Raymond J. Paige and Patricia C. Paige, His Wife v. United States
580 F.2d 960, 42 A.F.T.R.2d (RIA) 5974, 1978 U.S. App. LEXIS 9503 (1978)
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Rule of Law:
A corporation has more than one class of stock for subchapter S purposes if its outstanding shares are not identical with respect to the rights they convey in the control, profits, and assets of the corporation. The mere potential for shares to be treated differently due to externally imposed conditions is sufficient to create a second class of stock, regardless of whether those different rights are ever exercised.
Facts:
- Tackmer Corporation was formed with two groups of shareholders: 'cash shareholders' who paid cash for their stock, and 'property shareholders' who contributed an exclusive license agreement.
- Tackmer's Articles of Incorporation stated that 'No distinction shall exist between the shares of the corporation [or] the holders thereof.'
- As a condition of issuing stock, the California Department of Corporations required the property shareholders to agree to several restrictions to protect the cash shareholders.
- These state-imposed conditions subordinated the property shareholders' rights to dividends, giving cash shareholders priority to receive a 5% cumulative annual dividend before property shareholders received any.
- The conditions also subordinated the property shareholders' rights upon corporate dissolution, requiring cash shareholders to be fully repaid their investment plus dividends before property shareholders could receive any assets.
- The conditions further granted cash shareholders an irrevocable power of attorney to vote the property shareholders' shares if the company defaulted on dividend payments for two years.
- Despite these conditions being in effect, Tackmer Corporation actually made all dividend distributions on a pro-rata basis to all shareholders.
Procedural Posture:
- The plaintiff-taxpayers filed a joint tax return for 1970, claiming tax benefits related to Tackmer Corporation's subchapter S status.
- The Commissioner of Internal Revenue disallowed the claims on the grounds that Tackmer had more than one class of stock and assessed additional taxes.
- The taxpayers paid the tax deficiency and filed a timely claim for a refund, which the government formally disallowed.
- The taxpayers filed suit for a refund in the U.S. District Court for the Central District of California.
- On cross-motions for summary judgment, the district court entered judgment for the United States.
- The plaintiff-taxpayers, as appellants, appealed the district court's judgment to the United States Court of Appeals for the Ninth Circuit.
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Issue:
Does a corporation have more than one class of stock, thereby disqualifying it from subchapter S tax status, when state regulatory conditions create differences in rights to dividends, liquidation proceeds, and voting power between groups of shareholders, even if the corporation's articles of incorporation authorize only one class of stock and all actual distributions are made pro-rata?
Opinions:
Majority - Skopil, District Judge
Yes. A corporation has more than one class of stock when state-imposed conditions create such differences. The determination of whether a corporation qualifies for subchapter S is a federal question governed by Treasury Regulation § 1.1371-1(g), which looks to whether the outstanding shares are identical with respect to the rights they convey in the control, profits, and assets of the corporation. The conditions imposed by the California Department of Corporations created clear preferential rights for cash shareholders regarding dividends and asset distribution, and potential differences in voting control. The fact that these preferential rights were never exercised is irrelevant, as a corporation's qualification for subchapter S status is judged at the time of election based on the potential exercise of differing rights. The purpose of the one-class-of-stock rule is to avoid the complex tax allocation problems that could arise from such differences, and the subjective intent of the taxpayers to create only one class cannot override the objective requirements of the statute.
Analysis:
This decision solidifies the principle that the determination of 'one class of stock' for S-corporation status is a matter of substance over form, focusing on the legal rights of shareholders rather than the corporation's formal charter or actual practices. It establishes that externally imposed requirements, such as those from a state regulatory body, can create a disqualifying second class of stock even if unintended by the shareholders. This ruling reinforces the importance for tax planners to examine all governing documents and agreements for any differences in distribution, liquidation, or voting rights when advising a corporation on its S-corp eligibility, as the mere possibility of disproportionate treatment is disqualifying.
