## Facts

- William H. Kinch and Samuel J. Dark were the only shareholders of Rock Asphalt & Construction Company, Inc. (Rock Asphalt), and each owned both common and preferred shares.
- Over prior years, Rock Asphalt paid dividends on the common stock that exceeded the corporation’s earnings and profits, leaving Kinch’s and Dark’s bases in their common shares reduced to zero.
- Kinch and Dark still had unrecovered, cost bases in their preferred shares.
- Rock Asphalt later declared and paid another dividend expressly with respect to its common stock.
- The dividend exceeded Rock Asphalt’s earnings and profits for the year, and the parties stipulated the distribution was not made in partial or complete liquidation.
- Rock Asphalt’s corporate actions and records treated the payment only as a common-stock dividend; there was no declaration, allocation, redemption, or other corporate step treating any portion as a distribution on the preferred shares.
- On their individual returns, Kinch and Dark sought to treat the portion of the common-stock distribution that exceeded earnings and profits as a nontaxable return of capital on their preferred stock, reducing preferred basis and avoiding current gain.

## Issues

1. Whether a cash distribution declared and paid as a dividend with respect to common stock may be treated by shareholders, to the extent it exceeds earnings and profits, as a return of capital with respect to their preferred stock.
2. Whether shareholders may reduce preferred-stock basis using an excess distribution made with respect to common stock when the corporation took no action to distribute with respect to the preferred shares.

## Decision

- The Tax Court sustained the Commissioner’s deficiency determinations.
- The court treated the distribution as made with respect to the common stock, as declared and recorded by the corporation.
- The shareholders could not reassign the excess portion of the common-stock dividend to the preferred stock to obtain basis recovery on the preferred shares.
- Because Kinch’s and Dark’s bases in the common shares were already zero, the portion of the distribution exceeding earnings and profits was taxable to them as gain with respect to the common stock (rather than as a tax-free recovery of preferred basis).

## Legal Principles

- The tax character of a corporate distribution generally follows the corporation’s action identifying the stock with respect to which the distribution is made.
- A distribution’s treatment as dividend, return of capital, or gain is determined by applying earnings-and-profits and basis rules to the same class of stock on which the distribution is made.
- Shareholders may not, for tax reporting purposes, allocate a distribution from one class of shares to another class absent a corporate act supporting that allocation (such as an actual distribution on the other class, a redemption, or a transaction changing shareholder rights).
- Excess distributions do not automatically become returns of capital on some other stock merely because shareholders have remaining basis in that other stock; basis recovery is tied to the stock that actually received the distribution.

## Conclusion

Kinch and Dark could not treat the excess portion of a dividend declared and paid on common stock as a return of capital on their preferred stock, so the Tax Court upheld the Commissioner’s determination that the excess was taxable to them as gain with respect to their common shares.


Kinch v. Commissioner, T.C. Memo. 1942 (1942)