Roesel v. Commissioner

George A. Roesel and Patricia M. Roesel, Petitioner v. Commissioner of Internal Revenue, Respondent; Dorothy H. Marbut, Petitioner v. Commissioner of Internal Revenue, Respondent Roesel v. Commissioner Docket Nos. 374-68, 375-68 United States Tax Court 56 T.C. 14; 1971 U.S. Tax Ct. LEXIS 156; April 7, 1971, Filed *156 Decisions will be entered under Rule 50. On Feb. 28, 1963, and Feb. 29, 1964, a qualifying subchapter S corporation issued checks to its shareholders, including the petitioners, in the amounts of $ 345,000 and $ 165,745, respectively. On or about Mar. 1, 1963, and Mar. 1, 1964, the shareholders issued their checks to the corporation in the amounts of $ 117,500 and $ 69,505, respectively, and received debentures and short-term notes of the corporation in such amounts. Held, that in substance the issuance by the corporation of the above checks did not constitute distributions of money in the full amounts thereof, but rather the transactions constituted in substance distributions by the corporation of money in the amount of $ 227,500 and property in the amount of $ 117,500 on Feb. 28, 1963, and money in the amount of $ 96,240 and property in the amount of $ 69,505 on Feb. 29, 1964. Held, further, that the issuance of checks on Feb. 28, 1963, did not effect a distribution of the corporation's undistributed but previously taxed income, and that the distributions of debentures and notes constituted taxable dividends to the extent of available earnings and profits. James E. Johnson, Jr., and J. Larry Broyles, for the petitioners. David S. Meisel, for the respondent. Atkins, Judge. ATKINS *159 *15 The respondent determined deficiencies in income tax as follows: Petitioner Taxable year Deficiency George A. and Patricia M. Roesel [1963] $ 2,649.50 [1964] 387.92 Dorothy H. Marbut [1963] 17,968.75 The above cases were consolidated for trial and certain issues were settled by stipulation of the parties. The only issue remaining for decision is whether distributions received by petitioners during their taxable year 1963 as shareholders of a qualified subchapter S corporation constituted in part distributions of such corporation's undistributed but previously taxed income. FINDINGS OF FACT Some of the facts have been stipulated and are incorporated herein by this reference. Petitioners George A. and Patricia M. Roesel are husband and wife and at the time they filed their petition herein resided in Augusta, Ga. They filed joint Federal income tax returns for the taxable years 1963 and 1964 with the district director of internal revenue, Atlanta, Ga. Petitioner Dorothy H. Marbut filed an individual Federal income tax return for the taxable year 1963 with such district director and at the time she filed her petition herein resided in Augusta, Ga. Inasmuch *160 as George A. Roesel is party hereto solely because of having filed joint returns with his wife, Patricia M. Roesel and Dorothy H. Marbut will hereinafter be referred to as petitioners. Marbut Milling Co., Inc., hereinafter referred to as Milling, was *16 incorporated under the laws of Georgia on August 13, 1959. At all pertinent times it had 10 stockholders, the petitioners Marbut and Roesel owning 32 percent and 9 percent of its stock, respectively. Since its incorporation, Milling's principal business activity has been the manufacture and sale of feed. Its products were sold directly to farmers located within a 200-mile range of Augusta, Ga. Prior to its incorporation, Milling's business had been operated as a partnership. On September 11, 1959, Milling elected taxable status as a small business corporation under the provisions of subchapter S of the Internal Revenue Code of 1954. It has utilized the accrual method of accounting and a fiscal year ending on the last day of February for tax purposes. On its return for its taxable year ended February 29, 1960, Milling reported taxable income in the amount of $ 186,983.79. It made a distribution on February 29, 1960, in the*161 amount of $ 200,000, of which $ 186,983.79 was reported as a distribution out of its earnings and profits for such year and $ 13,016.21 as a distribution out of paid-in surplus. On its return for its taxable year ended February 28, 1961, Milling reported taxable income in the amount of $ 297,978.44. During that year it made distributions in the total amount of $ 294,800 which were reported as distributions out of its earnings and profits for such year. It reported undistributed taxable income in the amount of $ 3,178.44. During its taxable year ended February 28, 1962, Milling's taxable status as a subchapter S corporation was questioned by the Internal Revenue Service. In view of its liability for corporate income tax in the event its subchapter S status were terminated, Milling did not attempt to distribute all of its earnings for such year, but retained a portion thereof to meet any such liability. On its return for its taxable year ended February 28, 1962, Milling reported taxable income in the amount of $ 245,449.29. It made a distribution on February 28, 1962, in the amount of $ 125,500 which was reported as a distribution out of its earnings and profits for such year. *162 It reported undistributed taxable income in the amount of $ 119,949.29. At some time during its taxable year ended February 28, 1963, the controversy with respect to Milling's status as subchapter S corporation was resolved in its favor. During its taxable years ended February 28, 1963, and February 29, 1964, Milling maintained a checking account with the Georgia Railroad Bank & Trust Co. During such years it had a line of credit with such bank in the amount of $ 300,000. Two hundred thousand dollars *17 of such line of credit was available on an unsecured basis and the remaining $ 100,000 was available upon the assignment of Milling's accounts receivable as security. On its return for its taxable year ended February 28, 1963, Milling reported taxable income in the amount of $ 227,382.20. 1 On February 28, 1963, it borrowed $ 150,000 pursuant to its line of credit with the Georgia Railroad Bank & Trust Co. and deposited such funds in its checking account. After such borrowing its total liability to the bank was $ 151,375. On that date, it issued checks bearing the same date to its stockholders in the total amount of $ 345,000. Such checks were cashed or deposited by the*163 stockholders. The checks issued to petitioners Marbut and Roesel were in the respective amounts of $ 110,400 and $ 31,050. On its return for that year it reported distributions in the amount of $ 345,000, of which $ 227,382.20 was reported as a distribution out of its earnings and profits for its taxable year ended February 28, 1963, and $ 117,617.80 as a distribution of previously taxed income. Milling did not have sufficient funds in its checking account to fully cover the total amount of its checks dated February 28, 1963, and this gave rise to a bank overdraft on its books in the amount of $ 106,817.55. On March 1, 1963, Milling issued notes and debentures to its shareholders as follows: Percent Debentures issued Mar. 1, 1963 Notes issued Mar. 1, 1963 Shareholder shares held Amount of Percent total Amount of Percent total debentures debentures notes notes Marbut 32.0 $ 21,600 32.0 $ 16,000 32.00 Laurent 10.5 7,088 10.5 6,175 12.35 Wilson 10.5 7,088 10.5 6,175 12.35 Brown 10.5 7,088 10.5 6,175 12.35 Roesel 9.0 6,075 9.0 4,500 9.00 Hanlin 9.0 6,075 9.0 4,500 9.00 Ashley 5.5 3,712 5.5 3,225 6.45 Dunlap 5.5 3,712 5.5 3,250 6.50 Caylor 5.0 3,375 5.0 Chao 2.5 1,687 2.5 Totals 100.00 67,500 100.0 50,000 100.00 *164 On March 1, 1963, the shareholders issued checks to Milling in the above transactions totaling $ 117,500. Such checks, which were deposited by Milling in its checking account, were more than sufficient to offset the overdraft caused by its checks drawn on February 28, 1963, and none of Milling's checks were ever dishonored. The notes issued by Milling were short-term notes bearing interest at 6 percent. The debentures, payable in 10 years, bore interest at the rate of 6 percent which was payable annually. The debentures were *18 subordinated to all other creditors of Milling but were superior to the claims of its shareholders. Such debentures provided that if the cash position of Milling did not justify the payment of interest on any interest payment date, Milling could delay such payment for a period of 4 years, but that if such payment were delinquent for a period exceeding 4 years, the principal, together with accrued interest, would immediately become due and collectible. On its return for its taxable year ended February 29, 1964, Milling reported taxable income in the amount of $ 202,651.89. 2 On February 28, 1964, it borrowed $ 150,000 pursuant to its line of credit*165 with the Georgia Railroad Bank & Trust Co. and deposited such funds in its checking account. After such borrowing its total liability to the bank was $ 187,217.57. On February 29, 1964, it issued to its stockholders checks dated February 27, 1964, in the total amount of $ 165,745. Such checks were cashed or deposited by the shareholders. On its return for that year it reported such amount as a distribution out of its earnings and profits for such year. It reported undistributed taxable income in the amount of $ 36,906.89. Again, Milling did not have sufficient funds in its checking account to fully cover the total amount of the checks drawn on February 27, 1964, and on its books it reflected an overdraft of $ 46,273.59. On March 2, 1964, Milling issued notes and debentures dated March 1, 1964, to its shareholders as follows: Percent Debentures issued Mar. 2, 1963 Notes issued Mar. 2, 1963 Shareholder shares held Amount of Percent total Amount of Percent total debentures debentures notes notes Marbut 32.0 $ 6,240 32.0 $ 16,000 32.0 Laurent 10.5 2,050 10.5 5,250 10.5 Wilson 10.5 2,050 10.5 5,250 10.5 Brown 10.5 2,050 10.5 5,250 10.5 Roesel 9.0 1,755 9.0 4,500 9.0 Hanlin 9.0 1,755 9.0 4,500 9.0 Ashley 5.5 1,070 5.5 2,750 5.5 Dunlap 5.5 1,070 5.5 2,750 5.5 Caylor 5.0 [975] 5.0 2,500 5.0 Chao 2.5 [490] 2.5 1,250 2.5 Totals 100.0 19,505 100.0 50,000 100.0 *166 On or after March 1, 1964, the shareholders issued checks to Milling in the above transactions totaling $ 69,505. Such checks, which were deposited by Milling in its checking account, were more than sufficient to offset the overdraft caused by its checks dated February 27, 1964, and none of Milling's checks were ever dishonored. About the end of each of Milling's taxable years ended February 28, 1963, and February 29, 1964, its president or its comptroller had discussions *19 with the shareholders relating to the purchase of debentures from Milling and the making of short-term loans to Milling. Milling prepared its checks shortly before the end of such years and such checks were either mailed to the shareholders or picked up by them at Milling's office. 3 The shareholders delivered their checks to Milling either by mail or by hand delivery to its office. *167 If Milling's shareholders had not issued their checks to it subsequent to the close of its taxable years ended February 28, 1963, and February 29, 1964, Milling could have borrowed sufficient additional sums pursuant to its line of credit with the Georgia Railroad Bank & Trust Co. to cover the overdrafts caused by the checks which it issued on February 28, 1963, and February 29, 1964. Such borrowings could have been obtained simply upon Milling's request. Milling could have also generated sufficient additional funds either by delaying payment on its accounts payable or by discounting its accounts receivable. On her joint returns for the taxable years 1963 and 1964, petitioner Roesel reported income in the respective amounts of $ 20,464.40 and $ 18,238.67 as distributions received by her from Milling for such years. On her return for the taxable year 1963, petitioner Marbut reported income of $ 72,762.30 as distributions from Milling for such year. The amounts by which the checks issued by Milling to petitioners on February 28, 1963, exceeded the amounts reported by them as income for 1963, namely, $ 12,811.33 in the case of petitioner Roesel and $ 37,637.70 in the case of petitioner*168 Marbut, were viewed by them as nontaxable distributions of previously taxed income. In the notice of deficiency the respondent determined that Milling was not entitled to additions to its reserve for bad debts for its taxable years ended February 28, 1963, and February 29, 1964, since no additions were required to bring its bad debt reserve to a reasonable amount during such years, and he accordingly disallowed the deductions claimed for such years in the respective amounts of $ 11,364.13 and $ 12,676.90. 4 He therefore increased Milling's taxable income and earnings and profits for its taxable year ended February 28, 1963, by $ 11,364.13. This resulted in increasing the petitioners' prorata shares thereof (taxable to them in their taxable years 1963) by the amounts of $ 3,598.83 in the case of the petitioner Marbut and $ 1,012.17 in the case of the petitioner Roesel. In the notices of deficiency*169 the respondent further determined that Milling had not made money distributions to its shareholders of *20 $ 345,000 within its taxable year ended February 28, 1963, or of $ 165,745 within its taxable year ended February 29, 1964. He determined that Milling had made a money distribution to its shareholders of $ 227,500 on or about February 28, 1963, within its taxable year ended on that date, and a property distribution consisting of notes in the amount of $ 50,000 and debentures in the amount of $ 67,500 on or about March 1, 1963, within its taxable year ended February 29, 1964. He determined that Milling had made a money distribution to its shareholders in the amount of $ 96,240 on or about February 29, 1964, within its taxable year ended on that date, and a property distribution consisting of notes in the amount of $ 50,000 and debentures in the amount of $ 19,505 on or about March 1, 1964, within its taxable year ended February 28, 1965. Pursuant to sections 1.1373-1 and 1.1375-4, Income Tax Regs., the respondent further determined, in effect, that the property distribution on March 1, 1963, consisting of Milling's notes and debentures in the total amount of $ 117,500 did*170 not constitute a distribution of previously taxed income but, rather, a taxable distribution; that the excess of Milling's earnings and profits for its taxable year ended February 29, 1964, over its actual distributions of money during such year was in the amount of $ 119,088.79; 5 that such excess of earnings and profits was allocable ratably to actual distributions of property made during such taxable year and to the constructive distribution of undistributed taxable income for such taxable year; and that $ 59,144.49 of such excess earnings and profits was properly allocable to the property distributions on March 1, 1963, and $ 59,944.30 was allocable to the constructive distribution of undistributed taxable income for such taxable year ended February 29, 1964. He accordingly increased the income received by petitioner Roesel from Milling during her taxable year 1963 by the amount of $ 5,323, namely, her prorata share of the $ 59,144.49 of earnings and profits allocable to the property distributed to her on March 1, 1963. He increased the income received by petitioner Marbut from Milling during her taxable year 1963 by the amount of $ 18,926.24 namely, her prorata share of such*171 earnings and profits allocable to the property distributed to her on March 1, 1963. In the notice of deficiency to petitioner Roesel the respondent stated that if his determinations with respect to Milling's distributions are not upheld, but only in such event, then he determined the deficiency as set forth in our findings with respect to her taxable year 1964, namely, a deficiency asserted by reason of the disallowance of the deduction claimed by Milling for its taxable year ended February 29, 1964, for an addition to its reserve for bad debts. The respondent *34 issued a notice of deficiency*172 to the petitioner Marbut for her taxable years 1963 and 1964. However, prior to the issuance of such notice the petitioner paid the amount of the claimed deficiency for the year 1964 and the respondent moved to dismiss the case as to her year 1964. Upon her notice of no objection the respondent's motion to dismiss was granted. OPINION Milling, a qualifying subchapter S corporation, had undistributed taxable income for years prior to its taxable year ended February 28, 1963, which had been previously taxed to its shareholders. On the last day of such taxable year it initiated certain steps in an attempt to distribute to its shareholders substantially all of such previously taxed income. On February 28, 1963, it issued checks in the amount of $ 345,000 to them. On March 1, 1963, they issued their checks to Milling in the amount of $ 117,500 and received debentures and short-term notes from Milling in that amount. A similar procedure was followed around the end of Milling's taxable year ended February 29, 1964, although at such time Milling did not attempt to effect any distribution of previously taxed income. On February 29, 1964, Milling issued checks to its shareholders in *173 the total amount of $ 165,745. On or about March 1, 1964, they issued their checks to Milling in the total amount of $ 69,505 and received debentures and short-term notes from Milling in that amount. The basic question presented for our decision is whether Milling's issuance of checks on February 28, 1963, and February 29, 1964, constituted in full money distributions at those times or whether, as determined by the respondent, the above transactions constituted in substance money distributions only to the extent of $ 227,500 and $ 96,240, respectively, and property distributions of $ 117,500 on March 1, 1963, and $ 69,505 on March 1, 1964. At the outset it is helpful to outline the statutory and regulatory framework in which the present controversy arises. Subchapter S was added to the Internal Revenue Code of 1954 by the Technical Amendments Act of 1958. 6*175 Under section 1373 of the *22 Code, 7*176 the shareholders of an electing subchapter S corporation are required to include in their income the amount they would have received as dividends if the corporation's undistributed taxable income had been distributed pro rata to them on the last day of the corporation's taxable *174 year. During the years before us an electing corporation's undistributed taxable income for any year consisted of its taxable income, computed without regard to certain deductions, less the amount of money distributed during such year as dividends within the meaning of section 316(a)(2) of the Code. 8 Thus, the shareholders of an electing subchapter S corporation are required to include in their income their prorata shares of the corporation's taxable income to the extent of the corporation's current earnings and profits regardless of whether such income is distributed to them in money or retained by the corporation. And, under sections 312 and 1377 of the Code 9 the corporation's current earnings and profits are correspondingly reduced by the amounts of money distributed to its shareholders and by the amounts included by them as constructively received. *177 *23 Under section 1375(d) of the Code, 10 an electing corporation may distribute to any shareholder such shareholder's net share of the corporation's undistributed taxable income which has been included in his income in prior taxable years. Such a distribution is not treated as a dividend and the earnings and profits of the corporation are not reduced thereby. *178 Under various sections of the Income Tax Regulations promulgated with respect to the provisions of subchapter S, the respondent has adopted the position that distributions of property other than money by an electing corporation are to be governed by principles applicable to corporate distributions in general. Thus, sections 1.1372-1(c)(2) and 1.1372-1(c)(7) of the regulations 11 provide that property distributions are to be governed by section 301 and section 316 of the Code. Section 1.1373-1 of the regulations 12*180 provides that an electing corporation's current earnings and profits shall first be allocated to actual *24 distributions of money and that any remaining earnings and profits shall then be allocated ratably between actual distributions of property and the constructive distribution of undistributed taxable income. Under section 1.1375-4 of the regulations 13 distributions of property other than money do not qualify as distributions of undistributed taxable income which has been previously taxed to the shareholders. Such section provides that distributions of previously taxed income may occur only when, and to the extent that, an electing corporation makes money*179 distributions in excess of its current earnings and profits. *181 Under the above sections of the Code and the regulations it becomes evident that: (1) Because an electing corporation's taxable income *25 is reduced only by money distributions, in order to avoid having undistributed taxable income such corporation must currently distribute its taxable income in money; (2) once a corporation has undistributed taxable income which has been previously taxed to its shareholders such income may be distributed to them without dividend treatment only if, and to the extent that, the corporation makes money distributions in excess of its current taxable income; and (3) distributions of property other than money are taxable as dividends, first to the extent of their ratable share of the corporation's current earnings and profits, and then to the extent of such corporation's accumulated earnings and profits. The petitioners have not raised any issue as to the validity of the respondent's regulations and we accordingly express no opinion with regard thereto. Cf. DeTreville v. United States, (D.S.C.) 312 F. Supp. 362, on appeal (C.A. 4). Rather, it is petitioners' position that the issuance by Milling of checks in the*182 amounts of $ 345,000 on February 28, 1963, and $ 165,745 on February 29, 1964, constituted, in substance as well as in form, money distributions at those times; that the distribution on February 28, 1963, met the requirements of section 1.1375-4 of the respondent's regulations; and that, therefore, the amount distributed on February 28, 1963, in excess of Milling's taxable income for its taxable year ended on that date constituted a nondividend distribution of previously taxed income. It is the respondent's position that the substance of the transactions involved must prevail over their form for tax purposes; that in substance Milling's issuance of checks on February 28, 1963, and February 29, 1964, in the respective amounts of $ 345,000 and $ 165,745 constituted distributions of money at those times only to the extent of $ 227,500 and $ 96,240, respectively, and that this was followed by distributions of property consisting of notes and debentures on March 1, 1963, and March 1, 1964, in the respective amounts of $ 117,500 and $ 69,505; and that, therefore, a portion of Milling's earnings and profits for its taxable year ended February 29, 1964, is properly allocable to the property*183 distributed to petitioners on March 1, 1963, with the result that to such extent the petitioners received taxable dividends from Milling during their taxable years 1963. 14 We agree with the respondent that the economic substance of a transaction must govern for tax purposes rather than the time sequence *26 or form in which*184 such transaction is cast. Gregory v. Helvering, 293 U.S. 465. And it is well established that where a series of closely related steps are taken pursuant to a plan to achieve an intended result the transaction must be viewed as an integrated whole for tax purposes. Redwing Carriers, Inc. v. Tomlinson, (C.A. 5) 399 F. 2d 652, and cases cited therein. At the trial the petitioners adduced testimony to the effect that Milling did not know the extent to which its shareholders would make loans to it at the time its distributions were made, that such loans were voluntarily made by the shareholders, and that the loans were made by the shareholders because the notes and debentures represented sound investments. Be this as it may, the record as a whole convinces us that the purported loans by the shareholders were made pursuant to a general understanding between Milling and its shareholders. The conversations which were had between Milling's president or comptroller and the shareholders with respect to the purported loans, the degree of correspondence between the book overdrafts created by Milling's distributions and the*185 amounts purportedly loaned back by its shareholders, the close proximity in time of the purported loans and the issuance of checks by Milling, and the correlation between the amounts purportedly loaned by each shareholder and his interest in Milling, all serve to establish that the purported distributions and loans were but parts of interrelated transactions which must be viewed as such for tax purposes. Our view of the substance of the transactions in question, however, differs somewhat from that urged by the respondent. In our opinion, the distributions by Milling on February 28, 1963, and February 29, 1964, constituted, in substance, distributions on such dates of cash in the respective amounts of $ 227,500 and $ 96,240 and property consisting of notes and debentures in the respective amounts of $ 117,500 and $ 69,505. It is true, of course, that the notes and debentures were not formally issued by Milling until the dates following the dates upon which its checks were issued. However, it is clear that some portion of each check was issued pursuant to an understanding that notes and debentures would be substituted therefor. Under the circumstances, in substance, the notes and*186 debentures were issued on February 28, 1963, and February 29, 1964. Once an integrated transaction is to be viewed as such for tax purposes, its component parts do not admit of separation. Redwing Carriers v. Tomlinson, supra, and cases cited therein. In view of the above, it is our conclusion that the notes and debentures received by petitioners dated March 1, 1963, did not constitute nondividend distributions of undistributed but previously taxed income. Such notes and debentures are taxable to them in their taxable *27 years 1963 but only to the extent of a ratable portion of Milling's earnings and profits for its taxable year ended February 28, 1963, rather than a ratable portion of Milling's earnings and profits for its taxable year ended February 29, 1964, as determined by the respondent. The notes and debentures received by petitioner Roesel dated March 1, 1964, are taxable to her in her taxable year 1964 to the extent of a ratable portion of Milling's earnings and profits for its taxable year ended February 29, 1964. To the extent that the notes and debentures received by petitioners are not deemed to be out of Milling's earnings*187 and profits, the basis of petitioners' respective stock in Milling will be reduced pursuant to the provisions of section 301 of the Code. Decisions will be entered under Rule 50. Footnotes 1. On such return it claimed a deduction in the amount of $ 11,364.13 as an addition to its reserve for bad debts.↩ 2. On such return it claimed a deduction in the amount of $ 12,676.90 as an addition to its reserve for bad debts.↩ 3. During such years some of Milling's shareholders were living outside of Augusta, Ga. One shareholder was in Spain, one was living in Aiken, S.C., and another was living in Savannah, Ga.↩ 4. By stipulation entered into by the parties, the petitioners conceded that the claimed deductions were properly disallowed.↩ 5. Such amount was determined as follows: The reported taxable income of Milling for its taxable year ended Feb. 29, 1964, namely, $ 202,651.89, increased by the disallowed deduction for an addition to its bad debt reserve for such taxable year, namely, $ 12,676.90 (total equals $ 215,328.79), decreased by the actual distribution of money determined by respondent to have been made during such taxable year, namely, $ 96,240.↩ 6. The purpose of subch. S, as stated in S. Rept. No. 1983, 85th Cong., 2d Sess., pp. 87-88, was as follows: "To permit shareholders in small-business corporations, in lieu of payment of the corporate tax, to elect to be taxed directly on the corporation's earnings, your committee has added a new subchapter (subch. S, secs. 1371-1377) to the code. Where the tax treatment provided by this subchapter is elected, the shareholders include in their own income for tax purposes the current taxable income of the corporation, both the portion which is distributed and that which is not. * * * "Where a shareholder has been taxed on corporate earnings which were not at that time distributed, and then the corporation in a subsequent year distributes these earnings to such shareholders no further tax is required from the shareholder at that time, since these earnings have already been taxed to him in a prior year. Once all such earnings have been distributed, if further distributions are then made, and the corporation had earnings and profits before it elected this special tax treatment, then such distributions are to be taxed to the shareholders in the same manner as ordinary dividends from corporations."↩ 7. As applicable to the years before us, sec. 1373 provides in part as follows: SEC. 1373. CORPORATION UNDISTRIBUTED TAXABLE INCOME TAXED TO SHAREHOLDERS. (a) General Rule. -- The undistributed taxable income of an electing small business corporation for any taxable year shall be included in the gross income of the shareholders of such corporation in the manner and to the extent set forth in this section. (b) Amount Included in 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. (c) Undistributed Taxable Income Defined. -- For purposes of this section, the term "undistributed taxable income" means taxable income (computed as provided in subsection (d)) 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).↩ 8. Sec. 316 provides in part as follows: SEC. 316. DIVIDEND DEFINED. (a) General Rule. -- For purposes of this subtitle, the term "dividend" means any distribution of property made by a corporation to its shareholders -- (1) out of its earnings and profits accumulated after February 28, 1913, or (2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made.↩ Except as otherwise provided in this subtitle, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits. To the extent that any distribution is, under any provision of this subchapter, treated as a distribution of property to which section 301 applies, such distribution shall be treated as a distribution of property for purposes of this subsection. 9. Secs. 312 and 1377 provide in part as follows: SEC. 312. EFFECT ON EARNINGS AND PROFITS. (a) General Rule. -- Except as otherwise provided in this section, on the distribution of property by a corporation with respect to its stock, the earnings and profits of the corporation (to the extent thereof) shall be decreased by the sum of -- (1) the amount of money, (2) the principal amount of the obligations of such corporation, and (3) the adjusted basis of the other property, so distributed. SEC. 1377. SPECIAL RULES APPLICABLE TO EARNINGS AND PROFITS OF ELECTING SMALL BUSINESS CORPORATIONS. (a) Reduction for Undistributed Taxable Income. -- The accumulated earnings and profits of an electing small business corporation as of the close of its taxable year shall be reduced to the extent that its undistributed taxable income for such year is required to be included in the gross income of the shareholders of such corporation under section 1373(b).↩ 10. Sec. 1375(d) provides in part as follows: SEC. 1375. SPECIAL RULES APPLICABLE TO DISTRIBUTIONS OF ELECTING SMALL BUSINESS CORPORATIONS (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.↩ 11. As applicable to the years before us, secs. 1.1372-1(c)(2) and 1.1372-1(c)(7) of the regulations provide as follows: (2) Section 301, relating to distributions of property, applies to distributions by an electing small business corporation in the same manner that it would apply had no election been made; * * * * (7) Section 316, relating to the definition of a dividend, applies to distributions by an electing small business corporation except as provided in section 1375(d)(1), relating to distributions of previously taxed income, * * * (see paragraphs (d) and (e) of § 1.1373-1↩ for rules relating to allocation of current earnings and profits to distributions during the taxable year) * * * 12. As applicable to the years before us, sec. 1.1373-1 of the regulations provides in part as follows: Sec. 1.1373-1. Corporation undistributed taxable income taxed to shareholders. -- * * * * (d) Determination of dividends in money out of earnings and profits of the taxable year. In applying section 316(a) to distributions by an electing small business corporation, earnings and profits of the taxable year are first allocated to actual distributions of money made during such taxable year which are not in exchange for stock. Therefore, such distributions of money are dividends from earnings and profits of the taxable year to the extent of such earnings and profits even though there may be distributions of property other than money during such taxable year or constructive distributions pursuant to section 1373(b) at the end of such taxable year. If such distributions of money made during the taxable year exceed the earnings and profits of such year, then that proportion of each such distribution which the total of the earnings and profits of the year bears to the total of such distributions made during the year shall be regarded as out of the earnings and profits of that year. For purposes of section 1373(c) a distribution of money does not include a distribution of an obligation of the corporation or a distribution of property other than money in satisfaction of a dividend declared in money. * * * (e) Dividend resulting from constructive distribution of undistributed taxable income. The amount which would be treated as a dividend if the undistributed taxable income were distributed on the last day of the taxable year is determined in accordance with section 316. In determining the extent to which distributions of an electing small business corporation are out of earnings and profits of the taxable year, the following rules apply: (1) Earnings and profits of the taxable year are first allocated to the actual distributions of money described in paragraph (d) of this section, (2) The excess of such earnings and profits over such actual distributions of money is allocated ratably to the constructive distribution of undistributed taxable income and actual distributions of property other than money (taken into account at fair market value for purposes of this allocation) which are not in exchange for stock, * * *↩ 13. As applicable to the years before us, sec. 1.1375-4 of the regulations provides in part as follows: Sec. 1.1375-4. Distributions of previously taxed income. -- (a) In general. Under section 1375(d)(1), a distribution by an electing small business corporation to a shareholder of all or any portion of his net share of previously taxed income is considered a distribution which is not a dividend. Such a distribution reduces the basis of the shareholder's stock in the corporation in accordance with section 301(c)(2), and, if it exceeds such basis, is subject to the provisions of section 301(c)(3). The earnings and profits of the corporation are not reduced by reason of such a distribution. 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 nondividend distribution pursuant to this section. (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 in exchange for stock (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. 14. It should be noted that the respondent, on brief, concedes that the notes and debentures in question were valid and that they did not constitute a second class of stock. Moreover, by determining that the distributions of notes and debentures were taxable only to the extent of an allocable portion of Milling's earnings and profits for its taxable year ended Feb. 29, 1964, he, in effect, determined that Milling had no accumulated earnings and profits at that time. In any event, in view of Milling's operation as a partnership prior to its incorporation and its subsequent operating history, it seems clear that it did not have any accumulated earnings and profits during the years before us.↩