## Facts

- Fender Sales, Inc., a California corporation formed in 1953, had 100 shares outstanding, owned equally by E. Leo Fender and Donald D. Randall (50/50).
- Fender and Randall were key employees entitled to $15,000 annual salaries plus sales-based percentages (Randall 4% of sales; Fender 1%).
- The corporation suffered financial difficulty and accrued, but did not pay, substantial salary and commission obligations to Fender and Randall.
- In 1956, the corporation issued 450 shares to each of Fender and Randall to cancel $45,000 owed to each for unpaid compensation.
- In 1958, the corporation issued an additional 150 shares to each to cancel further unpaid compensation for 1957–1958.
- Each issuance was in identical amounts to Fender and Randall, leaving their proportional ownership interests unchanged.
- Fender and Randall did not report the stock received as taxable income; the corporation did not report income from eliminating the accrued salary liabilities.
- The Commissioner asserted deficiencies, contending either (a) the stock was taxable compensation to the individuals, or (b) if not, the corporation had taxable discharge-of-indebtedness income.

## Issues

1. Whether pro rata issuance of stock to employee-shareholders in satisfaction of accrued but unpaid salary obligations constitutes taxable income to the shareholders as compensation or otherwise.
2. If shareholders recognize no income, whether the corporation realizes taxable income from discharge of indebtedness when accrued salary liabilities are canceled by issuing stock.

## Decision

- The Ninth Circuit affirmed the Tax Court.
- The shareholder-employees realized no taxable income from receiving additional shares issued pro rata in cancellation of accrued unpaid compensation.
- The corporation realized no taxable discharge-of-indebtedness income from canceling the salary liabilities through issuance of its own stock.

## Legal Principles

- A pro rata stock issuance to existing shareholders that does not alter proportional ownership can be treated as a capital transaction rather than a taxable distribution or compensation event.
- Where shareholder-creditors exchange bona fide claims against a closely held corporation for additional shares on a pro rata basis, the transaction may be characterized as a recapitalization or contribution to capital, not an accession to wealth to the shareholders.
- A corporation generally does not realize discharge-of-indebtedness income when indebtedness to its shareholders is satisfied by issuing its own stock in a capital restructuring that does not produce net economic enrichment.

## Conclusion

Because the stock-for-accrued-salary exchanges were pro rata and left the shareholder-employees’ ownership interests unchanged, the transactions were properly treated as a nontaxable recapitalization: the individuals had no taxable compensation income and the corporation had no discharge-of-indebtedness income.


Commissioner of Internal Revenue v. Fender Sales, Inc., 338 F.2d 924 (9th Cir. 1964)