Bona Fide, Inc. v. Commissioner, 51 T. C. 1394 (1969)

Interest income from financing real estate transactions does not qualify as rent for personal holding company income exemptions if the corporation’s primary business is not selling real property.

Summary

Bona Fide, Inc. facilitated real estate financing but was deemed a personal holding company due to its interest income exceeding the statutory threshold. The Tax Court ruled that this income did not qualify as rent under the personal holding company rules because Bona Fide’s primary business was financing, not selling real property. Consequently, Bona Fide’s Subchapter S election was terminated in 1960 because its interest income exceeded 20% of its gross receipts. The court also upheld a 1964 distribution to a shareholder as a taxable dividend, given the termination of the Subchapter S status.

Facts

Bona Fide, Inc. , incorporated in Iowa in 1956, facilitated home purchases by providing financing to buyers unable to meet downpayment or equity requirements. The company purchased properties through Iowa Securities Co. and resold them to buyers on favorable terms. Bona Fide received payments consisting of principal, interest, and escrow payments for insurance and taxes. In 1959 and 1960, Bona Fide reported net income after treating interest receipts and payments as a wash transaction. In 1960, Bona Fide elected to be taxed as a Subchapter S corporation. In 1964, a distribution was made to shareholder Alfred M. Sieh.

Procedural History

The IRS determined deficiencies in Bona Fide’s and Alfred M. Sieh’s income taxes, asserting that Bona Fide was a personal holding company and its Subchapter S election was terminated. The case was heard by the Tax Court, which consolidated two related cases for trial, briefing, and opinion.

Issue(s)

1. Whether Bona Fide, Inc. was a personal holding company during the years 1959 and 1960, subject to the personal holding company tax under section 541.
2. Whether Bona Fide’s election to be taxed as a Subchapter S corporation was terminated as of January 1, 1960.
3. Whether Alfred M. Sieh received a dividend of $2,404. 10 from Bona Fide, Inc. , in the taxable year 1964.

Holding

1. Yes, because the interest income received by Bona Fide did not qualify as rent under section 543(a)(7) and exceeded 80% of its gross income, making it a personal holding company.
2. Yes, because the interest income exceeded 20% of Bona Fide’s gross receipts in 1960, terminating its Subchapter S election under section 1372(e)(5).
3. Yes, because the 1964 distribution to Alfred M. Sieh was a dividend under sections 301 and 316, as Bona Fide was not a valid Subchapter S corporation at that time.

Court’s Reasoning

The court applied sections 541, 542, and 543 of the Internal Revenue Code to determine if Bona Fide was a personal holding company. It found that the interest income did not qualify as rent under section 543(a)(7) because Bona Fide’s primary business was financing, not selling real property. The court rejected the petitioners’ argument that the interest constituted rent, emphasizing that Bona Fide acted as a financing conduit for Iowa Securities. The court also followed IRS regulations in defining gross receipts for Subchapter S termination, concluding that Bona Fide’s interest income exceeded 20% of its gross receipts in 1960. For the 1964 distribution, the court ruled it was a dividend because Bona Fide’s Subchapter S election had been terminated, and no valid election was in effect in 1964. The court dismissed the estoppel argument regarding the IRS agent’s advice, citing Bookwalter v. Mayer.

Practical Implications

This case clarifies that for personal holding company status, interest income from financing transactions is not considered rent unless the corporation’s primary business is selling real property. Legal practitioners should ensure that clients’ business operations align with their tax elections, especially when considering Subchapter S status. The decision also underscores the importance of accurately calculating gross receipts under the applicable accounting method to determine compliance with Subchapter S requirements. Businesses engaged in financing should be cautious about the potential for personal holding company tax implications. Subsequent cases may reference this decision when analyzing similar financing structures and their tax treatment.