Did Nathaniel Hawthorne\u27s novel, The Scarlet Letter, inspire Section 306 of the Internal Revenue Code? This code provision adopts a peculiarly Hawthorne-like solution to a tax avoidance scheme known as the  preferred stock bailout.  Section 306 taints the stock used in the scheme as  Section 306 stock.  Special rules then govern all subsequent dispositions of the tainted stock. With its concept of a taint that can dog a stock from acquisition to disposition, Section 306 might have been designed by a novelist rather than a tax technician

Cohen, Stephen B

Cohen, Stephen B.

English

Georgetown Law Scholarly Commons

Georgetown University Law Center Scholarship @ GEORGETOWN LAW 2001 Hester Prynne, Lydia Bennet, and Section 306 Stock: The Concept of Tainting in the American Novel, the British Novel, and the Internal Revenue Code Stephen B. Cohen Georgetown University Law Center, cohen@law.georgetown.edu Stephen B. Cohen Georgetown University Law Center, cohen@law.georgetown.edu   This paper can be downloaded free of charge from: https://scholarship.law.georgetown.edu/facpub/920 http://ssrn.com/abstract=288801  5 Green Bag 2d 5-9 (2001) This open-access article is brought to you by the Georgetown Law Library. Posted with permission of the author. Follow this and additional works at: https://scholarship.law.georgetown.edu/facpub  Part of the Securities Law Commons, Taxation-Federal Commons, and the Tax Law Commons Hester Prynne, Lydia Bennet, and Section 306 Stock:The Concept of Tainting in the American Novel, the British Novel,And the Internal Revenue CodeBy Stephen B. Cohen15 Green Bag 2d 5 (2001)I need to solve a literary-legal mystery: Did NathanielHawthorne’s novel, The Scarlet Letter, inspire Section 306 of theInternal Revenue Code?  The need is urgent.  With each passingday, Section 306 becomes increasingly irrelevant.  If an answer doesnot appear soon, literary theorists and tax lawyers may lose interest,and an insight into American culture may be lost.Section 306 adopts a peculiarly Hawthorne-like solution to a taxavoidance scheme known as the “preferred stock bailout.”  In 1953the Sixth Circuit, surprisingly, blessed the preferred stock bailout inthe case of Chamberlin v. Commissioner.3  One year later, Congressenacted Section 306 to reverse the Sixth Circuit’s decision.  The factsof the preferred stock bailout scheme in Chamberlin are as follows.                                                1 Stephen B. Cohen is Professor of Law at the Georgetown University Law Center2 I.R.C. § 306 (c).3 207 F. 2d 462 (6th Cir. 1953), cert. denied, 346 U.S. 918 (1954).C.P. Chamberlin and his wife, Grace, owned nearly 85 percentof the common stock of the Metal Moulding Corporation (MMC),located in Detroit, Michigan.  MMC, which began operations in 1924,sold bright metallic trim to the producers of American automobiles.With the end of World War II, American auto manufacturers shiftedtheir production from war materials to consumer goods.  There wastremendous pent-up consumer demand for cars and virtually nocompetition from foreign manufacturers.  Automobiles of that period,as older readers may recall, were garishly adorned with largeamounts of metallic trim of the type produced by MMC.Thus, after World War II, MMC began to earn enormous profits.In the year 1946 alone, the company’s accumulated profits increasedby 47 percent over the total for the previous 21 years of its operatinghistory.4These large profits created a tax problem for Mr. and Mrs.Chamberlin, MMC’s largest stockholders.  The Chamberlins wantedMMC to distribute its after-tax corporate profits.  However, the TaxCode decreed, then as now, that distributed corporate earnings aredividends and that a shareholder who receives dividends pays tax onthe entire amount at ordinary income rates.  For the 16 years afterWorld War II, the top ordinary income tax rate (to which theChamberlins were probably subject, given MMC’s prosperity) was anall-but-confiscatory 90 percent.5Therefore, the Chamberlins devised the following three-steptransaction.  In the first prearranged step, they caused thecorporation to distribute to its common stockholders a dividendconsisting not of cash but of newly issued shares of the corporation’sown nonvoting preferred stock.  In the second prearranged step, theshareholders sold their preferred stock to two insurance companiesfor about $800,000.  Finally, in the third prearranged step of the plan,stretching over seven years, the corporation itself redeemed theentire issue of preferred stock, buying it back from the insurancecompanies for $800,000.What tax treatment did the Chamberlins claim?  On the firststep, the distribution of the preferred stock dividend, they claimednonrecognition.  For this position they had solid authority:  TheSupreme Court had repeatedly held that such stock dividends, unlikedistributions of cash, are mere paper transactions and therefore merit                                                                                                                                                4 By the end of 1945, the total of accumulated after-tax profits was $1,425,000.  During 1946, accumulatednonrecognition.6   Moreover, Congress had acceded to the Court’sjudgment and amended the Internal Revenue Code to provide tax-free treatment for stock dividends distributed pro rata on commonstock.7As for the second step of the transaction, the sale of their newpreferred stock to the insurance companies for $800,000, theChamberlins argued that they should be taxed like any other seller ofproperty.  Therefore their income was not the entire $800,000 butonly the amount by which the sales price exceeded their basis in thestock.8  Moreover, this income was taxable only at the capital gainsrate, at the time 25 percent, much lower than the top 90 percent ratefor ordinary income.9Finally the Chamberlins stated that the third step of thetransaction, the corporation’s redemption of its stock from theinsurance companies, did not involve them at all and therefore shouldhave no effect on their tax treatment.                                                                                                                                                after-tax profits rose by an additional $665,000.5 B. Bittker & L. Lokken, Federal Taxation of Income, Estates, and Gifts, page 1-13 (3rd ed. 1999).6 Towne v. Eisner, 425 U.S. 418 (1918); Eisner v. Macomber, 252 U.S. 189 (1920); Helvering v. Griffiths,318 U.S. 371 (1943); Helvering v. Sprouse, 318 U.S. 604 (1943); Strassburger v. Comm’r, 318 U.S. 604(1943).7 Under current law, I.R.C. § 305(a) provides for tax-free treatment of stock dividends—subject, however,to numerous exceptions.8 Under current law, I.R.C. § 307(a) provides that the basis of the original common stock is allocatedbetween the original common stock and the preferred stock that is received as a tax-free dividend.9 Bittker & Lokken, supra , n. 3.Nevertheless, the net effect of all three steps taken togetherwas economically indistinguishable from a distribution by MMC to itsshareholders of an $800,000 cash dividend, which would have beentaxed to them in full as ordinary income.  After completion of theentire three-step transaction, the Chamberlins still owned nearly 85percent of MMC’s equity, which, as before the transaction started,consisted entirely of common stock.  The only changes at the end ofthe three-step transaction were that MMC had $800,000 less cash,and the Chamberlins and other common stockholders had $800,000more cash.  The insurance companies, for their part, appeared toserve as a mere conduit for disguising a cash dividend distributionfrom MMC as a sale to an outside party.  The Chamberlins had usedpreferred stock to distribute, or “bail out,” corporate profits at capitalgains rather than ordinary income rates.  Hence tax lawyersdescribed the scheme as a “preferred stock bailout.”The Chamberlins’ case went to the Tax Court, which showedno reluctance in holding that the Chamberlins had effectively receiveda cash dividend and should be taxed accordingly.10  Yet on appeal                                                10  18 T.C. 164 (1952).the Sixth Circuit reversed.  What might explain the Court of Appeals’extraordinary decision?One factor was that the Chamberlins, who had competent butundistinguished Detroit counsel in the Tax Court, retained newattorneys for the appeal to the Sixth Circuit.  In an inspired move, theChamberlins hired Randolph Paul and Louis Eisenstein ofWashington, D.C., considered the two most accomplished taxattorneys in the nation.  It must have been especially difficult for theInternal Revenue Service to litigate against Randolph Paul, co-authorof the standard treatise on federal income taxation,11 which judgesroutinely consulted in difficult tax cases.12In addition, the IRS weakened its case by making a muchbroader argument than it needed to win.  The Service might haveargued simply that the effect of all three steps of the Chamberlintransaction was equivalent to a cash dividend.  On two previousoccasions, the Supreme Court had already decided that if formally                                                11 Randolph E. Paul & Jacob Mertens, Jr., The Law of Federal Income Taxation (1935).12 Judge Jerome Frank, the distinguished Second Circuit jurist, referred to Randolph Paul as “our mosteminent tax commentator.”  Harry J. Rudick, Randolph E. Paul, 11 Tax L. Rev. 201 (1956).separate steps, like the three steps in Chamberlin, have the effect ofa dividend, they should be taxed as a dividend.13However, the IRS added that it was the distribution of thepreferred stock in step one of the transaction that should be treatedas producing a taxable dividend.  By refusing to concede that thedistribution of the preferred stock dividend should be tax-free, theService was attacking a long-established principle, explicitly approvedby both the Supreme Court and Congress.The Service’s “step one” argument thereby provided RandlophPaul and Louis Eisenstein with a delectable target.  Asking the SixthCircuit to reverse, they wrote,The issue in this case is easily stated.  May the[IRS] zealously disregard the network of rules so carefullydevised by Congress, the courts, and itself because itwould now write them differently if it were free to do so?The [IRS] tacitly assumes that [it] enjoys this sweepingpower to determine fiscal policy. . . .  We respectfullysubmit that the [IRS] has wandered well beyond therelevant statutes and disingenuously improvised a taxpolicy of its own . . . .The Tax Court, in the fashion of the [IRS], hascalled upon some brooding “spirit” that is neitherexpressed nor restrained by any words that Congress hasever used.  Since the opinion is untrammeled by anystatute, it is vagrant and unconfined.  Inevitably, it leads                                                13 Gregory v. Helvering, 293 U.S. 465 (1935); Bazley v. Comm’r, 331 U.S. 737, rehearing denied and priorop. amended, 332 U.S. 752 (1947).  Both opinions emphasized that the taxpayer’s predominant motive wastax avoidance, as was also the case in Chamberlin.into a quagmire of confusion where any intelligibleprinciples of law sink and disappear.  Whatever rule theTax Court’s opinion may attempt to state is no rule at all.The opinion is a standing invitation to chaos in thetaxation of stock dividends—a chaos [that] a properdeference to Congress would refuse to attribute to thatbody.14The Sixth Circuit, however, went too far in ignoring theconnections among the steps in the Chamberlin transaction.  Inrefusing to treat the entire transaction as a dividend, the Sixth Circuitemphasized that seven years elapsed between the sale of thepreferred stock to the insurance companies and the completeredemption of the preferred from the insurance companies by MMC.[I]n the absence of a finding that it was immediately orshortly thereafter redeemed . . . , we assume that a largeportion of [the preferred stock] has remained outstandingover a period of years with some of its still unredeemedafter nearly seven years.15However, contrary to the court’s assumption, the fact that thepreferred stock was outstanding for up to seven years seemsirrelevant.  The corporation had committed itself to redeem thepreferred at a definite price and according to a fixed schedule.  Thepreferred stock benefited from numerous protective provisions,including the requirement of a sinking fund to guarantee that MMC                                                14 Brief for Petitioners, Chamberlin v. Comm’r, supra, quoted in M. Carr Ferguson, The Legacy of Louiswould have enough cash to fulfill its redemption commitment.  Thus,at the moment when the Chamberlins made their sale to theinsurance companies in step two, it was nearly certain that MMCwould redeem the preferred stock in step three.  Indeed, had thereactually been a substantial risk of nonredemption, state prudentinvestor laws would probably have prohibited the insurancecompanies from purchasing the MMC preferred stock in the firstplace.The Sixth Circuit’s decision in favor of the taxpayers inChamberlin raised an ominous possibility.  The court had provided aroadmap for shareholders of close corporations who wished to cashout corporate profits while avoiding taxation at ordinary income rates.Instead of taking out such profits through cash dividend distributions,shareholders would simply employ preferred stock bailouts.  Closelyheld corporations might stop paying regular cash dividendsaltogether.Congress responded to this danger with Section 306, whichartfully avoids the weaknesses of the IRS’s position in Chamberlin.Section 306 does not tax the distribution of preferred stock as a                                                                                                                                                Eisenstein, 22 Tax L. Rev. 7, 9-10 (1966).dividend, the result advocated without success by the IRS inChamberlin.  Instead, Section 306 accepts the principle that adistribution of preferred stock on common shares should be tax-free.What Section 306 does instead of challenging this principle is to taintthe preferred stock.Section 306 labels the preferred stock as “Section 306 stock.”16Special rules then govern the subsequent disposition of this taintedstock.  If it is sold, the usual rules governing stock sales, includingrecovery of basis and capital gains treatment, do not apply.  Instead,the sale proceeds are in effect taxed as if a cash dividend had beenpaid.17  Thus, Section 306  attacks the Chamberlin transaction at“step two,” treating the sale proceeds as if they had been cashdividends received from the corporation.There are exceptions to the special disposition rules if the saleof Section 306 stock does not constitute a bailout.  For example, if ataxpayer sells his entire equity interest in a corporation, including both306 and non-306 stock, then the special disposition rules do notapply.18  Nor should they, because the shareholder could have sold                                                                                                                                                15 Chamberlin, 207 F. 2d at 471.16 I.R.C. § 306 (c).17 I.R.C. § 306(a)(1)(A).18 I.R.C. § 306(b)(1)(A).his entire stock interest before the distribution of Section 306 stockand received sales treatment, including recovery of basis and thebenefit of lower capital gains rates.  Section 306, with its concept of a taint that can dog a stockfrom acquisition to dispositon, seems designed by a novelist ratherthan a tax technician.  So I called a friend who teaches English at amajor university and asked specifically: Did Nathaniel Hawthorne’sThe Scarlet Letter inspire Section 306?  Here is a more-or-lessverbatim transcript of our conversation.I said, “Section 306 of the Internal Revenue Code was enactedto prevent tax avoidance.  If taxpayers acquire stock suitable for taxavoidance, Section 306 taints the stock and applies special rules tothe stock’s disposition.  This tainting of stock is like the tainting ofNathaniel Hawthorne’s heroine, Hester Prynne, who had to wear ascarlet A.  The comparison seems too close to be just coincidence.What do you think?”She said, “My field is the nineteenth-century British novel.  Ibarely remember The Scarlet Letter.  I haven’t read it since juniorhigh school.”I pressed on: “All right; in the nineteenth-century British novel,is there a similar concept of tainting?”She said, “It doesn’t apply.  In the nineteenth-century Britishnovel, you are either in or you are out.”I said, “What do you mean?”She said, “For example, take Jane Austen’s Pride andPrejudice.  Lydia Bennet runs off with Mr. Wickham.  They have anaffair.  But her family rushes in and quickly arranges a marriage.That is the only way she can remain in the novel.  If the family hadnot been able to arrange the marriage, Lydia would have beendropped from the novel altogether.  You see?  In the nineteenthcentury British novel, there is no concept of tainting.  Either you’re inor you’re out.”“So,” I said, “in the nineteenth-century British novel, tainting isnot an acceptable option.”She said, “Right.  Either your existence is fully acknowledged orit is not acknowledged at all.  Not like Hester Prynne in The ScarletLetter, who was tainted or half-acknowledged.”What my friend said about Jane Austen applies to the InternalRevenue Code as well.  Usually an asset is either a capital asset,whose disposition produces a favored capital gain, or it’s not.  But306 stock, like Hester Prynne, has an ambiguous status.  If thestockholder attempts to use the stock to achieve a bailout, ordinarydividend taxation results.  But if the owner, in an act of renunciation,sells his entire equity interest, the preferred stock is cleansed of itsSection 306 taint.Today, Section 306 is being overtaken by changes in the taxlaw.  The Code was recently amended to treat certain pro ratadistributions of preferred stock as taxable dividends rather thanaccord tax-free treatment.19  More fundamentally, closely heldbusinesses increasingly elect to be taxed not under the classic two-level corporation-shareholder tax system but instead as partnerships.Under the partnership model, business income is taxed directly to thepartners whether it is distributed or accumulated.20  The InternalRevenue Code, like the nineteenth century British novel, appearsincreasingly uncomfortable with the studied ambiguity that Section306 and Hester Prynne represent.                                                19 I.R.C. §§ 351(g), 354(a)(2)(C), 356(e).20 I.R.C. § 701.

Hester Prynne, Lydia Bennet, and Section 306 Stock: The Concept of Tainting in the American Novel, the British Novel, and the Internal Revenue Code

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Hester Prynne, Lydia Bennet, and Section 306 Stock: The Concept of Tainting in the American Novel, the British Novel, and the Internal Revenue Code

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