Rev. Rul. 77-220

Advice has been requested whether elections under section 1372(a) of the Internal Revenue Code of 1954 by the corporations described below to be treated as small business corporations will not be valid because the 10 shareholder limitation of section 1371 will have been violated.

Thirty unrelated individuals combined their capital and skills and entered into the joint operation of a single business. In order to take advantage of the income tax benefits of operating as small business corporations under section 1371 of the Code, the individuals divided into three groups, each consisting of ten individuals. Each group organized a separate corporation and the same amount of capital was contributed to each corporation in exchange for its stock. The three corporations, in turn, organized a partnership for the joint operation of the business. The corporations otherwise meet the definition of small business corporations as defined in section 1371.

The principal purpose of the thirty individuals for organizing three separate corporations to become partners in a single business, instead of organizing one corporation for that purpose, was to avoid the tax liability that would occur if they operated as one corporation, since if the business was operated by one corporation it would have more than ten shareholders and thus would not qualify as a small business corporation under section 1371 of the Code.

Section 1371(a) of the Code provides, in part, that for purposes of subchapters S (election of certain small business corporations as to taxable status), the term "small business corporation" means a domestic corporation that is not a member of an affiliated group (as defined in section 1504) and that, with certain exceptions not pertinent here, does not have more than 10 shareholders, that does not have as a shareholder a person (other than an estate or certain trusts) who is not an individual, that does not have a nonresident alien as a shareholder, and that does not have more than one class of stock.

Under section 1372(a) of the Code any small business corporation may elect not to be subject to income tax under chapter I.

In Gregory v. Helvering, 293 U.S. 465, XIV-I C.B. 193 (1935), it was contended on behalf of the taxpayer that since every element required by the statute involved was to be found in what was done, the tax result sought by the taxpayer had been effected, and that the motive of the taxpayer thereby to escape payment of a tax would not alter the result or make unlawful what the statute allowed. The Supreme Court of the United States pointed out that the whole undertaking, though conducted according to the terms of the statute, was in fact an elaborate and devious form of conveyance consummated solely for the purpose of tax avoidance. Accordingly, the Court ruled adversely to the taxpayer.

In Higgins v. Smith, 308 U.S. 473, 1940-1 C.B. 127, the Supreme Court of the United States stated that the United States Government may look at actualities in tax cases and, upon determination that the form employed for doing business or carrying out the challenged tax event is unreal or a sham, may sustain or disregard the effect of the fiction as best serves the purposes of the tax statute. To hold otherwise would permit schemes of taxpayers to supersede legislation in the determination of the time and manner of taxation.

Accordingly, in the instant case, since organizing three separate corporations instead of one corporation was for the principal purpose of being able to make the election under section 1372(a) of the Code, solely for the purpose of making such election the three corporations will be considered to be a single corporation. As a single corporation there will be 30 shareholders and, therefore, any elections made by them will not be valid because the 10 shareholder limitation of section 1371 will be considered to have been violated.