Commissioner v. Gordon

Background

A.T.&T. caused its subsidiary Pacific to create a new company, Northwest, to serve three States and planned to transfer Northwest shares to Pacific shareholders. In 1961 Pacific issued transferable rights allowing shareholders to buy Northwest stock for $16 plus multiple rights; that offering moved about 57% of Northwest’s stock. The IRS ruled that selling or exercising those rights could produce ordinary income equal to the difference between $16 and fair market value. Two small shareholders exercised or sold rights and did not report income. The Tax Court applied the tax‑free spin‑off rule (§355), but appeals courts disagreed, producing a circuit split the Supreme Court resolved here.

Reasoning

The main question was whether the 1961 action qualified for nonrecognition under §355, which requires that the distributing company transfer all or at least 80% control of the subsidiary as part of the distribution. The Court held the 1961 transfer conveyed only about 57% and therefore did not meet §355(a)(1)(D). The majority rejected the idea that a later 1963 sale could be counted in 1961 unless, at the time of the 1961 distribution, there was a binding, identifiable commitment to complete the divestiture. The Court emphasized that tax consequences must be determinable when the transaction occurs. As a result, shareholders who exercised or sold rights in 1961 realized ordinary income equal to the difference between $16 and fair market value at exercise.

Real world impact

This ruling means partial or staged stock distributions without a clear, binding plan to transfer control can trigger immediate ordinary income for shareholders who exercise or sell rights. It affects corporations using transferable purchase rights and shareholders receiving below‑market opportunities in staged reorganizations. The Court affirmed the Ninth Circuit and reversed the Second Circuit, while leaving other possible tax defenses under different Code sections for the Tax Court to consider.