HARVARD LAW REVIEW VOL. XXXIII MAY, 1920 No. 7 TAXABILITY OF STOCK DIVIDENDS AS INCOME A T the formation of a corporation, five thousand shares of its stock, each of a par value of $100, were issued for $500,000. The business of the corporation was successfully conducted; some of its profits were distributed from time to time to its stockholders, and the balance was carried to surplus account; its net assets came to be worth $1,000,000, so that it had a capital of $500,000 and a surplus of $500,000; the directors believed it wise not to distribute this surplus to the stockholders, but to retain it permanently in the business; they therefore paid a stock dividend of 100 per cent. Thus the surplus was capitalized. A fund out of which dividends might have been paid to the stockholders at the discretion of the directors became part of the corporate capital, and so a part of funds out of which dividends might never be paid. Before the payment of the stock dividend, the book value of each share was $200. After the payment of the stock dividend, the book value of each share was $100. Before the dividend, a stockholder had, say, one hundred shares; each of these shares had a book value of $200, so that the total book value of his shares was $20,000. After the dividend, this stockholder has two hundred shares; each of these shares has a book value of $100, so that the total book value of his shares remains at $20,000. The stockholder has precisely the same fractional interest in the corporate undertaking that he had before. It is obvious that the book value of a stockholder's holdings cannot be increased a penny by a stock dividend. From this, many a man in the street leaps to the conclusion that a stock dividend is not income. A two-dollar bill, he says, has been exchanged for two one-dollar bills. This is superficial, the problem is declared closed before it has been opened. After Eisner v. Macomber, the recent decision of the Supreme Court on this matter, was handed down, the stocks of many corporations which were likely to declare stock dividends rose in market value. It may well be that the market value of a stockholder's holdings, as distinguished from their book value, is increased by a stock dividend. This result is produced by a number of considerations operating upon the minds of persons who buy stocks, of which the following may be mentioned: 1. The market value of a stock is determined only partly by the asset or book value; the amount of dividends which is being paid, or which is likely to be paid in the near future, determines the rate of return which a stockholder may expect, and the rate of return is an influential factor in determining market value. A belief that the directors are soon to increase the amount of dividends will usually cause the market value of the shares to increase. Now the financial history of corporations shows that, after a stock dividend is declared, the cash dividends thereafter declared (on the increased amount of stock outstanding) will usually total more than the cash dividends theretofore declared. Thus the stockholder with one hundred shares may have been receiving $8.00 a year per share, or a total of $800; after the stock dividend the rate of cash dividend on his two hundred shares is likely to be better than $4.00 a share. Thus the declaration of a stock dividend is a circumstance which frequently produces the same result as is produced when, for any other cause, a belief becomes current that an increase in the dividend rate is at hand. 2. Persons become accustomed to see a share of stock of a particular corporation sell around $200. When a share of that corporation is to be had at $110, there are many persons who do not analyze the matter but feel that they are now getting a share at much less than the normal value. And there is a surprisingly large number of persons who before the stock dividend would have been afraid to buy a share of stock at $200, because the stock was at 1 U. S. Sup. Ct., October Term, No. 318 (March 8, 1920). a dizzy height and might have a great fall, and yet, after the stock dividend, would feel quite safe in buying two shares of the stock at $110 a share. Even if, however, the market value of a stockholder's holdings is increased by a stock dividend, the government did not purport to measure the tax by this increase in market value. The tax was not a tax on the difference between the market value of a stockholder's holdings before and after the payment of the dividend; under the Revenue Act of 1916 it was a tax on the whole cash value of the stock issued as a dividend. Thus if we assume that the stock sold, before the stock dividend, at $200 a share, and that it sold, after the stock dividend, at $110 a share, the stockholder who had one hundred shares of a total market value of $20,000 and now has two hundred shares of a total market value of $22,000, would be subjected to a tax, not on $2000, but on $11,000. These considerations of market value, therefore, are not a legitimate basis for the tax which Congress imposed. Assume that, in a particular case, there was no increase even in the market value of a stockholder's holdings (and this was the fact in Eisner v. Macomber). This brings us back to the argument that the stock dividend is not income, because its payment does not cause an increase in the stockholder's wealth. Reflection will show that there is nothing in this argument. A taxpayer is employed by a solvent corporation which promptly pays its debts. He receives his weekly wage of $50 at one o'clock on each Saturday, when his week's work is done. He is not $50 richer at one o'clock than he was at 12:59. He has been growing richer throughout the week as he was earning the $50. When he received the $50 he exchanged a right for cash. Possibly the cash is worth a little more than the right-it is comforting to have the cash in hand- but the difference in the case supposed is very slight. No one would claim that the government may tax as income only the difference between the $50 and the value of the right at 12:59. Take the case of a cash dividend. If the corporation with a capital of $500,000 and a surplus of $500,000 pays a cash dividend of $100 a share, the book value of the shares drops from $200 to $100 a share. Instead of one hundred shares of a total book value of $20,000, the stockholder now has $10,000 cash, and one hundred shares of a total book value of $10,000. His wealth has not been increased by $10,000, and yet no one disputes but that the Government may tax the whole $10,000 cash dividend as income. There is one case in which a person's wealth is increased by the amount which he receives. That is when something is given to him. If $1000 is given to him, he is worth $1000 more the instant it is received than he was the instant before the receipt. But Congress itself has expressly declared that gifts are not income. It is not profitable to multiply examples. It may well be that a stock dividend is income, although the taxpayer's wealth is not increased at the moment of its receipt. In Pollock v. Farmers' Loan & Trust Co.2 the court held, inter alia, that taxes upon returns from investments of personal property were direct taxes and that Congress could not impose such taxes without apportioning them among the states according to population, as required by Article I, section 2, clause 3, and section 9, clause 4, of the Constitution. Thereafter the Sixteenth Amendment was passed providing that "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." In the Revenue Act of 1916 Congress declared that "the term 'dividends' as used in this title. shall be held to mean any distribution made or ordered to be made by a corporation . . . out of its earnings or profits accrued since March first, nineteen hundred and thirteen, and payable to its shareholders, whether in cash or in stock of the corporation . . . which stock dividend shall be considered income, to the amount of its cash value." In Eisner v. Macomber the Supreme Court decided, four judges dissenting, that Congress could not constitutionally tax stock dividends as incomes. Mr. Justice Pitney delivered the opinion of the majority. Mr. Justice Brandeis delivered the principal dissenting opinion. 3 What is the proper mode of approach for the Supreme Court in dealing with the constitutionality of an act of Congress? We do not open any discussion of that great question. If the question were new, it might be urged that the court should interpret the Constitutional provisions to the best of its ability, uninfluenced by any interpretation which Congress may have made, and should sustain or reject acts of Congress according as they conformed or did not conform to the Constitution so judicially interpreted. But the question is not a new question; the Supreme Court has repeatedly stated that, since it is dealing with the act of a coördinate branch of the government, it will pay great respect to the legislative interpretation of the Constitution, and that no act of Congress will be declared unconstitutional if it is consistent with any reasonable interpretation of the Constitution. Our question therefore becomes this: Was this provision in the Revenue Act of 1916 consistent with any reasonable interpretation of the Constitutional provisions mentioned above? We should note at once the different methods of taxation which Congress has employed and now employs in taxing trusts, partnerships, and corporations. A trustee takes in the trust income, and distributes the net income to beneficiaries. Here are two acts, the receipt of income by the trustee, and the receipt of the net income by the beneficiaries from the trustee. Conceivably Congress might have enacted that the trustee should be taxed upon his receipt of income, and then that the beneficiaries should be taxed upon their receipt of net income from the trustee. In a business sense, this would obviously be double taxation, and Congress has not seen fit to make such enactment. As the law now stands, the trustee (under the kind of trust most commonly found, where it is the duty of the trustee to distribute income periodically) simply files an information return, no tax is assessed to him upon his receipt of income, but a tax is assessed to the beneficiaries upon their distributive shares of the net income, whether the income has in fact been distributed or not. Similarly with partnerships. The present law provides that "individuals carrying on business in partnership shall be liable for income tax only in their individual capacity. There shall be included in computing the net income of each partner his distributive share, whether distributed or not, of the net income of the partnership for the taxable year." That is, Congress does not treat the partnership as an entity separate from the partners, and tax it upon the receipt of income, and then also tax the members upon their receipt from that entity of their shares of net income. Congress adheres to the common-law conception that a receipt by a partnership is a receipt by the persons who are members of that partnership. |