Rev. Rul. 1969-440
Internal Revenue Service Revenue Ruling Rev. Rul. 69-440 1969-2 C.B. 46 Sec. 316 IRS Headnote If total distributions for two classes of stock are in excess of earnings and profits, dividends must be regarded as having been distributed to those stockholders having priority under corporate charter before any distributions to stockholders with lesser priority; G.C.M. 21122 superseded. Full Text Rev. Rul. 69-440 /1/ The purpose of this Revenue Ruling is to update and restate under the current statute and regulations the position set forth in G.C.M. 21122, C.B. 1939-1 (Part 1), 187. The question presented concerns the source of distributions under section 316 of the Internal Revenue Code of 1954 and section 1.316-2 of the Income Tax Regulations when such distributions are made with respect to classes of stock having priority over other classes of stock and the sum of the payments on all classes for the year is in excess of the earnings and profits. In 1968 a corporation had outstanding common stock, prior preferred cumulative stock entitled under the corporate charter to dividends at the rate of $6 per share before the payment of any dividend on any other class, and cumulative convertible stock entitled to cumulative dividends at the rate of $2 per share. During the year the corporation made distributions on the prior preferred stock in the total amount of $6 per share and on the cumulative convertible stock in the total amount of $2 per share. The total amount distributed in 1968 was 35x dollars but the corporation had earnings and profits for the taxable year 1968 of only 24x dollars and had no accumulated earnings and profits as of January 1, 1968. The earnings and profits of the corporation were sufficient to cover the dividend requirements on the prior preferred stock, and if applied first to the dividends on that stock, would leave earnings and profits to be applied to the dividends paid on the cumulative convertible stock equal to 12 percent of the amount distributed to holders of such stock. On the other hand, if the earnings and profits were prorated as to all the dividends paid, 68.57 percent of the amount received by the holders of each class of stock would be regarded as a distribution of earnings and profits and the remainder would constitute a distribution of capital. Section 1.316-2 of the regulations provides that if the distributions made during the taxable year exceed the earnings and profits of such year, that proportion of each distribution that the total of the earnings and profits of the year bears to the total distributions made during the year shall be regarded as out of the earnings or profits of that year. There is nothing in section 316 of the Code which impairs the contractual right of the stockholders. The pertinent portion of that section reads as follows: "Sec. 316. Dividend Defined. (a) General Rule.--For purposes of this subtitle, the term "dividend" means any distribution of property made by a corporation to its shareholders--(1) * * *, or (2) out of earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made." This provision is substantially the same as section 115(a). In explanation of the last clause, the Senate Committee on Finance in its report on the 1936 revenue bill (Report No. 2156, June 1, 1936, page 18) stated: "In order to enable corporations without regard to deficits existing at the beginning of the taxable year to obtain the benefit of the dividends paid credit for the purposes of the undistributed profits surtax, section 115(a) changes the definition of a dividend so as to include distributions out of the earnings or profits of the current taxable year. The amendment simplifies the determination by providing that distributions during the year, not exceeding in amount the current earnings, are dividends constituting taxable income to the shareholder and a dividends paid credit to the corporation. As respects such dividends the complicated determination of accumulated earnings or profits is rendered unnecessary." Thus, it appears that Congress intended that a corporation should compute its net earnings and profits as of the end of the year, and that if dividend distributions had been made in excess of that amount, the amount of each distribution that was paid out of earnings and profits would be determined on the pro rata basis rather than looking to the actual earnings on hand at the time of each distribution. However, it does not follow that where dividends are paid to different classes of stockholders the priorities as between stockholders must be disregarded. If, for example, a corporation earns only an amount sufficient to meet its preferred stock requirements and pays the required dividends on its preferred stock and also makes distributions on its common stock, the preferred stockholders should, nevertheless, report as dividends the entire amount distributed to them even though the corporation also made distributions to its common stockholders which, when added to the preferred stock dividends, were in excess of the corporate earnings and profits for that year. In such a case, if the preferred stockholders are entitled to payment of their dividends before any distribution can be made to common stockholders, it is apparent that the earnings and profits are used first for the preferred stockholders, and if the earnings and profits are thereby exhausted, the payments to the common stockholders merely reduce their equity and constitute in effect a return of capital. The right of a preferred stockholder to preference out of the earnings of the corporation for each year was recognized in Barclay et al. v. Wabash Ry. Co. et al., 30 F. 2d 260 (1929), wherein the court granted a decree forbidding payment of the dividends on junior stock out of earnings accumulated during the year for which the preferred dividends had not been paid. Thus, the preferred stockholders have an equitable claim on the earnings of the corporation for each year that must be met before any part of those earnings can be paid to other classes of stockholders. Accordingly, in the present case, the earnings and profits must be regarded as having been first used for the payment of the dividends on the prior preferred stock as required by the charter of the corporation and the contract with the prior preferred stockholders, and only the earnings and profits remaining after such dividend requirements have been met should be regarded as having been paid to the junior stockholders. In other words, the earnings and profits of the corporation for the year 1968 must be regarded as having been distributed in accordance with the provisions of the corporate charter giving the prior preferred stockholders the right to dividends before any earnings and profits can be distributed to the other stockholders. G.C.M. 21122 is hereby superseded since the position stated therein is restated under current law in this Revenue Ruling. /1/ Prepared pursuant to Rev. Proc. 67-6, C.B. 1967-1, 576.
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