W. G. Maguire & Co. v. Commissioner

W. G. Maguire & Co., Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent. William G. Maguire, Petitioner, v. Commissioner of Internal Revenue, Respondent. Marian L. Maguire, Petitioner, v. Commissioner of Internal Revenue, Respondent W. G. Maguire & Co. v. Commissioner Docket Nos. 36033, 36034, 36035 United States Tax Court 20 T.C. 20; 1953 U.S. Tax Ct. LEXIS 200; April 8, 1953, Promulgated *200 Decisions will be entered under Rule 50. 1. Mokan Corporation acquired Panhandle Eastern stock at a cost of $ 47.86 per share. During 1944, Mokan issued to its stockholders rights to buy Panhandle Eastern stock at $ 30 per share, and on the date the rights were issued the fair market value of each share was $ 40. During the period the rights were being exercised the value of the shares increased. Stockholders of Mokan, among whom were the petitioners, purchased 151,958 shares of the stock. In computing Mokan's "earnings or profits" for the year 1944, the Commissioner would allow no deduction from net income based on the sale of the 151,958 shares, while petitioners, stockholders of Mokan, contend that the loss to be deducted is $ 17.86 per share. Held, as petitioners' evidence identified the shares of stock in question, the basis of the stock is as contended by petitioners. Held, further, Mokan sustained a loss of $ 7.86 per share on Panhandle Eastern representing the amount by which market value at the time of distribution was less than cost, and this loss is to be used in computing "earnings or profits of the taxable year" within the meaning of section 115 (a) of*201 the Code. Held, further, where a corporate distribution is made out of capital pursuant to section 115 (d), the distribution is not taxable as a dividend but is applied as a reduction of the cost basis of the stock under which such distribution was made. Held, further, to the extent of $ 10 per share (the discount allowed to stockholders) a distribution was made by the corporation and this distribution is not to be taken into account in computing the "earnings or profits of the taxable year," but is to be applied to a reduction in the cost basis of the taxpayers' stock in Mokan. 2. Petitioners W. G. Maguire & Co., Inc., and William G. Maguire sold their rights and returned part of the proceeds as capital gain using $ 1 per right as their cost basis of the rights sold. The Commissioner determined that the entire proceeds resulting from the sale of the rights were taxable as ordinary income to petitioners. Held, the petitioners correctly used $ 1 as the cost basis for each right sold and did not err in returning the gain from the sale of such rights as capital gain, therefore, the Commissioner erred in determining that the entire proceeds from the sale of rights were taxable*202 income to petitioners. Francis D. Higson, Esq., and Joseph H. Spicer, C. P. A., for the petitioners. Joseph F. Lawless, Esq., for the respondent. Black, *203 Judge. BLACK *21 Respondent has determined deficiencies in petitioners' Federal taxes for the calendar year 1944, as follows: Amount of Delinquency Docket No. Tax deficiency penalty 36033 Income $ 1,579.66 Declared value excess-profits 946.04 Personal holding company surtax 6,926.61 $ 1,731.65 36034 Income 39,591.00 36035 Income 148.95 The three petitioners in these proceedings were all stockholders of Missouri-Kansas Pipe Line Co., a corporation hereinafter referred to as "Mokan." Inasmuch as the three proceedings involve common issues arising from the distributions of Mokan, the proceedings have been consolidated. In Docket No. 36033, W. G. Maguire & Co., Inc., petitioner, the deficiencies result from three adjustments to the net income reported on petitioner's return as follows: (a) Income from sale of stock rights $ 33,166.00 (b) Dividend income 4,403.45 (c) Expenses -- Dixon vs. W. G. Maguire & Co., Inc 1,381.50 $ 38,950.95 The adjustments are explained in the deficiency notice as follows: (a) In your return you reported as income $ 17,742.98 gain on sale of 33,166 rights to purchase stock of the Panhandle Eastern Pipe Line*204 Co. It is held that the correct income on this transaction was $ 50,908.98, the entire proceeds received on the sale. Net income has accordingly been increased $ 33,166.00. (b) During the taxable year you received a cash distribution of $ 18,241.30 from the Missouri-Kansas Pipe Line Co. It is held that of this distribution 24.14% or $ 4,403.45 constituted a taxable dividend. (c) It is held that deduction in the amount of $ 42,514.94 claimed on your return for this item, was overstated in the amount of $ 1,381.50. Petitioner does not assign any error as to adjustment (c). Petitioner does, however, assign errors as to adjustments (a) and (b) as follows: 5. The Commissioner erroneously determined that the entire proceeds of $ 50,908.98, or any part thereof, from the sale by petitioner of all of the rights which it received as a stockholder of the Missouri-Kansas Pipe Line Company (hereinafter referred to as Mokan) to purchase shares of stock of Panhandle Eastern Pipe Line Company constituted taxable income. 6. The Commissioner also erroneously determined that 24.14% of $ 18,241.30 or the sum of $ 4,403.45, or any part of said sum of $ 18,241.30 which was distributed in cash during*205 the year 1944 by Mokan to petitioner as a stockholder thereof constituted a taxable dividend or taxable income of any kind. *22 In Docket No. 36034, William G. Maguire petitioner, the deficiency results from four adjustments made by the Commissioner to the net income as disclosed by petitioner's return, as follows: (a) Dividend income $ 8,608.88 (b) Alimony 946.54 (c) Other income (1) 495.70 (2) 75,702.03 Nontaxable income and additional deductions: (d) Capital gain 12,098.48 Adjustment (a) is explained in the deficiency notice as adjustment (b) was explained in the deficiency notice to W. G. Maguire & Co., Inc., Docket No. 36033, above. Adjustments (c) (1) and (c) (2) and (d) are explained in the deficiency notice as follows: (c) (1) It is determined that you should have reported in your return $ 495.70. This amount represents 24.14% of the amount of a distribution of rights to subscribe to Panhandle Eastern Pipe Line Co. stock issued by Missouri-Kansas Pipe Line Co., computed as follows: [Here follows the details of the computation not needed here.] (c) (2) and (d) In your return you reported as income $ 12,067.24 gain on sale of 64,343 11/20ths*206 rights to purchase stock of Panhandle Eastern Pipe Line Co. 740 of these rights were acquired by you by purchase and the loss on their sale in 1944 was $ 31.24. You therefore computed in your return a gain of $ 12,098.48 on the sale of the balance of the rights. On the sale of this balance, representing rights received as a distribution from Missouri-Kansas Pipe Line Co., you received $ 75,702.03. It is determined that the entire proceeds of $ 75,702.03 constitutes income. * * * To the foregoing adjustments petitioner William G. Maguire assigned errors as follows: 5. The Commissioner erroneously determined that 24.14% of $ 35,662.33 or the sum of $ 8,608.88 or any part of said sum of $ 35,662.33 which was distributed in cash during the year 1944 by Missouri-Kansas Pipe Line Company (hereinafter referred to as Mokan) to petitioner as a stockholder thereof constituted a taxable dividend or taxable income of any kind. 6. The Commissioner erroneously determined that 24.14% of $ 2,053.44 or the sum of $ 495.70 or any part of said sum of $ 2,053.44 (which represents the excess of the fair market value of 114.08 shares of common stock of Panhandle Eastern Pipe Line Company on August *207 12, 1944, at $ 48 per share over the purchase or subscription price thereof at $ 30 per share) constituted a taxable distribution or other taxable income to petitioner. 7. The Commissioner also erroneously determined that the entire proceeds of $ 75,702.03, or any part thereof, from the sale by petitioner of all of the rights which he received as a stockholder of Mokan to purchase shares of stock of Panhandle Eastern Pipe Line Company, exclusive of 740 rights which he purchased and thereafter sold and of 1140 16/20 rights which he transferred by gift to his wife, constituted taxable income. In Docket No. 36035, Marian L. Maguire petitioner, the deficiency is due to three adjustments made by the Commissioner to the net income as reported on her return, as follows: *23 (a) Dividend income $ 114.08 (b) Other income 373.34 (c) Medical expense 24.37 Adjustments (a) and (b) are explained in the same manner as similar adjustments made in Docket No. 36034, William G. Maguire petitioner, under the heading of adjustments (a) and (c) (1). Petitioner's assignments of error as to adjustments (a) and (b) are similar to assignments of error made in Docket No. 36034, William G. *208 Maguire petitioner, contesting similar adjustments made in his case. Petitioner does not assign error as to adjustment (c) relating to medical expenses. FINDINGS OF FACT. Many of the facts have been stipulated and are found accordingly. As stockholders of Mokan the petitioners received during the taxable year 1944 two cash distributions and also they received a distribution of rights entitling them to purchase shares of stock of Panhandle Eastern Pipe Line Company, hereinafter referred to as "Panhandle Eastern," at $ 30 per share, which shares of stock were owned by Mokan. The petitioner W. G. Maguire & Co., Inc., is a corporation organized and existing under the laws of the State of Delaware. The petitioner William G. Maguire is an individual whose principal business office is in New York City. The petitioner Marian L. Maguire is an individual residing in New York City. Petitioners' tax returns for the taxable year 1944 were filed with the collector of internal revenue at Chicago, Illinois. Rights Issued by Mokan to Purchase Shares of Panhandle Eastern. Since the organization of W. G. Maguire & Co., Inc., it has been engaged in the business of holding securities and during*209 the taxable year all of its income was from securities. It had outstanding 1,000 shares of common stock, of which William G. Maguire owned 500 shares, Jessie J. Maguire owned 250 shares, and Marian L. Maguire owned 250 shares. The shares of stock of Mokan were owned by petitioners on July 12, 1944, in the following amounts: Common capital Class B common Petitioner stock capital of Mokan stock of Mokan W. G. Maguire & Co., Inc 33,166 William G. Maguire 57,550 143,822 Marian L. Maguire 17,184 On the same day, July 12, 1944, Mokan issued to its stockholders pro rata rights to purchase from Mokan shares of the common capital *24 stock of Panhandle Eastern (such shares being owned by Mokan) at $ 30 per share. One right was issued for each share of Mokan common, and one-twentieth of a right was issued for each share of Class B common of Mokan. Ten rights were necessary in order to purchase one share of Panhandle Eastern. The fair market value on July 12, 1944, of the rights issued by Mokan to purchase Panhandle Eastern common stock was $ 1 per right. W. G. Maguire & Co., Inc., as a stockholder of Mokan, received 33,166 of said rights; it sold its rights*210 in 1944 for $ 50,908.88. William G. Maguire received 63,603 11/20 rights. On July 12, 1944, he transferred by gift to Marian L. Maguire, his wife, 1,140 16/20 of his rights and later, in 1944, he sold the remainder, 62,462 15/20 of his rights, for the sum of $ 75,702.03. Marian L. Maguire received 859 4/20 rights. She exercised an aggregate of 2,000 rights consisting of the 859 4/20 rights received by her as a stockholder and the 1,140 16/20 rights received by her as a gift. Upon such exercise she acquired 200 shares of Panhandle Eastern for $ 6,000. At the time of the issuance of such rights Mokan had approximately 13,500 stockholders of whom about 1,300 could not be located. The Panhandle Eastern stock owned by Mokan was acquired as follows: Date No. of shares Cost Cost per share Dec. 31,1937 324,326 $ 15,522,198.72 $ 47.86 Sept. 30, 1939 14,949 664,914.74 44.48 May 24, 1940 — 100 — 3,316.00 33.16 May 27, 1940 — 100 — 3,316.00 33.16 Mar. 30, 1943 202,163 5,250,236.90 26.12 541,638 $ 21,443,982.36 Sold Apr. 8, 1943, from acquisition Mar. 30, — 1943 — 10,000 261,156.50 Balance Jan. 1, 1944 531,638 $ 21,182,825.86 In 1943, under a contract dated March*211 31, 1943, Phillips Petroleum Company purchased 404,326 shares of the common capital stock of Panhandle Eastern at $ 26.12 per share from the Columbia Oil & Gasoline Corporation, one-half for its own account and one-half for the account of Mokan. In order to finance the acquisition of these additional 202,163 shares of Panhandle Eastern common stock, Mokan borrowed $ 5,050,000. On February 14, 1944, the board of directors of Mokan, after deciding to pay the indebtedness, proposed as a means of raising funds, that Mokan sell to its stockholders through the issuance of rights, 163,710 shares of Panhandle Eastern common stock at $ 30 per share. Subsequently, Mokan actually sold to its stockholders during the period commencing in July and ending in November 1944, at $ 30 per share, 151,958 shares of Panhandle Eastern common stock. *25 The total consideration thus received was $ 4,558,740. These 151,958 shares were a part of the block of 324,326 shares of Panhandle Eastern acquired by Mokan on December 31, 1947, at a cost of $ 47.86 per share. On or about August 25, 1944, Mokan sold in the open market, 6,000 additional shares of Panhandle Eastern common stock at an average of*212 $ 46.125 per share, or for a total sum of $ 276,750. During 1943 and 1944, Panhandle Eastern had outstanding 810,000 shares of common capital stock. Of these shares, on July 12, 1944, Mokan held 531,638, Phillips Petroleum Company held 202,163, 16,300 shares were held by seven other persons, and the balance of the stock amounting to 59,899 shares was held in small lots by numerous stockholders. The transactions whereby Mokan transferred to its stockholders pursuant to rights issued to them 151,958 shares of Panhandle Eastern common stock at $ 30 per share were treated by Mokan in its books of account as sales of assets and not otherwise. Mokan made no charge against or deduction from its profit and loss, or earnings account, its earned surplus account, or its paid-in surplus account in connection with or as a result of the issuance of the rights issued to purchase Panhandle Eastern common stock. Mokan's deficit in earned surplus on December 31, 1943, was $ 2,184,094.12. Mokan computed its earnings or profits for the year 1944 available for dividends (without regard to any earnings or profits or deficit at the beginning of such year) to be a deficit of $ 4,943,535.08, while respondent*213 has computed net earnings of $ 856,880.94. The differences in the two computations are illustrated by the following: Statement of Mokan's Earnings of Profits Available for Dividends -- Year 1944 Per Mokan Per Commissioner Net taxable income $ 1,009,452.12 $ 1,009,452.12 Deduct: Federal income tax 60,660.32 60,561.18 Loss on sale of Kentucky Nat. Gas Corp. stock 3,167,347.00 81,000.00 Loss on sale of 6,000 shares of Panhandle Eastern Pipe Line Co. com. stock 11,010.00 11,010.00 Loss on sale of 151,958 shares of Panhandle Eastern Pipe Line Co. com. stock sold to stockholders 2,713,969.88 Net earnings available for dividends ($ 4,943,535.08) $ 856,880.94 On July 11, 1944, the bid prices for Panhandle Eastern common ranged from 38 1/2 to 40 and the asked prices from 40 1/2 to 41 1/4. The average bid and asked price per share of Panhandle Eastern common on August 11, 1944, was 48. The fair market value of Panhandle Eastern stock on the day Mokan issued the rights was $ 40 per share. *26 Cash Distribution to Mokan Stockholders. During the year 1944 Mokan made two cash distributions*214 to its stockholders, petitioners receiving sums as follows: W. G. Maguire & Co., Inc $ 18,241.30 William G. Maguire 35,662.33 Marian L. Maguire 472.56 Both of these cash distributions were made subsequent to the adoption of the Mokan Plan, which is hereinafter considered in some detail. Mokan Plan of Liquidation. On December 23, 1929, Panhandle Eastern was organized in Delaware and through this company, which became a wholly-owned subsidiary of Mokan, Mokan initiated and carried on the construction of a natural gas pipe line from the Panhandle of Texas through Kansas, Missouri, and Illinois, to a place near Indianapolis. As a means of obtaining funds for the construction of the pipe line, Mokan sold in 1930 to Columbia Oil & Gasoline Corporation (hereinafter referred to as Columbia Oil) one-half of the stock of Panhandle Eastern and, in effect, pledged in 1931 the remaining one-half of the Panhandle Eastern stock. On March 18, 1932, receivers in equity were appointed for Mokan in the equity courts of Delaware. Shortly thereafter, Columbia Oil acquired from Mokan the balance of the Panhandle Eastern stock. On March 6, 1935, the United States, by the Attorney General, *215 commenced an antitrust suit against Columbia Oil, Columbia Gas & Electric Corporation, and others involving the Mokan-Panhandle Eastern-Columbia situation. On January 20, 1936, a consent decree was entered in the suit requiring Columbia Oil to return to Mokan one-half of the stock of Panhandle Eastern. At this time there were 648,652 shares of Panhandle Eastern stock issued and outstanding. Mokan acquired 324,326 shares and, in addition, rights to subscribe for 80,000 shares, which rights were required to be distributed by Mokan to its stockholders. Columbia Oil retained the other 324,326 shares and, in addition, Columbia Oil exercised its rights to subscribe for 80,000 shares of Panhandle Eastern. As a result of this arrangement, Mokan held 324,326 shares of Panhandle Eastern and Columbia Oil held 404,326 shares. In 1943 Columbia Oil, after various actions had been started against it by Mokan and after proceedings before the Securities and Exchange Commission, agreed to divest itself of these 404,326 shares. Phillips Petroleum, acting on behalf of itself and Mokan, acquired the shares by purchase, each receiving one-half of the shares. These shares acquired by Mokan increased*216 Mokan's holdings in Panhandle *27 Eastern to 531,638 shares, or to approximately 65.63 per cent of all of Panhandle Eastern's stock, Mokan having acquired meanwhile 5,149 shares in the market. Mokan was released from its receivers in 1937. Prior to its release from receivership, a meeting of the stockholders of Mokan was held pursuant to the order of the Chancery Court of Delaware. At this time the question was raised whether Mokan should be completely liquidated. Two slates of directors were presented to the stockholders of Mokan. The two slates were backed by two contending groups of stockholders -- one slate represented by the Murphy Committee, also known as the National Committee, favored complete liquidation of Mokan, and the other slate represented by the Maguire Committee, also known as the Protective Committee for Stockholders, was opposed to liquidation. The stockholders elected the slate of directors proposed and supported by the Maguire Committee. In a letter dated June 7, 1937, the Protective Committee of Mokan explained its position to the Class B stockholders of Mokan in the following manner: There is only one issue facing Mo-Kan: Shall the company be dissolved*217 and the Columbia interests be allowed to operate the very profitable Panhandle Eastern Pipe Line, or shall Mo-Kan stockholders stick together and insist that the pipe line be operated so as to make the most money, no matter whose toes are stepped on? The "National" Committee advocates scrapping Mo-Kan. Parish, who supports this committee, also wants to scrap Mo-Kan. We have no doubt that the Columbia interests would be delighted if Mo-Kan were scrapped. We do not believe that Mo-Kan stockholders want it scrapped. Thousands of the common stockholders who voted in March sent us proxies to vote their stock because we were opposed to dissolution. By a letter dated July 31, 1937, the same committee advised all the stockholders of Mokan as follows: The two opposing proxies you are asked to sign differ essentially only in this respect: The Murphy Committee proxy authorizes them to cast your vote upon any and all proposals for the Liquidation and distribution of the assets of said company The Murphy Committee has stated that it was formed to procure a distribution of the Mo-Kan assets. Our proxy authorizes us To Vote Against any and all proposals for the liquidation of said*218 company. In a letter dated December 31, 1942, William G. Maguire, president of Mokan, stated to Mokan stockholders that at the time of the reorganization of Mokan in 1937, the management sought to attain four principal objectives: (1) the acquisition by Panhandle Eastern of the pipe line extension to Detroit, Michigan, then owned indirectly by Columbia Gas and Electric Corporation, (2) cancellation of the voting power of 10,000 shares of Class B preferred stock of Mokan all owned *28 by Columbia Oil & Gasoline Corporation, (3) retirement of 100,000 shares of Class A preferred stock of Mokan, then all owned by Columbia Oil & Gasoline Corporation, and (4) the divestment by the Columbia companies of their 50.1 per cent common stock interest in Panhandle Eastern. Maguire announced in his letter to the stockholders that the first three objectives had been accomplished, and in respect to the fourth principal objective he stated: 4. On July 7, 1942 a new settlement was made by the Columbia Companies which, so far as it affects Mo-Kan, accomplishes, among other things, the following: (a) Columbia Oil is to sell all of its Panhandle Eastern Common Stock, amounting to 50.1%, to Phillips*219 Petroleum Company for the joint account of that Company and ourselves. Your Company will then own approximately 66% of the Common Stock of Panhandle Eastern and Phillips Petroleum will own approximately 25%, the balance being publicly held. (b) All litigation between your Company and the Columbia System will be terminated. This settlement plan after extended hearings, has been approved by the Securities and Exchange Commission and submitted to the stockholders of Columbia Oil & Gasoline Corporation for their approval. The Columbia Oil meeting was held on December 30, 1942, but the results were not known in time to be included in this letter. You will be advised as to this later. It is obvious, of course, that the results to be obtained by this settlement agreement will be of great benefit to Mo-Kan and its stockholders. In the annual report made to Mokan stockholders on February 19, 1943, further reference to the July 7, 1942, settlement was made to the effect that: (a) Columbia Oil will sell to Phillips Petroleum Company for the joint account of itself and Mokan the 404,326 shares of common stock of Panhandle Eastern now owned by Columbia Oil at the price of $ 25.81 per share, *220 subject to certain minor adjustments. At the same time, Columbia Oil will tender to Panhandle Eastern for redemption and retirement all of the Class B Preferred stock of Panhandle Eastern now owned by Columbia Oil. Upon such redemption and retirement the only stock which will have the right to elect directors will be the common stock. As Mokan will acquire 202,163 additional shares of said stock, it will then have a total of 541,638 shares, or approximately 67%. (b) Phillips Petroleum Company will enter into a contract with Panhandle Eastern under which it will dedicate to Panhandle Eastern 175,000 acres of proven gas reserves in the Hugoton field in Oklahoma and Texas. This contract was negotiated by your company. Geologists and gas engineers have estimated that the reserves underlying this area will approximately double the gas reserves of Panhandle Eastern in that field. Testimony before the Securities and Exchange Commission in 1942 has established that if Panhandle Eastern is to greatly expand its sales in the future it must have large additional gas reserves such as are contemplated by this contract. We believe that Panhandle Eastern can greatly increase its sales if *221 allowed to carry out the policies of your company and therefore we believe that the Phillips Petroleum Company contract will prove highly beneficial and of great value to Panhandle Eastern upon the consummation of the present Plan. *29 (c) Mokan will deliver general releases to Columbia Gas and Columbia Oil and the officers and directors of each company, and certain other individuals, and will use its best efforts to procure appropriate Court orders dismissing all actions and proceedings against Columbia Gas, Columbia Oil and others, now pending in any Court in which Mokan is plaintiff. This settlement was approved by the Securities and Exchange Commission, the Columbia Oil stockholders, and the Mokan stockholders. In a letter to Mokan stockholders dated November 3, 1943, Maguire as president of Mokan stated: Under date of March 31, 1943, a contract was entered into among Mokan, Phillips Petroleum Company, and the Columbia Companies, ending the long fight to reestablish Mokan's position in the ownership of the capital stock of Panhandle Eastern Pipe Line Company. * * * * Under the terms of this settlement, Mokan acquired 202,163 additional shares of Panhandle's capital stock*222 at a cost of $ 26.12 per share. This acquisition gives to Mokan a present ownership of approximately two-thirds of the total outstanding common capital stock of Panhandle Eastern. These 202,163 shares have now a quoted market value of over two and one-half million dollars more than we paid for them. Maguire explained to the stockholders of Mokan that the directors at an adjourned meeting on November 3, 1943, adopted unanimously a resolution appointing a committee to consider and report on the most appropriate steps to be taken "to effect the orderly liquidation of Mokan and to guarantee the continued independent operation of Panhandle Eastern." The board of directors of Mokan met on February 14, 1944, and adopted resolutions to the effect: WHEREAS, the principal asset of this Corporation consists of 531,638 shares of the common capital stock of Panhandle Eastern Pipe Line Company (herein referred to as "Panhandle Eastern"); and WHEREAS, as of the date hereof this Corporation is indebted to banks and insurance companies in the sum of $ 5,050,000, with interest from February 1, 1944, and as collateral security for the repayment thereof this Corporation has deposited 372,147 shares*223 of the common capital stock of Panhandle Eastern, (herein referred to as the "secured debt"); and WHEREAS, this Board deems it for the best interests of this Corporation to repay its secured debt at the earliest possible date, and is of the opinion that this may best be accomplished by offering to the stockholders of this Corporation the right to purchase such number of its shares of Panhandle Eastern which, at the price offered, will be sufficient to repay the secured debt; and WHEREAS, many of the stockholders of this Corporation have urged that they be afforded the opportunity to exchange their shares in this Corporation for shares of the common stock of Panhandle Eastern owned by this Corporation; and WHEREAS, after the sale of the Panhandle Eastern shares required for the repayment of this Corporation's secured debt as aforesaid, this Corporation will own approximately 367,928 shares of Panhandle Eastern common stock, and it is proposed to offer substantially all of said Panhandle Eastern shares in exchange for shares in this Corporation on the basis hereinafter set forth; and *30 WHEREAS, in the opinion of the Board of Directors, the said objectives are desirable and for*224 the best interests of this Corporation and its stockholders. NOW THEREFORE, BE IT RESOLVED, that subject to ratification by a majority of the stockholders of this Corporation, and as and when the Registration Statement of Panhandle Eastern to be filed with the Securities & Exchange Commission, as hereinafter set forth, shall become duly effective, the following steps and proceeding shall be taken, to wit: FIRST The Directors shall set the record date (which shall be not longer than thirty (30) days after the Registration Statement shall become effective) for determining the stockholders entitled to notice of and the right to purchase the shares of Panhandle Eastern as aforesaid, and within said thirty (30) days, the officers of this Corporation shall offer to such registered holders of its common and Class B capital stock the Right to purchase, pro rata, 163,710 shares of the common capital stock of Panhandle Eastern owned by this Corporation, at the price of Thirty ($ 30) Dollars per share, and each such registered stockholder shall have the Right, within forty (40) days from the record date to purchase the pro rata number of shares of Panhandle Eastern to which the registered holder*225 may be entitled, under the following terms and conditions: I Subject to the provisions set forth in subdivision "II" hereof, there shall be issued to the registered holders of the capital stock of this Corporation transferable Rights to purchase 1/10th of a share of the common stock of Panhandle Eastern owned by this Corporation at the price of Thirty ($ 30) Dollars per share for (a) each share of common capital stock, or (b) every 20 shares of Class B capital stock, owned by them respectively in this Corporation. II The said Rights shall be subject to combination and division with respect to holders of both the common and Class B capital stock of this Corporation, but no fractional shares of the common stock of Panhandle Eastern shall be sold by this Corporation; and the said Rights shall expire forty (40) days after the record date as aforesaid. III Said Rights shall be in such form as may be determined by the officers of this Corporation with the advice of counsel. IV If any part of the secured debt remains unpaid after application of the proceeds derived from the sale of the shares of stock of Panhandle Eastern as aforesaid, then and thereupon, with respect to the shares of Panhandle*226 Eastern which shall not have been purchased by the stockholders of this Corporation entitled to purchase the same, as aforesaid, the officers shall be and they hereby are authorized, empowered and directed to sell, at the best price obtainable, enough of such remaining shares of common stock of Panhandle Eastern as may be necessary to pay in full this Corporation's secured debt; V The proceeds received from the exercise of any and all such Rights of purchase, as well as from the sale of any and all shares as to which Rights shall not have been exercised, as aforesaid, shall be promptly applied to the payment in full of this Corporation's secured debt. SECOND Upon the payment in full of this Corporation's secured debt, the Board of Directors shall immediately take all such steps as may be necessary to offer to the stockholders of this Corporation the right to exchange, in kind, the shares of stock owned by them in this Corporation for substantially all the *31 remaining shares of Panhandle Eastern then owned by this Corporation, under the following terms and conditions: A The Corporation shall extend to the stockholders (by written notice to stockholders of record as of a date*227 to be fixed by the Board of Directors, and by publication at least once each month during the period and until the expiration of such offer, in a daily newspaper published and in general circulation in the Borough of Manhattan, City of New York) the right to exchange, in kind, shares of common and/or Class B capital stock owned by them in this Corporation for shares of Panhandle Eastern owned by this Corporation, and after such effective date has been fixed, such stockholders shall be notified of the right to exchange on the basis of two (2) shares of Panhandle Eastern for (a) every nine (9) shares of the common capital stock of this Corporation, or (b) every one hundred and eighty (180) shares of Class B stock of this Corporation, or (c) every combination of common stock and/or Class B stock of this Corporation equivalent to either nine (9) shares of the common stock or one hundred and eighty (180) shares of Class B stock thereof; and such right to make exchange shall remain in force up to the close of business hours on April 15, 1945 for any person who may have theretofore duly accepted said offer by surrendering certificates for shares of the capital stock of this Corporation as*228 herein provided. B Any certificate for any shares of stock of this Corporation so exchanged shall be promptly surrendered and cancelled by the Corporation or its Agent appointed for that purpose, and the said shares of stock shall revert to the status of authorized but unissued stock, and when and as all Rights of exchange shall have expired, the proper officers of this Corporation shall thereupon be and they hereby are authorized, empowered and directed to execute and file with the Secretary of the State of Delaware, in accordance with the provisions of the Laws of the State of Delaware, a Certificate for the Reduction of the Capital Stock of this Corporation to the extent of the number of shares thus surrendered and cancelled; This resolution (hereinafter referred to as the Mokan Plan) was adopted by the stockholders of Mokan at their adjourned meeting on March 27, 1944. The first part of the Mokan Plan was carried out during 1944, including the sale of 6,000 shares of Panhandle Eastern stock on the open market on August 25, 1944, for $ 276,750. The second part of the Mokan Plan has not been carried out. Its execution has been extended from time to time, and as of the date of*229 the hearing the last extension was to June 30, 1952. Between June and August 1951, Mokan had several conferences with representatives of the Bureau of Internal Revenue concerning a plan of liquidation under which the distribution of all corporate assets in complete cancellation of all outstanding stock would take place in one calendar month of 1951. In a letter to Mokan stockholders dated August 13, 1951, Maguire explained the conferences, and wrote: Therefore, in view of the uncertainty that the stockholders would receive the benefits of Section 112 (b) (7), the Board of Directors do not propose to recommend such liquidation in 1951. In order to preserve the opportunity *32 for those Stockholders who may desire to exchange their shares of Mokan, the Board of Directors at a meeting held August 7, 1951, recommended that a Stockholders Meeting be convened on September 14, 1951, to consider, and, if agreeable, to approve the recommendation of the Board of Directors that the Exchange Offer be extended until June 30, 1952, subject to earlier termination by action of the stockholders, under the terms of which a Stockholder of Mokan will have the right to exchange Common and/or *230 Class B Stocks of Mokan for shares of Common Stock of Panhandle Eastern Pipe Line Company and Common Stock of Hugoton Production Company at the rate of eight shares of Common Stock of Panhandle Eastern and two shares of Common Stock of Hugoton for every nine shares of Common Stock of Mokan or 180 shares of Class B Stock of Mokan or any combination of Common and/or Class B Stock as equivalent thereto, taking each share of Class B as equal to 1/20th of a share of Common Stock. * * * As of December 31, 1943, Mokan had outstanding 1,594,755 shares of common stock and 847,006 shares of Class B stock. Pursuant to the Mokan Plan, Mokan received its shares in exchange for Panhandle Eastern and Hugoton stock as follows: Mokan Capital Stock Retired Shares of Shares of Year common Class B — 1944 — 163,888 12,190 — 1945 — 531,783 52,740 — 1946 — 149,421 64,875 — 1947 — 85,139 31,610 — 1948 — 99,214 173,425 — 1949 — 15,381 4,905 — 1950 — 27,892 42,767 — 1951 — 33,980 21,095 An indication of the nature of Mokan's business is given by the following summary of its assets as of December 31, 1943: Investments: Panhandle Eastern (531,638 shares) $ 21,182,800 Kentucky Natural Gas (2,860 shares of preferred) 286,000 Kentucky Natural Gas (19,788 shares of common) 3,086,300 Cash and receivables 233,700 Furniture and fixtures (net) 2,400 Deferred charges 102,600 Total assets $ 24,893.800 *231 In 1944 Mokan paid off its secured debt of $ 5,050,000, the funds being derived mainly from the consideration of $ 4,558,740 received from its stockholders and from its cash on hand as of the beginning of the year and dividends received during 1944, and from the $ 276,750 received from the sale of 6,000 shares of Panhandle Eastern. In 1943 Mokan had three full-time salaried officers and seven other full-time employees; in 1944, it had three salaried officers, one of *33 whom was part-time, and six other employees, one of whom was part-time; in 1945, Mokan had two salaried officers, one of whom was part-time, and five other employees, one of whom was part-time; and in 1951, Mokan had two salaried officers, one of whom was part-time, and two other employees, one of whom was part-time. In 1945, Mokan gave up all its office space except two rooms, one of which was used as an office and the other as a storage room for corporate records. The two cash distributions made by Mokan to its stockholders in 1944 were both made subsequent to the adoption of the Mokan Plan. These cash distributions as well as the distribution of rights to purchase Panhandle Eastern stock were designated as*232 "distributions in liquidation" by Mokan on information reports filed with the Bureau of Internal Revenue. These distributions were not made in partial liquidation of Mokan. OPINION. The three petitioners have in common the fact that during the taxable year 1944, they were three of the many stockholders of Mokan corporation. The principal issue here relates to the distributions made by Mokan to its stockholders during the taxable year. Mokan distributed an aggregate of $ 878,584.80 in cash, and, in addition, rights entitling its stockholders to purchase Panhandle Eastern Pipe Line Company shares at $ 30 per share. Of the 163,710 shares offered to stockholders, Mokan sold through the exercise of rights a total of 151,958 shares. Respondent determined that 24.14 per cent of Mokan's distributions to its stockholders was taxable as dividends and this percentage was applied in determining the taxability of certain of the distributions received from Mokan by petitioners. According to respondent's computations the total of Mokan's distributions, including cash and the rights, amounted to $ 3,550,213.33, but only 24.14 per cent of this sum, or $ 856,880.94, constituted dividends. The*233 distributions were only to this extent dividends because of the limitations imposed by the amount of Mokan's statutory "earnings or profits" for the taxable year. Petitioners contend on several grounds that no part of Mokan's distributions constitutes dividends taxable to them as stockholders. Petitioners' contentions as summarized in their brief are as follows: Point I. The cash distributions received in 1944 by the petitioners as shareholders of Mokan were returns of capital either A. because Mokan had no earnings or profits available for the payment of dividends or B. because they were amounts distributed in partial liquidation of Mokan. Any excess of capital returned over taxable basis would be, of course, capital gain. Point II. No income resulted from the exercise of rights to purchase Panhandle Eastern stock; and income, if any, which resulted from the sale of such rights was capital gain. *34 As we see it, four issues are presented by the pleadings for our decision. The first issue to be disposed of is an issue of fact, the other three issues are issues of law. Issue 1. One of the essential facts not stipulated to by the parties involves the question of what is*234 the proper basis to be used by Mokan for the shares of Panhandle Eastern stock which it sold. The question of basis depends upon the identity of the 151,958 shares sold by Mokan. At the time of sale, Mokan owned a total of 531,638 shares of Panhandle Eastern stock which were acquired in five different blocks at various prices. The details are set forth in our Findings of Fact and need not be repeated here. Petitioners introduced proof sufficient to identify the shares of stock in question as a part of the block of 324,326 shares acquired in 1937 at a cost of $ 15,500,000, or $ 47.86 per share. The basis of the shares of Panhandle Eastern stock is to be computed accordingly. Issue 2. The principal issue here arises out of respondent's determination that Mokan's distributions during 1944 were taxable as "dividends" to its stockholders, taxable that is to the extent of 24.14 per cent of the amount received by the stockholders. The taxability of the distributions was so limited by respondent because according to his computations, only $ 856,880.94 in earnings or profits was available to Mokan for distribution as dividends. The balance of Mokan's distributions during 1944 would*235 necessarily be from its capital. Respondent contends specifically that the taxable portion of the distributions, i. e., the dividends, was from "(2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made." The words embodied in the quotation are taken from section 115 (a) of the Code which appears in the margin. 1 *236 *35 The distributions in question, depending upon their source, must be one or the other: (1) dividends distributed "out of its earnings or profits" within the meaning of section 115 (a) of the Code, or (2) distributions from capital within the meaning of section 115 (d) of the Code. As will be explained, the source of the distributions in question was necessarily from Mokan's capital, therefore, the distributions fall within the purview of section 115 (d) of the Code, which reads as follows: (d) Other Distributions from Capital. -- If any distribution made by a corporation to its shareholders is not out of increase in value of property accrued before March 1, 1913, and is not a dividend, then the amount of such distribution shall be applied against and reduce the adjusted basis of the stock provided in section 113, and if in excess of such basis, such excess shall be taxable in the same manner as a gain from the sale or exchange of property. This subsection shall not apply to a distribution in partial or complete liquidation or to a distribution which, under subsection (f) (1), is not treated as a dividend, whether or not otherwise a dividend. It should be stated at the beginning*237 of our discussion for the sake of clarity that the issue before us involves a distribution of capital made under section 115 (d) of the Code, and the distribution was not made in liquidation or in partial liquidation within the meaning of section 115 (c) and (i) of the Code. Section 115 (a) of the Code provides that the source of a corporate dividend distribution may be from certain of its accumulated earnings or profits, see subsection (1) of section 115 (a) of the Code, or it may be from out of its earnings or profits of the taxable year, see subsection (2) of section 115 (a) of the Code. The parties are in agreement that the source of Mokan's distributions was not from its accumulated earning or profits for it is stipulated that it had a deficit of $ 2,184,094.12 in its accumulated earnings and profits at the beginning of the taxable year. If the distributions in question are dividends, then it must be because they were distributed from Mokan's "earnings or profits of the taxable year." The question before us then is to be answered by a consideration of the meaning of "earnings or profits of the taxable year." Petitioners compute Mokan's earnings to be one amount, respondent *238 computes them to be another amount. Both computations are set forth in our Findings of Fact, 2 with petitioners computing for Mokan a deficit of $ 4,943,535.08 for the taxable year and with respondent computing earnings *36 and profits of $ 856,880.94 for the taxable year. Both computations accept net taxable income as the starting point in computing the amount of earnings or profits of the taxable year. The amount of taxable net income for 1944 is agreed upon as being $ 1,009,452.12. From the taxable net income of Mokan for the taxable year, in determining earnings or profits available for distribution as dividends in the taxable year, petitioners make four reductions, while respondent makes only three. Comparing the two computations, we find two principal differences: (1) Are Mokan's earnings or profits of the taxable year to be reduced by $ 2,713,969.88 because of the sale to *239 its stockholders of 151,958 shares of Panhandle Eastern stock, and (2) did Mokan sustain a loss or reduction in earnings in 1944 on the sale of its stock in Kentucky Natural Gas Corporation in the amount of $ 3,167,347 as petitioners contend, or was the loss only $ 81,000 as respondent has determined? Of course, neither of these losses may be deducted in computing Mokan's taxable net income for the year 1944; however, they may or may not be deductible from Mokan's net income in computing the amount of 1944 earnings and profits available for dividends, as the case may be. It is the latter question which we have before us for decision. Inasmuch as our decision on (1) above is decisive of the issue as to Mokan's earnings and profits available for distribution as dividends in 1944, we find it unnecessary to decide as to petitioners' contention that Mokan suffered a loss of $ 3,167,347 from the sale of its stock in Kentucky Natural Gas Corporation in 1944. We have, therefore, omitted from our Findings of Fact any of the stipulated facts as to the sale of this Kentucky Natural Gas Corporation stock. We need to consider here only the first of the two differences between the parties, namely, *240 the one involving 151,958 shares of Panhandle Eastern stock. These shares were sold to Mokan stockholders pursuant to the Mokan Plan, that is, step one of the Mokan Plan. This plan consisting of a resolution adopted in 1944 by Mokan stockholders is set forth in our Findings of Fact. The plan is divisible into two distinct steps, each being severable and independent of the other. While the complete execution of the Mokan Plan will liquidate Mokan, it is the second step which would bring about the corporate liquidation. The carrying out of the first step obviously does not liquidate Mokan for Mokan remained a corporation in being after the first step was completed during 1944. The execution of step two does not automatically follow after execution of step one. As a matter of fact, the second step of the Mokan Plan has never been executed, except in part. So viewing the Mokan Plan, we see no merit in petitioners' contention that the distributions in question were made *37 in partial liquidation within the meaning of section 115 (c) and (i) of the Code. The essential facts relating to the Panhandle Eastern stock are these: Mokan stockholders of record on July 12, 1944, were*241 given rights to buy at $ 30 per share, 163,710 shares of Panhandle Eastern stock owned by Mokan. The offer to sell Panhandle Eastern stock at this price extended to November 1944. For every 10 shares of Mokan common, a Mokan stockholder was entitled to buy 1 share of Panhandle Eastern and for every 200 shares of Class B Mokan, a Mokan stockholder could purchase 1 Panhandle Eastern share. The fair market value of Panhandle Eastern stock on the date that the rights were issued was $ 40 per share. The required number of rights to purchase 1 share of Panhandle Eastern was worth $ 10 on July 12, 1944, or $ 1 per right. The total consideration received by Mokan from the sale of Panhandle Eastern shares to its stockholders was $ 4,558,740. Mokan computed the cost of the 151,958 shares to be $ 47.86 per share, or an aggregate cost or taxable basis of $ 7,272,709.88. Petitioners contend that as a result of this transaction Mokan's earnings or profits for 1944 are to be charged with a loss of $ 2,713,969.88 ($ 7,272,709.88 less $ 4,558.740). In addition to the sale of 151,958 shares to its stockholders, Mokan in August 1944, sold 6,000 shares of Panhandle Eastern on the open market for*242 $ 46.125 per share. From this sale on the open market, Mokan realized a loss of $ 11,010 which is conceded by respondent as one to be deducted from net income in computing the earnings or profits of the taxable year. From the sale of the entire 157,958 shares of stock, Mokan realized a total of $ 4,835,490 which sum, together with other funds of Mokan, was used pursuant to the Mokan Plan to pay off an indebtedness of $ 5,050,000 incurred by Mokan in connection with the purchase of Panhandle Eastern stock. Mokan's records indicate that in granting the rights to its stockholders it did not intend to declare a dividend, but even so the distribution may be a dividend if sufficient earnings or profits were available. It is apparent that Mokan made a bargain sale to its stockholders, and a bargain sale may in effect be a distribution taxable as a dividend provided, of course, that the source be from earnings or profits. See V. U. Young, 5 T. C. 1251, supplemental opinion, 6 T. C. 357; J. E. Timberlake, 46 B. T. A. 1082, affd. (C. A. 4, 1942) 132 F. 2d 259. Petitioners contend*243 that Mokan, for the purpose of computing its earnings or profits available for dividends, sustained a loss of $ 17.86 on each of the 151,958 shares of Panhandle Eastern sold based upon a cost price of $ 47.86 per share and sale price of $ 30 per share. The *38 respondent, in computing 1944 earnings or profits of Mokan, would allow no loss for the Panhandle Eastern shares sold relying for his authority on First Savings Bank of Ogden v. Burnet, (C. A. D. C., 1931) 53 F. 2d 919. The court there held that in computing net income no deduction is to be allowed where a corporation distributes as a dividend to the shareholders another corporation's shares of stock, the shares having at the time of distribution a market value of less than cost. The taxpayer, a corporation, claimed the deduction under section 23 (a) (4) of the Revenue Act of 1921, the Code equivalent of which is section 23 (f). A deduction under section 23 (f) of the Code is not claimed by petitioners; instead, the issue here relates to section 115 (a) of the Code and the amount of Mokan's 1944 earnings or profits. Respondent's authority is not in point. The treatment of distributions*244 in kind of appreciated property has been parallel and consistent for the purpose of determining statutory earnings or profits and realization of taxable net income, Estate of Ida S. Godley, 19 T. C. 1082. This is not to say, however, that "taxable net income" and "earnings or profits of the taxable year" are synonomous; frequently they are not the same. The principal problem here, as we see it, is one of properly determining from the facts the nature of the Panhandle Eastern transaction. It is not always easy to determine whether a transaction with stockholders is to be categorized as a sale, or is to be categorized as a distribution of assets to the stockholders. See and compare the different holdings of the three courts in: (1) Bradley W. Palmer, 32 B. T. A. 550, (2) our decision being reversed on appeal, 88 F. 2d 559, and (3) the judgment of the court of appeals was reversed, Palmer v. Commissioner, 302 U.S. 63. It is our conclusion here, after considering the facts carefully, that the transaction involving the 151,958 shares of Panhandle Eastern stock was*245 in part a sale by Mokan to its stockholders, and, at the same time, the transaction was in part a distribution. We think that the difference between the cost of $ 47.86 per share and the fair market value of $ 40 per share represents a transaction similar to a sale. To the extent of $ 7.86 per share of Panhandle Eastern sold by Mokan, a loss was realized. It would be unrealistic to contend that the $ 7.86 was distributed by Mokan to its stockholders. Based upon our holding in R. D. Merrill Co., 4 T. C. 955, we hold that this loss is to be deducted from Mokan's 1944 net income in arriving at the amount of its earnings or profits available for distribution as dividends. The loss sustained by Mokan was actually only $ 7.86 per share and the reduction of Mokan's net income for 1944, in determining its earnings or profits available for distribution, is necessarily limited to this amount. *39 We have used as the valuation date the date on which Mokan issued the rights to purchase Panhandle Eastern shares. It is immaterial here that subsequently, during the period that the rights were being exercised, the market price of Panhandle Eastern shares steadily*246 increased. Palmer v. Commissioner, supra, so holds. Of the total difference of $ 17.86 between cost and sale price of each share of stock, the remaining difference of $ 10 is made up of the difference between the fair market value ($ 40 per share) and the sale price ($ 30 per share). This $ 10 per share is nothing but a discount allowed by Mokan to its stockholders. We see no merit in petitioners' contention that the loss realized by Mokan on the sale of Panhandle Eastern shares must also include the discount allowed by Mokan to Mokan stockholders. Mokan, in selling the shares at bargain prices to Mokan stockholders, was in effect making a distribution of corporate property to Mokan stockholders. Since the discount was in effect a distribution by Mokan, it must be taken into account in computing for subsequent taxable years Mokan's capital and its accumulated earnings or profits available for distribution as dividends. While the amount distributed via a bargain sale to stockholders will reduce the accumulated earnings or profits available in subsequent years for dividends, it is not to be deducted in computing current earnings or profits. *247 Section 115 (a) of the Code so provides: "the earnings or profits for the taxable year" are to be "computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year." As already explained, we have before us a computation involving earnings or profits of the taxable year. In the instant proceeding the property distributed to the stockholders of Mokan had a fair market value less than cost, the same situation as was presented in R. D. Merrill Co., supra, see particularly page 961. We there held that in determining the effect of such a distribution upon earnings or profits, the accumulated earnings or profits should be charged with cost of the property. In Reynolds Spring Co. v. Commissioner, 181 F. 2d 638, the United States Court of Appeals, Sixth Circuit, cited with approval our decision in R. D. Merrill Co., supra, as follows: Petitioner properly charged the book value of the stock distributed to capital surplus in the sum of $ 2,412,875.83, and under § 718 (a) (2) this figure was used in computation of equity invested capital. *248 The deduction of the sum of $ 742,830, being the fair market value of the shares at the time of distribution, fails to take into account the fact that the property distributed was a part of the corporate investment. The bearing of this consideration has been excellently stated in R. D. Merrill Co. v. Commissioner, 4 T. C. 955. While the question in that case was whether the corporate property distributed in kind, which had declined to a value below cost, should be charged against earnings and profits figured at *40 cost, the rationale of decision was the same as in the instant case. The opinion states: "When property, as such, is distributed, it is no longer a part of the assets of the corporation, and the investment therein goes with it. That investment is the cost. An investment of corporate assets in property is not a mere book entry, as is indeed proven when it is distributed in kind. * * * When the res distributed leaves the corporation, that investment, i. e., that amount of corporate assets, also leaves, actually and physically; and nothing less than a charge of cost, i. e., the money originally converted to property, will represent*249 the true financial situation. Though the distributee is taxed upon fair market value, that is because of section 115 (j) [26 U. S. C. A., § 115 (j)]; and it is worthy of note that no statute sets a like rule for the corporation as to any profit to it when it distributes. Our conclusion is based upon mere realism: To charge earnings and profits with fair market value instead of a greater cost would create a book situation altogether contrary to the facts." We follow the principle of R. D. Merrill Co., supra, and here hold that the cost of the property distributed, that is, $ 17.86 per share of Panhandle Eastern, 3 is to be charged directly or indirectly to the accumulated earnings or profits available for dividends as of the end of the taxable year. We recognize, of course, that the charge to the extent of $ 7.86 of the $ 17.86 is made directly to earnings or profits of the taxable year and thus indirectly to accumulated earnings or profits. The remaining $ 10 of the $ 17.86 would be charged, just as a dividend is, directly to accumulated earnings or profits. *250 According to the respondent's computation Mokan had earnings or profits available for distribution for the taxable year of $ 856,880.94, and this amount was arrived at without any reduction whatsoever for the loss on the Panhandle Eastern stock. We have concluded that Mokan sustained a loss of $ 1,194,389.88 based upon the sale of 151,958 shares of Panhandle Eastern stock at $ 30 per share, the $ 1,194,389.88 being arrived at in the manner heretofore explained ($ 7,272,709.88 cost, diminished by $ 4,558,740 cash received from sale, diminished further by $ 1,519,580 to be charged to distribution on account of fair market value of stock being $ 10 in excess of $ 30 received for it, equals $ 1,194,389.88). We hold that this latter amount of $ 1,194,389.88 is to be used in computing Mokan's earnings or profits of the taxable year available for distribution as a taxable dividend. R. D. Merrill Co., supra.Therefore, the $ 1,194,389.88 loss must be deducted from the $ 856,880.44 earnings or profits otherwise available for distribution as computed by the respondent, resulting in Mokan having no "earnings or profits" available for distribution as dividends. *251 Consequently, we need not consider what was the correct basis to be used in computing *41 the loss realized by Mokan on the sale of Kentucky Natural Gas Corporation stock. In view of what we have heretofore decided, the distributions made by Mokan during the taxable year are necessarily distributions of capital within the meaning of section 115 (d) of the Code. We, therefore, hold that the cash distributions received in 1944 by petitioners as stockholders of Mokan were returns of capital. This holding disposes of the second issue. Issue 3. Like Issue 2, we find that Issue 3 also relates to Mokan and the sale of its Panhandle Eastern shares. One of the petitioners, Marian L. Maguire, exercised her rights to acquire shares of Panhandle Eastern stock; the other petitioners sold their rights. The third issue is whether or not income resulted from the exercise of rights to purchase Panhandle Eastern stock. The respondent in the deficiency notice of petitioner Marian L. Maguire treated the difference between the price paid for the stock and its fair market value at the time of the exercise of the rights as a dividend to the extent of earnings and profits. His computation*252 follows: Fair market value on 8/12/44 of 85.92 shares of Panhandle Eastern Pipe Line Co. stock at $ 48 $ 4,124.16 Subscription price of 85.92 shares at $ 30 2,577.60 Difference $ 1,546.56 24.14% of the above difference taxable as dividend $ 373.34 The respondent's determination is based upon the premise that Mokan had earnings or profits available for distribution as dividends. We have heretofore determined in Issue 2 that Mokan had no such earnings or profits. This being so, respondent erred in determining that the distribution was taxable to petitioner Marian L. Maguire as a dividend. This holding also disposes of adjustment (c) (1) made as to petitioner William G. Maguire and as to which the same issue exists. Issue 4. The fourth issue involves petitioner W. G. Maguire & Co., Inc., and petitioner William G. Maguire, who sold their rights to acquire Panhandle Eastern stock. As we have heretofore explained, the rights in question when exercised or sold constituted a distribution from capital within the meaning of section 115 (d) of the Code. On their respective tax returns petitioners reported gain from the sale of such rights as follows: *42 Petitioner Petitioner Item William G. W. G. Maguire Maguire & Co., Inc. Sale price $ 75,702.03 $ 50,908.98 Less: Cost or other basis 63,603.55 33,166.00 Short-term capital gain $ 12,098.48 $ 17,742.98 *253 Respondent has determined that the entire proceeds from the sale of rights must be included in net income. He gave petitioners no cost basis for their rights sold and, in the deficiency notices he increased the net income reported on petitioners' returns by $ 63,603.55 and $ 33,166, respectively. Petitioners contend that the proper basis of each right was $ 1, the fair market value of the right at the time of issuance. On their tax returns petitioners used this basis and the proceeds from the sale of rights in excess of such basis were reported as short-term capital gain. It should be noted, however, that William G. Maguire did not sell all the rights he had received. He gave some of them to his wife and sold the balance, which was 62,462 15/20 rights. Manifestly, in computing his gain from the sale, he is entitled to use the cost basis of only the 62,462 15/20 rights which he sold and not the 63,603 11/20 rights which he received. That adjustment should be made in a recomputation under Rule 50. Respondent has not explained the theory upon which he made his determination. It is apparent, however, that the only theory consistent with his determination is that the proper basis*254 for the rights is zero, rather than the $ 1 used by petitioners in their returns. The petitioners in their brief state the law as they interpret it with reference to the sale of their rights, as follows: The treatment by the Commissioner of the proceeds from the sale of the rights as ordinary income taxable in its entirety without reference to the provisions of the Code relating to the taxation of shareholders as shareholders in anomalous. Any income which a shareholder receives as a shareholder must be either a dividend or capital gain. Any distribution which a shareholder receives as a shareholder is either a return of capital (because the corporation is in liquidation or because the distribution contains no earnings), which may involve capital gain, or it is a share of the earnings of the corporation and taxable to the shareholder as a dividend. The quality which is peculiar to rights, but does not affect the foregoing conclusions, is that the mere receipt of the rights is not a taxable event. Such an event occurs only upon the sale or exercise of the rights. If they are allowed to lapse then there is no tax consequence. We think the foregoing statement is a correct summary*255 of the legal principles which must govern us in determining petitioners' gain from the sale of their rights. Petitioners, of course, paid no money for their rights and, in that sense, had no cost basis for them. But on account of the fact that Mokan was permitting its stockholders to purchase *43 Panhandle Eastern stock for $ 30 per share, which had a fair market value of $ 40 per share at the time the rights were distributed, we have held that in instances where the rights were exercised or sold there was a distribution to the stockholders of $ 10 for each share of Panhandle Eastern stock sold for $ 30 per share. We further held that this distribution was not out of earnings or profits of Mokan because it had no earnings or profits to distribute and that under section 115 (d) of the Code the distribution was to be applied as a reduction of the cost basis of Mokan shares held by the stockholders. Applying this holding to petitioners, it means that the cost basis of their stock in Mokan will be reduced by $ 1 per right received by them and subsequently sold. The rights, which they each received and sold, resulted in a distribution of capital to each of them. To this extent*256 their capital investment in Mokan shares was diminished and the rights thereby acquired a cost basis equal to such capital distributions. See section 115(d) of the Code already quoted elsewhere herein. We hold that petitioners have a cost basis of $ 1 per right and that cost basis should be used in computing their gain from the sale of their rights in 1944. The Commissioner erred in his determination that the entire amounts which petitioners received from the sale of their rights represented taxable income to them. Cf. Estate of Lauson Stone, 19 T. C. 872. In Docket No. 36033, W. G. Maguire & Co., Inc., the Commissioner determined a delinquency penalty of 25 per cent of the personal holding company surtax. Petitioner assigned no error contesting the imposition of this delinquency penalty. It is, therefore, sustained but will, of course, be recomputed along with the deficiency, if any, under Rule 50. Decisions will be entered under Rule 50. Footnotes 1. SEC. 115. DISTRIBUTIONS BY CORPORATIONS. (a) Definition of Dividend. -- The term "dividend" when used in this chapter (except in section 201 (c) (5), section 204 (c) (11) and section 207 (a) (2) and (b) (3) (where the reference is to dividends of insurance companies paid to policy holders)) means any distribution made by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. In the case of a corporation which, under the law applicable to the taxable year in which the distribution is made, is a personal holding company, or which, for the taxable year in respect of which the distribution is made under section 504 (c) or section 506 or a corresponding provision of a prior income-tax law, is a personal holding company under the law applicable to such taxable year, such term also means any distribution (whether or not a dividend as defined in the preceding sentence) to its shareholders, whether in money or in other property, to the extent of its subchapter A net income, less the sum of the following: (1) The net operating loss credit provided in section 26 (c) (1); (2) The dividend carry-over provided in section 27 (c); and (3) The deduction for amounts for retirement of indebtedness provided in section 504 (b).↩ 2. See in our Findings of Fact the table entitled: Statement of Mokan's Earnings or Profits Available for Dividends -- Year 1944.↩ 3. We have found that Mokan's cost basis per share of Panhandle Eastern was in fact $ 47.86. This cost must be reduced, of course, by the $ 30 per share received from those exercising rights to acquire the stock. Thus, we have a cost of $ 17.86 per share for the property distributed.↩