corporationsdividendssale of subsidiary stockfederal income taxsection 243(a)section 316(a)dividend paid by notesubstance over form
Facts
Litton owned all of Stouffer's stock and had discussed the possibility of selling Stouffer in early and mid-1972. On August 23, 1972, when Stouffer's accumulated earnings and profits exceeded $30 million, Stouffer declared a $30 million dividend and paid it to Litton with a negotiable promissory note. Two weeks later Litton publicly announced its interest in disposing of Stouffer and then explored multiple alternatives, including private sale, full public offering, and partial public offering. More than six months after the dividend, Nestle bought all of Stouffer's stock for about $75 million in cash and separately paid $30 million cash for the note.
Issue
Whether the $30 million declared by Stouffer and paid to Litton by promissory note was a true dividend for federal tax purposes, or whether it should be treated as part of the proceeds from Litton's later sale of Stouffer stock to Nestle.
Rule
Under section 316(a), a dividend is a distribution by a corporation to its shareholders out of earnings and profits, and such a dividend may be paid by note. When a subsidiary declares such a distribution before any prearranged or formally initiated sale, with no definite purchaser or agreed sale terms and with real commitment to the dividend independent of whether a sale occurs, the distribution is respected as a dividend rather than recharacterized as stock sale proceeds.
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One of 10 multiple-choice questions for this case. Pick an answer to see why.
Redwood Systems, Inc., based in San Diego, owned all the stock of Harbor Meal Co., a food-services subsidiary in Oregon. In January, Harbor Meal declared a $20 million distribution out of accumulated earnings and profits and delivered Redwood a negotiable promissory note; seven months later, after Redwood had explored several alternatives and only then found a buyer in Chicago, Redwood sold all Harbor Meal stock, and the buyer separately paid cash to acquire the note.
How should the $20 million note distribution most likely be treated for federal tax purposes?
Explanation. Under the majority opinion, a distribution by a wholly owned subsidiary out of earnings and profits may be a dividend even if paid by promissory note. When the dividend is declared before any prearranged or formally initiated sale, with no definite purchaser or agreed terms and substantial separation in time from the later stock sale, the distribution is respected as a separate dividend rather than recharacterized as sale proceeds. Those facts closely fit that rule.