Before Goodrich, McLAUGHLIN, and Kalodner, Circuit Judges.
This appeal is taken from the judgment of the United States District Court for the Western District of Pennsylvania in favor of T.F. Soles, as Executor, ("Taxpayer"), in the amount of $10,201.39, with interest, representing a refund of estate taxes.*fn1
Two questions are presented: (1) Whether a stock divident results where a corporation increases its capital account by a transfer from surplus and pursuant thereto effects a split-up of its common stock; and (2) whether a proportionate share of stock received by trustees of a testamentary trust in a recapitalization, decedent having been an income beneficiary of such a trust, is includible in decedent's gross estate, under Section 811(a) of the Internal Revenue Code.*fn2
The decedent, Terrissa C. Soles, was one of the income beneficiaries of a trust created by will of Terrissa C. McCune, who died June 8, 1934. The trust was for a ten-year term and the decedent had a one-third interest therein. Decedent died December 4, 1940, during the life of the trust.
The instant controversy arises out of the fact that the trust numbered among its assets 48 shares of stock of the Hookless Fastener Co., Inc. ("Corporation").*fn3 Corporation's Board of Directors on August 5, 1937, retired a number of shares held as treasury stock and transferred a substantial amount from surplus to capital account with the result that the stated value of the stock was increased from $900 to $1250 a share.*fn4 On October 5, 1937, the shares of Corporation were split up 250 to 1 upon approval by the stockholders of a proposal made by the directors at the August 5th meeting. As a result, the trust received 12,000 shares of the new stock in exchange for the old 48 shares.*fn5
Since these events took place during the period when the decedent was an income beneficiary of the residuary trust, the Commissioner determined that (1) there had been a stock dividend distribution; (2) the proportionate part of the new stock attributable to the amount transferred from surplus belonged to the tenants of the trust under the Pennsylvania Rule of Apportionment; and (3) decedent's share thereof was includible in her gross estate under Section 811(a) as property belonging to it although no apportionment ever took place.*fn6 According to the Commissioner, the transfer from earned surplus to capital and the increase in the shares of stock which included surplus were the equivalent of a declaration of a dividend of stock to the extent of onethird of 70/250ths of 12,000 shares or to 1,120 shares of common stock which should have been paid over to the decedent as a life tenant.*fn7
The Taxpayer contends that the Corporations' transfer from surplus to capital was separate and independent from the stock split-up and that the issuance of new shares for the old neither constituted a stock dividend, nor gave rise to a situation calling for apportionment of the new shares between income beneficiaries and remaindermen under Pennsylvania law. Finally, the Taxpayer urges that the decision of the Orphans' Court of Allegheny County in the Walker Estate*fn8 is controlling in the instant case.
The District Court subscribed in toto to the Taxpayer's contentions as above stated. It made a specific finding that the transfer from surplus to capital and the subsequent issue of the split-up stock "was not the equivalent of a declaration of a stock dividend or an apportionable distribution"*fn9 and accordingly entered judgment for the Taxpayer.
We approach consideration of the issues involved in this appeal with the wellsettled principle in mind that "State law creates legal interests and rights. The federal revenue acts designate what interests or rights, so created, shall be taxed." Morgan v. Commissioner, 1940, 309 U.S. 78, 80, 626, 60 S. Ct. 424, 426, 84 L. Ed. 585, 1035.
Our first problem is to determine whether a stock dividend resulted by reason of the transfer from surplus to capital and the subsequent stock split-up.
A stock dividend permits a corporation to retain for corporate purposes its accumulated profits and at the same time, in effect, to distribute such profits among its stockholders. The customary procedure incident to the creation and distribution of a stock dividend is as follows: (1) The capital stock is increased; (2) the new stock is paid up (by the corporation) with the accumulated corporate profits; (3) the new shares of paid-up stock are then distributed among the stockholders pro rata as a dividend.*fn10
In the instant case the Corporation followed the usual design in the stock dividend pattern when it capitalized $1,282,500 of its accumulated profits in the surplus account, increased authorized capital stock from 3906 shares without par value to 1,000,000 shares $5.00 par value, and issued 250 shares of the new stock for each share of the old. In our opinion the proportionate part of the new stock attributable to the amount transferred from surplus to capital constituted a stock dividend.*fn11
Our conclusion that a stock dividend eventuated brings us to the second question presented by this appeal: whether the Taxpayer's decedent, under Pennsylvania law, was entitled as an income beneficiary to a proportionate share of the stock dividend received by the trust estate.If she was, such share of the stock dividend is includible in her gross estate and taxable under Section 811(a). The fact that in the administration of the McCune trust the stock dividend was never actually distributed or credited to the decedent and ...