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 Reply Brief for the Petitioner 1. The question in this case is whether a shareholder is entitled to claim an ordinary loss upon a non-pro-rata surrender of shares to his corporation. Respondents devote much of their brief to quarreling with our submission that the surrender is best viewed as a "contribution to capital," and we will discuss those objections in due course. At the outset, however, it is revealing to note that respondents make little effort to demonstrate affirmatively that the surrender should be treated as a loss. This approach is understandable. For whatever uncertainty there may be over exactly how to characterize the stock surrender here, it is quite clear that it cannot sensibly be characterized as a "loss." a. In surrendering a portion of their shares to the corporation, respondents parted with something of value for no explicit consideration in return. Ordinarily, such an intentional parting with something of value might be thought to be a gift. A deliberate gift motivated by donative intent, of course, does not give rise to a loss, and making a gift does not entitle the donor to a tax deduction. Respondents were careful, however, to dispel any suggestion that the stock surrender could be viewed as a gift to the corporation, or to minority shareholders, to the extent of the slight increase in their fractional interest. The letters accompanying the surrender of their shares stated that they were taking this step "in order to improve the financial condition of the company" (Stip. Exhs. 7-G, 8-H; see also Resp. Br. 3). Thus, respondents averred that their surrender was not motivated by a donative intent, but rather was designed to improve the corporation's business condition. But the existence of that business justification for the surrender provides no basis whatsoever for respondents to claim a loss. There exist only three possible beneficiaries of the improved corporate performance that respondents' surrender was designed to enhance -- the corporation itself, respondents, and respondents' fellow shareholders. Regardless of who is thought to be the intended or actual beneficiary, established tax principles make it clear that allowance of an immediate loss deduction is not the correct tax treatment. First, respondents themselves, as the dominant shareholders, derived the principal benefit from the improved health of the corporation because they retained a 68.5% equity interest in it. As we explained in our opening brief (at 10-14), expenditures made to conserve or enhance the value of a taxpayer's shares are nondeductible capital expenditures. Thus, to the extent that respondents themselves benefited from the stock surrender they cannot possibly have suffered a loss. Second, to the extent that respondents themselves did not benefit from the stock surrender, a plausible beneficiary would be the corporation, which, after all, received something for nothing. But if the benefit of the stock surrender is viewed as rebounding to the corporation, there again can be no deductible loss. The transfer of property by a shareholder to his corporation for the corporation's benefit is the essence of a contribution to capital, which yields an adjustment to the basis of the shareholder's remaining shares but does not give rise to an immediately deductible loss. And even if characterizing the surrender as a "contribution to capital" is thought imprecise -- a point we address below -- there is no denying that respondents expended some of their assets on behalf of their corporation, which is an inherently capital expense. See Deputy v. du Pont, 308 U.S. 488 (1940). Thus, to the extent that the corporation itself benefited from the stock surrender, respondents cannot possibly have suffered a loss. Third, if respondents are correct in asserting that neither they nor their corporation really benefited from the surrender, the beneficiaries must necessarily have been respondents' fellow shareholders. Those individuals did not surrender any shares, and the effect of the surrender was thus to increase their percentage interest in the corporation's assets from 27.5% to 31.5%. But the conferral of a benefit upon the minority shareholders would not entitle respondents to a loss deduction either. One can imagine various reasons why respondents might have wanted to confer a benefit on those persons. Some of the minority shareholders were respondents' relatives (Pet. App. 30a) and thus were possible objects of respondents' bounty. Some of the minority shareholders may have been disgruntled because of the corporation's poor performance, and respondents may have desired to appease them or deter them from bringing a derivative suit. In either event, of course, respondents' action would not entitle them to a loss deduction. In the first case, the surrender might be a nondeductible gift. See Treas. Reg. Section 25.2511-1(h) (1). In the second case, it would be a nondeductible payment on behalf of the corporation. See Deputy v. du Pont, supra. The fact that respondents realized no loss on the stock surrender is highlighted if one recasts the transaction slightly. Suppose that, instead of employing a non-pro-rata stock surrender to reduce their ownership of the corporation by four percentage points, respondents had caused the corporation to issue a non-pro-rata stock dividend to the minority shareholders, so as to increase the latter's interest in the corporation by the identical margin. /1/ Under either scenario, the bottom line would be exactly the same: respondents' interest would decline from 72.5% to 68.5%, and the minority shareholders' interest would go up from 27.5% to 31.5%. Respondents could not possibly claim a loss deduction if this end result were accomplished by the stock-dividend route. This strongly suggests that they did not suffer any recognizable loss under the scenario that they did use, which differs from the stock-dividend scenario only in that the same ownership interests in the corporation were represented by fewer pieces of paper. In short, when a shareholder voluntarily transfers something of value to his corporation in exchange for the anticipated benefit of improving the company's financial situation, the shareholder has not realized any loss. This is so regardless of whether one views the shareholder, his fellow shareholders, or the corporation -- either separately or in combination-- as the true beneficiaries of the transaction. A shareholder obviously suffers no loss when he benefits himself or his corporation, and respondents have advanced no theory under which they could be thought to have suffered a loss by benefiting the minority shareholders. The surrender here was not a "loss" in any sense of the word; it was a deliberate expenditure designed to benefit the corporation and its various shareholders and as such was nondeductible. /2/ b. Respondents' affirmative argument that the stock surrender here should be viewed as a loss (Br. 12-13) is both brief and unconvincing. Respondents assert that a non-pro-rata stock surrender must give rise to a loss because it causes a percentage reduction in the surrendering shareholder's interest in the corporation, which may result ultimately in the loss of certain benefits, such as future dividends or a share of the corporation's assets in the event of a solvent liquidation. But there is little basis for the view that a percentage decrease in a shareholder's interest in a corporation is itself an event that gives rise to a loss. /3/ As noted above, if the corporation here had declared a non-pro-rata stock dividend to the minority shareholders, respondents' percentage interest in the corporation would have been reduced, but they would have had no colorable claim to an immediate loss deduction. And, as noted in our opening brief (at 29), if respondents had transferred a smaller number of their own shares directly to the minority shareholders, respondents' percentage ownership would also have been reduced, but they again would have had no colorable claim to an immediate loss deduction. Moreover, the adverse effects that respondents cite are all future events whose tax consequences inevitably will be taken into account when those events occur. To the extent respondents receive smaller dividends in the future or a smaller share of the assets upon liquidation, they will have commensurately less taxable income or, perhaps, a greater ultimate capital loss. There is no need to give them a loss now, upon occurrence of the event occasioning the reduction in their ownership interest, in order to recognize the loss that respondents may suffer in the future. More generally, the fact that respondents have "given something up" by surrendering a portion of their shares clearly provides no support for their claim for recognition of an immediate loss. Respondents concede (Br. 19) that a shareholder's contribution of cash or other property to his corporation, even if non-pro-rata, does not generate an immediate loss. In those situations, however, the shareholder has given something up just as surely as he had done in the case of a stock surrender. A shareholder's contribution of cash or property to his corporation, like a surrender of shares, also results in an enhancement of the minority shareholders' interests by increasing the value of each corporate share; but this circumstance does not entitle the contributing shareholder to claim a loss. In short, whether the shareholder contributes stock or other property, there is no need to allow an immediate loss deduction in order to take account of what he has done. Rather, any potential loss resulting from the contribution is reflected in an adjustment to the bases of the shareholder's remaining shares, and it can be deducted if and when the loss is actually realized through a taxable disposition of that stock. /4/ c. Respondents also rely (Br. 7, 13, 22) on an analogy drawn from this Court's decision in Koshland v. Helvering, 298 U.S. 441 (1936). The Court there reasoned that shareholders whose percentage interest increases because of a non-pro-rata stock dividend receive income in the constitutional sense, although it noted that the revenue act did not render that income recognizable. See also Helvering v. Gowran, 302 U.S. 238 (1937). If a non-pro-rata stock dividend yields income, respondents reason, a non-pro-rata stock surrender must yield a loss. This reasoning is seriously flawed. First, there is no reason why the tax treatment of a shareholder's receipt of a stock dividend from the corporation should have any particular relevance to the tax treatment of a shareholder's contribution of stock to the corporation. The receipt of property by a taxpayer is ordinarily a taxable event, whereas a shareholder's contribution of property to his corporation is ordinarily in the nature of an investment that has no immediate tax consequences. The simplest example is cash. A cash distribution from the corporation to its shareholder is recognized as income, but a cash contribution from a shareholder to the corporation is a contribution to capital that does not give rise to an immediate loss. Moreover, the so-called "proportional interest doctrine" (Resp. Br. 15) that respondents seek to derive from Koshland v. Helvering seems to point in a direction that is not particularly helpful to them. The Court there did not hold that a non-pro-rata stock dividend results in the recognition of a loss by the shareholders whose interest goes down. Rather, it held that such a dividend results in the receipt of income by the shareholders whose interest goes up. In the instant case, the consequence of respondents' stock surrender was that their interest went down and that the minority shareholders' interest went up. It is hard to see how Koshland supports respondents' ability to claim a loss in these circumstances. /5/ 2. In our opening brief (at 10-29), we explained that the surrender here is best characterized as a "contribution to capital," just the same as the contribution of any other form of property by a shareholder to his corporation would be characterized. Respondents rely on "two critical distinctions" (Br. 20) to justify their contention that the general rule governing contributions to capital does not apply when the contributed property is stock in the corporation. First, respondents assert (Br. 22) that non-pro-rata stock surrenders must be treated differently from contributions of other forms of property because the latter do not entail a change in a shareholder's percentage interest in the corporation. But this assertion completely begs the question. There is no dispute that the case is slightly different on its facts than the usual contribution-to-capital case because the property contributed here was stock in the corporation. Were it not for that difference, this case would indisputably be controlled by respondents' concession (Br. 19) that a contribution of any other form of property does not give rise to an immediate loss deduction. The question here is whether that slight difference is of any significance. To say that respondents' surrender yielded a change in their percentage interest in the corporation is simply another way of stating that the surrendered property was stock. But respondents do not explain why this particular factual distinction should lead to a difference in tax treatment. As we noted above (pages 4-5, supra), a non-pro-rata stock dividend to the minority shareholders would also have yielded a change in respondents' percentage interest in the corporation, yet that event indisputably would not be an appropriate occasion for respondents' recognition of a loss. Moreover, even if a substantial change in ownership of the corporation could be relevant, respondents are surely placing undue reliance on that factor here, inasmuch as "the diminution in (their) corporate control and equity interest (was) so minute as to be illusory" (Pet. App. 20a (Joiner, J., dissenting)). Respondents' other basis for distinction is their argument that the surrender here, unlike the contribution of cash or other property, cannot be treated as a contribution to capital because it did not technically increase the "capital" or net worth of the corporation. As we explained in our opening brief (at 23-25), the concept of a "contribution to capital" for tax purposes is not limited by accounting rules that concern the treatment of various transactions on the corporation's balance sheet. See Schleppy v. Commissioner, 601 F.2d 196, 197 n.2 (5th Cir. 1979); compare Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542-544 (1979). There are many transactions -- such as a shareholder's surrender of bonds, forgiveness of other corporate indebtedness, or payment of a corporate expense -- that are not contributions to "capital" in an accounting sense in that they do not increase the stated "capital" or the assets of the corporation. Yet these transactions are undeniably treated for tax purposes as "contributions to capital," with the shareholder receiving a basis adjustment rather than a loss deduction. The point is that respondents, in surrendering their stock, transferred valuable property to their corporation for the purpose of aiding the corporation. Because the corporation benefited thereby, respondents may properly be said to have "contributed to its capital," even though the contributed treasury stock was not technically an "asset" in accounting terminology. /6/ In any event, the accounting terminology employed by the corporation is manifestly irrelevant from respondents' perspective, which is the relevant one when it is their tax consequences that are at issue. In fact, as we explained in our opening brief (at 26-29), Congress already has indicated that it is appropriate to treat a non-pro-rata stock surrender as a "contribution to capital" for tax purposes. In enacting Section 83 of the Code in 1969, Congress stated that a shareholder's "bargain sale" of stock to a corporate employee, when designed to compensate that employee, should be treated as "a capital contribution" by the shareholder. S. Rep. 91-552, 91st Cong., 1st Sess. 123-124 (1969). Respondents concede the correctness of this treatment (Br. 26-27). Respondents also seem to concede that a shareholder would make a "contribution to capital" if, instead of transferring stock directly to the employee, he surrendered stock to the corporation, which in turn transferred the stock as compensation to the employee (Br. 27 n.9). Respondents thus appear to accept the principle that a stock surrender is properly regarded as a "contribution to capital" when the corporation subsequently uses the stock to discharge a particular sort of corporate liability -- a liability to compensate its employees. It is hard to see why the same stock surrender would cease to be a "contribution to capital" if the corporation chose to use the stock for some other corporate purpose. It is therefore apparent that Congress did not regard the technical accounting difference, with respect to a change in the corporation's "assets" or net worth, that exists when the property contributed to a corporation is its own stock, as an impediment to characterizing a stock surrender as a "contribution to capital." Respondents simply do not explain why a surrender of stock can be treated as a "contribution to capital" in the employee-compensation context, yet is inherently incapable of being a "contribution to capital" in any other context. If the "two critical distinctions" (Resp. Br. 20) that respondents identify between contributions of stock and contributions of other forms of property have any significance, they would equally require that the shareholder be entitled to take an immediate loss when he surrenders stock to the corporation for the payment of employee compensation. But Section 83 shows that that is not the law. Ultimately, respondents' objections to our position seem to boil down to semantics. Because the instant stock surrenders arguably did not increase Travco's "capital" in a technical accounting sense, respondents maintain that they cannot be treated as "contributions to capital." But semantics does not govern the proper tax treatment of these transactions. In our opening brief (at 30), we noted that Section 302 of the Code provides in the stock-redemption context that the basis of the retained shares when the distribution is taxed as a dividend. Respondents object that this treatment does not mean that the shares surrendered in the redemption are "contributed to capital," even though the addition of those shares' basis to the basis of the retained shares is the same tax result that would attend a contribution to capital. Rather, respondents say, Section 302 entails merely a "transfer of basis" (Br. 33 n.18). But perhaps the same is true here. If as respondents contend, there is something unsatisfying about labelling a stock surrender a "contribution to capital," we are content to say that a stock surrender requires a "transfer of basis." The label is unimportant; the tax consequences are important. Whatever label is used, the point is that respondents' stock surrender did not give rise to an immediate loss. The correct tax treatment is to reallocate respondents' basis in the surrendered shares to the shares that they retained. The impact of the surrender on respondents' tax liabilities will thus be recognized upon the disposition of those remaining shares. 3. Respondents accuse us of being "unprincipled" (Br. 34-36) in assertedly implying that a stock surrender that would qualify for "exchange" treatment if effected as a redemption under Section 302 -- e.g., a "substantially disproportionate" transfer that brought the surrendering shareholder's interest below 50% -- would give rise to a loss, whereas other types of stock surrenders would not. The premise of this accusation is unfounded, for we have not implied that such a surrender would give rise to a loss. To the contrary, we believe that any stock surrender fits the mold of a contribution to capital. We did note in our opening brief that a surrender that caused the surrendering shareholders to lose control of the corporation might present a more difficult question than the one presented here, where respondents' ownership interest declined only from 72.5% to 68.5%. The Second Circuit majority in Frantz v. Commissioner, 784 F.2d 119, 125 (1986), made the same point. To take an extreme example, the tax consequence of a "capital contribution" or "transfer of basis" would not seem entirely satisfactory, as a practical matter, in the case of a shareholder who surrendered 99,999 of his 100,000 shares. In our opening brief (at 20 n.7), we noted only that it is unnecessary for the Court to concern itself with this more difficult situation because respondents' surrender occasioned only a miniscule change in their ownership interest -- the sort of surrender that both the majority and concurring judges in Frantz agreed could not give rise to a deductible loss. There is every reason to believe, moreover, that the more difficult situation that respondents emphasize is a purely hypothetical one that will occur infrequently in practice. The reported cases indicate that rarely, if ever, has a shareholder surrendered enough shares to destroy his majority interest in a corporation; economic self-interest would appear to counsel strongly against such action. And even if a shareholder were inclined to surrender enough shares to cause loss of corporate control, he could easily structure his transfer as a redemption by having the corporation pay token consideration, thereby entitling him to "exchange" treatment -- and thus to a capital loss if his investment has been a poor one -- under the safe harbor provisions of Section 302. Accordingly, concern over the proper treatment of the unlikely hypothetical situation posited by respondents should not affect the Court's disposition of the quite different question presented here. For the foregoing reasons, and those stated in our opening brief, the judgment of the court of appeals should be reversed. Respectfully submitted. CHARLES FRIED Solicitor General APRIL 1987 /1/ Section 305 of the Code would govern whether the minority shareholders would have to recognize income upon receipt of such a stock dividend. We discuss that provision at note 5, infra. /2/ Respondents object (Br. 14-15, 24 n.8) to consideration of their motivation for the surrender in determining the appropriate tax treatment. But it ill behooves respondents to argue that their motivation should be ignored, for it is they who injected the question of motive into this case; if they lacked the business purpose that they assert, their surrender might well be viewed as a gift, and in that event they would clearly not be entitled to claim a loss. In any event, there is no merit to respondents' suggestion that motive generally should play no role in this type of determination. See I.R.C. Section 165(c)(2). Moreover, the determination of what constitutes a capital expenditure under I.R.C. Section 263 plainly contemplates some consideration of the taxpayer's motive in making the expenditure. See generally Commissioner v. Idaho Power Co., 418 U.S. 1 (1974). /3/ It should be noted that the amount of the "loss" respondents seek to deduct bears no relation to the amount of the "loss" allegedly occasioned by the reduction in their percentage interest in the corporation. The loss they seek to deduct is derived from their basis in the surrendered shares, and it does not depend at all on the extent to which they may be predicted to lose future dividends or a share of corporate assets upon dissolution. /4/ Respondents point out (Br. 23) that if Travco had been liquidated the day after the surrender, they would have received a smaller distribution than if no shares had been surrendered. But this potential "loss" upon liquidation is no different from that occasioned by a contribution of other property to a corporation, and there is no reason why the surrender itself should give rise to an immediately deductible loss. This similarity may be demonstrated by an example. Suppose that a shareholder holds a 75% interest in a corporation that has a liquidation value of $100,000, and that the shareholder also has $20,000 in the bank. To aid the corporation's financial position, the shareholder surrenders a portion of his shares, reducing his percentage interest to 70%. Respondents would say that the shareholder suffers a loss by reason of the surrender on the theory that the proceeds that would accrue to him on liquidation of the corporation would thereby be reduced by 5%, or $5,000. But suppose instead that the shareholder contributes his $20,000 to the corporation. If the corporation were then liquidated, he would receive a distribution of $90,000 (75% of $120,000). In both cases, he will end up with the same $90,000 in the bank, and the minority shareholders will end up with $30,000. In both cases, the shareholder can be said to have "given up" $5,000 by reason of the contribution, in the latter case because the contribution gives the minority shareholders a 25% interest in what previously was his own $20,000. But it is undisputed that the shareholder cannot recognize any loss upon contributing the $20,000 in cash, notwithstanding the $5,000 decline in his potential liquidation proceeds. There is no reason why the result should be different when he surrenders stock. /5/ In any event, the premise of respondents' argument by reverse analogy has been undermined by Congress. In the 1954 Code, Congress provided special statutory treatment of non-pro-rata stock dividends in Section 305 of the Code. The House Report on the 1954 provision specifically noted that "(a)s long as a shareholder's interest remains in corporate solution, there is no appropriate occasion for the imposition of a tax." The Committee added that generally no tax should be imposed upon the distribution of stock dividends, "without regard to whether or not a praticular shareholder's proportionate interest in the continuing business has varied." H.R. Rep. 1337, 83d Cong., 2d Sess. 35 (1954). The 1954 Code thus sought to eliminate the "problems" that Congress perceived in the line of cases emanating from Koshland that made non-pro-rata stock dividends generally taxable. H.R. Rep. 1337, supra, at A81. Although Congress has enacted several exceptions to Section 305(a) since 1954 to tax certain kinds of stock dividends -- including dividends where the shareholder receives or has the option of receiving cash or property instead of stock (see Section 305(b)) -- it has retained the "general rule" of Section 305(a) that "gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock." /6/ Indeed, respondents' idea that a corporation's own stock is not worth anything to it sounds rather odd at a time when this Nation's corporations are spending billions of dollars to buy back their stock on the open market. During 1985, for example, four major oil companies spent $13 billion to buy back their shares. Wall St. J., Jan. 2, 1986, at 6B, col. 2. In May 1986, IBM announced that it would spend $1.47 billion to buy back its stock, stating that the shares were "attractive at current prices" and represented a "good long-term investment." Wall St. J., May 28, 1986, at 4, col. 1. One of the reasons cited for such stock buy-backs was the need to acquire shares for use in employee pension and profit-sharing plans. See, e.g., Wall St. J., May 28, a986, at 5, col 1 (IBM); Wall St. J., May. 28, 1986, at 6, col. 2 (Martin Marietta Corp.); Wall St. J., Jan 21, 1986, at 6, col. 6 (General Motors Corp.). These actions by the Nation's leading corporations suggest that they regard their stock as valuable property, in part because it can be used to discharge various corporate liabilities. If IBM'S shareholders had decided to save it the expense of buying its stock on the open market by contributing their shares voluntarily, those individuals would surely be said to have made a "contribution to its capital." Common sense dictates the same conclusion here.