or transitional re-
lief should be provided for those who had made prior commitments
in reliance upon the existing tax advantage.' 2 Such a provision
may result in serious discrimination against new enterprises, how-
ever, by burdening their earnings with tax costs not shared by their
established competitors 1 i 3 I suggest, therefore, that the deducti-
bility of interest in excess of the prescribed limit be phased out
over a period reasonably sufficient to permit financial adjustments
to be made, without unduly prolonging the tax advantage for what
may often be the very long term of outstanding debt,1 14 and that
the limitation upon the deductibility of interest on newly created
debt, despite the absence of reliance upon the former rule, be
phased in at the same rate. Although no comparable hardship
would result from applying the limitation immediately to debts
held proportionately by shareholders, discrimination should be
avoided by first applying to such debts (in excess of the limitation)
a strict independent creditor test of reality,"" and then phasing
out the deductibility of the excess.5 16
1551 If, on the contrary, it is determined that interest deductions on higher propor-
tions of corporate debt are to be allowed in particular industries, and if such exceptions
are to be established, not by express statute or regulations but on the basis of com-
paratives establishing what is reasonable in a particular case (note 1423 supra),
Congress should seek some degree of uniformity in the application of such compara-
tives by confining review of the issue to the Tax Court. Of. Williamsport Wire Rope Co.
v. United States, 277 U.S. 551, 560-61 (1928).
155s While grandfather clauses are constitutional despite the resulting discrimination
(United States v. Maryland Savings-Share Ins. Corp., 400 U.S. 4 (1970)), unnecessary
discrimination ought to be avoided as a matter of legislative policy.
ir54 Although Congress in 1942 granted, without time limitation, a deduction for
dividends on then outstanding public utility preferred stock (note 1538 supra), it is
preferable to phase out gradually those tax advantages which have been relied upon
but are found to be unjustifiable as a matter of tax policy.
1r55 See text at notes 946-81 supra. Although, for purposes of the regulations under
section 385, I urged abandoning the independent creditor test as applied to the interest
deduction (see text at notes 1479-80 supra), the present question relates to phasing out
of deductions in excess of a generally applicable stattttory limitation, in a way that avoids
discrimination, in a situation (shareholder debt) where no undue hardship is ordinarily
involved.
5a6 Cf. section 1564, reflecting the determination of Congress that even the owner of
100 corporations, each previously enjoying a wholly unwarranted $5,000 tax benefit
through multiple surtax exemptions, was entitled to a phase-out of his bonanza over a

WUM)RAWAI OF CAPITAL
Essentially the same legislative choices are presented in the
second major area where the tax law differentiates between debt
and equity, namely, the withdrawal of one's capital investment
from a closely held corporation, free of dividend tax, while earn-
1 7
ings remain undistributed. '
Mr. William M. Goldstein, among others, has made a persuasive
case for removing the distinction by applying to repayments of
shareholder-held debts the same dividend equivalency standards
as are applicable to redemptions of preferred stockh. 153 With the
possible exception of short-term loans which are promptly repaid
-whentemporary needs have been met, 1 ' a debt arising from a loan
or sale by shareholders to their corporation is, almost ipso facto,
a prearranged bail-out device, 1 00 for the very intention and ex-
pectation to repay it from earnings, which qualifies it for recogni-
tion as a debt, marks it as such a device."'~ To permit the share-
holder to withdraw his stake tax-free in the guise of repayment
of debt, while retaining his ful proportionate interest in the busi-
ness (in which undistributed earnings have replaced the capital
withdrawn) is to open for the tax planner a gaping hole in the
wall of anti-bail-out provisions which Congress has erected to
preserve the integrity of the dual tax system.251 1
five year perioL See also 1969 IUouse Hearings, supra note 1241, at 516G-67, 5392, in
which the Treasury so recommended (although in different form than was adopted).
1-s Goldstein, Corporate Indebtedness to Shareholders: "2han Capitalicatfon" andX
Belated Problems, 16 TAx- L. REv. 1, 37-43, 76-79 (1960). The ALI,although recog.
nizing the similarities in principle, opted for preserving the distinction, on the 'reah
ground that "traditions ought to play a part" Cohen, Surrey, Tarleau & Warren, A
Technica .evsion of the FederalIncome Tax Treatnient o1 CorporateDfstrbuefons to
Slhareholders,52 CoLi. L. REv. 1, 27-28 (1952).
i5s- See text at notes 1288-91 supra.
1ZBo Goldstein, supra note 1558, at 39-43; accord, BrrT= & Eusnxcer, Fzrm.A In-
comm TAx:ATION op CORPOBATIONS AND SHAREHOLDERS 130 (2d ed. 1960); MHiller, Tax
PlansThat Faied,1951 S. CALW. IwST. 1, 17. See text at notes 1282-87 supra.
1581 Of course, repayment from cash flow in the absence of earnings would not r e-lt
in dividend taxation.
2162 See note 1284 supra. So long as the law permits the planned escape of dividend
tax by the original issuance of preferred stock for part of the shareholder's capital in.
vestment (although not in a reorganization or as a stock dividend), whieh they may
later sell to a third party from whom it wll still later be redeemed, it is idle to spealz
of closing the breach in the 'wall by conforming the debt rules to tho~o applicable to
preferred stock; for the wall is too easily scaled. Sec text at notes 760-63 supra. Section
306 should be expanded to impose ordinary income tax on the proceeds of transfers of
preferred stock issued for a contribution of money or property and, if the shareholder
debt rules axe otherwise conformed, transfers of such debts as well. The ALI staIZ pro-
posed, with respect to preferred stock not subject to section 300, that a prcarrangcdre-

TAX LAW RLTVI"W [Vol. 26 :
Others, to the contrary, have urged that the discrimination be
eliminated by extending to redemptions of preferred stock, if orig-
inally issued for cash or property, the same immunity from divi-
dend treatment that now applies to repayments of recognized debts
to shareholders, subject to some limitation upon the percentage of
paid-in capital that may thus be recouped. 1 3 The argument for
thus letting down the bars is, in effect, that since the double tax
may be avoided in other ways, it is discriminatory to close off this
approach. It is contended that discrimination results because
shareholders of public corporations may recover their capital and
realize upon accumulated income at will by selling all or part of
their stock, incurring no more than a capital gain tax, while the
investment of the owners of a small, closely held corporation may
be locked in for the life of the business, or until they sell out com-
pletely. 15 4 Perhaps more to the point, corporations, large or small,
which are in a position to sell preferred stock or debt instruments
to outside parties are enabled to apply their earnings to the retire-
ment of those securities, with no adverse tax effect upon the
common shareholders, 10 5 although the end result is exactly the
same as if the latter had themselves supplied the original capital
and then withdrawn it when accumulated earnings sufficed for
capital needs. To reason from the perhaps irremediable imperfec-
tions of the tax law, however, is a self-destructive course.""0 0 Until
such time as we may dispense with the dual tax system, the effort
should be to limit, if not prevent, the bail-out of earnings rather
than to make the bail-out opportunity more widely available.
demption following a transfer should be treated as a direct redemption from the trans.
feror, with a presumption of no prearrangement if redemption is deferred beyond five
years. ALI STAP, supra note 1257, at 82-84, 92-94. If section 308 is extended to
transfers of shareholder-held debt, which gives the transferee an enforceable right to
be paid at a fixed time, prearrangement should be deemed present in every ease.
1603 See Adt sory Group Hearings, supra note 1266, at 859-75. The Advisory Group
on Subehapter C considered the proposal but determined to make no recommendation
because of the possible impact on the revenue. Ia. at 489.
5,64 Advisory Group Hearings,supra note 1266, at 863. Public corporations, hiowevor,
conscious of the market effect of their dividend record, are loss likely than close cor.
porations to accumulate the major portion of their earnings.
1665 The mere increase in the value of the stock, resulting from the accumulation of
earnings and their application in payment of corporate debts or redemption of preferred

stock, does not result in taxable income to the common shareholders. Of. Holsoy v. Com.
missioner, 258 F.2d 865 (3d Cir. 1958), accepted in Rev. Rul. 58-614, 1958-2 0.13. 920.
1566 See Cohen, Surrey, Tarileau & Warren, supra note 1558, at 26-27, rejecting the
foregoing argument as a ground for relieving the common shareholders in cases whoro
they themselves supply the financing, "[s]ince there are difficulties in limiting the con.
tention and since if not adequately limited its ramifications are destructive of our basle
tax system."

The intermediate course would be to permit repayment of debt

to shareholders, and perhaps also of preferred stock, free of divi-
dend treatment, subject to a limitation comparable to that sug-
gested with respect to the interest deduction, in order to place
shareholder-financed businesses in this respect more nearly on a
parity with those which are able to borrow from or sell preferred
stock to others. To achieve that result, and not give a further
benefit to those that avail of the maximum outside financing and
then incur additional obligations to shareholders, the percentage
limitation should be related, not just to the shareholders' invest-
ment, but to the aggregate of all the equity and borrowed capital
and leased property. From two-thirds of that total (assuming for
illustration that a 2 to 1 ratio is acceptable) there should be de-
ducted all debts and preferred stock held by outsiders, or held by
common shareholders in excess of their proportionate amount, as
well as all leased property. The balance would be the amount of
proportionately held debt to shareholders which could be retired
without dividend consequences.1'7 There would be major, if not
insurmountable, technical difficulties in drafting and applying such
a limitation, with respect to fluctuations in the amounts of total
capital and debt, disproportionate repayments, and the like, which
may militate against attempting to provide such relief.
TAxABLE TRANSFER OF PROPERTY: STEP-UP OF BAsIs
Few would contend that the present uncertain distinction be-

tween securities and other debts, "68 an almost accidental by-prod-
G
uct of the continuity of interest doctrine in reorganizations, O
ought to be preserved. But here also a choice of directions is
presented.
It has sometimes been suggested that transfers to controlled
corporations, under section 351 of the Code, be made tax-free only
to the extent of the stock received, and that corporate obligations,
whether or not they are securities, be taxed as boot, with conse-
quent step-up of the corporate asset basis. There is a superficial
1567 Previous repayments of obligations proportionately bod by shareholders, if not
taxed as dividends, should be included in the total of borrowcd ana equity capital, ani
then dedueted from the fractional part thereof, in order to determine the amount sub-
sequently permitted to be retired free of dividend tax.
1569Griswold, "Securities" and "Continuity of Interest," 58 Hav. L. Izv. 705
(1945), arguing that all corporate debts should be comprehended in the term "securi.
ties," where continuity is provided through stock ownership.

equitable appeal in the view that the corporation should not be
saddled with the transferor 's basis when it has bound itself to pay
a greater sum for the property, whether the term of the obligation
be long or short; 1570 but the point has validity only when there is
marked disproportion between the stockholdings of the transferors
and their interests in the property transferred, 5 71 for in other
cases the obligation has no more significance than a promise to pay
a dividend.1 57 2 Sometimes taxability is advocated as a deterrent
to prearranged bail-outs through the creation of debts to be paid
from earnings over a period of years; but the way to check bail-
outs is to tax the withdrawal of earnings,1 , 3 not to nibble at the
edges by taxing the transfer, the tax on which may often be de-
ferred by using the installment basis and minimized by selecting
for sale the least appreciated assets and those which qualify for
capital gain treatment. 74 The abuses possible through basis step-
ups attendant upon taxable transfers to controlled corporations are
too ineffectively restrained by existing law 1575 to justify permit-
ting such step-ups in additional cases where the consideration con-
sists of long-term obligations or obligations issued at the launching
1570 See ALl STAPP, supra note 1257, at 438-39. See generally text at notes 1134-37
supra.
1571 Cf. Levin, The Case For a Stepped-Up Basis to the Transferee in Certain R2cor-
ganizations, 17 TAx L. REv. 511, 532, 536-37, 541 (1962); Brown, An Approaol& to
Subehapter 0, 3 COMPENDrUM O PAPERS ON BROADENING THE TAx BASE 1619, 1625-20
(Comm. Print 1959). The choice made in 1954 to discard rather than sot limits upon
the proportionate interest test under section 351 (H.R. REP. No. 1337, 83d Cong., 2d
Sess. A116-17 (1954)) merits reexamination.
1572 See text at note 1581 infra. Even where stock and debt are held substantially pro-
portionately, there may sometimes be inequity in causing a potential double tax on
preincorporation unrealized appreciation through carrying over the basis, but this is
equally so where the consideration is all stock (note 58 supra), and no difference in
treatment is justified merely because the transfer is accompanied by a corporate
promise of a later cash distribution to shareholders.
1574 The ALI considered the foregoing proposal for its effect "as a barrier to the
receipt of earnings at a later time without imposition of ordinary income tax," but
rejected it as ineffective for this purpose. 1954 AII, supra note 1266, at 305-06; Cohen,
Surrey, Tarleau & Warren, A Technical Revision of the Federal Income Tax Treatment
of Corporate Distributionsto Shareholders, 52 COLUm. L. REV. 1, 46 (1952). There is no
valid precedent for such treatment in the fact that sections 354(a) (2) and 356(d), in
order to forestall bail-outs following reorganizations, treat excess securities as boot.
In most reorganization exchanges, such boot would be subject to dividend tax (section
356(b)), while boot under section 351(b) would frequently be capital gain; and tax-
ability of boot to the shareholders in a reorganization does not result in a stop-up of
corporate asset basis (sections 361(a), 362(b)), as it does in a section 351(b) transaction
(section 362 (a)).
1575 See notes 60, 61 supra.

70
of the corporation,' which, if not deemed stock, at least are the
"substantial equivalent of equity securities." 5
The American Law Institute, therefore, proposed a move in the
direction of lessening rather than broadening the differentiation
between stock and shareholder-held debt, by treating as tax-free,
in a section 351 transaction, the receipt not merely of stock but
of any written evidence of indebtedness of the corporation which
was not payable -within one year. 578 It was not willing, however,
wholly to obliterate the distinction, lest it erect a deterrent to
"bona fide sales . . .by a stockholder unwilling to invest more
funds in his controlled corporation in need of the property." 157O
Sales for cash or for very short-term debt were still to result in
a step-up of basis, except in certain cases where the property had
a short depreciable life.180
1577 Campbell v. Carter Foundation Production Co, 320.F.2d 827, 835 (5th Cir. 1963).
1578 1954 ALI, supra note 1266, at 304-05. It rejected a five year cutoff suggested by
others (in effect a codification of the rule of thumb discernible in present decisions,
notes 1175-81 supra) because of diffculties envisioned in dealing with serial maturitie3,
prepayment privileges, et cetera. See ,ALI STAYF, supra note 1257, at 439-40. But the
ALI was apparently untroubled by the possibility that payment of a note formally duo
within one year might not in fact be demanded for an indefinite period (et. note 173
supra), or that one who, desiring tax-free treatment, set a longer term, migbt cauo
his corporation to pay him sooner (notes 1184-86 supra). For purposes of tho reorgan-
ization provisions, see notes 1138-44 supra, however, the treatment now accorded ce-
eurities was proposed to be extended to all debts regardless of term. See ALI STAFF,
supra note 1257, at 443.
15791 ALI FE. Icomr TAX STAT. at 372 (Feb. 1954 Draft). See 1954 ALT, supra
note 1266, at 305. This, it seems, is the familiar argument for the taxpayer's freedom to
select his capital structure, and to enjoy the resulting self-selected tax consequence3. See
text at notes 1490-1504 supra. Having found that making all transfers for debts of
controlled corporations taxable would not be an effective deterrent to bail-outs offected
through such arrangements (note 1574 supra), the ALI proposed no remedy for the
bail-out aspect of the broadened class of tax-free transfers. See text at notes 126G-71
and 1282 supra.
.580 The ALI opposed as "too drastic" either a dividend tax on the wi*thdrawal of
funds (see text at note 1586 infra) or the ordinary income tax which section 1239 im.
poses in limited circumstances upon the sale of depreciablo property to a closely con-
trolled corporation. The latter was found objectionable, among other reasons beeause it
was believed (erroneously, as it turned out (Bryan v. Comm'r, 281 F.2d 238 (4th Cir.
1960), cert. denied, 364 U.S. 951 (1961); Rev. flu]. 60-302, 1960-2 0.B. 223)) to be
inapplicable to transfers for stock and boot, and hence discriminatory against sales.
Instead, the ALl would generally apply capital gain treatment to the transferor but
would deny the corporation a basis step-up in the easo of property with a depreciable
life of less than five years (the advantage of obtaining a step-up at the cost of incurring
a capital gain tax being viewed as negligible in other cases). The gravest deficiency of
section 1239, however, its failure to touch proportionate transfers by more than one
transferor (except in the case of a spouse and minor descendants), see note 61 supra,

I submit, however, that the Institute stopped short of the proper
solution. A transfer of property by shareholders to their con-
trolled corporation has no more effect upon their beneficial inter-
est in the property when they receive short-term notes or cash
therefor than when they receive stock or bonds, or any combina-
tion of the foregoing. In each case, to the extent of the nonstock
consideration, the shareholders accomplish a withdrawal of cor-
porate funds, either mediately or immediately, and they will still
have their indirect beneficial interest in the property after they
have been fully paid. 15s1 Consistency of treatment suggests, there-
fore, that any transfer to a corporation controlled by the trans-
ferors 1582 be treated, in itself, as tax-free, whether the considera-
tion be stock, debt or cash; 1583 that the assets retain the basis they
had in the transferors' hands; 1184 and that, subject to possible
was preserved in the ALl substitute. 1 ALI FD. INcoME TAX STAT. at 371-78 (Fob.
1954 Draft). See Goldstein, Corporate Indebtedness to Shareholders: "Thin Capitaliza-
tion" and Belated Problems, 16 TAx L. REv. 1, 78 (1960).
15sCf. Rev. Rul. 55-15, 1955-1 C.B. 361, 362. That ruling was revoked by Rev.
Rul. 59-97, 1959-1 C.B. 684, following its rejection by the courts as an interpretation of
existing law in Commisioner v. Pope, 239 F.2d 881 (1st Cir. 1957), and other cases,
which adhered to Emma Cramer, 20 T.C. 679, 684 (1953), where the court had said,
"Such reasoning would make it impossible for a stockholder ever to sell for cash
property to a corporation in which he was interested. " Congress responded to the Cramer
case by enacting section 304(a) (1), under which (subject to the dividend equivalency
tests of section 302) a sale of stock of one controlled corporation to another controlled
corporation, leaving the seller still indirectly the beneficial owner of the stock sold, may
be treated as a capital contribution to and a dividend of cash or notes from the pur-
chasing corporation, even though its net assets are not reduced by the transaction. Bee
Radnitz v. United States, 187 F. Supp. 952, 958-59 (S.D.N.Y. 1960), aff'd, 204 F.2d
577 (2d Cir. 1961). The same principle might rationally be applied by Congress to
sales of any form of property to controlled corporations. See BivricM & Eusion,
FDEAL INcomE TA XATioN o CoRP0R&IoNs AxD SHAEHOLD mS 103-04 (2d ed. 1960);
Chirelstein, Learned Hand's Contribution to the Yaw of Tax Avoidance, 77 YALE L.J.
440, 472 (1968).
1582 The control test of section 368(c), lends itself to manipulation and needs re-
examination but, like other deficiencies in the operation of section 351, heretofore mon.
tioned, that is beyond the scope of this paper. See Plumb, Transfero of Property to
Controlled Corporations (unfinished manuscript in the library of the author).
1583 This is in general the effect of section 368(a) (1) (D), which treats as a ro-
organization "a transfer by a corporation of all or part of its assets to another corpo-
ration" in common control, without specifying the consideration, and henco is applied
even to transfers in the form of cash sales. Davant v. Comm'r, 366 1'.2d 874, 884-87
(5th Cir. 1966), cert. denied, 886 U.S. 1022 (1967); James Armour, Inc., 43 T.C. 295,
304-08 (1964). Section 202(e) (3) of the Revenue Act of 1921, the prototype of section
351, was similar in form and possibly in effect, but subsequent acts have required con.
sideration in "Istock or securities. "1
1584 Possibly an exception could be devised for the case where a transferor recolves
fixed obligations (or nonparticipating preferred stock) disproportionate to his interest
in the corporation. See note 1571 supra.

limitations suggested under the preceding subheading, the with-

drawal of funds in payment therefor, whether as a fixed obligation
or in the form of contingent royalties,51 15be taxed as a dividend
to the extent of earnings and profits at the time of payment.15so
OTHER AREAs
Space precludes consideration of possible legislative solutions of
the trichotomic debt-securities-equity problem in the other areas
heretofore discussed. Congress should determine, in the light of
the purposes of each of the several statutory provisions affected,
whether purported obligations not satisfying conventional debt
standards should be viewed as stockl18? (and if so, as a second
class of stock 1588) ; whether there really ought, under a particular
provision, to be any distinction drawn between stock and share-
holder-held debt, no matter how sound the financing; '"11 and
1M85 See text at notes 410-15 supra.
1586See text at notes 1558-62 and 1567 supra. The appropriate time for taxing the
distribution is when the debt is paid. Otherwise the stage could be sot for a later tax-
free withdrawal by making a sale for notes at a time 'when the corporation has no earn-
ings and profits, and subsequently paying the notes out of earnings.
1 7sUnder provisions which measure control by a percentage of the aggregate value of
the outstanding stock, should purported debt -which fails the standards, although not
held proportionately, be included or excluded (or should alternative tests be provided so
that these loophole closing provisions may not be escaped either way)? See text at
notes 127-30 supra. Should the taxability of formal debt received in exchange for stock
in a reorganization depend upon whether it meets the standards? See text at notes
137, 138 and 1331-34 supra. When a corporation redeems a shareholder's interest for
deferred payments, should strict debt-equity standards be applied in determining
whether, under section 302(e)(2), he has retained an interest "other than . . . as
a creditor"? See text at notes 141-42 supra. Should IIguaranty fund certificates," the
only equity capital of certain mutual companies, be deemed stock for general purposes
even though not for the purpose of denying them mutual status? See text at note 1336
supra. In the ease of a bootstrap purchase by an otherwise exempt organization of
property constituting a "related business" (e.g., a school or cemetery), should pay-
meats contingent upon earnings or otherwise failing certain standards be deemed to be
a disqualifying inurement of net earnings to private benefit? Sce text at notes 156-58
supra.
1 sIn what eireumstanees, if any, should purported debts to shareholders disqualify
a corporation for subehapter S relief? Bee text at notes 102-12 and 1322-28 supra.
Should unrecognized debt (or, for that matter, nonparticipating preferred stock), in
the hands of others preclude satisfaction of the control test of section 308(c) 1 Sec
text at notes 113-23 supra. Cf. text at notes 125-26 supra. For minor problems of this
nature, see text at notes 83-85 and 143 supra.
15S Should bad debts held substantially proportionately by shareholders be treated
more favorably than their worthless investment in stock or in debt formally evidenced
by securities? See text at notes 70-75 and 1319-21 supra. And hould such debts be less
favorably treated than stock in the case of a small business corporation under section
1244, a provision the technical conditions of which seem more to reflect budgetary con-
siderations (Godart v. Comm'r, 425 F.2d 633, 037 (2d Cir. 1970)) than policy? ee text

whether a distinction should be made between securities and other
debts, 1590 and if so how securities should be defined." 1
Envoi
There is no easy solution to the many problems discussed herein.
It is my conviction, however, that if a fraction of the time and
energy that has been and will be devoted to distinguishing the
indistinguishable, in countless litigated and audited cases and in
the regulations-to-be, were directed instead to resolving the basic
questions of tax policy, solutions would be found that would result
in a sounder and more equitable system. The foregoing legislative
proposals are not offered as final answers but as food for thought,
for they require exhaustive study by tax policymakers, by experts
in economics, and by those whose task it would be to administer
the law as amended, not to mention my colleagues at the bar.
at notes 76-81 supra. Should section 332 apply where a parent corporation receives a
distribution with respect to debt (or preferred stock) of its subsidiary but not with
respect to the common stock? See text at notes 86-98 supra. Should it bo requisito to
completion of liquidations under sections 332, 333 and 337 that debts to shareholders be
paid within the time prescribed; and, if so, should there be a distinction between debts
which are and are not recognized under conventional standards? See notes 99-101 supra.
Should shareholder-held debt be included in the measurement of a decedent's interest
in a corporation, in determining eligibility for redemption of stock under section 303?
See text at notes 131-36 supra. Should debt and preferred stock, received as dividends
or in a reorganization, be treated alike, either by tainting under an improved and ex-
panded version of section 306 (see Brown, An Approach to Bubehapter 0, 3 CoMPrsiuM
or PAPERS oN BROADENING mrE TAX BASE 1619, 1623-24 (Comm. Print 1959)), or by
taxing each upon receipt? See text at notes 137-39 supra. For minor problems of this
nature, see text at notes 144-55 supra.
1590 In a reorganization, should gain or loss be recognized upon the surrender, in
exchange for stock or securities, of a debt not constituting a security? See notes 1144
and 1578 supra. Should it be required, in connection with a spin-off or other corporate
separation, that debts other than securities be distributed along with stock? See text at
notes 124 and 1145-46 supra. Should stock which is issued in place of previously out.
standing securities be denied the benefit of section 1244, while stock which is substituted
for other debt may in some cases qualify? See text at notes 78-81 supra. Should the
treatment generally accorded nonbusiness bad debts be more favorable than that applied
to "Isecurities" (as defined in I.R.C. § 165(g) (2) (0)) I ee text at notes 70, 71 supra.

26 Tax L. Rev. 369 PDF

Caricato da

Informazioni sul documento

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

26 Tax L. Rev. 369 PDF

Caricato da

Copyright:

Formati disponibili

The Federal Income Tax Significance

[S]tockholders of corporations have always been free to commit to

In many ways-some obvious and well known, others more subtle

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

This vexing subject has no doubt been written to death.' Per-

Tax Effects of the Debt-Stock Distinction

Imaged with the Permission of N.Y.U. Tax Law Review

INTEREST, DIscouNT, PREMIUM, ET CETERA

Imaged with the Permission of N.Y.U. Tax Law Review

pay a $6 dividend on a share of preferred or common stock, a cor-

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

tax bracket, and the corporation is otherwise in a position to ac-

Imaged with the Permission of N.Y.U. Tax Law Review

579 (1958); G.C.M. 14349, XIV-1 C.B. 47 (1935).

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

For the closely held corporation, there is another advantage of

Imaged with the Permission of N.Y.U. Tax Law Review

planning, the well-advised businessman can set up a capital st'uc-

Imaged with the Permission of N.Y.U. Tax Law Review

TAxABim TRANSFER OF PROPERTY: STEP-UP OF BAsis

Corporate debt to shareholders may result not only from loans

Imaged with the Permission of N.Y.U. Tax Law Review

particular appeal if, as in the case of land which is about to be

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

WORTHLESSNESS OF THE ILMV STMNT

In many situations, debt enjoys no tax advantage over equity

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

COO ATE LiQOiRDATIOs

When a subsidiary corporation is liquidated, and its purported

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

have the interest coupons or registered form that would classify it

Imaged with the Permission of N.Y.U. Tax Law Review

The question whether advances not recognized as debt are to be

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

tributing corporation had control of the subsidiary, and hence may

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

In certain other provisions, including sections 269, 304 and 1551,

REDE Xm IONs TO PAY DEATH TAXEs

Imaged with the Permission of N.Y.U. Tax Law Review

There are countless other ways in which the distinction between

Imaged with the Permission of N.Y.U. Tax Law Review

bona fide debt, or purported stock with the characteristics of debt,

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

ration to acquire such replacement property; but if the taxpayer,

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

Imaged with the Permission of N.Y.U. Tax Law Review

Debt Distinguished From Equity Investment

The "vital difference between the shareholder and the creditor,"