Grojean, Thomas F. v. CIR ( 2001 )

In the
United States Court of Appeals
For the Seventh Circuit
No. 00-2252
Thomas F. Grojean and Therese Grojean,
Petitioners-Appellants,
v.
Commissioner of Internal Revenue,
Respondents-Appellees.
Appeal from the United States Tax Court.
No. 14374-98--David Laro, Judge.
Argued December 1, 2000--Decided April 13, 2001
Before Posner, Diane P. Wood, and Williams, Circuit
Judges.
Posner, Circuit Judge. The question presented by
this appeal from a decision by the Tax Court is
whether that court committed a clear error in
characterizing Thomas Grojean’s participation
interest in a loan made by American National Bank
to Grojean’s Subchapter S corporation, Schanno
Acquisition, Inc., as a guaranty.
Grojean had formed Schanno Acquisition in order
to buy a trucking company from Transamerica
Leasing Corporation. The price was a shade under
$14 million. To finance the purchase, Grojean
turned to American National Bank. He asked to
borrow $11 million from the bank, which was
willing but insisted that he personally guarantee
the loan. He refused, but continued negotiating
with the bank, and eventually they worked out a
deal by which the bank would make two loans to
Schanno, aggregating $10 million, plus a $1.2
million loan to Grojean conditioned on his
purchasing a $1.2 million participation in one of
the bank’s loans to Schanno, a loan for $8.4
million. The participation agreement subordinated
Grojean’s interest in that loan to the bank’s.
The interest rate was the same on both the $8.4
million bank loan to Schanno in which Grojean
participated and the $1.2 million bank loan to
Grojean, and it was agreed that he would receive
no payments on his participation interest until
the bank was repaid its share of the $8.4 million
loan. Thus, if Schanno repaid the $8.4 million
loan in accordance with its terms Grojean would
neither be out of pocket any cash nor receive any
cash--his participation interest in that loan,
and the bank’s loan to him, would cancel each
other out--while if Schanno defaulted, Grojean
would have to make good on the bank’s loss up to
$1.2 million, the amount the bank had lent him.
Although Schanno did not default, it did lose
money, and Grojean wanted to deduct those losses
on his federal income tax return, since the gains
and losses of Subchapter S corporations pass
through to the shareholders. But he could do this
only to the extent of his investment in Schanno,
consisting of the adjusted basis of his stock
plus any indebtedness of the corporation to him.
26 U.S.C. sec. 1366(d)(1). He treated his
participation interest in the bank’s $8.4 million
loan to Schanno as a $1.2 million indebtedness of
Schanno to him and it is this move that the Tax
Court rejected. It did so on the alternative
grounds that (1) the participation interest was
really a guaranty, not a loan, and (2) if a loan
it was a loan to American National, not to
Schanno. The parties agree that a guaranty is not
an investment for purposes of section 1366(d)(1).
A lender like a guarantor assumes a risk of
default and by doing so reduces the risk borne by
any creditor to whose interest the loan is
subordinated. From American National’s standpoint
it was irrelevant whether Grojean guaranteed $1.2
million of the bank’s loan to Schanno or took a
subordinated $1.2 million participation interest
in that loan. Lenders differ from guarantors,
however, in doing more than assuming risk: they
procure funds for the use of the borrower (often
just to replace a previous loan, but that of
course is a use by the borrower of the newly
borrowed funds). Grojean did not procure $1.2
million for the use of Schanno, as he would have
done had he gone to a bank or other lender,
borrowed $1.2 million from it, and written a
check for that amount to Schanno. Instead the
$1.2 million that Grojean "lent" Schanno was a
slice of the $8.4 million loan that the bank made
to Schanno. The only significance of Grojean’s
"loan," since it involved no transfer of money
from him to Schanno or any other entity, was that
it operated to guarantee that amount of American
National’s loan. Functionally, it was not a loan
or loan participation at all, but a guaranty, and
so the Tax Court committed no error, clear or
otherwise, in reclassifying it as a guaranty.
Otherwise a taxpayer could, by the kind of
restructuring engineered here, obtain for a
guaranty a tax advantage intended for a loan or
other indebtedness.
The difference between a loan and a guaranty may
seem a fine one, since, when the amount is the
same, the lender and guarantor assume the same
risk (subject to a possible wrinkle, concerning
bankruptcy, discussed later). The difference
between the two transactional forms may seem to
amount only to this: the loan supplies funds to
the borrower, and the guaranty enables funds to
be supplied to the borrower. That is indeed the
main difference, but it is not trivial or nominal
("formal"). As explained in Avery Katz, "An
Economic Analysis of the Guaranty Contract," 66
U. Chi. L. Rev. 47, 113-14 (1999), the three-
cornered arrangement (borrower, lender,
guarantor) created by a guaranty makes economic
sense only if the lender has a comparative
advantage in liquidity (that is, in being able to
come up with the money to lend the borrower) and
the guarantor a comparative advantage in bearing
risk. Otherwise the additional transaction costs
of the more complex arrangement would be
uneconomical.
At a high enough level of abstraction, it is
true, the difference between providing and
enabling the provision of funding may disappear.
Indeed, at that level, the difference between
equity and debt, as methods of corporate
financing, disappears. See Franco Modigliani &
Merton H. Miller, "The Cost of Capital,
Corporation Finance and the Theory of
Investment," 48 Am. Econ. Rev. 361 (1958). But at
the operational level, because of various
frictions that some economic models disregard,
such as transaction and liquidity costs, there
really is a substantive and not merely a formal
difference between lending and guaranteeing. In
contrast, the difference between a guaranty and
the form that Grojean’s loan participation
assumed was nothing but the label. It was a
purely formal difference, and in federal taxation
substance prevails over form. Gregory v.
Helvering, 293 U.S. 465 (1935); Williams v.
Commissioner, 1 F.3d 502, 505 (7th Cir. 1993);
Yosha v. Commissioner, 861 F.2d 494, 498-99 (7th
Cir. 1988); Boris I. Bittker & James S. Eustice,
Federal Income Taxation of Corporations and
Shareholders sec. 1.05[2][b] (7th ed. 2000).
If a transaction has "economic substance which
is compelled or encouraged by business or
regulatory realities, is imbued with tax-
independent considerations, and is not shaped
solely by tax-avoidance features that have
meaningless labels attached, the Government
should honor the allocation of rights and duties
effectuated by the parties." Frank Lyon Co. v.
United States, 435 U.S. 561, 583-84 (1978).
"Business realities" cast Grojean in the role of
guarantor rather than lender; no business
realities compelled him to recharacterize his
guaranty as a loan participation. The Internal
Revenue Service was therefore entitled to
recharacterize the participation as a guaranty,
in much the same way that it is entitled to
recharacterize a shareholder’s loan to his
corporation as an equity investment if the "loan"
label has no economic significance. Bittker &
Eustice, supra, sec. 1.05[2][b], p. 1-20. (In
some cases, tax considerations will point the
taxpayer the other way, toward recharacterizing a
loan as a guaranty. See Katz, supra, at 89.)
We pressed Grojean’s counsel at argument to
explain what functional--substantive--practical--
difference there was between a guaranty by
Grojean of $1.2 million of American National’s
$8.4 million loan to Schanno and Grojean’s $1.2
million participation interest in that loan. He
gave two answers. The first was that the
participation interest must have been worth more
to American National than a guaranty of the same
amount would have been (and so these could not be
the same animals however much they resemble each
other), because the bank allowed Grojean to
substitute a $1.2 million participation interest
for an $11 million guaranty. Several points are
ignored. The bank’s request for that guaranty was
just the opening bid in a negotiation, and there
is nothing in the record to indicate whether the
bank would have held out for such a guaranty,
which Grojean plainly was unwilling to give the
bank, to the end of the negotiation. The terms of
the ultimate deal between Schanno and American
National may have been more favorable to American
National in other dimensions besides guaranties,
such as interest rates and security, than the
deal first discussed, another issue on which the
record is silent. And Grojean has been unable to
explain on what possible basis a $1.2 million
participation could be worth more to the bank
than an $11 million guaranty by the same person.
The second answer that Grojean’s counsel gave to
our question was that the participation mode
would be more advantageous to Grojean if Schanno
was forced into bankruptcy during the six-year
term of the bank’s loan to it. Had Grojean
guaranteed $1.2 million of that loan and Schanno
defaulted, Grojean after paying off the bank to
the limit of the guaranty would under normal
principles of suretyship have had a $1.2 million
claim for reimbursement from Schanno. But if
Schanno paid Grojean any part of such a claim,
the payment would be a preference to an insider
creditor (because Grojean owns Schanno), so that
if Schanno declared bankruptcy within a year of
the payment Grojean would have to return it to
the debtor (or the trustee in bankruptcy, if one
was appointed) and take his place in line with
the other creditors. 11 U.S. sec. 547 (b)(4)(B);
Lawyers Title Ins. Corp. v. Dearborn Title Corp.,
118 F.3d 1157, 1160 (7th Cir. 1997); In re
Vitreous Steel Products Co., 911 F.2d 1223, 1238
n. 6 (7th Cir. 1990); Levit v. Ingersoll Rand
Financial Corp., 874 F.2d 1186, 1188 (7th Cir.
1989); In re Dorholt, Inc., 224 F.3d 871, 873-74
(8th Cir. 2000). If instead he had a
participation interest in the bank’s loan, he
would technically not be a creditor of Schanno
(since it was the bank’s loan, not his), and so
the normal 90-day preference period would apply.
Or so Grojean argues--for the bankruptcy court,
just like the Tax Court here, might reclassify
the participation interest as a guaranty, making
the guarantor (Grojean) a creditor of Schanno
once he made good on the guaranty. Cf. Bonded
Financial Services, Inc. v. European American
Bank, 838 F.2d 890, 894-96 (7th Cir. 1988). For
bankruptcy too has a "substance over form"
doctrine. In re Zedda, 103 F.3d 1195, 1203-04
(5th Cir. 1997); Brockington v. Scott, 381 F.2d
792, 794 (4th Cir. 1967).
We need not consider the applicability of that
doctrine (on which see Douglas G. Baird, The
Elements of Bankruptcy 188-89 (rev ed. 1993)) to
Schanno’s hypothetical bankruptcy. Grojean’s
bankruptcy argument does not identify a
functional difference between an outright
guaranty and the loan participation. It
identifies a merely formal difference that
Grojean hoped a bankruptcy court would not see
through. This is not to deny that the seeking of
a legal advantage can lend substance to the
choice of a transaction form. The choice to do
business in the corporate form is not treated as
an empty formality merely because the motive may
be to obtain (legally) limited liability for the
shareholders. But that formality has itself a
substantive purpose, that of facilitating the
raising of capital by protecting investors from
unlimited personal liability for the venture’s
debts. The advantage in bankruptcy that Grojean
sought by structuring his guaranty as a loan
participation was, in contrast, a pure
smokescreen--an endeavor to conceal his insider
status by having his loan to Schanno laundered by
American National.
Grojean’s bankruptcy argument shows up the
futility of another argument of his, that
previous cases of successful efforts by the
Internal Revenue Service to get loan
participations reclassified as guaranties
involved affiliated entities. See, e.g., Bergman
v. United States, 174 F.3d 928, 932-33 (8th Cir.
1999); Reser v. Commissioner, 112 F.3d 1258, 1264
(5th Cir. 1997); Wilson v. Commissioner, 1991
T.C. Memo 91,544. If Grojean owned American
National Bank, he would endeavor to structure any
transaction between him and it in a way that
would minimize his tax liability while maximizing
his rights in the event of bankruptcy. But he
would do this whether or not he had any control
over the bank. The bank would not resist. It has
no incentive to protect either the taxing
authorities or the other creditors of Schanno
from a deal that minimizes Grojean’s tax
liability and bankruptcy risks. On the contrary,
to the extent that structuring the deal in this
way would be valuable to Grojean, going along
with it would enable the bank to get better terms
from him.
Grojean’s invocation of bankruptcy actually
strengthens the Tax Court’s alternative ground
for refusing to classify the $1.2 million loan
participation as an indebtedness of Schanno to
Grojean. The alternative ground, recall, is that
whatever the economic realities, Grojean
technically was not a lender to Schanno; only
American National was. Schanno neither had a loan
agreement with Grojean nor issued him a
promissory note. In a loan participation, the
lead bank or other lead lender is the only
lender; the participants have a contractual
relation only with that bank. See, e.g., First
National Bank v. Continental Illinois National
Bank & Trust Co., 933 F.2d 466, 467 (7th Cir.
1991); In re Pearson Bros. Co., 787 F.2d 1157,
1161-62 (7th Cir. 1986); Carondelet Savings &
Loan Ass’n v. Citizens Savings & Loan Ass’n, 604
F.2d 464 (7th Cir. 1979); Den Norske Bank AS v.
First Nat’l Bank, 75 F.3d 49, 51 n. 2 (1st Cir
1996); Penthouse Int’l, Ltd. v. Dominion Federal
Savings & Loan Ass’n, 855 F.2d 963, 967 (2d Cir.
1988). The bank sells shares of the loan to the
participants, as one might sell shares in a
corporation.
Grojean cries foul. If the government can ignore
the form of his "guaranty," reclassifying it from
a loan participation to a guaranty on the basis
of its economic substance, why shouldn’t he be
allowed to reclassify his loan participation
interest as a loan by him to Schanno, since there
is (he argues) no functional difference between
the two characterizations? The answer is that the
doctrine of substance over form allows only the
government to recharacterize a transaction in
accordance with its commercial significance.
Commissioner v. Court Holding Co., 324 U.S. 331,
334 (1945); Gregory v. Helvering, supra;Continental Illinois Corp. v. Commissioner, 998
F.2d 513, 519 (7th Cir. 1993); Yosha v.
Commissioner, supra, 861 F.2d at 497-98; Twenty
Mile Joint Venture, PND, Ltd. v. Commissioner,
200 F.3d 1268, 1277 (10th Cir. 1999). The cases
assume rather than state this, but the assumption
is sound. Bittker & Eustice, supra, sec.
1.05[2][b], p. 1-21. The taxpayer’s position and
the government’s position in relation to the use
of transactional forms are asymmetrical. It is
the taxpayer rather than the government that
chooses the form. He can choose whatever form
seems apt to his purposes, but he is bound by his
choice; he cannot take the benefits of the form
but slough off the costs by asking that the
transaction be recharacterized.
The Bittker treatise suggests there may be an
exception to the onesidedness of the substance
over form doctrine, citing Bartels v. Birmingham,
332 U.S. 126 (1947). In that case the Supreme
Court allowed a dance hall whose contract with
the members of its dance bands described them as
employees of the hall to prove that really the
dance bands were independent contractors and the
members of the bands were their employees, not
the dance hall’s, and so the dance hall wasn’t
liable to pay social security tax. The Court
treated it as a case in which the IRS had simply
identified the wrong firm as the employer and
hence as the taxpayer. There is no suggestion in
this case that the IRS is picking on the wrong
person.
Even if a taxpayer could sometimes use the
doctrine of substance over form (as we doubt,
outside the narrow class of cases delimited by
Bartels), he could not use it in a case in which
he was trying both to employ the form to defeat
substance and the substance to defeat the form.
That is what Grojean is trying to do. He is
trying to use substance to defeat form in this
tax case, so far as the Tax Court’s alternative
ground (that a loan participant is not the lender
to the borrower of the loan), but he claims that
he would have been entitled to use form to defeat
substance had Schanno declared bankruptcy.
Remember that the theory by which structuring the
$1.2 million guaranty as a loan participation
would give Grojean an advantage in bankruptcy is
that as a loan participant he would technically
not be a creditor of Schanno and therefore he
would escape the one-year extended preference
period for insider creditors of a bankrupt firm.
He cannot have it both ways: if his technicality
works in bankruptcy, it binds him in tax. If it
fails in bankruptcy, this still leaves the Tax
Court its first ground, that the loan
participation was in reality a guaranty.
Affirmed.