STOCK DIVIDENDS

Stock dividends were declared non-taxable in Eisner v. Macomber (250 U. S. 189; decided April, 1920), and the general rules governing subsequent sales have already been discussed.1

Following the decision of Eisner v. Macomber the Treasury Department laid down the following rules:

(a) If the state law permits the issuance of stock dividends, stock dividends in themselves are not taxable income. (b) Where a stockholder is given the option to apply a dividend check (that is, not compelled to do so) towards the purchase of new stock, it is a cash dividend and so taxable.

(c) Where state laws do not permit stock dividends and the corporation pays a cash dividend under the agreement it is to be applied towards the payment of a new stock issue, it is nevertheless a cash dividend and so taxable.

(d) Where a corporation declares a dividend payable partly in cash and partly in new stock from earnings accumulated both before and after March 1, 1913, the cash dividend will be considered to be from earnings accumulated after March 1, 1913, as far as possible.

(e) A dividend paid in the stock of another corporation is taxable income to the recipient to the full amount of the market value. The market value (at the date distributed) is also the cost base for purposes of determining gain or loss arising from the sale of such stock at a subsequent date (T. D. 3052).

A stock dividend paid in preferred stock of the corporation is a stock dividend the same as if paid in common stock (O. D. 801), but if paid in debenture bonds is not a stock dividend (T. D. 3170). A company declaring a stock dividend issued scrip for the fractional shares which were sold by the company at the option of the stockholders; the scrip was held to be a stock dividend, also (O. D. 859 and 781). Where employees subscribed for stock which was to be paid for by applying dividends on the stock, the dividends were held not to be stock dividends (O. D. 763) but were taxable income to the employees as additional compensation (O. D. 791). A stock dividend may be issued by a national bank (I. T. 1605).

1 See page 60.

A stock dividend is not taxable if distributed to an income beneficiary in accordance with the law of various jurisdictions, but is regarded as a distribution of corpus; if sold, the cost is the same as though still owned by the trustee (I. T. 1622, overruling I. T. 1507).

PROFIT OF CORPORATIONS TAXABLE TO STOCKHOLDERS

If a corporation is formed or used for the purpose of collecting income and evading the tax by not paying dividends to stockholders, the distributive profits of the corporation may be taxed to the stockholders as in the case of partnerships, or the corporation may be subjected to an additional 25% tax (Sec. 220 and Art. 351-3, Regulations 45 and 62). Although cases have been presented to the Department, none of the penalties has as yet been invoked.

Whether a corporation is retaining profits for the reasonable requirements of the business or accumulating an unreasonable dividend depends upon what the corporation actually does with the profits (T. B. M. 2 and O. D. 106). The section relating to unreasonable profits cannot be used to force the distribution of unnecessary surplus accumulated in years prior to 1918 (0. D. 188), nor under the 1921 act does the provision affect accumulations prior to 1921 (I. T. 1572). Whether a surplus is an unreasonable accumulation of profits depends on facts and conditions such as the volume of business done and the principles of sound business management (S. 1117 overruling S. 153). If the corporation retires part of its common stock and allows the surplus to stand, it would be regarded as having an unreasonable surplus (O. D. 360). A corporation disposing of its property preparatory to winding up its affairs was permitted either to hold the profits from the sale of its assets until the final disposition of all assets or to distribute the profits immediately. If there was an accumulation for the purpose of preventing the imposition of surtaxes upon its stockholders, the profits would be taxed to the stockholders (O. D. 838). A corporation which is accumulating surplus according to the purposes outlined in its charter is not guilty of fraudulent action (A. R. R. 475). Reinvestment of profits is not a violation of the act (I. T. 1289). The provision to be taxed as a partnership is dependent on both the unanimous consent of the stockholders and the approval of the Commissioner (I. T. 1668).

VII

REORGANIZATIONS

Status of reorganizations under the 1921 Revenue Act. Reorganization of single proprietorship. Partnership reorganization. Partnership reorganization. Corporate organizations. Corporate reorganizations. Illustrations of reorganizations.

ON pages 45 to 47, the general rules applying to reorganizations and to the computation of profits derived by stockholders through reorganization proceedings were outlined. A summary of these points seems desirable, now that dividends have been considered. The word reorganization, as used here, refers to the formation of another organization of the same type; for example, a new partnership formed from an old is a reorganization, but a corporation formed from a partnership is merely a corporate organization.

Reorganization of single proprietorship. A taxable profit will arise if A sells his business to B and takes cash or notes or both in exchange, which, combined, are in excess of the cost of the business (or March 1, 1913, value if owned prior to that date) plus the unwithdrawn profits (which have been subject to tax since March 1, 1913) turned over to the new owner. But if the vendor agrees to take any portion of his compensation in the form of a note or open account dependent upon future profits or in the form of a percentage of future profits-unearned and not ascertainable at the time of sale the best procedure probably would be to apply against the cost and invested profits turned over to the purchaser the payments when the amounts thereof are ascertained and made available, until such cost and reinvested profits are absorbed, after which the amounts received by the vendor would be income in their entirety. The Department in its regulations has so far not linked the taxation of capital net gains with the sale of a proprietorship or partnership. It would seem that where such business is sold the profit thereon may properly be prorated as between the cost plus unwithdrawn

profits up to two years prior to the date of the sale and the unwithdrawn profits of the remaining two years. The first portion of the profits thus allocated would be a capital gain; the second, an ordinary gain.

Partnership reorganization. The rules outlined in connection with sales of single proprietorships apply with equal force to partnerships. In addition, the admission of a new partner and the adjustment of capital accounts at the time may offer new difficulties. The capital account of a new partner may be created by transferring portions of the existing capital accounts thereto, or by a cash or property payment directly to the partnership which is credited in toto to the account of the new partner; and where values established by new cash or property received by the partnership upon the admission of a new partner are not added to the capital accounts of the old partners, no taxable profit could possibly result.

Similarly, the creation of good-will or any addition thereto upon an adjustment of partners' interests does not give rise to taxable income merely because the capital accounts of the partners are increased, for the reason that the addition resulted from the creation of an intangible asset and not from a realized gain. But suppose that a newly admitted partner pays cash to the partnership which is credited, in whole or in part, to the capital accounts of the old partners, or pays cash directly to the individuals composing the partnership? In such cases the partners would be selling a portion of their interests for a consideration received by them, directly or indirectly, and a taxable gain or loss would apparently follow.

Corporate organizations. Another type of organization, specifically recognized by the law, is the formation of a corporation from a single proprietorship or partnership or from the merging of interests of any kind. Section 201 (c) (3) provides that if an interest of 80% or more in the corporate organization is retained no taxable profit will be recognized. The 80% interest is defined as 80% of the voting stock and 80% of all other classes of stock; and the interests of the new stockholders must be in "substantially the same proportion" as their interests in the old organization. Even though less than 80% is transferred to the old interest in the same proportion as their original holdings, or more than 80% in substantially different proportions, no taxable profit will arise if the stock received has no readily realizable market value. It is safe to say that in the average situation involving the incorporation of proprietorships or partnerships no

taxable profit need be reported by the stockholders, either because of the fact the corporation is merely a continuing business or because the stock received has no real market value. If any doubt exists in the minds of the incorporators as to the fulfilling of the conditions precedent to giving a non-taxable status to the reorganization, it would be well to form one or more preliminary corporations in which the conditions would be fulfilled and then forming a new corporation from the old corporation or corporations as described on page 85, under "Corporate reorganizations." The cost of the stock in the hands of the new stockholders is the cost or value of the old interest—that is, original cost if the investment was made after March 1, 1913, or March 1, 1913, value of the interest if owned prior to that date, plus, in either case, the undistributed profits subject to tax in past years which have accumulated and which are turned over to the new organization in the form of assets.1

At what value may the corporation put the newly acquired assets on its books? The point is of consequence because it involves not only the future deduction of depreciation, but also the proper values assignable to invested capital. The importance of invested capital did not end with the abolition of the excess profits tax in 1921. If Congress again levies any form of corporate surtax the relationship of invested capital to profits is likely to be a factor in the determination of the tax.

Values of the assets of a continuing business where the ownership remains the same should be limited to their cost to the old business; otherwise the transaction is a completed one and income taxes have been evaded. But the law does not say so. Section 331 of the 1921 law, which provided that no increase in invested capital was permissible if 50% or more of the interest or control of an enterprise was retained by a new organization, ceased to be effective December 31, 1921. This section also was limited to reorganizations after March 3, 1917, the date of the passage of the first excess profits tax act which marked, in the eyes of Congress, the end of the period in which reorganizations not for tax purposes might have taken place. If a provision for the computation of invested capital ever finds its way into a future tax law, the substance of Section 331 including the significant March 3, 1917, date will likely be reenacted. The computation of depreciation, however, remains an open question. None of the tax laws nor the regulations or decisions thereunder requires the continued use of cost to the old organization where a mere change in identity or form of organization has taken place. 1 See comment on page 55.