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contingent interest

Eisner v. Macomber

Eisner v. Macomber, , is a case in which the United States Supreme Court ruled 5-4 that a pro rata stock dividend where a shareholder received no actual cash or other property, and retained the same proportionate share of ownership of the corporation as was held prior to the dividend, was not taxable income to the shareholder within the meaning of the Sixteenth Amendment, and that an income tax imposed by the Revenue Act of 1916 on such dividend was unconstitutional, even where the dividend indirectly represented accrued earnings of the corporation.

Prior case

A nearly identical situation had been addressed by the Court in Towne v. Eisner . (Eisner was the person responsible for Internal Revenue Collection in both cases). Between the time the two cases were decided, the United States ratified the Sixteenth Amendment to the United States Constitution. The Sixteenth Amendment was ratified in response to Supreme Court decisions to the effect that although the Congress could impose taxes on income from vocations and employment without apportioning the taxes among the states according to population, the Congress had no power to levy taxes on income from property unless the taxes were apportioned by the population. Beginning in 1913, the Sixteenth Amendment allowed taxation of income without regard to source (i.e., whether income from property or income from vocations and employment), and without regard to a state's population. In addition, in the aftermath of Towne v. Eisner, the U.S. Congress, in its revenue collection statute, specifically stated that stock dividends were to be counted as income.

Facts of the case

In the case before the bar, a Mrs. Myrtle H. Macomber had received stock certificates from Standard Oil of California, some of which indirectly represented profits realized by the company that had been capitalized, but not actually distributed to her. She had already owned shares in the company, and her proportionate share of ownership did not change as a result of the "receipt" of the additional shares. The Internal Revenue Service (or the Bureau of Internal Revenue, as it was then known) contended that those certificates should be taxed as income to Mrs. Macomber as though the corporation had distributed money or other property to her. She paid the tax under protest and then sued Mr. Mark Eisner, the Collector of Internal Revenue, for a refund.

Economic substance of a stock dividend

The case dealt with a stock dividend that was essentially equivalent to a stock split, not a cash dividend on stock. In the case of this kind of "dividend" the stockholder does not actually receive anything or realize any additional value.

For example, if a stockholder owns 100 shares of stock having a value of $4 per share, the total value is $400. If the corporation declares a "two for one" stock dividend that is essentially similar to a stock split (and the corporation distributes no money or other property to any stockholder), the stockholder now has 200 shares with a value of $2 each, which is still $400 in value—i.e., no increase in value and no income. Metaphorically, the "pie" is still the same size—but it has been sliced into more pieces, each piece being proportionately smaller.

More directly to the point, there has been no "sale or other disposition" of the stock by the taxpayer. The taxpayer still owns the same proportionate percentage of the corporation he or she owned prior to the stock dividend. So, even if his or her basis amount (generally, the amount originally paid for the stock) is less than the $400 value (i.e., even if there is an unrealized gain), the taxpayer still has not yet "realized" any income.

Decision of the Supreme Court

In the majority opinion, Justice Mahlon Pitney ruled that the stock dividend in this case was not a realization of income by the taxpayer-shareholder for purposes of the Sixteenth Amendment.

The Court noted that in Towne v. Eisner, it had said in no uncertain language that stock dividends were not income, as nothing of value was received by Towne - the company was not worth any less than it was when the dividend was declared, and the total value of Towne's stock had not changed.

In rejecting the government's case, the Court in Eisner v. Macomber stated:

Throughout the argument of the Government, in a variety of forms, runs the fundamental error already mentioned—a failure to appraise correctly the force of the term "income" as used in the Sixteenth Amendment, or at least to give practical effect to it. Thus, the Government contends that the tax "is levied on income derived from corporate earnings," when in truth the stockholder has "derived" nothing except paper certificates which, so far as they have any effect, deny him [or "her" — in this case, Mrs. Macomber] present participation in such earnings. It [the government] contends that the tax may be laid when earnings "are received by the stockholder," whereas [s]he has received none; that the profits are "distributed by means of a stock dividend," although a stock dividend distributes no profits; that under the Act of 1916 "the tax is on the stockholder's share in corporate earnings," when in truth a stockholder has no such share, and receives none in a stock dividend; that "the profits are segregated from his [her] former capital, and [s]he has a separate certificate representing his [her] invested profits or gains," whereas there has been no segregation of profits, nor has [s]he any separate certificate representing a personal gain, since the certificates, new and old, are alike in what they represent—a capital interest in the entire concerns of the corporation.

Although the Court acknowledged the power of the Federal Government to tax income under the Sixteenth Amendment, the Court essentially said this did not give Congress the power to tax — as income — anything other than income, i.e., that Congress did not have the power to re-define the term income as it appeared in the Constitution. The Court ordered that Macomber be refunded the tax she overpaid.

Dissents

In the dissent, Justice Louis Brandeis wrote that Sixteenth Amendment authorized Congress to tax “incomes, from whatever source derived”, and the authors of the amendment “intended to include thereby everything which by reasonable understanding can fairly be regarded as income”, and that “Congress possesses the power which it exercised to make dividends representing profits, taxable as income, whether the medium in which the dividend is paid be cash or stock, and that it may define, as it has done, what dividends representing profits shall be deemed income”. Brandeis took issue with the majority's interpretation of income. He noted that in business circles, cash dividends and stock dividends were treated absolutely identically. Prior to the passage of the income tax act in question, it was common for a dividend to be paid out in cash, and then those receiving the dividend would be allowed to buy company stock at a price well below market if they signed back the dividend. This transaction would clearly be taxable as income, and Brandeis saw no reason why two essentially identical transactions should be treated differently for tax purposes.

Aftermath

In any event, the success of investors in avoiding tax was short lived. The following year, the Court ruled that capital gains were income, and that they should be recognized as income when the stock was sold. In addition, the exception for stock dividends was narrowed by the Court in such cases as United States v. Phellis, (shares in a subsidiary corporation issued to stockholders in the parent corporation were taxable as income); Rockefeller v. United States and Cullinan v. Walker (increase in capital accumulated by corporations over time were taxable when shares are distributed to stockholders in a successor corporation).

In 1940 the Supreme Court departed from the realization concept described in Eisner v. Macomber when the Court held, in Helvering v. Bruun, , that "severance" is not an element of realization. In Bruun, a taxpayer-landlord repossessed a property from a tenant—property that had been subject to a 99-year lease—after the tenant failed to pay rent and taxes. The lease had allowed for the tenant to construct a new building or other improvements. The tenant had removed the existing building and had built a new one. The value of the new building as of the date of repossession was $64,245.68. The government contended that the landlord realized a gain of $51,434.25, the difference between the value of the building at the date of repossession and the landlord's basis in the old building of $12,811.43. The landlord argued that there was no realization of the property because no transaction had occurred, and that the improvement of the property that created the gain was unseverable from the landlord's original capital. The Court ruled against the landlord, deciding that the landlord had realized a gain upon repossession of the property, and said that "severance" is no longer an element of realization.

Use by anti-tax activists

Eisner v. Macomber is a key case in income tax law. Its rather narrow but important application is often misapplied or misunderstood by tax protesters. Anti-tax activists often use this case to argue that wages from labor cannot be taxed as income. The decision in Eisner v. Macomber, however, was not about wages, and the exception for stock dividends was narrow.

This is a typical accurate, but misleading quote from the case:

" In order, therefore, that the clauses cited from Article I of the Constitution may have proper force and effect save only as modified by the Amendment, and that the latter also may have proper effect, it is essential to distinguish between what is and what is not 'income' as the term is there used; and to apply the distinction as cases arise according to truth and substance without regard to form. Congress by any definition it may adopt cannot conclude the matter, since it cannot by legislation alter the Constitution, from which it derives its power to legislate, and within whose limitations alone that power can be lawfully exercised" [emphasis added]

The Supreme Court did discuss what constituted income in Eisner v. Macomber, and quoted from Towne v. Eisner:

"Just as we deem the legislative intent manifest to tax the stockholder with respect to such accumulations only if and when, and to the extent that, his interest in them comes to fruition as income, that is, in dividends declared, so we can perceive no constitutional obstacle that stands in the way of carrying out this intent when dividends are declared out of a pre-existing surplus. ... Congress was at liberty under the amendment to tax as income, without apportionment, everything that became income, in the ordinary sense of the word, after the adoption of the amendment, including dividends received in the ordinary course by a stockholder from a corporation, even though they were extraordinary in amount and might appear upon analysis to be a mere realization in possession of an inchoate and contingent interest that the stockholder had in a surplus of corporate assets previously existing." [emphasis added]

An important principle taken from Eisner v. Macomber is that the word "income" in the Sixteenth Amendment is generally given its ordinary plain English meaning, and wealth and property that is not income may not be taxed as income by the Federal Government. The Court was clear, however, that taxes on property and wealth could be levied freely by the states, and could be levied by the Federal Government if each state were required to pay a proportion of the tax relative to its population.

See also

Further reading

  • Kornhauser, Marjorie E. (2002). Tax stories: An in-depth look at ten leading federal income tax cases. New York: Foundation Press.
  • Magill, Roswell F. (1933). "When Is Income Realized?". Harvard Law Review 46 (6): 933–953.

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