## Facts

- Indianapolis Water Company (Water Company), a regulated public utility, owned all stock of Shorewood Corporation (Shorewood), which held waterfront real estate near the utility’s reservoirs.
- Regulators indicated real estate development was not appropriate for a public utility and suggested separating Shorewood from the Water Company.
- Shorewood recapitalized and increased its authorized common stock substantially; Shorewood issued shares to the Water Company in exchange for the prior outstanding shares.
- The Water Company agreed to purchase additional Shorewood shares, increasing its Shorewood holdings.
- The Water Company’s board distributed to Water Company shareholders transferable stock rights (warrants) to acquire Shorewood common stock.
- The warrants permitted holders to obtain Shorewood shares by surrendering warrants and paying $5 per share; the subscription price was below fair market value, and a market developed for the warrants.
- After warrant exercises and related sales, Water Company shareholders held more than 50% of Shorewood, while the Water Company retained roughly 20%.
- The IRS determined the warrant distribution produced taxable income to shareholders and assessed deficiencies.
- The Tax Court treated the warrant distribution and subsequent Shorewood stock distribution as a single transaction under the step-transaction doctrine and found nonrecognition under I.R.C. § 355.
- The Commissioner appealed.

## Issues

1. Whether the distribution of valuable, transferable warrants to buy subsidiary stock at a bargain price was a taxable distribution of property (dividend) to shareholders.
2. Whether I.R.C. § 355 nonrecognition applied by treating the warrant issuance and later steps as a single corporate separation transaction under the step-transaction doctrine.

## Decision

- The Seventh Circuit reversed the Tax Court.
- The court held the distribution of Shorewood stock warrants constituted a dividend to shareholders to the extent of the Water Company’s earnings and profits.
- The court held § 355 did not apply to render the warrant distribution nontaxable, and the step-transaction doctrine did not justify collapsing the independently significant warrant distribution into a tax-free spin-off.

## Legal Principles

- A corporation’s distribution of property to shareholders is generally taxable as a dividend to the extent of earnings and profits under I.R.C. §§ 301–316.
- Stock rights or warrants can constitute “property” when they have ascertainable market value, are transferable, and provide a bargain purchase opportunity.
- I.R.C. § 355 provides nonrecognition for qualifying distributions of stock or securities of a controlled corporation; it does not automatically shelter other economically significant distributions associated with a separation.
- The step-transaction doctrine does not require collapsing separate steps when an intermediate step has independent economic significance and fits ordinary dividend characterization.

## Conclusion

The court treated the transferable, marketable warrants distributed to shareholders at a bargain price as a taxable dividend and refused to extend § 355 nonrecognition through the step-transaction doctrine to eliminate tax on a discrete, economically meaningful distribution.


Redding v. Commissioner of Internal Revenue, 630 F.2d 1169 (7th Cir. 1980)