32 Tax Notes 267

Tax Notes

JULY 21, 1986

LENGTH: 3154 words

DEPARTMENT: Special Reports (SPR)

CITE: 32 Tax Notes 267

HEADLINE: 32 Tax Notes 267 - DEDUCTION OF NONPRORATA SHAREHOLDER CONTRIBUTIONS IS A VIOLATION OF THE PRINCIPLES OF TAXATION.

AUTHOR: Johnson, Calvin H.

University of Texas Law School Tax Analysts

TEXT:

Calvin H. Johnson is a Professor of Law at the University of Texas School of Law. In this article, Professor Johnson argues that the Sixth Circuit decision in Fink v. United States wrongly allowed a loss deduction to a shareholder who voluntarily made nonprorata transfer of his stock to a corporation. He argues that such a transfer is a capital expenditure or investment by the shareholder, not a loss transaction. Even if there were a loss, the loss should be a capital loss. He recommends that current legislation reverse this result.

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In Fink v. United States, No. 84-1806, (6h Cir., April 30, 1986), the Sixth Circuit held that a shareholder could get an ordinary loss deduction for a voluntary, nonprorata transfer of his stock to his corporation. The transfer was intended to strengthen the shareholder's remaining shares and to facilitate sale of control of the corporation. Under the norms and consensus of taxation, the transfer was a capital expenditure. Giving an ordinary loss deduction for what is in fact an investment, and certainly no more than a capital loss, is a serious violation of the norms of taxation. The Second Circuit (Frantz v. Commissioner, No. 85-4062 (Feb. 1986)), the Fifth Circuit (Schleppy v. Commissioner, 601 F.2d 196 (1979)) and the Tax Court (Frantz v. Commissioner, 83 T.C. 162 (1984)) have correctly held that a nonprorata contribution is no deductible loss. Fink is, moreover, inconsistent with paramount Supreme Court authority.

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I. No Loss Was Incurred

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When a shareholder gives up stock in a nonprorata transfer to or for the benefit of his corporation, the shareholder must add his basis in the stock given up to his basis in his retained stock. The shareholder will thus have a capital gain or loss when he sells the retained stock rather than an ordinary deduction when he surrenders stock to prepare for the sale.

A. Capitalization

The costs of the transferred stock are a capital expenditure. The costs are not a loss, but 'assimilated into the cost' of the shareholder's retained interest. Idaho Power v. Commissioner, 418 U.S. 1, 14 (1974); Johnson, Tax Models for Nonprorata Shareholder Contributions, 3 VA. TAX REV. 81, 106 n. 131 (1983). Capital expenditure treatment overrides any other deduction authorization. Internal Revenue Code ('IRC') section 161; Idaho Power, 418 U.S. at 4.

1. Protection of Shareholdings. The shareholder surrenders his stock to preserve his remaining investment in the corporation. That motive mandates capitalization. 'Payments made by a shareholder of a corporation for the purpose of protecting his interest therein must be regarded as additional cost of his stock and such sums may not be deducted as ordinary and necessary expenses.' Eskimo Pie Corp. v. Commissioner, 4 T.C. 669, 676 (1945) and cases cited 3 VA. TAX REV. at 89-90. Capitalization is required whether the costs are incurred in cash or attached to stock. A nonprorata surrender of stock used to pay employees of the corporation, for instance, was held by the Tax Court, early in the history of the tax law, to be 'a capital transaction designed . . . to increase the value of the stock remaining in the shareholder's hands rather than expense in the current taxable year.' Ames v. Commisioner, 14 B.T.A. 1067 (1929) aff'd. 49 F.2d 853 (8th Cir. 1931) and cases cited 3 VA. TAX REV. at 87-89. Under paramount Supreme Court holdings, a shareholder's costs as shareholder are not ordinary deductions. (Deputy v. Dupont, 308 U.S. 488 (1940); Interstate Transit Line v. Commissioner, 319 U.S. 590 (1943)). See 3 VA. TAX REV. at 122-124. A taxpayer using his property to create or protect a capital asset must capitalize the cost to the retained property. Idaho Power v. Commissioner, 418 U.S. 1 (1974).

2. Costs Incidental to Sale. In Fink and Frantz, the shareholder surrendered his shares to improve the corporation's balance sheet to facilitate a sale to an outsider. Costs incidental to a capital transaction must be capitalized as a part of that transaction. Woodward v. Commissioner, 397 U.S. 572 (1970); United States v. Hilton Hotels Corp., 397 U.S. 580 (1970) and cases cited, 3 VA. TAX REV. at 90. The tax character of the transaction is determined by the larger transaction to which it relates. Arrowsmith v. Commissioner, 344 U.S. 6 (1952). The basis of the surrendered stock is accordingly related to the sale for tax purposes by adding the basis of the surrendered stock to the basis of the retained stock that will be sold.

3. Contribution to Capital. A contribution to the capital of a corporation is an example of capital expenditure. Treas. Reg. section 1.263(a)-2(f). Properly applied, 'contribution to capital' is a kind of shorthand, synonymous with capital expenditure. Fink and Frantz made a capital contribution or investment for the benefit of their corporation. But the contribution to capital test has sometimes misfocused the court's inquiry onto facts about the corporation instead of facts about the shareholder who makes the expenditure. See discussion, 3 VA. TAX REV. at 124-127. On the shareholder level, the shareholder has made a capital expenditure.

B. Open Transaction

A share of stock is a separate fragmented piece of property which can yield gain or loss when sold or disposed of, except when the transaction by which the stock is disposed of is an open transaction. A nonprorata shareholder contribution is an open transaction:

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'Whether the shareholder contributes stock or gives up part

of his stock . . . his reason for so doing is to protect and

make more valuable the stock which he continues to own. A

relationship between the stock he gives up and the stock that he

continues to hold is thus established and he can have no loss on

the one, when contributed but must wait until he finally

disposes of the other, for at that later time it may develop

that he has a gain on the whole transaction.' Murdock, J.

dissenting in Wright v. Commissioner, 18 B.T.A. at 473 (1929)

and cases cited 3 VA. TAX REV. at 107.

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The open transaction doctrine is a useful alternative rationale for reaching thesame result as capital expenditure. It is the primary rationale in the Tax Court. Frantz v. Commissioner, 83 T.C. 162 (1984).

C. Recapture of the Transferred Interest

1. Reduction of the Loss. No loss is allowed for pro rata contributions of stock because 'the remaining shares absorb the value inherent in the surrendered certificates.' Scoville v. Commissioner, 18 B.T.A. 261, 264 (1929) and cases cited, 3 VA. TAX REV. at 108. A surrender of stock has two parts. First the shareholder loses what he gives up. Then he recaptures part or all of what he gives up when the surrendered shares cease to be part of the outstanding fractional ownership. In Frantz, for instance, shareholder recaptured 65 percent of what he gave up (and 65 percent of what the other shareholder gave up) because he owned 65 percent of the common stock (the remainder interest) of the corporation's stock after the transaction was finished. In Fink the shareholder recaptured 68.5 percent of the stock given up. The shareholder's real loss in Frantz thus could not exceed 35 percent of his basis given up and in Fink could not exceed 31.5 percent of the stock given up. Burdick v. Commissioner, 20 B.T.A. 742 (1930) aff'd. 59 395 (3d Cir. 1932).

2. No Meaningful Reduction in Interest. No loss at all is allowed where the amount recaptured upon cancellation is so great that the shareholder has no meaningful reduction of his fractional interest under the Supreme Court's test in United States v. Davis. Schleppy v. Commissioner, 601 F.2d 196 (5th Cir. 1979), discussed at 3 VA. TAX REV. at 98-99. The Davis test and the nonprorata shareholder cases allowing losses are two prongs growing from Eisner v. Macomber, 252 U.S. 189 (1920), where the Supreme Court held that a pro rata stock dividend was not a meaningful enough event for tax. Macomber was used against the taxpayer in Scoville, 18 B.T.A. 261 (1929) to deny a loss on a pro rata surrender of stock because it was not economically meaningful; Scoville was distinguished in early tax cases allowing a loss on a nonprorata surrender, but the contribution must be substantially nonprorata. Murphy v. Commissioner, 4 T.C. M. 813 (1945) and cases discussed at 3 VA. TAX REV. at 92 n.50. The border between substantially pro rata and substantially nonprorata has been developed most richly in the other, redemption prong of the Macomber line of cases. Congress enacted the predecessor of section 302 to prevent the meaningless economic events of pro rata stock issues followed by pro rata redemptions from being the occasion to bail out corporate earnings. Section 302(b)(2) requires substantially nonprorata redemptions effecting real economic dispositions for the redemption to qualify as capital gain; the redemption must reduce the shareholder's interest to below 50 percent, so that the shareholder recaptures less than most of what he gives up. IRC section 302(b)(2)(B). In Davis the Supreme Court defined a significant enough change for a redemption to be considered a sale rather than 'substantially equivalent to a dividend' under section 302(b)(1). The sale must effect a substantial reduction of the shareholder's economic interest. Davis and section 302(b)(2) are appropriately applied to distinguish substantially pro rata from substantially nonprorata contributions, because they define meaningful economic events within the Macomber tradition.

In Frantz the shareholder gave up none of his common shares and he lost none of his fractional residual interest. In Fink the shareholder went from a 72.5 percent shareholder to a 68.5 percent shareholder. Neither shareholder had a meaningful reduction of his economic interest. Both recaptured more than 50 percent of what they gave up. IRC section 302(b)(2)(B).

(NOTE: This argument, while inherent in the cases first allowing losses on nonprorata contributions, while adopted by the Fifth Circuit and Tax Court and while cumulative to the capitalization rationale in result, is more convoluted than capitalization. Capitalization is a cleaner, simpler rationale.)

D. No Loss Occurred

'Loss' within the meaning of section 165 is an ambiguous word, but shareholders in nonprorata transfer claim loss under section 165 for something that is not a loss. The transfer was purely voluntary. 3 VA. TAX REV. at n. 134. The shareholder participates in the transfer too willingly for it to resemble a casualty loss or market decline. Real losses are not voluntarily incurred. The securities transferred still had value (If it did not, then section 165(g) governing worthless securities would deny the ordinary loss anyway (see II.D., below). The property was not abandoned. 3 VA. TAX REV. at 106 n.133. The transfer did not represent the expiration of any costs. Nor is the loss like the totalling upon completion of an investment in which 'loss' represents the excess of costs over income. 3 VA. TAX REV. at n.135. If the surrender was a 'loss' in any sense of the word, it is the kind of 'loss' that is synonomous with the phrases 'protective investment' and 'capital expenditure' and such expenditures are capitalized.

E. Fragmentation

In Fink, the court held that stock surrendered was an ordinary loss because stock is not unitary but fragmented. The 'fragmented' argument is a red herring. All stock is of course fragmented: the sale of any share of stock purchased in a block can produce gain or loss. The shareholder does not need to await disposition of his whole interest before computing any gain or loss if the sale is to an outsider. But even fragmented assets yield capital expenditures. Debt is similarly fragmented: purchase of debentures in a block and disposition in pieces requires the basis of the block to be allocated among the pieces; disposition of every piece can produce a gain or loss. (Treas. Reg. section 1.61-6(a)(Ex. 1)). Yet a nonprorata surrender of a debenture is no loss but rather an addition of its costs to the basis of shares retained. Perlman v. Commissioner, 252 F.2d 980 (2d Cir. 1958); Lidgerwood v. Commissioner, 229 F.2d 241 (2d Cir. 1956). Cash is similarly fragmented:

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'Each dollar is separate enough from other dollars for the

disposition of a single dollar to have tax consequences. A tax

system in which all of a taxpayer's dollars are considered so

unitary that no tax loss could arise unless the taxpayer had

disposed of all his cash is inconceivable. Cash and stock are

'fragmented' in the same sense.' 3 VA. TAX REV. at 106.

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Yet, nonprorata cash surrenders by a shareholder to or on behalf of his corporation are still capitalized costs. See, e.g., Deputy v. DuPont, 308 U.S. 488 (1940) (16 percent SH); Rand v. Commissioner, 35 T.C. 956 (1961) (33 percent SH); Ihrig v. Commissioner, 26 T.C. 73 (50 percent SH). The basis of each share of stock surrendered can be conceded as a separate cost -- and it has to be considered a separate cost if there is going to be any loss -- but the cost must still be assimilated into the cost of the interest that the shareholder retained. The fragmentation argument is not sufficient for the taxpayer to win.

F. Cases Allowing Ordinary Deduction

Cases allowing an ordinary loss have never considered capitalization. Judge L. Hand, for instance, showed that capitalization was not an issue before his court when he stated that the question in a nonprorata contribution was of allowing deduction of the shareholder's cost ''now or never.' Scherman v. Helvering, 74 F.2d 742, 743. Capitalization means not 'never' but that the costs are allowed when the retained stock is sold. The failure of the courts in the cases allowing ordinary loss to consider the question of capitalization renders the cases useless as precedents.

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II. Capital Loss

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A loss from a nonprorata surrender of stock, if considered realized notwithstanding the prior arguments, would nonetheless be a capital loss. Even under the tax bill now under consideration, there are limitations on the deduction of capital losses (IRC section 1211) and thus a distinction remains between ordinary and capital losses. The loss arising from a nonprorata surrender is a capital loss. The surrender is a capital loss because the surrender is a 'sale or exchange,' because ordinary loss would tilt the level playing field to encourage inferior investments, because the transfer was for tax avoidance, and because Congress mandated that losses from worthless securities be capital losses.

A. Constructive Sale or Exchange

A nonprorata surrender is a sale or exchange if a loss must be recognized. Downer v. Commissioner, 48 T.C. 86 (1967) discussed, 3 VA. TAX REV. at 100-104, 115-119. The transfer to the corporation was voluntary (See 3 VA. TAX REV. at n. 134) and the shareholder must be presumed to be rational. If he was rational, he must have received some intangible consideration in return for his transfer; absent the return, the shareholder was making a gift. 3 VA. TAX REV. at n. 133 citing Mack 129 F.2d 598 (2d Cir. 1942). Under Downer the intangible consideration which the shareholder received for his surrender makes the transaction a constructive sale. The function of the constructive sale or exchange doctrine is to prevent inappropriate ordinary losses and lead toward the capitalization result. 3 VA. TAX REV. at 115-119. The loss if any was accordingly capital loss from the sale or exchange of a capital asset.

B. Encouraging Inferior Investments

Ordinary deductions from some investments, including protective investments, but not other investments, will lead to inferior investments made solely for tax purposes. Under current law, an investment taxed in a normal way would have to yield a 75 percent economic profit just to catch up with a contribution that just breaks even, if the contribution is allowed as an ordinary deduction. 3 VA. TAX REV. at 110-113.

C. Tax Avoidance Purposes

Ordinary deduction of property encourages tax avoidance since shareholders would make nonprorata contributions of assets that have decreased in value merely to transmute what would be a capital loss into an ordinary deduction. United States v. Keeler, 308 F.2d 424 (9th Cir. 1962) and cases cited, 3 VA. TAX REV. at 159. The transactions in Frantz and Fink were plausibly for tax avoidance rather than for nontax business purpose.

D. Abandonment

Even if a surrender were not a constructive sale or exchange, still the loss is a capital loss since section 165(g) makes losses upon worthless securities a capital loss. If the transaction was not a sale or exchange (see II.A., above) because no intangible consideration was in fact received, then it follows that the securities voluntarily and rationally given up were worth what was received, i.e., the securities were worthless.

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III. What is the Status Quo?

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In Frantz and before the congressional staff, the taxpayers have characterized prior law so as to claim they must win under stare decisis or are entitled to protection from retroactive changes before Congress acts to end their abuse. The argument misdescribes the cases. The pre-existing case law (except for the simple paramount solution of capitalization) is in fact a morass: 'In over 50 years of cases, the courts . . . have applied three mutually inconsistent models. While each model imposes a different character and tax result on the transaction, each model has a rationale and a result that could govern all nonprorata contributions.' 3 VA. TAX REV. at 82. 'Three inconsistent models, each applicable to the full range of nonprorata contributions have led to inconsistent decisions on the same fact pattern and to wavering among the models. The Tax Court has changed its position eight times on the issue. Even in the few times the court attempted to distinguish prior cases, the proferred distinctions are not persuasive.' 3 VA. TAX REV. at 85. Arguably three inconsistent models are insufficient to describe the law; it plausibly took at least 14 categories to describe the mess. 3 VA. TAX REV. n.22. It is easy to simplify the pre-existing law by ignoring most of it. In any event, cases allowing ordinary loss upon a nonprorata contribution do exist, but they are the weakest of the three existing lines. The line is 'not tenable.' 3 VA. TAX REV. at 86. It is an 'odd forgotten island' allowing an immediate ordinary loss for what were in fact capital investments by the shareholder. 3 VA. TAX REV. at 108. The Tax Court was not so much reversing itself in Frantz as it was bowing to paramount authority.

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