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Choate v. Commissioner of Internal Revenue.

June 24, 1942


Petition to Review a Decision of the Board of Tax Appeals.

Author: Frank

Before SWAN, CHASE, and FRANK, Circuit Judges.

FRANK, Circuit Judge.

This petition involves the petitioner's liability for an asserted income tax deficiency of $2,789.45, imposed by reason of his receipt of stock purchase rights. The facts were stipulated before the Board, and were found by it as stipulated. The taxpayer owned 10,000 shares of the common stock of the Crane Company, an Illinois corporation, which had outstanding on May 1, 1937, 2,348,628 shares of common and 145,889 shares of seven percent cumulative preferred. In May, 1937, Crane's articles of incorporation were amended to authorize the issuance of 200,000 shares of five percent cumulative preferred, to be subject to the outstanding seven percent preferred. The new preferred was convertible into common stock at specified ratios varying from time to time. On May 28, 1937, the common stockholders, pro rata, were given the right to subscribe to the new preferred on or before June 17, 1937, at $100 a share (the par value) at the rate of one share of preferred to each twelve shares of common. Underwriters agreed with Crane to take, at par, any unsubscribed preferred.

Taxpayer received 10,000 rights, of a fair market value, at the time of receipt, of $4,375.00.On June 1, such rights were sold on the New York Stock Exchange at prices ranging between $.25 and $.34375. By June 15 and 16, the rights were quoted at an average of $.02033. The stock sold (on a when-issued basis) at about $104 on June 1, $101-1/2 on June 15, and $100-3/16 on June 17. On June 15, taxpayer gave his rights to various members of his family, and on June 17, the donees exercised all but four of the rights. The Board of Tax Appeals, with an opinion reported at 45 B.T.A. 574 held that $4,375, the value of the rights at the time of receipt, constituted income taxable to the taxpayer.

1. Petitioner argues that the transaction is subject to no tax, while the Commissioner asserts that the Board correctly held that there is a valid tax on the value of the rights when received by petitioner. We cannot agree with either contention.

2. Income tax "law" is not a matter of pure reason. It is a composite of constitutional doctrine and interpretations of changing statutory provisions each having its history. In ascertaining the meaning of those provisions, we must be guided by the light of Supreme Court decisions. We are merely a reflector, serving as a judicial moon.*fn1

Our light in this case comes chiefly from Palmer v. Commissioner, 302 U.S. 63, 58 S. Ct. 67, 82 L. Ed. 50. That case involved the question of the taxability of rights (options) issued by a company to its common stockholders to buy the stocks, owned by it, of other corporations. The basic factual premise of the decision was that, although the option price when the rights were exercised was substantially below the fair market value of the optioned stock, the Board found that when the rights were issued there was no such "spread." Beginning with a statement that the court accepted those findings of fact, the court's discussion, as we interpret it, was in outline as follows:

The tax statute there applicable (the Revenue Act of 1928) made no express mention of rights. The court looked to § 115(a), which then, as now, was restricted to corporate distributions out of post-1913 corporate profits or earnings.*fn2 The corporation there involved had such earnings. The basic question, then, said the court, was whether the corporate action in issuing the rights could be regarded as showing an intention to distribute corporate earnings. The court discussed divers situations:

(a) If such a corporation distributes to its stockholders property rather than cash, there is, nevertheless, of course, a taxable dividend.*fn3

(b) If it sells or contracts to sell property to its stockholders at its fair market value, so that no "spread" then exists, there is no corporate intention to distribute profits, and, therefore, no dividend.*fn4 If, after such a sale, or after such a contract to sell, the market value of the property increases, so that a "spread," beneficial to the stockholders then occurs, that "spread" is no more taxable than if the purchasers had not been stockholders, for an intention to distribute that "spread" cannot be imputed to the company.

(c) But if, at the very time of the sale to or the contract with the stockholders, there was a substantial "spread" favororable to the stockholders, it will be considered that there was a corporate intention to distribute that spread, i.e., that a corporate distribution of earnings, and, therefore, a dividend, was intended.*fn5 The situation is the same as if the company had sold the property to strangers and then distributed to its stockholders an amount of cash equal to that "spread." See Eastern Carbon Black Co. v. Brast, 4 Cir., 104 F.2d 460.

(d) We come, then, to a case where a company issues options to its stockholders to buy some of its property. If when the options are issued, there is no "spread," favorable to the stockholders, between the fair market value of the property and the option price, there cannot be said to be a corporate intention to distribute corporate earnings, and therefore there can be no taxable dividend resulting from the exercise of the options. And this is true even if such a "spread" occurs after the issuance, and even if one exists when the options are exercised. Having in mind the corporate intention as basic, the situation is the same as where a favorable spread first occurs after a company makes a sale to or contract to sell with its stockholders.Accordingly, in the Palmer case, as there was no spread when the options (rights) were issued, there was no taxable dividend merely because a spread occurred after the issuance or because there was a spread at the time of their exercise.

(e) If, however, when the options are issued, there is a substantial "spread" favoring the stockholders, then a corporate intention to distribute corporate earnings must ordinarily be regarded as existing.But the options are merely offers to distribute such earnings.Unless and until such an option is exercised, no distribution of corporate earnings occurs. Notwithstanding the option, the company's property and surplus are no less than they were before the options were issued.*fn6 The options are potential dividends but, in and of themselves, are not dividends taxable under § 115.*fn7 (It is significant that the court at this point cites Helvering v. San Joaquin Fruit & Investment Co., 297 U.S. 496, 56 S. Ct. 569, 80 L. Ed. 824; there it was held that, for purposes ...

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