*217 Decision will be entered under Rule 50.
A corporation having total earnings or profits available for dividends of $ 5,674,586.32 distributed to its shareholders cash in the amount of $ 2,113,722.03 with stock having a cost basis of $ 3,199,950 and a fair market value on the date of the distribution of $ 8,983,407.75. Held, the distributions were taxable as dividends only to the extent of earnings and profits available for dividends, section 115 (a) of the Code, and the appreciation in value of the property distributed does not serve to increase the corporation's "earnings or profits." Held, further, to the extent that the fair market value of the property distributed is not covered by the earnings or profits the excess is used to reduce the basis of the stock of the shareholder-distributees under section 115 (d), and such excess is not taxable to the shareholders as "other income" under section 22 (a) of the Internal Revenue Code.
*1083 The respondent determined a deficiency in the income tax of the petitioners' decedent for the taxable year 1947 in the amount of $ 550.47. The question presented for our decision is whether certain corporate distributions in cash and property made by Southern Natural Gas Company were taxable to the decedent, a stockholder, in full or only to the extent that the fair market value of the distributions was covered by earnings and profits, the balance being applied to reduce the basis at which the decedent held her stock.
FINDINGS OF FACT.
All of the facts are stipulated and are found accordingly.
The petitioners' decedent, Ida S. Godley, was an individual residing in Madison, New Jersey, during the taxable year 1947. The decedent filed her Federal income tax return for the calendar year 1947 with the collector of internal revenue for the fifth district of New Jersey.
Decedent died on February 9, 1952, leaving a last will and testament appointing petitioners Paul F. Godley and John W. Young, Jr., executors. The petitioners duly qualified as executors and have been and are now acting as executors of her estate.
The petitioners' decedent*220 was the owner of 200 shares of the outstanding common stock of Southern Natural Gas Company (hereinafter referred to as Southern), a Delaware corporation, with principal offices at Birmingham, Alabama. During the year 1947 she received cash distributions on March 12, June 12, September 12, and December 12 of $ 75 each, or $ 300 in the aggregate. On July 28, 1947, she received 200 shares of common stock of Southern Production Company, Inc. (a corporation organized by Southern in 1942), having a fair market value on this date of $ 6.375 per share. The total fair market value of the distributions received by decedent from Southern was $ 1,575.
By letter dated February 20, 1948, the decedent was advised by Southern that Southern's tax consultant had recommended two alternative methods of reporting the distributions received by stockholders from Southern during the year 1947. The decedent included in her income tax return for the year 1947 the distributions received by her from Southern as taxable to the extent of $ 740.25, having elected to follow one of the alternatives suggested in the letter from Southern dated February 20, 1948.
In the notice of deficiency the respondent determined*221 that the decedent understated her dividends in the amount of $ 2,074 and that the total distributions received by her from Southern were 100 per cent taxable.
The total distributions made by Southern to its stockholders in 1947 amounted to $ 2,113,722.03 in cash and 1,409,162 shares of common *1084 stock of Southern Production Company, Inc. The adjusted basis to Southern of the stock of Southern Production Company, Inc., was $ 3,199,950. The fair market value of the Southern Production Company, Inc., shares distributed by Southern in 1947 was $ 8,983,407.75. The earnings and profits of Southern for the year 1947 were $ 2,936,819.51. The accumulated earnings and profits as of January 1, 1947, were $ 2,737,766.81, or a total of earnings and profits available in 1947 for dividends of $ 5,674,586.32.
The respondent informed Southern by letter dated March 25, 1952, that it had been determined that the distributions made by Southern to its stockholders were 100 per cent taxable as follows: 51.13562% or $ 4.027 as ordinary dividends, and 48.86438% or $ 3.848 as other income.
A statement attached to the letter contained the following:
Since the available earnings exceed the cash *222 and cost of property distributed, the entire distribution to the extent of the available earnings is held 51.13562% taxable as an ordinary dividend and the balance is held taxable to the shareholders as other income.
The cost to the decedent of her 200 shares of stock of Southern was in excess of $ 769.60.
Southern was organized under the laws of Delaware on October 30, 1935, and acquired as of January 1, 1936, the business and properties of a predecessor company named Southern Natural Gas Corporation, pursuant to section 77B of the Bankruptcy Act. Southern operates an interstate natural gas pipeline system, extending from gas fields in Texas, Louisiana, and Mississippi to its principal markets in Mississippi, Alabama, and Georgia.
As of December 31, 1946, Southern's capitalization consisted of long-term debt in the amount of $ 22,500,000 and 1,409,212 shares of common stock of the par value of $ 7.50 each. Its earned surplus, according to the books, as of December 31, 1946, was $ 14,106,850.03. The net income for the year 1947, according to the books, was $ 3,226,156.79, and the book earned surplus at the end of the year 1947, including net adjustments to earned surplus and before*223 deducting dividends on the common stock, was $ 17,669,983.23.
Southern Production Company, Inc., was organized under the laws of Delaware on August 8, 1942. It acquired from Southern as a contribution to capital, all of the capital stock of Southern Production Company, Inc., an Alabama corporation, and all of the assets of the Alabama corporation by merger effective February 12, 1946. The Alabama corporation, Southern Production Company, Inc., was organized by Southern in 1940 for the purpose of acquiring oil and gas leases and engaging in the business of producing oil and gas. The cost to Southern of its stock interest in the Delaware corporation was as follows: *1085
| Paid to the Alabama corporation: | |
| May 31, 1940 | $ 1,000 |
| May 31, 1941 | 999,000 |
| August 21, 1941 | 75,000 |
| September 17, 1941 | 25,000 |
| $ 1,100,000 | |
| Paid to the Delaware corporation: | |
| December 1945 | $ 1,000 |
| February 12, 1946 | 800,000 |
| June 6, 1946 | 200,000 |
| July 29, 1946 | 200,000 |
| March 25, 1947 | 899,000 |
| $ 2,100,000 | |
| Total | $ 3,200,000 |
On July 28, 1947, Southern Production Company, Inc., had outstanding 1,409,212 shares of stock of the par value of $ 1 each, all of which were owned by Southern. Southern*224 distributed to its stockholders on July 28, 1947, 1,409,162 shares of the common stock of Southern Production Company, Inc., leaving 50 shares of such stock in the treasury of Southern. Such 50 shares were sold in the open market for $ 336.45. After this sale, the adjusted basis of the stock distributed was deemed to be $ 3,199,950 as a price of $ 1 a share was allocated to the stock sold in the open market.
The dividend of shares of stock of Southern Production Company, Inc., was declared by the board of directors of Southern at a meeting of the board duly called and held on June 15, 1947, by resolutions reading as follows:
RESOLVED, that a dividend be and the same hereby is declared in kind of one share of stock of Southern Production Company, Inc., a corporation of the State of Delaware, for each share of stock of Southern Natural Gas Company issued and outstanding, such dividend to be deliverable on July 28, 1947, to stockholders of record of Southern Natural Gas Company at the close of business on July 3, 1947; and further
RESOLVED, that the proper officers of the Company be and they hereby are authorized to charge the cost to the Company of the stock of Southern Production*225 Company, Inc. (i. e., the sum of $ 3,200,000.) to earned surplus on the books of account of the Company.
For the year 1947, on the books, Southern charged earned surplus with $ 2,113,722.03, representing the cash distributed as dividends during this year and $ 3,199,663.55, representing cost to Southern of the shares of the stock distributed to stockholders as a dividend. The book earned surplus of Southern on December 31, 1947, after making such deductions, was $ 12,356,597.65.
The parties agree that the correct amount of the total cash distributions made by Southern in 1947 is $ 2,113,722.03; that the total fair market value of the stock of Southern Production Company, Inc., on *1086 July 28, 1947, distributed to stockholders was $ 8,983,407.75; and that the adjusted basis to Southern of the stock of Southern Production Company, Inc., was $ 3,199,950.
In computing Southern's earnings and profits for tax purposes, as shown in letter of March 25, 1952, the amount of depreciation allowed or allowable during the period 1936 to 1947, inclusive, including accelerated amortization pursuant to section 124 of the Internal Revenue Code, exceeds the amount of depreciation taken on the*226 books of Southern during the period 1936-1947, inclusive, by over $ 10,500,000.
The salient facts concerning Southern's dividend distributions during 1947 are:
| Total earnings and profits available for 1947 dividends | $ 5,674,586.32 | |
| Distributions charged out by Southern | ||
| Cash $ 1.50 per share | $ 2,113,722.03 | |
| Property $ 6.375 per share cost | 3,199,950.00 | |
| Total charged out by corporation per books | $ 5,313,672.03 | |
| Distributions received by stockholders | ||
| Cash | $ 2,113,722.03 | |
| Property, at fair market value | 8,983,407.75 | |
| Total received by stockholders | $ 11,097,129.78 |
OPINION.
Although the first issue here presented by the parties had its birth in questions presented in previous litigation before this Court, it comes before us here in a new and unique form. The problem is this. Should the distributing corporation's statutory earnings or profits be reduced, because of a dividend in kind of property which has appreciated in value over cost or adjusted basis, by the fair market value of the property at the time of distribution or by the cost or adjusted basis of the property distributed?
The genesis of the problem before us was the holding in General Utilities & Operating Co. v. Helvering, 296 U.S. 200">296 U.S. 200.*227 In 1927 General Utilities acquired 20,000 shares of Islands Edison stock for a consideration of $ 2,000. The stock appreciated in value by over $ 1,000,000. The corporation wrote up this appreciated value on its books and the following year distributed the appreciated stock as a dividend in kind. Soon after receipt of the dividend all of the shareholders of General Utilities sold their Islands Edison stock at $ 56.12 1/2 per share and General Utilities reported a gain on 910 shares, which it had retained from the block of shares and sold directly, but not on the 19,090 shares distributed to the stockholders. The Commissioner sought to tax the difference between the cost of $ 2,000 and the selling *1087 price of all 20,000 shares as income to the corporation. Before the Board of Tax Appeals, the Commissioner, relying upon the Kirby Lumber Co. case, 1 argued that the form of the dividend declaration indebted the corporation to its shareholders in the amount of $ 1,071,426.25. The Board held that the dividend was intended as a dividend in kind and resulted in no taxable income to General Utilities. The case was appealed, 74 F. 2d 972, with *228 the Commissioner adding a new argument to the effect that the sale of the securities by the stockholders was in actuality a sale by the corporation through its shareholders with all terms agreed before the declaration of the dividend. The Board of Tax Appeals was affirmed upon the basis of its decision but on the matter newly raised the Commissioner was upheld. On certiorari to the Supreme Court, the Commissioner retained his two former arguments before the courts below and added yet a third: that where a corporation pays a dividend in property which has increased in value it thereby realizes the gain on its investment, a point conceded by the Commissioner to a contrary effect before the Board of Tax Appeals. No direct reference was made in the opinion by Justice McReynolds to the third argument made by the Commissioner but there are substantial reasons to believe that the Supreme Court rejected it for the Court refused to remand the cause for further findings of fact and held that both tribunals below had already decided that the taxpayer derived no taxable gain from the distribution among its stockholders of the dividend in kind. The Supreme Court's decision that the dividend*229 was in terms of property rather than dollars was significant only because a dividend of property was there regarded as incapable of constituting realization of income to the distributing corporation. There has been some qualification to the general rule laid down in General Utilities, supra.See Commissioner v. First State Bank of Stratford, 168 F. 2d 1004; Guinness v. United States, 73 F. Supp. 119">73 F. Supp. 119, certiorari denied 334 U.S. 819">334 U.S. 819; Commissioner v. Transport Trading & Terminal Corporation, 176 F. 2d 570, certiorari denied 338 U.S. 955">338 U.S. 955, rehearing denied 339 U.S. 916">339 U.S. 916. However, the exceptions to the rule have no applicability to our present problem. It is safe to say then that the General Utilities case holding still stands for the proposition that appreciation in value over cost or adjusted basis of property distributed as a dividend in kind does not constitute a realization of income to the distributing corporation.
*230 The theory of the General Utilities case has been generally applied to computation of a corporation's statutory earnings or profits even where no question of the effect on its taxable net income is involved, e. g., National Carbon Co., 2 T. C. 57, and Estate of H. H. Timken, 47 B. T. A. 494, affd. 141 F. 2d 625, where a dividend in kind was not *1088 regarded as a taxable dividend to the shareholders except in so far as there were sufficient statutory earnings or profits (computed without regard to increase in value of the res distributed in kind over cost) from other sources at the time of the distribution in kind to cover its fair market value. Thus it is seen that the treatment of distributions in kind of appreciated property for the purpose of determining statutory earnings or profits and realization of taxable net income have been parallel and consistent. 2
*231 However, some confusion has been caused in this field by a divergent theory which may be stated thusly, if the property distributed in kind was originally purchased out of post-1913 earnings then, without regard to the amount of statutory earnings or profits at the time of the distribution, the full market value of the distribution is taxable as a "dividend." Commissioner v. Wakefield, 139 F. 2d 280. See also in this connection Binzel v. Commissioner, 75 F.2d 989">75 F. 2d 989, and Timberlake v. Commissioner, 132 F. 2d 259. In these last two cited cases it did not appear that the distributor did not have sufficient earnings or profits to support a dividend to the extent of the fair market value of the property distributed, and hence they give no support to the rationale of the Wakefield decision.
The rationale of the court in the Wakefield case is apparently based upon the notion that once property is purchased out of earnings it continues to represent statutory earnings or profits even though the actual statutory earnings or profits of the corporation are far below its value at the*232 time of its distribution in kind. This is borne out by the following language in the opinion:
What the partnership received was not the cash paid for the stock, but the stock itself. The securities clearly did not represent capital, nor did their distribution deplete capital. The distribution was made possible only by the expenditure of earnings and profits, and it depleted only earnings and profits. Hence the transaction fell within the definition of § 115 (a) of the Revenue Act of 1936, and constituted a dividend * * *.
The opinion is then premised on the existence of a separate fund of earnings or profits regarded as an entity out of which property could be bought and assumes always that the fund was used to purchase the property distributed in kind rather than expended for other business purposes.
Having decided that the distribution was a "dividend" because the property was purchased from earnings or profits and hence qualified under section 115 (a), the court then relied upon section 115 (j) as an independent measure of taxability to the shareholder-distributees.
*1089 By elimination of the first premise, that is, that the purchase price of the asset distributed in*233 kind came out of earnings or profits, the argument is somewhat improved and identical with that adopted here by the respondent. Thus it is argued that where statutory earnings or profits cover the cost or adjusted basis of a distribution in kind the distribution in kind is "out of earnings or profits" under section 115 (a) 3*234 and backed by earnings or profits "to the extent" of cost or adjusted basis under section 115 (b) 4 and hence established as a dividend. Once section 115 (a) and (b) are used to characterize the distribution as a "dividend," then section 115 (j) 5 is relied upon to tax the distribution in kind to the distributees at its fair market value. See Dividends in Kind: Their Tax Aspects, New York University Ninth Annual Institute on Federal Taxation, 1029, 1045, et seq., on which the respondent here relies. A theory somewhat similar is found in a concurring opinion in Guinness v. United States, supra, at page 219.
If we follow the respondent's argument we must hold that what are not realized and recognized earnings and profits to the*235 distributor are a distribution of realized and recognized earnings or profits for the purpose of imposing a "dividend" tax on the distributees.
Examination of the respondent's argument indicates that he believes the purpose of section 115 (a) and (b) is to merely characterize a distribution as a "dividend." Under his theory section 115 (j) becomes all important and assumes to establish an independent standard of taxability in so far as the stockholder-distributee is concerned. In other words, all correlation between taxability to the shareholder-distributees and effect upon statutory earnings or profits of the corporation disappears. But if he is correct, why should the theory be limited to situations where earnings cover the cost or adjusted basis of the distributed property? Should not $ 1 of statutory earnings *1090 or profits bring into operation the independent measure of taxability to the distributees for which the respondent argues? And what happens when the statutory earnings or profits of the distributor are less than the cost or adjusted basis of the property distributed? Analysis indicates 2 portions of the fair market value to be taken into consideration, the*236 difference between $ 1 and the cost or adjusted basis of the property and the excess of fair market value over cost or adjusted basis. If cost or adjusted basis and fair market value were equal, is it not doubtful whether an approach such as that here adopted by the respondent would support the excess of cost over $ 1 statutory earnings or profits as a taxable dividend? Then why should the fact that there is also unrealized appreciation change the rule? If we follow respondent's argument apparently the difference between $ 1 and cost or adjusted basis should be regarded as a return of capital and the excess of fair market value over cost or adjusted basis as a taxable dividend. The ultimate logic of the respondent carries him to the position where all excess of fair market value over cost or adjusted basis must be regarded as a taxable dividend to the distributees upon a distribution in kind regardless of the amount of earnings or profits at the time. Thus if statutory earnings or profits are zero or a deficit, the invalidity of the argument is clear. So also its invalidity is clear though the distributor may have but $ 1 of earnings or profits or earnings or profits equal to*237 the cost or adjusted basis of the asset distributed.
Far from establishing the independent measure of taxability for which the respondent argues, we believe section 115 (j) was intended as a mere valuation provision. Its legislative history is scant, if not nonexistent. See Paul, Selected Studies in Federal Taxation, p. 152, et seq. Section 115 (j) is meaningless considered independently. Sections 115 (a) and (b) alone define "dividend." A dividend is a distribution "out" of earnings or profits "to the extent thereof."
Unless the taxation of corporate distributions in kind is to be a wilderness some correlation between taxability to the shareholders and effect on corporate earnings or profits is essential. See Paul, Selected Studies in Federal Taxation, p. 183. In August Horrmann, 34 B. T. A. 1178, the Board of Tax Appeals pointed this out in dealing with a slightly different issue in the following language:
The provisions of the statute relating to distribution are concerned with the effect on the stockholder of the distribution and not with its effect on the corporation. The aim is to tax to the stockholder the income realized by him through*238 the distribution of earnings or profits accumulated after March 1, 1913. This aim would be defeated if a nontaxable stock dividend were treated as diminishing the amount of earnings and profits available for subsequent distribution. Conversely, if a stock dividend were taxable and corporate earnings were not thereby diminished, the imposition of the tax on a subsequent distribution in cash or property would result in a double tax. A correlation between *1091 taxability to the stockholder and the effect on corporate earnings or profits avoids these situations. It does no violence to the statute, but rather harmonizes its provisions; in fact, it accords with what we believe was the intent of the statute as clarified by subsequent enactments hereinafter discussed. It also accords with the construction that has been given to the somewhat analogous question of the effect of stock issued in connection with a reorganization. * * * [Emphasis supplied.]
Nothing in the respondent's present argument is so persuasive as to attack the validity of the reasoning in the Horrmann opinion.
To support his position under this issue the respondent places his chief reliance upon the *239 case of R. D. Merrill Co., 4 T.C. 955">4 T. C. 955. There the shareholder-distributee, R. D. Merrill Company, a personal holding company which owned 50 per cent of the stock in T. D. & R. D. Merrill, Inc., received a dividend in kind which had a fair market value on the date of its distribution of $ 202 and an adjusted cost basis to T. D. & R. D. Merrill, Inc., of $ 57,316.67. There we held earnings or profits of the distributor to be reduced by the adjusted cost basis of the asset and the dividend taxable to the distributee to the extent of only $ 202 under section 115 (j).
Whether or not the logical application of the rule enunciated above would mean that only cost or adjusted basis should be deducted from earnings or profits in the case of appreciated as well as depreciated property, as contended by respondent, we are impelled by a long and consistent line of cases by this Court with affirmances thereof by the Courts of Appeal and the Supreme Court to hold on the facts in the instant proceeding that the fair market value of the distributed property is taxable as a dividend to the extent of the earnings or profits (without increase as a result of appreciation *240 in value over cost of the property distributed) of the distributing corporation.
To permit the respondent's argument to prevail here would permit him to accomplish indirectly what the court in General Utilities prevented him from doing directly, for the effect of respondent's argument is to write up the earnings or profits of the distributing corporation by the amount of the unrealized appreciation in the property distributed as a dividend in kind. For these reasons we must reject the respondent's argument and on this issue we hold for the petitioners.
The cases cited above point out the rule -- a distribution in kind by a corporation is out of its earnings or profits and therefore a dividend when the earnings or profits (without increase as a result of appreciation in value over cost of the property distributed) are sufficient in amount to cover a charge equal to the fair market value of the distribution. To the extent that the earnings or profits are insufficient for this purpose the stockholders have received a distribution in excess of earnings or profits and the amount of this excess is applied *1092 to reduce the basis at which the shareholder-distributees hold*241 their stock and any excess over basis is taxable to them as a capital gain under the provisions of section 115 (d). 6
If we understand the alternative argument of the respondent it means this -- a property distribution to the extent that the fair market value is not covered by earnings or profits must be taxed to the*242 shareholders as "other income" under the provisions of section 22 (a). This follows from the respondent's contention that a corporation has only 2 sources out of which it can make a distribution, that is, its paid-in capital and its earned surplus. Because the respondent, who still confuses accounting per books with tax accounting, follows his major premise with the minor premise that since the distribution here involved was not out of book capital the portion of the distribution in excess of Southern's earnings and profits must be "other income" taxable under section 22 (a).
The petitioners base their argument in opposition to the respondent upon the language of section 22 (e) of the Internal Revenue Code, which provides:
(e) Distributions by Corporations. -- Distributions by corporations shall be taxable to the shareholders as provided in section 115.
The term "distributions" is all inclusive and both denotes and connotes all that a corporation can pay out to its shareholders in their capacity as distributees. Thus the term is broad enough to include distributions qualifying as a dividend within the meaning of the Internal Revenue Code and capital, both in the usual accounting*243 sense of that term and in the sense in which it is used in section 115 (d) of the Code. Thus it is seen that distributions by corporations have been taken by Congressional action out of the operation of section 22 (a) and placed for tax treatment under the provisions of section 115. The regulations bear this out. Section 29.115-4 of Regulations 111, under the caption "Distributions Other than a Dividend," provides "Under section 115 (d), any distribution (including a distribution out of earnings or profits accumulated before March 1, 1913) other than * * * shall be applied against and reduce the adjusted basis of the stock * * *," and there is no suggestion in the regulations that section 115 (d) is inapplicable unless the distribution impairs the capital of the corporation shown per books.
*1093 From the above it is seen that appreciation in value of the stock here involved in so far as fair market value exceeds the earnings or profits of Southern must be used under section 115 (d) to reduce the basis at which the petitioners' decedent herein held her stock and in so far as the basis of her shares is exceeded, her estate will be taxed at capital gains rates on any excess *244 over basis received.
Decision will be entered under Rule 50.
Footnotes
1. United States v. Kirby Lumber Co., 284 U.S. 1↩.
2. For an elaborate listing of cases which have followed the General Utilities rule in computing taxable net income and ascertaining the effect on earnings or profits of both liquidating and nonliquidating distributions, see Molloy, Some Tax Aspects of Corporate Distributions in Kind, 6 Tax L. Rev., 57, 60↩, Note 20.
3. SEC. 115. DISTRIBUTIONS BY CORPORATIONS.
(a) Definition of Dividend. -- The term "dividend" when used in this chapter * * * means any distribution made by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. * * *↩
4. (b) Source of Distributions. -- For the purposes of this chapter every distribution is made out of earnings or profits to the extent thereof, and from the most recently accumulated earnings or profits. Any earnings or profits accumulated, or increase in value of property accrued, before March 1, 1913, may be distributed exempt from tax, after the earnings and profits accumulated after February 28, 1913, have been distributed, but any such tax-free distribution shall be applied against and reduce the adjusted basis of the stock provided in section 113. The preceding sentence shall not apply to a distribution which is a dividend within the meaning of the last sentence of subsection (a).↩
5. (j) Valuation of Dividend. -- If the whole or any part of a dividend is paid to a shareholder in any medium other than money the property received other than money shall be included in gross income at its fair market value at the time as of which it becomes income to the shareholder.↩
6. SEC. 115. DISTRIBUTIONS BY CORPORATIONS.
(d) Other Distributions from Capital. -- If any distribution made by a corporation to its shareholders is not out of increase in value of property accrued before March 1, 1913, and is not a dividend, then the amount of such distribution shall be applied against and reduce the adjusted basis of the stock provided in section 113, and if in excess of such basis, such excess shall be taxable in the same manner as a gain from the sale or exchange of property. This subsection shall not apply to a distribution in partial or complete liquidation or to a distribution which, under subsection (f) (1), is not treated as a dividend, whether or not otherwise a dividend.↩