Opinion
Docket No. 35057.
1953-03-19
ESTATE OF IDA S. GODLEY, DECEASED, PAUL F. GODLEY AND JOHN W. YOUNG, JR., COEXECUTORS, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Allen S. Hubbard, Esq., and John Westbrook Fager, Esq., for the petitioners. Stanley W. Herzfeld, Esq., for the respondent.
Allen S. Hubbard, Esq., and John Westbrook Fager, Esq., for the petitioners. Stanley W. Herzfeld, Esq., for the respondent.
A corporation having total earnings or profits available for dividends of $5,674,586.32 distributed to its shareholders cash in the amount of $2,113,722.03 with stock having a cost basis of $3,199,950 and a fair market value on the date of the distribution of $8,983,407.75. Held, the distributions were taxable as dividends only to the extent of earnings and profits available for dividends, section 115(a) of the Code, and the appreciation in value of the property distributed does not serve to increase the corporation's ‘earnings or profits.‘ Held, further, to the extent that the fair market value of the property distributed is not covered by the earnings or profits the excess is used to reduce the basis of the stock of the shareholder-distributees under section 115(d), and such excess is not taxable to the shareholders as ‘other income‘ under section 22(a) of the Internal Revenue Code.
The respondent determined a deficiency in the income tax of the petitioners' decedent for the taxable year 1947 in the amount of $550.47. The question presented for our decision is whether certain corporate distributions in cash and property made by Southern Natural Gas Company were taxable to the decedent, a stockholder, in full or only to the extent that the fair market value of the distributions was covered by earnings and profits, the balance being applied to reduce the basis at which the decedent held her stock.
FINDINGS OF FACT.
All of the facts are stipulated and are found accordingly.
The petitioners' decedent, Ida S. Godley, was an individual residing in Madison, New Jersey, during the taxable year 1947. The decedent filed her Federal income tax return for the calendar year 1947 with the collector of internal revenue for the fifth district of New Jersey.
Decedent died on February 9, 1952, leaving a last will and testament appointing petitioners Paul F. Godley and John W. Young, Jr., executors. The petitioners duly qualified as executors and have been and are now acting as executors of her estate.
The petitioners' decedent was the owner of 200 shares of the outstanding common stock of Southern Natural Gas Company (hereinafter referred to as Southern), a Delaware corporation, with principal offices at Birmingham, Alabama. During the year 1947 she received cash distributions on March 12, June 12, September 12, and December 12 of $75 each, or $300 in the aggregate. On July 28, 1947, she received 200 shares of common stock of Southern Production Company, Inc. (a corporation organized by Southern in 1942), having a fair market value on this date of $6.375 per share. The total fair market value of the distributions received by decedent from Southern was $1,575.
By letter dated February 20, 1948, the decedent was advised by Southern that Southern's tax consultant had recommended two alternative methods of reporting the distributions received by stockholders from Southern during the year 1947. The decedent included in her income tax return for the year 1947 the distributions received by her from Southern as taxable to the extent of $740.25, having elected to follow one of the alternatives suggested in the letter from Southern dated February 20, 1948.
In the notice of deficiency the respondent determined that the decedent understated her dividends in the amount of $2,074 and that the total distributions received by her from Southern were 100 per cent taxable.
The total distributions made by Southern to its stockholders in 1947 amounted to $2,113,722.03 in cash and 1,409,162 shares of common stock of Southern Production Company, Inc. The adjusted basis to Southern of the stock of Southern Production Company, Inc., was $3,199,950. The fair market value of the Southern Production Company, Inc., shares distributed by Southern in 1947 was $8,983,407.75. The earnings and profits of Southern for the year 1947 were $2,936,819.51. The accumulated earnings and profits as of January 1, 1947, were $2,737,766.81, or a total of earnings and profits available in 1947 for dividends of $5,674,586.32.
The respondent informed Southern by letter dated March 25, 1952, that it had been determined that the distributions made by Southern to its stockholders were 100 per cent taxable as follows: 51.13562% or $4.027 as ordinary dividends, and 48.86438% or $3.848 as other income.
A statement attached to the letter contained the following:
Since the available earnings exceed the cash and cost of property distributed, the entire distribution to the extent of the available earnings is held 51.13562% taxable as an ordinary dividend and the balance is held taxable to the shareholders as other income.
The cost to the decedent of her 200 shares of stock of Southern was in excess of $769.60.
Southern was organized under the laws of Delaware: on October 30, 1935, and acquired as of January 1, 1936, the business and properties of a predecessor company named Southern Natural Gas Corporation, pursuant to section 77B of the Bankruptcy Act. Southern operates an interstate natural gas pipeline system, extending from gas fields in Texas, Louisiana, and Mississippi to its principal markets in Mississippi, Alabama, and Georgia.
As of December 31, 1946, Southern's capitalization consisted of long-term debt in the amount of $22,500,000 and 1,409,212 shares of common stock of the par value of $7.50 each. Its earned surplus, according to the books, as of December 31, 1946, was $14,106,850.03. The net income for the year 1947, according to the books, was $3,226,156.79, and the book earned surplus at the end of the year 1947, including net adjustments to earned surplus and before deducting dividends on the common stock, was $17,669,983.23.
Southern Production Company, Inc., was organized under the laws of Delaware on August 8, 1942. It acquired from Southern as a contribution to capital, all of the capital stock of Southern Production Company, Inc., an Alabama corporation, and all of the assets of the Alabama corporation by merger effective February 12, 1946. The Alabama corporation, Southern Production Company, Inc., was organized by Southern in 1940 for the purpose of acquiring oil and gas leases and engaging in the business of producing oil and gas. The cost to Southern of its stock interest in the Delaware corporation was as follows:
+----------------------------------------------+ ¦Paid to the Alabama corporation: ¦ ¦ +-----------------------------------+----------¦ ¦May 31, 1940 ¦$1,000 ¦ +-----------------------------------+----------¦ ¦May 31, 1941 ¦999,000 ¦ +-----------------------------------+----------¦ ¦August 21, 1941 ¦75,000 ¦ +-----------------------------------+----------¦ ¦September 17, 1941 ¦25,000 ¦ +-----------------------------------+----------¦ ¦ ¦$1,100,000¦ +-----------------------------------+----------¦ ¦Paid to the Delaware corporation: ¦ ¦ +-----------------------------------+----------¦ ¦December 1945 ¦$1,000 ¦ +-----------------------------------+----------¦ ¦February 12, 1946 ¦800,000 ¦ +-----------------------------------+----------¦ ¦June 6, 1946 ¦200,000 ¦ +-----------------------------------+----------¦ ¦July 29, 1946 ¦200,000 ¦ +-----------------------------------+----------¦ ¦March 25, 1947 ¦899,000 ¦ +-----------------------------------+----------¦ ¦ ¦$2,100,000¦ +-----------------------------------+----------¦ ¦Total ¦$3,200,000¦ +----------------------------------------------+
On July 28, 1947, Southern Production Company, Inc., had outstanding 1,409,212 shares of stock of the par value of $1 each, all of which were owned by Southern. Southern distributed to its stockholders on July 28, 1947, 1,409,162 shares of the common stock of Southern Production Company, Inc., leaving 50 shares of such stock in the treasury of Southern. Such 50 shares were sold in the open market for $336.45. After this sale, the adjusted basis of the stock distributed was deemed to be $3,199,950 as a price of $1 a share was allocated to the stock sold in the open market.
The dividend of shares of stock of Southern Production Company, Inc., was declared by the board of directors of Southern at a meeting of the board duly called and held on June 15, 1947, by resolutions reading as follows:
RESOLVED, that a dividend be and the same hereby is declared in kind of one share of stock of Southern Production Company, Inc., a corporation of the State of Delaware, for each share of stock of Southern Natural Gas Company issued and outstanding, such dividend to be deliverable on July 28, 1947, to stockholders of record of Southern Natural Gas Company at the close of business on July 3, 1947; and further
RESOLVED, that the proper officers of the Company be and they hereby are authorized to charge the cost to the Company of the stock of Southern Production Company, Inc. (i.e., the sum of $3,200,000.) to earned surplus on the books of account of the Company.
For the year 1947, on the books, Southern charged earned surplus with $2,113,722.03, representing the cash distributed as dividends during this year and $3,199,663.55, representing cost to Southern of the shares of the stock distributed to stockholders as a dividend. The book earned surplus of Southern on December 31, 1947, after making such deductions, was $12,356,597.65.
The parties agree that the correct amount of the total cash distributions made by Southern in 1947 is $2,113,722.03; that the total fair market value of the stock of Southern Production Company, Inc., on July 28, 1947, distributed to stockholders was $8,983,407.75; and that the adjusted basis to Southern of the stock of Southern Production Company, Inc., was $3,199,950.
In computing Southern's earnings and profits for tax purposes, as shown in letter of March 25, 1952, the amount of depreciation allowed or allowable during the period 1936 to 1947, inclusive, including accelerated amortization pursuant to section 124 of the Internal Revenue Code, exceeds the amount of depreciation taken on the books of Southern during the period 1936-1947, inclusive, by over $10,500,000.
The salient facts concerning Southern's dividend distributions during 1947 are:
+-----------------------------------------------------------------------+ ¦Total earnings and profits available for 1947 dividends ¦$5,674,586.32 ¦ +--------------------------------------------------------+--------------¦ ¦ ¦ ¦ ¦ +------------------------------------------+-------------+--------------¦ ¦Distributions charged out by Southern ¦ ¦ ¦ +------------------------------------------+-------------+--------------¦ ¦Cash $1.50 per share ¦$2,113,722.03¦ ¦ +------------------------------------------+-------------+--------------¦ ¦Property $6.375 per share cost ¦3,199,950.00 ¦ ¦ +------------------------------------------+-------------+--------------¦ ¦ ¦ ¦ ¦ +------------------------------------------+-------------+--------------¦ ¦Total charged out by corporation per books¦ ¦$5,313,672.03 ¦ +------------------------------------------+-------------+--------------¦ ¦ ¦ ¦ ¦ +------------------------------------------+-------------+--------------¦ ¦Distributions received by stockholders ¦ ¦ ¦ +------------------------------------------+-------------+--------------¦ ¦Cash ¦$2,113,722.03¦ ¦ +------------------------------------------+-------------+--------------¦ ¦Property, at fair market value ¦8,983,407.75 ¦ ¦ +------------------------------------------+-------------+--------------¦ ¦ ¦ ¦ ¦ +------------------------------------------+-------------+--------------¦ ¦Total received by stockholders ¦ ¦$11,097,129.78¦ +-----------------------------------------------------------------------+
OPINION.
HILL, Judge:
Although the first issue here presented by the parties had its birth in questions presented in previous litigation before this Court, it comes before us here in a new and unique form. The problem is this. Should the distributing corporation's statutory earnings or profits be reduced, because of a dividend in kind of property which has appreciated in value over cost or adjusted basis, by the fair market value of the property at the time of distribution or by the cost or adjusted basis of the property distributed?
The genesis of the problem before us was the holding in General Utilities & Operating Co. v. Helvering, 296 U.S. 200. In 1927 General Utilities acquired 20,000 shares of Islands Edison stock for a consideration of $2,000. The stock appreciated in value by over $1,000,000. The corporation wrote up this appreciated value on its books and the following year distributed the appreciated stock as a dividend in kind. Soon after receipt of the dividend all of the shareholders of General Utilities sold their Island Edison stock at $56.12 1/2 per share and General Utilities reported a gain on 910 shares, which it had retained from the block of shares and sold directly, but not on the 19,090 shares distributed to the stockholders. The Commissioner sought to tax the difference between the cost of $2,000 and the selling price of all 20,000 shares as income to the corporation. Before the Board of Tax Appeals, the Commissioner, relying upon the Kirby Lumber Co. case, argued that the form of the dividend declaration indebted the corporation to its shareholders in the amount of $1,071,426.25. The Board held that the dividend was intended as a dividend in kind and resulted in no taxable income to General Utilities. The case was appealed, 74 F.2d 972, with the Commissioner adding a new argument to the effect that the sale of the securities by the stockholders was in actuality a sale by the corporation through its shareholders with all terms agreed before the declaration of the dividend. The Board of Tax Appeals was affirmed upon the basis of its decision but on the matter newly raised the Commissioner was upheld. On certiorari to the Supreme Court, the Commissioner retained his two former arguments before the courts below and added yet a third: that where a corporation pays a dividend in property which has increased in value it thereby realizes the gain on its investment, a point conceded by the Commissioner to a contrary effect before the Board of Tax Appeals. No direct reference was made in the opinion by Justice McReynolds to the third argument made by the Commissioner but there are substantial reasons to believe that the Supreme Court rejected it for the Court refused to remand the cause for further findings of fact and held that both tribunals below had already decided that the taxpayer derived no taxable gain from the distribution among its stockholders of the dividend in kind. The Supreme Court's decision that the dividend was in terms of property rather than dollars was significant only because a dividend of property was there regarded as incapable of constituting realization of income to the distributing corporation. There has been some qualification to the general rule laid down in General Utilities, supra. See Commissioner v. First State Bank of Stratford, 168 F.2d 1004; Guinness v. United States, 73 F.Supp. 119, certiorari denied 334 U.S. 819; Commissioner v. Transport Trading & Terminal Corporation, 176 F.2d 570, certiorari denied 338 U.S. 955, rehearing denied 339 U.S. 916. However, the exceptions to the rule have no applicability to our present problem. It is safe to say then that the General Utilities case holding still stands for the proposition that appreciation in value over cost or adjusted basis of property distributed as a dividend in kind does not constitute a realization of income to the distributing corporation.
The theory of the General Utilities case has been generally applied to computation of a corporation's statutory earnings or profits even where no question of the effect on its taxable net income is involved, e.g., National Carbon Co., 2 T.C. 57, and Estate of H. H. Timken, 47 B.T.A. 494, affd. 141 F.2d 625, where a dividend in kind was not regarded as a taxable dividend to the shareholders except in so far as there were sufficient statutory earnings or profits (computed without regard to increase in value of the res distributed in kind over cost) from the other sources at the time of the distribution in kind to cover its fair market value. Thus it is seen that the treatment of distributions in kind of appreciated property for the purpose of determining statutory earnings or profits and realization of taxable net income have been parallel and consistent.
However, some confusion has been caused in this field by a divergent theory which may be stated thusly, if the property distributed in kind was originally purchased out of post-1913 earnings then, without regard to the amount of statutory earnings or profits at the time of the distribution, the full market value of the distribution is taxable as a ‘dividend.‘ Commissioner v. Wakefield, 139 F.2d 280. See also in this connection Binzel v. Commissioner, 75 F.2d 989, and Timberlake v. Commissioner, 132 F.2d 259. In these last two cited cases it did not appear that the distributor did not have sufficient earnings or profits to support a dividend to the extent of the fair market value of the property distributed, and hence they give no support to the rationale of the Wakefield decision.
The rationale of the court in the Wakefield case is apparently based upon the notion that once property is purchased out of earnings it continues to represent statutory earnings or profits even though the actual statutory earnings or profits of the corporation are far below its value at the time of its distribution in kind. This is borne out by the following language in the opinion:
What the partnership received was not the cash paid for the stock, but the stock itself. The securities clearly did not represent capital, nor did their distribution deplete capital. The distribution was made possible only by the expenditure of earnings and profits, and it depleted only earnings and profits. Hence the transaction fell within the definition of sec. 115(a) of the Revenue Act of 1936, and constituted a dividend * * * .
The opinion is then premised on the existence of a separate fund of earnings or profits regarded as an entity out of which property could be bought and assumes always that the fund was used to purchase the property distributed in kind rather than expended for other business purposes.
Having decided that the distribution was a ‘dividend‘ because the property was purchased from earnings or profits and hence qualified under section 115(a), the court then relied upon section 115(j) as an independent measure of taxability to the shareholder-distributees.