Bradshaw v. United States

delivered the opinion of the court:

These consolidated tax refund cases are before the court on a Memorandum Report Returning Case to Court on Stipulation of Facts, filed by the trial judge pursuant to Rule 134(b)(2) on February 20, 1981. The essential facts stipulated are set forth below. Castlewood, Inc. (Castlewood), plaintiff in No. 473-77, is a cash method taxpayer and seeks a refund of federal income taxes and interest thereon paid with respect to its taxable years ended July 31, 1971, and July 31, 1972. Jolana S. Bradshaw (Jolana), plaintiff in No. 472-77, Lori Swift (Lori), plaintiff in No. 474-77, and Stephen T. Swift (Stephen), plaintiff in No. 475-77,1 are cash method, calendar year taxpayers. Each seeks a refund of federal income taxes and interest thereon paid with respect to their taxable years ended December 31, 1972. Frances H. Swift (Frances), plaintiff in No. 476-77,2 is also a cash method taxpayer and seeks a refund of federal income taxes and interest thereon paid with respect to her taxable years ended June 30, 1971, and June 30, 1972. These five actions were consolidated by order entered January 19, 1979, by the trial judge. The aggregate recovery sought is $81,400.38, plus assessed and statutory interest.

*146Both parties agree that there are only two questions for decision. The first is whether the transfer of real property to Castlewood, a controlled corporation, in exchange for installment obligations was a sale of the property to that corporation or, instead, was either a transfer of property to a controlled corporation solely in exchange for stock or securities of that corporation within the meaning of section 3513 or a capital contribution to that corporation. The second question is whether more than 20 percent of the gross receipts of SJL, Inc. (SJL), a second controlled corporation, constituted passive investment income within the meaning of section 1372(e)(5) so as to terminate that corporation’s status as a subchapter S corporation, thereby causing distributions from SJL to Jolana, Lori, Stephen and Frances to be treated as dividends.

We find that the transfer of real property to Castlewood in exchange for installment obligations was a sale rather than a transfer governed by section 351 or a capital contribution. We also find that the passive investment income received by SJL did not exceed 20 percent of its gross receipts and, therefore, that its subchapter S status was not terminated. Accordingly, we hold for the plaintiffs and against the defendant for the reasons hereafter stated.

I

On January 6,1961, Thomas E. Swift (Thomas) purchased a tract of land, consisting of approximately 200 acres, in Dalton, Whitfield County, Georgia, for $60,000. Two dispositions of property out of this 200 acres were made by Thomas in the summer of 1968. The consolidated cases herein concern one of these dispositions, the transfer of 40.427 acres, subsequently known as Castlewood Subdivision (the subdivision), to Castlewood on July 29, 1968. The conservative fair market value of the subdivision on the date of transfer was $250,000.4 Thomas’ adjusted basis in this portion of the property was $8,538. In exchange for the *147transfer, Thomas received from Castlewood five promissory notes (the Castlewood notes), each in the principal amount of $50,000 and bearing interest at the rate of 4 percent per annum. The first note matured on January 29, 1971, with each successive note maturing at 1-year intervals. Thomas received no down payment for the transfer, and no security or other collateral was taken for the purchase price. He elected to report his gain from the transaction on the installment method pursuant to section 453(b).

At the time of transfer, various opportunities were available to Thomas to dispose of the subdivision, including sale to third parties. While he had not developed property himself, Thomas was highly expert in real estate matters in the Dalton area. Based upon this knowledge, including knowledge of sales of other real estate in the vicinity of the subdivision, Thomas evaluated the prospects for the development of the subdivision to be bright, whether such development was undertaken by himself, by a corporation that he might organize, or by a third party. He considered the alternative opportunities available to him to dispose of the property and decided to develop the property himself through a corporation rather than sell it to a third party.5

Consequently, Castlewood was organized and incorporated on July 29,1968, under the laws of the State of Georgia, to obtain, subdivide, develop and sell lots in the subdivision. On July 29, 1968, Castlewood issued its Certificate No. 1, representing 50 shares of common stock, to Thomas in exchange for the transfer to the corporation of an automobile valued at $4,500. At all times relevant herein, Thomas was the sole shareholder of Castlewood6 and was responsi*148ble for conducting its business affairs. His expertise was available to and utilized by the corporation in its development of the subdivision, enabling it to minimize development costs and thus increase profits.

The expected source of income and anticipated profit of Castlewood, and the expected source of payment of the five notes, with interest, was from the sale of the lots in the subdivision. At the time of the transfer to the corporation, Thomas anticipated that when developed, lots from the subdivision could be sold at a profit by the corporation and that the amount of such profit would increase over time. He had a plan for the development of the property which was timed so as to take full advantage of the opportunities for profit. He further anticipated that the development of the property would succeed and yield a profit to the corporation in the range between $100,000 and $150,000. He expected a positive cash flow to the corporation within about a year and a half, thereby providing sufficient funds to pay the first of the notes, due in January of 1971, and that the corporation could in the regular course of its business pay the five notes as they came due.

Because of the growing character of, and need for housing in, the Dalton, Georgia area, the value of the subdivision was, at all times relevant herein, increasing. In fact, the character and location of the subdivision was such that the property could reasonably be anticipated to be readily marketable at its development. If, however, the subdivision had not been developed, or if the development process had been slowed, Castlewood could have borrowed the money against the property to pay off the notes.

Prior to the creation of Castlewood and the transfer of the property thereto, Thomas estimated that development costs for the subdivision would be approximately $50,000. He anticipated that he would have a ready source of funds from C&S Concrete Products Company (C&S) to meet these development expenses. C&S was a partnership formed by Thomas, which was engaged in the manufacture of concrete *149products used in the building trade. At all times relevant herein, C&S was wholly owned directly or beneficially by Thomas, his wife, Frances, and their three children, Jolana, Lori and Stephen. Thomas’ drawing account on C&S was, in essence, his personal bank account. Thomas had no personal bank account, and when using funds from his drawing account at C&S, he was in effect using his own personal funds.

As expected, the corporation’s development expenses were primarily funded through advances from the partnership, totalling $34,116.10, at various times from August 31, 1968 through August 10, 1970.7 These advances were treated as interest-free loans by both parties and were charged to an open account on the books of C&S. The partnership took no collateral or other security interest. The loans were repaid in four installments over an 8-year period.

Castlewood subdivided the subdivision into two tracts. Tract I consisted of 26 lots. Tract II consisted of eight lots. Each lot averaged approximately one acre. Lots were not formally offered for sale nor were any lots sold during the corporation’s first two fiscal years (ended July 31,1969, and July 31, 1970). Thomas was contacted by parties wishing to purchase lots before the development was completed, but before commencing the development, he had decided that no lots would be sold until all of the planned development activities had been completed. This was because, among other reasons, he did not want anyone coming onto the property and cutting up the roads that he had put in, to install subsequent improvements such as water lines. All of the improvements made by Castlewood were completed before any of the lots were sold or offered for sale.8 Except for paving on two lots and surveying, the eight lots in Tract II were essentially undeveloped. From August 1970 to April 1973, Castlewood sold 16 lots in Tract I and two lots in Tract II for an aggregate sales price of $239,880. It did not *150advertise the sale of these lots, use realtors, or pay sales commissions. The property sold had an allocated land cost (of the $250,000 purchase price) and development cost of $159,378.39, yielding a net return to the corporation of $80,501.11. Castlewood reported sales of lots on its federal income tax returns for the fiscal years ended July 31,1971, July 31,1972, and July 31,1973.9

Subsequent to its 1973 fiscal year, Castlewood, upon the advice of its accountant, decided to cease selling lots in the subdivision as a result of the position taken by the Commissioner of Internal Revenue (Commissioner) on audit. During the period when no sales were made, both Thomas and his son Stephen were contacted by parties seeking to purchase lots. Castlewood reported no income from operations for its remaining fiscal years and was liquidated on September 23, 1976.10 Castlewood never paid any salaries or declared or paid any dividends.

On December 21, 1970, prior to the time that the first Castlewood note became due, Thomas organized and incorporated SJL. This corporation was formed by Thomas as part of his estate planning and was established in order to provide funds and opportunities for dealings in and the development of real estate and related activities by his children.11 Its formation in December of 1970 was precipitated by the fact that the first Castlewood note was due in January of 1971. On December 28, 1970, Thomas transferred to SJL the five Castlewood notes in exchange for all of the stock of SJL in a transaction qualifying for nonrecognition of gain under section 351. On December 29,1970, and January 4, 1971, he made equal gifts of all of the stock of SJL to his wife and three children, so that after the gifts each owned one-fourth of the corporation.

*151On or about January 19,1971, SJL filed an election under section 1372(a) for status as a small business corporation (subchapter S corporation). This election was accepted by the Commissioner on February 1,1971.

The note due January 29, 1971, was paid by Castlewood as due, together with $5,000 interest, to SJL. The note due January 29, 1972, was paid on January 31, 1972, together with $7,000 interest. The note due January 29, 1973, was paid on February 14, 1973, together with $9,000 interest.12 The funds needed by Castlewood to repay the notes, plus interest, were generated solely from the sales of lots in the subdivision. Castlewood deducted the interest payments made to SJL on its relevant corporate income tax returns. On its subchapter S income tax returns for the 1971, 1972 and 1973 fiscal years, SJL reported the payments it received from Castlewood as long-term capital gain to the extent the principal of each note exceeded its adjusted basis in the note. Consistent with its subchapter S status, SJL paid no tax on this income or on the interest income received from Castlewood. Rather, the shareholders, Frances, Jolana, Lori and Stephen, reported and paid taxes on their allocable share of the long-term capital gain and interest income received by SJL.

On May 14, 1971, SJL distributed $4,000 to Jolana, Lori and Stephen and $2,000 to Frances. On January 31, 1972, SJL distributed $23,000 to Jolana, Lori and Stephen and $25,000 to Frances.

By statutory notice of deficiency dated September 20, 1976, the Commissioner determined that additional income tax was due from Castlewood for its 1971 and 1972 tax years, for the reason that the transfer of the subdivision to that corporation by Thomas was not a sale, as treated by the corporation on its tax returns, but rather a transfer of *152property solely in exchange for stock or securities within the meaning of section 351. Thus, he concluded that, pursuant to section 362, Castlewood’s predevelopment basis in the property was equal to that of the transferor immediately before the transfer, or $8,538. This, in turn, increased Castlewood’s taxable income on sales of lots. Additionally, the Commissioner concluded that no debtor-creditor relationship was established between Castlewood and Thomas, thereby disallowing certain deductions of interest paid to SJL on the notes taken for the purchase price of the property.

By statutory notice of deficiency dated September 20, 1976, the Commissioner determined that additional income tax was due from each of Jolana, Lori and Stephen for their 1972 tax years and from Frances for her 1971 and 1972 tax years. The Commissioner concluded that SJL no longer qualified as a subchapter S corporation because more than 20 percent of its gross receipts (amounts received as payment on the Castlewood notes) constituted passive investment income within the meaning of section 1372(e)(5). Accordingly, the distributions made by SJL to each shareholder,13 and reported as interest income and long-term capital gain, were actually taxable as dividends, due to the termination of SJL’s subchapter S status.14

Assessments of tax and interest were made on February 9, 1977, which were promptly paid. Claims for refund were formally denied on July 6, 1977. Each plaintiff filed a timely petition with this court on September 26,1977.

II

The first question concerns the proper tax treatment of Thomas’ transfer of the subdivision to Castlewood in exchange for the five $50,000 promissory notes. If the *153transfer is treated as a sale, as plaintiff contends, then Castlewood’s adjusted basis for its sales of the lots from the subdivision property would include the $250,000 purchase price (a cost basis), it would be allowed deductions of the interest paid on the notes and its taxable income would be generally as shown on its returns for the years in issue. However, if, as defendant claims, the transfer was not a sale but was either a transfer under section 35115 or a contribution to the corporation’s capital, then Castlewood’s adjusted basis in the lots sold would be reduced to Thomas’ original basis (a carryover basis) pursuant to section 362, it would be denied deductions of the interest paid on the notes and its taxable income would be generally as shown on the notice of deficiency issued with respect to it.

The sale versus capital contribution problem arises from a situation which often confronts taxpayers with holdings in undeveloped real estate. It is not uncommon for a landowner with a large tract of land suitable for development to want to freeze as capital gain the appreciation in the value of the property that has accrued during its ownership. While an outright sale of the property achieves this result, it also deprives the landowner of any participation in the profits to be reaped from its ultimate development. On the other hand, if the landowner develops and sells the property himself, he runs the risk of being treated as a dealer of the property and any gain generated through sales, including the gain associated with the land’s appreciation in value while undeveloped, is taxable to him at ordinary income rates. See, e.g., Goodman v. United States, 182 Ct. Cl. 662, 390 F.2d 915, cert. denied, 393 U.S. 824 (1968); Suburban Realty Co. v. United States, 615 F.2d 171 (5th Cir.), cert. denied, 449 U.S. 920 (1980).

In the face of such a dilemma, taxpayers have devised an apparently viable solution. By selling the real property to a controlled corporation, they can realize their capital gain on the appreciation which has accrued during their owner*154ship and, at the same time, preserve their opportunity to later participate in the developmental profits as shareholders of the development corporation. Moreover, the corporation obtains a cost basis in the real property, thereby reducing the amount of ordinary income to be received from subsequent sales.

Not unexpectedly, the Commissioner has repeatedly challenged the characterization of such a transaction as a sale, instead maintaining that the transfer is, in reality, a capital contribution and that the transferee corporation is only entitled to a carryover basis for the property. See, e.g., Burr Oaks Corp. v. Commissioner, 365 F.2d 24 (7th Cir. 1966), cert. denied, 385 U.S. 1007 (1967); Aqualane Shores, Inc. v. Commissioner, 269 F.2d 116 (5th Cir. 1959). The two principal reasons asserted for denying the desired tax treatment to the corporation have their origin in the dual subparts of section 362(a).16 While the main thesis is that section 351 governs such a transaction and that the corporation’s basis for the property is to be determined pursuant to section 362(aXl), it is also maintained that, regardless of the applicability of section 351, the transfer to the corporation is, in substance, a contribution to capital and that the adjusted basis for the property is to be determined under section 362(aX2).

Although often litigated, the courts which have considered the sale versus section 351/capital contribution question have not always been careful to distinguish between these two separate arguments. Indeed, it is understandable that the analyses of these prior cases have been fraught with overlap, for both propositions require an examination of substantially the same criteria. However, since a decision for plaintiff on the capital contribution question does not necessarily dispose of the section 351 question,17 our *155discussion proceeds in two stages. Initially, we consider the "sale” versus "capital contribution” distinction. Thereafter, we address defendant’s contention that section 351 applies to the subject transaction because the Castlewood notes constituted "stock or securities” within the intendment of the statute.

The proper characterization of a transaction, as a "sale” or a "capital contribution,” is a question of fact to be decided as of the time of the transfer on the basis of all of the objective evidence. Gooding Amusement Co. v. Commissioner, 236 F.2d 159, 165 (6th Cir. 1956), cert. denied, 352 U.S. 1031 (1957). While the form of the transaction is relevant, we are required to examine all of the pertinent factors in order to determine whether the substance of the transaction complies with its form. Gregory v. Helvering, 293 U.S. 465, 469-70 (1935). The essential nature of the transaction is to be determined from a consideration of all of the surrounding circumstances. Piedmont Corp. v. Commissioner, 388 F.2d 886, 889 (4th Cir. 1968).

In this case, the objective evidence points to a sale.18 First, and foremost, the price paid for the subdivision reflected its actual fair market value. Since it has been stipulated that the value of the subdivision was $250,000, the very amount for which it was sold to Castlewood, the transfer cannot be considered a "pretextuous device” to divert the earnings and profits of the corporation, otherwise taxable as ordinary income, into sales proceeds taxable as capital gain. Piedmont Corp. v. Commissioner, 388 F.2d 886, 889 (4th Cir. 1968). The sales price did not constitute an inflated value for the property, and, thus, did not represent an attempt to transfer to Thomas any subsequent capital increment in the value of the property, nor any of the gain from its development. In this respect, the transfer was clearly a sale.

Additionally, the various formalities of a sale were strictly observed. The five instruments involved constituted negotiable instruments in the form of "notes” under *156Georgia law, Ga. Code Ann. § 109A-3-104 (1979), contained an unqualified obligation to pay the principal amount, with fixed maturity dates ranging from two and one-half to six and one-half years after the date of sale and bore a reasonable rate of interest. The notes were not subordinated to general corporate creditors and contained a means for collection at maturity, which was never utilized as the principal and interest were always paid as due until the Commissioner challenged the tax treatment of those payments. On these bases, the notes contained all of the traditional elements of sales-generated debt.

Even so, defendant asks that upon consideration of the economic substance of the transfer, the transaction be recast as a capital contribution. This is so, we are told, because Congress has dictated that no tax consequences shall attach to a transaction where direct ownership of property is changed into indirect ownership through a proprietary interest in a corporation. Thus, where the circumstances of a purported sale demonstrate that the transferor, in fact, retained a continuing interest in the property transferred, the transaction is more appropriately characterized as a capital contribution.

Defendant calls our attention to an alleged factual pattern to be discerned in those instances where it has been determined that the economic substance of a purported sale was actually a contribution to capital. In such cases, it is claimed, a newly formed, inadequately capitalized corporation received assets which were essential to its purpose, and which required at the outset substantial improvements to convert them into income-producing property. Whereas, in those cases holding that the transaction resulted in a sale, the transfer involved proven, income-producing assets. Defendant submits that the distinction drawn in these cases turns on the nature and degree of risk inherent in the transfer of unproven assets and that in such instances, because of the high degree of risk, the transferor is likely to have retained a continuing interest in the property transferred.

In the present case, defendant maintains, unproven real property was transferred to an untried, undercapitalized business in return for notes, which were to be satisfied from *157the proceeds expected to be generated through the sale of lots. From this, defendant urges that we conclude that the notes represented a continuing interest in the corporate business, for repayment was totally dependent upon the success of the enterprise.

We cannot quarrel with the policies underlying section 351, nor with its intended scope. However, even accepting defendant’s premise that the prior cases can be meaningfully differentiated along the lines suggested, we are unable to agree with the conclusion defendant draws in this case. Rephrasing defendant’s position, we are asked to find that the degree of risk herein was of the type normally associated with a capital contribution. Thus stated, the salient inquiry is whether the notes occupied the position of equity, the assets and prospects of the business being unable to assure payment of the debt according to its terms.

Admittedly, the stipulated facts show Castlewood to have been a "thin” corporation. Its initial capitalization consisted entirely of an automobile valued at $4,500. The corporation then issued five notes, each in the face amount of $50,000, in consideration for the subdivision property. While an additional $3,200 was contributed to Castlewood 4 months later, in practical terms it had no funds of its own with which to conduct business, instead relying on advances totalling over $34,000 from C&S to develop the property. It cannot be refuted that Castlewood had a very high ratio of debt to equity. But the mere fact that a corporation is or is not thinly capitalized does not, per se, control the character of the transaction. See Gyro Eng. Corp. v. United States, 417 F.2d 437, 439 (9th Cir. 1969); Piedmont Corp. v. Commissioner, 388 F.2d 886, 890 (4th Cir. 1968); Sun Properties, Inc. v. United States, 220 F.2d 171, 175 (5th Cir. 1955). As these cases demonstrate, if the corporation is adequately capitalized for its intended purpose, then we are not prevented from treating the notes as valid debt.

The facts reveal that in addition to its formal capitalization, Castlewood anticipated having access to, did have access to, and utilized funds in the form of loans from C&S, the partnership owned by Thomas and his family, which served as Thomas’ personal bank account. Castlewood also had access to an important resource in the expertise *158Thomas brought to the business, which allowed the corporation to minimize its development expenses. See Murphy Logging Co. v. United States, 378 F.2d 222, 224 (9th Cir. 1967). Given these resources, which were certainly adequate to finance the level of development activities undertaken, and the absence of any need to employ advertising or to use realtors, there was little reason for the corporation to maintain a large surplus of liquid capital. Under the circumstances, we cannot say that undercapitalization is fatal to plaintiffs position.

Integrally related to this discussion, as defendant recognizes, is the nature or quality of the risk assumed by the transferor. However, unlike defendant, we do not find the fact that what was sold to Castlewood was unimproved real estate to be necessarily indicative of a high degree of risk. Concomitantly, nor do we view repayment of the Castle-wood notes to have been dependent upon the success of the business. Under the stipulated facts of this case, at the time of transfer, because of the character and location of the subdivision, there was a reasonable anticipation that the development of the property would succeed and yield a profit. And, as planned, the subdivision was developed, a cash flow generated and the notes paid, with interest, as due. While repayment from the receipts of the business was a logical necessity, repayment from the profits was not. A successful enterprise herein would have been one which realized a profit from its developmental activities, that is, one which generated income over and above the value of the property as purchased. And while that occurred, it was not from that success that the notes were paid, but from the value of the property which was there from the date of sale. It is of prime importance that the property was, at all times, saleable in its undeveloped condition.19 At the time of transfer, there existed contemporaneous opportunities to sell the property to third parties. In fact, a portion of the *159original tract had been sold, undeveloped, to a third party immediately before the sale to Castlewood. The record does not support defendant’s conclusion that the property required extensive improvements in order to convert it into an income-producing asset, or even to generate a cash flow. Although lots were not sold until development was finished, this was merely by design. Prospective purchasers had sought to buy lots before development was complete and, once sales were commenced, lots were sold undeveloped. Moreover, at all times the value of the property was increasing, irrespective of its development, and, if necessary, the corporation could have borrowed the money against the property to pay off the notes. Clearly, it was always within Castlewood’s ability to make payment as required. To be sure, as with any new venture, there was some risk of loss; but the evidence manifests that such risk was significantly reduced in this case. From the beginning, there existed a reasonable assurance of repayment of the notes regardless of the success of the business. To us, this is further indicia that the notes were debt, not equity. The facts just do not support the inference that, in holding the Castlewood notes, Thomas was assuming the risk of loss normally associated with equity participation.

We are referred by defendant to, among others, Burr Oaks Corp. v. Commissioner, 365 F.2d 24 (7th Cir. 1966), cert. denied, 385 U.S. 1007 (1967), and Aqualane Shores, Inc. v. Commissioner, 269 F.2d 116 (5th Cir. 1959), two of the leading decisions to hold a purported sale to be a contribution to capital. In Burr Oaks, undeveloped land, intended for subdivision, was transferred to a newly formed corporation for more than twice its fair market value. In exchange therefor, the transferors received back 2-year promissory notes. Development costs ran extremely high and sales of lots were, at best, slow. Consequently, the notes were only partially paid at maturity and new notes were given for the unpaid balance. Moreover, some of the property was eventually retransferred to the noteholders at little or no cost. On these facts, the Seventh Circuit had no difficulty affirming the decision of the Tax Court,20 finding a strong *160inference that the transfer was an equity contribution where "payment to the transferors [was] dependent on the success of an untried undercapitalized business with uncertain prospects.” 365 F.2d at 27. In Aqualane Shores, the land transferred to the development corporation was mangrove swamp. Thus, vast improvements were essential to its successful development, which, even then, was highly speculative. With its only source of revenue being the sale of lots, the corporation was forced to borrow substantial amounts of money in order to put the land in marketable condition. No payments on the notes taken back for the land were made for 4 years after maturity. On this basis, payment of the obligations to the transferors was deemed to be dependent upon and at the risk of the success of the venture, and the transfer subject to section 112(b)(5), the predecessor to section 351.269 F.2d at 119-20.

The evidentiary basis of the present case, as previously set forth, contrasts sharply with these decisions. Unlike either case, the prospects for financial success were bright, such success was realized, and the corporation was always able to meet its obligations as they matured. Moreover, the promise of repayment was never in jeopardy, for the properties’ self-liquidating potential guaranteed that repayment of the notes would not be subject to the fortunes of the business. In all major respects, the present case is more analogous to Piedmont Corp. v. Commissioner, 388 F.2d 886 (4th Cir. 1968), than to either Burr Oaks or Aqualane Shores.21 Piedmont involved successive transfers of options to purchase real property to a controlled corporation in exchange for unsecured promissory notes. The Fourth Circuit considered Burr Oaks and Aqualane Shores, but found both to be distinguishable.22 In reversing the decision *161of the Tax Court23 that the transfers were in effect a contribution to capital, the following were held to be determinative: (1) the facts24 indicated "some degree of certainty to the financial success of the venture”; (2) "a fair purchase price was paid”; (3) the corporation "paid the interest and installments of principal when due, promptly and regularly”; and (4) the corporation "did not retransfer any portion of any option, or any land which it acquired by exercise of an option” to the noteholders. Thereupon, the court concluded that "an evidentiary basis to disregard the purported sales as bona fide sales [was] lacking.” 388 F.2d at 890-91.

These same factors appear in this case25 and, accordingly, we choose to be guided in our deliberations by Piedmont, rather than by Burr Oaks or Aqualane Shores. As supported by the record and confirmed by Piedmont, the transfer was in substance, as well as in form, a sale and not a capital contribution.

Defendant’s remaining contention is that, notwithstanding a determination that the Castlewood notes were valid debt, the subject transaction falls within the literal provisions of section 351. The specific requirement in issue is whether the notes were "securities” within the meaning of the statute.26

A transferor has received a security if the instrument taken back in the exchange represents a continuing propri*162etary interest in the transferee corporation. LeTulle v. Scofield, 308 U.S. 415, 420 (1940); Pinellas Ice Co. v. Commissioner, 287 U.S. 462, 470 (1933). The test as to the "securities” status of debt obligations is set forth in Camp Wolters Enterprises, Inc. v. Commissioner, 22 T.C. 737 (1954), aff’d, 230 F.2d 555 (5th Cir.), cert. denied, 352 U.S. 826 (1956):

The test as to whether notes are securities is not a mechanical determination of the time period of the note. Though time is an important factor, the controlling consideration is an overall evaluation of the nature of the debt, degree of participation and continuing interest compared with similarity of the note to a cash payment, the purpose of the advances, etc. [22 T.C. at 751.] Defendant contends that the present case is not material-

ly different from the situation in United States v. Hertwig, 398 F.2d 452 (5th Cir. 1968); see also Dennis v. Commissioner, 473 F.2d 274 (5th Cir. 1973). In Hertwig, on the day that the corporation was formed, the promoters transferred $10,000 cash in exchange for stock, and patents worth $3,000,000 in exchange for unsecured promissory notes. The patents were the primary assets of the corporation. The notes were not subordinated and the promoters did not waive any of their rights to enforce the terms of the notes. It was stipulated that the price of $3,000,000 was reasonable and that the parties had a reasonable expectation that the notes would be paid. From this evidence, the Fifth Circuit held that the notes were "securities” within the meaning of the statute, since the promoters had retained a continuing proprietary interest in the success of the venture. 398 F.2d at 455.

Notwithstanding these factual similarities with the present case, we are not moved to characterize the Castle-wood notes as section 351 "securities.” To us, the critical distinction in Hertwig is that upon receiving the patents, the corporation therein then licensed two companies controlled by the transferor-promoters to use the inventions covered by the patents in return for an agreed royalty and also agreed to act as the sales agent for the licensees on a commission basis. In other words, payment of the notes was dependent upon the receipt of royalties and commissions from the licensees. It is readily apparent that the successful *163exploitation of the patents became necessary to satisfaction of the notes, thereby increasing the risk assumed by the noteholders. The extent of this risk is graphically illustrated by the fact that interest payments on the notes were discontinued only one year after issuance and further by the fact that the actual principal payments made to the noteholders fell far short of the amounts required to be paid, due largely to the inability of the licensees to pay the royalties and commissions owed to the corporation. 398 F.2d at 453-54. Clearly, these transferor-noteholders had a continuing proprietary stake in the business, for their ultimate payment was utterly contingent upon the profitable use of the patents.27

We have already given our reasons as to why the Castlewood notes did not constitute a continuing proprietary interest in Castlewood and we will not repeat them here. It is sufficient to say that the degree of risk represented by these notes was insubstantial in comparison to that existing in Hertwig. Our evaluation of the Castlewood notes convinces us that they were not "securities” within section 351.28

Ill

The second question presented is whether the receipt by SJL of the proceeds from payment of the Castlewood notes constituted passive investment income within the meaning of section 1372(e)(5) in excess of 20 percent of its gross receipts, so as to cause the termination of its subchapter S status. If so, defendant maintains, then the plaintiffs who *164were shareholders of SJL would be deemed to have received dividend distributions, reportable as ordinary income, to the extent of the corporation’s earnings and profits, rather than distributions of capital gain and ordinary interest income, as actually reported. According to defendant, their taxable income would then be generally as shown on the notices of deficiency issued with respect to each of them. In rebuttal, plaintiffs contend that such proceeds did not constitute passive investment income and that their taxable income for the years in issue should be generally as shown on their returns as filed, since SJL’s subchapter S status would be preserved.

Under section 1372(e)(5)(A), corporations which qualify under subchapter S will lose that status if, for any taxable year, the corporation has gross receipts more than 20 percent of which are passive investment income.29 The term "passive investment income” is defined to mean "gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities * * Section 1372(e)(5)(C).

As stipulated by the parties, SJL’s only receipts were the payments by Castlewood on the notes. It is undisputed that the portion of the proceeds received by SJL in payment of the Castlewood notes which comprised the payment of interest was passive investment income under the statute. However, plaintiffs point out that only this amount of passive investment income did not violate the 20 percent of *165gross receipts limitation. Thus, the question centers on the proper treatment of SJL’s receipt of the principal payments on the Castlewood notes.

Defendant bases its position on the argument that the principal payments on the Castlewood notes constituted receipts from the sale or exchange of stock or securities within the meaning of the statute.30 This raises two issues: whether satisfaction of the notes constituted a "sale or exchange” and whether the notes were "stock or securities.”

The latter question is easily answered. The pertinent subchapter S regulations direct reference to the personal holding company regulations for the meaning of the term "stock or securities” as used in section 1372(e)(5). Treas. Reg. § 1.1372^(b)(5)(x), T.D. 6960, 1968-2 C.B. 342. As defined in Treas. Reg. § 1.543 — l(b)(5)(i) (1960), "stock or securities” includes—

shares or certificates of stock, stock rights or warrants, or interest in any corporation * * *, certificates of interest or participation in any profit-sharing agreement, or in any oil, gas, or other mineral property, or lease, collateral trust certificates, voting trust c