Opinion
Docket No. 2939.
1945-06-28
A. J. LONG, JR., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
H. J. Siebenthaler, Esq., and Murray M. Flack, Esq., for the petitioner. John H. Pigg, Esq., for the respondent.
Petitioner was the owner of 12,121 of the 23,417 outstanding shares of common stock of the A. Nash Co. During the period 1920 to 1924, that company had capitalized earnings and profits accumulated since March 1, 1913, in the sum of $1,687,500 by issuance of 16,875 shares of $100 par value, in nontaxable stock dividends. On December 30, 1932, prior to the acquisition by petitioner of his stock, the par value of all the corporate stock was reduced from $100 to $25 per share and the total amount of that reduction was entered on the books as ‘capital surplus.‘ This total included $1,265,625 of the amounts of earned surplus formerly capitalized by stock dividends. On December 20, 1939, the corporation made a cash distribution of $9 per share to stockholders. Of this amount the company charged $0.4489 per share against its book balance of earned surplus, which exhausted that book balance. The remainder of the distribution, $8.5511 per share, was charged against ‘capital surplus.‘ On his return for that year petitioner reported as a taxable dividend only $0.4489 per share, treating the remainder as a return of capital. Held, that earnings accumulated subsequent to March 1, 1913, capitalized by the issuance of stock dividends, retain their character as earnings and constitute ‘dividends‘ as defined in section 115(a), I.R.C., when distributed. Commissioner v. Bedford, 325 U.S. 283. H. J. Siebenthaler, Esq., and Murray M. Flack, Esq., for the petitioner. John H. Pigg, Esq., for the respondent.
This controversy involves a deficiency in income tax for the calendar year 1939 in the amount of $43,057.05. The sole issue is whether the cash distribution of $109,089, made by the A. Nash Co. in 1939, constitutes an ordinary dividend taxable to him in its entirety. The case was submitted on a stipulation of facts and oral testimony. The facts as stipulated are adopted as our findings of fact.
FINDINGS OF FACT.
The petitioner is an individual, residing in Cincinnati, Ohio. His income tax return for the calendar year 1939 was filed with the collector of internal revenue for the first district of Ohio at Cincinnati, Ohio.
On June 15, 1931, petitioner acquired by gift one share of the common stock of the A. Nash Co. Between that date and July 19, 1939, he acquired by purchase 12,120 additional shares at an aggregate cost of $206,845. The company, at the latter date, had outstanding 23,417 shares of its common stock, which is the only class of shares it was then authorized to issue. The company was organized in 1916, with an authorized capital of $60,000, divided into 400 shares of common and 200 shares of convertible preferred, both of the par value of $100 per share. Thereafter and prior to December 1919, the preferred was converted into common. The company was engaged in the business of tailoring and selling men's made-to-measure suits and topcoats. In January 1920, by charter amendment, its authorized capital was increased to $90,000, consisting of 900 shares of common of the par value of $100 each. The additional 300 shares were sold for cash at par. Thereafter, from time to time until March 20, 1924, the authorized capital was increased to $3,000,000, divided into 30,000 shares of common of the par value of $100 each. No further change was made in the authorized capital of the company until December 31, 1932. From 1920 to 1924, inclusive, the company declared and paid nontaxable stock dividends on the dates and in the amounts as follows:
+-----------------------------------------+ ¦ ¦ ¦ ¦Value in ¦ +-------------+----------+------+---------¦ ¦Date ¦Percentage¦Shares¦dollars ¦ +-------------+----------+------+---------¦ ¦Jan. 1, 1921 ¦200 ¦1,800 ¦$180,000 ¦ +-------------+----------+------+---------¦ ¦Jan. 3, 1922 ¦100 ¦4,000 ¦400,000 ¦ +-------------+----------+------+---------¦ ¦June 8, 1923 ¦12 1/2 ¦1,075 ¦107,500 ¦ +-------------+----------+------+---------¦ ¦June 30, 1924¦100 ¦10,000¦1,000,000¦ +-------------+----------+------+---------¦ ¦Total ¦ ¦16,875¦1,687,500¦ +-----------------------------------------+
No stock dividends were paid after June 30, 1924. In the early and middle 1920's company was extremely successful and expanded its inventories and fixed investments. The additional capital was supplied by capitalizing earnings by the above stock dividends. These stock dividends were declared and paid for legitimate business purposes. From the time of its organization until December 1932, the company sold for cash at par (or delivered to employees as compensation) 8,840 shares of the par value of $100 per share. The remaining 16,875 shares of its then total issued shares of 25,715 had been issued as stock dividends. Of the 25,715 shares outstanding, 2,298 were then held in the company's treasury. Immediately prior to December 31, 1932, the company's capital account, as shown by its balance sheet, disclosed a ‘deficit‘ of $647,114.94. As of December 31, 1932, by appropriate corporate action and amendment to its charter, the par value of the common stock was reduced from $100 to $25 per share. This reduction was reflected on the company's books by ‘writing down‘ its capital stock account from $2,571,500 to $642,875. By appropriate corporate action the 2,298 shares held in the treasury were retired, further reducing the capital stock from $642,875 to $585,425. There were no further changes affecting the capital stock account.
Immediately prior to the reduction of the par value of the shares and the retirement of the 2,298 shares of treasury stock, the treasury stock was carried as an asset on the company's books and balance sheet in an account entitled ‘A. Nash Company treasury stock,‘ with a debit balance of $192,847, and its ‘capital‘ account was similarly reflected in a ‘capital stock account.‘ with a credit balance of $647,114.94. But for the above described stock dividends in the amount of $1,687,500, the company's earned surplus account as of December 31, 1932, would have disclosed a credit balance of $1,040,385.06 ($1,687,500-$647,114.94). Immediately after the book adjustments incident to the described reduction of par value and the retirement of the treasury shares, the debit balance in the treasury stock asset was eliminated and the capital account appeared with credit balances, as follows:
+-----------------------------------------------------------------------------+ ¦Capital stock, common $25 par value issued and outstanding 23,417¦$585,425.00¦ ¦shares ¦ ¦ +-----------------------------------------------------------------+-----------¦ ¦Capital surplus ¦928,113.06 ¦ +-----------------------------------------------------------------+-----------¦ ¦Surplus appropriated to meet probable losses ¦218,000.00 ¦ +-----------------------------------------------------------------------------+
Adjusting book entries appropriate to the accomplishment of the foregoing changes in the company's assets and capital account are as follows:
+-------------------------------------------------------------------+ ¦ ¦Debit ¦Credit ¦ +--------------------------------------------+----------+-----------¦ ¦Capital stock ¦$1,986,075¦ ¦ +--------------------------------------------+----------+-----------¦ ¦To treasury stock ¦ ¦$192,847.00¦ +--------------------------------------------+----------+-----------¦ ¦Surplus deficit ¦ ¦647,114.94 ¦ +--------------------------------------------+----------+-----------¦ ¦“Capital Surplus” ¦ ¦928,113.06 ¦ +--------------------------------------------+----------+-----------¦ ¦Surplus appropriated to meet probable losses¦ ¦218,000.00 ¦ +-------------------------------------------------------------------+
During the years 1933 to 1935, the ‘Capital Surplus‘ account remained unchanged. Various changes occurred in the account entitled ‘Surplus appropriated to meet probable losses‘ and also in ‘Earned Surplus‘ account, the latter to reflect earnings and losses for those years and cash dividends paid. In 1936 various adjustments were made to ‘Capital Surplus‘ account, including a transfer to that account of a then credit balance of $4,321.04 in the ‘Surplus appropriated to meet probable losses‘ account, increasing the ‘Capital Surplus‘ account to $945,639.29. This account then remained unchanged in the years 1937 and 1938. Various changes occurred in the years 1936, 1937, and 1938 in the ‘Earned Surplus‘ account to reflect earnings and losses and cash dividends paid. On December 31, 1938, the company's capital account as shown on its balance sheet was as follows:
+---------------------------------------------------------------------+ ¦Capital stock $25 par value issued and outstanding 23,417¦$585,425.00¦ +---------------------------------------------------------+-----------¦ ¦Capital surplus ¦945,639.29 ¦ +---------------------------------------------------------+-----------¦ ¦Earned surplus ¦9,463.95 ¦ +---------------------------------------------------------------------+
The amount of the accumulated undistributed earnings on December 31, 1920, immediately prior to the payment of the stock dividend of $180,000 on January 1, 1921, is not shown. The record discloses that cash dividends in the total amount of $21,428 were paid during the years 1917 to 1920, including a dividend of $8,228 paid in 1920. During the years 1920 to 1930, inclusive, 1935, 1936, and 1937, the net earnings amounted to $4,491,279.09, and the aggregate net losses in the years 1931 to 1934, inclusive, and 1938 amounted to $1,295,213.06. Of the aggregate excess net earnings of $3,196,066.03 for the period 1920 to 1938, inclusive, cash dividends of $1,785,769.19 were paid. Thus the company's undistributed net earnings amounted to $1,410,296.84 without regard to whatever amount the accumulated net earnings as of December 31, 1920, may have exceeded the stock dividend of $180,000 paid on January 1, 1921. In the year 1939, although a net operating loss of $1,190.73 was sustained, it had a per book net income of $1,048.27.
At a meeting of the board of directors held on December 20, 1939, resolutions were adopted authorizing a distribution of $9 per share. Extracts from the minutes of that meeting are as follows:
Our cash position at the end of the 11th period showed total Current Assets of $851,764 which includes $185,566 in cash. Our Accounts Payable amounted to $76,125, Accrued Liabilities and Deferred charges in the amount of $105,000, Total Current Liabilities $181,129. This shows a current working capital of $670,635.
Our inventory is in very excellent condition and at the end of the 11th period amounted to $443,000, against $409,000, for the previous year.
The consolidation of Nash and Schaefer Departments has been completely effected with the least amount of interruption and on a much more satisfactory basis than we had at first anticipated. While we have received considerable benefit from this consolidation, we did not receive full benefit for this season.
Our raw material commitments for the Spring season have been made on what we feel is an advantageous basis and we were not required to pay as much of an advance as the average concern in our industry. We feel that our competitive position next spring will be good and we are anticipating an increase in volume.
‘BE IT RESOLVED, that a dividend in the amount of Nine Dollars ($9.00) per share on the 23,417 shares of outstanding stock of this company be declared to be due and payable on the 28th day of December, 1939, to shareholders of record as shown by the books of the corporation, at the close of business on the 26th day of December, 1939, and that all of the Earned Surplus of the company as shown on its books at the close of business on December 30, 1939, be appropriated and set aside first for the payment thereof, and that the amount in excess of all Earned Surplus necessary to pay said dividend, be charged against and paid out of the Capital Surplus of the company; and
BE IT FURTHER RESOLVED, that the shareholders receiving such dividend be notified that the payment thereof will exhaust the Earned Surplus of the company as of December 30, 1939, and be paid in part out of the Capital Surplus and that as soon as the exact amount of Earned Surplus and Capital Surplus making up said dividend can be ascertained, the shareholders will be notified thereof.‘
On December 28, 1939, letters were mailed to stockholders enclosing checks at the rate of $9 per share and advising that said dividend was paid in part out of ‘Capital Surplus‘ after first using all of the ‘Earned Surplus‘ shown on the books as of December 30, 1939. On February 5, 1940, the shareholders were notified that the $9 per share dividend was paid out of ‘Earned Surplus‘ and ‘Capital Surplus‘ as follows: Out of earned surplus, $0.4489 per share; and out of capital surplus, $8.5511 per share.
After the distribution of $9 per share, the capital account on the balance sheet as of December 30, 1939, showed the following:
+-----------------------------------------------------------------------------+ ¦Capital stock, common, $25 par value: ¦ ¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Authorized 30,000 shares ¦ ¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Issued and outstanding 23,417 shares ¦ ¦$585,425.00¦ +-----------------------------------------------------+-----------+-----------¦ ¦Capital surplus: ¦ ¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Balance, Jan. 1, 1939 ¦$945,639.29¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Less, distribution during current year, $8.5511 ¦ ¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦per share ¦200,240.78 ¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦ ¦ ¦$745,398.51¦ +-----------------------------------------------------+-----------+-----------¦ ¦Earned surplus: ¦ ¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Balance, Jan. 1, 1939 ¦ ¦9,463.95 ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Net income for the period Jan. 1, 1939, to Dec. 30, ¦ ¦1,048.27 ¦ ¦1939 ¦ ¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦ ¦ ¦10,512.22 ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Cash dividends paid ¦ ¦10,512.22 ¦ +-----------------------------------------------------------------------------+
As of December 30, 1939, petitioner was the owner of 12,121 shares and received the sum of $109,089. In his 1939 income tax return he reported the sum of $5,441.12 as a taxable dividend representing the distribution of $0.4489 per share. The remainder amount of $103,647.88 was treated as a return of capital. The respondent determined that the entire distribution of $9 per share was taxable as an ordinary dividend. To the extent the cash distribution of $9 per share was not paid out of earnings or profits of the taxable year, it was paid out of earnings or profits accumulated after February 28, 1913.
OPINION.
LEECH, Judge:
In December 1939, the A. Nash Co. had issued and outstanding 23,417 shares of common stock of the par value of $25 per share, which was the only class of stock it was authorized to issue at that time. Of these shares petitioner held 12,121, a majority interest. On December 20, 1939, that company authorized a cash distribution of $9 per share, which was paid on December 29, 1939. Petitioner received a total amount of $109,089. On his 1939 Federal income tax return he reported as income $5,441.12, treating the balance, $103,647.88, as a return of capital. The respondent determined the entire amount was taxable as an ordinary dividend under section 115(a) and (b) of the Internal Revenue Code.
SEC. 115. DISTRIBUTIONS BY CORPORATIONS.(a) DEFINITION OF DIVIDEND.— The term ‘dividend‘ when used in this chapter (except in section 203(a)(3) and section 207(c)(1), relating to insurance companies) means any distribution made by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. * * *(b) SOURCE OF DISTRIBUTIONS.— For the purposes of this chapter every distribution is made out of earnings or profits to the extent thereof, and from the most recently accumulated earnings or profits. Any earnings or profits accumulated, or increase in value of property accrued, before March 1, 1913, may be distributed exempt from tax, after the earnings and profits accumulated after February 28, 1913, have been distributed, but any such tax-free distribution shall be applied against and reduce the adjust basis of the stock provided in section 113. * * *
Petitioner argues that respondent's determination is erroneous on three grounds. The first and principal ground is that petitioner was a purchaser for value and can not be taxed as receiving an ordinary dividend where the distribution consists of earnings which were capitalized by stock dividends prior to his purchase. Petitioner has requested a finding that he had no knowledge prior to his purchase of these shares that part of the capital structure consisted of earnings and profits capitalized through stock dividends. We have not done so, since we are not convinced that the evidence supports such a finding, if material, and we do not so regard it. Petitioner relies upon Commissioner v. Cordingley, 78 Fed.(2d) 118; Parker v. United States, 88 Fed.(2d) 907; and De Nobili Cigar Co., 1 T.C. 673; affd., 143 Fed.(2d) 436, in support of his contention. Assuming, arguendo, that petitioner was an innocent purchaser for value, the authorities he relies upon are not controlling under the facts here disclosed. Each of those cases involves the application of section 115(g)
and the facts disclose that a redemption or cancellation of some part of the capital stock had taken place. The deficiency here was not determined under section 115(g), and the respondent asserts that that section has no application. We agree. The documentary proof clearly shows that there was here no cancellation or redemption, except with respect to the retirement, in 1933, of the 2,298 shares held in the company's treasury, which has no bearing upon the cash distribution in 1939 we have under consideration. During the period January 1, 1921, to June 30, 1924, earnings and profits were capitalized by the issuance of nontaxable stock dividends to the extent of 16,875 shares of a par value of $100 per share, or $1,687,500. By corporate action and charter amendment the par value of the 25,715 then outstanding shares was reduced from $100 to $25 per share, thus reducing the capital by $1,928,625. The 2,298 shares were then retired. Thus the stated capital was reduced from $2,571,500 to $585,425. In a letter dated March 7, 1933, to the stockholders, proposing the reduction of the par value of the shares, it is stated:
SEC. 115. DISTRIBUTIONS BY CORPORATIONS.(g) REDEMPTION OF STOCK.— If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.
The capital surplus thereby created will be used in part to absorb the deficit of operations for the current and past years and to provide such reserves as may be considered necessary to meet such losses as may be sustained in 1933 in the liquidation of non-profitable departments.
By letter dated March 15, 1933, the stockholders were informed that the amendment to the charter reducing the par value of the shares from $100 to $25 had been effected. They were further advised:
As a result of creating this Capital Surplus, the Company will be in a position to declare dividends providing business conditions justify; whereas, if we had not made the change in the par value of the common stock, it would be necessary to defer all dividends until the earnings of your company absorbed the operating deficits of current and past years.
The Management is confident that the Company is on a sound basis, and with all expenses cut drastically, and with the closing of certain non-profitable departments of our business, we are in a position to march on.
It is clear that at the time of the reduction of the par value of the shares there was no thought of redemption or cancellation, or of liquidation of the company. The purpose to be served was obviously, as stated, to enable the company to declare and pay cash dividends. We have held that a mere reduction in the par value of the capital stock is not a cancellation or redemption of the shares. Mabel I. Wilcox, 43 B.T.A. 931; affd., 137 Fed.(2d) 136; John K. Beretta, 1 T.C. 86; affd., 141 Fed.(2d) 452. Petitioner suggests that we have taken a more liberal view in the recent cases of Estate of Henry E. Mills, 4 T.C. 820, and R. D. Merrill Co., 4 T.C. 955. We do not so view these cases. The factual circumstances involved are so dissimilar to those in the instant case that we think they furnish no support for petitioner's position. We conclude there was no cancellation or redemption of the shares of capital stock. Petitioner continued to hold his stock. Thus it is immaterial whether he was an innocent purchaser for value or not.
The next contention of petitioner is that a bona fide capitalization of earnings by the issue of stock dividends renders them ‘capital‘ and a subsequent distribution thereof is not a distribution of ‘earnings‘ taxable as a dividend. Commissioner v. Quackenbos, 78 Fed.(2d) 156; Patty v Helvering, 98 Fed.(2d) 717; Bedford v. Commissioner, 144 Fed.(2d) 272. Since petitioner's brief was filed the Supreme Court of the United States has reversed the Circuit Court of Appeals decision in the Bedford case, 325 U.S. 283. It was there held that a distribution out of accumulated earnings and profits previously capitalized by a nontaxable stock dividend is taxable as an ordinary dividend under section 115(a) of the Internal Revenue Code. That decision finally disposes of the petitioner's contention that earnings and profits capitalized through stock dividends retain their character as capital.
Finally, petitioner argues that the reduction of the par value of the shares, followed by the 1939 distribution of part of the funds thus made available, constitutes a partial liquidation as defined in section 115(i)
and the amounts received should be applied first to the reduction of his cost. The views expressed in answer to petitioner's prior contentions compel the conclusion that this argument is likewise unsound. It is based on the premise that earnings once capitalized through stock dividends retain their character as capital and a subsequent distribution thereof is a ‘liquidation‘ pro tanto. That this is not so appears to have been finally set at rest by the Bedford decision, supra. As heretofore observed, one of the main purposes underlying the reduction in the par value of the shares was to permit the declaration and payment of cash dividends. The other stated reasons, i.e., to absorb the deficit and to provide reserves to meet losses that might be sustained from the liquidation of the nonprofitable departments, having been accomplished, the company was in a position to carry out its main purpose of declaring and paying cash dividends. We perceive no other connection between the reduction of the par value of the shares as of December 30, 1932, and the 1939 resolution providing for the cash distribution of $9 per share. In the 1939 resolution no mention is made of any plan or purpose to liquidate, nor is there any reference to the previous reduction of the par value of the shares. The corporate minutes of December 20, 1939, providing for the cash distribution recite that as of November 30 the current assets were $851,764 and liabilities $181,129, leaving a working capital of $670,635. They state that the inventory is in ‘very excellent condition,‘ that ‘it‘ amounted to $443,000 against $409,000 for the previous year, and that ‘our competitive position next spring will be good and we are anticipating an increase in volume.‘ These optimistic statements indicate quite clearly that a partial liquidation was not considered or contemplated at that time. We conclude there was no partial liquidation as defined in section 115(i). There is no dispute that, except for the capitalization of the stock dividends, the company's accumulated earnings and profits would be in excess of $200,240.78, or $8.5511 on the 23,417 then outstanding shares alleged to have been distributed out of ‘capital surplus.‘ The fact that the company carried the amount resulting from the reduction of the par value of the shares as ‘capital surplus‘ does not alter the fact that a part, at least, was ‘earned income‘ for Federal tax purposes. Foster v. United States, 303 U.S. 118; Bedford v. Commissioner, supra; Commissioner v. Wheeler, 324 U.S. 542. We conclude that the entire amount of $109,089, received by petitioner in 1939 as a cash distribution from the A. Nash Co., was a ‘dividend‘ as defined by section 115(a) and taxable as an ordinary dividend under section 22(a). The respondent is sustained.
SEC. 115. DISTRIBUTIONS BY CORPORATIONS.(j) DEFINITION OF PARTIAL LIQUIDATION.— As used in this section the term ‘amounts distributed in partial liquidation‘ means a distribution by a corporation in complete cancellation or redemption of a part of its stock, or one of a series of distributions in complete cancellation or redemption of all or a portion of its stock.
Decision will be entered for the respondent.