Weekly SSRN Tax Article Review And Roundup: Saito Reviews Brooks's Stock Dividends, The Supreme Court, And The 1929 Crash

This week, Blaine Saito (Ohio State; Google Scholar) reviews a new work by John R. Brooks (Fordham; Google Scholar), Stock Dividends, the Supreme Court, and the Great Crash of 1929:  

Technical rules are often seem “small.” Their effects are usually confined to certain areas, even if they are important. But in his piece Stock Dividends, the Supreme Court, and the Great Crash of 1929, John R. Brooks shows how seemingly minor technical can burst into a wider reach. It shows how confusion of such rules and how they interact with broader social circumstances can create major problems.

Brooks shows how in the 1920s, stock dividends led to phantom income. The creation of that phantom income aided the frothiness that eventually led to the Great Crash of 1929–30. While today we think of a stock dividend as akin to a stock split, at the time there was a significant difference. 

When a corporation issued a stock dividend, the corporation took some amount out of retained earnings and booked it as stated capital. But, under the accounting rules of the time, when a corporation declared a stock dividend, the amount of money that would be put into stated capital would be the par value, which was often lower than the fair market value. Thus, a subsidiary would book the lower par value and a holding company up the chain would book income at the higher fair market value creating that phantom income.

Public utilities, one of the boom stocks of the 1920 that fell hard in the 1930s, were some of the biggest proponents of this scheme. Often operating companies were owned by a complex web of holding companies. These higher chain companies would own a controlling, but not complete, stake in operating and lower chain holding companies. The general public would own the rest of the shares. Using this stock dividend technique, higher chain companies were able to create income. But of course, given that there were public shareholders, stock dividends to create phantom income only worked if they escaped the income tax. Eisner v. Macomber provided that relief.

But such scheming created a problem. The scheming ended up tricking many investors, and the discussions in the press showed some of this confusion. Furthermore, as Brooks pointed out, in many industries that were capital intensive, like public utilities, cash became short because of this phantom income. Instead of paying regular dividends in cash, more stock was sold and issued because cash was needed to service the ever growing, and unsustainable debt burden.

Brooks sharpens his analysis of these problems with the case of Samuel Insull and the Middle West Public Utility empire he created. Insull’s empire spectacularly collapsed during the period of the Great Crash of 1929–30. He even went to trial for fraud. Through archival research, Brooks shows how the phantom income from stock dividends played a significant role that historians have missed. The phantom income Insull created would multiply in some instances 156 times to thousands of times the income the utilities actually created. While tried, Insull did get acquitted, and that was because the phantom income and stock dividend trick was also something technical and complicated that divided people in the tax and accounting world at the time.

Brooks then shows that stock dividends always had a murky treatment, and it was this confusion that led toward Insull’s acquittal and opened the door to Macomber and phantom income.  First, in trust law, a stock dividend was a question as to whether it was part of the corpus for a future beneficiary or the income for a current beneficiary. Eventually, the rule declared it part of the corpus, but now without some complicated struggles. Additionally, prior to changes in accounting rules, corporations would sometimes issue par value stock without any contribution to capital, thereby inflating stated capital solely on paper.

This background collided with the income tax in Macomber, which then set off the boom in stock dividends. First, during the Civil War income taxes, stock dividends were taxable. It arose, because undistributed profits from certain types of corporations were not taxed at the corporate level. If stock dividends were not taxed then the transformation of earnings into capital would escape any taxation.

After the Sixteenth Amendment, the income tax imposed the double layer corporate tax. In light of that, there was a question as to what the proper theory of stock dividends was. On the one hand, because it got capitalized, a stock dividend was some evidence of corporate earnings that could get attributed either to the corporation or the shareholders. On the other hand, some cases and other discussions in tax law focused instead on whether there was something else of value received.

The confusion post-Sixteenth Amendment on the theory of the stock dividend explains some of the majority’s reasoning and confusion in Macomber. It is important to note that what the Bureau of Internal Revenue sought to collect was a tax on the value of the transfer of the corporation’s earnings and profits to stated capital attributable to Mrs. Macomber and not the full fair market value of the stock she received. But the Supreme Court showed its confusion. In dissent, though, Justice Brandeis looked outward and noted that people saw stock dividends as something of value even if it was only phantom value. In doing so, he broke through the technical rules and noted how it had a real-world effect and even somewhat foresaw some of the future mess these stock dividends would create.

Brooks brings to light perhaps something that had always troubled me about reading Macomber. The opinion is rightfully attacked. But there was always something about it that seemed funny. And what Brooks reveals is that it is the very confusion of how stock dividends work, the accounting rules, and how people thought of their stock dividends at the time that muddles the majority’s reasoning. Thus, the mass confusion of the stock dividends and their power to create phantom income helps us understand better why Macomber came out the way it did.

The piece also shows how these technical complexities and a lack of clarity about them can have wide ranging effects. The confusion around stock dividends spawned Macomber, which in turn spawned a corporate finance scheme that contributed to part of the crash. Uncovering that story itself requires piecing through these technical matters. Perhaps one of the reasons why the story of Insull’s stock dividends and the crash were not told until Brooks’s work is because of that highly complex technical understanding and the interactions between accounting, corporate finance, and tax. Additionally, it serves as a warning for us all to be careful about our areas of technical matters lest we too create a tool or idea we cannot control that contributes in some way to havoc getting unleashed.

Here’s the rest of this week’s SSRN Tax Roundup:

• Jeff Gordon (Yale), Carbon Shelters: Carbon Accounting as Tax Law, 114 Calif. L. Rev. ­­__ (forthcoming 2026) (date posted: Feb. 18, 2025).
• Jeff Gordon (Yale), Statutory Contracts, 42 Yale J. on Reg. ___ (forthcoming 2025) (date posted: Feb. 19, 2025).
• Michael Hatfield (Univ. Washington), Tax in Law Schools, 78 Tax Law. 71 (2024) (date posted: Feb. 18, 2025).
• Ivan Ozai (York Osgoode Hall), Global Justice in Reshaping of International Tax, 27 J. Int’l Econ. L. 639 (2024) (date posted: Feb. 19, 2025).a
• Susannah Camic Tahk, A Tale of Two Credits (date posted: Feb. 19, 2025).
• Reid K. Weisbrod (Rutgers) & Stewart E. Sterk (Cardozo), Joint Bank Accounts: Who Needs Them?, 111 Iowa L. Rev. ___ (forthcoming 2025–26) (date posted: Feb. 18, 2025).