Harold S. Divine and Rita K. Divine v. Commissioner of Internal Revenue
34 A.F.T.R.2d (RIA) 5331, 500 F.2d 1041, 1974 U.S. App. LEXIS 8031 (1974)
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Rule of Law:
The difference between the fair market value of stock and the price paid by an employee exercising a statutory restricted stock option is a corporate expense that reduces the corporation's 'earnings and profits,' even though the Internal Revenue Code disallows a business expense deduction for it when calculating taxable income.
Facts:
- Rapid American Corporation ('Rapid') was a publicly traded company where Harold S. Divine was a shareholder.
- Rapid granted statutory restricted stock options to certain employees as a form of incentive compensation.
- Between 1957 and 1963, various employees exercised these options, purchasing Rapid's common stock for a total of $1,889,360, while the stock's fair market value was $5,307,206.
- The total difference, or 'bargain spread,' between the market value and the price paid by employees exceeded $3.6 million.
- In 1961 and 1962, Rapid made cash distributions to its shareholders, including Divine.
- Rapid advised its shareholders that these distributions were non-taxable returns of capital, not dividends, because its 'earnings and profits' were insufficient after being reduced by the bargain spread from the employee stock options.
- Relying on this advice, Divine did not report the distributions he received as ordinary income on his 1961 and 1962 tax returns.
Procedural Posture:
- The Commissioner of the Internal Revenue Service ('IRS') issued notices of deficiency to Harold S. Divine for the 1961 and 1962 tax years.
- In a separate case involving another shareholder of the same corporation, Sid Luckman, the U.S. Tax Court had previously ruled that the stock option spread did not reduce corporate earnings and profits.
- On appeal, the U.S. Court of Appeals for the Seventh Circuit reversed the Tax Court's decision in Luckman v. Commissioner.
- Divine then challenged his own deficiency notice by filing a petition in the U.S. Tax Court.
- The Tax Court, adhering to its own precedent from the Luckman case, ruled in favor of the Commissioner and found Divine liable for the tax deficiencies.
- Divine (appellant) appealed the Tax Court's decision to the U.S. Court of Appeals for the Second Circuit, with the Commissioner as appellee.
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Issue:
Does the 'bargain spread'—the difference between the fair market value of stock and the lower price paid by employees exercising statutory restricted stock options—reduce a corporation's 'earnings and profits' for purposes of determining whether a distribution to shareholders is a taxable dividend?
Opinions:
Majority - Waterman, J.
Yes, the 'bargain spread' reduces a corporation's 'earnings and profits.' The court first held that the Commissioner was not collaterally estopped from relitigating this issue, despite a prior loss in the Seventh Circuit, because of the strong policy in favor of allowing relitigation of tax issues across different circuits to ensure uniformity and eventual Supreme Court resolution. On the substantive issue, the court reasoned that 'earnings and profits' is an economic concept distinct from 'taxable income.' The bargain spread represents a real economic detriment to the corporation—a lost opportunity to sell shares at full market value—which constitutes a form of employee compensation. Although IRC § 421(a)(2) explicitly disallows a business expense deduction for this compensation when calculating taxable income, the statute is silent on its effect on earnings and profits. In the absence of an explicit statutory prohibition, an actual economic expense that reduces a corporation's net worth must also reduce its earnings and profits.
Concurring-in-part-and-dissenting-in-part - Friendly, J.
No, the 'bargain spread' does not reduce a corporation's 'earnings and profits.' While concurring on the collateral estoppel issue, the dissent argued that the spread is merely an 'opportunity cost,' not an out-of-pocket expense that impairs the corporation's ability to make distributions. In fact, the exercise of options adds capital to the corporation. The dissent viewed IRC § 421 as a legislative trade-off: employees receive favorable tax treatment on the options, and in exchange, the corporation forgoes any tax benefit, including a reduction in taxable income or earnings and profits. Allowing a reduction in earnings and profits would provide an unintended 'bonanza' to the corporation and its shareholders, contrary to the evident purpose of Congress.
Analysis:
This decision establishes the important principle that 'earnings and profits' is an economic measure of a corporation's dividend-paying capacity, separate and distinct from the technical calculation of 'taxable income.' It clarifies that an expenditure can be a real economic cost that reduces earnings and profits even if a specific Code section denies its deductibility for income tax purposes. The ruling significantly impacts corporate tax planning, particularly for companies that use stock-based compensation, as it increases the likelihood that distributions to shareholders will be classified as non-taxable returns of capital rather than taxable dividends. It also solidified a circuit split on the issue, inviting potential review by the Supreme Court.
