## Facts

- Three individuals acquired undeveloped land in 1957 for $100,000, intending to subdivide, improve, and sell lots.
- They formed Burr Oaks Corporation to carry out the development; the corporation had minimal stated paid-in capital relative to the contemplated project.
- The individuals transferred the land to the corporation and each received a two-year 6% promissory note for $110,000 (aggregate $330,000); the corporation also carried the remaining $30,000 owed on the original purchase as a mortgage obligation.
- Taxpayers asserted the land was worth at least $360,000 at the time of transfer, and the corporation’s records reflected the notes as a major liability tied to the land acquisition.
- Burr Oaks made some payments and repeatedly replaced the notes with new notes for remaining balances.
- In 1959, the corporation purported to retire the notes, but the individuals simultaneously re-loaned equivalent amounts back to the corporation for new notes.
- The individuals treated the 1957 transfer as a sale but reported no gain in 1957; they reported long-term capital gain in 1959 tied to the note “payoff.”
- The Commissioner determined the 1957 transfer was a contribution to capital, the notes were equity-like (preferred stock in substance), shareholder receipts were dividends/ordinary income, and the corporation could not use the claimed $360,000 basis (asserting a substantially lower fair market value).
- The Tax Court agreed that the transfer was a capital contribution and the notes were, in substance, preferred stock, resulting in corporate deficiencies for fiscal years ending in 1958–1960 and adjustments for the individuals (including an overpayment finding for 1959 but continuing characterization consequences).

## Issues

1. Whether the 1957 land transfer to a closely held, thinly capitalized corporation in exchange for shareholder promissory notes was a bona fide sale or a contribution to capital.
2. Whether the shareholder “notes” constituted true indebtedness or, in substance, equity (stock-like) interests.
3. What tax consequences followed for (a) the corporation’s basis in the land and (b) the character of amounts received by shareholders in 1959 (capital gain vs. dividend/ordinary income).

## Decision

- The Seventh Circuit affirmed the Tax Court.
- The court upheld the finding that the 1957 transfer was a contribution to capital rather than a sale.
- The court upheld the characterization of the promissory notes as equity in substance (preferred stock-like), not genuine debt.
- The court sustained the resulting tax consequences, including the corporation’s inability to claim the asserted sale-based basis and the treatment of shareholder receipts consistent with equity rather than debt.

## Legal Principles

- Federal tax treatment follows substance over form; instruments labeled “notes” may be recharacterized as equity based on their economic function.
- In debt-versus-equity analysis, courts consider whether purported debt in a thinly capitalized corporation actually serves as risk capital contributed by controlling shareholders.
- Where a property transfer to a controlled corporation is, in substance, capitalization and the consideration functions as equity, the transaction is treated as a capital contribution rather than a sale, affecting corporate basis and shareholder income characterization.
- Payments tied to equity-like instruments are treated as distributions (dividends/ordinary income) rather than interest or capital gain from debt retirement.

## Conclusion

The Seventh Circuit held that the shareholders’ land-for-notes transfer to Burr Oaks was a capital contribution and that the “notes” were equity in substance, supporting the Commissioner’s adjustments to the corporation’s basis and treating shareholder receipts as dividend-type ordinary income rather than capital gain.


Burr Oaks Corp. v. Commissioner, 365 F.2d 24 (7th Cir. 1966)