Sixteenth Amendment:

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.

Building upon definitions formulated in cases construing the Corporation Tax Act of 1909,1 the Court initially described income as “gain derived from capital, from labor, or from both combined,” inclusive of the “profit gained through a sale or conversion of capital assets.” 2 Consistent with the belief that all income “in the ordinary sense of the word” became taxable under the Sixteenth Amendment, the earliest decisions of the Court on the taxability of corporate dividends occasioned little comment.

Emphasizing that a stockholder should be viewed as “a different entity from the corporation,” the Court in Lynch v. Hornby,3 held that a cash dividend equal to 24% of the par value of the outstanding stock and made possible largely by converting assets earned prior to the adoption of the Amendment into money, was taxable income to the stockholder for the year in which he received it, although such an extraordinary payment might appear “to be a mere realization in possession of an inchoate and contingent interest . . . [of] the stockholder . . . in a surplus of corporate assets previously existing.” 4 In Peabody v. Eisner,5 decided the same day as Lynch, the Court ruled that a dividend paid in the stock of another corporation, although representing earnings that had accrued before ratification of the Amendment, was also taxable to the shareholder as income. The Court likened the dividend to a distribution in specie.6

Two years later, the Court decided Eisner v. Macomber.7 Departing from its earlier interpretations of the Sixteenth Amendment—that the Amendment corrected Pollock to restore income taxation to “the category of indirect taxation to which it inherently belonged” 8 —Justice Mahlon Pitney, writing for the Court, stated that the Sixteenth Amendment “did not extend the taxing power to new subjects, but merely removed the necessity which otherwise might exist for an apportionment among the States of taxes laid on income.” 9 Specifically, Eisner held that a stock dividend was capital when a stockholder of the issuing corporation received it and the dividend did not become taxable “income” until sold or converted, and then only to the extent that the stockholder realized a gain upon the proportion of the original investment that the stock represented. A stock dividend, Justice Mahlon Pitney maintained:

Conceding that a stock dividend represented a gain, Justice Mahlon Pitney concluded that the only gain taxable as “income” under the Amendment was “a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested or employed, and coming in, being 'derived,’ that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal;—that is income derived from property. Nothing else answers the description,” including “a gain accruing to capital, not a growth or increment of value in the investment.” 11

Although the Court has not overturned the principle it asserted in Eisner v. Macomber,12 it has narrowed its application. In United States v. Phellis, the Court treated as taxable income new stock issued in connection with a corporate reorganization designed to move the place of incorporation.13 The Court rejected a test that compared the market value of the shares in the older corporation with the aggregate market value of those shares plus the dividend shares immediately after the reorganization, which showed that the stockholders experienced no increase in aggregate wealth.14 Instead, the Court viewed the shareholders as having essentially exchanged stock in the old corporation for stock in the new corporation. The Phellis Court stated:

By contrast, in Miles v. Safe Deposit Company, the Court held that no taxable income resulted when a stockholder received rights to subscribe for shares in a new issue of capital stock, the intrinsic value of which was assumed to exceed the issuing price.16 The Court declared the right to subscribe to be analogous to a stock dividend, stating “the District Court rightly held defendant in error liable to income tax as to so much of the proceeds of sale of the subscription rights as represented a realized profit over and above the cost to it of what was sold.” 17

Footnotes

1

Stratton’s Independence, Ltd. v. Howbert, 231 U.S. 399 (1913); Doyle v. Mitchell Bros. Co., 247 U.S. 179 (1918).

2

Eisner v. Macomber, 252 U.S. 189, 207 (1920); Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926).

3

247 U.S. 339 (1918).

4

Id. at 344. In Lynch v. Turrish, 247 U.S. 221 (1918), the Court declared a single and final dividend distributed upon liquidation of a corporation’s entire assets, although equaling twice the par value of the capital stock, to represent only the corporation’s intrinsic value earned prior to the effective date of the Sixteenth Amendment. Consequently, the Court held the distribution was not taxable income to the shareholder in the year in which the shareholder actually received it. Similarly, Southern Pacific Co. v. Lowe, 247 U.S. 330 (1918), concerned a railway company whose entire capital stock was owned by and whose physical assets were leased to and used by another railway company. The Court held the dividends that the first railway company paid out of surplus accumulated before the Sixteenth Amendment’s effective date to be a nontaxable bookkeeping transaction between virtually identical corporations.

5

247 U.S. 347 (1918).

6

Id.

7

252 U.S. 189 (1920).

8

Stanton v. Baltic Mining Co., 240 U.S. 103, 112 (1916).

9

252 U.S. at 206.

10

Id. at 211, 212.

11

Id. at 207. See also Merchants’ L. & T. Co. v. Smietanka, 255 U.S. 509 (1921).

12

The Court refused to reconsider Eisner in Helvering v. Griffiths, 318 U.S. 371 (1943).

13

United States v. Phellis, 257 U.S. 156 (1921)

14

Id.; See also Rockefeller v. United States, 257 U.S. 176 (1921); Cullinan v. Walker, 262 U.S. 134 (1923). In Marr v. United States, 268 U.S. 536 (1925), the Court held that the increased market value of stock issued by a new corporation in exchange for the stock of an older corporation—the assets of which the new corporation would absorb—was taxable income to the holder, even though the income represented the older corporation’s profits and the capital remained invested in the same general enterprise. The Court likened Weiss v. Stearn, 265 U.S. 242 (1924), to Eisner v. Macomber, and distinguished it from the aforementioned cases on the ground of preservation of corporate identity. The Court observed that: “[Although the] new corporation had . . . been organized to take over the assets and business of the old . . . [,] the corporate identity was deemed to have been substantially maintained because the new corporation was organized under the laws of the same State with presumably the same powers as the old. There was also no change in the character of the securities issued. By reason of these facts, the proportional interest of the stockholder after the distribution of the new securities was deemed to be exactly the same . . . .” Marr, 268 U.S. at 541. Similarly, consistent with Eisner v. Macomber, the Court ruled that a dividend in common stock paid to holders of preferred stock, and a dividend in preferred stock paid to holders of common stock, constitute taxable income under the Sixteenth Amendment because they gave the stockholders an interest different from that represented by their prior holdings.

15

Phellis, 257 U.S. at 175.

16

Miles v. Safe Deposit Co., 259 U.S. 247 (1922). The Court stated: “The stockholder’s right to take his part of the new shares therefore—assuming their intrinsic value to have exceeded the issuing price—was essentially analogous to a stock dividend. . . . [T]he subscription right of itself constituted no gain, profit, or income taxable without apportionment under the Sixteenth Amendment.” Id. at 252.

17

Id. at 253.