Fin Hay Realty Co. v. United States - 398 F.2d 694 (3d Cir. 1968)

Rule:

In a corporation which has numerous shareholders with varying interests, the arm's-length relationship between the corporation and a shareholder who supplies funds to it inevitably results in a transaction whose form mirrors its substance. Where the corporation is closely held, however, and the same persons occupy both sides of the bargaining 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. This is particularly so where a shareholder can have the funds he advances to a corporation treated as corporate obligations instead of contributions to capital without affecting his proportionate equity interest. Labels, which are perhaps the best expression of the subjective intention of parties to a transaction, thus lose their meaningfulness. Under an objective test of economic reality it is useful to compare the form which a similar transaction would have taken had it been between the corporation and an outside lender, and if the shareholder's advance is far more speculative than what an outsider would make, it is a loan in name only.

Facts:

The taxpayer was a close corporation formed by two shareholders, who contributed equal amounts and thereafter advanced funds for which they received promissory notes. The taxpayer paid and deducted interest on the notes. The Internal Revenue Service disallowed the deductions. The taxpayer filed suit seeking a refund. The district court entered judgment for appellee United States, and the taxpayer sought review.

Issue:

Were funds paid to a close corporation by its shareholders additional contributions to capital or loans on which the corporation's payment of interest was deductible under § 163 of the Internal Revenue Code of 1954?

Answer:

No.

Conclusion:

In affirming the district court's judgment, the court noted that the burden was on the taxpayer to prove that the IRS' determination that the taxpayer's advances represented capital contributions rather than loans was incorrect. The court determined that the district court was justified in holding that the taxpayer failed to meet this burden. While the formal indicia of loan obligations were present, the corporation was the complete creature of the shareholders who had the power to create whatever appearance would be of benefit to them, despite the economic reality of the situation.