*211 Decision in each proceeding will be entered for the respondent.
Income -- Stock Dividend. -- The petitioners received a pro rata dividend paid in shares of preferred of the distributing corporation on its voting common, the only class then outstanding, pursuant to a prearranged plan embracing the authorization of the new preferred on terms imposed by insurance companies which agreed to purchase them for a stated consideration if, as, and when issued, the issuance thereof as a stock dividend, and the concurrent sale thereof for cash to petitioners. Held, that the purposes of the issuance of the preferred was concurrently to place that issue in the hands of others not then stockholders, thereby altering the preexisting proportionate interests of the common stockholders and setting up an entirely new relationship amongst all the stockholders and the corporation and at the same time to enable the common stockholders to derive cash in hand from their capital investment in the corporation. Held, further, that such dividend, when received, was the equivalent of a cash dividend constituting ordinary taxable income.
*164 These consolidated proceedings involve income tax deficiencies determined by respondent for the calendar year 1946, against petitioners in the respective amounts, as follows:
| Petitioner | Docket No. | Deficiency |
| C. P. Chamberlin | 27598 | $ 343,650.86 |
| Grace A. Chamberlin | 27599 | 63,225.55 |
| John H. Toner | 27600 | 19.620.37 |
| Benjamin James Carl | 27601 | 7.244.29 |
| Guy V. Schrock | 27602 | 9,177.83 |
| Robert Pierce and Josephine H. B. Pierce | 27603 | 14,635.19 |
In the proceeding of Grace A. Chamberlin, Docket No. 27599, the respondent also determined an income tax deficiency of $ 1.08 for the calendar year 1947 and petitioner concedes the correctness thereof.
The only issue presented is whether the petitioners received dividends taxable as ordinary income *214 in 1946, upon receipt of a pro rata dividend paid in shares of preferred stock of the distributing corporation on its voting common stock, the only class then outstanding, when the authorization of the new preferred and issuance thereof as a stock dividend and an immediate sale thereof for cash, were all in pursuance of a prearranged plan.
*165 The additional assignments of error in Docket Nos. 27602 and 27603 have been abandoned.
The stipulated facts and numerous exhibits made a part thereof are included herein by reference.
FINDINGS OF FACT.
The stipulated facts are so found.
The petitioners are individuals and during the period in question each was a resident of the State of Michigan. They filed their individual income tax returns for the calendar year 1946 with the collector of internal revenue at Detroit for the district of Michigan.
The Metal Mouldings Corporation, hereinafter referred to as the Metal Company, is a Michigan corporation with its principal office in Detroit, Michigan. For many years and at all times material here, the Metal Company has been engaged in the business of manufacturing metal mouldings and bright work trim used in the manufacture of automobiles.
*215 The Metal Company was incorporated on December 2, 1924, with an authorized common capital stock of $ 25,000 which was increased in 1935 to $ 150,000 represented by 1,500 shares of $ 100 par value voting common stock and remained at that authorization until further increased in 1946. From 1940 until December 20, 1946, the issued and outstanding common stock totaled 1,002 1/2 shares, of which Clarence P. Chamberlin and his wife Grace A. Chamberlin together owned 83.8 per cent, and during that period the only change in the holders of such outstanding stock was caused by the death of Edward W. Smith on October 11, 1946, and the transfer of his shares to his estate.
The directors of the Metal Company from 1940 to February 12, 1946, consisted of Clarence P. Chamberlin, Grace A. Chamberlin, and Edward W. Smith. On February 12, 1946, the board of directors was increased to five and in addition to the aforenamed persons also included John H. Toner and Raymond H. Berry. After Edward W. Smith's death on October 11, 1946, the board of directors consisted of the four remaining members for the balance of 1946.
The officers of the Metal Company from 1940 to the end of 1946 were as follows: Clarence*216 P. Chamberlin president and treasurer throughout; John H. Toner vice president and general manager throughout; Grace A. Chamberlin vice president and assistant treasurer until February 12, 1946, then vice president until October 18, 1946, and thereafter secretary; Edward W. Smith secretary until his death on October 11, 1946; and Benjamin J. Carl assistant secretary and assistant treasurer until February 12, 1946.
The business of the Metal Company prospered. As reflected by its books of account for the indicated years prior to 1946 and for the *166 first 6 months of 1946, its earned surplus, net profits after Federal income tax, and cash dividends paid on the outstanding common stock were as follows:
| Net profits | |||
| Year | Surplus | after tax | Dividends |
| 1937 | $ 307,137.71 | $ 294,651.49 | $ 175,437.50 |
| 1938 | 226,351.70 | 273,927.32 | 175,437.50 |
| 1939 | 272,954.56 | 414,552.56 | 300,750.00 |
| 1940 | 305,757.12 | 423,696.21 | 300,750.00 |
| 1941 | 678,863.71 | 438,966.74 | 200,500.00 |
| 1942 | 917,330.45 | 18,946.40 | 50,125.00 |
| 1943 | 964,990.47 | 276,603.92 | 100,250.00 |
| 1944 | 711,072.77 | 264.027.84 | 100,250.00 |
| 1945 | 1,086.552.60 | 346,540.59 | 200,500.00 |
| 1st 6 months 1946 | 1,267,566.77 | 215,184.84 |
*217 At the end of the first 6 months of 1946 the Metal Company's balance sheet reflected total assets of $ 2,488,836.53 and included in current assets, inter alia, $ 722,404.56 cash and $ 549,950 United States Government bonds and notes.
On December 16, 1946, the stockholders of the Metal Company adopted a resolution that the company's authorized capital stock be increased from $ 150,000 to $ 650,000 represented by 6,500 shares of $ 100 par value common stock, and on December 19, 1946, a Certificate of Increase of Capital Stock was duly filed. On December 20, 1946, the stockholders and directors of the Metal Company adopted identical resolutions declaring a dividend of five shares of common for each share of common outstanding, aggregating 5,012 1/2 shares, to be issued pro rata to the stockholders on that date and, further, that the company's accounts be adjusted by transferring $ 100 per share for each share so issued, or a total of $ 501,250 from earned surplus to capital account. The stock dividend was issued and the company's accounts were adjusted accordingly.
On December 26, 1946, the stockholders of the Metal Company adopted resolutions that article 5 of the articles of *218 incorporation of the Metal Company be amended to authorize a total of 14,520 shares of all classes of capital stock consisting of 8,020 shares of 4 1/2 per cent cumulative $ 100 par value preferred and 6,500 shares of $ 100 par value voting common. On December 27, 1946, a Certificate of Amendment of the company's articles of incorporation was duly filed with the Michigan authorities and as so amended set forth in lengthy detail all the designations and powers, preferences and rights, and the qualifications, limitations, or restrictions of all classes of stock. 1
*219 *167 On December 28, 1946, the Metal Company's stockholders and directors adopted identical resolutions declaring a stock dividend of 1 1/3 shares of the newly authorized 4 1/2 per cent cumulative preferred for each share of common outstanding, aggregating 8,020 shares, to be issued pro rata to the holders of common stock outstanding at the close of December 27, 1946, and, further, that the company's accounts be adjusted by transferring $ 100 per share for each share of preferred so issued, or a total of $ 802,000, from earned surplus to capital account. The stock dividend was issued and the company's accounts were adjusted accordingly.
The distribution of the Metal Company's outstanding capital stock immediately prior to and upon the above-mentioned recapitalizations and issuances of stock dividends, was as follows:
| No. of | |||
| shares | Stock dividend | ||
| common | Per cent of | in | |
| Stockholder | prior and | common | common |
| on 12/20/46 | owned | on 12/20/46 | |
| C. P. Chamberlin | 700 | 69.83 | 3,500 |
| G. A. Chamberlin | 140 | 13.97 | 700 |
| R. Pierce | 52.5 | 5.24 | 262.5 |
| J. H. Toner | 50 | 4.99 | 250 |
| G. V. Schrock | 32.5 | 3.24 | 162.5 |
| B. J. Carl | 25 | 2.49 | 125 |
| Est. E. W. Smith | 2.5 | .24 | 12.5 |
| Total | 1,002.5 | 100 | 5,012.5 |
| Common | ||
| stock (only | Stock dividend | |
| Stockholder | class) outstanding | in |
| at close of | preferred | |
| 12/27/46 | on 12/28/46 | |
| C. P. Chamberlin | 4,200 | 5,600 |
| G. A. Chamberlin | 840 | 1,120 |
| R. Pierce | 315 | 420 |
| J. H. Toner | 300 | 400 |
| G. V. Schrock | 195 | 260 |
| B. J. Carl | 150 | 200 |
| Est. E. W. Smith | 15 | 20 |
| Total | 6,015 | 8,020 |
The preferred shares issued by the Metal Company on December 28, 1946, to the persons and in the number of shares as set out in the next preceding paragraph, were temporary typewritten stock certificates which were complete in form. On the same day, the company purchased, affixed to its stock record book and canceled the required Federal documentary stamps with respect to the issuance of those shares.
*168 The Metal Company's balance sheets as of June 30, 1946, and December 31, 1946, are summarized as follows:
| Assets | June 30, 1946 | Dec. 31, 1946 |
| Cash | $ 722,404.56 | $ 445.836.53 |
| U. S. Government bonds and notes | 549,950.00 | 567,400.72 |
| Accounts receivable, less reserve | 144,977.97 | 283,372.57 |
| Inventories and work in process | 548,035.31 | 642,053.86 |
| Prepaid and deferred expenses | 65,739.02 | 28,684.67 |
| Plant and equipment, net | 457,729.67 | 475,478.84 |
| Cash earmarked for acquisition of plant facilities, | ||
| machinery, equipment | 226,000.00 | |
| Total assets | 2,488,836.53 | 2,668,827.19 |
| Liabilities and capital | ||
| Current and various others | $ 698,128.08 | $ 668,815.28 |
| Reserves, various | 207,706.84 | |
| Capital stock: | ||
| 4 1/2 percent cumulative preferred, $ 100 par, | ||
| outstanding | 802,000.00 | |
| Common stock, $ 100 par, outstanding | 100,250.00 | 601,500.00 |
| Earned surplus | 1,267,566.77 | 596,511.91 |
| Profit and loss, after estimated tax | 215,184.84 | |
| 2,488,836.53 | 2,668,827.19 |
*221 The earned surplus as of December 31, 1946, was in an amount as per an accompanying earned surplus statement, which is summarized as follows:
| Balance at Dec. 31, 1945, as restated (after including certain | ||
| adjustments of reserves) | $ 1,425,438.61 | |
| Net profit for year 1946, after income tax | 664,798.30 | |
| 2,090,236.91 | ||
| Deduct: | ||
| Cash dividends on common stock ($ 100 per share | ||
| on 1,002 1/2 shares and $ 15 per share on | ||
| 6,015 shares) | $ 190,475 | |
| Dividend of 5,012 1/2 shares common stock | ||
| at $ 100 par value | 501,250 | |
| Dividend of 8,020 shares 4 1/2 per cent | ||
| cumulative preferred stock at $ 100 par | ||
| value | 802,000 | 1,493,725.00 |
| Balance at Dec. 31, 1946 | 596,511.91 |
On December 30, 1946, as the result of prior negotiations, the individual holders of 8,000 shares of 4 1/2 per cent cumulative preferred stock of the Metal Company (which constituted all the outstanding preferred except for 20 shares held by the Estate of Edward W. Smith, deceased) signed a "Purchase Agreement" with the Lincoln National Life Insurance Company (hereinafter called Lincoln) and the Northwestern *169 Mutual Life Insurance Company (hereinafter called Northwestern). *222 The agreement provided that those individuals "hereby confirm their agreement with" the insurance companies, subject to the terms and conditions therein set forth, for the sale of 4,000 shares of such preferred stock to each of those insurance companies, severally, at a cash price of $ 100 per share plus the amount of dividends accrued thereon from November 1, 1946, to date of delivery. Each of the insurance companies "confirmed and accepted" that agreement as of December 30, 1946. As authorized by a board of directors' resolution of December 30, 1946, the Metal Company signed an endorsement of the purchase agreement for the stated purpose of making "to and with" the insurance companies "the representations, warranties and agreements contained in" several enumerated sections of that agreement and pertaining to affairs of and/or corporate actions by the Metal Company. 2
*223 On December 30, 1946, the individual holders of the 8,000 shares of preferred delivered their stock certificates endorsed in blank to the agents of the two insurance companies which transferred to Clarence P. Chamberlin, as agent for the stockholders, funds payable at a Detroit bank for the total amount of the purchase price. Chamberlin, by delivery of his personal checks, thereupon distributed the proceeds of the sale pro rata to the interested parties. The expenses incident to the sale which the individual stockholders were obligated to pay on a pro rata basis and which were paid by them on December 30, 1946, embraced $ 3,000 fee to the attorneys for the insurance companies; $ 2,000 fee to the attorneys for the stockholders; $ 8,000 commission to William Blair & Company, the broker in the transaction; $ 480 Federal documentary stamps; and $ 20.22 miscellaneous expense of the Detroit bank, or a total of $ 13,500.22. As to each of the individual stockholders, the number of 4 1/2 per cent cumulative preferred shares sold to the two insurance companies, the purchase price received *170 at $ 100 par plus dividends accrued to date, and the pro rata portion of the expense incurred, *224 are as follows:
| No. of shares | Price | ||
| Stockholder | sold | received | Expense |
| C. P. Chamberlin | 5,600 | $ 564,130.00 | $ 9,450.00 |
| G. A. Chamberlin | 1,120 | 112,826.00 | 1,890.00 |
| R. Pierce | 420 | 42,309.75 | 708.75 |
| J. H. Toner | 400 | 40,295.00 | 675,00 |
| G. V. Schrock | 260 | 26,191.75 | 438.75 |
| B. J. Carl | 200 | 20,147.50 | 337.50 |
| Totals | 8,000 | $ 805,900.00 | $ 13,500.00 |
Immediately upon completion of the sale of the 8,000 shares of preferred to the insurance companies on December 30, 1946, the certificates representing such shares were delivered to and canceled by the Metal Company. On the same date, there was issued to Lincoln and Northwestern, respectively, the Metal Company's temporary typewritten stock certificates for 4,000 shares of its 4 1/2 per cent cumulative preferred stock. On April 21, 1947, those temporary certificates, numbered 8 and 9, were canceled and in lieu thereof the Metal Company's definitive printed stock certificates, identical to the temporary ones except in form, were issued to the insurance companies.
On April 26, 1949, the Metal Company filed with the proper Michigan authorities, a Certificate of Decrease of Capital Stock pursuant to resolution that*225 the authorized preferred stock be decreased by 2,000 shares, which had theretofore been retired and canceled in accordance with the company's amended charter. On October 6, 1950, a similar certificate was filed for an additional decrease of 1,000 shares of preferred which had been likewise retired and canceled.
The above-mentioned transactions, in December 1946, involving the Metal Company's issuance of preferred shares as a stock dividend to petitioners herein and the latters' immediate sale thereof to the insurance companies, were the culmination of negotiations directed toward that result. In the latter part of 1945, Raymond H. Berry held a conference with Wallace Flower, a partner of William Blair & Company, investment bankers of Chicago, to consider certain income tax problems of Berry's clients, the Metal Company and its stockholders. It was explained that the Metal Company had such a large accumulated earned surplus it was fearful of being subjected to the surtax provided for by section 102, Internal Revenue Code, but that at the same time C. P. Chamberlin, the majority stockholder, was not willing to have the company distribute any substantial portion of its earned surplus*226 as ordinary dividends because his individual income was taxable at high surtax rates. Flower's advice was sought as to a means whereby the stockholders could withdraw, or otherwise derive cash benefits of about $ 1,000,000 of the Metal Company's accumulated *171 earnings in the form of capital gains rather than as taxable dividends. Flower advised that the tax problems might be solved by having the Metal Company capitalize $ 1,000,000 of its earned surplus through issuance of preferred stock, subject to provisions for rapid retirement, as a stock dividend to its common stockholders followed by their immediate sale thereof to a life insurance company for cash with the resulting profits taxed as capital gain. Chamberlin assented to the plan.
Prior to and during December 1945, Flower communicated with an official of Lincoln's investment department, giving detailed history and financial data of the Metal Company, the tax problem involved, and suggestions as to the proposed issuance and retirement of preferred stock. The Lincoln official answered that his company was interested if terms could be worked out as to the amount of preferred to be issued and proper safeguards thereof*227 including the Metal Company's maintenance at all times of net current assets equal to one and one-half times the amount of the preferred issue and of cash and United States bonds equal thereto. During 1946 Chamberlin sought and received legal advisory opinions on the proposed plan. In October 1946 Flower advised Lincoln as to the Metal Company's willingness to make any reasonable covenants as to the maintenance of assets and a retirement sinking fund, and also the desirability of proceeding with the plan prior to the end of that year. Shortly thereafter the Lincoln official went to Detroit, inspected the plant and business of the Metal Company, discussed the proposed plan, and suggested amendments thereto in accord with Lincoln's investment policies. On November 11, 1946, that official made a detailed written report to Lincoln as to the Metal Company's facilities, business, operations, earnings, etc., and stated, inter alia, that the "purpose of this [issue of $ 1,000,000 preferred] is to enable the owners to take money out of the company and to pay thereon a capital gains tax of 25 per cent rather than the normal personal income tax rates" and that the negotiated "terms seek*228 to give the degree of protection usually found in a first lien bond issue."
On November 20, 1946, Lincoln wrote to Flower that its finance committee approved of an $ 800,000 preferred stock issue and the purchase of one-half thereof on prescribed terms as to the dividend rate, sinking fund, etc., and also certain restrictions as to payment of any dividends on the common stock. Thereupon Flower communicated with Northwestern, giving all the details and terms of the proposed stock issue and seeking that company's interest in purchasing one-half thereof. Communications were exchanged between the two insurance companies and also the principals and the broker. Northwestern made a detailed investigation of the Metal Company, its affairs, and of the terms and conditions of the proposed preferred stock issue. About *172 two weeks before December 30, 1946, Northwestern's committee on investments approved the purchase of $ 400,000 of the preferred stock to be issued by the Metal Company and passed the matter over to its legal department for conclusion of the transaction.
No agreement of purchase and sale was entered into between any of the petitioners and either of the two insurance*229 companies prior to the "Purchase Agreement" executed on December 30, 1946, but the stockholders and directors of the Metal Company took the necessary actions to put the negotiated plan into effect, as hereinbefore set out, only after the insurance companies signified their willingness to participate in the purchase if, as, and when the preferred stock was issued on the terms and conditions prescribed by them and as specifically set out in company's charter as amended on December 27, 1946, authorizing the issuance of preferred shares, in the certificates of stock as issued on December 28, 1946, and in the "Purchase Agreement" as executed on December 30, 1946.
In reporting the sale of preferred stock of the Metal Company in their 1946 tax returns, each petitioner reported his proportion of the proceeds as a net long term capital gain from the sale of capital assets held for more than six months. Each petitioner used a substituted cost basis per share, in amounts as shown in the stipulation, and determined the holding period by including the holding period of the common. As to each petitioner, respondent determined that the value of the shares of the 4 1/2 per cent cumulative preferred*230 stock of the Metal Company received in December 1946 constituted a dividend taxable as ordinary income and further determined that the value was the amount received by each petitioner on the sale of the shares; that is, the par value plus dividends accrued from November 1, 1946, to December 30, 1946. Respondent allowed the expenses incurred in the sale as a deduction.
OPINION.
The petitioners contend that the essential facts material to a decision are that the Metal Company had only one class of stock outstanding, namely, voting common, on December 28, 1946, on which date it distributed a pro rata stock dividend of its preferred shares; that thus the facts herein parallel those in Strassburger v. Commissioner, 318 U.S. 604">318 U.S. 604; and that accordingly the rule in the cited case is conclusive of the present controversy in favor of petitioners. We do not agree. Without discussing the Strassburger case at the present time, it is our opinion that the issue presented of whether the stock dividend of preferred on common constituted income to the stockholders (petitioners) must be determined from a consideration of all the facts and circumstances surrounding*231 the issuance of such dividend and not by a consideration limited to the characteristics of the stock declared as a dividend.
*173 Congress has provided generally in section 22 (a) of the Internal Revenue Code for the inclusion in gross income of "dividends" and has defined that term in section 115 (a) of the Code. 3 However, Congress qualified both of those provisions by section 115 (f) (1)3 which excludes a stock dividend to the extent that it does not constitute income within the Sixteenth Amendment to the Constitution. Thus Congress has provided the statutory basis for taxing (as ordinary income) stock dividends to the full extent that thereby the stockholder's interest in the distributing corporation's accumulated earnings or profits come to fruition as "incomes" within the meaning of the Sixteenth Amendment.
*232 With respect to the constitutional issue involved the Supreme Court in Eisner v. Macomber, 252 U.S. 189">252 U.S. 189, said that a proper regard for the genesis as well as the clear language of the Sixteenth Amendment4 requires that, except as applied to income, it shall not be extended by loose construction so as to repeal or modify the clauses of Article 1 of the Constitution requiring apportionment and that in order to give proper force and effect to both provisions, "it becomes essential to distinguish between what is and what is not 'income' as the term is there used, and to apply the distinction, as cases arise, according to truth and substance, without regard to form." The Court further said that "Congress cannot by any definition it may adopt conclude the matter, since it cannot by legislation alter the Constitution, * * *." As to the constitutional meaning of the term "incomes," as involved in that case, the Court reiterated its earlier definition that "Income may be defined as the gain derived from capital, from labor, or from both combined," (with the proviso that it include profit from sale or conversion of capital assets) with further elucidation*233 by several succinct statements directed towards emphasis on a gain or something of exchangeable value, proceeding from property, severed from the capital however invested, and coming in, being derived; that is, received or drawn by the recipient for his separate use, benefit and *174 disposal, as constituting income from property within the concept of the Sixteenth Amendment.
A review of the Supreme Court decisions involving stock dividends (see footnote 5 for a limited discussion of cases as they arose) leads us to the conclusion that, irrespective of the varying provisions of the taxing statutes involved therein, each case was decided upon its own facts and circumstances as establishing whether the receipt of a particular kind of stock dividend is in fact taxable. We are led to *175 *234 the further conclusion that the principles announced in those cases certainly do not rest upon mere matters of the form or nomenclature attending a stock dividend distribution, but, rather, are rooted in the Court's firm conclusions of ultimate fact as to the real substance of the transaction involved, that is, the essential nature of the stock dividend distributed and the attendant interests and rights affected thereby.
*235 In the Macomber case the Court concluded that a "true stock dividend made lawfully and in good faith" is not income as distinguished from the normal dividend in money or other divisible property actually distributed out of the corporation's assets for the stockholder's separate use and benefit and thus representing income to the stockholder derived from his capital investment. The real substance of the transaction there involved, was that the corporation's undivided profits were so absorbed in its business as to be impracticable of separation for actual distribution, and a readjustment of capital for corporate purposes was made by declaring a dividend of common on common charged against surplus and credited to capital account. Under the circumstances that dividend did not, as the Court said, "alter the pre-existing proportionate interest of any stockholder or increase the intrinsic value of his holding or of the aggregate holdings of the other stockholders as they stood before." The net result was that each common stockholder merely had a pro rata increase in number of certificates evidencing the same proportionate interest he theretofore owned in the corporation as a whole*236 and nothing had been severed from his capital investment or realized as income derived therefrom.
In the Koshland case the corporation had outstanding voting common and preferred subject to redemption and preferential rights. It had sufficient cash surplus to pay a dividend on the preferred in cash but elected to pay in common shares. Subsequently the preferred was redeemed. Under the circumstances the receipt of the common did alter the preexisting proportionate interest represented by the preferred shares and further, the distribution of such a dividend disturbed the relationship previously existing amongst all the stockholders and the corporation. The real substance of the transaction was that new interests were thereby derived from the stockholder's capital investment and constituted income when received. Under essentially similar circumstances in the Gowran case a dividend on common was paid in preferred shares, which were subsequently redeemed, and the same rule obtained that such a stock dividend constitutes income when received.
The Griffiths case involved, as did Eisner v. Macomber, a dividend of common on common and since the Court construed the *237 statute as *176 embodying the result of Eisner v. Macomber, it held the dividend nontaxable.
In the Sprouse case the stock dividend of nonvoting common was distributed, against available earnings or profits, on both classes of stock outstanding consisting of voting and nonvoting common. The dividend distribution did not alter the voting rights of the voting common, or its rights to share in dividends and liquidation. The real substance of the transaction was that no essential change was brought about, by the issue of dividend shares, in the proportionate interests amongst all the stockholders. Thus it was held that the stock dividend was not taxable under the Griffiths rule as distinguished from Koshland.
The Sprouse case was decided in the same opinion with the Strassburger case wherein the circumstances were that the sole stockholder of common, the only class outstanding, received a dividend in nonvoting preferred declared against available earnings. The dividend stock was not sold or otherwise disposed of. The distribution brought about no substantial change in the stockholder's interest in the net value of the corporation; before he owned it*238 all and after the event he retained all the incidents of ownership. Therefore, the stock dividend was not taxable under the statute when received.
In the instant proceeding the Metal Company, as restated for the purpose of its books of account, had an earned surplus in excess of $ 1,425,000 on December 31, 1945. On June 30, 1946, that company's current assets included a total of $ 1,272,354.56 in cash and Government bonds and notes. Its net profits, after estimated income tax, amounted to $ 215,184.84 for the first six months of 1946 and to $ 664,798.30 for the entire year 1946. The Metal Company's accumulated earnings and profits to a large extent, were not absorbed in its plant, property, or business for corporate purposes and were available for distribution in cash or other divisible property as dividends on its voting common stock, its only class of capital stock of which 1,002 1/2 shares were outstanding and 83.8 per cent thereof held by Chamberlin and his wife and the balance by five other persons.
Notwithstanding the ability to pay out normal dividends in a very large amount which would represent income to the stockholders, the Metal Company elected to declare two successive*239 stock dividends in December 1946, both of which involved a recapitalization of the corporation by amendment to its charter and a transfer of an amount equivalent to the par value of both issues of stock dividends totaling $ 1,303,250 from surplus to capital account. After such stock dividends and also cash dividends of $ 190,475 on outstanding common during 1946, the Metal Company's earned surplus amounted to $ 596,511.91 at December 31, 1946. The first pro rata stock dividend of $ 501,250 par value common on outstanding common on December *177 20, 1946, is not at issue herein, but is a part of the factual circumstances involved. The second pro rata stock dividend of $ 802,000 par value preferred on outstanding common on December 28, 1946, is in issue.
Looking at the dividend of preferred on common from the standpoint of merely a pro rata distribution of new shares on the then one class of shares outstanding with the result that at the time received the same group of stockholders retained the same proportionate interests in the entire net value of the corporate assets as they had before and disregarding the circumstances and terms of the issue, it might be said that as a matter*240 of form the stock dividend constituted one which fell within the Sprouse and Strassburger cases. The primary burden of the petitioners' argument is to that effect. However, as established by the cited cases, not form, but the real substance of the transaction is controlling.
If we turn to what we consider to be the real substance of the transaction, the facts show conclusively that the stock dividends were not in good faith for any bona fide corporate business purpose. The company was concerned only with the immediate necessity of greatly reducing its accumulated earned surplus not needed in its business, which accumulated surplus otherwise would make it subject to the possible imposition of a surtax provided for by section 102, Internal Revenue Code. At the same time, the company's stockholders were concerned only with immediately realizing for themselves at least $ 800,000 cash in hand because of the existence of the company's accumulated earnings, but because of the individual tax consequences they wanted the distribution in some form other than as ordinary cash dividends. In order to accomplish these desired ends negotiations were had in which the Metal Company, *241 its stockholders, and the insurance companies participated and came to a complete understanding as to procedure, terms, etc.; the stage was set in detail to meet the requirements of all parties concerned for the two successive recapitalizations of December 20 and 28, 1946, and also for the formal execution of the prearranged contract of sale (the Purchase Agreement) of the preferred dividend shares on December 30, 1946, for cash in the amount of the par value plus dividends accrued to date of delivery. In the Purchase Agreement the Metal Company agreed that on the closing date it had surplus of not less than $ 350,000 available for dividends on the preferred or for use in redemption thereof. The parties contemplated closing the transaction not later than December 31, 1946.
The terms of the company's amended charter authorizing the issuance of the new preferred and the provisions contained in those shares were specifically dictated by the insurance companies to meet their investment requirements "to give the degree of protection usually *178 found in a first lien bond issue." The issuance of the two successive stock dividends against a transfer of $ 1,303,250 from surplus to*242 capital account was not because of investment or use thereof in the corporate business. Instead, it was solely for the security of the new preferred, and for that purpose the amended charter required, so long as any preferred remained outstanding, that the company maintain net working capital in an amount equal to 150 per cent of the par value of outstanding preferred or $ 750,000 whichever amount was greater and that the company maintain current assets in an amount not less than 200 per cent of current liabilities. Further, so long as the preferred remained outstanding, the amended charter immediately effected a material change not only in the dividend rights of the common shares, but also their voting rights as to further changes in the corporate charter, capital structure, and other matters.
The real purpose of the issuance of the preferred shares was concurrently to place them in the hands of others not then stockholders of the Metal Company, thereby substantially altering the common stockholders' preexisting proportionate interests in the corporation's net assets and thereby creating an entirely new relationship amongst all the stockholders and the corporation. Further, the*243 new preferred was to be redeemed out of the corporation's assets in a comparatively short period of time. With such a predetermined purpose, the dividend was not a true stock dividend made in good faith within the meaning of the cited Supreme Court decisions. A further real and, in fact, the most important, purpose of the issuance of the preferred was to enable the common stockholders to derive cash in hand almost simultaneously, in an agreed amount, solely because of and from their preexisting capital investment in the company. The entire plan was designed primarily for the benefit of the common stockholders whose will was the will of the corporation. The fact that in form no cash or divisible assets of the company were actually withdrawn from the corporation on December 28, 1946, is immaterial, for that condition existed in the Koshland and Gowran cases. Also, compare Bazley v. Commissioner, 331 U.S. 737">331 U.S. 737, where, after a recapitalization-reorganization involving an exchange of outstanding shares of a corporation for its short term debenture bonds was not recognized as a tax free reorganization within section 112 of the Code, it was *244 determined that the transaction had the same result, taxwise, as a distribution by the corporation of available cash earnings equivalent to the value of the bonds. In short, the last cited cases applied the doctrine that substance controls as opposed to form.
We think the attendant circumstances and the conditions under which the preferred stock in this case was issued effectively preclude application of the principles of Strassburger, supra. We conclude that the dividend received by petitioners on December 28, 1946, was *179 not a true stock dividend, but the equivalent of a cash dividend distribution out of available earnings thus constituting ordinary taxable income in the amount of the value of the preferred shares received. Having in mind the agreed sale price of the preferred shares and the company's agreement as to available surplus for dividends thereon on the closing date of the prearranged transaction, we further conclude that the value of the preferred shares, when received on December 28, 1946, was not less than the equivalent of the amount received from the concurrent sale, as determined by respondent.
The respondent's determination*245 is sustained.
Decision in each proceeding will be entered for the respondent.
Opper, J., concurring: The suggestion which I find implicit in the present opinion that the actual, rather than potential, sale of the preferred stock is what made this a taxable dividend and distinguishes it from Strassburger1 seems to me to impose additional difficulties in a field already overburdened with problems. 2
The decision in Strassburger being apparently the result of a chronological accident in the presentation of cases, and constituting what would otherwise presumably have been the view*246 of a minority of the justices then composing the Supreme Court 3 should, it seems to me, be limited rigorously to its precise facts. Among other distinctions, the taxpayer there was the sole stockholder of the declaring corporation so that any discussion of a change in proportionate interests flowing from that dividend is unwarranted. Cf., e. g., Higgins v. Smith, 308 U.S. 473">308 U.S. 473.
*247 But as long ago as 1938 it was held by us in a reviewed opinion without dissent that, in just such a case as this, a dividend of preferred on common where only common had been outstanding was taxable to the several shareholders of the corporation there concerned. *180 Frank J. and Hubert Kelly Trust, 38 B. T. A. 1014. 4*248 This was the result in essence of considering the attributes of the rights of common stockholders as among each other and against the corporation; and the effect of a dividend upon those rights in "that their interest after the dividend became to some extent transferable in parts where before it could be disposed of only as a whole." We went on to say in language that seems to me still peculiarly applicable to such situations as this (p. 1017): "Petitioner's donors, by transferring the preferred stock, as in fact they did, could then dispose of a part of their interest in the earnings and assets of the corporation without in any way disturbing the distribution of voting control." See also Helms Bakeries, 46 B. T. A. 308. 5
It would be my conclusion that not the fact but the possibility of such a sale as took place here is what made this dividend taxable, and that the significance of the sale here is not that it occurred, and certainly not that the taxability of the dividend depended upon it; but that it is cogent and in fact inescapable evidence of the critical proposition that such a sale could take place and that its effect could be precisely that described in the Kelly Trust case, supra.
I accordingly concur in the conclusion presently being reached but would arrive at the same one even though the stock in question were not actually the subject of a sale.
Arundell, J., dissenting: In holding that the dividend received by the petitioners was not "a true stock dividend made in good faith," I think that the majority fails to give due consideration*249 to one important factor. That is, that the character of what a stockholder receives from his corporation for tax, as well as other purposes, is definitively settled by the action of the directors of the corporation in making the declaration on which the distribution is based.
If, on the declaration of a dividend, the directors provide for the medium of distribution, the stockholders must take it in the form so provided. A corporate distribution must "be taken as it emanates from the board." State v. B. & O. R. R., 6 Gill, (Md.) 363; Staats v. Biograph Co., 236 F. 454">236 F. 454; General Utilities & Operating Co., 29 B. T. A. 934, affd. 296 U.S. 200">296 U.S. 200. If the directors declare, and the corporation pays, a stock dividend, that is all that the stockholder can receive. What constitutes a stock dividend has not been open to serious question, at least since the decision in Gibbons v. Mahon, 136 U.S. 549">136 U.S. 549, *181 was handed down in 1890. That decision laid down the proposition that in the receipt of a stock dividend "the proportional interest of each shareholder*250 remains the same. The only change is in the evidence that represents that interest * * *." 136 U.S. at 559, 560. The principle so declared in Gibbons v. Mahon was the basis of the decision in Towne v. Eisner, 245 U.S. 418">245 U.S. 418, and has been the touchstone of decision in cases involving the taxability of stock dividends ever since. See the summary of cases in the footnote in the majority opinion.
Whether or not a dividend in stock changes the proportional interest of shareholders needs no lengthy discussion in these cases. We know from the decisions that a dividend of common on common does not, Eisner v. Macomber, 252 U.S. 189">252 U.S. 189; neither does a dividend of preferred on common where only common is outstanding, Strassburger v. Commissioner, 318 U.S. 604">318 U.S. 604, while a dividend of common on preferred does work a change and results in the realization of constitutionally taxable income, Koshland v. Helvering, 298 U.S. 441">298 U.S. 441, even though not taxed by the Revenue Act then in force. In the Koshland case, the Court pointed out*251 that "The company had a surplus sufficient to pay the preferred dividends in cash, but elected to pay them in common stock" (emphasis added). This is in line with the thought expressed in Gibbons v. Mahon, supra, that whether a "distribution is an apportionment of additional stock representing capital, or a division of profits and income, depends upon the substance and intent of the action of the corporation, as manifested by its vote or resolution * * *."
None of the stock dividend cases turn upon the question of the intent of the stockholder, at the time of the receipt, as to the disposition that he will make of his dividend. He may have no intention or plan at all; he may intend to keep it, to give it away, or to sell it. But I do not see how these considerations can change the character of the distribution as manifested by the "substance and intent of the action of the corporation" in making the distribution. Gibbons v. Mahon, supra.Indeed, in the average case, the corporate directors and officers cannot be expected to know what disposition the stockholders will make of their dividend stock. One of*252 the stockholders in this company did not dispose of its dividend stock.
My view that the character of a distribution depends upon the intent and action of the corporation is supported by the wording of the Code. Section 115(f)(1) speaks of "A distribution made by a corporation to its shareholders * * *." It says nothing about what the stockholders do with the distributions. That is taken care of by other sections, such as the gain or loss provisions and the gift tax sections.
*182 I also think that in these cases we do not properly come to the question of good faith. That may be a proper consideration in cases where Congress has provided for the postponement of a tax under facts which, without statutory provision, would result in the imposition of a tax concurrently with the happening of the event. Under the early taxing statutes, reorganization exchanges gave rise to recognizable gains that were currently taxed. Marr v. United States, 263 U.S. 536">263 U.S. 536. By the enactment of provisions presently contained in Code section 112(b), the tax may be postponed. Under such provisions, it is proper to inquire as to whether there is a good faith compliance*253 with the statutory intent rather than a mere surface compliance. Gregory v. Helvering, 293 U.S. 465">293 U.S. 465. Here we start with the basic proposition that under the decisions of the Supreme Court stock dividends are not income. The Congress has manifested an intent not to treat them otherwise. Griffiths v. Commissioner, 308 U.S. 355">308 U.S. 355. Therefore, we have only the clear-cut question of whether the distributions here under consideration were, or were not, stock dividends. If they were, whatever plan there may be for their disposition cannot convert them into income any more than Congress could make them income as it attempted to do in the Revenue Act of 1916 and which gave rise to Eisner v. Macomber.
Footnotes
*. Proceedings of the following petitioners are consolidated herewith: Grace A. Chamberlin; John H. Toner; Benjamin James Carl; Guy V. Schrock; Robert Pierce and Josephine H. B. Pierce, Husband and Wife.↩
1. Except as specifically limited the common stock retained the usual privileges thereof. The preferred shares, among other things, are entitled to cumulative cash dividends at the rate of $ 4.50 per annum payable quarterly commencing from November 1, 1946; are subject to redemption on any quarterly dividend date in whole or in part (in multiples of 500 shares) at par plus specified premiums and accrued dividends; are subject to mandatory retirement, at par plus specified premiums and accrued dividends, in the amounts of 2,000 shares on May 1, 1948, and 1,000 shares on May 1st of each succeeding year until fully retired on May 1, 1954. In the event of certain default in dividend payments or annual retirements, the holders of the preferred, voting as a class, are entitled to elect a majority of the total number of the company's directors. So long as any preferred shares remain outstanding the consent of the holders of at least 75 per cent thereof, is required to validate certain actions including changing the articles of incorporation or capital structure, the sale of all or substantially all of the company's property, or the incurrence of indebtedness for borrowed money in excess of a certain amount. Also, so long as any preferred shares remain outstanding, inter alia↩, the company may not declare or pay cash dividends upon any stock junior to the preferred, unless there is no default in payment of dividends upon and the annual retirements of the preferred; unless the sum of amounts paid or made available for dividends, redemptions and additions to any sinking fund subsequent to December 31, 1946, on shares of any class, plus the proposed declaration on the junior stock, does not exceed the company's net income earned subsequent to December 31, 1946; and, further, unless after giving effect to the proposed declaration on the junior stock, (a) the net working capital of the company will not be reduced below an amount equal to 150 per cent of the aggregate par value of all outstanding preferred or $ 750,000 whichever amount is greater, and (b) the current assets of the company (as defined) will not be reduced to an amount less than 200 per cent of current liabilities of the company (as defined).
2. Those representations, etc., were, among other things, with respect to the validity of the corporate charter and of the authorization and issuance of the preferred stock; the financial condition of the company on November 30, 1946, as theretofore represented to the insurance companies; the issuance of the December 1946 common and preferred stock dividends and resulting adjustments to earned surplus and capital account and also the payment of certain cash dividends; the non-existence of any undisclosed contingent liabilities, pending suits or unusual contracts; the fact that there had been no negotiations for sale of the preferred to anyone but the insurance companies with reliance upon the latters' representation of purchase thereof for investment and that the issuance and private sale of the preferred would not fall within section 5 of the Securities Act of 1935, as amended; the appointment of a registrar and transfer agent for the preferred stock if requested; the subsequent furnishing of certified annual financial statements of the company to the insurance companies; the company's undertaking to have at the time of the closing of the purchase agreement a surplus of not less than $ 350,000 available for dividends on the preferred stock; and the company's agreement that its covenants and representations shall survive the execution of the purchase agreement and delivery of the preferred stock.↩
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. * * *
* * * *
(f) Stock Dividends. --
(1) General rule. -- A distribution made by a corporation to its shareholders in its stock or in rights to acquire its stock shall not be treated as a dividend to the extent that it does not constitute income to the shareholder within the meaning of the Sixteenth Amendment to the Constitution↩.
4. "The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration."↩
5. In the Revenue Act of 1913 Congress made no specific provision for taxing stock dividends and in Towne v. Eisner, 245 U.S. 418">245 U.S. 418 (1918) it was held that a dividend of common on common was not intended to be taxed as income. The Revenue Act of 1916, section 2 (a), in defining the term dividendsprovided, that a "stock dividend shall be considered income, to the amount of its cash value." In a test of that provision in Eisner v. Macomber, 252 U.S. 189 (1920), involving a dividend on outstanding common paid in common stock against earned surplus invested in plant and property for corporate purposes, it was held that under the Sixteenth AmendmentCongress lacked the power "to tax without apportionment a true stock dividend made lawfully and in good faith, or the accumulated profits behind it, as income of the stockholder [emphasis added]," and that the 1916 Act in imposing a tax because of such a dividend contravened cited clauses of Article 1 of the Constitution. Thereafter (as subsequently noted in the Koshland and Griffiths cases), although the Macomber case dealt with a stock dividend of common on common, it was immediately given a broader interpretation as a basis for tax exemption of stock dividends. In section 201 (d) of the 1921 Revenue Act Congress provided that "A stock dividend shall not be subject to tax * * *" and that statute and subsequent reenactments thereof until the 1936 Act were construed by Treasury Regulations as exempting all dividends paid in stock of the distributing corporation even though in the intervening years the Supreme Court had pointed out in numerous cases involving reorganizations that a distinction existed between the Macomber type of stock dividend and one which gave the stockholder a different proportionate interest than before. In Koshland v. Helvering, 298 U.S. 441">298 U.S. 441 (May 18, 1936) involving the basis for determining gain, under the Revenue Acts of 1926 and 1928, upon a sale or other disposition of preferred shares on which a dividend in voting common had been declared, the Court held that the dividend common shares gave the stockholder an interest different than theretofore owned and constituted income within the Sixteenth Amendment even though Congress had not taxed it as of the time of its receipt and therefore the basis of the preferred was not to be apportioned between the two classes of stock. The same rule was applied in Helvering v. Gowran, 302 U.S. 238">302 U.S. 238 (1937) involving a similar question under the 1928 Act, but where the taxpayer received a dividend of preferred on common when both classes were outstanding. In the Revenue Act approved June 22, 1936, Congress enacted a provision since retained in the law (section 115 (f) (1) of that Act and of the Code) which, while expressed in negative terms, taxes all stock dividends which constitute income within the Sixteenth Amendment. That provision was involved in Helvering v. Griffiths, 318 U.S. 371">318 U.S. 371 (March 1, 1943) wherein the Government sought to have the Supreme Court reconsider and overrule the Macomber case, but the Court did not reach that issue because it concluded that the statute before it did not undertake to impose the tax that was there challenged. The Court made an exhaustive review of the tax legislative history and court decisions on stock dividends and held that the new taxing provision was not intended as a Congressional attack on the law expressed in the Macomber case which remained the law except that the Koshland decision in effect limited Macomber to the kind of stock dividend there dealt with. In Helvering v. Sprouse and Strassburger v. Commissioner, decided together at 318 U.S. 604">318 U.S. 604 (April 5, 1943), involving section 115 (f) (1) of the 1936 Act, Sprouse received a dividend of nonvoting common on voting common in a pro rata distribution on both voting and nonvoting common outstanding, and Strassburger as the owner of the entire stock of a corporation received a dividend of preferred on common. With little discussion the Court held that neither stock dividend was taxable under the statute within the rule in the Griffiths case, in that as to Sprouse there was no change in the relationship amongst the stockholders or between them and the corporation and as to Strassburger, he owned the entire interest in the corporation both before and after. The Court distinguished Koshland↩, saying that in the circumstances there disclosed the common stock dividend on preferred with both classes outstanding was income in that there was a resultant essential change in the proportional interest of the stockholder.
1. Strassburger v. Commissioner, 318 U.S. 604">318 U.S. 604↩.
2. See, e. g., Edwin L. Wiegand, 14 T.C. 136">14 T. C. 136, reversed sub nom. Tourtelot v. Commissioner (C. A. 7), 189 F.2d 167">189 F. 2d 167, affd. (C. A. 3), 51-5 C. C. H. para. 9365 (June 26, 1951), 51-4 PH para. 72484, reversed on rehearing (C. A. 3), 194 F. 2d 479↩.
3. Of the eight justices participating in the Griffiths case ( Helvering v. Griffiths, 318 U.S. 371">318 U.S. 371), three dissented on the ground that after the 1936 amendment all stock dividends were taxable. Of the same eight justices participating in the Strassburger case these three apparently felt themselves committed by the Griffiths decision, but three different ones dissented on the ground that, although some stock dividends were not taxable, that case was ruled by Koshland v. Helvering, 298 U.S. 441">298 U.S. 441 -- which of course was the basis for the decision in Kelly Trust, infra -- that preferred on common had always been a taxable dividend even before the amendment. Thus, six out of the eight participating justices would presumably have held the Strassburger dividend taxable had that case been presented before the Griffiths case. See DeWind, "Preferred Stock 'Bail-Outs' and the Income Tax," 62 Harv. Law Rev. 1126, 1145; Darrell, "Recent Developments in Nontaxable Reorganizations and Stock Dividends," 61 Harv. Law Rev. 958↩.
4. This decision was at first affirmed on the same theory as that adopted in the opinion below (C. A. 8), 39-4 C. C. H. para. 9624 (July 19, 1939). Due, however, to the retroactive amendment to the basis provisions of section 113, that opinion was withdrawn and the case remanded for disposition in accordance with the subsequently enacted legislation, 106 F. 2d 1002↩.
5. "* * * It is obvious the preferred stockholders received property rights of actual and exchangeable value which changed the proportionate interest in the net assets of the corporation as between the preferred and the common stockholders." (p. 321.)↩