Luckman v. Commissioner of Internal Revenue

• Decision Date: 13 November 1969
• Docket Number: No. 17424.,17424.
• Citation: 418 F.2d 381
• Parties: Sid LUCKMAN and Estelle Luckman, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

418 F.2d 381 (1969)

Sid LUCKMAN and Estelle Luckman, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 17424.

United States Court of Appeals Seventh Circuit.

November 13, 1969.

Martin A. Coleman, Arnold Broser, New York City, for petitioners-appellants.

Johnnie M. Walters, Asst. Atty. Gen., Tax Division, William L. Goldman, Lee A. Jackson, Lester B. Snyder, Attys., Dept. of Justice, Washington, D. C., for respondent-appellee.

Before SWYGERT and CUMMINGS, Circuit Judges, and CAMPBELL,¹ District Judge.

CUMMINGS, Circuit Judge.

This is an appeal from a decision of the Tax Court upholding income tax deficiencies in the amount of $17,482.38 determined by the Commissioner of Internal Revenue for the calendar year 1961.² The decision below is reported in 50 T.C. 619 (1968).

The facts are undisputed. Taxpayers are husband and wife who file joint tax returns. During the taxable year he owned 100,000 shares of Rapid American Corporation ("Rapid") common stock. In 1961 he received $37,245.75 in corporate cash distributions. In February 1962, Rapid advised its stockholders that such distributions constituted a return of capital and were therefore non-taxable. In reliance on this information, taxpayers failed to include these sums in their income tax return for 1961.

During the period from January 1, 1957, to January 31, 1962, pursuant to restricted stock options,³ Rapid sold its employees 174,395 shares of its authorized but unissued common stock for $1,889,360. The fair market value of the stock at the time of issuance was $5,307,206. Taxpayers contend that the $3,417,846 difference between the fair market value and the price received represented compensation to the employees of Rapid and reduced the corporation's earnings and profits account. Such a reduction would create a deficit in earnings and profits, so that the 1961 distributions from Rapid to taxpayers would be a return of capital and not taxable as dividend income. However, the Tax Court held that

"* * * the statutory language and legislative history of Section 421 of the Internal Revenue Code of 1954 show that Congress did not intend for the exercise of restricted stock options to generate an expense, recognizable or otherwise. Thus, earnings and profits cannot be reduced." 50 T.C. at p. 625.

The full Tax Court denied the taxpayers' motion for review. We reverse and remand.

The Internal Revenue Code nowhere defines "earnings and profits." With few exceptions, the Code contains no guide to the effect of specific transactions upon earnings and profits. A corporation's earnings and profits are neither equivalent to its surplus nor to its total taxable income. R. M. Weyerhaeuser, 33 B.T.A. 594 (1935). As used in federal taxation, this concept represents an attempt to separate those corporate distributions with respect to stock which represent returns of capital contributed by the stockholders from those distributions which represent gain derived from the initial investment by virtue of the conduct of business. The crucial issue is whether a given transaction has a real effect upon the portion of corporate net worth which is not representative of contributed capital and which results from its conduct of business. In order to make this determination it is necessary to scrutinize the economic effects of the particular transaction as well as its character and relation to the corporate business. Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, § 5.03 (2d ed. 1966).

The effect of a transaction upon earnings and profits is not necessarily dependent upon the tax treatment of the transaction in determining net taxable income for a given year. Thus certain items which are excluded from taxable income increase earnings and profits. Treas.Reg. § 1.312-6(b); R. M. Weyerhaeuser, 33 B.T.A. 594 (1935); Golden v. Commissioner of Internal Revenue, 113 F.2d 590 (3d Cir. 1940); United States Trust Co. of New York, 13 B.T.A. 1074 (1928); Liberty Mirror Works, 3 T.C. 1018 (1944); see generally, Bittker and Eustice, supra. Conversely, transactions have no effect upon earnings and profits where they represent "artificially created deductions or credits which are allowed for purposes of computing taxable net income, but which do not represent actual expenses or expenditures, i. e., there is no outlay by the corporation for the deductions or credits represented by such items." Rudick, "Dividends" and "Earnings or Profits" Under the Income Tax Law: Corporate Non-Liquidating Distributions, 89 U.Pa.L.Rev. 865, 885 (1941); R. M. Weyerhaeuser,supra; Treas.Reg. 1.312-6(c); see Bittker and Eustice, supra. However, true expenses incurred by the corporation reduce earnings and profits despite their nondeductibility from current income for tax purposes. I.T. 3253, 1939 C.B. 178. Disallowed losses are generally taken into consideration in determining earnings and profits, as are nondeductible income and excess profits taxes. Jacob M. Kaplan, 43 T.C. 580, 599 (1965); I.T. 3764. This is even true of fraud penalties disallowed as deductions because of public policy. Estate of Esther M. Stein, 25 T.C. 940 (1956). These items reduce earnings and profits because they "clearly deplete the income available for distribution to the stockholders." Rudick, supra, at 887.

In the present case, the first question is whether below market value stock options generally represent economic expense to corporations, thereby reducing earnings and profits. As the Tax Court observed here,

"Stock options granted at less than fair market value to employees are sometimes recognized by both the accounting profession and the Treasury\'s regulations as giving rise to `actual\' business expenses of corporations, as opposed to artificial deductions, created solely for purposes of computing taxable income. Cf. Grady, `Inventory of Generally Accepted Accounting Principles for Business Enterprises,\' 7 Accounting Research Study 215; Finney and Miller, Principles of Accounting — Intermediate (6th ed. 1965); sec. 1.421-6(f), Income Tax Regs. Such actual expenses, when recognized for income tax purposes, are generally considered to reduce corporate earnings and profits available for dividends. Cf. Bittker, Federal Income Taxation of Corporations and Shareholders, sec. 5.04 (1965); sec. 1:312-6(a) and (b), Income Tax Regs." 50 T.C. at p. 624.

Such options represent a clearly discernible and taxable economic gain to the employee to the extent the stock value exceeds the cost to him. Commissioner of Internal Revenue v. Lo Bue, 351 U.S. 243, 76 S.Ct. 800, 100 L.Ed. 1142; Commissioner of Internal Revenue v. Smith, 324 U.S. 177, 65 S.Ct. 591, 89 L.Ed. 830; Rank v. United States, 345 F.2d 337, 343 (5th Cir. 1965). By the same token, that same margin has been held to represent an economic outlay that is deductible for purposes of computing taxable income. Rev.Rul. 62-217, 1962-2 C.B. 59; Rev. Rul. 69-75, I.R.B. No. 1969-8, p. 9, February 24, 1969. In Hudson Motor Car Co. v. United States, 3 F.Supp. 834, 78 Ct.Cl. 117 (1933), the court held stock compensation to be deductible and noted that

"* * * if the additional compensation had been paid in cash and the cash had been used to acquire the stock, no question * * * could have been raised as to its deductibility." 3 F. Supp. at 846.

This point is equally applicable to compensation which is made through the bargain purchase of stock by the employee on the exercise of his option. Had the compensation been paid in cash and then used to purchase stock, there could be no question that the corporation had incurred a true economic expense which reduced earnings and profits. The amount of corporate assets available for distribution to those who owned stock at the time of the transaction is reduced to the same extent in either case. The economic effect of the two transactions is identical.

The Commissioner has also overlooked the business character and purpose of employee stock options. They represent a form of compensation paid to employees in connection with successful present and future business performance. They constitute a particularly rewarding form of bonus. They are not distributions with respect to stock and are not comparable to non-taxable pro rata stock dividends. Cf. United States v. Ogilvie Hardware Co., 330 U.S. 709, 67 S.Ct. 997, 91 L.Ed. 1192; Commissioner of Internal Revenue v. Estate of Bedford, 325 U.S. 283, 65 S.Ct. 1157, 89 L.Ed. 1611. The difference in the nature of the transaction, as well as its economic effect, demonstrates the inapplicability of United National Corporation v. Commissioner of Internal Revenue, 143 F.2d 580 (9th Cir. 1944), and Grace H. Kelham, 13 T.C. 984 (1949), reversed on other grounds, 192 F.2d 785 (9th Cir. 1951), certiorari denied, 343 U.S. 927, 72 S.Ct. 760, 96 L.Ed. 1337. United National involved stock redemption as part of the reorganization of the corporation's capital structure. The transaction was strictly with respect to the company's stock and bore no relation to its business activities. The court properly viewed it as tantamount to a contribution to capital. Such transactions clearly do not affect either income or earnings and profits. Commissioner of Internal Revenue v. Inland Finance Co., 63 F.2d 886 (9th Cir. 1933); Rev. Rul. 66-353, 1966-2 C.B. 111; see also, Bittker and Eustice, supra. In Grace H. Kelham the notes payable represented long-term debt equity "invested" in the corporation. The loan did not affect income or earnings and profits at any time. The exchange of the notes for stock produced no gain to the corporation. Rather the transaction reorganized the company's capital. The result was the same as the satisfaction of the notes by cash followed by the investment of the cash in the corporation for stock.

The question remains whether Congress intended to prohibit expense treatment in the case of restricted stock options. There is no specific...