Commissioner v. Wheeler

delivered the opinion of the Court.

The Circuit Court of Appeals for the Ninth Circuit has held Section 501 (a) of the Second Revenue Act of 1940 to be unconstitutional.^[1] This of course called for grant of certiorari.^[2]

Since our problem is not computation of a tax, the facts relevant to the issues in the five cases, consolidated on appeal, may be shortly stated. In 1925, John H. Wheeler and his wife, Frances, organized under the laws of California the John H. Wheeler Company. Then and thereafter they transferred an assortment of securities to it in exchange for shares of its common stock. The securities had cost them $304,684.49 and at transfer had a fair market value of $491,800. In exchange the Wheelers received 4,918 shares with a par value of $100 each. No gain by them was recognized for income-tax purposes by reason of the exchange. Cf. Int. Rev. Code § 112 (b) (5).

For purposes of determining its income-tax liability on subsequent disposition of the securities, the corporation was obliged to and did use as a cost base the cost of the securities to the transferors, $304,684.49. Cf. Int. Rev. Code § 113 (a) (8). But for its corporate accounting the corporation set up a cost of $491,800, market value at the

After considering the applicability of § 112 (b) (7), the stockholders duly dissolved the corporation and distributed its assets during December 1938. They elected to be taxed on the gains on their shares pursuant to § 112 (b) (7), and they reported, of course, according to the higher or market-value basis for the securities acquired and disposed of by the Company. The Commissioner asserted a deficiency based on the lower cost to the transferors. In explaining his determination he relied on § 501 (a) of the Second Revenue Act of 1940, 54 Stat. 974,1004 , which provides that earnings and profits on the sale or other disposition of property shall be determined by using the adjusted basis for determining gains and by recognizing such gains to the extent that they are recognized for computing net income, and on § 501 (c), which makes the provisions of § 501 (a) applicable to prior years.

Although the term “earnings and profits” has long been in the revenue acts, in connection with the definition of dividends, it has never been defined by the statutes^[5] (except in so far as § 501 (a) of the Second Act of 1940 has now done so). But under the Revenue Act of 1934 and succeeding acts, the Commissioner dealt by regulation with that portion of the problem of definition relevant here. Article 115-3 of Treasury Regulations 101, promulgated under the 1938 Act, provided in part as follows: “Gains and losses within the purview of section 112 or corresponding provisions of prior Acts are brought into the earnings and profits at the time and to the extent such gains and losses are recognized under that section.”^[6] This regulation, if valid, disposes of the controversy, for when the corporation sold its securities acquired from the Wheelers it realized gain, based on transferor’s cost, which was fully recognized under § 112.

The only reason to doubt the validity of the regulation is found in certain decisions of the Board of Tax Appeals and lower courts, mentioned in the Tax Court’s opinion. Despite these adverse decisions, however, the Commis

We think the regulation is reasonable and a valid exercise of the rule-making power. The taxpayers are insisting on using as a base for tax purposes a figure that in itself had no relation to taxation. It was no doubt permissible and perhaps the correct accounting, for determining earned surplus for dividends and such corporate purposes, for the corporation to set up its books on the market value of its property at the time of acquisition, which determined the value of the stock it issued. But “earnings and profits” in the tax sense, although it does not correspond exactly to taxable income, does not necessarily follow corporate accounting concepts either.^[8] Congress has determined that in certain types of transaction the economic changes are not definitive enough to be given tax consequences, and has clearly provided that gains and losses on such transactions shall not be recognized for income-tax liability but shall be taken account of later. §§ 112, 113. It is sensible to carry through the theory in determining the tax effect of such transactions on earnings and profits. Compare Commissioner v. Sansome, 60 F. 2d 931 , and see Sen. Rep. No. 2156, 74th Cong., 2d Sess., p. 19; H. R. Rep. No. 2894, 76th Cong., 3d Sess., p. 41. Indeed, Congress appears to have provided for this result in the statute

We therefore think that on principles often reiterated^[10] the regulation is valid and decisive of this issue. There is no necessity to predicate the determination of deficiency on the 1940 amendment. The 1940 amendment conse