## Facts

- Three individuals (Elkind, Watkins, and Ritz) acquired undeveloped land in 1957 for $100,000 and later decided to subdivide, improve, and sell lots.
- They formed Burr Oaks Corporation to hold and develop the property.
- Relatives of the three individuals contributed $4,500 in cash and received the corporation’s common stock, but the relatives did not participate in the business; the three individuals dominated and controlled the corporation.
- The corporation was thinly capitalized and engaged in a speculative venture.
- The three individuals transferred the land to the corporation in exchange for three purported 2-year, 6% promissory notes of $110,000 each (total $330,000), and the corporation assumed roughly $30,000 of remaining acquisition debt.
- The court found the land was worth no more than $165,000 when transferred, far below the total stated obligations.
- The corporation made payments to the three individuals in 1959 that were treated by the parties as installment payments on the notes; the individuals reported long-term capital gain only as payments were received.
- The notes were not paid at maturity and were extended; portions remained outstanding through trial.

## Issues

1. Whether the land transfer in exchange for the corporation’s notes and assumption of debt was a bona fide sale creating true indebtedness, or a contribution to capital with the notes functioning as equity.
2. Whether the land and cash transfers were part of a single integrated exchange so that the transferors were in control immediately after the exchange under I.R.C. § 351, requiring substituted basis to the corporation.
3. Whether the 1959 payments to the three individuals were installment sale proceeds producing capital gain or distributions essentially equivalent to dividends taxable as ordinary income (subject to earnings and profits).

## Decision

- The Tax Court held the land transfer was a contribution to capital, not a sale; the purported promissory notes were in substance equity comparable to preferred stock.
- The court held the land and cash transfers were integrated, and the transferors were in control immediately after the exchange within the meaning of I.R.C. § 351.
- The corporation’s basis in the land was a substituted basis (carryover basis), not a cost basis equal to the notes’ face amounts.
- The 1959 payments were distributions with respect to an equity interest and were essentially equivalent to dividends to the extent of earnings and profits.

## Legal Principles

- Debt–equity classification turns on substance: thin capitalization, speculative business risk, lack of arm’s-length dealing, disregard of maturity terms, and a large mismatch between stated “debt” and underlying asset value support recharacterizing purported debt as equity.
- A purported “sale” to a closely controlled corporation may be treated as a capital contribution where the consideration is not genuine indebtedness in economic reality.
- For I.R.C. § 351, contemporaneous steps may be treated as an integrated exchange; control can be found based on actual dominion rather than nominal record ownership where stockholders are mere nominees.
- If § 351 applies, the transferee corporation generally takes a substituted basis in the transferred property rather than a stepped-up basis based on stated obligations.
- Payments on instruments recharacterized as equity are treated as corporate distributions potentially taxable as dividends to the extent of earnings and profits, rather than as capital-gain sale proceeds.

## Conclusion

The Tax Court recharacterized shareholders’ “notes” received for transferred land as equity because the corporation was undercapitalized, the transaction lacked arm’s-length features, and the obligations greatly exceeded the property’s value; it treated the exchange as a § 351 contribution with carryover basis and taxed subsequent payments as dividend-equivalent distributions rather than capital gain.


Burr Oaks Corp. v. Commissioner of Internal Revenue, 43 T.C. 635 (1965)