Opinion
Docket No. 22322.
1951-09-28
WILLIAM F. DAVIS, JR., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Charles C. MacLean, Jr., Esq., and Laurence F. Casey, Esq., for the petitioner. Joseph F. Rogers, Esq., for the respondent.
The Securities and Exchange Commission determined that the petitioner, who was an officer and director of the corporation in whose stock he was dealing, had violated section 16(b) of the Securities Exchange Act of 1934 through the sale of 1,000 shares of the company's stock and the repurchase of 1,000 shares at a lower price less than 6 months later. Pursuant to the sanction imposed by section 16(b), the petitioner paid to the corporation the difference between the amount which he realized from the sale and the cost to him of the shares subsequently purchased.
Held, the sanction imposed by section 16(b) is in the nature of a penalty and deduction of the payment made pursuant thereto is disallowed since it would mitigate the deterrent effect of the statute and subvert a sharply defined public policy. Charles C. MacLean, Jr., Esq., and Laurence F. Casey, Esq., for the petitioner. Joseph F. Rogers, Esq., for the respondent.
The Commissioner has determined a deficiency in the income tax liability of the petitioner for the year 1946 in the amount of $5,834.78. The petitioner concedes that part of the deficiency was properly determined. However, he contests the disallowance of a deduction in the amount of $12,659 which he contends is deductible under either section 23(a)(1) or section 23(e) of the Internal Revenue Code.
The issue in this proceeding arises from the fact that the petitioner, who was an officer and director of United Drug, Inc., sold 1,000 shares of his stock in the corporation on October 25, 1945, and December 1, 1945, for $25,441.50. On December 31, 1945, less than 6 months thereafter, he purchased 1,000 shares for $12,782.50. Under section 16(b) of the Securities Exchange Act of 1934, which provides that any profit realized by an officer or director of a corporation from any purchase and sale or sale and purchase of the corporation's stock within a period of 6 months shall inure to and be recoverable by the corporation, the petitioner thereupon became liable to United Drug, Inc., for $12,659. This amount represented the difference between the proceeds which he realized from the sale of 1,000 shares and the price which he subsequently paid for 1,000 shares. In 1946, the petitioner paid $12,659 to United Drug, Inc., because of his violation of section 16(b). He now seeks to deduct this payment either as a business expense under section 23(a)(1) or as a loss under section 23(e).
The petitioner, who is a resident of Los Angeles, filed his return for the year 1946 with the collector for the sixth district of California.
The record in this proceeding consists of a stipulation of facts, oral testimony, and various exhibits.
FINDINGS OF FACTS.
The facts which have been stipulated are found as stipulated.
United Drug, Inc. (hereinafter referred to as ‘U. D. Inc.‘), is a holding company which owns all the stock of United Drug Company (hereinafter referred to as ‘U.D. Co.‘). The headquarters of both corporations were in Boston until September 1945, at which time the headquarters were moved to Los Angeles. Since 1936 the petitioner has been the general counsel of both U.D. Inc. and U.D. Co. He has also been a vice president of each company since 1941 and a director of each company since 1942. During 1945 and 1946, and for many years prior thereto, the petitioner devoted his full time to the duties of the positions which he held with the two companies, except for a period of 15 months when he was on active duty with the United States Marine Corps.
Between 1938 and 1942 the petitioner bought 2,000 shares of the capital stock of U.D. Inc. on the open market. On October 25, 1945, the petitioner sold 500 of these shares on the open market, and on December 1, 1945, he sold an additional 500 shares. The petitioner received the total sum of $25,441.50 from these sales of 1,000 of his 2,000 shares. The basis of the shares sold was $4,971.88. On his Federal income tax return for the year 1945 the petitioner reported a long term capital gain of $20,469.62 from the sale of these shares.
At a meeting of U.D. Inc. on November 24, 1943, a resolution was adopted recommending to the subsidiary, U.D. Co., that U.D. Co. adopt a stock option plan under which certain of U.D. Co.'s executives would be given options to purchase a specified number of the shares of the stock of U.D. Inc. which were then owned by U.D. Co. U.D. Co. adopted the executives' stock option plan, which was made effective on February 15, 1944, and determined that the purchase price of the stock subject to the options would be $12,75, which was the average price of U.D. Inc. stock on the New York Stock Exchange on February 14, 1944. The purpose of the plan was to give an additional incentive to the executives and to provide them with greater interest and enthusiasm in the enterprise.
On February 16, 1944, U.D. Co. entered into an agreement with the petitioner which provided in part as follows:
The Executive is hereby given an option to purchase from the Company at any time and from time to time during the respective periods hereinafter mentioned and on the terms and conditions hereinafter set forth at $12.75 per share all of any part of the following amounts of the Common Capital Stock of United Drug, Inc.:
+----------------------------------------------------------------+ ¦On and after March 1, 1944 and prior to¦ ¦ ¦ +---------------------------------------+-----+------------------¦ ¦March 1, 1949 ¦1,000¦shares. ¦ +---------------------------------------+-----+------------------¦ ¦On and after March 1, 1945 and prior to¦ ¦ ¦ +---------------------------------------+-----+------------------¦ ¦March 1, 1950 ¦1,000¦additional shares.¦ +---------------------------------------+-----+------------------¦ ¦On and after March 1, 1946 and prior to¦ ¦ ¦ +---------------------------------------+-----+------------------¦ ¦March 1, 1951 ¦1,000¦additional shares.¦ +---------------------------------------+-----+------------------¦ ¦On and after March 1, 1947 and prior to¦ ¦ ¦ +---------------------------------------+-----+------------------¦ ¦March 1, 1952 ¦1,000¦additional shares.¦ +---------------------------------------+-----+------------------¦ ¦On and after March 1, 1948 and prior to¦ ¦ ¦ +---------------------------------------+-----+------------------¦ ¦March 1, 1953 ¦1,000¦additional shares.¦ +----------------------------------------------------------------+
U.D. Co. filed a report of the granting of the stock options with the Securities and Exchange Commission on March 9, 1944. This report set forth the names of the executives to whom options were granted, the number of shares covered by the options granted, and the terms and conditions of the options. The report also stated that:
There was no consideration as such for the granting of the options herein reported. They were granted by the Board of Directors of the Company because it believes that the success of the Company and its subsidiaries depends to a very large extent upon the interest and enthusiasm of its key executives, and that if its key executives are stockholders of United Drug, Inc., which is the sole holder of the common stock of United Drug Company, they will be disposed to have an even greater interest and enthusiasm in the enterprise.
As of December 31, 1945, the petitioner was entitled under his option agreement to purchase 2,000 shares of U.D. Inc. stock at $12.75 per share. Up to this time he had not elected to exercise his option to purchase stock. On December 31, 1945, the petitioner exercised his right granted under the executives' stock option plan to purchase 2,000 shares of U.D. Inc. stock from U.D. Co. This purchase increased his holdings to 3,000 shares. The cost of the stock purchased, including incidental expenses, was $25,565.
In accordance with section 16 of the Securities Exchange Act of 1934, 48 Stat. 896 (1934), 15 U.S.C.section 78(p), the petitioner reported the changes in his ownership of U.D. Inc. stock to the Securities and Exchange Commission on January 10, 1946.
On March 13, 1946, U.D. Inc. filed with the Securities and Exchange Commission copies of its preliminary proxy soliciting material in connection with the annual meeting of its stockholders which was scheduled to be held May 14, 1946. On March 21, 1946, the director of the Corporation Finance Division of the Securities and Exchange Commission informed U.D. Inc. that:
It is noted from reports filed by Mr. William F. Davis, Jr., that he sold and purchased shares of stock of the issuer within a period of six months. If these transactions resulted in profits to Mr. Davis which are recoverable by the issuer under Section 16(b) of the Securities Exchange Act of 1934, it appears that the facts with respect thereto should be disclosed in the proxy statement pursuant to Item 5(I)(4) of Schedule 14(A) of the proxy rules, to the extent that any such profits were material in amount.
Upon further examination of the transactions, the Securities and Exchange Commission determined that the sale of U.D. Inc. stock by the petitioner in October and December 1945 and his subsequent exercise of his option to purchase U.D. Inc. stock on December 31, 1945, were transactions which violated section 16(b) of the Securities Exchange Act of 1934. The provisions of section 16 are as follows:
(a) Every person who is directly or indirectly the beneficial owner of more than 10 per centum of any class of any equity security (other than an exempted security) which is registered on a national securities exchange, or who is a director or an officer of the issuer of such security, shall file, at the time of the registration of such security or within ten days after he becomes such beneficial owner, director, or officer, a statement with the exchange (and a duplicate original thereof with the Commission) of the amount of all equity securities of such issuer of which he is the beneficial owner, and within ten days after the close of each calendar month thereafter, if there has been any change in such ownership during such month, shall filed with the exchange a statement (and a duplicate original thereof with the Commission) indicating his ownership at the close of the calendar month and such changes in his ownership as have occurred during such calendar month.
(b) For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer, any profit realized by him from any purchase and sale, or any sale and purchase, of any equity security of such issuer (other than an exempted security) within any period of less than six months, unless such security was acquired in good faith in connection with a debt previously contracted, shall inure to and be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner, director or officer in entering into such transaction of holding the security purchased or of not repurchasing the security sold for a period exceeding six months. Suit to recover such profit may be instituted at law or in equity in any court of competent jurisdiction by the issuer, or by the owner of any security of the issuer in the name and in behalf of the issuer if the issuer shall fail or refuse to bring such suit within sixty days after request or shall fail diligently to prosecute the same thereafter; but no such suit shall be brought more than two years after the date such profit was realized. This subsection shall not be construed to cover any transaction where such beneficial owner was not such both at the time of the purchase and sale, or the sale and purchase, of the security involved, or any transaction or transactions which the Commission by rules and regulations may exempt as not comprehended within the purpose of this subsection.
Because of his violation of section 16(b) of the Securities Exchange Act of 1934, the Commission determined that the petitioner was liable to U.D. Inc. for $12,659, which was the difference between the $25,441.50 realized by the petitioner from the sale of 1,000 shares and the $12,782.50 paid by him for 1,000 of the 2,000 shares which he purchased less than 6 months thereafter. The Commission thereupon notified U.D. Inc. that either the petitioner must pay over to the corporation $12,659 or the corporation would have to disclose in its proxy material that the petitioner was indebted to the corporation for $12,659, which was recoverable by the corporation or by any holder of an equity security suing in its behalf, as well as the details of the transactions.
Upon being notified of the ruling of the Securities and Exchange Commission, the president and the members of the executive committee of U.D. Inc. requested the petitioner to pay over to the company the sum of $12,659 in order to eliminate the difficulties which had arisen with the Commission in connection with the annual stockholders' meeting. The petitioner, through his counsel, made a formal request to the Commission to exempt his transactions from the operation of section 16 as not comprehended within the purpose of the section. Under section 16 the Commission had discretion to grant such exemption. The Commission, however, refused to exempt the petitioner's transactions, and the petitioner's counsel advised him that he was liable to U.D. Inc. under section 16 for $12,659. The petitioner, who was a lawyer, also made a detailed study of section 16 and concluded that his transactions violated the letter of the statute.
After the treasurer of U.D. Inc. made a formal demand upon the petitioner for $12,659, the petitioner delivered his certified check for the above amount to U.D. Inc. on April 8, 1946.
OPINION.
HARRON, Judge:
The petitioner, who was an officer and director of United Drug, Inc., owned shares of stock in the corporation which he had purchased in 1938 and 1940. On October 25, 1945, and December 1, 1945, he sold 1,000 shares of this stock for $25,441.50, realizing a long term capital gain of $20,469.62. Less than 6 months after these sales, the petitioner purchased 1,000 shares of the company's stock under an option which had been granted to him and other executives of the corporation at an option price of $12.75 per share. Incidental expenses raised the total cost of the shares to $12,782.50. Because the purchase was made less than 6 months after the sale of the 1,000 shares previously held by the petitioner, the Securities and Exchange Commission determined that the petitioner had violated section 16(b) of the Securities Exchange Act of 1934
and that United Drug Inc., was entitled to recover $12,659, which was the difference between the $12,782.50 paid by the petitioner for 1,000 shares and the $25,441.50 realized by him from the sale of 1,000 shares less than 6 months previously. The Securities and Exchange Commission thereupon notified the United Drug, Inc., that the Commission would not approve the corporation's annual proxy statement unless either the petitioner paid over $12,659 to United Drug, Inc., or it was disclosed in the company's annual proxy statement that the petitioner was indebted to United Drug, Inc., for $12,659, which was recoverable by the company or any holder of one of its equity securities suing in its behalf under section 16(b) of the Securities Exchange Act of 1934. Thereafter, upon demand by United Drug, Inc., pursuant to section 16(b), the petitioner paid to the corporation $12,659 on April 8, 1946. The petitioner now seeks to deduct this payment either as a business expense under section 23(a)(1) of the Internal Revenue Code or as a loss under section 23(e).
48 Stat. 896 (1934), 15 U.S.C.,section 78(p)(b)(1940).
The respondent bases his determination that the payment is not a proper deduction under either section 23(a)(1) or section 23(e) primarily on the ground that the payment was a penalty imposed on the petitioner by section 16(b) of the Securities Exchange Act of 1934
and that to allow its deduction would frustrate the clear policy defined in section 16(b). The petitioner, however, contends that the obligation imposed by section 16(b) of the Securities Exchange Act of 1934 upon an officer or director of a corporation to pay over to his company the ‘insider's profits‘ realized from transactions within section 16(b) is not a penalty, and than even if the payment of such an obligation is a penalty, the allowance of a deduction for its payment would not contravene the public policy expressed in section 16(b).
SEC. 16. (a) Every person who is directly or indirectly the beneficial owner of more than 10 per centum of any class of any equity security (other than an exempted security) which is registered on a national securities exchange, or who is a director or an officer of the issuer of such security, shall file, at the time of the registration of such security or within ten days after he becomes such beneficial owner, director, or officer, a statement with the exchange (and a duplicate original thereof with the Commission) of the amount of all equity securities of such issuer of which he is the beneficial owner, and within ten days after the close of each calendar month thereafter, if there has been any change in such ownership during such month, shall file with the exchange a statement (and a duplicate original thereof with the Commission) indicating his ownership at the close of the calendar month and such changes in his ownership as have occurred during such calendar month.(b) For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer, any profit realized by him from any purchase and sale, or any sale and purchase, of any equity security of such issuer (other than an exempted security) within any period of less than six months, unless such security was acquired in good faith in connection with a debt previously contracted, shall inure to and be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner, director, or officer in entering into such transaction of holding the security purchased or of not repurchasing the security sold for a period exceeding six months. Suit to recover such profit may be instituted at law or in equity in any court of competent jurisdiction by the issuer, or by the owners of any security of the issuer in the name and in behalf of the issuer if the issuer shall fail or refuse to bring such suit within sixty days after request or shall fail diligently to prosecute the same thereafter; but no such suit shall be brought more than two years after the date such profit was realized. This subsection shall not be construed to cover any transaction where such beneficial owner was not such both at the time of the purchase and sale, or the sale and purchase, of the security involved, or any transaction or transactions which the Commission by rules and regulations may exempt as not comprehended within the purpose of this subsection.See, also, the similar provisions contained in section 17 of the Public Utility Holding Company Act of 1935, 49 Stat. 832 (1935, 15 U.S.C.section 79(g)(b)(1946), and section 30(f) of the Investment Company Banking Act of 1940, 54 Stat. 837 (1940), 15 U.S.C.section 80(a)-29b (1946). Up to June 30, 1949, 309,494 reports had been filed by 45,179 insiders of 2,733 issuers of publicly listed equity securities, 255 registered public utility holding companies, and 234 registered closed-end investment companies. 15 Ann.Rep.S.E.C. 47 (1949).
Decision that the payment in question was in the nature of a penalty will not resolve the ultimate issue in this proceeding. The essential inquiry must be not only into the character of the payment made but also into the cognate question of whether the deduction of the payment in issue will frustrate any sharply defined public policy expressed in section 16(b) of the Securities Exchange Act and subvert the purposes of that statute. As was said in National Brass Works, Inc. v. Commissioner, 182 F.2d 526:
The real reason for denying the deductibility of ‘penalties‘ is not that they are characterized as such but because allowance in many cases would be against public policy. As the Supreme Court stated in Commissioner v. Heininger, 320 U.S. 467, 473 (1943), a tax deduction must not ‘frustrate * * * (any) sharply defined * * * policies‘ of the sovereign. It is true that neither the tax statute nor the treasury regulations condition deductibility upon the lawful character, either directly or remotely, of the expenditure made, * * * But, in the nature of things, public policy must narrow the field of allowable deductions which rest as they do upon legislative indulgence.
See also, Rossman Corp. v. Commissioner, 175 F.2d 711, reversing 10 T.C. 468; Farmers Creamery Co. of Fredericksburg, Va., 14 T.C. 879.
Based upon our examinations of the extent and nature of the liability imposed by section 16(b) and the application of that section to the petitioner's transactions, we have concluded that the obligation imposed by the section is in the nature of a penalty and that allowance of its deduction under the circumstances of this proceeding would frustrate the public policy expressed in the section. The Securities Exchange Act of 1934 is a comprehensive statute whose prime objective was the establishment and maintenance of a free and open market for trading in securities in which the prices obtained would represent an evaluation of worth based upon a full knowledge by all traders of the pertinent and available date. Securities Exchange Act of 1934, section 2, 48 Stat. 881 (1934), 15 U.S.C., section 78 (b) (1946). Because corporate directors, officers, and substantial stockholders, by reason of their inside position, have access to information not available to the market generally and, by reason of their managerial control, are able to influence the destinies of their companies in order to profit from market activities, section 16(b) was devised to deprive such insiders of an incentive to take advantage of their corporate positions by removing the profit from all short-swing speculations by corporate directors, officers, or substantial stockholders. Report of the Senate Committee on Banking and Currency, S. Rept. No. 1455, 73d Cong., 2d Sess., p. 55 (1934); Smolowe v. Delendo, 136 F.2d 231; Benisch v. Cameron, 81 F.Supp. 882; Grossman v. Young, 70 F.Supp. 970. Section 16(b) provides that any profits realized by corporate insiders from ‘any purchase and sale, or any sale and purchase, of any equity security (of their own corporation) within any period of less than 6 months, shall inure to and be recoverable by‘ the corporation. The purpose of the section was to be ‘thorough-going, to squeeze all possible profits out of stock transactions, and thus to establish a standard so high as to prevent any conflict between the selfish interest of a fiduciary officer, director, or stockholder and the faithful performance of his duty.‘ Smolowe v. Delendo, supra.
Although ‘the words 'penal’ and 'penalty' have many different shades of meaning, and are in fact among the most elastic terms known to law,‘ Ward v. Rice, 29 F.Supp. 714, 715, in Rossman Corp. v. Commissioner, supra, the Court of Appeals for the Second Circuit examined the functional nature of a penalty and determined that:
Taken in its broadest sense that word (penalty) has a punitive, as opposed to a remedial, meaning; it covers fines and other exactions which are not restitution for a wrong, and are only justified as a deterrent, or in order to satisfy an atavistic craving for retaliation.
See also, Huntington v. Attrill, 146 U.S. 657; Atchison, Topeka & Santa Fe Ry. v. Nichols, 264 U.S. 348; Restatement, Conflict of Laws, section 611. The payment made by the petitioner to United Drug, Inc., under section 16(b) was not a restitution of a profit which properly belonged to the corporation, nor was the cause of action granted by the section a remedy predicated upon specific injury to a stockholder; rather, the cause of action was created to police insider activity, and the payment was imposed as a deterrent to action in violation of the statute. Because of the great difficulty of proving a conscious misuse of inside information by officers, directors, or substantial holders of securities in short-swing sales and purchases with a resulting profit, section 16(b) imposes on these parties as a prophylactic measure absolute liability for the profit resulting from the short-swing transactions. The profit realized is forfeited to the corporation, not restored to a stockholder who may have been injured. The statutory accountability to the corporation imposed by section 16(b), however, does not supersede any common-law liability to the person from whom the securities were bought or to whom they were sold. Securities Exchange Act of 1934, section 28(a), 48 Stat. 903 (1934), 15 U.S.C. section 78(bb) (1946). A stockholder aggrieved by a fraudulent misrepresentation or failure to disclose inside information may still sue the insider to recover either the shares sold or his damages from the transaction, despite the fact that the corporation is entitled to a separate recovery under section 16(b). Strong v. Repide, 213 U.S. 419; cf. Ballantine, Law of Corporations, 217 (rev. ed. 1946).
The liability imposed by section 16(b) springs from an act in violation of statute and is arbitrarily exacted for the violation. Unlike the situation under the O.P.A. regulations in the Rossman case supra, good faith, innocent transgression, or fair dealing neither excuse nor abate the statutory exaction,
which does not compensate for a financial loss suffered by the corporation but instead seeks to regulate human behavior through the threat of financial retribution. And the payment does not lose its character as a penalty because it is recoverable in a civil action, United States v. La Franca, 282 U.S. 568, 572— 4; United States v. Chouteau, 102 U.S. 603, 611; or because in the exercise of its discretion the legislature has provided that it is to be paid to an individual rather than to the sovereign. Liberty Warehouse Co. v. Burley Tobacco Growers' Co-op. Marketing Assn., 276 U.S. 71, 97; St. Louis I.M. & S.R. Co. v. Williams, 251 U.S. 63.
Smolowe v. Delendo, supra, at 237; Truncale v. Blumberg, 80 F.Supp. 387; see Securities & Exchange Commission v. Chenery, 318 U.S. 80.
The petitioner has referred us to the Report of the Securities and Exchange Commission on Proposal for Amendments to the Securities Act of 1933 and the Securities Exchange Act of 1934, dated August 7, 1941, page 36, in which, in opposing a proposal to repeal section 16(b), the Commission said:
The consequences of failing to comply with this standard (section 16(b)) are not penal. The section does not make insiders' trading unlawful; it does not even subject insiders to injunctive proceedings.
However, we are no more swayed by the characterization made under the conditions of that report than we are by the use of the word ‘penalty‘ in reference to a section 16(b) payment in Smolowe v. Delendo, supra. Although the sanction imposed by section 16(b) may not be ‘penal‘ in the sense of ‘criminal,‘ it still falls within the functional definition of ‘penalty‘ contained in the Rossman case and other cases cited supra, with their emphasis on the preventive as opposed to the remedial consequences of such payments.
It is not within the province of the Tax Court to remove any part of the naturally resulting punitive force from penalties imposed for acts contrary to public policy. Congress considered transactions in violation of section 16(b) to be detrimental to the public welfare and designated a money sanction equivalent to the profit realized from the proscribed short-swing transactions as a substantial deterrent to such activities. The activities of the petitioner fell within the proscription of the statute;
and after the Securities and Exchange Commission, which is concerned with the practical enforcement of section 16(b) and is in the best position to determine how important a particular sanction may be, refused to exempt the petitioner's activities from its operation, he paid the penalty therefor. Allowance of the deduction in question would weaken an effective method of enforcing the sharply defined policy expressed in section 16(b) by mitigating the deterrent effect of the sanction imposed and making the net effect of the transactions profitable through the gaining of a tax advantage.
Park & Tilford v. Schulte, 160 F.2d 984, certiorari denied 332 U.S. 761; see H. Rept. No. 1383, 73d Cong., 2d Sess., pp. 10-11 (1934); S. Rept. No. 1455, 73d Cong., 2d Sess., pp. 55-63 (1934).The petitioner has brought to our attention the fact that the Securities and Exchange Commission, in the exercise of its rule-making power, on May 12, 1949, exempted from the stricture of section 16(b) transactions involving the purchase of an equity security by a director or an officer where the security is acquired directly from the issuer or its subsidiaries solely in consideration of the services as an officer or employee and pursuant to a bonus, profit-sharing, or other similar plan approved by the security holders in which the amount of securities distributed or set aside for a fiscal year pursuant to the plan is related to the net profits of the issuer and its subsidiaries for such year. Rule X-16B-3, 17 Code Fed.Reg.section 240.16b-3. Even if this regulation had been in effect in 1945, however, the transactions of the petitioner would not have been exempted from the proscription of section 16(b) since they obviously would not have met the strict requirements of the regulation.
Cases such as William Zeigler, Jr., 5 T.C. 150; Robert S. Farrell, 44 B.T.A. 238; and Charles R. Stuart, 38 B.T.A. 1147, which were cited by the petitioner, are readily distinguishable. The element common to all of those cases, but which is lacking in this proceeding, is that in each case the payment was made as restitution to make an injured party whole, rather than as the result of a sanction imposed to effectuate the design of a statute. Because of the different nature of the payments in those cases, the question of whether or not their deduction would frustrate public policy as defined by a statute of the sovereign was not involved. In Commissioner v. Longhorn Portland Cement Co., 148 F.2d 276, reversing in part 3 T.C. 310, certiorari denied 326 U.S. 728, which held that a compromise payment in settlement of a violation of a state anti-trust law was not deductible, the Court said:
The sense of the rule that statutory penalties are not deductible from gross income is that the penalty is a punishment inflicted by the state upon those who commit acts violative of the fixed public policy of the sovereign, wherefore to permit the violator to gain a tax advantage through deducting the amount of the penalty as a business expense, and thus to mitigate the degree of his punishment, would frustrate the purpose and effectiveness of that public policy.
See also, Universal Atlas Cement Co., 9 T.C. 971, affd. per curiam, 171 F.2d 294, certiorari denied 336 U.S. 962; Davenshire, Inc., 12 T.C. 958; Helvering v. Superior Wines & Liquors, Inc., 134 F.2d 373.
The importance of effectively enforcing a regulation which was passed for the general welfare requires neither the lessening of the deterrent effect of the penalty imposed nor the granting of a tax advantage through the allowance of a deduction for the payment made. It is held that the respondent was correct in refusing to allow the deduction in question.
Reviewed by the Court.
Decision will be entered for the respondent.
DISNEY and RAUM, JJ., concur in the result.
MURDOCK, J., dissenting: The petitioner sold some stock in 1945 which had a basis to him of $4,971.88. He received $25,441.50 from the purchaser. However, he was required by law as a result of that transaction, together with a subsequent purchase of additional shares on December 31, 1945, to pay $12,659 to United Drug, Inc. He actually paid that amount on April 8, 1946. It was then not too late to file an amended return for 1945. The two transactions were inseparable for tax purposes. The amount which he had to pay to the company reduced for tax purposes the amount realized from the sale so that the net result of his transaction was a long term capital gain during 1945 of $7,810.62. If the payment to the company required by law had been made in 1945 when the obligation arose, a proper report for that year would have been a long term capital gain of $7,810.62.
It is taken for granted in the majority opinion that the petitioner, by making the payment to the company in 1946, in that year had a deductible business expense, a loss incurred in trade or business within section 23(e)(1) or a loss sustained in a transaction entered into for profit within section 23(e)(2). The evidence does not show that the payment was an ordinary and necessary expense of any business carried on by the petitioner, was connected with any trade or business carried on by him, or was connected with any transaction entered into for profit other than the sale of the securities. Since the sale of securities, even after the payment to the company, still resulted in a gain, it is difficult to see how section 23(e) would apply. Thus, if the repayment is to be considered a separate transaction, it is not apparent that any provision of the Code provides for its deduction, and the only way it could be deducted would be to consider it a part of the 1945 sale from which the net result in 1945 was a long term capital gain of $7,810.62 since $12,659 of the amount received from the purchaser did not belong to the petitioner but within the year was payable to United Drug, Inc.
The tax result should not be different or more favorable to the taxpayer merely because the petitioner delayed making the required payment to the company. The delay would not make the payment a loss where previously it had been merely a reduction of the amount realized as a profit in a sale. However, if the payment had some tax significance in 1946, it would have to be upon the theory that an excessive long term gain had been reported for 1945 and a balancing of accounts with the Commissioner would require an offsetting capital loss for 1946. But whatever the proper treatment under the Internal Revenue Code may be, it is not in violation of public policy under the facts of this case.
VAN FOSSAN, J., agrees with his dissent.
TIETJENS, Jr., dissenting: I respectfully record my dissent. Inherent in the majority opinion is recognition that petitioner suffered a loss within the provisions of the Internal Revenue Code providing for deductibility of losses. With this I agree. However, the majority denies petitioner the deduction of this loss on the ground that to do so would ‘frustrate‘ a well defined public policy. With this I disagree.
The majority seems to feel that to allow petitioner the deduction would in some way encourage corporate officers to indulge in shortswing speculation in the stocks of their companies despite the fact that the Securities Exchange Act would require any profits made from such transactions to be paid over by the officer to the corporation. I find nothing in the record to justify this fear. It is always ‘possible‘ that deductions will result in some advantage to a taxpayer. But that result flows from the very nature of deductions. Suffice it to say that there is nothing here to show that petitioner had any such motive in burying and selling stock. It is apparent that his liability to the corporation came as a surprise to him. He had reported as income and paid the required tax on the profits from his sale. That his subsequent purchase subjected him to the sanction of parting with a portion of the gain he had realized, so far as I can see, was unrelated to the fact that the Code might provide for deductibility of his loss or the possibility that the taxing authorities might deny him that deduction. To deny him the deduction, as the majority has done, seems to me to subject petitioner to a double sanction nowhere provided for, either by the Securities Exchange Act or the Internal Revenue Code. He paid the tax required on his profit. Part of the profit was later taken from him and turned over to the corporation. Why deny him the deduction?
Of course, as the majority says, the sanction imposed by the Securities Exchange Act of 1934 was designed as a deterrent to policy insider stock dealing. But in concluding that this Court must add a further deterrent, if it be a deterrent (and I cannot find that it would be) to such transactions, it think the majority is wrong.
The Exchange Act provides its own sanctions. If those sanctions are not harsh enough, Congress can remedy the situation. It has done so in similar situations. See Weather-Seal Manufacturing Co., 16 T.C. 1312. Too, I think the majority passes too lightly over the pronouncement of the Securities and Exchange Commission itself to the effect that failures to comply with the section of the Securities Exchange Act here involved are not ‘penal‘ or ‘unlawful‘ and do not even ‘subject insiders to injunctive proceedings.‘ The pronouncement continues: ‘It (sec. 16(b)) simply guards against the use of inside information since such information is not the personal property of the insiders themselves and since any profits resulting from its use belong to the insiders no more than does the information itself.‘ The majority is not ‘swayed by this characterization.‘ I would accord it more weight. Neither can I disregard the subsequent actions of the Commission in ameliorating the effect of section 16(b) so far as purchases by corporate officers of equities in their corporation or it subsidiaries pursuant to stock options, bonus plans, etc., are concerned. 17 C.F.R., section 240.16b-3. While the applicability of these actions is not too clear in the case at hand, the amendments made by the Commission indicate to me that the policy of the Securities Exchange Act with reference to transactions of the kind here involved is not as well defined as the prevailing opinion argues.
In my opinion, to allow this petitioner to deduct for tax purposes the amount he was required to pay over to the corporation will in no way interfere with the policy of the Securities Exchange Act of 1934. The exaction of that statute is more remedial than penal in providing that the profits of the transaction inure to the corporation rather than to the individual, and the payment made should have been allowed as a deduction.
ARUNDELL, VAN FOSSAN, BLACK, and JOHNSON, JJ., agree with this dissent.