McKelvy v. United States

Kashiwa, Judge,

delivered the opinion of the court:^*

The above-entitled claims are consolidated suits for the refund of federal income taxes for calendar year 1969. An assessment was made by the Government on a “distribution and loan-back” transaction made on or about April 12,1969, between McKelvy Furniture, Inc. and its shareholders, Robert H. and Maxine McKelvy and R. Hugh and Tula E. McKelvy, involving the amounts of $5,136.17 and $17,851.74, respectively. The total consolidated refund claimed is $6,192.02 ($1,570.51 claimed by Robert H. and Maxine McKelvy; $4,621.51 claimed by R. Hugh and Tula E. McKelvy) together with interest.

The sole question is whether the said April 12,1969, transaction was a taxable dividend to the extent of earnings and profits of McKelvy Furniture, Inc. for its fiscal year ending January 31,1970. We find for the defendant in both cases.

McKelvy Furniture, Inc. was incorporated under the laws of the State of Texas on February 1,1959; its place of business was Lubbock, Texas. From its inception through its fiscal year ending January 31, 1969, the corporation elected to be taxed as a small business corporation under Subchapter S of the Internal Revenue Code of 1954, as amended, 26 U.S.C. §§1871-1378 (1970) ,¹ The corporation properly terminated its election to be a small business corporation under Subchapter S beginning with its fiscal year ending January 31, 1970, that is, as of February 1, 1969. Plaintiffs Robert H. and Maxine McKelvy together owned, as their community property, 50 percent of the outstanding stock of the corporation, the remaining 50 percent being owned by plaintiffs R. Hugh and Tula E. McKelvy together as their community property. Such stock ownership was and has been the same for all periods material to this litigation. Taxpayers are on a calendar-year basis for the purpose of filing their personal income tax returns and were on such a calendar-year basis for the year 1969.

The corporation reported current earnings and profits of $21,058.33 for its fiscal year ending January 31, 1969, and $14,378.30 for its fiscal year ending January 31,1970. These figures are taken from the income tax returns of McKelvy Furniture, Inc. for its fiscal years ending January 31, 1969, and January 31, 1970, which have been stipulated as accurately reflecting earnings and profits for the purposes of these cases. At the beginning of the fiscal year ending January 31,1969, the corporation reported that it had previously taxed income (hereinafter referred to as PTI) totaling $36,017.97. By the end of that taxable year, the corporation reported on its books that this amount of PTI had been reduced by $35,941.67 ² to $76.30. No reduction was reported in the corporation’s capital stock account at any time during the fiscal years ending January 31,1969, or January 31,1970. On January 31,1969, McKelvy Furniture, Inc. had $3,465.86 in cash on hand.

On January 30,1969, the directors of the corporation lawfully and effectively adopted the following resolution:

RESOLVED, That there be declared, and there is hereby declared, a dividend payable to the shareholders of record at the present time in the amount of $57,000, such dividend to be paid as follows: All accounts receivable from R. Hugh McKelvy and Robert H. McKelvy shall be forgiven and cancelled on January 31,1969, and the balance of such dividend of $57,000 shall be paid in cash on or before April 15,1969.

The divided payable of $57,000, above mentioned, was paid by the corporation as shown below:

Robert H. R. Hugh

McKelvy McKelvy

By credit on the corporation’s books on January 31, 1969, to accounts receivable:

From Robert H. McKelvy_$23, 363. 83

From R. Hugh McKelvy_ $10, 648. 26

By the corporation’s check dated and

given April 12, 1969_ 5,136.17 17, 851: 74

Total_$28,500.00 $28,500.00

At the time (and immediately prior thereto) the corporation’s above-described checks, dated April 12, 1969, in the respective amounts of $5,136.17 and $17,851.74, were given to taxpayers, the corporation’s checking account showed a balance of $21,695.22. On April 11,1969, the matter of paying •the balance of the $57,000 dividend was discussed by taxpayers and the certified public accountant who represented the corporation and them. It was then agreed that to finance such a balance taxpayers would make loans back to the corporation. Upon receipt by taxpayers of the corporation’s checks, dated April 12, 1969, described above, the respective payees endorsed the checks and deposited them to the corporation’s checking account to the extent of $5,000 and $17,750, respectively, taking and retaining the balances of $136.17 and $101.74, respectively, in cash» The amounts so deposited to the corporation were treated by all parties thereto as loans from the respective taxpayers to the corporation. No notes were given by the corporation to evidence those loans.

At the end of the fiscal year ending January 31, 1969, the corporation’s balance sheet showed dividends payable of $22,987.91. This figure had been reduced to zero by the end of the fiscal year ending January 31, 1970, but nothing appears in any of the exhibits or stipulations to indicate exactly what happened to this figure. On their calendar year income tax returns for 1969, taxpayers each reported as income $10,529.16, their pro rata shares of the corporation’s current earnings and profits for its fiscal year ending January 31, 1969. Taxpayers reported no additional amount on their 1969 returns as a dividend or other income from McKelvy Furniture, Inc. In the audit of taxpayers’ 1969 income tax returns, the Internal Revenue Service determined that the loans from taxpayers to the corporation on the transaction heretofore described constituted dividends to taxpayers in calendar year 1969 out of earnings and profits of the corporation’s fiscal year ending January 31,1970, available in 1969. Based upon that determination, taxes and interest were assessed against taxpayers. The Government viewed the transactions as follows:

Fiscal 1969 earnings and profits (taxable to taxpayers in calendar 1969 under Subchapter S)_$21, 068. 33

Fiscal 1970 earnings and profits available in 1969 (taxable to taxpayers in calendar 1969 as a result of April 12, 1969, distribution of corporation obligations)_ 14, 378. 30

Balance of dividend obligation (tax effects not determined by Internal Revenue Service and not in issue here)---- 21, 463. 37

Total.....$57, 000. 00

Based upon this determination, taxes and interest were assessed against taxpayers. Taxpayers paid the assessments and filed timely claims for refund thereof, which claims were disallowed by the Commissioner of Internal Revenue on March 30,1971.

The very narrow question presented to this court is whether the above-described “distribution and loan-back” transaction of April 12, 1969, was a taxable dividend to the extent of earnings and profits of McKelvy Furniture, Inc. for its fiscal year ending January 31,1970 (in the amount of $14,378.30).³

Before reaching this question, however, it is necessary to distinguish the consequences of distributions with respect to regular Subchapter C corporations on the one band and Sub-chapter S corporations on the other. In a regular corporation, for federal tax purposes, distributions of cash or other property to stockholders are deemed dividends to the extent of current and accumulated ⁴ earnings and profits with current earnings and profits deemed to be the first source of payment. Section 316(a). Any such distributions after exhausting earnings and profits are deemed to be payment of capital and are not taxable income but reduce the basis of the shareholder’s stock. Section 301(c) (2). Distributions can only reduce basis to zero, and any distribution in excess of basis is governed by the rules of section 301 (c) (3) ,⁵ not here relevant.

A somewhat altered structure has been created in the Sub-chapter S context. If the electing corporation distributes dividends, they are includible in the shareholders’ gross income in the same manner as dividends distributed by regular corporations. Treas. Keg. § 1.1372-1 (c) (2) and (7); DeTreville v. United States, 445 F. 2d 1306, 1309 (4th Cir. 1971). The Subchapter S provisions go on to deal with a new category of account, known as “undistributed taxable income” (hereinafter referred to as UTI), and defined by section 1373 (c) to be:

* * * taxable income * * * minus * * * the amount of money distributed as dividends during the taxable year, to the extent that any such amount is a distribution out of earnings and profits of the taxable year 'as specified in section 316'(a) (2). [Emphasis supplied.]

After the amount of TJTI is calculated, section 1373(b), an operational section, prescribes the following addition to gross income, not contemplated by regular corporations:

(b) Amount included m gross income.

Each person who is a shareholder of an electing small business corporation on the last day of a taxable year of such corporation shall include in his gross income, for his taxable year in which or with which the taxable year of the corporation ends, the amount he would have received as a dividend, if on such last day there had been distributed pro rata to its shareholders by such corporation an amount equal to the corporation’s undistributed taxable income for the corporation’s taxable year. For purposes of this chapter, the amount so included shall be treated as an amount distributed as a dividend on the last day of the taxable year of the corporation.

Section 1377(a) provides that earnings and profits are reduced by these constructive dividends in the same way that actual dividends reduce earnings and profits.

Any amount which is included in the gross income of the shareholder as a constructive dividend by virtue of section 1373(b) increases the basis of his shares, just as if he had made a capital contribution to the corporation. Section 1376(a). To account for the fact that UTI is being taxed to the shareholders, the Subchapter S provisions set up a system whereby an actual distribution in a later year of these previously taxed constructive dividends may be received by the shareholder without the imposition of a second tax. Under section 1375(d), set out below,⁶ the shareholder computes his net share of the corporation’s UTI. This is the sum of all the amounts which, under 1373(b), have been included in his gross income as constructive dividends less the sum of both allowable net operating loss deductions passed through to him under section 1374(b) and, of course, any amounts previously distributed to the shareholder under the provisions of section 1375(d) itself. Treas. Reg. § 1.1375-4(fe)⁷ sets forth the requirement that distributions, to qualify for the benefits of section 1375(d), must be made in money. This is altogether consistent with the plan of Subchapter S since, as noted supra, a distribution to reduce UTI under section 1373(c) must be in money. It simply could not be the case that a shareholder who was prevented by the “money” requirement of section 1378(c) from reducing his UTI account in fiscal year one could, by the simple expedient of waiting for fiscal year two, be then entitled to reduce the PTI account by a property-other-than-money distribution. This would defeat the Subchapter S scheme because the shareholder’s PTI account is made up of the same UTI which was included in income 'as a constructive dividend pursuant to section 1373(b). See De Treville v. United States, supra, 445 F. 2d at 1311-1312, for a Case upholding the 'Validity of Treas. Reg. § 1.1375-4 (b). It should also be noted that under this same Regulation, the corporation must make a money distribution in excess of its current earnings and profits before amounts can be withdrawn from the PTI account.

It can thus be seen that the real value of the PTI account is that, if the distribution otherwise qualifies, the shareholder will be allowed to withdraw money without dividend consequences even though there are accumulated earnings and profits⁸ which, in the regular corporate situation, would precede all forms of capital and be available as a source for dividends. The Subchapter S election alters the basic order. However, a termination of the Subchapter S election alters this privileged treatment of the PTI funds and re-establishes the basic rule that all the earnings and profits, both current and accumulated, must be exhausted before the capital accounts may be invaded ⁹ (save for the exception of section 1375(f), to be considered infra).

Taxpayers make the argument that the April 12, 1969, “distribution and loan-back” transaction was a money distribution which, since made within 2months of the close of the corporation’s previous fiscal year, relates back to that previous fiscal year pursuant to the provisions of section 1875(f).¹⁰ If, as taxpayers argue, section 1375(f) applies, the distribution would be applied against the undistributed taxable income for the preceding year if such undistributed taxable income was required to be included in the shareholders’ gross 'income 'by virtue o'f section 1373 (b) .¹¹ The basic problem with this analysis is the factual premise upon which it is based. We find, for reasons hereinafter stated, that the April 12,1969, distribution was not a money distribution.

As noted above, at the time the checks, in the aggregate amount of $22,987.91, were issued, the corporation’s checking account showed a balance of $21,695.22. Thus, to finance the April distribution, the corporation found it necessary to have the checks endorsed back to it, the two parties retaining the odd dollar amounts totaling $237.91 (i.e., Robert H. McKelvy retained $136.17 and R. Hugh McKelvy retained $101.74) .¹² Looking to the substance of the transaction rather than its form and viewing this series of interrelated steps as an integrated whole, what we have is not a distribution of money, but, rather, the distribution of corporate obligations.¹³ George A. Roesel, 56 T.C. 14 (1971). See also Gregory v. Helvering, 293 U.S. 465 (1935), Redwing Carriers, Inc. v. Tomlinson, 399 F. 2d 652 (5th Cir. 1968).

The Regulations interpreting section 1375(f) address themselves to our particular case:

(iii) For purposes of this subparagraph and subpara-graph (3) (ii) of this paragraph, a distribution of money does not include a distribution of an obligation of the corporation? a distribution of property other than money in satisfaction of a dividend declared in money, or a distribution in exchange for stock. [Treas. Reg. § 1.1375-6(a) (2) (iii).]

The validity of this Regulation is beyond question, and it was so held in Randall N. Clark, supra, footnote 11. We hold this regulation to be reasonable and consistent with the normal meaning of the statutory language. Commissioner v. South Texas Lumber Co., 333 U.S. 496 (1948).

The taxpayers next argue that even if they do not qualify for the benefits of section 1375(f), the fiscal 1970 earnings and profits remain unavailable for taxable dividends despite the April, 1969, distribution, because of the effect of the January declaration. The effect of this argument is as follows : since a dividend was declared in the amount of $57,000 on January 30, 1969 (immediately prior to the end of fiscal 1969), the consequence of any later distribution in discharge of this $57,000 liability must be determined by reference to the earnings 'and profits, PTI account, accumulated earnings and profits, and capital of the corporation during fiscal 1969. They also argue that even if the April 12, 1969, transaction is a distribution of a corporate obligation, it relates back to Janu'ary 30,1969, the date of constructive receipt, in order to determine the nature of the distribution. Before entering into a discussion of this issue, it is necessary to appreciate the planning problems which confronted the Subchapter S corporation shareholders prior to the enactment of section 1375 (f), supra.

Section 1375 (d) ,¹⁴ as we have said, was designed to permit the tax-free distribution of amounts previously taxed to the Subchapter S shareholder as constructive dividends from undistributed taxable income. However, there were substantial limitations on the shareholder’s right freely to distribute from his PTI account. First, a distribution to qualify as coming from PTI, had to be in money. Treas. Reg. § 1.1375-4(b),¹⁵ DeTreville v. United States, supra. Second, the PTI account is subject to reduction by the amounts allowable as deductions under section 1375(b) (pass-through of net operating losses). Third, a tax-free distribution in a later year, even if in cash and even if there are sufficient amounts in PTI to cover the distribution, cannot be made until after the corporation’s current earnings and profits have been distributed. Treas. Reg. § 1.1375-4 (b).¹⁶

Finally, there existed the problem of a termination of the Subchapter S status. During Subchapter S status, cash distributions would be applied in the following order: First, to current earnings and profits; second, to previously taxed undistributed taxable income (PTI); third, to accumulated earnings and profits (if any) ; and finally, as in regular corporations, to a reduction of basis to zero with any distribution in excess of 'basis governed by the rules of section 301 (c) (3). However, once the Subchapter S election was terminated, the shareholder no longer had the privilege of a tax-free distribution out of 'PTI if accumulated earnings and profits were present.¹⁷ Of course, if there were no accumulated earnings and profits, then, after current earnings and profits were exhausted, the tax-free distribution could be made out of capital.

The cumulative effect of all these factors gave rise to a situation in which the taxpayer possessed a potentially advantageous PTI account, but was often unable, for the above-stated reasons, to derive any tax benefit from it. Thus, Congress, in 1966, addressed itself to the problem of these so-called “locked-in” earnings.¹⁸

In order to prevent a lock-in of earnings, shareholders had been under pressure accurately to forecast the earnings by the year’s end in order to prevent any amount from being taxed as a constructive dividend under section 1373 (b). Congress’ solution was to enact section 1375(f).¹⁹ Generally speaking, under this remedial provision, all money distributions made within 2% months of the close of the corporation’s previous fiscal year are treated as distributions of the corporation’s undistributed taxable income for the previous year. In other words, Congress provided, with respect to money distributions, a limited relation-back provision. The money distribution was deemed to have been received in the prior fiscal year. If the standards of section 1375(f) were met, the shareholder Was no longer fa'ced with the problem of first having to exhaust his current earnings and profits. The shareholder simply reduced his undistributed taxable income for the previous year. The plaintiffs, in effect are telling us that they did not need section 1375(f) to provide them with a justification for relating back subsequent distributions to the previous year. Plaintiffs assert that the judicial doctrine of constructive receipt already existed with respect 'to Subchapter S to the same extent that the doctrine exists -with respect to regular corporations. It is our view that the plaintiffs :are completely in error in this assertion. While we are mindful of the general proposition that Subehapter S corporations are subject to the general corporate provisions, we must also realize that the Subchapter S provisions in certain areas displace the general corporate rules. This principle is most clearly evident with respect to the highly technical rules of Subchapter S, which allow, in very prescribed situations, non-dividend treatment.

In Attebury v. United States, 430 F. 2d 1162 (5th Cir. 1970), the taxpayer made a similar contention. The facts of that case, as simplified for discussion, are as follows: The corporation declared a dividend during fiscal year one. No actual distributions, however, were received by the shareholders during fiscal year one. During fiscal year two, many cash distributions were made. The Government conceded, at the time of appeal, that the cash distributions made within 3 y2 months ²⁰ of the close of fiscal year one satisfied section 1375(f) and related back to fiscal year one to reduce undistributed taxable income with no dividend consequences. With respect to the cash distributions made after the 3%-month grace period, the taxpayers pointed out that these amounts had already been included in their personal calendar year one returns by virtue of sections 1373 (a) and (b). They put forth two arguments: (1) that they were in “constructive receipt” of all the corporation’s undistributed taxable income as if such income had been distributed to them on the last day of the corporation’s fiscal year one; and (2) that the cash distributions were payments by the corporation to them on corporate debts created prior to the end of the corporation’s fiscal year one by the declaration of a dividend equal to the amount of the corporation’s taxable income. The Government, on the other hand, contended that the payments after the 314-month grace period (but still during the taxpayers’ personal year one calendar year) were taxable as dividends to the extent of the corporation’s earnings and profits for its fiscal year two.

The Fifth. Circuit in Attebury noted that section 1373(c) defines “undistributed taxable income” as

* * * taxable income * * * minus * * * the amount of money distributed as dividends during the taxable year * * *. ’[Emphasis supplied.]

The court then went on to hold that because of the clear language of section 1373(c) the taxpayers could not employ the constructive receipt doctrine in a new definition of what amounts were distributed during the taxable year. Bather, the only amounts which could be considered as distributed during fiscal year one (and which would reduce undistributed taxable income) were actual cash distributions to shareholders before the end of the corporate year. Section 1375(f) merely extends for 2% months (or in some cases 314 months) the right to make a cash distribution to reduce the undistributed taxable income. The Government’s basic argument was that the doctrine of constructive receipt was not applicable to Subchapter S corporations since the dividend declaration added nothing to the taxability of the otherwise undistributed current earnings and profits of the corporation. Thus, cash distributions made during fiscal year two, after the relief period for fiscal year one, had to repi’esent a distribution of earnings and profits for fiscal year two. We are in agreement with the Fifth Circuit’s analysis:

The legislative history of section 1375(f) clearly demonstrates that the relief provision was intended to solve the bunching-of-income problem, resulting from a Subchapter S corporation’s inability to make actual cash distributions of its taxable income before the end of its taxable year. From the above legislative history, it is clear to us that Congress interpreted the Subchapter S provisions as requiring the following: Unless such actual cash distributions were made before the close of the corporation’s tax year (thus reducing the amount of undistributed taxable income for that year to the extent such distributions were dividends), they were includable in the shareholders’ gross income when ultimately distributed in the subsequent tax year of the corporation to the extent of that year’s earnings and profits. This analysis forecloses use of the constructive receipt doctrine in the manner proposed by taxpayers and implemented by the district court. [Footnotes omitted.] [430 F. 2d at 1170-1171.] [Emphasis supplied.]

In the instant case, the taxpayers are faced with further difficulties. Treas. Reg. §1.451-2 (b) (1969), which defines the constructive receipt doctrine, requires that

* * * Dividends on corporate stock are constructively received when unqualifiedly made subject to the demands of the shareholder * * *.

Even assuming the applicability of the constructive receipt doctrine to the cases at bar, taxpayers have failed to show that the precise requirements of the doctrine have been met with respect to the transactions being considered.

Treas. Reg. § 1.451-2 (a) (1969) explains that even in situations where the doctrine can legally be applied, “income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.” Since taxpayers are contending that the amount of the April 12 distribution was constructively received by January 31, 1969, they must show that there were no “substantial limitations or restrictions” to their control of the money on January 31, 1969. It has long been held that lack of available funds by a corporation to pay a dividend does constitute a substantial limitation to the shareholder’s control of the funds in question. Johnson v. Commissioner, 25 T.C. 499 (1955); Estate of Bach v. Commissioner, 9 B.T.A. 1404 (1928); Northern Trust Co. v. Commissioner, 8 B.T.A. 685 (1927).

The balance sheet attached to the corporation’s fiscal 1969 income tax return, Joint Exhibit 3-C, shows that the corporation had only $3,465.86 in cash on hand on January 31, 1969, with which it could have paid the purported dividend liabilities, as well as any other current liabilities.

The Attebivry decision also rejected the taxpayers’ assertion that distributions made in the corporation’s second fiscal year were payments on corporate debts created prior to the •end of the tax year by the declaration of a dividend equal to the amount of the corporation’s taxable income. The taxpayers in the cases before us make a similar argument focusing on the asserted dividend liabilities created prior to the end of the corporation’s first fiscal year. Those cases cited by taxpayers²¹ were all Cases under the law prior to the enactment of the Subchapter S provisions. The Fifth Circuit, which had decided the Roe case, made the following statement with respect to the effect of the Sub-chapter S provisions on the previous law:

Implicit in our decision in Roe * * * is the inclusion in the shareholder’s gross income, when the dividend is declared, of an amount equal to the declared dividends, pursuant to the constructive receipt doctrine. 192 F. 2d at 402-403. Since we have concluded that the constructive receipt doctrine is inapplicable, * * * the Roe decision is clearly distinguishable. * * * [430 F. 2d at 1172.]

While Attebury involved the Subchapter S provisions requiring a cash distribution of current earnings (section 1373 (c) and the Regulations, thereunder), the theory of its holding is applicable to the Subchapter S regulations requiring a cash distribution from the PTI account made consistent with all the other rules of section 1375(d). Since the constructive receipt doctrine is not applicable to either case, what is required, under the Subchapter S structure, is an actual and timely distribution of money.

■In a final attempt to distinguish the Attebury case, the plaintiffs in the instant cases assert that even assuming that the Fifth Circuit was correct, the fact that the Subchapter S election was terminated after the corporation’s first fiscal year in the instant cases, while the Attebury corporation retained its Subchapter S status throughout, is significant. We hold that the termination of the Subchapter S election for fiscal year two does not mean that the regular corporate rules (of Which constructive receipt may be one) apply to the declaration made in fiscal year one, an admitted Subchapter S year. 'It is true that section 1375(f) permits a money distribution to be made within 2% months after the close of the previous fiscal year, even if the corporation ceases to 'be governed by Subchapter S for the second fiscal year. However, this remedial provision is limited and provides the only possible way that the taxpayers in our case could take advantage of Subchapter S privileges. Unfortunately for the plaintiffs, the April, 1969, transaction was not a money distribution. Thus, when actually made, this distribution must be governed by the rules of regular corporations under which all distributions, including distributions of corporate obligations, are taxable to the shareholders to the extent of earnings and profits.²² Thus,

* * * [T]he right to make a nondividend distribution of previously taxed income under § 1375(d) [although the relief provisions of section 1375(f) remain available if the standards are -met] lasts only as long as the Subchapter S election remains in force, and evaporates if the election is terminated. A post-termination distribution will be governed by the usual rules of § 301, under which all current and accumulated earnings and profits must be distributed as dividends 'before the corporation can make a nondividend distribution. Thus, a distribution that would have been shielded by § 1375 (d) if the Subchapter S election had remained in effect may constitute a dividend if made after the election is terminated. Of course, this will be true only if the corporation has current or accumulated earnings and profits when the distribution is made. In this connection, it should be noted that the corporation might have earnings and profits because (a) it had an accumulation of earnings and profits when it made the Subchapter S election, which were not distributed while the election was in force; (b) it accumulated some earnings and profits during the Subehapter S period; or (c) its operations after the election was terminated produced earnings and profits. [Footnotes omitted.] [Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders 6-29, 6-30 (3d ed. 1971).]

Since, in the instant case, McKelvy Furniture, Inc. produced $14,378.30 of earnings and profits during its fiscal year ended January 31,1970 (when it was not a Subchapter S corporation), the Government’s position that these earnings and profits were available for dividend distribution is correct. Therefore, plaintiffs are not entitled to recover and the petitions are dismissed.

* This opinion contains all the essential findings of fact as stipulated by the parties.

1 All references to statutory tax provisions are to the Internal Revenue Code of 1954, as amended.

2 This $35,941.67 plus $21,058.33 current earnings and profits for the corporation’s fiscal year ending January 31, 1969, totals $57,000.00. Thus, It Is clear that the taxpayers’ original Intent, as expressed In the resolution recited In the next paragraph, was to distribute, totally, current earnings and profits as well as nearly all of the PTI.

3 We note that the parties have avoided discussion of the $21,463.37 which the Government designates “(tax effects not determined by Internal Revenue Service and not in issue here).” We restrict ourselves specifically to the sole question above Indicated.

4 We omit from this discussion, here and infra, those exceptional circumstances involving earnings and profits accumulated on or before February 28, 1913. Section 301(c) (1) ; section 316(a) (1).

5 We omit from this discussion, here and infra, those exceptional circumstances involving distributions out of an increase in value accrued before March 1,1913. Section 301(c) (3) (B).

6 “(d) Distributions of undistributed taxable income previously taxed to shareholders.

"(1) Distributions not considered as dividends. An electing small business corporation may distribute, In accordance -with regulations prescribed by the Secretary or his delegate, to any shareholder all or any portion of the shareholder’s net share of the corporation’s undistributed taxable Income for taxable years prior to the taxable year In which such distribution Is made. Any such distribution shall, for purposes of this chapter, be considered a distribution which is not a dividend, but the earnings and profits of the corporation shall not be reduced by reason of any such distribution.

“(2) Shareholder’s net share of undistributed taxable income. For purposes of this subsection, a shareholder’s net share of the undistributed taxable income of an electing small business corporation is an amount equal to—

“ (A) the sum of the amounts included in the gross income of the shareholder under section 1373(b) for all prior taxable years (excluding any taxable year to which the provisions of this section do not apply and all taxable years preceding such year), reduced by “ (B) the sum of—

“(i) the amounts allowable under section 1374(b) as a deduction from gross income of the shareholder for all prior taxable years (excluding any taxable year to which the provisions of this section do not apply and all taxable years preceding such year), and

“ (ii) all amounts previously distributed during the taxable year and all prior taxable years (excluding any taxable year to which the provisions of this section do not apply and all taxable years preceding such year) to the shareholder which under subsection (f) or paragraph (1) of this subsection were considered distributions which were not dividends.”

7 “(b) Source of distribution. Except as provided in paragraph (c) of this section, any actual distribution of money by an electing small business corporation to a shareholder which, but for the operation of this section, would be a dividend out of accumulated earnings and profits shall be considered a distribution of previously taxed income to the extent of the shareholder’s net share of previously taxed income immediately before the distribution. Thus, a distribution of property other than money or a distribution in exchange for stock, or a constructive distribution under section 1373(b), is never a distribution of previously taxed income. Since current earnings and profits are first applied to distributions of money which are not (1) in exchange for stock, or (2) distributions of the corporation’s undistributed taxable income for the immediately preceding taxable year under section 1375(f) and § 1.1375--6 (see paragraphs (d) and (e) of §1.1373-1), a distribution of previously taxed income may occur only if during its taxable year the corporation makes such money distributions in excess of its earnings and profits for such taxable year. (See § 1.1375-5 for rules with respect to certain distributions of money which may be treated as having been made in a preceding taxable year.)”

8 We include this as background to our discussion, infra, of legislative intent. Actually, 'McKelvy Furniture, Inc. did not have any accumulated earnings and profits.

9 Sec. 1.1375-4(a) provides In part:

«* * * 'If an election is terminated under section 1372(e), the corporation may not, during the first taxable year to which the termination applies or during any subsequent taxable year, distribute previously taxed income of taxable years prior to the termination as a non-dividend distribution pursuant to this section. * * *”

10 Section 1375 (f) continues the Subchapter S scheme of requiring money distributions in order to receive non-dividend treatment. This Is true in all cases, other than a classic return of capital (as contrasted with a return of PTI). See our discussion, supra, with respect to present year reductions of UTI (section 1373(c)) and later withdrawals from PTI (section 1375(d)). Section 1375(f) reads as follows:

“(f) Distributions within 2 y2 -month period after close of tamable year.

“(1) Distributions considered as distributions of undistributed taxable income. Any distribution of money made by a corporation after the close of a taxable year with respect to which it was an electing small business corporation and on or before the 15th day of the third month following the close of such taxable year to a person who was a shareholder of such corporation at the close of such taxable year shaU be treated as a distribution of the corporation’s undistributed taxable Income for such year, to the extent such distribution (when added to the sum of all prior distributions of money made to such person by such corporation following the close of such year) does not exceed such person’s share of the corporation’s undistributed taxable Income for such year. Any distribution so treated shall, for purposes of this chapter, be considered a distribution which Is not a dividend, and the earnings and profits of the corporation shall not be reduced by reason of such distribution.

"(2) Share of undistributed taxable income. For purposes of paragraph (1), a person’s share of a corporation’s undistributed taxable income for a taxable year is the amount required to be included in his gross income under section 1373(b) as a shareholder of such corporation for his taxable year in which or with which the taxable year of the corporation ends.

“(3) Election under subsection (e). Paragraph (1) shall not apply to any distribution with respect to which an election under subsection (e) applies.”

11 The Government might have argued that the January 31, 1969, transaction whereby the loan accounts of the shareholders were canceled, was in reality a money distribution. If we were to adopt this position, there would be no UTI for fiscal 1969 to which a later distribution (even if otherwise qualifying under section 1375(f) by being in money) could be applied against. See Randall N. Clark, 58 T.C. 91 (1972). If, on the other hand, the January distribution is one of property other than money, then the complex allocation provisions set forth in Treas. Reg. § 1.1373-l'(e) and (g) would be applicable. Whatever amount of UTI which is the subject of a constructive dividend could, of course, be offset by a subsequent cash distribution otherwise complying with section 1375(f). While It may be true that a portion of the distributions involved may receive non-dividend treatment, it is clear that the earnings and profits of both fiscal years will be consumed as dividends (actual or constructive) no matter what method is chosen.

In any event, since the Government has chosen to rely on the fact that the April “check-loanback” transaction was not a money distribution and since we agree with the Government on this point, there is no need to categorize the January cancellation of the loan accounts. The basis for the tax deficiency in this case only concerns whether or not the earnings and profits of fiscal 1970 are available for dividends because of the April distribution.

12 Although the parties have not drawn our attention to the problem, It is evident that, to the extent of the $287.91; a money distribution was made. However, since the earnings and profits which the Government seeks to make available for taxable dividends (less than $15,000) is so much less than the amount of the April distribution (more than $22,000), our holding Is not altered.

13 The parties agree that the amounts endorsed over to the corporation were treated by all parties as loans to the corporation, although no formal notes were given to evidence these loans.

14 See footnote 6, supra.

15 See footnote 7, supra.

16 See also Treas. Reg. §1.1373-1 (d) and (e), which provides that money-distributed must be treated as a taxable dividend to the extent of current earnings and profits.

17 See Treas. Reg. §1.1375-4 (a) (last sentence) and § 1375(d) (2) (A) (parenthetical).

18 See Note, “Locted-In Earnings” — How Serious a Problem under Sub-chapter S?, 49 Va. U. Rev. 1516 (1963).

19 See, generally, S. Rep. No. 1007, 89th Cong., 2d SESS., pp. 1-6 (1966-1 CUM. BULL., pp. 527-531).

20 A 3%-month period may be elected for pre-April 14, 1966, distributions.

21 Roe v. Commissioner, 192 F. 2d 398 (5th Clr. 1951), Commissioner v. Goldwyn, 175 F. 2d 641 (9th Cir. 1949). See Fehrs Finance Co., 58 T.C. 174, 192-194 (1972), for a recent and very restrictive Interpretation of the Qoldwyn case.

22 See O. D. and Sarah Fountain, et al59 T.C. 693', No. 69, decided February 22, 1973. The court, after finding that a distribution of checks under the circumstances of that case -was a distribution of property and not money, held that the benefits of section 1375(f) were not available and therefore the dividend was measured by the current and accumulated earnings and profits of the actual year of distribution, which was fiscal year two of the corporation. The taxpayers had argued, inter alia, that the extent to which the issuance of checks should be taxed as dividends was limited to the earnings and profits accumulated at the end of the taxable year prior to fiscal year one of the corporation. As in the instant case, the corporation in Fountain was governed by Subchapter S in fiscal year one, and not in fiscal year two.