Commissioner of Internal Revenue v. Gordon

American Telephone and Telegraph Company held 90 percent of the stock of its subsidiary, Pacific Telephone and Telegraph Company (Pacific). Pacific was divided, and operations in Oregon, Washington, and Idaho were transferred into Pacific Northwest Bell Telephone Company (Northwest). Operations in California remained in Pacific. The spin-off plan initially transferred about 57 percent of the Northwest stock to shareholders of Pacific in 1961, with the remainder expected to be sold within three years, as capital was needed, at a price determined by the board of directors. The remaining 43 percent of the shares were distributed two years later. Gordon (plaintiff) was a minority shareholder of Pacific. In 1961, Gordon exercised rights to purchase 256 shares of Northwest at $16 per share in accordance with the division plan; the fair market value of Northwest shares at the time was $26 per share. Gordon sold the remaining rights under the plan for $6.36 at the same time. Gordon did not report any income from the transactions on his 1961 tax return. The commissioner of Internal Revenue (defendant) assessed tax, contending that the $6.36 was ordinary income and that the difference between the price paid for the Northwest shares and the fair market value ($10 per share, or $2,560) also was ordinary income. Gordon appealed to the United States Tax Court, which entered judgment in favor of Gordon. The commissioner appealed to the United States Court of Appeals for the Second Circuit, which ruled that the income was taxable as capital gain rather than ordinary income. Gordon appealed the decision to the United States Supreme Court, which granted certiorari and combined the case with a related case from the Ninth Circuit Court of Appeals (Baan v. Commissioner of Internal Revenue) in order to reconcile a conflict between the two circuits.