The United States Supreme Court's 1924 Weiss v. Stearn decision involved a classic case of corporate dilution. In that case, a corporation ("Oldco') transferred its business to a new corporation ("Newco ') in a transaction in which the Oldco shareholders surrendered all their stock for 50 percent of the stock of Newco (and cash). The transaction diluted the proprietary interest of the Oldco shareholders from 100 percent to 50 percent. Because the Oldco shareholders surrendered control of the enterprise, the 50 percent interest they received in Newco was fundamentally different from the 100 percent interest they had owned in Oldco.
Nevertheless, the Court held that the receipt of the Newco shares was not a taxable event (a "realization event") to the Oldco shareholders. The Court reached this result by ignoring the dilution that occurred in the case.
In 1991, the Supreme Court resurrected the Weiss v. Stearn decision in the Cottage Savings case. There, the Court relied on Weiss v. Stearn to establish that the exchange of property triggers a realization event only if the property received is "materially different" from the property surrendered Once again, the Court ignored the dilution that occurred in Weiss v. Stearn. As a result, Supreme Court jurisprudence sheds no light on the question of whether corporate dilution can trigger realization.
Corporate dilution is a common phenomenon. It can result from an actual exchange of proprietary interests, like the transaction in Weiss v. Stearn. It can also occur when a shareholder does not physically transfer shares. For example, if a sole shareholder of a corporation sells 50 percent of her stock to a third party, the diluted 50 percent interest she retains is as different from the 100 percent interest she previously owned, as were the interests in Weiss v. Stearn. Notwithstanding the pervasiveness of dilutive transactions, no significant scholarship addresses the impact of dilution on realization.
This Article explores the fundamental question of when corporate dilution should trigger realization. By virtue of the "material difference" standard that emerged from Cottage Savings, the transaction in Weiss v. Steam should be treated as a realization event. Specifically, the loss of control that resulted from the Stearn transaction left the original shareholders with a materially different interest in the enterprise. More significantly, the material difference standard should be extended to treat realization as occurring in an equally dilutive transaction that does not entail a physical transfer of the diluted interest. As long as a material difference exists, the shareholder should be treated as engaging in a "deemed exchange" of the 100 percent interest for the 50 percent interest, thereby triggering a realization event. Now that nine decades have passed since the Stearn decision was rendered, it is high time for the impact of dilution on realization to be clarified.
Copyright 2015 Jeffrey L. Kwall.