## Facts

- Savannah Inn and Country Club, Inc. operated a resort and country club business and initially had 15 shareholders.
- Facing financial difficulty, Savannah sought additional capital contributions from shareholders.
- Five shareholders refused to contribute further capital and, pursuant to an internal arrangement, exchanged their shares for interest-bearing corporate obligations issued by Savannah.
- After the exchange, the five individuals no longer held any stock, did not vote, and ceased participation in corporate affairs or management.
- Savannah then elected to be taxed as a Subchapter S small business corporation.
- The Commissioner disallowed the election, asserting Savannah still had more than the then-permitted 10 shareholders because the five former shareholders should be treated as shareholders notwithstanding the exchange.
- The Commissioner determined income tax deficiencies against the remaining shareholders based on treating Savannah as a non-Subchapter S corporation; the shareholders petitioned the Tax Court for redetermination.

## Issues

1. Whether the five individuals who surrendered their stock for interest-bearing corporate obligations remained “shareholders” for purposes of the Subchapter S shareholder limitation.
2. Whether Savannah had 10 or fewer shareholders after the refinancing, so that its Subchapter S election was valid and its status continued for the years at issue.
3. Whether the Commissioner’s deficiency determinations, premised on invalid Subchapter S status, were erroneous.

## Decision

- The Tax Court ruled for the petitioning shareholders.
- The court held that the five former stockholders were no longer shareholders after exchanging their shares for interest-bearing obligations.
- Because Savannah had 10 or fewer shareholders after the exchange, it satisfied the Subchapter S shareholder-number requirement and its election was effective.
- The Commissioner’s deficiency determinations, to the extent based on denying Subchapter S treatment for excessive shareholders, could not be sustained.

## Legal Principles

- For Subchapter S eligibility, shareholder-count limits apply by reference to actual stock ownership; holders of bona fide corporate debt are not counted as shareholders.
- A stock-for-debt exchange that fully terminates shareholder rights (including voting and participation in corporate governance) may be respected as converting equity holders into creditors.
- Subchapter S qualification depends on meeting statutory requirements at the time of election and on a continuing basis; a refinancing does not terminate S status if those requirements remain satisfied.

## Conclusion

The Tax Court treated the exchanged instruments as genuine corporate debt and the former stockholders as creditors rather than shareholders, leaving the corporation within the statutory shareholder limit and preserving Subchapter S pass-through treatment for the remaining shareholders.


Mazo v. Commissioner, T.C. Memo. 1973-125 (1973)