A new corporation, which we will call the X Company, was then formed, under the laws of another state, which took over all the assets and assumed all the liabilities of the Dupont Powder Company. In payment for this property it issued to the Dupont Powder Company its debenture bonds of a par value of $50,000,000, and shares of its common stock of a par value of $60,000,000. At this state of the transaction the books of the Dupont Powder Company might be said to reflect the financial condition of the old company as follows:

It then declared a dividend to the common stockholders of $60,000,000, which was paid by distributing to them the common stock of the X Company. Afterwards, all of the Dupont Powder Company's own outstanding capital stock and bonds were called in an dthe $50,000,000 worth of debenture bonds was paid out in liquidation thereof. Phellis received a part of this X Company stock and the government contended that this constituted a dividend payment in specie which was taxable as income.

The taxpayer contended, however, that, in the aggregate, there was merely a re-organization which did not change the nature of the business nor the aggregate interest which the stockholders had in the corporate entity. Mr. Justice Pitney, who had delivered the opinion of the Supreme Court in Eisner v. Macomber, holding that a stock dividend was not taxable, also delivered the opinion in this case. He stated that the inquiry was the same as in the former case; that is, whether the receipt of the dividend in question "constituted a gain derived from capital, not a gain accruing to capital, nor a growth or increment of value in the investment, but a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested, and coming in, that is, received or

drawn by the claimant for his separate use, benefit and disposal." Speaking of the position of the individual stockholder prior to the reorganization, Justice Pitney observed that whatever increment of value had accrued to them prior to that time was, by reason of the surplus profits that had been accumulated by the company, "still a part of claimant's capital for which, as yet, he had derived no actual and therefore, no taxable income so far as the surplus remained undistributed. As yet he had no right to withdraw it or any part of it, could not have such right until action by the company or its representatives, and his interest still was but the general property interest of a stockholder in the entire assets, business and affairs of the company-a capital interest.

"The transfer of the old company's assets to the new company in exchange for the securities issued by the latter, and the distribution of these securities by the old company among its stockholders, changed the former situation materially. The common stock of the new company, after its transfer to the old company and prior to its distribution, constituted assets of the old company which it then held to represent its surplus of accumulated profits-still, however, a common fund in which the individual stockholders of the cld company had no separate interest. But, when this common stock was distributed among the common stockholders of the old company as a dividend, then at once,unless the two companies must be regarded as substantially identical-the individual stockholders of the old company, including claimant, received assets of exchangeable and actual value severed from their capital interest in the old company, proceeding from it as the result of a division of former corporate profits, and drawn by them severally for their individual and separate use and benefit, such a gain resulting from their ownership of stock in the old company and proceeding from it constituted income in the proper sense." (Italics ours.)

The court disposed of the contention that the new company, after reorganization, was identical with the old by pointing out that the new corporation was organized under the laws of a different state, that the amount of capital stock outstanding was considerably more, and that the new

securities were to be applied partly to retire the old outstanding stock and partly to pay off the bonds, while the remainder was considered as being distributed as surplus; so that, in fact, as well as in appearance, there was a new corporation formed which was materially different from the old, and not merely a reorganization of it.

Considering alone the one fact which was really in issue— the declaration of a dividend of $60,000,000, payable in the stock of the X company-it is apparent that the surplus of the old company at the time the dividend was declared consisted of the stock of the new company, and this was actually severed from the corporate fund of the old company's assets, and became the property of the individual stockholdObviously this was a distribution of specific assets and constituted income.

ers.

Weiss v. Stearn.-In this case the stockholders of the A ocmpany deposited all their shares of common stock, totalling $2,500,000, with a trust company, which acted as depositor. A new corporation was formed which took over the entire business of the A company and issued common stock of a par value of five times the amount of the old company or $12,500,000 to the depositor in payment therefor. This stock was then turned over to the old stockholders in place of their original holdings. The Supreme Court observed "that for purposes of taxation where a stock dividend is declared, the essential and controlling fact is that the recipient receives nothing out of the company's assets for his separate use and benefit," and, after comparing the substantial effect in this case with the effect of a stock dividend, concluded that no gain resulted from a "mere change for purposes of reorganization in the technical ownership of an enterprise." "Some

thing more is necessary-something which gives the stockholder a thing really different from what he theretofore had."

36

Weiss v. Stearn is identical with the Phellis case, except in two particulars. The corporate assets in both cases re

36 Towne v. Eisner, 45 U. S. 418, 38 Sup. Ct. 158; Southern Pacific Company v. Lowe, 2470 S. 330, 38 Sup. Ct. 540; Gulf Oil Corporation v. Lewellyn, 248 U. S. 71, 39 Sup. Ct. 35.

mained unchanged, the old and new officers were the same and the proportionate share of each individual shareholder remained the same. In the Phellis case, however, the new corporation was organized under the laws of a State different from the old, while in Weiss v. Stearn the new charter vas issued by the same state. This can hardly be considered a controlling factor, however, for in practice it is too immaterial a change to affect the nature of the shares owned by the individual." The only important difference, therefore, lies in the fact that in the Phellis case there was a segregation of surplus from capital by means of the issuance of different kinds of securities. By reference to the schedules included in the consideration of that case it will be seen that before the reorganization, there were three classes of security holders; viz., bondholders, preferred stockholders and common stockholders. The bondholders and preferred stockholders received out of the reorganization the new debenture bonds in dollar for dollar exchange for their holdings so we may disregard them. The holders of the common stock before the reorganization owned common stock of a par value of $30,000,000, and also owned the undivided right to $60,000,000 worth of surplus, if and when distributed. Their entire property was represented by the shares of common stock which had a par value of $30,000,000, but had an apparent book value of $90,000,C00. After the reorganization they owned debenture bonds of a par value of $30,000,000 and common stock with a par value of $60,000,000 still having in the aggregate, however, the same total book value of $90,000,000. The significant

fact is that they had, after the reorganization, something really different from what they owned before, because debenture bonds are different from shares of common stock and common stock subject to the prior lien of debenture bonds is different from common stock, subject to the prior lien of preferred stock and mortgage bonds.

In the Weiss v. Stearn case the taxpayers owned all the common stock in one business, before the change of char

"See, however, Marr v. U. S. U. S. (October, 1924 term, not yet reported) wherein particular stress is laid upon this fact-which point is ignored by four dissenting members of the court.

ters, and also owned all the same kind of stock in the same business afterwards.

The question is not whether the stock increases in value by the exchange, but whether the property is exchanged for something different, and thereby the increase in value, which has taken place over some past period, is realized. The real test, therefore, is whether the stockholder acquires something in the exchange which is really different from what he theretofore had, and this difference may be said to arise in any one of three ways, as follows:

1. The legal nature of his securities may be changed; e. g., he may receive bonds in place of his stock."

2. The proportion of his holdings to the total holdings may be changed; e. g., new stockholders may be admitted who invest additional capital, thereby lessening the proportion of his holdings to the total shares outstanding."

3. The inherent nature of the new corporation may be changed; e. g., the old company may be an operating company, and the new company a holding company, which owns no business assets, but only stock in other corporations."

In each of these classes of cases there is a vital change in the nature of the thing owned. Either the form of the securities is changed or the nature of the business which is owned by the shares is changed. This change is the fact which causes the stockholder to be considered as having disposed of his former property for something else which has a value in excess of the cost of his original property and this excess over original cost, as in the case of an outright sale of property, is income. If, on the other hand, the new thing received is, in fact, the same as the old, there is no disposal, and the increment is still "unrealized."

Many of the questions arising out of such re-organizations have now been disposed of by the express provisions of the Revenue Act of 1926 which provides generally that no income shall be recognized as resulting from the distribution of securities resulting from re-organizations in cases wherein the majority of the voting shares of stock and at

aU. S. v. Phellis, supra.

39 Marr v. U. S., supra.

40 Cullinan v. Walker, 262 U. S. 134.