Litton Industries, Inc. v. Commissioner

United States Tax Court · 1987 · Corporations

CorporationsDividendsSale of subsidiary stockTax characterizationsection 243(a)section 316(a)dividend paid by noteearnings and profits

Facts

Litton owned all of Stouffer's stock, and by August 1, 1972, Stouffer had accumulated earnings and profits exceeding $30 million. On August 23, 1972, before Litton publicly announced any sale effort, 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 over the next six months it explored various sale and public offering possibilities. On March 5, 1973, Nestle bought all of Stouffer's stock for about $75 million in cash and separately paid $30 million in cash for the note.

Issue

Was the $30 million declared by Stouffer and paid to Litton by promissory note a true dividend for federal tax purposes, or should it be treated as part of the proceeds of Litton's later sale of Stouffer stock to Nestle?

Rule

A dividend under section 316(a) is a distribution by a corporation to its shareholders out of earnings and profits, and a dividend may be paid by note. When a subsidiary declares such a dividend before any prearranged sale, with no definite purchaser or agreed sale terms and with substantial temporal separation from a later stock sale, the distribution is respected as a dividend rather than collapsed into the later sale proceeds; taxpayers may structure transactions to minimize taxes so long as the transaction has substance and is not a sham or subterfuge.

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One of 10 multiple-choice questions for this case. Pick an answer to see why.

North Harbor Systems, Inc., based in Seattle, owned all of Cascade Kitchen Group. Cascade had accumulated earnings and profits of $18 million. On January 10, Cascade declared a $12 million dividend to North Harbor and delivered a negotiable promissory note; seven months later, after exploring both an IPO in Chicago and several private bids, North Harbor sold all Cascade stock to Lakeview Foods Holding, which separately paid cash for the note.

For federal tax characterization, the $12 million is most likely treated as:

Explanation. The majority rule is that a distribution by a subsidiary to its parent out of earnings and profits may be a dividend even if paid by promissory note. When the distribution is declared before any prearranged sale, no definite purchaser or agreed terms exist at that time, and the eventual stock sale occurs after substantial time has passed, the distribution is respected as a dividend rather than recharacterized as sale proceeds.