Taxpayers appeal from U.S. Tax Court decision, 59 T.C. 152, holding them liable for deficiencies in their personal income taxes for the tax years 1961 and 1962. They maintain that certain shareholder distributions they received, held by the Tax Court to have been "dividends," were not dividends but distributions of capital and therefore are not taxable as ordinary income. Decision below reversed and case remanded to U.S. Tax Court with directions to redetermine tax liability.
Waterman, Friendly and Timbers, Circuit Judges.
This appeal is taken from two decisions of the Tax Court, 59 T.C. 152 (1972), which held petitioners (appellants herein) liable for deficiencies in their personal income taxes of $9,416.35 and $20,944.40 for the calendar years 1961 and 1962, respectively. Inasmuch as appellants resided in the State of New York when they filed their petitions with the Tax Court seeking redetermination of tax liability, venue on this appeal is properly laid in this circuit, 26 U.S.C. § 7482(b) (1) (A); and we have jurisdiction under 26 U.S.C. § 7482(a).
The outcome of this case depends on our resolution of two legal issues. First, do the attendant circumstances permit or require application of the doctrine of collateral estoppel against the Commissioner of the Internal Revenue Service ("IRS")? Second, when, pursuant to the terms of statutory restricted stock options*fn1 granted by a corporation to its employees, those employees who, in exercising the options, purchased the stock for less than the stock's fair market value, should the corporation's "earnings and profits" under § 316 of the Internal Revenue Code ("IRC" or "Code") be reduced by the difference between the fair market value of the stock so purchased and the prices paid by the employees? Appellants contend that either of these questions can be answered in the affirmative.
We do not agree that the Commissioner is collaterally estopped from relitigating the substantive tax question at issue here. On the substantive tax issue, an unusually complex issue, we are of the opinion, on balance, that the result for which the appellants contend is the correct one. Accordingly, we reverse the decision of the Tax Court and remand for redeterminations of appellants' tax liabilities for the tax year 1961.*fn2
As Rita K. Divine is a party herein because she signed and filed joint tax returns with her husband, Harold S. Divine, the other appellant here, we shall refer to the taxpayers-petitioners-appellants in the singular. The stipulated facts have been fully and accurately set forth in the opinion of the Tax Court below.*fn3 It is necessary, however, for us to summarize briefly those facts which are helpful to an understanding of the issues which we are required to resolve.
Rapid American Corporation (hereinafter "Rapid" or the "Corporation") is a publicly owned corporation. Its common stock during the years 1961 and 1962 was listed on the American Stock Exchange. As of January 31, 1963, Rapid had over 2,000 shareholders who held in the aggregate more than 2,000,000 shares of Rapid's common stock. Appellant Divine was one of those shareholders; his approximate holdings amounted to 37,000 shares in 1961 and rose to 40,000 in 1962.
During the years 1961 and 1962, Rapid made certain cash distributions, totaling some $840,840.53 in 1961, and $1,024,836.93 in 1962, to its shareholders. Appellant's portions of these disbursements were $18,501.40 in 1961 and $20,572.04 in 1962. Rapid advised the shareholders that the distributions did not have to be included by them in their individual personal income tax returns. This advice was predicated on the belief that Rapid's "earnings and profits" were insufficient to render these distributions dividends taxable as ordinary income to the recipients, but, rather, the recipients should consider the payments to be returns of capital and hence non-taxable.
At issue in this case is the manner in which Rapid's "current earnings and profits" and "accumulated earnings and profits" for its taxable years 1961 and 1962 should be computed. Specifically at issue is the correctness of a reduction of earnings and profits to account for purported "compensation expenses" measured by the "loss" Rapid absorbed in making "bargain" sales of its common stock to certain of its employees who possessed restricted stock options to purchase the stock. Pursuant to the terms of these restricted stock options, during the period from January 1, 1957 to January 31, 1962, Rapid sold 174,395 shares of its common stock to some of its employees. Although these shares had a fair market value of $5,307,206, the corporation received only $1,889,360 from the employees who exercised their options. Rapid thus received $3,417,846 less for its stock than it could have received if the shares had been sold on the open market. In the period from February 1, 1962 to January 31, 1963 corporation employees purchased an additional 12,163 shares pursuant to the terms of options they held. Again, the prices paid by the employees, $155,388 in the aggregate, were substantially below the fair market value of the shares of stock, $363,914. It is argued that these differences of $3,417,846 and $208,526 represent compensation expense which should reduce corporate earnings and profits.
As already indicated, Rapid had advised its shareholders that these distributions for their tax years 1961 and 1962 did not constitute income taxable to the recipients. One of those receiving a portion of the 1961 distributions was a Mr. Sid Luckman. In reliance on the advice from Rapid, neither Divine nor Luckman considered these distributions as ordinary income. Later, the Commissioner mailed notices of deficiency to all Rapid shareholders, including Luckman and appellant Divine. These two shareholders challenged these alleged deficiencies by filing petitions in the Tax Court. In 1968, while Divine's petition for redetermination was still before the Tax Court, that court ruled against Luckman, see Sid Luckman, 50 T.C. 619 (1968), holding that a corporation's earnings and profits cannot be reduced by the spread between the fair market value of its stock and the prices paid for the stock by employees who purchased it by exercising restricted stock options the corporations had granted. Upon appeal the Seventh Circuit, reaching the opposite conclusion on the earnings and profits issue, reversed the decision of the Tax Court. See Luckman v. Commissioner of Internal Revenue, 418 F.2d 381 (7 Cir. 1969).
Undaunted by its defeat in the Seventh Circuit, the Internal Revenue Service adhered to its position on this issue, and in the Tax Court below the Commissioner contested Divine's petition seeking redetermination of his tax liability. Invoking the Seventh Circuit's decision in Luckman v. Commissioner, supra, which had expressly rejected the Commissioner's stance on the earnings and profits issue therein, appellant Divine argued to the Tax Court that the Commissioner was collaterally estopped from relitigating that precise issue against him. The Tax Court not only rejected this procedural argument but also refused in Divine's case to recognize Luckman as binding upon it, and refused to deviate from its own holding on the substantive issue in Luckman which the Seventh Circuit had nullified. The within appeal followed.
As in the Tax Court below, Divine claims that the decision of the Seventh Circuit in Luckman v. Commissioner of Internal Revenue, supra, collaterally estops the Commissioner from litigating against appellant the same issue litigated in the Seventh Circuit; i.e., whether Rapid's earnings and profits should have been reduced to account for the "expense" allegedly incurred by the corporation in connection with its sale of its common stock to certain of its employees pursuant to the terms of restricted stock options held by those employees.
The American Law Institute's Restatement of Judgments provides a concise statement of one aspect of the classical view of "collateral estoppel" or "issue preclusion":
Where a question of law is actually litigated and determined in an action, the determination is ordinarily conclusive between the parties in a subsequent action involving the same subject matter or transaction, although based upon a different cause of action from that upon which the original action was based. Restatement of Judgments § 70, comment (b) (1942).
Refinement of the scope of "issue preclusion" requires reference to two additional sections of that Restatement. Section 83 expanded the category of those who might be precluded from bringing suit by explaining that "[a] person who is not a party but who is in privity with the parties in an action terminating in a valid judgment is . . . bound [under the rule of collateral estoppel]." Section 93, however, is more significant here: "[A] person who is not a party or privy to a party to an action in which a valid judgment . . . is rendered . . . (b) is not bound by . . . an adjudication upon any matter decided in the action." This rule, the "requirement of mutuality," prevented one from applying collateral estoppel against a party unless the one invoking the doctrine was himself bound by the former judgment. In the instant case, were the classical view of "collateral estoppel" still accepted by the courts and the academicians, Divine most certainly could not utilize the Seventh Circuit's holding against the Commissioner since Divine was neither a party to nor in privity to a party to that action.
Nevertheless, the issue is not so easily resolved, for even in the years prior to the Restatement's articulation of the principle of collateral estoppel the requirement of mutuality of estoppel had come increasingly under attack from the courts and the intellectual community, and this assault has continued unabated. See, e.g., Bruszewski v. United States, 181 F.2d 419 (3 Cir.), cert. denied, 340 U.S. 865, 95 L. Ed. 632, 71 S. Ct. 87 (1950); Bernhard v. Bank of America National Trust & Savings Association, 19 Cal. 2d 807, 122 P.2d 892 (1942); Currie, Mutuality of Collateral Estoppel: Limits of the Bernhard Doctrine, 9 Stan. L. Rev. 281 (1957).
That the attack has been successful is evidenced by the number and source of the judicial decisions which have eroded the requirement of mutuality to the point where it might be supposed that it has been or should be finally interred. See, e.g., Blonder-Tongue Laboratories, Inc. v. University of Illinois Foundation, 402 U.S. 313, 28 L. Ed. 2d 788, 91 S. Ct. 1434, 169 U.S.P.Q. (BNA) 513 (1971); Zdanok v. Glidden Co., Durkee Famous Foods Division, 327 F.2d 944 (2 Cir. 1964); Bruszewski v. United States, supra.
It would be incorrect, however, to assume that the requirement has met its demise. For example, Zdanok, generally regarded as being one of the most important blows struck against the mutuality requirement, has been read restrictively in a number of subsequent cases. See Berner v. British Commonwealth Pacific Airlines, Ltd., 346 F.2d 532 (2 Cir. 1965), cert. denied, 382 U.S. 982, 86 S. Ct. 559, 15 L. Ed. 2d 472 (1966); Fink v. Coates, 323 F. Supp. 988 (SDNY 1971); Agrashell, Inc. v. Bernard Sirotta Co., 281 F. Supp. 704, 708, 157 U.S.P.Q. (BNA) 260 (SDNY 1968) ("The rule of Zdanok is one of economy of administration and not one of abstractly perfect justice; indeed, even res judicata in its strictest aspect yields where an issue deeply invested with public concerns is involved.") In fact, the continuing life of the mutuality requirement in certain circumstances is suggested by the Supreme Court's careful and precise phrasing of the issue before it in Blonder-Tongue Laboratories, Inc.v. University of Illinois Foundation, supra:
"Obviously, these mutations in estoppel doctrine are not before us for wholesale approval or rejection. But at the very least they counsel us to re-examine whether mutuality of estoppel is a viable rule where a patentee seeks to relitigate the validity of a patent ...