## Facts

- Pacific Telephone & Telegraph Co. (Pacific), controlled about 90% by AT&T, transferred certain assets to a new subsidiary, Pacific Northwest Bell Telephone Co. (Northwest), receiving all Northwest common stock and some debt.
- In 1961, Pacific distributed to its shareholders rights to purchase about 57% of Northwest common stock at $16 per share, a price below fair market value.
- Pacific stated it expected that within about three years it would offer the remaining Northwest shares for sale, but it did not undertake a binding obligation to do so.
- The IRS took the position that exercising the rights generated taxable income equal to the spread between fair market value and the $16 paid; selling the rights generated taxable income equal to the proceeds.
- Minority shareholders (the Gordons and related taxpayers) sold some rights and/or exercised the rest, but reported no income from exercise, claiming the 1961 transaction qualified for tax-free treatment under I.R.C. § 355.
- The Tax Court treated the 1961 transaction as meeting § 355, so no gain was recognized on receipt or exercise of the rights, but it treated proceeds from sold rights as ordinary income.
- The Second Circuit largely agreed § 355 applied but treated amounts from sold rights as capital gain; the Ninth Circuit (in a companion case) rejected § 355 treatment and taxed the spread on exercise.
- The Supreme Court granted certiorari in the companion cases and decided the matter in a unanimous opinion by Justice Harlan.

## Issues

1. Whether a corporation’s bargain-price sale of property to shareholders (through rights) constitutes a taxable “distribution of property” (dividend) to the extent of earnings and profits, absent an applicable statutory exception.
2. Whether the 1961 rights distribution qualified for nonrecognition under I.R.C. § 355 when it did not itself divest the distributing corporation of the requisite control and was not made pursuant to a binding commitment to complete the divestiture.

## Decision

- The Court held that a bargain-price sale by a corporation to its shareholders that reduces corporate net worth constitutes a “distribution of property,” producing dividend income to the extent of earnings and profits unless a specific exception applies.
- The Court held the 1961 transaction did not qualify under § 355 because “the distribution” did not itself divest Pacific of control (all or at least 80%) of Northwest.
- The Court rejected treating the 1961 transfer as a “first step” of a multi-step § 355 divestiture because there was no binding commitment in 1961 to complete the later distribution.
- The Court reversed the Second Circuit and sustained taxation of the spread between $16 and fair market value upon exercise of the rights.

## Legal Principles

- A corporation’s bargain sale of property to shareholders (or their assignees) at less than fair market value, diminishing corporate net worth, is treated as a “distribution of property” and results in a dividend to the extent of earnings and profits unless a statutory exception applies.
- I.R.C. § 355 nonrecognition requires that “the distribution” itself divest the distributing corporation of control (all or at least 80%) of the controlled corporation.
- A partial transfer can be treated as a first step toward a qualifying divestiture only if, at the time of the initial transfer, later steps are fixed by a binding commitment; a stated expectation or plan is insufficient.
- Code provisions are construed to keep the tax character of a transaction determinable within the annual accounting system, rather than contingent on indefinite future events.

## Conclusion

The Court held that shareholders who acquired subsidiary stock through rights at a bargain price realized taxable dividend income equal to the spread, because the rights offering was a below-market distribution and did not qualify for § 355 nonrecognition absent a control-divesting distribution or a binding commitment to complete such a divestiture.


Commissioner v. Gordon, 391 U.S. 83 (1968)