Harold S. Divine and Rita K. Divine v. Commissioner of Internal Revenue

* This appeal is taken from two decisions of the Tax Court, 59 T.C. 152 (1972), which held petitioners (appellants herein) liable for deficiencies in their personal income taxes of $9,416.35 and $20,944.40 for the calendar years 1961 and 1962, respectively. Inasmuch as appellants resided in the State of New York when they filed their petitions with the Tax Court seeking redetermination of tax liability, venue on this appeal is properly laid in this circuit, 26 U.S.C. 7482(b)(1)(A); and we have jurisdiction under 26 U.S.C. 7482(a).

The outcome of this case depends on our resolution of two legal issues. First, do the attendant circumstances permit or require application of the doctrine of collateral estoppel against the Commissioner of the Internal Revenue Service ('IRS')? Second, when, pursuant to the terms of statutory restricted stock options1 granted by a corporation to its employees, those employees, in exercising the options, purchased the stock for less than the stock's fair market value, should the corporation's 'earnings and profits' under 316 of the Internal Revenue Code ('IRC' or 'Code') be reduced by the difference between the fair market value of the stock so purchased and the prices paid by the employees? Appellants contend that either of these questions can be answered in the affirmative.

We do not agree that the Commissioner is collaterally estopped from relitigating the substantive tax question at issue here. On the substantive tax issue, an unusually complex issue, we are of the opinion, on balance, that the result for which the appellants contend is the correct one. Accordingly, we reverse the decision of the Tax Court and remand for redeterminations of appellants' tax liabilities for the tax year 1961.2

As Rita K. Divine is a party herein because she signed and filed joint tax returns with her husband, Harold S. Divine, the other appellant here, we shall refer to the taxpayers-petitioners-appellants in the singular. The stipulated facts have been fully and accurately set forth in the opinion of the Tax Court below.3 It is necessary, however, for us to summarize briefly those facts which are helpful to an understanding of the issues which we are required to resolve.

Rapid American Corporation (hereinafter 'Rapid' or the 'Corporation') is a publicly owned corporation. Its common stock during the years 1961 and 1962 was listed on the American Stock Exchange. As of January 31, 1963, Rapid had over 2,000 shareholders who held in the aggregate more than 2,000,000 shares of Rapid's common stock. Appellant Divine was one of those shareholders; his approximate holdings amounted to 37,000 shares in 1961 and rose to 40,000 in 1962.

During the years 1961 and 1962, Rapid made certain cash distributions, totaling some $840,840.53 in 1961, and $1,024,836.93 in 1962, to its shareholders. Appellant's portions of these disbursements were $18,501.40 in 1961 and $20,572.04 in 1962. Rapid advised the shareholders that the distributions did not have to be included by them in their individual personal income tax returns. This advice was predicated on the belief that Rapid's 'earnings and profits' were insufficient to render these distributions dividends taxable as ordinary income to the recipients, but, rather, the recipients should consider the payments to be returns of capital and hence non-taxable.

At issue in this case is the manner in which Rapid's 'current earnings and profits' and 'accumulated earnings and profits' for its taxable years 1961 and 1962 should be computed. Specifically at issue is the correctness of a reduction of earnings and profits to account for purported 'compensation expenses' measured by the 'loss' Rapid absorbed in making 'bargain' sales of its common stock to certain of its employees who possessed restricted stock options to purchase the stock. Pursuant to the terms of these restricted stock options, during the period from January 1, 1957 to January 31, 1962, Rapid sold 174,395 shares of its common stock to some of its employees. Although these shares had a fair market value of $5,307,206, the corportion received only $1,889,360 from the employees who exercised their options. Rapid thus received $3,417,846 less for its stock than it could have received if the shares had been sold on the open market. In the period from February 1, 1962 to January 31, 1963 corporation employees purchased an additional 12,163 shares pursuant to the terms of options they held. Again, the prices paid by the employees, $155,388 in the aggregate, were substantially below the fair market value of the shares of stock, $363,914. It is argued that these differences of $3,417,846 and $208,526 represent compensation expense which should reduce corporate earnings and profits.

As already indicated, Rapid had advised its shareholders that these distributions for their tax years 1961 and 1962 did not constitute income taxable to the recipients. One of those receiving a portion of the 1961 distributions was a Mr. Sid Luckman. In reliance on the advice from Rapid, neither Divine nor Luckman considered these distributions as ordinary income. Later, the Commissioner mailed notices of deficiency to all Rapid shareholders, including Luckman and appellant Divine. These two shareholders challenged these alleged deficiencies by filing petitions in the Tax Court. In 1968, while Divine's petition for redetermination was still before the Tax Court, that court ruled against Luckman, see Sid Luckman, 50 T.C. 619 (1968), holding that a corporation's earnings and profits cannot be reduced by the spread between the fair market value of its stock and the prices paid for the stock by employees who purchased it by exercising restricted stock options the corporations had granted. Upon appeal the Seventh Circuit, reaching the opposite conclusion on the earnings and profits issue, reversed the decision of the Tax Court. See Luckman v. Commissioner of Internal Revenue, 418 F.2d 381 (7 Cir. 1969).

Undaunted by its defeat in the Seventh Circuit, the Internal Revenue Service adhered to its position on this issue, and in the Tax Court below the Commissioner contested Divine's petition seeking redetermination of his tax liability. Invoking the Seventh Circuit's decision in Luckman v. Commissioner, supra, which had expressly rejected the Commissioner's stance on the earnings and profits issue therein, appellant Divine argued to the Tax Court that the Commissioner was collaterally estopped from relitigating that precise issue against him. The Tax Court not only rejected this procedural argument but also refused in Divine's case to recognize Luckman as binding upon it, and refused to deviate from its own holding on the substantive issue in Luckman which the Seventh Circuit had nullified. The within appeal followed.

As in the Tax Court below, Divine claims that the decision of the Seventh Circuit in Luckman v. Commissioner of Internal Revenue, supra, collaterally estops the Commissioner from litigating against appellant the same issue litgated in the Seventh Circuit; i.e., whether Rapid's earnings and profits should have been reduced to account for the 'expense' allegedly incurred by the corporation in connection with its sale of its common stock to certain of its employees pursuant to the terms of restricted stock options held by those employees.

The American Law Institute's Restatement of Judgments provides a concise statement of one aspect of the classical view of 'collateral estoppel' or 'issue preclusion':

Where a question of law is actually litigated and determined in an action, the determination is ordinarily conclusive between the parties in a subsequent action involving the same subject matter or transaction, although based upon a different cause of action from that upon which the original action was based. Restatement of Judgments 70, comment (b) (1942).

Refinement of the scope of 'issue preclusion' requires reference to two additional sections of that Restatement. Section 83 expanded the category of those who might be precluded from bringing suit by explaining that '(a) person who is not a party but who is in privity with the parties in an action terminating in a valid judgment is . . . bound (under the rule of collateral estoppel).' Section 93, however, is more significant here: '(A) person who is not a party or privy to a party to an action in which a valid judgment . . . is rendered . . . (b) is not bound by . . . an adjudication upon any matter decided in the action.' This rule, the 'requirement of mutuality,' prevented one from applying collateral estoppel against a party unless the one invoking the doctrine was himself bound by the former judgment. In the instant case, were the classical view of 'collateral estoppel' still accepted by the courts and the academicians, Divine most certainly could not utilize the Seventh Circuit's holding against the Commissioner since Divine was neither a party to nor in privity to a party to that action.

Nevertheless, the issue is not so easily resolved, for even in the years prior to the Restatement's articulation of the principle of collateral estoppel the requirement of mutuality of estoppel had come increasingly under attack from the courts and the intellectual community, and this assault has continued unabated. See, e.g., Bruszewski v. United States, 181 F.2d 419 (3 Cir.), cert. denied, 340 U.S. 865, 71 S.Ct. 87, 95 L.Ed. 632 (1950); Bernhard v. Bank of America National Trust & Savings Association, 19 Cal.2d 807, 122 P.2d 892 (1942); Currie, Mutuality of Collateral Estoppel: Limits of the Bernhard Doctrine, 9 Stan.L.Rev. 281 (1957).

That the attack has been successful is evidenced by the number and source of the judicial decisions which have eroded the requirement of mutuality to the point where it might be supposed that it has been or should be finally interred. See, e.g., Blonder-Tongue Laboratories, Inc. v. University of Illinois Foundation, 402 U.S. 313, 91 S.Ct. 1434, 28 L.Ed.2d 788 (1971); Zdanok v. Glidden Co., Durkee Famous Foods Division, 327 F.2d 944 (2 Cir. 1964); Bruszewski v. United States, supra.

It would be incorrect, however, to assume that the requirement has met its demise. For example, Zdanok, generally regarded as being one of the most important blows struck against the mutuality requirement, has been read restrictively in a number of subsequent cases. See Berner v. British Commonwealth Pacific Airlines, Ltd., 346 F.2d 532 (2 Cir. 1965), cert. denied, 382 U.S. 982, 86 S.Ct. 559, 15 L.Ed.2d 472 (1966); Fink v. Coates, 323 F.Supp. 988 (SDNY 1971); Agrashell, Inc. v. Bernard Sirotta Co., 281 F.Supp. 704, 708 (SDNY 1968) ('The rule of Zdanok is one of economy of administration and not one of abstractly perfect justice; indeed, even res judicata in its strictest aspect yields where an issue deeply invested with public concerns is involved.') In fact, the continuing life of the mutuality requirement in certain circumstances is suggested by the Supreme Court's careful and precise phrasing of the issue before it in Blonder-Tongue Laboratories, Inc. v. University of Illinois Foundation, supra:

'Obviously, these mutations in estoppel doctrine are not before us for wholesale approval or rejection. But at the very least they counsel us to re-examine whether mutuality of estoppel is a viable rule where a patentee seeks to relitigate the validity of a patent once a federal court has declared it to be invalid.' 402 U.S. at 327, 91 S.Ct. 1442.

As there has been no 'wholesale rejection' of the doctrine we must inquire whether it is appropriate for us to disapprove relitigation here by the Commissioner of the very issue decided against him by the Seventh Circuit.

To support his argument that the Commissioner should be precluded from relitigating that issue appellant relies principally on two cases, Blonder-Tongue Laboratories, Inc. v. University of Illinois Foundation, supra, and Zdanok v. Glidden Co., Durkee Famous Foods Division, supra. In Blonder-Tongue, the narrow issue before the Court was whether a patentee whose patent has once been declared invalid by a federal court should be permitted to relitigate against another alleged infringer the validity of the patent. See 402 U.S. at 327, 91 S.Ct. 1434. Under the existing rule of Triplett v. Lowell, 297 U.S. 638, 56 S.Ct. 645, 80 L.Ed. 949 (1936), the patentee had this right. Blonder-Tongue "overruled (Triplett) to the extent it forecloses a plea of estoppel by one facing a charge of infringement of a patent that has once been declared invalid.' 402 U.S. at 350, 91 S.Ct. at 1453. Thus, the previously existing absolute right to relitigate was rescinded, and the right to relitigate (by recognizing in later actions estoppel defenses raised by non-parties to the first action) would be denied unless the patentee could 'demonstrate, if he can, that he did not have 'a fair opportunity procedurally, substantively and evidentially to pursue his claim the first time," id. at 333, 91 S.Ct. at 1445, quoting in part from Eisel v. Columbia Packing Co., 181 F.Supp. 298, 301 (D.Mass.1960). In reaching its decision the Supreme Court engaged in an exhaustive analysis of a number of policy factors and found that allowing a patentee the general right to relitigate alleged infringements could cause an inordinate waste of judicial time and litigants' resources and could have unjustifiable anti-competitive effects in the market place. On the other hand, there was no substantial countervailing policy reason favoring a retention of the right to continue to relitigate against different alleged infringers the question of whether the patent was a valid one.

In Zdanok we also conditioned the right to relitigate an issue on whether there had been 'a full and fair opportunity to litigate the issue effectively' the first time, 327 F.2d at 956, quoting Currie, supra at 308. The issue there, however, was a very narrow one-- 'the construction of a written contract' by a judge, 327 F.2d at 956; it involved an issue which could not be 'subject to the varying appraisals of the facts by different juries.' Id. The reasons for denying relitigation in Blonder-Tongue and the unexpressed reason for denying relitigation in Zdanok, see Agrashell, Inc. v. Bernard Sirotta Co., supra, 281 F.Supp. at 708 (The rule of Zdanok is one of economy of administration . . .') built the rationale in each of these cases, the rationale that the litigant wishing to relitigate had already had a 'full and fair opportunity' to substantiate his claim.

Appellant does not contend that Blonder-Tongue and Zdanok automatically foreclose the Commissioner's relitigation of all tax issues. What Divine does argue, however, is that under the circumstances here we should immediately proceed to apply the 'full and fair opportunity' tests articulated by those decisions. This approach fails to comprehend that these tests appear to have been intended only to apply to certain classes of issues which for policy reasons it has been decided should generally be litigable only once. We do not reach application of these tests in this case, for we find that both Blonder-Tongue and Zdanok are fairly distinguishable from the case at bar and thus neither controls our decision here. At first blush Zdanok might appear to be comprehensive enough to foreclose a litigant's right to relitigate most legal issues. Subsequent cases, however, have perceived the characterization of the issue in that case as being one not 'subject to the varying appraisals of the facts by different juries,' 327 F.2d at 956, a ground for finding that certain classes of issues are not within the Zdanok rule. For instance, in Berner v. British Commonwealth Pacific Airlines, Ltd., supra 346 F.2d at 541, we distinguished Zdanok on the ground that 'the issues (in Zdanok)-- interpretation of a collective bargaining agreement-- were not likely to be decided on the basis of a jury's choice among different factual inferences, as was the case (in Berner).' In Fink v. Coates, supra, at that time the most recent case in the Texas Gulf Sulphur securities law litigation, shareholders were suing their corporation and some of its officers and directors under Section 10(b) of the Securities Exchange Act of 1934 for damages sustained by virtue of the issuance of a press release alleged to have been false and misleading. These shareholder-plaintiffs argued that the defendants were collaterally estopped from litigating the issues of the material falsity, and the defendants' knowledge thereof, because these same defendants had already lost a suit brought by other shareholders in the District of Utah in which this precise issue had been decided adversely to defendants. See Reynolds v. Texas Gulf Sulphur Co., 309 F.Supp. 548 (D.Utah 1970), aff'd in part and rev'd in part, 446 F.2d 90 (10 Cir. 1971), cert. denied, 405 U.S. 918, 92 S.Ct. 943, 30 L.Ed.2d 788 (1972). In refusing to apply collateral estoppel, Judge Bonsal, 323 F.Supp. at 989-990, distinguished Zdanok, at least partially, on the ground that the issue in Zdanok was one the resolution of which would be the same in any forum. As evidence of the fact that the issue of the defendants' knowledge of falsity was a difficult one and one subject to varying appraisals, the court adverted to the language of judges of the Second Circuit and the Southern District of New York rendered during the course of the principal Texas Gulf Sulphur litigation, which language fell short of stating that there was knowledge of falsity. See SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 863 (2 Cir. 1968), cert. denied, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969) (Waterman, J.) ('cannot . . . definitively conclude that (the press release) was deceptive or misleading'); id. at 866 (Friendly, J., concurring) ('No one has asserted, or reasonably could assert, that the purpose for issuing a release was anything but good.'); SEC v. Texas Gulf Sulphur Co., 258 F.Supp. 262, 296 (SDNY 1966), aff'd in part and rev'd in part, 401 F.2d 833 (2 Cir. 1968) (Bonsal, J.) (those issuing release 'exercised reasonable business judgment under the circumstances'). These judicial views were thus incompatible with the opinion of the district court for the District of Utah and clearly demonstrated that the resolution of the legal issue of knowledge of falsitymight very well differ from forum to forum.

It goes without saying that the issue being here litigated is one which is 'subject to varying appraisals.' The Tax Court has twice expressed its opinion on the matter, and it has maintained its position despite an intervening reversal by the Seventh Circuit in Luckman v. Commissioner, supra. As we already stated, we are in accord with the result reached by the Seventh Circuit; the substantive issue here is undoubtedly a complex one however, subject to vastly disparate appraisals of different adjudicatory bodies. We thus think that the Zdanok holding is distinguishable from the case before us on the basis that the issue which confronts us is one which is 'subject to varying appraisals.'

Blonder-Tongue is more readily distinguishable. We could rely solely on the specificity with which the question before the Court was presented. The Court disclaimed any intention to decide more than 'whether mutality of estoppel is a viable rule where a patentee seeks to relitigate the validity of a patent once a federal court has declared it to be invalid.' 402 U.S. at 327, 91 S.Ct. at 1442. Beyond this, however, the policy reasons so carefully explicated by the Court to justify the general denial of the right to relitigate the validity of a patent do not preclude the Commissioner's relitigation of important tax issues here. In assessing the effects of allowing relitigation of patent validity, the Supreme Court found that patent litigation consumed a disproportionate amount of the federal courts' time, it had proven to be extraordinarily expensive to the litigants (particularly to the alleged infringer), that, for smaller companies who were allegedly infringing, this expense was prohibitive, and that allowing relitigation produced profound anticompetitive results in the market place. These phenomena are peculiar to patent validity relitigation, however, and have no bearing upon the consideration of the problem before us. Further, the Court was able to discover no legitimate countervailing reason for permitting this type of litigation.

Since neither Blonder-Tongue nor Zdanok is controlling in our determination of whether the tax issue here can be relitigated, our decision must ultimately rest on policy considerations. The absence of substantial justification for permitting relitigation of either patent validity or issues not 'subject to varying appraisals' should be contrasted with the formidable policy justifications for sanctioning the Commissioner's relitigation in different circuits of legally identical tax issues, factually differentiable only in the identity of the taxpayer involved. The desirability of uniformity of administration of the tax laws certainly does not require extended discussion on our part. We would mention, however, certain features of tax issues which the federal courts are called upon to resolve. More so than most laws, the tax statutes are far reaching and affect or might affect millions of citizens. The issues which arise in the course of administering these laws are thus of importance not only to the particular litigants but also to the general public. Moreover, because of the sheer extent of the subject matter of the revenue laws and their intricate language, the issues which confront the courts will often be pure issues of law concerning the interpretation of novel and cryptic sections of the Code. Thus, because of the unusual complexity of the tax laws, judicial conflicts over interpretations of law, as opposed to disagreement as to how the law should be applied to specific facts, are much more apt to occur than in other areas of federal concern. For example, judicial conflicts in the patent area typically concern the application of undisputed principles of law to a complicated array of facts and do not reflect differences over what the governing principles of law mean. See, e.g., Nyyssonen v. Bendix Corp., 342 F.2d 531 (1 Cir.), cert. denied, 382 U.S. 847, 86 S.Ct. 63, 15 L.Ed.2d 86 (1965). So, most unfortunately, in an area where the needs for uniformity and certainty are so great, small indeed are the prospects that they will be achieved fortuitously through courts of coordinate authority reaching compatible decisions.

In federal tax cases disputed questions of law are satisfactorily resolved only by U.S. Supreme Court decisions, for the Commissioner of the Internal Revenue Service has on many occasions taken the position, as he has in this litigation, that a Court of Appeals decision with which he disagrees has no binding effect on the Service's policies in other circuits. The uncertainty which may result is exacerbated by the fact that the decisions of a U.S. Court of Appeals are not habitually reviewed by the Supreme Court. There is no right of appeal from such a decision, see 28 U.S.C. 1254, and under the guidelines of Supreme Court Rule 19 the granting of certiorari is often withheld until two or more circuits have adopted conflicting positions. See J. Mertens, Law of Federal Income Taxation, 51.20, at 51-38 nn. 94, 95 (Supp.1974); United States v. O'Malley, 383 U.S. 627, 86 S.Ct. 1123, 16 L.Ed.2d 145 (1966). There may therefore be substantial periods of time during which a federal tax issue remains unresolved. We regard this as being a patently undesirable sitution. A fortiori, any action on our part which might further inhibit expeditious resolution by the Supreme Court would be imprudent, if not irresponsible. The appellant has requested us to hold that under the unique circumstances of this case, where the Commissioner is relitigating an issue which he has previously lost in a suit factually distinguishable only in the identity of the taxpayer-shareholder, the Commissioner should be held collaterally estopped. Although this contention is not an unappealing one, we feel constrained to reject it, for it contains two infirmities. First, as we have demonstrated, there can exist at times intolerable uncertainties in the interpretation of the tax laws which, as a practical matter, are eliminated only when the Supreme Court grants certiorari after the development of a conflict in the circuits. If we adopted the holding appellant seeks from us and our position were generally accepted, inquiry by other circuits might be foreclosed and thus chances for the early precipitation of a conflict on a disputed question be diminished. For example, although a majority of the panel agrees with the substantive result reached by the Seventh Circuit in Luckman, the earnings and profits issue we resolve is one on which there is very strong disagreement-- compare the Seventh Circuit's reasoning in Luckman with that of the Tax Court in Luckman and here in Divine4 and it would be disingenuous for us to deny that a conflict in the circuits might be achieved if the Commissioner should choose to pursue the question further in another circuit in still another case. Acceptance of appellant's collateral estoppel argument, even as narrowly framed as it is, would decrease the probability that a conflict will be created as quickly as possible. On the other hand, of course, a conflict may not arise. Even so, having a number of circuits consider the substantive tax issue is desirable inasmuch as several consecutive adverse rulings may convince the Commissioner that the issue should no longer be contested. See, e.g., Stockstrom v. Commissioner of Internal Revenue, 88 U.S.App.D.C. 286, 190 F.2d 283, 284 n. 2 (D.C.Cir. 1951) which was subsequently overruled on other grounds in Automobile Club v. Commissioner, 353 U.S. 180, 183-184, 77 S.Ct. 707, 1 L.Ed.2d 746 (1957). We are also reluctant to accept appellant's argument because we discern no principled distinction between estopping the Commissioner here and estopping the Commissioner when the legal issue is the same but the attendant facts may be very much different. As there is no apparent rational distinction, our holding here could with little difficulty be extrapolated to estop the Commissioner from relitigating a tax issue when thefacts are quite dissimilar.

In concluding our analysis, we think it important to mention that our decision is consonant with the often articulated grounds justifying the rule permitting collateral estoppel. The rule developed as a means of protecting a person from legal harassment and redundant legal fees. Divine will be subject to neither.

Inasmuch as the Commissioner is not estopped from relitigating the earnings and profits issue previously decided in the Seventh Circuit in Luckman we must now decide whether we agree with the result reached by that court or whether we should adopt the position twice advocated by the Tax Court.

In this case the Commissioner claims that the cash distributions made to appellant by Rapid Constitute 'dividend' income which under 61(a)(7) of the IRC is taxable to appellant as ordinary income. The word 'dividend' is a term of art, the definition of which is found in 316 IRC: A 'dividend' is 'any distribution of property made by a corporation to its shareholders-- (1) out of its earnings and profits accumulated after February 28, 1913, or (2) out of its earnings and profits of the (current) taxable year.' Much to our chagrin, and that of many of our judicial ancestors, however, the Internal Revenue Code does not define the operative phrase 'earnings and profits' or describe the manner in which that elusive quantity should be calculated. Congress could, and certainly should, rectify this deficiency by promulgating guidelines to assist the courts which must control the evolution of the concept. Be that as it may, such legislative guidelines do not now exist, so we must treat the problem as adequately as we can with the resources at our disposal.

Most of the commentators have experienced no difficulty in explaining what 'earnings and profits' are not. For example, the term is synonymous with neither 'corporate surplus,' see B. Bittker & J. Eustice, Federal Income Texation of Corporations and Shareholders, P7.03, at 7-11 to 7-12 (Supp.1973); Luckman v. Commissioner of Internal Revenue, supra at 383; R.M. Weyerhaeuser, 33 B.T.A. 594 (1935), nor with 'taxable income,' see Bittker & Eustice, supra, P7.03, at 7-13; J. Mertens, Law of Federal Income Taxation, 9.28, at 9-84 to 9-85 (Supp.1973); Luckman v. Commissioner of Internal Revenue, supra, 418 F.2d at 383, R. M. Weyerhaeuser, supra. Notably less successful have been the copious attempts to establish a coherent and workable scheme for determining when particular corporate transactions should reduce or increase a corporation's 'earnings and profits.' One of the more traditional approaches explains:

'Earnings and profits, on the other hand, are not defined by act; but they have a settled and well defined meaning in accounting. Generally speaking, they are computed by deducting from gross receipts the expense of producing them. Thus, under the ordinary method of accounting, in computing earnings and profits there will be deducted, not only the items shown above, but others which are not, under the statute, deductible in computing taxable net income. In this classification may be listed such items as extraordinary expenses, charitable contributions, taxes paid the Federal Government, and taxes assessed against local benefits tending to increase the value of the property. Again, many items, such as interest upon the obligations of a state or political subdivision, tax-free Federal securities, and dividends from other corporations, must necessarily be considered in computing earnings and profits, though forming no part of taxable net income.' R. M. Weyerhaeuser, 33 B.T.A. 594, 597 (1935).

The Seventh Circuit has expanded upon this exposition:

'As used in federal taxation, this concept represents an attempt to separate those corporate distributions with respect to stock which represent returns of capital contributed by the stockholders from those distributions which represent gain derived from the initial investment by virtue of the conduct of business. The crucial issue is whether a given transaction has a real effect upon the portion of corporate net worth which is not representative of contributed capital and which results from the conduct of business. In order to make this determination it is necessary to scrutinize the economic effects of the particular transaction as well as its character and relation to the corporate business.' Luckman v. Commissioner of Internal Revenue, supra, 418 F.2d at 383.

We propose first to determine whether in general the option spread 'loss' suffered by a corporation upon an employee's exercise of a stock option is an 'expense of producing gross receipts,' resulting in a reduction of 'earnings and profits.' Should this be so, we must then determine whether the express terms or legislative history of 421, the statute pertaining to the restricted stock options involved in this case, dictates a different result when dealing with this type of device.

Compensation paid to and received by the employees of a business are, of course, business 'expenses of producing gross receipts' and therefore reduce earnings and profits. We must therefore ascertain whether the 'bargain spread' existing when an employee exercises a stock option is a 'compensation expense.' Compensation of employees for past, present and future services represents one of the most fundamental and necessary expenses of operating a business. Payment may be made in myriad modes; it need not always be by way of cash disbursement. For instance, an employee may be paid in stock. In lieu of such an immediate transfer of stock t