Corporate Distributions and the Income Tax: A Consideration of the Inconsistency Between Subchapter C and Its Underlying Policy
Republished as lead article in THE MONTHLY DIGEST OF TAX ARTICLES (November 1981)
The issue of whether the sale of shares to an issuer shall be treated as a dividend or as received in exchange for a capital asset has troubled Congress, courts, and commentators since the Revenue Act of 1913. If a corporation redeems some of its shares or distributes all of its assets in complete liquidation, the transaction is generally described as having the characteristics of a divided to the extent the distribution is ‘out of earnings and profits' and the characteristics of a sale to the extent that it terminates the equity interest of the redeemed party. In light of the existence of equally compelling analogies, each suggesting the opposite treatment, it has been suggested that in determining the appropriate treatment of distribution in complete liquidation or redemption, analogizing the transaction to a sale or a dividend is of limited value. A critical error permeates this analysis. The assumption is made that to the extent that a corporate distribution is ‘out of earnings and profits,’ the distribution is analogous to a dividend. This assumption leads proponents of reform to suggest dividend treatment, or its equivalent, for distributions in redemption of some or all of a corporation's shares. Meaningful suggestions for reform must, however, begin with an understanding of when a distribution is, or is not, analogous to a dividend under the present system - that is, with an understanding of how one must define a dividend to comport with the fundaments of the present system. This article suggests that although one part of a corporate distribution may be analogous to a sale and the remainder to a dividend, there is no overlap of, or competition between, analogies. This lack of overlap is apparent when one realizes that a dividend and a sale are methods of realizing different types of gain, rather than alternative methods of realizing the same type of gain. This article examines the basic conceptual model underlying the present system of taxing corporate distributions, describes the appropriate treatment of corporate distributions that is suggested by an understanding of the underlying concepts, and indicates the discrepancies between the present Code and this model.