Federal Taxation - Kimberly S. Piar, Donald P. Hensel, M. Todd Prewett, and Donald R. Bly

• Publication year: 2000

Federal Taxationby Kimberly S. Piar* Donald P. Hensel** M. Todd Prewett*" and Donald R. Bly****

I. Introduction

In 1999 the Eleventh Circuit Court of Appeals decided several substantive tax cases as well as a number of procedural cases. The substantive tax issues addressed by the court included the definition of "control" under Internal Revenue Code Section 1504(a); whether S corporation shareholders can increase basis in their stock by the amount of guaranteed loans; the allocation of the purchase price of real property among depreciable and nondepreciable assets; employment tax issues; and worthless debt deductions under Internal Revenue Code Section 166. As to procedural issues, the court decided cases relating to remittances made in connection with Form 4868, the statute of limitations for willful evasion of payment of tax, and how bankruptcy stays affect the period for appealing Tax Court decisions.

II. The Definition of Control Under Section 1504(a)

In Alumax Inc. v. Commissioner,¹ the Eleventh Circuit affirmed a Tax Court decision holding that Alumax Inc. could not join the consolidated return of its shareholder, Amax Inc., for the years 1984 through 1986 because Amax did not have control of eighty percent of the voting power in Alumax as required by Section 1504(a).² The decision resulted in a deficiency for federal tax purposes of $129,000,000 for the years 1981 through 1986.³

Alumax is a Delaware corporation based in Atlanta that manufactures aluminum products. From 1974 until 1984 Alumax's voting shares were owned equally by Amax and a changing group of Japanese interests (including at times, Nippon Steel Corporation and Mitsui & Co. Ltd.). During this period votes on shareholder matters, board elections, and board voting were distributed equally between Amax and the Japanese interests.⁴

In 1984 Alumax underwent a restructuring. While the number of voting shares owned by Amax and the Japanese interests stayed the same, the number of votes per share of stock changed to four votes per share held by Amax and one vote per share held by the Japanese. The Japanese-held stock also was given a call right to purchase the Amax-held stock under certain circumstances described below, subject to a right of Amax to exchange its shares for shares in Alumax with only one vote per share. New class voting requirements were also instituted.⁵ After the restructuring, a majority of each class of stock (e.g., stock held by Amax or stock held by the Japanese interests) was required for any of the following:

[1] any merger; [2] purchase or sale of any asset worth at least 5% of Alumax's net worth (about $36 million between 1984 and 1986); [3] partial or complete liquidation or dissolution of Alumax; [4] capital appropriation or asset disposition worth more than $30 million (about 1.8% of Alumax's total asets); [5] election or dismissal of Alumax's chief executive officer; and [6] loans to affiliated corporations not in the ordinary course of business.⁶

Under the new voting regime, Amax had the power to elect four of six voting directors of the Alumax board. The Japanese interest elected the remaining two voting directors.⁷ The Amax-elected directors held two votes each and the Japanese-elected directors held one vote. While this arrangement gave the Amax-elected directors eighty percent of the voting power over most matters, a majority vote of the Japanese-elected directors and a majority vote of the Amax-elected directors was required in the six instances outlined above. In addition, if any Japanese-elected director disagreed with a board vote he could object, and if ratified by the appropriate Japanese corporation, the objection would nullify the Alumax board vote. This procedure, in essence, gave the Japanese-elected directors veto rights over decisions by the Alumax board. Amax could challenge the veto, however, within five days of notice. Once challenged, if a panel of arbitrators ruled within fourteen days that the vote would not have a material adverse effect on the Japanese interest's investment, the veto would be overridden. If Amax lost the challenge, the vote would remain ineffective and the call right held by the Japanese-interests as described above would become effective.⁸ Similar veto provisions were applicable to shareholder votes as well.⁹

Finally, the authority of the Alumax board was limited under its certificate of incorporation. Contrary to the default provisions of Delaware law which permit a board of directors to determine the timing and amount of dividends made, the Alumax certificate of incorporation required Alumax to pay out a certain percentage of its net income as a dividend every year. Further, eighty percent of these dividends were required to be paid to the Japanese interests and twenty percent to Amax.¹⁰

For Alumax to join in the consolidated return of Amax, Alumax had to be in Amax's affiliated group.¹¹ Prior to amendment in 1984, Section 1504(a)(2) required a parent of an affiliated group to own at least eighty percent of the voting power of all classes of subsidiary stock and at least eighty percent of each class of nonvoting subsidiary stock for the subsidiary to be included in the affiliated group.¹² From the discussion in the Tax Court, it appears Alumax was not authorized to issue any nonvoting stock.¹³

The Deficit Reduction Act of 1984¹⁴ amended Section 1504(a)(2) to require a parent to own both eighty percent of the voting power of all classes of stock and eighty percent of the fair market value of each class of stock.¹⁵ Corporations meeting the old test on June 22, 1984 were grandfathered for years prior to 1988.¹⁶ The Eleventh Circuit ruled that because Alumax's restructuring was completed before June 22, 1984, it only had to meet the pre-1984 test to be included in Amax's consolidated return for the years 1984 through 1986.¹⁷ The Tax Court correctly stated that if it held that the pre-1984 voting requirement was not met, Amax would have to meet the post-1984 requirements (i.e., eighty percent vote and value) to be permitted to file a consolidated return with Alumax for Amax in 1985 and 1986.¹⁸ However, given that the tests interpreting voting power are the same before and after the 1984 amendments, this distinction is ultimately irrelevant, except to the extent that the voting power requirements were met, in which case the value requirement would have to be met too. In any event, the Eleventh Circuit only ruled on the question of whether Amax held at least eighty percent of the voting power of Alumax.¹⁹

To answer this question, the court first considered the statutory construction of Section 1504, which it determined was not conclusive.²⁰ Next, the court examined judicial interpretations of Section 1504. The court stated that "historical judicial and IRS interpretation is that 'voting power' means the power to control the corporation's business through the election of the board of directors."²¹ The court posited that this rule is built on the following assumptions: "(1) that the directors manage a corporation's business; and (2) that a supermajority of directors controls the board."²² However, as the court pointed out, these assumptions do not hold true in the case of Amax, in which majority shareholder and board votes were required because the Japanese-interest shareholders had virtual veto rights over board votes, because contingent call arrangements existed, and, to a lesser extent, because the Alumax board itself lacked customary powers to determine dividend amounts and times.²³

Nevertheless, petitioner argued that it had met the eighty percent voting power requirement because it could elect directors with eighty percent of the vote.²⁴ The court rejected this purely mechanical test, finding that it failed to take into account circumstances, such as those of Alumax, where the underlying assumptions of Section 1504 were invalid.²⁵ The appropriate analysis in the eyes of the court was that of the Tax Court, which analyzed the effect on voting power of the limitations on the Alumax stock held by Amax.²⁶ Concluding that these limitations restricted Amax's voting power to a level below eighty percent, the court affirmed the Tax Court's ruling that Alumax was not entitled to join Amax's consolidated return.²⁷

III. S Corporation Stock Basis and Allocation of Real Property Purchase Price

In Sleiman v. Commissioner,²⁸ the Eleventh Circuit considered the following two issues arising from the businesses of three brothers: (1) whether S corporation shareholders can increase the basis in their stock by the amount of loans to the S corporations that they guaranteed, and (2) whether the Commissioner is able to allocate the purchase price of real property among depreciable and nondepreciable assets in a method contrary to the terms of the sale agreement.

A. Basis in S Corporation Stock

In July 1991 Eli Sleiman ("Eli") entered into a lease agreement with Blockbuster Video, Inc. ("Blockbuster"). This agreement obligated Eli to purchase land on Dunn Avenue (located in Jacksonville, Florida), build a store on the land, and subsequently lease the Dunn Avenue property to Blockbuster. The agreement also allowed Blockbuster to terminate the lease if the property was environmentally contaminated. In August 1991 Eli formed Real Estate Equities, Inc. ("REE"), an S corporation, and assigned his rights under the lease to REE. By October 1991 REE had identified the Dunn Avenue property that it wished to purchase but encountered difficulties in obtaining financing. The financing difficulties had the following two sources: (1) REE had no history of long-term financing, and (2) the Dunn Avenue property was environmentally contaminated.²⁹

Finally, in October 1991 REE obtained a one-year, $450,000 loan from SouthTrust Bank of Alabama, N.A. ("SouthTrust"). As security for this loan REE pledged the Dunn Avenue property (and any improvements thereon) and its interest in the Blockbuster lease...