Webb v. Commissioner
67 T.C. 1008, 1977 U.S. Tax Ct. LEXIS 133 (1977)
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Rule of Law:
When a corporation redeems its stock for less than its original issuance price, the entire distribution is charged to the capital account and does not affect earnings and profits. Additionally, a corporation using the cash method of accounting for income tax purposes must also use the cash method for calculating its earnings and profits, meaning unpaid accrued taxes do not reduce earnings and profits until they are actually paid.
Facts:
- Continental Equities, Inc. (Continental), a corporation using the cash method of accounting, was incorporated in 1959.
- In September 1959, the Hanover Bank, as trustee for the Rainforth Trust, purchased 8,500 shares of Continental's preferred stock for $1,062,500 ($125 per share).
- Shortly thereafter, Hanover Bank alleged fraud against Continental's incorporators.
- In December 1959, the dispute was settled by a payment of $400,000 to the Rainforth Trust in exchange for all 8,500 shares of the preferred stock, which were then held by the Wirt Peters-Tom Maxey partnership.
- On June 11, 1968, William C. Webb (the petitioner) acquired 4,250 of these preferred shares from the partnership.
- On August 15, 1968, after Wirt Peters' death, his estate received the remaining 4,250 preferred shares from the liquidating partnership.
- On that same day, Continental redeemed the 4,250 shares from the Peters estate in exchange for a $400,000 promissory note, which was a redemption price of approximately $94 per share.
- During 1968, 1969, and 1970, Webb received constructive distributions from Continental, the taxability of which as dividends depended on the calculation of Continental's accumulated earnings and profits.
Procedural Posture:
- The Commissioner of Internal Revenue determined deficiencies in William C. Webb's federal income taxes for 1968, 1969, and 1970, based on constructive dividends received from Continental Equities, Inc.
- William C. Webb, the petitioner, challenged the Commissioner's determination by filing a petition in the United States Tax Court.
- The parties settled most issues through stipulation, leaving for the court's decision two questions regarding the proper calculation of Continental's accumulated earnings and profits.
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Issue:
Does a corporation's redemption of its preferred stock for an amount less than the original issuance price affect its earnings and profits? And, for a corporation using the cash method of accounting, do accrued but unpaid federal income taxes reduce its earnings and profits in the year they accrue?
Opinions:
Majority - Simpson, Judge
No. A redemption of preferred stock at less than its issuance price does not affect the earnings and profits of the redeeming corporation, and no, a cash-method corporation may not reduce its earnings and profits for accrued but unpaid taxes. Regarding the stock redemption, under IRC § 312(e), a redemption qualifying as an exchange under § 302(a) is properly chargeable to the capital account. Following the rule in Helvering v. Jarvis, the charge to the capital account is proportional to the percentage of shares redeemed (here, 50%). However, because the redemption price ($400,000) was less than the pro rata share of the capital account attributable to those shares ($531,250), the charge to the capital account is limited to the actual amount of the distribution. Therefore, the entire distribution is charged against capital, and the earnings and profits account is undisturbed. The discount represents a contribution to capital, not an increase in earnings and profits. Regarding the accrued taxes, Treasury Regulation § 1.312-6(a) requires a corporation to use the same accounting method for computing earnings and profits as it does for computing taxable income. As Continental is a cash-method taxpayer, it can only deduct taxes from its earnings and profits in the year of payment, not in the year of accrual. The court acknowledged a circuit split on this issue but reaffirmed its long-standing position, finding no persuasive reason to treat accrued taxes differently from any other accrued but unpaid expense for a cash-method corporation.
Analysis:
This decision solidifies the Tax Court's position on two key aspects of calculating corporate earnings and profits (E&P). By limiting the charge to the capital account to the actual distribution amount in a discount redemption, the court ensures that such transactions are treated strictly as capital events that do not artificially inflate E&P. More significantly, the court entrenches the circuit split regarding the E&P treatment of taxes for cash-basis corporations, firmly siding with the Eighth Circuit and its own precedent. This creates a potential 'dividend trap' for shareholders of cash-basis corporations, as E&P can appear artificially high before taxes are paid, leading to distributions being taxed as dividends that might otherwise have been a non-taxable return of capital.
