DIVIDENDS ON STOCK HELD IN ESCROW FOR EMPLOYEES.-In Schneider's Appeal (3 B. T. A. 920) the Board held that dividends on stock (held in escrow for employees and later turned over to them as compensation for services) constituted income for services when received and were subject to the normal tax.

DECISION. The right to receive dividends or other increment of the stock is an incident of stock ownership-but is there any doubt that an owner of stock may by agreement, separate this incident from his ownership and vest it in another without thereby making that other a stockholder?

Constructive receipt of dividends.3—

REGULATION.

A taxable distribution made by a corporation to its shareholders shall be included in the gross income of the distributees when the cash or other property is unqualifiedly made subject to their demands. ... (Art. 1541.)

The foregoing article (which was also in Regulations 65, interpreting the 1924 law) is practically the same as section 201 (e) of the 1921 law, which was eliminated, however, in the 1924 law. Why the provision in the law should be eliminated while the regulation is retained is not clear. Mr. Gregg in his explanation of the draft of the 1924 law said:

Subdivision (e) of the present law (1921) is omitted in this draft. This subdivision provided that a dividend should be included in the gross income of the stockholder as of the date when the cash was unqualifiedly made subject to his demands. This provision is only a specific instance of the general rule uniformly applied by the Department, as, for example, in the case of coupons on bonds, maturing on December first but not clipped off and cashed until the following January. It was feared that the express inclusion of the rule as to dividends might cast doubt on the rulings of the Department in other cases, and it was, therefore, omitted.

When stockholders do not have individual accounts they rarely have information as to when dividends are declared. Their records show only the receipts of dividends, even when accounts are kept on an accrual basis. It would be difficult for a taxpayer keeping accounts on a cash basis to make the necessary adjustments at the beginning and end of each year. Such stockholders who report dividends as of date of receipt will ordinarily be complying with the law because that is usually the date when the funds are unqualifiedly made subject to their demands. (See Titus's Appeal, page 633.) In the case of close corporations, however, the individual accounts of stock

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[Former Procedure] See Income Tax Procedure, 1926, page 1025.

holders may be treated as bank accounts and it is reasonable to charge such stockholders with notice as to the dates when dividends are credited.

Thus, the crediting by a sole shareholder to his personal account of the corporate surplus has been held to be a dividend to him. (C. B. III-1, 24; I. T. 2023.) Similarly, where a corporation loaned money to shareholders on a pledge of their corporate stock, no dividends being paid thereon, it was held that these shareholders had in substance received dividends to the same extent as non-borrowing shareholders, and had paid interest to the corporation in a like amount. (C. B. II-1, 64; I. T. 1666.)

The Treasury held in a case where a dividend was used by agreement of the stockholders for acquiring the stock of another company, that such dividend had been "received" by such stockholders. (C. B. I-1, 12; I. T. 1336; see also C. B. III-1, 24; A. R. R. 4919; and V-33-2874; I. T. 2301.) In another case stock was sold, payment to be made in installments, the vendor depositing the stock in bank in escrow, and dividends on the stock reducing each installment. It was held that the vendees had "constructively received" such dividends. (C. B. III-1, 3; I. T. 1958.) Withdrawals by stockholders in 1917 and 1918 not covered by charge to surplus and credit to the stockholders as dividends until 1920, were held to be "dividends received" in the former years. (C. B. II-2, 80; I. T. 1872.)

In Harkness's Appeal (1 B. T. A. 127) the taxpayer owned certificates of a trust which in turn owned shares of stock. The certificates were convertible into the stock, but under the special circumstances, the taxpayer did not and could not have made the exchange. When the certificates were subsequently sold at a large advance over cost, the taxpayer contended that part of the price was dividends taxable at the rates effective for the years when they actually were received by the trustee. In other words, they claimed that dividends had been constructively received. The Board denied the contention, holding that the excess over the cost was a profit in the year of sale, subject both to normal taxes and surtaxes.

Date of DECLARATION OR DATE OF PAYMENT.-A series of cases has involved the question of when a corporate distribution is madewhether at the time of declaration or of actual payment. These cases have arisen under section 31 (b) of the 1917 law, whereby a distribution made in 1917 was deemed to have been made from most

recently accumulated undivided profits or surplus, and was taxable to the distributee at the rate prescribed by law for the years in which the profits or surplus were accumulated by the corporation. In U. S. v. Guinzberg (278 Fed. 363) the court had held that a declaration of a dividend prior to March 1, 1913, creates a debt; that even though it is paid thereafter, it is not taxable income. Following this doctrine, the district court in Phillips v. U. S. [12 F. (2d) 598] and the Board on Stange's Appeal [1 B. T. A. 810 (NA)] concluded that the words "any distribution made" as used in the law, refer to the date of the declaration rather than the date of payment.

On the other hand, in Routzahn v. Mason (13 F. (2d) 702) the court, following what it believed to be the holding in Edwards v. Douglas (269 U. S. 204), concluded that dividends declared in 1916 and paid in 1917 were subject to the 1917 rates, on the theory that a "dividend declared this year, payable in the next or some more distant year, is not within the normal conception of income for this year."

In Edwards v. Douglas, the Supreme Court held, four justices dissenting, that dividends received and declared during 1917 must be deemed to have been declared out of 1917 rather than 1916 earnings, where the 1917 earnings were ample to pay them, even though the corporation did not close its books for 1917 until December 31. The court said.

DECISION. To accomplish the purpose of congress it was necessary that the dividend be deemed to have been paid out of the available profits on earnings of the most recent year or years. Its intention so to provide was adequately expressed by the use of the phrase "most recently accumulated" in connection with the words "undivided profits or surplus." As, in the case at bar, there were profits of the year 1917 ample to cover all dividends, those here in suit must be deemed to have been paid therefrom.

Although the courts in each case apparently based their conclusions on their differing opinions as to when a distribution is "made," it is believed that actually two distinct propositions are involved, both of which may be sound. In determining out of what profits a dividend has been paid, there is much to be said for using the date of declaration as the basis for the determination, i.e., that the directors must be taken to declare dividends out of their existing profits rather than out of profits to be accumulated before the date of payment. On the other hand, in determining in what year a shareholder receives income, the date of payment rather than the date of

declaration, it seems, should be controlling. This distinction, however, does not reconcile the cases, since in each, the question was out of what profits the distribution was made. The Commissioner has, apparently, in general applied the theory which will yield the largest tax in the particular case. However, in other analogous cases, the second proposition has been applied. Thus, in Titus's Appeal [2 B. T. A. 754 (A)] the taxpayer received on January 2, 1918, a check mailed to him by a client in 1917. He claimed it as 1917 income. (The 1918 rates were higher than 1917.) The Commissioner said, not so, you kept your accounts on a cash basis and the income was not received until 1918. The Board upheld the Commissioner.

Following the line of reasoning in Edwards v. Douglas, the Board in Stranahan's Appeal (4 B. T. A. 1141) held that dividends paid in 1917 were taxable at 1917 rates to the extent of the current 1917 earnings to the time of the declaration of dividends, and only after the current earnings were exhausted could any distributions made in 1917 be returned as taxable at rates applicable to earlier years. The Board also approved the Commissioner's pro rata method that onesixth of the 1917 earnings were available for distribution on March 1, 1917, the date dividends were declared.

The Board has definitely stated in Hendrick's Appeal (4 B. T. A. 1257) its position that the date of declaration rather than the date of payment of dividends governs in determining the earnings available for distribution.

DECISION. We have carefully considered the case of Edwards v. Douglas, supra, but we are unable to agree with the Commissioner that it is authority for holding that the words any distribution made, as used in section 31 (b) of the Revenue Act of 1917, relates to the time of payment. We therefore hold that the resolution of the board of directors of Hendricks Brothers, Inc., of January 17, 1917, constituted a dividend at that time, regardless of the fact that part of the dividend was not paid until later.

Deferred dividends on preferred stock are payable only when declared. They become a liability of the corporation at date of declaration and will be allocated to surplus accumulated at that date.

DIVIDENDS ON PART-PAID STOCK.—A corporation's stock was 80 per cent paid in. The directors authorized a journal entry to be made, debiting profit and loss and crediting capital stock, for an amount sufficient to make the stock full paid. The Committee held

(C. B. I-2,

that the transaction was a cash-not a stock-dividend. 8; A. R. R. 1127. To the same effect see C. B. II-2, 82; I. T. 1740.)

The ruling is sound. There was no distribution of assets, neither was there a dividend paid in stock. Until stock is fully paid, the unpaid portion is an obligation entered into by the stockholders when subscriptions are made. The discharge of this obligation partakes more of the nature of a cash than of a stock dividend.

TAXES WITH HELD AT SOURCE ON DIVIDENDS OF FOREIGN CORPORATIONS. Where a foreign corporation is required to deduct and pay at the source a tax on the dividends declared by it, the recipient in the United States must include the gross dividend as income. (C. B. IV-2, 82; I. T. 2235.) The recipient may claim credit for the taxes so paid. (See page 138.)

May a dividend be rescinded by directors or returned by stockholders?-It sometimes happens that a dividend is declared on the strength of book or paper profits and subsequently it becomes necessary or desirable to reverse the action and arrange to secure a return of the funds paid out or credited to the accounts of stockholders.

If a single stockholder objects to the rescinding, after the formal declaration of a dividend is communicated to him or after the dividend has been credited, no legal remedy is available to compel action on his part. If, however, the dividend has been paid out of capital, the so-called dividend is not taxable at all to the stockholders except to the extent that it might be taxable as a liquidating dividend and the directors may be required to reimburse the corporation to the extent to which the dividend was illegal.1

If directors pay a dividend which proves to be unwise, or excessive or illegal, and every stockholder agrees to return the amounts paid or credited, it may be expected that no court will hold that the payments represent income when received and capital payments when refunded, even though the dividends were paid or credited during one taxable year and the refunds occurred during the next year. If the entire transaction occurred during the same taxable year it would not even appear in the returns of the taxpayer. In effect it would be a transaction marked "void." Therefore, when one

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Auditing, Theory and Practice, Vol. I (1921 edition), by R. H. Montgomery, pages 670-677. See also C. B. 1, 25; T. B. M. 77.