
    MINETTE G. STEIN v. THE UNITED STATES
    [No. 45596.
    Decided October 1, 1945]
    
      The Reporter’s statement of the ease;
    
      Mr. Llewellyn A. Luce for the plaintiff.
    
      Mr. J. W. Hussey, with whom was Mr. Assistant Attorney General Samuel O. Glarh, Jr., for the defendant. Messrs. Robert N. Anderson and Fred K. Dyar were on the brief.
   Madden, Judge,

delivered the opinion of the court:

The plaintiff, at the time of the original formation of the Puro corporation in 1926, acquired by subscription shares of its Class B 6% preferred $100 par value stock, at $100 per share. With each share of preferred went a share of common stock of no par value. Neither the plaintiff nor any other stockholder paid any separate cash consideration for the common stock, though they assigned to the corporation an option for exclusive negotiation with the stockholders of the Chicago Water Purifying Company for the purchase of their stock, which option had been acquired by S. M. Stein, the plaintiff’s husband, the moving party in the formation of Puro, and had been assigned by him to the small group of his friends and associates who subscribed for stock in Puro. The Chicago company had an established business of selling and leasing water filters.

The investors in Puro stock thought that their investment was somewhat speculative, as to the security of their capital since the physical property of the Chicago company whose stock they hoped to obtain was a specialized machinery which would have little salvage value if Chicago should, as it might, install a municipally owned filtration plant. They also were aware, at the time they subscribed for their stock, that the purchase of the Chicago company’s stock might fall through, in which case they would have wanted to get their money' back. For these reasons, perhaps inter alia, they had the articles of incorporation of Puro provide for the redemption of the Class B preferred stock upon order of the board of directors.

The stock of the Chicago company was obtained and the business was operated profitably. No dividends were paid on the Puro common stock until 1936, but, beginning in 1932, approximately one-tenth of the preferred stock of the company was redeemed each half year, so that by the end of 1936, eight of these redemptions had occurred and most of the preferred stockholders had been paid four-fifths of the amounts originally paid for their stock. Yet on January 1, 1936, Puro had undivided profits of $353,013.17, or considerably more than the amount originally paid for the Class B preferred and the common stock.

The plaintiff was required to pay income taxes upon the payments made to her upon the redemption of her preferred stock, upon the basis that these payments were, for tax purposes, the equivalent of dividends, and were not returns of capital. For the taxes so paid by the plaintiff on the $12,033.24 of redemption money she received in 1936, she brings this suit.

Section 115 of the Revenue Act of 1936, c. 690, 49 Stat. 1648, says:

(a) Definition of Dividend. — The term “dividend” when used in this title (except in section 203 (a) (3) and section 207 (c) (1), relating to insurance companies) 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.
(c) Disteibutions in Liquidation. — Amounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock, and amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock. The gain or loss to the dis-tributee resulting from such exchange shall be determined under section 111, but shall be recognized only to the extent provided in section 112. Despite the provisions of section 117 (a), 100 per centum of the gain so recognized shall be taken into account in computing net income, except in the case of amounts distributed in complete liquidation of a corporation. For the purpose of the preceding sentence, “complete liquidation” includes any one of a series of distributions made by a corporation in complete cancellation or redemption of all of its stock in accordance with a bona fide plan of liquidation and under which the transfer of the property under the liquidation is to be completed within a time specified in the plan, not exceeding two years from the close of the taxable year during which is made the first of the series of distributions under the plan. In the case of amounts distributed (whether before January 1,1934, or on or after such date) in partial liquidation (other than a distribution within the provisions of subsection (h) of this section of stock or securities in connection with a reorganization) the part of such distribution which is properly chargeable to capital account shall not be considered a distribution of earnings or profits.
$ H* $ ‡ $
(g) Redemption of Stock. — If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.
(i) Definition of Partial Liquidation. — As used in this section the term “amounts distributed in partial liquidation” means a distribution by a corporation in complete cancellation or redemption of a part of its stock, or one of a series of distributions in complete cancellation or redemption of all or a portion of its stock.

Treasury Regulations 94, promulgated under the Revenue Act of 1936, contains the following:

ART. 115-9. Distribution in redemption or cancellation of stock taxable as a dividend. — * * *.
The question whether a distribution in connection with a'cancellation or redemption of stock is essentially equivalent to the distribution of a taxable dividend depends upon the circumstances of each case. A cancellation or redemption by a corporation of a portion of its stock pro rata among all the shareholders will generally be considered as effecting a distribution essentially equivalent to a dividend distribution to the extent of the earnings and profits accumulated after February 28, 1913. On the other hand, a cancellation or redemption by a corporation of all the stock of a particular shareholder, so that the shareholder ceases to be interested in the affairs of the corporation, does not effect a distribution of a taxable dividend. A bona fide distribution in complete cancellation or redemption of all of the stock of a corporation, or one of a series of bona fide distributions in complete cancellation or redemption of all of the stock of a corporation, is not essentially equivalent to the distribution of a taxable dividend. * * *

The Government says that Section 115 (g), quoted above, is applicable; that the payments to the plaintiff in redemption of her preferred stock were made to her “at such time and in such manner as to make the distribution * * * essentially equivalent to the distribution of a taxable dividend * * *”; and that they were, therefore, properly taxed. We agree. The corporation had large net earnings, and had no thought of liquidating its operating assets, or curtailing its operations. It was distributing a part of its net earnngs or profits. If it had, as it might have, distributed some of those earnings to the holders of its common stock, that distribution would undoubtedly have been a taxable dividend. Instead, it distributed the earnings as the price of the redemption of its preferred stock. To whatever extent the ownership of the preferred and common stock was, as it was of the time of the original issue, in the same persons, share for share, the distribution went to the same persons in the same amounts as it would have gone if it had been distributed as a dividend on the common stock. The shares, the redemption money for which was taxed to the plaintiff, were shares originally issued to her. The record does not show whether she still had the common shares similarly acquired, though it does show that she still had common shares. If there had been a change in the facts in this regard, and if it is material whether there was such a change, the plaintiff could and should have proved the facts as they were in 1936.

One of the reasons for the provision in Puro’s articles of incorporation for redemption of the preferred stock was the thought of the original investors that, while the business might be profitable for a time, it might be ruined, with a large loss of capital asset value, by the installation by the City of Chicago of a municipal filtration plant. The investors seem, therefore, to have desired to have their capital paid hack to them out of current profits, while retaining, in their common shares, the share in the earnings of the company which they had before, less the 6% which the preferred stock paid.

The plaintiff contends that, since the redemption was an honest business transaction, it is not taxable. We think that the question of whether a distribution is “essentially equivalent to the distribution of a taxable dividend” under section 115 (g) does not depend on the presence or absence of honesty in the distribution: The question is, as the statute makes it, a question of equivalence, and if that is present, the statute expressly taxes the distribution.

In Rheinstrom v. Conner, Collector of Internal Revenue, 125 F. (2d) 790, the Circuit Court of Appeals for the Sixth Circuit listed a number of factors which are of assistance in determining equivalence. On the facts before us, as recited in the findings, we think the requisite equivalence was present and the payments were taxable as income.

The plaintiff’s petition will be dismissed. It is so ordered..

JoNes, Judge/ and Whaley, Chief Justice, concur.

Whitaker, Judge,

dissenting:

The inclusion in plaintiff’s income of the entire amount received by her for the redemption of her preferred stock in the Puro corporation was proper only if “the distribution and cancellation or redemption in whole or in part [was] essentially equivalent to the distribution of a taxable dividend.” The majority opinion holds that it was. I do not think so.

Plaintiff and other holders of the preferred stock paid cash for it. They received their common stock in consideration of the transfer to the corporation of their option to purchase the stock of the Chicago Water Purifying Company. At the time they bought the preferred stock it was agreed that it would be redeemed at the discretion of the Board of Directors. It was redeemed pursuant to this agreement.

In the opinion and in the findings it is said that it was redeemed from earnings and profits. This is a conclusion that I do not think is justified. Whether or not it was redeemed from earnings or profits or with the money which these people originally paid for the stock, it is impossible to say.

Moreover, at the time it was redeemed some of the holders held only the preferred stock. They did not own any common stock, and when their preferred stock was redeemed, their interest in the company ceased. Nor is it true that the preferred stock was redeemed pro rata until after the corporation called it and required all holders of it to permit its redemption. Before this some of the holders of it preferred to keep the stock and declined to allow it to be redeemed.

For the distribution to have been essentially equivalent to the payment of a dividend, the distribution must have been out of earnings and profits, it must have been pro rata, and it must have been to persons who remained stockholders after the redemption. It did not fulfill these requirements and, therefore, I cannot agree that it was proper to include within the plaintiff’s income the entire amount she received upon the redemption of her stock.

LittlbtoN, Judge, concurs in the foregoing opinion.  