## Facts

- Harold S. Divine and Rita K. Divine were shareholders of Rapid American Corporation (Rapid) and filed joint federal income tax returns for 1961 and 1962.
- Rapid maintained a plan under which employees received statutory restricted stock options allowing purchase of Rapid shares below fair market value.
- From 1957 to 1962, employees paid about $1.89 million for shares with an aggregate fair market value of about $5.3 million, creating a “bargain element” of roughly $3.4 million.
- The Divines held about 37,000 shares in 1961 and 40,000 in 1962 and received distributions of about $18,500 (1961) and $20,500 (1962).
- Rapid advised shareholders that the distributions were not dividends because Rapid’s earnings and profits (E&P) were insufficient after reducing E&P by the bargain element from employee option exercises; the Divines did not report the distributions as dividends.
- The Commissioner determined deficiencies for 1961 and 1962, treating the distributions as taxable dividends on the view that Rapid’s E&P could not be reduced by the bargain element.
- The Tax Court upheld the Commissioner, rejecting the E&P reduction and declining to preclude relitigation based on a prior appellate decision involving the same corporate option program.

## Issues

1. Whether the Commissioner was barred by collateral estoppel from litigating, against different taxpayers, whether Rapid’s E&P could be reduced by the bargain element of statutory restricted stock options.
2. Whether, for purposes of determining dividend treatment under I.R.C. § 316, a corporation’s E&P must be reduced by the difference between fair market value and the employee purchase price when statutory restricted stock options are exercised.

## Decision

- The Second Circuit held collateral estoppel did not bar the Commissioner from relitigating the E&P issue in a different circuit against different taxpayers.
- The court held Rapid’s E&P should be reduced by the bargain element realized when employees purchased shares under statutory restricted stock options.
- The court reversed the Tax Court and remanded for redetermination of the Divines’ tax liabilities consistent with the reduced E&P computation.

## Legal Principles

- Nonmutual collateral estoppel generally does not preclude the federal government from litigating the same legal issue against different taxpayers, particularly where continued litigation may be necessary to obtain uniform interpretation of national tax law.
- Under I.R.C. § 316, dividend characterization depends on whether a distribution is made out of corporate E&P, a measure aimed at a corporation’s economic capacity to make dividend distributions.
- In computing E&P, economically significant corporate outlays may require adjustment even if they do not produce a corresponding deduction in taxable income.
- The bargain element of statutory restricted stock options represents an economic cost to the corporation and reduces E&P by the difference between the stock’s fair market value and the price paid by employees at exercise.

## Conclusion

The Second Circuit permitted the IRS to relitigate the E&P question despite a prior adverse circuit decision, but ruled for the taxpayers on the merits, holding that statutory option bargain elements reduce corporate E&P and therefore limit the extent to which shareholder distributions are taxable as dividends under I.R.C. § 316.


Divine v. Commissioner, 500 F.2d 1041 (2d Cir. 1974)