Helvering v. Horst, 311 U.S.
112 (1940) property would seem to be the enjoyment of the income whether the
FACTS:
- In 1934 and 1935, respondent, the owner of negotiable bonds, detached from
them negotiable interest coupons shortly before their due date and delivered
them as a gift to his son, who, in the same year, collected them at maturity.
- The Commissioner ruled that, under the applicable § 22 of the Revenue Act
of 1934, 48 Stat. 680, 686, the interest payments were taxable, in the years
when paid, to the respondent donor, who reported his income on the cash
receipts basis.
- The circuit court of appeals reversed the order of the Board of Tax Appeals
sustaining the tax.
ISSUE:
Whether the gift, during the donor's taxable year, of interest coupons detached
from the bonds, delivered to the donee and later in the year paid at maturity, is
the realization of income taxable to the donor.
COURT: YES
The court below thought that, as the consideration for the coupons had passed
to the obligor, the donor had, by the gift, parted with all control over them and
their payment, and for that reason the case was distinguishable from Lucas v.
Earl, supra, and Burnet v. Leininger, 285 U. S. 136, where the assignment of
compensation for services had preceded the rendition of the services, and where
the income was held taxable to the donor.
The holder of a coupon bond is the owner of two independent and
separable kinds of right. One is the right to demand and receive at maturity
the principal amount of the bond representing capital investment. The other is
the right to demand and receive interim payments of interest on the investment
in the amounts and on the dates specified by the coupons. Together, they are
an obligation to pay principal and interest given in exchange for money or
property which was presumably the consideration for the obligation of the
bond. Here respondent, as owner of the bonds, had acquired the legal right
to demand payment at maturity of the interest specified by the coupons
and the power to command its payment to others which constituted an
economic gain to him.
Admittedly not all economic gain of the taxpayer is taxable income. From
the beginning, the revenue laws have been interpreted as defining
"realization" of income as the taxable event, rather than the acquisition of
the right to receive it. And "realization" is not deemed to occur until the
income is paid. But the decisions and regulations have consistently recognized
that receipt in cash or property is not the only characteristic of realization of
income to a taxpayer on the cash receipts basis. Where the taxpayer does not
receive payment of income in money or property, realization may occur when
the last step is taken by which he obtains the fruition of the economic gain
which has already accrued to him.
In the ordinary case the taxpayer who acquires the right to receive income
is taxed when he receives it, regardless of the time when his right to receive
payment accrued. But the rule that income is not taxable until realized has
never been taken to mean that the taxpayer, even on the cash receipts basis, who
has fully enjoyed the benefit of the economic gain represented by his right to
receive income can escape taxation because he has not himself received
payment of it from his obligor. The rule, founded on administrative
convenience, is only one of postponement of the tax to the final event of
enjoyment of the income, usually the receipt of it by the taxpayer, and not one
of exemption from taxation where the enjoyment is consummated by some
event other than the taxpayer's personal receipt of money or property. This may
occur when he has made such use or disposition of his power to receive or
control the income as to procure in its place other satisfactions which are of
economic worth. The question here is whether, because one who in fact
receives payment for services or interest payments is taxable only on his receipt
of the payments, he can escape all tax by giving away his right to income in
advance of payment. If the taxpayer procures payment directly to his
creditors of the items of interest or earnings due him, or if he sets up a
revocable trust with income payable to the objects of his bounty, he does
not escape taxation because he did not actually receive the money.
Underlying the reasoning in these cases is the thought that income is "realized"
by the assignor because he, who owns or controls the source of the income, also
controls the disposition of that which he could have received himself and
diverts the payment from himself to others as the means of procuring the
satisfaction of his wants. The taxpayer has equally enjoyed the fruits of his
labor or investment and obtained the satisfaction of his desires whether he
collects and uses the income to procure those satisfactions or whether he
disposes of his right to collect it as the means of procuring them.
Although the donor here, by the transfer of the coupons, has precluded any
possibility of his collecting them himself, he has nevertheless, by his act,
procured payment of the interest, as a valuable gift to a member of his
family. Such a use of his economic gain, the right to receive income, to procure
a satisfaction which can be obtained only by the expenditure of money or
satisfaction is the purchase of goods at the corner grocery, the payment of his
debt there, or such nonmaterial satisfactions as may result from the payment of
a campaign or community chest contribution, or a gift to his favorite son. Even
though he never receives the money, he derives money's worth from the
disposition of the coupons which he has used as money or money's worth in the
procuring of a satisfaction which is procurable only by the expenditure of
money or money's worth. The enjoyment of the economic benefit accruing to
him by virtue of his acquisition of the coupons is realized as completely as
it would have been if he had collected the interest in dollars and expended
them for any of the purposes named.
In a real sense, he has enjoyed compensation for money loaned or services
rendered, and not any the less so because it is his only reward for them. To
say that one who has made a gift thus derived from interest or earnings
paid to his donee has never enjoyed or realized the fruits of his investment
or labor because he has assigned them instead of collecting them himself
and then paying them over to the donee is to affront common
understanding and to deny the facts of common experience. Common
understanding and experience are the touchstones for the interpretation of the
revenue laws.
The power to dispose of income is the equivalent of ownership of it. The
exercise of that power to procure the payment of income to another is the
enjoyment, and hence the realization, of the income by him who exercises
it. We have had no difficulty in applying that proposition where the assignment
preceded the rendition of the services, Lucas v. Earl, supra; Burnet v. Leininger,
supra, for it was recognized in the Leininger case that, in such a case, the
rendition of the service by the assignor was the means by which the income was
controlled by the donor, and of making his assignment effective. But it is the
assignment by which the disposition of income is controlled when the service
precedes the assignment, and, in both cases, it is the exercise of the power of
disposition of the interest or compensation, with the resulting payment to the
donee, which is the enjoyment by the donor of income derived from them.
This was emphasized in Blair v. Commissioner, 300 U. S. 5, on which
respondent relies, where the distinction was taken between a gift of income
derived from an obligation to pay compensation and a gift of income-producing
property. In the circumstances of that case, the right to income from the trust
property was thought to be so identified with the equitable ownership of the
property from which alone the beneficiary derived his right to receive the
income and his power to command disposition of it that a gift of the income by
the beneficiary became effective only as a gift of his ownership of the property
producing it. Since the gift was deemed to be a gift of the property, the income
from it was held to be the income of the owner of the property, who was the
donee, not the donor, a refinement which was unnecessary if respondent's
contention here is right, but one clearly inapplicable to gifts of interest or
wages. Unlike income thus derived from an obligation to pay interest or
compensation, the income of the trust was regarded as no more the income of
the donor than would be the rent from a lease or a crop raised on a farm after
the leasehold or the farm had been given away. We have held without
deviation that, where the donor retains control of the trust property, the
income is taxable to him although paid to the donee.
The dominant purpose of the revenue laws is the taxation of income to
those who earn or otherwise create the right to receive it and enjoy the
benefit of it when paid.The tax laid by the 1934 Revenue Act upon income
"derived from . . . wages, or compensation for personal service, of whatever
kind and in whatever form paid . . . ; also from interest . . ." therefore cannot
fairly be interpreted as not applying to income derived from interest or
compensation when he who is entitled to receive it makes use of his power to
dispose of it in procuring satisfactions which he would otherwise procure only
by the use of the money when received.
It is the statute which taxes the income to the donor although paid to his
donee. True, in those cases, the service which created the right to income
followed the assignment, and it was arguable that, in point of legal theory, the
right to the compensation vested instantaneously in the assignor when paid,
although he never received it, while here, the right of the assignor to receive the
income antedated the assignment which transferred the right, and thus
precluded such an instantaneous vesting. But the statute affords no basis for
such "attenuated subtleties." The distinction was explicitly rejected as the basis
of decision in Lucas v. Earl. It should be rejected here, for no more than in
the Earl case can the purpose of the statute to tax the income to him who earns
or creates and enjoys it be escaped by "anticipatory arrangements . . . however
skilfully devised" to prevent the income from vesting even for a second in the
donor.
Nor is it perceived that there is any adequate basis for distinguishing between
the gift of interest coupons here and a gift of salary or commissions. The owner
of a negotiable bond and of the investment which it represents, if not the lender,
stands in the place of the lender. When, by the gift of the coupons, he has
separated his right to interest payments from his investment and procured the
payment of the interest to his donee, he has enjoyed the economic benefits of
the income in the same manner and to the same extent as though the transfer
were of earnings, and, in both cases, the import of the statute is that the fruit is
not to be attributed to a different tree from that on which it grew.
COMMISSIONER VS. LOBUE
FACTS: In recognition of his "contribution and efforts in making the operation
of the Company successful," a corporation gave an employee options to
purchase stock in the corporation. The options were nontransferable and
were contingent upon continued employment.
After some time had elapsed and the value of the shares had increased, the
employee exercised the options and purchased the stock at less than the
then current market price.
For some of the shares, he gave the employer a promissory note for the option
price; but the shares were not delivered until the notes were paid in cash,
when the value of the shares had increased.
Held: Under the Internal Revenue Code of 1939, as amended, the resulting
gain to the employee was taxable as income received at the time he exercised
the option and purchased the stock, and his taxable gain should be measured as
of the time when the options were exercised and not as of the time when
they were granted.
(a) In defining "gross income" as broadly as it did in § 22(a) of the Internal
Revenue Code of 1939, as amended, Congress intended to tax all gains except
those specifically exempted . P. 351 U. S. 246.
(b) The only exemption that could possibly apply to these transactions is the
gift exemption of § 22(b)(3), and these transactions were not "gifts" in the
statutory sense. Pp. 351 U. S. 246-247.
(c) There is no statutory basis for excluding such transactions from "gross
income" on the ground that one purpose of the employer was to confer on the
employee a "proprietary interest" in the business. P. 351 U. S. 247.
(d) The employee received a substantial economic and financial benefit
from his employer, prompted by the employer's desire to get better work
from the employee, and this is "compensation for personal service" within
the meaning of § 22(a). P. 351 U. S. 247.
(e) In these circumstances, the employee "realized" a taxable gain when he
purchased the stock. P. 351 U. S. 248.
(f) The employee's taxable gain should be measured by the difference between
the option price and the market value of the shares as of the time when the
options were exercised, and not as of the time when the options were granted.
Pp. 351 U. S. 248-249.
(g) On remand, the Tax Court may consider the question, not previously passed
on, whether delivery of a promissory note for the purchase price marked the
completion of the stock purchase, and whether the gain should be measured as
of that date or as of the date the note was paid. P. 351 U. S. 250.
223 F.2d 367 reversed and remanded.
MR. JUSTICE BLACK delivered the opinion of the Court.
This case involves the federal income tax liability of respondent LoBue for the
years 1946 and 1947. From 1941 to 1947, LoBue was manager of the New
York Sales Division of the Michigan Chemical Corporation, a producer and
distributor of chemical supplies. In 1944, the company adopted a stock option
plan making 10,000 shares of its common stock available for distribution to key
employees at $5 per share over a 3-year period. LoBue and a number of other
employees were notified that they had been tentatively chosen to be recipients
of nontransferable stock options contingent upon their continued employment.
LoBue's notice told him: "You may be assigned a greater or less amount of
stock based entirely upon your individual results and that of the entire
organization." About 6 months later, he was notified that he had been definitely
awarded an option to buy 150 shares of stock in recognition of his "contribution
and efforts in making the operation of the Company successful." As to future
allotments, he was told "It is up to you to justify your participation in the plan
during the next two years."
LoBue's work was so satisfactory that the company in the course of 3 years
delivered to him 3 stock options covering 340 shares. He exercised all these $5
per share options in 1946 and in 1947, [Footnote 1] paying the company only
$1,700 for stock having a market value when delivered of $9,930. Thus, at the
end of these transactions, LoBue's employer was worth $8,230 less to its
stockholders and LoBue was worth $8,230 more than before. [Footnote 2] The
company deducted this sum as an expense in its 1946 and 1947 tax returns, but
LoBue did not report any part of it as income. Viewing the gain to LoBue as
compensation for personal services, the Commissioner levied a deficiency
assessment against him, relying on § 22(a) of the Internal Revenue Code of
1939, 53 Stat. 9, as amended, 53 Stat. 574, which defines gross income as
including "gains, profits, and income derived from . . . compensation for
personal service . . . of whatever kind and in whatever form paid. . .
LoBue petitioned the Tax Court to redetermine the deficiency, urging that
"The said options were not intended by the Corporation or the petitioner to
constitute additional compensation, but were granted to permit the
petitioner to acquire a proprietary interest in the Corporation and to
provide him with the interest in the successful operation of the
Corporation deriving from an ownership interest."
TAX COURT: LoBue had a taxable gain if the options were intended as
compensation, but not if the options were designed to provide him with "a
proprietary interest in the business." Finding after hearings that the options
were granted to give LoBue "a proprietary interest in the corporation, and not
as compensation for services," the Tax Court held for LoBue.
CA: affirmed CTA
- "This was a factual issue which it was the peculiar responsibility of
the Tax Court to resolve. From our examination of the evidence, we
cannot say that its finding was clearly erroneous."
We have repeatedly held that, in defining "gross income" as broadly as it did in
§ 22(a), Congress intended to "tax all gains except those specifically
exempted." See, e.g., Commissioner v. Glenshaw Glass Co., 348 U. S. 426, 348
U. S. 429-430. The only exemption Congress provided from this very
comprehensive definition of taxable income that could possibly have
application here is the gift exemption of § 22(b)(3). But there was not the
slightest indication of the kind of detached and disinterested generosity which
might evidence a "gift" in the statutory sense. These transfers of stock bore
none of the earmarks of a gift. They were made by a company engaged in
operating a business for profit, and the Tax Court found that the stock option
plan was designed to achieve more profitable operations by providing the
employees "with in incentive to promote the growth of the company by
permitting them to participate in its success." 22 T.C. at 44
Under these circumstances, the Tax Court and the Court of Appeals
properly refrained from treating this transfer as a gift. The company was
not giving something away for nothing
Since the employer's transfer of stock to its employee LoBue for much less than
the stock's value was not a gift, it seems impossible to say that it was not
compensation. The Tax Court held there was no taxable income, however, on
the ground that one purpose of the employer was to confer a "proprietary
interest." [Footnote 5] But there is not a word in § 22(a) which indicates that its
broad coverage should be narrowed because of an employer's intention to enlist
more efficient service from his employees by making them part proprietors of
his business. In our view, there is no statutory basis for the test established
by the courts below. When assets are transferred by an employer to an
employee to secure better services, they are plainly compensation. It makes
no difference that the compensation is paid in stock, rather than in money.
Section 22(a) taxes income derived from compensation "in whatever form
paid." And, in another stock option case, we said that § 22(a)
"is broad enough to include in taxable income any economic or financial
benefit conferred on the employee as compensation, whatever the form or mode
by which it is effected."
Commissioner v. Smith, 324 U. S. 177, 324 U. S. 181. LoBue received a very
substantial economic and financial benefit from his employer prompted by
the employer's desire to get better work from him. This is "compensation for
personal service" within the meaning of § 22(a).
LoBue nonetheless argues: that we should treat this transaction as a mere
purchase of a proprietary interest on which no taxable gain was "realized"
in the year of purchase.
COURT: It is true that our taxing system has ordinarily treated an arm's length
purchase of property, even at a bargain price, as giving rise to no taxable gain in
the year of purchase. See Palmer v. Commissioner, 302 U. S. 63, 302 U. S. 69.
But that is not to say that, when a transfer which is in reality compensation is
given the form of a purchase, the Government cannot tax the gain under §
22(a). The transaction here was unlike a mere purchase. It was not an
arm's length transaction between strangers. Instead, it was an
arrangement by which an employer transferred valuable property to his
employees in recognition of their services. We hold that LoBue realized
taxable gain when he purchased the stock
A question remains as to the time when the gain on the shares should be
measured. LoBue gave his employer promissory notes for the option price of
the first 300 shares, but the shares were not delivered until the notes were paid
in cash. [Footnote 7] The market value of the shares was lower when the notes
were given than when the cash was paid.
Commissioner: measured the taxable gain by the market value of the shares
when the cash was paid.
LoBue contends: that this was wrong, and that the gain should be measured
either when the options were granted or when the notes were given.
It is, of course, possible for the recipient of a stock option to realize an
immediate taxable gain. See Commissioner v. Smith, 324 U. S. 177, 324 U. S.
181-182. The option might have a readily ascertainable market value, and the
recipient might be free to sell his option. But this is not such a case. These
three options were not transferable, [Footnote 8] and LoBue's right to buy
stock under them was contingent upon his remaining an employee of the
company until they were exercised. Moreover, the uniform Treasury practice
since 1923 has been to measure the compensation to employees given stock
options subject to contingencies of this sort by the difference between the
option price and the market value of the shares at the time the option is
exercised. [Footnote 9] We relied in part upon this practice in Commissioner v.
Smith, 324 U. S. 177, 324 U. S. 695. And, in its 1950 Act affording limited tax
benefits for "restricted stock option plans," Congress adopted the same kind of
standard for measurement of gains. § 130A, Internal Revenue Code of 1939, 64
Stat. 942. And see § 421, Internal Revenue Code of 1954, 68A Stat. 142. Under
these circumstances there is no reason for departing from the Treasury practice.
The taxable gain to LoBue should be measured as of the time the options
were exercised, and not the time they were granted.
It is possible that a bona fide delivery of a binding promissory note could mark
the completion of the stock purchase, and that gain should be measured as of
that date. Since neither the Tax Court nor the Court of Appeals passed on this
question, the judgment is reversed and the case is remanded to the Court of
Appeals with instructions to remand the case to the Tax Court for further Eisner v. Macomber
proceedings.
Reversed and remanded. FACTS:

- On January 1, 1916, the Standard Oil Company of California, a corporation

of that state, out of an authorized capital stock of $100,000,000, had shares
of stock outstanding, par value $100 each, amounting in round figures to
$50,000,000. In addition, it had surplus and undivided profits invested in
plant, property, and business and required for the purposes of the
corporation, amounting to about $45,000,000, of which about $20,000,000
had been earned prior to March 1, 1913, the balance thereafter.

- In January, 1916, in order to readjust the capitalization, the board of directors

decided to issue additional shares sufficient to constitute a stock dividend of
50 percent of the outstanding stock, and to transfer from surplus account to
capital stock account an amount equivalent to such issue. Appropriate
resolutions were adopted, an amount equivalent to the par value of the
proposed new stock was transferred accordingly, and the new stock duly
issued against it and divided among the stockholders.

- Defendant , being the owner of 2,200 shares of the old stock, received
certificates for 1,100 additional shares, of which 18.07 percent, or 198.77
shares, par value $19,877, were treated as representing surplus earned
between March 1, 1913, and January 1, 1916.

- She was called upon to pay, and did pay under protest, a tax imposed
under the Revenue Act of 1916, based upon a supposed income of
$19,877 because of the new shares, and, an appeal to the Commissioner
of Internal Revenue having been disallowed, she brought action against
the Collector to recover the tax.

- In her complaint, she alleged the above facts and contended that, in
imposing such a tax the Revenue Act of 1916 violated article 1, § 2, cl. 3,
and Article I, § 9, cl. 4, of the Constitution of the United States, requiring
direct taxes to be apportioned according to population, and that the stock
dividend was not income within the meaning of the Sixteenth
Amendment.

ISSUE:
Whether, by virtue of the Sixteenth Amendment, Congress has the power to tax,
as income of the stockholder and without apportionment, a stock dividend made
lawfully and in good faith against profits accumulated by the corporation since
March 1, 1913.

COURT:

In Towne v. Eisner, the question was whether a stock dividend made in 1914
against surplus earned prior to January 1, 1913, was taxable against the
stockholder under the Act of October 3, 1913, c. 16, 38 Stat. 114, 166, which
provided that net income should include "dividends," and also "gains or profits
and income derived from any source whatever." Suit having been brought by a
stockholder to recover the tax assessed against him by reason of the dividend,
the district court sustained a demurrer to the complaint. 242 F. 702. The court
treated the construction of the act as inseparable from the interpretation of the
Sixteenth Amendment; and, having referred to Pollock v. Farmers' Loan &
Trust Co., 158 U. S. 601, and quoted the Amendment, proceeded very properly
to say (p. 704):

"It is manifest that the stock dividend in question cannot be reached

by the Income Tax Act and could not, even though Congress expressly
declared it to be taxable as income, unless it is in fact income."

"A stock dividend really takes nothing from the property of the corporation, and
adds nothing to the interests of the shareholders. Its property is not diminished,
and their interests are not increased. . . . The proportional interest of each
shareholder remains the same. The only change is in the evidence which
represents that interest, the new shares and the original shares together
representing the same proportional interest that the original shares represented
before the issue of the new ones."

"Gibbons v. Mahon, In short, the corporation is no poorer and the

stockholder is no richer than they were before."

"Income may be defined as the gain derived from capital, from labor, or
from both combined," provided it be understood to include profit gained
through a sale or conversion of capital assets, to which it was applied in
the Doyle case.

Brief as it is, it indicates the characteristic and distinguishing attribute of

income essential for a correct solution of the present controversy. The
government, although basing its argument upon the definition as quoted, placed
chief emphasis upon the word "gain," which was extended to include a
variety of meanings; while the significance of the next three words was either
overlooked or misconceived. "Derived from capital;" "the gain derived from
capital," etc. Here, we have the essential matter: not a gain accruing to
capital; not a growth or increment of value in the investment; but a gain, a
profit, something of exchangeable value, proceeding from the
property, severed from the capital, however invested or employed,
and coming in, being "derived" -- that is, received or drawn by the recipient
(the taxpayer) for his separate use, benefit and disposal -- that is income
derived from property. Nothing else answers the description.
The same fundamental conception is clearly set forth in the Sixteenth
Amendment -- "incomes, from whatever source derived" -- the essential thought
being expressed with a conciseness and lucidity entirely in harmony with the
form and style of the Constitution.
Can a stock dividend, considering its essential character, be brought within the
definition? To answer this, regard must be had to the nature of a corporation
and the stockholder's relation to it. We refer, of course, to a corporation such as
the one in the case at bar, organized for profit, and having a capital stock
divided into shares to which a nominal or par value is attributed.
that does not affect the aggregate assets of the corporation or its outstanding
liabilities; it affects only the form, not the essence, of the "liability"
acknowledged by the corporation to its own shareholders, and this through a
readjustment of accounts on one side of the balance sheet only, increasing
"capital stock" at the expense of "surplus"; it does not alter the preexisting
proportionate interest of any stockholder or increase the intrinsic value of his
holding or of the aggregate holdings of the other stockholders as they stood
before. The new certificates simply increase the number of the shares, with
consequent dilution of the value of each share.
A "stock dividend" shows that the company's accumulated profits have
been capitalized, instead of distributed to the stockholders or retained as
surplus available for distribution in money or in kind should opportunity
offer. Far from being a realization of profits of the stockholder, it tends
rather to postpone such realization, in that the fund represented by the
new stock has been transferred from surplus to capital, and no longer is
available for actual distribution.

Certainly the interest of the stockholder is a capital interest, and his
certificates of stock are but the evidence of it. They state the number of
shares to which he is entitled and indicate their par value and how the stock
may be transferred. They show that he or his assignors, immediate or
remote, have contributed capital to the enterprise, that he is entitled to a
corresponding interest proportionate to the whole, entitled to have the
property and business of the company devoted during the corporate existence to
attainment of the common objects, entitled to vote at stockholders' meetings, to
receive dividends out of the corporation's profits if and when declared,
and, in the event of liquidation, to receive a proportionate share of the net
assets, if any, remaining after paying creditors. Short of liquidation, or until
dividend declared, he has no right to withdraw any part of either capital or
profits from the common enterprise; on the contrary, his interest pertains
not to any part, divisible or indivisible, but to the entire assets, business,
and affairs of the company. Nor is it the interest of an owner in the assets
themselves, since the corporation has full title, legal and equitable, to the
whole. The stockholder has the right to have the assets employed in the
enterprise, with the incidental rights mentioned; but, as stockholder, he has no
right to withdraw, only the right to persist, subject to the risks of the
enterprise, and looking only to dividends for his return. If he desires to
dissociate himself from the company, he can do so only by disposing of his
stock.
For bookkeeping purposes, the company acknowledges a liability in form
to the stockholders equivalent to the aggregate par value of their stock,
evidenced by a "capital stock account." If profits have been made and not
divided, they create additional bookkeeping liabilities under the head of "profit
and loss," "undivided profits," "surplus account," or the like. None of these,
however, gives to the stockholders as a body, much less to any one of them,
either a claim against the going concern for any particular sum of money or a
right to any particular portion of the assets or any share in them unless or until
the directors conclude that dividends shall be made and a part of the company's
assets segregated from the common fund for the purpose. The dividend
normally is payable in money, under exceptional circumstances in some
other divisible property, and when so paid, then only (excluding, of course,
a possible advantageous sale of his stock or winding-up of the company)
does the stockholder realize a profit or gain which becomes his separate
property, and thus derive income from the capital that he or his
predecessor has invested.
The essential and controlling fact is that the stockholder has received
nothing out of the company's assets for his separate use and benefit; on the
contrary, every dollar of his original investment, together with whatever
accretions and accumulations have resulted from employment of his money and
that of the other stockholders in the business of the company, still remains the
property of the company, and subject to business risks which may result in
wiping out the entire investment. Having regard to the very truth of the matter,
to substance and not to form, he has received nothing that answers the
definition of income within the meaning of the Sixteenth Amendment.
We are clear that not only does a stock dividend really take nothing from the
property of the corporation and add nothing to that of the shareholder, but
that the antecedent accumulation of profits evidenced thereby, while
indicating that the shareholder is the richer because of an increase of his
capital, at the same time shows he has not realized or received any income
in the transaction.
RE: SELLING STOCK DIVIDEND
It is said that a stockholder may sell the new shares acquired in the stock
dividend, and so he may, if he can find a buyer. It is equally true that, if he does
sell, and in doing so realizes a profit, such profit, like any other, is income,
and, so far as it may have arisen since the Sixteenth Amendment, is taxable
by Congress without apportionment. The same would be true were he to sell
some of his original shares at a profit. But if a shareholder sells dividend stock,
he necessarily disposes of a part of his capital interest, just as if he should sell a
part of his old stock, either before or after the dividend. What he retains no
longer entitles him to the same proportion of future dividends as before the sale.
His part in the control of the company likewise is diminished.
Yet, without selling, the shareholder, unless possessed of other resources, has
not the wherewithal to pay an income tax upon the dividend stock. Nothing
could more clearly show that to tax a stock dividend is to tax a capital
increase, and not income, than this demonstration that, in the nature of things,
it requires conversion of capital in order to pay the tax.

In the present case, the corporation had surplus and undivided profits invested
in plant, property, and business, and required for the purposes of the
corporation, amounting to about $45,000,000, in addition to outstanding capital
stock of $50,000,000. In this, the case is not extraordinary. The profits of a
corporation, as they appear upon the balance sheet at the end of the year, need
not be in the form of money on hand in excess of what is required to meet
current liabilities and finance current operations of the company. Often,
especially in a growing business, only a part, sometimes a small part, of the
year's profits is in property capable of division, the remainder having been
absorbed in the acquisition of increased plant, equipment, stock in trade, or
accounts receivable, or in decrease of outstanding liabilities. When only a part
is available for dividends, the balance of the year's profits is carried to the
credit of undivided profits, or surplus, or some other account having like
significance. If thereafter the company finds itself in funds beyond current
needs, it may declare dividends out of such surplus or undivided profits;
otherwise it may go on for years conducting a successful business, but requiring
more and more working capital because of the extension of its operations, and
therefore unable to declare dividends approximating the amount of its profits.
Thus, the surplus may increase until it equals or even exceeds the par value
of the outstanding capital stock. This may be adjusted upon the books in
the mode adopted in the case at bar -- by declaring a "stock dividend."

This, however, is no more than a book adjustment, in essence -- not a dividend,

but rather the opposite; no part of the assets of the company is separated
from the common fund, nothing distributed except paper certificates that
evidence an antecedent increase in the value of the stockholder's capital
interest resulting from an accumulation of profits by the company, but
profits so far absorbed in the business as to render it impracticable to
separate them for withdrawal and distribution. In order to make the
adjustment, a charge is made against surplus account with corresponding credit
to capital stock account, equal to the proposed "dividend;" the new stock is
issued against this and the certificates delivered to the existing stockholders in
proportion to their previous holdings. This, however, is merely bookkeeping
COMMISSIONER VS. LOBUE
FACTS: In recognition of his "contribution and efforts in making the operation
of the Company successful," a corporation gave an employee options to
purchase stock in the corporation. The options were nontransferable and
were contingent upon continued employment.
After some time had elapsed and the value of the shares had increased, the
employee exercised the options and purchased the stock at less than the
then current market price.
For some of the shares, he gave the employer a promissory note for the option
price; but the shares were not delivered until the notes were paid in cash,
when the value of the shares had increased.
Held: Under the Internal Revenue Code of 1939, as amended, the resulting
gain to the employee was taxable as income received at the time he exercised
the option and purchased the stock, and his taxable gain should be measured as
of the time when the options were exercised and not as of the time when
they were granted.
(a) In defining "gross income" as broadly as it did in § 22(a) of the Internal
Revenue Code of 1939, as amended, Congress intended to tax all gains except
those specifically exempted . P. 351 U. S. 246.
(b) The only exemption that could possibly apply to these transactions is the
gift exemption of § 22(b)(3), and these transactions were not "gifts" in the
statutory sense. Pp. 351 U. S. 246-247.
(c) There is no statutory basis for excluding such transactions from "gross
income" on the ground that one purpose of the employer was to confer on the
employee a "proprietary interest" in the business. P. 351 U. S. 247.
(d) The employee received a substantial economic and financial benefit
from his employer, prompted by the employer's desire to get better work
from the employee, and this is "compensation for personal service" within
the meaning of § 22(a). P. 351 U. S. 247.
(e) In these circumstances, the employee "realized" a taxable gain when he
purchased the stock. P. 351 U. S. 248.
(f) The employee's taxable gain should be measured by the difference between
the option price and the market value of the shares as of the time when the
options were exercised, and not as of the time when the options were granted.
Pp. 351 U. S. 248-249.
(g) On remand, the Tax Court may consider the question, not previously passed
on, whether delivery of a promissory note for the purchase price marked the
completion of the stock purchase, and whether the gain should be measured as
of that date or as of the date the note was paid. P. 351 U. S. 250.
223 F.2d 367 reversed and remanded.
MR. JUSTICE BLACK delivered the opinion of the Court.
This case involves the federal income tax liability of respondent LoBue for the
years 1946 and 1947. From 1941 to 1947, LoBue was manager of the New
York Sales Division of the Michigan Chemical Corporation, a producer and
distributor of chemical supplies. In 1944, the company adopted a stock option
plan making 10,000 shares of its common stock available for distribution to key
employees at $5 per share over a 3-year period. LoBue and a number of other
employees were notified that they had been tentatively chosen to be recipients
of nontransferable stock options contingent upon their continued employment.
LoBue's notice told him: "You may be assigned a greater or less amount of
stock based entirely upon your individual results and that of the entire
organization." About 6 months later, he was notified that he had been definitely
awarded an option to buy 150 shares of stock in recognition of his "contribution
and efforts in making the operation of the Company successful." As to future
allotments, he was told "It is up to you to justify your participation in the plan
during the next two years."
LoBue's work was so satisfactory that the company in the course of 3 years
delivered to him 3 stock options covering 340 shares. He exercised all these $5
per share options in 1946 and in 1947, [Footnote 1] paying the company only
$1,700 for stock having a market value when delivered of $9,930. Thus, at the
end of these transactions, LoBue's employer was worth $8,230 less to its
stockholders and LoBue was worth $8,230 more than before. [Footnote 2] The
company deducted this sum as an expense in its 1946 and 1947 tax returns, but
LoBue did not report any part of it as income. Viewing the gain to LoBue as
compensation for personal services, the Commissioner levied a deficiency
assessment against him, relying on § 22(a) of the Internal Revenue Code of
1939, 53 Stat. 9, as amended, 53 Stat. 574, which defines gross income as
including "gains, profits, and income derived from . . . compensation for
personal service . . . of whatever kind and in whatever form paid. . .
LoBue petitioned the Tax Court to redetermine the deficiency, urging that
"The said options were not intended by the Corporation or the petitioner to
constitute additional compensation, but were granted to permit the
petitioner to acquire a proprietary interest in the Corporation and to
provide him with the interest in the successful operation of the
Corporation deriving from an ownership interest."
TAX COURT: LoBue had a taxable gain if the options were intended as
compensation, but not if the options were designed to provide him with "a
proprietary interest in the business." Finding after hearings that the options
were granted to give LoBue "a proprietary interest in the corporation, and not
as compensation for services," the Tax Court held for LoBue.
CA: affirmed CTA
- "This was a factual issue which it was the peculiar responsibility of
the Tax Court to resolve. From our examination of the evidence, we
cannot say that its finding was clearly erroneous."
We have repeatedly held that, in defining "gross income" as broadly as it did in
§ 22(a), Congress intended to "tax all gains except those specifically
exempted." See, e.g., Commissioner v. Glenshaw Glass Co., 348 U. S.
426, 348 U. S. 429-430. The only exemption Congress provided from this very
comprehensive definition of taxable income that could possibly have
application here is the gift exemption of § 22(b)(3). But there was not the
slightest indication of the kind of detached and disinterested generosity which
might evidence a "gift" in the statutory sense. These transfers of stock bore
none of the earmarks of a gift. They were made by a company engaged in
operating a business for profit, and the Tax Court found that the stock option
plan was designed to achieve more profitable operations by providing the
employees "with in incentive to promote the growth of the company by
permitting them to participate in its success." 22 T.C. at 44
Under these circumstances, the Tax Court and the Court of Appeals
properly refrained from treating this transfer as a gift. The company was
not giving something away for nothing
Since the employer's transfer of stock to its employee LoBue for much less than
the stock's value was not a gift, it seems impossible to say that it was not
compensation. The Tax Court held there was no taxable income, however, on
the ground that one purpose of the employer was to confer a "proprietary
interest." [Footnote 5] But there is not a word in § 22(a) which indicates that its
broad coverage should be narrowed because of an employer's intention to enlist
more efficient service from his employees by making them part proprietors of
his business. In our view, there is no statutory basis for the test established
by the courts below. When assets are transferred by an employer to an
employee to secure better services, they are plainly compensation. It makes
no difference that the compensation is paid in stock, rather than in money.
Section 22(a) taxes income derived from compensation "in whatever form
paid." And, in another stock option case, we said that § 22(a)
"is broad enough to include in taxable income any economic or financial
benefit conferred on the employee as compensation, whatever the form or mode
by which it is effected."
Commissioner v. Smith, 324 U. S. 177, 324 U. S. 181. LoBue received a
very substantial economic and financial benefit from his employer prompted
by the employer's desire to get better work from him. This is "compensation
for personal service" within the meaning of § 22(a).
LoBue nonetheless argues: that we should treat this transaction as a mere
purchase of a proprietary interest on which no taxable gain was "realized"
in the year of purchase.
COURT: It is true that our taxing system has ordinarily treated an arm's length
purchase of property, even at a bargain price, as giving rise to no taxable gain in
the year of purchase. See Palmer v. Commissioner, 302 U. S. 63, 302 U. S.
69. But that is not to say that, when a transfer which is in reality compensation
is given the form of a purchase, the Government cannot tax the gain under §
22(a). The transaction here was unlike a mere purchase. It was not an
arm's length transaction between strangers. Instead, it was an
arrangement by which an employer transferred valuable property to his
employees in recognition of their services. We hold that LoBue realized
taxable gain when he purchased the stock
A question remains as to the time when the gain on the shares should be
measured. LoBue gave his employer promissory notes for the option price of
the first 300 shares, but the shares were not delivered until the notes were paid
in cash. [Footnote 7] The market value of the shares was lower when the notes
were given than when the cash was paid.
Commissioner: measured the taxable gain by the market value of the shares
when the cash was paid.
LoBue contends: that this was wrong, and that the gain should be measured
either when the options were granted or when the notes were given.
It is, of course, possible for the recipient of a stock option to realize an
immediate taxable gain. See Commissioner v. Smith, 324 U. S. 177, 324 U.
S. 181-182. The option might have a readily ascertainable market value, and the
recipient might be free to sell his option. But this is not such a case. These
three options were not transferable, [Footnote 8] and LoBue's right to buy
stock under them was contingent upon his remaining an employee of the
company until they were exercised. Moreover, the uniform Treasury practice
since 1923 has been to measure the compensation to employees given stock
options subject to contingencies of this sort by the difference between the
option price and the market value of the shares at the time the option is
exercised. [Footnote 9] We relied in part upon this practice in Commissioner
v. Smith, 324 U. S. 177, 324 U. S. 695. And, in its 1950 Act affording limited
tax benefits for "restricted stock option plans," Congress adopted the same kind
of standard for measurement of gains. § 130A, Internal Revenue Code of 1939,
64 Stat. 942. And see § 421, Internal Revenue Code of 1954, 68A Stat. 142.
Under these circumstances there is no reason for departing from the Treasury
practice. The taxable gain to LoBue should be measured as of the time the
options were exercised, and not the time they were granted.
It is possible that a bona fide delivery of a binding promissory note could
mark the completion of the stock purchase, and that gain should be measured as
of that date. Since neither the Tax Court nor the Court of Appeals passed on this
question, the judgment is reversed and the case is remanded to the Court of
Appeals with instructions to remand the case to the Tax Court for further COMMISSIONER OF INTERNAL REVENUE, petitioner,
proceedings. vs.
MELCHOR J. JAVIER, JR. and THE COURT OF TAX
Reversed and remanded. APPEALS, respondents.

FACTS:

2. That on or about June 3, 1977, Victoria L. Javier, the wife of the petitioner
(private respondent herein), received from the Prudential Bank and Trust
Company in Pasay City the amount of US$999,973.70 remitted by her sister,
Mrs. Dolores Ventosa, through some banks in the United States, among which
is Mellon Bank, N.A.

3. That on or about June 29, 1977, Mellon Bank, N.A. filed a complaint
with the Court of First Instance of Rizal, against the private respondent
herein, his wife and other defendants, claiming that its remittance of
US$1,000,000.00 was a clerical error and should have been US$1,000.00
only, and praying that the excess amount of US$999,000.00 be returned on
the ground that the defendants are trustees of an implied trust for the
benefit of Mellon Bank with the clear, immediate, and continuing duty to
return the said amount from the moment it was received.

4. That on or about November 5, 1977, the City Fiscal of Pasay City filed an
Information with the then Circuit Criminal Court private respondent herein and
his wife with the crime of estafa, alleging that they misappropriated,
misapplied, and converted to their own personal use and benefit the amount of
US$999,000.00 which they received under an implied trust for the benefit of
Mellon Bank and as a result of the mistake in the remittance by the latter.

5. That on March 15, 1978, private respondent herein filed his Income Tax
Return for the taxable year 1977 showing a gross income of P53,053.38 and
a net income of P48,053.88 and stating in the footnote of the return that
"Taxpayer was recipient of some money received from abroad which he
presumed to be a gift but turned out to be an error and is now subject of
litigation."

6. That on or before December 15, 1980, private respondent herein received

a letter from the acting Commissioner of Internal Revenue dated
November 14, 1980, together with income assessment notices for the years
1976 and 1977, demanding that private respondent herein pay on or before
December 15, 1980 the amount of P1,615.96 and P9,287,297.51 as
deficiency assessments for the years 1976 and 1977 respectively. . . .

7. That on December 15, 1980, the private respondent herein wrote the BIR that
he was paying the deficiency income assessment for the year 1976 but denying
that he had any undeclared income for the year 1977 and requested that the
assessment for 1977 be made to await final court decision on the case filed
against him for filing an allegedly fraudulent return. . . .

8. That on November 11, 1981, private respondent herein received from Acting
Commissioner of Internal Revenue Romulo Villa a letter dated October 8, 1981
stating in reply to his December 15, 1980 letter-protest that "the amount of
Mellon Bank's erroneous remittance which you were able to dispose, is
definitely taxable." . . .

The Commissioner also imposed a 50% fraud penalty against Javier.

Disagreeing, Javier filed an appeal6 before the respondent CTA on December

10, 1981.

CTA- decided in favor of private respondents herein and the 50% surcharge
imposed in the deficiency assessment is ordered to be deleted.

The Commissioner of Internal Revenue, not satisfied with the respondent

CTA's ruling, elevated the matter to us, by the present petition.

CIR’S CONTENTION:

The petitioner contends that the private respondent committed fraud by not
declaring the "mistaken remittance" in his income tax return and by merely
making a footnote thereon which read: "Taxpayer was the recipient of some
money from abroad which he presumed to be a gift but turned out to be an error
and is now subject of litigation."

JAVIER’S POSITION:

Javier candidly stated in his Memorandum,9 that he "did not appeal the decision
which held him liable for the basic deficiency income tax (excluding the 50%
surcharge for fraud)." However, he submitted in the same memorandum "that
the issue may be raised in the case not for the purpose of correcting or setting
aside the decision which held him liable for deficiency income tax, but only to
show that there is no basis for the imposition of the surcharge." This subsequent
disavowal therefore renders moot and academic the posturings articulated in as
Comment10 on the non-taxability of the amount he erroneously received and the
bulk of which he had already disbursed. In any event, an appeal at that time (of
the filing of the Comments) would have been already too late to be seasonable.
ISSUE:
WHETHER OR NOT PRIVATE RESPONDENT IS LIABLE FOR THE 50%
FRAUD PENALTY?8
COURT: NO
It is respectfully submitted that the said return was not fraudulent. The footnote
was practically an invitation to the petitioner to make an investigation, and to
make the proper assessment.
The rule in fraud cases is that the proof "must be clear and convincing", that is,
it must be stronger than the "mere preponderance of evidence" which would be
sufficient to sustain a judgment on the issue of correctness of the deficiency
itself apart from the fraud penalty. The following circumstances attendant to
the case at bar show that in filing the questioned return, the private
respondent was guided, not by that "willful and deliberate intent to
prevent the Government from making a proper assessment" which
constitute fraud, but by an honest doubt as to whether or not the
"mistaken remittance" was subject to tax.
In the case at bar, there was no actual and intentional fraud through willful
and deliberate misleading of the government agency concerned, the
Bureau of Internal Revenue, headed by the herein petitioner. The
government was not induced to give up some legal right and place itself at a
disadvantage so as to prevent its lawful agents from proper assessment of tax
liabilities because Javier did not conceal anything. Error or mistake of law is
not fraud. The petitioner's zealousness to collect taxes from the unearned
windfall to Javier is highly commendable.1âwphi1 Unfortunately, the
imposition of the fraud penalty in this case is not justified by the extant facts.
Javier may be guilty of swindling charges, perhaps even for greed by spending
most of the money he received, but the records lack a clear showing of fraud
committed because he did not conceal the fact that he had received an amount
of money although it was a "subject of litigation." As ruled by respondent Court
of Tax Appeals, the 50% surcharge imposed as fraud penalty by the petitioner
against the private respondent in the deficiency assessment should be deleted.

First, this Honorable Court will take judicial notice of the fact that so-called
"million dollar case" was given very, very wide publicity by media; and
only one who is not in his right mind would have entertained the idea that
the BIR would not make an assessment if the amount in question was
indeed subject to the income tax.

Second, as the respondent Court ruled, "the question involved in this case is of
first impression in this jurisdiction" Even in the United States, the authorities
are not unanimous in holding that similar receipts are subject to the income tax.
It should be noted that the decision in the Rutkin case is a five-to-four decision;
and in the very case before this Honorable Court, one out of three Judges of the
respondent Court was of the opinion that the amount in question is not taxable.
Thus, even without the footnote, the failure to declare the "mistaken
remittance" is not fraudulent.

Third, when the private respondent filed his income tax return on March 15,
1978 he was being sued by the Mellon Bank for the return of the money, and
was being prosecuted by the Government for estafa committed allegedly by his
failure to return the money and by converting it to his personal benefit. The
basic tax amounted to P4,899,377.00 and could not have been paid without
using part of the mistaken remittance. Thus, it was not unreasonable for the
private respondent to simply state in his income tax return that the amount
received was still under litigation. If he had paid the tax, would that not
constitute estafa for using the funds for his own personal benefit? and
would the Government refund it to him if the courts ordered him to refund
the money to the Mellon Bank?12

xxx xxx xxx

Under the then Section 72 of the Tax Code (now Section 248 of the 1988
National Internal Revenue Code), a taxpayer who files a false return is liable to
pay the fraud penalty of 50% of the tax due from him or of the deficiency tax in
case payment has been made on the basis of the return filed before the
discovery of the falsity or fraud.

We are persuaded considerably by the private respondent's contention that there

is no fraud in the filing of the return and agree fully with the Court of Tax
Appeals' interpretation of Javier's notation on his income tax return filed on
March 15, 1978 thus: "Taxpayer was the recipient of some money from abroad
which he presumed to be a gift but turned out to be an error and is now subject
of litigation that it was an "error or mistake of fact or law" not constituting
fraud, that such notation was practically an invitation for investigation and that
Javier had literally "laid his cards on the table."13

In Aznar v. Court of Tax Appeals,14 fraud in relation to the filing of income tax
return was discussed in this manner:

. . . The fraud contemplated by law is actual and not constructive. It must be

intentional fraud, consisting of deception willfully and deliberately done or
resorted to in order to induce another to give up some legal right. Negligence,
whether slight or gross, is not equivalent to the fraud with intent to evade the
tax contemplated by law. It must amount to intentional wrong-doing with the
sole object of avoiding the tax. It necessarily follows that a mere mistake
cannot be considered as fraudulent intent, and if both petitioner and respondent
Commissioner of Internal Revenue committed mistakes in making entries in the
returns and in the assessment, respectively, under the inventory method of
determining tax liability, it would be unfair to treat the mistakes of the
petitioner as tainted with fraud and those of the respondent as made in good
faith.

Fraud is never imputed and the courts never sustain findings of fraud upon
circumstances which, at most, create only suspicion and the mere
understatement of a tax is not itself proof of fraud for the purpose of tax
evasion.15

A "fraudulent return" is always an attempt to evade a tax, but a merely "false

return" may not be, Rick v. U.S., App. D.C., 161 F. 2d 897, 898.16