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 Petition for a Writ of Certiorari to the United States Court of Appeals for the Sixth Circuit The Solicitor General, on behalf of the Commissioner of Internal Revenue, petitions for a writ of certiorari to review the judgment of the United States Court of Appeals for the Sixth Circuit in this case. TABLE OF CONTENTS Opinions below Jurisdiction Statutes involved Question Presented Statement Reasons for granting the petition Conclusion Appendix A Appendix B Appendix C Appendix D OPINIONS BELOW The opinion of the court of appeals (App., infra, 1a-20a) is reported at 789 F.2d 427. The opinion of the Tax Court (App., infra, 23a-33a) is unofficially reported at 48 T.C.M. (CCH) 786. JURISDICTION The judgment of the court of appeals (App., infra, 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 jurisdiction of this Court is invoked under 28 U.S.C. 1254(1). STATUTES INVOLVED The relevant portions of Sections 165 and 1016(a) (1) of the Internal Revenue Code of 1954 (26 U.S.C.) are set forth in the Appendix, infra, 34a-35a. QUESTION 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 (App., infra, 2a). Travco had one class of common stock outstanding, of which Peter owned 52.2% and Karla 20.3% (id. at 27a, 30a). When the corporation encountered financial difficulties (see id. at 25a-27a), respondents surrendered a portion of their shares to the corporation in order "to improve (its) financial position, to preserve its business, and to increase (its) attractiveness * * * to outside investors" (id. at 3a, 28a). 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). 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 (App., infra, 32a). He accordingly determined deficiencies of $131,885 for 1976 and $133,826 for 1977 (id. at 23a). Petitioners sought redetermination of the deficiencies in the Tax Court. That Court sustained the Commissioner's position, 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 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; rather, his basis in the shares he retains. The Tax 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 provide 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 concluded, "(w)hether (he) 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 accordingly held in the instant case that respondents' stock surrenders did not give rise to immediately deductible losses, but rather must be treated as contributions to Travco's capital (App., infra, 32a-33a). 3. A divided court of appeals reversed (App., infra, 1a-20a). According to the majority's analysis, the outcome depended on whether it was proper to adopt a "unitary" or a "fragmented" view of stock ownership for purposes of the presented case (see id. at 4a-10a). Under the "fragmented" view, "each share of stock is considered a separate investment," and gain or loss is computed separately on the sale or dispostion of each share (id. 5a). Under the "unitary" view, "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 result in 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 adopt the "unitary" 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 in original)). The court of appeals specifically rejected the contrary holdings of the Second Circuit in Frantz V. Commissioner, supra, and of the Fifth Circuit in Schleppy v. Commissioner, 601 F.2d 196 (1979), both of which had held that similar stock surrenders did not give rise to an immediate loss deduction. Judge Joiner dissented (App., infra, 17a-20a). He 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). REASONS FOR GRANTING THE PETITION The court of appeals has created a direct conflict with the decisions of two other circuits concerning an important question of tax law -- the proper treatment for income tax purposes of a stockholder's non-pro-rata surrender of corporate shares. Because this issue has been a recurring one, and because the court of appeals' erroneous decision raises the possibility that taxpayers will be encouraged to make such surrenders to gain an undeserved and improper tax advantage, it appears likely that the conflict, if allowed to persist, will result in disparate tax treatment for a significant number of taxpayers. Review by this Court is warranted to resolve this conflict in the circuits and to correct the mistaken statutory interpretation of the decision below. 1. The court of appeals in this case has taken the position that a shareholder's non-pro-rata surrender of stock entitles him to an immediate loss deduction. The amount of this deduction will typically be measured by the taxpayer's cost or "basis" in the surrendered stock, with perhaps some adjustment for any increase in value of his remaining shares that is attributable to the surrender. See App., infra, 14a; Comment, Frantz v. Commissioner, Non Pro Rata Surrender of Stock to the Issuing Corporation, 38 Tax Law. 739, 742 (1985). The Court of appeals' holding to this effect squarely conflicts with the decisions of the Second Circuit in Frantz v. Commissioner, supra, and the Fifth Circuit in Schleppy v. Commissioner, supra. In Frantz, the dominant shareholder had sought to improve the corporation's financial condition by surrendering his preferred stock (784 F.2d at 121). The court of appeals affirmed the Tax Court's decision that the taxpayer was not entitled to an immediate loss as a result of this surrender. The court explained that "it is questionable whether a controlling stockholding 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 in Frantz 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 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 hence that the surrender 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 decision below cannot be reconciled with Frantz or Schleppy. The inflexible rule adopted by the court below permits the immediate recognition of loss as a result of a non-pro-rata stock surrender, regardless of how insignificantly the surrendering shareholder's ownership interest is thereby reduced and regardless of whether he has suffered any loss as a practical matter. Indeed, the facts of the instant case, involving a stock surrender that reduced the taxpayers' 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 App., infra, 30a with 601 F.2d at 198. There can thus be no doubt that cases identical to Schleppy or Frantz would be decided in favor of the taxpayer's request for immediate loss recognition should they arise in the Sixth Circuit. Indeed, the court of appeals below made no attempt to harmonize its decision with Frantz and Schleppy; it restricted its discussion of those cases to criticisms of their rationale. See App., infra, 12a-14a. /1/ 2. Resolution of this direct conflict is a matter of substantial administrative importance. As the number of cases already decided suggests, the treatment of non-pro-rata stock surrenders has proven to be a recurring issue, and there is every reason to expect that litigation concerning this question will persist, and probably increase, in the wake of the court of appeals' decision here. That is especially true because acceptance of the taxpayer's position on this question, as the Tax Court noted in Frantz, would encourage the use of stock surrenders as a planning tool by which taxpayers might obtain unjustified tax advantages. See 83 T.C. at 182. First of all, the decision below would permit taxpayers to accelerate their tax deductions, enabling them to recognize a currently deductible loss on a transfer which, if effected by the use of any property other than corporate stock, would result in a nondeductible contribution to the corporation's capital. Moreover, the decision below could also permit "a conversion of eventual capital losses into immediate ordinary losses" (83 T.C. at 182). Under Section 165(g)(1) of the Code, /2/ a loss on worthless stock is "treated as a loss from the sale or exchange * * * of a capital asset," and is thus subject to the limitation on deductibility of capital losses established in Section 1211. Because a unilateral surrender of stock would usually not be deemed to involve a "sale or exchange," however, a loss realized on such a surrender has been held in the past by the Tax Court not to be a capital loss but rather to be an ordinary loss deductible in full under Section 165(c)(2). See Frantz, 784 F.2d at 124-125; 83 T.C. at 182; I.R.C. Sections 165(f) and 1211(b). Thus, "(s)hareholders of a corporation on the verge of complete failure could * * * avoid the section 165(g) limitations by surrendering shares in disproportionate amounts" just before their stock becomes completely worthless (83 T.C. at 182). For the courts to sanction such a result would, as the Tax Court observed (ibid), effect "the practical equivalent of a judicial repeal of section 165(g)." The court of appeals in Frantz echoed these two themes, noting that acceptance of the taxpayer's position may give the surrendering taxpayer "an undeserved and illogical tax advantage" (784 F.2d at 124). See Gebhardt, When Are Loss Deductions Available on the Voluntary Surrender Stock?, 43 J. Tax. 22 (1975) (suggesting the use of stock surrenders as a tax planning device). The revenue consequences of stock-surrender transactions are generally quite substantial. In this case, for example, the tax deficiencies asserted for a stock surrender in which "the diminution in the shareholders' corporate control and equity interest (was) so minute as to be illusory" (App., infra, 20a (Joiner, J., dissenting)) exceed a quarter of a million dollars. It can thus be expected that the decision below will lead to increased litigation concerning the proper tax treatment of non-pro-rata stock surrenders unless this Court intervenes to resolve the existing conflict in the circuits. 3. The court of appeals' approval of an immediate loss deduction for a non-pro-rata stock surrender is a serious misapplication of tax law principles. It has long been established that transfers by a shareholder to his corporation are treated, not as losses, but as contributions to capital that have no immediate tax consequences. The Treasury 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). /3/ More generally, "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). Pursuant to Section 1016(a) (1) of the Code, such contributions to capital result not in a loss but in an increase in the basis of the shareholder's shares by the amount of his basis in the debt or other property transferred. These regulations 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 outlays 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 -- a transaction that 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 designed to further the corporation's business, did not give rise to a personal deduction for the taxpayer even though he hoped to derive some indirect benefit from them by virtue of his stock investment in the company (id. at 494). See also Interstate Transit Lines v. Commissioner, 319 U.S. 590 (1943). The lower courts have recognized that 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 shareholder's basis in his shares. See, e.g., Rittenberg v. United States, 267 F.2d 605 (5th Cir. 1959), cert. denied, 361 U.S. 931 (1960); Eskimo Pie Corp. v. Commissioner, 4 T.C. 669 (1945), aff'd, 153 F.2d 301 (3d Cir. 1946); Ihrig v. Commissioner, 26 T.C. 73 (1956). It thus follows inexorably from du Pont and its progeny that, contrary to the decision below, a shareholder's contribution of a portion of his stock to the corporation for the purpose of improving its financial condition yields an increase in the shareholder's basis in his remaining shares and does not give rise to an immediate loss. See generally Johnson, Tax Models for Nonprorata Shareholder Contributions, 3 Va. Tax Rev. 81 (1983). The court of appeals failed to reach this result because it mistakenly perceived this case as turning on a supposed distinction between the "fragmented" and "unitary" views of stock ownership. See App., infra, 4a-10a. This alleged difference is in fact specious, and it provides no guidance whatever 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 other property, his gain or loss on the transaction 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 naturally applies to stock. An individual who owns shares in a corporation may have quite different bases in the several shares, depending on 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). /4/ 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, stocks 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 stock once issued by the corporation but 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. A shareholder's donation of cash or tangible property, or his surrender of indebtedness, is treated as a contribution to the corporation's capital that does not give rise to a 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 his fellow shareowners will be benefitted to some extent by his transfer does not entitle him to a current tax deduction. And this result does not follow from any abstract distinction between "fragmented" and "unitary" views of stock ownership. It follows, rather, from (1) the significant difference between a shareholder's transfer of property to his own corporation and an arm's-length "sale 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. /5/ As the Second Circuit and the Tax Court explained in Frantz (see 784 F.2d at 123-124; 83 T.C. at 179-181), the fact that a shareholder's surrender of stock is intended to improve the financial position of his corporation -- and hence to enhance the value of his remaining stock -- means that the surrender itself does not result in any genuine and immediate loss to him. To the contrary, the surrender in reality is an "open transaction"; whether or not it will result in a loss depends upon the extent to which the surrender ultimately succeeds in enhancing the value of the taxpayer's remaining stock. That can be determined only when the transaction is "closed" by the disposition of his remaining shares. See also Kistler v. Burnet, 58 F.2d 687, 689 (D.C. Cir. 1932) (explaining that tax consequences of partial surrender will be assessed upon disposition of remaining shares). 4. Established principles regarding the tax treatment of stock redemptions further demonstrate that the court of appeals erred in allowing respondents a loss deduction for their non-pro-rata surrender of shares to their corporation. A redemption occurs when a shareholder surrenders stock and receives cash or other property in return (I.R.C. Section 317(b)). A redemption is treated as a "sale or exchange" of the stock, thereby giving rise to immediate recognition of gain or loss, only if there is a substantial, or "meaningful," reduction in the shareholder's interest in the corporation. United States v. Davis, 397 U.S. 301, 313 (1970); I.R.C. Section 302(a), (b), and (d). /6/ Absent such a substantial reduction in the shareholder's overall interest in the corporation, the 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). The surrender of shares 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). In this case, respondents' surrender of shares to their corporation 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" (App., infra, 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, 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. Because respondents received no cash, their transaction did not fall within the literal terms of the redemption provisions, and Section 302 therefore does not 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 immediately deductible loss -- and an ordinary rather than a capital loss -- simply by foregoing 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 longer-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, maintaining the same effective control over the corporation that he had before, he has suffered no loss. 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. 5. As noted above, the decision in this case directly conflicts with Frantz v. Commissioner, supra, in which a petition for certiorari is pending, No. 86-11. We are filing contemporaneously with this petition a brief outlining our views in Frantz. As we explain in that brief (at 7-9), we believe that the instant case is somewhat preferable to Frantz as a vehicle for resolving the existing circuit conflict. It would therefore be appropriate for the Court to grant certiorari here and hold the petition in Frantz pending disposition of the instant case. Alternatively, the Court may wish to grant certiorari in Frantz and hold this case pending the outcome of that one. CONCLUSION The petition for a writ of certiorari should be granted. Alternatively, if certiorari is granted in Frantz v. Commissioner, No. 86-11, the petition should be held and disposed of as appropriate in light of the disposition of that case. 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 SEPTEMBER 1986 /1/ The fact that the decision below cannot be squared with Frantz is highlighted by the fact that Judge Parker, the author of the dissent in Frantz (83 T.C. at 187-193), wrote the Tax Court decision below in favor of the Commissioner. Judge Parker in this case reiterated her view that Frantz had been wrongly decided (App., infra, 33a n.3), but she nevertheless concluded that the Tax Court's decision in Frantz could not be distinguished and was "dispositive" in the instant case (id. at 33a). /2/ Unless otherwise noted, all statutory references are to the Internal Revenue Code of 1954 (26 U.S.C.), as amended (the Code or I.R.C.). /3/ This provision dates back to Art. 51 of Regulations 45 under the Revenue Act of 1918. See Commissioner v. Auto Strop Safety Razor Co., 74 F.2d 226 (2d Cir. 1934). /4/ 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. 1.1012-1(c)(1). /5/ The error of the court of appeals' focus on the "fragmented" and "unitary" views of stock ownership becomes particularly clear when one considers the consequences that flow from a shareholder's surrender of debt to his corporation. If a shareholder surrenders some of his debentures, it is settled beyond any doubt that the transaction is a contribution to the corporation's capital, resulting in an adjustment of the shareholder's basis in his shares. See Treas. Reg. Section 1.61-12(a). Clearly, this rule has never been thought to undermine the "fragmented" view of bond ownership -- the rule that the sale or exchange of individual debt instruments is a taxable event even if the bondholder continues to hold other bonds from the same debtor. /6/ Congress has quantified the concept of a "meaningful" reduction under the rubric of a "substantially disproportionate" redemption. See I.R.C. Section 302(b)(2); Treas. Reg. 1.302-3. Of particular relevance here, the "safe harbor" provision of Section 302 provides, as a threshold requirement that must be met before application of this provision can result in sale-or-exchange treatment, that the shareholder must hold less than 50% of the corporation's voting stock immediately after the redemption. I.R.C. Section 302(b)(2)(B). Respondents here, of course, owned 68.5% of Travco's voting stock immediately after their stock surrender. See page 2, supra.