Divine v. Commissioner

Rapid American Corporation (Rapid) was a publicly owned corporation with over 2,000 shareholders and over 2,000,000 shares of issued stock. From 1957 to 1962, Rapid offered its employees bargain stock options, meaning the employees could purchase shares of stock in Rapid at prices below fair market value. During this time, Rapid received around $1,890,000 for shares of stock worth $5,300,000. Harold and Rita Divine (plaintiffs) owned 37,000 shares of Rapid in 1961 and 40,000 shares in 1962. The Divines received distributions of approximately $18,500 in 1961 and $20,500 in 1962. Rapid told the Divines and its other shareholders that they did not have to report the distributions as dividends on their income-tax returns because Rapid’s earnings and profits were not sufficient to pay out the distributions as dividends. In coming to this conclusion, Rapid subtracted from its earnings and profits as business expenses the difference between the fair market value of the stocks it sold its employees and the bargain prices the employees paid. The Divines did not include the distributions from Rapid as ordinary income on their income-tax return. The Commissioner of Internal Revenue (the Commissioner) determined deficiencies against the Divines. The Commissioner argued the distributions were taxable income because they were dividends paid out of Rapid’s earnings and profits. The United States Tax Court upheld the Commissioner’s determination, holding that Rapid was not allowed to reduce its earnings and profits by the difference between the bargain prices its employees paid to exercise their stock options and the fair market value of the shares of stock. The Divines appealed.