Kean v. Commissioner
469 F.2d 1183 (1972)
Premium Feature
Subscribe to Lexplug to listen to the Case Podcast.
Rule of Law:
For Subchapter S elections, the term 'shareholder' includes beneficial owners of stock, not solely shareholders of record, and a District Director abuses discretion by arbitrarily refusing to grant an extension for filing consents when there was reasonable cause for the failure to consent and no demonstrable jeopardy to government interests.
Facts:
- Ocean Shores Bowl, Inc. ('Bowl'), a Washington corporation, was formed on March 20, 1962, and had only one class of stock issued and outstanding.
- 125 shares of Bowl stock and some Bowl debentures were issued in the name of William MacPherson.
- William MacPherson and his brother, Murdock MacPherson, jointly invested in the 125 shares and debentures through their company, MacPhersons, Inc., with the cost of purchase charged equally against their respective drawing accounts.
- Murdock MacPherson was never repaid by William MacPherson for the amounts taken out of his drawing account to pay for the stock and debentures.
- Murdock MacPherson was not a shareholder of record of Bowl and did not file a consent to Bowl's Subchapter S election.
- None of the other shareholders of Bowl knew that Murdock MacPherson was involved with the company until a 1965 Internal Revenue Service audit.
Procedural Posture:
- Ocean Shores Bowl, Inc. filed a timely election to be taxed as a small business corporation (Subchapter S) in October 1962.
- Petitioners (shareholders of Bowl) deducted Bowl’s net operating losses on their personal tax returns for 1962 and 1963.
- A 1965 Internal Revenue Service audit disclosed Murdock MacPherson's beneficial ownership of Bowl stock and his failure to consent to the Subchapter S election.
- The Commissioner of Internal Revenue challenged the validity of Bowl's Subchapter S election and disallowed the petitioners' deductions for corporate losses.
- The Tax Court held that Bowl's Subchapter S election was invalid because Murdock MacPherson, as a beneficial owner of Bowl stock, was a shareholder within the meaning of § 1372 and had not consented to the election, thereby disallowing the petitioners' deductions.
- After the Tax Court's judgment, petitioners requested an extension of time from the District Director to file consents, pursuant to Treas.Reg. § 1.1372-3(c), which the District Director denied.
- Petitioners filed a motion in the Tax Court for retrial, further trial, or reconsideration, seeking a review of the District Director’s exercise of discretion.
- The Tax Court denied the petitioners' motion.
- Petitioners appealed the Tax Court's judgment to the United States Court of Appeals for the Ninth Circuit.
Premium Content
Subscribe to Lexplug to view the complete brief
You're viewing a preview with Rule of Law, Facts, and Procedural Posture
Issue:
1. Does the term 'shareholder' in § 1372 of the Internal Revenue Code, requiring consent for a Subchapter S election, include beneficial owners of stock who are not shareholders of record? 2. Did the District Director abuse his discretion by refusing to grant an extension of time for filing Subchapter S election consents when a beneficial owner failed to consent due to a good faith belief their consent was not required, and did the Tax Court err in refusing to review this discretionary denial?
Opinions:
Majority - WM. MATTHEW BYRNE, Jr., District Judge
Yes, the term 'shareholder' under § 1372 includes beneficial owners of stock, and yes, the District Director abused his discretion by refusing to grant an extension for filing consents. The court determined that the question of who constitutes a 'shareholder' for Subchapter S purposes is governed by federal law, not state law (citing Putnam's Estate and Morgan). Treasury Regulation § 1.1371-1(d)(1), which defines 'shareholders' as those who would include dividends in gross income, is consistent with the 'all pervasive legislative purpose' of Subchapter S to tax the real owners of stock, overriding any 'fragmentary phrase' in legislative history suggesting only shareholders of record (affirming Alfred N. Hoffman). The court found that Murdock MacPherson was a beneficial owner of one half of the 125 shares issued to William MacPherson due to their joint investment and allocation of costs, and thus his failure to consent invalidated Bowl's Subchapter S election initially. However, the court found that the District Director abused his discretion by denying the petitioners' request for an extension to file consents under Treas. Reg. § 1.1372-3(c). The Director's reasons for denial (Tax Court opinion issued and non-compliance with the regulation) were invalid. Murdock MacPherson had 'reasonable cause' for not filing a timely consent, as he was not a shareholder of record and believed his consent was not required until a judicial determination. Furthermore, no government interest would be jeopardized by validating the election after the fact, especially since other shareholders were unaware of Murdock's beneficial ownership. The regulation was intended to prevent harsh results in such cases. Therefore, the court affirmed the Tax Court's finding regarding beneficial ownership and the initial invalidity of the election but reversed its refusal to review the District Director's discretion, ordering the Director to grant the extension.
Analysis:
This case is significant for clarifying the definition of 'shareholder' under Subchapter S, prioritizing beneficial ownership over record ownership, and affirming the deference afforded to Treasury Regulations that align with legislative intent. It also establishes an important precedent for judicial review of a District Director's discretionary decisions regarding Subchapter S election extensions, providing relief for taxpayers who can demonstrate reasonable cause for non-compliance and a lack of prejudice to the government. This ruling limits the arbitrary exercise of administrative discretion and promotes fairness in tax administration by allowing for correction of good-faith errors in complex tax matters where the underlying intent of the law is still served.
