Corporate Dividends: When Taxable

Corporate Dividends: When Taxable.—Rendered in conformity with the belief that all income ''in the ordinary sense of the word'' became taxable under the Sixteenth Amendment, the earliest decisions of the Court on the taxability of corporate dividends occasioned little comment. Emphasizing that in all such cases the stockholder is to be viewed as ''a different entity from the corporation,'' the Court in Lynch v. Hornby,16 held that a cash dividend equal to 24 percent of the par value of the outstanding stock and made possible largely by the conversion into money of assets earned prior to the adoption of the Amendment, was income taxable to the stockholder for the year in which he received it, notwithstanding that such an extraordinary payment might appear ''to be a mere realization in possession of an inchoate and contingent interest . . . [of] the stockholder . . . in a surplus of corporate assets previously existing.'' In Peabody v. Eisner,17 decided on the same day and deemed to have been controlled by the preceding case, the Court ruled that a dividend paid in the stock of another corporation, although representing earnings that had accrued before ratification of the Amendment, was also taxable to the shareholder as income. The dividend was likened to a distribution in specie.

Two years later the Court decided Eisner v. Macomber,18 and the controversy which that decision precipitated still endures. Departing from the interpretation placed upon the Sixteenth Amendment in the earlier cases, i.e., that the purpose of the Amendment was to correct the ''error'' committed in the Pollock case and to restore income taxation to ''the category of indirect taxation to which it inherently belonged,'' Justice Pitney, who delivered the Court's opinion in the Eisner case, indicated that the sole purpose of the Sixteenth Amendment was merely to ''remove the necessity which otherwise might exist for an apportionment among the States of taxes laid on income.'' He thereupon undertook to demonstrate how what was not income, but an increment of capital when received, could later be transmitted into income upon sale or conversion and could be taxed as such without the necessity of apportionment. In short, the term ''income'' acquired to some indefinite extent a restrictive significance.

16 247 U.S. 339, 344 (1918). On the other hand, in Lynch v. Turrish, 247 U.S. 221 (1918), the single and final dividend distributed upon liquidation of the entire assets of a corporation, although equaling twice the par value of the capital stock, was declared to represent only the intrinsic value of the latter earned prior to the effective date of the Amendment, and hence was not taxable as income to the shareholder in the year in which actually received. Similarly, in Southern Pacific Co. v. Lowe, 247 U.S. 330 (1918), dividends paid out of surplus accumulated before the effective date of the Amendment by a railway company whose entire capital stock was owned by another railway company and whose physical assets were leased to and used by the latter was declared to be a nontaxable bookkeeping transaction between virtually identical corporations.

17 247 U.S. 347 (1918).

18 252 U.S. 189, 206-08 (1920).

Specifically, the Court held that a stock dividend was capital when received by a stockholder of the issuing corporation and did not become taxable without apportionment, that is, as ''income,'' until sold or converted, and then only to the extent that a gain was realized upon the proportion of the original investment which such stock represented. ''A stock dividend,'' Justice Pitney maintained, ''far from being a realization of profits to the stockholder, . . . tends rather to postpone such realization, in that the fund represented by the new stock has been transferred from surplus to capital, and no longer is available for actual distribution . . . not only does a stock dividend really take nothing from . . . the corporation and add nothing to that of the shareholder, but . . . the antecedent accumulation of profits evidenced thereby, while indicating that the shareholder is richer because of an increase of his capital, at the same time shows [that] he has not realized or received any income in'' what is no more than a ''bookkeeping transaction.'' But conceding that a stock dividend represented a gain, the Justice concluded that the only gain taxable as ''income'' under the Amendment was ''a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested or employed, and coming in, being 'derived,' that is, received or drawn by the recipient [the taxpayer] for his separate use, benefit, and disposal; …'' Only the latter in his opinion, answered the description of income ''derived'' from property, whereas ''a gain accruing to a capital, not a growth or an increment of value in the investment'' did not.19

Although steadfastly refusing to depart from the principle20 which it asserted in Eisner v. Macomber, the Court in subsequent decisions has, however, slightly narrowed the application thereof. Thus, the distribution, as a dividend, to stockholders of an existing corporation of the stock of a new corporation to which the former corporation, under a reorganization, had transferred all its assets, including a surplus of accumulated profits, was treated as taxable income. The fact that a comparison of the market value of the shares in the older corporation immediately before, with the aggregate market value of those shares plus the dividend shares immediately after, the dividend showed that the stockholders experienced no increase in aggregate wealth was declared not to be a proper test for determining whether taxable income had been received by these stockholders.21 On the other hand, no taxable income was held to have been produced by the mere receipt by a stockholder of rights to subscribe for shares in a new issue of capital stock, the intrinsic value of which was assumed to be in excess of the issuing price. The right to subscribe was declared to be analogous to a stock divided, and ''only so much of the proceeds obtained upon the sale of such rights as represents a realized profit over cost'' to the stockholders was deemed to be taxable income.22 Similarly, on grounds of consistency with Eisner v. Macomber, the Court has ruled that inasmuch as it gave the stockholder an interest different from that represented by his former holdings, a dividend in common stock to holders of preferred stock,23 or a dividend in preferred stock accepted by a holder of common stock24 was income taxable under the Sixteenth Amendment.

19 252 U.S. at 211-12. This decision has been severely criticized, chiefly on the ground that gains accruing to capital over a period of years are not income and are not transformed into income by being dissevered from capital through sale or conversion. Critics have also experienced difficulty in understanding how a tax on income which has been severed from capital can continue to be labeled a ''direct'' tax on the capital from which the severance has thus been made. Finally, the contention has been made that in stressing the separate identities of a corporation and its stockholders, the Court overlooked the fact that when a surplus has been accumulated, the stockholders are thereby enriched, and that a stock dividend may therefore be appropriately viewed simply as a device whereby the corporation reinvests money earned in their behalf. See also Merchants' L. & T. Co. v.Smietanka, 255 U.S. 509 (1921).

20 Reconsideration was refused in Helvering v. Griffths, 318 U.S. 371 (1943).

21 United States v. Phellis, 257 U.S. 156 (1921); Rockefeller v. United States, 257 U.S. 176 (1921). See also Cullinan v. Walker, 262 U.S. 134 (1923).

In Marr v. United States, 268 U.S. 536, 540-41 (1925), it was held that the increased market value of stock issued by a new corporation in exchange for stock of an older corporation, the assets of which it was organized to absorb, was subject to taxation as income to the holder, notwithstanding that the income represented profits of the older corporation and that the capital remained invested in the same general enterprise. Weiss v. Stearn, 265 U.S. 242 (1924), in which the additional value in new securities was held not taxable, was likened to Eisner v. Macomber, and distinguished from the aforementioned cases on the ground of preservation of corporate identity. Although the ''new corporation had . . . been organized to take over the assets and business of the old . . . , the corporate identity was deemed to have been substantially maintained because the new corporation was organized under the laws of the same State with presumably the same powers as the old. There was also no change in the character of the securities issued,'' with the result that ''the proportional interest of the stockholder after the distribution of the new securities was deemed to be exactly the same.''

Under existing law, however, when a taxpayer exchanges all of the outstanding stock for a minor percentage of the total shares of a larger corporation, plus cash, the gain to be recognized in full is not limited to the cash but embraces the excess of the sum of the market value of the stock acquired plus the cash over the cost of the original stock plus the expenses of the sale. Turnbow v. Commissioner, 368 U.S. 337 (1961).

22 Miles v. Safe Deposit Co., 259 U.S. 247 (1922).

23 Koshland v. Helvering, 298 U.S. 441 (1936).

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