COMMISSIONER OF INTERNAL REVENUE, PETITIONER V. PETER R. FINK ET
   UX.

   No. 86-511

   In the Supreme Court of the United States

   October Term, 1986

   On Writ of Certiorari to the United States Court of Appeals for the
Sixth Circuit

   Brief for the Petitioner

            TABLE OF CONTENTS
   Opinions below
   Jurisdiction
   Statute involved
   Question presented
   Statement
   Summary of argument
   Argument:
      Respondents' surrender of stock to their corporation in
      order to improve the corporation's financial condition
      does not give rise to an immediately deductible loss
      A. A shareholder's transfer of property to his
         corporation, whether the property consists of stock or of
         other assets, is a contribution to capital that does not
         give rise to an immediate deduction
      B. Allowing a shareholder to claim an immediate loss
         deduction for a stock surrender creates substantial
         tension with other provisions of the Code
         1. The law pertaining to stock redemptions indicates
            that stock surrenders do not generate an immediate
            loss
         2. The decision below may enable a stockholder in a failing
            corporation to avoid the tax consequences prescribed by
            Section 165(g) of the Code
         3. The court of appeals' proposed method of computing
            respondents' alleged "loss" is both unprecedented and
            impractical
   Conclusion
   Appendix

                            OPINIONS BELOW

   The opinion of the court of appeals (Pet. App. 1a-20a) is reported
at 789 F.2d 427.  The opinion of the Tax Court (Pet. App. 23a-33a) is
unofficially reported at 48 T.C.M. (CCH) 786.

                             JURISDICTION

   The judgment of the court of appeals (Pet. App. 21a-22a) was
entered on April 30, 1986.  On July 18, 1986, Justice O'Connor
extended the time for filing a petition for a writ of certiorari to
and including September 27, 1986.  The petition was filed on September
26, 1986, and was granted on November 17, 1986.  The jurisdiction of
this Court is invoked under 28 U.S.C. 1254(1).

                           STATUTE INVOLVED

   The relevant portions of Sections 165, 302 and 1016(a)(1) of the
Internal Revenue Code (26 U.S.C.) are set out in a statutory appendix
(App., infra, 1a-5a).

                          QUESTIONS PRESENTED

   Whether the surrender by a corporation's dominant shareholders of a
small portion of their shares in order to improve the corporation's
financial position gives rise to an immediately deductible loss in the
computation of the shareholders' taxable income.

                               STATEMENT

   1. Respondents Peter and Karla Fink, who are husband and wife, were
the principal shareholders of Travco Corporation (Pet. App. 2a).
Travco had one class of common stock outstanding, of which Peter owned
52.2% and Karla owned 20.3% (id. at 27a, 30a).  Most of the rest of
the stock was owned by other family members (id. at 30a).  /1/ When
Travco encountered financial difficulties in the mid-1970s (id. at
25a-27a), respondents voluntarily surrendered a portion of their
shares to the corporation.  Specifically, Peter surrendered 116,146 of
his 802,300 shares in 1976, and Karla surrendered 80,000 of her
311,359 shares in 1977.  No other shareholder surrendered any shares
(id. at 28a-30a).  By virtue of these stock surrenders, respondents
reduced their combined interest in the corporation from 72.5% of the
outstanding shares to 68.5% (id. at 30a, 32a).

   The purpose of respondents' voluntary stock surrender was "to
improve Travco's financial position, to preserve its business, and to
increase (its) attractiveness * * * to outside investors" (Pet. App.
3a, 28a).  /2/ For federal income tax purposes, respondents claimed
the entire amount of their cost or "basis" in the surrendered shares
-- $197,782 for Peter and $191,258 for Karla -- as ordinary loss
deductions on their 1976 and 1977 joint tax returns (id. at 3a-4a).

   2. The Commissioner disallowed the claimed deductions.  He
determined that respondents' surrenders of stock to their corporation
did not generate currently deductible losses, but rather constituted
contributions to the corporation's capital (Pet. App. 32a).  He
accordingly determined deficiencies of $131,885 for 1976 and $133,826
for 1977 (id. at 23a).

   Respondents sought redetermination of the deficiencies in the Tax
Court.  That court sustained the Commissioner's position (Pet. App.
23a-33a), relying on its reviewed decision in Frantz v. Commissioner,
83 T.C. 162, 174-182 (1984), aff'd, 784 F. 2d 119 (2d Cir. 1986),
petition for cert. pending, No. 86-11, which was decided on the same
day.  In Frantz, the Tax Court held that a stockholder's non-pro-rata
surrender of shares to his corporation does not entitle him to deduct
his basis in those shares as an immediate loss.  The Frantz court
held, rather, that the taxpayer's basis in the surrendered shares must
be added to his basis in the shares he retains.  The court explained
(83 T.C. at 181) that "(t)his conclusion * * * necessarily follows
from a recognition of the purpose of the transfer, that is, to bolster
the financial position of (the corporation) and, hence, to protect and
make more valuable (the stockholder's) retained shares." Because the
stockholder in surrendering his shares was "attempting to decrease or
avoid a loss on his overall investment," the Tax Court was "unable to
conclude that (he) sustained a loss at the time of the transaction."
Instead, the court reasoned, "(w)hether (the shareholder) would
sustain a loss, and if so, the amount thereof, could only be
determined when he subsequently disposed of the stock that the
surrender was intended to protect and make more valuable" (ibid.).

   The Tax Court in Frantz acknowledged that some of its prior
opinions lent support to the taxpayers' position on the
stock-surrender issue.  83 T.C. at 174-178.  /3/ But the court decided
that these prior opinions were "incorrect as a technical matter" and
that they had the undesirable tendency "to encourage a conversion of
eventual capital losses into immediate ordinary losses" (id. at 182).
The court concluded that "(t)o perpetuate (this) line of authority * *
* seems particularly inappropriate when we consider its possible
ramifications on the tax system as whole," stating that the decisions
in question were "expressly overruled" (ibid.).  The Frantz court
accordingly held that a shareholder's non-pro-rata surrender of stock
to his corporation is to be treated as a nondeductible contribution to
the corporation's capital (id. at 181-182).

   Applying the holding of Frantz to the facts of the instant case,
the Tax Court held that respondents' stock surrenders did not give
rise to immediately deductible losses (Pet. App. 32a-33a).  The court
therefore sustained the Commissioner's determination of deficiencies
in the amount of $131,885 for 1976 and $133,826 for 1977 (id. at 23a,
33a).

   3. A divided court of appeals reversed (Pet. App. 1a-20a).
According to the majority, the outcome depended on whether a "unitary"
or a "fragmented" view of stock ownership provided the proper
framework for analyzing stock transactions (see id. at 4a-10a).  Under
the so-called "fragmented" view, "each share of stock is considered a
separate investment," and gain or loss is computed separately on the
sale or disposition of each share (id. at 5a).  Under the so-called
"unitary" theory, "the stockholder's entire investment is viewed as a
single indivisible property unit," with the result that a sale or
disposition of a portion of his shares can produce an ascertainable
loss only "when the stockholder has disposed of his remaining shares"
(id. at 5a, 12a (original quotation marks omitted)).  The majority
concluded that affirmance of the Tax Court would have required it to
forsake the "fragmented" view of stock ownership, and it declined to
do so.  It noted that each share of stock is normally treated as a
separate unit for tax purposes, and it held that the particular
situation involved here -- a majority shareholder's non-pro-rata
surrender of a small portion of his shares -- presented
"(in)sufficient justification for abandoning the 'fragmented view'"
(id. at 11a (emphasis deleted)).

   The majority therefore concluded that respondents' stock surrender
gave rise to an immediate tax loss.  It remanded the case to the Tax
Court for a computation of the amount of the loss, stating that the
trier of fact was to make "a determination of whether (respondents')
surrender of the stock * * * resulted in an increase in the value of
their remaining shares" (Pet. App. 16a).  The court of appeals stated
that, "(b)arring such a finding, taxpayers are entitled to an ordinary
loss deduction for the full amount of their basis in the surrendered
shares" (ibid.).

   Judge Joiner dissented (Pet. App. 17a-20a).  He argued that the
Second Circuit in Frantz v. Commissioner, supra, and the Fifth Circuit
in Schleppy v. Commissioner, 601 F.2d 196 (1979), had correctly held
that similar stock surrenders did not give rise to an immediate loss
deduction.  Judge Joiner pointed out that where, as here, "the
taxpayers' sole motivation in disposing of certain shares is to
benefit the other shares they hold," the majority's insistence upon
"(v)iewing the surrender of each share as the termination of an
individual investment ignores the very reason for the surrender" (id.
at 20a).  He emphasized that respondents had "reduced their corporate
ownership only slightly * * * and (had) maintained their corporate
control," so that they remained after the stock surrender "in
substantially the same position that they previously held (and had)
not suffered any sort of meaningful loss" (id. at 18a).  "Particularly
in cases * * * where the diminution in the shareholder's corporate
control and equity interest is so minute as to be illusory," Judge
Joiner reasoned, "the stock surrender should be regarded as a
contribution to capital" (id. at 20a).  He accordingly concluded that,
"(w)hatever validity the 'fragmented view' may have outside of the
present context, it should not be applied here" (id. at 19a).

                          SUMMARY OF ARGUMENT

   A. 1. It is well established that a shareholder's transfer of cash
or other property to his corporation is treated not as a loss, but as
a contribution to capital.  See Internal Revenue Code Section 263(a)
(the Code or I.R.C.);  Treas. Reg. Sections 1.61-12(a) and
1.263(a)-2(f) (26 C.F.R.).  This rule reflects the general
proposition, recognized by this Court in Deputy v. du Pont, 308 U.S.
488 (1940), that a shareholder may not take a deduction for outlays
made to benefit his corporation.  Such contributions to capital result
not in an immediate tax deduction, but rather in an upward adjustment
to the "basis" of the stockholder's shares by the amount of his
"basis" in the debt or other property transferred.  The rationale for
this treatment is that the purpose of the shareholder's transfer is to
enhance the value of his equity investment in the corporation;
because he has made a capital outlay intended to achieve long-term
benefits, he may not deduct that outlay as an immediate expense or
loss.  There is no reason to deviate from this well-settled rule
where, as here, the property contributed to the corporation takes the
form of shares of its stock.

   A non-pro-rata stock surrender lacks the attributes normally
associated with a "loss." It is not a permanent and absolute parting
with something of value;  rather, it is a deliberate expenditure taken
for the purpose of improving the corporation's financial position and
ultimately producing a benefit to the contributing shareholder.
Moreover, the fact that the stock surrender is designed to aid the
corporation and thereby enhance the value of the stockholder's
remaining shares demonstrates that it is an "open" transaction that
cannot yet give rise to a deductible loss.  See Treas. Reg. Section
1.165-1(b).  Whether or not the surrender will ultimately result in a
loss depends upon the extent to which the surrender succeeds in
achieving its goals of enhancing the fortunes of the corporation and
the value of the stockholder's investment.  That cannot be determined
until the transaction is "closed" by the disposition of the
shareholder's remaining shares.  In short, a stock surrender is a
prototypical contribution to capital and should be subject to the
standard tax treatment that such contributions receive;  an increase
in the basis of the stockholder's shares without the recognition of
any immediate loss.

   2. The court of appeals erred in asserting that
contribution-to-capital treatment of a stock surrender is inconsistent
with the so-called "fragmented" view of stock ownership that governs
sales or exchanges of stock.  The general principle is that shares of
stock are treated just like other forms of property.  When shares are
sold or exchanged, gain or loss is recognized on the transaction
measured by the difference between the basis of the stock sold and the
amount realized upon the sale.  Similarly, when shares are contributed
to a corporation's capital, an adjustment to the basis of the
shareholder's remaining stock should be made and no loss should be
recognized, just as if any other form of property had been contributed
to the corporation's capital.

   For example, if a shareholder surrenders some of the bonds that he
holds, it is clear that the transaction would be treated as a capital
contribution and not as a loss.  That result obviously does not
undermine what the court of appeals would term the "fragmented" view
of bond ownership -- namely, the rule that the sale or exchange of
bonds is a taxable event even if the bondholder continues to hold
other bonds of the same debtor.  The critical distinction that
determines whether a loss is immediately recognized is whether the
transaction is a contribution to capital or a sale or exchange, not
whether the property contributed is stock or something else.

   3. Congress's enactment of Section 83(h) in 1969 confirms that
contribution-to-capital treatment of stock surrenders is consistent
with the structure of the Code.  Section 83(h) provides that a
shareholder's "bargain sale" of stock to a corporate employee as part
of the latter's compensation gives rise to a corporate business
deduction.  The theory of this treatment is that the transfer is in
reality a two-step transaction -- a contribution by the shareholder of
stock to the corporation, followed by the corporation's payment of
that stock to the employee as compensation.  See S. Rep. 91-552, 91st
Cong., 1st Sess. 123-124 (1969).  This congressional determination is
an unequivocal rejection of the notion that the "fragmented" view of
securities ownership that governs sales and exchanges prevents a stock
surrender from being treated as a nondeductible capital expenditure.
See Tilford v. Commissioner, 705 F.2d 828, 829 (6th Cir.), cert.
denied, 464 U.S. 992 (1983).

   B. 1. Established principles regarding the tax treatment of stock
redemptions further confirm that respondents' stock surrender should
not generate an immediately deductible loss.  A redemption of shares
of stock is treated as a "sale or exchange" only if it yields a
"meaningful" reduction in the shareholder's equity interest in the
corporation.  United States v. Davis, 397 U.S. 301, 313 (1970);
I.R.C. Section 302.  Absent such a substantial reduction, the
redemption is broken down into two parts for tax purposes.  The
receipt of cash is generally treated as a dividend.  The surrender of
shares results in no immediate gain or loss, but rather in an upward
adjustment to the basis of the remaining shares -- i.e., it is viewed
independently as a contribution to capital.

   The instant stock surrender reduced respondents' interest in their
corporation by an insubstantial amount -- from 72.5% to 68.5%.  Thus,
if respondents had received even one penny a share for their
surrendered stock, the surrender would have been classified as a
redemption, and Section 302 would have precluded their recognition of
a loss.  Clearly, respondents should not receive the radically
different tax treatment of an immediate loss deduction just because
they elected to forgo a miniscule amount of consideration.

   2. If the loss deduction supposedly generated by a stock surrender
is an "ordinary" rather than a "capital" loss, as the court of appeals
apparently thought (see Pet. App. 16a), the decision below opens the
door for the use of stock surrenders as a tax planning device that
would frustrate Congress's intent in enacting Section 165(g)(1) of the
Code.  That Section specifically provides that the loss incurred when
a share of stock becomes worthless is a capital loss.  Under the
reasoning of the court below, shareholders of a failing corporation
would be able to evade the effect of this provision by surrendering
their stock just before it became worthless, thereby generating an
ordinary loss deduction in the same amount that Section 165(g)(1)
would have prescribed as a capital loss.  Thus, the interplay of stock
surrender treatment with other provisions of the Code makes it clear
that such surrenders must be treated as nondeductible contributions to
capital.

                               ARGUMENT

 RESPONDENT'S SURRENDER OF STOCK TO THEIR CORPORATION IN ORDER TO
IMPROVE THE CORPORATIONS FINANCIAL CONDITION DOES NOT GIVE RISE TO AN
IMMEDIATELY DEDUCTIBLE LOSS

   The court of appeals has held that a shareholder's non-pro-rata
surrender of stock entitles him to an immediate loss deduction.  This
holding is at odds with fundamental and well-established principles
concerning the tax treatment of shareholder contributions to their
corporations.  The court of appeals' holding, moreover, creates
disharmony in the Internal Revenue Code by according substantially
similar transactions -- stock "surrenders" and stock "redemptions" --
highly disparate tax treatment.  Taken in conjunction with other
provisions of the Code, the decision below would permit individuals to
use stock surrenders as a planning tool to obtain unjustified tax
benefits -- approximately $265,000 in this case -- by engaging in
transactions that give rise to no genuine "loss" and that have little,
if any, practical economic effect.

 A. A Shareholder's Transfer Of Property To His Corporation, Whether
The Property Consists Of Stock Or Of Other Assets, Is A Contribution
To Capital That Does Not Give Rise To An Immediate Deduction

   1. It has long been established that transfers by a shareholder to
his corporation are not treated as losses, but as contributions to
capital that have no immediate tax consequences.  Section 263 of the
Code generally provides that "capital expenditures" are not
deductible.  The Treasury Regulations state that "voluntary
contributions by shareholders to the capital of the corporation for
any corporate purpose" are regarded as "capital investments and are
not deductible." Treas. Reg. Section 1.263(a)-2(f).  More
specifically, the Regulations provide that "if a shareholder in a
corporation which is indebted to him gratuitously forgives the debt,
the transaction amounts to a contribution to the capital of the
corporation to the extent of the principal of the debt." Treas. Reg.
Section 1.61-12(a).  This latter provision dates back to regulations
issued under the Revenue Act of 1918.  See Commissioner v. Auto Strop
Safety Razor Co., 74 F.2d 226 (2d Cir. 1934).

   Pursuant to Section 1016(a)(1) of the Code, a shareholder's
contribution to the capital of his corporation produces an increase in
the basis of his shares in an amount equal to his basis in the debt or
other property transferred.  See, e.g., Betson v. Commissioner, 802
F.2d 365, 368 (9th Cir. 1986);  Perlman v. Commissioner, 252 F.2d 890
(2d Cir. 1958);  aff'g 27 T.C. 755 (1957);  Bratton v. Commissioner,
217 F.2d 486 (6th Cir. 1954).  By virtue of this adjustment to basis,
the taxpayer will eventually "recover" his investment for tax purposes
when he disposes of his shares in an arm's-length sale or exchange.
This recovery of capital typically will take the form of a smaller
taxable gain, or a larger deductible loss, at that future time.  /4/

   These well-established principles governing the transfer of
property by a shareholder to his corporation reflect the general
proposition, recognized by this Court in Deputy v. du Pont, 308 U.S.
488 (1940), that a shareholder may not take a deduction for an outlay
made to benefit his corporation.  In du Pont, the taxpayer incurred
certain expenses in connection with the transfer of some of his
stockholdings to new executives of the corporation.  The transaction
was undertaken because, "(f)or business reasons, (the corporation)
thought it desirable that these men have a financial interest in the
company" (308 U.S. at 490).  The Court held that these expenses,
because they were intended to further the corporation's business, did
not give rise to a deduction for the taxpayer individually.  And this
was so even though the taxpayer, by virtue of his stock investment in
the company, hoped to derive some indirect benefit from his outlay in
the form of improved (and hence more profitable) corporate
performance.  See id. at 494;  see also Interstate Transit Lines v.
Commissioner, 319 U.S. 590 (1943).

   As Professor Bittker has explained, the payments that the
shareholder sought to deduct in du Pont are most logically viewed as
"expenditures to conserve and enhance the value of (the) taxpayer's
stock." 1 B. Bittker, Federal Taxation of Income, Estates & Gifts
Paragraph 20.1.4, at 20-12 (1981) (footnote omitted).  Those
expenditures therefore "resembled nondeductible capital outlays to
achieve long-term benefits, rather than currently deductible expenses
of carrying on business" (ibid.).  It necessarily follows from du Pont
that transfers made to third parties for the benefit of one's
corporation, like direct transfers to the corporation itself, result
in an increase in the basis of one's shares, not in an immediate tax
deduction.  See Rittenberg v. United States, 267 F.2d 605 (5th Cir.
1959), cert. denied, 361 U.S. 931 (1960) (shareholder's payment of
rent to owners of land on which his corporation had constructed a
building);  South American Gold & Platinum Co. v. Commissioner, 8 T.C.
1297, 1301 (1947), aff'd, 168 F.2d 71 (2d Cir. 1948) (shareholder's
payment of legal fees to settle litigation against his corporation);
Eskimo Pie Corp. v. Commissioner, 4 T.C. 669 (1945), aff'd, 153 F.2d
301 (3d Cir. 1946);  Koree v. Commissioner, 40 T.C. 961, 965 (1963);
Ihrig v. Commissioner, 26 T.C. 73 (1956).  And this result follows
whether the transfer of property is pro-rata or non-pro-rata as
between the taxpayer and his fellow shareholders.  Indeed, it is "well
settled that a contribution to capital need not be proportionate to
the stockholdings of the contributor." 10 J. Mertens, supra, Section
38.22, at 50.  See, e.g., Perlman v. Commissioner, 252 F.2d at 892;
Sackstein v. Commissioner, 14 T.C. 566, 569 (1950).

   2. The principles just outlined establish the general rule that a
shareholder's voluntary transfer of property to his corporation, or
his transfer of property to a third party for the benefit of his
corporation, represents a nondeductible capital contribution.  This
general rule applies to transfers not only of cash or tangible
property but also of securities, including debt of the shareholder's
corporation or stock of another corporation.  The question here is
whether this general rule is wholly inapplicable when the property
transferred is stock of the shareholder's corporation.  The court of
appeals held that the general rule does not apply in such
circumstances, and that a non-pro-rata stock surrender /5/ represents
not a capital contribution but a currently deductible "loss." But
whether one analyzes the situation from a practical, common-sense
perspective or from a technical viewpoint, it is clear that a stock
surrender of the sort made by respondents does not give rise to a
"loss."

   First, the concept of a "loss" generally connotes a permanent and
absolute parting with something of value.  In the typical situation
where a loss concern -- for example, a casualty loss, a theft loss, or
a loss on the sale of property for less than one paid for it -- the
amount that is claimed as a loss by the taxpayer is a function of
market conditions or other factors over which the taxpayer lacks
control.  The fact that he realizes less than his basis, or nothing at
all, upon disposition of the property is essentially unavoidable.

   Here, by contrast, the event that respondents seek to characterize
as a loss was a voluntary parting with something of value in which
respondents intentionally chose not to receive fair market value in
return.  Respondents' decision to forgo any immediate return
consideration was made in the hope of realizing a more substantial
ultimate return on their overall equity investment.  Such a
transaction is more in the nature of a deliberate "expenditure," like
an investment or gift, than a "loss." See Transport Mfg. & Equipment
Co. v. Commissioner, 27 T.C.M. (CCH) 924 (1968), aff'd, 431 F.2d 729
(8th Cir. 1970) (below-market sale to related corporation should be
treated as a contribution to the capital of the purchasing corporation
that does not give rise to a loss on the part of the seller);  see
also Mack v. Commissioner, 45 B.T.A. 602 (1941), aff'd, 129 F.2d 598
(2d Cir. 1942);  Evans v. Rothensies, 114 F.2d 958, 961-962 (3d Cir.
1940);  Hoile v. Commissioner, 4 T.C.M. (CCH) 247, 253-254 (1945);
see generally Johnson, Tax Models for Nonprorata Shareholder
Contributions, 3 Va. Tax Rev. 81, 106-107 (1983);  1 B. Bittker,
Federal Taxation of Income, Estates & Gifts Paragraph 25.3, at 25-7 to
25-8 (1981).  Thus, transactions like the stock surrender here fall
within the general rule that "(i)f the contribution (to the
corporation) is voluntary, it does not produce gain or loss to the
shareholder," but rather is treated as a contribution of capital in
the amount of the contributed property.  B. Bittker & J. Eustice,
Federal Income Taxation of Corporations & Shareholders Paragraph 3.14,
at 3-59 (4th ed. 1979).

   Secondly, and more importantly, it is clear that a "loss," in order
to be deductible, must be "evidenced by closed and completed
transactions, fixed by identifiable events, and * * * actually
sustained during the taxable year." Treas. Reg. Section 1.165-1(b);
Boehm v. Commissioner, 326 U.S. 287, 291-292 (1945).  These
requirements plainly are not satisfied in this case.  As the Second
Circuit and the Tax Court explained in Frantz (see 784 F.2d at
123-124;  83 T.C. at 179-181), a non-pro-rata surrender by the
dominant shareholder, like the one involved here, is in reality an
"open transaction." The fact that the shareholder's surrender of stock
is intended to improve the financial position of his corporation --
and hence to enhance the value of his remaining shares -- means that
the surrender itself does not result in any genuine and immediate loss
to him.  Whether or not the surrender will result in a loss depends
upon the extent to which the shareholder ultimately succeeds in his
objective of preserving the value of his stockholding.

   The ultimate success of the shareholder's endeavor, of course, can
be determined only when the transaction is "closed" by the disposition
of his remaining shares.  See Lidgerwood Manufacturing Co. v.
Commissioner, 229 F.2d 241, 243 (2d Cir. 1956).  If his investment
decision to surrender his stock turns out to be a bad one and the
entire transaction turns out to be a loss, the shareholder will
receive full recognition of that loss for tax purposes when the shares
are sold.  On the other hand, if the investment decision turns out to
be a good one, there will be no ultimate loss as a result of the
surrender;  the taxpayer will again receive the appropriate tax
treatment (in the form of an increased basis and hence a lower capital
gain) upon the closing of the transaction by the disposition of the
remaining shares.

   In the case of any stock surrender, it is impossible to tell
whether the shareholder's effort to improve his company's financial
condition will succeed -- and hence whether the surrender has yielded
a genuine economic loss -- until he sells the shares whose value the
surrender was designed to enhance.  Regardless of the ultimate
outcome, therefore, the correct tax treatment is not to regard the
stock surrender as an immediate loss.  Rather, the correct tax
treatment is that described by the Second Circuit in Perlman v.
Commissioner, 252 F.2d at 892 (quoting 27 T.C. at 758):  "'(The
contribution) increased the basis of (the taxpayer's remaining) stock,
and he will obtain tax benefit therefrom when he subsequently sells or
otherwise disposes of his stock in a taxable transaction.'" See also
Whitney v. Commissioner, 8 T.C. 1016, 1035-1036 (1947), aff'd on this
issue, 169 F.2d 562, 569 (2d Cir.), cert. denied, 335 U.S. 892 (1948)
(denying shareholders a loss deduction for their contribution of
depreciated securities because there was no "closed transaction giving
rise to gain or loss");  Kistler v. Burnet, 58 F.2d 687, 689 (D.C.
Cir. 1932) (explaining that the tax consequences of a partial
surrender will be assessed upon disposition of remaining shares).

   It is of course true that a voluntary stock surrender, while
intended to preserve the long-term value of the shareholder's
investment, might be called a "loss" in a colloquial sense, since the
shareholder has parted with a particular asset that he previously
owned.  But this is not the sort of "loss" that can be recognized for
tax purposes, for it is precisely the sort of "loss" that occurs
whenever a shareholder contributes capital (such as cash or property)
to his corporation.  The effect of any capital contribution, whether
of cash, property, debt, or stock, is to reduce the contributing
shareholder's net worth, and at the same time to benefit the
corporation as a whole (directly) and the corporation's other
shareholders (indirectly).  If the reduction in the contributing
shareholder's net worth occasioned by the classic capital expenditure
does not give rise to an immediate loss -- and the Code explicitly
provides (I.R.C. Section 263(a)) that it does not -- there is no
reason why a contribution in the form of stock should produce the
opposite result.  In each situation, the shareholder has acted with
the investment purpose of helping his corporation, and in each
situation the reduction in his net worth should be treated as a
contribution to capital and not as a loss.  /6/

   For these reasons, it seems manifest that the court of appeals
erred in holding that respondents' surrender of their stock was a
"loss," rather than a nondeductible contribution to Travco's capital.
Respondents' stock surrender falls into the prototypical mold of a
capital expenditure -- the contribution of a portion of the
shareholder's property (here, stock) for the purpose of improving the
company's financial condition and thereby enhancing the value of the
remainder of the shareholder's investment in it.  Logically, such a
contribution should have the effect of increasing the shareholder's
basis in his remaining shares and should not give rise to an immediate
tax deduction.  See generally Johnson, Tax Models for Nonprorata
Shareholder Contributions, 3 Va. Tax Rev. 81 (1983).

   3. Apart from the court of appeals below, every court of appeals
that has considered the question has held that non-pro-rata stock
surrenders do not give rise to an immediate loss, a conclusion that
accords with current controlling precedent in the Tax Court.  In
Frantz v. Commissioner, 784 F.2d 119 (1968), petition for cert.
pending, No. 86-11, the Second Circuit held that a dominant
shareholder's surrender of his preferred stock to improve the
corporation's financial condition "was properly treated by the Tax
Court as a contribution to the capital of (the corporation), as it had
expressly been labeled by the parties at the time of the surrender"
(784 F.2d at 125-126).  The court noted the general rule that
"(p)ayments made to further ongoing investments are not normally
considered losses, but rather (are) capital expenditures" (id. at
123), and the court found no reason to depart from this rule where the
shareholder's payment takes the form of stock.  The court explained
that "it is questionable whether a controlling stockholder who
voluntarily surrenders stock to his corporation for the purpose of
strengthening it but continues his control through stock retained by
him, thereby benefiting from the surrender, necessarily suffers any
recognizable loss at the time of the surrender" (id. at 125).  Because
the change in the taxpayer's interest in the corporation as a result
of the surrender "was miniscule compared with (his) retained interest
in the company," the Second Circuit concluded that the surrender
should not be treated as giving rise to an immediate loss but rather
should be regarded "as a non-deductible capital expenditure" (ibid.).

   The Fifth Circuit in Schleppy v. Commissioner, 601 F.2d 196 (1979),
similarly held that a controlling shareholder's "surrender of a very
small part of (his) stockholdings * * * to the corporation itself to
improve its financial position" did not give rise to a currently
deductible loss (601 F.2d at 199).  Speaking for a unanimous court,
Judge Tuttle noted "the general proposition that voluntary payments by
a stockholder to his corporation in order to bolster its financial
position cannot be claimed as a loss," but rather must be "added to
the basis of the stock in the stockholder's hands" (id. at 197).  "It
is difficult to perceive why any distinction should arise," the court
continued, "if, instead of paying cash to the corporation, the
shareholder surrenders part of his shares to bolster (its) financial
health" (ibid.).  The court noted that the dominant shareholders'
surrender of their stock had reduced their controlling interest in the
corporation only slightly -- from 70.12% to 68.57% -- and thus had
"left them in substantially the same position that they previously
held" (id. at 198).  The court concluded that the shareholders' action
could not be characterized as generating a "loss" and held that their
basis in the shares surrendered "is to be added to their basis in
their remaining shares" (id. at 198-199).

   The courts in both Schleppy (601 F.2d at 198) and Frantz (784 F.2d
at 125) emphasized that the stock surrenders in those cases had no
appreciable impact on the taxpayer's position as the dominant
shareholder in the corporation.  These comments correctly recognize
the difference in economic effect between a minimal reduction in a
majority shareholder's ownership percentage and a reduction that
causes him to lose control of the corporation -- a difference that is
explicitly reflected in the Code's redemption provisions.  See I.R.C.
Section 302(b)(2) (providing "exchange" rather than "dividend"
treatment where a shareholder receives a "substantially
disproportionate redemption of stock" that brings his ownership
percentage below 50%);  I.R.C. section 302(b)(3) (providing "exchange"
rather than "dividend" treatment where a redemption completely
terminates a shareholder's interest);  pages 29-32, infra.  Like
Schleppy and Frantz, this case presents the typical scenario in which
the stock surrender leaves the surrendering shareholders firmly in
control of the corporation.  Indeed, the facts of the instant case,
involving a stock surrender that reduced respondents' controlling
interest from 72.5% to 68.5%, are substantially identical to the facts
in Schleppy, where the stock surrender reduced the taxpayers'
controlling interest from 70.1% to 68.6%.  Compare Pet. App. 30a with
601 F.2d at 198.  In the words of Judge Joiner, dissenting from the
decision below, "the diminution in (respondents') corporate control
and equity interest (was) so minute as to be illusory" (Pet. App.
20a).  /7/

   4. The court of appeals below failed to reach what we believe to be
the correct result because it perceived this case as turning on a
supposed distinction between the "fragmented" and "unitary" theories
of stock ownership (see Pet. App. 4a-10a).  The source of this
erroneous perception (see id. at 7a, 11a, 14a-15a) is the Tax Court's
analysis of these theories in Downer v. Commissioner, 48 T.C. 86,
90-91 (1967), an analysis that the Tax Court has since abandoned.  See
Frantz, 83 T.C. at 174-175, 179, 182 (explicitly overruling Downer).
The court of appeals' method of viewing the case is seriously
misconceived, and the analysis that it engenders provides no guidance
whatsoever in resolving the question presented here.

   It is, of course, well settled that if a person owns a piece of
property and sells or exchanges it for cash or other property in an
arm's-length transaction, his gain or loss on the deal is measured by
the difference between his basis in the property sold or exchanged and
the amount realized upon the sale or exchange (I.R.C. Section
1001(a)).  The same rule applies to stock.  An individual who owns
shares in a corporation may have quite different bases in the several
shares, depending upon their purchase price and his mode of acquiring
them.  If he sells or exchanges some of the shares, his gain or loss
is measured by the difference between the amount realized and the
basis, or bases, of the particular shares sold or exchanged.  See,
e.g., Davidson v. Commissioner, 305 U.S. 44 (1938);  Helvering v.
Rankin, 295 U.S. 123 (1935).  /8/ Only in very limited circumstances,
such as after a corporate reorganization, will the differing bases of
different blocks of stock be averaged and applied evenly to the total
number of shares.  See Arrott v. Commissioner, 136 F.2d 449 (3d Cir.
1943).  Thus, shares of stock that are sold or exchanged are treated
just like other types of property that are sold or exchanged, with
gain or loss being computed by reference to their individual bases.

   Our position in this case casts no doubt upon this well-settled
rule, which the court of appeals would term the "fragmented" view of
stock ownership.  This case does not involve a sale or exchange.
Rather, it involves a contribution to a corporation of property in the
form of shares once issued by the corporation and now held by an
individual shareholder.  Just as a sale or exchange of stock is
treated like the sale or exchange of other property, so, too, a
surrender of stock should be treated like the surrender of other
property.  As explained above, a shareholder's surrender of other
property -- whether tangible assets, cash, or debt -- is treated as a
contribution to the corporation's capital that does not give rise to
an immediate deduction.  There is no sound justification for treating
a surrender of stock any differently.  Regardless of what sort of
property the shareholder decides to transfer to his corporation, his
transfer is made for the purpose of enhancing or protecting the value
of the shares he retains.  The fact that the corporation (and, to some
extent, his fellow shareholders) will also benefit from his transfer
does not entitle him to a current tax deduction.  This result does not
follow from any abstract notion of "unitary" stock ownership, nor does
it reflect any tension with the so-called "fragmented" theory
governing sales and exchanges of stock.  Rather, the difference in tax
treatment governing stock surrenders and stock sales necessarily flows
from (1) the significant difference between a shareholder's transfer
of property to his own corporation and an arm's-length 99sale or
exchange," and (2) the lack of any significant difference between a
shareholder's transfer of shares to his corporation and his transfer
of some other form of property to it.

   Our point may be illustrated by an example.  There is absolutely no
doubt that a shareholder's surrender of debt to his corporation
constitutes a contribution to capital.  See Treas. Reg. Section
1.61-12(a).  Accordingly, if a shareholder surrenders some of the
debentures that he holds, it is settled that the transaction results
in an adjustment of the shareholder's basis in his shares, and does
not give rise to an immediate loss.  As the Tax Court stated in
Thompson v. Commissioner, 6 T.C. 285, 294 (1946), aff'd, 161 F.2d 185
(2d Cir. 1947), "(e)ven if it be assumed that the purpose of the
(partial) surrender was to enhance the value of (the taxpayer's)
remaining bonds, what he did was to make a capital investment of which
the law takes cognizance when the transaction is finally closed by the
disposition of his remaining interest." See also Lidgerwood
Manufacturing Co. v. Commissioner, supra;  Boone v. Commissioner, 33
T.C.M. (CCH) 663 (1974).  Clearly, this rule has never been thought to
undermine what the court of appeals might term the "fragmented" view
of bond ownership -- namely, the precept that the sale or exchange of
individual bonds is a taxable event even if the bondholder continues
to hold other bonds of the same corporation.  Thus, it is apparent
that concern over the integrity of the "fragmented" theory of
securities ownership provides no justification for the decision below.
 The court of appeals simply failed to appreciate the difference
between a disposition of stock or bonds by means of a "capital
contribution" and a disposition of them by means of a "sale or
exchange." See Johnson, Tax Models for Nonprorata Shareholder
Contributions, 3 Va. Tax Rev. 105-106 (1983).

   5. The court of appeals sought to distinguish "the situation where
a shareholder surrenders shares * * * from the circumstance where a
shareholder gives cash or property to the corporation," reasoning
that, "(w)hen cash or property is given to the corporation, (its)
capital is increased by the value of the property contributed" (Pet.
App. 15a).  This objection is premised on a superficial, and
ultimately erroneous, view of the accounting treatment of a stock
surrender, a view that does not comport with the economic reality of
the transaction.  It is of course true that a corporation's treasury
stock, /9/ whether acquired by purchase, by exchange for debt, or by
shareholder contribution, is not generally regarded as a corporate
"asset" for financial accounting purposes, but rather is shown as an
offset to shareholder's equity on the liability side of the balance
sheet.  G. Johnson & J. Gentry, Finney and Miller's Principles of
Accounting 538 (7th ed. 1974).  This accounting treatment flows from
the fact that "(a) corporation that acquires its own stock obviously
cannot acquire the basic rights inherent in stock ownership:  the
right to vote, the right to participate in dividend distributions, * *
* and the right to receive a proportionate share of the corporation's
assets in the event of liquidation" (ibid.).

   Notwithstanding this technical accounting treatment, however,
treasury stock is valuable property that a corporation can use for
various corporate purposes.  Treasury stock may be sold to obtain
working capital.  It may be reissued to a new shareholder or given as
a bonus to the purchasers of other securities.  Or it may be used to
discharge the corporation's liability to its officers or employers
under a profit-sharing or pension plan.  See G. Johnson & J. Gentry,
supra, at 538;  Bolding, Non-Pro Rata Stock Surrenders:  Capital
Contribution, Capital Loss or Ordinary Loss?, 32 Tax Law. 275, 277
n.12 (1979).  A corporation might often be able to achieve these
objectives equally well by issuing new shares.  But corporations
frequently prefer to employ previously-issued treasury shares instead,
not only to avoid possible restrictions imposed by their charters or
state law, /10/ but also to avoid diluting the equity of their
existing shareholders.

   When a corporation acquires treasury stock for free by shareholder
contribution, rather than having to purchase it for cash in the open
market, the corporation has received an obvious benefit from the
shareholder.  Although the stock thus acquired is not an "asset" in
balance-sheet terms, it is functionally equivalent to an asset, since
it may be used to acquire corporate assets or discharge corporate
liabilities.  A shareholder's surrender of stock to his corporation is
thus reasonably regarded as a "contribution to capital" from the
corporation's point of view.  See Schleppy v. Commissioner, 601 F.2d
at 197 n.2.  /11/

   Indeed, actions taken by shareholders to benefit their corporations
are routinely treated as "contributions to capital" for tax purposes,
even though they do not increase the corporation's stated capital or
assets in a technical accounting sense.  For example, as provided by
Treas. Reg. Section 1.61-12(a), a shareholder's forgiveness of a
corporation's indebtedness to him "amounts to a contribution to the
capital of the corporation," although neither stated capital nor
assets are increased.  And a shareholder's payment of an expense of
his corporation is regarded as a "contribution to capital," although
such payment discharges the corporation's liability rather than adding
to its capital or assets.  See Rittenberg v. United States, supra;
Koree v. Commissioner, supra.

   In each of these situations, what is important is not the
transaction's effect on the corporation's balance sheet, but whether
the transaction is a "capital expenditure" on the part of the
shareholder, in which case the Code prohibits the shareholder from
claiming an immediate loss deduction.  As the Tax Court explained in
Ihrig v. Commissioner, 26 T.C. at 76, a shareholder's expenditure "to
safeguard and maintain the existence of the corporation() so as not to
jeopardize his personal interest" is an inherently capital expense.
"Payments made by a stockholder of a corporation for the purpose of
protecting his interest therein must be regarded as "(an) additional
cost of his stock," and such an expenditure cannot be currently
deducted.  Eskimo Pie Corp. v. Commissioner, 4 T.C. at 676.  See
Johnson, Tax Models for Nonprorata Shareholder Contributions, 3 Va.
Tax Rev. 81, 127 (1983).  /12/

   6. In 1969, Congress confirmed the correctness of our view that a
stock surrender designed to advance the financial interest of the
corporation does not generate an immediate loss deduction for the
shareholder, but rather should be treated as a contribution to the
corporation's capital.  In that year, Congress added Section 83 to the
Code to address the tax consequences of the transfer of restricted
stock to an employee as compensation.  Tax Reform Act of 1969, Pub. L.
No. 91-172, Section 321(a), 83 Stat. 588;  H.R. Rep. 91-413, 91st
Cong., 1st Sess. 86-89 (1969);  S. Rep. 91-522, 91st Cong., 1st Sess.
119-124 (1969).  One of the problems that arose in the drafting of
this Section was to determine the correct way to treat the situation
where a shareholder, rather than the corporate employer, makes a
"bargain sale" of stock to an officer or employee.  In Downer v.
Commissioner, supra, the source of the "fragmented" theory of stock
ownership on which the court of appeals below relied (see Pet. App.
7a, 11a, 14a-15a), the Tax Court had held that the shareholder could
take an immediate loss deduction on such a sale.  Congress in 1969
specifically declined to adopt that approach.

   In Section 83(h), Congress provided that the corporation may take a
business-expense deduction for the amount by which the employee is
deemed to have been compensated by such a stock transfer.  The Senate
Finance Committee (S. Rep. 91-522, supra, at 123-124) explained the
rationale for this treatment as follows:

         In general, where a parent company's or a shareholder's stock
      is used to compensate employees under a restricted stock plan,
      the transfer of the stock by the parent company or shareholder
      is to be treated as a capital contribution to the company which
      is to be entitled to a deduction in accordance with the
      restricted property rules.  The parent company or the
      shareholder merely is to reflect the contribution as an increase
      of the equity in the company which is entitled to the
      compensation deduction.

   See also Treas. Reg. Section 1.83-6(d).  Congress thus recognized
in Section 83(h) that a "bargain sale" from a shareholder to an
employee for the benefit of the corporation should not be treated as a
routine "sale or exchange." Rather, the purpose and effect of the
transaction mandates that the bargain element of the stock transfer be
treated as a contribution to capital by the selling shareholder,
followed by the payment of compensation by the corporation to the
employee.  The corollary of this treatment, of course, is that the
selling shareholder is not entitled to an immediate loss deduction on
the bargain element of the sale.

   As the Sixth Circuit observed in Tilford v. Commissioner, 705 F.2d
828, cert. denied, 464 U.S. 992 (1983), the enactment of Section 83(h)
was a repudiation of the Tax Court's reasoning in Downer.  Congress
concluded that, despite what the Tax Court referred to as the
"fragmented" view of stock ownership, a shareholder's transfer of
stock to a corporate employee to further the purposes of the
corporation should be treated as a contribution to capital that has no
immediate tax consequences for the shareholder.  In the words of the
Sixth Circuit, the enactment of Section 83(h) reflected the "apparent
intention on the part of the Congress to embrace a theory contrary to
the one underlying the Downer case" (705 F.2d at 829).  Congress's
action in 1969 thus lends strong support to our contention that the
"fragmented" view of stock ownership, which governs the tax treatment
of sales and exchanges, has no application where (as here) a
stockholder makes a contribution to capital by transferring stock to
or for the benefit of his corporation.  /13/

   The court below sought to limit Tilford to its facts (Pet. App.
15a-16a).  But there is no rational basis for treating a shareholder's
transfer of stock to an employee as a contribution to capital, yet
failing to accord the same treatment to a shareholder's surrender of
stock directly to the issuing corporation.  See Frantz v.
Commissioner, 83 T.C. at 178 n.15.  This point may be illustrated by a
simple example.  Assume a corporation with 100 shares outstanding, of
which X owns 80 shares and Y owns 20 shares.  Assume that the
corporation wishes to increase Y's ownership percentage to 25%, but
wishes to do so without issuing any new stock.  This result could be
accomplished in two ways.  X could surrender 20 shares to the
corporation, leaving him with 60 shares and Y with 20.  Or X could
transfer five shares to Y, leaving X with 75 shares and Y with 25.  In
either event, X will own 75% of the corporation, and Y will own 25%,
after the transaction has been consummated.  In enacting Section
83(h), Congress made clear that X in the latter situation should be
deemed to have made a contribution to the corporation's capital, and
that his basis in the transferred shares should be added to the basis
of the shares he retains.  There is no conceivable justification for
permitting X to take an immediate loss deduction when the same end
result is accomplished by the former route.  Congress's action in 1969
thus confirms that, when a shareholder surrenders a portion of his
stock holdings in an effort to improve the financial condition of the
corporation, his transfer is properly viewed not as a loss but as a
contribution to capital.

 B. Allowing a Shareholder to Claim an Immediate Loss Deduction For a
Stock Surrender Creates Substantial Tension with Other Provisions of
The Code

 1. The Law Pertaining to Stock Redemptions Indicates that Stock
Surrenders do not Generate an Immediate Loss

   The court of appeals' approval of immediate loss treatment for
respondents' non-pro-rata stock surrender cannot be reconciled with
established principles regarding the tax treatment of stock
redemptions.  A "redemption" occurs when a shareholder surrenders
stock to his corporation and receives cash or other property in return
(I.R.C. Section 317(b)).  It is normally advantageous for the
shareholder to have a redemption treated as a "sale or exchange" of
his stock, in which case he will recognize an immediate capital gain
or loss.  "Sale or exchange" treatment is accorded to the shareholder,
however, only if the redemption yields a substantial, or "meaningful,"
reduction in his percentage interest in the corporation.  United
States v. Davis, 397 U.S. 301, 313 (1970);  I.R.C. Section 302(a), (b)
and (d).  /14/

   Absent a substantial reduction in the shareholder's overall
interest in the corporation, a stock redemption is broken down into
two parts for tax purposes, with the receipt of cash or property being
dissociated from the surrender of shares.  The receipt of cash or
property is generally treated as a dividend.  See I.R.C. Section
302(d), cross-referring to I.R.C. Section 301(c).  The surrender of
shares is viewed independently and results in no immediate gain or
loss.  Rather, the shareholder's basis in the surrendered shares is
added to his basis in the stock retained.  See United States v. Davis,
397 U.S. at 307-308 n.9;  Treas. Reg. Section 1.302-2(c);  Brodsky &
Pincus, The Case of the Reappearing Basis, 34 Taxes 675, 676-677
(1956).  Thus, if a stock redemption fails to produce a meaningful
reduction in the redeeming shareholder's ownership interest, the
redemption is not treated as a "sale or exchange," but rather is
treated as a contribution to capital in the form of a stock surrender,
coupled with the separate payment of a cash distribution to the
shareholder.

   In this case, respondent's surrender of shares to Travco reduced
their interest in the corporation from 72.5% to 68.5%, a reduction
that Judge Joiner correctly characterized as "so minute as to be
illusory" (Pet. App. 20a).  If respondents had received any cash in
conjunction with the surrender -- even one penny a share -- the
surrender would have been treated as a redemption subject to the
provisions of Section 302.  In that event, the cash would have been
treated as a dividend or other distribution, and respondents' basis in
the surrendered shares would have been added to their basis in the
shares retained, just as if they had made a contribution to capital in
an amount equal to their basis in the surrendered shares.  Because
respondents received no cash, their transaction did not fall within
the literal terms of the redemption provisions, and Section 302
therefore does not itself mandate the tax treatment just described.
But it would indeed be a perverse result if respondents could secure
the radically different tax treatment of an immediate deductible loss
simply by forgoing a peppercorn of consideration.

   Practically speaking, a stock surrender resembles a redemption for
a zero dividend.  More precisely, a stock surrender is equivalent to a
redemption in which the quid-pro-quo for the shareholder is not the
immediate and direct benefit of a cash dividend, but rather the more
indirect and long-term benefit of enhancing his overall investment in
the corporation through the improvement of its financial condition.
Thus, redemption principles strongly indicate that when a shareholder
makes a non-pro-rata stock surrender to improve the financial position
of his corporation, while maintaining the same effective control over
the corporation that he had before, he has suffered no loss.  See
Frantz, 784 F.2d at 125;  Arlinghaus, Tax Court Questions Validity of
Restricted Property Regulations, 59 Taxes 261, 264-265 (1981).  The
tax consequences of the transaction should therefore be the same as
those that would attend a redemption of his shares, namely, the
addition of the basis in the surrendered shares to the basis in the
shares he retains.  /15/

 2. The Decision Below May Enable A Stockholder In A Failing
Corporation To Avoid The Tax Consequences Prescribed By Section 165(g)
Of The Code

   The court of appeals' decision confers at least one, and perhaps
two, unjustified tax benefits upon taxpayers who make non-pro-rata
stock surrenders.  First, the decision below permits the acceleration
of tax deductions through the recognition of a currently deductible
loss on a transfer that, if effected by the use of any property other
than corporate stock, would result in a nondeductible contribution to
the corporation's capital.  This is true regardless of whether the
loss is characterized as capital or ordinary.  If the loss is
characterized as ordinary, however, as both the court of appeals (Pet.
App. 16a) and the Tax Court in Frantz (83 T.C. at 182) apparently
assumed that it would be, /16/ the decision below opens the door to a
second, and even greater, windfall for shareholders of failing
corporations.  Indeed, it would lay the foundation for the use of
stock surrenders as a tax planning tool by which shareholders could
unjustifiably avoid the tax treatment mandated by other provisions of
the Code.

   Prior to 1938, the Code had provided that losses sustained when
stock became worthless were treated as ordinary losses, even though
the sale or exchange of such stock before it became worthless would
have given rise to a capital loss.  Congress recognized that this
disparate treatment was "not satisfactory, since, in either case, the
loss sustained by the taxpayer is a loss of capital and consequently
should be treated similarly for tax purposes." H.R. Rep. 1860, 75th
Cong., 3d Sess. 18 (1938).  Accordingly, Congress enacted what is now
Section 165(g)(1) of the Code, which generally provides that the loss
incurred when stock becomes worthless is a capital loss.  /17/ See
generally B. Bittker & J. Eustice, Federal Income Taxation of
Corporations & Shareholders Paragraph 4.09, at 4-34 (4th ed. 1979).

   If the decision below is permitted to stand, and if the court of
appeals is correct in stating that shareholders who surrender stock
"are entitled to an ordinary loss" (Pet. App. 16a), taxpayers will
easily be able to thwart Congress's purpose in enacting Section
165(g)(1).  As explained by the Tax Court in Frantz (83 T.C. at 182),
shareholders of financially distressed corporations who reasonably
expect their stock to become worthless need not sit idly by and accept
the capital-loss treatment mandated by Section 165(g)(1).  /18/ If
they surrender their shares to the corporation just before the shares
become worthless, they will be able to take an ordinary loss in the
same amount that Section 165(g)(1) would have contemplated that they
take a capital loss.  Indeed, a blueprint for converting capital
losses to ordinary losses in precisely this fashion is contained in a
practitioner's article published in 1975.  See Gebhardt, When Are Loss
Deductions Available on the Voluntary Surrender of Stock?, 43 J. Tax.
22 (1975).  /19/

   Adverting to these tax-avoidance possibilities, the Section Circuit
in Frantz held that there is no justification for treating a stock
surrender as a loss.  "To do so," the court explained, "would enable a
taxpayer, who acts voluntarily in making the surrender, to manipulate
his holdings for tax advantages that would not be available if he sold
his shares without any such interlocking of equity interests in the
corporations" (784 F.2d at 125).  The Tax Court likewise was not
engaging in overstatement when it said that permitting a shareholder
to take an ordinary loss deduction upon surrendering stock to his
closely-held corporation "could encourage the practical equivalent of
a judicial repeal of section 165(g)." Frantz, 83 T.C. at 182.  /20/
Thus, the interplay of stock-surrender treatment with other provisions
of the Code confirms that such surrenders must be treated as
nondeductible contributions to capital.

 3. The Court of Appeals' Proposed Method Of Computing Respondents'
Alleged "Loss" Is Both Unprecedented and Impractical

   Although the court of appeals concluded that respondents' stock
surrender entitled them to a loss deduction, the court did not hold
that the amount of their deduction would necessarily be equal to their
cost or "basis" in the stock surrendered.  Rather, the court remanded
"for a determination of whether the surrender of the stock by the
taxpayers resulted in an increase in the value of their remaining
shares" (Pet. App. 16a).  The court of appeals did not elaborate on
the point, but such increase in value might occur in at least two
ways.  First, respondents' surrender would cause the worth of the
corporation to be allocated among fewer outstanding shares, so that
respondents' remaining shares would have a higher value per-share than
they had previously.  /21/ Second, respondents' stock surrender was
designed to improve the corporation's financial position -- by making
the company more attractive to outside investors, for instance -- and
the surrender could thus be expected to have some
difficult-to-quantify impact on the "market value" of respondents'
remaining stock.  The court of appeals intimated (ibid.) that any
increase in value resulting from the surrender should be subtracted
from respondents' basis in the surrendered shares in order to
determine the magnitude of their supposed "loss."

   If one were to accept the court of appeals' erroenous premise that
a voluntary stock surrender generates a loss, the court's proposed
method of computing the amount of that loss would arguably make some
sense in a world of pure theory.  But "(t)axation is a practical
matter" (Harrison v. Schaffner, 312 U.S. 579, 582 (1941)), and the
court's propsed computation would be extremely difficult in practical
terms.  Closely-held family corporations are notoriously difficult to
value, particularly when they are in financial distress and when
factors like "enhanced attractiveness to outside investors" must be
taken into account.  See Frantz, 784 F.2d at 124.  The court's
proposed computation, moreover, is unprecedented -- at least outside
the stock-surrender arena -- and is bizarre as a matter of basic tax
principles.  The premise of the proposed computation is that
respondents have realized a loss upon surrendering their shares.  But
respondents obviously have not realized any gain on the shares that
they have retained.  We can think of no instance in which the Internal
Revenue Code provides that a deduction is to be computed by offsetting
a realized loss by an unrealized gain.

   These computational difficulties, like the difficulties that attend
the determination whether respondents' supposed "loss" should be
deemed capital or ordinary (see note 16, supra), are not, we submit,
accidental.  Rather, they point up the fundamental error of the court
of appeals' premise -- that a stock surrender generates a "loss" of
any sort.  If respondents' stock surrender is held to be a capital
contribution, all of these difficulties will be avoided.  We urge the
Court to avoid them.

                              CONCLUSION

   The judgment of the court of appeals should be reversed.

   Respectfully submitted.

   CHARLES FRIED

      Solicitor General

   ROGER M. OLSEN

      Assistant Attorney General

   ALBERT G. LAUBER, JR.

      Deputy Solicitor General

   ALAN I. HOROWITZ

      Assistant to the Solicitor General

   JONATHAN S. COHEN

   DAVID I. PINCUS

      Attorneys

   JANUARY 1987

   /1/ Peter's sister owned a 10% interest, his brother-in-law owned a
4.1% interest, and his mother owned a 2.2% interest (Pet. App. 30a).

   /2/ The business purpose asserted for the surrender was to make
Travco more attractive to a new investor who (it was hoped) would
inject new capital into the company through the purchase of a
substantial quantity of new stock (see Pet. App. 28a-29a).  No such
new investor appeared and, some two months after Karla surrendered her
stock, Peter, Karla, and Peter's mother subscribed to 700,000 new
shares themselves (id. at 31a).

   /3/ See, e.g., Tilford v. Commissioner, 75 T.C. 134 (1980), rev'd,
705 F.2d 828 (6th Cir.), cert. denied, 464 U.S. 992 (1983);  Smith v.
Commissioner, 66 T.C. 622, 628 (1976), rev'd sub nom. Schleppy v.
Commissioner, 601 F.2d 196 (5th Cir. 1979);  Downer v. Commissioner,
48 T.C. 86, 91 (1967).  Although the Tax Court's early decisions on
the subject had reflected considerable uncertainty and inconsistency
about the correct way to treat these transactions (see, e.g., Ames v.
Commissioner, 14 B.T.A. 1067, 1072 (1929), aff'd, 49 F.2d 853 (8th
Cir. 1931);  Wright v. Commissioner, 18 B.T.A. 471, 473 (1929)
(Murdock, J., dissenting), modified, 47 F.2d 871 (7th Cir. 1931)), the
weight of the Tax Court's more recent authority was that a
non-pro-rata stock surrender gives rise to an immediate loss.  See
generally Johnson, Tax Models for Nonprorata Shareholder
Contributions, 3 Va. Tax Rev. 81, 84-86 & nn. 18, 22 (1983).

   /4/ The corollary of the principle that capital contributions are
not immediately deductible by the shareholder is that such
contributions are not taxable as income to the corporation.  See
I.R.C. Section 118;  Treas. Reg. Section 1.118-1;  10 J. Mertens, Law
of Federal Income Taxation Section 38.22, at 50 (1984).  The term
"capital contribution," of course, does not presuppose on the
shareholder's part "a donative intent, in the sense that there must be
no business motive for making it." Id. at 52.  To the contrary,
capital contributions are ordinarily made (as they were made in the
instant case, see Pet. App. 3a, 28a) for the purpose of improving the
fortunes of the corporation, and hence are intended to redound to the
long-term interests of the contributing shareholder.

   /5/ Everyone of course agrees that a pro-rata stock surrender,
which leaves all shareholders owning the same percentage of the
corporation that they previously owned, is not an event for loss
recognition.  Frantz v. Commissioner, 784 F.2d 119, 123 n.3 (2d Cir.
1986), petition for cert. pending, No. 86-11.  See Eisner v. Macomber,
252 U.S. 189 (1920).

   /6/ As respondents (Br. in Opp. 9) and the court of appeals (Pet.
App. 15a) point out, one effect of a non-pro-rata stock surrender is
to reduce the shareholder's proportionate interest in the company,
which can have such future effects as a reduction in dividends or
voting power.  Practically speaking, of course, these future effects
are likely to be marginal where (as here) a controlling shareholder
surrenders a small portion of his shares to a corporation in financial
difficulties.  A slight diminution in voting power is usually
immaterial to a shareholder who continues to hold a controlling stock
interest.  Corporations in financial difficulties, moreover, generally
do not pay dividends, and they are likely to resume paying dividends
only if the business recovers, in which case the stock surrender may
well turn out to have yielded the contributor an ultimate gain rather
than a loss.  In any event, even if a prospective reduction of
dividends or voting power did constitute a real economic detriment,
such future effects would not represent a currently deductible "loss."
To the extent that the stock surrender ultimately proves to have an
adverse economic impact upon the shareholder (for example, in the form
of reduced dividends or a reduced share of corporate assets upon
dissolution (see Br. in Opp. 9)), the tax consequences will be
recognized at the time of the events (such as sale of the stock or
liquidation of the corporation) that "close" the transaction.  After
all, a shareholder who surrenders debt to his corporation may cite
numerous adverse future effects, such as loss of interest, loss of
principal, and loss of potential voting power in the event of
insolvency or bankruptcy.  Yet it is clear beyond peradventure that a
surrender of debt represents a capital contribution and does not
generate a current tax deduction.  See Treas. Reg. Section 1.61-12(a);
 pages 10-11, supra.

   /7/ Because the instant stock surrender did not cause respondents
to lose control of Travco, there is no need for the Court here to
consider the proper tax treatment of a stock surrender that does lead
to forfeiture of corporate control.

   /8/ In the absence of specific identification of shares, the
Regulations provide that gains or losses are measured by assigning
basis to the shares that are sold or exchanged on a first-in,
first-out method.  See Treas. Reg. Section 1.1012-1(c)(1).

   /9/ "Treasury stock is a corporation's own stock, once issued and
later reacquired but not cancelled.  Technically, it is still classed
as issued stock, although no longer outstanding." G. Johnson & J.
Gentry, Finney and Miller's Principles of Accounting 537 (7th ed.
1974).

   /10/ See G. Johnson & J. Gentry, supra, at 537 (noting that
"(s)tockholders' preemptive rights do not apply to treasury stock;
treasury shares may be returned to an outstanding status without
stockholders' authorization;  * * * and if treasure stock was fully
paid when originally issued, it can be reissued at a discount without
imposing any discount liability on the new owner").

   /11/ Although there are various methods of accounting for stock
surrenders on a company's balance sheet, under one commonly-used
method "donated treasury stock is recorded following the same
procedures used for purchased treasury stock, except that the credit
is to Donated Capital." G. Johnson & J. Gentry, supra, at 549.

   /12/ The court of appeals suggested that a stock surrender cannot
properly be viewed as "represent(ing) an additional price paid for the
stock" (Pet. App. 15a), but this statement is plainly mistaken.  The
effect of respondents' stock surrender was to convert their original
purchase of Travco shares into a purchase of a smaller percentage of
the company for the same total price.  Thus, while respondents'
surrender did not inject any new cash into Traveco, it did cause them,
retroactively as it were, to pay a higher per share price for the
stock that they retained, and the surrender thus represented "an
additional price paid for (that) stock" (ibid.).  The tax treatment
that we believe proper -- namely, an increase in the cost or "basis"
of respondents' retained shares in an amount equal to their cost or
"basis" in the shares that they surrendered -- thus comports exactly
with the economic reality of the situation.

   /13/ The court of appeals suggested (Pet. App. 15a-16a) that
Congress's enactment of Section 83(h) could be read to support its
holding, on the theory that a negative inference could be drawn from
Congress's decision to address shareholder transfers of stock to
corporate employees, without simultaneously addressing shareholder
surrenders of stock directly to the corporation.  This suggestion is
specious.  In drafting Section 83, Congress was attempting to deal
with all relevant aspects of a particular issue -- transfers of
restricted stock to employees as compensation.  To perform this task
fully, Congress was required to deal with the situation in which stock
was transferred to an employee by a shareholder rather than by the
corporation itself, as happened in Downer.  Congress simply had no
occasion to consider stock surrenders that are unconnected to employee
compensation and that are made to the corporation rather than to its
employees.  The negative inference that the court of appeals sought to
draw from Congress's enactment of Section 83(h) is thus illogical.  As
pointed out in the text, the relevant inference that should be drawn
from that enactment is that Congress disapproved the reasoning of the
Tax Court's decision in Downer, reasoning on which the court of
appeals heavily and erroneously relied.

   /14/ Congress has quantified the concept of a "meaningful"
reduction in a pair of safe-harbor provisions.  Specifically, Section
302(b)(3) provides "sale or exchange" treatment when a redemption
completely terminates a shareholder's equity interest in the
corporation.  And Section 302(b)(2) provides "sale or exchange"
treatment when a redemption is "substantially disproportionate" with
respect to the redeeming shareholder.  Of particular relevance here,
the latter provision requires that the redeeming shareholder own less
than 50% of the corporation's voting stock immediately after the
redemption in order for the redemption to be deemed "substantially
disproportionate." I.R.C. Section 302(b)(2)(B).  Respondents togethr
owned 68.5% of Travco's voting stock immediately after their stock
surrenders (Pet. App. 32a) and, for purposes of Section 302(b), each
would be deemed to own the other's stock as well as his own.  See
I.R.C. Section 302(c)(1), cross-referring to I.R.C. Section
318(a)(1)(A)(i) (providing that an individual shall be considered as
owning stock owned directly or indirectly by his spouse).

   /15/ It is of course true that the tax abuse at which the Code's
redemption provisions were aimed (the bailout of corporate earnings to
shareholders as capital gains rather than as dividends) is not the
same as the tax abuse that may accompany unilateral stock surrenders
(the acceleration of capital loss deductions and their possible
conversion into ordinary losses).  Cf. Frantz, 83 T.C. at 178 n.16.
But that by no means suggests any inappropriateness in the redemption
analogy that we have drawn in the text.  The redemption provisions
reflect Congress's determination (1) that a shareholder's surrender of
stock to his corporation should not be treated as a "sale or
exchange," and hence should not be the occasion for recognizing a
loss, unless the reduction in the shareholder's ownership interest is
meaningful;  and (2) that a shareholder's surrender of shares, in the
absence of such a meaningful reduction, should be accounted for by
increasing the basis of his retained shares, just as if he had made a
contribution to the corporation's capital.  Both of these principles
are fully applicable to the instant case and dictate its proper
outcome.

   /16/ The issue of whether any loss realized on a stock surrender
should be characterized as capital or ordinary was not briefed by the
parties below.  The court of appeals nevertheless stated in the last
sentence of its opinion that respondents would be "entitled to an
ordinary loss deduction" (Pet. App. 16a).  That view is supported by
some older Tax Court decisions, which were overruled in Frantz.  See
Smith v. Commissioner, 66 T.C. at 648;  Budd Int'l Corp. v.
Commissioner, 45 B.T.A. 737, 756 (1941).  See Frantz, 83 T.C. at 175.
And characterization of the supposed loss as ordinary would derive
some support from the text of Section 1211, which speaks of "losses
from sales or exchanges of capital assets," since a stock surrender is
not literally a "sale or exchange." See generally Frantz, 784 F.2d at
124.  On the other hand, there is authority to support the proposition
that such a loss would be capital.  The Tax Court in Downer viewed as
capital the loss supposedly realized upon a shareholder's transfer of
stock to a corporate employee (48 T.C. at 92-93), and it has been
suggested by commentators that this view would be preferable to
treating the loss as ordinary.  See Johnson, Tax Models for Nonprorata
Shareholder Contributions, 3 Va. Tax Rev. 81, 117 (1983);  Comment,
Frantz v. Commissioner, Non Pro Rata Surrender of Stock to the Issuing
Corporation, 38 Tax Law. 739, 754-757 (1985).  In truth, neither
characterization of the loss supposedly realized on a stock surrender
is wholly satisfactory.  The correct resolution of the dilemma is of
course to recognize that, for the reasons we have stated, a
shareholder's voluntary surrender of stock does not generate any kind
of immediately deductible loss.

   /17/ Section 165(g)(1) provides that "(i)f any security which is a
capital asset becomes worthless during the taxable year, the loss
resulting therefrom shall, for purposes of this subtitle, be treated
as a loss from the sale or exchange, on the last day of the taxable
year, of a capital asset." Section 165(g)(2)(A) in turn defines
"security" to include "a share of stock in a corporation."

   /18/ The distinction between capital losses and ordinary losses
retains considerable importance even though the Tax Reform Act of 1986
has eliminated the differential in tax rates as between capital gains
and ordinary income.  Pub. L. No. 99-514, Sections 301, 311 (Oct. 22,
1986).  That is because the new Code retains the limitation,
applicable under previous law, that allows individuals annually to
deduct only $3,000 of net capital losses against ordinary income;
that limitation also prohibits corporate taxpayers from deducting any
capital losses against ordinary income.  I.R.C. Section 1211;  see 2
H.R. Conf. Rep. 99-841, 99th Cong., 2d Sess. 105-106 (1986).  Ordinary
losses, by contrast, are generally deductible in full against ordinary
income.  I.R.C. Section 165(a), (b) and (c)(2).  Thus, unless a
taxpayer has capital gains against which a capital loss can be offset,
he typically will be able to obtain only a limited current tax benefit
from the loss if it is characterized as capital rather than ordinary.

   /19/ The article characterizes the stock surrender as "a viable
relatively risk-free way of converting part of a shareholder's capital
loss on his investment into an ordinary loss" (43 J. Tax. at 26).  The
article explains the scheme as follows (id. at 25-26 (footnote
omitted)):

         The stock surrender * * * should have distinct application to
      tax planning with respect to corporations in failing financial
      health.  One or more stockholders could surrender some, but not
      all * * *, of their shares to the corporation in
      disproportionate amounts;  under the applicable case law they
      can obtain ordinary loss deductions for either their full cost
      basis for the surrendered shares or their cost basis for the
      surrendered shares less the enhancement of the book value of
      their remaining shares, depending on which view is applied in
      determining the amount of loss.  Such a surrender should be
      procedurally accomplished by assigning and delivering the
      certificates to the corporation.  It would also seem appropriate
      to accompany the certificates with a letter expressing the
      unconditional nature of the assignment and stating that the
      purpose of the assignment is to improve the corporation's
      financial position.

                      * * * * *

         If the corporation were about to fail completely, a stock
      surrender to the corporation could also be used to obtain an
      ordinary loss deduction for a shareholder in the manner
      previously described.  It would be necessary to make the
      surrender when the corporation's stock still had value, since a
      loss on worthless stock is capital and subject to the
      restrictions of Sections 1011 and 1012.  It would seem hard for
      the Service to segregate, for purposes of disallowing the loss
      deduction, the desire to aid the corporation's finances and
      protect the retained investment from the tax planning (or tax
      avoidance) motive of converting an eventual capital loss into a
      partial ordinary loss.

   /20/ The Tax Court found in this case that respondent's stock
surrenders had a business purpose and "were not primarily tax
motivated" (Pet. App. 32a).  We do not challenge that factual finding.
 It bears mentioning, however, that respondent Peter Fink testified
that he followed the advice of tax counsel in deciding which shares to
surrender (Tr. 35-36).  It also bears mentioning that, when
respondents surrendered their shares, they forwarded their
certificates to the corporation accompanied by letters stating that
they were "unconditionally surrendering" their shares and were doing
so, "in order to improve the financial condition of the company"
(Stip. Exhs. 7-G, 8-H) -- precisely as recommended in Mr. Gebhardt's
blueprint for creating ordinary loss deductions, which was published
just over a year before.  See 43 J. Tax. at 25-26 (quoted in note 19,
supra).

   /21/ This effect may be illustrated by reference to our example
(pages 28-29, supra) concerning a hypothetical corporation with 100
outstanding shares, 80 of which are owned by X and 20 of which are
owned by Y.  Assume that the corporation is worth $100, so that X's 80
shares are worth $80.  Assume that X then surrenders 20 shares,
leaving him with 60 and Y with 20.  Since the corporation is still
worth at least $100 after the surrender, and since X owns 75% of the
stock after the surrender, his 60 shares are now worth $75, whereas
those 60 shares were worth only $60 before.

   APPENDIX