47 Tax Notes 1635

Tax Notes

JUNE 25, 1990

LENGTH: 1450 words

DEPARTMENT: Current and Quotable (CQT)

CITE: 47 Tax Notes 1635

HEADLINE: 47 Tax Notes 1635 - CAPITAL GAINS AND DEADWOOD: SECTION 301(c)(3).

AUTHOR: Johnson, Calvin

University of Texas School of Law

TEXT:

Set forth below is the full text of a June 10, 1990 letter to Ronald A. Pearlman, chief of staff of the Joint Committee on Taxation, from Calvin Johnson, Arnold, White & Durkee Centennial Professor of Law, University of Texas School of Law, Austin, Tex. The full text of the letter also has been placed in the July 2, 1990 Tax Notes Microfiche Database as Doc 90-4405.

Dear Mr. Pearlman:

In connection with the proposed rate reductions for capital gains, the JCT staff should be working to simplify the law of capital gains and to clean out some of the deadwood. The historical law of capital gains has anomalies and convolutions that have nothing to do with increasing voluntary realizations nor with any other articulated rationale for lowering rates for capital gains. In the compromises that will inevitably occur, members of Congress on both sides of the aisle can support staff work that rationalizes and recodifies the law to strike the most glaring anomalies. It is the duty of the staff, moreover, to help members avoid misunderstanding what the term 'capital gains' means when they vote and avoid letting decisions reached under one set of policies or definitions govern where the decisions do not rationally apply. Congress also can call on the Treasury Department to study the historical law of capital gains with a view toward identifying the areas where the law can be simplified because the rate cuts are inappropriate.

Congress should, for instance, reverse section 301(c)(3), which now provides that a corporate distribution to a shareholder 'shall be treated as a sale or exchange' if the distribution exceeds both the corporation's earnings and profits ('E&P') and the shareholder's basis. Treatment as a deemed 'sale or exchange' means the distribution usually qualifies as a capital gain.

Distributions falling only under section 301(c)(3) are not in fact sales or exchanges nor appropriately treated as capital gains. Normal corporate distributions on stock are ordinary income rather than capital gain because 'the shareholder retains his underlying investment interest, and neither his voting power or rights to future income have been altered.' Cohen, Surrey, Tarleau & Warren, 'A Technical Revision of the Federal Income Tax Treatment of Corporate Distributions to Shareholders,' 52 Colum. L. Rev. 1, 5 (1952). Section 301(c)(3) distributions are like rent or interest or a carve out payment on property the taxpayer has retained. Since there is no real sale or exchange, the distributions are no more under shareholder voluntary control than ordinary income is; thus, reducing the tax on the section 301(c)(3) distributions cannot be expected to increase realizations sufficiently to approach revenue neutrality. Distributions that effect a liquidation or 'meaningful reduction' of the shareholder's fractional interest in the corporation would continue to qualify for capital gain under IRC sections 302 or 331, notwithstanding the repeal of section 301(c)(3).

The fact that the corporate distribution exceeds both E&P and basis provides no independent policy reason why the tax rate should be lower than normal. Distributions falling under section 301(c)(3) are not subject to double tax on corporate income because if the corporation had paid corporate tax on the amounts distributed, the corporate income would have increased earnings and profits and brought the distribution out of section 301(c)(3). Similarly the distribution cannot be viewed as a passthrough to the shareholder of the proper tax character of the transaction determined at the corporate level: again if a corporation had had capital gain, that would have increased earnings and profits and made section 301(c)(3) not apply.

The shareholder has recovered all of his capital before section 301(c)(3) can apply so that the shareholder has no capital that needs to be indexed for inflation. Since the shareholder has withdrawn and recovered all his capital for section 301(c)(3) to apply, the distribution cannot fairly be attributed to a return on or appreciation of the shareholder's already-taxed capital. There is no necessary bunching of many years of income because the stock is retained and there will be future distributions.

Distributions by a corporation in excess of earnings and profits tend to occur because the corporation's earnings and profits account failed to describe the corporation's unrestricted and distributable income. Taxpayers who get into section 301(c)(3) situations tend to be scoundrels who take advantage of the accounting misdescriptions. In Commissioner v. Gross, 236 F.2d 612 (2d Cir. 1956), for instance, developers saved over $3 million in tax by distributing profits before they had sold the houses their corporation had built. If the distributions had occurred after the constructed houses had been sold, the distributions would have been out of earnings and profits, rather than capital gain. In Divine v. Commissioner, 500 F.2d 1041 (2d Cir. 1974), the corporation would have had earnings and profits except for qualified stock compensation given out to its executives. The court gave the corporation a double reduction in earnings and profits -- once for the stock that represented future dividends and once for the dividends themselves. The accounting was like allowing a corporation a deduction for an expense both when it accrues and when it is paid.

Congress has amended section 312 repeatedly to try to prevent the accounting anomalies that allow distributions that are not out of earnings and profits, but the job of constantly repolicing earnings and profits accounting is hard and ongoing and leads to extraordinarily convoluted law. It is time to simplify by reducing the inappropriate tax advantages to be gained from distributions not out of earnings and profits.

Section 301(c)(3), as a matter of history, arose from concepts of 'capital' that have nothing to do with modern tax thinking and which have largely been abandoned elsewhere. Early in the income tax, the term 'capital' was associated with the concept of 'corpus' under early British property and trust law, rather than with the concept of 'basis' or 'adjusted basis' as it is today. Under feudal property systems, land was the primary form of wealth and most land was entailed for the benefit of heirs and could not be sold. In a trust, the land was the 'corpus' that had to be preserved for the remainderman. The only 'income' that could be distributed to a life tenant or income beneficiary was the proceeds of the annual harvest, i.e., the fruits of the land. See, e.g., L. Seltzer, 'The Nature and Tax Treatment of Capital Gains and Losses' 26-35 (1951). Section 301(c)(3) was originally adopted under the vaguely felt view that corporate E&P identified the only harvest or 'income,' so that distributions in excess of E&P had to be 'capital.'

More modern thinking identifies 'capital' with 'invested cost' or 'basis.' In 1921, for instance, the Supreme Court finally settled that an 'income' tax could reach the proceeds of sales of corpus property to the extent the proceeds were in excess of the taxpayer's basis. (Merchants' Loan & Trust Co. v. Smietanka, 255 U.S. 509 (1921)). Under modern concepts of 'capital,' a taxpayer does not have a return or recovery of his 'capital' if the amount received is greater than his adjusted basis. Once the taxpayer has recovered his adjusted basis, the distributions are properly taxed under modern notions as noncapital distributions just as like any other distribution.

Our most respected commentators have recommended repeal of the earnings and profits account in full (primarily because the E&P account does not do a good job of distinguishing between income and reduction of investment) to treat all distributions that are not redemptions or liquidations as ordinary income. See Andrews, 'Out of Its Earnings and Profits: Some Reflections on the Taxation of Dividends,' 69 Harv. L. Rev. 1403 (1956); Blum, 'The Earnings and Profits Limitation on Dividend Income: A Reappraisal,' 53 Taxes 68 (1975); Colby, Blackburn & Trier, 'Eliminating Earnings and Profits from the Internal Revenue Code,' 39 Tax Lawyer 285 (1986) (ABA Task Force). The proposal here to take away the capital gains advantage of distributions in excess of E&P and basis is consistent with those proposals, but it does not go so far. It is more of a clearing of deadwood than a fundamental reform.

Please call on me if I can provide any further aid or information.

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Sincerely,

Calvin H. Johnson

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