Ivan Allen Co. v. United States

with whom Mr. Justice Douglas and Mr. Justice Stewart join, dissenting.

The Court’s decision departs significantly from the relevant statutory language, creates a rule of additional *636tax liability that places business management in a perilous position, and vests in the Internal Revenue Service an inappropriate degree of discretion in administering a punitive statute. I therefore dissent.

I

Petitioner, a corporation with 34 stockholders, is engaged in selling office supplies and equipment. In the late 1950’s, because petitioner was a retail outlet for equipment of the Xerox Corp., it invested $147,-000 of its earnings and profits in securities of Xerox. The market value of that investment increased substantially over the years, and by the end of petitioner’s 1965 and 1966 tax years the unrealized market appreciation1 of those securities approximated $1,475,000 and $2,416,000 respectively.2 For the purpose of determining the applicability of the additional penalty tax liability under 26 U. S. C. § 531, the Commissioner valued these securities at their year-end market price. He thereupon assessed the tax here at issue.

The question is one of statutory construction: In determining whether a corporation has accumulated earnings and profits in excess of reasonable business needs within the meaning of 26 U. S. C. § 533 (a), are assets purchased with earnings and profits to be valued at the amount invested in them — their cost — or at their market *637price,3 which reflects both cost and unrealized appreciation? The question has not heretofore been decided by this Court and has been considered infrequently by other federal courts.

II

I address first the statutory language, which in my view is controlling. Section 531 imposes a tax “[i]n addition to other taxes imposed by this chapter ... on the accumulated taxable income ... of every corporation” identified by § 532. Section 532 makes the § 531 tax applicable to every corporation “formed or availed of for the purpose of avoiding the income tax with respect to its shareholders ... by permitting earnings and profits to accumulate instead of being divided or distributed.” If “the earnings and profits of a corporation are permitted to accumulate” beyond its reasonable needs, § 533 establishes a rebuttable presumption that the corporation is one “formed or availed of for the purpose of avoiding the income tax” and that it is therefore liable for the § 531 tax.

The central element of this statutory scheme is the unreasonable accumulation of earnings and profits beyond the corporation’s reasonable needs. It is stipulated in this case that there is no unreasonable accumulation and no additional tax unless the unrealized appreciation of the Xerox securities is added to petitioner’s actual accumulated earnings and profits (i. e., to its earned sur*638plus account) .4 Under normal concepts of tax law and accounting the Government’s position is therefore untenable on its face. Unrealized appreciation of assets is not considered in computing ordinary corporate or individual taxable income. Indeed, sound accounting practice requires that assets be recorded and carried at cost,5 and this requirement is enforced with respect to filings with the Securities and Exchange Commission (SEC). Similarly, if assets of a corporation are distributed to shareholders “in kind,” the company is credited for a dividend payment only on the basis of the cost of those assets, not their appreciated value.

In view of this unanimity of law and practice, what theory is devised by the Government and the Court today as justification for a different rule for this penalty tax? I look to the Court’s opinion for the answer. It is conceded that “unrealized appreciation does not enter into the computation of the corporation’s . . . [accumulated] ‘earnings and profits.’ ” Ante, at 627. Neverthe*639less, the Court holds that such appreciation “becomes important” and must be taken into account “in measuring [the] reasonableness” of such accumulation. Ante, at 628. In short, the Court construes the statute to mean that although unrealized appreciation is not includable in computing earnings and profits, it is includable in determining whether earnings and profits have been accumulated unreasonably.

The statute provides no basis whatever for this distinction. According to its own terms, selected with full knowledge of accepted tax and accounting principles, the penalty tax applies only if there is an unreasonable accumulation of earnings and profits; the statute contains no reference to the addition of unrealized appreciation to the accumulated earnings and profits which constitute the only basis for imposing the tax. Nor does the history or purpose of the statute support the “add on” of an unrealized increment of value conceded by the Court to be neither earnings nor profits. By authorizing this “add on,” the Court’s decision effectively converts the tax on excessive accumulation of earnings and profits to a tax on the retention of certain assets that appreciate in value. Although current accumulated taxable income remains the measure of the tax, its application in many cases will be controlled simply by the existence of unrealized appreciation in the value of these assets.

The purpose of the statute, as the Court states, is “to force the distribution of unneeded corporate earnings.” Ante, at 624. Such a distribution is accomplished by the payment of dividends, which normally are declared and paid only out of current earnings or earned surplus, determined in accordance with sound accounting practice. Absent authorization in a statute or corporate charter, corporate directors who pay dividends from unrealized *640appreciation risk personal liability at the suit of stockholders or injured creditors.6

Ill

The plain language of the Code resolves this case for me. But even if the statute could be thought ambigu*641ous on the point, the tax is, as the Court concedes, a “penalty and therefore [must] be strictly construed ... Ante, at 627. See Commissioner v. Acker, 361 U. S. 87, 91 (1969). This means, at a minimum, that doubts and ambiguities must be resolved in favor of a fair and equitable construction that is as free from the hazards of uncertainty as the statutory language and purpose will allow. It seems to me that the Court’s opinion ignores the meaning of this canon of construction. Rather than construe the statute narrowly, today’s decision extends the presumptive reach of this tax beyond the language of the Code and creates a number of perplexing uncertainties.

Businesses normally are conducted, and management decisions made, on the basis of financial information that is maintained in accordance with sound accounting practice. The most elementary principle of accounting practice is that assets are recorded at cost. This is true with respect to the computation of earnings and profits, payment of ordinary corporate taxes, determination of dividend policy, and reporting to stockholders, the SEC, and other regulatory agencies. Corporate books and records -are audited only on that basis. Whatever may be said for the Court’s view of the “unreality” of adhering to the principles of sound accounting practice, ante, at 629-630, those principles are the best system yet devised for guiding management, informing shareholders, and determining tax liability. They have the not inconsiderable virtues of consistency, regularity, and certainty — virtues that also assure fairness and reasonable *642predictability in the Commissioner’s administration of this penalty tax.

The Court today abandons accounting principles confirmed by the wisdom of business experience and announces a new rule with far-reaching consequences. In my view, this rule will create uncertainty and open wide possibilities for unfairness.

A

Both taxpayers and the Government know what is meant by “cost basis,” and a corporation’s earned surplus account, which reflects accumulated earnings and profits from which dividends normally are paid, is an established accounting fact. There is no comparable certainty or dependability in the rule devised by the Court:

“Cost of the marketable securities on the assets side of the corporation’s balance sheet would appear to be largely an irrelevant gauge of the taxpayer’s true financial condition. . . . Realistic financial condition is the focus ... of the Commissioner’s inquiry in determining the applicability of the accumulated earnings tax.” Ante, at 629^630 (emphasis added).

In this case, involving marketable securities, the computation of the true value for purposes of the tax appears at first blush to present no serious problem of uncertainty. The Court simply equates market price at the end of the tax year with true value, and adds the resulting excess over cost to the book value of the securities. Apart from the questionable assumption that market quotations represent the true value of a retained common stock, the Court’s new formulation poses perplexing definitional questions for management.

An initial uncertainty results from the Court’s ambiguous use of the term “securities.” As defined in the *643Securities Act of 1933 and the Securities Exchange Act of 1934, the term is quite comprehensive.7 Even so, its meaning is not always self-evident, as can be seen by examining some of the extensive litigation on this question. See, e. g., 1050 Tenants Corp. v. Jakobson, 503 F. 2d 1375 (CA2 1974); SEC v. Glenn W. Turner Enterprises, Inc., 474 F. 2d 476 (CA9), cert. denied, 414 U. S. 821 (1973); Lehigh Valley Trust Co. v. Central National Bank of Jacksonville, 409 F. 2d 989 (CA5 1969).

In addition, uncertainties will arise in ascertaining whether the asset is sufficiently “readily marketable” to satisfy the Court's test. The Court attaches significance to whether the security is “listed” on a stock exchange. It is indeed true that the great majority of common stocks listed on the New York Stock Exchange are readily marketable, unless the number of shares to be sold is too large for the market to absorb. The same cannot be said, however, of all bonds listed on that Exchange. Moreover, there are other exchanges on which securities are listed and traded: the American Stock Exchange, over the counter, and scores of local exchanges. While many securities traded' on these exchanges may be “readily marketable,” perhaps the majority could not fairly be so characterized. In countless situations corporate management will be unable to determine, short of attempting to sell the security, whether it is “readily marketable” or not.

*644B

The uncertainty engendered by today’s opinion will not be limited to its undifferentiated treatment of marketable securities. A more fundamental question arising from the rationale of the Court’s decision is whether the test of “true” or “realistic” financial condition will be applied to other assets. Nothing in the relevant statutory provisions suggests a distinction between securities and other assets, or even between assets with varying degrees of marketability. The Court nevertheless appears to read into the statutes a distinction based on “liquidity,” at various points referring interchangeably to “readily marketable securities,” “current assets,” and “quick or liquid assets.” Ante, at 622, 628. Although the Court’s holding is limited in this case to readily marketable securities, see ante, at 629 n. 9, its rationale is not so easily contained.

The Court states categorically that the “focus” of the Commissioner’s inquiry, in determining the application of this tax, must be on what it calls true or realistic financial condition. Ante, at 629-630. In view of this postulation, and the absence of any distinction in the statute among types of assets, is the Commissioner now free to include in his computation the unrealized appreciation of all corporate assets? Once cost basis is abandoned, and “realistic” value becomes the standard, the uncertainties confronting prudent management in many cases will be profoundly disquieting. To be sure, read narrowly, the Court’s decision applies only to readily marketable securities, with emphasis on “liquidity.” But this is another relative term, depending on the nature of the asset and the uncertainties of market conditions at the time.

The potential sweep of the Court’s decision is forecast by the response of Government counsel to questions *645about unrealized appreciation on real estate. At one point counsel stated that real estate would not be sufficiently liquid to be includable at market value in the tax calculation, Tr. of Oral Arg. 36, but he later qualified this statement by suggesting that land might be includable if it could be established that it was readily marketable, id., at 42.8

The types of assets in which corporations lawfully may invest earnings and profits embrace the total range of property interests. They include, to name only a few examples, unimproved real estate within the anticipated growth pattern of a major urban area, improved real estate, unlisted securities of growth corporations that have not “gone public,” undivided interests in oil or mining ventures, and even objects of art. At various times and depending upon conditions, any of these assets may be viewed as — and in fact may be — readily marketable and therefore “liquid.” The unrealized appreciation of such assets may well bear upon the realistic financial condition of a corporation, however it is defined. In light of these economic facts, the sweep of today’s decision presents problems both for corporate taxpayers and the Government.9

*646c

I further think that the Court’s decision to attach significant tax consequences to the market price of a volatile stock at a particular point in time will lead to unfairness in the application of the accumulated earnings tax. The Court’s net liquidation formulation seems to assume, and nothing in the opinion dispels this assumption, that readily marketable assets are to be valued as of the end of the tax year in question. Moreover, the Court apparently would treat all marketable securities the same for the purpose of this valuation. No distinction is drawn or even suggested among the wide variety of securities that are held as corporate assets.

The market price of a short-term Treasury note, at most only fractionally different fitom its cost basis, would represent its value under any test. But few financial analysts or economists would say that the market quotation of a common stock at any particular time necessarily *647reflects its “true” or “realistic” value unless the stock is sold at that price.10 Over a sufficiently long term, the market price of a common stock will reflect, and vary with, the fundamental strength of the issuing corporation’s balance sheet, its earnings record, and its future earnings prospects. But a variety of other factors also affect market price, producing wide swings that do not necessarily correspond to those economic facts. These factors include current conditions of supply and demand in the stock market, immediate confidence in the market in general and in the overall state of the economy, international stability or instability, notions of what is fashionable to buy at a particular time, and a variety of other intangibles. The extent to which the market prices of common stocks fluctuate, often without regard to any concept of “real” value, is illustrated by the tables in the Appendices to this opinion.

Bearing in mind the actual variations in the price of *648Xerox stock, can it be said that its market price at any given time fairly represents its true or realistic value for the purpose of determining whether earnings and profits have been accumulated unreasonably? The negative answer to this question is indicated, at least for me, by the following hypothetical example. In 1965, one of the tax years at issue in this case, the highest price at which Xerox sold was $71 and the lowest was $31. If two competing corporations each owned 10,000 shares of Xerox stock purchased prior to 1965 at the identical price of $31 per share, and Corporation A’s tax year ended on the day that Xerox hit $71, while Corporation B’s tax year ended on the day it hit $31, Corporation A would have had an unrealized appreciation of $400,000, whereas Corporation B would have had none.

By departing from the cost-basis standard of sound accounting practice, and compelling reliance on an isolated market price of a retained common stock, the Court itself departs from its avowed goal of “economic reality.” Ante, at 627. An average price range at which the stock might have been sold over a relatively long period might produce a more equitable result in some cases. It would not, however, alleviate the basic problem inherent in the Court’s formulation. The taxpayer still could be penalized for having failed to consider, in planning future business needs, the highly ephemeral “value” of unrealized appreciation on common stock. The effect of today’s decision is to hold business management accountable for unrealized appreciation as if it were cash in hand, probably forcing corporate management in many cases to liquidate securities that otherwise it would have elected to retain.11 *649Management decisions during the course of a year, including decisions whether and when to pay dividends and in what amounts, cannot be made intelligently on the basis of an asset so volatile that it may depreciate in market value as much as 8% in a single day and 61% in a year. Uncertainty of this magnitude could only be avoided by liquidation of assets that have appreciated in value. I find nothing in the language or purpose of this tax that justifies such detrimental interference with sound corporate management.

IV

The Court places major reliance on Helvering v. National Grocery Co., 304 U. S. 282 (1938), finding that that opinion “forecloses the present taxpayer’s case.” Ante, at 631. I respectfully suggest that the Court’s interpretation of National Grocery will not withstand close scrutiny of the facts or its actual holding.12

*650National Grocery, its stock owned by a sole shareholder, was organized in 1908 with an authorized capital of $5,000; its business prospered over the years, so that by January 31, 1931 (the taxable year there at issue), its earned surplus was $7,939,000. These earnings notwithstanding, National Grocery’s “only dividends . . . ever paid ... up to January 31, 1931, were a dividend of $25,000 in 1917, and a dividend of a like amount in 1918.” National Grocery Co. v. Commissioner, 35 B. T. A. 163, 164 (1936). The corporation’s net profits for the four fiscal years preceding fiscal year 1931, all of which were retained rather than distributed, averaged in excess of $800,000 annually. National Grocery earned some $864,-000 during the tax year in question, none, of which was distributed as a dividend. Addressing the taxpayer’s attempt to offset the depreciation of some of its assets, the Court noted:

“Depreciation in any of the assets is evidence to be considered by the Commissioner and the Board in determining the issue of fact whether the accumulation of profits was in excess of the reasonable needs of the business. But obviously depreciation in the market value of securities which the corporation continues to hold does not, as matter of law, preclude a finding that the accumulation of the year’s profits was in excess of the reasonable needs of the business.” 304 U. S., at 291.

When National Grocery is read in light of the facts and issues there presented — as it must be in order to understand the Court’s passing statement — it is readily apparent that the holding in that case does not govern the issue here. The central issue there was the *651definition of “gains and profits”: specifically, whether “gains,” a term replaced in the present statute by “earnings,” qualified the meaning of “profits.” The Court apparently felt justified in devoting little attention to the issue, for it was plain in light of the huge accumulation of earnings over time that the taxpayer would be liable even if it were allowed to offset the asserted depreciation. Finally, it is significant that National Grocery’s “accumulation of earnings” was computed on the basis of book value or cost. Indeed, all of the relevant figures were so computed, including the $7,393,000 surplus that had been accumulated over time.

I therefore find no justification for the view that National Grocery forecloses consideration of the question here presented. Moreover, even if I could agree with the Court’s interpretation of that case, I would refuse to follow a rationale so plainly at odds with the statutory language and so conducive to uncertainty and unfairness.

V

The uncertainties the Court has now read into this penal statute correspondingly vest in the Internal Revenue Service an inappropriate latitude in its administration. In light of today’s decision, the Commissioner will have wide and virtually uncontrolled discretion in deciding which corporations will be subject to additional taxation, or at least in deciding which will be required to rebut the presumption that earnings were accumulated to evade shareholder tax liability. Until today’s decision, management, in trying to anticipate what a Commissioner would deem an unreasonable accumulation, at least could rely on the corporation’s earned surplus account as establishing its accumulated earnings and profits. Now this dependable benchmark has become an “irrelevant gauge” of a corporation’s “true financial con*652dition,” and in many cases management can only speculate about the Commissioner’s future determination of values nowhere reflected in the corporation’s books. As commentators have noted, see B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 8.01, p. 8-4 (3d ed. 1971), the decision to impose the accumulated earnings tax inevitably involves “a hindsight verdict on management’s business judgment.” The Court’s decision does not impose identifiable standards on the Commissioner’s exercise of this extraordinary “hindsight” authority, but leaves it open-ended. It is unlikely, to say the least, that Congress intended to leave small and medium-sized businesses— those most often the target of this tax — exposed to this degree of administrative discretion in the imposition of a potentially heavy penalty tax.

*653APPENDIX A-l TO OPINION OF POWELL, J., DISSENTING

The volatility and transient character of market prices of a common stock are illustrated by the following tables:*

TABLE I

XEROX CORP. COMMON STOCK†

% Change

High Low High to Low

Fluctuations in a single day:

June 14, 1965........... 48.25 45 - 6.7

May 16, 1975........... 87 78.50 - 9.8

Fluctuations in a single month:

November 1965.......... 66.50 57.50 —13.6

August 1974............. 98 74.25 -24.2

Fluctuations in a single year:

1965.................... 71 31 -56.3

1974.................... 127 49 -61.4

*654