Anderson v. Comm'r of Internal Revenue

• Decision Date: 22 December 1976
• Docket Number: Docket No. 1727-74.
• Citation: 67 T.C. 522
• Parties: RONALD D. ANDERSON AND MARILYN J. ANDERSON, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

67 T.C. 522

RONALD D. ANDERSON AND MARILYN J. ANDERSON, PETITIONERS
v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 1727-74.

United States Tax Court

Filed December 22, 1976.

Petitioners, as stockholders of Associates, the parent corporation of an affiliated group, received distributions from Associates during the year 1971 with respect to their stock. The basic issue is whether the entire amount of the distributions was taxable to petitioners as ordinary dividends or whether a part thereof was nontaxable as a return of capital. Determination of the basic issue requires determination of several subsidiary issues involving the effect on the earnings and profits of Associates and its subsidiaries of various transactions that occurred during the computation years.

1. Held, the formula approved in Helvering v. Jarvis, 123 F.2d 742 (4th Cir. 1974), affg. 43 B.T.A. 439 (1941), rather than the formula prescribed by respondent in Rev. Rul. 70-531, 1970-2 C.B. 76, is the correct formula to apply in determining the proper charge to capital account in a redemption distribution under sec. 312(e), I.R.C. 1954, and the resultant charge to earnings and profits of the redeeming corporation.

2. Corporations which subsequently became subsidiaries of Associates issued qualified stock options for their stock to their employees. Upon the merger and reorganization of those corporations with Associates becoming the parent corporation, Associates assumed the stock options within the meaning of sec. 425(a) of the Code and Associates' stock became subject to the options. Thereafter qualified stock options with respect to Associates' stock were issued to employees of the subsidiaries and dual employees of both Associates and the subsidiaries. The employees exercised some of the options during the computation years. Assuming that the spread between the option price and the fair market value of the option stock on the date of exercise is a proper charge to earnings and profits, see Luckman v. Commissioner, 418 F.2d 381 (7th Cir. 1969), revg. 50 T.C. 619 (1968), it is Held, further, the spread is chargeable against the earnings and profits of the employer corporation rather than the issuing corporation.

3. Held, further: Where a corporation with no accumulated earnings and profits at the beginning of its taxable year makes both ordinary cash distributions and redemption distributions to its stockholders during the taxable year which together exceed its current earnings and profits for the taxable year, computed as of the end of the taxable year without diminution by reason of either the ordinary cash distributions or the redemption distributions, the ordinary cash distributions were dividends as defined in sec. 316(a)(2), I.R.C. 1954, to the extent of the current taxable year's earnings and profits, includable in the gross income of the distributees under sec. 301(c), I.R.C. 1954. Interrelationship of secs. 312(a) and 316(a)(2), I.R.C. 1954, discussed. Sec. 312(a), I.R.C. 1954, does not permit a charge against current earnings and profits as of the date of a redemption distribution under these circumstances, which would reduce the amount of current earnings and profits available for dividends.

[67 T.C. 523]

Robert A. Schnur, for the petitioners.

Joseph R. Peters and John J. Reid, for the respondent.

OPINION DRENNEN, Judge:

Respondent determined a deficiency in petitioners' income tax for the calendar year 1971 in the amount of $539.83. The ultimate issue for our decision is the extent, if any, to which corporate distributions received by petitioners with respect to their stock in the distributing corporation constituted dividends to them taxable in the year of receipt as ordinary income. This ultimate issue depends upon the extent that such distributions were made out of the distributing corporation's earnings and profits and this determination depends principally upon a resolution of the following issues:¹

(1) What is the correct method for determining the proper charge to a corporation's capital account under section 312(e), I.R.C. 1954,² and the resulting charge to its earnings and profits as a result of a section 302(a) redemption distribution;

[67 T.C. 524]

(2) On the assumption that the exercise of a stock option issued pursuant to section 422 generates a reduction in corporate earnings and profits by the difference between the fair market value of the stock at the date of exercise and the option price, which corporation is entitled to this reduction, the issuing corporation or the employer corporation, when a parent issues the stock to employees of its subsidiary; and

(3) When a corporation begins a taxable year with no accumulated earnings and profits but generates earnings and profits during said year and makes two categories of distributions to its shareholders during the year, ordinary cash distributions and a section 302(a) redemption distribution, the sum of which exceeds the amount of the current earnings, which category of distributions, if either, is to be given priority as a charge against said current earnings and profits.

This case was submitted fully stipulated pursuant to Rule 122, Tax Court Rules of Practice and Procedure. The stipulation of facts together with associated exhibits attached thereto are incorporated herein by this reference. The facts are summarized herein, where appropriate.

Petitioners Ronald D. Anderson and Marilyn J. Anderson (hereinafter referred to as petitioners), husband and wife, resided at Wauwatosa, Wis., when they filed their 1971 joint income tax return (Form 1040), as well as when they filed the petition herein.

Petitioners filed their joint Federal income tax return for the year 1971 with the Midwest Service Center of the Internal Revenue Service at Kansas City, Mo.

American Appraisal Associates, Inc. (hereinafter referred to as Associates), is a Delaware corporation with its principal offices at Milwaukee, Wis. Associates files its corporate income tax returns on the basis of a fiscal year ending March 31. Associates had one class of stock, common stock, which is traded over the counter. The number of Associates' shareholders and the approximate number of its outstanding shares of common stock as of March 31, 1970, 1971, and 1972, are as follows:

+---------------------------------------------+
                ¦ ¦ ¦Shares ¦
                +----------------+--------------+-------------¦
                ¦FYE Mar. 31— ¦Shareholders ¦outstanding ¦
                +----------------+--------------+-------------¦
                ¦ ¦ ¦ ¦
                +----------------+--------------+-------------¦
                ¦1970 ¦299 ¦114,160 ¦
                +----------------+--------------+-------------¦
                ¦1971 ¦322 ¦113,240 ¦
                +----------------+--------------+-------------¦
                ¦3 1972 ¦1,052 ¦1,810,000 ¦
                +---------------------------------------------+
                

[67 T.C. 525]

As of January 1, 1971, petitioners owned individually or jointly 250 shares of Associates' common stock, which increased to 3,750 shares after the 15-for-1 split on April 28, 1971. Petitioners acquired no additional shares of Associates during 1971 and, on June 21, 1971, they sold 700 of their shares. During 1971, petitioners received the following cash distributions from Associates with respect to the shares owned by them on the indicated payment dates:

+------------------------+
                ¦Payment date ¦Amount ¦
                +---------------+--------¦
                ¦ ¦ ¦
                +---------------+--------¦
                ¦Feb. 9, 1971 ¦$437.51 ¦
                +---------------+--------¦
                ¦Apr. 13, 1971 ¦499.99 ¦
                +---------------+--------¦
                ¦July 30, 1971 ¦320.25 ¦
                +---------------+--------¦
                ¦Nov. 10, 1971 ¦320.25 ¦
                +---------------+--------¦
                ¦ ¦1,578.00¦
                +------------------------+
                

On each of the above-described payment dates, the adjusted basis of the petitioners in each of their shares of Associates' stock exceeded the amount of the distribution made to them on such date with respect to such share.

On their 1971 income tax return, petitioners reported the above-described distributions as follows:

+------------------------------------------------+
                ¦ ¦Reported as ¦ ¦
                +--------------+------------------+--------------¦
                ¦ ¦taxable dividend ¦Reported as ¦
                +--------------+------------------+--------------¦
                ¦ ¦(before sec. 116 ¦nontaxable ¦
                +--------------+------------------+--------------¦
                ¦Payment date ¦exclusion ¦distribution ¦
                +--------------+------------------+--------------¦
                ¦ ¦ ¦ ¦
                +--------------+------------------+--------------¦
                ¦Feb. 9, 1971 ¦— (0%) ¦$437.51 (100%)¦
                +--------------+------------------+--------------¦
                ¦Apr. 13, 1971 ¦$4.99 (1%) ¦495.00 ( 99%) ¦
                +--------------+------------------+--------------¦
                ¦July 30, 1971 ¦3.20 (1%) ¦317.05 ( 99%) ¦
                +--------------+------------------+--------------¦
                ¦Nov. 10, 1971 ¦3.20 (1%) ¦317.05 ( 99%) ¦
                +--------------+------------------+--------------¦
                ¦ ¦1 11.39 ¦2 1,566.61 ¦
                +--------------+------------------+--------------¦
                ¦ ¦ ¦ ¦
                +------------------------------------------------+
                

This manner of reporting the distributions was based on advice received by petitioners from Associates that (a) no portion of the distribution made by Associates to its shareholders on February 9, 1971, constituted a distribution out of

[67 T.C. 526]

Associates' current or accumulated earnings and profits within the meaning of section 316, and (b) only 1 percent of the distributions made by Associates to its shareholders on April 13, July 30, and November 10, 1971, constituted a distribution out of Associates' current or accumulated earnings and profits within the meaning of section 316.

Respondent, in his notice of deficiency dated February 13, 1974, determined that all of the $1,578 in distributions received by petitioners from Associates in 1971 should have been reported as taxable dividends; accordingly, respondent increased petitioners' taxable income by $1,378 (the amount of the distributions minus the $200 exclusion permitted by section 116), resulting in an income tax deficiency of $539.83. This adjustment was based on respondent's position that the entire amount of the distributions received by...