V

SALES AND EXCHANGES: STOCKS AND

BONDS RIGHTS MISCELLANEOUS

Sale and exchange of stocks and bonds. Effect of non-taxable dividends, including stock dividends. Non-taxable exchanges and their effect on values carried forward. Sale of rights. Miscellaneous sales and exchanges.

EACH block of stock or bonds owned by an individual or corporation must be regarded as a separate piece of property having a definite and ascertainable cost, or value in lieu of cost (Art. 39). Rules governing the computation of the cost of stocks and bonds, which is necessary when sales are made, are as follows:

1. If a portion of a block of stock or bonds is sold a proportionate amount (based on shares or par value) of the cost should be allocated to the sale.

2. Averaged costs cannot be used even though sanctioned by good accounting (Art. 39). The use of averaged costs is not specifically referred to in the 1921 Revenue Act but the regulations are definite and the courts thus far have upheld the regulations.

3. Sales of a portion of a block cannot be credited to the unabsorbed cost of the balance of the block except as noted below (Art. 39).

4. Where it is impossible to identify stock certificates or bonds with particular purchases, sales are regarded as proceeding from the earliest purchase or purchases. This was a rule upheld in Towne v. McElligott (274 Fed. 960, issued as T. D. 3252).

5. An ordinary stock dividend has the effect of distribut

ing the cost of the original stock ratably over the old and the new shares. Three cases arise:

(a) If the stock dividend is of the same class as the original issue, the new cost of each old and new share is the old cost or March 1, 1913, value divided by the total of the old and new shares (Art. 1548(1)).

(b) If the original lots cannot be identified, or if the dividend stock cannot be identified with any one lot, the dividend stock sold will be regarded as pertaining to the earliest purchase or purchases (Art. 1548, T. D. 3238 and T. D. 3252; note that T. D. 3238 overrules O. D. 735).

(c) If the dividend stock differs in character from the original stock, the old cost is to be divided between the old and the new in proportion to their market values at the time the dividend stock is issued (Art. 1548 and O. D. 732 and 478).

6. Property and cash dividends have no effect on stock costs or sales unless they are liquidating dividends or dividends paid from surplus accumulated or accrued before March 1, 1913 (Art. 1544-5). According to regulations covering the 1918 act, any "liquidating" dividend, declared as such by the board of directors, whether or not involving earned surplus, reduced the value of the stock (Art. 1548, Regulations 45). Under the present regulations a liquidating dividend is a reduction of stock cost only to the extent it is not paid from earned surplus; and earned surplus must be absorbed first even though the directors may declare to the contrary (Art. 1545).

7. If a dividend is declared from surplus accumulated or accrued prior to March 1, 1913, the resulting payment is not only taxfree, but need not, for tax purposes, be considered in computing the profit when the stock is sold. Any loss on the stock, however, claimed as a deduction must be reduced by the total amount of tax-free dividends received.

This rule applies to 1921 and succeeding years and was inserted in the 1921 act by Congress after the Supreme Court had declared (in Lynch v. Hornby, 247 U. S. 339) that nothing in the 1913 act prohibited the taxation of cash dividends paid from accumulations of any period prior to March 1, 1913 (Art. 1543). The Solicitor had ruled with respect to the 1918 act that dividends from a realization in 1918 of appreciation prior to 1913 were taxable (L. O. 1073).

8. Bonus stock acquired in connection with other securities purchased should be valued at the excess of the purchase price actually paid over the price the other securities would have sold for without the bonus stock. If this difference cannot be ascertained (in most cases, it is safe to say, it cannot) and no other basis of proration is practicable, amounts realized from the sale of the stock or other security are regarded as reductions of the total cost until the latter is absorbed, after which further sales are looked upon as taxable income in their entirety (Art. 39, 832; 1567(a)).

9. The only type of reorganization not questioned as to its taxability under the 1918 act was one in which the par value of stock received did not exceed that of the stock given in exchange. Any reorganization, recapitalization, or mere change in identity involving an exchange of securities became non-taxable commencing with 1921, the old corporation and its stockholders being alike exempt. If property, other than securities was received in exchange, the fair value of such property was credited to the cost or the March 1, 1913, value of the original securities; this rule of Regulations 62 held good for 1921 and 1922 (Art. 1568). Commencing with 1923 the taxable profit was limited to the fair value of the other property received, if any. For a further discussion of reorganizations, including the transfer of property to a corporation with the retention of at least an 80% control, see Chapter VII.

10. In reorganizations under the 1918 act the receipt of two or more classes of stocks for a single security surrendered might have resulted in a taxable profit measured by the lower of (a) the excess of the par values of the new stocks over the par value of the old, and (b) the excess of the combined market values of the new over the cost of the old (Art. 1569, Regulations 45). The rule laid down in the 1921 act reads that the cost of the old shares must be split as between the new issues in such a manner that the proportion shall be the same as that existing between their respective market values at the date of the new issue (similar to the rule under (5) (c), above). If the respective market values cannot be ascertained, the rule in the last sentence of paragraph 8, above, applies (Art. 1566(b), 1567(a)).

II. An exchange of the stock of one corporation for the stock of another corporation was not taxable under the 1921 act for the first time, providing the stock was held for investment (apparently not limited to two-year holdings) purposes. The cost of the old securities remained as the cost of the new, less any cash received, or plus any cash paid out in the exchange (Art. 1566(a), 1568). This rule held good for the calendar years 1921-22 only and was eliminated by the act of March 4, 1923.

12. A "wash" sale is a sale coupled with a purchase of the same kind of security. The 1921 act does not permit deductions to be made on account of losses from security sales where the same kind of security is purchased 30 days before or after such sale, the rule being effective after November 23, 1921, the date of the passage of the act. If only a portion of the security is repurchased, only a similar portion of the loss will be disallowed (Art. 147, 1567(C)). The losses disallowed should be carried forward in memorandum accounts or added to the cost of the replaced stock so that when the new stock is sold, not under the same

conditions, the combined cost and the loss on the first sale may be set off against the selling price.

13. A drop in the market price of securities cannot be claimed as a loss unless the securities are sold. The exception, of course, is the dealer in securities, in whose hands stocks and bonds are merchandise, subject, if he elects, to the rule of cost or market, whichever is lower. The cost of worthless securities, however, may be claimed as a deduction providing they cannot be sold and their worthlessness can otherwise be proved (Art. 144).

14. "Capital gains" arise most frequently in connection with security transactions. A "capital asset" the sale of which may result in a "capital gain" is defined in the law as property held for profit or investment for more than two years with the specific exclusion of property held for individual consumption or use and property which is stock in trade (Art. 1651). A discussion of the applicability of the 122% rate will be found on page 48 and is illustrated on pages 229-230.

Under the 1918 act, an exchange of stock of one corporation for stock in another, the beneficial interest remaining the same, resulted in a taxable gain or deductible loss (O. D. 1051; A. R. M. 67 and A. R. R. 289) in the year the exchange was made (O. D. 480 and 1071). Even an exchange of common stock for preferred stock of the same corporation, the exchange being between two individuals, was held to result in taxable income to the extent that the fair market value of the preferred exceeded the cost of the common (O. D. 1008). If the cost of the old lies between the par value and the market value of the new, neither loss nor gain was realized (O. D. 932). Transfers resulting in no taxable gain or deductible loss were limited to exchanges involving no greater par values (O. D. 335), no matter whether the number of shares was increased or decreased (T. B. R. 39); or whether the par value was reduced through a receivership from $100 to $50 (A. R. R. 665); that is, as long as no greater par value is received by the individual stockholder (O. D. 204). No deductible loss could be claimed where, through a reorganization, the new par values received were the same as the old, despite the fact that the intrinsic value of a stockholder's interest, as evidenced by offerings of the new stock,